Datasets:

c3po-ai

/

edgar-corpus

like 9

Follow

C3PO-AI 4

200245_1993.txt

200245

1993

ITEM 1. BUSINESS Salomon Inc ("the Company") was incorporated in 1960 under the laws of the State of Delaware. At December 31, 1993, its full time equivalent number of employees was 8,640. Information concerning the business of Salomon Inc under the following captions in Exhibit 13, "Salomon Inc 1993 Annual Report Financial Information," is deemed part of this Annual Report on Form 10-K and is hereby incorporated herein by reference: Salomon Inc - Overview of 1993 (on pages 13 through 19) Salomon Brothers - Description of Business (on pages 21 through 23) Phibro Division - Description of Business (on page 27) Phibro USA - Description of Business (on pages 28 through 30) Note 1. Industry Segment and Geographic Data (on pages 60 through 62) Note 9. Net Capital (on pages 67 and 68) ITEM 2.

ITEM 2. PROPERTIES Information concerning the Company's properties under the following captions in Exhibit 13, "Salomon Inc 1993 Annual Report Financial Information," is deemed part of this Annual Report on Form 10-K and is hereby incorporated herein by reference: Salomon Brothers - Description of Business (on pages 21 through 23) Phibro Division - Description of Business (on page 27) Phibro USA - Description of Business (on pages 28 through 30) Note 3. Property, Plant and Equipment (on page 63) ITEM 3.

ITEM 3. LEGAL PROCEEDINGS I. U.S. Treasury Auction and Related Matters ----------------------------------------- Governmental Actions - -------------------- On August 9, 1991, the Company announced that it had uncovered irregularities by certain employees of its indirect wholly owned subsidiary Salomon Brothers Inc ("SBI") in connection with certain auctions of U.S. Treasury securities. During the 1991 third quarter the Company recorded a pretax charge of $200 million to establish a reserve for estimated monetary damages, settlement costs, fines, penalties, legal expenses and other related costs expected to be incurred in connection with the private actions and investigations by certain U.S. governmental authorities, state agencies and self-regulatory authorities arising out of this matter. In a settlement with U.S. governmental authorities announced on May 20, 1992, the Company and SBI consented to various sanctions including the payment of $190 million, the establishment of an additional $100 million private civil claims fund, the issuance of an injunction and the adoption of an administrative order, and in connection with the matter SBI was also temporarily suspended from dealing directly with the Federal Reserve Bank and from executing customer transactions in Treasury auctions. As a result of the settlement, the Company recorded an additional pretax charge of $185 million in the 1992 second quarter. The settlement did not resolve the ongoing industry-wide investigation by the Antitrust Division of the U.S. Department of Justice into possible collusion by primary dealers and others in bidding at U.S. Treasury auctions. In January and February of 1993, the Company and SBI made payments of approximately $4 million to settle claims with 42 states and the District of Columbia arising out of the U.S. Treasury auction and related matters. Private Actions - --------------- Over 50 private actions were commenced against the Company, SBI or certain present and former directors, officers and employees of the Company or SBI with respect to the U.S. Treasury auction and related matters. All but one of the actions brought to date can be grouped into three categories: securities litigation, Treasury litigation and derivative litigation. Forty-two of the actions were class and derivative actions which have been consolidated for pre-trial or discovery purposes into three actions in the United States District Court for the Southern District of New York (the "Southern District of New York") before The Honorable Robert P. Patterson, Jr. Amended consolidated complaints have been filed by lead counsel in each of the three consolidated groups of class actions. In addition, three individual actions have been coordinated or consolidated with the class actions for pre- trial purposes. A. Securities Litigation --------------------- The securities litigation is comprised of two individual actions (which the Company believes are not material) and In re Salomon Inc Securities Litigation, --------------------------------------- 91 Civ. 5442 (S.D.N.Y., consolidated Aug. 30, 1991), which consolidated for pre- trial purposes 16 purported class actions and one individual action (Discount -------- Bank and Trust Company v. Salomon Inc., et al.) brought by purchasers of various - ---------------------------------------------- of the Company's publicly traded securities, including Common Stock, Preferred Stock and debt instruments. These actions claim, among other things, that the defendants (the Company, SBI and others) violated provisions of the Federal securities laws by knowingly or recklessly not disclosing improprieties with respect to U.S. Treasury securities and potential adverse financial and business consequences of the improprieties, and by falsely portraying the Company as a well-run, conservatively managed enterprise whose activities were in compliance with government rules and regulations. The actions allege that the market prices of the Company's securities were artificially inflated or maintained as a consequence of the alleged Federal securities law violations, and that plaintiffs purchased their securities at such artificial prices. The actions primarily seek unspecified compensatory and punitive damages for plaintiffs as a result of such alleged misconduct, as well as costs, interests and other relief. Following an agreement in principle reached on June 10, 1993, on September 13, 1993 the Company, while denying any violation of law, entered into a formal stipulation of settlement to settle the consolidated class action. The settlement is subject to court approval, and hearings have been held to determine whether the settlement should be approved. Under the terms of the settlement, $54.5 million will be paid to the plaintiff class out of the $100 million private claims fund established pursuant to the 1992 settlement described above. The Company also has agreed to pay plaintiffs' attorneys' fees and expenses as awarded by the court, in an amount not to exceed $12.5 million. B. Treasury Litigation ------------------- The Treasury litigation is comprised of six individual actions and In re ----- Salomon Brothers Treasury Litigation, 91 Civ. 5471 (S.D.N.Y., consolidated Aug. - ------------------------------------ 28, 1991), which consolidated for discovery purposes 10 purported class actions. Three of the six individual actions (Three Crown Limited Partnership, et al. v. ------------------------------------------ Salomon Brothers, Inc., et al., 92 Civ. 3142; Kevin Connors & Co., L.P. v. - ------------------------------ ---------------------------- Salomon Brothers, Inc., 92 Civ. 3714 (currently stayed and the parties ordered - ---------------------- to proceed in arbitration); and New York Capital Markets Inc. v. Salomon ---------------------------------------- Brothers, Inc., et. al., 92 Civ. 5885), as well as In re Salomon Brothers - ----------------------- ---------------------- Treasury Litigation, were each originally brought in the Southern District of - ------------------- New York and are pending before The Honorable Robert P. Patterson, Jr. Two individual actions (Commonwealth Financial Futures Fund, et al. v. Salomon ------------------------------------------------------ Brothers Inc., 92 Civ. 7691; SWS Financial Fund A, et al. v. Salomon Brothers - ------------- ------------------------------------------------ Inc., 92 Civ. 6602, 92 Civ. 6935), were transferred to the Southern District of - ---- New York by the Judicial Panel on Multidistrict Litigation and assigned to Judge Patterson for inclusion in the coordinated or consolidated pre-trial proceedings taking place in connection with In re Salomon Brothers Treasury Litigation. The ------------------------------------------ final individual action (State of Louisiana v. Salomon, Inc., et al., No. 94- ------------------------------------------- 0904I), was filed on March 17, 1994 in the United States District Court for the Eastern District of Louisiana. These actions claim, among other things, that the Company, SBI and certain former officers and employees violated provisions of the Federal securities laws, the Racketeer Influenced and Corrupt Organization Act ("RICO") and the antitrust laws, in some instances in collusion with others, by repeatedly purchasing quantities of U.S. Treasury securities in excess of Federal regulatory limits and manipulating the market in U.S. Treasury securities. The actions primarily seek unspecified compensatory and punitive damages, and treble damages pursuant to the antitrust and RICO counts, for plaintiffs as a result of such alleged misconduct, as well as costs, interest and other relief. On March 30, 1994, the Company and SBI advised Judge Patterson that they had reached an agreement in principle, while denying any violation of law, to settle the class actions included in the Treasury Litigation. The settlement is subject to approval by the court. Under the terms of the settlement, which involves other defendants, the Company and SBI will pay $66 million. This amount includes plaintiffs' attorneys' fees to be awarded by the court. The Company and SBI expect that substantially more than half of the $66 million payment will be paid from the $100 million private claims fund established pursuant to the 1992 settlement described above. C. Derivative Litigation --------------------- In re Salomon Inc Shareholders' Derivative Litigation, 91 Civ. 5500 (S.D.N.Y., ----------------------------------------------------- consolidated Aug. 30, 1991), consolidated for all pre-trial purposes 16 actions which asserted derivative claims purportedly on behalf of the Company against members of the Company's Board of Directors and others. The actions claim, among other things, that SBI employees violated U.S. Treasury and Federal Reserve Board regulations governing the purchase of U.S. Treasury securities at auctions by repeatedly purchasing quantities of U.S. Treasury securities in excess of federal regulatory limits and submitting bids for those securities in the names of persons who had not authorized such bids. The claims, as originally filed, further asserted that the director defendants breached their fiduciary obligations to the Company by engaging in or recklessly disregarding these allegedly illegal practices, thereby exposing the Company to potential liabilities and adverse business consequences. The actions seek to require the individual defendants to recompense the Company for all damages caused by them, to return compensation received by them and to pay punitive damages, as well as costs, interest and other relief. The Company moved to dismiss the complaint on the grounds that plaintiffs had failed to make a demand on the Company's Board of Directors. Thereafter the parties entered into a stipulation and order which deferred consideration of the motion to dismiss the amended consolidated complaint until the earlier of (i) final resolution by judgment or settlement of all actions pending before Judge Patterson arising out of the U.S. Treasury auction and related matters or (ii) a request by all parties to the stipulation and order to undertake further consideration of the motion. In January 1994, the derivative plaintiffs amended their complaint to, among other things, dismiss without prejudice their complaint against all defendants other than those who ceased to be officers or directors of the Company following the announcement of irregularities in August 1991. In addition to the foregoing purported derivative actions, a purported derivative action asserting claims similar to those in In re Salomon Inc ----------------- Shareholders' Derivative Litigation, Sands, et al. v. Salomon Inc, et al. Civil - ----------------------------------- ------------------------------------ Action No. 1155-K, was filed in Delaware Chancery Court for Kent County. On November 4, 1991, a motion was made to dismiss this action, but it has not been briefed. A briefing schedule on the motion will be set by the court shortly. Private Claims Fund - ------------------- The private claims fund described above will be available to pay judgments and settlements (including interest thereon) with respect to claims for compensatory damages against the Company or SBI in these and any future private actions with respect to the U.S. Treasury auction and related matters. The fund does not cover attorneys' fees or expenses or certain other liabilities. The residual amount, if any, in the fund will be paid to the United States. The liability of the Company and SBI for private compensatory damages with respect to the U.S. Treasury auction and related matters may exceed the amount in the fund. The proposed settlements in the Securities Litigation and the Treasury Litigation described above would, if approved, exhaust all but a relatively small portion of the fund. Former Officers - --------------- In late 1992 and early 1993, the Company and SBI settled certain employment- related compensation claims with three of the four senior officers whose employment with the Company and SBI ended following the August 1991 announcement of certain earlier improprieties by former employees. The Company has not resolved the compensation claims of the remaining former officer, John Gutfreund; these claims are now the subject of arbitration pursuant to New York Stock Exchange rules. Additional Information - ---------------------- Additional information concerning proceedings relating to the U.S. Treasury auction and related matters is contained in Note 14, "Legal Proceedings", of Exhibit 13, "Salomon Inc 1992 Annual Report to Stockholders", and is hereby incorporated herein by reference. For further information, copies of documents relating to the settlement with certain governmental authorities and copies of the amended consolidated complaints were filed as Exhibits 28(a) and 28(b), respectively, to the Company's 1992 Annual Report on Form 10-K. Based on information currently available and established reserves, the Company believes the ultimate disposition of pending legal proceedings in connection with the United States Treasury auction and related matters will not have a material adverse effect on the Company's consolidated financial condition. II. Other Legal Proceedings ----------------------- Commencing in 1987, 21 purported derivative lawsuits were filed in Delaware Chancery Court, New Castle County, New York Supreme Court, New York County and in the Southern District of New York (In re Salomon Inc Shareholder Litigation) ----------------------------------------- against, among others, the Company and its directors (including its current directors other than Messrs. Buffett, Denham, Hall, Maughan, Munger, Simpson and Young) and in two instances Berkshire Hathaway Inc. ("Berkshire") arising out of the Company's purchase of 21,282,070 shares of its Common Stock beneficially owned by Minerals and Resources Corporation Limited at $38.00 per share and the Company's sale for $700 million of 700,000 shares of its Preferred Stock to affiliates of Berkshire. In addition, the lawsuits challenge the Company's distribution of Preferred Share Purchase Rights to its shareholders on February 18, 1988 and the amendment of certain of the Company's employment benefit plans. The complaints allege, among other things, that the aforesaid corporate actions were part of a scheme to maintain the positions of the defendant directors with the Company in derogation of their fiduciary duties and that the Company had the opportunity to sell the Preferred Stock on superior terms. The complaints seek, among other things, injunctive relief with respect to the challenged corporate actions, rescission of such corporate actions and monetary damages. The litigation in Delaware (consisting of 19 of the purported derivative lawsuits) had been consolidated under the caption In re Salomon Inc Shareholder ----------------------------- Litigation, Civil Action No. 9296. The Delaware court, on May 24, 1993, entered - ---------- into a stipulation and order of dismissal without prejudice with respect to this consolidated action. SBI has been named as a defendant in a purported class action brought in May 1988 in the Delaware Chancery Court for New Castle County (Shields and Van De ------------------ Walle v. L.F. Rothchild, Unterberg, Towbin Holdings, Inc., et al.). The - ----------------------------------------------------------------- defendants include L.F. Rothchild, Unterberg, Towbin Holdings, Inc. ("Holdings"), certain of its officers and directors, certain selling shareholders and controlling persons and the lead underwriters for Holdings' March 1986 public offering of 7,676,325 shares of Common Stock at $20.50 per share. Plaintiffs purport to represent a class of all persons who purchased stock pursuant to that offer. Together with Shearson Lehman Brothers Incorporated and L.F. Rothchild Incorporated ("L.F. Rothchild"), SBI acted as one of the lead underwriters with a participation of 1,074,441 shares. In general, the complaint alleges that the prospectus prepared in connection with the offering contained untrue statements of material fact and omitted to state material facts in violation of the Federal securities laws. The complaint seeks, among other things, compensation and punitive damages in unspecified amounts as well as the costs of the action. Both Holdings and L.F. Rothchild have been reorganized in bankruptcy proceedings which are continuing. In February 1990, the court determined that the action should be stayed as to all defendants pending resolution of a class proof of claim filed by the Shields and Van De Walle plaintiffs in the Holdings ------------------------ bankruptcy proceeding that alleges the same claims contained in the Shields and ----------- Van De Walle complaint. That proof of claim was withdrawn, and with the - ------------ completion of the reorganization of Holdings, the stay has been lifted and pre- trial proceedings have resumed. Numerous purported class actions, which are consolidated in the United States District Court for the Eastern District of Louisiana (In re Taxable Municipal ------------------------ Bond Securities Litigation), were commenced in 1990 and 1991 in connection with - -------------------------- various taxable municipal bond offerings in 1986 managed by Drexel Burnham Lambert Incorporated ("Drexel Burnham"), including bonds issued by authorities in Colorado, Louisiana, Nebraska, Tennessee and Texas. The defendants include the issuing authorities, the co-managers of the offerings (other than Drexel Burnham which has undergone bankruptcy proceedings) and certain of their officers, Michael R. Milken, Executive Life Insurance Company, First Executive Corporation, law firms, the bond trustees, and the underwriting syndicates for the offerings. SBI was a member of the above underwriting syndicates with an aggregate participation of approximately $50 million, and has been named as a defendant in certain of the actions described above. The plaintiffs purport to represent a class of bond purchasers who purchased the various bonds during the period from the issuance of the bonds in 1986 through approximately April 1990 and were damaged thereby. In general, the complaints allege that the offering documents prepared in connection with the offerings contained untrue statements of material fact and omitted to state material facts in violation of various Federal and state securities laws as well as fraud, negligent misrepresentation and breach of fiduciary duty. The complaints seek, among other things, compensatory and punitive damages in unspecified amounts, rescission, interest and costs and expenses of the actions. Executive Life Insurance Company, the company that issued and guaranteed investment contracts in which the proceeds of the bond issues were invested, has been placed in conservatorship by the California Commissioner of Insurance. Salomon Forex Inc ("Salomon Forex"), an indirect wholly owned subsidiary of the Company, filed an amended complaint in a collection action in the United States District Court for the Eastern District of Virginia (Salomon Forex Inc v. --------------------- Tauber) in November 1991 against Laszlo N. Tauber ("Tauber") seeking to recover - ------ approximately $26 million payable under certain foreign exchange transactions Salomon Forex entered at various dates which matured in July and August 1991. Tauber filed an answer raising numerous defenses and a counterclaim and third- party complaint raising numerous claims against Salomon Forex, the Company and SBI, as well as certain employees of SBI, asserting that the counterclaim and third-party defendants violated U.S. commodities, New York and Virginia gambling and New York bucketing laws, as well as committed common law fraud, breach of fiduciary duty, breach of implied covenants of good faith and fair dealing and breach of a duty to disclose material information. The counterclaim and third- party complaint sought unspecified compensatory damages asserted to exceed $20 million, unspecified punitive damages in an amount equal to twice compensatory damages and a judgment that certain transactions be declared null and void. On March 27, 1992, summary judgment was entered in favor of Salomon Forex for the principal amount due of $25,831,453.01, plus prejudgment interest of $1,435,134.79. Tauber appealed unsuccessfully to the United States Court of Appeals for the Fourth Circuit and has petitioned the United States Supreme Court for review of that decision. SBI privately placed in three separate offerings approximately $157.2 million of first mortgage notes issued by Motels of America, Inc. ("MOA") to finance the purchases of three portfolios of motel properties: $70.6 million of such notes placed in August 1987 ("Portfolio I"); $23.4 million of such notes placed in March 1988 ("Portfolio II"); and $63.2 million of such notes placed in August 1989 ("Portfolio III"). In each offering, the notes were nonrecourse to MOA and secured by mortgages on the respective portfolios of motel properties being purchased by MOA. SBI received three participation interests in net operating income from the properties securing the mortgage notes, 95% of which in two instances and 100% of which in one instance were then sold to Ameritech Pension Trust ("APT") for purchase prices aggregating approximately $19.3 million. Following MOA's bankruptcy filing in the United States Bankruptcy Court for the District of Delaware, in or about December 1991, MOA and Ben Franklin Properties, Inc. ("Ben Franklin"), an assignee of the participation interests which had been sold to APT, commenced an adversary proceeding in the MOA bankruptcy case against SBI and Salomon Brothers Realty Corporation ("SBRC"). Although SBI and SBRC denied the material allegations of the adversary complaint, on March 27, 1992, SBI and SBRC entered into a settlement agreement with MOA and Ben Franklin, which settlement was approved by the Bankruptcy Court on July 23, 1992. On September 9, 1992, the Bankruptcy Court approved the plan of reorganization for MOA. In September 1992, Harris Trust and Savings Bank (as trustee for APT), Ameritech Corporation, and an officer of Ameritech filed a complaint against SBI and SBRC in the United States District Court for the Northern District of Illinois (the "Northern District of Illinois"), alleging that all three purchases by APT of MOA participation interests, as well as a fourth purchase by APT of a similar participation interest with respect to a portfolio of motels owned by Best Inns, violated the Employee Retirement Income Security Act ("ERISA"), and that the purchase of the participation interest for Portfolio III violated RICO and the Illinois Consumer Fraud and Deceptive Business Practices Act, and is actionable as common law fraud and negligent misrepresentation. SBI and SBRC moved to dismiss the APT complaint. On December 24, 1992, the Court dismissed one of the ERISA claims and all of the RICO claims. On March 5, 1993, plaintiffs filed a second amended complaint alleging that all four purchases of the participation interests violated ERISA and that the purchases of the participation interests for Portfolio III and for the Best Inns portfolio violated RICO and state law. Plaintiffs' second amended complaint seeks (i) a judgment on the ERISA claims in the amount of the purchase prices of the four participation interests (alleged to be approximately $20.9 million), for rescission and for disgorgement of profits, as well as other relief, and (ii) a judgment on the claims brought under RICO and state law in the amount of $12.3 million, with damages trebled to $37 million on the RICO claims and punitive damages in excess of $37 million on certain of the state law claims, as well as other relief. On April 5, 1993 SBI and SBRC answered the second amended complaint in part, moved to dismiss in part and asserted counterclaims against plaintiff Ameritech Corp. On August 16, 1993 the court (i) again dismissed the RICO claims as well as plaintiffs' claims for breach of contract and unjust enrichment; (ii) denied SBI's motion to dismiss the repleaded claim under ERISA alleging that SBI participated in a fiduciary's breach; and (iii) denied Ameritech's motion to dismiss SBI's counterclaims. Discovery with respect to the remaining claims is ongoing. The Department of Labor has advised SBI that it is reviewing the transactions in which APT acquired such participation interests. Golder, Thoma, Cressey Fund III Limited Partnership, et al. v. Salomon ---------------------------------------------------------------------- Brothers Inc, is a lawsuit brought by Golder, Thoma, Cressey Fund III Limited - ------------ Partnership and three individuals purporting to represent eleven members of senior management of Health Care and Retirement Corporation of America ("HCRA"), in the Circuit Court of Cook County, Illinois on July 10, 1992 against SBI in connection with SBI's performance in providing financial advisory services for the proposed acquisition by the plaintiffs of HCRA in 1991. The lawsuit asserts claims for negligence, breach of fiduciary duty, negligent misrepresentation and breach of contract. Plaintiffs seek to recover damages purported to exceed $190 million due to their alleged inability to complete the acquisition at an advantageous price, $6 million of alleged fees and expenses, punitive damages and attorneys' fees, as well as costs and other relief. SBI is a defendant in three actions arising out of the acquisition of The Pacific Lumber Company ("Pacific Lumber") in 1985 by MAXXAM Group, Inc. ("MAXXAM") in which SBI acted as financial adviser to Pacific Lumber. One of such actions, originally filed in October 1988, was transferred on May 25, 1989 and is now pending in the United States District Court for the Southern District of New York as part of a consolidated proceeding captioned In re Ivan F. ------------- Boesky Securities Litigation, MDL No. 732. The complaint in this action - ---------------------------- asserts federal securities law claims against SBI by individual plaintiffs who claim to be former shareholders of Pacific Lumber, and includes allegations that there were allegedly false and misleading statements or omissions in connection with SBI's opinion that the final price of $40 per share offered and ultimately paid by MAXXAM for the approximately 20 million outstanding shares of Pacific Lumber stock in the acquisition was fair to the shareholders of Pacific Lumber from a financial point of view. The complaint also asserts claims against several other defendants in connection with the acquisition of Pacific Lumber, including MAXXAM and various of its affiliates, as well as Pacific Lumber and the former directors of Pacific Lumber. Although the complaint does not specify the amount of damages sought from the defendants, plaintiffs claim that the Pacific Lumber stock was worth substantially more than what was paid by MAXXAM. A trial date of April 11, 1994 has been scheduled by the Court in this action. SBI is also named as a defendant in two state court class actions arising out of the acquisition of Pacific Lumber, Russ et al. v. -------------- Milken et al. DR 85429, and Thompson, et al. v. Elam, et al., which were filed - ------------- -------------------------------- in October 1989 in the Humboldt County Superior Court in California. The state court actions have been stayed pursuant to stipulations between counsel. Information concerning environmental proceedings involving the Company contained in the third through ninth paragraphs of Note 14, "Legal Proceedings" of Exhibit 13, "Salomon Inc 1993 Annual Report Financial Information", is hereby incorporated herein by reference. In addition, other legal proceedings are pending against or involve the Company and its subsidiaries. Based on information currently available and established reserves, the Company believes the ultimate disposition of legal proceedings involving the Company will not have a material adverse effect on the Company's consolidated financial condition. ITEM 4.

ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS There were no matters submitted to a vote of security holders during the fourth quarter of 1993. EXECUTIVE OFFICERS OF THE REGISTRANT Name and Age Office - ------------ ------ Jerome H. Bailey (41) Chief Financial Officer since June 1993, previously employed at Morgan Stanley in various executive capacities for more than five years Robert E. Denham (48)* Chairman and Chief Executive Officer since June 1992; previously General Counsel from September 1991; previously a partner in the law firm of Munger, Tolles & Olson, Los Angeles, California, for more than four years. He rejoined Munger, Tolles & Olson as a partner in August 1992 and resigned from that firm on December 31, 1993. David C. Fisher (47) Controller since 1989; previously employed by Salomon Brothers Inc in various executive capacities from 1985 EXECUTIVE OFFICERS OF THE REGISTRANT (CONTINUED) Name and Age Office - ------------ ------ Andrew J. Hall (43)* Executive Vice President since May 1991; Chairman and President of the Phibro Division since January 1, 1993; Chairman and Chief Executive Officer of Phibro Energy, Inc. from January 1992 to December 1992 and President of Phibro Energy, Inc. from 1987 to December 1992 Gedale B. Horowitz (61)* Executive Vice President since 1981 John G. Macfarlane (39) Treasurer since 1989; Treasurer of Salomon Brothers Inc since 1989; previously employed by Salomon Brothers Inc in various executive capacities from 1979 Deryck C. Maughan (46)* Executive Vice President since May 1993; Chairman and Chief Executive Officer of Salomon Brothers Inc since May 1992; previously Chief Operating Officer of Salomon Brothers Inc from August 1991; Vice Chairman of Salomon Brothers Inc from January 1991 to August 1991; Chairman of Salomon Brothers Asia Limited from 1986 to 1991 Robert H. Mundheim (61) Executive Vice President and General Counsel since December 1993; General Counsel since September 1992; previously co-chairman of the law firm Fried, Frank, Harris, Shriver and Jacobson, New York, from March 1990 after having served as Dean of the University of Pennsylvania Law School for more than seven years * Also a Director of Salomon Inc Officers of the Registrant are elected annually at the May meeting of the Company's Board of Directors that follows the Annual Meeting of Stockholders. PART II ITEM 5.

ITEM 5. MARKET FOR THE REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS Information concerning the market for the Registrant's common equity and related stockholder matters in Exhibit 13, "Salomon Inc 1993 Annual Report Financial Information," under the caption "Common Stock Data" on page 85, is deemed part of this Annual Report on Form 10-K and is hereby incorporated herein by reference. ITEM 6.

ITEM 6. SELECTED FINANCIAL DATA Selected financial data in Exhibit 13, "Salomon Inc 1993 Annual Report Financial Information," under the caption "Five Year Summary of Selected Financial Information" on page 86, is deemed part of this Annual Report on Form 10-K and is hereby incorporated herein by reference. ITEM 7.

ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Management's Discussion and Analysis of Financial Condition and Results of Operations contained under the following captions in Exhibit 13, "Salomon Inc 1993 Annual Report Financial Information," is deemed part of this Annual Report on Form 10-K and is hereby incorporated herein by reference: Financial Highlights (page 1) Overview of 1993 (on pages 13 through 19) Segment Information (on pages 20 through 30) Capital and Liquidity Management (on pages 31 through 38) Risk Management (on pages 39 through 45) ITEM 8.

ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA The Consolidated Financial Statements of the Company and subsidiaries, together with the Summary of Accounting Policies, the Notes to Consolidated Financial Statements and the Report of Independent Public Accountants, contained in Exhibit 13, "Salomon Inc 1993 Annual Report Financial Information" on pages 48 through 84, and the information appearing under the caption "Selected Quarterly Financial Data (Unaudited)" on page 85 of such Exhibit are deemed part of this Annual Report on Form 10-K and are hereby incorporated herein by reference. ITEM 9.

ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE There were no changes in or disagreements with accountants reportable herein. PART III ITEM 10.

ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT (a) Directors - --------- Information concerning directors of the Registrant is contained under the caption "Election of Directors" in the Proxy Statement for the 1994 Annual Meeting of Stockholders, which information is hereby incorporated herein by reference. (b) Executive Officers - ------------------ Information concerning executive officers of the Registrant is presented in Part I of this Annual Report on Form 10-K. ITEM 11.

ITEM 11. EXECUTIVE COMPENSATION Information concerning executive compensation is contained under the captions "Election of Directors - Executive Compensation" and "Election of Directors - Board of Directors' Meetings, Committees and Fees" in the Proxy Statement for the 1994 Annual Meeting of Stockholders, which information is hereby incorporated herein by reference. ITEM 12.

ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT Information concerning security ownership of certain beneficial owners and management is contained under the caption "Election of Directors - Information as to Certain Stockholdings" in the Proxy Statement for the 1994 Annual Meeting of Stockholders, which information is hereby incorporated herein by reference. ITEM 13.

ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS Information concerning certain relationships and related transactions is contained under the caption "Election of Directors - Certain Transactions and Legal Matters" in the Proxy Statement for the 1994 Annual Meeting of Stockholders, which information is hereby incorporated herein by reference. PART IV ITEM 14.

ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K (a) Financial Statements and Schedules ---------------------------------- (1) Financial Statements The Consolidated Financial Statements of the Company and subsidiaries, together with the Summary of Accounting Policies, the Notes to Consolidated Financial Statements and the Report of Independent Public Accountants, dated February 10, 1994, are contained in Exhibit 13, "Salomon Inc 1993 Annual Report Financial Information," and are hereby incorporated herein by reference. (2) Schedules Report of Independent Public Accountants on Schedules I and II Schedule I - Marketable Securities Schedule II - Amounts Receivable From Related Parties and Underwriters, Promoters and Employees Other Than Related Parties (Other schedules are omitted because the required information either is not applicable or is included in the financial statements or the notes thereto.) (3) Exhibits 3(a) Certificate of Incorporation of the Company, as amended (incorporated by reference to Exhibits 3 to Quarterly Reports on Form 10-Q for the quarters ended June 30, 1987 and June 30, 1986, Exhibit 4(a) to Registration Statement Number 2-84733 on Form S-3 filed June 30, 1983, Exhibit 4 to Quarterly Report on Form 10-Q for the quarter ended September 30, 1987, Exhibit A to Exhibit 1 to Registration Statement on Form 8-A filed February 11, 1988, Exhibit 3 to Current Report on Form 8-K dated June 13, 1991, and Exhibit 4(a) to Current Report on Form 8-K dated February 22, 1993) 3(b) By-laws of the Company, as amended (incorporated by reference to Exhibit 3 to Quarterly Report on Form 10-Q for the quarter ended September 30, 1992) 4(a) Certificate of Incorporation of the Company. See Exhibit 3(a) above. 4(b) Rights Agreement dated as of February 8, 1988 between Salomon Brothers Inc and Morgan Shareholders Services Trust Company and related letter dated February 9, 1988 from Berkshire Hathaway Inc. (incorporated by reference to Exhibit 28 to Annual Report on Form 10-K for the year ended December 31, 1987) ITEM 14. (CONTINUED) (c) Exhibits (continued) -------------------- 4(c) First Amendment dated December 7, 1988 to Rights Agreement dated as of February 8, 1988 between Salomon Inc and Morgan Shareholder Services Trust Company (incorporated by reference to Exhibit 28 to Annual Report on Form 10-K for the year ended December 31, 1988) 4(d) Contract dated September 27, 1987 between Berkshire Hathaway Inc. and Salomon Inc and letter dated September 28, 1987 amending said contract (incorporated by reference to Exhibit 10(c) to Annual Report on Form 10-K for the year ended December 31, 1987) 4(e) The Company agrees to furnish the Securities and Exchange Commission upon its request a copy of any instrument which defines the rights of holders of long-term debt of the Company and its consolidated subsidiaries that does not exceed 10 percent of the total consolidated assets of the Company. 10(a) Lease between 7 World Trade Center Company and Salomon Inc dated November 23, 1988 (incorporated by reference to Exhibit 10(a) to the Annual Report on Form 10-K, as amended, for the year ended December 31, 1991) 10(b) Foundation Agreement for the creation of the Joint Enterprise "White Nights" between Varyeganneftegaz Production Association, Phibro Energy Production, Inc. and Anglo-Suisse (U.S.S.R.) L.P. dated November 1, 1990. (incorporated by reference to Exhibit 10(b) to the Annual Report on Form 10-K, as amended, for the year ended December 31, 1991) 10(c) Charter of the Joint Enterprise "White Nights" (incorporated by reference to Exhibit 10(c) to the Annual Report on Form 10-K, as amended, for the year ended December 31, 1991) 10(d) Non-Qualified Stock Option Plan of 1984 (incorporated by reference to Exhibit A to the Proxy Statement for the 1988 Annual Meeting of the Stockholders) 12(a)* Calculation of Ratio of Earnings to Fixed Charges 12(b)* Calculation of Ratio of Earnings to Combined Fixed Charges and Preferred Dividends 13* Salomon Inc 1993 Annual Report Financial Information (furnished for the information of the Securities and Exchange Commission and not deemed "filed" as part of this Report except for those portions which are expressly incorporated by reference) 21* Subsidiaries of the Registrant 23* Consent of Independent Public Accountants 24* Powers of Attorney * Filed herewith ITEM 14. (CONTINUED) (c) Exhibits (continued) -------------------- 99(a) Copies of the settlement documents relating to the resolution of certain governmental investigations with respect to the U.S. Treasury auction and related matters. (incorporated by reference to Exhibit 28(a) to the Annual Report on Form 10-K for the year ended December 31, 1992) 99(b) Copies of the amended consolidated complaints filed in connection with In re Salomon Inc Securities Litigation, In re Salomon Brothers Treasury Litigation and In re Salomon Inc Shareholders' Derivative Litigation. (incorporated by reference to Exhibit 28(b) to the Annual Report on Form 10-K for the year ended December 31, 1992) 99(c) Summaries of the complaints filed against the Company, SBI and certain present and former directors, officers and employees of the Company and SBI in the six individual actions named in Item 3 with respect to the U.S. Treasury auction and related matters. (incorporated by reference to Exhibit 28(c) to the Annual Report on Form 10-K for the year ended December 31, 1992) 99(d) Copies of the six complaints summarized in Exhibit 28(c) which were filed against the Company, SBI or certain present and former directors, officers and employees of the Company and SBI with respect to the U.S. Treasury auction and related matters (incorporated by reference to Exhibit 28(c) to the Company's Annual Report on Form 10-K, as amended, for the year ended December 31, 1991; Exhibit 28(h) to the Company's Quarterly Report on Form 10-Q for the quarter ended September 30, 1991; Exhibit 28(b) to the Company's Quarterly Report on Form 10-Q for the quarter ended March 31, 1992; Exhibit 28(a) to the Company's Quarterly Report on Form 10-Q for the quarter ended June 30, 1992; Exhibit 28(f) to the Company's Current Report on Form 8-K dated September 16, 1991 and Exhibits 28(b) and (c) to the Company's Current Report on Form 8-K dated July 28, 1992. ITEM 14. (CONTINUED) (b) Reports on Form 8-K ------------------- The Company filed a Current Report on Form 8-K dated November 5, 1993, reporting under Item 5 ("Other Events:") and Item 7 ("Financial Statements, Pro Forma Financial Information and Exhibits") the completed offering and sale of 1,150,000 of the Company's AMEX Hong Kong 30 Index Call Warrants Expiring November 3, 1995 and the related Underwriting Agreement, Warrant Agreement and Opinions of counsel. The Company filed a Current Report on Form 8-K dated December 17, 1993, reporting under Item 7 ("Financial Statements, Pro Forma Financial Information and Exhibits") a Form T-1 Statement of Eligibility. The Company filed a Current Report on Form 8-K dated January 12, 1994, reporting under Item 7 ("Financial Statements, Pro Forma Financial Information and Exhibits") a Form T-1 Statement of Eligibility. The Company filed a Current Report on Form 8-K dated January 18, 1994, reporting under Item 7 ("Financial Statements, Pro Forma Financial Information and Exhibits") an Indenture and a Form T-1 Statement of Eligibility. The Company filed a Current Report on Form 8-K dated January 27, 1994, reporting under Item 5 ("Other Events:") and Item 7 ("Financial Statements, Pro Forma Financial Information and Exhibits") the issuance of a press release. The Company filed a Current Report on Form 8-K dated March 7, 1994, reporting under Item 7 ("Financial Statements, Pro Forma Financial Information and Exhibits") a Form T-1 Statement of Eligibility. SALOMON INC FINANCIAL STATEMENT SCHEDULE INDEX Schedule Number Description - ------ ----------- Report of Independent Public Accountants on Schedules I and II I Marketable Securities II Amounts Receivable From Related Parties and Underwriters, Promoters and Employees Other Than Related Parties Report of Independent Public Accountants on Schedules I and II - To Salomon Inc: We have audited in accordance with generally accepted auditing standards, the consolidated financial statements of Salomon Inc and subsidiaries included in Exhibit 13, "Salomon Inc 1993 Annual Report Financial Information," incorporated by reference and deemed part of this Annual Report on Form 10-K, and have issued our report thereon dated February 10, 1994. Our audits were made for the purpose of forming an opinion on those financial statements taken as a whole. Schedules I and II are the responsibility of the Company's management. They are presented for purposes of complying with the Securities and Exchange Commission's rules and are not part of the basic financial statements. These schedules have been subjected to the auditing procedures applied in our audits of the basic financial statements and, in our opinion, fairly state in all material respects the financial data required to be set forth therein in relation to the basic financial statements taken as a whole. New York, New York ARTHUR ANDERSEN & CO. February 10, 1994 SCHEDULE I SALOMON INC AND SUBSIDIARIES MARKETABLE SECURITIES DECEMBER 31, 1993 * No individual issuer or counterparty exceeds 2% of consolidated total assets. SCHEDULE II SALOMON INC AND SUBSIDIARIES AMOUNTS RECEIVABLE FROM RELATED PARTIES AND UNDERWRITERS, PROMOTERS AND EMPLOYEES OTHER THAN RELATED PARTIES FOR THE THREE YEARS ENDED DECEMBER 31, 1993 * All loans outstanding at December 31, 1993 are non-interest bearing except for Chris Franke who is no longer an employee. (a) In February 1994 the Company assumed title to the home financed by this loan, thus eliminating the obligation. (b) Remaining balance of $200,000 repaid January 15, 1994. (c) Remaining balance of $250,000 repaid January 31, 1994. (d) $5,000 repaid January 16, 1994, remainder due upon sale of home. (e) Balance payable in three $200,000 and one $300,000 annual installments commencing November 30, 1995. (f) Remaining balance payable in three $18,750 annual installments commencing January 31, 1994. (g) $700,000 due upon sale of home. SCHEDULE II (Continued) SALOMON INC AND SUBSIDIARIES AMOUNTS RECEIVABLE FROM RELATED PARTIES AND UNDERWRITERS, PROMOTERS AND EMPLOYEES OTHER THAN RELATED PARTIES FOR THE THREE YEARS ENDED DECEMBER 31, 1993 SIGNATURES 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, on the 30th day of March, 1994. SALOMON INC By /s/ Arnold S. Olshin - ----------------------- -------------------------- (Registrant) (Secretary) Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated. Robert E. Denham Chief Executive Officer and Director March 30, 1994 Jerome H. Bailey Chief Financial Officer March 30, 1994 David C. Fisher Chief Accounting Officer March 30, 1994 Dwayne O. Andreas* Director March 30, 1994 Warren E. Buffett* Director March 30, 1994 Andrew J. Hall* Director March 30, 1994 Gedale B. Horowitz* Director March 30, 1994 Deryck C. Maughan* Director March 30, 1994 William F. May* Director March 30, 1994 Charles T. Munger* Director March 30, 1994 Louis A. Simpson* Director March 30, 1994 David I. Young* Director March 30, 1994 Robert G. Zeller* Director March 30, 1994 *The undersigned, by signing his name hereto, does hereby sign this report on behalf of each of the above-indicated directors of the Registrant pursuant to powers of attorney, executed on behalf of each such director, on the 30th day of March, 1994. By /s/ Arnold S. Olshin ----------------------------- (Attorney-In-Fact) SALOMON INC FORM 10-K EXHIBIT INDEX Certain exhibits to this Form 10-K have been incorporated by reference in Part IV Item 14. The following exhibits are being filed herewith: Exhibit Number Description - -------------- ----------- 12(a) Calculation of Ratio of Earnings to Fixed Charges 12(b) Calculation of Ratio of Earnings to Combined Fixed Charges and Preferred Dividends 13 Salomon Inc 1993 Annual Report Financial Information 21 Subsidiaries of the Registrant 23 Consent of Independent Public Accountants 24 Powers of Attorney

310433_1993.txt

310433

1993

Item 1. Business. The Company C-TEC Corporation was organized in 1979. It is incorporated under the laws of the Commonwealth of Pennsylvania and has its principal office in Wilkes-Barre, Pennsylvania. C-TEC is a holding company with wholly-owned subsidiaries, which are engaged in various aspects of the communications industry and which are organized into five principal groups - Telephone, Cable Television, Communications Services, Mobile Services, and Long Distance. Through its wholly-owned subsidiaries, C-TEC also has ownership interests of 80% in a cable television subsidiary; 79.98% and 93.05% in two cellular telephone subsidiaries; and 53.55% in an alternative access telephone service provider. Operations Telephone The Telephone Group consists of a Pennsylvania public utility providing local telephone service to a 19 county, 5,067 square mile service territory in Pennsylvania. As of December 31, 1993, the Telephone Group provided service to approximately 211,000 main access lines. Of these 167,000 are residential and 44,000 primarily relate to business. This Group's operating territory is rural, containing only 38.8 access lines per square mile as compared to a Pennsylvania average of 151.0 lines per square mile. The Group's 79 central offices serve an average of 2,500 lines and 65 square miles. In addition to providing local telephone service, this Group provides network access and long distance services to interexchange carriers. This Group also has other revenues which are considered non-regulated and primarily relate to telecommunications equipment sales and services and billing/ collection services for interexchange long distance carriers. Today, this Group's greatest competition is for the sale of telecommunications equipment. This revenue source is not a significant portion of the Group's business. Intralata toll bypass and alternative local access telephone service providers are potential competitive threats, although no significant competition has occurred to date. Intralata toll and access revenue comprise a significant portion of the Group's business. Cable The Cable Group is a cable television operator with cable television systems located in the States of New York, New Jersey, Michigan, Delaware and Pennsylvania. The Group owns and operates cable television systems serving 224,000 customers and manages cable television systems with an additional 34,000 customers, ranking it in the top 35 of U.S. multiple system operators. - - -1- PART I Item 1. Business, continued Cable, continue During 1993, the Cable Group restructured rates and channel offerings to comply with the basic rate regulations and to minimize the impact on revenue of the Cable Television Consumer Protection and Competition Act of 1992 (the "Act"). The future impact of the Act on the Cable Group and the cable television industry is still unclear. The Cable Group's 1993 operating results were not significantly impacted by the Act. The Group's performance is dependent to a large extent on its ability to obtain and renew its franchise agreements from local government authorities on acceptable terms. To date, all of the Group's franchises have been renewed or extended, generally at or prior to their stated expirations and on acceptable terms. During 1993, the Cable Group completed negotiations with 64 communities resulting in franchise renewals on terms which are acceptable to the Group. The Cable Group has 369 franchises, 63 of which are in the 3 year Federal Communications Commission franchise renewal window at December 31, 1993. No one franchise accounts for more than 10% of the Group's total revenue. Competition for the Group's services traditionally has come from a variety of providers including broadcast television, video cassette recorders and home satellite dishes. Direct broadcast satellite (DBS) which will allow a consumer to receive cable programming for a fee once they purchase an 18 inch receiving dish and a set-top terminal for approximately $700 may increase competition in the future. Two DBS companies are scheduled to launch their services in April 1994. In addition, recent changes in federal regulation allow telephone companies to lease their networks to video programmers under the video dial-tone platform. Also, in 1993, the announced mergers of various telephone and cable companies heightened the questions about competition in the future. The current regulatory environment appears to be fostering competition in cable television by telephone companies, and in telephone by cable companies, however these regulations are still evolving. The Cable and Telephone Groups continue to monitor the progress of regulations affecting the telecommunications industry and are developing a business plan to meet future competition. It is impossible to predict at this time the impact of these technological and regulatory developments on the cable television industry in general or on the Group in particular. Mobile Services The Mobile Services Group currently operates cellular telephone systems in metropolitan service areas (MSAs) and rural areas (RSAs) throughout eight counties in Northeastern and Central Pennsylvania and 24 counties in Southeast Iowa ("IA"), serving a total population of 1.5 million. The Group also operates paging and message management services in Northeastern Pennsylvania. - - -2- PART I Item 1. Business, continued Mobile Services, continued The Pennsylvania cellular territory consists of 2 MSA and 3 RSA service areas. Vanguard Cellular is the primary competitor in the 2 MSA markets and in 1 RSA market. There is no competition in the other two RSA markets. The Iowa cellular territory consists of 1 MSA and 4 RSA markets. The Iowa market is fragmented in regards to competition. Centel Cellular is the primary competitor in the MSA market, U.S. Cellular in IA RSA 3, Contel in IA RSA 4, and CommNet 2000 in IA RSA 6. The IA RSA 11 territory is covered by two cellular competitors - U.S. West and Centel. The Group's service territory was increased with the activation of three new cell sites in Pennsylvania in 1993. The Iowa cellular properties benefited from four new cell sites in 1993. The Group increased subscribers by approximately 53% in 1993. In 1993, the Group introduced a call delivery Supersystem. Through a key strategic relationship with a neighboring service provider in Pennsylvania, the Group is now able to offer over 12,000 square miles of seamless cellular service in major surrounding travel corridors. The Supersystem allows customers to have calls automatically delivered to their roaming location in the Supersystem. Callers need only dial the customary seven-digit cellular phone number to contact the customer; roaming access numbers and codes are no longer necessary. To be competitive, the Group eliminated daily roaming charges and reduced roaming rates throughout the Supersystem area. Also instrumental in the subscriber growth has been the success of the Group's venture in the retail arena. The first company-operated retail location was opened in the fourth quarter of 1992. During 1993, the group added four additional kiosks in key population areas in the Pennsylvania market. The kiosks allow the Group to reach the ever-growing consumer market by being strategically positioned in major shopping malls, providing added shopping convenience and a continued marketing presence. Communication Services The Communications Services Group presently carries out business in the Northeastern United States providing telecommunications-related engineering and technical services. These services are provided out of the headquarters in Wilkes-Barre, Pennsylvania, and regional offices in Pennsylvania, New York City and Virginia. The services provided by the Group include telephony engineering; system integration; operation and management of telecommunications facilities for large corporate clients, hospitals and universities; and installation of premises distribution systems in large campus environments. In addition, the Communications Services Group sells, installs and maintains private branch exchanges (PBXs) in Pennsylvania and New Jersey. The Group has also expanded its engineering services to include video and data engineering, and successfully implemented several major projects during 1993. - - -3- PART I Item 1. Business, continued Communication Services, continued The Group encounters major competition from interexchange carriers (AT&T), regional bell operating companies, independent telephone companies, system integrators, interconnect companies and small independent consultants. The competition from various sources results in significant downward pressure on the prices and margins for the services the Group provides. The Group's cost effective operations and competitive pricing, flexibility to meet customer requirements, and reputation in the telecommunications industry for quality service have been its primary strengths against the competition. Long Distance The Long Distance Group presently operates in two territories. The Group began operations in 1990 by servicing the local service area of the Telephone Group. In late 1992, the Long Distance Group entered the Wilkes-Barre/Scranton territory served by Bell of PA. The primary focus in this market is the business segment. In late 1993, the Long Distance Group established sales offices in additional markets served by Bell of PA - Philadelphia, Pittsburgh, Harrisburg and Allentown. The Group provides several types of services. The primary service offered is a switched service in which a customer chooses the Long Distance Group as their long distance provider and dials the common "1+" to use the service. In addition to providing customers with direct dial long distance service, equal access also requires the Long Distance Group to offer operator services - referred to as "0+". This service provides the additional capabilities of third party billing, and calling card service, among others. The Group also provides private line service, 800 service and calling card service. The Long Distance Group is basically a "reseller" of the above services and employs the networks of several long distance providers on a wholesale basis. The Group also provides telemarketing services, primarily to cable companies. Additionally, the Long Distance Group recognized the need for an AT&T product to sell nationwide to large business customers with multiple locations. In 1992, the Group procured an AT&T Tariff 12 agreement and has also included this service as an additional line of business. The Group's recent expansion of services includes wholesale activities in which a complete line of services is offered, including marketing, billing and collection. PART I Item 1. Business, continued Long Distance, continued As a result of expansion, in 1993, the Group procured its own long distance switch. The Northern Telecom DMS-250 switch will enable the Long Distance Group to provide full service long distance, including, but not limited to, switched services, private line services, 800 services, operator services, calling card services and enhanced platform services such as message delivery and debit card at reduced rates to customers while providing quality customer service. In conjunction with the switch implementation, the Group has invested in an improved billing system possessing the capabilities to provide real time customer service inquiry, toll investigation, trouble ticketing, immediate customer interface with the local exchange carriers and direct billing on a "one bill" concept with the local exchange telephone companies. The interexchange carrier market is crowded and competitive. Recent industry surveys indicate an estimated 350-400 interexchange carriers in operation. A key development was the rapid revenue growth by regional and niche oriented companies. Although the top three carriers (AT&T, MCI and Sprint) account for almost 90% of all interexchange carrier revenue, that share declines as other interexchange carrier revenue grows almost 13% annually. Intense competition in the mid-sized business market reflects the rapid growth of business customer revenue. Estimates indicate the business market has doubled the growth rate of the residential market. It is the regional interexchange carriers who have been the major beneficiaries of the battle for the mid-sized business market. This group has shown triple revenue growth for this market segment compared to the top three carriers. The residential market is still dominated by the top three carriers. However, this domination should decline given increased price pressure combined with more aggressive marketing by the regional carriers. Locally, the Long Distance Group has mirrored the overall growth statistics of the regional carriers. Competition for the mid-sized business market has come from other similarly situated carriers rather than the top three. The primary deviation from industry growth trends is seen in the residential market segment in the Telephone Group's operating territories. Here the Long Distance Group has continued to hold the predominant market share. This dominance has not gone unnoticed however, as marketing activities by the top three carriers have been increasing in the territory. A combination of value priced products, exceptional customer service and aggressive marketing activities has been the Group's primary strength against competition. Financial information regarding the Registrant's industry segments is set forth on page XX of this Form 10-K. As of December 31, 1993, the Company had 1,282 full-time employees including general office and administrative personnel. - - -5- PART I Item 2.

Item 2. Properties. C-TEC, the holding company, does not own any physical properties. The Telephone Group owns and maintains in good operating condition switching centers, cables and wires connecting the telephone company and its customers with the switching centers and other telephone instruments and equipment. These properties enable the Telephone Group to provide customers with prompt and reliable telephone service. Substantially all of the properties of the Telephone Group are subject to mortgage liens held by the United States of America acting through the Rural Electrification Administration, Federal Financing Bank, and the Rural Telephone Bank. C-TEC Cable Systems of New York, Inc., ComVideo Systems, Inc., C-TEC Cable Systems of Michigan, Inc. (the "Cable Television Group") own and maintain in good operating condition head-end, distribution and subscriber equipment. These properties enable the Cable Television Group to provide customers with state-of-the-art, reliable cable television service. Paging Plus, Inc. owns paging and answering service assets. Cellular Plus of Iowa, Inc., Iowa City Cellular Telephone Company, Inc., a 93.95% owned subsidiary, Northeast Pennsylvania SMSA Limited Partnership, a 78.98% owned subsidiary, and C-TEC Cellular Centre County, Inc. own and maintain cellular electronic equipment which provides cellular telephone services to designated metropolitan and rural service areas. Also, SRHC Inc. owns buildings in Wilkes-Barre and Dallas, PA. Item 3.

Item 3. Legal Proceedings. In the normal course of business, there are various legal proceedings outstanding. In the opinion of management, these proceedings will not have a material adverse effect on financial condition. Item 4.

Item 4. Submission of Matters to a Vote of Security Holders. No matters were submitted to a vote of security holders of the Registrant during the fourth quarter of the Registrant's 1993 fiscal year. EXECUTIVE OFFICER OF THE REGISTRANT Pursuant to General Instruction G(3) of Form 10-K, the following list is included as an un-numbered Item in Part I of this Report in lieu of being included in the definitive proxy statement relating to the Registrant's Annual Meeting of Shareholders to be filed by Registrant with the Commission pursuant to section 14 (A) of the Securities Exchange Act of 1934 (the "1934 Act"). Information with respect to Executive Officers who are also Directors is set forth in the definitive proxy statement relating to Registrant's Annual Meeting of Shareholders, and is hereby specifically incorporated herein by reference thereto. - - -6- Executive Officers of the Registrant, continued Age as of Office and Date Office Held Since: Name March 1, 1994 Other Positions Held Michael Adams 36 Vice President of Technology (since November 1993); Vice President of Technology - Mercom, Inc. (since November 1993); Vice President of Engineering - RCN Corporation (since September 1992); Vice President - McCourt Communications Co., Inc. (since June 1992); Vice President of Business Development - McCourt/Kiewit International (May 1991 - June 1992); Managing Director - McCourt Cable & Communications, Ltd. (October 1990 - June 1992); Director of Operations - MFS/McCourt (January 1990 - October 1990); Vice President of Engineering - McCourt Cable Systems, Inc. (June 1982 - January 1990). John C. Balan 59 Executive Vice President - Commonwealth Communications, Inc. (since July 1990); Vice President Marketing and Sales - Commonwealth Communications, Inc. (September 1989 - July 1990); Vice President - Marketing and Sales - Fairchild Industries (January 1984 - September 1989). Richard J. Burnheimer 35 Treasurer (since February 1994); Treasurer - Mercom, Inc. (since February 1994); Director of Finance (since February 1992); Assistant Treasurer (December 1987 - February 1994). Marc C. Elgaway 39 Executive Vice President - Mobile Services Group (since April 1989); Vice President - Mobile Services Group (since July 1988); General Manager - Commonwealth Communications, Inc., (January 1988 - July 1988); Senior Manager - Commonwealth Communications, Inc. (April 1987 - January 1988); Senior Manager Planning & Marketing Strategies - Commonwealth Communications, Inc. (August 1985 - April 1987). - - -7- Executive Officers of the Registrant, continued Age as of Office and Date Office Held Since: Name March 1, 1994 Other Positions Held Mark Haverkate 39 Vice President of Development (since December 1993); Vice President - Cable Television Group (October 1989 - December 1993); Director of Acquisitions and Development (July 1988 - October 1989); Corporate Marketing Manager - Cable Television Group (May 1987 - July 1988). Kenneth M. Jantz 51 Executive Vice President and Chief Financial Officer (since February 1994); Executive Vice President and Chief Financial Officer - Mercom, Inc. (since February 1994); Executive Vice President - Kiewit Industrial Co. (March 1992 - October 1993); Vice President and Controller - Morrison Knudsen Corporation (July 1966 - - - March 1992). B. Stephen May 45 Executive Vice President - Long Distance Group (since July 1993); Corporate Director of Marketing - Consolidated Communications, Inc. (1991 - 1993); Vice President and General Manager - American Express ISC (1989 - 1991). Michael J. Mahoeny 43 President - C-TEC Corporation (since February 1994); President - Mercom, Inc. (since February 1994); Executive Vice President - Cable Television Group (June 1991 - February 1994); Executive Vice President of Mercom, Inc., an affiliate of C-TEC (December 17, 1991 - February 1994); Chief Operating Officer - Harron Communications Corp. (April 1983 - December 1990). Paul W. Mazza 49 Executive Vice-President - Telephone Group (since December 1990); Executive Vice President - - - Cable Television Group (September 1981 - November 1990); Executive Vice President - Mobile Services Group (February 1986 - - - July 1988). - - -8- Executive Officers of the Registrant, continued Age as of Office and Date Office Held Since: Name March 1, 1994 Other Positions Held John J. Menapace 49 Vice President - Chief Administrative Officer (since December 1990); Vice President - Chief Administrative Officer - Mercom, Inc. (since March 1992); Vice President Human Resources and Administration September 1986 - December 1990); Director Network Services - Commonwealth Telephone Co. (May 1985 - September 1986); Director - Operations - Commonwealth Telephone Co. (January 1984 - May 1985); Staff & Services Manager - Commonwealth Telephone Co. (April 1983 - January 1984). Raymond B. Ostroski 39 Vice President and General Counsel (since December 1990); Secretary and General Counsel - Mercom, Inc. (since December 17, 1991); Corporate Secretary - C-TEC (since October 1989); Corporate Counsel C-TEC (August 1988 - - - December 1990); Assistant Corporate Secretary - C-TEC (April 1986 - October 1989); Associate Counsel - C-TEC (August 1985 - August 1988). PART II Item 5.

Item 5. Market for the Registrant's Common Stock and Related Stockholders There were approximately 2,258 holders of Registrant's Common Stock and 979 holders of Registrant's Class B Common Stock on March 1, 1994. The Company has maintained a no cash dividend policy since 1989. The Company does not intend to alter this policy in the foreseeable future. Other information required under Item 5 of Part II is set forth in Note 17 to the consolidated financial statements included in Part IV Item 14(a)(1) of this Form 10-K. Item 6.

Item 6. Selected Financial Data. Information required under Item 6 of Part II is set forth in Part IV Item 14(a)(1) of this Form 10-K. Item 7.

Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations. Information required under Item 7 of Part II is set forth in Part IV Item 14(a)(1) of this Form 10-K. - - -9- Item 8.

Item 8. Financial Statements and Supplementary Data. The consolidated financial statements and supplementary data required under Item 8 of Part II are set forth in Part IV Item 14(a)(1) of this Form 10-K. Item 9.

Item 9. Disagreements on Accounting and Financial Disclosure. During the two years preceding December 31, 1993, there has been neither a change of accountants of the Registrant nor any disagreement on any matter of accounting principles, practices or financial statement disclosure. PART III Item 10.

Item 10. Directors and Executive Officers of the Registrant The information required under Item 10 of Part III with respect to the Directors of Registrant is set forth in the definitive proxy statement relating to Registrant's Annual Meeting of Shareholders to be filed by the Registrant with the Commission pursuant to Section 14(A) of the 1934 Act and is hereby specifically incorporated herein by reference thereto. The information required under Item 10 of Part III with respect to the executive officers of the Registrant is set forth at the end of Part I hereof. Item 11.

Item 11. Executive Compensation The information required under Item 11 of Part III is set forth in the definitive proxy statement relating to Registrant's Annual Meeting of Shareholders to be filed by the Registrant with the Commission pursuant to Section 14(A) of the 1934 Act, and is hereby specifically incorporated herein by reference thereto. Item 12.

Item 12. Security Ownership of Certain Beneficial Owners and Management The information required under Item 12 of Part III is included in the definitive Proxy Statement relating to Registrant's Annual Meeting of Shareholders to be filed by Registrant with the Commission pursuant to Section 14(A) of the 1934 Act, and is hereby specifically incorporated herein by reference thereto. Item 13.

Item 13. Certain Relationships and Related Transactions The information required under Item 13 of Part III is included in the definitive proxy statement to Registrant's Annual Meeting of Shareholders to be filed by Registrant with the Commission pursuant to Section 14(A) of the 1934 Act, and is hereby specifically incorporated herein by reference thereto. PART IV Item 14.

Item 14. Exhibits, Financial Statement Schedules and Report on Form 8-K. (a)(1) Financial Statements: Description Page Selected Financial Data Management's Discussion and Analysis of Financial Condition and Results of Operations Consolidated Statements of Operations for Years Ended December 31, 1993, 1992 and 1991 - - -10- Item 14. Exhibits, Financial Statement Schedules and Report on Form 8-K. (a)(1) Financial Statements: Description Page Consolidated Statements of Cash Flows for Years Ended December 31, 1993, 1992 and 1991 Consolidated Balance Sheets - December 31, 1993 and 1992 Consolidated Statements of Common Shareholders' Equity for Years Ended December 31, 1993, 1992 and 1991 Notes to Consolidated Financial Statements Report of Independent Accountants (a)(2) Financial Statement Schedules: Description Condensed Financial Information of Registrant for the Years Ended December 31, 1993, 1992 and 1991 (Schedule III) Property, Plant and Equipment for the Years Ended December 31, 1993, 1992 and 1991 (Schedule V) Accumulated Depreciation and Amortization of Property, Plant and Equipment for the Years Ended December 31, 1993, 1992 and 1991 (Schedule VI) (a)(2) Financial Statement Schedules continued Valuation and Qualifying Accounts and Reserves for the Years Ended December 31, 1993, 1992 and 1991 (Schedule VIII) Short Term Borrowings for the Years Ended December 31, 1993, 1992 and 1991 (Schedule IX) Supplementary Income Statement Information for the Years Ended December 31, 1993, 1992 and 1991 (Schedule X) All other financial statement schedules not listed have been omitted since the required information is included in the consolidated financial statements or the notes thereto, or are not applicable or required. (a)(3) Exhibits Exhibits marked with an asterisk are filed herewith and are listed in the index to exhibits on page E-1 of this Form 10-K. The remainder of the exhibits have been filed with the Commission and are incorporated herein by reference. (3) Articles of Incorporation and By-Laws - - -11- Item 14. Exhibits, Financial Statement Schedules and Report on Form 8-K - continued. (a) Articles of Incorporation of Registrant as amended and restated April 24, 1986 are incorporated herein by reference to Exhibit 3(a) to the Company's Annual Report on Form 10-K for the year ended December 31, 1986, (Commission File No. 0-11053). (b) By-laws of Registrant, as amended through October 28, 1993. (4) Instruments Defining the Rights of Security Holders, Including Indentures (a) Telephone Loan Contract dated as of March 1, 1977 between Commonwealth Telephone Company ("CTCo") and the United States of America, ("USA") acting through the Administrator of the Rural Electrification Administration ("REA") is incorporated herein by reference to Exhibit 4(a) to the Company's Annual Report on Form 10-K for the year ended December 31, 1980, (Commission File No. 0-1094). (b) Mortgage Note dated as of June 14, 1977 made by CTCo. to the Federal Financing Bank ("FFB") is incorporated herein by reference to Exhibit B to the Form 10-Q Report of CTCo. for the quarter ended June 30, 1977. (c) Mortgage and Security Agreement dated as of June 16, 1977 made by and between CTCo. and USA acting through REA is incorporated herein by reference to Exhibit C to the Form 10-Q Report of CTCo. for the quarter ended June 30, 1977. (d) Telephone Loan Contract Amendment dated as of January 30, 1978 between CTCo., Rural Telephone Bank ("RTB"), corporation existing under the laws of the USA, and USA is incorporated herein by reference to Exhibit 4(d) to the Company's Annual Report on Form 10-K for the year ended December 31, 1989, (Commission File No. 0-1094). (e) Evidence of indebtedness dated as of May 26, 1978 issued under Telephone Loan Contract Amendment identified in 4(d) made by CTCo. to RTB is incorporated herein by reference to Exhibit 4(e) to the Company's Annual Report on Form 10-K for the year ended December 31, 1989, (Commission File No. 0-1094). (f) Supplemental Mortgage and Security Agreement dated as of May 26, 1978 made by and among CTCo., RTB and USA acting through the Administrator of REA is incorporated herein by reference to Exhibit B to the Form 10-Q Report of CTCo. for the quarter ended June 30, 1978. - - -12- Item 14. Exhibits, Financial Statement Schedules and Report on Form 8-K - continued. (g) Telephone Loan Contract Amendment dated as of September 11, 1978 among CTCo., RTB and USA acting through the Administrator of REA is incorporated herein by reference to Exhibit 4(g) to the Company's Annual Report on Form 10-K for the year ended December 31, 1980, (Commission File No. 0-1094). (h) Mortgage Note dated as of March 19, 1980 made by CTCo. to RTB is incorporated herein by reference to Exhibit 4(h) to the Company's Annual Report on Form 10-K for the year ended December 31, 1980, (Commission File No. 0-1094). (i) Supplement to Supplemental Mortgage and Security Agreement dated as of March 19, 1980 by and among CTCo., RTB and USA acting through the Administrator of REA is incorporated herein by reference to Exhibit 4(i) to the Company's Annual Report on Form 10-K for the year ended December 31, 1980, (Commission File No. 0-1094). (j) Senior Secured Note Purchase Agreement dated as of July 31, 1989 among C-TEC Cable Systems, Inc., C-TEC, and various purchasers of the Senior Secured Notes is incorporated herein by reference to Exhibit 4(j) to the Company's Annual Report on Form 10-K for the year ended December 31, 1989, (Commission File No. 0-110-53). (k) Revolving Secured Credit Agreement dated as of July 31, 1989 among C-TEC Cable Systems, Inc., C-TEC and a group of commercial banks is incorporated herein by reference to Exhibit 4(k) to the Company's Annual Report on Form 10-K for the year ended December 31, 1989, (Commission File No. 0-110-53). (l) Telephone Loan Contract Amendment, dated as of September 12, 1989, among CTCo, USA acting through the Administrator of the REA, and the RTB is incorporated herein by reference to Exhibit 4(m) to the Company's Annual Report on Form 10-K for the year ended December 31, 1990, (Commission File No. 0-110-53). (m) Mortgage Note, dated July 5, 1990 payable to the order of the RTB is incorporated herein by reference to Exhibit 4(n) to the Company's Annual Report on Form 10-K for the year ended December 31, 1990, (Commission File No. 0-110-53). (n) Supplement to Supplemental Mortgage and Security Agreement, dated as of July 5, 1990, among CTCo, USA and the RTB is incorporated herein by reference to Exhibit 4(o) to the Company's Annual Report on Form 10-K for the year ended December 31, 1990, (Commission File No. 0-110-53). - - -13- Item 14. Exhibits, Financial Statement Schedules and Report on Form 8-K - continued. (o) Note Purchase Agreement dated as of December 1, 1991 among C-TEC and various purchasers of senior secured notes is incorporated herein by reference to Exhibit 4(q) to the Company's Annual Report on Form 10-K for the year ended December 31, 1991, (Commission File No. 0-110- 53). (p) Amended and Restated Credit Agreement dated as of March 27, 1992 among C-TEC and a syndicate of banks is incorporated herein by reference to Exhibit 4(p) to the Company's Annual Report on Form 10-K for the year ended December 31, 1992, (Commission File No. 0-11053). (q) Amendment to 9.65% Senior Secured Note Purchase Agreement is incorporated herein by reference to Exhibit 4(q) to the Company's report on Form 10-Q for the quarter ended September 30, 1993, (Commission File No. 0-11053). (r) Amendment to Credit Agreement dated as of July 31, 1989 is incorporated herein by reference to Exhibit 4(r) to the Company's report on Form 10-Q for the quarter ended September 30, 1993, (Commission File No. 0-11053). (s) Amendment to 9.52% Senior Secured Note Purchase Agreement is incorporated herein by reference to Exhibit 4(s) to the Company's report on form 10-Q for the quarter ended September 30, 1993, (Commission File No. 0-11053). (t) Amendment to Amended and Restated Credit Agreement dated as of March 27, 1992 is incorporated herein by reference to Exhibit 4(t) to the Company's report on Form 10-Q for the quarter ended September 30, 1993, (Commission File No. 0-11053). (10) Material Contracts (a) C-TEC Corporation, 1984 Stock Option and Stock Appreciation Rights Plan (as amended) is incorporated herein by reference to Exhibit 10(a) to Form S-8 Registration Statement (as amended) of Registrant filed with the Commission, Registration Nos. 2-98305 and 33-5723. (b) Form of Stock Option Agreement is incorporated herein by reference to Exhibit 10(b) to Form S-8 Registration Statements (as amended) of Registrant filed with the Commission, Registration Nos. 2-98305 and 33-5723. - - -14- Item 14. Exhibits, Financial Statement Schedules and Report on Form 8-K - continued. (c) Form of Stock Option Agreements is incorporated herein by reference to Exhibit 10(c) to Form S-8 Registration Statements (as amended) of Registrant filed with the Commission, Registration Nos. 2-98305 and 33-5723. (d) C-TEC Corporation, Common-Wealth Builder Employee Savings Plan is incorporated herein by reference to Exhibit 28(b) to Form S-8 Registration Statements (as amended) of Registrant filed with the Commission, Registration No. 2-98306 and 33-13066. (e) Performance Incentive Compensation Plan is incorporated herein by reference to Exhibit 10(g) to the Company's Annual Report on Form 10-K for the year ended December 31, 1986, (Commission File No. 0-11053). (f) C-TEC Corporation 1994 Stock Option Plan. * (11) Computation of Per Share Earnings * (13) Annual Report to Security Holders * Registrant's Annual Report to Shareholders for 1993. (22) Subsidiaries of the Registrant * Subsidiaries of Registrant as of December 31, 1993. (24) Consent of Independent Accountants * (28) Additional Exhibits (a) Undertakings to be incorporated by reference into Form S-8 Registration Statement Nos. 2-98305, 33-5723, 2-98306 and 33-13066 are incorporated herein by reference to Exhibit 28(a) to the Company's Annual Report on Form 10-K for the year ended December 31, 1987, (Commission File No. 01-110-53). (b) Report on Form 11-K with respect to the Common-Wealth Builder Plan will be filed as an amendment to this report on Form 10-K. (b) Report on Form 8-K No report on Form 8-K has been filed by Registrant during the last quarter of the period covered by this report on Form 10-K. - - -15- SIGNATURES Pursuant to the requirements of Section 13 or 15(d) 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. C-TEC CORPORATION Date: March 30, 1994 By David C. McCourt, Chief Executive Officer Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated. Signature Title Date PRINCIPAL EXECUTIVE OFFICERS: David C. McCourt Chief Executive Officer March 30, 1994 Michael J. Mahoney President March 30, 1994 PRINCIPAL FINANCIAL OFFICER: Kenneth M. Jantz Executive Vice President March 30, 1994 and Chief Financial Officer - - -16- DIRECTORS: March 30, David C. McCourt March 30, 1994 James Q. Crowe March 30, 1994 Walter E. Scott, Jr. March 30, Richard R. Jaros March 30, Robert E. Julian March 30, Thomas C. Stortz March 30, David C. Mitchell March 30, Frank M. Henry March 30, Donald G. Reinhard March 30, Eugene Roth, Esquire March 30, Stuart E. Graham - - -17- Form 10-K Index to Exhibits Certain exhibits to this report on Form 10-K have been incorporated by reference. For a list of these and all exhibits, see Item 14 (a)(3) hereof. The following exhibits are being filed herewith. Exhibit No. Page (3) Articles of Incorporation and By-laws (b) By-laws of Registrant, as amended through October 28, 1993 (4) Instruments Defining the Rights of Security Holders, Including Indentures (11) Computation of Per Share Earnings (13) Annual Report to Security Holders (22) Subsidiaries of the Registrant (24) Consent of Independent Accountants - - -18-

860004_1993.txt

860004

1993

Item 1. Business The Sears Credit Account Trust 1990 B (the "Trust") was formed pursuant to the Pooling and Servicing Agreement dated as of February 22, 1990 (the "Pooling and Servicing Agreement") among Sears, Roebuck and Co. ("Sears") as Servicer, its wholly-owned subsidiary, Sears Receivables Financing Group, Inc. ("SRFG") as Seller, and Continental Bank, National Association as trustee (the "Trustee"). The Trust's only business is to act as a passive conduit to permit investment in a pool of retail consumer receivables. Item 2.

Item 2. Properties The property of the Trust includes a portfolio of receivables (the "Receivables") arising in selected accounts under open-end credit plans of Sears (the "Accounts") and all monies received in payment of the Receivables. At the time of the Trust's formation, Sears sold and contributed to SRFG, which in turn conveyed to the Trust, all Receivables existing under the Accounts as of the end of certain of Sears regular billing cycles ending in February, 1990 and all Receivables arising under the Accounts from time to time thereafter until the termination of the Trust. Information related to the performance of the Receivables during 1993 is set forth in the ANNUAL STATEMENT filed as Exhibit 21 to this Annual Report on Form 10-K. Item 3.

Item 3. Legal Proceedings None Item 4.

Item 4. Submission of Matters to a Vote of Security Holders None PART II Item 5.

Item 5. Market for Registrant's Common Equity and Related Stockholder Matters Investor Certificates are held and delivered in book-entry form through the facilities of The Depository Trust Company ("DTC"), a "clearing agency" registered pursuant to the provisions of Section 17A of the Securities Exchange Act of 1934, as amended. All outstanding definitive Investor Certificates are held by CEDE and Co., the nominee of DTC. Item 9.

Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure None PART III Item 12.

Item 12. Security Ownership of Certain Beneficial Owners and Management As of March 15, 1994, 100% of the Investor Certificates were held in the nominee name of CEDE and Co. for beneficial owners. SRFG, as of March 15, 1994, owned 100% of the Seller Certificate, which represented beneficial ownership of a residual interest in the assets of the Trust as provided in the Pooling and Servicing Agreement. Item 13.

Item 13. Certain Relationships and Related Transactions None PART IV Item 14.

Item 14. Exhibits, Financial Statement Schedules, and Reports on Form 8-K (a) Exhibits: 21. 1993 ANNUAL STATEMENT prepared by the Servicer. 28. ANNUAL INDEPENDENT AUDITOR'S REPORTS pursuant to Section 3.06 of the Pooling and Servicing Agreement. (a) Review of servicing procedures. (b) Annual Servicing Letter. (b) Reports on Form 8-K: Current reports on Form 8-K are filed on or before the Distribution Date each month (on, or the first business day after, the 15th of the month). The reports include as an exhibit, the MONTHLY INVESTOR CERTIFICATEHOLDERS' STATEMENT. Current Reports on Form 8-K were filed on October 15, 1993, November 15, 1993, and December 15, 1993. SIGNATURES Pursuant to the requirements of Section 13 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. Sears Credit Account Trust 1990 B (Registrant) By: Sears Receivables Financing Group, Inc. (Originator of the Trust) By: /S/ALICE M. PETERSON _____________________________________ Alice M. Peterson President and Chief Executive Officer Dated: March 30, 1994 EXHIBIT INDEX Page number in sequential Exhibit No. number system 21. 1993 ANNUAL STATEMENT prepared by the Servicer. 28. ANNUAL INDEPENDENT AUDITOR'S REPORTS pursuant to Section 3.06 of the Pooling and Servicing Agreement. (a) Review of servicing procedures. (b) Annual Servicing Letter. Exhibit 21 SEARS CREDIT ACCOUNT TRUST 1990 B 8.75% CREDIT ACCOUNT PASS-THROUGH CERTIFICATES 1993 ANNUAL STATEMENT Pursuant to the terms of the letter issued by the Securities and Exchange Commission dated March 30, 1990 (granting relief to the Trust from certain reporting requirements of the Securities Exchange Act of 1934, as amended), aggregated information regarding the performance of Accounts and payments to Investor Certificateholders in respect of the Due Periods related to the twelve Distribution Dates which occurred in 1993 is set forth below. 1) The total amount of the distribution to Investor Certificateholders during 1993, per $1,000 interest............................................$87.50 2) The amount of the distribution set forth in paragraph 1 above in respect of interest on the Investor Certificates, per $1,000 interest....................$87.50 3) The amount of the distribution set forth in paragraph 1 above in respect of principal on the Investor Certificates, per $1,000 interest....................$0.00 4) The aggregate amount of Collections of Principal Receivables processed during the related Due Periods....................................$232,857,461.00 5) The aggregate amount of Collections of Finance Charge Receivables processed during the related Due Periods.....................................$56,875,137.31 6) The aggregate amount of Collections of Principal Receivables processed during the related Due Periods which were allocated in respect of the Investor Certificates...............$170,434,077.86 7) The aggregate amount of Collections of Finance Charge Receivables processed during the related Due Periods which were allocated in respect of the Investor Certificates................................$21,664,238.33 8) The aggregate amount of Collections of Principal Receivables processed during the related Due Periods which were allocated in respect of the Seller Certificate.................................$62,423,383.14 9) The aggregate amount of Collections of Finance Charge Receivables processed during the related Due Periods which were allocated in respect of the Seller Certificate.................................$35,210,898.98 10) The excess of the Investor Charged-Off Amount over the sum of (i) payments in respect of the Available Subordinated Amount and (ii) Excess Servicing, if any (an "Investor Loss"), per $1,000 interest............$0.00 11) The aggregate amount of Investor Losses in the Trust as of the end of the day on December 15, 1993, per $1,000 interest......................................$0.00 12) The total reimbursed to the Trust from the sum of the Available subordinated Amount and Excess Servicing, if any, in respect of Investor Losses, per $1,000 interest.............................................$0.00 13) The amount of the Investor Monthly Servicing Fee payable by the Trust to the Servicer.........$2,314,814.82 14) The aggregate amount which was deposited in the Principal Funding Account in respect of Collections of Principal Receivables during the related Due Periods................................$111,111,111.12 15) The aggregate amount of Investment Income during the related Due Periods.........................$11,747,685.19 16) The total amount on deposit in the Principal Funding Account in respect of Collections of Principal Receivables, as of the end of the reportable year.......................................$194,444,444.46 17) The Deficit Accumulation Amount, as of the end of the reportable year......................................$0.00 Exhibit 28(a) February 11, 1994 Ms. Alice M. Peterson Ms. Cynthia K. Duncan Vice President and Treasurer Trust Officer Sears, Roebuck and Co. as Servicer Continental Bank, National Sears Tower Association as Trustee Chicago, Illinois 60684 231 South La Salle Street Chicago, Illinois 60697 We have applied the procedures listed below to the accounting records of Sears, Roebuck and Co. ("Sears") relating to the servicing procedures performed by Sears as Servicer under Section 3.06(b) of the Pooling and Servicing Agreement (the "Agreement") for the following Trusts: Date of Pooling and Trust Servicing Agreement Sears Credit Account Trust 1989E November 13, 1989 Sears Credit Account Trust 1990A January 12, 1990 Sears Credit Account Trust 1990B February 22, 1990 Sears Credit Account Trust 1990C July 31, 1990 Sears Credit Account Trust 1990D October 15, 1990 Sears Credit Account Trust 1990E December 1, 1990 It is understood that this report is solely for your information and is not to be referred to or distributed for any purpose to anyone other than Continental Bank, National Association as Trustee, Investor Certificateholders or the management of Sears. The procedures we performed are as follows: Compared the mathematical calculations of each amount set forth in each monthly certificate forwarded by the Servicer, pursuant to Section 3.04(b) of the Agreement, during the calendar year 1993 to the Servicer's computer-generated Portfolio Monitoring and Monthly Cash Flow Allocations Report. We found such amounts to be in agreement. February 11, 1994 Ms. Alice M. Peterson Ms. Cynthia K. Duncan Vice President and Treasurer Trust Officer Sears, Roebuck and Co. as Servicer Continental Bank, National Association as Trustee Because the above procedures do not constitute an audit conducted in accordance with generally accepted auditing standards, we do not express an opinion on any of the items referred to above. As a result of the procedures performed, no matters came to our attention that caused us to believe that the amounts in the monthly certificates require adjustment. Had we performed additional procedures or had we conducted an audit of the monthly certificates in accordance with generally accepted auditing standards, matters might have come to our attention that would have been reported to you. This report relates only to the items specified above and does not extend to any financial statements of Sears taken as a whole.

754737_1993.txt

754737

1993

ITEM 1. BUSINESS THE COMPANY ORGANIZATION SCANA, a South Carolina corporation having general business powers, was incorporated on October 10, 1984 and is a public utility holding company within the meaning of PUHCA but is presently exempt from registration under such Act (see Regulation). SCANA has its principal executive office at 1426 Main Street, Columbia, South Carolina 29201, telephone number (803) 748-3000. SCANA holds all the capital stock of each of its subsidiaries except for the Preferred Stock of SCE&G and the capital stock of SCANA's indirect, wholly owned subsidiaries which are not material individually or in the aggregate. SCANA and its subsidiaries had 4,788 full-time, permanent employees as of December 31, 1993 as compared to 4,849 full-time, permanent employees as of December 31, 1992. SEGMENTS OF BUSINESS SCANA neither owns nor operates any physical properties. It currently has 11 direct, wholly owned subsidiaries which are engaged in the functionally distinct operations described below. Regulated Utilities The Company's principal subsidiary, SCE&G, is a regulated public utility engaged in the generation, transmission, distribution and sale of electricity and in the purchase and sale, primarily at retail, of natural gas in South Carolina. SCE&G also renders urban bus service in the metropolitan areas of Columbia and Charleston, South Carolina. SCE&G's business is subject to seasonal fluctuations. Generally, sales of electricity are higher during the summer and winter months because of air-conditioning and heating requirements, and sales of natural gas are greater in the winter months due to its use for heating requirements. SCE&G's electric service area extends into 24 counties covering more than 15,000 square miles in the central, southern and southwestern portions of South Carolina. The service area for natural gas encompasses all or part of 29 of the 46 counties in South Carolina and covers more than 19,000 square miles. Total estimated population of counties representing the combined service area is approximately 2.3 million. The predominant industries in the territories served by SCE&G include: synthetic fibers; chemicals and allied products; fiberglass and fiberglass products; paper and wood products; metal fabrication; stone, clay and sand mining and processing; and various textile-related products. GENCO owns and operates Williams Station and sells electricity solely to SCE&G. Fuel Company acquires, owns and provides financing for SCE&G's nuclear and fossil fuel requirements. Pipeline Corporation is engaged in the purchase, transmission and sale of natural gas on a wholesale basis to distribution companies and directly to industrial customers in 39 counties throughout South Carolina. Pipeline Corporation owns LNG liquefaction and storage facilities. It also supplies the natural gas for SCE&G's gas distribution system. Other resale customers include municipalities and county gas authorities and gas utilities. The industrial customers of Pipeline Corporation are primarily engaged in the manufacturing or processing of ceramics, paper, metal, food and textiles. Nonregulated Businesses Petroleum Resources owns and operates oil and gas producing properties with net proven reserves in 16 states and Federal waters offshore Texas and Louisiana. Hydrocarbons markets natural gas and light hydrocarbons. It also owns and operates an 80 million gallon underground propane storage cavern near York, South Carolina and a 62 mile, six-inch propane pipeline that connects the cavern facility with Dixie Pipeline Company near Bethune, South Carolina. The cavern leases storage space to industries, utilities and propane suppliers. Hydrocarbons also owns and operates the Wilburton Gathering System in Oklahoma. Suburban purchases, delivers and sells propane. In 1993 Suburban sold approximately 20 million gallons of propane and had approximately 31,400 residential, commercial and industrial customers at year end. MPX Systems, Inc. is involved in telecommunication related ventures providing fiber optic telecommunications, video conferencing and specialized mobile radio services. Having installed over 600 miles of fiber optic cable in South Carolina, Georgia and Alabama, the company has recently turned its efforts toward video conferencing and the establishment of a Specialized Mobile Radio system in South Carolina. Both new ventures capitalize on the fiber infrastructure in place and provide for expansion of the network. Development Corporation is engaged in the development, management and sale of real estate. In January 1994 SCANA signed an agreement to sell in 1994 substantially all of the real estate assets of Development Corporation to Liberty Properties Group, Inc. of Greenville, South Carolina for $91.5 million. On March 4, 1994 the Company and Liberty amended the agreement regarding the sale. Under the terms of the amended agreement certain projects currently under construction will be excluded from the transaction and the sales price will be $49.6 million. All of the sales price will be received at the time of closing. The transaction will not have a material impact on the Company's financial position or results of operation. Primesouth, Inc. is engaged in power plant management and maintenance services. SCANA Capital Resources, Inc. has provided equity capital for diversified investments. Information with respect to major segments of business for the years ended December 31, 1993, 1992 and 1991 is contained in Note 11 of the Notes to Consolidated Financial Statements and all such information is incorporated herein by reference. CAPITAL REQUIREMENTS AND FINANCING PROGRAM Capital Requirements The cash requirements of the Company arise primarily from SCE&G's operational needs, the Company's construction program and the need to fund the activities or investments of the Company's nonregulated subsidiaries. The ability of the Company's regulated subsidiaries to replace existing plant investment, as well as to expand to meet future demand for electricity and gas, will depend upon their ability to attract the necessary financial capital on reasonable terms. The Company's regulated subsidiaries recover the costs of providing services through rates charged to customers. Rates for regulated services are generally based on historical costs. As customer growth and inflation occur and the regulated subsidiaries expand their construction programs, it is necessary to seek increases in rates. As a result the Company's future financial position and results of operations will be affected by the regulated subsidiaries' ability to obtain adequate and timely rate relief. As discussed in Note 2A of Notes to Consolidated Financial Statements, on June 7, 1993 the PSC issued an order granting SCE&G a 7.4% annual increase in retail electric rates to be implemented in two phases of $42.0 million annually effective June 1993 and $18.5 million annually effective June 1994, based on a test year. During 1994 the Company is expected to meet its capital requirements principally through internally generated funds (approximately 38% excluding dividends), sales of additional shares of common stock including sales pursuant to the DRP and SPSP, and the issuance and sale of debt securities. Short-term liquidity is expected to be provided by issuance of commercial paper. The timing and amount of such sales and the type of securities to be sold will depend upon market conditions and other factors. The Company's estimates of its cash requirements for construction (excluding potential oil and gas investments) and nuclear fuel expenditures, which are subject to continuing review and adjustment, for 1994 and the four-year period 1995-1998 as now scheduled are as follows: Construction The Company's cost estimates for its construction program for the periods 1994 and 1995-1998 shown in the above table include costs of the projects described below. SCE&G entered into a contract with Duke/Fluor Daniel in 1991 to design, engineer and build a 385 MW coal-fired electric generating plant near Cope, South Carolina in Orangeburg County. Construction of the plant began in November 1992 with commercial operation expected in late 1995 or early 1996. The estimated price of the Cope plant, excluding financing costs and AFC but including an allowance for escalation, is $450 million. In addition, the transmission lines for interconnection with SCE&G's system are expected to cost $26 million. The steam generators at Summer Station will be replaced during the 1994 regularly scheduled refueling outage. In January 1994 SCE&G, acting on behalf of itself and the PSA (as co-owners of the 885 Megawatt Summer Station), reached a settlement with Westinghouse Electric Corporation (Westinghouse) resolving a dispute involving steam generators provide by Westinghouse to Summer Station which are defective in design, workmanship and materials. Terms of the settlement are confidential by agreement of the parties and order of the court. SCE&G had filed an action in May 1990 against Westinghouse in the U. S. District Court for South Carolina; an order dismissing this suit was issued on January 12, 1994. Pipeline Corporation completed construction in 1993 of an LNG facility near Sally, South Carolina at a price of $23.5 million. The facility will store up to 900,000 MCF of LNG. During 1993 SCE&G and GENCO expended approximately $24 million as part of a program to extend the operating lives of certain generating facilities. Additional improvements to be made under the program during 1994 are estimated to cost approximately $22 million. Additional Capital Requirements In addition to the Company's capital requirements for 1994 described above, $25.6 million will be required for refunding and retiring outstanding securities and obligations. For the years 1995-1998, the Company has an aggregate of $255.8 million of long-term debt maturing (including approximately $43.9 million for sinking fund requirements, of which $43.5 million may be satisfied by deposit and cancellation of bonds issued upon the basis of property additions or bond retirement credits) and $9.9 million of purchase or sinking fund requirements for preferred stock. Actual 1994 expenditures may vary from the estimates set forth above due to factors such as inflation, economic conditions, regulation, legislation, rates of load growth, environmental protection standards and the cost and availability of capital. Financing Program The Company has in effect a medium-term note program for the issuance from time to time of unsecured medium-term debt securities. The proceeds from the sales of these securities may be used to fund additional business activities in nonutility subsidiaries, to reduce short-term debt incurred in connection therewith or for general corporate purposes. In 1993 the Company issued $60 million of such medium-term notes. The proceeds from the sales of these securities were used for the funding of nonutility subsidiary activities. At December 31, 1993 the Company had available for issuance $67.6 million under this program. SCE&G's First and Refunding Mortgage Bond Indenture, dated April 1, 1945 (Old Mortgage) contains provisions prohibiting the issuance of additional bonds thereunder (Class A Bonds) unless net earnings (as therein defined) for 12 consecutive months out of the 15 months prior to the month of issuance is at least twice the annual interest requirements on all Class A Bonds to be outstanding (Bond Ratio). For the year ended December 31, 1993 the Bond Ratio was 3.70. The issuance of additional Class A Bonds is restricted also to an additional principal amount equal to 60% of unfunded net property additions (which unfunded property additions totaled approximately $219.9 million at December 31, 1993), Class A Bonds issued on the basis of retirements of Class A Bonds (which retirement credits totaled $10.9 million at December 31, 1993) and Class A Bonds issued on the basis of cash on deposit with the Trustee. SCE&G has placed a new bond indenture (New Mortgage) dated April 1, 1993 on substantially all of its electric properties under which its future mortgage-backed debt (New Bonds) will be issued. New Bonds are expected to be issued under the New Mortgage on the basis of a like principal amount of Class A Bonds issued under the Old Mortgage, which have been deposited with the Trustee of the New Mortgage (of which $157 million were available for such purpose at December 31, 1993), until such time as all presently outstanding Class A Bonds are retired. Thereafter, New Bonds will be issuable on the basis of property additions in a principal amount equal to 70% of the original cost of electric and common plant properties (compared to 60% of value for Class A Bonds under the Old Mortgage), cash deposited with the Trustee, and retirement of New Bonds. New Bonds will be issuable under the New Mortgage only if adjusted net earnings (as therein defined) for 12 consecutive months out of the 18 months immediately preceding the month of issuance are at least twice the annual interest requirements on all outstanding bonds (including Class A Bonds) and New Bonds to be outstanding (New Bond Ratio). For the year ended December 31, 1993 the New Bond Ratio was 5.0. On April 29, 1993 the Securities and Exchange Commission (SEC) declared effective a registration statement for the issuance of up to $700 million of New Bonds by SCE&G. The following series, aggregating $600 million, have been issued under such registration statement: On June 9, 1993, $100 million, 7 5/8% Series due June 1, 2023 to repay short-term borrowings in a like amount. On July 1, 1993, $100 million, 6% Series due June 15, 2000, and $150 million, 7 1/8% Series due June 15, 2013, and on July 20, 1993, $150 million, 7 1/2% Series due June 15, 2023, to redeem, on July 20, 1993, $382,035,000 of First and Refunding Mortgage Bonds maturing between 1999 and 2017 and bearing interest at rates between 8% and 9 7/8% per annum. On December 20, 1993, $100 million, 6 1/4% Series due December 15, 2003 to repay short-term borrowings in a like amount. The following additional financing transactions have occurred since December 31, 1992: On January 15, 1993 the Company closed on an unsecured bank loan in the principal amount of $60 million, due January 14, 1994, and used the proceeds to pay off a loan in a like amount. The interest rate is the three month LIBOR plus 30 basis points and is reset quarterly. On January 14, 1994 the Company refinanced the loan with unsecured bank loans totaling $60 million, due January 13, 1995 at interest rates between 3.875% and 3.89%. On April 15, 1993 the Company arranged for a $15 million term loan, due April 14, 1994, to repay short-term borrowings in a like amount. The interest rate is the three month LIBOR plus 16 basis points and is reset quarterly. On June 1, 1993 SCE&G redeemed the following amounts of First and Refunding Mortgage Bonds: $35 million, 10 1/8% Series due 2009 and $13 million, 9 7/8% Series due 2009. On June 2, 1993 the Company entered into a $123 million 90-day bank loan (90-day bank loan) to finance the acquisition by Petroleum Resources of approximately 125 billion cubic feet equivalent of natural gas reserves through the purchase of NICOR Exploration and Production Co. On July 1, 1993 the Company issued $60 million of medium-term notes bearing interest at the following rates and maturing on the following dates in the following amounts: $20 million, 5.76%, due July 1, 1998; $20 million, 6.15%, due July 3, 2000; $20 million, 6.51%, due July 1, 2003. The proceeds were used to repay a portion of the 90-day bank loan discussed above. In early August 1993 the Company issued 1,467,000 shares of common stock with net proceeds totalling $69,345,090. The proceeds were used to repay the remainder of the 90-day bank loan discussed above and for general corporate purposes. On September 30, 1993 Pipeline Corporation sold unsecured promissory notes totalling $25 million, 6.72% due September 30, 2013. The proceeds were used to repay short-term borrowings in a like amount. Without the consent of at least a majority of the total voting power of SCE&G's preferred stock, SCE&G may not issue or assume any unsecured indebtedness if, after such issue or assumption, the total principal amount of all such unsecured indebtedness would exceed 10% of the aggregate principal amount of all of SCE&G's secured indebtedness and capital and surplus; provided, however, that no such consent shall be required to enter into agreements for payment of principal, interest and premium for securities issued for pollution control purposes. Pursuant to Section 204 of the Federal Power Act, SCE&G and GENCO must obtain FERC authority to issue short-term in- debtedness. The FERC has authorized SCE&G to issue up to $200 million of unsecured promissory notes or commercial paper with maturity dates of 12 months or less but not later than December 31, 1995. GENCO has not sought such authorization. The Company had $175.0 million authorized lines of credit and had unused lines of credit of $148.0 million at December 31, 1993. SCE&G's Restated Articles of Incorporation prohibit issuance of additional shares of preferred stock without consent of the preferred stockholders unless net earnings (as defined therein) for the 12 consecutive months immediately preceding the month of issuance is at least one and one-half times the aggregate of all interest charges and preferred stock dividend requirements (Preferred Stock Ratio). For the year ended December 31, 1993 the Preferred Stock Ratio was 2.52. On October 12, 1993 the Company registered with the SEC 2,000,000 additional shares of the Company's common stock to be issued and sold under the DRP. During 1993 the Company issued 529,954 shares of the Company's common stock under the DRP. In addition, the Company issued 705,498 shares of its common stock pursuant to its SPSP. The Company has authorized and reserved for issuance, and registered under effective registration statements, 2,065,824 and 872,420 shares of common stock pursuant to the DRP and the SPSP, respectively. In January 1994 SCANA signed an agreement to sell in 1994 substantially all of the real estate assets of Development Corporation to Liberty Properties Group, Inc. of Greenville, South Carolina for $91.5 million. On March 4, 1994 the Company and Liberty amended the agreement regarding the sale. Under the terms of the amended agreement certain projects currently under construction will be excluded from the transaction and the sales price will be $49.6 million. All of the sales price will be received at the time of closing. The net proceeds from the sale will be used to retire Development Corporation's debt and for general corporate purposes, including the funding of other nonutility subsidiaries' business activities. The transaction will not have a material impact on the Company's financial position or results of operations. The ratio of earnings to fixed charges (SEC method) was 3.41, 2.79, 3.24, 4.07 and 2.93 for the years ended December 31, 1993, 1992, 1991, 1990 and 1989 respectively. The Company expects that it has or can obtain adequate sources of financing to meet its projected cash requirements. Fuel Financing Agreements SCE&G has assigned to Fuel Company all of its rights and interests in its various contracts relating to the acquisition and ownership of nuclear and fossil fuel. To finance nuclear and fossil fuel inventories, Fuel Company issues, from time to time, its promissory notes with maturities of less than 270 days (Commercial Paper). The issuance of Commercial Paper is supported by an irrevocable revolving credit agreement which expires July 31, 1996 and is guaranteed by SCE&G. Accordingly, the amounts outstanding have been included in long-term debt. The credit agreement provides for a maximum amount of $75 million that may be outstanding at any time. At December 31, 1993 Commercial Paper outstanding for nuclear and fossil fuel inventories was approximately $36.8 million at a weighted average interest rate of 3.47%. ELECTRIC OPERATIONS Electric Sales In 1993 residential sales of electricity accounted for 43% of electric sales revenues; commercial sales 29%; industrial sales 21%; sales for resale 4%; and all other 3%. KWH sales by classification for the years ended December 31, 1993 and 1992 are presented below: Sales KWH % Classification 1993 1992 Change (thousands) Residential 5,650,753 5,155,886 9.60 Commercial 4,835,492 4,531,683 6.70 Industrial 4,887,121 4,684,012 4.34 Sale for resale 1,005,968 946,357 6.30 Other 500,937 476,064 5.22 Total Territorial 16,880,271 15,794,002 6.88 Interchange 198,059 77,046 157.07 Total 17,078,330 15,871,048 7.61 SCE&G furnishes electricity for resale to three municipalities, three investor-owned utilities, two electric cooperatives and one public power authority. Such sales for resale accounted for 4% of SCE&G's total electric sales revenues in 1993. An increase of 6,974 electric customers to 468,874 total customers contributed to in an all-time peak demand record of 3,557 MW on July 29, 1993. The previous years' record of 3,380 MW was set July 13, 1992. Electric Interconnections SCE&G's transmission system is part of the interconnected grid extending over a large part of the southern and eastern portion of the nation. SCE&G, Virginia Power Company, Duke Power Company, Carolina Power & Light Company, Yadkin, Incorporated and PSA are members of the Virginia-Carolinas Reliability Group, one of the several geographic divisions within the Southeastern Electric Reliability Council which provides for coordinated planning for reliability among bulk power systems in the Southeast. SCE&G is also interconnected with Georgia Power Company, Savannah Electric & Power Company, Oglethorpe Power Corporation and Southeastern Power Administration's Clark Hill Project. Fuel Costs The following table sets forth the average cost of nuclear fuel and coal and the weighted average cost of all fuels (including oil and natural gas) used by the Company for the years 1991-1993. 1991 1992 1993 Nuclear: Per million BTU $ .57 $ .52 $ .47 Coal: Per ton $41.78 $40.45 $40.48 Per million BTU 1.63 1.57 1.57 Weighted Average Cost of All Fuels: Per million BTU $ 1.38 $ 1.27 $ 1.33 The fuel costs shown above exclude the effects of a PSC approved offsetting of fuel costs through the application of credits carried on SCE&G's books as a result of a 1980 settlement of certain litigation. Fuel Supply The following table shows the sources and approximate percentages of total KWH generation by each category of fuel for the years 1991-1993 and the estimates for 1994 and 1995. Percent of Total KWH Generated Actual Estimated 1991 1992 1993 1994 1995 Coal 68% 65% 72% 77% 69% Nuclear 21 29 22 17 26 Hydro 5 5 5 5 5 Natural Gas & Oil 6 1 1 1 - 100% 100% 100% 100% 100% Coal is currently used at all four of SCE&G's major fossil fuel-fired plants and GENCO's Williams Station. Unit train deliveries are used at all of these plants. On December 31, 1993 SCE&G had approximately a 73-day supply of coal in inventory and GENCO had approximately a 56-day supply. The supply of coal is obtained through contracts and purchases on the spot market. Spot market purchases are expected to continue for coal requirements in excess of those provided by the Company's existing contracts. Contracts for the purchase of coal represent the following percentages of estimated requirements for 1994 (approximately 5.3 million tons) and expire at the dates indicated (giving effect to the Company's potential to exercise renewal options): Range of % of Final No. of Tons % of 1994 Sulfur Content Expiration Renegotiation Per Year Requirement per Contract Date (1) Date (1) 966,664 18.2 up to 1.55 02/28/2001 02/28/1995 360,000 6.8 1.00-1.80 12/31/2002 12/31/1996 134,000 2.5 1.10-2.00 03/31/1996 03/31/1994 120,000 2.3 1.10-1.60 04/30/1996 04/30/1994 972,000 18.3 up to 1.50 12/31/2002 12/31/1996 192,832 3.6 0.80-1.50 06/30/2000 06/30/1994 2,745,496 51.7 (1) Contract extensions beyond the stated renegotiation date to the final expiration date are subject to mutual agreement on price, terms, quantity and quality. All of the above contracts, except the contracts expiring in March 1994 and April 1994 which have firm prices, are subject to periodic price adjustments based on changes in indices published by the U. S. Department of Labor. Coal purchased in December 1993 had an average sulfur content of 1.17%, which permitted SCE&G and GENCO to comply with existing environmental regulations. The Company believes that SCE&G's and GENCO's operations are in substantial compliance with all existing regulations relating to the discharge of sulfur dioxide. The Company has not been advised by officials of DHEC that any more stringent sulfur content requirements for existing plants are contemplated. However, the Company will be required to meet the more stringent emissions standards established by the Clean Air Act (see "Environmental Control Matters"). SCE&G currently has adequate supplies of uranium under contract to manufacture nuclear fuel for Summer Station through 1996. The following table summarizes all contract commitments for the stages of nuclear fuel assemblies: Commitment Contractor Regions(1) Term Uranium NUEXCO Trading Corporation 11 1994 Uranium Energy Resources of Australia 9-13 1990-1996 Uranium Everest Minerals 9-13 1990-1996 Conversion Sequoyah Fuel Corp. 8-12 1989-1995 Enrichment DOE (2) Through 2022 Fabrication Westinghouse 1-21 1982-2009 Reprocessing None (1) A region represents approximately one-third to one-half of the nuclear core in the reactor at any one time. Region no. 10 was loaded in 1993 and region no. 11 will be loaded in 1994. (2) The contract with the DOE is a "requirements" type contract whereby the DOE supplies total enrichment requirements for the unit through the year 2022, as specified by its then current schedule. SCE&G has on-site spent fuel storage capability until at least 2008 and expects to be able to expand its storage capacity to accommodate the spent fuel output for the life of the plant through rod consolidation, dry cask storage or other technology as it becomes available. In addition, there is sufficient on- site storage capacity over the life of Summer Station to permit storage of the entire reactor core in the event that complete unloading should become desirable or necessary for any reason. (See "Nuclear Fuel Disposal" under "Environmental Control Matters" for information regarding the contract with the DOE for disposal of spent fuel.) GAS OPERATIONS Gas Sales In 1993 residential sales accounted for 13% of gas sales revenues; commercial sales 9%; industrial sales 30%; sales for resale 19% and transportation gas 29%. Dekatherm sales by classification for the years ended December 31, 1993 and 1992 are presented below: SALES DEKATHERMS % CLASSIFICATION 1993 1992 CHANGE Residential 12,651,000 11,847,723 6.8 Commercial 9,611,556 9,729,723 (1.2) Industrial 30,335,059 33,157,246 (8.5) Sale for resale 19,144,130 21,437,448 (10.7) Transportation gas 29,542,805 25,720,633 14.9 Total 101,284,550 101,892,773 (0.6) During 1993 the Company added 3,853 customers, increasing its total customers to 234,736. The demand for gas is affected by conservation, the weather, the price relationship between gas and alternative fuels and other factors. The deregulation of natural gas prices at the wellhead which took place on January 1, 1985, and the changes in the prices of natural gas that have occurred under Federal regulation have resulted in the development of a spot market for natural gas in the producing areas of the country. Pipeline Corporation has been successful in purchasing lower cost natural gas in the spot market and arranging for its transportation to South Carolina. Pipeline Corporation has also negotiated contracts with certain direct and indirect industrial customers for the transportation of natural gas that the industrial customers purchase directly from suppliers. On April 8, 1992, the FERC promulgated its Order No. 636, which is intended to deregulate the markets for interstate sales of natural gas by requiring that pipelines provide transportation services that are equal in quality for all gas supplies whether the customer purchases gas from the pipeline or another supplier. Both of Pipeline Corporation's interstate suppliers initiated transportation services in compliance with FERC Order No. 636 on November 1, 1993. The Company's gas subsidiaries are positioned for the related market changes arising from this order. Pipeline Corporation, operating wholly within the State of South Carolina, provides natural gas utility service, including transportation services, for its customers, and supplies natural gas to SCE&G and other wholesale purchasers. Hydrocarbons acquires and sells natural gas in the newly deregulated markets. Petroleum Resources owns natural gas reserves that supply natural gas for the interstate markets. Neither Hydrocarbons nor Petroleum Resources supply natural gas to any affiliate for use in providing regulated gas utility services. To reduce dependence on imported oil, NEPA imposes purchase requirements for alternate fuel vehicles for federal, state, municipal and private fleets which increase over a period of years. The Company expects these requirements for alternate fuel vehicles to develop business opportunities for the sale of compressed natural gas as fuel for vehicles, but it cannot predict the extent of this new market. Expansion SCANA and Sonat, Inc., parent company of Southern Natural, are evaluating the potential market to determine the feasibility of providing natural gas transportation service to North Carolina. Gas Cost and Supply Pipeline Corporation purchases natural gas under contracts with producers, brokers and interstate pipelines. The gas is brought to South Carolina through contracts with both Southern Natural and Transco. The volume of gas which Pipeline Corporation is entitled to transport through these contracts is shown below: Maximum Daily Supplier Contract Demand Capacity (MCF) Southern Natural Firm Transportation 160,000 Transco Firm Transportation 29,900 Total 189,900 A liquid natural gas storage facility was completed in 1993 and has been used and useful in providing supplemental supplies to meet firm system requirements this winter season. No difficulty in obtaining natural gas is anticipated. During 1993 the average cost per MCF of natural gas purchased for resale, including spot market purchases, was approximately $2.68 compared to approximately $2.51 during 1992. To meet the requirements of its high priority natural gas customers during periods of maximum demand, Pipeline Corporation supplements its supplies of natural gas from two LNG plants. The LNG storage tanks are capable of storing the liquefied equivalent of 1,900,000 MCF of natural gas, of which approximately 1,450,000 MCF were in storage at December 31, 1993. On peak days the LNG plants can regasify up to 150,000 MCF per day. Additionally, Pipeline Corporation had contracted for 6,398,035 MCF of natural gas storage space on December 31, 1993, of which 4,880,484 MCF were in storage at such date. Propane air peak shaving facilities located in the Company's service area can supply an additional 137,400 MCF per day. The Company believes that current supplies under contract and spot market purchases of natural gas are adequate to meet existing customer demands for service and to accommodate growth. Curtailment Plans The FERC has established allocation priorities applicable to firm and interruptible capacities on interstate pipeline companies to their customers which require Southern Natural and Transco to allocate capacity to Pipeline Corporation. The FERC allocation priorities are not applicable to deliveries by Pipeline Corporation to its customers, which are governed by a separate curtailment plan approved by the PSC. Gas Reserves Petroleum Resources is actively involved in oil and natural gas development and production activities. It currently own and operates oil and gas production properties with net proven reserves in Texas, Louisiana, Mississippi, Oklahoma, California, Arkansas, Nebraska, Colorado, Kansas, Montana, North Dakota, Michigan, Illinois, New Mexico, Alabama, Wyoming and Federal waters offshore Texas and Louisiana. Gas Marketing Hydrocarbons markets natural gas as well as other light hydrocarbons. Propane Operations Suburban purchases, delivers and sells propane. In 1993 Suburban sold approximately 20 million gallons of propane and had approximately 31,400 residential, commercial and industrial customers at year end. Hydrocarbons owns and operates an 80 million gallon under- ground propane storage facility that leases storage space to industrial companies, utilities and others. It also owns and operates a 62 mile propane pipeline connected to the Dixie Pipeline System which traverses central South Carolina. Hydrocarbons also owns and operates the Wilburton Gathering System in Oklahoma. REGULATION General SCANA is a public utility holding company within the meaning of PUHCA, but is exempt under Section 3(a)(1) of PUHCA, from regulation by the SEC as a registered holding company, unless and until the SEC shall otherwise order, except for Section 9(a)(2) thereof prohibiting the acquisition of securities of other public utilities without a prior order of the SEC. SCE&G is subject to the jurisdiction of the PSC as to retail electric, gas and transit rates, service, accounting, issuance of securities (other than short-term promissory notes) and other matters. National Energy Policy Act of 1992 Congress has passed NEPA, the principal thrust of which is to create a more competitive wholesale power supply market by creating "exempt wholesale generators" (EWGs) designated by the FERC, which are independent power producers (IPPs) whose owners will not become holding companies under PUHCA. Upon application of a wholesaler of electric energy, the FERC may order any electric utility that owns transmission facilities used for wholesale sales of electric energy to provide transmission service (including any enlargement of transmission capacity needed to provide the service) to the applicant. Charges for transmission service must be "just and reasonable" and a utility is entitled to recover "all legitimate, verifiable economic costs" incurred in connection with any transmission service so ordered. The FERC may not order such service where it (1) would "unreasonably impair the continued reliability of electric wheeling" judged by reference to "consistently applied regional or national reliability standards, guidelines or criteria;" (2) would result in "retail wheeling;" or (3) would conflict with state laws governing retail marketing areas of electric utilities. Electric utilities, including exempt and non-exempt holding companies, may own and operate EWGs subject to advance approval by state utility commissions, which are given access to books and records of the EWG and its affiliates to the extent that such a commission requires access to perform its regulatory duties. It allows both registered and exempt utility holding companies to acquire interests in foreign utility companies engaged in the generation, transmission or distribution of electricity or the retail distribution of gas, where a state commission has certified that it has the ability to protect the utility's retail ratepayers against adverse investments in foreign utilities by affiliates of public utilities that such commissions regulate. State Commissions must consider rate making changes and other regulatory reform to ensure that electric utilities' investments in energy efficiency and demand side management programs are at least as profitable as investing in new generating capacity. FERC has issued a Notice of Proposed Rule Making to develop regulations under NEPA concerning EWGs and electric transmission service. NEPA also has provisions concerning nuclear power, alternate fuel vehicles, minimum efficiency standards, integrated resource planning, demand side management incentives, a variety of energy research projects relating to environmental measures, electric and magnetic fields, hydroelectric projects, and global warming. It authorizes one step licensing for nuclear power plants and requires EPA to issue standards for the Yucca Mountain repository site for nuclear waste (see "Nuclear Fuel Disposal" under "Environmental Control Matters"). To reduce dependence on imported oil, NEPA imposes purchase requirements for alternate fuel vehicles for federal, state, municipal and private fleets which increase over a period of years (see "Gas Operations"). In the opinion of the Company, it will be able to meet successfully the challenges of an altered business climate for electric and gas utilities and natural gas businesses. Neither the application of NEPA or FERC Order No. 636 to it and its subsidiaries, nor the development of an EWG industry, new markets and obligations for transmission services for wholesale sales of electricity, nor deregulated interstate natural gas markets is expected to have a material adverse impact on the results of its operations, its financial position or its business prospects. Federal Energy Regulatory Commission SCE&G and GENCO are subject to regulatory jurisdiction under the Federal Power Act, administered by the FERC and the DOE, in the transmission of electric energy in interstate commerce and in the sale of electric energy at wholesale for resale, as well as with respect to licensed hydroelectric projects and certain other matters, including accounting and the issuance of short-term promissory notes. SCE&G holds licenses under the Federal Water Power Act or the Federal Power Act with respect to all its hydroelectric projects. The expiration dates of the licenses covering the projects are as follows: Neal Shoals (5,000 KW capability) and Stevens Creek (9,000 KW capability) 1993; Columbia (10,000 KW capability) 2000; Saluda Project (206,000 KW capability) 2007; and Parr Shoals (14,000 KW capability) and Fairfield Pumped Storage Project (512,000 KW capability) 2020. Pursuant to the provisions of the Federal Power Act as amended by the Electric Consumers Protection Act of 1986, applications for new licenses for Neal Shoals and Stevens Creek were filed with the FERC on December 30, 1991. No competing applications were filed. The Neal Shoals license application was accepted for filing by the FERC on September 30, 1992 and the Stevens Creek application was accepted September 15, 1993. FERC has issued Notices of Authorization for Continued Project Operation for both projects until FERC has acted on SCE&G's applications for new licenses. FERC has announced its intentions to perform a Multiple-project Environmental Assessment for Neal Shoals, and a Multiple-project Environmental Impact Statement for Stevens Creek. At the termination of a license under the Federal Power Act, the United States Government may take over the project covered thereby, or the FERC may extend the license or issue a license to another applicant. If the United States takes over a project or the FERC issues a license to another applicant, the original licensee shall be paid its net investment in the project (not to exceed fair value) plus severance damages. Nuclear Regulatory Commission SCE&G is subject to regulation by the NRC with respect to the ownership and operation of Summer Station. The NRC's jurisdiction encompasses broad supervisory and regulatory powers over the construction and operation of nuclear reactors, including matters of health and safety, antitrust considerations and environmental impact. The NRC conducts semiannual reviews that identify plants that have demonstrated an excellent level of safety performance. Summer Station was recognized in both 1993 reviews as one of the top nuclear plants in the country. In addition, the Federal Emergency Management Agency is responsible for the review, in conjunction with the NRC, of certain aspects of emergency planning relating to the operation of nuclear plants. RATE MATTERS The following table presents a summary of significant rate activity for the years 1990 - 1993 based on test years: On June 7, 1993 the PSC issued an order on the Company's pending electric rate proceeding allowing an authorized return on common equity of 11.5%, resulting in a 7.4% annual increase in retail electric rates, or a projected $60.5 million annually based on a test year. These rates are to be implemented in two phases over a two-year period: phase one, effective June 1993, producing $42.0 million annually, and phase two, effective June 1994, producing $18.5 million annually, based on a test year. The Company's request, as modified, had proposed a return on equity of 12.05% and had projected annual increases of $53.0 million and $19.0 million for phases one and two, respectively. On September 14, 1992 the PSC issued an order granting SCE&G a $.25 increase in transit fares from $.50 to $.75 in both Columbia and Charleston, South Carolina; however, the PSC also required $.40 fares for low income customers and denied SCE&G's request to reduce the number of routes and frequency of service. The new rates were placed into effect on October 5, 1992. SCE&G has appealed the PSC's order to the Circuit Court. During oral arguments in February 1994 the Circuit Court retained jurisdiction and remanded the decision to the PSC for the limited purpose of answering questions concerning the applicable regulatory principles used by the PSC in determining these transit rates. Since November 1, 1991 SCE&G's gas rate schedules for its residential, small commercial and small industrial customers have included a weather normalization adjustment (WNA). The WNA minimizes fluctuations in gas revenues due to abnormal weather conditions and has been approved through November 1994 subject to an annual review by the PSC. The PSC order was based on a return on common equity of 12.25%. The WNA became effective the first billing cycle in December 1991. In May 1989 the PSC approved a volumetric and direct billing method for Pipeline Corporation to recover take-or-pay costs incurred from its interstate pipeline suppliers pursuant to FERC-approved final and non-appealable settlements. In December 1992 the Supreme Court approved Pipeline Corporation's full recovery of the take-or-pay charges imposed by its suppliers and treatment of these charges as a cost of gas. However, the Supreme Court declared the PSC-approved "purchase deficiency" methodology for recovery of these costs to be unlawful retroactive ratemaking and remanded the docket to the PSC to reconsider its recovery methodology. The Company believes that the elimination of the purchase deficiency method of recovery will affect the timing for recovery of take-or-pay charges and shift the allocations among Pipeline Corporation's customers (including SCE&G) but that all such charges should be ultimately recovered. The case has been remitted to the PSC by the Supreme Court and the Company anticipates the PSC will issue an Order authorizing full recovery of incurred take-or-pay costs on a prospective volumetric basis after the completion of accounting verification by the PSC Staff of the principal and associated interest costs. On August 8, 1990 the PSC issued an order effective November 1, 1990, approving changes in Pipeline Corporation's gas rate design for sales for resale service and upholding the "value-of- service" method of regulation for its direct industrial service. Direct industrial customers seeking "cost-of-service" based rates initiated two separate appeals to the Circuit Court, which reversed and remanded to the PSC its August 8, 1990 order. Pipeline Corporation appealed that decision to the Supreme Court which reversed the two Circuit Court decisions and reinstated the PSC Order. The Supreme Court held that the industrial customer group's appeal was premature and failed to exhaust administrative remedies. Additionally, the Supreme Court interpreted the rate- making statutes of South Carolina to give discretion to the PSC in selecting the methodology to be used in setting rates for natural gas service. On July 3, 1989 the PSC granted SCE&G approximately $21.9 million of a requested $27.2 million annual increase in retail electric revenues based upon an allowed return on common equity of 13.25%. The Consumer Advocate appealed the decision to the Supreme Court which, on August 31, 1992, found that the evidence in the record of that case did not support a return on common equity higher than 13.0% and remanded to the PSC a portion of its July 1989 order for a determination of the proper return on common equity consistent with the Supreme Court's opinion. On January 19, 1993 the PSC issued an order allowing a return on common equity of 13.0%, approving a refund based on the difference in rates created by the difference between the 13.0% and the 13.25% return on common equity and making other non- material adjustments to the calculation of cost-of-service. The total refund, before interest and income taxes, was approximately $14.6 million and was charged against 1992 "Electric Revenues." The refund plus interest was made during 1993. On November 28, 1989 the PSC granted SCE&G an increase in firm retail natural gas rates, effective November 30, 1989, designed to increase annual revenues by $10.1 million, or 89.5% out of the requested increase of approximately $11.3 million. In its order the PSC authorized a 12.75% return on common equity. The Consumer Advocate appealed to the Supreme Court which on August 31, 1992 remanded the order to the PSC for redetermination of the proper amount of litigation expenses to include in the test period. In January 1993 the PSC reduced the amount of litigation expense and ordered a refund totaling approximately $163,000 which was charged against 1992 "Gas Revenues." The refund was made during 1993. Fuel Cost Recovery Procedures The PSC has established a fuel recovery procedure which determines the fuel component in SCE&G's retail electric base rates semiannually based on projected fuel costs for the ensuing six-month period, adjusted for any overcollection or undercollection from the preceding six-month period. SCE&G has the right to request a formal proceeding at any time should circumstances dictate such a review. In the April 1993 semiannual review of the fuel cost component of electric rates, the PSC voted to reduce the rate from 13.5 mills per KWH to 13.0 mills per KWH, a monthly decrease of $.50 for an average customer using 1,000 KWH per month. This reduction coincided with the retail electric rate case effective June 1993. For the October 1993 review the PSC voted to continue the rate of 13.0 mills per KWH. SCE&G's gas rate schedules and contracts include mechanisms which allow it to recover from its customers changes in the actual cost of gas. SCE&G's firm gas rates allow for the recovery of a fixed cost of gas, based on projections, as established by the PSC in annual gas cost and gas purchase practice hearings. Any differences between actual and projected gas costs are deferred and included when projecting gas costs during the next annual gas cost recovery hearing. In the October 1993 review the PSC authorized an increase in the base cost of gas from 41.963 cents per therm to 47.100 cents per therm which resulted in a monthly increase of $5.14 (including applicable taxes) based on an average of 100 therms per month on a residential bill during the heating season. In July 1990 the PSC initiated proceedings for a generic hearing on the Industrial Sales Program Rider (ISPR) for SCE&G and Pipeline Corporation. The PSC issued an order dated December 20, 1991 approving a Stipulation and Agreement signed in December 1991 by all parties involved which retained the ISPR with modifications to Pipeline Corporation's gas cost mechanisms. ENVIRONMENTAL CONTROL MATTERS General Federal and state authorities have imposed environmental control requirements relating primarily to air emissions, wastewater discharges and solid, toxic and hazardous waste management. The Company is attempting to ensure that its operations meet applicable environmental regulations and standards. It is difficult to forecast the ultimate effect of environmental quality regulations upon the existing and proposed operations. Moreover, developments in these and other areas may require that equipment and facilities be modified, supplemented or replaced. Capital Expenditures In the years 1991 through 1993, capital expenditures for environmental control amounted to approximately $83.9 million. In addition, approximately $9.4 million, $7.9 million, and $6.5 million of environmental control expenditures were made during 1993, 1992 and 1991, respectively, which are included in "Other operation" and "Maintenance" expenses. It is not possible to estimate all future costs for environmental purposes but forecasts for minimum capitalized expenditures are $44.7 million for 1994 and $320.8 million for the four-year period 1995 through 1998. These expenditures are included in the Company's construction program. Air Quality Control The Federal Clean Air Act of 1970 (the "1970 Act") requires that electric generating plants comply with primary and secondary ambient air quality standards with respect to certain air pollutants including particulates, sulfur oxides and nitrogen oxides and imposes economic penalties for noncompliance. This Act was amended with the passage of the Clean Air Act Amendments of 1990. Currently, the Company uses a variety of methods to comply with the State Implementation Plan (developed pursuant to the 1970 Act), including the use of low sulfur fuel, fuel switching, reduction of load during periods when compliance cannot be met at full power, maintenance and improvement of existing electrostatic precipitators and the installation of new baghouses. SCE&G and GENCO have been able to purchase sufficient fuel meeting current sulfur standards for all of their plants. With respect to sulfur dioxide emissions, none of the Company's electric generating plants is included among the Phase I plants listed in the Clean Air Act Amendments of 1990 with a compliance date of January 1, 1995. Both companies will, however, be affected by Phase II requirements, which have a compliance date of January 1, 2000. The companies undertook a study in 1992 to determine the most cost-effective mix of control options to meet the requirements of the Clean Air Act. Such a control strategy will most likely result in requiring SCE&G and GENCO to utilize a combination of the following alternatives to meet its compliance requirements: (1) burn lower sulfur coal, (2) burn natural gas, (3) retrofit at least one coal-fired electric generating unit with a scrubber to remove sulfur dioxide and (4) purchase sulfur dioxide emission allowances to the extent necessary. In addition, the Company will install on most of its coal-fired units low nitrogen oxide burners to reduce nitrogen oxide emissions. The Company currently estimates that air emissions control equipment will require capital expenditures of $252 million over the 1994-1998 period to retrofit existing facilities and an increased operation and maintenance cost of $31 million per year. Total capital expenditures required to meet compliance requirements through the year 2003 are anticipated to be approximately $275 million. Water Quality Control The Federal Clean Water Act, as amended, provides for the imposition of effluent limitations that require various levels of treatment for each wastewater discharge. Under this Act, compliance with applicable limitations is achieved under a national permit program. Discharge permits have been issued for all and renewed for nearly all of SCE&G's and GENCO's generating units. Commensurate with renewal of these permits has been implementation of a more rigorous control program on behalf of the permitting agency. The facilities have been developing compliance plans to meet the additional parameters of control and compliance has involved updating wastewater treatment technologies. Amendments to the Clean Water Act proposed recently in Congress include several provisions which could prove costly to SCE&G. These include limitations to mixing zones and the implementation of technology-based standards. Superfund Act and Environmental Assessment Program As described in Note 1L of Notes to Consolidated Financial Statements, the Company has an environmental assessment program to identify and assess current and former operations sites that could require environmental cleanup. As site assessments are initiated, an estimate is made of the amount of expenditures, if any, necessary to investigate and clean up each site. These estimates are refined as additional information becomes available; therefore actual expenditures could significantly differ from the original estimates. Amounts estimated and accrued to date ($19.6 million) for site assessments and cleanup relate primarily to regulated operations; such amounts have been deferred and are being amortized and recovered through rates over a ten-year period. Estimates to date include, among other things, the costs estimated to be associated with the matters discussed in the following paragraphs. The Company and its principal subsidiary, SCE&G, each own two decommissioned manufactured gas plant sites which contain residues of by-product chemicals. The Company and SCE&G have each maintained an active review of their respective sites to monitor the nature and extent of the residual contamination. In September 1992 the EPA notified SCE&G, the City of Charleston and the Charleston Housing Authority of their potential liability for the investigation and cleanup of the Calhoun Park Area Site in Charleston, South Carolina. This site originally encompassed approximately 18 acres and included properties which were the locations for industrial operations, including a wood preserving (creosote) plant and one of SCE&G's decommissioned manufactured gas plants. The original scope of this investigation has been expanded to approximately 30 acres including adjacent properties owned by the National Park Service and the City of Charleston, and private properties. The site has not been placed on the National Priority List, but may be added before cleanup is initiated. The potentially responsible parties (PRP) have agreed with the EPA to participate in an innovative approach to site investigation and cleanup called "Superfund Accelerated Cleanup Model," allowing the pre-cleanup site investigations process to be compressed significantly. The PRPs have negotiated an administrative order by consent for the conduct of a Remedial Investigation/Feasibility Study (RI/FS) and a corresponding Scope of Work. Actual field work began November 1, 1993 after final approval and authorization was granted by EPA. SCE&G is also working with the City of Charleston to investigate potential contamination from the manufactured gas plant at the city's aquarium site. During 1993 SCE&G settled its obligations at the Yellow Water Road Superfund Site near Jacksonville, Florida, the Spencer Transformer and Equipment Site in West Virginia and Elliott's Auto Parts in Benton, Arkansas. No further expenses are anticipated for these sites. SCE&G has been listed as a PRP and has recorded liabilities, which are not considered material, for the Macon-Dockery waste disposal site near Rockingham, North Carolina, the Aqua-Tech Environmental, Inc. site in Greer, South Carolina and a landfill owned by Lexington County in South Carolina. Solid Waste Control The South Carolina Solid Waste Policy and Management Act of 1991 requires promulgation of regulations addressing specified subjects, one of which affects the management of industrial solid waste. This regulation will establish minimum criteria for industrial landfills as mandated under the Act. The proposed regulation, if adopted as a final regulation in its present form, could significantly impact SCE&G's and GENCO's engineering, design and operation of existing and future ash management facilities. Potential cost impacts could be substantial. Nuclear Fuel Disposal The Nuclear Waste Policy Act of 1982 (the "1982 Act") requires that the Federal Government make available by 1998 a permanent repository for high level radioactive waste and spent nuclear fuel and imposes a fee of 1.0 mill per KWH of net nuclear generation after April 7, 1983. Payments, which began in 1983, are subject to change and will extend through the life of SCE&G's Summer Station. SCE&G entered into a contract with the DOE on June 29, 1983 providing for permanent disposal of its spent nuclear fuel by the DOE. The DOE presently estimates that the permanent storage facility will not be available until 2010. SCE&G has on-site spent fuel storage capability until at least 2008 and expects to be able to expand its storage capacity to accommodate the spent fuel output for the life of the plant through rod consolidation, dry cask storage or other technology as it becomes available. The 1982 Act also imposes on utilities the primary responsibility for storage of their spent nuclear fuel until the repository is available. (See "Fuel Supply" under "Electric Operations" for a discussion of spent fuel storage facilities at Summer Station.) OTHER MATTERS With regard to SCE&G's insurance coverage for Summer Station, reference is made to Note 10B of Notes to Consolidated Financial Statements, which is incorporated herein by reference. ITEM 2.

ITEM 2. PROPERTIES The parent company, SCANA Corporation, owns no property other than the capital stock of each of its subsidiaries. It owns all of the capital stock of each subsidiary except for the Preferred Stock of SCE&G and the capital stock of SCANA's indirect, wholly owned subsidiaries which are not material individually or in the aggregate. The assets formerly belonging to Peoples, which were owned by SCANA Corporation, were transferred to SCE&G on January 1, 1994. Reference is made to Schedule V - Property Plant and Equipment, pages 65 through 70, for information concerning investments in utility plant and nonutility property. SCE&G's bond indentures, securing the First and Refunding Mortgage Bonds and First Mortgage Bonds issued thereunder, constitute direct mortgage liens on substantially all of its property. GENCO's Williams Station is subject to a first mortgage lien. For a brief description of the properties of the Company's other subsidiaries, which are not significant as defined in Rule 1-02 of Regulation S-X, see Item 1., "Business." ELECTRIC The following table gives information with respect to electric generating facilities, all of which are owned by SCE&G except as noted. Net Generating Present Year Capability Facility Fuel Capability Location In-Service (KW)(1) Steam Urquhart Coal/Gas Beech Island, SC 1953 250,000 McMeekin Coal/Gas Irmo, SC 1958 252,000 Canadys Coal/Gas Canadys, SC 1962 430,000 Wateree Coal Eastover, SC 1970 700,000 Williams (2) Coal Goose Creek, SC 1973 560,000 Summer (3) Nuclear Parr, SC 1984 590,000 Gas Turbines Burton Gas/Oil Burton, SC 1961 28,500 Faber Place Gas Charleston, SC 1961 9,500 Hardeeville Oil Hardeeville, SC 1968 14,000 Canadys Gas/Oil Canadys, SC 1968 14,000 Urquhart Gas/Oil Beech Island, SC 1969 26,000 Coit Gas/Oil Columbia, SC 1969 30,000 Parr (4) Gas/Oil Parr, SC 1970 60,000 Williams (5) Gas/Oil Goose Creek, SC 1972 49,000 Hagood Gas/Oil Charleston, SC 1991 95,000 Hydro Neal Shoals Carlisle, SC 1905 5,000 Parr Shoals Parr, SC 1914 14,000 Stevens Creek Martinez, GA 1914 9,000 Columbia Columbia, SC 1927 10,000 Saluda Irmo, SC 1930 206,000 Pumped Storage Fairfield Parr, SC 1978 512,000 Total 3,864,000 (1) Summer rating. (2) The steam unit at Williams Station, owned by GENCO, was converted from oil-fired to coal-fired operation in 1984 and, with modifications, can be reconverted to oil-fired operation should the need arise. (3) Represents SCE&G's two-thirds portion of the Summer Station. (4) Two of the four Parr gas turbines are leased and have a net capability of 34,000 KW. This lease expires on June 29, 1996. (5) The two gas turbines at Williams are leased and have a net capability of 49,000 KW. This lease expires on June 29, 1997. SCE&G owns 424 substations having an aggregate transformer capacity of 18,624,780 KVA. The transmission system consists of 3,033 miles of lines and the distribution system consists of 15,186 pole miles of lines and 3,006 trench miles of underground lines. GAS Natural Gas SCE&G's gas system, including the system acquired by the Company from Peoples and transferred to SCE&G on January 1, 1994, consists of approximately 6,629 miles of three-inch equivalent distribution pipelines and approximately 10,864 miles of distribution mains and related service facilities. Pipeline Corporation's gas system consists of approximately 1,735 miles of transmission pipeline of up to 24 inches in diameter which connect its resale customers' distribution systems with transmission systems of Southern Natural and Transco. Pipeline Corporation owns two LNG plants, one located near Charleston, South Carolina the other in Salley, South Carolina. The Charleston facility can liquefy up to 6,000 MCF per day and store the liquefied equivalent of 1,000,000 MCF of natural gas. The Salley facility, which became operational in 1994, can store the liquefied equivalent of 900,000 MCF of natural gas and has no liquefying capabilities. On peak days, the Charleston facility can regasify up to 60,000 MCF per day and the Salley facility can regasify up to 90,000 MCF. Petroleum Resources owns and operates oil and gas producing properties with net proven reserves in Texas, Louisiana, Mississippi, Oklahoma, California, Arkansas, Nebraska, Colorado, Kansas, Montana, North Dakota, Michigan, Illinois, New Mexico, Alabama, Wyoming and Federal Waters offshore Texas and Louisiana. Propane SCE&G has propane air peak shaving facilities which can supplement the supply of natural gas by gasifying propane to yield the equivalent of 102,000 MCF per day of natural gas. TRANSIT SCE&G owns 93 motor coaches which operate on a route system of 285 miles. ITEM 3.

ITEM 3. LEGAL PROCEEDINGS For information regarding legal proceedings, see ITEM 1., "BUSINESS" and Note 10 of Notes to Consolidated Financial Statements appearing in Item 8., "FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA." ITEM 4.

ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS Not Applicable CORPORATE STRUCTURE SCANA CORPORATION A Holding Company, Owning Eleven Direct, Wholly Owned Subsidiaries SOUTH CAROLINA MPX SYSTEMS, INC. ELECTRIC & GAS COMPANY Provides fiber optic Generates and sells electricity telecommunications, video to wholesale and retail customers, conferencing and specialized purchases, sells and transports mobile radio services. natural gas at retail and provides public transit service in Columbia SCANA DEVELOPMENT and Charleston. CORPORATION Engages in the acquisition, SOUTH CAROLINA GENERATING development, management and COMPANY, INC. sale of real estate. Owns and operates Williams Station and sells electricity PRIMESOUTH, INC. to SCE&G. Engages in power plant management and maintenance SOUTH CAROLINA FUEL services. COMPANY, INC. Acquires, owns and provides for SCANA HYDROCARBONS, INC. financing for SCE&G's nuclear and Markets natural gas as well fossil fuel requirements. as other light hydrocarbons. Owns and operates a propane SUBURBAN PROPANE GROUP, INC. pipeline and provides for Purchases, delivers and transportation and bulk sells propane. storage of propane. SCANA CAPITAL RESOURCES, INC. SCANA PETROLEUM RESOURCES, INC. Has provided equity capital Owns and operates oil and gas for diversified investments. producing properties. SOUTH CAROLINA PIPELINE CORPORATION Purchases, sells and transports natural gas to wholesale and direct industrial customers. Owns and operates an LNG plant for the liquefaction, regasification and storage of natural gas. Each of the above listed companies is organized and incorporated under the laws of the State of South Carolina. EXECUTIVE OFFICERS OF THE REGISTRANT The executive officers are elected at the annual organizational meeting of the Board of Directors, held immediately after the annual meeting of stockholders, and hold office until the next such organization meeting, unless the Board of Directors shall otherwise determine, or unless a resignation is submitted. Positions Held During Name Age Past Five Years Dates L.M. Gressette, Jr. 62 Chairman of the Board, Chief Executive Officer and President 1990-present President 1989-1990 B.D. Kenyon 51 President and Chief Operating Officer, SCE&G 1990-present Senior Vice President - Division Operations, Pennsylvania Power and Light Company *-1990 C.B. Novinger 44 Senior Vice President - Administration *-present W.B. Timmerman 47 Senior Vice President, Chief Financial Officer and Controller *-present Max Earwood 61 President and Treasurer - South Carolina Pipeline Corporation *-present President and Treasurer - SCANA Hydrocarbons, Inc.; SCANA Petroleum Resources, Inc.; and Carolina Exploration Corporation *-present Vice President - Gas Distribution, SCE&G *-1991 K.B. Marsh 38 Vice President - Finance, Treasurer & Secretary 1992-present Vice President of Corporate Planning - SCE&G 1991 Vice President and Controller - SCE&G 1989-1991 *Indicates position held at least since March 1, 1989 ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS LIQUIDITY AND CAPITAL RESOURCES The cash requirements of the Company arise primarily from SCE&G's operational needs, the Company's construction program and the need to fund the activities or investments of the Company's nonregulated subsidiaries. The ability of the Company's regulated subsidiaries to replace existing plant investment, as well as to expand to meet future demand for electricity and gas, will depend upon their ability to attract the necessary financial capital on reasonable terms. The Company's regulated subsidiaries recover the costs of providing services through rates charged to customers. Rates for regulated services are generally based on historical costs. As customer growth and inflation occur and the regulated subsidiaries expand their construction programs, it is necessary to seek increases in rates. As a result the Company's future financial position and results of operations will be affected by the regulated subsidiaries' ability to obtain adequate and timely rate relief. Due to continuing customer growth, SCE&G entered into a contract with Duke/Fluor Daniel in 1991 to design, engineer and build a 385 MW coal-fired electric generating plant near Cope, South Carolina in Orangeburg County. Construction of the plant began in November 1992 with commercial operation expected in late 1995 or early 1996. The estimated price of the Cope plant, excluding financing costs and AFC but including an allowance for escalation, is $450 million. In addition, the transmission lines for interconnection with the Company's system are expected to cost $26 million. Until the completion of the new plant, SCE&G is contracting for additional capacity as necessary to ensure that the energy demands of its customers can be met. As discussed in Note 2A of Notes to Consolidated Financial Statements, on June 7, 1993 the PSC issued an order granting SCE&G a 7.4% annual increase in retail electric rates to be implemented in two phases of $42.0 million annually effective June 1993 and $18.5 million annually effective June 1994, based on a test year. The estimated primary cash requirements for 1994, excluding requirements for fuel liabilities and short-term borrowings, and the actual primary cash requirements for 1993 are as follows: 1994 1993 (Thousands of Dollars) Property additions and construction expenditures, excluding allowance for funds used during construction (AFC) $506,010 $381,141 Acquisition of oil and gas producing properties - 122,621 Nuclear fuel expenditures 28,064 7,177 Maturing obligations, redemptions and sinking and purchase fund requirements 25,627 16,530 Total $559,701 $527,469 Approximately 28% of total cash requirements (excluding dividends) was provided from internal sources in 1993 as compared to 40% in 1992. The Company has in effect a medium-term note program for the issuance from time to time of unsecured medium-term debt securities. The proceeds from the sales of these securities may be used to fund additional business activities in nonutility subsidiaries, to reduce short-term debt incurred in connection therewith or for general corporate purposes. In 1993 the Company issued $60 million of such medium-term notes. The proceeds from the sales of these securities were used for the funding of nonutility subsidiary activities. At December 31, 1993 the Company had available for issuance $67.6 million under the current registration statement. SCE&G's First and Refunding Mortgage Bond Indenture, dated April 1, 1945 (Old Mortgage), contains provisions prohibiting the issuance of additional bonds thereunder (Class A Bonds) unless net earnings (as therein defined) for 12 consecutive months out of the 15 months prior to the month of issuance is at least twice the annual interest requirements on all Class A Bonds to be outstanding (Bond Ratio). For the year ended December 31, 1993 the Bond Ratio was 3.70. The issuance of additional Class A Bonds is restricted also to an additional principal amount equal to 60% of unfunded net property additions (which unfunded net property additions totaled approximately $219.9 million at December 31, 1993), Class A Bonds issued on the basis of retirements of Class A Bonds (which retirement credits totaled $10.9 million at December 31, 1993), and Class A Bonds issued on the basis of cash on deposit with the Trustee. SCE&G has placed a new bond indenture (New Mortgage) dated April 1, 1993 on substantially all of its electric properties under which its future mortgage-backed debt (New Bonds) will be issued. New Bonds are expected to be issued under the New Mortgage on the basis of a like principal amount of Class A Bonds issued under the Old Mortgage which have been deposited with the Trustee of the New Mortgage (of which $157 million were available for such purpose as of December 31, 1993), until such time as all presently outstanding Class A Bonds are retired. Thereafter, New Bonds will be issuable on the basis of property additions in a principal amount equal to 70% of the original cost of electric and common plant properties (compared to 60% of value for Class A Bonds under the Old Mortgage), cash deposited with the Trustee, and retirement of New Bonds. New Bonds will be issuable under the New Mortgage only if adjusted net earnings (as therein defined) for 12 consecutive months out of the 18 months immediately preceding the month of issuance are at least twice the annual interest requirements on all outstanding bonds (including Class A Bonds) and New Bonds to be outstanding (New Bond Ratio). For the year ended December 31, 1993 the New Bond Ratio was 5.0. On April 29, 1993 the Securities and Exchange Commission (SEC) declared effective a registration statement for the issuance of up to $700 million of New Bonds. The following series, aggregating $600 million, have been issued under such registration statement: On June 9, 1993, $100 million, 7 5/8% Series due June 1, 2023 to repay short-term borrowings in a like amount. On July 1, 1993, $100 million, 6% Series due June 15, 2000; and $150 million, 7 1/8% Series due June 15, 2013; and on July 20, 1993, $150 million, 7 1/2% Series due June 15, 2023, to redeem, on July 20, 1993, $382,035,000 of First and Refunding Mortgage Bonds maturing between 1999 and 2017 and bearing interest at rates between 8% and 9 7/8% per annum. On December 20, 1993, $100 million, 6 1/4% Series due December 15, 2003 to repay short-term borrowings in a like amount. The following additional financing transactions have occurred since December 31, 1992: On January 15, 1993 the Company closed on an unsecured bank loan in the principal amount of $60 million, due January 14, 1994, and used the proceeds to pay off a loan in a like amount. The interest rate is the three month LIBOR plus 30 basis points and is reset quarterly. On January 14, 1994 the Company refinanced the loan with unsecured bank loans totaling $60 million, due January 13, 1995 at interest rates between 3.875% and 3.89%. On April 15, 1993 the Company arranged for a $15 million term loan, due April 14, 1994, to repay short-term borrowings in a like amount. The interest rate is the three month LIBOR plus 16 basis points and is reset quarterly. On June 1, 1993 SCE&G redeemed the following amounts of First and Refunding Mortgage Bonds: $35 million, 10 1/8% Series due 2009 and $13 million, 9 7/8% Series due 2009. On June 2, 1993 the Company entered into a $123 million 90-day bank loan (90-day bank loan) to finance the acquisition by Petroleum Resources of approximately 125 billion cubic feet equivalent of natural gas reserves through the purchase of NICOR Exploration and Production Company (NICOR). On July 1, 1993 the Company issued $60 million of medium-term notes bearing interest at the following rates and maturing on the following dates in the following amounts: $20 million, 5.76%, due July 1, 1998; $20 million, 6.15%, due July 3, 2000; and $20 million, 6.51%, due July 1, 2003. The proceeds were used to repay a portion of the 90-day bank loan discussed above. In early August 1993 the Company issued 1,467,000 shares of common stock with net proceeds totaling $69,345,090. The proceeds were used to repay the remainder of the 90-day bank loan discussed above and for general corporate purposes. On September 30, 1993 Pipeline Corporation sold unsecured promissory notes totaling $25 million, 6.72% due September 30, 2013. The proceeds were used to repay short-term borrowings in a like amount. Without the consent of at least a majority of the total voting power of SCE&G's preferred stock, SCE&G may not issue or assume any unsecured indebtedness if, after such issue or assumption, the total principal amount of all such unsecured indebtedness would exceed 10% of the aggregate principal amount of all of SCE&G's secured indebtedness and capital and surplus; provided, however, that no such consent shall be required to enter into agreements for payment of principal, interest and premium for securities issued for pollution control purposes. Pursuant to Section 204 of the Federal Power Act, SCE&G and GENCO must obtain FERC authority to issue short-term indebtedness. The FERC has authorized SCE&G to issue up to $200 million of unsecured promissory notes or commercial paper with maturity dates of 12 months or less but not later than December 31, 1995. GENCO has not sought such authorization. The Company had $175.0 million authorized lines of credit and had unused lines of credit of $148.0 million at December 31, 1993. In addition, the Company has a credit agreement for a maximum of $75 million to finance nuclear and fossil fuel inventories, with $38.2 million available at December 31, 1993. SCE&G's Restated Articles of Incorporation prohibit issuance of additional shares of preferred stock without consent of the preferred stockholders unless net earnings (as defined therein) for the 12 consecutive months immediately preceding the month of issuance is at least one and one-half times the aggregate of all interest charges and preferred stock dividend requirements (Preferred Stock Ratio). For the year ended December 31, 1993 the Preferred Stock Ratio was 2.52. On October 12, 1993 the Company registered with the SEC 2,000,000 additional shares of the Company's common stock to be issued and sold under the Dividend Reinvestment and Stock Purchase Plan (DRP). During 1993 the Company issued 529,954 shares of the Company's common stock under the DRP. In addition, the Company issued 705,498 shares of its common stock pursuant to its Stock Purchase-Savings Plan (SPSP). The Company has authorized and reserved for issuance, and registered under effective registration statements, 2,065,824 and 872,420 shares of common stock pursuant to the DRP and the SPSP, respectively. In January 1994 the Company signed an agreement to sell in 1994 substantially all of the real estate assets of SCANA Development Corporation (Development Corporation) to Liberty Properties Group, Inc. of Greenville, South Carolina for $91.5 million. Under the terms of the agreement, a portion of the sales price will be received in cash at the time of closing. The remainder of the sales price, which is related to certain projects currently under construction, will be received in cash as those projects are completed. On March 4, 1994 the Company and Liberty amended the agreement regarding the sale. Under the terms of the amended agreement certain projects currently under construction will be excluded from the transaction and the sales price will be $49.6 million. All of the sales price will be received at the time of closing. The net proceeds from the sale will be used to retire Development Corporation's debt and for general corporate purposes, including the funding of other nonutility subsidiaries' business activities. The transaction will not have a material impact on the Company's financial position or results of operations. The Company anticipates that its 1994 cash requirements of $559.7 will be met through internally generated funds (approximately 38% excluding dividends), the sales of additional equity securities and the incurrence of additional short-term and long-term indebtedness. The timing and amount of such financing will depend upon market conditions and other factors. Actual 1994 expenditures may vary from the estimates set forth above due to factors such as inflation and economic conditions, regulation and legislation, rates of load growth, environmental protection standards and the cost and availability of capital. The Company expects that it has or can obtain adequate sources of financing to meet its projected cash requirements. Environmental Matters The Clean Air Act requires electric utilities to reduce substantially emissions of sulfur dioxide and nitrogen oxide by the year 2000. These requirements are being phased in over two periods. The first phase has a compliance date of January 1, 1995 and the second, January 1, 2000. The Company meets all requirements of Phase I and therefore will not have to implement changes until compliance with Phase II requirements is necessary. The Company then will most likely meet its compliance requirements through the burning of natural gas and/or lower sulfur coal, the addition of scrubbers to coal-fired generating units, and the purchase of sulfur dioxide emission allowances. Low nitrogen oxide burners will be installed to reduce nitrogen oxide emissions. The Company is continuing to refine a compliance plan that must be filed with the U.S. Environmental Protection Agency (EPA) by January 1, 1996. The Company currently estimates that air emissions control equipment will require capital expenditures of $252 million over the 1994-1998 period to retrofit existing facilities and an increased operation and maintenance cost of $31 million per year. To meet compliance requirements through the year 2003, the Company anticipates total capital expenditures of $275 million. The South Carolina Solid Waste Policy and Management Act of 1991 requires promulgation of regulations addressing specified subjects, one of which affects the management of industrial solid waste. This regulation will establish minimum criteria for industrial landfills as mandated under the Act. The proposed regulation, if adopted as a final regulation in its present form, could significantly impact SCE&G's and GENCO's engineering, design and operation of existing and future ash management facilities. Potential cost impacts could be substantial. As described in Note 1L of Notes to Consolidated Financial Statements, the Company has an environmental assessment program to identify and assess current and former operations sites that could require environmental cleanup. As site assessments are initiated, an estimate is made of the amount of expenditures, if any, necessary to investigate and clean up each site. These estimates are refined as additional information becomes available; therefore actual expenditures could significantly differ from the original estimates. Amounts estimated and accrued to date ($19.6 million) for site assessments and cleanup of regulated operations have been deferred and are being amortized and recovered through rates over a ten-year period. Estimates to date include, among other things, the costs estimated to be associated with the matters discussed in the following paragraphs. The Company and its principal subsidiary, SCE&G, each own two decommissioned manufactured gas plant sites which contain residues of by-product chemicals. The Company and SCE&G have each maintained an active review of their respective sites to monitor the nature and extent of the residual contamination. In September 1992 the EPA notified SCE&G, the City of Charleston and the Charleston Housing Authority of their potential liability for the investigation and cleanup of the Calhoun Park Area Site in Charleston, South Carolina. This site originally encompassed approximately 18 acres and included properties which were the locations for industrial operations, including a wood preserving (creosote) plant and one of SCE&G's decommissioned manufactured gas plants. The original scope of this investigation has been expanded to approximately 30 acres including adjacent properties owned by the National Park Service and the City of Charleston, and private properties. The site has not been placed on the National Priority List, but may be added before cleanup is initiated. The potentially responsible parties (PRP) have agreed with the EPA to participate in an innovative approach to site investigation and cleanup called "Superfund Accelerated Cleanup Model," allowing the pre-cleanup site investigations process to be compressed significantly. The PRPs have negotiated an administrative order by consent for the conduct of a Remedial Investigation/Feasibility Study (RI/FS) and a corresponding Scope of Work. Actual field work began November 1, 1993 after final approval and authorization was granted by EPA. SCE&G is also working with the City of Charleston to investigate potential contamination from the manufactured gas plant at the city's aquarium site. During 1993 SCE&G settled its obligations at the Yellow Water Road Superfund Site near Jacksonville, Florida, the Spencer Transformer and Equipment Site in West Virginia and Elliott's Auto Parts in Benton, Arkansas. No further expenses are anticipated for these sites. SCE&G has been listed as a PRP and has recorded liabilities, which are not considered material, for the Macon-Dockery waste disposal site near Rockingham, North Carolina, the Aqua-Tech Environmental, Inc. site in Greer, South Carolina and a landfill owned by Lexington County in South Carolina. Litigation In January 1994 SCE&G, acting on behalf of itself and the PSA (as co-owners of Summer Station), reached a settlement with Westinghouse Electric Corporation (Westinghouse) resolving a dispute involving steam generators provided by Westinghouse to Summer Station which are defective in design, workmanship and materials. Terms of the settlement are confidential. SCE&G had filed an action in May 1990 against Westinghouse in the U.S. District Court for South Carolina; an order dismissing this suit was issued on January 12, 1994. Regulatory Matters On June 7, 1993 the PSC issued an order on SCE&G's pending electric rate proceeding allowing an authorized return on common equity of 11.5%, resulting in a 7.4% annual increase in retail electric rates, or a projected $60.5 million annually on a test year basis. These rates are to be implemented in two phases over a two-year period: phase one, effective June 1993, producing $42.0 million annually, and phase two, effective June 1994, producing $18.5 million annually, on a test year basis. The Company's regulated business operations are likely to be impacted by the National Energy Policy Act (NEPA) and FERC Order No. 636. NEPA is designed to create a more competitive wholesale power supply market by creating "exempt wholesale generators" and by potentially requiring utilities owning transmission facilities provide transmission access to wholesalers. Order No. 636 is intended to deregulate the markets for interstate sales of natural gas by requiring that pipelines provide transportation services that are equal in quality for all gas suppliers whether the customer purchases gas from the pipeline or another supplier. In the opinion of the Company, it will be able to meet successfully the challenges of these altered business climates. Other In November 1992 the Financial Accounting Standards Board issued Statement No. 112 "Employers' Accounting for Postemployment Benefits." The Statement, which is effective for calendar year 1994, establishes certain conditions for the recognition of costs of benefits to former employees after employment but before retirement. The Statement requires recognition of the obligation to provide postemployment benefits if such obligation is attributable to services previously rendered, the obligation relates to rights which vest, payment of the benefits is probable and the amount of such benefits can be reasonably estimated. The Company does not anticipate that application of this Statement will have a significant impact on results of operations or financial position. RESULTS OF OPERATIONS Earnings and Dividends Earnings per share of common stock, the percent increase (decrease) from the previous year and the rate of return earned on common equity for the years 1991 through 1993 were as follows: 1993 1992 1991 Earnings per share $3.72 $2.84 $3.37 Percent increase (decrease) in earnings per share 31.0% (15.7%) (24.1%) Return earned on common equity (year-end) 12.6% 10.1% 13.2% 1993 Earnings per share and return on common equity increased in 1993 primarily due to a higher electric sales margin and additional nonoperating income. 1992 Earnings per share and return on common equity in 1992 decreased primarily due to the recording of an $11.1 million (after interest and income taxes) reserve against earnings related to the August 31, 1992 retail electric rate ruling from the South Carolina Supreme Court (see Note 2F of Notes to the Consolidated Financial Statements) and increases in other operating and interest expenses. The Company's financial statements include AFC. AFC is a utility accounting practice whereby a portion of the cost of both equity and borrowed funds used to finance construction (which is shown on the balance sheet as construction work in progress) is capitalized. Both an equity and debt portion of AFC are included in nonoperating income as noncash items which have the effect of increasing reported net income. AFC represented approximately 5.8% of income before income taxes in 1993, 5.5% in 1992 and 3.9% in 1991. In 1993 the Company's Board of Directors raised the quarterly cash dividend on common stock to 68.5 cents per share from 67 cents per share. The increase, effective with the dividend payable on April 1, 1993, raised the indicated annual dividend rate to $2.74 per share from $2.68. The Company has increased the dividend rate on its common stock in 40 of the last 41 years. Electric Operations Electric sales margins for 1993, 1992 and 1991 were as follows: 1993 1992 1991 (Millions of Dollars) Electric revenues $940.1 $829.5 $867.2 Less: Fuel used in electric generation 228.7 206.2 224.9 Purchased power 13.0 7.3 9.8 Margin $698.4 $616.0 $632.5 1993 The increase in electric sales margin from 1992 to 1993 is primarilya result of increased residential and commercial KWH sales due to weather and customer growth, an increase in retail electric rates beginning in June 1993 and the recording in 1992 of a $14.6 million reserve as discussed below. 1992 The 1992 electric sales margin decreased from 1991 due to therecording of a $14.6 million reserve, before interest and income taxes, related to the August 31, 1992 ruling from the South Carolina Supreme Court (see Note 2F of Notes to Consolidated Financial Statements) and a $1.9 million billing related litigation settlement included in 1991 electric operating revenues. Warmer weather and an increase in the number of electric customers resulted in an all-time peak demand record of 3,557 MW on July 29, 1993. The previous year's record of 3,380 MW was set on July 13, 1992. Gas Operations Gas sales margins for 1993, 1992 and 1991 were as follows: 1993 1992 1991 (Millions of Dollars) Gas revenues $320.2 $305.3 $276.7 Less: Gas purchased for resale 209.7 191.6 171.9 Margin $110.5 $113.7 $104.8 1993 In 1993 the gas sales margin decreased from 1992 as a result of higher gas prices which reduced Pipeline Corporation's sales due to the competitiveness of alternative fuels. This reduction was partially offset by increases in higher margin residential and commercial sales and increased transportation volumes. 1992 The gas sales margin for 1992 increased from 1991 as a result of recoveries of $4.2 million allowed under a weather normalization adjustment which became effective the first billing cycle in December 1991; increases in residential usage due to cooler weather during 1992; and increased transportation volumes. Other Operating Expenses and Taxes Increases (decreases) in other operating expenses, including taxes, are presented in the following table: Increase (Decrease) From Prior Year Classification 1993 1992 (Millions of Dollars) Other operation and maintenance $ 9.6 $ 11.0 Depreciation and amortization 4.5 5.6 Income taxes 29.1 (16.6) Other taxes .6 4.6 Total $43.8 $ 4.6 , 1993 Other operation and maintenance expenses increased for 1993 primarily due to the implementation of Financial Accounting Standards Board Statement No. 106 (see Note 1J of Notes to Consolidated Financial Statements) pursuant to the June 1993 PSC electric rate order and the amortization of environmental expenses. The depreciation and amortization increase reflects additions to plant in service. The increase in income taxes corresponds to the increase in income and reflects the increase in the corporate tax rate from 34% to 35% retroactive to January 1, 1993. 1992 Other operation and maintenance expenses increased for 1992 primarily due to increases in administrative and general expenses, increases in nuclear regulatory fees and nuclear and transmission systems maintenance. The increase in depreciation and amortization expense reflects additions to plant in service. Income taxes decreased primarily due to the tax impact of the rate refund (see Note 2F of Notes to Consolidated Financial Statements) and to other decreases in income. Other taxes increased primarily from higher property taxes caused by property additions and increased millage rates. In addition to the above, other taxes increased due to increases in state license fees. Other income, net of income taxes, increased approximately $14.7 million in 1993 primarily due to additional income from Petroleum Resources related to higher natural gas prices and additional income resulting from the acquisition of NICOR in June 1993. Interest Expense Increases (decreases) in interest expense are presented in the following table: Increase (Decrease) From Prior Year Classification 1993 1992 (Millions of Dollars) Interest on long-term debt, net $5.6 $4.3 Other interest expense (.1) 1.2 Total $5.5 $5.5 1993 Interest on long-term debt increased approximately $5.6 million in 1993 compared to 1992 due to the issuance of $72.4 million medium-term notes during the latter part of 1992 and $60 million medium-term notes in July 1993 to finance acquisitions of natural gas reserves and the issuance of $200 million of SCE&G's First Mortgage Bonds to finance utility construction. The resulting increases more than offset the interest savings resulting from the redemption and refinancing of $382 million of First and Refunding Mortgage Bonds with the proceeds from the issuance of $400 million of First Mortgage Bonds by SCE&G at lower interest rates. 1992 Interest on long-term debt increased approximately $4.4 million in 1992 compared to 1991 due to the issuances of $145 million and $155 million of First and Refunding Mortgage Bonds on July 24, 1991 and August 29, 1991, respectively, which more than offset the decreases in interest expense resulting from the repayment of debt and lower interest rates on remaining debt. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA TABLE OF CONTENTS OF CONSOLIDATED FINANCIAL STATEMENTS AND SUPPLEMENTARY FINANCIAL DATA Page Independent Auditor's Report....................................... 39 Consolidated Financial Statements: Consolidated Balance Sheets as of December 31, 1993 and 1992... 40 Consolidated Statements of Income and Retained Earnings for the years ended December 31, 1993, 1992 and 1991............. 42 Consolidated Statements of Cash Flows for the years ended December 31, 1993, 1992 and 1991............................. 43 Consolidated Statements of Capitalization as of December 31, 1993 and 1992................................... 44 Notes to Consolidated Financial Statements..................... 46 Supplemental Financial Statement Schedules: Schedule V - Property, Plant and Equipment for the years ended December 31, 1993, 1992 and 1991................. 65 Schedule VI - Accumulated Depreciation and Amortization of Property, Plant and Equipment for the years ended December 31, 1993, 1992 and 1991....................... 68 Schedule X - Supplementary Income Statement Information for the years ended December 31, 1993, 1992 and 1991............................. 71 Supplemental financial statement schedules other than those listed above are omitted because of the absence of conditions under which they are required or because the required information is included in the consolidated financial statements or in the notes thereto. INDEPENDENT AUDITORS' REPORT SCANA CORPORATION: We have audited the accompanying Consolidated Balance Sheets and Consolidated Statements of Capitalization of SCANA Corporation and subsidiaries (Company) as of December 31, 1993 and 1992 and the related Consolidated Statements of Income and Retained Earnings and of Cash Flows for each of the three years in the period ended December 31, 1993. Our audits also included the financial statement schedules listed in the index on page 38. These financial statements and financial statement schedules are the responsibility of the Company's management. Our responsibility is to express an opinion on the financial statements and financial statement schedules based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, such consolidated financial statements present fairly, in all material respects, the financial position of the Company at December 31, 1993 and 1992, and the results of its operations and its cash flows for each of the three years in the period ended December 31, 1993 in conformity with generally accepted accounting principles. Also, in our opinion, such financial statement schedules, when considered in relation to the basic financial statements taken as a whole, present fairly in all material respects the information set forth therein. s/Deloitte & Touche DELOITTE & TOUCHE Columbia, South Carolina February 7, 1994 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES: A. Organization and Principles of Consolidation SCANA Corporation (Company), a South Carolina corporation, is a public utility holding company within the meaning of the Public Utility Holding Company Act of 1935, but is exempt from registration under such Act. The accompanying Consolidated Financial Statements reflect the consolidation of the accounts of the Company and its wholly owned subsidiaries: Regulated utilities South Carolina Electric & Gas Company (SCE&G) South Carolina Fuel Company, Inc. South Carolina Generating Company, Inc. (GENCO) South Carolina Pipeline Corporation (Pipeline Corporation) Nonregulated businesses SCANA Petroleum Resources, Inc. (Petroleum Resources) SCANA Hydrocarbons, Inc. Suburban Propane Group, Inc. SCANA Development Corporation MPX Systems, Inc. Primesouth, Inc. SCANA Capital Resources, Inc. Investments in joint ventures in real estate are reported using the equity method of accounting. Significant intercompany balances and transactions have been eliminated in consolidation. In January 1994 the Company signed an agreement to sell in 1994 substantially all of the real estate assets of SCANA Development Corporation to Liberty Properties Group, Inc. of Greenville, South Carolina for $91.5 million. Under the terms of the agreement, a portion of the sales price will be received in cash at the time of closing. The remainder of the sales price, which is related to certain projects currently under construction, will be received in cash as those projects are completed. The transaction will not have a material impact on results of operations. B. System of Accounts The accounting records of the Company's regulated subsidiaries are maintained in accordance with the Uniform System of Accounts prescribed by the Federal Energy Regulatory Commission (FERC) and as adopted by the Public Service Commission of South Carolina (PSC). C. Utility Plant Utility plant is stated substantially at original cost. The costs of additions, renewals and betterments to utility plant, including direct labor, material and indirect charges for engineering, supervision and an allowance for funds used during construction, are added to utility plant accounts. The original cost of utility property retired or otherwise disposed of is removed from utility plant accounts and generally charged, along with the cost of removal, less salvage, to accumulated depreciation. The costs of repairs, replacements and renewals of items of property determined to be less than a unit of property are charged to maintenance expense. SCE&G, operator of the V. C. Summer Nuclear Station (Summer Station), and the South Carolina Public Service Authority (PSA) are joint owners of Summer Station in the proportions of two- thirds and one-third, respectively. The parties share the op- erating costs and energy output of the plant in these proportions. Each party, however, provides its own financing. Plant in service related to SCE&G's portion of Summer Station was approximately $920.2 million and $916.0 million as of December 31, 1993 and 1992, respectively. Accumulated depreciation associated with SCE&G's share of Summer Station was approximately $285.3 million and $262.2 million as of December 31, 1993 and 1992, respectively. SCE&G's share of the direct expenses associated with operating Summer Station is included in the Company's "Other operation" and "Maintenance" expenses. D. Allowance for Funds Used During Construction Allowance for funds used during construction (AFC), a noncash item, reflects the period cost of capital devoted to plant under construction. This accounting practice results in the inclusion, as a component of construction cost, of the costs of debt and equity capital dedicated to construction investment. AFC is included in rate base investment and depreciated as a component of plant cost in establishing rates for utility services. The Company's regulated subsidiaries calculated AFC using composite rates of 9.3%, 9.6% and 9.7% for 1993, 1992 and 1991, respectively. These rates do not exceed the maximum allowable rate as calculated under FERC Order No. 561. Interest on nuclear fuel in process is capitalized at the actual interest amount. E. Deferred Return on Plant Investment Commencing July 1, 1987, as approved by a PSC order on that date, SCE&G ceased the deferral of carrying costs associated with 400 MW of electric generating capacity previously removed from rate base and began amortizing the accumulated deferred carrying costs on a straight-line basis over a ten-year period. Amortization of deferred carrying costs, included in "Depreciation and amortization," was approximately $4.2 million for each of 1993, 1992 and 1991. F. Revenue Recognition Customers' meters are read and bills are rendered on a monthly cycle basis. Base revenue is recorded during the accounting period in which the meters are read. Fuel costs for electric generation are collected through the fuel component in retail electric rates. The fuel component contained in electric rates is established by the PSC during semiannual fuel cost hearings. Any difference between actual fuel cost and that contained in the fuel component is deferred and included when determining the fuel cost component during the next semiannual fuel cost hearing. At December 31, 1993 and 1992 SCE&G had overcollected through the electric fuel clause component approximately $9.2 million and $17.7 million, respectively, which are included in "Deferred Credits-Other." Customers subject to the gas cost adjustment clause are billed based on a fixed cost of gas determined by the PSC during annual gas cost recovery hearings. Any difference between actual gas cost and that contained in the rates is deferred and included when establishing gas costs during the next annual gas cost recovery hearing. At December 31, 1993 and 1992 the Company had undercollected through the gas cost recovery procedure approximately $12.0 million and $6.2 million, respectively, which are included in "Deferred Debits-Other." G. Depreciation, Depletion and Amortization Provisions for depreciation are recorded using the straight- line method for financial reporting purposes and are based on the estimated service lives of the various classes of property. The composite weighted average depreciation rates were as follows: Fair values of investments and long-term debt are based on quoted market prices for similar instruments, or for those instruments for which there are no quoted market prices available, fair values are based on net present value calculations. Investments which are not considered to be financial instruments (goodwill) have been excluded from the carrying amount and estimated fair value. Settlement of long-term debt may not be possible or may not be a prudent management decision. Short-term borrowings are valued at their carrying amount. The fair value of preferred stock (subject to purchase or sinking funds) and gas futures contracts is estimated on the basis of market prices. Potential taxes and other expenses that would be incurred in an actual sale or settlement have not been taken into consideration. 9. SHORT-TERM BORROWINGS: The Company pays fees to banks as compensation for its lines of credit. Commercial paper borrowings are for 270 days or less. Details of lines of credit and short-term borrowings at December 31, 1993, 1992 and 1991 and for the years then ended are as follows: 1993 1992 1991 (Millions of Dollars) Authorized lines of credit at year-end $175.0 $153.9 $141.7 Unused lines of credit at year-end $148.0 $127.8 $141.6 Short-term borrowings (including commercial paper) during the year: Maximum outstanding $304.8 $143.0 $134.0 Average outstanding $117.2 $ 75.3 $ 74.3 Weighted average daily interest rates: Bank loans 3.57% 4.47% 6.32% Commercial paper 3.13% 3.69% 6.31% Short-term borrowings outstanding at year-end: Bank loans $ 42.0 $ 41.1 $ 20.7 Weighted average interest rate 3.71% 4.49% 5.89% Commercial paper $ 1.0 - - Weighted average interest rate 3.50% - - 10. COMMITMENTS AND CONTINGENCIES: A. Construction SCE&G entered into a contract with Duke/Fluor Daniel in 1991 to design, engineer and build a 385 MW coal-fired electric generating plant near Cope, South Carolina in Orangeburg County. Construction of the plant began in November 1992 and commercial operation is expected in late 1995 or early 1996. The estimated price of the Cope plant, excluding financing costs and AFC but including an allowance for escalation, is $450 million. In addition, the transmission lines for interconnection with the Company's system are expected to cost $26 million. Under the Duke/Fluor Daniel contract SCE&G must make specified monthly minimum payments. These minimum payments do not include amounts for inflation on a portion of the contract which is subject to escalation (approximately 34% of the total contract amount). The aggregate amount of such required minimum payments remaining at December 31, 1993 is as follows (thousands of dollars): 1994 $168,152 1995 59,766 1996 5,603 Total $233,521 Through December 31, 1993 SCE&G paid $142.0 million under the contract. B. Nuclear Insurance The Price-Anderson Indemnification Act, which deals with public liability for a nuclear incident, currently establishes the liability limit for third-party claims associated with any nuclear incident at $9.4 billion. Each reactor licensee is currently liable for up to $79.3 million per reactor owned for each nuclear incident occurring at any reactor in the United States, provided that not more than $10 million of the liability per reactor would be assessed per year. SCE&G's maximum assessment, based on its two-thirds ownership of Summer Station, would be approximately $52.9 million per incident, but not more than $6.7 million per year. SCE&G currently maintains policies (for itself and on behalf of the PSA) with Nuclear Electric Insurance Limited (NEIL) and American Nuclear Insurers (ANI) providing combined property and decontamination insurance coverage of $1.4 billion for any losses in excess of $500 million pursuant to existing primary coverages (with ANI) on Summer Station. SCE&G pays annual premiums and, in addition, could be assessed a retroactive premium not to exceed 7 1/2 times its annual premium in the event of property damages loss to any nuclear generating facilities covered by NEIL. Based on the current annual premium, this retroactive premium would not exceed $8.1 million. To the extent that insurable claims for property damage, decontamination, repair and replacement and other costs and expenses arising from a nuclear incident at Summer Station exceed the policy limits of insurance, or to the extent such insurance becomes unavailable in the future, and to the extent that SCE&G's rates would not recover the cost of any purchased replacement power, SCE&G will retain the risk of loss as a self-insurer. SCE&G has no reason to anticipate a serious nuclear incident at Summer Station. If such an incident were to occur, it could have a materially adverse impact on the Company's financial position. C. Litigation In January 1994 SCE&G, acting on behalf of itself and the PSA (as co-owners of Summer Station), reached a settlement with Westinghouse Electric Corporation (Westinghouse) resolving a dispute involving steam generators provided by Westinghouse to Summer Station which are defective in design, workmanship and materials. Terms of the settlement are confidential. SCE&G had filed an action in May 1990 against Westinghouse in the U.S. District Court for South Carolina; an order dismissing this suit was issued on January 12, 1994. D. Environmental As described in Note 1L, the Company has an environmental assessment program to identify and assess current and former operations sites that could require environmental cleanup. As site assessments are initiated, an estimate is made of the amount of expenditures, if any, necessary to investigate and clean up each site. These estimates are refined as additional information becomes available; therefore actual expenditures could significantly differ from the original estimates. Amounts estimated and accrued to date for site assessments and cleanup relate primarily to regulated operations; such amounts have been deferred and are being amortized and recovered through rates over a ten-year period. 11. SEGMENT OF BUSINESS INFORMATION: Segment information at December 31, 1993, 1992 and 1991 and for the years then ended is as follows: Electric Gas Transit Total (Thousands of Dollars) Operating revenues $ 940,121 $320,195 $ 3,851 $1,264,167 Operating expenses, excluding depreciation and amortization 620,291 275,984 9,737 906,012 Depreciation and amortization 97,849 14,820 175 112,844 Total operating expenses 718,140 290,804 9,912 1,018,856 Operating income (loss) $ 221,981 $ 29,391 $(6,061) 245,311 Add - Other income, net 30,076 Less - Interest charges 101,189 - Preferred stock dividends 6,217 Net income $ 167,981 Capital expenditures: Identifiable $ 279,082 $ 28,761 $ 604 $ 308,447 Utilized for overall Company operations 13,934 Total $ 322,381 Identifiable assets at December 31, 1993: Utility plant, net $2,628,374 $312,437 $ 1,673 $2,942,484 Inventories 77,805 22,019 463 100,287 Total $2,706,179 $334,456 $ 2,136 3,042,771 Assets utilized for overall Company operations 997,755 Total assets $4,040,526 Electric Gas Transit Total (Thousands of Dollars) Operating revenues $ 829,477 $305,275 $ 3,623 $1,138,375 Operating expenses, excluding depreciation and amortization 554,897 256,178 9,205 820,280 Depreciation and amortization 93,978 14,174 163 108,315 Total operating expenses 648,875 270,352 9,368 928,595 Operating income (loss) $ 180,602 $ 34,923 $(5,745) 209,780 Add - Other income, net 11,883 Less - Interest charges 97,600 - Preferred stock dividends 6,473 Net income $ 117,590 Capital expenditures: Identifiable $ 234,918 $ 33,495 $ 346 $ 268,759 Utilized for overall Company operations 8,877 Total $ 277,636 Identifiable assets at December 31, 1992: Utility plant, net $2,456,691 $299,591 $ 1,240 $2,757,522 Inventories 82,717 8,155 481 91,353 Total $2,539,408 $307,746 $ 1,721 2,848,875 Assets utilized for overall Company operations 708,846 Total assets $3,557,721 Electric Gas Transit Total (Thousands of Dollars) Operating revenues $ 867,215 $ 276,742 $ 3,869 $1,147,826 Operating expenses, excluding depreciation and amortization 580,265 233,509 9,023 822,797 Depreciation and amortization 88,803 13,720 146 102,669 Total operating expenses 669,068 247,229 9,169 925,466 Operating income (loss) $ 198,147 $ 29,513 $ (5,300) 222,360 Add - Other income, net 11,655 Less - Interest charges 91,458 - Preferred stock dividends 6,706 Net income $ 135,851 Capital expenditures: Identifiable $ 205,704 $ 25,380 $ 89 $ 231,173 Utilized for overall Company operations 7,967 Total $ 239,140 Identifiable assets at December 31, 1991: Utility plant, net $2,333,877 $ 280,805 $ 1,073 $2,615,755 Inventories 83,637 7,242 476 91,355 Total $2,417,514 $ 288,047 $ 1,549 2,707,110 Assets utilized for overall Company operations 598,752 Total assets $3,305,862 12. QUARTERLY FINANCIAL DATA (UNAUDITED): First Second Third Fourth Quarter Quarter Quarter Quarter Annual Total operating revenues (000) $321,840 $280,382 $359,453 $302,492 $1,264,167 Operating income (000) 63,714 45,370 84,638 51,589 245,311 Net income (000) 45,110 26,909 64,427 31,535 167,981 Earnings per weighted average share of common stock as reported 1.02 .61 1.41 .68 3.72 First Second Third Fourth Quarter Quarter Quarter Quarter Annual Total operating revenues (000) $297,414 $255,343 $305,594 $280,024 $1,138,375 Operating income (000) 56,978 40,203 64,486 48,113 209,780 Net income (000) 34,132 16,753 39,643 27,062 117,590 Earnings per weighted average share of common stock as reported .83 .41 .96 .64 2.84

ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS LIQUIDITY AND CAPITAL RESOURCES The cash requirements of the Company arise primarily from SCE&G's operational needs, the Company's construction program and the need to fund the activities or investments of the Company's nonregulated subsidiaries. The ability of the Company's regulated subsidiaries to replace existing plant investment, as well as to expand to meet future demand for electricity and gas, will depend upon their ability to attract the necessary financial capital on reasonable terms. The Company's regulated subsidiaries recover the costs of providing services through rates charged to customers. Rates for regulated services are generally based on historical costs. As customer growth and inflation occur and the regulated subsidiaries expand their construction programs, it is necessary to seek increases in rates. As a result the Company's future financial position and results of operations will be affected by the regulated subsidiaries' ability to obtain adequate and timely rate relief. Due to continuing customer growth, SCE&G entered into a contract with Duke/Fluor Daniel in 1991 to design, engineer and build a 385 MW coal-fired electric generating plant near Cope, South Carolina in Orangeburg County. Construction of the plant began in November 1992 with commercial operation expected in late 1995 or early 1996. The estimated price of the Cope plant, excluding financing costs and AFC but including an allowance for escalation, is $450 million. In addition, the transmission lines for interconnection with the Company's system are expected to cost $26 million. Until the completion of the new plant, SCE&G is contracting for additional capacity as necessary to ensure that the energy demands of its customers can be met. As discussed in Note 2A of Notes to Consolidated Financial Statements, on June 7, 1993 the PSC issued an order granting SCE&G a 7.4% annual increase in retail electric rates to be implemented in two phases of $42.0 million annually effective June 1993 and $18.5 million annually effective June 1994, based on a test year. The estimated primary cash requirements for 1994, excluding requirements for fuel liabilities and short-term borrowings, and the actual primary cash requirements for 1993 are as follows: 1994 1993 (Thousands of Dollars) Property additions and construction expenditures, excluding allowance for funds used during construction (AFC) $506,010 $381,141 Acquisition of oil and gas producing properties - 122,621 Nuclear fuel expenditures 28,064 7,177 Maturing obligations, redemptions and sinking and purchase fund requirements 25,627 16,530 Total $559,701 $527,469 Approximately 28% of total cash requirements (excluding dividends) was provided from internal sources in 1993 as compared to 40% in 1992. The Company has in effect a medium-term note program for the issuance from time to time of unsecured medium-term debt securities. The proceeds from the sales of these securities may be used to fund additional business activities in nonutility subsidiaries, to reduce short-term debt incurred in connection therewith or for general corporate purposes. In 1993 the Company issued $60 million of such medium-term notes. The proceeds from the sales of these securities were used for the funding of nonutility subsidiary activities. At December 31, 1993 the Company had available for issuance $67.6 million under the current registration statement. SCE&G's First and Refunding Mortgage Bond Indenture, dated April 1, 1945 (Old Mortgage), contains provisions prohibiting the issuance of additional bonds thereunder (Class A Bonds) unless net earnings (as therein defined) for 12 consecutive months out of the 15 months prior to the month of issuance is at least twice the annual interest requirements on all Class A Bonds to be outstanding (Bond Ratio). For the year ended December 31, 1993 the Bond Ratio was 3.70. The issuance of additional Class A Bonds is restricted also to an additional principal amount equal to 60% of unfunded net property additions (which unfunded net property additions totaled approximately $219.9 million at December 31, 1993), Class A Bonds issued on the basis of retirements of Class A Bonds (which retirement credits totaled $10.9 million at December 31, 1993), and Class A Bonds issued on the basis of cash on deposit with the Trustee. SCE&G has placed a new bond indenture (New Mortgage) dated April 1, 1993 on substantially all of its electric properties under which its future mortgage-backed debt (New Bonds) will be issued. New Bonds are expected to be issued under the New Mortgage on the basis of a like principal amount of Class A Bonds issued under the Old Mortgage which have been deposited with the Trustee of the New Mortgage (of which $157 million were available for such purpose as of December 31, 1993), until such time as all presently outstanding Class A Bonds are retired. Thereafter, New Bonds will be issuable on the basis of property additions in a principal amount equal to 70% of the original cost of electric and common plant properties (compared to 60% of value for Class A Bonds under the Old Mortgage), cash deposited with the Trustee, and retirement of New Bonds. New Bonds will be issuable under the New Mortgage only if adjusted net earnings (as therein defined) for 12 consecutive months out of the 18 months immediately preceding the month of issuance are at least twice the annual interest requirements on all outstanding bonds (including Class A Bonds) and New Bonds to be outstanding (New Bond Ratio). For the year ended December 31, 1993 the New Bond Ratio was 5.0. On April 29, 1993 the Securities and Exchange Commission (SEC) declared effective a registration statement for the issuance of up to $700 million of New Bonds. The following series, aggregating $600 million, have been issued under such registration statement: On June 9, 1993, $100 million, 7 5/8% Series due June 1, 2023 to repay short-term borrowings in a like amount. On July 1, 1993, $100 million, 6% Series due June 15, 2000; and $150 million, 7 1/8% Series due June 15, 2013; and on July 20, 1993, $150 million, 7 1/2% Series due June 15, 2023, to redeem, on July 20, 1993, $382,035,000 of First and Refunding Mortgage Bonds maturing between 1999 and 2017 and bearing interest at rates between 8% and 9 7/8% per annum. On December 20, 1993, $100 million, 6 1/4% Series due December 15, 2003 to repay short-term borrowings in a like amount. The following additional financing transactions have occurred since December 31, 1992: On January 15, 1993 the Company closed on an unsecured bank loan in the principal amount of $60 million, due January 14, 1994, and used the proceeds to pay off a loan in a like amount. The interest rate is the three month LIBOR plus 30 basis points and is reset quarterly. On January 14, 1994 the Company refinanced the loan with unsecured bank loans totaling $60 million, due January 13, 1995 at interest rates between 3.875% and 3.89%. On April 15, 1993 the Company arranged for a $15 million term loan, due April 14, 1994, to repay short-term borrowings in a like amount. The interest rate is the three month LIBOR plus 16 basis points and is reset quarterly. On June 1, 1993 SCE&G redeemed the following amounts of First and Refunding Mortgage Bonds: $35 million, 10 1/8% Series due 2009 and $13 million, 9 7/8% Series due 2009. On June 2, 1993 the Company entered into a $123 million 90-day bank loan (90-day bank loan) to finance the acquisition by Petroleum Resources of approximately 125 billion cubic feet equivalent of natural gas reserves through the purchase of NICOR Exploration and Production Company (NICOR). On July 1, 1993 the Company issued $60 million of medium-term notes bearing interest at the following rates and maturing on the following dates in the following amounts: $20 million, 5.76%, due July 1, 1998; $20 million, 6.15%, due July 3, 2000; and $20 million, 6.51%, due July 1, 2003. The proceeds were used to repay a portion of the 90-day bank loan discussed above. In early August 1993 the Company issued 1,467,000 shares of common stock with net proceeds totaling $69,345,090. The proceeds were used to repay the remainder of the 90-day bank loan discussed above and for general corporate purposes. On September 30, 1993 Pipeline Corporation sold unsecured promissory notes totaling $25 million, 6.72% due September 30, 2013. The proceeds were used to repay short-term borrowings in a like amount. Without the consent of at least a majority of the total voting power of SCE&G's preferred stock, SCE&G may not issue or assume any unsecured indebtedness if, after such issue or assumption, the total principal amount of all such unsecured indebtedness would exceed 10% of the aggregate principal amount of all of SCE&G's secured indebtedness and capital and surplus; provided, however, that no such consent shall be required to enter into agreements for payment of principal, interest and premium for securities issued for pollution control purposes. Pursuant to Section 204 of the Federal Power Act, SCE&G and GENCO must obtain FERC authority to issue short-term indebtedness. The FERC has authorized SCE&G to issue up to $200 million of unsecured promissory notes or commercial paper with maturity dates of 12 months or less but not later than December 31, 1995. GENCO has not sought such authorization. The Company had $175.0 million authorized lines of credit and had unused lines of credit of $148.0 million at December 31, 1993. In addition, the Company has a credit agreement for a maximum of $75 million to finance nuclear and fossil fuel inventories, with $38.2 million available at December 31, 1993. SCE&G's Restated Articles of Incorporation prohibit issuance of additional shares of preferred stock without consent of the preferred stockholders unless net earnings (as defined therein) for the 12 consecutive months immediately preceding the month of issuance is at least one and one-half times the aggregate of all interest charges and preferred stock dividend requirements (Preferred Stock Ratio). For the year ended December 31, 1993 the Preferred Stock Ratio was 2.52. On October 12, 1993 the Company registered with the SEC 2,000,000 additional shares of the Company's common stock to be issued and sold under the Dividend Reinvestment and Stock Purchase Plan (DRP). During 1993 the Company issued 529,954 shares of the Company's common stock under the DRP. In addition, the Company issued 705,498 shares of its common stock pursuant to its Stock Purchase-Savings Plan (SPSP). The Company has authorized and reserved for issuance, and registered under effective registration statements, 2,065,824 and 872,420 shares of common stock pursuant to the DRP and the SPSP, respectively. In January 1994 the Company signed an agreement to sell in 1994 substantially all of the real estate assets of SCANA Development Corporation (Development Corporation) to Liberty Properties Group, Inc. of Greenville, South Carolina for $91.5 million. Under the terms of the agreement, a portion of the sales price will be received in cash at the time of closing. The remainder of the sales price, which is related to certain projects currently under construction, will be received in cash as those projects are completed. On March 4, 1994 the Company and Liberty amended the agreement regarding the sale. Under the terms of the amended agreement certain projects currently under construction will be excluded from the transaction and the sales price will be $49.6 million. All of the sales price will be received at the time of closing. The net proceeds from the sale will be used to retire Development Corporation's debt and for general corporate purposes, including the funding of other nonutility subsidiaries' business activities. The transaction will not have a material impact on the Company's financial position or results of operations. The Company anticipates that its 1994 cash requirements of $559.7 will be met through internally generated funds (approximately 38% excluding dividends), the sales of additional equity securities and the incurrence of additional short-term and long-term indebtedness. The timing and amount of such financing will depend upon market conditions and other factors. Actual 1994 expenditures may vary from the estimates set forth above due to factors such as inflation and economic conditions, regulation and legislation, rates of load growth, environmental protection standards and the cost and availability of capital. The Company expects that it has or can obtain adequate sources of financing to meet its projected cash requirements. Environmental Matters The Clean Air Act requires electric utilities to reduce substantially emissions of sulfur dioxide and nitrogen oxide by the year 2000. These requirements are being phased in over two periods. The first phase has a compliance date of January 1, 1995 and the second, January 1, 2000. The Company meets all requirements of Phase I and therefore will not have to implement changes until compliance with Phase II requirements is necessary. The Company then will most likely meet its compliance requirements through the burning of natural gas and/or lower sulfur coal, the addition of scrubbers to coal-fired generating units, and the purchase of sulfur dioxide emission allowances. Low nitrogen oxide burners will be installed to reduce nitrogen oxide emissions. The Company is continuing to refine a compliance plan that must be filed with the U.S. Environmental Protection Agency (EPA) by January 1, 1996. The Company currently estimates that air emissions control equipment will require capital expenditures of $252 million over the 1994-1998 period to retrofit existing facilities and an increased operation and maintenance cost of $31 million per year. To meet compliance requirements through the year 2003, the Company anticipates total capital expenditures of $275 million. The South Carolina Solid Waste Policy and Management Act of 1991 requires promulgation of regulations addressing specified subjects, one of which affects the management of industrial solid waste. This regulation will establish minimum criteria for industrial landfills as mandated under the Act. The proposed regulation, if adopted as a final regulation in its present form, could significantly impact SCE&G's and GENCO's engineering, design and operation of existing and future ash management facilities. Potential cost impacts could be substantial. As described in Note 1L of Notes to Consolidated Financial Statements, the Company has an environmental assessment program to identify and assess current and former operations sites that could require environmental cleanup. As site assessments are initiated, an estimate is made of the amount of expenditures, if any, necessary to investigate and clean up each site. These estimates are refined as additional information becomes available; therefore actual expenditures could significantly differ from the original estimates. Amounts estimated and accrued to date ($19.6 million) for site assessments and cleanup of regulated operations have been deferred and are being amortized and recovered through rates over a ten-year period. Estimates to date include, among other things, the costs estimated to be associated with the matters discussed in the following paragraphs. The Company and its principal subsidiary, SCE&G, each own two decommissioned manufactured gas plant sites which contain residues of by-product chemicals. The Company and SCE&G have each maintained an active review of their respective sites to monitor the nature and extent of the residual contamination. In September 1992 the EPA notified SCE&G, the City of Charleston and the Charleston Housing Authority of their potential liability for the investigation and cleanup of the Calhoun Park Area Site in Charleston, South Carolina. This site originally encompassed approximately 18 acres and included properties which were the locations for industrial operations, including a wood preserving (creosote) plant and one of SCE&G's decommissioned manufactured gas plants. The original scope of this investigation has been expanded to approximately 30 acres including adjacent properties owned by the National Park Service and the City of Charleston, and private properties. The site has not been placed on the National Priority List, but may be added before cleanup is initiated. The potentially responsible parties (PRP) have agreed with the EPA to participate in an innovative approach to site investigation and cleanup called "Superfund Accelerated Cleanup Model," allowing the pre-cleanup site investigations process to be compressed significantly. The PRPs have negotiated an administrative order by consent for the conduct of a Remedial Investigation/Feasibility Study (RI/FS) and a corresponding Scope of Work. Actual field work began November 1, 1993 after final approval and authorization was granted by EPA. SCE&G is also working with the City of Charleston to investigate potential contamination from the manufactured gas plant at the city's aquarium site. During 1993 SCE&G settled its obligations at the Yellow Water Road Superfund Site near Jacksonville, Florida, the Spencer Transformer and Equipment Site in West Virginia and Elliott's Auto Parts in Benton, Arkansas. No further expenses are anticipated for these sites. SCE&G has been listed as a PRP and has recorded liabilities, which are not considered material, for the Macon-Dockery waste disposal site near Rockingham, North Carolina, the Aqua-Tech Environmental, Inc. site in Greer, South Carolina and a landfill owned by Lexington County in South Carolina. Litigation In January 1994 SCE&G, acting on behalf of itself and the PSA (as co-owners of Summer Station), reached a settlement with Westinghouse Electric Corporation (Westinghouse) resolving a dispute involving steam generators provided by Westinghouse to Summer Station which are defective in design, workmanship and materials. Terms of the settlement are confidential. SCE&G had filed an action in May 1990 against Westinghouse in the U.S. District Court for South Carolina; an order dismissing this suit was issued on January 12, 1994. Regulatory Matters On June 7, 1993 the PSC issued an order on SCE&G's pending electric rate proceeding allowing an authorized return on common equity of 11.5%, resulting in a 7.4% annual increase in retail electric rates, or a projected $60.5 million annually on a test year basis. These rates are to be implemented in two phases over a two-year period: phase one, effective June 1993, producing $42.0 million annually, and phase two, effective June 1994, producing $18.5 million annually, on a test year basis. The Company's regulated business operations are likely to be impacted by the National Energy Policy Act (NEPA) and FERC Order No. 636. NEPA is designed to create a more competitive wholesale power supply market by creating "exempt wholesale generators" and by potentially requiring utilities owning transmission facilities provide transmission access to wholesalers. Order No. 636 is intended to deregulate the markets for interstate sales of natural gas by requiring that pipelines provide transportation services that are equal in quality for all gas suppliers whether the customer purchases gas from the pipeline or another supplier. In the opinion of the Company, it will be able to meet successfully the challenges of these altered business climates. Other In November 1992 the Financial Accounting Standards Board issued Statement No. 112 "Employers' Accounting for Postemployment Benefits." The Statement, which is effective for calendar year 1994, establishes certain conditions for the recognition of costs of benefits to former employees after employment but before retirement. The Statement requires recognition of the obligation to provide postemployment benefits if such obligation is attributable to services previously rendered, the obligation relates to rights which vest, payment of the benefits is probable and the amount of such benefits can be reasonably estimated. The Company does not anticipate that application of this Statement will have a significant impact on results of operations or financial position. RESULTS OF OPERATIONS Earnings and Dividends Earnings per share of common stock, the percent increase (decrease) from the previous year and the rate of return earned on common equity for the years 1991 through 1993 were as follows: 1993 1992 1991 Earnings per share $3.72 $2.84 $3.37 Percent increase (decrease) in earnings per share 31.0% (15.7%) (24.1%) Return earned on common equity (year-end) 12.6% 10.1% 13.2% 1993 Earnings per share and return on common equity increased in 1993 primarily due to a higher electric sales margin and additional nonoperating income. 1992 Earnings per share and return on common equity in 1992 decreased primarily due to the recording of an $11.1 million (after interest and income taxes) reserve against earnings related to the August 31, 1992 retail electric rate ruling from the South Carolina Supreme Court (see Note 2F of Notes to the Consolidated Financial Statements) and increases in other operating and interest expenses. The Company's financial statements include AFC. AFC is a utility accounting practice whereby a portion of the cost of both equity and borrowed funds used to finance construction (which is shown on the balance sheet as construction work in progress) is capitalized. Both an equity and debt portion of AFC are included in nonoperating income as noncash items which have the effect of increasing reported net income. AFC represented approximately 5.8% of income before income taxes in 1993, 5.5% in 1992 and 3.9% in 1991. In 1993 the Company's Board of Directors raised the quarterly cash dividend on common stock to 68.5 cents per share from 67 cents per share. The increase, effective with the dividend payable on April 1, 1993, raised the indicated annual dividend rate to $2.74 per share from $2.68. The Company has increased the dividend rate on its common stock in 40 of the last 41 years. Electric Operations Electric sales margins for 1993, 1992 and 1991 were as follows: 1993 1992 1991 (Millions of Dollars) Electric revenues $940.1 $829.5 $867.2 Less: Fuel used in electric generation 228.7 206.2 224.9 Purchased power 13.0 7.3 9.8 Margin $698.4 $616.0 $632.5 1993 The increase in electric sales margin from 1992 to 1993 is primarilya result of increased residential and commercial KWH sales due to weather and customer growth, an increase in retail electric rates beginning in June 1993 and the recording in 1992 of a $14.6 million reserve as discussed below. 1992 The 1992 electric sales margin decreased from 1991 due to therecording of a $14.6 million reserve, before interest and income taxes, related to the August 31, 1992 ruling from the South Carolina Supreme Court (see Note 2F of Notes to Consolidated Financial Statements) and a $1.9 million billing related litigation settlement included in 1991 electric operating revenues. Warmer weather and an increase in the number of electric customers resulted in an all-time peak demand record of 3,557 MW on July 29, 1993. The previous year's record of 3,380 MW was set on July 13, 1992. Gas Operations Gas sales margins for 1993, 1992 and 1991 were as follows: 1993 1992 1991 (Millions of Dollars) Gas revenues $320.2 $305.3 $276.7 Less: Gas purchased for resale 209.7 191.6 171.9 Margin $110.5 $113.7 $104.8 1993 In 1993 the gas sales margin decreased from 1992 as a result of higher gas prices which reduced Pipeline Corporation's sales due to the competitiveness of alternative fuels. This reduction was partially offset by increases in higher margin residential and commercial sales and increased transportation volumes. 1992 The gas sales margin for 1992 increased from 1991 as a result of recoveries of $4.2 million allowed under a weather normalization adjustment which became effective the first billing cycle in December 1991; increases in residential usage due to cooler weather during 1992; and increased transportation volumes. Other Operating Expenses and Taxes Increases (decreases) in other operating expenses, including taxes, are presented in the following table: Increase (Decrease) From Prior Year Classification 1993 1992 (Millions of Dollars) Other operation and maintenance $ 9.6 $ 11.0 Depreciation and amortization 4.5 5.6 Income taxes 29.1 (16.6) Other taxes .6 4.6 Total $43.8 $ 4.6 , 1993 Other operation and maintenance expenses increased for 1993 primarily due to the implementation of Financial Accounting Standards Board Statement No. 106 (see Note 1J of Notes to Consolidated Financial Statements) pursuant to the June 1993 PSC electric rate order and the amortization of environmental expenses. The depreciation and amortization increase reflects additions to plant in service. The increase in income taxes corresponds to the increase in income and reflects the increase in the corporate tax rate from 34% to 35% retroactive to January 1, 1993. 1992 Other operation and maintenance expenses increased for 1992 primarily due to increases in administrative and general expenses, increases in nuclear regulatory fees and nuclear and transmission systems maintenance. The increase in depreciation and amortization expense reflects additions to plant in service. Income taxes decreased primarily due to the tax impact of the rate refund (see Note 2F of Notes to Consolidated Financial Statements) and to other decreases in income. Other taxes increased primarily from higher property taxes caused by property additions and increased millage rates. In addition to the above, other taxes increased due to increases in state license fees. Other income, net of income taxes, increased approximately $14.7 million in 1993 primarily due to additional income from Petroleum Resources related to higher natural gas prices and additional income resulting from the acquisition of NICOR in June 1993. Interest Expense Increases (decreases) in interest expense are presented in the following table: Increase (Decrease) From Prior Year Classification 1993 1992 (Millions of Dollars) Interest on long-term debt, net $5.6 $4.3 Other interest expense (.1) 1.2 Total $5.5 $5.5 1993 Interest on long-term debt increased approximately $5.6 million in 1993 compared to 1992 due to the issuance of $72.4 million medium-term notes during the latter part of 1992 and $60 million medium-term notes in July 1993 to finance acquisitions of natural gas reserves and the issuance of $200 million of SCE&G's First Mortgage Bonds to finance utility construction. The resulting increases more than offset the interest savings resulting from the redemption and refinancing of $382 million of First and Refunding Mortgage Bonds with the proceeds from the issuance of $400 million of First Mortgage Bonds by SCE&G at lower interest rates. 1992 Interest on long-term debt increased approximately $4.4 million in 1992 compared to 1991 due to the issuances of $145 million and $155 million of First and Refunding Mortgage Bonds on July 24, 1991 and August 29, 1991, respectively, which more than offset the decreases in interest expense resulting from the repayment of debt and lower interest rates on remaining debt. ITEM 8.

ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA TABLE OF CONTENTS OF CONSOLIDATED FINANCIAL STATEMENTS AND SUPPLEMENTARY FINANCIAL DATA Page Independent Auditor's Report....................................... 39 Consolidated Financial Statements: Consolidated Balance Sheets as of December 31, 1993 and 1992... 40 Consolidated Statements of Income and Retained Earnings for the years ended December 31, 1993, 1992 and 1991............. 42 Consolidated Statements of Cash Flows for the years ended December 31, 1993, 1992 and 1991............................. 43 Consolidated Statements of Capitalization as of December 31, 1993 and 1992................................... 44 Notes to Consolidated Financial Statements..................... 46 Supplemental Financial Statement Schedules: Schedule V - Property, Plant and Equipment for the years ended December 31, 1993, 1992 and 1991................. 65 Schedule VI - Accumulated Depreciation and Amortization of Property, Plant and Equipment for the years ended December 31, 1993, 1992 and 1991....................... 68 Schedule X - Supplementary Income Statement Information for the years ended December 31, 1993, 1992 and 1991............................. 71 Supplemental financial statement schedules other than those listed above are omitted because of the absence of conditions under which they are required or because the required information is included in the consolidated financial statements or in the notes thereto. INDEPENDENT AUDITORS' REPORT SCANA CORPORATION: We have audited the accompanying Consolidated Balance Sheets and Consolidated Statements of Capitalization of SCANA Corporation and subsidiaries (Company) as of December 31, 1993 and 1992 and the related Consolidated Statements of Income and Retained Earnings and of Cash Flows for each of the three years in the period ended December 31, 1993. Our audits also included the financial statement schedules listed in the index on page 38. These financial statements and financial statement schedules are the responsibility of the Company's management. Our responsibility is to express an opinion on the financial statements and financial statement schedules based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, such consolidated financial statements present fairly, in all material respects, the financial position of the Company at December 31, 1993 and 1992, and the results of its operations and its cash flows for each of the three years in the period ended December 31, 1993 in conformity with generally accepted accounting principles. Also, in our opinion, such financial statement schedules, when considered in relation to the basic financial statements taken as a whole, present fairly in all material respects the information set forth therein. s/Deloitte & Touche DELOITTE & TOUCHE Columbia, South Carolina February 7, 1994 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES: A. Organization and Principles of Consolidation SCANA Corporation (Company), a South Carolina corporation, is a public utility holding company within the meaning of the Public Utility Holding Company Act of 1935, but is exempt from registration under such Act. The accompanying Consolidated Financial Statements reflect the consolidation of the accounts of the Company and its wholly owned subsidiaries: Regulated utilities South Carolina Electric & Gas Company (SCE&G) South Carolina Fuel Company, Inc. South Carolina Generating Company, Inc. (GENCO) South Carolina Pipeline Corporation (Pipeline Corporation) Nonregulated businesses SCANA Petroleum Resources, Inc. (Petroleum Resources) SCANA Hydrocarbons, Inc. Suburban Propane Group, Inc. SCANA Development Corporation MPX Systems, Inc. Primesouth, Inc. SCANA Capital Resources, Inc. Investments in joint ventures in real estate are reported using the equity method of accounting. Significant intercompany balances and transactions have been eliminated in consolidation. In January 1994 the Company signed an agreement to sell in 1994 substantially all of the real estate assets of SCANA Development Corporation to Liberty Properties Group, Inc. of Greenville, South Carolina for $91.5 million. Under the terms of the agreement, a portion of the sales price will be received in cash at the time of closing. The remainder of the sales price, which is related to certain projects currently under construction, will be received in cash as those projects are completed. The transaction will not have a material impact on results of operations. B. System of Accounts The accounting records of the Company's regulated subsidiaries are maintained in accordance with the Uniform System of Accounts prescribed by the Federal Energy Regulatory Commission (FERC) and as adopted by the Public Service Commission of South Carolina (PSC). C. Utility Plant Utility plant is stated substantially at original cost. The costs of additions, renewals and betterments to utility plant, including direct labor, material and indirect charges for engineering, supervision and an allowance for funds used during construction, are added to utility plant accounts. The original cost of utility property retired or otherwise disposed of is removed from utility plant accounts and generally charged, along with the cost of removal, less salvage, to accumulated depreciation. The costs of repairs, replacements and renewals of items of property determined to be less than a unit of property are charged to maintenance expense. SCE&G, operator of the V. C. Summer Nuclear Station (Summer Station), and the South Carolina Public Service Authority (PSA) are joint owners of Summer Station in the proportions of two- thirds and one-third, respectively. The parties share the op- erating costs and energy output of the plant in these proportions. Each party, however, provides its own financing. Plant in service related to SCE&G's portion of Summer Station was approximately $920.2 million and $916.0 million as of December 31, 1993 and 1992, respectively. Accumulated depreciation associated with SCE&G's share of Summer Station was approximately $285.3 million and $262.2 million as of December 31, 1993 and 1992, respectively. SCE&G's share of the direct expenses associated with operating Summer Station is included in the Company's "Other operation" and "Maintenance" expenses. D. Allowance for Funds Used During Construction Allowance for funds used during construction (AFC), a noncash item, reflects the period cost of capital devoted to plant under construction. This accounting practice results in the inclusion, as a component of construction cost, of the costs of debt and equity capital dedicated to construction investment. AFC is included in rate base investment and depreciated as a component of plant cost in establishing rates for utility services. The Company's regulated subsidiaries calculated AFC using composite rates of 9.3%, 9.6% and 9.7% for 1993, 1992 and 1991, respectively. These rates do not exceed the maximum allowable rate as calculated under FERC Order No. 561. Interest on nuclear fuel in process is capitalized at the actual interest amount. E. Deferred Return on Plant Investment Commencing July 1, 1987, as approved by a PSC order on that date, SCE&G ceased the deferral of carrying costs associated with 400 MW of electric generating capacity previously removed from rate base and began amortizing the accumulated deferred carrying costs on a straight-line basis over a ten-year period. Amortization of deferred carrying costs, included in "Depreciation and amortization," was approximately $4.2 million for each of 1993, 1992 and 1991. F. Revenue Recognition Customers' meters are read and bills are rendered on a monthly cycle basis. Base revenue is recorded during the accounting period in which the meters are read. Fuel costs for electric generation are collected through the fuel component in retail electric rates. The fuel component contained in electric rates is established by the PSC during semiannual fuel cost hearings. Any difference between actual fuel cost and that contained in the fuel component is deferred and included when determining the fuel cost component during the next semiannual fuel cost hearing. At December 31, 1993 and 1992 SCE&G had overcollected through the electric fuel clause component approximately $9.2 million and $17.7 million, respectively, which are included in "Deferred Credits-Other." Customers subject to the gas cost adjustment clause are billed based on a fixed cost of gas determined by the PSC during annual gas cost recovery hearings. Any difference between actual gas cost and that contained in the rates is deferred and included when establishing gas costs during the next annual gas cost recovery hearing. At December 31, 1993 and 1992 the Company had undercollected through the gas cost recovery procedure approximately $12.0 million and $6.2 million, respectively, which are included in "Deferred Debits-Other." G. Depreciation, Depletion and Amortization Provisions for depreciation are recorded using the straight- line method for financial reporting purposes and are based on the estimated service lives of the various classes of property. The composite weighted average depreciation rates were as follows: Fair values of investments and long-term debt are based on quoted market prices for similar instruments, or for those instruments for which there are no quoted market prices available, fair values are based on net present value calculations. Investments which are not considered to be financial instruments (goodwill) have been excluded from the carrying amount and estimated fair value. Settlement of long-term debt may not be possible or may not be a prudent management decision. Short-term borrowings are valued at their carrying amount. The fair value of preferred stock (subject to purchase or sinking funds) and gas futures contracts is estimated on the basis of market prices. Potential taxes and other expenses that would be incurred in an actual sale or settlement have not been taken into consideration. 9. SHORT-TERM BORROWINGS: The Company pays fees to banks as compensation for its lines of credit. Commercial paper borrowings are for 270 days or less. Details of lines of credit and short-term borrowings at December 31, 1993, 1992 and 1991 and for the years then ended are as follows: 1993 1992 1991 (Millions of Dollars) Authorized lines of credit at year-end $175.0 $153.9 $141.7 Unused lines of credit at year-end $148.0 $127.8 $141.6 Short-term borrowings (including commercial paper) during the year: Maximum outstanding $304.8 $143.0 $134.0 Average outstanding $117.2 $ 75.3 $ 74.3 Weighted average daily interest rates: Bank loans 3.57% 4.47% 6.32% Commercial paper 3.13% 3.69% 6.31% Short-term borrowings outstanding at year-end: Bank loans $ 42.0 $ 41.1 $ 20.7 Weighted average interest rate 3.71% 4.49% 5.89% Commercial paper $ 1.0 - - Weighted average interest rate 3.50% - - 10. COMMITMENTS AND CONTINGENCIES: A. Construction SCE&G entered into a contract with Duke/Fluor Daniel in 1991 to design, engineer and build a 385 MW coal-fired electric generating plant near Cope, South Carolina in Orangeburg County. Construction of the plant began in November 1992 and commercial operation is expected in late 1995 or early 1996. The estimated price of the Cope plant, excluding financing costs and AFC but including an allowance for escalation, is $450 million. In addition, the transmission lines for interconnection with the Company's system are expected to cost $26 million. Under the Duke/Fluor Daniel contract SCE&G must make specified monthly minimum payments. These minimum payments do not include amounts for inflation on a portion of the contract which is subject to escalation (approximately 34% of the total contract amount). The aggregate amount of such required minimum payments remaining at December 31, 1993 is as follows (thousands of dollars): 1994 $168,152 1995 59,766 1996 5,603 Total $233,521 Through December 31, 1993 SCE&G paid $142.0 million under the contract. B. Nuclear Insurance The Price-Anderson Indemnification Act, which deals with public liability for a nuclear incident, currently establishes the liability limit for third-party claims associated with any nuclear incident at $9.4 billion. Each reactor licensee is currently liable for up to $79.3 million per reactor owned for each nuclear incident occurring at any reactor in the United States, provided that not more than $10 million of the liability per reactor would be assessed per year. SCE&G's maximum assessment, based on its two-thirds ownership of Summer Station, would be approximately $52.9 million per incident, but not more than $6.7 million per year. SCE&G currently maintains policies (for itself and on behalf of the PSA) with Nuclear Electric Insurance Limited (NEIL) and American Nuclear Insurers (ANI) providing combined property and decontamination insurance coverage of $1.4 billion for any losses in excess of $500 million pursuant to existing primary coverages (with ANI) on Summer Station. SCE&G pays annual premiums and, in addition, could be assessed a retroactive premium not to exceed 7 1/2 times its annual premium in the event of property damages loss to any nuclear generating facilities covered by NEIL. Based on the current annual premium, this retroactive premium would not exceed $8.1 million. To the extent that insurable claims for property damage, decontamination, repair and replacement and other costs and expenses arising from a nuclear incident at Summer Station exceed the policy limits of insurance, or to the extent such insurance becomes unavailable in the future, and to the extent that SCE&G's rates would not recover the cost of any purchased replacement power, SCE&G will retain the risk of loss as a self-insurer. SCE&G has no reason to anticipate a serious nuclear incident at Summer Station. If such an incident were to occur, it could have a materially adverse impact on the Company's financial position. C. Litigation In January 1994 SCE&G, acting on behalf of itself and the PSA (as co-owners of Summer Station), reached a settlement with Westinghouse Electric Corporation (Westinghouse) resolving a dispute involving steam generators provided by Westinghouse to Summer Station which are defective in design, workmanship and materials. Terms of the settlement are confidential. SCE&G had filed an action in May 1990 against Westinghouse in the U.S. District Court for South Carolina; an order dismissing this suit was issued on January 12, 1994. D. Environmental As described in Note 1L, the Company has an environmental assessment program to identify and assess current and former operations sites that could require environmental cleanup. As site assessments are initiated, an estimate is made of the amount of expenditures, if any, necessary to investigate and clean up each site. These estimates are refined as additional information becomes available; therefore actual expenditures could significantly differ from the original estimates. Amounts estimated and accrued to date for site assessments and cleanup relate primarily to regulated operations; such amounts have been deferred and are being amortized and recovered through rates over a ten-year period. 11. SEGMENT OF BUSINESS INFORMATION: Segment information at December 31, 1993, 1992 and 1991 and for the years then ended is as follows: Electric Gas Transit Total (Thousands of Dollars) Operating revenues $ 940,121 $320,195 $ 3,851 $1,264,167 Operating expenses, excluding depreciation and amortization 620,291 275,984 9,737 906,012 Depreciation and amortization 97,849 14,820 175 112,844 Total operating expenses 718,140 290,804 9,912 1,018,856 Operating income (loss) $ 221,981 $ 29,391 $(6,061) 245,311 Add - Other income, net 30,076 Less - Interest charges 101,189 - Preferred stock dividends 6,217 Net income $ 167,981 Capital expenditures: Identifiable $ 279,082 $ 28,761 $ 604 $ 308,447 Utilized for overall Company operations 13,934 Total $ 322,381 Identifiable assets at December 31, 1993: Utility plant, net $2,628,374 $312,437 $ 1,673 $2,942,484 Inventories 77,805 22,019 463 100,287 Total $2,706,179 $334,456 $ 2,136 3,042,771 Assets utilized for overall Company operations 997,755 Total assets $4,040,526 Electric Gas Transit Total (Thousands of Dollars) Operating revenues $ 829,477 $305,275 $ 3,623 $1,138,375 Operating expenses, excluding depreciation and amortization 554,897 256,178 9,205 820,280 Depreciation and amortization 93,978 14,174 163 108,315 Total operating expenses 648,875 270,352 9,368 928,595 Operating income (loss) $ 180,602 $ 34,923 $(5,745) 209,780 Add - Other income, net 11,883 Less - Interest charges 97,600 - Preferred stock dividends 6,473 Net income $ 117,590 Capital expenditures: Identifiable $ 234,918 $ 33,495 $ 346 $ 268,759 Utilized for overall Company operations 8,877 Total $ 277,636 Identifiable assets at December 31, 1992: Utility plant, net $2,456,691 $299,591 $ 1,240 $2,757,522 Inventories 82,717 8,155 481 91,353 Total $2,539,408 $307,746 $ 1,721 2,848,875 Assets utilized for overall Company operations 708,846 Total assets $3,557,721 Electric Gas Transit Total (Thousands of Dollars) Operating revenues $ 867,215 $ 276,742 $ 3,869 $1,147,826 Operating expenses, excluding depreciation and amortization 580,265 233,509 9,023 822,797 Depreciation and amortization 88,803 13,720 146 102,669 Total operating expenses 669,068 247,229 9,169 925,466 Operating income (loss) $ 198,147 $ 29,513 $ (5,300) 222,360 Add - Other income, net 11,655 Less - Interest charges 91,458 - Preferred stock dividends 6,706 Net income $ 135,851 Capital expenditures: Identifiable $ 205,704 $ 25,380 $ 89 $ 231,173 Utilized for overall Company operations 7,967 Total $ 239,140 Identifiable assets at December 31, 1991: Utility plant, net $2,333,877 $ 280,805 $ 1,073 $2,615,755 Inventories 83,637 7,242 476 91,355 Total $2,417,514 $ 288,047 $ 1,549 2,707,110 Assets utilized for overall Company operations 598,752 Total assets $3,305,862 12. QUARTERLY FINANCIAL DATA (UNAUDITED): First Second Third Fourth Quarter Quarter Quarter Quarter Annual Total operating revenues (000) $321,840 $280,382 $359,453 $302,492 $1,264,167 Operating income (000) 63,714 45,370 84,638 51,589 245,311 Net income (000) 45,110 26,909 64,427 31,535 167,981 Earnings per weighted average share of common stock as reported 1.02 .61 1.41 .68 3.72 First Second Third Fourth Quarter Quarter Quarter Quarter Annual Total operating revenues (000) $297,414 $255,343 $305,594 $280,024 $1,138,375 Operating income (000) 56,978 40,203 64,486 48,113 209,780 Net income (000) 34,132 16,753 39,643 27,062 117,590 Earnings per weighted average share of common stock as reported .83 .41 .96 .64 2.84

74783_1993.txt

74783

1993

ITEM 1. BUSINESS. The Company Acceptance Insurance Companies Inc. (the "Company") is a holding company engaged in the specialty property and casualty insurance business through its operating subsidiaries. At December 31, 1993, the Company had total assets of approximately $409 million and gross written premiums of approximately $256 million for the year then ended. The Company concentrates its efforts on insurance programs in which special underwriting, marketing or claims handling approaches give it a competitive advantage in underwriting particular risks and serving the needs of particular geographic regions or groups of insureds or particular insurance agents. Recent Developments Effective March 31, 1994, the Company entered into an Agreement and Plan of Merger with Statewide Insurance Corporation, the exclusive general agent for the Company's non- standard automobile insurance program underwritten by Phoenix Indemnity Insurance Company ("Phoenix Indemnity"), and the owner of 20% of the outstanding shares of common stock of Phoenix Indemnity, pursuant to which the Company will acquire by merger (the "Merger"), in consideration of shares of common stock, Statewide Insurance Corporation (except for certain assets and liabilities relating to its agency operations other than the non- standard automobile program, which will be divested prior to the Merger). Fiscal Year 1993 Developments On January 27, 1993, the Company completed a Rights Offering to its shareholders resulting in the issuance of 3,992,480 units, for a subscription price of $8.00 per unit, consisting of one share of common stock and one warrant for the purchase of one share of common stock exercisable at $11.00 per share until January 27, 1997, resulting in net proceeds of approximately $31.2 million. Proceeds were used to retire $9.5 million of Secured Subordinated Notes and to provide capital to the Company's insurance subsidiaries. See Note 2 to the Notes to Consolidated Financial Statements. Effective April 15, 1993, a $7 million secured subordinated note issued by a subsidiary of the Company was exchanged for 875,000 units identical to those issued in the Rights Offering. See Note 2 to the Notes to Consolidated Financial Statements. On August 13, 1993, the Company completed the acquisition of 100% of the outstanding common and preferred stock and common stock purchase warrants of The Redland Group, Inc. ("Redland"), a Council Bluffs, Iowa-based holding company engaged through its subsidiaries in the specialty property and casualty insurance business, concentrating on crop insurance coverages and other insurance products marketed to farmers and the rural community. The effective date of this acquisition was July 1, 1993, and the financial and other data set forth herein include the operations of Redland commencing July 1, 1993. See Note 3 to the Notes to Consolidated Financial Statements. Historical Development The Company was incorporated in 1968 in Ohio under the name National Fast Food Corp. In 1969, it was reincorporated in Delaware and thereafter operated under the names NFF Corp. (1971 to 1973), Orange-co, Inc. (1973 to 1987), Stoneridge Resources, Inc. (1987 to 1992), and Acceptance Insurance Companies Inc. from December 1992 until the present. In April 1990, the Company acquired Acceptance Insurance Holdings Inc. ("Acceptance"), a Nebraska corporation which owns as operating subsidiaries Acceptance Insurance Company, a Nebraska-domiciled insurance company; Acceptance Insurance Services, Inc. a Nebraska-domiciled licensed third-party administrator; Phoenix Indemnity, an Arizona-domiciled insurance company (80% owned); Acceptance Indemnity Insurance Company, a Nebraska-domiciled insurance company, and Seaboard Underwriters, Inc., a North Carolina specialty insurance managing general agency. See "Recent Developments" for a description of the Company's plans to acquire the remaining 20% of Phoenix Indemnity along with certain agency operations of Statewide Insurance Corporation, owner of 20% of Phoenix Indemnity. Effective July 1, 1993, the Company acquired Redland in an exchange of its common stock. Redland owns as operating subsidiaries Redland Insurance Company, an Iowa-domiciled insurance company; American Growers Insurance Company, a Nebraska-domiciled insurance company; American Agrisurance, Inc., an Iowa-domiciled marketer of crop insurance; Agro International, Inc., an Iowa-domiciled insurance consulting group (80% owned); American Agrijusters Co., an Iowa-domiciled provider of crop insurance adjusting services; U.S. Ag Insurance Services, Inc., a Texas-domiciled marketer of crop insurance (60% owned); and Crop Insurance Marketing, Inc., an Iowa-domiciled marketer of crop insurance. The insurance underwriting operations of both Acceptance and Redland commenced in 1979 with, as to Acceptance, the formation of Acceptance Insurance Company, and, as to Redland, the formation of Redland Insurance Company. Prior to becoming involved in the specialty property and casualty insurance business through the acquisitions described above, the Company had been actively engaged in the real estate business, principally in Florida, and in the citrus business in Florida. Insurance Programs The Company is a Nebraska-based specialty property and casualty insurance company concentrating on specialty insurance programs principally in the excess and surplus lines of business. The Company's insurance operations are conducted through its subsidiaries domiciled in Nebraska, Iowa, Texas, North Carolina and Arizona. The Company concentrates its efforts on insurance programs in which special underwriting, marketing or claims handling approaches give it a competitive advantage in underwriting a particular risk or serving the needs of a particular geographic region or group of insureds or particular insurance agents. The table below sets forth the amount of net written (net of reinsurance) and gross written premium, respectively, for the specialty insurance programs underwritten by the Company's insurance subsidiaries for the periods set forth below. The Company does not write environmental pollution coverages, specifically excludes environmental pollution risks in substantially all of its policies, and has not experienced any material exposure to environmental pollution claims. Specialty General Agent Programs. The Company offers a variety of specialty insurance coverages through its network of independent general agents. The Company attempts to select general agents who are experienced in specialty coverages written by the Company and can help screen risks written on behalf of the Company and to price the Company's lines of insurance adequately to guard against unanticipated risk exposure. The principal types of specialty insurance coverages written by the independent general agent network include: (1) specialty automobile lines (property and casualty coverages for high value automobiles, local haulers of specialized freight and other motor vehicle coverages not normally underwritten by standard carriers); (2) surplus lines liability and substandard property coverages for small businesses normally not actively sought out by larger insurers; (3) liquor liability or dram shop coverages for liquor stores and taverns and restaurants serving alcoholic beverages insuring against personal injuries and property damage caused by intoxicated persons served alcoholic beverages in insured facilities; (4) used car dealer and automobile repair shop property and casualty coverages; and (5) excess liability, including commercial umbrella policies (covering liability exposure in excess of underlying policies or self-insurance retention) and policies providing a layer of coverage in excess of limits provided by primary liability carriers. Non-Standard Automobile. The Company writes non-standard private passenger automobile coverages principally in the southwest United States and expects continued growth in written premiums from this line of business in future periods through geographic expansion. This program provides minimum coverages for drivers who do not qualify for standard or preferred treatment with standard line companies. Transportation Insurance. The Company's transportation coverages include property and casualty coverages written by Seaboard for long haul truckers, generally dry freight haulers, operating throughout the United States, and upper-midwest regional and national truck companies underwritten through the Redland agency network, principally for rural products, e.g., livestock, processed meat and grains. Acceptance Risk Managers, Inc. ("ARM"). ARM is an independent general agency which began operations in late 1991 specializing in underwriting difficult general liability risks, including products liability coverages, unique professional liability and excess liability coverages, on a surplus lines (non-admitted) basis. ARM currently writes business exclusively on behalf of the Company. The two founders of ARM have each been actively involved with these lines of business as insurance company executives for over 30 years. ARM operations are controlled both contractually and operationally to insure maintenance of proper underwriting standards. Contractually, officers of the Company comprise over 50% of the members of the board of directors of ARM, and the authority of ARM is limited to specific types of insurance detailed in reinsurance treaties written for this business unit. All claims are reported to the Company, and key policy and claims information is maintained in the Company's data base. Policy payments are deposited to a Company lock box account and all claims are funded individually by the Company into a Company controlled account. In addition, the Company requires weekly management reports from ARM. The Company and each of the four reinsurers participating in this business periodically audit the underwriting operations of ARM, and each has conducted at least two audits in the past twelve months. The reinsurers participating in this business are Constitution Reinsurance Corporation, ReCapital Reinsurance Corporation, Northstar Reinsurance Corporation and Christiana General Insurance Corporation, each of which is liable only for its own retention. Workers Compensation. The Company writes limited specialty workers' compensation insurance coverages principally in Minnesota. The Company's workers' compensation insurance program attempts to control losses through the application of stringent return to work claims management programs. Prior to April 1992, the return to work program was administered by an independent third party claims manager under an agreement which was terminated, as the workers' compensation program was not profitable because of the high expense ratios incurred with the third party claims manager. Redland Insurance Programs Multi-Peril Crop Insurance ("MPCI") and Hail Insurance. The written premium from MPCI and crop hail insurance represents the bulk of premium revenues for the Redland group of companies. MPCI insures a percentage (up to 75%) of the historic yield on growing crops against substantially all natural perils while crop hail insurance insures spot losses on growing crops resulting from hail storms. Rural Agents Programs. This program is designed to offer to the network of Redland agents (historically crop agents) standard basic property and casualty coverages (home, automobile and limited commercial coverages) underwritten by one of the Company's subsidiaries. The Company has found that larger insurance companies concentrate more on high volume agencies, and that many rural agencies experience difficulty in finding markets for their insureds. Specialty Lines. A variety of specialty insurance programs are offered by the Redland insurance companies through an independent agent network developed over a number of years by Redland management. These insurance programs include property and casualty coverages for race tracks, automobile repair shops, temporary help agencies and animal mortality coverages. The program also offers insurance covering damage from floods in rural areas covered by Redland general agents. Seaboard Underwriters, Inc. In October 1991, The Company acquired Seaboard, a North Carolina insurance agency acting as a general agent for insurance companies, including one or more of the Company's subsidiaries, specializing principally in the writing of property and casualty insurance coverages for long haul truckers. During the year ended December 31, 1993, Seaboard received commission income of $4,119,000, and incurred operating expenses of $3,794,000. Reinsurance The Company limits its exposure under individual policies by purchasing excess of loss and quota share reinsurance from other insurance companies, and it maintains catastrophe reinsurance to protect against catastrophic occurrences where claims can arise under several policies due to a single event. Reinsurance does not legally discharge the Company from its primary liability to the insured for the full amount of a claim, but it does make the reinsurer liable to the Company to the extent of the reinsured portion of any loss ultimately incurred. The Company retains the first $500,000 of risk under its casualty lines, ceding the next $2,500,000 to reinsurers. Under its property lines, the Company retains 25% of the first $500,000 of risk, ceding the other 75% to quota share reinsurers and the next $1,000,000 to other reinsurers. For workers' compensation lines the Company reinsures 50% of the first $230,000 of each risk, and 100% of any excess. The Company also maintains a separate 80% quota share treaty for business written through ARM. To the extent that individual policies in any line exceed reinsurance treaty limits, the Company purchases individual reinsurance on a facultative (specific policy) basis. The Company maintains catastrophe reinsurance for its casualty lines which provide coverages of $3,000,000 in excess of $3,000,000 of risk retained by the Company and its reinsurers and for its property lines which provide catastrophe coverages of 95% of $6,500,000 in excess of the $1,000,000 of risk retained by the Company. Under its non-standard automobile program, the Company maintains catastrophe reinsurance which provides coverages of 95% of $1,000,000 in excess of the $100,000 of risk retained by the Company for physical damage coverage and 100% of $900,000 in excess of the $100,000 of risk retained by the Company for liability coverage. A substantial portion (approximately 87%) of the Company's crop hail business is reinsured through quota share agreements supplemented by surplus and stop loss contracts. Surplus agreements limit quota share exposure to $1,500,000 per county or township. The stop loss reinsurance reduces the Company's net retained (not reinsured) quota share exposure by 95% once net retained losses exceed 90% of retained premiums. The Company's MPCI business is reinsured by the FCIC. Under FCIC's reinsurance program, the Company may (at the Company's election) cede to FCIC levels of exposure under MPCI policies, ranging from 0 to 80% of such exposure. In 1993, the average level of the Company's retention was 53.3% of such exposure. The reinsurance agreement also contains provisions that further reduce net retentions non-proportionally on a state- by-state basis. Net underwriting gains or losses are allocated to the company by the FCIC annually. The Company's net exposure on MPCI business is further reduced by privately placed stop loss reinsurance. The Company's farmowners business is reinsured by a 70% quota share contract. Quota share retentions are further reinsured by excess of loss and catastrophe loss contracts. Other non-crop property and casualty lines are reinsured by excess of loss agreements that limit net exposure to $250,000 per risk. Federal flood insurance is reinsured 100% by the Federal Emergency Management Administration ("FEMA") through its sub- agency, Federal Insurance Administration ("FIA"). Reinsurance treaties are renegotiated and renewed annually by the Company. The Company closely monitors the quality and performance of its reinsurers and for the year ended December 31, 1993, approximately 80% of the Company's reinsurance business was ceded to reinsurance companies rated A- (Excellent) by A.M. Best Company, or was reinsured by FCIC or FEMA. Investments The Company's investment results for the periods indicated are set forth below: The Company's investment portfolio at December 31, 1993, consisted of the following: Carrying Type of Investment Amount __________________ ________ (in thousands) Fixed maturities held for investment (1) $ 51,756 Fixed maturities available for sale (1) 95,836 Common stock 5,426 Preferred stock 8,446 Real estate 4,266 Mortgage loans and other investments 2,852 Short-term investments: Commercial Paper 4,668 U.S. Government/Agency securities 14,000 Certificate of Deposit 551 Money Market Account 185 _______ Total short-term investments 19,404 _______ Total investments (2) $187,986 ======= ______________________ (1) At December 31, 1993, approximately 68% of the fixed maturities were invested in United States Treasury and government agency securities and collateralized mortgage obligations backed by U.S. government agency securities. (2) All investments are carried at amortized cost, except common stock and preferred stock, which are carried at market value and fixed maturities held for sale which are carried at the lower of cost or market. GAAP Combined Loss and Expense Ratio The Company's underwriting experience is indicated by its "combined ratio" which is the sum of (1) the ratio of losses and loss adjustment expenses incurred to net premiums earned (the "Loss Ratio") and (2) the ratio of policy acquisition costs, other underwriting costs, and other expenses incurred to net premiums written (the "Expense Ratio"). The Company's ratios, computed in accordance with generally accepted accounting principles ("GAAP"), are set forth in the following table (a combined ratio below 100% indicates a profit from underwriting activities): Years Ended December 31, ______________________________ 1993 1992 1991 ______ __________ ______ Loss Ratio 72.5% 75.8% (1) 72.0% Expense Ratio 28.4 29.1 29.0 _____ _____ _____ Combined Ratio 100.9% 104.9% 101.0% ===== ===== ===== _______________ (1) The higher loss ratio for 1992 resulted in part from an approximate $2.1 million strengthening of the Company's loss and loss adjustment expense reserves for its workers' compensation and liquor liability lines, and $1.7 million of incurred losses relating to Hurricanes Andrew and Iniki, collectively 4.8% of the 1992 loss ratio. Losses and Loss Adjustment Expense Reserves The Company maintains reserves for estimates of liability for reported losses, losses which have occurred but which have not yet been reported, and for the expenses of investigating, processing and settling claims under outstanding policies. Such reserves are estimates by the Company primarily based on company and industry experience with the types of risks involved, knowledge of the circumstances surrounding individual claims, and company and industry experience with respect to the probable number and nature of claims arising from losses not yet reported. The effects of inflation are implicitly reflected in these loss reserves through the industry data utilized in establishing such reserves. Since 1985, the Company has annually obtained an independent review of its loss reserving process and reserve estimates by a professional actuary as part of the annual audit of its financial statements. The Company adopted Statement of Financial Accounting Standards ("SFAS") No. 113, "Accounting and Reporting for Reinsurance for Short-Duration and Long-Duration Contracts," effective January 1, 1993. The effect of the application of SFAS No. 113 resulted in the reclassification of amounts ceded to reinsurance previously reported as a reduction in unearned premium and unpaid losses and loss adjustment expenses, to assets on the consolidated balance sheet. The table below includes a reconciliation of net loss and loss adjustment expense reserves to amounts presented on the consolidated balance sheet after reclassifications related to the adoption of SFAS No. 113. The gross cumulative redundancy in the table on the following page is presented for 1992, the only year on the table for which the Company has restated amounts in accordance with SFAS No. 113. The following table presents an analysis of the Company's reserves, reconciling beginning and ending reserve balances for the periods indicated: The following table presents the development of balance sheet loss reserves from calendar years 1983 through 1992. The top line of the table shows the loss reserves at the balance sheet date for each of the indicated years. These amounts are the estimates of losses and loss adjustment expenses for claims arising in all prior years that are unpaid at the balance sheet date, including losses that had been incurred but not yet reported to the Company. The middle section of the table shows the cumulative amount paid with respect to previously recorded reserves as of the end of each succeeding year. The lower section of the table shows the reestimated amount of the previously recorded reserves based on experience as of the end of each succeeding year. The "Cumulative redundancy (deficiency)" caption represents the aggregate change in the estimates over all prior years. Conditions and trends that have affected the development of loss reserves in the past may not necessarily occur in the future. Accordingly, it may not be appropriate to extrapolate future redundancies or deficiencies based on this information. The Company computes the cumulative redundancy (deficiency) annually on a calendar year basis. Uncertainties Affecting the Insurance Business The property and casualty insurance business is highly competitive, with over 3,000 insurance companies transacting such business in the United States, many of whom have substantially greater financial and other resources, and may offer a broader variety of coverages than those offered by the Company. Beginning in the latter half of the 1980s, there has been severe price competition in the insurance industry which has resulted in a reduction in the volume of premiums written by the Company in some of its lines of businesses, because of its unwillingness to reduce prices to meet competition. The specialty property and casualty coverages underwritten by the Company may involve greater risks than more standard property and casualty lines. These risks may include a lack of predictability, and in some instances, the absence of a long-term, reliable historical data base upon which to estimate losses. The Company's strategy is to offer specialized property and casualty insurance programs as to which there is limited competition from larger insurers. Pricing in the property and casualty insurance industry is cyclical in nature, fluctuating from periods of intense price competition, which led to record underwriting losses during the early 1980's, to periods of increased market opportunity as some carriers withdrew from certain market segments. Despite increased price competition in recent years, the Company has maintained consistent earned premium income during such periods, principally through geographic expansion and implementation of new insurance programs. The Company's results also may be influenced by factors influencing the insurance industry generally and which are largely beyond the Company's control. Such factors include (a) weather related catastrophes; (b) taxation and regulatory reform at both the federal and state level; (c) changes in industry standards regarding rating and policy forms; (d) significant changes in judicial attitudes towards liability claims; (e) the cyclical nature of pricing in the industry; and (f) changes in the rate of inflation, interest rates and general economic conditions. Adverse loss experience in two lines of insurance written by the Company resulted in a strengthening of loss and loss adjustment expense reserves in 1992 by approximately $2.1 million. The crop insurance coverages underwritten by the Redland group of companies has experienced adverse loss experience over the last two years largely because of unusual and adverse weather conditions which affected crop yields. During the second fiscal quarter of 1993, Redland strengthened loss and loss adjustment reserves by $3 million, partly as a result of suggestions made by the Company in the course of the negotiations leading to the acquisition of Redland. See "Management's Discussion and Analysis of Financial Condition and Results of Operations" for discussion of the impact of these uncertainties on the Company's financial condition and operating results. Marketing The Company generally markets the insurance products of the Acceptance group of companies through independent general agents. These agents deal with local agents and brokers who are in direct contact with insurance buyers. The number of general agents marketing the Company's Acceptance insurance lines has increased from approximately 58 in 1988 to approximately 104 in 1993. General agents are compensated on a commission basis. Workers' compensation coverages are written directly through agents who are in direct contact with insurance buyers. The Company writes the insurance products of the Acceptance group of companies in 22 states as an admitted carrier and in 37 states as an approved non-admitted carrier. Non-admitted carriers are normally restricted to writing lines of business not regularly written in the standard admitted market, but have greater freedom to design policy provisions and charge appropriate premiums on an unregulated basis. The Company generally seeks to have an insurance subsidiary licensed as an admitted carrier, as well as another insurance subsidiary operating as an approved non-admitted carrier in each state in which it writes insurance, in order to offer insurance products in both the admitted as well as the non-admitted market. For the years ended December 31, 1993 and 1992, the Company wrote 51% of its written premiums from the Acceptance group as a non-admitted carrier and 49% as an admitted carrier. The Company has expanded the geographic distribution of its business from the Acceptance group in recent years from 18 states in 1986 to 39 states in 1993. New insurance programs in liquor liability, workers' compensation and non-standard automobile coverages, initiated in 1989, and business written through Seaboard and ARM beginning in 1991, has led to further geographic expansion. The crop and other rural coverages underwritten by the Redland group are marketed through a network of approximately 2,500 independent agents in 43 states who sell MPCI, hail and flood insurance directly to farmers, as well as other insurance products underwritten by the Redland group of companies. The Company intends to offer standard basic property and casualty coverages (home, automobile and limited commercial coverages) underwritten by one of the Company's subsidiaries to the Redland network of rural agents. With the acquisition of Redland, at December 31, 1993, the Company now offers its insurance products, through an admitted carrier in 44 states and the District of Columbia, and through a non-admitted carrier in 41 states and the District of Columbia. During the year ended December 31, 1993, five agents produced approximately 34% of the Company's direct written premiums. Two of these agents, Acceptance Risk Managers, Inc. and Statewide Insurance Corporation produced, respectively, approximately 12% and 12%, of the direct written premiums for the year ended December 31, 1993. No other agent produced more than 10% of direct written premiums for that year. See "Recent Developments" for a discussion of the Company's plans to acquire in a stock merger Statewide Insurance Corporation. The states in which the Company wrote more than 5% of its written premium in 1993 are shown below with the amounts written in such states in the two prior years. Years Ended December 31, _________________________________ 1993 1992 1991 _____ _____ _____ Texas 13.5% 14.5% 12.0% Minnesota 8.5 15.9 19.7 California 7.5 6.5 4.5 Nebraska 7.1 1.5 1.7 Illinois 5.8 4.3 5.3 Arizona 5.6 12.0 12.9 Iowa 5.5 4.1 5.7 Regulation Insurance companies operate in a highly regulated industry and are subject to a variety of governmental regulations and the supervision of regulatory agencies in the states in which they conduct business. The primary purpose of such regulations is the protection of policyholders and claimants rather than shareholders. State insurance departments have broad regulatory authority over insurance companies selling insurance in their states. Depending on whether the insurance company is domiciled in the state and whether it is an admitted or non-admitted insurer, such authority may extend to such things as (i) periodic financial examination; (ii) approval of rates and policy forms; (iii) monitoring loss reserve adequacy; (iv) solvency monitoring; (v) restrictions on the payment of dividends; (vi) approval of changes in control and (vii) authorization of investments. The Company is also subject to statutes governing insurance holding companies. These statutes require the Company, among other things, to file periodic information with state regulatory authorities including information concerning its capital structure, ownership, financial condition and general business operations; limit certain transactions between the Company, its affiliates and its insurance subsidiaries; and restrict the ability of any one person to acquire certain levels of the Company's voting securities without prior regulatory approval. Nebraska law limits Nebraska insurance companies' capacity to pay dividends and conduct other financial transactions with their shareholders and affiliates without prior regulatory approval. Dividends or distributions made within the preceding 12 months may not exceed the lesser of (a) 10% of the policyholders' surplus as of the December 31 preceding the date of determination or (b) net income, not including realized capital gains, for the twelve-month period ending on December 31 preceding the date of determination. In determining net income available for dividends, an insurer may carry forward net income from the second and third full calendar years preceding the date of determination, again excluding realized capital gains, less dividends paid in such prior calendar years preceding the date of determination. The States of Iowa and Arizona regulate insurance companies' capacity to pay dividends and to conduct other financial transactions with their shareholders and affiliates, without prior regulatory approval, in a manner substantially similar to Nebraska. The Company's MPCI and federal flood insurance programs are federally regulated insurance products. Consequently, these programs are subject to oversight by the legislative and executive branches of the federal government. These regulations generally require compliance with federal guidelines with respect to underwriting, rating and claims administration. The Company is required to perform continuous internal audit procedures and is subject to audit by several federal government agencies. Employees At March 21, 1994 the Company and its subsidiaries employed 30 salaried executive and 534 salaried administrative personnel. The Merger with Statewide Insurance Corporation (see "Recent Developments") will result in the addition of 98 additional salaried administrative personnel in Phoenix. Acceptance believes that relations with its employees are satisfactory. There are no longer any individuals employed by the Company at the parent level. ITEM 2.

ITEM 2. PROPERTIES. The following table sets forth certain information regarding the principal properties of the Company. General Location Character Size Leased/Owned ___________________ _________ ______________ ____________ Omaha, NE Office 44,000 sq. ft. Leased(1) Council Bluffs, IA Office 62,000 sq. ft. Leased(1) Burlington, NC Office 15,000 sq. ft. Leased(1) Phoenix, AZ Office 6,500 sq. ft. Month-to-Month Rental Scottsdale, AZ Office 11,000 sq. ft. Leased(1) ______________________ (1) The range of expiration dates for these leases is November 30, 2001 (Omaha), February 1, 1996 (Burlington), December, 1998 (Scottsdale), and June 30, 1997 (Council Bluffs). (2) The Company leases, generally on a month-to-month rental basis, small facilities in various parts of the United States in connection with its crop insurance operations. ITEM 3.

ITEM 3. LEGAL PROCEEDINGS. There are no material legal proceedings pending involving the Company or any of its subsidiaries which require reporting pursuant to this Item. ITEM 4.

ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS. No matters were submitted to a vote of security holders during the fourth quarter of the fiscal year ended December 31, 1993. PART II ITEM 5.

ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS. The Company's Common Stock is listed and traded on the NYSE. The following table sets forth the high and low closing sales prices per share of Common Stock as reported on the NYSE Composite Tape for the fiscal quarters indicated. The prices set forth below through December 22, 1992, in the fourth quarter of the fiscal year ended December 31, 1992, reflect the prices of the shares of Common Stock on the NYSE prior to the one-for-four reverse stock split effected December 22, 1992. The prices set forth beginning December 23, 1992 reflect the prices of the shares of Common Stock after the reverse stock split. High Low ____ ___ Year Ended December 31, 1992 First Quarter 2-7/8 2 Second Quarter 2-7/8 2-1/4 Third Quarter 2-1/2 1-5/8 Fourth Quarter (through December 22, 1992, pre-split) 3-1/2 1-5/8 Fourth Quarter (beginning December 23, 1992, post-split) 10-5/8 9-5/8 Year Ended December 31, 1993 First Quarter 13-1/4 8-1/4 Second Quarter 14-1/3 12 Third Quarter 15-1/4 12-1/2 Fourth Quarter 15-5/8 11-1/4 Year Ended December 31, 1994 First Quarter (through March 21, 1994) 13-3/4 11-1/4 The closing sales price of the Common Stock on March 21, 1994, as reported on the NYSE Composite Tape, was $11.375 per share. As of March 21, 1994, there were approximately 1,900 holders of record of the Common Stock. As a holding company, the Company is dependent for cash flows upon dividends or other distributions from its operating subsidiaries. To the extent that the Company experiences positive cash flows from its operations, it intends, generally, to reinvest any such excess cash in the Company's insurance operations. The Company has not paid cash dividends during the periods indicated above and does not anticipate that it will pay cash dividends in the foreseeable future. Because of regulatory restrictions and the terms of the Company's loan agreements, dividends or other cash flow from the insurance subsidiaries in the foreseeable future is not anticipated. The foregoing obligations of the Company prohibit the declaration or payment of dividends to the Company by its subsidiaries, or payment of dividends by the Company to its shareholders, without approval of the bank lenders. See Note 14 to the Notes to Consolidated Financial Statements. ITEM 6.

ITEM 6. SELECTED FINANCIAL DATA. The following tables set forth certain information concerning the insurance operations of the Company and its general operations, and should be read in conjunction with, and are qualified in their entirety by, the Consolidated Financial Statements and the notes thereto appearing elsewhere in this report. This selected financial data has been derived from the audited Consolidated Financial Statements of the Company and its subsidiaries. The "Pre-Acquisition" information set forth below is not included in the Company's Consolidated Financial Statements relating to periods prior to the Company's acquisition of Acceptance in April 1990. ITEM 7.

ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS. The following discussion and analysis of financial condition and results of operations of the Company and its consolidated subsidiaries is based upon the consolidated financial statements, and the notes thereto included herein. Results of Operations Year Ended December 31, 1993 Compared to Year Ended December 31, 1992. The Company's net income increased by $8.5 million from 1992 to 1993 as net income improved from a loss of $.9 million for the year ended December 31, 1992 to income of $7.6 million for the year ended December 31, 1993. This increase was attributable primarily to four factors: 1) improved underwriting results combined with an increase in premiums earned, 2) growth in the investment income of the Company, 3) continued reduction in the general and administrative expenses of the Company, and 4) a reduction in interest expense. In addition, the real estate interests of the Company had very little impact on the change in net income for 1993 as compared to 1992. Insurance premiums earned increased by 61.8% from 1992 to 1993. Excluding the increase in premiums written resulting from the merger with The Redland Group, Inc. ("Redland"), the Company's direct written premiums increased a modest 11.9%. Net premiums, however, increased 45.2% due to the Company's ability to retain more premiums as a result of increased capital from the Equity Rights Offering completed in January, 1993 which raised $31.2 million. In addition, during 1993, the new Redland operations added $16.2 million in earned premiums to the Company's revenues. With the inclusion of the Redland operations for an entire year, the expansion of the Company's general agency programs as a result of the opening of a new branch office in Scottsdale, Arizona and the business opportunities developed from the Company's merger with Redland, it is expected that the growth in premium revenue will continue during 1994. This increase in earned premium revenue translated into improved results in 1993 as compared to 1992 as the Company experienced a reduced combined loss and expense ratio from insurance operations of 100.9% during the twelve months ended December 31, 1993 as compared to 104.9% during the same period in 1992. With the inclusion of Redland, the Company's expense ratio fell slightly from 29.1% in 1992 to 28.4% in 1993. The Company's loss ratio decreased from 75.8% during 1992 to 72.5% during 1993. The results in 1992 were affected by Hurricane's Andrew and Iniki as well as reserve strengthening in the Company's workers' compensation and liquor liability lines. These events did not reoccur during 1993 contributing to the decline in the Company's loss ratio. The seasonal nature of crop insurance writings combined with unpredictable weather patterns are expected to create more volatility in the Company's quarter to quarter earnings in the future, and thus, results in one quarter will provide a less reliable forecast of subsequent quarterly results. The Company's investment income increased 41.3% from the year ended December 31, 1992 to the year ended December 31, 1993. This increase is attributable primarily to the increase in the Company's investment portfolio from an average of $113 million during 1992 to an average portfolio of $173 million during 1993. This increase in the size of the portfolio resulted from a capital infusion of funds derived from the Company's Equity Rights Offering completed in January, 1993, the Company's ability to cede less of its premium to reinsurers as a result of this capital infusion, growth in the Company's direct premiums, and additional investment assets acquired in the merger with Redland. In terms of generating investment income, the increase in the size of the portfolio more than offset the reduction in the average yield on the investment portfolio from 7.3% during the year ended December 31, 1992 to 6.3% during the 1993 year. This reduction in average yield primarily was due to the reduced yields available for investment grade securities in the marketplace, the addition to the Company's portfolio of tax free securities which, in general, have a lower yield than equivalent taxable securities, the short term nature of Redland's portfolio, and amortization of premiums paid for certain of the Company's mortgage backed securities caused by an acceleration in the prepayment speed of the underlying mortgages. If the Company's net tax operating losses continue to diminish, the Company will seek additional opportunities in the tax free investment sector. During 1993, the Company was able to further reduce its general and administrative expenses as compared to those experienced in 1992. Two factors served to decrease the general and administrative expenses. First, the Company combined its real estate and portfolio management operations during 1993, thus reducing administrative expenses associated with real estate activities. In addition, the Company continued to reduce expenses as a result of the consolidation of operations between the parent Company and its insurance company subsidiaries. This consolidation was initiated by the movement of the Company's home office from Bloomfield Hills, Michigan to Omaha, Nebraska in July, 1992. Offsetting decreases in general and administrative expenses were increases associated with Redland. These expenses include normal administrative expenses associated with the running of the Redland operations as well as the amortization of certain identifiable intangible assets and the excess of costs over acquired net assets. The Company does not expect further reductions in its general and administrative expenses during 1994. The Company's interest expense continued to decline during 1993 compared to 1992. This was due primarily to a decrease in the Company's outstanding debt as well as a reduction in the Company's average interest costs on such debt. On May 28, 1992, the Company completed the sale of its 5,355,166 shares of Common Stock of Orange-co for $31 million in cash, resulting in net proceeds of approximately $29 million. The Company applied approximately $22.4 million to retire its bank term loan. On January 27, 1993, the Company successfully completed a $31.9 million Common Stock Rights Offering. Proceeds from this offering were used to retire $9.5 million of secured subordinated notes plus accrued interest thereon. Effective April 15, 1993 the holder of a $7 million secured subordinated note of one of the Company's subsidiaries, which had been assumed by the Company, exchanged such note for 875,000 shares of Common Stock and Warrants to purchase, at a price of $11 per share during a period ending January 27, 1997, 875,000 additional shares of Common Stock. All of these events reduced debt carried at higher interest rates than the Company's other bank borrowings, and therefore, with the retirement of these debts, the Company also reduced the average cost of its outstanding debt. In March, 1994, the Company agreed to amend borrowing arrangements with its bank lenders. The new structure is a $35 million line of credit with interest payable quarterly at the prime rate or at LIBOR plus a margin of 1% to 1.75%, depending on the Company's debt to equity ratio. The line of credit will mature in four years and may be extended to five years by the bank lenders. The line of credit will be consummated once final legal documentation is completed which is anticipated to be in April, 1994. Such facility will increase the Company's borrowing capacity and, in the current interest rate environment, should reduce the interest rate which the Company pays on its debt. Since the interest rate is a floating rate, the Company has no guarantee that such reduction will be a permanent one. Year Ended December 31, 1992 Compared to Year Ended December 31, 1991 The Company's net loss decreased $42 million to $.9 million for the year ended December 31, 1992 as compared to $42.9 million for the previous year. This decrease was mainly attributable to a $19.6 million provision for the expected loss on disposal of the Company's investment in Orange-co and a $15.3 million write- down of the Company's equity investment in Major Realty to estimated net realizable value, both recorded during the year ended December 31, 1991. The remaining approximate $7.1 million related to a decrease in general and administrative expenses of $5.7 million, a decrease in other expense of $2.6 million, principally related to a loss in 1991 which did not reoccur in 1992, a decrease in interest expense of $1.3 million, and an increase in investment income of $1.2 million. These improvements were partially offset by a $2.1 million reserve strengthening in the insurance operations and a $1.7 million incurred loss from Hurricanes Andrew and Iniki. Insurance premiums earned increased 21.5% to $79.2 million for the year ended December 31, 1992 from $65.2 million in the previous year. This increase is attributable primarily to growth in workers' compensation, non-standard private passenger and specialty automobile and the Acceptance Risk Managers programs. During the year ended December 31, 1992, loss and loss adjustment expenses increased 27.9% as compared to the previous year. This higher rate of growth in losses (27.9%) compared to premium revenues (21.5%) was attributable primarily to increased loss development in the Company's workers' compensation and liquor liability lines as well as losses incurred from Hurricanes Andrew and Iniki. During 1992, through analysis of additional claims information and additional data processing capability which came "on-line," it became apparent that the liquor and workers' compensation lines of business were developing worse than had been anticipated. This judgment was based upon several factors: discussion with the claims staff and counsel regarding specific claims, adjudicated cases and the estimated effect thereof as precedents for similar claims, additional claims filed, the severity thereof, and the effect of these new claims as an indicator of additional incurred but not reported loss development. Management believes that the reserves recorded for these lines of business and events now provide adequate reserves for future payments. Insurance operational expense ratios for the years ended December 31, 1992 and 1991 remained consistent at 29.1% and 29.0%, respectively. In October 1991, Acceptance acquired Seaboard Underwriters, Inc. ("Seaboard"), a North Carolina-based managing general agency specializing in transportation business. Seaboard's agency commissions during the year ended December 31, 1992, aggregated approximately $4.0 million while agency expenses totaled approximately $3.7 million. Acceptance's insurance subsidiaries have been underwriting a portion of the business produced by Seaboard. During the year ended December 31, 1991, the Company's investment strategy provided for investment principally in U.S. Government securities with maturities of two years or less as well as realizing gains within the portfolio as the interest rate environment changed. During the year ended December 31, 1992, the Company changed its investment strategy to one whereby various securities of the U.S. Government, U.S. Government agencies, corporate securities and collateralized mortgage obligations backed by U.S. Government Agency Securities were combined to result in an average duration for the entire portfolio of between 3.5 and 4 years. This change in strategy as well as an overall increase in the size of the portfolio resulted in an increase in the interest income of the portfolio. These factors combined to create an overall increase in the Company's net investment income for the year ended December 31, 1992, as compared to the previous year. U.S. Government Securities and collateralized mortgage obligations backed by U.S. Government Agency Securities comprised 74% of the entire investment portfolio as of December 31, 1992. Revenues from the Company's real estate operations for the year ended December 31, 1992, were $2,610,000 of which $1,522,000 related to fees earned in connection with Major Group's management and real estate advisory agreement with Major Realty which terminated June 30, 1992. Included in the $1,522,000 is a non-recurring fee of $925,000 paid by Major Realty to Major Group in the form of a promissory note recorded in connection with the settlement and termination of the advisory agreement with Major Realty. On September 25, 1992, the Company completed the merger with The Major Group, Inc. Pursuant to Settlement Agreements among the Company, Major Group and certain secured creditors (the "Term Sheet Creditors"), Major Group (1) conveyed substantially all of its assets, except for certain property located in Fort Lauderdale, Florida (the "Fort Lauderdale Commerce Center Property") and two promissory notes from Major Realty Corporation (the "Major Realty Notes"), to the Term Sheet Creditors in satisfaction of all of Major Group's obligations due to them; (2) the Fort Lauderdale Commerce Center Property and the Major Realty Notes were transferred to the Company in satisfaction of all amounts due the Company under a note of a subsidiary of Major Group, which was secured by a mortgage on the Fort Lauderdale Commerce Center Property and guaranteed by Major Group; and (3) the Company issued a promissory note in the principal amount of $500,000 payable in installments over one year to the Term Sheet Creditors in exchange for all of the Major Group preferred stock held by the Term Sheet Creditors. Assets conveyed to the Term Sheet Creditors and liabilities satisfied approximated $5.7 million. Immediately upon conclusion of these transactions, Major Group was merged into a wholly owned subsidiary of the Company. In addition, Major Group settled certain claims by agreeing to pay $150,000 in cash and other consideration, payment of which is guaranteed by the Company, payable over a two year period and payment of the net cash proceeds from the sale of certain sewer connections not to exceed $150,000. In connection with the above, the Company issued approximately 52,000 shares of Common Stock to complete the merger. The net effect of the transactions among Major Group, the Term Sheet Creditors and the Company upon the results of operations was insignificant. Consolidated interest expense decreased $1.3 million from the prior year to $4.4 million for the year ended December 31, 1992. Total indebtedness was $33.6 million at December 31, 1992, a decrease of $21.9 million from $55.5 million at December 31, 1991. At December 31, 1992, the Company had approximately $23.7 million of net operating loss carryforwards for financial reporting purposes and $14 million of net operating loss carryforwards for tax reporting purposes. LIQUIDITY AND CAPITAL RESOURCES The Company has included a discussion of the liquidity and capital resources requirement of the Company and the Company's insurance subsidiaries. The Company -- Parent Only On January 27, 1993, the Company completed a $31.9 million Common Stock Equity Rights Offering. This resulted in the issuance of 3,992,480 shares of Common Stock and an equal amount of Warrants, each Warrant providing for the purchase of one share of Common Stock exercisable at $11.00 until January 27, 1997, unless called under certain conditions. The net proceeds of approximately $31.2 million were used to retire $9.5 million of secured subordinated notes plus accrued interest thereon and increase the insurance subsidiaries capital by $12.5 million with the balance retained as working capital. With this addition to working capital, the Company has been able to meet all short term cash needs, and as of December 31, 1993 has no long term liabilities or long term commitments. The Company also assumed a $7 million secured subordinated note outstanding from one of its insurance company subsidiaries and subsequently retired said note in April, 1993 in exchange for 875,000 shares of Common Stock and 875,000 Warrants identical to those issued in the Rights Offering. Dividends from the insurance subsidiaries are not available to the Company because of restrictive covenants set forth in the term and revolving loan agreements of the Company's insurance subsidiaries which prohibit dividends from the insurance subsidiaries to the Company without the expressed consent from the holders of the debt obligation. In March, 1994, the Company agreed to amend its borrowing arrangements with its bank lenders. The new arrangements will transfer the debt obligations from the holding companies of the insurance subsidiaries to the parent company. At such time, the new loan agreements will no longer impose restrictions on dividends from the insurance subsidiaries to the Company. The new structure is a $35 million line of credit with interest payable quarterly at the prime rate or at LIBOR plus a margin of 1% to 1.75% depending on the Company's debt to equity ratio. The line of credit will mature in four years and may be extended to five years by the bank lenders. This line of credit will be consummated once final legal documentation is completed which is anticipated to be in April, 1994. In addition, dividends from the insurance subsidiaries to the Company are regulated by the state regulatory authorities of the states in which each insurance subsidiary is domiciled. The laws of such states generally restrict dividends from insurance companies to parent companies to certain statutorily approved limits. As of December 31, 1993, the statutory limitations on dividends from the insurance company subsidiaries to the parent without further insurance department approval are approximately $3.4 million. Insurance Subsidiaries The Company's insurance subsidiaries are highly liquid and are able to meet their cash requirements on a timely basis. At December 31, 1993, the insurance subsidiaries outstanding debt consisted of a $12 million term loan note, a $6,597,000 revolving promissory note and $354,000 of other borrowings. The $12 million note was collateralized by the Company's Acceptance Common Stock, with principal of $1 million plus interest at prime plus .5% or at the Company's option LIBOR plus 2.5% payable quarterly with a maturity of October 1, 1996. The revolving promissory note was collateralized by Redland Common Stock with interest payable at the Federal funds rate plus 2.75%, maturing on January 5, 1995. Both of these borrowings will be replaced in April, 1994 with the funds from the new loan arrangement described above. Servicing of these debt obligations of the insurance subsidiaries has been provided by funds derived either from tax sharing payments made by the operating subsidiaries to the Company which are sheltered by the Company's tax net operating loss carryforwards and reinvested in the insurance holding company or through dividends and/or advances. On a longer term basis, the principal liquidity needs of the insurance company subsidiaries are to fund loss payments and loss adjustment expenses required in the operation of its insurance business. Primarily, the available sources to fund these obligations are new premiums received and to a lesser extent cash flows from the Company's portfolio operations. The Company monitors its cash flow carefully and attempts to maintain its portfolio at a duration which approximates the estimated cash requirements for loss and loss adjustment expenses. The seasonal nature of the Company's crop business generates a reverse cash flow with acquisition costs in the first part of the year, losses being paid over the summer months, and the related premium not collected until after the fall harvest. Cash flows from the crop programs are similar in nature to cash flows in the farming business. Changes in Financial Condition Four events occurring during 1993 strengthened the financial condition of the Company at December 31, 1993 as compared to the Company's position at December 31, 1992. These events were the completion of the Company's Equity Rights Offering, the conversion of certain subordinated notes to equity, the merger of the Company with Redland and the Company's profitable operating results for 1993. As described earlier, the Company completed a $31.9 million Common Stock Rights Offering in January, 1993. The net proceeds of approximately $31.2 million were used to retire $9.5 million of secured subordinated notes plus accrued interest thereon and increased the insurance subsidiaries capital by $12.5 million with the balance retained as working capital. In April, 1993, the Company retired $7 million of secured subordinated notes outstanding in exchange for 875,000 shares of Common Stock and 875,000 Warrants identical to those issued in the Equity Rights Offering. In August, 1993, the Company completed an Exchange Agreement whereby the holders of 100% of the outstanding Redland Class B Preferred Stock, Warrants to purchase Redland Common Stock and 100% of the outstanding Redland Common Stock were validly tendered in exchange for shares of the Company's Common Stock. The Company's acquisition of Redland resulted in an increase of approximately $112 million in total assets and $96 million in total liabilities at December 31, 1993. The most significant increases in the components comprising total assets were $11 million of investments, $21 million of receivables, $54 million of reinsurance recoverable on unpaid loss and loss adjustment expenses, $5 million of prepaid reinsurance premiums and $14 million of excess of cost over acquired net assets. The most significant increase in components comprising total liabilities were $66 million of loss and loss adjustment expenses, $14 million of unearned premiums, $6 million of accounts payable on accrued liabilities and $7 million of bank borrowings. In addition, during 1993, Company operating profit of $10.6 million and net income of $7.6 million also improved the Company's financial condition, with stockholders equity increasing 177% from $34.5 million at December 31, 1992 to $95.7 million at December 31, 1993. These four factors combined to effect the size of the Company's investment portfolio, with investments increasing by 51.2% at December 31, 1993 as compared to the same date in 1992. Within the portfolio, the Company also restructured the distribution of its investments in order to more accurately reflect the characteristics of its operating businesses as well as to provide added flexibility to respond to changes in the Company's tax position, business mix and the interest rate environment for fixed income securities. Accordingly, the Company changed its investment policy to emphasize securities categorized as available for sale, with this category accounting for 64.9% of its securities at December 31, 1993 as compared to 32.1% of its securities at December 31, 1992. The enlargement of this category of securities will provide more flexibility for the Company to respond to the changing interest rate environment as well as to allow its portfolio to more accurately reflect the characteristics of its changing business mix. In addition, short term investments increased 153.4% from 1993 to 1992. This was principally due to the nature of the portfolio which was added from Redland. Redland's principal business operations require near term payment of most of its losses, and therefore, require a greater amount of securities kept in short term investments. In addition, the more adequate capitalization provided by the aforementioned events allowed the Company to expand its equity portfolio 323.6% from December 31, 1992 as compared to December 31, 1993. The Company believes that the increased volatility and risk of this increased equity portfolio was reasonable considering the improvement in its capital position and will allow the Company to enhance the overall yield of its investment portfolio over time. As of December 31, 1993 and 1992, the Company held an approximate 33% equity investment in Major Realty, a publicly traded real estate company engaged in the ownership and development of its undeveloped land in Orlando, Florida. At December 31, 1993, the carrying value of the Company's investment in Major Realty approximated $5.4 million or $2.36 per share. Additionally at that date, Major Realty had stockholders equity of approximately $14,000 and the quoted market price of Major Realty on NASDAQ was $1.69 per share. The Company expects to realize a minimum of its carrying value in Major Realty based on the estimated net realizable value of Major Realty's underlying assets. The Company's estimate of net realizable value is based upon several factors including estimates from Major Realty's management, assets, appraisals and sales to date of Major Realty's assets. During 1993 and the first quarter of 1994, Major Realty sold five parcels of land amounting to 297.83 acres of land with gross sale proceeds of approximately $58.5 million. All of these sales and proceeds supported the Company's estimate of net realizable value of its investment in Major Realty. Consolidated Cash Flows The Company's net cash provided by operating activities increased from a negative $.7 million during 1992 to a positive $24.6 million for the year ended December 31, 1993. The Company's improved operating cash flow for the 1993 year resulted primarily from the insurance subsidiaries retaining more of their direct premium while ceding less to reinsurers. Cash flows from investing activities were effected by the investment of the proceeds from the Company's Rights Offering in January, 1993, an emphasis on purchasing securities categorized as available for sale, and faster than expected prepayments of certain of the Company's mortgage backed securities. Cash flows from financing activities were impacted by the Equity Rights Offering completed in January, 1993 including the retirement of $9.5 million of term notes from the proceeds of such Offering. Inflation The Company does not believe that inflation has had a material impact on its financial condition or the results of operations. Impact of Recently Adopted Accounting Standards The Company adopted Statement of Financial Accounting Standards (SFAS) No. 109, "Accounting for Income Taxes", effective January 1, 1993. The prospective application of SFAS No. 109 resulted in no effect upon net income for the year ended December 31, 1993. SFAS No. 109 requires that the Company recognize a deferred tax asset for all temporary differences and net operating loss carryforwards and a related valuation allowance account when realization of the asset is uncertain. The Company's deferred tax asset at December 31, 1993 is $16.3 million which is offset by the valuation allowance of $16.3 million. The Company adopted Statement of Financial Accounting Standards (SFAS) No. 113, "Accounting and Reporting for Reinsurance of Short-Duration and Long-Duration Contracts", effective January 1, 1993. The effect of the application of SFAS No. 113 resulted in the reclassification of amounts ceded to reinsurers previously reported as a reduction in unearned premium and unpaid losses and loss adjustment expenses, to assets on the consolidated balance sheet. The application included a restatement of amounts as of December 31, 1992. In April, 1993, the Financial Accounting Standards Board approved for issuance Statement of Financial Accounting Standards (SFAS) No. 115, "Accounting for Certain Investments in Debt and Equity Securities". The standard will be adopted effective January 1, 1994. The effect of adoption of this pronouncement will be that securities designated as available for sale will be reported at market value with unrealized gains and losses reported as a separate component of stockholders' equity which is not expected to be significant. ITEM 8.

ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA. See Item 14 hereof and the Consolidated Financial Statements attached hereto. ITEM 9.

ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE. The disclosure called for by Item 9 was previously reported under Item 4 in the Registrant's current Report on Form 8-K, dated March 11, 1992, which is incorporated herein by reference. There have been no disagreements with the Registrant's former independent accountants of the nature calling for disclosure under Item 9. PART III. ITEM 10.

ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT. The information required by Item 10 with respect to the Registrant's executive officers and directors will be set forth under the captions "Election of Directors" and "Executive Officers" in the Company's 1994 Proxy Statement included as Exhibit 99.4 hereto and incorporated herein by reference. ITEM 11.

ITEM 11. EXECUTIVE COMPENSATION. The information required by Item 11 will be set forth under the caption "Compensation of Executive Officers and Directors" in the Company's 1994 Proxy Statement included as Exhibit 99.4 hereto and incorporated herein by reference. ITEM 12.

ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT. The information required by Item 12 will be set forth under the caption "Security Ownership of Certain Beneficial Owners and Management" in the Company's 1994 Proxy Statement included as Exhibit 99.4 hereto and incorporated herein reference. ITEM 13.

ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS. The information required by Item 13 will be set forth under the caption "Certain Transactions" in the Company's 1994 Proxy Statement included as Exhibit 99.4 hereto and incorporated herein by reference. PART IV. ITEM 14.

ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K. (a) The following documents are filed as a part of this Report: 1. Financial Statements. The Company's audited Consolidated Financial Statements for the years ended December 31, 1993 and 1992 consisting of the following: Reports of Independent Accountants Consolidated Balance Sheets Consolidated Statements of Operations Consolidated Statements of Cash Flows Consolidated Statements of Stockholders' Equity Notes to Consolidated Financial Statements 2. Financial Statement Schedules. The Company's Financial Statement Schedules as of December 31, 1993 and 1992, consisting of the following: I. Summary of Investments II. Amounts Receivable From Related Parties III. Condensed Financial Information of Registrant IV. Indebtedness to Related Parties -- Not Current V. Supplemental Insurance Information VIII. Valuation Accounts IX. Short-Term Borrowings X. Supplementary Income Statement Information All other schedules to the Consolidated Financial Statements required by Article 12 of Regulation S-X are not required under the related instruction or are inapplicable and therefore have been omitted, or are included in the Consolidated Financial Statements. 3. The Exhibits filed herewith are set forth in the Exhibit Index attached hereto. (b) No Current Reports on Form 8-K have been filed during the last fiscal quarter of the period covered by this Report. SIGNATURES Pursuant to the requirements of Section 13 or 15(d) 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. ACCEPTANCE INSURANCE COMPANIES INC. Kenneth C. Coon By __________________________________ Dated: March 24, 1994 Kenneth C. Coon Chairman, President and Chief Executive Officer Georgia M. Mace By __________________________________ Dated: March 24, 1994 Georgia M. Mace Treasurer and Chief Accounting Officer Pursuant to the requirements of the Securities Exchange Act of 1934, this Report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated. Jay A. Bielfield Dated: March 24, 1994 ___________________________________ Jay A. Bielfield, Director Kenneth C. Coon Dated: March 24, 1994 ___________________________________ Kenneth C. Coon, Director Edward W. Elliott, Jr. Dated: March 24, 1994 ___________________________________ Edward W. Elliott, Jr., Director Robert LeBuhn Dated: March 24, 1994 ___________________________________ Robert LeBuhn, Director Michael R. McCarthy Dated: March 24, 1994 ___________________________________ Michael R. McCarthy, Director John P. Nelson Dated: March 24, 1994 ___________________________________ John P. Nelson, Director R. L. Richards Dated: March 24, 1994 ___________________________________ R. L. Richards, Director David L. Treadwell Dated: March 24, 1994 ___________________________________ David L. Treadwell, Director Doug T. Valassis Dated: March 24, 1994 ___________________________________ Doug T. Valassis, Director ACCEPTANCE INSURANCE COMPANIES INC. ANNUAL REPORT ON FORM 10-K FISCAL YEAR ENDED DECEMBER 31, 1993 EXHIBIT INDEX NUMBER EXHIBIT DESCRIPTION 3.1 Restated Certificate of Incorporation of Acceptance Insurance Companies Inc. 3.2 Restated By-laws of Acceptance Insurance Companies Inc. 4.1 Form of Stock Certificate representing shares of Acceptance Insurance Companies Inc., Common Stock, $.40 par value. Incorporated by reference to Exhibit 4.1 to Registrant's Annual Report on Form 10-K for the fiscal year ended December 31, 1992. 4.2 Form of Warrant Certificate representing Acceptance Insurance Companies Inc., Warrants. Incorporated by reference to Exhibit 4.2 to Registrant's Annual Report on Form 10-K for the fiscal year ended December 31, 1992. 4.3 Warrant Agreement dated as of December 22, 1992, between Stoneridge Resources, Inc., (now, by change of name, Acceptance Insurance Companies Inc.) and Society National Bank, Cleveland, Ohio as Warrant Agent incorporated by reference to Exhibit 10.25 to the Stoneridge Resources, Inc. Registration Statement on Form S-1, Registration No. 33-53730. 4.4 Amendment to Warrant Agreement made as of February 2, 1993, to Warrant Agreement dated as of December 22, 1992, between Stoneridge Resources, Inc. (now, by change of name, Acceptance Insurance Companies Inc.), and Society National Bank, Cleveland, Ohio, as Warrant Agent. Incorporated by reference to Exhibit 10.19 to the Registrant's Annual Report on Form 10-K for the fiscal year ended December 31, 1992. 8 Opinion of Deloitte & Touche, Accountants and Auditors for the Registrant, dated October 21, 1992, relating to tax matters. Incorporated by reference to Exhibit 5.2 to the Stoneridge Resources, Inc. (now, by change of name, Acceptance Insurance Companies Inc.) Registration Statement on Form S-1, Registration No. 33-53730. 10.1 Office Building Lease dated July 19, 1991, between State of California Public Employees' Retirement System and Acceptance Insurance Company. Incorporated by reference to Exhibit 10.7 to the Stoneridge Resources, Inc. Annual Report on Form 10-K for the fiscal year ended December 31, 1991. 10.2 Intercompany Federal Income Tax Allocation Agreement between Acceptance Insurance Holdings Inc. and its subsidiaries and Stoneridge Resources, Inc. dated April 12, 1990, and related agreements. Incorporated by reference to Exhibit 10i to Stoneridge Resources, Inc.'s Annual Report on Form 10-K for the fiscal year ended August 31, 1990. 10.3 Warrant to purchase 489,919 shares of common stock ($.10 par value) of Stoneridge Resources, Inc., dated March 14, 1990, issued by Stoneridge Resources, Inc. to Samelson Development Company. Incorporated by reference to Exhibit 4a to Stoneridge Resources, Inc.'s Quarterly Report on Form 10-Q for the period ended May 31, 1990. 10.4 Amended and Restated Registration Rights Agreement, dated April 9, 1990, between Stoneridge Resources, Inc. and Patricia Investments, Inc. Incorporated by reference to Exhibit 10d to Stoneridge Resources, Inc.'s Quarterly Report on Form 10-Q for the period ended May 31, 1990. 10.5 Warrants to purchase a total of 389,507 shares of common stock ($.10 par value) of Stoneridge Resources, Inc. dated April 10, 1992, issued by Stoneridge Resources, Inc. to the various purchasers of the Floating Rate Secured Subordinated Notes, due 1993, Series A and B. Incorporated by reference to Exhibit 10.41 to the Stoneridge Resources, Inc., Annual Report on Form 10-K for the fiscal year ended December 31, 1991. 10.6 Term Loan Agreement dated April 10, 1992, by and among Acceptance Insurance Holdings Inc., NBD Bank, N.A., First National Bank of Omaha, Manufacturers Bank, N.A., Comerica Bank, First Bank and NBD, N.A., as Agent. Incorporated by reference to Exhibit 10.44 to the Stoneridge Resources, Inc., Annual Report on Form 10-K for the fiscal year ended December 31, 1991. 10.7 First Amendment to Term Loan Agreement, dated as of June 1, 1992, by and among Acceptance Insurance Holdings Inc., NBD Bank, N.A., First National Bank of Omaha, Manufacturers Bank, N.A., First Bank and NBD, N.A., as Agent. Incorporated by reference to Exhibit 10.11 to the Registrant's Annual Report on Form 10-K for the fiscal year ended December 31, 1992. 10.8 Second Amendment to Term Loan Agreement, dated as of November 15, 1992, by and among Acceptance Insurance Holdings Inc., NBD Bank, N.A., First National Bank of Omaha, Manufacturers Bank, N.A., First Bank and NBD, N.A., as Agent. Incorporated by reference to Exhibit 10.12 to the Registrant's Annual Report on Form 10-K for the fiscal year ended December 31, 1992. 10.9 Stock Option Agreement between Stoneridge Resources, Inc. and Robert W. Anestis, dated July 2, 1991. Incorporated by reference to Exhibit 10.5 to Stoneridge Resources, Inc.'s Quarterly Report on Form 10-Q for the quarter ended June 30, 1991. 10.10 Stock Option Agreement between Stoneridge Resources, Inc. and Thomas L. Kelly, II, dated July 2, 1991. Incorporated by reference to Exhibit 10.6 to Stoneridge Resources, Inc.'s Quarterly Report on Form 10-Q for the quarter ended June 30, 1991. 10.11 Employment Agreement dated February 19, 1990 between Acceptance Insurance Holdings Inc., Stoneridge Resources, Inc. and Kenneth C. Coon. Incorporated by reference to Exhibit 10.65 to the Stoneridge Resources, Inc., Annual Report on Form 10-K for the fiscal year ended December 31, 1991. 11 Computation of Income (Loss) per share. 16 Letter to the Securities and Exchange Commission from Coopers & Lybrand dated March 16, 1992, with respect to changes in Stoneridge Resources, Inc.'s certifying accountant. Incorporated by reference to Exhibit 16.1 to Stoneridge Resources, Inc.'s Current Report on Form 8-K dated March 16, 1992. 21 Subsidiaries of the Registrant. 23.1 Consent of Deloitte & Touche. 23.2 Report on schedules of Deloitte & Touche. 23.3 Consent of Crosby, Guenzel, Davis, Kessner & Kuester. 28P Schedule P -- Analysis of Losses and Loss Expenses of Consolidated Annual Statement for the year 1993. 99.1 Acceptance Insurance Companies Inc., 1992 Incentive Stock Option Plan effective as of December 22, 1992. Incorporated by reference to Exhibit 10.1 to the Stoneridge Resources, Inc. (now, by change of name, Acceptance Insurance Companies Inc.) Registration Statement on Form S-1, Registration No. 33-53730. 99.2 Acceptance Insurance Companies Inc., Employee Stock Purchase Plan, effective as of December 22, 1992. Incorporated by reference to Exhibit 10.2 to the Stoneridge Resources, Inc. (now, by change of name, Acceptance Insurance Companies Inc.) Registration Statement on Form S-1, Registration No. 33-53730. 99.3 Acceptance Insurance Companies Inc., Employee Stock Ownership and Tax Deferred Savings Plan as merged, amended and restated effective October 1, 1990. Incorporated by reference as Exhibit 10.4 to Stoneridge Resources, Inc.'s Quarterly Report on Form 10-Q for the quarter ended November 30, 1990. 99.4 First Amendment to Acceptance Insurance Companies Inc. Employee Stock Ownership and Tax Deferred Savings Plan. 99.5 Second Amendment to Acceptance Insurance Companies Inc. Employee Stock Ownership and Tax Deferred Savings Plan. 99.6 Proxy Statement for 1994 Annual Meeting of Shareholders filed on or prior to April 30, 1994. INDEPENDENT AUDITORS' REPORT To the Board of Directors and Stockholders of Acceptance Insurance Companies Inc. We have audited the accompanying consolidated balance sheets of Acceptance Insurance Companies Inc. and its subsidiaries as of December 31, 1993 and 1992, and the related consolidated statements of operations, stockholders' equity and cash flows for each of the three years in the period ended December 31, 1993. These consolidated financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, such consolidated financial statements present fairly, in all material respects, the financial position of Acceptance Insurance Companies Inc. and subsidiaries as of December 31, 1993 and 1992, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 1993, in conformity with generally accepted accounting principles. As discussed in Note 1 to the consolidated financial statements, in 1993 the Company adopted Statement of Financial Accounting Standards No. 113, Accounting and Reporting of Reinsurance for Short-Duration and Long-Duration Contracts. DELOITTE & TOUCHE Omaha, Nebraska March 28, 1994 ACCEPTANCE INSURANCE COMPANIES INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES Description of Operations - Acceptance Insurance Companies Inc. (the "Company") is primarily engaged in the specialty property and casualty insurance business through its wholly-owned subsidiaries, Acceptance Insurance Holdings Inc. ("Acceptance") and The Redland Group, Inc. ("Redland"), which the Company acquired on April 11, 1990 and August 13, 1993, respectively. The Company previously conducted citrus operations through its approximate 52% owned subsidiary, Orange-co, Inc. ("Orange-co"). In December 1991, the Company decided to sell its interest in Orange-co and in May 1992 its interest was sold. As a result, the Company's share of the net loss of Orange-co is presented separately as discontinued operations on the consolidated statements of operations. The Company holds a 33% equity investment in Major Realty Corporation ("Major Realty"), a Florida based real estate company. Principles of Consolidation - The Company's consolidated financial statements include the accounts of its majority-owned subsidiaries. All significant intercompany transactions have been eliminated. Insurance Accounting - Premiums are recognized as income ratably over the terms of the related policies. Benefits and expenses are associated with premiums earned, resulting in the recognition of profits over the term of the policies. This association is accomplished through amortization of deferred policy acquisition costs and provisions for unearned premiums and loss reserves. The liability for unearned premiums represents the portion of premiums written which relates to future periods and is calculated generally using the pro rata method. The Company also provides a liability for policy claims based on its review of individual claim cases and the estimated ultimate settlement amounts. This liability also includes estimates of claims incurred but not reported based on Company and industry paid and reported claim and settlement expense experience. Differences which arise between the ultimate liability for claims incurred and the liability established will be reflected in the statement of operations of future periods as additional claim information becomes available. Certain costs of acquiring new insurance business, principally commissions, premium taxes, and other underwriting expenses, have been deferred. Such costs are being amortized as the premiums are earned. Anticipated investment income is considered in computing premium deficiencies, if any. Statements of Cash Flows - The Company aggregates cash and short- term investments with maturity dates of three months or less from the date of purchase for purposes of reporting cash flows. As of December 31, 1993 and 1992, approximately $4,737,000 and $227,000 of short-term investments had maturity dates at acquisition of greater than three months. Investments - Effective September 30, 1992, the Company has designated fixed maturities as either securities held for investment or securities available for sale. Securities held for investment represent those securities which the Company has the intent and ability to hold to maturity. Securities available for sale represent those securities which might be sold in response to changes in various economic conditions to maintain a portfolio duration which approximates the estimated settlement of reserves for loss and loss adjustment expenses. Securities held for investment are valued at amortized cost while securities available for sale are valued at the lower of amortized cost or market value. Marketable equity securities are carried at market and any net unrealized gain or loss is reflected separately as a component of stockholders' equity. Mortgage loans are carried at the lower of their unpaid principal balance or their estimated net realizable value. Real estate is stated at the lower of cost or estimated net realizable value and is non-income producing. Property and Equipment - Property and equipment are stated at cost, net of accumulated depreciation. Depreciation is recognized principally using the straight-line method over a period of five to ten years. Excess of Cost Over Acquired Net Assets - The excess of cost over equity in acquired net assets is being amortized principally using the straight-line method over periods not exceeding 40 years. Fair Value of Financial Instruments - Estimated fair values of financial instruments have been determined by the Company, using available market information and appropriate valuation methodologies. However, judgment is necessarily required in interpreting market data to develop the estimates of fair value. Accordingly, the estimates presented herein are not necessarily indicative of the amounts that the Company could realize in a current market exchange. The use of different market assumptions may have an effect on the estimated fair value amounts presented. The fair value of fixed maturities and equity securities disclosed in the financial statements are determined by the quoted market price or modeling techniques for asset-backed securities not actively traded. The book value of mortgage loans, short-term investments, and other investments approximate fair value at December 31, 1993. The book value of cash, receivables, equity investment in Major Realty Corporation, accounts payable and borrowings approximate fair value. Per Share Data - Primary earnings per share and fully diluted earnings per share are based on weighted average shares outstanding of approximately 11.6 million and 11.9 million, respectively, for the year ended December 31, 1993, and approximately 3.4 million for the years ended December 31, 1992 and 1991. Included in weighted average shares outstanding in 1993 is the assumed conversion of all outstanding options and warrants utilizing the treasury stock method with appropriate adjustment to net income attributable to the assumed use of proceeds. Recent Statements of Financial Accounting Standards - The Company adopted Statement of Financial Accounting Standards (SFAS) No. 113, "Accounting and Reporting for Reinsurance of Short-Duration and Long-Duration Contracts", effective January 1, 1993. The effect of the application of SFAS No. 113 resulted in the reclassification of amounts ceded to reinsurers previously reported as a reduction in unearned premium and unpaid losses and loss adjustment expenses, to assets on the consolidated balance sheet. The application included a restatement of amounts as of December 31, 1992. In April 1993, the Financial Accounting Standards Board approved for issuance Statement of Financial Accounting Standards (SFAS) No. 115, "Accounting for Certain Investments in Debt and Equity Securities". The standard will be adopted effective January 1, 1994. The effect of adoption of this pronouncement will be that securities designated as available for sale will be reported at market value with unrealized gains and losses reported as a separate component of stockholders' equity which is not expected to be significant. Reclassifications - Certain prior period accounts have been reclassified to conform with current year presentation. 2. COMMON STOCK ISSUED On January 27, 1993, the Company completed a Common Stock Rights Offering to raise additional equity capital. The Rights Offering was fully subscribed resulting in the issuance of 3,992,480 units, at $8.00 per unit, consisting of one share of common stock and a warrant for the purchase of one share of common stock exercisable at $11.00 until January 27, 1997, unless called under certain provisions. Net proceeds of approximately $31.2 million were used to retire $9.5 million of Secured Subordinated Notes (see Note 7). Effective April 15, 1993, the holder of a $7,000,000 Secured Subordinated Note of one of the Company's subsidiaries, which had been assumed by the Company, exchanged such note for 875,000 shares of common stock and warrants to purchase, at a price of $11.00 per share during a period ending January 27, 1997, 875,000 additional shares of common stock. The shares of common stock and warrants were identical to the shares and warrants issued in the Company's Rights Offering. 3. REDLAND ACQUISITION On August 13, 1993, the Company acquired all of the outstanding common stock, warrants to purchase common stock, and preferred stock of Redland pursuant to an Exchange Agreement. Redland underwrites multi-peril crop, crop hail, specialty automobile, and farmowner insurance coverages. The acquisition of Redland was accounted for as a purchase transaction. The purchase price of approximately $15.4 million, comprised of 1,339,000 shares of the Company's common stock and acquisition related costs of $306,000, was allocated based upon the estimated fair market value of assets acquired and liabilities assumed. The purchase price in excess of the fair market value of the net assets acquired is being amortized using the straight-line method over 40 years. The results of operations for Redland are included in the accompanying financial statements effective July 1, 1993. The purchase price does not reflect 240,000 shares issued by the Company and held in escrow pursuant to the Exchange Agreement, as a fund against which the Company may assert certain claims. The primary contingency under which claims may be asserted is the ultimate development of Redland's liability for losses and loss adjustment expenses. Upon resolution of contingencies related to the acquisition, such shares will be returned to the Company or released to former Redland stockholders. The pro forma financial data, which gives effect to the acquisition of Redland as though it had been completed January 1, 1993, for the year ended December 31, 1993 and January 1, 1992, for the year ended December 31, 1992, is as follows (in thousands, except per share data): 1993 1992 Revenues $157,299 $123,598 ======== ======== Loss from continuing operations $ (1,292) $ (3,649) ======== ======== Net loss $ (1,292) $ (3,732) ======== ======== Earnings per share: Primary and fully diluted: Continuing operations $ (0.14) $ (0.76) Discontinued operations - (0.02) -------- -------- Net loss per share $ (0.14) $ (0.78) ======== ======== The pro forma financial data for the year ended December 31, 1993, is not necessarily indicative of the results had the Company actually acquired Redland on January 1, 1993, as the financial data includes $3.9 million of charges to earnings taken by Redland in the first and second quarters of 1993. The charges were comprised of a $900,000 write-down of a marketable equity security and a $3.0 million strengthening of reserves, both of which would have been adjusted to their fair market value on January 1, 1993, and thus would have been excluded from the 1993 results of operations. 4. INVESTMENTS A summary of net investment income earned on the investment portfolio for the years ended December 31, 1993, 1992 and 1991 is as follows (in thousands): 1993 1992 1991 Interest on fixed maturities $ 9,177 $7,339 $4,692 Interest on short-term investments 711 659 1,600 Net realized gains on sales of investments 2,250 1,046 1,953 Other 1,338 391 328 ------- ------ ------ 13,476 9,435 8,573 Investment expenses (382) (169) (517) ------- ------ ------ Net investment income $13,094 $9,266 $8,056 ======= ====== ====== The amortized cost and related market values of fixed maturities in the accompanying balance sheets are as follows (in thousands): The amortized cost and related market values of the debt securities as of December 31, 1993 are shown below by stated maturity dates. Actual maturities may differ from stated maturities because the borrowers may have the right to call or prepay obligations with or without call or prepayment penalties. Amortized Market Cost Value (in thousands) Fixed maturities held for investment: Due after one year through five years $ 7,345 $ 7,672 Due after five years through ten years 10,837 11,533 Due after ten years 504 530 ------- ------- 18,686 19,735 Mortgage-backed securities 33,070 34,319 ------- ------- $51,756 $54,054 ======= ======= Fixed maturities available for sale: Due after one year through five years $21,382 $21,452 Due after five years through ten years 10,071 10,225 Due after ten years 23,696 23,987 ------- ------- 55,149 55,664 Mortgage-backed securities 40,687 40,786 ------- ------- $95,836 $96,450 ======= ======= As of December 31, 1993, the weighted average duration of the mortgage-backed securities is expected to be less than four years. Proceeds from sales of debt securities during the years ended December 31, 1993, 1992 and 1991 were approximately $115,339,000, $76,457,000 and $241,216,000, respectively. Gross realized gains on sales of debt securities were approximately $2,023,000, $1,362,000 and $2,688,000, and gross realized losses on sales of debt securities were approximately $17,000, $85,000 and $506,000 during the years ended December 31, 1993, 1992 and 1991, respectively. On May 31, 1993, all of the Company's investments in fixed maturities of financial service entities were transferred to securities available for sale from securities held for investment. The Company's core business is inherently subject to the same market fluctuations as the financial services industry. Consequently, the Company believes this action is prudent to mitigate its aggregate industry exposure. The amortized cost and market value at date of transfer aggregated approximately $9,704,000 and $10,206,000, respectively. As required by insurance regulatory laws, certain bonds with an amortized cost of approximately $11,401,000 and short-term investments of approximately $376,000 at December 31, 1993 were deposited in trust with regulatory agencies. 5. RECEIVABLES The major components of receivables are summarized at December 31 as follows (in thousands): 1993 1992 Insurance premiums and agents' balances due $33,801 $18,841 Amounts recoverable from reinsurers on paid losses 10,978 5,617 Accrued interest 2,126 1,308 Installment notes receivable 1,768 1,197 Other 1,586 770 Less allowance for doubtful accounts (2,093) (1,207) ------- ------- $48,166 $26,526 ======= ======= 6. EQUITY INVESTMENT IN MAJOR REALTY CORPORATION As of December 31, 1993 and 1992, the Company held an approximate 33% equity investment in Major Realty, a publicly traded real estate company engaged in the ownership and development of its undeveloped land in Orlando, Florida. In accordance with Accounting Principles Board Opinion No. 18 and other authoritative pronouncements, the Company recorded a non- cash charge of $15,300,000 in the accompanying consolidated statement of operations for the year ended December 31, 1991 to reflect its equity investment in Major Realty at estimated net realizable value. This provision was necessitated by the weak economic conditions surrounding the real estate industry generally, which have negatively impacted the financial condition and prospects of Major Realty which, at that time, raised doubt about its ability to continue to meet its obligations as they came due. At December 31, 1993, the carrying value of the Company's investment in Major Realty approximated $5.4 million or $2.36 per share. Additionally at that date, Major Realty had a stockholders' equity of approximately $14,000 and the quoted market price of Major Realty on NASDAQ was $1.69 per share. The Company expects to realize a minimum of its carrying value in Major Realty based on the estimated net realizable values of Major Realty's underlying assets. The Company's estimate of net realizable value is based upon several factors including estimates from Major Realty's management, assets appraisals and sales to date of Major Realty's assets. Commencing in 1992, the Company has not recognized its share of net gains realized by Major Realty on sales of real estate but continues to recognize its share of expenses recorded by Major Realty. The extraordinary item reflected in the accompanying consolidated statement of operations for the year ended December 31, 1991 represents the Company's interest in an extraordinary gain recorded at Major Realty in February 1991. This extraordinary gain resulted from the conveyance of Major Realty's interest in the Major Centre Plaza office building and the payment of $170,000 in cash to the mortgage note holder in exchange for the full satisfaction and release of an $8,080,000 mortgage note. No related federal income tax provision was provided since this extraordinary gain was offset by losses incurred at Major Realty during the year ended December 31, 1991. The following summary financial data for Major Realty as of and for the years ended December 31, 1993 and 1992 was obtained from Major Realty's consolidated financial statements (in thousands): 1993 1992 Land held for sale or development $ 7,283 $56,442 Other assets 3,621 1,741 ------- ------- Total assets $10,904 $58,183 ======= ======= Mortgage and other notes payable $ 9,438 $51,745 Other liabilities 1,452 7,315 Stockholders' deficit 14 (877) ------- ------- Total liabilities and stockholders' $10,904 $58,183 equity ======= ======= Total revenues $55,199 $ 4,794 ======= ======= Gross profit $ 2,895 $ 1,640 ======= ======= Net income (loss) $ 891 $(3,671) ======= ======= 7. BANK BORROWINGS, TERM DEBT AND OTHER BORROWINGS AND NOTES PAYABLE TO AFFILIATES In March 1994, the Company agreed to amend its borrowing arrangements with its bank lenders. The proposed structure is a $35 million line of credit with interest payable quarterly at the prime rate or at LIBOR plus a margin of 1% to 1.75%, depending on the Company's debt to equity ratio. The line of credit will mature in four years and may be extended to five years by the bank lenders. The line of credit will be consummated once final legal documentation is completed which is anticipated to be in April 1994. The following information relates to the debt agreements in effect as of December 31, 1993 and 1992: December 31, 1993 1992 (in thousands) Bank borrowings: Term loan at the prime rate of interest plus .5% or at the Company's option, LIBOR plus 2.5% $12,000 $15,500 Revolving promissory note at the federal funds rate 6,597 - plus 2.75% Notes payable to affiliates: Secured subordinated notes at the prime rate of interest plus 6% - 9,500 Secured subordinated convertible note at the prime rate of interest plus 6% - 7,000 Term debt and other borrowings 354 1,567 ------- ------- $18,951 $33,567 ======= ======= At December 31, 1993, the $12.0 million note payable was collateralized by the Company's Acceptance common stock. Principal of $1,000,000 and interest on the note is due quarterly with a maturity of October 1, 1996. In August 1993, Redland refinanced its existing notes payable to a bank with a new $7,500,000 revolving promissory note with a maturity of January 5, 1995 which is collateralized by Redland common stock. At December 31, 1993, $6,597,000 was outstanding under this agreement. The Company issued $9.5 million of Secured Subordinated Notes to certain directors or stockholders in April 1992 through the exchange of previously issued secured and unsecured notes aggregating approximately $8.3 million and cash. Additionally, the Company issued to the holders of the Secured Subordinated Notes approximately 97,500 common stock warrants exercisable for five years at a price of $9.50 per share. In January 1993, these notes were redeemed. In April 1992, Acceptance issued a $7 million secured subordinated convertible note maturing in 1997. In April, 1993, this note was converted into 875,000 units of common stock and warrants identical to those issued in the Rights Offering (see Note 2). Aggregate maturities are as follows (in thousands): 1994 $ 4,354 1995 10,597 1996 4,000 ------- $18,951 ======= Cash payments for interest were approximately $2.5 million, $4.2 million and $5.7 million during the years ended December 31, 1993, 1992 and 1991, respectively. 8. INCOME TAXES The Company adopted Statement of Financial Accounting Standards (SFAS) No. 109, "Accounting for Income Taxes", effective January 1, 1993. The prospective application of SFAS No. 109 resulted in no effect upon net income for the year ended December 31, 1993. SFAS No. 109 requires that the Company recognize a deferred tax asset for all temporary differences and net operating loss carryforwards and a related valuation allowance account when realization of the asset is uncertain. Accordingly, a valuation allowance has been recorded for the full amount of the deferred tax asset. During 1993, the valuation allowance decreased $1,560,000, the same amount the net deferred tax asset decreased. The significant items comprising the Company's net deferred tax asset as of December 31, 1993 are as follows (in thousands): Net operating loss carryforwards expiring in varying amounts through 2006 $ 2,440 Unpaid losses and loss adjustment expenses 6,581 Unearned premiums 3,037 Allowances for doubtful accounts 712 Major Realty basis difference 7,531 -------- Deferred tax asset 20,301 -------- Deferred policy acquisition costs (4,017) Other (23) -------- Deferred tax liability (4,040) -------- 16,261 Valuation allowance (16,261) -------- Net deferred tax asset $ - ======== The Company recognized a current tax expense of approximately $167,000 for the year ended December 31, 1993 as a result of amounts due under alternative minimum taxable income provisions which limit net operating loss carryforwards. Cash payments for income taxes were approximately $232,000 during the year ended December 31, 1993. 9. OPERATING LEASES The Company leases office space and certain furniture and equipment under various operating leases. Future minimum obligations under these operating leases are as follows (in thousands): 1994 $1,675 1995 1,494 1996 1,355 1997 1,176 1998 899 Thereafter 1,886 ------ $8,485 ====== Rental expense totaled approximately $1,169,000, $1,014,000 and $569,000 for the years ended December 31, 1993, 1992 and 1991, respectively. 10. STOCK OPTIONS AND AWARDS In December 1992, stockholders approved an incentive stock option plan under which options granted to employees vest over the four years following the date of grant, options granted to non-employee directors are vested one year from the date of grant and all options terminate ten years from the date of grant. A maximum of 500,000 shares are available for the plan and 94,500 options were granted during 1993. On January 27, 1993, certain executive officers of the Company were awarded non-qualified options entitling these officers to purchase a total of 72,500 shares of the Company's Common Stock at a price of $8.75 per share, which are currently exercisable through January 27, 1998. In connection with consulting agreements entered into in May 1991 with certain of its directors, the Company incurred approximately $100,000 and $528,000 of expense during the years ended December 31, 1992 and 1991, respectively. Under the same agreements and in addition to the above, these directors received a total of 62,210 options to purchase Company common stock at a price of $10.25 per share, subject to certain antidilution provisions, which are exercisable through May 1996. Changes in stock options are as follows: All shares under option at December 31, 1993 were exercisable, except for 94,500 options issued in 1993 under the incentive stock option plan. In December 1992, stockholders approved an employee stock purchase plan whereby eligible employees will be given the opportunity to subscribe for the purchase of the Company's common stock for 85% of its fair market value as defined. During 1993, 12,639 shares were issued under this plan. 11. RELATED PARTY TRANSACTIONS Included in real estate revenues for the years ended December 31, 1992 and 1991, is fee income totaling approximately $1,522,000 and $1,850,000, respectively, for real estate advisory services provided by Major Group to Major Realty. Revenues for the year ended December 31, 1992 included a non-recurring fee of $925,000 associated with the settlement and termination of the advisory agreement in March 1992, effective January 1, 1992. As part of the termination and settlement agreement, Major Realty issued two promissory notes aggregating $1,514,581 to Major Group representing payment of all deferred fees and interest thereon and payment of the termination fee. The promissory notes bear interest at 12%, mature in 1997 and are collateralized by second and third mortgages on certain real property owned by Major Realty. One note, on which principal and accrued interest totals approximately $143,000 at December 31, 1993, is convertible into Major Realty common stock at any time, while the remaining note, on which principal and accrued interest totals approximately $278,000 at December 31, 1993, may be converted into Major Realty common stock beginning March 1995. 12. INSURANCE PREMIUMS AND CLAIMS Insurance premiums written and earned by the Company's insurance subsidiaries at December 31, 1993, 1992 and 1991 are as follows (in thousands): 1993 1992 1991 Direct premiums written $253,359 $144,464 $103,594 Assumed premiums written 2,683 7,627 1,259 Ceded premiums written (118,537) (68,006) (41,871) -------- -------- -------- Net premiums written $137,505 $ 84,085 $ 62,982 ======== ======== ======== Direct premiums earned $250,074 $134,551 $100,109 Assumed premiums earned 3,642 7,048 908 Ceded premiums earned (125,634) (62,435) (35,853) -------- -------- -------- Net premiums earned $128,082 $ 79,164 $ 65,164 ======== ======== ======== Insurance loss and loss adjustment expenses have been reduced by recoveries recognized under reinsurance contracts of $216,246,000 for the year ended December 31, 1993. Five insurance agencies produced direct premiums written aggregating approximately 34%, 51% and 46% of total direct premiums during the years ended December 31, 1993, 1992 and 1991, respectively. Insurance loss and loss adjustment expenses paid totaled approximately $68,217,000, $48,530,000 and $39,224,000 during the years ended December 31, 1993, 1992 and 1991, respectively. 13. REINSURANCE The Company's insurance subsidiaries cede insurance to other companies under quota share, excess of risk and facultative treaties. The insurance subsidiaries also maintain catastrophe reinsurance to protect against catastrophic occurrences where claims can arise under numerous policies due to a single event. The reinsurance agreements are tailored to the various programs offered by the insurance subsidiaries. The largest amount retained in any one risk by the insurance subsidiaries during 1993 was $500,000. The insurance subsidiaries are contingently liable if the reinsurance companies are unable to meet their obligations. The methods used for recognizing income and expenses related to reinsurance contracts have been applied in a manner consistent with the recognition of income and expense on the underlying direct and assumed business. 14. DIVIDEND RESTRICTIONS AND REGULATORY MATTERS Dividends from the Acceptance insurance subsidiaries and Redland insurance subsidiaries are not available to the Company because of restrictive covenants set forth in loan agreements which prohibit dividends from Acceptance or Redland to the Company without the express consent of the respective holders of these obligations. Acceptance's insurance subsidiaries reported to regulatory authorities total policyholders' surplus of approximately $57,044,000 and $33,324,000 at December 31, 1993 and 1992, respectively, and total statutory net income of $2,712,000 and $1,304,000 for the years ended December 31, 1993 and 1992, respectively. Redland's insurance subsidiaries reported to regulatory authorities total policyholders' surplus of approximately $14,719,000 at December 31, 1993 and statutory net loss of approximately $5,052,000 for the year ended December 31, 1993. 15. MAJOR GROUP ACQUISITION On September 25, 1992, the Company completed a merger with Major Group which increased the Company's ownership interest to 100%. Pursuant to Settlement Agreements among the Company, Major Group and certain secured creditors (the "Term Sheet Creditors"), Major Group (1) conveyed substantially all of its assets, except for certain property located in Fort Lauderdale, Florida (the "Fort Lauderdale Commerce Center Property") and two promissory notes from Major Realty Corporation (the "Major Realty Notes"), to the Term Sheet Creditors in satisfaction of all of Major Group's obligations due to them; (2) the Fort Lauderdale Commerce Center Property and the Major Realty Notes were transferred to the Company in satisfaction of all amounts due the Company under a note of a subsidiary of Major Group, which was secured by a mortgage on the Fort Lauderdale Commerce Center Property and guaranteed by Major Group; and (3) the Company issued a promissory note in the principal amount of $500,000 payable in installments over one year to the Term Sheet Creditors in exchange for all of the Major Group preferred stock held by the Term Sheet Creditors. Assets conveyed to the Term Sheet Creditors and liabilities satisfied approximated $5.7 million. Immediately upon conclusion of these transactions, Major Group was merged into a wholly-owned subsidiary of the Company. In addition, Major Group settled certain claims by agreeing to pay $150,000 in cash and other consideration, payment of which is guaranteed by the Company, payable over a two year period and payment of the net cash proceeds from the sale of certain sewer connections not to exceed $150,000. In connection with the above, the Company issued approximately 52,000 shares of common stock to complete the merger. The Company recorded approximately $494,000 of excess of cost over acquired net assets which is being amortized over five years. The net effect of the transactions among Major Group, the Term Sheet Creditors and the Company upon results of operations was insignificant. 16. DISCONTINUED OPERATIONS In December 1991, the Company decided to sell its approximate 52% interest in Orange-co, its Florida based subsidiary primarily engaged in growing and processing citrus products as well as packaging and marketing these citrus and other beverage products. The Company, therefore, recorded a provision for the expected loss on disposal, including estimated costs of disposition, of approximately $19,600,000, with no related federal income tax effect. Additionally, revenues and expenses of Orange-co were reclassified as net income (loss) from discontinued operations. The Company's interest in the estimated earnings of Orange-co during the disposal period were not recognized because such earnings were not expected to be realized. On May 28, 1992, the Company consummated the sale of Orange-co for $31,000,000. After payment of expenses of the transaction, $2,030,000, the Company realized a loss on the transaction of $83,000. Net sales of Orange-co for the year ended December 31, 1991, were $80,357,000. 17. CONTINGENCIES The Company is involved in various insurance related claims and other legal actions arising from the normal conduct of business. Management believes that the outcome of these proceedings will not have a material effect on the consolidated financial statements of the Company. A subsidiary of the Company has guaranteed debt of $775,000 relating to a real estate partnership in which the subsidiary has a limited partnership interest. 18. INTERIM FINANCIAL INFORMATION (UNAUDITED) Fully Primary Diluted Net Net Net Income Income Income (Loss) (Loss) Quarters Ended Revenues (Loss) Per Share Per Share (In thousands, except per share data) 1993: December 31 $ 43,821 $ 2,152 $ 0.21 $ 0.21 September 30 38,460 2,167 0.22 0.22 June 30 32,581 1,715 0.20 0.20 March 31 30,433 1,552 0.24 0.23 -------- ------- ------- ------- $145,295 $ 7,586 $ 0.86 (2) $ 0.85 (2) ======== ======= ======== ======= 1992: December 31 $ 24,434 $ 814 $ 0.24 $ 0.24 September 30 25,280 756 0.22 0.22 June 30 23,182 (2,608) (1) (0.76) (0.76) March 31 22,136 129 0.04 0.04 -------- ------- -------- ------- $ 95,032 $ (909) $ (0.26) $ (0.26) ======== ======= ======== ======= (1) The net loss for the quarter ended June 30, 1992 was primarily due to the $2,100,000 strengthening of the Company's loss reserves for its workers' compensation and liquor liability business. (2) Quarterly net income per share numbers for 1993 do not add to the annual net income per share due to rounding. 19. SUBSEQUENT EVENT In March 1994, the Company entered into an Agreement and Plan of Merger with Statewide Insurance Corporation, the exclusive general agent for the Company's non-standard automobile insurance program underwritten by Phoenix Indemnity Insurance Company ("Phoenix Indemnity"), and the owner of 20% of the outstanding shares of common stock of Phoenix Indemnity pursuant to which the Company will acquire by merger (the "Merger") Statewide Insurance Corporation (except for certain assets and liabilities relating to its agency operations other than the non-standard automobile program which will be divested prior to the merger). The effective date of the Merger is March 31, 1994. ACCEPTANCE INSURANCE COMPANIES INC. SCHEDULE III - (Continued) CONDENSED FINANCIAL INFORMATION OF REGISTRANT YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 STATEMENTS OF CASH FLOWS (Parent Company Only) In January 1993, the Company assumed a $7 million note from one of its subsidiaries. In April 1993, this note was exchanged for 875,000 shares of common stock and warrants to purchase common stock. (See Note 2 to the Consolidated Financial Statements.) In August 1993, the Company acquired Redland and the purchase price of $15.4 million was comprised of 1,339,000 shares of the Company's common stock and acquisition related costs of $306,000. (See Note 3 to the Consolidated Financial Statements.) In September 1992, the Settlement Agreement and merger with Major Group resulted in non-cash transactions in which (1) the Company received certain real estate and notes receivable from Major Realty in satisfaction of a note receivable due the Company from Major Group; (2) a promissory note in the principal amount of $500,000 was issued by the Company in exchange for all of the Major Group preferred stock; and (3) the Company issued approximately 52,000 shares of common stock which increased its ownership interest in Major Group from approximately 51% to 100%. In addition, the Company contributed the notes receivable from Major Realty of approximately $1.3 million to Acceptance in September 1992. (See Note 15 to the Consolidated Financial Statements.) Cash payments for interest were $1,019,000, $1,960,000 and $3,253,000 during the years ended December 31, 1993, 1992 and 1991, respectively. ACCEPTANCE INSURANCE COMPANIES INC. ACCEPTANCE INSURANCE COMPANIES INC. SCHEDULE V SUPPLEMENTAL INSURANCE INFORMATION YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 (In Thousands) Net Claims and Claim Adjustment Expenses Incurred Related to ------------------ (1) (2) Other Current Prior Operating Year Years Expenses Year Ended December 31, 1993 $90,250 $2,555 $1,821 Year Ended December 31, 1992 $57,678 $2,347 $1,466 Year Ended December 31, 1991 $46,719 $ 198 $1,550 ACCEPTANCE INSURANCE COMPANIES INC. SCHEDULE X SUPPLEMENTARY INCOME STATEMENT INFORMATION YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 (In Thousands) Column B Charged to Costs and Expenses ----------------------- 1993 1992 1991 Depreciation and amortization $3,533 $1,552 $2,572 Taxes, other than payroll and income taxes $3,748 $1,859 $1,403 Other captions provided for under this schedule are excluded as the amounts related to such caption are not material.

1800_1993.txt

1800

1993

ITEM 1. BUSINESS GENERAL DEVELOPMENT OF BUSINESS Abbott Laboratories is an Illinois corporation, incorporated in 1900. The Company's* principal business is the discovery, development, manufacture, and sale of a broad and diversified line of health care products and services. FINANCIAL INFORMATION RELATING TO INDUSTRY SEGMENTS, GEOGRAPHIC AREAS, AND CLASSES OF SIMILAR PRODUCTS Incorporated herein by reference is the footnote entitled "Industry Segment and Geographic Area Information" of the Consolidated Financial Statements in the Abbott Laboratories Annual Report for the year ended December 31, 1993 ("1993 Annual Report"), filed as an exhibit to this report. Also incorporated herein by reference is the text and table of sales by class of similar products included in the section of the 1993 Annual Report captioned "Financial Review." NARRATIVE DESCRIPTION OF BUSINESS PHARMACEUTICAL AND NUTRITIONAL PRODUCTS Included in this segment is a broad line of adult and pediatric pharmaceuticals and nutritionals. These products are sold primarily on the prescription or recommendation of physicians or other health care professionals. The segment also includes agricultural and chemical products, bulk pharmaceuticals, and consumer products. Principal pharmaceutical and nutritional products include the anti-infectives clarithromycin, sold in the United States under the trademark Biaxin-R- and outside the United States primarily under the trademark Klacid-R- and tosufloxacin, sold in Japan under the trademark Tosuxacin-TM-; various forms of the antibiotic erythromycin, sold primarily as PCE-R- or polymer-coated erythromycin, Erythrocin-R-, and E.E.S.-R-; agents for the treatment of epilepsy, including Depakote-R-; a broad line of cardiovascular products, including Loftyl-R-, a vasoactive agent sold outside the United States; Hytrin-R-, used as an anti-hypertensive and for the treatment of benign prostatic hyperplasia; Abbokinase-R-, a thrombolytic drug; Survanta-R-, a bovine derived lung surfactant; various forms of prepared infant formula, including Similac-R-, Isomil-R-, and Alimentum-R-; and other medical and pediatric nutritionals, including Ensure-R-, Ensure Plus-R-, Jevity-R-, Glucerna-R-, Advera-TM-, PediaSure-R-, Pedialyte-R- and Gain-R-. Consumer products include the dandruff shampoo Selsun Blue-R-; Murine-R- eye care and ear care products; Tronolane-R- hemorrhoid medication; and Faultless-R- rubber sundry products. Agricultural and chemical products include plant growth regulators, including ProGibb-R-; herbicides; larvicides, including Vectobac-R-; and biologically derived insecticides, including DiPel-R- and XenTari-R-. Pharmaceutical and nutritional products are generally sold directly to retailers, wholesalers, health care facilities, and government agencies. In most cases, they are distributed from Company-owned distribution centers or public warehouses. Certain products are co-marketed with other companies. In certain overseas countries, some of these products are marketed and distributed through distributors. Primary marketing efforts for pharmaceutical and nutritional products are directed toward securing the prescription or recommendation of the Company's brand of products by physicians or other health care professionals. Managed care purchasers, for example health maintenance organizations (HMOs) and pharmacy benefit managers, are becoming increasingly important customers. Competition is generally from other broad line and specialized health care manufacturers. A significant aspect of competition is the search for technological innovations. The - ------------------------ * As used throughout the text of this Report, the term "Company" refers to Abbott Laboratories, an Illinois corporation, or Abbott Laboratories and its consolidated subsidiaries, as the context requires. introduction of new products by competitors and changes in medical practices and procedures can result in product obsolescence. In addition, the substitution of generic drugs for the brand prescribed has increased competitive pressures on pharmaceutical products. Consumer products are promoted directly to the public by consumer advertising. These products are generally sold directly to retailers and wholesalers. Competitive products are sold by other diversified consumer and health care companies. Competitive factors include consumer advertising, scientific innovation, price, and availability of generic product forms. Agricultural and chemical products are generally sold to agricultural distributors and pharmaceutical companies. Competition is primarily from large chemical and agricultural companies and companies selling specialized agricultural products. Competition is based on numerous factors depending on the market served. Important competitive factors include product performance for specialized industrial and agricultural uses, price, and technological advantages. The Company is the leading worldwide producer of the antibiotic erythromycin. Similac-R- is the leading infant formula product in the United States. Under an agreement between the Company and Takeda Chemical Industries, Ltd. of Japan (Takeda), TAP Pharmaceuticals Inc. (TAP), owned 50 percent by the Company and 50 percent by Takeda, develops and markets in the United States products based on Takeda research. TAP markets Lupron-R-, an LH-RH analog, and Lupron Depot-R-, a sustained release form of Lupron-R-, in the United States. These agents are used for the treatment of advanced prostatic cancer, endometriosis, and central precocious puberty. The Company also has marketing rights to certain Takeda products in select Latin American markets. The Company also markets Lupron-R-, Lupron Depot-R-, and Lupron Depot-Ped-R- in select markets outside the United States. HOSPITAL AND LABORATORY PRODUCTS Hospital and laboratory products include diagnostic systems for blood banks, hospitals, commercial laboratories, and alternate-care testing sites; intravenous and irrigation fluids and related administration equipment, including electronic drug delivery systems; drugs and drug delivery systems; anesthetics; critical care products; and other medical specialty products for hospitals and alternate-care sites. The principal products included in this segment are parenteral (intravenous or I.V.) solutions and related administration equipment sold as the LifeCare-R- line of products, LifeShield-R- sets, and Venoset-R- products; irrigating fluids; parenteral nutritionals such as Aminosyn-R- and Liposyn-R-; Plum-R- and Omni-Flow-R- electronic drug delivery systems; Abbott Pain Management Provider-R-; patient-controlled analgesia (PCA) systems; venipuncture products; hospital injectables; premixed I.V. drugs in various containers; ADD-Vantage-R- and Nutrimix-R- drug and nutritional delivery systems; anesthetics, including Pentothal-R-, isoflurane, and enflurane; hemodynamic monitoring equipment; Calcijex-R-, an injectable agent for treatment of bone disease in hemodialysis patients; critical care products including Opticath-R-; screening tests for hepatitis B, HTLV-1, hepatitis B core, and hepatitis C; tests for detection of AIDS antibodies and antigens, and other infectious disease detection systems; tests for determining levels of abused drugs with the ADx-R- instrument; physiological diagnostic tests; cancer monitoring tests including tests for prostate specific antigen; laboratory tests and therapeutic drug monitoring systems such as TDx-R-; clinical chemistry systems such as Abbott Spectrum-R-, Abbott Spectrum-R- EPx-R-, Abbott Spectrum-R- CCx-TM-, and Quantum-TM-; Commander-R- and IMx-R- lines of diagnostic instruments and chemical reagents used with immunoassay diagnostics; Abbott Vision-R-, a desk-top blood analyzer, the Abbott TestPack-R- system for diagnostic testing, and a full line of hematology systems and reagents known as the Cell-Dyn-R- series. The hospital and laboratory products the Company expects to introduce in the United States in 1994 include: AxSym-TM-, a diagnostic system; Abbott Maestro-TM-, a data management system; and EnCounter-R-, a desktop hematology analyzer. The Company markets hospital and laboratory products in the United States and many other countries. These products are generally distributed to wholesalers and directly to hospitals, laboratories, and physicians' offices from distribution centers maintained by the Company. Sales are also made in the home infusion services market directly to patients receiving treatment outside the hospital through marketing arrangements with hospitals and other health care providers. Overseas sales are made either directly to customers or through distributors, depending on the market served. The hospital and laboratory products industry segment is highly competitive, both in the United States and overseas. This segment is subject to competition in technological innovation, price, convenience of use, service, instrument warranty provisions, product performance, long-term supply contracts, and product potential for overall cost effectiveness and productivity gains. Products in this segment can be subject to rapid product obsolescence. The Company has benefitted from technological advantages of certain of its current products; however, these advantages may be reduced or eliminated as competitors introduce new products. The Company is one of the leading domestic manufacturers of I.V. and irrigating solutions and related administration equipment, parenteral nutritional products, anesthesia products, and drug delivery systems. It is also the worldwide leader in in vitro diagnostic products, including thyroid tests, therapeutic drug monitoring, cancer monitoring tests, diagnostic tests for the detection of hepatitis and AIDS antibodies, and immunodiagnostic instruments. INFORMATION WITH RESPECT TO THE COMPANY'S BUSINESS IN GENERAL SOURCES AND AVAILABILITY OF RAW MATERIALS The Company purchases, in the ordinary course of business, necessary raw materials and supplies essential to the Company's operations from numerous suppliers in the United States and overseas. There have been no recent availability problems or significant supply shortages. PATENTS, TRADEMARKS, AND LICENSES The Company is aware of the desirability for patent and trademark protection for its products. The Company owns, has applications pending for, and is licensed under a substantial number of patents. Accordingly, where possible, patents and trademarks are sought and obtained for the Company's products in the United States and all countries of major marketing interest to the Company. Principal trademarks and the products they cover are discussed in the Narrative Description of Business on pages 1 and 2. These, and various patents which expire during the period 1994 to 2011, in the aggregate, are believed to be of material importance in the operation of the Company's business. However, the Company believes that no single patent, license, trademark, (or related group of patents, licenses, or trademarks) is material in relation to the Company's business as a whole. SEASONAL ASPECTS, CUSTOMERS, BACKLOG, AND RENEGOTIATION There are no significant seasonal aspects to the Company's business. The incidence of certain infectious diseases which occur at various times in different areas of the world does, however, affect the demand for the Company's anti-infective products. Orders for the Company's products are generally filled on a current basis, and order backlog is not material to the Company's business. No single customer accounted for sales equaling 10 percent or more of the Company's consolidated net sales. No material portion of the Company's business is subject to renegotiation of profits or termination of contracts at the election of the government. RESEARCH AND DEVELOPMENT The Company spent $880,974,000 in 1993, $772,407,000 in 1992, and $666,336,000 in 1991 on research to discover and develop new products and processes and to improve existing products and processes. The Company continues to concentrate research expenditures in pharmaceutical and diagnostic products. ENVIRONMENTAL MATTERS The Company believes that its operations comply in all material respects with applicable laws and regulations concerning environmental protection. Regulations under federal and state environmental laws impose stringent limitations on emissions and discharges to the environment from various manufacturing operations. The Company's capital and operating expenditures for pollution control in 1993 were approximately $32 million and $31 million, respectively. Capital and operating expenditures for pollution control are estimated to approximate $39 million and $36 million, respectively, in 1994. The Company is participating as one of many potentially responsible parties in investigation and/ or remediation at eight locations in the United States and Puerto Rico under the Comprehensive Environmental Response, Compensation, and Liability Act, commonly known as Superfund. The aggregate costs of remediation at these sites by all identified parties are uncertain but have been subject to widely ranging estimates totaling as much as several hundred million dollars. In many cases, the Company believes that the actual costs will be lower than these estimates, and the fraction for which the Company may be responsible is anticipated to be considerably less and will be paid out over a number of years. The Company expects to participate in the investigation or cleanup at these sites. The Company is also voluntarily investigating potential contamination at five Company-owned sites, and has initiated voluntary remediation at four Company-owned sites, in cooperation with the Environmental Protection Agency (EPA) or similar state agencies. While it is not feasible to predict with certainty the costs related to the previously described investigation and cleanup activities, the Company believes that such costs, together with other expenditures to maintain compliance with applicable laws and regulations concerning environmental protection, should not have a material adverse effect on the Company's earnings or competitive position. EMPLOYEES The Company employed 49,659 persons as of December 31, 1993. REGULATION The development, manufacture, sale, and distribution of the Company's products are subject to comprehensive government regulation, and the general trend is toward more stringent regulation. Government regulation by various federal, state, and local agencies, which includes detailed inspection of and controls over research and laboratory procedures, clinical investigations, and manufacturing, marketing, sampling, distribution, recordkeeping, storage and disposal practices, substantially increases the time, difficulty, and costs incurred in obtaining and maintaining the approval to market newly developed and existing products. Government regulatory actions can result in the seizure or recall of products, suspension or revocation of the authority necessary for their production and sale, and other civil or criminal sanctions. Continuing studies of the utilization, safety, and efficacy of health care products and their components are being conducted by industry, government agencies, and others. Such studies, which employ increasingly sophisticated methods and techniques, can call into question the utilization, safety, and efficacy of previously marketed products and in some cases have resulted, and may in the future result, in the discontinuance of marketing of such products and give rise to claims for damages from persons who believe they have been injured as a result of their use. The cost of human health care products continues to be a subject of investigation and action by governmental agencies, legislative bodies, and private organizations in the United States and other countries. In the United States, most states have enacted generic substitution legislation requiring or permitting a dispensing pharmacist to substitute a different manufacturer's version of a pharmaceutical product for the one prescribed. Federal and state governments continue to press efforts to reduce costs of Medicare and Medicaid programs, including restrictions on amounts agencies will reimburse for the use of products. Manufacturers must pay certain statutorily-prescribed rebates on Medicaid purchases for reimbursement on prescription drugs under state Medicaid plans. In addition, the Federal government follows a diagnosis-related group (DRG) payment system for certain institutional services provided under Medicare or Medicaid. The DRG system entitles a health care facility to a fixed reimbursement based on discharge diagnoses rather than actual costs incurred in patient treatment, thereby increasing the incentive for the facility to limit or control expenditures for many health care products. The Veterans Health Care Act of 1992 requires manufacturers to extend additional discounts on pharmaceutical products to various federal agencies, including the Department of Veterans Affairs, Department of Defense, and Public Health Service entities and institutions. In the United States, governmental cost-containment efforts have extended to the federally subsidized Special Supplemental Food Program for Women, Infants, and Children (WIC). All states participate in WIC and have sought and obtained rebates from manufacturers of infant formula whose products are used in the program. All of the states have also conducted competitive bidding for infant formula contracts which require the use of specific infant formula products for the state WIC program. The Child Nutrition and WIC Reauthorization Act of 1989 requires all states participating in WIC to engage in competitive bidding upon the expiration of their existing infant formula contracts. Governmental regulatory agencies now require manufacturers to pay additional fees. Under the Prescription Drug User Fee Act of 1992, the Federal Food and Drug Administration imposes substantial fees on various aspects of the approval, manufacture and sale of prescription drugs. Congress is now considering expanding user fees to medical devices. The Company believes that such legislation, if enacted, will add considerable expense for the Company. In the United States comprehensive legislation has been proposed that would make significant changes to the availability, delivery and payment for healthcare products and services. It is the intent of such proposed legislation to provide health and medical insurance for all United States citizens and to reduce the rate of increases in United States healthcare expenditures. If such legislation is enacted, the Company believes it could have the effect of reducing prices for, or reducing the rate of price increases for health and medical insurance and medical products and services. International operations are also subject to a significant degree of government regulation. Many countries, directly or indirectly through reimbursement limitations, control the selling price of most health care products. Furthermore, many developing countries limit the importation of raw materials and finished products. International regulations are having an impact on United States regulations, as well. The International Organization for Standardization ("ISO") provides the voluntary criteria for regulating medical devices within the European Economic Community. The Food and Drug Administration ("FDA") has announced that it will attempt to harmonize its regulation of medical devices with that of the ISO. Recently published changes to the FDA's regulations governing the manufacture of medical devices appear to encompass and exceed the ISO's approach to regulating medical devices. The FDA's adoption of the ISO's approach to regulation and other changes to the manner in which the FDA regulates medical devices will increase the cost of compliance with those regulations. Efforts to reduce health care costs are also being made in the private sector. Health care providers have responded by instituting various cost reduction and containment measures. It is not possible to predict the extent to which the Company or the health care industry in general might be affected by the matters discussed above. INTERNATIONAL OPERATIONS The Company markets products in approximately 130 countries through affiliates and distributors. Most of the products discussed in the preceding sections of this report are sold outside the United States. In addition, certain products of a local nature and variations of product lines to meet local regulatory requirements and marketing preferences are manufactured and marketed to customers outside the United States. International operations are subject to certain additional risks inherent in conducting business outside the United States, including price and currency exchange controls, changes in currency exchange rates, limitations on foreign participation in local enterprises, expropriation, nationalization, and other governmental action. ITEM 2.

ITEM 2. PROPERTIES The Company's corporate offices are located at One Abbott Park Road, Abbott Park, Illinois 60064-3500. The locations of a number of the Company's principal plants are listed below. In addition to the above, the Company has manufacturing facilities in eight other locations in the United States and Puerto Rico. Overseas manufacturing facilities are located in 19 other countries. The Company's facilities are deemed suitable, provide adequate productive capacity, and are utilized at normal and acceptable levels. In the United States and Puerto Rico, the Company owns seven distribution centers. The Company also has twelve United States research and development facilities located at Abbott Park, Illinois; Andover, Massachusetts; Ashland, Ohio; Columbus, Ohio (2 locations); Irving, Texas; Long Grove, Illinois; Madera, California; Mountain View, California; North Chicago, Illinois; Salt Lake City, Utah; and Santa Clara, California. Overseas, the Company has research and development facilities in Argentina, Australia, Canada, Germany, Italy, Japan, The Netherlands, and the United Kingdom. The corporate offices, all manufacturing plants, and all other facilities in the United States and overseas are owned or leased by the Company or subsidiaries of the Company. ITEM 3.

ITEM 3. LEGAL PROCEEDINGS The Company is involved in various claims and legal proceedings including (as of January 31, 1994) 7 antitrust suits and 6 investigations in connection with the Company's sale and marketing of infant formula products, 138 product liability cases that allege injuries to the offspring of women who ingested a synthetic estrogen (DES) during pregnancy and 22 antitrust suits in connection with the Company's sale and marketing of pharmaceuticals. The infant formula antitrust suits, which are pending in various federal and state courts, allege that the Company conspired with one or more of its competitors to fix prices for infant formula, to rig a bid on a contract to provide infant formula under the federal government's Special Supplemental Food Program for Women, Infants, and Children (WIC), to deprive states of the benefits of competition in providing rebates to the state pursuant to WIC sales, and to restrain trade and monopolize the market for infant formula products in violation of state and federal antitrust laws. The suits were brought on behalf of individuals, a competitor, the Federal Trade Commission, and state governmental agencies seeking treble damages, civil penalties, and other relief. Three of the 7 cases are pending in state courts in Calhoun County and Shelby County, Alabama and in Austin, Texas. The Calhoun County suit purports to be a class action on behalf of Alabama consumers. The 4 other cases are pending in federal courts in Los Angeles, California, Tallahassee, Florida, Baton Rouge, Louisiana (this suit purports to be a class action on behalf of Louisiana consumers), and Washington, D.C. The Company has filed responses to the complaints denying all substantive allegations. The investigations are being conducted by the Attorneys General of the states of California, Connecticut, New York, Pennsylvania and Wisconsin and by the Canadian Bureau of Competition Policy. The four shareholder derivative suits (which were consolidated in federal court in Chicago, Illinois) that had been filed against certain of the Company's officers and directors regarding the Company's sale and marketing of infant formula products were dismissed with prejudice on January 31, 1994. Twelve of the 22 pharmaceutical antitrust suits are pending in the United States District Court for the Southern District of New York; 4 are pending in state court in San Francisco County, California; the 6 remaining cases are pending in federal district courts in San Francisco, California, Savannah, Georgia, Minneapolis, Minnesota, Charleston, South Carolina, Austin, Texas, and Galveston, Texas. These suits allege that various pharmaceutical manufacturers have conspired to fix drug prices and/or to discriminate in pricing to retail pharmacies by providing discounts to mail-order pharmacies, institutional pharmacies, and HMOs. The suits were brought on behalf of retail pharmacies, seek treble damages and other relief, and some purport to be class actions. The Company intends to respond to the complaints denying all substantive allegations. While it is not feasible to predict the outcome of such pending claims, proceedings, and investigations with certainty, management is of the opinion, with which its General Counsel concurs, that their ultimate disposition should not have a material adverse effect on the Company's financial position. ITEM 4.

ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS None. EXECUTIVE OFFICERS OF THE REGISTRANT Officers of the Company are elected annually by the board of directors at the first meeting held after the annual shareholders meeting. Each officer holds office until a successor has been duly elected and qualified or until the officer's death, resignation, or removal. Vacancies may be filled at any meeting of the board. Any officer may be removed by the board of directors when, in its judgment, removal would serve the best interests of the Company. Current corporate officers, and their ages as of February 11, 1994, are listed below. The officers' principal occupations and employment from January 1989 to present and the dates of their first election as officers of the Company are also shown. Unless otherwise stated, employment was by the Company for the period indicated. There are no family relationships between any corporate officers or directors. DUANE L. BURNHAM**, 52 1989 -- Vice Chairman and Chief Financial Officer, and Director. 1989 to 1990 -- Vice Chairman and Chief Executive Officer, and Director. 1990 to present -- Chairman of the Board and Chief Executive Officer, and Director. Elected Corporate Officer -- 1982. THOMAS R. HODGSON**, 52 1989 to 1990 -- Executive Vice President and Director. 1990 to present -- President and Chief Operating Officer, and Director. Elected Corporate Officer -- 1980. ROBERT N. BECK**, 53 1989 to 1992 -- Executive Vice President, BankAmerica and Bank of America. 1992 to present -- Senior Vice President, Human Resources. Elected Corporate Officer -- 1992. PAUL N. CLARK**, 47 1989 to 1990 -- Vice President, Pharmaceutical Operations. 1990 to present -- Senior Vice President, Pharmaceutical Operations. Elected Corporate Officer -- 1985. GARY P. COUGHLAN**, 49 1989 -- Senior Vice President and Chief Financial Officer, Kraft, Inc. 1989 to 1990 -- Senior Vice President, Finance, Kraft General Foods. 1990 to present -- Senior Vice President, Finance and Chief Financial Officer. Elected Corporate Officer -- 1990. LAEL F. JOHNSON**, 56 1989 -- Vice President, Secretary and General Counsel. 1989 to present -- Senior Vice President, Secretary and General Counsel. Elected Corporate Officer -- 1981. JOHN G. KRINGEL**, 54 1989 to 1990 -- Vice President, Hospital Products. 1990 to present -- Senior Vice President, Hospital Products. Elected Corporate Officer -- 1981. J. DUNCAN MCINTYRE**, 56 1989 to 1990 -- Vice President. 1990 to present -- Senior Vice President, International Operations. Elected Corporate Officer -- 1987. THOMAS M. MCNALLY**, 46 1989 -- Area Vice President, Pacific, Asia and Africa, Abbott International, Ltd. (a subsidiary of the Company). 1989 to 1990 -- Vice President, Chemical and Agricultural Products. 1990 to 1993 -- Senior Vice President, Chemical and Agricultural Products. 1993 to present -- Senior Vice President, Ross Products. Elected Corporate Officer -- 1989. ROBERT L. PARKINSON, JR.**, 43 1989 -- Divisional Vice President, Commercial Operations. 1989 to 1990 -- Vice President, Corporate Hospital Marketing. 1990 to 1993 -- Vice President, European Operations. 1993 to present -- Senior Vice President, Chemical and Agricultural Products. Elected Corporate Officer -- 1989. DAVID A. THOMPSON**, 52 1989 to 1990 -- Vice President, Diagnostic Operations. 1990 to present -- Senior Vice President, Diagnostic Operations. Elected Corporate Officer -- 1982. JOY A. AMUNDSON**, 39 1989 to 1990 -- General Manager, Alternate Site. 1990 -- Divisional Vice President and General Manager, Hospital Products Business Sector. 1990 to 1994 -- Vice President, Corporate Hospital Marketing. 1994 to present -- Vice President, Health Systems. Elected Corporate Officer -- 1990. CHRISTOPHER B. BEGLEY, 41 1989 -- Director, Hospital Products Business Sector. 1989 to 1990 -- General Manager, Hospital Products Business Sector. 1990 to 1993 -- Divisional Vice President and General Manager, Hospital Products Business Sector. 1993 -- Vice President, Hospital Products Business Sector. Elected Corporate Officer -- 1993. THOMAS D. BROWN, 45 1989 to 1992 -- Divisional Vice President, Western Hemisphere. 1992 to 1993 -- Divisional Vice President, Diagnostic Commercial Operations. 1993 to present -- Vice President, Diagnostic Commercial Operations. Elected Corporate Officer -- 1993. GARY R. BYERS**, 52 1989 to 1993 -- Divisional Vice President, Corporate Auditing. 1993 to present -- Vice President, Internal Audit. Elected Corporate Officer -- 1993. KENNETH W. FARMER**, 48 1989 -- Vice President, Management Information Services. 1989 to present -- Vice President, Management Information Services and Administration. Elected Corporate Officer -- 1985. THOMAS C. FREYMAN**, 39 1989 to 1991 -- Treasurer, Abbott International, Ltd. (a subsidiary of the Company). 1991 to present -- Vice President and Treasurer. Elected Corporate Officer -- 1991. JAY B. JOHNSTON, 50 1989 to 1992 -- President, Dainabot Co., Ltd. (an affiliate of the Company) and General Manager Asia Pacific, Abbott Diagnostics Division. 1992 -- Divisional Vice President, Business Development. 1992 to 1993 -- Divisional Vice President and General Manager, Diagnostic Assays and Operations. 1993 to present -- Corporate Vice President, Diagnostic Assays and Operations. Elected Corporate Officer -- 1993. JAMES J. KOZIARZ, 44 1989 to 1990 -- General Manager, Hepatitis/Retrovirus Business Sector. 1990 to 1992 -- Vice President and General Manager, Diagnostic Assays. 1992 to present -- Vice President, Diagnostic Products Research and Development. Elected Corporate Officer -- 1993. CHRISTOPHER A. KUEBLER, 40 1989 to 1992 -- Divisional Vice President, Marketing. 1992 to 1993 -- Divisional Vice President, Sales and Marketing. 1993 to present -- Vice President, European Operations. Elected Corporate Officer -- 1993. JOHN F. LUSSEN**, 52 1989 to present -- Vice President, Taxes. Elected Corporate Officer -- 1985. DAVID V. MILLIGAN, PH.D., 53 1989 to 1992 -- Vice President, Diagnostic Products Research and Development. 1992 to present -- Vice President, Pharmaceutical Products Research and Development. Elected Corporate Officer -- 1984. RICHARD H. MOREHEAD**, 59 1989 to present -- Vice President, Corporate Planning and Development. Elected Corporate Officer -- 1985. THEODORE A. OLSON**, 55 1989 to present -- Vice President and Controller. Elected Corporate Officer -- 1988. CARL A. SPALDING, 48 1989 to 1992 -- Vice President, International, Johnson & Johnson. 1992 to present -- Vice President, General Manager, Ross Products. Elected Corporate Officer -- 1993. WILLIAM H. STADTLANDER, 48 1989 to 1992 -- Divisional Vice President, Medical Nutritionals. 1992 to present -- Divisional Vice President and General Manager, Medical Nutritionals. Elected Corporate Officer -- 1993. DANIEL O. STRUBLE**, 53 1989 to present -- Vice President, Corporate Engineering. Elected Corporate Officer -- 1987. ELLEN M. WALVOORD**, 54 1989 to 1991 -- Director, Corporate Communications. 1991 -- Vice President, Investor Relations. 1991 to present -- Vice President, Investor Relations and Public Affairs. Elected Corporate Officer -- 1991. JOSEF WENDLER, 44 1989 to 1990 -- General Manager, Austria & Switzerland. 1990 to 1992 -- Regional Director, Europe, Diagnostic Division. 1992 to 1993 -- Divisional Vice President, Pacific, Asia, Africa. 1993 to present -- Vice President, Pacific/ Asia /Africa Operations. Elected Corporate Officer -- 1993. MILES D. WHITE, 38 1989 to 1990 -- Director of Marketing for the U.S., Abbott Diagnostics Division. 1990 -- Business Unit General Manager, Physiological Diagnostics, Abbott Diagnostics Division and Business Unit General Manager, Cancer Diagnostics. 1990 to 1992 -- Divisional Vice President and General Manager, Hospital Laboratory Sector. 1992 to 1993 -- Divisional Vice President and General Manager, Diagnostic Systems and Operations. 1993 to present -- Vice President, Diagnostic Systems and Operations. Elected Corporate Officer -- 1993. DON G. WRIGHT**, 51 1989 to present -- Vice President, Corporate Quality Assurance and Regulatory Affairs. Elected Corporate Officer -- 1988. - ------------------------ ** Pursuant to Item 401(b) of Regulation S-K the Company has identified these persons as "executive officers" within the meaning of Item 401(b). PART II ITEM 5.

ITEM 5. MARKET FOR THE REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS PRINCIPAL MARKET The principal market for the Company's common shares is the New York Stock Exchange. Shares are also listed on the Chicago and Pacific Stock Exchanges and are traded on the Boston, Cincinnati, and Philadelphia Exchanges. Overseas, the Company's shares are listed on the London Stock Exchange, Tokyo Stock Exchange, and the Swiss Stock Exchanges of Zurich, Basel, Geneva, and Lausanne. Market prices are as reported by the New York Stock Exchange composite transaction reporting system. SHAREHOLDERS There were 82,947 shareholders of record of Abbott common shares as of December 31, 1993. DIVIDENDS Quarterly dividends of $.17 per share and $.15 per share were declared on common shares in 1993 and 1992, respectively after reflecting the May 29, 1992 stock split. ITEM 6.

ITEM 6. SELECTED FINANCIAL DATA Incorporated herein by reference for the years 1989 through 1993 are the applicable portions of the section captioned "Summary of Selected Financial Data" of the 1993 Annual Report. ITEM 7.

ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Incorporated herein by reference is management's discussion and analysis of financial condition and results of operations for the years 1993, 1992, and 1991 found under the section captioned "Financial Review" of the 1993 Annual Report. ITEM 8.

ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA Incorporated herein by reference are the portions of the 1993 Annual Report captioned Consolidated Balance Sheet, Consolidated Statement of Income, Consolidated Statement of Cash Flows, Consolidated Statement of Shareholders' Investment, Notes to Consolidated Financial Statements and Report of Independent Public Accountants (which contains the related report of Arthur Andersen & Co. dated January 14, 1994). Data relating to quarterly interim results is found in Note 8. ITEM 9.

ITEM 9. DISAGREEMENTS ON ACCOUNTING AND FINANCIAL DISCLOSURE None. PART III ITEM 10.

ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT Incorporated herein by reference are "Information Concerning Nominees for Directors" and "Compliance with Section 16(a) of The Securities Exchange Act of 1934" found in the 1994 Abbott Laboratories Proxy Statement ("1994 Proxy Statement"), which will be filed with the Commission on or about March 4, 1994. ITEM 11.

ITEM 11. EXECUTIVE COMPENSATION The material in the 1994 Proxy Statement under the heading "Executive Compensation," other than the Report of the Compensation Committee and the Performance Graph, are hereby incorporated by reference. ITEM 12.

ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT Incorporated herein by reference is the text found under the caption "Information Concerning Security Ownership" in the 1994 Proxy Statement. ITEM 13.

ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS Incorporated herein by reference is that portion of the 1994 Proxy Statement under the caption "Compensation Committee Interlocks and Insider Participation." PART IV ITEM 14.

ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K (a) DOCUMENTS FILED AS PART OF THIS FORM 10-K. 1. FINANCIAL STATEMENTS: The Consolidated Financial Statements for the years ended December 31, 1993, 1992, and 1991 and the related report of Arthur Andersen & Co. dated January 14, 1994 appearing under the portions of the 1993 Annual Report captioned Consolidated Balance Sheet, Consolidated Statement of Earnings, Consolidated Statement of Cash Flows, Consolidated Statement of Shareholders' Investment, Notes to Consolidated Financial Statements and Report of Independent Public Accountants, respectively, are incorporated by reference in response to Item 14(a)1. With the exception of the portions of the 1993 Annual Report specifically incorporated herein by reference, such Report shall not be deemed filed as part of this Annual Report on Form 10-K or otherwise deemed subject to the liabilities of Section 18 of the Securities Exchange Act of 1934. 2. FINANCIAL STATEMENT SCHEDULES: The required financial statement schedules are found on the pages indicated below. These schedules should be read in conjunction with the Consolidated Financial Statements in the 1993 Annual Report: 3. EXHIBITS REQUIRED BY ITEM 601 OF REGULATION S-K: The information called for by this paragraph is incorporated herein by reference to the Exhibit Index on pages 16 and 17 of this Form 10-K. (b) REPORTS ON FORM 8-K DURING THE QUARTER ENDED DECEMBER 31, 1993: No reports on Form 8-K were filed during the quarter ended December 31, 1993. (c) EXHIBITS FILED (SEE EXHIBIT INDEX ON PAGES 16 AND 17). (D) FINANCIAL STATEMENT SCHEDULES FILED (SEE PAGES 18 THROUGH 23). SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, Abbott Laboratories has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. ABBOTT LABORATORIES By /s/ DUANE L. BURNHAM Duane L. Burnham Chairman of the Board and Chief Executive Officer Date: February 11, 1994 Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of Abbott Laboratories and in the capacities and on the dates indicated: /s/ DUANE L. BURNHAM Duane L. Burnham Chairman of the Board, Chief Executive Officer, and Director of Abbott Laboratories (principal executive officer) Date: February 11, 1994 /s/ GARY P. COUGHLAN Gary P. Coughlan Senior Vice President, Finance and Chief Financial Officer (principal financial officer) Date: February 11, 1994 /s/ THOMAS R. HODGSON Thomas R. Hodgson President, Chief Operating Officer, and Director of Abbott Laboratories Date: February 11, 1994 /s/ THEODORE A. OLSON Theodore A. Olson Vice President and Controller (principal accounting officer) Date: February 11, 1994 /s/ K. FRANK AUSTEN K. Frank Austen, M.D. Director of Abbott Laboratories Date: February 11, 1994 /s/ H. LAURANCE FULLER H. Laurance Fuller Director of Abbott Laboratories Date: February 11, 1994 /s/ BERNARD J. HAYHOE Bernard J. Hayhoe Director of Abbott Laboratories Date: February 11, 1994 /s/ ALLEN F. JACOBSON Allen F. Jacobson Director of Abbot Laboratories Date: February 11, 1994 /s/ DAVID A. JONES David A. Jones Director of Abbott Laboratories Date: February 11, 1994 /s/ BOONE POWELL, JR. Boone Powell, Jr. Director of Abbott Laboratories Date: February 11, 1994 /s/ A. BARRY RAND A. Barry Rand Director of Abbott Laboratories Date: February 11, 1994 /s/ W. ANN REYNOLDS W. Ann Reynolds Director of Abbott Laboratories Date: February 11, 1994 /s/ WILLIAM D. SMITHBURG William D. Smithburg Director of Abbott Laboratories Date: February 11, 1994 /s/ JOHN R. WALTER John R. Walter Director of Abbott Laboratories Date: February 11, 1994 /s/ WILLIAM L. WEISS William L. Weiss Director of Abbott Laboratories Date: February 11, 1994 EXHIBIT INDEX ABBOTT LABORATORIES ANNUAL REPORT FORM 10-K - --------- * Incorporated herein by reference. The Company will furnish copies of any of the above exhibits to a shareholder upon written request to the Corporate Secretary, Abbott Laboratories, One Abbott Park Road, Abbott Park, Illinois 60064-3500. ABBOTT LABORATORIES AND SUBSIDIARIES SCHEDULE I--INVESTMENT SECURITIES MATURING AFTER ONE YEAR DECEMBER 31, 1993 (DOLLARS IN THOUSANDS) ABBOTT LABORATORIES AND SUBSIDIARIES SCHEDULE V--PROPERTY AND EQUIPMENT FOR THE YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 (DOLLARS IN THOUSANDS) ABBOTT LABORATORIES AND SUBSIDIARIES SCHEDULE VI--ACCUMULATED DEPRECIATION AND AMORTIZATION OF PROPERTY AND EQUIPMENT FOR THE YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 (DOLLARS IN THOUSANDS) ABBOTT LABORATORIES AND SUBSIDIARIES SCHEDULE VIII--VALUATION AND QUALIFYING ACCOUNTS FOR THE YEARS ENDED DECEMBER 31, 1993, 1992, AND 1991 (DOLLARS IN THOUSANDS) ABBOTT LABORATORIES AND SUBSIDIARIES SCHEDULE IX SHORT-TERM BORROWINGS FOR THE YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 (DOLLARS IN THOUSANDS) ABBOTT LABORATORIES AND SUBSIDIARIES SCHEDULE X-SUPPLEMENTARY CONSOLIDATED STATEMENT OF EARNINGS INFORMATION FOR THE YEARS ENDED DECEMBER 31, 1993, 1992, AND 1991 (DOLLARS IN THOUSANDS)

105418_1993.txt

105418

1993

Item 1. Business: (a) Weis Markets, Inc. is a Pennsylvania business corporation formed in 1924. The Company is engaged principally in the retail sale of food. There was no material change in the nature of the company's business during fiscal 1993. (b) The principal business activity which the company has been engaged in for the last five fiscal years is the retail sale of food. (c)(1)(i) The company operates 117 retail food markets in Pennsylvania, 15 in Maryland, 1 in New Jersey, 3 in New York, 4 in Virginia, and 1 in West Virginia. The stores trade under the name Weis Markets, except for 18 Pennsylvania stores which trade as Mr. Z's Food Mart, 2 Pennsylvania stores which trade as Erb's, 4 Pennsylvania stores which trade as Scot's Lo Cost, and 1 Pennsylvania store which trades as Big Top Market. During the past fiscal year, 4 new stores were opened and 3 were closed. The company also owns and operates Weis Food Service, a restaurant and institutional supplier. The company supplies its stores from distribution centers in Sunbury, Northumberland, and Milton, Pennsylvania. The percentage of net sales contributed by each class of similar products for each of the five fiscal years ended December 25, 1993 was: Grocery Meat Produce Other 1989 62.89 15.03 11.69 10.39 1990 62.73 14.99 11.21 11.07 1991 61.27 14.49 10.95 13.29 1992 60.81 14.15 10.78 14.26 1993 60.74 14.80 11.06 13.40 (c)(1)(vi)The Company has its own distribution center with warehouses located within a 15 mile radius of its corporate offices in Sunbury, Pennsylvania. The Company is required to use a significant amount of working capital to provide for the required amount of inventory to meet demand for its products with efficient use of buying power and space in the warehouse facilities. (c)(1)(x)The business of the company is highly competitive, and, in the areas served by it, the company competes based on price and service with national retail food chains, local chains and many independent food stores. The following list includes, but is not limited to, the competitors of the Company: Acme Markets, Inc., Giant Foods of Carlisle, Giant Foods of Landover, Festival Foods, Shop Rite, Super Rite, Giant Eagle, Riverside Markets, Super Valu, Aldi, Insalaco, Walmart, K-Mart, Sam's and A&P. On the basis of sales volume, the company believes it is the leading food retailer in the majority of the areas in which it operates. (c)(1)(xiii)The company has approximately 15,000 employees. Item 2.

Item 2. Properties: The company owns and operates 68 of its stores and leases and operates 73 stores under operating leases for varying periods of time up to the year 2013. The company owns all of its trade fixtures and equipment in its stores and several parcels of vacant land which are available as locations for possible future stores or other expansion. The company owns and operates two warehouses in Sunbury, Pennsylvania totaling approximately 551,000 square feet: one in Milton, Pennsylvania of approximately 1,016,000 square feet, and two in Northumberland, Pennsylvania totaling approximately 121,000 square feet. Weis Markets also operates an ice cream plant, meat processing plant and milk processing plant at its Sunbury location. Item 3.

Item 3. Legal Proceedings: Neither the company nor any subsidiary is presently a party to, nor is any of their property subject to, any material pending legal proceedings, other than routine litigation incidental to the business. Item 4.

Item 4. Submission of Matters to a Vote of Security Holders: There were no matters submitted to a vote of security holders during the fourth quarter of 1993. PART II Item 5.

Item 5. Market for Registrant's Common Equity and Related Stockholder Matters: "Stock Prices and Dividend Information by Quarter" on page 15 and "Stock Traded" on the inside back cover of the 1993 Weis Markets, Inc. Annual Report to Shareholders are incorporated herein by reference. The computation of the approximate number of stockholders on December 25, 1993 is based upon the approximate number of shareholders as determined by the Company's transfer agent. Item 6.

Item 6. Selected Financial Data: "Five-Year Review of Operations" on page 15 of the 1993 Weis Markets, Inc. Annual Report to Shareholders is incorporated herein by reference. Item 7.

Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations: "Management's Discussion and Analysis of Financial Condition and Results of Operations" on page 6 of the 1993 Weis Markets, Inc. Annual Report to Shareholders is incorporated herein by reference. Item 8.

Item 8. Financial Statements and Supplementary Data: The following information in the 1993 Weis Markets, Inc. Annual Report to Shareholders is incorporated herein by reference: The consolidated financial statements on pages 7 to 9, the notes to consolidated financial statements on pages 10 to 14 and the independent auditors' report on page 14. Item 9.

Item 9. Changes in and Disagreements With Accountants on Accounting and Financial Disclosure: None. PART III Item 10.

Item 10. Directors and Executive Officers of the Registrant: "Election of Directors" on pages 4 and 5 of the Weis Markets, Inc. definitive proxy statement dated March 18, 1994 is incorporated herein by reference. Item 11.

Item 11. Executive Compensation: "Board Compensation Committee Report on Executive Compensation," "Summary Compensation Table," "Option/SAR Grants in Last Fiscal Year," "Aggregated Option/SAR Exercises in Last Fiscal Year and FY-End Option/SAR Values," "Retirement Plans," "Pension Plan Table," "Shareholder Return Performance," "Comparative Five-Year Total Returns," and "Comparative Ten-Year Income Percentages" on pages 5 to 9 of the Weis Markets, Inc. definitive proxy statement dated March 18, 1994 is incorporated herein by reference. Item 12.

Item 12. Security Ownership of Certain Beneficial Owners and Management: "Outstanding Voting Securities and Voting Rights" on page 3 of the Weis Markets, Inc. definitive proxy statement dated March 18, 1994 is incorporated herein by reference. Item 13.

Item 13. Certain Relationships and Related Transactions: "Compensation Committee Interlocks and Insider Participation", "Board Compensation Committee Report on Executive Compensation," "Summary Compensation Table," "Option/SAR Grants in Last Fiscal Year, "Aggregated Option/SAR Exercises in Last Fiscal Year and FY-End Option/SAR Values," "Retirement Plans," "Pension Plan Table," "Shareholder Return Performance," "Comparative Five-Year Total Returns," and "Comparative Ten-Year Income Percentages," on pages 5 to 9 of the Weis Markets, Inc. definitive proxy statement dated March 18, 1994 is incorporated herein by reference. PART IV Item 14.

Item 14. Exhibits, Financial Statements, Schedules and Reports on Form 8-K The following information is incorporated herein by reference from the 1993 Weis Markets, Inc. Annual Report to Shareholders: the consolidated financial statements on pages 7 to 9, the notes to consolidated financial statements on pages 10 to 14 and the independent auditors' report on page 14. (a) The following documents are filed as a part of this report: Page 1.Report of Independent Auditors on Financial Statement Schedules 2.Financial Statement Schedules: I. Marketable Securities V. Property, Plant and Equipment VI. Accumulated Depreciation, Depletion and Amortization of Property, Plant and Equipment Schedules other than those listed above are omitted for the reason that they are either not applicable or not required or because the information required is contained in the financial statements or notes thereto. (b) There were no reports on Form 8-K filed during the quarter ended December 25, 1993. (c) A listing of exhibits filed or incorporated by reference is as follows: Exhibit No. 3-A Articles of Incorporation 3-B By-Laws 10-A Deferred Compensation Plan 10-B Profit Sharing Plan 10-C Employee Stock Ownership Plan 10-D Stock Appreciation Rights Program 10-E Stock Option Plan 13 Annual Report to Shareholders for the Fiscal Year ended December 25, 1993 22 Subsidiaries of the Registrant 24 Consent of Independent Auditors The exhibits listed above, except for exhibits 13, 22 and 24, have been filed as exhibits under Part IV, Item 14(c) in Form 10-K for the fiscal year ended December 27, 1980 and are incorporated herein by reference. The foregoing exhibits are available upon request from the Secretary of the Company at a fee of $10.00 per copy. SIGNATURES Pursuant to the requirements of Section 13 or 15(d) 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. WEIS MARKETS, INC. (Registrant) Date Sigfried Weis President Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated. Date Sigfried Weis (Principal Executive Officer) President and Director Date Robert F. Weis (Principal Financial Officer) Vice President and Treasurer and Director Date Norman S. Rich Vice President and Secretary and Director Date William R. Mills Vice President Finance Independent Auditors' Report The Board of Directors and Shareholders of Weis Markets, Inc.: Under date of January 28, 1994, we reported on the consolidated balance sheets of Weis Markets, Inc. and subsidiaries as of December 25, 1993 and December 26, 1992 and the related consolidated statements of income, shareholders' equity, and cash flows for each of the years in the three-year period ended December 25, 1993, as contained in the 1993 annual report to shareholders. These consolidated financial statements and our report thereon are incorporated by reference in the annual report on Form 10-K for the year 1993. In connection with our audits of the aforementioned consolidated financial statements, we also audited the related financial statement schedules as listed at Item 14(a)2. These financial statement schedules are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statement schedules based on our audits. In our opinion, such schedules, when considered in relation to the basic consolidated financial statements taken as a whole, present fairly, in all material respects, the information set forth therein. KPMG PEAT MARWICK Harrisburg, Pennsylvania January 28, 1994 EXHIBIT 13 WEIS MARKETS, INC. Annual Report to Shareholders for the fiscal year ended December 25, 1993. WEIS MARKETS, INC. 1993 ANNUAL REPORT Weis Markets, Inc. Weis Markets, Inc. is a successful supermarket chain with 141 stores located in Pennsylvania, Maryland, New Jersey, New York, Virginia, and West Virginia. Started in 1912 as a cash-and-carry grocery store, Weis became publicly owned in 1965. Its stock is listed on the New York Stock Exchange under the symbol WMK. Over 15,000 employees contribute to the Company's continuing success. Many of the Company's 1,800 private label products are supplied by its own manufacturing and processing plants. Distribution centers located in Milton and Sunbury are served by a Company owned fleet of tractor-trailers. In addition to supermarkets, the Company owns and operates Weis Food Service, a distributor to restaurant and institutional customers. To Our Shareholders We are pleased to report that sales for Weis Markets for the 52-week fiscal year ended December 25, 1993, increased 11.8% to $1,441,090,000 compared with $1,289,195,000 for the same period a year ago. Earnings were $72,953,000 compared to $72,716,000 last year, an increase of .3%. Earnings per share were $1.66 compared with $1.65 per share last year. Depreciation and amortization increased to $28,959,000 from $26,358,000 in 1992 and return on equity was 10.3%. Shareholders' equity rose to $738,115,000 from $680,265,000 in 1992. Sales increases came primarily from new and enlarged stores and Mr. Z's Food Mart stores in Northeastern Pennsylvania, which were acquired at the beginning of the year. Increased competition, weakness in the economy, lower retail prices, low inflation, and increased promotional expense continued to characterize the year 1993 in our trading area. This environment was conducive to increasing the sales of private label merchandise, one of the company's strongest assets. In 1993, we added 562,839 square feet of retail space. Four new super stores were opened in Pennsylvania and New Jersey, averaging about 45,000 square feet with pharmacies, floral departments, bakeries, delis, and salad bars. One of these stores was opened under the Scot's Lo-Cost format, a warehouse-type market. Full-service banks were installed in a number of stores. Thirteen stores were enlarged or remodeled. Retail space now totals 5,142,000 square feet. More than half of all stores are new or have been remodeled in the last five years. At the end of the year, construction was substantially completed on the 184,000 square-foot addition to the Milton Distribution Center. It will house Shamrock Wholesale Distributing Company, a wholly owned organization developed to buy, sell, and distribute nonfoods, health and beauty care, and other products. The addition will also provide new space for distribution of private label bread, snacks, and other grocery items. At the end of the year, Weis Markets had 141 stores in Pennsylvania, Maryland, New Jersey, New York, Virginia, and West Virginia, and Weis Food Service - a restaurant and institutional supplier. Three stores were closed during the year. After the end of the year, the company made an investment in several large pet supply stores in Ohio called SuperPetz. It is anticipated that the number of these stores will grow into a successful chain in many areas of the country. The Company continues to develop improved programs to meet the needs of its customers. We installed a targeted coupon dispensing system at more than two thirds of all checkouts before the end of 1993. The point-of-sale computer- based system dispenses coupons based on customers' purchases and will be installed company wide before the end of this first quarter of 1994. The Company's front-end systems will be enhanced in many stores to allow use of three major credit cards.At our general office, improvements will continue with the installation of a new central computer system. This system is based on newly developed technology which will provide almost triple the processing speed while requiring significantly less maintenance and energy consumption. The upgraded equipment is to be installed in the first quarter of 1994, just in advance of planned improvements in store communication and merchandising information systems. Capital expenditures including acquisitions for 1993 totaled about $64,412,000, compared to the budgeted figures of $55,527,000. We expect to spend about $76,000,000 over the next eighteen months, provided that our program of new and remodeled stores can be completed. Long approval times still make predicting project completion a tentative factor. Two new stores are now under construction. Eight more are in the planning or approval stage and should be completed in the next eighteen months. Over this period of time, about twenty stores should be remodeled or enlarged. Construction is underway on several of these projects. New stores are planned for Pennsylvania, Maryland, and New Jersey. Financing for the new and remodeled stores will come from company funds, and the company will continue to have no debt. Mr. Charles H. Watts II, director for eighteen years, will not be standing for reelection this year. We wish to extend our appreciation for his guidance and counsel as a member of the board during a period of greatcompany growth. With our new and acquired stores, plus our capable and energetic Weis Markets people, our company should have a successful year, growth and profits in 1994. Sigfried Weis President Robert F. Weis Vice President and Treasurer Service and Value Old-Fashioned Quality and Innovative Programs Lead the Way During these uncertain economic times, the last thing anyone should have to worry about is a grocery bill. At Weis Markets, we understand that - after all, we buy groceries, too. That's why we're ahead of the rest in finding new ways to give our loyal customers the service and value they deserve at a price they can afford. Checkout Coupons: Personalized for the Way You Shop No two shoppers are exactly alike. Their tastes, needs, and shopping habits vary as much as their clothing style or the cars they drive. Yet every year, in newspapers, magazines, and even the U.S. mail, they receive thousands of coupons that they will never use. At Weis Markets, we know the value of coupon shopping when the coupons match the products our customers actually buy. That's the theory behind Checkout Coupons, our individualized coupon program. Shoppers simply buy their groceries as usual. As their items are rung up, our computerized registers print out Checkout Coupons right along with their receipt. No hold-ups at the checkout line, no coupons for products our shoppers don't need or want. Just super coupon values designed to meet personal shopping needs. With Weis Markets Checkout Coupons it's easy to stretch a weekly food budget. More than two thirds of our supermarkets offered Checkout Coupons at the close of 1993, and during the first quarter of 1994 this program will be expanded to all stores with checkout scanners. Weis Vision Value Club: Frequent Shopper Points Add Up Many Weis shoppers visit our stores weekly. And with our new Vision Value Club, currently being tested in a limited area, frequent shoppers can earn points for free gifts at no extra charge. . .and no extra effort! Membership in the Vision Value Club isn't exclusive - it's a breeze. After signing up, frequent shoppers simply make their purchases as usual. As items are totaled, points are accumulated and stored electronically on a special computer chip membership card right at the checkout. Shoppers may redeem those points for brand name merchandise through the Vision Value Club gift catalog. And as a bonus, specials like coupons, recipes, sweepstakes, games and more appear automatically on the Vision Screen during checkout, adding further value to frequent shopping. New Store Locations and Acquisitions: Convenience and Competition Wins Hands Down With today's shoppers' busy schedules, even the most innovative and profitable savings programs can't match the value of convenient shopping locations. That's why we at Weis Markets are always looking for ways to expand our service area. In 1993, we acquired fourteen Mr. Z's Markets, bringing the total number of our convenient shopping locations to 141. Mr. Z's Markets are concentrated in the Northeastern Pennsylvania area. Of course, customers will see the same low prices and excellent service they've come to expect at all Weis Markets locations. In addition to acquisitions, we've opened new Weis Markets in Elizabethtown, Pennsylvania and in Newton, New Jersey, the first Weis Markets in New Jersey. A Scot's Lo-Cost Supermarket was opened in Montoursville, Pennsylvania and a new Mr. Z' s in Waverly, Pennsylvania. Our growing customer base is proof that it's quality products and dollar value that count. . .week after week. Business As Usual: Those Little "Extras" Make Shopping a Pleasure No matter which store they visit, our customers know that service and value are just "company policy" at Weis Markets. More than 15,000 employees are hard at work to make shopping a little more pleasant at every convenient location. For example, our informative deli people can help busy shoppers find the perfect prepared food to take home to a hungry family, without sacrificing nutritional value. And with new products being added all the time, they don't have to forego variety either. In the pharmacy, our professional staff is waiting to answer questions regarding medicines and health concerns. Third Party Departments and Weis' own computerized patient profile system make getting prescriptions that much easier. Of course, our butchers are always happy to provide special meat cuts, while our bakery specialists add just the right touches to festive party delicacies. And checking out isn't a hassle, either. Courteous register clerks and baggers end the shopping trip on an upbeat note. At Weis Markets, we know that special deals and exciting programs - though valuable - aren't enough. Getting more for their money on everyday buys is what brings our shoppers back week after week. From well- stocked fresh produce aisles, to a wide variety of succulent meats, to thousands of brand names, our customers find competitive prices on everything they need. More than 1,800 of our own private label products - including "Weis Quality," "Big Top" and "The Way It Was" - line our shelves, ensuring that shoppers don't have to sacrifice top quality for extra value. And Weis Markets' SUPER BUYS add yet another way to save; economical larger sizes, bonus packs and special features mean greater savings on weekly shopping budgets. In the supermarket business, the competition can be keen. And at Weis Markets, we know that creative solutions to meeting our shoppers' needs are crucial to our continued success. But we haven't forgotten that good old-fashioned excellent service and unbeatable quality are what guarantees customer satisfaction. You might just say that's what puts Weis Markets Ahead of the Rest. Management's Discussion and Analysis of Financial Condition and Results of Operations Results of Operations Sales for the 52 - week period ended December 25, 1993 of $1,441,090,000 increased 11.8% over sales of $1,289,195,000 for the 1992 fiscal year. Sales in 1992 had decreased .4% compared with fiscal 1991 sales of $1,294,332,000. The majority of the sales increase in the current year was generated from the 14 IGA stores acquired. Same store sales decreased 1.2 % in 1993. During the last three years, the Company has experienced increased competitive activity in a weak economy with very little price inflation in each of the three years. Management anticipates a slight increase in inflation in 1994 but no decline in competitive activity. Expressed as a percentage of sales, the gross profit at 25.5% in 1993, compares with 25.4% in 1992 and 25.7% in 1991. The Company has maintained its gross margin at a consistent rate over the past three years through its use of category management and the fact that suppliers have shifted traditional promotional funding towards the cost of product. The LIFO inventory adjustment in 1993 resulted in a charge to earnings of $510,000 compared to $2,321,000 in 1992. Operating, general and administrative expenses of 20.0% as a percentage of fiscal 1993 sales compares with 19.5% in 1992 and 18.9% in 1991. The majority of the total dollar increase in 1993 expenses was directly associated with the operation of the new stores acquired at the beginning of the year. Labor and associated fringe benefit costs, as a percentage of sales, increased .28% from 1992 to 1993. Advertising expenditures, net of promotional funding, increased .34% from 1992 to 1993. Interest and dividend income of $21,528,000, at 1.5% of sales in 1993 compared to $23,783,000, at 1.8% of sales in 1992, and $25,935,000, at 2.0% of sales in 1991. Investment income has continued to decline as a result of the decline in market rates over the past three years. The investment portfolio consists of Pennsylvania tax free municipal bonds, U.S. Treasury securities, equity securities and other short-term investments. The Company has made an effort to offset the decline in short term yields by extending its investment maturities. It is management's intent to maintain a liquid portfolio to take advantage of acquisition or other investment opportunities; therefore all securities are classified as available-for-sale. Other income is primarily generated from rental income, coupon handling fees, cardboard salvage and gains on sales of fixed assets. Other income increased $1,421,000 in 1993 compared to 1992 as a result of the acquired stores. Expressed as a percentage of sales, other income at .9% in 1993, compared to .9% in 1992, and .8% in 1991. The effective tax rate was 35.8% in 1993, 35.0% in 1992, and 35.1% in 1991. Corporate federal tax rates increased from 34% to 35% during the current year, having a negative impact of $928,000 to the current year profits. The Company adopted Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes," as of December 29, 1991, which resulted in a cumulative effect adjustment of $1,046,000 in the first quarter of fiscal 1992. During fiscal 1993, the Company opened four new stores, closed three existing stores, remodeled 13 stores, and completed the acquisition of 14 IGA stores located in Northeastern Pennsylvania. The distribution center was enlarged by 184,000 square feet to meet the current and future service demands associated with the store growth. As of its fiscal year end Weis Markets, Inc. was operating 141 retail food stores and Weis Food Service, a restaurant and institutional supplier. The company currently operates stores in Pennsylvania, Maryland, New Jersey, New York, Virginia and West Virginia. Liquidity and Capital Resources The Company has consistently funded its working capital requirements each year through internally generated cash flows from operations. Net cash provided by operating activities was $104,103,000 in 1993, compared to $83,282,000 in 1992 and $98,796,000 in 1991. Working capital has increased by 6.1% in 1993, 5.9% in 1992 and 5.7% in 1991. The increase in working capital in 1993 was impacted by the adoption of the provisions of the Statement of Financial Accounting Standards No. 115, Accounting for Certain Investments in Debt and Equity Securities" (Statement 115). Had Statement 115 not been adopted, working capital would have increased by 2.7% in 1993. The Company continues to use its cash for acquisitions, the construction of new supermarkets, the expansion and remodeling of existing stores, the securing of sites for future expansion, and the upgrading of the processing and distribution facilities. Property, equipment and other acquisition expenditures during fiscal 1993 amounted to $64,412,000 compared to $31,985,000 in 1992 and $40,526,000 in 1991. Treasury Stock purchases amounted to $1,149,000 in 1993, compared to $10,044,000 in 1992, and $14,914,000 in 1991. The Board of Directors' 1991 resolution authorizing the purchase of treasury stock has a remaining balance of 696,000 shares. Total cash dividend payments on common stock amounted to $.70 per share in 1993, compared to $.68 in 1992 and $.64 in 1991. The Company's current store development plans will require investment of approximately $76,000,000 during the next eighteen months. This includes the opening of ten new stores, completion of 20 store remodels, and significant improvements in the area of store and general office technology. The Company is actively seeking acquisitions and investment opportunities so as to enhance future performance. In view of the Company's significant liquid assets, no existing debt financing, and its ability to generate working capital internally, it is not expected that any type of external financing will be needed. Notes to Consolidated Financial Statements (1) Summary of Significant Accounting Policies The following is a summary of the significant accounting policies followed in preparing the Company's consolidated financial statements: (a) Definition of Fiscal Year The Company's fiscal year ends on the last Saturday in December. Fiscal 1993, 1992, and 1991 were each comprised of 52 weeks. (b) Principles of Consolidation The consolidated financial statements include the accounts of the Company and its subsidiaries. (c) Business Segment The principal business activity reflected in the accompanying consolidated financial statements is the retail sale of food. (d) Intangible Assets Intangible assets are generally amortized over periods ranging from 3 to 40 years. A portion of the excess of cost of investments over net assets acquired prior to November 1, 1970, ($2,322,000) is not being amortized because, in the opinion of management, there has been no decrease in value. (e) Inventories Inventories are valued at the lower of cost or market, using both the last-in, first-out (LIFO) and average cost methods. (f) Marketable securities Marketable securities at December 25, 1993, consist of Pennsylvania municipal bonds, U.S. Treasury securities, equity securities, and other short-term investments. The Company adopted the provisions of Statement of Financial Accounting Standards No. 115, "Accounting for Certain Investments in Debt and Equity Securities" (Statement 115) at December 25, 1993. Under Statement 115, the Company classifies all of its marketable securities as available-for- sale. Available-for-sale securities are recorded at fair value. Unrealized holding gains and losses, net of the related tax effect, are excluded from earnings and are reported as a separate component of shareholders' equity until realized. A decline in the market value below cost that is deemed other than temporary results in a charge to earnings and the establishment of a new cost basis for the security. Dividend and interest income are recognized when earned. Realized gains and losses are included in earnings and are derived using the specific identification method for determining the cost of securities. Prior to adopting Statement 115, the Company valued its'securities in accordance with Statement of Financial Accounting Standards No. 12, "Accounting for Certain Marketable Securities" (Statement 12) and related interpretations. Marketable debt securities were carried at amortized cost and marketable equity securities were carried at the lower of cost or market. (g) Property and Equipment Depreciation is provided on the cost of buildings and improvements and equipment principally using accelerated methods. Leasehold improvements are amortized over the terms of the lease or the useful lives of the assets, whichever is shorter. Maintenance and repairs are charged to income and renewals and betterments are capitalized. When assets are retired or otherwise disposed of, the assets and accumulated depreciation are removed from the respective accounts and any profit or loss on the disposition is credited or charged to income. (h) Income Taxes In February 1992, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes" (Statement 109). Statement 109 requires a change from the deferred method of accounting for income taxes of APB Opinion 11 to the asset and liability method of accounting for income taxes. Under the asset and liability method of Statement 109, deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. Under Statement 109, the effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date. Effective December 29, 1991, the Company adopted Statement 109 and has reported the cumulative effect of that change in the method of accounting for income taxes in the 1992 consolidated statement of income. Pursuant to the deferred method under APB Opinion 11, which was applied in 1991 and prior years, deferred income taxes are recognized for income and expense items that are reported in different years for financial reporting purposes and income tax purposes using the tax rate applicable for the year of the calculation. Under the deferred method, deferred taxes are not adjusted for subsequent changes in tax rates. (i) Earnings Per Share The earnings per share computations are based upon the weighted average number of common shares and common share equivilants outstanding during the year. (j) Reclassification Certain amounts in prior-year financial statements have been reclassified to conform with current year classifications. (2) Income Taxes As discussed in note 1, the Company adopted Statement 109 as of December 29, 1991. The cumulative effect of this change in accounting for income taxes of $1,046,000 is determined as of December 29, 1991, and is reported separately in the consolidated statement of income for the year ended December 26, 1992. Prior years' financial statements have not been restated to apply the provisions of Statement 109. The following is a reconciliation between the applicable income tax expense and the amount of income taxes which would have been provided at the Federal statutory rate. The statutory rate was 35% in 1993, 34% in 1992, and 34% in 1991. The tax rate change in 1993 had a negative impact of $928,000 to the current year profits. Cash paid for income taxes was $40,530,000, $43,171,000 and $40,621,000 in 1993, 1992 and 1991, respectively. For the year ended December 28, 1991, deferred income tax expense of $676,000 results from timing differences in the recognition of income and expense for income tax and financial reporting purposes. The sources and tax effects of those timing differences are presented as follows: (3) Inventories Merchandise inventories as of December 25, 1993, and December 26, 1992, were valued as follows: If all inventories were valued on the average cost method, which approximates current cost, total inventories would have been $40,395,000 and $39,885,000 higher than as reported on the above methods as of December 25, 1993, and December 26, 1992, respectively. Although management believes the use of the LIFO method for valuing certain inventories (as set forth above) represents the most appropriate matching of costs and revenues in the Company's circumstances, the following summary of net income and per share amounts based on the use of the average cost method for valuing all inventories is presented for comparative purposes. (4) Property and EquipmentProperty and equipment as of December 25, 1993, and December 26, 1992, consisted of: (5) Marketable SecuritiesAs discussed in note 1, the Company adopted Statement 115 as of December 25, 1993. The impact of this change in accounting principle resulted in an increase in marketable securities of $29,349,000 and an increase in shareholders' equity of $16,740,000, representing the after-tax impact. Marketable Securities as of December 25, 1993, consisted of: Maturities of investment securities classified as available-for- sale at December 25, 1993, were as follows: For the year ended December 26, 1992, marketable debt securities and marketable equity securities were valued in accordance with Statement 12. Marketable debt securities consisted primarily of Pennsylvania municipal bonds and U. S. Treasury securities and had a cost of $408,978,000 at December 26, 1992, and a market value of $419,701,000. Gross unrealized gains amounted to $10,723,000. Also included in marketable securities were marketable equity securities having a cost of $10,337,000 at December 26, 1992, and a market value of $21,780,000. Gross unrealized gains amounted to $11,443,000. Unrealized gross losses and realized gains and losses of the marketable securities portfolios were not significant. (6) Retirement Plans The Company has a noncontributory defined benefit pension plan covering substantially all full-time employees, a noncontributory profit-sharing plan covering eligible employees and a supplemental retirement plan covering certain officers of the company. An eligible employee as defined in the Profit Sharing Plan includes salaried employees, store management and administrative support personnel. The Company's policy is to fund pension and profit-sharing cost accrued, but not supplemental retirement costs. Contri-butions to the defined benefit pension plan are based on guidelines of the Employee Retirement Income Security Act of 1974, whereas contributions to the profit-sharing plan are made at the sole discretion of the Company. The Company's supplemental retirement plan provides for the payment of specific amounts of annual retirement benefits to the officers or to their beneficiaries over an actuarially computed normal life expectancy. The actuarial present value of accumulated benefits amounted to $5,408,000 and $4,782,000 at December 25, 1993, and December 26, 1992, respectively. Plan costs are based upon the deferral of retirement rather than upon future service and all benefits are fully vested. Retirement plan costs amounted to: The net periodic defined benefit pension expense iscomputed as follows: The funded status of the Company's pension plan at September 30, 1993, and September 30, 1992, (the measurement dates) is as follows: (b) Company Appreciation Plan Under a Company Appreciation Plan, officers and other employees are awarded rights equivalent to shares of Company common stock. At the maturity date, usually one year after the date of award, the value of any appreciation from the original date of issue is paid in cash to the participants. During 1993, 1992 and 1991, 17,500, 16,900 and 17,800 rights were awarded under the program. In 1993, 1992 and 1991, $37,000, $11,000 and $35,000, respectively, were charged to earnings. (8) Lease Commitments At December 25, 1993, the Company leased approximately 55% of its facilities under operating leases which expire at various dates up to 2013. These leases generally provide for fixed annual rentals; however, several provide for minimum annual rentals plus contingent rentals as a percentage of annual sales and a number of leases require the Company to pay for all or a portion Of insurance, real estate taxes, water and sewer rentals and repairs, the cost of which is charged to the related expense category rather than being accounted for as rent expense. Most of the leases contain multiple renewal options, under which the Company may extend the lease terms from 5 to 20 years. Rent expense on all leases consists of: The following is a schedule by year of future minimum rental payments required under operating leases that have initial or remaining noncancelable lease terms in excess of one year as of December 25, 1993. (9) Fair Value Information The carrying amounts for cash, trade receivables and trade payables approximate fair value because of the short maturities of these instruments. The fair values of the Company's marketable securities are based on quoted market prices. (10) Acquisitions On December 31, 1992, the Company acquired 14 retail grocery stores from IGA Food Mart, Inc., of Stroudsburg, Pennsylvania. The cash only transaction was made from internally generated funds and was accounted for by the purchase method. Goodwill arising from this transaction, which was not material, is being amortized over a 15 year period on a straight line basis. (11) Summary of Quarterly Results (Unaudited) Quarterly financial data for 1993 and 1992 is as follows: Directors Sigfried Weis Robert F. Weis Norman S. Rich President Vice President and Treasurer Vice President and Secretary Micheal C. Rheam Charles H. Watts, II Peter M. Sacerdote Special Projects Educational and Financial Limited Partner, Coordinator Consultant Goldman Sachs & Co. Officers Sigfried Weis President Alan L. Barrick Walter B. Bruce Robert E. Lutz Vice President Vice President Vice President Engineering and Private Label Grocery Merchandising Robert F. Weis Manufacturing Vice President and Treasurer Stephen J. Bowers Richard L. Kunkle William R. Mills Vice President Vice President Vice President Norman S. Rich Weis Food Service Pharmacy Finance Finance Vice President and Secretary Annual Meeting The annual meeting of the shareholders of the Company will be held at 10 a.m. on Monday, April 4, 1994, at the Corporate offices, 1000 South Second Street, Sunbury, PA 17801. Registrar and Transfer Agent American Stock Transfer & Trust Company 40 Wall Street, 46th Floor New York, NY 10005 Auditors KPMG Peat MarwickCertified Public Accountants 225 Market StreetSuite 300 P.O. Box 1190 Harrisburg, PA 17108-1190 Stock Traded New York Stock Exchange EXHIBIT 22 EXHIBIT 24 Consent of Independent Auditors The Board of Directors Weis Markets, Inc.: We consent to incorporation by reference in the registration statement on Form S-8 of Weis Markets, Inc. of our report dated January 28, 1994, relating to the consolidated balance sheets of Weis Markets, Inc. and subsidiaries as of December 25, 1993 and December 26, 1992 and the related consolidated statements of income, shareholders' equity, and cash flows for each of the years in the three-year period ended December 25, 1993, which report appears in the December 25, 1993 Annual Report to Shareholders on Form 10-K of Weis Markets, Inc. and is incorporated herein by reference. We also consent to incorporation by reference in the registration statement on Form S-8 of Weis Markets, Inc. of our report dated January 28, 1994, relating to the financial statement schedules as listed at Item 14(a) 2 of the Company's December 25, 1993 Annual Report on Form 10-K, which report appears in the Company's December 25, 1993 Annual Report on Form 10-K. KPMG PEAT MARWICK Harrisburg, Pennsylvania March 18, 1994

711513_1993.txt

711513

1993

Item 1. Business General McDonnell Douglas Finance Corporation and its subsidiaries (the "Company") is a wholly-owned subsidiary of McDonnell Douglas Financial Services Corporation ("MDFS"), a wholly-owned subsidiary of McDonnell Douglas Corporation ("MDC"). The Company was incorporated in Delaware in 1968 and originally financed only MDC manufactured commercial jet transport aircraft. While this continues to represent a significant portion of the Company's business, the Company also provides a diversified range of financing including loans, finance leases and operating leases, primarily involving equipment for commercial and industrial customers. At December 31, 1993, the Company had approximately 110 employees. Beginning in 1990, as a result of the lowering of the Company's credit ratings, capital constraints imposed by MDC, the recession and the failure of most of its non-core businesses to achieve a satisfactory return, the Company significantly scaled back its operations and focused its new business efforts almost entirely within its two core business units, commercial aircraft financing and commercial equipment leasing ("CEL"), businesses in which the Company historically has achieved satisfactory returns. For the five years ended 1993, the core businesses earned $262.0 million or 133% of the total net earnings of the Company, excluding the 1989 cumulative effect of change in accounting principle. In 1991, the Company determined to exit each of its non-core businesses as market conditions permitted. The Company now operates in three segments: commercial aircraft financing, CEL and non-core businesses. Non-core businesses represent market segments in which the Company is no longer active. The non-core businesses consist primarily of the remaining assets of three business units: McDonnell Douglas Bank Limited ("MD Bank"), receivable inventory financing ("RIF") and real estate financing ("RE"). Non-core new business volume in 1993 and 1992 represent previous contractual commitments and extensions of maturing transactions. The Company does not intend to seek new contractual commitments in its non-core businesses. The Company is actively managing the remaining non-core business portfolios with a view toward liquidating those portfolios over time. Information on the Company's new business volume and portfolio balances is included in the following tables. New Business Volume Years ended December 31, (Dollars in millions) 1993 1992 1991 1990 1989 Commercial aircraft $ 411.4 $153.2 $100.9 $ 155.4 $ 121.0 financing Commercial equipment 41.5 50.7 91.8 189.1 305.4 leasing Non-core businesses 0.1 2.6 38.6 416.8 536.2 $ 453.0 $206.5 $231.3 $ 761.3 $ 962.6 Portfolio Balances December 31, (Dollars in millions) 1993 1992 1991 1990 1989 Commercial aircraft $ 1,237.5 $1,001.1 $ 907.8 $ 1,048.1 $ 948.1 financing Commercial equipment 422.3 557.4 668.9 965.1 1,001.2 leasing Non-core businesses 173.7 227.9 595.6 1,245.9 1,113.2 $ 1,833.5 $1,786.4 $2,172.3 $ 3,259.2 $ 3,062.5 For financial information about the Company's segments, see Notes to Consolidated Financial Statements included in Item 8. Commercial Aircraft Financing Segment The Company's commercial aircraft financing group, located in Long Beach, California, provides customer financing services to Douglas Aircraft Company, a division of MDC, and finances the acquisition of MDC aircraft by purchasing such aircraft subject to lease to airlines and by providing secured and unsecured notes receivable financing in connection with the acquisition of such aircraft. Beginning in 1986, the Company began providing financing to airlines for aircraft manufactured by manufacturers other than MDC, but a substantial majority of the commercial aircraft portfolio is comprised of aircraft manufactured by MDC. Portfolio balances for the Company's commercial aircraft financing segment are summarized as follows: Commercial Aircraft Portfolio by Product Type December 31, (Dollars in millions) 1993 1992 1991 1990 1989 Aircraft leases: Finance leases Domestic $ 638.8 $601.5 $609.2 $ 798.2 $ 717.4 Foreign 297.3 54.6 70.9 71.5 83.6 Operating leases Domestic 149.8 111.4 81.5 56.9 53.6 Foreign 50.3 39.9 10.9 10.9 - 1,136.2 807.4 772.5 937.5 854.6 Aircraft related notes receivable: Domestic obligors Senior 51.5 88.0 47.1 20.4 25.5 Subordinated - - 14.5 13.5 13.6 Foreign obligors Senior 49.8 105.7 73.7 76.7 54.4 101.3 193.7 135.3 110.6 93.5 $ 1,237.5 1,001.1 $907.8 $1,048.1 $ 948.1 Commercial Aircraft Portfolio by Aircraft Type December 31, (Dollars in millions) 1993 1992 1991 1990 1989 MDC aircraft financing: Finance leases $ 813.1 $ 506.2 $465.6 $ 604.7 $ 592.0 Operating leases 144.2 93.7 30.0 15.6 20.2 Notes receivable 77.7 169.4 107.4 66.6 82.6 1,035.0 769.3 603.0 686.9 694.8 Other commercial aircraft financing: Finance leases 123.0 149.9 214.6 265.0 209.0 Operating leases 55.9 57.6 62.3 52.2 33.4 Notes receivable 23.6 24.3 27.9 44.0 10.9 202.5 231.8 304.8 361.2 253.3 $1,237.5 $ 1,001.1 $907.8 $ 1,048.1 $ 948.1 At December 31, 1993, the Company's commercial aircraft portfolio was comprised of finance leases to 23 customers (18 domestic and five foreign) with a carrying amount of $936.1 million (51.1% of total Company portfolio), notes receivable from eight customers (four domestic and four foreign) with a carrying amount of $101.3 million (5.5% of total Company portfolio) and operating leases to nine customers (seven domestic and two foreign) with a carrying amount of $200.1 million (10.9% of total Company portfolio). The five largest commercial aircraft financing customers accounted for $718.5 million (39.2% of total Company portfolio) and $445.1 million (24.9% of total Company portfolio) at December 31, 1993 and 1992. At December 31, 1993, 56.5% of the Company's total portfolio consisted of financings related to MDC aircraft, compared with 43.1% and 27.8% in 1992 and 1991. - - - Factors Affecting the Commercial Aircraft Financing Portfolio A substantial portion of the Company's aircraft financings are to airlines which either have recently emerged from bankruptcy or are in poor financial health. The Company's two largest commercial aircraft financing customers, Trans World Airlines, Inc. ("TWA") and Continental Airlines, Inc. and its affiliated companies ("Continental"), have recently emerged from bankruptcy. Company financings to TWA accounted for $253.2 million (13.8% of total Company portfolio) and $102.9 million (5.8% of total Company portfolio) at December 31, 1993 and 1992. On November 3, 1993, TWA emerged from Chapter 11 bankruptcy. At December 31, 1993, the Company had commitments to provide additional aircraft-related financing to TWA of $22.9 million. Company financings to Continental accounted for $116.4 million (6.4% of total Company portfolio) and $120.9 million (6.8% of total Company portfolio) at December 31, 1993 and 1992. During periods in 1991 and 1992 when Continental was in bankruptcy, the Company agreed to accept the deferral of certain payments due from Continental which totaled $6.1 million at December 31, 1993. On April 27, 1993, Continental emerged from Chapter 11 bankruptcy. Pursuant to the terms of supplemental guaranties recently executed by MDC in favor of the Company, up to an additional $25.0 million of the Company's financings to TWA and up to an additional $15.0 million of the Company's financings to Continental are guaranteed by MDC. These guaranties supplement individual guaranties provided by MDC with respect to certain of the Company's financings to TWA and Continental to the extent that the estimated fair market value of the financings (after applying the individual guaranties) is less than the net asset value of the financings on the Company's books. The supplemental guaranties terminate in March 1996, but may be extended under certain circumstances. In June 1991, America West Airlines, Inc. ("America West") filed for protection under Chapter 11 of the Federal Bankruptcy Code. The Company participated in the financing of six aircraft which were returned by America West in December 1992. Five of the aircraft are on lease to a new customer and the sixth will be sold, subject to partial financing, in early 1994. During 1993, the Company and America West entered into an agreement whereby the Company settled its bankruptcy claims against America West in exchange for America West airline passenger tickets. The Company continues to market these tickets. As part of a reorganization plan, on November 30, 1992, PWA Corporation ("PWA") ceased making payments to all of its creditors. Time Air, Inc. ("Time Air"), a subsidiary of PWA, became delinquent in December 1992 under its financing of a commuter aircraft which as of December 31, 1993, had a net carrying value of $5.7 million. The Company has agreed to a deferral of certain payments with Time Air, which agreement was amended in February 1994 to lengthen the deferral. The Company has not suffered a material adverse effect upon its financial condition as a result of the above-mentioned bankruptcies. In addition, the Company historically has not been materially adversely affected by bankruptcies involving its commercial aircraft customers because of the collateral value of the aircraft and, to a lesser extent, MDC guaranties obtained in connection with certain of the financings. However, should one or more of the Company's major airline customers encounter financial difficulties and liquidate its fleet, the large number of aircraft which would be added to the already saturated market would make it difficult for the Company to realize the carrying value of the aircraft leased to such airline(s). In March 1994, the Company reached an agreement in principle with an airline leasing an aircraft with a December 31, 1993 carrying amount of $23.0 million who had become delinquent on its lease payments. Pursuant to the agreement in principle , the term of the lease was extended and the payment schedule was adjusted. - - - Current Commercial Aircraft Market Conditions The current severe economic downturn within the airline industry has diminished significantly the demand for new and used aircraft, with some airlines defaulting on contracts for firm orders or postponing orders with the manufacturer while also disposing of or grounding a portion of their fleets. This has resulted in an oversupply of aircraft in the market, which has materially adversely affected the values of the Company's aircraft. It is not clear whether this decline in aircraft values will continue. Despite the erosion of aircraft values, the Company believes that the value of realizable sales prices at the end of the lease terms for substantially all the aircraft the Company has leased exceeds the book value projected at the end of the lease terms. If aircraft values remain depressed or continue to decline and the Company is required as a result of customer defaults to repossess a substantial number of aircraft prior to the expiration of the related lease or financing, the Company could incur substantial losses in remarketing the aircraft, which could have a material adverse effect on the financial condition of the Company. In this regard, the Company's financial performance is dependent in part upon general economic conditions which may affect the profitability of commercial airlines. During 1993, the Company held for sale or lease 17 aircraft and successfully remarketed 11 aircraft, reducing its inventory of aircraft to six at December 31, 1993, with a carrying value of $26.3 million. At December 31, 1993, five of the six aircraft in inventory were the subject of lease commitments with TWA and will be delivered during 1994. The remaining aircraft will be sold to TWA, on a partially financed basis, in early 1994. - - - Aircraft Leasing The Company normally purchases commercial aircraft for lease to airlines only when such aircraft are subject to a signed lease contract. At December 31, 1993, the Company owned or participated in the ownership of 109 leased commercial aircraft, including 56 jet transports manufactured by MDC. - - - Factors Affecting Aircraft Financing Volume As in the past, the Company anticipates continued fluctuations in the volume of its aircraft financing transactions. Current market conditions may limit many airlines' ability to access financing and present more opportunities to the Company. The Company's decision to exit its non-core businesses and the increased need of certain of MDC's commercial aircraft customers for financing resulted in the Company financing a substantial amount of aircraft manufactured by MDC in 1993. The Company had commitments to provide aircraft related financing of $38.5 million at December 31, 1993 and $1.8 million at December 31, 1992. (See "Competition and Economic Factors.") The following lists information on new business volume for the Company's commercial aircraft financing segment: Years ended December 31, (Dollars in millions) 1993 1992 1991 1990 1989 MDC aircraft financing volume: Finance leases $ 357.3 $ 95.0 $ 19.2 $ 29.7 $ 37.3 Operating leases 33.8 53.5 30.0 - - Notes receivable 19.1 4.7 21.5 - - 410.2 153.2 70.7 29.7 37.3 Other commercial aircraft financing volume: Finance leases - - 23.9 69.3 67.9 Operating leases 0.7 - 6.3 21.0 13.8 Notes receivable 0.5 - - 35.4 2.0 1.2 - 30.2 125.7 83.7 $ 411.4 $ 153.2 $ 100.9 $ 155.4 $ 121.0 - - - Aircraft Financing Guaranties At December 31, 1993, the Company had $318.2 million of guaranties with respect to its commercial aircraft financing portfolio relating to transactions with a carrying value of $1,237.5 million (25.7% of the commercial aircraft financing portfolio). The following table summarizes such guaranties: (Dollars in millions) Domestic Foreign Total Amounts guaranteed by: MDC $127.2 $134.4 $261.6 Foreign governments - 14.5 14.5 Other 28.3 13.8 42.1 Total guaranties $155.5 $162.7 $318.2 The Company has no reason to believe that any such guaranteed amounts will be ultimately unenforceable or uncollectible. See "Relationship With MDC." Commercial Equipment Leasing Segment CEL provides single-investor, tax-oriented lease financing as its primary product. CEL, which maintains its principal operation in Long Beach, California and has marketing offices in Chicago, Illinois and Detroit, Michigan, obtains its business primarily through direct solicitation by its marketing personnel. CEL specializes in leasing equipment such as over-the- road transportation equipment, executive aircraft, machine tools, shipping containers, printing equipment, textile manufacturing equipment and other types of equipment which it believes will maintain strong collateral and residual values. The lease term is generally between three and ten years and transaction sizes usually range between $2.0 million and $10.0 million. In addition to financing transactions for the Company, CEL arranges third party financings of equipment. Portfolio balances for the Company's CEL segment are summarized as follows: December 31, (Dollars in millions) 1993 1992 1991 1990 1989 Finance leases $ 235.2 $325.9 $ 425.9 $ 655.8 $ 705.4 Operating leases 157.5 179.9 198.7 244.8 222.3 Notes receivable 28.8 50.7 41.5 59.4 64.0 Preferred and preference 0.8 0.9 2.8 5.1 9.5 stock $ 422.3 $557.4 $ 668.9 $ 965.1 $ 1,001.2 - - - Factors Affecting CEL Volume The Company's recent CEL volume has been affected by limitations on the availability of capital to commit to new transactions and higher cost of capital. In addition, there has been an increased need of certain of MDC's commercial aircraft customers for financing, resulting in the Company devoting a higher percentage of its available capital to MDC aircraft financing. Based on the Company's current increased availability to lower cost funds, CEL's new business volume in 1994 is expected to exceed its 1993 volume. At December 31, 1993 and 1992, the Company had commitments to provide CEL leasing and financing of $4.6 million and $20.7 million. The following lists information on new business volume for the Company's CEL segment: Years ended December 31, (Dollars in millions) 1993 1992 1991 1990 1989 Finance leases $ 15.3 $ 24.9 $ 55.6 $ 109.4 $ 143.6 Operating leases 22.9 18.2 30.3 73.2 98.3 Notes receivable 3.3 7.6 5.9 6.5 63.5 $ 41.5 $ 50.7 $ 91.8 $ 189.1 $ 305.4 Non-Core Businesses Segment Since 1990, the Company has significantly scaled back its operations and is focusing its new business efforts within its two core businesses, commercial aircraft financing and CEL. The non-core businesses consist primarily of the following three business units: - - - McDonnell Douglas Bank Limited While MD Bank is an indirect wholly-owned subsidiary of MDC, through intercompany arrangements between MDC and the Company, MD Bank is treated as a wholly-owned subsidiary of the Company. MD Bank, located in the United Kingdom, has not written any new business since 1991 and in 1993, surrendered its banking license and returned deposits. The remaining portfolio of MD Bank is being run off and disposed of as conditions permit. - - - Receivable Inventory Financing RIF finances dealers of rent-to-own products such as home appliances, electronics and furniture through note arrangements secured by the products and the rental amounts to be collected. RIF ceased pursuing new business during 1991, but continues to service and finance its existing customers. - - - Real Estate Financing RE previously specialized in fixed-rate, medium-term loans secured by a first deed-of-trust or mortgage on commercial real estate properties such as office buildings and small shopping centers. RE ceased originating new transactions in 1990 but continues to manage its current portfolio. On September 28, 1993, the Company sold, at estimated fair value, six real estate owned properties to McDonnell Douglas Realty Company, a wholly-owned subsidiary of MDC, and financed the sale by taking a $28.9 million note. The Company recorded a pretax loss of $5.7 million (after applying reserves) on the transfer, which is reflected in other expenses in the consolidated statement of income. The note is payable on demand and accrues interest at a rate equal to the average borrowing cost of MDFS. At December 31, 1993, the largest concentration of the Company's real estate assets was in the Western region of the U.S., representing $70.3 million or 54.6% of the Company's real estate holdings. At December 31, 1993, the Company had $33.9 million or 26.3% of its real estate holdings in Southern California, where values continue to remain depressed. Office buildings, which represent the largest Southern California real estate holding, totaled $41.8 million at December 31, 1993. At December 31, 1993 and 1992, real estate owned through foreclosure totaled $12.9 million and $55.2 million. Portfolio balances for the Company's non-core businesses segment are summarized as follows: December 31, (Dollars in millions) 1993 1992 1991 1990 1989 Finance leases $ 2.2 $ 11.8 $ 174.1 $ 587.2 $ 464.8 Operating leases 0.6 1.7 121.1 181.6 192.7 Notes receivable 170.9 214.4 300.4 477.1 455.7 $ 173.7 $ 227.9 $ 595.6 $ 1,245.9 $ 1,113.2 Business units comprising the Company's non-core businesses segment portfolio are summarized as follows: (Dollars in millions) December 31, Business Unit 1993 1992 1991 1990 1989 Real estate financing $ 115.8 $ 136.9 $ 181.9 $ 213.9 $ 264.0 Receivable inventory 31.0 43.5 52.8 55.8 40.0 financing McDonnell Douglas Bank 20.7 36.0 216.3 354.9 205.0 Limited Marketable debt securities 3.3 7.4 24.2 130.6 120.6 Business credit group 2.2 2.6 2.9 100.9 65.2 McDonnell Douglas Capital Corporation 0.7 1.5 44.9 66.1 85.9 McDonnell Douglas Auto Leasing Corporation - - - 210.1 211.1 McDonnell Douglas Truck - - 72.6 113.6 121.4 Services Inc. $ 173.7 $ 227.9 $ 595.6 $ 1,245.9 $ 1,113.2 - - - Factors Affecting Non-Core Business Volume As a result of the Company's decision to exit its non-core businesses, there has been almost no new business volume since 1991. Non-core new business volume in 1993 and 1992 represent previous contractual commitments and extensions of maturing transactions. The Company does not intend to seek new contractual commitments in its non-core businesses. The Company is actively managing the remaining non-core business portfolios with a view toward liquidating those portfolios over time. At December 31, 1993 and 1992, unused credit lines available to RIF customers totaled $6.6 million and $14.3 million. The Company had no commitments to provide non-core business financing at December 31, 1993 and had commitments of $0.6 million at December 31, 1992. The following lists information on new business volume for the Company's non-core businesses: Years ended December 31, (Dollars in millions) 1993 1992 1991 1990 1989 Finance leases $ - $ - $ 12.8 $ 240.7 $ 331.0 Operating leases - 0.8 5.5 39.7 95.6 Notes receivable 0.1 1.8 20.1 136.4 109.6 $ 0.1 $ 2.6 $ 38.6 $ 416.8 $ 536.2 Non-U.S. Financing A portion of the Company's business, primarily in the commercial aircraft financing segment, is conducted with non-U.S. companies. In evaluating non- U.S. transactions, the Company must take into account certain additional risks not encountered in U.S. transactions. For example, payment obligations of non-U.S. obligors from time to time may be subject to foreign exchange restrictions of their respective countries. Additionally, equipment financing is subject to potential risks related to taxation, national policies, political and economic instability, limitations on legal remedies, and currency fluctuations. The Company has not experienced any material problems related to such risks, but no assurances can be given that such factors will not adversely affect the Company in the future. (See "Competition and Economic Factors" and Notes to Consolidated Financial Statements included in Item 8.) Cross-Border Outstandings The extension of credit to borrowers located outside of the U.S. is called "cross-border" credit. In addition to the credit risk associated with any borrower, these particular credits are also subject to "country risk" - economic and political risk factors specific to the country of the borrower which may make the borrower unable or unwilling to pay principal and interest according to contractual terms. Other risks associated with these credits include the possibility of insufficient foreign exchange and restrictions on its availability. To minimize country risk, the Company monitors its foreign credits in each country with specific consideration given to maturity, currency, industry and geographic concentration of the credits. The Company has minimal local currency outstandings to the individual countries listed in the following table that are not hedged or are not funded by local currency borrowings. The countries in which the Company's cross border outstandings exceeded 1% of consolidated assets consist of the following at December 31: (Dollars in millions) December 31, Country Finance Notes Operating 1993 Leases Receivable Leases Guaranties Total Indonesia $154.8 $ - $ - $ - $154.8 Mexico 23.0 - 23.6 - 46.6 United Kingdom 14.3 23.0 - - 37.3 $192.1 $ 23.0 $ 23.6 $ - $238.7 Canada $ 12.7 $ 5.7 $ 0.3 $ 3.5 $ 22.2 Mexico 24.3 - 26.5 - 50.8 United Kingdom 23.9 42.7 0.4 - 67.0 $ 60.9 $ 48.4 $ 27.2 $ 3.5 $ 140.0 Mexico $ 39.9 $ 4.0 $ - $ - 43.9 United Kingdom 184.4 34.8 10.0 - 229.2 $ 224.3 $ 38.8 $ 10.0 $ - $ 273.1 As of December 31, 1993, the Company had equipment in the Netherlands under an operating lease agreement with a net carrying amount of $18.0 million, representing outstandings between 0.75% and 1% of the Company's total assets. As of December 31, 1992 and 1991, there were no countries whose outstandings were between 0.75% and 1% of the Company's total assets. Maturities and Sensitivity to Interest Rate Changes The following table shows the maturity distribution and sensitivity to changes in interest rates of the Company's domestic and foreign financing receivables at December 31, 1993: (Dollars in millions) Maturity Distribution Domestic Foreign Total 1994 $ 259.1 $ 64.0 $ 323.1 1995 203.3 40.3 243.6 1996 166.0 37.7 203.7 1997 137.7 34.7 172.4 1998 131.8 37.2 169.0 1999 and thereafter 547.7 308.5 856.2 $ 1,445.6 $ 522.4 $ 1,968.0 Financing Receivables Due 1995 and Thereafter Fixed interest rates $ 1,127.6 $ 269.0 $ 1,396.6 Variable interest rates 57.7 189.4 247.1 $ 1,185.3 $ 458.4 $ 1,643.7 Allowance for Losses on Financing Receivables and Credit Loss Experience Analysis of Allowance for Losses on Financing Receivables December 31, (Dollars in millions) 1993 1992 1991 1990 1989 Allowance for losses on financing $ 37.4 $ 46.7 $ 61.6 $ 46.9 $ 44.1 receivables at beginning of year Provision for losses 8.6 19.1 47.2 57.3 13.2 Write-offs, net of (10.4) (27.4) (56.7) (44.1) (11.4) recoveries Other - (1.0) (5.4) 1.5 1.0 Allowance for losses on financing receivables at $ 35.6 $ 37.4 $ 46.7 $ 61.6 $ 46.9 end of year Allowance as percent of 1.9% 2.1% 2.2% 1.9% 1.5% total portfolio Net write-offs as percent of average portfolio 0.6% 1.4% 2.0% 1.4% 0.4% More than 90 days delinquent: Amount of delinquent $ 3.7 $ 4.6 $ 19.0 $ 5.2 $ 6.5 instalments Total receivables due from delinquent obligors $ 108.4 $ 10.5 $ 42.8 $ 42.1 $ 52.8 Total receivables due from delinquent obligors as a percentage of total 5.9% 0.6% 2.0% 1.3% 1.7% portfolio The 1993 increase of total receivables from delinquent obligors is primarily attributable to rent not paid by a single airline customer who has agreed to repay the past due rents in 1994. The portfolio at December 31, 1993 includes 13 CEL obligors, two airline obligors and four non-core obligors to which payment extensions have been granted. At December 31, 1993, payments so extended amounted to $14.8 million ($5.4 million airline-related), and the aggregate carrying amount of the related receivables was $167.8 million ($122.2 million airline-related). Receivable Write-offs, Net of Recoveries by Business Unit The following table summarizes the loss experience for each of the business units: Years ended % of Respective December 31, Average Portfolio (Dollars in millions) 1993 1992 1993 1992 Commercial aircraft financing $ (1.5) $ 6.6 (0.15)% 0.68% Commercial equipment leasing 3.9 5.3 0.80 0.89 Core businesses 2.4 11.9 Non-Core Businesses: Real estate financing 6.4 7.7 5.15 4.67 Receivable inventory financing - 3.2 - 6.77 Marketable debt securities 0.8 1.2 12.75 6.77 McDonnell Douglas Bank Limited 0.3 2.8 1.26 1.81 McDonnell Douglas Truck Services - 0.5 - 2.88 Inc. McDonnell Douglas Capital 0.1 0.1 5.53 0.47 Corporation Business credit group 0.4 - 20.90 - 8.0 15.5 $ 10.4 $ 27.4 In its analysis of the allowance for losses on financing receivables, the Company has taken into consideration the current economic and market conditions and provided $8.6 million and $19.1 million in 1993 and 1992 for losses. The Company believes that the allowance for losses on financing receivables is adequate at December 31, 1993 to cover potential losses in the Company's total portfolio. If, however, certain major customers defaulted and the Company were forced to take possession of and dispose of significant amounts of real estate, aircraft or equipment, losses in excess of the allowance could be incurred, which would be charged directly against earnings. The Company's receivable write-offs, net of recoveries, have decreased in 1993 as compared to 1992. The decrease is largely due to the substantial liquidation during 1992 and 1991 of the asset portfolios in the non-core businesses segment. - - - The commercial aircraft financing segment experienced recoveries of $1.5 million and write-offs of $6.6 million in 1993 and 1992 related to aircraft returned by America West. - - - The asset portfolios in the non-core businesses segment have declined from $1,245.9 million at December 31, 1990 to $173.7 million at December 31, 1993 and, therefore, net write-offs also have declined. Nonaccrual and Past Due Financing Receivables Financing receivables accounted for on a nonaccrual basis consisted of the following at December 31: (Dollars in millions) 1993 1992 Domestic $ 17.1 $ 25.0 Foreign 23.7 0.9 $ 40.8 $ 25.9 Financing receivables being accrued which are contractually past due 90 days or more as to principal and interest payments consisted of domestic financings of $76.6 million and $2.7 million at December 31, 1993 and 1992. Borrowing Operations The following table sets forth the average debt of the Company by borrowing classification: (Dollars in millions) Average Average Years ended Short-Term Long-Term Average December 31, Debt Debt Total Debt 1993 $ 113.0 1,153.7$ $1,266.7 1992 118.2 1,513.1 1,631.3 1991 341.1 1,750.4 2,091.5 1990 393.2 1,888.0 2,281.2 1989 263.6 1,656.3 1,919.9 The weighted average interest rates on all outstanding indebtedness computed for the relevant period were as follows: Weighted Average Weighted Average Weighted Average Years ended Short-Term Long-Term Total Debt December 31, Interest Rate Interest Rate Interest Rate 1993 5.97% 9.53% 9.19% 1992 12.38 8.75 9.00 1991 10.28 9.73 9.82 1990 10.86 9.62 9.83 1989 10.56 9.85 9.95 (See Schedule IX - "Short Term Borrowings" and Notes to Consolidated Financial Statements included in Item 8.) In February 1993, Moody's Investor Service ("Moody's") announced the downgrade of MDC's debt credit ratings. Concurrent with this downgrade of the parent, Moody's reduced the Company's senior debt, subordinated debt and commercial paper to Ba1, Ba3 and Not Prime, respectively. In March 1994, Moody's announced the upgrade to Baa3, Ba2 and P3 for MDC's and the Company's senior debt, subordinated debt and commercial paper credit ratings. In June 1993, Duff and Phelps, Inc. rated the Company's senior and subordinated debt as BBB and BBB-, and Standard and Poor's Corporation affirmed the Company's senior and subordinated debt ratings of BBB and BBB-. A security rating is not a recommendation to buy, sell or hold securities. In addition, a security rating is subject to revision or withdrawal at any time by the assigning rating organization and each rating should be evaluated independently of any other rating. Competition and Economic Factors The Company is subject to competition from other financial institutions, including commercial banks, finance companies and leasing companies, some of which are larger than the Company and have greater financial resources, greater leverage ability and lower effective borrowing costs. These factors permit many competitors to provide financing at lower rates than the Company. In its commercial equipment leasing and commercial aircraft financing segments, the ability of the Company to compete in the marketplace is principally based on rates which the Company charges its customers, which rates are related to the Company's access to and cost of funds and to the ability of the Company to utilize tax benefits attendant to leasing. (See "Relationship With MDC.") Competitive factors also include, among other things, the Company's ability to be flexible in its financing arrangements with new and existing customers. The Company has in the past obtained a significant portion of its leasing business and notes receivable in connection with the lease or sale of MDC aircraft. The Company's relationship with MDC has in many cases presented opportunities for such business and has caused MDC to offer to the Company substantially all of the notes receivable taken by MDC upon the sale of its aircraft. (See "Relationship With MDC".) In past years many customers have obtained their financing for MDC aircraft through sources other than the Company or MDC, reflecting a broader range of competitive financing alternatives available to MDC customers. However, the worldwide downturn in the airline business, together with the general tightening of credit has presented and may continue to present increased opportunities for aircraft financing business for the Company. The Company's ability to take advantage of these opportunities depends in substantial part on its ability to obtain the necessary capital. The consolidation in the U.S. airline industry as a result of bankruptcies and mergers has resulted in an increase in the concentration of the Company's MDC aircraft financings in a smaller number of larger airlines at the same time that the Company's decision to exit its non- core businesses has resulted in a greater concentration of the Company's portfolio in commercial aircraft financing. With a larger portion of the portfolio concentrated in MDC aircraft financings, the risk to the Company resulting from the declining creditworthiness of many airlines has increased. (See "Commercial Aircraft Financing Segment" and "Analysis of Allowance for Losses on Financing Receivables and Credit Loss Experience.") Aircraft owned or financed by the Company may become significantly less valuable because of the introduction of new aircraft models, which may be more economical to operate, the aging of particular aircraft, technological obsolescence such as that caused by legislation for noise abatement which will over time prohibit the use of older, noisier (Stage 2) aircraft in the U.S., or an oversupply of aircraft for sale (such as presently exists). In any such event, carrying amounts on the Company's books may be reduced if, in the judgment of management, such carrying amounts are greater than market value, which would result in recognition of a loss to the Company. At December 31, 1993, the Company's carrying amount of Stage 2 aircraft totaled $68.4 million (5.4% of the Company's total aircraft portfolio, including held for sale or re-lease), which includes $26.3 million of aircraft held for sale or re-lease. Although the Company is particularly subject to risks attendant to the airline and aircraft manufacturing industries, the ability of the Company to generate new business also is dependent upon, among other factors, the capital equipment requirements of U.S. businesses and the availability of capital. Relationship With MDC MDC is principally engaged in the design, development and production of defense and commercial aerospace products. For the year ended December 31, 1993, MDC recorded revenues of $14.5 billion and net earnings of $396.0 million. At December 31, 1993, MDC had assets of $12.0 billion and shareholders' equity of $3.4 billion. One of the five directors of the Company is a director of MDC and four of the Company's directors are officers of MDC. The financial well-being of MDC is vital to the Company's ability to enter into significant amounts of new business in the future. Primarily as a result of certain downgrades in the credit ratings of MDC in 1991 and in early 1993, the Company's credit ratings were downgraded at the same time. Beginning in the early 1990's and continuing through mid-1993, the Company's access to new capital was severely limited due to a lowering of the Company's credit ratings, the recession and constraints imposed by MDC. However, as 1993 progressed, all of these factors had a much smaller impact on the Company and consequently, the Company's access to new capital improved. Approximately 25% of the receivables from the Company's total aircraft portfolio are supported by guaranties from MDC. In the event a substantial portion of the guaranties become payable and in the unlikely event that MDC is unable to honor its obligations under these guaranties, such event could have a material adverse effect on the financial condition of the Company. In addition, MDC participates as an intermediary in financings to a small number of the Company's commercial aircraft customers and largely as a result thereof, MDC is the fourth largest commercial aircraft financing customer of the Company. Two of the principal industry segments in which MDC operates, military aircraft and commercial aircraft, are especially competitive and have a limited number of customers. As the Company focuses on its core businesses, and primarily aircraft financing, its future business prospects become more closely tied to the success of MDC, and especially the ability of MDC's commercial aircraft business to generate additional sales. The commercial aircraft business is market sensitive, which causes disruptions in production and procurement and attendant costs, and requires large investments to develop new derivatives of existing aircraft or new aircraft. The depressed conditions in the airline industry have resulted and may continue to result in airlines not taking deliveries of commercial transport aircraft, defaulting on contracts for firm orders, requests for changes in delivery schedules of existing orders, not exercising options or reserves and a dramatic decline in new orders. MDC expects the weakness of the commercial aircraft market to continue during 1994 and MDC does not expect a strong industry-wide resumption in orders for new aircraft until 1995, at the earliest. MDC's market share of firm order backlog for new commercial aircraft has declined significantly in the past several years and operating revenues for MDC's commercial aircraft segment decreased 28% in 1993. MDC also has made guaranties to non-affiliate third parties in connection with the marketing of commercial aircraft. MDC does not anticipate that the existence of such guaranties will have a material adverse effect upon its financial condition. In addition, some existing commercial aircraft contracts contain provisions requiring MDC to repurchase used aircraft at the option of the commercial customers. In view of the current market conditions for used aircraft, MDC's earnings and cash flows could be adversely impacted by the exercise of such options. However, it is not anticipated that the existence of such repurchase obligations will have a material adverse effect on MDC's cash flow or financial position. The trend of reduced commercial aircraft orders and reduced defense spending has resulted in a significant downsizing of MDC over the last several years. MDC's most significant customer in its military aircraft and missiles, space, and electronic systems segments is the U.S. Government. In addition to the risks found in any business, companies engaged in supplying military and space equipment to the U.S. Government are subject to a number of other risks, including dependence on Congressional appropriations and annual administrative allotment of funds, general reductions in the U.S. defense budget, and changes in Government policies. Defense spending by the U.S. Government has declined and is likely to continue to decline. Further significant reductions in defense spending and a decision made by the U.S. Government to emphasize weapons research over production may have a material impact on MDC. The loss of a major program or a major reduction or stretch-out in one or more programs could have a material adverse impact on MDC's future revenues, earnings and cash flow. MDC also incurs risk if it enters into firm fixed-price contracts with the U.S. Government pursuant to which work is performed and paid for at a fixed amount without adjustment for actual costs experienced in connection with the contract. While this arrangement offers MDC opportunities for increased profits if costs are lower than expected, risk of loss due to increased cost is also borne by MDC. MDC, as a large defense contractor, is subject to many audits, reviews and investigations by the U.S. Government of its negotiation and performance of, accounting for, and general practices relating to U.S. Government contracts. An indictment of a contractor may result in suspension from eligibility for award of any new government contract, and a guilty plea or conviction may result in debarment from eligibility for awards. The U.S. Government may, in certain cases, also terminate existing contracts, recover damages, and impose other sanctions and penalties. Contracts may be terminated by the U.S. Government either for default, if the contractor materially breaches the contract, or "for the convenience" of the Government. Under contracts terminated for the convenience of the Government, a contractor is generally entitled to receive payments for its contract cost and the proportionate share of its fee or earnings for work done, subject to availability of funding. One of MDC's largest programs for the U.S. Government is the C-17 Globemaster III. The C-17 program is completing development and moving into full production. However, MDC has incurred significant C-17 related losses as a result of its cost estimate at completion exceeding the fixed-price ceiling set for development and initial production. In addition, as of December 31, 1993, the U.S.Air Force had withheld approximately $312 million from MDC's progress payment requests principally as a result of the higher cost estimates and the reclassification of certain costs. In May 1993, a Defense Acquisition Board initiated by the Under Secretary of Defense for Acquisition began a review of the C-17 program in an effort to resolve outstanding issues and to make recommendations regarding the C-17's future. In connection with the review, MDC provided data and participated in numerous discussions. In January 1994, MDC and the Department of Defense agreed to a business settlement of a variety of issues concerning the C-17. MDC and the U.S. Air Force will be developing plans and contractual modifications and agreements to implement the business settlement, which is subject to Congressional authorization and appropriations. This process is expected to be completed during 1994. The settlement covered issues open as of the date of the settlement, including the allocation of sustaining engineering costs to the development and production contracts, the sharing of flight test costs over a previous level, and the resolution of claims and of performance/specification issues. The settlement also stipulated that MDC will expend additional funds in an effort to achieve product and systems improvements. MDC estimated the financial impact of the settlement in conjunction with a review of the estimated remaining costs on the C-17 development and initial production contracts. As a result, MDC recorded a loss provision of $450 million (excluding general and administrative and other period expenses) in the fourth quarter of 1993. On June 7, 1991, the U.S. Navy notified MDC and General Dynamics Corporation ("GD") that it was terminating for default the contract for development and initial production of the A-12 aircraft. The Navy has agreed to continue to defer repayment of $1.335 billion alleged to be due, with interest, from MDC and GD as a result of the termination for default of the A-12 program. The agreement provides that it will remain in force until the dispute as to the type of termination is resolved by pending litigation in the U.S. Court of Federal Claims or negotiated settlement, subject to review by the U.S. Government annually on December 1, to determine if there has been a substantial change in the financial condition of either MDC or GD such that deferment is no longer in the best interest of the Government. The Government, which extended the December 1, 1993 review beyond the time to which MDC and GD agreed, has not advised the contractors of the results of that review. However, the United States Court of Federal Claims has issued an order deferring rulings on the merits of the A-12 termination case until July 21, 1994. The court's order is based upon an undertaking by the Government that it would not seek to terminate the A-12 deferment agreement between MDC, GD and the Navy in the interim. MDC firmly believes it is entitled to continuation of the deferment agreement in accordance with its terms. However, if the agreement is not continued, MDC intends to contest collection efforts. If payment of the deferred amounts were required, such payment would have a material adverse effect on MDC's cash flows. Although MDC has established a provision of $350 million for loss on the contract, if, contrary to MDC's belief, the termination of the contract is not determined to be for the convenience of the U.S. Government, it is estimated that an additional loss would be incurred which could amount to approximately $1.2 billion. Also, a 1991 Securities and Exchange Commission investigation looking into whether MDC violated certain federal securities laws in connection with disclosures about, and accounting for, the A-12 aircraft has been broadened to include the C-17 and possibly other programs. For a further description of these and other factors which may affect MDC's financial condition, see MDC's Form 10-K for the year ended December 31, 1993 (Securities and Exchange Commission file number 1-3685.) - - - Operating Agreement The relationship between the Company and MDC is governed by an operating agreement (the "Operating Agreement"), which formalizes certain aspects of the relationship between the companies, principally those relating to the purchase and sale of MDC aircraft receivables, the leasing of MDC aircraft, the resale of MDC aircraft returned to, or repossessed by, the Company under leases or secured notes, and the allocation of federal income taxes between the companies. Under the Operating Agreement, MDC is required to offer to the Company all promissory notes, conditional sales contracts and certain other receivables obtained by MDC in connection with the sale of its commercial transport aircraft, except for any receivable that MDC acquires in a transaction which, in its opinion, involves unusual or exceptional circumstances or which it acquires with the expressed intention of selling to a purchaser other than the Company. The Company is obligated under the Operating Agreement to purchase all aircraft receivables offered to it, unless (a) it is unable or deems it inappropriate to obtain or allocate funds for the acquisition, (b) the receivables do not meet the Company's customary standards as to terms and conditions or creditworthiness, or (c) the amount of the receivable offered, when added to the amount of receivables of the same obligor then held by the Company, would exceed the amount that the Company deems prudent to hold. The prices to be paid for notes receivable purchased from MDC are intended to produce reasonable returns to the Company, taking into account the rates of return realized by independent finance companies, the Company's assessment of the credit risk and the Company's projected borrowing costs and expenses. In cases where credit risks associated with a note receivable are not acceptable to the Company, the Company will refuse to accept the note receivable or will condition its acceptance upon receipt of a guaranty from MDC with a negotiated fee to be paid by the Company for the guaranty. (See "Commercial Aircraft Financing Segment - Aircraft Financing Guaranties.") With respect to aircraft leasing activities, unlike the purchase of other aircraft receivables which are acquired by MDC and sold to the Company, the Company may make lease proposals directly to the prospective customers. If a lease proposal is accepted, the Company enters into a lease with the customer and purchases the aircraft from MDC on the terms negotiated between MDC and the customer. Under the Operating Agreement the Company may make a lease proposal to any customer desiring to lease an aircraft for two years or more, but the Company may decline to make a proposal or may condition its proposal upon a full or partial guaranty from MDC, with a negotiated fee to be paid by the Company for the guaranty. The Company has the option under the Operating Agreement to tender to MDC any MDC aircraft returned to or repossessed by the Company under a lease or security instrument at a price equal to the fair market value of the aircraft less 10%. This provision does not include MDC aircraft leased under a partnership arrangement in which the Company is one of the partners, or MDC aircraft subject to third party liens or other security interests, unless the Company and MDC determine that purchase by MDC is desirable. At December 31, 1993, the carrying amount of MDC aircraft and MDC aircraft held for sale or lease excluded by this provision amounts to approximately $127.4 million and $1.3 million, respectively. - - - Federal Income Taxes The Company and MDC presently file consolidated federal income tax returns, with the consolidated tax payments, if any, being made by MDC. The Operating Agreement provides that so long as consolidated federal tax returns are filed, payments shall be made, directly or indirectly, by MDC to the Company or by the Company to MDC, as appropriate, equal to the difference between the consolidated tax liability and MDC's tax liability computed without consolidation with the Company. If, subsequent to any such payments by MDC, it incurs tax losses which may be carried back to the year for which such payments were made, the Company nevertheless will not be obligated to repay to MDC any portion of such payments. The Company and MDC have been operating since 1975 under an informal arrangement which has entitled the Company to rely upon the realization of tax benefits for the portion of projected taxable earnings of MDC allocated to the Company. This has been important in planning the volume of and pricing for the Company's leasing activities. Under this arrangement, the Company is entitled to receive on a current basis not less than 50% of the potential tax savings generated by the Company's leasing activities with the remaining portion of such tax benefits to be deferred for a one-year period. The Company's ability to price its business competitively and obtain new business volume is significantly dependent on its ability to realize the tax benefits generated by its leasing business. In some cases, the yields on receivables, without regard to tax benefits, may be less than the Company's related financing costs. To the extent that MDC would be unable on a long- term basis to utilize such tax benefits, or if the informal arrangement is not continued in its present form, the Company would be required to restructure its financing activities and to reprice its new financing transactions so as to make them profitable without regard to MDC's utilization of tax benefits since there can be no assurance that the Company would be able to utilize such benefits currently. No assurances can be given that the Company would be successful in restructuring its financing activities. (See "Competition and Economic Factors.") - - - Intercompany Services MDC provides to the Company certain payroll, employee benefit, facilities and other services, for which the Company generally pays MDC the actual cost. (See Notes to Consolidated Financial Statements included in Item 8.) Commencing in the second quarter of 1994, the Company will move to new facilities to be leased by the Company from MDC. The Company formerly provided substantial financial services to MDC in connection with MDC's marketing of its aircraft, particularly in assisting its customers in obtaining financing for their aircraft acquisitions. The Company's function in this area included assistance with respect to the form and terms of MDC's participation in such financing where necessary, and negotiation of these terms with the customer on behalf of MDC. In January 1994, the 10 Company employees who were primarily responsible for providing these services were transferred to Douglas Aircraft Company, a division of MDC, to more closely align them with the primary focus of their efforts. - - - Intercompany Credit Arrangements The Company and MDC maintain separate borrowing facilities and there are no arrangements for joint use of credit lines by the companies. Bank credit and other borrowing facilities are negotiated by the Company on its own behalf. There are no provisions in the Company's debt instruments that provide that a default by MDC on MDC debt constitutes a default on Company debt. There are no guaranties, direct or indirect, by MDC of the payment of any debt of the Company. The Company has an arrangement with MDC, terminable at the discretion of either of the parties, pursuant to which the Company may borrow from MDC and MDC may borrow from the Company, funds for 30-day periods at a market rate of interest or at MDFS's average borrowing rate. Under these arrangements, there were no outstanding balances at December 31, 1993 and at December 31, 1992, $49.0 million was receivable from MDC. During 1992, the Company made no borrowings under this agreement and the maximum receivable from MDC under this arrangement was $49.0 million. Under a similar borrowing arrangement, McDonnell Douglas Realty Company owed the Company $29.6 million at December 31, 1993. As of that date, the Company was also owed $18.3 million by MDFS under a borrowing based on short-term borrowing costs of the Company, supporting a bridge financing which was repaid in March 1994. Item 2.

Item 2. Properties The Company leases all of its office space and other facilities. Commencing in the second quarter of 1994, the Company will sublease from MDC, at fair market value, approximately 40,000 square feet of office space to be used as the Company's principal offices. The Company believes that its properties, including the equipment located therein, are suitable and adequate to meet the requirements of its business. Item 3.

Item 3. Legal Proceedings In 1990, the Company was named as a defendant in three class action suits (the Carpi, Edelman, and Waldman "Actions") for alleged violations of securities laws in connection with the public offering of limited partnership interests in certain equipment leasing limited partnerships, the sponsor of which was McDonnell Douglas Capital Corporation ("MDCC"), a wholly-owned subsidiary of the Company. A court-approved settlement of the Carpi, Edelman, and Waldman Actions became effective as of December 1, 1993, pursuant to which the defendants will pay plaintiffs approximately $14.8 million, approximately $13.4 million of which will be paid by MDCC, its corporate affiliates and the individual defendants (a portion of which will be paid from the officers and directors liability insurance covering the individual defendants). As part of the settlement, MDCC purchased the equipment portfolios of the limited partnerships for 121% of the $1.0 million net book value. The Company adequately reserved for the settlement of the Actions and the settlement will not have a significant adverse impact on its financial condition or results of operations. In March 1993, Wilmington Trust Company, CoreStates Bank, N.A., Midlantic National Bank and Continental Bank (collectively the "Banks") filed suit against the Company's wholly-owned subsidiary, MDFC Equipment Leasing Corporation ("ELC"), in the Superior Court of the State of Delaware seeking to recover payments made under letters of credit issued by the Banks in an aggregate amount of $2.8 million plus interest on such payments. In March 1994, ELC reached an agreement in principle to settle the suit by agreeing to pay the Banks a de minimus amount. Part II Item 5. Market for Registrant's Common Equity and Related Stockholder Matters. All of the Company's preferred and common stock is owned by MDFS. In 1993, the Company declared and paid no dividends to MDFS on its common stock compared to $102.3 million declared and paid in 1992. The 1992 common stock dividends declared and paid were unusually high due to the downsizing of the Company. The Company paid $3.6 million and $3.5 million in dividends on its preferred stock in 1993 and 1992. Preferred stock dividends of $0.5 million payable to MDFS were accrued at December 31, 1993. The Company currently expects to pay common stock dividends of at least $13.0 million to MDFS in 1994. The provisions of various credit and debt agreements require the Company to maintain a minimum net worth, restrict indebtedness, and limit cash dividends and other distributions. Under the most restrictive provision, $49.4 million of the Company's income retained for growth was available for dividends at December 31, 1993. Item 6. Selected Financial Data The selected consolidated financial data should be read in conjunction with the Company's consolidated financial statements at December 31, 1993 and for the year then ended and with Item 7. The following table sets forth selected consolidated financial data for the Company: Years Ended December 31, (Dollars in millions) 1993 1992 1991 1990 1989 Financing volume $ 453.0 $ 206.5 $ 231.3 $ 761.3 $ 962.6 Operating income: Finance lease income $ 94.7 $ 113.0 $ 179.3 $ 210.0 $ 174.2 Interest on notes 35.8 47.9 61.5 80.8 65.8 receivable Operating lease 34.3 33.3 34.1 36.9 32.7 income, net Net gain on disposal or re-lease 23.7 37.1 45.8 90.0 34.8 of assets Postretirement - 2.8 - - - benefit curtailment Other 9.9 20.6 21.6 13.1 13.2 198.5 254.7 342.3 430.8 320.7 Expenses: Interest expense 116.4 145.9 198.5 216.4 184.0 Provision for losses 8.6 19.1 47.2 57.3 13.2 Operating expenses 20.3 27.4 35.6 55.1 41.5 Other 12.4 14.3 3.8 3.1 6.4 157.7 206.7 285.1 331.9 245.1 Income from continuing operations before income taxes 40.8 48.0 57.2 98.9 75.6 and cumula- tive effect of accounting change Provision for taxes 24.0 15.9 19.1 34.6 24.9 on income Income from continuing operations before cumulative 16.8 32.1 38.1 64.3 50.7 effect of accounting change Discontinued - (2.5) (1.4) 1.2 (1.0) operations, net Cumulative effect of - (1.9) - - 100.0 accounting change Net income $ 16.8 $ 27.7 $ 36.7 $ 65.5 $ 149.7 Cash dividends paid $ 3.6 $ 105.8 $ 59.0 $ 23.5 $ 142.2 Ratio of income to 1.34 1.32 1.28 1.45 1.41 fixed charges Balance sheet data: Total assets $2,063.1 $1,999.0 $2,582.3 $3,443.7 $ 3,133.7 Total debt 1,361.2 1,330.4 1,730.7 2,443.2 2,222.3 Shareholder's equity 269.4 256.4 340.5 364.9 317.0 Dividends accrued on preferred stock at $ 0.6 $ 0.5 $ 0.5 $ 0.5 $ 0.5 year end (1) For the purpose of computing the ratio of income to fixed charges, income consists of income from continuing operations before income taxes, cumulative effect of accounting change and fixed charges; and fixed charges consist of interest expense and preferred stock dividends. Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations The following should be read in conjunction with the consolidated financial statements included in Item 8. Capital Resources and Liquidity The Company has significant liquidity requirements. If cash provided by operations, borrowings under bank credit lines, unsecured term borrowings and the normal run-off of the Company's portfolio do not provide the necessary liquidity, the Company would be required to restrict its new business volume unless it obtained access to other sources of capital at rates that would allow for a reasonable return on new business. The Company has been accessing the public debt market since mid-1993 and anticipates using proceeds from the issuance of additional public debt to fund future growth. The Company has traditionally attempted to match-fund its business such that scheduled receipts from its portfolio will at least cover its expenses and debt payments as they become due. The Company believes that, absent a severe or prolonged economic downturn which results in defaults materially in excess of those provided for, receipts from the portfolio will cover the payment of expenses and debt payments when due. In funding its operations, the Company had traditionally obtained cash from operating activities, placements of term debt, issuance of commercial paper and the normal run-off of its portfolio. However, beginning in the early 1990's and continuing through mid-1993, the Company's access to new capital was severely limited due to a lowering of the Company's credit ratings, the recession, and capital constraints imposed by MDC (see "Relationship With MDC") and, as a result, the Company used asset sales and secured borrowings as a source of funding at various times during this period. However, as 1993 progressed, all of these conditions had a much smaller impact on the Company and the Company's access to new capital improved. Beginning late in the second quarter of 1993, the Company resumed issuing public debt. In June 1993 the Company commenced offering securities as part of a $250 million retail medium term note program. As of December 31, 1993, the Company had issued $81.1 million of retail medium term notes. Beginning in the fourth quarter of 1993, the Company returned to the institutional medium term note market, issuing $90.0 million in debt as of December 31, 1993. During the years ended 1993, 1992 and 1991, the Company reduced the portfolio amount in its non-core businesses segment by a total of $1,117.4 million. The majority of the proceeds received from this reduction has been used to repay outstanding debt. At December 31, 1993, the Company had committed revolving credit agreements under which it could borrow a maximum of $170.0 million through January 31, 1994. The maximum amount which the Company can borrow will be reduced by $25.0 million each quarter through January 1995. At December 31, 1993, the Company had borrowed $53.0 million under these facilities, leaving $117.0 million unused. 1993 vs. 1992 Finance lease income decreased $18.3 million (16.2%) in 1993 compared to 1992 primarily due to the 1992 disposition of a significant portion of the assets of MD Bank and the normal run-off of the portfolio. Interest on notes receivable in 1993 was $12.1 million (25.3%) lower than 1992, reflecting an overall smaller portfolio. Net gain on disposal or re-lease of assets decreased $13.4 million (36.1%) in 1993, primarily attributable to 1992 non-recurring gains aggregating $9.4 million recorded in connection with the disposition of a significant portion of the assets of MD Bank. A lower level of short-term investments largely contributed to the 1993 decrease of $10.7 million (51.9%) in other income. The higher level of short- term investments during 1992 resulted from excess cash generated from the 1992 sales of selected assets and the sale of the Company's full-service leasing segment, operating as McDonnell Douglas Truck Services, Inc. Interest expense decreased $29.5 million (20.2%) in 1993 compared to 1992, resulting from decreased bank borrowings, retirement of debt with call options due to increased liquidity of the Company, offset by issuances of debt with favorable interest rates. The provision for losses decreased $10.5 million (55.0%) during 1993 compared to 1992, primarily as a result of the 1992 disposition of MD Bank assets, decreased write-offs within the real estate portfolio and an overall smaller portfolio. Operating expenses decreased $7.1 million (25.9%) during 1993 compared to 1992, attributable primarily to reductions in the Company's personnel and lower costs associated with administering a smaller asset portfolio. During the third quarter of 1993, the Company's effective tax rate was affected by an additional tax provision of $8.4 million associated with the tax rate increase included in the Omnibus Budget Reconciliation Act of 1993. 1992 vs. 1991 Finance lease income decreased $66.3 million (37.0%) in 1992 compared to 1991 due to the 1991 sale of substantially all the assets of McDonnell Douglas Auto Leasing Corporation ("MDAL") and the business credit group ("BCG"), the 1992 disposition of a significant portion of the assets of MD Bank, the sale of selected assets and the normal run-off of the portfolio. Interest on notes receivable in 1992 was $13.6 million (22.1%) lower than 1991 reflecting the sale of high-yield corporate bonds, delinquent real estate loans on nonaccrual status and an overall smaller portfolio. Interest expense decreased $52.6 million (26.5%) in 1992 compared to 1991, resulting from decreased short-term bank borrowings by MD Bank, the repurchase of debt securities, scheduled debt maturities and retirement of debt with call options. Total debt decreased to $1.3 billion at December 31, 1992 from $1.7 billion at December 31, 1991. The provision for losses decreased $28.1 million (59.5%) during 1992 compared to 1991, primarily as result of a change in the classification to other expenses of foreclosure expenses and writedowns of real estate owned totaling $7.9 million in 1992, which were previously charged to the allowance, the 1991 sale of substantially all of the assets of MDAL and BCG and decreased write- offs in 1992. Operating expenses decreased $8.2 million (23.0%) during 1992 compared to 1991 due primarily to major reductions in the Company's personnel and lower costs attendant to administering a smaller portfolio. At December 31, 1992, the Company had approximately 175 employees, reduced from 600 employees at December 31, 1991. Other expenses increased $10.5 million in 1992 compared to 1991 attributable to foreclosure expenses and writedowns in 1992 of real estate owned. These expenses were charged to the allowance in 1991. New Accounting Standards In December 1992, the Financial Accounting Standards Board issued SFAS No. 112, "Employers' Accounting for Postemployment Benefits." The Statement is effective in 1994 and requires using an accrual approach for accounting for benefits other than retiree health care to former or inactive employees. The impact of the Company's adoption of this Statement is not expected to be material. In May 1993, the Financial Accounting Standards Board issued Statement No. 114, "Accounting by Creditors for Impairment of a Loan." This Statement requires that impaired loans be measured on the present value of expected future cash flows discounted at the loan's effective interest rate, or at the loan's observable market price or the fair value of the collateral if the loan is collateral dependent. Adoption of this Statement is required no later than 1995, although earlier application is permitted. The Company presently intends to adopt this pronouncement in 1995. The effect of applying this Statement is not expected to have a material impact on the financial statements of the Company. Item 8. Financial Statements and Supplementary Data The following pages include the consolidated financial statements of the Company as described in Item 14.(a) 1. and 2. herein. Report of Independent Auditors Shareholder and Board of Directors McDonnell Douglas Finance Corporation We have audited the accompanying consolidated balance sheet of McDonnell Douglas Finance Corporation (a wholly-owned subsidiary of McDonnell Douglas Financial Services Corporation) and subsidiaries as of December 31, 1993 and 1992, and the related consolidated statements of income and income retained for growth, and cash flows for each of the three years in the period ended December 31, 1993. Our audits also included the financial statement schedules listed in the Index at Item 14(a). These financial statements and schedules are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements and schedules based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the consolidated financial position of McDonnell Douglas Finance Corporation and subsidiaries at December 31, 1993 and 1992, and the consolidated results of their operations and their cash flows for each of the three years in the period ended December 31, 1993, in conformity with generally accepted accounting principles. Also, in our opinion, the related financial statement schedules, when considered in relation to the basic financial statements taken as a whole, present fairly in all material respects the information set forth therein. We have also previously audited, in accordance with generally accepted auditing standards, the consolidated balance sheets as of December 31, 1991, 1990 and 1989, and the related consolidated statements of income and income retained for growth, and cash flows for the years ended December 31, 1990 and 1989 (none of which are presented separately herein); and we expressed unqualified opinions on those consolidated financial statements. In our opinion, the information set forth in the selected financial data for each of the five years in the period ended December 31, 1993, appearing on pages 26 - 28, is fairly stated in all material respects in relation to the consolidated financial statements from which it has been derived. As discussed in the notes to the consolidated financial statements, in 1992 the Company changed its method of accounting for retiree health care benefits. /s/ Ernst & Young Orange County, California January 18, 1994 McDonnell Douglas Finance Corporation and Subsidiaries Consolidated Balance Sheet December 31, (Dollars in millions, except per share amounts) 1993 1992 ASSETS Financing receivables: Investment in finance leases $1,173.5 $ 993.8 Notes receivable 301.8 459.7 1,475.3 1,453.5 Allowance for losses on financing (35.6) (37.4) receivables Financing receivables, net 1,439.7 1,416.1 Cash and cash equivalents 65.5 11.6 Equipment under operating leases, net 358.2 332.9 Equipment held for sale or re-lease 32.0 56.6 Real estate owned 12.9 55.2 Accounts with MDC and MDFS 70.4 40.9 Other assets 84.5 85.7 $2,063.2 $ 1,999.0 LIABILITIES AND SHAREHOLDER'S EQUITY Short-term notes payable $ 202.6 $ 133.5 Accounts payable and accrued expenses 59.2 41.2 Other liabilities 74.5 73.9 Deferred income taxes 298.9 297.1 Long-term debt: Senior 1,080.8 1,104.2 Subordinated 77.8 92.7 1,793.8 1,742.6 Commitments and contingencies - Note 8 Shareholder's equity: Preferred stock - no par value; authorized 100,000 shares: Series A; $5,000 stated value; authorized, issued and outstanding 50.0 50.0 10,000 shares Common stock $100 par value; authorized 100,000 shares; issued 5.0 5.0 and outstanding 50,000 shares Capital in excess of par value 89.5 89.5 Income retained for growth 129.6 116.4 Cumulative foreign currency (4.7) (4.5) translation adjustment 269.4 256.4 $2,063.2 $ 1,999.0 See notes to consolidated financial statements. McDonnell Douglas Finance Corporation and Subsidiaries Consolidated Statement of Income and Income Retained for Growth Years ended December 31, (Dollars in millions) 1993 1992 1991 OPERATING INCOME Finance lease income $ 94.7 $ 113.0 $ 179.3 Interest income on notes receivable 35.8 47.9 61.5 Operating lease income, net of depreciation expense of $39.0, $48.8 34.4 33.3 34.1 and $60.0 in 1993, 1992 and 1991, respectively Net gain on disposal or re-lease of 23.7 37.1 45.8 assets Postretirement benefit curtailment - 2.8 - gain Other 9.9 20.6 21.6 198.5 254.7 342.3 EXPENSES Interest expense 116.4 145.9 198.5 Provision for losses 8.6 19.1 47.2 Operating expenses 20.3 27.4 35.6 Other 12.4 14.3 3.8 157.7 206.7 285.1 Income from continuing operations before income taxes and cumulative 40.8 48.0 57.2 effect of accounting change Provision for income taxes 24.0 15.9 19.1 Income from continuing operations before cumulative effect 16.8 32.1 38.1 of accounting change Discontinued operations, net - (2.5) (1.4) Cumulative effect of new accounting standard for postretirement benefits - (1.9) - Net income 16.8 27.7 36.7 Income retained for growth at beginning 116.4 194.5 216.8 of year Dividends (3.6) (105.8) (59.0) Income retained for growth at end of $ 129.6 $ 116.4 $ 194.5 year See notes to consolidated financial statements. McDonnell Douglas Finance Corporation and Subsidiaries Consolidated Statement of Cash Flows Years Ended December 31, (Dollars in millions) 1993 1992 1991 OPERATING ACTIVITIES Income from continuing operations before cumulative effect of $ 16.8 $ 32.1 $ 38.1 accounting change Adjustments to reconcile income from continuing operations before cumulative effect of accounting change to net cash provided by (used in) operating activities: Depreciation expense - 39.0 48.8 60.0 equipment under operating leases Net gain on disposal or re- (23.7) (37.1) (45.8) lease of assets Provision for losses 8.6 19.1 47.2 Change in assets and liabilities: Accounts with MDC and MDFS (29.5) 18.4 (58.1) Other assets 1.2 (8.2) (9.9) Accounts payable 18.0 (16.1) (32.5) Other liabilities 0.6 (6.2) 5.3 Deferred income taxes 1.8 (76.6) (97.3) Other, net 4.2 (16.2) 1.7 Discontinued operations - 0.4 18.5 37.0 (41.6) (72.8) INVESTING ACTIVITIES Net change in short-term notes and 91.3 (77.9) (21.2) leases receivable Purchase of equipment for operating (57.4) (71.8) (66.7) leases Proceeds from disposition of 139.5 323.2 790.6 equipment, notes and leases receivable Collection of notes and leases 202.7 278.7 354.5 receivable Acquisition of notes and leases (385.7) (153.2) (168.9) receivable Discontinued operations - 69.4 19.8 (9.6) 368.4 908.1 FINANCING ACTIVITIES Net change in short-term borrowings 69.1 16.5 (444.4) Debt having maturities more than 90 days: Proceeds 183.0 34.9 585.6 Repayments (222.0) (440.8) (840.9) Payment of cash dividends (3.6) (105.8) (59.0) Discontinued operations - (6.9) (2.7) 26.5 (502.1) (761.4) Increase (decrease) in cash and cash 53.9 (175.3) 73.9 equivalents Cash and cash equivalents at 11.6 186.9 113.0 beginning of year Cash and cash equivalents $ 65.5 $ 11.6 $ 186.9 at end of year See notes to consolidated financial statements. McDonnell Douglas Finance Corporation and Subsidiaries Notes to Consolidated Financial Statements December 31, 1993 Note 1 - Organization and Summary of Significant Accounting Policies Organization McDonnell Douglas Finance Corporation (the "Company") is a wholly-owned subsidiary of McDonnell Douglas Financial Services Corporation ("MDFS"), a wholly-owned subsidiary of McDonnell Douglas Corporation ("MDC"). The Company was incorporated in Delaware in 1968 and provides a diversified range of equipment financing and leasing arrangements to commercial and industrial markets. Consolidation The consolidated financial statements include the accounts of the Company and its wholly-owned subsidiaries. All significant intercompany accounts and transactions have been eliminated. Certain amounts have been reclassified to conform to the 1993 presentation. Finance Leases At lease commencement, the Company records the lease receivable, estimated residual value of the leased equipment and unearned lease income. Income from leases is recognized over the terms of the leases so as to approximate a level rate of return on the net investment. Residual values, which are reviewed periodically, represent the estimated amount to be received at lease termination from the disposition of leased equipment. Initial Direct Costs Initial direct costs are deferred and amortized over the related financing terms. Cash Equivalents The Company considers all cash investments with original maturities of three months or less to be cash equivalents. Cash equivalents at December 31, 1993 were $58.8 million. There were no cash equivalents at December 31, 1992. At December 31, 1993 and 1992, the Company has classified as other assets restricted cash deposited with banks in interest bearing accounts of $44.3 million and $39.7 million for compensating balances, specific lease rents and contractual purchase price related to certain aircraft leased by the Company under capital lease obligations, and security against recourse provisions related to certain note and lease receivable sales. Allowance for Losses on Financing Receivables The allowance for losses on financing receivables includes consideration of such factors as the risk rating of individual credits, economic and political conditions, prior loss experience and results of periodic credit reviews. Collateral that is formally or substantively repossessed in satisfaction of a receivable is written down to estimated fair value and is transferred to equipment held for sale or re-lease or real estate owned. Subsequent to such transfer, these assets are carried at the lower of cost or estimated net realizable value. In May 1993, the Financial Accounting Standards Board issued Statement No. 114, "Accounting by Creditors for Impairment of a Loan." This Statement requires that impaired loans be measured on the present value of expected future cash flows discounted at the loan's effective interest rate, or at the loan's observable market price, or the fair value of the collateral if the loan is collateral dependent. Adoption of this Statement is required no later than 1995, although earlier application is permitted. The Company presently intends to adopt this pronouncement in 1995. The effect of applying this Statement is not expected to have a material impact on the financial condition or results of operations of the Company. Equipment Under Operating Leases Rental equipment subject to operating leases is recorded at cost and depreciated over its useful life or lease term to an estimated salvage value, primarily on a straight-line basis. Income Taxes The operations of the Company and its subsidiaries are included in the consolidated federal income tax return of MDC. MDC presently charges or credits the Company for the corresponding increase or decrease in MDC's taxes resulting from such inclusion. Intercompany payments are made when such taxes are due or tax credits are realized by MDC. Investment tax credits (which were repealed by the Tax Reform Act of 1986) related to property subject to financing transactions are deferred and amortized over the terms of the financing transactions. The provision for taxes on income is computed at current tax rates and adjusted for items that do not have tax consequences, temporary differences and the cumulative effect of any changes in tax rates from those previously used to determine deferred income taxes. In 1992, the Company adopted Statement of Financial Accounting Standards ("SFAS") No. 109, "Accounting for Income Taxes." The impact of the adoption of SFAS No. 109 had no material effect on the Company's accounting for income taxes. SFAS No. 109 requires financial statements reflect deferred income taxes for future tax consequences of events recognized in different years for financial and tax reporting purposes. Foreign Currency Translation McDonnell Douglas Bank Limited ("MD Bank"), a United Kingdom company, is an indirect wholly-owned subsidiary of MDC. Through intercompany arrangements between MDC and the Company, MD Bank is consolidated as if it were a wholly-owned subsidiary of the Company. Adjustments from translating the assets and liabilities of MD Bank from the functional currency of the pound sterling into U.S. dollars at the year-end exchange rate are accumulated and reported as a separate component of equity. Operating results are translated at average monthly exchange rates. Note 2 - Dispositions During the second quarter of 1992, the Company completed the sale of the remaining assets of its full-service leasing segment, operating as McDonnell Douglas Truck Services Inc. ("MDTS"). These assets were sold to various parties for approximately $58.6 million. This segment has been reported as a discontinued operation. Accordingly, the consolidated financial statements for 1992 and 1991 have been reclassified to report separately the operating results of this discontinued operation. Included in 1992 discontinued operations is the MDTS loss on sale of $1.6 million, net of income tax benefits of $0.9 million and the MDTS loss from operations of $0.9 million, net of income tax benefits of $0.5 million. Included in 1991 discontinued operations is the MDTS loss from operations of $1.4 million, net of income tax benefits of $0.8 million. Operating income of MDTS was $3.4 million and $22.9 million for 1992 and 1991. During 1992, in three separate transactions, MD Bank sold a significant portion of its portfolio and received cash proceeds of approximately $70.8 million and an amortizing note receivable of $29.7 million. These sales resulted in pretax gains aggregating $9.4 million. The cash proceeds were applied to reduce MD Bank's bank borrowings, resulting in losses totaling $2.3 million on the termination of interest rate swaps. The note, which was concurrently sold to the Company at par, bears an interest rate of LIBOR plus 1.5%. At December 31, 1993 and 1992, $4.5 million and $18.7 million was outstanding under this note. At December 31, 1993, the Company had an outstanding foreign currency swap agreement to hedge this note. Foreign currency transaction losses incurred in conjunction with this note amounted to $0.4 million and $1.2 million in 1993 and 1992. During the fourth quarter 1992, the Company sold substantially all of the assets of McDonnell Douglas Capital Corporation ("MDCC"), a wholly-owned subsidiary of the Company, for $13.5 million, resulting in a pretax gain of $1.3 million. The assets consisted primarily of equipment subject to operating leases. Operating income of MDCC was $5.9 million and $4.7 million in 1992 and 1991. On October 18, 1991, the Company completed the sale of substantially all of the assets of McDonnell Douglas Auto Leasing Corporation ("MDAL"), a wholly- owned subsidiary of the Company, for $154.7 million. The Company recorded a pretax loss of $2.5 million on the disposition. Operating income of MDAL was $17.2 million in 1991. In two separate transactions, the Company sold substantially all of the assets of the business credit group ("BCG"). The first transaction, occurring in May 1991, resulted in proceeds of $19.9 million and a pretax loss of $1.2 million. On July 1, 1991, the second transaction was consummated and provided the Company with proceeds of $58.7 million and a pretax gain of $0.6 million. Note 3 - Investment in Finance Leases The following lists the components of the investment in finance leases at December 31: (Dollars in millions) 1993 1992 Minimum lease payments receivable $ 1,668.9 $ 1,326.7 Estimated residual value of leased assets 273.2 221.7 Unearned income (772.3) (558.8) Deferred initial direct costs 3.7 4.2 $ 1,173.5 $ 993.8 The following lists the components of the investment in finance leases at December 31 that relate to aircraft leased by the Company under capital leases that have been leased to others: (Dollars in millions) 1993 1992 Minimum lease payments receivable $ 81.2 $ 88.5 Estimated residual value of leased 15.1 15.1 assets Unearned income (41.1) (45.9) Deferred initial direct costs 0.2 0.2 $ 55.4 $ 57.9 At December 31, 1993, finance lease receivables of $267.9 million serve as collateral to senior long-term debt. At December 31, 1993, finance lease receivables are due in installments as follows: 1994, $216.6 million; 1995, $187.4 million; 1996, $166.8 million; 1997, $150.1 million; 1998, $141.0 million; 1999 and thereafter, $807.0 million. During 1993, the Company leased, under a finance lease agreement, a DC-10-30 aircraft to MDC with a carrying amount of $32.9 million at December 31, 1993. The lease requires monthly rent payments of $0.4 million through April 14, 2004. Note 4 - Notes Receivable The following lists the components of notes receivable at December 31: (Dollars in millions) 1993 1992 Principal $ 299.1 $ 454.2 Accrued interest 2.8 5.6 Unamortized discount (1.3) (1.7) Deferred initial direct costs 1.2 1.6 $ 301.8 $ 459.7 At December 31, 1993, notes receivables are due in installments as follows: 1994, $106.5 million; 1995, $56.2 million; 1996, $36.9 million; 1997, $22.3 million; 1998, $28.0 million; 1999 and thereafter, $49.2 million. Note 5 - Equipment Under Operating Leases Equipment under operating leases consists of the following at December 31: (Dollars in millions) 1993 1992 Commercial aircraft $ 216.4 $ 160.1 Executive aircraft 88.7 91.9 Highway vehicles 76.7 108.2 Printing equipment 32.0 17.2 Medical equipment 21.9 26.8 Machine tools and production equipment 21.1 27.1 Computers and related equipment 9.3 4.1 Other 3.1 2.6 469.2 438.0 Accumulated depreciation and (106.6) (103.4) amortization Rentals receivable 5.0 7.8 Deferred lease income (10.8) (11.1) Deferred initial direct costs 1.4 1.6 $ 358.2 $ 332.9 At December 31, 1993, future minimum rentals scheduled to be received under the noncancelable portion of operating leases are as follows: 1994, $60.3 million; 1995, $45.6 million; 1996, $38.6 million; 1997, $34.1 million; 1998, $27.4 million; 1999 and thereafter, $41.1 million. At December 31, 1993, equipment under operating leases of $30.4 million are assigned as collateral to senior long-term debt. Equipment under operating leases of $15.3 million at December 31, 1993, relate to commercial aircraft leased by the Company under capital lease obligations. Under an operating lease agreement, the Company leases four MD-82 aircraft to MDC. The leases require quarterly rent payments of $2.1 million through May 31, 2002. At December 31, 1993 and 1992, the carrying amount of these aircraft was $60.4 million and $64.6 million. Note 6 - Income Taxes The components of the provision (benefit) for taxes on income from continuing operations before cumulative effect of accounting change are as follows: (Dollars in millions) 1993 1992 1991 Current: Federal $ 19.8 $ 48.1 $ 100.2 State 2.4 3.4 2.7 22.2 51.5 102.9 Deferred: Federal 1.0 (36.6) (82.7) Foreign 0.8 1.0 (1.1) 1.8 (35.6) (83.8) $ 24.0 $ 15.9 $ 19.1 Temporary differences represent the cumulative taxable or deductible amounts recorded in the financial statements in different years than recognized in the tax returns. The components of the net deferred income tax liability consist of the following at December 31: (Dollars in millions) 1993 1992 Deferred tax assets: Allowance for losses $ 11.9 $ 12.8 Other 20.0 2.6 31.9 15.4 Deferred tax liabilities: Leased assets (311.6) (291.9) Deferred installment sales (2.8) (3.4) MD Bank - (3.7) Other (16.4) (13.5) (330.8) (312.5) Net deferred tax liability $ (298.9) $ (297.1) Income taxes computed at the United States federal income tax rate and the provision for taxes on income from continuing operations before cumulative effect of accounting change differ as follows: (Dollars in millions) 1993 1992 1991 Tax computed at federal $ 14.3 $ 16.3 $ 19.4 statutory rate State income taxes, net of 1.5 1.3 1.8 federal tax benefit Effect of foreign tax rates 0.1 0.8 - U.S. tax effect on foreign 0.8 (2.1) - income Effect of investment tax (0.6) (1.1) (1.7) credits Effect of tax rate change 8.4 - - Other (0.5) 0.7 (0.4) $ 24.0 $ 15.9 $ 19.1 During the third quarter of 1993, the Company's effective tax rate was affected by an additional tax provision of $8.4 million associated with the tax rate increase included in the Omnibus Budget Reconciliation Act of 1993. MDFS is currently under examination by the Internal Revenue Service ("IRS") for the tax years 1986 through 1989. The IRS audit is not expected to have a material effect on the Company's financial condition or results of operations. Provisions have been made for estimated United States and foreign income taxes which may be incurred upon the repatriation of MD Bank's undistributed earnings. Income taxes paid by the Company totaled $54.0 million in 1993, $86.1 million in 1992 and $76.2 million in 1991. Note 7 - Indebtedness Short-term notes payable consist of the following at December 31: (Dollars in millions) 1993 1992 Short-term bank borrowings $ 149.6 $ - Lines of credit 53.0 124.0 MDFS - 9.5 $ 202.6 $ 133.5 At December 31, 1993, the Company had a revolving credit agreement under which it could borrow a maximum of $125.0 million to be reduced by $25.0 million each quarter through January 1995. The interest rate, at the option of the Company, is either a floating rate generally based on a defined prime rate, a fixed rate related to either LIBOR or a certificate of deposit rate, or a rate as quoted under a competitive bid. Borrowings of $53.0 million and $108.0 million were outstanding under this agreement at December 31, 1993 and 1992. At December 31, 1993, MDFS and the Company had a joint revolving credit agreement under which MDFS could borrow a maximum of $6.0 million and the Company could borrow a maximum of $45.0 million, reduced by any MDFS borrowings under this agreement. The interest rate, at the option of the Company, is either a floating rate generally based on a defined prime rate or fixed rate related to LIBOR. There were no outstanding borrowings under this agreement at December 31, 1993. At December 31, 1993, the Company had non-recourse short-term bank borrowings totaling $149.6 million, at LIBOR based interest rates, due and payable on November 4, 1994. MD Bank borrowings of $16.0 million were outstanding at December 31, 1992 under a committed credit agreement which subsequently expired. Senior long-term debt consists of the following at December 31: (Dollars in millions) 1993 1992 9.0% Note due through 1993 $ - $ 9.7 7.75% - 7.91% Notes due through 1993 - 3.3 5.0% Note due through 1994, net of discount based on imputed interest rate 0.5 1.1 of 7.95% 13.0% Notes due through 1995 0.6 1.1 9.15% Note due 1994 19.4 17.4 8.46% Note due 1995 8.0 8.0 10.52% Note due 1995 52.0 52.0 7.0% Notes due through 1996 2.1 3.0 7.0% Notes due through 1998, net of discount based on imputed interest rate 3.4 4.1 of 10.8% 3.9% Notes due through 1999, net of discount based on imputed interest 9.4 10.9 rates of 9.15% - 10.6% 5.75% - 6.875% Notes due through 2000, net of discount based on imputed 11.8 13.3 interest rates of 9.75% - 11.4% 6.65% - 10.18% Notes due through 2001 93.2 94.9 5.25% - 8.375% Retail medium term notes 79.1 - due through 2008 4.625% - 13.55% Medium term notes due 713.4 792.0 through 2005 Capital lease obligations due through 87.9 93.4 $ 1,080.8 $ 1,104.2 The 9.15% Note due 1994, related to a borrowing denominated in Japanese yen, and the 10.52% Note due 1995, related to a borrowing denominated in Swiss francs, have been adjusted by $20.9 million at December 31, 1993 ($19.0 million at December 31, 1992) to reflect the dollar value of each liability at the current exchange rate. To hedge against the risk of future currency exchange rate fluctuations on such debt, the Company entered into foreign currency swap agreements at the time of borrowing whereby it may purchase foreign currency sufficient to retire such debt at exchange rates in effect at the initial dates of the agreements. Changes in the market value of the swap agreements due to changes in exchange rates are included in other assets and effectively offset changes in the value of the foreign denominated obligations. As of December 31, 1993, $98.6 million of senior long-term debt was collateralized by equipment. This debt is composed of the 7.0% Notes due through 1996, 7.0% Notes due through 1998, and the 6.65% - 10.18% Notes due through 2001. The Company leases aircraft under capital leases which have been sub-leased to others. The Company has guaranteed the repayment of $9.7 million in capital lease obligations associated with a 50% partner. Subordinated long-term debt consists of the following at December 31: (Dollars in millions) 1993 1992 12.63% Note due 1993 $ - $ 5.0 8.25% - 9.26% Notes due through 1996 5.0 10.0 10.25% Notes due through 1997 20.0 25.0 12.35% Note due 1997 20.0 20.0 8.93% - 9.92% Medium term notes due through 32.8 32.7 $ 77.8 $ 92.7 Payments required on long-term debt and capital lease obligations during the years ending December 31 are as follows: Long-Term Capital (Dollars in millions) Debt Leases 1994 $ 185.7 $ 15.1 1995 202.2 15.1 1996 98.5 15.1 1997 106.4 15.1 1998 135.8 15.1 1999 and thereafter 347.4 62.1 1,076.0 137.6 Deferred debt expenses (5.4) (0.9) Imputed interest - (48.8) $ 1,070.6 $ 87.9 The provisions of various credit and debt agreements require the Company to maintain a minimum net worth, restrict indebtedness, and limit cash dividends and other distributions. Under the most restrictive provision, $49.4 million of the Company's income retained for growth was available for dividends at December 31, 1993. Interest payments totaled $116.3 million in 1993, $154.0 million in 1992 and $205.2 million in 1991. Note 8 - Commitments and Contingencies At December 31, 1993 and 1992, the Company had unused credit lines available to customers totaling $6.6 million and $14.3 million; and commitments to provide leasing and other financing totaling $43.6 million and $23.1 million. In 1990, the Company was named as a defendant in three class action suits (the "Actions") for alleged violations of securities laws in connection with the public offering of limited partnership interests in certain equipment leasing limited partnerships, the sponsor of which was MDCC. In 1993, the Company settled the Actions for approximately $14.8 million. As part of the settlement, MDCC purchased the equipment portfolios of the limited partnerships for 121% of the $1.0 million net book value, which approximated fair value. The Company adequately reserved for the settlement of the Actions. At December 31, 1993, in conjunction with prior asset dispositions, at December 31, 1993, the Company is subject to a maximum recourse of $42.0 million. Based on trends to date, the Company's exposure to such loss is not expected to be significant. Note 9 - Transactions with MDC and MDFS Accounts with MDC and MDFS consist of the following at December 31: (Dollars in millions) 1993 1992 Notes receivable $ 47.9 $ 49.0 Federal income tax payable 25.8 (15.4) State income tax receivable - 8.3 Other payables (3.3) (1.0) $ 70.4 $ 40.9 The Company has arrangements with MDC, terminable at the discretion of either of the parties, pursuant to which the Company may borrow from MDC and MDC may borrow from the Company, funds for 30-day periods at a market rate of interest or at MDFS's average borrowing rate. Under these arrangements, there were no outstanding balances at December 31, 1993 and at December 31, 1992, $49.0 million was receivable from MDC. Under a similar arrangement, the Company may borrow from MDFS and MDFS may borrow from the Company, funds for 30-day periods at the Company's cost of funds for short-term borrowings. Under these arrangements, receivables of $18.3 million and borrowings of $9.5 million were outstanding at December 31, 1993 and 1992. On September 28, 1993, the Company sold, at estimated fair value, real estate owned properties to McDonnell Douglas Realty Company, a wholly-owned subsidiary of MDC, and financed the sale by taking a $28.9 million note. The Company recorded a pretax loss of $5.7 million on the transfer, which is included in other expenses in the consolidated statement of income. The note is payable on demand and accrues interest at a rate equal to the average borrowing cost of MDFS. At December 31, 1993, $29.6 million was outstanding under this note. During 1993, 1992 and 1991, the Company purchased aircraft and aircraft related notes from MDC in the amount of $400.2 million, $160.5 million and $119.1 million, respectively. At December 31, 1993 and 1992, $270.0 million and $152.2 million of the commercial aircraft financing portfolio was guaranteed by MDC. During 1993, 1992 and 1991, the Company collected $0.2 million, $0.6 million and $0.8 million, respectively, under these guaranties. On September 29, 1992, the Company purchased a bridge note issued by Irish Aerospace Leasing Limited, a wholly-owned subsidiary of Irish Aerospace Limited, which previously was 25% owned by MDC, for $22.0 million with an effective interest rate of 9.4%. This note was repaid in 1993. On December 31, 1991, MDC sold an MD-11 flight simulator to the Company for $30.0 million and simultaneously leased it back under an operating lease agreement. On March 5, 1992, the Company sold the MD-11 flight simulator to a third party for approximately book value. During 1992, the $9.9 million long-term debt issued by MDFS to MD Bank in 1990 was prepaid. This note was payable in ten equal semi-annual instalments beginning on May 20, 1996, at LIBOR based interest rates. The Series A Preferred Stock is redeemable at the Company's option at $5,000 per share, has no voting privileges and is entitled to cumulative semi-annual dividends of $175 per share. Such dividends have priority over cash dividends on the Company's common stock. Accrued dividends on preferred stock amounted to $0.6 and $0.5 million at December 31, 1993 and 1992. Substantially all employees of MDC and its subsidiaries are members of defined benefit pension plans and insurance plans. MDC also provides eligible employees the opportunity to participate in savings plans that permit both pretax and after-tax contributions. MDC generally charges the Company with the actual cost of these plans which are included with other MDC charges for support services and reflected in operating expenses. MDC charges for services provided during 1993, 1992 and 1991 totaled $1.1 million, $2.1 million and $2.9 million, respectively. Additionally, the Company was compensated by certain affiliates for a number of support services, which are net against operating expenses, amounting to $1.8 million, $2.5 million and $2.7 million in 1993, 1992 and 1991, respectively. Prior to 1992, Company-paid retiree health care benefits were included in costs as covered expenses were actually incurred. In December 1990, the Financial Accounting Standards Board issued SFAS No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions." The Statement required companies to change, by 1993, their method of accounting for the costs of these benefits to one that accelerates the recognition of costs by causing their full accrual over the employees' years of service up to their date of full eligibility. MDC, and therefore the Company, elected to implement this Statement for 1992 by immediately recognizing the January 1, 1992 accumulated postretirement benefit obligation of $3.1 million ($1.9 million after-tax). On October 8, 1992, effective January 1, 1993, MDC terminated Company-paid retiree health care for both current and future non-union retirees and their survivors and replaced it with a new arrangement that will be funded entirely by participant contributions. The Company recorded a pretax curtailment gain of $2.8 million ($1.7 million after-tax) in the fourth quarter of 1992, reflecting the termination of Company-paid retiree health care for both current and future non-union retirees. In December 1992, the Financial Accounting Standards Board issued SFAS No. 112, "Employers' Accounting for Postemployment Benefits." The Statement will be effective in 1994 and will require using an accrual approach for accounting for benefits other than retiree health care to former or inactive employees. The impact of the Company's adoption of this Statement is not expected to be material. Note 10 - Fair Value of Financial Instruments The estimated fair value amounts of the Company's financial instruments have been determined by the Company, using appropriate market information and valuation methodologies. The following methods and assumptions were used to estimate the fair value of each class of financial instruments: Cash and Cash Equivalents Because of the short maturity of these instruments, the carrying amount approximates fair value. Notes Receivable For variable rate notes that reprice frequently and with no significant change in credit risk, fair values are based on carrying values. The fair values of fixed rate notes are estimated using discounted cash flow analyses, using interest rates currently being offered for loans with similar terms to borrowers of similar credit quality. Short and Long-Term Debt The carrying amount of the Company's short-term borrowings approximates its fair value. The fair value of the Company's long- term debt is estimated using discounted cash flow analyses, based on the Company's current incremental borrowing rates for similar types of borrowing arrangements. Off-Balance Sheet Instruments Fair values for the Company's off-balance sheet instruments (swaps and financing commitments) are based on quoted market prices of comparable instruments (currency and interest rate swaps); and the counterparties' credit standing, taking into account the remaining terms of the agreements (financing commitments). The estimated fair values of the Company's financial instruments consist of the following at December 31: (Dollars in millions) 1993 1992 Carrying Fair Carrying Fair Asset (Liability) Amount Value Amount Value ASSETS Cash and cash equivalents $ 65.5 $ 65.5 $ 11.6 $ 11.6 Notes receivable 301.8 301.8 459.7 458.2 LIABILITIES Short-term notes payable (203.3) (203.3) (124.2) (124.2) to banks Long-term debt: Senior, excluding capital (1,014.0) (1,090.3) (1,034.8) (1,055.2) lease obligations Subordinated (80.7) (89.1) (96.1) (99.2) OFF BALANCE SHEET INSTRUMENTS Commitments to extend (50.2) (50.2) (16.8) (16.8) credit Foreign currency swaps 20.9 18.5 19.0 13.3 Interest rate swaps (0.2) (0.7) (0.1) (1.4) Note 11 - Segment Information The Company provides a diversified range of financing and leasing arrangements to customers and industries throughout the United States, the United Kingdom and, to a lesser extent, other countries. The Company's operations include three financial reporting segments: commercial aircraft financing, commercial equipment leasing and non-core businesses. The commercial aircraft financing segment provides customer financing services to MDC components, primarily Douglas Aircraft Company, and also provides financing for the acquisition of non-MDC aircraft. The commercial equipment leasing segment is principally involved in large financing and leasing transactions for a diversified range of equipment. Non- core businesses represent market segments in which the Company is no longer active. The non-core businesses consist primarily of the remaining assets of three business units: MD Bank, receivable inventory financing and real estate financing. MD Bank provided financing in the United Kingdom similar to that provided in the United States by the commercial equipment leasing segment. Receivable inventory financing provides financing to dealers of rent-to-own products. Real estate financing previously specialized in fixed rate, medium term commercial real estate loans. The Company's financing and leasing portfolio consists of the following at December 31: (Dollars in millions) 1993 1992 Commercial aircraft financing: MDC aircraft financing $ 1,035.1 56.5% $ 769.3 43.1% Other commercial aircraft 202.4 11.0 231.8 13.0 financing 1,237.5 67.5 1,001.1 56.1 Commercial equipment leasing: Transportation services 69.3 3.8 96.9 5.4 Transportation equipment 42.7 2.3 39.0 2.2 Trucking and warehousing 38.7 2.1 66.6 3.7 Other 271.6 14.8 354.9 19.9 422.3 23.0 557.4 31.2 Non-core businesses: Real estate 123.6 6.7 146.7 8.2 Furniture and home furnishings stores 31.0 1.7 43.2 2.4 Air transportation 5.1 0.3 5.5 0.3 Other 14.0 0.8 32.5 1.8 173.7 9.5 227.9 12.7 Total portfolio $1,833.5 100.0% $1,786.4 100.0% The single largest commercial aircraft financing customer accounted for $253.2 million (13.8% of total Company portfolio) and $120.9 million (6.8% of total Company portfolio) at December 31, 1993 and 1992. The five largest commercial aircraft financing customers accounted for $718.5 million (39.2% of total Company portfolio) and $445.1 million (24.9% of total Company portfolio) at December 31, 1993 and 1992. There were no significant concentrations by customer within the commercial equipment leasing and non-core businesses portfolios. The Company generally holds title to all leased equipment and generally has a perfected security interest in the assets financed through note and loan arrangements. Information about the Company's operations in its different financial reporting segments for the past three years is as follows: (Dollars in millions) 1993 1992 1991 Operating income: Commercial aircraft financing $ 107.4 $ 107.7 $ 125.6 Commercial equipment leasing 64.0 79.1 117.5 Non-core businesses 24.4 56.1 94.3 Corporate 2.7 11.8 4.9 $ 198.5 $ 254.7 $ 342.3 Income (loss) from continuing operations before income taxes and cumulative effect of accounting change: Commercial aircraft financing $ 26.3 $ 28.3 $ 50.7 Commercial equipment leasing 30.8 31.1 42.0 Non-core businesses (10.7) (11.4) (25.6) Corporate (5.6) - (9.9) $ 40.8 $ 48.0 $ 57.2 Identifiable assets at December 31: Commercial aircraft $ 1,369.0 $ 1,085.2 $ 1,106.7 financing Commercial equipment leasing 420.2 590.5 747.2 Non-core businesses 247.6 301.2 694.3 Corporate 26.4 22.1 34.1 $ 2,063.2 $ 1,999.0 $ 2,582.3 Depreciation expense - equipment under operating leases: Commercial aircraft financing $ 10.1 $ 5.9 $ 2.6 Commercial equipment leasing 28.2 31.8 39.4 Non-core businesses 0.7 11.1 18.0 $ 39.0 $ 48.8 $ 60.0 Equipment acquired for operating leases, at cost: Commercial aircraft financing $ 34.5 $ 53.5 $ 36.3 Commercial equipment leasing 22.9 18.2 30.3 Non-core businesses - 0.1 0.1 $ 57.4 $ 71.8 $ 66.7 The Company's operations are classified into two geographic segments, the United States and the United Kingdom. United Kingdom operations consist of MD Bank. Information about the Company's operations in its different geographic segments for the past three years is as follows: (Dollars in millions) 1993 1992 1991 Operating income: United States $ 194.1 $227.7 $305.7 United Kingdom 4.4 27.0 36.6 $ 198.5 $254.7 $342.3 Income (loss) from continuing operations before income taxes and cumulative effect of accounting change: United States $ 41.2 $ 41.0 $ 60.5 United Kingdom (0.4) 7.0 (3.3) $ 40.8 $ 48.0 $ 57.2 Identifiable assets at December 31: United States $ 2,033.7 $ 1,950.0 $ 2,347.8 United Kingdom 29.5 49.0 234.5 $ 2,063.2 $ 1,999.0 $ 2,582.3 Operating income from financing of assets located outside the United States by the Company's United States geographic segment totaled $20.9 million, $21.6 million and $18.1 million in 1993, 1992 and 1991, respectively. McDonnell Douglas Finance Corporation and Subsidiaries Schedule II - Amounts Receivable From Related Parties and Underwriters, Promoters, and Employees Other Than Related Parties Balance at (Dollars in End of millions) Deductions Year ------------------- ----------------- Balance at Amounts Beginning of Amounts Written Non Year Additions Collected Off Current Current 1993: Irish $ 22.3 $ - $ 22.3 $ - $ - $ - 1992: Irish $ 6.3 $ 22.3 $ 6.3 $ - $ 22.3 $ - 1991: Irish $ - $ 6.3 $ - $ - $ 6.3 $ - McDonnell Douglas Finance Corporation and Subsidiaries Schedule VIII - Valuation and Qualifying Accounts (Dollars in millions) Balance Charged Allowance for at to Balance Losses on Beginning Costs at end Financing of and Other Deductions of Receivables Year Expenses Year 1993 $ 37.4 $ 8.6 $ - $ (10.4) $ 35.6 1992 $ 46.7 $ 19.1 $ (1.0) $ (27.4) $ 37.4 1991 $ 61.6 $ 47.2 $ (5.4) $ (56.7) $ 46.7 The 1991 amount includes allowances that were reclassified in conjunction with the sale of substantially all of the assets of MDAL and BCG. Write-offs net of recoveries. McDonnell Douglas Finance Corporation and Subsidiaries Schedule IX - Short-Term Borrowings (Dollars in millions) Weighted Average Weighted Average Maximum Interest Amount Amount Average Balance Rate Outstanding Outstanding Interest Category of at End of at End During the During the Rate Aggregate Period of Period Period Period During the Short-term Period Borrowings Year ended December 31, 1993: MDC $ - - % $ 190.4 $ 23.0 4.33% MDFS - - 27.5 6.0 4.96 Banks - U.S. 202.6 4.35 203.0 72.8 4.66 Banks - U.K. - - 15.9 11.3 13.13 Year ended December 31, 1992: MDFS $9.5 5.94% $ 16.1 $ 6.4 5.35% Banks - U.S. 108.0 6.00 108.0 24.5 3.94 Banks - U.K. 16.0 12.44 124.1 87.3 14.68 Year ended December 31, 1991: Commercial $ - -% $ 44.0 $ 2.1 9.20% paper MDC - - 4.6 0.5 8.85 MDFS 4.4 5.83 22.9 1.0 8.02 Banks - U.S. - - 300.0 140.2 7.10 Banks - U.K. 158.0 12.25 289.3 197.2 12.34 Commercial paper was issued from time to time at various maturities and short-term notes payable to MDC are issued for 30 days. Computed by dividing the total of daily principal balances by the number of days in the year. Computed by dividing the actual interest expense by average short-term debt outstanding. The effective interest rate on short-term borrowings including the effect of fees was 5.97% in 1993, 12.38% in 1992 and 10.28% in 1991. Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure None. Part IV Item 14. Exhibits, Financial Statement Schedules, and Reports on Form 8-K Page Number in Form 10-K (a) 1. Financial Statements Report of Independent Auditors 33 Consolidated Balance Sheet at December 31, 1993 and 1992 34 Consolidated Statement of Income and Income Retained for Growth for the Years Ended December 31, 1993, 1992 and 1991 36 Consolidated Statement of Cash Flows for the Years Ended December 31, 1993, 1992 and 1991 38 Notes to Consolidated Financial Statements 40-55 2. Financial Statement Schedules Schedule II - Amounts Receivable From Related Parties and Underwriters, Promoters, and Employees Other Than Related Parties 56 Schedule VIII - Valuation and Qualifying Accounts 58 Schedule IX - Short-Term Borrowings 60 Schedules for which provision is made in the applicable regulation of the Securities and Exchange Commission (the "SEC"), except Schedules II, VIII and IX which are included herein, have been omitted because they are not required, or the information is set forth in the financial statements or notes thereto. 3. Exhibits 3.1 Restated Certificate of Incorporation of the Company dated June 29, 1989. 3.2 By-Laws of the Company, as amended to date. 4.4 Form of Indenture, dated as of April 1, 1983, between the Company and Bankers Trust Company, incorporated herein by reference to Exhibit 4(a) to Amendment No. 1 to the Form S-3 Registration Statement of the Company effective April 22, 1983. 4.5 Form of Subordinated Indenture, dated as of June 15, 1988, by and between the Company and Bankers Trust Company of California, N.A., as Subordinated Indenture Trustee, incorporated by reference to Exhibit 4(b) to the Form S-3 Registration Statement of the Company, as filed with the SEC on June 24, 1988. 4.6 Form of Indenture, dated as of April 15, 1987, incorporated herein by reference to Exhibit 4 to the Form S-3 Registration Statement of the Company as filed with the SEC on April 24, 1987. 4.7 Form of Series I Medium Term Note, incorporated herein by reference to Exhibit 4(b) to the Form S-3 Registration Statement of the Company effective April 22, 1983. 4.8 Form of Series II Medium Term Note, incorporated herein by reference to Exhibit 4(c) to the Form 8-K of the Company dated August 22, 1983. 4.9 Form of Series III Medium Term Note, incorporated herein by reference to Exhibit 4(b) to the Form S-3 Registration Statement of the Company effective June 17, 1985. 4.10 Form of Series IV Medium Term Note, incorporated herein by reference to Exhibit 4 to the Form S-3 Registration Statement of the Company effective June 17, 1985. 4.11 Form of Series V Medium Term Note, incorporated herein by reference to Exhibit 4 to the Form S-3 Registration Statement of the Company , as filed with the SEC on April 24, 1987. 4.12 Form of Series VI Medium Term Note, incorporated herein by reference to Exhibit 4 to the Form S-3 Registration Statement of the Company, as filed with the SEC on April 24, 1987. 4.13 Form of Series VII Medium Term Note, incorporated herein by reference to Exhibit 4 to the Form S-3 Registration Statement of the Company, as filed with the SEC on April 24, 1987. 4.14 Form of Series VIII Senior Medium Term Note, incorporated herein by reference to Exhibit 4(c) to the Form S-3 Registration Statement of the Company, as filed with the SEC on June 24, 1988. 4.15 Form of Series VIII Subordinated Medium Term Note, incorporated herein by reference to Exhibit 4(d) to the Form S-3 Registration Statement of the Company, as filed with the SEC on June 24, 1988. 4.16 Form of Series IX Senior Medium Term Note, incorporated herein by reference to Exhibit 4(c) to the Form S-3 Registration Statement of the Company, as filed with the SEC on October 4, 1989. 4.17 Form of Series IX Subordinated Medium Term Note, incorporated herein by reference to Exhibit 4(d) to the Form S-3 Registration Statement of the Company, as filed with the SEC on October 4, 1989. 4.18 Form of General Term Note(R), incorporated herein by reference to Exhibit 4(c) to Form 8-K of the Company dated May 26, 1993. Pursuant to Item 601 (b)(4)(iii) of Regulation S-K, the Company is not filing certain instruments with respect to its long-term debt since the total amount of securities currently provided for under each of such instruments does not exceed 10 percent of the total assets of the Company and its subsidiaries on a consolidated basis. The Company hereby agrees to furnish a copy of any such instrument to the SEC upon request. 10.1 Amended and Restated Operating Agreement among MDC, the Company and MDFS dated as of April 12, 1993. 10.2 Operating Agreement by and between the Company and MDFS effective as of February 8, 1989, incorporated herein by reference to Exhibit 10.3 to the Company's Form 10-K for the year ended December 31, 1989. 10.3 By-Laws of MDC as amended January 29, 1993, incorporated by reference from MDC's Exhibit 3.2 to its Form 8-K Report filed February 1, 1993 (file No. 1-3685). 10.4 Supplemental Guaranty Agreement by and between the Company and MDC, dated as of December 30, 1993. 10.5 Supplemental Guaranty Agreement by and between the Company and MDC, dated as of December 30, 1993. 12.1 Statement regarding computation of ratio of earnings to fixed charges. 23.1 Consent of Ernst & Young. (b) Reports on Form 8-K On February 3, 1994, the Company filed a current report on Form 8-K, which included the Company's Consolidated Balance Sheet at December 31, 1993 and 1992 and Consolidated Statement of Income and Income Retained for Growth for each of the years ended December 31, 1993, 1992 and 1991. Signatures Pursuant to the requirements of Section 13 or 15(d) 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. McDonnell Douglas Finance Corporation By /s/ Douglas E. Scudamore March 30, 1994 Vice President and Controller Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed by the following persons on behalf of the registrant and in the capacities and on the dates indicated. Signature Title Date /s/ Herbert J. Lanese Chairman March 30, 1994 /s/ George M. Rosen President and Director March 30, 1994 (Principal Executive Officer) /s/ Robert W. Owsley Sr. Vice President March 30, 1994 (Principal & Treasurer Financial Officer) /s/ Douglas E. Scudamore Vice President March 30, 1994 (Principal & Controller Accounting Officer) F. Mark Kuhlmann Director /s/ Thomas J. Lawlor, Jr. Director March 30, 1994 John F. McDonnell Director

Item 5. Market for Registrant's Common Equity and Related Stockholder Matters. All of the Company's preferred and common stock is owned by MDFS. In 1993, the Company declared and paid no dividends to MDFS on its common stock compared to $102.3 million declared and paid in 1992. The 1992 common stock dividends declared and paid were unusually high due to the downsizing of the Company. The Company paid $3.6 million and $3.5 million in dividends on its preferred stock in 1993 and 1992. Preferred stock dividends of $0.5 million payable to MDFS were accrued at December 31, 1993. The Company currently expects to pay common stock dividends of at least $13.0 million to MDFS in 1994. The provisions of various credit and debt agreements require the Company to maintain a minimum net worth, restrict indebtedness, and limit cash dividends and other distributions. Under the most restrictive provision, $49.4 million of the Company's income retained for growth was available for dividends at December 31, 1993. Item 6.

Item 6. Selected Financial Data The selected consolidated financial data should be read in conjunction with the Company's consolidated financial statements at December 31, 1993 and for the year then ended and with Item 7.

Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations The following should be read in conjunction with the consolidated financial statements included in Item 8.

Item 8. Financial Statements and Supplementary Data The following pages include the consolidated financial statements of the Company as described in Item 14.(a) 1. and 2. herein. Report of Independent Auditors Shareholder and Board of Directors McDonnell Douglas Finance Corporation We have audited the accompanying consolidated balance sheet of McDonnell Douglas Finance Corporation (a wholly-owned subsidiary of McDonnell Douglas Financial Services Corporation) and subsidiaries as of December 31, 1993 and 1992, and the related consolidated statements of income and income retained for growth, and cash flows for each of the three years in the period ended December 31, 1993. Our audits also included the financial statement schedules listed in the Index at Item 14(a). These financial statements and schedules are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements and schedules based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the consolidated financial position of McDonnell Douglas Finance Corporation and subsidiaries at December 31, 1993 and 1992, and the consolidated results of their operations and their cash flows for each of the three years in the period ended December 31, 1993, in conformity with generally accepted accounting principles. Also, in our opinion, the related financial statement schedules, when considered in relation to the basic financial statements taken as a whole, present fairly in all material respects the information set forth therein. We have also previously audited, in accordance with generally accepted auditing standards, the consolidated balance sheets as of December 31, 1991, 1990 and 1989, and the related consolidated statements of income and income retained for growth, and cash flows for the years ended December 31, 1990 and 1989 (none of which are presented separately herein); and we expressed unqualified opinions on those consolidated financial statements. In our opinion, the information set forth in the selected financial data for each of the five years in the period ended December 31, 1993, appearing on pages 26 - 28, is fairly stated in all material respects in relation to the consolidated financial statements from which it has been derived. As discussed in the notes to the consolidated financial statements, in 1992 the Company changed its method of accounting for retiree health care benefits. /s/ Ernst & Young Orange County, California January 18, 1994 McDonnell Douglas Finance Corporation and Subsidiaries Consolidated Balance Sheet December 31, (Dollars in millions, except per share amounts) 1993 1992 ASSETS Financing receivables: Investment in finance leases $1,173.5 $ 993.8 Notes receivable 301.8 459.7 1,475.3 1,453.5 Allowance for losses on financing (35.6) (37.4) receivables Financing receivables, net 1,439.7 1,416.1 Cash and cash equivalents 65.5 11.6 Equipment under operating leases, net 358.2 332.9 Equipment held for sale or re-lease 32.0 56.6 Real estate owned 12.9 55.2 Accounts with MDC and MDFS 70.4 40.9 Other assets 84.5 85.7 $2,063.2 $ 1,999.0 LIABILITIES AND SHAREHOLDER'S EQUITY Short-term notes payable $ 202.6 $ 133.5 Accounts payable and accrued expenses 59.2 41.2 Other liabilities 74.5 73.9 Deferred income taxes 298.9 297.1 Long-term debt: Senior 1,080.8 1,104.2 Subordinated 77.8 92.7 1,793.8 1,742.6 Commitments and contingencies - Note 8 Shareholder's equity: Preferred stock - no par value; authorized 100,000 shares: Series A; $5,000 stated value; authorized, issued and outstanding 50.0 50.0 10,000 shares Common stock $100 par value; authorized 100,000 shares; issued 5.0 5.0 and outstanding 50,000 shares Capital in excess of par value 89.5 89.5 Income retained for growth 129.6 116.4 Cumulative foreign currency (4.7) (4.5) translation adjustment 269.4 256.4 $2,063.2 $ 1,999.0 See notes to consolidated financial statements. McDonnell Douglas Finance Corporation and Subsidiaries Consolidated Statement of Income and Income Retained for Growth Years ended December 31, (Dollars in millions) 1993 1992 1991 OPERATING INCOME Finance lease income $ 94.7 $ 113.0 $ 179.3 Interest income on notes receivable 35.8 47.9 61.5 Operating lease income, net of depreciation expense of $39.0, $48.8 34.4 33.3 34.1 and $60.0 in 1993, 1992 and 1991, respectively Net gain on disposal or re-lease of 23.7 37.1 45.8 assets Postretirement benefit curtailment - 2.8 - gain Other 9.9 20.6 21.6 198.5 254.7 342.3 EXPENSES Interest expense 116.4 145.9 198.5 Provision for losses 8.6 19.1 47.2 Operating expenses 20.3 27.4 35.6 Other 12.4 14.3 3.8 157.7 206.7 285.1 Income from continuing operations before income taxes and cumulative 40.8 48.0 57.2 effect of accounting change Provision for income taxes 24.0 15.9 19.1 Income from continuing operations before cumulative effect 16.8 32.1 38.1 of accounting change Discontinued operations, net - (2.5) (1.4) Cumulative effect of new accounting standard for postretirement benefits - (1.9) - Net income 16.8 27.7 36.7 Income retained for growth at beginning 116.4 194.5 216.8 of year Dividends (3.6) (105.8) (59.0) Income retained for growth at end of $ 129.6 $ 116.4 $ 194.5 year See notes to consolidated financial statements. McDonnell Douglas Finance Corporation and Subsidiaries Consolidated Statement of Cash Flows Years Ended December 31, (Dollars in millions) 1993 1992 1991 OPERATING ACTIVITIES Income from continuing operations before cumulative effect of $ 16.8 $ 32.1 $ 38.1 accounting change Adjustments to reconcile income from continuing operations before cumulative effect of accounting change to net cash provided by (used in) operating activities: Depreciation expense - 39.0 48.8 60.0 equipment under operating leases Net gain on disposal or re- (23.7) (37.1) (45.8) lease of assets Provision for losses 8.6 19.1 47.2 Change in assets and liabilities: Accounts with MDC and MDFS (29.5) 18.4 (58.1) Other assets 1.2 (8.2) (9.9) Accounts payable 18.0 (16.1) (32.5) Other liabilities 0.6 (6.2) 5.3 Deferred income taxes 1.8 (76.6) (97.3) Other, net 4.2 (16.2) 1.7 Discontinued operations - 0.4 18.5 37.0 (41.6) (72.8) INVESTING ACTIVITIES Net change in short-term notes and 91.3 (77.9) (21.2) leases receivable Purchase of equipment for operating (57.4) (71.8) (66.7) leases Proceeds from disposition of 139.5 323.2 790.6 equipment, notes and leases receivable Collection of notes and leases 202.7 278.7 354.5 receivable Acquisition of notes and leases (385.7) (153.2) (168.9) receivable Discontinued operations - 69.4 19.8 (9.6) 368.4 908.1 FINANCING ACTIVITIES Net change in short-term borrowings 69.1 16.5 (444.4) Debt having maturities more than 90 days: Proceeds 183.0 34.9 585.6 Repayments (222.0) (440.8) (840.9) Payment of cash dividends (3.6) (105.8) (59.0) Discontinued operations - (6.9) (2.7) 26.5 (502.1) (761.4) Increase (decrease) in cash and cash 53.9 (175.3) 73.9 equivalents Cash and cash equivalents at 11.6 186.9 113.0 beginning of year Cash and cash equivalents $ 65.5 $ 11.6 $ 186.9 at end of year See notes to consolidated financial statements. McDonnell Douglas Finance Corporation and Subsidiaries Notes to Consolidated Financial Statements December 31, 1993 Note 1 - Organization and Summary of Significant Accounting Policies Organization McDonnell Douglas Finance Corporation (the "Company") is a wholly-owned subsidiary of McDonnell Douglas Financial Services Corporation ("MDFS"), a wholly-owned subsidiary of McDonnell Douglas Corporation ("MDC"). The Company was incorporated in Delaware in 1968 and provides a diversified range of equipment financing and leasing arrangements to commercial and industrial markets. Consolidation The consolidated financial statements include the accounts of the Company and its wholly-owned subsidiaries. All significant intercompany accounts and transactions have been eliminated. Certain amounts have been reclassified to conform to the 1993 presentation. Finance Leases At lease commencement, the Company records the lease receivable, estimated residual value of the leased equipment and unearned lease income. Income from leases is recognized over the terms of the leases so as to approximate a level rate of return on the net investment. Residual values, which are reviewed periodically, represent the estimated amount to be received at lease termination from the disposition of leased equipment. Initial Direct Costs Initial direct costs are deferred and amortized over the related financing terms. Cash Equivalents The Company considers all cash investments with original maturities of three months or less to be cash equivalents. Cash equivalents at December 31, 1993 were $58.8 million. There were no cash equivalents at December 31, 1992. At December 31, 1993 and 1992, the Company has classified as other assets restricted cash deposited with banks in interest bearing accounts of $44.3 million and $39.7 million for compensating balances, specific lease rents and contractual purchase price related to certain aircraft leased by the Company under capital lease obligations, and security against recourse provisions related to certain note and lease receivable sales. Allowance for Losses on Financing Receivables The allowance for losses on financing receivables includes consideration of such factors as the risk rating of individual credits, economic and political conditions, prior loss experience and results of periodic credit reviews. Collateral that is formally or substantively repossessed in satisfaction of a receivable is written down to estimated fair value and is transferred to equipment held for sale or re-lease or real estate owned. Subsequent to such transfer, these assets are carried at the lower of cost or estimated net realizable value. In May 1993, the Financial Accounting Standards Board issued Statement No. 114, "Accounting by Creditors for Impairment of a Loan." This Statement requires that impaired loans be measured on the present value of expected future cash flows discounted at the loan's effective interest rate, or at the loan's observable market price, or the fair value of the collateral if the loan is collateral dependent. Adoption of this Statement is required no later than 1995, although earlier application is permitted. The Company presently intends to adopt this pronouncement in 1995. The effect of applying this Statement is not expected to have a material impact on the financial condition or results of operations of the Company. Equipment Under Operating Leases Rental equipment subject to operating leases is recorded at cost and depreciated over its useful life or lease term to an estimated salvage value, primarily on a straight-line basis. Income Taxes The operations of the Company and its subsidiaries are included in the consolidated federal income tax return of MDC. MDC presently charges or credits the Company for the corresponding increase or decrease in MDC's taxes resulting from such inclusion. Intercompany payments are made when such taxes are due or tax credits are realized by MDC. Investment tax credits (which were repealed by the Tax Reform Act of 1986) related to property subject to financing transactions are deferred and amortized over the terms of the financing transactions. The provision for taxes on income is computed at current tax rates and adjusted for items that do not have tax consequences, temporary differences and the cumulative effect of any changes in tax rates from those previously used to determine deferred income taxes. In 1992, the Company adopted Statement of Financial Accounting Standards ("SFAS") No. 109, "Accounting for Income Taxes." The impact of the adoption of SFAS No. 109 had no material effect on the Company's accounting for income taxes. SFAS No. 109 requires financial statements reflect deferred income taxes for future tax consequences of events recognized in different years for financial and tax reporting purposes. Foreign Currency Translation McDonnell Douglas Bank Limited ("MD Bank"), a United Kingdom company, is an indirect wholly-owned subsidiary of MDC. Through intercompany arrangements between MDC and the Company, MD Bank is consolidated as if it were a wholly-owned subsidiary of the Company. Adjustments from translating the assets and liabilities of MD Bank from the functional currency of the pound sterling into U.S. dollars at the year-end exchange rate are accumulated and reported as a separate component of equity. Operating results are translated at average monthly exchange rates. Note 2 - Dispositions During the second quarter of 1992, the Company completed the sale of the remaining assets of its full-service leasing segment, operating as McDonnell Douglas Truck Services Inc. ("MDTS"). These assets were sold to various parties for approximately $58.6 million. This segment has been reported as a discontinued operation. Accordingly, the consolidated financial statements for 1992 and 1991 have been reclassified to report separately the operating results of this discontinued operation. Included in 1992 discontinued operations is the MDTS loss on sale of $1.6 million, net of income tax benefits of $0.9 million and the MDTS loss from operations of $0.9 million, net of income tax benefits of $0.5 million. Included in 1991 discontinued operations is the MDTS loss from operations of $1.4 million, net of income tax benefits of $0.8 million. Operating income of MDTS was $3.4 million and $22.9 million for 1992 and 1991. During 1992, in three separate transactions, MD Bank sold a significant portion of its portfolio and received cash proceeds of approximately $70.8 million and an amortizing note receivable of $29.7 million. These sales resulted in pretax gains aggregating $9.4 million. The cash proceeds were applied to reduce MD Bank's bank borrowings, resulting in losses totaling $2.3 million on the termination of interest rate swaps. The note, which was concurrently sold to the Company at par, bears an interest rate of LIBOR plus 1.5%. At December 31, 1993 and 1992, $4.5 million and $18.7 million was outstanding under this note. At December 31, 1993, the Company had an outstanding foreign currency swap agreement to hedge this note. Foreign currency transaction losses incurred in conjunction with this note amounted to $0.4 million and $1.2 million in 1993 and 1992. During the fourth quarter 1992, the Company sold substantially all of the assets of McDonnell Douglas Capital Corporation ("MDCC"), a wholly-owned subsidiary of the Company, for $13.5 million, resulting in a pretax gain of $1.3 million. The assets consisted primarily of equipment subject to operating leases. Operating income of MDCC was $5.9 million and $4.7 million in 1992 and 1991. On October 18, 1991, the Company completed the sale of substantially all of the assets of McDonnell Douglas Auto Leasing Corporation ("MDAL"), a wholly- owned subsidiary of the Company, for $154.7 million. The Company recorded a pretax loss of $2.5 million on the disposition. Operating income of MDAL was $17.2 million in 1991. In two separate transactions, the Company sold substantially all of the assets of the business credit group ("BCG"). The first transaction, occurring in May 1991, resulted in proceeds of $19.9 million and a pretax loss of $1.2 million. On July 1, 1991, the second transaction was consummated and provided the Company with proceeds of $58.7 million and a pretax gain of $0.6 million. Note 3 - Investment in Finance Leases The following lists the components of the investment in finance leases at December 31: (Dollars in millions) 1993 1992 Minimum lease payments receivable $ 1,668.9 $ 1,326.7 Estimated residual value of leased assets 273.2 221.7 Unearned income (772.3) (558.8) Deferred initial direct costs 3.7 4.2 $ 1,173.5 $ 993.8 The following lists the components of the investment in finance leases at December 31 that relate to aircraft leased by the Company under capital leases that have been leased to others: (Dollars in millions) 1993 1992 Minimum lease payments receivable $ 81.2 $ 88.5 Estimated residual value of leased 15.1 15.1 assets Unearned income (41.1) (45.9) Deferred initial direct costs 0.2 0.2 $ 55.4 $ 57.9 At December 31, 1993, finance lease receivables of $267.9 million serve as collateral to senior long-term debt. At December 31, 1993, finance lease receivables are due in installments as follows: 1994, $216.6 million; 1995, $187.4 million; 1996, $166.8 million; 1997, $150.1 million; 1998, $141.0 million; 1999 and thereafter, $807.0 million. During 1993, the Company leased, under a finance lease agreement, a DC-10-30 aircraft to MDC with a carrying amount of $32.9 million at December 31, 1993. The lease requires monthly rent payments of $0.4 million through April 14, 2004. Note 4 - Notes Receivable The following lists the components of notes receivable at December 31: (Dollars in millions) 1993 1992 Principal $ 299.1 $ 454.2 Accrued interest 2.8 5.6 Unamortized discount (1.3) (1.7) Deferred initial direct costs 1.2 1.6 $ 301.8 $ 459.7 At December 31, 1993, notes receivables are due in installments as follows: 1994, $106.5 million; 1995, $56.2 million; 1996, $36.9 million; 1997, $22.3 million; 1998, $28.0 million; 1999 and thereafter, $49.2 million. Note 5 - Equipment Under Operating Leases Equipment under operating leases consists of the following at December 31: (Dollars in millions) 1993 1992 Commercial aircraft $ 216.4 $ 160.1 Executive aircraft 88.7 91.9 Highway vehicles 76.7 108.2 Printing equipment 32.0 17.2 Medical equipment 21.9 26.8 Machine tools and production equipment 21.1 27.1 Computers and related equipment 9.3 4.1 Other 3.1 2.6 469.2 438.0 Accumulated depreciation and (106.6) (103.4) amortization Rentals receivable 5.0 7.8 Deferred lease income (10.8) (11.1) Deferred initial direct costs 1.4 1.6 $ 358.2 $ 332.9 At December 31, 1993, future minimum rentals scheduled to be received under the noncancelable portion of operating leases are as follows: 1994, $60.3 million; 1995, $45.6 million; 1996, $38.6 million; 1997, $34.1 million; 1998, $27.4 million; 1999 and thereafter, $41.1 million. At December 31, 1993, equipment under operating leases of $30.4 million are assigned as collateral to senior long-term debt. Equipment under operating leases of $15.3 million at December 31, 1993, relate to commercial aircraft leased by the Company under capital lease obligations. Under an operating lease agreement, the Company leases four MD-82 aircraft to MDC. The leases require quarterly rent payments of $2.1 million through May 31, 2002. At December 31, 1993 and 1992, the carrying amount of these aircraft was $60.4 million and $64.6 million. Note 6 - Income Taxes The components of the provision (benefit) for taxes on income from continuing operations before cumulative effect of accounting change are as follows: (Dollars in millions) 1993 1992 1991 Current: Federal $ 19.8 $ 48.1 $ 100.2 State 2.4 3.4 2.7 22.2 51.5 102.9 Deferred: Federal 1.0 (36.6) (82.7) Foreign 0.8 1.0 (1.1) 1.8 (35.6) (83.8) $ 24.0 $ 15.9 $ 19.1 Temporary differences represent the cumulative taxable or deductible amounts recorded in the financial statements in different years than recognized in the tax returns. The components of the net deferred income tax liability consist of the following at December 31: (Dollars in millions) 1993 1992 Deferred tax assets: Allowance for losses $ 11.9 $ 12.8 Other 20.0 2.6 31.9 15.4 Deferred tax liabilities: Leased assets (311.6) (291.9) Deferred installment sales (2.8) (3.4) MD Bank - (3.7) Other (16.4) (13.5) (330.8) (312.5) Net deferred tax liability $ (298.9) $ (297.1) Income taxes computed at the United States federal income tax rate and the provision for taxes on income from continuing operations before cumulative effect of accounting change differ as follows: (Dollars in millions) 1993 1992 1991 Tax computed at federal $ 14.3 $ 16.3 $ 19.4 statutory rate State income taxes, net of 1.5 1.3 1.8 federal tax benefit Effect of foreign tax rates 0.1 0.8 - U.S. tax effect on foreign 0.8 (2.1) - income Effect of investment tax (0.6) (1.1) (1.7) credits Effect of tax rate change 8.4 - - Other (0.5) 0.7 (0.4) $ 24.0 $ 15.9 $ 19.1 During the third quarter of 1993, the Company's effective tax rate was affected by an additional tax provision of $8.4 million associated with the tax rate increase included in the Omnibus Budget Reconciliation Act of 1993. MDFS is currently under examination by the Internal Revenue Service ("IRS") for the tax years 1986 through 1989. The IRS audit is not expected to have a material effect on the Company's financial condition or results of operations. Provisions have been made for estimated United States and foreign income taxes which may be incurred upon the repatriation of MD Bank's undistributed earnings. Income taxes paid by the Company totaled $54.0 million in 1993, $86.1 million in 1992 and $76.2 million in 1991. Note 7 - Indebtedness Short-term notes payable consist of the following at December 31: (Dollars in millions) 1993 1992 Short-term bank borrowings $ 149.6 $ - Lines of credit 53.0 124.0 MDFS - 9.5 $ 202.6 $ 133.5 At December 31, 1993, the Company had a revolving credit agreement under which it could borrow a maximum of $125.0 million to be reduced by $25.0 million each quarter through January 1995. The interest rate, at the option of the Company, is either a floating rate generally based on a defined prime rate, a fixed rate related to either LIBOR or a certificate of deposit rate, or a rate as quoted under a competitive bid. Borrowings of $53.0 million and $108.0 million were outstanding under this agreement at December 31, 1993 and 1992. At December 31, 1993, MDFS and the Company had a joint revolving credit agreement under which MDFS could borrow a maximum of $6.0 million and the Company could borrow a maximum of $45.0 million, reduced by any MDFS borrowings under this agreement. The interest rate, at the option of the Company, is either a floating rate generally based on a defined prime rate or fixed rate related to LIBOR. There were no outstanding borrowings under this agreement at December 31, 1993. At December 31, 1993, the Company had non-recourse short-term bank borrowings totaling $149.6 million, at LIBOR based interest rates, due and payable on November 4, 1994. MD Bank borrowings of $16.0 million were outstanding at December 31, 1992 under a committed credit agreement which subsequently expired. Senior long-term debt consists of the following at December 31: (Dollars in millions) 1993 1992 9.0% Note due through 1993 $ - $ 9.7 7.75% - 7.91% Notes due through 1993 - 3.3 5.0% Note due through 1994, net of discount based on imputed interest rate 0.5 1.1 of 7.95% 13.0% Notes due through 1995 0.6 1.1 9.15% Note due 1994 19.4 17.4 8.46% Note due 1995 8.0 8.0 10.52% Note due 1995 52.0 52.0 7.0% Notes due through 1996 2.1 3.0 7.0% Notes due through 1998, net of discount based on imputed interest rate 3.4 4.1 of 10.8% 3.9% Notes due through 1999, net of discount based on imputed interest 9.4 10.9 rates of 9.15% - 10.6% 5.75% - 6.875% Notes due through 2000, net of discount based on imputed 11.8 13.3 interest rates of 9.75% - 11.4% 6.65% - 10.18% Notes due through 2001 93.2 94.9 5.25% - 8.375% Retail medium term notes 79.1 - due through 2008 4.625% - 13.55% Medium term notes due 713.4 792.0 through 2005 Capital lease obligations due through 87.9 93.4 $ 1,080.8 $ 1,104.2 The 9.15% Note due 1994, related to a borrowing denominated in Japanese yen, and the 10.52% Note due 1995, related to a borrowing denominated in Swiss francs, have been adjusted by $20.9 million at December 31, 1993 ($19.0 million at December 31, 1992) to reflect the dollar value of each liability at the current exchange rate. To hedge against the risk of future currency exchange rate fluctuations on such debt, the Company entered into foreign currency swap agreements at the time of borrowing whereby it may purchase foreign currency sufficient to retire such debt at exchange rates in effect at the initial dates of the agreements. Changes in the market value of the swap agreements due to changes in exchange rates are included in other assets and effectively offset changes in the value of the foreign denominated obligations. As of December 31, 1993, $98.6 million of senior long-term debt was collateralized by equipment. This debt is composed of the 7.0% Notes due through 1996, 7.0% Notes due through 1998, and the 6.65% - 10.18% Notes due through 2001. The Company leases aircraft under capital leases which have been sub-leased to others. The Company has guaranteed the repayment of $9.7 million in capital lease obligations associated with a 50% partner. Subordinated long-term debt consists of the following at December 31: (Dollars in millions) 1993 1992 12.63% Note due 1993 $ - $ 5.0 8.25% - 9.26% Notes due through 1996 5.0 10.0 10.25% Notes due through 1997 20.0 25.0 12.35% Note due 1997 20.0 20.0 8.93% - 9.92% Medium term notes due through 32.8 32.7 $ 77.8 $ 92.7 Payments required on long-term debt and capital lease obligations during the years ending December 31 are as follows: Long-Term Capital (Dollars in millions) Debt Leases 1994 $ 185.7 $ 15.1 1995 202.2 15.1 1996 98.5 15.1 1997 106.4 15.1 1998 135.8 15.1 1999 and thereafter 347.4 62.1 1,076.0 137.6 Deferred debt expenses (5.4) (0.9) Imputed interest - (48.8) $ 1,070.6 $ 87.9 The provisions of various credit and debt agreements require the Company to maintain a minimum net worth, restrict indebtedness, and limit cash dividends and other distributions. Under the most restrictive provision, $49.4 million of the Company's income retained for growth was available for dividends at December 31, 1993. Interest payments totaled $116.3 million in 1993, $154.0 million in 1992 and $205.2 million in 1991. Note 8 - Commitments and Contingencies At December 31, 1993 and 1992, the Company had unused credit lines available to customers totaling $6.6 million and $14.3 million; and commitments to provide leasing and other financing totaling $43.6 million and $23.1 million. In 1990, the Company was named as a defendant in three class action suits (the "Actions") for alleged violations of securities laws in connection with the public offering of limited partnership interests in certain equipment leasing limited partnerships, the sponsor of which was MDCC. In 1993, the Company settled the Actions for approximately $14.8 million. As part of the settlement, MDCC purchased the equipment portfolios of the limited partnerships for 121% of the $1.0 million net book value, which approximated fair value. The Company adequately reserved for the settlement of the Actions. At December 31, 1993, in conjunction with prior asset dispositions, at December 31, 1993, the Company is subject to a maximum recourse of $42.0 million. Based on trends to date, the Company's exposure to such loss is not expected to be significant. Note 9 - Transactions with MDC and MDFS Accounts with MDC and MDFS consist of the following at December 31: (Dollars in millions) 1993 1992 Notes receivable $ 47.9 $ 49.0 Federal income tax payable 25.8 (15.4) State income tax receivable - 8.3 Other payables (3.3) (1.0) $ 70.4 $ 40.9 The Company has arrangements with MDC, terminable at the discretion of either of the parties, pursuant to which the Company may borrow from MDC and MDC may borrow from the Company, funds for 30-day periods at a market rate of interest or at MDFS's average borrowing rate. Under these arrangements, there were no outstanding balances at December 31, 1993 and at December 31, 1992, $49.0 million was receivable from MDC. Under a similar arrangement, the Company may borrow from MDFS and MDFS may borrow from the Company, funds for 30-day periods at the Company's cost of funds for short-term borrowings. Under these arrangements, receivables of $18.3 million and borrowings of $9.5 million were outstanding at December 31, 1993 and 1992. On September 28, 1993, the Company sold, at estimated fair value, real estate owned properties to McDonnell Douglas Realty Company, a wholly-owned subsidiary of MDC, and financed the sale by taking a $28.9 million note. The Company recorded a pretax loss of $5.7 million on the transfer, which is included in other expenses in the consolidated statement of income. The note is payable on demand and accrues interest at a rate equal to the average borrowing cost of MDFS. At December 31, 1993, $29.6 million was outstanding under this note. During 1993, 1992 and 1991, the Company purchased aircraft and aircraft related notes from MDC in the amount of $400.2 million, $160.5 million and $119.1 million, respectively. At December 31, 1993 and 1992, $270.0 million and $152.2 million of the commercial aircraft financing portfolio was guaranteed by MDC. During 1993, 1992 and 1991, the Company collected $0.2 million, $0.6 million and $0.8 million, respectively, under these guaranties. On September 29, 1992, the Company purchased a bridge note issued by Irish Aerospace Leasing Limited, a wholly-owned subsidiary of Irish Aerospace Limited, which previously was 25% owned by MDC, for $22.0 million with an effective interest rate of 9.4%. This note was repaid in 1993. On December 31, 1991, MDC sold an MD-11 flight simulator to the Company for $30.0 million and simultaneously leased it back under an operating lease agreement. On March 5, 1992, the Company sold the MD-11 flight simulator to a third party for approximately book value. During 1992, the $9.9 million long-term debt issued by MDFS to MD Bank in 1990 was prepaid. This note was payable in ten equal semi-annual instalments beginning on May 20, 1996, at LIBOR based interest rates. The Series A Preferred Stock is redeemable at the Company's option at $5,000 per share, has no voting privileges and is entitled to cumulative semi-annual dividends of $175 per share. Such dividends have priority over cash dividends on the Company's common stock. Accrued dividends on preferred stock amounted to $0.6 and $0.5 million at December 31, 1993 and 1992. Substantially all employees of MDC and its subsidiaries are members of defined benefit pension plans and insurance plans. MDC also provides eligible employees the opportunity to participate in savings plans that permit both pretax and after-tax contributions. MDC generally charges the Company with the actual cost of these plans which are included with other MDC charges for support services and reflected in operating expenses. MDC charges for services provided during 1993, 1992 and 1991 totaled $1.1 million, $2.1 million and $2.9 million, respectively. Additionally, the Company was compensated by certain affiliates for a number of support services, which are net against operating expenses, amounting to $1.8 million, $2.5 million and $2.7 million in 1993, 1992 and 1991, respectively. Prior to 1992, Company-paid retiree health care benefits were included in costs as covered expenses were actually incurred. In December 1990, the Financial Accounting Standards Board issued SFAS No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions." The Statement required companies to change, by 1993, their method of accounting for the costs of these benefits to one that accelerates the recognition of costs by causing their full accrual over the employees' years of service up to their date of full eligibility. MDC, and therefore the Company, elected to implement this Statement for 1992 by immediately recognizing the January 1, 1992 accumulated postretirement benefit obligation of $3.1 million ($1.9 million after-tax). On October 8, 1992, effective January 1, 1993, MDC terminated Company-paid retiree health care for both current and future non-union retirees and their survivors and replaced it with a new arrangement that will be funded entirely by participant contributions. The Company recorded a pretax curtailment gain of $2.8 million ($1.7 million after-tax) in the fourth quarter of 1992, reflecting the termination of Company-paid retiree health care for both current and future non-union retirees. In December 1992, the Financial Accounting Standards Board issued SFAS No. 112, "Employers' Accounting for Postemployment Benefits." The Statement will be effective in 1994 and will require using an accrual approach for accounting for benefits other than retiree health care to former or inactive employees. The impact of the Company's adoption of this Statement is not expected to be material. Note 10 - Fair Value of Financial Instruments The estimated fair value amounts of the Company's financial instruments have been determined by the Company, using appropriate market information and valuation methodologies. The following methods and assumptions were used to estimate the fair value of each class of financial instruments: Cash and Cash Equivalents Because of the short maturity of these instruments, the carrying amount approximates fair value. Notes Receivable For variable rate notes that reprice frequently and with no significant change in credit risk, fair values are based on carrying values. The fair values of fixed rate notes are estimated using discounted cash flow analyses, using interest rates currently being offered for loans with similar terms to borrowers of similar credit quality. Short and Long-Term Debt The carrying amount of the Company's short-term borrowings approximates its fair value. The fair value of the Company's long- term debt is estimated using discounted cash flow analyses, based on the Company's current incremental borrowing rates for similar types of borrowing arrangements. Off-Balance Sheet Instruments Fair values for the Company's off-balance sheet instruments (swaps and financing commitments) are based on quoted market prices of comparable instruments (currency and interest rate swaps); and the counterparties' credit standing, taking into account the remaining terms of the agreements (financing commitments). The estimated fair values of the Company's financial instruments consist of the following at December 31: (Dollars in millions) 1993 1992 Carrying Fair Carrying Fair Asset (Liability) Amount Value Amount Value ASSETS Cash and cash equivalents $ 65.5 $ 65.5 $ 11.6 $ 11.6 Notes receivable 301.8 301.8 459.7 458.2 LIABILITIES Short-term notes payable (203.3) (203.3) (124.2) (124.2) to banks Long-term debt: Senior, excluding capital (1,014.0) (1,090.3) (1,034.8) (1,055.2) lease obligations Subordinated (80.7) (89.1) (96.1) (99.2) OFF BALANCE SHEET INSTRUMENTS Commitments to extend (50.2) (50.2) (16.8) (16.8) credit Foreign currency swaps 20.9 18.5 19.0 13.3 Interest rate swaps (0.2) (0.7) (0.1) (1.4) Note 11 - Segment Information The Company provides a diversified range of financing and leasing arrangements to customers and industries throughout the United States, the United Kingdom and, to a lesser extent, other countries. The Company's operations include three financial reporting segments: commercial aircraft financing, commercial equipment leasing and non-core businesses. The commercial aircraft financing segment provides customer financing services to MDC components, primarily Douglas Aircraft Company, and also provides financing for the acquisition of non-MDC aircraft. The commercial equipment leasing segment is principally involved in large financing and leasing transactions for a diversified range of equipment. Non- core businesses represent market segments in which the Company is no longer active. The non-core businesses consist primarily of the remaining assets of three business units: MD Bank, receivable inventory financing and real estate financing. MD Bank provided financing in the United Kingdom similar to that provided in the United States by the commercial equipment leasing segment. Receivable inventory financing provides financing to dealers of rent-to-own products. Real estate financing previously specialized in fixed rate, medium term commercial real estate loans. The Company's financing and leasing portfolio consists of the following at December 31: (Dollars in millions) 1993 1992 Commercial aircraft financing: MDC aircraft financing $ 1,035.1 56.5% $ 769.3 43.1% Other commercial aircraft 202.4 11.0 231.8 13.0 financing 1,237.5 67.5 1,001.1 56.1 Commercial equipment leasing: Transportation services 69.3 3.8 96.9 5.4 Transportation equipment 42.7 2.3 39.0 2.2 Trucking and warehousing 38.7 2.1 66.6 3.7 Other 271.6 14.8 354.9 19.9 422.3 23.0 557.4 31.2 Non-core businesses: Real estate 123.6 6.7 146.7 8.2 Furniture and home furnishings stores 31.0 1.7 43.2 2.4 Air transportation 5.1 0.3 5.5 0.3 Other 14.0 0.8 32.5 1.8 173.7 9.5 227.9 12.7 Total portfolio $1,833.5 100.0% $1,786.4 100.0% The single largest commercial aircraft financing customer accounted for $253.2 million (13.8% of total Company portfolio) and $120.9 million (6.8% of total Company portfolio) at December 31, 1993 and 1992. The five largest commercial aircraft financing customers accounted for $718.5 million (39.2% of total Company portfolio) and $445.1 million (24.9% of total Company portfolio) at December 31, 1993 and 1992. There were no significant concentrations by customer within the commercial equipment leasing and non-core businesses portfolios. The Company generally holds title to all leased equipment and generally has a perfected security interest in the assets financed through note and loan arrangements. Information about the Company's operations in its different financial reporting segments for the past three years is as follows: (Dollars in millions) 1993 1992 1991 Operating income: Commercial aircraft financing $ 107.4 $ 107.7 $ 125.6 Commercial equipment leasing 64.0 79.1 117.5 Non-core businesses 24.4 56.1 94.3 Corporate 2.7 11.8 4.9 $ 198.5 $ 254.7 $ 342.3 Income (loss) from continuing operations before income taxes and cumulative effect of accounting change: Commercial aircraft financing $ 26.3 $ 28.3 $ 50.7 Commercial equipment leasing 30.8 31.1 42.0 Non-core businesses (10.7) (11.4) (25.6) Corporate (5.6) - (9.9) $ 40.8 $ 48.0 $ 57.2 Identifiable assets at December 31: Commercial aircraft $ 1,369.0 $ 1,085.2 $ 1,106.7 financing Commercial equipment leasing 420.2 590.5 747.2 Non-core businesses 247.6 301.2 694.3 Corporate 26.4 22.1 34.1 $ 2,063.2 $ 1,999.0 $ 2,582.3 Depreciation expense - equipment under operating leases: Commercial aircraft financing $ 10.1 $ 5.9 $ 2.6 Commercial equipment leasing 28.2 31.8 39.4 Non-core businesses 0.7 11.1 18.0 $ 39.0 $ 48.8 $ 60.0 Equipment acquired for operating leases, at cost: Commercial aircraft financing $ 34.5 $ 53.5 $ 36.3 Commercial equipment leasing 22.9 18.2 30.3 Non-core businesses - 0.1 0.1 $ 57.4 $ 71.8 $ 66.7 The Company's operations are classified into two geographic segments, the United States and the United Kingdom. United Kingdom operations consist of MD Bank. Information about the Company's operations in its different geographic segments for the past three years is as follows: (Dollars in millions) 1993 1992 1991 Operating income: United States $ 194.1 $227.7 $305.7 United Kingdom 4.4 27.0 36.6 $ 198.5 $254.7 $342.3 Income (loss) from continuing operations before income taxes and cumulative effect of accounting change: United States $ 41.2 $ 41.0 $ 60.5 United Kingdom (0.4) 7.0 (3.3) $ 40.8 $ 48.0 $ 57.2 Identifiable assets at December 31: United States $ 2,033.7 $ 1,950.0 $ 2,347.8 United Kingdom 29.5 49.0 234.5 $ 2,063.2 $ 1,999.0 $ 2,582.3 Operating income from financing of assets located outside the United States by the Company's United States geographic segment totaled $20.9 million, $21.6 million and $18.1 million in 1993, 1992 and 1991, respectively. McDonnell Douglas Finance Corporation and Subsidiaries Schedule II - Amounts Receivable From Related Parties and Underwriters, Promoters, and Employees Other Than Related Parties Balance at (Dollars in End of millions) Deductions Year ------------------- ----------------- Balance at Amounts Beginning of Amounts Written Non Year Additions Collected Off Current Current 1993: Irish $ 22.3 $ - $ 22.3 $ - $ - $ - 1992: Irish $ 6.3 $ 22.3 $ 6.3 $ - $ 22.3 $ - 1991: Irish $ - $ 6.3 $ - $ - $ 6.3 $ - McDonnell Douglas Finance Corporation and Subsidiaries Schedule VIII - Valuation and Qualifying Accounts (Dollars in millions) Balance Charged Allowance for at to Balance Losses on Beginning Costs at end Financing of and Other Deductions of Receivables Year Expenses Year 1993 $ 37.4 $ 8.6 $ - $ (10.4) $ 35.6 1992 $ 46.7 $ 19.1 $ (1.0) $ (27.4) $ 37.4 1991 $ 61.6 $ 47.2 $ (5.4) $ (56.7) $ 46.7 The 1991 amount includes allowances that were reclassified in conjunction with the sale of substantially all of the assets of MDAL and BCG. Write-offs net of recoveries. McDonnell Douglas Finance Corporation and Subsidiaries Schedule IX - Short-Term Borrowings (Dollars in millions) Weighted Average Weighted Average Maximum Interest Amount Amount Average Balance Rate Outstanding Outstanding Interest Category of at End of at End During the During the Rate Aggregate Period of Period Period Period During the Short-term Period Borrowings Year ended December 31, 1993: MDC $ - - % $ 190.4 $ 23.0 4.33% MDFS - - 27.5 6.0 4.96 Banks - U.S. 202.6 4.35 203.0 72.8 4.66 Banks - U.K. - - 15.9 11.3 13.13 Year ended December 31, 1992: MDFS $9.5 5.94% $ 16.1 $ 6.4 5.35% Banks - U.S. 108.0 6.00 108.0 24.5 3.94 Banks - U.K. 16.0 12.44 124.1 87.3 14.68 Year ended December 31, 1991: Commercial $ - -% $ 44.0 $ 2.1 9.20% paper MDC - - 4.6 0.5 8.85 MDFS 4.4 5.83 22.9 1.0 8.02 Banks - U.S. - - 300.0 140.2 7.10 Banks - U.K. 158.0 12.25 289.3 197.2 12.34 Commercial paper was issued from time to time at various maturities and short-term notes payable to MDC are issued for 30 days. Computed by dividing the total of daily principal balances by the number of days in the year. Computed by dividing the actual interest expense by average short-term debt outstanding. The effective interest rate on short-term borrowings including the effect of fees was 5.97% in 1993, 12.38% in 1992 and 10.28% in 1991. Item 9.

Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure None. Part IV Item 14. Exhibits, Financial Statement Schedules, and Reports on Form 8-K Page Number in Form 10-K (a) 1. Financial Statements Report of Independent Auditors 33 Consolidated Balance Sheet at December 31, 1993 and 1992 34 Consolidated Statement of Income and Income Retained for Growth for the Years Ended December 31, 1993, 1992 and 1991 36 Consolidated Statement of Cash Flows for the Years Ended December 31, 1993, 1992 and 1991 38 Notes to Consolidated Financial Statements 40-55 2. Financial Statement Schedules Schedule II - Amounts Receivable From Related Parties and Underwriters, Promoters, and Employees Other Than Related Parties 56 Schedule VIII - Valuation and Qualifying Accounts 58 Schedule IX - Short-Term Borrowings 60 Schedules for which provision is made in the applicable regulation of the Securities and Exchange Commission (the "SEC"), except Schedules II, VIII and IX which are included herein, have been omitted because they are not required, or the information is set forth in the financial statements or notes thereto. 3. Exhibits 3.1 Restated Certificate of Incorporation of the Company dated June 29, 1989. 3.2 By-Laws of the Company, as amended to date. 4.4 Form of Indenture, dated as of April 1, 1983, between the Company and Bankers Trust Company, incorporated herein by reference to Exhibit 4(a) to Amendment No. 1 to the Form S-3 Registration Statement of the Company effective April 22, 1983. 4.5 Form of Subordinated Indenture, dated as of June 15, 1988, by and between the Company and Bankers Trust Company of California, N.A., as Subordinated Indenture Trustee, incorporated by reference to Exhibit 4(b) to the Form S-3 Registration Statement of the Company, as filed with the SEC on June 24, 1988. 4.6 Form of Indenture, dated as of April 15, 1987, incorporated herein by reference to Exhibit 4 to the Form S-3 Registration Statement of the Company as filed with the SEC on April 24, 1987. 4.7 Form of Series I Medium Term Note, incorporated herein by reference to Exhibit 4(b) to the Form S-3 Registration Statement of the Company effective April 22, 1983. 4.8 Form of Series II Medium Term Note, incorporated herein by reference to Exhibit 4(c) to the Form 8-K of the Company dated August 22, 1983. 4.9 Form of Series III Medium Term Note, incorporated herein by reference to Exhibit 4(b) to the Form S-3 Registration Statement of the Company effective June 17, 1985. 4.10 Form of Series IV Medium Term Note, incorporated herein by reference to Exhibit 4 to the Form S-3 Registration Statement of the Company effective June 17, 1985. 4.11 Form of Series V Medium Term Note, incorporated herein by reference to Exhibit 4 to the Form S-3 Registration Statement of the Company , as filed with the SEC on April 24, 1987. 4.12 Form of Series VI Medium Term Note, incorporated herein by reference to Exhibit 4 to the Form S-3 Registration Statement of the Company, as filed with the SEC on April 24, 1987. 4.13 Form of Series VII Medium Term Note, incorporated herein by reference to Exhibit 4 to the Form S-3 Registration Statement of the Company, as filed with the SEC on April 24, 1987. 4.14 Form of Series VIII Senior Medium Term Note, incorporated herein by reference to Exhibit 4(c) to the Form S-3 Registration Statement of the Company, as filed with the SEC on June 24, 1988. 4.15 Form of Series VIII Subordinated Medium Term Note, incorporated herein by reference to Exhibit 4(d) to the Form S-3 Registration Statement of the Company, as filed with the SEC on June 24, 1988. 4.16 Form of Series IX Senior Medium Term Note, incorporated herein by reference to Exhibit 4(c) to the Form S-3 Registration Statement of the Company, as filed with the SEC on October 4, 1989. 4.17 Form of Series IX Subordinated Medium Term Note, incorporated herein by reference to Exhibit 4(d) to the Form S-3 Registration Statement of the Company, as filed with the SEC on October 4, 1989. 4.18 Form of General Term Note(R), incorporated herein by reference to Exhibit 4(c) to Form 8-K of the Company dated May 26, 1993. Pursuant to Item 601 (b)(4)(iii) of Regulation S-K, the Company is not filing certain instruments with respect to its long-term debt since the total amount of securities currently provided for under each of such instruments does not exceed 10 percent of the total assets of the Company and its subsidiaries on a consolidated basis. The Company hereby agrees to furnish a copy of any such instrument to the SEC upon request. 10.1 Amended and Restated Operating Agreement among MDC, the Company and MDFS dated as of April 12, 1993. 10.2 Operating Agreement by and between the Company and MDFS effective as of February 8, 1989, incorporated herein by reference to Exhibit 10.3 to the Company's Form 10-K for the year ended December 31, 1989. 10.3 By-Laws of MDC as amended January 29, 1993, incorporated by reference from MDC's Exhibit 3.2 to its Form 8-K Report filed February 1, 1993 (file No. 1-3685). 10.4 Supplemental Guaranty Agreement by and between the Company and MDC, dated as of December 30, 1993. 10.5 Supplemental Guaranty Agreement by and between the Company and MDC, dated as of December 30, 1993. 12.1 Statement regarding computation of ratio of earnings to fixed charges. 23.1 Consent of Ernst & Young. (b) Reports on Form 8-K On February 3, 1994, the Company filed a current report on Form 8-K, which included the Company's Consolidated Balance Sheet at December 31, 1993 and 1992 and Consolidated Statement of Income and Income Retained for Growth for each of the years ended December 31, 1993, 1992 and 1991. Signatures Pursuant to the requirements of Section 13 or 15(d) 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. McDonnell Douglas Finance Corporation By /s/ Douglas E. Scudamore March 30, 1994 Vice President and Controller Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed by the following persons on behalf of the registrant and in the capacities and on the dates indicated. Signature Title Date /s/ Herbert J. Lanese Chairman March 30, 1994 /s/ George M. Rosen President and Director March 30, 1994 (Principal Executive Officer) /s/ Robert W. Owsley Sr. Vice President March 30, 1994 (Principal & Treasurer Financial Officer) /s/ Douglas E. Scudamore Vice President March 30, 1994 (Principal & Controller Accounting Officer) F. Mark Kuhlmann Director /s/ Thomas J. Lawlor, Jr. Director March 30, 1994 John F. McDonnell Director

Item 14. Exhibits, Financial Statement Schedules, and Reports on Form 8-K Page Number in Form 10-K (a) 1. Financial Statements Report of Independent Auditors 33 Consolidated Balance Sheet at December 31, 1993 and 1992 34 Consolidated Statement of Income and Income Retained for Growth for the Years Ended December 31, 1993, 1992 and 1991 36 Consolidated Statement of Cash Flows for the Years Ended December 31, 1993, 1992 and 1991 38 Notes to Consolidated Financial Statements 40-55 2. Financial Statement Schedules Schedule II - Amounts Receivable From Related Parties and Underwriters, Promoters, and Employees Other Than Related Parties 56 Schedule VIII - Valuation and Qualifying Accounts 58 Schedule IX - Short-Term Borrowings 60 Schedules for which provision is made in the applicable regulation of the Securities and Exchange Commission (the "SEC"), except Schedules II, VIII and IX which are included herein, have been omitted because they are not required, or the information is set forth in the financial statements or notes thereto. 3. Exhibits 3.1 Restated Certificate of Incorporation of the Company dated June 29, 1989. 3.2 By-Laws of the Company, as amended to date. 4.4 Form of Indenture, dated as of April 1, 1983, between the Company and Bankers Trust Company, incorporated herein by reference to Exhibit 4(a) to Amendment No. 1 to the Form S-3 Registration Statement of the Company effective April 22, 1983. 4.5 Form of Subordinated Indenture, dated as of June 15, 1988, by and between the Company and Bankers Trust Company of California, N.A., as Subordinated Indenture Trustee, incorporated by reference to Exhibit 4(b) to the Form S-3 Registration Statement of the Company, as filed with the SEC on June 24, 1988. 4.6 Form of Indenture, dated as of April 15, 1987, incorporated herein by reference to Exhibit 4 to the Form S-3 Registration Statement of the Company as filed with the SEC on April 24, 1987. 4.7 Form of Series I Medium Term Note, incorporated herein by reference to Exhibit 4(b) to the Form S-3 Registration Statement of the Company effective April 22, 1983. 4.8 Form of Series II Medium Term Note, incorporated herein by reference to Exhibit 4(c) to the Form 8-K of the Company dated August 22, 1983. 4.9 Form of Series III Medium Term Note, incorporated herein by reference to Exhibit 4(b) to the Form S-3 Registration Statement of the Company effective June 17, 1985. 4.10 Form of Series IV Medium Term Note, incorporated herein by reference to Exhibit 4 to the Form S-3 Registration Statement of the Company effective June 17, 1985. 4.11 Form of Series V Medium Term Note, incorporated herein by reference to Exhibit 4 to the Form S-3 Registration Statement of the Company , as filed with the SEC on April 24, 1987. 4.12 Form of Series VI Medium Term Note, incorporated herein by reference to Exhibit 4 to the Form S-3 Registration Statement of the Company, as filed with the SEC on April 24, 1987. 4.13 Form of Series VII Medium Term Note, incorporated herein by reference to Exhibit 4 to the Form S-3 Registration Statement of the Company, as filed with the SEC on April 24, 1987. 4.14 Form of Series VIII Senior Medium Term Note, incorporated herein by reference to Exhibit 4(c) to the Form S-3 Registration Statement of the Company, as filed with the SEC on June 24, 1988. 4.15 Form of Series VIII Subordinated Medium Term Note, incorporated herein by reference to Exhibit 4(d) to the Form S-3 Registration Statement of the Company, as filed with the SEC on June 24, 1988. 4.16 Form of Series IX Senior Medium Term Note, incorporated herein by reference to Exhibit 4(c) to the Form S-3 Registration Statement of the Company, as filed with the SEC on October 4, 1989. 4.17 Form of Series IX Subordinated Medium Term Note, incorporated herein by reference to Exhibit 4(d) to the Form S-3 Registration Statement of the Company, as filed with the SEC on October 4, 1989. 4.18 Form of General Term Note(R), incorporated herein by reference to Exhibit 4(c) to Form 8-K of the Company dated May 26, 1993. Pursuant to Item 601 (b)(4)(iii) of Regulation S-K, the Company is not filing certain instruments with respect to its long-term debt since the total amount of securities currently provided for under each of such instruments does not exceed 10 percent of the total assets of the Company and its subsidiaries on a consolidated basis. The Company hereby agrees to furnish a copy of any such instrument to the SEC upon request. 10.1 Amended and Restated Operating Agreement among MDC, the Company and MDFS dated as of April 12, 1993. 10.2 Operating Agreement by and between the Company and MDFS effective as of February 8, 1989, incorporated herein by reference to Exhibit 10.3 to the Company's Form 10-K for the year ended December 31, 1989. 10.3 By-Laws of MDC as amended January 29, 1993, incorporated by reference from MDC's Exhibit 3.2 to its Form 8-K Report filed February 1, 1993 (file No. 1-3685). 10.4 Supplemental Guaranty Agreement by and between the Company and MDC, dated as of December 30, 1993. 10.5 Supplemental Guaranty Agreement by and between the Company and MDC, dated as of December 30, 1993. 12.1 Statement regarding computation of ratio of earnings to fixed charges. 23.1 Consent of Ernst & Young. (b) Reports on Form 8-K On February 3, 1994, the Company filed a current report on Form 8-K, which included the Company's Consolidated Balance Sheet at December 31, 1993 and 1992 and Consolidated Statement of Income and Income Retained for Growth for each of the years ended December 31, 1993, 1992 and 1991. Signatures Pursuant to the requirements of Section 13 or 15(d) 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. McDonnell Douglas Finance Corporation By /s/ Douglas E. Scudamore March 30, 1994 Vice President and Controller Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed by the following persons on behalf of the registrant and in the capacities and on the dates indicated. Signature Title Date /s/ Herbert J. Lanese Chairman March 30, 1994 /s/ George M. Rosen President and Director March 30, 1994 (Principal Executive Officer) /s/ Robert W. Owsley Sr. Vice President March 30, 1994 (Principal & Treasurer Financial Officer) /s/ Douglas E. Scudamore Vice President March 30, 1994 (Principal & Controller Accounting Officer) F. Mark Kuhlmann Director /s/ Thomas J. Lawlor, Jr. Director March 30, 1994 John F. McDonnell Director

48305_1993.txt

48305

1993

ITEM 1. BUSINESS Honeywell Inc., a Delaware corporation incorporated in 1927, is a Minneapolis-based international controls corporation that supplies automation and control systems, components, software, products and services for homes and buildings, industry, and space and aviation. The purpose of the company is to develop and apply advanced-technology products, systems and services to conserve energy, improve productivity, protect the environment, enhance comfort and increase safety. Development and modification occur continuously in Honeywell's business as new or improved products and services are introduced, new markets are created or entered, distribution methods are revised, and products and services are discontinued. INDUSTRY SEGMENT INFORMATION Honeywell's products and services are classified by management into three industry segments: (i) Home and Building Control, (ii) Industrial Control, and (iii) Space and Aviation Control. Financial information relating to these industry segments is set forth in Part II, Item 6 at pages 9 and 10. HOME AND BUILDING CONTROL Honeywell's Home and Building Control business provides controls and systems for building automation, energy management, fire and security, as well as thermostats, air cleaners and other environmental controls and services for buildings and homes. Honeywell manufactures, markets and installs mechanical, pneumatic, electrical and electronic control products and systems for heating, ventilation and air conditioning in homes and commercial, industrial and public buildings. The systems, which may be generic or specifically designed for each application, may include panels and computers to centralize control of mechanical and electrical functions. Honeywell also produces building management systems for commercial buildings, burner and boiler controls, lighting controls, thermostatic radiator valves, pressure regulators for water systems, thermostats, actuators, humidistats, relays, contactors, transformers, air-quality products, and gas valves and ignition controls for homes and commercial buildings. Sales of these products are made directly to original equipment manufacturers, including manufacturers of heating and air conditioning equipment, through wholesalers, distributors, dealers, contractors, hardware stores and home-care centers, and also through the company's nationwide sales and service organization. Services provided include indoor air-quality services, central-station burglary and fire protection services for homes and commercial buildings, video surveillance, access control and entry management services for commercial buildings, contract maintenance services for commercial building mechanical and control systems, automated management of building operations for building complexes, energy management services, energy retrofit services and training. INDUSTRIAL CONTROL The Industrial Control business serves the automation and control needs of its worldwide industrial customers as a major supplier of products, systems and services ranging from sensors to integrated systems designed for specific applications. Honeywell's Industrial Control segment supplies process control systems and associated software and services to customers in the refining, petrochemical, bulk and fine chemical, pulp-and-paper, electric utility, food and consumer goods, pharmaceutical, metals and transportation markets, as well as other industries. Honeywell also designs and manufactures process instruments, process controllers, recorders, programmers, programmable controllers, transmitters and other field instruments. These products are sold as stand-alone products or integrated into systems. These products are generally used in indicating, recording and automatically controlling process variables. Under the MICRO SWITCH trademark, Honeywell manufactures solid-state sensors (position, pressure, airflow, temperature and current), sensor interface devices, manual controls, explosion-proof switches and precision snap-acting switches, as well as proximity, photoelectric and mercury switches and lighted/unlighted push-buttons. These products are used in industrial, commercial, business equipment, and in consumer, medical, automotive, aerospace and computer applications. Other products include solenoid valves, optoelectronic devices, fiber-optic systems and components, as well as microcircuits, sensors, transducers and high-accuracy, noncontact measurement and detection products for factory automation, quality inspection and robotics applications. Honeywell also furnishes services, including product and component testing, instrument maintenance, repair and calibration, contract services for industrial control equipment and third-party maintenance for CAD/CAM and other industrial control equipment, training, applications service and a range of customer support services. Services are generally sold directly to users on a monthly or annual contract basis. Products are customarily sold by Honeywell on a delivered, supervised or installed basis directly to end users, to equipment manufacturers and contractors, or through third-party channels such as distributors and systems houses. SPACE AND AVIATION CONTROL Honeywell's Space and Aviation Control business supplies avionics for the commercial, military and space markets. The company designs, manufactures, services and markets a variety of sophisticated electronic control systems and components that are used on commercial and business aircraft, military aircraft and spacecraft. Products manufactured for aircraft use include ring laser gyro-based inertial reference systems, navigation and guidance systems, flight control systems, flight management systems, inertial sensors, air data computers, radar altimeters, automatic test equipment, cockpit display systems and other communication and flight instrumentation. Honeywell products and services have been involved in every major U.S. space mission since the mid-1960s. Products include guidance systems for launch and re-entry vehicles, flight and engine control systems for manned spacecraft, precision components for strategic missiles and on-board data processing. Other products include spacecraft attitude and positioning systems, and precision pointing and isolation systems. Space and Aviation Control products are sold through an integrated international marketing organization, with customer service centers providing international service for commercial and business aviation users. OTHER PRODUCTS Products and services not included in the foregoing segment information are described below. Honeywell provides systems analysis and applied research and development on systems and products, including space systems technology, application software, sensors and artificial intelligence. The company is involved in the design and development of gallium arsenide integrated circuits and the development of very high-speed integrated circuit (VHSIC) technology. Solid State Electronics Center, a semiconductor facility in Minnesota, designs and manufactures integrated circuits for Honeywell and its government customers. Honeywell, through its Aerospace and Defense Group in Germany, develops, markets and sells to European countries, among other things, military avionics and electro-optic devices for flight control and nautical systems, including sonar transducers and echo sounders. GENERAL INFORMATION RAW MATERIALS Honeywell experienced no significant or unusual problems in the purchase of raw materials and commodities in 1993. Although it is impossible to predict what effects shortages or price increases may have in the future, at present management has no reason to believe a shortage of raw materials will cause any material adverse impact during 1994. PATENTS, TRADEMARKS, LICENSES AND DISTRIBUTION RIGHTS Honeywell owns, or is licensed under, a large number of patents, patent applications and trademarks acquired over a period of many years, which relate to many of its products or improvements thereon and are of importance to its business. From time to time, new patents and trademarks are obtained and patent and trademark licenses and rights are acquired from others. In addition, Honeywell has distribution rights of varying terms in a number of products and services produced by other companies. In the judgment of management, such rights are adequate for the conduct of the business being done by Honeywell. See Item 3 at page 7 for information concerning litigation in which Honeywell is involved relating to patents. SEASONALITY Although Honeywell's business is not seasonal in the traditional sense, revenues and earnings have tended to concentrate to some degree in the fourth quarter of each calendar year, reflecting the tendency of customers to increase ordering and spending for capital goods late in the year. MAJOR CUSTOMER Approximately 4 percent of Honeywell's total sales for 1993 was attributable to sales of products and services to the United States government as a prime contractor or subcontractor, the majority of which are described under the heading "Space and Aviation Control" on page 2. Such business is significant because of its volume and its contribution to Honeywell's technical capabilities, but Honeywell's dependence upon individual programs is minimized by the large variety of products and services it provides. Contracts and subcontracts for all of such sales are subject to the standard provisions permitting the government to terminate for convenience or default. BACKLOG The total dollar amount of backlog of Honeywell's orders believed to be firm was approximately $3,128 million at December 31, 1993, and $3,603 million at December 31, 1992. All but approximately $481 million of the 1993 backlog is expected to be delivered within the current fiscal year. Backlog is not a reliable indicator of Honeywell's future revenues because a substantial portion of backlog represents the value of orders that are cancelable at the customer's option. COMPETITION Honeywell is subject to active competition in substantially all products and services. Competitors generally are engaged in business on a nationwide or an international scale. Honeywell is the largest producer of control systems and products used to regulate and control heating and air conditioning in commercial buildings, and of systems to control industrial processes worldwide. Honeywell is also a leading supplier of commercial aviation, space and avionics systems. Honeywell's automation and control businesses compete worldwide, supported by a strong distribution network with manufacturing and/or marketing capabilities, for at least a portion of these businesses, in 95 countries. Competitive conditions vary widely among the thousands of products and services provided by Honeywell, and vary as well from country to country. Markets, customers and competitors are becoming more international in outlook. In those areas of environmental and industrial components and controls where sales are primarily to equipment manufacturers, price/performance is probably the most significant competitive factor, but customer service and applied technology are also important. Competition is increasingly being applied to government procurements to improve price and product performance. In service businesses, quality, reliability and promptness of service are the most important competitive factors. Service must be offered from many areas because of the localized nature of such business. In engineering, construction, consulting and research activities, technological capability and a record of proven reliability are generally the principal competitive factors. Although in a small number of highly specialized products and services Honeywell may have relatively few significant competitors, in most markets there are many competitors. RESEARCH AND DEVELOPMENT During 1993 Honeywell spent approximately $742.2 million on research and development activities, including $404.8 million in customer-funded research, relating to the development of new products or services, or the improvement of existing products or services. Honeywell spent $703.1 million in 1992 and $674.2 million in 1991 on research and development activities, including $390.5 million and $373.5 million, respectively, in customer-funded research. No single product or service accounted for a material portion of Honeywell's research and development expenditures. ENVIRONMENTAL PROTECTION Compliance with current federal, state and local provisions regulating the discharge of materials into the environment, or otherwise relating to the protection of the environment, has not had, and in the opinion of management will not have, a material effect upon Honeywell's capital expenditures, earnings or competitive position. See Item 7 at page 13 for further information concerning environmental matters. EMPLOYEES Honeywell employed approximately 52,300 persons in total operations as of December 31, 1993. GEOGRAPHIC AREAS Honeywell engages in material operations in foreign countries. A large majority of Honeywell's foreign business is in Western Europe, Canada and the Asian Pacific Rim. Although there are risks attendant to foreign operations, such as potential nationalization of facilities, currency fluctuation and restrictions on movement of funds, Honeywell has taken action reasonably calculated to mitigate such risks. Financial information related to geographic areas is included in Note 18 to the financial statements in Part II, Item 8 at page 36. EXECUTIVE OFFICERS OF THE REGISTRANT ITEM 2.

ITEM 2. PROPERTIES Honeywell and its subsidiaries operate facilities worldwide comprising approximately 20,340,000 square feet of space for use as manufacturing, office and warehouse space, of which approximately 12,438,600 square feet is owned and approximately 7,901,400 square feet is leased. The facilities used by Honeywell are adequate and suitable for the purposes they serve. Facilities allocated for corporate use in the United States, including sales offices, comprise approximately 3,379,000 square feet of space, of which approximately 1,512,200 square feet is owned and approximately 1,866,800 square feet is leased. These figures include Honeywell's principal executive offices in Minneapolis, Minnesota which comprise approximately 957,400 square feet, all of which is owned. A summary of properties held by each segment of Honeywell is set forth below, showing major plants, their location, size and type of holding. The descriptions include approximately 232,400 square feet of space owned or leased by Honeywell's operations in the United States that has been leased or subleased to third parties. In addition, approximately 4,628,100 square feet of previously leased space in the United States is under assignment to third parties (including 2,851,700 square feet, 451,400 square feet and 102,600 square feet which is assigned to Alliant Techsystems Inc., Federal Systems Inc. and Bull HN Information Systems, Inc., respectively, all of which were formerly affiliates of the company). HOME AND BUILDING CONTROL Home and Building Control occupies approximately 2,402,000 square feet of space for operations in the United States, of which approximately 1,887,900 square feet is owned and approximately 514,100 square feet is leased. Outside the United States, Home and Building Control operations occupy approximately 3,204,900 square feet, of which approximately 1,670,100 square feet is owned and approximately 1,534,800 square feet is leased. Principal facilities operated outside the United States are located in Canada, Germany, The Netherlands, the United Kingdom and Australia. Facilities in the United States comprising 300,000 square feet or more are listed below. INDUSTRIAL CONTROL Industrial Control occupies approximately 3,320,300 square feet of space for operations in the United States, of which approximately 2,233,200 square feet is owned and approximately 1,087,100 square feet is leased. Outside the United States, Industrial Control operations occupy approximately 2,228,500 square feet, of which approximately 862,200 square feet is owned and approximately 1,366,300 square feet is leased. Principal facilities operated outside the United States are located in the United Kingdom, Australia, Canada, Switzerland, France, Germany, Belgium and The Netherlands. Facilities in the United States comprising 300,000 square feet or more are listed below. SPACE AND AVIATION CONTROL Space and Aviation Control occupies approximately 5,244,500 square feet of space for operations in the United States, of which approximately 3,819,100 square feet is owned and approximately 1,425,400 square feet is leased. Outside the United States, Space and Aviation Control operations occupy approximately 540,300 square feet, of which approximately 433,400 square feet is owned and approximately 106,900 square feet is leased. Principal facilities operated outside the United States are located in Canada, the United Kingdom and Singapore. Facilities in the United States comprising 300,000 square feet or more are listed below. OTHER Honeywell operations not included in the foregoing segment information occupy approximately 20,500 square feet of space in areas outside the United States, all of which is owned. ITEM 3.

ITEM 3. LEGAL PROCEEDINGS On March 13, 1990, Litton Systems Inc. filed suit against Honeywell in U.S. District Court, Central District of California, alleging Honeywell patent infringement relating to the process used by Honeywell to coat mirrors incorporated in its ring laser gyroscopes; attempted monopolization by Honeywell of certain alleged markets for products containing ring laser gyroscopes; and intentional interference by Honeywell with Litton's prospective advantage in European markets and with its contractual relationships with Ojai Research, Inc., a California corporation. Honeywell has filed counterclaims against Litton alleging, among other things, violations by Litton of various antitrust laws including attempted monopolization of markets for inertial systems and interference with Honeywell's relationships with suppliers. The trial of the patent infringement and intentional interference claims commenced June 4, 1993, and on August 31, 1993, a federal court jury in U.S. District Court in Los Angeles returned a verdict against Honeywell on each of these claims and awarded damages in the amount of $1.2 billion and concluded that the patent infringement was willful. Honeywell believes the verdict is unsupported by the facts; that the Litton patent is invalid; and that Honeywell's process differs from Litton's. The judge in the case held a hearing November 22, 1993, on various issues including, among others, Honeywell's claims that the patent was improperly obtained due to alleged "inequitable conduct" on the part of Litton and Honeywell's other legal and equitable defenses. The court has not yet entered a judgment. The trial will conclude when the court has resolved legal issues that could alter or eliminate the jury verdict. Honeywell will evaluate the outcome of the trial, including appealing any significant judgment against the company. No trial date has been set for the antitrust claims of Litton and Honeywell. The court has yet to rule on significant, complex and interrelated issues that could alter or eliminate the jury verdict; therefore, Honeywell and its counsel have determined that it is not possible to estimate the amount of damages, if any, that may ultimately be incurred. As a result, no provision has been made in the financial statements with respect to this contingent liability. Honeywell is a party to other various claims, legal and governmental proceedings, including claims relating to previously reported environmental matters. It is the opinion of management that losses in connection with these matters and the resolution of the environmental claims will not have a material effect on income. ITEM 4.

ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS No matters were submitted to a vote of security holders during the fourth quarter of 1993. PART II ITEM 5.

ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS The principal U.S. market for Honeywell's common stock is The New York Stock Exchange. The high and low sales prices for the stock as reported by the consolidated transaction reporting system, of the two most recent fiscal years is set forth in Part II, Item 8 at page 41. In November 1990, as part of Honeywell's program to enhance shareholder value, the company authorized the repurchase of up to 4 million shares of its common stock in open market transactions. In 1991, Honeywell repurchased 4 million shares under this program. In November 1991, the Board of Directors authorized the repurchase of additional shares during the next five years for an amount not to exceed $600 million. In 1991, 1992 and 1993, $3 million, $189 million and $240 million, respectively, of share repurchases were made under this program. Stockholders of record on March 1, 1994 totaled 33,159, excluding individual participants in security position listings. ITEM 6.

ITEM 6. SELECTED FINANCIAL DATA HONEYWELL INC. AND SUBSIDIARIES (DOLLARS AND SHARES IN MILLIONS EXCEPT PER SHARE AMOUNTS) (DOLLARS AND SHARES IN MILLIONS EXCEPT PER SHARE AMOUNTS) ITEM 7.

ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS OPERATIONS SALES Honeywell's 1993 sales were $5.963 billion, compared with $6.223 billion in 1992 and $6.193 billion in 1991. Both U.S. and international sales declined from 1992. U.S. sales of $3.895 billion were down 3 percent primarily due to a continuing cyclical downturn in the Space and Aviation Control commercial aviation market. International sales, which represent 35 percent of total sales, declined 6 percent from 1992 to $2.068 billion. The international sales decline was the result of negative currency effects as the dollar strengthened an average of 9 percent against local currencies in countries where Honeywell does business. This decline was partially offset by positive sales growth of 4 percent measured in local currency. U.S. export sales, including exports to foreign affiliates, were $769 million in 1993, compared with $830 million in 1992 and $808 million in 1991. COST OF SALES Cost of sales was $4.020 billion in 1993, or 67.4 percent of sales, compared with $4.195 billion (67.4 percent) in 1992 and $4.185 billion (67.6 percent) in 1991. Cost as a percentage of sales remained flat for 1993 during a period of tough competitive markets and stagnation for a majority of economic sectors. Honeywell remains committed to efforts to reduce operating costs and improve margins. RESEARCH AND DEVELOPMENT Honeywell spent $337 million, or 5.7 percent of sales, on research and development in 1993, compared with $313 million (5.0 percent) in 1992 and $301 million (4.9 percent) in 1991. Honeywell also received $405 million in funds for customer-funded research and development in 1993, compared with $390 million in 1992 and $373 million in 1991. The higher R&D percentage in 1993 reflects significant investments in next-generation technologies. The company expects to return to approximately the same rate of R&D spending in 1994 as in 1992. OTHER EXPENSES AND INCOME Selling, general and administrative expenses were $1.076 billion in 1993, or 18.0 percent of sales, compared with $1.197 billion (19.2 percent) in 1992 and $1.151 billion (18.6 percent) in 1991. Excluding royalties from autofocus licensing agreements (see Note 3 to Financial Statements on page 25), the percent of sales would have been 18.6 percent and 19.5 percent in 1993 and 1992, respectively. The higher percentage in 1992 was due to increased international selling expenses. On April 16, 1993, Honeywell announced the settlement of its lawsuits against the Unisys Corporation and other parties in connection with Honeywell's 1986 purchase of the Sperry Aerospace Group. Honeywell received $70 million in cash and notes, and recorded a gain of $22 million, or $14 million ($0.10 per share) after income taxes, to offset previously incurred costs associated with the matter (see Note 3 to Financial Statements on page 25). In April 1987, Honeywell filed suit against Minolta Camera Co. alleging that Minolta autofocus cameras infringe Honeywell patents. Subsequently, Honeywell filed similar suits against other major camera manufacturers that employ autofocus technology. In March 1992, following a jury award in Honeywell's favor, Minolta agreed to pay Honeywell $127 million in settlement of the damages and Honeywell's claims for interest and legal fees. In addition to the Minolta settlement, agreements were reached with various camera manufacturers for their use of Honeywell's patented automatic focus camera technology. The total of all autofocus settlements recorded, after associated expenses, was $10 million, or $6 million ($0.05 per share) after income taxes, in 1993 and $288 million, or $171 million ($1.24 per share) after income taxes, in 1992. The pre-tax gains from litigation settlements are included in litigation settlements and special charges on the income statement. Also included in litigation settlements and special charges are provisions for special charges of $51 million, or $29 million ($0.22 per share) after income taxes, in 1993 and $128 million, or $85 million ($0.62 per share) after income taxes, in 1992. The 1993 charges were the result of implementing programs to improve productivity and reduce costs in each of Honeywell's business segments. Charges in 1992 were made to appropriately size the Space and Aviation Control business segment to current market conditions and to reposition the Home and Building Control and Industrial Control business segments to capitalize on emerging market opportunities. The special charges include provisions for work-force reductions, worldwide facilities consolidation and organizational changes in both 1993 and 1992. Net interest expense was $51 million in 1993, $59 million in 1992 and $61 million in 1991. In 1992, Honeywell reduced total debt by $108 million, including redemption of high-coupon, long-term debt. Earnings of companies owned 20 percent to 50 percent (primarily Yamatake-Honeywell), which are accounted for using the equity method, were $18 million in 1993, $16 million in 1992 and $15 million in 1991. INCOME TAXES The provision for income taxes was $156 million in 1993, compared with $235 million in 1992 and $178 million in 1991. The enactment by Congress of the Omnibus Budget Reconciliation Act of 1993, which raised the U.S. federal statutory income tax rate for corporations from 34 percent to 35 percent retroactive to January 1, 1993, did not have a material impact on the 1993 provision but did result in the recognition of a one-time gain of $9 million ($0.07 per share) in 1993 from the revaluation of deferred tax assets. Further information about income taxes is provided in Note 4 to Financial Statements on page 25. EXTRAORDINARY ITEM In 1992, Honeywell recorded an extraordinary loss of $14 million, or $9 million ($0.06 per share) after income taxes, as a result of early debt redemptions that required the payment of premiums and the recognition of unamortized discounts and deferred costs. These redemptions were undertaken as part of Honeywell's efforts to reduce its debt and manage its interest-rate exposure. ACCOUNTING CHANGES In 1992, Honeywell adopted three new Statements of Financial Accounting Standards. Statement of Financial Accounting Standards No. 106 (SFAS 106), "Employers' Accounting for Postretirement Benefits Other Than Pensions," required recognition of the expected cost of providing postretirement benefits over the time employees earn these benefits. Before adopting SFAS 106, Honeywell recognized the costs of providing these benefits on a pay-as-you-go basis by expensing the cost in the year the benefit was provided. The cumulative effect of adopting SFAS 106 at January 1, 1992, was a charge to income of $244 million, or $151 million ($1.09 per share) after income taxes. The operating impact of adopting SFAS 106 for 1992 was additional expense of $16 million, or $11 million ($0.08 per share) after income taxes. Statement of Financial Accounting Standards No. 109 (SFAS 109), "Accounting for Income Taxes," allowed consideration of future events in assessing the likelihood that tax benefits will be realized in future tax returns. The cumulative effect of adopting SFAS 109 at January 1, 1992, was an increase in income of $31 million ($0.23 per share) resulting from Honeywell's ability to recognize additional deferred tax assets. Statement of Financial Accounting Standards No. 112 (SFAS 112), "Employers' Accounting for Postemployment Benefits," required that the estimated cost of providing postemployment benefits be recognized on an accrual basis. The cumulative effect of adopting SFAS 112 at January 1, 1992, was a charge to income of $40 million, or $25 million ($0.18 per share) after income taxes. The operating impact of adopting SFAS 112 for 1992 was additional expense of $4 million, or $2 million ($0.02 per share) after income taxes. NET INCOME Honeywell's net income was $322 million ($2.40 per share) in 1993, compared with $247 million ($1.78 per share) in 1992 and $331 million ($2.35 per share) in 1991. Net income in 1993 includes an after-tax gain from litigation settlements, after associated expenses, of $20 million ($0.15 per share); an after-tax provision for special charges of $29 million ($0.22 per share); and a gain of $9 million ($0.07 per share) from the revaluation of deferred tax assets. Net income in 1992 includes an after-tax gain from litigation settlements, after associated expenses, of $171 million ($1.24 per share); an after-tax provision for special charges of $85 million ($0.62 per share); an extraordinary loss after income taxes of $9 million ($0.06 per share) from the early redemption of long-term debt; and an after-tax reduction of $145 million ($1.04 per share) for the cumulative effect of accounting changes. Net income in 1992 also included the operating impact of SFAS 106 and SFAS 112, or an after-tax expense of $13 million ($0.10 per share). RETURN ON EQUITY AND INVESTMENT Return on equity was 18.4 percent in 1993, 13.8 percent in 1992 and 19.2 percent in 1991. Return on investment was 14.6 percent in 1993, 11.8 percent in 1992 and 15.4 percent in 1991. The adoption of SFAS 106 and SFAS 112 significantly reduced ROE and ROI in 1992. CURRENCY The U.S. dollar strengthened an average of 9 percent in 1993 compared with 1992 in relation to the principal foreign currencies in countries where Honeywell products are sold. A stronger dollar has a negative effect on international results because foreign-exchange-denominated profits translate into fewer U.S. dollars of profit; a weaker dollar has a positive translation effect. INFLATION Highly competitive market conditions and a relatively stagnant economy minimized inflation's impact on the selling prices of Honeywell's products and the cost of its purchased materials. Productivity improvements and cost-reduction programs largely offset the effects of inflation on other costs and expenses. EMPLOYMENT Honeywell employed 52,300 people worldwide at year-end 1993, compared with 55,400 people in 1992 and 58,200 people in 1991. Approximately 33,200 employees work in the United States, with 19,100 employed outside the country, primarily in Europe. Total compensation and benefits in 1993 were $2.7 billion, or 49 percent of total costs and expenses. Sales per employee were $110,900 in 1993, compared with $109,600 in 1992 and $106,100 in 1991. ENVIRONMENTAL MATTERS Honeywell is committed to protecting the environment, a commitment evidenced by both Honeywell's products and Honeywell's manufacturing operations. Honeywell's manufacturing sites generate both hazardous and nonhazardous wastes, the treatment, storage, transportation and disposal of which are subject to various local, state and national laws relating to protection of the environment. Honeywell is in varying stages of investigation or remediation of potential, alleged or acknowledged contamination at current or previously owned or operated sites and at off-site locations where its wastes were taken for treatment or disposal. In connection with the cleanup of various off-site locations, Honeywell, along with a large number of other entities, has been designated a potentially responsible party (PRP) by the U.S. Environmental Protection Agency under the Comprehensive Environmental Response, Compensation and Liability Act or by state agencies under similar state laws (Superfund), which potentially subjects PRPs to joint and several liability for the costs of such cleanup. In addition, Honeywell is incurring costs relating to environmental remediation pursuant to the federal Resource Conservation and Recovery Act. Based on Honeywell's assessment of the costs associated with its environmental responsibilities, compliance with federal, state and local laws regulating the discharge of materials into the environment, or otherwise relating to the protection of the environment, has not had, and in the opinion of Honeywell management, will not have a material effect on Honeywell's financial position, results of operations, capital expenditures or competitive position. Honeywell's opinion with regard to Superfund matters is based on its assessment of the predicted investigation, remediation and associated costs, its expected share of those costs and the availability of legal defenses. Honeywell's policy is to record environmental liabilities when loss amounts are probable and reasonably estimable. DISCUSSION AND ANALYSIS BY SEGMENT HOME AND BUILDING CONTROL Sales in Home and Building Control were $2.424 billion in 1993, compared with $2.394 billion in 1992 and $2.249 billion in 1991. Sales in 1993 were up slightly as stronger U.S. sales were mostly offset by a stronger U.S. dollar and economic weakness in international markets, driven in large part by the continuing recession in Europe. Home Control gained market share in the United States through new product introductions and greater penetration of the OEM market. TotalHome-R- was introduced outside the United States in 1993. The acquisition of Enviracaire in December 1992 also contributed to the improvement in U.S. sales. Building Control experienced strong U.S. interest in its comprehensive retrofit and service solutions for schools and other institutions. The U.S. economy continues to show signs of improvement in these markets, while international market conditions have continued to deteriorate. Economic conditions may continue to impede new construction markets in 1994; however, Home and Building Control's large worldwide installed product base and market strategies should continue to support continued sales growth, given that retrofit and service revenues account for the largest portion of business. The sales increase in 1992 reflected worldwide improvement for both Home Control and Building Control despite weak commercial construction markets and erratic housing markets. Home Control experienced increased market penetration with original equipment manufacturers and retailers, and achieved growth with new product introductions. Building Control made market share gains in small-and medium-sized commercial buildings, and there was solid growth in vertical markets such as schools and health-care facilities in the United States. Home and Building Control operating profit was $233 million in 1993, compared with $193 million in 1992 and $229 million in 1991. Excluding the impact of special charges, operating profit increased slightly in 1993 despite the deepening European recession, a stronger U.S. dollar, unfavorable intra-European currency fluctuations, additional costs associated with streamlining the U.S. field organization, and costs associated with introducing the new EXCEL 5000TM building automation platform in the United States. Operating profit included special charges of $10 million for implementation of programs to improve productivity and competitiveness. Operating profit in 1992 included special charges of $43 million for costs associated with worldwide facilities consolidation, organizational changes and work-force reductions incurred to capitalize on emerging market opportunities. Excluding these added costs, operating profit increased over 1991, paced by strong performance in Home Control in the United States. Orders improved modestly in 1993 as stronger orders in the United States for both Home Control and Building Control offset international weakness and a stronger U.S. dollar. The backlog of orders showed a slight increase for 1993. INDUSTRIAL CONTROL Industrial Control sales were $1.692 billion in 1993, compared with $1.744 billion in 1992 and $1.627 billion in 1991. Sales declined slightly in 1993 due to negative currency translation trends and the divestiture of the Keyboard Division, which was sold to Key Tronic Corporation in the third quarter of 1993. Excluding these items, both Industrial Automation and Control and Control Components grew at moderate rates despite weak market conditions in the United States, Europe and Latin America. Industrial Automation and Control reported solid penetration gains in targeted worldwide markets despite a weak capital spending environment in the United States and Europe. Demand for industrial systems increased in the Middle East and Asia Pacific. Sales of field instruments showed a strong increase due to broad acceptance of Industrial Automation and Control's smart field products. Control Components experienced significant growth in solid state sensors for on-board automotive and information technology and appliance market segments as demand for durable goods improved. The company expects a slight increase in 1994 Industrial Control sales despite a slow economic environment worldwide. Industrial Control sales for 1992 increased moderately, despite the deferral of industrial automation systems purchases in the United States due to the inherent uncertainty of the economy and worldwide weakness in durable goods markets. There was modest growth in Industrial Automation and Control sales in the United States as increased sales of services and measurement and control products offset weakness in automation systems. Control Component sales increased moderately in 1992, benefiting from the trend by equipment manufacturers to increase sensor utilization for quality and productivity improvements. Industrial Control operating profit was $190 million in 1993, $157 million in 1992 and $224 million in 1991. Excluding the impact of special charges, operating profit showed a slight increase in 1993. Profits were affected by the weak capital spending environment in the United States and Europe, strength of the U.S. dollar and aggressive investments in new technologies, with R&D spending up 26 percent over 1992. Operating profit included special charges of $9 million for implementation of programs to improve productivity and competitiveness. Operating profit in 1992 included special charges of $39 million for costs associated with worldwide facilities consolidation, organizational changes and work-force reductions to capitalize on emerging market opportunities. Before special charges, operating profit was down in 1992 as a result of lower profit margins reflecting a changing product mix in Industrial Automation and Control. In 1993, Industrial Control orders declined slightly, due to negative currency translation trends. Excluding this effect, Industrial Automation and Control orders increased modestly as a result of solid showings in Asia Pacific and Latin America. Control Components orders declined slightly due to the divestiture of the Keyboard Division. Micro Switch orders were strong in North America and Asia Pacific. The backlog of orders was down modestly for the year. SPACE AND AVIATION CONTROL Sales in Space and Aviation Control were $1.675 billion in 1993, compared with $1.933 billion in 1992 and $2.132 billion in 1991. Sales in 1993 continued to decline as anticipated as a result of the continuing cyclical decline in commercial aircraft production, weak demand in the business jet market and decreased spending in the military market. We expect these trends to continue in 1994. Anticipated growth in 1992 did not materialize, and 1992 sales for commercial flight systems declined sharply as financial pressures caused airlines to defer, and in some instances cancel, aircraft and spare parts purchases. As expected, military markets were weak as a result of declining defense spending and flat NASA funding. Space and Aviation Control operating profit was $148 million in 1993, compared with $176 million in 1992 and $226 million in 1991. Operating profit declined in 1993 due to the sharp volume decline in sales of commercial flight systems and significant investments in next-generation avionics. Operating profit included special charges of $7 million for implementation of programs to improve productivity and competitiveness. Because of continued weak market conditions, revenue and operating profit are expected to decline again in 1994. Operating profit in 1992 included special charges of $35 million for costs associated with facilities consolidation, organizational changes and severance pay incurred to appropriately size operations to current and anticipated market conditions. Excluding these special charges, operating profit was down moderately in 1992 as a sharp volume decline in the commercial aviation business was partially offset by an improved cost structure and a favorable sales mix in military avionics. Space and Aviation orders were down in 1993 as commercial flight systems and military avionics showed sharp declines. Space systems orders increased moderately. The backlog of orders declined sharply from 1992 levels. OTHER Sales from other operations were $172 million in 1993, $152 million in 1992 and $185 million in 1991. These sales included the activities of various business units, such as the Solid State Electronics Center and the Systems and Research Center, which do not correspond with Honeywell's primary business segments. These operations incurred operating losses of $2 million in 1993, $9 million in 1992 and $3 million in 1991. The 1993 loss included special charges of $16 million for organizational changes and work-force reductions. The 1992 loss included special charges of $3 million that were also associated with organizational changes and work-force reductions. FINANCIAL POSITION FINANCIAL CONDITION At year-end 1993, Honeywell's capital structure comprised $188 million of short-term debt, $504 million of long-term debt and $1.773 billion of stockholders' equity. The ratio of debt to total capital was 28 percent and remained unchanged from year-end 1992. Honeywell's debt-to-total capital policy range is 30 to 40 percent. Honeywell managed its capital structure during 1993 at or below the low end of this range. Total debt decreased $9 million during 1993 to $692 million. Stockholders' equity decreased $17 million in 1993. Contributing to the decrease was a $209 million increase in treasury stock. Other changes in stockholders' equity included an increase in retained earnings of $322 million from net income, offset by dividends of $122 million; a $3 million decrease in the accumulated foreign currency translation; and a $13 million decrease from the recognition of a pension liability adjustment under Statement of Financial Accounting Standards No. 87, "Employers' Accounting for Pensions," (see Note 16 to Financial Statements on page 33). Several events and trends that affected Honeywell's financial position are discussed below. CASH GENERATION In 1993, $475 million of cash was generated from operating activities, compared with $532 million in 1992 and $489 million in 1991. Included in 1992 operating cash flow was $194 million, net of expenses and taxes, from autofocus settlements. In 1993, cash generated from investing and financing activities included $47 million of proceeds from the sale of assets, $20 million from a reduction of investment in Sperry Aerospace Group and $18 million of proceeds from employee stock plans. These funds were primarily used to support $232 million of capital expenditures, $14 million of acquisitions, $122 million of dividend payments, $241 million of share repurchases and $7 million of long-term debt repayments. Cash balances decreased $100 million in 1993. WORKING CAPITAL Cash used for increases in the portion of working capital consisting of trade and long-term receivables and inventories, offset by accounts payable and customer advances, was $2 million in 1993. This portion of working capital as a percentage of sales was 28 percent, compared with 26 percent in 1992. Trade receivables sold at year-end 1993 were $38 million, an increase of $22 million in 1993. CAPITAL EXPENDITURES AND ACQUISITIONS Capital expenditures for property, plant and equipment in 1993 were $232 million, compared with $244 million in 1992 and $240 million in 1991. The 1993 depreciation charges were $235 million. Honeywell continues to invest at levels believed to be adequate to maintain its technological position in areas providing long-term returns. During 1993, Honeywell invested $14 million in complementary business acquisitions. SHARE REPURCHASE PLANS In November 1990, the board of directors authorized a 4 million share repurchase program. This program was completed in 1991. In November 1991, the board of directors authorized a five-year program to purchase up to $600 million of Honeywell shares. Under terms of this authorization, which expires December 31, 1996, the program may be altered depending on economic conditions, share prices and cash-flow availability. Honeywell repurchased $3 million of shares in 1991, $189 million of shares in 1992 and $240 million of shares in 1993, and has $168 million remaining under this authorization. At year-end 1993, Honeywell had 188 million shares issued, 132 million shares outstanding and 33,382 stockholders of record. At year-end 1992, Honeywell had 188 million shares issued, 137 million shares outstanding and 34,571 stockholders of record. DIVIDENDS In November 1992, the board of directors approved an 8 percent increase in the regular annual dividend to $0.89 per share, from $0.825 per share, effective in the fourth quarter 1992. In November 1993, the board of directors approved an additional 8 percent increase in the regular annual dividend to $0.96 per share effective in the fourth quarter 1993. Honeywell paid $0.9075 per share in dividends in 1993, compared with $0.84125 in 1992 and $0.76875 in 1991. Honeywell has paid a quarterly dividend since 1932 and has increased the annual payout per share in each of the last 18 years. EMPLOYEE STOCK PROGRAM Honeywell contributed 643,913 shares of Honeywell common stock to employees under its U.S. employee stock match savings plans in 1993. The number of shares contributed under this program depends on employee savings levels and company performance. PENSION CONTRIBUTIONS Cash contributions to Honeywell's Retirement Plan for U.S. non-union employees were $105 million in 1993, $79 million in 1992 and $61 million in 1991. Cash contributions to the Pension Plan for U.S. union employees were $36 million in 1993, $27 million in 1992 and $27 million in 1991. TAXES In 1993, taxes paid were $92 million. Accrued income taxes and related interest decreased $18 million during 1993. FUNDING SPECIAL CHARGES During 1993 and 1992, the company established reserves for productivity initiatives to strengthen the company's competitiveness. Future cash flows from operating activities are expected to be sufficient to fund these accrued costs. LIQUIDITY Short-term debt at year-end 1993 was $188 million, consisting of $181 million of commercial paper and $7 million of notes payable and current maturities of long-term debt. Short-term debt at year-end 1992 totaled $188 million, consisting of $182 million of notes payable and commercial paper and $6 million of current maturities of long-term debt. Through its banks, Honeywell has access to various credit facilities, including committed credit lines for which Honeywell pays commitment fees and uncommitted lines provided by banks on a non-committed, best-efforts basis. Available lines of credit at year-end 1993 totaled $2.272 billion. This consists of $1.875 billion of committed credit lines to meet Honeywell's financing requirements, including support of commercial paper and bank note borrowings and an appeal bond which could be required in the Litton litigation as described in Litigation below, and $397 million of uncommitted credit lines available to certain foreign subsidiaries. This compared with $1.002 billion of available credit lines at year-end 1992, consisting of $645 million of committed credit lines and $357 million of uncommitted credit lines available to certain foreign subsidiaries. Cash and short-term investments totaled $256 million at year-end 1993 and $346 million at year-end 1992. Honeywell believes its available cash and committed credit lines provide adequate liquidity. LITIGATION On August 31, 1993, a federal court jury in U.S. District Court in Los Angeles returned a verdict against Honeywell on patent infringement and intentional interference claims in the amount of $1.2 billion. These claims were part of a lawsuit brought by Litton Systems Inc. alleging, among other things, Honeywell patent infringement relating to the process used by Honeywell to coat mirrors incorporated in its ring laser gyroscopes. Honeywell believes the verdict is unsupported by the facts; that the Litton patent is invalid; and that Honeywell's process differs from Litton's. The judge in the case held a hearing November 22, 1993, on various issues including, among others, Honeywell's claims that the patent was improperly obtained due to alleged "inequitable conduct" on the part of Litton and Honeywell's other legal and equitable defenses. The court has yet to enter a judgment. The trial will conclude when the court has resolved legal issues that could alter or eliminate the jury verdict. Honeywell will evaluate the outcome of the trial, including appealing any significant judgment against the company. No trial date has been set for the antitrust claims of Litton and Honeywell. The court has yet to rule on significant, complex and interrelated issues that could alter or eliminate the jury verdict; therefore, Honeywell and its counsel have determined that it is not possible to estimate the amount of damages, if any, that may ultimately be incurred. As a result, no provision has been made in the financial statements with respect to this contingent liability. Honeywell continues to believe the lawsuit is without merit, and its financial position, liquidity and business strategies have not been adversely affected by the jury verdict. CREDIT RATINGS Honeywell's credit ratings remained unchanged during 1993. Ratings for long-term and short-term debt are, respectively, A/A-1 by Standard and Poor's Corporation, A/Duff1 by Duff and Phelps Corporation and A3/P-2 by Moody's Investor Service, Inc. On August 31, 1993, Moody's Investor Service, Inc. placed Honeywell on credit watch status as a result of the jury verdict in the Litton litigation. Any lowering of Honeywell's present credit ratings could lead to higher interest costs by potentially reducing Honeywell's ability to access the commercial paper market and other unsecured borrowing sources on terms as favorable as those currently available. STOCK PERFORMANCE The market price of Honeywell stock ranged from $39 3/8 to $31 in 1993, and was $34 1/4 at year end. Book value at year end was $13.48 in 1993 and $13.10 in 1992. ITEM 8.

ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA INDEPENDENT AUDITORS' REPORT To the Stockholders of Honeywell Inc.: We have audited the statement of financial position of Honeywell Inc. and subsidiaries as of December 31, 1993 and 1992, and the related statements of income and cash flows for each of the three years in the period ended December 31, 1993. Our audits also included the financial statement schedules listed at Item 14(a)2. These financial statements and financial statement schedules are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits. We have conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, such financial statements present fairly, in all material respects, the financial position of Honeywell Inc. and subsidiaries at December 31, 1993 and 1992, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 1993, in conformity with generally accepted accounting principles. Also in our opinion, such financial statement schedules, when considered in relation to the basic financial statements taken as a whole, present fairly in all material respects the information set forth therein. As discussed in Note 19 to the financial statements, Honeywell is a defendant in litigation alleging (1) patent infringement, (2) market monopolization and (3) interference with the plaintiff's markets and contractual relationships. A federal court jury has returned a verdict against Honeywell on the patent infringement and intentional interference claims in the case in the amount of $1.2 billion; however, the court has yet to rule on significant, complex and interrelated issues that could alter or eliminate the jury verdict. The ultimate outcome of the litigation cannot presently be determined. Accordingly, no provision for any loss that may result from the resolution of this matter has been made in the accompanying financial statements. As discussed in Notes 1, 4 and 17 to the financial statements, in 1992 the Company changed its method of accounting for postemployment benefits, income taxes and postretirement benefits other than pensions. Deloitte & Touche Minneapolis, Minnesota February 11, 1994 INCOME STATEMENT HONEYWELL INC. AND SUBSIDIARIES (DOLLARS AND SHARES IN MILLIONS EXCEPT PER SHARE AMOUNTS) See accompanying Notes to Financial Statements. STATEMENT OF FINANCIAL POSITION HONEYWELL INC. AND SUBSIDIARIES (DOLLARS IN MILLIONS) ASSETS See accompanying Notes to Financial Statements. STATEMENT OF CASH FLOWS HONEYWELL INC. AND SUBSIDIARIES (DOLLARS IN MILLIONS) See accompanying Notes to Financial Statements. NOTES TO FINANCIAL STATEMENTS HONEYWELL INC. AND SUBSIDIARIES (DOLLARS IN MILLIONS EXCEPT PER SHARE AMOUNTS) NOTE 1 -- ACCOUNTING POLICIES CONSOLIDATION The consolidated financial statements and accompanying data include Honeywell Inc. and subsidiaries. All material intercompany transactions are eliminated. SALES Product sales are recorded when title is passed to the customer, which usually occurs at the time of delivery or acceptance. Sales under long-term contracts are recorded on the percentage-of-completion method measured on the cost-to-cost basis for engineering-type contracts and the units-of-delivery basis for production-type contracts. Provisions for anticipated losses on long-term contracts are recorded in full when they become evident. INCOME TAXES Income taxes are accounted for in accordance with Statement of Financial Accounting Standards No. 109 (see Note 4). Interest costs related to prior years' tax issues are included in the provision for income taxes in 1993. EARNINGS PER COMMON SHARE Earnings per common share are based on the average number of common shares outstanding during the year. STATEMENT OF CASH FLOWS Cash equivalents are all highly liquid, temporary cash investments purchased with a maturity of three months or less. Cash flows from contracts used to hedge cash dividend payments from subsidiaries are classified as part of the effect of exchange rate changes on cash. INVENTORIES Inventories are valued at the lower of cost or market. Cost is determined using the weighted-average method. Market is based on net realizable value. Payments received from customers relating to the uncompleted portion of contracts are deducted from applicable inventories. INVESTMENTS Investments in companies owned 20 to 50 percent are accounted for using the equity method. PROPERTY Property is carried at cost and depreciated primarily using the straight-line method over estimated useful lives of 10 to 40 years for buildings and improvements, and three to 15 years for machinery and equipment. INTANGIBLES Intangibles are carried at cost and amortized using the straight-line method over their estimated useful lives of not more than 40 years for goodwill, three to 17 years for patents, licenses and trademarks, and six to 24 years for software and other intangibles. Intangibles also include the asset resulting from recognition of the defined benefit pension plan minimum liability, which is amortized as part of net periodic pension cost. NOTES TO FINANCIAL STATEMENTS (CONTINUED) HONEYWELL INC. AND SUBSIDIARIES (DOLLARS IN MILLIONS EXCEPT PER SHARE AMOUNTS) NOTE 1 -- ACCOUNTING POLICIES (CONTINUED) FOREIGN CURRENCY Foreign currency assets and liabilities are generally translated into U.S. dollars using the exchange rates in effect at the statement of financial position date. Results of operations are generally translated using the average exchange rates throughout the period. The effects of exchange rate fluctuations on translation of assets, liabilities and hedges of cash dividend payments from subsidiaries are reported as accumulated foreign currency translation and reduced stockholders' equity $3.0 in 1993, $74.8 in 1992 and $0.1 in 1991. The carrying amounts of foreign currency contracts purchased to hedge firm foreign currency commitments are deferred and included in the measurement of the related foreign currency transaction. Foreign currency contracts that are not hedges of firm foreign currency commitments are marked to market on a current basis. Gains and losses from foreign currency transactions are included in selling, general and administrative expenses on the income statement and were not material in any year. POSTEMPLOYMENT BENEFITS In 1992, Honeywell adopted Statement of Financial Accounting Standards No. 112 (SFAS 112), "Employers' Accounting for Postemployment Benefits." The pre-tax cumulative effect of this accounting change to January 1, 1992, was $39.7 and resulted in a reduction in net income of $24.6 ($0.18 per share). The effect of this accounting change for 1992 was a decrease in income before income taxes of $3.8, or $2.5 ($0.02 per share) after income taxes. The enactment by Congress of the Omnibus Budget Reconciliation Act of 1993, which made Medicare the primary provider of medical benefits for disabled former employees after 29 months of disability, reduced the accumulated benefit obligation for postemployment benefits by $33.4 in the fourth quarter of 1993. This change in estimate is included in cost of sales on the income statement. RECLASSIFICATIONS Certain amounts in the 1992 statement of financial position have been reclassified to conform to the presentation of similar amounts in the 1993 statement of financial position. NOTE 2 -- ACQUISITIONS AND SALE OF ASSETS Honeywell acquired eight companies in 1993 and nine companies in 1992 for $14.2 and $83.5 in cash, respectively. These acquisitions were accounted for as purchases, and accordingly, the assets and liabilities of the acquired entities have been recorded at their estimated fair values at the dates of acquisition. The excess of purchase price over the estimated fair values of the net assets acquired, in the amount of $11.8 in 1993 and $44.2 in 1992, has been recorded as goodwill and is amortized over estimated useful lives. The pro forma results for 1993 and 1992, assuming these acquisitions had been made at the beginning of the year, would not be significantly different from reported results. In 1993, Honeywell sold its Keyboard Division to Key Tronic Corporation for $29.7 in cash, notes and common stock. Proceeds from other asset sales, including the collection of notes receivable and sale of stock received from asset sales made in previous years, amounted to $22.9. Gains and losses from asset sales were not material in any year and are included in selling, general and administrative expenses on the income statement. NOTES TO FINANCIAL STATEMENTS (CONTINUED) HONEYWELL INC. AND SUBSIDIARIES (DOLLARS IN MILLIONS EXCEPT PER SHARE AMOUNTS) NOTE 3 -- LITIGATION SETTLEMENTS AND SPECIAL CHARGES LITIGATION SETTLEMENTS On April 16, 1993, Honeywell announced the settlement of its lawsuits against the Unisys Corporation and other parties in connection with Honeywell's 1986 purchase of the Sperry Aerospace Group. Honeywell received $70.0 in cash and notes and recorded a gain of $22.4 in the second quarter of 1993 to offset previously incurred costs associated with the matter. In addition, the portion of the purchase price originally allocated to goodwill and other intangibles was reduced by $47.6. Honeywell has reached agreement with various camera manufacturers for their use of Honeywell's patented automatic focus camera technology. The total of all one-time settlements recorded in these matters, after associated expenses, resulted in a gain of $10.2 in the third quarter of 1993 and $287.9 in 1992. Several settlements also included licensing agreements that require the payment of royalties to Honeywell based upon the amount of product manufactured or sold by the licensee. Autofocus royalty income from the licensing agreements amounted to $31.4 in 1993 and $14.9 in 1992, and is included in selling, general and administrative expenses on the income statement. SPECIAL CHARGES Honeywell recorded special charges of $23.2 and $28.0 in the second and third quarters of 1993, respectively, for productivity initiatives to strengthen the company's competitiveness. In 1992, special charges of $128.4 were recorded to appropriately size the Space and Aviation Control business segment and to reposition the Home and Building Control and Industrial Control business segments to capitalize on emerging market opportunities. Special charges include costs for work-force reductions, worldwide facilities consolidation, organizational changes and other cost accruals. NOTE 4 -- INCOME TAXES The components of income before income taxes consist of the following: The provision for income taxes on that income is as follows: The enactment by Congress of the Omnibus Budget Reconciliation Act of 1993, which raised the U.S. federal statutory income tax rate for corporations from 34 percent to 35 percent retroactive to NOTES TO FINANCIAL STATEMENTS (CONTINUED) HONEYWELL INC. AND SUBSIDIARIES (DOLLARS IN MILLIONS EXCEPT PER SHARE AMOUNTS) NOTE 4 -- INCOME TAXES (CONTINUED) January 1, 1993, did not have a material impact on the 1993 provision for income taxes; however, the enactment of this legislation did result in a one-time gain of $9.2 million ($0.07 per share) in the third quarter of 1993 from the revaluation of deferred tax assets. In 1992, Honeywell adopted Statement of Financial Accounting Standards No. 109 (SFAS 109), "Accounting for Income Taxes," and elected not to restate prior years. The cumulative effect of this accounting change to January 1, 1992, was an increase in net income of $31.4 ($0.23 per share), resulting from the recognition of unrecorded deferred tax assets. This accounting change had no effect on the 1992 provision for income taxes. A reconciliation of the provision for income taxes to the amount computed using U.S. federal statutory rates is as follows: Taxes paid were $91.8 in 1993, $244.0 in 1992 and $190.4 in 1991. Deferred income taxes are provided for the temporary differences between the financial reporting basis and the tax basis of Honeywell's assets and liabilities. Temporary differences comprising the net deferred taxes shown on the statement of financial position are: The components of net deferred taxes shown on the statement of financial position are: NOTES TO FINANCIAL STATEMENTS (CONTINUED) HONEYWELL INC. AND SUBSIDIARIES (DOLLARS IN MILLIONS EXCEPT PER SHARE AMOUNTS) NOTE 4 -- INCOME TAXES (CONTINUED) Provision has not been made for U.S. or additional foreign taxes on $654.7 of undistributed earnings of international subsidiaries as those earnings are considered to be permanently reinvested in the operations of those subsidiaries. It is not practicable to estimate the amount of tax that might be payable on the eventual remittance of such earnings. At December 31, 1993, foreign subsidiaries had tax operating loss carryforwards of $5.4. NOTE 5 -- RECEIVABLES Receivables have been reduced by an allowance for doubtful accounts as follows: Receivables include approximately $21.1 in 1993 and $26.3 in 1992 billed to customers but not paid pursuant to contract retainage provisions. These balances are due upon completion of the contracts, generally within one year. Unbilled receivables related to long-term contracts amount to $275.6 in 1993 and $241.1 in 1992 and are generally billable and collectible within one year. Long-term, interest-bearing notes receivable from the sale of assets have been reduced by valuation reserves of $3.6 in 1993 and $2.9 in 1992 to an amount that approximates realizable value. In 1992, Honeywell entered into a three-year agreement, whereby it can sell an undivided interest in a designated pool of trade accounts receivable up to a maximum of $50.0 on an ongoing basis. As collections reduce accounts receivable sold, Honeywell may sell an additional undivided interest in new receivables to bring the amount sold up to the $50.0 maximum. The uncollected balance of receivables sold amounted to $37.9 and $16.0 at December 31, 1993 and 1992, respectively, and averaged $21.7 and $11.6 during those respective years. The discount recorded on sale of receivables is included in selling, general and administrative expenses on the income statement and amounted to $0.7, $0.6 and $5.3 in 1993, 1992 and 1991, respectively. Honeywell, as agent for the purchaser, retains collection and administrative responsibilities for the participating interests sold. NOTE 6 -- INVENTORIES Inventories related to long-term contracts are net of payments received from customers relating to the uncompleted portions of such contracts in the amounts of $36.8 and $65.0 at December 31, 1993 and 1992, respectively. NOTES TO FINANCIAL STATEMENTS (CONTINUED) HONEYWELL INC. AND SUBSIDIARIES (DOLLARS IN MILLIONS EXCEPT PER SHARE AMOUNTS) NOTE 7 -- PROPERTY, PLANT AND EQUIPMENT NOTE 8 -- FOREIGN SUBSIDIARIES The following is a summary of financial data pertaining to foreign subsidiaries: Insofar as can be reasonably determined, there are no foreign-exchange restrictions that materially affect the financial position or the operating results of Honeywell and its subsidiaries. NOTE 9 -- INVESTMENTS IN OTHER COMPANIES Following is a summary of financial data pertaining to companies 20 to 50 percent owned. The principal company included is Yamatake-Honeywell Co., Ltd., of which Honeywell owns 24.2 percent of the outstanding common stock. NOTES TO FINANCIAL STATEMENTS (CONTINUED) HONEYWELL INC. AND SUBSIDIARIES (DOLLARS IN MILLIONS EXCEPT PER SHARE AMOUNTS) NOTE 10 -- INTANGIBLE ASSETS Intangible assets have been reduced by accumulated amortization as follows: NOTE 11 -- DEBT SHORT-TERM DEBT Honeywell has lines of credit available totaling $2,271.9 at December 31, 1993. Domestic revolving credit lines with 14 banks total $1,875.0, which management believes is adequate to meet its financing requirements, including support of commercial paper and bank note borrowings and an appeal bond that could be required in the Litton litigation (see Note 19). These domestic lines have commitment fee requirements. There were no borrowings on these lines at December 31, 1993. The remaining credit facilities of $396.9 have been arranged by non-U.S. subsidiaries in accordance with customary lending practices in their respective countries of operation. Borrowings against these lines amounted to $6.6 at December 31, 1993. Short-term debt consists of the following: LONG-TERM DEBT The 8 percent dual-currency yen/U.S. dollar notes due 1995 are repayable at a fixed exchange rate and are linked to a currency exchange agreement that results in a fixed U.S. dollar interest cost of 10.5 percent. The 6 1/4 percent Deutsche mark bonds due 1997 are linked to a currency exchange agreement that converts principal and interest payments into fixed U.S. dollar obligations with an interest cost of 8.17 percent. NOTES TO FINANCIAL STATEMENTS (CONTINUED) HONEYWELL INC. AND SUBSIDIARIES (DOLLARS IN MILLIONS EXCEPT PER SHARE AMOUNTS) NOTE 11 -- DEBT (CONTINUED) In 1992, Honeywell entered into interest rate swap agreements effectively converting $100.0 of its 8 5/8 percent debentures due 2006 from fixed-rate debt to floating-rate debt based on six-month LIBOR rates. During 1993, $50.0 of the $100.0 swap was terminated resulting in a gain of $0.9, which is being amortized over the remaining life of the swap agreement. In 1993, Honeywell entered into interest rate swap agreements effectively converting the 9.6 percent Canadian dollar notes due 1996 to floating-rate debt based on three-month Canadian bankers acceptance rates. The differential to be paid or received is accrued as interest rates change and is charged to interest expense over the lives of the agreements, which expire in September 1995 for the 8 5/8 percent debentures and December 1996 for the 9.6 percent Canadian dollar notes. Honeywell is exposed to credit risk to the extent of nonperformance by the counterparties to the currency exchange agreements and the interest rate swaps discussed above. However, the credit ratings of the counterparties, which consist of a diversified group of financial institutions, are regularly monitored and risk of default is considered remote. In 1992, Honeywell redeemed its 9 3/8 percent debentures due 2005 to 2009, its 8.2 percent debentures due 1996 to 1998, its 9 7/8 percent debentures due 1998 to 2017, and certain notes due 1993 to 2004, amounting to $9.6 with interest rates ranging from 7.5 percent to 11.75 percent. These early redemptions required the payment of premiums and the recognition of unamortized discounts and deferred cost resulting in the recording of an extraordinary loss of $13.8, or $8.6 ($0.06 per share) after income taxes. Honeywell redeemed an additional $5.9 of notes due 1993 to 2000 with interest rates ranging from 10 percent to 12.1 percent in the first quarter of 1993 with no additional income statement impact. Annual sinking-fund and maturity requirements for the next five years on long-term debt outstanding at December 31, 1993, are as follows: Interest paid amounted to $63.9, $98.5 and $96.9 in 1993, 1992 and 1991, respectively. NOTE 12 -- FAIR VALUE OF FINANCIAL INSTRUMENTS The estimated fair value of Honeywell's financial instruments at December 31, 1993 and 1992, is as follows: The estimated fair value of long-term debt is based on quoted market prices for the same or similar issues or on current rates available to Honeywell for debt of the same remaining maturities. The estimated fair value of interest-rate and currency contracts is based on quotes obtained from various financial institutions that deal in these types of instruments. The estimated fair values of all other financial instruments approximate their carrying amounts in the statement of financial position. NOTES TO FINANCIAL STATEMENTS (CONTINUED) HONEYWELL INC. AND SUBSIDIARIES (DOLLARS IN MILLIONS EXCEPT PER SHARE AMOUNTS) NOTE 13 -- LEASING ARRANGEMENTS As lessee, Honeywell has minimum annual lease commitments outstanding at December 31, 1993, with the majority of the leases having initial periods ranging from one to 10 years. Following is a summary of operating lease information. Rent expense for operating leases was $134.2 in 1993, $128.0 in 1992 and $119.6 in 1991. Substantially all leases are for plant, warehouse, office space and automobiles. A number of the leases contain renewal options ranging from one to 10 years. NOTE 14 -- CAPITAL STOCK NOTES TO FINANCIAL STATEMENTS (CONTINUED) HONEYWELL INC. AND SUBSIDIARIES (DOLLARS IN MILLIONS EXCEPT PER SHARE AMOUNTS) NOTE 14 -- CAPITAL STOCK (CONTINUED) STOCK SPLIT On November 9, 1992, the board of directors authorized a two-for-one stock split in the form of a stock dividend payable to stockholders of record November 27, 1992. All references in the financial statements to average number of shares outstanding and related prices, per share amounts, stock plan data and the 1992 share amounts in the table above have been restated to reflect this split. KEY EMPLOYEE PLANS In 1993, the board of directors adopted, and the stockholders approved, the 1993 Honeywell Stock and Incentive Plan. The plan, which terminates December 31, 1998, provides for the award of up to 7,500,000 shares of common stock. The purpose of the plan is to further the growth, development and financial success of Honeywell and its subsidiaries by aligning the personal interests of key employees, through the ownership of shares of common stock and through other incentives, to those of Honeywell stockholders. The plan is further intended to provide flexibility to Honeywell in its ability to compensate key employees and to motivate, attract and retain the services of such key employees who have the ability to enhance the value of Honeywell and its subsidiaries. Awards made under the plan may be in the form of stock options, stock appreciation rights or other stock based awards. The plan replaced existing similar plans. Awards currently outstanding under those plans are not affected, but no new awards will be made. There were 15,118,538 shares reserved for all key employee plans at December 31, 1993. Stock options to purchase common stock have been granted to key employees at 100 percent of the market price at time of granting, pursuant to plans approved by the stockholders. The following is a summary of stock options: Options totaling 3,779,200 shares at prices ranging from $12 to $37 per share were exercisable at December 31, 1993. Restricted common stock is issued to certain key employees as compensation. Restricted shares are awarded with a fixed restriction period, usually five years, or a restriction period dependent on the achievement of performance goals within a specified measurement period. Participants have the rights of stockholders, including the right to receive cash dividends and the right to vote. Restricted shares forfeited revert to Honeywell at no cost. Restricted shares issued totaled 533,995 in 1993, 47,812 in 1992 and 174,518 in 1991. The cost of restricted stock is charged to income over the restriction period and amounted to $6.3 in 1993, $6.5 in 1992 and $6.4 in 1991. At December 31, restricted shares outstanding for key employee plans totaled 775,861 in 1993, 412,872 in 1992 and 968,750 in 1991. NOTES TO FINANCIAL STATEMENTS (CONTINUED) HONEYWELL INC. AND SUBSIDIARIES (DOLLARS IN MILLIONS EXCEPT PER SHARE AMOUNTS) NOTE 14 -- CAPITAL STOCK (CONTINUED) EMPLOYEE STOCK MATCH AND STOCK PURCHASE PLANS In 1990, Honeywell adopted Stock Match and Performance Stock Match plans under which Honeywell matches, in the form of Honeywell common stock, certain eligible U.S. employee savings plan contributions. Shares issued under the stock match plans totaled 643,913 shares in 1993, 977,716 shares in 1992 and 933,344 shares in 1991 at a cost of $22.3, $33.3 and $27.9, respectively. There were 2,348,295 shares reserved for employee stock match plans at December 31, 1993. Honeywell has granted to eligible foreign subsidiary employees the right to purchase common stock, principally at the lower of 85 percent of the market price at the time of grant or at the time of purchase. At December 31, 1993, there were 335,537 shares reserved for foreign subsidiary employee stock purchase plans. Total shares issued under the foreign stock purchase plans amounted to 49,250 in 1992 and 66,096 in 1991 at an average price per share of $33 and $27, respectively. There were no shares issued in 1993. STOCK PLEDGE In 1993, Honeywell pledged to the Honeywell Foundation a 5-year option to purchase 2,000,000 shares of common stock at $33 per share. This option is exercisable in whole or in part, subject to certain conditions, from time to time during its term. No shares were purchased under this option in 1993 and at December 31, 1993, there were 2,000,000 shares reserved for this pledge. PREFERENCE STOCK Twenty-five million preference shares with a par value of $1 have been authorized. None has been issued at December 31, 1993. NOTE 15 -- RETAINED EARNINGS Included in retained earnings are undistributed earnings of companies 20 to 50 percent owned, amounting to $121.3 at December 31, 1993. NOTE 16 -- PENSION PLANS Honeywell and its subsidiaries have noncontributory defined benefit pension plans that cover substantially all of their U.S. employees. The plan covering non-union employees provides pension benefits based on employee average earnings during the highest paid 60 consecutive calendar months of employment during the 10 years prior to retirement. The plan covering union employees provides pension benefits of stated amounts for each year of credited service. Funding for these plans is provided solely through contributions from Honeywell determined by the board of directors after consideration of recommendations from the plans' independent actuary. Such recommendations are based on actuarial valuations of benefits payable under the plans. NOTES TO FINANCIAL STATEMENTS (CONTINUED) HONEYWELL INC. AND SUBSIDIARIES (DOLLARS IN MILLIONS EXCEPT PER SHARE AMOUNTS) NOTE 16 -- PENSION PLANS (CONTINUED) The components of net periodic pension cost for U.S. defined benefit pension plans are as follows: Assumptions used in the accounting for the U.S. defined benefit plans were: Employees in foreign countries who are not U.S. citizens are covered by various retirement benefit arrangements, some of which are considered to be defined benefit pension plans for accounting purposes. The cost of all foreign pension plans charged to income was $14.2 in 1993, $9.0 in 1992 and $9.8 in 1991. The components of net periodic pension cost for foreign defined benefit pension plans are as follows: Assumptions used in the accounting for foreign defined benefit plans were: NOTES TO FINANCIAL STATEMENTS (CONTINUED) HONEYWELL INC. AND SUBSIDIARIES (DOLLARS IN MILLIONS EXCEPT PER SHARE AMOUNTS) NOTE 16 -- PENSION PLANS (CONTINUED) The plans' funded status as of September 30 and amounts recognized in Honeywell's statement of financial position for its pension plans are summarized below. Adjustments recorded to recognize the minimum liability required for defined benefit pension plans whose accumulated benefits exceed assets amounted to $113.0 in 1993 and $74.7 in 1992. A corresponding amount was recognized as an intangible asset to the extent of unrecognized prior service cost and unrecognized transition obligation. In 1993, $21.0 of excess minimum liability resulted in a reduction in stockholders' equity, net of income taxes, of $12.8. Plan assets are held by trust funds devoted to servicing pension benefits and are not available to Honeywell until all covered benefits are satisfied after a plan is terminated. The assets held by the trust funds consist of a diversified portfolio of fixed-income investments and equity securities. NOTES TO FINANCIAL STATEMENTS (CONTINUED) HONEYWELL INC. AND SUBSIDIARIES (DOLLARS IN MILLIONS EXCEPT PER SHARE AMOUNTS) NOTE 17 -- POSTRETIREMENT BENEFITS OTHER THAN PENSIONS In 1992, Honeywell adopted Statement of Financial Accounting Standards No. 106 (SFAS 106), "Employers' Accounting for Postretirement Benefits Other Than Pensions," which requires recognition of the expected cost of providing postretirement benefits over the time employees earn the benefits. Before adopting SFAS 106, Honeywell recognized the cost of providing these benefits on a pay-as-you-go basis by expensing the cost in the year the benefit was provided. Substantially all of Honeywell's domestic and Canadian employees who retire from Honeywell between the ages of 55 and 65 with 10 or more years of service are eligible to receive health-care benefits until age 65 identical to those available to active employees. Honeywell continues to fund postretirement benefits on a pay-as-you-go basis. Honeywell elected to immediately recognize the cumulative effect of this change in accounting for postretirement benefits for both U.S. and Canadian plans, reducing net income by $151.3 ($1.09 per share). The pre-tax cumulative effect of $244.1 represents the accumulated postretirement benefit obligation (APBO) existing at January 1, 1992, less $11.3 related to discontinued product lines recorded in prior years. The effect of this accounting change for 1992 was a decrease in income before income taxes of $16.4, or $10.9 ($0.08 per share) after income taxes. The pro forma effect of this change on years prior to 1992 would have been a decrease in net income in amounts approximately equal to the 1992 effect. The components of net periodic postretirement benefit cost are as follows: The amounts recognized in Honeywell's statement of financial position are as follows: The discount rate used in determining the APBO was 7.0 percent in 1993 and 8.5 percent in 1992. The assumed health-care cost trend rate used in measuring the APBO was 10.0 percent in 1993 and 1994, then declining by 0.6 percent per year to an ultimate rate of 5.5 percent. The health-care cost trend rate assumption has a significant effect on the amounts reported. For example, a 1 percent increase in the health-care trend rate would increase the APBO by 11 percent at December 31, 1993, and the net periodic postretirement benefit cost by 14 percent for 1993. NOTE 18 -- SEGMENT INFORMATION Honeywell's operations are engaged in the design, development, manufacture, marketing and service of control solutions in three industry segments -- Home and Building Control, Industrial Control and Space and Aviation Control. NOTES TO FINANCIAL STATEMENTS (CONTINUED) HONEYWELL INC. AND SUBSIDIARIES (DOLLARS IN MILLIONS EXCEPT PER SHARE AMOUNTS) NOTE 18 -- SEGMENT INFORMATION (CONTINUED) Home and Building Control provides products and services to create efficient, safe, comfortable environments by offering controls for heating, ventilation, humidification and air-conditioning equipment; security and fire alarm systems; home automation systems; energy-efficient lighting controls; and building management systems and services. Industrial Control produces systems for the automation and control of process operations in industries such as oil refining, oil and gas drilling, pulp and paper manufacturing, food processing, chemical manufacturing and power generation; solid-state sensors for position, pressure, air flow, temperature and current; precision electromechanical switches; manual controls; advanced vision-based sensors; fiber-optic components; and solenoid valves used in fluid control and processing industries. Space and Aviation Control is a full-line avionics supplier and systems integrator for commercial, military and space applications, providing automatic flight control systems, electronic cockpit displays, flight management systems, navigation, surveillance and warning systems, severe weather avoidance systems and flight reference sensors. The "other" category comprises various operations, such as Solid State Electronics Center and Systems and Research Center, that are not a significant part of Honeywell's operations either individually or in the aggregate. Information concerning Honeywell's sales, operating profit and identifiable assets by industry segment can be found in Item 6. Selected Financial Data at page 9. This information for 1993, 1992 and 1991 is an integral part of these financial statements. Sales include external sales only. Intersegment sales are not significant. Corporate and other assets include the assets of the entities in the "other" category, and cash, short term investments, investments, property and deferred taxes held by corporate. Following is additional financial information relating to industry segments: Honeywell engages in material operations in foreign countries, the majority of which are located in Europe. Other geographic areas of operation include Canada, Mexico, Australia, South America and the Far East. NOTES TO FINANCIAL STATEMENTS (CONTINUED) HONEYWELL INC. AND SUBSIDIARIES (DOLLARS IN MILLIONS EXCEPT PER SHARE AMOUNTS) NOTE 18 -- SEGMENT INFORMATION (CONTINUED) Following is financial information relating to geographic areas: Honeywell transfers products from one geographic region for resale in another. These transfers are priced to provide both areas with an equitable share of the overall profit. Operating profit is net of provision for special charges amounting to $51.2 and $128.4 in 1993 and 1992, respectively, (see Note 3) as follows: United States -- $22.4 and $79.8, Europe -- $20.3 and $29.7, other areas -- $9.3 in 1992. General corporate expense includes special charges of $8.5 in 1993 and $9.6 in 1992. General corporate expense has been reduced by royalty income of $31.4 in 1993 and $14.9 in 1992 (see Note 3). NOTES TO FINANCIAL STATEMENTS (CONTINUED) HONEYWELL INC. AND SUBSIDIARIES (DOLLARS IN MILLIONS EXCEPT PER SHARE AMOUNTS) NOTE 18 -- SEGMENT INFORMATION (CONTINUED) The operating profit impact of implementing SFAS 106 was additional expense of $16.4 in 1992 (see Note 17) as follows: United States -- $15.3, other areas - -- $0.5, general corporate expense -- $0.6. The operating profit impact of implementing SFAS 112 was additional expense of $3.8 in 1992 (see Note 1) as follows: United States -- $3.6, general corporate expense -- $0.2. NOTE 19 -- CONTINGENCIES LITTON LITIGATION On March 13, 1990, Litton Systems Inc. filed suit against Honeywell in U.S. District Court, Central District of California, alleging Honeywell patent infringement relating to the process used by Honeywell to coat mirrors incorporated in its ring laser gyroscopes; attempted monopolization by Honeywell of certain alleged markets for products containing ring laser gyroscopes; and intentional interference by Honeywell with Litton's prospective advantage in European markets and with its contractual relationships with Ojai Research, Inc., a California corporation. Honeywell has filed counterclaims against Litton alleging, among other things, violations by Litton of various antitrust laws including attempted monopolization of markets for inertial systems and interference with Honeywell's relationships with suppliers. The trial of the patent infringement and intentional interference claims commenced June 4, 1993, and on August 31, 1993, a federal court jury in U.S. District Court in Los Angeles returned a verdict against Honeywell on each of these claims and awarded damages in the amount of $1,200.0 and concluded that the patent infringement was willful. Honeywell believes the verdict is unsupported by the facts; that the Litton patent is invalid; and that Honeywell's process differs from Litton's. The judge in the case held a hearing November 22, 1993, on various issues including, among others, Honeywell's claims that the patent was improperly obtained due to alleged "inequitable conduct" on the part of Litton and Honeywell's other legal and equitable defenses. The court has not yet entered a judgment. The trial will conclude when the court has resolved legal issues that could alter or eliminate the jury verdict. Honeywell will evaluate the outcome of the trial, including appealing any significant judgment against the company. No trial date has been set for the antitrust claims of Litton and Honeywell. The court has yet to rule on significant, complex and interrelated issues that could alter or eliminate the jury verdict; therefore, Honeywell and its counsel have determined that it is not possible to estimate the amount of damages, if any, that may ultimately be incurred. As a result, no provision has been made in the financial statements with respect to this contingent liability. ENVIRONMENTAL MATTERS Honeywell's manufacturing sites generate both hazardous and nonhazardous wastes, the treatment, storage, transportation and disposal of which are subject to various local, state and national laws relating to protection of the environment. Honeywell is in varying stages of investigation or remediation of potential, alleged or acknowledged contamination at current or previously owned or operated sites and at off-site locations where its wastes were taken for treatment or disposal. In connection with the cleanup of various off-site locations, Honeywell, along with a large number of other entities, has been designated a potentially responsible party (PRP) by the U.S. Environmental Protection Agency under the Comprehensive Environmental Response, Compensation and Liability Act or by state agencies under similar state laws (Superfund), which potentially subjects PRPs to joint and several liability for the costs of such cleanup. In addition, Honeywell is incurring costs relating to environmental remediation pursuant to the federal Resource Conservation and Recovery Act. Based on Honeywell's assessment of the costs associated with its environmental responsibilities, compliance NOTES TO FINANCIAL STATEMENTS (CONTINUED) HONEYWELL INC. AND SUBSIDIARIES (DOLLARS IN MILLIONS EXCEPT PER SHARE AMOUNTS) NOTE 19 -- CONTINGENCIES (CONTINUED) with federal, state and local laws regulating the discharge of materials into the environment, or otherwise relating to the protection of the environment, has not had, and in the opinion of Honeywell management, will not have a material effect on Honeywell's financial position, results of operations, capital expenditures or competitive position. Honeywell's opinion with regard to Superfund matters is based on its assessment of the predicted investigation, remediation and associated costs, its expected share of those costs and the availability of legal defenses. Honeywell's policy is to record environmental liabilities when loss amounts are probable and reasonably estimable. OTHER MATTERS Honeywell is a party to a large number of other legal proceedings, some of which are for substantial amounts. It is the opinion of management that losses in connection with these matters will not have a material effect on net income. The transfer of assets by Honeywell in the 1990 spinoff of the Defense and Marine Systems Business to Alliant Techsystems Inc. (Alliant) included the assignment of various contracts between Honeywell and the U.S. government. As required by federal procurement regulations applicable to government contracts, Honeywell has entered into novation agreements with Alliant and the U.S. government that will provide, among other things, for Honeywell to directly or indirectly guarantee or otherwise become liable for the performance of Alliant's obligations under such contracts. NOTE 20 -- QUARTERLY DATA (UNAUDITED) The third quarter of 1993 includes a gain of $9.2 from the revaluation of deferred tax assets (see Note 4). The fourth quarter of 1993 benefited from a change in estimate of $33.4 for postemployment benefits (see Note 1) that was partially offset by accruals for facilities closures and other expenses in the amount of $26.9. Following is a summary of other significant items affecting 1993 results. NOTES TO FINANCIAL STATEMENTS (CONTINUED) HONEYWELL INC. AND SUBSIDIARIES (DOLLARS IN MILLIONS EXCEPT PER SHARE AMOUNTS) NOTE 20 -- QUARTERLY DATA (UNAUDITED) (CONTINUED) The first quarter of 1992 includes the cumulative effects of adopting SFAS 106 (see Note 17), SFAS 109 (see Note 4) and SFAS 112 (see Note 1) at January 1, 1992. The 1992 impact of adopting these accounting changes was a decrease in income before income taxes of approximately $5.1 on a combined basis, or $3.4 ($0.03 per share) after income taxes, for each quarter. Other significant items affecting 1992 results include the following: Stockholders of record on February 2, 1994, totaled 33,166. ITEM 9.

ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE No report on Form 8-K reporting a change in Honeywell's certifying independent accountants has been filed within the 24 months prior to the date of the most recent financial statements. PART III ITEM 10.

ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT Pages 3 through 9 and page 14 of the Honeywell Notice of 1994 Annual Meeting and Proxy Statement are incorporated herein by reference. ITEM 11.

ITEM 11. EXECUTIVE COMPENSATION Pages 14 through 20 of the Honeywell Notice of 1994 Annual Meeting and Proxy Statement are incorporated herein by reference. ITEM 12.

ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT Pages 10 through 11 of the Honeywell Notice of 1994 Annual Meeting and Proxy Statement are incorporated herein by reference. ITEM 13.

ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS None. PART IV ITEM 14.

ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K (A) DOCUMENTS FILED AS A PART OF THIS REPORT 1. FINANCIAL STATEMENTS The financial statements required to be filed as part of this Annual Report on Form 10-K are listed below with their location in this report. 2. FINANCIAL STATEMENT SCHEDULES The schedules required to be filed as part of this Annual Report on Form 10-K are listed below with their location in this report. All schedules, other than indicated above, are omitted because of the absence of the conditions under which they are required or because the information required is shown in the financial statements or notes thereto. 3. EXHIBITS Documents Incorporated by Reference: 3. EXHIBITS (CONTINUED) SIGNATURES Pursuant to the requirements of Section 13 or 15(d) 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. HONEYWELL INC. By: /s/ SIGURD UELAND, JR. -------------------------------------- Sigurd Ueland, Jr., Vice President Dated: March 4, 1994 Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated. By: /s/ SIGURD UELAND, JR. -------------------------------------- Sigurd Ueland, Jr., ATTORNEY-IN-FACT March 4, 1994 SCHEDULE V HONEYWELL INC. AND SUBSIDIARIES PROPERTY, PLANT AND EQUIPMENT FOR THE YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 (DOLLARS IN MILLIONS) SCHEDULE VI HONEYWELL INC. AND SUBSIDIARIES ACCUMULATED DEPRECIATION FOR THE YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 (DOLLARS IN MILLIONS) SCHEDULE VIII HONEYWELL INC. AND SUBSIDIARIES VALUATION RESERVES FOR THE YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 (DOLLARS IN MILLIONS) SCHEDULE IX HONEYWELL INC. AND SUBSIDIARIES SHORT-TERM BORROWINGS FOR THE YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 (DOLLARS IN MILLIONS) ------------------------ SCHEDULE X HONEYWELL INC. AND SUBSIDIARIES SUPPLEMENTARY INCOME STATEMENT INFORMATION FOR THE YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 (DOLLARS IN MILLIONS) EXHIBIT (11) HONEYWELL INC. AND SUBSIDIARIES COMPUTATION OF EARNINGS PER SHARE FOR THE FIVE YEARS ENDED DECEMBER 31, 1993 (DOLLARS IN MILLIONS EXCEPT PER SHARE AMOUNTS) EXHIBIT (24) CONSENT OF INDEPENDENT AUDITORS Honeywell Inc.: We consent to the incorporation by reference in Registration Statements Nos. 2-64351, 2-98660, 33-29442, 33-44282, 33-44283, 33-44284 and 33-49819 on Form S-8, and No. 33-62300 on Form S-3, of our reports dated February 11, 1994, appearing in and incorporated by reference in the Annual Report on Form 10-K of Honeywell Inc. for the year ended December 31, 1993. Deloitte & Touche Minneapolis, Minnesota March 3, 1994

711604_1993.txt

711604

1993

ITEM 1. BUSINESS Unless otherwise indicated, all references to "Notes" are to Notes to Consolidated Financial Statements contained in this report. The registrant, Carlyle Real Estate Limited Partnership-XIII (the "Partnership"), is a limited partnership formed in late 1982 and currently governed by the Revised Uniform Limited Partnership Act of the State of Illinois to invest in improved income-producing commercial and residential real property. The Partnership sold 366,177.57 limited partnership interests (the "Interests") commencing on June 9, 1983, pursuant to a Registration Statement on Form S-11 under the Securities Act of 1933 (Registration No. 2- 81125 and No. 2-87033). A total of 366,177.57 Interests have been sold to the public at $1,000 per Interest. The offering closed on May 22, 1984. No Limited Partner has made any additional capital contribution after such date. The Limited Partners of the Partnership share in their portion of the benefits of ownership of the Partnership's real property investments according to the number of Interests held. The Partnership is engaged solely in the business of the acquisition, operation and sale and disposition of equity real estate investments. Such equity investments are held by fee title, leasehold estates and/or through joint venture partnership interests. The Partnership's real estate investments are located throughout the nation and it has no real estate investments located outside of the United States. A presentation of information about industry segments, geographic regions, raw materials or seasonality is not applicable and would not be material to an understanding of the Partnership's business taken as a whole. Pursuant to the Partnership agreement, the Partnership is required to terminate on or before December 31, 2033. Accordingly, the Partnership intends to hold the real properties it acquires for investment purposes until such time as sale or other disposition appears to be advantageous. Unless otherwise described, the Partnership expects to hold its properties for long-term investment. Due to certain market conditions, the Partnership is not able to determine the holding period for its remaining properties. At sale of a particular property, the net proceeds, if any, are generally distributed or reinvested in existing properties rather than invested in acquiring additional properties. The Partnership has made the real property investments set forth in the following table: The Partnership's real property investments are subject to competition from similar types of properties (including in certain areas, properties owned or advised by affiliates of the General Partners or properties owned by certain of the joint venture partners) in the respective vicinities in which they are located. Such competition is generally for the retention of existing tenants. Additionally, the Partnership is in competition for new tenants in markets where significant vacancies are present. Reference is made to Item 7 below for a discussion of competitive conditions and capital improvement plans of the Partnership and certain of its significant investment properties. Approximate occupancy levels for the properties are set forth in the table in Item 2

Item 2 below to which reference is hereby made. The Partnership maintains the suitability and competitiveness of its properties in its markets primarily on the basis of effective rents, tenant allowances and services provided to tenants. In the opinion of the Corporate Managing General Partner of the Partnership, all of the investment properties held at December 31, 1993 are adequately insured. Although there is earthquake insurance coverage for a portion of the value of the Partnership's investment properties, the Corporate General Partner does not believe that such coverage for the entire replacement cost of the investment properties is available on economic terms. In March 1993, the Partnership sold the land, related improvements and personal property of the Rio Cancion Apartments located in Tucson, Arizona, as described in the Partnership's Report on Form 8-K (File No. 0-12791) for March 31, 1993, which description is hereby incorporated herein by reference to such reports. Reference is made to Note 7(e) for a further description of such transaction. In April 1993, the Partnership sold the land, related improvements and personal property of the Greenwood Creek II Apartments located in Benbrook (Fort Worth), Texas. Reference is made to Note 7(f) for a further description of such transaction. In May 1993, the Partnership negotiated another loan modification for the existing mortgage note secured by Eastridge Apartments located in Tucson, Arizona. Reference is made to Note 4(b)(5) for a further description of such transaction. In August 1993, the Partnership, through Orchard Associates, sold its interest in the Old Orchard Shopping Center located in Skokie, Illinois, as described in the Partnership's Report on Form 8-K (File No. 0-12791) for August 30, 1993, which description is hereby incorporated herein by reference to such report. Reference is also made to Note 3(d) for a further description of such transaction. In September 1993, Carrollwood Station Associates, Ltd. refinanced the existing mortgage note secured by the Carrollwood Apartments, located in Tampa, Florida. Reference is made to Note 4(b)(11) for a further description of such transaction. In November 1993, the Partnership transferred title to the 1001 Fourth Avenue Plaza Office Building located in Seattle, Washington, as described in the Partnership's Report on Form 8-K (File No. 0-12791) for November 1, 1993, which description is hereby incorporated herein by reference to such report. Reference is also made to Note 4(b)(4) for a further description of such transaction. In November 1993, the Partnership negotiated another loan modification for the existing mortgage note secured by Sherry Lane Place Office Building, located in Dallas, Texas. Reference is made to Note 4(b)(1) for a further description of such transaction. In January 1994, the Partnership transferred title to the University Park Office Building located in Sacramento, California. Reference is made to Notes 4(b)(6) and 11 (b) for a further description of such transaction. In January 1994, the Partnership transferred title to the Gables Corporate Plaza Office Building located in Coral Gable, Florida. Reference is made to Notes 4(b)(7) and 11(b) for a further description of such transaction. Reference is made to Note 8(a) and to Note 4 of Notes to Combined Financial Statements filed with this annual report for a schedule of minimum lease payments to be received in each of the next five years, and in the aggregate thereafter, under leases in effect at certain of the Partnership's properties as of December 31, 1993. At December 31, 1993, the Partnership had 23 full-time and 3 part-time personnel, none of whom are officers or directors of the Corporate General Partner of the Partnership. Such persons perform on-site duties at certain of the Partnership's properties. The terms of transactions between the Partnership, the General Partners and their affiliates are set forth in Item 11 below to which reference is hereby made for a description of such terms and transactions. Base Rent Scheduled Lease Lease b) Significant Tenants Square Feet Per Annum Expiration Date Renewal Option(s) ------------------- ----------- --------- --------------- ------------------ J. Walter Thompson 456,132 $ 9,529,966 8/2006 N/A Company (Advertising Agency) North American 251,952 10,101,248 8/2001 N/A Reinsurance Company (Insurance Company) /TABLE c) The following table sets forth certain information with respect to the expiration of leases for the next ten years: Annualized Percent of Number of Approx. Total Base Rent Total 1993 Year Ending Expiring GLA of Expiring of Expiring Base Rent December 31, Leases Leases (1) Leases Expiring ------------ --------- --------------- ----------- ---------- 1994 2 57,936 $1,806,484 5% 1995 1 900 40,000 -- 1996 2 34,630 1,527,700 4% 1997 2 29,121 1,505,072 4% 1998 - -- -- -- 1999 6 121,165 5,155,499 15% 2000 1 3,450 189,750 1% 2001 9 255,047 10,220,240 30% 2002 - -- -- -- 2003 2 18,388 754,975 2% (1) Excludes leases that expire in 1994 for which renewal leases or leases with replacement tenants have been executed as of March 25, 1993. /TABLE ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS LIQUIDITY AND CAPITAL RESOURCES On June 9, 1983, the Partnership commenced an offering of $260,000,000 of Limited Partnership Interests pursuant to a Registration Statement on Form S-11 under the Securities Act of 1933. On October 7, 1983, the Partnership registered an additional $140,000,000 of Limited Partnership Interests. A total of 366,177.57 Interests were sold to the public at $1,000 per interest (fractional interests are due to the Distribution Reinvestment Program) between June 9, 1983 and May 22, 1984 pursuant to a public offering. After deducting selling expenses and other offering costs, the Partner- ship had approximately $326,000,000 with which to make investments in income-producing commercial and residential real property, to pay legal fees and other costs (including acquisition fees) related to such investments and to satisfy working capital requirements. A portion of the proceeds was utilized to acquire the properties described in Item 1 above. At December 31, 1993, the Partnership and its consolidated ventures had cash and cash equivalents of approximately $5,362,000. Such funds and short- term investments of approximately $23,096,000 are available for distributions to partners, leasing and capital improvement costs and/or operating deficits at Long Beach Plaza and the Plaza Tower Office Building, and for the paydown of the mortgage obligation at the Marshall's Aurora Plaza and for working capital requirements and potential future operating deficits and significant leasing and tenant improvement costs at certain of the Partnership's other investment properties. The Partnership and its consolidated ventures have currently budgeted in 1994 approximately $7,203,000 for tenant improvements and other capital expenditures. The Partnership's share of such items and its share of such similar items for its unconsolidated ventures in 1994 is currently budgeted to be $5,697,000. Actual amounts expended may vary depending on a number of factors including actual leasing activity, results of property operations, liquidity considerations and other market conditions over the course of the year. The source of capital for such items and for both short-term and long-term future liquidity and distributions is expected to be through the net cash generated by the Partnership's investment properties and through the sale or refinancing of such investments. The Partnership's and its ventures' mortgage obligations are generally non-recourse and therefore the Partnership and its ventures generally are not personally obligated to pay such mortgage indebtedness. Many of the Partnership's investment properties currently operate in overbuilt markets which are characterized by lower than normal occupancies and/or reduced rent levels. Such competitive conditions have resulted in the operating deficits described below. Based upon estimated operations of certain of the Partnership's investment properties and on the anticipated requirements of the Partnership to fund its share of potential leasing and capital improvement costs at these properties, the Partnership reduced operating cash distributions to the Limited and General Partners effective as of the third quarter of 1991 and subsequently suspended all distributions effective as of the first quarter of 1992. As described more fully in Note 4, the Partnership has received or is negotiating mortgage note modifications (certain of which have expired and others of which expire at various dates commencing October 1996) on the Sherry Lane Place office building, Glades Apartments, Eastridge Apartments, Long Beach Plaza, Carrollwood Apartments, Marshall's Aurora Plaza and Copley Place multi-use complex. The Partnership had been unsuccessful in its efforts to obtain modifications of the loans secured by the 1001 Fourth Avenue office building, University Park office building and the Gables Corporate Plaza, as further discussed below and in Note 4. The Partnership has not remitted the required debt service payments pursuant to the loan agreements on the Gables Corporate Plaza, Long Beach Plaza, and University Park office building as discussed below. Therefore, at December 31, 1993, the corresponding balances of their respective mortgage notes and related deferred accrued interest thereon have been classified as current liabilities in the accompanying Consolidated Financial Statements (see Note 4(a)). In March 1993, the Partnership sold its interest in the Rio Cancion Apartments and the related mortgage loan was discharged out of the sales proceeds (reference is made to Notes (4)(b)(3) and 7(e)). In April 1993, the Partnership sold its interest in the Greenwood Creek II Apartments and the related mortgage loan was discharged by the lender (reference is made to Note (4)(b)(8) and Note 7(f)). In August 1993, Orchard Associates sold its interest in the Old Orchard shopping center (reference is made to Note 3(d)). In November 1993, the Partnership transferred title to the 1001 Fourth Avenue office Building to the lender and the related mortgage loan was discharged by the lender (reference is made to note 4(b)(4)). In January 1994, the Partnership transferred title to the University Park Office Building to the lender and the related mortgage loan was discharged by the lender (reference is made to note 11(b)). In January 1994, the Partnership through Gables Corporate Plaza Associates transferred title to the Gables Corporate Plaza Office Building to the lender and the related mortgage loan was discharged by the lender (reference is made to note 11(a)). For those investment properties where modifications are being sought, or with expired modifications or short-term modifications, if the Partnership is unable to secure new or additional modifications to the loans, based upon current and anticipated market conditions, the Partnership may decide not to commit any significant additional amounts to any of the properties which are incurring, or in the future do incur, operating deficits. This would result in the Partnership no longer having an ownership interest in such property and would result in gain for financial reporting and Federal income tax purposes to the Partnership with no corresponding distributable proceeds. Such decisions would be made on a property-by-property basis. The underlying indebtedness on certain other of the Partnership's investment properties matures and is due and payable commencing in 1994 and subsequent years (reference is made to Note 4 and to Note 3 of Notes to the Combined Financial Statements). The source of repayment is expected to be from proceeds from sale or refinancing, or extension of such indebtedness. However, there can be no assurance that any such sales, refinancings or extensions will occur. Copley Place Although occupancy at the property increased due to recent leasing activity, the Boston office market remains very competitive due to the large supply of available space and to the prevalence of concessions being offered to attract and retain tenants. Commencing January 1, 1992, cash deficits and funding requirements are allocated equally between the Partnership and the joint venture partner. The joint venture has obtained a modification of the existing first mortgage note effective March 1, 1992. The modification lowered the pay rate from 12% to 9% per annum through August 1993, and at that time, further reduced it to 7-1/2% per annum through August 1998. The contract rate has been lowered to 10% per annum through August 1993 and at that time further reduced to 8-1/2% per annum through August 1998. After each monthly payment, the difference between the contract interest rate on the outstanding principal balance of the loan, including deferred interest, and interest paid at the applicable pay rate (as defined) will be added to the principal balance and will accrue interest at the contract interest rate. The outstanding principal balance, including the unpaid deferred interest, is due and payable on August 31, 1998. In return, the lender will be entitled to receive, as additional interest, a minority residual participation of 10% of net proceeds (as defined) from a sale or refinancing after the Partnership and its joint venture partner have recovered their investments (as defined). Any cash flow from the property, after all capital and leasing expenditures, will be escrowed for the purpose of paying for future capital and leasing requirements. As a result of the debt modification, the property produced cash flow in 1993, which has been escrowed for future potential leasing requirements as set forth in the current loan modification. In 1994, the property is expected to experience a significant loss in rental income in connection with the expiration of the IBM lease (245,339 square feet in April 1994 and 34,093 square feet in October 1994) representing 23% of the leasable office space in the aggregate. Although the structure of the modification of the first mortgage loan took into account the potential downsizing of IBM, it was originally anticipated that IBM would renew approximately 80,000 square feet. However, IBM has notified the joint venture that it intends to renew only 10,000 square feet. Therefore, the property's operations will be insufficient to pay the modified debt service. The joint venture has initiated discussions with the first mortgage lender regarding an additional modification of the loan. There can be no assurances such remodification will be consummated. If the joint venture is unable to secure such remodification, the joint venture may decide not to commit any significant additional amounts to the property. This could result in the joint venture no longer having an ownership interest in the property and would result in a gain for financial reporting and Federal income tax purposes with no corresponding distributable proceeds. The joint venture is aggressively marketing IBM's upcoming vacant space. In addition, the manager, an affiliate of the General Partners, has agreed to defer certain management fees. Orchard Associates On September 2, 1993, effective August 30, 1993, Orchard Associates (in which the Partnership and an affiliated partnership sponsored by the Corporate General Partner each have a 50% interest) sold its interest in the Old Orchard shopping center (reference is made to Note 3(d)). The Partnership is currently retaining its share of the net proceeds from the sale for working capital purposes. JMB/NYC At the 2 Broadway building, occupancy increased slightly to 30% during the fourth quarter 1993, up from 29% in the previous quarter. The Downtown Manhattan office leasing market remains depressed due to the significant supply of, and the relatively weak demand for, tenant space. As previously reported, Merrill Lynch, Pierce, Fenner & Smith, Incorporated's lease of approximately 497,000 square feet of space (31% of the building's total space) expired in August 1993. A majority of the remaining tenant roster at the property includes several major financial services companies whose leases expire in 1994. Most of these companies maintain back office support operations in the building which can be easily consolidated or moved. The Bear Stearns Co.'s lease of approximately 186,000 square feet of space (12% of the building's total space), which expires in April 1994, is not expected to be renewed. In addition to the competition for tenants in the Downtown Manhattan market from other buildings in the area, there is ever increasing competition from less expensive alternatives to Manhattan, such as locations in New Jersey and Brooklyn, which are also experiencing high vacancy levels. Rental rates in the Downtown market continue to be at depressed levels and this can be expected to continue while the large amount of vacant space is gradually absorbed. Little, if any, new construction is planned for Downtown over the next few years. It is expected that 2 Broadway will continue to be adversely affected by a high vacancy rate and the low effective rental rates achieved upon releasing of space under existing leases which expire over the next few years. In addition, the property is in need of a major renovation in order to compete in the office leasing market. However, there are currently no plans for a renovation because of the potential sale of the property discussed below and because the effective rents that could be obtained under current market conditions may not be sufficient to justify the costs of the renovation. Occupancy at 1290 Avenue of the Americas increased to 98%, up from 95% in the previous quarter primarily due to Prudential Bache Securities, Inc. occupying 25,158 square feet. The Midtown Manhattan office leasing market remains very competitive. It is expected that the property will continue to be adversely affected by low effective rental rates achieved upon releasing of space covered by existing leases which expire over the next couple years and may be adversely affected by an increased vacancy rate over the next few years. Negotiations are currently being conducted with certain tenants who in the aggregate occupy in excess of 300,000 square feet for the renewal of their leases that expire in 1994 and 1995. John Blair & Co., ("Blair") a major lessee at 1290 Avenue of the Americas (leased space approximates 253,000 square feet or 13% of the building), has filed for Chapter XI bankruptcy. Because much of the Blair space is subleased, the 1290 venture is collecting approximately 70% of the monthly rent due under the leases from the subtenants. There is uncertainty regarding the collection of the balance of the monthly rents from Blair. Accordingly, a provision for doubtful accounts related to the rent and other receivables and accrued rents receivable aggregating $7,659,366 has been recorded at December 31, 1993 in the accompanying combined financial statements related to this tenant. Occupancy at 237 Park Avenue decreased slightly to 98% in the fourth quarter 1993, down from 99% in the previous quarter. It is expected that the property will be adversely affected by the low effective rental rates achieved upon releasing of existing leases which expire over the next few years and may be adversely affected by an increased vacancy rate over the next few years. JMB/NYC has had a dispute with the unaffiliated venture partners who are affiliates (hereinafter sometimes referred to as the "Olympia & York affiliates") of Olympia and York Developments, Ltd. (hereinafter sometimes referred to as "O & Y") over the calculation of the effective interest rate with reference to the first mortgage loan, which covers all three properties, for the purpose of determining JMB/NYC's deficit funding obligation commencing in 1992, as described more fully in Note 3(c). Under JMB/NYC's interpretation of the calculation of the effective rate of interest, 2 Broadway operated at a deficit for the year ended December 31, 1993. During the first quarter of 1993, an agreement was reached between JMB/NYC and the Olympia & York affiliates which rescinded the default notices previously received by JMB/NYC and eliminated any alleged operating deficit funding obligation of JMB/NYC for the period January 1, 1992 through June 30, 1993. Accordingly, during this period, JMB/NYC recorded interest expense at 1-3/4% over the short-term U.S. Treasury obligation rate (subject to a minimum rate of 7% per annum), which is the interest rate on the underlying first mortgage loan. Under the terms of this agreement, during this period, the amount of capital contributions that the Olympia & York affiliates and JMB/NYC would have been required to make to the Joint Ventures, as if the first mortgage loan bore interest at a rate of 12.75% per annum (the Olympia & York affiliates' interpretation), became a priority distribution level to the Olympia & York affiliates from the Joint Ventures' annual cash flow or net sale or refinancing proceeds. The agreement also entitles the Olympia & York affiliates to a 7% per annum return on such unpaid priority distribution level amount. It was also agreed that during this period, the excess available operating cash flow after the payment of the priority distribution level discussed above from any of the Three Joint Ventures will be advanced in the form of loans to pay operating deficits and/or unpaid priority distribution level amounts of any of the other Three Joint Ventures. Such loans will bear a market rate of interest, have a final maturity of ten years from the date when made and will be repayable only out of first available annual cash flow or net sale or refinancing proceeds. The agreement also provides that except as specifically agreed otherwise, the parties each reserves all rights and claims with respect to each of the Three Joint Ventures and each of the partners thereof, including, without limitation, the interpretation of or rights under each of the joint venture partnership agreements for the Three Joint Ventures. The agreement expired on June 30, 1993. Therefore, effective July 1, 1993, JMB/NYC is recording interest expense at 1-3/4% over the short-term U.S. Treasury obligation rate plus any excess operating cash flow after capital costs of the Three Joint Ventures, such sum not to be less than 7% nor exceed a 12-3/4% per annum interest rate. The Olympia & York affiliates dispute this calculation and contend that the 12-3/4% per annum fixed rate applies. JMB/NYC continues to seek, among other things, a restructuring of the joint venture agreements or otherwise to reach an acceptable understanding regarding its long-term funding obligations. If JMB/NYC is unable to achieve this, based upon current and anticipated market conditions mentioned above, JMB/NYC may decide not to commit any additional amounts to 2 Broadway and 1290 Avenue of the Americas, which could, under certain circumstances, result in the loss of the interest in the related ventures. The loss of an interest in a particular venture could, under certain circumstances, permit an acceleration of the maturity of the related Purchase Note (each Purchase Note is secured by JMB/NYC's interest in the related venture). The failure to repay a Purchase Note could, under certain circumstances, constitute a default that would permit an immediate acceleration of the maturity of the Purchase Notes for the other ventures. In such event, JMB/NYC may decide not to repay, or may not have sufficient funds to repay, any of the Purchase Notes and accrued interest thereon. This could result in JMB/NYC no longer having an interest in any of the related ventures, which in that event would result in substantial net gain for financial reporting and Federal income tax purposes to JMB/NYC (and through JMB/NYC and the Partnership, to the Limited Partners) with no distributable proceeds. In addition, under certain circumstances as more fully discussed in Note 3(c), JMB/NYC may be required to make additional capital contributions to certain of the Joint Ventures in order to fund the deficit restoration obligation associated with a deficit balance in its capital account, and the Partnership could be required to bear a share of such capital contributions obligation. If JMB/NYC is successful in its negotiations to restructure the Three Joint Ventures agreements and retains an interest in one or more of these investment properties, there would nevertheless need to be a significant improvement in current market and property operating conditions (including a major renovation of the 2 Broadway building) resulting in a significant increase in value of the properties before JMB/NYC would receive any share of future net sale or refinancing proceeds. The Joint Ventures that own the 2 Broadway building and land have no plans for a renovation of the property because of the potential sale of the property discussed below and because the effective rents that could be obtained under the current office market conditions may not be sufficient to justify the costs of the renovation. Given the current market and property operating conditions, it is likely that the property would sell at a price significantly lower than the allocated portion of the underlying debt. The first mortgage lender and JMB/NYC would need to approve any sale of this property. The O&Y affiliates have informed JMB/NYC that they have now received a written proposal for the sale of 2 Broadway for a net purchase price of $15 million. The first mortgage lender has preliminarily agreed to the concept of a sale of the building but has not approved the terms of any proposed offer for purchase. Accordingly, a sale pursuant to the proposal received by the O&Y affiliates would be subject to, among other things, the approval of the first mortgage lender as well as JMB/NYC. While there can be no assurance that a sale would occur pursuant to such proposal or any other proposal, if this proposal were to be accepted by or consented to by all required parties and the sale completed pursuant thereto, and if discussions with the O&Y affiliates relating to the proposal were finalized to allocate the unpaid first mortgage indebtedness currently allocated to 2 Broadway to 237 Park and 1290 Avenue of the Americas after completion of the sale, then the 2 Broadway Joint Ventures would incur a significant loss for financial reporting purposes. Accordingly, a provision for value impairment has been recorded for financial reporting purposes for $192,627,560, net of the non-recourse portion of the Purchase Notes including related accrued interest related to the 2 Broadway Joint Venture interests that are payable by JMB/NYC to the O&Y affiliates in the amount of $46,646,810. The provision for value impairment has been allocated $136,534,366 and $56,093,194 to the O&Y affiliates and JMB/NYC, respectively. Such provision has been allocated to the partners to reflect their respective ownership percentages before the effect of the non- recourse promissory notes including related accrued interest. The provision for value impairment is not a loss recognizable for Federal income tax purposes. There are certain risks and uncertainties associated with the Partnership's investments made through joint ventures, including the possibility that the Partnership's joint venture partners might become unable or unwilling to fulfill their financial or other obligations, or that such joint venture partners may have economic or business interests or goals that are inconsistent with those of the Partnership. O & Y and certain of its affiliates have been involved in bankruptcy proceedings in the United States and Canada and similar proceedings in England. The Olympia & York affiliates have not been directly involved in these proceedings. During the quarter ended March 31, 1993, O & Y emerged from bankruptcy protection in the Canadian proceedings. In addition, a reorganization of the company's United States operations has been completed, and affiliates of O & Y are in the process of renegotiating or restructuring a number of loans affecting various properties in the United States in which they have an interest. The Partnership is unable to assess and cannot presently determine to what extent these events may adversely affect the willingness and ability of the Olympia & York affiliates either to meet their own obligations to the Joint Ventures and JMB/NYC or otherwise reach an understanding with JMB/NYC regarding any funding obligation of JMB/NYC. However, the financial difficulties of O&Y and its affiliates may be adversely affecting the Three Joint Ventures' efforts to restructure the mortgage loan and to re-lease vacant space in the building. During the fourth quarter of 1992, the Joint Ventures received a notice from the first mortgage lender alleging a default for failure to meet certain reporting requirements of the Olympia & York affiliates contained in the first mortgage loan documents. No monetary default has been alleged. The Olympia & York affiliates have responded to the lender that the Joint Ventures are not in default. JMB/NYC is unable to determine if the Joint Ventures are in default. Accordingly, the balance of the first mortgage loan has been classified as a current liability in the accompanying combined financial statements at December 31, 1992 and 1993. There have not been any further notices from the first mortgage lender. However, the Olympia & York affiliates, on behalf of the Three Joint Ventures, continue to negotiate with representatives of the lender (consisting of a steering committee of holders of notes evidencing the mortgage loan) to restructure certain terms of the existing mortgage loan in order to provide for, among other things, a fixed rate of interest on the loan during the remaining loan term until maturity. In conjunction with the negotiations, the Olympia & York affiliates reached an agreement with the first mortgage lender whereby effective January 1, 1993, the Olympia & York affiliates are limited to taking distributions of $250,000 on a monthly basis from the Three Joint Ventures reserving the remaining excess cash flow in a separate interest-bearing account to be used exclusively to meet the obligations of the Three Joint Ventures as approved by the lender. There is no assurance that a restructuring of the loan will be obtained. Interest on the first mortgage loan is calculated based upon a variable rate related to the short-term U.S. Treasury obligation rate, subject to a minimum rate on the loan of 7% per annum. A significant increase in the short-term U.S. Treasury obligation rate could result in increased interest payable on the first mortgage loan by the Three Joint Ventures. Long Beach Plaza In March 1993, the Partnership completed a settlement of its litigation with Australian Ventures, Inc. ("AVI") involving a long-term ground and improvement lease for approximately 144,000 square feet at the shopping center. Under the terms of the settlement, AVI paid the Partnership $550,000, and the parties terminated the ground and improvement lease. In addition, both parties dismissed their respective claims in the lawsuit with prejudice. The Partnership has paid the $550,000 received from AVI to the mortgage lender for the property as scheduled debt service due for April and part of May 1993 on the loan secured by the property. The Partnership is seeking a replacement tenant for the vacated space. In January 1994, the Partnership received an offer to lease approximately 27,200 square feet of the first floor of the vacated Buffum's building from Ross Dress for Less. In addition, Gold's Gym has offered to lease approximately 34,000 square feet of the third floor of the vacated Buffum's building and relocate from their current 9,813 square foot space on Pine Avenue. The Partnership has several prospects for the smaller Gold's Gym space. There can be no assurance these leases will be consummated. The Partnership had discussions with several other tenants regarding their requests for temporary rent relief of approximately $500,000 in the aggregate in 1992. The tenants indicated that, due to the poor sales levels of their stores at the mall, such relief was necessary if they were to continue to operate. After review of those tenants requesting relief, the Partnership decided to grant temporary relief (approximately 50% of their minimum rent) to certain tenants through December 31, 1992. The Partnership had re-evaluated each tenant's sales level and financial situation for 1993. Based on discussions with the tenants, additional relief was granted for 1993 and the tenants may be granted additional relief in 1994. As a result of the foregoing, the Partnership has initiated discussions with the first mortgage lender regarding a modification of its mortgage loan secured by the property. Due to declining retail sales at the center along with one of the center's anchor tenants vacating its space in 1991, the Partnership has not remitted all of the scheduled debt service payments since June 1993. There can be no assurance that such modification will be consummated (reference is made to Note 4(b)(13)). Greenwood Creek II On April 6, 1993, the Partnership transferred title to the Greenwood Creek II Apartments to the lender for a transfer price of $100,000 (before selling costs and prorations) in excess of the existing mortgage balance. The Partnership recognized a gain in 1993 for financial reporting purposes and recognized a gain for Federal income tax purposes in 1993. Reference is made to Note 7(f). University Park University Park office building's major tenant, California Vision Services, vacated its space of 70,697 square feet (59% of the building) upon the expiration of its lease in April 1993. The tenant's anticipated space requirements over the next several years were expected to grow over 200,000 square feet which the property is unable to accommodate. The Partnership had actively marketed the vacated space. As a result of Cal-Vision's move out, the Partnership was unable to remit the full debt service payment and has submitted cash flow from the property for April through November, 1993. In addition, the Partnership's discussions with the first mortgage lender to further modify the note had been unsuccessful. The Partnership transferred title to the property to the lender in January 1994. Given the current vacancy level of the building and the current and projected market conditions, the likelihood of recovering any additional cash investment necessary to retain ownership of the building would have been remote. This has resulted in the Partnership no longer having an ownership interest in the property and will result in net gain for financial reporting and Federal income tax purposes to the Partnership in 1994 with no corresponding distributable proceeds (reference is made to Note 4(b)(6)). Rio Cancion On March 31, 1993, the Partnership sold the Rio Cancion Apartments. The mortgage loan was satisfied in full from the sales proceeds (reference is made to Note 7(e)). Carrollwood In September 1993, the venture refinanced the mortgage loan, secured by the property, with a third party lender (reference is made to Note 4(b)(11)). The venture did not receive any significant proceeds upon refinancing. 1001 Fourth Avenue In recent years, the Seattle, Washington office market has been very competitive due to significant overbuilding, especially in the Central Business District where 1001 Fourth Avenue Plaza is located. Current vacancy rates exceed 15%, and rental rates remain significantly depressed. In addition, a substantial amount of sublease space had become available in the immediate downtown area. Given the current and projected market conditions, the likelihood of recovering the additional cash investment necessary to fund anticipated operating deficits would for 1001 Fourth Avenue Plaza have been remote. As discussed more fully in Note 1, the Partnership recorded, as a matter of prudent accounting practice, a provision at June 30, 1992, for value impairment to reduce the net carrying value of the 1001 Fourth Avenue Plaza office building to the then outstanding balance of the related non-recourse financing due to the uncertainty of the Partnership's ability to recover the net carrying value of the investment property through future operations or sale. In addition, certain disputes had arisen between the Partnership and the lender regarding a $2,000,000 letter of credit maintained by the Partnership as additional security for the lender in connection with the existing loan modification. As a result of defaults alleged by the lender, the lender attempted to draw on the $2,000,000 letter of credit prior to its expiration in November 1992. The Partnership obtained a temporary restraining order from the Supreme Court of the State of New York disallowing the lender from drawing on the letter of credit in consideration for the Partnership renewing the letter of credit for a period of ninety days to allow the parties to attempt to resolve their differences. In February 1993, the Partnership extended the letter of credit for an additional sixty days in an attempt to resolve the disputes with the lender. Subsequently, in March 1993, the temporary restraining order expired. The Supreme Court of the State of New York agreed to extend the temporary restraining order providing the Partnership post a $2,000,000 bond by April 1, 1993. The Partnership posted a $2,000,000 bond on April 1, 1993. The lender appealed this entire order. On April 29, 1993, the Partnership was notified by the Supreme Court of the State of New York that a decision was rendered in favor of the Partnership regarding the disputes surrounding the letter of credit. In late June 1993 an order was entered by the court reflecting said decision. The lender notified the Partnership that it had intended to appeal the order. As a result, the lender claimed that the release of the bond and the return of the letter of credit had been stayed pending the appeal. Negotiations with the lender for a loan modification have been unsuccessful. On November 1, 1993, the Partnership transferred title to the 1001 Fourth Avenue Plaza office building in full satisfaction of the Partnership's mortgage obligation (which had an outstanding balance, including accrued interest, of approximately $102,607,000). In exchange for the transfer of title, the lender had agreed to settle its litigation against the Partnership and return the Partnership's bond and letter of credit. This transfer has resulted in the Partnership no longer having an ownership interest in the property. Reference is made to Note 4(b)(4). Eastridge Apartments The Partnership reached an agreement with the lender for another modification effective May 1, 1993 on the mortgage loan secured by the property. Reference is made to Note 4(b)(5) for a description of the loan modification. Sherry Lane Place The Partnership reached an agreement with the lender for another modification effective November 1993 on the mortgage loan secured by the property. Reference is made to Note 4(b)(1) for a description of the loan modification. Marshall's Aurora Plaza In January 1994, the Partnership reached an agreement with the lender for a loan modification and extension on the mortgage loan secured by the property effective November 1993. Reference is made to Note 4(b)(12) for a description of the loan modification. Gables Corporate Plaza In January 1994, the venture transferred title to the property to the lender. Therefore, neither the venture nor the Partnership have an ownership interest in the property. This transfer will result in net gain for financial reporting and Federal income tax purposes in 1994 with no corresponding distributable proceeds. Reference is made to Note 4(b)(7) and 11(a). Plaza Tower The first mortgage loan secured by the property matures in November 1994. The property produced cash flow in 1993 and is expected to operate at or near the break even level in 1994. This is due primarily to anticipated leasing costs associated with the rollover in tenant leases in 1994 and 1995. Currently, the Partnership is exploring its refinancing possibilities. However, there can be no assurance that the Partnership will be able to refinance the mortgage loan or obtain a loan extension. General An affiliate of the General Partners that acts as the property manager at a number of the Partnership's investment properties has deferred receipt of its property management and leasing fees. The cumulative amount of deferred property management and leasing fees at December 31, 1993 was approximately $13,671,000 (approximately $37 per $1,000 Interest). The amounts do not bear interest and are payable in the future. A number of the Partnership's investments have been made through joint venture investments. There are certain risks associated with the Partnership's investments made through joint ventures including the possibility that the Partnership's joint venture partners might become unable or unwilling to fulfill their financial or other obligations or, that such joint venture partners may have economic or business interests or goals that are inconsistent with those of the Partnership. Due to the market conditions and property specific factors discussed above and the general lack of buyers of real estate today, it is likely that the Partnership may hold some of its investment properties longer than originally anticipated in order to maximize the recovery of its investments and any potential return thereon. However, in light of the current severely depressed real estate markets, it currently appears that the Partnership's goal of capital appreciation will not be achieved. Although the Partnership expects to distribute from sale proceeds some portion of the Limited Partners' original capital, without a dramatic improvement in market conditions, the Limited Partners will not receive a full return of their original investment. RESULTS OF OPERATIONS The increase in cash and cash equivalents and short-term investments at December 31, 1993 as compared to December 31, 1992 is due primarily to the distributions of $16,978,465 from Orchard Associates as a result of its redemption (sale) of its interest in Old Orchard shopping center as more fully described in Note 3(d). In addition, the increase in cash is due to cash flow generated from property operations at the Copley Place multi-use complex being reserved to fund budgeted capital improvements pursuant to the loan modification agreement as more fully described in Note 4(b)(10) and the receipt of sales proceeds from the sales of the Rio Cancion Apartments in March 1993 and the Greenwood Creek II Apartments in April 1993. Reference is made to Notes 7(e) and 7(f). The decrease in restricted funds at December 31, 1993 as compared to December 31, 1992 is due primarily to the Partnership being released from its letter of credit obligation as a result of the transfer of title to the 1001 Fourth Avenue office building as more fully described in Note 4(b)(4). The increase in escrow deposits and accrued real estate taxes at December 31, 1993 as compared to December 31, 1992 is due primarily to the timing of real estate tax payments at certain of the Partnership's investment properties. The decrease in investment in unconsolidated venture at equity at December 31, 1993 as compared to December 31, 1992 is due primarily to the distributions of $16,978,465 from Orchard Associates as a result of its redemption of interest in Old Orchard Shopping Center. In addition, the decrease was partially offset by the Partnership's share of gain on sale of interest in unconsolidated venture of $7,898,727 as a result of the above event (Note 3(d)). Also, the decrease was partially offset by the $1,200,400 investment, which represents the Partnership's paid-in capital obligation, in Carlyle Investors, Inc. (the general partner of Carlyle-XIII Associates, L.P.) and Carlyle Managers, Inc. (the general partner of JMB Office Building Associates, L.P.) of which the Partnership is a 20% shareholder (see Note 3(c)). The corresponding increase in amounts due affiliates is primarily the result of the above stated obligation. The increase in venture partners' subordinated equity in ventures at December 31, 1993 as compared to December 31, 1992 and the corresponding decrease in venture partners' share of loss from ventures operations for the twelve months ended December 31, 1993 as compared to the twelve months ended December 31, 1992 and 1991 is due primarily to the decrease in operating losses which resulted from the lower accrual rate on the loan modification as well as higher occupancy at the Copley Place multi-use complex. The increase in rents and other receivables at December 31, 1993 as compared to December 31, 1992 is due primarily to the timing of escalations from tenants relating to 1993 at certain of the partnership investment properties. The decreases in prepaid expenses, land and leasehold interests, building and improvements, accumulated depreciation, deferred expenses, accrued rents receivable, current portion of long term debt, unearned rents, tenant security deposits and long term debt at December 31, 1993 as compared to December 31, 1992 and the related decreases in rental income, mortgage and other interests, depreciation property operating expenses and general and administrative expenses and the increase in amortization for the year ended December 31, 1993 as compared to the year ended December 31, 1992 are due primarily to the transfer of title to the 1001 Fourth Avenue office building in November 1993 (reference is made to Note 4(b)(4) and the sales of the Rio Cancion Apartments in March 1993 and the Greenwood Creek II Apartments in April 1993 (reference is made to Notes 7(e) and 7(f)). The decrease in rental income, mortgage and other interest, depreciation, and general and administrative expenses for the twelve months ended December 31, 1992 as compared to the twelve months ended December 31, 1991 is due primarily to the sales of Quail Place and Heritage Park II Apartments in March 1992 and Bridgeport Apartments in April 1992 (as more fully discussed in Note 7). The decrease in interest income for the year ended December 31, 1993 as compared to the year ended December 31, 1992 and 1991 is due primarily to lower yields and lower average balances held in interest bearing U.S. government obligations in the subsequent periods. The increase in property operating expenses for the year ended December 31, 1992 as compared to the year ended December 31, 1991 is primarily due to increased repairs and maintenance and utilities expense during 1992 at the Copley Place multi-use complex. The increase is partially offset by the sales of the Quail Place and Heritage Park II Apartments in March 1992 and Bridgeport Apartments in April 1992 (as more fully discussed in Note 7). The increase in professional services for the year ended December 31, 1992 as compared to the year ended December 31, 1991 is primarily attributable to legal fees associated with the litigation involving the Long Beach Plaza. The increase in amortization of deferred expenses for the year ended December 31, 1992 as compared to the year ended December 31, 1991 is due to increased leasing commissions recorded and amortized at certain of the investment properties during 1992. The provision for value impairment of $6,409,039 at December 31, 1992 is due primarily to the reduction of the net carrying value of the 1001 Fourth Avenue office building as of June 30, 1992. (See Note 1.) The increase in the Partnership's share of the loss from operations of unconsolidated ventures and the related increase in the Partnership's deficit investment in unconsolidated venture for the year ended December 31, 1993 as compared to the year ended December 31, 1992 is due primarily to (i) a $192,627,560 provision for value impairment recorded in 1993 for 2 Broadway due to the potential sale of the property at a sales price significantly below its net carrying value, as more fully discussed above, (ii) an $11,946,285 provision for doubtful accounts recorded by JMB/NYC due to the uncertainty of collectibility of amounts due from the Olympia & York affiliates to the Three Joint Ventures, (iii) an $11,551,049 provision for doubtful accounts recorded by JMB/NYC due to the uncertainty of collectibility of amounts due from tenants at the Three Joint Ventures' real estate investment properties, and (iv) increased aggregate interest accrued with reference to the Three Joint Ventures' mortgage loan commencing July 1, 1993 as a result of the expiration of the agreement with the Olympia & York affiliates, as more fully discussed in Note 3(c). The decrease in the Partnership's share of loss of operations of unconsolidated ventures for the year ended December 31, 1992 as compared to the year ended December 31, 1991 is primarily due to (i) the change in profit and loss allocation from 1991 to 1992 pursuant to the Three Joint Ventures' agreements, as more fully described in Note 3(c) of Notes to Financial Statements, (ii) the collection in 1992 of $6,069,444 of a total $13,340,601 bankruptcy claim against Drexel Burnham Lambert, a former tenant of the 2 Broadway Building, and (iii) the reduced aggregate interest accrued on the joint ventures' mortgage loan commencing in 1992 based upon the interest accrual determined by JMB/NYC, as more fully described above. The net gain of $11,083,791 consists of a gain on the sale of the Rio Cancion Apartments of $2,524,958 (see Note 7(e)), a gain on the sale of the Greenwood Creek II Apartments of $1,787,073 (see Note 7(f)), a gain on the transfer of title to the 1001 Fourth Avenue office building of $6,771,760 (see Note 4(b)(4)). The extraordinary item is the Partnership's share of prepayment penalty of $141,776 relating to the refinancing of the original mortgage note at the Carrollwood Apartments (see Note 4(b)(11)). The net gain on sale in 1992 of $9,422,815 related to the sales of the Quail Place and Heritage Park II Apartments in March 1992, and Bridgeport Apartments in April 1992 has been reflected as a gain on sales of $2,132,879, and an extraordinary gain of forgiveness of indebtedness of $7,289,936 (as more fully discussed in Note 7). In addition, the extraordinary item includes the Partnership's share of the prepayment penalty (of $150,000) related to the refinancing of the original mortgage note at the Glades Apartments (as more fully discussed in Note 4(b)(2)). INFLATION Due to the decrease in the level of inflation in recent years, inflation generally has not had a material effect on rental income or property operating expenses. To the extent that inflation does have an adverse impact on property operating expenses, the increased expense may be offset by amounts recovered from tenants, as many long-term leases at the Partnership's commercial properties have escalation clauses covering increases in the cost of operating and maintaining the properties as well as real estate taxes. Therefore, the effect on operating earnings generally will depend upon whether properties remain substantially occupied. In addition, substantially all of the leases - at the Partnership's shopping center investments contain provisions which entitle the property owner to participate in gross receipts of tenants above fixed minimum amounts. Future inflation may also tend to cause capital appreciation of the Partnership's investment properties over a period of time as rental rates and replacement costs of properties increase. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA CARLYLE REAL ESTATE LIMITED PARTNERSHIP - XIII (A LIMITED PARTNERSHIP) AND CONSOLIDATED VENTURES INDEX Independent Auditors' Report Consolidated Balance Sheets, December 31, 1993 and 1992 Consolidated Statements of Operations, years ended December 31, 1993, 1992 and 1991 Consolidated Statements of Partners' Capital Accounts (Deficits), years ended December 31, 1993, 1992 and 1991 Consolidated Statements of Cash Flows, years ended December 31, 1993, 1992 and 1991 Notes to Consolidated Financial Statements SCHEDULE -------- Supplementary Income Statement Information X Consolidated Real Estate and Accumulated Depreciation XI SCHEDULES NOT FILED: All schedules other than those indicated in the index have been omitted as the required information is inapplicable or the information is presented in the consolidated financial statements or related notes. JMB/NYC OFFICE BUILDING ASSOCIATES AND UNCONSOLIDATED VENTURES INDEX Independent Auditors' Report Combined Balance Sheets, December 31, 1993 and 1992 Combined Statements of Operations, years ended December 31, 1993, 1992 and 1991 Combined Statements of Partners' Capital Accounts (Deficit), years ended December 31, 1993, 1992 and 1991 Combined Statements of Cash Flows, years ended December 31, 1993, 1992 and 1991 Notes to Combined Financial Statements SCHEDULE -------- Supplementary Income Statement Information X Combined Real Estate and Accumulated Depreciation XI SCHEDULES NOT FILED: All schedules other than those indicated in the index have been omitted as the required information is inapplicable or the information is presented in the combined financial statements or related notes. INDEPENDENT AUDITORS' REPORT The Partners CARLYLE REAL ESTATE LIMITED PARTNERSHIP - XIII: We have audited the consolidated financial statements of Carlyle Real Estate Limited Partnership - XIII, a limited partnership, (the Partnership), and consolidated ventures as listed in the accompanying index. In connection with our audits of the consolidated financial statements, we also have audited the financial statement schedules as listed in the accompanying index. These consolidated financial statements and financial statement schedules are the responsibility of the General Partners of the Partnership. Our responsibility is to express an opinion on these consolidated financial statements and financial statement schedules based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by the General Partners of the Partnership, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of the Partnership and consolidated ventures at December 31, 1993 and 1992, and the results of their operations and their cash flows for each of the years in the three-year period ended December 31, 1993, in conformity with generally accepted accounting principles. Also in our opinion, the related financial statement schedules, when considered in relation to the basic consolidated financial statements taken as a whole, present fairly, in all material respects, the information set forth therein. As discussed in Note 3(c) to the consolidated financial statements, the Partnership and its affiliated partners in JMB/NYC Office Building Associates, L.P. (JMB/NYC) are in dispute with the unaffiliated partners in the real estate ventures over the calculation of the effective interest rate with reference to the first mortgage loan which covers all the real estate owned through JMB/NYC's joint ventures. The Partnership and its affiliated partners in JMB/NYC believe that, for purposes of calculating cash flow deficits and for financial reporting purposes, the joint venture agreements for JMB/NYC's real estate joint ventures require interest to be computed at an effective rate of 1-3/4% over the short-term U.S. Treasury obligation rate (subject to a minimum rate of 7% per annum) plus any excess monthly Net Cash Flow of the real estate owned through JMB/NYC's joint ventures, such sum not to exceed 12- 3/4% per annum. The unaffiliated partners in the real estate joint ventures contend that a 12-3/4% per annum interest rate applies. The Partnership's share of disputed interest aggregated $2,386,000 at December 31, 1993. The ultimate outcome of the dispute cannot presently be determined. Accordingly, the Partnership's share of the disputed interest has not been included in the Partnership's share of operations of unconsolidated ventures for 1993. In (Continued) addition, as described in Notes 3 and 4 of the notes to the consolidated financial statements, the Partnership is in dispute or negotiations with various lenders and venture partners in connection with certain of its investment properties. Such disputes or negotiations could result, under certain circumstances, in the Partnership no longer having an ownership interest in these investment properties. The ultimate outcome of these disputes or negotiations cannot be presently determined. The consolidated financial statements do not include any adjustments that might result from these uncertainties. KPMG PEAT MARWICK Chicago, Illinois March 28, 1994 CARLYLE REAL ESTATE LIMITED PARTNERSHIP - XIII (A LIMITED PARTNERSHIP) AND CONSOLIDATED VENTURES CONSOLIDATED BALANCE SHEETS DECEMBER 31, 1993 AND 1992 ASSETS 1993 1992 ------------ ----------- Current assets: Cash and cash equivalents (note 1) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 5,362,152 2,627,520 Short-term investments (note 1). . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 23,095,901 4,624,942 Restricted funds . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 538,800 2,857,906 Rents and other receivables. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,711,359 3,280,727 Prepaid expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 397,109 498,106 Escrow deposits. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,918,882 3,284,294 ------------ ------------ Total current assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 37,024,203 17,173,495 Investment properties, at cost (notes 2, 3 and 4) - Schedule XI: Land and leasehold interests . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 27,002,062 39,324,545 Buildings and improvements . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 447,201,128 588,491,034 ------------ ------------ 474,203,190 627,815,579 Less accumulated depreciation. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 149,914,951 178,425,639 ------------ ------------ Total investment properties, net of accumulated depreciation . . . . . . . . . . . . . . . . 324,288,239 449,389,940 ------------ ------------ Investment in unconsolidated venture, at equity (notes 1 and 3). . . . . . . . . . . . . . . . . . . . 2,446,681 9,598,799 Deferred expenses (note 1) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5,983,034 7,214,461 Accrued rents receivable (note 1). . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 487,289 3,243,021 Venture partners' deficits in ventures (note 1). . . . . . . . . . . . . . . . . . . . . . . . . . . . 4,557,854 3,067,356 ------------ ------------ $374,787,300 489,687,072 ============ ============ CARLYLE REAL ESTATE LIMITED PARTNERSHIP - XIII (A LIMITED PARTNERSHIP) AND CONSOLIDATED VENTURES CONSOLIDATED BALANCE SHEETS - CONTINUED 1993 1992 ------------ ----------- LIABILITIES AND PARTNERS' CAPITAL ACCOUNTS (DEFICITS) Current liabilities: Current portion of long-term debt (note 4) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 94,086,630 96,553,360 Accounts payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,397,159 2,387,568 Amounts due to affiliates (note 9) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14,894,459 13,668,292 Unearned rents . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 770,237 1,128,152 Accrued interest . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8,591,163 7,988,024 Accrued real estate taxes. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,064,479 1,373,462 ------------ ------------ Total current liabilities. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 122,804,127 123,098,858 Tenant security deposits . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 880,056 999,795 Investment in unconsolidated venture, at equity (notes 1, 3 and 10). . . . . . . . . . . . . . . . . . 72,546,193 50,385,319 Long-term debt, less current portion (note 4). . . . . . . . . . . . . . . . . . . . . . . . . . . . . 360,881,897 464,855,926 ------------ ------------ Total liabilities. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 557,112,273 639,339,898 Venture partners' subordinated equity in venture (note 1). . . . . . . . . . . . . . . . . . . . . . . 330,185 814,880 Partners' capital accounts (deficits) (notes 1 and 5): General partners: Capital contributions. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,000 1,000 Cumulative net losses. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (19,664,338) (18,232,317) Cumulative cash distributions. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (1,039,022) (1,039,022) ------------ ------------ (20,702,360) (19,270,339) ------------ ------------ Limited partners (366,183 interests): Capital contributions, net of offering costs . . . . . . . . . . . . . . . . . . . . . . . . . . 326,224,167 326,224,167 Cumulative net losses. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (458,202,076) (427,446,645) Cumulative cash distributions. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (29,974,889) (29,974,889) ------------ ------------ (161,952,798) (131,197,367) ------------ ------------ Total partners' capital (deficits) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (182,655,158) (150,467,706) ------------ ------------ Commitments and contingencies (notes 2, 3, 4, 7, 8 and 11) $374,787,300 489,687,072 ============ ============ See accompanying notes to consolidated financial statements. /TABLE CARLYLE REAL ESTATE LIMITED PARTNERSHIP - XIII (A LIMITED PARTNERSHIP) AND CONSOLIDATED VENTURES CONSOLIDATED STATEMENTS OF OPERATIONS YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 1993 1992 1991 ------------ ------------ ------------ Income: Rental income. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 84,609,796 92,814,257 93,080,468 Interest income. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 583,997 795,627 1,105,368 ------------ ------------ ------------ 85,193,793 93,609,884 94,185,836 ------------ ------------ ------------ Expenses (Schedule X): Mortgage and other interest. . . . . . . . . . . . . . . . . . . . . . . . . . 50,753,647 57,574,370 64,090,897 Depreciation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 18,343,123 19,490,916 20,391,223 Property operating expenses. . . . . . . . . . . . . . . . . . . . . . . . . . 43,065,564 45,068,702 43,979,318 Professional services. . . . . . . . . . . . . . . . . . . . . . . . . . . . . 708,403 681,645 576,360 Amortization of deferred expenses. . . . . . . . . . . . . . . . . . . . . . . 2,410,540 1,671,011 284,201 Management fees to general partners. . . . . . . . . . . . . . . . . . . . . . -- 12,715 108,075 General and administrative . . . . . . . . . . . . . . . . . . . . . . . . . . 532,727 640,821 658,203 Provision for value impairment (note 1). . . . . . . . . . . . . . . . . . . . -- 6,409,039 -- ------------ ------------ ------------ 115,814,004 131,549,219 130,088,277 ------------ ------------ ------------ Operating loss. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30,620,211 37,939,335 35,902,441 Partnership's share of loss from operations of unconsolidated ventures (notes 1 and 10) . . . . . . . . . . . . . . . . . . . 22,416,922 8,007,990 13,356,918 Venture partners' share of loss of ventures' operations. . . . . . . . . . . . . (2,008,939) (3,376,600) (6,392,827) ------------ ------------ ------------ Net operating loss . . . . . . . . . . . . . . . . . . . . . . . . . . . 51,028,194 42,570,725 42,866,532 Gain on sale or disposition of investment properties and extinguishment of debt (notes 4 and 7) . . . . . . . . . . . . . . . . . . . . (11,083,791) (2,132,879) (1,476,395) Gain on sale of interest in unconsolidated venture (note 3(d)) . . . . . . . . . (7,898,727) -- -- Loss on venture partners' relinquishment of interest in investment property (note 3(e)) . . . . . . . . . . . . . . . . . . . . . . -- -- 1,161,626 ------------ ------------ ------------ Net loss before extraordinary items. . . . . . . . . . . . . . . . . . . 32,045,676 40,437,846 42,551,763 CARLYLE REAL ESTATE LIMITED PARTNERSHIP - XIII (A LIMITED PARTNERSHIP) AND CONSOLIDATED VENTURES CONSOLIDATED STATEMENTS OF OPERATIONS - CONTINUED 1993 1992 1991 ------------ ------------ ------------ Extraordinary items (notes 4(b)(2), 7(b) and (c)). . . . . . . . . . . . . . . . 141,776 (7,139,936) -- ------------ ------------ ------------ Net loss. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 32,187,452 33,297,910 42,551,763 ============ ============ ============ Net loss per limited partnership interest (note 1): Net operating loss . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 134.92 111.62 112.38 Gain on sale or disposition of investment properties and extinguishment of debt . . . . . . . . . . . . . . . . . . . . . . . . (29.97) (5.77) (3.99) Gain on sale of interest in unconsolidated venture . . . . . . . . . . . . . (21.35) -- -- Loss on venture partners' relinquishment of interest in investment property . . . . . . . . . . . . . . . . . . . . . . . . . . -- -- 3.14 Extraordinary items. . . . . . . . . . . . . . . . . . . . . . . . . . . . . .38 (19.31) -- ------------ ------------ ------------ Net loss . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 83.98 86.54 111.53 ============ ============ ============ See accompanying notes to consolidated financial statements. /TABLE CARLYLE REAL ESTATE LIMITED PARTNERSHIP - XIII (A LIMITED PARTNERSHIP) AND CONSOLIDATED VENTURES CONSOLIDATED STATEMENTS OF PARTNERS' CAPITAL ACCOUNTS (DEFICITS) YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 GENERAL PARTNERS LIMITED PARTNERS (366,183 INTERESTS) -------------------------------------------------------- ------------------------------------------------ CONTRI- BUTIONS NET NET OF NET CONTRI- EARNINGS CASH OFFERING EARNINGS CASH BUTIONS (LOSS) DISTRIBUTIONS TOTAL COSTS (LOSS) DISTRIBUTIONS TOTAL ------- ---------- ------------- ----------- ------------ ------------ ------------- ------------ Balance (deficit) December 31, 1990 . $1,000 (14,910,702) (966,548) (15,876,250) 326,224,167 (354,918,587) (28,235,517) (56,929,937) Net loss . . . . . . -- (1,711,514) -- (1,711,514) -- (40,840,249) -- (40,840,249) Cash distributions ($4.25 per limited partnership interest) . . . . . -- -- (64,845) (64,845) -- -- (1,556,280) (1,556,280) ------ ----------- ---------- ----------- ------------ ------------ ----------- ------------ Balance (deficit) December 31, 1991 . 1,000 (16,622,216) (1,031,393) (17,652,609) 326,224,167 (395,758,836) (29,791,797) (99,326,466) Net loss . . . . . . -- (1,610,101) -- (1,610,101) -- (31,687,809) -- (31,687,809) Cash distributions ($.50 per limited partnership interest) . . . . . -- -- (7,629) (7,629) -- -- (183,092) (183,092) ------ ----------- ---------- ----------- ------------ ------------ ----------- ------------ Balance (deficit) December 31, 1992 . 1,000 (18,232,317) (1,039,022) (19,270,339) 326,224,167 (427,446,645) (29,974,889) (131,197,367) Net loss . . . . . . -- (1,432,021) -- (1,432,021) -- (30,755,431) -- (30,755,431) Cash distributions ($0 per limited partnership interest) . . . . . -- -- -- -- -- -- -- -- ------ ----------- ---------- ----------- ------------ ------------ ----------- ------------ Balance (deficit) December 31, 1993 . $1,000 (19,664,338) (1,039,022) (20,702,360) 326,224,167 (458,202,076) (29,974,889) (161,952,798) ====== =========== ========== =========== ============ ============ =========== ============ See accompanying notes to consolidated financial statements. /TABLE CARLYLE REAL ESTATE LIMITED PARTNERSHIP - XIII (A LIMITED PARTNERSHIP) AND CONSOLIDATED VENTURES CONSOLIDATED STATEMENTS OF CASH FLOWS YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 1993 1992 1991 ------------ ------------ ------------ Cash flows from operating activities: Net loss . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $(32,187,452) (33,297,910) (42,551,763) Items not requiring (providing) cash or cash equivalents: Depreciation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 18,343,123 19,490,916 20,391,223 Amortization of deferred expenses. . . . . . . . . . . . . . . . . . . . . . 2,410,540 1,671,011 284,201 Amortization of discount on long-term debt . . . . . . . . . . . . . . . . . 103,298 91,671 81,354 Long-term debt - deferred accrued interest . . . . . . . . . . . . . . . . . 13,461,723 13,710,342 13,040,330 Partnership's share of loss from operations of unconsolidated ventures, net of distributions . . . . . . . . . . . . . . . . . . . . . . . . . . . 22,416,922 8,007,990 13,356,918 Venture partners' share of ventures' operations. . . . . . . . . . . . . . . (2,008,939) (3,376,600) (6,392,827) Gain on sale of investment property and extinguishment of debt . . . . . . . (11,083,791) (2,132,879) (1,476,395) Provision for value impairment (note 1). . . . . . . . . . . . . . . . . . . -- 6,409,039 -- Extraordinary items. . . . . . . . . . . . . . . . . . . . . . . . . . . . . 141,776 (7,139,936) -- Gain on sale of interest in unconsolidated venture . . . . . . . . . . . . . (7,898,727) -- -- Loss on venture partner's relinquishment of interest of investment property. -- -- 1,161,626 Changes in: Restricted funds . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,319,106 (272,906) -- Rents and other receivables. . . . . . . . . . . . . . . . . . . . . . . . . (430,632) 1,227,951 393,766 Prepaid expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 100,997 50,122 (38,636) Escrow deposits. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (634,588) (2,054,307) 175,311 Accrued rents receivable . . . . . . . . . . . . . . . . . . . . . . . . . . 2,755,732 824,390 (7,307) Accounts payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9,591 (1,224,442) 343,870 Unearned rents . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (357,915) (26,887) 314,346 Accrued interest . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,957,457 546,217 2,272,377 Accrued real estate taxes. . . . . . . . . . . . . . . . . . . . . . . . . . 691,017 179,232 40,859 Amounts due to affiliates. . . . . . . . . . . . . . . . . . . . . . . . . . 26,167 2,390,394 2,485,952 Tenant security deposits . . . . . . . . . . . . . . . . . . . . . . . . . . (119,739) (305,083) 353,786 ------------ ------------ ------------ Net cash provided by operating activities. . . . . . . . . . . . . . . 10,015,666 4,768,325 4,228,991 ------------ ------------ ------------ Cash flows from investing activities: Cash proceeds from sale of investment properties, net of selling expenses (note 7) 1,220,737 338,196 -- Additions to investment properties . . . . . . . . . . . . . . . . . . . . . . (3,188,425) (6,144,928) (3,741,972) Cash expended in disposition of investment properties. . . . . . . . . . . . . (55,111) -- -- Net sales (purchases) of short-term investments. . . . . . . . . . . . . . . . (18,470,959) 3,311,641 -- Partnership's distributions from unconsolidated ventures . . . . . . . . . . . 16,978,465 -- 2,772,501 Partnership's contributions to unconsolidated ventures . . . . . . . . . . . . (983,668) (1,796,723) (2,895,937) Payment of deferred expenses . . . . . . . . . . . . . . . . . . . . . . . . . (1,030,569) (2,444,529) (2,062,606) ------------ ------------ ------------ (A LIMITED PARTNERSHIP) AND CONSOLIDATED VENTURES CONSOLIDATED STATEMENTS OF CASH FLOWS YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 1993 1992 1991 ------------ ------------ ------------ Net cash used in investing activities. . . . . . . . . . . . . . . . . (5,529,530) (6,736,343) (5,928,014) ------------ ------------ ------------ Cash flows from financing activities: Proceeds from refinancing of long-term debt. . . . . . . . . . . . . . . . . . 4,253 10,840,261 -- Retirement of long-term debt . . . . . . . . . . . . . . . . . . . . . . . . . -- (10,726,327) -- Proceeds from long-term debt . . . . . . . . . . . . . . . . . . . . . . . . . -- -- 4,210,508 Principal payments on long-term debt . . . . . . . . . . . . . . . . . . . . . (1,789,503) (841,946) (1,575,082) Venture partners' contributions to ventures. . . . . . . . . . . . . . . . . . 33,746 158,931 290,979 Distributions to limited partners. . . . . . . . . . . . . . . . . . . . . . . -- (183,092) (1,556,280) Distributions to general partners. . . . . . . . . . . . . . . . . . . . . . . -- (7,629) (64,845) ------------ ------------ ------------ Net cash provided by (used in) financing activities. . . . . . . . . . (1,751,504) (759,802) 1,305,280 ------------ ------------ ------------ Net increase (decrease) in cash and cash equivalents . . . . . . . . . $ 2,734,632 (2,727,820) (393,743) ============ ============ ============ Supplemental disclosure of cash flow information: Cash paid for mortgage and other interest. . . . . . . . . . . . . . . . . . . $ 35,628,310 43,340,504 48,442,796 ============ ============ ============ Total sales price of investment properties, net of selling expenses. . . . . . $ 18,479,297 18,442,566 -- Mortgage loan payable. . . . . . . . . . . . . . . . . . . . . . . . . . . . . (17,258,560) (18,104,370) -- ------------ ------------ ------------ Cash sales proceeds from sale of investment properties, net of selling expenses. . . . . . . . . . . . . . . . . . . . . . . . . . $ 1,220,737 338,196 -- ============ ============ ============ Proceeds from refinancing of long-term debt (note 3(l)). . . . . . . . . . . . $ 7,455,000 -- -- Payoff of long-term debt . . . . . . . . . . . . . . . . . . . . . . . . . . . (7,160,425) -- -- Prepayment penalty . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (141,776) -- -- Refinancing costs. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (148,546) -- -- ------------ ------------ ------------ Proceeds from refinancing of long-term debt. . . . . . . . . . . . . . $ 4,253 -- -- ============ ============ ============ (A LIMITED PARTNERSHIP) AND CONSOLIDATED VENTURES CONSOLIDATED STATEMENTS OF CASH FLOWS YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 1993 1992 1991 ------------ ------------ ------------ Non-cash investing and financing activities: Contributions payable to unconsolidated venture (note 3(b)) . . . . . . . $ 1,200,000 -- -- ============ ============ ============ Disposition of investment properties (notes 1 and 4(b)(9)): Balance due on long-term debt cancelled. . . . . . . . . . . . . . . . $ -- -- 13,660,000 Reduction of accrued interest payable. . . . . . . . . . . . . . . . . -- -- 1,038,448 Reduction of investment properties . . . . . . . . . . . . . . . . . . -- -- (13,214,358) Disposition costs. . . . . . . . . . . . . . . . . . . . . . . . . . . -- -- (7,695) ------------ ------------ ------------ Non-cash gain recognized due to lender realizing upon security. . . . . . $ -- -- 1,476,395 ============ ============ ============ Principal balance due on mortgages payable. . . . . . . . . . . . . . . . $ -- 13,589,936 -- Payment on long-term debt from sale of investment properties. . . . . . . -- (6,300,000) -- ------------ ------------ ------------ Extraordinary items - non-cash gain recognized on forgiveness of indebtedness. . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ -- 7,289,936 -- ============ ============ ============ Total sales price, net of selling expenses (notes 7(e) and (f)) . . . . . $ 18,479,297 -- -- Reduction in land . . . . . . . . . . . . . . . . . . . . . . . . . . . . (12,322,483) -- -- Reduction in buildings and improvements . . . . . . . . . . . . . . . . . (143,821,518) -- -- Reduction in accumulated depreciation . . . . . . . . . . . . . . . . . . 46,196,996 -- -- Balance due on long-term debt cancelled (note 4(b)(4)). . . . . . . . . . 102,606,610 -- -- Cash expended in disposition of investment property . . . . . . . . . . . (55,111) -- -- ------------ ------------ ------------ Gain on sale of investment property and extinguishment of debt . . . . $ 11,083,791 -- -- ============ ============ ============ See accompanying notes to consolidated financial statements. /TABLE CARLYLE REAL ESTATE LIMITED PARTNERSHIP - XIII (A LIMITED PARTNERSHIP) AND CONSOLIDATED VENTURES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 1993, 1992 AND 1991 (1) BASIS OF ACCOUNTING The accompanying consolidated financial statements include the accounts of the Partnership and its consolidated ventures (note 3) - Partridge Place Limited Partnership ("Heritage"), Quail Springs Limited Partnership ("Quail"), Eastridge Associates Limited Partnership ("Eastridge"), Copley Place Associates ("Copley Place"), Gables Corporate Plaza Associates ("Gables"), Carrollwood Station Associates, Ltd. ("Carrollwood"), Jacksonville Cove I Associates, Ltd. ("Glades") and Sherry Lane Associates ("Sherry Lane"). The effect of all transactions between the Partnership and the ventures has been eliminated. The equity method of accounting has been applied in the accompanying consolidated financial statements with respect to the Partnership's interests in Orchard Associates (note 3(d)) and the Partnership's indirect interest in (through Carlyle-XIII Associates, L.P.) JMB/NYC Office Building Associates, L.P. ("JMB/NYC" note 3(c)). The Partnership records are maintained on the accrual basis of accounting as adjusted for Federal income tax reporting purposes. The accompanying consolidated financial statements have been prepared from such records after making appropriate adjustments to present the Partnership's accounts in accordance with generally accepted accounting principles ("GAAP") and to consolidate the accounts of the ventures as described above. Such adjustments are not recorded on the records of the Partnership. The effect of these items for the years ended December 31, 1993 and 1992 is summarized as follows: CARLYLE REAL ESTATE LIMITED PARTNERSHIP - XIII (A LIMITED PARTNERSHIP) AND CONSOLIDATED VENTURES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED 1993 1992 ------------------------------ ------------------------------ GAAP BASIS TAX BASIS GAAP BASIS TAX BASIS ------------ ----------- ------------- ------------ Total assets . . . . . . . . . . . . . . . . . . . . . . . $374,787,300 99,599,312 489,687,072 97,192,182 Partners' capital accounts (deficits) (note 5): General partners. . . . . . . . . . . . . . . . . . . . (20,702,360) (34,839,564) (19,270,339) (38,961,003) Limited partners. . . . . . . . . . . . . . . . . . . . (161,952,798) (218,137,769) (131,197,367) (240,626,413) Net earnings (loss) (note 5): General partners. . . . . . . . . . . . . . . . . . . . (1,432,021) 4,121,438 (1,610,101) (1,598,313) Limited partners. . . . . . . . . . . . . . . . . . . . (30,755,431) 22,488,643 (31,687,809) (26,035,220) Net earnings (loss) per limited partnership interest . . . (83.98) 61.41 (86.54) (71.10) ============ ============ ============ ============ /TABLE CARLYLE REAL ESTATE LIMITED PARTNERSHIP - XIII (A LIMITED PARTNERSHIP) AND CONSOLIDATED VENTURES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED The net loss per limited partnership interest is based upon the limited partnership interests outstanding at the end of the period (366,183). Deficit capital accounts will result, through the duration of the Partnership, in net gain for financial reporting and Federal income tax purposes. Certain reclassifications have been made to the 1992 financial statements in order to conform with the 1993 presentation. Statement of Financial Accounting Standards No. 95 requires the Partnership to present a statement which classifies receipts and payments according to whether they stem from operating, investing or financing activities. The required information has been segregated and accumulated according to the classifications specified in the pronouncement. Partnership distributions from unconsolidated ventures are considered cash flow from operating activities only to the extent of the Partnership's cumulative share of net earnings. In addition, the Partnership records amounts held in U.S. Government obligations at cost, which approximates market. For the purposes of these statements, the Partnership's policy is to consider all such amounts held with original maturities of three months or less (none and $500,000 at December 31, 1993 and 1992, respectively) as cash equivalents with any remaining amounts reflected as short-term investments. The Partnership terminated negotiations for a partial renewal of the lease of the primary tenant at the Commercial Union Building, which expired in June 1991. Due to the extreme softness of the metropolitan Boston real estate market, the Partnership decided not to commit any significant additional capital to this property (see note 4(b)(9)). In August 1991, the second mortgage lender realized upon its security interest by taking title to the Commercial Union Building as a result of the Partnership not remitting the required debt service payments. This resulted in the Partnership no longer having an ownership interest in the property and resulted in a gain to the Partnership of approximately $1,476,000 for financial reporting purposes and $3,240,000 for Federal income tax purposes with no corresponding distributable proceeds in 1991. In July 1992, the Partnership executed a lease with the 1001 Fourth Avenue Plaza office building's largest tenant, Seattle-First National Bank, for a renewal of a portion of their current space effective October 1993, when its existing 259,000 square foot lease expired. The renewal resulted in Seattle-First National Bank leasing 95,000 square feet for a ten year period. The new lease, which included a significant free rent period for the tenant, as well as considerable tenant improvement costs, had a material negative impact on the cash flow from the property commencing in late 1993 and placed the property in a position whereby the net operating income would have been insufficient to cover both debt service payments and leasing costs (see note 4(b)(4)). Due to the uncertainty of the Partnership's ability to recover the net carrying value of the 1001 Fourth Avenue office building investment property through future operations and sales, as of June 30, 1992, the Partnership recorded, as a matter of prudent accounting practice, a provision for value impairment of such investment property of $6,409,039. Such provision was recorded to reduce the net carrying value of the investment property to the then outstanding balance of the related non-recourse financing. Due to the extreme softness of the Seattle, Washington office market and other factors, the Partnership decided not to commit any significant additional capital to this property (see note 4(b)(4)). In November 1993, the Partnership agreed with the mortgage lender to transfer title to the 1001 Fourth Avenue Office Building to the lender. This has resulted in 1993 in the Partnership no longer having an ownership interest in the property and has resulted in a net gain to the Partnership of approximately $6,772,000 for financial reporting purposes and gain of approximately $27,567,000 for Federal income tax purposes with no corresponding distributable proceeds. CARLYLE REAL ESTATE LIMITED PARTNERSHIP - XIII (A LIMITED PARTNERSHIP) AND CONSOLIDATED VENTURES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED As more fully discussed in Note 3(c) due to the potential sale of the 2 Broadway building at a sales price significantly below its net carrying value and due to discussions with the O & Y affiliates regarding the reallocation of the unpaid first mortgage indebtedness currently allocated to 2 Broadway, the 2 Broadway venture has made a provision for value impairment on such investment property of $192,627,560. The provision for value impairment has been allocated to the partners to reflect their respective ownership percentages before the effect of the non-recourse promissory notes, in the amounts of $136,534,366 and $56,093,194 to the O & Y affiliates and to JMB/NYC, respectively. Due to the uncertainty of the 1290 Associates venture's ability to recover the net carrying value of the 1290 Avenue of the Americas Building through future operations and sale, the 1290 Associates venture made a provision for value impairment on such investment property of $51,423,084. Such provision at September 30, 1992 was recorded to effectively reduce the net carrying value of the investment property and the related deferred expenses to the then outstanding balance of the related non-recourse financing allocated to the joint venture and its property. This provision was allocated to the unaffiliated venture partners in accordance with the terms of the venture agreement and accordingly is not included in the financial statements (see notes 1, 3 and 5 in Notes to Combined Financial Statements). Deferred expenses are comprised principally of leasing fees which are amortized using the straight-line method over the terms stipulated in the related agreements, and commitment fees which are amortized over the related commitment periods. Although certain leases of the Partnership provide for tenant occupancy during periods for which no rent is due and/or increases in minimum lease payments over the term of the lease, the Partnership accrues prorated rental income for the full period of occupancy on a straight-line basis. Statement of Financial Accounting Standards No. 107, "Disclosures about Fair Value of Financial Instruments", requires entities with total assets exceeding $150 million at December 31, 1993 to disclose the SFAS 107 value of all financial assets and liabilities for which it is practicable to estimate. Value is defined in the Statement as the amount at which the instrument could be exchanged in a current transaction between willing parties, other than in a forced or liquidation sale. The Partnership believes the carrying amount of its financial instruments classified as current assets and liabilities (excluding current portion of long-term debt) approximates SFAS 107 value due to the relatively short maturity of these instruments. There is no quoted market value available for any of the Partnership's other instruments. As the debt secured by the University Park office building, Long Beach Plaza and Gables Corporate Plaza has been classified by the Partnership as a current liability at December 31, 1993 (see note 4(b)), and because the resolution of such defaults are uncertain, as the debt on the University Park Office Building and the Gables Corporate Plaza was satisfied in January 1994 pursuant to deeds in lieu and because the resolution of Long Beach Plaza is uncertain, the Partnership considers the disclosure of such long-term debt to be impracticable. The remaining debt, with a carrying balance of $454,968,527, has been calculated to have an SFAS 107 value of $362,710,962 by discounting the scheduled loan payments to maturity. Due to restrictions on transferability and prepayment, and the inability to obtain comparable financing due to previously modified debt terms or other property specific competitive conditions, the Partnership would be unable to refinance these properties to obtain such assumed debt amounts reported (see note 4). The Partnership has no other significant financial instruments. CARLYLE REAL ESTATE LIMITED PARTNERSHIP - XIII (A LIMITED PARTNERSHIP) AND CONSOLIDATED VENTURES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED No provision for State or Federal income taxes has been made as the liability for such taxes is that of the partners rather than the Partnership. However, in certain instances, the Partnership has been required under applicable law to remit directly to the tax authorities amounts representing withholding from distributions paid to partners. (2) INVESTMENT PROPERTIES (a) General The Partnership has acquired, either directly or through joint ventures (note 3), nine apartment complexes, three shopping centers, ten office buildings and a multi-use complex. Nine properties have been sold or disposed of by the Partnership as of December 31, 1993. All of the remaining properties owned at December 31, 1993 were operating. In January 1994, the lender took title to the University Park office building and Gables Corporate Plaza as described in Notes 4(b)(6), 4(b)(7) and 11(a) and (b). The cost of the investment properties represents the total cost to the Partnership or its ventures plus miscellaneous acquisition costs. Significant betterments and improvements are capitalized and depreciated over their estimated useful lives. Maintenance and repair expenses are charged to operations as incurred. Depreciation on the operating properties has been provided over the estimated useful lives of 5 to 30 years using the straight-line method. All investment properties are pledged as security for the long-term debt, for which generally there is no recourse to the Partnership. A portion of the long-term debt on the Copley Place multi-use complex and Gables Corporate Plaza represent mortgage loans which are subordinated to the existing senior mortgage loans. (b) Long Beach Plaza The Partnership purchased Long Beach Plaza located in Long Beach, California for $45,839,458 (net of discount on long-term debt of $10,330,542). In January 1981, Australian Ventures, Inc. ("AVI") signed a 99 year ground and improvement lease at the Long Beach Plaza shopping center located in Long Beach, California for approximately 144,000 square feet. AVI sublet the space to Buffum's Department Store, an affiliate of AVI. In March 1991, Buffum's filed for protection from creditors under Chapter XI of the United States Bankruptcy Code. In May 1991, Buffum's vacated the leased premises. As a result and pursuant to certain provisions of the ground and improvement lease that, among other things, requires continuous operation of a store at the premises during the lease term, the Partnership sought a termination of the lease and to obtain possession of the premises. In March 1993, the Partnership completed a settlement of its litigation with AVI involving the lease. Under the terms of the settlement, AVI paid the Partnership $550,000, and the parties terminated the ground and improvement lease. In addition, both parties dismissed their respective claims in the lawsuit with prejudice. The Partnership paid the $550,000 received from AVI to the mortgage lender for the property as scheduled debt service due for April and part of May 1993 on the loan secured by the property. The Partnership has initiated discussions with the first mortgage lender regarding a modification of its mortgage loan secured by the property. There can be no assurance that such modification will be consummated. If the Partnership is unable to secure a modification to the loan, the Partnership may decide not to commit any significant additional amounts of the property. This would result in the Partnership no longer having an ownership interest in such property and would result in gain for financial reporting and Federal income tax purposes to the Partnership with no corresponding distributable proceeds. CARLYLE REAL ESTATE LIMITED PARTNERSHIP - XIII (A LIMITED PARTNERSHIP) AND CONSOLIDATED VENTURES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED (3) VENTURE AGREEMENTS (a) General The Partnership at December 31, 1993 is a party to nine operating joint venture agreements. Pursuant to such agreements, the Partnership made initial capital contributions of approximately $231,529,000 (before legal and other acquisition costs and its share of operating deficits as discussed below). In general, the joint venture partners, who are either the sellers (or their affiliates) of the property investments being acquired, or parties which have contributed an interest in the property being developed, or were subsequently admitted to the ventures, make no cash contributions to the ventures, but their retention of an interest in the property, through the joint venture, is taken into account in determining the purchase price of the Partnership's interest, which was determined by arm's-length negotiations. Under certain circumstances, either pursuant to the venture agreements or due to the Partnership's obligations as a general partner, the Partnership may be required to make additional cash contributions to the ventures. The Partnership has acquired, through the above ventures, three apartment complexes, five office buildings, and a multi-use complex. The joint venture partners (who were primarily responsible for constructing the properties) contributed any excess of cost over the aggregate amount available from the Partnership contributions and financing and, to the extent such funds exceeded the aggregate costs, were to retain such excesses. Certain of the venture properties have been financed under various long-term debt arrangements as described in Note 4 and 3 and to Note 5 of Notes to the Combined Financial Statements. The Partnership generally has a cumulative preferred interest in net cash receipts (as defined) from the properties. Such preferential interest relates to a negotiated rate of return on contributions made by the Partnership. After the Partnership receives its preferential return, the venture partner is generally entitled to a non-cumulative return on its interest in the venture; net cash receipts are generally shared in a ratio relating to the various ownership interests of the Partnership and its venture partners. During 1993, 1992 and 1991, two, three and three, respectively, of the ventures' properties produced net cash receipts. In addition, the Partnership generally has preferred positions (related to the Partnership's cash investment in the ventures) with respect to distribution of sale or refinancing proceeds from the ventures. In general, operating profits and losses are shared in the same ratio as net cash receipts; however, if there are no net cash receipts, substantially all profits or losses are allocated to the partners in accordance with their respective economic interest. Physical management of the properties generally was performed by affiliates of the venture partners during the development period and rent-up period. The managers were responsible for cash flow deficits (after debt service requirements). Compensation to the managers during such periods for management and leasing was limited to specified payments made by the ventures, plus any excess net cash receipts generated by the properties during the periods. Thereafter, the management agreements generally provide for an extended term during which the management fee is calculated as a percentage of certain types of cash income from the property. The management terms are in the extended term for all of the ventures. There are certain risks associated with the Partnership's investments made through joint ventures including the possibility that the Partnership's joint venture partners in an investment might become unable or unwilling to fulfill their financial or other obligations, or that such joint venture partners may have economic or business interests or goals that are inconsistent with those of the Partnership. CARLYLE REAL ESTATE LIMITED PARTNERSHIP - XIII (A LIMITED PARTNERSHIP) AND CONSOLIDATED VENTURES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED The terms of certain of the venture agreements are summarized as follows: (b) Copley Place The Partnership acquired in 1983, through a joint venture with the developer, an interest in a portion of Copley Place, a multi-use complex in Boston, Massachusetts. Initially, the Partnership purchased an interest in the complex from the developer for a purchase price of $20,000,000 which was paid by giving a purchase price note to the developer. Subsequently, the Partnership and the developer formed Copley Place Associates which purchased the balance of the office and retail portion of the complex from the developer for $245,000,000. The Partnership contributed its previously acquired interest in the property and made total cash contributions of $60,000,000 for its interest in Copley Place Associates. In December 1984, an affiliate of the Corporate General Partner of the Partnership acquired ownership of the joint venture partner (see note 9). The joint venture partner was obligated to fund (through capital contributions and loans, as defined) any deficiency in the Partnership's guaranteed return to 1989 and any operating deficits (as defined). Commencing January 1, 1990, the Partnership was entitled to a preferred return of $6,000,000 per year through December 31, 1991 of any available cash flow. The joint venture partner was obligated through December 31, 1991 to loan amounts to pay for any operating deficits (as defined). The joint venture partner has loaned approximately $13,398,000 through December 31, 1993 to fund its required obligations. The loan accrues interest at the contract rate based on the joint venture partner's line of credit. The line of credit bears interest at a floating rate (currently averaging 4.75% at December 31, 1993). The loan is to be repaid from future available cash flow, as defined. In addition, the Partnership and the joint venture partner were obligated to equally contribute towards tenant improvement and other capital costs beginning in 1990. The Partnership contributed $958,000 in 1991 and $847,022 in 1990 as its 50% share of capital and tenant improvement costs at the property. In addition, the venture partner and the Partnership each contributed $7,786,931 in October 1990 to retire a line of credit (see note 4(b)(10)). Commencing January 1, 1992, the Partnership and the venture partner are required to equally fund all cash deficits of the property. In addition, commencing January 1, 1992, annual cash flow (as defined) after repayment to the venture partner of operating deficit loans, is to be allocated equally between the Partnership and joint venture partner. Operating profits and losses of the joint venture are 50% to the Partnership and 50% to the joint venture partner. The joint venture agreement further provides that, in general, upon any sale or refinancing of the complex the first $60,000,000 of net proceeds will be distributed equally between the Partnership and the joint venture partner. The Partnership will then be entitled to receive an amount equal to any cumulative deficiencies of its annual preferred return of cash flow for 1990 and 1991 (balance at December 31, 1993 is $12,000,000). The Partnership will then be entitled to receive the next $190,000,000 plus an amount equal to certain interest which has been paid or is payable to the developer on its $20,000,000 purchase price note. The joint venture partner will then be entitled to receive the next $190,000,000 plus an amount equal to certain interest paid to it on the $20,000,000 purchase price note, with any remaining proceeds distributable equally to the Partnership and the joint venture partner. Reference is made to Note 4(b)(10) for a discussion of the modification of the mortgage loan (effective March 1, 1992) for the property. CARLYLE REAL ESTATE LIMITED PARTNERSHIP - XIII (A LIMITED PARTNERSHIP) AND CONSOLIDATED VENTURES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED An affiliate of the joint venture partner manages the portion of the complex owned by the joint venture, pursuant to an agreement similar to those described in Note 3(a). (c) JMB/NYC The Partnership owns indirectly through Carlyle-XIII Associates, L.P. and JMB/NYC an interest in (i) the 237 Park Avenue Associates venture which owns an existing 23-story office building, (ii) the 1290 Associates venture which owns an existing 44-story office building, and (iii) the 2 Broadway Associates and 2 Broadway Land Co. ventures which own an existing 32-story office building (together "Three Joint Ventures" and individually a "Joint Venture"). All of the buildings are located in New York, New York. In addition to JMB/NYC, the partners of the Three Joint Ventures include O&Y Equity Company, L.P. and O&Y NY Building Corp. (hereinafter sometimes referred to as the "Olympia & York affiliates"), both of which are affiliates of Olympia and York Developments, Ltd. (hereinafter sometimes referred to as "O&Y"). JMB/NYC is a joint venture among Carlyle-XIII Associates, L.P. (of which the Partnership holds a 99% limited partnership interest), Carlyle-XIV Associates, L.P. and Property Partners, L.P. as limited partners and Carlyle Managers, Inc. as the sole general partner. Effective March 25, 1993, the Partnership became a 20% shareholder of Carlyle Managers, Inc. Related to this investment, the Partnership has an obligation to fund $600,000 of additional paid-in capital to Carlyle Managers, Inc. (reflected in amounts due to affiliates in the accompanying financial statements). The terms of the JMB/NYC venture agreement generally provide that JMB/NYC's share of the Three Joint Ventures' annual cash flow, sale or refinancing proceeds, operating and capital costs (to the extent not covered by cash flow from a property) and profit and loss will be distributed to, contributed by or allocated to the Partnership in proportion to its (indirect) share of capital contributions to JMB/NYC. In March 1993, JMB/NYC, originally a general partnership, was converted to a limited partnership, and the Partnership's interest in JMB/NYC, which previously had been held directly, was contributed to Carlyle-XIII Associates, L.P. As a result of these transactions, the Partnership currently holds, indirectly as a limited partner of Carlyle-XIII Associates, L.P., an approximate 25% limited partnership interest in JMB/NYC. The sole general partner of Carlyle-XIII Associates, L.P. is Carlyle Investors, Inc., of which the Partnership became a 20% shareholder effective March 25, 1993. Related to this investment, the Partnership has an obligation to fund $600,000 of additional paid-in capital (reflected in amounts due to affiliates in the accompanying financial statements). The general partner in each of JMB/NYC and Carlyle-XIII Associates, L.P. is an affiliate of the Partnership. For financial reporting purposes, the allocation of profits and losses of JMB/NYC to the Partnership is 25%. There are certain risks and uncertainties associated with the Partnership's investments made through joint ventures, including the possibility that the Partnership's joint venture partners might become unable or unwilling to fulfill their financial or other obligations (as discussed below), or that such joint venture partners may have economic or business interests or goals that are inconsistent with those of the Partnership. JMB/NYC purchased a 46.5% interest in each of the Three Joint Ventures for approximately $173,600,000, subject to a long-term first mortgage loan which has been allocated among the individual Joint Ventures. A portion of the purchase price is represented by four 12-3/4% promissory notes (the "Purchase Notes") which have an aggregate outstanding principal balance of $34,158,225 at December 31, 1993 and 1992. Such Purchase Notes, which contain cross-default provisions, and are non-recourse to JMB/NYC, are secured by JMB/NYC's interests in the Three Joint Ventures, and such Purchase Note relating to the purchase of the interest in the ventures owning the 2 Broadway CARLYLE REAL ESTATE LIMITED PARTNERSHIP - XIII (A LIMITED PARTNERSHIP) AND CONSOLIDATED VENTURES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED Building is additionally secured by JMB/NYC's interest in $19,000,000 of distributable sale proceeds from the other two Joint Ventures. A default under the Purchase Notes would include, among other things, a failure by JMB/NYC to repay a Purchase Note upon acceleration of the maturity, and could cause an immediate acceleration of the Purchase Notes for the other ventures. Beginning in 1992, the Purchase Notes provide for monthly interest only payments on the principal and accrued interest based upon the level of distributions payable to JMB/NYC discussed below. If there are no distributions payable to JMB/NYC or if the distributions are insufficient to cover monthly interest on the Purchase Notes, then the shortfall interest (as defined) accrues and compounds monthly. Interest accruals total $78,605,523 at December 31, 1993. During 1993, no payments were made on the Purchase Notes. All of the principal and accrued interest on the Purchase Notes is due in 1999 or, if earlier, on the sale or refinancing of the related property. Prior to 1992, operating profits (excluding depreciation and amortization) were allocated 30% to JMB/NYC and 70% to the Olympia & York affiliates, and operating losses (excluding depreciation and amortization) were allocated 96% to JMB/NYC and 4% to the Olympia & York affiliates. Depreciation and amortization were allocated 46.5% to JMB/NYC and 53.5% to the Olympia & York affiliates. Subsequent to 1991, pursuant to the agreement between JMB/NYC and the Olympia & York affiliates, for the period January 1, 1992 to June 30, 1993, as discussed below, gross income is allocable to the Olympia & York affiliates to the extent of the distributions of excess monthly cash flow received for the period with the balance of operating profits or losses allocated 46.5% to JMB/NYC and 53.5% to the Olympia & York affiliates. Beginning July 1, 1993, operating profits or losses, in general, are allocated 46.5% to JMB/NYC and 53.5% to the Olympia & York affiliates. The Three Joint Ventures agreements further provide that, in general, upon sale or refinancing of the properties, net sale or refinancing proceeds will be distributable 46.5% to JMB/NYC and 53.5% to the Olympia & York affiliates subject to, as described above, repayment by JMB/NYC of its Purchase Notes. Under the terms of the Three Joint Ventures agreements, JMB/NYC was entitled to a preferred return of annual cash flow, with any additional cash flow distributable 99% to the Olympia & York affiliates and 1% to JMB/NYC, through 1991. The Olympia & York affiliates were obligated to make capital contributions to the Three Joint Ventures to pay any operating deficits (as defined) and to pay JMB/NYC's preferred return through December 31, 1991. JMB/NYC did not receive its preferred return for the fourth quarter 1991. Subsequent to 1991, capital contributions to pay for property operating deficits and other requirements that may be called for under the Three Joint Ventures agreements are required to be shared 46.5% by JMB/NYC and 53.5% by the Olympia & York affiliates. Pursuant to the Three Joint Ventures agreements between the Olympia & York affiliates and JMB/NYC, the effective rate of interest with reference to the first mortgage loan for calculating JMB/NYC's share of operating cash flow or deficits through 1991 was as though the rate were fixed at 12-3/4% per annum (versus the short-term U.S. Treasury obligation rate plus 1-3/4% per annum (with a minimum 7%) payable on the first mortgage loan). JMB/NYC believes that, commencing in 1992, the joint venture partnership agreements for the Three Joint Ventures require an effective rate of interest with reference to the first mortgage loan, based upon each Joint Venture's allocable share of the loan, to be 1-3/4% over the short-term U.S. Treasury obligation rate plus any excess monthly operating cash flow after capital costs of the Three Joint Ventures, such sum not to be less than a 7% nor exceed a 12-3/4% per annum interest rate, rather than the 12-3/4% per annum fixed rate that applied prior to 1992. The Olympia & York affiliates dispute this calculation of interest expense for the period commencing July 1, 1993 and contend that the 12-3/4% per annum fixed rate applies. CARLYLE REAL ESTATE LIMITED PARTNERSHIP - XIII (A LIMITED PARTNERSHIP) AND CONSOLIDATED VENTURES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED During the quarter ended March 31, 1993, an agreement was reached between JMB/NYC and the Olympia & York affiliates which rescinded default notices previously received by JMB/NYC alleging defaults for failing to make capital contributions and eliminated the alleged operating deficit funding obligation of JMB/NYC for the period January 1, 1992 through June 30, 1993. Accordingly, during this period, JMB/NYC recorded interest expense at 1-3/4% over the short-term U.S. Treasury obligation rate (subject to a minimum rate of 7% per annum), which is the interest rate on the underlying first mortgage loan. Under the terms of this agreement, during this period, the amount of capital contributions that the Olympia & York affiliates and JMB/NYC would have been required to make to the Three Joint Ventures as if the first mortgage loan bore interest at a rate of 12.75% per annum (the Olympia & York affiliates' interpretation), became a priority distribution level to the Olympia & York affiliates from the Three Joint Ventures' annual cash flow or net sale or refinancing proceeds. The agreement also entitles the Olympia & York affiliates to a 7% per annum return on such unpaid priority distribution level. It was also agreed that during this period, the excess available operating cash flow after the payment of the priority distribution level discussed above from any of the Three Joint Ventures will be advanced in the form of loans to pay operating deficits and/or unpaid priority distribution level amounts of any of the Three Joint Ventures. Such loans will bear a market rate of interest, have a final maturity of ten years from the date when made and will be repayable only out of first available annual cash flow or net sale or refinancing proceeds. The agreement also provides that except as specifically agreed otherwise, the parties each reserves all rights and claims with respect to each of the Three Joint Ventures and each of the partners thereof, including, without limitation, the interpretation of or rights under each of the joint venture partnership agreements for the Three Joint Ventures. As a result of the above noted agreement with the Olympia & York affiliates, for the six months ended June 30, 1993, $32,523,137 represents the minimum 7% per annum interest. Excess net cash flow, as defined, through June 30, 1993 totalled $11,648,285. Pursuant to an agreement with the first mortgage lender discussed below, $250,000 per month is payable as a distribution to the Olympia & York affiliates. During the period January 1, 1993 through June 30, 1993, $6,257,236 was distributed to the O&Y affiliates. The balance of $15,067,149 represents a priority distribution level to the Olympia & York affiliates payable from the Three Joint Ventures' annual cash flow or net sale or refinancing proceeds, if any. The cumulative priority distribution level payable to the Olympia & York affiliates at December 31, 1993 is $48,522,601. The agreement expired on June 30, 1993. Therefore, effective July 1, 1993, JMB/NYC is recording interest expense at 1-3/4% over the short-term U.S. Treasury obligation rate plus any excess operating cash flow after capital costs of the Three Joint Ventures, such sum not to be less than 7% nor exceed a 12-3/4% per annum interest rate. The Olympia & York affiliates dispute this calculation and contend that the 12-3/4% per annum fixed rate applies. Based upon the Olympia & York affiliates' interpretation, interest expense for the Three Joint Ventures for the six months ended December 31, 1993 was $58,962,793. Based upon the amount of interest determined by JMB/NYC for the six months ended December 31, 1993, interest expense for the Three Joint Ventures was $38,441,967. Pursuant to an agreement with the first mortgage lender, $1,500,000 of the interest payable to the Olympia & York affiliates of $6,079,237 for the six months ended December 31, 1993 was paid. The remaining $4,570,237 is due to the Olympia & York affiliates. O & Y and certain of its affiliates have been involved in bankruptcy proceedings in the United States and Canada and similar proceedings in England. The Olympia & York affiliates have not been directly involved in these proceedings. During the quarter ended March 31, 1993, O & Y emerged from bankruptcy protection in the Canadian proceedings. In addition, a reorganization of the management of the company's United States operations has been completed, and affiliates of O & Y are in the process of renegotiating or restructuring a number of loans affecting various properties in the United CARLYLE REAL ESTATE LIMITED PARTNERSHIP - XIII (A LIMITED PARTNERSHIP) AND CONSOLIDATED VENTURES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED States in which they have an interest. The Partnership is unable to assess and cannot presently determine to what extent these events may adversely affect the willingness and ability of the Olympia & York affiliates either to meet their own obligations to the Three Joint Ventures and JMB/NYC or to negotiate a restructuring of the joint venture agreements, or otherwise reach an understanding with JMB/NYC regarding any future funding obligation of JMB/NYC. During the fourth quarter of 1992, the Three Joint Ventures received a notice from the first mortgage lender alleging a default for failure to meet certain reporting requirements of the Olympia & York affiliates contained in the first mortgage loan documents. No monetary default has been alleged. The Olympia & York affiliates have responded to the lender that the Three Joint Ventures are not in default. JMB/NYC is unable to determine if the Three Joint Ventures are in default. Accordingly, the balance of the first mortgage loan has been classified as a current liability in the accompanying combined financial statements at December 31, 1993 and 1992. There have not been any further notices from the first mortgage lender. The Olympia & York affiliates, on behalf of the Three Joint Ventures, continue to negotiate with representatives of the lender (consisting of a steering committee of holders of notes evidencing the mortgage loan), to restructure certain terms of the existing mortgage loan in order to provide for, among other things, a potential sale of the 2 Broadway building and a fixed rate of interest on the loan during the remaining loan term until maturity. In conjunction with the negotiations, the Olympia & York affiliates reached an agreement with the first mortgage lender whereby effective January 1, 1993, the Olympia & York affiliates are limited to taking distributions of $250,000 on a monthly basis from the Three Joint Ventures reserving the remaining excess cash flow in a separate interest-bearing account to be used exclusively to meet the obligations of the Three Joint Ventures as approved by the lender. There is no assurance that a restructuring of the loan will be obtained. Interest on the first mortgage loan is calculated based upon a variable rate related to the short-term U.S. Treasury obligation rate, subject to a minimum rate on the loan of 7% per annum. An increase in the short-term U.S. Treasury obligation rate could result in increased interest payable on the first mortgage loan by the Three Joint Ventures. The Olympia & York affiliates and certain other affiliates of O & Y reached an agreement with the City of New York to defer the payment of real estate taxes owed in July 1992 and January 1993 on properties in which O&Y affiliates have an ownership interest, including the 237 Park Avenue, 1290 Avenue of the Americas and 2 Broadway buildings. Payment of the July 1992 real estate taxes was made in six equal monthly installments from July through December of 1992. A similar payment program existed for the period January through December of 1993. The March 1994 monthly real estate tax installment payment related to the 2 Broadway building has not been paid and there is uncertainty regarding the remittance of future installment payments related to the building. JMB/NYC continues to seek, among other things, a restructuring of the joint venture partnership agreements or otherwise to reach an acceptable understanding regarding its long-term funding obligations. If JMB/NYC is unable to achieve this, based upon current and anticipated market conditions mentioned above, JMB/NYC may decide not to commit any additional amounts to the Three Joint Ventures, which could, under certain circumstances, result in the loss of the interest in the related ventures. The loss of an interest in a particular venture could, under certain circumstances, permit an acceleration of the maturity of the related Purchase Note (each Purchase Note is secured by JMB/NYC's interest in the related venture). Under certain circumstances, the failure to repay a Purchase Note could constitute a default under, and permit an immediate acceleration of, the maturity of the Purchase Notes for the other ventures. In such event, JMB/NYC may decide not to repay, CARLYLE REAL ESTATE LIMITED PARTNERSHIP - XIII (A LIMITED PARTNERSHIP) AND CONSOLIDATED VENTURES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED or may not have sufficient funds to repay, any of the Purchase Notes and accrued interest thereon. This could result in JMB/NYC no longer having an interest in any of the related ventures, which would result in substantial net gain for financial reporting and Federal income tax purposes to JMB/NYC with no distributable proceeds. In such event, the Partnership would then proceed to terminate its affairs. If JMB/NYC is successful in its negotiations to restructure the Three Joint Venture agreements and retains an interest in one or more of these investment properties, there would nevertheless need to be a significant improvement in current market and property operating conditions resulting in a significant increase in value of the properties before JMB/NYC would receive any share of future net sale or refinancing proceeds. Although the 2 Broadway building is in need of a major renovation, the Joint Ventures that own the 2 Broadway building and land have no plans for a renovation of the property because of a potential sale of the building and because the effective rents that could be obtained under the current office market conditions may not be sufficient to justify the costs of the renovation. Given the current market and property operating conditions, it is likely that the property would sell at a price significantly lower than the allocated portion of the underlying debt. The first mortgage lender and JMB/NYC would need to approve any sale of this property. The O & Y affiliates have informed JMB/NYC that they have now received a written proposal for the sale of 2 Broadway for a net purchase price of $15,000,000. The first mortgage lender has preliminarily agreed to the concept of a sale of the building but has not approved the terms of any proposed offer for purchase. Accordingly, a sale pursuant to the proposal received by the O & Y affiliates would be subject to, among other things, the approval of the first mortgage lender as well as JMB/NYC. While there can be no assurance that a sale would occur pursuant to such proposal or any other proposal, if this proposal were to be accepted by or consented to by all required parties and the sale completed pursuant thereto, and if discussions with the O & Y affiliates relating to the proposal were finalized to allocate the unpaid first mortgage indebtedness currently allocated to 2 Broadway to 237 Park and 1290 Avenue of the Americas after completion of the sale, then the 2 Broadway Joint Ventures would incur a significant loss for financial reporting purposes. Accordingly, a provision for value impairment has been recorded for financial reporting purposes for $192,627,560, net of the non- recourse portion of the Purchase Notes related to the 2 Broadway Joint Venture interests that are payable by JMB/NYC to the O & Y affiliates in the amount of $46,646,810. The provision for value impairment has been allocated $136,534,366 and $56,093,194 to the O & Y affiliates and to JMB/NYC, respectively. Such provisions has been allocated to the partners to reflect their respective ownership percentages before the effect of the non-recourse promissory notes, including related accrued interest. The provision for value impairment is not a loss recognizable for Federal income tax purposes. In the event of a dissolution and liquidation of a Joint Venture, the terms of the joint venture partnership agreements between the Olympia & York affiliates and JMB/NYC for the Three Joint Ventures provide that if there is a deficit balance in the tax basis capital account of JMB/NYC, after the allocation of profits or losses and the distribution of all liquidation proceeds, then JMB/NYC generally would be required to contribute cash to the Joint Venture in the amount of its deficit capital account balance. Taxable gain arising from the sale or other disposition of a Joint Venture's property generally would be allocated to the joint venture partner or partners then having a deficit balance in its or their respective capital accounts in accordance with the terms of the joint venture partnership agreement. However, if such taxable gain is insufficient to eliminate the deficit balance CARLYLE REAL ESTATE LIMITED PARTNERSHIP - XIII (A LIMITED PARTNERSHIP) AND CONSOLIDATED VENTURES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED in its account in connection with a liquidation of a Joint Venture, JMB/NYC would be required to contribute funds to the Joint Venture (regardless of whether any proceeds were received by JMB/NYC from the disposition of the Joint Venture's property) to eliminate any remaining deficit capital account balance. The Partnership's liability for such contribution, if any, would be its share, if any, of the liability of JMB/NYC and would depend upon, among other things, the amounts of JMB/NYC's and the Olympia & York affiliates' respective capital accounts at the time of a sale or other disposition of Joint Venture property, the amount of JMB/NYC's share of the taxable gain attributable to such sale or other disposition of the Joint Venture property and the timing of the dissolution and liquidation of the Joint Venture. In such event, the Partnership could be required to sell or dispose of its other assets in order to satisfy any obligation attributable to it as a partner of JMB/NYC to make such contribution. Although the amount of such liability could be material, the Limited Partners of the Partnership would not be required to make additional contributions of capital to satisfy such obligation of the Partnership. The Partnership's deficit investment balance in JMB/NYC as reflected in the balance sheet (aggregating $72,546,193 at December 31, 1993) does not necessarily represent the amount, if any, the Partnership would be required to pay to satisfy its deficit restoration obligation. The properties are being managed by an affiliate of the Olympia & York affiliates under a long-term agreement for a management fee equal to 1% of gross receipts. An affiliate of the Olympia & York affiliates performs certain maintenance and repair work and construction of certain tenant improvements at the investment properties. Additionally, the Olympia & York affiliates have lease agreements and occupy approximately 95,000 square feet of space at 237 Park Avenue at rental rates which approximate market. (d) Orchard Associates The Partnership's interest in Old Orchard shopping center (through Orchard Associates and Old Orchard Urban Venture ("OOUV") was sold in September 1993, as described below. The maturity date for Orchard Associates' loan in the amount of $18,000,000 from a commercial bank, secured solely by its interest in Old Orchard shopping center, and originally due October 1, 1991, was extended to December 31, 1993. The agreement required monthly installments of interest only at the prime rate plus 1% per annum. Orchard Associates continued to negotiate with the lender for permanent financing of this note prior to its payoff in September 1993 as described below. On September 2, 1993, effective August 30, 1993, OOUV and an unaffiliated third party contributed the Old Orchard shopping center and $60,366,572 in cash (before closing costs and prorations), respectively, to a newly formed limited partnership. Immediately at closing, the new partnership distributed to OOUV $60,366,572 in cash (before closing costs and prorations) in redemption of approximately 89.5833% of OOUV's interest in the new partnership. OOUV, the limited partner, has retained a 10.4167% interest in the new limited partnership after such redemption. OOUV is also entitled to receive up to an additional $4,300,000 based upon certain events (as defined) and may earn up to an additional $3,400,000 based upon certain future earnings of the property (as defined). CARLYLE REAL ESTATE LIMITED PARTNERSHIP - XIII (A LIMITED PARTNERSHIP) AND CONSOLIDATED VENTURES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED Contemporaneously with the formation of the new limited partnership, OOUV redeemed Orchard Associates' ("Orchard") interest in OOUV for $56,689,747 (before closing costs and prorations). Orchard used a portion of these redemption proceeds to repay in full its $18,000,000 loan obligation plus accrued interest. This transaction has resulted in Orchard having no ownership interest in the property as of the effective date of the redemption agreement. Orchard recognized a gain of $15,797,454 for financial reporting purposes ($7,898,727 allocable to the Partnership) and recognized a gain for Federal income tax reporting purposes of $32,492,776, $16,246,388 allocable to the Partnership in 1993. OOUV and Orchard have also entered into a contribution agreement whereby they have agreed to share future gains and losses which may arise with respect to potential revenues and liabilities from events which predated the contribution of the property to the new venture (including, without limitation, potential future distributions to OOUV the $4,300,000 and $3,400,000 amounts as described above) in accordance with their pre- contribution percentage interests. Upon receipt of all or a portion of these contingent amounts, Orchard and the Partnership would expect to recognize additional gain for Federal income tax and financial reporting purposes in the year of such receipts. However, there can be no assurance that any portion of these contingent amounts will be received. (e) Eastridge Apartments In late 1986, an affiliate of the Corporate General Partner assumed management of the Eastridge Apartments. The apartment complex had been managed by the venture partner who defaulted in its obligations under the joint venture partnership and management agreements. In July 1991, the Partnership finalized an agreement with the joint venture partner whereby the partner relinquished its interest in the joint venture in return for a full release of all past and future obligations. Upon the venture partner's relinquishment, the balance of the venture partner's deficit capital account was deemed uncollectible. Accordingly, in 1991, the Partnership recorded a loss on relinquishment of venture partner's interest of $1,161,626. Such loss was recorded to eliminate the venture partner's deficit capital account. (4) LONG-TERM DEBT (a) General As described in Note 4(b) and in response to operating deficits incurred at certain properties, the Partnership is seeking and/or has received mortgage note modifications on certain properties. Certain of the modifications received which have expired and others expire on various dates commencing October 1996. In addition, certain properties have loans with scheduled maturities commencing November 1994. Upon expiration of such modifications or at maturity , should the Partnership be unable to secure new or additional modifications to or refinancing of the loans, based upon current and anticipated future market conditions, the Partnership may not commit any significant additional amounts to these properties. This generally would result in the Partnership no longer having an ownership interest in such properties and may result in gain for financial reporting and Federal income tax purposes without any net distributable proceeds. Such decisions would be made on a property-by-property basis. CARLYLE REAL ESTATE LIMITED PARTNERSHIP - XIII (A LIMITED PARTNERSHIP) AND CONSOLIDATED VENTURES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED Long-term debt consists of the following at December 31, 1993 and 1992: 1993 1992 ------------ ----------- 11.5% Purchase Price mortgage note; secured by Copley Place multi-use complex in Boston, Massachusetts; accruing interest through August 31, 1998 when the entire balance is payable (note 3(b)) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 62,818,952 56,025,355 12% mortgage note due August 1998; secured by Copley Place multi-use complex in Boston, Massachusetts; balance originally payable in monthly installments of principal and interest of $2,184,042 from October 1, 1983 through September 30, 1993 and thereafter at the then prevailing market terms of such financing (The note has been modified; see note 4(b)(10)) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 209,716,711 208,858,722 12.5% to 13.875% mortgage note originally due June 15, 1999; secured by the 1001 Fourth Avenue Plaza office building in Seattle, Washington and a $2,000,000 letter of credit secured by Partnership investments in U.S. Government obligations in an equal amount; originally payable in monthly installments of principal and interest of $897,458, $937,337 and $969,688 for five year periods ending June 15, 1989, 1994 and 1999, respectively. (The note has been modified and was satisfied in 1993; see note 4(b)(4)). . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . -- 101,185,922 9-5/8% mortgage note; secured by the Plaza Tower office building in Knoxville, Tennessee; payable in monthly installments of principal and interest of $184,421 until November 1, 1994 when the remaining principal of $17,758,395 is payable . . . . . . . 18,160,291 18,602,047 12.80% mortgage note; secured by the Gables Corporate Plaza office building in Coral Gables, Florida; originally payable in monthly installments of principal and interest until May 1, 1993 when the remaining principal balance was payable (The note has been modified and was discharged in January 1994; see notes 4(b)(7) and 11(a)) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 24,967,836 20,389,624 13-1/8% mortgage note; secured by the Sherry Lane Place office building in Dallas, Texas; originally payable in monthly installments of principal and interest until December 27, 1995 when the remaining principal balance is payable. (The note has been remodified; see note 4(b)(1)). . . . . . . . . . . . . . . . . . . . . . . . . . . . . 40,498,538 40,166,829 (A LIMITED PARTNERSHIP) AND CONSOLIDATED VENTURES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED 1993 1992 ------------ ----------- 13% mortgage note secured by the Long Beach Plaza shopping center in Long Beach, California; payable in monthly installments of principal and interest of $372,583 until June 27, 1994 when the remaining principal balance of $33,651,475 is payable . . . . 33,734,354 33,782,085 12-1/4% mortgage note; secured by the Rio Cancion apartment complex in Tucson, Arizona; originally payable in monthly installments of principal and interest of $123,703 until January 10, 1993 when the remaining principal balance of $10,974,572 was scheduled to be payable. (The note has been remodified and satisfied in 1993; see notes 4(b)(3) and 7(e)). . . . . . . . . . . . . . . . . . . . . . . -- 11,946,741 12-1/2% mortgage note; secured by the University Park office building in Sacramento, California; originally payable in monthly installments of interest only at the rate of 11% per annum with the difference accruing until maturity on July 1, 1993. (The note has been modified and was discharged in January 1994; see notes 4(b)(6) and 11(b)). . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 16,294,125 14,593,476 Other Mortgage Loans: Gables Corporate Plaza office building, 12.9%, due 1996 (satisfied in 1993, see notes 4(b)(7) and 11(a)). . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . -- 2,958,900 Long Beach Plaza shopping center, non-interest bearing, (net of $9,082,213 and $9,185,511 unamortized discount at 12% at December 31, 1993 and 1992, respectively), due 2014. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 917,787 814,489 Marshalls Aurora Plaza shopping center, 12-3/4%; originally payable in monthly installments of principal and interest until June 30, 1993 when the remaining principal balance was scheduled to be payable. (The note has been modified; see note 4(b)(12) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6,468,313 6,532,937 Eastridge apartment complex, 10.34%, due 1995 (modified July 1, 1987, see note 4(b)(5)) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9,752,617 10,385,522 Greenwood Creek II apartment complex, 13-1/4%, due 1997 (satisfied in 1993, see notes 4(b)(8) and 7(f)) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . -- 3,746,866 CARLYLE REAL ESTATE LIMITED PARTNERSHIP - XIII (A LIMITED PARTNERSHIP) AND CONSOLIDATED VENTURES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED 1993 1992 ------------ ----------- Glades apartment complex, 6.1%, due 2002 (refinanced in 1992, see note 4(b)(2)) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9,890,000 9,890,000 Glades apartment complex, 6% (plus, subsequent to April 1995, 50% of cash flows (as defined)), accruing interest through October 1, 2002 when the entire balance is payable (refinanced in 1992, see note 4(b)(2)) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 950,261 950,261 Carrollwood apartment complex, 7.45%, due 1998 (refinanced in 1993, see note 4(b)(11)) . . 7,400,309 7,181,077 Other. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13,398,433 13,398,433 ------------ ------------ Total debt . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 454,968,527 561,409,286 Less current portion of long-term debt (see note 4(b)) . . . . . . . . . . . . . . 94,086,630 96,553,360 ------------ ------------ Total long-term debt . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $360,881,897 464,855,926 ============ ============ /TABLE CARLYLE REAL ESTATE LIMITED PARTNERSHIP - XIII (A LIMITED PARTNERSHIP) AND CONSOLIDATED VENTURES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED Included in the above total long-term debt is $62,095,000 and $69,355,510, for 1993 and 1992, respectively, which represents mortgage interest accrued but not currently payable pursuant to the terms of the various notes. Five year maturities of long-term debt are as follows: 1994. . . . . . . . . . . . . . $94,086,630 1995. . . . . . . . . . . . . . 782,482 1996. . . . . . . . . . . . . . 6,159,597 1997. . . . . . . . . . . . . . 573,288 1998. . . . . . . . . . . . . . 331,738,472 =========== (b) Long-term Debt Modifications (1) Sherry Lane Place Office Building The existing long-term note secured by the Sherry Lane Place office building located in Dallas, Texas was modified effective February 1, 1988 to lower both the contract and payment interest rates. The contract interest rate was reduced to 9% per annum for the period from March 1, 1988 through February 28, 1993 and to 10% per annum for the period from March 1, 1993 through April 1, 1998. Interest only was payable at 6.5% per annum from February 1, 1988 through July 31, 1991, at 8% per annum from August 1, 1991 through July 31, 1994 and at 10% per annum from August 1, 1994 through March 1, 1998. The difference between the contract rate and the interest paid was to be deferred and bore interest at 13.125% per annum from February 1, 1988 through February 28, 1988, at 9% per annum from March 1, 1988 through February 28, 1993 and at 10% per annum from March 1, 1993 through April 1, 1998. In addition, upon the earlier of the subsequent sale of the property or maturity of the note, the lender was entitled to a residual participation equal to 40% of the applicable value (as defined). In connection with the modification, the Partnership prepaid $1,665,000 of principal without a prepayment penalty, and paid a loan modification fee of $2,335,000. In November 1993, the Partnership reached an agreement with the current lender to further modify the existing long-term non-recourse mortgage note secured by the property. Under the terms of the remodification, the existing mortgage balance was divided into two notes. The first note of $22,000,000 bears a contract interest rate of 8% per annum for the period retroactive from January 1, 1993 through December 31, 1994, increasing to 8.5% per annum for the period from January 1, 1995 through April 1, 1998. Interest only is payable on the first note at 5.75% per annum for the period retroactive to January 1, 1993 through December 31, 1993, at 8% per annum from January 1, 1994 through December 31, 1994 and at 8.5% per annum from January 1, 1995 through April 1, 1998. The second note, consisting of the remaining unpaid principal and accrued interest, has a zero pay and accrual rate. All excess cash flow above debt service on the first note is to be applied first against accrued interest on the first note and then as contingent interest on the second note (as defined). (2) The Glades Apartments The long-term mortgage note secured by the Glades Apartments located in Jacksonville, Florida was modified whereby the interest payment rate was reduced for the period December 1, 1987 to November 30, 1989 and the difference between the contract rate and the interest paid was deferred until CARLYLE REAL ESTATE LIMITED PARTNERSHIP - XIII (A LIMITED PARTNERSHIP) AND CONSOLIDATED VENTURES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED December 1, 1989 when the accrued interest and the then outstanding principal balance began to amortize over a thirty year period at the original interest rate. The entire balance was to be due and payable on October 1, 1995. The venture received a remodification from the lender to extend the initial payment terms of the modification through the January 1, 1991 payment. Subsequently, the venture reached an agreement to further extend the initial payment terms of the modification through the January 1, 1992 payment. The venture was negotiating with the first mortgage lender regarding an additional modification or refinancing, and submitted debt service payments under the previously modified terms to the extent of available property cash flow through September 30, 1992. On October 1, 1992, the venture refinanced the existing long-term mortgage note (of approximately $10,426,000) with a first and second mortgage note. The venture paid a prepayment penalty relating to the original mortgage of $300,000 in connection with the refinancing. The Partnership recognized its share of $150,000 as an extraordinary item for financial reporting purposes. The new first mortgage loan of $9,890,000 provides for interest only payments of 6.1% from October 1, 1992 through March 31, 1995. Thereafter, monthly installments of principal and interest will be due (amortized over a 30 year term) through the maturity of the loan on October 1, 2002. The second mortgage loan of $950,261 accrues simple interest of 6% per annum and requires quarterly payments of 50% of the net cash flow (as defined) beginning April 1, 1995 through the earlier of the repayment or maturity of the loan on October 1, 2002. There were no distributable proceeds from the refinancing. (3) Rio Cancion Apartments The mortgage note secured by the Rio Cancion apartments located in Tucson, Arizona and related deferred interest was satisfied on March 31, 1993 upon sale of the property (see note 7(e)). The first mortgage loan was modified, effective November 1, 1987, to lower the interest payable for a period of two years. The terms of the first mortgage loan were modified to lower the interest payable from 12.25% per annum to 10.25% per annum with the difference being added to the outstanding principal balance and due upon the earlier of available cash flow (as defined) or maturity of the loan. The Partnership reached an agreement to remodify the first mortgage loan, effective upon the expiration of the first modification agreement. Under the terms of the new agreement, the Partnership was obligated to pay interest only at a rate of 10.25% per annum from December 1989 through November 1991 on the balance of the outstanding principal and deferred interest as of October 31, 1989. On June 9, 1992, the Partnership reached an agreement for an additional modification to the first mortgage loan effective November 1, 1991. Through December 31, 1992, the Partnership was required to submit debt service payments under the previously remodified terms. On January 1, 1993, the contract rate of 12.25% per annum and the pay rate of 10.25% per annum was permanently lowered to 10%. The additional modification also extended the maturity date to January 1, 1997. In return, the lender was entitled to, as additional interest, a minority residual participation of 25% of net sales proceeds (as defined) after the Partnership had recovered its investment (as defined). CARLYLE REAL ESTATE LIMITED PARTNERSHIP - XIII (A LIMITED PARTNERSHIP) AND CONSOLIDATED VENTURES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED (4) 1001 Fourth Avenue Plaza The Partnership transferred title to the property to the lender on November 1, 1993, as discussed below. The long-term mortgage note secured by the 1001 Fourth Avenue Plaza office building located in Seattle, Washington was modified effective June 16, 1987 to lower both the contract and payment interest rates. The contract interest rate had been reduced to 9% per annum for the period from June 16, 1987 through December 15, 1992, to 10% per annum for the period from December 16, 1992 through May 15, 1994 and to 12% per annum for the period from May 16, 1994 through May 15, 1995. In addition, the interest payment rate had been reduced to 7% per annum from June 16, 1987 through May 15, 1989, at 8% per annum from May 16, 1989 through December 15, 1992 and at 9% per annum from December 16, 1992 through May 15, 1995. The difference between the contract rate and the interest paid was deferred and bore interest at 9% per annum. In addition, any Net Cash Flow (as defined) from the property was escrowed for future capital improvements. On May 16, 1995, the note was to revert to its original terms. In addition, upon the subsequent sale of the property, the lender would have been entitled to a minority residual participation beginning at 30% and decreasing to 15% of Net Proceeds (as defined) from such sale or refinancing. The Partnership continued to maintain a $2,000,000 letter of credit as additional security for the lender for the modification of interest rates, repayment schedule and other terms of the original loan. The letter of credit was secured by the Partnership's investments in U.S. government obligations in an equal amount. The letter of credit was to be renewed annually until the earlier of June 15, 1995 or the date on which Operating Income (as defined) from the property equaled at least 1.2 times the original debt service for a twelve month period. In October 1992, the Partnership notified the lender of its intent not to renew the letter of credit based on the property generating sufficient Operating Income (as defined) to meet the calculation requirement described above. As a result, the lender subsequently notified the Partnership that the Partnership was in default for non-submittal of Net Cash Flow (as defined). Although the Partnership had escrowed certain amounts for 1991 and 1992, the Partnership did not believe it was in default with respect to such escrow obligations. As a result of the alleged defaults, the lender subsequently attempted to draw on the $2,000,000 letter of credit prior to the letter of credit expiring in November 1992. The Partnership obtained a temporary restraining order from the Supreme Court of the State of New York disallowing the lender from drawing on the letter of credit in consideration for the Partnership renewing the letter of credit for a period of ninety days to allow the parties to attempt to resolve their differences. In February 1993, the Partnership extended the letter of credit for an additional sixty days in a further attempt to resolve the disputes with the lender. Subsequently, in March 1993, the temporary restraining order expired. The Supreme Court of the State of New York had agreed to extend the temporary restraining order providing the Partnership post a $2,000,000 bond by April 1, 1993. The Partnership posted a $2,000,000 bond on April 1, 1993. The lender appealed this entire order. On April 29, 1993, the Partnership was notified by the Supreme Court of the State of New York that a decision was rendered in favor of the Partnership regarding the disputes surrounding the letter of credit. In late June 1993, an order was entered by the court reflecting said decision. The lender notified the Partnership that they CARLYLE REAL ESTATE LIMITED PARTNERSHIP - XIII (A LIMITED PARTNERSHIP) AND CONSOLIDATED VENTURES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED intended to appeal the order. As a result, the lender claimed that the release of the bond and the return of the letter of credit had been stayed pending the appeal. As previously reported, the Partnership was attempting to obtain an additional loan modification from the mortgage lender. Such negotiations proved to be unsuccessful and in November 1993, the Partnership transferred title to the property in full satisfaction of the Partnership's mortgage obligation. As part of the agreement to transfer title, the lender agreed to settle the litigation and agreed to the return of the Partnership's bond and letter of credit. The transfer of the Partnership's ownership interest resulted in a net gain of $6,771,760 for financial reporting purposes and a gain of $27,567,458 for Federal income tax purposes with no corresponding distributable proceeds in 1993. (5) Eastridge Apartments In August 1990, the Partnership reached an agreement to remodify the mortgage note effective July 1, 1989 to lower both the contract rate (as defined) and interest payment rates for a thirty-six month period. The contract interest rate is based on a floating index tied to the weighted average cost of funds to members of the Federal Home Loan Bank of San Francisco, as defined, which is adjusted on the first of each month. Interest only was payable at 7.54% per annum from August 1, 1989 through July 1, 1990, at 7.78% per annum from August 1, 1990 through July 1, 1991, and at 8.29% per annum from August 1, 1991 through July 1, 1992. The difference between the contract rate and the interest paid was deferred and bore interest when added to the outstanding principal balance of the note on July 1, 1992. Thereafter, monthly installments, payable at 10.34% per annum, of principal and interest were due (amortized on a 30 year term) until maturity of the loan in March 1995. The Partnership was negotiating with the first mortgage lender regarding an additional modification or refinancing of the first mortgage loan. As of August 1992, the Partnership had been remitting debt service payments under the previously remodified terms. However, the Partnership was notified that the loan had been sold to a third party. The Partnership continued its negotiations with the new lender and reached an agreement for another modification on the existing loan. The remodification extended the maturity date to May 1, 1998 and adjusted the contract rate to 8% per annum. The remodification became effective May 1, 1993 and the Partnership is required to submit equal payments of principal and interest (amortized over approximately 22 years) until maturity when all outstanding principal and interest is due. The remodification establishes release prices for the mortgage obligation (as defined), upon execution until May 1, 1995. (6) University Park Office Building Effective July 1989, the Partnership remodified the note such that the interest payment rate was reduced to 10% per annum for a period of two years, at which time the loan was to be due and payable. The difference between the contract rate and the interest paid is deferred and is accruing at 12.5% per annum. The Partnership exercised its option to extend the maturity date from July 1991 to July 1993, during which time interest only payments were due at a rate of 10.66% per annum. CARLYLE REAL ESTATE LIMITED PARTNERSHIP - XIII (A LIMITED PARTNERSHIP) AND CONSOLIDATED VENTURES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED In April 1993, the Partnership began submitting cash flow debt service payments to the lender due to the move-out of the building's primary tenant. The Partnership's discussions with the first mortgage lender to further modify the note were unsuccessful. The Partnership transferred to the lender title to the property in January 1994. This resulted in the Partnership no longer having an ownership interest in the property, and will result in net gain for financial reporting and Federal income tax purposes to the Partnership with no corresponding distributable proceeds in 1994. Payments of interest in arrears were approximately $884,000 at the date of transfer (see note 11(b)). (7) Gables Corporate Plaza The Gables venture reached an agreement to modify the long-term first mortgage note secured by Gables Corporate Plaza located in Coral Gables, Florida. Effective April 1, 1989, the contract rate was permanently lowered from 12.8% to 10.75% per annum from January 1, 1989 through December 31, 1993; interest only payments were due at a rate of 7% per annum. The difference between the interest paid and the contract rate was deferred and was accrued at the contract rate. Deferred interest is due monthly from cash flow or upon maturity of the note. From April 1, 1994 through maturity in 1996, interest only payments was due at the original contract rate. In addition, the Partnership agreed with the joint venture partner to defer interest payments on its second and third mortgage notes for the same five year period. The interest rate was permanently lowered for the five years from 12.9% per annum to 11.99% per annum. The Partnership also agreed with the joint venture partner to reduce the consolidated second and third mortgage notes by $230,000 and treat this amount as a capital contribution by the joint venture partner. The Partnership agreed to pay operating deficits at the property of up to $1,200,000 from January 1, 1989 through December 31, 1993. Gables venture had recently negotiated for an additional modification or refinancing of the first mortgage loan. Since January 1991, interest only payments were remitted at a 5% pay rate instead of the required 7% rate to the extent of available property cash flow. Negotiations with the lender were unsuccessful and the Partnership on behalf of the venture decided to not commit any significant additional amounts to the property. On May 3, 1993, the lender appointed a receiver and took possession and control of the property. In addition, the venture entered into an agreement with the lender whereby the venture would transfer title to the lender in January, 1994. During this period, the venture attempted to sell the property. The venture was unable to sell the property during the allotted time, and therefore, transferred title of the property to the lender in accordance with its previous agreement. This resulted in the venture no longer having an ownership interest and will result in net gain for financial reporting and Federal income tax purposes without any net distributable proceeds in 1994. Accordingly, the balances of the mortgage note and related accrued interest with a combined outstanding balance of approximately $24,970,000 and $20,390,000 at December 31, 1993 and at December 31, 1992, respectively, have been classified as current liabilities in the accompanying consolidated financial statements at December 31, 1993. Payments of principal and interest in arrears were approximately $944,000 at the date of transfer (see note 11(a)). CARLYLE REAL ESTATE LIMITED PARTNERSHIP - XIII (A LIMITED PARTNERSHIP) AND CONSOLIDATED VENTURES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED (8) Greenwood Creek II Apartments The Partnership was negotiating for modification of the long-term mortgage note secured by Greenwood Creek II Apartments located in Benbrook (Fort Worth), Texas. As a result of the negotiations, the Partnership made monthly debt service payments of interest only at a rate of 8% per annum between January 1989 and January 1990. In February 1990, the Partnership ceased making debt service until March 1991. The Partnership had reached an agreement in principle with the lender to submit the monthly cash flow as debt service payments beginning April 1991 while continuing to negotiate for the modification. However, the Partnership was notified that the loan had been sold to a third party. The Partnership was not successful in securing a modification. On April 6, 1993, the Partnership transferred title of the property to the lender for a transfer price of $100,000 (before selling costs and prorations) in excess of the existing mortgage balance. The Partnership recognized a gain for financial reporting and recognized a gain for Federal income tax purposes in 1993 (see note 7(f)). As of the date of sale, payments of principal and interest in arrears were approximately $598,000. (9) Commercial Union The Partnership had been unsuccessful in its attempts to obtain another primary tenant for the Commercial Union Office Building and due to the extreme softness of the Metropolitan Boston real estate market, the Partnership decided not to commit any significant additional capital to this property. Therefore, the Partnership negotiated an agreement with the second mortgage lender to realize upon its security interest in full satisfaction of the Partnership's first and second mortgage obligations. On August 15, 1991, the second mortgage lender concluded proceedings to realize upon its security interest. This resulted in the Partnership no longer having an ownership interest in the property and resulted in taxable income to the Partnership of approximately $3,200,000 with no corresponding distributable proceeds in 1991. The Partnership recognized a gain of approximately $1,476,000 for financial reporting purposes in 1991. As a result of the second mortgage lender realizing upon its security, the litigation involving, among others, the Partnership and the building's primary tenant was settled by all parties dismissing their claims. (10) Copley Place Associates The joint venture modified the existing first mortgage note effective March 1, 1992. The modification lowers the pay rate from 12% to 9% per annum through August 1993, and at that time, further reduces it to 7-1/2% per annum through August 1998. The contract rate has been lowered to 10% per annum through August 1993 and, at that time is further reduced to 8-1/2% per annum through August 1998. After each monthly payment, the difference between the contract interest rate on the outstanding principal balance on the loan, including deferred interest, and interest paid at the applicable pay rate (as defined), will be added to the principal balance and will accrue interest at the contract interest rate. All outstanding principal balance, including the unpaid deferred interest, is due and payable on August 31, 1998. In return, the lender will be entitled to receive, as additional interest, a minority residual participation of 10% of net proceeds (if any, as defined) from a sale or refinancing after the Partnership and its joint venture partner have recovered their investments (as defined). Any cash flow from the property, after all capital and leasing expenditures, will be escrowed for the purpose of paying for future capital and leasing requirements. CARLYLE REAL ESTATE LIMITED PARTNERSHIP - XIII (A LIMITED PARTNERSHIP) AND CONSOLIDATED VENTURES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED As a result of the debt modification, the property produced cash flow in 1993. This cash flow has been escrowed for future potential leasing requirements as set forth in the loan modification. The property is expected to experience a significant loss of rental income due to the expiration of a major tenant's lease. Based on this fact, the joint venture has initiated discussions with the first mortgage lender regarding an additional modification of the loan. There can be no assurances such remodification will be consummated. If the joint venture is unable to secure such remodification, it may decide not to commit any significant additional amounts to the property. This would result in the joint venture no longer having an ownership interest in the property and would result in a net gain for financial reporting and Federal income tax purposes with no corresponding distributable proceeds. The joint venture is aggressively marketing the upcoming vacant space. (11) Carrollwood Apartments In September 1993, the venture refinanced with a third party lender the existing underlying mortgage loan with a balance of approximately $7,200,000 payable at 12-3/4% per annum due in 1995. The new loan is in the amount of $7,455,000. The loan is payable in monthly installments of principal and interest and bears interest at 7.45% per annum for a five year period until maturity. The venture paid a prepayment penalty relating to the original mortgage of approximately $143,200 in connection with the refinancing. The Partnership recognized its share of approximately $141,700 as an extraordinary loss for financial reporting purposes. In addition, the venture was obligated to establish an escrow account for future capital improvements. The escrow account was initially funded by the Partnership's capital contribution to the venture and is subsequently funded by the operations of the venture. As of the date of this report, no amounts have been withdrawn. (12) Marshall's Aurora Plaza The long-term note secured by the Marshall's Aurora Plaza shopping center located in Aurora, Colorado reached its scheduled maturity in June 1993. The mortgage note has an outstanding balance of approximately $6,470,000 at December 31, 1993. The Partnership had been remitting debt service under the original terms of the loans. In January 1994, effective November 1993, the Partnership reached an agreement with the current lender to modify and extend the existing long-term note. The modification lowered the pay and accrual rates from 12.75% per annum to 8.375% per annum and extended the loan for a three year period to October 1996. Concurrent with the closing of the modification, the Partnership paid down the existing mortgage balance in the amount of $250,000. (13) Long Beach Plaza The Partnership has initiated discussions with the first mortgage lender regarding a modification of the mortgage loan secured by the Long Beach Plaza located in Long Beach, California. There can be no assurance that any modification agreement will be executed. If the Partnership is unable to secure such modification, it may decide not to commit any significant additional amounts to the property. This would result in the Partnership no longer having an ownership interest in the property and would result in a net gain for financial reporting and Federal income tax purposes with no corresponding distributable proceeds. The Partnership has not remitted all of the scheduled debt service payments since June 1993. Accordingly, the combined balances of the mortgage note and related accrued interest of approximately $35,449,000 at December 31, 1993 have been classified as current liabilities in the accompanying consolidated financial statements. As of the date of this report, payments of principal and interest in arrears are approximately $2,236,000. CARLYLE REAL ESTATE LIMITED PARTNERSHIP - XIII (A LIMITED PARTNERSHIP) AND CONSOLIDATED VENTURES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED (5) PARTNERSHIP AGREEMENT Pursuant to the terms of the Partnership Agreement, net profits and losses of the Partnership from operations are allocated 96% to the Limited Partners and 4% to the General Partners. Profits from the sale of investment properties are to be allocated to the General Partners to the greatest of (i) 1% of such profits, (ii) the amount of cash distributions to the General Partners, or (iii) an amount which will reduce the General Partners' capital account deficits (if any) to a level consistent with the gain anticipated to be realized from the sale of properties. Losses from the sale of properties are to be allocated 1% to the General Partners. The remaining profits and losses will be allocated to the Limited Partners. The General Partners are not required to make any additional capital contributions except under certain limited circumstances upon termination of the Partnership. Distributions of "Net cash receipts" of the Partnership are allocated 90% to the Limited Partners and 10% to the General Partners (of which 6.25% constitutes a management fee to the Corporate General Partner for services in managing the Partnership). The Partnership Agreement provides that, subject to certain conditions, the General Partners shall receive as a distribution from the sale of a real property by the Partnership up to 3% of the selling price, and that the remaining proceeds (net after expenses and retained working capital) be distributed 85% to the Limited Partners and 15% to the General Partners. However, prior to such distributions being made, the Limited Partners are entitled to receive 99% of net sale and financing proceeds and the General Partners shall receive 1% until the Limited Partners (i) have received cash distributions of sale or refinancing proceeds in an amount equal to the Limited Partners' aggregate initial capital investment in the Partnership and (ii) have received cumulative cash distributions from the Partnership's operations which, when combined with sale or refinancing proceeds previously distributed, equal a 6% annual return on the Limited Partners' average capital investment for each year (their initial capital investment as reduced by sale or refinancing proceeds previously distributed). If upon the completion of the liquidation of the Partnership and the distribution of all Partnership funds, the Limited Partners have not received the amounts in (i) and (ii) above, the General Partners will be required to return all or a portion of the 1% distribution of sale or financing proceeds described above in an amount equal to such deficiency in payments to the Limited Partners pursuant to (i) and (ii) above. (6) MANAGEMENT AGREEMENTS - OTHER THAN VENTURES The Partnership has entered into agreements for the operation and management of the investment properties. Such agreements are summarized as follows: The Partnership entered into an agreement with an affiliate of the seller for the operation and management of Marshall's Aurora Plaza, Aurora, Colorado for a management fee calculated at a percentage of certain types of cash income from the property. The Long Beach Plaza in Long Beach, California, Plaza Tower office building in Knoxville, Tennessee, the two apartment complexes known as Quail Place Apartments and Heritage Park II Apartments in Oklahoma City, Oklahoma (prior to their sales in March 1992), Greenwood Creek II Apartments in Benbrook, Texas, (prior to its sale in April 1993) Rio Cancion Apartments (prior to its sale in March 1993) and Eastridge Apartments in Tucson, Arizona, University Park office building in Sacramento, California, (prior to transferring the property to the lender in January 1994) 1001 Fourth Avenue CARLYLE REAL ESTATE LIMITED PARTNERSHIP - XIII (A LIMITED PARTNERSHIP) AND CONSOLIDATED VENTURES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED Plaza office building in Seattle, Washington, (prior to transferring the property to the lender in November 1993), Sherry Lane Place office building in Dallas, Texas, Commercial Union Building in Quincy, Massachusetts (prior to the lender realizing upon its security in August 1991), Gables Corporate Plaza in Coral Gables, Florida (prior to transferring the property to the lender in January 1994), and the Bridgeport Apartments in Irving, Texas (prior to its sale in April 1992) are or were managed by an affiliate of the Corporate General Partner for a fee equal to a percentage of defined gross income from the property. (7) SALE OF INVESTMENT PROPERTIES (a) Allied Automotive Center On October 10, 1990, the Partnership sold the land, building, and related improvements of the Allied Automotive Center located in Southfield, Michigan for $19,613,121 (in cash before prorations and cost of sale). The sale included the adjacent undeveloped land, building and improvements owned by two other partnerships affiliated with the Corporate General Partner. The Partnership has retained title to a defined 1.9 acre piece of land (the "Parcel"). During the buyer's due diligence investigation, the buyer found traces of contamination located on a portion of the Parcel as well as on a portion of the land owned by the two affiliated selling entities. It was subsequently determined that such contamination was most likely the result of certain activities of the previous owner. As a result, the purchase price was reduced by approximately $682,000 for the Partnership's excluded land. The land may be purchased by the buyer after the environmental clean-up is completed. As a condition of the sale, the Partnership has agreed to conduct investigations to determine all contaminants and to conduct clean-up of any such contaminants. The Partnership was also required to indemnify the buyer from specified potential clean-up related liabilities. If the clean-up is successful, the buyer will purchase the excluded land for $682,000, the purchase price adjustment. In addition, the Partnership has reached an agreement with the previous owner of the Allied Automotive Center, who has agreed to cause such investigation and clean-up to be done at the previous owner's expense. The previous owner has also indemnified the Partnership from specified potential clean-up related liabilities. As a result of such agreements, the Partnership has offset any liability for such costs against amounts to be paid by the previous owners. The Partnership, in cooperation with the previous owner, is currently working on a plan to clean up the land. The gain associated with this Parcel, approximately $543,000, will be recognized when the closing occurs. There can be no assurance that the sale of this Parcel will be consummated. (b) Heritage Park-II Apartments On March 26, 1992 the Partnership, through Partridge Place Limited Partnership, sold the land, related improvements, and personal property of the Heritage Park-II Apartments, located in Oklahoma City, Oklahoma for $4,326,000 (before selling costs and prorations) which was paid in cash at closing. In addition, the buyer paid to the Partnership incentive management fees of $199,960. The seller paid an outside broker's commission of $126,000 from the sales proceeds. In conjunction with the sale, the mortgage note and related accrued interest of approximately $8,173,000 was satisfied in full through a discounted payment of approximately $4,200,000. The Partnership recognized a net gain from this transaction in 1992 of approximately $2,688,000 (reflected as a loss on sale of approximately $1,285,000 and an extraordinary gain on forgiveness of indebtedness of approximately $3,973,000) for financial reporting purposes and recognized a gain of approximately $4,624,000 for Federal income tax purposes. CARLYLE REAL ESTATE LIMITED PARTNERSHIP - XIII (A LIMITED PARTNERSHIP) AND CONSOLIDATED VENTURES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED (c) Quail Place Apartments On March 26, 1992 the Partnership, through Quail Springs Limited Partnership, sold the land, related improvements, and personal property of the Quail Place Apartments, located in Oklahoma City, Oklahoma for $2,163,000 (before selling costs and prorations) which was paid in cash at closing. In addition, the buyer paid to the Partnership incentive management fees of $175,180. The seller paid an outside broker's commission of $63,000 from the sales proceeds. In conjunction with the sale, the mortgage note and related accrued interest of approximately $5,417,000 was satisfied in full through a discounted payment of approximately $2,100,000. The Partnership recognized a net gain from this transaction in 1992 of approximately $1,659,000 (reflected as a loss on sale of approximately $1,658,000 and an extraordinary gain on forgiveness of indebtedness of approximately $3,317,000) for financial reporting purposes and recognized a gain of approximately $2,879,000 for Federal income tax purposes. (d) Bridgeport Apartments On April 2, 1992, the Partnership sold the land, related improvements and personal property of the Bridgeport Apartments, located in Irving, Texas to the existing lender for $430,000 in excess of the existing mortgage note (before closing costs and prorations) which was paid in cash at closing. As a result of the sale, the Partnership will not have any further liability or obligation under the mortgage note which had an unpaid principal balance of approximately $9,342,000 and an unpaid accrued interest balance of approximately $2,462,000 at the date of the sale. The Partnership recognized a gain in 1992 of approximately $5,076,000 for financial reporting purposes and recognized a gain of approximately $6,142,000 for Federal income tax purposes. (e) Rio Cancion Apartments On March 31, 1993, the Partnership sold the land, related improvements, and personal property of the Rio Cancion Apartments, located in Tucson, Arizona for $13,700,000 (before selling costs and prorations) which was paid in cash at closing. In conjunction with the sale, the mortgage note and related accrued interest with a balance of approximately $12,157,000 was satisfied in full. The lender received, as its 25% minority residual participation (as defined), approximately $317,000 (see note 4(b)(3)). The Partnership received net sales proceeds of approximately $809,000. The Partnership recognized a gain from this transaction in 1993 of $2,524,958 for financial reporting purposes and recognized a gain of $7,865,633 for Federal income tax purposes in 1993. (f) Greenwood Creek II Apartments On April 6, 1993, the Partnership transferred title to the existing lender to the land, related improvements, and personal property of the Greenwood Creek II Apartments, located in Benbrook, (Fort Worth) Texas for a transfer price of $100,000 (before selling costs and prorations) in excess of the existing mortgage balance of approximately $3,747,000 (see note 4(b)(8)). The Partnership recognized a gain for financial reporting purposes in 1993 of $1,787,073 and recognized a gain of $1,823,988 for Federal income tax purposes in 1993. CARLYLE REAL ESTATE LIMITED PARTNERSHIP - XIII (A LIMITED PARTNERSHIP) AND CONSOLIDATED VENTURES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED (8) LEASES (a) As Property Lessor At December 31, 1993, the Partnership and its consolidated ventures' principal assets are five office buildings, two shopping centers, a multi-use complex and three apartment complexes. The Partnership has determined that all leases relating to these properties are properly classified as operating leases; therefore, rental income is reported when earned and the cost of each of the properties, excluding cost of land, is depreciated over the estimated useful lives. Leases with commercial tenants range in term from one to 30 years and provide for fixed minimum rent and partial reimbursement of operating costs. In addition, leases with shopping center tenants generally provide for additional rent based upon percentages of tenants' sales volumes. With respect to the Partnership's shopping center investments, a substantial portion of the ability of retail tenants to honor their leases is dependent upon the retail economic sector. Apartment complex leases in effect at December 31, 1993 are generally for a term of one year or less and provide for annual rents of approximately $5,719,000. Cost and accumulated depreciation of the leased assets are summarized as follows at December 31, 1993: Shopping centers: Cost. . . . . . . . . . . . . $ 51,183,724 Accumulated depreciation. . (16,384,628) ------------ 34,799,096 ------------ Office buildings: Cost. . . . . . . . . . . . 106,451,082 Accumulated depreciation. . (31,940,110) ------------ 74,510,972 ------------ Multi-use complex: Cost. . . . . . . . . . . . 285,870,905 Accumulated depreciation. . (91,998,239) ------------ 193,872,666 ------------ Apartment complexes: Cost. . . . . . . . . . . . 30,697,479 Accumulated depreciation. . (9,591,974) ------------ 21,105,505 ------------ Total . . . . . . . $324,288,239 ============ CARLYLE REAL ESTATE LIMITED PARTNERSHIP - XIII (A LIMITED PARTNERSHIP) AND CONSOLIDATED VENTURES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED Minimum lease payments receivable including amounts representing executory costs (e.g., taxes, maintenance, insurance), and any related profit in excess of specific reimbursements, to be received in the future under the above operating commercial lease agreements, are as follows: 1994. . . . . . . . . . . $ 43,284,626 1995. . . . . . . . . . . 35,684,088 1996. . . . . . . . . . . 33,052,124 1997. . . . . . . . . . . 30,827,874 1998. . . . . . . . . . . 28,067,260 Thereafter. . . . . . . . 88,555,330 ============ Additional rent based upon percentages of tenants' sales volumes included in rental income aggregated approximately $1,804,123, $1,464,841 and $1,010,529 for the years ended December 31, 1993, 1992 and 1991, respectively. (b) As Property Lessee The following lease agreements have been determined to be operating leases: The Partnership owns the leasehold rights to the parking structure adjacent to the Long Beach, California shopping center. The lease has an initial term of 50 years which commenced in 1981 with one 49-year renewal option exercisable by a local municipal authority. The lease provides for annual rental of $745,000, which is subject to decrease based on formulas which relate to the amount of real estate taxes assessed against the shopping center and the parking structure. The rental expense for 1993, 1992 and 1991 under the above operating lease was $528,276, $538,962 and $532,653, respectively, and consisted exclusively of minimum rent. The Copley Place venture has leased the air rights over the Massachusetts Turnpike located beneath the Boston, Massachusetts multi-use complex. The lease has a term of 99 years which commenced in 1978. The total rent due under the terms of the air rights lease was prepaid by the seller and is being amortized over the term of the air rights lease. (9) TRANSACTIONS WITH AFFILIATES In December 1984, Urban Holdings, Inc., an affiliate of the Corporate General Partner of the Partnership, purchased all the outstanding stock of the developer (joint venture partner) and property manager of the Old Orchard shopping center and the Copley Place multi-use complex. Consequently, the developer is an affiliate of the Corporate General Partner and continues to possess all of the rights and obligations granted the developer under the terms of the respective acquisition and related agreements. Fees, commissions and other expenses required to be paid by the Partnership and its consolidated ventures to the General Partners and their affiliates as of December 31, 1993 and for the years ended December 31, 1993, 1992 and 1991 are as follows: CARLYLE REAL ESTATE LIMITED PARTNERSHIP - XIII (A LIMITED PARTNERSHIP) AND CONSOLIDATED VENTURES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED UNPAID AT DECEMBER 31, 1993 1992 1991 1993 ---------- --------- --------- -------------- Property management and leasing fees . . . . . . . . . . . . . . $3,001,759 5,042,311 5,904,944 13,670,682 Insurance commissions. . . . . . . . . . . . . . . . . . . . . . 214,278 223,748 320,110 -- Reimbursement (at cost) for accounting services. . . . . . . . . 148,712 180,688 127,675 148,712 Reimbursement (at cost) for legal services . . . . . . . . . . . 30,381 36,411 66,522 30,381 Reimbursement (at cost) for out-of-pocket expenses . . . . . . . 45,143 210,065 210,664 -- Management fees to corporate general partner . . . . . . . . . . -- 12,715 108,075 -- Reimbursement (at cost) for out-of-pocket salary and salary related expenses relating to on-site and other costs for the Partnership and its investment properties. . . . . . . . . . . . . . . . . -- -- 2,823 -- ---------- ---------- ---------- ---------- $3,440,273 5,705,938 6,740,813 13,849,775 ========== ========== ========== ========== /TABLE CARLYLE REAL ESTATE LIMITED PARTNERSHIP - XIII (A LIMITED PARTNERSHIP) AND CONSOLIDATED VENTURES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED Payment of certain property management and leasing fees payable under the terms of the management agreements ($13,671,000, approximately $37 per $1,000 interest) at December 31, 1993 has been deferred. All amounts currently payable do not bear interest and are expected to be paid in future periods. (10) INVESTMENT IN UNCONSOLIDATED VENTURES Summary combined financial information for JMB/NYC and its unconsolidated ventures (note 3(c)) as of and for the years ended December 31, 1993 and 1992 are as follows: 1993 1992 ------------- ------------- Current assets . . . . . . . . . . . $ 17,668,206 20,133,526 Current liabilities (includes $923,041,198 and $931,654,790 of current portion of long-term debt at December 31, 1993 and December 31, 1992, respectively) (940,836,999) (947,314,271) ------------- ------------- Working capital (deficit). . . . (923,168,793) (927,180,745) ------------- ------------- Investment property, net . . . . . . 746,632,895 977,278,400 Accrued rent receivable. . . . . . . 50,369,613 58,019,584 Deferred expenses. . . . . . . . . . 11,096,044 12,358,603 Other liabilities. . . . . . . . . . (114,381,260) (100,815,520) Venture partners' deficit (equity) . 156,904,193 (70,045,641) ------------- ------------- Partnership's capital (deficit). $ (72,547,308) (50,385,319) ============= ============= Represented by: Invested capital . . . . . . . . . $ 43,728,411 43,723,411 Cumulative net losses. . . . . . . (106,901,970) (84,734,981) Cumulative cash distributions. . . (9,373,749) (9,373,749) ------------- ------------- $ (72,547,308) (50,385,319) ============= ============= Total income . . . . . . . . . . . . $ 168,002,257 177,682,092 ============= ============= Expenses applicable to operating loss $ 411,977,853 243,630,397 ============= ============= Net loss . . . . . . . . . . . . . . $(243,975,596) (65,948,305) ============= ============= Also, for the year ended December 31, 1991, total income was $176,041,995, expenses applicable to operating loss were $244,372,557 and the net loss was $68,330,562 for JMB/NYC and the unconsolidated ventures. CARLYLE REAL ESTATE LIMITED PARTNERSHIP - XIII (A LIMITED PARTNERSHIP) AND CONSOLIDATED VENTURES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONCLUDED (11) SUBSEQUENT EVENTS (a) Gables Corporate Plaza On January 5, 1994, the Partnership, through Gables Corporate Plaza Associates, ("the Venture") transferred title to the Gables Corporate Plaza office building as previously agreed upon in full satisfaction of the Venture's mortgage obligation. The mortgage had an outstanding balance, including accrued interest, of approximately $24,967,000. As a result of the transfer, neither the Partnership nor the Venture have an ownership interest in the property. The transfer will result in a net gain of approximately $10,524,000 for financial reporting purposes. The Partnership expects to recognize a gain of approximately $12,460,000 for Federal income tax purposes in 1994 with no corresponding distributable proceeds (see Note 4(b)(7)). (b) University Park office building As a result of the Partnership's unsuccessful negotiations with the mortgage lender, the Partnership transferred title to the University Park office building on January 10, 1994 in full satisfaction of the Partnership's mortgage obligation. The mortgage had an outstanding balance, including accrued interest, of approximately $16,294,000. As a result of the transfer, the Partnership no longer has an ownership interest in the property. The transfer will result in a net gain of approximately $5,620,000 for financial reporting purposes and expects to recognize a gain of approximately $6,885,000 for Federal income tax purposes in 1994 with no corresponding distributable proceeds (see note 4(b)(6)). SCHEDULE X CARLYLE REAL ESTATE LIMITED PARTNERSHIP - XIII (A LIMITED PARTNERSHIP) AND CONSOLIDATED VENTURES SUPPLEMENTARY INCOME STATEMENT INFORMATION YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 CHARGED TO COSTS AND EXPENSES ---------------------------------------------- 1993 1992 1991 ------------ ------------ ------------ Maintenance and repairs. $ 8,393,532 9,544,259 7,728,419 Depreciation . . . . . . 18,343,123 19,490,916 20,391,223 Amortization . . . . . . 2,410,540 1,671,011 284,201 Taxes: Real estate . . . . . 11,372,379 11,077,556 11,645,018 Other . . . . . . . . 87,928 20,786 162,829 Advertising. . . . . . . 441,742 533,259 729,591 ============ ============ ============ SCHEDULE XI CARLYLE REAL ESTATE LIMITED PARTNERSHIP - XIII (A LIMITED PARTNERSHIP) AND CONSOLIDATED VENTURES CONSOLIDATED REAL ESTATE AND ACCUMULATED DEPRECIATION DECEMBER 31, 1993 COSTS CAPITALIZED INITIAL COST TO SUBSEQUENT TO GROSS AMOUNT AT WHICH CARRIED PARTNERSHIP (a) ACQUISITION AT CLOSE OF PERIOD (b) -------------------------- ------------- ------------------------------------------ LAND AND BUILDINGS LAND LAND AND BUILDINGS LEASEHOLD AND BUILDINGS AND LEASEHOLD AND DESCRIPTION ENCUMBRANCE INTEREST IMPROVEMENTS IMPROVEMENTS INTEREST IMPROVEMENTS TOTAL(m) - ----------- ----------- ----------- ------------ -------------- ---------- ------------ ---------- APARTMENT BUILDINGS: Irving, Texas (j) . . .$ -- 1,746,622 7,886,542 (9,633,164) -- -- -- Tucson, Arizona (k) . . -- 1,935,049 13,129,268 (15,064,317) -- -- -- Oklahoma City, Oklahoma (e)(i) . . . . . . . . -- 779,748 4,370,567 (5,150,315) -- -- -- Oklahoma City, Oklahoma (e)(i) . . . . . . . . -- 745,101 6,844,687 (7,589,788) -- -- -- Tampa, Florida(e) . . . 7,400,309 1,092,010 7,408,618 221,691 1,092,010 7,630,309 8,722,319 Tucson, Arizona(e). . . 9,752,617 1,673,067 8,429,627 263,131 1,673,067 8,692,758 10,365,825 Fort Worth, Texas (l) . -- 804,874 4,037,342 (4,842,216) -- -- -- Jacksonville, Florida(e)10,840,261 1,905,940 9,664,038 39,357 1,815,262 9,794,073 11,609,335 OFFICE BUILDINGS: Seattle, Washington(d). -- 10,198,309 111,051,956 (121,250,265) -- -- -- Knoxville, Tennessee(f) 18,160,291 -- 28,884,725 3,910,724 1,508,417 31,287,032 32,795,449 Coral Gables, Florida(e)24,967,836 2,884,661 15,864,501 1,929,703 2,884,661 17,794,204 20,678,865 Dallas, Texas(e). . . . 40,498,538 7,902,979 35,029,347 (5,072,944) 6,198,484 31,660,898 37,859,382 Sacramento, California. 16,294,125 1,508,526 11,907,858 1,561,876 1,508,526 13,469,734 14,978,260 Quincy, Massachusetts(h) -- 2,033,367 17,404,970 (19,438,337) -- -- -- Southfield, Michigan(g) -- 1,715,373 -- (1,576,247) 139,126 -- 139,126 SHOPPING CENTERS: Long Beach, California. 34,652,141 3,801,066 42,765,277 (4,215,322) 3,376,877 38,974,144 42,351,021 Aurora, Colorado. . . . 6,468,313 2,035,721 6,674,891 122,091 2,035,721 6,796,982 8,832,703 MULTI-USE COMPLEX: Boston, Massachusetts (c)(e) . . . . . . . .285,934,096 4,769,913 271,584,219 9,516,773 4,769,912 281,100,993 285,870,905 ------------ ----------- ----------- ----------- ----------- ----------- ----------- Total . . . . . . .$454,968,527 47,532,326 602,938,433 (176,267,569) 27,002,063 447,201,127 474,203,190 ============ =========== =========== =========== =========== =========== =========== /TABLE SCHEDULE XI - CONTINUED CARLYLE REAL ESTATE LIMITED PARTNERSHIP - XIII (A LIMITED PARTNERSHIP) AND CONSOLIDATED VENTURES CONSOLIDATED REAL ESTATE AND ACCUMULATED DEPRECIATION DECEMBER 31, 1993 LIFE ON WHICH DEPRECIATION IN LATEST STATEMENT OF 1993 ACCUMULATED DATE OF DATE OPERATION REAL ESTATE DESCRIPTION DEPRECIATION(n) CONSTRUCTION ACQUIRED IS COMPUTED TAXES - ----------- ---------------- ------------ ---------- --------------- ----------- APARTMENT BUILDINGS: Irving, Texas (j) . . . . . . . . . . . . . $ -- 1983 9/30/83 5-30 years -- Tucson, Arizona (k) . . . . . . . . . . . . -- 1983 8/18/83 5-30 years 45,125 Oklahoma City, Oklahoma (e)(i) . . . . . . . . . . . . . . . . . . -- 1983 7/1/83 5-30 years -- Oklahoma City, Oklahoma (e)(i) . . . . . . . . . . . . . . . . . . -- 1984 7/1/83 5-30 years -- Tampa, Florida(e) . . . . . . . . . . . . . 2,871,053 1984 12/16/83 5-30 years 207,021 Tucson, Arizona(e). . . . . . . . . . . . . 3,446,759 1984 8/23/83 5-30 years 142,144 Fort Worth, Texas (l) . . . . . . . . . . . -- 1984 3/30/84 5-30 years -- Jacksonville, Florida(e). . . . . . . . . . 3,274,162 1985 10/9/84 5-30 years 213,469 OFFICE BUILDINGS: Seattle, Washington(d). . . . . . . . . . . -- 1969 9/1/83 5-30 years 758,739 Knoxville, Tennessee(f) . . . . . . . . . . 10,206,630 1979 10/26/83 5-30 years 895,382 Coral Gables, Florida(e). . . . . . . . . . 6,234,925 1983 11/15/83 5-30 years 152,654 Dallas, Texas(e). . . . . . . . . . . . . . 11,204,248 1983 12/1/83 5-30 years 517,699 Sacramento, California. . . . . . . . . . . 4,294,307 1981 1/16/84 5-30 years 134,537 Quincy, Massachusetts(h). . . . . . . . . . -- 1981 3/12/84 5-30 years -- Southfield, Michigan(g) . . . . . . . . . . -- 1974 3/30/84 5-30 years (778) SHOPPING CENTERS: Long Beach, California. . . . . . . . . . . 13,936,858 1982 6/22/83 5-30 years 945,986 Aurora, Colorado. . . . . . . . . . . . . . 2,447,770 1982 4/1/83 5-30 years 108,019 MULTI-USE COMPLEX: Boston, Massachusetts (c)(e) . . . . . . . . . . . . . . . . . . 91,998,239 1983 9/1/83 5-30 years 7,252,382 ------------ ----------- Total . . . . . . . . . . . . . . . . . $149,914,951 11,372,379 ============ =========== SCHEDULE XI - CONTINUED CARLYLE REAL ESTATE LIMITED PARTNERSHIP - XIII (A LIMITED PARTNERSHIP) AND CONSOLIDATED VENTURES CONSOLIDATED REAL ESTATE AND ACCUMULATED DEPRECIATION DECEMBER 31, 1993 - --------------- Notes: (a) The initial cost to the Partnership represents the original purchase price of the properties, including amounts incurred subsequent to acquisition which were contemplated at the time the property was acquired. (b) The aggregate cost of real estate owned at December 31, 1993 for Federal income tax purposes was approximately $98,358,000. (c) Property operated under air rights; see Note 8(b). (d) Purchase price subject to adjustment. Property recorded a provision for value impairment in 1992. The Partnership transferred title of the property to the lender in November 1993. (e) Properties owned and operated by joint ventures; see Note 3. (f) The Partnership purchased the land underlying Plaza Tower office building in December 1985. (g) Property sold except for a 1.9 acre parcel; see Note 7(a). (h) Property recorded a provision for value impairment in 1990; Lender realized upon its security and took title to property August 1991, see Note 4(b)(9). (i) Property sold March 1992; see Note 7. (j) Property sold April 1992; see Note 7. (k) Property sold March 1993. (l) Property sold April 1993. /TABLE SCHEDULE XI - CONTINUED CARLYLE REAL ESTATE LIMITED PARTNERSHIP - XIII (A LIMITED PARTNERSHIP) AND CONSOLIDATED VENTURES CONSOLIDATED REAL ESTATE AND ACCUMULATED DEPRECIATION DECEMBER 31, 1993 1993 1992 1991 ------------- ------------- ------------- (m) Reconciliation of real estate carrying costs: Balance at beginning of period . . . . . . . $627,815,579 650,806,083 664,568,420 Additions during period. . . . . . . . . . . 3,188,425 6,144,928 3,741,972 Reductions during period . . . . . . . . . . (156,800,814) (29,135,432) (17,504,309) ------------ ------------ ------------ Balance at end of period . . . . . . . . . . $474,203,190 627,815,579 650,806,083 ============ ============ ============ (n) Reconciliation of accumulated depreciation: Balance at beginning of period . . . . . . . $178,425,639 165,375,392 149,274,120 Depreciation expense . . . . . . . . . . . . 18,343,123 19,490,916 20,391,223 Reductions during period . . . . . . . . . . (46,853,811) (6,440,669) (4,289,951) ------------ ------------ ------------ Balance at end of period . . . . . . . . . . $149,914,951 178,425,639 165,375,392 ============ ============ ============ /TABLE INDEPENDENT AUDITORS' REPORT The Partners CARLYLE REAL ESTATE LIMITED PARTNERSHIP-XIII: We have audited the combined financial statements of JMB/NYC Office Building Associates, L.P. (JMB/NYC) and unconsolidated ventures as listed in the accompanying index. In connection with our audits of the combined financial statements, we also have audited the financial statement schedules as listed in the accompanying index. These combined financial statements and financial statement schedules are the responsibility of the General Partners of Carlyle Real Estate Limited Partnership-XIII (the Partnership). Our responsibility is to report on these combined financial statements and financial statement schedules based on the results of our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by the General Partners of the Partnership, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our report. In our opinion, the 1992 and 1991 combined financial statements referred to above present fairly, in all material respects, the financial position of JMB/NYC and unconsolidated ventures as of December 31, 1992, and the results of their operations and their cash flows for the years ended December 31, 1992 and 1991, in conformity with generally accepted accounting principles. Also in our opinion, the related 1992 and 1991 financial statement schedules, when considered in relation to the basic combined financial statements taken as a whole, present fairly, in all material respects, the information set forth therein. As discussed in Note 3 of the Partnership's notes to the financial statements incorporated by reference in Note 2 of the combined financial statements, JMB/NYC is in dispute with the unaffiliated partners in the real estate ventures over the calculation of the effective interest rate with reference to the first mortgage loan, which covers all the real estate owned through JMB/NYC's joint ventures. JMB/NYC believes that, for purposes of calculating cash flow deficits and for financial reporting purposes, the joint venture agreements for JMB/NYC's real estate joint ventures require interest to be computed at an effective rate of 1-3/4% over the short-term U.S. Treasury obligation rate (subject to a minimum rate of 7% per annum) plus any excess monthly Net Cash Flow of the real estate owned through JMB/NYC's joint ventures, such sum not to exceed 12-3/4% per annum. The unaffiliated partners in the real estate joint ventures contend that a 12-3/4% per annum interest rate applies. The disputed interest aggregated $20,521,000 at December 31, 1993. The ultimate outcome of the dispute cannot presently be determined. Accordingly, the disputed interest has not been included in mortgage and other interest for 1993 in the accompanying combined financial statements. The accompanying combined financial statements and financial statement schedules have been prepared assuming that JMB/NYC and the unconsolidated ventures will continue as going concerns. As discussed in Note 3 of the Partnership's notes to financial statements, incorporated by reference in Note 2 of the combined financial statements, certain of the unconsolidated ventures (Continued) have suffered recurring losses from operations and expect to incur cash flow deficits in the future. Such deficits may be impacted by the resolution of the dispute referred to above. JMB/NYC's interest in each of the ventures is pledged to secure its obligations under the joint venture agreements, including its obligations to fund possible cash flow deficits incurred by the real estate ventures commencing July 1, 1993. There can be no assurance that either the unaffiliated venture partners or JMB/NYC will be able to fund possible cash flow deficits in the future. Also, as described in Note 3, during 1992, the holder of the first mortgage loan alleged certain technical defaults under the loan agreements. Such defaults are currently being disputed by the unaffiliated venture partners. These circumstances raise substantial doubt about JMB/NYC and the unconsolidated ventures' ability to continue as going concerns. The General Partners' plans in regard to these matters are also described in Note 3 of the Partnership's Notes to the Financial Statements. The combined financial statements and financial statement schedules do not include any adjustments that might result from the outcome of this uncertainty. Because of the effects on the combined financial statements and financial statement schedules of such adjustments, if any, as might have been required had the outcome of the uncertainties described in the preceding two paragraphs been known, we are unable to, and do not express, an opinion on the accompanying 1993 combined financial statements and financial statement schedules. KPMG PEAT MARWICK Chicago, Illinois March 28, 1994 JMB/NYC OFFICE BUILDING ASSOCIATES, L.P. AND UNCONSOLIDATED VENTURES COMBINED BALANCE SHEETS DECEMBER 31, 1993 AND 1992 ASSETS ------ 1993 1992 -------------- -------------- Current assets: Cash (including amounts held by property managers) . . . . . . . . . . . . . . . . . . . . . $ 839,552 4,868,371 Restricted funds . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11,638,258 -- Rents and other receivables (net of allowance for doubtful accounts of $5,777,252 for 1993 and $1,900,622 for 1992. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,985,810 2,279,185 Prepaid expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 457,098 254,034 Escrow deposits. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,508,043 1,483,549 Tenant notes receivable. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 239,445 478,327 Due from affiliates (net of allowance for uncollectibility of $11,946,284 at December 31, 1993) (note 2) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . -- 10,770,060 -------------- -------------- Total current assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17,668,206 20,133,526 -------------- -------------- Investment properties, at cost (notes 1, 2 and 3) -- Schedule XI: Land . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 168,798,314 183,979,962 Buildings and improvements . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 954,150,721 1,132,409,431 -------------- -------------- 1,122,949,035 1,316,389,393 Less accumulated depreciation. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 376,316,140 339,110,993 -------------- -------------- Total investment properties, net of accumulated depreciation . . . . . . . . . . . . 746,632,895 977,278,400 -------------- -------------- Accrued rents receivable (note 1). . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 50,369,613 58,019,584 Deferred expenses (note 1) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11,096,044 12,358,603 -------------- -------------- $ 825,766,758 1,067,790,113 ============== ============== JMB/NYC OFFICE BUILDING ASSOCIATES, L.P. AND UNCONSOLIDATED VENTURES COMBINED BALANCE SHEETS - CONTINUED LIABILITIES AND PARTNERS' CAPITAL ACCOUNTS (DEFICITS) ----------------------------------------------------- 1993 1992 -------------- -------------- Current liabilities: Current portion of long-term debt (note 3) . . . . . . . . . . . . . . . . . . . . . . . . . $ 923,041,198 931,654,790 Accounts payable and accrued expenses. . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,492,409 4,789,399 Tenant allowances payable. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,369,373 3,553,916 Accrued interest . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5,384,407 5,434,655 Unearned rent. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,979,375 1,881,511 Interest payable to the O&Y affiliates . . . . . . . . . . . . . . . . . . . . . . . . . . . 4,570,237 -- -------------- -------------- Total current liabilities. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 940,836,999 947,314,271 Notes payable (note 5) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 34,158,225 34,158,225 Deferred interest payable (note 5) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 78,605,523 65,173,746 Tenant security deposits . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,617,512 1,483,549 -------------- -------------- Total liabilities. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,055,218,259 1,048,129,791 Partners' capital accounts (note 2): Carlyle-XIII: Capital contributions. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 43,728,411 43,723,411 Cumulative net losses. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (106,901,970) (84,734,981) Cumulative cash distributions. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (9,373,749) (9,373,749) -------------- -------------- (72,547,308) (50,385,319) -------------- -------------- Venture partners: Capital contributions. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 608,381,190 607,265,180 Cumulative net losses. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (683,400,633) (461,592,026) Cumulative cash distributions. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (81,884,750) (75,627,513) -------------- -------------- (156,904,193) 70,045,641 -------------- -------------- Total partners' capital accounts (deficit) . . . . . . . . . . . . . . . . . . . . . (229,451,501) 19,660,322 -------------- -------------- Commitments and contingencies (notes 1 and 2) $ 825,766,758 1,067,790,113 ============== ============== See accompanying notes to combined financial statements. /TABLE JMB/NYC OFFICE BUILDING ASSOCIATES, L.P. AND UNCONSOLIDATED VENTURES COMBINED STATEMENTS OF OPERATIONS YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 1993 1992 1991 ------------ ------------ ------------ Income: Rental income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 167,820,507 177,499,667 175,864,368 Interest income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 181,750 182,425 177,627 ------------- ------------ ------------ 168,002,257 177,682,092 176,041,995 ------------- ------------ ------------ Expenses - Schedule X: Mortgage and other interest (note 3). . . . . . . . . . . . . . . . . . . . . . 86,030,245 78,390,256 130,655,792 Depreciation. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 39,102,045 41,410,478 41,696,115 Property operating expenses . . . . . . . . . . . . . . . . . . . . . . . . . . 66,232,722 67,994,678 67,030,647 Professional services . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,314,088 1,286,443 664,560 Amortization of deferred expenses . . . . . . . . . . . . . . . . . . . . . . . 2,173,860 2,321,741 2,236,756 Provision for value impairment (note 1) . . . . . . . . . . . . . . . . . . . . 192,627,560 51,423,084 -- Provision for doubtful accounts (note 2). . . . . . . . . . . . . . . . . . . . 23,497,333 803,717 2,088,687 ------------- ------------ ------------ 411,977,853 243,630,397 244,372,557 ------------- ------------ ------------ Net loss . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $(243,975,596) (65,948,305) (68,330,562) ============= ============ ============ See accompanying notes to combined financial statements. /TABLE JMB/NYC OFFICE BUILDING ASSOCIATES, L.P. AND UNCONSOLIDATED VENTURES COMBINED STATEMENTS OF PARTNERS' CAPITAL ACCOUNTS (DEFICIT) YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 CARLYLE REAL ESTATE LIMITED VENTURE PARTNERSHIP-XIII PARTNERS ----------------- --------------- Balance at December 31, 1990 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ (28,606,693) 161,273,005 Capital contributions. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9,000 44,226,669 Net loss . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (12,323,342) (56,007,219) Cash distributions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (2,375,000) (11,762,000) ------------- ------------ Balance at December 31, 1991 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (43,296,035) 137,730,455 Capital contributions. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 35,000 15,139,959 Net loss . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (7,124,284) (58,824,021) Cash distributions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . -- (24,000,752) ------------- ------------ Balance at December 31, 1992 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (50,385,319) 70,045,641 Capital contributions. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5,000 1,116,010 Net loss . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (22,166,989) (221,808,607) Cash distributions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . -- (6,257,237) ------------- ------------ Balance at December 31, 1993 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ (72,547,308) (156,904,193) ============= ============ See accompanying notes to combined financial statements /TABLE JMB/NYC OFFICE BUILDING ASSOCIATES, L.P. AND UNCONSOLIDATED VENTURES COMBINED STATEMENTS OF CASH FLOWS YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 1993 1992 1991 ------------ ------------ ------------ Cash flows from operating activities: Net loss . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $(243,975,596) (65,948,305) (68,330,562) Items not requiring (providing) cash: Depreciation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 39,102,045 41,410,478 41,696,115 Amortization of deferred expenses. . . . . . . . . . . . . . . . . . . . . . 2,173,860 2,321,741 2,236,756 Provision for value impairment . . . . . . . . . . . . . . . . . . . . . . . 192,627,560 51,423,084 -- Provision for doubtful accounts. . . . . . . . . . . . . . . . . . . . . . . 23,497,333 803,717 2,088,687 Changes in: Rents and other receivables. . . . . . . . . . . . . . . . . . . . . . . . . (4,583,255) (192,043) 364,238 Prepaid expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (203,064) (35,972) 181,322 Escrow deposits. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (24,494) (11,376) 23,287 Tenant notes receivable. . . . . . . . . . . . . . . . . . . . . . . . . . . 238,882 (164,720) 147,224 Due from the O&Y affiliates. . . . . . . . . . . . . . . . . . . . . . . . . -- -- 705,251 Accrued rents receivable . . . . . . . . . . . . . . . . . . . . . . . . . . (24,448) 152,092 (5,730,142) Interest payable to the O&Y affiliates . . . . . . . . . . . . . . . . . . . 4,570,237 (1,171,214) 307,929 Accounts payable and other accrued expenses. . . . . . . . . . . . . . . . . (1,296,990) 621,288 (1,876,251) Accrued interest . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (50,248) (4,545,929) (73,026) Unearned rent. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 97,864 (1,869,845) 197,097 Deferred interest payable. . . . . . . . . . . . . . . . . . . . . . . . . . 13,431,777 11,831,860 10,422,516 Tenant security deposits . . . . . . . . . . . . . . . . . . . . . . . . . . 133,963 11,376 (23,287) ------------ ------------ ------------ Net cash provided by (used in) operating activities . . . . . . . . . . 25,715,426 34,636,232 (17,662,846) ------------ ------------ ------------ Cash flows from investing activities: Restricted funds . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (11,638,258) -- -- Additions to investment properties, net of tenant allowances payable. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (1,785,586) (1,709,278) (6,463,169) Payment of deferred expenses . . . . . . . . . . . . . . . . . . . . . . . . . (1,394,358) (943,675) (947,528) ------------ ------------ ------------ Net cash used in investing activities . . . . . . . . . . . . . . . . . (14,818,202) (2,652,953) (7,410,697) ------------ ------------ ------------ JMB/NYC OFFICE BUILDING ASSOCIATES, L.P. AND UNCONSOLIDATED VENTURES COMBINED STATEMENTS OF CASH FLOWS - CONTINUED 1993 1992 1991 ------------ ------------ ------------ Cash flows from financing activities: Capital contributions. . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,121,010 15,174,959 44,235,669 Advances to O&Y affiliates . . . . . . . . . . . . . . . . . . . . . . . . . . (1,176,224) (10,770,060) -- Principal payments on long-term debt . . . . . . . . . . . . . . . . . . . . . (8,613,592) (7,694,263) (6,873,039) Distributions to partners. . . . . . . . . . . . . . . . . . . . . . . . . . . (6,257,237) (24,000,752) (14,137,000) ------------ ------------ ------------ Net cash provided by (used in) financing activities . . . . . . . . . . (14,926,043) (27,290,116) 23,225,630 ------------ ------------ ------------ Net increase (decrease) in cash and cash equivalents. . . . . . . . . . . . . . . . . . . . . . . . . . . $ (4,028,819) 4,693,163 (1,847,913) ============ ============ ============ Supplemental disclosure of cash flow information: Cash paid for mortgage and other interest. . . . . . . . . . . . . . . . . . $ 68,078,479 71,104,325 120,306,302 Non-cash investing and financing activities: Retirement of investment property. . . . . . . . . . . . . . . . . . . . $ 1,896,898 -- 1,494,965 ============ ============ ============ See accompanying notes to combined financial statements. /TABLE JMB/NYC OFFICE BUILDING ASSOCIATES AND UNCONSOLIDATED VENTURES NOTES TO COMBINED FINANCIAL STATEMENTS DECEMBER 31, 1993, 1992 AND 1991 (1) BASIS OF ACCOUNTING The accompanying combined financial statements have been prepared for the purpose of complying with Rule 3.09 of Regulation S-X of the Securities and Exchange Commission. The entities included in the combined financial statements are as follows: JMB/NYC Office Building Associates ("JMB/NYC") (a) - 237 Park Avenue Associates (b)} - 1290 Associates (b) } - (together "Three Joint Ventures") - 2 Broadway Associates and } 2 Broadway Land Company (b)} (a) The Partnership owns an indirect ownership interest in this unconsolidated venture through Carlyle-XIII Associates, L.P., an unconsolidated venture. (b) The Partnership owns an indirect ownership interest in these joint ventures through JMB/NYC an unconsolidated venture. For purposes of preparing the combined financial statements, the effect of all transactions between JMB/NYC and the Three Joint Ventures has been eliminated. The records of JMB/NYC and the Three Joint Ventures (the "Combined Ventures") are maintained on the accrual basis of accounting as adjusted for Federal income tax reporting purposes. The accompanying combined financial statements have been prepared from such records after making appropriate adjustments to present the Three Joint Ventures' accounts in accordance with generally accepted accounting principles. Such adjustments are not recorded on the records of the Three Joint Ventures. Statement of Financial Accounting Standards No. 95 requires the Combined Ventures to present a statement which classifies receipts and payments according to whether they stem from operating, investing or financing activities. The required information has been segregated and accumulated according to the classifications specified in the pronouncement. In conjunction with the negotiations with representatives of the first mortgage lender regarding a loan restructure, the Olympia & York affiliates reached an agreement with the first mortgage lender whereby effective January 1, 1993, the Olympia & York affiliates are limited to taking distributions of $250,000 on a monthly basis from the Three Joint Ventures reserving the remaining excess cash flow in a separate-interest bearing account to be used exclusively to meet the obligations of the Three Joint Ventures as approved by the lender. Such reserved amounts, aggregating approximately $11,638,000, are classified as restricted funds in the accompanying combined balance sheet. As more fully discussed in Note 3(c) of Carlyle-XIII's financial statements filed with this annual report, due to the potential sale of the 2 Broadway building at a sales price significantly below its net carrying value and due to discussions with the O&Y affiliates regarding the reallocation of the unpaid first mortgage indebtedness currently allocated to 2 Broadway, the 2 Broadway venture has made a provision for value impairment on such investment property of $192,627,560. The provision for value impairment has been allocated $136,534,366 and $56,093,194 to the O&Y affiliates and to JMB/NYC, respectively. Such provision has been allocated to the partners to reflect their respective ownership percentages before the effect of the non- recourse promissory notes including related accrued interest. JMB/NYC OFFICE BUILDING ASSOCIATES AND UNCONSOLIDATED VENTURES NOTES TO COMBINED FINANCIAL STATEMENTS - CONTINUED In response to persistent operating deficits and vacancy levels at the 2 Broadway Building and due to the uncertainty of the 2 Broadway joint ventures' ability to recover the net carrying value of the investment property through future operations and sale, the 2 Broadway joint ventures made a provision for value impairment on such investment property of $38,689,928. Such provision at December 31, 1990 was recorded to effectively reduce the net carrying value of the investment property to the then outstanding balance of the related non- recourse financing allocated to the joint ventures and their property and was allocated to the unaffiliated venture partners in accordance with the terms of the venture agreement (see notes 3 and 5). Due to the uncertainty of the 1290 Associates venture's ability to recover the net carrying value of the 1290 Avenue of the Americas Building through future operations and sale, the 1290 Associates venture made a provision for value impairment on such investment property of $51,423,084. Such provision at September 30, 1992 was recorded to effectively reduce the net carrying value of the investment property and the related deferred expenses to the then outstanding balance of the related non-recourse financing allocated to the joint venture and its property. This provision was allocated to the unaffiliated venture partners in accordance with the terms of the venture agreement (see notes 3 and 5). Prior to their agreement with the underlying first mortgage lender, which became effective January 1, 1993, the Olympia & York affiliates borrowed cash generated from the Three Joint Ventures aggregating $11,946,284 and $10,770,060, respectively at December 31, 1993 and 1992. Due to the financial difficulties of O & Y and its affiliates, as more fully discussed in Note 3(c) of Carlyle XIII filed with this annual report, and the resulting uncertainty of collectibility of these amounts from the Olympia & York affiliates, JMB/NYC has recorded a provision for doubtful accounts at December 31, 1993 for the full receivable amount ($11,946,285) at December 31, 1993, which is reflected in the accompanying combined financial statements. Due to the uncertainty of collectibility of amounts due from certain tenants at the Three Joint Venture investment properties, a provision for doubtful accounts of $11,551,048, $803,717 and $2,088,687 at December 31, 1993, 1992 and 1991, respectively, is reflected in the accompanying combined financial statements. The provision recorded at December 31, 1993 includes approximately $7,659,000 of past due and future rents (included in accrued rents receivable in the accompanying combined financial statements) from John Blair & Co., a major lessee at the 1290 Avenue of the Americas building, due to a filing of Chapter XI bankruptcy by the tenant. Deferred expenses are comprised of leasing and renting costs which are amortized using the straight-line method over the terms of the related leases. No provision for State or Federal income taxes has been made as the liability for such taxes is that of the venture partners rather than the ventures. Depreciation on the investment properties has been provided over the estimated useful lives of 5 to 30 years using the straight-line method. Although certain leases of the Three Joint Ventures' investment properties provide for tenant occupancy during periods for which no rent is due, the ventures accrue prorated rental income for the full period of occupancy. In addition, although certain leases provide for step increases in rent during the lease term, the ventures recognize the total rent due on a straight-line basis over the entire lease. Such amounts are reflected in accrued rents receivable in the accompanying combined balance sheets. Straight-line rental income (reduction) was $24,448, $(152,092) and $5,730,142 for the years ended December 31, 1993, 1992 and 1991, respectively. JMB/NYC OFFICE BUILDING ASSOCIATES AND UNCONSOLIDATED VENTURES NOTES TO COMBINED FINANCIAL STATEMENTS - CONTINUED Maintenance and repair expenses are charged to operations as incurred. Significant betterments and improvements are capitalized and depreciated over their estimated useful lives. An affiliate of the joint venture partners perform certain maintenance and repair work and construction of certain tenant improvements at the investment properties. Certain amounts in the 1992 and 1991 combined financial statements have been reclassified to conform with the 1993 presentation. Statement of Financial Accounting Standards No. 107 ("SFAS 107"), "Disclosures about Fair Value of Financial Instruments", requires entities with total assets exceeding $150,000,000 at December 31, 1993 to disclose the SFAS 107 value of all financial assets and liabilities for which it is practicable to estimate. Value is defined in the Statement as the amount at which the instrument could be exchanged in a current transaction between willing parties, other than in a forced or liquidation sale. The Combined Ventures believe the carrying amount of its financial instruments classified as current assets and liabilities (excluding current portion of long-term debt) approximates SFAS 107 value due to the relatively short maturity of these instruments. SFAS 107 states that quoted market prices are the best evidence of the SFAS 107 value of financial instruments, even for instruments traded only in thin markets. The first mortgage loan is evidenced by certain bonds which are traded in extremely thin markets. As of December 31, 1993 and through the date of this report, a limited number of bonds have been sold and purchased in transactions arranged by brokers for amounts ranging from approximately $.60 to $.70 on the dollar. Assuming a rate of $.60 on the dollar, the implied SFAS 107 value of the bonds (with an aggregate carrying balance of $923,041,198, in the accompanying Combined Financial Statements) would be approximately $554,000,000. Due to the significant discount at which the bonds are currently trading, the SFAS 107 value of the promissory notes payable and related deferred interest (aggregating $112,763,748) would be at a discount significantly greater than that at which the bonds are currently traded. Due to, among other things, the likely inability to obtain comparable financing under current market conditions and other property specific competitive conditions, and due to the disputes with the venture partner including the alleged defaults on the first mortgage loan, the Combined Ventures would likely be unable to refinance these properties to obtain such calculated debt amounts reported (see notes 3 and 5). The Combined Ventures have no other significant financial instruments. (2) VENTURE AGREEMENTS A description of the venture agreements is contained in Note 3(c) of Notes to Financial Statements filed with this annual report. Such note is incorporated herein by reference. (3) LONG-TERM DEBT Long-term debt consists of the following at December 31, 1993 and 1992: 1993 1992 ------------------------ First mortgage loan bearing interest at the short-term U.S. Treasury obligation note rate plus 1-3/4% with a minimum rate on the loan of 7% per annum; allocated among and cross- collaterally secured by the 237 Park Avenue JMB/NYC OFFICE BUILDING ASSOCIATES AND UNCONSOLIDATED VENTURES NOTES TO COMBINED FINANCIAL STATEMENTS - CONTINUED 1993 1992 ------------------------ Building, 1290 Avenue of the Americas Building, 2 Broadway Land and 2 Broadway Building; payments of principal and interest based upon a 30-year amortization schedule are due monthly, however, commencing on a date six months following the attainment of a certain level of annualized cash flow, any interest in excess of 12% per annum may be accrued, to the extent that monthly cash flow is insufficient to pay the full monthly debt service, by adding such deferred amount to the outstanding balance of the loan; the loan is in non-monetary default at December 31, 1992 and 1993 (Reference is made to Note 3(c) of Notes to Carlyle Real Estate Limited Partnership-XIII Financial Statements filed with this annual report as to the calculation of interest rate with reference to this first mortgage loan); the stated maturity of principal of $857,784,000 and accrued interest is March 1999. . . . . . . . . . . . . . . . . $923,041,198 931,654,790 Less current portion of long-term debt . . 923,041,198 931,654,790 ------------ ----------- Total long-term debt . . . . . . . $ -- -- ============ =========== The allocation of the first mortgage loan among the joint ventures is as follows (which is non-recourse to the joint ventures) (see note 1): 1993 1992 ------------ ------------ 237 Park Avenue Associates. . . $214,107,494 216,105,492 1290 Avenue Associates. . . . . 453,194,197 457,423,293 2 Broadway Land Company . . . . 17,842,291 18,008,791 2 Broadway Associates . . . . . 237,897,216 240,117,214 ------------ ------------ $923,041,198 931,654,790 ============ ============ (4) LEASES At December 31, 1993, the properties in the combined group consisted of three office buildings. All leases relating to the properties are properly classified as operating leases; therefore, rental income is reported when earned and the cost of each of the properties, excluding the cost of land, is depreciated over the estimated useful lives. Leases with commercial tenants range in term from one to 25 years and provide for fixed minimum rent and partial to full reimbursement of operating costs. Affiliates of the joint venture partners have lease agreements and occupy approximately 95,000 square feet of space at 237 Park Avenue at rental rates which approximate market. During 1993 and 1992, 2 Broadway Associates collected $4,781,158 and $6,069,444 of a total $13,340,601 bankruptcy claim against Drexel Burnham Lambert, a former tenant of the 2 Broadway Building and is included in rental income in the 1993 and 1992 accompanying combined income statement. All remaining claims against Drexel Burnham Lambert were sold during 1993. JMB/NYC OFFICE BUILDING ASSOCIATES AND UNCONSOLIDATED VENTURES NOTES TO COMBINED FINANCIAL STATEMENTS - CONTINUED Minimum lease payments including amounts representing executory costs (e.g., taxes, maintenance, insurance), and any related profit in excess of specific reimbursements, to be received in the future under the above operating commercial lease agreements, are as follows: 1994. . . . . . . .$ 92,366,352 1995. . . . . . . . 83,462,935 1996. . . . . . . . 74,169,081 1997. . . . . . . . 69,897,639 1988. . . . . . . . 66,432,323 Thereafter. . . . . 324,714,863 ------------ $711,043,193 ============ (5) NOTES PAYABLE Notes payable consist of the following at December 31, 1993 and 1992: 1993 1992 ----------------------- Promissory notes payable to an affiliate of the unaffiliated venture partners in the Three Joint Ventures, bearing interest at 12.75% per annum; cross-collaterally secured by JMB/NYC's interest in the Three Joint Ventures one of which is additionally secured by $19,000,000 of distributable proceeds from two of the Three Joint Ventures; interest accrues and is deferred, compounded monthly, until December 31, 1991; monthly payments of accrued interest, based upon the level of distributions to JMB/NYC, thereafter until maturity; principal and accrued interest due March 20, 1999. Accrued deferred interest of $78,605,523 and $65,173,746 is outstanding at December 31, 1993 and 1992, respectively. . . . . . . . . . . . $34,158,225 34,158,225 ----------- ---------- Less current portion of notes payable . . -- -- ----------- ---------- Long-term notes payable . . . . . . . . . $34,158,225 34,158,225 =========== ========== The allocation of the promissory notes and related deferred interest among the joint ventures is as follows: 1993 1992 ---------------------- 237 Park Avenue Associates. . . . . . . . $ 14,902,454 13,127,359 1290 Associates . . . . . . . . . . . . . 32,214,484 28,377,278 2 Broadway Land Company . . . . . . . . . 2,877,196 2,534,480 2 Broadway Associates . . . . . . . . . . 62,769,614 55,292,854 ----------------------- $112,763,748 99,331,971 ======================= SCHEDULE X JMB/NYC OFFICE BUILDING ASSOCIATES AND UNCONSOLIDATED VENTURES SUPPLEMENTARY INCOME STATEMENT INFORMATION YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 CHARGED TO COSTS AND EXPENSES ---------------------------------------------- 1993 1992 1991 ------------ ------------ ------------ Depreciation . . . . . . $39,102,045 41,410,478 41,696,115 Amortization . . . . . . 2,173,860 2,321,741 2,236,756 Real estate taxes. . . . 39,589,367 40,609,489 38,358,812 Repairs and maintenance. 8,954,975 9,441,699 10,892,232 =========== ========== =========== SCHEDULE XI JMB/NYC OFFICE BUILDING ASSOCIATES AND UNCONSOLIDATED VENTURES COMBINED REAL ESTATE AND ACCUMULATED DEPRECIATION DECEMBER 31, 1993 COSTS CAPITALIZED INITIAL COST TO SUBSEQUENT TO GROSS AMOUNT AT WHICH CARRIED UNCONSOLIDATED VENTURES(A) TO ACQUISITION AT CLOSE OF PERIOD (B) -------------------------- -------------- -------------------------------------- BUILDINGS BUILDINGS AND BUILDINGS AND AND DESCRIPTION ENCUMBRANCE(C) LAND IMPROVEMENTS IMPROVEMENTS LAND IMPROVEMENTS TOTAL (E) - ----------- -------------- ----------- ------------ -------------- ---------- ------------ ---------- OFFICE BUILDINGS: New York, New York (237 Park Avenue). $214,107,494 79,653,996 226,634,894 1,208,552 79,653,996 227,843,446 307,497,442 New York, New York (1290 Avenue of the Americas). . . 453,194,197 90,952,993 556,434,718 (9,814,514) 84,285,719 553,287,478 637,573,197 New York, New York (2 Broadway) . . . 255,739,507 26,421,677 378,445,199 (226,988,480) 4,858,599 173,019,797 177,878,396 ------------ ----------- ------------- ------------ ----------- ------------- ------------- Total. . . . . . $923,041,198 197,028,666 1,161,514,811 (235,594,442) 168,798,314 954,150,721 1,122,949,035 ============ =========== ============= ============ =========== ============= ============= /TABLE SCHEDULE XI - CONTINUED JMB/NYC OFFICE BUILDING ASSOCIATES AND UNCONSOLIDATED VENTURES SUPPLEMENTARY INCOME STATEMENT INFORMATION YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 LIFE ON WHICH DEPRECIATION IN LATEST STATEMENT OF 1993 ACCUMULATED DATE OF DATE OPERATION REAL ESTATE DESCRIPTION DEPRECIATION(F) CONSTRUCTION ACQUIRED IS COMPUTED TAXES - ----------- ---------------- ------------ ---------- --------------- ----------- OFFICE BUILDINGS: New York, New York (237 Park Avenue). . . . . . . . . . . . . $ 70,997,283 1981 8/14/84 5-30 years 10,356,858 New York, New York (1290 Avenue of the Americas). . . . . . . 188,932,678 1963 7/27/84 5-30 years 19,040,331 New York, New York (2 Broadway) . . . . . . . . . . . . . . . 116,386,179 1959 8/14/84 5-30 years 10,192,178 ------------ ---------- Total. . . . . . . . . . . . . . . . . . $376,316,140 39,589,367 ============ ========== - ----------------- Notes: (A) The initial cost represents the original purchase price of the property, including amounts incurred subsequent to acquisition which were contemplated at the time the property was acquired. (B) The aggregate cost of real estate owned at December 31, 1993 for Federal income tax purposes was approximately $1,361,603,548 (see Note 1 of Notes to Combined Financial Statements). (C) Reference is made to Note 5 of Combined Financial Statements for the current outstanding principal balances and a description of the notes payable secured by JMB/NYC's interests in the Three Joint Ventures which are not included in the amounts stated above. (D) Includes provision for value impairment at 2 Broadway of $192,144,503 recorded December 31, 1993, 1290 Avenue of the Americas of $50,446,010 recorded September 30, 1992 and 2 Broadway of $38,689,928 recorded December 31, 1990. See Note 1 of Notes to Combined Financial Statements for further discussion. /TABLE SCHEDULE XI - CONTINUED JMB/NYC OFFICE BUILDING ASSOCIATES AND UNCONSOLIDATED VENTURES SUPPLEMENTARY INCOME STATEMENT INFORMATION YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 (E) Reconciliation of real estate owned: 1993 1992 1991 -------------- -------------- ------------- Balance at beginning of period . . . . . . . $1,316,389,393 1,366,280,363 1,365,517,662 Additions during period. . . . . . . . . . . 601,043 555,040 2,257,666 Provision for value impairment . . . . . . . (192,144,503) (50,446,010) -- Retirements during period. . . . . . . . . . (1,896,898) -- (1,494,965) -------------- ------------- ------------- Balance at end of period . . . . . . . . . . $1,122,949,035 1,316,389,393 1,366,280,363 ============== ============= ============= (F) Reconciliation of accumulated depreciation: Balance at beginning of period . . . . . . . $ 339,110,993 297,700,515 257,499,365 Depreciation expense . . . . . . . . . . . . 39,102,045 41,410,478 41,696,115 Retirements during period. . . . . . . . . . (1,896,898) -- (1,494,965) -------------- ------------- ------------- Balance at end of period . . . . . . . . . . $ 376,316,140 339,110,993 297,700,515 ============== ============= ============= /TABLE Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure There were no changes in or disagreements with accountants during fiscal year 1993 and 1992. PART III ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE PARTNERSHIP The Corporate General Partner of the Partnership is JMB Realty Corporation ("JMB"), a Delaware corporation. JMB as the Corporate General Partner has responsibility for all aspects of the Partnership's operations, subject to the requirement that sales of real property must be approved by the Associate General Partner of the Partnership, Realty Associates-XIII L.P., an Illinois Limited Partnership with JMB as the sole general partner. The Associate General Partner shall be directed by a majority in interest of its limited partners (who are generally officers, directors and affiliates of JMB or its affiliates) as to whether to provide its approval of any sale of real property (or any interest therein) of the Partnership. Various relationships of the Partnership to the Corporate General Partner and its affiliates are described under the caption "Conflicts of Interest" at pages 12-18 of the Prospectus, of which description is hereby incorporated herein by reference to Exhibit 28-A to the Partnership's Report for December 31, 1992 on Form 10-K (File No. 0-12791) dated March 30, 1993. The names, positions held and length of service therein of each director and executive officer and certain officers of the Managing General Partner of the Partnership are as follows: SERVED IN NAME OFFICE OFFICE SINCE - ---- ------ ------------ Judd D. Malkin Chairman 5/03/71 Director 5/03/71 Neil G. Bluhm President 5/03/71 Director 5/03/71 Jerome J. Claeys III Director 5/09/88 Burton E. Glazov Director 7/01/71 Stuart C. Nathan Executive Vice President 5/08/79 Director 3/14/73 A. Lee Sacks Director 5/09/88 John G. Schreiber Director 3/14/73 H. Rigel Barber Chief Executive Officer 8/01/93 and Executive Vice President 1/02/87 Jeffrey R. Rosenthal Chief Financial Officer 8/01/93 Gary Nickele Executive Vice President 1/01/92 General Counsel 2/27/84 Ira J. Schulman Executive Vice President 6/01/88 Gailen J. Hull Senior Vice President 6/01/88 Howard Kogen Senior Vice President 1/02/86 Treasurer 1/01/91 There is no family relationship among any of the foregoing directors or officers. The foregoing directors have been elected to serve one-year terms until the annual meeting of the Corporate General Partner to be held on June 7, 1994. All of the foregoing officers have been elected to serve one-year terms until the first meeting of the Board of Directors held after the annual meeting of the Corporate General Partner to be held on June 7, 1994. There are no arrangements or understandings between or among any of said directors or officers and any other person pursuant to which any director or officer was elected as such. JMB is the Corporate General Partner of Carlyle Real Estate Limited Partnership-VII ("Carlyle-VII"), Carlyle Real Estate Limited Partnership-IX ("Carlyle-IX"), Carlyle Real Estate Limited Partnership-X ("Carlyle-X"), Carlyle Real Estate Limited Partnership-XI ("Carlyle-XI"), Carlyle Real Estate Limited Partnership-XII ("Carlyle-XII"), Carlyle Real Estate Limited Partnership-XIV ("Carlyle-XIV"), Carlyle Real Estate Limited Partnership-XV ("Carlyle-XV"), Carlyle Real Estate Limited Partnership-XVI ("Carlyle-XVI"), Carlyle Real Estate Limited Partnership-XVII ("Carlyle-XVII"), JMB Mortgage Partners, Ltd. ("Mortgage Partners"), JMB Mortgage Partners, Ltd.-II ("Mortgage Partners-II"), JMB Mortgage Partners, Ltd.-III ("Mortgage Partners-III"), JMB Mortgage Partners, Ltd-IV ("Mortgage Partners-IV"), Carlyle Income Plus, Ltd. ("Carlyle Income Plus") and Carlyle Income Plus, L.P.-II ("Carlyle Income Plus-II") and the managing general partner of JMB Income Properties, Ltd.-IV ("JMB Income-IV"), JMB Income Properties, Ltd.-V ("JMB Income-V"), JMB Income Properties, Ltd.-VI ("JMB Income-VI"), JMB Income Properties, Ltd.-VII ("JMB Income-VII"), JMB Income Properties, Ltd.-VIII ("JMB Income-VIII"), JMB Income Properties, Ltd.-IX ("JMB Income-IX"), JMB Income Properties, Ltd.-X ("JMB Income-X"), JMB Income Properties, Ltd.-XI ("JMB Income-XI"), JMB Income Properties, Ltd.-XII ("JMB Income-XII"), and JMB Income Properties, Ltd.-XIII ("JMB Income-XIII"). Most of the foregoing directors and officers are also officers and/or directors of various affiliated companies of JMB including Arvida/JMB Managers, Inc. (the general partner of Arvida/JMB Partners, L.P. ("Arvida")), Arvida/JMB Managers-II, Inc. (the general partner of Arvida/JMB Partners, L.P.-II ("Arvida-II")), and Income Growth Managers, Inc. (the corporate general partner of IDS/JMB Balanced Income Growth, Ltd. ("IDS/BIG")). Most of such directors and officers are also partners, directly or indirectly, of certain partnerships which are associate general partners in the following real estate limited partnerships: the Partnership, Carlyle-VII, Carlyle-IX, Carlyle-X, Carlyle-XI, Carlyle-XII, Carlyle-XIV, Carlyle-XV, Carlyle-XVI, Carlyle-XVII, JMB Income-VI, JMB Income-VII, JMB Income-VIII, JMB Income-IX, JMB Income-X, JMB Income-XI, JMB Income-XII, JMB Income-XIII, Mortgage Partners, Mortgage Partners-II, Mortgage Partners-III, Mortgage Partners-IV, Carlyle Income Plus, Carlyle Income Plus-II and IDS/BIG. The business experience during the past five years of each such director and officer of the Corporate General Partner of the Partnership in addition to that described above is as follows: Judd D. Malkin (age 56) is an individual general partner of JMB Income-II, JMB Income-IV and JMB Income-V. Mr. Malkin has been associated with JMB since October, 1969. He is a Certified Public Accountant. Neil G. Bluhm (age 56) is an individual general partner of JMB Income-II, JMB Income-IV and JMB Income-V. Mr. Bluhm has been associated with JMB since August, 1970. He is a member of the Bar of the State of Illinois and a Certified Public Accountant. Jerome J. Claeys III (age 51) (Chairman and Director of JMB Institutional Realty Corporation) has been associated with JMB since September, 1977. He holds a Masters degree in Business Administration from the University of Notre Dame. Burton E. Glazov (age 55) has been associated with JMB since June, 1971 and served as an Executive Vice President of JMB until December 1990. He is a member of the Bar of the State of Illinois and a Certified Public Accountant. Stuart C. Nathan (age 52) has been associated with JMB since July, 1972. He is a member of the Bar of the State of Illinois. A. Lee Sacks (age 60) (President of JMB Insurance Agency, Inc.) has been associated with JMB since December, 1972. John G. Schreiber (age 47) has been associated with JMB since December, 1970 and served as an Executive Vice President of JMB until December 1990. He holds a Masters degree in Business Administration from Harvard University Graduate School of Business. H. Rigel Barber (age 45) has been associated with JMB since March, 1982. He holds a J.D. degree from the Northwestern Law School and is a member of the Bar of the State of Illinois. Jeffrey R. Rosenthal (age 43) has been associated with JMB since December, 1987. He is a Certified Public Accountant. Gary Nickele (age 41) has been associated with JMB since February, 1984. He holds a J.D. degree from the University of Michigan Law School and is a member of the Bar of the State of Illinois. Ira J. Schulman (age 42) has been associated with JMB since February, 1983. He holds a Masters degree in Business Administration from the University of Pittsburgh. Gailen J. Hull (age 45) has been associated with JMB since March, 1982. He holds a Masters degree in Business Administration from Northern Illinois University and is a Certified Public Accountant. Howard Kogen (age 58) has been associated with JMB since March, 1973. He is a Certified Public Accountant. ITEM 11. EXECUTIVE COMPENSATION The Partnership has no officers or directors. The Partnership is required to pay a management fee to the Corporate General Partner and the General Partners are entitled to receive a share of cash distributions, when and as cash distributions are made to the Limited Partners, and a share of profits or losses as described under the caption " Compensation and Fees" at pages 8-11, "Cash Distributions" at pages 69-71, "Allocation of Profits or Losses for Tax Purposes" at pages 68-69 of the Prospectus and at pages A-7 to A-12 of the Partnership Agreement, included as an exhibit to the Prospectus, which descriptions are incorporated herein by reference to Exhibit 28-A to the Partnership's Report for December 31, 1992 on Form 10-K (File No. 0-12791) dated March 30, 1993. Reference is also made to Notes 5 and 9 for a description of such transactions, distributions and allocations. In 1993, 1992 and 1991, the General Partners received distributions of $0, $7,629 and $64,845, respectively, and the Corporate General Partner received a management fee of $0, $12,715 and $108,075, respectively. The General Partners received a share of Partnership gains for tax purposes aggregating $4,121,438 in 1993 and losses aggregating, $1,598,313 and $2,214,779 in 1992 and 1991, respectively. Such losses may benefit the General Partners (or the partners thereof) to the extent that such losses may be offset against taxable income from the Partnership or other sources. The Partnership is permitted to engage in various transactions involving affiliates of the Corporate General Partner of the Partnership, as described under the captions "Compensation and Fees" at pages 8-11, "Conflicts of Interest" at pages 12-18 of the Prospectus and at pages A-14 to A-20 of the Partnership Agreement, included as an exhibit to the Prospectus, which descriptions are hereby incorporated herein by reference to Exhibit 28-A to the Partnership's Report for December 31, 1992 on Form 10-K (File No. 0-12791) dated March 30, 1993. The relationship of the Corporate General Partner (and its directors and officers) to its affiliates is set forth above in Item 10. An affiliate of the Corporate General Partner provided property management services for all or part of 1993 for the 1001 Fourth Avenue Plaza office building in Seattle, Washington, the University Park office building in Sacramento, California, the Plaza Tower office building in Knoxville, Tennessee, the Rio Cancion Apartments in Tucson, Arizona, the Long Beach Plaza in Long Beach, California, the Eastridge Apartments in Tucson, Arizona, the Copley Place multi-use complex in Boston, Massachusetts, the Gables Corporate Plaza in Coral Gables, Florida, the Greenwood Creek II Apartments in Benbrook, Texas, and the Sherry Lane Place office building in Dallas, Texas at various fees calculated based upon the gross income from the properties. In 1993, such affiliate earned property management and leasing fees amounting to $3,001,759 for such services. The cumulative amount of property management and leasing fees owed to an affiliate of the Corporate General Partner as of December 31, 1993 was $13,670,682. As set forth in the Prospectus of the Partnership, the Corporate General Partner must negotiate such agreements on terms no less favorable to the Partnership than those customarily charged for similar services in the relevant geographical area (but in no event at rates greater than 6% of the gross income from a property), and such agreements must be terminable by either party thereto, without penalty, upon 60 days' notice. JMB Insurance Agency, Inc., an affiliate of the Corporate General Partner, earned insurance brokerage commissions in 1993 aggregating $214,278 in connection with the providing of insurance coverage for certain of the real property investments of the Partnership, all of which was paid at December 31, 1993. Such commissions are at rates set by insurance companies for the classes of coverage provided. The General Partners of the Partnership or their affiliates may be reimbursed for their direct expenses or out-of-pocket expenses and salaries and related salary expenses relating to the administration of the Partnership and the acquisition and operation of the Partnership's real property investments. In 1993, the Corporate General Partner of the Partnership was due reimbursement for such out-of-pocket expenses in the amount of $45,143, all of which was paid at December 31, 1993. Additionally, the General Partners are also entitled to reimbursements for legal and accounting services. Such costs for 1993 were $148,712 and $30,381, respectively, all of which were unpaid as of December 31, 1993. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT (a) No person or group is known by the Partnership to own beneficially more than 5% of the outstanding Interests of the Partnership. (b) The Corporate General Partner and its officers and directors own the following Interests of the Partnership: NAME OF AMOUNT AND NATURE BENEFICIAL OF BENEFICIAL PERCENT TITLE OF CLASS OWNER OWNERSHIP OF CLASS - -------------- ---------- ----------------- -------- Limited Partnership Interests JMB Realty Corporation 5 Interests directly Less than 1% Limited Partnership Interests Corporate General 6.79 Interests directly (1) Less than 1% Partner and its officers and directors as a group (1) Includes 1.79 Interests owned by officers or their relatives for which each officer has investment and voting power as to such Interests so owned. No officer or director of the Corporate General Partner of the Partnership possesses a right to acquire beneficial ownership of Interests of the Partnership. (c) There exists no arrangement, known to the Partnership, the operation of which may at a subsequent date result in a change in control of the Partnership. /TABLE ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS There were no significant transactions or business relationships with the Corporate General Partner, affiliates or their management other than those described in Items 10 and 11 above. PART IV ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K (a) The following documents are filed as part of this report: (1) Financial Statements (See Index to Financial Statements filed with this annual report). (2) Exhibits. 3.* Amended and Restated Agreement of Limited Partnership set forth as Exhibit A to the Prospectus, and which is hereby incorporated by reference. 4-A. Documents relating to the mortgage loan secured by the 1001 Fourth Avenue Plaza in Seattle, Washington are also hereby incorporated herein by reference to Post-Effective Amendment No. 2 in the Partnership's Registration Statement on Form S-11 (File No. 2-81125) dated June 9, 1983. 4-B. Documents relating to the mortgage loan secured by the Copley Place multi-use complex, in Boston Massachusetts, are also hereby incorporated herein by reference to Post-Effective Amendment No. 2 in the Partnership's Registration Statement on Form S-11 (File No. 2-81125) dated June 9, 1983. 4-C.* Documents relating to the modification of the mortgage loan secured by 1001 Fourth Avenue Plaza are hereby incorporated herein by reference. 4-D.* Documents relating to the modification of the mortgage loan secured by the Copley Place multi-use complex are hereby incorporated herein by reference. 10-A. Acquisition documents relating to the purchase by the Partnership of an interest in the 1001 Fourth Avenue Plaza in Seattle, Washington, are hereby incorporated herein by reference to Post- Effective Amendment No. 2 to the Partnership's Registration Statement on Form S-11 (File No. 2-81125) dated June 9, 1983. 10-B. Acquisition documents relating to the purchase by the Partnership of an interest in the Copley Place multi-use complex in Boston, Massachusetts, are hereby incorporated herein by reference to Post-Effective Amendment No. 2 to the Partnership's Registration Statement on Form S-11 (File No. 2-81125) dated June 9, 1983. 10-C. Documents relating to the sale by the Partnership of an interest in the Allied Automotive Center, in Southfield, Michigan, are hereby incorporated herein by reference to the Partnership's Report on Form 8-K (File No. 0-12791) for October 10, 1990, dated October 30, 1990. 10-D. Documents describing the transferred title of the Partnership's interest in the Commercial Union Office Building to the second mortgage lender, are hereby incorporated herein by reference to the Partnership's Report on Form 8-K (File No. 0-12791) for August 15, 1991, dated September 18, 1991. 10-E. Agreement dated March 25, 1993 between JMB/NYC and the Olympia & York affiliates regarding JMB/NYC's deficit funding obligations from January 1, 1992 through June 30, 1993 are filed herewith. 10-F. Agreement of Limited Partnership of Carlyle-XIII Associates L.P. is hereby incorporated by reference to the Partnership's Report on Form 10-Q (File No. 0-12791) dated May 14, 1993. 10-G. Documents relating to the sale by the Partnership of its interest in the Rio Cancion Apartments in Tucson, Arizona, are herein incorporated by reference to the Partnership's Report on Form 8-K (File No. 0-12791) for March 31, 1993, dated May 14, 1993. 10-H. Documents relating to the sale by the Partnership of its interest in the Old Orchard Urban Venture are herein incorporated by reference to the Partnership's Report on Form 8-K (File No. 0-12791) for August 30, 1993, dated November 12, 1993. 10-I. Documents describing the transferred title of the Partnership's interest in the 1001 Fourth Avenue Office Building to the first mortgage lender, are hereby incorporated herein by reference to the Partnership's Report on Form 8-K (File No. 0-12791) for November 1, 1993, dated November 12, 1993. 10-J. Second Amended and Restated Articles of Partnership of JMB/NYC Office Building Associates, a copy of which is filed herewith. 10-K. Amended and Restated Certificate of Incorporation of Carlyle-XIV Managers, Inc., a copy of which is filed herewith. 10-L. Amended and Restated Certificate of Incorporation of Carlyle-XIII Managers, Inc., a copy of which is filed herewith. 10-M. $600,000 demand note between Carlyle-XIII Associates, L.P. and Carlyle Managers, Inc., a copy of which is filed herewith. 10-N. $600,000 demand note between Carlyle-XIII Associates, L.P. and Carlyle Investors, Inc., a copy of which is filed herewith. 10-O. Settlement Agreement between Gables Corporate Plaza Associates and Aetna Life Insurance Company, a copy of which is filed herewith. 21. List of Subsidiaries. 24. Powers of Attorney. 99-A. The Partnership's Report on Form 10-Q (File No. 0-12791) for May 14, 1993 and exhibits thereto are hereby incorporated herein by reference. 99-B. The Partnership's Report on Form 8-K (File No. 0-12791) for May 14, 1993 and exhibits thereto are hereby incorporated herein by reference. 99-C. The Partnership's Report on Form 8-K (File No. 0-12791) for November 12, 1993 and exhibits thereto are hereby incorporated herein by reference. 99-D. The Partnership's Report on Form 8-K (File No. 0-12791) for November 12, 1993 and exhibits thereto are hereby incorporated herein by reference. Although certain additional long-term debt instruments of the Registrant have been excluded from Exhibit 4 above, pursuant to Rule 601(b)(4)(iii), the Registrant commits to provide copies of such agreements to the SEC upon request. (b) The following Report on Form 8-K has been filed for the quarter covered by this report. (1) The Partnership's Report on Form 8-K (File No. 0- 12791) for November 1, 1993 (describing under Item 2 of such report the Partnership's transfer of the land, related improvements and personal property as of the 1001 Fourth Avenue Office Building) was filed. The report is dated November 12, 1992. No financial statements were required to be filed therewith. ---------------- * Previously filed as Exhibits 3, 4-C and 4-D, respectively, to the Partnership's Report on Form 10-K to the Securities Exchange Act of 1934 (File No. 0-12791) dated March 30, 1993 are hereby incorporated herein by reference. No annual report or proxy material for the fiscal year 1993 has been sent to the Partners of the Partnership. An annual report will be sent to the Partners subsequent to this filing. SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Partnership has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. CARLYLE REAL ESTATE LIMITED PARTNERSHIP - XIII By: JMB Realty Corporation Corporate General Partner GAILEN J. HULL By: Gailen J. Hull Senior Vice President Date:March 28, 1994 Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated. By: JMB Realty Corporation Corporate General Partner JUDD D. MALKIN* By: Judd D. Malkin, Chairman and Director Date:March 28, 1994 NEIL G. BLUHM* By: Neil G. Bluhm, President and Director Date:March 28, 1994 H. RIGEL BARBER* By: H. Rigel Barber, Chief Executive Officer Date:March 28, 1994 JEFFREY R. ROSENTHAL* By: Jeffrey R. Rosenthal, Chief Financial Officer Principal Financial Officer Date:March 28, 1994 GAILEN J. HULL By: Gailen J. Hull, Senior Vice President Principal Accounting Officer Date:March 28, 1994 By: A. LEE SACKS* A. Lee Sacks, Director Date:March 28, 1994 By: STUART C. NATHAN* Stuart C. Nathan, Executive Vice President and Director Date:March 28, 1994 *By:GAILEN J. HULL, Pursuant to a Power of Attorney GAILEN J. HULL By: Gailen J. Hull, Attorney-in-Fact Date:March 28, 1994 CARLYLE REAL ESTATE LIMITED PARTNERSHIP - XIII EXHIBIT INDEX Document Incorporated By Reference Page ------------ ---- 3. Amended and Restated Agreement of Limited Partnership set forth as Exhibit A to the Prospectus Yes 4-A. Mortgage loan documents secured by the 1001 Fourth Avenue Plaza Yes 4-B. Mortgage loan documents secured by the Copley Place multi-use complex Yes 4-C. Remodification of mortgage loan documents secured by 1001 Fourth Avenue Plaza Yes 4-D. Remodification of mortgage loan documents secured by Copley Place multi-use complex.Yes 10-A. Acquisition documents related to the 1001 Fourth Avenue Plaza Yes 10-B. Acquisition documents related to the Copley Place multi-use complex Yes 10-C. Documents related to the sale of Allied Automotive Center. Yes 10-D. Documents related to the transferred title of Commercial Union Office Building Yes 10-E. Agreement relating to JMB/NYC's deficit funding obligations from January 1, 1992 through June 30, 1993. Yes 10-F. Agreement of Limited Partnership of Carlyle-XIII Associates L.P. Yes 10-G. Documents relating to the sale by the Partnership of its interest in the Rio Cancion Apartments Yes 10-H. Documents relating to the sale of its interest in the Old Orchard Urban Venture Yes 10-I. Documents related to the transferred title to the Commercial Union Office Building Yes 10-J. Second Amended and Restated Articles of Partnership of JMB/NYC Office Building Associates No 10-K. Amended and Restated Certificate of Incorporation of Carlyle-XIV Managers, Inc. No 10-L. Amended and Restated Certificate of Incorporation of Carlyle-XIII Managers, Inc. No 10-M. $600,000 demand note between Carlyle-XIII Associates, Ltd. and Carlyle Managers, Inc. No CARLYLE REAL ESTATE LIMITED PARTNERSHIP - XIII EXHIBIT INDEX - CONTINUED Document Incorporated By Reference Page ------------ ---- 10-N. $600,000 demand note between Carlyle-XIII Associates, Ltd. and Carlyle Investors, Inc. No 10-O. Settlement Agreement between Gables Corporate Plaza Associates and Aetna Life Insurance Company No 21. List of Subsidiaries Yes 24. Powers of Attorney Yes 99-A. Form 10-Q for May 14, 1993 and exhibits thereto Yes 99-B. Form 8-K for May 14, 1993 and exhibits thereto Yes 99-C. Form 8-K for November 12, 1993 and exhibits thereto Yes 99-D. Form 8-K for November 12, 1993 and exhibits thereto Yes - ------------------ * Previously filed as exhibits to the Partnership's Registration Statement on Form S-11 (as amended) under the Securities Exchange Act of 1933 and the Partnership's prior Reports on Form 8-K and Form 10-K of the Securities Exchange Act of 1934. AGREEMENT FOR THE DELIVERY OF A DEED IN LIEU OF FORECLOSURE AGREEMENT made as of the 29th day of October, 1993, between 1001 FOURTH AVENUE ASSOCIATES, an Illinois general partnership having its principal place of business and post office address at c/o JMB Realty Corporation, 900 North Michigan Avenue, Suite 1900, Chicago, Illinois 60611 ("Mortgagor") and SEAFO, INC., a Delaware corporation, having a post office address at c/o the Comptroller of the State of New York As Trustee of the Common Retirement Fund of the State of New York ("CRF"), 270 Broadway, New York, New York 10007 ("Mortgagee"). RECITALS A. Mortgagor is the owner of certain fee and leasehold interests in the real property having a street address of 1001 Fourth Avenue, Seattle, Washington and the improvements located thereat. B. Mortgagee is the holder of a certain Deed of Trust Note, dated as of April 26, 1984, between Mortgagor and the Comptroller of the State of New York as Trustee of the Common Retirement Fund of the State of New York ("CRF"), as amended by the Deed of Trust Note Modification Agreement, dated as of October 5, 1987 (the "Existing Deed of Trust Note"), and the beneficiary of a certain deed of trust securing such Existing Deed of Trust Note (the "Existing Deed of Trust"). C. Mortgagor desires to convey, assign and transfer such real property and improvements and all of Mortgagor's interests therein to Mortgagee, in satisfaction of its obligations under the Existing Deed of Trust and Existing Deed of Trust Note, and Mortgagee is willing to accept same from Mortgagor, upon the terms and subject to the conditions hereinafter set forth. AGREEMENT: NOW, THEREFORE, in consideration of the premises and covenants herein and other good and valuable consideration, the receipt and sufficiency of which are hereby acknowledged, the parties hereby agree as follows: 1. Definitions In this Agreement, the following terms shall have the following meanings: 1.1 "Assignment and Assumption of Contracts" has the meaning set forth in Section 7.2.4. 1.2 "Assignment and Assumption of Leases" has the meaning set forth in Section 7.2.3. 1.3 "Assignment and Assumption of the Tax and Insurance Escrow Account" has the meaning set forth in Section 7.2.6. 1.4 "Assignment of Future Tax or Insurance Refunds" has the meaning set forth in Exhibit 7.2.7. 1.5 "Assignment of Intangible Property" has the meaning set forth in Section 7.2.5. 1.6 Intentionally Deleted. 1.7 "Building Complex" means the Land, the Improvements and the Personal Property. 1.8 "Closing" has the meaning set forth in Section 7.1. 1.9 "Contracts" means those service, maintenance and other contracts and agreements and all equipment and other leases (excluding Existing Leases) affecting all or any portion of the Building Complex and binding upon Mortgagor which the parties have agreed will be assigned to Mortgagee at the Closing. The Contracts are listed in Exhibit B attached hereto. 1.10 "Deed" has the meaning set forth in Section 7.2.1. 1.11 "Excess Net Cash Flow" has the meaning set forth in Section 7.2.15. 1.12 "Existing Deed of Trust" has the meaning set forth in the Recitals. 1.13 "Existing Deed of Trust Note" has the meaning set forth in the Recitals. 1.14 "Existing Loan Documents" means all documents evidencing or securing the Existing Deed of Trust Note, as the same may have heretofore been modified from time to time. 1.15 "Existing Leases" means those existing leases affecting portions of the Improvements and binding upon Mortgagor as landlord. 1.16 "Improvements" means the buildings and all other structures and improvements (on, over or below the surface of the Land) at the Building Complex. 1.17 "Land" means, that certain parcel of land situated in the City of Seattle, County of King, State of Washington, as more particularly described in Exhibit A. 1.18 "Letter of Credit" shall mean that Two Million and 00/100 Dollars ($2,000,000) irrevocable letter of credit at Chemical Bank, No. C- 237248, dated November 9, 1987, and as amended from time to time, held as collateral for the performance of certain obligations of Mortgagor under the Existing Deed of Trust. 1.19 "Mortgagee's Agents" means Mortgagee's attorneys, employees, agents, engineers, lenders, consultants, financial advisors and representatives. 1.20 "Notice" has the meaning set forth in Section 9. 1.21 "Permits" has the meaning set forth in Section 3.5. 1.22 "Personal Property" means all appliances, apparatus, fixtures and equipment (including, without limitation all heating, ventilating, incinerating, lighting, plumbing, electrical and air-conditioning fixtures and equipment), machinery, fittings and other articles of personal property now situate in or on or attached to the Building Complex, including all furniture, fixtures and equipment in the management office, and excluding only personal property owned by tenants under the Existing Leases or by parties other than Mortgagor under the Contracts and the Unassumed Contracts. 1.23 "Property" means the Land, the Improvements, the Personal Property and the property described in Section 3 and specifically excludes the Unassumed Contracts. 1.24 "Review Materials" shall mean, collectively, the Existing Leases, the Contracts and other materials relating to the ownership, construction, renovation, leasing or operation of the Property. 1.25 "Title Company" means Chicago Title Insurance Company. 1.26 "Unassumed Contracts" means those service, maintenance and other contracts and agreements and all equipment and other leases (excluding Existing Leases) affecting all or any portion of the Building Complex and binding upon Mortgagor other than the Contracts. 2. Agreement to Convey 2.1 Agreement to Convey and Accept Such Conveyance. Mortgagor agrees to convey, assign and transfer the Property to Mortgagee, without recourse or warranty except as expressly set forth herein, and Mortgagee agrees to accept such conveyance of the Property from Mortgagor, upon the terms and subject to the conditions set forth herein, without consideration other than the covenants and conditions herein. 3. Other Property Included in the Conveyance For this Agreement, all right, title and interest of Mortgagor, if any, in and to the following shall be included within the term "Property." 3.1 all easements, rights of way, strips, gores, privileges, licenses, appurtenances and other rights and benefits running with the owner of the Property; 3.2 any land lying in the bed of any street, road or avenue adjoining or below the Land; 3.3 the Existing Leases, all unapplied security deposits made by tenants under the Existing Leases, all guarantees by third parties of the obligation of tenants thereunder, and all letters of credit and other instruments or property issued or given as security for the obligation of tenants thereunder; 3.4 all advance rentals, and other advance payments made by tenants under the Existing Leases; 3.5 the certificates of occupancy with respect to the Improvements and, to the extent maintained by or on behalf of Mortgagor, all other transferable licenses, certificates and permits issued by any governmental or quasi-governmental authority with respect to the Property or the use, maintenance and operation thereof (collectively, the "Permits"); 3.6 all architectural, mechanical, engineering and other plans and specifications within Mortgagor's possession or subject to its control relating to the completed construction or renovation of or other work at the Building Complex and any unexpired warranties, guaranties or sureties in favor of Mortgagor with respect thereto; 3.7 all promotional advertising literature and materials, catalogs, booklets and manuals relating to the Property or the use, operation and maintenance thereof; 3.8 all of the Contracts and all deposits made by Mortgagor thereunder, to the extent transferable by their terms; 3.9 all intangible personal property relating to the ownership, construction, renovation, operation and leasing of the Property, including, without limitation, the good will pertaining thereto; 3.10 all environmental reports, asbestos reports and files relating to asbestos work within Mortgagor's possession; 3.11 all accounting, financial and operating information located at the Property; and 3.12 all transferable or assignable warranties, guaranties, contract rights and miscellaneous rights, if any, with respect to the Property, including any of the property described in Sections 3.1 through 3.11 above. 4. Release 4.1 Release. Mortgagor and Mortgagee hereby mutually release each other from any and all obligations and liabilities remaining under the Existing Loan Documents. 5. Mortgagee's Inspection of the Property 5.1 Condition. Mortgagee acknowledges that Mortgagee has inspected the Building Complex and will accept same "as is" as of the date hereof. Mortgagee shall assume responsibility for the physical condition of the Building Complex. 6. Brokerage, Management and Site Personnel 6.1 Brokerage. 6.1.1 The Mortgagee hereby retains JMB Properties Company, an Illinois corporation, ("Properties") as its leasing agent with respect to pending negotiations for leases at the Property with persons or entities set forth in Exhibit D, and Properties accepts such assignment. In the event that Mortgagee executes a lease, lease renewal or lease expansion for space in the Property with any person or entities listed on Exhibit D on or before February 28, 1994, then and in each such event, Mortgagee shall pay and Properties shall be entitled to receive, a brokerage commission with respect thereto payable, one-half of such commission on execution of such lease, lease renewal or lease expansion and one-half of such commission on the entry into substantial occupancy by the tenant thereunder, at the following commission rates: (i) For leases other than month-to-month -- $1.50 per rentable square foot, for new leases, renewal leases or expansion space; and (ii) For month to month leases -- no commission. 6.1.2 No brokerage commission shall be earned until a lease, lease renewal or lease expansion has been fully executed by Mortgagee. Properties shall provide the services of Steven Hisken to perform its obligations hereunder, and shall pay all compensation to him, including any leasing commissions, by separate agreement. In the event Properties has been paid all commissions in accordance with the foregoing, Properties shall indemnify and hold Mortgagee harmless from any claims of Steven Hisken including reasonable legal fees, for brokerage commissions for any lease, lease renewal or lease expansion executed by Mortgagee with any person listed on Exhibit D at any time on or before February 28, 1994. 6.2 Site Employees. 6.2.1 Employees. Properties shall make available to Mortgagee's managing agent and Mortgagee the persons through December 31, 1993 listed on Exhibit P to perform the services for Mortgagee and Mortgagee's managing agent under their direction as such persons have been performing services for Properties and Mortgagor prior to the Closing. In consideration for the providing of such employees, Mortgagee, has on even date herewith, paid Properties the sum of $ 52,091.00, by allowing Mortgagor to deduct such sum from moneys otherwise being transmitted to Mortgagee pursuant to Section 7.2.14. On or before January 31, 1994, Properties shall deliver a statement to Mortgagee showing the actual out-of-pocket salaries, bonus and benefit costs of such employees for the period between the Closing and December 31, 1993. Mortgagee and Properties shall thereafter promptly adjust the payment to reflect the actual employee costs, but in no event shall actual out-of- pocket salary bonus and benefit costs exceed $57,300.00 for the purpose of such adjustment. 6.2.2 Severance. In addition, Mortgagee shall on January 31, 1994, pay any severance payment owed to any such employee in accordance with severance amounts indicated on Exhibit P in the event that such employee is terminated by Mortgagee or its managing agent on or before December 31, 1993, unless such termination was for cause, or unless such employee continues in the employ of Properties after January 1, 1994 or is offered a comparable position and similar salary by Mortgagee or Mortgagee's managing agent. 6.3. Termination of Management Agreement. Mortgagor and Properties hereby terminate the Management Agreement between them relating to the Property. Properties hereby releases Mortgagee from any claim for fees or compensation under such Management Agreement, except as provided in Section 6.1, 6.2, and 6.4 hereof. 6.4. Management Fees. Mortgagee has paid Properties $43,406.00, being an amount equal to those management fees estimated to arise between Closing and December 31, 1993 calculated at three (3%) percent of gross revenue from the Property, the actual amount to be reconciled on or before January 31, 1994 with Mortgagee and Properties to promptly adjust the payment to reflect the actual amount of gross revenue from the Property during that period. Payment has been made by allowing Mortgagor to deduct such amount from moneys otherwise being transmitted to Mortgagee pursuant to Section 7.2.14. 6.5 Survival. The provisions of this Article 6 shall survive the Closing. 7. Closing 7.1 Time and Place. The closing contemplated by this Agreement (the "Closing"), shall take place at the time of the execution of this Agreement at the offices of Rogers & Wells, 200 Park Avenue, New York, New York 10166. 7.2 Mortgagor's Closing Documentation and Requirements. At the Closing, Mortgagor shall deliver the following to Mortgagee: 7.2.1 a deed in lieu of foreclosure without covenants (the "Deed"), duly executed by Mortgagor and acknowledged and in recordable form, in substantially the form of Exhibit F hereto; 7.2.2 a bill of sale, duly executed by Mortgagor and acknowledged, transferring to Mortgagee title to the Personal Property, in substantially the form of Exhibit G hereto; 7.2.3 an assignment and assumption of leases (the "Assignment and Assumption of Leases"), duly executed and acknowledged, assigning and transferring to Mortgagee the lessor's interest under the Existing Leases and any security deposits and advance rentals made under the Existing Leases, in substantially the form of Exhibit H hereto; 7.2.4 an assignment and assumption of contracts (the "Assignment and Assumption of Contracts"), duly executed and acknowledged, assigning and transferring to Mortgagee all right, title and interest of Mortgagor in and to the Contracts and all deposits and advance payments made by Mortgagor thereunder, in substantially the form of Exhibit I hereto; 7.2.5 an assignment of intangible property (the "Assignment of Intangible Property"), duly executed and acknowledged, assigning and transferring to Mortgagee those items referred to in Sections 3.1, 3.5, 3.6, 3.7, 3.9 3.10, 3.11 and 3.12 in substantially the form of Exhibit J hereto; 7.2.6 an release to CRF of the tax and insurance escrow account (the "Tax and Insurance Escrow Account"), which Tax and Insurance Escrow Account is currently held by CRF, in substantially the form of Exhibit M hereto; 7.2.7 an assignment of all future refunds from any taxing authority or insurer with respect to premiums paid for insurance on the Property (the "Assignment of Future Tax or Insurance Refunds"), (which refunds Mortgagor shall hold in trust for the benefit of Mortgagee) duly executed and acknowledged, assigning and transferring to Mortgagee all right title and interest of Mortgagor in and to all future tax or insurance refunds, in substantially the form of Exhibit N hereto; 7.2.8 an affidavit executed by Mortgagor stating, under penalty of perjury, its United States taxpayer identification number and that Mortgagor is not a "foreign person" as defined in Section 1445(f)(3) of the Internal Revenue Code of 1986, as amended, and otherwise in the form prescribed by the Internal Revenue Service; 7.2.9 executed originals of the Existing Leases; 7.2.10 notices to tenants under the Existing Leases of the sale, in substantially the form of Exhibit C hereto, and to be executed by Mortgagor; 7.2.11 originals (or copies certified by Mortgagor) of the Contracts, the Permits and those items specified in Section 3 (to the extent reduced to writing); 7.2.12 a Statement of Net Cash Flow with respect to the Property, in the form of Exhibit E hereto; 7.2.13 Intentionally Deleted. 7.2.14 the payment, as of Closing, by wire transfer, in accordance with the wire instructions as set forth on Exhibit O, of Net Cash Flow. 7.2.15 a release to CRF of any positive Net Cash Flow in excess of the Approved Working Reserve ("Excess Net Cash Flow"), pursuant to the Commitment for Modification of First Deed of Trust Note between CRF and Mortgagor, dated October 5, 1987, which Excess Net Cash Flow is currently held by CRF, in substantially the form of Exhibit K hereto; 7.2.16 Intentionally Deleted. 7.2.17 a real estate excise tax affidavit to be filed with the State of Washington Department of Revenue, duly executed by Mortgagor and Mortgagee; 7.2.18 an estoppel affidavit duly executed by Mortgagor, pursuant to the requirements of the Title Company; and 7.2.19 such other documents and instruments as Mortgagee may reasonably request in order to consummate the transaction herein contemplated. 7.3 Mortgagee's Closing Documentation and Requirements. At or prior to the Closing, Mortgagee shall deliver the following to Mortgagor: 7.3.1 the Letter of Credit; 7.3.2 the Existing Deed of Trust Note endorsed as cancelled; 7.3.3 an executed and acknowledged copy of the Assignment and Assumption of Leases, and the Assignment and Assumption of Contracts; and 7.3.4 Litigation Settlement. At Closing, Mortgagee shall deliver executed copies of all documents relating to the settlement of all pending litigation matters between Mortgagor, CRF, Jones Lang Wootton Realty Advisors and Chemical Bank, in substantially the form of Exhibit L hereto. The Mortgagee shall concurrently deliver a letter to Chemical Bank in the form annexed as Exhibit Q. 7.3.5 Such other documents and instruments as Mortgagor may reasonably request in order to effectuate the immediate return to Mortgagor of any collateral for the Letter of Credit and any collateral for the bond previously furnished in the pending litigation described in Section 7.3.4. 7.4 Further Assurances. After the Closing, either party shall, upon the reasonable request of the other party, but at no expense to it, execute any instruments to confirm, assure or validate the transaction contemplated by this Agreement. 8. Expenses 8.1 Expenses of Mortgagee. Mortgagee shall pay (a) the premium for the Title Policy and the cost of all endorsements and any extended coverage obtained by Mortgagee under the Title Policy; (b) the cost of the Survey; and (c) all state, county and city transfer taxes with respect to the transaction contemplated hereby. Mortgagee shall indemnify and hold Mortgagor harmless from and against all claims, expenses and costs (including reasonable attorneys' fees) relating to such transfer taxes. The parties shall at their separate expense cooperate in good faith and in a timely manner with respect to preparing and delivering submissions, filings and other supporting documentation required in connection with transfer taxes. 8.2 Attorneys' Fees and Other Expenses. Each party shall pay its own attorneys' fees and all of its other expenses, except as otherwise expressly set forth herein. 9. Notices Any notice, demand, consent, authorization or other communication (collectively, a "Notice") which either party is required or may desire to give to or make upon the other party pursuant to this Agreement shall be effective and valid only if in writing, signed by the party giving such Notice, to the other party or sent by facsimile transmission with receipt acknowledged, express courier or delivery service or by registered or certified mail of the United States Postal Service, return receipt requested, and addressed to the other party as follows (or to such other address or person as either party or person entitled to notice may, by notice to the other specify): To Mortgagor: JMB Realty Corporation 900 North Michigan Avenue Suite 1900 Chicago, Illinois 60611 Attention: Norman Geller, Senior Vice President with copies to: Pircher, Nichols & Meeks 1999 Avenue of the Stars Los Angeles, California 90067 Attention: Real Estate Notices To Mortgagee: Jones Lang Wootton Realty Advisors 101 East 52nd Street New York, New York 10022 Attention: Frank L. Sullivan, Jr., Managing Director with copies to: Common Retirement Fund of the State of New York Office of the State Comptroller 270 Broadway Suite 2300 New York, New York 10007 Attention: Robert J. Steves, Assistant Deputy Comptroller and to: Common Retirement Fund of the State of New York Office of the State Comptroller 270 Broadway Suite 2300 New York, New York 10007 Attention: Marjorie Tsang, Esq., Legal Department - Real Estate Bureau and to: Rogers & Wells 200 Park Avenue New York, New York 10166 Attention: Lewis Bart Stone, Esq. Fax: (212) 878-8375 and to: Carney Badley Smith & Spellman 2200 Columbia Center 701 Fifth Avenue Seattle, Washington 96104-7091 Attention: Stephen C. Sieberson, Esq. and William M. Wood, Esq. Unless otherwise specified, Notices shall be deemed given when received, but if delivery is not accepted, on the earlier of the date delivery is refused or the fourth day after the same is deposited with the United States Postal Service. 10. General Provisions 10.1 Successors and Assigns. This Agreement shall bind and inure to the benefit of the respective successors and permitted assigns of the parties hereto. 10.2 Gender and Number. Whenever the context so requires, the singular number shall include the plural and the plural the singular, and the use of any gender shall include all genders. 10.3 Entire Agreement. This Agreement contains the complete and entire agreement between the parties respecting the transaction contemplated herein, and supersedes all prior negotiations, agreements, representations and understandings, if any, between the parties respecting such matters. 10.4 Counterparts. This Agreement may be executed in any number of original counterparts, all of which evidence only one agreement and only one of which need be produced for any purpose. 10.5 Modifications. This Agreement may not be modified, discharged or changed in any respect whatsoever, except by a further agreement in writing duly executed by the parties. However, any consent, waiver, approval or authorization shall be effective if signed by the party granting or making such consent, waiver, approval or authorization. 10.6 Governing Law. This Agreement shall be governed by and construed in accordance with the laws of the State of New York. Mortgagor and Mortgagee hereby irrevocably agree that all actions or proceedings in any way, manner or respect, arising out of or from or related to this Agreement shall be litigated only in courts having situs within the State of New York. Mortgagor and Mortgagee hereby consent and submit to the jurisdiction of any state court located within the County of New York or federal court located within the Southern District of New York. Each party hereby irrevocably waives any right it may have to transfer or change the venue from New York of any litigation brought against it by the other party pursuant to this Agreement. Notwithstanding the foregoing, any documents of conveyance, assignment or encumbrance relating to the Property shall be governed by the laws of the State of Washington, excluding its rules relating to the choice of laws. 10.7 Captions. The captions of this Agreement are for convenience and reference only, and in no way define, describe, extend or limit the scope, meaning or intent of this Agreement. 10.8 Severability. The invalidation or unenforceability in any particular circumstance of any provision of this Agreement shall in no way affect any of the other provisions hereof, which shall remain in full force and effect. 10.9 No Joint Venture. This Agreement shall not be construed as in any way establishing a partnership, joint venture, express or implied agency, or employer-employee relationship between the parties. 10.10 No Third-Party Beneficiaries. This Agreement is for the sole benefit of the parties hereto, their respective successors and permitted assigns, and no other person or entity shall be entitled to rely upon or receive any benefit from this Agreement or any term hereof. 10.11 Execution. The submission of this Agreement for examination does not constitute an offer by or to either party. This Agreement shall be effective and binding only after due execution and delivery by the parties hereto. 10.12 Exculpation. Notwithstanding anything to the contrary in this Agreement or in any of the closing documents, neither any present or future constituent partner in or agent of Mortgagor, nor any shareholder, officer, director, employee, trustee, beneficiary or agent of any corporation or trust that is or becomes a constituent partner in Mortgagor shall be personally liable, directly or indirectly, under or in connection with this Agreement or any of the closing documents or any other instrument or certificate executed in connection herewith or the Closing or any amendments or modifications to any of the foregoing made at this time or times, heretofore or hereafter; and Mortgagee and each of its successors and assigns waives any such personal liability. As used herein, a "constituent partner" in a particular partnership means a partner having an interest in a partnership that has a direct or indirect interest (through one or more partnerships) in such particular partnership. In the event of any inconsistency between the provisions of this Section 10.12 and the provisions of any closing document, the provisions of this Section 10.12 shall govern. 10.13 Payment of Operating Expenses. Mortgagee agrees to indemnify and save Mortgagor and Properties harmless from and against any unpaid operating expenses of the Property as follows: (a) For operating expenses incurred by or for the account of Mortgagor in connection with operation of the Property from January 1, 1991 through December 31, 1992, Mortgagee's obligation shall be limited to an aggregate of $100,000. (b) For operating expenses incurred by or for the account of Mortgagor in connection with the operation of the Property from January 1, 1993 through the Closing, Mortgagee's obligation shall be limited to an aggregate of One Million Four Hundred Thousand ($1,400,000) Dollars plus Mortgagee's obligation as landlord under the Seafirst lease dated May 18, 1992, Mortgagee's obligations under the Contracts, Mortgagee's obligations to pay real estate taxes and Mortgagee's obligation to pay ordinary operating expenses, usually billed on a monthly basis, incurred in the month of October 1993. (c) Mortgagee shall have no obligation under this Section 10.13 (i) for any expense for which an invoice or bill is submitted to Mortgagor or its agent on or after January 1, 1995 relating to operating expenses incurred prior to October 22, 1993, or (ii) for any expense incurred by or any invoice or bill submitted by any affiliate of Mortgagor, except as expressly provided in Article 6. (d) Mortgagor shall upon the receipt of any invoice for operating expenses which are to be paid by Mortgagee hereunder, promptly submit the same for payment to Mortgagee, and shall at Mortgagee's request provide such information as it or its affiliates may have as may be reasonably necessary to determine the propriety of such bill and shall cooperate with Mortgagee in connection with any dispute of any such bill which Mortgagee reasonably decides to dispute, but shall not be obligated to incur any out-of- pocket expense. Mortgagor shall and shall cause its affiliates to preserve records kept by them to enable Mortgagee to ascertain the validity of bills to which this section applies and to enable Mortgagee to object thereto in proper circumstances. To the extent Mortgagee shall not have given notice on or before April 1, 1995 as to any record or information pertaining to a bill to which this section may apply, Mortgagor's obligation to maintain such records hereunder shall expire. (e) Mortgagee shall hold Mortgagor harmless from any expenses, costs or liabilities (including reasonable legal fees) relating to any failure to carry out Mortgagee's obligations under this Section 10.13. 10.14 Survival. The provisions of Article 4, Sections 7.2.19, 7.3.5, 7.4 and Articles 8, 9 and 10 shall survive the Closing. 10.15 Tenants' Tax Refunds. To the extent a tenant of the Property shall become entitled, pursuant to its lease to any portion of a tax refund which refund has been released pursuant to Exhibit N, Mortgagee shall indemnify and hold harmless Mortgagor and Properties (including reasonable legal fees) from any claims of such tenant against Mortgagor or Properties with respect thereto. IN WITNESS WHEREOF, the parties have caused this instrument to be executed as of the date first above written. MORTGAGOR: 1001 FOURTH AVENUE ASSOCIATES an Illinois general partnership By: Carlyle Real Estate Limited Partnership - XIII, Managing General Partner By: JMB Realty Corporation, Corporate General Partner of Carlyle Real Estate Limited Partnership - XIII By: Julie A. Strocchia Its: Vice President MORTGAGEE: SEAFO, INC. By: Its: Agreed: JMB PROPERTIES COMPANY By: __________________________ Julie A. Strocchia Its: Vice President EXHIBIT A LEGAL DESCRIPTION [TO BE ATTACHED] EXHIBIT B CONTRACTS 1. Agreement for Provision of Security Services dated September 1, 1983, between 1001 Fourth Avenue Associates, as Owner, and Seattle-First National Bank, as Contractor; 2. Vertical Transportation Contract, dated July 1, 1992, between 1001 Fourth Avenue Associates, as Owner, and Schindler Elevator Corporation, as Contractor; 3. Modernization/Repair Contract and all Supplemental Proposals thereto, dated October 6, 1992, between 1001 Fourth Avenue Associates, by JMB Properties Company, as agent, and Schindler Elevator Corporation; 4. Master Agreement, dated May 31, 1991, as amended by the Master Agreement Extension and Amendment Agreement No. 1, dated December 30, 1992, between Turner Construction Company, as Contractor, and JMB Properties Company, as agent for the property owner; 5. Work/Construction Agreement, dated August 20, 1993, between 1001 Fourth Avenue Associates, as Owner, and Auburn Mechanical, Inc., as Contractor; 6. Settlement and Mutual Release of All Claims, dated September 16, 1993, between 1001 Fourth Avenue Associates, by and through JMB Properties Company, its agent, the Municipality of Metropolitan Seattle, Mortrude Floor Company and Tri-State Construction, Inc.; 7. Continuing Service Agreement, dated, August 20, 1993, between 1001 Fourth Avenue Associates by JMB Properties Company, as agent, and P&G Plant Company; and 8. Property Operation and Maintenance Agreement, dated March 23, 1993, between JMB Properties Company, as agent for the property owner, and Urban Engineering Co., as Contractor. 9. Work Construction Agreement, dated April 5, 1993, between 1001 Fourth Avenue Associates, as Owner, and Aluminum and Bronze Fabricators, Inc., as Contractor. EXHIBIT C NOTICES TO EXISTING TENANTS November 1, 1993 BY CERTIFIED MAIL RETURN RECEIPT REQUESTED All Tenants of 1001 Fourth Avenue Seattle, Washington Re: 1001 Fourth Avenue Seattle, Washington Gentlemen and Ladies: Please take notice that the property known as 1001 Fourth Avenue, Seattle, Washington (the "Property") has been conveyed on the date hereof to Seafo, Inc. ("Purchaser"), and, simultaneously herewith, 1001 Fourth Avenue Associates ("Owner") has assigned to Purchaser all of Owner's interest in your lease at the Property. All future rental or other payments under your lease (including any payments now due or overdue) should be made payable to Purchaser until you are otherwise directed by Purchaser and should be sent to: Seafo, Inc. P.O. Box 34936 Department 4002 Seattle, Washington 98124-1936 Furthermore, please be advised (i) that any security deposit under your lease has been transferred to Purchaser; and (ii) that Seafo, Inc. should be added as an additional insured to the insurance policies which you are required to carry under your lease. Thank you for your cooperation in this matter. Sincerely, 1001 FOURTH AVENUE ASSOCIATES By_____________________________ Name: Title: EXHIBIT D Pending Leases 1. Cowan & Kerr 2. Palmer Groth & Pietka 3. Schwabe Law Firm 4. Nippon Kaiji Kyokai 5. Kobe Trade Information Office 6. Sinsheimer Meltzer Inc. EXHIBIT E STATEMENT OF NET CASH FLOW [TO BE ATTACHED] EXHIBIT F DEED Filed for Record at Request of: Rogers & Wells 200 Park Avenue New York, New York 10166 Attention: Lewis Bart Stone, Esq. QUIT CLAIM DEED IN LIEU OF FORECLOSURE The Grantor, 1001 Fourth Avenue Associates, an Illinois general partnership, for and in consideration of the sum of Ten Dollars ($10.00) and other good and valuable consideration, and in lieu of foreclosure of the below-mentioned Deed of Trust, conveys and quit claims to Seafo, Inc., a Delaware corporation, the following described real estate, situated in the County of King, State of Washington (the "Property"): See Exhibit A attached. This deed is an absolute conveyance of title in effect as well as in form, and is not intended as a mortgage, trust conveyance, or security of any kind. Consideration for this deed consists of full release of the Grantor from all debts and obligations of Grantor as secured by the deed of trust on the Property dated April 26, 1984 and recorded on the same date under Recording No. 8404260342, Records of King County, Washington, as modified by a Modification of Deed of Trust dated October 5, 1987 and recorded November 17, 1987 under Recording No. 8711171151, Records of King County, Washington (the "Deed of Trust"). This deed fully satisfies the indebtedness of the Deed of Trust and terminates in all respects the Deed of Trust, the note secured thereby, and all related security documents. DATED this ___, day of October, 1993. 1001 FOURTH AVENUE ASSOCIATES an Illinois general partnership By: Carlyle Real Estate Limited Partnership - XIII, Managing General Partner By: JMB Realty Corporation, Corporate General Partner of Carlyle Real Estate Limited Partnership - XIII By: Authorized Signatory Its: STATE OF NEW YORK ) ) ss.: COUNTY OF NEW YORK ) On the ______ day of October, 1993, before me personally came sworn, Julie A. Strocchia, did depose and say that she resides at 900 North Michigan Avenue, Chicago, Illinois; that she is the Vice President of JMB REALTY CORPORATION, the corporation described in and which executed the foregoing instrument as a general partner of CARLYLE REAL ESTATE LIMITED PARTNERSHIP - XIII, as a general partner of 1001 FOURTH AVENUE ASSOCIATES; and that she signed her name there by like order. _________________________ Notary Public My Commission expires: ___________________. City of Residence: _______________________. EXHIBIT G BILL OF SALE This Bill of Sale is made as of this ____ day of November, 1993 by 1001 FOURTH AVENUE ASSOCIATES, an Illinois general partnership ("Mortgagor") to SEAFO, INC., a Delaware corporation ("Mortgagee"). Terms not otherwise defined herein shall have the same meanings as set forth in that certain Agreement For the Delivery of a Deed in Lieu of Foreclosure dated as of October 29, 1993, between Mortgagor and Mortgagee. WITNESSETH, that Mortgagor, for and in consideration of the sum of Ten Dollars ($10.00) and other good and valuable consideration, the receipt and sufficiency of which are hereby acknowledged, does hereby ASSIGN, TRANSFER and DELIVER to Mortgagee all appliances, apparatus, fixtures, equipment (including, without limitation, all heating, ventilating, incinerating, lighting, plumbing, electrical and air-conditioning fixtures and equipment), machinery, fittings and other articles of personal property now situate in or on or attached to the Building Complex (collectively, the "Personal Property"). Notwithstanding the foregoing, the term "Personal Property" shall exclude all such above listed items to the extent owned by tenants under the Existing Leases or by parties other than Mortgagor under the Contracts. TO HAVE AND TO HOLD the Personal Property unto Mortgagee, its successors and assigns, forever. And the Mortgagor shall warrant and defend the title to the Personal Property unto Mortgagee, its successors and assigns forever against the lawful claims of all persons and entities claiming by, through or under Mortgagor. IN WITNESS WHEREOF, the parties have caused this instrument to be duly executed as of the date and year first above written. MORTGAGOR: 1001 FOURTH AVENUE ASSOCIATES an Illinois general partnership By: Carlyle Real Estate Limited Partnership - XIII, Managing General Partner By: JMB Realty Corporation, Corporate General Partner of Carlyle Real Estate Limited Partnership - XIII By: ______________________ Julie Strocchia Vice President STATE OF NEW YORK ) ) ss.: COUNTY OF NEW YORK ) On the day of November, 1993, before me personally came Julie Strocchia, to me known, who, being by me duly sworn, did depose and say that she resides at 900 North Michigan Avenue, Chicago, Illinois; that she is the Vice President of JMB REALTY CORPORATION, the corporation described in and which executed the foregoing instrument as a general partner of CARLYLE REAL ESTATE LIMITED PARTNERSHIP - XIII, as a general partner of 1001 FOURTH AVENUE ASSOCIATES; and that she signed her name there by like order. Notary Public My Commission expires: . City of Residence: . EXHIBIT H RECORD AND RETURN TO: Rogers & Wells 200 Park Avenue New York, New York 10166 Attn: Lewis Bart Stone, Esq. ASSIGNMENT AND ASSUMPTION OF LEASES AND RENTS This Assignment and Assumption of Leases, made as of this 1st day of November, 1993 between 1001 FOURTH AVENUE ASSOCIATES, an Illinois general partnership ("Assignor") and SEAFO, INC., a Delaware corporation ("Assignee"). WITNESSETH, that Assignor, for and in consideration of the sum of Ten Dollars ($10.00) and other good and valuable consideration, the receipt and sufficiency of which are hereby acknowledged, does hereby ASSIGN, TRANSFER, AND CONVEY unto Assignee, its successors and assigns, all right, title and interest of Assignor in, to and under all existing leases, together with all security deposits, advance rentals and other advance payments payable by tenants thereunder (collectively, the "Leases") demising portions of the improvements located on the real property described in Exhibit "A" attached hereto. TO HAVE AND TO HOLD the Leases, together with all rights and privileges thereunto belonging unto Assignee, its successors and assigns, including, without limitation, all security deposits, any documents or instruments securing the obligations of the tenants thereunder and advance rentals paid for the month of November, 1993 or thereafter and other advance payments made or given thereunder, for and during the remainder of the terms of the Leases, as well as all rents received by Assignor on or after October 23, 1993. Assignee does hereby covenant to and agree with Assignor that Assignee accepts the foregoing assignment and assumes all of the terms, covenants and provisions of the Leases on the part of Assignee thereunder to be performed and arising or accruing on and after the date hereof. This Assignment and Assumption of Leases shall be governed by and construed in accordance with the internal laws of the State of Washington without regard to principles of conflict of law. IN WITNESS WHEREOF, the parties hereto have caused this instrument to be duly executed as of the day and year first above written. ASSIGNOR: 1001 FOURTH AVENUE ASSOCIATES an Illinois general partnership By: Carlyle Real Estate Limited Partnership - XIII, Managing General Partner By: JMB Realty Corporation, Corporate General Partner of Carlyle Real Estate Limited Partnership - XIII By: Julie Strocchia Vice President ASSIGNEE: SEAFO, INC. By: Its: STATE OF NEW YORK ) ) ss.: COUNTY OF NEW YORK ) On the day of November, 1993, before me personally came Julie Strocchia, to me known, who, being by me duly sworn, did depose and say that she resides at 900 North Michigan Avenue, Chicago, Illinois; that she is the Vice President of JMB REALTY CORPORATION, the corporation described in and which executed the foregoing instrument as a general partner of CARLYLE REAL ESTATE LIMITED PARTNERSHIP - XIII, as a general partner of 1001 FOURTH AVENUE ASSOCIATES; and that she signed her name there by like order. Notary Public My Commission expires: . City of Residence: . STATE OF NEW YORK ) ) ss.: COUNTY OF NEW YORK ) On the day of November, 1993, before me personally came , to me known, who, being by me duly sworn, did depose and say that he resides at ; that he is the of SEAFO, INC., the corporation described in and which executed the foregoing instrument; and that he signed his name there by like order. Notary Public My Commission expires: . City of Residence: . EXHIBIT I RECORD AND RETURN TO: Rogers & Wells 200 Park Avenue New York, New York 10166 Attn: Lewis Bart Stone, Esq. ASSIGNMENT AND ASSUMPTION OF CONTRACTS This Assignment and Assumption of Contracts made as of this ____ day of November, 1993, between 1001 FOURTH AVENUE ASSOCIATES, an Illinois general partnership ("Assignor"), and SEAFO, INC., a Delaware corporation ("Assignee"). WITNESSETH, that Assignor, for and in consideration of the sum of Ten Dollars ($10.00) and other good and valuable consideration, the receipt and sufficiency of which are hereby acknowledged, does hereby ASSIGN, TRANSFER, AND CONVEY unto Assignee, its successors and assigns, all right, title and interest of Assignor in, to and under those certain service, maintenance and other contracts and agreements and equipment and other leases (excluding space leases) more fully described in Exhibit "A" attached hereto and made a part hereof (collectively, the "Contracts") with respect to the improvements and personal property located on the real property described in Exhibit "B" attached hereto. TO HAVE AND TO HOLD the Contracts, together with all rights and privileges thereunto belonging and all transferable or assignable deposits made by Assignor thereunder, unto Assignee, its successors and assigns, for and during the remainder of the terms of the Contracts. Assignee does hereby covenant to and agree with Assignor that Assignee accepts the foregoing assignment and assumes all of the terms, covenants and provisions of the Contracts on the part of Assignee thereunder to be performed or complied with and arising or accruing on and after the date hereof. This Assignment and Assumption of Contracts shall be governed by and construed in accordance with the internal laws of the State of Washington without regard to principles of conflict of law. IN WITNESS WHEREOF, the parties have caused this instrument to be duly executed as of the day and year first above written. ASSIGNOR: 1001 FOURTH AVENUE ASSOCIATES an Illinois general partnership By: Carlyle Real Estate Limited Partnership - XIII Managing General Partner By: JMB Realty Corporation, Corporate General Partner of Carlyle Real Estate Limited Partnership - XIII By: Julie Strocchia Vice President ASSIGNEE: SEAFO, INC. By: Its: STATE OF NEW YORK ) ) ss.: COUNTY OF NEW YORK ) On the day of November, 1993, before me personally came Julie Strocchia, to me known, who, being by me duly sworn, did depose and say that she resides at 900 North Michigan Avenue, Chicago, Illinois; that she is the Vice President of JMB REALTY CORPORATION, the corporation described in and which executed the foregoing instrument as a general partner of CARLYLE REAL ESTATE LIMITED PARTNERSHIP - XIII, as a general partner of 1001 FOURTH AVENUE ASSOCIATES; and that she signed her name there by like order. Notary Public My Commission expires: . City of Residence: . STATE OF NEW YORK ) ) ss.: COUNTY OF NEW YORK ) On the day of November, 1993, before me personally came , to me known, who, being by me duly sworn, did depose and say that he resides at ; that he is the of SEAFO, INC., the corporation described in and which executed the foregoing instrument; and that he signed his name there by like order. Notary Public My Commission expires: . City of Residence: . EXHIBIT J ASSIGNMENT OF INTANGIBLE PROPERTY WITNESSETH, that 1001 FOURTH AVENUE ASSOCIATES, an Illinois general partnership (collectively, "Assignor"), for and in consideration of the sum of Ten Dollars ($10.00) and other good and valuable consideration to it in hand paid by SEAFO, INC., a Delaware corporation ("Assignee"), the receipt and sufficiency of which are hereby acknowledged, has ASSIGNED, TRANSFERRED, SET OVER, DELIVERED AND CONVEYED and by these presents does hereby ASSIGN, TRANSFER, SET OVER, DELIVER AND CONVEY unto Assignee, its successors and assigns all right, title and interest of Assignor in and to all of the following (hereinafter collectively referred to as the "Assigned Property") to the extent that the same apply to that certain real property described in "Exhibit A" attached hereto and the improvements located thereon and subject to the terms and conditions of that certain Agreement for the Delivery of a Deed In Lieu of Foreclosure dated as of October 29, 1993, between Assignor and Assignee (the "Agreement") (all capitalized terms not otherwise defined herein shall have the meaning as set forth in the Agreement): (1) the certificates of occupancy with respect to the Improvements and, to the extent maintained by or on behalf of Assignor, all other transferable licenses, certificates and permits issued by any governmental or quasi-governmental authority with respect to the Property or the use, maintenance and operations thereof; (2) all architectural, mechanical, engineering and other plans and specifications within Assignor's possession or subject to its control relating to the completed construction or renovation of or other work at the Building Complex and any unexpired warranties, guaranties or sureties in favor of Assignor with respect thereto; (3) all promotional advertising literature and materials, catalogs, booklets and manuals relating to the Property or the use, operation or maintenance thereof; (4) all intangible personal property relating to the ownership, construction, renovation, operation and leasing of the Property, including, without limitation, the good will pertaining thereto; (5) all environmental reports, asbestos reports and files relating to asbestos work within Assignor's possession; (6) all accounting, financial and operating information located at the Property; (7) the Order Granting Summary Judgment Against UCAQ International, Inc., as entered as Case No. 92-2-13158-7, and entitled 1001 Fourth Avenue Associates, a corporation, Plaintiff v. UCAQ International, Inc., a corporation, and Masao Matsumoto, an individual and the marital community thereof, Defendants, in the Superior Court of the State of Washington for King County; (8) the Default Judgment against Masao Matsumoto, as entered as Case No. 92-2-13158-7, in the Superior Court of the State of Washington for King County; (9) the Judgment and Order Directing Issuance of Writ of Restitution, as entered as Case No. 90-2-21313-7, and entitled 1001 Fourth Avenue Associates, an Illinois General Partnership, Plaintiff v. Mirabeau, Inc., a Washington corporation, Defendant, in the Superior Court of the State of Washington in and for the County of King; (10) the First Amended Complaint For Unlawful Detainer, as entered as Case No. 93-2-23702-2, and entitled 1001 Fourth Avenue Associates, an Illinois general partnership, Plaintiff, v. Trans Pacific Stores, Ltd., a corporation, Defendant, in the Superior Court of the State of Washington in and for the County of King; and (11) all transferable or assignable warranties, guaranties, contract rights and miscellaneous rights, if any, with respect to the Property, including any of the property described in items (1) through (10) above. TO HAVE AND TO HOLD the Assigned Property, together with all rights and privileges thereunto belonging unto Assignee, its successors and assigns, forever. This Assignment of Intangible Property shall be governed by and construed in accordance with the internal laws of the State of Washington without regard to principles of conflict of law. EXECUTED AND DELIVERED this day of November, 1993. ASSIGNOR: 1001 FOURTH AVENUE ASSOCIATES an Illinois general partnership By: Carlyle Real Estate Limited Partnership - XIII, Managing General Partner By: JMB Realty Corporation, Corporate General Partner of Carlyle Real Estate Limited Partnership - XIII By: _________________________ Julie Strocchia Vice President STATE OF NEW YORK ) ) ss.: COUNTY OF NEW YORK ) On the day of November, 1993, before me personally came Julie Strocchia, to me known, who, being by me duly sworn, did depose and say that she resides at 900 North Michigan Avenue, Chicago, Illinois; that she is the Vice President of JMB REALTY CORPORATION, the corporation described in and which executed the foregoing instrument as a general partner of CARLYLE REAL ESTATE LIMITED PARTNERSHIP - XIII, as a general partner of 1001 FOURTH AVENUE ASSOCIATES; and that she signed her name there by like order. Notary Public My Commission expires: . City of Residence: . EXHIBIT K RELEASE OF EXCESS NET CASH FLOW 1001 FOURTH AVENUE ASSOCIATES c/o JMB Realty Corporation 900 North Michigan Avenue Suite 1900 Chicago, Illinois 60611 November 1, 1993 Common Retirement Fund of the State of New York Office of the State Comptroller 270 Broadway New York, NY 10007 Gentlemen: Reference is made to that certain Agreement for the Delivery of a Deed In Lieu of Foreclosure dated as of October 29, 1993 between 1001 Fourth Avenue Associates, as Mortgagor, and Seafo, Inc., as Mortgagee (the "Agreement"). All capitalized terms used herein which are not otherwise defined herein shall have the respective meanings ascribed to them in the Agreement. This letter shall confirm our understanding, that pursuant to Mortgagor's closing requirements under Section 7.2.15 of the Agreement, the undersigned, JMB Realty Corporation ("JMB"), hereby releases to the Common Retirement Fund of the State of New York ("CRF") and hereafter shall have no future claim, right or title to any positive Net Cash Flow in excess of the Approved Working Reserve ("Excess Net Cash Flow"), as such term is defined in the Commitment for Modification of First Deed of Trust Note between CRF and Mortgagor, dated October 5, 1987. Such Excess Net Cash Flow is currently being held by CRF. Very truly yours, 1001 FOURTH AVENUE ASSOCIATES an Illinois general partnership By: Carlyle Real Estate Limited Partnership - XIII, Managing General Partner By: JMB Realty Corporation, Corporate General Partner of Carlyle Real Estate Limited Partnership - XIII By: _____________________________ Julie Strocchia Vice President EXHIBIT L LITIGATION SETTLEMENT DOCUMENTS SUPREME COURT OF THE STATE OF NEW YORK APPELLATE DIVISION - FIRST DEPARTMENT - - - - - - - - - - - - - - - - - - - - -x 1001 FOURTH AVENUE ASSOCIATES, Plaintiff/Appellant/Cross-Respondent, - against - JONES LANG WOOTTON REALTY ADVISORS, and COMPTROLLER OF THE STATE OF NEW YORK AS TRUSTEE OF THE COMMON RETIREMENT FUND OF THE STATE OF NEW YORK, Defendants/Respondents/Cross-Appellants, - and - : : : : : : : : : New York County Clerk's Index No. 30222/92 STIPULATION WITHDRAWING APPEALS AND CROSS-APPEAL CHEMICAL BANK, Defendant/Respondent. : :- - - - - - - - - - - - - - - - - - - -x IT IS HEREBY STIPULATED, by and between the parties hereto, through their undersigned counsel, that each appeal and cross-appeal taken in this action is, and the same hereby are, withdrawn and dismissed with prejudice, each party to bear its own costs, expenses and attorneys' fees. Dated: New York, New York October __, 1993 _____________________________ _______________________ OBER, KALER, GRIMES & SHRIVER ROGERS & WELLS Attorneys for 1001 Fourth Avenue Attorneys for Jones Lang Associates Wootton Realty Advisors 1345 Avenue of the Americas and New York, New York 10105 Comptroller of The State of 212-315-3200 New York as Trustee of The Common Retirement Fund of The State of New York 200 Park Avenue New York, New York 10166 212-878-8000 SUPREME COURT OF THE STATE OF NEW YORK COUNTY OF NEW YORK - - - - - - - - - - - - - - - - - - - - -x 1001 FOURTH AVENUE ASSOCIATES, Plaintiff, - against - JONES LANG WOOTTON REALTY ADVISORS, COMPTROLLER OF THE STATE OF NEW YORK AS TRUSTEE OF THE COMMON RETIREMENT FUND OF THE STATE OF NEW YORK and CHEMICAL BANK, Defendants. : : : : : : :Index No. 30222/92 Hon. Burton S. Sherman IAS Part 19 STIPULATION AND ORDER DISCONTINUING ACTION WITH PREJUDICE - - - - - - - - - - - - - - - - - - - -x IT IS HEREBY STIPULATED AND AGREED, by and among the parties hereto, through their undersigned counsel, that all claims of the plaintiff against all defendants in this action, and all claims of defendants against the bond posted in this action by or on behalf of the plaintiff, are hereby discontinued with prejudice, each party to bear its own costs, expenses and attorneys' fees. Dated: New York, New York October , 1993 _____________________________ _______________________ OBER, KALER, GRIMES & SHRIVER ROGERS & WELLS Attorneys for 1001 Fourth Avenue Attorneys for Jones Lang Associates Wootton Realty Advisors 1345 Avenue of the Americas and New York, New York 10105 Comptroller of The State of 212-315-3200 New York as Trustee of The Common Retirement Fund of The State of New York 200 Park Avenue New York, New York 10166 212-878-8000 Page 1 of 2 CHEMICAL BANK LEGAL DEPARTMENT By:___________________________ Andrew N. Keen, Esq. Attorneys for Defendant Chemical Bank 270 Park Avenue - 39th Floor New York, New York 10017 212-270-0088 SO ORDERED: Justice Burton S. Sherman October __, 1993 Page 2 of 2 EXHIBIT M RELEASE OF TAX AND INSURANCE ESCROW ACCOUNT 1001 FOURTH AVENUE ASSOCIATES c/o JMB Realty Corporation 900 North Michigan Avenue Suite 1900 Chicago, Illinois 60611 November 1, 1993 Common Retirement Fund of the State of New York Office of the State Comptroller 270 Broadway New York, NY 10007 Gentlemen: Reference is made to that certain Agreement for the Delivery of a 2Deed In Lieu of Foreclosure dated as of October 29, 1993 between 1001 Fourth Avenue Associates, as Mortgagor, and Seafo, Inc., as Mortgagee (the "Agreement"). All capitalized terms used herein which are not otherwise defined herein shall have the respective meanings ascribed to them in the Agreement. This letter shall confirm our understanding, that pursuant to Mortgagor's closing requirements under Section 7.2.6 of the Agreement, the undersigned, JMB Realty Corporation ("JMB"), hereby releases to the Common Retirement Fund of the State of New York ("CRF") and hereafter shall have no future claim, right or title to that certain tax and insurance escrow account relating to the Property (the "Tax and Insurance Escrow Account"). The Tax and Insurance Escrow Account is currently being held by CRF. Very truly yours, 1001 FOURTH AVENUE ASSOCIATES an Illinois general partnership By: Carlyle Real Estate Limited Partnership - XIII, Managing General Partner By: JMB Realty Corporation, Corporate General Partner of Carlyle Real Estate Limited Partnership - XIII By: _____________________________ Julie Strocchia Vice President EXHIBIT N ASSIGNMENT OF FUTURE TAX OR INSURANCE REFUNDS WITNESSETH, that 1001 FOURTH AVENUE ASSOCIATES, an Illinois general partnership (collectively, "Assignor"), for and in consideration of the sum of Ten Dollars ($10.00) and other good and valuable consideration to it in hand paid by SEAFO, INC., a Delaware corporation ("Assignee"), the receipt and sufficiency of which are hereby acknowledged, has ASSIGNED, TRANSFERRED, SET OVER, DELIVERED AND CONVEYED and by these presents does hereby ASSIGN, TRANSFER, SET OVER, DELIVER AND CONVEY unto Assignee, its successors and assigns all right, title and interest of Assignor in and to all of the following (hereinafter collectively referred to as the "Assigned Property") to the extent that the same apply to that certain real property described in "Exhibit A" attached hereto and the improvements located thereon and subject to the terms and conditions of that certain Agreement for the Delivery of a Deed In Lieu of Foreclosure dated as of October 29, 1993, between Assignor and Assignee (the "Agreement") (all capitalized terms not otherwise defined herein shall have the meaning as set forth in the Agreement): (1) all future refunds from any taxing authority (which refunds Assignor shall hold in trust for the benefit of Assignee); and (2) all future refunds from any insurer with respect to premiums paid for insurance on the Property (which refunds Assignor shall hold in trust for the benefit of Assignee). TO HAVE AND TO HOLD the Assigned Property, together with all rights and privileges thereunto belonging unto Assignee, its successors and assigns, forever. This Assignment of Future Tax or Insurance Refunds shall be governed by and construed in accordance with the internal laws of the State of Washington without regard to principles of conflict of law. EXECUTED AND DELIVERED this day of November, 1993. ASSIGNOR: 1001 FOURTH AVENUE ASSOCIATES an Illinois general partnership By: Carlyle Real Estate Limited Partnership - XIII, Managing General Partner By: JMB Realty Corporation, Corporate General Partner of Carlyle Real Estate Limited Partnership-XIII By: _________________________ Julie Strocchia Vice President STATE OF NEW YORK ) ) ss.: COUNTY OF NEW YORK ) On the day of November, 1993, before me personally came Julie Strocchia, to me known, who, being by me duly sworn, did depose and say that she resides at 900 North Michigan Avenue, Chicago, Illinois; that she is the Vice President of JMB REALTY CORPORATION, the corporation described in and which executed the foregoing instrument as a general partner of CARLYLE REAL ESTATE LIMITED PARTNERSHIP - XIII, as a general partner of 1001 FOURTH AVENUE ASSOCIATES; and that she signed her name there by like order. Notary Public My Commission expires: . City of Residence: . EXHIBIT O WIRE INSTRUCTIONS [TO BE ATTACHED] EXHIBIT P SITE EMPLOYEES EXHIBIT Q LETTER TO CHEMICAL BANK State of New York Office of the State Comptroller Albany, New York 12236 October 29, 1993 Mr. Anthony Capasso Vice President Chemical Bank Letter of Credit Department 55 Water Street - Room 1708 New York, New York 10017 Re: Chemical Bank Letter of Credit No. C-237248, dated November 9, 1987, as amended and The action entitled: 1001 Fourth Avenue Associates vs. Jones Lang, et al., Index No. 30222/92, pending in the Supreme Court of the State of New York for the County of New York Dear Mr. Capasso: In connection with the above letter of credit issued to the benefit of the New York State Employees Retirement System (the "Credit"), this is to advise Chemical Bank that all drawings on the Credit, including the drawing submitted on or about November 6, 1992 by Jones Lang Wootton Realty Advisors ("JLW"), are hereby withdrawn, and the undersigned acknowledges that the Credit has expired and that there will not be any further drawings on the Credit. The documents presented to Chemical Bank by JLW with respect to the Credit should please be returned to the undersigned. Very truly yours, COMPTROLLER OF THE STATE OF NEW YORK AS TRUSTEE OF THE COMMON RETIREMENT FUND By:_________________________ John E. Hull Deputy Comptroller, Division of Investments and Cash Management AGREEMENT FOR THE DELIVERY OF A DEED IN LIEU OF FORECLOSURE BETWEEN 1001 FOURTH AVENUE ASSOCIATES MORTGAGOR and SEAFO, INC. MORTGAGEE 1001 FOURTH AVENUE PLAZA BUILDING SEATTLE, WASHINGTON Dated: as of October 29, 1993 AGREEMENT FOR THE DELIVERY OF A DEED IN LIEU OF FORECLOSURE BETWEEN 1001 FOURTH AVENUE ASSOCIATES MORTGAGOR and SEAFO, INC. MORTGAGEE Article Page 1. Definitions. . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1 2. Agreement to Convey. . . . . . . . . . . . . . . . . . . . . . . . . 3 3. Other Property Included in the Conveyance. . . . . . . . . . . . . . 4 4. Release. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5 5. Mortgagee's Inspection of the Property . . . . . . . . . . . . . . . 5 6. Brokerage, Management and Site Personnel . . . . . . . . . . . . . . 5 7. Closing. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7 8. Expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9 9. Notices. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9 10. General Provisions . . . . . . . . . . . . . . . . . . . . . . . . . 11 EXHIBITS A - Legal Description B - Contracts C - Notices to Existing Tenants D - Pending Leases E - Statement of Net Cash Flow F - Deed G - Bill of Sale H - Assignment and Assumption of Leases I - Assignment and Assumption of Contracts J - Assignment of Intangible Property K - Release of Excess Net Cash Flow L - Litigation Settlement Documents M - Release of Tax and Insurance Escrow Account N - Assignment of Future Tax or Insurance Refunds O - Wire Instructions P - Site Employees Q - Letter to Chemical Bank BILL OF SALE This Bill of Sale is made as of this 1st day of November, 1993 by 1001 FOURTH AVENUE ASSOCIATES, an Illinois general partnership ("Mortgagor") to SEAFO, INC., a Delaware corporation ("Mortgagee"). Terms not otherwise defined herein shall have the same meanings as set forth in that certain Agreement For the Delivery of a Deed in Lieu of Foreclosure dated as of October 29th, 1993, between Mortgagor and Mortgagee. WITNESSETH, that Mortgagor, for and in consideration of the sum of Ten Dollars ($10.00) and other good and valuable consideration, the receipt and sufficiency of which are hereby acknowledged, does hereby ASSIGN, TRANSFER and DELIVER to Mortgagee all appliances, apparatus, fixtures, equipment (including, without limitation, all heating, ventilating, incinerating, lighting, plumbing, electrical and air-conditioning fixtures and equipment), machinery, fittings and other articles of personal property now situate in or on or attached to the Building Complex (collectively, the "Personal Property"). Notwithstanding the foregoing, the term "Personal Property" shall exclude all such above listed items to the extent owned by tenants under the Existing Leases or by parties other than Mortgagor under the Contracts. TO HAVE AND TO HOLD the Personal Property unto Mortgagee, its successors and assigns, forever. And the Mortgagor shall warrant and defend the title to the Personal Property unto Mortgagee, its successors and assigns forever against the lawful claims of all persons and entities claiming by, through or under Mortgagor. IN WITNESS WHEREOF, the parties have caused this instrument to be duly executed as of the date and year first above written. MORTGAGOR: 1001 FOURTH AVENUE ASSOCIATES an Illinois general partnership By: Carlyle Real Estate Limited Partnership - XIII, Managing General Partner By: JMB Realty Corporation, Corporate General Partner of Carlyle Real Estate Limited Partnership - XIII By: -------------------------- Julie A. Strocchia Its: Vice President STATE OF NEW YORK ) ) ss.: COUNTY OF NEW YORK ) On the 1st day of November, 1993, before me personally came JULIE A. STROCCHIA, to me known, who, being by me duly sworn, did depose and say that she resides at 900 North Michigan Avenue, Chicago, Illinois; that she is the Vice President of JMB REALTY CORPORATION, the corporation described in and which executed the foregoing instrument as a general partner of CARLYLE REAL ESTATE LIMITED PARTNERSHIP - XIII, as a general partner of 1001 FOURTH AVENUE ASSOCIATES; and that she signed her name there by like order. ------------------------------ Notary Public My Commission expires: -------------- City of Residence: ------------------ RECORD AND RETURN TO: Rogers & Wells 200 Park Avenue New York, New York 10166 Attn: Lewis Bart Stone, Esq. ASSIGNMENT AND ASSUMPTION OF CONTRACTS This Assignment and Assumption of Contracts made as of this 1st day of November, 1993, between 1001 FOURTH AVENUE ASSOCIATES, an Illinois general partnership ("Assignor"), and SEAFO, INC., a Delaware corporation ("Assignee"). WITNESSETH, that Assignor, for and in consideration of the sum of Ten Dollars ($10.00) and other good and valuable consideration, the receipt and sufficiency of which are hereby acknowledged, does hereby ASSIGN, TRANSFER, AND CONVEY unto Assignee, its successors and assigns, all right, title and interest of Assignor in, to and under those certain service, maintenance and other contracts and agreements and equipment and other leases (excluding space leases) more fully described in Exhibit "A" attached hereto and made a part hereof (collectively, the "Contracts") with respect to the improvements and personal property located on the real property described in Exhibit "B" attached hereto. TO HAVE AND TO HOLD the Contracts, together with all rights and privileges thereunto belonging and all transferable or assignable deposits made by Assignor thereunder, unto Assignee, its successors and assigns, for and during the remainder of the terms of the Contracts. Assignee does hereby covenant to and agree with Assignor that Assignee accepts the foregoing assignment and assumes all of the terms, covenants and provisions of the Contracts on the part of Assignee thereunder to be performed or complied with and arising or accruing on and after the date hereof. This Assignment and Assumption of Contracts shall be governed by and construed in accordance with the internal laws of the State of Washington without regard to principles of conflict of law. IN WITNESS WHEREOF, the parties have caused this instrument to be duly executed as of the day and year first above written. ASSIGNOR: 1001 FOURTH AVENUE ASSOCIATES an Illinois general partnership By: Carlyle Real Estate Limited Partnership - - XIII, Managing General Partner By: JMB Realty Corporation, Corporate General Partner of Carlyle Real Estate Limited Partnership - XIII By: _________________________ Julie A. Strocchia Its: Vice President ASSIGNEE: SEAFO, INC. By: __________________________________ Its: _____________________________ STATE OF NEW YORK) ) ss.: COUNTY OF NEW YORK ) On the 1st day of November, 1993, before me personally came JULIE A. STROCCHIA, to me known, who, being by me duly sworn, did depose and say that she resides at 900 North Michigan Avenue, Chicago, Illnois; that she is the Vice President of JMB REALTY CORPORATION, the corporation described in and which executed the foregoing instrument as a general partner of CARLYLE REAL ESTATE LIMITED PARTNERSHIP - XIII, as a general partner of 1001 FOURTH AVENUE ASSOCIATES; and that she signed her name there by like order. _____________________________ Notary Public My Commission expires: _____________ . City of Residence: _________________ . STATE OF NEW YORK) ) ss.: COUNTY OF NEW YORK ) On the 1st day of November, 1993, before me personally came ______________________________, to me known, who, being by me duly sworn, did depose and say that he resides at _______________ _________________________; that he is the _______________________ of SEAFO, INC., the corporation described in and which executed the foregoing instrument; and that he signed his name there by like order. _____________________________ Notary Public My Commission expires: _____________ . City of Residence: _________________ . EXHIBIT A CONTRACTS 1. Agreement for Provision of Security Services dated September 1, 1983, between 1001 Fourth Avenue Associates, as Owner, and Seattle-First National Bank, as Contractor; 2. Vertical Transportation Contract, dated July 1, 1992, between 1001 Fourth Avenue Associates, as Owner, and Schindler Elevator Corporation, as Contractor; 3. Modernization/Repair Contract and all Supplemental Proposals thereto, dated October 6, 1992, between 1001 Fourth Avenue Associates, by JMB Properties Company, as agent, and Schindler Elevator Corporation; 4. Master Agreement, dated May 31, 1991, as amended by the Master Agreement Extension and Amendment Agreement No. 1, dated December 30, 1992, between Turner Construction Company, as Contractor, and JMB Properties Company, as agent for the property owner; 5. Work/Construction Agreement, dated August 20, 1993, between 1001 Fourth Avenue Associates, as Owner, and Auburn Mechanical, Inc., as Contractor; 6. Settlement and Mutual Release of All Claims, dated September 16, 1993, between 1001 Fourth Avenue Associates, by and through JMB Properties Company, its agent, the Municipality of Metropolitan Seattle, Mortrude Floor Company and Tri-State Construction, Inc.; 7. Continuing Service Agreement, dated, August 20, 1993, between 1001 Fourth Avenue Associates by JMB Properties Company, as agent, and P&G Plant Company; and 8. Property Operation and Maintenance Agreement, dated March 23, 1993, between JMB Properties Company, as agent for the property owner, and Urban Engineering Co., as Contractor. 9. Work Construction Agreement, dated April 5, 1993, between 1001 Fourth Avenue Associates, as Owner, and Aluminum and Bronze Fabricators, Inc., as Contractor. 1001 FOURTH AVENUE ASSOCIATES C/O JMB REALTY CORPORATION 900 NORTH MICHIGAN AVENUE SUITE 1900 CHICAGO, ILLINOIS 60611 November 1, 1993 Common Retirement Fund of the State of New York Office of the State Comptroller 270 Broadway New York, NY 10007 Gentlemen: Reference is made to that certain Agreement for the Delivery of a Deed In Lieu of Foreclosure dated as of October 29, 1993 between 1001 Fourth Avenue Associates, as Mortgagor, and Seafo, Inc., as Mortgagee (the "Agreement"). All capitalized terms used herein which are not otherwise defined herein shall have the respective meanings ascribed to them in the Agreement. This letter shall confirm our understanding, that pursuant to Mortgagor's closing requirements under Section 7.2.15 of the Agreement, the undersigned, JMB Realty Corporation ("JMB"), hereby releases to the Common Retirement Fund of the State of New York ("CRF") and hereafter shall have no future claim, right or title to any positive Net Cash Flow in excess of the Approved Working Reserve ("Excess Net Cash Flow"), as such term is defined in the Commitment for Modification of First Deed of Trust Note between CRF and Mortgagor, dated October 5, 1987. Such Excess Net Cash Flow is currently being held by CRF. Very truly yours, 1001 FOURTH AVENUE ASSOCIATES an Illinois general partnership By: Carlyle Real Estate Limited Partnership - XIII, Managing General Partner By: JMB Realty Corporation, Corporate General Partner of Carlyle Real Estate Limited Partnership - XIII By: _____________________________ Julie A. Strocchia Its: Vice President 1001 FOURTH AVENUE ASSOCIATES C/O JMB REALTY CORPORATION 900 NORTH MICHIGAN AVENUE SUITE 1900 CHICAGO, ILLINOIS 60611 November 1, 1993 Common Retirement Fund of the State of New York Office of the State Comptroller 270 Broadway New York, NY 10007 Gentlemen: Reference is made to that certain Agreement for the Delivery of a Deed In Lieu of Foreclosure dated as of October 29, 1993 between 1001 Fourth Avenue Associates, as Mortgagor, and Seafo, Inc., as Mortgagee (the "Agreement"). All capitalized terms used herein which are not otherwise defined herein shall have the respective meanings ascribed to them in the Agreement. This letter shall confirm our understanding, that pursuant to Mortgagor's closing requirements under Section 7.2.6 of the Agreement, the undersigned, JMB Realty Corporation ("JMB"), hereby releases to the Common Retirement Fund of the State of New York ("CRF") and hereafter shall have no future claim, right or title to that certain tax and insurance escrow account relating to the Property (the "Tax and Insurance Escrow Account"). The Tax and Insurance Escrow Account is currently being held by CRF. Very truly yours, 1001 FOURTH AVENUE ASSOCIATES an Illinois general partnership By: Carlyle Real Estate Limited Partnership - XIII, Managing General Partner By: JMB Realty Corporation, Corporate General Partner of Carlyle Real Estate Limited Partnership - XIII By: _____________________________ Julie A. Strocchia Its: Vice President Filed for Record at Request of: Rogers & Wells 200 Park Avenue New York, New York 10166 Attention: Lewis Bart Stone, Esq. QUIT CLAIM DEED IN LIEU OF FORECLOSURE The Grantor, 1001 Fourth Avenue Associates, an Illinois general partnership, for and in consideration of the sum of Ten Dollars ($10.00) and other good and valuable consideration, and in lieu of foreclosure of the below-mentioned Deed of Trust, conveys and quit claims to Seafo, Inc., a Delaware corporation, the following described real estate, situated in the County of King, State of Washington (the "Property"): See Exhibit A attached. This deed is an absolute conveyance of title in effect as well as in form, and is not intended as a mortgage, trust conveyance, or security of any kind. Consideration for this deed consists of full release of the Grantor from all debts and obligations of Grantor as secured by the deed of trust on the Property dated April 26, 1984 and recorded on the same date under Recording No. 8404260342, Records of King County, Washington, as modified by a Modification of Deed of Trust dated October 5, 1987 and recorded November 17,1987 under Recording No. 8711171151, Records of King County, Washington (the "Deed of Trust"). This deed fully satisfies the indebtedness of the Deed of Trust and terminates in all respects the Deed of Trust, the note secured thereby, and all related security documents. DATED this 29th day of October, 1993. 1001 FOURTH AVENUE ASSOCIATES an Illinois general partnership By: Carlyle Real Estate Limited Partnership - XIII, Managing General Partner By: JMB Realty Corporation, Corporate General Partner of Carlyle Real Estate Limited Partnership - XIII By: Authorized Signatory Its: ------------------------- RECORD AND RETURN TO: Rogers & Wells 200 Park Avenue New York, New York 10166 Attn: Lewis Bart Stone, Esq. ASSIGNMENT AND ASSUMPTION OF LEASES AND RENTS This Assignment and Assumption of Leases, made as of this 1st day of November, 1993 between 1001 FOURTH AVENUE ASSOCIATES, an Illinois general partnership ("Assignor") and SEAFO, INC., a Delaware corporation ("Assignee"). WITNESSETH, that Assignor, for and in consideration of the sum of Ten Dollars ($10.00) and other good and valuable consideration, the receipt and sufficiency of which are hereby acknowledged, does hereby ASSIGN, TRANSFER, AND CONVEY unto Assignee, its successors and assigns, all right, title and interest of Assignor in, to and under all existing leases, together with all security deposits, advance rentals and other advance payments payable by tenants thereunder (collectively, the "Leases") demising portions of the improvements located on the real property described in Exhibit "A" attached hereto. TO HAVE AND TO HOLD the Leases, together with all rights and privileges thereunto belonging unto Assignee, its successors and assigns, including, without limitation, all security deposits, any documents or instruments securing the obligations of the tenants thereunder and advance rentals paid for the month of November, 1993 or thereafter and other advance payments made or given thereunder, for and during the remainder of the terms of the Leases, as well as all rents received by Assignor on or after October 23, 1993. Assignee does hereby covenant to and agree with Assignor that Assignee accepts the foregoing assignment and assumes all of the terms, covenants and provisions of the Leases on the part of Assignee thereunder to be performed and arising or accruing on and after the date hereof. This Assignment and Assumption of Leases shall be governed by and construed in accordance with the internal laws of the State of Washington without regard to principles of conflict of law. IN WITNESS WHEREOF, the parties hereto have caused this instrument to be duly executed as of the day and year first above written. ASSIGNOR: 1001 FOURTH AVENUE ASSOCIATES an Illinois general partnership By: Carlyle Real Estate Limited Partnership - XIII, Managing General Partner By: JMB Realty Corporation, Corporate General Partner of Carlyle Real Estate Limited Partnership - XIII By: ____________________________ Julie A. Strocchia Its: Vice President ASSIGNEE: SEAFO, INC. By:________________________________ Its:_______________________________ STATE OF NEW YORK ) ) ss.: COUNTY OF NEW YORK ) On the 1st day of November, 1993, before me personally came JULIE A. STROCCHIA, to me known, who, being by me duly sworn, did depose and say that she resides at 900 North Michigan Avenue, Chicago, Illinois; that she is the Vice President of JMB REALTY CORPORATION, the corporation described in and which executed the foregoing instrument as a general partner of CARLYLE REAL ESTATE LIMITED PARTNERSHIP - XIII, as a general partner of 1001 FOURTH AVENUE ASSOCIATES; and that she signed her name there by like order. ______________________________ Notary Public My Commission expires: ______________. City of Residence: __________________. STATE OF NEW YORK ) ) ss.: COUNTY OF NEW YORK ) On the 1st day of November, 1993, before me personally came _________________, to me known, who, being by me duly sworn, did depose and say that he resides at ____________________________ ___________; that he is the ________________________ of SEAFO, INC., the corporation described in and which executed the foregoing instrument; and that he signed his name there by like order. ______________________________ Notary Public My Commission expires: ______________. City of Residence: __________________. ASSIGNMENT OF INTANGIBLE PROPERTY WITNESSETH, that 1001 FOURTH AVENUE ASSOCIATES, an Illinois general partnership (collectively, "Assignor"), for and in consideration of the sum of Ten Dollars ($10.00) and other good and valuable consideration to it in hand paid by SEAFO, INC., a Delaware corporation ("Assignee"), the receipt and sufficiency of which are hereby acknowledged, has ASSIGNED, TRANSFERRED, SET OVER, DELIVERED AND CONVEYED and by these presents does hereby ASSIGN, TRANSFER, SET OVER, DELIVER AND CONVEY unto Assignee, its successors and assigns all right, title and interest of Assignor in and to all of the following (hereinafter collectively referred to as the "Assigned Property") to the extent that the same apply to that certain real property described in "Exhibit A" attached hereto and the improvements located thereon and subject to the terms and conditions of that certain Agreement for the Delivery of a Deed In Lieu of Foreclosure dated as of October 29th, 1993, between Assignor and Assignee (the "Agreement") (all capitalized terms not otherwise defined herein shall have the meaning as set forth in the Agreement): (1) the certificates of occupancy with respect to the Improvements and, to the extent maintained by or on behalf of Assignor, all other transferable licenses, certificates and permits issued by any governmental or quasi-governmental authority with respect to the Property or the use, maintenance and operations thereof; (2) all architectural, mechanical, engineering and other plans and specifications within Assignor's possession or subject to its control relating to the completed construction or renovation of or other work at the Building Complex and any unexpired warranties, guaranties or sureties in favor of Assignor with respect thereto; (3) all promotional advertising literature and materials, catalogs, booklets and manuals relating to the Property or the use, operation or maintenance thereof; (4) all intangible personal property relating to the ownership, construction, renovation, operation and leasing of the Property, including, without limitation, the good will pertaining thereto; (5) all environmental reports, asbestos reports and files relating to asbestos work within Assignor's possession; (6) all accounting, financial and operating information located at the Property; (7) the Order Granting Summary Judgment Against UCAQ International, Inc., as entered as Case No. 92-2-13158-7, and entitled 1001 Fourth Avenue Associates, a corporation, Plaintiff v. UCAQ International, Inc., a corporation, and Masao Matsumoto, an individual and the marital community thereof, Defendants, in the Superior Court of the State of Washington for King County; (8) the Default Judgment against Masao Matsumoto, as entered as Case No. 92-2-13158-7, in the Superior Court of the State of Washington for King County; (9) the Judgment and Order Directing Issuance of Writ of Restitution, as entered as Case No. 90-2-21313-7, and entitled 1001 Fourth Avenue Associates, an Illinois General Partnership, Plaintiff v. Mirabeau, Inc., a Washington corporation, Defendant, in the Superior Court of the State of Washington in and for the County of King; (10) the First Amended Complaint For Unlawful Detainer, as entered as Case No. 93-2-23702-2, and entitled 1001 Fourth Avenue Associates, an Illinois general partnership, Plaintiff, v. Trans Pacific Stores, Ltd., a corporation, Defendant, in the Superior Court of the State of Washington in and for the County of King; and (11) all transferable or assignable warranties, guaranties, contract rights and miscellaneous rights, if any, with respect to the Property, including any of the property described in items (1) through (10) above. TO HAVE AND TO HOLD the Assigned Property, together with all rights and privileges thereunto belonging unto Assignee, its successors and assigns, forever. This Assignment of Intangible Property shall be governed by and construed in accordance with the internal laws of the State of Washington without regard to principles of conflict of law. EXECUTED AND DELIVERED this 1st day of November, 1993. ASSIGNOR: 1001 FOURTH AVENUE ASSOCIATES an Illinois general partnership By: Carlyle Real Estate Limited Partnership - XIII, Managing General Partner By: JMB Realty Corporation, Corporate General Partner of Carlyle Real Estate Limited Partnership - XIII By: _________________________ Julie A. Strocchia Its: Vice President STATE OF NEW YORK) ) ss.: COUNTY OF NEW YORK) On the 1st day of November, 1993, before me personally came JULIE A. STROCCHIA, to me known, who, being by me duly sworn, did depose and say that she resides at 900 North Michigan Avenue, Chicago, Illinois; that she is the Vice President of JMB REALTY CORPORATION, the corporation described in and which executed the foregoing instrument as a general partner of CARLYLE REAL ESTATE LIMITED PARTNERSHIP - XIII, as a general partner of 1001 FOURTH AVENUE ASSOCIATES; and that she signed her name there by like order. _____________________________ Notary Public My Commission expires: _____________ . City of Residence: _________________ . ASSIGNMENT OF FUTURE TAX OR INSURANCE REFUNDS WITNESSETH, that 1001 FOURTH AVENUE ASSOCIATES, an Illinois general partnership (collectively, "Assignor"), for and in consideration of the sum of Ten Dollars ($10.00) and other good and valuable consideration to it in hand paid by SEAFO, INC., a Delaware corporation ("Assignee"), the receipt and sufficiency of which are hereby acknowledged, has ASSIGNED, TRANSFERRED, SET OVER, DELIVERED AND CONVEYED and by these presents does hereby ASSIGN, TRANSFER, SET OVER, DELIVER AND CONVEY unto Assignee, its successors and assigns all right, title and interest of Assignor in and to all of the following (hereinafter collectively referred to as the "Assigned Property") to the extent that the same apply to that certain real property described in "Exhibit A" attached hereto and the improvements located thereon and subject to the terms and conditions of that certain Agreement for the Delivery of a Deed In Lieu of Foreclosure dated as of October 29, 1993, between Assignor and Assignee (the "Agreement") (all capitalized terms not otherwise defined herein shall have the meaning as set forth in the Agreement): (1) all future refunds from any taxing authority (which refunds Assignor shall hold in trust for the benefit of Assignee); and (2) all future refunds from any insurer with respect to premiums paid for insurance on the Property (which refunds Assignor shall hold in trust for the benefit of Assignee). TO HAVE AND TO HOLD the Assigned Property, together with all rights and privileges thereunto belonging unto Assignee, its successors and assigns, forever. This Assignment of Future Tax or Insurance Refunds shall be governed by and construed in accordance with the internal laws of the State of Washington without regard to principles of conflict of law. EXECUTED AND DELIVERED this 1st day of November, 1993. ASSIGNOR: 1001 FOURTH AVENUE ASSOCIATES an Illinois general partnership By: Carlyle Real Estate Limited Partnership - XIII, Managing General Partner By: JMB Realty Corporation, Corporate General Partner of Carlyle Real Estate Limited Partnership - XIII By: _________________________ Julie A. Strocchia Its: Vice President STATE OF NEW YORK ) ) ss.: COUNTY OF NEW YORK) On the 1st day of November, 1993, before me personally came JULIE A. STROCCHIA, to me known, who, being by me duly sworn, did depose and say that she resides at 900 North Michigan Avenue, Chicago, Illinois; that she is the Vice President of JMB REALTY CORPORATION, the corporation described in and which executed the foregoing instrument as a general partner of CARLYLE REAL ESTATE LIMITED PARTNERSHIP - XIII, as a general partner of 1001 FOURTH AVENUE ASSOCIATES; and that she signed her name there by like order. _____________________________ Notary Public My Commission expires: _____________ . City of Residence: _________________ . AMENDED AND RESTATED CERTIFICATE OF INCORPORATION OF CARLYLE-XIII MANAGERS, INC. WHEREAS, this corporation desires to change its name to Carlyle Investors, Inc. NOW, THEREFORE, the Certificate of Incorporation as filed with the Delaware Secretary of State on March 25, 1993 is hereby amended and restated to read as follows: ARTICLE ONE: The name of this corporation is Carlyle Investors, Inc. ARTICLE TWO: The address of its registered office in the State of Delaware is Corporation Trust Center, 1209 Orange Street, in the City of Wilmington, County of New Castle, 19801. The name of its registered agent at such address is The Corporation Trust Company. ARTICLE THREE: The nature of the business or purpose to be conducted or promoted is: to engage in any lawful act or activity for which corporations may be organized under the General Corporation Law of Delaware. ARTICLE FOUR: The total number of shares of stock which this corporation shall have authority to issue is 1,000 and the par value of each of such shares is One Dollar ($1.00) amounting in the aggregate to One Thousand Dollars ($1,000.00). ARTICLE FIVE: The number of directors constituting the Board of Directors shall be that number as shall be fixed by the by-laws of this Corporation. ARTICLE SIX: The corporation is to have perpetual existence. ARTICLE SEVEN: In furtherance and not in limitation of the powers conferred by statute, the Board of Directors of this corporation is expressly authorized to make, alter or repeal the by-laws of this corporation. ARTICLE EIGHT: Elections of directors need not be by written ballot unless the by-laws of this corporation shall so provide. Meetings of the stockholders may be held within or without the State of Delaware, as the by- laws may provide. The books of this corporation may be kept (subject to any provision contained in the statutes) outside the State of Delaware at such place or places as may be designated from time to time by the Board of Directors or in the by-laws of this corporation. ARTICLE NINE: The corporation reserves the right to amend, alter, change or repeal any provision contained in this Amended and Restated Certificate of Incorporation, in the manner now and hereafter prescribed by statute, and all rights conferred upon stockholders herein are granted subject to this reservation. ARTICLE TEN: To the fullest extent permitted by the General Corporation Law of the State of Delaware as it now exists or may hereafter be amended, no director of this corporation shall be liable to this corporation or its stockholders for monetary damages arising from a breach of fiduciary duty owed to this corporation. ARTICLE ELEVEN: This Amended and Restated Certificate of Incorporation was duly adopted by the stockholders of this corporation pursuant to Section 242 of the General Corporation Law of Delaware on March 29, 1993. This Amended and Restated Certificate of Incorporation was duly adopted by the stockholders of this corporation pursuant to Section 242 of the General Corporation Law of Delaware on April 6, 1993. IN WITNESS WHEREOF, the President has signed, and the Secretary has attested, this Amended and Restated Certificate of Incorporation this 6th day of April, 1993. NEIL G. BLUHM ------------- Neil G. Bluhm President ATTEST: Kevin B. Yates Secretary STATE OF ILLINOIS ) ) ss COUNTY OF COOK ) I, the undersigned, a Notary Public in and for said County, in the State aforesaid, DO HEREBY CERTIFY that Kevin B. Yates, the Secretary of Carlyle-XIII Managers, Inc., acknowledged that the statements set forth in the foregoing instrument are true and correct, and that he signed the foregoing instrument as his free and voluntary act for the uses and purposes therein set forth. Subscribed and sworn to before me this 6th day of April, 1993. Mona Sarnoff Notary Public AMENDED AND RESTATED CERTIFICATE OF INCORPORATION OF CARLYLE-XIV MANAGERS, INC. WHEREAS, this corporation desires to change its name to Carlyle Managers, Inc. NOW, THEREFORE, the Certificate of Incorporation as filed with the Delaware Secretary of State on March 25, 1993 is hereby amended and restated to read as follows: ARTICLE ONE: The name of this corporation is Carlyle Managers, Inc. ARTICLE TWO: The address of its registered office in the State of Delaware is Corporation Trust Center, 1209 Orange Street, in the City of Wilmington, County of New Castle, 19801. The name of its registered agent at such address is The Corporation Trust Company. ARTICLE THREE: The nature of the business or purpose to be conducted or promoted is: to engage in any lawful act or activity for which corporations may be organized under the General Corporation Law of Delaware. ARTICLE FOUR: The total number of shares of stock which this corporation shall have authority to issue is 1,000 and the par value of each of such shares is One Dollar ($1.00) amounting in the aggregate to One Thousand Dollars ($1,000.00). ARTICLE FIVE: The number of directors constituting the Board of Directors shall be that number as shall be fixed by the by-laws of this Corporation. ARTICLE SIX: The corporation is to have perpetual existence. ARTICLE SEVEN: In furtherance and not in limitation of the powers conferred by statute, the Board of Directors of this corporation is expressly authorized to make, alter or repeal the by-laws of this corporation. ARTICLE EIGHT: Elections of directors need not be by written ballot unless the by-laws of this corporation shall so provide. Meetings of the stockholders may be held within or without the State of Delaware, as the by- laws may provide. The books of this corporation may be kept (subject to any provision contained in the statutes) outside the State of Delaware at such place or places as may be designated from time to time by the Board of Directors or in the by-laws of this corporation. ARTICLE NINE: The corporation reserves the right to amend, alter, change or repeal any provision contained in this Amended and Restated Certificate of Incorporation, in the manner now and hereafter prescribed by statute, and all rights conferred upon stockholders herein are granted subject to this reservation. ARTICLE TEN: To the fullest extent permitted by the General Corporation Law of the State of Delaware as it now exists or may hereafter be amended, no director of this corporation shall be liable to this corporation or its stockholders for monetary damages arising from a breach of fiduciary duty owed to this corporation. This Amended and Restated Certificate of Incorporation was duly adopted by the stockholders of this corporation pursuant to Section 242 of the General Corporation Law of Delaware on April 6, 1993. IN WITNESS WHEREOF, the President has signed, and the Secretary has attested, this Amended and Restated Certificate of Incorporation this 6th day of April, 1993. NEIL G. BLUHM ------------- Neil G. Bluhm President ATTEST: Kevin B. Yates Secretary STATE OF ILLINOIS ) ) ss COUNTY OF COOK ) I, the undersigned, a Notary Public in and for said County, in the State aforesaid, DO HEREBY CERTIFY that Kevin B. Yates, the Secretary of Carlyle-XIV Managers, Inc., acknowledged that the statements set forth in the foregoing instrument are true and correct, and that he signed the foregoing instrument as his free and voluntary act for the uses and purposes therein set forth. Subscribed and sworn to before me this 6th day of April, 1993. Mona Sarnoff Notary Public DEMAND NOTE $600,000.00 March 25, 1993 FOR VALUE RECEIVED, the undersigned, Carlyle Real Estate Limited Partnership-XIII, an Illinois limited partnership (hereinafter referred to as "Payor"), hereby promises to pay Carlyle Investors, Inc., a Delaware corporation (hereinafter referred to as "Payee"), on demand the principal sum of $600,000.00 (hereinafter referred to as the "Principal Amount"). The Principal Amount shall bear interest at the Alternate Federal Short-Term rate (the "Rate") as of the date hereof, which rate shall change to the Rate then in effect as of every six months from the date hereof (the "Compounding Date"); all interest shall be compounded as of every Compounding Date. Payor may at any time elect to prepay all or any portion of the Principal Amount, together with any accrued but unpaid interest thereon, without premium or penalty. IN WITNESS WHEREOF, Payor has executed this Demand Note this 25th day of March, 1993. CARLYLE REAL ESTATE LIMITED PARTNERSHIP-XIII By: JMB Realty Corporation a Delaware corporation Corporate General Partner By: NEIL G. BLUHM -------------- Neil G. Bluhm President DEMAND NOTE $600,000.00 March 25, 1993 FOR VALUE RECEIVED, the undersigned, Carlyle Real Estate Limited Partnership-XIII, an Illinois limited partnership (hereinafter referred to as "Payor"), hereby promises to pay Carlyle Managers, Inc., a Delaware corporation (hereinafter referred to as "Payee"), on demand the principal sum of $600,000.00 (hereinafter referred to as the "Principal Amount"). The Principal Amount shall bear interest at the Alternate Federal Short-Term rate (the "Rate") as of the date hereof, which rate shall change to the Rate then in effect as of every six months from the date hereof (the "Compounding Date"); all interest shall be compounded as of every Compounding Date. Payor may at any time elect to prepay all or any portion of the Principal Amount, together with any accrued but unpaid interest thereon, without premium or penalty. IN WITNESS WHEREOF, Payor has executed this Demand Note this 25th day of March, 1993. CARLYLE REAL ESTATE LIMITED PARTNERSHIP-XIII By: JMB Realty Corporation a Delaware corporation Corporate General Partner By: Neil G. Bluhm President SECOND AMENDED AND RESTATED ARTICLES OF PARTNERSHIP OF JMB/NYC OFFICE BUILDING ASSOCIATES These Second Amended and Restated Articles of Partnership made and entered into as of March 30, 1993, by and between Carlyle-XIV Managers, Inc., an Delaware corporation (hereinafter referred to as "General Partner"), and Carlyle-XIII Associates, L.P., an Delaware limited partnership, Carlyle-XIV Associates, L.P., a Delaware limited partnership, and Property Partners, L.P., a Delaware limited partnership, as the limited partners (hereinafter collectively referred to as the "Limited Partners"). W I T N E S S E T H THAT WHEREAS, this partnership (hereinafter referred to as the "Partnership") was heretofore formed pursuant to the Uniform Partnership Act of the State of Illinois by Carlyle Real Estate Limited Partnership-XIII, an Illinois limited partnership, Carlyle Real Estate Limited Partnership-XIV, an Illinois limited partnership, and JMB/NYC Associates, an Illinois general partnership (hereinafter collectively referred to as the "Original Partners"); and THAT WHEREAS, the Original Partners have each individually assigned their respective partnership interests to the Limited Partners pursuant to that certain Amendment No. 1 to the Amended and Restated Agreement of Partnership of the Partnership (the "Agreement"); and THAT WHEREAS, the parties hereto desire to continue the partnership as a limited partnership pursuant to the Revised Uniform Limited Partnership Act as in effect in the State of Illinois, as amended (the "Act"), for the purposes and on the terms and conditions hereinafter set forth; and THAT WHEREAS, the General Partner desires to: (i) be admitted into the Partnership as a general partner, (ii) perform all of the duties and responsibilities of a general partner under the Act, and (iii) acquire a general partnership interest in the Partnership, and the Limited Partners, by their execution hereof, desire to evidence their consent to said admission and to the continuance of the Partnership as a limited partnership; and THAT WHEREAS, the parties hereto desire to amend and restate the partnership so that it appears in its entirety as follows. NOW THEREFORE, the undersigned hereby continue the partnership as a limited partnership under the provisions of the Act, except as hereinafter provided, for the purposes and on the terms and conditions as hereinafter set forth, and do hereby agree: 1. Name of Partnership. The name of the Partnership shall be "JMB/NYC Office Building Associates, L.P." 2. Character of the Partnership's Business. The character of the business of the Partnership will be to acquire, hold, and otherwise use for profit an interest in each of the following general partnerships: 237 Park Avenue Associates, 1290 Associates, 2 Broadway Land Company and 2 Broadway Associates which partnerships own the land (and improvements thereon) more particularly described on Exhibit A attached hereto, and to engage in any and all activities related or incidental thereto. Whenever the term "Property" appears in these Articles such term shall mean any property, real or personal, tangible or intangible, at any time owned by the Partnership, including the Partnership's respective interests in the aforementioned general partnerships and any property at any time owned by a partnership or joint venture in which the Partnership is a partner. 3. Location of the Principal Place of Business. The location of the principal place of business of the Partnership shall be 900 North Michigan Avenue, Chicago, Illinois 60611 or such other location as shall be designated by the Partners. 4. Names and Places of Residence of Partners. The names of the Partners of the Partnership and their respective addresses are as set forth after each respective name as follows: General Partner Residence Carlyle-XIV Managers, Inc. 900 North Michigan Chicago, IL 60611 Limited Partners Residence Carlyle-XIII Associates, L.P. 900 North Michigan Chicago, IL 60611 Carlyle-XIV Associates, L.P. 900 North Michigan Chicago, IL 60611 Property Partners, L.P. 900 North Michigan Chicago, IL 60611 As used herein, the term "Partner" shall refer to any of the General Partner or Limited Partners and the term "Partners" shall refer to the General Partner and the Limited Partners collectively and shall include their respective successors and assigns, as the case may be. 5. Term of Partnership. The term for which the Partnership shall exist shall be until December 31, 2034 unless sooner terminated as hereinafter provided. 6. Contributions of the Members of the Partnership. A. Contributions. The Original Partners have contributed the sums set forth opposite each Partner's name on the attached Exhibit B. Each of the Limited Partners have contributed hereto the partnership interests in the Partnership assigned to them by each of the Original Partners, respectively. In the event that any Partner makes an additional contributions to the Partnership or receives a return of all or part of its contributions to the Partnership, Exhibit B shall be promptly and appropriately amended to reflect such additional or returned contribution. B. Withdrawals of Capital. Except as otherwise herein provided, no Partner shall be entitled to withdraw capital or to receive distributions of or against capital without the prior written consent of, and upon the terms and conditions specified by, the General Partner. C. Capital Accounts. The Partnership shall maintain for each of the Partners a Capital Account, which shall be the aggregate amount of the contributions to the Partnership made by such Partner, as set forth in Exhibit B, reduced by the aggregate amount of any losses allocated, and any distributions of cash or the fair market value of other assets of the Partnership made, to such Partner and increased by the aggregate amount of any profits allocated to such Partner. D. Loans. Except as provided in Section 8D hereof, all advances or payments to the Partnership by any Partner shall be deemed to be loans by such Partner to the Partnership, and the Partner making the same shall be entitled to interest thereon at such rates per annum as the General Partner may determine, and the same, together with interest as aforesaid, shall be repaid before any distribution shall be made hereunder to the other Partners. No such loan to the Partnership shall be made without the prior written consent of the General Partner and, unless all of the Partners otherwise agree, shall be required to be made by all of the Partners in proportion to their respective Partnership Shares (as hereinafter defined). 7. Partnership Shares. A. As used herein, "profits and losses" include, without limitation, each item of Partnership income, gain, loss and deduction as determined for Federal income tax purposes, and "Partnership Share" means the percentage for each Patner as set forth in Exhibit B. All net profits or losses from the operations of the Partnership for a fiscal year or part thereof shall be allocated to the Partners based upon their respective Partnership Shares. Any credits of the Partnership for a fiscal year shall be allocated in the same manner as are profits of the Partnership pursuant to this Section 7A (without regard to Section 7B), except that any investment tax credit shall be allocated only among those Partners who were partners (for Federal income tax purposes) on the date the property with respect to which such credit is earned was placed in service. B. There shall be allocated to each Partner (i) the amount of any profits attributable to interest, "points", financing fees and other amounts paid by such Partner to the Partnership with respect to loans made by the Partnership to such Partner and (ii) the amount of any losses attributable to interest, "points", financing fees and other amounts paid by the Partnership to a third party lender with respect to borrowings incurred by the Partnership to make loans by the Partnership to such Partner. C. (i) All net profits or losses from the sale or other disposition of all or any substantial portion of the Property shall be allocated to the Partners in accordance with their respective Partnership Shares on the date on which the Partnership recognized such profits or losses for Federal income tax purposes. Notwithstanding allocations in the first sentence of this Section 7C(i) if, at any time profit or loss, as the case may be, is realized by the Partnership on the sale or other disposition of all or any substantial portion of the Property, the Capital Account balances of the Partners are not in the ratio of their respective Partnership Shares (the "Equalization Ratio"), then gain shall be allocated to those Partners whose Capital Account balances are less than they would be if they were in the Equalization Ratio (or loss shall be allocated to those Partners whose Capital Account balances are greater than they would be if they were in the Equalization Ratio), in either case up to and in proportion to the amount necessary to cause the Capital Account balances of the Partners to be in the Equalization Ratio and then in accordance with the first sentence in this Section 7C(i). Notwithstanding any adjustment of the allocation of profits or losses provided in this Agreement by any judicial body or governmental agency, the allocations of profits of losses provided in this Agreement shall control for purposes of this Agreement (or any amendment hereto pursuant to Section 12B), including without limitation, the determination of the Partners' Capital Accounts. (ii) The portion of any gain allocated under Section 7C(i) above that represents ordinary income attributable to "Unrealized Receivables" and "Substantially Appreciated Inventory Items", as such terms are defined in Section 751(c) and (d), respectively, of the Internal Revenue Code of 1954, as amended (the "Code"), shall be allocated among the Partners in the proportions in which depreciation deductions on the Partnership Property sold, or tax benefits attributable to or giving rise to such Unrealized Receivables or Substantially Appreciated Inventory Items, were originally allocated to their Partnership interests. No Partner shall relinquish such Partner's share of "Unrealized Receivables" (as such term is defined in Section 751(c) of the Code) attributable to depreciation recapture in the case of a distribution or constructive distribution of property arising in connection with admission to the Partnership of another person as Person. D. Each distribution to the Partners of cash or other assets of the Partnership made prior to the dissolution of the Partnership, including, but not limited to, each distribution of net proceeds received by the Partnership from the sale or refinancing of all or any substantial portion of the Property, shall be made to the Partners in accordance with their respective Partnership Shares owned on the date of such distribution; provided, however, that if, at the time of any such distribution, the Capital Account balances of the Partners are not in the Equalization Ratio, then the proceeds of any such distribution shall be distributed first to the Partners having Capital Account balances greater than they would be if the Capital Account balances of all Partners were in the Equalization Ratio, up to and in proportion to the amount necessary to cause the Capital Account balances of all Partners to be in the Equalization Ratio, and then in accordance with the respective Partnership Shares of the Partners on the date of such distribution. Each distribution of cash or other assets of the Partnership made after dissolution of the Partnership shall be made in accordance with Section 11C. Distributions to the Partners will be made in such amounts and at such times as shall be determined by the General Partner. E. The Partnership Shares of each of the Partners are as follows: 1% to the General Partner, 24.75% to Carlyle-XIII Associates, L.P., 49.5% to Carlyle-XIV Associates, L.P., and 24.75% to Property Partners, L.P. 8. Powers, Rights and Duties of the Partners. A. Except as otherwise provided herein, the General Partner alone shall have the full, exclusive and complete power, authority and responsibility to manage and control the affairs and funds of the Partnership in the ordinary course of its activities for the purposes herein stated, including the power to take (or omit) all or any such action as he may from time to time deem appropriate or desirable in connection therewith. In furtherance of the powers granted to the General Partner herein, and in no way in limitation thereof, the General Partner, for and on behalf of the Partnership, shall have full, exclusive and complete power and responsibility to enter into agreements of whatever nature necessary to effect the acquisition of the Partnership's assets, and such amendments and restatements thereof and supplements and modifications thereto as it amy consider to be in the best interests of the Partnership to perform all duties and obligations, and exercise all rights, as provided under such agreements in such manner as it may determine; to act on behalf of the Partnership in dealing with third parties and to manage, operate and undertake the funds and affairs of the Partnership for the purposes of conducting its business and of making, holding, conducting and disposing of assets and investments. The president or any vice president of the General Partner may act for and in the name of the Partnership in the exercise by the Partnership of any of its rights and powers hereunder. In dealing with the president or any vice president of the General Partner, no person shall be required to inquire into the authority of such individual acting on behalf of the Partnership to bind the Partnership. Persons dealing with the Partnership are entitled to rely conclusively on the power and authority of the president or any vice president of the General Partner as set forth in this Agreement. B. Notwithstanding any provision of this Agreement to the contrary, in the event that the Partners cannot reach unanimous agreement concerning a decision regarding the sale of all or any substantial portion of the Property (other than any property owned by a partnership or joint venture, directly or indirectly through another partnership or joint venture, in which the Partnership is a partner), the Partner or Partners desiring a sale thereof (the "Notifying Party") shall give notice to the other Partner or Partners (the "Notified Party") of the proposed transaction and shall deliver to the Notified Party with such notice a copy of the bona fide written offer from the prospective purchaser setting forth the name of the prospective purchaser and all of the material terms and conditions on which it is intended that the Property, or specified portion thereof, be sold. The Notified Party shall then have 30 days after receiving such notice to elect (by giving notice of the same to the Notifying Party) either (a) to purchase the specified Property (other than any property owned by a partnership or joint venture, in which the Partnership is a partner) for the purchase price and on the terms and conditions as set forth in such offer or (b) to acquire a proportionate share of the Notifying Party's interest in the Partnership for an amount equal to the amount which the Notifying Party would have received as its share of the net proceeds from the sale of the specified Property. In the event that the Notified Party makes either such election, the Partners shall close on the transaction as elected by the Notified Party within a period equal to the later of 90 days after the making of such election or the closing date specified in such written offer, with the time, place and date (within such period) as specified by the Notified Party by notice to the Notifying Party within 30 days after the making of such election. If the Notified Party does not make either election, then the Notifying Party may conclude a sale of such specified Property, without the agreement of the Notified Party, at any time or times within 180 days after the giving of notice of the proposed sale thereof, for a purchase price and on terms which are at least as favorable to the Partnership as those contained in the written offer and only to the purchaser identified in such written offer or to an "Affiliate" (as hereinafter defined) of such purchaser, if the Affiliate is specified in such written offer or such notice, but if a sale is not consummated within such period, then the right of the Notified Party to receive notice and to purchase or to acquire as aforesaid will continue as to any future proposed sale. In the event that the Notified Party includes more than one Partner, the election made by the Notified Party must be consented to by each such Partner and the purchase from the Notifying Party shall be made by the Partners comprising the Notified Partner based upon their respective Partnership Shares at the time of such election; provided, however, that if one such Partner fails or refuses to consent to either election, the other such Partner may, at its option, make the election of its choice and undertake the entire purchase or acquisition from the Notifying Party. C. Neither the General Partner nor any of its Affiliates shall be required to manage the Partnership as its sole and exclusive function and it may have other business interests and may engage in other activities in addition to those relating to the Partnership, including the making or management of other investments. Without limitation on the generality of the foregoing, each Partner recognizes that each Partner was formed for the purpose of investing in, operating, transferring, leasing and otherwise using real property and interests therein for profit and engaging in any and all activities related or incidental thereto and that each Partner will or may make other investments consistent with such purpose. Neither the Partnership nor any Partner shall have any right by virtue of this Agreement or the Partnership relationship created hereby in or to such other ventures or activities or to the income or proceeds derived therefrom, and the pursuit of such other ventures or activities by each Partner or any of their Affiliates, even if competitive with the business of the Partnership, is hereby consented to by all Partners and shall not be deemed wrongful or improper. Except as otherwise permitted in this Agreement or in any agreement among the Partners, no Partner or any Affiliate of a Partner shall be obligated to present any particular investment opportunity to the Partnership even if such opportunity is of a character which, if presented to the Partnership, could be taken by the Partnership, and each Partner or any Affiliate of a Partner shall have the right to take for its own account, or to recommend to others, any such particular investment opportunity. D. "Affiliate(s)" of a person means (i) any officer, director, employee, shareholder, partner or relative within the third degree of kindred of such person: (ii) any corporation, partnership, trust or other entity controlling, controlled by or under common control with such person or any such relative of such person; and (iii) any officer, director, trustee, general partner or employee of any entity described in (ii) above. Affiliates of a Partner may receive commissions when the Partnership buys or sells the Property or any portion thereof and may be employed to provide property management for the Partnership or any of the Property, but no commissions or compensation payable to such Affiliate for the same may exceed the normal and competitive rates for similar services in the locality where provided. The Partnership may borrow funds for the purpose of lending such funds to all or any of its Partners; provided, however, that the cost of such funds charged to the Partnership (including financing fees, "points" and interest charged with respect to such funds) by a third party shall not exceed the amount charged by the Partnership to such Partner or Partners for the use of such funds. The Partnership may enter into agreements with Affiliates of a Partner to provide insurance brokerage or similar services to the Partnership or any of the Property; provided that any such services by Affiliates shall be at rates at least as favorable to the Partnership as those available from unaffiliated parties. The validity of any transaction, agreement or payment involving the Partnership and any Affiliate of a Partner shall not be affected by reason of the relationship between the Partner and such Affiliate or the approval of said transaction, agreement or payment by officers, directors or partners of such Affiliate all or some of whom are also Affiliates of a Partner or are officers, directors or partners or are otherwise interested in or related to such Partner or its Affiliates. E. No Partner nor any Affiliate of any Partner nor any officer, director, shareholder, employee or partner of any such Affiliate shall be liable, responsible or accountable in damages or otherwise to the Partnership or to any other Partner for any action taken or failure to act on behalf of the Partnership within the scope of the authority conferred on such Partner or such Affiliate or such other person by this Agreement or by law unless such action or omission was performed or omitted fraudulently or in bad faith or constituted wanton and willful misconduct. F. The Partnership shall indemnify and hold harmless each Partner, any Affiliate of any Partner and any officer, director, shareholder, employee or partner of any such Affiliate (the "Indemnified Parties") from and against any loss, expense, damage or injury suffered or sustained by any Indemnified Party by reason of any acts, omissions or alleged acts or omissions arising out of its activities on behalf of the Partnership or in furtherance of the interest of the Partnership, including, but not limited to, any judgment, award, settlement, reasonable attorneys' fees and other costs and expenses incurred in connection with the defense of any actual or threatened action, proceeding or claim; provided that the acts or omissions or alleged acts or omissions upon which such actual or threatened action, proceeding or claim are based were performed or omitted in good faith and were not performed or omitted fraudulently or in bad faith or as a result of wanton and willful misconduct. G. The Limited Partners shall not participate in the management or control of the Partnership's business, nor shall they transact any business for the Partnership, nor shall they have the power to act for or bind the Partnership, said powers being vested solely and exclusively in the General Partner as provided herein (and except as provided herein). The Limited Partners shall not have any personal liability whatever, whether to the Partnership, to any Partner or to the creditors of the Partnership, for the debts of the Partnership or any of its losses once it has paid to the Partnership the amount of its capital contribution set forth in Exhibit B. The partnership interest of the Limited Partners in the Partnership shall be fully paid and non-assessable. H. The General Partner may in its sole discretion, make or seek to revoke the election referred to in Section 745 of the Internal Revenue Code of 1986, as amended, (herein the "Code") or any similar provision exacted in lieu thereof. Each of the Partners will upon request supply the information necessary to properly give effect to any such election. I. The General Partner shall, at the Partnership's expense and within a reasonable time after the close of each fiscal year, cause each Partner to be furnished with such statements of the Partnership's assets and liabilities as of the close of such year (if any), such profit and loss statement for such year (if any), such statement of the capital and profit account of each Partner (if any), and such other reports (if any), all as the General Partner may deem appropriate. J. The General Partner shall, at the Partnership's expense, cause the Partnership's Federal and state income and other tax returns to be prepared and filed and shall furnish copies to each Partner of any information on such returns needed for the preparation of each Partner's own tax returns. 9. Books and Records of the Partnership; Fiscal Year. The General Partner shall keep and maintain the books and records of the Partnership at the principal place of business of the Partnership. The fiscal year of the Partnership shall end on the 31st day of December in each year. The books of the Partnership shall be kept on the cash or accrual basis, and the Partnership shall be on the cash or accrual basis for tax purposes, as determined by the General Partner. The books and records of the Partnership shall be audited at such times and by such accountants as shall be determined from time to time by the General Partner. The funds of the Partnership shall be deposited in such bank accounts or invested in such interest-bearing or non-interest-bearing investments as shall be determined by the General Partner. 10. Transfer of Partnership Interest. A. No Partner may sell, assign, transfer, encumber or hypothecate the whole or any part of its Partnership interest (including, but not limited to, its interest in the capital or profits of the Partnership) without prior written consent of the General Partner. B. Any party or person admitted to the Partnership as a substituted Partner shall be subject to and bound by all of the provisions of this Agreement as if originally a party to this Agreement and as a condition to such admission shall be required to execute a copy of this Agreement as amended to the date of such admission. C. A Partner shall have no liability hereunder (including, but not limited to, any liability as a surety but excluding the repayment of any outstanding principal and interest on loans made by the Partnership to such Partner) for any obligations accruing under or in connection with the Partnership and relating to events occurring after such Partner shall have sold, assigned or transferred its entire Partnership interest. 11. Dissolution of the Partnership. A. No act, thing, occurrence, event or circumstances shall cause or result in the dissolution of the Partnership except the matters specified in subsection B below. B. The happening of any one of the following events shall work a dissolution of the Partnership: (1) The bankruptcy, resignation, legal incapacity, dissolution, termination, or expulsion of the General Partner; provided, however, that in such event the remaining Partners shall have the right to elect to continue the Partnership's business by depositing at the office of the Partnership a writing evidencing such an election. No other act shall be required to effect such continuation; (2) The sale of all or substantially all of the assets of the Partnership; (3) The unanimous agreement in writing by all of the Partners to dissolve the Partnership; or (4) The termination of the term of the Partnership pursuant to Section 5 hereof. Without limitation on the other provisions hereof, the admission of a new Partner shall not work a dissolution of the Partnership. Except as otherwise provided in this Agreement, each Partner agrees that, without the consent of the General Partner, a Partner may not withdraw from or cause a voluntary dissolution of the Partnership. C. Upon the occurrence of any of the events specified in subsection B above causing a dissolution of the Partnership and except as otherwise provided in subsection B above, the remaining Partner or Partners shall commence to wind up the affairs of the Partnership and to liquidate its investments (and in this connection shall have full right and unlimited discretion to determine in good faith the time, manner and terms of any sale or sales of Partnership Property). The Partner or Partners obligated to wind up the affairs of the Partnership as aforesaid shall herein be called the "Winding-Up Party". The Partners and their legal representatives, successors and assignees shall continue to share in profits and losses during the period of liquidation in the same manner and proportion as immediately before the dissolution. Following the payment of all debts and liabilities of the Partnership and all expenses of liquidation and subject to the right of the Winding-Up Party to set up such cash reserves as, and for so long as, it may deem reasonably necessary, the proceeds of the liquidation and any other funds of the Partnership shall be distributed to the Partners (after deducting from the distributive share of a Partner any sum such Partner owes the Partnership) in accordance with Section 7 hereof. No Partner shall have any right to demand or receive property other than cash upon dissolution or termination of the Partnership. Upon the completion of the liquidation of the Partnership and of the distribution of all Partnership funds, the Partnership shall terminate and the Winding-Up Party shall have the authority to execute any and all documents required in its judgment to effectuate the dissolution and termination of the Partnership. Each Partners shall look solely to the assets of the Partnership for all distributions with respect to the Partnership and its capital contributions thereto and share of profits or losses therefrom, and shall have no recourse therefor against any Partner; provided that nothing herein contained shall relieve any Partner of such Partner's obligation to pay any liability or indebtedness owing to the Partnership by such Partner. 12. Notices; Amendment. A. Any notice which a Partner is required or may desire to give any other Partner shall be in writing, and may be given by personal delivery or by mailing the same by United States registered or certified mail, return receipt required, to the Partner to whom such notice is directed at the address of such Partner as hereinabove set forth, subject to the right of a Partner to designate a different address for itself by notice similarly given. Any notice so given by United States mail shall be deemed to have been given on the second day after the same is deposited in the United States mail as registered or certified mail, addressed as above provided, with postage thereon fully prepaid. Any such notice not given by registered or certified mail as aforesaid shall be deemed to be given upon receipt of the same by the party to whom the same is to be given. B. This Agreement may be amended by written agreement of amendment executed by all the Partners, but not otherwise. 13. New General Partner. All of the Partners may agree in writing from time to time to admit to the Partnership one or more new General Partners. The General Partner may, on behalf of all Partners, cause Exhibit B hereto and the Partnership's Certificate of Limited Partnership to be appropriately amended and cause the same to be recorded in the event of each such appointment. No such addition or substitution of a new General Partner shall work a dissolution of the Partnership or otherwise affect the continuity of the Partnership. 14. Miscellaneous. Each Partner hereby irrevocably waives any and all rights that it may have to maintain any action for partition of any of the Partnership Property. This Agreement constitutes the entire agreement between the parties. This Agreement supersedes any prior agreement or understanding between the parties. This Agreement and the rights of the parties hereunder shall be governed by and interpreted in accordance with the laws of the State of Illinois. Except as herein otherwise specifically provided, this Agreement shall be binding upon and inure to the benefit of the parties and their legal representatives, successors and assignees. Captions contained in the Agreement in no way define, limit or extend the scope or intent of this Agreement. If any provision of this Agreement, or the application of such provision to any person or circumstance shall be held invalid, the remainder of this Agreement, or the application of such provision to other persons or circumstances, shall not be affected thereby. This Agreement may be executed in several counterparts, each of which shall be deemed an original but all of which shall constitute one and the same instrument. The opinion of the independent certified public accountants retained by the Partnership from time to time shall be final and binding with respect to all computations and determinations required to be made under Section 7 hereof (including computations and determinations in connection with any distribution following or in connection with dissolution of the Partnership). If the Partnership or any Partner obtains a judgment against any other party by reason of breach of this Agreement or failure to comply with the provisions hereof, a reasonable attorneys' fee as fixed by the court shall be included in such judgment. Any Partner shall be entitled to maintain, on its own behalf or on behalf of the Partnership, any action or proceeding against any other Partner or the Partnership (including, without limitation, any action for damages, specific performance or declaratory relief) for or by reason of breach by such party of this Agreement, notwithstanding the fact that any or all of the parties to such proceeding may then be a partner in the Partnership, and without dissolving the Partnership as a partnership. No remedy conferred upon the Partnership or any partner in this Agreement is intended to be exclusive of any other remedy herein or by law provided or permitted, but each shall be cumulative and shall be in addition to every other remedy given hereunder or now or hereafter existing at law or in equity or by stature (subject, however, to the limitations expressly herein set forth). No waiver by a Partner or the Partnership of any breach of this Agreement shall be deemed to be a waiver of any other breach of any kind or nature and no acceptance of payment or performance by a Partner of the Partnership after any such breach shall be deemed to be a waiver of any breach of this Agreement whether or not such Partner or the Partnership knows of such breach at the time it accepts such payment or performance. No failure or delay on the part of a Partner or the Partnership to exercise any right it may have shall prevent the exercise thereof by such Partner or the Partnership at any time such other Partner may continue to be so in default, and no such failure or delay shall operate as a waiver of any default. Power of Attorney The undersigned Partners of JMB/NYC Office Building Associates, L.P., a limited partnership pursuant to the laws of the State of Illinois, hereby jointly and severally irrevocably constitute and appoint the General Partner with full power of substitution, their true and lawful attorney-in-fact, in their name, place and stead to make, execute, sign, acknowledge, record and file, on behalf of them and on behalf of the Partnership the following: (i) A Certificate of Limited Partnership and any other certificates or instruments which may be required to be filed by the Partnership or the Partners under the laws of the State of Illinois and any other jurisdiction whose laws may be applicable; (ii) Such instruments or documents as may be deemed necessary or desirable by the General Partner in connection with the termination of the Partnership's business; (iii) Any and all amendments of the instruments described in clauses (i) and (ii) above, provided such amendments either are required by law to be filed or are consistent with the Agreement of Limited Partnership of the Partnership as it may exist from time to time, or have been authorized by the particular Partner or Partners; and (iv) Any amendment of this Agreement authorized to be made by the General Partner under this Agreement. The foregoing grant of authority: (i) Is a Special Power of Attorney coupled with an interest, is irrevocable and shall survive the death or incapacity of the Partner granting the power; (ii) May be exercised by the General Partner on behalf of each Partner by a facsimile signature or by listing all of the Partners executing any instrument with a single signature as attorney-in-fact for all of them; and (iii) Shall survive the withdrawal, dissolution, legal incapacity, bankruptcy or resignation of a Partner from the Partnership or the delivery of an assignment by a Partner of the whole or any portion of his interest in the Partnership. IN WITNESS WHEREOF, the undersigned have executed these Second Amended and Restated Articles of Limited Partnership of JMB/NYC Office Building Associates, L.P. as of the day and year first above written. General Partner Limited Partners CARLYLE-XIV MANAGERS, INC., CARLYLE-XIII ASSOCIATES, L.P., a Delaware corporation a Delaware limited partnership NEIL G. BLUHM By: CARLYLE INVESTORS, INC., By: ------------- a Delaware corporation, Neil G. Bluhm Corporate General Partner President By: NEIL G. BLUHM -------------- Neil G. Bluhm President CARLYLE-XIV ASSOCIATES, L.P., a Delaware limited partnership By: CARLYLE INVESTORS, INC., a Delaware corporation, Corporate General Partner By: NEIL G. BLUHM ------------- Neil G. Bluhm President PROPERTY PARTNERS, L.P., a Delaware limited partnership By: CARLYLE INVESTORS, INC., a Delaware corporation, General Partner By: NEIL G. BLUHM ------------- Neil G. Bluhm President EXHIBIT A 1. An approximate 1-1/2 acre site bounded by the Helmsley Building located on Park Avenue on the west, East 46th Street on the north, Lexington Avenue on the east and East 45th Street on the south in the Grand Central District of Midtown Manhattan, New York, New York and known as 237 Park Avenue. 2. An approximate 2.1 acre site bounded by the Avenue of the Americas on the west, West 52nd Street on the north and West 51st Street on the south in the Rockefeller Center District of Midtown Manhattan, New York, New York and known as 1290 Avenue of the Americas. 3. A leasehold estate in an approximately 1.7 acre site bounded by Broadway on the west, Beaver and Marketfield Streets on the north, Broad and New Streets on the east and Stone Street on the south in the Financial District of Downtown Manhattan, New York, New York and known as 2 Broadway. 4. The lessor's estate in the approximately 1.7 acre site described in 3 above. EXHIBIT B AMOUNT OF AGREED PARTNERSHIP CAPITAL CONTRIBUTION SHARE GENERAL PARTNER Carlyle-XIV Managers, Inc. $ 100 1% LIMITED PARTNERS Carlyle-XIII Associates, L.P. $42,014,983 24.75% Carlyle-XIV Associates, L.P. $84,029,965 49.5% Property Partners, L.P. $42,014,983 24.75% SETTLEMENT AGREEMENT This Agreement (this "Agreement") made and entered into this 21st day of April, 1993 by and between Gables Corporate Plaza Associates, a Florida general partnership consisting of Carlyle Real Estate Limited Partnership-XIII, an Illinois limited partnership ("Carlyle"), and Gables Corporate Plaza, Ltd., a Florida limited partnership, for and on behalf of itself, its successors and assigns, (hereinafter sometimes collectively referred to as "Gables Associates" or "Borrower"), Gables Corporate Plaza, Ltd., a Florida limited partnership ("Gables Limited'') and Aetna Life Insurance Company, a Connecticut corporation, for and on behalf of itself and its successors and assigns (hereinafter referred to as "Aetna"). W I T N E S S E T H: WHEREAS, Southeast First National Bank of Miami, a national banking association ("Southeast") extended a loan to Gables Corporate Plaza, a Florida general partnership ("GCP") in the amount of Twelve Million Dollars ($12,000,000.00), evidenced by a Promissory note dated July 7, 1981 (the "First Note"); WHEREAS, on July 7, 1981, GCP executed and delivered to Southeast a mortgage (the "First Mortgage") securing payment of the First Note to Southeast. The First Mortgage was recorded in Official Records 11151, Page 40 of the Public Records of Dade County, Florida; WHEREAS, to further secure the payment of the First Note, GCP executed and delivered to Southeast that certain Conditional Assiqnment of Rents and Leases (the "First Rents Assignment") assiqning to Southeast any right, title and interest of GCP in, to and under all leases affecting the Property (as hereinafter defined) and granting the right to receive and collect all of the rents, income and profits as they become due from the Property and under any and all leases of all or any part of the Property, as more particularly set forth in the First Rents Assignment, which is recorded in Official Records Book 11151, Page 45, of the Public Records of Dade County, Florida; WHEREAS, Gables Corporate Plaza, Ltd., a Florida limited partnership ("Gables Limited") acquired title to the Property by virtue of that certain Quit Claim Deed executed and delivered by GCP in favor of Gables Limited dated March 9, 1982 and recorded March 31, 1982 in Official Records Book 11396, Page 617 of the Public Records of Dade County, Florida; WHEREAS, in connection with the acquisition of the Property by Gables Limited, GCP and Gables Limited executed and Southeast approved that certain Assumption and Assignment Acreement dated as of March 9, 1982, and recorded in Official Records Book 11411, Page 1335 of the Public Records of Dade County, Florida, whereby among other things Gables Limited assumed all of the obligations set forth in the loan documents originally executed by GCP; WHEREAS, on Auqust 9, 1982, Gables Limited executed and delivered to Southeast that certain Future Advance Note dated Auqust 9, 1982 in the original principal amount of One Million ($l,000,000.00) Dollars (the "Second Note"); WHEREAS, the Second Note was executed pursuant to the provisions of Paraqraph 16 of the First Mortgage which allows for future advances to be made up to a maximum of one hundred fifty percent (150%) of the original principal balance; WHEREAS, on August 9, 1982, Gables Limited executed and delivered to Southeast that certain Notice of Advances to be made dated August 9, 1982, and recorded Auqust 10, 1982, in Official Records Book 11523, Page 2073, of the Public Records of Dade County, Florida (the "Notice of Advances to be Made"); WHEREAS, on Auqust 9, 1982, Gables Limited executed and delivered to Southeast that certain UCC-l Financing Statement recorded on August 16, 1982 with the Secretary of State, State of Florida under File Number 1820113943 (the "First Gables Limited UCC-1-State"). The First Gables Limited UCC-l-State fully assigned to Aetna pursuant to that certain UCC-3 filed with the Secretary of State, State of Florida, on March 14, was 1983, under File Number 3830011076. The First Gables Limited UCC-l-State was continued pursuant to that certain UCC-3 filed with the Secretary of State, State of Florida on August 14, 1987 under File Number 3870055193; WHEREAS, on or about February 11, 1983, Gables Limited executed and delivered to Southeast that certain Promissory Note dated February 11, 1983, in the original principal amount of Five Million Two Hundred and Fifty Thousand ($5,250,000.00) Dollars (the "Third Note"); WHEREAS, on February 11, 1983, Gables Limited executed and delivered to Southeast a mortgage (the "Second Mortgage") dated February 11, 1983 and recorded February 16, 1983, in Official Records Book 11700, Page 1564 of the Public Records of Dade County, Florida in order to secure repayment of the Third Note; WHEREAS, on February 11, 1983, Gables Limited executed and delivered to Southeast, a Supplemental Assiqnment of Rents and Leases dated the llth day of February, 1983 and recorded on February 16, 1983 in Official Records Book 11700, Page 1569 of the Public Records of Dade County, Florida (the "First Supplemental Assignment of Rents and Leases"); WHEREAS, on February 11, 1983, Gables Limited executed and delivered to Southeast a UCC-l-Financing Statement recorded on February 16, 1983 in Official Records Book 11700, Page 1576 of the Public Records of Dade County, Florida (the "Gables Limited UCC-l-Local''). The Gables Limited UCC-l-Local was continued and fully assigned to Aetna pursuant to that certain UCC-3 recorded in Official Records Book 13553, Page 2549 of the Public Records of Dade County, Florida; WHEREAS, on February 11, 1983, Gables Limited executed and delivered to Southeast a UCC-l-Financing Statement filed on February 18, 1983 with the Secretary of State, State of Florida under File Number 1830025592 (the "Second Gables Limited UCC-l-State"). The Second Gables Limited UCC-l-State was fully assigned to Aetna pursuant to that certain UCC-3 filed with the Secretary of State, State of Florida, on March 14, 1983, under File Number 3830011075. The Second Gables Limited UCC-l-State was continued and assigned to Aetna pursuant to that certain UCC-3 filed with the Secretary of State, State of Florida on January 28, 1988 under File Number 3880005857; WHEREAS, on February 16, 1983, the First Note, the Second Note and the Third Note, together with the First Mortgage and the Second Mortgage were consolidated and modified by that certain Note and Mortgage Modification Agreement dated February 16, 1983, and recorded February 16, 1983, in Official Records Book 11700, Page 1579, of the Public Records of Dade County, Florida ("the First Note and Mortgage Modification Agreement"); WHEREAS, on February 28, 1983, Aetna purchased from Southeast the First Note, the Second Note and the Third Note (collectively, the "Notes"), and the First Mortgage and the Second Mortgage (collectively, the "Mortgages"), as consolidated and modified by the First Note and Mortgage Modification Agreement and all related loan documents, and Southeast assiqned its interest in said loan documents pursuant to that certain Assignment dated February 28, 1983 and recorded on February 28, 1983, in Official Records Book 11711, Page 417 of the Public Records of Dade County, Florida (the "Assignment"); WHEREAS, on or about November 7, 1983, Gables Associates acquired title to the Property by virtue of that certain Special Warranty Deed executed and delivered by Gables Limited in favor of Gables Associates dated November 7, 1983, and recorded November 14, 1983, in Official Records Book 11967, Page 476, of the Public Records of Dade County, Florida; WHEREAS, on May 21, 1984, Aetna and Gables Associates entered into that certain Note and Mortgage Modification Agreement dated May 21, 1984, and recorded May 25, 1984, and Official Records Book 12158, Paqe 2601, Public Records of Dade County, Florida (the "Second Note and Mortgage Modification Agreement"); WHEREAS, on May 21, 1984, Gables Associates executed and delivered that certain Supplemental Assiqnment of Rents and Leases dated May 21, 1984 and recorded on May 25, 1984 in Official Records Book 12158, Page 2596 of the Public Records of Dade County, Florida (the "Second Supplemental Assignment of Rents and Leases"); WHEREAS, on May 21, 1984, Gables Associates executed and delivered to Aetna that certain UCC-l Financing Statement filed with the Secretary of State, State of Florida on May 29, 1984 under File Number 1840092087 (the "Gables Associates UCC-l-State") The Gables Associates UCC-l-State was continued pursuant to that certain UCC-3 filed with the Secretary of State, State of Florida, on May 5, 1989 under File Number 89-0000123298; WHEREAS, on May 21, 1984, Gables Associates executed and delivered that certain UCC-l Financing Statement to Aetna recorded on May 25, 1984 in Official Records Book 12158, Page 2610 of the Public Records of Dade County, Florida (the "Gables Associates UCC-l-Local"). The Gables Associates UCC-l-Local was continued pursuant to that certain UCC-3 recorded on May 5, 1989 in Official Records Book 14096, Page 1495 of the Public Records of Dade County, Florida; WHEREAS, on June 26, 1990, Aetna and Gables Associates entered into that certain Note and Mortgage Modification Agreement effective as of the 1st day of March, 1989, and recorded July 13, 1990, in Official Records Book 14624, Page 848, of the Public Records of Dade County, Florida (the "Third Note and Mortgage Modification Agreement"); WHEREAS, in connection with the Third Note and Mortgage Modification Agreement, Gables Associates executed and delivered to Aetna that certain Restated Renewal Note dated March 1, 1989, in the amount of Sixteen Million Six Hundred Sixty-Seven Thousand Five Hundred Sixteen and 89/100 Dollars ($16,667,516.89), (the "Restated Renewal Note"). The First Note, First Mortgage, First Rents Assignment, Second Note, Notice of Advances to be Made, First Gables Limited UCC-l-State, Third Note, Second Mortgage, First Supplemental Assiqnment of Rents and Leases, Gables Limited UCC-1-Local, Second Gables Limited UCC-l-State, First Note and Mortgage Modification Agreement, Second Note and Mortgage Modification Agreement, Second Supplemental Assignment of Rents and Leases, Gables Associates UCC-l-State, Gables Associates UCC-l-Local, Third Note and Mortgage Modification Agreement, the Restated Renewal Note and any other documents executed in connection with the foregoing documents are hereinafter sometimes collectively referred to as the "Loan Documents". WHEREAS, due to a default under the Loan Documents, Aetna has declared the full amount payable under the terms of the Restated Renewal Note and the other Loan Documents to be due; WHEREAS, Gables Associates acknowledges and agrees that Aetna is due Sixteen Million Six Hundred Sixty-Seven Thousand Five Hundred Sixteen and 89/100 Dollars ($16,667,516.89) as principal under the Restated Renewal Note plus interest thereon as set forth in said note, as well as costs expended by Aetna in connection with the collection of the sums due under the Restated Renewal Note, including, but not limited to attorneys' fees and costs; and WHEREAS, for the purpose of avoiding lengthy and expensive litigation and in order to reach an amicable resolution of their differences, Borrower on the one hand, and Aetna on the other hand, desire to reach a final compromise and settlement of any and all claims, demands, controversies, disputes, defenses, counterclaims and causes of action which each of them may have had, may now have, or may in the future have against the other arising out of or in connection with the Loan Documents. NOW, THEREFORE, in consideration of the premises, the covenants set forth herein, and other good and valuable considerations as set forth more fully below, the receipt and sufficiency of which are hereby acknowledqed by each of the parties hereto, the parties hereby agree as follows: ARTICLE I Whereas Clauses and Definitions 1.1 Whereas Clauses. The parties hereto agree that the above recitals are true and correct, and are hereby incorporated by reference. 1.2 Certain Defined Terms. As used herein the following terms shall have the following meanings (such meanings shall be applicable to both the singular and plural forms of the terms defined): 1.2.1 "Agreement" shall mean this Settlement Agreement executed by Gables Associates and Aetna. 1.2.2 "Closing" shall mean the execution and delivery of all documents contemplated by this Agreement to be executed and delivered on the Closing Date, and the delivery of such documents to the parties entitled thereto. 1.2.3 "Closing Date" shall be April 20, 1993. 1.2.4 "Escrow Agent" shall mean Steel Hector & Davis, with an office and mailing address at 200 South Biscayne Boulevard, Suite 4000, Miami, Florida 33131-2398, Attn: Thomas V. Eagan, P.A. 1.2.5 "Escrow Agreement" shall mean that certain escrow agreement attached hereto as Exhibit B. 1.2.6 "Improvements" shall mean one (1) approximately 106,289 net rentable square foot 13-story office building and internal deck for approximately 285 automobiles located at 2100 Ponce de Leon Boulevard, Coral Gables, Dade county, Florida, and any and all other improvements on the Land. 1.2.7 "Land" shall mean the land, the legal description of which is set forth in Exhibit A attached hereto, and also including, without limitation, Gables Associates' right, title and interest (if any) in any walks, ways, strips and gores of land, streets, alleys, passages, all reversions in adjacent streets, and all easements and appurtenances whatsoever adjacent to or in any way belonging, relating or appertaining to any of the aforesaid real property. 1.2.8 "Leases" shall mean any and all leases, subleases, licenses or other occupancy agreements (written or verbal) which grant any possessory interest in any space situated on the Property and as more particularly described in Exhibit C attached hereto. 1.2.9 "Lease Summary" shall mean the list of tenants and Leases set forth in Exhibit C attached hereto. 1.2.10 "Licenses" shall mean all permits, certificates, authorizations, approvals and licenses necessary to operate the Improvements, including, but not limited to, those described in Exhibit D attached hereto. 1.2.11 "Miscellaneous Property" shall; mean all miscellaneous property related to the Land or the Improvements constructed thereon, including, but not limited to the books and records; contract rights; claims and counterclaims against third parties or to the design or construction of the Improvements; escrow accounts and other deposits and accounts with respect to the Property; appraisals; surveys; site pians; plans and specifications (including construction and as-built plans and specifications); the most recent landscape designs and architectural drawinqs relative to the Land or the Improvements; unpaid insurance proceeds and condemnation awards relative to the Land or the Improvements except as otherwise provided in this Agreement; Licenses; third party warranties and guaranties (to the extent assignable); general intangibles and goodwill of every nature used or usable in connection with the Land or the Improvements; utility agreements and allocations; development rights or orders; other rights relative to the Land or the Improvements; and other assets of Gables Associates related to the Land or the Improvements. 1.2.12 "Permitted Exceptions" shall mean (a) the exceptions to title listed in-Exhibit E, and (b) the Leases. 1.2.13 "Personal Property" shall mean all apparatus, equipment, machinery, fittings, furniture, furnishings, minor movables, fixed asset supplies and inventories and other intangibles and articles of personal property of every kind and nature whatsoever attached to or located on the Land and used or usable in connection With the Property and owned by Gables Associates, including without limitation the items of personal property listed in Exhibit F attached hereto, but excluding the items of personal property owned or stored by the tenants under the Leases as described in Exhibit C attached hereto. 1.2.14 "Property" shall mean the Land, the Improvements, the Personal Property and the Miscellaneous Property. 1.2.15 "Security Deposits" shall mean the security deposits paid by tenants to the landlord under the Leases as described in Exhibit G attached hereto. 1.2.16 "Service Contract" shall mean any service, maintenance, supply, management, operating or employment contracts, as amended affecting the use, ownership, management, leasing, maintenance or operation of all or any part of the Property, including, without limitation, the contracts listed in Exhibit H attached hereto. 1.2 17 "Utility Deposits" shall mean any security deposit held by any electric, telephone, or other utility company supplyinq services to the Property, as described in Exhibit 1 attached hereto. 1.3 Other Terms All defined terms (denoted by capitalization or other indication. of special definition such as quotation marks) used in this Agreement which are not defined This Article I, shall have the meaning set forth elsewhere in this Agreement. ARTICLE II Preservation of Property 2.1 Appointment of Receiver. In order to best preserve and protect the Property, the parties have mutually agreed that Hank Brenner should be appointed receiver (the "Receiver") by the court, at such time as Aetna files its foreclosure action. Gables Associates agrees to fully cooperate with the Receiver in his efforts to take possession of, operate and maintain the Property. ARTICLE III Closing 3.1 Place and Time. The Closing shall take place at the offices of Steel Hector & Davis, 200 South Biscayne Boulevard, Suite 4000, Miami, Florida 33131-2398 at 2:00 p.m. on the Closing Date at which time all instruments due to be made, executed and delivered at Closing shall be made, executed and delivered by the respective parties to the Escrow Agent to be held in escrow pursuant to the terms of the Escrow Agreement. The parties agree to have a pre-closing telephone conference the day before the Closing Date commencing at 10:00 a.m. 3.2 Closinq Costs. 3.2.1 Gables Associates' Closing Cost. Gables Associates shall pay the cost of recording any document required to satisfy any liens against the Property. 3.2.2 Aetna's Closinq Cost. Aetna shall pay the cost of any title search fee or title insurance commitment fee, the cost of the owner's title insurance premium, the expense of recording the Special Warranty deed, including the documentary stamp taxes and surtaxes required to be paid in connection with recording said deed, and the consulting fees incurred by Aetna in the course of conducting due diligence on the Property. 3.2.3 Attorneys Fees. Except as provided in Section 14 5, attorneys fees shall be paid by the party incurring said expense. 3.3. Rents, revenues and receipts (a) Any rents, revenues and receipts paid to Gables Associates after the Closing Date shall be applied by Gables Associates towards the operation and maintenance of the Property and the debt service owed pursuant to the Loan Documents; provided, however, that after April 30, 1993, all such rents, revenues and receipts shall be paid by Gables Associates to the Receiver. (b) Insurance Proceeds Any proceeds of loss of rent or business interruption insurance shall be payable to Aetna regardless of the period during which the loss is sustained. 3.3 1 Security Deposits. At the time that the Receiver is appointed, Gables Associates shall transfer to the Receiver all Security Deposits and advance rent under the Leases, which have not been applied by Gables Associates under the terms and conditions of the Leases. ARTICLE IV Deliveries 4.1 Gables Associates Deliveries. Gables Associates will furnish to Aetna on or before the Closing Date, the following: 4.1.1 Leases. Copies of the Leases, identified in Exhibit C and letters of intent or other information relating to the Leases or prospective leases for office space in the Property, including, without limitation, any and all side letters concerning concessions given to tenants whether or not such concessions are still outstanding. 4.1.2 Taxes. Copies of the 1991 and 1992 real estate and personal property tax statements for the Property. 4.1.3 Survey. Copy of Gables Associates' most recent survey of the Land. 4.1.4 Utility Bills. Copies of the most recent utility bills regarding the Property 4.1.5 Service Contracts. Copies of all Service Contracts. 4.1.6 Licenses. Copies of all Licenses 4.1.7 Warranties and Guaranties Copies of all warranties and guaranties relating to the Property. 4.1 8 Permits To the extent in Gables Associates' possession or control, copies of building permits, Zoning variances (if any), certificates of occupancy, subdivision plats, governmental permits, approvals, development orders, orders, certificates and other licenses relating to the construction, use, occupancy and operation of the Property and other correspondence with governmental author ties related to the foregoing (including, without limitation, any default notices) 4.1.9 Certificates of Occupancy Copies of all certificates of occupancy relating to the Property. 4.1.10 Insurance Policies. Copies of all insurance policies relating to the Property. 4.1.11 Orqanizational Documents. Copies of the partnership agreements for Gables Associates, Carlyle Real Estate Limited Partnership-XIII, an Illinois limited partnership and Gables Limited, as well as the articles of incorporation and by-laws of JMB Realty Corporation, a Delaware corporation. ARTICLE V Gables Associates' Representations, Warranties and Covenants 5.1 The Property. Gables Associates represents, warrants and covenants with Aetna as of the date hereof as follows: 5.1.1 Ownership. Gables Associates is the owner of good and marketable title in fee simple to the Land and Improvements free and clear of all liens, claims and other encumbrances whatsoever, except the Permitted Exceptions and such other matters as Gables Associates shall cause to be removed at or prior to Closing. The Personal Property and the Miscellaneous Property are owned by Gables Associates free and clear of any and all liens, encumbrances and security interests other than the Permitted Exceptions and such other matters as Gables Associates shall cause to be removed at or prior to the Closing. 5.1.2 Leases. As of the date hereof, there are no rights to use, occupy or purchase the Land or Improvements or any portion thereof other than the Leases and the rights of Gables Associates, and the Lease Summary is a true, accurate and complete list of all Leases, true, complete and correct copies Of which will be submitted to Aetna pursuant to Section 4.1.1. As of the date hereof, except as otherwise set forth in the r ease Summary attached hereto as Exhibit C: (a) the Leases are in full force and effect; (b) the landlord is not in default in the performance of any covenant, agreement or condition contained in any of the Leases; (c) the tenants are not n default in the performance of any covenant, agreement or condition contained in any of the Leases; and (d) all tenants are in possession of their respective premises. 5.1.3 Contracts and Warranties. Exhibit K is a correct and complete list of all warranties and guaranties pertaining to the Property, true and correct copies of which will be delivered to Aetna pursuant to Section 4.1 7. Exhibit H is a correct and complete list of all Service Contracts, true and correct copies of which will be delivered to Aetna pursuant to Section 4.1 5. Except as set forth on Exhibit H, the Service Contracts are in full force and effect and unmodified, no default exists under any Service Contract, and the Service Contracts are freely assignable, do not run with the Land, and can be cancelled upon no more than thirty (30) days notice from either party. Gables Associates represents that it has not sent or received any notice regarding the cancellation or termination of any Service Contract. 5.1.4 Ability to Perform. Gables Associates has full power to execute, deliver and carry out the terms and provisions of this Agreement and has taken all necessary action to authorize the execution, delivery and performance of this Agreement. The execution, delivery and performance of this Agreement by Gables Associates, in accordance with its terms will not violate its partnership agreement, or any law, regulation, contract, agreement, commitment, order, judgment or decree to which Gables Associates is a party or by which it is bound. The persons executing this Agreement on behalf of Gables Associates have been duly authorized to do so, and this Agreement constitutes the legal, valid and binding obligation of Gables Associates enforceable in accordance with its terms, except as limited by applicable bankruptcy or other laws relating to creditors rights generally. No order, permission, consent, approval, license, authorization, registration or validation of, or filing with, or exemption by, any governmental agency, commission, board or public authority is required to authorize, or is required in connection with, the execution, delivery and performance of this Agreement by Gables Associates or the taking by Gables Associates of any action contemplated by this Agreement. Upon request from Aetna or its counsel, Gables Associates shall deliver reasonable evidence of Gables Associates' authority to execute and deliver the documents necessary to consummate the Closing. 5.1.5 Solvency If requested by Aetna, Gables Associates shall provide Aetna with a solvency affidavit regarding Gables Associates at the time of closing in the form attached hereto as Exhibit L, or Gables Associates shall provide such other affidavit as the title insurance underwriter may reasonably require 5.1 6 No Actions. Except as set forth in Exhibit M attached hereto and made a part hereof, Gables Associates has received no written notice of and there do not exist, any actions or proceedings pending or threatened against or relating to the construction. ownership, use, possession or operation of the Property, including, without limitation, actions for condemnation of the Property or any part thereof. 5.1.7 Compliance with Law Except as itemized in Exhibit N attached hereto and made a part hereof, Gables Associates has received no written notice from any governmental authorities and has no other reason to believe that the present physical condition or use of the Property is in violation of an laws, regulations, permits, orders and insurance requirements applicable to such use. Gables Associates has received no written notice and otherwise has no reason to believe that any of the permits, certificates, licenses and approvals required for the use and operation of the Property for its existing uses, is not in full force and effect. Without limiting the generality of the foregoing, Gables Associates has received no written notice or citation: (a) from any federal, state, county or municipal authority alleging any fire, health, safety, building, pollution, environmental, zoning or other violation of any law, regulation, permit, order or directive in respect of the Property or any part thereof; (b) concerning the condemnation or any threatened condemnation of any part of the Land and Improvements, or the widening, change of grade of any roads, rights-of-way, etc. or concerning any special taxes or assessments levied against the Land and Improvements or any part thereof; (c) from any insurance company or bonding company of any defects or inadequacies in the Property or any part thereof, which would adversely affect the insurability of the same or of any termination or threatened termination of any policy of insurance or bond; (d) concerning any change in the land use classification or the zoning classification of the Land and Improvements or any part thereof; (e) concerning the possible or anticipated revocation, non-renewal or disapproval of any of the Licenses; or (f) of any other impediment to the continued use and operation of the Property for its existing uses If any such written notice is received prior to the Closing, Gables Associates shall notify Aetna promptly thereof, and, to the extent that actions are required thereby to be taken by Gables Associates prior to Closing, shall cause such actions to be taken; provided, however, that Gables Associates shall not be required to advance any of its monies in order to comply with any such notice. 5.1.8 Utilities. There is no pending or threatened curtailment of any utility service presently being supplied to the Land and Improvements. 5.1.9 Assessments. No special assessments for public improvements have been made against the Property which are unpaid, including, without limitation, those for construction of sewer, water and other utility lines, streets, sidewalks and curbs, and there are no pending liens on account thereof. 5.1.10 Environmental. Gables Associates represents and warrants that: (a) Gables Associates has not been involved in, and Gables Associates is not aware of any prior owner of the Property having been involved in the generation, storage, transportation, disposal, release or discharge of hazardous materials, hazardous waste, hazardous substances, solid waste or pollution upon, in, over or under the Property and that, to the best of Gables Associates' knowledge, no such materials or pollution has migrated to the Property from neighboring property; (b) Gables Associates has not received any notice from any governmental agency or authority or from any tenant or other occupant with respect to any generation, storage, transportation, disposal, release or discharge of hazardous materials, hazardous waste, hazardous substances, solid waste or pollution upon, in, over or under the Property; (c) there is no asbestos or asbestos-containing materials, PCB's, radon gas, urea formaldehyde foam insulation or underground storage tank(s) at or within the Property; (d) that Gables Associates and any tenant of the Property is not and will not become involved in operations at the Property or at other locations owned or operated by Gables Associates which would lead to the imposition on Gables Associates of liability under Chapter 403, Florida Statutes. the Resource Conservation and Recovery Act, 42 U.S.C. 6901 et seq. ("RCRA"), the Comprehensive Enviromental Response Compensation and Liability Act of 1980, 42 U.S.C. 9601 et seq. ("CERCLA") or any other federal, state or local ordinances, laws or regulations regarding environmental matters or hazardous substances, (e) Gables Associates will cooperate with the Receiver in complying with, and will take such action as may be required in order to promptly comply with, the requirements of Chapter 403, Florida Statutes, RCRA, CERCLA and all federal, state and local laws and regulations regarding environmental matters or hazardous substances as the same may each be amended from time to time (including all federal, state and local laws and regulations regarding underground storage tanks), and all such laws and regulations relating to asbestos and asbestos-containing materials, PCB's, radon gas, urea formaldehyde foam insulation (provided, however, Gables Associates shall not be required to spend any monies in order to comply with any of the foregoing requirements), and wil' notify Aetna promptly in the event of any release or discharge or a threatened release or discharge of hazardous materials, hazardous wastes, hazardous substances, solid waste or pollution upon, in, over or under the Property as those terms are defined in Chapter 403, Florida Statutes and any federal, state or local ordinances, laws or regulations regarding environmental matters or hazardous substances, or the presence of asbestos or asbestos-containing materials, PCB's, radon gas or urea formaldehyde foam insulation at the Property, or of the receipt by Gables Associates of any notice from any governmental agency or authority or from any tenant or other occupant or from any other person or entity with respect to any alleged such release or presence promptly upon discovery of such release, or promptly upon receipt of such notice, and will promptly send Aetna copies of all results of any tests regarding same on the Property and (f) there are no electrical transformers located on the Property. 5.1.11 Landfill. The Property has not been used as a solid waste or liquid waste landfill, or trash dump. 5.1.12 Licenses. Exhibit D contains a correct and complete list of all Licenses, true and correct copies of which will be delivered to Aetna pursuant to Section 4.1.6. 5.1.13 Brokeraqe Commissions. There are no commitments, agreements or contracts for brokerage commissions or similar compensation due (or to become due in connection with renewals of leases) tO any broker or similar person in connection with any Lease and future Lease, except as set forth in Exhibit C. 5.1.14 Orqanization and Authority. Gables Associates is a general partnership duly formed and validly existing in Florida, with full power and authority to carry on its business as now conducted. 5.1.15 Zoning. Gables Associates represents that the Property is zoned CB (commercial use) pursuant to the City of Coral Gables Zoning Code, that said classification allows for office building use, and there are no ordinances or regulations affecting the Land and the Improvements which would serve to restrict or prohibit the use of the Land and the Improvements in conformity with such zoning. Gables Associates represents that to the best of Gables Associates' knowledge, the Property is in compliance with zoning laws, as well as all other applicable laws, ordinances and regulations. 5.1.16 Commitments to Governmental Authorities. Gables Associates has made no commitments to any governmental authority, utility company, school board, church or any other religious body regarding the Property which would impose an obligation upon Aetna or its successors or assigns to make a contribution of money or dedications of land, or to construct, install or maintain any improvements of a public or private nature on or off the Property. 5.1.17 Notices. Gables Associates has not received any written notices from any insurance company of any defects or inadequacies in the Property or any part thereof which would materially and adversely affect the insurability of the Property or the premiums for the insurance thereof, and no notice has been given by any insurance company which has issued a policy with respect to any portion of the Property or by any board of fire underwriters (or other body exercising similar functions) requesting the performance of any alterations or other work which has not been complied with. 5.1.18 Possession. There are no parties in possession of any portion of the Property except for the tenants described in Exhibit C attached hereto and made a part hereof, and such other tenants as may be added pursuant to Section 9.1. 5.1.19 Disclosure. Except for the condition of the commercial leasing market in Dade County, Florida, there is no fact regarding the Property within Gables Associates' knowledge which adversely affects the Property in a material fashion which has not been set forth in this Agreement or an exhibit hereto or in a certificate or writing furnished in connection herewith. In the event that Gables Associates becomes aware of any fact regarding the Property which adversely affects the Property in a material fashion, Gables Associates will promptly notify Aetna, in writing, of such fact 5.1.20 Other Contracts. Gables Associates is not obligated under any contract; or agreement which has not been disclosed in connection herewith or a true copy of which have been previously delivered to Aetna. 5.1.21 Condition of Property Gables Associates represents that the Propersy (including the plumbing systems and fixtures, electrical systems and fixtures and sprinkler systems (if any)) is in good condition and repair, is termite free and that all electrical and mechanical appliances and equipment of whatever kind and nature are in good working condition, and that the Improvements are free from structural defect. ARTICLE VI Aetna's Representations, Warranties and Covenants Aetna represents. warrants and covenants with Gables Associates as of the date hereof as follows: 6.1 Organization and Authority. Aetna is a Connecticut corporation duly formed and validly existing under the laws of the State of Connecticut with full power and authority to carry on its business as now conducted and as is contemplated from and after the consummation of the transaction which is the subject of this Agreement. 6.2 Ability to Perform. Aetna has full power to execute, deliver and carry out the terms and provisions of this Agreement and has taken all necessary action to authorize the execution, delivery and performance of this Agreement The persons executing this Agreement on behalf of Aetna have been duly authorized to do so, and this Agreement constitutes the legal, valid and binding obligation of Aetna enforceable in accordance with its terms, except as limited by applicable bankruptcy or other laws relating to creditor's rights generally. No order, permission, consent, approval, license, authorization, registration or validation of, or filing with, or exemption by, any governmental agency, commission, board or public authority is required to authorize, or is required in connection with the execution, delivery and performance of this Agreement by Aetna or the taking by Aetna of any action contemplated by this Agreement. 6.3 No Violation. The execution, delivery and performance of this Agreement, in accordance with its terms, will not violate, conflict with or result in the breach of any provision of the articles of incorporation of Aetna, or any law, regulation, contract, agreement, commitment order, judgement or decree tO which Aetna is a party or by which it may be bound ARTICLE VII Conditions Precedent to Closinq 7.1 Aetna's Conditions Precedent to Closing The following shall be express conditions precedent to the obligations of Aetna under this Agreement, and are for the benefit of Aetna but may be waived by Aetna in whole or in part in its sole discretion: 7.1 1 No Default No breach or default under this Agreement shall have occurred on the part of Gables Associates which is continuing uncured at Closing. 7.1.2 Closinq Obliqations and Representations. Gables Associates shall have complied in all respects with the requirements of Article IV and Article X, as of the Closing Date, and the representations and warranties in the certificate to be delivered under Section 10.7 shall be true and correct in all respects as of the Closing Date. 7.1.3 Inspections. Gables Associates shall provide to Aetna and/or its designee access to the Property at reasonable times prior to the Closing for the purposes of conducting inspections of same, including, but not limited to termite inspections, roof inspections, structural integrity inspections, environmental inspections and other inspections of the Property 7.1.4 Title. Good, marketable and fee simple title of record and in fact to the Land and the Improvements shall be vested in Gables Associates at Closing, subject only to the Permitted Exceptions and such other matters as Gables Associates shall cause to be removed at or prior to Closing. In the event that title is found to be other than good and marketable, free from liens, reverters, restrictions and other encumbrances and clouds, except for the Permitted Exceptions, it shall be the duty and obligation of Gables Associates to remove any such defects or objections on or before the Closing Date. 7.1.5 Estoppel Certificates. Gables Associates shall cooperate with the Manager in obtaining and delivering to Aetna prior to the Closing Date estoppel certificates from each utility company furnishing services to any portion of the Property in the form attached hereto as Exhibit O, and in the event that the Manager is unable to obtain said estoppel certificates, Gables Associates shall use its best efforts to obtain and deliver same to Aetna prior to the Closing. In the event that the Manager or Gables Associates are not able to deliver said utility estoppel certificates to Aetna prior to the Closing Date, Gables Associates shall substitute its own estoppel letter in the form attached hereto as Exhibit O. 7.1.6 Possession. At the Closing, Gables Associates shall deliver full possession of The Property to Aetna (i) free of all tenants or occupants, except the tenants under the Leases reflected on Exhibit C and such other tenants as may be added pursuant to the provisions of Section 9.1, and (ii) not subject to any encumbrance other than the Permitted Exceptions. 7.1.7 Tenant Estoppel Letters. Gables Associates shall use its best efforts to obtain and deliver estoppel letters in the form attached hereto as Exhibit P prior to the Closing from all of the tenants identified in Exhibit C. Notwithstanding the foregoing, in the event that Gables Associates is unable to deliver said tenant estoppel letters to Aetna at or prior to the Closing from all of the tenants identified in Exhibit C, Gables Associates shall substitute its own estoppel letter in the form attached hereto as Exhibit P for those tenants from whom Gables Associates was unable to obtain estoppel letters. 7.1.8 No Material Chanqe. No material adverse change shall have occurred with respect to the Property since the date hereof. 7.1.9 Closing Documents. 7.1.9.1 Property Conveyance. The Land and the Improvements shall be conveyed by Special Warranty Deed, the Personal Property shall be conveyed by a proper Bill of Sale (with warranties of title) and the Miscellaneous Property, Licenses, Leases and Service Contracts shall be conveyed by a proper assignment. 7.1.9.2 Removal of Liens. Gables Associates shall cause to be made and delivered to Aetna an Affidavit of No Lien (Mechanic's Lien Affidavit) as to the Land and the Improvements in the form attached hereto as Exhibit Q. Gables Associates shall deliver to Aetna original lien waivers as well as releases from all contractors, subcontractors and/or materialmen who have not been paid and who have performed work or furnished materials prior to the Closing and/or for work in progress or who have pending liens on the Property. 7.1.10 No Cancellation of Lease. No condemnation or casualty which allows any tenant to cancel its lease pursuant to the terms thereof shall have occurred. 7.1.11 UCC Search. Gables Associates shall deliver to Aetna prior to the Closing Date a UCC Financing Statement search indicating that there are no outstanding financing statements or security agreements regarding Gables Associates or the Property which remain unsatisfied other than the UCC-ls in favor of Aetna, or provide payoff letters (satisfactory to Aetna) from any secured party for any outstanding financing statements at time of Closing. 7.1.12 Stipulation and Final Judgment of Foreclosure. Gables Associates hereby instructs its counsel to execute the Stipulation and Final Judgment in form and substance as appears on Exhibit V attached hereto and made a part hereof (the "Stipulation") and to deliver the Stipulation in escrow to the Escrow Agent at time of Closing, to be held pursuant to the terms of the Escrow Agreement. 7.1.13 Stipulation and Joint Motion for Ex Parte Appointment of Receiver. Gables Associates hereby instructs its counsel to execute the Stipulation and Joint Motion for Ex Parte Appointment of Receiver in form and substance as it appears on Exhibit X attached hereto and made a part hereof and to deliver the Stipulation and Joint Motion for Ex Parte Appointment of Receiver to Aetna at the time of Closing. Aetna shall be free to file the Stipulation and Joint Motion for Ex Parte Appointment of Receiver at any time after the filing of its foreclosure action to enforce the Loan Documents on April 30, l993 . 7.2 Gables Associates' Conditions Precedent to Closing. The following shall be express conditions precedent to the obligations of Gables Associates under this Agreement, and are for the benefit of Gables Associates, but may be waived by Gables Associates, in whole or in part in its sole discretion: 7.2.1 No Default. No breach or default under this Aqreement shall have occurred on the part of Aetna which is continuing and uncured at Closing. 7.2.2 Closing Obligations and Representations. Aetna shall have complied in all respects with the requirements on Aetna's part to be complied with under Article XI hereof, and the representations and warranties of Aetna contained in the certificate to be delivered under Section 11.1 shall be true and correct in all respects as of the Closing Date. ARTICLE VIII Insurance, Casualty, Condemnation 8.1 Fire or Casualty. If the Property or any portion whereof is damaged or destroyed by fire or other casualty prior to the Closing, Aetna shall proceed with the transaction contemplated herein, and Aetna shall be entitled to such insurance as is paid on the claim of loss. 8.2 Condemnation. In the event that all or any portion of the Property becomes the subject of a condemnation proceeding or threat thereof by a public or quasi-public authority having the power of eminent domain prior to the Closing, Gables Associates shall immediately notify Aetna whereof in writing, and Aetna shall proceed with the transaction contemplated herein and shall be entitled to receive all proceeds of any award or payment in lieu thereof resulting from such proceedings or threat thereof. ARTICLE IX Obligations Pending Closing 9.1 Access, Riqht of Inspection and Termination. (a) Aetna, its engineers, appraisers, attorneys and other representatives shall have the right, at Aetna's sole cost, risk and expense, to enter onto the Property during normal business hours on reasonable notice and in a reasonable manner, without interference with the operation of the Property, for the purpose of making such tests and inspections as Aetna deems necessary or appropriate in connection with this Agreement. (b) Gables Associates shall make all of its files and records relating to the operation of the Property available to Aetna for copying, which obligation shall survive the Closing. 9.2 Notice of Changes. Each party shall promptly give written notice to the other of the occurrence of any event materially affecting the substance of the representations made hereunder. ARTICLE X Gables Associates' Closing Obligations 10.1 Deliveries at Closing. At the Closing, Gables Associates shall deliver or cause to be delivered the following documents to the Escrow Agent to be held in escrow pursuant to the terms of the Escrow Aqreement: 10.1.1 an executed and acknowledged Special Warranty Deed in form and substance as appears on Exhibit S transferring fee simple title to the Land and Improvements to Aetna or its designee, subject only to the Permitted Exceptions; Notwithstanding anything to the contrary contained in this Agreement or the exhibits attached hereto, it is the intent of the parties hereto that the transfer of title to the Property from Gables Associates to Aetna shall not act as a merger of title as to any security interests Aetna may currently hold in the Property pursuant to the Loan Documents. 10.1.2 an executed and acknowledged assignment assigning Gables Associates' interest in, among other things, the Service Contracts, Leases, Licenses, warranties and guaranties in form and substance as appears on Exhibit T; 10.1.3 an executed and acknowledged assignment assigning to Aetna all of the Utility Deposits; 10.1.4 an executed and acknowledged Bill of Sale (with warranties of title) transferring to Aetna the Personal Property and any remaining items of Miscellaneous Property not otherwise assigned or conveyed in form and substance as appears on Exhibit U. 10.1.5 an executed and acknowledged satisfaction of mortgage in form satisfactory to the title insurance underwriter from Gables Limited, the holder of a second mortgage and a third mortgage on the Property. 10.2 Lien Waivers. Gables Associates shall deliver to Aetna original lien waivers as well as releases from all contractors, subcontractors and/or materialmen who have not been paid and who have performed work or furnished materials prior to the Closing and/or for work in progress or who have pending liens on the Property. 10.3 Service Contracts. Executed counterparts of all other Service Contracts other than Service Contracts which are permitted to be terminated in accordance with this Agreement or, if Gables Associates is unable to produce the same, a copy of any such Service Contracts certified by Gables Associates to be true, correct and complete. 10.4 Tax Receipts. A receipt or receipts from the appropriate taxing authorities evidencing that all personal and real property taxes affecting the Property which were due and payable have been paid. 10.5 Documents. Original copies of the most recent site plans, surveys, soil and substrata studies, architectural drawings, plans and specifications, graphic boards, schematic plans, renderings, engineering plans and studies, floor plans, landscape plans and other plans or studies of any kind that relate to all or any part of the Property in the possession or control of Gables Associates. Gables Associates shall also deliver (i) original copies of all then effective guaranties and warranties made by any person for the benefit of Gables Associates, with respect to the Property or any of its components, and (ii) originals of all Licenses and Miscellaneous Property, except that photocopies may be substituted if the originals are required to be posted at the Property. 10.6 Licenses. The Licenses, provided that photocopies may be substituted if the originals are required to be posted at the Property. 10.7 Certificate of Article V Representations, Warranties and Covenants. A certificate of Gables Associates updating the representations and warranties contained in Article V hereof. 10.8 Estoppel Certificates. The estoppel certificates or other deliveries described in Sections 7.1.5 and 7.1.7 to the extent not previously delivered. l0.9 Other Documents. Any other document (i) required by this Agreement to be delivered by Gables Associates or (ii) otherwise reasonably necessary to consummate the transaction contemplated hereby and in form reasonably acceptable to Aetna and Aetna's counsel. l0.10 Authority. Evidence of Gables Associates' authority for the execution of this Agreement and the consummation of the transactions contemplated by this Agreement including such evidence as may be reasonably requested by Aetna and Aetna's counsel. l0.11 No Foreign Person. Affidavit, under penalty of perjury, confirming Gables Associates' United States taxpayer identification number is 36-3298386 and stating that Gables Associates is not a foreign person, in a form sufficient to exempt Aetna from the withholding provisions of Section 1445 of the Code. 10.12 Deliveries required by the Title Commitment. Satisfactions, releases or other documents required by Attorneys' Title Insurance Fund, Inc. Title Insurance Commitment bearing File No. 01-93-10244M, in order to delete all of the requirements contained in Schedule B-I. 10.13 Delivery of Leases/Rent Roll. To the extent in Gables Associates' possession, the landlord's original executed counterparts of all Leases and related documents In addition, an executed and acknowledged current rent roll for the Property certified by Gables Associates to be true and correct, including a statement as to the current status of payment for all tenants. 10.14 Rent Records. To the extent in Gables Associates' possession, originals of all rent records (including Lease summaries in the same format as the Lease Summary attached as Exhibit C dated as of the Closing Date), and related documents in the possession or under the control of Gables Associates. 10.15 Letters to Tenants. A sufficient quantity of original letters to tenants under the Leases, contractors under Service Contracts, utilities or others, advising such persons of the transfer of ownership to Aetna and of the address to which further notices and rental payments are to be made. 10.16 Solvency Affidavit. If requested by Aetna, Gables Associates shall provide Aetna with the Solvency Affidavit regarding Gables Associates in the form attached hereto as Exhibit L, or such other affidavit as may be reasonably required by the title insurance underwriter. ARTICLES XI Aetna's Closing Obligations At the Closing, Aetna shall deliver to Gables Associates or as otherwise provided below, or cause to happen: 11.1 Certificate of Aetna's Representations. A certificate of Aetna updating the representations and warranties of Aetna contained in Article VI hereof. 11.2 Aetna's Authority. Evidence of Aetna's authority for the consummation of the transactions contemplated hereunder including evidence of incumbency and such other evidence of authority as may be reasonably requested by Gables Associates. 11.3 Other Documents. All other documents (i) required by this Agreement to be delivered by Aetna, or (ii) otherwise reasonably necessary to consummate the transaction contemplated hereby and in form reasonably satisfactory to Gables Associates and Gables Associates' counsel on, at or before the Closing; provided, however, that any request hereunder shall be made on a timely basis so that Aetna shall have a reasonable period of time to satisfy such request. ARTICLE XII Continuing Obligations 12.1 Sale of Property. After the Closing date, Gables Associates shall continue to attempt to sell the Property for a purchase price of at least $8,000,000.00. Should Gables Associates enter into a contract for sale and purchase on or before April 30, 1993 and close and disburse the proceeds from said sale prior to June 30. 1993, Aetna will release its first mortgage on the Property upon receipt of a sum in the amount of $7,680,000.00 In the event that the purchase price of $8,000,000.00 is increased by a figure up to $100,000.00, then Aetna will release its first mortgage encumbering the Property upon receipt of $7,680,000.00, plus 20% of said increase. In the event that the purchase price is increased above $8,100,000.00 by a figure up to $100,000.00, then Aetna will release its first mortgage encumbering the Property upon receipt of $7,680,000.00, plus 20% of the first $100,000.00 above $8,000,000.00, and 50% of the next $100,000.00 above $8,100,000.00. In the event that the purchase price is increased above $8,200,000.00, then Aetna will release its first mortgage encumbering the Property upon receipt of $7,680,000.00, plus 20% of the first $100,000.00 above $8,000,000.00, 50% of the next $100,000.00 above $8,100,000.00, and any additional monies above $8,200,000.00, unless Aetna, in writing, agrees to another arrangement as to the payment of monies in excess of $8,200,000.00. Gables Associates hereby represents to Aetna that Gables Associates, Carlyle Real Estate Limited Partnership XIII, Gables Corporate Plaza, Ltd., Michael L. Katz, Alberto Socol, and/or any related or affiliated persons, entities or parties (hereinafter collectively referred to as the "Seller") will not be receiving monies or other valuable consideration of any nature in connection with the sale of the Property, including, but not limited to the payoff of the second and/or third mortgages encumbering the Property, real estate brokerage commission(s) or fee(s), participation interest, or contingent interest, in excess of the amount set forth below in connection with the specified purchase price, to wit: (i) Purchase Price of $8,000,000.00 - Seller will not receive monies or other consideration in excess of $320,000.00. (ii) Purchase Price in excess of $8,000,000.00, but less than $8,100,001.00 - Seller will not receive monies or other consideration in excess of $400,000.00. (iii) Purchase Price in excess of $8,100,000.00 - Seller will not receive monies or other consideration in excess of $450,000.00. 12.2 Escrow Agent. The Escrow Agent is hereby instructed, and the Escrow Agreement shall provide that (i) the Escrow Agent shall destroy the documents delivered to it in escrow in the event that Gables Associates sells and closes on the Property pursuant to the provisions of Sections 12.1, or otherwise sells and closes on the Property prior to January 5, 1994 on terms and conditions acceptable to Aetna, in Aetna's sole discretion; and (ii) the Escrow Agent shall release the documents held in escrow to Aetna on January 5, 1994, which may then be filed by Aetna in the Circuit Court of Dade County, Florida, recording in the Public Records of Dade County, Florida, or otherwise held or disbursed by Aetna, as appropriate, in the event that Gables Associates has not sold and closed on the Property pursuant to the provisions of Section 12.1, or otherwise sold and closed on the property prior to January 5, 1994 on terms acceptable to Aetna, in Aetna's sole discretion. 12.3 Further Assurances. After the Closing Date, Gables Associates and Aetna shall cooperate with one another at reasonable times and on reasonable conditions and shall execute and deliver such instruments and documents as may be reasonably necessary in order fully to carry out the intent and purposes of the transactions contemplated hereby. 12.4 Survival. All representations and warranties made by Gables Associates under Article V and made by Aetna under Article VI of this Agreement and in certificates delivered at Closing pursuant to Section 10.7 by Gables Associates and Section 11.1 by Aetna, as well as all other covenants set forth in this Agreement shall survive the Closing until,such time as Aetna acquires title to the Property, excluding the provisions of this Section 12.4, as well as the provisions of Article XIV which shall under all circumstances survive the Closing; provided, however, that Gables Associates and its partners shall have no personal liability for money damages arising out of the inaccuracy or falsity of the above described representations and warranties if Gables Associates o its partners do not take any action after the date of this Agreement to thwart, deter, hinder or delay Aetna or its designee from taking title to the Property, or otherwise frustrate the purpose of this Agreement. Notwithstanding the foregoing, it is the intention and the agreement of the parties hereto that the expiration of the above described representations, warrarnties and covenants then Aetna acquires title to the Property shall not be applicable to or in any way effect the representations, warranties or covenants set forth in the Special Warranty Deed, Bill of Sale, Assignment, Mechanics' Lien Affidavit, Solvency Affidavit, satisfactions for the subordinate mortgages described in Section 10.1.5 or any other affidavit or document required by the title insurance underwriter (the "Real Estate Closing Documents") or the Stipulation and Final Judqment of Foreclosure, and the Stipulation and Joint Motion for Ex Parte Appointment of Receiver. ARTICLE XIII Remedies 13.1 Default 13.1.1 Aetna's Default. In the event Aetna shall fail to perform its obligations hereunder by or on the Closing Date, and all conditions to such performance have then been satisfied, Gables Associates shall have the right to pursue such remedies as are available at law or in equity and to assert Gables Associates' rights under Section 14.5. 13.1.2 Gables Associates' Default or Force Majeure. In the event that Gables Associates shall fail to perform its obligations hereunder by or on the Closing Date, and that all conditions to Gables Associates' performance have been satisfied on the Closing Date, and Aetna is not in default hereunder, Aetna shall have the right to pursue such remedies as are available at law or in equity, including the riqht to bring an action for specific performance to enforce this Agreement and to assert Aetna's rights under Section 14.5, provided, however, notwithstanding anything to the c ontrary in this Agreement or in any "Ancillary Agreement" (i.e., any agreement, stipulation, instrument, pleading, judgment, court order or other document executed or otherwise created in connection herewith, including, but not limited to, the Real Estate Closing Documents), the remedies of Aetna or any other person or entity for a default or breach under this Agreement or under any of the Ancillary Documents shall be limited to Aetna's rights against the Property; and Gables Associates, Carlyle Real Estate Limited Partnership-XIII ("Carlyle") and Gables Limited and the direct or indirect general partners of Carlyle or of Gables Limited shall not have any personal liability under or in connection with this Agreement or any of the Ancillary Documents, except that each of said parties shall have personal liability for monetary damages incurred by Aetna to the extent caused by any respective action taken by such party after the date of this Agreement with the intent to thwart, deter, hinder or delay Aetna or its designee from taking title to the Property notwithstanding the foregoing: (1) in no event shall any direct or indirect partner in Carlyle have any personal liability under or in connection with this Agreement or any Ancillary Document; and (2) in no event shall a negative capital account or any contribution or payment obligation of a direct or indirect partner in Gables Associates (or Carlyle) be deemed to be an asset of Gables Associates (or Carlyle) or otherwise subject to recourse by Aetna for the purpose of satisfying any liability or obligation under the Loan. Documents, this Agreement, or any Ancillary Document. The provisions of this Section 13.1.2 shall survive any termination of this Agreement or the consummation of any of the transactions contemplated hereby, including, but not limited to the delivery of the Ancillary Documents to Aetna pursuant to the Escrow Agreement and the recording Of the Special Warranty Deed in the Public Records of Dade County, Florida. 13.2 Use of Proceeds to Clear Title. All unpaid taxes, assessments, water charges and sewer rents, together with the interest and penalties thereon to the time of the Closing, and all other liens and encumbrances which Gables Associates is obligated to pay and discharge, together with the cost of recording or filing any instruments necessary to discharge such liens and encumbrances of record, shall be paid by Gables Associates at the Closing ARTICLE XIV Miscellaneous Provisions 14.1 Exhibits. Exhibits A through X attached hereto are hereby made a part hereof as fully as if set forth in the text of this Agreement (it being understood that no signatory to this Agreement shall be deemed liable as a result of this Section 14.1 for any agreement attached as an exhibit hereto to which such signatory is not a party). 14.2 Purchasinq Entity; Successors and Assigns. Aetna may assign all of its riqht, title and interest in this Agreement to a wholly owned subsidiary of Aetna. 14.3 Governinq Law. This Agreement shall be governed and construed in accordance with the laws of the State of Florida, without regard to conflict of law principles thereunder. 14.4 Headings. Headings and captions at the beginning of each numbered section of this Agreement are solely for the reference of the parties and are not a part of or affect the interpretation of this Agreement. 14.5 Attorneys' fees. In the event of any litigation arising out of a breach or claimed breach of this Agreement or of the Escrow Agreement, the prevailing party shall be entitled to recover all costs and expenses incurred, including reasonable attorneys' fees. References to "reasonable attorneys' fees" herein shall be deemed to include all such fees in connection with litigation, including any trial or appeal. 14.6 WAIVER OF JURY TRIAL: AETNA AND GABLES ASSOCIATES HEREBY KNOWINGLY, VOLUNTARILY AND INTENTIONALLY WAIVE THE RIGHT ANY ONE OR MORE OF THEM MAY HAVE TO A TRIAL BY JURY IN RESPECT OF ANY LITIGATION BASED HEREON, OR ARISING OUT OF, UNDER OR IN CONNECTION WITH THE LOAN OR ANY AGREEMENT EXECUTED IN CONJUNCTION THEREWITH, OR ANY COURSE OF CONDUCT, COURSE OF DEALING, STATEMENTS (WHETHER VERBAL OR WRITTEN) OR ACTIONS OF ANY PARTY HERETO. THIS PROVISION IS A MATERIAL INDUCEMENT TO AETNA TO ENTER INTO THIS AGREEMENT. 14.7 Counterparts. This Agreement may be executed in two or more counterparts, each of which shall be an original but all of which shall together constitute one and the same agreement. 14.8 Interpretation. This Agreement shall be construed without regard to any presumption or other rule requiring construction against the party causing this Agreement to be drafted. If any words or phrases in this Agreement shall have been stricken out or otherwise eliminated, whether or not any other words or phrases have been added, and initialed by the party against which such words or phrases are construed, this Agreement shall be construed as if the words or phrases so stricken out or otherwise eliminated were never included in this Agreement and no implication or inference shall be drawn from the fact that such words or phrases were so stricken out or otherwise eliminated. If any provision of this Agreement shall not be enforceable or shall be determined by any court to be invalid, all other provisions of this Agreement shall be unaffected thereby and shall remain in full force and effect. All terms and words used in this Agreement, regardless of the number or gender in which they are used, shall be deemed to include any other number and any other gender as the context may require. 14.9 Amendment. This Agreement can be modified or rescinded only by writing expressly referring to this Agreement and signed by all of the parties. 14.10 Notices. Any notice, report, demand or other instrument authorized or required to be given or furnished to either party under this Agreement shall be sent to such party at the address of such party set forth below and mailed registered or certified mail, return receipt requested, or overnight delivery service, postage paid and shall be deemed given on the earliest to occur of (i) receipt therof (ii) the third day after deposit in the United States Postal Service with propoer postage affixed, or (iii) the day following the delivery to such overnight delivery service. The addresses of the parties are as follows: If to Gables Associates: Carlyle Real Estate Limited Partnership - XIII 900 North Michigan Avenue 19th Floor Chicago, Illinois 60611 Attn: Mr. Norman Geller Gables Corporate Plaza, Ltd. 1401 Brickell Avenue Suite 803 Miami, Florida 33131 Attn: Mr. Michael L. Katz with a copy to: Rubin, Baum, Levin, et al. 200 South Biscayne Boulevard Suite 2500 Miami, Florida 33131-2398 Attn: Brian L. Bilzin, Esq. If to Aetna: Aetna Life & Casualty Insurance Company City Place 151 Farmington Avenue Hartford, Connecticut 06156-3419 Attn: Garrett Delehanty, Esq. with a copy to: Steel Hector & Davis 200 South Biscayne Boulevard Suite 4000 Miami, Florida 33131-2398 Attn: Thomas V. Eagan, P.A. Each party may change the address to which any such notice, report, demand or other instrument is to be mailed, by furnishing written notice of such change to the other party. 14.11 Entire Agreement. All understandings and agreements heretofore made between the parties are merged in this Agreement. There are no oral promises, conditions, representations, understandings, interpretations or terms of any kind as conditions or inducements to the execution of this Agreement in effect between the parties. No change or modification of this Agreement shall be valid unless the same is in writing and signed by the parties hereto. No waiver of any of the provisions of this Agreement shall be valid unless the same is in writing and is signed by the party against which it is sought to be enforced and shall be valid only for the particular time and circumstances for which it is obtained. 14.10 Document Evidencing Termination. In the event this Agreement shall be terminated by either party in accordance with the terms hereof, either party shall, at the request of the other, execute and deliver an agreement in form reasonably satisfactory to Gables Associates and Aetna evidencing such termination. The obligations of Gables Associates and Aetna under this Section 14.12 shall survive the termination of this Agreement. 14.13 Time of the Essence. Time is of the essence in the performance by the parties hereto of each and every obligation under this Agreement. 14.14 Confidentiality. The parties hereto acknowledge and agree that the terms and conditions of this Agreement shall be held in confidence by the parties hereto and shall not be disclosed to any party at anytime without the express written consent of the parties hereto. In the event that either party hereto discloses the terms and conditions of this Agreement without the prior written consent of the other party hereto, then the disclosing party shall be held liable for any and all damages suffered by the other party hereto resulting from such disclosure, including, but not limited to court costs and attorneys' fees on the trial court and any appellate levels. 14.15 Liens Unimpaired. The parties hereby agree that the execution of this Agreement will not discharge, interrupt, impair, abate or otherwise modify the priority or validity of any lien or security interest securing payment of the obligations or indebtedness evidenced and secured by any of the Loan Documents. The parties further agree that in all respects, the Note, the Mortgage and all other Loan Documents remain in full force and effect and unabated and Gales Associates hereby reaffirms its obligations under the Loan Documents. At such time as the Third Note and Mortgage Modification Agreement and related Loan Documents are satisfied of record, Aetna will deliver the original and Restated Renewal Note marked "Paid and Cancelled" to Gales Associates. 14.16 No Third Party Beneficiaries. The parties hereto, for themselves and their heirs, personal representatives, successors and assigns agree that there are no third party beneficiaries to this Agreement, any exhibits attached hereto or any document referenced herein. Nothing in this Agreement or in any of the documents references herein or to be executed in connection herewith, whether expressed or implied, is intended to confer any rights or remedies on any persons, entities or associations other than the parties to this Agreement, nor is anything in this Agreement or in any of the documents referenced herein or to be executed in connection herewith intended to relieve or discharge the obligation or liability of any third persons or (except as expressly provided to the contrary herein) any party to this Agreement or any of the documents referenced herein or to be executed in connection herewith which survives the execution of this Settlement Agreement. 14.17 No Admission. The undersigned agree that the actions by the parties hereto do not constitute an admission of liability by any party hereto, and that the payment being made and value being tendered constitutes simply the compromise of doubtful and disputed claims. 14.18 Advice of Counsel. By their execution of this Agreement, or any and all counterparts thereof, each of the parties does hereby expressly acknowledge that they have executed the same freely and voluntarily and they have had advice of counsel of their choice, accountants and financial advisors regarding the effect of the execution and delivery of this Agreement or a counterpart of it and the originals or counterparts of the documents attached hereto as exhibits. It is understood and agreed by the parties hereto that the monetary facts with respect to which this Agreement is made may hereafter prove to be different from the monetary facts now known by the parties hereto or any of them or believed by any of them to be true. Each of the parties hereto expressly accepts and assumes the risk of the monetary facts proven to be so different, and each of the parties hereto agrees that all terms, covenants, and conditions of this Agreement are in all respects effective and not subject to termination or rescission by any such difference in such monetary facts. 14.19 Benefit of Agreement. All of the terms, covenants, conditions, agreements, and undertakings contained in this Agreement and in the exhibits attached hereto have been made by the undersigned solely and exclusively for their benefit, and no other person, corporation or entity shall, under any circumstances, be deemed to be a beneficiary, including an incidental or third party beneficiary, of such terms, covenants, conditions, agreements, and undertakings. 14.20 Effective Date. The effective date of this Settlement Agreement shall be the date this Settlement Agreement has been executed by the last party required to execute this Settlement Agreement or any counterpart thereof (the "Effective Date"). 14.21 Tolling Agreement. In the event that Aetna, in its sole discretion, deems it necessary or desirable to hereafter file an action to collect upon or enforce any of the Loan Documents, Gables Associates expressly agrees to and does hereby waive any right or privilege to object or raise any defense to such an action based, in whole or in part, upon the passage of time, including, without limitation, any statute of limitation or the equitable doctrine of laches, and Gables Associates does hereby further agree not to plead or assert any defense or objection in such action based, in whole or in part, upon the passage of time, including, without limitation, any statute of limitation or the equitable doctrine of laches. Notwithstanding anything to the contrary in this Agreement, the provisions of this paragraph 14.21 shall survive the Closing and any termination of this Agreement and shall remain in full force and effect for a period of seven (7) years from the date of this Agreement. 14.22 Waiver of Bankruptcy Stay. Gables Associates hereby agrees that it shall consent, and shall not oppose, any request by Aetna for relief of stay in the event that it seeks relief under the United States Bankruptcy Code at any time after executing this Agreement. Notwithstanding anything to the contrary in this Agreement, the provisions of this paragraph 14.22 shall survive the Closing and any termination of this Agreement and shall remain in full force and effect for a period of seven (7) years from the date of this Agreement. 14.23 Foreclosure Action. Gables Associates agrees that Aetna may, at any time after April 30, 1993, file its foreclosure action to enforce the Loan Documents against the Property, as well s the Plaintiff's Verified Motion for Appointment of Receiver and Alternatively for Sequestration of Rents attached hereto as Exhibit W and made a part hereof. Gables Associates, Gables Limited and Carlyle Real Estate Limited Partnership - XIII, an Illinois limited partnership hereby designate Brian L. Bilzin, Esquire of the law firm of Rubin, Baum, Levin, et al., 200 South Biscayne Boulevard, Suite 2500, Miami, Florida 33131-2398 as designated and authorized agent to accept service of process and all papers to be filed and served in connection with the above-described foreclosure action, as well as to sign the Stipulation and Joint Motion for Ex Parte Appointment of Receiver, and the Stipulation and Final Judgment of Foreclosure. 14.24 Frustration of Purpose. Gables Associates represents that it will not take any action to thwart, deter, hinder or delay Aetna or its designee from taking title to the Property pursuant to the Special Warranty Deed or otherwise tristrate the purpose of this Agreement. IN WITNESS WHEREOF, the parties have executed this Agreement in multiple original counterparts, each of which shall be deemed to be an original hereof, as of the day and year first written above. Signed, sealed and delivered AETNA LIFE INSURANCE COMPANY in the presence of: a Connecticut corporation S/Marianna Petrocelli By: S/Matilda Alfonso S/ Name: MATILDA ALFONSO Title: VICE PRESIDENT (Corporate Seal) GABLES CORPORATE PLAZA ASSOCIATES, a Florida general partnership Carlyle Real Estate Limited Partnership-XIII, an Illinois limited partnership, general partner By: JMB Realty Corporation, a Delaware corporation, general partner S/Lisa K. McGready By: S/Julie A. Strocchia S/Debra A. Jackson Name: JULIE A. STROCCHIA Title: VICE PRESIDENT Gables Corporate Plaza, Ltd., a Florida limited partnership, general partner S/ By: S/Albert J. Socol Albert J. Socol, general S/ partner S/ By: S/Michael L. Katz Michael L. Katz, general S/ partner GABLES CORPORATE PLAZA, LTD., a Florida limited partnership S/ By: S/Albert J. Socol Albert J. Socol, general S/ partner S/ By: S/Michael L. Katz Michael L. Katz, general S/ partner JDS/4013 Exhibit 21 LIST OF SUBSIDIARIES The Partnership is a partner of Gables Corporate Plaza Associates, a general partnership which holds title to the Gables Corporate Plaza in Coral Gables, Florida. The developer of the property is a partner in the joint venture. The Partnership is a partner of Sherry Lane Associates, a general partnership which holds title to the Sherry Lane Place Office Building in Dallas, Texas. The Partnership is a limited partner of Eastridge Associates Limited Partnership, a limited partnership which holds title to the Eastridge Apartments in Tucson, Arizona. An affiliate of the General Partners of the Partnership is the general partner in the joint venture. The Partnership is a partner of Copley Place Associates, a limited partnership which holds title to Copley Place in Boston, Massachusetts. The developer of the property is a partner in the joint venture. The Partnership is a partner of Carrollwood Station Associates, Ltd., a limited partnership which holds title to the Carrollwood Station Apartments in Tampa, Florida. The developer of the property is a partner in the joint venture. The Partnership is a partner of Jacksonville Cove Associates, Ltd., a limited partnership which holds title to The Glades Apartments in Jacksonville, Florida. The developer of the property is a partner in the joint venture. The Partnership is a 20% shareholder in Carlyle Managers, Inc. and 20% shareholder in Carlyle Investors, Inc. Reference is made to Note 3 for a description of the terms of such joint venture partnerships. The Partnership's interest in the joint ventures and the results of its operations are included in the Consolidated Financial Statements of the Partnership filed with this annual report. POWER OF ATTORNEY KNOW ALL MEN BY THESE PRESENTS, that the undersigned officers and directors of JMB Realty Corporation, the managing general partner of CARLYLE REAL ESTATE LTD. -XIII, do hereby nominate, constitute and appoint GARY NICKELE, GAILEN J. HULL, DENNIS M. QUINN or any of them, attorneys and agents of the undersigned with full power of authority to sign in the name and on behalf of the undersigned officer or directors a Report on Form 10-K of said partnership for the fiscal year ended December 31, 1993, and any and all amendments thereto, hereby ratifying and confirming all that said attorneys and agents and any of them may do by virtue hereof. IN WITNESS WHEREOF, the undersigned have executed this Power of Attorney the 23rd day of March, 1994. JUDD D. MALKIN - ------------------- Chairman and Director Judd D. Malkin NEIL G. BLUHM - ------------------- President and Director Neil G. Bluhm H. RIGEL BARBER - ------------------- Chief Executive Officer H. Rigel Barber JEFFREY R. ROSENTHAL - ----------------------- Chief Financial Officer Jeffrey R. Rosenthal The undersigned hereby acknowledge and accept such power of authority to sign, in the name and on behalf of the above named officer and directors, a Report on Form 10-K of said partnership for the fiscal year ended December 31, 1993, and any and all amendments thereto, the 23rd day of March, 1994. GARY NICKELE ------------ Gary Nickele GAILEN J. HULL --------------- Gailen J. Hull DENNIS M. QUINN --------------- Dennis M. Quinn POWER OF ATTORNEY ----------------- KNOW ALL MEN BY THESE PRESENTS, that the undersigned officer and directors of JMB Realty Corporation, the managing general partner of CARLYLE REAL ESTATE LTD. - XI, do hereby nominate, constitute and appoint GARY NICKELE, GAILEN J. HULL, DENNIS M. QUINN or any of them, attorneys and agents of the undersigned with full power of authority to sign in the name and on behalf of the undersigned officer or directors a Report on Form 10-K of said partnership for the fiscal year ended December 31, 1993, and any and all amendments thereto, hereby ratifying and confirming all that said attorneys and agents and any of them may do by virtue hereof. IN WITNESS WHEREOF, the undersigned have executed this Power of Attorney the 26th day of January, 1994. STUART C. NATHAN _________________________ Executive Vice President and Director of Stuart C. Nathan General Partner A. LEE SACKS _________________________ Director of General Partner A. Lee Sacks The undersigned hereby acknowledge and accept such power of authority to sign, in the name on behalf of the above named officer and directors, a Report on Form 10-K of said partnership for the fiscal year ended December 31, 1993, and any and all amendments thereto, the 26th day of January, 1994. GARY NICKELE ______________________ Gary Nickele GAILEN J. HULL ______________________ Gailen J. Hull DENNIS M. QUINN ___________________________ Dennis M. Quinn

ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS LIQUIDITY AND CAPITAL RESOURCES On June 9, 1983, the Partnership commenced an offering of $260,000,000 of Limited Partnership Interests pursuant to a Registration Statement on Form S-11 under the Securities Act of 1933. On October 7, 1983, the Partnership registered an additional $140,000,000 of Limited Partnership Interests. A total of 366,177.57 Interests were sold to the public at $1,000 per interest (fractional interests are due to the Distribution Reinvestment Program) between June 9, 1983 and May 22, 1984 pursuant to a public offering. After deducting selling expenses and other offering costs, the Partner- ship had approximately $326,000,000 with which to make investments in income-producing commercial and residential real property, to pay legal fees and other costs (including acquisition fees) related to such investments and to satisfy working capital requirements. A portion of the proceeds was utilized to acquire the properties described in Item 1 above. At December 31, 1993, the Partnership and its consolidated ventures had cash and cash equivalents of approximately $5,362,000. Such funds and short- term investments of approximately $23,096,000 are available for distributions to partners, leasing and capital improvement costs and/or operating deficits at Long Beach Plaza and the Plaza Tower Office Building, and for the paydown of the mortgage obligation at the Marshall's Aurora Plaza and for working capital requirements and potential future operating deficits and significant leasing and tenant improvement costs at certain of the Partnership's other investment properties. The Partnership and its consolidated ventures have currently budgeted in 1994 approximately $7,203,000 for tenant improvements and other capital expenditures. The Partnership's share of such items and its share of such similar items for its unconsolidated ventures in 1994 is currently budgeted to be $5,697,000. Actual amounts expended may vary depending on a number of factors including actual leasing activity, results of property operations, liquidity considerations and other market conditions over the course of the year. The source of capital for such items and for both short-term and long-term future liquidity and distributions is expected to be through the net cash generated by the Partnership's investment properties and through the sale or refinancing of such investments. The Partnership's and its ventures' mortgage obligations are generally non-recourse and therefore the Partnership and its ventures generally are not personally obligated to pay such mortgage indebtedness. Many of the Partnership's investment properties currently operate in overbuilt markets which are characterized by lower than normal occupancies and/or reduced rent levels. Such competitive conditions have resulted in the operating deficits described below. Based upon estimated operations of certain of the Partnership's investment properties and on the anticipated requirements of the Partnership to fund its share of potential leasing and capital improvement costs at these properties, the Partnership reduced operating cash distributions to the Limited and General Partners effective as of the third quarter of 1991 and subsequently suspended all distributions effective as of the first quarter of 1992. As described more fully in Note 4, the Partnership has received or is negotiating mortgage note modifications (certain of which have expired and others of which expire at various dates commencing October 1996) on the Sherry Lane Place office building, Glades Apartments, Eastridge Apartments, Long Beach Plaza, Carrollwood Apartments, Marshall's Aurora Plaza and Copley Place multi-use complex. The Partnership had been unsuccessful in its efforts to obtain modifications of the loans secured by the 1001 Fourth Avenue office building, University Park office building and the Gables Corporate Plaza, as further discussed below and in Note 4. The Partnership has not remitted the required debt service payments pursuant to the loan agreements on the Gables Corporate Plaza, Long Beach Plaza, and University Park office building as discussed below. Therefore, at December 31, 1993, the corresponding balances of their respective mortgage notes and related deferred accrued interest thereon have been classified as current liabilities in the accompanying Consolidated Financial Statements (see Note 4(a)). In March 1993, the Partnership sold its interest in the Rio Cancion Apartments and the related mortgage loan was discharged out of the sales proceeds (reference is made to Notes (4)(b)(3) and 7(e)). In April 1993, the Partnership sold its interest in the Greenwood Creek II Apartments and the related mortgage loan was discharged by the lender (reference is made to Note (4)(b)(8) and Note 7(f)). In August 1993, Orchard Associates sold its interest in the Old Orchard shopping center (reference is made to Note 3(d)). In November 1993, the Partnership transferred title to the 1001 Fourth Avenue office Building to the lender and the related mortgage loan was discharged by the lender (reference is made to note 4(b)(4)). In January 1994, the Partnership transferred title to the University Park Office Building to the lender and the related mortgage loan was discharged by the lender (reference is made to note 11(b)). In January 1994, the Partnership through Gables Corporate Plaza Associates transferred title to the Gables Corporate Plaza Office Building to the lender and the related mortgage loan was discharged by the lender (reference is made to note 11(a)). For those investment properties where modifications are being sought, or with expired modifications or short-term modifications, if the Partnership is unable to secure new or additional modifications to the loans, based upon current and anticipated market conditions, the Partnership may decide not to commit any significant additional amounts to any of the properties which are incurring, or in the future do incur, operating deficits. This would result in the Partnership no longer having an ownership interest in such property and would result in gain for financial reporting and Federal income tax purposes to the Partnership with no corresponding distributable proceeds. Such decisions would be made on a property-by-property basis. The underlying indebtedness on certain other of the Partnership's investment properties matures and is due and payable commencing in 1994 and subsequent years (reference is made to Note 4 and to Note 3 of Notes to the Combined Financial Statements). The source of repayment is expected to be from proceeds from sale or refinancing, or extension of such indebtedness. However, there can be no assurance that any such sales, refinancings or extensions will occur. Copley Place Although occupancy at the property increased due to recent leasing activity, the Boston office market remains very competitive due to the large supply of available space and to the prevalence of concessions being offered to attract and retain tenants. Commencing January 1, 1992, cash deficits and funding requirements are allocated equally between the Partnership and the joint venture partner. The joint venture has obtained a modification of the existing first mortgage note effective March 1, 1992. The modification lowered the pay rate from 12% to 9% per annum through August 1993, and at that time, further reduced it to 7-1/2% per annum through August 1998. The contract rate has been lowered to 10% per annum through August 1993 and at that time further reduced to 8-1/2% per annum through August 1998. After each monthly payment, the difference between the contract interest rate on the outstanding principal balance of the loan, including deferred interest, and interest paid at the applicable pay rate (as defined) will be added to the principal balance and will accrue interest at the contract interest rate. The outstanding principal balance, including the unpaid deferred interest, is due and payable on August 31, 1998. In return, the lender will be entitled to receive, as additional interest, a minority residual participation of 10% of net proceeds (as defined) from a sale or refinancing after the Partnership and its joint venture partner have recovered their investments (as defined). Any cash flow from the property, after all capital and leasing expenditures, will be escrowed for the purpose of paying for future capital and leasing requirements. As a result of the debt modification, the property produced cash flow in 1993, which has been escrowed for future potential leasing requirements as set forth in the current loan modification. In 1994, the property is expected to experience a significant loss in rental income in connection with the expiration of the IBM lease (245,339 square feet in April 1994 and 34,093 square feet in October 1994) representing 23% of the leasable office space in the aggregate. Although the structure of the modification of the first mortgage loan took into account the potential downsizing of IBM, it was originally anticipated that IBM would renew approximately 80,000 square feet. However, IBM has notified the joint venture that it intends to renew only 10,000 square feet. Therefore, the property's operations will be insufficient to pay the modified debt service. The joint venture has initiated discussions with the first mortgage lender regarding an additional modification of the loan. There can be no assurances such remodification will be consummated. If the joint venture is unable to secure such remodification, the joint venture may decide not to commit any significant additional amounts to the property. This could result in the joint venture no longer having an ownership interest in the property and would result in a gain for financial reporting and Federal income tax purposes with no corresponding distributable proceeds. The joint venture is aggressively marketing IBM's upcoming vacant space. In addition, the manager, an affiliate of the General Partners, has agreed to defer certain management fees. Orchard Associates On September 2, 1993, effective August 30, 1993, Orchard Associates (in which the Partnership and an affiliated partnership sponsored by the Corporate General Partner each have a 50% interest) sold its interest in the Old Orchard shopping center (reference is made to Note 3(d)). The Partnership is currently retaining its share of the net proceeds from the sale for working capital purposes. JMB/NYC At the 2 Broadway building, occupancy increased slightly to 30% during the fourth quarter 1993, up from 29% in the previous quarter. The Downtown Manhattan office leasing market remains depressed due to the significant supply of, and the relatively weak demand for, tenant space. As previously reported, Merrill Lynch, Pierce, Fenner & Smith, Incorporated's lease of approximately 497,000 square feet of space (31% of the building's total space) expired in August 1993. A majority of the remaining tenant roster at the property includes several major financial services companies whose leases expire in 1994. Most of these companies maintain back office support operations in the building which can be easily consolidated or moved. The Bear Stearns Co.'s lease of approximately 186,000 square feet of space (12% of the building's total space), which expires in April 1994, is not expected to be renewed. In addition to the competition for tenants in the Downtown Manhattan market from other buildings in the area, there is ever increasing competition from less expensive alternatives to Manhattan, such as locations in New Jersey and Brooklyn, which are also experiencing high vacancy levels. Rental rates in the Downtown market continue to be at depressed levels and this can be expected to continue while the large amount of vacant space is gradually absorbed. Little, if any, new construction is planned for Downtown over the next few years. It is expected that 2 Broadway will continue to be adversely affected by a high vacancy rate and the low effective rental rates achieved upon releasing of space under existing leases which expire over the next few years. In addition, the property is in need of a major renovation in order to compete in the office leasing market. However, there are currently no plans for a renovation because of the potential sale of the property discussed below and because the effective rents that could be obtained under current market conditions may not be sufficient to justify the costs of the renovation. Occupancy at 1290 Avenue of the Americas increased to 98%, up from 95% in the previous quarter primarily due to Prudential Bache Securities, Inc. occupying 25,158 square feet. The Midtown Manhattan office leasing market remains very competitive. It is expected that the property will continue to be adversely affected by low effective rental rates achieved upon releasing of space covered by existing leases which expire over the next couple years and may be adversely affected by an increased vacancy rate over the next few years. Negotiations are currently being conducted with certain tenants who in the aggregate occupy in excess of 300,000 square feet for the renewal of their leases that expire in 1994 and 1995. John Blair & Co., ("Blair") a major lessee at 1290 Avenue of the Americas (leased space approximates 253,000 square feet or 13% of the building), has filed for Chapter XI bankruptcy. Because much of the Blair space is subleased, the 1290 venture is collecting approximately 70% of the monthly rent due under the leases from the subtenants. There is uncertainty regarding the collection of the balance of the monthly rents from Blair. Accordingly, a provision for doubtful accounts related to the rent and other receivables and accrued rents receivable aggregating $7,659,366 has been recorded at December 31, 1993 in the accompanying combined financial statements related to this tenant. Occupancy at 237 Park Avenue decreased slightly to 98% in the fourth quarter 1993, down from 99% in the previous quarter. It is expected that the property will be adversely affected by the low effective rental rates achieved upon releasing of existing leases which expire over the next few years and may be adversely affected by an increased vacancy rate over the next few years. JMB/NYC has had a dispute with the unaffiliated venture partners who are affiliates (hereinafter sometimes referred to as the "Olympia & York affiliates") of Olympia and York Developments, Ltd. (hereinafter sometimes referred to as "O & Y") over the calculation of the effective interest rate with reference to the first mortgage loan, which covers all three properties, for the purpose of determining JMB/NYC's deficit funding obligation commencing in 1992, as described more fully in Note 3(c). Under JMB/NYC's interpretation of the calculation of the effective rate of interest, 2 Broadway operated at a deficit for the year ended December 31, 1993. During the first quarter of 1993, an agreement was reached between JMB/NYC and the Olympia & York affiliates which rescinded the default notices previously received by JMB/NYC and eliminated any alleged operating deficit funding obligation of JMB/NYC for the period January 1, 1992 through June 30, 1993. Accordingly, during this period, JMB/NYC recorded interest expense at 1-3/4% over the short-term U.S. Treasury obligation rate (subject to a minimum rate of 7% per annum), which is the interest rate on the underlying first mortgage loan. Under the terms of this agreement, during this period, the amount of capital contributions that the Olympia & York affiliates and JMB/NYC would have been required to make to the Joint Ventures, as if the first mortgage loan bore interest at a rate of 12.75% per annum (the Olympia & York affiliates' interpretation), became a priority distribution level to the Olympia & York affiliates from the Joint Ventures' annual cash flow or net sale or refinancing proceeds. The agreement also entitles the Olympia & York affiliates to a 7% per annum return on such unpaid priority distribution level amount. It was also agreed that during this period, the excess available operating cash flow after the payment of the priority distribution level discussed above from any of the Three Joint Ventures will be advanced in the form of loans to pay operating deficits and/or unpaid priority distribution level amounts of any of the other Three Joint Ventures. Such loans will bear a market rate of interest, have a final maturity of ten years from the date when made and will be repayable only out of first available annual cash flow or net sale or refinancing proceeds. The agreement also provides that except as specifically agreed otherwise, the parties each reserves all rights and claims with respect to each of the Three Joint Ventures and each of the partners thereof, including, without limitation, the interpretation of or rights under each of the joint venture partnership agreements for the Three Joint Ventures. The agreement expired on June 30, 1993. Therefore, effective July 1, 1993, JMB/NYC is recording interest expense at 1-3/4% over the short-term U.S. Treasury obligation rate plus any excess operating cash flow after capital costs of the Three Joint Ventures, such sum not to be less than 7% nor exceed a 12-3/4% per annum interest rate. The Olympia & York affiliates dispute this calculation and contend that the 12-3/4% per annum fixed rate applies. JMB/NYC continues to seek, among other things, a restructuring of the joint venture agreements or otherwise to reach an acceptable understanding regarding its long-term funding obligations. If JMB/NYC is unable to achieve this, based upon current and anticipated market conditions mentioned above, JMB/NYC may decide not to commit any additional amounts to 2 Broadway and 1290 Avenue of the Americas, which could, under certain circumstances, result in the loss of the interest in the related ventures. The loss of an interest in a particular venture could, under certain circumstances, permit an acceleration of the maturity of the related Purchase Note (each Purchase Note is secured by JMB/NYC's interest in the related venture). The failure to repay a Purchase Note could, under certain circumstances, constitute a default that would permit an immediate acceleration of the maturity of the Purchase Notes for the other ventures. In such event, JMB/NYC may decide not to repay, or may not have sufficient funds to repay, any of the Purchase Notes and accrued interest thereon. This could result in JMB/NYC no longer having an interest in any of the related ventures, which in that event would result in substantial net gain for financial reporting and Federal income tax purposes to JMB/NYC (and through JMB/NYC and the Partnership, to the Limited Partners) with no distributable proceeds. In addition, under certain circumstances as more fully discussed in Note 3(c), JMB/NYC may be required to make additional capital contributions to certain of the Joint Ventures in order to fund the deficit restoration obligation associated with a deficit balance in its capital account, and the Partnership could be required to bear a share of such capital contributions obligation. If JMB/NYC is successful in its negotiations to restructure the Three Joint Ventures agreements and retains an interest in one or more of these investment properties, there would nevertheless need to be a significant improvement in current market and property operating conditions (including a major renovation of the 2 Broadway building) resulting in a significant increase in value of the properties before JMB/NYC would receive any share of future net sale or refinancing proceeds. The Joint Ventures that own the 2 Broadway building and land have no plans for a renovation of the property because of the potential sale of the property discussed below and because the effective rents that could be obtained under the current office market conditions may not be sufficient to justify the costs of the renovation. Given the current market and property operating conditions, it is likely that the property would sell at a price significantly lower than the allocated portion of the underlying debt. The first mortgage lender and JMB/NYC would need to approve any sale of this property. The O&Y affiliates have informed JMB/NYC that they have now received a written proposal for the sale of 2 Broadway for a net purchase price of $15 million. The first mortgage lender has preliminarily agreed to the concept of a sale of the building but has not approved the terms of any proposed offer for purchase. Accordingly, a sale pursuant to the proposal received by the O&Y affiliates would be subject to, among other things, the approval of the first mortgage lender as well as JMB/NYC. While there can be no assurance that a sale would occur pursuant to such proposal or any other proposal, if this proposal were to be accepted by or consented to by all required parties and the sale completed pursuant thereto, and if discussions with the O&Y affiliates relating to the proposal were finalized to allocate the unpaid first mortgage indebtedness currently allocated to 2 Broadway to 237 Park and 1290 Avenue of the Americas after completion of the sale, then the 2 Broadway Joint Ventures would incur a significant loss for financial reporting purposes. Accordingly, a provision for value impairment has been recorded for financial reporting purposes for $192,627,560, net of the non-recourse portion of the Purchase Notes including related accrued interest related to the 2 Broadway Joint Venture interests that are payable by JMB/NYC to the O&Y affiliates in the amount of $46,646,810. The provision for value impairment has been allocated $136,534,366 and $56,093,194 to the O&Y affiliates and JMB/NYC, respectively. Such provision has been allocated to the partners to reflect their respective ownership percentages before the effect of the non- recourse promissory notes including related accrued interest. The provision for value impairment is not a loss recognizable for Federal income tax purposes. There are certain risks and uncertainties associated with the Partnership's investments made through joint ventures, including the possibility that the Partnership's joint venture partners might become unable or unwilling to fulfill their financial or other obligations, or that such joint venture partners may have economic or business interests or goals that are inconsistent with those of the Partnership. O & Y and certain of its affiliates have been involved in bankruptcy proceedings in the United States and Canada and similar proceedings in England. The Olympia & York affiliates have not been directly involved in these proceedings. During the quarter ended March 31, 1993, O & Y emerged from bankruptcy protection in the Canadian proceedings. In addition, a reorganization of the company's United States operations has been completed, and affiliates of O & Y are in the process of renegotiating or restructuring a number of loans affecting various properties in the United States in which they have an interest. The Partnership is unable to assess and cannot presently determine to what extent these events may adversely affect the willingness and ability of the Olympia & York affiliates either to meet their own obligations to the Joint Ventures and JMB/NYC or otherwise reach an understanding with JMB/NYC regarding any funding obligation of JMB/NYC. However, the financial difficulties of O&Y and its affiliates may be adversely affecting the Three Joint Ventures' efforts to restructure the mortgage loan and to re-lease vacant space in the building. During the fourth quarter of 1992, the Joint Ventures received a notice from the first mortgage lender alleging a default for failure to meet certain reporting requirements of the Olympia & York affiliates contained in the first mortgage loan documents. No monetary default has been alleged. The Olympia & York affiliates have responded to the lender that the Joint Ventures are not in default. JMB/NYC is unable to determine if the Joint Ventures are in default. Accordingly, the balance of the first mortgage loan has been classified as a current liability in the accompanying combined financial statements at December 31, 1992 and 1993. There have not been any further notices from the first mortgage lender. However, the Olympia & York affiliates, on behalf of the Three Joint Ventures, continue to negotiate with representatives of the lender (consisting of a steering committee of holders of notes evidencing the mortgage loan) to restructure certain terms of the existing mortgage loan in order to provide for, among other things, a fixed rate of interest on the loan during the remaining loan term until maturity. In conjunction with the negotiations, the Olympia & York affiliates reached an agreement with the first mortgage lender whereby effective January 1, 1993, the Olympia & York affiliates are limited to taking distributions of $250,000 on a monthly basis from the Three Joint Ventures reserving the remaining excess cash flow in a separate interest-bearing account to be used exclusively to meet the obligations of the Three Joint Ventures as approved by the lender. There is no assurance that a restructuring of the loan will be obtained. Interest on the first mortgage loan is calculated based upon a variable rate related to the short-term U.S. Treasury obligation rate, subject to a minimum rate on the loan of 7% per annum. A significant increase in the short-term U.S. Treasury obligation rate could result in increased interest payable on the first mortgage loan by the Three Joint Ventures. Long Beach Plaza In March 1993, the Partnership completed a settlement of its litigation with Australian Ventures, Inc. ("AVI") involving a long-term ground and improvement lease for approximately 144,000 square feet at the shopping center. Under the terms of the settlement, AVI paid the Partnership $550,000, and the parties terminated the ground and improvement lease. In addition, both parties dismissed their respective claims in the lawsuit with prejudice. The Partnership has paid the $550,000 received from AVI to the mortgage lender for the property as scheduled debt service due for April and part of May 1993 on the loan secured by the property. The Partnership is seeking a replacement tenant for the vacated space. In January 1994, the Partnership received an offer to lease approximately 27,200 square feet of the first floor of the vacated Buffum's building from Ross Dress for Less. In addition, Gold's Gym has offered to lease approximately 34,000 square feet of the third floor of the vacated Buffum's building and relocate from their current 9,813 square foot space on Pine Avenue. The Partnership has several prospects for the smaller Gold's Gym space. There can be no assurance these leases will be consummated. The Partnership had discussions with several other tenants regarding their requests for temporary rent relief of approximately $500,000 in the aggregate in 1992. The tenants indicated that, due to the poor sales levels of their stores at the mall, such relief was necessary if they were to continue to operate. After review of those tenants requesting relief, the Partnership decided to grant temporary relief (approximately 50% of their minimum rent) to certain tenants through December 31, 1992. The Partnership had re-evaluated each tenant's sales level and financial situation for 1993. Based on discussions with the tenants, additional relief was granted for 1993 and the tenants may be granted additional relief in 1994. As a result of the foregoing, the Partnership has initiated discussions with the first mortgage lender regarding a modification of its mortgage loan secured by the property. Due to declining retail sales at the center along with one of the center's anchor tenants vacating its space in 1991, the Partnership has not remitted all of the scheduled debt service payments since June 1993. There can be no assurance that such modification will be consummated (reference is made to Note 4(b)(13)). Greenwood Creek II On April 6, 1993, the Partnership transferred title to the Greenwood Creek II Apartments to the lender for a transfer price of $100,000 (before selling costs and prorations) in excess of the existing mortgage balance. The Partnership recognized a gain in 1993 for financial reporting purposes and recognized a gain for Federal income tax purposes in 1993. Reference is made to Note 7(f). University Park University Park office building's major tenant, California Vision Services, vacated its space of 70,697 square feet (59% of the building) upon the expiration of its lease in April 1993. The tenant's anticipated space requirements over the next several years were expected to grow over 200,000 square feet which the property is unable to accommodate. The Partnership had actively marketed the vacated space. As a result of Cal-Vision's move out, the Partnership was unable to remit the full debt service payment and has submitted cash flow from the property for April through November, 1993. In addition, the Partnership's discussions with the first mortgage lender to further modify the note had been unsuccessful. The Partnership transferred title to the property to the lender in January 1994. Given the current vacancy level of the building and the current and projected market conditions, the likelihood of recovering any additional cash investment necessary to retain ownership of the building would have been remote. This has resulted in the Partnership no longer having an ownership interest in the property and will result in net gain for financial reporting and Federal income tax purposes to the Partnership in 1994 with no corresponding distributable proceeds (reference is made to Note 4(b)(6)). Rio Cancion On March 31, 1993, the Partnership sold the Rio Cancion Apartments. The mortgage loan was satisfied in full from the sales proceeds (reference is made to Note 7(e)). Carrollwood In September 1993, the venture refinanced the mortgage loan, secured by the property, with a third party lender (reference is made to Note 4(b)(11)). The venture did not receive any significant proceeds upon refinancing. 1001 Fourth Avenue In recent years, the Seattle, Washington office market has been very competitive due to significant overbuilding, especially in the Central Business District where 1001 Fourth Avenue Plaza is located. Current vacancy rates exceed 15%, and rental rates remain significantly depressed. In addition, a substantial amount of sublease space had become available in the immediate downtown area. Given the current and projected market conditions, the likelihood of recovering the additional cash investment necessary to fund anticipated operating deficits would for 1001 Fourth Avenue Plaza have been remote. As discussed more fully in Note 1, the Partnership recorded, as a matter of prudent accounting practice, a provision at June 30, 1992, for value impairment to reduce the net carrying value of the 1001 Fourth Avenue Plaza office building to the then outstanding balance of the related non-recourse financing due to the uncertainty of the Partnership's ability to recover the net carrying value of the investment property through future operations or sale. In addition, certain disputes had arisen between the Partnership and the lender regarding a $2,000,000 letter of credit maintained by the Partnership as additional security for the lender in connection with the existing loan modification. As a result of defaults alleged by the lender, the lender attempted to draw on the $2,000,000 letter of credit prior to its expiration in November 1992. The Partnership obtained a temporary restraining order from the Supreme Court of the State of New York disallowing the lender from drawing on the letter of credit in consideration for the Partnership renewing the letter of credit for a period of ninety days to allow the parties to attempt to resolve their differences. In February 1993, the Partnership extended the letter of credit for an additional sixty days in an attempt to resolve the disputes with the lender. Subsequently, in March 1993, the temporary restraining order expired. The Supreme Court of the State of New York agreed to extend the temporary restraining order providing the Partnership post a $2,000,000 bond by April 1, 1993. The Partnership posted a $2,000,000 bond on April 1, 1993. The lender appealed this entire order. On April 29, 1993, the Partnership was notified by the Supreme Court of the State of New York that a decision was rendered in favor of the Partnership regarding the disputes surrounding the letter of credit. In late June 1993 an order was entered by the court reflecting said decision. The lender notified the Partnership that it had intended to appeal the order. As a result, the lender claimed that the release of the bond and the return of the letter of credit had been stayed pending the appeal. Negotiations with the lender for a loan modification have been unsuccessful. On November 1, 1993, the Partnership transferred title to the 1001 Fourth Avenue Plaza office building in full satisfaction of the Partnership's mortgage obligation (which had an outstanding balance, including accrued interest, of approximately $102,607,000). In exchange for the transfer of title, the lender had agreed to settle its litigation against the Partnership and return the Partnership's bond and letter of credit. This transfer has resulted in the Partnership no longer having an ownership interest in the property. Reference is made to Note 4(b)(4). Eastridge Apartments The Partnership reached an agreement with the lender for another modification effective May 1, 1993 on the mortgage loan secured by the property. Reference is made to Note 4(b)(5) for a description of the loan modification. Sherry Lane Place The Partnership reached an agreement with the lender for another modification effective November 1993 on the mortgage loan secured by the property. Reference is made to Note 4(b)(1) for a description of the loan modification. Marshall's Aurora Plaza In January 1994, the Partnership reached an agreement with the lender for a loan modification and extension on the mortgage loan secured by the property effective November 1993. Reference is made to Note 4(b)(12) for a description of the loan modification. Gables Corporate Plaza In January 1994, the venture transferred title to the property to the lender. Therefore, neither the venture nor the Partnership have an ownership interest in the property. This transfer will result in net gain for financial reporting and Federal income tax purposes in 1994 with no corresponding distributable proceeds. Reference is made to Note 4(b)(7) and 11(a). Plaza Tower The first mortgage loan secured by the property matures in November 1994. The property produced cash flow in 1993 and is expected to operate at or near the break even level in 1994. This is due primarily to anticipated leasing costs associated with the rollover in tenant leases in 1994 and 1995. Currently, the Partnership is exploring its refinancing possibilities. However, there can be no assurance that the Partnership will be able to refinance the mortgage loan or obtain a loan extension. General An affiliate of the General Partners that acts as the property manager at a number of the Partnership's investment properties has deferred receipt of its property management and leasing fees. The cumulative amount of deferred property management and leasing fees at December 31, 1993 was approximately $13,671,000 (approximately $37 per $1,000 Interest). The amounts do not bear interest and are payable in the future. A number of the Partnership's investments have been made through joint venture investments. There are certain risks associated with the Partnership's investments made through joint ventures including the possibility that the Partnership's joint venture partners might become unable or unwilling to fulfill their financial or other obligations or, that such joint venture partners may have economic or business interests or goals that are inconsistent with those of the Partnership. Due to the market conditions and property specific factors discussed above and the general lack of buyers of real estate today, it is likely that the Partnership may hold some of its investment properties longer than originally anticipated in order to maximize the recovery of its investments and any potential return thereon. However, in light of the current severely depressed real estate markets, it currently appears that the Partnership's goal of capital appreciation will not be achieved. Although the Partnership expects to distribute from sale proceeds some portion of the Limited Partners' original capital, without a dramatic improvement in market conditions, the Limited Partners will not receive a full return of their original investment. RESULTS OF OPERATIONS The increase in cash and cash equivalents and short-term investments at December 31, 1993 as compared to December 31, 1992 is due primarily to the distributions of $16,978,465 from Orchard Associates as a result of its redemption (sale) of its interest in Old Orchard shopping center as more fully described in Note 3(d). In addition, the increase in cash is due to cash flow generated from property operations at the Copley Place multi-use complex being reserved to fund budgeted capital improvements pursuant to the loan modification agreement as more fully described in Note 4(b)(10) and the receipt of sales proceeds from the sales of the Rio Cancion Apartments in March 1993 and the Greenwood Creek II Apartments in April 1993. Reference is made to Notes 7(e) and 7(f). The decrease in restricted funds at December 31, 1993 as compared to December 31, 1992 is due primarily to the Partnership being released from its letter of credit obligation as a result of the transfer of title to the 1001 Fourth Avenue office building as more fully described in Note 4(b)(4). The increase in escrow deposits and accrued real estate taxes at December 31, 1993 as compared to December 31, 1992 is due primarily to the timing of real estate tax payments at certain of the Partnership's investment properties. The decrease in investment in unconsolidated venture at equity at December 31, 1993 as compared to December 31, 1992 is due primarily to the distributions of $16,978,465 from Orchard Associates as a result of its redemption of interest in Old Orchard Shopping Center. In addition, the decrease was partially offset by the Partnership's share of gain on sale of interest in unconsolidated venture of $7,898,727 as a result of the above event (Note 3(d)). Also, the decrease was partially offset by the $1,200,400 investment, which represents the Partnership's paid-in capital obligation, in Carlyle Investors, Inc. (the general partner of Carlyle-XIII Associates, L.P.) and Carlyle Managers, Inc. (the general partner of JMB Office Building Associates, L.P.) of which the Partnership is a 20% shareholder (see Note 3(c)). The corresponding increase in amounts due affiliates is primarily the result of the above stated obligation. The increase in venture partners' subordinated equity in ventures at December 31, 1993 as compared to December 31, 1992 and the corresponding decrease in venture partners' share of loss from ventures operations for the twelve months ended December 31, 1993 as compared to the twelve months ended December 31, 1992 and 1991 is due primarily to the decrease in operating losses which resulted from the lower accrual rate on the loan modification as well as higher occupancy at the Copley Place multi-use complex. The increase in rents and other receivables at December 31, 1993 as compared to December 31, 1992 is due primarily to the timing of escalations from tenants relating to 1993 at certain of the partnership investment properties. The decreases in prepaid expenses, land and leasehold interests, building and improvements, accumulated depreciation, deferred expenses, accrued rents receivable, current portion of long term debt, unearned rents, tenant security deposits and long term debt at December 31, 1993 as compared to December 31, 1992 and the related decreases in rental income, mortgage and other interests, depreciation property operating expenses and general and administrative expenses and the increase in amortization for the year ended December 31, 1993 as compared to the year ended December 31, 1992 are due primarily to the transfer of title to the 1001 Fourth Avenue office building in November 1993 (reference is made to Note 4(b)(4) and the sales of the Rio Cancion Apartments in March 1993 and the Greenwood Creek II Apartments in April 1993 (reference is made to Notes 7(e) and 7(f)). The decrease in rental income, mortgage and other interest, depreciation, and general and administrative expenses for the twelve months ended December 31, 1992 as compared to the twelve months ended December 31, 1991 is due primarily to the sales of Quail Place and Heritage Park II Apartments in March 1992 and Bridgeport Apartments in April 1992 (as more fully discussed in Note 7). The decrease in interest income for the year ended December 31, 1993 as compared to the year ended December 31, 1992 and 1991 is due primarily to lower yields and lower average balances held in interest bearing U.S. government obligations in the subsequent periods. The increase in property operating expenses for the year ended December 31, 1992 as compared to the year ended December 31, 1991 is primarily due to increased repairs and maintenance and utilities expense during 1992 at the Copley Place multi-use complex. The increase is partially offset by the sales of the Quail Place and Heritage Park II Apartments in March 1992 and Bridgeport Apartments in April 1992 (as more fully discussed in Note 7). The increase in professional services for the year ended December 31, 1992 as compared to the year ended December 31, 1991 is primarily attributable to legal fees associated with the litigation involving the Long Beach Plaza. The increase in amortization of deferred expenses for the year ended December 31, 1992 as compared to the year ended December 31, 1991 is due to increased leasing commissions recorded and amortized at certain of the investment properties during 1992. The provision for value impairment of $6,409,039 at December 31, 1992 is due primarily to the reduction of the net carrying value of the 1001 Fourth Avenue office building as of June 30, 1992. (See Note 1.) The increase in the Partnership's share of the loss from operations of unconsolidated ventures and the related increase in the Partnership's deficit investment in unconsolidated venture for the year ended December 31, 1993 as compared to the year ended December 31, 1992 is due primarily to (i) a $192,627,560 provision for value impairment recorded in 1993 for 2 Broadway due to the potential sale of the property at a sales price significantly below its net carrying value, as more fully discussed above, (ii) an $11,946,285 provision for doubtful accounts recorded by JMB/NYC due to the uncertainty of collectibility of amounts due from the Olympia & York affiliates to the Three Joint Ventures, (iii) an $11,551,049 provision for doubtful accounts recorded by JMB/NYC due to the uncertainty of collectibility of amounts due from tenants at the Three Joint Ventures' real estate investment properties, and (iv) increased aggregate interest accrued with reference to the Three Joint Ventures' mortgage loan commencing July 1, 1993 as a result of the expiration of the agreement with the Olympia & York affiliates, as more fully discussed in Note 3(c). The decrease in the Partnership's share of loss of operations of unconsolidated ventures for the year ended December 31, 1992 as compared to the year ended December 31, 1991 is primarily due to (i) the change in profit and loss allocation from 1991 to 1992 pursuant to the Three Joint Ventures' agreements, as more fully described in Note 3(c) of Notes to Financial Statements, (ii) the collection in 1992 of $6,069,444 of a total $13,340,601 bankruptcy claim against Drexel Burnham Lambert, a former tenant of the 2 Broadway Building, and (iii) the reduced aggregate interest accrued on the joint ventures' mortgage loan commencing in 1992 based upon the interest accrual determined by JMB/NYC, as more fully described above. The net gain of $11,083,791 consists of a gain on the sale of the Rio Cancion Apartments of $2,524,958 (see Note 7(e)), a gain on the sale of the Greenwood Creek II Apartments of $1,787,073 (see Note 7(f)), a gain on the transfer of title to the 1001 Fourth Avenue office building of $6,771,760 (see Note 4(b)(4)). The extraordinary item is the Partnership's share of prepayment penalty of $141,776 relating to the refinancing of the original mortgage note at the Carrollwood Apartments (see Note 4(b)(11)). The net gain on sale in 1992 of $9,422,815 related to the sales of the Quail Place and Heritage Park II Apartments in March 1992, and Bridgeport Apartments in April 1992 has been reflected as a gain on sales of $2,132,879, and an extraordinary gain of forgiveness of indebtedness of $7,289,936 (as more fully discussed in Note 7). In addition, the extraordinary item includes the Partnership's share of the prepayment penalty (of $150,000) related to the refinancing of the original mortgage note at the Glades Apartments (as more fully discussed in Note 4(b)(2)). INFLATION Due to the decrease in the level of inflation in recent years, inflation generally has not had a material effect on rental income or property operating expenses. To the extent that inflation does have an adverse impact on property operating expenses, the increased expense may be offset by amounts recovered from tenants, as many long-term leases at the Partnership's commercial properties have escalation clauses covering increases in the cost of operating and maintaining the properties as well as real estate taxes. Therefore, the effect on operating earnings generally will depend upon whether properties remain substantially occupied. In addition, substantially all of the leases - at the Partnership's shopping center investments contain provisions which entitle the property owner to participate in gross receipts of tenants above fixed minimum amounts. Future inflation may also tend to cause capital appreciation of the Partnership's investment properties over a period of time as rental rates and replacement costs of properties increase. ITEM 8.

ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA CARLYLE REAL ESTATE LIMITED PARTNERSHIP - XIII (A LIMITED PARTNERSHIP) AND CONSOLIDATED VENTURES INDEX Independent Auditors' Report Consolidated Balance Sheets, December 31, 1993 and 1992 Consolidated Statements of Operations, years ended December 31, 1993, 1992 and 1991 Consolidated Statements of Partners' Capital Accounts (Deficits), years ended December 31, 1993, 1992 and 1991 Consolidated Statements of Cash Flows, years ended December 31, 1993, 1992 and 1991 Notes to Consolidated Financial Statements SCHEDULE -------- Supplementary Income Statement Information X Consolidated Real Estate and Accumulated Depreciation XI SCHEDULES NOT FILED: All schedules other than those indicated in the index have been omitted as the required information is inapplicable or the information is presented in the consolidated financial statements or related notes. JMB/NYC OFFICE BUILDING ASSOCIATES AND UNCONSOLIDATED VENTURES INDEX Independent Auditors' Report Combined Balance Sheets, December 31, 1993 and 1992 Combined Statements of Operations, years ended December 31, 1993, 1992 and 1991 Combined Statements of Partners' Capital Accounts (Deficit), years ended December 31, 1993, 1992 and 1991 Combined Statements of Cash Flows, years ended December 31, 1993, 1992 and 1991 Notes to Combined Financial Statements SCHEDULE -------- Supplementary Income Statement Information X Combined Real Estate and Accumulated Depreciation XI SCHEDULES NOT FILED: All schedules other than those indicated in the index have been omitted as the required information is inapplicable or the information is presented in the combined financial statements or related notes. INDEPENDENT AUDITORS' REPORT The Partners CARLYLE REAL ESTATE LIMITED PARTNERSHIP - XIII: We have audited the consolidated financial statements of Carlyle Real Estate Limited Partnership - XIII, a limited partnership, (the Partnership), and consolidated ventures as listed in the accompanying index. In connection with our audits of the consolidated financial statements, we also have audited the financial statement schedules as listed in the accompanying index. These consolidated financial statements and financial statement schedules are the responsibility of the General Partners of the Partnership. Our responsibility is to express an opinion on these consolidated financial statements and financial statement schedules based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by the General Partners of the Partnership, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of the Partnership and consolidated ventures at December 31, 1993 and 1992, and the results of their operations and their cash flows for each of the years in the three-year period ended December 31, 1993, in conformity with generally accepted accounting principles. Also in our opinion, the related financial statement schedules, when considered in relation to the basic consolidated financial statements taken as a whole, present fairly, in all material respects, the information set forth therein. As discussed in Note 3(c) to the consolidated financial statements, the Partnership and its affiliated partners in JMB/NYC Office Building Associates, L.P. (JMB/NYC) are in dispute with the unaffiliated partners in the real estate ventures over the calculation of the effective interest rate with reference to the first mortgage loan which covers all the real estate owned through JMB/NYC's joint ventures. The Partnership and its affiliated partners in JMB/NYC believe that, for purposes of calculating cash flow deficits and for financial reporting purposes, the joint venture agreements for JMB/NYC's real estate joint ventures require interest to be computed at an effective rate of 1-3/4% over the short-term U.S. Treasury obligation rate (subject to a minimum rate of 7% per annum) plus any excess monthly Net Cash Flow of the real estate owned through JMB/NYC's joint ventures, such sum not to exceed 12- 3/4% per annum. The unaffiliated partners in the real estate joint ventures contend that a 12-3/4% per annum interest rate applies. The Partnership's share of disputed interest aggregated $2,386,000 at December 31, 1993. The ultimate outcome of the dispute cannot presently be determined. Accordingly, the Partnership's share of the disputed interest has not been included in the Partnership's share of operations of unconsolidated ventures for 1993. In (Continued) addition, as described in Notes 3 and 4 of the notes to the consolidated financial statements, the Partnership is in dispute or negotiations with various lenders and venture partners in connection with certain of its investment properties. Such disputes or negotiations could result, under certain circumstances, in the Partnership no longer having an ownership interest in these investment properties. The ultimate outcome of these disputes or negotiations cannot be presently determined. The consolidated financial statements do not include any adjustments that might result from these uncertainties. KPMG PEAT MARWICK Chicago, Illinois March 28, 1994 CARLYLE REAL ESTATE LIMITED PARTNERSHIP - XIII (A LIMITED PARTNERSHIP) AND CONSOLIDATED VENTURES CONSOLIDATED BALANCE SHEETS DECEMBER 31, 1993 AND 1992 ASSETS 1993 1992 ------------ ----------- Current assets: Cash and cash equivalents (note 1) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 5,362,152 2,627,520 Short-term investments (note 1). . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 23,095,901 4,624,942 Restricted funds . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 538,800 2,857,906 Rents and other receivables. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,711,359 3,280,727 Prepaid expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 397,109 498,106 Escrow deposits. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,918,882 3,284,294 ------------ ------------ Total current assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 37,024,203 17,173,495 Investment properties, at cost (notes 2, 3 and 4) - Schedule XI: Land and leasehold interests . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 27,002,062 39,324,545 Buildings and improvements . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 447,201,128 588,491,034 ------------ ------------ 474,203,190 627,815,579 Less accumulated depreciation. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 149,914,951 178,425,639 ------------ ------------ Total investment properties, net of accumulated depreciation . . . . . . . . . . . . . . . . 324,288,239 449,389,940 ------------ ------------ Investment in unconsolidated venture, at equity (notes 1 and 3). . . . . . . . . . . . . . . . . . . . 2,446,681 9,598,799 Deferred expenses (note 1) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5,983,034 7,214,461 Accrued rents receivable (note 1). . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 487,289 3,243,021 Venture partners' deficits in ventures (note 1). . . . . . . . . . . . . . . . . . . . . . . . . . . . 4,557,854 3,067,356 ------------ ------------ $374,787,300 489,687,072 ============ ============ CARLYLE REAL ESTATE LIMITED PARTNERSHIP - XIII (A LIMITED PARTNERSHIP) AND CONSOLIDATED VENTURES CONSOLIDATED BALANCE SHEETS - CONTINUED 1993 1992 ------------ ----------- LIABILITIES AND PARTNERS' CAPITAL ACCOUNTS (DEFICITS) Current liabilities: Current portion of long-term debt (note 4) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 94,086,630 96,553,360 Accounts payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,397,159 2,387,568 Amounts due to affiliates (note 9) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14,894,459 13,668,292 Unearned rents . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 770,237 1,128,152 Accrued interest . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8,591,163 7,988,024 Accrued real estate taxes. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,064,479 1,373,462 ------------ ------------ Total current liabilities. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 122,804,127 123,098,858 Tenant security deposits . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 880,056 999,795 Investment in unconsolidated venture, at equity (notes 1, 3 and 10). . . . . . . . . . . . . . . . . . 72,546,193 50,385,319 Long-term debt, less current portion (note 4). . . . . . . . . . . . . . . . . . . . . . . . . . . . . 360,881,897 464,855,926 ------------ ------------ Total liabilities. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 557,112,273 639,339,898 Venture partners' subordinated equity in venture (note 1). . . . . . . . . . . . . . . . . . . . . . . 330,185 814,880 Partners' capital accounts (deficits) (notes 1 and 5): General partners: Capital contributions. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,000 1,000 Cumulative net losses. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (19,664,338) (18,232,317) Cumulative cash distributions. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (1,039,022) (1,039,022) ------------ ------------ (20,702,360) (19,270,339) ------------ ------------ Limited partners (366,183 interests): Capital contributions, net of offering costs . . . . . . . . . . . . . . . . . . . . . . . . . . 326,224,167 326,224,167 Cumulative net losses. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (458,202,076) (427,446,645) Cumulative cash distributions. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (29,974,889) (29,974,889) ------------ ------------ (161,952,798) (131,197,367) ------------ ------------ Total partners' capital (deficits) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (182,655,158) (150,467,706) ------------ ------------ Commitments and contingencies (notes 2, 3, 4, 7, 8 and 11) $374,787,300 489,687,072 ============ ============ See accompanying notes to consolidated financial statements. /TABLE CARLYLE REAL ESTATE LIMITED PARTNERSHIP - XIII (A LIMITED PARTNERSHIP) AND CONSOLIDATED VENTURES CONSOLIDATED STATEMENTS OF OPERATIONS YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 1993 1992 1991 ------------ ------------ ------------ Income: Rental income. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 84,609,796 92,814,257 93,080,468 Interest income. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 583,997 795,627 1,105,368 ------------ ------------ ------------ 85,193,793 93,609,884 94,185,836 ------------ ------------ ------------ Expenses (Schedule X): Mortgage and other interest. . . . . . . . . . . . . . . . . . . . . . . . . . 50,753,647 57,574,370 64,090,897 Depreciation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 18,343,123 19,490,916 20,391,223 Property operating expenses. . . . . . . . . . . . . . . . . . . . . . . . . . 43,065,564 45,068,702 43,979,318 Professional services. . . . . . . . . . . . . . . . . . . . . . . . . . . . . 708,403 681,645 576,360 Amortization of deferred expenses. . . . . . . . . . . . . . . . . . . . . . . 2,410,540 1,671,011 284,201 Management fees to general partners. . . . . . . . . . . . . . . . . . . . . . -- 12,715 108,075 General and administrative . . . . . . . . . . . . . . . . . . . . . . . . . . 532,727 640,821 658,203 Provision for value impairment (note 1). . . . . . . . . . . . . . . . . . . . -- 6,409,039 -- ------------ ------------ ------------ 115,814,004 131,549,219 130,088,277 ------------ ------------ ------------ Operating loss. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30,620,211 37,939,335 35,902,441 Partnership's share of loss from operations of unconsolidated ventures (notes 1 and 10) . . . . . . . . . . . . . . . . . . . 22,416,922 8,007,990 13,356,918 Venture partners' share of loss of ventures' operations. . . . . . . . . . . . . (2,008,939) (3,376,600) (6,392,827) ------------ ------------ ------------ Net operating loss . . . . . . . . . . . . . . . . . . . . . . . . . . . 51,028,194 42,570,725 42,866,532 Gain on sale or disposition of investment properties and extinguishment of debt (notes 4 and 7) . . . . . . . . . . . . . . . . . . . . (11,083,791) (2,132,879) (1,476,395) Gain on sale of interest in unconsolidated venture (note 3(d)) . . . . . . . . . (7,898,727) -- -- Loss on venture partners' relinquishment of interest in investment property (note 3(e)) . . . . . . . . . . . . . . . . . . . . . . -- -- 1,161,626 ------------ ------------ ------------ Net loss before extraordinary items. . . . . . . . . . . . . . . . . . . 32,045,676 40,437,846 42,551,763 CARLYLE REAL ESTATE LIMITED PARTNERSHIP - XIII (A LIMITED PARTNERSHIP) AND CONSOLIDATED VENTURES CONSOLIDATED STATEMENTS OF OPERATIONS - CONTINUED 1993 1992 1991 ------------ ------------ ------------ Extraordinary items (notes 4(b)(2), 7(b) and (c)). . . . . . . . . . . . . . . . 141,776 (7,139,936) -- ------------ ------------ ------------ Net loss. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 32,187,452 33,297,910 42,551,763 ============ ============ ============ Net loss per limited partnership interest (note 1): Net operating loss . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 134.92 111.62 112.38 Gain on sale or disposition of investment properties and extinguishment of debt . . . . . . . . . . . . . . . . . . . . . . . . (29.97) (5.77) (3.99) Gain on sale of interest in unconsolidated venture . . . . . . . . . . . . . (21.35) -- -- Loss on venture partners' relinquishment of interest in investment property . . . . . . . . . . . . . . . . . . . . . . . . . . -- -- 3.14 Extraordinary items. . . . . . . . . . . . . . . . . . . . . . . . . . . . . .38 (19.31) -- ------------ ------------ ------------ Net loss . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 83.98 86.54 111.53 ============ ============ ============ See accompanying notes to consolidated financial statements. /TABLE CARLYLE REAL ESTATE LIMITED PARTNERSHIP - XIII (A LIMITED PARTNERSHIP) AND CONSOLIDATED VENTURES CONSOLIDATED STATEMENTS OF PARTNERS' CAPITAL ACCOUNTS (DEFICITS) YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 GENERAL PARTNERS LIMITED PARTNERS (366,183 INTERESTS) -------------------------------------------------------- ------------------------------------------------ CONTRI- BUTIONS NET NET OF NET CONTRI- EARNINGS CASH OFFERING EARNINGS CASH BUTIONS (LOSS) DISTRIBUTIONS TOTAL COSTS (LOSS) DISTRIBUTIONS TOTAL ------- ---------- ------------- ----------- ------------ ------------ ------------- ------------ Balance (deficit) December 31, 1990 . $1,000 (14,910,702) (966,548) (15,876,250) 326,224,167 (354,918,587) (28,235,517) (56,929,937) Net loss . . . . . . -- (1,711,514) -- (1,711,514) -- (40,840,249) -- (40,840,249) Cash distributions ($4.25 per limited partnership interest) . . . . . -- -- (64,845) (64,845) -- -- (1,556,280) (1,556,280) ------ ----------- ---------- ----------- ------------ ------------ ----------- ------------ Balance (deficit) December 31, 1991 . 1,000 (16,622,216) (1,031,393) (17,652,609) 326,224,167 (395,758,836) (29,791,797) (99,326,466) Net loss . . . . . . -- (1,610,101) -- (1,610,101) -- (31,687,809) -- (31,687,809) Cash distributions ($.50 per limited partnership interest) . . . . . -- -- (7,629) (7,629) -- -- (183,092) (183,092) ------ ----------- ---------- ----------- ------------ ------------ ----------- ------------ Balance (deficit) December 31, 1992 . 1,000 (18,232,317) (1,039,022) (19,270,339) 326,224,167 (427,446,645) (29,974,889) (131,197,367) Net loss . . . . . . -- (1,432,021) -- (1,432,021) -- (30,755,431) -- (30,755,431) Cash distributions ($0 per limited partnership interest) . . . . . -- -- -- -- -- -- -- -- ------ ----------- ---------- ----------- ------------ ------------ ----------- ------------ Balance (deficit) December 31, 1993 . $1,000 (19,664,338) (1,039,022) (20,702,360) 326,224,167 (458,202,076) (29,974,889) (161,952,798) ====== =========== ========== =========== ============ ============ =========== ============ See accompanying notes to consolidated financial statements. /TABLE CARLYLE REAL ESTATE LIMITED PARTNERSHIP - XIII (A LIMITED PARTNERSHIP) AND CONSOLIDATED VENTURES CONSOLIDATED STATEMENTS OF CASH FLOWS YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 1993 1992 1991 ------------ ------------ ------------ Cash flows from operating activities: Net loss . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $(32,187,452) (33,297,910) (42,551,763) Items not requiring (providing) cash or cash equivalents: Depreciation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 18,343,123 19,490,916 20,391,223 Amortization of deferred expenses. . . . . . . . . . . . . . . . . . . . . . 2,410,540 1,671,011 284,201 Amortization of discount on long-term debt . . . . . . . . . . . . . . . . . 103,298 91,671 81,354 Long-term debt - deferred accrued interest . . . . . . . . . . . . . . . . . 13,461,723 13,710,342 13,040,330 Partnership's share of loss from operations of unconsolidated ventures, net of distributions . . . . . . . . . . . . . . . . . . . . . . . . . . . 22,416,922 8,007,990 13,356,918 Venture partners' share of ventures' operations. . . . . . . . . . . . . . . (2,008,939) (3,376,600) (6,392,827) Gain on sale of investment property and extinguishment of debt . . . . . . . (11,083,791) (2,132,879) (1,476,395) Provision for value impairment (note 1). . . . . . . . . . . . . . . . . . . -- 6,409,039 -- Extraordinary items. . . . . . . . . . . . . . . . . . . . . . . . . . . . . 141,776 (7,139,936) -- Gain on sale of interest in unconsolidated venture . . . . . . . . . . . . . (7,898,727) -- -- Loss on venture partner's relinquishment of interest of investment property. -- -- 1,161,626 Changes in: Restricted funds . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,319,106 (272,906) -- Rents and other receivables. . . . . . . . . . . . . . . . . . . . . . . . . (430,632) 1,227,951 393,766 Prepaid expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 100,997 50,122 (38,636) Escrow deposits. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (634,588) (2,054,307) 175,311 Accrued rents receivable . . . . . . . . . . . . . . . . . . . . . . . . . . 2,755,732 824,390 (7,307) Accounts payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9,591 (1,224,442) 343,870 Unearned rents . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (357,915) (26,887) 314,346 Accrued interest . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,957,457 546,217 2,272,377 Accrued real estate taxes. . . . . . . . . . . . . . . . . . . . . . . . . . 691,017 179,232 40,859 Amounts due to affiliates. . . . . . . . . . . . . . . . . . . . . . . . . . 26,167 2,390,394 2,485,952 Tenant security deposits . . . . . . . . . . . . . . . . . . . . . . . . . . (119,739) (305,083) 353,786 ------------ ------------ ------------ Net cash provided by operating activities. . . . . . . . . . . . . . . 10,015,666 4,768,325 4,228,991 ------------ ------------ ------------ Cash flows from investing activities: Cash proceeds from sale of investment properties, net of selling expenses (note 7) 1,220,737 338,196 -- Additions to investment properties . . . . . . . . . . . . . . . . . . . . . . (3,188,425) (6,144,928) (3,741,972) Cash expended in disposition of investment properties. . . . . . . . . . . . . (55,111) -- -- Net sales (purchases) of short-term investments. . . . . . . . . . . . . . . . (18,470,959) 3,311,641 -- Partnership's distributions from unconsolidated ventures . . . . . . . . . . . 16,978,465 -- 2,772,501 Partnership's contributions to unconsolidated ventures . . . . . . . . . . . . (983,668) (1,796,723) (2,895,937) Payment of deferred expenses . . . . . . . . . . . . . . . . . . . . . . . . . (1,030,569) (2,444,529) (2,062,606) ------------ ------------ ------------ (A LIMITED PARTNERSHIP) AND CONSOLIDATED VENTURES CONSOLIDATED STATEMENTS OF CASH FLOWS YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 1993 1992 1991 ------------ ------------ ------------ Net cash used in investing activities. . . . . . . . . . . . . . . . . (5,529,530) (6,736,343) (5,928,014) ------------ ------------ ------------ Cash flows from financing activities: Proceeds from refinancing of long-term debt. . . . . . . . . . . . . . . . . . 4,253 10,840,261 -- Retirement of long-term debt . . . . . . . . . . . . . . . . . . . . . . . . . -- (10,726,327) -- Proceeds from long-term debt . . . . . . . . . . . . . . . . . . . . . . . . . -- -- 4,210,508 Principal payments on long-term debt . . . . . . . . . . . . . . . . . . . . . (1,789,503) (841,946) (1,575,082) Venture partners' contributions to ventures. . . . . . . . . . . . . . . . . . 33,746 158,931 290,979 Distributions to limited partners. . . . . . . . . . . . . . . . . . . . . . . -- (183,092) (1,556,280) Distributions to general partners. . . . . . . . . . . . . . . . . . . . . . . -- (7,629) (64,845) ------------ ------------ ------------ Net cash provided by (used in) financing activities. . . . . . . . . . (1,751,504) (759,802) 1,305,280 ------------ ------------ ------------ Net increase (decrease) in cash and cash equivalents . . . . . . . . . $ 2,734,632 (2,727,820) (393,743) ============ ============ ============ Supplemental disclosure of cash flow information: Cash paid for mortgage and other interest. . . . . . . . . . . . . . . . . . . $ 35,628,310 43,340,504 48,442,796 ============ ============ ============ Total sales price of investment properties, net of selling expenses. . . . . . $ 18,479,297 18,442,566 -- Mortgage loan payable. . . . . . . . . . . . . . . . . . . . . . . . . . . . . (17,258,560) (18,104,370) -- ------------ ------------ ------------ Cash sales proceeds from sale of investment properties, net of selling expenses. . . . . . . . . . . . . . . . . . . . . . . . . . $ 1,220,737 338,196 -- ============ ============ ============ Proceeds from refinancing of long-term debt (note 3(l)). . . . . . . . . . . . $ 7,455,000 -- -- Payoff of long-term debt . . . . . . . . . . . . . . . . . . . . . . . . . . . (7,160,425) -- -- Prepayment penalty . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (141,776) -- -- Refinancing costs. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (148,546) -- -- ------------ ------------ ------------ Proceeds from refinancing of long-term debt. . . . . . . . . . . . . . $ 4,253 -- -- ============ ============ ============ (A LIMITED PARTNERSHIP) AND CONSOLIDATED VENTURES CONSOLIDATED STATEMENTS OF CASH FLOWS YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 1993 1992 1991 ------------ ------------ ------------ Non-cash investing and financing activities: Contributions payable to unconsolidated venture (note 3(b)) . . . . . . . $ 1,200,000 -- -- ============ ============ ============ Disposition of investment properties (notes 1 and 4(b)(9)): Balance due on long-term debt cancelled. . . . . . . . . . . . . . . . $ -- -- 13,660,000 Reduction of accrued interest payable. . . . . . . . . . . . . . . . . -- -- 1,038,448 Reduction of investment properties . . . . . . . . . . . . . . . . . . -- -- (13,214,358) Disposition costs. . . . . . . . . . . . . . . . . . . . . . . . . . . -- -- (7,695) ------------ ------------ ------------ Non-cash gain recognized due to lender realizing upon security. . . . . . $ -- -- 1,476,395 ============ ============ ============ Principal balance due on mortgages payable. . . . . . . . . . . . . . . . $ -- 13,589,936 -- Payment on long-term debt from sale of investment properties. . . . . . . -- (6,300,000) -- ------------ ------------ ------------ Extraordinary items - non-cash gain recognized on forgiveness of indebtedness. . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ -- 7,289,936 -- ============ ============ ============ Total sales price, net of selling expenses (notes 7(e) and (f)) . . . . . $ 18,479,297 -- -- Reduction in land . . . . . . . . . . . . . . . . . . . . . . . . . . . . (12,322,483) -- -- Reduction in buildings and improvements . . . . . . . . . . . . . . . . . (143,821,518) -- -- Reduction in accumulated depreciation . . . . . . . . . . . . . . . . . . 46,196,996 -- -- Balance due on long-term debt cancelled (note 4(b)(4)). . . . . . . . . . 102,606,610 -- -- Cash expended in disposition of investment property . . . . . . . . . . . (55,111) -- -- ------------ ------------ ------------ Gain on sale of investment property and extinguishment of debt . . . . $ 11,083,791 -- -- ============ ============ ============ See accompanying notes to consolidated financial statements. /TABLE CARLYLE REAL ESTATE LIMITED PARTNERSHIP - XIII (A LIMITED PARTNERSHIP) AND CONSOLIDATED VENTURES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 1993, 1992 AND 1991 (1) BASIS OF ACCOUNTING The accompanying consolidated financial statements include the accounts of the Partnership and its consolidated ventures (note 3) - Partridge Place Limited Partnership ("Heritage"), Quail Springs Limited Partnership ("Quail"), Eastridge Associates Limited Partnership ("Eastridge"), Copley Place Associates ("Copley Place"), Gables Corporate Plaza Associates ("Gables"), Carrollwood Station Associates, Ltd. ("Carrollwood"), Jacksonville Cove I Associates, Ltd. ("Glades") and Sherry Lane Associates ("Sherry Lane"). The effect of all transactions between the Partnership and the ventures has been eliminated. The equity method of accounting has been applied in the accompanying consolidated financial statements with respect to the Partnership's interests in Orchard Associates (note 3(d)) and the Partnership's indirect interest in (through Carlyle-XIII Associates, L.P.) JMB/NYC Office Building Associates, L.P. ("JMB/NYC" note 3(c)). The Partnership records are maintained on the accrual basis of accounting as adjusted for Federal income tax reporting purposes. The accompanying consolidated financial statements have been prepared from such records after making appropriate adjustments to present the Partnership's accounts in accordance with generally accepted accounting principles ("GAAP") and to consolidate the accounts of the ventures as described above. Such adjustments are not recorded on the records of the Partnership. The effect of these items for the years ended December 31, 1993 and 1992 is summarized as follows: CARLYLE REAL ESTATE LIMITED PARTNERSHIP - XIII (A LIMITED PARTNERSHIP) AND CONSOLIDATED VENTURES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED 1993 1992 ------------------------------ ------------------------------ GAAP BASIS TAX BASIS GAAP BASIS TAX BASIS ------------ ----------- ------------- ------------ Total assets . . . . . . . . . . . . . . . . . . . . . . . $374,787,300 99,599,312 489,687,072 97,192,182 Partners' capital accounts (deficits) (note 5): General partners. . . . . . . . . . . . . . . . . . . . (20,702,360) (34,839,564) (19,270,339) (38,961,003) Limited partners. . . . . . . . . . . . . . . . . . . . (161,952,798) (218,137,769) (131,197,367) (240,626,413) Net earnings (loss) (note 5): General partners. . . . . . . . . . . . . . . . . . . . (1,432,021) 4,121,438 (1,610,101) (1,598,313) Limited partners. . . . . . . . . . . . . . . . . . . . (30,755,431) 22,488,643 (31,687,809) (26,035,220) Net earnings (loss) per limited partnership interest . . . (83.98) 61.41 (86.54) (71.10) ============ ============ ============ ============ /TABLE CARLYLE REAL ESTATE LIMITED PARTNERSHIP - XIII (A LIMITED PARTNERSHIP) AND CONSOLIDATED VENTURES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED The net loss per limited partnership interest is based upon the limited partnership interests outstanding at the end of the period (366,183). Deficit capital accounts will result, through the duration of the Partnership, in net gain for financial reporting and Federal income tax purposes. Certain reclassifications have been made to the 1992 financial statements in order to conform with the 1993 presentation. Statement of Financial Accounting Standards No. 95 requires the Partnership to present a statement which classifies receipts and payments according to whether they stem from operating, investing or financing activities. The required information has been segregated and accumulated according to the classifications specified in the pronouncement. Partnership distributions from unconsolidated ventures are considered cash flow from operating activities only to the extent of the Partnership's cumulative share of net earnings. In addition, the Partnership records amounts held in U.S. Government obligations at cost, which approximates market. For the purposes of these statements, the Partnership's policy is to consider all such amounts held with original maturities of three months or less (none and $500,000 at December 31, 1993 and 1992, respectively) as cash equivalents with any remaining amounts reflected as short-term investments. The Partnership terminated negotiations for a partial renewal of the lease of the primary tenant at the Commercial Union Building, which expired in June 1991. Due to the extreme softness of the metropolitan Boston real estate market, the Partnership decided not to commit any significant additional capital to this property (see note 4(b)(9)). In August 1991, the second mortgage lender realized upon its security interest by taking title to the Commercial Union Building as a result of the Partnership not remitting the required debt service payments. This resulted in the Partnership no longer having an ownership interest in the property and resulted in a gain to the Partnership of approximately $1,476,000 for financial reporting purposes and $3,240,000 for Federal income tax purposes with no corresponding distributable proceeds in 1991. In July 1992, the Partnership executed a lease with the 1001 Fourth Avenue Plaza office building's largest tenant, Seattle-First National Bank, for a renewal of a portion of their current space effective October 1993, when its existing 259,000 square foot lease expired. The renewal resulted in Seattle-First National Bank leasing 95,000 square feet for a ten year period. The new lease, which included a significant free rent period for the tenant, as well as considerable tenant improvement costs, had a material negative impact on the cash flow from the property commencing in late 1993 and placed the property in a position whereby the net operating income would have been insufficient to cover both debt service payments and leasing costs (see note 4(b)(4)). Due to the uncertainty of the Partnership's ability to recover the net carrying value of the 1001 Fourth Avenue office building investment property through future operations and sales, as of June 30, 1992, the Partnership recorded, as a matter of prudent accounting practice, a provision for value impairment of such investment property of $6,409,039. Such provision was recorded to reduce the net carrying value of the investment property to the then outstanding balance of the related non-recourse financing. Due to the extreme softness of the Seattle, Washington office market and other factors, the Partnership decided not to commit any significant additional capital to this property (see note 4(b)(4)). In November 1993, the Partnership agreed with the mortgage lender to transfer title to the 1001 Fourth Avenue Office Building to the lender. This has resulted in 1993 in the Partnership no longer having an ownership interest in the property and has resulted in a net gain to the Partnership of approximately $6,772,000 for financial reporting purposes and gain of approximately $27,567,000 for Federal income tax purposes with no corresponding distributable proceeds. CARLYLE REAL ESTATE LIMITED PARTNERSHIP - XIII (A LIMITED PARTNERSHIP) AND CONSOLIDATED VENTURES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED As more fully discussed in Note 3(c) due to the potential sale of the 2 Broadway building at a sales price significantly below its net carrying value and due to discussions with the O & Y affiliates regarding the reallocation of the unpaid first mortgage indebtedness currently allocated to 2 Broadway, the 2 Broadway venture has made a provision for value impairment on such investment property of $192,627,560. The provision for value impairment has been allocated to the partners to reflect their respective ownership percentages before the effect of the non-recourse promissory notes, in the amounts of $136,534,366 and $56,093,194 to the O & Y affiliates and to JMB/NYC, respectively. Due to the uncertainty of the 1290 Associates venture's ability to recover the net carrying value of the 1290 Avenue of the Americas Building through future operations and sale, the 1290 Associates venture made a provision for value impairment on such investment property of $51,423,084. Such provision at September 30, 1992 was recorded to effectively reduce the net carrying value of the investment property and the related deferred expenses to the then outstanding balance of the related non-recourse financing allocated to the joint venture and its property. This provision was allocated to the unaffiliated venture partners in accordance with the terms of the venture agreement and accordingly is not included in the financial statements (see notes 1, 3 and 5 in Notes to Combined Financial Statements). Deferred expenses are comprised principally of leasing fees which are amortized using the straight-line method over the terms stipulated in the related agreements, and commitment fees which are amortized over the related commitment periods. Although certain leases of the Partnership provide for tenant occupancy during periods for which no rent is due and/or increases in minimum lease payments over the term of the lease, the Partnership accrues prorated rental income for the full period of occupancy on a straight-line basis. Statement of Financial Accounting Standards No. 107, "Disclosures about Fair Value of Financial Instruments", requires entities with total assets exceeding $150 million at December 31, 1993 to disclose the SFAS 107 value of all financial assets and liabilities for which it is practicable to estimate. Value is defined in the Statement as the amount at which the instrument could be exchanged in a current transaction between willing parties, other than in a forced or liquidation sale. The Partnership believes the carrying amount of its financial instruments classified as current assets and liabilities (excluding current portion of long-term debt) approximates SFAS 107 value due to the relatively short maturity of these instruments. There is no quoted market value available for any of the Partnership's other instruments. As the debt secured by the University Park office building, Long Beach Plaza and Gables Corporate Plaza has been classified by the Partnership as a current liability at December 31, 1993 (see note 4(b)), and because the resolution of such defaults are uncertain, as the debt on the University Park Office Building and the Gables Corporate Plaza was satisfied in January 1994 pursuant to deeds in lieu and because the resolution of Long Beach Plaza is uncertain, the Partnership considers the disclosure of such long-term debt to be impracticable. The remaining debt, with a carrying balance of $454,968,527, has been calculated to have an SFAS 107 value of $362,710,962 by discounting the scheduled loan payments to maturity. Due to restrictions on transferability and prepayment, and the inability to obtain comparable financing due to previously modified debt terms or other property specific competitive conditions, the Partnership would be unable to refinance these properties to obtain such assumed debt amounts reported (see note 4). The Partnership has no other significant financial instruments. CARLYLE REAL ESTATE LIMITED PARTNERSHIP - XIII (A LIMITED PARTNERSHIP) AND CONSOLIDATED VENTURES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED No provision for State or Federal income taxes has been made as the liability for such taxes is that of the partners rather than the Partnership. However, in certain instances, the Partnership has been required under applicable law to remit directly to the tax authorities amounts representing withholding from distributions paid to partners. (2) INVESTMENT PROPERTIES (a) General The Partnership has acquired, either directly or through joint ventures (note 3), nine apartment complexes, three shopping centers, ten office buildings and a multi-use complex. Nine properties have been sold or disposed of by the Partnership as of December 31, 1993. All of the remaining properties owned at December 31, 1993 were operating. In January 1994, the lender took title to the University Park office building and Gables Corporate Plaza as described in Notes 4(b)(6), 4(b)(7) and 11(a) and (b). The cost of the investment properties represents the total cost to the Partnership or its ventures plus miscellaneous acquisition costs. Significant betterments and improvements are capitalized and depreciated over their estimated useful lives. Maintenance and repair expenses are charged to operations as incurred. Depreciation on the operating properties has been provided over the estimated useful lives of 5 to 30 years using the straight-line method. All investment properties are pledged as security for the long-term debt, for which generally there is no recourse to the Partnership. A portion of the long-term debt on the Copley Place multi-use complex and Gables Corporate Plaza represent mortgage loans which are subordinated to the existing senior mortgage loans. (b) Long Beach Plaza The Partnership purchased Long Beach Plaza located in Long Beach, California for $45,839,458 (net of discount on long-term debt of $10,330,542). In January 1981, Australian Ventures, Inc. ("AVI") signed a 99 year ground and improvement lease at the Long Beach Plaza shopping center located in Long Beach, California for approximately 144,000 square feet. AVI sublet the space to Buffum's Department Store, an affiliate of AVI. In March 1991, Buffum's filed for protection from creditors under Chapter XI of the United States Bankruptcy Code. In May 1991, Buffum's vacated the leased premises. As a result and pursuant to certain provisions of the ground and improvement lease that, among other things, requires continuous operation of a store at the premises during the lease term, the Partnership sought a termination of the lease and to obtain possession of the premises. In March 1993, the Partnership completed a settlement of its litigation with AVI involving the lease. Under the terms of the settlement, AVI paid the Partnership $550,000, and the parties terminated the ground and improvement lease. In addition, both parties dismissed their respective claims in the lawsuit with prejudice. The Partnership paid the $550,000 received from AVI to the mortgage lender for the property as scheduled debt service due for April and part of May 1993 on the loan secured by the property. The Partnership has initiated discussions with the first mortgage lender regarding a modification of its mortgage loan secured by the property. There can be no assurance that such modification will be consummated. If the Partnership is unable to secure a modification to the loan, the Partnership may decide not to commit any significant additional amounts of the property. This would result in the Partnership no longer having an ownership interest in such property and would result in gain for financial reporting and Federal income tax purposes to the Partnership with no corresponding distributable proceeds. CARLYLE REAL ESTATE LIMITED PARTNERSHIP - XIII (A LIMITED PARTNERSHIP) AND CONSOLIDATED VENTURES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED (3) VENTURE AGREEMENTS (a) General The Partnership at December 31, 1993 is a party to nine operating joint venture agreements. Pursuant to such agreements, the Partnership made initial capital contributions of approximately $231,529,000 (before legal and other acquisition costs and its share of operating deficits as discussed below). In general, the joint venture partners, who are either the sellers (or their affiliates) of the property investments being acquired, or parties which have contributed an interest in the property being developed, or were subsequently admitted to the ventures, make no cash contributions to the ventures, but their retention of an interest in the property, through the joint venture, is taken into account in determining the purchase price of the Partnership's interest, which was determined by arm's-length negotiations. Under certain circumstances, either pursuant to the venture agreements or due to the Partnership's obligations as a general partner, the Partnership may be required to make additional cash contributions to the ventures. The Partnership has acquired, through the above ventures, three apartment complexes, five office buildings, and a multi-use complex. The joint venture partners (who were primarily responsible for constructing the properties) contributed any excess of cost over the aggregate amount available from the Partnership contributions and financing and, to the extent such funds exceeded the aggregate costs, were to retain such excesses. Certain of the venture properties have been financed under various long-term debt arrangements as described in Note 4 and 3 and to Note 5 of Notes to the Combined Financial Statements. The Partnership generally has a cumulative preferred interest in net cash receipts (as defined) from the properties. Such preferential interest relates to a negotiated rate of return on contributions made by the Partnership. After the Partnership receives its preferential return, the venture partner is generally entitled to a non-cumulative return on its interest in the venture; net cash receipts are generally shared in a ratio relating to the various ownership interests of the Partnership and its venture partners. During 1993, 1992 and 1991, two, three and three, respectively, of the ventures' properties produced net cash receipts. In addition, the Partnership generally has preferred positions (related to the Partnership's cash investment in the ventures) with respect to distribution of sale or refinancing proceeds from the ventures. In general, operating profits and losses are shared in the same ratio as net cash receipts; however, if there are no net cash receipts, substantially all profits or losses are allocated to the partners in accordance with their respective economic interest. Physical management of the properties generally was performed by affiliates of the venture partners during the development period and rent-up period. The managers were responsible for cash flow deficits (after debt service requirements). Compensation to the managers during such periods for management and leasing was limited to specified payments made by the ventures, plus any excess net cash receipts generated by the properties during the periods. Thereafter, the management agreements generally provide for an extended term during which the management fee is calculated as a percentage of certain types of cash income from the property. The management terms are in the extended term for all of the ventures. There are certain risks associated with the Partnership's investments made through joint ventures including the possibility that the Partnership's joint venture partners in an investment might become unable or unwilling to fulfill their financial or other obligations, or that such joint venture partners may have economic or business interests or goals that are inconsistent with those of the Partnership. CARLYLE REAL ESTATE LIMITED PARTNERSHIP - XIII (A LIMITED PARTNERSHIP) AND CONSOLIDATED VENTURES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED The terms of certain of the venture agreements are summarized as follows: (b) Copley Place The Partnership acquired in 1983, through a joint venture with the developer, an interest in a portion of Copley Place, a multi-use complex in Boston, Massachusetts. Initially, the Partnership purchased an interest in the complex from the developer for a purchase price of $20,000,000 which was paid by giving a purchase price note to the developer. Subsequently, the Partnership and the developer formed Copley Place Associates which purchased the balance of the office and retail portion of the complex from the developer for $245,000,000. The Partnership contributed its previously acquired interest in the property and made total cash contributions of $60,000,000 for its interest in Copley Place Associates. In December 1984, an affiliate of the Corporate General Partner of the Partnership acquired ownership of the joint venture partner (see note 9). The joint venture partner was obligated to fund (through capital contributions and loans, as defined) any deficiency in the Partnership's guaranteed return to 1989 and any operating deficits (as defined). Commencing January 1, 1990, the Partnership was entitled to a preferred return of $6,000,000 per year through December 31, 1991 of any available cash flow. The joint venture partner was obligated through December 31, 1991 to loan amounts to pay for any operating deficits (as defined). The joint venture partner has loaned approximately $13,398,000 through December 31, 1993 to fund its required obligations. The loan accrues interest at the contract rate based on the joint venture partner's line of credit. The line of credit bears interest at a floating rate (currently averaging 4.75% at December 31, 1993). The loan is to be repaid from future available cash flow, as defined. In addition, the Partnership and the joint venture partner were obligated to equally contribute towards tenant improvement and other capital costs beginning in 1990. The Partnership contributed $958,000 in 1991 and $847,022 in 1990 as its 50% share of capital and tenant improvement costs at the property. In addition, the venture partner and the Partnership each contributed $7,786,931 in October 1990 to retire a line of credit (see note 4(b)(10)). Commencing January 1, 1992, the Partnership and the venture partner are required to equally fund all cash deficits of the property. In addition, commencing January 1, 1992, annual cash flow (as defined) after repayment to the venture partner of operating deficit loans, is to be allocated equally between the Partnership and joint venture partner. Operating profits and losses of the joint venture are 50% to the Partnership and 50% to the joint venture partner. The joint venture agreement further provides that, in general, upon any sale or refinancing of the complex the first $60,000,000 of net proceeds will be distributed equally between the Partnership and the joint venture partner. The Partnership will then be entitled to receive an amount equal to any cumulative deficiencies of its annual preferred return of cash flow for 1990 and 1991 (balance at December 31, 1993 is $12,000,000). The Partnership will then be entitled to receive the next $190,000,000 plus an amount equal to certain interest which has been paid or is payable to the developer on its $20,000,000 purchase price note. The joint venture partner will then be entitled to receive the next $190,000,000 plus an amount equal to certain interest paid to it on the $20,000,000 purchase price note, with any remaining proceeds distributable equally to the Partnership and the joint venture partner. Reference is made to Note 4(b)(10) for a discussion of the modification of the mortgage loan (effective March 1, 1992) for the property. CARLYLE REAL ESTATE LIMITED PARTNERSHIP - XIII (A LIMITED PARTNERSHIP) AND CONSOLIDATED VENTURES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED An affiliate of the joint venture partner manages the portion of the complex owned by the joint venture, pursuant to an agreement similar to those described in Note 3(a). (c) JMB/NYC The Partnership owns indirectly through Carlyle-XIII Associates, L.P. and JMB/NYC an interest in (i) the 237 Park Avenue Associates venture which owns an existing 23-story office building, (ii) the 1290 Associates venture which owns an existing 44-story office building, and (iii) the 2 Broadway Associates and 2 Broadway Land Co. ventures which own an existing 32-story office building (together "Three Joint Ventures" and individually a "Joint Venture"). All of the buildings are located in New York, New York. In addition to JMB/NYC, the partners of the Three Joint Ventures include O&Y Equity Company, L.P. and O&Y NY Building Corp. (hereinafter sometimes referred to as the "Olympia & York affiliates"), both of which are affiliates of Olympia and York Developments, Ltd. (hereinafter sometimes referred to as "O&Y"). JMB/NYC is a joint venture among Carlyle-XIII Associates, L.P. (of which the Partnership holds a 99% limited partnership interest), Carlyle-XIV Associates, L.P. and Property Partners, L.P. as limited partners and Carlyle Managers, Inc. as the sole general partner. Effective March 25, 1993, the Partnership became a 20% shareholder of Carlyle Managers, Inc. Related to this investment, the Partnership has an obligation to fund $600,000 of additional paid-in capital to Carlyle Managers, Inc. (reflected in amounts due to affiliates in the accompanying financial statements). The terms of the JMB/NYC venture agreement generally provide that JMB/NYC's share of the Three Joint Ventures' annual cash flow, sale or refinancing proceeds, operating and capital costs (to the extent not covered by cash flow from a property) and profit and loss will be distributed to, contributed by or allocated to the Partnership in proportion to its (indirect) share of capital contributions to JMB/NYC. In March 1993, JMB/NYC, originally a general partnership, was converted to a limited partnership, and the Partnership's interest in JMB/NYC, which previously had been held directly, was contributed to Carlyle-XIII Associates, L.P. As a result of these transactions, the Partnership currently holds, indirectly as a limited partner of Carlyle-XIII Associates, L.P., an approximate 25% limited partnership interest in JMB/NYC. The sole general partner of Carlyle-XIII Associates, L.P. is Carlyle Investors, Inc., of which the Partnership became a 20% shareholder effective March 25, 1993. Related to this investment, the Partnership has an obligation to fund $600,000 of additional paid-in capital (reflected in amounts due to affiliates in the accompanying financial statements). The general partner in each of JMB/NYC and Carlyle-XIII Associates, L.P. is an affiliate of the Partnership. For financial reporting purposes, the allocation of profits and losses of JMB/NYC to the Partnership is 25%. There are certain risks and uncertainties associated with the Partnership's investments made through joint ventures, including the possibility that the Partnership's joint venture partners might become unable or unwilling to fulfill their financial or other obligations (as discussed below), or that such joint venture partners may have economic or business interests or goals that are inconsistent with those of the Partnership. JMB/NYC purchased a 46.5% interest in each of the Three Joint Ventures for approximately $173,600,000, subject to a long-term first mortgage loan which has been allocated among the individual Joint Ventures. A portion of the purchase price is represented by four 12-3/4% promissory notes (the "Purchase Notes") which have an aggregate outstanding principal balance of $34,158,225 at December 31, 1993 and 1992. Such Purchase Notes, which contain cross-default provisions, and are non-recourse to JMB/NYC, are secured by JMB/NYC's interests in the Three Joint Ventures, and such Purchase Note relating to the purchase of the interest in the ventures owning the 2 Broadway CARLYLE REAL ESTATE LIMITED PARTNERSHIP - XIII (A LIMITED PARTNERSHIP) AND CONSOLIDATED VENTURES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED Building is additionally secured by JMB/NYC's interest in $19,000,000 of distributable sale proceeds from the other two Joint Ventures. A default under the Purchase Notes would include, among other things, a failure by JMB/NYC to repay a Purchase Note upon acceleration of the maturity, and could cause an immediate acceleration of the Purchase Notes for the other ventures. Beginning in 1992, the Purchase Notes provide for monthly interest only payments on the principal and accrued interest based upon the level of distributions payable to JMB/NYC discussed below. If there are no distributions payable to JMB/NYC or if the distributions are insufficient to cover monthly interest on the Purchase Notes, then the shortfall interest (as defined) accrues and compounds monthly. Interest accruals total $78,605,523 at December 31, 1993. During 1993, no payments were made on the Purchase Notes. All of the principal and accrued interest on the Purchase Notes is due in 1999 or, if earlier, on the sale or refinancing of the related property. Prior to 1992, operating profits (excluding depreciation and amortization) were allocated 30% to JMB/NYC and 70% to the Olympia & York affiliates, and operating losses (excluding depreciation and amortization) were allocated 96% to JMB/NYC and 4% to the Olympia & York affiliates. Depreciation and amortization were allocated 46.5% to JMB/NYC and 53.5% to the Olympia & York affiliates. Subsequent to 1991, pursuant to the agreement between JMB/NYC and the Olympia & York affiliates, for the period January 1, 1992 to June 30, 1993, as discussed below, gross income is allocable to the Olympia & York affiliates to the extent of the distributions of excess monthly cash flow received for the period with the balance of operating profits or losses allocated 46.5% to JMB/NYC and 53.5% to the Olympia & York affiliates. Beginning July 1, 1993, operating profits or losses, in general, are allocated 46.5% to JMB/NYC and 53.5% to the Olympia & York affiliates. The Three Joint Ventures agreements further provide that, in general, upon sale or refinancing of the properties, net sale or refinancing proceeds will be distributable 46.5% to JMB/NYC and 53.5% to the Olympia & York affiliates subject to, as described above, repayment by JMB/NYC of its Purchase Notes. Under the terms of the Three Joint Ventures agreements, JMB/NYC was entitled to a preferred return of annual cash flow, with any additional cash flow distributable 99% to the Olympia & York affiliates and 1% to JMB/NYC, through 1991. The Olympia & York affiliates were obligated to make capital contributions to the Three Joint Ventures to pay any operating deficits (as defined) and to pay JMB/NYC's preferred return through December 31, 1991. JMB/NYC did not receive its preferred return for the fourth quarter 1991. Subsequent to 1991, capital contributions to pay for property operating deficits and other requirements that may be called for under the Three Joint Ventures agreements are required to be shared 46.5% by JMB/NYC and 53.5% by the Olympia & York affiliates. Pursuant to the Three Joint Ventures agreements between the Olympia & York affiliates and JMB/NYC, the effective rate of interest with reference to the first mortgage loan for calculating JMB/NYC's share of operating cash flow or deficits through 1991 was as though the rate were fixed at 12-3/4% per annum (versus the short-term U.S. Treasury obligation rate plus 1-3/4% per annum (with a minimum 7%) payable on the first mortgage loan). JMB/NYC believes that, commencing in 1992, the joint venture partnership agreements for the Three Joint Ventures require an effective rate of interest with reference to the first mortgage loan, based upon each Joint Venture's allocable share of the loan, to be 1-3/4% over the short-term U.S. Treasury obligation rate plus any excess monthly operating cash flow after capital costs of the Three Joint Ventures, such sum not to be less than a 7% nor exceed a 12-3/4% per annum interest rate, rather than the 12-3/4% per annum fixed rate that applied prior to 1992. The Olympia & York affiliates dispute this calculation of interest expense for the period commencing July 1, 1993 and contend that the 12-3/4% per annum fixed rate applies. CARLYLE REAL ESTATE LIMITED PARTNERSHIP - XIII (A LIMITED PARTNERSHIP) AND CONSOLIDATED VENTURES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED During the quarter ended March 31, 1993, an agreement was reached between JMB/NYC and the Olympia & York affiliates which rescinded default notices previously received by JMB/NYC alleging defaults for failing to make capital contributions and eliminated the alleged operating deficit funding obligation of JMB/NYC for the period January 1, 1992 through June 30, 1993. Accordingly, during this period, JMB/NYC recorded interest expense at 1-3/4% over the short-term U.S. Treasury obligation rate (subject to a minimum rate of 7% per annum), which is the interest rate on the underlying first mortgage loan. Under the terms of this agreement, during this period, the amount of capital contributions that the Olympia & York affiliates and JMB/NYC would have been required to make to the Three Joint Ventures as if the first mortgage loan bore interest at a rate of 12.75% per annum (the Olympia & York affiliates' interpretation), became a priority distribution level to the Olympia & York affiliates from the Three Joint Ventures' annual cash flow or net sale or refinancing proceeds. The agreement also entitles the Olympia & York affiliates to a 7% per annum return on such unpaid priority distribution level. It was also agreed that during this period, the excess available operating cash flow after the payment of the priority distribution level discussed above from any of the Three Joint Ventures will be advanced in the form of loans to pay operating deficits and/or unpaid priority distribution level amounts of any of the Three Joint Ventures. Such loans will bear a market rate of interest, have a final maturity of ten years from the date when made and will be repayable only out of first available annual cash flow or net sale or refinancing proceeds. The agreement also provides that except as specifically agreed otherwise, the parties each reserves all rights and claims with respect to each of the Three Joint Ventures and each of the partners thereof, including, without limitation, the interpretation of or rights under each of the joint venture partnership agreements for the Three Joint Ventures. As a result of the above noted agreement with the Olympia & York affiliates, for the six months ended June 30, 1993, $32,523,137 represents the minimum 7% per annum interest. Excess net cash flow, as defined, through June 30, 1993 totalled $11,648,285. Pursuant to an agreement with the first mortgage lender discussed below, $250,000 per month is payable as a distribution to the Olympia & York affiliates. During the period January 1, 1993 through June 30, 1993, $6,257,236 was distributed to the O&Y affiliates. The balance of $15,067,149 represents a priority distribution level to the Olympia & York affiliates payable from the Three Joint Ventures' annual cash flow or net sale or refinancing proceeds, if any. The cumulative priority distribution level payable to the Olympia & York affiliates at December 31, 1993 is $48,522,601. The agreement expired on June 30, 1993. Therefore, effective July 1, 1993, JMB/NYC is recording interest expense at 1-3/4% over the short-term U.S. Treasury obligation rate plus any excess operating cash flow after capital costs of the Three Joint Ventures, such sum not to be less than 7% nor exceed a 12-3/4% per annum interest rate. The Olympia & York affiliates dispute this calculation and contend that the 12-3/4% per annum fixed rate applies. Based upon the Olympia & York affiliates' interpretation, interest expense for the Three Joint Ventures for the six months ended December 31, 1993 was $58,962,793. Based upon the amount of interest determined by JMB/NYC for the six months ended December 31, 1993, interest expense for the Three Joint Ventures was $38,441,967. Pursuant to an agreement with the first mortgage lender, $1,500,000 of the interest payable to the Olympia & York affiliates of $6,079,237 for the six months ended December 31, 1993 was paid. The remaining $4,570,237 is due to the Olympia & York affiliates. O & Y and certain of its affiliates have been involved in bankruptcy proceedings in the United States and Canada and similar proceedings in England. The Olympia & York affiliates have not been directly involved in these proceedings. During the quarter ended March 31, 1993, O & Y emerged from bankruptcy protection in the Canadian proceedings. In addition, a reorganization of the management of the company's United States operations has been completed, and affiliates of O & Y are in the process of renegotiating or restructuring a number of loans affecting various properties in the United CARLYLE REAL ESTATE LIMITED PARTNERSHIP - XIII (A LIMITED PARTNERSHIP) AND CONSOLIDATED VENTURES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED States in which they have an interest. The Partnership is unable to assess and cannot presently determine to what extent these events may adversely affect the willingness and ability of the Olympia & York affiliates either to meet their own obligations to the Three Joint Ventures and JMB/NYC or to negotiate a restructuring of the joint venture agreements, or otherwise reach an understanding with JMB/NYC regarding any future funding obligation of JMB/NYC. During the fourth quarter of 1992, the Three Joint Ventures received a notice from the first mortgage lender alleging a default for failure to meet certain reporting requirements of the Olympia & York affiliates contained in the first mortgage loan documents. No monetary default has been alleged. The Olympia & York affiliates have responded to the lender that the Three Joint Ventures are not in default. JMB/NYC is unable to determine if the Three Joint Ventures are in default. Accordingly, the balance of the first mortgage loan has been classified as a current liability in the accompanying combined financial statements at December 31, 1993 and 1992. There have not been any further notices from the first mortgage lender. The Olympia & York affiliates, on behalf of the Three Joint Ventures, continue to negotiate with representatives of the lender (consisting of a steering committee of holders of notes evidencing the mortgage loan), to restructure certain terms of the existing mortgage loan in order to provide for, among other things, a potential sale of the 2 Broadway building and a fixed rate of interest on the loan during the remaining loan term until maturity. In conjunction with the negotiations, the Olympia & York affiliates reached an agreement with the first mortgage lender whereby effective January 1, 1993, the Olympia & York affiliates are limited to taking distributions of $250,000 on a monthly basis from the Three Joint Ventures reserving the remaining excess cash flow in a separate interest-bearing account to be used exclusively to meet the obligations of the Three Joint Ventures as approved by the lender. There is no assurance that a restructuring of the loan will be obtained. Interest on the first mortgage loan is calculated based upon a variable rate related to the short-term U.S. Treasury obligation rate, subject to a minimum rate on the loan of 7% per annum. An increase in the short-term U.S. Treasury obligation rate could result in increased interest payable on the first mortgage loan by the Three Joint Ventures. The Olympia & York affiliates and certain other affiliates of O & Y reached an agreement with the City of New York to defer the payment of real estate taxes owed in July 1992 and January 1993 on properties in which O&Y affiliates have an ownership interest, including the 237 Park Avenue, 1290 Avenue of the Americas and 2 Broadway buildings. Payment of the July 1992 real estate taxes was made in six equal monthly installments from July through December of 1992. A similar payment program existed for the period January through December of 1993. The March 1994 monthly real estate tax installment payment related to the 2 Broadway building has not been paid and there is uncertainty regarding the remittance of future installment payments related to the building. JMB/NYC continues to seek, among other things, a restructuring of the joint venture partnership agreements or otherwise to reach an acceptable understanding regarding its long-term funding obligations. If JMB/NYC is unable to achieve this, based upon current and anticipated market conditions mentioned above, JMB/NYC may decide not to commit any additional amounts to the Three Joint Ventures, which could, under certain circumstances, result in the loss of the interest in the related ventures. The loss of an interest in a particular venture could, under certain circumstances, permit an acceleration of the maturity of the related Purchase Note (each Purchase Note is secured by JMB/NYC's interest in the related venture). Under certain circumstances, the failure to repay a Purchase Note could constitute a default under, and permit an immediate acceleration of, the maturity of the Purchase Notes for the other ventures. In such event, JMB/NYC may decide not to repay, CARLYLE REAL ESTATE LIMITED PARTNERSHIP - XIII (A LIMITED PARTNERSHIP) AND CONSOLIDATED VENTURES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED or may not have sufficient funds to repay, any of the Purchase Notes and accrued interest thereon. This could result in JMB/NYC no longer having an interest in any of the related ventures, which would result in substantial net gain for financial reporting and Federal income tax purposes to JMB/NYC with no distributable proceeds. In such event, the Partnership would then proceed to terminate its affairs. If JMB/NYC is successful in its negotiations to restructure the Three Joint Venture agreements and retains an interest in one or more of these investment properties, there would nevertheless need to be a significant improvement in current market and property operating conditions resulting in a significant increase in value of the properties before JMB/NYC would receive any share of future net sale or refinancing proceeds. Although the 2 Broadway building is in need of a major renovation, the Joint Ventures that own the 2 Broadway building and land have no plans for a renovation of the property because of a potential sale of the building and because the effective rents that could be obtained under the current office market conditions may not be sufficient to justify the costs of the renovation. Given the current market and property operating conditions, it is likely that the property would sell at a price significantly lower than the allocated portion of the underlying debt. The first mortgage lender and JMB/NYC would need to approve any sale of this property. The O & Y affiliates have informed JMB/NYC that they have now received a written proposal for the sale of 2 Broadway for a net purchase price of $15,000,000. The first mortgage lender has preliminarily agreed to the concept of a sale of the building but has not approved the terms of any proposed offer for purchase. Accordingly, a sale pursuant to the proposal received by the O & Y affiliates would be subject to, among other things, the approval of the first mortgage lender as well as JMB/NYC. While there can be no assurance that a sale would occur pursuant to such proposal or any other proposal, if this proposal were to be accepted by or consented to by all required parties and the sale completed pursuant thereto, and if discussions with the O & Y affiliates relating to the proposal were finalized to allocate the unpaid first mortgage indebtedness currently allocated to 2 Broadway to 237 Park and 1290 Avenue of the Americas after completion of the sale, then the 2 Broadway Joint Ventures would incur a significant loss for financial reporting purposes. Accordingly, a provision for value impairment has been recorded for financial reporting purposes for $192,627,560, net of the non- recourse portion of the Purchase Notes related to the 2 Broadway Joint Venture interests that are payable by JMB/NYC to the O & Y affiliates in the amount of $46,646,810. The provision for value impairment has been allocated $136,534,366 and $56,093,194 to the O & Y affiliates and to JMB/NYC, respectively. Such provisions has been allocated to the partners to reflect their respective ownership percentages before the effect of the non-recourse promissory notes, including related accrued interest. The provision for value impairment is not a loss recognizable for Federal income tax purposes. In the event of a dissolution and liquidation of a Joint Venture, the terms of the joint venture partnership agreements between the Olympia & York affiliates and JMB/NYC for the Three Joint Ventures provide that if there is a deficit balance in the tax basis capital account of JMB/NYC, after the allocation of profits or losses and the distribution of all liquidation proceeds, then JMB/NYC generally would be required to contribute cash to the Joint Venture in the amount of its deficit capital account balance. Taxable gain arising from the sale or other disposition of a Joint Venture's property generally would be allocated to the joint venture partner or partners then having a deficit balance in its or their respective capital accounts in accordance with the terms of the joint venture partnership agreement. However, if such taxable gain is insufficient to eliminate the deficit balance CARLYLE REAL ESTATE LIMITED PARTNERSHIP - XIII (A LIMITED PARTNERSHIP) AND CONSOLIDATED VENTURES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED in its account in connection with a liquidation of a Joint Venture, JMB/NYC would be required to contribute funds to the Joint Venture (regardless of whether any proceeds were received by JMB/NYC from the disposition of the Joint Venture's property) to eliminate any remaining deficit capital account balance. The Partnership's liability for such contribution, if any, would be its share, if any, of the liability of JMB/NYC and would depend upon, among other things, the amounts of JMB/NYC's and the Olympia & York affiliates' respective capital accounts at the time of a sale or other disposition of Joint Venture property, the amount of JMB/NYC's share of the taxable gain attributable to such sale or other disposition of the Joint Venture property and the timing of the dissolution and liquidation of the Joint Venture. In such event, the Partnership could be required to sell or dispose of its other assets in order to satisfy any obligation attributable to it as a partner of JMB/NYC to make such contribution. Although the amount of such liability could be material, the Limited Partners of the Partnership would not be required to make additional contributions of capital to satisfy such obligation of the Partnership. The Partnership's deficit investment balance in JMB/NYC as reflected in the balance sheet (aggregating $72,546,193 at December 31, 1993) does not necessarily represent the amount, if any, the Partnership would be required to pay to satisfy its deficit restoration obligation. The properties are being managed by an affiliate of the Olympia & York affiliates under a long-term agreement for a management fee equal to 1% of gross receipts. An affiliate of the Olympia & York affiliates performs certain maintenance and repair work and construction of certain tenant improvements at the investment properties. Additionally, the Olympia & York affiliates have lease agreements and occupy approximately 95,000 square feet of space at 237 Park Avenue at rental rates which approximate market. (d) Orchard Associates The Partnership's interest in Old Orchard shopping center (through Orchard Associates and Old Orchard Urban Venture ("OOUV") was sold in September 1993, as described below. The maturity date for Orchard Associates' loan in the amount of $18,000,000 from a commercial bank, secured solely by its interest in Old Orchard shopping center, and originally due October 1, 1991, was extended to December 31, 1993. The agreement required monthly installments of interest only at the prime rate plus 1% per annum. Orchard Associates continued to negotiate with the lender for permanent financing of this note prior to its payoff in September 1993 as described below. On September 2, 1993, effective August 30, 1993, OOUV and an unaffiliated third party contributed the Old Orchard shopping center and $60,366,572 in cash (before closing costs and prorations), respectively, to a newly formed limited partnership. Immediately at closing, the new partnership distributed to OOUV $60,366,572 in cash (before closing costs and prorations) in redemption of approximately 89.5833% of OOUV's interest in the new partnership. OOUV, the limited partner, has retained a 10.4167% interest in the new limited partnership after such redemption. OOUV is also entitled to receive up to an additional $4,300,000 based upon certain events (as defined) and may earn up to an additional $3,400,000 based upon certain future earnings of the property (as defined). CARLYLE REAL ESTATE LIMITED PARTNERSHIP - XIII (A LIMITED PARTNERSHIP) AND CONSOLIDATED VENTURES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED Contemporaneously with the formation of the new limited partnership, OOUV redeemed Orchard Associates' ("Orchard") interest in OOUV for $56,689,747 (before closing costs and prorations). Orchard used a portion of these redemption proceeds to repay in full its $18,000,000 loan obligation plus accrued interest. This transaction has resulted in Orchard having no ownership interest in the property as of the effective date of the redemption agreement. Orchard recognized a gain of $15,797,454 for financial reporting purposes ($7,898,727 allocable to the Partnership) and recognized a gain for Federal income tax reporting purposes of $32,492,776, $16,246,388 allocable to the Partnership in 1993. OOUV and Orchard have also entered into a contribution agreement whereby they have agreed to share future gains and losses which may arise with respect to potential revenues and liabilities from events which predated the contribution of the property to the new venture (including, without limitation, potential future distributions to OOUV the $4,300,000 and $3,400,000 amounts as described above) in accordance with their pre- contribution percentage interests. Upon receipt of all or a portion of these contingent amounts, Orchard and the Partnership would expect to recognize additional gain for Federal income tax and financial reporting purposes in the year of such receipts. However, there can be no assurance that any portion of these contingent amounts will be received. (e) Eastridge Apartments In late 1986, an affiliate of the Corporate General Partner assumed management of the Eastridge Apartments. The apartment complex had been managed by the venture partner who defaulted in its obligations under the joint venture partnership and management agreements. In July 1991, the Partnership finalized an agreement with the joint venture partner whereby the partner relinquished its interest in the joint venture in return for a full release of all past and future obligations. Upon the venture partner's relinquishment, the balance of the venture partner's deficit capital account was deemed uncollectible. Accordingly, in 1991, the Partnership recorded a loss on relinquishment of venture partner's interest of $1,161,626. Such loss was recorded to eliminate the venture partner's deficit capital account. (4) LONG-TERM DEBT (a) General As described in Note 4(b) and in response to operating deficits incurred at certain properties, the Partnership is seeking and/or has received mortgage note modifications on certain properties. Certain of the modifications received which have expired and others expire on various dates commencing October 1996. In addition, certain properties have loans with scheduled maturities commencing November 1994. Upon expiration of such modifications or at maturity , should the Partnership be unable to secure new or additional modifications to or refinancing of the loans, based upon current and anticipated future market conditions, the Partnership may not commit any significant additional amounts to these properties. This generally would result in the Partnership no longer having an ownership interest in such properties and may result in gain for financial reporting and Federal income tax purposes without any net distributable proceeds. Such decisions would be made on a property-by-property basis. CARLYLE REAL ESTATE LIMITED PARTNERSHIP - XIII (A LIMITED PARTNERSHIP) AND CONSOLIDATED VENTURES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED Long-term debt consists of the following at December 31, 1993 and 1992: 1993 1992 ------------ ----------- 11.5% Purchase Price mortgage note; secured by Copley Place multi-use complex in Boston, Massachusetts; accruing interest through August 31, 1998 when the entire balance is payable (note 3(b)) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 62,818,952 56,025,355 12% mortgage note due August 1998; secured by Copley Place multi-use complex in Boston, Massachusetts; balance originally payable in monthly installments of principal and interest of $2,184,042 from October 1, 1983 through September 30, 1993 and thereafter at the then prevailing market terms of such financing (The note has been modified; see note 4(b)(10)) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 209,716,711 208,858,722 12.5% to 13.875% mortgage note originally due June 15, 1999; secured by the 1001 Fourth Avenue Plaza office building in Seattle, Washington and a $2,000,000 letter of credit secured by Partnership investments in U.S. Government obligations in an equal amount; originally payable in monthly installments of principal and interest of $897,458, $937,337 and $969,688 for five year periods ending June 15, 1989, 1994 and 1999, respectively. (The note has been modified and was satisfied in 1993; see note 4(b)(4)). . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . -- 101,185,922 9-5/8% mortgage note; secured by the Plaza Tower office building in Knoxville, Tennessee; payable in monthly installments of principal and interest of $184,421 until November 1, 1994 when the remaining principal of $17,758,395 is payable . . . . . . . 18,160,291 18,602,047 12.80% mortgage note; secured by the Gables Corporate Plaza office building in Coral Gables, Florida; originally payable in monthly installments of principal and interest until May 1, 1993 when the remaining principal balance was payable (The note has been modified and was discharged in January 1994; see notes 4(b)(7) and 11(a)) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 24,967,836 20,389,624 13-1/8% mortgage note; secured by the Sherry Lane Place office building in Dallas, Texas; originally payable in monthly installments of principal and interest until December 27, 1995 when the remaining principal balance is payable. (The note has been remodified; see note 4(b)(1)). . . . . . . . . . . . . . . . . . . . . . . . . . . . . 40,498,538 40,166,829 (A LIMITED PARTNERSHIP) AND CONSOLIDATED VENTURES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED 1993 1992 ------------ ----------- 13% mortgage note secured by the Long Beach Plaza shopping center in Long Beach, California; payable in monthly installments of principal and interest of $372,583 until June 27, 1994 when the remaining principal balance of $33,651,475 is payable . . . . 33,734,354 33,782,085 12-1/4% mortgage note; secured by the Rio Cancion apartment complex in Tucson, Arizona; originally payable in monthly installments of principal and interest of $123,703 until January 10, 1993 when the remaining principal balance of $10,974,572 was scheduled to be payable. (The note has been remodified and satisfied in 1993; see notes 4(b)(3) and 7(e)). . . . . . . . . . . . . . . . . . . . . . . -- 11,946,741 12-1/2% mortgage note; secured by the University Park office building in Sacramento, California; originally payable in monthly installments of interest only at the rate of 11% per annum with the difference accruing until maturity on July 1, 1993. (The note has been modified and was discharged in January 1994; see notes 4(b)(6) and 11(b)). . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 16,294,125 14,593,476 Other Mortgage Loans: Gables Corporate Plaza office building, 12.9%, due 1996 (satisfied in 1993, see notes 4(b)(7) and 11(a)). . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . -- 2,958,900 Long Beach Plaza shopping center, non-interest bearing, (net of $9,082,213 and $9,185,511 unamortized discount at 12% at December 31, 1993 and 1992, respectively), due 2014. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 917,787 814,489 Marshalls Aurora Plaza shopping center, 12-3/4%; originally payable in monthly installments of principal and interest until June 30, 1993 when the remaining principal balance was scheduled to be payable. (The note has been modified; see note 4(b)(12) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6,468,313 6,532,937 Eastridge apartment complex, 10.34%, due 1995 (modified July 1, 1987, see note 4(b)(5)) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9,752,617 10,385,522 Greenwood Creek II apartment complex, 13-1/4%, due 1997 (satisfied in 1993, see notes 4(b)(8) and 7(f)) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . -- 3,746,866 CARLYLE REAL ESTATE LIMITED PARTNERSHIP - XIII (A LIMITED PARTNERSHIP) AND CONSOLIDATED VENTURES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED 1993 1992 ------------ ----------- Glades apartment complex, 6.1%, due 2002 (refinanced in 1992, see note 4(b)(2)) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9,890,000 9,890,000 Glades apartment complex, 6% (plus, subsequent to April 1995, 50% of cash flows (as defined)), accruing interest through October 1, 2002 when the entire balance is payable (refinanced in 1992, see note 4(b)(2)) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 950,261 950,261 Carrollwood apartment complex, 7.45%, due 1998 (refinanced in 1993, see note 4(b)(11)) . . 7,400,309 7,181,077 Other. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13,398,433 13,398,433 ------------ ------------ Total debt . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 454,968,527 561,409,286 Less current portion of long-term debt (see note 4(b)) . . . . . . . . . . . . . . 94,086,630 96,553,360 ------------ ------------ Total long-term debt . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $360,881,897 464,855,926 ============ ============ /TABLE CARLYLE REAL ESTATE LIMITED PARTNERSHIP - XIII (A LIMITED PARTNERSHIP) AND CONSOLIDATED VENTURES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED Included in the above total long-term debt is $62,095,000 and $69,355,510, for 1993 and 1992, respectively, which represents mortgage interest accrued but not currently payable pursuant to the terms of the various notes. Five year maturities of long-term debt are as follows: 1994. . . . . . . . . . . . . . $94,086,630 1995. . . . . . . . . . . . . . 782,482 1996. . . . . . . . . . . . . . 6,159,597 1997. . . . . . . . . . . . . . 573,288 1998. . . . . . . . . . . . . . 331,738,472 =========== (b) Long-term Debt Modifications (1) Sherry Lane Place Office Building The existing long-term note secured by the Sherry Lane Place office building located in Dallas, Texas was modified effective February 1, 1988 to lower both the contract and payment interest rates. The contract interest rate was reduced to 9% per annum for the period from March 1, 1988 through February 28, 1993 and to 10% per annum for the period from March 1, 1993 through April 1, 1998. Interest only was payable at 6.5% per annum from February 1, 1988 through July 31, 1991, at 8% per annum from August 1, 1991 through July 31, 1994 and at 10% per annum from August 1, 1994 through March 1, 1998. The difference between the contract rate and the interest paid was to be deferred and bore interest at 13.125% per annum from February 1, 1988 through February 28, 1988, at 9% per annum from March 1, 1988 through February 28, 1993 and at 10% per annum from March 1, 1993 through April 1, 1998. In addition, upon the earlier of the subsequent sale of the property or maturity of the note, the lender was entitled to a residual participation equal to 40% of the applicable value (as defined). In connection with the modification, the Partnership prepaid $1,665,000 of principal without a prepayment penalty, and paid a loan modification fee of $2,335,000. In November 1993, the Partnership reached an agreement with the current lender to further modify the existing long-term non-recourse mortgage note secured by the property. Under the terms of the remodification, the existing mortgage balance was divided into two notes. The first note of $22,000,000 bears a contract interest rate of 8% per annum for the period retroactive from January 1, 1993 through December 31, 1994, increasing to 8.5% per annum for the period from January 1, 1995 through April 1, 1998. Interest only is payable on the first note at 5.75% per annum for the period retroactive to January 1, 1993 through December 31, 1993, at 8% per annum from January 1, 1994 through December 31, 1994 and at 8.5% per annum from January 1, 1995 through April 1, 1998. The second note, consisting of the remaining unpaid principal and accrued interest, has a zero pay and accrual rate. All excess cash flow above debt service on the first note is to be applied first against accrued interest on the first note and then as contingent interest on the second note (as defined). (2) The Glades Apartments The long-term mortgage note secured by the Glades Apartments located in Jacksonville, Florida was modified whereby the interest payment rate was reduced for the period December 1, 1987 to November 30, 1989 and the difference between the contract rate and the interest paid was deferred until CARLYLE REAL ESTATE LIMITED PARTNERSHIP - XIII (A LIMITED PARTNERSHIP) AND CONSOLIDATED VENTURES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED December 1, 1989 when the accrued interest and the then outstanding principal balance began to amortize over a thirty year period at the original interest rate. The entire balance was to be due and payable on October 1, 1995. The venture received a remodification from the lender to extend the initial payment terms of the modification through the January 1, 1991 payment. Subsequently, the venture reached an agreement to further extend the initial payment terms of the modification through the January 1, 1992 payment. The venture was negotiating with the first mortgage lender regarding an additional modification or refinancing, and submitted debt service payments under the previously modified terms to the extent of available property cash flow through September 30, 1992. On October 1, 1992, the venture refinanced the existing long-term mortgage note (of approximately $10,426,000) with a first and second mortgage note. The venture paid a prepayment penalty relating to the original mortgage of $300,000 in connection with the refinancing. The Partnership recognized its share of $150,000 as an extraordinary item for financial reporting purposes. The new first mortgage loan of $9,890,000 provides for interest only payments of 6.1% from October 1, 1992 through March 31, 1995. Thereafter, monthly installments of principal and interest will be due (amortized over a 30 year term) through the maturity of the loan on October 1, 2002. The second mortgage loan of $950,261 accrues simple interest of 6% per annum and requires quarterly payments of 50% of the net cash flow (as defined) beginning April 1, 1995 through the earlier of the repayment or maturity of the loan on October 1, 2002. There were no distributable proceeds from the refinancing. (3) Rio Cancion Apartments The mortgage note secured by the Rio Cancion apartments located in Tucson, Arizona and related deferred interest was satisfied on March 31, 1993 upon sale of the property (see note 7(e)). The first mortgage loan was modified, effective November 1, 1987, to lower the interest payable for a period of two years. The terms of the first mortgage loan were modified to lower the interest payable from 12.25% per annum to 10.25% per annum with the difference being added to the outstanding principal balance and due upon the earlier of available cash flow (as defined) or maturity of the loan. The Partnership reached an agreement to remodify the first mortgage loan, effective upon the expiration of the first modification agreement. Under the terms of the new agreement, the Partnership was obligated to pay interest only at a rate of 10.25% per annum from December 1989 through November 1991 on the balance of the outstanding principal and deferred interest as of October 31, 1989. On June 9, 1992, the Partnership reached an agreement for an additional modification to the first mortgage loan effective November 1, 1991. Through December 31, 1992, the Partnership was required to submit debt service payments under the previously remodified terms. On January 1, 1993, the contract rate of 12.25% per annum and the pay rate of 10.25% per annum was permanently lowered to 10%. The additional modification also extended the maturity date to January 1, 1997. In return, the lender was entitled to, as additional interest, a minority residual participation of 25% of net sales proceeds (as defined) after the Partnership had recovered its investment (as defined). CARLYLE REAL ESTATE LIMITED PARTNERSHIP - XIII (A LIMITED PARTNERSHIP) AND CONSOLIDATED VENTURES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED (4) 1001 Fourth Avenue Plaza The Partnership transferred title to the property to the lender on November 1, 1993, as discussed below. The long-term mortgage note secured by the 1001 Fourth Avenue Plaza office building located in Seattle, Washington was modified effective June 16, 1987 to lower both the contract and payment interest rates. The contract interest rate had been reduced to 9% per annum for the period from June 16, 1987 through December 15, 1992, to 10% per annum for the period from December 16, 1992 through May 15, 1994 and to 12% per annum for the period from May 16, 1994 through May 15, 1995. In addition, the interest payment rate had been reduced to 7% per annum from June 16, 1987 through May 15, 1989, at 8% per annum from May 16, 1989 through December 15, 1992 and at 9% per annum from December 16, 1992 through May 15, 1995. The difference between the contract rate and the interest paid was deferred and bore interest at 9% per annum. In addition, any Net Cash Flow (as defined) from the property was escrowed for future capital improvements. On May 16, 1995, the note was to revert to its original terms. In addition, upon the subsequent sale of the property, the lender would have been entitled to a minority residual participation beginning at 30% and decreasing to 15% of Net Proceeds (as defined) from such sale or refinancing. The Partnership continued to maintain a $2,000,000 letter of credit as additional security for the lender for the modification of interest rates, repayment schedule and other terms of the original loan. The letter of credit was secured by the Partnership's investments in U.S. government obligations in an equal amount. The letter of credit was to be renewed annually until the earlier of June 15, 1995 or the date on which Operating Income (as defined) from the property equaled at least 1.2 times the original debt service for a twelve month period. In October 1992, the Partnership notified the lender of its intent not to renew the letter of credit based on the property generating sufficient Operating Income (as defined) to meet the calculation requirement described above. As a result, the lender subsequently notified the Partnership that the Partnership was in default for non-submittal of Net Cash Flow (as defined). Although the Partnership had escrowed certain amounts for 1991 and 1992, the Partnership did not believe it was in default with respect to such escrow obligations. As a result of the alleged defaults, the lender subsequently attempted to draw on the $2,000,000 letter of credit prior to the letter of credit expiring in November 1992. The Partnership obtained a temporary restraining order from the Supreme Court of the State of New York disallowing the lender from drawing on the letter of credit in consideration for the Partnership renewing the letter of credit for a period of ninety days to allow the parties to attempt to resolve their differences. In February 1993, the Partnership extended the letter of credit for an additional sixty days in a further attempt to resolve the disputes with the lender. Subsequently, in March 1993, the temporary restraining order expired. The Supreme Court of the State of New York had agreed to extend the temporary restraining order providing the Partnership post a $2,000,000 bond by April 1, 1993. The Partnership posted a $2,000,000 bond on April 1, 1993. The lender appealed this entire order. On April 29, 1993, the Partnership was notified by the Supreme Court of the State of New York that a decision was rendered in favor of the Partnership regarding the disputes surrounding the letter of credit. In late June 1993, an order was entered by the court reflecting said decision. The lender notified the Partnership that they CARLYLE REAL ESTATE LIMITED PARTNERSHIP - XIII (A LIMITED PARTNERSHIP) AND CONSOLIDATED VENTURES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED intended to appeal the order. As a result, the lender claimed that the release of the bond and the return of the letter of credit had been stayed pending the appeal. As previously reported, the Partnership was attempting to obtain an additional loan modification from the mortgage lender. Such negotiations proved to be unsuccessful and in November 1993, the Partnership transferred title to the property in full satisfaction of the Partnership's mortgage obligation. As part of the agreement to transfer title, the lender agreed to settle the litigation and agreed to the return of the Partnership's bond and letter of credit. The transfer of the Partnership's ownership interest resulted in a net gain of $6,771,760 for financial reporting purposes and a gain of $27,567,458 for Federal income tax purposes with no corresponding distributable proceeds in 1993. (5) Eastridge Apartments In August 1990, the Partnership reached an agreement to remodify the mortgage note effective July 1, 1989 to lower both the contract rate (as defined) and interest payment rates for a thirty-six month period. The contract interest rate is based on a floating index tied to the weighted average cost of funds to members of the Federal Home Loan Bank of San Francisco, as defined, which is adjusted on the first of each month. Interest only was payable at 7.54% per annum from August 1, 1989 through July 1, 1990, at 7.78% per annum from August 1, 1990 through July 1, 1991, and at 8.29% per annum from August 1, 1991 through July 1, 1992. The difference between the contract rate and the interest paid was deferred and bore interest when added to the outstanding principal balance of the note on July 1, 1992. Thereafter, monthly installments, payable at 10.34% per annum, of principal and interest were due (amortized on a 30 year term) until maturity of the loan in March 1995. The Partnership was negotiating with the first mortgage lender regarding an additional modification or refinancing of the first mortgage loan. As of August 1992, the Partnership had been remitting debt service payments under the previously remodified terms. However, the Partnership was notified that the loan had been sold to a third party. The Partnership continued its negotiations with the new lender and reached an agreement for another modification on the existing loan. The remodification extended the maturity date to May 1, 1998 and adjusted the contract rate to 8% per annum. The remodification became effective May 1, 1993 and the Partnership is required to submit equal payments of principal and interest (amortized over approximately 22 years) until maturity when all outstanding principal and interest is due. The remodification establishes release prices for the mortgage obligation (as defined), upon execution until May 1, 1995. (6) University Park Office Building Effective July 1989, the Partnership remodified the note such that the interest payment rate was reduced to 10% per annum for a period of two years, at which time the loan was to be due and payable. The difference between the contract rate and the interest paid is deferred and is accruing at 12.5% per annum. The Partnership exercised its option to extend the maturity date from July 1991 to July 1993, during which time interest only payments were due at a rate of 10.66% per annum. CARLYLE REAL ESTATE LIMITED PARTNERSHIP - XIII (A LIMITED PARTNERSHIP) AND CONSOLIDATED VENTURES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED In April 1993, the Partnership began submitting cash flow debt service payments to the lender due to the move-out of the building's primary tenant. The Partnership's discussions with the first mortgage lender to further modify the note were unsuccessful. The Partnership transferred to the lender title to the property in January 1994. This resulted in the Partnership no longer having an ownership interest in the property, and will result in net gain for financial reporting and Federal income tax purposes to the Partnership with no corresponding distributable proceeds in 1994. Payments of interest in arrears were approximately $884,000 at the date of transfer (see note 11(b)). (7) Gables Corporate Plaza The Gables venture reached an agreement to modify the long-term first mortgage note secured by Gables Corporate Plaza located in Coral Gables, Florida. Effective April 1, 1989, the contract rate was permanently lowered from 12.8% to 10.75% per annum from January 1, 1989 through December 31, 1993; interest only payments were due at a rate of 7% per annum. The difference between the interest paid and the contract rate was deferred and was accrued at the contract rate. Deferred interest is due monthly from cash flow or upon maturity of the note. From April 1, 1994 through maturity in 1996, interest only payments was due at the original contract rate. In addition, the Partnership agreed with the joint venture partner to defer interest payments on its second and third mortgage notes for the same five year period. The interest rate was permanently lowered for the five years from 12.9% per annum to 11.99% per annum. The Partnership also agreed with the joint venture partner to reduce the consolidated second and third mortgage notes by $230,000 and treat this amount as a capital contribution by the joint venture partner. The Partnership agreed to pay operating deficits at the property of up to $1,200,000 from January 1, 1989 through December 31, 1993. Gables venture had recently negotiated for an additional modification or refinancing of the first mortgage loan. Since January 1991, interest only payments were remitted at a 5% pay rate instead of the required 7% rate to the extent of available property cash flow. Negotiations with the lender were unsuccessful and the Partnership on behalf of the venture decided to not commit any significant additional amounts to the property. On May 3, 1993, the lender appointed a receiver and took possession and control of the property. In addition, the venture entered into an agreement with the lender whereby the venture would transfer title to the lender in January, 1994. During this period, the venture attempted to sell the property. The venture was unable to sell the property during the allotted time, and therefore, transferred title of the property to the lender in accordance with its previous agreement. This resulted in the venture no longer having an ownership interest and will result in net gain for financial reporting and Federal income tax purposes without any net distributable proceeds in 1994. Accordingly, the balances of the mortgage note and related accrued interest with a combined outstanding balance of approximately $24,970,000 and $20,390,000 at December 31, 1993 and at December 31, 1992, respectively, have been classified as current liabilities in the accompanying consolidated financial statements at December 31, 1993. Payments of principal and interest in arrears were approximately $944,000 at the date of transfer (see note 11(a)). CARLYLE REAL ESTATE LIMITED PARTNERSHIP - XIII (A LIMITED PARTNERSHIP) AND CONSOLIDATED VENTURES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED (8) Greenwood Creek II Apartments The Partnership was negotiating for modification of the long-term mortgage note secured by Greenwood Creek II Apartments located in Benbrook (Fort Worth), Texas. As a result of the negotiations, the Partnership made monthly debt service payments of interest only at a rate of 8% per annum between January 1989 and January 1990. In February 1990, the Partnership ceased making debt service until March 1991. The Partnership had reached an agreement in principle with the lender to submit the monthly cash flow as debt service payments beginning April 1991 while continuing to negotiate for the modification. However, the Partnership was notified that the loan had been sold to a third party. The Partnership was not successful in securing a modification. On April 6, 1993, the Partnership transferred title of the property to the lender for a transfer price of $100,000 (before selling costs and prorations) in excess of the existing mortgage balance. The Partnership recognized a gain for financial reporting and recognized a gain for Federal income tax purposes in 1993 (see note 7(f)). As of the date of sale, payments of principal and interest in arrears were approximately $598,000. (9) Commercial Union The Partnership had been unsuccessful in its attempts to obtain another primary tenant for the Commercial Union Office Building and due to the extreme softness of the Metropolitan Boston real estate market, the Partnership decided not to commit any significant additional capital to this property. Therefore, the Partnership negotiated an agreement with the second mortgage lender to realize upon its security interest in full satisfaction of the Partnership's first and second mortgage obligations. On August 15, 1991, the second mortgage lender concluded proceedings to realize upon its security interest. This resulted in the Partnership no longer having an ownership interest in the property and resulted in taxable income to the Partnership of approximately $3,200,000 with no corresponding distributable proceeds in 1991. The Partnership recognized a gain of approximately $1,476,000 for financial reporting purposes in 1991. As a result of the second mortgage lender realizing upon its security, the litigation involving, among others, the Partnership and the building's primary tenant was settled by all parties dismissing their claims. (10) Copley Place Associates The joint venture modified the existing first mortgage note effective March 1, 1992. The modification lowers the pay rate from 12% to 9% per annum through August 1993, and at that time, further reduces it to 7-1/2% per annum through August 1998. The contract rate has been lowered to 10% per annum through August 1993 and, at that time is further reduced to 8-1/2% per annum through August 1998. After each monthly payment, the difference between the contract interest rate on the outstanding principal balance on the loan, including deferred interest, and interest paid at the applicable pay rate (as defined), will be added to the principal balance and will accrue interest at the contract interest rate. All outstanding principal balance, including the unpaid deferred interest, is due and payable on August 31, 1998. In return, the lender will be entitled to receive, as additional interest, a minority residual participation of 10% of net proceeds (if any, as defined) from a sale or refinancing after the Partnership and its joint venture partner have recovered their investments (as defined). Any cash flow from the property, after all capital and leasing expenditures, will be escrowed for the purpose of paying for future capital and leasing requirements. CARLYLE REAL ESTATE LIMITED PARTNERSHIP - XIII (A LIMITED PARTNERSHIP) AND CONSOLIDATED VENTURES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED As a result of the debt modification, the property produced cash flow in 1993. This cash flow has been escrowed for future potential leasing requirements as set forth in the loan modification. The property is expected to experience a significant loss of rental income due to the expiration of a major tenant's lease. Based on this fact, the joint venture has initiated discussions with the first mortgage lender regarding an additional modification of the loan. There can be no assurances such remodification will be consummated. If the joint venture is unable to secure such remodification, it may decide not to commit any significant additional amounts to the property. This would result in the joint venture no longer having an ownership interest in the property and would result in a net gain for financial reporting and Federal income tax purposes with no corresponding distributable proceeds. The joint venture is aggressively marketing the upcoming vacant space. (11) Carrollwood Apartments In September 1993, the venture refinanced with a third party lender the existing underlying mortgage loan with a balance of approximately $7,200,000 payable at 12-3/4% per annum due in 1995. The new loan is in the amount of $7,455,000. The loan is payable in monthly installments of principal and interest and bears interest at 7.45% per annum for a five year period until maturity. The venture paid a prepayment penalty relating to the original mortgage of approximately $143,200 in connection with the refinancing. The Partnership recognized its share of approximately $141,700 as an extraordinary loss for financial reporting purposes. In addition, the venture was obligated to establish an escrow account for future capital improvements. The escrow account was initially funded by the Partnership's capital contribution to the venture and is subsequently funded by the operations of the venture. As of the date of this report, no amounts have been withdrawn. (12) Marshall's Aurora Plaza The long-term note secured by the Marshall's Aurora Plaza shopping center located in Aurora, Colorado reached its scheduled maturity in June 1993. The mortgage note has an outstanding balance of approximately $6,470,000 at December 31, 1993. The Partnership had been remitting debt service under the original terms of the loans. In January 1994, effective November 1993, the Partnership reached an agreement with the current lender to modify and extend the existing long-term note. The modification lowered the pay and accrual rates from 12.75% per annum to 8.375% per annum and extended the loan for a three year period to October 1996. Concurrent with the closing of the modification, the Partnership paid down the existing mortgage balance in the amount of $250,000. (13) Long Beach Plaza The Partnership has initiated discussions with the first mortgage lender regarding a modification of the mortgage loan secured by the Long Beach Plaza located in Long Beach, California. There can be no assurance that any modification agreement will be executed. If the Partnership is unable to secure such modification, it may decide not to commit any significant additional amounts to the property. This would result in the Partnership no longer having an ownership interest in the property and would result in a net gain for financial reporting and Federal income tax purposes with no corresponding distributable proceeds. The Partnership has not remitted all of the scheduled debt service payments since June 1993. Accordingly, the combined balances of the mortgage note and related accrued interest of approximately $35,449,000 at December 31, 1993 have been classified as current liabilities in the accompanying consolidated financial statements. As of the date of this report, payments of principal and interest in arrears are approximately $2,236,000. CARLYLE REAL ESTATE LIMITED PARTNERSHIP - XIII (A LIMITED PARTNERSHIP) AND CONSOLIDATED VENTURES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED (5) PARTNERSHIP AGREEMENT Pursuant to the terms of the Partnership Agreement, net profits and losses of the Partnership from operations are allocated 96% to the Limited Partners and 4% to the General Partners. Profits from the sale of investment properties are to be allocated to the General Partners to the greatest of (i) 1% of such profits, (ii) the amount of cash distributions to the General Partners, or (iii) an amount which will reduce the General Partners' capital account deficits (if any) to a level consistent with the gain anticipated to be realized from the sale of properties. Losses from the sale of properties are to be allocated 1% to the General Partners. The remaining profits and losses will be allocated to the Limited Partners. The General Partners are not required to make any additional capital contributions except under certain limited circumstances upon termination of the Partnership. Distributions of "Net cash receipts" of the Partnership are allocated 90% to the Limited Partners and 10% to the General Partners (of which 6.25% constitutes a management fee to the Corporate General Partner for services in managing the Partnership). The Partnership Agreement provides that, subject to certain conditions, the General Partners shall receive as a distribution from the sale of a real property by the Partnership up to 3% of the selling price, and that the remaining proceeds (net after expenses and retained working capital) be distributed 85% to the Limited Partners and 15% to the General Partners. However, prior to such distributions being made, the Limited Partners are entitled to receive 99% of net sale and financing proceeds and the General Partners shall receive 1% until the Limited Partners (i) have received cash distributions of sale or refinancing proceeds in an amount equal to the Limited Partners' aggregate initial capital investment in the Partnership and (ii) have received cumulative cash distributions from the Partnership's operations which, when combined with sale or refinancing proceeds previously distributed, equal a 6% annual return on the Limited Partners' average capital investment for each year (their initial capital investment as reduced by sale or refinancing proceeds previously distributed). If upon the completion of the liquidation of the Partnership and the distribution of all Partnership funds, the Limited Partners have not received the amounts in (i) and (ii) above, the General Partners will be required to return all or a portion of the 1% distribution of sale or financing proceeds described above in an amount equal to such deficiency in payments to the Limited Partners pursuant to (i) and (ii) above. (6) MANAGEMENT AGREEMENTS - OTHER THAN VENTURES The Partnership has entered into agreements for the operation and management of the investment properties. Such agreements are summarized as follows: The Partnership entered into an agreement with an affiliate of the seller for the operation and management of Marshall's Aurora Plaza, Aurora, Colorado for a management fee calculated at a percentage of certain types of cash income from the property. The Long Beach Plaza in Long Beach, California, Plaza Tower office building in Knoxville, Tennessee, the two apartment complexes known as Quail Place Apartments and Heritage Park II Apartments in Oklahoma City, Oklahoma (prior to their sales in March 1992), Greenwood Creek II Apartments in Benbrook, Texas, (prior to its sale in April 1993) Rio Cancion Apartments (prior to its sale in March 1993) and Eastridge Apartments in Tucson, Arizona, University Park office building in Sacramento, California, (prior to transferring the property to the lender in January 1994) 1001 Fourth Avenue CARLYLE REAL ESTATE LIMITED PARTNERSHIP - XIII (A LIMITED PARTNERSHIP) AND CONSOLIDATED VENTURES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED Plaza office building in Seattle, Washington, (prior to transferring the property to the lender in November 1993), Sherry Lane Place office building in Dallas, Texas, Commercial Union Building in Quincy, Massachusetts (prior to the lender realizing upon its security in August 1991), Gables Corporate Plaza in Coral Gables, Florida (prior to transferring the property to the lender in January 1994), and the Bridgeport Apartments in Irving, Texas (prior to its sale in April 1992) are or were managed by an affiliate of the Corporate General Partner for a fee equal to a percentage of defined gross income from the property. (7) SALE OF INVESTMENT PROPERTIES (a) Allied Automotive Center On October 10, 1990, the Partnership sold the land, building, and related improvements of the Allied Automotive Center located in Southfield, Michigan for $19,613,121 (in cash before prorations and cost of sale). The sale included the adjacent undeveloped land, building and improvements owned by two other partnerships affiliated with the Corporate General Partner. The Partnership has retained title to a defined 1.9 acre piece of land (the "Parcel"). During the buyer's due diligence investigation, the buyer found traces of contamination located on a portion of the Parcel as well as on a portion of the land owned by the two affiliated selling entities. It was subsequently determined that such contamination was most likely the result of certain activities of the previous owner. As a result, the purchase price was reduced by approximately $682,000 for the Partnership's excluded land. The land may be purchased by the buyer after the environmental clean-up is completed. As a condition of the sale, the Partnership has agreed to conduct investigations to determine all contaminants and to conduct clean-up of any such contaminants. The Partnership was also required to indemnify the buyer from specified potential clean-up related liabilities. If the clean-up is successful, the buyer will purchase the excluded land for $682,000, the purchase price adjustment. In addition, the Partnership has reached an agreement with the previous owner of the Allied Automotive Center, who has agreed to cause such investigation and clean-up to be done at the previous owner's expense. The previous owner has also indemnified the Partnership from specified potential clean-up related liabilities. As a result of such agreements, the Partnership has offset any liability for such costs against amounts to be paid by the previous owners. The Partnership, in cooperation with the previous owner, is currently working on a plan to clean up the land. The gain associated with this Parcel, approximately $543,000, will be recognized when the closing occurs. There can be no assurance that the sale of this Parcel will be consummated. (b) Heritage Park-II Apartments On March 26, 1992 the Partnership, through Partridge Place Limited Partnership, sold the land, related improvements, and personal property of the Heritage Park-II Apartments, located in Oklahoma City, Oklahoma for $4,326,000 (before selling costs and prorations) which was paid in cash at closing. In addition, the buyer paid to the Partnership incentive management fees of $199,960. The seller paid an outside broker's commission of $126,000 from the sales proceeds. In conjunction with the sale, the mortgage note and related accrued interest of approximately $8,173,000 was satisfied in full through a discounted payment of approximately $4,200,000. The Partnership recognized a net gain from this transaction in 1992 of approximately $2,688,000 (reflected as a loss on sale of approximately $1,285,000 and an extraordinary gain on forgiveness of indebtedness of approximately $3,973,000) for financial reporting purposes and recognized a gain of approximately $4,624,000 for Federal income tax purposes. CARLYLE REAL ESTATE LIMITED PARTNERSHIP - XIII (A LIMITED PARTNERSHIP) AND CONSOLIDATED VENTURES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED (c) Quail Place Apartments On March 26, 1992 the Partnership, through Quail Springs Limited Partnership, sold the land, related improvements, and personal property of the Quail Place Apartments, located in Oklahoma City, Oklahoma for $2,163,000 (before selling costs and prorations) which was paid in cash at closing. In addition, the buyer paid to the Partnership incentive management fees of $175,180. The seller paid an outside broker's commission of $63,000 from the sales proceeds. In conjunction with the sale, the mortgage note and related accrued interest of approximately $5,417,000 was satisfied in full through a discounted payment of approximately $2,100,000. The Partnership recognized a net gain from this transaction in 1992 of approximately $1,659,000 (reflected as a loss on sale of approximately $1,658,000 and an extraordinary gain on forgiveness of indebtedness of approximately $3,317,000) for financial reporting purposes and recognized a gain of approximately $2,879,000 for Federal income tax purposes. (d) Bridgeport Apartments On April 2, 1992, the Partnership sold the land, related improvements and personal property of the Bridgeport Apartments, located in Irving, Texas to the existing lender for $430,000 in excess of the existing mortgage note (before closing costs and prorations) which was paid in cash at closing. As a result of the sale, the Partnership will not have any further liability or obligation under the mortgage note which had an unpaid principal balance of approximately $9,342,000 and an unpaid accrued interest balance of approximately $2,462,000 at the date of the sale. The Partnership recognized a gain in 1992 of approximately $5,076,000 for financial reporting purposes and recognized a gain of approximately $6,142,000 for Federal income tax purposes. (e) Rio Cancion Apartments On March 31, 1993, the Partnership sold the land, related improvements, and personal property of the Rio Cancion Apartments, located in Tucson, Arizona for $13,700,000 (before selling costs and prorations) which was paid in cash at closing. In conjunction with the sale, the mortgage note and related accrued interest with a balance of approximately $12,157,000 was satisfied in full. The lender received, as its 25% minority residual participation (as defined), approximately $317,000 (see note 4(b)(3)). The Partnership received net sales proceeds of approximately $809,000. The Partnership recognized a gain from this transaction in 1993 of $2,524,958 for financial reporting purposes and recognized a gain of $7,865,633 for Federal income tax purposes in 1993. (f) Greenwood Creek II Apartments On April 6, 1993, the Partnership transferred title to the existing lender to the land, related improvements, and personal property of the Greenwood Creek II Apartments, located in Benbrook, (Fort Worth) Texas for a transfer price of $100,000 (before selling costs and prorations) in excess of the existing mortgage balance of approximately $3,747,000 (see note 4(b)(8)). The Partnership recognized a gain for financial reporting purposes in 1993 of $1,787,073 and recognized a gain of $1,823,988 for Federal income tax purposes in 1993. CARLYLE REAL ESTATE LIMITED PARTNERSHIP - XIII (A LIMITED PARTNERSHIP) AND CONSOLIDATED VENTURES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED (8) LEASES (a) As Property Lessor At December 31, 1993, the Partnership and its consolidated ventures' principal assets are five office buildings, two shopping centers, a multi-use complex and three apartment complexes. The Partnership has determined that all leases relating to these properties are properly classified as operating leases; therefore, rental income is reported when earned and the cost of each of the properties, excluding cost of land, is depreciated over the estimated useful lives. Leases with commercial tenants range in term from one to 30 years and provide for fixed minimum rent and partial reimbursement of operating costs. In addition, leases with shopping center tenants generally provide for additional rent based upon percentages of tenants' sales volumes. With respect to the Partnership's shopping center investments, a substantial portion of the ability of retail tenants to honor their leases is dependent upon the retail economic sector. Apartment complex leases in effect at December 31, 1993 are generally for a term of one year or less and provide for annual rents of approximately $5,719,000. Cost and accumulated depreciation of the leased assets are summarized as follows at December 31, 1993: Shopping centers: Cost. . . . . . . . . . . . . $ 51,183,724 Accumulated depreciation. . (16,384,628) ------------ 34,799,096 ------------ Office buildings: Cost. . . . . . . . . . . . 106,451,082 Accumulated depreciation. . (31,940,110) ------------ 74,510,972 ------------ Multi-use complex: Cost. . . . . . . . . . . . 285,870,905 Accumulated depreciation. . (91,998,239) ------------ 193,872,666 ------------ Apartment complexes: Cost. . . . . . . . . . . . 30,697,479 Accumulated depreciation. . (9,591,974) ------------ 21,105,505 ------------ Total . . . . . . . $324,288,239 ============ CARLYLE REAL ESTATE LIMITED PARTNERSHIP - XIII (A LIMITED PARTNERSHIP) AND CONSOLIDATED VENTURES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED Minimum lease payments receivable including amounts representing executory costs (e.g., taxes, maintenance, insurance), and any related profit in excess of specific reimbursements, to be received in the future under the above operating commercial lease agreements, are as follows: 1994. . . . . . . . . . . $ 43,284,626 1995. . . . . . . . . . . 35,684,088 1996. . . . . . . . . . . 33,052,124 1997. . . . . . . . . . . 30,827,874 1998. . . . . . . . . . . 28,067,260 Thereafter. . . . . . . . 88,555,330 ============ Additional rent based upon percentages of tenants' sales volumes included in rental income aggregated approximately $1,804,123, $1,464,841 and $1,010,529 for the years ended December 31, 1993, 1992 and 1991, respectively. (b) As Property Lessee The following lease agreements have been determined to be operating leases: The Partnership owns the leasehold rights to the parking structure adjacent to the Long Beach, California shopping center. The lease has an initial term of 50 years which commenced in 1981 with one 49-year renewal option exercisable by a local municipal authority. The lease provides for annual rental of $745,000, which is subject to decrease based on formulas which relate to the amount of real estate taxes assessed against the shopping center and the parking structure. The rental expense for 1993, 1992 and 1991 under the above operating lease was $528,276, $538,962 and $532,653, respectively, and consisted exclusively of minimum rent. The Copley Place venture has leased the air rights over the Massachusetts Turnpike located beneath the Boston, Massachusetts multi-use complex. The lease has a term of 99 years which commenced in 1978. The total rent due under the terms of the air rights lease was prepaid by the seller and is being amortized over the term of the air rights lease. (9) TRANSACTIONS WITH AFFILIATES In December 1984, Urban Holdings, Inc., an affiliate of the Corporate General Partner of the Partnership, purchased all the outstanding stock of the developer (joint venture partner) and property manager of the Old Orchard shopping center and the Copley Place multi-use complex. Consequently, the developer is an affiliate of the Corporate General Partner and continues to possess all of the rights and obligations granted the developer under the terms of the respective acquisition and related agreements. Fees, commissions and other expenses required to be paid by the Partnership and its consolidated ventures to the General Partners and their affiliates as of December 31, 1993 and for the years ended December 31, 1993, 1992 and 1991 are as follows: CARLYLE REAL ESTATE LIMITED PARTNERSHIP - XIII (A LIMITED PARTNERSHIP) AND CONSOLIDATED VENTURES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED UNPAID AT DECEMBER 31, 1993 1992 1991 1993 ---------- --------- --------- -------------- Property management and leasing fees . . . . . . . . . . . . . . $3,001,759 5,042,311 5,904,944 13,670,682 Insurance commissions. . . . . . . . . . . . . . . . . . . . . . 214,278 223,748 320,110 -- Reimbursement (at cost) for accounting services. . . . . . . . . 148,712 180,688 127,675 148,712 Reimbursement (at cost) for legal services . . . . . . . . . . . 30,381 36,411 66,522 30,381 Reimbursement (at cost) for out-of-pocket expenses . . . . . . . 45,143 210,065 210,664 -- Management fees to corporate general partner . . . . . . . . . . -- 12,715 108,075 -- Reimbursement (at cost) for out-of-pocket salary and salary related expenses relating to on-site and other costs for the Partnership and its investment properties. . . . . . . . . . . . . . . . . -- -- 2,823 -- ---------- ---------- ---------- ---------- $3,440,273 5,705,938 6,740,813 13,849,775 ========== ========== ========== ========== /TABLE CARLYLE REAL ESTATE LIMITED PARTNERSHIP - XIII (A LIMITED PARTNERSHIP) AND CONSOLIDATED VENTURES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED Payment of certain property management and leasing fees payable under the terms of the management agreements ($13,671,000, approximately $37 per $1,000 interest) at December 31, 1993 has been deferred. All amounts currently payable do not bear interest and are expected to be paid in future periods. (10) INVESTMENT IN UNCONSOLIDATED VENTURES Summary combined financial information for JMB/NYC and its unconsolidated ventures (note 3(c)) as of and for the years ended December 31, 1993 and 1992 are as follows: 1993 1992 ------------- ------------- Current assets . . . . . . . . . . . $ 17,668,206 20,133,526 Current liabilities (includes $923,041,198 and $931,654,790 of current portion of long-term debt at December 31, 1993 and December 31, 1992, respectively) (940,836,999) (947,314,271) ------------- ------------- Working capital (deficit). . . . (923,168,793) (927,180,745) ------------- ------------- Investment property, net . . . . . . 746,632,895 977,278,400 Accrued rent receivable. . . . . . . 50,369,613 58,019,584 Deferred expenses. . . . . . . . . . 11,096,044 12,358,603 Other liabilities. . . . . . . . . . (114,381,260) (100,815,520) Venture partners' deficit (equity) . 156,904,193 (70,045,641) ------------- ------------- Partnership's capital (deficit). $ (72,547,308) (50,385,319) ============= ============= Represented by: Invested capital . . . . . . . . . $ 43,728,411 43,723,411 Cumulative net losses. . . . . . . (106,901,970) (84,734,981) Cumulative cash distributions. . . (9,373,749) (9,373,749) ------------- ------------- $ (72,547,308) (50,385,319) ============= ============= Total income . . . . . . . . . . . . $ 168,002,257 177,682,092 ============= ============= Expenses applicable to operating loss $ 411,977,853 243,630,397 ============= ============= Net loss . . . . . . . . . . . . . . $(243,975,596) (65,948,305) ============= ============= Also, for the year ended December 31, 1991, total income was $176,041,995, expenses applicable to operating loss were $244,372,557 and the net loss was $68,330,562 for JMB/NYC and the unconsolidated ventures. CARLYLE REAL ESTATE LIMITED PARTNERSHIP - XIII (A LIMITED PARTNERSHIP) AND CONSOLIDATED VENTURES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONCLUDED (11) SUBSEQUENT EVENTS (a) Gables Corporate Plaza On January 5, 1994, the Partnership, through Gables Corporate Plaza Associates, ("the Venture") transferred title to the Gables Corporate Plaza office building as previously agreed upon in full satisfaction of the Venture's mortgage obligation. The mortgage had an outstanding balance, including accrued interest, of approximately $24,967,000. As a result of the transfer, neither the Partnership nor the Venture have an ownership interest in the property. The transfer will result in a net gain of approximately $10,524,000 for financial reporting purposes. The Partnership expects to recognize a gain of approximately $12,460,000 for Federal income tax purposes in 1994 with no corresponding distributable proceeds (see Note 4(b)(7)). (b) University Park office building As a result of the Partnership's unsuccessful negotiations with the mortgage lender, the Partnership transferred title to the University Park office building on January 10, 1994 in full satisfaction of the Partnership's mortgage obligation. The mortgage had an outstanding balance, including accrued interest, of approximately $16,294,000. As a result of the transfer, the Partnership no longer has an ownership interest in the property. The transfer will result in a net gain of approximately $5,620,000 for financial reporting purposes and expects to recognize a gain of approximately $6,885,000 for Federal income tax purposes in 1994 with no corresponding distributable proceeds (see note 4(b)(6)). SCHEDULE X CARLYLE REAL ESTATE LIMITED PARTNERSHIP - XIII (A LIMITED PARTNERSHIP) AND CONSOLIDATED VENTURES SUPPLEMENTARY INCOME STATEMENT INFORMATION YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 CHARGED TO COSTS AND EXPENSES ---------------------------------------------- 1993 1992 1991 ------------ ------------ ------------ Maintenance and repairs. $ 8,393,532 9,544,259 7,728,419 Depreciation . . . . . . 18,343,123 19,490,916 20,391,223 Amortization . . . . . . 2,410,540 1,671,011 284,201 Taxes: Real estate . . . . . 11,372,379 11,077,556 11,645,018 Other . . . . . . . . 87,928 20,786 162,829 Advertising. . . . . . . 441,742 533,259 729,591 ============ ============ ============ SCHEDULE XI CARLYLE REAL ESTATE LIMITED PARTNERSHIP - XIII (A LIMITED PARTNERSHIP) AND CONSOLIDATED VENTURES CONSOLIDATED REAL ESTATE AND ACCUMULATED DEPRECIATION DECEMBER 31, 1993 COSTS CAPITALIZED INITIAL COST TO SUBSEQUENT TO GROSS AMOUNT AT WHICH CARRIED PARTNERSHIP (a) ACQUISITION AT CLOSE OF PERIOD (b) -------------------------- ------------- ------------------------------------------ LAND AND BUILDINGS LAND LAND AND BUILDINGS LEASEHOLD AND BUILDINGS AND LEASEHOLD AND DESCRIPTION ENCUMBRANCE INTEREST IMPROVEMENTS IMPROVEMENTS INTEREST IMPROVEMENTS TOTAL(m) - ----------- ----------- ----------- ------------ -------------- ---------- ------------ ---------- APARTMENT BUILDINGS: Irving, Texas (j) . . .$ -- 1,746,622 7,886,542 (9,633,164) -- -- -- Tucson, Arizona (k) . . -- 1,935,049 13,129,268 (15,064,317) -- -- -- Oklahoma City, Oklahoma (e)(i) . . . . . . . . -- 779,748 4,370,567 (5,150,315) -- -- -- Oklahoma City, Oklahoma (e)(i) . . . . . . . . -- 745,101 6,844,687 (7,589,788) -- -- -- Tampa, Florida(e) . . . 7,400,309 1,092,010 7,408,618 221,691 1,092,010 7,630,309 8,722,319 Tucson, Arizona(e). . . 9,752,617 1,673,067 8,429,627 263,131 1,673,067 8,692,758 10,365,825 Fort Worth, Texas (l) . -- 804,874 4,037,342 (4,842,216) -- -- -- Jacksonville, Florida(e)10,840,261 1,905,940 9,664,038 39,357 1,815,262 9,794,073 11,609,335 OFFICE BUILDINGS: Seattle, Washington(d). -- 10,198,309 111,051,956 (121,250,265) -- -- -- Knoxville, Tennessee(f) 18,160,291 -- 28,884,725 3,910,724 1,508,417 31,287,032 32,795,449 Coral Gables, Florida(e)24,967,836 2,884,661 15,864,501 1,929,703 2,884,661 17,794,204 20,678,865 Dallas, Texas(e). . . . 40,498,538 7,902,979 35,029,347 (5,072,944) 6,198,484 31,660,898 37,859,382 Sacramento, California. 16,294,125 1,508,526 11,907,858 1,561,876 1,508,526 13,469,734 14,978,260 Quincy, Massachusetts(h) -- 2,033,367 17,404,970 (19,438,337) -- -- -- Southfield, Michigan(g) -- 1,715,373 -- (1,576,247) 139,126 -- 139,126 SHOPPING CENTERS: Long Beach, California. 34,652,141 3,801,066 42,765,277 (4,215,322) 3,376,877 38,974,144 42,351,021 Aurora, Colorado. . . . 6,468,313 2,035,721 6,674,891 122,091 2,035,721 6,796,982 8,832,703 MULTI-USE COMPLEX: Boston, Massachusetts (c)(e) . . . . . . . .285,934,096 4,769,913 271,584,219 9,516,773 4,769,912 281,100,993 285,870,905 ------------ ----------- ----------- ----------- ----------- ----------- ----------- Total . . . . . . .$454,968,527 47,532,326 602,938,433 (176,267,569) 27,002,063 447,201,127 474,203,190 ============ =========== =========== =========== =========== =========== =========== /TABLE SCHEDULE XI - CONTINUED CARLYLE REAL ESTATE LIMITED PARTNERSHIP - XIII (A LIMITED PARTNERSHIP) AND CONSOLIDATED VENTURES CONSOLIDATED REAL ESTATE AND ACCUMULATED DEPRECIATION DECEMBER 31, 1993 LIFE ON WHICH DEPRECIATION IN LATEST STATEMENT OF 1993 ACCUMULATED DATE OF DATE OPERATION REAL ESTATE DESCRIPTION DEPRECIATION(n) CONSTRUCTION ACQUIRED IS COMPUTED TAXES - ----------- ---------------- ------------ ---------- --------------- ----------- APARTMENT BUILDINGS: Irving, Texas (j) . . . . . . . . . . . . . $ -- 1983 9/30/83 5-30 years -- Tucson, Arizona (k) . . . . . . . . . . . . -- 1983 8/18/83 5-30 years 45,125 Oklahoma City, Oklahoma (e)(i) . . . . . . . . . . . . . . . . . . -- 1983 7/1/83 5-30 years -- Oklahoma City, Oklahoma (e)(i) . . . . . . . . . . . . . . . . . . -- 1984 7/1/83 5-30 years -- Tampa, Florida(e) . . . . . . . . . . . . . 2,871,053 1984 12/16/83 5-30 years 207,021 Tucson, Arizona(e). . . . . . . . . . . . . 3,446,759 1984 8/23/83 5-30 years 142,144 Fort Worth, Texas (l) . . . . . . . . . . . -- 1984 3/30/84 5-30 years -- Jacksonville, Florida(e). . . . . . . . . . 3,274,162 1985 10/9/84 5-30 years 213,469 OFFICE BUILDINGS: Seattle, Washington(d). . . . . . . . . . . -- 1969 9/1/83 5-30 years 758,739 Knoxville, Tennessee(f) . . . . . . . . . . 10,206,630 1979 10/26/83 5-30 years 895,382 Coral Gables, Florida(e). . . . . . . . . . 6,234,925 1983 11/15/83 5-30 years 152,654 Dallas, Texas(e). . . . . . . . . . . . . . 11,204,248 1983 12/1/83 5-30 years 517,699 Sacramento, California. . . . . . . . . . . 4,294,307 1981 1/16/84 5-30 years 134,537 Quincy, Massachusetts(h). . . . . . . . . . -- 1981 3/12/84 5-30 years -- Southfield, Michigan(g) . . . . . . . . . . -- 1974 3/30/84 5-30 years (778) SHOPPING CENTERS: Long Beach, California. . . . . . . . . . . 13,936,858 1982 6/22/83 5-30 years 945,986 Aurora, Colorado. . . . . . . . . . . . . . 2,447,770 1982 4/1/83 5-30 years 108,019 MULTI-USE COMPLEX: Boston, Massachusetts (c)(e) . . . . . . . . . . . . . . . . . . 91,998,239 1983 9/1/83 5-30 years 7,252,382 ------------ ----------- Total . . . . . . . . . . . . . . . . . $149,914,951 11,372,379 ============ =========== SCHEDULE XI - CONTINUED CARLYLE REAL ESTATE LIMITED PARTNERSHIP - XIII (A LIMITED PARTNERSHIP) AND CONSOLIDATED VENTURES CONSOLIDATED REAL ESTATE AND ACCUMULATED DEPRECIATION DECEMBER 31, 1993 - --------------- Notes: (a) The initial cost to the Partnership represents the original purchase price of the properties, including amounts incurred subsequent to acquisition which were contemplated at the time the property was acquired. (b) The aggregate cost of real estate owned at December 31, 1993 for Federal income tax purposes was approximately $98,358,000. (c) Property operated under air rights; see Note 8(b). (d) Purchase price subject to adjustment. Property recorded a provision for value impairment in 1992. The Partnership transferred title of the property to the lender in November 1993. (e) Properties owned and operated by joint ventures; see Note 3. (f) The Partnership purchased the land underlying Plaza Tower office building in December 1985. (g) Property sold except for a 1.9 acre parcel; see Note 7(a). (h) Property recorded a provision for value impairment in 1990; Lender realized upon its security and took title to property August 1991, see Note 4(b)(9). (i) Property sold March 1992; see Note 7. (j) Property sold April 1992; see Note 7. (k) Property sold March 1993. (l) Property sold April 1993. /TABLE SCHEDULE XI - CONTINUED CARLYLE REAL ESTATE LIMITED PARTNERSHIP - XIII (A LIMITED PARTNERSHIP) AND CONSOLIDATED VENTURES CONSOLIDATED REAL ESTATE AND ACCUMULATED DEPRECIATION DECEMBER 31, 1993 1993 1992 1991 ------------- ------------- ------------- (m) Reconciliation of real estate carrying costs: Balance at beginning of period . . . . . . . $627,815,579 650,806,083 664,568,420 Additions during period. . . . . . . . . . . 3,188,425 6,144,928 3,741,972 Reductions during period . . . . . . . . . . (156,800,814) (29,135,432) (17,504,309) ------------ ------------ ------------ Balance at end of period . . . . . . . . . . $474,203,190 627,815,579 650,806,083 ============ ============ ============ (n) Reconciliation of accumulated depreciation: Balance at beginning of period . . . . . . . $178,425,639 165,375,392 149,274,120 Depreciation expense . . . . . . . . . . . . 18,343,123 19,490,916 20,391,223 Reductions during period . . . . . . . . . . (46,853,811) (6,440,669) (4,289,951) ------------ ------------ ------------ Balance at end of period . . . . . . . . . . $149,914,951 178,425,639 165,375,392 ============ ============ ============ /TABLE INDEPENDENT AUDITORS' REPORT The Partners CARLYLE REAL ESTATE LIMITED PARTNERSHIP-XIII: We have audited the combined financial statements of JMB/NYC Office Building Associates, L.P. (JMB/NYC) and unconsolidated ventures as listed in the accompanying index. In connection with our audits of the combined financial statements, we also have audited the financial statement schedules as listed in the accompanying index. These combined financial statements and financial statement schedules are the responsibility of the General Partners of Carlyle Real Estate Limited Partnership-XIII (the Partnership). Our responsibility is to report on these combined financial statements and financial statement schedules based on the results of our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by the General Partners of the Partnership, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our report. In our opinion, the 1992 and 1991 combined financial statements referred to above present fairly, in all material respects, the financial position of JMB/NYC and unconsolidated ventures as of December 31, 1992, and the results of their operations and their cash flows for the years ended December 31, 1992 and 1991, in conformity with generally accepted accounting principles. Also in our opinion, the related 1992 and 1991 financial statement schedules, when considered in relation to the basic combined financial statements taken as a whole, present fairly, in all material respects, the information set forth therein. As discussed in Note 3 of the Partnership's notes to the financial statements incorporated by reference in Note 2 of the combined financial statements, JMB/NYC is in dispute with the unaffiliated partners in the real estate ventures over the calculation of the effective interest rate with reference to the first mortgage loan, which covers all the real estate owned through JMB/NYC's joint ventures. JMB/NYC believes that, for purposes of calculating cash flow deficits and for financial reporting purposes, the joint venture agreements for JMB/NYC's real estate joint ventures require interest to be computed at an effective rate of 1-3/4% over the short-term U.S. Treasury obligation rate (subject to a minimum rate of 7% per annum) plus any excess monthly Net Cash Flow of the real estate owned through JMB/NYC's joint ventures, such sum not to exceed 12-3/4% per annum. The unaffiliated partners in the real estate joint ventures contend that a 12-3/4% per annum interest rate applies. The disputed interest aggregated $20,521,000 at December 31, 1993. The ultimate outcome of the dispute cannot presently be determined. Accordingly, the disputed interest has not been included in mortgage and other interest for 1993 in the accompanying combined financial statements. The accompanying combined financial statements and financial statement schedules have been prepared assuming that JMB/NYC and the unconsolidated ventures will continue as going concerns. As discussed in Note 3 of the Partnership's notes to financial statements, incorporated by reference in Note 2 of the combined financial statements, certain of the unconsolidated ventures (Continued) have suffered recurring losses from operations and expect to incur cash flow deficits in the future. Such deficits may be impacted by the resolution of the dispute referred to above. JMB/NYC's interest in each of the ventures is pledged to secure its obligations under the joint venture agreements, including its obligations to fund possible cash flow deficits incurred by the real estate ventures commencing July 1, 1993. There can be no assurance that either the unaffiliated venture partners or JMB/NYC will be able to fund possible cash flow deficits in the future. Also, as described in Note 3, during 1992, the holder of the first mortgage loan alleged certain technical defaults under the loan agreements. Such defaults are currently being disputed by the unaffiliated venture partners. These circumstances raise substantial doubt about JMB/NYC and the unconsolidated ventures' ability to continue as going concerns. The General Partners' plans in regard to these matters are also described in Note 3 of the Partnership's Notes to the Financial Statements. The combined financial statements and financial statement schedules do not include any adjustments that might result from the outcome of this uncertainty. Because of the effects on the combined financial statements and financial statement schedules of such adjustments, if any, as might have been required had the outcome of the uncertainties described in the preceding two paragraphs been known, we are unable to, and do not express, an opinion on the accompanying 1993 combined financial statements and financial statement schedules. KPMG PEAT MARWICK Chicago, Illinois March 28, 1994 JMB/NYC OFFICE BUILDING ASSOCIATES, L.P. AND UNCONSOLIDATED VENTURES COMBINED BALANCE SHEETS DECEMBER 31, 1993 AND 1992 ASSETS ------ 1993 1992 -------------- -------------- Current assets: Cash (including amounts held by property managers) . . . . . . . . . . . . . . . . . . . . . $ 839,552 4,868,371 Restricted funds . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11,638,258 -- Rents and other receivables (net of allowance for doubtful accounts of $5,777,252 for 1993 and $1,900,622 for 1992. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,985,810 2,279,185 Prepaid expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 457,098 254,034 Escrow deposits. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,508,043 1,483,549 Tenant notes receivable. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 239,445 478,327 Due from affiliates (net of allowance for uncollectibility of $11,946,284 at December 31, 1993) (note 2) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . -- 10,770,060 -------------- -------------- Total current assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17,668,206 20,133,526 -------------- -------------- Investment properties, at cost (notes 1, 2 and 3) -- Schedule XI: Land . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 168,798,314 183,979,962 Buildings and improvements . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 954,150,721 1,132,409,431 -------------- -------------- 1,122,949,035 1,316,389,393 Less accumulated depreciation. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 376,316,140 339,110,993 -------------- -------------- Total investment properties, net of accumulated depreciation . . . . . . . . . . . . 746,632,895 977,278,400 -------------- -------------- Accrued rents receivable (note 1). . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 50,369,613 58,019,584 Deferred expenses (note 1) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11,096,044 12,358,603 -------------- -------------- $ 825,766,758 1,067,790,113 ============== ============== JMB/NYC OFFICE BUILDING ASSOCIATES, L.P. AND UNCONSOLIDATED VENTURES COMBINED BALANCE SHEETS - CONTINUED LIABILITIES AND PARTNERS' CAPITAL ACCOUNTS (DEFICITS) ----------------------------------------------------- 1993 1992 -------------- -------------- Current liabilities: Current portion of long-term debt (note 3) . . . . . . . . . . . . . . . . . . . . . . . . . $ 923,041,198 931,654,790 Accounts payable and accrued expenses. . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,492,409 4,789,399 Tenant allowances payable. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,369,373 3,553,916 Accrued interest . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5,384,407 5,434,655 Unearned rent. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,979,375 1,881,511 Interest payable to the O&Y affiliates . . . . . . . . . . . . . . . . . . . . . . . . . . . 4,570,237 -- -------------- -------------- Total current liabilities. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 940,836,999 947,314,271 Notes payable (note 5) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 34,158,225 34,158,225 Deferred interest payable (note 5) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 78,605,523 65,173,746 Tenant security deposits . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,617,512 1,483,549 -------------- -------------- Total liabilities. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,055,218,259 1,048,129,791 Partners' capital accounts (note 2): Carlyle-XIII: Capital contributions. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 43,728,411 43,723,411 Cumulative net losses. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (106,901,970) (84,734,981) Cumulative cash distributions. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (9,373,749) (9,373,749) -------------- -------------- (72,547,308) (50,385,319) -------------- -------------- Venture partners: Capital contributions. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 608,381,190 607,265,180 Cumulative net losses. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (683,400,633) (461,592,026) Cumulative cash distributions. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (81,884,750) (75,627,513) -------------- -------------- (156,904,193) 70,045,641 -------------- -------------- Total partners' capital accounts (deficit) . . . . . . . . . . . . . . . . . . . . . (229,451,501) 19,660,322 -------------- -------------- Commitments and contingencies (notes 1 and 2) $ 825,766,758 1,067,790,113 ============== ============== See accompanying notes to combined financial statements. /TABLE JMB/NYC OFFICE BUILDING ASSOCIATES, L.P. AND UNCONSOLIDATED VENTURES COMBINED STATEMENTS OF OPERATIONS YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 1993 1992 1991 ------------ ------------ ------------ Income: Rental income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 167,820,507 177,499,667 175,864,368 Interest income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 181,750 182,425 177,627 ------------- ------------ ------------ 168,002,257 177,682,092 176,041,995 ------------- ------------ ------------ Expenses - Schedule X: Mortgage and other interest (note 3). . . . . . . . . . . . . . . . . . . . . . 86,030,245 78,390,256 130,655,792 Depreciation. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 39,102,045 41,410,478 41,696,115 Property operating expenses . . . . . . . . . . . . . . . . . . . . . . . . . . 66,232,722 67,994,678 67,030,647 Professional services . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,314,088 1,286,443 664,560 Amortization of deferred expenses . . . . . . . . . . . . . . . . . . . . . . . 2,173,860 2,321,741 2,236,756 Provision for value impairment (note 1) . . . . . . . . . . . . . . . . . . . . 192,627,560 51,423,084 -- Provision for doubtful accounts (note 2). . . . . . . . . . . . . . . . . . . . 23,497,333 803,717 2,088,687 ------------- ------------ ------------ 411,977,853 243,630,397 244,372,557 ------------- ------------ ------------ Net loss . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $(243,975,596) (65,948,305) (68,330,562) ============= ============ ============ See accompanying notes to combined financial statements. /TABLE JMB/NYC OFFICE BUILDING ASSOCIATES, L.P. AND UNCONSOLIDATED VENTURES COMBINED STATEMENTS OF PARTNERS' CAPITAL ACCOUNTS (DEFICIT) YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 CARLYLE REAL ESTATE LIMITED VENTURE PARTNERSHIP-XIII PARTNERS ----------------- --------------- Balance at December 31, 1990 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ (28,606,693) 161,273,005 Capital contributions. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9,000 44,226,669 Net loss . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (12,323,342) (56,007,219) Cash distributions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (2,375,000) (11,762,000) ------------- ------------ Balance at December 31, 1991 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (43,296,035) 137,730,455 Capital contributions. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 35,000 15,139,959 Net loss . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (7,124,284) (58,824,021) Cash distributions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . -- (24,000,752) ------------- ------------ Balance at December 31, 1992 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (50,385,319) 70,045,641 Capital contributions. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5,000 1,116,010 Net loss . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (22,166,989) (221,808,607) Cash distributions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . -- (6,257,237) ------------- ------------ Balance at December 31, 1993 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ (72,547,308) (156,904,193) ============= ============ See accompanying notes to combined financial statements /TABLE JMB/NYC OFFICE BUILDING ASSOCIATES, L.P. AND UNCONSOLIDATED VENTURES COMBINED STATEMENTS OF CASH FLOWS YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 1993 1992 1991 ------------ ------------ ------------ Cash flows from operating activities: Net loss . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $(243,975,596) (65,948,305) (68,330,562) Items not requiring (providing) cash: Depreciation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 39,102,045 41,410,478 41,696,115 Amortization of deferred expenses. . . . . . . . . . . . . . . . . . . . . . 2,173,860 2,321,741 2,236,756 Provision for value impairment . . . . . . . . . . . . . . . . . . . . . . . 192,627,560 51,423,084 -- Provision for doubtful accounts. . . . . . . . . . . . . . . . . . . . . . . 23,497,333 803,717 2,088,687 Changes in: Rents and other receivables. . . . . . . . . . . . . . . . . . . . . . . . . (4,583,255) (192,043) 364,238 Prepaid expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (203,064) (35,972) 181,322 Escrow deposits. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (24,494) (11,376) 23,287 Tenant notes receivable. . . . . . . . . . . . . . . . . . . . . . . . . . . 238,882 (164,720) 147,224 Due from the O&Y affiliates. . . . . . . . . . . . . . . . . . . . . . . . . -- -- 705,251 Accrued rents receivable . . . . . . . . . . . . . . . . . . . . . . . . . . (24,448) 152,092 (5,730,142) Interest payable to the O&Y affiliates . . . . . . . . . . . . . . . . . . . 4,570,237 (1,171,214) 307,929 Accounts payable and other accrued expenses. . . . . . . . . . . . . . . . . (1,296,990) 621,288 (1,876,251) Accrued interest . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (50,248) (4,545,929) (73,026) Unearned rent. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 97,864 (1,869,845) 197,097 Deferred interest payable. . . . . . . . . . . . . . . . . . . . . . . . . . 13,431,777 11,831,860 10,422,516 Tenant security deposits . . . . . . . . . . . . . . . . . . . . . . . . . . 133,963 11,376 (23,287) ------------ ------------ ------------ Net cash provided by (used in) operating activities . . . . . . . . . . 25,715,426 34,636,232 (17,662,846) ------------ ------------ ------------ Cash flows from investing activities: Restricted funds . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (11,638,258) -- -- Additions to investment properties, net of tenant allowances payable. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (1,785,586) (1,709,278) (6,463,169) Payment of deferred expenses . . . . . . . . . . . . . . . . . . . . . . . . . (1,394,358) (943,675) (947,528) ------------ ------------ ------------ Net cash used in investing activities . . . . . . . . . . . . . . . . . (14,818,202) (2,652,953) (7,410,697) ------------ ------------ ------------ JMB/NYC OFFICE BUILDING ASSOCIATES, L.P. AND UNCONSOLIDATED VENTURES COMBINED STATEMENTS OF CASH FLOWS - CONTINUED 1993 1992 1991 ------------ ------------ ------------ Cash flows from financing activities: Capital contributions. . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,121,010 15,174,959 44,235,669 Advances to O&Y affiliates . . . . . . . . . . . . . . . . . . . . . . . . . . (1,176,224) (10,770,060) -- Principal payments on long-term debt . . . . . . . . . . . . . . . . . . . . . (8,613,592) (7,694,263) (6,873,039) Distributions to partners. . . . . . . . . . . . . . . . . . . . . . . . . . . (6,257,237) (24,000,752) (14,137,000) ------------ ------------ ------------ Net cash provided by (used in) financing activities . . . . . . . . . . (14,926,043) (27,290,116) 23,225,630 ------------ ------------ ------------ Net increase (decrease) in cash and cash equivalents. . . . . . . . . . . . . . . . . . . . . . . . . . . $ (4,028,819) 4,693,163 (1,847,913) ============ ============ ============ Supplemental disclosure of cash flow information: Cash paid for mortgage and other interest. . . . . . . . . . . . . . . . . . $ 68,078,479 71,104,325 120,306,302 Non-cash investing and financing activities: Retirement of investment property. . . . . . . . . . . . . . . . . . . . $ 1,896,898 -- 1,494,965 ============ ============ ============ See accompanying notes to combined financial statements. /TABLE JMB/NYC OFFICE BUILDING ASSOCIATES AND UNCONSOLIDATED VENTURES NOTES TO COMBINED FINANCIAL STATEMENTS DECEMBER 31, 1993, 1992 AND 1991 (1) BASIS OF ACCOUNTING The accompanying combined financial statements have been prepared for the purpose of complying with Rule 3.09 of Regulation S-X of the Securities and Exchange Commission. The entities included in the combined financial statements are as follows: JMB/NYC Office Building Associates ("JMB/NYC") (a) - 237 Park Avenue Associates (b)} - 1290 Associates (b) } - (together "Three Joint Ventures") - 2 Broadway Associates and } 2 Broadway Land Company (b)} (a) The Partnership owns an indirect ownership interest in this unconsolidated venture through Carlyle-XIII Associates, L.P., an unconsolidated venture. (b) The Partnership owns an indirect ownership interest in these joint ventures through JMB/NYC an unconsolidated venture. For purposes of preparing the combined financial statements, the effect of all transactions between JMB/NYC and the Three Joint Ventures has been eliminated. The records of JMB/NYC and the Three Joint Ventures (the "Combined Ventures") are maintained on the accrual basis of accounting as adjusted for Federal income tax reporting purposes. The accompanying combined financial statements have been prepared from such records after making appropriate adjustments to present the Three Joint Ventures' accounts in accordance with generally accepted accounting principles. Such adjustments are not recorded on the records of the Three Joint Ventures. Statement of Financial Accounting Standards No. 95 requires the Combined Ventures to present a statement which classifies receipts and payments according to whether they stem from operating, investing or financing activities. The required information has been segregated and accumulated according to the classifications specified in the pronouncement. In conjunction with the negotiations with representatives of the first mortgage lender regarding a loan restructure, the Olympia & York affiliates reached an agreement with the first mortgage lender whereby effective January 1, 1993, the Olympia & York affiliates are limited to taking distributions of $250,000 on a monthly basis from the Three Joint Ventures reserving the remaining excess cash flow in a separate-interest bearing account to be used exclusively to meet the obligations of the Three Joint Ventures as approved by the lender. Such reserved amounts, aggregating approximately $11,638,000, are classified as restricted funds in the accompanying combined balance sheet. As more fully discussed in Note 3(c) of Carlyle-XIII's financial statements filed with this annual report, due to the potential sale of the 2 Broadway building at a sales price significantly below its net carrying value and due to discussions with the O&Y affiliates regarding the reallocation of the unpaid first mortgage indebtedness currently allocated to 2 Broadway, the 2 Broadway venture has made a provision for value impairment on such investment property of $192,627,560. The provision for value impairment has been allocated $136,534,366 and $56,093,194 to the O&Y affiliates and to JMB/NYC, respectively. Such provision has been allocated to the partners to reflect their respective ownership percentages before the effect of the non- recourse promissory notes including related accrued interest. JMB/NYC OFFICE BUILDING ASSOCIATES AND UNCONSOLIDATED VENTURES NOTES TO COMBINED FINANCIAL STATEMENTS - CONTINUED In response to persistent operating deficits and vacancy levels at the 2 Broadway Building and due to the uncertainty of the 2 Broadway joint ventures' ability to recover the net carrying value of the investment property through future operations and sale, the 2 Broadway joint ventures made a provision for value impairment on such investment property of $38,689,928. Such provision at December 31, 1990 was recorded to effectively reduce the net carrying value of the investment property to the then outstanding balance of the related non- recourse financing allocated to the joint ventures and their property and was allocated to the unaffiliated venture partners in accordance with the terms of the venture agreement (see notes 3 and 5). Due to the uncertainty of the 1290 Associates venture's ability to recover the net carrying value of the 1290 Avenue of the Americas Building through future operations and sale, the 1290 Associates venture made a provision for value impairment on such investment property of $51,423,084. Such provision at September 30, 1992 was recorded to effectively reduce the net carrying value of the investment property and the related deferred expenses to the then outstanding balance of the related non-recourse financing allocated to the joint venture and its property. This provision was allocated to the unaffiliated venture partners in accordance with the terms of the venture agreement (see notes 3 and 5). Prior to their agreement with the underlying first mortgage lender, which became effective January 1, 1993, the Olympia & York affiliates borrowed cash generated from the Three Joint Ventures aggregating $11,946,284 and $10,770,060, respectively at December 31, 1993 and 1992. Due to the financial difficulties of O & Y and its affiliates, as more fully discussed in Note 3(c) of Carlyle XIII filed with this annual report, and the resulting uncertainty of collectibility of these amounts from the Olympia & York affiliates, JMB/NYC has recorded a provision for doubtful accounts at December 31, 1993 for the full receivable amount ($11,946,285) at December 31, 1993, which is reflected in the accompanying combined financial statements. Due to the uncertainty of collectibility of amounts due from certain tenants at the Three Joint Venture investment properties, a provision for doubtful accounts of $11,551,048, $803,717 and $2,088,687 at December 31, 1993, 1992 and 1991, respectively, is reflected in the accompanying combined financial statements. The provision recorded at December 31, 1993 includes approximately $7,659,000 of past due and future rents (included in accrued rents receivable in the accompanying combined financial statements) from John Blair & Co., a major lessee at the 1290 Avenue of the Americas building, due to a filing of Chapter XI bankruptcy by the tenant. Deferred expenses are comprised of leasing and renting costs which are amortized using the straight-line method over the terms of the related leases. No provision for State or Federal income taxes has been made as the liability for such taxes is that of the venture partners rather than the ventures. Depreciation on the investment properties has been provided over the estimated useful lives of 5 to 30 years using the straight-line method. Although certain leases of the Three Joint Ventures' investment properties provide for tenant occupancy during periods for which no rent is due, the ventures accrue prorated rental income for the full period of occupancy. In addition, although certain leases provide for step increases in rent during the lease term, the ventures recognize the total rent due on a straight-line basis over the entire lease. Such amounts are reflected in accrued rents receivable in the accompanying combined balance sheets. Straight-line rental income (reduction) was $24,448, $(152,092) and $5,730,142 for the years ended December 31, 1993, 1992 and 1991, respectively. JMB/NYC OFFICE BUILDING ASSOCIATES AND UNCONSOLIDATED VENTURES NOTES TO COMBINED FINANCIAL STATEMENTS - CONTINUED Maintenance and repair expenses are charged to operations as incurred. Significant betterments and improvements are capitalized and depreciated over their estimated useful lives. An affiliate of the joint venture partners perform certain maintenance and repair work and construction of certain tenant improvements at the investment properties. Certain amounts in the 1992 and 1991 combined financial statements have been reclassified to conform with the 1993 presentation. Statement of Financial Accounting Standards No. 107 ("SFAS 107"), "Disclosures about Fair Value of Financial Instruments", requires entities with total assets exceeding $150,000,000 at December 31, 1993 to disclose the SFAS 107 value of all financial assets and liabilities for which it is practicable to estimate. Value is defined in the Statement as the amount at which the instrument could be exchanged in a current transaction between willing parties, other than in a forced or liquidation sale. The Combined Ventures believe the carrying amount of its financial instruments classified as current assets and liabilities (excluding current portion of long-term debt) approximates SFAS 107 value due to the relatively short maturity of these instruments. SFAS 107 states that quoted market prices are the best evidence of the SFAS 107 value of financial instruments, even for instruments traded only in thin markets. The first mortgage loan is evidenced by certain bonds which are traded in extremely thin markets. As of December 31, 1993 and through the date of this report, a limited number of bonds have been sold and purchased in transactions arranged by brokers for amounts ranging from approximately $.60 to $.70 on the dollar. Assuming a rate of $.60 on the dollar, the implied SFAS 107 value of the bonds (with an aggregate carrying balance of $923,041,198, in the accompanying Combined Financial Statements) would be approximately $554,000,000. Due to the significant discount at which the bonds are currently trading, the SFAS 107 value of the promissory notes payable and related deferred interest (aggregating $112,763,748) would be at a discount significantly greater than that at which the bonds are currently traded. Due to, among other things, the likely inability to obtain comparable financing under current market conditions and other property specific competitive conditions, and due to the disputes with the venture partner including the alleged defaults on the first mortgage loan, the Combined Ventures would likely be unable to refinance these properties to obtain such calculated debt amounts reported (see notes 3 and 5). The Combined Ventures have no other significant financial instruments. (2) VENTURE AGREEMENTS A description of the venture agreements is contained in Note 3(c) of Notes to Financial Statements filed with this annual report. Such note is incorporated herein by reference. (3) LONG-TERM DEBT Long-term debt consists of the following at December 31, 1993 and 1992: 1993 1992 ------------------------ First mortgage loan bearing interest at the short-term U.S. Treasury obligation note rate plus 1-3/4% with a minimum rate on the loan of 7% per annum; allocated among and cross- collaterally secured by the 237 Park Avenue JMB/NYC OFFICE BUILDING ASSOCIATES AND UNCONSOLIDATED VENTURES NOTES TO COMBINED FINANCIAL STATEMENTS - CONTINUED 1993 1992 ------------------------ Building, 1290 Avenue of the Americas Building, 2 Broadway Land and 2 Broadway Building; payments of principal and interest based upon a 30-year amortization schedule are due monthly, however, commencing on a date six months following the attainment of a certain level of annualized cash flow, any interest in excess of 12% per annum may be accrued, to the extent that monthly cash flow is insufficient to pay the full monthly debt service, by adding such deferred amount to the outstanding balance of the loan; the loan is in non-monetary default at December 31, 1992 and 1993 (Reference is made to Note 3(c) of Notes to Carlyle Real Estate Limited Partnership-XIII Financial Statements filed with this annual report as to the calculation of interest rate with reference to this first mortgage loan); the stated maturity of principal of $857,784,000 and accrued interest is March 1999. . . . . . . . . . . . . . . . . $923,041,198 931,654,790 Less current portion of long-term debt . . 923,041,198 931,654,790 ------------ ----------- Total long-term debt . . . . . . . $ -- -- ============ =========== The allocation of the first mortgage loan among the joint ventures is as follows (which is non-recourse to the joint ventures) (see note 1): 1993 1992 ------------ ------------ 237 Park Avenue Associates. . . $214,107,494 216,105,492 1290 Avenue Associates. . . . . 453,194,197 457,423,293 2 Broadway Land Company . . . . 17,842,291 18,008,791 2 Broadway Associates . . . . . 237,897,216 240,117,214 ------------ ------------ $923,041,198 931,654,790 ============ ============ (4) LEASES At December 31, 1993, the properties in the combined group consisted of three office buildings. All leases relating to the properties are properly classified as operating leases; therefore, rental income is reported when earned and the cost of each of the properties, excluding the cost of land, is depreciated over the estimated useful lives. Leases with commercial tenants range in term from one to 25 years and provide for fixed minimum rent and partial to full reimbursement of operating costs. Affiliates of the joint venture partners have lease agreements and occupy approximately 95,000 square feet of space at 237 Park Avenue at rental rates which approximate market. During 1993 and 1992, 2 Broadway Associates collected $4,781,158 and $6,069,444 of a total $13,340,601 bankruptcy claim against Drexel Burnham Lambert, a former tenant of the 2 Broadway Building and is included in rental income in the 1993 and 1992 accompanying combined income statement. All remaining claims against Drexel Burnham Lambert were sold during 1993. JMB/NYC OFFICE BUILDING ASSOCIATES AND UNCONSOLIDATED VENTURES NOTES TO COMBINED FINANCIAL STATEMENTS - CONTINUED Minimum lease payments including amounts representing executory costs (e.g., taxes, maintenance, insurance), and any related profit in excess of specific reimbursements, to be received in the future under the above operating commercial lease agreements, are as follows: 1994. . . . . . . .$ 92,366,352 1995. . . . . . . . 83,462,935 1996. . . . . . . . 74,169,081 1997. . . . . . . . 69,897,639 1988. . . . . . . . 66,432,323 Thereafter. . . . . 324,714,863 ------------ $711,043,193 ============ (5) NOTES PAYABLE Notes payable consist of the following at December 31, 1993 and 1992: 1993 1992 ----------------------- Promissory notes payable to an affiliate of the unaffiliated venture partners in the Three Joint Ventures, bearing interest at 12.75% per annum; cross-collaterally secured by JMB/NYC's interest in the Three Joint Ventures one of which is additionally secured by $19,000,000 of distributable proceeds from two of the Three Joint Ventures; interest accrues and is deferred, compounded monthly, until December 31, 1991; monthly payments of accrued interest, based upon the level of distributions to JMB/NYC, thereafter until maturity; principal and accrued interest due March 20, 1999. Accrued deferred interest of $78,605,523 and $65,173,746 is outstanding at December 31, 1993 and 1992, respectively. . . . . . . . . . . . $34,158,225 34,158,225 ----------- ---------- Less current portion of notes payable . . -- -- ----------- ---------- Long-term notes payable . . . . . . . . . $34,158,225 34,158,225 =========== ========== The allocation of the promissory notes and related deferred interest among the joint ventures is as follows: 1993 1992 ---------------------- 237 Park Avenue Associates. . . . . . . . $ 14,902,454 13,127,359 1290 Associates . . . . . . . . . . . . . 32,214,484 28,377,278 2 Broadway Land Company . . . . . . . . . 2,877,196 2,534,480 2 Broadway Associates . . . . . . . . . . 62,769,614 55,292,854 ----------------------- $112,763,748 99,331,971 ======================= SCHEDULE X JMB/NYC OFFICE BUILDING ASSOCIATES AND UNCONSOLIDATED VENTURES SUPPLEMENTARY INCOME STATEMENT INFORMATION YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 CHARGED TO COSTS AND EXPENSES ---------------------------------------------- 1993 1992 1991 ------------ ------------ ------------ Depreciation . . . . . . $39,102,045 41,410,478 41,696,115 Amortization . . . . . . 2,173,860 2,321,741 2,236,756 Real estate taxes. . . . 39,589,367 40,609,489 38,358,812 Repairs and maintenance. 8,954,975 9,441,699 10,892,232 =========== ========== =========== SCHEDULE XI JMB/NYC OFFICE BUILDING ASSOCIATES AND UNCONSOLIDATED VENTURES COMBINED REAL ESTATE AND ACCUMULATED DEPRECIATION DECEMBER 31, 1993 COSTS CAPITALIZED INITIAL COST TO SUBSEQUENT TO GROSS AMOUNT AT WHICH CARRIED UNCONSOLIDATED VENTURES(A) TO ACQUISITION AT CLOSE OF PERIOD (B) -------------------------- -------------- -------------------------------------- BUILDINGS BUILDINGS AND BUILDINGS AND AND DESCRIPTION ENCUMBRANCE(C) LAND IMPROVEMENTS IMPROVEMENTS LAND IMPROVEMENTS TOTAL (E) - ----------- -------------- ----------- ------------ -------------- ---------- ------------ ---------- OFFICE BUILDINGS: New York, New York (237 Park Avenue). $214,107,494 79,653,996 226,634,894 1,208,552 79,653,996 227,843,446 307,497,442 New York, New York (1290 Avenue of the Americas). . . 453,194,197 90,952,993 556,434,718 (9,814,514) 84,285,719 553,287,478 637,573,197 New York, New York (2 Broadway) . . . 255,739,507 26,421,677 378,445,199 (226,988,480) 4,858,599 173,019,797 177,878,396 ------------ ----------- ------------- ------------ ----------- ------------- ------------- Total. . . . . . $923,041,198 197,028,666 1,161,514,811 (235,594,442) 168,798,314 954,150,721 1,122,949,035 ============ =========== ============= ============ =========== ============= ============= /TABLE SCHEDULE XI - CONTINUED JMB/NYC OFFICE BUILDING ASSOCIATES AND UNCONSOLIDATED VENTURES SUPPLEMENTARY INCOME STATEMENT INFORMATION YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 LIFE ON WHICH DEPRECIATION IN LATEST STATEMENT OF 1993 ACCUMULATED DATE OF DATE OPERATION REAL ESTATE DESCRIPTION DEPRECIATION(F) CONSTRUCTION ACQUIRED IS COMPUTED TAXES - ----------- ---------------- ------------ ---------- --------------- ----------- OFFICE BUILDINGS: New York, New York (237 Park Avenue). . . . . . . . . . . . . $ 70,997,283 1981 8/14/84 5-30 years 10,356,858 New York, New York (1290 Avenue of the Americas). . . . . . . 188,932,678 1963 7/27/84 5-30 years 19,040,331 New York, New York (2 Broadway) . . . . . . . . . . . . . . . 116,386,179 1959 8/14/84 5-30 years 10,192,178 ------------ ---------- Total. . . . . . . . . . . . . . . . . . $376,316,140 39,589,367 ============ ========== - ----------------- Notes: (A) The initial cost represents the original purchase price of the property, including amounts incurred subsequent to acquisition which were contemplated at the time the property was acquired. (B) The aggregate cost of real estate owned at December 31, 1993 for Federal income tax purposes was approximately $1,361,603,548 (see Note 1 of Notes to Combined Financial Statements). (C) Reference is made to Note 5 of Combined Financial Statements for the current outstanding principal balances and a description of the notes payable secured by JMB/NYC's interests in the Three Joint Ventures which are not included in the amounts stated above. (D) Includes provision for value impairment at 2 Broadway of $192,144,503 recorded December 31, 1993, 1290 Avenue of the Americas of $50,446,010 recorded September 30, 1992 and 2 Broadway of $38,689,928 recorded December 31, 1990. See Note 1 of Notes to Combined Financial Statements for further discussion. /TABLE SCHEDULE XI - CONTINUED JMB/NYC OFFICE BUILDING ASSOCIATES AND UNCONSOLIDATED VENTURES SUPPLEMENTARY INCOME STATEMENT INFORMATION YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 (E) Reconciliation of real estate owned: 1993 1992 1991 -------------- -------------- ------------- Balance at beginning of period . . . . . . . $1,316,389,393 1,366,280,363 1,365,517,662 Additions during period. . . . . . . . . . . 601,043 555,040 2,257,666 Provision for value impairment . . . . . . . (192,144,503) (50,446,010) -- Retirements during period. . . . . . . . . . (1,896,898) -- (1,494,965) -------------- ------------- ------------- Balance at end of period . . . . . . . . . . $1,122,949,035 1,316,389,393 1,366,280,363 ============== ============= ============= (F) Reconciliation of accumulated depreciation: Balance at beginning of period . . . . . . . $ 339,110,993 297,700,515 257,499,365 Depreciation expense . . . . . . . . . . . . 39,102,045 41,410,478 41,696,115 Retirements during period. . . . . . . . . . (1,896,898) -- (1,494,965) -------------- ------------- ------------- Balance at end of period . . . . . . . . . . $ 376,316,140 339,110,993 297,700,515 ============== ============= ============= /TABLE Item 9.

Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure There were no changes in or disagreements with accountants during fiscal year 1993 and 1992. PART III ITEM 10.

ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE PARTNERSHIP The Corporate General Partner of the Partnership is JMB Realty Corporation ("JMB"), a Delaware corporation. JMB as the Corporate General Partner has responsibility for all aspects of the Partnership's operations, subject to the requirement that sales of real property must be approved by the Associate General Partner of the Partnership, Realty Associates-XIII L.P., an Illinois Limited Partnership with JMB as the sole general partner. The Associate General Partner shall be directed by a majority in interest of its limited partners (who are generally officers, directors and affiliates of JMB or its affiliates) as to whether to provide its approval of any sale of real property (or any interest therein) of the Partnership. Various relationships of the Partnership to the Corporate General Partner and its affiliates are described under the caption "Conflicts of Interest" at pages 12-18 of the Prospectus, of which description is hereby incorporated herein by reference to Exhibit 28-A to the Partnership's Report for December 31, 1992 on Form 10-K (File No. 0-12791) dated March 30, 1993. The names, positions held and length of service therein of each director and executive officer and certain officers of the Managing General Partner of the Partnership are as follows: SERVED IN NAME OFFICE OFFICE SINCE - ---- ------ ------------ Judd D. Malkin Chairman 5/03/71 Director 5/03/71 Neil G. Bluhm President 5/03/71 Director 5/03/71 Jerome J. Claeys III Director 5/09/88 Burton E. Glazov Director 7/01/71 Stuart C. Nathan Executive Vice President 5/08/79 Director 3/14/73 A. Lee Sacks Director 5/09/88 John G. Schreiber Director 3/14/73 H. Rigel Barber Chief Executive Officer 8/01/93 and Executive Vice President 1/02/87 Jeffrey R. Rosenthal Chief Financial Officer 8/01/93 Gary Nickele Executive Vice President 1/01/92 General Counsel 2/27/84 Ira J. Schulman Executive Vice President 6/01/88 Gailen J. Hull Senior Vice President 6/01/88 Howard Kogen Senior Vice President 1/02/86 Treasurer 1/01/91 There is no family relationship among any of the foregoing directors or officers. The foregoing directors have been elected to serve one-year terms until the annual meeting of the Corporate General Partner to be held on June 7, 1994. All of the foregoing officers have been elected to serve one-year terms until the first meeting of the Board of Directors held after the annual meeting of the Corporate General Partner to be held on June 7, 1994. There are no arrangements or understandings between or among any of said directors or officers and any other person pursuant to which any director or officer was elected as such. JMB is the Corporate General Partner of Carlyle Real Estate Limited Partnership-VII ("Carlyle-VII"), Carlyle Real Estate Limited Partnership-IX ("Carlyle-IX"), Carlyle Real Estate Limited Partnership-X ("Carlyle-X"), Carlyle Real Estate Limited Partnership-XI ("Carlyle-XI"), Carlyle Real Estate Limited Partnership-XII ("Carlyle-XII"), Carlyle Real Estate Limited Partnership-XIV ("Carlyle-XIV"), Carlyle Real Estate Limited Partnership-XV ("Carlyle-XV"), Carlyle Real Estate Limited Partnership-XVI ("Carlyle-XVI"), Carlyle Real Estate Limited Partnership-XVII ("Carlyle-XVII"), JMB Mortgage Partners, Ltd. ("Mortgage Partners"), JMB Mortgage Partners, Ltd.-II ("Mortgage Partners-II"), JMB Mortgage Partners, Ltd.-III ("Mortgage Partners-III"), JMB Mortgage Partners, Ltd-IV ("Mortgage Partners-IV"), Carlyle Income Plus, Ltd. ("Carlyle Income Plus") and Carlyle Income Plus, L.P.-II ("Carlyle Income Plus-II") and the managing general partner of JMB Income Properties, Ltd.-IV ("JMB Income-IV"), JMB Income Properties, Ltd.-V ("JMB Income-V"), JMB Income Properties, Ltd.-VI ("JMB Income-VI"), JMB Income Properties, Ltd.-VII ("JMB Income-VII"), JMB Income Properties, Ltd.-VIII ("JMB Income-VIII"), JMB Income Properties, Ltd.-IX ("JMB Income-IX"), JMB Income Properties, Ltd.-X ("JMB Income-X"), JMB Income Properties, Ltd.-XI ("JMB Income-XI"), JMB Income Properties, Ltd.-XII ("JMB Income-XII"), and JMB Income Properties, Ltd.-XIII ("JMB Income-XIII"). Most of the foregoing directors and officers are also officers and/or directors of various affiliated companies of JMB including Arvida/JMB Managers, Inc. (the general partner of Arvida/JMB Partners, L.P. ("Arvida")), Arvida/JMB Managers-II, Inc. (the general partner of Arvida/JMB Partners, L.P.-II ("Arvida-II")), and Income Growth Managers, Inc. (the corporate general partner of IDS/JMB Balanced Income Growth, Ltd. ("IDS/BIG")). Most of such directors and officers are also partners, directly or indirectly, of certain partnerships which are associate general partners in the following real estate limited partnerships: the Partnership, Carlyle-VII, Carlyle-IX, Carlyle-X, Carlyle-XI, Carlyle-XII, Carlyle-XIV, Carlyle-XV, Carlyle-XVI, Carlyle-XVII, JMB Income-VI, JMB Income-VII, JMB Income-VIII, JMB Income-IX, JMB Income-X, JMB Income-XI, JMB Income-XII, JMB Income-XIII, Mortgage Partners, Mortgage Partners-II, Mortgage Partners-III, Mortgage Partners-IV, Carlyle Income Plus, Carlyle Income Plus-II and IDS/BIG. The business experience during the past five years of each such director and officer of the Corporate General Partner of the Partnership in addition to that described above is as follows: Judd D. Malkin (age 56) is an individual general partner of JMB Income-II, JMB Income-IV and JMB Income-V. Mr. Malkin has been associated with JMB since October, 1969. He is a Certified Public Accountant. Neil G. Bluhm (age 56) is an individual general partner of JMB Income-II, JMB Income-IV and JMB Income-V. Mr. Bluhm has been associated with JMB since August, 1970. He is a member of the Bar of the State of Illinois and a Certified Public Accountant. Jerome J. Claeys III (age 51) (Chairman and Director of JMB Institutional Realty Corporation) has been associated with JMB since September, 1977. He holds a Masters degree in Business Administration from the University of Notre Dame. Burton E. Glazov (age 55) has been associated with JMB since June, 1971 and served as an Executive Vice President of JMB until December 1990. He is a member of the Bar of the State of Illinois and a Certified Public Accountant. Stuart C. Nathan (age 52) has been associated with JMB since July, 1972. He is a member of the Bar of the State of Illinois. A. Lee Sacks (age 60) (President of JMB Insurance Agency, Inc.) has been associated with JMB since December, 1972. John G. Schreiber (age 47) has been associated with JMB since December, 1970 and served as an Executive Vice President of JMB until December 1990. He holds a Masters degree in Business Administration from Harvard University Graduate School of Business. H. Rigel Barber (age 45) has been associated with JMB since March, 1982. He holds a J.D. degree from the Northwestern Law School and is a member of the Bar of the State of Illinois. Jeffrey R. Rosenthal (age 43) has been associated with JMB since December, 1987. He is a Certified Public Accountant. Gary Nickele (age 41) has been associated with JMB since February, 1984. He holds a J.D. degree from the University of Michigan Law School and is a member of the Bar of the State of Illinois. Ira J. Schulman (age 42) has been associated with JMB since February, 1983. He holds a Masters degree in Business Administration from the University of Pittsburgh. Gailen J. Hull (age 45) has been associated with JMB since March, 1982. He holds a Masters degree in Business Administration from Northern Illinois University and is a Certified Public Accountant. Howard Kogen (age 58) has been associated with JMB since March, 1973. He is a Certified Public Accountant. ITEM 11.

ITEM 11. EXECUTIVE COMPENSATION The Partnership has no officers or directors. The Partnership is required to pay a management fee to the Corporate General Partner and the General Partners are entitled to receive a share of cash distributions, when and as cash distributions are made to the Limited Partners, and a share of profits or losses as described under the caption " Compensation and Fees" at pages 8-11, "Cash Distributions" at pages 69-71, "Allocation of Profits or Losses for Tax Purposes" at pages 68-69 of the Prospectus and at pages A-7 to A-12 of the Partnership Agreement, included as an exhibit to the Prospectus, which descriptions are incorporated herein by reference to Exhibit 28-A to the Partnership's Report for December 31, 1992 on Form 10-K (File No. 0-12791) dated March 30, 1993. Reference is also made to Notes 5 and 9 for a description of such transactions, distributions and allocations. In 1993, 1992 and 1991, the General Partners received distributions of $0, $7,629 and $64,845, respectively, and the Corporate General Partner received a management fee of $0, $12,715 and $108,075, respectively. The General Partners received a share of Partnership gains for tax purposes aggregating $4,121,438 in 1993 and losses aggregating, $1,598,313 and $2,214,779 in 1992 and 1991, respectively. Such losses may benefit the General Partners (or the partners thereof) to the extent that such losses may be offset against taxable income from the Partnership or other sources. The Partnership is permitted to engage in various transactions involving affiliates of the Corporate General Partner of the Partnership, as described under the captions "Compensation and Fees" at pages 8-11, "Conflicts of Interest" at pages 12-18 of the Prospectus and at pages A-14 to A-20 of the Partnership Agreement, included as an exhibit to the Prospectus, which descriptions are hereby incorporated herein by reference to Exhibit 28-A to the Partnership's Report for December 31, 1992 on Form 10-K (File No. 0-12791) dated March 30, 1993. The relationship of the Corporate General Partner (and its directors and officers) to its affiliates is set forth above in Item 10. An affiliate of the Corporate General Partner provided property management services for all or part of 1993 for the 1001 Fourth Avenue Plaza office building in Seattle, Washington, the University Park office building in Sacramento, California, the Plaza Tower office building in Knoxville, Tennessee, the Rio Cancion Apartments in Tucson, Arizona, the Long Beach Plaza in Long Beach, California, the Eastridge Apartments in Tucson, Arizona, the Copley Place multi-use complex in Boston, Massachusetts, the Gables Corporate Plaza in Coral Gables, Florida, the Greenwood Creek II Apartments in Benbrook, Texas, and the Sherry Lane Place office building in Dallas, Texas at various fees calculated based upon the gross income from the properties. In 1993, such affiliate earned property management and leasing fees amounting to $3,001,759 for such services. The cumulative amount of property management and leasing fees owed to an affiliate of the Corporate General Partner as of December 31, 1993 was $13,670,682. As set forth in the Prospectus of the Partnership, the Corporate General Partner must negotiate such agreements on terms no less favorable to the Partnership than those customarily charged for similar services in the relevant geographical area (but in no event at rates greater than 6% of the gross income from a property), and such agreements must be terminable by either party thereto, without penalty, upon 60 days' notice. JMB Insurance Agency, Inc., an affiliate of the Corporate General Partner, earned insurance brokerage commissions in 1993 aggregating $214,278 in connection with the providing of insurance coverage for certain of the real property investments of the Partnership, all of which was paid at December 31, 1993. Such commissions are at rates set by insurance companies for the classes of coverage provided. The General Partners of the Partnership or their affiliates may be reimbursed for their direct expenses or out-of-pocket expenses and salaries and related salary expenses relating to the administration of the Partnership and the acquisition and operation of the Partnership's real property investments. In 1993, the Corporate General Partner of the Partnership was due reimbursement for such out-of-pocket expenses in the amount of $45,143, all of which was paid at December 31, 1993. Additionally, the General Partners are also entitled to reimbursements for legal and accounting services. Such costs for 1993 were $148,712 and $30,381, respectively, all of which were unpaid as of December 31, 1993. ITEM 12.

ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT (a) No person or group is known by the Partnership to own beneficially more than 5% of the outstanding Interests of the Partnership. (b) The Corporate General Partner and its officers and directors own the following Interests of the Partnership: NAME OF AMOUNT AND NATURE BENEFICIAL OF BENEFICIAL PERCENT TITLE OF CLASS OWNER OWNERSHIP OF CLASS - -------------- ---------- ----------------- -------- Limited Partnership Interests JMB Realty Corporation 5 Interests directly Less than 1% Limited Partnership Interests Corporate General 6.79 Interests directly (1) Less than 1% Partner and its officers and directors as a group (1) Includes 1.79 Interests owned by officers or their relatives for which each officer has investment and voting power as to such Interests so owned. No officer or director of the Corporate General Partner of the Partnership possesses a right to acquire beneficial ownership of Interests of the Partnership. (c) There exists no arrangement, known to the Partnership, the operation of which may at a subsequent date result in a change in control of the Partnership. /TABLE ITEM 13.

ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS There were no significant transactions or business relationships with the Corporate General Partner, affiliates or their management other than those described in Items 10 and 11 above. PART IV ITEM 14.

ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K (a) The following documents are filed as part of this report: (1) Financial Statements (See Index to Financial Statements filed with this annual report). (2) Exhibits. 3.* Amended and Restated Agreement of Limited Partnership set forth as Exhibit A to the Prospectus, and which is hereby incorporated by reference. 4-A. Documents relating to the mortgage loan secured by the 1001 Fourth Avenue Plaza in Seattle, Washington are also hereby incorporated herein by reference to Post-Effective Amendment No. 2 in the Partnership's Registration Statement on Form S-11 (File No. 2-81125) dated June 9, 1983. 4-B. Documents relating to the mortgage loan secured by the Copley Place multi-use complex, in Boston Massachusetts, are also hereby incorporated herein by reference to Post-Effective Amendment No. 2 in the Partnership's Registration Statement on Form S-11 (File No. 2-81125) dated June 9, 1983. 4-C.* Documents relating to the modification of the mortgage loan secured by 1001 Fourth Avenue Plaza are hereby incorporated herein by reference. 4-D.* Documents relating to the modification of the mortgage loan secured by the Copley Place multi-use complex are hereby incorporated herein by reference. 10-A. Acquisition documents relating to the purchase by the Partnership of an interest in the 1001 Fourth Avenue Plaza in Seattle, Washington, are hereby incorporated herein by reference to Post- Effective Amendment No. 2 to the Partnership's Registration Statement on Form S-11 (File No. 2-81125) dated June 9, 1983. 10-B. Acquisition documents relating to the purchase by the Partnership of an interest in the Copley Place multi-use complex in Boston, Massachusetts, are hereby incorporated herein by reference to Post-Effective Amendment No. 2 to the Partnership's Registration Statement on Form S-11 (File No. 2-81125) dated June 9, 1983. 10-C. Documents relating to the sale by the Partnership of an interest in the Allied Automotive Center, in Southfield, Michigan, are hereby incorporated herein by reference to the Partnership's Report on Form 8-K (File No. 0-12791) for October 10, 1990, dated October 30, 1990. 10-D. Documents describing the transferred title of the Partnership's interest in the Commercial Union Office Building to the second mortgage lender, are hereby incorporated herein by reference to the Partnership's Report on Form 8-K (File No. 0-12791) for August 15, 1991, dated September 18, 1991. 10-E. Agreement dated March 25, 1993 between JMB/NYC and the Olympia & York affiliates regarding JMB/NYC's deficit funding obligations from January 1, 1992 through June 30, 1993 are filed herewith. 10-F. Agreement of Limited Partnership of Carlyle-XIII Associates L.P. is hereby incorporated by reference to the Partnership's Report on Form 10-Q (File No. 0-12791) dated May 14, 1993. 10-G. Documents relating to the sale by the Partnership of its interest in the Rio Cancion Apartments in Tucson, Arizona, are herein incorporated by reference to the Partnership's Report on Form 8-K (File No. 0-12791) for March 31, 1993, dated May 14, 1993. 10-H. Documents relating to the sale by the Partnership of its interest in the Old Orchard Urban Venture are herein incorporated by reference to the Partnership's Report on Form 8-K (File No. 0-12791) for August 30, 1993, dated November 12, 1993. 10-I. Documents describing the transferred title of the Partnership's interest in the 1001 Fourth Avenue Office Building to the first mortgage lender, are hereby incorporated herein by reference to the Partnership's Report on Form 8-K (File No. 0-12791) for November 1, 1993, dated November 12, 1993. 10-J. Second Amended and Restated Articles of Partnership of JMB/NYC Office Building Associates, a copy of which is filed herewith. 10-K. Amended and Restated Certificate of Incorporation of Carlyle-XIV Managers, Inc., a copy of which is filed herewith. 10-L. Amended and Restated Certificate of Incorporation of Carlyle-XIII Managers, Inc., a copy of which is filed herewith. 10-M. $600,000 demand note between Carlyle-XIII Associates, L.P. and Carlyle Managers, Inc., a copy of which is filed herewith. 10-N. $600,000 demand note between Carlyle-XIII Associates, L.P. and Carlyle Investors, Inc., a copy of which is filed herewith. 10-O. Settlement Agreement between Gables Corporate Plaza Associates and Aetna Life Insurance Company, a copy of which is filed herewith. 21. List of Subsidiaries. 24. Powers of Attorney. 99-A. The Partnership's Report on Form 10-Q (File No. 0-12791) for May 14, 1993 and exhibits thereto are hereby incorporated herein by reference. 99-B. The Partnership's Report on Form 8-K (File No. 0-12791) for May 14, 1993 and exhibits thereto are hereby incorporated herein by reference. 99-C. The Partnership's Report on Form 8-K (File No. 0-12791) for November 12, 1993 and exhibits thereto are hereby incorporated herein by reference. 99-D. The Partnership's Report on Form 8-K (File No. 0-12791) for November 12, 1993 and exhibits thereto are hereby incorporated herein by reference. Although certain additional long-term debt instruments of the Registrant have been excluded from Exhibit 4 above, pursuant to Rule 601(b)(4)(iii), the Registrant commits to provide copies of such agreements to the SEC upon request. (b) The following Report on Form 8-K has been filed for the quarter covered by this report. (1) The Partnership's Report on Form 8-K (File No. 0- 12791) for November 1, 1993 (describing under Item 2 of such report the Partnership's transfer of the land, related improvements and personal property as of the 1001 Fourth Avenue Office Building) was filed. The report is dated November 12, 1992. No financial statements were required to be filed therewith. ---------------- * Previously filed as Exhibits 3, 4-C and 4-D, respectively, to the Partnership's Report on Form 10-K to the Securities Exchange Act of 1934 (File No. 0-12791) dated March 30, 1993 are hereby incorporated herein by reference. No annual report or proxy material for the fiscal year 1993 has been sent to the Partners of the Partnership. An annual report will be sent to the Partners subsequent to this filing. SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Partnership has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. CARLYLE REAL ESTATE LIMITED PARTNERSHIP - XIII By: JMB Realty Corporation Corporate General Partner GAILEN J. HULL By: Gailen J. Hull Senior Vice President Date:March 28, 1994 Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated. By: JMB Realty Corporation Corporate General Partner JUDD D. MALKIN* By: Judd D. Malkin, Chairman and Director Date:March 28, 1994 NEIL G. BLUHM* By: Neil G. Bluhm, President and Director Date:March 28, 1994 H. RIGEL BARBER* By: H. Rigel Barber, Chief Executive Officer Date:March 28, 1994 JEFFREY R. ROSENTHAL* By: Jeffrey R. Rosenthal, Chief Financial Officer Principal Financial Officer Date:March 28, 1994 GAILEN J. HULL By: Gailen J. Hull, Senior Vice President Principal Accounting Officer Date:March 28, 1994 By: A. LEE SACKS* A. Lee Sacks, Director Date:March 28, 1994 By: STUART C. NATHAN* Stuart C. Nathan, Executive Vice President and Director Date:March 28, 1994 *By:GAILEN J. HULL, Pursuant to a Power of Attorney GAILEN J. HULL By: Gailen J. Hull, Attorney-in-Fact Date:March 28, 1994 CARLYLE REAL ESTATE LIMITED PARTNERSHIP - XIII EXHIBIT INDEX Document Incorporated By Reference Page ------------ ---- 3. Amended and Restated Agreement of Limited Partnership set forth as Exhibit A to the Prospectus Yes 4-A. Mortgage loan documents secured by the 1001 Fourth Avenue Plaza Yes 4-B. Mortgage loan documents secured by the Copley Place multi-use complex Yes 4-C. Remodification of mortgage loan documents secured by 1001 Fourth Avenue Plaza Yes 4-D. Remodification of mortgage loan documents secured by Copley Place multi-use complex.Yes 10-A. Acquisition documents related to the 1001 Fourth Avenue Plaza Yes 10-B. Acquisition documents related to the Copley Place multi-use complex Yes 10-C. Documents related to the sale of Allied Automotive Center. Yes 10-D. Documents related to the transferred title of Commercial Union Office Building Yes 10-E. Agreement relating to JMB/NYC's deficit funding obligations from January 1, 1992 through June 30, 1993. Yes 10-F. Agreement of Limited Partnership of Carlyle-XIII Associates L.P. Yes 10-G. Documents relating to the sale by the Partnership of its interest in the Rio Cancion Apartments Yes 10-H. Documents relating to the sale of its interest in the Old Orchard Urban Venture Yes 10-I. Documents related to the transferred title to the Commercial Union Office Building Yes 10-J. Second Amended and Restated Articles of Partnership of JMB/NYC Office Building Associates No 10-K. Amended and Restated Certificate of Incorporation of Carlyle-XIV Managers, Inc. No 10-L. Amended and Restated Certificate of Incorporation of Carlyle-XIII Managers, Inc. No 10-M. $600,000 demand note between Carlyle-XIII Associates, Ltd. and Carlyle Managers, Inc. No CARLYLE REAL ESTATE LIMITED PARTNERSHIP - XIII EXHIBIT INDEX - CONTINUED Document Incorporated By Reference Page ------------ ---- 10-N. $600,000 demand note between Carlyle-XIII Associates, Ltd. and Carlyle Investors, Inc. No 10-O. Settlement Agreement between Gables Corporate Plaza Associates and Aetna Life Insurance Company No 21. List of Subsidiaries Yes 24. Powers of Attorney Yes 99-A. Form 10-Q for May 14, 1993 and exhibits thereto Yes 99-B. Form 8-K for May 14, 1993 and exhibits thereto Yes 99-C. Form 8-K for November 12, 1993 and exhibits thereto Yes 99-D. Form 8-K for November 12, 1993 and exhibits thereto Yes - ------------------ * Previously filed as exhibits to the Partnership's Registration Statement on Form S-11 (as amended) under the Securities Exchange Act of 1933 and the Partnership's prior Reports on Form 8-K and Form 10-K of the Securities Exchange Act of 1934. AGREEMENT FOR THE DELIVERY OF A DEED IN LIEU OF FORECLOSURE AGREEMENT made as of the 29th day of October, 1993, between 1001 FOURTH AVENUE ASSOCIATES, an Illinois general partnership having its principal place of business and post office address at c/o JMB Realty Corporation, 900 North Michigan Avenue, Suite 1900, Chicago, Illinois 60611 ("Mortgagor") and SEAFO, INC., a Delaware corporation, having a post office address at c/o the Comptroller of the State of New York As Trustee of the Common Retirement Fund of the State of New York ("CRF"), 270 Broadway, New York, New York 10007 ("Mortgagee"). RECITALS A. Mortgagor is the owner of certain fee and leasehold interests in the real property having a street address of 1001 Fourth Avenue, Seattle, Washington and the improvements located thereat. B. Mortgagee is the holder of a certain Deed of Trust Note, dated as of April 26, 1984, between Mortgagor and the Comptroller of the State of New York as Trustee of the Common Retirement Fund of the State of New York ("CRF"), as amended by the Deed of Trust Note Modification Agreement, dated as of October 5, 1987 (the "Existing Deed of Trust Note"), and the beneficiary of a certain deed of trust securing such Existing Deed of Trust Note (the "Existing Deed of Trust"). C. Mortgagor desires to convey, assign and transfer such real property and improvements and all of Mortgagor's interests therein to Mortgagee, in satisfaction of its obligations under the Existing Deed of Trust and Existing Deed of Trust Note, and Mortgagee is willing to accept same from Mortgagor, upon the terms and subject to the conditions hereinafter set forth. AGREEMENT: NOW, THEREFORE, in consideration of the premises and covenants herein and other good and valuable consideration, the receipt and sufficiency of which are hereby acknowledged, the parties hereby agree as follows: 1. Definitions In this Agreement, the following terms shall have the following meanings: 1.1 "Assignment and Assumption of Contracts" has the meaning set forth in Section 7.2.4. 1.2 "Assignment and Assumption of Leases" has the meaning set forth in Section 7.2.3. 1.3 "Assignment and Assumption of the Tax and Insurance Escrow Account" has the meaning set forth in Section 7.2.6. 1.4 "Assignment of Future Tax or Insurance Refunds" has the meaning set forth in Exhibit 7.2.7. 1.5 "Assignment of Intangible Property" has the meaning set forth in Section 7.2.5. 1.6 Intentionally Deleted. 1.7 "Building Complex" means the Land, the Improvements and the Personal Property. 1.8 "Closing" has the meaning set forth in Section 7.1. 1.9 "Contracts" means those service, maintenance and other contracts and agreements and all equipment and other leases (excluding Existing Leases) affecting all or any portion of the Building Complex and binding upon Mortgagor which the parties have agreed will be assigned to Mortgagee at the Closing. The Contracts are listed in Exhibit B attached hereto. 1.10 "Deed" has the meaning set forth in Section 7.2.1. 1.11 "Excess Net Cash Flow" has the meaning set forth in Section 7.2.15. 1.12 "Existing Deed of Trust" has the meaning set forth in the Recitals. 1.13 "Existing Deed of Trust Note" has the meaning set forth in the Recitals. 1.14 "Existing Loan Documents" means all documents evidencing or securing the Existing Deed of Trust Note, as the same may have heretofore been modified from time to time. 1.15 "Existing Leases" means those existing leases affecting portions of the Improvements and binding upon Mortgagor as landlord. 1.16 "Improvements" means the buildings and all other structures and improvements (on, over or below the surface of the Land) at the Building Complex. 1.17 "Land" means, that certain parcel of land situated in the City of Seattle, County of King, State of Washington, as more particularly described in Exhibit A. 1.18 "Letter of Credit" shall mean that Two Million and 00/100 Dollars ($2,000,000) irrevocable letter of credit at Chemical Bank, No. C- 237248, dated November 9, 1987, and as amended from time to time, held as collateral for the performance of certain obligations of Mortgagor under the Existing Deed of Trust. 1.19 "Mortgagee's Agents" means Mortgagee's attorneys, employees, agents, engineers, lenders, consultants, financial advisors and representatives. 1.20 "Notice" has the meaning set forth in Section 9. 1.21 "Permits" has the meaning set forth in Section 3.5. 1.22 "Personal Property" means all appliances, apparatus, fixtures and equipment (including, without limitation all heating, ventilating, incinerating, lighting, plumbing, electrical and air-conditioning fixtures and equipment), machinery, fittings and other articles of personal property now situate in or on or attached to the Building Complex, including all furniture, fixtures and equipment in the management office, and excluding only personal property owned by tenants under the Existing Leases or by parties other than Mortgagor under the Contracts and the Unassumed Contracts. 1.23 "Property" means the Land, the Improvements, the Personal Property and the property described in Section 3 and specifically excludes the Unassumed Contracts. 1.24 "Review Materials" shall mean, collectively, the Existing Leases, the Contracts and other materials relating to the ownership, construction, renovation, leasing or operation of the Property. 1.25 "Title Company" means Chicago Title Insurance Company. 1.26 "Unassumed Contracts" means those service, maintenance and other contracts and agreements and all equipment and other leases (excluding Existing Leases) affecting all or any portion of the Building Complex and binding upon Mortgagor other than the Contracts. 2. Agreement to Convey 2.1 Agreement to Convey and Accept Such Conveyance. Mortgagor agrees to convey, assign and transfer the Property to Mortgagee, without recourse or warranty except as expressly set forth herein, and Mortgagee agrees to accept such conveyance of the Property from Mortgagor, upon the terms and subject to the conditions set forth herein, without consideration other than the covenants and conditions herein. 3. Other Property Included in the Conveyance For this Agreement, all right, title and interest of Mortgagor, if any, in and to the following shall be included within the term "Property." 3.1 all easements, rights of way, strips, gores, privileges, licenses, appurtenances and other rights and benefits running with the owner of the Property; 3.2 any land lying in the bed of any street, road or avenue adjoining or below the Land; 3.3 the Existing Leases, all unapplied security deposits made by tenants under the Existing Leases, all guarantees by third parties of the obligation of tenants thereunder, and all letters of credit and other instruments or property issued or given as security for the obligation of tenants thereunder; 3.4 all advance rentals, and other advance payments made by tenants under the Existing Leases; 3.5 the certificates of occupancy with respect to the Improvements and, to the extent maintained by or on behalf of Mortgagor, all other transferable licenses, certificates and permits issued by any governmental or quasi-governmental authority with respect to the Property or the use, maintenance and operation thereof (collectively, the "Permits"); 3.6 all architectural, mechanical, engineering and other plans and specifications within Mortgagor's possession or subject to its control relating to the completed construction or renovation of or other work at the Building Complex and any unexpired warranties, guaranties or sureties in favor of Mortgagor with respect thereto; 3.7 all promotional advertising literature and materials, catalogs, booklets and manuals relating to the Property or the use, operation and maintenance thereof; 3.8 all of the Contracts and all deposits made by Mortgagor thereunder, to the extent transferable by their terms; 3.9 all intangible personal property relating to the ownership, construction, renovation, operation and leasing of the Property, including, without limitation, the good will pertaining thereto; 3.10 all environmental reports, asbestos reports and files relating to asbestos work within Mortgagor's possession; 3.11 all accounting, financial and operating information located at the Property; and 3.12 all transferable or assignable warranties, guaranties, contract rights and miscellaneous rights, if any, with respect to the Property, including any of the property described in Sections 3.1 through 3.11 above. 4. Release 4.1 Release. Mortgagor and Mortgagee hereby mutually release each other from any and all obligations and liabilities remaining under the Existing Loan Documents. 5. Mortgagee's Inspection of the Property 5.1 Condition. Mortgagee acknowledges that Mortgagee has inspected the Building Complex and will accept same "as is" as of the date hereof. Mortgagee shall assume responsibility for the physical condition of the Building Complex. 6. Brokerage, Management and Site Personnel 6.1 Brokerage. 6.1.1 The Mortgagee hereby retains JMB Properties Company, an Illinois corporation, ("Properties") as its leasing agent with respect to pending negotiations for leases at the Property with persons or entities set forth in Exhibit D, and Properties accepts such assignment. In the event that Mortgagee executes a lease, lease renewal or lease expansion for space in the Property with any person or entities listed on Exhibit D on or before February 28, 1994, then and in each such event, Mortgagee shall pay and Properties shall be entitled to receive, a brokerage commission with respect thereto payable, one-half of such commission on execution of such lease, lease renewal or lease expansion and one-half of such commission on the entry into substantial occupancy by the tenant thereunder, at the following commission rates: (i) For leases other than month-to-month -- $1.50 per rentable square foot, for new leases, renewal leases or expansion space; and (ii) For month to month leases -- no commission. 6.1.2 No brokerage commission shall be earned until a lease, lease renewal or lease expansion has been fully executed by Mortgagee. Properties shall provide the services of Steven Hisken to perform its obligations hereunder, and shall pay all compensation to him, including any leasing commissions, by separate agreement. In the event Properties has been paid all commissions in accordance with the foregoing, Properties shall indemnify and hold Mortgagee harmless from any claims of Steven Hisken including reasonable legal fees, for brokerage commissions for any lease, lease renewal or lease expansion executed by Mortgagee with any person listed on Exhibit D at any time on or before February 28, 1994. 6.2 Site Employees. 6.2.1 Employees. Properties shall make available to Mortgagee's managing agent and Mortgagee the persons through December 31, 1993 listed on Exhibit P to perform the services for Mortgagee and Mortgagee's managing agent under their direction as such persons have been performing services for Properties and Mortgagor prior to the Closing. In consideration for the providing of such employees, Mortgagee, has on even date herewith, paid Properties the sum of $ 52,091.00, by allowing Mortgagor to deduct such sum from moneys otherwise being transmitted to Mortgagee pursuant to Section 7.2.14. On or before January 31, 1994, Properties shall deliver a statement to Mortgagee showing the actual out-of-pocket salaries, bonus and benefit costs of such employees for the period between the Closing and December 31, 1993. Mortgagee and Properties shall thereafter promptly adjust the payment to reflect the actual employee costs, but in no event shall actual out-of- pocket salary bonus and benefit costs exceed $57,300.00 for the purpose of such adjustment. 6.2.2 Severance. In addition, Mortgagee shall on January 31, 1994, pay any severance payment owed to any such employee in accordance with severance amounts indicated on Exhibit P in the event that such employee is terminated by Mortgagee or its managing agent on or before December 31, 1993, unless such termination was for cause, or unless such employee continues in the employ of Properties after January 1, 1994 or is offered a comparable position and similar salary by Mortgagee or Mortgagee's managing agent. 6.3. Termination of Management Agreement. Mortgagor and Properties hereby terminate the Management Agreement between them relating to the Property. Properties hereby releases Mortgagee from any claim for fees or compensation under such Management Agreement, except as provided in Section 6.1, 6.2, and 6.4 hereof. 6.4. Management Fees. Mortgagee has paid Properties $43,406.00, being an amount equal to those management fees estimated to arise between Closing and December 31, 1993 calculated at three (3%) percent of gross revenue from the Property, the actual amount to be reconciled on or before January 31, 1994 with Mortgagee and Properties to promptly adjust the payment to reflect the actual amount of gross revenue from the Property during that period. Payment has been made by allowing Mortgagor to deduct such amount from moneys otherwise being transmitted to Mortgagee pursuant to Section 7.2.14. 6.5 Survival. The provisions of this Article 6 shall survive the Closing. 7. Closing 7.1 Time and Place. The closing contemplated by this Agreement (the "Closing"), shall take place at the time of the execution of this Agreement at the offices of Rogers & Wells, 200 Park Avenue, New York, New York 10166. 7.2 Mortgagor's Closing Documentation and Requirements. At the Closing, Mortgagor shall deliver the following to Mortgagee: 7.2.1 a deed in lieu of foreclosure without covenants (the "Deed"), duly executed by Mortgagor and acknowledged and in recordable form, in substantially the form of Exhibit F hereto; 7.2.2 a bill of sale, duly executed by Mortgagor and acknowledged, transferring to Mortgagee title to the Personal Property, in substantially the form of Exhibit G hereto; 7.2.3 an assignment and assumption of leases (the "Assignment and Assumption of Leases"), duly executed and acknowledged, assigning and transferring to Mortgagee the lessor's interest under the Existing Leases and any security deposits and advance rentals made under the Existing Leases, in substantially the form of Exhibit H hereto; 7.2.4 an assignment and assumption of contracts (the "Assignment and Assumption of Contracts"), duly executed and acknowledged, assigning and transferring to Mortgagee all right, title and interest of Mortgagor in and to the Contracts and all deposits and advance payments made by Mortgagor thereunder, in substantially the form of Exhibit I hereto; 7.2.5 an assignment of intangible property (the "Assignment of Intangible Property"), duly executed and acknowledged, assigning and transferring to Mortgagee those items referred to in Sections 3.1, 3.5, 3.6, 3.7, 3.9 3.10, 3.11 and 3.12 in substantially the form of Exhibit J hereto; 7.2.6 an release to CRF of the tax and insurance escrow account (the "Tax and Insurance Escrow Account"), which Tax and Insurance Escrow Account is currently held by CRF, in substantially the form of Exhibit M hereto; 7.2.7 an assignment of all future refunds from any taxing authority or insurer with respect to premiums paid for insurance on the Property (the "Assignment of Future Tax or Insurance Refunds"), (which refunds Mortgagor shall hold in trust for the benefit of Mortgagee) duly executed and acknowledged, assigning and transferring to Mortgagee all right title and interest of Mortgagor in and to all future tax or insurance refunds, in substantially the form of Exhibit N hereto; 7.2.8 an affidavit executed by Mortgagor stating, under penalty of perjury, its United States taxpayer identification number and that Mortgagor is not a "foreign person" as defined in Section 1445(f)(3) of the Internal Revenue Code of 1986, as amended, and otherwise in the form prescribed by the Internal Revenue Service; 7.2.9 executed originals of the Existing Leases; 7.2.10 notices to tenants under the Existing Leases of the sale, in substantially the form of Exhibit C hereto, and to be executed by Mortgagor; 7.2.11 originals (or copies certified by Mortgagor) of the Contracts, the Permits and those items specified in Section 3 (to the extent reduced to writing); 7.2.12 a Statement of Net Cash Flow with respect to the Property, in the form of Exhibit E hereto; 7.2.13 Intentionally Deleted. 7.2.14 the payment, as of Closing, by wire transfer, in accordance with the wire instructions as set forth on Exhibit O, of Net Cash Flow. 7.2.15 a release to CRF of any positive Net Cash Flow in excess of the Approved Working Reserve ("Excess Net Cash Flow"), pursuant to the Commitment for Modification of First Deed of Trust Note between CRF and Mortgagor, dated October 5, 1987, which Excess Net Cash Flow is currently held by CRF, in substantially the form of Exhibit K hereto; 7.2.16 Intentionally Deleted. 7.2.17 a real estate excise tax affidavit to be filed with the State of Washington Department of Revenue, duly executed by Mortgagor and Mortgagee; 7.2.18 an estoppel affidavit duly executed by Mortgagor, pursuant to the requirements of the Title Company; and 7.2.19 such other documents and instruments as Mortgagee may reasonably request in order to consummate the transaction herein contemplated. 7.3 Mortgagee's Closing Documentation and Requirements. At or prior to the Closing, Mortgagee shall deliver the following to Mortgagor: 7.3.1 the Letter of Credit; 7.3.2 the Existing Deed of Trust Note endorsed as cancelled; 7.3.3 an executed and acknowledged copy of the Assignment and Assumption of Leases, and the Assignment and Assumption of Contracts; and 7.3.4 Litigation Settlement. At Closing, Mortgagee shall deliver executed copies of all documents relating to the settlement of all pending litigation matters between Mortgagor, CRF, Jones Lang Wootton Realty Advisors and Chemical Bank, in substantially the form of Exhibit L hereto. The Mortgagee shall concurrently deliver a letter to Chemical Bank in the form annexed as Exhibit Q. 7.3.5 Such other documents and instruments as Mortgagor may reasonably request in order to effectuate the immediate return to Mortgagor of any collateral for the Letter of Credit and any collateral for the bond previously furnished in the pending litigation described in Section 7.3.4. 7.4 Further Assurances. After the Closing, either party shall, upon the reasonable request of the other party, but at no expense to it, execute any instruments to confirm, assure or validate the transaction contemplated by this Agreement. 8. Expenses 8.1 Expenses of Mortgagee. Mortgagee shall pay (a) the premium for the Title Policy and the cost of all endorsements and any extended coverage obtained by Mortgagee under the Title Policy; (b) the cost of the Survey; and (c) all state, county and city transfer taxes with respect to the transaction contemplated hereby. Mortgagee shall indemnify and hold Mortgagor harmless from and against all claims, expenses and costs (including reasonable attorneys' fees) relating to such transfer taxes. The parties shall at their separate expense cooperate in good faith and in a timely manner with respect to preparing and delivering submissions, filings and other supporting documentation required in connection with transfer taxes. 8.2 Attorneys' Fees and Other Expenses. Each party shall pay its own attorneys' fees and all of its other expenses, except as otherwise expressly set forth herein. 9. Notices Any notice, demand, consent, authorization or other communication (collectively, a "Notice") which either party is required or may desire to give to or make upon the other party pursuant to this Agreement shall be effective and valid only if in writing, signed by the party giving such Notice, to the other party or sent by facsimile transmission with receipt acknowledged, express courier or delivery service or by registered or certified mail of the United States Postal Service, return receipt requested, and addressed to the other party as follows (or to such other address or person as either party or person entitled to notice may, by notice to the other specify): To Mortgagor: JMB Realty Corporation 900 North Michigan Avenue Suite 1900 Chicago, Illinois 60611 Attention: Norman Geller, Senior Vice President with copies to: Pircher, Nichols & Meeks 1999 Avenue of the Stars Los Angeles, California 90067 Attention: Real Estate Notices To Mortgagee: Jones Lang Wootton Realty Advisors 101 East 52nd Street New York, New York 10022 Attention: Frank L. Sullivan, Jr., Managing Director with copies to: Common Retirement Fund of the State of New York Office of the State Comptroller 270 Broadway Suite 2300 New York, New York 10007 Attention: Robert J. Steves, Assistant Deputy Comptroller and to: Common Retirement Fund of the State of New York Office of the State Comptroller 270 Broadway Suite 2300 New York, New York 10007 Attention: Marjorie Tsang, Esq., Legal Department - Real Estate Bureau and to: Rogers & Wells 200 Park Avenue New York, New York 10166 Attention: Lewis Bart Stone, Esq. Fax: (212) 878-8375 and to: Carney Badley Smith & Spellman 2200 Columbia Center 701 Fifth Avenue Seattle, Washington 96104-7091 Attention: Stephen C. Sieberson, Esq. and William M. Wood, Esq. Unless otherwise specified, Notices shall be deemed given when received, but if delivery is not accepted, on the earlier of the date delivery is refused or the fourth day after the same is deposited with the United States Postal Service. 10. General Provisions 10.1 Successors and Assigns. This Agreement shall bind and inure to the benefit of the respective successors and permitted assigns of the parties hereto. 10.2 Gender and Number. Whenever the context so requires, the singular number shall include the plural and the plural the singular, and the use of any gender shall include all genders. 10.3 Entire Agreement. This Agreement contains the complete and entire agreement between the parties respecting the transaction contemplated herein, and supersedes all prior negotiations, agreements, representations and understandings, if any, between the parties respecting such matters. 10.4 Counterparts. This Agreement may be executed in any number of original counterparts, all of which evidence only one agreement and only one of which need be produced for any purpose. 10.5 Modifications. This Agreement may not be modified, discharged or changed in any respect whatsoever, except by a further agreement in writing duly executed by the parties. However, any consent, waiver, approval or authorization shall be effective if signed by the party granting or making such consent, waiver, approval or authorization. 10.6 Governing Law. This Agreement shall be governed by and construed in accordance with the laws of the State of New York. Mortgagor and Mortgagee hereby irrevocably agree that all actions or proceedings in any way, manner or respect, arising out of or from or related to this Agreement shall be litigated only in courts having situs within the State of New York. Mortgagor and Mortgagee hereby consent and submit to the jurisdiction of any state court located within the County of New York or federal court located within the Southern District of New York. Each party hereby irrevocably waives any right it may have to transfer or change the venue from New York of any litigation brought against it by the other party pursuant to this Agreement. Notwithstanding the foregoing, any documents of conveyance, assignment or encumbrance relating to the Property shall be governed by the laws of the State of Washington, excluding its rules relating to the choice of laws. 10.7 Captions. The captions of this Agreement are for convenience and reference only, and in no way define, describe, extend or limit the scope, meaning or intent of this Agreement. 10.8 Severability. The invalidation or unenforceability in any particular circumstance of any provision of this Agreement shall in no way affect any of the other provisions hereof, which shall remain in full force and effect. 10.9 No Joint Venture. This Agreement shall not be construed as in any way establishing a partnership, joint venture, express or implied agency, or employer-employee relationship between the parties. 10.10 No Third-Party Beneficiaries. This Agreement is for the sole benefit of the parties hereto, their respective successors and permitted assigns, and no other person or entity shall be entitled to rely upon or receive any benefit from this Agreement or any term hereof. 10.11 Execution. The submission of this Agreement for examination does not constitute an offer by or to either party. This Agreement shall be effective and binding only after due execution and delivery by the parties hereto. 10.12 Exculpation. Notwithstanding anything to the contrary in this Agreement or in any of the closing documents, neither any present or future constituent partner in or agent of Mortgagor, nor any shareholder, officer, director, employee, trustee, beneficiary or agent of any corporation or trust that is or becomes a constituent partner in Mortgagor shall be personally liable, directly or indirectly, under or in connection with this Agreement or any of the closing documents or any other instrument or certificate executed in connection herewith or the Closing or any amendments or modifications to any of the foregoing made at this time or times, heretofore or hereafter; and Mortgagee and each of its successors and assigns waives any such personal liability. As used herein, a "constituent partner" in a particular partnership means a partner having an interest in a partnership that has a direct or indirect interest (through one or more partnerships) in such particular partnership. In the event of any inconsistency between the provisions of this Section 10.12 and the provisions of any closing document, the provisions of this Section 10.12 shall govern. 10.13 Payment of Operating Expenses. Mortgagee agrees to indemnify and save Mortgagor and Properties harmless from and against any unpaid operating expenses of the Property as follows: (a) For operating expenses incurred by or for the account of Mortgagor in connection with operation of the Property from January 1, 1991 through December 31, 1992, Mortgagee's obligation shall be limited to an aggregate of $100,000. (b) For operating expenses incurred by or for the account of Mortgagor in connection with the operation of the Property from January 1, 1993 through the Closing, Mortgagee's obligation shall be limited to an aggregate of One Million Four Hundred Thousand ($1,400,000) Dollars plus Mortgagee's obligation as landlord under the Seafirst lease dated May 18, 1992, Mortgagee's obligations under the Contracts, Mortgagee's obligations to pay real estate taxes and Mortgagee's obligation to pay ordinary operating expenses, usually billed on a monthly basis, incurred in the month of October 1993. (c) Mortgagee shall have no obligation under this Section 10.13 (i) for any expense for which an invoice or bill is submitted to Mortgagor or its agent on or after January 1, 1995 relating to operating expenses incurred prior to October 22, 1993, or (ii) for any expense incurred by or any invoice or bill submitted by any affiliate of Mortgagor, except as expressly provided in Article 6. (d) Mortgagor shall upon the receipt of any invoice for operating expenses which are to be paid by Mortgagee hereunder, promptly submit the same for payment to Mortgagee, and shall at Mortgagee's request provide such information as it or its affiliates may have as may be reasonably necessary to determine the propriety of such bill and shall cooperate with Mortgagee in connection with any dispute of any such bill which Mortgagee reasonably decides to dispute, but shall not be obligated to incur any out-of- pocket expense. Mortgagor shall and shall cause its affiliates to preserve records kept by them to enable Mortgagee to ascertain the validity of bills to which this section applies and to enable Mortgagee to object thereto in proper circumstances. To the extent Mortgagee shall not have given notice on or before April 1, 1995 as to any record or information pertaining to a bill to which this section may apply, Mortgagor's obligation to maintain such records hereunder shall expire. (e) Mortgagee shall hold Mortgagor harmless from any expenses, costs or liabilities (including reasonable legal fees) relating to any failure to carry out Mortgagee's obligations under this Section 10.13. 10.14 Survival. The provisions of Article 4, Sections 7.2.19, 7.3.5, 7.4 and Articles 8, 9 and 10 shall survive the Closing. 10.15 Tenants' Tax Refunds. To the extent a tenant of the Property shall become entitled, pursuant to its lease to any portion of a tax refund which refund has been released pursuant to Exhibit N, Mortgagee shall indemnify and hold harmless Mortgagor and Properties (including reasonable legal fees) from any claims of such tenant against Mortgagor or Properties with respect thereto. IN WITNESS WHEREOF, the parties have caused this instrument to be executed as of the date first above written. MORTGAGOR: 1001 FOURTH AVENUE ASSOCIATES an Illinois general partnership By: Carlyle Real Estate Limited Partnership - XIII, Managing General Partner By: JMB Realty Corporation, Corporate General Partner of Carlyle Real Estate Limited Partnership - XIII By: Julie A. Strocchia Its: Vice President MORTGAGEE: SEAFO, INC. By: Its: Agreed: JMB PROPERTIES COMPANY By: __________________________ Julie A. Strocchia Its: Vice President EXHIBIT A LEGAL DESCRIPTION [TO BE ATTACHED] EXHIBIT B CONTRACTS 1. Agreement for Provision of Security Services dated September 1, 1983, between 1001 Fourth Avenue Associates, as Owner, and Seattle-First National Bank, as Contractor; 2. Vertical Transportation Contract, dated July 1, 1992, between 1001 Fourth Avenue Associates, as Owner, and Schindler Elevator Corporation, as Contractor; 3. Modernization/Repair Contract and all Supplemental Proposals thereto, dated October 6, 1992, between 1001 Fourth Avenue Associates, by JMB Properties Company, as agent, and Schindler Elevator Corporation; 4. Master Agreement, dated May 31, 1991, as amended by the Master Agreement Extension and Amendment Agreement No. 1, dated December 30, 1992, between Turner Construction Company, as Contractor, and JMB Properties Company, as agent for the property owner; 5. Work/Construction Agreement, dated August 20, 1993, between 1001 Fourth Avenue Associates, as Owner, and Auburn Mechanical, Inc., as Contractor; 6. Settlement and Mutual Release of All Claims, dated September 16, 1993, between 1001 Fourth Avenue Associates, by and through JMB Properties Company, its agent, the Municipality of Metropolitan Seattle, Mortrude Floor Company and Tri-State Construction, Inc.; 7. Continuing Service Agreement, dated, August 20, 1993, between 1001 Fourth Avenue Associates by JMB Properties Company, as agent, and P&G Plant Company; and 8. Property Operation and Maintenance Agreement, dated March 23, 1993, between JMB Properties Company, as agent for the property owner, and Urban Engineering Co., as Contractor. 9. Work Construction Agreement, dated April 5, 1993, between 1001 Fourth Avenue Associates, as Owner, and Aluminum and Bronze Fabricators, Inc., as Contractor. EXHIBIT C NOTICES TO EXISTING TENANTS November 1, 1993 BY CERTIFIED MAIL RETURN RECEIPT REQUESTED All Tenants of 1001 Fourth Avenue Seattle, Washington Re: 1001 Fourth Avenue Seattle, Washington Gentlemen and Ladies: Please take notice that the property known as 1001 Fourth Avenue, Seattle, Washington (the "Property") has been conveyed on the date hereof to Seafo, Inc. ("Purchaser"), and, simultaneously herewith, 1001 Fourth Avenue Associates ("Owner") has assigned to Purchaser all of Owner's interest in your lease at the Property. All future rental or other payments under your lease (including any payments now due or overdue) should be made payable to Purchaser until you are otherwise directed by Purchaser and should be sent to: Seafo, Inc. P.O. Box 34936 Department 4002 Seattle, Washington 98124-1936 Furthermore, please be advised (i) that any security deposit under your lease has been transferred to Purchaser; and (ii) that Seafo, Inc. should be added as an additional insured to the insurance policies which you are required to carry under your lease. Thank you for your cooperation in this matter. Sincerely, 1001 FOURTH AVENUE ASSOCIATES By_____________________________ Name: Title: EXHIBIT D Pending Leases 1. Cowan & Kerr 2. Palmer Groth & Pietka 3. Schwabe Law Firm 4. Nippon Kaiji Kyokai 5. Kobe Trade Information Office 6. Sinsheimer Meltzer Inc. EXHIBIT E STATEMENT OF NET CASH FLOW [TO BE ATTACHED] EXHIBIT F DEED Filed for Record at Request of: Rogers & Wells 200 Park Avenue New York, New York 10166 Attention: Lewis Bart Stone, Esq. QUIT CLAIM DEED IN LIEU OF FORECLOSURE The Grantor, 1001 Fourth Avenue Associates, an Illinois general partnership, for and in consideration of the sum of Ten Dollars ($10.00) and other good and valuable consideration, and in lieu of foreclosure of the below-mentioned Deed of Trust, conveys and quit claims to Seafo, Inc., a Delaware corporation, the following described real estate, situated in the County of King, State of Washington (the "Property"): See Exhibit A attached. This deed is an absolute conveyance of title in effect as well as in form, and is not intended as a mortgage, trust conveyance, or security of any kind. Consideration for this deed consists of full release of the Grantor from all debts and obligations of Grantor as secured by the deed of trust on the Property dated April 26, 1984 and recorded on the same date under Recording No. 8404260342, Records of King County, Washington, as modified by a Modification of Deed of Trust dated October 5, 1987 and recorded November 17, 1987 under Recording No. 8711171151, Records of King County, Washington (the "Deed of Trust"). This deed fully satisfies the indebtedness of the Deed of Trust and terminates in all respects the Deed of Trust, the note secured thereby, and all related security documents. DATED this ___, day of October, 1993. 1001 FOURTH AVENUE ASSOCIATES an Illinois general partnership By: Carlyle Real Estate Limited Partnership - XIII, Managing General Partner By: JMB Realty Corporation, Corporate General Partner of Carlyle Real Estate Limited Partnership - XIII By: Authorized Signatory Its: STATE OF NEW YORK ) ) ss.: COUNTY OF NEW YORK ) On the ______ day of October, 1993, before me personally came sworn, Julie A. Strocchia, did depose and say that she resides at 900 North Michigan Avenue, Chicago, Illinois; that she is the Vice President of JMB REALTY CORPORATION, the corporation described in and which executed the foregoing instrument as a general partner of CARLYLE REAL ESTATE LIMITED PARTNERSHIP - XIII, as a general partner of 1001 FOURTH AVENUE ASSOCIATES; and that she signed her name there by like order. _________________________ Notary Public My Commission expires: ___________________. City of Residence: _______________________. EXHIBIT G BILL OF SALE This Bill of Sale is made as of this ____ day of November, 1993 by 1001 FOURTH AVENUE ASSOCIATES, an Illinois general partnership ("Mortgagor") to SEAFO, INC., a Delaware corporation ("Mortgagee"). Terms not otherwise defined herein shall have the same meanings as set forth in that certain Agreement For the Delivery of a Deed in Lieu of Foreclosure dated as of October 29, 1993, between Mortgagor and Mortgagee. WITNESSETH, that Mortgagor, for and in consideration of the sum of Ten Dollars ($10.00) and other good and valuable consideration, the receipt and sufficiency of which are hereby acknowledged, does hereby ASSIGN, TRANSFER and DELIVER to Mortgagee all appliances, apparatus, fixtures, equipment (including, without limitation, all heating, ventilating, incinerating, lighting, plumbing, electrical and air-conditioning fixtures and equipment), machinery, fittings and other articles of personal property now situate in or on or attached to the Building Complex (collectively, the "Personal Property"). Notwithstanding the foregoing, the term "Personal Property" shall exclude all such above listed items to the extent owned by tenants under the Existing Leases or by parties other than Mortgagor under the Contracts. TO HAVE AND TO HOLD the Personal Property unto Mortgagee, its successors and assigns, forever. And the Mortgagor shall warrant and defend the title to the Personal Property unto Mortgagee, its successors and assigns forever against the lawful claims of all persons and entities claiming by, through or under Mortgagor. IN WITNESS WHEREOF, the parties have caused this instrument to be duly executed as of the date and year first above written. MORTGAGOR: 1001 FOURTH AVENUE ASSOCIATES an Illinois general partnership By: Carlyle Real Estate Limited Partnership - XIII, Managing General Partner By: JMB Realty Corporation, Corporate General Partner of Carlyle Real Estate Limited Partnership - XIII By: ______________________ Julie Strocchia Vice President STATE OF NEW YORK ) ) ss.: COUNTY OF NEW YORK ) On the day of November, 1993, before me personally came Julie Strocchia, to me known, who, being by me duly sworn, did depose and say that she resides at 900 North Michigan Avenue, Chicago, Illinois; that she is the Vice President of JMB REALTY CORPORATION, the corporation described in and which executed the foregoing instrument as a general partner of CARLYLE REAL ESTATE LIMITED PARTNERSHIP - XIII, as a general partner of 1001 FOURTH AVENUE ASSOCIATES; and that she signed her name there by like order. Notary Public My Commission expires: . City of Residence: . EXHIBIT H RECORD AND RETURN TO: Rogers & Wells 200 Park Avenue New York, New York 10166 Attn: Lewis Bart Stone, Esq. ASSIGNMENT AND ASSUMPTION OF LEASES AND RENTS This Assignment and Assumption of Leases, made as of this 1st day of November, 1993 between 1001 FOURTH AVENUE ASSOCIATES, an Illinois general partnership ("Assignor") and SEAFO, INC., a Delaware corporation ("Assignee"). WITNESSETH, that Assignor, for and in consideration of the sum of Ten Dollars ($10.00) and other good and valuable consideration, the receipt and sufficiency of which are hereby acknowledged, does hereby ASSIGN, TRANSFER, AND CONVEY unto Assignee, its successors and assigns, all right, title and interest of Assignor in, to and under all existing leases, together with all security deposits, advance rentals and other advance payments payable by tenants thereunder (collectively, the "Leases") demising portions of the improvements located on the real property described in Exhibit "A" attached hereto. TO HAVE AND TO HOLD the Leases, together with all rights and privileges thereunto belonging unto Assignee, its successors and assigns, including, without limitation, all security deposits, any documents or instruments securing the obligations of the tenants thereunder and advance rentals paid for the month of November, 1993 or thereafter and other advance payments made or given thereunder, for and during the remainder of the terms of the Leases, as well as all rents received by Assignor on or after October 23, 1993. Assignee does hereby covenant to and agree with Assignor that Assignee accepts the foregoing assignment and assumes all of the terms, covenants and provisions of the Leases on the part of Assignee thereunder to be performed and arising or accruing on and after the date hereof. This Assignment and Assumption of Leases shall be governed by and construed in accordance with the internal laws of the State of Washington without regard to principles of conflict of law. IN WITNESS WHEREOF, the parties hereto have caused this instrument to be duly executed as of the day and year first above written. ASSIGNOR: 1001 FOURTH AVENUE ASSOCIATES an Illinois general partnership By: Carlyle Real Estate Limited Partnership - XIII, Managing General Partner By: JMB Realty Corporation, Corporate General Partner of Carlyle Real Estate Limited Partnership - XIII By: Julie Strocchia Vice President ASSIGNEE: SEAFO, INC. By: Its: STATE OF NEW YORK ) ) ss.: COUNTY OF NEW YORK ) On the day of November, 1993, before me personally came Julie Strocchia, to me known, who, being by me duly sworn, did depose and say that she resides at 900 North Michigan Avenue, Chicago, Illinois; that she is the Vice President of JMB REALTY CORPORATION, the corporation described in and which executed the foregoing instrument as a general partner of CARLYLE REAL ESTATE LIMITED PARTNERSHIP - XIII, as a general partner of 1001 FOURTH AVENUE ASSOCIATES; and that she signed her name there by like order. Notary Public My Commission expires: . City of Residence: . STATE OF NEW YORK ) ) ss.: COUNTY OF NEW YORK ) On the day of November, 1993, before me personally came , to me known, who, being by me duly sworn, did depose and say that he resides at ; that he is the of SEAFO, INC., the corporation described in and which executed the foregoing instrument; and that he signed his name there by like order. Notary Public My Commission expires: . City of Residence: . EXHIBIT I RECORD AND RETURN TO: Rogers & Wells 200 Park Avenue New York, New York 10166 Attn: Lewis Bart Stone, Esq. ASSIGNMENT AND ASSUMPTION OF CONTRACTS This Assignment and Assumption of Contracts made as of this ____ day of November, 1993, between 1001 FOURTH AVENUE ASSOCIATES, an Illinois general partnership ("Assignor"), and SEAFO, INC., a Delaware corporation ("Assignee"). WITNESSETH, that Assignor, for and in consideration of the sum of Ten Dollars ($10.00) and other good and valuable consideration, the receipt and sufficiency of which are hereby acknowledged, does hereby ASSIGN, TRANSFER, AND CONVEY unto Assignee, its successors and assigns, all right, title and interest of Assignor in, to and under those certain service, maintenance and other contracts and agreements and equipment and other leases (excluding space leases) more fully described in Exhibit "A" attached hereto and made a part hereof (collectively, the "Contracts") with respect to the improvements and personal property located on the real property described in Exhibit "B" attached hereto. TO HAVE AND TO HOLD the Contracts, together with all rights and privileges thereunto belonging and all transferable or assignable deposits made by Assignor thereunder, unto Assignee, its successors and assigns, for and during the remainder of the terms of the Contracts. Assignee does hereby covenant to and agree with Assignor that Assignee accepts the foregoing assignment and assumes all of the terms, covenants and provisions of the Contracts on the part of Assignee thereunder to be performed or complied with and arising or accruing on and after the date hereof. This Assignment and Assumption of Contracts shall be governed by and construed in accordance with the internal laws of the State of Washington without regard to principles of conflict of law. IN WITNESS WHEREOF, the parties have caused this instrument to be duly executed as of the day and year first above written. ASSIGNOR: 1001 FOURTH AVENUE ASSOCIATES an Illinois general partnership By: Carlyle Real Estate Limited Partnership - XIII Managing General Partner By: JMB Realty Corporation, Corporate General Partner of Carlyle Real Estate Limited Partnership - XIII By: Julie Strocchia Vice President ASSIGNEE: SEAFO, INC. By: Its: STATE OF NEW YORK ) ) ss.: COUNTY OF NEW YORK ) On the day of November, 1993, before me personally came Julie Strocchia, to me known, who, being by me duly sworn, did depose and say that she resides at 900 North Michigan Avenue, Chicago, Illinois; that she is the Vice President of JMB REALTY CORPORATION, the corporation described in and which executed the foregoing instrument as a general partner of CARLYLE REAL ESTATE LIMITED PARTNERSHIP - XIII, as a general partner of 1001 FOURTH AVENUE ASSOCIATES; and that she signed her name there by like order. Notary Public My Commission expires: . City of Residence: . STATE OF NEW YORK ) ) ss.: COUNTY OF NEW YORK ) On the day of November, 1993, before me personally came , to me known, who, being by me duly sworn, did depose and say that he resides at ; that he is the of SEAFO, INC., the corporation described in and which executed the foregoing instrument; and that he signed his name there by like order. Notary Public My Commission expires: . City of Residence: . EXHIBIT J ASSIGNMENT OF INTANGIBLE PROPERTY WITNESSETH, that 1001 FOURTH AVENUE ASSOCIATES, an Illinois general partnership (collectively, "Assignor"), for and in consideration of the sum of Ten Dollars ($10.00) and other good and valuable consideration to it in hand paid by SEAFO, INC., a Delaware corporation ("Assignee"), the receipt and sufficiency of which are hereby acknowledged, has ASSIGNED, TRANSFERRED, SET OVER, DELIVERED AND CONVEYED and by these presents does hereby ASSIGN, TRANSFER, SET OVER, DELIVER AND CONVEY unto Assignee, its successors and assigns all right, title and interest of Assignor in and to all of the following (hereinafter collectively referred to as the "Assigned Property") to the extent that the same apply to that certain real property described in "Exhibit A" attached hereto and the improvements located thereon and subject to the terms and conditions of that certain Agreement for the Delivery of a Deed In Lieu of Foreclosure dated as of October 29, 1993, between Assignor and Assignee (the "Agreement") (all capitalized terms not otherwise defined herein shall have the meaning as set forth in the Agreement): (1) the certificates of occupancy with respect to the Improvements and, to the extent maintained by or on behalf of Assignor, all other transferable licenses, certificates and permits issued by any governmental or quasi-governmental authority with respect to the Property or the use, maintenance and operations thereof; (2) all architectural, mechanical, engineering and other plans and specifications within Assignor's possession or subject to its control relating to the completed construction or renovation of or other work at the Building Complex and any unexpired warranties, guaranties or sureties in favor of Assignor with respect thereto; (3) all promotional advertising literature and materials, catalogs, booklets and manuals relating to the Property or the use, operation or maintenance thereof; (4) all intangible personal property relating to the ownership, construction, renovation, operation and leasing of the Property, including, without limitation, the good will pertaining thereto; (5) all environmental reports, asbestos reports and files relating to asbestos work within Assignor's possession; (6) all accounting, financial and operating information located at the Property; (7) the Order Granting Summary Judgment Against UCAQ International, Inc., as entered as Case No. 92-2-13158-7, and entitled 1001 Fourth Avenue Associates, a corporation, Plaintiff v. UCAQ International, Inc., a corporation, and Masao Matsumoto, an individual and the marital community thereof, Defendants, in the Superior Court of the State of Washington for King County; (8) the Default Judgment against Masao Matsumoto, as entered as Case No. 92-2-13158-7, in the Superior Court of the State of Washington for King County; (9) the Judgment and Order Directing Issuance of Writ of Restitution, as entered as Case No. 90-2-21313-7, and entitled 1001 Fourth Avenue Associates, an Illinois General Partnership, Plaintiff v. Mirabeau, Inc., a Washington corporation, Defendant, in the Superior Court of the State of Washington in and for the County of King; (10) the First Amended Complaint For Unlawful Detainer, as entered as Case No. 93-2-23702-2, and entitled 1001 Fourth Avenue Associates, an Illinois general partnership, Plaintiff, v. Trans Pacific Stores, Ltd., a corporation, Defendant, in the Superior Court of the State of Washington in and for the County of King; and (11) all transferable or assignable warranties, guaranties, contract rights and miscellaneous rights, if any, with respect to the Property, including any of the property described in items (1) through (10) above. TO HAVE AND TO HOLD the Assigned Property, together with all rights and privileges thereunto belonging unto Assignee, its successors and assigns, forever. This Assignment of Intangible Property shall be governed by and construed in accordance with the internal laws of the State of Washington without regard to principles of conflict of law. EXECUTED AND DELIVERED this day of November, 1993. ASSIGNOR: 1001 FOURTH AVENUE ASSOCIATES an Illinois general partnership By: Carlyle Real Estate Limited Partnership - XIII, Managing General Partner By: JMB Realty Corporation, Corporate General Partner of Carlyle Real Estate Limited Partnership - XIII By: _________________________ Julie Strocchia Vice President STATE OF NEW YORK ) ) ss.: COUNTY OF NEW YORK ) On the day of November, 1993, before me personally came Julie Strocchia, to me known, who, being by me duly sworn, did depose and say that she resides at 900 North Michigan Avenue, Chicago, Illinois; that she is the Vice President of JMB REALTY CORPORATION, the corporation described in and which executed the foregoing instrument as a general partner of CARLYLE REAL ESTATE LIMITED PARTNERSHIP - XIII, as a general partner of 1001 FOURTH AVENUE ASSOCIATES; and that she signed her name there by like order. Notary Public My Commission expires: . City of Residence: . EXHIBIT K RELEASE OF EXCESS NET CASH FLOW 1001 FOURTH AVENUE ASSOCIATES c/o JMB Realty Corporation 900 North Michigan Avenue Suite 1900 Chicago, Illinois 60611 November 1, 1993 Common Retirement Fund of the State of New York Office of the State Comptroller 270 Broadway New York, NY 10007 Gentlemen: Reference is made to that certain Agreement for the Delivery of a Deed In Lieu of Foreclosure dated as of October 29, 1993 between 1001 Fourth Avenue Associates, as Mortgagor, and Seafo, Inc., as Mortgagee (the "Agreement"). All capitalized terms used herein which are not otherwise defined herein shall have the respective meanings ascribed to them in the Agreement. This letter shall confirm our understanding, that pursuant to Mortgagor's closing requirements under Section 7.2.15 of the Agreement, the undersigned, JMB Realty Corporation ("JMB"), hereby releases to the Common Retirement Fund of the State of New York ("CRF") and hereafter shall have no future claim, right or title to any positive Net Cash Flow in excess of the Approved Working Reserve ("Excess Net Cash Flow"), as such term is defined in the Commitment for Modification of First Deed of Trust Note between CRF and Mortgagor, dated October 5, 1987. Such Excess Net Cash Flow is currently being held by CRF. Very truly yours, 1001 FOURTH AVENUE ASSOCIATES an Illinois general partnership By: Carlyle Real Estate Limited Partnership - XIII, Managing General Partner By: JMB Realty Corporation, Corporate General Partner of Carlyle Real Estate Limited Partnership - XIII By: _____________________________ Julie Strocchia Vice President EXHIBIT L LITIGATION SETTLEMENT DOCUMENTS SUPREME COURT OF THE STATE OF NEW YORK APPELLATE DIVISION - FIRST DEPARTMENT - - - - - - - - - - - - - - - - - - - - -x 1001 FOURTH AVENUE ASSOCIATES, Plaintiff/Appellant/Cross-Respondent, - against - JONES LANG WOOTTON REALTY ADVISORS, and COMPTROLLER OF THE STATE OF NEW YORK AS TRUSTEE OF THE COMMON RETIREMENT FUND OF THE STATE OF NEW YORK, Defendants/Respondents/Cross-Appellants, - and - : : : : : : : : : New York County Clerk's Index No. 30222/92 STIPULATION WITHDRAWING APPEALS AND CROSS-APPEAL CHEMICAL BANK, Defendant/Respondent. : :- - - - - - - - - - - - - - - - - - - -x IT IS HEREBY STIPULATED, by and between the parties hereto, through their undersigned counsel, that each appeal and cross-appeal taken in this action is, and the same hereby are, withdrawn and dismissed with prejudice, each party to bear its own costs, expenses and attorneys' fees. Dated: New York, New York October __, 1993 _____________________________ _______________________ OBER, KALER, GRIMES & SHRIVER ROGERS & WELLS Attorneys for 1001 Fourth Avenue Attorneys for Jones Lang Associates Wootton Realty Advisors 1345 Avenue of the Americas and New York, New York 10105 Comptroller of The State of 212-315-3200 New York as Trustee of The Common Retirement Fund of The State of New York 200 Park Avenue New York, New York 10166 212-878-8000 SUPREME COURT OF THE STATE OF NEW YORK COUNTY OF NEW YORK - - - - - - - - - - - - - - - - - - - - -x 1001 FOURTH AVENUE ASSOCIATES, Plaintiff, - against - JONES LANG WOOTTON REALTY ADVISORS, COMPTROLLER OF THE STATE OF NEW YORK AS TRUSTEE OF THE COMMON RETIREMENT FUND OF THE STATE OF NEW YORK and CHEMICAL BANK, Defendants. : : : : : : :Index No. 30222/92 Hon. Burton S. Sherman IAS Part 19 STIPULATION AND ORDER DISCONTINUING ACTION WITH PREJUDICE - - - - - - - - - - - - - - - - - - - -x IT IS HEREBY STIPULATED AND AGREED, by and among the parties hereto, through their undersigned counsel, that all claims of the plaintiff against all defendants in this action, and all claims of defendants against the bond posted in this action by or on behalf of the plaintiff, are hereby discontinued with prejudice, each party to bear its own costs, expenses and attorneys' fees. Dated: New York, New York October , 1993 _____________________________ _______________________ OBER, KALER, GRIMES & SHRIVER ROGERS & WELLS Attorneys for 1001 Fourth Avenue Attorneys for Jones Lang Associates Wootton Realty Advisors 1345 Avenue of the Americas and New York, New York 10105 Comptroller of The State of 212-315-3200 New York as Trustee of The Common Retirement Fund of The State of New York 200 Park Avenue New York, New York 10166 212-878-8000 Page 1 of 2 CHEMICAL BANK LEGAL DEPARTMENT By:___________________________ Andrew N. Keen, Esq. Attorneys for Defendant Chemical Bank 270 Park Avenue - 39th Floor New York, New York 10017 212-270-0088 SO ORDERED: Justice Burton S. Sherman October __, 1993 Page 2 of 2 EXHIBIT M RELEASE OF TAX AND INSURANCE ESCROW ACCOUNT 1001 FOURTH AVENUE ASSOCIATES c/o JMB Realty Corporation 900 North Michigan Avenue Suite 1900 Chicago, Illinois 60611 November 1, 1993 Common Retirement Fund of the State of New York Office of the State Comptroller 270 Broadway New York, NY 10007 Gentlemen: Reference is made to that certain Agreement for the Delivery of a 2Deed In Lieu of Foreclosure dated as of October 29, 1993 between 1001 Fourth Avenue Associates, as Mortgagor, and Seafo, Inc., as Mortgagee (the "Agreement"). All capitalized terms used herein which are not otherwise defined herein shall have the respective meanings ascribed to them in the Agreement. This letter shall confirm our understanding, that pursuant to Mortgagor's closing requirements under Section 7.2.6 of the Agreement, the undersigned, JMB Realty Corporation ("JMB"), hereby releases to the Common Retirement Fund of the State of New York ("CRF") and hereafter shall have no future claim, right or title to that certain tax and insurance escrow account relating to the Property (the "Tax and Insurance Escrow Account"). The Tax and Insurance Escrow Account is currently being held by CRF. Very truly yours, 1001 FOURTH AVENUE ASSOCIATES an Illinois general partnership By: Carlyle Real Estate Limited Partnership - XIII, Managing General Partner By: JMB Realty Corporation, Corporate General Partner of Carlyle Real Estate Limited Partnership - XIII By: _____________________________ Julie Strocchia Vice President EXHIBIT N ASSIGNMENT OF FUTURE TAX OR INSURANCE REFUNDS WITNESSETH, that 1001 FOURTH AVENUE ASSOCIATES, an Illinois general partnership (collectively, "Assignor"), for and in consideration of the sum of Ten Dollars ($10.00) and other good and valuable consideration to it in hand paid by SEAFO, INC., a Delaware corporation ("Assignee"), the receipt and sufficiency of which are hereby acknowledged, has ASSIGNED, TRANSFERRED, SET OVER, DELIVERED AND CONVEYED and by these presents does hereby ASSIGN, TRANSFER, SET OVER, DELIVER AND CONVEY unto Assignee, its successors and assigns all right, title and interest of Assignor in and to all of the following (hereinafter collectively referred to as the "Assigned Property") to the extent that the same apply to that certain real property described in "Exhibit A" attached hereto and the improvements located thereon and subject to the terms and conditions of that certain Agreement for the Delivery of a Deed In Lieu of Foreclosure dated as of October 29, 1993, between Assignor and Assignee (the "Agreement") (all capitalized terms not otherwise defined herein shall have the meaning as set forth in the Agreement): (1) all future refunds from any taxing authority (which refunds Assignor shall hold in trust for the benefit of Assignee); and (2) all future refunds from any insurer with respect to premiums paid for insurance on the Property (which refunds Assignor shall hold in trust for the benefit of Assignee). TO HAVE AND TO HOLD the Assigned Property, together with all rights and privileges thereunto belonging unto Assignee, its successors and assigns, forever. This Assignment of Future Tax or Insurance Refunds shall be governed by and construed in accordance with the internal laws of the State of Washington without regard to principles of conflict of law. EXECUTED AND DELIVERED this day of November, 1993. ASSIGNOR: 1001 FOURTH AVENUE ASSOCIATES an Illinois general partnership By: Carlyle Real Estate Limited Partnership - XIII, Managing General Partner By: JMB Realty Corporation, Corporate General Partner of Carlyle Real Estate Limited Partnership-XIII By: _________________________ Julie Strocchia Vice President STATE OF NEW YORK ) ) ss.: COUNTY OF NEW YORK ) On the day of November, 1993, before me personally came Julie Strocchia, to me known, who, being by me duly sworn, did depose and say that she resides at 900 North Michigan Avenue, Chicago, Illinois; that she is the Vice President of JMB REALTY CORPORATION, the corporation described in and which executed the foregoing instrument as a general partner of CARLYLE REAL ESTATE LIMITED PARTNERSHIP - XIII, as a general partner of 1001 FOURTH AVENUE ASSOCIATES; and that she signed her name there by like order. Notary Public My Commission expires: . City of Residence: . EXHIBIT O WIRE INSTRUCTIONS [TO BE ATTACHED] EXHIBIT P SITE EMPLOYEES EXHIBIT Q LETTER TO CHEMICAL BANK State of New York Office of the State Comptroller Albany, New York 12236 October 29, 1993 Mr. Anthony Capasso Vice President Chemical Bank Letter of Credit Department 55 Water Street - Room 1708 New York, New York 10017 Re: Chemical Bank Letter of Credit No. C-237248, dated November 9, 1987, as amended and The action entitled: 1001 Fourth Avenue Associates vs. Jones Lang, et al., Index No. 30222/92, pending in the Supreme Court of the State of New York for the County of New York Dear Mr. Capasso: In connection with the above letter of credit issued to the benefit of the New York State Employees Retirement System (the "Credit"), this is to advise Chemical Bank that all drawings on the Credit, including the drawing submitted on or about November 6, 1992 by Jones Lang Wootton Realty Advisors ("JLW"), are hereby withdrawn, and the undersigned acknowledges that the Credit has expired and that there will not be any further drawings on the Credit. The documents presented to Chemical Bank by JLW with respect to the Credit should please be returned to the undersigned. Very truly yours, COMPTROLLER OF THE STATE OF NEW YORK AS TRUSTEE OF THE COMMON RETIREMENT FUND By:_________________________ John E. Hull Deputy Comptroller, Division of Investments and Cash Management AGREEMENT FOR THE DELIVERY OF A DEED IN LIEU OF FORECLOSURE BETWEEN 1001 FOURTH AVENUE ASSOCIATES MORTGAGOR and SEAFO, INC. MORTGAGEE 1001 FOURTH AVENUE PLAZA BUILDING SEATTLE, WASHINGTON Dated: as of October 29, 1993 AGREEMENT FOR THE DELIVERY OF A DEED IN LIEU OF FORECLOSURE BETWEEN 1001 FOURTH AVENUE ASSOCIATES MORTGAGOR and SEAFO, INC. MORTGAGEE Article Page 1. Definitions. . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1 2. Agreement to Convey. . . . . . . . . . . . . . . . . . . . . . . . . 3 3. Other Property Included in the Conveyance. . . . . . . . . . . . . . 4 4. Release. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5 5. Mortgagee's Inspection of the Property . . . . . . . . . . . . . . . 5 6. Brokerage, Management and Site Personnel . . . . . . . . . . . . . . 5 7. Closing. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7 8. Expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9 9. Notices. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9 10. General Provisions . . . . . . . . . . . . . . . . . . . . . . . . . 11 EXHIBITS A - Legal Description B - Contracts C - Notices to Existing Tenants D - Pending Leases E - Statement of Net Cash Flow F - Deed G - Bill of Sale H - Assignment and Assumption of Leases I - Assignment and Assumption of Contracts J - Assignment of Intangible Property K - Release of Excess Net Cash Flow L - Litigation Settlement Documents M - Release of Tax and Insurance Escrow Account N - Assignment of Future Tax or Insurance Refunds O - Wire Instructions P - Site Employees Q - Letter to Chemical Bank BILL OF SALE This Bill of Sale is made as of this 1st day of November, 1993 by 1001 FOURTH AVENUE ASSOCIATES, an Illinois general partnership ("Mortgagor") to SEAFO, INC., a Delaware corporation ("Mortgagee"). Terms not otherwise defined herein shall have the same meanings as set forth in that certain Agreement For the Delivery of a Deed in Lieu of Foreclosure dated as of October 29th, 1993, between Mortgagor and Mortgagee. WITNESSETH, that Mortgagor, for and in consideration of the sum of Ten Dollars ($10.00) and other good and valuable consideration, the receipt and sufficiency of which are hereby acknowledged, does hereby ASSIGN, TRANSFER and DELIVER to Mortgagee all appliances, apparatus, fixtures, equipment (including, without limitation, all heating, ventilating, incinerating, lighting, plumbing, electrical and air-conditioning fixtures and equipment), machinery, fittings and other articles of personal property now situate in or on or attached to the Building Complex (collectively, the "Personal Property"). Notwithstanding the foregoing, the term "Personal Property" shall exclude all such above listed items to the extent owned by tenants under the Existing Leases or by parties other than Mortgagor under the Contracts. TO HAVE AND TO HOLD the Personal Property unto Mortgagee, its successors and assigns, forever. And the Mortgagor shall warrant and defend the title to the Personal Property unto Mortgagee, its successors and assigns forever against the lawful claims of all persons and entities claiming by, through or under Mortgagor. IN WITNESS WHEREOF, the parties have caused this instrument to be duly executed as of the date and year first above written. MORTGAGOR: 1001 FOURTH AVENUE ASSOCIATES an Illinois general partnership By: Carlyle Real Estate Limited Partnership - XIII, Managing General Partner By: JMB Realty Corporation, Corporate General Partner of Carlyle Real Estate Limited Partnership - XIII By: -------------------------- Julie A. Strocchia Its: Vice President STATE OF NEW YORK ) ) ss.: COUNTY OF NEW YORK ) On the 1st day of November, 1993, before me personally came JULIE A. STROCCHIA, to me known, who, being by me duly sworn, did depose and say that she resides at 900 North Michigan Avenue, Chicago, Illinois; that she is the Vice President of JMB REALTY CORPORATION, the corporation described in and which executed the foregoing instrument as a general partner of CARLYLE REAL ESTATE LIMITED PARTNERSHIP - XIII, as a general partner of 1001 FOURTH AVENUE ASSOCIATES; and that she signed her name there by like order. ------------------------------ Notary Public My Commission expires: -------------- City of Residence: ------------------ RECORD AND RETURN TO: Rogers & Wells 200 Park Avenue New York, New York 10166 Attn: Lewis Bart Stone, Esq. ASSIGNMENT AND ASSUMPTION OF CONTRACTS This Assignment and Assumption of Contracts made as of this 1st day of November, 1993, between 1001 FOURTH AVENUE ASSOCIATES, an Illinois general partnership ("Assignor"), and SEAFO, INC., a Delaware corporation ("Assignee"). WITNESSETH, that Assignor, for and in consideration of the sum of Ten Dollars ($10.00) and other good and valuable consideration, the receipt and sufficiency of which are hereby acknowledged, does hereby ASSIGN, TRANSFER, AND CONVEY unto Assignee, its successors and assigns, all right, title and interest of Assignor in, to and under those certain service, maintenance and other contracts and agreements and equipment and other leases (excluding space leases) more fully described in Exhibit "A" attached hereto and made a part hereof (collectively, the "Contracts") with respect to the improvements and personal property located on the real property described in Exhibit "B" attached hereto. TO HAVE AND TO HOLD the Contracts, together with all rights and privileges thereunto belonging and all transferable or assignable deposits made by Assignor thereunder, unto Assignee, its successors and assigns, for and during the remainder of the terms of the Contracts. Assignee does hereby covenant to and agree with Assignor that Assignee accepts the foregoing assignment and assumes all of the terms, covenants and provisions of the Contracts on the part of Assignee thereunder to be performed or complied with and arising or accruing on and after the date hereof. This Assignment and Assumption of Contracts shall be governed by and construed in accordance with the internal laws of the State of Washington without regard to principles of conflict of law. IN WITNESS WHEREOF, the parties have caused this instrument to be duly executed as of the day and year first above written. ASSIGNOR: 1001 FOURTH AVENUE ASSOCIATES an Illinois general partnership By: Carlyle Real Estate Limited Partnership - - XIII, Managing General Partner By: JMB Realty Corporation, Corporate General Partner of Carlyle Real Estate Limited Partnership - XIII By: _________________________ Julie A. Strocchia Its: Vice President ASSIGNEE: SEAFO, INC. By: __________________________________ Its: _____________________________ STATE OF NEW YORK) ) ss.: COUNTY OF NEW YORK ) On the 1st day of November, 1993, before me personally came JULIE A. STROCCHIA, to me known, who, being by me duly sworn, did depose and say that she resides at 900 North Michigan Avenue, Chicago, Illnois; that she is the Vice President of JMB REALTY CORPORATION, the corporation described in and which executed the foregoing instrument as a general partner of CARLYLE REAL ESTATE LIMITED PARTNERSHIP - XIII, as a general partner of 1001 FOURTH AVENUE ASSOCIATES; and that she signed her name there by like order. _____________________________ Notary Public My Commission expires: _____________ . City of Residence: _________________ . STATE OF NEW YORK) ) ss.: COUNTY OF NEW YORK ) On the 1st day of November, 1993, before me personally came ______________________________, to me known, who, being by me duly sworn, did depose and say that he resides at _______________ _________________________; that he is the _______________________ of SEAFO, INC., the corporation described in and which executed the foregoing instrument; and that he signed his name there by like order. _____________________________ Notary Public My Commission expires: _____________ . City of Residence: _________________ . EXHIBIT A CONTRACTS 1. Agreement for Provision of Security Services dated September 1, 1983, between 1001 Fourth Avenue Associates, as Owner, and Seattle-First National Bank, as Contractor; 2. Vertical Transportation Contract, dated July 1, 1992, between 1001 Fourth Avenue Associates, as Owner, and Schindler Elevator Corporation, as Contractor; 3. Modernization/Repair Contract and all Supplemental Proposals thereto, dated October 6, 1992, between 1001 Fourth Avenue Associates, by JMB Properties Company, as agent, and Schindler Elevator Corporation; 4. Master Agreement, dated May 31, 1991, as amended by the Master Agreement Extension and Amendment Agreement No. 1, dated December 30, 1992, between Turner Construction Company, as Contractor, and JMB Properties Company, as agent for the property owner; 5. Work/Construction Agreement, dated August 20, 1993, between 1001 Fourth Avenue Associates, as Owner, and Auburn Mechanical, Inc., as Contractor; 6. Settlement and Mutual Release of All Claims, dated September 16, 1993, between 1001 Fourth Avenue Associates, by and through JMB Properties Company, its agent, the Municipality of Metropolitan Seattle, Mortrude Floor Company and Tri-State Construction, Inc.; 7. Continuing Service Agreement, dated, August 20, 1993, between 1001 Fourth Avenue Associates by JMB Properties Company, as agent, and P&G Plant Company; and 8. Property Operation and Maintenance Agreement, dated March 23, 1993, between JMB Properties Company, as agent for the property owner, and Urban Engineering Co., as Contractor. 9. Work Construction Agreement, dated April 5, 1993, between 1001 Fourth Avenue Associates, as Owner, and Aluminum and Bronze Fabricators, Inc., as Contractor. 1001 FOURTH AVENUE ASSOCIATES C/O JMB REALTY CORPORATION 900 NORTH MICHIGAN AVENUE SUITE 1900 CHICAGO, ILLINOIS 60611 November 1, 1993 Common Retirement Fund of the State of New York Office of the State Comptroller 270 Broadway New York, NY 10007 Gentlemen: Reference is made to that certain Agreement for the Delivery of a Deed In Lieu of Foreclosure dated as of October 29, 1993 between 1001 Fourth Avenue Associates, as Mortgagor, and Seafo, Inc., as Mortgagee (the "Agreement"). All capitalized terms used herein which are not otherwise defined herein shall have the respective meanings ascribed to them in the Agreement. This letter shall confirm our understanding, that pursuant to Mortgagor's closing requirements under Section 7.2.15 of the Agreement, the undersigned, JMB Realty Corporation ("JMB"), hereby releases to the Common Retirement Fund of the State of New York ("CRF") and hereafter shall have no future claim, right or title to any positive Net Cash Flow in excess of the Approved Working Reserve ("Excess Net Cash Flow"), as such term is defined in the Commitment for Modification of First Deed of Trust Note between CRF and Mortgagor, dated October 5, 1987. Such Excess Net Cash Flow is currently being held by CRF. Very truly yours, 1001 FOURTH AVENUE ASSOCIATES an Illinois general partnership By: Carlyle Real Estate Limited Partnership - XIII, Managing General Partner By: JMB Realty Corporation, Corporate General Partner of Carlyle Real Estate Limited Partnership - XIII By: _____________________________ Julie A. Strocchia Its: Vice President 1001 FOURTH AVENUE ASSOCIATES C/O JMB REALTY CORPORATION 900 NORTH MICHIGAN AVENUE SUITE 1900 CHICAGO, ILLINOIS 60611 November 1, 1993 Common Retirement Fund of the State of New York Office of the State Comptroller 270 Broadway New York, NY 10007 Gentlemen: Reference is made to that certain Agreement for the Delivery of a Deed In Lieu of Foreclosure dated as of October 29, 1993 between 1001 Fourth Avenue Associates, as Mortgagor, and Seafo, Inc., as Mortgagee (the "Agreement"). All capitalized terms used herein which are not otherwise defined herein shall have the respective meanings ascribed to them in the Agreement. This letter shall confirm our understanding, that pursuant to Mortgagor's closing requirements under Section 7.2.6 of the Agreement, the undersigned, JMB Realty Corporation ("JMB"), hereby releases to the Common Retirement Fund of the State of New York ("CRF") and hereafter shall have no future claim, right or title to that certain tax and insurance escrow account relating to the Property (the "Tax and Insurance Escrow Account"). The Tax and Insurance Escrow Account is currently being held by CRF. Very truly yours, 1001 FOURTH AVENUE ASSOCIATES an Illinois general partnership By: Carlyle Real Estate Limited Partnership - XIII, Managing General Partner By: JMB Realty Corporation, Corporate General Partner of Carlyle Real Estate Limited Partnership - XIII By: _____________________________ Julie A. Strocchia Its: Vice President Filed for Record at Request of: Rogers & Wells 200 Park Avenue New York, New York 10166 Attention: Lewis Bart Stone, Esq. QUIT CLAIM DEED IN LIEU OF FORECLOSURE The Grantor, 1001 Fourth Avenue Associates, an Illinois general partnership, for and in consideration of the sum of Ten Dollars ($10.00) and other good and valuable consideration, and in lieu of foreclosure of the below-mentioned Deed of Trust, conveys and quit claims to Seafo, Inc., a Delaware corporation, the following described real estate, situated in the County of King, State of Washington (the "Property"): See Exhibit A attached. This deed is an absolute conveyance of title in effect as well as in form, and is not intended as a mortgage, trust conveyance, or security of any kind. Consideration for this deed consists of full release of the Grantor from all debts and obligations of Grantor as secured by the deed of trust on the Property dated April 26, 1984 and recorded on the same date under Recording No. 8404260342, Records of King County, Washington, as modified by a Modification of Deed of Trust dated October 5, 1987 and recorded November 17,1987 under Recording No. 8711171151, Records of King County, Washington (the "Deed of Trust"). This deed fully satisfies the indebtedness of the Deed of Trust and terminates in all respects the Deed of Trust, the note secured thereby, and all related security documents. DATED this 29th day of October, 1993. 1001 FOURTH AVENUE ASSOCIATES an Illinois general partnership By: Carlyle Real Estate Limited Partnership - XIII, Managing General Partner By: JMB Realty Corporation, Corporate General Partner of Carlyle Real Estate Limited Partnership - XIII By: Authorized Signatory Its: ------------------------- RECORD AND RETURN TO: Rogers & Wells 200 Park Avenue New York, New York 10166 Attn: Lewis Bart Stone, Esq. ASSIGNMENT AND ASSUMPTION OF LEASES AND RENTS This Assignment and Assumption of Leases, made as of this 1st day of November, 1993 between 1001 FOURTH AVENUE ASSOCIATES, an Illinois general partnership ("Assignor") and SEAFO, INC., a Delaware corporation ("Assignee"). WITNESSETH, that Assignor, for and in consideration of the sum of Ten Dollars ($10.00) and other good and valuable consideration, the receipt and sufficiency of which are hereby acknowledged, does hereby ASSIGN, TRANSFER, AND CONVEY unto Assignee, its successors and assigns, all right, title and interest of Assignor in, to and under all existing leases, together with all security deposits, advance rentals and other advance payments payable by tenants thereunder (collectively, the "Leases") demising portions of the improvements located on the real property described in Exhibit "A" attached hereto. TO HAVE AND TO HOLD the Leases, together with all rights and privileges thereunto belonging unto Assignee, its successors and assigns, including, without limitation, all security deposits, any documents or instruments securing the obligations of the tenants thereunder and advance rentals paid for the month of November, 1993 or thereafter and other advance payments made or given thereunder, for and during the remainder of the terms of the Leases, as well as all rents received by Assignor on or after October 23, 1993. Assignee does hereby covenant to and agree with Assignor that Assignee accepts the foregoing assignment and assumes all of the terms, covenants and provisions of the Leases on the part of Assignee thereunder to be performed and arising or accruing on and after the date hereof. This Assignment and Assumption of Leases shall be governed by and construed in accordance with the internal laws of the State of Washington without regard to principles of conflict of law. IN WITNESS WHEREOF, the parties hereto have caused this instrument to be duly executed as of the day and year first above written. ASSIGNOR: 1001 FOURTH AVENUE ASSOCIATES an Illinois general partnership By: Carlyle Real Estate Limited Partnership - XIII, Managing General Partner By: JMB Realty Corporation, Corporate General Partner of Carlyle Real Estate Limited Partnership - XIII By: ____________________________ Julie A. Strocchia Its: Vice President ASSIGNEE: SEAFO, INC. By:________________________________ Its:_______________________________ STATE OF NEW YORK ) ) ss.: COUNTY OF NEW YORK ) On the 1st day of November, 1993, before me personally came JULIE A. STROCCHIA, to me known, who, being by me duly sworn, did depose and say that she resides at 900 North Michigan Avenue, Chicago, Illinois; that she is the Vice President of JMB REALTY CORPORATION, the corporation described in and which executed the foregoing instrument as a general partner of CARLYLE REAL ESTATE LIMITED PARTNERSHIP - XIII, as a general partner of 1001 FOURTH AVENUE ASSOCIATES; and that she signed her name there by like order. ______________________________ Notary Public My Commission expires: ______________. City of Residence: __________________. STATE OF NEW YORK ) ) ss.: COUNTY OF NEW YORK ) On the 1st day of November, 1993, before me personally came _________________, to me known, who, being by me duly sworn, did depose and say that he resides at ____________________________ ___________; that he is the ________________________ of SEAFO, INC., the corporation described in and which executed the foregoing instrument; and that he signed his name there by like order. ______________________________ Notary Public My Commission expires: ______________. City of Residence: __________________. ASSIGNMENT OF INTANGIBLE PROPERTY WITNESSETH, that 1001 FOURTH AVENUE ASSOCIATES, an Illinois general partnership (collectively, "Assignor"), for and in consideration of the sum of Ten Dollars ($10.00) and other good and valuable consideration to it in hand paid by SEAFO, INC., a Delaware corporation ("Assignee"), the receipt and sufficiency of which are hereby acknowledged, has ASSIGNED, TRANSFERRED, SET OVER, DELIVERED AND CONVEYED and by these presents does hereby ASSIGN, TRANSFER, SET OVER, DELIVER AND CONVEY unto Assignee, its successors and assigns all right, title and interest of Assignor in and to all of the following (hereinafter collectively referred to as the "Assigned Property") to the extent that the same apply to that certain real property described in "Exhibit A" attached hereto and the improvements located thereon and subject to the terms and conditions of that certain Agreement for the Delivery of a Deed In Lieu of Foreclosure dated as of October 29th, 1993, between Assignor and Assignee (the "Agreement") (all capitalized terms not otherwise defined herein shall have the meaning as set forth in the Agreement): (1) the certificates of occupancy with respect to the Improvements and, to the extent maintained by or on behalf of Assignor, all other transferable licenses, certificates and permits issued by any governmental or quasi-governmental authority with respect to the Property or the use, maintenance and operations thereof; (2) all architectural, mechanical, engineering and other plans and specifications within Assignor's possession or subject to its control relating to the completed construction or renovation of or other work at the Building Complex and any unexpired warranties, guaranties or sureties in favor of Assignor with respect thereto; (3) all promotional advertising literature and materials, catalogs, booklets and manuals relating to the Property or the use, operation or maintenance thereof; (4) all intangible personal property relating to the ownership, construction, renovation, operation and leasing of the Property, including, without limitation, the good will pertaining thereto; (5) all environmental reports, asbestos reports and files relating to asbestos work within Assignor's possession; (6) all accounting, financial and operating information located at the Property; (7) the Order Granting Summary Judgment Against UCAQ International, Inc., as entered as Case No. 92-2-13158-7, and entitled 1001 Fourth Avenue Associates, a corporation, Plaintiff v. UCAQ International, Inc., a corporation, and Masao Matsumoto, an individual and the marital community thereof, Defendants, in the Superior Court of the State of Washington for King County; (8) the Default Judgment against Masao Matsumoto, as entered as Case No. 92-2-13158-7, in the Superior Court of the State of Washington for King County; (9) the Judgment and Order Directing Issuance of Writ of Restitution, as entered as Case No. 90-2-21313-7, and entitled 1001 Fourth Avenue Associates, an Illinois General Partnership, Plaintiff v. Mirabeau, Inc., a Washington corporation, Defendant, in the Superior Court of the State of Washington in and for the County of King; (10) the First Amended Complaint For Unlawful Detainer, as entered as Case No. 93-2-23702-2, and entitled 1001 Fourth Avenue Associates, an Illinois general partnership, Plaintiff, v. Trans Pacific Stores, Ltd., a corporation, Defendant, in the Superior Court of the State of Washington in and for the County of King; and (11) all transferable or assignable warranties, guaranties, contract rights and miscellaneous rights, if any, with respect to the Property, including any of the property described in items (1) through (10) above. TO HAVE AND TO HOLD the Assigned Property, together with all rights and privileges thereunto belonging unto Assignee, its successors and assigns, forever. This Assignment of Intangible Property shall be governed by and construed in accordance with the internal laws of the State of Washington without regard to principles of conflict of law. EXECUTED AND DELIVERED this 1st day of November, 1993. ASSIGNOR: 1001 FOURTH AVENUE ASSOCIATES an Illinois general partnership By: Carlyle Real Estate Limited Partnership - XIII, Managing General Partner By: JMB Realty Corporation, Corporate General Partner of Carlyle Real Estate Limited Partnership - XIII By: _________________________ Julie A. Strocchia Its: Vice President STATE OF NEW YORK) ) ss.: COUNTY OF NEW YORK) On the 1st day of November, 1993, before me personally came JULIE A. STROCCHIA, to me known, who, being by me duly sworn, did depose and say that she resides at 900 North Michigan Avenue, Chicago, Illinois; that she is the Vice President of JMB REALTY CORPORATION, the corporation described in and which executed the foregoing instrument as a general partner of CARLYLE REAL ESTATE LIMITED PARTNERSHIP - XIII, as a general partner of 1001 FOURTH AVENUE ASSOCIATES; and that she signed her name there by like order. _____________________________ Notary Public My Commission expires: _____________ . City of Residence: _________________ . ASSIGNMENT OF FUTURE TAX OR INSURANCE REFUNDS WITNESSETH, that 1001 FOURTH AVENUE ASSOCIATES, an Illinois general partnership (collectively, "Assignor"), for and in consideration of the sum of Ten Dollars ($10.00) and other good and valuable consideration to it in hand paid by SEAFO, INC., a Delaware corporation ("Assignee"), the receipt and sufficiency of which are hereby acknowledged, has ASSIGNED, TRANSFERRED, SET OVER, DELIVERED AND CONVEYED and by these presents does hereby ASSIGN, TRANSFER, SET OVER, DELIVER AND CONVEY unto Assignee, its successors and assigns all right, title and interest of Assignor in and to all of the following (hereinafter collectively referred to as the "Assigned Property") to the extent that the same apply to that certain real property described in "Exhibit A" attached hereto and the improvements located thereon and subject to the terms and conditions of that certain Agreement for the Delivery of a Deed In Lieu of Foreclosure dated as of October 29, 1993, between Assignor and Assignee (the "Agreement") (all capitalized terms not otherwise defined herein shall have the meaning as set forth in the Agreement): (1) all future refunds from any taxing authority (which refunds Assignor shall hold in trust for the benefit of Assignee); and (2) all future refunds from any insurer with respect to premiums paid for insurance on the Property (which refunds Assignor shall hold in trust for the benefit of Assignee). TO HAVE AND TO HOLD the Assigned Property, together with all rights and privileges thereunto belonging unto Assignee, its successors and assigns, forever. This Assignment of Future Tax or Insurance Refunds shall be governed by and construed in accordance with the internal laws of the State of Washington without regard to principles of conflict of law. EXECUTED AND DELIVERED this 1st day of November, 1993. ASSIGNOR: 1001 FOURTH AVENUE ASSOCIATES an Illinois general partnership By: Carlyle Real Estate Limited Partnership - XIII, Managing General Partner By: JMB Realty Corporation, Corporate General Partner of Carlyle Real Estate Limited Partnership - XIII By: _________________________ Julie A. Strocchia Its: Vice President STATE OF NEW YORK ) ) ss.: COUNTY OF NEW YORK) On the 1st day of November, 1993, before me personally came JULIE A. STROCCHIA, to me known, who, being by me duly sworn, did depose and say that she resides at 900 North Michigan Avenue, Chicago, Illinois; that she is the Vice President of JMB REALTY CORPORATION, the corporation described in and which executed the foregoing instrument as a general partner of CARLYLE REAL ESTATE LIMITED PARTNERSHIP - XIII, as a general partner of 1001 FOURTH AVENUE ASSOCIATES; and that she signed her name there by like order. _____________________________ Notary Public My Commission expires: _____________ . City of Residence: _________________ . AMENDED AND RESTATED CERTIFICATE OF INCORPORATION OF CARLYLE-XIII MANAGERS, INC. WHEREAS, this corporation desires to change its name to Carlyle Investors, Inc. NOW, THEREFORE, the Certificate of Incorporation as filed with the Delaware Secretary of State on March 25, 1993 is hereby amended and restated to read as follows: ARTICLE ONE: The name of this corporation is Carlyle Investors, Inc. ARTICLE TWO: The address of its registered office in the State of Delaware is Corporation Trust Center, 1209 Orange Street, in the City of Wilmington, County of New Castle, 19801. The name of its registered agent at such address is The Corporation Trust Company. ARTICLE THREE: The nature of the business or purpose to be conducted or promoted is: to engage in any lawful act or activity for which corporations may be organized under the General Corporation Law of Delaware. ARTICLE FOUR: The total number of shares of stock which this corporation shall have authority to issue is 1,000 and the par value of each of such shares is One Dollar ($1.00) amounting in the aggregate to One Thousand Dollars ($1,000.00). ARTICLE FIVE: The number of directors constituting the Board of Directors shall be that number as shall be fixed by the by-laws of this Corporation. ARTICLE SIX: The corporation is to have perpetual existence. ARTICLE SEVEN: In furtherance and not in limitation of the powers conferred by statute, the Board of Directors of this corporation is expressly authorized to make, alter or repeal the by-laws of this corporation. ARTICLE EIGHT: Elections of directors need not be by written ballot unless the by-laws of this corporation shall so provide. Meetings of the stockholders may be held within or without the State of Delaware, as the by- laws may provide. The books of this corporation may be kept (subject to any provision contained in the statutes) outside the State of Delaware at such place or places as may be designated from time to time by the Board of Directors or in the by-laws of this corporation. ARTICLE NINE: The corporation reserves the right to amend, alter, change or repeal any provision contained in this Amended and Restated Certificate of Incorporation, in the manner now and hereafter prescribed by statute, and all rights conferred upon stockholders herein are granted subject to this reservation. ARTICLE TEN: To the fullest extent permitted by the General Corporation Law of the State of Delaware as it now exists or may hereafter be amended, no director of this corporation shall be liable to this corporation or its stockholders for monetary damages arising from a breach of fiduciary duty owed to this corporation. ARTICLE ELEVEN: This Amended and Restated Certificate of Incorporation was duly adopted by the stockholders of this corporation pursuant to Section 242 of the General Corporation Law of Delaware on March 29, 1993. This Amended and Restated Certificate of Incorporation was duly adopted by the stockholders of this corporation pursuant to Section 242 of the General Corporation Law of Delaware on April 6, 1993. IN WITNESS WHEREOF, the President has signed, and the Secretary has attested, this Amended and Restated Certificate of Incorporation this 6th day of April, 1993. NEIL G. BLUHM ------------- Neil G. Bluhm President ATTEST: Kevin B. Yates Secretary STATE OF ILLINOIS ) ) ss COUNTY OF COOK ) I, the undersigned, a Notary Public in and for said County, in the State aforesaid, DO HEREBY CERTIFY that Kevin B. Yates, the Secretary of Carlyle-XIII Managers, Inc., acknowledged that the statements set forth in the foregoing instrument are true and correct, and that he signed the foregoing instrument as his free and voluntary act for the uses and purposes therein set forth. Subscribed and sworn to before me this 6th day of April, 1993. Mona Sarnoff Notary Public AMENDED AND RESTATED CERTIFICATE OF INCORPORATION OF CARLYLE-XIV MANAGERS, INC. WHEREAS, this corporation desires to change its name to Carlyle Managers, Inc. NOW, THEREFORE, the Certificate of Incorporation as filed with the Delaware Secretary of State on March 25, 1993 is hereby amended and restated to read as follows: ARTICLE ONE: The name of this corporation is Carlyle Managers, Inc. ARTICLE TWO: The address of its registered office in the State of Delaware is Corporation Trust Center, 1209 Orange Street, in the City of Wilmington, County of New Castle, 19801. The name of its registered agent at such address is The Corporation Trust Company. ARTICLE THREE: The nature of the business or purpose to be conducted or promoted is: to engage in any lawful act or activity for which corporations may be organized under the General Corporation Law of Delaware. ARTICLE FOUR: The total number of shares of stock which this corporation shall have authority to issue is 1,000 and the par value of each of such shares is One Dollar ($1.00) amounting in the aggregate to One Thousand Dollars ($1,000.00). ARTICLE FIVE: The number of directors constituting the Board of Directors shall be that number as shall be fixed by the by-laws of this Corporation. ARTICLE SIX: The corporation is to have perpetual existence. ARTICLE SEVEN: In furtherance and not in limitation of the powers conferred by statute, the Board of Directors of this corporation is expressly authorized to make, alter or repeal the by-laws of this corporation. ARTICLE EIGHT: Elections of directors need not be by written ballot unless the by-laws of this corporation shall so provide. Meetings of the stockholders may be held within or without the State of Delaware, as the by- laws may provide. The books of this corporation may be kept (subject to any provision contained in the statutes) outside the State of Delaware at such place or places as may be designated from time to time by the Board of Directors or in the by-laws of this corporation. ARTICLE NINE: The corporation reserves the right to amend, alter, change or repeal any provision contained in this Amended and Restated Certificate of Incorporation, in the manner now and hereafter prescribed by statute, and all rights conferred upon stockholders herein are granted subject to this reservation. ARTICLE TEN: To the fullest extent permitted by the General Corporation Law of the State of Delaware as it now exists or may hereafter be amended, no director of this corporation shall be liable to this corporation or its stockholders for monetary damages arising from a breach of fiduciary duty owed to this corporation. This Amended and Restated Certificate of Incorporation was duly adopted by the stockholders of this corporation pursuant to Section 242 of the General Corporation Law of Delaware on April 6, 1993. IN WITNESS WHEREOF, the President has signed, and the Secretary has attested, this Amended and Restated Certificate of Incorporation this 6th day of April, 1993. NEIL G. BLUHM ------------- Neil G. Bluhm President ATTEST: Kevin B. Yates Secretary STATE OF ILLINOIS ) ) ss COUNTY OF COOK ) I, the undersigned, a Notary Public in and for said County, in the State aforesaid, DO HEREBY CERTIFY that Kevin B. Yates, the Secretary of Carlyle-XIV Managers, Inc., acknowledged that the statements set forth in the foregoing instrument are true and correct, and that he signed the foregoing instrument as his free and voluntary act for the uses and purposes therein set forth. Subscribed and sworn to before me this 6th day of April, 1993. Mona Sarnoff Notary Public DEMAND NOTE $600,000.00 March 25, 1993 FOR VALUE RECEIVED, the undersigned, Carlyle Real Estate Limited Partnership-XIII, an Illinois limited partnership (hereinafter referred to as "Payor"), hereby promises to pay Carlyle Investors, Inc., a Delaware corporation (hereinafter referred to as "Payee"), on demand the principal sum of $600,000.00 (hereinafter referred to as the "Principal Amount"). The Principal Amount shall bear interest at the Alternate Federal Short-Term rate (the "Rate") as of the date hereof, which rate shall change to the Rate then in effect as of every six months from the date hereof (the "Compounding Date"); all interest shall be compounded as of every Compounding Date. Payor may at any time elect to prepay all or any portion of the Principal Amount, together with any accrued but unpaid interest thereon, without premium or penalty. IN WITNESS WHEREOF, Payor has executed this Demand Note this 25th day of March, 1993. CARLYLE REAL ESTATE LIMITED PARTNERSHIP-XIII By: JMB Realty Corporation a Delaware corporation Corporate General Partner By: NEIL G. BLUHM -------------- Neil G. Bluhm President DEMAND NOTE $600,000.00 March 25, 1993 FOR VALUE RECEIVED, the undersigned, Carlyle Real Estate Limited Partnership-XIII, an Illinois limited partnership (hereinafter referred to as "Payor"), hereby promises to pay Carlyle Managers, Inc., a Delaware corporation (hereinafter referred to as "Payee"), on demand the principal sum of $600,000.00 (hereinafter referred to as the "Principal Amount"). The Principal Amount shall bear interest at the Alternate Federal Short-Term rate (the "Rate") as of the date hereof, which rate shall change to the Rate then in effect as of every six months from the date hereof (the "Compounding Date"); all interest shall be compounded as of every Compounding Date. Payor may at any time elect to prepay all or any portion of the Principal Amount, together with any accrued but unpaid interest thereon, without premium or penalty. IN WITNESS WHEREOF, Payor has executed this Demand Note this 25th day of March, 1993. CARLYLE REAL ESTATE LIMITED PARTNERSHIP-XIII By: JMB Realty Corporation a Delaware corporation Corporate General Partner By: Neil G. Bluhm President SECOND AMENDED AND RESTATED ARTICLES OF PARTNERSHIP OF JMB/NYC OFFICE BUILDING ASSOCIATES These Second Amended and Restated Articles of Partnership made and entered into as of March 30, 1993, by and between Carlyle-XIV Managers, Inc., an Delaware corporation (hereinafter referred to as "General Partner"), and Carlyle-XIII Associates, L.P., an Delaware limited partnership, Carlyle-XIV Associates, L.P., a Delaware limited partnership, and Property Partners, L.P., a Delaware limited partnership, as the limited partners (hereinafter collectively referred to as the "Limited Partners"). W I T N E S S E T H THAT WHEREAS, this partnership (hereinafter referred to as the "Partnership") was heretofore formed pursuant to the Uniform Partnership Act of the State of Illinois by Carlyle Real Estate Limited Partnership-XIII, an Illinois limited partnership, Carlyle Real Estate Limited Partnership-XIV, an Illinois limited partnership, and JMB/NYC Associates, an Illinois general partnership (hereinafter collectively referred to as the "Original Partners"); and THAT WHEREAS, the Original Partners have each individually assigned their respective partnership interests to the Limited Partners pursuant to that certain Amendment No. 1 to the Amended and Restated Agreement of Partnership of the Partnership (the "Agreement"); and THAT WHEREAS, the parties hereto desire to continue the partnership as a limited partnership pursuant to the Revised Uniform Limited Partnership Act as in effect in the State of Illinois, as amended (the "Act"), for the purposes and on the terms and conditions hereinafter set forth; and THAT WHEREAS, the General Partner desires to: (i) be admitted into the Partnership as a general partner, (ii) perform all of the duties and responsibilities of a general partner under the Act, and (iii) acquire a general partnership interest in the Partnership, and the Limited Partners, by their execution hereof, desire to evidence their consent to said admission and to the continuance of the Partnership as a limited partnership; and THAT WHEREAS, the parties hereto desire to amend and restate the partnership so that it appears in its entirety as follows. NOW THEREFORE, the undersigned hereby continue the partnership as a limited partnership under the provisions of the Act, except as hereinafter provided, for the purposes and on the terms and conditions as hereinafter set forth, and do hereby agree: 1. Name of Partnership. The name of the Partnership shall be "JMB/NYC Office Building Associates, L.P." 2. Character of the Partnership's Business. The character of the business of the Partnership will be to acquire, hold, and otherwise use for profit an interest in each of the following general partnerships: 237 Park Avenue Associates, 1290 Associates, 2 Broadway Land Company and 2 Broadway Associates which partnerships own the land (and improvements thereon) more particularly described on Exhibit A attached hereto, and to engage in any and all activities related or incidental thereto. Whenever the term "Property" appears in these Articles such term shall mean any property, real or personal, tangible or intangible, at any time owned by the Partnership, including the Partnership's respective interests in the aforementioned general partnerships and any property at any time owned by a partnership or joint venture in which the Partnership is a partner. 3. Location of the Principal Place of Business. The location of the principal place of business of the Partnership shall be 900 North Michigan Avenue, Chicago, Illinois 60611 or such other location as shall be designated by the Partners. 4. Names and Places of Residence of Partners. The names of the Partners of the Partnership and their respective addresses are as set forth after each respective name as follows: General Partner Residence Carlyle-XIV Managers, Inc. 900 North Michigan Chicago, IL 60611 Limited Partners Residence Carlyle-XIII Associates, L.P. 900 North Michigan Chicago, IL 60611 Carlyle-XIV Associates, L.P. 900 North Michigan Chicago, IL 60611 Property Partners, L.P. 900 North Michigan Chicago, IL 60611 As used herein, the term "Partner" shall refer to any of the General Partner or Limited Partners and the term "Partners" shall refer to the General Partner and the Limited Partners collectively and shall include their respective successors and assigns, as the case may be. 5. Term of Partnership. The term for which the Partnership shall exist shall be until December 31, 2034 unless sooner terminated as hereinafter provided. 6. Contributions of the Members of the Partnership. A. Contributions. The Original Partners have contributed the sums set forth opposite each Partner's name on the attached Exhibit B. Each of the Limited Partners have contributed hereto the partnership interests in the Partnership assigned to them by each of the Original Partners, respectively. In the event that any Partner makes an additional contributions to the Partnership or receives a return of all or part of its contributions to the Partnership, Exhibit B shall be promptly and appropriately amended to reflect such additional or returned contribution. B. Withdrawals of Capital. Except as otherwise herein provided, no Partner shall be entitled to withdraw capital or to receive distributions of or against capital without the prior written consent of, and upon the terms and conditions specified by, the General Partner. C. Capital Accounts. The Partnership shall maintain for each of the Partners a Capital Account, which shall be the aggregate amount of the contributions to the Partnership made by such Partner, as set forth in Exhibit B, reduced by the aggregate amount of any losses allocated, and any distributions of cash or the fair market value of other assets of the Partnership made, to such Partner and increased by the aggregate amount of any profits allocated to such Partner. D. Loans. Except as provided in Section 8D hereof, all advances or payments to the Partnership by any Partner shall be deemed to be loans by such Partner to the Partnership, and the Partner making the same shall be entitled to interest thereon at such rates per annum as the General Partner may determine, and the same, together with interest as aforesaid, shall be repaid before any distribution shall be made hereunder to the other Partners. No such loan to the Partnership shall be made without the prior written consent of the General Partner and, unless all of the Partners otherwise agree, shall be required to be made by all of the Partners in proportion to their respective Partnership Shares (as hereinafter defined). 7. Partnership Shares. A. As used herein, "profits and losses" include, without limitation, each item of Partnership income, gain, loss and deduction as determined for Federal income tax purposes, and "Partnership Share" means the percentage for each Patner as set forth in Exhibit B. All net profits or losses from the operations of the Partnership for a fiscal year or part thereof shall be allocated to the Partners based upon their respective Partnership Shares. Any credits of the Partnership for a fiscal year shall be allocated in the same manner as are profits of the Partnership pursuant to this Section 7A (without regard to Section 7B), except that any investment tax credit shall be allocated only among those Partners who were partners (for Federal income tax purposes) on the date the property with respect to which such credit is earned was placed in service. B. There shall be allocated to each Partner (i) the amount of any profits attributable to interest, "points", financing fees and other amounts paid by such Partner to the Partnership with respect to loans made by the Partnership to such Partner and (ii) the amount of any losses attributable to interest, "points", financing fees and other amounts paid by the Partnership to a third party lender with respect to borrowings incurred by the Partnership to make loans by the Partnership to such Partner. C. (i) All net profits or losses from the sale or other disposition of all or any substantial portion of the Property shall be allocated to the Partners in accordance with their respective Partnership Shares on the date on which the Partnership recognized such profits or losses for Federal income tax purposes. Notwithstanding allocations in the first sentence of this Section 7C(i) if, at any time profit or loss, as the case may be, is realized by the Partnership on the sale or other disposition of all or any substantial portion of the Property, the Capital Account balances of the Partners are not in the ratio of their respective Partnership Shares (the "Equalization Ratio"), then gain shall be allocated to those Partners whose Capital Account balances are less than they would be if they were in the Equalization Ratio (or loss shall be allocated to those Partners whose Capital Account balances are greater than they would be if they were in the Equalization Ratio), in either case up to and in proportion to the amount necessary to cause the Capital Account balances of the Partners to be in the Equalization Ratio and then in accordance with the first sentence in this Section 7C(i). Notwithstanding any adjustment of the allocation of profits or losses provided in this Agreement by any judicial body or governmental agency, the allocations of profits of losses provided in this Agreement shall control for purposes of this Agreement (or any amendment hereto pursuant to Section 12B), including without limitation, the determination of the Partners' Capital Accounts. (ii) The portion of any gain allocated under Section 7C(i) above that represents ordinary income attributable to "Unrealized Receivables" and "Substantially Appreciated Inventory Items", as such terms are defined in Section 751(c) and (d), respectively, of the Internal Revenue Code of 1954, as amended (the "Code"), shall be allocated among the Partners in the proportions in which depreciation deductions on the Partnership Property sold, or tax benefits attributable to or giving rise to such Unrealized Receivables or Substantially Appreciated Inventory Items, were originally allocated to their Partnership interests. No Partner shall relinquish such Partner's share of "Unrealized Receivables" (as such term is defined in Section 751(c) of the Code) attributable to depreciation recapture in the case of a distribution or constructive distribution of property arising in connection with admission to the Partnership of another person as Person. D. Each distribution to the Partners of cash or other assets of the Partnership made prior to the dissolution of the Partnership, including, but not limited to, each distribution of net proceeds received by the Partnership from the sale or refinancing of all or any substantial portion of the Property, shall be made to the Partners in accordance with their respective Partnership Shares owned on the date of such distribution; provided, however, that if, at the time of any such distribution, the Capital Account balances of the Partners are not in the Equalization Ratio, then the proceeds of any such distribution shall be distributed first to the Partners having Capital Account balances greater than they would be if the Capital Account balances of all Partners were in the Equalization Ratio, up to and in proportion to the amount necessary to cause the Capital Account balances of all Partners to be in the Equalization Ratio, and then in accordance with the respective Partnership Shares of the Partners on the date of such distribution. Each distribution of cash or other assets of the Partnership made after dissolution of the Partnership shall be made in accordance with Section 11C. Distributions to the Partners will be made in such amounts and at such times as shall be determined by the General Partner. E. The Partnership Shares of each of the Partners are as follows: 1% to the General Partner, 24.75% to Carlyle-XIII Associates, L.P., 49.5% to Carlyle-XIV Associates, L.P., and 24.75% to Property Partners, L.P. 8. Powers, Rights and Duties of the Partners. A. Except as otherwise provided herein, the General Partner alone shall have the full, exclusive and complete power, authority and responsibility to manage and control the affairs and funds of the Partnership in the ordinary course of its activities for the purposes herein stated, including the power to take (or omit) all or any such action as he may from time to time deem appropriate or desirable in connection therewith. In furtherance of the powers granted to the General Partner herein, and in no way in limitation thereof, the General Partner, for and on behalf of the Partnership, shall have full, exclusive and complete power and responsibility to enter into agreements of whatever nature necessary to effect the acquisition of the Partnership's assets, and such amendments and restatements thereof and supplements and modifications thereto as it amy consider to be in the best interests of the Partnership to perform all duties and obligations, and exercise all rights, as provided under such agreements in such manner as it may determine; to act on behalf of the Partnership in dealing with third parties and to manage, operate and undertake the funds and affairs of the Partnership for the purposes of conducting its business and of making, holding, conducting and disposing of assets and investments. The president or any vice president of the General Partner may act for and in the name of the Partnership in the exercise by the Partnership of any of its rights and powers hereunder. In dealing with the president or any vice president of the General Partner, no person shall be required to inquire into the authority of such individual acting on behalf of the Partnership to bind the Partnership. Persons dealing with the Partnership are entitled to rely conclusively on the power and authority of the president or any vice president of the General Partner as set forth in this Agreement. B. Notwithstanding any provision of this Agreement to the contrary, in the event that the Partners cannot reach unanimous agreement concerning a decision regarding the sale of all or any substantial portion of the Property (other than any property owned by a partnership or joint venture, directly or indirectly through another partnership or joint venture, in which the Partnership is a partner), the Partner or Partners desiring a sale thereof (the "Notifying Party") shall give notice to the other Partner or Partners (the "Notified Party") of the proposed transaction and shall deliver to the Notified Party with such notice a copy of the bona fide written offer from the prospective purchaser setting forth the name of the prospective purchaser and all of the material terms and conditions on which it is intended that the Property, or specified portion thereof, be sold. The Notified Party shall then have 30 days after receiving such notice to elect (by giving notice of the same to the Notifying Party) either (a) to purchase the specified Property (other than any property owned by a partnership or joint venture, in which the Partnership is a partner) for the purchase price and on the terms and conditions as set forth in such offer or (b) to acquire a proportionate share of the Notifying Party's interest in the Partnership for an amount equal to the amount which the Notifying Party would have received as its share of the net proceeds from the sale of the specified Property. In the event that the Notified Party makes either such election, the Partners shall close on the transaction as elected by the Notified Party within a period equal to the later of 90 days after the making of such election or the closing date specified in such written offer, with the time, place and date (within such period) as specified by the Notified Party by notice to the Notifying Party within 30 days after the making of such election. If the Notified Party does not make either election, then the Notifying Party may conclude a sale of such specified Property, without the agreement of the Notified Party, at any time or times within 180 days after the giving of notice of the proposed sale thereof, for a purchase price and on terms which are at least as favorable to the Partnership as those contained in the written offer and only to the purchaser identified in such written offer or to an "Affiliate" (as hereinafter defined) of such purchaser, if the Affiliate is specified in such written offer or such notice, but if a sale is not consummated within such period, then the right of the Notified Party to receive notice and to purchase or to acquire as aforesaid will continue as to any future proposed sale. In the event that the Notified Party includes more than one Partner, the election made by the Notified Party must be consented to by each such Partner and the purchase from the Notifying Party shall be made by the Partners comprising the Notified Partner based upon their respective Partnership Shares at the time of such election; provided, however, that if one such Partner fails or refuses to consent to either election, the other such Partner may, at its option, make the election of its choice and undertake the entire purchase or acquisition from the Notifying Party. C. Neither the General Partner nor any of its Affiliates shall be required to manage the Partnership as its sole and exclusive function and it may have other business interests and may engage in other activities in addition to those relating to the Partnership, including the making or management of other investments. Without limitation on the generality of the foregoing, each Partner recognizes that each Partner was formed for the purpose of investing in, operating, transferring, leasing and otherwise using real property and interests therein for profit and engaging in any and all activities related or incidental thereto and that each Partner will or may make other investments consistent with such purpose. Neither the Partnership nor any Partner shall have any right by virtue of this Agreement or the Partnership relationship created hereby in or to such other ventures or activities or to the income or proceeds derived therefrom, and the pursuit of such other ventures or activities by each Partner or any of their Affiliates, even if competitive with the business of the Partnership, is hereby consented to by all Partners and shall not be deemed wrongful or improper. Except as otherwise permitted in this Agreement or in any agreement among the Partners, no Partner or any Affiliate of a Partner shall be obligated to present any particular investment opportunity to the Partnership even if such opportunity is of a character which, if presented to the Partnership, could be taken by the Partnership, and each Partner or any Affiliate of a Partner shall have the right to take for its own account, or to recommend to others, any such particular investment opportunity. D. "Affiliate(s)" of a person means (i) any officer, director, employee, shareholder, partner or relative within the third degree of kindred of such person: (ii) any corporation, partnership, trust or other entity controlling, controlled by or under common control with such person or any such relative of such person; and (iii) any officer, director, trustee, general partner or employee of any entity described in (ii) above. Affiliates of a Partner may receive commissions when the Partnership buys or sells the Property or any portion thereof and may be employed to provide property management for the Partnership or any of the Property, but no commissions or compensation payable to such Affiliate for the same may exceed the normal and competitive rates for similar services in the locality where provided. The Partnership may borrow funds for the purpose of lending such funds to all or any of its Partners; provided, however, that the cost of such funds charged to the Partnership (including financing fees, "points" and interest charged with respect to such funds) by a third party shall not exceed the amount charged by the Partnership to such Partner or Partners for the use of such funds. The Partnership may enter into agreements with Affiliates of a Partner to provide insurance brokerage or similar services to the Partnership or any of the Property; provided that any such services by Affiliates shall be at rates at least as favorable to the Partnership as those available from unaffiliated parties. The validity of any transaction, agreement or payment involving the Partnership and any Affiliate of a Partner shall not be affected by reason of the relationship between the Partner and such Affiliate or the approval of said transaction, agreement or payment by officers, directors or partners of such Affiliate all or some of whom are also Affiliates of a Partner or are officers, directors or partners or are otherwise interested in or related to such Partner or its Affiliates. E. No Partner nor any Affiliate of any Partner nor any officer, director, shareholder, employee or partner of any such Affiliate shall be liable, responsible or accountable in damages or otherwise to the Partnership or to any other Partner for any action taken or failure to act on behalf of the Partnership within the scope of the authority conferred on such Partner or such Affiliate or such other person by this Agreement or by law unless such action or omission was performed or omitted fraudulently or in bad faith or constituted wanton and willful misconduct. F. The Partnership shall indemnify and hold harmless each Partner, any Affiliate of any Partner and any officer, director, shareholder, employee or partner of any such Affiliate (the "Indemnified Parties") from and against any loss, expense, damage or injury suffered or sustained by any Indemnified Party by reason of any acts, omissions or alleged acts or omissions arising out of its activities on behalf of the Partnership or in furtherance of the interest of the Partnership, including, but not limited to, any judgment, award, settlement, reasonable attorneys' fees and other costs and expenses incurred in connection with the defense of any actual or threatened action, proceeding or claim; provided that the acts or omissions or alleged acts or omissions upon which such actual or threatened action, proceeding or claim are based were performed or omitted in good faith and were not performed or omitted fraudulently or in bad faith or as a result of wanton and willful misconduct. G. The Limited Partners shall not participate in the management or control of the Partnership's business, nor shall they transact any business for the Partnership, nor shall they have the power to act for or bind the Partnership, said powers being vested solely and exclusively in the General Partner as provided herein (and except as provided herein). The Limited Partners shall not have any personal liability whatever, whether to the Partnership, to any Partner or to the creditors of the Partnership, for the debts of the Partnership or any of its losses once it has paid to the Partnership the amount of its capital contribution set forth in Exhibit B. The partnership interest of the Limited Partners in the Partnership shall be fully paid and non-assessable. H. The General Partner may in its sole discretion, make or seek to revoke the election referred to in Section 745 of the Internal Revenue Code of 1986, as amended, (herein the "Code") or any similar provision exacted in lieu thereof. Each of the Partners will upon request supply the information necessary to properly give effect to any such election. I. The General Partner shall, at the Partnership's expense and within a reasonable time after the close of each fiscal year, cause each Partner to be furnished with such statements of the Partnership's assets and liabilities as of the close of such year (if any), such profit and loss statement for such year (if any), such statement of the capital and profit account of each Partner (if any), and such other reports (if any), all as the General Partner may deem appropriate. J. The General Partner shall, at the Partnership's expense, cause the Partnership's Federal and state income and other tax returns to be prepared and filed and shall furnish copies to each Partner of any information on such returns needed for the preparation of each Partner's own tax returns. 9. Books and Records of the Partnership; Fiscal Year. The General Partner shall keep and maintain the books and records of the Partnership at the principal place of business of the Partnership. The fiscal year of the Partnership shall end on the 31st day of December in each year. The books of the Partnership shall be kept on the cash or accrual basis, and the Partnership shall be on the cash or accrual basis for tax purposes, as determined by the General Partner. The books and records of the Partnership shall be audited at such times and by such accountants as shall be determined from time to time by the General Partner. The funds of the Partnership shall be deposited in such bank accounts or invested in such interest-bearing or non-interest-bearing investments as shall be determined by the General Partner. 10. Transfer of Partnership Interest. A. No Partner may sell, assign, transfer, encumber or hypothecate the whole or any part of its Partnership interest (including, but not limited to, its interest in the capital or profits of the Partnership) without prior written consent of the General Partner. B. Any party or person admitted to the Partnership as a substituted Partner shall be subject to and bound by all of the provisions of this Agreement as if originally a party to this Agreement and as a condition to such admission shall be required to execute a copy of this Agreement as amended to the date of such admission. C. A Partner shall have no liability hereunder (including, but not limited to, any liability as a surety but excluding the repayment of any outstanding principal and interest on loans made by the Partnership to such Partner) for any obligations accruing under or in connection with the Partnership and relating to events occurring after such Partner shall have sold, assigned or transferred its entire Partnership interest. 11. Dissolution of the Partnership. A. No act, thing, occurrence, event or circumstances shall cause or result in the dissolution of the Partnership except the matters specified in subsection B below. B. The happening of any one of the following events shall work a dissolution of the Partnership: (1) The bankruptcy, resignation, legal incapacity, dissolution, termination, or expulsion of the General Partner; provided, however, that in such event the remaining Partners shall have the right to elect to continue the Partnership's business by depositing at the office of the Partnership a writing evidencing such an election. No other act shall be required to effect such continuation; (2) The sale of all or substantially all of the assets of the Partnership; (3) The unanimous agreement in writing by all of the Partners to dissolve the Partnership; or (4) The termination of the term of the Partnership pursuant to Section 5 hereof. Without limitation on the other provisions hereof, the admission of a new Partner shall not work a dissolution of the Partnership. Except as otherwise provided in this Agreement, each Partner agrees that, without the consent of the General Partner, a Partner may not withdraw from or cause a voluntary dissolution of the Partnership. C. Upon the occurrence of any of the events specified in subsection B above causing a dissolution of the Partnership and except as otherwise provided in subsection B above, the remaining Partner or Partners shall commence to wind up the affairs of the Partnership and to liquidate its investments (and in this connection shall have full right and unlimited discretion to determine in good faith the time, manner and terms of any sale or sales of Partnership Property). The Partner or Partners obligated to wind up the affairs of the Partnership as aforesaid shall herein be called the "Winding-Up Party". The Partners and their legal representatives, successors and assignees shall continue to share in profits and losses during the period of liquidation in the same manner and proportion as immediately before the dissolution. Following the payment of all debts and liabilities of the Partnership and all expenses of liquidation and subject to the right of the Winding-Up Party to set up such cash reserves as, and for so long as, it may deem reasonably necessary, the proceeds of the liquidation and any other funds of the Partnership shall be distributed to the Partners (after deducting from the distributive share of a Partner any sum such Partner owes the Partnership) in accordance with Section 7 hereof. No Partner shall have any right to demand or receive property other than cash upon dissolution or termination of the Partnership. Upon the completion of the liquidation of the Partnership and of the distribution of all Partnership funds, the Partnership shall terminate and the Winding-Up Party shall have the authority to execute any and all documents required in its judgment to effectuate the dissolution and termination of the Partnership. Each Partners shall look solely to the assets of the Partnership for all distributions with respect to the Partnership and its capital contributions thereto and share of profits or losses therefrom, and shall have no recourse therefor against any Partner; provided that nothing herein contained shall relieve any Partner of such Partner's obligation to pay any liability or indebtedness owing to the Partnership by such Partner. 12. Notices; Amendment. A. Any notice which a Partner is required or may desire to give any other Partner shall be in writing, and may be given by personal delivery or by mailing the same by United States registered or certified mail, return receipt required, to the Partner to whom such notice is directed at the address of such Partner as hereinabove set forth, subject to the right of a Partner to designate a different address for itself by notice similarly given. Any notice so given by United States mail shall be deemed to have been given on the second day after the same is deposited in the United States mail as registered or certified mail, addressed as above provided, with postage thereon fully prepaid. Any such notice not given by registered or certified mail as aforesaid shall be deemed to be given upon receipt of the same by the party to whom the same is to be given. B. This Agreement may be amended by written agreement of amendment executed by all the Partners, but not otherwise. 13. New General Partner. All of the Partners may agree in writing from time to time to admit to the Partnership one or more new General Partners. The General Partner may, on behalf of all Partners, cause Exhibit B hereto and the Partnership's Certificate of Limited Partnership to be appropriately amended and cause the same to be recorded in the event of each such appointment. No such addition or substitution of a new General Partner shall work a dissolution of the Partnership or otherwise affect the continuity of the Partnership. 14. Miscellaneous. Each Partner hereby irrevocably waives any and all rights that it may have to maintain any action for partition of any of the Partnership Property. This Agreement constitutes the entire agreement between the parties. This Agreement supersedes any prior agreement or understanding between the parties. This Agreement and the rights of the parties hereunder shall be governed by and interpreted in accordance with the laws of the State of Illinois. Except as herein otherwise specifically provided, this Agreement shall be binding upon and inure to the benefit of the parties and their legal representatives, successors and assignees. Captions contained in the Agreement in no way define, limit or extend the scope or intent of this Agreement. If any provision of this Agreement, or the application of such provision to any person or circumstance shall be held invalid, the remainder of this Agreement, or the application of such provision to other persons or circumstances, shall not be affected thereby. This Agreement may be executed in several counterparts, each of which shall be deemed an original but all of which shall constitute one and the same instrument. The opinion of the independent certified public accountants retained by the Partnership from time to time shall be final and binding with respect to all computations and determinations required to be made under Section 7 hereof (including computations and determinations in connection with any distribution following or in connection with dissolution of the Partnership). If the Partnership or any Partner obtains a judgment against any other party by reason of breach of this Agreement or failure to comply with the provisions hereof, a reasonable attorneys' fee as fixed by the court shall be included in such judgment. Any Partner shall be entitled to maintain, on its own behalf or on behalf of the Partnership, any action or proceeding against any other Partner or the Partnership (including, without limitation, any action for damages, specific performance or declaratory relief) for or by reason of breach by such party of this Agreement, notwithstanding the fact that any or all of the parties to such proceeding may then be a partner in the Partnership, and without dissolving the Partnership as a partnership. No remedy conferred upon the Partnership or any partner in this Agreement is intended to be exclusive of any other remedy herein or by law provided or permitted, but each shall be cumulative and shall be in addition to every other remedy given hereunder or now or hereafter existing at law or in equity or by stature (subject, however, to the limitations expressly herein set forth). No waiver by a Partner or the Partnership of any breach of this Agreement shall be deemed to be a waiver of any other breach of any kind or nature and no acceptance of payment or performance by a Partner of the Partnership after any such breach shall be deemed to be a waiver of any breach of this Agreement whether or not such Partner or the Partnership knows of such breach at the time it accepts such payment or performance. No failure or delay on the part of a Partner or the Partnership to exercise any right it may have shall prevent the exercise thereof by such Partner or the Partnership at any time such other Partner may continue to be so in default, and no such failure or delay shall operate as a waiver of any default. Power of Attorney The undersigned Partners of JMB/NYC Office Building Associates, L.P., a limited partnership pursuant to the laws of the State of Illinois, hereby jointly and severally irrevocably constitute and appoint the General Partner with full power of substitution, their true and lawful attorney-in-fact, in their name, place and stead to make, execute, sign, acknowledge, record and file, on behalf of them and on behalf of the Partnership the following: (i) A Certificate of Limited Partnership and any other certificates or instruments which may be required to be filed by the Partnership or the Partners under the laws of the State of Illinois and any other jurisdiction whose laws may be applicable; (ii) Such instruments or documents as may be deemed necessary or desirable by the General Partner in connection with the termination of the Partnership's business; (iii) Any and all amendments of the instruments described in clauses (i) and (ii) above, provided such amendments either are required by law to be filed or are consistent with the Agreement of Limited Partnership of the Partnership as it may exist from time to time, or have been authorized by the particular Partner or Partners; and (iv) Any amendment of this Agreement authorized to be made by the General Partner under this Agreement. The foregoing grant of authority: (i) Is a Special Power of Attorney coupled with an interest, is irrevocable and shall survive the death or incapacity of the Partner granting the power; (ii) May be exercised by the General Partner on behalf of each Partner by a facsimile signature or by listing all of the Partners executing any instrument with a single signature as attorney-in-fact for all of them; and (iii) Shall survive the withdrawal, dissolution, legal incapacity, bankruptcy or resignation of a Partner from the Partnership or the delivery of an assignment by a Partner of the whole or any portion of his interest in the Partnership. IN WITNESS WHEREOF, the undersigned have executed these Second Amended and Restated Articles of Limited Partnership of JMB/NYC Office Building Associates, L.P. as of the day and year first above written. General Partner Limited Partners CARLYLE-XIV MANAGERS, INC., CARLYLE-XIII ASSOCIATES, L.P., a Delaware corporation a Delaware limited partnership NEIL G. BLUHM By: CARLYLE INVESTORS, INC., By: ------------- a Delaware corporation, Neil G. Bluhm Corporate General Partner President By: NEIL G. BLUHM -------------- Neil G. Bluhm President CARLYLE-XIV ASSOCIATES, L.P., a Delaware limited partnership By: CARLYLE INVESTORS, INC., a Delaware corporation, Corporate General Partner By: NEIL G. BLUHM ------------- Neil G. Bluhm President PROPERTY PARTNERS, L.P., a Delaware limited partnership By: CARLYLE INVESTORS, INC., a Delaware corporation, General Partner By: NEIL G. BLUHM ------------- Neil G. Bluhm President EXHIBIT A 1. An approximate 1-1/2 acre site bounded by the Helmsley Building located on Park Avenue on the west, East 46th Street on the north, Lexington Avenue on the east and East 45th Street on the south in the Grand Central District of Midtown Manhattan, New York, New York and known as 237 Park Avenue. 2. An approximate 2.1 acre site bounded by the Avenue of the Americas on the west, West 52nd Street on the north and West 51st Street on the south in the Rockefeller Center District of Midtown Manhattan, New York, New York and known as 1290 Avenue of the Americas. 3. A leasehold estate in an approximately 1.7 acre site bounded by Broadway on the west, Beaver and Marketfield Streets on the north, Broad and New Streets on the east and Stone Street on the south in the Financial District of Downtown Manhattan, New York, New York and known as 2 Broadway. 4. The lessor's estate in the approximately 1.7 acre site described in 3 above. EXHIBIT B AMOUNT OF AGREED PARTNERSHIP CAPITAL CONTRIBUTION SHARE GENERAL PARTNER Carlyle-XIV Managers, Inc. $ 100 1% LIMITED PARTNERS Carlyle-XIII Associates, L.P. $42,014,983 24.75% Carlyle-XIV Associates, L.P. $84,029,965 49.5% Property Partners, L.P. $42,014,983 24.75% SETTLEMENT AGREEMENT This Agreement (this "Agreement") made and entered into this 21st day of April, 1993 by and between Gables Corporate Plaza Associates, a Florida general partnership consisting of Carlyle Real Estate Limited Partnership-XIII, an Illinois limited partnership ("Carlyle"), and Gables Corporate Plaza, Ltd., a Florida limited partnership, for and on behalf of itself, its successors and assigns, (hereinafter sometimes collectively referred to as "Gables Associates" or "Borrower"), Gables Corporate Plaza, Ltd., a Florida limited partnership ("Gables Limited'') and Aetna Life Insurance Company, a Connecticut corporation, for and on behalf of itself and its successors and assigns (hereinafter referred to as "Aetna"). W I T N E S S E T H: WHEREAS, Southeast First National Bank of Miami, a national banking association ("Southeast") extended a loan to Gables Corporate Plaza, a Florida general partnership ("GCP") in the amount of Twelve Million Dollars ($12,000,000.00), evidenced by a Promissory note dated July 7, 1981 (the "First Note"); WHEREAS, on July 7, 1981, GCP executed and delivered to Southeast a mortgage (the "First Mortgage") securing payment of the First Note to Southeast. The First Mortgage was recorded in Official Records 11151, Page 40 of the Public Records of Dade County, Florida; WHEREAS, to further secure the payment of the First Note, GCP executed and delivered to Southeast that certain Conditional Assiqnment of Rents and Leases (the "First Rents Assignment") assiqning to Southeast any right, title and interest of GCP in, to and under all leases affecting the Property (as hereinafter defined) and granting the right to receive and collect all of the rents, income and profits as they become due from the Property and under any and all leases of all or any part of the Property, as more particularly set forth in the First Rents Assignment, which is recorded in Official Records Book 11151, Page 45, of the Public Records of Dade County, Florida; WHEREAS, Gables Corporate Plaza, Ltd., a Florida limited partnership ("Gables Limited") acquired title to the Property by virtue of that certain Quit Claim Deed executed and delivered by GCP in favor of Gables Limited dated March 9, 1982 and recorded March 31, 1982 in Official Records Book 11396, Page 617 of the Public Records of Dade County, Florida; WHEREAS, in connection with the acquisition of the Property by Gables Limited, GCP and Gables Limited executed and Southeast approved that certain Assumption and Assignment Acreement dated as of March 9, 1982, and recorded in Official Records Book 11411, Page 1335 of the Public Records of Dade County, Florida, whereby among other things Gables Limited assumed all of the obligations set forth in the loan documents originally executed by GCP; WHEREAS, on Auqust 9, 1982, Gables Limited executed and delivered to Southeast that certain Future Advance Note dated Auqust 9, 1982 in the original principal amount of One Million ($l,000,000.00) Dollars (the "Second Note"); WHEREAS, the Second Note was executed pursuant to the provisions of Paraqraph 16 of the First Mortgage which allows for future advances to be made up to a maximum of one hundred fifty percent (150%) of the original principal balance; WHEREAS, on August 9, 1982, Gables Limited executed and delivered to Southeast that certain Notice of Advances to be made dated August 9, 1982, and recorded Auqust 10, 1982, in Official Records Book 11523, Page 2073, of the Public Records of Dade County, Florida (the "Notice of Advances to be Made"); WHEREAS, on Auqust 9, 1982, Gables Limited executed and delivered to Southeast that certain UCC-l Financing Statement recorded on August 16, 1982 with the Secretary of State, State of Florida under File Number 1820113943 (the "First Gables Limited UCC-1-State"). The First Gables Limited UCC-l-State fully assigned to Aetna pursuant to that certain UCC-3 filed with the Secretary of State, State of Florida, on March 14, was 1983, under File Number 3830011076. The First Gables Limited UCC-l-State was continued pursuant to that certain UCC-3 filed with the Secretary of State, State of Florida on August 14, 1987 under File Number 3870055193; WHEREAS, on or about February 11, 1983, Gables Limited executed and delivered to Southeast that certain Promissory Note dated February 11, 1983, in the original principal amount of Five Million Two Hundred and Fifty Thousand ($5,250,000.00) Dollars (the "Third Note"); WHEREAS, on February 11, 1983, Gables Limited executed and delivered to Southeast a mortgage (the "Second Mortgage") dated February 11, 1983 and recorded February 16, 1983, in Official Records Book 11700, Page 1564 of the Public Records of Dade County, Florida in order to secure repayment of the Third Note; WHEREAS, on February 11, 1983, Gables Limited executed and delivered to Southeast, a Supplemental Assiqnment of Rents and Leases dated the llth day of February, 1983 and recorded on February 16, 1983 in Official Records Book 11700, Page 1569 of the Public Records of Dade County, Florida (the "First Supplemental Assignment of Rents and Leases"); WHEREAS, on February 11, 1983, Gables Limited executed and delivered to Southeast a UCC-l-Financing Statement recorded on February 16, 1983 in Official Records Book 11700, Page 1576 of the Public Records of Dade County, Florida (the "Gables Limited UCC-l-Local''). The Gables Limited UCC-l-Local was continued and fully assigned to Aetna pursuant to that certain UCC-3 recorded in Official Records Book 13553, Page 2549 of the Public Records of Dade County, Florida; WHEREAS, on February 11, 1983, Gables Limited executed and delivered to Southeast a UCC-l-Financing Statement filed on February 18, 1983 with the Secretary of State, State of Florida under File Number 1830025592 (the "Second Gables Limited UCC-l-State"). The Second Gables Limited UCC-l-State was fully assigned to Aetna pursuant to that certain UCC-3 filed with the Secretary of State, State of Florida, on March 14, 1983, under File Number 3830011075. The Second Gables Limited UCC-l-State was continued and assigned to Aetna pursuant to that certain UCC-3 filed with the Secretary of State, State of Florida on January 28, 1988 under File Number 3880005857; WHEREAS, on February 16, 1983, the First Note, the Second Note and the Third Note, together with the First Mortgage and the Second Mortgage were consolidated and modified by that certain Note and Mortgage Modification Agreement dated February 16, 1983, and recorded February 16, 1983, in Official Records Book 11700, Page 1579, of the Public Records of Dade County, Florida ("the First Note and Mortgage Modification Agreement"); WHEREAS, on February 28, 1983, Aetna purchased from Southeast the First Note, the Second Note and the Third Note (collectively, the "Notes"), and the First Mortgage and the Second Mortgage (collectively, the "Mortgages"), as consolidated and modified by the First Note and Mortgage Modification Agreement and all related loan documents, and Southeast assiqned its interest in said loan documents pursuant to that certain Assignment dated February 28, 1983 and recorded on February 28, 1983, in Official Records Book 11711, Page 417 of the Public Records of Dade County, Florida (the "Assignment"); WHEREAS, on or about November 7, 1983, Gables Associates acquired title to the Property by virtue of that certain Special Warranty Deed executed and delivered by Gables Limited in favor of Gables Associates dated November 7, 1983, and recorded November 14, 1983, in Official Records Book 11967, Page 476, of the Public Records of Dade County, Florida; WHEREAS, on May 21, 1984, Aetna and Gables Associates entered into that certain Note and Mortgage Modification Agreement dated May 21, 1984, and recorded May 25, 1984, and Official Records Book 12158, Paqe 2601, Public Records of Dade County, Florida (the "Second Note and Mortgage Modification Agreement"); WHEREAS, on May 21, 1984, Gables Associates executed and delivered that certain Supplemental Assiqnment of Rents and Leases dated May 21, 1984 and recorded on May 25, 1984 in Official Records Book 12158, Page 2596 of the Public Records of Dade County, Florida (the "Second Supplemental Assignment of Rents and Leases"); WHEREAS, on May 21, 1984, Gables Associates executed and delivered to Aetna that certain UCC-l Financing Statement filed with the Secretary of State, State of Florida on May 29, 1984 under File Number 1840092087 (the "Gables Associates UCC-l-State") The Gables Associates UCC-l-State was continued pursuant to that certain UCC-3 filed with the Secretary of State, State of Florida, on May 5, 1989 under File Number 89-0000123298; WHEREAS, on May 21, 1984, Gables Associates executed and delivered that certain UCC-l Financing Statement to Aetna recorded on May 25, 1984 in Official Records Book 12158, Page 2610 of the Public Records of Dade County, Florida (the "Gables Associates UCC-l-Local"). The Gables Associates UCC-l-Local was continued pursuant to that certain UCC-3 recorded on May 5, 1989 in Official Records Book 14096, Page 1495 of the Public Records of Dade County, Florida; WHEREAS, on June 26, 1990, Aetna and Gables Associates entered into that certain Note and Mortgage Modification Agreement effective as of the 1st day of March, 1989, and recorded July 13, 1990, in Official Records Book 14624, Page 848, of the Public Records of Dade County, Florida (the "Third Note and Mortgage Modification Agreement"); WHEREAS, in connection with the Third Note and Mortgage Modification Agreement, Gables Associates executed and delivered to Aetna that certain Restated Renewal Note dated March 1, 1989, in the amount of Sixteen Million Six Hundred Sixty-Seven Thousand Five Hundred Sixteen and 89/100 Dollars ($16,667,516.89), (the "Restated Renewal Note"). The First Note, First Mortgage, First Rents Assignment, Second Note, Notice of Advances to be Made, First Gables Limited UCC-l-State, Third Note, Second Mortgage, First Supplemental Assiqnment of Rents and Leases, Gables Limited UCC-1-Local, Second Gables Limited UCC-l-State, First Note and Mortgage Modification Agreement, Second Note and Mortgage Modification Agreement, Second Supplemental Assignment of Rents and Leases, Gables Associates UCC-l-State, Gables Associates UCC-l-Local, Third Note and Mortgage Modification Agreement, the Restated Renewal Note and any other documents executed in connection with the foregoing documents are hereinafter sometimes collectively referred to as the "Loan Documents". WHEREAS, due to a default under the Loan Documents, Aetna has declared the full amount payable under the terms of the Restated Renewal Note and the other Loan Documents to be due; WHEREAS, Gables Associates acknowledges and agrees that Aetna is due Sixteen Million Six Hundred Sixty-Seven Thousand Five Hundred Sixteen and 89/100 Dollars ($16,667,516.89) as principal under the Restated Renewal Note plus interest thereon as set forth in said note, as well as costs expended by Aetna in connection with the collection of the sums due under the Restated Renewal Note, including, but not limited to attorneys' fees and costs; and WHEREAS, for the purpose of avoiding lengthy and expensive litigation and in order to reach an amicable resolution of their differences, Borrower on the one hand, and Aetna on the other hand, desire to reach a final compromise and settlement of any and all claims, demands, controversies, disputes, defenses, counterclaims and causes of action which each of them may have had, may now have, or may in the future have against the other arising out of or in connection with the Loan Documents. NOW, THEREFORE, in consideration of the premises, the covenants set forth herein, and other good and valuable considerations as set forth more fully below, the receipt and sufficiency of which are hereby acknowledqed by each of the parties hereto, the parties hereby agree as follows: ARTICLE I Whereas Clauses and Definitions 1.1 Whereas Clauses. The parties hereto agree that the above recitals are true and correct, and are hereby incorporated by reference. 1.2 Certain Defined Terms. As used herein the following terms shall have the following meanings (such meanings shall be applicable to both the singular and plural forms of the terms defined): 1.2.1 "Agreement" shall mean this Settlement Agreement executed by Gables Associates and Aetna. 1.2.2 "Closing" shall mean the execution and delivery of all documents contemplated by this Agreement to be executed and delivered on the Closing Date, and the delivery of such documents to the parties entitled thereto. 1.2.3 "Closing Date" shall be April 20, 1993. 1.2.4 "Escrow Agent" shall mean Steel Hector & Davis, with an office and mailing address at 200 South Biscayne Boulevard, Suite 4000, Miami, Florida 33131-2398, Attn: Thomas V. Eagan, P.A. 1.2.5 "Escrow Agreement" shall mean that certain escrow agreement attached hereto as Exhibit B. 1.2.6 "Improvements" shall mean one (1) approximately 106,289 net rentable square foot 13-story office building and internal deck for approximately 285 automobiles located at 2100 Ponce de Leon Boulevard, Coral Gables, Dade county, Florida, and any and all other improvements on the Land. 1.2.7 "Land" shall mean the land, the legal description of which is set forth in Exhibit A attached hereto, and also including, without limitation, Gables Associates' right, title and interest (if any) in any walks, ways, strips and gores of land, streets, alleys, passages, all reversions in adjacent streets, and all easements and appurtenances whatsoever adjacent to or in any way belonging, relating or appertaining to any of the aforesaid real property. 1.2.8 "Leases" shall mean any and all leases, subleases, licenses or other occupancy agreements (written or verbal) which grant any possessory interest in any space situated on the Property and as more particularly described in Exhibit C attached hereto. 1.2.9 "Lease Summary" shall mean the list of tenants and Leases set forth in Exhibit C attached hereto. 1.2.10 "Licenses" shall mean all permits, certificates, authorizations, approvals and licenses necessary to operate the Improvements, including, but not limited to, those described in Exhibit D attached hereto. 1.2.11 "Miscellaneous Property" shall; mean all miscellaneous property related to the Land or the Improvements constructed thereon, including, but not limited to the books and records; contract rights; claims and counterclaims against third parties or to the design or construction of the Improvements; escrow accounts and other deposits and accounts with respect to the Property; appraisals; surveys; site pians; plans and specifications (including construction and as-built plans and specifications); the most recent landscape designs and architectural drawinqs relative to the Land or the Improvements; unpaid insurance proceeds and condemnation awards relative to the Land or the Improvements except as otherwise provided in this Agreement; Licenses; third party warranties and guaranties (to the extent assignable); general intangibles and goodwill of every nature used or usable in connection with the Land or the Improvements; utility agreements and allocations; development rights or orders; other rights relative to the Land or the Improvements; and other assets of Gables Associates related to the Land or the Improvements. 1.2.12 "Permitted Exceptions" shall mean (a) the exceptions to title listed in-Exhibit E, and (b) the Leases. 1.2.13 "Personal Property" shall mean all apparatus, equipment, machinery, fittings, furniture, furnishings, minor movables, fixed asset supplies and inventories and other intangibles and articles of personal property of every kind and nature whatsoever attached to or located on the Land and used or usable in connection With the Property and owned by Gables Associates, including without limitation the items of personal property listed in Exhibit F attached hereto, but excluding the items of personal property owned or stored by the tenants under the Leases as described in Exhibit C attached hereto. 1.2.14 "Property" shall mean the Land, the Improvements, the Personal Property and the Miscellaneous Property. 1.2.15 "Security Deposits" shall mean the security deposits paid by tenants to the landlord under the Leases as described in Exhibit G attached hereto. 1.2.16 "Service Contract" shall mean any service, maintenance, supply, management, operating or employment contracts, as amended affecting the use, ownership, management, leasing, maintenance or operation of all or any part of the Property, including, without limitation, the contracts listed in Exhibit H attached hereto. 1.2 17 "Utility Deposits" shall mean any security deposit held by any electric, telephone, or other utility company supplyinq services to the Property, as described in Exhibit 1 attached hereto. 1.3 Other Terms All defined terms (denoted by capitalization or other indication. of special definition such as quotation marks) used in this Agreement which are not defined This Article I, shall have the meaning set forth elsewhere in this Agreement. ARTICLE II Preservation of Property 2.1 Appointment of Receiver. In order to best preserve and protect the Property, the parties have mutually agreed that Hank Brenner should be appointed receiver (the "Receiver") by the court, at such time as Aetna files its foreclosure action. Gables Associates agrees to fully cooperate with the Receiver in his efforts to take possession of, operate and maintain the Property. ARTICLE III Closing 3.1 Place and Time. The Closing shall take place at the offices of Steel Hector & Davis, 200 South Biscayne Boulevard, Suite 4000, Miami, Florida 33131-2398 at 2:00 p.m. on the Closing Date at which time all instruments due to be made, executed and delivered at Closing shall be made, executed and delivered by the respective parties to the Escrow Agent to be held in escrow pursuant to the terms of the Escrow Agreement. The parties agree to have a pre-closing telephone conference the day before the Closing Date commencing at 10:00 a.m. 3.2 Closinq Costs. 3.2.1 Gables Associates' Closing Cost. Gables Associates shall pay the cost of recording any document required to satisfy any liens against the Property. 3.2.2 Aetna's Closinq Cost. Aetna shall pay the cost of any title search fee or title insurance commitment fee, the cost of the owner's title insurance premium, the expense of recording the Special Warranty deed, including the documentary stamp taxes and surtaxes required to be paid in connection with recording said deed, and the consulting fees incurred by Aetna in the course of conducting due diligence on the Property. 3.2.3 Attorneys Fees. Except as provided in Section 14 5, attorneys fees shall be paid by the party incurring said expense. 3.3. Rents, revenues and receipts (a) Any rents, revenues and receipts paid to Gables Associates after the Closing Date shall be applied by Gables Associates towards the operation and maintenance of the Property and the debt service owed pursuant to the Loan Documents; provided, however, that after April 30, 1993, all such rents, revenues and receipts shall be paid by Gables Associates to the Receiver. (b) Insurance Proceeds Any proceeds of loss of rent or business interruption insurance shall be payable to Aetna regardless of the period during which the loss is sustained. 3.3 1 Security Deposits. At the time that the Receiver is appointed, Gables Associates shall transfer to the Receiver all Security Deposits and advance rent under the Leases, which have not been applied by Gables Associates under the terms and conditions of the Leases. ARTICLE IV Deliveries 4.1 Gables Associates Deliveries. Gables Associates will furnish to Aetna on or before the Closing Date, the following: 4.1.1 Leases. Copies of the Leases, identified in Exhibit C and letters of intent or other information relating to the Leases or prospective leases for office space in the Property, including, without limitation, any and all side letters concerning concessions given to tenants whether or not such concessions are still outstanding. 4.1.2 Taxes. Copies of the 1991 and 1992 real estate and personal property tax statements for the Property. 4.1.3 Survey. Copy of Gables Associates' most recent survey of the Land. 4.1.4 Utility Bills. Copies of the most recent utility bills regarding the Property 4.1.5 Service Contracts. Copies of all Service Contracts. 4.1.6 Licenses. Copies of all Licenses 4.1.7 Warranties and Guaranties Copies of all warranties and guaranties relating to the Property. 4.1 8 Permits To the extent in Gables Associates' possession or control, copies of building permits, Zoning variances (if any), certificates of occupancy, subdivision plats, governmental permits, approvals, development orders, orders, certificates and other licenses relating to the construction, use, occupancy and operation of the Property and other correspondence with governmental author ties related to the foregoing (including, without limitation, any default notices) 4.1.9 Certificates of Occupancy Copies of all certificates of occupancy relating to the Property. 4.1.10 Insurance Policies. Copies of all insurance policies relating to the Property. 4.1.11 Orqanizational Documents. Copies of the partnership agreements for Gables Associates, Carlyle Real Estate Limited Partnership-XIII, an Illinois limited partnership and Gables Limited, as well as the articles of incorporation and by-laws of JMB Realty Corporation, a Delaware corporation. ARTICLE V Gables Associates' Representations, Warranties and Covenants 5.1 The Property. Gables Associates represents, warrants and covenants with Aetna as of the date hereof as follows: 5.1.1 Ownership. Gables Associates is the owner of good and marketable title in fee simple to the Land and Improvements free and clear of all liens, claims and other encumbrances whatsoever, except the Permitted Exceptions and such other matters as Gables Associates shall cause to be removed at or prior to Closing. The Personal Property and the Miscellaneous Property are owned by Gables Associates free and clear of any and all liens, encumbrances and security interests other than the Permitted Exceptions and such other matters as Gables Associates shall cause to be removed at or prior to the Closing. 5.1.2 Leases. As of the date hereof, there are no rights to use, occupy or purchase the Land or Improvements or any portion thereof other than the Leases and the rights of Gables Associates, and the Lease Summary is a true, accurate and complete list of all Leases, true, complete and correct copies Of which will be submitted to Aetna pursuant to Section 4.1.1. As of the date hereof, except as otherwise set forth in the r ease Summary attached hereto as Exhibit C: (a) the Leases are in full force and effect; (b) the landlord is not in default in the performance of any covenant, agreement or condition contained in any of the Leases; (c) the tenants are not n default in the performance of any covenant, agreement or condition contained in any of the Leases; and (d) all tenants are in possession of their respective premises. 5.1.3 Contracts and Warranties. Exhibit K is a correct and complete list of all warranties and guaranties pertaining to the Property, true and correct copies of which will be delivered to Aetna pursuant to Section 4.1 7. Exhibit H is a correct and complete list of all Service Contracts, true and correct copies of which will be delivered to Aetna pursuant to Section 4.1 5. Except as set forth on Exhibit H, the Service Contracts are in full force and effect and unmodified, no default exists under any Service Contract, and the Service Contracts are freely assignable, do not run with the Land, and can be cancelled upon no more than thirty (30) days notice from either party. Gables Associates represents that it has not sent or received any notice regarding the cancellation or termination of any Service Contract. 5.1.4 Ability to Perform. Gables Associates has full power to execute, deliver and carry out the terms and provisions of this Agreement and has taken all necessary action to authorize the execution, delivery and performance of this Agreement. The execution, delivery and performance of this Agreement by Gables Associates, in accordance with its terms will not violate its partnership agreement, or any law, regulation, contract, agreement, commitment, order, judgment or decree to which Gables Associates is a party or by which it is bound. The persons executing this Agreement on behalf of Gables Associates have been duly authorized to do so, and this Agreement constitutes the legal, valid and binding obligation of Gables Associates enforceable in accordance with its terms, except as limited by applicable bankruptcy or other laws relating to creditors rights generally. No order, permission, consent, approval, license, authorization, registration or validation of, or filing with, or exemption by, any governmental agency, commission, board or public authority is required to authorize, or is required in connection with, the execution, delivery and performance of this Agreement by Gables Associates or the taking by Gables Associates of any action contemplated by this Agreement. Upon request from Aetna or its counsel, Gables Associates shall deliver reasonable evidence of Gables Associates' authority to execute and deliver the documents necessary to consummate the Closing. 5.1.5 Solvency If requested by Aetna, Gables Associates shall provide Aetna with a solvency affidavit regarding Gables Associates at the time of closing in the form attached hereto as Exhibit L, or Gables Associates shall provide such other affidavit as the title insurance underwriter may reasonably require 5.1 6 No Actions. Except as set forth in Exhibit M attached hereto and made a part hereof, Gables Associates has received no written notice of and there do not exist, any actions or proceedings pending or threatened against or relating to the construction. ownership, use, possession or operation of the Property, including, without limitation, actions for condemnation of the Property or any part thereof. 5.1.7 Compliance with Law Except as itemized in Exhibit N attached hereto and made a part hereof, Gables Associates has received no written notice from any governmental authorities and has no other reason to believe that the present physical condition or use of the Property is in violation of an laws, regulations, permits, orders and insurance requirements applicable to such use. Gables Associates has received no written notice and otherwise has no reason to believe that any of the permits, certificates, licenses and approvals required for the use and operation of the Property for its existing uses, is not in full force and effect. Without limiting the generality of the foregoing, Gables Associates has received no written notice or citation: (a) from any federal, state, county or municipal authority alleging any fire, health, safety, building, pollution, environmental, zoning or other violation of any law, regulation, permit, order or directive in respect of the Property or any part thereof; (b) concerning the condemnation or any threatened condemnation of any part of the Land and Improvements, or the widening, change of grade of any roads, rights-of-way, etc. or concerning any special taxes or assessments levied against the Land and Improvements or any part thereof; (c) from any insurance company or bonding company of any defects or inadequacies in the Property or any part thereof, which would adversely affect the insurability of the same or of any termination or threatened termination of any policy of insurance or bond; (d) concerning any change in the land use classification or the zoning classification of the Land and Improvements or any part thereof; (e) concerning the possible or anticipated revocation, non-renewal or disapproval of any of the Licenses; or (f) of any other impediment to the continued use and operation of the Property for its existing uses If any such written notice is received prior to the Closing, Gables Associates shall notify Aetna promptly thereof, and, to the extent that actions are required thereby to be taken by Gables Associates prior to Closing, shall cause such actions to be taken; provided, however, that Gables Associates shall not be required to advance any of its monies in order to comply with any such notice. 5.1.8 Utilities. There is no pending or threatened curtailment of any utility service presently being supplied to the Land and Improvements. 5.1.9 Assessments. No special assessments for public improvements have been made against the Property which are unpaid, including, without limitation, those for construction of sewer, water and other utility lines, streets, sidewalks and curbs, and there are no pending liens on account thereof. 5.1.10 Environmental. Gables Associates represents and warrants that: (a) Gables Associates has not been involved in, and Gables Associates is not aware of any prior owner of the Property having been involved in the generation, storage, transportation, disposal, release or discharge of hazardous materials, hazardous waste, hazardous substances, solid waste or pollution upon, in, over or under the Property and that, to the best of Gables Associates' knowledge, no such materials or pollution has migrated to the Property from neighboring property; (b) Gables Associates has not received any notice from any governmental agency or authority or from any tenant or other occupant with respect to any generation, storage, transportation, disposal, release or discharge of hazardous materials, hazardous waste, hazardous substances, solid waste or pollution upon, in, over or under the Property; (c) there is no asbestos or asbestos-containing materials, PCB's, radon gas, urea formaldehyde foam insulation or underground storage tank(s) at or within the Property; (d) that Gables Associates and any tenant of the Property is not and will not become involved in operations at the Property or at other locations owned or operated by Gables Associates which would lead to the imposition on Gables Associates of liability under Chapter 403, Florida Statutes. the Resource Conservation and Recovery Act, 42 U.S.C. 6901 et seq. ("RCRA"), the Comprehensive Enviromental Response Compensation and Liability Act of 1980, 42 U.S.C. 9601 et seq. ("CERCLA") or any other federal, state or local ordinances, laws or regulations regarding environmental matters or hazardous substances, (e) Gables Associates will cooperate with the Receiver in complying with, and will take such action as may be required in order to promptly comply with, the requirements of Chapter 403, Florida Statutes, RCRA, CERCLA and all federal, state and local laws and regulations regarding environmental matters or hazardous substances as the same may each be amended from time to time (including all federal, state and local laws and regulations regarding underground storage tanks), and all such laws and regulations relating to asbestos and asbestos-containing materials, PCB's, radon gas, urea formaldehyde foam insulation (provided, however, Gables Associates shall not be required to spend any monies in order to comply with any of the foregoing requirements), and wil' notify Aetna promptly in the event of any release or discharge or a threatened release or discharge of hazardous materials, hazardous wastes, hazardous substances, solid waste or pollution upon, in, over or under the Property as those terms are defined in Chapter 403, Florida Statutes and any federal, state or local ordinances, laws or regulations regarding environmental matters or hazardous substances, or the presence of asbestos or asbestos-containing materials, PCB's, radon gas or urea formaldehyde foam insulation at the Property, or of the receipt by Gables Associates of any notice from any governmental agency or authority or from any tenant or other occupant or from any other person or entity with respect to any alleged such release or presence promptly upon discovery of such release, or promptly upon receipt of such notice, and will promptly send Aetna copies of all results of any tests regarding same on the Property and (f) there are no electrical transformers located on the Property. 5.1.11 Landfill. The Property has not been used as a solid waste or liquid waste landfill, or trash dump. 5.1.12 Licenses. Exhibit D contains a correct and complete list of all Licenses, true and correct copies of which will be delivered to Aetna pursuant to Section 4.1.6. 5.1.13 Brokeraqe Commissions. There are no commitments, agreements or contracts for brokerage commissions or similar compensation due (or to become due in connection with renewals of leases) tO any broker or similar person in connection with any Lease and future Lease, except as set forth in Exhibit C. 5.1.14 Orqanization and Authority. Gables Associates is a general partnership duly formed and validly existing in Florida, with full power and authority to carry on its business as now conducted. 5.1.15 Zoning. Gables Associates represents that the Property is zoned CB (commercial use) pursuant to the City of Coral Gables Zoning Code, that said classification allows for office building use, and there are no ordinances or regulations affecting the Land and the Improvements which would serve to restrict or prohibit the use of the Land and the Improvements in conformity with such zoning. Gables Associates represents that to the best of Gables Associates' knowledge, the Property is in compliance with zoning laws, as well as all other applicable laws, ordinances and regulations. 5.1.16 Commitments to Governmental Authorities. Gables Associates has made no commitments to any governmental authority, utility company, school board, church or any other religious body regarding the Property which would impose an obligation upon Aetna or its successors or assigns to make a contribution of money or dedications of land, or to construct, install or maintain any improvements of a public or private nature on or off the Property. 5.1.17 Notices. Gables Associates has not received any written notices from any insurance company of any defects or inadequacies in the Property or any part thereof which would materially and adversely affect the insurability of the Property or the premiums for the insurance thereof, and no notice has been given by any insurance company which has issued a policy with respect to any portion of the Property or by any board of fire underwriters (or other body exercising similar functions) requesting the performance of any alterations or other work which has not been complied with. 5.1.18 Possession. There are no parties in possession of any portion of the Property except for the tenants described in Exhibit C attached hereto and made a part hereof, and such other tenants as may be added pursuant to Section 9.1. 5.1.19 Disclosure. Except for the condition of the commercial leasing market in Dade County, Florida, there is no fact regarding the Property within Gables Associates' knowledge which adversely affects the Property in a material fashion which has not been set forth in this Agreement or an exhibit hereto or in a certificate or writing furnished in connection herewith. In the event that Gables Associates becomes aware of any fact regarding the Property which adversely affects the Property in a material fashion, Gables Associates will promptly notify Aetna, in writing, of such fact 5.1.20 Other Contracts. Gables Associates is not obligated under any contract; or agreement which has not been disclosed in connection herewith or a true copy of which have been previously delivered to Aetna. 5.1.21 Condition of Property Gables Associates represents that the Propersy (including the plumbing systems and fixtures, electrical systems and fixtures and sprinkler systems (if any)) is in good condition and repair, is termite free and that all electrical and mechanical appliances and equipment of whatever kind and nature are in good working condition, and that the Improvements are free from structural defect. ARTICLE VI Aetna's Representations, Warranties and Covenants Aetna represents. warrants and covenants with Gables Associates as of the date hereof as follows: 6.1 Organization and Authority. Aetna is a Connecticut corporation duly formed and validly existing under the laws of the State of Connecticut with full power and authority to carry on its business as now conducted and as is contemplated from and after the consummation of the transaction which is the subject of this Agreement. 6.2 Ability to Perform. Aetna has full power to execute, deliver and carry out the terms and provisions of this Agreement and has taken all necessary action to authorize the execution, delivery and performance of this Agreement The persons executing this Agreement on behalf of Aetna have been duly authorized to do so, and this Agreement constitutes the legal, valid and binding obligation of Aetna enforceable in accordance with its terms, except as limited by applicable bankruptcy or other laws relating to creditor's rights generally. No order, permission, consent, approval, license, authorization, registration or validation of, or filing with, or exemption by, any governmental agency, commission, board or public authority is required to authorize, or is required in connection with the execution, delivery and performance of this Agreement by Aetna or the taking by Aetna of any action contemplated by this Agreement. 6.3 No Violation. The execution, delivery and performance of this Agreement, in accordance with its terms, will not violate, conflict with or result in the breach of any provision of the articles of incorporation of Aetna, or any law, regulation, contract, agreement, commitment order, judgement or decree tO which Aetna is a party or by which it may be bound ARTICLE VII Conditions Precedent to Closinq 7.1 Aetna's Conditions Precedent to Closing The following shall be express conditions precedent to the obligations of Aetna under this Agreement, and are for the benefit of Aetna but may be waived by Aetna in whole or in part in its sole discretion: 7.1 1 No Default No breach or default under this Agreement shall have occurred on the part of Gables Associates which is continuing uncured at Closing. 7.1.2 Closinq Obliqations and Representations. Gables Associates shall have complied in all respects with the requirements of Article IV and Article X, as of the Closing Date, and the representations and warranties in the certificate to be delivered under Section 10.7 shall be true and correct in all respects as of the Closing Date. 7.1.3 Inspections. Gables Associates shall provide to Aetna and/or its designee access to the Property at reasonable times prior to the Closing for the purposes of conducting inspections of same, including, but not limited to termite inspections, roof inspections, structural integrity inspections, environmental inspections and other inspections of the Property 7.1.4 Title. Good, marketable and fee simple title of record and in fact to the Land and the Improvements shall be vested in Gables Associates at Closing, subject only to the Permitted Exceptions and such other matters as Gables Associates shall cause to be removed at or prior to Closing. In the event that title is found to be other than good and marketable, free from liens, reverters, restrictions and other encumbrances and clouds, except for the Permitted Exceptions, it shall be the duty and obligation of Gables Associates to remove any such defects or objections on or before the Closing Date. 7.1.5 Estoppel Certificates. Gables Associates shall cooperate with the Manager in obtaining and delivering to Aetna prior to the Closing Date estoppel certificates from each utility company furnishing services to any portion of the Property in the form attached hereto as Exhibit O, and in the event that the Manager is unable to obtain said estoppel certificates, Gables Associates shall use its best efforts to obtain and deliver same to Aetna prior to the Closing. In the event that the Manager or Gables Associates are not able to deliver said utility estoppel certificates to Aetna prior to the Closing Date, Gables Associates shall substitute its own estoppel letter in the form attached hereto as Exhibit O. 7.1.6 Possession. At the Closing, Gables Associates shall deliver full possession of The Property to Aetna (i) free of all tenants or occupants, except the tenants under the Leases reflected on Exhibit C and such other tenants as may be added pursuant to the provisions of Section 9.1, and (ii) not subject to any encumbrance other than the Permitted Exceptions. 7.1.7 Tenant Estoppel Letters. Gables Associates shall use its best efforts to obtain and deliver estoppel letters in the form attached hereto as Exhibit P prior to the Closing from all of the tenants identified in Exhibit C. Notwithstanding the foregoing, in the event that Gables Associates is unable to deliver said tenant estoppel letters to Aetna at or prior to the Closing from all of the tenants identified in Exhibit C, Gables Associates shall substitute its own estoppel letter in the form attached hereto as Exhibit P for those tenants from whom Gables Associates was unable to obtain estoppel letters. 7.1.8 No Material Chanqe. No material adverse change shall have occurred with respect to the Property since the date hereof. 7.1.9 Closing Documents. 7.1.9.1 Property Conveyance. The Land and the Improvements shall be conveyed by Special Warranty Deed, the Personal Property shall be conveyed by a proper Bill of Sale (with warranties of title) and the Miscellaneous Property, Licenses, Leases and Service Contracts shall be conveyed by a proper assignment. 7.1.9.2 Removal of Liens. Gables Associates shall cause to be made and delivered to Aetna an Affidavit of No Lien (Mechanic's Lien Affidavit) as to the Land and the Improvements in the form attached hereto as Exhibit Q. Gables Associates shall deliver to Aetna original lien waivers as well as releases from all contractors, subcontractors and/or materialmen who have not been paid and who have performed work or furnished materials prior to the Closing and/or for work in progress or who have pending liens on the Property. 7.1.10 No Cancellation of Lease. No condemnation or casualty which allows any tenant to cancel its lease pursuant to the terms thereof shall have occurred. 7.1.11 UCC Search. Gables Associates shall deliver to Aetna prior to the Closing Date a UCC Financing Statement search indicating that there are no outstanding financing statements or security agreements regarding Gables Associates or the Property which remain unsatisfied other than the UCC-ls in favor of Aetna, or provide payoff letters (satisfactory to Aetna) from any secured party for any outstanding financing statements at time of Closing. 7.1.12 Stipulation and Final Judgment of Foreclosure. Gables Associates hereby instructs its counsel to execute the Stipulation and Final Judgment in form and substance as appears on Exhibit V attached hereto and made a part hereof (the "Stipulation") and to deliver the Stipulation in escrow to the Escrow Agent at time of Closing, to be held pursuant to the terms of the Escrow Agreement. 7.1.13 Stipulation and Joint Motion for Ex Parte Appointment of Receiver. Gables Associates hereby instructs its counsel to execute the Stipulation and Joint Motion for Ex Parte Appointment of Receiver in form and substance as it appears on Exhibit X attached hereto and made a part hereof and to deliver the Stipulation and Joint Motion for Ex Parte Appointment of Receiver to Aetna at the time of Closing. Aetna shall be free to file the Stipulation and Joint Motion for Ex Parte Appointment of Receiver at any time after the filing of its foreclosure action to enforce the Loan Documents on April 30, l993 . 7.2 Gables Associates' Conditions Precedent to Closing. The following shall be express conditions precedent to the obligations of Gables Associates under this Agreement, and are for the benefit of Gables Associates, but may be waived by Gables Associates, in whole or in part in its sole discretion: 7.2.1 No Default. No breach or default under this Aqreement shall have occurred on the part of Aetna which is continuing and uncured at Closing. 7.2.2 Closing Obligations and Representations. Aetna shall have complied in all respects with the requirements on Aetna's part to be complied with under Article XI hereof, and the representations and warranties of Aetna contained in the certificate to be delivered under Section 11.1 shall be true and correct in all respects as of the Closing Date. ARTICLE VIII Insurance, Casualty, Condemnation 8.1 Fire or Casualty. If the Property or any portion whereof is damaged or destroyed by fire or other casualty prior to the Closing, Aetna shall proceed with the transaction contemplated herein, and Aetna shall be entitled to such insurance as is paid on the claim of loss. 8.2 Condemnation. In the event that all or any portion of the Property becomes the subject of a condemnation proceeding or threat thereof by a public or quasi-public authority having the power of eminent domain prior to the Closing, Gables Associates shall immediately notify Aetna whereof in writing, and Aetna shall proceed with the transaction contemplated herein and shall be entitled to receive all proceeds of any award or payment in lieu thereof resulting from such proceedings or threat thereof. ARTICLE IX Obligations Pending Closing 9.1 Access, Riqht of Inspection and Termination. (a) Aetna, its engineers, appraisers, attorneys and other representatives shall have the right, at Aetna's sole cost, risk and expense, to enter onto the Property during normal business hours on reasonable notice and in a reasonable manner, without interference with the operation of the Property, for the purpose of making such tests and inspections as Aetna deems necessary or appropriate in connection with this Agreement. (b) Gables Associates shall make all of its files and records relating to the operation of the Property available to Aetna for copying, which obligation shall survive the Closing. 9.2 Notice of Changes. Each party shall promptly give written notice to the other of the occurrence of any event materially affecting the substance of the representations made hereunder. ARTICLE X Gables Associates' Closing Obligations 10.1 Deliveries at Closing. At the Closing, Gables Associates shall deliver or cause to be delivered the following documents to the Escrow Agent to be held in escrow pursuant to the terms of the Escrow Aqreement: 10.1.1 an executed and acknowledged Special Warranty Deed in form and substance as appears on Exhibit S transferring fee simple title to the Land and Improvements to Aetna or its designee, subject only to the Permitted Exceptions; Notwithstanding anything to the contrary contained in this Agreement or the exhibits attached hereto, it is the intent of the parties hereto that the transfer of title to the Property from Gables Associates to Aetna shall not act as a merger of title as to any security interests Aetna may currently hold in the Property pursuant to the Loan Documents. 10.1.2 an executed and acknowledged assignment assigning Gables Associates' interest in, among other things, the Service Contracts, Leases, Licenses, warranties and guaranties in form and substance as appears on Exhibit T; 10.1.3 an executed and acknowledged assignment assigning to Aetna all of the Utility Deposits; 10.1.4 an executed and acknowledged Bill of Sale (with warranties of title) transferring to Aetna the Personal Property and any remaining items of Miscellaneous Property not otherwise assigned or conveyed in form and substance as appears on Exhibit U. 10.1.5 an executed and acknowledged satisfaction of mortgage in form satisfactory to the title insurance underwriter from Gables Limited, the holder of a second mortgage and a third mortgage on the Property. 10.2 Lien Waivers. Gables Associates shall deliver to Aetna original lien waivers as well as releases from all contractors, subcontractors and/or materialmen who have not been paid and who have performed work or furnished materials prior to the Closing and/or for work in progress or who have pending liens on the Property. 10.3 Service Contracts. Executed counterparts of all other Service Contracts other than Service Contracts which are permitted to be terminated in accordance with this Agreement or, if Gables Associates is unable to produce the same, a copy of any such Service Contracts certified by Gables Associates to be true, correct and complete. 10.4 Tax Receipts. A receipt or receipts from the appropriate taxing authorities evidencing that all personal and real property taxes affecting the Property which were due and payable have been paid. 10.5 Documents. Original copies of the most recent site plans, surveys, soil and substrata studies, architectural drawings, plans and specifications, graphic boards, schematic plans, renderings, engineering plans and studies, floor plans, landscape plans and other plans or studies of any kind that relate to all or any part of the Property in the possession or control of Gables Associates. Gables Associates shall also deliver (i) original copies of all then effective guaranties and warranties made by any person for the benefit of Gables Associates, with respect to the Property or any of its components, and (ii) originals of all Licenses and Miscellaneous Property, except that photocopies may be substituted if the originals are required to be posted at the Property. 10.6 Licenses. The Licenses, provided that photocopies may be substituted if the originals are required to be posted at the Property. 10.7 Certificate of Article V Representations, Warranties and Covenants. A certificate of Gables Associates updating the representations and warranties contained in Article V hereof. 10.8 Estoppel Certificates. The estoppel certificates or other deliveries described in Sections 7.1.5 and 7.1.7 to the extent not previously delivered. l0.9 Other Documents. Any other document (i) required by this Agreement to be delivered by Gables Associates or (ii) otherwise reasonably necessary to consummate the transaction contemplated hereby and in form reasonably acceptable to Aetna and Aetna's counsel. l0.10 Authority. Evidence of Gables Associates' authority for the execution of this Agreement and the consummation of the transactions contemplated by this Agreement including such evidence as may be reasonably requested by Aetna and Aetna's counsel. l0.11 No Foreign Person. Affidavit, under penalty of perjury, confirming Gables Associates' United States taxpayer identification number is 36-3298386 and stating that Gables Associates is not a foreign person, in a form sufficient to exempt Aetna from the withholding provisions of Section 1445 of the Code. 10.12 Deliveries required by the Title Commitment. Satisfactions, releases or other documents required by Attorneys' Title Insurance Fund, Inc. Title Insurance Commitment bearing File No. 01-93-10244M, in order to delete all of the requirements contained in Schedule B-I. 10.13 Delivery of Leases/Rent Roll. To the extent in Gables Associates' possession, the landlord's original executed counterparts of all Leases and related documents In addition, an executed and acknowledged current rent roll for the Property certified by Gables Associates to be true and correct, including a statement as to the current status of payment for all tenants. 10.14 Rent Records. To the extent in Gables Associates' possession, originals of all rent records (including Lease summaries in the same format as the Lease Summary attached as Exhibit C dated as of the Closing Date), and related documents in the possession or under the control of Gables Associates. 10.15 Letters to Tenants. A sufficient quantity of original letters to tenants under the Leases, contractors under Service Contracts, utilities or others, advising such persons of the transfer of ownership to Aetna and of the address to which further notices and rental payments are to be made. 10.16 Solvency Affidavit. If requested by Aetna, Gables Associates shall provide Aetna with the Solvency Affidavit regarding Gables Associates in the form attached hereto as Exhibit L, or such other affidavit as may be reasonably required by the title insurance underwriter. ARTICLES XI Aetna's Closing Obligations At the Closing, Aetna shall deliver to Gables Associates or as otherwise provided below, or cause to happen: 11.1 Certificate of Aetna's Representations. A certificate of Aetna updating the representations and warranties of Aetna contained in Article VI hereof. 11.2 Aetna's Authority. Evidence of Aetna's authority for the consummation of the transactions contemplated hereunder including evidence of incumbency and such other evidence of authority as may be reasonably requested by Gables Associates. 11.3 Other Documents. All other documents (i) required by this Agreement to be delivered by Aetna, or (ii) otherwise reasonably necessary to consummate the transaction contemplated hereby and in form reasonably satisfactory to Gables Associates and Gables Associates' counsel on, at or before the Closing; provided, however, that any request hereunder shall be made on a timely basis so that Aetna shall have a reasonable period of time to satisfy such request. ARTICLE XII Continuing Obligations 12.1 Sale of Property. After the Closing date, Gables Associates shall continue to attempt to sell the Property for a purchase price of at least $8,000,000.00. Should Gables Associates enter into a contract for sale and purchase on or before April 30, 1993 and close and disburse the proceeds from said sale prior to June 30. 1993, Aetna will release its first mortgage on the Property upon receipt of a sum in the amount of $7,680,000.00 In the event that the purchase price of $8,000,000.00 is increased by a figure up to $100,000.00, then Aetna will release its first mortgage encumbering the Property upon receipt of $7,680,000.00, plus 20% of said increase. In the event that the purchase price is increased above $8,100,000.00 by a figure up to $100,000.00, then Aetna will release its first mortgage encumbering the Property upon receipt of $7,680,000.00, plus 20% of the first $100,000.00 above $8,000,000.00, and 50% of the next $100,000.00 above $8,100,000.00. In the event that the purchase price is increased above $8,200,000.00, then Aetna will release its first mortgage encumbering the Property upon receipt of $7,680,000.00, plus 20% of the first $100,000.00 above $8,000,000.00, 50% of the next $100,000.00 above $8,100,000.00, and any additional monies above $8,200,000.00, unless Aetna, in writing, agrees to another arrangement as to the payment of monies in excess of $8,200,000.00. Gables Associates hereby represents to Aetna that Gables Associates, Carlyle Real Estate Limited Partnership XIII, Gables Corporate Plaza, Ltd., Michael L. Katz, Alberto Socol, and/or any related or affiliated persons, entities or parties (hereinafter collectively referred to as the "Seller") will not be receiving monies or other valuable consideration of any nature in connection with the sale of the Property, including, but not limited to the payoff of the second and/or third mortgages encumbering the Property, real estate brokerage commission(s) or fee(s), participation interest, or contingent interest, in excess of the amount set forth below in connection with the specified purchase price, to wit: (i) Purchase Price of $8,000,000.00 - Seller will not receive monies or other consideration in excess of $320,000.00. (ii) Purchase Price in excess of $8,000,000.00, but less than $8,100,001.00 - Seller will not receive monies or other consideration in excess of $400,000.00. (iii) Purchase Price in excess of $8,100,000.00 - Seller will not receive monies or other consideration in excess of $450,000.00. 12.2 Escrow Agent. The Escrow Agent is hereby instructed, and the Escrow Agreement shall provide that (i) the Escrow Agent shall destroy the documents delivered to it in escrow in the event that Gables Associates sells and closes on the Property pursuant to the provisions of Sections 12.1, or otherwise sells and closes on the Property prior to January 5, 1994 on terms and conditions acceptable to Aetna, in Aetna's sole discretion; and (ii) the Escrow Agent shall release the documents held in escrow to Aetna on January 5, 1994, which may then be filed by Aetna in the Circuit Court of Dade County, Florida, recording in the Public Records of Dade County, Florida, or otherwise held or disbursed by Aetna, as appropriate, in the event that Gables Associates has not sold and closed on the Property pursuant to the provisions of Section 12.1, or otherwise sold and closed on the property prior to January 5, 1994 on terms acceptable to Aetna, in Aetna's sole discretion. 12.3 Further Assurances. After the Closing Date, Gables Associates and Aetna shall cooperate with one another at reasonable times and on reasonable conditions and shall execute and deliver such instruments and documents as may be reasonably necessary in order fully to carry out the intent and purposes of the transactions contemplated hereby. 12.4 Survival. All representations and warranties made by Gables Associates under Article V and made by Aetna under Article VI of this Agreement and in certificates delivered at Closing pursuant to Section 10.7 by Gables Associates and Section 11.1 by Aetna, as well as all other covenants set forth in this Agreement shall survive the Closing until,such time as Aetna acquires title to the Property, excluding the provisions of this Section 12.4, as well as the provisions of Article XIV which shall under all circumstances survive the Closing; provided, however, that Gables Associates and its partners shall have no personal liability for money damages arising out of the inaccuracy or falsity of the above described representations and warranties if Gables Associates o its partners do not take any action after the date of this Agreement to thwart, deter, hinder or delay Aetna or its designee from taking title to the Property, or otherwise frustrate the purpose of this Agreement. Notwithstanding the foregoing, it is the intention and the agreement of the parties hereto that the expiration of the above described representations, warrarnties and covenants then Aetna acquires title to the Property shall not be applicable to or in any way effect the representations, warranties or covenants set forth in the Special Warranty Deed, Bill of Sale, Assignment, Mechanics' Lien Affidavit, Solvency Affidavit, satisfactions for the subordinate mortgages described in Section 10.1.5 or any other affidavit or document required by the title insurance underwriter (the "Real Estate Closing Documents") or the Stipulation and Final Judqment of Foreclosure, and the Stipulation and Joint Motion for Ex Parte Appointment of Receiver. ARTICLE XIII Remedies 13.1 Default 13.1.1 Aetna's Default. In the event Aetna shall fail to perform its obligations hereunder by or on the Closing Date, and all conditions to such performance have then been satisfied, Gables Associates shall have the right to pursue such remedies as are available at law or in equity and to assert Gables Associates' rights under Section 14.5. 13.1.2 Gables Associates' Default or Force Majeure. In the event that Gables Associates shall fail to perform its obligations hereunder by or on the Closing Date, and that all conditions to Gables Associates' performance have been satisfied on the Closing Date, and Aetna is not in default hereunder, Aetna shall have the right to pursue such remedies as are available at law or in equity, including the riqht to bring an action for specific performance to enforce this Agreement and to assert Aetna's rights under Section 14.5, provided, however, notwithstanding anything to the c ontrary in this Agreement or in any "Ancillary Agreement" (i.e., any agreement, stipulation, instrument, pleading, judgment, court order or other document executed or otherwise created in connection herewith, including, but not limited to, the Real Estate Closing Documents), the remedies of Aetna or any other person or entity for a default or breach under this Agreement or under any of the Ancillary Documents shall be limited to Aetna's rights against the Property; and Gables Associates, Carlyle Real Estate Limited Partnership-XIII ("Carlyle") and Gables Limited and the direct or indirect general partners of Carlyle or of Gables Limited shall not have any personal liability under or in connection with this Agreement or any of the Ancillary Documents, except that each of said parties shall have personal liability for monetary damages incurred by Aetna to the extent caused by any respective action taken by such party after the date of this Agreement with the intent to thwart, deter, hinder or delay Aetna or its designee from taking title to the Property notwithstanding the foregoing: (1) in no event shall any direct or indirect partner in Carlyle have any personal liability under or in connection with this Agreement or any Ancillary Document; and (2) in no event shall a negative capital account or any contribution or payment obligation of a direct or indirect partner in Gables Associates (or Carlyle) be deemed to be an asset of Gables Associates (or Carlyle) or otherwise subject to recourse by Aetna for the purpose of satisfying any liability or obligation under the Loan. Documents, this Agreement, or any Ancillary Document. The provisions of this Section 13.1.2 shall survive any termination of this Agreement or the consummation of any of the transactions contemplated hereby, including, but not limited to the delivery of the Ancillary Documents to Aetna pursuant to the Escrow Agreement and the recording Of the Special Warranty Deed in the Public Records of Dade County, Florida. 13.2 Use of Proceeds to Clear Title. All unpaid taxes, assessments, water charges and sewer rents, together with the interest and penalties thereon to the time of the Closing, and all other liens and encumbrances which Gables Associates is obligated to pay and discharge, together with the cost of recording or filing any instruments necessary to discharge such liens and encumbrances of record, shall be paid by Gables Associates at the Closing ARTICLE XIV Miscellaneous Provisions 14.1 Exhibits. Exhibits A through X attached hereto are hereby made a part hereof as fully as if set forth in the text of this Agreement (it being understood that no signatory to this Agreement shall be deemed liable as a result of this Section 14.1 for any agreement attached as an exhibit hereto to which such signatory is not a party). 14.2 Purchasinq Entity; Successors and Assigns. Aetna may assign all of its riqht, title and interest in this Agreement to a wholly owned subsidiary of Aetna. 14.3 Governinq Law. This Agreement shall be governed and construed in accordance with the laws of the State of Florida, without regard to conflict of law principles thereunder. 14.4 Headings. Headings and captions at the beginning of each numbered section of this Agreement are solely for the reference of the parties and are not a part of or affect the interpretation of this Agreement. 14.5 Attorneys' fees. In the event of any litigation arising out of a breach or claimed breach of this Agreement or of the Escrow Agreement, the prevailing party shall be entitled to recover all costs and expenses incurred, including reasonable attorneys' fees. References to "reasonable attorneys' fees" herein shall be deemed to include all such fees in connection with litigation, including any trial or appeal. 14.6 WAIVER OF JURY TRIAL: AETNA AND GABLES ASSOCIATES HEREBY KNOWINGLY, VOLUNTARILY AND INTENTIONALLY WAIVE THE RIGHT ANY ONE OR MORE OF THEM MAY HAVE TO A TRIAL BY JURY IN RESPECT OF ANY LITIGATION BASED HEREON, OR ARISING OUT OF, UNDER OR IN CONNECTION WITH THE LOAN OR ANY AGREEMENT EXECUTED IN CONJUNCTION THEREWITH, OR ANY COURSE OF CONDUCT, COURSE OF DEALING, STATEMENTS (WHETHER VERBAL OR WRITTEN) OR ACTIONS OF ANY PARTY HERETO. THIS PROVISION IS A MATERIAL INDUCEMENT TO AETNA TO ENTER INTO THIS AGREEMENT. 14.7 Counterparts. This Agreement may be executed in two or more counterparts, each of which shall be an original but all of which shall together constitute one and the same agreement. 14.8 Interpretation. This Agreement shall be construed without regard to any presumption or other rule requiring construction against the party causing this Agreement to be drafted. If any words or phrases in this Agreement shall have been stricken out or otherwise eliminated, whether or not any other words or phrases have been added, and initialed by the party against which such words or phrases are construed, this Agreement shall be construed as if the words or phrases so stricken out or otherwise eliminated were never included in this Agreement and no implication or inference shall be drawn from the fact that such words or phrases were so stricken out or otherwise eliminated. If any provision of this Agreement shall not be enforceable or shall be determined by any court to be invalid, all other provisions of this Agreement shall be unaffected thereby and shall remain in full force and effect. All terms and words used in this Agreement, regardless of the number or gender in which they are used, shall be deemed to include any other number and any other gender as the context may require. 14.9 Amendment. This Agreement can be modified or rescinded only by writing expressly referring to this Agreement and signed by all of the parties. 14.10 Notices. Any notice, report, demand or other instrument authorized or required to be given or furnished to either party under this Agreement shall be sent to such party at the address of such party set forth below and mailed registered or certified mail, return receipt requested, or overnight delivery service, postage paid and shall be deemed given on the earliest to occur of (i) receipt therof (ii) the third day after deposit in the United States Postal Service with propoer postage affixed, or (iii) the day following the delivery to such overnight delivery service. The addresses of the parties are as follows: If to Gables Associates: Carlyle Real Estate Limited Partnership - XIII 900 North Michigan Avenue 19th Floor Chicago, Illinois 60611 Attn: Mr. Norman Geller Gables Corporate Plaza, Ltd. 1401 Brickell Avenue Suite 803 Miami, Florida 33131 Attn: Mr. Michael L. Katz with a copy to: Rubin, Baum, Levin, et al. 200 South Biscayne Boulevard Suite 2500 Miami, Florida 33131-2398 Attn: Brian L. Bilzin, Esq. If to Aetna: Aetna Life & Casualty Insurance Company City Place 151 Farmington Avenue Hartford, Connecticut 06156-3419 Attn: Garrett Delehanty, Esq. with a copy to: Steel Hector & Davis 200 South Biscayne Boulevard Suite 4000 Miami, Florida 33131-2398 Attn: Thomas V. Eagan, P.A. Each party may change the address to which any such notice, report, demand or other instrument is to be mailed, by furnishing written notice of such change to the other party. 14.11 Entire Agreement. All understandings and agreements heretofore made between the parties are merged in this Agreement. There are no oral promises, conditions, representations, understandings, interpretations or terms of any kind as conditions or inducements to the execution of this Agreement in effect between the parties. No change or modification of this Agreement shall be valid unless the same is in writing and signed by the parties hereto. No waiver of any of the provisions of this Agreement shall be valid unless the same is in writing and is signed by the party against which it is sought to be enforced and shall be valid only for the particular time and circumstances for which it is obtained. 14.10 Document Evidencing Termination. In the event this Agreement shall be terminated by either party in accordance with the terms hereof, either party shall, at the request of the other, execute and deliver an agreement in form reasonably satisfactory to Gables Associates and Aetna evidencing such termination. The obligations of Gables Associates and Aetna under this Section 14.12 shall survive the termination of this Agreement. 14.13 Time of the Essence. Time is of the essence in the performance by the parties hereto of each and every obligation under this Agreement. 14.14 Confidentiality. The parties hereto acknowledge and agree that the terms and conditions of this Agreement shall be held in confidence by the parties hereto and shall not be disclosed to any party at anytime without the express written consent of the parties hereto. In the event that either party hereto discloses the terms and conditions of this Agreement without the prior written consent of the other party hereto, then the disclosing party shall be held liable for any and all damages suffered by the other party hereto resulting from such disclosure, including, but not limited to court costs and attorneys' fees on the trial court and any appellate levels. 14.15 Liens Unimpaired. The parties hereby agree that the execution of this Agreement will not discharge, interrupt, impair, abate or otherwise modify the priority or validity of any lien or security interest securing payment of the obligations or indebtedness evidenced and secured by any of the Loan Documents. The parties further agree that in all respects, the Note, the Mortgage and all other Loan Documents remain in full force and effect and unabated and Gales Associates hereby reaffirms its obligations under the Loan Documents. At such time as the Third Note and Mortgage Modification Agreement and related Loan Documents are satisfied of record, Aetna will deliver the original and Restated Renewal Note marked "Paid and Cancelled" to Gales Associates. 14.16 No Third Party Beneficiaries. The parties hereto, for themselves and their heirs, personal representatives, successors and assigns agree that there are no third party beneficiaries to this Agreement, any exhibits attached hereto or any document referenced herein. Nothing in this Agreement or in any of the documents references herein or to be executed in connection herewith, whether expressed or implied, is intended to confer any rights or remedies on any persons, entities or associations other than the parties to this Agreement, nor is anything in this Agreement or in any of the documents referenced herein or to be executed in connection herewith intended to relieve or discharge the obligation or liability of any third persons or (except as expressly provided to the contrary herein) any party to this Agreement or any of the documents referenced herein or to be executed in connection herewith which survives the execution of this Settlement Agreement. 14.17 No Admission. The undersigned agree that the actions by the parties hereto do not constitute an admission of liability by any party hereto, and that the payment being made and value being tendered constitutes simply the compromise of doubtful and disputed claims. 14.18 Advice of Counsel. By their execution of this Agreement, or any and all counterparts thereof, each of the parties does hereby expressly acknowledge that they have executed the same freely and voluntarily and they have had advice of counsel of their choice, accountants and financial advisors regarding the effect of the execution and delivery of this Agreement or a counterpart of it and the originals or counterparts of the documents attached hereto as exhibits. It is understood and agreed by the parties hereto that the monetary facts with respect to which this Agreement is made may hereafter prove to be different from the monetary facts now known by the parties hereto or any of them or believed by any of them to be true. Each of the parties hereto expressly accepts and assumes the risk of the monetary facts proven to be so different, and each of the parties hereto agrees that all terms, covenants, and conditions of this Agreement are in all respects effective and not subject to termination or rescission by any such difference in such monetary facts. 14.19 Benefit of Agreement. All of the terms, covenants, conditions, agreements, and undertakings contained in this Agreement and in the exhibits attached hereto have been made by the undersigned solely and exclusively for their benefit, and no other person, corporation or entity shall, under any circumstances, be deemed to be a beneficiary, including an incidental or third party beneficiary, of such terms, covenants, conditions, agreements, and undertakings. 14.20 Effective Date. The effective date of this Settlement Agreement shall be the date this Settlement Agreement has been executed by the last party required to execute this Settlement Agreement or any counterpart thereof (the "Effective Date"). 14.21 Tolling Agreement. In the event that Aetna, in its sole discretion, deems it necessary or desirable to hereafter file an action to collect upon or enforce any of the Loan Documents, Gables Associates expressly agrees to and does hereby waive any right or privilege to object or raise any defense to such an action based, in whole or in part, upon the passage of time, including, without limitation, any statute of limitation or the equitable doctrine of laches, and Gables Associates does hereby further agree not to plead or assert any defense or objection in such action based, in whole or in part, upon the passage of time, including, without limitation, any statute of limitation or the equitable doctrine of laches. Notwithstanding anything to the contrary in this Agreement, the provisions of this paragraph 14.21 shall survive the Closing and any termination of this Agreement and shall remain in full force and effect for a period of seven (7) years from the date of this Agreement. 14.22 Waiver of Bankruptcy Stay. Gables Associates hereby agrees that it shall consent, and shall not oppose, any request by Aetna for relief of stay in the event that it seeks relief under the United States Bankruptcy Code at any time after executing this Agreement. Notwithstanding anything to the contrary in this Agreement, the provisions of this paragraph 14.22 shall survive the Closing and any termination of this Agreement and shall remain in full force and effect for a period of seven (7) years from the date of this Agreement. 14.23 Foreclosure Action. Gables Associates agrees that Aetna may, at any time after April 30, 1993, file its foreclosure action to enforce the Loan Documents against the Property, as well s the Plaintiff's Verified Motion for Appointment of Receiver and Alternatively for Sequestration of Rents attached hereto as Exhibit W and made a part hereof. Gables Associates, Gables Limited and Carlyle Real Estate Limited Partnership - XIII, an Illinois limited partnership hereby designate Brian L. Bilzin, Esquire of the law firm of Rubin, Baum, Levin, et al., 200 South Biscayne Boulevard, Suite 2500, Miami, Florida 33131-2398 as designated and authorized agent to accept service of process and all papers to be filed and served in connection with the above-described foreclosure action, as well as to sign the Stipulation and Joint Motion for Ex Parte Appointment of Receiver, and the Stipulation and Final Judgment of Foreclosure. 14.24 Frustration of Purpose. Gables Associates represents that it will not take any action to thwart, deter, hinder or delay Aetna or its designee from taking title to the Property pursuant to the Special Warranty Deed or otherwise tristrate the purpose of this Agreement. IN WITNESS WHEREOF, the parties have executed this Agreement in multiple original counterparts, each of which shall be deemed to be an original hereof, as of the day and year first written above. Signed, sealed and delivered AETNA LIFE INSURANCE COMPANY in the presence of: a Connecticut corporation S/Marianna Petrocelli By: S/Matilda Alfonso S/ Name: MATILDA ALFONSO Title: VICE PRESIDENT (Corporate Seal) GABLES CORPORATE PLAZA ASSOCIATES, a Florida general partnership Carlyle Real Estate Limited Partnership-XIII, an Illinois limited partnership, general partner By: JMB Realty Corporation, a Delaware corporation, general partner S/Lisa K. McGready By: S/Julie A. Strocchia S/Debra A. Jackson Name: JULIE A. STROCCHIA Title: VICE PRESIDENT Gables Corporate Plaza, Ltd., a Florida limited partnership, general partner S/ By: S/Albert J. Socol Albert J. Socol, general S/ partner S/ By: S/Michael L. Katz Michael L. Katz, general S/ partner GABLES CORPORATE PLAZA, LTD., a Florida limited partnership S/ By: S/Albert J. Socol Albert J. Socol, general S/ partner S/ By: S/Michael L. Katz Michael L. Katz, general S/ partner JDS/4013 Exhibit 21 LIST OF SUBSIDIARIES The Partnership is a partner of Gables Corporate Plaza Associates, a general partnership which holds title to the Gables Corporate Plaza in Coral Gables, Florida. The developer of the property is a partner in the joint venture. The Partnership is a partner of Sherry Lane Associates, a general partnership which holds title to the Sherry Lane Place Office Building in Dallas, Texas. The Partnership is a limited partner of Eastridge Associates Limited Partnership, a limited partnership which holds title to the Eastridge Apartments in Tucson, Arizona. An affiliate of the General Partners of the Partnership is the general partner in the joint venture. The Partnership is a partner of Copley Place Associates, a limited partnership which holds title to Copley Place in Boston, Massachusetts. The developer of the property is a partner in the joint venture. The Partnership is a partner of Carrollwood Station Associates, Ltd., a limited partnership which holds title to the Carrollwood Station Apartments in Tampa, Florida. The developer of the property is a partner in the joint venture. The Partnership is a partner of Jacksonville Cove Associates, Ltd., a limited partnership which holds title to The Glades Apartments in Jacksonville, Florida. The developer of the property is a partner in the joint venture. The Partnership is a 20% shareholder in Carlyle Managers, Inc. and 20% shareholder in Carlyle Investors, Inc. Reference is made to Note 3 for a description of the terms of such joint venture partnerships. The Partnership's interest in the joint ventures and the results of its operations are included in the Consolidated Financial Statements of the Partnership filed with this annual report. POWER OF ATTORNEY KNOW ALL MEN BY THESE PRESENTS, that the undersigned officers and directors of JMB Realty Corporation, the managing general partner of CARLYLE REAL ESTATE LTD. -XIII, do hereby nominate, constitute and appoint GARY NICKELE, GAILEN J. HULL, DENNIS M. QUINN or any of them, attorneys and agents of the undersigned with full power of authority to sign in the name and on behalf of the undersigned officer or directors a Report on Form 10-K of said partnership for the fiscal year ended December 31, 1993, and any and all amendments thereto, hereby ratifying and confirming all that said attorneys and agents and any of them may do by virtue hereof. IN WITNESS WHEREOF, the undersigned have executed this Power of Attorney the 23rd day of March, 1994. JUDD D. MALKIN - ------------------- Chairman and Director Judd D. Malkin NEIL G. BLUHM - ------------------- President and Director Neil G. Bluhm H. RIGEL BARBER - ------------------- Chief Executive Officer H. Rigel Barber JEFFREY R. ROSENTHAL - ----------------------- Chief Financial Officer Jeffrey R. Rosenthal The undersigned hereby acknowledge and accept such power of authority to sign, in the name and on behalf of the above named officer and directors, a Report on Form 10-K of said partnership for the fiscal year ended December 31, 1993, and any and all amendments thereto, the 23rd day of March, 1994. GARY NICKELE ------------ Gary Nickele GAILEN J. HULL --------------- Gailen J. Hull DENNIS M. QUINN --------------- Dennis M. Quinn POWER OF ATTORNEY ----------------- KNOW ALL MEN BY THESE PRESENTS, that the undersigned officer and directors of JMB Realty Corporation, the managing general partner of CARLYLE REAL ESTATE LTD. - XI, do hereby nominate, constitute and appoint GARY NICKELE, GAILEN J. HULL, DENNIS M. QUINN or any of them, attorneys and agents of the undersigned with full power of authority to sign in the name and on behalf of the undersigned officer or directors a Report on Form 10-K of said partnership for the fiscal year ended December 31, 1993, and any and all amendments thereto, hereby ratifying and confirming all that said attorneys and agents and any of them may do by virtue hereof. IN WITNESS WHEREOF, the undersigned have executed this Power of Attorney the 26th day of January, 1994. STUART C. NATHAN _________________________ Executive Vice President and Director of Stuart C. Nathan General Partner A. LEE SACKS _________________________ Director of General Partner A. Lee Sacks The undersigned hereby acknowledge and accept such power of authority to sign, in the name on behalf of the above named officer and directors, a Report on Form 10-K of said partnership for the fiscal year ended December 31, 1993, and any and all amendments thereto, the 26th day of January, 1994. GARY NICKELE ______________________ Gary Nickele GAILEN J. HULL ______________________ Gailen J. Hull DENNIS M. QUINN ___________________________ Dennis M. Quinn

9659_1993.txt

9659

1993

ITEM 1. BUSINESS. General The Registrant is a registered bank holding company, incorporated in Virginia in 1962, and had consolidated assets of $11.8 billion as of December 31, 1993. On the basis of total assets and deposits at December 31, 1993, the Registrant is the second largest banking organization headquartered in Virginia. The Registrant provides interstate financial services through three principal subsidiaries: Signet Bank/Virginia, headquartered in Richmond, Virginia; Signet Bank/Maryland, headquartered in Baltimore, Maryland; and Signet Bank N.A., headquartered in Washington, D.C. The Registrant is engaged in the general commercial and consumer banking business through its three principal bank subsidiaries, which are members of the Federal Reserve System. The bank subsidiaries provide financial services through banking offices located throughout Virginia, Maryland and Washington, D.C. and a 24-hour full-service Telephone Banking Center. Signet is a major issuer of credit cards nationwide, offering a broad spectrum of card products designed to meet the unique needs of differing market segments. Signet Bank/Virginia owns a commercial bank operating in the Bahamas. International banking operations are conducted through foreign branches of Signet Bank/Virginia and Signet Bank/Maryland. Service subsidiaries are engaged in writing insurance in connection with the lending activities of the banks and bank-related subsidiaries and owning real estate for banking premises. Other subsidiaries are engaged in trust operations, various kinds of lending and leasing activities, insurance agency activities, mortgage lending, certain investment banking activities and broker and dealer activities relating to certain phases of the domestic securities business. As of December 31, 1993, the Registrant and its subsidiaries employed 5,753 full-time and 1,386 part-time employees. Domestic Banking Operations Signet Bank/Virginia, incorporated under the laws of Virginia, had assets of $9.0 billion at December 31, 1993. Signet Bank/Maryland, incorporated under the laws of Maryland, had assets of $3.2 billion at December 31, 1993. Signet Bank N.A., incorporated under the laws of the United States, had assets of $624 million at December 31, 1993. The bank subsidiaries provide all customary banking services to businesses and individuals. Domestic Trust Operations Trust operations are administered by Signet Trust Company, a subsidiary of the Registrant which presently operates four offices in Virginia, one office in Maryland and one office in Washington, D.C. International Banking Operations International banking operations are conducted through Signet Bank/Maryland's and Signet Bank/Virginia's international divisions and through Signet Bank (Bahamas), Ltd., a subsidiary of Signet Bank/Virginia. Signet Bank/Virginia and Signet Bank/Maryland also conduct international banking operations through foreign branches located in the Bahamas and Cayman Islands, respectively. International banking is subject to special risks such as exchange controls and other regulatory or political policies of governments, both foreign and domestic. Currency devaluation is an additional risk of international banking; however, substantially all of the Registrant's international assets are repayable in U.S. dollars. Domestic Bank-Related Activities Signet Commercial Credit Corporation, a wholly-owned subsidiary of the Registrant, is engaged in bank-related activities in the United States. It makes loans that are often secured by inventory, accounts receivable or like security and are generally structured on a revolving basis. Signet Insurance Services, Inc. and Signet Insurance Services, Inc./Maryland, wholly-owned subsidiaries of the Registrant, provide, as agents, a full line of life and property/casualty insurance coverage for both individuals and business enterprises. Signet Mortgage Corporation, a wholly-owned subsidiary of Signet Bank/Virginia, engages in the business of originating, servicing, and selling mortgage loans. Signet Leasing and Financial Corporation, a wholly-owned subsidiary of Signet Bank/Maryland, engages in diversified equipment lease financing activities (excluding passenger automobiles) for commercial customers primarily in Maryland and the Mid-Atlantic region. Signet Financial Services, Inc., formerly Signet Investment Corporation, a wholly-owned subsidiary of the Registrant, acts as a broker and dealer in certain phases of the domestic securities business. Signet Investment Banking Company, a wholly-owned subsidiary of the Registrant, is engaged in certain investment banking activities. Competition The Registrant is subject to substantial competition in all phases of its business. Its banks compete not only with other commercial banks but with other financial institutions, including brokerage firms, savings and loan associations and savings banks, credit unions, consumer loan companies, finance companies, insurance companies and certain governmental agencies. The Registrant's non-banking subsidiaries also operate in highly competitive fields and compete with organizations substantially larger than themselves. See "Regulation" below for a discussion of legislation which has increased competition in the markets served by the Registrant. Government Policy The earnings of the Registrant are affected not only by general economic conditions but also by the policies of various governmental regulatory authorities. In particular, the Federal Reserve System regulates money and credit conditions in order to influence general economic conditions, primarily through open market transactions in U.S. Government securities, varying the discount rate on member bank borrowings and setting reserve requirements against member bank deposits. These policies have a significant influence on overall growth and distribution of bank loans, investments and deposits, and affect interest rates charged on loans or paid for time and savings deposits. Federal Reserve monetary policies have had a significant effect on the operating results of commercial banks in the past and are expected to continue to do so in the future. The Registrant cannot accurately predict the effect such policies may have in the future on its business and earnings. Capital Guidelines The Board of Governors of the Federal Reserve System (the "Federal Reserve Board") has adopted final risk-based capital guidelines for bank holding companies. The minimum guidelines for the ratio of capital to risk- weighted assets (including certain off-balance-sheet activities, such as standby letters of credit) is 8 percent. At least half of the total capital must be composed of common equity, retained earnings and qualifying perpetual preferred stock less disallowed intangibles, including goodwill ("Tier I capital"). The remainder may consist of qualifying subordinated debt, other preferred stock and a limited amount of the loan loss allowance. At December 31, 1993, the Registrant's Tier I and total capital ratios were 11.12 percent and 15.02 percent, respectively. In addition, the Federal Reserve Board has established minimum leverage ratio guidelines for bank holding companies. These guidelines provide for a minimum leverage ratio of Tier I capital to adjusted average quarterly assets equal to 3 percent for bank holding companies that meet certain specified criteria, including that they have the highest regulatory rating. All other bank holding companies are generally required to maintain a leverage ratio of 3 percent plus an additional cushion of at least 100 to 200 basis points. The Registrant's leverage ratio at December 31, 1993 was 8.13 percent. The guidelines also provide that bank holding companies experiencing internal growth or making acquisitions will be expected to maintain strong capital positions substantially above the minimum supervisory levels without significant reliance on intangible assets. Furthermore, the Federal Reserve Board has indicated that it will continue to consider a "tangible Tier I leverage ratio" (deducting all intangibles) in evaluating proposals for expansion or new activities. Each of the Registrant's subsidiary banks is subject to similar capital requirements adopted by the appropriate federal bank regulator. Following are the capital ratios for the Company's three principal subsidiaries at December 31, 1993: Ratio Signet Bank/Virginia Signet Bank/Maryland Signet Bank N.A. Tier I 9.26% 10.82% 19.28% Total Capital 11.74 13.38 20.57 Leverage 6.84 6.75 9.02 Failure to meet capital guidelines could subject a national or state member bank to a variety of enforcement remedies, including the termination of deposit insurance by the FDIC and a prohibition on the taking of brokered deposits. Bank regulators continue to indicate their desire to raise capital requirements applicable to banking organizations beyond current levels. However, management is unable to predict whether and when higher capital requirements would be imposed and, if so, at what levels and on what schedule. For further discussion, refer to the portions of the 1993 Annual Report to Shareholders incorporated by reference herein (Exhibit 13.1). Supervision Signet Bank/Virginia and Signet Bank/Maryland are supervised and regularly examined by the Federal Reserve Board and by the Bureau of Financial Institutions of the Virginia State Corporation Commission or the Maryland Bank Commissioner. Signet Bank N.A. is subject to regulation, supervision and examination by the Office of the Comptroller of the Currency. Each of such banking subsidiaries is subject to regulation and examination by the Federal Deposit Insurance Corporation. The Registrant is also subject to examination by the Federal Reserve Board. The Registrant's non-banking subsidiaries are supervised by the Federal Reserve Board. In addition, Signet Insurance Services, Inc. and Signet Insurance Services, Inc./Maryland are subject to insurance laws and regulations of Virginia and Maryland, respectively, and the activities of Signet Financial Services, Inc. are governed by the Securities and Exchange Commission, the National Association of Securities Dealers, Inc. and state securities laws. Regulation The Registrant is registered under the Bank Holding Company Act of 1956, as amended (the "BHC Act"). The BHC Act restricts the activities of the Registrant and requires prior approval of the Federal Reserve Board of any acquisition by the Registrant of more than 5% of the voting shares of any bank or bank holding company, any acquisition of all or substantially all of the assets of a bank and any merger or consolidation with another bank holding company. Under the BHC Act, the Registrant may not acquire any domestic bank located outside of Virginia unless such acquisition is specifically authorized by statute in the state where the bank is located. (See the discussion of interstate banking legislation below.) The BHC Act also prohibits the Registrant from engaging in any business in the United States other than that of managing or controlling banks or businesses closely related to banking, or of furnishing services to or performing services for subsidiaries and, with certain limited exceptions, from acquiring more than 5% of the voting shares of any company. The Federal Reserve Board generally follows a restrictive policy in permitting the entry of bank holding companies and other bank affiliates into domestic and foreign bank-related activities. Further, under Section 106 of the 1970 Amendments to the BHC Act and the Federal Reserve Board's regulations, a bank holding company and its subsidiaries are prohibited from engaging in certain tie-in arrangements in connection with any extension of credit or provision of any property or service. Federal law imposes limitations on the ability of the Registrant and its subsidiaries to engage in certain phases of the domestic securities business. The Registrant is a bank holding company and is a legal entity separate and distinct from its banking and other subsidiaries. The principal sources of the Registrant's revenues are interest income derived from loans to and deposits in subsidiaries and dividends the Registrant receives from its subsidiaries. The right of the Registrant to participate as a shareholder in any distribution of assets of any subsidiary upon its liquidation or reorganization or otherwise is subject to the prior claims of creditors of any such subsidiary. Signet Bank/Virginia, Signet Bank/Maryland and Signet Bank N.A. are subject to claims by creditors for long-term and short-term debt obligations, including substantial obligations for federal funds purchased and securities sold under repurchase agreements, as well as deposit liabilities. There are also a number of federal and state legal limitations on the extent to which Signet Bank/Virginia, Signet Bank/Maryland and Signet Bank N.A. may pay dividends or otherwise supply funds to the Registrant or its affiliates. The prior approval of the appropriate federal bank regulator is required if the total of all dividends declared by a national bank or state member bank in any calendar year will exceed the sum of such bank's net profits, as defined by the regulators, for the year and its retained net profits for the preceding two calendar years. In addition, a dividend may not be paid in excess of a bank's undivided profits then on hand, after deducting losses and bad debts in excess of the allowance for loan and lease losses. The payment of dividends by the Registrant and its banking subsidiaries may also be affected or limited by other factors, such as the requirement to maintain adequate capital above regulatory minimums. In addition, the appropriate federal regulatory authority is authorized to determine under certain circumstances relating to the financial condition of a national bank, a state member bank or a bank holding company that the payment of dividends would be an unsafe or unsound practice and to prohibit payment thereof. The payment of dividends that deplete a bank's capital base could be deemed to constitute such an unsafe or unsound practice. The Federal Reserve Board and the Office of the Comptroller of the Currency have each indicated that banking organizations should generally pay dividends only out of current operating earnings. Under applicable regulatory restrictions, all of the Registrant's banking subsidiaries were able to pay dividends to the Registrant as of January 1, 1994. Under federal law, Signet Bank/Virginia, Signet Bank/Maryland and Signet Bank N.A. may not, subject to certain limited exceptions, make loans or extensions of credit to, or investments in the securities of, the Registrant or any non-bank subsidiary or take their securities as collateral for loans to any borrower. In addition, federal law requires that certain transactions between Signet Bank/Virginia, Signet Bank/Maryland and Signet Bank N.A. and their affiliates, including sales of assets and furnishing of services, must be on terms that are at least as favorable to the banks as those prevailing in transactions with independent third parties. Signet Bank/Virginia, Signet Bank/Maryland and Signet Bank N.A. are subject to various statutes and regulations relating to required reserves, investments, loans, acquisitions of fixed assets, interest rates payable on deposits, requirements for meeting community credit needs, transactions among affiliates and the Registrant, mergers and consolidations, and other aspects of their operations. Virginia, Maryland and the District of Columbia have each adopted interstate banking statutes under which bank holding companies located in certain other states (primarily Southeastern states) may acquire banks or bank holding companies located in Virginia, Maryland or the District of Columbia, as applicable, provided the laws of the state in which the bank holding company making the acquisition has its principal place of business permit bank holding companies located in Virginia, Maryland or the District of Columbia, as applicable, to acquire banks and bank holding companies in that state. In addition, a number of other states have adopted interstate banking statutes that permit bank holding companies located in Virginia, Maryland or the District of Columbia to acquire out-of-state banks or bank holding companies, either on a reciprocal basis or without regard to reciprocity. Many of these statutes, and many of the interstate banking statutes referred to above, contain provisions which could restrict acquisitions by the Registrant of out-of-state banks or bank holding companies and, conversely, acquisitions of the Registrant by out-of-state banks or bank holding companies. On February 23, 1994, the Virginia General Assembly passed legislation which amends Virginia's interstate banking statutes to allow Virginia bank holding companies to acquire banking institutions located in any state with reciprocal national banking laws and out-of-state bank holding companies to acquire Virginia banking institutions if the laws of the out-of-state bank holding company's home state permit acquisitions of banking institutions in that state by Virginia bank holding companies under the same conditions. The new legislation has not yet been signed by the Governor of Virginia. If signed by the Governor, it will become effective July 1, 1994. Other provisions of Maryland law affect the competitive posture of Maryland banks. Under Maryland law, an out-of-state bank holding company, regardless of location, may establish new banks in Maryland that may compete generally with Maryland banks, provided certain capital investment and employment requirements are met and, unless otherwise waived, the out-of- state bank holding company agrees to locate the headquarters of the new Maryland bank in a designated enterprise zone. Maryland law allows branching, subject to regulatory approval. Virginia law provides that a bank may establish new branches, subject to regulatory approval, anywhere in the state. District of Columbia law allows branching by District of Columbia banks within the District, subject to regulatory approval. The Financial Institutions Reform, Recovery, and Enforcement Act of 1989 ("FIRREA"), enacted August 9, 1989, contains a number of provisions which directly or indirectly affect the activities of federally insured national and state-chartered commercial banks. FIRREA made a number of important changes in the deposit insurance system. FIRREA established separate insurance funds for banks (the Bank Insurance Fund ("BIF")) and savings associations (the Savings Association Insurance Fund) to be managed by the Federal Deposit Insurance Corporation (the "FDIC"). All national and state-chartered commercial banks that were insured by the FDIC at the time of the enactment of FIRREA were automatically insured by BIF. FIRREA allows the FDIC to recover from a depository institution for any loss or anticipated loss to the FDIC that results from the default of a commonly controlled insured depository institution or from assistance provided to such an institution. Signet Bank/Virginia, Signet Bank/Maryland and Signet Bank N.A. are commonly controlled for purposes of this provision. The FDIC's claim for loss reimbursement under the "cross-guaranty" provisions is superior to any claims of shareholders of the liable institution or any claims of affiliates of such institution (other than claims on secured debt that existed as of May 1, 1989). The FDIC's claim is subordinate to the claims of depositors, third party secured creditors, senior and general creditors and holders of subordinated debt other than affiliates. FIRREA gives the Federal Reserve Board specific authority to permit the acquisition of healthy, as well as failing, savings associations by a bank holding company under the BHC Act. FIRREA enhances the enforcement powers of the federal banking regulators, increases the penalties for violations of law and substantially revises and codifies the powers of receivers and conservators of depository institutions. The receivership and conservatorship provisions of FIRREA include a statutory claims procedure and provisions which confirm the powers of the FDIC to obtain a stay of pending litigation and to repudiate certain contracts or leases. The Crime Control Act of 1990, enacted November 29, 1990, also contains a number of provisions which enhance the enforcement powers of the federal banking regulators and increase the penalties for violations of law. Under the National Bank Act, if the capital stock of a national bank, such as Signet Bank N.A., is impaired by losses or otherwise, the Office of the Comptroller of the Currency is authorized to require payment of the deficiency by assessment upon the bank's shareholders, prorata, and to the extent necessary, if any such assessment is not paid by any shareholder after three months notice, to sell the stock of such shareholder to make good the deficiency. Under Federal Reserve Board policy, the Registrant is expected to act as a source of financial strength to each of its subsidiary banks and to commit resources to support each of such subsidiaries. This support may be required at times when, absent such Federal Reserve Board policy, the Registrant may not find itself able to provide it. The Registrant's subsidiary banks are subject to FDIC deposit insurance assessments. FIRREA requires that the FDIC reach an insurance fund reserve for the BIF of $1.25 for every $100 of insured deposits. If the reserve ratio of the BIF is less than the designated reserve ratio, the FDIC is required to set assessment rates sufficient to increase the ratio to the required ratio, and is authorized to impose special additional assessments. A significant increase in the assessment could have an adverse impact on the Registrant's results of operations. See discussion below under Federal Deposit Insurance Corporation Improvement Act of 1991 ("FDICIA"), for further information on the risk-based insurance assessment system adopted by the FDIC. In December 1991, FDICIA was enacted. FDICIA substantially revises the bank regulatory and funding provisions of the Federal Deposit Insurance Act and makes revisions to several other federal banking statutes. FDICIA requires the federal banking agencies to take "prompt corrective action" with depository institutions that do not meet minimum capital requirements. FDICIA establishes five capital tiers: "well capitalized", "adequately capitalized", "undercapitalized", "significantly undercapitalized" and "critically undercapitalized". A depository institution's capital tier depends upon where its capital levels are in relation to various relevant capital measures, which include a risk-based capital measure and a leverage ratio capital measure, and certain other factors. As of December 31, 1993, all three of the Registrant's banks met the "well capitalized" criteria. A depository institution is well capitalized if it significantly exceeds the minimum level required by regulation for each relevant capital measure, adequately capitalized if it meets each such measure, undercapitalized if it fails to meet any such measure, significantly undercapitalized if it is significantly below any such measure and critically undercapitalized if it fails to meet any critical capital level set forth in regulations. The critical capital level must be a level of tangible equity equal to not less than two percent of total assets and not more than 65 percent of the minimum leverage ratio to be prescribed by regulation (except to the extent that two percent would be higher than such 65 percent level). An institution may be deemed to be in a capitalization category that is lower than is indicated by its actual capital position if, among other things, it receives an unsatisfactory examination rating. FDICIA generally prohibits a depository institution from making any capital distribution (including payment of a dividend) or paying any management fee to its holding company if the depository institution would thereafter be undercapitalized. Undercapitalized depository institutions are subject to restrictions on borrowing from the Federal Reserve System. In addition, undercapitalized depository institutions are subject to growth limitations and are required to submit a capital restoration plan. The federal banking agencies may not accept a capital plan without determining, among other things, that the plan is based on realistic assumptions and is likely to succeed in restoring the depository institution's capital. For a capital restoration plan to be acceptable, the depository institution's parent holding company must guarantee that the institution will comply with such capital restoration plan. The aggregate liability of the parent holding company is limited to the lesser of (i) an amount equal to 5 percent of the depository institution's total assets at the time it became undercapitalized and (ii) the amount which is necessary (or would have been necessary) to bring the institution into compliance with all capital standards applicable with respect to such institution as of the time it fails to comply with the plan. If a depository institution fails to submit an acceptable plan, it is treated as if it is significantly undercapitalized. Significantly undercapitalized depository institutions may be subject to a number of requirements and restrictions, including orders to sell sufficient voting stock to become adequately capitalized, requirements to reduce total assets, and cessation of receipt of deposits from correspondent banks. Critically undercapitalized institutions are subject to the appointment of a receiver or conservator. Under FDICIA, an institution that is not well capitalized is generally prohibited from accepting brokered deposits and offering interest rates on deposits higher than the prevailing rate in its market. In addition, "pass through" insurance coverage may not be available for certain employee benefit accounts. FDICIA restated Section 22(h) of the Federal Reserve Act, a statutory provision which, among other points, restricts the amounts and terms of extensions of credit which may be made by a bank to its executive officers, directors, principal shareholders (collectively, "insiders"), and to their related interest. In addition to limitations previously in place, FDICIA requires a bank, when lending to insiders, to follow credit underwriting procedures that are not less stringent than those applicable to comparable transactions by the bank with persons outside the bank. Directors and their related interests are now subject to the same aggregate lending limits previously applicable to executive officers and their principal shareholders and their related interests; further, the amount a bank can lend in the aggregate to insiders, and to their related interests, is limited to an amount equal to the bank's unimpaired capital and surplus. Insiders are also prohibited from knowingly receiving, or knowingly permitting their related interests to receive, any extension of credit not authorized by Section 22(h) of the Federal Reserve Act. Under FDICIA, each insured depository institution will be required to submit annual financial statements to the FDIC, its primary federal regulatory, and any appropriate state banking supervisor and a report signed by the chief executive officer and chief accounting or financial officer which contains (i) a statement of management's responsibilities for preparing financial reports, establishing and maintaining an adequate internal control structure, and complying with laws and regulations relating to safety and soundness, and (ii) an assessment of the effectiveness of such structures and compliance effort. The institution's independent public accountant will then be required to attest to and report separately on the assertions of the institution's management. Under FDICIA, the appropriate federal banking agencies have issued regulations requiring insured depository institutions to have annual independent audits (which can be performed only by accounting firms which have, among other points, agreed to provide related working papers, policies and procedures to the FDIC, and the appropriate federal and state banking authorities, if so requested). In the case of institutions that are subsidiaries of holding companies, the audit requirement can be met by an audit of the holding company. The accountants must issue reports in compliance with generally accepted accounting principles and FDICIA. The scope of the audit shall include a review of whether the financial statements of the institution are presented fairly in accordance with generally accepted accounting principles and whether they comply with such other disclosure requirements as the federal banking agencies may prescribe. Also, the accountants must apply procedures agreed upon by the FDIC to determine objectively if an institution is in compliance with laws and regulations. Institutions are required to provide their accountants copies of reports of condition, examination reports, and information concerning any agency enforcement actions. Copies of the accounting firm reports are to be provided to the FDIC and the appropriate federal banking agency. Each insured depository institution will be required to have an independent audit committee made up entirely of outside directors who are independent of management of the institution and who satisfy any specific requirements the FDIC may establish. Their duties are to include review of the various new reports required under FDICIA. In the case of any insured depository institution which the FDIC determines to be a "large institution", the audit committee must include members with banking or related financial expertise. Also, in the case of such large institutions, the committee must have access to its own outside counsel, and may not include any large customers of the institution. There are certain exemptions for institutions that are part of a holding company structure, but the institution must have total assets of less than $9 billion, and an examination rating of 1 or 2. FDICIA amends the Federal Deposit Insurance Act by inserting a new provision concerning accounting objectives, standards, and requirements. Among other matters, the federal banking agencies are required to: (i) review the accounting principles used by depository institutions in preparing financial reports required to be filed with a federal banking agency and related matters with respect to such reports; (ii) modify or eliminate any accounting principles or reporting requirements which are inconsistent with FDICIA's objectives of effective supervision, prompt corrective action, and increased accuracy of financial statements; (iii) prescribe regulations which require that all assets and liabilities, including contingent assets and liabilities, of insured depository institutions be reported in, or otherwise taken into account of, in the preparation of any balance sheet, financial statement, report of condition, or other report required to be filed with the federal banking agency; and (iv) develop jointly with the other appropriate federal banking agencies, a method for insured depository institutions to provide supplemental disclosure of the estimated fair market value of assets and liabilities, to the extent feasible and practical, in any such reports. All financial reports and statements are to be prepared in accordance with generally accepted accounting principles, except that each federal banking agency has the power to implement more stringent procedures in certain instances. FDICIA also imposes certain operational and managerial standards on financial institutions relating to internal controls, loan documentation, credit underwriting, interest rate exposure, asset growth, and compensation, fees and benefits. FDICIA also imposes new restrictions on activities and investments of insured state banks, and prescribes limitations on risks posed by exposure of insured banks to other depository institutions, including adoption of policies to limit overnight credit exposures to correspondent banks. FDICIA requires the federal banking regulators to adopt rules prescribing certain safety and soundness standards for insured depository institutions and their holding companies. Proposed regulations implementing these standards to cover operations and management, asset quality and earnings, and employee compensation are pending adoption. The standards are intended to enable the regulatory agencies to address problems at depository institutions and holding companies before the problems cause significant deterioration in the financial condition of the institution. The proposal would establish the objectives of proper operations and management, but would leave specific methods for achieving those objectives to each institution. FDICIA set forth a new Truth in Savings Act. The Federal Reserve Board has adopted regulations implementing the Truth in Savings Act. A variety of significant new disclosure requirements are imposed concerning interest rates and terms of deposit accounts. A requirement is also imposed that interest paid on interest-bearing accounts must be calculated on the full amount of principal, as opposed to on only non-reservable balances. Under FDICIA, the federal banking agencies adopted regulations providing standards for extensions of credit that are secured by liens on interest in real estate or made for the purpose of financing the construction of building or other improvements of real estate. In prescribing standards, the agencies are to consider the risk posed to the deposit insurance fund, the need for safe and sound operation of depository institutions, and the availability of credit. Under FDICIA, the FDIC adopted a risk-based insurance assessment system for implementation January 1, 1994 that evaluates an institution's potential for causing a loss to the insurance fund and to base deposit insurance premiums upon individual bank profiles. A transitional risk-based assessment system was in place during 1993. There were no significant changes between the transitional system and the final regulation. Under the risk-based assessment system, each institution pays FDIC insurance premiums within a range from 23 cents to 31 cents per $100 of deposits, depending on the institution's capital adequacy and a supervisory judgment of overall risk. As of December 31, 1993, all three of the registrant's banks pay the lowest FDIC insurance premium, 23 cents per $100 of deposits. From time to time, various legislative proposals are submitted to and considered by Congress concerning the banking industry. Recent legislative initiatives have included, among other things, proposals to reform deposit insurance, limit the investments that a depository institution may make with insured funds, eliminate restrictions on interstate banking, expand the powers of banking organizations to enter into new financial service industries and revise the structure of the Bank regulatory system. The Registrant cannot determine the ultimate effect that FDICIA and the implementing regulations adopted or to be adopted thereunder, or any potential legislation, if enacted, would have upon its financial condition or operations. Executive Officers of the Registrant The following table sets forth information with respect to the Registrant's executive officers: Names, Positions and Offices With Registrant During Last An Officer of the Five Years Age Registrant Since Robert M. Freeman 52 1978 Chairman and Chief Executive Officer. Prior to April, 1990, he was President and Chief Executive Officer. Prior to April, 1989, he was President and Chief Operating Officer. Malcolm S. McDonald 55 1982 President and Chief Operating Officer. Prior to April 1990, he was Vice Chairman. David L. Brantley 44 1988 Senior Vice President and Treasurer. Prior to August, 1988, he was Managing Director of Signet Investment Banking Company. Robert L. Bryant 43 1990 Executive Vice President. Prior to February, 1990, he was Senior Vice President, Signet Bank/Virginia. George P. Clancy, Jr. 51 1988 Senior Executive Vice President. Philip H. Davidson 49 1977 Executive Vice President. T. Gaylon Layfield, III 42 1988 Senior Executive Vice President. Robert J. Merrick 48 1984 Executive Vice President and Chief Credit Officer. Wallace B. Millner, III 54 1971 Senior Executive Vice President and Chief Financial Officer (Principal Financial Officer). Names, Positions and Offices With Registrant During Last An Officer of the Five Years Age Registrant Since Andrew T. Moore, Jr. 53 1972 Senior Vice President and Corporate Secretary. David S. Norris 55 1973 Executive Vice President and Controller (Principal Accounting Officer). Anthony Torentinos 45 1993 Executive Vice President and Officer in charge of Human Resources Kenneth H. Trout 45 1990 Senior Executive Vice President. Prior to May, 1991, he was an Executive Vice President. Prior to July, 1990, he was Executive Vice President, Signet Bank N.A. Sara R. Wilson 43 1980 Executive Vice President and General Counsel. Prior to January, 1994, she was Senior Vice President and Senior Corporate Counsel Randolph W. Wyckoff 46 1989 Executive Vice President. There are no family relationships (as defined in the applicable regulations) among the above listed officers. The executive officers of the Registrant are elected to serve until the next organizational meeting of the board of directors of the Registrant following the next annual meeting of the stockholders of the Registrant and until their successors are elected. Statistical Information The statistical information required by Item 1 is in the Registrant's Annual Report to its shareholders for the year ended December 31, 1993, and is incorporated herein by reference, as follows: Page in the Registrant's Annual Report to its shareholders for Guide 3 Disclosure the year ended December 31, 1993 I. Distribution of Assets, Liabilities and Stockholders' Equity; Interest Rates and Interest Differential A. Average Balance Sheet 30 & 31 B. Net Interest Earnings Analysis 30 & 31 C. Rate/Volume Analysis 23 II. Investment Portfolio A. Book Value of Investment Securities 59 B. Maturities of Investment Securities 32 C. Investment Securities Concentrations 33 III. Loan Portfolio A. Types of Loans 33 B. Maturities and Sensitivities of Loans to Changes in Interest Rates 34 C. Risk Elements 1. Nonaccrual, Past Due and Restructured Loans 36, 37 & 38 2. Potential Problem Loans 38 3. Foreign Outstandings Not Applicable 4. Loan Concentrations 33 D. Other Interest Bearing Assets Not Applicable IV. Summary of Loan Loss Experience A. Analysis of Allowance for Loan Losses 25 B. Allocation of the Allowance for Loan Losses 26 V. Deposits A. Average Balances 30 & 31 B. Maturities of Large Denomination Certificates 41 C. Foreign Deposit Liability Disclosure 41 VI. Return on Equity and Assets A. Return on Assets 22 B. Return on Equity 22 C. Dividend Payout Ratio 42 D. Equity to Assets Ratio 22 VII. Short-Term Borrowings 61 & 62 ITEM 2.

ITEM 2. PROPERTIES. The executive offices of the Registrant and Signet Bank/Virginia are located at 7 N. Eighth St., Richmond, Virginia, in a building owned by a subsidiary of the Registrant. The Registrant's main operations center and its bank card center are located in Henrico County, Virginia, in two office buildings owned by a subsidiary of Signet Bank/Virginia. The principal offices of Signet Bank/Maryland are located at 7 St. Paul St., Baltimore, Maryland. The principal offices of Signet Bank N.A. are located at 1130 Connecticut Ave. N.W., Washington, D.C. The principal offices of Signet Bank/Maryland and Signet Bank N.A. are leased. Of the 239 domestic banking locations, 104 are owned by subsidiaries of the Registrant, of which one is subject to mortgage indebtedness of approximately $691,000. The remaining 135 banking locations and offices of other subsidiaries are leased for various terms at an aggregate annual rent of approximately $19,426,000, of which approximately $4,690,000 is for Signet Bank/Maryland's principal offices. ITEM 3.

ITEM 3. LEGAL PROCEEDINGS. The Registrant and its subsidiaries are parties plaintiff or defendant to numerous suits arising out of the collection of loans and the enforcement or defense of the priority of its security interests. Management believes that the pending actions against the Registrant or its subsidiaries, both individually and in the aggregate, will not have a material adverse effect on the financial condition or future operations of the Registrant. ITEM 4.

ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS. None. PART II ITEM 5.

ITEM 5. MARKET FOR REGISTRANT'S COMMON STOCK AND RELATED STOCKHOLDER MATTERS. The information required by Item 5 is included in the Registrant's Annual Report to its shareholders for the year ended December 31, 1993 on page 81 under the heading "Selected Quarterly Financial Data" and on page 67 in Note L, and is incorporated herein by reference. ITEM 6.

ITEM 6. SELECTED FINANCIAL DATA. The information required by Item 6 is included in the Registrant's Annual Report to its shareholders for the year ended December 31, 1993 on pages 22 and 42 under the headings "Selected Financial Data" and "Risk-Based and Other Capital Data", respectively, and is incorporated herein by reference. ITEM 7.

ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS. The information required by Item 7 is included in the Registrant's Annual Report to its shareholders for the year ended December 31, 1993 on pages 21_51 under the heading "Management's Discussion and Analysis of Financial Condition and Results of Operations", and is incorporated herein by reference. ITEM 8.

ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA. The information required by Item 8 is included in the Registrant's Annual Report to its shareholders for the year ended December 31, 1993 on pages 52_76 under the heading "Signet Banking Corporation Consolidated Financial Statements" and on page 81 under the heading "Selected Quarterly Financial Data", and is incorporated herein by reference. ITEM 9.

ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE. None. PART III ITEM 10.

ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT. The information required by Item 10 as to the directors of the Registrant is included in the Registrant's 1994 Proxy Statement on pages 2_5 under the headings "Election of Directors" and "Other Directorships", and is incorporated herein by reference. The information required by Item 10 as to the executive officers of the Registrant is included in Item 1 under the heading "Executive Officers of the Registrant". ITEM 11.

ITEM 11. EXECUTIVE COMPENSATION. The information required by Item 11 is included in the Registrant's 1994 Proxy Statement on pages 8_13 under the headings "Compensation of the Board" and "Executive Compensation", and is incorporated herein by reference. Information under the headings "Organization and Compensation Committee Report on Executive Compensation" and "Performance Graph" in the Registrant's 1994 Proxy Statement is not incorporated herein by reference. ITEM 12.

ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT. The information required by Item 12 is included in the Registrant's 1994 Proxy Statement on pages 1, 5 and 6 under the headings "Proxy Statement" and "Stock Ownership", and is incorporated herein by reference. ITEM 13.

ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS. The information required by Item 13 is included in the Registrant's 1994 Proxy Statement on pages 6 and 7 under the heading "Transactions", and is incorporated herein by reference. PART IV ITEM 14.

ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K (a) (1) The following consolidated financial statements of Signet Banking Corporation and Subsidiaries, included in the Registrant's Annual Report to its shareholders for the year ended December 31, 1993, are incorporated herein by reference in Item 8: Consolidated Balance Sheet - December 31, 1993 and 1992 Statement of Consolidated Operations - Years ended December 31, 1993, 1992 and 1991 Statement of Consolidated Cash Flows - Years ended December 31, 1993, 1992 and 1991 Statement of Changes in Consolidated Stockholders' Equity - Years ended December 31, 1993, 1992 and 1991 Notes to Consolidated Financial Statements Report of Ernst & Young, Independent Auditors (2) All schedules are omitted since the required information is either not applicable, not deemed material, or is shown in the respective financial statements or in notes thereto. (3) Exhibits: 3.1 Articles of Incorporation (Incorporated by reference to Exhibit 3.1 to Annual Report on Form 10_K for the fiscal year ended December 31, 1992). 3.2 Bylaws (Filed herewith). 4.1 Indenture dated as of May 1, 1972 Providing for Issuance of Unlimited Senior Debt Securities (Incorporated by reference to Exhibit 4-3 to Registration Statement No. 2-43731). 4.2 First Supplemental Indenture dated as of November 1, 1972 relating to 7 3/4% Senior Debentures due November 1, 1997 (Incorporated by reference to Exhibit 4-5 to Registration Statement No. 2-45986). 4.3 Indenture dated as of September 1, 1970 Providing for Issuance of Unlimited Capital Notes (Incorporated by reference to Exhibit 4-2 to Registration Statement No. 2-37919). 4.4 Indenture dated as of May 1, 1985 relating to $50,000,000 Floating Rate Subordinated Notes due 1997 (Incorporated by reference to Exhibit 4(a) to Registration Statement No. 2-97720). 4.5 Indenture dated as of April 1, 1986 Providing for Issuance of Unlimited Subordinated Debt Securities (Incorporated by reference to Exhibit 4(a) to Registration Statement No. 33-4491). 4.6 Officer's Certificate dated as of April 4, 1986 setting forth the form and terms of $100,000,000 of unsecured floating rate Subordinated Notes due in 1998 (Incorporated by reference to Exhibit 4.11 to Annual Report on Form 10-K for the fiscal year ended December 31, 1989). 4.7 Officers' certificate dated as of May 23, 1989 setting forth the form and terms of $100,000,000 of unsecured 9 5/8% Subordinated Notes due in 1999 (Incorporated by reference to Exhibit 4.12 to Annual Report on Form 10-K for the fiscal year ended December 31, 1989). 4.8 Articles of Amendment, Rights Agreement, Series A Junior Participating Preferred Stock (Incorporated by reference to Exhibit 1 to Current Report on Form 8-K dated May 23, 1989). 10.0 Management Contracts and Compensatory Plans Required to be filed as Exhibits 10.1 Executive Incentive Compensation Plans (2)(Incorporated by reference to Exhibit 10.2 to Annual Report on Form 10-K for the fiscal year ended December 31, 1982). 10.2 Executive Employee Supplemental Retirement Plan (Incorporated by reference to Exhibit 10.4 to Annual Report on Form 10-K for the fiscal year ended December 31, 1988). 10.3 Form of Executive Employment Agreement between the Registrant and David L. Brantley, Robert L. Bryant, George P. Clancy, Jr., Philip H. Davidson, William C. Dieter, Jr., Robert M. Freeman, T.Gaylon Layfield, III, Malcolm S. McDonald, Robert J. Merrick, Wallace B. Millner, III, Andrew T. Moore, Jr., David S. Norris, Anthony Torentinos, Kenneth H. Trout, Sara R. Wilson and Randolph W. Wyckoff (Incorporated by reference to Exhibit 10.8 on Form 10-K for the fiscal year ended December 31, 1989). 10.4 1983 Stock Option Plan (Incorporated by reference to Exhibit A to Proxy Statement for 1983 Annual Meeting of Shareholders). 10.5 1985 Union Trust Bancorp Key Employee Stock Option Plan (Incorporated by reference to Exhibit 10.13 to Annual Report on Form 10-K for the fiscal year ended December 31, 1985). 10.6 Union Trust Bancorp 1985 Restricted Stock Award Plan (Incorporated by reference to Exhibit 10.12 to Annual Report on Form 10-K for the fiscal year ended December 31, 1988). 10.7 1992 Stock Option Plan (Incorporated by reference to Exhibit II to Proxy Statement for 1992 Annual Meeting of Shareholders). 10.8 Executive Employee Excess Savings Plan (Incorporated by reference to Exhibit 10.14 to Annual Report on Form 10-K for the fiscal year ended December 31, 1987). 10.9 Split Dollar Life Insurance Plan and Agreement (Incorporated by reference to Exhibit 10.13 to Annual Report on Form 10-K for the fiscal year ended December 31, 1989). 10.10 Executive Employee Deferred Compensation Plan (Incorporated by reference to Exhibit 10.15 to Annual Report on Form 10-K for the fiscal year ended December 31, 1988). 10.11 1988 Deferred Compensation Plan (Incorporated by reference to Exhibit 10.16 to Annual Report on Form 10- K for the fiscal year ended December 31, 1988). 10.12 Excess Benefit Retirement Plan (Incorporated by reference to Exhibit 10.17 to Annual Report on Form 10- K for the fiscal year ended December 31, 1988). 11.1 Computation of Earnings Per Share (Filed herewith). 13.1 1993 Annual Report to Shareholders (Filed herewith). 22.1 Subsidiaries of the Registrant (Filed herewith). 24.1 Consent of Ernst & Young (Filed herewith). 25.1 Power of Attorney (Filed herewith). (b) Reports on Form 8-K The Registrant filed a Current Report on Form 8_K, dated February 22, 1994, reporting the agreement to merge between Signet Banking Corporation and Pioneer Financial Corporation. SIGNATURES Pursuant to the requirements of Section 13 or 15(d) 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. SIGNET BANKING CORPORATION Date: March 25, 1994 By /s/ D. S. Norris D. S. Norris, Executive Vice President and Controller Pursuant to the requirements of the Securities Exchange Act of 1934, this Report has been signed below by the following persons on behalf of the Registrant and in the capacities indicated on the 25th day of March, 1994. SIGNATURES TITLE Robert M. Freeman* Director, Chairman and Chief Executive Officer (Principal Executive Officer) Malcolm S. McDonald* Director, President and Chief Operating Officer /s/ Wallace B. Millner Senior Executive Vice President and Wallace B. Millner, III Chief Financial Officer (Principal Financial Officer) /s/ D.S. Norris Executive Vice President and Controller D. S. Norris (Principal Accounting Officer) J. Henry Butta* Director SIGNATURES TITLE William C. DeRusha* Director William R. Harvey, Ph.D.* Director Elizabeth G. Helm* Director Robert M. Heyssel, M.D.* Director Henry A. Rosenberg, Jr.* Director Louis B. Thalheimer* Director Stanley I. Westreich* Director *By /s/ Andrew T. Moore Andrew T. Moore, Jr. Attorney-in-Fact EXHIBITS TO SIGNET BANKING CORPORATION ANNUAL REPORT ON FORM 10-K DATED DECEMBER 31, 1993 COMMISSION FILE NO. 1-6505 EXHIBIT INDEX

9534_1993.txt

9534

1993

ITEM 1. BUSINESS All references herein to the "Corporation" or "Bandag" refer to Bandag, Incorporated and its subsidiaries unless the context indicates otherwise. Bandag is engaged in the production and sale of precured tread rubber and equipment used by its franchisees for the retreading of tires for trucks, buses, light commercial trucks, industrial equipment, off-the-road equipment and passenger cars. Bandag specializes in a patented cold-bonding retreading process which it introduced to the United States in 1957. The Bandag Method, as it is called, separates the process of vulcanizing the tread rubber from the process of bonding the tread rubber to the tire casing, allowing for optimization of temperature and pressure levels at each stage of the retreading process. Although a Bandag retread is typically sold at a higher unit price than the alternative "hot-capped" process, as well as retreads sold using competitive precured systems, the Bandag product is considered to be superior, resulting in a longer lasting retread and lower user cost per mile. The Corporation and its licensees have 1,325 franchisees worldwide, with 38% located in the United States and 62% internationally. The majority of Bandag's franchisees are independent operators of full service tire distributorships. Bandag's revenues primarily come from the sale of retread material and equipment to its franchisees. Bandag's products compete with new tire sales, as well as retreads produced using other retread processes. The Corporation concentrates its marketing effort on existing franchisees and on expanding their respective market penetration. Due to its strong distribution system, marketing efforts, and leading technology, Bandag, through its independent franchisee network, has been able to maintain the largest market presence in the retreading industry. The Company as a tread rubber supplier to its independent network of franchisees competes in the light and heavy truck tire replacement market. Both new tire manufacturers and tread rubber suppliers compete in this market. While the Company has independent franchisees in over 110 countries, and competes in all of these geographic markets, its largest market is the United States. Truck tires retreaded by the Company's franchisees make up approximately 16% of the U.S. light and heavy truck tire replacement market. The Company's primary competitors are new tire manufacturers such as Goodyear Tire and Rubber Company, Bridgestone Corporation and Groupe Michelin. Goodyear Tire and Rubber Company also competes in the U.S. market as a tread rubber supplier to a combination of company owned and independent retreaders. As a result of a recapitalization of the Corporation approved by the Corporation's shareholders on December 30, 1986, and substantially completed in February 1987, the Carver Family (as hereinafter defined) obtained absolute voting control of the Corporation. As of March 21, 1994 the Carver Family beneficially owned shares of Common Stock and Class B Common Stock constituting 73% of the votes entitled to be cast in the election of directors and other corporate matters. The "Carver Family" is composed of (i) Lucille A. Carver, a director and widow of Roy J. Carver, (ii) the lineal descendants of Roy J. Carver and their spouses, and (iii) certain trusts and other entities for the benefit of the Carver Family members. Description of Business The Corporation's business consists of the franchising of patented processes for the retreading of tires for trucks, buses, light commercial trucks, industrial equipment, off-the-road equipment, and passenger cars, and the production and sale of precured tread rubber and related products used in connection with these processes. The Bandag retreading process can be divided into two steps: (i) manufacturing the tread rubber and (ii) bonding the tread to a tire casing. Bandag manufactures over 500 separate tread designs and sizes, treads specifically designed for various applications, allowing fleet managers to fine-tune their tire program. Bandag tread rubber is vulcanized prior to shipment to its independent franchisees. The Bandag franchisee performs the retreading process of bonding the cured tread to a prepared tire casing. This two-step process allows utilization of the optimum temperature and pressure levels at each step. Lower temperature levels during the bonding process results in a more consistent, higher quality finished retread with less damage to the casing. Bandag has developed a totally integrated retreading system with the raw materials, bonding process and manufacturing equipment specifically designed to work together as a whole. The Corporation also franchises the use of another cold process precured retreading system, the Vakuum Vulk Method, for which the Corporation owns worldwide rights. In connection with the Vakuum Vulk Method, the Corporation currently sells tread rubber, equipment, and supplies to franchisees located in certain European countries. Markets and Distribution The principal market categories for tire retreading are truck and bus, with more than 90% of the tread rubber sold by the Corporation used in the retreading of these tires. Additionally, the Corporation markets tread rubber for the retreading of off-the-road equipment, industrial and light commercial vehicle and passenger car tires; however, historically, sales of tread rubber for these applications have not contributed materially to the Corporation's results of operations. Trucks and Buses Tread rubber, equipment, and supplies for retreading and repairing truck and bus tires are sold primarily to independent franchisees by the Corporation to use the Bandag Method for that purpose. Bandag has 1,325 franchisees throughout North America, Central America, South America, Europe, Africa, Far East, Australia and New Zealand. These franchisees are owned and operated by independent franchisees and corporations, some with multiple franchises and/or locations. Of these franchisees 500 are located in the United States. Additionally, the Corporation has approximately 65 franchisees in Europe who retread tires using the Vakuum Vulk Method. One hundred twenty-three of Bandag's foreign franchisees are franchised by licensees of the Corporation in Australia and India. A limited number of franchisees are trucking companies which operate retread shops essentially for their own needs. A few franchisees also offer "hot-cap" retreading and most sell one or more lines of new tires. The current franchise agreement offered by the Corporation grants the franchisee the non-exclusive retread manufacturing rights to use the Bandag Method for one or more applications and the Bandag trademarks in connection therewith within a specified territory, but the franchisee is free to market Bandag products outside the territory. No initial franchise fee is paid by a franchisee for his franchise. Other Applications The Corporation continues to manufacture and supply to its franchisees a limited amount of tread for Off-the-Road (OTR) tires. The Corporation's program for retreading of industrial tires includes all varieties, solid and pneumatic, and its light commercial vehicle program is directed at the market of light trucks and recreational vehicles. Regulations Various federal and state authorities have adopted safety and other regulations with respect to motor vehicles and components, including tires, and various states and the Federal Trade Commission enforce statutes or regulations imposing obligations on franchisors, primarily a duty to disclose material facts concerning a franchise to prospective franchisees. Management is unaware of any present or proposed regulations or statutes which would have a material adverse effect upon the Corporation's business, but cannot predict what other regulations or statutes might be adopted or what their effect on the Corporation's business might be. Competition The Corporation faces strong competition in the market for replacement truck and bus tires, the principal retreading market which it serves. The competition comes not only from the major manufacturers of new tires, but also from manufacturers of retread- ing materials. Competitors include producers of "camelback", "strip stock", and "slab stock" for "hot-cap" retreading, as well as a number of producers of precured tread rubber. Various methods for bonding precured tread rubber to tire casings are used by competitors. Bandag retreads are often sold at a higher price than tires retreaded by the "hot-cap" process. The Corporation believes that the superior quality and greater mileage of Bandag retreads and expanded service programs to franchisees and end users outweigh any price differential. Bandag franchisees compete with many new tire dealers and retreading operators of varying sizes, which include shops operated by the major new tire manufacturers, large independent retread companies, retreading operations of large trucking companies, and smaller commercial tire dealers. Sources of Supply The Corporation manufactures the precured tread rubber, cushion gum, and related supplies in Corporation-owned manufacturing plants in the United States, Canada, Brazil, Belgium, South Africa, Mexico, Malaysia and New Zealand. The Corporation has a 40% minority interest in its licensee in India. The Corporation also manufactures pressure chambers, tire casing analyzers, buffers, tire builders, tire handling systems, and other items of equipment used in the Bandag and Vakuum Vulk retreading methods. Curing rims, chucks, spreaders, rollers, certain miscellaneous equipment, and various retreading supplies, such as repair patches sold by the Corporation, are purchased from others. The Corporation purchases rubber and other materials for the production of tread rubber and other rubber products from a number of suppliers. The rubber for tread is primarily synthetic and obtained principally from sources which most conveniently serve the respective areas in which the Corporation's plants are located. Although synthetic rubber and other petrochemical products have periodically been in short supply and significant cost fluctuations have been experienced in previous years, the Corporation to date has not experienced any significant difficulty in obtaining an adequate supply of such materials. However, the effect on operations of future shortages will depend upon their duration and severity and cannot presently be forecast. The principal source of natural rubber, used for the Corporation's cushion gum, is the Far East. The supply of natural rubber has historically been adequate for the Corporation's purposes. Natural rubber is a commodity subject to wide price fluctuations as a result of the forces of supply and demand. Synthetic prices have historically been related to the cost of petrochemical feedstocks which are relatively stable. A relationship between natural rubber and synthetic rubber prices exists, but it is by no means exact. Patents The Corporation owns or has licenses for the use of a number of United States and foreign patents covering various elements of the Bandag and Vakuum Vulk Methods. The Corporation has patents covering improved features which began expiring in 1993, and the Corporation has applications pending for additional patents. The Corporation's patent counsel has advised the Corporation that the United States patents are by law presumed valid and that the Corporation does not infringe upon the patent rights of others. While the outcome of litigation can never be predicted with certainty, such counsel has advised the Corporation that, in his opinion, in the event of litigation placing the validity of such patents at issue, the Corporation's United States patent position should remain adequate. The protection afforded the Bandag Method by foreign patents owned by the Corporation, as well as those under which it is licensed, varies among different countries depending mainly upon the extent to which the elements of the Bandag Method are covered, the strength of the patent laws and the degree to which patent rights are upheld by the courts. Patent counsel for the Corporation is of the opinion that its patent position in the foreign countries in which its principal sales are made is adequate and does not infringe upon the rights of others. The Corporation has, however, extended its foreign market penetration to some countries where little or no patent protection exists. The Corporation does not consider that patent protection is the primary factor in its successful retreading operation, but rather, that its proprietary technical "know-how", product quality, franchisee support programs and effective marketing programs are more important to its success. The Corporation has secured registrations for its trademark and service mark BANDAG, as well as other trademarks and service marks, in the United States and most of the other important commercial countries. Other Information The Corporation conducts research and development of new products, primarily in the tire retreading field, and the improvement of materials, equipment, and retreading processes. The cost of this research and development program was approximately $14,715,000 in 1991, $12,612,000 in 1992, and $12,321,000 in 1993. The Company's business has seasonal characteristics which are tied not only to the overall performance of the economy, but more specifically to the level of activity in the trucking industry. Tire demand does, however, lag the seasonality of the trucking industry. The Company's third and fourth quarters have historically been the strongest in terms of sales volume and earnings. As stated in the Company's 13D filed pursuant to the acquisition of the HON Industries common stock, "The shares of Common Stock purchased by Bandag have been acquired for investment purposes. Bandag believes that the Common Stock represents an attractive investment opportunity at this time." The Company continues to believe that HON Industries' common stock is a good, long-term investment consistent with the Company's overall corporate strategy to maximize long term shareholder value. The Company purchased the stock in 1987 and 1988 at a cost of $25.3 million and its market value at the end of 1993 was $69.5 million. The Corporation has sought to comply with all statutory and administrative requirements concerning environmental quality. The Corporation has made and will continue to make necessary capital expenditures for environmental protection. It is not anticipated that such expenditures will materially affect the Corporation's earnings or competitive position. As of December 31, 1993, the Corporation had 2,334 employees. Financial Information about Industry Segments As stated above, the Corporation's continuing operations are conducted in one principal business and, accordingly, the Corporation's financial statements contain information concerning a single industry segment. Revenues of Principal Product Groups The following table sets forth (in millions of dollars), for each of the last three fiscal years, revenues attributable to the Corporation's principal product groups: 1993 1992 1991 Revenues: Tread rubber, cushion gum, and retreading supplies $555.9 $544.9 $524.4 Other products (1) 39.8 51.6 64.9 Corporate (2) 5.4 5.9 4.6 _____ _____ _____ Total $601.1 $602.4 $593.9 (1) Includes retreading equipment, rubber compounds, and the sale of new and retreaded tires and related services. (2) Consists of interest and dividend income. Financial Information about Foreign and Domestic Operations Financial Statement "Operations in Different Geographic Areas and Sales by Principal Products" follows on page 10. Operations in Different Geographic Areas and Sales by Principal Products The Company's operations are conducted in one principal business, which includes the manufacture of precured tread rubber, equipment and supplies for retreading tires. Information concerning the Company's operations by geographic area and sales by principal product for the years ended December 31, 1993, 1992 and 1991 is shown below (in millions): Information concerning operations in different geographic areas: The Company does not have a formal continuous exchange risk hedging program, but selectively hedges transactions which are believed to be subject to unacceptable foreign currency exchange risk. Executive Officers of the Corporation The following table sets forth the names and ages of all executive officers of the Corporation, the period of service of each with the Corporation, positions and offices with the Corporation presently held by each, and the period during which each officer has served in his present office: Period of Present Period in Service with Position or Present Name Age Corporation Office Office Martin G. Carver* 45 15 Yrs. Chairman of the 13 Yrs. Board, Chief Executive Officer and President Lucille A. Carver* 76 36 Yrs. Treasurer 35 Yrs. Gary L. Carlson 43 20 Yrs. Sr. Vice President 1 Mo. and General Manager Eastern Hemisphere Retreading Division (EHRD) Donald F. Chester 58 11 Yrs. Sr. Vice President, 11 Yrs. International Nathaniel L. Derby II 51 22 Yrs. Vice President, 8 Yrs. Engineering Thomas E. Dvorchak 61 23 Yrs. Sr. Vice President 16 Yrs. and Chief Financial Officer Stuart C. Green 52 2 Yrs. Sr. Vice President, 2 Yrs. 7 Mos. Manufacturing 7 Mos. William D. Herd 50 16 Yrs. Sr. Vice President, 4 Yrs. Sales & Marketing Melvin P. Hershey 48 10 Yrs. Vice President, 5 Yrs. Personnel Administration John A. Lodge 51 14 Yrs. Vice President, 2 Yrs. Materials 8 Mos. Dr. Floyd S. Myers 53 12 Yrs. Vice President, 8 Yrs. Technical * Denotes that officer is also a director of the Corporation. Mr. Martin G. Carver was elected Chairman of the Board effective June 23, 1981, Chief Executive Officer effective May 18, 1982, and President effective May 25, 1983. Prior to his present position, Mr. Carver was also Vice Chairman of the Board from January 5, 1981 to June 23, 1981. Mrs. Carver, has, for more than five years, served as a Director and Treasurer of the Corporation. Mr. Carlson joined Bandag in 1974. In 1985 he was appointed to Vice President, Personnel Administration and in 1989 was appointed Vice President, Planning and Development. In November 1993, he was named to his current position of Sr. Vice President and General Manager EHRD. Mr. Chester joined Bandag in 1983 and was elected Senior Vice President, International. From 1969 to 1983, he was employed by the Singer Corporation, serving as President, Singer Mexicana S.A. de C.V. from 1981 to 1983. Mr. Derby joined Bandag in 1971 and was appointed to his present position in 1985 as Vice President, Engineering. Mr. Dvorchak joined Bandag in 1971 and has held his present office since January 1978. Mr. Green joined Bandag in 1991 and was elected Senior Vice President, Manufacturing. From 1981 to that date, he was employed by Nissan Motor Manufacturing Corporation in various management positions in manufacturing, the latest of which was Director, Manufacturing Vehicle Assembly, Component Assembly and Paint Plants, Manufacturing Division. Mr. Herd joined Bandag in 1977 as Canadian Division Manager and was appointed to Vice President, North American Sales in August 1982. He was elected to the position of Senior Vice President, North American Sales in 1983, and in 1990 he was elected to his current office of Senior Vice President, Sales and Marketing. Mr. Hershey joined Bandag in 1983 as Plant Manager and was appointed to Vice President, Marketing in 1986. He was appointed to his present position as Vice President, Personnel Administration in 1989. Mr. Lodge joined Bandag in 1979 as a Systems Analyst. He was promoted to Manager of Domestic Customer Service in 1984; in 1985 he was promoted to the position of Personnel Manager; and in 1988 he became Manager of Management Services. Mr Lodge served as Manager, Materials since 1990 before being appointed to his current position in 1991. Dr. Myers joined Bandag in 1982 as Vice President, Advanced Research and was appointed to his present position as Vice President, Technical in 1985. All of the above-named executive officers are elected annually by the Board of Directors or are appointed by the Chairman of the Board and serve at the pleasure of the Board of Directors, or the Chairman of the Board as the case may be. ITEM 2.

ITEM 2. PROPERTIES The general offices of the Corporation are located in a seventeen- year-old, 56,000 square foot leased office building in Muscatine, Iowa. The tread rubber manufacturing plants of the Corporation are located to service principal markets. The Corporation operates fourteen of such plants, six of which are located in the United States, and the remainder in Canada, Belgium, South Africa, Brazil, New Zealand, Mexico, Malaysia and Venezuela. The plants vary in size from 9,600 square feet to 194,000 square feet with the first plant being placed into production during 1959. All of the plants are owned in fee or under lease purchase contracts, except for the plants located in New Zealand, Malaysia and Venezuela, which are under standard lease contracts. Retreading equipment is manufactured at a company-owned plant of approximately 60,000 square feet in Muscatine. In addition, the Corporation owns a research and development center in Muscatine of approximately 58,400 square feet; a 26,000 square foot facility, used primarily for training franchisees and franchisee personnel; and a 26,000 square foot office and warehouse facility. In addition, the Corporation mixes rubber and produces cushion gum at a company-owned 168,000 square foot plant in California. The Company owns its European headquarters office in Belgium and a 129,000 square foot warehouse in the Netherlands. In the opinion of the Corporation, its properties are maintained in good operating condition and the production capacity of its plants is adequate for the near future. Because of the nature of the activities conducted, necessary additions can be made within a reasonable period of time. At December 31, 1993, the net carrying amount of property, plant, and equipment pledged as collateral on other liabilities was approximately $16,047,000. ITEM 3.

ITEM 3. LEGAL PROCEEDINGS None ITEM 4.

ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS None PART II ITEM 5.

ITEM 5. MARKET FOR THE REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS. Information concerning cash dividends declared and market prices of the Company's Common Stock and Class A Common Stock for the last three fiscal years is as follows: ITEM 5. MARKET FOR THE REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS (Cont.) The approximate number of record holders of the Corporation's Common Stock as of March 21, 1994, was 2,029, the number of holders of Class A Common Stock was 1,990 and the number of holders of Class B Common Stock was 351. The Common Stock and Class A Common Stock are traded on the New York Stock Exchange and the Chicago Stock Exchange. There is no established trading market for the Class B Common Stock. ITEM 6.

ITEM 6. SELECTED FINANCIAL DATA The following table sets forth certain Consolidated Selected Financial Data for the periods and as of the dates indicated: ITEM 7.

ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS 1993-1992 Consolidated net sales were approximately equal with 1992, whereas unit volume increased by 4%. Selling prices were generally stable, except in some European markets, but the U.S. dollar strengthened during 1993 and this had an unfavorable impact on the translated value of the Company's foreign-currency-denominated sales. The Company's seasonal sales pattern, which is closely related to trucking industry activity and shows the highest activity during the third and fourth quarters, was similar to previous years. Because of stable selling prices, domestic unit volume and sales showed 5% and 4% improvements, respectively, over the prior year. Western Europe, while experiencing a relatively small 1% decrease in unit volume, showed a 13% decrease in sales revenue. Contributing factors were the unfavorable impact of currency rates and lower selling prices in some European markets, with the currency rate having the greater impact. Unit volume for the Company's other combined foreign operations improved 7% over the previous year, but sales did not increase accordingly. This again was due to the stronger U.S. dollar and the resulting unfavorable impact when translating foreign-currency-denominated sales at lower rates and, to a lesser extent, due to the discontinuance of sales in certain of the Company's markets. Consolidated net earnings decreased by 5% compared to 1992. The Company's consolidated gross profit margin declined by 2.4 percentage points, but this was partially offset by a 1.5 percentage point decline in total operating expenses as a percent of sales because of generally lower spending in many categories. The Company's decrease in gross margin was primarily due to higher depreciation expense attributable to higher capital spending in recent years and higher overall manufacturing costs in line with generally higher cost levels. Although total domestic revenues increased by 4%, domestic earnings before income taxes was the same as the previous year, with higher product costs only partially offset by decreased operating expenses. The Company's foreign operations comprised 37% and 14% of this year's revenues and earnings before income taxes, respectively. This represented a two percentage point decline as a percent of total revenues and a three percentage point decline as a percent of total earnings before income taxes compared to the previous year. The Western European operation's earnings before income taxes were adversely impacted again this year, decreasing by 60% from the previous year. The earnings decrease was due primarily to the lower translation rate, combined with a five percentage point drop in gross profit margin. The lower gross profit margin was due to higher raw material and manufacturing costs, which the Company absorbed because of strong competitive pressures, and non-recurring inventory valuation adjustments. Earnings before income taxes for the combined other foreign operations decreased 12% from last year primarily due to lower gross margins in Brazil and Canada. Brazil's lower margin was primarily due to a refinement in the methodology used to determine certain manufacturing costs. Canada's lower gross margin was the result of a higher-than-usual amount of finished goods imported from the U.S. this year and the plant being shut down for an extended period in December in order to relocate its finished goods inventory to a distribution center closer to major markets in Southeastern Canada. The Company's effective income tax rate increased from 36.5% in 1992 to 37% in 1993, reflecting the higher federal income tax rates enacted for 1993. This increase in tax rate reduced net earnings by $625,000 and earnings per share by $.02 compared to the prior year. Earnings per share were $.10 lower in 1993, which represents a 3% decrease from the previous year. During the third quarter of 1993, the Company acquired 144,200 shares of its outstanding Common Stock and Class A Common Stock for $6,797,000 at prevailing market prices. There were fewer shares outstanding in 1993 as a result of these purchases. The cumulative current year impact of these purchases and those made in the previous year had a $.02 favorable impact on earnings per share. 1992-1991 Consolidated net sales increased 1% from 1991, which was 4 percentage points less than the unit volume increase due mainly to the impact of discontinuing the sale of custom compounding services to outside customers. Partially offsetting this decrease was the favorable impact of the higher translated value of foreign-currency-denominated sales. Domestic unit volume showed nominal improvement despite the soft North American economy, with foreign markets, in total, showing a slightly better performance than the domestic markets. Consolidated net earnings increased 4% from 1991. The Company's selling price increases were not sufficient to offset the increases in raw material and plant costs during the year, which resulted in a slight drop in gross profit margin. This was offset by a decrease in operating expenses and higher interest income. The decrease in operating expenses resulted primarily from reduced spending for R&D and marketing programs, especially in the United States. R&D spending was lower in 1992 than the previous year because the previous year included heavy spending on the development of the Eclipse System, which is now substantially complete. Earnings from foreign operations represented 17% and 24% of total earnings before taxes in 1992 and 1991, respectively. Net earnings from operations in Western Europe declined by 70% from 1991, even though net sales were 7% higher on a 4% increase in unit volume. The percentage differential between the net sales and volume increases was due primarily to favorable foreign translation rates into U. S. dollars. Net earnings for the year were adversely impacted by a substantial increase in operating expenses and unusually high foreign exchange losses due to devaluations of several European countries' currencies in which sales are denominated. The Company has undertaken a concerted effort to increase market share in Western Europe, and spending related to this effort is primarily responsible for the substantial increase in operating expenses. Net sales for the other combined foreign operations increased 10% over last year, with the operations in Mexico and Brazil accounting for the majority of the increase. Net earnings were 14% higher than last year primarily due to improved gross margins in Brazil and slightly lower operating expenses, as a percentage of net sales. The Company's effective income tax rate decreased from 38% in 1991 to 36.5% in 1992, having a positive impact on net income. Earnings per share before the cumulative effect of changes in accounting methods increased $.13, a 5% increase from 1991. During the year, the Company acquired 451,300 shares of its outstanding Common Stock and Class A Common Stock. These purchases took place during the latter half of the year and, therefore, did not significantly affect the average shares outstanding. The Company adopted, effective January 1, 1992, Financial Accounting Standards No. 106 "Employers' Accounting for Postretirement Benefits Other Than Pensions" (FAS 106) and No. 109 "Accounting for Income Taxes" (FAS 109). The cumulative effect of adopting FAS 106 reduced net earnings by $.09 per share. The cumulative effect of adopting FAS 109 increased net earnings by $.08 per share. Adoption of FAS 106 and 109 did not significantly impact operating results for 1992. See Notes D and G for further details. 1991-1990 Consolidated net sales decreased 1% from 1990 due to a combination of lower effective selling prices and flat unit volume. Volume in the United States market was impacted by the depressed economy and the work-off of dealer inventories accumulated late in 1990 during the uncertainty surrounding the Gulf War. The effective selling price was also impacted by the Gulf War as raw material costs rose sharply in late 1990, but dropped back again to previous levels in 1991. Volume in foreign markets, in total, showed a slight increase compared to the previous year. Consolidated net earnings increased 1% from 1990. Lower effective selling prices were offset by lower raw material costs, keeping gross profit margin stable. Operating and other expenses increased only slightly from 1990 as reduced spending on marketing programs offset higher expenses in other categories. The Company's effective income tax rate decreased from 38.5% in 1990 to 38% in 1991, having a positive impact on net income. Earnings per share increased $.11, a 4% increase from 1990. The percentage increase in earnings per share was higher than the increase in net earnings due to fewer average shares outstanding during 1991, as a result of the full year impact of shares acquired in 1990. Impact of Inflation and Changing Prices Although the Company has generally been able to adjust its effective selling prices in response to changes in product costs, during the past two fiscal years the Company's gross profit margin has declined because the Company, due to competitive conditions, has elected not to increase its selling prices in response to increased product costs. Replacement of fixed assets requires a greater investment than the original asset cost due to the impact of increases in the general price level over the useful lives of plant and equipment. This increased capital investment would result in higher depreciation charges affecting both inventories and cost of products sold. However, for new assets, the replacement cost depreciation, calculated on a straight-line basis, is not significantly greater than historical depreciation that has principally been calculated by accelerated methods resulting in higher depreciation charges in the early years of an asset's life. Capital Resources and Liquidity Current assets exceeded current liabilities by $213,599,000 at the end of 1993, while cash and cash equivalents increased by $24,187,000 from December 31, 1992, and totaled $58,004,000 at year-end. The Company invests excess funds over various terms, but only instruments with an original maturity date of over 90 days are classified as investments. The increase in cash flow from operating activities was primarily from higher income taxes payable and reduced inventories. No major changes in working capital requirements are foreseen, except for those normally faced in the growth of the business. The Company funds its capital expenditures from the cash flow generated from operations. During 1993 the Company spent $40,472,000 for capital additions, including a major expansion at its Oxford, North Carolina plant. As of December 31, 1993, the Company had available uncommitted lines of credit totaling $86,000,000 in the United States for working capital purposes. Also, the Company's foreign subsidiaries have approximately $31,000,000 credit and overdraft facilities available to them. From time to time during 1993, the Company's Western Europe subsidiary borrowed funds to supplement its operational cash flow needs or to repay intercompany transactions. The Company's other liabilities totaled $11,039,000, which are 2.6% of the sum of other liabilities and stockholders' equity. The Company has no plans at this time to undertake additional other liabilities of any material amount. During the year, the Company acquired 144,200 shares of its outstanding Common Stock and Class A Common Stock for $6,797,000 at prevailing market prices and paid cash dividends amounting to $18,033,000. The Company generally funds its dividends and stock repurchases from the cash flow generated from its operations, and the Company has historically utilized excess funds to purchase its own shares, believing the acquisition of the Company's stock to be a good investment. In 1993, the Company adopted FAS 115 and recorded the related non-cash effect to the Company's balance sheet. See Note B for further details. ITEM 8.

ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA Index to Consolidated Financial Statements Page Report of Independent Auditors 22 Consolidated Balance Sheets as of December 31, 1993, 1992 and 1991 23 - 24 Consolidated Statements of Earnings for the Years Ended December 31, 1993, 1992 and 1991 25 Consolidated Statements of Changes in Stockholders' Equity for the Years Ended December 31, 1993, 1992 and 1991 26 Consolidated Statements of Cash Flows for the Years Ended December 31, 1993, 1992 and 1991 27 Notes to Consolidated Financial Statements 28 - 36 Report of Independent Auditors Stockholders and Board of Directors Bandag, Incorporated We have audited the accompanying consolidated balance sheets of Bandag, Incorporated and subsidiaries as of December 31, 1993, 1992 and 1991, and the related consolidated statements of changes of stockholders' equity, earnings and cash flows for the years then ended. Our audits also included the financial statement schedules listed in the Index at Item 14(a). These financial statements and schedules are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements and schedules based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform and audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the consolidated financial position of Bandag, Incorporated and subsidiaries at December 31, 1993, 1992 and 1991, and the consolidated results of their operations and their cash flows for the years then ended in conformity with generally accepted accounting principles. Also, in our opinion, the related financial statement schedules, when considered in relation to the basic financial statements taken as a whole, present fairly in all material respects the information set forth therein. As discussed in Note B to the consolidated financial statements, as of December 31, 1993, the Company changed its method of accounting for certain investments in debt and equity securities. As discussed in Notes D and G to the consolidated financial statements, in 1992 the Company changed its method of accounting for income taxes and postretirement employee benefits other than pensions. ERNST & YOUNG February 4, 1994 See notes to consolidated financial statements. Consolidated Statements of Earnings See notes to consolidated financial statements See notes to consolidated financial statements. Notes to Consolidated Financial Statements A. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES Principles of Consolidation: The consolidated financial statements include the accounts and transactions of all subsidiaries. Significant intercompany accounts and transactions have been eliminated in consolidation. Cash Equivalents: The Company considers all highly liquid investments with a maturity of three months or less when purchased to be cash equivalents. The carrying amount reported in the consolidated balance sheet for cash and cash equivalents approximates its fair value. Accounts Receivable and Concentrations of Credit Risk: Concentrations of credit risk with respect to accounts receivable are limited due to the number of customers the Company has and their geographic dispersion. The Company maintains close working relationships with these customers and performs ongoing credit evaluations of their financial condition. No one customer is large enough to pose a significant financial risk to the Company. The Company maintains an allowance for losses based upon the expected collectibility of accounts receivable. Credit losses have been within management's expectations. Inventories: Inventories are valued at the lower of cost, determined by the last in, first out (LIFO) method, or market. The excess of current cost over the amount stated for inventories valued by the LIFO method amounted to approximately $20,189,000, $18,145,000, and $16,111,000 at December 31, 1993, 1992, and 1991, respectively. Property, Plant, and Equipment: Provisions for depreciation and amortization of plant and equipment are principally computed using declining-balance methods, based upon the estimated useful lives of the various classes of depreciable assets. Foreign Currency Translation: Assets and liabilities of foreign subsidiaries are translated at the current exchange rate and items of income and expense are translated at the average exchange rate for the year. The effects of these translation adjustments as well as gains and losses from certain hedges are reported in a separate component of stockholders' equity. Exchange gains and losses arising from transactions denominated in a currency other than the functional currency of the foreign subsidiary and translation adjustments in countries with highly inflationary economies or in which operations are directly and integrally linked to the Company's U.S. operations are included in income. Research and Development: Expenditures for research and development are expensed as incurred. Revenue Recognition: Sales are recognized when products are shipped to dealers at which time costs associated with the sale are recognized. B. INVESTMENTS In May 1993 the Financial Accounting Standards Board issued Statement of Financial Accounting Standards No.115, "Accounting for Certain Investments in Debt and Equity Securities." As permitted under the Statement, the Company elected to adopt the provisions of the new standard as of December 31, 1993. In accordance with the Statement, prior period financial statements have not been restated to reflect the change in accounting principle. The effect of adopting the Statement increased stockholders' equity $27,693,000 (net of $16,500,000 of deferred tax) to reflect the net unrealized holding gain on securities classified as available-for-sale. Under Statement 115, management determines the appropriate classification of debt securities at the time of purchase and reevaluates such designation as of each balance sheet date. Debt securities are classified as held-to-maturity based upon the positive intent and ability of the Company to hold the securities to maturity. Held-to-maturity securities are stated at amortized cost, adjusted for amortization of premiums and accretion of discounts to maturity. Such amortization and accretion is included in investment income. Interest on securities classified as held-to-maturity is included in investment income. Marketable equity securities are classified as available-for-sale. Available-for-sale securities are carried at fair value with the unrealized gains, net of tax, reported in a separate component of stockholders' equity. Realized gains and losses and declines in value judged to be other-than-temporary on available-for-sale securities are included in investment income. The cost of securities sold is based on the specific identification method. Dividends on securities classified as available-for-sale are included in investment income. The following is a summary of securities held-to-maturity and available-for-sale: At December 31, 1993, securities held-to-maturity are due in one year or less and include $51,850,000 reported as cash equivalents. Prior to the adoption of Statement 115, investments other than marketable equity securities were carried at cost and include short-term investments with maturities greater than three months when purchased. The carrying amount of such investments approximates its fair value. Marketable equity securities, prior to the adoption of Statement 115, were carried at lower of cost or market value. At December 31, 1992, and 1991, the market value of the investment in marketable equity securities, based on quoted market prices, ($58,327,000, and $47,779,000, respectively) exceeded cost by $33,024,000, and $22,476,000, respectively. C. SHORT-TERM NOTES PAYABLE The carrying amount reported in the consolidated balance sheet of the Company's short- term notes payable approximates its fair value. Total available funds under unused lines of credit and foreign credit and overdraft facilities at December 31, 1993 amounted to $117 million. Interest paid on short-term notes payable and other obligations amounted to $1,529,000, $1,598,000 and $2,421,000 in 1993, 1992, and 1991, respectively. D. INCOME TAXES In February 1992, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes." Effective January 1, 1992, the Company adopted the provisions of Statement 109 and changed its method of accounting for income taxes. As permitted by Statement 109, prior-year consolidated financial statements have not been restated to reflect the change in accounting method. The cumulative effect of adopting Statement 109 as of January 1, 1992, was to increase net earnings by $2,215,000 or $.08 per share. Other than the cumulative effect of adoption, Statement 109 did not have a material effect on the remaining quarterly operating results for 1992. Under Statement 109, the liability method is used in accounting for income taxes. Under this method, deferred tax assets and liabilities are determined based on differences between financial reporting and tax bases of assets and liabilities and are measured using the enacted tax rates and laws that will be in effect when the differences are expected to reverse. Prior to the adoption of Statement 109, income tax expense was determined using the deferred method. Deferred tax expense was based on items of income and expense that were reported in different years in the financial statements and tax returns and were measured at the tax rate in effect in the year the difference originated. Significant components of the Company's deferred tax assets (liabilities) reflecting the net tax effects of temporary differences are summarized as follows: (In thousands) December 31 1993 1992 Obligation to provide postretirement benefits $1,728 $2,242 Marketing programs 8,515 9,994 Accounts receivable valuation allowances 2,690 2,445 Unremitted earnings of foreign subsidiaries (3,886) (4,760) Excess pension funding (2,761) (2,512) Purchased tax benefits Unrealized holding gain on marketable equity securities (16,500) - Other, net 8,724 4,644 _______ ______ Net deferred tax assets (liabilities) ($3,848) $9,431 _______ ______ The components of earnings before income taxes are summarized as follows: Significant components of the provision for income tax expense (credit) attributable to continuing operations under the liability method in 1993 and 1992 and the deferred method in 1991 are summarized as follows: The components of the provision (credit) for deferred income taxes for the year ended December 31, 1991, principally relate to undistributed earnings of certain subsidiaries, provisions for depreciation, and accrued marketing expenses. No timing difference had a tax effect in excess of 5% of the income tax expense computed at the statutory rate. No item, other than state income taxes in 1993, 1992 and 1991, affects the Company's effective income tax rate by an amount which exceeds 5% of the income tax expense computed at the statutory rate. Undistributed earnings of subsidiaries on which deferred income taxes have not been provided are not significant. Income taxes paid amounted to $42,840,000, $56,319,000, and $56,417,000 in 1993, 1992, and 1991, respectively. E. STOCKHOLDERS' EQUITY On May 6, 1992, the Company's stockholders adopted an amendment to the Company's articles of incorporation establishing a new class of common stock, Class A Common Stock, and the Board of Directors authorized a stock dividend whereby one share of Class A Common Stock was distributed for each share of Common Stock and Class B Common Stock outstanding at the close of business on May 27,1992. Class A Common Stock and Class B Common Stock have the same rights regarding dividends and distributions upon liquidation as Common Stock. However, Class A Common Stockholders are not entitled to vote, Class B Common Stockholders are entitled to ten votes for each share held and Common Stockholders are entitled to one vote for each share held. Transfer of shares of Class B Common Stock is substantially restricted and must be converted to Common Stock prior to sale. In certain instances, outstanding shares of Class B Common Stock will be automatically converted to shares of Common Stock. Unless extended for an additional period of five years by the Board of Directors, all then-outstanding shares of Class B Common Stock will be converted to shares of Common Stock on January 16, 2002. Under the terms of the Bandag, Incorporated Restricted Stock Grant Plan, the Company is authorized to grant up to an aggregate of 100,000 shares of Common Stock and 100,000 shares of Class A Common Stock to certain key employees. The Shares granted under the plan will entitle the grantee to all dividends and voting rights; however, such shares will not vest until seven years after the date of grant. If a grantee's employment is terminated prior to the end of the seven-year period for any reason other than death, disability or termination of employment after age 60, the shares will be forfeited and made available for future grants. A grantee who has attained age 60 and employment is then terminated prior to the end of the seven-year vesting period does not forfeit the nonvested shares. During the years ended December 31, 1993, 1992, and 1991, 5,150 shares, 5,500 shares and 2,550 shares of Common Stock, respectively, were granted under the Plan. The resulting charge to net earnings amounted to $495,000, $532,000, and $493,000, in 1993, 1992, and 1991, respectively. At December 31, 1993, 54,325 shares of Common Stock and 64,975 shares of Class A Common Stock are available for grant under the Plan. Under the terms of the Bandag, Incorporated Nonqualified Stock Option Plan, the Company is authorized to grant options to purchase up to 500,000 shares of Common Stock and 500,000 shares of Class A Common Stock to certain key employees. The option price is equal to the market value of the shares on the date of grant. At December 31, 1993, options to purchase 100,000 shares of Common Stock and 100,000 shares of Class A Common Stock are outstanding and exercisable at $23.458 per share for Common Stock options and $22.792 per share for Class A Common Stock options. Options to purchase 20,000 shares of Common Stock and 20,000 shares of Class A Common Stock expire on November 13, 1997, and each of the four anniversaries thereafter. At December 31, 1993, no options granted under this Plan have been exercised and options to purchase 400,000 shares of Common Stock and 400,000 shares of Class A Common Stock are available for grant. No options may be granted after November 13, 1997. Earnings per share amounts are based upon the weighted average number of shares of Common Stock, Class A Common Stock, Class B Common Stock, and common stock equivalents (dilutive stock options) outstanding during each year. The weighted average number of shares assumed outstanding was 27,337,000 in 1993, 27,743,000 in 1992, and 27,842,000 in 1991. These amounts and the related earnings and cash dividend per share information have been adjusted to reflect the 1992 stock dividend on a retroactive basis. F. EMPLOYEE PENSION PLANS The Company sponsors defined-benefit pension plans covering substantially all of its full-time employees in North America. Benefits are based on years of service and, for salaried employees, the employee's average annual compensation for the last five years of employment. The Company's funding policy is to contribute annually the maximum amount that can be deducted for income tax purposes. Contributions are intended to provide for benefits attributed to service to date and those expected to be earned in the future. Aggregate accumulated benefit obligations and projected benefit obligations, as estimated by consulting actuaries, and plan net assets and funded status are as follows: Assumptions used in the determination of the actuarial present value of the projected benefit obligation and net pension cost are as follows: Assets of the plans are principally invested in guaranteed interest contracts and common stock. The pension expense is composed of the following: The Company also sponsors defined-contribution plans, covering substantially all salaried employees in the United States. The annual contributions are made in such amounts as determined by the Company's Board of Directors. Although employees may contribute up to 12% of their annual compensation from the Company, they are generally not required to make contributions in order to participate in the plans. The Company recorded aggregate expense in connection with employee pension plans in the amount of $2,921,000, $2,685,000, and $2,432,000 in 1993, 1992, and 1991, respectively. G. OTHER POSTRETIREMENT EMPLOYEE BENEFITS The Company provides certain medical benefits under its self-insured health benefit plan to certain individuals who retired from employment before January 1, 1993. The program is contributory, with retiree contributions adjusted periodically. The program also contains co-insurance provisions, which result in shared costs between the Company and the retiree. In addition, the company provides post-termination benefit continuation in accordance with the requirements of the Omnibus Budget Reconciliation Act of 1989 ("OBRA"). The Company does not maintain any separate fund to provide postretirement medical obligations. Substantially all employees with the Company on and after January 1, 1993 are covered by the Bandag Security Program, which provides fully vested benefits with only 5 years of service. Benefits under this program are available upon retirement or separation for any other reason and may be used in connection with medical expense or for any other purpose. The periodic cost and benefit obligation information for the Bandag Security Program is reflected in Note F. In December 1990, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions." Effective January 1, 1992, the Company adopted the provisions of Statement 106 and, as permitted by the Statement, elected to immediately recognize the transition obligation. The cumulative effect of adopting Statement 106 was to decrease net earnings by approximately $2,435,000 or $.09 per share (net of the related tax effect of approximately $1,400,000 or $.05 per share). Postretirement benefit costs for prior periods have not been restated. Other than the cumulative effect of adoption, Statement 106 did not have a material effect on the remaining quarterly operating results for 1992. The following table sets forth amounts recognized in the Company's consolidated balance sheet: The weighted-average annual assumed rate of increase in the per capita cost of covered benefits is 13% for 1994 and is assumed to decrease gradually to 7% for 2001 and remain at that level thereafter. Increasing the assumed health care cost trend rates by one percentage point in each year would increase the accumulated postretirement benefit obligation as of December 31, 1993, by $569,000, and the aggregate of the service and interest cost components of net periodic postretirement benefit cost for 1993 by $114,000. The weighted-average discount rate used in determining the accumulated postretirement benefit obligation was 6.5% at December 31, 1993 and 1992. Employees in most foreign countries are covered by various postretirement benefit arrangements generally sponsored by the foreign governments. The Company's contributions to foreign plans were not significant in 1993, 1992 and 1991. H. BUSINESS INFORMATION BY GEOGRAPHIC AREA The information regarding operations in different geographic areas is presented on page 10 of this report and is included herein by reference. I. SUMMARY OF UNAUDITED QUARTERLY RESULTS OF OPERATIONS Unaudited quarterly results of operations for the years ended December 31, 1993 and 1992 are summarized as follows: Results for the quarter ended March 31, 1992, have been restated to retroactively reflect the changes in accounting methods described in Notes D and G, which resulted in a decrease in previously reported net earnings of $220,000 or $.01 per share. These changes in accounting methods did not have a material effect on the remaining quarterly operating results for 1992. ITEM 9.

ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE None PART III ITEM 10.

ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT The information called for by Item 10 (with respect to the directors of the registrant) is incorporated herein by reference from the registrant's definitive Proxy Statement involving the election of directors filed or to be filed pursuant to Regulation 14A not later than 120 days after December 31, 1993. In accordance with General Instruction G (3) to Form 10-K, the information with respect to executive officers of the Corporation required by Item 10 has been included in Part I hereof. ITEM 11.

ITEM 11. EXECUTIVE COMPENSATION The information called for by Item 11 is incorporated herein by reference from the registrant's definitive Proxy Statement involving the election of directors filed or to be filed pursuant to Regulation 14A not later than 120 days after December 31, 1993. ITEM 12.

ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT The information called for by Item 12 is incorporated herein by reference from the registrant's definitive Proxy Statement involving the election of directors filed or to be filed pursuant to Regulation 14A not later than 120 days after December 31, 1993. ITEM 13.

ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS The information called for by Item 13 is incorporated herein by reference from the registrant's definitive Proxy Statement involving the election of directors filed or to be filed pursuant to Regulation 14A not later than 120 days after December 31, 1993. PART IV ITEM 14.

ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K (a) (1) Financial Statements The following consolidated financial statements are included in Part II, Item 8: Page Consolidated Balance Sheets as of December 31, 1993, 1992 and 1991 23 - 24 Consolidated Statements of Income for the Years Ended December 31, 1993, 1992 and 1991 25 Consolidated Statements of Stockholders' Equity for the Years Ended December 31, 1993, 1992 and 1991 26 Consolidated Statements of Cash Flows for the Years Ended December 31, 1993, 1992 and 1991 27 Notes to Consolidated Financial Statements 28 - 36 (2) Financial Statements Schedules Page Schedule I Marketable securities - other investments. 39 Schedule V Property, plant and equipment. 40 Schedule VI Accumulated depreciation, depletion and amortization of property, plant and equipment. 41 Schedule VIII Valuation and qualifying accounts and reserves. 42 Schedule IX Short-term borrowings. 43 Schedule X Supplementary income statement information. All other schedules for which provision is made in the applicable accounting regulation of the Securities and Exchange Commission are not required under the related instructions or are inapplicable, and therefore have been omitted. Amounts for other items have been omitted as such amounts are less than 1% of total sales and revenues in the respective year. Item 14 (Cont.) (3) Exhibits Exhibit No. Description 3.1 Bylaws: As amended November 13, 1987. (Incorporated by reference to Exhibit No. 3.1 to the Corporation's Form 10-K for the year ended December 31, 1987.) 3.2 Restated Articles of Incorporation, effective December 30, 1986. (Incorporated by reference to Exhibit No. 3.2 to the Corporation's Form 10-K for the year ended December 31, 1992.) 3.3 Articles of Amendment to Bandag, Incorporated's Articles of Incorporation, effective May 6, 1992. (Incorporated by reference to Exhibit No. 3.3 to the Corporation's Form 10-K for the year ended December 31, 1992.) 4 Instruments defining the rights of security holders. (Incorporated by reference to Exhibit Nos. 3.2 and 3.3 to the Corporation's Form 10-K for the year ended December 31, 1992.) The Corporation agrees to furnish copies of its long-term debt agreements to the Commission on request. 10.1 *1984 Bandag, Incorporated Restricted Stock Grant Plan, as amended May 6, 1992. (Incorporated by reference to Exhibit No. 10.1 to the Corporation's Form 10-K for the year ended December 31, 1992.) 10.2 U. S. Bandag System Franchise Agreement Truck and Bus Tires. 10.3 Agreement of Lease dated June 27, 1975 and Amendment dated November 14, 1982 by and between Bandag, Incorporated and Macomb Motel, Inc. (Incorporated by reference as Exhibit No. 10.5 to the Corporation's Form 10-K for the year ended December 31, 1985.) 10.4 *Miscellaneous Fringe Benefits for Executives. 10.5 *Nonqualified Stock Option Plan, as amended May 6, 1992. (Incorporated by reference as Exhibit No. 10.6 to the Corporation's Form 10-K for the year ended December 31, 1992.) 10.6 *Nonqualified Stock Option Agreement of Martin G. Carver dated November 13, 1987, as amended by an Addendum dated June 12, 1992. (Incorporated by reference as Exhibit No. 10.7 to the Corporation's Form 10-K for the year ended December 31, 1992.) 10.7 *Form of Participation Agreement under the 1984 Bandag, Incorporated Restricted Stock Grant Plan. (Incorporated by reference as Exhibit No. 10.8 to the Corporation's Form 10-K for the year ended December 31, 1992.) 10.8 *Employment Agreement with Michel Petiot effective January 1, 1994, dated December 20, 1993. 11 Computation of earnings per share. 21 Subsidiaries of Registrant. *Represents a management compensatory plan or arrangement. (b) Reports on Form 8-K: No report on Form 8-K was filed during the last quarter of the period covered by this report. SIGNATURES Pursuant to the requirements of Section 13 or 15(d) 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. BANDAG, INCORPORATED By /s/ Martin G. Carver Martin G. Carver Chairman of the Board, Chief Executive Officer, President and Director (Principal Executive Officer) Date: March 29, 1994 Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated. By /s/ Stephen A. Keller By /s/ Stanley E. G. Hillman Stephen A. Keller Stanley E. G. Hillman Director Director By ______________________ By /s/ R. Stephen Newman Edgar D. Jannotta R. Stephen Newman Director Director By /s/ James R. Everline By /s/ Martin G. Carver James R. Everline Martin G. Carver Director Chairman of the Board, Chief Executive Officer, President and Director (Principal Executive Officer) By /s/ Thomas E. Dvorchak Thomas E. Dvorchak Senior Vice President and Chief Financial Officer (Chief Accounting Officer) Date: March 29, 1994 EXHIBIT INDEX Exhibit No. Page No. Description 3.1 Bylaws: As amended November 13, 1987. (Incorporated by reference to Exhibit No. 3.1 to the Corporation's Form 10-K for the year ended December 31, 1987.) 3.2 Restated Articles of Incorporation, effective December 30, 1986. (Incorporated by reference to Exhibit No. 3.2 to the Corporation's Form 10-K for the year ended December 31, 1992.) 3.3 Articles of Amendment to Bandag, Incorporated's Articles of Incorporation, effective May 6, 1992. (Incorporated by reference to Exhibit No. 3.3 to the Corporation's Form 10-K for the year ended December 31, 1992.) 4 Instruments defining the rights of Security Holders. (Incorporated by reference to Exhibit Nos. 3.2 and 3.3 to the Corporation's Form 10-K for the year ended December 31, 1992.) The Corporation agrees to furnish copies of its long-term debt agreements to the Commission on request. 10.1 *1984 Bandag, Incorporated Restricted Stock Grant Plan, as amended May 6, 1992. (Incorporated by reference to Exhibit No. 10.1 to the Corporation's Form 10-K for the year ended December 31, 1992.) 10.2 50 U. S. Bandag System Franchise Agreement Truck and Bus Tires. 10.3 Agreement of Lease dated June 27, 1975 and Amendment dated November 14, 1982 by and between Bandag, Incorporated and Macomb Motel, Inc. (Incorporated by reference as Exhibit No. 10.5 to the Corporation's Form 10-K for the year ended December 31, 1985.) 10.4 *Miscellaneous Fringe Benefits for Executives. 10.5 *Nonqualified Stock Option Plan, as amended May 6, 1992. (Incorporated by reference as Exhibit No. 10.6 to the Corporation's Form 10-K for the year ended December 31, 1992.) 10.6 *Nonqualified Stock Option Agreement of Martin G. Carver dated November 13, 1987, as amended by an Addendum dated June 12, 1992. (Incorporated by reference as Exhibit No. 10.7 to the Corporation's Form 10-K for the year ended December 31, 1992.) 10.7 *Form of Participation Agreement under the 1984 Bandag, Incorporated Restricted Stock Grant Plan. (Incorporated by reference as Exhibit No. 10.8 to the Corporation's Form 10-K for the year ended December 31, 1992.) 10.8 68 *Employment Agreement with Michel Petiot effective January 1, 1994, dated December 20, 1993. 11 69 Computation of earnings per share. 21 71 Subsidiaries of Registrant. * Represents a management compensatory plan or arrangement.

59198_1993.txt

59198

1993

ITEM 1. Business. (a) TRINOVA Corporation ("TRINOVA") is a world leader in the manufacture and distribution of engineered components and systems for industry, sold through its operating companies, Aeroquip Corporation ("Aeroquip") and Vickers, Incorporated ("Vickers"), to the industrial, automotive, and aerospace & defense markets. On January 28, 1993, two new directors, Delmont A. Davis, President and Chief Executive Officer of Ball Corporation, and David R. Goode, Chairman of the Board, President and Chief Executive Officer of Norfolk Southern Corporation, were elected to the Board of Directors of TRINOVA. On February 25, 1993, Gregory R. Papp was elected Corporate Controller of TRINOVA. Mr. Papp was formerly Vice President and Controller for Aeroquip. In the 1993 first quarter, TRINOVA adopted Statement of Financial Accounting Standards No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions" (FAS 106). TRINOVA elected to recognize the transition obligation in the 1993 first quarter as the cumulative effect of a change in accounting principle resulting in a non-cash charge to income of $113,229,000 pretax, $70,229,000 after tax, or $2.47 per share for the year. On April 15, 1993, A. Paul Funkhouser and Robert M. Schaeberle retired from the Board of Directors of TRINOVA. In the 1993 second quarter, TRINOVA recorded a $26 million ($18.2 million after tax, or $.64 per share) provision for severance and other personnel-related costs associated with worldwide work force reductions, primarily focusing on TRINOVA's industrial operations in Europe. During the 1993 fourth quarter, TRINOVA recognized a charge of $7 million ($4.7 million after tax, or $.17 per share) to provide for prior years' value-added taxes in Brazil which have been unsuccessfully contested by TRINOVA and for which no provision had been made. No business acquisitions were completed in 1993. On September 1, 1993, TRINOVA sold the assets, net of certain liabilities, of its plastics compounding business located in Cleveland, Ohio. On December 21, 1993, TRINOVA sold the assets, net of certain liabilities, of its radial piston motor business located in Plymouth, Devon, United Kingdom. These businesses were sold as part of TRINOVA's ongoing program to eliminate businesses and product lines which do not fit its strategies. (b) "Note 13 - Business Segments" on pages 87-89 of Exhibit (13) filed hereunder is incorporated herein by reference. (c) A description of the business done and intended to be done by TRINOVA and its subsidiaries in each industry segment follows. (1) INDUSTRIAL: Aeroquip manufactures and sells all pressure ranges of hose and fittings; adapters; self-sealing couplings; and molded, extruded and co-extruded plastic products. Vickers manufactures and sells hydraulic, electrohydraulic, pneumatic and electronic control devices; piston and vane pumps and motors; servovalves and controls; hydraulic and pneumatic cylinders; hydraulic power packages; electric motors and drives; and filters and fluid evaluation services. Principal markets for these products include construction, mining, logging and farm equipment; machine tool; process industries; electrical machinery, refrigeration and air conditioning; appliances and communications equipment; electronics; lift truck; material handling; plant maintenance; and housing and commercial construction. Sales are dispersed geographically across a broad customer base. Products are sold directly to original equipment manufacturers ("OEMs") and through a worldwide network of distributors serving aftermarket and small OEM customers. The industrial business is highly competitive in terms of price, quality and service. TRINOVA believes that Aeroquip has significant market position worldwide for industrial hose, fittings, couplings and adapters. TRINOVA also believes that Vickers has significant market position worldwide for mobile and industrial vane pumps, solenoid-operated directional valves, mobile hydraulic control valves for forklift trucks, cartridge valve systems, piston pumps for high-horsepower agricultural tractors, hydraulic tilt-train technology, and utility vehicle hydraulic equipment. TRINOVA serves many customers in the highly diverse and fragmented industrial markets. Due to the diversity of TRINOVA's products, there are a large number of competitors scattered across a wide variety of market segments, with no single competitor competing in each of TRINOVA's product lines. The order backlog for the industrial business was $148.4 million as of December 31, 1993, compared to $152.2 million as of December 31, 1992. Substantially all of the December 31, 1993 backlog is expected to be filled in 1994. (2) AUTOMOTIVE: Aeroquip manufactures and sells air conditioning, power steering, oil and transmission cooler, and fuel line components and assemblies; body side moldings; bumper nerf strips; fascias; window frames; instrument panels; radio bezels; louvers and trim plates; consoles; engine covers; garnish moldings; bumper beams; engine components; and height sensors. The automotive businesses of Aeroquip serve worldwide automobile, light truck and van manufacturers. Products are primarily sold directly to manufacturers. Approximately 51 percent of sales of TRINOVA's automotive business is comprised of worldwide sales made to three major U.S. automobile manufacturers. The automotive business is a highly competitive industry in terms of price, quality and service. Aeroquip is a preferred supplier to the major U.S. and European automobile manufacturers. Competition for products in the automotive industry is very fragmented. (3) AEROSPACE & DEFENSE: Aeroquip manufactures and sells hose, fittings, couplings, swivels, V-band couplings, fuel-handling products and high-pressure tube fittings. Vickers manufactures and sells fixed- and variable-displacement pumps; fuel pumps; hydraulic motors and motor packages; motorpumps and generator packages; high-pressure hydraulic systems; valves and valve packages; electrohydraulic and electromechanical actuators; integrated packages and accessories; AC and DC generators, electric motors and motor packages; and sensors and monitoring devices. The aerospace & defense businesses of Aeroquip and Vickers serve worldwide commercial aerospace and military markets including commercial aircraft, air defense, cargo handling, combat and support vehicles, commuter aircraft, engines, marine, military aircraft, military weaponry, missiles and naval machinery. Products are sold directly to OEM businesses and the Government and through a large distributor network. Approximately 19 percent of sales of TRINOVA's aerospace & defense business is comprised of sales made to two major U.S. airframe manufacturers. The aerospace & defense business is highly competitive in terms of price, quality and service. TRINOVA believes that Aeroquip has significant market position worldwide for aerospace hose, fittings and quick-disconnect couplings. TRINOVA also believes Vickers has significant market position worldwide for aerospace piston pumps and motors, and lube system diagnostics. TRINOVA serves a large number of customers in the diverse and fragmented aerospace and defense markets. Due to the diversity of TRINOVA's products, there are a large number of competitors scattered across a wide variety of market segments, with no single competitor competing in each of TRINOVA's product lines. The order backlog for the aerospace & defense business was $278.4 million as of December 31, 1993, compared to $321.6 million as of December 31, 1992. Approximately 30 percent of the December 31, 1993 backlog is not expected to be filled in 1994 because certain contracts require deliveries after 1994. Approximately 24 percent of the December 31, 1993 backlog represents direct Government contracts or subcontracts on Government programs, which are subject to termination for convenience by the Government. (4) OTHER INFORMATION: TRINOVA and its subsidiaries are generally not dependent upon any one source for raw materials or purchased components essential to their businesses, and it is believed that such raw materials and components will be available in adequate quantities to meet anticipated production schedules. Patents owned by TRINOVA are considered important to the conduct of its present businesses. TRINOVA is licensed under a number of patents, none of which are considered material to its businesses. TRINOVA is the owner of a number of U.S. and non-U.S. trademark registrations. TRINOVA devotes engineering, research and development efforts to new products and improvement of existing products and production processes. During 1993, 1992 and 1991, TRINOVA spent a total of $55.3 million, $65.3 million and $74.9 million, respectively, on these efforts. TRINOVA employed 15,012 persons at December 31, 1993. (d) "Note 14 - Non-U.S. Operations" on page 90 of Exhibit (13) filed hereunder is incorporated herein by reference. TRINOVA believes the risk attendant to non-U.S. operations, which are primarily in developed countries, is not significantly greater than that attendant to its U.S. operations. ITEM 2.

ITEM 2. Properties. A description of TRINOVA's principal properties follows. Except as otherwise indicated, all properties are owned by TRINOVA or its subsidiaries. TRINOVA's executive offices (leased) are located in Maumee, Ohio. INDUSTRIAL: Aeroquip Corporation has executive and administrative offices in Maumee, Ohio (leased); technical centers in Ann Arbor, Michigan (leased) and Maumee, Ohio (leased); and manufacturing facilities throughout the United States and abroad, including plants in Mountain Home, Arkansas; Fitzgerald, Georgia; Elkhart and New Haven, Indiana; Williamsport, Maryland; Forest City and Norwood, North Carolina; Van Wert, Ohio; Gainesboro, Tennessee; Bassett, Virginia; Wausau, Wisconsin; Rio de Janeiro, Brazil; Chambray-Les-Tours, France; Baden-Baden and Hann-Muenden, Germany; Livorno, Italy; Barcelona, Spain; and Cardiff, United Kingdom. Aeroquip also owns or leases warehouse, assembly and distribution facilities and sales offices in the United States and abroad. Vickers, Incorporated has executive and administrative offices in Maumee, Ohio (leased); administrative offices in Troy, Michigan (leased); a technical center in Rochester Hills (leased), Michigan; and manufacturing facilities throughout the United States and abroad, including plants in Decatur, Alabama; Searcy, Arkansas; Carol Stream and Springfield (leased), Illinois; Grand Blanc and Jackson, Michigan; Columbia, Missouri; Omaha, Nebraska; White City, Oregon; Victoria, Australia (leased); Sao Paulo, Brazil; Bad Homburg, Germany; Casella, Vignate (leased), Settimo Milanese (leased) and Valperga, Italy; and Havant and Telford (leased), United Kingdom. Vickers also owns or leases warehouse, assembly and distribution facilities and sales offices in the United States and abroad. AUTOMOTIVE: Aeroquip has executive and administrative offices in Maumee, Ohio (leased); technical and administrative offices in Mt. Clemens, Michigan (leased); a technical center in Ann Arbor, Michigan (leased); and manufacturing facilities throughout the United States and abroad, including plants in Atlanta, Georgia; Kendallville, Indiana; Henderson, Kentucky; Clinton Township (leased), Mt. Clemens, Port Huron, Spring Arbor and Sterling Heights, Michigan; Mooresville, North Carolina; Livingston, Tennessee; Baden- Baden, Reichelsheim (leased) and Roedelheim (leased), Germany; Alcala de Henares, Spain; and Brierley Hill, United Kingdom. Aeroquip also owns or leases warehouse, assembly and distribution facilities and sales offices in the United States and abroad. AEROSPACE & DEFENSE: Aeroquip Corporation has executive and administrative offices in Maumee, Ohio (leased); administrative offices in Jackson, Michigan (leased); a technical center in Ann Arbor, Michigan (leased); and manufacturing facilities throughout the United States and abroad, including plants in Toccoa, Georgia; Jackson, Michigan; Middlesex, North Carolina; Pau, France (leased); and Lakeside, United Kingdom (leased). Aeroquip also owns or leases warehouse, assembly and distribution facilities and sales offices in the United States and abroad. Vickers, Incorporated has executive and administrative offices in Maumee, Ohio (leased); and manufacturing facilities throughout the United States and abroad, including plants in Los Angeles, California; Maysville, Kentucky (leased); Grand Rapids, Michigan; Jackson, Mississippi; Hi-Nella, New Jersey; Glenolden, Pennsylvania; Bad Homburg, Germany; and Bedhampton, United Kingdom. Vickers also owns or leases warehouse, assembly and distribution facilities and sales offices in the United States and abroad. ITEM 3.

ITEM 3. Legal Proceedings. As previously reported, on March 26, 1992, the United States Environmental Protection Agency ("USEPA") issued an Administrative Order ("Order") under Section 106 of the Comprehensive Environmental Response, Compensation, and Liability Act ("CERCLA") to TRINOVA's subsidiary, Aeroquip Corporation, and five other Potentially Responsible Parties ("PRPs") relative to the San Fernando Valley Burbank Operable Unit, involving groundwater contamination. (Reference is made to Part I, Item 3, of TRINOVA's Annual Report on Form 10-K for the year ended December 31, 1992.) The Order requires the six PRPs to design and construct a water blending facility at a cost now estimated to be approximately $4.8 million. TRINOVA's portion of any such cost is estimated to be 18.33 percent based on a cost-sharing agreement among the six PRPs which was executed by TRINOVA on July 6, 1992. As previously reported, on November 13, 1992, the USEPA, Region IX, issued a General Notice of Liability letter to TRINOVA's subsidiary, Sterer Engineering and Manufacturing Company ("Sterer"). (Reference is made to Part II, Item 1, of TRINOVA's Quarterly Report on Form 10-Q for the quarter ended June 30, 1993.) The letter notifies Sterer of potential liability, as defined by Section 107(a) of CERCLA, that it may incur with respect to the San Fernando Valley Glendale South Operable Unit, involving groundwater contamination. The USEPA issued its Record of Decision ("ROD") on June 18, 1993. The interim remedy proposed in the ROD for both the North and South Operable Units is projected by the USEPA to cost approximately $45 million. Twenty-seven PRPs have presented a good faith offer to USEPA to conduct the Remedial Design ("RD") phase of the interim remedy. The estimated cost of the RD phase is $3 million. Sterer's portion of the RD costs is estimated to be 2.07 percent based on an interim allocation agreement among the PRPs. As previously reported, on July 31, 1992, the Maine Department of Environmental Protection issued an Administrative Enforcement Order to TRINOVA and its wholly owned subsidiaries, Aeroquip Corporation and Sterling Engineered Products Inc. ("Sterling"), as well as one other party, Pioneer Plastics Corporation ("Pioneer Plastics"), (collectively the "respondents"), pursuant to Title 38, section 1304(12) of the Maine Revised Statutes. (Reference is made to Part II, Item 1, of TRINOVA's Quarterly Report on Form 10-Q for the quarter ended June 30, 1993.) The Order, which was issued without a prior hearing, required the respondents to conduct a complete Phase II environmental assessment of alleged soil and groundwater contamination at a manufacturing site in Auburn, Maine, which was formerly owned by Sterling and is now owned by Pioneer Plastics. The Order further required the respondents to remediate any environmental contamination identified in the Phase II assessment. Sterling and the other respondents filed applications for a hearing on the Order and for other procedural and substantive relief; the Order was stayed while administrative proceedings were pending. On May 5, 1993, a Compliance Order on Consent ("COC") was entered into by the State of Maine, Sterling and Pioneer Plastics. The COC replaces and revokes the Order issued July 31, 1992. The COC requires Sterling to conduct a site investigation and to develop and implement a remedial work plan. The cost to Sterling to conduct the COC site investigation is estimated to be approximately $535,000. Sterling's remediation costs are undetermined at this time because the site investigation has not been completed. TRINOVA and certain subsidiaries are defendants in various lawsuits. While the ultimate outcome of these lawsuits and the above environmental matters cannot now be predicted, management is of the opinion, based on the facts now known to it, that the liability, if any, in these lawsuits (to the extent not provided for by insurance or otherwise) and the above environmental matters will not have a material adverse effect upon TRINOVA's consolidated financial position. ITEM 4.

ITEM 4. Submission of Matters to a Vote of Security Holders. None. EXECUTIVE OFFICERS OF THE REGISTRANT The names, ages, positions and recent business experience of the executive officers of TRINOVA as of February 22, 1994, are listed below. Officers of TRINOVA are elected annually in April by the Board of Directors at the organization meeting immediately following the annual meeting of shareholders. NAME AND POSITION AGE BUSINESS EXPERIENCE Darryl F. Allen, 50 Chairman of the Board, President Chairman of the Board, and Chief Executive Officer of President and Chief TRINOVA since 1991. President and Executive Officer Chief Executive Officer of TRINOVA from 1986 to 1991. William R. Ammann, 52 Vice President-Administration Vice President-Administration and Treasurer of TRINOVA since and Treasurer April 1992. Vice President - Administration of TRINOVA from 1983 to April 1992. Warren N. Bimblick 39 Vice President-Corporate Vice President-Corporate Communications of TRINOVA since Communications 1990. Director-Investor Relations and Corporate Communications of TRINOVA from 1985 to 1990. NAME AND POSITION AGE BUSINESS EXPERIENCE James E. Kline, 52 Vice President & General Counsel Vice President and of TRINOVA since 1989. Partner of General Counsel Shumaker, Loop & Kendrick (law firm), Toledo, Ohio, from 1984 to 1989. James McKee, 62 Executive Vice President of Executive Vice President of TRINOVA since 1989 and President TRINOVA and President of of Vickers, Incorporated since Vickers, Incorporated 1987. Vice President of TRINOVA from 1987 to 1989. James M. Oathout, 49 Secretary and Associate General Secretary and Counsel of TRINOVA since 1988. Associate General Counsel Gregory R. Papp, 47 Corporate Controller of TRINOVA Corporate Controller since February 1993. Vice President and Controller of Aeroquip Corporation from July 1991 to February 1993. Vice President Planning and Control - Automotive Products Group of Aeroquip Corporation from January 1991 to July 1991. Group Controller - Garrett Automotive Group of Allied- Signal Corporation from 1987 to 1991. David M. Risley, 49 Vice President - Finance and Chief Vice President - Finance Financial Officer of TRINOVA since and Chief Financial Officer October 1992. Group Vice President - Administration and Control of Aeroquip Corporation from 1991 to October 1992. Vice President and Controller of Aeroquip Corporation from 1990 to 1991. Controller of TRINOVA from 1984 to 1990. Howard M. Selland, 50 Executive Vice President of Executive Vice President of TRINOVA and President of Aeroquip TRINOVA and President of Corporation since 1989. Vice Aeroquip Corporation President of TRINOVA and President of Sterling Engineered Products Inc. from 1984 to 1989. Philip G. Simonds, 53 Vice President-Taxation of TRINOVA Vice President-Taxation since 1983. There are no family relationships among the persons named above. PART II ITEM 5.

ITEM 5. Market for Registrant's Common Equity and Related Stockholder Matters. "Stock Exchanges," "Stock Ownership," "Dividend Information," "Quarterly Common Stock Information" and "Dividend Payments per Share of Common Stock" on page 93 of Exhibit (13) filed hereunder are incorporated herein by reference. ITEM 6.

ITEM 6. Selected Financial Data. "11-Year Summary of Selected Financial Data" on pages 54-56 of Exhibit (13) filed hereunder is incorporated herein by reference. ITEM 7.

ITEM 7. Management's Discussion and Analysis of Financial Condition and Results of Operation. "Analysis of Operations," "Effects of Inflation" and "Liquidity, Working Capital and Capital Investment" on pages 57-64 of Exhibit (13) filed hereunder are incorporated herein by reference. ITEM 8.

ITEM 8. Financial Statements and Supplementary Data. "Quarterly Results of Operations" and the consolidated financial statements of the registrant and its subsidiaries on pages 65-92 of Exhibit (13) filed hereunder are incorporated herein by reference. ITEM 9.

ITEM 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure. None. PART III ITEM 10.

ITEM 10. Directors and Officers of the Registrant. "Election of Directors" on pages 1-2 of the proxy statement for the annual meeting to be held on April 21, 1994, is incorporated herein by reference. Information regarding executive officers is set forth in Part I of this report under the caption "Executive Officers of the Registrant." ITEM 11.

ITEM 11. Executive Compensation. "Compensation of Directors" and "Executive Compensation" (excluding material under the captions "TRINOVA Stock Performance Graph" and "Board Compensation Committee Report on Executive Compensation") on pages 3 and 5-9, respectively, of the proxy statement for the annual meeting to be held on April 21, 1994, are incorporated herein by reference. ITEM 12.

ITEM 12. Security Ownership of Certain Beneficial Owners and Management. "Security Ownership" on page 4 of the proxy statement for the annual meeting to be held on April 21, 1994, is incorporated herein by reference. ITEM 13.

ITEM 13. Certain Relationships and Related Transactions. None. PART IV ITEM 14.

ITEM 14. Exhibits, Financial Statement Schedules, and Reports on Form 8-K. (a) The following documents are filed as a part of this report. (1) The following consolidated financial statements of TRINOVA and its subsidiaries, included on pages 67-92 of Exhibit (13) filed hereunder are incorporated by reference in Item 8. Management's Statement on Responsibility for Financial Statements Report of Ernst & Young, Independent Auditors Statement of Operations - Years ended December 31, 1993, 1992 and 1991 Statement of Financial Position - December 31, 1993 and 1992 Statement of Cash Flows - Years ended December 31, 1993, 1992 and 1991 Statement of Shareholders' Equity - Years ended December 31, 1993, 1992 and 1991 Notes to Financial Statements - December 31, 1993 (2) The following consolidated financial statement schedules of TRINOVA and its subsidiaries are filed under Item 14(d): SCHEDULE PAGE(S) Schedule V - Property, plant and equipment 17-19 Schedule VI - Accumulated depreciation, depletion and amortization of property, plant and equipment 20-22 Schedule VIII - Valuation and qualifying accounts 23-25 Schedule IX - Short-term borrowings 26 Schedule X - Supplementary income statement information 27 All other schedules for which provision is made in the applicable accounting regulations of the Securities and Exchange Commission are either not required under the related instructions or are inapplicable, and therefore have been omitted. (3) The following exhibits are incorporated by reference hereunder; and those exhibits marked with an asterisk (*) (together with those exhibits so marked on page 14) are management contracts or compensatory plans or arrangements required to be filed as exhibits pursuant to Item 14(c) of this report: EXHIBIT NUMBER (3)-1 Amended Code of Regulations (amended April 21, 1988), filed as Exhibit (3) to Form SE filed on March 18, 1993 (4)-1 First Supplemental Indenture, dated as of May 4, 1992, between TRINOVA Corporation and NBD Bank, N.A., with respect to the issuance of $75,000,000 aggregate principal amount of TRINOVA Corporation 7.95% Notes Due 1997, filed as Exhibit (4)-1 Form SE filed on May 6, 1992 (4)-2 7.95% Notes Due 1997, issued pursuant to the Indenture, dated as of January 28, 1988, between TRINOVA Corporation and NBD Bank, N.A. (formerly National Bank of Detroit), as supplemented by the First Supplemental Indenture, dated as of May 4, 1992, between TRINOVA Corporation and NBD Bank, N.A., filed as Exhibit (4)-2 to Form SE filed on May 6, 1992 (4)-3 Officers' Certificate of TRINOVA Corporation, dated May 4, 1992, pursuant to Section 2.01 of the Indenture, dated as of January 28, 1988, between TRINOVA Corporation and NBD Bank, N.A. (formerly National Bank of Detroit), as supplemented by the First Supplemental Indenture, dated as of May 4, 1992, between TRINOVA Corporation and NBD Bank, N.A., filed as Exhibit (4)-3 to Form SE filed on May 6, 1992 (4)-4 Rights Agreement, dated January 26, 1989, between TRINOVA Corporation and First Chicago Trust Company of New York filed as Exhibit (2) to Form 8-A filed on January 27, 1989, as amended by the First Amendment to Rights Agreement filed as Exhibit (5) to Form 8 filed on July 1, 1992 (4)-5 Form of Share Certificate for Common Shares, $5 par value, of TRINOVA Corporation, filed as Exhibit (4)-2 to Form SE filed on July 1, 1992 (4)-6 Fiscal Agency Agreement, dated as of October 26, 1987, between TRINOVA Corporation, as Issuer, and Bankers Trust Company, as Fiscal Agent, with respect to $100,000,000 aggregate principal amount of TRINOVA Corporation 6% Convertible Subordinated Debentures Due 2002, filed as Exhibit (4)-1 to Form SE filed on March 18, 1993 (4)-7 Indenture, dated as of January 28, 1988, between TRINOVA Corporation and NBD Bank, N.A. (formerly National Bank of Detroit), with respect to the issuance of $50,000,000 aggregate principal amount of TRINOVA Corporation 9.55% Senior Sinking Fund Debentures Due 2018, and the issuance of $75,000,000 aggregate principal amount of TRINOVA Corporation 7.95% Notes Due 1997, filed as Exhibit (4)-2 to Form SE filed on March 18, *(10)-1 TRINOVA Corporation Plan for Optional Deferment of Directors' Fees (Restated January 25, 1990), filed as Exhibit (10)-2 to Form SE filed on March 20, 1990 *(10)-2 TRINOVA Corporation Directors' Retirement Plan (Restated January 1, 1990), filed as Exhibit (10)-3 to Form SE filed on March 20, 1990 *(10)-3 Aeroquip Corporation Incentive Compensation Plan, filed as Exhibit (10)-4 to Form SE filed on March 20, 1990 *(10)-4 Vickers, Incorporated Incentive Compensation Plan, filed as Exhibit (10)-5 to Form SE filed on March 20, 1990 *(10)-5 TRINOVA Corporation Supplemental Benefit Plan (Restated January 1, 1989), filed as Exhibit (19)-1 to Form SE filed on November 6, 1992 *(10)-6 TRINOVA Corporation 1982 Stock Option Plan, filed as Exhibit (10)-1 to Form SE filed on March 18, 1993 *(10)-7 TRINOVA Corporation 1984 Incentive Compensation Plan, filed as Exhibit (10)-2 to Form SE filed on March 18, 1993 *(10)-8 TRINOVA Corporation 1987 Stock Option Plan, filed as Exhibit (10)-3 to Form SE filed on March 18, 1993 *(10)-9 Change in Control Agreement for Officers, filed as Exhibit (10)- 4 to Form SE filed on March 18, 1993 (the Agreements executed by the Company and various executive officers of the Company are identical in all respects to the form of Agreement filed as an Exhibit to Form SE except as to differences in the identity of the officers and the dates of execution, and as to other variations directly necessitated by said differences) *(10)-10 Change in Control Agreement for Non-officers, filed as Exhibit (10)-5 to Form SE filed on March 18, 1993 (the Agreements executed by the Company and various non-officer employees of the Company are identical in all respects to the form of Agreement filed as an Exhibit to Form SE except as to differences in the identity of the employees and the dates of execution, and as to other variations directly necessitated by said differences) *(10)-11 TRINOVA Corporation 1994 Stock Incentive Plan, filed as Appendix A to the proxy statement for the annual meeting to be held on April 21, 1994 (such Plan is subject to shareholder approval at such annual meeting) (99(i))-1 Revolving Credit Agreements, dated as of September 30, 1992, between TRINOVA Corporation and The Bank of Tokyo Trust Company, Chemical Bank, Citicorp U.S.A, Dresdner Bank AG, The First National Bank of Chicago, Morgan Guaranty Trust Company of New York, J. P. Morgan Delaware, NBD Bank, N.A. and Union Bank of Switzerland, filed as Exhibit (4)-1 to Form SE filed on November 6, 1992 (The Agreements executed by the Company and the various banks are identical in all respects to the form of Agreement filed as an Exhibit hereto except as to differences in the identity of the bank and the amount of the commitment [each as indicated in Exhibit A to the Agreement filed herewith] and other variations directly necessitated by said differences) The following exhibits are filed hereunder; and those exhibits marked with an asterisk (*) (together with those so marked on page 13) are management contracts or compensatory plans or arrangements required to be filed as exhibits pursuant to Item 14(c) of this report: (3) Amended Articles of Incorporation (amended January 26, 1989) *(10) TRINOVA Corporation 1989 Non-Employee Directors' Equity Plan (11) Statement re: Computation of Per Share Earnings (13) Portions of the 1993 Annual Report to Security Holders (to the extent incorporated by reference hereunder) (21) Subsidiaries of the Registrant (23)-1 Consent of Independent Auditors (23)-2 Consent of Independent Auditors (24) Powers of Attorney (99(i)) TRINOVA Corporation Directors' Charitable Award Program (b) TRINOVA did not file any reports on Form 8-K during the fourth quarter of 1993. (c) The exhibits which are listed under Item 14(a)(3) are filed or incorporated by reference hereunder. (d) The financial statement schedules which are listed under Item 14(a)(2) are filed hereunder. SIGNATURES Pursuant to the requirements of Section 13 or 15(d) 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. TRINOVA CORPORATION (Registrant) By: /S/ DARRYL F. ALLEN Darryl F. Allen Director, Chairman of the Board, President and Chief Executive Officer Date: March 18, 1994 Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated. /S/ DARRYL F. ALLEN Darryl F. Allen 3/18/94 Director, Chairman of the (Date) Board, President and Chief Executive Officer (Principal Executive Officer) /S/ DAVID M. RISLEY David M. Risley 3/18/94 Vice President - Finance (Date) and Chief Financial Officer (Principal Financial Officer) /S/ GREGORY R. PAPP Gregory R. Papp 3/18/94 Corporate Controller (Principal Accounting Officer) PURDY CRAWFORD* Purdy Crawford* 3/18/94 Director (Date) DELMONT A. DAVIS* Delmont A. Davis* 3/18/94 Director (Date) DAVID R. GOODE* David R. Goode* 3/18/94 Director (Date) PAUL A. ORMOND* Paul A. Ormond* 3/18/94 Director (Date) JOHN P. REILLY* John P. Reilly* 3/18/94 Director (Date) ROBERT H. SPILMAN* Robert H. Spilman* 3/18/94 Director (Date) WILLIAM R. TIMKEN, JR.* William R. Timken, Jr.* 3/18/94 Director (Date) *By James E. Kline, Attorney-in-fact /S/ JAMES E. KLINE James E. Kline 3/18/94 Vice President and General Counsel (Date) SCHEDULE X - SUPPLEMENTARY INCOME STATEMENT INFORMATION TRINOVA CORPORATION - ----------------------------------------------------------------------------- COL. A COL. B - ----------------------------------------------------------------------------- Item Charged to Costs and Expenses - ----------------------------------------------------------------------------- (In Thousands) Year Ended December 31 -------------------------------------- 1993 1992 1991 ---- ---- ---- Maintenance and repairs $ 34,162 $ 37,644 $ 40,869 Taxes, other than payroll and income taxes Note A Note A 17,480 Note A - Amounts for depreciation and amortization of intangible assets; pre-operating cost and similar deferrals; taxes, other than payroll and income taxes; royalties; and advertising costs are not presented if such amounts are less than 1 percent of total sales and revenues.

351145_1993.txt

351145

1993

ITEM 1. BUSINESS Intergraph Corporation was founded in 1969, and is organized as a Delaware corporation. Unless the context of this discussion dictates otherwise, references to the "Company" or "Intergraph" include Intergraph Corporation and subsidiaries. Intergraph's business is principally in one industry segment: interactive computer graphics systems. With an emphasis on technical disciplines, Intergraph systems combine graphics workstations, servers, and peripheral hardware with operating system and application-specific software programs authored by Intergraph and third party software developers to perform such functions as design, drafting, mapping, modeling, analysis, and documentation. These systems are developed, manufactured, sold, and serviced by the Company. Intergraph systems support the creation, analysis, display, output, and maintenance of virtually every type of design, drawing, map, and other graphic representation, while simultaneously providing capabilities to manage a database of non-graphic descriptive information associated with the graphics data. Systems hardware consists of: * Workstations and servers based on reduced instruction set computing (RISC) or Intel Corporation (Intel) microprocessors * A variety of Intergraph and third-party peripheral devices * Industry-standard networking Software includes applications for computer-aided design/computer- aided manufacturing/computer-aided engineering (CAD/CAM/CAE), mapping and geographic information systems, electronic publishing, technical information management, and database management. INTERGRAPH SYSTEMS Intergraph systems include hardware and application software developed by the Company and others. These products can be configured to address the needs of any size organization. The Company provides solutions which are integrated -- workstations, servers, peripherals, and software configured by the Company to work together and satisfy each customer's requirements. All Intergraph workstations and servers are currently based on the Company's microprocessor with a UNIX operating system or Intel microprocessors with the Windows/DOS or Windows NT operating system. The Company has historically manufactured workstations and servers based on its own microprocessor technology, and offered its software applications on the UNIX operating system, with only limited availability of its software applications on hardware platforms of other vendors. In late 1992, the Company announced its decision to port its technical software applications to Microsoft Corporation's new Windows NT operating system for high-end computing, and to make Windows NT available on Intergraph workstations. Microsoft's standard Windows system is widely accepted in the personal computing (PC) market. The effect of this decision is to expand the availability of the Company's workstations and software applications to Windows-based computing environments not previously addressed, including the availability of Intergraph software applications that will operate on selected hardware platforms of other manufacturers that use the Windows NT operating system. At the same time, the Company continues to develop and maintain products in the UNIX operating system environment, the foundation for its software applications before Windows NT, thereby offering existing and potential customers a choice of UNIX or Windows NT operating systems. In addition, the Company believes Intel's architecture has an important role in the technical computing market it serves and now offers a hardware platform for all its software applications based on Intel microprocessors under the Windows NT operating system. Limited shipments of Windows NT-based applications software began in the fourth quarter of 1993. Most of the Company's software applications are expected to be available on Windows NT during 1994. The Company began shipping new Intel-based workstations in third quarter 1993, and expects that Intel-based systems will represent the majority of its 1994 workstation shipments. In addition, the Company has ceased design of its own microprocessor and has entered into an agreement with Sun Microsystems Computer Corporation (Sun) that, among other things, provides for the Company's purchase from Sun beginning in the second half of 1995 of a microprocessor to be co-developed by the Company and Sun. The Company may choose to offer future products based on the Sun microprocessor. See "Management's Discussion and Analysis of Financial Condition and Results of Operations" for further discussion of the Sun agreement. The Company supports industry standards for operating systems, windowing, graphics, peripherals, and communication networks, allowing its systems to operate in computing environments with products from other vendors who support the same industry standards. Intergraph offers more than 1,200 interactive graphics application programs, including more than 700 developed by third parties. Systems currently sold by the Company are configured using a combination of the following: (1) Workstations manufactured by the Company that offer user- selectable main memory capacity and performance levels. This flexibility allows customers to match hardware capabilities with their production requirements. All Intergraph-manufactured workstations are based on its 32-bit RISC microprocessor or Intel microprocessors. Intergraph workstations are general-purpose computer systems that can run third-party application, data management, and data processing software packages. (2) RISC-based and Intel-based servers that function as plot, file, compute, and database nodes. The servers off-load these functions from standalone workstations and enable workstation users to share data and system resources in a distributed network. Intergraph's servers offer user-selectable configurations and performance levels. (3) Special-purpose peripherals, including scanners, scanner/plotters, photoplotters, electrostatic and pen plotters, color and monochrome hardcopy devices, magnetic and optical disk technology, a variety of disk and tape drives, alphanumeric terminals, screen image cameras, line printers, and other devices available from the Company, either manufactured in-house or as original equipment from third parties. (4) A broad range of UNIX application software and increasing numbers of applications based on Windows/DOS and Windows NT. See "Intergraph Applications Software" below. (5) MicroStation core graphics software from Bentley Systems, Inc., an Intergraph affiliate, for various operating systems and hardware platforms. (6) An open network architecture that ties Intergraph hardware and software products together and provides access to other systems and processes. PRODUCT TRANSITION The Company believes that offering a choice of UNIX and Windows NT operating systems and Intergraph and Intel hardware platforms will expand the market for its products. However, while the Company believes that Windows NT will become the dominant operating system in the markets it serves, other operating systems are available in the market, and several competitors of the Company also use UNIX or are adopting the Windows NT system for their product offerings. As in any product transition, the Company is unable to predict the precise effects of the transition on its revenues, margins, and profitability for 1994, but believes the transition may continue to adversely affect orders and revenues through the first half of 1994. See "Product Development" and "Competition" below. INTERGRAPH SYSTEMS SOFTWARE At the systems software level, Intergraph develops software to provide graphics and database management capabilities on Intergraph systems, advanced compilers for Intergraph systems, and utilities to enable interoperability with systems from other vendors. The graphics software foundation for many Intergraph UNIX-based software applications is MicroStation 32, a graphics software product owned by Bentley Systems, Inc., an Intergraph affiliate. MicroStation 32 provides fundamental graphics element creation, maintenance, and display functions. In addition to MicroStation 32 for Intergraph workstations, other versions of MicroStation are available on many hardware platforms from other vendors, including MicroStation PC for personal computers, MicroStation Mac for the Apple Macintosh, MicroStation Sun for Sun SPARCstations and MicroStation HP700 for the Hewlett-Packard HP700 workstation. A Japanese language version of MicroStation (release 4.0) runs on the NEC personal computer. MicroStation is compatible with Intergraph's original core graphics software, the Interactive Graphics Design System, which runs on Digital Equipment Corporation (DEC) VAX- based systems. Intergraph supports relational database management systems for attribute (non-graphic) data management on its own workstations and servers, as well as on systems from other vendors. Currently supported are Ingres, Oracle, Informix, DB2, Rdb, and SyBase. Intergraph's Relational Interface System (RIS) is a core product that provides database-independent access to data stored in supported databases. To facilitate the use of Intergraph systems with those from other vendors, the Company develops software for translating data into Intergraph formats, inputting large volumes of text into graphics and attribute files, and communicating with other computer systems. Additionally, Intergraph provides interfaces to various models of electrostatic and pen plotters (both online and offline), online typesetters, units producing computer output microfilm, and other output devices such as those used in the graphic arts industry. INTERGRAPH APPLICATIONS SOFTWARE Intergraph offers a broad suite of graphics and data management applications software. Architecture/engineering/construction (AEC), mapping and geographic information systems (GIS), and mechanical design, engineering, and manufacturing (MDEM) applications have dominated the product mix over the last three years, with no other single application representing more than 10% of systems revenue. The following is a brief description of the Company's major product application areas. Each product organization is led by a senior executive responsible for product development, marketing, training, support, and documentation. ARCHITECTURE/ENGINEERING/CONSTRUCTION. Intergraph's architectural, facility management, and engineering product line automates the project design and management process. With this software, users can develop and model building concepts, produce construction documents, and manage space and assets in a finished facility. The system serves the needs of architecture/engineering firms and corporate or governmental facility management offices. Included are capabilities for producing three-dimensional models of design concepts, architectural drawings, reports, engineering plans, and construction drawings (for example, heating, ventilation, and air conditioning; electrical; and plumbing). Packages are also offered for space planning and facility layout. Intergraph's civil engineering software includes capabilities for coordinate geometry and for structural, site, water resources, bridge, geotechnical and transportation engineering. Structural engineering software is used to create two- and three-dimensional structural models that serve as the basis for frame and finite element-based structural design and analysis of steel and concrete structures. For construction needs, the products support traditional drafting and report requirements. The Company's highway, rail, site, and hydraulic/hydrologic engineering products link traditional workflow activities from data collection to plan and profile production, to generation of construction drawings. The Company's plant design software addresses the needs of process and power plant design efforts. The Plant Design System (PDS) product supports piping and instrumentation diagram generation, electrical, structural, and other design aspects of a plant. Three- dimensional modeling capabilities are provided. The system performs interference-checking and provides reports, materials lists, and drawings. A supporting product provides "walk-throughs" of three- dimensional plant models. The electrical engineering products are used for engineering and analysis of power systems, panel layout, raceway design, and wiring diagram production. MAPPING AND GEOGRAPHIC INFORMATION SYSTEMS. Intergraph offers a range of GIS and mapping solutions to assist businesses, governments, and academic institutions in solving geography-based problems. Intergraph's GIS/mapping software tools address the entire life cycle of GIS/mapping projects from project and data management, through data collection and integration, spatial query and analysis, to output and map production. Intergraph's GIS/mapping solutions help companies address workflows in several major industries. These products support solutions for all levels of government including infrastructure management, planning, growth management, economic development, land information management, public safety and security, public works, redistricting, tactical and strategic defense applications (such as land-based command and control operations), and hydrographic systems. Transportation industry applications range from decision support activities such as policy, planning, and programming to the creation of operations systems that support such day-to-day tasks in transportation agencies. Utility companies utilize Intergraph's GIS/mapping products to develop cost-effective, efficient ways to automate management and analysis applications such as market analyses, environmental impact studies for siting, permitting, contaminant studies, and risk evaluation, long-range planning and forecasting, corridor evaluation and selection, and right-of-way analysis. Environmental and natural resource management applications include monitoring, evaluating and managing, conservation and remediation of the environment. Energy exploration and production products assist geoscientists in every phase of geological analysis related to energy exploration and production and mineral extraction. Intergraph also provides solutions for end-to-end digital map and chart publishing, digital image processing, orthophoto production, and digital photogrammetry. MECHANICAL DESIGN, ENGINEERING AND MANUFACTURING. For the mechanical design and manufacturing market, Intergraph offers software to automate the product development cycle from design through analysis, manufacturing, and documentation. Customers use the system to design mechanical parts and assemblies, defining complex parts with specialized sculptured surface and solid modeling software. Detailing, dimensioning, and drafting capabilities are included for the production of engineering drawings. Engineering software evaluates product designs for functional and structural integrity, predicting behavior under service or test conditions. Finite element modeling and analysis software evaluates designs by simulating stresses encountered in end use. Other products assist in optimizing material usage and cutting cycles for metalworking and fabrication. In addition, a data management system organizes shared product databases for coordination and management of product cycle phases. PRODUCT DEVELOPMENT The Company believes a strong commitment to ongoing product development is critical to success in the interactive computer graphics industry. Significant resources are devoted to development of Intergraph products, and the Company believes its product offerings are responsive to market and competitive demands. Product development expenditures include all costs related to designing new or improving existing equipment and software. During the year ended December 31, 1993, the Company spent $160.3 million (15.3% of revenues) for product development activities compared to $150.2 million (12.8% of revenues) in 1992, and $134.4 million (11.3% of revenues) in 1991. The interactive computer graphics industry is characterized by intense price and performance competition and short product cycles, which necessitate new product development on an ongoing basis. The future operating results of the Company, and of others in the industry, depend in large part on the ability to rapidly and continuously develop and deliver new hardware and software products that are competitively priced and offer enhanced performance. MANUFACTURING AND SOURCES OF SUPPLY The Company's primary manufacturing activities consist of the fabrication and testing of Company-designed electronic circuits and the assembly and testing of components and subassemblies manufactured by the Company and others. In January, 1994 the Company announced its decision to close its manufacturing facility located in Nijmegen, The Netherlands. The decision was made to take advantage of lower costs of production and distribution in the U.S., and to utilize existing capacity in the U.S. manufacturing operation. The facility will be closed in phases over the course of 1994, with all manufacturing and distribution activity transferred to the Company's U.S. manufacturing facility. European sales and support activity will continue to be provided by the Company's subsidiary operations located throughout Europe and by its European headquarters located in The Netherlands. The Company plans to sell or lease the Nijmegen facility. As described under "Intergraph Systems" above, the Company no longer designs its own microprocessor. The Company has agreements in place currently with Intel, and beginning in the second half of 1995, with Sun for provision of its microprocessor needs. The Company believes it has good relationships with Intel and Sun and is unaware of any reason that Intel or Sun might encounter difficulties in meeting the Company's microprocessor needs. An inability to obtain a sufficient supply of microprocessors from Intel and Sun would adversely affect the Company's results of operations. The Company is not dependent on any other sole source supplier of purchased parts, components, or peripherals used in the systems manufactured by the Company. The Company is not required to carry extraordinary amounts of inventory to meet customer demands or to ensure allotment of parts from its suppliers. SALES AND SUPPORT SALES. The Company's systems are sold by its direct sales force through sales offices in 52 countries worldwide. The efforts of the direct sales force are augmented by dealers, value-added-resellers, distributors, and system integrators. In general, the direct sales force is compensated on a combined base salary and commission basis. Sales quotas are established along with certain incentives for exceeding those quotas. Additional specific incentive programs may be established periodically. The Company's sales organization is organized along industry lines to focus on key industries (transportation, utilities, local government, defense, building, vehicle design, electronics, manufacturing, etc.). The Company believes this structure enables it to better meet the specialized needs of these industries. International markets, particularly Europe, continue to increase in importance to the industry and to the Company. The percentage of total Company revenues from customers outside the United States was 51% for the last two fiscal years. European customers represented 35% of total Company revenues in 1993 and 38% in 1992. There are currently wholly-owned sales and support subsidiaries of the Company located in every major European country. European subsidiaries are supported by service and technical assistance operations located in The Netherlands. Outside of Europe, Intergraph systems are sold and supported through a combination of subsidiaries and distributorships. At December 31, 1993, the Company had approximately 1,900 employees in Europe and 900 employees in other international locations. The Company's operations are subject to and may be adversely affected by a variety of risks inherent in doing business internationally, such as government policies or restrictions, currency exchange fluctuations, and other factors. See Management's Discussion and Analysis of Financial Condition and Results of Operations and Notes 1 and 9 of Notes to Consolidated Financial Statements contained in the Company's 1993 Annual Report, portions of which are incorporated herein by reference, for further discussion of the Company's international operations. CUSTOMER SUPPORT. The Company believes that a high level of customer support is important to the sale of interactive graphics systems. Customer support includes pre-installation guidance, education services, customer training, onsite installation, hardware preventive maintenance, repair service, software help desk and technical support services in addition to consultative professional services. The Company employs engineers and technical specialists to provide customer assistance, maintenance, and training. Maintenance and repair of systems are covered by standard warranties and by maintenance agreements to which substantially all users subscribe. U.S. GOVERNMENT BUSINESS Revenues from the United States government were $165.7 million in 1993 (16% of total revenue), $186.5 million in 1992 (16% of total revenue), and $172.3 million in 1991 (14% of total revenue). Approximately 40% of total federal government revenues are earned under long-term contracts. The Company believes it has a good relationship with the federal government. While it is fully anticipated that these contracts will remain in effect through their expiration, the contracts are subject to termination at the election of the government (with damages paid to the Company). Any loss of a significant government contract through termination or expiration without renewal or replacement would have an adverse impact on the results of operations of the Company. No other customer exceeds 10% of the total revenue of the Company. BACKLOG An order is entered into backlog only when the Company receives a firm purchase commitment from a customer. The Company's backlog of unfilled systems orders at December 31, 1993, was $232 million. At December 31, 1992, backlog was $275 million. Substantially all of the December 1993 backlog of orders is expected to be shipped during 1994. The Company does not consider its business to be seasonal, though typically fourth quarter orders and revenues exceed those of other quarters. The Company does not ordinarily provide return of merchandise or extended payment terms to its customers. COMPETITION The industry in which the Company competes continues to be characterized by price and performance competition. To compete successfully, the Company and others in the industry must continuously develop products with enhanced performance that can be offered at a competitive price. The Company, along with other companies in the industry, engages in the practice of price discounting to meet competitive industry conditions. Other important competitive factors include quality, reliability, and customer service, support, and training. Management of the Company believes that competition will remain intense. Competition in the interactive computer graphics industry varies among the different application areas. The Company considers its principal competitors in the interactive computer graphics market to be IBM, Computervision Corp., Hewlett-Packard Corp., DEC, Sun, Unigraphics (a division of Electronic Data Systems, Inc.), Silicon Graphics, Inc., and Mentor Graphics, Inc. In the personal computer-based graphics market, Intergraph competes with the products of Autodesk, Inc. and Computervision. Several companies with greater financial resources than the Company, including IBM, DEC, and Hewlett-Packard, are increasing their activities in the industry. The Company provides solutions which are integrated -- workstations, servers, peripherals, and software configured by the Company to work together and satisfy each customer's requirements. By delivering such integration, the Company believes it has an advantage over other vendors who provide only hardware or software, leaving system integration to the customer. In addition, the Company believes that its experience and extensive worldwide customer service and support infrastructure represent a competitive advantage. ENVIRONMENTAL AFFAIRS The Company's manufacturing facilities are subject to numerous laws and regulations designed to protect the environment, particularly from plant wastes and emissions. In the opinion of the Company, compliance with these laws and regulations has not had, and should not have, a material effect on the capital expenditures, earnings, or competitive position of the Company. LICENSES, COPYRIGHTS, TRADEMARKS, AND PATENTS The Company develops its own graphics, data management, and applications software as part of its continuing product development activities. The Company has standard license agreements with UNIX Systems Laboratories for use and distribution of the UNIX operating system, and with Microsoft Corporation for use and distribution of the Windows NT operating system. The license agreements are perpetual and allow the Company to sublicense the operating systems software upon payment of required sublicensing fees. In addition, the Company has an exclusive worldwide license agreement with Bentley Systems, Inc. (a 50%-owned affiliate of the Company) to market, use, distribute, and sublicense MicroStation software. See Item 3. Legal Proceedings for further details. The Company has an extensive program for the licensing of third- party application and general utility software for use on systems and workstations. The Company owns and maintains a number of registered patents and registered and unregistered copyrights, trademarks, and servicemarks. The patents and copyrights held by the Company are the principal means by which the Company preserves and protects the intellectual property rights embodied in the Company's hardware and software products. Similarly, trademark rights held by the Company are used to preserve and protect the goodwill represented by the Company's registered and unregistered trademarks, such as the federally registered trademark "Intergraph". As industry standards proliferate, there is a possibility that the patents of others may become a significant factor in the Company's business. Personal computer technology, for example, is widely available, and many companies, including Intergraph, are attempting to develop patent positions concerning technological improvements related to PCs and workstations. At present, it does not appear that Intergraph will be prevented from using the technology necessary to compete successfully since patented technology is typically available in the industry under royalty- bearing licenses or patent cross-licenses, or the technology can be purchased on the open market. Any increase in royalty payments or purchase costs would increase the Company's costs of manufacture, however, and it is possible, though not anticipated, that some key improvement necessary to compete successfully in some markets served by the Company may not be available. The Company is actively engaged in a program to protect by patents the technology it is developing. The Company believes its success depends less on its ability to obtain and defend copyrights, trademarks, and patents than on its ability to offer higher-performance products for specific solutions at competitive prices. EMPLOYEES At December 31, 1993, the Company had approximately 9,500 employees. Of these, approximately 2,800 were employed outside the United States. The Company's employees are not subject to collective bargaining agreements, and there have been no work stoppages due to labor difficulties. Management of the Company believes it has a good relationship with its employees. Total employment is approximately 800 less than at December 31, 1992. The reduction was achieved both through direct action by the Company and through normal attrition. See Management's Discussion and Analysis of Financial Condition and Results of Operations for further details. ITEM 2.

ITEM 2. PROPERTIES The Company's corporate offices and primary manufacturing facility are located in Huntsville, Alabama. Manufacturing facilities located in Nijmegen, The Netherlands will be closed in 1994, as explained under "Manufacturing and Sources of Supply" above. Sales and support facilities are maintained throughout the world. The Company owns over 2,000,000 square feet of space in Huntsville that is utilized for manufacturing, product development, sales and administration. The Huntsville facilities also include over 500 acres of unoccupied land that can be used for future expansion. The Company maintains subsidiary company facilities and sales and support locations in major U.S. cities outside of Huntsville, primarily through operating leases. Outside the U.S., the Company owns approximately 500,000 square feet of space, primarily its Nijmegen manufacturing facility and European headquarters facility. Sales and support facilities are leased in most major international locations. The Company considers its facilities to be adequate for the immediate future. ITEM 3.

ITEM 3. LEGAL PROCEEDINGS The Company is a 50% owner of Bentley Systems, Inc. (BSI). BSI granted Intergraph an exclusive worldwide license to distribute MicroStation, which is a basic software package utilized by many of Intergraph's software applications. BSI notified Intergraph on February 3, 1994, that in its opinion certain events have occurred under the terms of the license agreement which make the license nonexclusive, and as a result, BSI may compete with Intergraph in the distribution of MicroStation and in the development and distribution of additional software products. Intergraph disputes that the license agreement has changed, and pursuant to the license agreement, Intergraph has submitted the dispute to arbitration under the rules of the American Arbitration Association. Related lawsuits were filed in February 1994, among BSI, Intergraph, and the other 50% shareholders of BSI in the Court of Common Pleas, Chester County, Pennsylvania, the Circuit Court of Madison County, Alabama and the United States District Court for the Eastern District of Pennsylvania. The principal relief sought is a declaration of the rights of the parties under the license and related agreements. The Company has entered into negotiations which could result in settlement of this matter. See the discussion under Results of Operations set forth in Management's Discussion and Analysis of Financial Condition and Results of Operations contained in the Company's 1993 Annual Report. ITEM 4.

ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SHAREHOLDERS None. EXECUTIVE OFFICERS OF THE COMPANY Certain information with respect to the executive officers of the Company is set forth below. Officers serve at the discretion of the Board of Directors. James W. Meadlock is a founder of the Company, has served as Chairman of the Board of Directors since the Company's inception in 1969, and is Chief Executive Officer. Mr. Meadlock and Nancy B. Meadlock are husband and wife. Larry J. Laster joined the Company in June 1981. Since that time, he has held several managerial positions in the Company's Finance Department and Federal Systems Division. He was elected Vice President in December 1986, named Chief Financial Officer in February 1987, elected to the Board of Directors in April 1987, and is currently Executive Vice President. Mr. Laster is a certified public accountant. Nancy B. Meadlock is a founder of the Company and has been a Director since 1969, excluding the period from February 1970 to February 1972. Mrs. Meadlock served as Secretary for ten years, was elected Vice President in 1979, and is currently Executive Vice President and Director. She holds a master's degree in business administration. Mrs. Meadlock and James W. Meadlock are wife and husband. Robert E. Thurber is a founder of the Company and has been a Director since 1972. He is responsible for the development of applications software to support AEC, mapping/GIS and utilities disciplines. In June 1977, Mr. Thurber was elected Vice President and is currently Executive Vice President. Mr. Thurber holds a master's degree in engineering. Lawrence F. Ayers, Jr., joined the Company in September 1987 after 32 years in federal government mapping where he became the Civilian Director of the Defense Mapping Agency. He served as Vice President for International Federal Marketing until February 1993 and is currently Executive Vice President with responsibility for commercial mapping and utility products. Mr. Ayers holds a bachelors of science degree in civil engineering and a master's degree in public administration. Neil E. Keith joined the Company in December 1981. He was elected Vice President in September 1985 and is currently Executive Vice President. He has extensive experience in manufacturing management and is responsible for the Company's manufacturing operations worldwide. Stephen J. Phillips joined the Company as Vice President and General Counsel in November 1987 when Intergraph purchased the Advanced Processor Division of Fairchild Semiconductor, where Mr. Phillips was General Patent Counsel. He was elected Executive Vice President in August 1992. Mr. Phillips holds a master's degree in electrical engineering and a juris doctor in law. Maurice G. Romine joined the Company in October 1976 in a Federal Systems support role and has since held key positions in the Company responsible for sales, marketing, development and support of the Company's computer graphics systems. He was responsible for organizing and managing the Company's European operations starting in January 1979. He was elected Vice President of European Operations in 1983 where he served until July 1986, when he returned to the U.S. as Vice President of the Mapping and Energy software product center. He was elected Executive Vice President in January 1987. Mr. Romine reassumed responsibility for the European operations in January 1987 until October 1989. In November 1989 Mr. Romine was appointed as Executive Vice President of Corporate Marketing and later also given responsibility for the MicroStation software product center. Since October 1992, he has served as Executive Vice President of Corporate Operations. William E. Salter joined the Company in April 1973. Since that time, he has held several managerial positions in the Company's Federal Systems Division and has served as Manager of Marketing Communications. Dr. Salter was elected Vice President in August 1984 and is currently Executive Vice President with responsibility for the Company's Federal Systems Division. He holds a doctorate in electrical engineering. Tommy D. Steele joined the Company in June 1992 as Executive Vice President with responsibility for software systems, mechanical design and technical information management applications, and professional services. Mr. Steele came to Intergraph from IBM Corporation, where he was employed 28 1/2 years. At IBM, he worked on Apollo/Skylab/Saturn programs, the space shuttle, and a number of Department of Defense programs. In his last four years with IBM, he managed PC Operating Systems (OS/2, DOS, and AIX) for IBM. Herman E. Thomason joined the Company in 1985 and was involved in the development of the Company's federal government business. In 1991, he was elected Executive Vice President with responsibility for the Company's scanning and imaging hardware and software, as well as for the graphic arts and publishing products. He holds a doctorate in electrical engineering. John M. Thorington, Jr., joined the Company in August 1977 and was responsible for the design, development, and manufacture of many of the Company's hardware products. In May 1980, Dr. Thorington was elected Vice President, Graphics Engineering, and is currently Executive Vice President. He holds a doctorate in electrical engineering. Damian Walters joined the Company in 1984 as the Managing Director of Intergraph Australia, a subsidiary of the Company. In 1986, he established the Intergraph office in New Zealand and in 1987 established the Asia Pacific regional headquarters operation in Hong Kong. In 1991, Mr. Walters was elected Vice President. In 1994, he was elected Executive Vice President. Mr. Walters is currently responsible for the Company's Asia Pacific region. Allan B. Wilson joined the Company in 1980 and was responsible for the development of international operations outside of Europe and North America. He was elected Vice President in May 1982 and Executive Vice President in November 1982. Mr. Wilson is responsible for corporate marketing (including marketing communications) as well as office automation standards and support. He holds a master's degree in electrical engineering. Manfred Wittler joined the Company in 1989 as Vice President. In 1991, he was elected Executive Vice President and is currently responsible for sales and support for Europe and the Americas. From 1983 through 1989, Mr. Wittler served as Division Vice President for Data General Corporation in Europe. PART II ITEM 5.

ITEM 5. MARKET FOR THE COMPANY'S COMMON STOCK AND RELATED SHAREHOLDER MATTERS The information appearing under "Dividend Policy" and "Price Range of Common Stock" on page 27 of the Intergraph Corporation 1993 Annual Report to Shareholders is incorporated by reference in this Form 10-K Annual Report. ITEM 6.

ITEM 6. SELECTED FINANCIAL DATA Selected financial data for the five years ended December 31, 1993, appearing under "Five-Year Financial Summary" on the inside front cover page of the Intergraph Corporation 1993 Annual Report to Shareholders are incorporated by reference in this Form 10-K Annual Report. ITEM 7.

ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Management's discussion and analysis of financial condition and results of operations appearing on pages 8 to 12 of the Intergraph Corporation 1993 Annual Report to Shareholders is incorporated by reference in this Form 10-K Annual Report. ITEM 8.

ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA The consolidated financial statements appearing on pages 13 to 26 of the Intergraph Corporation 1993 Annual Report to Shareholders are incorporated by reference in this Form 10-K Annual Report. ITEM 9.

ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE None. PART III ITEM 10.

ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE COMPANY The information appearing under "Election of Directors" and "Board Committees and Attendance" on pages 4 to 5 of the Intergraph Corporation Proxy Statement relative to the Annual Meeting of Shareholders to be held May 12, 1994, is incorporated by reference in this Form 10-K Annual Report. Directors are elected for terms of one year at the annual meeting of the Company's shareholders. Information relating to the executive officers of the Company appearing under "Executive Officers of the Company" on pages 9 to 10 in this Form 10-K Annual Report is incorporated herein by reference. ITEM 11.

ITEM 11. EXECUTIVE COMPENSATION The information appearing under "Executive Compensation" on pages 5 to 12 of the Intergraph Corporation Proxy Statement relative to the Annual Meeting of Shareholders to be held May 12, 1994, is incorporated by reference in this Form 10-K Annual Report. ITEM 12.

ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT The information appearing under "Common Stock Outstanding and Principal Shareholders" on pages 2 to 3 of the Intergraph Corporation Proxy Statement relative to the Annual Meeting of Shareholders to be held May 12, 1994, is incorporated by reference in this Form 10-K Annual Report. ITEM 13.

ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS The information appearing under "Certain Relationships and Related Transactions" on page 5 of the Intergraph Corporation Proxy Statement relative to the Annual Meeting of Shareholders to be held May 12, 1994, is incorporated by reference in this Form 10-K Annual Report. PART IV ITEM 14.

ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K Page in Annual Report * -------- (a) 1) The following consolidated financial statements of Intergraph Corporation and subsidiaries and the report of independent auditors thereon are incorporated by reference from the Intergraph Corporation 1993 Annual Report to Shareholders: Consolidated Balance Sheets at December 31, 1993 and 1992 13 Consolidated Statements of Income for the three years ended December 31, 1993 14 Consolidated Statements of Cash Flows for the three years ended December 31, 1993 15 Consolidated Statements of Shareholders' Equity for the three years ended December 31, 1993 16 Notes to Consolidated Financial Statements 17 - 26 Report of Independent Auditors 27 Page in Form 10-K --------- 2) Financial Statement Schedules: Schedule II - Amounts Receivable from Related Parties and Underwriters, Promoters, and Employees Other than Related Parties for the three years ended December 31, 1993 17 Schedule V - Property, Plant, and Equipment for the three years ended December 31, 1993 18 Schedule VI - Accumulated Depreciation of Property, Plant, and Equipment for the three years ended December 31, 1993 19 Schedule VIII - Valuation and Qualifying Accounts and Reserves for the three years ended December 31, 1993 20 Schedule IX - Short-Term Borrowings for the three years ended December 31, 1993 21 Schedule X - Supplementary Income Statement Information for the three years ended December 31, 1993 22 All other schedules are omitted because they are not applicable or the required information is shown in the financial statements or notes thereto. Financial statements of 20%- to 50%-owned companies have been omitted because the registrant's proportionate share of income before income taxes and total assets of the companies is less than 20% of the respective consolidated amounts, and the investments in and advances to the companies are less than 20% of consolidated total assets. * Incorporated by reference from the indicated pages of the 1993 Annual Report to Shareholders. 3) Exhibits Page in Number Description Form 10-K ------ ----------- --------- 3(a) Certificate of Incorporation, Bylaws, and Certificate of Merger. (1) 3(b) Amendment to Certificate of Incorporation. (2) 3(c) Restatement of Bylaws. (3) 4 Shareholder Rights Plan, dated August 25, 1993. (4) 10(a) 1990 Intergraph Corporation Employee Stock Option Plan. *(5) 10(b) Intergraph Corporation 1992 Stock Option Plan. *(6) 10(c) Employment contracts of Manfred Wittler, dated November 1, 1989 (7) and April 18, 1991. * 10(d) Loan program for executive officers of the Company. *(7) 10(e) Employment contract of Howard G. Sachs, dated February 8, 1993. * 10(f) Termination agreement with Howard G. Sachs, dated August 9, 1993. * 10(g) Consulting contract of Keith H. Schonrock, Jr., dated January 17, 1990. * 10(h) Agreement between Intergraph Corporation and Green Mountain, Inc., dated February 23, 1994. * 11 Computation of Earnings (Loss) Per Share 23 13 Portions of the Intergraph Corporation 1993 Annual Report to Shareholders incorporated by reference in this Form 10-K Annual Report 21 Subsidiaries of the Company 24 23 Consent of Independent Auditors 25 - -------------------- (1) Incorporated by reference to exhibits filed with the Company's Quarterly Report on Form 10-Q for the quarter ended June 30, 1984, under the Securities Exchange Act of 1934, File No. 0-9722. (2) Incorporated by reference to exhibits filed with the Company's Quarterly Report on Form 10-Q for the quarter ended March 31, 1987, under the Securities Exchange Act of 1934, File No. 0-9722. (3) Incorporated by reference to exhibits filed with the Company's Quarterly Report on Form 10-Q for the quarter ended June 30, 1993, under the Securities Exchange Act of 1934, File No. 0-9722. (4) Incorporated by reference to exhibits filed with the Company's Current Report on Form 8-K dated August 25, 1993, under the Securities Exchange Act of 1934, File No. 0-9722. (5) Incorporated by reference to exhibits filed with the Company's Annual Report on Form 10-K for the fiscal year ended December 31, 1989, under the Securities Exchange Act of 1934, File No. 0-9722. (6) Incorporated by reference to exhibits filed with the Company's Annual Report on Form 10-K for the fiscal year ended December 31, 1991, under the Securities Exchange Act of 1934, File No. 0-9722. (7) Incorporated by reference to exhibits filed with the Company's Annual Report on Form 10-K for the fiscal year ended December 31, 1992, under the Securities Exchange Act of 1934, File No. 0-9722. * Denotes management contract or compensatory plan, contract or arrangement required to be filed as an Exhibit to this Form 10-K. - -------------------- (b) No reports on Form 8-K were filed during the fourth quarter of the fiscal year ended December 31, 1993. (c) Exhibits - the response to this portion of Item 14 is submitted as a separate section of this report. (d) Financial statement schedules - the response to this portion of Item 14 is submitted as a separate section of this report. SIGNATURES Pursuant to the requirements of Section 13 or 15(d) 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. INTERGRAPH CORPORATION By Larry J. Laster Date: March 18, 1994 -------------------------- Larry J. Laster Executive Vice President, Chief Financial Officer and Director Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated. Date ---- James W. Meadlock - ---------------------- Chief Executive Officer and March 18, 1994 James W. Meadlock Chairman of the Board (Principal Executive Officer) Larry J. Laster - ---------------------- Executive Vice President, Chief March 18, 1994 Larry J. Laster Financial Officer and Director (Principal Financial Officer) Nancy B. Meadlock - ---------------------- Executive Vice President March 18, 1994 Nancy B. Meadlock and Director Robert E. Thurber - ---------------------- Executive Vice President March 18, 1994 Robert E. Thurber and Director Roland E. Brown - ---------------------- Director March 18, 1994 Roland E. Brown Keith H. Schonrock, Jr. - ---------------------- Director March 18, 1994 Keith H. Schonrock, Jr. James F. Taylor, Jr. - ---------------------- Director March 18, 1994 James F. Taylor, Jr. John W. Wilhoite - ---------------------- Vice President and Controller March 18, 1994 John W. Wilhoite (Principal Accounting Officer) INTERGRAPH CORPORATION AND SUBSIDIARIES SCHEDULE II ---- AMOUNTS RECEIVABLE FROM RELATED PARTIES AND UNDERWRITERS, PROMOTERS, AND EMPLOYEES OTHER THAN RELATED PARTIES (1) Amount represents an unsecured promissory note receivable from Mr. Meadlock, who is Chief Executive Officer of the Company. Interest is charged at the prime rate. The loan is due in full by the earlier to occur of the date of sale of any common stock of the Company by Mr. Meadlock or May 20, 1994. This loan was executed under the provisions of the Executive Officer Loan Program. (2) Amount represented an unsecured promissory note receivable from Mr. Meadlock. The note was paid in full in 1992. Interest was charged at a rate of prime plus 2%. (3) Amount represented a non-interest bearing note receivable from Mr. Epstein, who was a Vice President of the Company. The note was a housing bridge loan secured by a mortgage on real estate. The note was paid in full in 1991. INTERGRAPH CORPORATION AND SUBSIDIARIES SCHEDULE V ---- PROPERTY, PLANT AND EQUIPMENT (In Thousands) (1) Additions to equipment, furniture and fixtures in each year consist primarily of computer hardware manufactured by the Company and used in product development. (2) Non-cash additions consist of additions to a building at a cost of $7,246 through a long-term debt transaction in 1991. (3) Other changes consist primarily of changes in the reported dollar amounts of fixed assets held by international subsidiaries as the result of changes in currency translation rates. (4) As a part of changes in the Company's product, sales and manufacturing strategies, the Company will eliminate certain operations in phases over the course of 1994. Included in property, plant and equipment is $13.3 million in net book value of assets related to these operations, consisting primarily of $10.6 million in net book value of land and buildings comprising the Company's Netherlands manufacturing facility. The net book value of that facility approximates market value. The Company will sell or lease the facility. Certain reclassifications have been made to the previously reported 1991 and 1992 balances to provide comparability with the current year presentation. INTERGRAPH CORPORATION AND SUBSIDIARIES SCHEDULE VI ---- ACCUMULATED DEPRECIATION OF PROPERTY, PLANT AND EQUIPMENT (In Thousands) (1) Depreciation is provided using the straight-line method over the estimated useful lives of the assets. Asset lives range from three to thirty years. (2) Other changes consist primarily of changes in the reported dollar amounts of accumulated depreciation on fixed assets held by international subsidiaries as the result of changes in currency translation rates. (3) See Note 4 in Schedule V regarding operations to be eliminated. Certain reclassifications have been made to the previously reported 1991 and 1992 balances to provide comparability with the current year presentation. INTERGRAPH CORPORATION AND SUBSIDIARIES SCHEDULE VIII ---- VALUATION AND QUALIFYING ACCOUNTS AND RESERVES (1) Uncollectible accounts written off, net of recoveries. (2) Obsolete inventory reduced to net realizable value. INTERGRAPH CORPORATION AND SUBSIDIARIES SCHEDULE IX ---- SHORT-TERM BORROWINGS (1) Represents financing arranged on behalf of an international subsidiary with repayment guaranteed by the parent company. (2) The average amount outstanding during the period was computed by dividing the total of month-end outstanding principal balances by 12. (3) The weighted average interest rate during the period was computed by dividing actual interest expense for the period by the weighted average amount outstanding during the period. INTERGRAPH CORPORATION AND SUBSIDIARIES SCHEDULE X ---- SUPPLEMENTARY INCOME STATEMENT INFORMATION Column A Column B ----------------- -------------------- Charged to costs Item and expenses ----------------- -------------------- Amortization of intangible assets 1993 $20,072,000 1992 $12,800,000 1991 $ 9,168,000 Royalties 1993 $40,048,000 1992 $37,175,000 1991 $31,168,000 Advertising 1993 $10,609,000 1992 $10,800,000 1991 $11,826,000

51296_1993.txt

51296

1993

Item 1. BUSINESS Navistar International Transportation Corp., hereinafter referred to as "the Company" and "Transportation," is the wholly-owned subsidiary of a holding company, Navistar International Corporation, hereinafter referred to as "Navistar" and the "Parent Company." Transportation, operates in one principal business segment, the manufacture and marketing of medium and heavy diesel trucks, including school bus chassis, mid-range diesel engines and service parts in North America and in selected export markets. Transportation is the industry market share leader in the North American combined medium and heavy truck market, offering a full line of diesel-powered products in the common carrier, private carrier, government/service, leasing, construction, energy/petroleum and student transportation markets. Transportation also produces mid-range diesel engines for use in its medium trucks and for sale to original equipment manufacturers. Transportation markets its products through an extensive distribution network which includes 950 North American dealer and distribution outlets. Service and customer support are also supplied at these outlets. As a further extension of its business, Transportation provides financing and insurance for its dealers, distributors and retail customers through its wholly-owned subsidiary, Navistar Financial Corporation, referred to as "Navistar Financial". See "Important Supporting Operations". THE MEDIUM AND HEAVY TRUCK INDUSTRY Transportation competes in the North American market for medium and heavy trucks, including school bus chassis, which spans weight classes 5 and above (16,000 lbs. and over). This market is subject to considerable volatility as it moves in response to cycles in the overall business environment and is particularly sensitive to the industrial sector which generates a significant portion of the freight tonnage hauled. Government regulation has impacted and will continue to impact trucking operations and efficiency and the specifications of equipment. The following table shows retail deliveries in the combined United States and Canadian markets for the five years ended October 31, 1993, in thousands of units. YEARS ENDED OCTOBER 31, ----------------------- 1993 1992 1991 1990 1989 ----- ----- ----- ----- ----- Medium trucks and school bus chassis .. 122.5 118.3 120.1 149.8 162.8 Heavy trucks .............. 166.4 125.2 109.0 139.0 172.2 ----- ----- ----- ----- ----- Total ..................... 288.9 243.5 229.1 288.8 335.0 ===== ===== ===== ===== ===== Source: Based upon monthly data by the American Automobile Manufacturers Associations (AAMA) in the United States and Canada and other sources. The North American truck market is highly competitive. Major domestic competitors include PACCAR, Ford and General Motors, as well as foreign-controlled manufacturers, such as Freightliner, Mack and Volvo GM. In addition, manufacturers from Japan (Hino, Isuzu, Nissan, Mitsubishi) are attempting to increase their North American sales levels. The intensity of this competitiveness, which is expected to continue, results in price discounting and margin pressures throughout the industry. In addition to the influence of price, market position is driven by product quality, engineering, styling and utility and a comprehensive distribution system. TRANSPORTATION MARKET SHARE Transportation delivered 79,800 medium and heavy trucks in North America in fiscal 1993, compared to a total of 69,300 for fiscal 1992, an increase of 15.1% in overall units. Transportation's combined share of the medium and heavy truck market in 1993 was 27.6%; continuing its leadership in combined market share in North America over the last 13 fiscal years. PRODUCTS AND SERVICES The following table illustrates the percentage of Transportation's sales by class of product by dollar amount: YEARS ENDED OCTOBER 31, -------------------------- PRODUCT CLASS 1993 1992 1991 - ------------- ---- ---- ---- Medium trucks and school bus chassis ........ 35% 40% 44% Heavy trucks .................... 40 34 31 Service parts ................... 14 16 16 Engines ......................... 11 10 9 ---- ---- ---- Total ......................... 100% 100% 100% ==== ==== ==== Transportation offers a full line of medium and heavy trucks, with the objective of serving the customer better and more effectively by addressing requirements for increased performance and value. Transportation has made continuing improvements in its heavy truck image and performance and has responded to drivers' desires for increased amenities with the introduction of new sleeper compartments, interiors and aerodynamic chassis skirts for premium conventional models. New interiors were also introduced for cabover and severe service trucks. In addition, new mid-range DT 408 and DT 466 diesel engines were introduced into the medium model trucks which meet 1994 diesel emission control standards without the need for catalytic converters. These engines will further enhance medium truck operating performance and life. In 1993, Transportation introduced new products including the 9200 model premium conventional tractor as well as other enhancements to its products to improve operating performance and durability. In addition, Transportation has launched special "NavTrucks" programs to meet the needs of customers in targeted regional vocations. Each NavTruck program tailors existing medium, heavy and severe service truck models to an individual regional vocation by packaging appropriate vehicle specifications and marketing programs. According to a recent survey conducted by J. D. Power and Associates on 1993 Medium-Duty Truck Customer Satisfaction, Navistar ranked number one in customer satisfaction in product and service for medium conventional trucks. For over two decades, Transportation has been the leading supplier of school bus chassis in the United States. Chassis have traditionally been sold to body companies, which complete the buses and deliver them to the ultimate customer. Transportation manufactures chassis for conventional and transit-style school buses, as well as chassis for use in small capacity buses designed to meet the needs of disabled students. In addition to its traditional chassis business, Transportation has invested in American Transportation Corporation (AmTran), a manufacturer of school bus bodies. Through its relationship with AmTran, Transportation participates in the trend toward the integrated design and manufacture of school buses, which offers the potential for improved production and marketing efficiencies and a reduction in the school bus order cycle. Transportation offers only diesel-powered trucks and buses because of their improved fuel economy, ease of serviceability and greater durability over gasoline-powered vehicles. Transportation's heavy trucks use diesel engines purchased from outside suppliers, while its medium trucks are powered by diesel engines manufactured by Transportation. In 1993, Transportation launched its all new world class series of in-line six cylinder diesel engines for bus, medium and heavy models. Transportation is the leading supplier of mid-range diesel engines in the 150-300 horsepower range according to data supplied by a private research firm, Power Systems Research of Minneapolis, Minnesota. Based upon information published by R.L. Polk & Company, diesel-powered medium truck shipments represented 81% of all medium truck shipments for fiscal year 1993 in North America. Transportation's North American truck manufacturing operations consist principally of the assembly of components manufactured by its suppliers, although Transportation produces its own medium range truck engines, sheet metal components (including cabs) and miscellaneous other parts. The following is a summary of Transportation's truck manufacturing capacity utilization for the five years ended October 31, 1993. YEARS ENDED OCTOBER 31, ------------------------------------------- 1993 1992 1991 1990 1989 ------- ------- ------- ------- ------- Production units .......... 88,274 73,901 70,502 80,737 90,897 Total production capacity ................ 106,032 106,088 106,762 114,402 119,325 Capacity utilization ...... 83.3% 69.7% 66.0% 70.6% 76.2% Total production capacity varies as a result of changes in the number of days of production during a year as well as changes in production constraints. ENGINE & FOUNDRY Transportation builds diesel engines for use in its medium trucks and for sale to original equipment manufacturers. Production in 1993 totalled 175,500 units, an increase of 18% from the 149,000 units produced in 1992. In 1993, Transportation produced the DTA 466 (195-270 horsepower), DTA 360 (170-190 horsepower) and 7.3 liter (155-190 horsepower) mid-range diesel engines. In September 1993, the DT 408 (175-230 horsepower) was introduced which replaced the DTA 360 while the DT 466 (195-275 horsepower) replaced the DTA 466. Transportation believes that its family of mid-range diesel engines, each designed to provide superior performance in customer applications, offers both the lowest cost of ownership and excellent durability to users. Based on U.S. registrations published by R.L. Polk & Company, the 7.3 liter diesel engine is the leading engine of its class. In addition to its strong contribution to the market position of Transportation's medium trucks, the 7.3 liter engine and the predecessor 6.9 liter engine have had significant external sales. Engine sales to original equipment manufacturers are primarily made to a major automotive company, which currently accounts for approximately 91% of sales, and to DINA Camiones, S.A. (DINA), a major truck manufacturer in Mexico. The automotive company uses the engine in all of its diesel-powered light trucks and vans having a gross vehicle weight between 8,500 pounds and 14,000 pounds. Shipments to original equipment manufacturers totalled a record 118,200 units in 1993, an increase of 21% from the 97,400 units shipped in 1992. In addition to the use of foundry castings in its products, Transportation sells castings to other original equipment manufacturers. Sales of rough grey iron engine blocks and cylinder heads to Consolidated Diesel Corporation (CDC) for its B and C engines were 24,700 tons in 1993 and represented 26% of total foundry capacity. 1993 was the fifth year of a five year agreement with CDC. The following is a summary of Transportation's engine capacity utilization for the five years ended October 31, 1993. YEARS ENDED OCTOBER 31, ------------------------------------------- 1993 1992 1991 1990 1989 ------- ------- ------- ------- ------- Engine production units ... 175,464 148,991 126,103 160,434 169,797 Total production capacity ................ 166,260 166,260 166,720 166,720 167,242 Capacity utilization ...... 105.5% 89.6% 75.6% 96.2% 101.5% Total production capacity varies as a result of changes in product mix. Transportation recently completed a major capital improvement program in its engine facilities to manufacture a new generation of mid-range diesel engines in both the in-line six cylinder and V-8 configurations to be used in its trucks and school bus chassis and also sold to other original equipment manufacturers. This new generation of engines is designed to respond to customer demands for engines that have more power, improved fuel economy, longer life, and meet current emission requirements through 1997. The engines also will be offered in a wider horsepower range, which will give Transportation an opportunity to expand the number of applications for its engines and broaden its customer base. In September 1993, Transportation introduced three new in-line six cylinder engines that replaced its current DT family of engines in International medium trucks. These new engines, which offer displacements of 408, 466 and 530 cubic inches and encompass a horsepower range from 175 to 300, feature 20 percent longer life as a result of larger main and rod bearings, stronger crankshafts, gear driven accessories and, in 1994, electronically controlled fuel systems will be introduced. With their expanded horsepower range and larger displacement, Transportation will also be able to offer the new engines as a lighter-weight, more cost- effective product, which meets emission standards, to customers who currently buy heavier engines from other suppliers. The 7.3 Liter V-8 diesel engine product will also be replaced in February 1994, when Transportation begins production of an entirely new product, with electronically controlled fuel injection. This new diesel engine will offer significant customer advantages, with a 10 to 15 percent improvement in fuel economy, 30 to 40 percent enhancement in durability, and improved power and torque, when compared to Transportation's existing V-8 product. The new V-8 also will meet the 1994 emissions requirements cost-effectively and will allow such options as cruise control, electronically controlled power take-off and diagnostics capabilities. Transportation has entered into an agreement to supply the new 7.3 Liter engine to a major automotive company through the year 2000 for use in all of its diesel-powered light trucks and vans. Transportation is exploring the development of alternative fuel engines, including engines powered by compressed natural gas. Transportation has entered into an agreement with Detroit Diesel Corporation to develop a natural gas engine based upon one of Transportation's existing engines and Detroit Diesel's electronic alternative fuel technology. SERVICE PARTS The service parts business is a significant contributor to Transportation's sales and gross margin and to the maintenance of its medium and heavy truck customer base. In North America, Transportation operates seven regional parts distribution centers, which allows it to offer 24-hour availability and same day shipment of the parts most frequently requested by customers. Transportation is undertaking initiatives to increase parts sales outside of North America. As customers have explored ways to reduce their costs and improve efficiency, Transportation and its dealers have established programs to help them manage the parts and maintenance aspects of their businesses more efficiently. Transportation also offers a "Fleet Charge" program, which allows participating customers to purchase parts on credit at all of its dealer locations at consistent and competitive prices. In 1993, service parts sales increased as a result of higher net selling prices, export business expansion and growth in dealer and national accounts. MARKETING AND DISTRIBUTION North American Operations. Transportation's truck products are distributed in virtually all key markets in North America through the largest retail organization specializing in medium and heavy trucks. As part of its continuing program to adapt to changing market conditions, Transportation has been assisting dealers to expand their operations to better serve their customer base. Transportation's truck distribution and service network in North America was composed of 950, 952 and 919 dealers and retail outlets at October 31, 1993, 1992 and 1991, respectively. Included in these totals were 467, 460 and 415 secondary and associate locations at October 31, 1993, 1992 and 1991, respectively. Retail dealer activity is supported by 5 regional operations in the United States and a Canadian general office. Transportation has a national account sales group responsible for its 175 major national account customers. Transportation's 10 retail and 6 wholesale North American used truck centers provide sales and trade-in benefits to its dealers and retail customers. International Operations. International Operations exports trucks, components and service parts, both wholesale and retail, to more than 70 countries around the world and is active in procurement of United States Government business worldwide. Transportation exported 5,300 trucks in 1993 and 4,900 trucks in 1992 and cumulatively, from 1986 through 1992, was the leading North American exporter of Class 6-8 trucks from the United States and Canada, according to data provided by the AAMA. In Mexico, Transportation has an agreement with DINA to supply product technology, components and technical services for assembly of DINA trucks and buses. In 1993, Transportation exported almost 7,000 engines to DINA, bringing the total engines shipped to approximately 20,000 over the past three years. Transportation also has initiated sales of the in- line six cylinder family of mid-range diesel engines to Perkins Group, Ltd., of Peterborough, England, for worldwide distribution and to Detroit Diesel Corporation, the North American distributor of Perkins. NAVISTAR FINANCIAL CORPORATION Navistar Financial is engaged in the wholesale, retail and to a lesser extent lease financing of new and used trucks sold by Transportation and its dealers in the United States. Navistar Financial also finances wholesale accounts and selected retail accounts receivable of Transportation. To a minor extent, sales of new products (including trailers) of other manufacturers are also financed regardless of whether designed or customarily sold for use with Transportation's truck products. During fiscal 1993 and 1992, Navistar Financial provided wholesale financing for 90% and 89%, respectively, of the new truck units sold by Transportation to its dealers and distributors, and retail financing for approximately 15% and 14%, respectively, of the new truck units sold by Transportation and its dealers and distributors in the United States. Navistar Financial's wholly-owned insurance subsidiary, Harco National Insurance Company, provides commercial physical damage and liability insurance coverage to Transportation's dealers and retail customers and to the general public through an independent insurance agency system. IMPORTANT SUPPORTING OPERATIONS Third Party Sales Financing Agreements. In the United States, Transportation has an agreement with Associates Commercial Corporation (Associates) to provide wholesale financing to certain of its truck dealers and retail financing to their customers. During fiscal 1993 and 1992, Associates provided 10% and 11%, respectively, of the wholesale financing utilized by Transportation's dealers and distributors. Navistar International Corporation Canada has an agreement with a subsidiary of General Electric Canadian Holdings Limited to provide financing for Canadian dealers and customers. Foreign Insurance Subsidiaries. Harbour Assurance Company of Bermuda Limited offers a variety of programs to Transportation, including general liability insurance, ocean cargo coverage for shipments to and from foreign distributors and reinsurance coverage for various Transportation policies. The company also writes minimal third party coverage and provides a variety of insurance programs to Transportation, its dealers, distributors and customers. CAPITAL EXPENDITURES AND RESEARCH AND DEVELOPMENT Transportation designs and manufactures its trucks and diesel engines to meet or exceed specific industry requirements. New models are introduced and improvements of current models are made, from time to time, in accordance with operating plans and market requirements and not on a predetermined cycle. During 1993, capital expenditures totalled $110 million. Major product program expenditures included continued investment in machinery and equipment at the Melrose Park, Illinois and Indianapolis, Indiana engine facilities to manufacture a new generation of mid-range diesel engines to be used in trucks and school bus chassis manufactured by Transportation and also sold to other original equipment manufacturers. Transportation began introducing these engines in the fall of 1993. Other expenditures were made for truck product improvements, modernization of facilities and compliance with environmental regulations. Capital expenditures totalled $55 million in 1992. Major product program expenditures included machinery and equipment to manufacture the new series of mid-range diesel engines at the Melrose Park, Illinois and Indianapolis, Indiana engine facilities. Other expenditures were made for truck product improvements, modernization of facilities and compliance with environmental regulations. In 1991, capital expenditures were $77 million. Product development is an ongoing process at Transportation. Research and development activities are directed toward the introduction of new products and improvement of existing products and processes used in their manufacture. Spending for company-sponsored activities totalled $95 million, $90 million and $87 million for 1993, 1992 and 1991, respectively. BACKLOG The backlog of unfilled truck orders (subject to cancellation or return in certain events) was as follows: AT OCTOBER 31 MILLIONS OF DOLLARS UNITS ------------- ------------------- ------- 1993 ....... $ 1,353 23,939 1992 ....... $ 1,124 20,456 1991 ....... $ 613 13,534 Although the backlog of unfilled orders is one of many indicators of market demand, many factors may affect point-in-time comparisons such as changes in production rates, available capacity, new product introductions and competitive pricing actions. EMPLOYEES The following table summarizes employment levels as of the end of fiscal years 1991 through 1993: TOTAL AT OCTOBER 31 EMPLOYMENT ------------- ---------- 1993 ......................... 13,611 1992 ......................... 13,944 1991 ......................... 13,471 LABOR RELATIONS At October 31, 1993, the United Automobile, Aerospace and Agricultural Implement Workers of America (UAW) represented approximately 7,144 of Transportation's active employees in the U.S., and the Canadian Auto Workers (CAW) represented approximately 1,393 active employees in Canada. Other unions represented approximately 1,342 active employees in North America. Transportation entered into collective bargaining agreements with the UAW and CAW in 1993 which expire on October 1, 1995 and October 24, 1996, respectively. These agreements permit greater productivity and efficiency, manufacturing flexibility and customer responsiveness, which will contribute to a reduction in costs and the goal of improved profitability. PATENTS AND TRADEMARKS Transportation continuously obtains patents on its inventions and thus owns a significant patent portfolio. Additionally, many of the components which Transportation purchases for its products are protected by patents that are owned or controlled by the component manufacturer. Transportation has licenses under third party patents relating to its products and their manufacture, and Transportation grants licenses under its patents. The royalties paid or received under these licenses are not significant. No particular patent or group of patents is considered by Transportation to be essential to its business as a whole. Like all businesses which offer well-known products or services, Transportation's primary trademarks symbolize its goodwill and provide instant identification of its products and services in the marketplace and thus, are an important part of its worldwide sales and marketing efforts. To support these efforts, Transportation maintains, or has pending, registrations of its primary trademarks in those countries in which it does business or expects to do business. RAW MATERIALS AND ENERGY SUPPLIES Transportation purchases raw materials, parts and components from numerous outside suppliers but relies upon some suppliers for a substantial number of components for its truck products. Transportation's purchasing strategies have been designed to improve access to the lowest cost, highest quality sources of raw materials, parts and components, and to reduce inventory carrying requirements. A portion of Transportation's requirements for raw materials and supplies is filled by single source suppliers. The impact of an interruption in supply will vary by commodity. Some parts are generic to the industry while others are of a proprietary design requiring unique tooling which would require time to recreate. However, Transportation's exposure to a disruption in production as a result of an interruption of raw materials and supplies is no greater than the industry as a whole. In order to remedy any losses resulting from an interruption in supply, contingent business interruption insurance is maintained. Transportation does not currently foresee critical shortages of raw materials and supplies. IMPACT OF GOVERNMENT REGULATION Truck and engine manufacturers have faced continually increasing governmental regulation of their products especially in the environmental and safety areas. In particular, diesel engine manufacturers will be required to achieve lower emission levels in terms of unburned hydrocarbons, particulates and oxides of nitrogen. These regulations have and will impose significant research, design and tooling costs on diesel engine manufacturers. They may also result in the use of after-treatment equipment, such as particulate traps and catalytic converters, which will add to the cost of the vehicle emission control system. Transportation's engines are subject to extensive regulatory requirements. Specific emissions standards for diesel engines are imposed by the U.S. Environmental Protection Agency (the U.S. EPA) and by other regulatory agencies such as the California Air Resources Board (CARB). Transportation believes that its diesel engine products comply with all applicable emissions requirements currently in effect. Transportation's ability to comply with emissions requirements which may be imposed in the future is an important element in maintaining and improving its position in the diesel engine marketplace. Capital and operating expenditures will continue to be required to comply with these emissions requirements. The 1990 Clean Air Act amendments established the U.S. emissions standards for on-highway diesel engines produced through 2001. Insofar as light and medium heavy duty diesel engines are concerned, the CARB standards are similar to those adopted by the U.S. EPA. Transportation's products meet the U.S. EPA and CARB standards for on-highway diesel engines produced through 1993. Transportation expects that its engines will satisfy all U.S. EPA and CARB on-highway emissions control requirements applicable through 1997. In North America, both Canada and Mexico are expected to adopt U.S. emissions standards. Various diesel engine manufacturers, including Transportation, have voluntarily signed a memorandum of understanding with the Canadian government, pursuant to which these manufacturers have agreed to sell only U.S. certified engines in Canada beginning in 1995. In June 1993, Mexico proposed a regulatory program that incorporates U.S. standards and test procedures. This program is expected to be in place in 1994. Truck manufacturers are subject to various noise standards imposed by federal, state and local regulations. The engine is one of a truck's primary noise sources, and Transportation therefore works closely with original equipment manufacturers to develop strategies to reduce engine noise. Transportation is also subject to the National Traffic and Motor Vehicle Safety Act (Safety Act) and Federal Motor Vehicle Safety Standards (Safety Standards) promulgated by the National Highway Traffic Safety Administration and believes it is in compliance with the Safety Act and the Safety Standards. Expenditures to comply with various environmental regulations relating to the control of air, water and land pollution at production facilities and to control noise levels and emissions from Transportation's products have not been material. Investigations into the nature and extent of cleanup activities under the Superfund law are being conducted at two sites formerly owned by Transportation. The eventual scope, timing and cost of such activities as well as the availability of defenses to any such claims, and possible claims against third parties and insurance companies are not known and cannot be reasonably estimated; however, substantial claims could be asserted against Transportation. See Environmental Matters in Management's Discussion and Analysis. ITEM 2.

ITEM 2. PROPERTIES Transportation has 7 manufacturing and assembly plants in the United States and 1 in Canada. All plants are owned by Transportation. The aggregate floor space of these 8 plants is approximately 8 million square feet. Transportation also owns or leases other significant properties in the United States and Canada, including a paint facility, a small component fabrication plant, vehicle and parts distribution centers, sales offices, engineering centers and its headquarters in Chicago. ITEM 3.

ITEM 3. LEGAL PROCEEDINGS ENVIRONMENTAL MATTERS Beginning in March 1984, Transportation received several enforcement notices from the U.S. EPA, all of which relate to Transportation's painting activities at its Springfield, Ohio assembly and body plants. The notices alleged that these painting activities violated the Federal Clean Air Act because the paint contained volatile organic compounds (VOC) in greater quantities than permitted under applicable Ohio regulations (the VOC Regulations). In an administrative action instituted under Section 120 of the Clean Air Act, begun in September 1984, U.S. EPA seeks to recover a noncompliance penalty, measured as the costs allegedly saved by Transportation by not complying with the VOC Regulations at the assembly plant. Transportation has calculated that it did not save any costs. The case went to a hearing before an administrative law judge who ruled in early 1987 that Transportation was liable for a noncompliance penalty in an amount to be determined in a subsequent hearing. All Transportation appeals of this ruling were denied. No hearing to determine the amount of the noncompliance penalty has yet been scheduled. In a court action instituted under Section 113(b) of the Clean Air Act, the United States filed civil complaints pertaining to the assembly plant (filed on April 30, 1985) and the body plant (filed on November 3, 1986) in the U.S. District Court in the Southern District of Ohio. These complaints ask the judge to impose fines of up to $25,000 per violation of the VOC Regulations per day since December 31, 1982, and also ask the judge to issue an injunction prohibiting Transportation from continuing the alleged violations. In March 1993, the judge granted the United States motion for partial summary judgment, ruling that Transportation violated the VOC Regulations at the assembly plant during the period from December 31, 1982 to April 30, 1985. The judge has not yet made any determination as to fines for the violation. Transportation built a new paint facility adjacent to the assembly plant which replaced some of the painting activities formerly performed at the assembly plant and the body plant. New technology at the paint facility reduces or destroys VOCs emitted in the painting operations. These reductions enabled Transportation to apply for a bubble variance, an administrative exemption which permits Transportation to comply with the VOC Regulations by averaging VOC emissions from the assembly and body plants with VOC emissions from the paint facility. Ohio EPA issued the bubble variance to Transportation in February 1989. U.S. EPA approved the bubble variance in December 1990, effective January 1991. In November 1993, Transportation received a settlement offer from U.S. EPA to settle all allegations contained in both the administrative action and the court action in exchange for a payment of $2.7 million. Transportation is pursuing settlement discussions to resolve these cases. OTHER MATTERS In July 1992, Transportation announced its decision to change its retiree health care benefit plans and concurrently filed a declaratory judgment class action lawsuit in the U.S. District Court for the Northern District of Illinois (Illinois Court) to confirm its right to change these benefits. A countersuit was filed against Transportation by its unions in the U.S. District Court for the Southern District of Ohio (Ohio Court). On October 16, 1992, Transportation withdrew its declaratory judgment action in the Illinois Court and began negotiations with the UAW to resolve issues affecting both retirees and employees. On December 17, 1992, Transportation announced that a tentative agreement had been reached with the UAW on restructuring retiree health care and life insurance benefits (the Settlement Agreement). During the third quarter of 1993, all court, regulatory agency and shareowner approvals required to implement the Settlement Agreement concerning retiree health care benefit plans were obtained. The Settlement Agreement became effective and the restructured retiree health care and life insurance plan was implemented on July 1, 1993. In May 1993, a jury issued a verdict in favor of Vernon Klein Truck & Equipment, Inc. and against Transportation in the amount of $10.8 million in compensatory damages and $15 million in punitive damages. In order to appeal the verdict in the case, Transportation was required to post a bond collateralized with $30 million in cash. This amount has been recorded as restricted cash on the Statement of Financial Condition. The amount of any potential liability is uncertain and Transportation believes that there are meritorious arguments for overturning or diminishing the verdict. Transportation and its subsidiaries are subject to various other claims arising in the ordinary course of business, and are parties to various legal proceedings which constitute ordinary routine litigation incidental to its business and that of its subsidiaries. In the opinion of Transportation's management, none of these proceedings or claims are material to the business or the financial condition of the Company. ITEM 4.

ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS Intentionally omitted. See the index page of this Report for explanation. PART II Page -------- ITEM 5.

ITEM 5. MARKET FOR THE REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS 59 ITEM 6.

ITEM 6. SELECTED FINANCIAL DATA Intentionally omitted. See the index page to this Report for explanation. ITEM 7.

ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION Transportation manufactures and markets medium and heavy trucks, including school bus chassis, mid-range diesel engines and service parts in North America. These products also are sold to distributors in selected export markets. Its financial services subsidiaries provide wholesale, retail and lease financing, and commercial physical damage and liability insurance, principally to Transportation's dealers and retail customers. As discussed in Note 1 to the Financial Statements, finance and insurance operations are materially different from the manufacturing and marketing of trucks, diesel engines and service parts. Therefore, this discussion and analysis reviews separately the operating and financial results of "Manufacturing" and "Financial Services." Manufacturing includes the consolidated financial results of Transportation's manufacturing operations with its wholly-owned financial services subsidiaries included on a one-line basis under the equity method of accounting. Financial Services includes Transportation's wholly-owned subsidiary, Navistar Financial Corporation (Navistar Financial), and other wholly-owned foreign finance and insurance companies. Management's discussion and analysis of results of operations should be read in conjunction with the Financial Statements and the Notes to the Financial Statements. Significant Events During 1993, Transportation negotiated collective bargaining agreements with the United Automobile, Aerospace and Agricultural Implement Workers of America (UAW) and most of its other unions, restructured its retiree health care and life insurance plans and its Parent Company completed a public offering of common shares. These events are part of a program to reduce Transportation's operating cost structure and enable it to compete successfully. On January 23, 1993, a new labor agreement was ratified by the members of the UAW. This agreement, which expires on October 1, 1995, permits greater productivity and efficiency, manufacturing flexibility and customer responsiveness. On July 1, 1993, Transportation implemented a restructured retiree health care and life insurance plan (the Plan) which previously had been approved by the U.S. District Court in Dayton, Ohio on May 27, 1993, and by the Parent Company's shareowners on June 29, 1993. The Plan provides retirees with modified health care and life insurance benefits for life. The Parent Company's shareowners also approved a one-for-ten reverse stock split of its Common Stock and approved the issuance of 25.6 million shares of Class B Common Stock. The Class B shares, valued at $513 million, were purchased by Transportation from the Parent Company and contributed to a separate independent retiree Supplemental Benefit Trust as a part of the Plan. The Plan reduced Transportation's liability for retiree health care and life insurance benefits from approximately $2.6 billion to $1.1 billion worldwide. On October 21, 1993, the Parent Company completed a public offering of 23.6 million Common shares, from which it realized net proceeds of $492 million. The net proceeds were lent to Transportation which used $300 million to pre-fund benefit liabilities under the Plan. Transportation will use the remaining proceeds for working capital purposes. Results of Operations Consolidated The components of net income (loss) for the three years ended October 31 are as follows: Millions of dollars 1993 1992 1991 - ----------------------------------------------------------------------- Income (loss) before Supplemental Trust contribution and income taxes ...................... $ 51 $ (151) $ (189) Supplemental Trust contribution: - Manufacturing ......................... (509) - - - Financial Services .................... (4) - - Income tax expense ........................ (19) (15) (22) ------- ------- ------- Income (loss) of continuing operations................. (481) (166) (211) Discontinued operations ................... - (65) - Cumulative effect of accounting changes ... (1,144) - - ------- ------- ------- Net loss ................................. $(1,625) $ (231) $ (211) ======= ======= ======= Reflecting improved operating results in both manufacturing operations and financial services, Transportation reported income of $51 million in 1993 before the Supplemental Trust contribution and income taxes compared with a pretax loss of $151 million last year and a pretax loss of $189 million in 1991. The 1993 loss of continuing operations was $481 million after the one-time charge for the Supplemental Trust contribution of $513 million and income tax expense of $19 million. In the 1993 third quarter, Transportation adopted Statement of Financial Accounting Standards No. 106 (SFAS 106), "Employers' Accounting for Postretirement Benefits Other Than Pensions," and Statement of Financial Accounting Standards No. 109 (SFAS 109), "Accounting for Income Taxes" retroactive to November 1, 1992. Prior years were not restated. As a result of Transportation's Tax Agreement with the Parent Company, substantially all of the deferred tax asset and corresponding income tax benefit resulting from adopting SFAS 106 and SFAS 109 is reflected on the financial statements of the Parent Company and, therefore, had minimal effect on Transportation's cumulative effect of changes in accounting policy. The cumulative effect of these changes resulted in a charge to income of $1,144 million. Transportation incurred a net loss of $1,625 million for 1993. The net loss of $231 million for 1992 included a $65 million charge to discontinued operations for the settlement of suits brought by the Pension Benefit Guaranty Corporation (PBGC) related to a previously owned business. Consolidated sales and revenues of $4,694 million in 1993 were 21% higher than the $3,871 million reported in 1992 and 36% above the $3,460 million reported in 1991 as a result of a strong cyclical recovery in the demand for trucks, diesel engines and service parts. Manufacturing Manufacturing reported a loss of $14 million before a one-time $509 million charge for the Supplemental Trust contribution and income taxes. Losses of $203 million and $249 million were recorded in 1992 and 1991, respectively. The 1992 results included a $47 million one-time charge for a voluntary product recall. The components of Manufacturing loss, excluding Financial Services and before taxes, are as follows: Millions of dollars 1993 1992 1991 - ----------------------------------------------------------------------- Pretax loss before Supplemental Trust contribution and income taxes ...................... $ (14) $ (203) $ (249) Supplemental Trust contribution ........... (509) - - ------ ------ ------ Loss before income taxes ............ $ (523) $ (203) $ (249) ====== ====== ====== The improvement in 1993 operating results is the result of increased sales volume, higher selling prices and programs implemented to improve Transportation's cost structure. Cost improvement programs included implementation of the restructured retiree benefit Plan and continued investment in new products and processes to increase efficiency and lower manufacturing hours per unit. The reduction in the loss between 1992 and 1991 was primarily the result of increased sales volume, ongoing cost improvement programs and lower financing charges offset in part by higher health care costs, reduced interest income and an increase in interest expense on obligations to the Parent Company. Sales. Reflecting improvements in the U.S. and Canadian economies, 1993 North American industry retail sales of medium and heavy trucks totalled 288,900 units, a 19% increase over 1992 and a 26% increase from the 229,100 units sold in 1991. Compared with 1992 levels, heavy truck industry sales increased 33% to 166,400 units, led by higher demand from major leasing companies and large fleet operators. Industry sales of medium trucks, including school bus chassis, increased 4% to 123,000 units. Medium truck industry shipments were up 4% from 1992 and 11% from 1991. Industry sales of school bus chassis, about 25% of the medium truck market, increased 3% from 1992 but were 19% below 1991. The demand for school buses reflects the timing of state and local government funding of student transportation. Transportation's sales of trucks, diesel engines and service parts during 1993 totalled $4,510 million, 22% above the $3,685 million reported for 1992 and 38% higher than the $3,259 million recorded in 1991. The sales increase principally reflects the improved demand for heavy trucks, higher shipments of mid-range diesel engines to original equipment manufacturers and improved sales of service parts. Retail deliveries of medium and heavy trucks totalled 79,800 units in 1993, an increase of 15% from 1992 and 19% higher than in 1991. Transportation maintained its position as sales leader in the North American combined medium and heavy truck market in 1993 with a 27.6% market share. Shipments of mid-range diesel engines to original equipment manufacturers during 1993 totalled a record 118,200 units, an increase of 21% from 1992 and 58% from 1991. Higher shipments to a major automotive manufacturer to meet consumer demand for the light trucks and vans which use this engine was the primary reason for the increase. Service parts sales of $632 million in 1993 were 11% higher than the $571 million reported in 1992 and 19% higher than the $530 million in 1991. The increase between 1993 and 1992 was the result of growth in sales to dealers and national fleets and improved price realization. The increase between 1992 and 1991 was the result of higher net selling prices, export business expansion and sales growth in dealer and national retail accounts. Operating Costs and Expenses. Manufacturing gross margin, the relationship of sales to cost of sales, was 13.2% in 1993. Gross margin in 1992, excluding one-time product recall expenses, was 13.0%, an increase from 11.5% in 1991. Factors which led to the improvement in gross margin between 1993 and 1992 included higher sales volume, improved price realization and programs implemented to improve Transportation's cost structure. These favorable effects were partially offset by increases in purchased material and labor costs and a higher level of manufacturing start-up costs for new truck and engine products. The improvement in gross margin between 1992 and 1991 was primarily the result of higher sales volume combined with the impact of cost improvement programs. Postretirement benefits, which include pension expense for employees and retirees and postretirement health care and life insurance coverage for employees, retirees, surviving spouses and dependents, totalled $208 million in 1993. Pension expense of $107 million in 1993 was about level with 1992 and 1991. A 30% reduction in retiree health care and life insurance expense in 1993 to $101 million was primarily the result of an $87 million year-over-year decline in expense following implementation in 1993 of the new retiree benefit plan partially offset by a $41 million increase in expense related to the adoption of SFAS 106. This statement requires the accrual of the expected cost of providing postretirement benefits during employees' active service periods. Prior to 1993, the cost of these benefits was recorded as payments were made. From 1991 to 1992, postretirement benefit expense other than pensions increased from $138 million to $146 million as cost containment programs only partially offset health care economic cost increases. In 1993, Transportation continued its commitment to allocate resources for improvement of existing products and processes and the development of new truck and diesel engine products. Engineering expense increased to $94 million in 1993 from $92 million in 1992 and $88 million in 1991 reflecting the completion of the development and introduction of a new series of diesel engines as well as continuing development of new and existing truck products. Marketing and administrative expense of $225 million was about equal to the amounts reported in 1992 and 1991. Interest expense of $29 million was $17 million higher than in 1992 and $12 million higher than in 1991. The increase is the result of higher interest payments on obligations to the Parent Company. The decrease in interest expense between 1992 and 1991 is the result of lower interest payments to the Parent Company and the differing levels of capitalized interest on major capital projects. Finance service charges on sold receivables increased 8% to $56 million in 1993 reflecting higher truck sales. These charges decreased 20% between 1992 and 1991 as a result of lower interest rates. The provision for losses on receivables was reduced to $5 million in 1993 from $18 million in 1992 following improvements in the economy and improved credit review procedures. Interest income declined to $9 million in 1993 from $12 million in 1992 primarily as a result of a reduction in the amount of marketable securities held by Transportation through most of the year and lower interest rates. Discontinued Operations. A provision was recorded in the third quarter of 1992 as a loss of discontinued operations for the settlement for $65 million of the litigation commonly referred to as the Wisconsin Steel Pension Plan Cases. Financial Services Income of the subsidiaries comprising Financial Services is as follows: Millions of dollars 1993 1992 1991 - ----------------------------------------------------------------------- Income before Supplemental Trust contribution and income taxes: Navistar Financial Corporation ......... $ 53 $ 46 $ 53 Foreign Subsidiaries ................... 12 6 7 ---- ---- ---- Total ................................ 65 52 60 Supplemental Trust contribution ............ (4) - - Income tax expense ......................... (22) (20) (23) ---- ---- ---- Income before cumulative effect of accounting changes ................... 39 32 37 Cumulative effect of accounting changes ... (9) - - ---- ---- ---- Net income ............................... $ 30 $ 32 $ 37 ==== ==== ==== Navistar Financial's income in 1993 before the one-time charge for the Supplemental Trust contribution and income taxes was $53 million compared with $46 million in 1992. The increase was primarily the result of increased income from sales of retail notes receivable partially offset by higher loss experience from Navistar Financial's insurance subsidiary. Earnings from the foreign subsidiaries increased $6 million as a result of lower loss reserve requirements. During the third quarter of 1993, Navistar Financial adopted SFAS 106 and SFAS 109 retroactive to November 1, 1992. The cumulative effect of adopting these changes in accounting policy resulted in an after-tax charge to income of $9 million. Income before income taxes for Navistar Financial decreased 13% between 1992 and 1991 as a result of lower margins earned on the finance receivables portfolio partially offset by a lower provision for credit losses. Earnings from Navistar Financial's insurance subsidiary were equal to 1991. Total Navistar Financial revenue for 1993 was $220 million, unchanged from 1992 and 3% below 1991. During 1993, increased revenues from higher average wholesale note and account balances were offset by lower revenues from the insurance subsidiary. The decline in revenues in 1992 from 1991 reflects a decrease in retail and wholesale notes financed. These decreases were partially offset by an increase in revenues from Navistar Financial's insurance subsidiary. Interest expense for Navistar Financial declined to $75 million in 1993 from $82 million in 1992 and $90 million in 1991. The declines in 1993 and 1992 primarily reflect the effect of lower interest rates. The provision for losses on receivables decreased to $1 million in 1993 from $3 million in 1992 and $6 million in 1991. The decreases in the provision reflect lower losses on both retail and wholesale notes. Liquidity and Capital Resources Consolidated Total cash, cash equivalents and marketable securities amounted to $493 million and $378 million at October 31, 1993 and 1992, respectively. At October 31, 1993 and 1992, approximately $160 million and $165 million, respectively, was held by Transportation's insurance subsidiaries and not available for general corporate purposes. The following discussion has been organized to discuss separately the cash flows of Transportation's Manufacturing and Financial Services operations. Manufacturing Liquidity available to Manufacturing in the form of cash, cash equivalents and marketable securities totalled $316 million at October 31, 1993, $132 million at October 31, 1992, and $207 million at October 31, 1991. Cash and cash equivalents of Manufacturing totalled $262 million at October 31, 1993, an increase from the $125 million at October 31, 1992. Summarized below is the cash flow for fiscal 1993. Millions of dollars 1993 - ------------------------------------------------------------------------ Cash and cash equivalents provided by (used in): Operations ....................................... $ 166 Investment programs .............................. (504) Financing activities ............................. 475 ----- Increase in cash and cash equivalents .......... $ 137 ===== Operations. In 1993, operations provided $166 million in cash as follows: Millions of dollars 1993 - ------------------------------------------------------------------------ Net loss ........................................... $(1,625) Items not affecting cash: Supplemental Trust contribution .................. 509 Cumulative effect of accounting changes .......... 1,144 Depreciation and other items ..................... 66 Change in operating assets and liabilities: Decrease in receivables ........................ $ 1 Increase in inventories ........................ (51) Increase in accounts payable ................... 122 72 ----- ------- Cash provided by continuing operations ............. $ 166 ======= The $72 million net change in operating assets and liabilities was primarily the result of higher production schedules in 1993. Investment programs. Investment programs used $504 million in cash during 1993 including pre-funding $300 million of the retiree benefit Plan liability, capital expenditures of $110 million, a net increase of $46 million in marketable securities and $30 million for the cash collateralization of a bond related to current legal proceedings. Financing programs. Financing activities provided $475 million in cash in 1993 primarily from $493 million in funds loaned to Transportation by the Parent Company. See Note 14 to the Financial Statements. This increase in cash was offset by an $18 million reduction in debt. Management's discussion of the future liquidity of manufacturing operations is included in the Business Outlook section of Management's Discussion and Analysis. Financial Services The Financial Services subsidiaries provide product financing and insurance coverage to Transportation's dealers and retail customers. Traditionally, funds to finance Transportation's products come from a combination of commercial paper, short- and long-term bank borrowings, medium- and long-term debt issues, sales of receivables and equity capital. The lowering of Navistar Financial's debt ratings in fiscal 1992 restricted its ability to place commercial paper and term debt securities. Accordingly, Navistar Financial increased its use of bank borrowings through its revolving credit facility and sales of retail notes as funding sources. Insurance operations are funded from premiums and income from investments. Total cash, cash equivalents and marketable securities of Financial Services were $177 million at October 31, 1993, $246 million at October 31, 1992 and $189 million at October 31, 1991. Cash and cash equivalents of Financial Services totalled $44 million at October 31, 1993, $103 million at October 31, 1992 and $39 million at October 31, 1991. The cash flow for Financial Services for 1993 is summarized as follows: Millions of dollars 1993 - ----------------------------------------------------------------------- Cash and cash equivalents provided by (used in): Operations ....................................... $ 63 Investment programs .............................. (65) Financing activities ............................. (57) ----- Decrease in cash and cash equivalents .......... $ (59) ===== Operations. Operations provided $63 million in cash in 1993 primarily from net income of $30 million, a $19 million decrease in working capital and non-cash expense of $9 million for the cumulative effect of the adoption of SFAS 106 and SFAS 109. Investment Programs. The Financial Services investment programs used $65 million in 1993 as a result of a net increase of $62 million in retail and wholesale finance receivables and a $14 million increase in property and equipment leased to others, partially offset by an $11 million decrease in marketable securities. Navistar Financial supplied 90% of the wholesale financing of new trucks to Transportation's dealers compared with 89% in 1992 and 1991. Navistar Financial's share of retail financing of new trucks sold to customers in the United States increased to 15.3% in 1993 from 13.7% in 1992 and 13.1% in 1991. Financing Activities. Financial Services used $57 million in 1993 for financing activities consisting of $99 million for principal payments on long-term debt and $33 million of dividends paid to Transportation. Cash from financing activities was increased by $75 million of short-term borrowings. At October 31, 1993, Navistar Financial had $1,327 million of committed credit facilities. The facilities consisted of a contractually committed bank revolving credit facility of $727 million and a contractually committed retail notes receivable purchase facility of $600 million. Unused commitments under the receivable purchase facility were $157 million, $75 million of which was used to back the short-term bank borrowings at October 31, 1993. The remaining $82 million, when combined with unrestricted cash and cash equivalents, made $105 million available to fund the general business purposes of Navistar Financial at October 31, 1993. The bank revolving credit facility was fully utilized at October 31, 1993. In addition to the committed credit facilities, Navistar Financial also utilizes a $300 million revolving wholesale note sales trust providing for the continuous sale of eligible wholesale notes on a daily basis. The sales trust is composed of three $100 million pools of notes maturing serially from 1997 to 1999. Management's discussion of the future liquidity of financial services operations is included in the Business Outlook section of Management's Discussion and Analysis. Environmental Matters Transportation has been named a potentially responsible party (PRP), in conjunction with other parties, in a number of cases arising under an environmental protection law commonly known as the Superfund law. These cases involve sites which allegedly have received wastes from its current or former operations. The Superfund law requires environmental investigation and/or cleanup where waste products from various manufacturing processes and operations have been stored, treated or disposed of. Based on information available to Transportation which in most cases includes estimates from PRPs and/or Federal or State regulatory agencies for the investigation, cleanup costs at these sites, data related to quantities and characteristics of material generated at or shipped to each site, a reasonable estimate is calculated of Transportation's share, if any, of the costs. Transportation believes that, based on these calculations, its share of the costs for each site is not material and in total the anticipated cleanup costs of current PRP actions at October 31, 1993 would not have a material impact on Transportation's financial condition, liquidity or operating results except with respect to the potential for liability discussed below. The anticipated costs associated with the current PRP actions at October 31, 1993, are reflected in Transportation's $10 million accrued liability. Transportation reviews its accruals as additional information becomes available. The present owner of Transportation's former Wisconsin Steel facility in Chicago, Illinois has been investigating the nature and extent of any required cleanup activities at this site. In addition, the present owner of Transportation's former Solar Division in San Diego, California is conducting similar activities with respect to that site. Environmental protection agencies in each of these states are monitoring these investigations. Both of the present owners have demanded that Transportation pay for these activities. As to both sites, the eventual scope, timing and cost of such activities as well as the availability of defenses to any such claims, and possible claims against third parties and insurance companies are not known and cannot be reasonably estimated; however, substantial claims could be asserted against Transportation. Business Outlook Current economic trends indicate continued moderate growth in the North American economy, resulting in improved market conditions for the truck industry. Based on current order backlogs, order receipt trends and key market indicators, Transportation currently projects 1994 North American medium truck demand, including school bus chassis, to be 136,000 units, an 11% increase from 1993. Heavy truck demand is projected at 160,000 units, approximately level with 1993. Transportation's diesel engine sales to original equipment manufacturers in 1994 are expected to be about the same as in 1993. Sales of service parts by Transportation are forecast to grow 3%. As the Federal government and private industry consider solutions to the rising cost of medical care, Transportation took decisive action with implementation of a restructured retiree health care and life insurance benefit plan on July 1, 1993 and a $300 million pre-funding of this obligation. Transportation intends to further reduce retiree health care costs by pre-funding an additional $200 million of the retiree health care and life insurance benefit liability within the next five years. Additional annual health care savings of up to $15 million are projected from managed care programs for employees and certain retirees to be implemented in 1994. In 1994, the introduction of new truck and engine products, focused marketing programs and implementation of programs to streamline marketing, engineering and manufacturing processes are expected to further improve Transportation's competitiveness. It is management's opinion that current and forecasted cash flow will provide a basis for financing operating requirements and capital expenditures. In addition, management believes that collections on the outstanding receivables portfolios as well as funds available from various funding sources will permit the Financial Services subsidiaries to meet the financing requirements of Transportation's dealers and customers. ITEM 8.

ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA Page ------ Navistar International Transportation Corp.: Statement of Income (Loss) ......................... 29 Statement of Financial Condition ................... 30 Statement of Cash Flow ............................. 31 Statement of Shareowner's Equity ................... 33 Notes to Financial Statements ...................... 34 Independent Auditors' Report ....................... 62 Finance and Insurance Subsidiaries: The financial statements of Navistar Financial Corporation for the years ended October 31, 1993, 1992 and 1991 appearing on pages 5 through 7 in the Annual Report on Form 10-K for Navistar Financial Corporation for the fiscal year ended October 31, 1993, Commission No. 1-4146-1, are incorporated herein by reference and filed as Exhibit 28.1 to this Form 10-K. Financial information regarding all Transportation subsidiaries engaged in finance and insurance operations, including Navistar Financial Corporation, appears as supplemental information to the Financial Statements of Navistar International Transportation Corp. which follow. NAVISTAR INTERNATIONAL TRANSPORTATION CORP. AND SUBSIDIARIES ========== NOTES TO FINANCIAL STATEMENTS FOR THE THREE YEARS ENDED OCTOBER 31, 1993 1. SUMMARY OF ACCOUNTING POLICIES Basis of Consolidation Navistar International Transportation Corp., hereafter referred to as "the Company" and "Transportation," is the wholly-owned subsidiary of Navistar International Corporation, hereafter referred to as "Parent Company." Transportation operates in one principal industry segment, the manufacture and marketing of medium and heavy trucks, including school bus chassis, mid-range diesel engines and service parts in North America and selected export markets. In addition to the consolidated financial statements, Transportation has elected to provide financial information in a format that presents the operating results, financial condition and cash flow from operations designated as "Manufacturing" and "Financial Services." Manufacturing includes the consolidated financial results of Transportation's manufacturing operations with its wholly-owned financial services subsidiaries included on a one-line basis under the equity method of accounting. Financial Services includes Transportation's wholly-owned subsidiary, Navistar Financial Corporation (Navistar Financial), and other wholly-owned foreign finance and insurance companies. Through the first two quarters of 1992, Financial Services included the results of Harbour Assurance Company (U.K.) Ltd. This subsidiary was sold in July 1992. Navistar Financial's primary business is the retail and wholesale financing of products sold by Transportation and its dealers within the United States and the providing of commercial physical damage and liability insurance to Transportation's dealers and retail customers and to the general public through an independent insurance agency system. Harbour Bermuda's primary business is the insuring of general and product liability risks of Transportation. The effects of transactions between Manufacturing and Financial Services have been eliminated to arrive at the consolidated totals. See Note 2 to the Financial Statements. The distinction between current and long-term assets and liabilities in the Statement of Financial Condition is not meaningful when finance, insurance and manufacturing subsidiaries are combined; therefore, Transportation has adopted an unclassified presentation. Certain 1992 and 1991 amounts have been reclassified to conform with the presentation used in the 1993 financial statements. Cash and Cash Equivalents All highly liquid financial instruments with maturities of three months or less from date of purchase, consisting primarily of bankers' acceptances, commercial paper and U.S. government securities, are classified as cash equivalents in the Statement of Financial Condition and Statement of Cash Flow. Marketable Securities Marketable securities are carried at cost or amortized cost which approximates market value. ========== NOTES TO FINANCIAL STATEMENTS-- (CONTINUED) 1. SUMMARY OF ACCOUNTING POLICIES (continued) Inventory Inventory is valued at the lower of average cost or market. Property Significant expenditures for replacement of equipment, tooling and pattern equipment, and major rebuilding of machine tools are capitalized. Depreciation and amortization are generally computed on the straight-line basis; gains and losses on property disposal are included in other income and expense. Research and Development Activities related to new product development and major improvements to existing products and processes are expensed as incurred and were $95 million, $90 million and $87 million in 1993, 1992 and 1991, respectively. Engineering expense, as shown in the Statement of Income (Loss), includes certain research and development expenses and routine ongoing costs associated with improving existing products and processes. Income Taxes Under Statement of Financial Accounting Standards No. 109 (SFAS 109), "Accounting for Income Taxes," recognition of a net deferred tax asset is allowed if future realization is more likely than not. The Parent Company files a consolidated U.S. federal income tax return which includes Transportation and its U.S. subsidiaries. Transportation has a tax allocation agreement (Tax Agreement) with the Parent Company which requires Transportation to compute its separate federal income tax expense based on its adjusted book income. Any resulting tax liability is paid to the Parent Company. In addition, under the Tax Agreement, Transportation is required to pay to the Parent Company any tax payments received from its subsidiaries. The effect of the Tax Agreement is to allow the Parent Company rather than Transportation to utilize U.S. operating losses and loss carryforwards generated in earlier years. As of October 31, 1993, Transportation had $22 million of domestic net operating loss carryforwards available to offset future taxable income generated by the subsidiaries. The adoption of SFAS 109 does not have a material impact on Transportation, as a result of the Tax Agreement. Substantially all of the deferred tax asset and corresponding income tax benefit resulting from the adoption of SFAS 109 is reflected on the financial statements of the Parent Company. ========== NOTES TO FINANCIAL STATEMENTS-- (CONTINUED) 1. SUMMARY OF ACCOUNTING POLICIES (continued) Revenue on Receivables Finance charges on retail notes and finance leases are recognized as income by Navistar Financial over the term of the receivables on the accrual basis utilizing the actuarial method. Interest from interest- bearing notes and accounts is recognized on the accrual basis. Gains or losses on sales of receivables are credited or charged to revenue in the period in which the sale occurs. Losses on Receivables The allowance for losses on receivables is maintained at an amount management considers appropriate in relation to the outstanding receivables portfolio. Receivables are charged to the allowance for losses when they are determined to be uncollectible. Receivable Sales Navistar Financial sells and securitizes receivables to public and private investors with limited recourse and continues to service the receivables, for which a servicing fee is received from the investors. Insurance Premiums and Loss Reserves Premiums and underwriting costs of insurance operations are recognized on a pro-rata basis over the terms of the policies. Underwriting losses and outstanding loss reserve balances are based on individual case estimates of the ultimate cost of settlement, including actual losses, and determinations of amounts required for losses incurred but not reported. Changes in Accounting Policy In the third quarter of fiscal 1993, Transportation adopted Statement of Financial Accounting Standards No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions" (SFAS 106) and Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes" (SFAS 109) retroactive to November 1, 1992. As required, previously reported first and second quarter results for 1993 have been restated for the effects of the changes in accounting policy. See Notes 4, 5 and 20 to the Financial Statements. ========== NOTES TO FINANCIAL STATEMENTS-- (CONTINUED) 2. FINANCIAL STATEMENT ELIMINATIONS The consolidated columns of the financial statements represent the summation of Manufacturing and Financial Services after intercompany transactions between Manufacturing and Financial Services have been eliminated. The following are the intercompany amounts which have been eliminated to arrive at the consolidated financial statements. The presence or absence of brackets indicates reductions or additions, respectively, necessary to compute the consolidated amounts. STATEMENT OF INCOME (LOSS) Millions of dollars 1993 1992 1991 - ---------------------------------------------------------------------- Sales and revenues, Financial Services .... $ (42) $ (40) $ (41) ====== ====== ====== Costs and expenses Financing charges on sold receivables ... $ (42) $ (40) $ (41) ====== ====== ====== Income before income taxes, Financial Services ...................... $ (61) $ (52) $ (60) ====== ====== ====== STATEMENT OF FINANCIAL CONDITION Millions of dollars 1993 1992 - ------------------------------------------------------------- Receivables, net .......................... $ (16) $ - Equity in Financial Services subsidiaries . (241) (240) ------ ------ Total assets .............................. $ (257) $ (240) ====== ====== Accounts payable .......................... $ (16) $ - Shareowner's equity, Financial Services ... (241) (240) ------ ------ Total liabilities and shareowner's equity . $ (257) $ (240) ====== ====== STATEMENT OF CASH FLOW Millions of dollars 1993 1992 1991 - ---------------------------------------------------------------------- Cash and cash equivalents provided by (used in): Operations ........................... $ (220) $ (87) $ 288 Investment programs .................. 187 67 (369) Financing activities ................. 33 20 81 ------ ------ ------ Increase during the year in cash and cash equivalents ........... $ - $ - $ - ====== ====== ====== ========== NOTES TO FINANCIAL STATEMENTS-- (CONTINUED) 3. INFORMATION RELATED TO THE STATEMENT OF CASH FLOW The following provides information related to the change in operating assets and liabilities included in cash and cash equivalents provided by (used in) operations: Millions of dollars 1993 1992 1991 - ---------------------------------------------------------------------- MANUFACTURING (Increase) decrease in receivables ...... $ 1 $ (118) $ 42 (Increase) decrease in inventories ...... (51) (37) 13 (Increase) in prepaid and other current assets .............. (10) (9) - Increase (decrease) in accounts payable . 122 187 (100) Increase in accrued liabilities ......... 10 126 74 ------ ------ ------ Manufacturing change in operating assets and liabilities ................ 72 149 29 ------ ------ ------ FINANCIAL SERVICES (Increase) decrease in receivables ...... 2 8 (3) Increase (decrease) in accounts payable and accrued liabilities ............... 17 (25) - ------ ------ ------ Financial Services change in operating assets and liabilities ... 19 (17) (3) ------ ------ ------ Eliminations/reclassifications (a) ........ (192) (69) 325 ------ ------ ------ Change in operating assets and liabilities. $ (101) $ 63 $ 351 ====== ====== ====== (a) Eliminations and reclassifications to the Statement of Cash Flow primarily consist of "Acquisitions (over) under cash collections" relating to Navistar Financial's wholesale notes and accounts. These amounts are included on a consolidated basis as a change in operating assets and liabilities under cash flow from operations which differs from the Financial Services classification in which net changes in wholesale notes and accounts are classified as cash flow from investment programs. In 1991, this amount included $300 million of proceeds from Navistar Financial's initial offering of pass-through certificates backed by certain wholesale notes receivable. ========== NOTES TO FINANCIAL STATEMENTS-- (CONTINUED) 4. POSTRETIREMENT BENEFITS Transportation provides postretirement benefits to substantially all of its employees. Expenses associated with postretirement benefits include pension expense for employees, retirees and surviving spouses, and postretirement health care and life insurance coverage for employees, retirees, surviving spouses and dependents. These costs are segregated as a separate component in the Statement of Income (Loss) and are as follows: Millions of dollars 1993 1992 1991 - ---------------------------------------------------------------------- Pension expense ........................... $ 107 $ 109 $ 101 Health/life insurance ..................... 102 146 138 ------ ------ ------ Total postretirement benefits expense ..... $ 209 $ 255 $ 239 ====== ====== ====== On the Statement of Financial Condition the postretirement benefits liability of $1,370 million includes $600 million for pension and $770 million of liabilities for postretirement health care and life insurance benefits. Generally, the pension plans are non-contributory with benefits related to an employee's length of service and compensation rate. Transportation's policy is to fund its pension plans in accordance with applicable government regulations and to make additional payments as funds are available to achieve full funding of the vested accumulated benefit obligation. The pension plans vary in the extent to which they are funded, but for plan years which ended during the current fiscal year, all legal funding requirements have been met. Plan assets are invested primarily in dedicated portfolios of long-term fixed income securities. In addition to providing pension benefits, Transportation provides health care and life insurance for a majority of its retired employees in the United States (U.S.) and Canada. For most retirees in the U.S., these benefits are defined by the terms of an agreement between Transportation and its employees, retirees and collective bargaining organizations (the Settlement Agreement) which provides such benefits (the Plan). The Plan, which was implemented on July 1, 1993, provides for cost sharing between Transportation and retirees in the form of premiums, co-payments and deductibles. A Base Program Trust has been established to provide a vehicle for funding of the health care liability through Transportation's contributions and retiree premiums. A separate independent Retiree Supplemental Benefit Program was also established, which included Transportation's contribution of the Parent Company's Class B Common Stock valued at $513 million, to potentially reduce retiree premiums, co- payments and deductibles and provide additional benefits in the future. ========== NOTES TO FINANCIAL STATEMENTS-- (CONTINUED) 4. POSTRETIREMENT BENEFITS (continued) Pension Expense Net pension expense included in the Statement of Income (Loss) is composed of the following: Millions of dollars 1993 1992 1991 - ---------------------------------------------------------------------- Service cost-benefits earned during the period ....................... $ 27 $ 25 $ 20 Interest on projected benefit obligation .. 220 219 221 Other pension costs ....................... 43 54 54 Less expected return on assets ............ (183) (189) (194) ------ ------ ------ Net pension expense ....................... $ 107 $ 109 $ 101 ====== ====== ====== Actual return on assets ................... $ 427 $ 218 $ 329 "Other pension costs" in the above table include principally the amortization of the net transition obligation and amortization of the cost of plan amendments. The net transition obligation of $467 million is being amortized on a straight-line basis over 15 years through the year 2002. The costs of plan amendments resulting from negotiated contracts are amortized principally over the average remaining service life of active employees. The determination of the projected benefit obligation is based on actuarial assumptions and discount rates that reflect the current level of interest rates. The return on assets is based on long-term expectations. Annual differences between such expectations and actual experience are deferred unless the cumulative amount exceeds a specified level. As of October 31, 1993, the cumulative actual returns on plan assets exceeded cumulative expected returns by $434 million. As a result of accumulated reductions in the discount rate and net actuarial losses, the actual projected benefit obligation exceeds the expected liability by $720 million. Pension Assets and Liabilities Included in the Statement of Financial Condition is an additional pension liability based on the excess of accumulated benefit obligations over the fair value of assets of Transportation's underfunded pension plans and an intangible asset representing previously incurred pension costs not yet expensed. The difference between the additional liability and the intangible asset represents net accumulated gains and losses from actuarial valuations, investment experience and changes in assumptions. This difference resulted in accumulated charges to equity of $229 million and $101 million as of October 31, 1993 and 1992, respectively. ========== NOTES TO FINANCIAL STATEMENTS-- (CONTINUED) 4. POSTRETIREMENT BENEFITS (continued) Pension Assets and Liabilities (continued) The funded status of Transportation's plans as of October 31, 1993 and 1992, and a reconciliation with amounts recognized in the Statement of Financial Condition are provided below. Plans in Which Plans in Which Assets Exceed Accumulated Benefits Accumulated Benefits Exceed Assets --------------------- -------------------- Millions of dollars 1993 1992 1993 1992 - -------------------------------------------------------------------------- Actuarial present value of: Vested benefits ............ $ (87) $ (71) $ (2,618) $ (2,235) Non-vested benefits ........ (4) (6) (213) (204) -------- -------- -------- -------- Accumulated benefit obligation ............. (91) (77) (2,831) (2,439) Effect of projected future compensation levels ...... (6) (6) (40) (58) -------- -------- -------- -------- Projected benefit obligation.. (97) (83) (2,871) (2,497) Plan assets at fair value .... 122 98 2,262 2,070 -------- -------- -------- -------- Funded status at October 31 .. 25 15 (609) (427) Unamortized pension costs: Net losses ............... 26 38 260 151 Prior service costs ...... 1 1 49 54 (Asset) liability at date of transition ..... (1) (2) 301 324 Adjustment for the minimum liability .......... - - (570) (471) -------- -------- -------- -------- Net asset (liability) ........ $ 51 $ 52 $ (569) $ (369) ======== ======== ======== ======== As shown above, for all plans, the sum of the $51 million net asset and the $569 million net liability was $518 million and is the amount recognized in the Statement of Financial Condition at October 31, 1993. This total includes $82 million of prepaid pension assets representing advance contributions to certain plans, and $600 million of net pension liabilities included in the $1,370 million postretirement benefits liability on the Statement of Financial Condition. ========== NOTES TO FINANCIAL STATEMENTS-- (CONTINUED) 4. POSTRETIREMENT BENEFITS (continued) Pension Assets and Liabilities (continued) The weighted average actuarial assumptions used in determining pension costs and the projected benefit obligation were: Millions of dollars 1993 1992 1991 - ---------------------------------------------------------------------- Discount rate used to determine present value of projected benefit obligation .............................. 7.3% 8.8% 9.1% Expected long-term rate of return on plan assets .......................... 8.8% 9.2% 10.1% Expected rate of increase in future compensation levels ........... 3.5% 5.5% 5.5% Transportation uses a weighted average discount rate based on the internal rate of return on its dedicated portfolio of high-quality bonds and an estimated yield available on high-quality fixed income securities which could be purchased to effectively settle the remaining portion of the obligation. The decrease in the discount rate to 7.3% in 1993 from 8.8% in 1992 reflects the decline in long-term interest rates during the past year. Transportation also reduced the assumption for future salary increases from 5.5% to 3.5% to reflect current expectations. Other Postretirement Benefits Transportation adopted SFAS 106 for its U.S. and Canadian plans in the third quarter of fiscal 1993, retroactive to November 1, 1992. Transportation elected to recognize the SFAS 106 transition obligation as a one-time non-cash charge to earnings. The cumulative effect of this change in accounting policy, as of November 1, 1992, was $1,149 million. Prior years have not been restated. The $1,144 million cumulative charge for the changes in accounting policy reported on the Statement of Income (Loss) includes the $1,149 million charge from the adoption of SFAS 106 which was partially offset by the $5 million benefit from the adoption of SFAS 109. Transportation's previous practice was to expense other postretirement benefits on a pay-as-you-go basis. The effect of adopting SFAS 106 in 1993 was an increase in annual expense of $41 million, or $25 million net of tax. The adoption of SFAS 106 does not affect cash flow, but it does change the timing of the recognition of costs. SFAS 106 requires the accrual of the expected cost of providing postretirement benefits during employees' active service periods. ========== NOTES TO FINANCIAL STATEMENTS-- (CONTINUED) 4. POSTRETIREMENT BENEFITS (continued) Other Postretirement Benefits (continued) The components of expense under SFAS 106 for postretirement benefits other than pensions that are included in the Statement of Income (Loss) for 1993 include the following: Millions of dollars 1993 - ----------------------------------------------------------------------- Service cost - benefits earned during the year .... $ 12 Interest cost on the accumulated benefit obligation 91 Expected return on assets ......................... (1) ------ Total postretirement benefits other than pensions . $ 102 ====== The funded status of postretirement benefits other than pensions as of October 31, 1993, is as follows: Millions of dollars 1993 - ------------------------------------------------------------------------ Accumulated postretirement benefit obligation (APBO): Retirees and their dependents ..................... $ (765) Active employees eligible to retire ............... (163) Other active participants ......................... (176) ------- Total APBO ........................................ (1,104) Plan assets at fair value ......................... 302 ------- APBO in excess of plan assets ..................... (802) Unrecognized net (gain)/loss ...................... 32 ------- Net liability ..................................... $ (770) ======= During fiscal 1993, Transportation pre-funded $300 million of this liability from proceeds lent to Transportation by the Parent Company as a result of a public offering of Common Stock. According to the terms of the Settlement Agreement, Transportation was required to fund at least $100 million of this liability prior to January 1, 1994. Further, Transportation will be required to make additional pre-funding contributions to the liability on or prior to July 1, 1998, such that the total of all pre-funding contributions will equal the total net proceeds from all sales of Common Stock by the Parent Company through such date, but not to exceed $500 million. Additionally, Transportation is required to annually pre-fund an amount equal to annual service cost. Under the terms of the Settlement Agreement, these funds will be used to pay a portion of current benefits; the remainder to be invested primarily in equities with an expected return of 9%. ========== NOTES TO FINANCIAL STATEMENTS-- (CONTINUED) 4. POSTRETIREMENT BENEFITS (continued) Other Postretirement Benefits (continued) The discount rate used to determine the accumulated postretirement benefit obligation at October 31, 1993, was 7.5%, based on estimated income on high-quality fixed income securities which could be purchased to effectively settle the obligation. As interest rates have declined, inflation rates and their effect on future health care cost trend rates have been contained and are experiencing a downward trend. Combined with internal containment programs and the government program on national health care, the period to reach an ultimate ongoing inflation rate may also shorten. For 1994, the weighted average rate of increase in the per capita cost of covered medical benefits is projected to be 10.5% for participants under the age of 65 and 8.5% for participants age 65 or over. The rate of increase for drugs is projected to be 11.5% for all participants. The rates are projected to decrease on an annual basis to 5% in the year 2003 and remain at that level each year thereafter. If the cost trend rate assumptions were increased by one percentage point for each year, the accumulated postretirement benefit obligation would increase by approximately $120 million and the associated expense recognized for the year ended October 31, 1993 would increase by an estimated $13 million. Conversely, a decrease in the cost trend rate would lower the accumulated postretirement benefit obligation and the associated expense. 5. INCOME TAXES During the third quarter of 1993, Transportation adopted SFAS 109, "Accounting for Income Taxes," with retroactive application to November 1, 1992. Under SFAS 109, deferred tax assets and liabilities are generally determined based on the difference between the financial statement and tax bases of assets and liabilities using enacted tax rates in effect for the year in which the differences are expected to reverse. SFAS 109 allows recognition of deferred tax assets if future realization is more likely than not. The Parent Company files a consolidated U.S. federal income tax return which includes Transportation and its U.S. subsidiaries. Transportation has a tax allocation agreement (Tax Agreement) with the Parent Company which requires Transportation to compute its separate federal income tax expense based on its adjusted book income. Any resulting tax liability is paid to the Parent Company. In addition, under the Tax Agreement, Transportation is required to pay to the Parent Company any tax payments received from its subsidiaries. The effect of the Tax Agreement is to allow the Parent Company rather than Transportation to utilize U.S. operating losses and net operating loss carryforwards (NOLs) generated in earlier years. As of October 31, 1993, Transportation had $22 million of domestic NOLs available to offset future taxable income generated by the subsidiaries. ========== NOTES TO FINANCIAL STATEMENTS-- (CONTINUED) 5. INCOME TAXES (continued) The adoption of SFAS 109 does not have a material impact on Transportation, as a result of the Tax Agreement. Substantially all of the deferred tax asset and corresponding income tax benefit resulting from the adoption of SFAS 109 is reflected on the financial statements of the Parent Company. Taxes on income (loss) are analyzed by categories as follows: Millions of dollars 1993 1992 1991 - --------------------------------------------------------------------- Current: Federal ................................ $ 12 $ 12 $ 17 State and local ........................ 3 3 5 ------ ------ ------ Total current ........................ 15 15 22 Deferred taxes ........................... 4 - - ------ ------ ------ Total income tax expense ................. $ 19 $ 15 $ 22 ====== ====== ====== The difference between the provision for income taxes and income taxes computed using the U.S. federal income tax statutory rate in 1993, 1992 and 1991 was as follows: Millions of dollars 1993 1992 1991 - ------------------------------------------------------------------------ Amount computed using the U.S. federal statutory rate ............ $ (165) $ (68) $ (65) Increase (reduction) in taxes resulting from: State income taxes, net ............. 3 3 4 Current year losses for which no benefit is available ..... 182 83 87 Other................................ (1) (3) (4) ------ ------ ------ Provision for income taxes ............ $ 19 $ 15 $ 22 ====== ====== ====== ========== NOTES TO FINANCIAL STATEMENTS-- (CONTINUED) 5. INCOME TAXES (continued) The components of the deferred tax asset (liability), in millions of dollars, are as follows: October 31,1993 --------------- United States - ------------- Deferred tax asset, net operating loss carryforwards $ 8 Less valuation allowance ............................ (8) ------ Net deferred tax assets ........................... $ - ====== Foreign - ------- Deferred tax assets: Net operating loss carryforwards .................. $ 11 Postretirement benefits ........................... 16 ------ Total deferred tax assets ....................... 27 ------ Deferred tax liabilities: Prepaid pension assets ............................. (16) ------ Total deferred tax liabilities ................... (16) ------ Total ............................................ 11 Less valuation allowance ............................ (27) ------ Net deferred tax liabilities .................... $ (16) ====== A valuation allowance has been provided for those net operating loss carryforwards and temporary differences which are estimated to expire before they are utilized. Because the foreign tax carryforward period is relatively short, a full allowance has been provided against the total deferred tax assets. The U.S. valuation allowance increased by $4 million during 1993 which is attributable to 1993 losses for which no tax benefits have been recognized. The foreign valuation allowance decreased $6 million during 1993 resulting from recognizing tax benefits from the utilization of NOL carryforwards attributable to 1993 foreign operating income and fluctuations in foreign exchange rates. ========== NOTES TO FINANCIAL STATEMENTS-- (CONTINUED) 5. INCOME TAXES (continued) SFAS 109 requires that individual tax paying entities of Transportation offset all deferred tax assets and liabilities within each tax jurisdiction and present them in a single amount in the Statement of Financial Condition. Amounts in different tax jurisdictions cannot be offset against each other. 6. DISCONTINUED OPERATIONS A provision of $65 million was recorded in the third quarter of 1992 as a loss of discontinued operations for the settlement of litigation commonly referred to as the Wisconsin Steel Pension Plan Cases. The court held Transportation liable for pension liabilities to former employees of the Wisconsin Steel Division prior to its sale to EDC Holding Company in 1977. Under the terms of the settlement, the Company paid the Pension Benefit Guaranty Corporation (PBGC) $20 million, issued to the PBGC 357,000 shares of Navistar International Corporation Common Stock and delivered to the PBGC an eight percent ten-year note with a face amount of $36.6 million and maturing August 15, 2002. 7. MARKETABLE SECURITIES Marketable securities at October 31 are as follows: Millions of dollars 1993 1992 - ------------------------------------------------------------------------ MANUFACTURING Corporate and other securities .................... $ - $ - U.S. government securities ........................ 54 7 ------ ------ Manufacturing marketable securities ............. 54 7 ------ ------ FINANCIAL SERVICES Corporate securities .............................. 18 29 U.S. government and federal agency securities ..... 70 61 Mortgage and asset-backed securities .............. 36 39 Foreign government securities ..................... 9 14 ------ ------ Financial Services marketable securities......... 133 143 ------ ------ Total marketable securities ......................... $ 187 $ 150 ====== ====== ========== NOTES TO FINANCIAL STATEMENTS-- (CONTINUED) 7. MARKETABLE SECURITIES (continued) Additional information related to the Financial Services' marketable securities carried at amortized cost at October 31, all of which are held by insurance affiliates, is as follows: ---------------------------- Gross Amortized Unrealized Fair Millions of dollars Cost Gains Value - ------------------------------------------------------------------------- Corporate securities ........................ $ 18 $ 1 $ 19 U.S. government and federal agency securities 70 5 75 Mortgage and asset-backed securities ........ 36 1 37 Foreign government securities ............... 9 - 9 ------ ------ ------ Total Financial Services marketable securities ..................... $ 133 $ 7 $ 140 ====== ====== ====== ---------------------------- Gross Amortized Unrealized Fair Millions of dollars Cost Gains Value - ------------------------------------------------------------------------- Corporate securities ....................... $ 29 $ 1 $ 30 U.S. government and federal agency securities 61 2 63 Mortgage and asset-backed securities ........ 39 1 40 Foreign government securities ............... 14 - 14 ------ ------ ------ Total Financial Services marketable securities ..................... $ 143 $ 4 $ 147 ====== ====== ====== Contractual maturities of Financial Services' marketable debt securities at October 31, 1993 are as follows: Amortized Fair Millions of dollars Cost Value - ------------------------------------------------------------------------- Due in one year or less ..................... $ 6 $ 6 Due after one year through five years ...... 62 65 Due after five years through ten years ...... 26 28 Due after ten years ......................... 3 3 ------ ------ 97 102 Mortgage and asset-backed securities ...... 36 38 ------ ------ Total debt securities ................... $ 133 $ 140 ====== ====== ========== NOTES TO FINANCIAL STATEMENTS-- (CONTINUED) 7. MARKETABLE SECURITIES (continued) Proceeds from sales or maturities of investments in debt securities were $86 million during 1993 and $121 million during 1992. Gross gains of $6 million and $4 million were realized on such sales or maturities in 1993 and 1992, respectively. There were gross losses of $2 million in 1993 and 1992. At October 31, 1993 and 1992, Financial Services had $27 million and $20 million, respectively, of marketable securities on deposit with various state departments of insurance or otherwise restricted as to use. These securities are included in total marketable securities balances at October 31, 1993 and 1992. 8. RECEIVABLES Receivables at October 31 are summarized by major classification as follows: Millions of dollars 1993 1992 - ------------------------------------------------------------------------ MANUFACTURING Customers ........................................ $ 149 $ 151 Allowance for losses ............................. (24) (20) ------ ------ Manufacturing receivables, net ................. 125 131 ------ ------ FINANCIAL SERVICES Retail notes and lease financing ................. 831 971 Wholesale notes .................................. 259 128 Accounts receivable .............................. 275 216 Amounts due from sales of receivables ............ 76 41 Reinsurance balance receivables .................. 5 6 ------ ------ Total accounts and notes receivables ............. 1,446 1,362 Allowance for losses ............................. (13) (14) ------ ------ Financial Services receivables, net ............ 1,433 1,348 ------ ------ Eliminations ................................... (16) - ------ ------ Total receivables, net.............................. $1,542 $1,479 ====== ====== The allowance for losses of Manufacturing includes amounts associated with receivables financed by the Financial Services' subsidiaries and receivables on products sold to distributors in export markets. ========== NOTES TO FINANCIAL STATEMENTS-- (CONTINUED) 8. RECEIVABLES (continued) Financial Services Navistar Financial purchases the majority of the wholesale notes receivable and some retail notes and accounts receivable arising from Transportation's operations in the United States. A portion of Navistar Financial's funding for retail and wholesale notes comes from sales of those receivables by Navistar Financial to third parties with limited recourse. Proceeds from sales of receivables were $1,741 million in 1993, $1,285 million in 1992 and $1,470 million in 1991. Uncollected sold receivable balances totalled $839 million and $533 million as of October 31, 1993 and 1992, respectively. A portion of the receivables is sold by Navistar Financial to third parties with recourse. Navistar Financial's maximum exposure under all receivable sale recourse provisions at October 31, 1993 is $130 million which includes holdback reserves of $69 million, subordinated retained interest in securitized receivable sales of $54 million and $6 million of certain cash deposits established as a result of the securitized receivables recourse provisions. Contractual maturities of notes and lease financing outstanding at October 31, 1993, are summarized as follows. Prepayments may cause the average actual life to be shorter. Retail Notes and Lease Wholesale Accounts Millions of dollars Financing Notes Receivable - ------------------------------------------------------------------------ Gross finance receivables due in: 1994 ........................... $ 337 $ 145 $ 275 1995 ........................... 249 114 - 1996 ........................... 173 - - 1997 and thereafter ............ 165 - - ------- ------- ------- Gross finance receivables .... 924 259 275 Unearned finance charges ......... 93 - - ------- ------- ------- Total finance receivables ........ $ 831 $ 259 $ 275 ======= ======= ======= ========== NOTES TO FINANCIAL STATEMENTS-- (CONTINUED) 9. INVENTORIES Inventories at October 31 are as follows: Millions of dollars 1993 1992 - ------------------------------------------------------------------------ Finished products .................................. $ 196 $ 180 Work in process .................................... 73 67 Raw materials and supplies ......................... 142 118 ------ ------ Total inventories .................................. $ 411 $ 365 ====== ====== 10. PROPERTY At October 31, property includes the following: Millions of dollars 1993 1992 - ------------------------------------------------------------------------ MANUFACTURING Land ............................................. $ 8 $ 8 ------ ------ Buildings, machinery and equipment at cost: Plants ......................................... 1,087 995 Distribution ................................... 72 72 Other .......................................... 82 76 ------ ------ Subtotal ..................................... 1,241 1,143 ------ ------ Total property ................................... 1,249 1,151 Less accumulated depreciation and amortization ... (641) (588) ------ ------ Manufacturing property, net .................... 608 563 ------ ------ FINANCIAL SERVICES Total property ................................... 34 24 Less accumulated depreciation and amortization ... (6) (5) ------ ------ Financial Services property, net ............... 28 19 ------ ------ Total property and equipment, net .................. $ 636 $ 582 ====== ====== Included in the gross property of Manufacturing is property under capitalized lease obligations of $28 million at October 31, 1993, and $54 million at October 31, 1992. ========== NOTES TO FINANCIAL STATEMENTS-- (CONTINUED) 11. LEASES Transportation has long-term noncancellable leases for use of various equipment and facilities. Lease terms are generally for 5 to 25 years and in many cases provide for renewal options. Transportation is generally obligated for the cost of property taxes, insurance and maintenance. Transportation leases office buildings, distribution centers, furniture and equipment, machinery and equipment and computer equipment. Total operating lease expense was $30 million in 1993, 1992 and 1991. Income received from sublease rentals was $6 million in 1993, 1992 and 1991. At October 31, 1993, consolidated future minimum lease payments required under capital and noncancellable operating leases having lease terms in excess of one year are as follows: Capital Operating Millions of dollars Leases Leases - ----------------------------------------------------------------- 1994 ...................................... $ 4 $ 22 1995 ...................................... 4 20 1996 ...................................... 3 20 1997 ...................................... 3 19 Thereafter ................................ 13 72 ------ ------ Total minimum payments .................... 27 $ 153 ====== Less imputed interest ..................... (8) ------ Present value of minimum lease payments . $ 19 ====== Future income from subleases ............ $ 39 ====== ========== NOTES TO FINANCIAL STATEMENTS-- (CONTINUED) 12. ACCOUNTS PAYABLE Major classifications of accounts payable at October 31 are as follows: Millions of dollars 1993 1992 - ----------------------------------------------------------------- MANUFACTURING Trade ........................................ $ 669 $ 577 Other ........................................ 16 4 ------ ------ Manufacturing accounts payable ............. 685 581 ------ ------ FINANCIAL SERVICES Other ........................................ 63 56 Manufacturing ................................ 22 - ------ ------ Financial Services accounts payable ........ 85 56 ------ ------ Eliminations ................................... (16) - ------ ------ Total accounts payable ......................... $ 754 $ 637 ====== ====== 13. ACCRUED LIABILITIES Major classifications of accrued liabilities at October 31 are as follows: Millions of dollars 1993 1992 - ----------------------------------------------------------------- MANUFACTURING Employee related benefits ................... $ 35 $ 51 Product liability and warranty .............. 108 94 Payroll and commissions ..................... 59 67 Taxes ....................................... 21 22 Interest .................................... 4 4 Other ....................................... 132 124 ------ ------ Manufacturing accrued liabilities ......... 359 362 ------ ------ FINANCIAL SERVICES Interest .................................... 14 20 Taxes ....................................... 5 5 Product liability ........................... 2 2 Other ....................................... 3 6 ------ ------ Financial Services accrued liabilities .... 24 33 ------ ------ Total accrued liabilities ..................... $ 383 $ 395 ====== ====== ========== NOTES TO FINANCIAL STATEMENTS-- (CONTINUED) 14. DEBT Short-Term Debt Millions of dollars 1993 1992 - ------------------------------------------------------------------- MANUFACTURING Notes payable and current maturities of long-term debt .............................. $ 25 $ 15 Parent Company notes payable ..................... 33 - ------ ------ Manufacturing short-term debt .................. 58 15 ------ ------ FINANCIAL SERVICES Bank borrowings .................................. 75 - Current maturities of long-term debt ............. 80 99 ------ ------ Financial Services short-term debt ............. 155 99 ------ ------ Total short-term debt .............................. $ 213 $ 114 ====== ====== Long-Term Debt Millions of dollars 1993 1992 - ------------------------------------------------------------------- MANUFACTURING Subordinated Parent Company Notes 9.05% Stock Purchase Agreement (Class B Common), due 2003 ................... $ 478 $ - 9% Loan Agreement, due 2013 .................... 493 - ------ ------ Long-term debt due Parent Company ................ $ 971 $ - ====== ====== ----------------------------------------------- MANUFACTURING 8 5/8% Sinking Fund Debentures, due 1995 ......... $ 9 $ 15 6 1/4% Sinking Fund Debentures, due 1998 ......... 11 14 9% Sinking Fund Debentures, due 2004 ............. 75 83 8% Secured Note, due 2002 ........................ 37 37 Capitalized leases ............................... 15 19 Other ............................................ 3 4 ------ ------ Manufacturing long-term debt ................... 150 172 ------ ------ FINANCIAL SERVICES Senior Debentures and Notes 7 1/2%, due 1994 ............................... - 75 9.35% to 9.75%, medium-term, due 1994 to 1996 217 222 Bank revolver, variable rate, due November 1995 727 727 ------ ------ Total senior debt ............................ 944 1,024 Subordinated Debentures, 11.95%, due December 1995 100 100 Unamortized discount ............................. - (5) ------ ------ Financial Services long-term debt .............. 1,044 1,119 ------ ------ Total long-term debt ............................... $1,194 $1,291 ====== ====== ========== NOTES TO FINANCIAL STATEMENTS-- (CONTINUED) 14. DEBT (continued) Long-Term Debt (continued) The aggregate annual maturities and sinking fund requirements for long-term debt for the years ended October 31 are as follows: Financial Millions of dollars Manufacturing Services Total - ------------------------------------------------------------------------- 1995 .................................. 59 100 159 1996 .................................. 58 944 1,002 1997 .................................. 60 - 60 1998 .................................. 64 - 64 Thereafter ............................ 880 - 880 Weighted average interest rate on total debt including short-term debt and the effect of discounts and related amortization ................ 9.0% 7.2% 7.2% Manufacturing's eight percent secured note, due 2002, is secured by certain plant assets. In conjunction with approval of the Settlement Agreement and implementation of the Plan, Transportation entered into a Stock Purchase Agreement with the Parent Company at 9.05%, due 2003, for the purchase of Class B Common Stock. Transportation contributed the stock, which was valued at $513 million, to an independent retiree Supplemental Trust on July 1, 1993. On October 21, 1993, the Parent Company completed a public offering of common shares. The proceeds were loaned to Transportation at 9%, due 2013. Transportation used $300 million to pre-fund benefit liabilities under the Plan and will use the remaining proceeds for working capital purposes. At October 31, 1993, Navistar Financial had contractually committed facilities of $1,327 million consisting of a bank revolving credit facility of $727 million and a retail notes receivable purchase facility of $600 million. In April 1993, Navistar Financial amended and restated the credit and purchase facility agreements extending the maturity date of these facilities to November 15, 1995. The amended and restated credit facility granted security interests in substantially all of Navistar Financial's assets, provided for a reduction in the credit facility commitment in the amount of 50% of any new senior debt issued after April 30, 1993 with a term of three years or longer and permitted Navistar Financial to declare a special dividend to Transportation not to exceed $20 million upon implementation of the Plan. ========== NOTES TO FINANCIAL STATEMENTS-- (CONTINUED) 14. DEBT (continued) Long-Term Debt (continued) Unused commitments under the credit and purchase facilities were $157 million, $75 million of which was used to back short-term bank borrowings at October 31, 1993. The remaining $82 million, when combined with unrestricted cash and cash equivalents, made $105 million available for the general business purposes of Navistar Financial at October 31, 1993. Compensating cash balances are not required under the revolving credit facility, but commitment fees are paid on the unused portions of the bank revolving credit and retail notes receivable purchase facilities. Navistar Financial also pays a facility fee on the $600 million retail notes receivable purchase facility. Navistar Financial has two wholly-owned subsidiaries, Navistar Financial Retail Receivables Corporation (NFRRC) and Navistar Financial Securities Corporation (NFSC), which have a limited purpose of purchasing retail and wholesale receivables, respectively, and transferring an undivided ownership interest in such notes to investors in exchange for pass-through notes and certificates. These subsidiaries have limited recourse on the sold receivables and their assets are available to satisfy the claims of their creditors prior to such assets becoming available to Navistar Financial or affiliated companies. At October 31, 1993, NFSC had in place a $300 million revolving wholesale note sales trust providing for the continuous sale of wholesale notes on a daily basis. The sales trust is comprised of three $100 million pools of notes maturing serially from 1997 to 1999. On September 16, 1993, NFRRC filed a shelf registration with the Securities and Exchange Commission providing for the issuance from time to time of $1 billion of asset-backed securities. On November 10, 1993, Navistar Financial sold $335 million of retail notes to NFRRC which, in turn, sold to investors $323 million of notes and $12 million of certificates issued by an owner trust. The net proceeds of $334 million were used by Navistar Financial for general working capital purposes and to establish a $25 million reserve account with the trust. On November 16, 1993, Navistar Financial sold $100 million of 8 7/8% Senior Subordinated Notes due 1998 and used the proceeds to redeem its 11.95% Subordinated Debentures due December 1995. Navistar Financial will also redeem its 7 1/2% Senior Debentures due January 1994 on December 15, 1993. Consolidated interest payments were $93 million in 1993 and 1992, and $97 million in 1991. ========== NOTES TO FINANCIAL STATEMENTS-- (CONTINUED) 15. OTHER LONG-TERM LIABILITIES Major classifications of other long-term liabilities at October 31 are as follows: Millions of dollars 1993 1992 - ------------------------------------------------------------------- MANUFACTURING Product liability and warranty .............. $ 170 $ 183 Restructuring costs ......................... 8 16 Other ....................................... 77 85 ------ ------ Manufacturing other long-term liabilities . 255 284 FINANCIAL SERVICES Product liability ........................... 9 10 ------ ------ Total other long-term liabilities ............. $ 264 $ 294 ====== ====== 16. FINANCIAL INSTRUMENTS During fiscal 1993, Transportation adopted SFAS 107, "Disclosures about Fair Value of Financial Instruments." This statement requires disclosure of the fair value of financial instruments and a description of the methods and assumptions used to estimate fair value. The carrying amounts of financial instruments on a consolidated basis, as reported on the Statement of Financial Condition and described in the various footnotes to the financial statements and their fair values at October 31, 1993, are as follows: Carrying Fair Millions of dollars Amount Value - ------------------------------------------------------------------------ Marketable securities ....................... $ 187 $ 194 Receivables, net ............................ 1,542 1,558 Investments and other assets ................ 234 279 Long-term debt .............................. 2,165 2,198 The carrying amounts of cash and cash equivalents approximate fair value. The fair value of marketable securities is estimated based on quoted market prices, when available. If a quoted market price is not available, fair value is estimated using quoted market prices for similar financial instruments. The fair value of Financial Services' marketable securities held by insurance affiliates at October 31, 1993 is disclosed, as required, in Note 7 to the Financial Statements, and included above. ========== NOTES TO FINANCIAL STATEMENTS-- (CONTINUED) 16. FINANCIAL INSTRUMENTS (continued) The carrying amounts of Manufacturing's customer receivables and Navistar Financial's wholesale notes and retail and wholesale accounts and other variable-rate retail notes approximate fair value because of the short-term maturities of the financial instruments. The fair value of Navistar Financial's truck retail notes is estimated based on quoted market prices of similar sold receivables. The fair value of amounts due from sales of receivables is estimated using cash flow analyses based on interest rates currently offered by Navistar Financial's finance operations. The carrying amounts of short-term debt and variable-rate borrowings under Navistar Financial's bank revolving credit agreement, which is repriced frequently, approximate fair value. The fair value of long-term debt is estimated based on quoted market prices, when available. If a quoted market price is not available, fair value is estimated using quoted market prices for similar financial instruments or discounting future cash flows. The fair value of investments and other assets is estimated based on quoted market prices or by discounting future cash flows. 17. COMMITMENTS, CONTINGENT LIABILITIES AND RESTRICTIONS ON ASSETS At October 31, 1993, commitments for capital expenditures in progress were approximately $17 million. Transportation was contingently liable at October 31, 1993, for approximately $4 million for guarantees of debt and for bid and performance bonds. As of October 31, 1993, Harbour Bermuda was contingently liable for claims in the amount of $5 million. At October 31, 1993, the Canadian operating subsidiary was contingently liable for retail customers' contracts and leases financed by a third party. Transportation is subject to maximum recourse of $94 million on retail contracts and $9 million on retail leases. Based on historical loss trends however, Transportation's exposure to loss is not considered material. The Canadian operating subsidiary and certain subsidiaries included in Financial Services are parties to agreements which restrict the amounts which can be distributed to Transportation in the form of dividends or loans and advances which can be made. As of October 31, 1993, these subsidiaries had $313 million of net assets, of which $238 million was restricted as to distribution. The Parent Company and Transportation are obligated under certain agreements with public and private lenders of Navistar Financial to maintain the subsidiary's income before interest expense and income taxes at not less than 125% of its total interest expense. No income maintenance payments were required for the three years ended October 31, 1993. ========== NOTES TO FINANCIAL STATEMENTS-- (CONTINUED) 17. COMMITMENTS, CONTINGENT LIABILITIES AND RESTRICTIONS ON ASSETS (continued) Transportation has been named as a potentially responsible party (PRP), in conjunction with other parties, in a number of cases arising under an environmental protection law commonly known as the Superfund law. The anticipated known costs associated with the current PRP actions on October 31, 1993, are reflected in Transportation's $10 million accrued liability. Investigations into the nature and extent of cleanup activities under the Superfund law are being conducted at two sites formerly owned by Transportation. The eventual scope, timing and cost of such activities as well as the availability of defense to any such claims, and possible claims against third parties and insurance companies are not known and cannot be reasonably estimated; however, substantial claims could be asserted against Transportation. 18. LEGAL PROCEEDINGS In July 1992, Transportation announced its decision to change its retiree health care benefit plans and concurrently filed a declaratory judgment class action lawsuit in the U.S. District Court for the Northern District of Illinois (Illinois Court) to confirm its right to change these benefits. A countersuit was filed against Transportation by its unions in the U.S. District Court for the Southern District of Ohio (Ohio Court). On October 16, 1992, Transportation withdrew its declaratory judgment action in the Illinois Court and began negotiations with the United Automobile, Aerospace and Agricultural Implement Workers of America (UAW) to resolve issues affecting both retirees and employees. On December 17, 1992, Transportation announced that a tentative agreement had been reached with the UAW on restructuring retiree health care and life insurance benefits (the Settlement Agreement). During the third quarter of 1993, all court, regulatory agency and shareowner approvals required to implement the Settlement Agreement concerning retiree health care benefit plans were obtained. The Settlement Agreement became effective and the restructured retiree health care and life insurance plan was implemented on July 1, 1993. In May 1993, a jury issued a verdict in favor of Vernon Klein Truck & Equipment, Inc. and against Transportation in the amount of $10.8 million in compensatory damages and $15 million in punitive damages. In order to appeal the verdict in the case, Transportation was required to post a bond collateralized with $30 million in cash. This amount has been recorded as restricted cash on the Statement of Financial Condition. The amount of any potential liability is uncertain and Transportation believes that there are meritorious arguments for overturning or diminishing the verdict. Transportation and its subsidiaries are subject to various other claims arising in the ordinary course of business, and are parties to various legal proceedings which constitute ordinary routine litigation incidental to its business and that of its subsidiaries. In the opinion of Transportation's management, none of these proceedings or claims are material to the business or the financial condition of Transportation. 19. SHAREOWNER'S EQUITY The number of authorized shares of Transportation's capital stock at October 31, 1993, was 100,000 with a par value of $1.00 per share and the number of issued and outstanding shares was 1,000. All the issued and outstanding stock is owned by Navistar International Corporation and no shares are reserved for officers and employees or for options, warrants, conversions and other rights. ========== NOTES TO FINANCIAL STATEMENTS-- (CONTINUED) ========== NOTES TO FINANCIAL STATEMENTS-- (CONTINUED) 20. SELECTED QUARTERLY FINANCIAL DATA (Unaudited) (continued) FOURTH QUARTER 1993 RESULTS Fourth quarter consolidated sales and revenues of $1,300 million were 14% higher than the same period a year ago. Transportation's medium and heavy truck shipments increased 13% from the prior year's quarter. The higher shipments reflect improvement in North American industry retail sales of medium and heavy trucks which totalled 77,200 units, an increase of 13%, from the same quarter last year. For the fourth quarter, Transportation maintained its leadership in the North American combined medium and heavy truck market with a market share of 27.9%. Shipments of 32,700 mid-range diesel engines to original equipment manufacturers were 18% higher than the same quarter of 1992 reflecting consumer demand for the diesel-powered light trucks and vans which use this engine. Service parts sales increased 11% from the fourth quarter of 1992. Net income for the fourth quarter of 1993 was $12 million, an increase from the $33 million loss for the same period in 1992. The 1992 loss included $23 million of expense related to a voluntary vehicle recall. Manufacturing gross margin for the period was 14.3% up from 13.9% in the fourth quarter of 1992 prior to a one-time charge for vehicle recalls. The increase in margin can be attributed primarily to increased sales volume, higher net selling prices and savings from the restructured retiree benefit Plan implemented July 1, 1993. Partially offsetting these favorable factors was an increase in start-up costs associated with new truck and engine product introductions. Financial Services income before taxes increased to $15 million in the fourth quarter of 1993 from $11 million in 1992. The increase in income is primarily from higher earnings from wholesale financing and a lower provision for credit losses. ========== NAVISTAR INTERNATIONAL TRANSPORTATION CORP. AND SUBSIDIARIES ------------------------------------------- INDEPENDENT AUDITORS' REPORT ---------------------------- Navistar International Transportation Corp.: We have audited the financial statements and financial statement schedules of Navistar International Transportation Corp. and Consolidated Subsidiaries listed in Item 8 and Item 14. These consolidated financial statements and financial statement schedules are the responsibility of Transportation's management. Our responsibility is to express an opinion on these consolidated financial statements and financial statement schedules based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the consolidated financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the consolidated financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the accompanying consolidated financial statements present fairly, in all material respects, the financial position of Navistar International Transportation Corp. and Consolidated Subsidiaries at October 31, 1993 and 1992, and the results of their operations and their cash flow for each of the three years in the period ended October 31, 1993, in conformity with generally accepted accounting principles. Also, in our opinion, such financial statement schedules, when considered in relation to the basic consolidated financial statements taken as a whole, present fairly in all material respects the information set forth therein. As discussed in Note 1, in accordance with the provisions of Statements of Financial Accounting Standards No. 106 and No. 109, effective November 1, 1992, Transportation changed its methods of accounting for postretirement benefits other than pensions and for income taxes. Deloitte & Touche December 15, 1993 Chicago, Illinois Exhibit 24 ========== NAVISTAR INTERNATIONAL TRANSPORTATION CORP. AND SUBSIDIARIES ------------------------------------------- INDEPENDENT AUDITORS' CONSENT Navistar International Transportation Corp.: We consent to the incorporation by reference in this Post-Effective Amendment No. 1 to Registration No. 2-70979 of Navistar International Transportation Corp. on Form S-8 of our report dated December 15, 1993 (which includes an explanatory paragraph relating to the change in methods of accounting for postretirement benefits other than pensions and for income taxes as required by Statements of Financial Accounting Standards No. 106 and No. 109) appearing in the Annual Report on Form 10-K of Navistar International Transportation Corp. for the year ended October 31, 1993. Deloitte & Touche January 27, 1994 Chicago, Illinois ITEM 9.

ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE None PART III ITEMS 10, 11, 12 AND 13 Intentionally omitted. See the index page to this Report for explanation. PART IV ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K Financial Statements - -------------------- See Index to Financial Statements in Item 8. Schedules Page ---- VII - Guarantees of Securities of Other Issuers .............. VIII - Valuation and Qualifying Accounts and Reserves ......... IX - Short-Term Borrowings .................................. X - Supplementary Income Statement Information ............. All schedules other than those indicated above are omitted because of the absence of the conditions under which they are required or because information called for is shown in the financial statements and notes thereto. Exhibits, Including those Incorporated by Reference Page - --------------------------------------------------- ---- (3) Articles of Incorporation and By-Laws ................... E-1 (4) Instruments Defining the Rights of Security Holders, including Indentures ............. E-2 (10) Material Contracts ...................................... E-3 (24) Independent Auditors' Consent . ......................... 63 (25) Power of Attorney ....................................... 68 (28.1) Navistar Financial Corporation Annual Report on Form 10-K for the fiscal year ended October 31, 1993 ............ N/A All exhibits other than those indicated above are omitted because of the absence of the condition under which they are required or because information called for is shown in the financial statements and notes thereto. Reports on Form 8-K - ------------------- A report on Form 8-K dated December 9, 1992, was filed by Transportation to describe developments in negotiations with the United Automobile, Aerospace and Agricultural Implement Workers of America. A report on Form 8-K dated December 9, 1992, was filed by Transportation to disclose a change in credit rating. A report on Form 8-K dated December 14, 1992, was filed by Transportation to disclose a change in credit rating. A report on Form 8-K dated December 18, 1992, was filed by Transportation to announce a tentative agreement on restructuring retiree health care and life insurance benefits. PART IV ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K Reports on Form 8-K (continued) - ------------------- A report on Form 8-K, dated May 14, 1993, was filed by Transportation indicating Navistar Financial Corporation granted security interests in substantially all of its assets pursuant to an Amended and Restated Credit Agreement and amended and restated an existing revolving credit facility and a retail notes receivable purchase facility. A report on Form 8-K, dated May 28, 1993, was filed by Transportation announcing court approval of a retiree health care and life insurance benefit settlement. A report on Form 8-K, dated July 1, 1993, was filed by Transportation describing Parent Company shareowner approval of the postretirement health care and life insurance benefits settlement as well as a one-for-ten reverse split of the Common stock and Class B Common stock. SIGNATURE NAVISTAR INTERNATIONAL TRANSPORTATION CORP. AND SUBSIDIARIES ------------------------------------------- SIGNATURE Pursuant to the requirements of Section 13 and 15(d) 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. NAVISTAR INTERNATIONAL TRANSPORTATION CORP. - ------------------------------------------- (Registrant) /s/ Robert I. Morrison - ---------------------------------- Robert I. Morrison January 27, 1994 Vice President and Controller (Principal Accounting Officer) SIGNATURE NAVISTAR INTERNATIONAL TRANSPORTATION CORP. AND SUBSIDIARIES ------------------------------------------- POWER OF ATTORNEY Each person whose signature appears below does hereby make, constitute and appoint John R. Horne, Robert I. Morrison and Robert A. Boardman and each of them acting individually, true and lawful attorneys- in-fact and agents with power to act without the other and with full power of substitution, to execute, deliver and file, for and on such person's behalf, and in such person's name and capacity or capacities as stated below, any amendment, exhibit or supplement to the Form 10-K Report making such changes in the report as such attorney-in-fact deems appropriate. SIGNATURES Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated: Signature Title Date - ----------------------- -------------------------- ---------------- /s/ James C. Cotting - -------------------- James C. Cotting Chairman January 27, 1994 and Chief Executive Officer and Director (Principal Executive Officer) /s/ John R. Horne - -------------------- John R. Horne President January 27, 1994 and Chief Operating Officer and Director /s/ Robert C. Lannert - --------------------- Robert C. Lannert Executive Vice President January 27, 1994 and Chief Financial Officer and Director

ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K Financial Statements - -------------------- See Index to Financial Statements in Item 8. Schedules Page ---- VII - Guarantees of Securities of Other Issuers .............. VIII - Valuation and Qualifying Accounts and Reserves ......... IX - Short-Term Borrowings .................................. X - Supplementary Income Statement Information ............. All schedules other than those indicated above are omitted because of the absence of the conditions under which they are required or because information called for is shown in the financial statements and notes thereto. Exhibits, Including those Incorporated by Reference Page - --------------------------------------------------- ---- (3) Articles of Incorporation and By-Laws ................... E-1 (4) Instruments Defining the Rights of Security Holders, including Indentures ............. E-2 (10) Material Contracts ...................................... E-3 (24) Independent Auditors' Consent . ......................... 63 (25) Power of Attorney ....................................... 68 (28.1) Navistar Financial Corporation Annual Report on Form 10-K for the fiscal year ended October 31, 1993 ............ N/A All exhibits other than those indicated above are omitted because of the absence of the condition under which they are required or because information called for is shown in the financial statements and notes thereto. Reports on Form 8-K - ------------------- A report on Form 8-K dated December 9, 1992, was filed by Transportation to describe developments in negotiations with the United Automobile, Aerospace and Agricultural Implement Workers of America. A report on Form 8-K dated December 9, 1992, was filed by Transportation to disclose a change in credit rating. A report on Form 8-K dated December 14, 1992, was filed by Transportation to disclose a change in credit rating. A report on Form 8-K dated December 18, 1992, was filed by Transportation to announce a tentative agreement on restructuring retiree health care and life insurance benefits. PART IV ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K Reports on Form 8-K (continued) - ------------------- A report on Form 8-K, dated May 14, 1993, was filed by Transportation indicating Navistar Financial Corporation granted security interests in substantially all of its assets pursuant to an Amended and Restated Credit Agreement and amended and restated an existing revolving credit facility and a retail notes receivable purchase facility. A report on Form 8-K, dated May 28, 1993, was filed by Transportation announcing court approval of a retiree health care and life insurance benefit settlement. A report on Form 8-K, dated July 1, 1993, was filed by Transportation describing Parent Company shareowner approval of the postretirement health care and life insurance benefits settlement as well as a one-for-ten reverse split of the Common stock and Class B Common stock. SIGNATURE NAVISTAR INTERNATIONAL TRANSPORTATION CORP. AND SUBSIDIARIES ------------------------------------------- SIGNATURE Pursuant to the requirements of Section 13 and 15(d) 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. NAVISTAR INTERNATIONAL TRANSPORTATION CORP. - ------------------------------------------- (Registrant) /s/ Robert I. Morrison - ---------------------------------- Robert I. Morrison January 27, 1994 Vice President and Controller (Principal Accounting Officer) SIGNATURE NAVISTAR INTERNATIONAL TRANSPORTATION CORP. AND SUBSIDIARIES ------------------------------------------- POWER OF ATTORNEY Each person whose signature appears below does hereby make, constitute and appoint John R. Horne, Robert I. Morrison and Robert A. Boardman and each of them acting individually, true and lawful attorneys- in-fact and agents with power to act without the other and with full power of substitution, to execute, deliver and file, for and on such person's behalf, and in such person's name and capacity or capacities as stated below, any amendment, exhibit or supplement to the Form 10-K Report making such changes in the report as such attorney-in-fact deems appropriate. SIGNATURES Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated: Signature Title Date - ----------------------- -------------------------- ---------------- /s/ James C. Cotting - -------------------- James C. Cotting Chairman January 27, 1994 and Chief Executive Officer and Director (Principal Executive Officer) /s/ John R. Horne - -------------------- John R. Horne President January 27, 1994 and Chief Operating Officer and Director /s/ Robert C. Lannert - --------------------- Robert C. Lannert Executive Vice President January 27, 1994 and Chief Financial Officer and Director

15840_1993.txt

15840

1993

Item 1. Business (a) General Development of Business The Company was founded as a partnership in 1901. It was incorporated in Missouri in 1902 and reincorporated in Delaware in 1969. Its corporate headquarters are located in Kansas City, Missouri, and principal plants and offices are operated throughout the continental United States. Principal international operations are conducted through Butler Building Systems, Ltd., a wholly owned United Kingdom subsidiary acquired in 1991, and a Saudi Arabian joint venture. The Company and its subsidiaries are primarily engaged in the design, manufacture and sale of systems and components for nonresidential structures. Products and services fall into three principal business segments: (1) Building Systems, consisting primarily of custom designed and pre-engineered steel and wood frame building systems for commercial, community, industrial and agricultural uses; (2) Construction and construction management services for purchasers of large, complex or multiple site building projects; and (3) Other Building Products for low, medium and high-rise nonresidential buildings, consisting primarily of curtain wall and storefront systems, skylights and roof vents. This group also includes the manufacture and sale of grain storage bins and the distribution of grain handling and conditioning equipment. The Company's products are sold primarily through numerous independent dealers. Other Company products are sold through a variety of distribution arrangements. (b) Financial Information about Industry Segments The information required by Item 1(b) is hereby incorporated by reference to page 21 and 22 of the Company's Annual Report furnished to the Commission pursuant to Rule 14a-3(b) and attached as Exhibit 13.0 to this report (see also items 6, 7, and 8 of this report). (c) Narrative Description of Business Building Systems The Company's largest segment, Building Systems, includes the U.S. steel and wood frame pre-engineered building systems; a 100% wholly owned United Kingdom subsidiary (Butler Building Systems, Ltd.); and a 30% owned Saudi Arabian joint venture (Saudi Building Systems, Ltd.), all of which manufacture and market pre-engineered steel frame building systems; Butler Real Estate, Inc. a real estate developer; and a 45% owned Japanese joint venture marketing pre-engineered building systems to Japanese firms to meet their U.S. and international building requirements. The Company's building systems consist primarily of custom designed and pre-engineered one to five-story steel and one to two-story wood framed buildings for commercial, community, industrial and agricultural uses such as office buildings, manufacturing facilities, warehouses, schools, shopping centers and farm buildings. Principal product components of the systems are structural members and a variety of pre-engineered wall and roof components. These are fabricated according to standard or customer specifications and shipped to building sites for assembly by independent dealers. Building components are manufactured in plants located at Galesburg and Charleston, Illinois; Laurinburg, North Carolina; Birmingham, Alabama; Visalia, California; Annville, Pennsylvania; San Marcos, Texas; Lester Prairie, Minnesota; and Clear Brook, Virginia. Butler Building Systems, Ltd. manufactures and markets the Company's pre-engineered steel frame buildings primarily for the United Kingdom and European markets from its facility in Kirkcaldy, Scotland. Saudi Building Systems, Ltd. manufactures and markets pre-engineered steel frame buildings for Middle Eastern markets at manufacturing facilities located in Jeddah, Saudi Arabia. The Company serves the Canadian market through a branch office in Burlington, Ontario. Building Systems' products are distributed throughout the world by independent Butler dealers. The dealers provide construction services and in many cases complete design and engineering capabilities. Nonresidential pre-engineered buildings compete with ordinary forms of building construction in the low-rise commercial, community, industrial and agricultural markets. Competition is primarily based upon cost, time of construction, appearance, thermal efficiency and other specific customer requirements. The Company also competes with numerous pre-engineered steel frame building manufacturers doing business within the United States, Canada, and the United Kingdom. Approximately four of these manufacturers account for the majority of industry sales. The Company believes that its 1993 sales of steel frame pre-engineered buildings within the United States exceeded those of any other nonresidential steel frame pre-engineered buildings manufacturer, with its next largest competitors being Varco-Pruden Buildings, a division of United Dominion Industries Ltd., Ceco and Star Buildings Systems combined, a division of Robertson - Ceco Corporation, and American Buildings Company. Competition among manufacturers of pre-engineered buildings is based primarily upon price, service, product design and performance, and marketing capabilities. The Company's Lester wood frame buildings business ranks second in sales to the industry leader, Morton Buildings, Inc., a major manufacturer which sells direct to the end user. Butler Real Estate, Inc., a wholly-owned subsidiary of the Company, provides real estate development services in cooperation with Butler dealers. On the basis of commitments to lease obtained from credit worthy customers, Butler Real Estate, Inc. acquires building sites, arranges with Butler dealers for construction of project improvements, and then sells the completed projects to investors. BMC Real Estate, Inc., a wholly-owned subsidiary of the Company, participates solely in four land development ventures. Three of the ventures are partnerships with ownership interests ranging from 35% to 50%. The fourth venture is wholly-owned. Construction Services The Company's Construction Services segment consists of a wholly-owned construction subsidiary, BUCON, Inc. which provides comprehensive design, planning, execution and construction management services to major purchasers of construction. Revenues of the segment are derived primarily from general contracting. In addition, the Construction Services segment performs "furnish and erect" and "materials only" subcontracts using products from several Company divisions, predominantly the Company's Buildings Division. Competition is primarily based upon price, time necessary to complete a project, design, and product performance. Construction Services competes with national, regional, and local general contracting firms, and whenever possible, performs projects in conjunction with independent Butler dealers. Other Building Products This segment includes the operations of the Vistawall, Walker and Grain Systems Divisions. The Walker business was sold December 6, 1993. The Vistawall business designs, manufactures and markets architecturally oriented component systems for the nonresidential construction market. The Grain Systems' business manufactures and markets grain storage bins and also distributes grain conditioning and handling equipment. The Vistawall Division designs, manufactures and sells aluminum curtain wall systems for mid and high-rise office markets, and entry doors and other standard storefront products for low-rise retail and commercial markets. The products are distributed on a material supply basis to either curtain wall erection subcontractors or general contractors, and through distribution warehouses to glazing contractors for the storefront and entry door products. Manufacturing and distribution facilities are located in Lincoln, Rhode Island; Atlanta, Georgia; Modesto and Hayward, California; Cincinnati, Ohio; Terrell, Houston and Dallas, Texas; Orlando and Tampa, Florida; Washington, D.C.; Chicago, Illinois; and St. Louis, Missouri. The Division operates in highly competitive markets with other national manufacturers which operate multiple plants and distribution facilities, and with regional manufacturers. Competition is primarily based on cost, delivery capabilities, appearance and other specific customer requirements. The Vistawall Division at its Terrell, Texas location also designs, manufactures and installs Naturalite skylights of all types, from the more standard designs used in commercial and industrial buildings, to highly complex engineered solutions for monumental building projects. In addition, the Division designs and manufactures roof accessories, such as smoke and heat vents, for conventional and pre-engineered buildings. The Division markets its Naturalite products through its existing independent representative organization. There are numerous competitors in this industry with competition primarily based on price, engineering and installation capabilities, delivery, and other specific customer requirements. The Walker Division, which was sold to The Wiremold Company in December, 1993, manufactured a full array of power, lighting, electronics and communication distribution systems for office, retail, and institutional buildings. Principal products consisted of underfloor duct and cellular floor systems. The Grain Systems Division manufactures and markets grain storage bins from its Kansas City, Missouri plant. It also distributes grain conditioning and handling equipment. The Division's products are sold primarily to farmers and commercial grain elevators through a nationwide network of independent dealers. Products are also manufactured for export. Grain systems are sold in highly competitive markets in direct competition with national companies and smaller regional manufacturers. Competition is principally based on price, delivery schedules, and product performance. Manufacturing and Materials The Company's manufacturing operations include most conventional metal fabricating operations, such as punching, shearing, welding, extruding and forming of sheet and structural steel and aluminum. The Company also operates painting and anodizing lines for structural steel and aluminum components, respectively. Wood frame manufacturing operations include sawing and truss fabrication. The principal materials used in the manufacture of the Company's products include steel, aluminum, wood, and purchased parts. All materials are presently available to the Company in sufficient quantities to meet current needs. Seasonal Business Historically, the Company's sales and net earnings have been affected by cycles in the general economy which influence nonresidential construction markets (see in particular Item 7 of this report). In addition, the Company's sales usually reach a peak during the summer when construction activity is highest. Sales for the first, second, third and fourth quarters of 1993 were $111 million, $145 million, $164 million and $156 million, respectively. Backlog The Company's backlog of orders believed to be firm was $140 million at December 31, 1993 and $117 million at December 31, 1992 (excluding the Walker Division backlog). The Construction Services segment, where margins are significantly lower than those associated with product sales, accounted for $26 million of the year-end 1993 backlog and $20 million of the year-end 1992 backlog. Employees At December 31, 1993 the Company employed 3,064 persons, 2,248 of whom were non-union employees, and 816 were hourly paid employees who were members of five unions. At December 31, 1992 the Company employed 3,169 persons. A labor agreement with the union at the Buildings Division Birmingham, Alabama plant will expire in 1994. Item 2.

Item 2. Properties The principal plants and physical properties of the Company consist of the manufacturing facilities described under item 1, and the Company's executive offices in Kansas City. The 142,000 square foot Vistawall facility located in Lincoln, Rhode Island which has light manufacturing and fabrication operations is classified under "Assets held for sale". The 144,000 square foot Garland, Texas facility previously used for the operations of Naturalite is owned subject to a $2.7 million deed of trust. This facility is currently under a lease agreement with an option to purchase on January 1, 1995 and is recorded in "Investments and other assets". Both properties are described in the "Restructuring and Dissolution of Businesses" footnote on page 21 in the Company's Annual Report. Through a subsidiary, the Company also owns a land development venture with property located on a 108 acre site in San Marcos, Texas. The property is recorded in "Assets held for sale" and described in the "Real Estate Subsidiaries" footnote on page 21 in the Company's Annual Report. All other plants and offices described under item 1 are utilized by the Company and are generally suitable and adequate for the business activity conducted therein, and have production capacities sufficient to meet current and foreseeable needs. Except for leased facilities listed below, all of the Company's principal plants and offices are owned subject to the security interest of a Bank Loan described on page 26 in the Company's Annual Report: (1) Leased space used for the Company's executive offices in Kansas City, Missouri (104,524 sq. ft. lease expiring in the year 2001 with an option to renew). (2) Leased space used for the Vistawall Division plant in Terrell, Texas (145,000 sq. ft. and 121,000 sq. ft. with leases expiring in 2006 and 1995, respectively, both containing options to renew), and fabrication and distribution facilities in Dallas and Houston, Texas; St. Louis, Missouri; Chicago, Illinois; Washington, D.C.; Cincinnati, Ohio; Atlanta, Georgia; Orlando and Tampa, Florida; and Modesto and Hayward, California (231,000 sq. ft. leased with various expiration dates). Item 3.

Item 3. Legal Proceedings. There are no material legal or environmental proceedings pending as of March 9, 1994. Proceedings which are pending consist of matters normally incident to the business conducted by the Company and taken together do not appear to be material. Item 4.

Item 4. Submissions of Matters to a Vote of Security Holders. No matters have been submitted to a vote of stockholders since the last annual meeting of shareholders on April 20, 1993. PART II Item 5.

Item 5. Market for Registrant's Common Equity and Related Stockholder Matters. Incorporated by reference to the information under "Quarterly Financial Information (Unaudited)", "Price Range of Common Stock (Unaudited)" and "Historical Review 1993-1989" on pages 27 and 28 of the Annual Report. Item 6.

Item 6. Selected Financial Data. Incorporated by reference to the information under "Historical Review 1993-1989" on page 28 of the Annual Report. Item 7.

Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations. Incorporated by reference to the information under "Management's Discussion and Analysis of Financial Condition and Results of Operations" on pages 12 through 14 of the Annual Report. Item 8.

Item 8. Financial Statements and Supplementary Data. Incorporated by reference to the consolidated financial statements and related notes on pages 15 through 27 of the Annual Report. Item 9.

Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure. Not applicable. PART III Item 10.

Item 10. Directors and Executive Officers of the Registrant. Information as to Directors is incorporated herein by reference to pages 3 through 5 of the Proxy Statement. The Executive Officers, their ages, their positions and offices with the Company and their principal occupations during the past five years are shown below: Corporate Executive Officers Robert H. West - age 55, Chairman of the Board and Chief Executive Officer; Chairman of the Executive Committee and member of the Board Organization Committee. He joined the Company in 1968, became President in 1978 and Chairman of the Board in 1986. Mr. West is a director of Commerce Bancshares, Inc., Santa Fe Pacific Corp., Kansas City Power & Light Company, and St. Luke's Hospital. He is a trustee of the University of Missouri at Kansas City. Donald H. Pratt - age 56, President; member of the Executive Committee. He joined Butler in 1965, became Executive Vice President in 1980, and President of the Company in 1986. Mr. Pratt is also a director of Union Bancshares, Inc., Wichita, Kansas, and is a trustee of the Kansas City Art Institute and Midwest Research Institute. Richard O. Ballentine - age 57, Vice President, General Counsel, and Secretary since 1978. He joined Butler in 1975 as Vice President - Legal. Dennis S. Brown - age 48, Vice President - Corporate Development since 1993. He joined Butler in 1975 and became President, Walker Division in 1988. John T. Cole - age 43, Controller since 1990. He joined Butler in 1977 and previously was Corporate Audit Manager. John J. Holland - age 43, Vice President - Finance since 1990. He joined Butler in 1980 and became Vice President - Controller in 1986. John W. Huey - age 46, Vice President - Administration since 1993 and Assistant Secretary since 1987. He joined Butler in 1978 and was previously Assistant General Counsel. Larry C. Miller - age 37, Treasurer since 1989. He joined Butler in 1980 and became Assistant Treasurer in 1985. Division Executive Officers Moufid (Mike) Alossi - age 51, President, Butler World Trade since 1993. He joined Butler in 1968 and previously was Vice President-International Sales and Marketing. William D. Chapman - age 51, President, International Operations since 1992. He joined Butler in 1979 and was previously Vice President, International Operations. Thomas J. Hall - age 48, President, Butler Real Estate, Inc. since 1991. He joined Butler in 1969, and was named Vice President and General Manager of Butler Real Estate, Inc. in 1987. Larry D. Hayes - age 55, President, Lester Building Systems Division since 1991. He joined Butler in 1975 and previously was President, Rural Systems Division. Richard S. Jarman - age 47, President, Buildings Division since 1986. He joined Butler in 1974. William L. Johnsmeyer - age 46, President Butler Construction (Bucon, Inc.) since 1990. He joined Butler in 1982 became President, Walker Division in 1984. Robert J. Kronschnabel - age 58, Vice President and General Manager, Grain Systems Division since 1991. He joined Butler in 1979 and was previously President, Naturalite/EPI. Nelson R. Markel - age 47, Managing Director, Butler Building Systems. Ltd. since 1991 and was previously Marketing Manager, Buildings Division. Ronald F. Rutledge - age 52, President Vistawall Division since 1984 when he joined Butler. Item 11.

Item 11. Executive Compensation. Incorporated by reference to the information under "Report on Executive Compensation", "Summary Compensation Table" and "Aggregated Option/SAR Exercises and Fiscal Year-End Option/SAR Value Table" on pages 7 through 10 of the Proxy Statement. Item 12.

Item 12. Security Ownership of Certain Beneficial Owners and Management. Incorporated by reference to the information under "Beneficial Ownership Table" on pages 13 and 14 of the Proxy Statement. Item 13.

Item 13. Certain Relationships and Related Transactions. Incorporated by reference to the information under "Election of Class B Directors" on pages 2 through 9 and "Report on Executive Compensation" in the Proxy Statement. PART IV Item 14.

Item 14. Exhibits, Financial Statement Schedules and Reports on Form 8-K. The following documents are filed as part of this report: (a) Financial Statements: Consolidated Balance Sheets as of December 31, 1993 and 1992. Consolidated Statements of Operations and Retained Earnings - Years Ended December 31, 1993, 1992 and 1991. Consolidated Statements of Cash Flow - Years Ended December 31, 1993, 1992 and 1991. Notes to Consolidated Financial Statements. The foregoing have been incorporated by reference to the Annual Report as indicated under Item 8. (b) Financial Statement Schedules: Auditors' Report on Financial Statement Schedules I - Marketable Securities - Other Investments V - Property, Plant and Equipment VI - Accumulated Depreciation, Depletion and Amortization of Property,Plant and Equipment VIII - Valuation and Qualifying Accounts IX - Short-Term Borrowings X - Supplementary Income Statement Information All other schedules are omitted because they are not applicable or the information is contained in the consolidated financial statements or notes thereto. (c) Exhibits: 3.1 Certificate of Incorporation (incorporated by reference to Exhibit 3.5 to Company's Form 10-K for year ended, December 31, 1986). 3.2 Bylaws of Butler Manufacturing Company (incorporated by reference to Exhibit 3.7 to Company's Form 10-K for year ended December 31, 1987). 4.1 Credit Agreement between the Company and Banks dated as of August 24, 1989 (incorporated by reference to Exhibit 4.1 of the Company's Form 8-K dated August 28, 1989). 4.2 Amendment No. 1, dated December 29, 1989 to the Credit Agreement (incorporated by reference to Exhibit 4.2 of the Company's Form 10-K for the year ended December 31, 1989). 4.3 Amendment No. 2, dated June 30, 1990 to the Bank Credit Agreement dated August 28, 1989 (incorporated by reference to Exhibit 4.1 to the Company's Form 10-K for the year ended December 31, 1990). 4.4 Amendment No. 3, dated November 28, 1990 to the Bank Credit Agreement dated August 28, 1989 (incorporated by reference to Exhibit 4.2 to the Company's Form 10-K for the year ended December 31, 1990). 4.5 Amendment No. 4, dated April 10, 1991 to the Bank Credit Agreement dated August 28, 1989 (incorporated by reference to Exhibit 4.1 to the Company's Form 10-K for the year ended December 31, 1990). 4.6 Amendment No. 5, dated July 30, 1991 to the Bank Credit Agreement dated August 29, 1989 (incorporated by reference to Exhibit 4 to the Company's Form 10-Q for the quarter ended September 30, 1991). 4.7 Amendment No. 6, dated March 9, 1992 to the Bank Credit Agreement dated August 29, 1989 (incorporated by reference to the Company's 10-K for the year ended December 31, 1991). 4.8 Amendment No. 7, dated May 6, 1992 to the Bank Credit Agreement dated August 29, 1989 (incorporated by reference to Exhibit 4 to the Company's Form 10-Q for the quarter ended June 30, 1992). 4.9 Amendment No. 8, dated April 26, 1993 to the Bank Credit Agreement dated August 28, 1989. 4.10 Amendment No. 9, dated October 15, 1993 to the Bank Credit Agreement dated August 28, 1989. 10.1 Butler Manufacturing Company Executive Deferred Compensation Plan as amended (incorporated by reference to Exhibit 10.2 to the Company's Form 10-K for the year ended December 31, 1989). 10.2 Butler Manufacturing Company Stock Incentive Plan for 1987, as amended (incorporated by reference to Exhibit 10.1 to the Company's Form 10-K for the year ended December 31, 1990). 10.3 Butler Manufacturing Company Stock Incentive Plan of 1979, as amended (incorporated by reference to Exhibit 10.2 to the Company's Form 10-K for the year ended December 31, 1990). 10.4 Form of Change of Control Employment Agreements, as amended, between the Company and each of six executive officers (incorporated by reference to Exhibit 10.3 to the Company's Form 10-K for the year ended December 31, 1990). 13.0 Butler Manufacturing Company 1993 Annual Report (only the information expressly incorporated herein by reference). 21.0 Set forth below is a list as of March 9, 1994 of subsidiaries of the Company and their respective jurisdictions of incorporation. Subsidiaries not listed, when considered in the aggregate as a single subsidiary, do not constitute a significant subsidiary. 24.0 Power of Attorney to sign this Report by each director. A report on Form 8-K dated December 6, 1993 was filed by the Company during the quarter ended December 31, 1993. The calculation of the aggregate market value of the Common Stock of the Company held by non-affiliates as reflected on the front of the cover page is based on the assumption that non-affiliates do not include directors. Such assumption does not reflect a belief by the Company or any director that any director is an affiliate of the Company. SIGNATURES Pursuant to the requirements of Section 13 or 15(d) 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 on this 8th day of March, 1994. BUTLER MANUFACTURING COMPANY BY /S/Robert H. West ------------------- Robert H. West Chairman of the Board Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant in the capacities indicated on the dates indicated. /S/ Robert H. West Chairman of the Board March 8, 1994 - --------------------- (Principal Executive Officer) Robert H. West /S/ John J. Holland Vice President-Finance March 8, 1994 - --------------------- (Principal Financial Officer) John J. Holland /S/ John T. Cole Controller March 8, 1994 - --------------------- (Principal Accounting Officer) John T. Cole /S/ Harold G. Bernthal By Richard O. Ballentine, Attorney-in-fact Director March 17, 1994 - ----------------------- Harold G. Bernthal /S/ Robert E. Cook By Richard O. Ballentine, Attorney-in-fact Director March 17, 1994 - ------------------------ Robert E. Cook /S/ Robert L. Geddes Director March 10, 1994 - ------------------------ Robert L. Geddes /S/ Alan M. Hallene Director March 9, 1994 - ------------------------ Alan M. Hallene /S/ C.L. William Haw Director March 9, 1994 - ------------------------- C.L. William Haw /S/ George E. Powell, Jr. Director March 12, 1994 - ------------------------- George E. Powell, Jr. /S/ Donald H. Pratt Director March 10, 1994 - -------------------------- Donald H. Pratt /S/ Judith A. Rogala By Richard O. Ballentine, Attorney-in-fact Director March 17, 1994 - -------------------------- Judith A. Rogala CONSENT OF INDEPENDENT CERTIFIED PUBLIC ACCOUNTANTS The Board of Directors Butler Manufacturing Company We consent to the incorporation by reference in Registration Statements Nos. 33-14464, 2-63830, 2-55753 and 2-36370 on Form S-8 and the related Prospectus dated June 11, 1987, with Appendix dated March 7, 1994, of Butler Manufacturing Company of our reports dated February 4, 1994 which contained an explanatory paragraph regarding the adoption of Statements of Financial Accounting Standards No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions" and No. 109, "Accounting for Income Taxes", relating to the consolidated balance sheets of Butler Manufacturing Company and subsidiaries as of December 31, 1993, and 1992, and the related consolidated statements of operations and retained earnings and cash flows and related schedules for each of the years in the three-year period ended December 31, 1993, which reports appear in or are incorporated by reference in the Annual Report on Form 10-K of Butler Manufacturing Company for the fiscal year ended December 31, 1993. We also consent to the reference to our firm under the heading "Experts" in the Prospectus to the Registration Statements. /S/ KPMG PEAT MARWICK --------------------- KPMG PEAT MARWICK Kansas City, Missouri March 25, 1994 BUTLER MANUFACTURING COMPANY AND SUBSIDIARIES KANSAS CITY, MISSOURI Consolidated Financial Statement Schedules (Form 10-K) December 31, 1993, 1992 and 1991 (With Auditors' Report Thereon) INDEPENDENT AUDITORS' REPORT The Board of Directors Butler Manufacturing Company: Under date of February 4, 1994, we reported on the consolidated balance sheets of Butler Manufacturing Company and subsidiaries as of December 31, 1993 and 1992, and the related consolidated statements of operations and retained earnings and cash flows for each of the years in the three-year period ended December 31, 1993, as contained in the 1993 Annual Report. That report included an explanatory paragraph regarding the adoption of Statements of Financial Accounting Standards No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions" and No. 109, "Accounting for Income Taxes". These consolidated financial statements and our report thereon are incorporated by reference in the Annual Report on Form 10-K for the year 1993. In connection with our audits of the aforementioned consolidated financial statements, we also audited the related consolidated financial statement schedules as listed in item 14. These consolidated financial statement schedules are the responsibility of the Company's management. Our responsibility is to express an opinion on these consolidated financial statement schedules based on our audits. In our opinion, such schedules, when considered in relation to the basic consolidated financial statements taken as a whole, present fairly, in all material aspects, the information set forth therein. /S/ KPMG PEAT MARWICK ---------------------- KPMG PEAT MARWICK Kansas City, Missouri February 4, 1994. S-1 SCHEDULE I BUTLER MANUFACTURING COMPANY AND SUBSIDIARIES Marketable Securities - Other Investments December 31, 1993 S-2 SCHEDULE V BUTLER MANUFACTURING COMPANY AND SUBSIDIARIES Property, Plant, and Equipment (Thousands of Dollars) (A) Property, plant, and equipment of subsidiaries and divisions acquired and sold and transfer of assets held for sale. S-3 SCHEDULE VI BUTLER MANUFACTURING COMPANY AND SUBSIDIARIES Accumulated Depreciation, Depletion and Amortization of Property, Plant, and Equipment (Thousands of Dollars) (A)Accumulated depreciation of subsidiaries and divisions acquired and sold and transfer of assets held for sale. S-4 SCHEDULE VIII BUTLER MANUFACTURING COMPANY AND SUBSIDIARIES Valuation and Qualifying Accounts (Thousands of Dollars) (A) Includes acquisition and disposition of divisions and subsidiaries. (B) "Credited to earnings" reflects adjustments to t.e original estimated loss provision for receivables reassessment of the collection status of trade receivables made during the year. S-5 SCHEDULE IX BUTLER MANUFACTURING COMPANY AND SUBSIDIARIES Short-term Borrowings (Thousands of Dollars) (1) Average amount outstanding during the period is calculated by dividing the total of the daily outstanding balances for the year, by the number of days outstanding during the year. (2) Weighted average interest rate during the period is calculated by dividing the interest expense during the year, by the average short-term borrowings, for the number of days outstanding. (3) Butler Manufacturing Company (BMC), Butler Real Estate, Inc. (BRE), and Butler Building Systems, Ltd. (BBSL). (4) See also page 14 "Management's Discussion and Analysis of Financial Condition and Results of Operations" in the Company's 1993 Annual Report to Stockholders. S-6 SCHEDULE X BUTLER MANUFACTURING COMPANY AND SUBSIDIARIES Supplementary Income Statement Information (Thousands of Dollars) S-7

71180_1993.txt

71180

1993

ITEM 1. BUSINESS THE COMPANY Nevada Power Company (the Company), incorporated in 1929 under the laws of Nevada, is an operating public utility engaged in the electric utility business in the City of Las Vegas and vicinity in Southern Nevada. Most of the Company's operations are conducted in Clark County, Nevada (with an estimated service area population of 916,000 at December 31, 1993) where the Company furnishes electric service in the communities of Las Vegas, North Las Vegas, Henderson, Searchlight, Laughlin and adjoining areas and to Nellis Air Force Base (a permanent military installation northeast of Las Vegas and the USAF Tactical Fighter Weapons Center). Electric service is also supplied to the Department of Energy at Mercury and Jackass Flats in Nye County, where the Nevada Test Site is located. SOURCES OF ELECTRIC ENERGY SUPPLY The electric energy obtained from the Company's own generating facilities will be produced at the following plants: Number Net Capacity Plant of Units (Megawatts) ----- -------- ------------ Coal Fuel: Reid Gardner (Steam).............. 3 330 Reid Gardner Unit No. 4 (Steam)... 1 275(1) Mohave (Steam).................... 2 178(2) Navajo (Steam).................... 3 255(3) Natural Gas and Oil Fuel: Clark (Steam)..................... 3 175 Clark (Gas Turbine).............. 1 50 Clark (Combined Cycle)............ 2 466(4) Sunrise (Steam)................... 1 80 Sunrise (Gas Turbine)............. 1 69 ----- 1,878 _________________ ===== (1) This represents 25 megawatts of base load capacity, 235 megawatts of peaking capacity and 15 megawatts upgrade capacity. Reid Gardner Unit No. 4, placed in service July 25, 1983, is a coal- fired unit which is owned 32.2% by the Company and 67.8% by the Department of Water Resources of the State of California. The Company is entitled to use 100% of the unit's capacity for 1,500 hours each year excepting that from 1993 through 1997, the Company has agreed to reduce its allocation of peaking capacity by 20 MW. The Company is entitled to 9.6% of the first 260 megawatts of capacity and associated energy and is entitled to all the 15 megawatt upgrade accomplished in 1990. Beginning in 1998, the Company has options for the use of increasing amounts of energy from the unit so that the Company may be entitled to use all of the unit's output 15 years from that date. The 1998 option for 10.17 MW was not exercised by the Company and has expired. (2) This represents the Company's 14% undivided interest in the Mohave Generating Station as tenant in common without right of partition with three other non-affiliated utilities. (3) This represents the Company's 11.3% undivided interest in the Navajo Generating Station as tenant in common without right of partition with five other non-affiliated utilities. (4) This includes additional capacity of 87 MW expected to be available in April 1994, due to conversion from simple cycle combustion turbine to combined cycle operation. The Company purchases Hoover Dam power pursuant to a contract with the State of Nevada which became effective June 1, 1987 and will continue through September 30, 2017. The Company's allocation of capacity is 235 MW. The peak electric demand experienced by the Company was 2,681 megawatts on August 2, 1993. This demand plus a reserve margin was served by a combination of Company owned generation, and firm and short-term power purchases. For 1994, the Company has contracts to purchase power from an independent power producer (IPP) and four qualifying facilities (QF), also known as cogenerators, as follows: Contract Term --------------------- Net Capacity From To (Megawatts) -------- -------- ------------ Independent Power Producer: --------------------------- Nevada Sun-Peak Limited Partnership 06/08/91 05/31/16 210 Qualifying Facilities: ---------------------- Saguaro Power Company 10/17/91 04/30/22 90 Nevada Cogeneration Associates #1 06/18/92 04/30/23 85 Nevada Cogeneration Associates #2 02/01/93 04/30/23 85 Las Vegas Cogeneration Limited Partnership 06/01/94(1) 05/31/24 45 --- === (1) Expected operation date. The Company's total generating capacity of 2,628 megawatts, including 235 megawatts of Hoover Dam power, 210 megawatts of IPP power and 305 megawatts of QF power, for the summer of 1994 will not be sufficient to meet the 1994 anticipated peak load demand and reserve margin needs. Accordingly, the Company has agreements with other utilities to purchase 465 megawatts of firm capacity and associated energy and plans to enter into agreements for an estimated additional 100 megawatts of firm capacity and associated energy for the months of June, July and August 1994. FUEL SUPPLIES The fuels used to provide energy for the Company's generating facilities are coal, natural gas and oil. Its other sources of electricity are hydroelectric (Hoover Dam) and purchased power. The Company's primary fuel source for generation is coal. The following table shows the actual sources of fuel for generation for 1993 and anticipated sources of fuel for generation in 1994 and 1995. 1993 1994 1995 ---- ---- ---- Coal........................ 93% 93% 93% Natural Gas................. 7 7 7 --- --- --- 100% 100% 100% === === === The Company's average delivered cost per ton of coal burned was as follows: 1991 - $32.78; 1992 - $34.54; 1993 - $34.43. Coal for both the Mohave and Navajo Stations is obtained from surface mining operations conducted by Peabody Coal Company (Peabody) on portions of the Black Mesa in Arizona within the Navajo and Hopi Indian reservations. The supply contracts with Peabody extend to December 31, 2005 for Mohave and to June 1, 2011 for Navajo, each contract having an option to extend for an additional 15 years. The anticipated full requirements for coal at the Reid Gardner Generating Station are covered by contracts through 1994. Partial requirements for coal are presently under contract through the year 2007. The Company anticipates no major difficulties in purchasing the remainder of its coal requirements based upon current coal market conditions in the Western United States. All coal for Reid Gardner presently comes from underground mines in Utah and Colorado. All of the Company's long-term coal supply contracts contain provisions providing for adjustments in the price of coal to reflect increases or decreases in the costs of mining operations. The Company's natural gas supply is subject to curtailment due to limited pipeline capacity. All the Company's plants using natural gas also have the capability of burning oil on a sustained basis. CONSTRUCTION AND FINANCING PROGRAMS The Company carries on a continuing program to extend and enlarge its facilities to meet current and future loads on its system. Gross plant additions and retirements for the five years ended December 31, 1993 amounted to $880,969,000 and $50,047,000 respectively. The following table sets forth the Company's actual construction expenditures for 1993, and currently estimated construction expenditures, including Allowance for Funds Used During Construction, for 1994 and 1995. 1993 1994 1995 -------- -------- -------- (In Thousands) Generating Facilities............ $ 74,456 $ 65,026 $ 62,769 Transmission Facilities.......... 10,112 28,812 35,724 Distribution Facilities.......... 72,865 71,160 66,017 Other............................ 15,704 9,890 10,000 -------- -------- -------- $173,137 $174,888 $174,510 ======== ======== ======== The Company's construction program and estimated expenditures are subject to continuing review and are revised from time to time due to various factors, including the rate of load growth, escalation of construction costs, availability of fuel types, changes in environmental regulations, adequacy of rate relief and the Company's ability to raise necessary capital. To meet capital expenditure requirements through 1995, the Company will utilize internally generated cash, the proceeds from industrial development revenue bonds, first mortgage bonds, and common stock issues through public offerings and the Stock Purchase and Dividend Reinvestment Plan (SPP). The Company has the option of issuing new shares or using open market purchases of its common stock to meet the requirements of the SPP. The Company issued 1,640,326 shares of its common stock in 1993 under the SPP. At the end of 1993, common equity represented 46.0% of total capitalization. The Company sold 2.7 million shares of common stock for net proceeds of $65.7 million through an underwritten public offering in 1993. The net proceeds were used to reduce short-term debt which was incurred primarily to construct necessary plant facilities. On January 13, 1993, the Company sold $45 million of First Mortgage Bonds, Series Z, through a public offering. The bonds will mature in 2023 and will require interest payments due on January 1 and July 1 at the annual rate of 8.50%. Net proceeds from the sale of the bonds were used for the redemption of the Company's 9.375% Series S on February 15, 1993. The Indenture under which the Company's first mortgage bonds are issued provides that no additional bonds may be issued unless earnings as defined equal at least two and one-half times the interest requirements on all bonds to be outstanding after the new issue. Based on its earnings through December 31, 1993 and assuming an 8 1/2 percent interest rate on new bonds, the Company would be able to issue approximately $379 million of additional first mortgage bonds. The Company's ability to issue additional debt is also limited by the need to maintain a reasonable ratio of debt to equity. The Company's ability to sell additional preferred stock is limited by the necessity to meet required dividend coverages. At December 31, 1993, this test would permit the issuance of $371 million of additional preferred stock at a dividend rate of 8 1/2 percent. RESOURCE PLANNING The Company's rate of customer growth, especially in recent years, has been among the highest in the nation. The annual customer growth rate was 5.4 percent, 4.6 percent, and 5.3 percent in 1993, 1992, and 1991, respectively. The peak demand for electricity by the Company's customers increased from 2,501 megawatts in 1992 to 2,681 megawatts in 1993. The Company's 1993 energy sales reached 11,155,270 megawatthours, an increase of 5.8 percent over 1992. Every three years Nevada law requires the Company to file with the Public Service Commission of Nevada (PSC) a forecast of electricity demands for the next 20 years and the Company's plans to meet those demands. On September 16, 1991, the PSC approved the Company's 1991 Resource Plan, and during 1992 and 1993, the PSC approved the first through fourth amendments to the Resource Plan. The Resource Plan, as amended and approved in 1992 and 1993, includes the following major projects: (1) two 90 megawatt (MW) combined-cycle generating units at the Clark Generating Station, one added in 1993 and one to be added in 1994; (2) the construction of two 70 (MW) combustion turbine generating units at the Harry Allen Project site, one unit in 1995 and one unit in 1996. The 1996 Allen combustion turbine will be subject to a cost comparison of purchased power resources that will be competitively bid with the least expensive resource taken as the Company's supply choice; (3) a total of 305 (MW) in purchased power from four qualifying facilities, with 175 (MW) and 85 (MW) received beginning in 1992 and 1993, respectively, and 45 (MW) expected to be received beginning in 1994; (4) planning costs for a 500 kilovolt (KV) transmission system from the Harry Allen Substation, located north of the Las Vegas Valley, to Marketplace, a future 500 KV switching station located near the McCullough Substation south of the Las Vegas Valley. The Company must present final plans on this system for PSC approval. If PSC approval is received, the transmission system could be operational by 1998; (5) installation of additional emissions reduction equipment at the Navajo Generating Station; (6) firm purchased power of 75 (MW); (7) the construction of a 230 KV transmission line from Arden Substation, located southwest of Las Vegas, to Northwest Substation, located northwest of Las Vegas; and (8) several demand-side pilot projects. On September 29, 1993, a fifth amendment to the Company's 20-year Resource Plan was filed with the PSC. On February 25, 1994, the PSC approved a stipulation among the Company, PSC Staff, Office of the Consumer Advocate and other intervenors granting the Company's request. The amendment calls for three purchase power contracts with Southern California Edison, the City of Glendale and the Salt River Project totaling 160 MWs for the years 1996 to 2000. These purchase power contracts are a result of the Company's 1996 Request for Proposal for supply-side resources. The stipulation also approved a 50 (MW) purchase power contract with Arizona Public Service for the years 1995 to 1997. The Company will file its 1994 Resource Plan on July 1, 1994. As part of the plan, the Company anticipates a portion of the supply-side resources and demand-side programs to be obtained through a Request For Proposal process. REGULATION AND RATES The Company is subject to regulation by the PSC which has regulatory powers with respect to rates, facilities, services, reports, issuance of securities and other matters. Following is a summary of the rate increases or decreases that have been granted the Company during the past three years. Amount in Effective Millions Date Nature of Increase (Decrease) of Dollars ------------- ------------------------------ ---------- Jan. 1, 1991 Energy rate increase 24.4 March 4, 1991 Energy and resource plan rate increase 1.0 Nov. 12, 1991 General rate increase 12.2 Energy rate increase 11.4 July 27, 1992 General rate increase 22.2 Energy and resource plan net rate decrease (26.4) June 28, 1993 Energy and resource plan net rate increase 42.1 All amounts are on an annual basis. In 1985, the Company incurred $15.8 million in increased fuel and purchased power expenses after a ruptured steam line at the jointly owned Mohave Generating Station resulted in a loss of the plant for six months. The PSC allowed the Company to recover one half of the increased expenses subject to refund. Fourth quarter 1990 earnings reflected a $12.9 million charge to record a subsequent proposed order issued by the PSC which stated that the Company shall not recover any of the increased costs. The Company has fully reserved for any negative financial effect related to the proposed order. In 1991, the PSC set aside the proposed order and ordered the parties to participate in joint hearings before the California Public Utilities Commission (CPUC). The CPUC hearings are now concluded, and the PSC will prepare its own opinion based on the record created in the CPUC hearings. In January 1994, the administrative law judge in the CPUC proceeding issued a proposed opinion denying recovery to Southern California Edison (SCE) of its incremental purchased power costs resulting from the accident. SCE has filed comments with the CPUC concerning the proposed decision. On August 12, 1993, the Company filed a request with the PSC to recover additional fuel and purchased power costs of $29.7 million under the state's deferred energy accounting procedures. This request included $9.8 million of deferred energy costs for the period of December 1, 1992, to May 31, 1993, and $19.9 million to adjust the base energy rate. The Company subsequently amended its request to $26.8 million. Hearings in this matter were concluded in December 1993, and the PSC granted an increase in rates of $23.6 million, effective February 1, 1994. The PSC order resulted in fourth quarter 1993 charges of $2 million net of taxes for deferred energy costs. On November 19, 1993, the PSC Staff filed a petition with the PSC alleging that the Company may be overearning as much as $17 million annually because business conditions have changed substantially since the Company received its last general rate case decision in July 1992. On January 10, 1994, the PSC voted to open an investigation into the Company's earnings. Management believes the Company's earnings are within the authorized rate of return granted to the Company in July 1992. Hearings on this proceeding are scheduled to commence in June 1994. On February 28, 1994, the Company filed requests with the PSC to recover additional fuel and purchased power costs of $38.5 million and resource planning costs of $1 million. The energy rate request included $28.7 million of deferred energy costs for the test period ended November 30, 1993, and $9.8 million to adjust the base energy rate. As permitted by state statute, the Company defers differences between the current cost of fuel and purchased power, and base energy costs as defined. Under regulations adopted by the PSC, the balance in the deferred energy account at the end of twelve months should be cleared, over a subsequent period. Recovery of increased costs is permitted to the extent that the Company has not realized its authorized overall rate of return. If the Company has exceeded the authorized rate of return, the portion of deferred energy costs represented in such excess is transferred to the next deferred energy recovery period. The energy costs deferred are included as a current item in determining taxable income for federal income tax purposes. However, for financial statement purposes, the federal income tax effect is deferred and amortized to income as the deferred energy account is cleared. PSC regulations allow the fuel base portion of the Company's general rates to be changed at the time of a hearing to clear the balance in the deferred energy account. This permits the recovery of fuel expenses on a deferred basis, however, recovery will have no effect on the Company's earnings. The Company is allowed to recover on an annual basis the costs of developing its 20-year resource plan. Also, by an order of the PSC in June 1988, the Company is allowed to capitalize certain costs associated with Commission approved conservation programs. ENVIRONMENTAL MATTERS The Company is subject to regulation by federal, state and local authorities with regard to air and water quality control and other environmental matters. Environmental expenditures made by the Company are currently being recovered through customer rates. Management believes environmental expenditures will increase over time and the increased costs will also be recovered as necessary utility expenses. A discussion of pending environmental matters is provided below. The Federal Clean Air Act Amendments of 1990 include provisions which will affect the Company's existing steam generating facilities and all new fossil fuel fired facilities. Title IV of the Amendments provides a national cap on sulfur dioxide emissions by mandating emissions reductions for many electric steam generating facilities. The sulfur dioxide provisions of the Amendments will not adversely affect the Company because the Company's steam units burn low sulfur fuels or have sulfur dioxide control equipment. Title IV of the Amendments also provides for reduction of emissions of oxides of nitrogen by establishing new emission limits for coal-fired generating units. This Title will require the installation of additional pollution-control technology at some of the Reid Gardner Station generating units before 2000 at an estimated cost to the Company of no more than $6 million. Other provisions of the Amendments will require the Company to install or upgrade Continuous Emission Monitoring systems at all steam generating units before 1995, at an expected cost of up to $3.3 million. The United States Congress authorized $2 million for the Environmental Protection Agency (EPA) to study the potential impact the Mohave Generating Station (MGS) may have on visibility in the Grand Canyon. The EPA report is expected to be finalized in late 1995, with a follow-up report from the Grand Canyon Visibility Transport Commission in late 1996. Also, the Nevada Division of Environmental Protection has imposed more stringent stack opacity limits for the MGS. This change may affect the Company's utilization of resources, but, until more experience is gained by operating at the new opacity levels, any effect cannot be determined. As a 14 percent owner of the MGS, the Company will be required to fund any plant improvements that may result from the EPA study and operation at the new opacity levels. The cost of any potential improvements cannot be estimated at this time. In 1991, the U.S. Environmental Protection Agency published an order requiring the Navajo Generating Station (NGS) to install scrubbers to remove 90 percent of sulfur dioxide beginning in 1997. As an 11.3 percent owner of the NGS, the Company will be required to fund an estimated $46.6 million for installation of the scrubbers. In 1992, the Company received resource planning approval from the PSC for its share of the cost of the scrubbers up to $46.6 million. COMPETITION Deregulation of the electric utility industry is accelerating with the enactment of the National Energy Policy Act of 1992 (Act). Deregulation will lead to further competition in the industry as generators of power obtain greater access to transmission facilities linking them to potential new customers. Most observers believe the electric utility beneficiaries of the Act will be twofold; those who can provide low cost generation for sale and those who have strategically located transmission highways that can transmit low cost power from one area to another. Within the region the Company's residential rates are competitive. However, large industrial customer rates may require adjustment to remain competitive in the changing environment. In recognition of the changing regional competitive environment, the Company is focusing on the costs of serving various classes of customers and the appropriate rates to be charged based on those costs of service. The Company will seek through the PSC any rate adjustments necessary to maintain a competitive position. An opportunity exists given the Company's strategic location in the center of a region of price diversity. As generators arrange for sales of electricity to customers in other areas, some of the power may need to be transmitted through the Company's service territory. The Company would have an opportunity to charge the generators for the transmission of energy through its system. The Company is studying the feasibility of constructing additional cost effective transmission facilities to maximize the advantage of its strategic location. In September 1993, as a part of a comprehensive organizational study, the Company offered a voluntary early retirement package to 175 employees who would be at least 55 years of age, and have completed at least 10 years of service by March 31, 1994. A total of 109 employees, or approximately 6 percent of the work force, accepted the package. In October 1993, the Company's Board of Directors unanimously approved a new organization structure that realigns functions to improve operations and customer service. The Company expects that the net result from the change in organizational structure will be a leaner work force that operates more efficiently and makes the Company more competitive in a changing electric energy industry. At December 31, 1993, organizational study, early retirement and severance costs of $6.7 million are included in other deferred charges. EMPLOYEES The Company had 1,741 active employees at December 31, 1993. ITEM 2.

ITEM 2. PROPERTIES The Company's generating facilities are described under "Item 1. Business, Sources of Electric Energy Supply". The Company shares ownership in a 59-mile, 500 kilovolt line and two 15-mile, 230 kilovolt lines that transmit power from the Mohave Generating Station near Davis Dam on the Colorado River via Eldorado Substation to Mead Substation located near Boulder City, Nevada. The Company has 32 miles of 230 kilovolt line from Mead Substation to Las Vegas. This line, together with two Company-owned 230 kilovolt lines presently connected to the Bureau of Reclamation lines between Mead Substation and Henderson, Nevada, transmit the Mohave Generating Station power to the Las Vegas area. A 25-mile, 230 kilovolt line between the Mead Substation and the Company's Winterwood Substation was energized in 1988. This line brings the additional Hoover energy to the Las Vegas Area and increases the Company's interconnected transmission capabilities. The Company shares ownership in 76 miles of 500 kilovolt transmission line from the Navajo Generating Station to the Moenkopi Switchyard in Coconino County, Arizona (the Southern Transmission System) and 274 miles of 500 kilovolt transmission line from the Navajo Generating Station to the McCullough Substation in Clark County, Nevada (the Western Transmission System). Power is transmitted from the McCullough Substation to the Las Vegas area via three 230 kilovolt lines of 23 miles, 25 miles and 32 miles in length, respectively. The 25-mile line was energized in May 1992. Two 39-mile, 230 kilovolt lines transmit power from the Reid Gardner Station located near Glendale, Nevada to the Pecos Substation near North Las Vegas. A 7 mile, 230 kilovolt line between Westside and Decatur Substations, both located in Las Vegas, was energized in 1991. In addition to the above, the Company has 263 miles of 138 kilovolt and 483 miles of 69 kilovolt transmission lines in service. In 1990 the Company added a new transmission interconnection consisting of a 345 kilovolt line from Harry Allen Substation in Southern Nevada to Red Butte Substation in Southern Utah near the City of St. George and a 230 kilovolt line from Harry Allen Substation to Westside Substation which is located in Las Vegas. The Company owns the 50-mile, 230 kilovolt line and 100 percent of the 69 miles of the 345 kilovolt line from Harry Allen Substation to the Nevada-Utah border; PacifiCorp owns 100 percent of the 345 kilovolt line portion from the Nevada-Utah border to Red Butte Substation. At December 31, 1993, the Company owned 98 transmission and distribution substations with a total installed transformer capacity of 10,186,441 kilovolt-amperes. In addition it co-owns with others the above mentioned Eldorado Substation with installed transformer capacity of 1,000,000 kilovolt-amperes, the McCullough Substation with installed transformer capacity of 1,250,000 kilovolt-amperes and the Reid Gardner Unit No. 4 Substation with installed capacity of 318,000 kilovolt-amperes. At Harry Allen Substation, the Company has a 336,000 kilovolt-ampere transformer and two 336,000 kilovolt-ampere 345 kilovolt phase shifting transformers which are used for necessary voltage transformations and to control flows on the interconnection. As of December 31, 1993, there were approximately 3,029 miles of pole line together with approximately 5,609 cable miles of underground in the Company's distribution system with a total installed distribution transformer capacity of 5,160,941 kilovolt-amperes. ITEM 3.

ITEM 3. LEGAL PROCEEDINGS SUSPENDED DELIVERIES UNDER MOUNTAIN COAL COMPANY CONTRACT In December 1992, the Company suspended deliveries under a coal contract with Mountain Coal Co. based on a pricing dispute. Mountain Coal Co. filed a lawsuit in the federal district court for the State of Utah seeking a determination that the Company had repudiated the coal supply agreement. In October 1993, the court found in favor of Mountain Coal Co.'s position. The Company appealed the court's order, however, in March 1994, the Company resolved the litigation and bought out the remaining obligation under the contract by issuing a promissory note (bearing interest at 10%) for a total of $25 million. The facility using the coal under this contract is jointly owned; accordingly, the Company's portion of this settlement is $15.25 million. The settlement and buyout have been recorded as of December 31, 1993, with $25 million included in notes payable, $15.25 million included in deferred energy costs and $9.75 million included in other receivables. The settlement and buyout will result in lower fuel costs to the Company's customers over the otherwise remaining life of the contract; accordingly, based on similar past buyouts, management believes that the cost of the buyout will be recovered through Nevada's deferred energy accounting procedures. ITEM 4.

ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS No matter was submitted to a vote of security holders during the fourth quarter of the fiscal year covered by this report, through the solicitation of proxies or otherwise. SUPPLEMENTAL ITEM. EXECUTIVE OFFICERS OF REGISTRANT The Company's executive officers are as follows: Age as of Name December 31, 1993 Position ---- ----------------- -------- Charles A. Lenzie 56 Chairman of the Board and Chief Executive Officer James C. Holcombe 48 President and Chief Operating Officer David G. Barneby 48 Vice President, Power Delivery Cynthia K. Gilliam 45 Vice President, Retail Customer Operations Richard L. Hinckley 38 Vice President, Secretary and General Counsel Steven W. Rigazio 39 Vice President, Finance and Planning, Treasurer, Chief Financial Officer Gloria T. Banks Weddle 44 Vice President, Human Resources and Corporate Services Each of the executive officers has been actively engaged in the business of the Company for more than five years. Charles A. Lenzie was elected Chairman of the Board and Chief Executive Officer on May 1, 1989. Prior to that time he was President of the Company. James C. Holcombe joined the Company as Executive Vice President on March 1, 1989 and was elected President and Chief Operating Officer on May 1, 1989. Prior to joining the Company he was Vice President of Resource Development for San Diego Gas and Electric Company. David G. Barneby was elected Vice President, Power Delivery effective October 14, 1993. He joined the Company in 1965 as a Student Engineer and was made a Junior Engineer in 1967. He was promoted to Superintendent of the Reid Gardner Generating Station in 1976; Project Manager - Reid Gardner Unit 4 in 1979 and in 1985 appointed Manager - Generation Engineering and Construction. He was elected Vice President - Generation in 1989. His title was changed to Vice President - Power Supply later that year. Cynthia K. Gilliam was elected Vice President - Retail Customer Operations effective October 14, 1993. She joined the Company in 1974 as a Rate Analyst and was promoted to Rates Administrator in 1979 and to Manager of Financial Planning in 1983. In 1987, she was appointed Manager of Human Resource Planning. She was elected Vice President - Personnel in l988 and her title was changed to Vice President - Human Resources in l989. In 1992, she was elected Vice President - Customer Service. Richard L. Hinckley was elected Vice President, Secretary and General Counsel effective October 14, 1993. He joined the Company as Staff Counsel in l985; was promoted to Assistant Secretary and Chief Counsel in 1989 and elected Vice President, Chief Counsel and secretary in 1991. Prior to joining the Company, he served as Staff Attorney with the Nevada Public Service Commission and as Assistant Attorney General in Utah. Steven W. Rigazio was elected Vice President, Finance and Planning, Treasurer, Chief Financial Officer effective October 14, 1993. He joined the Company in l984 as a Rates Administrator and was promoted to Supervisor of Rates and Regulations in l985, Manager of Rates and Regulatory Affairs in l986, Director of System Planning in l990, Vice President - Planning in 1991 and Vice President and Treasurer, Chief Financial Officer in 1992. Gloria T. Banks Weddle was elected Vice President - Human Resources and Corporate Services effective October 14, 1993. She first joined the Company in 1973, was promoted to Manager of Compensation and Benefits in 1988 and Director of Human Resources in 1991. She was elected Vice President - Human Resources in 1992. PART II ITEM 5.

ITEM 5. MARKET FOR THE REGISTRANT'S COMMON STOCK AND RELATED SECURITY HOLDER MATTERS Information with respect to the principal market for the Company's common stock, securities exchange, shareholders of record, quarterly high and low sales prices and quarterly dividend payments for 1992 and 1991 are hereby incorporated by reference from page 43 of the Company's Annual Report to Shareholders for the year ended December 31, 1993, which is filed herewith as Exhibit 13. ITEM 6.

ITEM 6. SELECTED FINANCIAL DATA The information required by Item 6 is hereby incorporated by reference from pages 44 to 45 of the Company's Annual Report to Shareholders for the year ended December 31, 1993, which is filed herewith as Exhibit 13. ITEM 7.

ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATION The information required by Item 7 is hereby incorporated by reference from pages 16 to 21 of the Company's Annual Report to Shareholders for the year ended December 31, 1993, which are filed herewith as Exhibit 13. ITEM 8.

ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA The Company's financial statements for the years ended December 31, 1993, 1992 and 1991 together with the auditors' report thereon required by Item 8 are incorporated by reference from the following pages of the Company's Annual Report to Shareholders for the year ended December 31, 1993, which are filed herewith as Exhibit 13. Annual Report Page ------ Statements of Income for the Years Ended December 31, 1993, 1992 and 1991...................... 22 Statements of Retained Earnings for the Years Ended December 31, 1993, 1992 and 1991................ 23 Balance Sheets - December 31, 1993 and 1992............ 24-25 Schedules of Capitalization - December 31, 1993 and 1992............................ 26-27 Schedules of Long-Term Debt - December 31, 1993 and 1992............................ 28-29 Statements of Cash Flows for the Years Ended December 31, 1993, 1992 and 1991...................... 30 Notes to Financial Statements.......................... 31-41 Independent Auditors' Report........................... 42 Report of Management................................... 42 See Note 10 of Notes to Financial Statements in the Company's Annual Report to Shareholders for the unaudited selected quarterly financial data required to be presented in this Item 8. Financial statements and supplemental schedules of the Company's subsidiaries are omitted since their aggregate total assets, sales and revenues, and income before income taxes are not material in relation to the Company's total assets, sales and revenues, and income before income taxes. ITEM 9.

ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE There has been no Report on Form 8-K filed within the twenty-four months prior to the date of the most recent financial statements, December 31, 1993, reporting a change of accountants. PART III ITEM 10.

ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT Information required by Item 10 with respect to the Company's executive officers is set forth in Part I, Item 4., under the preceding heading "Supplemental Item. Executive Officers of Registrant". The other information required by Item 10 is hereby incorporated by reference from the Company's definitive Proxy Statement dated March 14, 1994 and heretofore filed with the Securities and Exchange Commission ("SEC"). (See the heading therein "Election of Directors".) ITEM 11.

ITEM 11. EXECUTIVE COMPENSATION The information required by Item 11 is hereby incorporated by reference from the Company's definitive Proxy Statement dated March 14, 1994 and heretofore filed with the SEC. (See the heading therein "Executive Compensation".) ITEM 12.

ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT The information required by Item 12 is hereby incorporated by reference from the Company's definitive Proxy Statement dated March 14, 1994 and heretofore filed with the SEC. (See the heading therein "Security Ownership of Management".) ITEM 13.

ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS The Management of the Company has no knowledge of any transaction, relationship or indebtedness which is required to be disclosed by Item 13. PART IV ITEM 14.

ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K The Company's financial statements for the years ended December 31, 1993, 1992 and 1991 together with the auditors' report appearing on pages 22 to 42 of Nevada Power Company's 1993 Annual Report to Shareholders are incorporated herein by reference and filed as Exhibit 13. FINANCIAL STATEMENT SCHEDULES FOR THE YEARS ENDED DECEMBER 31, 1993, 1992, and 1991 PAGE - ------------------------------------------------------------------------- Independent Auditors' Consent and Report on Schedules............. 24 Schedule V - Electric Plant....................................... 25-27 Schedule VI - Accumulated Depreciation............................ 25-27 Schedule VIII - Valuation and Qualifying Accounts................. 28 All other schedules and financial statements of subsidiaries not consolidated are omitted because they are not applicable, not required, or because the information is included in the financial statements or notes thereto. EXHIBITS FILED DESCRIPTION - -------------- ----------- 13 Pages 16 to 45 of Nevada Power Company's Annual Report to Shareholders for the Year Ended December 31, 1993 (incorporated by reference in Parts II and IV hereof). 10.69 Long-Term Incentive Plan dated as of January 1, 1993. 10.70 Contract for Long-Term Power Purchases from Qualifying Facilities dated May 27, 1992 between Las Vegas Co-generation, Inc. and Nevada Power Company, Replaces Exhibit 10.50. 10.71 Settlement Agreement and Promissory Note between Mountain Coal Company and Atlantic Richfield Company and Nevada Power Company dated March 9, 1994. In addition to those Exhibits shown above, the Company hereby incorporates the following Exhibits pursuant to Exchange Act Rule 12B-32 and Regulation #201.24 by reference to the filings set forth below: EXHIBIT ORIGINALLY FILED NO. DESCRIPTION AS EXHIBIT FILE NO. - ------- ----------- ---------------- -------- 3.1 Bylaws, as amended February 9, 1984 3 to Form 10-K 1-4698 Year 1983 3.2 Restated Bylaws, as amended May 13, 1988 4.8 to Form S-3 33-33545 January 10, 1991 3.2 to Form 10-K 1-4698 Year 1990 3.3 Restated Articles of Incorporation, 2.2 to Form S-7 2-65097 filed November 7, 1978 3.4 Amendment to Restated Articles of 2.3 to Form S-16 2-67853 Incorporation, filed May 19, 1980 3.5 Amendment to Restated Articles of 3.4 to Form 10-K 1-4698 Incorporation filed May 31, 1983 Year 1983 3.6 Amendment to Restated Articles of 4.4 to Form S-3 33-4567 Incorporation, filed May 12, 1986 3.7 Amendment to Restated Articles of 4.6 to Form S-3 33-15554 Incorporation, filed May 12, 1987 3.8 Amendment to Restated Articles of 3.7 to Form 10-K 1-4698 Incorporation filed June 10, 1988 Year 1988 3.9 Restated Articles of Incorporation 3.8 to Form 10-K 1-4698 filed June 10, 1988 Year 1988 3.10 Amendment to Restated Articles of 4.7 to Form S-8 33-32372 Incorporation filed May 23, 1989. 3.11 Amendment to Restated Articles of 4.8 to Form S-3 33-55698 Incorporation filed June 8, 1992. 4.1 Certificate of Designation of Cumulative Preferred Stock as follows: 5.40% Series 2.1 to Form S-1 2-16968 5.20% Series 2.1 to Form S-1 2-20618 4.70% Series 3.2 to Form 8-K 1-4698 July 1965 8% Series 2.1 to Form S-7 2-44513 8.70% Series 2.1 to Form S-7 2-49622 11.50% Series 2.1 to Form S-7 2-52238 9.75% Series 2.1 to Form S-7 2-56788 Auction Series A 4.6 to Form S-3 33-15554 Auction Series A as amended November 14, 1991 4.9 to Form S-3 33-44460 Auction Series A as amended December 12, 1991 4.1 to Form 10-K 1-4698 Year 1992 9.90% Series 4.1 to Form 10-K 1-4698 Year 1992 4.2 Indenture of Mortgage and Deed of 4.2 to Form S-1 2-10932 Trust Providing for First Mortgage Bonds, dated October 1, 1953 and Nineteen Supplemental Indentures as follows: First Supplemental Indenture, 4.2 to Form S-1 2-11440 dated August 1, 1954 Second Supplemental Indenture, 4.9 to Form S-1 2-12566 dated September 1, 1956 Third Supplemental Indenture, 4.13 to Form S-1 2-14949 dated May 1, 1959 EXHIBIT ORIGINALLY FILED NO. DESCRIPTION AS EXHIBIT FILE NO. - ------- ----------- ---------------- -------- Fourth Supplemental Indenture, 4.5 to Form S-1 2-16968 dated October 1, 1960 Fifth Supplemental Indenture, 4.6 to Form S-16 2-74929 dated December 1, 1961 Sixth Supplemental Indenture, 4.6A to Form S-1 2-21689 dated October 1, 1963 Seventh Supplemental Indenture, 4.6B to Form S-1 2-22560 dated August 1, 1964 Eighth Supplemental Indenture, 4.6C to Form S-9 2-28348 dated April 1, 1968 Ninth Supplemental Indenture, 4.6D to Form S-1 2-34588 dated October 1, 1969 Tenth Supplemental Indenture, 4.6E to Form S-7 2-38314 dated October 1, 1970 Eleventh Supplemental Indenture, 2.12 to Form S-7 2-45728 dated November 1, 1972 Twelfth Supplemental Indenture, 2.13 to Form S-7 2-52350 dated December 1, 1974 Thirteenth Supplemental 4.14 to Form S-16 2-74929 Indenture, dated October 1, Fourteenth Supplemental 4.15 to Form S-16 2-74929 Indenture, dated May 1, 1977 Fifteenth Supplemental 4.16 to Form S-16 2-74929 Indenture dated September 1, Sixteenth Supplemental Indenture, 4.17 to Form S-16 2-74929 dated December 1, 1981 Seventeenth Supplemental 4.2 to Form 10-K 1-4698 Indenture, dated August 1, 1982 Year 1982 Eighteenth Supplemental Indenture, 4.6 to Form S-3 33-9537 dated November 1, 1986 Nineteenth Supplemental Indenture, 4.2 to Form 10-K 1-4698 dated October 1, 1989 Year 1989 Twentieth Supplemental Indenture, 4.21 to Form S-3 33-53034 dated May 1, 1992 Twenty-First Supplemental 4.22 to Form S-3 33-53034 Indenture, dated June 1, 1992 Twenty-Second Supplemental 4.23 to Form S-3 33-53034 Indenture, dated June 1, 1992 Twenty-Third Supplemental 4.23 to Form S-3 33-53034 Indenture, dated October 1, 1992 Twenty-Fourth Supplemental 4.23 to Form S-3 33-53034 Indenture, dated October 1, 1992 Twenty-Fifth Supplemental 4.23 to Form S-3 33-53034 Indenture, dated January 1, 1993 4.3 Instrument of Further Assurance 4.8 to Form S-1 2-12566 dated April 1, 1956 to Indenture of Mortgage and Deed of Trust dated October 1, 1953 4.4 Rights Agreement dated October 15, 4.1 to Form 8-A 1-4698 1990 between Manufacturers Hanover Year 1990 Trust Company and Nevada Power Company EXHIBIT ORIGINALLY FILED NO. DESCRIPTION AS EXHIBIT FILE NO. - ------- ----------- ---------------- -------- 10.1 Contract for Sale of Electrical 13.9A to Form S-1 2-10932 Energy between State of Nevada and the Company, dated October 10, 1941 10.2 Amendment dated June 30, 1953 to 13.9A to Form S-1 2-10932 Exhibit 10.1 10.3 Contract for Sale of Electrical 13.10 to Form S-1 2-10932 Energy between State of Nevada and the Company, dated June 1, 10.4 Agreement dated November 10, 1948 13.18 to Form S-1 2-12697 between the Company and Lincoln County Power District No. 1 and Overton Power District No. 5 10.5 Agreement dated October 21, 1949 13.19 to Form S-9 2-12697 between the Company and Lincoln County Power District No. 1 and Overton Power District No. 5 10.6 Mohave Project Plant Site 13.27 to Form S-9 2-28348 Conveyance and Co-tenancy Agreement dated May 29, 1967 between the Company and Salt River Project Agricultural Improvement and Power District Southern California Edison Company 10.7 Eldorado System Conveyance and 13.30 to Form S-9 2-28348 Co-tenancy Agreement dated December 20, 1967 between the Company and Salt River Project Agricultural Improvement and Power District and Southern California Edison Company 10.8 Mohave Operating Agreement dated 13.26F to Form S-1 2-38314 July 6, 1970 between the Company, Salt River Project Agricultural Improvement and Power District, Southern California Edison Company and Department of Water and Power of the City of Los Angeles 10.9 Navajo Project Participation 13.27A to Form S-1 2-38314 Agreement dated September 30, 1969 between the Company, the United States of America, Arizona Public Service Company, Department of Water and Power of the City of Los Angeles, Salt River Project Agricultural Improvement and Power District and Tucson Gas & Electric Company EXHIBIT ORIGINALLY FILED NO. DESCRIPTION AS EXHIBIT FILE NO. - ------- ----------- ---------------- -------- 10.10 Navajo Project Coal Supply 13.27B to Form S-1 2-38314 Agreement dated June 1, 1970 between the Company, the United States of America, Arizona Public Service Company, Department of Water and Power of the City of Los Angeles, Salt River Project Agricultural District, Tucson Gas & Electric Company and the Peabody Coal Company 10.11 Contract dated January 1, 1968 13.32 to Form S-1 2-34588 between the Company and United States Bureau of Reclamation for interconnections at Mead Station 10.12 Note Agreement dated December 11, 5.35 to Form S-7 2-49622 1973 relating to $25,000,000 8-1/2% Promissory Notes due 1998 10.13 Reclaimed Wastewater Purchase 5.36 to Form S-7 2-52238 Agreement dated June 21, 1974 among City of Las Vegas, Nevada, Clark County Sanitation District No. 1, County of Clark, Nevada and Nevada Power Company 10.14 Equipment Lease dated as of 5.37 to Form 8-K 1-4698 March 1, 1974 between Nevada Power April 1974 Company, Lessor, and Clark County, Nevada, Lessee 10.15 Sublease Agreement dated as of 5.38 to Form 8-K 1-4698 March 1, 1974 between Clark April 1974 County, Nevada, Sublessor, and Nevada Power Company, Sublessee 10.16 Guaranty Agreement dated as of 5.39 to Form 8-K 1-4698 March 1, 1974 between Nevada April 1974 Power Company and Commerce Union Bank as Trustee 10.17 Navajo Project Co-tenancy 5.31 to Form 8-K 1-4698 Agreement dated March 23, 1976 April 1974 between the Company, Arizona Public Service Company, Department of Water and Power of the City of Los Angeles, Salt River Project Agricultural Improvement and Power District, Tucson Gas & Electric Company and the United States of America 10.18 Amended Mohave Project Coal Supply 5.35 to Form S-7 2-56356 Agreement dated May 26, 1976 between the Company and Southern California Edison Company, Department of Water and Power of the City of Los Angeles, Salt River Project Agricultural Improvement and Power District and the Peabody Coal Company EXHIBIT ORIGINALLY FILED NO. DESCRIPTION AS EXHIBIT FILE NO. - ------- ----------- ---------------- -------- 10.19 Amended Mohave Project Coal Slurry 5.36 to Form S-7 2-56356 Pipeline Agreement dated May 26, 1976 between Peabody Coal Company and Black Mesa Pipeline, Inc. (Exhibit B to Exhibit 10.18) 10.20 Coal Supply Agreement dated October 5.38 to Form S-7 2-56356 15, 1975 between the Company and United States Fuel Company 10.21 Amendment dated November 19, 1976 5.30 to Form S-7 2-62105 to Exhibit 10.20 10.22 Participation Agreement Reid 5.34 to Form S-7 2-65097 Gardner Unit No. 4 dated July 11, 1979 between the Company and California Department of Water Resources 10.23 Coal Supply Agreement dated 5.37 to Form S-7 2-62509 March 1, 1980 between the Company and Beaver Creek Coal Company 10.24 Coal Supply Agreement dated 5.38 to Form S-7 2-62509 March 1, 1980 between the Company and Trail Mountain Coal Company 10.25 Coal Supply Agreement dated 10.26 to Form 10-K 1-4698 December 8, 1980 between the Year 1981 Company and Plateau Mining Company 10.26 Coal Supply Agreement dated 10.26 to Form 10-K 1-4698 August 31, 1982 between Year 1982 the Company and CO-OP Mining Company 10.27 Coal Supply Agreement dated 10.27 to Form 10-K 1-4698 September 8, 1982 between the Year 1982 Company and Getty Mining Company 10.28 Coal Supply Agreement dated 10.28 to Form 10-K 1-4698 September 8, 1982 between the Year 1982 Company and Tower Resources, Inc. 10.29 Coal Supply Agreement dated 10.29 to Form 10-K 1-4698 September 22, 1982 between the Year 1982 Company and Beaver Creek Coal Company 10.30 Memorandum of Understanding 10.30 to Form 10-K 1-4698 Concerning Interconnection Year 1983 between Utah Power & Light Company and Nevada Power Company dated February 2, 1984 10.31 Sublease Agreement between Powveg 10.31 to Form 10-K 1-4698 Leasing Corp., as Lessor and Year 1983 Nevada Power Company as Lessee, dated January 11, 1984 for lease of administrative headquarters EXHIBIT ORIGINALLY FILED NO. DESCRIPTION AS EXHIBIT FILE NO. - ------- ----------- ---------------- -------- 10.32 Participation Agreement between 10.32 to Form 10-K 1-4698 Utah Power & Light Company and Year 1985 the Company dated December 19, 10.33 Sale and Purchase Agreement dated 10.33 to Form 10-K 1-4698 as of December 23, 1985 by and Year 1985 between Nevada Power Company and CP National Corporation 10.34 Restated Coal Sales Agreement as 10.34 to Form 10-K 1-4698 of July 1, 1985 by and between Year 1985 Nevada Power Company and Trail Mountain Coal Company 10.35 Summary of Supplemental Executive 10.35 to Form 10-K 1-4698 Retirement Plan as approved Year 1985 November 14, 1985 10.36 Financing Agreement dated as of 10.36 to Form 10-K 1-4698 February 1, 1983 between Clark Year 1985 County, Nevada and Nevada Power Company 10.37 Financing Agreement between Clark 10.37 to Form 10-K 1-4698 County, Nevada and Nevada Power Year 1985 Company dated as of December 1, 10.38 Reimbursement Agreement dated 10.38 to Form 10-K 1-4698 as of December 1, 1985 between Year 1986 The Fuji Bank, Limited and Nevada Power Company 10.39 Contract for Sale of Electrical 10.39 to Form 10-K 1-4698 Energy between the State of Year 1987 Nevada and the Company, dated July 8, 1987 10.40 Power Sales Agreement between 10.40 to Form 10-K 1-4698 Utah Power & Light Company and Year 1987 the Company, dated August 17, 10.41 Transmission Facilities Agreement 10.41 to Form 10-K 1-4698 between Utah Power & Light Year 1987 Company and the Company, dated August 17, 1987 10.42 Financing Agreement between Clark 10.42 to Form 10-K 1-4698 County, Nevada and Nevada Power Year 1988 Company dated as of November 1, 10.43 Reimbursement Agreement dated 10.43 to Form 10-K 1-4698 as of November 1, 1988 between Year 1988 The Fuji Bank, Limited and Nevada Power Company 10.44 401(k) Savings Plan 28.1 to Form S-8 33-32372 10.45 Power Purchase Contract dated 10.45 to Form 10-K 1-4698 February 15, 1990 between Year 1989 Mission Energy Company and Nevada Power Company EXHIBIT ORIGINALLY FILED NO. DESCRIPTION AS EXHIBIT FILE NO. - ------- ----------- ---------------- -------- 10.46 Contact for Long-Term Power 10.46 to Form 10-K 1-4698 Purchases from Qualifying Year 1989 Facilities dated May 1, 1989 between Oxford Energy of Nevada and Nevada Power Company 10.47 Contract A for Long-Term Power 10.47 to Form 10-K 1-4698 Purchases from Qualifying Year 1989 Facilities dated May 2, 1989 between Bonneville Nevada Corporation and Nevada Power Company 10.48 Contract for Long-Term Power 10.48 to Form 10-K 1-4698 Purchases from Qualifying Year 1989 Facilities dated April 10, 1989 between Magna Energy Systems, Eastern Sierra Energy Company and Nevada Power Company 10.49 Contract B for Long-Term Power 10.49 to Form 10-K 1-4698 Purchases from a Qualifying Year 1989 Facility dated October 27, 1989 between Bonneville Nevada Corporation and Nevada Power Company 10.50 Contract for Long-Term Power 10.50 to Form 10-K 1-4698 Purchases from Qualified Year 1989 Facilities dated February 12, 1990 between Las Vegas Co-generation, Inc. and Nevada Power Company 10.51 Agreement for Transmission 10.51 to Form 10-K 1-4698 Service dated March 29, 1989 Year 1989 between Overton Power District No. 5 , Lincoln County Power District No. 1 and Nevada Power Company 10.52 Contract dated June 30, 1988 10.52 to Form 10-K 1-4698 between United States Department Year 1989 of Energy Western Area Power Administration and Nevada Power Company 10.53 Executive Performance Incentive 10.53 to Form 10-K 1-4698 Plan dated as of January 1, 1989 Year 1989 10.54 Severance Allowance Plan 10.54 to Form 10-K 1-4698 adopted September 14, 1989 Year 1989 10.55 Power Purchase Contract dated 10.55 to Form 10-K 1-4698 July 5, 1990 between Year 1990 Mission Energy Company and Nevada Power Company 10.56 Contract B for Long-Term Power 10.56 to Form 10-K 1-4698 Purchases from a Qualifying Year 1990 Facility dated May 24, 1990 between Bonneville Nevada Corporation and Nevada Power Company 10.57 Amendment dated June 15, 1989 to 10.57 to Form 10-K 1-4698 Exhibit 10.46 Year 1990 EXHIBIT ORIGINALLY FILED NO. DESCRIPTION AS EXHIBIT FILE NO. - ------- ----------- ---------------- -------- 10.58 Amendment dated August 23, 1989 10.58 to Form 10-K 1-4698 to Exhibit 10.46 Year 1990 10.59 Amendment dated April 23, 1990 10.59 to Form 10-K 1-4698 to Exhibit 10.46 Year 1990 10.60 Exhibit H dated August 13, 1990 10.60 to Form 10-K 1-4698 to Exhibit 10.46 Year 1990 10.61 Western Systems Power Pool 10.61 to Form 10-K 1-4698 Agreement (Agreement) dated Year 1990 January 2, 1991 between thirty-nine other Western Systems Power Pool members as listed on pages 1 and 2 of the Agreement and Nevada Power Company 10.62 Financing Agreement between Clark 10.62 to Form 10-K 1-4698 County, Nevada and Nevada Power Year 1990 Company dated June 1, 1990 10.63 Restated Power Sales Agreement 10.63 to Form 10-K 1-4698 dated March 25, 1991 between Year 1991 Pacificorp and Nevada Power Company 10.64 Amendment dated July 17, 1990 to 10.64 to Form 10-K 1-4698 Exhibit 10.55 Year 1991 10.65 Financing Agreement between Clark 10.65 to Form 10-K 1-4698 County, Nevada and Nevada Power Year 1992 Company dated June 1, 1992 (Series 1992A) 10.66 Financing Agreement between Clark 10.66 to Form 10-K 1-4698 County, Nevada and Nevada Power Year 1992 Company dated June 1, 1992 (Series 1992B) 10.67 Financing Agreement between Clark 10.67 to Form 10-K 1-4698 County, Nevada and Nevada Power Year 1992 Company dated October 1, 1992 10.68 Power Sales Agreement dated 10.68 to Form 10-K 1-4698 October 19, 1992 Between the Year 1992 Department of Water and Power of the City of Los Angeles and Nevada Power Company REPORTS ON FORM 8-K The Company filed no current report on Form 8-K during the quarter ended December 31, 1993. INDEPENDENT AUDITORS' CONSENT AND REPORT ON SCHEDULES We consent to the incorporation by reference in Registration Statement No. 33-18622 on Form S-3 and in Registration Statement No. 33-15554 on Form S-3 of Nevada Power Company of our report dated February 10, 1994 (March 11, 1994 as to the fourth paragragh of Note 7) (which expresses an unqualified opinion and includes an explanatory paragraph relating to the Company's change in method of accounting for income taxes to conform with Statement of Financial Accounting Standards No. 109) incorporated by reference in this Annual Report on Form 10-K of Nevada Power Company for the year ended December 31, 1993. Our audits of the financial statements referred to in our aforementioned report also included the financial statement schedules of Nevada Power Company, listed in Item 14. These financial statement schedules are the responsibility of Nevada Power Company's management. Our responsibility is to express an opinion based on our audits. In our opinion, such financial statement schedules, when considered in relation to the basic financial statements taken as a whole, present fairly in all material respects the information set forth therein. DELOITTE & TOUCHE DELOITTE & TOUCHE Las Vegas, Nevada March 28, 1994 NEVADA POWER COMPANY SCHEDULE V - ELECTRIC PLANT FOR THE YEAR ENDED DECEMBER 31, 1993 (IN THOUSANDS OF DOLLARS) Balance at Balance at Beginning Additions Retirements End of of Period At Cost (1) and Other Period ---------- ----------- ----------- ---------- Production............$ 588,492 $ 93,859 $ (824) $ 681,527 Transmission.......... 263,807 13,869 (133) 277,543 Distribution.......... 536,644 61,923 (3,693) 594,874 General............... 77,402 7,927 (713) 84,616 Construction work-in- progress............. 172,093 (4,441) -- 167,652 Property under capital lease................ 96,753 -- (5,236) 91,517 Plant held for future use.................. 4,442 -- (723) 3,719 ---------- ----------- ----------- ---------- $1,739,633 $ 173,137 $ (11,322) $1,901,448 ========== =========== =========== ========== SCHEDULE VI - ACCUMULATED DEPRECIATION FOR THE YEAR ENDED DECEMBER 31, 1993 (IN THOUSANDS OF DOLLARS) Balance at Salvage, Less Balance at Beginning Cost of End of of Period Provisions(2) Removal Retirements Period ---------- ----------- ---------- --------- --------- Production...$ 250,545 $ 19,919 $ (87) $ (823) $ 269,554 Transmission. 50,030 6,658 (108) (133) 56,447 Distribution. 98,355 14,817 121 (2,717) 110,576 General...... 12,755 3,104 74 (713) 15,220 Retirement work- in-progress. (722) -- 227 -- (495) ---------- ----------- ---------- --------- --------- $ 410,963 $ 44,498 $ 227 $ (4,386) $ 451,302 ========== =========== ========== ========= ========= ______________ (1) Additions include Allowance for Funds Used During Construction capitalized in the amount of $9,880,000. (2) Provisions include $43,341,000 charged to income and $1,157,000 charged to other accounts. The depreciation provision on the statement of income includes additional amounts for amortization of the electric plant acquisition adjustments in the amount of $17,000. NEVADA POWER COMPANY SCHEDULE V - ELECTRIC PLANT FOR THE YEAR ENDED DECEMBER 31, 1992 (IN THOUSANDS OF DOLLARS) Balance at Balance at Beginning Additions Retirements End of of Period At Cost (1) and Other Period ---------- ----------- ----------- ---------- Production............$ 577,565 $ 12,222 $ (1,295) $ 588,492 Transmission.......... 235,282 28,719 (194) 263,807 Distribution.......... 460,406 66,383 9,855 (2) 536,644 General............... 70,917 8,913 (2,428) 77,402 Construction work-in- progress............. 112,257 62,382 (2,546)(3) 172,093 Property under capital lease................ 96,358 -- 395 96,753 Plant held for future use.................. 9,706 -- (5,264)(4) 4,442 ---------- ----------- ----------- ---------- $1,562,491 $ 178,619 $ (1,477) $1,739,633 ========== =========== =========== ========== SCHEDULE VI - ACCUMULATED DEPRECIATION FOR THE YEAR ENDED DECEMBER 31, 1992 (IN THOUSANDS OF DOLLARS) Balance at Salvage, Less Balance at Beginning Cost of End of of Period Provisions(5) Removal Retirements Period ---------- ----------- ---------- --------- --------- Production...$ 233,539 $ 18,190 $ 111 $ (1,295) $ 250,545 Transmission. 44,151 6,102 (40) (183) 50,030 Distribution. 86,574 14,925 266 (3,410) 98,355 General...... 12,229 2,910 44 (2,428) 12,755 Retirement work- in-progress. (726) -- 4 -- (722) ---------- ----------- ---------- --------- --------- $ 375,767 $ 42,127 $ 385 $ (7,316) $ 410,963 ========== =========== ========== ========= ========= ______________ (1) Additions include Allowance for Funds Used During Construction capitalized in the amount of $7,544,000. (2) Included in retirements and other is $13,567,000 for AFUDC on Industrial Development Revenue Bond Trust Fund balances reclassified from other deferred charges. (3) Included in retirements and other is $2,546,000 for costs related to a property loss at Reid Gardner Generating Station No. 4 which were reclassified to other deferred charges. (4) Included in retirements and other is $5,794,000 reclassified as property under capital lease. (5) Provisions include $39,433,000 charged to income and $2,694,000 charged to other accounts. The depreciation provision on the statement of income includes additional amounts for amortization of the electric plant acquisition adjustments in the amount of $18,000. NEVADA POWER COMPANY SCHEDULE V - ELECTRIC PLANT FOR THE YEAR ENDED DECEMBER 31, 1991 (IN THOUSANDS OF DOLLARS) Balance at Balance at Beginning Additions Retirements End of of Period At Cost (1) and Other Period ---------- ----------- ----------- ---------- Production............$ 562,858 $ 20,347 $ (5,640) $ 577,565 Transmission.......... 217,852 18,214 (784) 235,282 Distribution.......... 400,869 76,386 (16,849)(2) 460,406 General............... 63,597 8,013 (693) 70,917 Construction work-in- progress............. 75,946 30,992 5,319 (3) 112,257 Property under capital lease................ 18,199 83,000 (5) (4,841) 96,358 Plant held for future use.................. 5,786 3,188 732 (4) 9,706 ---------- ----------- ----------- ---------- $1,345,107 $ 240,140 $ (22,756) $1,562,491 ========== =========== =========== ========== SCHEDULE VI - ACCUMULATED DEPRECIATION FOR THE YEAR ENDED DECEMBER 31, 1991 (IN THOUSANDS OF DOLLARS) Balance at Salvage, Less Balance at Beginning Cost of End of of Period Provisions(6) Removal Retirements Period ---------- ----------- ---------- --------- --------- Production...$ 217,606 $ 19,807 $ 1,766 $ (5,640) $ 233,539 Transmission. 39,999 5,001 (65) (784) 44,151 Distribution. 80,618 9,084 152 (3,280) 86,574 General...... 10,633 2,151 38 (593) 12,229 Retirement work- in-progress. (634) -- (92) -- (726) ---------- ----------- ---------- --------- --------- $ 348,222 $ 36,043 $ 1,799 $ (10,297) $ 375,767 ========== =========== ========== ========= ========= ______________ (1) Additions include Allowance for Funds Used During Construction capitalized in the amount of $6,051,000. (2) Included in retirements and other is $13,567,000 for AFUDC over- accrued on Industrial Development Revenue Bond Trust Fund balances and reclassified to other deferred charges to be amortized over eight years. (3) Included in retirements and other is $5,319,000 for costs related to the Company's Harry Allen Generating Facility project which were reclassified from other deferred charges. (4) Included in retirements and other is $732,000 for amortization and interest cost for l991 reclassified as plant held for future use. (5) Additions include $83,000,000 for a capitalized lease which was recorded as a result of a power purchase contract between the Company and Mission Energy Company. (6) Provisions include $34,663,000 charged to income and $l,380,000 charged to other accounts. The depreciation provision on the statement of income includes additional amounts for amortization of the electric plant acquisition adjustments in the amount of $485,000. NEVADA POWER COMPANY SCHEDULE VIII - VALUATION AND QUALIFYING ACCOUNTS FOR THE YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 (IN THOUSANDS OF DOLLARS) Reserve for Doubtful Accounts ---------- BALANCE AT DECEMBER 31, 1990............................. $ 924 Provision charged to income............................. 2,487 Amounts written off, less recoveries.................... (2,305) ------- BALANCE AT DECEMBER 31, 1991............................. $ 1,106 Provision charged to income............................. 2,068 Amounts written off, less recoveries.................... (2,371) ------- BALANCE AT DECEMBER 31, 1992............................. $ 803 Provision charged to income............................. 3,161 Amounts written off, less recoveries.................... (2,839) ------- BALANCE AT DECEMBER 31, 1993............................ $ 1,125 ======= SIGNATURES Pursuant to the requirements of Section 13 or 15(d) 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. NEVADA POWER COMPANY ------------------------------------- (Registrant) March 28, 1994 By CHARLES A. LENZIE ------------------------------------- Charles A. Lenzie Chairman of the Board and Chief Executive Officer Pursuant to the requirements of the Securities Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated. March 28, 1994 By CHARLES A. LENZIE ------------------------------------- Charles A. Lenzie, Chairman of the Board, Chief Executive Officer and Director (Principal Executive Officer) March 28, 1994 By STEVEN W. RIGAZIO ------------------------------------- Steven W. Rigazio, Vice President, Finance and Planning, Treasurer, Chief Financial Officer (Principal Financial and Principal Accounting Officer) March 28, 1994 By JAMES CASHMAN III ------------------------------------- James Cashman III, Director March 28, 1994 By MARY LEE COLEMAN ------------------------------------- Mary Lee Coleman, Director March 28, 1994 By FRED D. GIBSON JR. ------------------------------------- Fred D. Gibson Jr., Director March 28, 1994 By JOHN L. GOOLSBY ------------------------------------- John L. Goolsby, Director March 28, 1994 By JERRY HERBST ------------------------------------- Jerry Herbst, Director March 28, 1994 By JAMES C. HOLCOMBE ------------------------------------- James C. Holcombe, President and Director March 28, 1994 By CONRAD L. RYAN ------------------------------------- Conrad L. Ryan, Director March 28, 1994 By FRANK E. SCOTT ------------------------------------- Frank E. Scott, Director March 28, 1994 By ARTHUR M. SMITH ------------------------------------- Arthur M. Smith, Director March 28, 1994 By JELINDO A. TIBERTI ------------------------------------- Jelindo A. Tiberti, Director

34501_1993.txt

34501

1993

Item 1. BUSINESS Scope of Business - Farah Incorporated (formerly Farah Manufacturing Company, Inc.) was incorporated as a Texas corporation in 1947. Farah Incorporated and its subsidiaries (collectively, the "Company") are engaged in the production and sale of multiple apparel lines for men, young men and boys. Farah U.S.A., Inc. ("Farah U.S.A.") is the Company's largest operating subsidiary. Its products are sold throughout the United States. The largest area of sales volume for Farah U.S.A. is Men's apparel ("Men's"), with Boys' apparel ("Boys'") and Young Men's apparel ("Young Men's") being the next most significant, in that order. The major apparel items included in Farah U.S.A.'s lines are dress and casual slacks, sport coats and suit separates. The products are manufactured in a variety of fabrics, styles, colors and sizes. The Company believes that Farah U.S.A. is among the largest United States sources of Men's and Boys' slacks. Farah U.S.A. sales are made primarily through an employee sales force. Farah U.S.A. sells most of its products under the Farah, Farah Clothing Company and Savane labels. PROCESS 2000 is a trademark used to signify easy care fabrics, and is widely used on a number of Savane products. Farah U.S.A. also has an exclusive license agreement to manufacture and sell men's slacks, trousers, blazers, sport coats and shorts in the United States, its territories and possessions and Canada under the John Henry label. The Company believes all of the above trademarks to be important and material. Farah U.S.A. owns the Farah, Farah Clothing Company, Savane and Process 2000 trademarks. The John Henry trademark is under license from Zodiac International Trading Corporation and is renewable through May 31, 2038. Farah U.S.A. sells its products primarily to major department stores and specialty retailers. Farah International, Inc. ("Farah International") products are sold primarily through individual subsidiaries in the United Kingdom, Ireland, Australia and New Zealand. Farah International's largest subsidiary, Farah Manufacturing (U.K.) Limited ("Farah U.K."), is a wholesale apparel supplier in the United Kingdom. It also operates retail outlets in customer stores. Sales in the U.K. are primarily men's slacks, and to a lesser extent shirts, knitwear and sweaters. Farah Australia is the Company's other significant international subsidiary which sells its products in Australia. Sales in Australia are primarily men's slacks. The Company also sells products in New Zealand and certain European countries. Farah International sales are made primarily through employee sales forces, supplemented to a lesser degree by foreign distributors. Farah International sales are made primarily under the Farah label which the Company considers to be important and material. Additional information on foreign operations is presented in Note 9 to the consolidated financial statements, which is incorporated by reference. Value Slacks, Inc. ("Value Slacks") is the Company's factory outlet division which is used primarily to sell excess or slow moving Farah U.S.A. product. Value Slacks also sells shirts and other apparel accessory items sourced from third party vendors. As of November 5, 1993, Value Slacks operated 20 U.S. stores and 11 Puerto Rican stores. The Company's apparel is primarily marketed for the Spring and Fall retail selling seasons each year, with interim lines introduced periodically to complement the two primary lines. In past years, sales volume for the first quarter was generally the lowest of the year with each quarter getting progressively larger. However, with the introduction of more year-round basic products, the seasonality has been diminished somewhat. The Company anticipates that its first quarter will remain its lowest sales volume quarter. Farah U.S.A. closes some of its factories in the first quarter for approximately two weeks at Christmas time. This, combined with lower first quarter sales volumes, normally results in the first quarter being the lowest quarter in terms of profitability. The remaining three quarters are expected to be comparable in terms of sales and profitability, with the fourth quarter being somewhat higher than the second and third. Production - Farah U.S.A. and Farah International sourced approximately 67% and 94%, respectively, of their 1993 production from their own manufacturing facilities and the remainder from outside contractors. In response to increased sales, Farah U.S.A. has increased the use of outside production contractors. Additional needs in 1994 are anticipated to be satisfied through increased efficiencies in owned facilities and use of outside contractors. Farah U.S.A. considers its contractors to be an important component of its product sourcing strategy. In an effort to minimize the risk that would result from the failure of any one contractor, Farah U.S.A. uses a number of different contractors in different countries for production. Raw materials used in manufacturing operations consist mainly of fabrics made from cottons, wools, synthetics and blends of synthetics with cotton and wool. These fabrics are purchased principally from major textile producers located in the United States. In addition, the Company purchases such items as thread, zippers and trim from a large number of other suppliers. Five vendors supplied approximately 73% and 52% of Farah U.S.A.'s and Farah International's fabric and trim requirements, respectively, during the fiscal year ended November 5, 1993. The Company has no long-term contracts with any of its suppliers, nor does it anticipate shortages of raw materials in 1994. In order to be responsive to customer's "Quick Response" needs (see "Backlog" for more discussion), the Company maintains base stocks of certain raw materials and finished goods. However, most inventory is produced in response to indications of demand provided by customers. Competition - The apparel industry is highly competitive and includes a number of concerns (domestic and foreign) which have financial resources greater than those of the Company. Farah U.S.A.'s primary branded competitors are Haggar Corp. and Levi Strauss & Co. The Company believes that these competitors may have greater financial resources than those of the Company. In addition, there are a number of other competitors, including customer's private label products. The primary competitive factors in the apparel industry are styling, quality, price, customer service and brand recognition. The Company believes it is a significant supplier because of its volume, recent product innovations, and quality. Competitors of Farah U.K. are primarily its customer's private label products. The primary competitors of Farah Australia are other branded resources. The same competitive factors affecting Farah U.S.A. also affect Farah International. The Company's primary market is department stores. During fiscal year 1993, The May Department Stores Company, an unrelated company, accounted for approximately 12.4% of the Company's consolidated revenues. Backlog - Many of Farah U.S.A.'s major customers participate in an inventory replenishment concept referred to as "Quick Response". Essentially, Quick Response means that the Company will maintain enough shelf stock of certain key items to meet the customer's needs on short notice. As a result, customers tend to place orders closer to delivery dates than has been the historic case in the apparel industry. In addition, because of the trend toward Quick Response, orders which are received are not necessarily firm commitments. Therefore, the Company does not consider customer orders to be "backlog" or necessarily an indication of future sales. Inventory Management - As discussed above, the retail industry is requiring its manufacturing sources to maintain inventory for Quick Response purposes. As a result, Farah U.S.A. has maintained higher inventory levels during 1993 than was necessary historically. This, in turn, has resulted in higher borrowings by Farah U.S.A. to finance such inventories. Other Matters - In the fiscal years ended November 5, 1993, November 6, 1992 and October 31, 1991 the Company spent approximately $744,000, $530,000 and $530,000, respectively, on activities relating to the development of new products and the improvement of existing products. As of November 5, 1993, the Company employed approximately 5,300 people. Item 2.

Item 2. PROPERTIES The following table reflects the Company's significant real properties: APPROXIMATE TYPE OF LOCATION SQUARE FEET PROPERTY Owned: El Paso, Texas (1) 116,000 Garment manufacturing plant Chihuahua, Mexico 54,000 Garment manufacturing plant San Jose, Costa Rica 168,000 Two garment manufacturing plants Galway & Kiltimagh, Ireland 59,000 Two garment manufacturing plants Leased (2)(3): El Paso, Texas (4) 1,033,000 Garment manufacturing plant, warehouse and office facility Piedras Negras, Mexico 98,000 Four garment manufacturing plants Ballyhaunis, Ireland 24,000 Garment manufacturing plant Sydney, Australia 15,000 Office/Warehouse Suva, Fiji 24,000 50% owned joint venture for garment manufacturing Witham, United Kingdom 57,000 Office/Warehouse Auckland, New Zealand 6,000 Office/Warehouse Various retail locations in the United States and Puerto Rico 118,000 Retail stores (1) Building is under lien (see Note 3 to the consolidated financial statements, included in the Company's 1993 Annual Report to Shareholders). Underlying land is leased through February 2002. (2) Leased properties are occupied under non-cancellable leases which expire at various dates through 2016. (3) See Note 8 to the consolidated financial statements included in the Company's 1993 Annual Report to Shareholders, for discussion of leases. (4) Originally owned by the Company and sold and leased back in 1988. Initial lease term is ten years ending in 1998. The Company's garment manufacturing plants and offices are of steel and masonry construction. All facilities are kept in good condition. The Company considers both its domestic and international facilities to be suitable and adequate for current operations. During 1993, all properties were fully utilized. Farah U.S.A. has sub-leased approximately 45% of the El Paso, Texas building through May 31, 1998. Including such sub-lease, all of the El Paso, Texas building is fully utilized. In increased sales, Farah U.S.A. has increased the use of outside production contractors. Additional needs in 1994 are anticipated to be satisfied through increased efficiencies in owned facilities and use of outside contractors. Item 3.

Item 3. LEGAL PROCEEDINGS The Company is a defendant in several legal actions. In the opinion of management, based upon the advice of the respective attorneys handling such actions, the aggregate of expected fees, expenses, possible settlements and liability is not material. Item 4.

Item 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS None PART II Item 5.

Item 5. MARKET FOR THE REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS The information required under this item is set forth under the caption "Common Stock" on page 29 of the Company's Annual Report to Shareholders for the fiscal year ended November 5, 1993 and is incorporated herein by reference. Item 6.

Item 6. SELECTED FINANCIAL DATA The information required under this item is set forth under the caption "Selected Financial Data" on page 39 of the Company's Annual Report to Shareholders for the fiscal year ended November 5, 1993 and is incorporated herein by reference. Item 7.

Item 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The information required under this Item is set forth under the caption "Management's Discussion and Analysis of Financial Condition and Results of Operations" on pages 30 to 38 of the Company's Annual Report to Shareholders for the fiscal year ended November 5, 1993 and is incorporated herein by reference. Item 8.

Item 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA The following consolidated financial statements of Farah Incorporated and Subsidiaries included in the Company's Annual Report to Shareholders for fiscal year ended November 5, 1993 on page 28 and 12 through 27 are incorporated herein by reference: Quarterly Data (Unaudited) - Supplementary Data for fiscal years 1993 and 1992 Consolidated Statements of Operations - Years ended November 5, 1993, November 6, 1992 and October 31, 1991 Consolidated Balance Sheets - November 5, 1993 and November 6, 1992 Consolidated Statements of Shareholders' Equity - Years ended November 5, 1993, November 6, 1992 and October 31, 1991 Consolidated Statements of Cash Flows - Years ended November 5, 1993, November 6, 1992 and October 31, 1991 Notes to Consolidated Financial Statements - November 5, 1993, November 6, 1992 and October 31, 1991 Report of Independent Public Accountants Item 9.

Item 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE None PART III Item 10.

Item 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT The information required under this item is set forth under the caption "Directors and Executive Officers" on pages 4 and 5 of the Company's Proxy Statement prepared in connection with its 1994 Annual Meeting of Shareholders and is incorporated herein by reference. Item 11.

Item 11. EXECUTIVE COMPENSATION The information required under this item is set forth under the caption "Compensation of Executive Officers" on pages 7 through 10 of the Company's Proxy Statement prepared in connection with its 1994 Annual Meeting of Shareholders and is incorporated herein by reference. Item 12.

Item 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT The information required under this item is set forth under the caption "Ownership of Common Stock" on pages 2 and 3 of the Company's Proxy Statement prepared in connection with its 1994 Annual Meeting of Shareholders and is incorporated herein by reference. Item 13.

Item 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS Information required under this item is set forth under the captions "Certain Matters Involving Directors and Shareholders" and "Compensation of Directors" on pages 6 and 7 and 10 and 11, respectively, of the Company's Proxy Statement prepared in connection with its 1994 Annual Meeting of Shareholders and is incorporated herein by reference. PART IV Item 14.

Item 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K (a) The consolidated financial statements and notes together with the Report of Independent Public Accountants and Selected Financial Highlights as included in the Company's Annual Report to Shareholders for fiscal year ended November 5, 1993 filed with this Annual Report on Form 10-K are incorporated herein by reference (only the financial statements listed below, which are included in the Annual Report to Shareholders for the fiscal year ended November 5, 1993, are filed herewith and the remainder of the Annual Report to Shareholders for the fiscal year ended November 5, 1993 is furnished to the Commission for its information): Consolidated Statements of Operations - Years ended November 5, 1993, November 6, 1992 and October 31, 1991 Consolidated Balance Sheets - November 5, 1993 and November 6, 1992 Consolidated Statements of Shareholders' Equity - Years ended November 5, 1993, November 6, 1992 and October 31, 1991 Consolidated Statements of Cash Flows - Years ended November 5, 1993, November 6, 1992 and October 31, 1991 Notes to Consolidated Financial Statements Report of Independent Public Accountants Quarterly Data (unaudited) - Supplementary Data for fiscal years 1993 and 1992 Selected Financial Data for fiscal years ended 1989 to 1993 (b) Reports on Form 8-K. No reports on Form 8-K were filed during the last quarter of the period for which this report is filed. (c) Exhibits. 3 Articles of Incorporation and Bylaws. * 3.1Restated Articles of Incorporation dated March 29, 1988 (filed as Exhibit 3.1 to Form 10-K as of October 31, 1988). 3.2 Bylaws of Farah Incorporated Amended and Restated as of September 1, 1993. 4 Instruments defining the Rights of Security Holders, including Indentures. *4.1 Indenture, dated as of February 1, 1969 (filed as Exhibit 2.4 to Form 10- K as of October 31, 1980). Pursuant to subsection (b)(4)(iii) of Item 601 of Regulation S-K, Registrant hereby agrees to furnish to the Commission upon request copies of other instruments defining rights of holders of long-term debt, none of which instruments authorizes indebtedness in an amount in excess of 10% on consolidated assets. 10 Material Contracts. * 10.1 Employment Agreement dated March 1, 1993, (filed as Exhibit 10.4- 22 to Form 10-Q as of May 7, 1993). * 10.2 Employment Agreement dated March 1, 1993 (filed as Exhibit 10.4- 23 to Form 10-Q as of May 7, 1993). 10.3 Amended and Restated Employment Agreement dated September 30, 1993. 10.4 Amended and Restated Employment Agreement dated September 30, 1993. 10.5 Amended and Restated Employment Agreement dated September 30, 1993. * 10.6 Net Lease, dated as of May 16, 1988, between Farah U.S.A., Inc. and Far Pass Realty Associates, Ltd. (filed as Exhibit 5 to Form 8-K dated May 25, 1988). * 10.7 Guarantee of Lease by Farah Incorporated (filed as Exhibit 6 to Form 8-K dated May 25, 1988). * 10.8 Pledge Agreement by Farah U.S.A., Inc. to Far Pass Realty Associates, Ltd. (filed as Exhibit 7 to Form 8-K dated May 25, 1988). * 10.9 Amended and Restated Farah Manufacturing Company, Inc. 1986 Stock Option Plan, and Form of Stock Option Agreement (filed as Exhibit 4 (a) to the Company's Registration Statement on Form S- 8, Registration No. 2-75949). * 10.10 Farah Manufacturing Company, Inc. Executive Stock Option Plan, as amended, and form of Stock Option Agreement (filed as Exhibit 10.29 to Form 10-K as of October 31, 1988). * 10.11 Amended and Restated Farah Manufacturing Company, Inc. 1981 Stock Option Plan, and form of Stock Option Agreement (filed as Exhibit 28.2 to the Company's Registration Statement on Form S- 8, Registration No. 33-11930). * 10.12 Farah Incorporated 1988 Non- Employee Directors Stock Option Plan and form of Stock Option Agreement (filed as Exhibit 10.31 to Form 10-K as of October 31, 1988). * 10.13 Accounts Financing Agreement (Security Agreement), dated August 2, 1990 between Farah U.S.A., Inc. ("Farah U.S.A.") and Congress Financial Corporation (Southwest) ("Congress") (filed as Exhibit 10.53 to Form 10-Q as of July 31, 1990). * 10.14 Covenant Supplement to Accounts Financing Agreement (Security Agreement) dated August 2, 1990, between Farah U.S.A. and Congress (filed as Exhibit 10.54 to Form 10-Q as of July 31, 1990). * 10.15 Inventory and Equipment Security Agreement Supplement to Accounts Financing Agreement (Security Agreement) dated August 2, 1990, between Farah U.S.A. and Congress (filed as Exhibit 10.56 to Form 10-Q as of July 31, 1990). *10.16 Trade Financing Agreement Supplement to Accounts Financing Agreement (Security Agreement) dated August 2, 1990, between Farah U.S.A. and Congress (filed as Exhibit 10.57 to Form 10-Q as of July 31, 1990). * 10.17 Form of Pledge and Security Agreement, dated August 2, 1990 (filed as Exhibit 10.58 to Form 10-K as of October 31, 1990). * 10.18 Collateral Assignment of License, dated August 2, 1990, by Farah U.S.A. in favor of Congress (filed as Exhibit 10.60 to Form 10-Q as of July 31, 1990). * 10.19 Estoppel and Consent Agreement, dated August 2, 1990 by Farah Incorporated ("Farah") (filed as Exhibit 10.61 to Form 10-Q as of July 31, 1990). * 10.20 Deed of Trust and Security Agreement, dated July 30, 1990, by Farah U.S.A. and Farah in favor of Congress (filed as Exhibit 10.63 to Form 10-Q as of July 31, 1990). * 10.21 Form of Guarantee and Waiver, dated August 2, 1990 (filed as Exhibit 10.64 to Form 10-K as of October 31, 1990). * 10.22 Collateral Assignment of Agreements, dated August 2, 1990, by Farah in favor of Congress (filed as Exhibit 10.68 to Form 10-Q as of July 31, 1990). * 10.23 Collateral Assignment of Agreements, dated August 2, 1990, by Farah Manufacturing Company of New Mexico, Inc. in favor of Congress (filed as Exhibit 10.69 to Form 10-Q as of July 31, 1990). * 10.24 Subordination Agreement, dated August 2, 1990, by Farah U.S.A. and Farah (filed as Exhibit 10.70 to Form 10-Q as of July 31, 1990). * 10.25 Form of Pledge and Security Agreement, dated August 2, 1990 (filed as Exhibit 10.71 to Form 10-K as of October 31, 1990). * 10.26 Trademark Collateral Assignment and Security Agreement, dated August 2, 1990, by Farah in favor of Congress (filed as Exhibit 10.75 to Form 10-Q as of July 31, 1990). * 10.27 Patent Collateral Assignment and Security Agreement, dated August 2, 1990, by Farah in favor of Congress (filed as Exhibit 10.76 to Form 10-Q as of July 31, 1990). * 10.28 General Security Agreement, dated August 2, 1990, by Farah in favor of Congress (filed as Exhibit 10.77 to Form 10-Q as of July 31, 1990). * 10.29 Form of General Security Agreement, dated August 2, 1990 (filed as Exhibit 10.78 to Form 10-K as of October 31, 1990). * 10.30 Amendment No. 1, dated November 5, 1990, to Financing Agreements dated August 2, 1990 (filed as Exhibit 10.98 to Form 10-K as of October 31, 1990). * 10.31 Amendment No. 2 dated February 11, 1991, to Financing Agreements dated August 2, 1990 (filed as Exhibit 10.103 to Form 10-Q as of January 31, 1991). * 10.32 Sublease between Farah U.S.A., Inc. and The Tonka Corporation, dated January 6, 1992 (filed as Exhibit 10.107 to Form 10-K as of October 31, 1991). * 10.33 Farah Incorporated 1991 Stock Option and Restricted Stock Plan dated October 15, 1991 (filed as Exhibit 10.108 to Form 10-K as of October 31, 1991). * 10.34 Amendment No. 3 dated January 29, 1992, to Financing Agreements dated August 2, 1990 (filed as Exhibit 10.112 to Form 10-Q as of February 7, 1992). * 10.35 Amendment No. 4 dated June 25, 1992, to Accounts Financing Agreement dated August 2, 1990 between Congress Financial Corporation (Southwest) and Farah U.S.A., Inc. (filed as Exhibit 10.118 to Form 10-Q as of August 7, 1992). * 10.36 Amendment No. 5 dated August 31, 1992, to Accounts Financing Agreement dated August 2, 1990 between Congress Financial Corporation (Southwest) and Farah U.S.A., Inc. (filed as Exhibit 10.119 to Form 10-Q as of August 7, 1992). * 10.37 Amendment No. 6 dated September 4, 1992, to Accounts Financing Agreement dated August 2, 1990 between Congress Financial Corporation (Southwest) and Farah U.S.A., Inc. (filed as Exhibit 10.120 to Form 10-Q as of August 7, 1992). * 10.38 Amendment No. 7 dated September 16, 1992, to Accounts Financing Agreement dated August 2, 1990 between Congress Financial Corporation (Southwest) and Farah U.S.A., Inc. (filed as Exhibit 10.121 to Form 10-Q as of August 7, 1992). * 10.39 Stock Purchase Agreement dated August 4, 1992, between Farah Incorporated and Marciano Investments, Inc. (filed as Exhibit 10.122 to Form 10-Q as of August 7, 1992). * 10.40 Letter Agreement dated October 28, 1992, amending the Accounts Financing Agreement dated August 2, 1990 between Farah U.S.A., Inc. and Congress Financial Corporation (Southwest), (filed as Exhibit 10.125 to Form 10-K as of November 6, 1992). * 10.41 Amended and Restated Farah Savings and Retirement Plan, as of January 1, 1991, (filed as Exhibit 10.125 to Form 10-K as of November 6, 1992). * 10.42 Amended and Restated Stock Purchase Agreement dated March 12, 1993 (amending and restating the stock purchase agreement dated February 23, 1993) between Farah Incorporated, the Georges Marciano Trust and the Paul Marciano Trust, (filed as Exhibit 10.128 to Form 10-Q as of May 7, 1993). * 10.43 Amendment No. 8 to Financing Agreements as of May 7, 1993 between Farah U.S.A., Inc. and Congress Financial Corporation (Southwest), (filed as Exhibit 10.129 to Form 10-Q as of May 7, 1993). * 10.44 Amendment No. 9 dated July 16, 1993 to Accounts Financing Agreement dated August 2, 1990 between Congress Financial Corporation (Southwest) and Farah U.S.A., Inc., (filed as Exhibit 10.130 to Form 10-Q as of August 6, 1993). * 10.45 Consulting Agreement dated June 15, 1993, (filed as Exhibit 10.131 to Form 10-Q as of August 6, 1993). * 10.46 Deferred Compensation Agreement dated July 30, 1993, (filed as Exhibit 10.132 to Form 10-Q as of August 6, 1993). * 10.47 Deferred Compensation Agreement dated July 30, 1993, (filed as Exhibit 10.133 to Form 10-Q as of August 6, 1993). 10.48 Deferred Compensation Agreement dated July 30, 1993. 10.49 Amendment No. 10 dated November 5, 1993 to Accounts Financing Agreement dated August 2, 1990 between Congress Financial Corporation (Southwest) and Farah U.S.A., Inc. *Incorporated herein by reference. 22 Subsidiaries of Farah Incorporated 24 Consent of Independent Public Accountants (d) The following consolidated financial statement schedules are included in the Annual Report on Form 10-K along with the Report of Independent Public Accountants on supporting schedules: Page Report of Independent Public Accountants on Supporting Schedules 14 II- Amounts receivable from related parties, underwriters, promoters and employees other than related parties - Years ended November 5, 1993, November 6, 1992 and October 31, 1991 15 X- Supplementary Income Statement Information - Years ended November 5, 1993, November 6, 1992 and October 31, 1991 16 All other schedules are omitted because they are not applicable, not required under the instructions, or the information is reflected in the consolidated financial statements or notes thereto. For the purposes of complying with the amendments to the rules governing Form S-8 (effective July 13, 1990) under the Securities Act of 1933, the undersigned registrant hereby undertakes as follows, which undertaking shall be incorporated by reference into registrant's Registration Statements on Form S-8 Nos. 33-46661 (filed March 24, 1992), 33-11930 (filed February 12, 1987) and 2-75949 (filed February 4, 1982): Insofar as indemnification for liabilities arising under the Securities Act of 1933 may be permitted to directors, officers and controlling persons of the registrant pursuant to the foregoing provisions, or otherwise the registrant has been advised that in the opinion of the Securities and Exchange Commission such indemnification is against public policy as expressed in the Securities Act of 1933 and is, therefore, unenforceable, in the event that a claim for indemnification against such liabilities (other than the payment by the registrant of expenses incurred or paid by a director, officer or controlling person of the registrant in the successful defense of any action, suit or proceeding) is asserted by such director, officer or controlling person in connection with the securities being registered, the registrant will, unless in the opinion of its counsel the matter has been settled by controlling precedent, submit to a court of appropriate jurisdiction the question whether such indemnification by it is against public policy as expressed in the Act and will be governed by the final adjudication of such issue. SIGNATURES Pursuant to the requirements of Section 13 or 15(d) 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. FARAH INCORPORATED (Registrant) /s/ James C. Swaim James C. Swaim Principal Financial Officer Principal Accounting Officer Dated: January 28, 1994 Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant and in the capacities indicated on January 28, 1994. /s/ Richard C. Allender Richard C. Allender President and Chief Executive Officer, Director /s/ Christopher L. Carameros Christopher L. Carameros Director /s/ Sylvan Landau Sylvan Landau Director /s/ Edward J. Monahan Edward J. Monahan Director /s/ Timothy B. Page Timothy B. Page Director /s/ Byron H. Rubin Byron H. Rubin Director /s/ James C. Swaim James C. Swaim Executive Vice President, Chief Financial Officer and Director /s/ Thomas G. Wyman Thomas G. Wyman Director FARAH INCORPORATED AND SUBSIDIARIES REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS ON SUPPORTING SCHEDULES To the Shareholders of Farah Incorporated: We have audited in accordance with generally accepted auditing standards, the consolidated financial statements included in Farah Incorporated's annual report to shareholders incorporated by reference in this Form 10-K, and have issued our report thereon dated December 15, 1993. Our audits were made for the purpose of forming an opinion on those statements taken as a whole. Schedules II and X are the responsibility of the company's management and are presented for purposes of complying with the Securities and Exchange Commission's rules and are not part of the basic financial statements. These schedules have been subjected to the auditing procedures applied in the audits of the basic financial statements and, in our opinion, fairly state in all material respects the financial data required to be set forth therein in relation to the basic financial statements taken as a whole. /s/ Arthur Andersen & Co. ARTHUR ANDERSEN & CO. Dallas, Texas December 15, 1993 Schedule II FARAH INCORPORATED AND SUBSIDIARIES AMOUNTS RECEIVABLE FROM RELATED PARTIES, UNDERWRITERS, PROMOTERS AND EMPLOYEES OTHER THAN RELATED PARTIES YEARS ENDED NOVEMBER 5, 1993, NOVEMBER 6, 1992 AND OCTOBER 31, 1991 PART ONE OF SCHEDULE II TABLE: Balance at Year beginning ended Name of debtor of period 10/31/91 William F. Farah $ 100,708 11/6/92 - - 11/5/93 - - PART TWO OF SCHEDULE II TABLE: Deducted Year Amounts Amounts ended Additions Collectedwritten off 10/31/91 - 100,708 - 11/6/92 - - - 11/5/93 - - - PART THREE OF SCHEDULE II TABLE: Balance at end of period Year Not ended Current Current 10/31/91 - - 11/6/92 - - 11/5/93 - - Schedule X FARAH INCORPORATED AND SUBSIDIARIES SUPPLEMENTARY INCOME STATEMENT INFORMATION For years ended November 5, 1993, November 6, 1992 and October 31, 1991 November 5, November 6, October 31, 1993 1992 1991 (thousands of dollars) Amortization of intangible assets $ 200 489 592 Taxes other than income taxes and payroll taxes $ 843 934 1,096 Advertising $ 11,230 6,825 4,719 Neither royalties nor repairs and maintenance exceeded 1% of revenues in fiscal 1993. FARAH INCORPORATED AND SUBSIDIARIES FORM 10-K INDEX TO ATTACHED EXHIBITS (All Exhibits listed are on pages 17 through 113) Page Numbers Exhibit 3.2 Bylaws of Farah Incorporated Amended 18 and Restated as of September 1, 1993. Exhibit 10.3 Amended and Restated Employment Agreement 38 dated September 30, 1993. Exhibit 10.4 Amended and Restated Employment Agreement 47 dated September 30, 1993. Exhibit 10.5 Amended and Restated Employment Agreement 54 dated September 30, 1993. Exhibit 10.48 Deferred Compensation Agreement dated 62 July 30, 1993. Exhibit 10.49 Amendment No. 10 dated November 5, 1993 64 to Accounts Financing Agreement dated August 2, 1990 between Congress Financial Corporation (Southwest) and Farah U.S.A., Inc. Exhibit 13 Annual Report to Shareholders for Fiscal 83 Year 1993. Exhibit 22 Subsidiaries of Farah Incorporated. 112 Exhibit 24 Consent of Independent Public Accountants. 113

7431_1993.txt

7431

1993

Item 1. Business - ----------------- Armstrong World Industries, Inc. is a Pennsylvania corporation incorporated in 1891. The Company is a manufacturer of interior furnishings, including floor coverings, building products and furniture, which are sold primarily for use in the furnishing, refurbishing, repair, modernization and construction of residential, commercial and institutional buildings. It also manufactures various industrial and other products. In late 1989, most of the assets (primarily inventory and plant, property and equipment) of the Company's carpet operations and the Company's subsidiary, Applied Color Systems, Inc., were divested. Unless the context indicates otherwise, the term "Company" means Armstrong World Industries, Inc. and its consolidated subsidiaries. Industry Segments The company operates worldwide in four reportable segments: floor coverings, building products, furniture, and industry products. Floor coverings sales include resilient floors, ceramic tile, and accessories. - 3 - Note 2: Narrative Description of Business The Company manufactures and sells interior furnishings, including floor coverings (resilient flooring and all ceramic tile), building products, and furniture, and makes and markets a variety of specialty products for the building, automotive, textile, and other industries. The Company's activities extend worldwide. Floor Coverings The Company is a prominent manufacturer of floor coverings for the interiors of homes and commercial and institutional buildings, with a broad range of resilient flooring, ceramic tile for floors, walls and countertops, together with adhesives, installation and maintenance materials and accessories. Resilient flooring, in both sheet and tile form, is made in a wide variety of types, designs, and colors. Included are types of flooring that offer such features as ease of installation, reduced maintenance (no-wax), and cushioning for greater underfoot comfort. Ceramic products include glazed wall and floor tile and marble (a portion of which is imported) and glazed and unglazed ceramic mosaic tile, all featuring a range of designs and colors, as well as quarry tile, natural stone and related installation products. Floor covering products are sold to the commercial and residential market segments through wholesalers, retailers, and contractors, and to the hotel/motel and manufactured homes industries. Ceramic products also are sold through sales service centers operated by American Olean Tile Company, Inc. ("American Olean"), a wholly-owned subsidiary which manufactures and markets ceramic tile. Building Products A major producer of ceiling materials in the United States and abroad, the Company markets both residential and architectural ceiling systems. Ceiling materials for the home are offered in a variety of types and designs; most provide noise reduction and incorporate Company-designed features intended to permit ease of installation. These residential ceiling products are sold through wholesalers and retailers. Architectural ceiling systems, designed for use in shopping centers, offices, schools, hospitals, and other commercial and institutional structures, are available in numerous colors, performance characteristics and designs and offer characteristics such as acoustical control, rated fire protection, and aesthetic appeal. Architectural ceiling - 4 - materials and accessories, along with acoustical wall panels, are sold by the Company to ceiling systems contractors and to resale distributors. Furniture A wholly-owned subsidiary, Thomasville Furniture Industries, Inc., and its subsidiaries manufacture and market traditional and contemporary wood and upholstered furniture for use in dining rooms, bedrooms, living rooms, hotels/motels and other residential and commercial interior areas. Thomasville furniture is sold to retailers, contract accounts and government agencies. Thomasville also manufactures both assembled and ready-to-assemble furniture which is sold to retailers, wholesalers and contract accounts under the Armstrong name. In addition, it sells a line of imported furniture made by other producers. Industry Products The Company, including a number of its subsidiaries, makes and sells a variety of specialty products for the building, automotive, textile and other industries. These products include flexible pipe insulation sold for use in construction and in original equipment manufacture; gasket materials for new equipment and replacement use in the automotive, farm equipment, appliance, and other industries; textile mill supplies including cots and aprons sold to equipment manufacturers and textile mills; adhesives; and certain cork products. Industry products are sold, depending on type and ultimate use, to original equipment manufacturers, contractors, wholesalers, fabricators and end users. ----------------------------------- The principal raw materials used in the manufacture of the Company's products are synthetic resins, lumber, plasticizers, latex, mineral fibers and fillers, clays, starches, perlite, and pigments and inks. In addition, the Company uses a wide variety of other raw materials. Most raw materials are purchased from sources outside of the Company. The Company also purchases significant amounts of packaging materials for the containment and shipment of its various products. During 1993, adequate supplies of raw materials were available to all of the Company's industry segments. Customers' orders for the Company's products are mostly for immediate shipment. Thus, in each industry segment, the Company has implemented inventory systems, including its "just in time" inventory system, pursuant to which orders are promptly filled out of inventory on hand or the product is manufactured to meet the delivery date specified in the order. As a result, there historically has been no material backlog in any industry segment. The competitive position of the Company has been enhanced by patents on products and processes developed or perfected within the Company or obtained through acquisition. Although the Company considers that, in the aggregate, its patents constitute a valuable asset, it does not regard any industry segment as being materially dependent upon any single patent or any group of related patents. There is significant competition in all the industry segments in which the Company does business. Competition in each industry segment includes numerous active companies (domestic and foreign), with emphasis on price, product performance and service. In addition, with the exception of industrial and other products and services, product styling is a significant method of competition in the Company's industry segments. Increasing domestic competition from foreign producers is apparent in certain industry segments and actions continue to be taken to meet this competition. - 5 - The Company invested $117.6 million in 1993, $115.8 million in 1992, and $133.8 million in 1991 for additions to its property, plant and equipment. Research and development activities are important and necessary in assisting the Company to carry on and improve its business. Principal research and development functions include the development of new products and processes and the improvement of existing products and processes. Research and development activities are conducted principally at the Company's Innovation Center in Lancaster, Pennsylvania. The Company spent $59.5 million in 1993, $60.3 million in 1992, and $55.6 million in 1991 on research and development activities worldwide for the continuing businesses. The Company will incur capital expenditures in order to meet the new requirements of the Clean Air Act of 1990 and is awaiting the final promulgation of implementing regulations by various state agencies to determine the magnitude of additional costs and the time period over which they will be incurred. In 1993, the Company incurred capital expenditures of approximately $2.6 million for environmental compliance and control facilities and anticipates comparable annual expenditures for those purposes for the years 1994 and 1995. As with many industrial companies, the Company is involved in proceedings under the Comprehensive Environmental Response, Compensation and Liability Act ("Superfund"), and similar state laws at approximately 21 sites. In most cases, the Company is one of many potentially responsible parties ("PRPs") who have voluntarily agreed to jointly fund the required investigation and remediation of each site. With regard to some sites, however, the Company disputes either liability or the proposed cost allocation. Sites where the Company is alleged to have contributed a significant volume of waste material include a former municipal landfill site in Volney, New York; and a former county landfill site in Buckingham County, Virginia, which is alleged to have received material from Thomasville Furniture Industries, Inc. Armstrong may also have rights of contribution or reimbursement from other parties or coverage under applicable insurance policies. The Company is also remediating environmental contamination resulting from past industrial activity at certain of its current plant sites. Estimates of future liability are based on an evaluation of currently available facts regarding each individual site and consider factors including existing technology, presently enacted laws and regulations, and prior Company experience in remediation of contaminated sites. Although current law imposes joint and several liability on all parties at any Superfund site, the Company's contribution to the remediation of these sites is expected to be limited by the number of other companies which have also been identified as potentially liable for site costs. As a result, the Company's estimated liability reflects only the Company's expected share. In determining the probability of contribution, the Company considers the solvency of the parties, whether responsibility is being disputed, the terms of any existing agreements, and experience regarding similar matters. The estimated liabilities do not take into account any claims for recoveries from insurance or third parties, unless a coverage commitment has been provided by the insurer. Because of uncertainties associated with remediation activities and technologies, regulatory interpretations, and the allocation of those costs among various other parties, the Company has accrued $4.9 million to reflect its estimated liability for environmental remediation. As assessments and remediation activities progress at each individual site, these liabilities are reviewed to reflect additional information as it becomes available. - 6 - Actual costs to be incurred at identified sites in the future may vary from the estimates, given the inherent uncertainties in evaluating environmental liabilities. Subject to the imprecision in estimating environmental remediation costs, the Company believes that any sum it may have to pay in connection with environmental matters in excess of the amounts noted above would not have a materially adverse effect on its financial condition liquidity or results of operations. As of December 31, 1993, the Company had approximately 21,000 active employees, of whom approximately 4,150 are located outside the United States. Year-end employment in 1993 was below the level at the end of 1992. About 38% of the Company's approximately 11,950 hourly-paid employees in the United States are represented by labor unions. Geographic Areas United States net trade sales include export sales to non-affiliated customers of $27.0 million in 1993, $24.4 million in 1992, and $29.3 million in 1991. "Europe" includes operations located primarily in England, France, Germany, Italy, the Netherlands, Spain, and Switzerland. Operations in Australia, Canada, China, Hong Kong, Indonesia, Japan, Korea, Singapore, and Thailand are in "Other foreign." Transfers between geographic areas and commissions paid to affiliates marketing exported products are accounted for by methods that approximate arm's-length transactions, after considering the costs incurred by the selling company and the return on assets employed of both the selling unit and the purchasing unit. Operating profits of a geographic area include profits accruing from sales to affiliates. - 7 - Note 1: Identifiable assets for geographic areas and industry segments exclude cash, marketable securities, and assets of a corporate nature. Capital additions for industry segments include property, plant, and equipment from acquisitions. The Company's foreign operations are subject to foreign government legislation involving restrictions on investments (including transfers thereof), tariff restrictions, personnel administration, and other actions by foreign governments. In addition, consolidated earnings are subject to both U.S. and foreign tax laws with respect to earnings of foreign subsidiaries, and to the effects of currency fluctuations. Item 2.

Item 2. Properties - ------------------- The Company produces and markets its products and services throughout the world, operating 73 manufacturing plants in 11 countries, 56 of which are located throughout the United States. Additionally, affiliates operate eight plants in four countries. Floor covering products are produced at 23 plants with principal manufacturing facilities located in Lancaster and Lansdale, Pennsylvania. American Olean owns or leases various quarries throughout the United States for the supply of clays and shale. Under a long-term lease, a quarry in Newfoundland, Canada, also supplies a raw material important to American Olean's manufacture of glazed tile at a proven reserve level of approximately 50 years at current production levels. Building products are produced at 13 plants with principal facilities in Macon, Georgia, the Florida-Alabama Gulf Coast area and Marietta, Pennsylvania. Furniture is manufactured at 27 plants, 14 of which are located at Thomasville, North Carolina. Insulating materials, textile mill supplies, fiber gasket materials, adhesives and other products for industry are manufactured at 14 plants with principal manufacturing facilities at Munster, Germany, Braintree, Massachusetts and Fulton, New York. Numerous sales offices are leased worldwide, and leased facilities are utilized for American Olean's distribution centers and to supplement the Company's owned warehousing facilities. Productive capacity and extent of utilization of the Company's facilities are difficult to quantify with certainty because in any one facility maximum capacity and utilization varies periodically depending upon the product that is being manufactured and individual facilities manufacture more than one type of product. In this context, the Company estimates that the production facilities in each of its industry segments were effectively utilized during 1993 at 80% to 90% of overall productive capacity in meeting market conditions. Remaining productive capacity is sufficient to meet expected customer demands. - 8 - The Company believes its various facilities are adequate and suitable. Additional incremental investments in plant facilities are being made as appropriate to balance capacity with anticipated demand, improve quality and service, and reduce costs. Item 3.

Item 3. Legal Proceedings - -------------------------- The Company is named as one of many defendants in pending lawsuits and claims involving, as of February 28, 1994, approximately 72,125 individuals alleging personal injury from exposure to asbestos or asbestos-containing products. (In late 1993, the Company revised its claims handling procedures to provide for individual claim information to be supplied by the Center for Claims Resolution referred to below. The claim numbers have been received from the Center. A reconciliation is underway to match the Company claims with the Center's and the reconciliation will continue until completion. Since the reported data will be more current under the revised claims handling procedure, the data reflects a decrease from the past year in the number of outstanding claims.) A total of about 24,036 lawsuits and claims were received by the Company in 1993, compared with 28,997 in 1992. Nearly all the personal injury suits and claims allege general and punitive damages arising from alleged exposures, during a period of years, commencing during World War II onward into the 1970s, to asbestos- containing insulation products used, manufactured or sold by the companies involved in the asbestos-related litigation. Claims against the Company generally involve allegations of negligence, strict liability, breach of warranty and conspiracy with other defendants in connection with alleged exposure generally to asbestos-containing insulation products; the Company discontinued the sale of all such products in 1969. The first asbestos-related lawsuit was filed against the Company in 1970, and such lawsuits and claims continue to be filed against the Company. The claims generally allege that injury may be determined many years (up to 40 years) after alleged exposure to asbestos or asbestos-containing products. Nearly all suits include a number of defendants (including both members of the Center and other companies), and well over 100 different companies are reportedly involved as defendants in the litigation. A significant number of suits in which the Company does not believe it should be involved have been filed by persons engaged in vehicle tire production, aspects of the construction industry, and the steel industry. The Company believes that a large number of the plaintiffs filing suit are unimpaired individuals. Although a large number of suits and claims have either been put on inactive lists, settled, dismissed or otherwise resolved, and the Company is generally involved in all stages of claims resolution and litigation, including trials and appeals, and while the number of pending cases reflects a decrease during the past year, neither the rate of future dispositions nor the number of future potential unasserted claims can be reasonably predicted at this time. Attention has been given by various judges both individually and collectively to finding a comprehensive solution to the large number of pending as well as potential future asbestos-related personal injury claims. Discussions have been undertaken by attorneys for plaintiffs and defendants to devise methods or procedures for the comprehensive treatment of asbestos-related personal injury suits and claims. The Judicial Panel for Multi-district Litigation ordered the transfer of all federal cases not in trial to a single court, the Eastern District Court of Pennsylvania in Philadelphia, for pretrial purposes. The Company has supported such action. The Court to which the cases have been assigned has been instrumental in having the parties settle large numbers of cases in various jurisdictions and has been receptive to different approaches to the resolution of asbestos-related personal injury claims. A national class action was filed in the Eastern District of Texas; it was not certified and the cases involved were also transferred to the Eastern District Court of Pennsylvania for pretrial purposes. Periodically, this Court returns certain cases for trial to the courts from which the cases were originally transferred, although the issue of punitive damages is retained by the Eastern District Court. A settlement class action which includes essentially all future asbestos-related personal injury claims against members of the Center for Claims Resolution was filed in Philadelphia, in the Federal - 9 - District Court for the Eastern District of Pennsylvania on January 15, 1993. The proposed settlement class action was negotiated by the Center and two leading plaintiffs' law firms. The settlement class action is designed to establish a non-litigation system for the resolution of essentially all future asbestos-related personal injury claims against the Center members including this Company. Other defendant companies which are not Center members may be able to join the class action later. The class action proposes a voluntary settlement that offers a method for prompt compensation to claimants who were occupationally exposed to asbestos if they are impaired by such exposure. Claimants must meet certain exposure and medical criteria to receive compensation which is derived from historical settlement data. Under limited circumstances and in limited numbers, qualifying claimants may choose to litigate certain claims in court or through alternative dispute resolution, rather than accept an offered settlement amount, after their claims are processed within the system. No punitive damages will be paid under the proposed settlement. The settlement is designed to minimize transactional costs, including attorneys fees, and to relieve the courts of the burden of handling future asbestos-related personal injury claims. Each member of the Center has an obligation for its own fixed share in this proposed settlement. The settlement class action does not include asbestos-related personal injury claims which were filed before January 15, 1993, or asbestos-related property damage claims. Agreed upon annual case flow caps and agreed upon compensation ranges for each compensable medical category including amounts paid even more promptly under the simplified payment procedures,have been established for an initial period of ten years. Case flow caps may be increased during the second five-year period depending upon case flow during the first five-year period. The case flow figures and annual compensation levels are subject to renegotiation after the initial 10-year period. The Court has preliminarily approved the settlement, and notification has been provided to potential class members who were offered the opportunity to opt out by January 24, 1994. The Center had reserved the right to withdraw from the program if an excessive number of individuals opted out. The Center has determined that there is not an excessive number of opt outs and will proceed with the settlement class action. The opt outs are not asbestos-related claims as such but reservations of rights to possibly bring court actions in the future. The opt outs are currently the subject of a motion before the Court which questions the validity of most of the opt outs and seeks a further notice process to determine whether or not they wish to remain in the class action. Therefore, the total number of effective opt outs cannot be determined at this time. The Court is holding a final fairness hearing which began on February 22, 1994. The settlement will become final only after it has been approved by the Federal District Court and the federal appellate courts. The Center members have stated their intention to resolve over a five-year period the asbestos- related personal injury claims pending prior to the date the settlement class action was filed. A significant number of these pending claims have been settled with a number of plaintiffs' counsel and a number of these claims are currently the subject of settlement negotiations, in both instances, based upon historical averages. The Company is seeking agreement from its carriers or a ruling from the Court that the settlement class action will not jeopardize existing insurance coverage. Certain unresolved insurance coverage issues involving certain Center members' insurance carriers acceptance of the proposed settlement will be resolved either by alternative dispute resolution procedures in the case of the insurance carriers which subscribed to the Wellington Agreement referred to below, or by litigation against those carriers which did not subscribe to the Wellington Agreement. The Company believes that the future claimants settlement class action will be approved. However, the potential exists that either the Federal District Court or an appellate court will reject the settlement class action and that the above-referenced companion insurance action will not be successful. A few state judges and federal judges have undertaken to consolidate numbers of asbestos-related personal injury cases for trial. The Company has generally opposed as unfair the consolidation of numerous cases for trial. In 1992 in Baltimore, Maryland, the Center for Claims Resolution referred to herein settled during trial on behalf of the Company and other Center members certain asbestos- related personal injury claims. In most of the approximately 8,500 cases consolidated for trial, Armstrong was a named defendant. The multiphase Baltimore trial dealt with various issues including the individual claims of six plaintiffs, as well as product defect and negligence, and whether and on what basis punitive damages should be awarded. The Center for Claims Resolution is periodically drawing upon the Company's insurance assets to pay the settled individual claims. In 1983, three of the Company's four primary insurers entered into an Interim Agreement with the Company to provide defense and indemnity coverage on an interim basis for asbestos-related personal injury claims and for the defense of asbestos-related property damage claims which are described below. One - 10 - primary insurer did not enter into the Interim Agreement, but did subscribe to the Wellington Agreement as noted below. The Interim Agreement was superseded by the Wellington Agreement with respect to the coverage issues for asbestos- related personal injury claims. The one primary insurer of the four primary carriers that did not subscribe to the Wellington Agreement subsequently entered into a separate agreement with the Company resolving coverage issues for asbestos-related property damage claims and for asbestos-related personal injury claims which complements the Wellington Agreement. All of the Company's primary insurers are paying for the defense of asbestos-related property damage claims in accordance with the provisions of the Interim Agreement pending the final resolution on appeal of the coverage issues for asbestos-related property damage claims in the California insurance litigation referenced later in this note. The Company's insurance carriers providing coverage for asbestos-related claims are as follows: Reliance Insurance, Aetna Insurance and Liberty Mutual Insurance Companies are primary insurers that have subscribed to the Wellington Agreement. Travelers Insurance Company is a primary insurer that entered into a settlement agreement which complements Wellington. The excess insurers which subscribed to Wellington are Aetna Insurance Company, Fireman's Fund Insurance Company, Insurance Company of North America, Lloyds of London, Fidelity and Casualty Insurance Company, First State Insurance Company and U.S. Fire Insurance Company. Home Insurance Company and Travelers Insurance Company are excess insurers which entered into settlement agreements for coverage of personal injury claims which complement Wellington, and Great American is an excess insurer which also entered into a settlement agreement with the Company. The Company also entered into a settlement agreement with American Home Assurance Company and National Union Fire Insurance Company (known as the AIG Companies) which complements the Wellington Agreement. Other excess insurers against whom the Company has received a favorable trial and appellate court decision in the California insurance litigation described below are: Central National Insurance Company, Interstate Insurance Company, Puritan Insurance Company, CNA Insurance Company and Commercial Union Insurance Company. Midland Insurance Company, an excess carrier, which insured the Company with $25 million of coverage, became insolvent during the trial. The Company is pursuing claims with the state guaranty associations on account of the Midland insolvency and is currently exploring how the Midland Insurance Company insolvency gaps can be otherwise addressed by payments from the Company's other insurance carriers. Certain companies in the London block of coverage and certain carriers providing coverage at the excess level for property damage claims only have also become insolvent. In addition to the aforementioned insurance carriers, certain insurance carriers which were not included in the Company's California insurance litigation described later herein also provide insurance for asbestos-related property damage claims. The Company along with 52 other companies (defendants in the asbestos-related litigation and certain of their insurers) signed the 1985 Agreement Concerning Asbestos-Related Claims (the "Wellington Agreement"). This Agreement provided for a final settlement of nearly all disputes concerning insurance for asbestos- related personal injury claims between the Company and three of its primary insurers and seven of its excess insurers which also subscribed to the Wellington Agreement. The one primary insurer that did not sign the Wellington Agreement had earlier entered into the Interim Agreement with the Company and had paid into the Wellington Asbestos Claims Facility (the "Facility"). The Wellington Agreement provides for those insurers to indemnify the Company up to the policy limits for claims that trigger policies in the insurance coverage period, and nearly all claims against the Company fall within the coverage period; both defense and indemnity are paid under the policies and there are no deductibles under the applicable Company policies. The Wellington Agreement addresses both products and non-products coverage. One of the Company's larger excess insurance carriers entered into a settlement agreement in 1986 with the Company under which payments also were made through the Facility and are now being paid through the Center for Claims - 11 - Resolution referenced below in this note. Coverage for asbestos-related property damage claims was not included in the settlement, and the agreement provides that either party may reinstitute a lawsuit in the event the coverage issues for property damage claims are not amicably resolved. In 1987, an excess insurer also made, under reservation of rights, certain payments which were processed through the Facility. These payments were made under reservation because no settlement of the outstanding coverage issues has been effected with that carrier. The Wellington Agreement also provided for the establishment of the Facility to evaluate, settle, pay and defend all pending and future asbestos-related personal injury claims against those companies which subscribed to the Agreement. The insurance coverage designated by the Company for coverage in the Facility consists of all relevant insurance policies issued to the Company from 1942 through 1976. Liability payments and allocated expenses with respect to each claim filed against Wellington Agreement subscribers who were defendants in the underlying asbestos-related personal injury litigation were allocated on a formula percentage basis to each such defendant, including the Company. The Facility, which has dissolved, over time was negatively impacted by concerns raised by certain subscribers relating to their share of liability payments and allocated expenses and by certain insurer concerns with respect to defense costs and Facility operating expenses. As a result of seven subscribing companies giving notice that they wished to withdraw their cases from the Facility, a majority of the insurers and the company subscribing members agreed to dissolve the ongoing operation of the Facility as of October 3, 1988 and the Facility has now been fully dissolved. Except for eliminating the future availability of an insurer-paid special defense fund benefit linked to the existence of the Facility, a benefit not deemed material to the Company, the dissolution of the Facility essentially did not affect the Company's overall Wellington Agreement insurance settlement, which stood on its own separate from the Facility. The relinquishment of the insurer-paid special defense fund benefit was a condition of insurer support for the creation of the Center and its expected benefits. A new asbestos-related personal injury claims handling organization known as the Center for Claims Resolution (the "Center") was created in October 1988 by Armstrong and 20 other companies, all of which were former members of the Facility. Insurance carriers are not members of the Center, although certain of the insurance carriers for those members that joined the Center signed an agreement to provide approximately 70% of the financial support for the Center's operational costs during its first year of existence; they also are represented ex officio on the Center's governing board. The Center adopted many of the conceptual features of the Facility, and the members' insurers generally provide coverage under the Wellington Agreement terms. The Center has operated under a revised concept of allocated shares of liability payments and defense costs for its members based primarily on historical experience and has defended the members' interests and addressed the claims in a manner consistent with the prompt, fair resolution of meritorious claims. In late 1991, the Center sharing formula was revised to provide that members will pay only on claims in which the member is a named defendant. This change has caused a slight increase in the Company's share, but has enhanced the Company's case management focus. Future claim payments by the Center pursuant to the proposed settlement class action will require each member to pay its own fixed share. A large share member earlier withdrew from the Center. Accordingly, the allocated shares of liability payments and defense costs of the Center were recalculated with the remaining members' shares being increased. Under the class action settlement resolution, if a member withdraws from the Center or the settlement, the shares of those remaining members would not be increased. It is expected that the Center members will reach an agreement with the insurers relating to the continuing operation of the Center and that the insurers' will fund the Center's operating expenses for its sixth year of operation. With the filing of the settlement class action, the Center will continue to process pending claims and will handle the program for processing future claims if the settlement class action is approved by the courts. - 12 - Consistent with the Center's objective of prompt resolution of meritorious claims, and to establish the Center's credibility after the cessation of the Facility and for other strategic reasons, a planned increase in claims resolution by the Center was implemented during the first two years. This increased the rate of utilization of Company insurance for claims resolution, offset in part by savings in defense costs. During the first three years, the rate of claims resolution had about trebled from the prior two years of experience. An increase in the utilization of the Company's insurance also will occur as a result of the class action settlement due to the commitment to attempt to resolve pending claims within five years. Aside from the commitments under the class action settlement, no forecast can be made for future years regarding either the rate of claims or the rate of pending and future claims resolution by the Center or the rate of utilization of Company insurance. If the settlement class action is finally approved, projections of the rate of disposition of future cases may be made and the rate of insurance usage will be accelerated as an effort is made to resolve both outstanding cases and address future claims. The Company is also one of many defendants in a total of 73 pending lawsuits and claims, including class actions, as of February 28, 1994, brought by public and private entities, including public school districts and public and private building owners. These lawsuits and claims include allegations of damage to buildings caused by asbestos-containing products and generally claim compensatory and punitive damages and equitable relief, including reimbursement of expenditures, for removal and replacement of such products. They appear to be aimed at friable (easily crumbled) asbestos-containing products, although allegations in some suits encompass all asbestos-containing products, including allegations with respect to asbestos-containing resilient floor covering materials. Class actions have been certified involving four distinct classes of building owners: public and private schools; Michigan state public and private schools; colleges and universities, and private property owners who leased facilities to the federal government. Subject to fairness hearings, resolution has been reached with the class representatives for the national public and private schools class action as well as with the class representatives for the private property owners who leased facilities to the federal government. The Company vigorously denies the validity of the allegations against it contained in these suits and claims. Increasing defense costs, paid by the Company's insurance carriers either under reservation or settlement arrangement, will be incurred. As a consequence of the California insurance litigation discussed elsewhere in this note, the Company believes that it is probable that costs of the property damage litigation that are being paid by the Company's insurance carriers under reservation of rights will not be subject to recoupment. These suits and claims were not handled by the former Facility nor are they being handled by the Center. Certain co-defendant companies in the asbestos-related litigation have filed for reorganization under Chapter 11 of the Federal Bankruptcy Code. As a consequence, this litigation with respect to these co-defendants (with several exceptions) has been stayed or otherwise impacted by the restrictions placed on proceeding against these co-defendants. Due to the uncertainties involved, the long-term effect of these Chapter 11 proceedings on the litigation cannot be predicted. The Company concluded in early 1989 the trial phase of a coordinated lawsuit in a California state court to resolve a dispute concerning certain of its insurance carriers' obligations with respect to insurance coverage for alleged - 13 - personal injury and property damage asbestos-related lawsuits and claims. The trial court issued favorable final decisions in important phases of the trial relating to coverage for personal injury and property damage lawsuits and claims. The Company earlier dismissed from the asbestos-related personal injury coverage portion of the litigation those insurance carriers which had subscribed to the Wellington Agreement, and the excess carriers which entered into a settlement agreement with the Company which complements Wellington also have been dismissed. As indicated above, the California trial court issued final decisions in various phases in the insurance lawsuit. One decision concluded that the trigger of insurance coverage for asbestos-related personal injury claims was continuous from exposure through death or filing of a claim. The court also found that a triggered insurance policy should respond with full indemnification up to exhaustion of the policy limits. The court concluded that any defense obligation ceases upon exhaustion of policy limits. Although not as comprehensive, another important decision in the trial established a favorable defense and indemnity coverage result for asbestos-related property damage claims; the final decision holds that, in the event the Company is held liable for an underlying property damage claim, the Company would have coverage under policies in effect during the period of installation and during any subsequent period in which a release of fibers occurred. Appeals were filed from the trial court's final decision by those carriers still in the litigation and the California Court of Appeal has substantially upheld the trial court's final decisions. The insurance carriers have petitioned the California Supreme Court to hear the various asbestos-related personal injury and property damage coverage issues. The California Supreme Court recently accepted review pending its review of related issues in another California case. Based upon the trial court's favorable final decisions in important phases of the trial relating to coverage for asbestos-related personal injury and property damage lawsuits and claims, including the favorable decision by the California Court of Appeal, and a review of the coverage issues by its trial counsel, the Company believes that it has a substantial legal basis for sustaining its right to defense and indemnification. After concluding the last phase of the trial against one of its primary carriers, which is also an excess carrier, the Company and the carrier reached a settlement agreement on March 31, 1989. Under the terms of the settlement agreement, coverage is provided for asbestos-related bodily injury and property damage claims generally consistent with the interim rulings of the California trial court and complements the coverage framework established by the Wellington Agreement. The parties also agreed that a certain minimum and maximum percentage of indemnity and allocated expenses incurred with respect to asbestos-related personal injury claims would be deemed allocable to non- products claims coverage and that the percentage amount would be negotiated between the Company and the insurance carrier. These negotiations continue. The Company also settled both asbestos-related personal injury and property damage coverage issues with a small excess carrier and in 1991 settled those same issues with a larger excess carrier. In these settlements, the Company and the insurers agreed to abide by the final judgment of the trial court in the California insurance litigation with respect to coverage for asbestos-related claims. Non-products claims coverage insurance is available under the Wellington Agreement (and the previously-referenced settlement agreement with one primary carrier) for such claims. Certain excess policies also provide non-products coverage. Non-products claims include claims that may have arisen out of exposure during installation of asbestos materials or before control of such materials has been relinquished. Negotiations have been undertaken with the Company's primary insurance carriers and are currently underway with several of them to categorize the percentage of previously resolved and to be resolved asbestos-related personal injury claims as non-products claims and to establish the entitlement to such - 14 - coverage. The additional coverage potentially available to pay claims categorized as non-products, at both the primary and excess levels, is substantial, and at the primary level, includes defense costs in addition to limits. No agreement has been reached with the primary carriers on the amount of non-products coverage attributable to claims that have been disposed of or the type of claims that should be covered by non-products insurance. One of the primary carriers alleges that it is no longer bound by the Wellington Agreement and one primary carrier seemingly takes the view that the Company verbally waived certain rights regarding non-products coverage against that carrier at the time the Wellington Agreement was signed. All the carriers presumably raise other reasons why they should not pay their coverage obligations. The Company is entitled to pursue alternative dispute resolution proceedings against the primary and certain excess carriers to resolve the non- products coverage issues. ACandS, Inc., a former subsidiary of the Company, which for certain insurance periods has coverage rights under some insurance policies, and has accessed such coverage on the same basis as the Company, was a subscriber to the Wellington Agreement, but was not a subscriber to the Center. ACandS, Inc. had filed a lawsuit against the Company to partition certain insurance policies and for an accounting. It sought to have a certain amount of insurance from the joint policies reserved solely for its use in the payment of defense and indemnity costs for asbestos-related claims. The two companies have negotiated a settlement of their dispute and have signed a settlement agreement. Based upon the Company's experience with this litigation and its disputes with insurance carriers, a reserve was recorded in June 1983 to cover estimated potential liability and settlement costs and legal and administrative costs not covered under the Interim Agreement, cost of litigation against the Company's insurance carriers, and other factors involved in the litigation which are referred to herein about which uncertainties exist. As a result of the Wellington Agreement, the reserve was earlier reduced for that portion associated with pending personal injury suits and claims. As a result of the March 31, 1989, settlement referenced above, the Company received $11.0 million, of which approximately $4.4 million was credited to income with nearly all of the balance being recorded as an increase to its reserve for potential liabilities and other costs and uncertainties associated with the asbestos- related litigation. Future costs of litigation against the Company's insurance carriers and other legal costs indirectly related to the litigation will be expensed outside the reserve. The Company does not know how many claims will be filed against it in the future, nor the details thereof or of pending suits not fully reviewed, nor the expense and any liability that may ultimately result therefrom, nor does the Company know whether the settlement class action will ultimately succeed, nor the annual claims flow caps to be negotiated after the initial 10-year period for the settlement class action or the then compensation levels to be negotiated for such claims or the success the Company may have in addressing the Midland Insurance Company insolvency with its other insurers. Subject to the foregoing and based upon its experience and other factors referred to elsewhere in this note, the Company believes that it is probable that substantially all of the expenses and any liability payments associated therewith within the framework of the class action settlement and the initial ten-year period thereof will be paid--in the case of the personal injury claims, by agreed-to coverage under the Wellington Agreement and by payments by nonsubscribing insurers that entered into settlement agreements with the Company and additional insurance coverage reasonably anticipated from the outcome of the insurance litigation and from the Company's claims for non-products coverage both under certain insurance policies covered by the Wellington Agreement and under certain insurance policies not covered by the Wellington Agreement which claims have yet to be accepted by the carriers--and in the case of the asbestos- related property damage claims, under an existing interim agreement, by insurance coverage settlement agreements and through additional coverage reasonably anticipated from the outcome of the insurance litigation. Accordingly, the Company believes that it is probable that charges to expense associated with such suits and claims should not be significant. Even though uncertainties still remain as to the potential number of unasserted claims, liability resulting therefrom, and the ultimate scope of its insurance coverage, after consideration of the factors involved, including the Wellington Agreement, the referenced settlements with other insurance carriers, the results of the trial phase and the first level appellate stage - 15 - of the California insurance coverage litigation, the remaining reserve, the establishment of the Center, the proposed settlement class action, and its experience, the Company believes the asbestos-related lawsuits and claims against the Company will not have a material adverse effect on its earnings or financial position. ------------------------------- In 1984, suit was filed against the Company in the U. S. District Court for the District of New Jersey (the "Court") by The Industry Network System (TINS), a producer of video magazines in cassette form, and Elliot Fineman, a consultant (Fineman and The Industry Network System, Inc. v. Armstrong World Industries, - ----------------------------------------------------------------------------- Inc., C.A. No. 84-3837 JWB). At trial, TINS claimed, among other things, that - -------------------------- the Company had improperly interfered with a tentative contract which TINS had with an independent distributor of the Company's flooring products and further claimed that the Company used its alleged monopoly power in resilient floor coverings to obtain a monopoly in the video magazine market for floor covering retailers in violation of federal antitrust laws. The Company denied all allegations and continues to do so. On April 19, 1991, after a three-month trial, the jury rendered a verdict in the case, which as entered by the court in its order of judgment, awarded the plaintiffs the alternative, after all post- trial motions and appeals were completed, of either their total tort claim damages (including punitive damages), certain pre-judgment interest, and post- judgment interest or their trebled antitrust claim damages, post-judgment interest and attorneys fees. The higher amount awarded to the plaintiffs as a result of these actions totaled $224 million in tort claim damages and pre- judgment interest, including $200 million in punitive damages. On June 20, 1991, the Court granted judgment for the Company notwithstanding the jury's verdict, thereby overturning the jury's award of damages and dismissing the plaintiffs' claims with prejudice. Furthermore, on June 25, 1991, the Court ruled that, in the event of a successful appeal restoring the jury's verdict in the case, the Company would be entitled to a new trial on the matter. On October 28, 1992, the United States Court of Appeals for the Third Circuit issued an opinion in Fineman v. Armstrong World Industries, Inc. (No. 91-5613). ------------------------------------------- The appeal was taken to the Court of Appeals from the two June 1991 orders of the United States District Court in the case. In its decision on the plaintiff's appeal of these rulings, the Court of Appeals sustained the U. S. District Court's decision granting the Company a new trial, but overturned in certain respects the District Court's grant of judgment for the Company notwithstanding the jury's verdict. The Court of Appeals affirmed the trial judge's order granting Armstrong a new trial on all claims of plaintiffs remaining after the appeal; affirmed the trial judge's order granting judgment in favor of Armstrong on the alleged actual monopolization claim; affirmed the trial judge's order granting judgment in favor of Armstrong on the alleged attempt to monopolize claim; did not disturb the District Court's order dismissing the alleged conspiracy to monopolize claim; affirmed the trial judge's order dismissing all of Fineman's personal claims, both tort and antitrust; and affirmed the trial judge's ruling that plaintiffs could not recover the aggregate amount of all damages awarded by the jury and instead must elect damages awarded on one legal theory. However, the Third Circuit, contrary to Armstrong's arguments: reversed the trial judge's judgment for Armstrong on TINS's claim for an alleged violation of Section 1 of the Sherman Act; reversed the trial judge's judgment in favor of Armstrong on TINS's claim for tortious interference; reversed the trial judge's judgment in favor of Armstrong on TINS's claim for punitive damages; and reversed the trial judge's ruling that had dismissed TINS's alleged breach of contract claim. - 16 - The Court of Appeals, in affirming the trial court's new trial order, agreed that the trial court did not abuse its discretion in determining that the jury's verdict was "clearly against the weight of the evidence" and that a new trial was required due to the misconduct of plaintiffs' counsel. The foregoing summary of the Third Circuit's opinion is qualified in its entirety by reference thereto. The Court of Appeals granted the Company's motion to stay return of the case to the District Court pending the Company's Petition for Certiorari to the Supreme Court appealing certain antitrust rulings of the Court of Appeals. The Company was informed on February 22 that the Supreme Court denied its Petition. The case has been remanded by the Third Circuit Court of Appeals in Philadelphia to the U. S. District Court in Newark, New Jersey, and a new trial has been set for late April 1994. It is unknown what damage claims TINS will be permitted upon retrial of the case. But during the first trial, claims for actual damages of at least $17.5 million were asserted by plaintiffs' expert and even greater amounts were asserted by Mr. Fineman. Under the antitrust laws, proven damages are trebled. In addition, plaintiff would likely ask for punitive damages, companion to its request for tort damages. Other damages which would likely be sought include reimbursement of attorneys' fees and interest, including prejudgment interest. The Company denies all of TINS's claims and accordingly is vigorously defending the matter. In the event that a jury finds against the Company, such jury verdict could entail unknown amounts which, if sustained, could have a material adverse effect on its earnings and financial position. -------------------- As previously discussed on pages 6 and 7, with regard to a former county landfill in Buckingham County, Virginia, Thomasville Furniture Industries, Inc., and seven other parties have been identified by the U.S. Environmental Protection Agency ("USEPA") as potentially responsible parties ("PRPs") to fund the cost of remediating environmental conditions at this federal Superfund site. After review of investigative studies to determine the nature and extent of contamination and identify various remediation alternatives, USEPA issued its Proposed Remedial Action Plan in May 1993 proposing a $21 million clean-up cost. In November 1993, however, USEPA issued a revised plan which recommended a reduced $3.5 million alternative, subject to additional costs depending on test results. The PRPs believe that other alternatives are appropriate and discussions with USEPA and Virginia State officials continue. Spent finishing materials from Thomasville's Virginia furniture plants at Appomattox and Brookneal allegedly comprise a significant portion of the waste presently believed to have been taken to the site by a now defunct disposal firm in the late 1970s. Accordingly, Thomasville could be called upon to fund a significant portion of the eventual remedial costs. - 17 - Item 4.

Item 4. Submission of Matters to a Vote of Security Holders - ------------------------------------------------------------ Not applicable. Executive Officers of the Registrant - ------------------------------------- The information appearing in Item 10 hereof under the caption "Executive Officers of the Registrant" is incorporated by reference herein. PART II ------- Item 5.

Item 5. Market for the Registrant's Common Stock and Related Security Holder - ----------------------------------------------------------------------------- Matters ------- The Company's Common Stock is traded on the New York Stock Exchange, Inc., the Philadelphia Stock Exchange, Inc., and the Pacific Stock Exchange, Inc. As of January 28, 1994, there were approximately 7,876 holders of record of the Company's Common Stock. - 18 - Item 6.

Item 6. Selected Financial Data - --------------------------------- - -------------------------------------------------------------------------------- EIGHT - YEAR SUMMARY - -------------------------------------------------------------------------------- - 19 - Notes: (a) After deducting preferred dividend requirements and adding the tax benefits for unallocated shares. (b) See definition of fully diluted earnings per share on page 38. (c) Total debt includes short-term debt, current installments of long-term debt, long-term debt, and ESOP loan guarantee. Total capital includes total debt and total shareholders' equity. (d) Includes one trustee who is the shareholder of record on behalf of approximately 4,300 employees in 1993, 4,500 employees in 1992, 4,600 employees in 1991, 4,500 employees in 1990, 4,700 employees in 1989, and 4,400 employees in 1988 who have beneficial ownership through the company's retirement savings plans. (e) Includes, for 1987 and 1986, a trustee who was the shareholder of record on behalf of approximately 11,000 employees who obtained beneficial ownership through the Armstrong Stock Ownership Plan, which was terminated at the end of 1987. - 20 - Item 7.

Item 7. Management's Discussion and Analysis of Financial Condition and - ------------------------------------------------------------------------- Results of Operations --------------------- 1993 compared with 1992 Financial condition As shown on the Consolidated Statements of Cash Flows, net cash provided by operating activities in 1993 was $291.2 million which was more than sufficient to cover investments in property, plant, and equipment and dividends. The excess cash, plus cash proceeds from the sale of assets and the decrease in cash and cash equivalents, was used to reduce debt by $124.1 million. For 1993, the company recorded an $89.9 million charge before tax ($60.0 million after tax) for restructuring resulting from 1993 decisions associated with major process improvements and significant organizational changes recommended by the teams of project PATH (a company initiative announced in August 1993 to strengthen its global competitiveness). Approximately 80% of the before-tax losses were related to charges for severance and special retirement incentives associated with the elimination of employee positions, and approximately one-third of the before-tax loss represented future cash outlays. Most of the cash outlays are expected to occur in 1994 and to be offset by operating savings. The operating cash savings, resulting from restructuring actions taken during 1993 and 1992, more than offset the 1993 cash outlays of $39.3 million for restructuring. During the fourth quarter of 1993, the company terminated, prior to maturity, interest rate swaps totaling $100 million, and currency swaps totaling $37.2 million. Working capital was $204.1 million as of December 31, 1993--$37.0 million higher than the $167.1 million at year-end 1992. The primary reason for the increase in working capital was the repayment of short-term debt. Accounts receivable and inventories declined $19.1 million and $33.2 million, respectively, both reflecting reductions in most business units with half of the reductions attributed to the European building products business. A financing arrangement of a foreign subsidiary's principal pension plan, whereby the subsidiary became self-insured for its pension obligations, resulted in recording a noncurrent asset and long-term liability of $37.7 million (see page 42). The company's 1993 year-end ratio of current assets to current liabilities was 1.47 to 1, compared with 1.31 to 1 ratio reported in 1992. The 1993 and 1992 year-end ratio of total debt to total capital was 52.2% and 57.2%, respectively. The company is involved in significant asbestos-related litigation which is described more fully under "Litigation" on pages 60-64 and which should be read in connection with this discussion and analysis. The company does not know how many claims will be filed against it in the future, nor the details thereof or of pending suits not fully reviewed, nor the expense and any liability that may ultimately result therefrom, nor does the company know the annual claims flow caps to be negotiated after the initial 10-year period for the settlement class action or the then compensatory levels to be negotiated for such claims or the success the company may have in addressing the Midland Insurance Company insolvency with its other insurers. Subject to the foregoing and based upon its experience and other factors, the company believes that it is probable that substantially all of the expenses and any liability payments associated therewith will be paid--in the case of the personal injury claims, by agreed-to coverage under the Wellington Agreement and supplemented by payments by non- subscribing insurers that entered into settlement agreements with the company and additional insurance coverage reasonably anticipated from the outcome of the insurance litigation and from the company's claims for non-products coverage both under certain insurance policies covered by the Wellington Agreement and under certain insurance policies not covered by the Wellington Agreement which claims have yet to be accepted by the carriers--and in the case of the asbestos- related property damage claims, under - 21 - an existing interim agreement, by insurance coverage settlement agreements and through additional coverage reasonably anticipated from the outcome of the insurance litigation. To the extent that costs of the property damage litigation are being paid by the company's insurance carriers under reservation of rights, the company believes that it is probable that such payments will not be subjected to recoupment. Thus, the company has not recorded any liability for any defense costs or indemnity relating to these lawsuits other than a reserve in "Other long-term liabilities" for the estimated potential liability associated with claims pending and intended to cover potential liability and settlement costs, legal and administrative costs not covered under the agreements, and certain other factors which have been involved in the litigation about which uncertainties exist. Even though uncertainties still remain as to the potential number of unasserted claims, the liability resulting therefrom, and the ultimate scope of its insurance coverage, after consideration of the factors involved, including the Wellington Agreement, the settlements with other insurance carriers, the results of the trial phase and the first level appellate stage of the California insurance litigation, the remaining reserve, the establishment of the Center for Claims Resolution, the proposed settlement class action, and its experience, the company believes that this litigation will not have a material adverse effect on its earnings, liquidity, or financial position. The accounting treatment for the Company's asbestos-related personal injury litigation will be affected by changes in accounting practices required by the Financial Accounting Standards Board Interpretation Number 39 (FIN 39) and the Securities and Exchange Commission Staff Accounting Bulletin No. 92 (SAB 92). FIN 39, which is effective beginning in 1994, does not permit offsetting unless a right of set off exists. Historically, the Company has been following the practice of offsetting the liability for asserted claims with expected insurance coverage. The Company intends to reflect the required changes in its first quarter 1994 Form 10-Q and, therefore, will record a liability for asbestos-related personal injury claims and an asset for insurance coverage deemed probable. Reference is made to the litigation involving The Industry Network System, Inc. (TINS), discussed on pages 64-65. The company denies all of TINS' claims and accordingly is vigorously defending the matter. In the event that a jury finds against the company, such jury verdict could entail unknown amounts which, if sustained, could have a material adverse effect on its earnings and financial position. Reference is also made to environmental issues as discussed on pages 51, 52, and 61. The company believes any sum it may have to pay in connection with environmental matters in excess of amounts accrued would not have a material adverse effect on its financial condition, liquidity, or results of operations. Long-term debt, excluding the company's guarantee of the ESOP loan, was reduced by $9.8 million in 1993. At year-end 1993, long-term debt represented 45% of shareholders' equity compared with 47% at the end of 1992. Should a need develop for additional financing, it is management's opinion that the company has sufficient financial strength to warrant the required support from lending institutions and financial markets. - 22 - Consolidated results Net sales in 1993 of $2.53 billion decreased 1.0% compared with 1992 sales of $2.55 billion. The weaker European exchange rates were a key factor in the sales decline. Translating foreign currency sales to U.S. dollars at 1992 exchange rates would have resulted in a year-to-year sales increase of 1.9%. Armstrong's residential markets were very positive in the U.S., but the weakness in the European economies and the lackluster commercial markets worldwide reduced the overall opportunity. While sales in the first two quarters of 1993 were lower than the comparable 1992 quarters, third and fourth quarter sales did exceed those of the prior year. Net earnings were $63.5 million compared with a net loss in 1992 of $227.7 million. Net earnings per common share were $1.32 on a primary basis and $1.26 on a fully diluted basis. The net loss per share of common stock was $6.49 on both a primary and fully diluted basis for 1992. The return on common shareholders' equity in 1993 was 9.0% compared with a negative 33.9% in 1992. The 1992 loss reflects charges of $167.8 million after tax related to the company's adoption, retroactive to January 1, 1992, of SFAS 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions;" and SFAS 112, "Employers' Accounting for Postemployment Benefits." The computation of SFAS 112 was refined during 1993 with the net loss in 1992 being reduced and restated by $6.5 million or 18 cents per share. The restated 1992 net loss from continuing businesses totaled $59.9 million, or a $1.98 loss per share of common stock. The effective tax rate for 1993 was 30.0%. This reflects the company's higher use of foreign tax credits, reductions of deferred taxes because some foreign countries reduced their statutory tax rates, and lower foreign tax rates, which more than offset the 1% increase in the U.S. statutory tax rate. The net loss from 1992 included an effective tax benefit rate of only 1.0%, primarily because some of the restructuring charges did not provide tax benefits. The company also adopted SFAS 109, "Accounting for Income Taxes," resulting in tax benefits of $5.5 million for 1992 being credited directly to retained earnings rather than to income taxes on the consolidated statement of earnings. Restructuring charges for 1993, totaling $89.9 million before tax, were included in the earnings from continuing businesses and were associated with Armstrong initiatives to enhance its global competitiveness. These costs are primarily associated with the elimination of employee positions in the U.S. and Europe. For the full year 1992, restructuring charges totaled $165.5 million before tax and related to the closing of four major manufacturing plants; the scaling back of operations in certain other plants in the U. S. and abroad; accruals for costs associated with the elimination of positions throughout the rest of the company; as well as write-downs of the value of land, buildings, equipment, and intangible assets of the company. Cash outlays for the 1993 restructuring charges will occur primarily throughout 1994 and should be fully recovered within two to three years. - 23 - The cost of goods sold for 1993, when expressed as a percent of sales, was 71.4%--the lowest level for the last four years--and compares favorably with 1992's cost of goods sold of 74.1%. These lower costs reflect the positive effects of the 1992 restructuring activities, productivity gains, some pricing increases, and product mix enhancements. Interest expense was favorably affected by lower debt levels and lower interest accruals for tax obligations. Miscellaneous income and expense in 1993 included the positive effects of lower amortization of acquired intangibles as a result of the 1992 restructuring, profits resulting from the closing out of some interest rate swaps in anticipation of interest rate increases, and gain on sale of assets. Partially offsetting these positive effects were some increased environmental expenses and a small foreign exchange loss in 1993 compared with a small foreign exchange gain in 1992. Geographic area results (see pages 7 and 8) United States--Sales increased by nearly 4% from 1992 levels. The 1992 net sales included five months of the building products segment's grid sales that were made prior to the formation of the Armstrong and Worthington Industries joint venture (WAVE) effective June 1, 1992. Removing these sales from 1992 would result in an additional 1% increase in the year-to-year sales comparison. Operating profits jumped 251% when comparing 1993 with those of 1992. The continuing economic recovery provided increased opportunity in our end-use markets. During 1993, single family housing starts increased 6% and the sale of existing single family homes rose nearly 8%. Nonresidential new construction appeared to be close to the bottom of its cycle. A major source of higher sales in 1993 was the significant increase in business channeled through national home centers and mass merchandisers. These sales, coupled with the stronger resilient flooring business, were major factors in generating significantly higher operating profits. The furniture and ceramic tile businesses also generated higher sales, while sales in the building products and textile products businesses were lower. The operating profit improvements were also driven by the 1992 restructuring activities that resulted in lower manufacturing costs in most domestic businesses, by some higher sales levels, and by continuing productivity improvements. Operating profits for both years included significant restructuring charges. The 1993 and 1992 restructuring charges total about $37 million and $98 million, respectively. The 1993 restructuring charges were primarily attributable to position eliminations. The 1992 restructuring charges included closing two plants, the write-down of fixed assets, and the elimination of employee positions. Export sales of Armstrong products from the U.S. to trade customers increased nearly $3 million, or 11%, compared with 1992. Europe--The 1993 European economic environment continued to be weak in both the commercial and residential markets; however, the British market offered some improvement for Armstrong products. Net sales decreased 16%, but two-thirds of the decline reflected the weakening of European currencies. Excluding the impact of the strong U.S. dollar, insulation products was the only business in Europe that recorded a year-to-year sales increase. The European building products business relies entirely on commercial construction and had the largest decline, nearly 12%. Even with lower sales, operating profits for Europe improved 41%. This improvement was primarily the result of lower costs caused by restructuring actions taken in the latter part of 1992, including the closing of the Ghlin, Belgium, ceilings manufacturing facility. Other foreign--Sales in 1993 declined nearly 4% from those of 1992. Operating profits were recorded for 1993 compared with an operating loss in 1992. The 1992 operating loss resulted from restructuring charges associated with the closing of the Gatineau, Canada, ceilings manufacturing plant. The overall sales decline was a result of lower sales of resilient flooring in Japan and Southeast Asia that were partially offset by higher sales of flooring in Australia and Canada and of building products in the Pacific Rim. Excluding the impact of the restructuring charges in 1992, operating profit for 1993 increased in the year- to-year comparison. Industry segment results (see pages 3 and 4) Floor coverings--Worldwide sales were 5% higher in 1993 than in 1992, with operating profits increasing threefold from 1992 levels. The operating profit included restructuring charges in 1993 of almost $28 million compared with nearly $81 million in 1992. Almost three-fourths of the 1993 restructuring charges were related to ceramic tile with the remainder recorded in resilient flooring. Nearly all of the 1992 restructuring charges related to ceramic tile. Sales in the resilient flooring portion increased in North America but were lower in the European and Pacific areas. The North American increase was driven by sales in the U.S. market with strong growth through national account home centers and mass merchandisers as well as modest growth through wholesalers. The U.S. resilient flooring business was also helped by higher sales of existing homes and new housing construction. Ceramic tile recorded a modest sales increase primarily because of its residential business. The commercial institutional market for ceramic tile continued to be weak, providing little sales growth in 1993 compared with 1992. - 24 - Operating profits, excluding the effects of restructuring charges, increased 42%. Resilient flooring operating profits improved because of the higher sales levels and because of significantly lower manufacturing costs that were achieved by process improvement and productivity gains. Ceramic tile continued to record a loss in 1993 as it did in 1992, but the losses were less in each of the 1993 quarters when compared with 1992. The ceramic tile business was adversely affected by very competitive pricing and a shift in product mix to lower margin products. Capital investments for 1993 were higher than those of 1992 with continued concentration of these expenditures in improving and maintaining the current manufacturing processes and in generating additional capacity from existing equipment. Building products--On a worldwide basis, market conditions did not improve in the commercial construction markets in 1993. The North American sales comparison reflects a decline because the first five months of 1992 included grid that was sold prior to the formation of the WAVE joint venture. The European markets, with the exception of the United Kingdom, were weaker in 1993. European sales declined by nearly 22%, of which half was caused by weaker European currencies. The 1993 operating profit included restructuring charges of nearly $14 million, while the 1992 operating loss included $35 million of restructuring charges. This segment lowered its cost structure significantly as a result of restructuring actions taken in 1992 that included the closing of two manufacturing facilities and productivity improvements that were attained in 1993. Even with lower sales and competitive pricing early in 1993, the lower cost structure that was put in place, coupled with some higher sales prices in the second half of 1993, permitted this segment to increase operating profits. Capital investments in 1993 were about the same as 1992, but both years' expenditures were lower than depreciation levels. Furniture--Operating results for this segment were positive--1993 sales nearly 3% higher than those of 1992 and operating profits more than 150% higher than last year. Both years contained restructuring charges that were less than $1 million in 1993 and nearly $5 million in 1992. Exclusive of restructuring charges, this segment recorded operating profits that were 80% higher than last year. With the U.S. consumer household durable goods spending increasing in 1993, modest sales increases were recorded in the Thomasville wood and upholstery business that more than offset declines in the Armstrong retail, ready-to- assemble furniture, and the contract business. The operating profit improvement was driven by higher sales volume, lower costs resulting from the 1992 restructuring program, and improved productivity. Higher lumber costs had a negative impact on 1992 operating results and continued to increase throughout much of 1993 but were offset by increased sales prices. Capital expenditures in 1993 increased modestly over those of 1992. Industry products--Almost three-quarters of the sales of this segment generally occur in European markets, which in 1993 remained in recession, limiting growth opportunities. Worldwide sales declined nearly 7%, with the stronger U.S. dollar accounting for 95% of the decline. Operating profits declined by slightly more than 7%, with restructuring charges of almost $13 million in each year. The insulation business remains the most significant portion of this segment. Excluding the negative effect of currency translation, sales grew modestly while operating profits recorded a small decline. The German market remained relatively strong for this business while markets in the other European countries were adversely affected by weak economies. Sales in North America and the Pacific Rim recorded a small increase in 1993. While the insulation business restructuring programs did lower costs, they were not able to offset the impact of the lower sales and competitive pricing pressures. The textile mill supplies business recorded significantly lower sales that were driven by the worldwide recession in the textile industry. This business, while lowering its cost structure, was unable to offset the impact of the significantly lower sales worldwide. The gasket materials business recorded slightly lower sales, with a small decline in operating profit from 1992 levels. Capital expenditures were reduced by about one-third from 1992 levels, but were almost 40% greater than annual depreciation levels. The capital investments continue generally to support future growth of this segment. - 25 - 1992 compared with 1991 Financial condition As shown on the Consolidated Statements of Cash Flows, net cash provided by operating activities in 1992 was $186.8 million, more than sufficient to cover investments in property, plant, and equipment, and dividends, and an investment in a new joint venture. The balance of cash, including cash proceeds from sale of assets, was used to reduce debt and increase cash and cash equivalents. During the first quarter of 1992, the company redeemed, for $8.8 million, all outstanding 8% sinking-fund debentures due in 1996 at face value plus accrued interest to the date of redemption. For 1992, the company recorded a $165.5 million charge before tax ($123.8 million after tax) in connection with a restructuring plan designed to increase the overall profitability of the company by closing four major plants; scaling back of certain operations; elimination of positions throughout the company; and write-downs of land, buildings, equipment and intangible assets. Approximately two-thirds of the before-tax losses were noncash charges related to the write-down of assets. Cash outlays for restructuring charges in 1992 were approximately $9.4 million. Most of the cash outlays are expected to occur in 1993 and to be offset by operating savings resulting from the restructuring. During the fourth quarter of 1992, the company adopted three new financial accounting statements: SFAS 106, SFAS 109 and SFAS 112. Adoption of these financial accounting statements had no current cash flow impact on the company. Receivables declined $2.7 million and inventories declined $17.0 million. Each reflects the translation of foreign currency receivables or inventories to U.S. dollars at lower exchange rates. Higher sales volume late in the fourth quarter increased receivables and helped lower inventories. Current income tax benefits increased $8.1 million, principally because of deferred tax benefits related to restructuring charges. Other noncurrent assets decreased $53.1 million because of a $30.0 million write-off of intangible assets and a $30.0 million reduction of prepaid pension costs, both attributable to restructuring activities. Partially offsetting the decreases in noncurrent assets were investments in the WAVE grid joint venture. - 26 - The company's year-end ratio of current assets to current liabilities declined to approximately 1.3 to 1 from the 1.5 to 1 ratio reported in 1991. The major cause of the decline is the $47.9 million of accrued expenses associated with restructuring activities. The company is involved in significant litigation, which is described more fully under "Litigation" on pages 60-65 and which should be read in connection with this discussion and analysis. Although the company does not know how many claims will be filed against it in the future, nor the details thereof or of pending suits not fully reviewed, nor the expense and any liability that may ultimately result therefrom, based upon its experience and other factors, the company believes that it is probable that nearly all of the expenses and any liability payments associated therewith will be paid--in the case of the personal injury claims, by agreed-to coverage under the Wellington Agreement and supplemented by payments by nonsubscribing insurers that entered into settlement agreements with the company and additional insurance coverage reasonably anticipated from the outcome of the insurance litigation and from the company's claims for non-products coverage, both under certain insurance policies covered by the Wellington Agreement and under certain insurance policies not covered by the Wellington Agreement which claims have yet to be accepted by the carriers--and in the case of the property damage claims, under an existing interim agreement, by insurance coverage settlement agreements and through additional coverage reasonably anticipated from the outcome of the insurance litigation. To the extent that costs of the property damage litigation are being paid by the company's insurance carriers under reservation of rights, the company believes that it is probable that such payments will not be subjected to recoupment. Thus, the company has not recorded any liability for any defense costs or indemnity relating to these lawsuits other than a reserve in "Other long-term liabilities" for the estimated potential liability associated with claims pending intended to cover potential liability and settlement costs, legal and administrative costs not covered under the agreements, and certain other factors which have been involved in the litigation about which uncertainties exist. Even though uncertainties still remain as to the potential number of unasserted claims, the liability resulting therefrom, and the ultimate scope of its insurance coverage, after consideration of the factors involved, including the Wellington Agreement, the settlements with other insurance carriers, the remaining reserve, the establishment of the Center for Claims Resolution, the proposed settlement class action, and its experience, the company believes that this litigation will not have a material adverse effect on its earnings, liquidity, or financial position. Reference is made to the litigation involving The Industry Network System, Inc. (TINS), discussed on pages 64-65. The company denies all of TINS' claims and accordingly is vigorously defending the matter. In the event that a jury finds against the company, such jury verdict could entail unknown amounts which, if sustained, could have a material adverse effect on its earnings and financial position. Long-term debt, excluding the company's guarantee of the ESOP loan, was reduced by $34.8 million in 1992. At year-end 1992, long-term debt represented 47% of shareholders' equity compared with 34% at the end of 1991. The increase is the result of shareholder equity reductions caused primarily by the cumulative-effect charges from adoption of accounting statements and restructuring charges previously discussed. Should a need develop for additional financing, it is management's opinion that the company has sufficient financial strength to warrant the required support from lending institutions and financial markets. In June 1992, the company's registration statement for $250 million of debt securities was declared effective. Consolidated results Record net sales in 1992 of $2.55 billion increased 4.5% from $2.44 billion in 1991. Increased sales opportunity was provided by the residential, do-it- yourself, and industrial markets, while for the fifth consecutive year, commercial markets remained depressed. European economies continued - 27 - to reflect a recessionary environment, which resulted in reduced demands for the company's products. Sales in each of the 1992 quarters were above those of 1991. The rate of growth was highest in the first quarter, but was lower during the last three quarters of the year. Net losses in 1992 were $227.7 million, compared with net earnings of $48.2 million in 1991. Net losses per share of common stock for 1992 were $6.49 on both a primary and fully diluted basis compared with 1991 net earnings of 77 cents per share. The return on common shareholders' equity in 1992 was a negative 33.9% compared with a positive return of 3.3% in 1991. The 1992 losses reflect charges of $167.8 million after tax related to the company's adoption, retroactive to January 1, 1992, of SFAS 106 and SFAS 112. The 1991 net earnings included a $12.4 million after-tax provision related to discontinued businesses. Losses from continuing businesses in 1992 totaled $59.9 million, compared with earnings from continuing businesses of $60.6 million in 1991. The loss per share of common stock from continuing businesses was $1.98 on both a primary and fully diluted basis compared with 1991 earnings per share of $1.11. The net loss for 1992 included an effective tax benefit rate of 1.0% compared with 1991's effective tax rate of 39.6%. The reduced 1992 tax benefit rate is generally because some of the restructuring charges do not provide tax benefits. In addition, a lower share of foreign countries' earnings resulted in lower tax rates. The company also adopted SFAS 109 resulting in tax benefits of $5.5 million for 1992 being credited directly to retained earnings rather than to income taxes on the consolidated statement of earnings. The 1991 effective tax rate included an increased share of the company's earnings coming from foreign countries with higher tax rates and a $3.7 million deferred income tax charge reflecting increases in state income tax rates. The loss from continuing businesses before income taxes was $60.4 million, compared to earnings from continuing businesses before income taxes in 1991 of $100.3 million. Included in the loss from continuing businesses for the full year 1992 were restructuring charges of $165.5 million before tax. These restructuring charges related to the closing of four major manufacturing plants--two in the U.S., one in Canada, one in Belgium--and to the scaling back of operations in certain other plants in the U.S. and abroad. Also included were accruals for costs associated with elimination of positions throughout the company, as well as write-downs of the value of land, buildings, equipment, and intangible assets of the company. The cash outlays for the restructuring charges will occur primarily in 1993 and are expected to be recovered by the savings resulting from the restructuring. Restructuring charges for 1991 amounted to $8.4 million after tax. Lower short-term interest rates favorably affected interest expense. Miscellaneous income and expense in 1992 included the positive effects of an insurance reimbursement for certain costs associated with the 1990 takeover threat, foreign exchange gains, lower amortization of intangibles, and a gain from the early retirement of certain debt; the 1991 results included foreign exchange gains of $5.9 million. The cost of goods sold for 1992, when expressed as a percent of sales, was 74.1% compared with 1991's 73.8%. This higher cost relationship is the result of the previously mentioned expense accruals required by SFAS 106 and SFAS 112. Operating results were affected by competitive pricing pressures and higher fixed costs concurrent with slow sales growth. - 28 - Geographic area results (see pages 7 and 8) United States--Sales increased more than 4% while operating profits declined 61% when compared with 1991. Residential end-use markets improved significantly in 1992 when compared with 1991. Single family housing starts increased at a double digit rate while the sales of existing single family homes provided a more modest increase. New construction put in place for private nonresidential buildings was significantly lower in 1992 than in 1991. The 1992 net sales included only five months of the building products segment's grid sales compared with a full year's sales in 1991 as a result of the grid joint venture with Worthington Industries effective June 1, 1992. Results after that date have been recorded on an equity-accounting basis. The major contributor to increased sales in 1992 was the resilient flooring business which benefited from significant new product introductions and year-to-year improvements in the previously mentioned single family housing starts and sales of existing homes. Most domestic businesses were affected by competitive and promotional pricing and less favorable product mix. Costs associated with the expansion of the residential ceramic tile program adversely impacted profit performance. The largest decline in operating profit is attributable to the major restructuring charges recorded during 1992, including the closing of the Pleasant Garden, N.C., furniture plant, the closing of the Quakertown, Pa., quarry-tile ceramic plant, and related accruals for the write-downs of land, buildings, and equipment, as well as elimination of employee positions. Export sales of Armstrong products from the U.S. to trade customers declined $5 million or 17% during 1992 when compared with 1991. Europe--The 1992 economic environment in Europe continued to weaken in both the commercial and residential markets. Net sales increased 7%, but more than half of the increase was the result of translating foreign currency sales to - 29 - U.S. dollars at higher exchange rates. Operating profits declined 56%. Nearly 60% of this decline was due to restructuring charges related to the closing of the Ghlin, Belgium, plant and to accruals for the elimination of employee positions. The European insulation business continued its sales and operating profit improvement, primarily as a result of a strong German insulation market. This business's operating profit was reduced by start-up costs related to new facilities in Spain and Germany during 1992. The European ceilings business was affected by the depressed commercial markets coupled with competitive pricing and a less favorable product mix. Other foreign--Sales in 1992 declined 3% from those of 1991 while an operating loss was recorded for the year. The operating loss included restructuring charges associated with the closing of the Gatineau, Canada, ceilings manufacturing plant. Sales improvement was recorded in the Southeast Asian area, but operating profits declined in this area as a result of increased costs that are designed to obtain future growth. Industry segment results (see pages 3 and 4) Floor coverings--Sales were 7% higher in 1992 than in 1991, with operating profits declining by 64%. Operating profits include restructuring charges in 1992 of nearly $81 million compared with $3 million in 1991. Nearly all of the restructuring charges relate to ceramic tile. Sales in the resilient flooring portion increased significantly, paced by sales in North America, where a new annual sales record was set with the help of the introduction of the largest-ever assortment of new flooring products during the second quarter of 1992. Ceramic tile recorded a small increase in sales primarily because of the developments in the residential ceramic tile markets through American Olean and Armstrong distribution channels. The ceramic tile portion continues to be adversely affected by the depressed commercial institutional market and recorded losses in both 1992 and 1991. Operating profits during 1992, while positively affected by the sales growth, were adversely affected by competitive pricing, movement towards a lower margin sales mix, small increases in raw material costs in the second half of the year, and continuing costs related to the new residential ceramic tile businesses. Capital investments for 1992 were lower than 1991 but continued to be directed toward product development, cycle-time reduction, and manufacturing process improvements. Building products--On a worldwide basis, market conditions remained depressed in the commercial construction markets, resulting in lower opportunity and declining product prices. Sales declined nearly 3% year to year while recording an operating loss that included restructuring charges of $35 million in 1992 compared with $4.3 million in 1991. The year-to-year sales decline was caused by the transfer of grid sales for the last seven months of 1992 to the WAVE joint venture. The continued decline of nonresidential construction in the U.S. and abroad significantly affected the operating results. Worldwide competitive pricing pressures and lack of sales growth eroded operating profit faster than the company's ability to lower costs. - 30 - Capital investments in 1992 were reduced significantly from prior year levels and were directed towards manufacturing process improvement and consolidations. During 1992, the company closed its Gatineau, Canada, and Ghlin, Belgium, ceilings plants and scaled back other operations. In 1991, Armstrong exited certain wall businesses and its Forms + Surfaces architectural products business. Furniture--The 1992 sales increased 5%, while operating profits declined 43%, including restructuring charges of $4.8 million. The contract furniture, ready-to-assemble furniture, and upholstered furniture businesses reflected sales increases that were partially offset by lower sales in the Thomasville wood business. Operating results were adversely affected by promotional pricing efforts, higher lumber costs, and increased costs for employee medical benefits. Actions were taken in 1992 to monitor customer satisfaction, increase square footage of the Thomasville Home Furnishings Stores, reengineer upholstery operations to improve service, and develop a computerized order service system for expediting shipments. Investments in these areas increased capital expenditures modestly for 1992 compared with 1991. Restructuring actions included closing the Pleasant Garden manufacturing facility and elimination of salaried employee positions. Industry products--Worldwide sales increased 11% while operating profits declined $7.7 million, or 18%. Restructuring charges were $12.5 million in 1992 and $2.2 million in 1991. The insulation business remained strong in 1992 because of the European markets, particularly in Germany. New product introductions and improved technical values through new formulations aided the success of this business. Profitability was slowed somewhat by start-up costs for new facilities in Spain and Germany that increased capacity. The gasket materials business recorded strong sales and operating profit increases when compared with 1991. The textile mill supplies business recorded small sales increases, but operating results declined because of cost and pricing pressures. - 31 - Item 8.

Item 8. Financial Statements and Supplementary Data - ---------------------------------------------------- FINANCIAL STATEMENTS AND REVIEW CONSOLIDATED STATEMENTS OF EARNINGS The Financial Review, pages 38-65, is an integral part of these statements. - 32 - - 33 - FINANCIAL STATEMENTS AND REVIEW CONSOLIDATED BALANCE SHEETS The Financial Review, pages 38-65, is an integral part of these statements. - 34 - - 35 - FINANCIAL STATEMENTS AND REVIEW CONSOLIDATED STATEMENTS OF CASH FLOWS The Financial Review, pages 38-65, is an integral part of these statements. - 36 - - 37 - FINANCIAL REVIEW The consolidated financial statements and the accompanying data in this report include the accounts of the parent Armstrong World Industries, Inc., and its domestic and foreign subsidiaries. All significant intercompany transactions have been eliminated from the consolidated statements. OPERATING STATEMENT ITEMS Net sales in 1993 total $2,525.4 million, 1.0% below the 1992 total of $2,549.8 million. 1992 sales were 4.5% above the 1991 total of $2,439.3 million. The amounts reported as net sales are the total sales billed during the year less the sales value of goods returned, trade discounts and customers' allowances, and freight costs incurred in delivering products to customers. Net earnings of $63.5 million for 1993 compared with a net loss for 1992 of $227.7 million and earnings of $48.2 million for 1991. Included in the earnings for 1993 were restructuring charges of $60.0 million after tax. For years 1992 and 1991, after-tax restructuring charges were $123.8 million and $8.4 million, respectively. The 1992 loss also included a $167.8 million after-tax charge for the cumulative effect of changes in accounting related to the adoption of Statement of Financial Accounting Standards (SFAS) 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions," and SFAS 112, "Employers' Accounting for Postemployment Benefits." Earnings (loss) per common share are presented on the Consolidated Statements of Earnings on page 32. Primary earnings (loss) per share, for "Earnings (loss) from continuing businesses" and "Net earnings (loss)," are determined by dividing the earnings (loss), after deducting preferred dividends (net of tax benefits on unallocated shares), by the average number of common shares outstanding and shares issuable under stock options, if dilutive. Fully diluted earnings (loss) per share include the shares of common stock outstanding and the adjustments to common shares and earnings (loss) required to portray the convertible preferred shares on an "if converted" basis unless the effect is antidilutive. Research and development costs were $59.5 million in 1993, $60.3 million in 1992, and $55.6 million in 1991. Advertising costs were $37.8 million in 1993, $42.4 million in 1992, and $42.9 million in 1991. Maintenance and repair costs were $126.1 million in 1993, $137.2 million in 1992, and $138.1 million in 1991. Depreciation and amortization amounted to $130.0 million in 1993, $136.9 million in 1992, and $135.3 million in 1991. These amounts include amortization of intangible assets of $10.0 million in 1993, $16.2 million in 1992, and $18.0 million in 1991. - 38 - Depreciation charges for financial reporting purposes are determined generally on the straight-line basis at rates calculated to provide for the retirement of assets at the end of their useful lives. Accelerated depreciation is generally used for tax purposes. When assets are disposed of or retired, their costs and related depreciation are removed from the books, and any resulting gains or losses are reflected in "Miscellaneous income (expense)." Intangibles are amortized over periods ranging from three to 40 years. Restructuring charges amounted to $89.9 million in 1993 compared with similar charges of $165.5 million in 1992 and $12.8 million in 1991. The 1993 charges were primarily the result of accruals for severance and special retirement incentives associated with the elimination of employee positions. The 1992 charges relate to the company's closing of four major manufacturing facilities--two in the U.S., one in Canada, one in Belgium--and to the scaling back of operations in certain other plants in the U.S. and abroad. The provision also includes accruals for costs associated with the elimination of positions throughout the company, as well as write-downs of the value of land, buildings, equipment and intangible assets of the company. Employee compensation is presented in the table below and excludes restructuring charges for severance costs and early retirement incentives. Average total employment of 21,682 in 1993 compares with 23,500 in 1992 and 24,066 in 1991. - 39 - Pension costs The company and a number of its subsidiaries have pension plans covering substantially all employees. Benefits from the principal plan are based on the employee's compensation and years of service. Generally, the company's practice is to fund the actuarially determined current service costs and the amounts necessary to amortize prior service obligations over periods ranging up to 30 years, but not in excess of the full funding limitation. Funding requirements are determined independently of expense, using an expected long-term rate of return on assets of 8.67%. The company's principal plan is subject to the full funding limitation in 1993, 1992, and 1991, and the company made no contribution to that plan in any of these years. Contributions of $.8 million in 1993, $.6 million in 1992, and $.3 million in 1991 were made to defined-benefit plans of company subsidiaries. The total pension cost from all plans are presented in the table below. The net credit for U.S. defined-benefit pension plans is presented in the table below. - 40 - Accruals for the cost of early retirement incentives were $38.0 million in 1993 compared with $30.0 million in 1992. The cost of these incentives is included as a part of the restructuring charges discussed on page 39. The company has defined-contribution pension plans for eligible employees at certain of its U.S. subsidiaries, such as the Employee Stock Ownership Plan (ESOP) described on page 44. Company contributions and accrued compensation expense related to the ESOP are included with other plans' contributions and costs, based on the compensation of each eligible employee. The costs of such plans totaled $6.0 million in 1993, $5.9 million in 1992, and $5.3 million in 1991. The funded status of the company's U.S. defined-benefit pension plans is presented in the following table. The plan assets at each December 31 are based on measurements from October 31 to December 31. Stated at fair value, they are primarily listed stocks, bonds, and investments with a major insurance company. Note: Rates used in determining the actuarial present value of the projected benefit obligation at the end of 1993 and 1992 are: (1) the discount rate or the assumed rate at which the pension benefits could be effectively settled, 7.00% in 1993 and 7.25% in 1992; and (2) the compensation rate or the long-term rate at which compensation is expected to increase as a result of inflation, promotions, seniority, and other factors, 4.75% in both 1993 and 1992. The expected long-term rate of return on assets was 8.25% in both 1993 and 1992. The company has pension plans covering employees in a number of foreign countries which utilize assumptions that are consistent, but not identical, with those of the U.S. plans. The following table presents the funded status of the non-U.S. defined- benefit pension plans at December 31. - 41 - In 1993, a foreign subsidiary reorganized the financing arrangement of its principal pension plan and became self-insured. As a result, the subsidiary recorded, as of December 31, 1993, plan-related liabilities of $37.7 million and assets of equal value. Prior to 1993, the asset value had been reported as an asset of the pension plan. Postretirement benefits other than pensions and postemployment benefits The company has plans that provide for medical and life insurance benefits to certain eligible employees, worldwide, when they retire from active service. The company funds these benefit costs primarily on a pay-as-you-go basis, with the retiree paying a portion of the cost for health-care benefits through deductibles and contributions. In 1992, the company adopted SFAS 106, which recognizes the estimated future cost of providing health-care and other postretirement benefits on an accrual basis over the active service life of the employee. Prior to 1992, postretirement benefit expenses were recognized as claims were incurred. Armstrong elected to immediately recognize the cumulative effect of the change in accounting for postretirement benefits of $220.3 million ($135.4 million after taxes) which represented the unfunded accumulated postretirement benefit obligation (APBO) as of January 1, 1992. Under the new standard, total retiree health-care and life insurance expense was $21.2 million in 1993 and $22.3 million in 1992. These costs were $12.7 million in 1991. The company announced in 1989-90 a 15-year phaseout of its cost of health-care benefits for certain future retirees. These future retirees include parent company nonunion employees and some union employees. Shares of ESOP convertible preferred stock (see page 44) are scheduled to be allocated to these employees, based on employee age and years to expected retirement. In addition, they may enroll in a voluntary portion of the ESOP to purchase additional shares. - 42 - The following tables set forth the funded status of the company's postretirement benefit plans at December 31 and the periodic postretirement benefit costs. The assumed health-care cost trend rate used to measure the APBO was 14% in 1992, decreasing 1% per year to an ultimate rate of 6% by the year 2000. The health-care cost trend rate assumption has a significant effect on the amounts reported. To illustrate, if the health-care cost trend rate assumptions were increased by 1%, the APBO as of December 31, 1993, would be increased by $22.5 million. The effect of this change on the total of service and interest costs for 1993 would be an increase of $2.3 million. The APBO at December 31, 1993, was determined utilizing a discount rate of 7.75% and a compensation rate of 4.75%. The discount and compensation rates used in determining the APBO at December 31, 1992, were 8.25% and 4.75%, respectively. The company provides certain postemployment benefits to eligible parent company and subsidiary employees. These benefits are provided to former or inactive employees and their dependents during the time period following employment but before retirement. Prior to 1992, postemployment benefit expenses were recognized on a pay-as- you-go basis. In 1992, the company adopted SFAS 112, which recognizes the estimated future cost of providing postemployment benefits on an accrual basis over the active service life of the employee. Armstrong elected to immediately recognize the cumulative effect of the change in accounting for postemployment benefits of $53.3 million ($32.4 million after tax), which represented the unfunded accumulated postemployment benefit obligation (APBO) as of January 1, 1992. A refinement of the computation in 1993 resulted in restatements of the 1992 financial statements. The effect of the restatements was to reduce the previously reported loss from continuing businesses by $1.7 million or 5 cents per share and to - 43 - reduce the previously reported net loss by $6.5 million or 18 cents per share. Total postemployment benefit expense was $4.6 million in 1993 and $6.3 million in 1992. Employee Stock Ownership Plan (ESOP) In 1989, Armstrong established an ESOP that borrowed $270 million from banks and insurance companies, repayable over 15 years and guaranteed by the company. The ESOP used the proceeds to purchase 5,654,450 shares of a new series of convertible preferred stock issued by the company. Through December 31, 1993, the ESOP allocated to participants 1,276,350 shares and retired 126,758 shares. The preferred stock has a minimum conversion value of $47.75 per share with an annual dividend of $3.462. The ESOP currently covers parent company nonunion employees, some union employees, and those employees of major domestic subsidiaries who wish to participate in the voluntary contribution portion of the plan. Armstrong used the proceeds from the 1989 sale of preferred stock to repurchase common stock in 1989 and 1990 for the company treasury. The company's guarantee of the ESOP loan has been recorded as a long-term obligation and as a reduction of shareholders' equity on its consolidated balance sheet. The company recorded costs for the ESOP, utilizing the 80% of the shares allocated method, of $4.5 million in 1993, $4.4 million in 1992, and $3.6 million in 1991, consisting primarily of accrued compensation expenses plus company contributions. Costs for all years continue to be offset by savings from changes to company-sponsored health-care benefits and elimination of a contribution-matching feature in the company-sponsored voluntary retirement savings plan. - 44 - Taxes totaled $113.6 million in 1993, $92.4 million in 1992, and $126.4 million in 1991. In 1992, the company adopted SFAS 109, "Accounting for Income Taxes," which supersedes SFAS 96. Under SFAS 109, deferred tax assets and liabilities are recognized using enacted tax rates for the expected future tax consequences of events that have been recognized in the financial statements or tax returns. Generally, SFAS 96 prohibited consideration of any future events in calculating deferred taxes. SFAS 109 also requires recognition in shareholders' equity of the tax benefit for dividends paid on unallocated shares of stock held by the ESOP which amounted to $5.3 million in 1993 and $5.5 million in 1992. Under SFAS 96, this benefit was recognized in the statement of earnings and amounted to $6.0 million in 1991. The tax benefit for dividends paid on allocated shares held by an ESOP are recognized in the statements of earnings under the provisions of both SFAS 109 and SFAS 96. - 45 - At December 31, 1993, unremitted earnings of subsidiaries outside the United States were $93.1 million (at current balance sheet exchange rates) on which no U.S. taxes have been provided. If such earnings were to be remitted without offsetting tax credits in the United States, withholding taxes would be $11.5 million. The company's intention, however, is to permanently reinvest those earnings or to repatriate them only when it is tax effective to do so. BALANCE SHEET ITEMS Cash and cash equivalents decreased to $9.1 million at the end of 1993 from $15.2 million at the end of 1992. Operating and other factors associated with the decrease in cash and cash equivalents are detailed in the Consolidated Statements of Cash Flows on page 36. Short-term investments, substantially all of which have maturities of three months or less when purchased, are considered to be cash equivalents and are carried at cost or less, generally approximating market value. Receivables declined $19.1 million in 1993, with most of the decrease related to the collection of customer notes and miscellaneous receivables, and a $5.3 million reserve increase for discounts and losses. Customers' receivables declined $2.0 million even though sales increased by 4% in the fourth quarter. - 46 - Generally, the company sells its products to select, preapproved groups of customers that include: flooring and building material distributors, ceiling systems contractors, regional and national mass merchandisers and home centers, original equipment manufacturers, and large furniture retailers. The businesses of these customers are directly affected by changes in economic and market conditions. The company considers these factors and the financial condition of each customer when establishing its allowance for losses from doubtful accounts. The carrying amount of the receivables approximates fair value because of the short maturity of these items. Trade receivables are recorded in gross billed amounts as of date of shipment. Provision is made for estimated applicable discounts and losses. Inventories were $33.2 million lower at the end of 1993, a 10 percent decline from the 1992 year-end position. The decrease was primarily a result of the successful ongoing process changes that reduced cycle time and improved inventory turnover from 8.0 to 8.8 turns on sales. Approximately half of the inventory reduction occurred in Europe with about $4.0 million of the reduction related to the translation of foreign currency inventories to U.S. dollars at lower exchange rates. Approximately 51% in 1993 and 48% in 1992 of the company's total inventory is valued on a LIFO (last-in, first-out) basis. Such inventory values were lower than would have been reported on a total FIFO (first-in, first-out) basis, by $109.7 million at the end of 1993 and $108.3 million at year-end 1992. Inventories are valued at the lower of cost or market. Approximately two- thirds of 1993's domestic inventories are valued using the LIFO method. Other inventories are generally determined on a FIFO method. Income tax benefits were $36.8 million in 1993 and $43.2 million in 1992. Of these amounts, deferred tax benefits were $34.1 million in 1993 and $39.9 million in 1992. Other current assets were $24.8 million in 1993, a decrease of $7.5 million from the $32.3 million in 1992. The decrease primarily reflects a reduction in prepaid costs. The $37.5 million increase in gross book value to $2,045.8 million at the end of 1993 includes $117.6 million for capital additions; a $12.5 million write-down for restructuring; and a $42.6 million reduction from sales, retirements, dispositions and other changes. Also, because of translating foreign currency property, plant, and equipment into U.S. dollars at lower exchange rates, 1993 gross book value was reduced by $25.0 million and net book value decreased by $11.8 million. The unexpended cost of approved capital appropriations amounted to $69.8 million at December 31, 1993, substantially all of which is scheduled to be expended during 1994. Property, plant, and equipment values are stated at acquisition cost, with accumulated depreciation and amortization deducted to arrive at net book value. - 47 - Significant items included in the $24.7 million increase were a $37.7 million addition of paid up insurance policy assets that were previously part of a foreign subsidiary pension plan's assets (see page 42) and a deferred income tax benefit of $13.5 million. Partially offsetting these increases were a net charge of $19.8 million to the prepaid pension asset and a $6.4 million write-off of certain intangible assets. Noncurrent assets are carried at cost or less or under the equity method of accounting. The carrying amount of accounts payable and accrued expenses approximates fair value because of the short maturity of these items. - 48 - The tax effects of principal temporary differences between the carrying amounts of assets and liabilities and their tax bases are summarized in the preceding table. Under current law, the alternative minimum tax credits have an unlimited carryforward life for U.S. tax purposes. A valuation allowance was not established for these benefits because management believes the company will earn sufficient taxable income to utilize the benefits. The tax audit reviews have been completed for years 1988 through 1990, and the company believes that there will be no adverse effect on the company's financial condition. - 49 - The December 31, 1993, carrying amounts of short-term debt ($105.4 million) and current installments of long-term debt ($5.8 million) approximate fair value because of the short maturity of these items. The December 31, 1993, carrying amount of net long-term debt was $256.8 million, compared with a fair value estimate of $301.3 million. The fair value estimates of long-term debt were based upon quotes from major financial institutions, taking into consideration current rates offered to the company for debt of the same remaining maturities. The medium-term notes were issued at rates from 8% to 9% with maturities ranging from 1994 to 2001. The 9 3/4% debentures and the medium-term notes are not redeemable by the company until maturity and there are no sinking-fund requirements. In 1983, the company issued a $37.2 million noninterest-bearing installment note and has made the first of two required payments. The second installment payment of $18.6 million is due in 2013. The $1.5 million present value of this payment is recorded in other long-term debt. The estimated fair value at December 31, 1993, was $4.4 million. Armstrong currently has unused domestic short-term lines of credit of approximately $245 million from eight banks. In addition, the company's foreign subsidiaries have approximately $144 million of unused short-term lines of credit available from banks. Most of the credit lines are extended on a fee basis. The company can borrow from its banks generally at rates approximating the lowest available to commercial borrowers and can issue short-term commercial notes supported by the lines of credit. Financial instruments with off-balance sheet risks The company uses forward contracts, foreign currency options, and interest rate or currency swaps to selectively hedge foreign currency and interest rate risk exposures. Realized and unrealized gains and losses on contracts that hedge expected future cash flows are recognized in other income and expense. Realized and unrealized gains and losses on contracts that hedge net investment in foreign subsidiaries are recognized in shareholders' equity. At December 31, 1993, forward contracts and foreign currency options hedging anticipated transactions totaled approximately U.S. $142.6 million and were primarily denominated in European currencies. The forward contracts and options mature within one year. The estimated market value of the forward contracts and foreign currency options at December 31, 1993, was $.8 million and was included in "Other current assets." These values were obtained from dealer quotes and published foreign currency market rates. In 1987, the company entered into a $15 million interest rate swap agreement. The swap expires in 1994 and provides for the company to pay interest at the 30-day U.S. commercial paper rate and to receive interest at an average fixed annual rate of 10.22%. In 1993, the company terminated prior to expiration interest rate swaps totaling $100 million and currency swaps totaling $37.2 million. Also, the company entered into a $25 million interest rate swap agreement. The swap expires in 1998 and provides for the company to pay interest at the six-month London interbank offered rate, and to receive interest at a fixed rate of 5.575%. The carrying values of the interest rate agreements represent a net asset of $.6 million, compared with a net asset of $1.0 million at fair value, based on quotes from major financial institutions. The fair values represent the estimated amount the company would have received by terminating these agreements on December 31, 1993. - 50 - The counterparties to these instruments are major international financial institutions, and the company continually monitors its position and the credit ratings of the counterparties. The company does not anticipate a loss resulting from any credit risk of these institutions. For reporting purposes, the assets and liabilities of the forward contracts, foreign currency options, and interest rate swaps are offset because the agreements provide for a right of offset. As of December 31, 1993, the company had provided $62 million in standby letters of credit and financial guarantees. The company's policy does not normally require collateral or other security to support these instruments. Other long-term liabilities were $99.6 million in 1993 and $52.9 million in 1992. The significant item included in the $46.7 million increase is the $37.7 million of pension liabilities assumed by the company as a result of becoming self-insured for the pension obligations in a foreign subsidiary (see page 42). Other long-term liabilities include amounts for pensions, deferred compensation, workers' compensation, vacation accrual, and a reserve for the estimated potential liability primarily associated with claims pending in the company's asbestos-related litigation. Based upon the company's experience with this litigation--as well as the Wellington Agreement, other settlement agreements with certain of the company's insurance carriers, and an earlier interim agreement with several primary carriers--this reserve is intended to cover potential liability and settlement costs, legal and administrative costs not covered under the agreements, and certain other factors which have been involved in the litigation about which uncertainties exist. Future costs of litigation against the company's insurance carriers and other legal costs indirectly related to the litigation, expected to be modest, will be expensed outside the reserve. Amounts, primarily insurance litigation costs, estimated to be payable within one year are included under current liabilities. The company does not know how many claims will be filed against it in the future, nor the details thereof or of pending claims and suits not fully reviewed, nor the expense and any liability that may ultimately result therefrom, nor does the company know the annual claims flow caps to be negotiated after the initial 10-year period for the settlement class action or the then compensation levels to be negotiated for such claims or the success the company may have in addressing the Midland Insurance Company insolvency with its other insurers. Subject to the foregoing and based upon its experience and other factors referred to under "Litigation" on pages 60-64, the company believes that it is probable that such charges to expense associated with the suits and claims should not be significant. The fair value of other long-term liabilities was estimated to be $87.2 million at December 31, 1993, using a discounted cash flow approach. Environmental The company will incur capital expenditures in order to meet the new requirements of the Clean Air Act of 1990 and is awaiting the final promulgation of implementing regulations by various state agencies to determine the magnitude of additional costs and the time period over which they will be incurred. In 1993, the company incurred capital - 51 - expenditures of approximately $2.6 million for environmental compliance and control facilities, and anticipates comparable annual expenditures for those purposes for the years 1994 and 1995. As with many industrial companies, Armstrong is involved in proceedings under the Comprehensive Environmental Response, Compensation and Liability Act ("Superfund"), and similar state laws at approximately 21 sites. In most cases, Armstrong is one of many potentially responsible parties ("PRPs") who have voluntarily agreed to jointly fund the required investigation and remediation of each site. With regard to some sites, however, Armstrong disputes either liability or the proposed cost allocation. Sites where Armstrong is alleged to have contributed a significant volume of waste material include a former municipal landfill site in Volney, New York, and a former county landfill site in Buckingham County, Virginia, which is alleged to have received material from Thomasville Furniture Industries, Inc. (see page 65). Armstrong may also have rights of contribution or reimbursement from other parties or coverage under applicable insurance policies. The company is also remediating environmental contamination resulting from past industrial activity at certain of its current plant sites. Estimates of future liability are based on an evaluation of currently available facts regarding each individual site and consider factors including existing technology, presently enacted laws and regulations, and prior company experience in remediation of contaminated sites. Although current law imposes joint and several liability on all parties at any Superfund site, Armstrong's contribution to the remediation of these sites is expected to be limited by the number of other companies also identified as potentially liable for site costs. As a result, the company's estimated liability reflects only the company's expected share. In determining the probability of contribution, the company considers the solvency of the parties, whether responsibility is being disputed, the terms of any existing agreements, and experience regarding similar matters. The estimated liabilities do not take into account any claims for recoveries from insurance or third parties, unless a coverage commitment has been provided by the insurer. Because of uncertainties associated with remediation activities and technologies, regulatory interpretations, and the allocation of those costs among various other parties, the company has accrued $4.9 million to reflect its estimated liability for environmental remediation. As assessments and remediation activities progress at each individual site, these liabilities are reviewed to reflect additional information as it becomes available. Actual costs to be incurred at identified sites in the future may vary from the estimates, given the inherent uncertainties in evaluating environmental liabilities. Subject to the imprecision in estimating environmental remediation costs, the company believes that any sum it may have to pay in connection with environmental matters in excess of the amounts noted above would not have a material adverse effect on its financial condition, liquidity, or results of operations. - 52 - Geographic Areas United States net trade sales include export sales to non-affiliated customers of $27.0 million in 1993, $24.4 million in 1992, and $29.3 million in 1991. "Europe" includes operations located primarily in England, France, Germany, Italy, the Netherlands, Spain, and Switzerland. Operations in Australia, Canada, China, Hong Kong, Indonesia, Japan, Korea, Singapore, and Thailand are in "Other foreign." Transfers between geographic areas and commissions paid to affiliates marketing exported products are accounted for by methods that approximate arm's-length transactions, after considering the costs incurred by the selling company and the return on assets employed of both the selling unit and the purchasing unit. Operating profits of a geographic area include profits accruing from sales to affiliates. - 53 - Note 1: Identifiable assets for geographic areas and industry segments exclude cash, marketable securities, and assets of a corporate nature. Capital additions for industry segments include property, plant, and equipment from acquisitions. The Company's foreign operations are subject to foreign government legislation involving restrictions on investments (including transfers thereof), tariff restrictions, personnel administration, and other actions by foreign governments. In addition, consolidated earnings are subject to both U.S. and foreign tax laws with respect to earnings of foreign subsidiaries, and to the effects of currency fluctuations. - 54 - Industry Segments The company operates worldwide in four reportable segments: floor coverings, building products, furniture, and industry products. Floor coverings sales include resilient floors, ceramic tile, and accessories. - 55 - Note 2: - 56 - Stock options No further options may be granted under the 1984 Long-Term Stock Option Plan for Key Employees since the 1993 Long-Term Stock Incentive Plan, approved by the shareholders in April 1993, replaced the 1984 Plan for purposes of granting additional options. Awards under the 1993 Long-Term Stock Incentive Plan may be in the form of stock options, stock appreciation rights in conjunction with stock options, performance restricted shares and restricted stock awards. No more than 4,300,000 shares of common stock may be issued under the Plan, and no more than 430,000 shares of common stock may be awarded in the form of restricted stock awards. The Plan extends to April 25, 2003. Pre-1993 grants made under predecessor plans will be governed under the provisions of those plans. At December 31, 1993, there were 3,987,295 shares available for grant under the 1993 Plan. Options are granted to purchase shares at prices not less than the closing market price of the shares on the dates the options were granted, and expire 10 years from the date of grant. The average share price of all options exercised was $27.41 in 1993, $12.34 in 1992, and $13.20 in 1991. Performance restricted shares is a feature of the 1993 Long-Term Stock Incentive Plan which entitles certain key executive employees to earn shares of Armstrong's common stock, only if the company meets certain predetermined performance measures during a three-year performance period. At the end of the performance period, common stock awarded will generally carry an additional four-year restriction period whereby the shares will be held in custody by the company until the expiration or termination of the restriction. Compensation expense will be charged to earnings over the period in which the restrictions lapse. At the end of 1993, there were 68,505 performance restricted shares outstanding, with associated potential future common stock awards falling in the range of zero to 205,515 shares of Armstrong common stock. - 57 - Restricted stock awards can be used for the purposes of recruitment, special recognition, and retention of key employees. There were no restricted stock awards granted during 1993. Shareholders' equity changes for 1993, 1992, and 1991 are summarized below: - 58 - Treasury shares changes for 1993, 1992, and 1991 are as follows: Preferred stock purchase rights plan In 1986, the Board of Directors declared a distribution of one right for each share of the company's common stock outstanding on and after March 21, 1986. Following the two-for-one stock split later in 1986, one-half of one right attaches to each share of common stock outstanding. In general, the rights become exercisable at $175 per right for a fractional share of a new series of Class A preferred stock (which will differ from the Series A Convertible Preferred Stock issued to the Employee Stock Ownership Plan described on page 44) 10 days after a person or group either acquires beneficial ownership of shares representing 20% or more of the voting power of the company or announces a tender or exchange offer that could result in such person or group beneficially owning shares representing 28% or more of the voting power of the company. If thereafter any person or group becomes the beneficial owner of 28% or more of the voting power of the company or if the company is the surviving company in a merger with a person or group that owns 20% or more of the voting power of the company, then each owner of a right (other than such 20% stockholder) would be entitled to purchase shares of common stock having a value equal to twice the exercise price of the right. Should the company be acquired in a merger or other business combination, or sell 50% or more of its assets or earnings power, each right would entitle the holder to purchase, at the exercise price, common shares of the acquirer having a value of twice the exercise price of the right. The exercise price was determined on the basis of the Board's view of the long-term value of the company's common stock. The rights have no voting power nor do they entitle a holder to receive dividends. At the company's option, the rights are redeemable prior to becoming exercisable at five cents per right. The rights expire on March 21, 1996. - 59 - Litigation The company is one of many defendants in pending lawsuits and claims involving, as of December 31, 1993, approximately 78,437 individuals alleging personal injury from exposure to asbestos-containing products. A total of about 24,036 lawsuits and claims were received by the company in 1993, compared with 28,997 in 1992. Nearly all the personal injury suits and claims seek compensatory and punitive damages arising from alleged exposure to asbestos-containing insulation products used, manufactured, or sold by the company. The company discontinued the sale of all asbestos-containing insulation products in 1969. A significant number of suits in which the company believes it should not be involved were filed in 1993 by persons engaged in vehicle tire production, aspects of the construction industry and the steel industry. Although a large number of suits and claims pending in prior years have been resolved, neither the rate of future dispositions nor the number of future potential unasserted claims can be reasonably predicted. Attention continues to be given by various judges to finding a comprehensive solution to the large number of pending as well as potential future asbestos- related personal injury claims, and the Judicial Panel for Multi-district Litigation ordered the transfer of all federal cases not in trial to the Eastern District Court in Philadelphia for pretrial purposes. A settlement class action which includes essentially all future asbestos- related personal injury claims against members of the Center for Claims Resolution referred to below was filed in Philadelphia on January 15, 1993, in Federal District Court for the Eastern District of Pennsylvania. The proposed class action settlement was negotiated by the Center and two leading plaintiffs' law firms. The settlement class action is designed to establish a nonlitigation system for the resolution of essentially all future asbestos- related personal injury claims against the Center members including this company. Other defendant companies which are not Center members may be able to join the class action later. The class action proposes a voluntary settlement that offers a method for prompt compensation to claimants who were occupationally exposed to asbestos if they are impaired by such exposure. Claimants must meet certain exposure and medical criteria to receive compensation which is derived from historical settlement data. Under limited circumstances and in limited numbers, qualifying claimants may choose to litigate certain claims in court or through alternative dispute resolution, rather than choose an offered settlement amount, after their claims are processed within the system. No punitive damages will be paid under the proposed settlement. The settlement is designed to minimize transactional costs, including attorneys' fees, and to relieve the courts of the burden of handling future asbestos-related personal injury claims. Each member of the Center has an obligation for its own fixed share in this proposed settlement. The settlement class action does not include asbestos-related personal injury claims which were filed before January 15, 1993, or asbestos-related property damage claims. Agreed upon annual case flow caps and agreed upon compensation levels for each compensable medical category have been established for an initial period of ten years. The case flow figures and annual compensation levels are subject to renegotiation after the initial ten-year period. The Court has preliminarily approved the settlement, and notification has been provided to potential class members which were offered an opportunity to opt out by January 24, 1994. The Court will hold a final fairness hearing on February 22, 1994. If a significant number of future claimants choose to opt out, the Center members also reserve the right to withdraw from the program. The settlement will become final only after it has been approved by the courts. The Center members also have stated their intention to resolve over a five-year period the asbestos personal injury claims pending prior to the date the settlement class action was filed. A significant number of these pending claims have been settled with a number of the plaintiffs' counsel. - 60 - The company is seeking agreement from its insurance carriers or a ruling from the Court that the settlement class action will not jeopardize existing insurance coverage. Certain unresolved insurance coverage issues involving certain Center members' insurance carriers acceptance of the proposed settlement will be resolved either by alternative dispute resolution in the case of the insurance carriers which subscribed to the Wellington Agreement or by litigation against those carriers which did not subscribe to the Wellington Agreement. A few state judges have been undertaking to consolidate numbers of asbestos personal injury cases for trial. The company generally opposes these actions as being unfair. Approximately 8,500 cases were consolidated in 1992 in a multiphase trial in Baltimore, Maryland. The multiphase trial dealt with various issues and a settlement was effected during the trial of those claims in which the company was a named defendant. The pending personal injury lawsuits and claims against the company are being paid by insurance proceeds under the 1985 Agreement Concerning Asbestos-Related Claims, the "Wellington Agreement." A new claims handling organization, known as the Center for Claims Resolution, was created in October 1988 by Armstrong and 20 other companies to replace the Wellington Asbestos Claims Facility, which has been dissolved. Except for eliminating the future availability of an insurer- paid special defense fund linked to the existence of the Facility, the dissolution of the Facility does not essentially affect the company's overall Wellington insurance settlement which provides for a final settlement of nearly all disputes concerning insurance for asbestos-related personal injury claims as between the company and three of its primary insurers and eight of its excess insurers. The one primary carrier that did not sign the Wellington Agreement paid into the Wellington Facility and settled with the company in March 1989 all outstanding issues relating to insurance coverage for asbestos-related personal injury and property damage claims. In addition, one of the company's large excess-insurance carriers entered into a settlement agreement in 1986 with the company under which payments for personal injury claims were made through the Wellington Facility, and this carrier continues to make payments for such claims through the Center for Claims Resolution. Other excess-insurance carriers also have entered into settlement agreements with the company which - 61 - Litigation (continued) complement Wellington. ACandS, Inc., a former subsidiary of the company, which for certain insurance periods has coverage rights under some company insurance policies, subscribed to the Wellington Agreement but did not become a member of the Center for Claims Resolution. One excess carrier and certain companies in an excess carrier's block of coverage have become insolvent. Certain carriers providing excess level coverage solely for property damage claims also have become insolvent. However, it is not expected that the insolvency of these carriers will affect the company's ability to have insurance available to pay asbestos-related claims. ACandS, Inc., had filed a lawsuit against the company to have a certain amount of insurance from the joint policies reserved solely for its use in the payment of the costs associated with the asbestos-related personal injury and property damage claims. The two companies have negotiated a settlement of their dispute and have signed a settlement agreement. The Center for Claims Resolution operates under a concept of allocated shares of liability payments and defense costs for its members based primarily on historical experience, and it defends the members' interest and addresses pending and future claims in a manner consistent with the prompt, fair resolution of meritorious claims. In late 1991, the Center sharing formula was revised to provide that members will pay only on claims in which the member is a named defendant. This change has caused a slight increase in the company's share, but has enhanced the company's case management focus. Although the Center members and their participating insurers were not obligated beyond one year, the insurance companies are expected to commit to the continuous operation of the Center for a sixth year and to the funding of the Center's operating expenses. With the filing of the settlement class action, the Center will continue to process pending claims and will handle the program for processing future asbestos-related personal injury claims if the class action settlement is approved by the courts. No forecast can be made for future years regarding either the rate of pending and future claims resolution by the Center or the rate of utilization of company insurance, although it is expected if the settlement class action is approved that the rate of insurance usage will be accelerated. The company is also one of many defendants in a total of 73 pending lawsuits and claims, including class actions, as of December 31, 1993, brought by public and private entities, including public school districts, and public and private building owners. These lawsuits and claims include allegations of property damage to buildings caused by asbestos-containing products and generally claim compensatory and punitive damages and equitable relief, including reimbursement of expenditures, or removal and replacement of such products. These suits and claims appear to be aimed at friable (easily crumbled) asbestos-containing products although allegations in some suits encompass other asbestos-containing products, including allegations with respect to asbestos-containing resilient floor tile. The company vigorously denies the validity of the allegations against it contained in these suits and claims. Increasing defense costs, paid by the company's insurance carriers either under reservation or settlement arrangement, will be incurred. These suits and claims are not encompassed within the Wellington Agreement nor are they being handled by the Center for Claims Resolution. - 62 - In 1989, Armstrong concluded the trial phase of a lawsuit in California state court to resolve disputes concerning certain of its insurance carriers' obligations with respect to personal injury and property damage liability coverage, including defense costs, for alleged personal injury and property damage asbestos-related lawsuits and claims. As indicated earlier, the company reached a settlement agreement after the conclusion of the trial phase with one of its primary carriers which is also an excess carrier. The Court issued final decisions, and the carriers appealed. The California Court of Appeal has substantially upheld the trial court's final decisions and the insurance carriers have petitioned the California Supreme Court to hear the asbestos- related personal injury and property damage coverage issues. The California Supreme Court recently accepted review pending its review of related issues in another California case. Based upon the trial court's favorable final decisions in important phases of the trial relating to coverage for asbestos-related personal injury and property damage lawsuits and claims, including the favorable decision by the California Court of Appeal, and a review of the coverage issues by its counsel, the company believes it has a substantial legal basis for sustaining its right to defense and indemnification. For the same reasons, the company also believes that it is probable that claims by the several primary carriers for recoupment of defense expenses in the property damage litigation, which the carriers also appealed, will ultimately not be successful. The company is currently negotiating with the company's primary insurance carriers to categorize the percentage of previously resolved and to be resolved asbestos-related personal injury claims as non-products claims and to establish the entitlement to such coverage. Such non-product claims coverage insurance is available under the Wellington Agreement and the settlement agreement with one of its primary carriers referred to above for such claims. Non-products claims include claims that may have arisen out of exposure during installation of asbestos materials or before control of such materials has been relinquished. Certain excess policies also provide non-products coverage. The additional coverage potentially available to pay claims categorized as non-products, at both the primary and excess levels is substantial and, at the primary level, includes defense costs in addition to limits. The company is entitled to pursue alternative dispute resolution proceedings against the primary and certain excess carriers to resolve the non-products coverage issues. The company does not know how many claims will be filed against it in the future, nor the details thereof or of pending suits not fully reviewed, nor the expense and any liability that may ultimately result therefrom, nor does the company know the annual claims flow caps to be negotiated after the initial ten- year period for the settlement class action or the then compensation levels to be negotiated for such claims or the success the company may have in addressing the Midland Insurance Company insolvency with its other insurers. Subject - 63 - Litigation (continued) to the foregoing and based upon its experience and other factors referred to above, the company believes that it is probable that substantially all of the expenses and any liability payments associated therewith will be paid--in the case of the personal injury claims, by agreed-to coverage under the Wellington Agreement and supplemented by payments by nonsubscribing insurers that entered into settlement agreements with the company and additional insurance coverage reasonably anticipated from the outcome of the insurance litigation and from the company's claims for non-products coverage both under certain insurance policies covered by the Wellington Agreement and under certain insurance policies not covered by the Wellington Agreement which claims have yet to be accepted by the carriers--and in the case of the asbestos-related property damage claims, under an existing interim agreement, by insurance coverage settlement agreements and through additional coverage reasonably anticipated from the outcome of the insurance litigation. Thus, the company has not recorded any liability for any defense costs or indemnity relating to these lawsuits other than as described in the "Other long-term liabilities" section regarding the reserve on page 51. Even though uncertainties still remain as to the potential number of unasserted claims, the liability resulting therefrom, and the ultimate scope of its insurance coverage, after consideration of the factors involved, including the Wellington Agreement, the settlements with other insurance carriers, the results of the trial phase and the first level appellate stage of the California insurance litigation, the remaining reserve, the establishment of the Center for Claims Resolution, the proposed settlement class action, and its experience, the company believes that this litigation will not have a material adverse effect on its earnings, liquidity, or financial position. - -------------------------------------------------------------------------------- In October 1992, the U.S. Court of Appeals for the Third Circuit issued its decision in a lawsuit brought by The Industry Network System, Inc. (TINS), and its founder, Elliot Fineman. The plaintiffs alleged that in 1984 Armstrong had engaged in antitrust and tort law violations and breach of contract which damaged TINS' ability to do business. The Court of Appeals sustained the U.S. District Court's decision that the April 1991 jury verdict against Armstrong in the amount of $224 million including $200 million in punitive damages should be vacated, and that there should be a new trial on all claims remaining after the appeal. The Court of Appeals sustained the District Court ruling that the jury's verdict had reflected prejudice and passion due to the improper conduct of plaintiffs' counsel and was clearly contrary to the weight of the evidence. The Court of Appeals affirmed or did not disturb the trial court's order dismissing all of TINS' claims under Section 2 of the Sherman Act for alleged conspiracy, monopolization and attempt to monopolize and dismissing all of Mr. Fineman's personal claims. These claims will not be the subject of a new trial. However, the Court of Appeals reversed the trial court's directed verdict for Armstrong on TINS' claim under Section 1 of the Sherman Act, reversed the summary judgment in Armstrong's favor on TINS' claim for breach of contract based on a 1984 settlement agreement, and reversed the judgment n.o.v. for Armstrong on TINS' tortious interference and related punitive damage claims. These claims will be the subject of a new trial. - 64 - The Court of Appeals granted the company's motion to stay return of the case to the District Court pending the company's Petition for Certiorari to the Supreme Court appealing certain antitrust rulings of the Court of Appeals. The company was informed on February 22, 1993, that the Supreme Court denied its Petition. The case has been remanded by the Third Circuit Court of Appeals in Philadelphia to the U.S. District Court in Newark, New Jersey, and a new trial has been set for early April 1994. It is unknown what damage claims TINS will allege upon retrial of the case. But during the first trial, claims for actual damages of at least $17.5 million were asserted by plaintiffs' expert and even greater amounts were asserted by Mr. Fineman. Under the antitrust laws, proven damages are trebled. In addition, plaintiff would likely ask for punitive damages, companion to its request for tort damages. Other damages which would likely be sought include reimbursement of attorneys' fees and interest, including prejudgment interest. The company denies all of TINS' claims and accordingly is vigorously defending the matter. In the event that a jury finds against the company, such jury verdict could entail unknown amounts which, if sustained, could have a material adverse effect on its earnings and financial position. - -------------------------------------------------------------------------------- As previously discussed on pages 51 and 52 under "Environmental" with regard to a former county landfill in Buckingham County, Virginia, Thomasville Furniture Industries, Inc. and seven other parties have been identified by the U.S. Environmental Protection Agency ("USEPA") as Potentially Responsible Parties ("PRPs") to fund the cost of remediating environmental conditions at this federal Superfund site. After review of investigative studies to determine the nature and extent of contamination and identify various remediation alternatives, USEPA issued its Proposed Remedial Action Plan in May 1993 proposing a $21 million clean-up cost. In November 1993, however, USEPA issued a revised plan which recommended a reduced $3.5 million alternative, subject to additional costs depending on test results. The PRPs believe that other alternatives are appropriate and discussions with USEPA and Virginia State officials continue. Spent finishing materials from Thomasville's Virginia furniture plants at Appomattox and Brookneal allegedly comprise a significant portion of the waste presently believed to have been taken to the site by a now defunct disposal firm in the late 1970s. Accordingly, Thomasville could be called upon to fund a significant portion of the eventual remedial costs. - 65 - Independent Auditors' Report The Board of Directors and Shareholders, Armstrong World Industries, Inc.: We have audited the consolidated financial statements of Armstrong World Industries, Inc. and its subsidiaries as listed in the accompanying index. In connection with our audits of the consolidated financial statements, we also have audited the related supplementary information on depreciation rates and schedules listed in the accompanying index. These consolidated financial statements and supplementary information and schedules are the responsibility of the Company's management. Our responsibility is to express an opinion on these consolidated financial statements and supplementary information and schedules based on our audits. We conducted our audits in accordance with generally accepted auditing standards. These standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatements. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Armstrong World Industries, Inc., and subsidiaries at December 31, 1993 and 1992, and the results of their operations and their cash flows for each of the years in the three-year period ended December 31, 1993, in conformity with generally accepted accounting principles. Also, in our opinion the related supplementary information and schedules, when considered in relation to the basic financial statements taken as a whole, present fairly in all material respects, the information set forth therein. As discussed under litigation in the Financial Review section, the Company is involved in antitrust litigation, the outcome of which cannot presently be determined. Accordingly, no provision for any liability that may result has been made in the accompanying consolidated financial statements. Also, as discussed in the Financial Review section, effective January 1, 1992, the Company changed its methods of accounting to adopt the provisions of the Statement of Financial Accounting Standards (SFAS) 109, "Accounting for Income Taxes," SFAS 106, "Employers' Accounting for Postretirement Benefits Other than Pensions" and SFAS 112, "Employers' Accounting for Postemployment Benefits." KPMG PEAT MARWICK Philadelphia, Pa. February 14, 1994 - 66 - * Quarterly earnings (loss) per-share data do not always equal the total year amounts due to changes in the average shares outstanding and, for fully diluted data, the exclusion of the antidilutive effect in certain quarters and for the total year. - 67 - Fourth quarter 1993 compared with fourth quarter 1992 Fourth quarter sales from continuing businesses rose to record levels at $624.4 million, an increase of 4% from the $600.1 million from last year. The net loss for the fourth quarter was $22.0 million, or 68 cents per share of common stock. This loss included $60.0 million after tax of restructuring charges primarily related to the elimination of employee positions in the U.S. and Europe. The fourth quarter 1992 net loss was $15.6 million, or 51 cents per share of common stock. Also included in this reporting were restructuring charges of $24.3 million after tax related to the closing of a ceiling materials plant in Ghlin, Belgium, and provisions for charges related to the elimination of employee positions on a worldwide basis. Despite the negative impact of restructuring charges in the fourth quarter of 1993, the company benefitted from higher sales levels in most businesses, some sales price increases, and from lower manufacturing costs, resulting from the 1992 restructuring actions and from improved productivity. This resulted in the company's cost of goods sold as a percent of sales declining to 70.8% compared with 76.6% last year. Nonmanufacturing costs were comparable to 1992. Armstrong also experienced lower interest costs during the quarter from lower debt levels and tax obligations. The 1992 fourth quarter results also included a $5.5 million after-tax gain from foreign exchange compared with only $.8 million after-tax gain this year. The 1993 effective tax benefit rate was 39.9% compared with only 7.1% last year. Armstrong's current year fourth quarter reflected recovery of deferred taxes resulting from some reduced foreign statutory tax rates, and most of the restructuring charges provided tax benefits. The 1992 effective tax benefit rate was much lower because some of the restructuring charges did not provide tax benefits. Of Armstrong's four industry segments, floor coverings and furniture showed sales increases in the fourth quarter compared with year-ago levels, while sales in the building products and industry products segments were below those of 1992. Operating results were higher in the building products and furniture segments, while floor coverings and industry products declined. Excluding restructuring charges, all four segments recorded improved operating profits. The floor coverings operating profit of $12.9 million in 1993 and $13.4 million in 1992 includes restructuring charges of $27.7 million and $7.6 million, respectively. Exclusive of these charges, the improved profit levels were driven by higher U.S. resilient flooring sales, a modest increase in ceramic sales, and lower manufacturing costs. The building products' fourth quarter 1993 operating loss of $2.4 million includes a restructuring charge of $13.7 million compared with a 1992 operating loss of $14.9 million that included an $11.9 restructuring charge. Despite lower sales in building products, this segment's operating results improved because of extensive restructuring programs, lower operating costs, and some pricing actions in Europe and North America. The furniture segment's sales and operating profits improved from those of last year. Higher sales, along with lower costs, aided the profit improvement as did inventory valuation reserve adjustments. The industry products segment was adversely affected by unfavorable European exchange rates and the continuing lack of growth in the European economies. Operating profits were lowered by competitive pricing pressures, while restructuring charges of $12.9 million and $1.2 million were recorded for 1993 and 1992, respectively. Item 9.

Item 9. Changes in and Disagreements with Accountants on Accounting and - ------------------------------------------------------------------------- Financial Disclosure --------------------- Not applicable. - 68 - PART III -------- Item 10.

Item 10. Directors and Executive Officers of the Registrant - ------------------------------------------------------------ Directors of the Registrant - --------------------------- The information appearing in the tabulation in the section captioned "Election of Directors" on pages 1-5 of the Company's 1994 Proxy Statement is incorporated by reference herein. Executive Officers of the Registrant - ------------------------------------- William W. Adams* -- Age 59; Chairman of the Board since September 7, 1993; Chairman of the Board and President (Chief Executive Officer) 1988-1993; . E. Allen Deaver* -- Age 58; Executive Vice-President since March 1, 1988. George A. Lorch* -- Age 52; President (Chief Executive Officer) since September 7, 1993; Executive Vice-President 1988-1993. Henry A. Bradshaw -- Age 58; Group Vice-President, Worldwide Building Products Operations since February 1, 1993; Group Vice-President, Building Products Operations, 1990-1993; General Manager Manufacturing, Building Products Operations, 1985-1990. Dennis M. Draeger -- Age 53; Group Vice-President, Worldwide Floor Products Operations since February 1, 1993; Group Vice-President Floor Products Operations 1988-1993. William W. Locke -- Age 58; Group Vice-President, Worldwide Industry Products and Pacific Operations since February 1, 1993; Group Vice-President, International and Industry Products Operations, 1990-1993; Group Vice-President, International Operations, 1983-1990. Robert J. Shannon, Jr. -- Age 45; President, American Olean Tile Company, Inc. since March 1, 1992; and the following positions with Armstrong World Industries, Inc.: General Manager, Worldwide Gasket Products, International and Industry Product Operations, 1991-1992; Manager, Fiber Products, Industry Products Division, 1989-1991; Marketing Manager, Adhesives and Coatings, Corporate Markets Division, 1986-1989. Frederick B. Starr -- Age 61; President, Thomasville Furniture Industries, Inc. since 1982. Larry A. Pulkrabek -- Age 54; Senior Vice-President, Secretary and General Counsel since February 1, 1990; Vice-President, Secretary and General Counsel, 1977-1990. William J. Wimer -- Age 59; Senior Vice-President, Finance since January 25, 1993; Senior Vice-President, Finance, and Treasurer, 1990-1993; Vice-President and Controller, 1978-1990. Stephen C. Hendrix -- Age 53; Treasurer since January 25, 1993; and the following positions with SmithKline Beecham Corporation (Pharmaceuticals, Consumer Products): Vice-President and Treasurer, 1989-1991; Vice-President and Assistant Treasurer, International, 1987-1989. Bruce A. Leech, Jr. -- Age 51; Controller since February 1, 1990; Controller, International Operations, 1983-1990. - 69 - All information presented above is current as of March 1, 1994. The term of office for each Executive Officer in his present capacity is one year, and each such Executive Officer will serve until reelected or until a successor is elected at the annual meeting of directors which follows the annual shareholders' meeting. Each Executive Officer has been employed by the Company in excess of five continuous years with the exception of Mr. Hendrix. Members of the Executive Committee of the Board of Directors as of March 1, 1994, are designated by an asterisk(*) following each of their names. The Executive Committee consists of those Executive Officers who serve as Directors. Item 11.

Item 11. Executive Compensation - -------------------------------- The information appearing in the sections captioned "Compensation Committee Interlocks and Insider Participation," "Executive Officers' Compensation," (other than the information contained under the subcaption "Performance Graph") and "Retirement Income Plan Benefits," on pages 11-17 of the Company's 1994 Proxy Statement is incorporated by reference herein. Item 12.

Item 12. Security Ownership of Certain Beneficial Owners and Management - ------------------------------------------------------------------------ The information appearing in the sections captioned "Stock Ownership of Certain Beneficial Owners" on page 18 and "Directors' and Executive Officers' Security Ownership" on page 7 of the Company's 1994 Proxy Statement is incorporated by reference herein. Item 13.

Item 13. Certain Relationships and Related Transactions - -------------------------------------------------------- Not applicable. PART IV Item 14.

Item 14. Exhibits, Financial Statement Schedules, and Reports on Form 8-K - -------------------------------------------------------------------------- The financial statements and schedules filed as a part of this Annual Report on Form 10-K are listed in the "Index to Financial Statements and Schedules" on page 75. - 70 - a. The following exhibits are filed as a part of this Annual Report on Form 10-K: - 71 - - 72 - - 73 - b. During the last quarter of 1993, no reports on Form 8K were filed. SIGNATURES Pursuant to the requirements of Section 13 or 15(d) 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. ARMSTRONG WORLD INDUSTRIES, INC. -------------------------------- (Registrant) By /s/ George A. Lorch ----------------------------- President Date March 28, 1994 --------------------------- Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated. Directors and Principal Officers of the registrant: - 74 - ARMSTRONG WORLD INDUSTRIES, INC. AND SUBSIDIARIES Index to Financial Statements and Schedules The following consolidated financial statements and Financial Review are filed as a part of this Annual Report on Form 10-K: Consolidated Balance Sheets as of December 31, 1993 and 1992 Consolidated Statements of Earnings for the Years Ended December 31, 1993, 1992 and 1991 Consolidated Statements of Cash Flows for the Years Ended December 31, 1993, 1992, and 1991 The following additional financial data should be read in conjunction with the financial statements. Schedules not included with this additional data have been omitted because they are not applicable or the required information is presented in the financial statements or the financial review. - 75 - Computation for Primary Earnings Per Share for Years ended December 31 (Amounts in millions except for per-share data)(a) (a) In 1992 the Company adopted Statement of Financial Accounting Standards (SFAS) 109 "Accounting for Income Taxes." SFAS 109 requires recognition in shareholders' equity of the tax benefit for dividends paid on unallocated shares of stock held by an Employee Stock Ownership Plan which amounted to $5.3 million in 1993 and $5.5 million in 1992. Under SFAS 96, this benefit was recognized in the statement of earnings and amounted to $6.0 million in 1991. (b) In 1992 the Company adopted SFAS 112 "Employer's Accounting for Postemployment Benefits." A refinement of the computation in 1993 resulted in restatements of the 1992 earnings. The effect of the restatements was to reduce the previously reported loss from continuing businesses by $1.7 million or 5 cents per share and to reduce the previously reported net loss by $6.5 million or 18 cents per share. - 76 - Computation for Fully Diluted Earnings Per Share for Years ended December 31 (Amounts in millions except for per-share data) (a) Fully diluted earnings per share for years 1992 and 1991 were antidilutive. - 77 - ARMSTRONG WORLD INDUSTRIES, INC. AND SUBSIDIARIES Supplementary Information to Financial Review Depreciation - ------------ The approximate average effective rates of depreciation are as follows: - 78 - ARMSTRONG WORLD INDUSTRIES, INC. AND SUBSIDIARIES ------------------------------------------------- Property, Plant, and Equipment ------------------------------ Year Ended December 31, 1993 ---------------------------- (millions) SCHEDULE V ----------- Page 1 of 3 (a) includes writedowns relating to restructuring activities of: (b) transferred to/from other accounts and miscellaneous adjustments - 79 - ARMSTRONG WORLD INDUSTRIES, INC. AND SUBSIDIARIES ------------------------------------------------- Property, Plant, and Equipment ------------------------------ Year Ended December 31, 1992 ---------------------------- (millions) SCHEDULE V ---------- Page 2 of 3 (a) includes writedowns relating to restructuring activities of: (b) includes contribution of $6.8 million of Machinery and Equipment and $1.7 million of Construction in Progress to the Worthington Armstrong Venture (c) transferred to/from other accounts and miscellaneous adjustments - 80 - ARMSTRONG WORLD INDUSTRIES, INC. AND SUBSIDIARIES ------------------------------------------------- Property, Plant, and Equipment ------------------------------ Year Ended December 31, 1991 ---------------------------- (millions) SCHEDULE V ---------- Page 3 of 3 (a) transferred to/from other accounts, and miscellaneous adjustments - 81 - ARMSTRONG WORLD INDUSTRIES, INC. AND SUBSIDIARIES ------------------------------------------------- Accumulated Depreciation and Amortization of Property, Plant, and Equipment -------------------------------------------- Year Ended December 31, 1993 ---------------------------- (millions) SCHEDULE VI ----------- Page 1 of 3 (a) transferred to/from other accounts and miscellaneous adjustments - 82 - ARMSTRONG WORLD INDUSTRIES, INC. AND SUBSIDIARIES ------------------------------------------------- Accumulated Depreciation and Amortization of Property, Plant, and Equipment -------------------------------------------- Year Ended December 31, 1992 ---------------------------- (millions) SCHEDULE VI ----------- Page 2 of 3 (a) transferred to/from other accounts and miscellaneous adjustments - 83 - ARMSTRONG WORLD INDUSTRIES, INC. AND SUBSIDIARIES ------------------------------------------------- Accumulated Depreciation and Amortization of Property, Plant, and Equipment -------------------------------------------- Year Ended December 31, 1991 ---------------------------- (millions) SCHEDULE VI ----------- Page 3 of 3 (a) transferred to/from other accounts and miscellaneous adjustments - 84 - ARMSTRONG WORLD INDUSTRIES, INC. AND SUBSIDIARIES ------------------------------------------------- Valuation and Qualifying Reserves --------------------------------- Years Ended December 31, 1993, 1992 and 1991 -------------------------------------------- (millions) SCHEDULE VIII -------------- (a) includes discounts granted and uncollectible receivables, less recoveries and valuation reserves related to discontinued businesses that have been classified as other assets - 85 - ARMSTRONG WORLD INDUSTRIES, INC. AND SUBSIDIARIES ------------------------------------------------- SCHEDULE IX ----------- Short-Term Borrowings(a) --------------------- (millions) Page 1 of 2 (a) the terms and conditions of the various categories of short-term borrowings were those typically offered by lenders to companies with excellent credit ratings (b) based on total periods' interest expense (related to short-term borrowings) divided by the average amount outstanding during the period (c) based on daily balances divided by 365 days (d) based on daily balances divided by 365 days and, in some instances, based on total of 12 month-end balances divided by 12 - 86 - ARMSTRONG WORLD INDUSTRIES, INC. AND SUBSIDIARIES ------------------------------------------------- SCHEDULE IX ----------- Short-Term Borrowings(a) --------------------- (millions) Page 2 of 2 (a) the terms and conditions of the various categories of short-term borrowings were those typically offered by lenders to companies with excellent credit ratings (b) based on total periods' interest expense (related to short-term borrowings) divided by the average amount outstanding during the period (c) based on daily balances divided by 365 days (d) based on daily balances divided by 365 days and, in some instances, based on total of 12 month-end balances divided by 12 - 87 - EXHIBIT INDEX - 88 - - 89 - - 90 -

310158_1993.txt

310158

1993

Item 1. Business General Schering-Plough*, incorporated in 1970, is a worldwide company engaged in the research, development, manufacturing and marketing of pharmaceutical and health care products. Products include prescription drugs, vision care, animal health, over-the-counter (OTC), foot care and sun care products. Business Segment and Other Financial Information The "Business Segment Data" as set forth in the Notes to Consolidated Financial Statements in the Company's 1993 Annual Report to Shareholders is incorporated herein by reference. Sales by major product groups for each of the three years in the period ended December 31, 1993 were as follows (dollars in millions): 1993 1992 1991 Respiratory $1,185 $1,063 $ 986 Anti-infective and Anticancer 1,032 906 629 Dermatologicals 443 451 416 Cardiovasculars 316 267 238 Other Pharmaceuticals 399 405 345 OTC 312 346 376 Foot Care 240 214 218 Animal Health 154 157 141 Sun Care 131 117 113 Vision Care 112 111 140 Other Health Care Products 17 19 14 Consolidated Sales $4,341 $4,056 $3,616 Pharmaceutical Products The Company's pharmaceutical operations include prescription drugs, vision care products and animal health products. Principal prescription products include: CELESTAMINE, CLARITIN, POLARAMINE, PROVENTIL, THEO- DUR, TRINALIN, VANCENASE and VANCERIL, respiratory; CEDAX, EULEXIN, GARAMYCIN, INTRON A, ISEPACIN and NETROMYCIN, anti-infective and anticancer; DIPROLENE, DIPROSONE, ELOCON, FULVICIN, LOTRIMIN, LOTRISONE, QUADRIDERM and VALISONE, dermatologicals; K-DUR, NITRO-DUR and NORMODYNE, cardiovascular; CELESTONE, DIPROSPAN, LOSEC, NOIN, PALACOS and TRILAFON, other pharmaceuticals. * As used herein, the term "Schering-Plough" or "Company" refers to Schering-Plough Corporation and its consolidated subsidiaries unless the context indicates otherwise. Item 1. Business (continued) The Company's major vision care product line is contact lenses sold under the DURASOFT trademark. The leading product within the DURASOFT line is DURASOFT Colors, a soft lens that can alter the appearance of eye color. Also, in early 1994 the Company received marketing clearance from the U.S. Food and Drug Administration for its FRESHLOOK line of disposable contact lenses. Animal health biological and pharmaceutical products include antibiotics, vaccines, anti-arthritics, steroids and nutritionals. Major animal health products are: GENTOCIN and GARASOL, antibiotics, and BANAMINE, an anti-arthritic. Pharmaceutical products also include pharmaceutical chemical substances sold in bulk to third parties for production of their own products. Prescription drugs are introduced and made known to physicians, pharmacists, hospitals and managed care organizations by trained professional service representatives, and are sold to hospitals, managed care organizations and wholesale and retail druggists. Pharmaceutical products are also promoted through journal advertising, direct mail advertising and by distributing samples to physicians. Vision care products are promoted and sold by a separate sales force to practitioners and retail outlets. Animal health products are promoted and sold by a separate sales force to veterinarians, distributors and animal producers. To meet the anticipated worldwide need for its biotechnology-based pharmaceutical compounds, the Company is expanding its manufacturing facility in Brinny, Ireland. The total cost of the expansion is expected to be approximately $160 million. The Company is also expanding its Rathdrum, Ireland manufacturing operation to meet increasing demands. The overall cost of this project is expected to approximate $78 million. The Company's subsidiaries own (or have licensed rights under) a number of patents and patent applications, both in the United States and abroad. In the aggregate, patents and patent applications are believed to be of material importance to the operations of the pharmaceutical segment. In December 1989, the U.S. patent covering PROVENTIL, an asthma product, expired. The PROVENTIL formulations of the tablet, syrup and solution have been subject to generic competition. In January 1994, the Food and Drug Administration issued bioequivalence standards for generic albuterol metered dose inhalers, which may result in generic inhaler entries late in 1994. The introduction of a generic inhaler will negatively affect the sales and profitability of PROVENTIL. Raw materials essential to this segment are available in adequate quantities from a number of potential suppliers. Energy was and is expected to be available to the Company in sufficient quantities to meet operating requirements. Worldwide, the Company's pharmaceutical products are sold under trademarks. Trademarks are considered in the aggregate to be of material importance to the pharmaceutical business and are protected by registration or common law in the United States and most other markets where the products are sold or likely to be sold. Item 1. Business (continued) Seasonal patterns do not have a pronounced effect on the combined activities of this industry segment. There is generally no significant backlog of orders since the Company's business is normally conducted on an immediate shipment basis. The pharmaceutical industry is highly competitive and includes other large companies with substantial resources for research, product development and promotion. There are numerous domestic and international competitors in this industry. Some of the principal competitive techniques used by the Company for its pharmaceutical products include research and development of new and improved products, product quality, varied dosage forms and strengths, and educational services for the medical community. Health Care Products The principal product categories in the health care segment are the Company's over-the-counter (OTC) medicines, foot care and sun care products primarily sold in the United States. Principal products include: AFRIN and DURATION nasal decongestants; CHLOR-TRIMETON antihistamine; CORICIDIN and DRIXORAL cold and decongestant tablets; CORRECTOL laxative; CLEAR AWAY and DUO BRAND wart remover; DI-GEL antacid; GYNE-LOTRIMIN and FEMCARE for vaginal yeast infections; DR. SCHOLL'S foot care products; LOTRIMIN AF and TINACTIN antifungals; COPPERTONE, QT, SHADE, SOLARCAINE and TROPICAL BLEND sun care products; A and D ointment; and PAAS egg coloring and holiday products. Business in this segment is conducted through wholesale and retail drug, food chain and variety outlets, and is promoted directly to the consumer through television, radio, print and other advertising media. Raw materials essential to this segment are available in adequate quantities from a number of potential suppliers. Energy was and is expected to be available to the Company in sufficient quantities to meet operating requirements. Trademarks for the major products included in this segment are registered in the United States and most overseas countries where these products are marketed. Trademarks are considered to be vital to the operations of this segment. Principally due to the seasonal sales of sun care products, operating profits in this segment are relatively higher in the first half of the year. There is generally no significant backlog of orders since the Company's business is normally conducted on an immediate shipment basis. The health care products' industry is highly competitive and includes other large companies with substantial resources for product development and promotion. There are several dozen significant competitors in this industry. The Company believes that in the United Item 1. Business (continued) States it has a leading position in the foot care and sun care industries, with its DR. SCHOLL'S lines of foot pads, cushions, wart removal and other treatments and its brands of sun care products. In addition, the Company's brands are among the leaders in nasal sprays, laxatives, antifungals and vaginal yeast infection treatments sold OTC. The principal competitive techniques used by the Company in this industry segment include switching prescription products to OTC medicines, the development and introduction of new and improved products, and product promotion methods to gain and retain consumer acceptance. Foreign Operations Foreign activities are carried out primarily through wholly-owned subsidiaries wherever market potential is adequate and circumstances permit. In addition, the Company is represented in some markets through joint ventures, licensees or other distribution arrangements. There are approximately 11,200 employees outside the United States. Foreign operations are subject to certain risks which are inherent in conducting business overseas. These risks include possible national- ization, expropriation, importation limitations and other restrictive governmental actions. Also, fluctuations in foreign currency exchange rates can significantly impact the Company's consolidated financial results. For additional information on foreign operations, see "Management's Discussion and Analysis of Operations and Financial Condition" and "Business Segment Data" in the Company's 1993 Annual Report to Shareholders which is incorporated herein by reference. Operations in Puerto Rico The Company has operations in Puerto Rico that manufacture products for distribution to both domestic and foreign markets. These businesses operate under tax-relief and other incentives granted by the government of Puerto Rico that expire at various dates through 2018. The Company has also been exempt from U.S. tax on certain income derived from its operations in Puerto Rico. The Omnibus Budget Reconciliation Act of 1993 will phase down this exemption over the next five years to 40 percent of the pre-amendment level. The Company will be partially impacted by this change in 1994. Under present U.S. tax laws, accumulated funds generated from operations in Puerto Rico can be remitted tax-free to the parent company. Under recently revised Puerto Rico tax laws, remittance of these funds, with the exception of certain amounts qualifying for tax free distribution, will result in a tollgate tax of from 5 percent to 10 percent based upon prescribed dividend and investment restrictions. For additional information relating to the Puerto Rico operations, see "Income Taxes" in the Notes to Consolidated Financial Statements in the Company's 1993 Annual Report to Shareholders which is incorporated herein by reference. Item 1. Business (continued) Research and Development The Company's research activities are primarily aimed at discovering and developing new and enhanced pharmaceutical products of medical and commercial significance. Company sponsored research and development expenditures were $577.6 million, $521.5 million and $425.9 million in 1993, 1992, and 1991, respectively. Research expenditures represented approximately 13 percent of consolidated sales in 1993 and 1992 and 12 percent in 1991. The Company's pharmaceutical research activities are concentrated in the therapeutic areas of allergic and inflammatory disorders, infectious and cardiovascular diseases, oncology and central nervous system disorders. The Company also has substantial efforts directed toward biotechnology and immunology. While several pharmaceutical compounds are in varying stages of development, it cannot be predicted when or if products will become available for commercial sale. Government Regulation Most products manufactured or sold by the Company are subject to varying degrees of governmental regulation in the countries in which operations are conducted. In the United States, the drug industry has long been subject to regulation by various federal, state and local agencies, primarily as to product safety, efficacy, advertising and labeling. Compliance with the broad regulatory powers of the Food and Drug Administration (the "FDA") requires significant amounts of Company time, testing and documentation, and corresponding costs to obtain clearance of new drugs. Similar product regulations also apply in many international markets. In the United States, many of the Company's pharmaceutical products are subject to competitive pricing as managed care groups, institutions and the government seek price discounts. President Clinton's health care reform proposal includes several measures that, if enacted, will have an impact on operations of the Company. These measures include, but are not limited to, the requirement of all health plans to offer prescription drug coverage, the extension of Medicare coverage to include outpatient drugs, and rebates on Medicare sales. In addition, prices of new drugs would be reviewed with the Secretary of Health and Human Services, who would be empowered to deny Medicare reimbursement for those drugs deemed too expensive. In most international markets, the Company operates in an environment of government-mandated cost containment programs. In addition, several markets have enacted across-the-board price reductions or directly control selling prices as a further method of cost control. Currently, a number of other international markets are reviewing the implementation of additional programs to contain health care costs. For additional information on prescription drug pricing, see "Management's Discussion and Analysis of Operations and Financial Condition" in the Company's 1993 Annual Report to Shareholders which is incorporated herein by reference. Item 1. Business (continued) The Company has and will continue to comply with the government regulations of the countries in which operations are conducted. Environment To date, compliance with federal, state and local environmental protection laws has not had a materially adverse effect on the Company. The Company has and will continue to make necessary expenditures for environmental protection. Worldwide capital expenditures during 1993 included approximately $31.7 million for environmental control purposes. It is anticipated that continued compliance with such environmental regulations will not significantly affect the Company's financial condition, results of operations or its competitive position. For additional information on environmental matters, see "Legal and Environmental Matters" in the Notes to the Consolidated Financial Statements in the Company's 1993 Annual Report to Shareholders which is incorporated herein by reference. Employees There were approximately 21,600 people employed by the Company at December 31, 1993. Item 2.

Item 2. Properties The Company's corporate headquarters are located in Madison, New Jersey. Principal manufacturing facilities are located in Kenilworth and Union, New Jersey, Des Plaines, Illinois, Miami, Florida, the Commonwealth of Puerto Rico, Argentina, Australia, Belgium, Canada, Colombia, France, Ireland, Italy, Japan, Mexico and Spain (pharmaceutical products); Cleveland and Memphis, Tennessee (health care products). The Company's principal research facilities are located in Kenilworth and Union, New Jersey and Palo Alto, California (DNAX Research Institute). The major portion of properties is owned by the Company. These properties are maintained in good operating condition, and the manufacturing plants have capacities considered appropriate to meet the Company's needs. Item 3.

Item 3. Legal Proceedings Schering Corporation and White Laboratories, Inc., which are Company subsidiaries, are defendants in approximately 95 lawsuits, involving approximately 140 plaintiffs, arising out of the use of synthetic estrogens by the mothers of the plaintiffs. In many of these lawsuits, a substantial number of other drug companies are also defendants. The female plaintiffs claim various injuries, including cancerous or precancerous lesions of the vagina and cervix and a multiplicity of pregnancy problems. A number of suits involve infants with birth defects born to daughters whose mothers took the drug. The total amount claimed against all defendants in all the suits amounts to approximately $750 million. While it is not possible to precisely predict the outcome of these proceedings, it is management's opinion that the ultimate liability, if any, will not have a material impact on the Company's consolidated financial position or results of operations. Item 3. Legal Proceedings (continued) The Company has been named as a potentially responsible party ("PRP") by the government under the Comprehensive Environmental Response, Compensation and Liability Act, commonly known as Superfund. The Company is also a party to a number of proceedings brought under Superfund. These proceedings seek to require the owners or operators of facilities that treated, stored or disposed of hazardous substances and transporters and generators of such substances to clean up contaminated facilities or reimburse the government for its clean up costs. The Company has been named a PRP or a party to these proceedings as an alleged generator of hazardous substances found at certain facilities. In each proceeding, the government or private litigants allege that the Company is jointly and severally liable for clean up costs. Although joint and several liability is alleged, a company's share of clean up costs is frequently determined on the basis of the type and quantity of hazardous substances sent to a facility by the generator. However, this allocation process varies greatly from facility to facility and can take years to complete. The Company's potential share of clean up costs also depends on how many other parties are involved in the proceedings, insurance coverage, available indemnity contracts and contribution rights against other parties. While it is not feasible to predict or determine the outcome of these proceedings, in the opinion of management, such proceedings should not ultimately result in a liability which would have a material adverse effect on the Company's consolidated financial position or results of operations. The Company is a defendant in approximately sixty antitrust lawsuits filed in several states and federal courts, including California, Georgia, Illinois, Louisiana, Minnesota, New York, Pennsylvania, South Carolina and Texas. More than fifty of these are class action lawsuits. These actions were commenced in the second half of 1993 and in 1994 by independent and chain pharmacies against the Company and other pharmaceutical manufacturers, and in some instances, wholesalers and mail order pharmacies, alleging (1) conspiracy to restrain trade by jointly refusing to sell pharmaceuticals at discounted prices to plaintiffs, and/or (2) price discrimination. The federal cases have all been consolidated in the United States District Court for the Northern District of Illinois for pretrial and discovery purposes. Plaintiffs seek treble damages in an unspecified amount and an injunction against the allegedly unlawful conduct. The Company has not conspired to restrain trade and believes that its pricing practices have been and are in compliance with the law. The Company will defend itself vigorously against the claims in all these actions. While it is not feasible to predict or determine the outcome of these actions, management believes that such actions should not result in any liability which would have a material adverse effect on the Company's consolidated financial position or results of operations. Item 4.

Item 4. Submission of Matters to a Vote of Security Holders Not applicable. Executive Officers of the Registrant The following information regarding executive officers is included herein in accordance with Part III, Item 10. Officers are elected to serve for one year and until their successors shall have been duly elected. Name and Current Position Business Experience Age Robert P. Luciano Present position 1986 60 Chairman and Chief Executive Officer Richard J. Kogan Present position 1986 52 President and Chief Operating Officer David E. Collins Present position 1989; President 59 Executive Vice President and Chief Operating Officer - Galen and President Associates, Inc. 1988-1989 Schering-Plough HealthCare Products Donald R. Conklin Present position 1989; Executive 57 Executive Vice President Vice President - Pharmaceutical and President Operations 1987-1989 Schering-Plough Pharmaceuticals Hugh A. D'Andrade Present position 1984 55 Executive Vice President Administration Harold R. Hiser, Jr. Present position 1986 62 Executive Vice President Finance Joseph C. Connors Present position 1992; Vice 45 Senior Vice President President and General Counsel and General Counsel 1991; Staff Vice President and Deputy General Counsel 1987-1991 Allan S. Kushen Present position 1981 64 Senior Vice President Public Affairs Daniel A. Nichols Present position 1991; Vice 53 Senior Vice President President Taxes 1983-1991 Taxes Executive Officers of the Registrant (continued) Name and Current Position Business Experience Age Gordon C. O'Brien Present position 1988 53 Senior Vice President Human Resources J. Martin Comey Present position 1991; Vice 59 Vice President President and Treasurer Administration and Business 1979-1990 Development John T. Fogarty Present position 1990; Staff 64 Vice President, Secretary Vice President and Secretary and Associate General Counsel 1980-1989 Geraldine U. Foster Present position 1988 51 Vice President Investor Relations Domenic Guastadisegni Present position 1990; Staff 63 Vice President Vice President - Corporate Audits Corporate Audits 1980-1989 Thomas H. Kelly Present position 1991; Partner, 44 Vice President and Deloitte & Touche 1982-1990 Controller Robert S. Lyons Present Position 1991; Staff 53 Vice President Vice President - Corporate Corporate Information Information Services 1988-1990 Services Jack L. Wyszomierski Present position 1991; Staff 38 Vice President and Vice President - Planning Treasurer and Business Development 1987-1990 Part II Item 5.

Item 5.Market for Registrant's Common Equity and Related Stockholder Matters The Common Share Dividends and Market Data as set forth in the Company's 1993 Annual Report to Shareholders are incorporated herein by reference. Item 6.

Item 6.Selected Financial Data The Six-Year Selected Financial and Statistical Data as set forth in the Company's 1993 Annual Report to Shareholders is incorporated herein by reference. Item 7.

Item 7.Management's Discussion and Analysis of Financial Condition and Results of Operations Management's Discussion and Analysis of Operations and Financial Condition as set forth in the Company's 1993 Annual Report to Shareholders is incorporated herein by reference. Item 8.

Item 8.Financial Statements and Supplementary Data The Consolidated Balance Sheets as of December 31, 1993 and 1992, and the related Statements of Consolidated Income, Consolidated Retained Earnings and Consolidated Cash Flows for each of the three years in the period ended December 31, 1993, Notes to Consolidated Financial Statements, the Independent Auditors' Report of Deloitte & Touche and Quarterly Results of Operations, as set forth in the Company's 1993 Annual Report to Shareholders, are incorporated herein by reference. Item 9.

Item 9.Changes in and Disagreements with Accountants on Accounting and Financial Disclosure Not applicable. Part III Item 10.

Item 10.Directors and Executive Officers of the Registrant The information concerning directors and nominees for directors as set forth in the Company's Proxy Statement for the annual meeting of share- holders on April 26, 1994 is incorporated herein by reference. Information required as to executive officers is included in Part I of this filing under the caption "Executive Officers of the Registrant." Item 11.

Item 11.Executive Compensation Executive compensation information as set forth in the Company's Proxy Statement for the annual meeting of shareholders on April 26, 1994 is incorporated herein by reference. Item 12.

Item 12.Security Ownership of Certain Beneficial Owners and Management Information concerning security ownership of certain beneficial owners and management as set forth in the Company's Proxy Statement for the annual meeting of shareholders on April 26, 1994 is incorporated herein by reference. Item 13.

Item 13.Certain Relationships and Related Transactions Information concerning certain relationships and related transactions as set forth in the Company's Proxy Statement for the annual meeting of shareholders on April 26, 1994 is incorporated herein by reference. Part IV Item 14.

Item 14.Exhibits, Financial Statement Schedules, and Reports on Form 8-K (a) 1.Financial Statements The following consolidated financial statements and independent auditors' report, included in the Company's 1993 Annual Report to Shareholders, are incorporated herein by reference. Statements of Consolidated Income for the Years Ended December 31, 1993, 1992 and 1991 Statements of Consolidated Retained Earnings for the Years Ended December 31, 1993, 1992 and 1991 Statements of Consolidated Cash Flows for the Years Ended December 31, 1993, 1992 and 1991 Consolidated Balance Sheets at December 31, 1993 and 1992 Notes to Consolidated Financial Statements Independent Auditors' Report (a) 2.Financial Statement Schedules Page in Form 10-K Independent Auditors' Report . . . . . . . . . . . . 18 Schedule I - Marketable Securities - Other Investments. . . . . . . . . . . . . . . . . . . . 19 Schedule V - Property, Plant and Equipment . . . . . 20 Schedule VI - Accumulated Depreciation of Property, Plant and Equipment. . . . . . . . . . . 21 Schedule VIII - Valuation and Qualifying Accounts. . 22 Schedule IX - Short-term Borrowings. . . . . . . . . 23 Schedule X - Supplementary Income Statement Information. . . . . . . . . . . . . . . . . . . . 24 Item 14. (continued) (a) 2.Financial Statement Schedules (continued) Schedules not included have been omitted because they are not applicable or not required or because the required information is set forth in the financial statements or the notes thereto. Columns omitted from schedules filed have been omitted because the information is not applicable. Financial statements of fifty percent or less owned companies accounted for by the equity method have been omitted because, considered individually or in the aggregate, they do not constitute a significant subsidiary. (a) 3. Exhibits Exhibit Method Number Description of Filing 3(a) A complete copy of the Certificate Incorporated by of Incorporation as amended and reference to Exhibit currently in effect. 3(a) to the Company's Annual Report for 1989 on Form 10-K 3(b) A complete copy of the By-Laws Incorporated by as amended and currently in effect. reference to Exhibit 4(b) to the Company's Form S-8 (No. 33- 19013) 4(a) Rights Agreement between the Incorporated by Company and The Bank of New York reference to Exhibit 4 dated July 25, 1989. to the Company's Quarterly Report for the period ended June 30, 1989 on Form 10-Q 4(b) Indenture dated as of November 1, Incorporated by 1982 between the Company and The reference to Exhibit Chase Manhattan Bank, N.A. as 4(a) to the Company's Trustee. Registration Statement on Form S-3, File No. 2-80012 4(c) Supplemental Indenture No. 1 Incorporated by dated as of November 1, 1991 reference to Exhibit 4.1 to Indenture dated as of to the Company's Report November 1, 1982. on Form 8-K dated November 20, 1991 4(d) LYNX Equity Unit Agreement Incorporated by reference to Exhibit 10.1 to the Company's Report on Form 8-K dated October 1, 1991 Item 14. (continued) (a) 3. Exhibits (continued) Exhibit Method Number Description of Filing 4(e) LYNX Equity Unit Guarantee Incorporated by Agreement reference to Exhibit 10.1 to the Company's Report on Form 8-K dated October 1, 1991 10(a) The Company's Executive Incentive Plan incorporated by Plan (as amended) and Trust related reference to Exhibit thereto 10(a) to the Company's Annual Report for 1991 on Form 10-K. Trust Agreement incorporated by reference to Exhibit 10(a) to the Company's Annual Report for 1988 on Form 10-K 10(b) The Company's 1983 Stock Incentive Incorporated by Plan (as amended) reference to Exhibit 10(c) to the Company's Annual Report for 1988 on Form 10-K 10(c) The Company's 1987 Stock Incentive Incorporated by Plan (as amended) reference to Exhibit 10(d) to the Company's Annual Report for 1990 on Form 10-K 10(d) The Company's 1992 Stock Incentive Incorporated by Plan (as amended) reference to Exhibit 10(d) to the Company's Annual Report for 1992 on Form 10-K 10(e)(i) Employment agreement between the Incorporated by Company and Robert P. Luciano reference to Exhibit 10(e)(i) to the Company's Annual Report for 1989 on Form 10-K 10(e)(ii) Employment agreement between the Incorporated by Company and Richard J. Kogan reference to Exhibit 10(e)(ii) to the Company's Annual Report for 1989 on Form 10-K 10(e)(iii) Employment agreement between the Incorporated by Company and David E. Collins reference to Exhibit 10(e)(iv) to the Company's Annual Report for 1989 on Form 10-K Item 14. (continued) (a) 3. Exhibits (continued) Exhibit Method Number Description of Filing 10(e) Agreements between the Company and Incorporated by (iv) certain executive officers related reference to Exhibit to termination payments 10(e)(v) to the Company's Annual Report for 1989 on Form 10-K 10(f) Directors Deferred Compensation Plan incorporated by Plan and Trust related thereto reference to Exhibit 10 (f) to the Company's Annual Report for 1991 on Form 10-K. Trust Agreement incorporated by reference to Exhibit 10(a) to the Company's Annual Report for 1988 on Form 10-K 10(g) Pension Plan for Directors Plan incorporated by and Trust related thereto reference to Exhibit 10(g) to the Company's Annual Report for 1987 on Form 10-K; Trust Agreement incorporated by reference to Exhibit 10(g) to the Company's Annual Report for 1988 on Form 10-K; Amendment to Trust Agreement filed with this document 10(h) Supplemental Executive Retirement Plan incorporated by Plan and Trust related thereto reference to Exhibit 10(h) to the Company's Annual Report for 1987 on Form 10-K; Trust Agreement incorporated by reference to Exhibit 10(g) to the Company's Annual Report for 1988 on Form 10-K; Amendment to Trust Agreement filed with this document in 10(g) above 10(i) Directors Stock Award Plan Incorporated by reference to Exhibit 10(i) to the Company's Annual Report for 1988 on Form 10-K 11 Computation of Earnings Per Filed with this document Common Share Item 14. (continued) (a) 3. Exhibits (continued) Exhibit Method Number Description of Filing 12 Computation of Ratio of Filed with this document Earnings to Fixed charges 13 The Financial Section of the Filed with this document Company's 1993 Annual Report to Shareholders. With the exception of those portions of said Annual Report which are specifically incorporated by reference in this Form 10-K, such report shall not be deemed filed as part of this Form 10-K 22 Subsidiaries of the registrant Filed with this document 24 Consents of experts and counsel Filed with this document 25 Power of attorney Filed with this document All other exhibits are not applicable. Copies of above exhibits will be furnished upon request. (b) Reports on Form 8-K None SIGNATURES Pursuant to the requirements of Section 13 or 15 (d) 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. Schering-Plough Corporation (Registrant) Date March 4, 1994 By /s/ Thomas H. Kelly Thomas H. Kelly Vice President and Controller Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the date indicated. By * By * Robert P. Luciano Regina E. Herzlinger Chairman and Chief Executive Director Officer and Director By * By * Richard J. Kogan H. Barclay Morley President and Chief Operating Director Officer and Director By * By * Harold R. Hiser, Jr. Richard de J. Osborne Executive Vice President - Finance Director and Principal Financial Officer By * By * Thomas H. Kelly William A. Schreyer Vice President and Controller Director and Principal Accounting Officer By * By * Hans W. Becherer Robert F. W. van Oordt Director Director By * By * Hugh A. D'Andrade R. J. Ventres Director Director By * By * Virginia A. Dwyer James Wood Director Director By * David C. Garfield Director *By /s/ Thomas H. Kelly Date March 4, 1994 Thomas H. Kelly Attorney-in-fact INDEPENDENT AUDITORS' REPORT Schering-Plough Corporation: We have audited the consolidated balance sheets of Schering-Plough Corporation and subsidiaries as of December 31, 1993 and 1992 and the related statements of consolidated income, retained earnings and cash flows for each of the three years in the period ended December 31, 1993, and have issued our report thereon dated February 15, 1994; such financial statements and report are included in your 1993 Annual Report to Shareholders and are incorporated herein by reference. Our audits also included the financial statement schedules of Schering-Plough Corporation and subsidiaries, listed in Item 14. These financial statement schedules are the responsibility of the Company's management. Our responsibility is to express our opinion based on our audits. In our opinion, such financial statement schedules, when considered in relation to the basic financial statements taken as a whole, present fairly in all material respects the information set forth therein. /s/DELOITTE & TOUCHE Parsippany, New Jersey February 15, 1994 SCHEDULE V PAGE SCHEDULE VI ________________________________________________________________

7649_1993.txt

7649

1993

ITEM 1. BUSINESS Asarco, a New Jersey corporation organized in 1899, is one of the world's leading producers of nonferrous metals, principally copper, lead, zinc, silver and gold. Asarco also produces specialty chemicals, minerals and provides environmental services. Asarco has substantial interests in three mining companies; a 17.2% stake in M.I.M. Holdings Limited (MIM) in Australia, a 52.3% interest in Southern Peru Copper Corporation (SPCC) and a 28.3% holding in Mexico Desarrollo Industrial Minero, S.A. de C.V. (MEDIMSA). Asarco or its associated companies operate mines in the United States, Australia, Mexico and Peru. Asarco and its associated companies together in 1993 accounted for about 13% of western world mine production of copper, 13% of silver, 22% of lead and 13% of zinc. All tonnages are expressed in short tons. All ounces are troy ounces. Dollar amounts are expressed in U.S. dollars unless otherwise indicated. "Asarco" or "the Company" includes Asarco and its consolidated subsidiaries. Reference is made to the following Financial Statement footnotes included in this report: Acquisitions on page A40, Investments on pages A40 through A43, and Business Segments on pages A49 through A51. Additional business information follows: PRIMARY METALS PRINCIPAL PRODUCTS AND MARKETS COPPER The primary domestic uses of copper are in the building and construction industry, electrical and electronic products and, to a lesser extent, industrial machinery and equipment, consumer and general products and transportation. A substantial portion of Asarco's copper sales are made under annual contracts to industrial users. In the second quarter of 1993, the Company was reorganized to bring under common management all of the Company's copper properties. This organizational change coincided with the completion of Asarco's copper modernization and expansion program, begun in 1989. That program raised the Company's mined copper production sufficiently to fully supply its smelter capacity. The Company's copper operations are now managed from Tucson, Arizona. The principal focus of copper operations management's attention in 1993 was to establish operating goals for all employees, defining what each needed to accomplish daily for the Company to meet its long-term production and cost objectives. Today, employees in the copper operations know specifically what is required of them and improvements in production are becoming increasingly evident. The Mission and Ray mines and the Hayden smelter in Arizona, and the El Paso smelter and the Amarillo refinery in Texas are the Company's principal copper operating units. Asarco also owns a 49.9% interest in Montana Resources, which supplies copper concentrates to the Company's smelters, and owns the Silver Bell mine in Arizona and the Troy mine in Montana, which are temporarily shut down. Since 1985, the Company has increased its ore reserves eight fold to more than 2 billion tons at the end of 1993. Mine production of 332,600 tons of contained copper, including electrowon cathodes, in 1993 was five times the 1985 level of production. The Ray mine is Asarco's largest copper mine, which can produce 165,000 tons per year of contained copper. Last year was the first full year of production for Ray's expanded copper concentrate operation. Concentrate capacity has been increased by two-thirds at Ray since its acquisition by Asarco in 1986. Production at the mine was hampered in late 1992 and early 1993 by severe rains and flooding. Flooding severed the rail line to the Hayden concentrator for three weeks in the first quarter and disrupted mining operations, resulting in lost production and added costs totalling $22 million after-tax. While the severe effect of the rains was overcome by the second quarter, substantial amounts of water retained in the pit continued to affect operations for the balance of the year. A2 The Ray mine produced 159,300 tons of copper in 1993. Production of copper in concentrates in 1993 was 122,700 tons which, despite the rain and flooding, was about the same level of production as in 1992. Production of solvent extraction/electro-winning (SX/EW) copper in 1993 decreased 13% from 1992 to 36,600 tons of copper in cathodes. This reduction represented both rain-related production losses and a reduction in the rate at which silicate ore is being processed. As a result of the reduction in the processing of silicate ore, future SX/EW production rates will be approximately the same level as 1993 production. Ray's ore reserves at year-end were 1.1 billion tons. Asarco's Mission mine has more than doubled its capacity since 1985. Asarco began production at the Mission mine in 1961. Over the last several years the contiguous Eisenhower and Pima mines were acquired and incorporated into a single open pit. Production at the Mission Complex in 1993 increased 14% over 1992 to 117,900 tons of copper contained in concentrates. Mission's ore reserves at year-end were 543 million tons. Production of copper concentrates from the Ray and Mission mines and Montana Resources in 1993 fully met the concentrate feed requirements at the Hayden and newly modernized El Paso smelters. The Hayden smelter processes copper concentrate from the Mission and the Ray Mines, using oxygen flash furnace technology. Production of copper in anodes at Hayden decreased 7% to 194,200 tons in 1993 due to scheduled maintenance during the first quarter of the year. The El Paso plant uses a new continuous top-feed oxygen process (CONTOP) to produce copper in anode. The new system, which expanded smelter capacity from 80,000 to 110,000 tons per year of copper in anode, also improved the sulfur dioxide recapture rate from 65% to 98%. Sulfur dioxide is recovered and treated at El Paso's acid plants. The new furnace achieved 90% of design capacity by year-end, following modifications during a nine month shakedown period. Although production was affected by the startup, the 272,700 tons of concentrates smelted at El Paso in 1993 equalled the amount smelted in 1992. Anode production at El Paso was 15% lower due to lower copper content in concentrates processed and lower blister and scrap treated. Anodes produced by the El Paso and Hayden smelters are refined at Asarco's Amarillo refinery, which produces copper cathodes. Late in the year, the Amarillo Copper Refinery completed installation and startup of a new electrolyte purification facility to improve copper quality and permit the refinery to operate at a higher rate. The facility removes impurities, principally antimony and bismuth from the electrolyte. Amarillo's 1993 cathode production of 460,000 tons was slightly below that of 1992. Asarco also processes about half of the output of Montana Resources, in which the Company has a 49.9% interest. Montana Resources produced 47,200 tons of copper in concentrates in 1993. LEAD, ZINC, SILVER AND MINERAL OPERATIONS The Company's lead, zinc, silver and mineral operations also were integrated under common management in the second quarter of 1993. Management's attention was focused principally on spending and production targets and on fully utilizing existing capacity. Each operation developed plans identifying the resources needed to meet these targets and specific responsibilities were established with each employee. Progress toward achieving these targets is monitored through new reporting techniques developed to track results and to provide feedback. As a result, operations during the second half of 1993 improved and became more consistent and predictable. Total Quality Management programs, emphasizing employee empowerment, were used extensively in 1993 to improve purchasing practices and reduce costs. LEAD The primary domestic uses of lead are for automotive and industrial batteries and, to a lesser extent, for lead oxide for glass, solder and other industrial users. A substantial portion of Asarco's lead sales are made under annual contracts to industrial users. Asarco's lead business consists of two quite distinct operations. In Missouri, the Company operates an integrated lead circuit consisting of the West Fork and Sweetwater mines which provide over 90% of the feed for the nearby Glover smelter and refinery. In the west, the Company operates a custom lead business, processing concentrates for others at the East Helena smelter and the Omaha refinery. This circuit also is supplied with A3 concentrates from the Company's mine in Leadville, Colorado and the Quiruvilca mine in Peru. The West Fork and Sweetwater mines produce lead concentrates and achieved record concentrate production of 158,900 tons, 16% more than in 1992. Refined production at the Glover smelter declined 5% to 124,200 tons due to equipment failures early in the year. During the second half of the year, the consistency of operations at Glover and production rates improved significantly. The 73,500 tons of refined lead production from the custom lead circuit declined 2% from 1992 due to interruptions of concentrate deliveries from South America early in the year. These interruptions were eliminated later in 1993 due to changes in shipping arrangements, resulting in improved production. ZINC Zinc is primarily used in the United States to make galvanized metal products, zinc-based alloys, brass products, zinc oxide, rolled zinc and for other industrial uses. Zinc is sold in concentrate form under contracts of 1-3 years duration. Asarco is one of the nation's leading zinc miners producing 61,800 tons of zinc contained in concentrates from its four mines in Tennessee. In addition, the Sweetwater, West Fork and Leadville mines produced 32,800 tons of zinc contained in concentrate. The Company sells all of its zinc concentrates to smelters owned by others. A failure of the ball mill at the Young mill in July suspended operations at three of the Tennessee mines for over three months. The production lost was partially offset by improved zinc production in Missouri. The Company's Quiruvilca mine in Peru produced 18,600 tons of zinc contained in concentrates. Total zinc production declined 6%, to 113,200 tons, from the previous year. SILVER The principal uses for silver in the United States are for photographic, electrical and electronic products and, to a lesser extent, brazing alloys and solder, jewelry, coinage, silverware, catalysts and other miscellaneous uses. Silver is sold under monthly contracts or in spot sales to industrial users. While silver is found as a co-product in the ores mined at various Asarco properties, Asarco put its last major silver-producing mine, the Troy mine, on standby in April 1993 due to low silver prices. Asarco's two silver mines in Idaho, Coeur and Galena, also are on standby. Silver production declined 29% in 1993 as a result of these mine closures. While the price of silver rose in 1993 to $4.22 per ounce, from $3.97 per ounce in 1992, it will take higher sustained silver prices to justify the reopening of the Company's silver mines. GOLD The Company's principal gold mining activities have been conducted through Asarco Australia Limited (Asarco Australia). In mid 1993, Asarco sold a portion of its previously 60% owned subsidiary and shortly after year-end sold its remaining interest in Asarco Australia. The results of the final sale will be recorded in 1994. In the last eight years Asarco has realized over $106 million in cash from its original investment of $4 million in Asarco Australia. MINERALS Sales of American Limestone Company, Asarco's wholly owned construction aggregate and ready-mixed concrete and agricultural limestone subsidiary, grew slightly in 1993 due to increased construction activity in its operating area in the southeastern part of the United States. Earnings, however, remained level due to increased competition and higher production costs. SPECIALTY CHEMICALS Enthone-OMI produces high performance coating technologies for engineering, functional and decorative applications which it supplies worldwide to the electronics and metal finishing industries. Earnings improved in 1993 as a result of the recovery in U.S. chemical sales and continued growth in Asia. European operations were restructured in mid 1993 in response to sales declines in that region. This restructuring brought European operations to break-even by year-end 1993 and places Enthone-OMI in a good position to capitalize on the expected recovery in European business levels in 1994. A4 ENVIRONMENTAL SERVICES Asarco's Environmental Services business include: Encycle/Texas, Inc. of Corpus Christi, Texas, Hydrometrics, Inc. of Helena, Montana and Biotrace Laboratories, Incorporated of Salt Lake City, Utah. Encycle operates a waste recycling facility in Corpus Christi which recovers and recycles nonferrous metals from hazardous and nonhazardous inorganic solids and solutions. The recovered metals are returned to commerce. Hydrometrics, with several offices in the west, provides a wide range of professional consulting services for industrial clients, municipalities and public agencies. The construction division of Hydrometrics provides complete remediation and cleanup services for contaminated industrial sites as well as Superfund sites. Biotrace specializes in biological laboratory analysis for trace metals and chemicals. The three companies, while small, are growing. ASSOCIATED COMPANIES Asarco made good progress in 1993 in its efforts to improve the cash returns on its investments in associated companies. M.I.M Holdings Limited (MIM) of Australia, in which Asarco has a 17.2% interest, had net earnings in its latest fiscal year of A$74.0 million, compared with prior year earnings of A$106.3 million. Sales for the most recent fiscal year were A$1.93 billion, compared with A$1.75 billion the year earlier. Asarco received $8.3 million in dividends from MIM in 1993, compared with $8.8 million in 1992. MIM has been pursuing cost-reduction measures throughout its copper, lead, zinc, silver, gold and coal operations. MIM, which also has interests in metals companies in Europe and North America, completed a five-year program of capital expenditures in 1993 that increases mine capacity and production and enhances processing technology and environmental performance. In November 1993, Asarco reached agreement with Grupo Industrial Minera Mexico, S.A. de C.V. (Grupo Mexico) to restructure Asarco's 28.3% holding in Mexico Desarrollo Industrial Minero S.A. de C.V. (MEDIMSA). Under the terms of the agreement, MEDIMSA will be combined with Grupo Mexico, a publicly traded company, and Asarco will own a 23.6% stake in the new public corporation. The agreement is subject to governmental and regulatory approvals. The agreement with Grupo Mexico, by giving Asarco access to public international financial markets for a portion of its investment in Grupo Mexico, will improve the liquidity of Asarco's investment. Southern Peru Copper Corporation (SPCC), 52.3% owned by Asarco, operates two open-pit copper mines and a smelter in Peru. SPCC paid dividends to Asarco of $9.4 million in 1993, compared with $7.8 million in 1992. During 1993, Peru reached agreement with a number of major international financial organizations, including the World Bank and the IMF, and in November, following a national referendum, a constitutional government was restored. As a consequence of these and other favorable developments, Asarco resumed equity accounting for its investment in SPCC in the fourth quarter of 1993. SPCC signed an agreement in May 1993 for $60 million of financing for a 41,000 ton solvent extraction/electro-winning operation near its Cuajone and Toquepala mines. The plant, which will cost $106 million, is part of a five-year, $300 million capital program to expand production, replace equipment and improve the environmental operations at SPCC's facilities. SPCC also received commitments from Peruvian banks for $25 million of financing. In January 1994, SPCC signed an agreement for $115 million of financing with a group of European banks which, combined with previously completed financing, provides SPCC with a total of $200 million of financing for its expansion program. ENVIRONMENTAL PROTECTION AT ASARCO Asarco's objective is not only to comply with existing environmental, safety and health laws and regulations but also to support activities that contribute to environmental protection, responsible resource management and the safety and health of employees, customers and members of the community. The Company policy states: "ASARCO Incorporated recognizes and believes that all operations and activities of the Company should be conducted responsibly and in a manner designed to protect the health and safety of its employees, its customers, the public and the environment. Asarco's operations interact with the environment daily, and consideration of these concerns must be a way of life within the Company. Asarco is committed to responsible management of our natural resources." A5 To assure compliance with this policy, a senior executive was named in 1993 to oversee all of Asarco's environmental efforts. The Company has extensive internal compliance review programs and all domestic units will have been visited by mid-1994 by compliance review teams. BACKLOG OF ORDERS Substantially all of the Company's metal production is sold under annual contracts. To the extent not sold under annual contracts, production can be sold in terminal markets or on commodities exchanges. Sales values cannot be determined until the sale is priced based on prevailing commodity prices at the time the price is fixed under the terms of the contract. The backlog for other product classes and services is not material. COMPETITIVE CONDITIONS In the United States and abroad, Asarco and its foreign nonconsolidated asso- ciated companies are subject to competition from other producers in all major product lines. Asarco's metal products also compete with other materials, including aluminum, stainless steel, plastics, glass and wood. Competition in nonferrous metals is principally on a price and service basis, with price being by far the most important consideration when supplies of the commodities involved are ample. In construction aggregates, geographic location of facilities in relation to the point of consumption, and price are by far the most important competitive factors. In specialty chemicals, Asarco competes against a substantial number of large and small companies both in the United States and overseas. EMPLOYEES At December 31, 1993, Asarco employed about 8,500 persons, of whom about 3,900 were covered by contracts with various unions, most of which were affiliated with the AFL-CIO. ENERGY MATTERS Asarco's energy requirements are met from a variety of sources, including fuel oil, diesel fuel, gasoline, natural gas, coke and electric power. Asarco has a large number of contracts of varying duration for its energy needs, typically negotiated on an individual basis from time to time. Generally, substitute sources are available except where requirements are guaranteed by local utility companies. No reductions or interruptions of any operations because of energy shortages were experienced in 1993. The cost of coke decreased; fuel oil, diesel fuel and natural gas increased, while cost of gasoline and electric power remained about the same on average. A6 ENVIRONMENTAL, SAFETY AND HEALTH MATTERS Asarco's operations are subject to environmental regulation by various federal, state, local, and foreign governments. Asarco's principal involvement in this area concerns compliance by its existing and former operations with federal and state air and water quality and solid and hazardous waste regulations. The Company believes that its operations are currently in substantial compliance with applicable environmental laws and regulations. As of December 31, 1993, there remained $11.6 million of previously appropriated funds yet to be expended for ongoing environmental control projects at the Company's operating units. The majority of these funds are scheduled to be expended during 1994. Capital expenditures by Asarco at its operating U.S. mines and plants in order to comply with environmental standards in the past three years have been (in millions): 1993-$21.3; 1992-$8.3; 1991-$4.8. In 1993, these expenditures included modernization and improvement of environmental controls at the Amarillo, Texas, East Helena, Montana, Glover, Missouri, Omaha, Nebraska, Hayden, Arizona, El Paso, Texas plants, the Ray and Mission mines in Arizona and the Immel Mine in Tennessee. Estimated environmental operating costs before taxes and depreciation but including interest on environmental improvement bonds and other debt incurred for environmental control facilities reduced pre-tax earnings by (in millions): 1993-$96; 1992-$87; 1991-$73. Environmental matters are discussed in the Contingencies and Litigation Note to the Financial Statements on page A43 and A44 of this report and in Management's Discussion and Analysis of Operations and Financial Condition on pages A28 through A31. The following is additional information with respect to notices that Asarco has received from the United States Environmental Protection Agency ("EPA") that it and, in most instances, numerous other parties are potentially responsible to correct alleged hazardous substance releases under the Comprehensive Environmental Response, Compensation and Liability Act of 1980 ("CERCLA") at the following locations on the dates indicated: the Commencement Bay and related areas in Tacoma, Washington (1982 and subsequent years); the Leadville, Colorado site, including the Yak drainage tunnel (1983); the Company's former Tacoma smelter site (1984); lead and zinc mining areas in the Picher Mining Field in southeastern Cherokee County, Kansas (1985); the East Helena smelter (1987); the Ruston, Washington area (1988); the Kansas City smelter site in Kansas (1989); the Bunker Hill mining and smelting site in Kellogg, Idaho (1990); Jasper County, Missouri (1990); the Summitville site in Rio Grande County, Colorado (1993); the Circle Smelting site in Beckemeyer, Illinois (1993); the Apache Powder site in Benson, Arizona (1993); the Colorado School of Mines Research Institute in Golden, Colorado (1993); the ILCO Superfund site in Leeds, Alabama (1993); the Mingo smelter site in Sandy, Utah (1993); the Triumph Mine Tailings Pile proposed site in Triumph, Idaho (1993). In December 1992 and June 1993, the Company received similar notices from the United States Forest Service with respect to, respectively, the Bonanza mining site in Saguache County, Colorado and a former exploration project known as the Buckskin Mine located in Humboldt County, Nevada. In addition, as a result of the acquisition in June 1989 of a 49.9% partnership interest in the Montana copper mine owned by Montana Resources, Inc., Asarco and a subsidiary have been named as potentially responsible parties for certain CERCLA sub-sites in Butte, Montana. In 1993, the Murray smelter site in Murray, Utah, formerly owned by the Company, and the Company's Globe plant have been proposed for inclusion on the EPA's National Priority List. In 1987, part of a subsidiary's former plant site in Houston was listed on the Texas "Superfund Registry." In 1991, the State of Washington named the Company as a potentially liable person at a site in Everett, Washington where the Company operated a smelter early in the century. The State of Montana notified Asarco in 1991 that it had been identified as a potentially liable person for hazardous or deleterious substance contamination of the Upper Blackfoot River allegedly resulting from the release of materials from Asarco's former Mike Horse mine in Lewis and Clark County, Montana, a property previously mined by Asarco and several others. In June 1992, the State of Mississippi informed the Company it may be responsible for remediation at the Pascagoula Marine Terminal at the Port of the same name. In March 1992 the New Mexico Environmental Department notified the Company that it was evaluating sites near Deming and Magdalena for potential inclusion on the National Priorities List and invited the Company to negotiate investigation and remediation actions at the sites. In April 1993, the State of Texas notified the Company that it and ten other persons were potentially responsible parties with respect to the Col-Tex Refinery State Superfund Site in Mitchell County, Texas, where the Company stored diesel fuel in the mid-1970's. The A7 Company has also been named as one of a number of other defendants in eleven lawsuits filed by or on behalf of 188 persons who have lived or owned property near the Col-Tex Refinery Site seeking compensatory and punitive damages for alledged wrongful death, personal injury, and property damage. The Company and certain of its subsidiaries are cooperating with environmental authorities at other sites to undertake studies of the sites and remediate where necessary. Remedial action is being undertaken by the Company at the Yak drainage tunnel, Ruston, Bunker Hill, Mike Horse, Deming, Magdalena and Everett sites. At the Everett site, the Company has offered to purchase approximately 20 residences located on the former smelter site. The Company is discussing with the United States Forest Service a voluntary remedial action for the Bonanza mine. At the Yak drainage tunnel, the Res-Asarco Joint Venture has been ordered to conduct a remediation program which was substantially completed in 1992. The Company's fifty percent share of this program is expected to cost approximately $13.7 million most of which has been expended. Over the next several years, additional remedial programs not included in this order, and remedial programs addressing other areas in and around Leadville, will be required. With respect to Leadville, the Company is currently involved in detailed multi-party settlement negotiations with the EPA and several others and has included in its environmental reserves a provision for the anticipated cost of a settlement to the extent that a reasonable estimate can be made. At the Jasper, Missouri site the Company and other potentially responsible parties have been ordered to supply bottled water to over 60 residences because of contamination in the shallow aquifer. At Ruston, Washington, remediation consisting of removal and replacement of soils at ten public access sites as part of an expedited response action has been completed. In 1993, the EPA issued an Administrative Order to the Company to remediate residential soils in the town. At the Bunker Hill site, remediation is currently being undertaken as part of an emergency response action. The Company and at least five other potentially responsible parties are negotiating with the EPA an overall long-term remediation program that will involve substantial additional costs to be shared among the parties. Resolution of this matter is expected later in 1994. The Company signed a Consent Decree with the EPA on August 28, 1991 in which the Company agreed to undertake partial remediation, including certain stabilization and demolition activities, at the Company's former Tacoma, Washington smelter. The program commenced in January 1993 and is estimated to cost approximately $12 million over a period of two to three years. The Company signed a Consent Decree with EPA on July 16, 1991 to resolve some of the issues in proceedings involving the Company's East Helena, Montana smelter. In the Consent Decree, the Company agreed to take certain remedial actions with regard to residential soils surrounding the smelter involving approximately $10 million in ongoing remediation costs over the next three to five years. In addition, other remediation activities at East Helena are taking place pursuant to a 1990 Consent Decree. In early 1992, the Company notified the EPA that it would not contest an order issued by the EPA to undertake remediation work at a former Kansas City, Kansas smelter site which had been owned by a former subsidiary early in this century. The remediation work has been completed. In 1992, the Company completed initial remediation work at a former smelter site in Everett, Washington pursuant to an order from the Washington Department of Ecology. Additional sampling is ongoing. With respect to the Circle Smelting Superfund site in Beckemeyer, Illinois, on March 9, 1994, the Company and Federated Metals Corporation ("Federated"), a wholly-owned subsidiary, were notified that the EPA is planning to conduct a time-critical emergency removal action at the site. The notice requested the Company and Federated to perform or finance those actions and reimburse the EPA for its costs. The Company is negotiating with EPA concerning implementation of the removal at the site. The Company is involved in litigation under CERCLA and state law involving alleged hazardous substance releases at the Leadville site, various log sort yards and a landfill in Tacoma, the Company's Globe Plant in Denver, and Everett, Washington. The suits seek substantial damages and remediation costs. With respect to the Globe case, on February 18, 1993, the State of Colorado issued its Record of Decision regarding its proposed remediation plan for the Company's plant located in Denver, Colorado. The Record of Decision has been approved by the U.S. District Court. With respect to the log sort yard cases, in 1991 a federal court and jury in Tacoma determined that Asarco's responsibility A8 for remediation costs at six log yards and a landfill ranges from 75 percent to 100 percent. The cost of the remediation at one log yard has been determined to be approximately $5.6 million. The costs at the other yards and at the landfill are expected to be determined in future proceedings. Asarco was also found responsible for attorneys' fees and interest in the amount of approximately $5 million. Asarco appealed these rulings to the United States Court of Appeals for the Ninth Circuit which in September 1993 affirmed the lower court rulings except for certain elements of the state law claims, the award of attorneys' fees, and damages for the loss of use of the properties in question. Certain claims were also remanded to the trial court for further proceedings. Petitions for rehearing of certain aspects of the decision remain pending. The Company is considering whether to seek further judicial review. Certain events and circumstances arising in 1990 and 1992 allowed Asarco to make reasonable estimates of the extent and cost of environmental contingencies at the above and other sites and thus record additional reserves. At Tacoma, Leadville, Bunker Hill, and East Helena there were developments such as draft feasibility studies, work plans and negotiations or agreements with the EPA. Based on these and other developments, the reserves for these and other sites were increased. In total, the Company's environmental and closed plant reserves were increased by $75.5 million in 1990, $7.3 million in 1991, $72.4 million in 1992 and $6.2 million during 1993. In October 1992, the United States Department of Justice on behalf of EPA notified the Company that it intends to sue seeking civil penalties for alleged violation of the Company's water discharge permit at the Company's Ray Complex. Under the Clean Water Act civil penalties may amount to $25,000 per day for each violation. The Company is negotiating with EPA and the Department of Justice to resolve this matter. On March 2, 1994, the Company was notified by the United States Department of Justice that it was seeking a civil penalty of $389,000 in connection with emissions from the ore storage building baghouse at the East Helena Plant. The Company is currently negotiating with EPA and the Department of Justice to resolve this matter. Also in 1993, the Company's Glover Smelter and West Fork Mine were issued Notices of Violation of their National Pollution Discharge Elimination System ("NPDES") permits by the State of Missouri Department of Natural Resources. The Company is negotiating settlements in both matters. In January 1994, the Company received a notice from the EPA regarding alleged violations of the Resource Conservation and Recovery Act ("RCRA") at the smelter facility in El Paso, Texas. The proposed civil penalty in this matter is $140,400. The citation relates to sand-blasting material utilizing slag from the smelter's operations left on site by a contractor prior to May 1993. The Company is cooperating with the EPA to resolve this matter. In January 1994 the Company received notification dated January 13, 1994 from an attorney that upon the expiration of a 60-day statutory notice period a suit on behalf of two citizens would be filed against it under the Clean Water Act for operating the Company's Omaha plant without a NPDES permit unless the Nebraska Department of Environmental Quality ("NDEQ") took appropriate enforcement action. Asarco had applied to NDEQ for a NPDES permit in 1982 and had been operating the plant under stipulations with NDEQ entered in 1985 and 1988. On March 14, 1994 the Company filed an action in federal district court in Lincoln, Nebraska with the NDEQ as defendant, seeking a declaration that by reason of the stipulations with NDEQ, and actions taken in conjunction with the stipulations, Asarco is not discharging in violation of the Clean Water Act. On March 15, 1994 the citizens' suit was filed in the federal district court in Omaha, Nebraska seeking to enjoin further discharges from the Omaha Plant, penalties of up to $25,000 per day for past and future discharges, and costs and fees. On March 16 Asarco moved to consolidate the two actions in federal court in Lincoln, Nebraska and to stay the citizens' suit until the underlying issues in the first action are decided. On March 4, 1992 the Company's Glover, Missouri lead smelter and refinery received a Notice of Violation for monitored levels of lead in excess of the ambient air lead standard at two off-site monitoring stations. The Company is investigating the cause of these excess levels and intends to work with the Missouri Department of Natural Resources to develop a new State Implementation Plan for lead. Additionally, the Missouri Department of Natural Resources ordered the Company to conduct stack testing at the plant to determine whether the plant is in compliance with applicable emission regulations. State implementation plans designed to achieve compliance within two to three years with the EPA ambient air quality standard for lead of 1.5 micrograms per cubic meter of air have been or are being developed in each state in which Asarco has a facility. These plans will require the construction of additional controls at Asarco's East Helena, A9 Glover, and Omaha facilities. The Omaha Plant has been issued a complaint and compliance order by the Nebraska Department of Environmental Quality for violating the lead standard. A request for a hearing before the Department has been filed. With respect to regulation of the Company's wastes under RCRA, the Company is studying means of compliance through process changes at its facilities, where feasible, to manage the wastes not presently excluded from regulation. Mine tailings; slag and slag tailings from primary copper processing; calcium sulfate wastewater treatment plant sludge from primary copper processing; and slag from primary lead processing of the Company's operations are still automatically excluded from RCRA regulation. The Company's Glover smelter has executed a proposed Consent Decree with the Missouri Department of Natural Resources, in which the Company has agreed to implement certain process changes and conduct various sampling and testing plans to remain in compliance with RCRA requirements. Asarco is subject to federal and state legislation and regulations pertaining to plant and mine safety and health conditions, including the Occupational Safety and Health Act of 1970 and the Federal Mine Safety and Health Act of 1977. Asarco has made, and is likely to continue to make, expenditures to comply with such legislation and regulations. A10 ITEM 2.

ITEM 2. PROPERTIES ASARCO WORLDWIDE OPERATIONS METALS COPPER MINES(1) Mission; Sahuarita, Arizona Montana Resources; Butte, Montana Ray; Hayden Arizona Silver Bell(3); Silver Bell, Arizona PLANTS Amarillo, Texas (Refinery) (Also Selenium, Tellurium) El Paso, Texas (Smelter) (Also Sulfuric Acid) Hayden, Arizona (Smelter) (Also Sulfuric Acid) Ray; Hayden, Arizona (Smelter(3)) (Electrowinning Plant) LEAD MINES (1) Leadville; Leadville, Colorado Sweetwater; Reynolds County, Missouri West Fork, Reynolds County, Missouri PLANTS East Helena, Montana (Smelter) (Also Sulfuric Acid) Glover, Missouri (Smelter, Refinery) Omaha, Nebraska (Refinery) (Also Bismuth) ZINC MINES (1) Coy; Jefferson County, Tennessee Immel; Knox County, Tennessee New Market; Jefferson County, Tennessee Young; Jefferson County, Tennessee A11 SILVER MINES (1) Coeur(3); Wallace, Idaho Galena(3); Wallace, Idaho Troy(3); Troy, Montana Quiruvilca (Corporacion Minera Nor Peru, S.A.) (Also Copper, Lead and Zinc); Peru GOLD MINES (1) Aquarius(3); Timmins, Ontario, Canada Asarco Australia Limited(4); Wiluna, Western Australia Jundee, Western Australia PRECIOUS METALS PLANTS SILVER AND GOLD, Amarillo, Texas (Refinery) PALLADIUM AND PLATINUM (CRUDE) Amarillo, Texas SPECIALTY CHEMICALS ENTHONE-OMI North America Long Beach, California Bridgeview, Illinois West Haven, Connecticut Orange, Connecticut Warren, Michigan Toronto, Canada Mexico City, Mexico Europe Barcelona, Spain s-Hertogenbosch, Netherlands Woking, United Kingdom Milan, Italy Turin, Italy Marne-La-Vallee, France Brunn Am Gebirge, Austria Erkrath, Germany Norrkoping, Sweden Geneva, Switzerland Pacific Rim Thomastown, Australia Kowloon, Hong Kong Singapore (2) Shen Zhen, People's Republic of China (2) Tokyo, Japan (2) Taipei, Taiwan MINERALS AMERICAN LIMESTONE COMPANY Construction Aggregates Concrete, Agricultural Limestone Knoxville, Tennessee Tri-Cities, Tennessee Nashville, Tennessee Abingdon, Virginia A12 ENVIRONMENTAL SERVICES Encycle/Texas, Inc. Corpus Christi, Texas Hydrometrics, Inc. Helena, Montana Biotrace Laboratories, Inc., Salt Lake City, Utah OTHER ANTIMONY OXIDE, Omaha, Nebraska HIGH PURITY METALS, Denver, Colorado LEAD FABRICATION Lone Star Lead Construction Corp. Houston, Texas ASSOCIATED COMPANIES M.I.M. HOLDINGS LIMITED (17.2%) Australia Mount Isa (copper, silver, lead, zinc) Hilton (silver, lead, zinc) Townsville (copper refinery) Newlands, Collinsville (coal) (75% MIM interest) Oaky Creek (coal) (86.5% MIM interest) Ravenswood, Tick Hill (gold) England Britannia Refined Metals Limited (lead and silver refiners, secondary lead plant) Britannia Recycling Limited (secondary lead plant) Avonmouth (zinc smelter) Datteln, Germany Zinc refinery (45% MIM interest) Zinc products (33.3% MIM interest) Hamburg, Germany (Copper smelter, copper, lead and gold refineries) (35% MIM interest) Duisburg, Germany (50% MIM interest) zinc-lead smelting/refining Brixlegg, Austria Copper refinery, recycling (25.5% MIM interest) Papua New Guinea Highlands Gold Limited (65% MIM interest) 30% Porgera mine (gold) Investments in resources companies: ASARCO Incorporated (25.0%), Cominco Ltd. (effectively 22.5%), Granges Inc. (37.5%) and Metallgesellschaft AG (3.5%) and Metal Trader Metallgesellschaft Limited (33.3%). A13 MEXICO DESARROLLO INDUSTRIAL MINERO, S.A. de C.V. (MEDIMSA) (28.3%) Thirteen mines, nine metallurgical plants throughout Mexico, including: La Caridad and Cananea (Copper, Lead, Zinc, Silver, Gold, Coal, Coke, Fluorspar, Sulfuric Acid) SOUTHERN PERU COPPER CORPORATION (52.3%) Cuajone (Copper, Silver, Molybdenum) Toquepala (Copper, Silver, Molybdenum) Ilo (Copper Smelter) (1)Interest in mines is shown in Mineral Reserves tables starting on page A15 (2)Joint venture interests (3)On standby (4)Asarco's investment in Asarco Australia was sold in January 1994. (5)(Percent ownership of companies shown in parentheses) COEUR, GALENA AND LEADVILLE These mines are operated by Asarco under lease and joint venture agreements. In Coeur (50%) and Leadville (53.1%), Asarco has a interest in operating expenses and profits or losses in proportion to the related ownership interest. In Galena, Asarco receives 75% of profits remaining after royalty payments to the lessor of 50% of operating profits before depletion, depreciation and Idaho tax. The Coeur mine was temporarily shut down commencing in April 1991 due to depressed silver prices. The Galena mine was temporarily shut down commencing in July, 1992, also due to depressed silver prices. TROY Troy is operated by Asarco under a lease agreement. Asarco retains 75% of net proceeds after operating expenses but before depletion, depreciation and income taxes. The Troy mine was temporarily shut down commencing in April 1993 due to depressed silver prices. QUIRUVILCA The Quiruvilca mine is operated under a Peruvian government concession held by Corporacion Minera Nor Peru, S.A., an 80% owned subsidiary of a wholly owned Asarco subsidiary. MISSION MINE A portion of the mine is held under long-term leases in which the lessors have retained a royalty interest. SILVER BELL Only copper precipitates are currently produced. WEST FORK A portion of the mine is held under a long-term lease in which the lessor has retained a royalty interest. ASSOCIATED COMPANIES Southern Peru Copper Corporation, a 52.3% owned associated company, operates the Cuajone and Toquepala mines under Peruvian government concessions. Mexico Desarrollo Industrial Minero, S.A. de C.V. (MEDIMSA), a 28.3% owned associated company, operates thirteen mines under concessions granted by the Mexican government. The Company sold its remaining 45.3% interest (66.5 million shares) in Asarco Australia for $79.5 million, in January 1994. A14 The following production information is provided: A15 METAL PRODUCTION STATISTICS COPPER A16 METAL PRODUCTION STATISTICS (continued) LEAD A17 METAL PRODUCTION STATISTICS (continued) ZINC (000s TONS) A18 METAL PRODUCTION STATISTICS (continued) SILVER A19 METAL PRODUCTION STATISTICS (continued) GOLD A20 All mineral reserves represent 100% of the reserves for that mine and the percentage ownership of Asarco and associated companies is separately indicated. All mineral reserves are as of December 31, 1993, except for M.I.M. Holdings Limited which are as of June 30, 1993, and MEDIMSA which are as of December 31, 1992. Reserves are estimated quantities of proven and probable ore that under present and anticipated conditions may be economically mined and processed for the extraction of their mineral content. The data for MIM and MEDIMSA are as published by those companies and supplemental information to support the reserves for those companies has not been reviewed by the U.S. Securities and Exchange Commission. Controlled mineral deposits include those owned, directly or indirectly through subsidiaries, partnerships or joint ventures, optioned, leased, or held under government concession. All production figures represent entire amounts of operations, including those under lease, joint venture, government concessions or operated by subsidiaries or associated companies. Metal production figures for associated companies are from mines. Data for MIM are based on its June 30 fiscal year. OTHER OPERATIONS The following is additional information on other operations of the Company. The principal activities included in the business segment entitled "Other" are those of Capco Pipe Company, Inc. ("Capco"), a wholly owned subsidiary that manufactures polyvinyl chloride pipe, ("PVC") the environmental services operations of other subsidiaries and the zinc oxide production of a unit operating in Hillsboro, Illinois. None of these operations constitute a significant portion of the total operations of the Company. During 1993 Capco permanently shut down its asbestos cement pipe business. The Company plans to dispose of its PVC and zinc oxide operations in 1994. ITEM 3.

ITEM 3. LEGAL PROCEEDINGS Reference is made to the Contingencies and Litigation Note to the Financial Statements on page A43 and A44 of this report. The following is additional information with respect to the asbestos personal injury litigation. While no one personal injury action is exactly like any other, the following three pending lawsuits are typical of those in which employees of other companies allege death or injury resulting from alleged exposure to asbestos fiber supplied by Lac d'Amiante du Quebec, Ltee ("LAQ"), a wholly-owned subsidiary, and other suppliers to their employers' manufacturing operations: 1) In POGORZELSKI, ET AL. V. AMTORG TRADING CORPORATION, ET AL., Docket No. L-12274-91, pending since October 31, 1991 in the Superior Court of New Jersey, Middlesex County, 19 primary and 8 secondary plaintiffs sued LAQ and 25 other defendants that allegedly supplied asbestos fiber or asbestos containing products to Johns-Manville's Manville, New Jersey facility for substantial compensatory and punitive damages for death or injuries allegedly resulting from the primary plaintiffs' exposure to asbestos fiber while employed at that facility. The claims of seven of the primary plaintiffs were dismissed as to LAQ in June 1992. The plaintiffs allege a broad range of respiratory and other injuries including disabling lung changes, asbestosis, cancer, and mesothelioma. Liability is alleged on theories of strict liability, negligence, breach of warranty, misrepresentation, ultra hazardous activity and conduct, conspiracy, concert of action, market share or enterprise liability, and alternative liability. The thrust of the complaint is that the defendants, individually or collectively, failed to warn the primary plaintiffs of the possible hazards associated with inhalation of asbestos fibers while working with or being exposed to such fibers. 2) In CAMPBELL V. W.R. GRACE AND COMPANY, ET AL., Docket No. CV-92-0295147S, pending since May 14, 1992 in the Superior Court of Connecticut for the Judicial District of Fairfield at Bridgeport, one primary and one secondary plaintiff sued LAQ and 14 other defendants that allegedly supplied asbestos fiber or asbestos containing products to various job sites in Connecticut including the Raybestos-Manhattan facility in Stratford, Connecticut. Plaintiffs seek substantial compensatory and punitive damages for pleural plaques allegedly resulting from primary plaintiff's exposure to asbestos fiber while employed at these job sites. The thrust of the complaint is similar to the POGORZELSKI case. A21 3) In RETTBERG V. ARMSTRONG WORLD INDUSTRIES, INC., ET AL., Case No. May Term 1993, No. 1734, pending since May 11, 1993 in the Pennsylvania Court of Common Pleas, Philadelphia County, one primary and one secondary plaintiff sued LAQ and nine other defendants that allegedly supplied asbestos fiber or asbestos containing products to Owens-Corning Fiberglas Corporation's Berlin, New Jersey facility or various other job sites including Quaker Shipyard, R.T.C. Shipyard, Universal-Dundle, New York Shipyard, and RCA. The plaintiffs demand substantial compensatory and punitive damages for "bilateral pleural thickening" allegedly resulting from primary plaintiff's exposure to asbestos fiber while employed at these facilities. The thrust of the complaint is similar to the POGORZELSKI case. The WELSH V. ASBESTOS CORPORATION, LTD., ET AL. case described in Item 3 of Asarco's 1992 Form 10-K was settled in February 1993 and the BATTEN V. GARLOCK, INC. ET AL. case also described in the same item was administratively dismissed in October 1993. In addition to these personal injury lawsuits arising out of alleged asbestos exposure to employees of other companies using asbestos fiber in their manufacturing operations, included in the asbestos product liability lawsuits pending against LAQ and Asarco are numerous lawsuits arising from products (such as insulation and brake linings) manufactured by others. These cases typically allege a failure to warn of possible health hazards associated with those products and proceed on theories similar to those asserted in the POGORZELSKI case. In many such cases LAQ and Asarco, having never manufactured such products, have obtained dismissals. Typical of lawsuits in which plaintiffs allege asbestos exposure due to products manufactured by others are: 1) BITTINGER V. ACME SAFETY PRODUCTS, ET AL., Case No. 88-7-2206, pending since July 10, 1989 in the Ohio Court of Common Pleas, Summit County, where 120 primary and 99 secondary plaintiffs sued LAQ and 69 other defendants that allegedly supplied asbestos, talc and/or products or components containing asbestos or talc, to the primary plaintiffs' employers in the tire and rubber industry in Ohio. (The claims of two of the primary plaintiffs were dismissed as to all defendants in 1992 and 1993). The plaintiffs demand substantial compensatory and punitive damages for injuries allegedly resulting from their exposure to talc and asbestos. The thrust of the complaint is similar to the POGORZELSKI case. 2) ABRAMS, ET AL. V. OWENS-CORNING FIBERGLAS CORP., ET AL., Civil Action Nos. 93-C-6152 through 93-C-6265 (made part of IN RE: MASS III KANAWHA COUNTY ASBESTOS CASES, Civil Action No. 92-C-8888), pending since September 22, 1993 in the Circuit Court of Kanawha County, West Virginia, where 114 primary and 91 secondary plaintiffs sued LAQ, Asarco and 65 other defendants that allegedly supplied asbestos and/or products containing asbestos to the primary plaintiffs' employers in West Virginia. The plaintiffs demand substantial compensatory and punitive damages for injuries allegedly resulting from their exposure to asbestos. The thrust of the complaint is similar to the POGORZELSKI case. 3) ABERNATHY V. AC&S, INC., ET AL., Case No. A9209667-C, pending since September 17, 1992 in the District Court of Orange County, Texas, where 2,733 primary and 2,229 secondary plaintiffs sued Asarco and its wholly-owned subsidiary Capco as well as 70 other defendants that allegedly supplied asbestos and/or products containing asbestos (or that were allegedly alter egos to or "controlling producers" of such suppliers) to the primary plaintiffs' employers in Alabama. The plaintiffs demand substantial compensatory and punitive damages for injuries allegedly resulting from their exposure to asbestos. The thrust of the complaint is similar to the POGORZELSKI case. During 1993 the case was settled as to Asarco. Capco remains a defendant in this and 69 other cases brought by 1,399 additional primary plaintiffs. The total of 13,940 pending primary plaintiffs reported for the Company and two of its subsidiaries at December 31, 1993 includes approximately 8,100 primary plaintiffs' claims in West Virginia, that were settled in February 1994. In 1991, the Judicial Panel on Multidistrict Litigation transferred all asbestos cases pending in federal court to the United States District Court for the Eastern District of Pennsylvania for coordinated and consolidated pretrial proceedings. Cases containing approximately 2 percent of LAQ's primary plaintiffs are affected by this action. As of December 31, 1993, LAQ, Asarco and Capco have settled or been dismissed from a total of approximately 4,357 asbestos personal injury lawsuits brought by approximately 18,114 primary and approximately 10,554 secondary plaintiffs. A22 With respect to the actions relating to asbestos-containing products in structures reported in the Contingencies and Litigation Note, the following supplemental information is provided. THE SCHOOL DISTRICT OF LANCASTER, ET AL. V. LAKE ASBESTOS OF QUEBEC, LTD., ET AL., Civil Action No. 83-0286, was filed in 1983 in United States District Court for the Eastern District of Pennsylvania. Subsequently, cases were filed by different school districts in the same court seeking the same relief on behalf of the same class (BARNWELL SCHOOL DISTRICT NO. 45 V. U.S. GYPSUM, ET AL., Civil Action No. 83-1395, filed in 1983; BOARD OF EDUCATION OF THE MEMPHIS CITY SCHOOLS, ET AL. V. U.S. GYPSUM, ET AL., Civil Action No. 84-2312, filed in 1984). In 1984, these actions were consolidated as IN RE ASBESTOS SCHOOL LITIGATION, Civil Action No. 83-0268, and the case was certified to proceed on behalf of a class of all public school districts and private primary and secondary educational institutions in the United States. LAQ settled this action in March 1989, and all necessary court approvals have been obtained. The other actions, including some purported class actions, involve colleges and universities, real estate companies, transit corporations, private buildings under lease to the federal government, schools, and public buildings in cities and states. Each of these actions seeks substantial actual damages, and most but not all seek punitive damages. As of December 31, 1993, LAQ has settled four and been dismissed from another 79 actions involving asbestos in structures. Asarco has been dismissed from all eleven actions in which it had been named. In 1987, LAQ began litigation against certain excess liability insurers for a declaration of insurance coverage for its asbestos cases similar to the one that had been obtained by LAQ against certain other insurers in a 1985 court ruling that held that the comprehensive continuous theory of coverage applies to those insurers' policies as regards LAQ's asbestos personal injury and property damage litigation. Settlements have been reached with certain of these insurers and the case remains pending in federal court in the Southern District of New York. In June 1993, the Company was sued by two of its liability insurance carriers, the Insurance Company of North America and California Union Insurance Company, in state court in New Brunswick, New Jersey for a declaration that the insurance companies have no insurance obligation for environmental matters for which the Company is seeking coverage. The insurance companies also included Asarco's other liability insurers in the lawsuit, and they have sought similar declaratory relief. Asarco has filed cross claims and counterclaims in this lawsuit seeking a court declaration that insurance coverage of its environmental matters does exist. In November 1990 the Company filed a lawsuit against several of its liability insurers in state court in King County, Washington seeking insurance coverage for the Tacoma log sort yard cases. In January 1994 the Company filed a similar lawsuit in state court in Denver, Colorado seeking insurance coverage for a class action lawsuit concerning the Company's Globe Plant that had been settled during 1993. In March 1993 a lawsuit was filed in United States District Court in Tacoma, Washington on behalf of classes of persons who own or rent residential property within two miles of the Company's former Tacoma plant. In May 1993, it was transferred to the United States District Court in Seattle, Washington. The action asserts claims of trespass, nuisance, negligence, strict liability, and unjust enrichment, as well as under CERCLA, for property damage due to past emissions of metals from the plant. The action also seeks the establishment of a fund to pay for the medical monitoring of an alleged class of persons who now reside or who in the future will reside on property located within two miles of the plant. In September 1993 the court certified the action to proceed as a class action. Plaintiffs' counsel has represented that the Medical Monitoring Class consists of an estimated 18,000 individuals, and the other two classes consist of more than 5,000 owners or renters. The Company has legal and factual defenses including the comprehensive remediation programs that have been and will be taken under EPA Superfund proceedings regarding the subject matter of the lawsuit. In April 1993, the Town of Ruston, Washington filed a lawsuit against the Company in United States District Court in Tacoma, Washington. The lawsuit asserts claims for damage to property owned by the town due to the operation of the Company's former Tacoma plant similar to the claims asserted in the class action lawsuit referred to in the immediately preceding paragraph, and it has been consolidated with that suit and transferred to the United States District Court in Seattle. The lawsuit had originally stated claims for lost tax revenue, but these claims were dismissed by the court on Asarco's motion. A23 In May 1989, a lawsuit was filed in state court in Butte, Montana by Montana Mining Properties ("MMP") which claims to have had a contractual first right of refusal on the 49.9% interest in the Montana copper mining business of Montana Resources, Inc. that was sold to Asarco in June 1989. MMP seeks an injunction and compensatory and punitive damages from Asarco for alleged tortious interference with its contract with Montana Resources, Inc. On October 8, 1991, ARCO Incorporated ("ARCO") filed suit in federal court in Montana against Montana Resources and its partners, including Asarco and one of its subsidiaries, alleging breach of contract resulting from defendants' failure to reclaim contaminated water in an abandoned mining pit (the Berkeley Pit) at partnership-owned property in Butte, Montana. ARCO demanded compensation for study costs under CERCLA with respect to such water, and a determination that defendants are responsible for reclamation of the pit. The defendants assert that ARCO is responsible for such CERCLA and reclamation costs. Trial has been set for mid-1995. In March 1993 the Arizona Department of Environmental Quality notified the Company that it was seeking fines of approximately $700,000 for alleged violations of the Clean Air Act at the Company's Ray Complex in Arizona relating to disposal of asbestos cement pipe. On July 6, 1993 the State of Arizona filed suit seeking civil penalties for the alleged violations and other relief. The Company is negotiating to resolve this matter. The opinion of management regarding the outcome of legal proceedings and environmental contingencies, set forth in the Contingencies and Litigation Note (Note 8) to the Financial Statements, is based on considerations including experience relating to previous court judgments and settlements and remediation costs and terms. The financial viability of other potentially responsible parties has been considered when relevant and no credit has been assumed for any potential insurance recoveries when availability of insurance is not established. The Company considered such factors in establishing its environmental reserve in December of 1990 and in determining modifications to its reserve in 1991, 1992 and 1993. See also Item 1, "Environmental, Safety and Health Matters," for further information concerning pending legal or administrative proceedings involving Asarco. ITEM 4.

ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS None. A24 EXECUTIVE OFFICERS OF ASARCO AND BUSINESS EXPERIENCE DURING THE PAST FIVE YEARS (As of February 23, 1994) Officer Name Office and Experience Age Since - ---- --------------------- --- ------- Richard de J. Osborne 1989-1994 Chairman of the Board, Chief 59 1975 Executive Officer and President Francis R. McAllister 1993-1994 Executive Vice President, 51 1978 Copper Operations 1992-1993 Executive Vice President, Finance and Administration and Chief Financial Officer 1989-1992 Vice President, Finance and Administration and Chief Financial Officer Robert J. Bothwell, Jr. 1989-1994 Vice President, Sales 56 1987 Thomas J. Findley, Jr. 1991-1994 Treasurer 46 1991 1989-1990 Director of Management Information Services James J. Kerr 1992-1994 Vice President, Commercial 63 1991 1991-1992 Vice President, Ore 1989-1991 Vice President-Elders Raw Materials Limited Augustus B. Kinsolving 1989-1994 Vice President, General 54 1983 Counsel and Secretary Kevin R. Morano 1993-1994 Vice President, Finance and 40 1993 Chief Financial Officer 1991-1993 General Manager, Ray Complex 1989-1991 Treasurer Robert J. Muth 1989-1994 Vice President, Government 60 1977 and Public Affairs Robert M. Novotny 1993-1994 Vice President, Lead, Zinc, 45 1988 Silver and Mineral Operations 1989-1993 Vice President, Operations Ronald J. O'Keefe 1989-1994 Controller 52 1982 Gerald D. Van Voorhis 1992-1994 Vice President, Exploration 55 1992 1989-1991 Vice President-Socorro Mining Company Michael O. Varner 1993-1994 Vice President, Environmental 52 1993 Operations 1992-1993 General Manager, Western Metals 1989-1992 Director, Technical Services James L. Wiers 1989-1994 General Auditor 49 1987 David B. Woodbury 1993-1994 Vice President, Human 53 1993 Resources 1989-1993 Vice President, Human Resources - Ferro Corporation A25 PART II ITEM 5.

ITEM 5. MARKET FOR REGISTRANTS COMMON SHARE AND RELATED STOCKHOLDER MATTERS At March 16, 1994, there were approximately 10,072 common stockholders of record. The principal market for Asarco's Common Stock is the New York Stock Exchange. The Stock Exchange symbol for Asarco's common stock is AR. High and low stock prices and dividends for last two years were: A26 ITEM 6.

ITEM 6. SELECTED FINANCIAL DATA FIVE-YEAR SELECTED FINANCIAL AND STATISTICAL DATA (in millions, except per share data) A27 A28 ITEM 7.

ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS EARNINGS: The Company reported net earnings for the year ended December 31, 1993 of $15.6 million, or $.38 per share, compared with a net loss of $83.1 million, or $2.01 per share in 1992 and net earnings of $46.0 million, or $1.12 per share, in 1991. Net earnings in 1993 include $104.5 million of previously unrecognized results of the Company's investments in Peru. In the fourth quarter of 1993, the Company resumed equity accounting for its 52.3% interest in Southern Peru Copper Corporation (SPCC) and recorded the results of its 80% owned subsidiary Corporacion Minera Nor Peru, S.A. (Nor Peru). The change in accounting for Asarco's investments in Peru resulted from the improvements in the political, economic and operating conditions in Peru, which included the ratification of a new constitution and the successful completion of SPCC's capital program financing, which restored management's influence over its Peruvian operations. To reflect this change, the Company recorded $18.2 million of previously unrecognized earnings relating to the period 1988 through 1993 from its investments in Peru and $86.3 million, or $2.08 per share, for the cumulative effect of a change in accounting principle resulting from SPCC's adoption of SFAS 109, "Accounting for Income Taxes". The Company also recorded an after-tax charge of $16.7 million ($25.6 million pre-tax) related to the valuation of certain inventories and additions to reserves, principally for assets planned for disposition. Also included in 1993 earnings are LIFO profits of $5.9 million after-tax ($9.2 million pre-tax) resulting from the reduction of inventories accounted for on a LIFO basis due principally to the completion of the integration of the Company's copper business. Results were adversely impacted beginning in late 1992 and into early 1993 by unusually heavy rains in Arizona which affected operations at two of the Company's principal copper properties. While the most severe effect of the rains was overcome by the second quarter of 1993, the limitations imposed on mining operations at the Ray mine by the substantial amount of water retained in the pit continued to affect operations through the balance of the year. As a result, copper production was reduced from expected levels, costs were higher and net earnings were reduced by $22 million. Completion of the major expansions at the Company's Mission and Ray mines in Arizona resulted in increased copper mine production in 1993 and 1992 compared with 1991, but principally because of the heavy rains in Arizona, copper mine production did not meet expectations. Asarco earnings are heavily influenced by the metals markets. The economic recovery in the United States created increasingly strong demand for the Company's products domestically but economic weakness in continental Europe and in Japan offset most of the growth in the U.S., Southeast Asia and Latin America. As a result of the imbalance in supply and demand, prices for all of the Company's principal base metal products, copper, lead and zinc, reached new lows for this economic cycle in 1993. Silver prices however, increased in 1993 compared to 1992 and 1991 as speculative buying and concern over inflation renewed investor demand for precious metals. Compared with 1992, the Company's 1993 earnings were lowered by $96 million due to these price declines. The net loss of $83.1 million in 1992 includes an after-tax charge of $122.1 million consisting of $56 million for the adoption of SFAS 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions", $44 million for environmental costs, and $21.1 million for the reduction in carrying value of certain facilities. Net earnings of $46 million in 1991 were reduced by a charge of $6.6 million after-tax, to establish a reserve for a receivable from a copper customer which filed for bankruptcy protection and were benefited by an after-tax profit of $5.4 million from the sale of the Company's direct interest in Highlands Gold Limited. In August 1993, the Company sold a 9.9% interest in Asarco Australia Limited (Asarco Australia), its gold mining subsidiary for $13.8 million. The sale resulted in a pre-tax gain of approximately $10.3 million ($5.4 million after- tax). Owning less than 50% of Asarco Australia following the sale, the Company began to account for this investment by the equity method. In September 1993, Asarco Australia offered 13.3 million shares of previously unissued common stock to the public, resulting in net cash proceeds of A$16.4 million. As a result of this share issuance, the Company's ownership was reduced to 45.3% and a $3.3 million pre-tax gain ($2.1 million after-tax) was recognized as the shares were sold at a price exceeding the book value per share of the Company's investment. In January 1994, the Company sold its remaining 45.3% interest (66.5 million shares) for $79.5 million. The sale resulted in a pre-tax gain of $58.5 million which will be reported in the first quarter of 1994. A29 PRICES: Prices for the Company's metals are established principally on the New York Commodity Exchange (COMEX) or the London Metal Exchange (LME). Thus, it is not possible to predict prices for future metal sales. Price volume analysis: The following prices and volumes were realized. SALES: Sales in 1993 were $1,736.4 million, compared with $1,908.5 million in 1992 and $1,911.8 million for 1991. The decline in sales dollars caused by lower prices for copper and lead in 1993 was partially offset by increased volumes for both metals. Accounting for the Company's investment in Asarco Australia as an equity investment rather than as a consolidated subsidiary reduced 1993 sales by approximately $25 million. COST OF PRODUCTS AND SERVICES: Cost of products and services in 1993 were $1,638.0 million, compared with $1,647.3 million in 1992 and $1,634.2 million in 1991. The decrease in 1993 was caused principally by the elimination of operating costs at operations on standby status. In April 1993, the Company put its Troy, Montana, copper-silver mine on standby due to low silver prices. The Troy shutdown followed the suspension of production at the Galena mine in 1992 and the Coeur mine in 1991. LIFO profits of $9.2 million, the deconsolidation of Asarco Australia and other operating cost reductions, $8.2 million of previously unrecognized losses of Nor Peru and higher purchases of refined copper also affected cost of products and services. The Company's cost for purchased refined copper approximates the market price at which it is sold. Cost of products and services were negatively impacted by the heavy rains in Arizona in late 1992 and early 1993. The increase in 1992 was from increases in copper sales volumes, net of the impact of lower lead and silver sales volumes and lower purchases of refined copper. In 1991, equipment availability problems, higher reagent usage, pump repairs and train derailments at the Ray mine, resulted in reduced production and higher operating costs. OTHER EXPENSES: Selling and administrative costs decreased by $1.8 million in 1993 and $7.1 million in 1992, principally as a result of cost reduction programs. The 1991 provision for doubtful accounts includes a $10.6 million bad debt reserve for receivables from Laribee Wire Manufacturing Company, Inc. and its affiliated companies. Depreciation and depletion expense decreased by $6 million in 1993 as a result of the temporary closure of the Troy mine, the deconsolidation of Asarco Australia and lower production at the Ray mine due to heavy rains. Depreciation and depletion expense increased by $11.8 million in 1992 primarily as a result of higher production following the completion of the expansion programs at Mission in October 1991 and Ray in February 1992. Increases in ore reserves at Ray extended the economic life of the mine, reducing depreciation and depletion expense. Research and exploration expense declined by $5.0 million in 1992 as a result of reduced levels of exploration activity, and that level was maintained in 1993. A30 NONOPERATING ITEMS: Interest expense increased a further $6.1 million in 1993 after increasing by $5.0 million in 1992 as compared to 1991 as a result of higher borrowings. The amount of interest capitalized has been declining as a result of the completion of portions of the copper expansion program. Interest expense has been reduced by lower interest rates paid on floating rate debt. The weighted average interest rate on this debt was 3.7% in 1993 compared to 4.2% in 1992 and 6.5% in 1991. Other income was $30.2 million in 1993, $23.9 million in 1992 and $22.9 million in 1991. Other income in 1993 includes a $10.3 million gain on the sale of a 9.9% interest in Asarco Australia and $9.4 million of dividends from SPCC, recorded prior to resuming equity accounting. Other income in 1992 includes $7.8 million of dividends from SPCC and in 1991 an $8.7 million gain on the sale of Highlands Gold Limited shares. Dividends from M.I.M. Holdings Limited included in other income were $8.3 million in 1993, $8.8 million in 1992 and $9.5 million in 1991. TAXES ON INCOME: The tax benefits in 1993 and 1992 result principally from operating losses and, in 1992, from the settlement of a Canadian tax assessment. Taxes in 1993 include $2.8 million for additional deferred Federal Income taxes as a result of the increase in the statutory tax rate to 35% and higher taxes on the gain realized on the sale of 9.9% of the shares of Asarco Australia, as a result of providing taxes on earnings previously treated as permanently reinvested while Asarco Australia was a consolidated subsidiary. Taxes on income were reduced for 1991 as a result of percentage depletion, partially offset by the tax effect of the pro rata repurchase of outstanding shares by SPCC. Net operating loss carryforwards have reduced the Company's deferred tax liability by $127.6 million at December 31, 1993. The Company believes that these carryforwards, which expire in 2006, 2007 and 2008, will reduce future federal income taxes otherwise payable and, if necessary, the Company could implement available tax planning strategies, including the sale of certain assets, to realize the tax benefit of the carryforwards. EQUITY IN EARNINGS OF NONCONSOLIDATED ASSOCIATED COMPANIES: Equity earnings in 1993 are principally from the previously unrecognized results of SPCC. In the second quarter of 1991, the Company discontinued equity accounting for its investment in Mexico Desarrollo Industrial Minero, S.A. de C.V. (MEDIMSA), after announcing that it was considering the sale or other form of disposition of some or all of its investment. In light of this and other factors, the Company's equity earnings from MEDIMSA include earnings for the first quarter of 1991 only. In January 1994, the Company signed an agreement with Grupo Industrial Minera Mexico, S.A. de C.V. (Grupo Mexico) for combining MEDIMSA with Grupo Mexico, its publicly traded parent. The agreement is subject to a number of approvals. Under the terms of the agreement with Grupo Mexico, the Company will hold a 23.6% stake in the new Grupo Mexico upon completion of the transaction. This transaction will ultimately provide greater liquidity for the Company as its holdings will be in a publicly traded entity. CASH FLOWS - OPERATING ACTIVITIES: Net cash provided from operating activities was $38.9 million in 1993, compared with $105.7 million in 1992 and $67.5 million in 1991. The $66.8 million decrease in 1993 from 1992, was from lower earnings due to a decline in metals prices and other items noted above, net of $101.5 million of operating cash provided from inventory and receivable reductions and higher accounts payable. Setting aside the effect of the $122.1 million provision, which is a noncash charge, and other noncash items, the $38.2 million increase in 1992 from 1991 results from $13.9 million from operating activities and $24.3 million from a reduction in operating assets net of liabilities. CASH FLOWS - INVESTING ACTIVITIES: Capital expenditures were $112.3 million in 1993, of which $23.8 million was spent on the completion of the El Paso copper smelter modernization. Capital expenditures in 1992 were $134.6 million, including $70.3 million for the copper expansion and modernization program at the Ray mine and El Paso smelter and $9.5 million for participation payments on previously acquired properties. Capital expenditures in 1991 were $282.9 million, of which $207.5 million was spent on the expansion and modernization program at the Mission and Ray mines and the El Paso smelter. The expansion and modernization at Mission was completed in the fourth quarter of 1991 and at Ray in the first quarter of 1992. The Company's planned capital expenditures in 1994 are estimated to be about $90 million. The proceeds from sale of securities and property represents, principally, the investment portfolio of Geominerals Insurance Company, Ltd. which for the most part is reinvested by purchasing additional securities. Proceeds of $13.8 million from the sale of a 9.9% interest in Asarco Australia are included in proceeds from sale of securities in 1993. In 1992, the Company did not exercise a $40 million option to purchase 16,705,527 shares of MEDIMSA which it held under a 1989 agreement, effectively lowering its ownership interest to 28.3%. Included in purchases of investments in 1991 is $24.9 million for a stock subscription of MEDIMSA by a wholly owned subsidiary of the Company. The Company received A31 proceeds of $25.8 million in 1991 from the sale of shares of Highlands Gold Limited and received $31.4 million from a SPCC pro rata repurchase of outstanding shares which is included in proceeds from sale of securities. The Company reduced its carrying value in SPCC by the amount of these proceeds. In 1991, Asarco Australia, previously a 60% owned subsidiary of the Company, acquired the remaining 50% interest in the Wiluna gold mine owned by its former partner for $17.4 million. LIQUIDITY AND CAPITAL RESOURCES: Debt securities in the amount of $250 million were issued in 1993 including $100 million of 7 3/8% Notes due in 2003, $100 million of 7 7/8% Debentures due in 2013 and $50 million of 7% Notes due in 2001. Proceeds of these debt issues were used to reduce borrowings under revolving credit loan agreements. In addition, after year-end, the Company prepaid its 9 3/4% Sinking Fund Debentures at par value plus a premium of .9%. In 1993, the Company also entered into a new five-year $320 million revolving credit agreement to replace a $260 million revolving credit agreement which expired. At December 31, 1993, the Company's debt as a percentage of total capitalization was 38.0%, compared with 39.0% at the end of 1992 and 35.2% at the end of 1991. Debt at the end of 1993 was $900.5 million, compared with $868.8 million in 1992 and $801.6 million at the end of 1991. Additional available credit under existing loan agreements totaled $339 million at the end of 1993. The Company adopted SFAS 115, "Accounting for Certain Investments in Debt and Equity Securities" in the fourth quarter of 1993, which increased stockholders equity by an after-tax credit of $112.7 million ($173.4 million pre-tax) to reflect the increased net value of its cost investments, principally M.I.M. Holdings Limited. Earnings were not affected by this accounting change. The Company expects that it will meet its cash requirements in 1994 and beyond from internally generated funds, from proceeds of the sale of its remaining interest in Asarco Australia in January 1994 and from borrowings, if necessary, under its revolving credit agreements, or from additional debt financing. DIVIDENDS AND CAPITAL STOCK: The Company paid dividends of $20.8 million, or 50 cents per share, in 1993 and $33.0 million, or 80 cents per share, in 1992. In 1991, the Company purchased 67,314 shares of common stock at a cost of $1.8 million and paid dividends of $65.8 million, or $1.60 per share. At the end of 1993, the Company had 41,718,000 common shares issued and outstanding, compared with 41,467,000 at the end of 1992 and 41,249,000 at the end of 1991. CLOSED FACILITIES AND ENVIRONMENTAL MATTERS: During 1993, the reserve for environmental matters was increased by $6.2 million for ongoing evaluations of environmental costs. As a result of developments during 1992, at a number of the Company's properties where it was probable that an environmental liability had been incurred, the Company was able to further refine previous estimates with requisite certainty for a substantial portion of the anticipated costs at those sites. Accordingly, in 1992, the Company recorded a pre-tax charge of $72.4 million to provide additional reserves for these environmental costs. At the end of 1993, reserves for closed plant and environmental matters totaled $116.1 million. Cash expenditures charged to these reserves were $44 million in 1993, $36 million in 1992 and $32 million in 1991. The increased level of expenditures in 1993 are due to settlement of litigation concerning past operations at the Company's Globe plant in Denver. Future environmentally related expenditures cannot be reliably determined in many circumstances due to the early stages of investigation, the uncertainties relating to specific remediation and clean-up methods and therefore the related costs, the possible participation of other potentially responsible parties, insurance coverage issues and changing environmental laws and interpretations. It is the opinion of Management that the outcome of these environmental matters will not materially adversely affect the financial position of Asarco and its consolidated subsidiaries. However, it is possible that future environmental contingencies could have a material effect on quarterly or annual operating results, when they are resolved in future periods. This opinion is based on considerations including experience related to previous court judgments and settlements and remediation costs and terms. The financial viability of other potentially responsible parties has been considered when relevant and no credit has been assumed for any potential insurance recoveries when the availability of insurance has not been determined. In 1992, the Company concluded that certain facilities, primarily at the El Paso, Texas, smelter, were unlikely to be used following completion of its modernization and expansion program in 1993. Accordingly, the Company recorded a pre-tax charge of $31.9 million to reduce the carrying value of these facilities. ACCOUNTING MATTERS: In 1993, the Company adopted SFAS 112, "Employers' Accounting for Post Employment Benefits", which had no net effect on earnings. A32 ITEM 8

ITEM 8 - FINANCIAL STATEMENTS AND SUPPLEMENTAL DATA ASARCO Incorporated and Consolidated Subsidiaries CONSOLIDATED STATEMENT OF EARNINGS A33 ASARCO Incorporated and Consolidated Subsidiaries CONSOLIDATED BALANCE SHEET A34 ASARCO Incorporated and Consolidated Subsidiaries CONSOLIDATED STATEMENT OF CASH FLOWS A35 ASARCO Incorporated and Consolidated Subsidiaries CONSOLIDATED STATEMENT OF CHANGES IN COMMON STOCKHOLDERS' EQUITY A36 ASARCO Incorporated and Consolidated Subsidiaries NOTES TO FINANCIAL STATEMENTS (1) Summary of Significant Accounting Policies Principles of Consolidation: The consolidated financial statements include all significant subsidiaries in which the Company has voting control. Significant investments in the capital stock of associated companies and subsidiaries over which the Company has significant influence but does not have voting control are accounted for by the equity method. Cash Equivalents: The Company considers all highly liquid investments with a maturity of three months or less when purchased to be cash equivalents. Inventories: Company-owned metals processed by smelters and refineries are valued at the lower of last-in, first-out (LIFO) cost or market. Other inventories are valued at the lower of first-in, first-out (FIFO) or average cost or market. Investments: The Company adopted Statement of Financial Accounting Standards (SFAS) 115 "Accounting for Certain Investments in Debt and Equity Securities", in 1993. Investment in equity securities that have readily determinable fair values and all debt securities are classified as held to maturity, trading, or available-for-sale securities. The unrealized gains or losses for trading securities are included in net earnings, while the unrealized gains or losses on securities classified as available-for-sale (reported at fair value) are included as a separate component of Stockholders' equity. Property: Assets are valued at cost or less. Betterments, renewals, costs of bringing new mineral properties into production, and the cost of major development programs at existing mines are capitalized. Maintenance, repairs, development costs to maintain production at existing mines, and gains or losses on assets retired or sold are reflected in earnings as incurred. Plant assets are depreciated over their estimated useful lives, generally by the units-of- production method. Depreciation and depletion of mine assets are computed generally by the units-of-production method using proven and probable ore reserves. Revenue Recognition: Revenue is recognized on metals sold at the time a sales contract is executed and the sales price is fixed in accordance with the terms of the contract. Exploration: Tangible and intangible costs incurred in the search for mineral properties are charged against earnings when incurred. Hedge Contracts: The Company periodically uses futures and options contracts to hedge the effect of price changes on a portion of the primary metals it sells. Gains and losses on hedge contracts are reported as a component of the related transaction. Taxes on Income: Deferred income taxes reflect the future tax consequences of differences between the tax bases of assets and liabilities and their financial reporting amounts at each year-end. No deferred income taxes have been provided for the income tax liability which would be incurred on repatriation of the undistributed earnings of the Company's consolidated foreign subsidiaries because the Company intends indefinitely to reinvest these earnings outside the United States. General business credits are accounted for by the flow-through method. The Company adopted SFAS 109 "Accounting for Income Taxes", in 1992, and restated prior period financial statements to reflect the change. A37 Subsidiary Stock Issuance: Gains or losses arising from the sale of previously unissued shares to an unrelated party by a subsidiary are recognized as a component of net earnings to the extent that the net book value of the shares owned by the parent after the sale exceeds or is lower than the net book value per share immediately prior to the sale of the shares by the subsidiary. (2) Other Income - ----------------- Other Income consists of the following: (3) Taxes on Income - -------------------- Earnings (loss) before taxes on income is as follows: A38 Tax Expense: The components of the provision for taxes on income are as follows: Total taxes paid (refunded) were: 1993-($3.1) million; 1992-$2.6 million and 1991-($16.3) million. Reconciliation of Statutory Income Tax Rate: A39 Temporary differences and carryforwards which give rise to deferred tax assets and liabilities are as follows: At December 31, 1993, the Company had $364.6 million of net operating loss carryforwards which expire, if unused, in 2006, 2007 and 2008 and $7.4 million of alternative minimum tax credits which are not subject to expiration. The Company believes that these carryforwards will be available to reduce future federal income tax liabilities and has recorded the tax benefit of these carryforwards as deferred tax assets. Because of shorter carryforward periods and other statutory differences, the Company's net operating loss carryforwards for state purposes are not significant and, therefore, have not been recorded as deferred tax assets. U.S. deferred income taxes have not been recognized on approximately $267.0 million in 1993 ($167.0 million in 1992 and $174.6 million in 1991) of undistributed earnings of foreign subsidiaries and nonconsolidated associated companies more than 50% owned, because assets representing those earnings are permanently invested. It is not practicable to determine the amount of income taxes that would be payable upon remittance of assets that represent those earnings. The amount of foreign withholding taxes that would be payable upon remittance of assets that represent those earnings would be approximately $2.8 million in 1993 ($3.4 million in 1992 and $3.9 million in 1991). A40 (4) Inventories - ---------------- Replacement cost exceeds inventories valued at LIFO cost by approximately $114.1 million in 1993 (1992-$125.2 million). Liquidation of LIFO inventories resulted in recognition of pre-tax earnings of $9.2 million in 1993. (5) Acquisitions - ----------------- Asarco Australia Limited, previously a 60% owned subsidiary of the Company, invested $17.4 million in 1991 to acquire the remaining 50% interest in the Wiluna gold mine owned by its former partner. Acquisitions are accounted for as purchases and, accordingly, acquired assets and liabilities have been recorded at their estimated fair market values at the date of acquisition. Operating results are included in the Consolidated Statement of Earnings from the acquisition dates. The excess of the purchase price over the valuation of the net assets acquired of $59.0 million at December 31, 1993 is recorded as goodwill in Intangible and other assets. Goodwill is generally amortized over either the mine life up to a maximum of 40 years on a units-of-production basis or over 40 years on a straight-line basis. Accumulated amortization was $9.3 million and $7.7 million at December 31, 1993 and 1992, respectively. (6) Investments - ---------------- The Company has substantial interests in associated companies in Mexico, Peru and Australia, which are engaged principally in mining, smelting and refining nonferrous metals. These companies are Mexico Desarrollo Industrial Minero, S.A. de C.V. (MEDIMSA), Southern Peru Copper Corporation (SPCC), M.I.M. Holdings Limited (MIM) and Asarco Australia Limited (Asarco Australia). The fiscal year for MIM ends June 30. MEDIMSA, Asarco Australia and SPCC report on a calendar- year basis. MEDIMSA: In 1991, the Company announced that it was considering the sale or other form of disposition of some or all of its investment in MEDIMSA. In light of this action and other factors, the Company changed from the equity method of accounting for its interest in MEDIMSA to the cost method, effective with the second quarter of 1991. At December 31, 1993, cumulative losses that would have been recognized had equity accounting been continued totaled $7 million. In the second quarter of 1991, a wholly owned subsidiary of Asarco invested an additional $24.9 million in MEDIMSA under a rights offering. As a result of not subscribing to its full share of the offering, the Company's interest in MEDIMSA declined to 31.2% from 34.0%. Pursuant to a financing and option agreement entered into in 1989 with a subsidiary of the Chase Manhattan Bank, N.A., the Company exchanged 16,705,527 shares of MEDIMSA for $38.4 million of previously issued exchangeable preferred stock of a wholly owned subsidiary of the Company in December 1992, decreasing ownership to 28.3%. In January 1994, the Company signed an agreement with Grupo Industrial Minera Mexico S.A. de C.V. (Grupo Mexico) on terms for combining Medimsa with Grupo Mexico, its publicly traded parent. Under the terms of the agreement, which is subject to regulatory and other approvals, the Company will hold a 23.6% stake in the new Grupo Mexico, upon completion of the transaction. A41 SPCC: In 1988, the Company changed from the equity method of accounting for SPCC to the cost method. This change followed the deterioration in the economy of Peru, inflation and level of foreign exchange reserves, the economic uncertainty for the near term outlook and the foreign exchange restrictions on the remittance of profits then in place. In addition, the Company discontinued consolidating its interest in Corporacion Minera Nor Peru, S.A. (Nor Peru) for similar reasons. Conditions have improved and stabilized to the point where the Company has the ability to reassert influence and act without the governmental oversight that previously existed. Economic and political conditions have improved significantly as indicated by the ratification of a new constitution by voters in Peru in October 1993 and the successful completion of SPCC's financing of its $300 million capital program in December. Therefore, in the fourth quarter of 1993, the Company resumed equity accounting and recorded $26.4 million of previously unrecognized equity earnings for SPCC and resumed consolidation of Nor Peru by recording $8.2 million of previously unrecognized losses. Effective January 1, 1993, SPCC adopted SFAS 109, "Accounting for Income Taxes". The impact of adopting this statement on SPCC was to increase retained earnings as of January 1, 1993 and decrease deferred taxes by $165 million, ASARCO's share of which is $86.3 million, which is reported as the cumulative effect of a change in accounting principle. In December 1991, SPCC repurchased approximately 13.8% of its outstanding common shares pro rata from its shareholders, from which Asarco received proceeds of $31.4 million. The Company reduced its carrying value in SPCC by the amount of these proceeds. Dividends received (prior to the resumption of equity accounting) of $9.4 million in 1993 and $7.8 million in 1992 were recorded as dividend income. Asarco Australia: In August 1993, the Company sold a 9.9% interest in Asarco Australia, its gold mining subsidiary for $13.8 million. The sale resulted in a pre-tax gain of approximately $10.3 million ($5.4 million after-tax) and reduced the Company's interest in Asarco Australia to 49.8%. As a result of this sale, the Company began to account for its investment in Asarco Australia using the equity method. In September 1993, Asarco Australia offered 13.3 million shares of previously unissued common stock to th e public, resulting in net cash proceeds of A$16.4 million. As a result of this share issuance, the Company's ownership interest was reduced to 45.3% and a $3.3 million pre-tax gain ($2.1 million after-tax) was recognized as the shares were sold at a price exceeding the book value per share of the Company's investment. In January 1994, the Company sold its remaining 45.3% interest (66.5 million shares) in Asarco Australia for $79.5 million. The sale resulted in a pretax gain of $58.5 million which will be reported in the first quarter of 1994. SFAS 115: In the fourth quarter of 1993, the Company adopted SFAS 115. Accordingly, certain of the Company's investments, principally M.I.M., have been classified as available-for-sale securities and are reported at their fair value of $482.6 million compared to a historical cost of $309.1 million. The unrealized gains of $173.4 million are reported as a separate component of stockholders' equity, before deferred taxes of $60.7 million. Investments accounted for using the equity method of accounting (SPCC) and investments which do not have readily determinable fair market values (MEDIMSA), are not affected by this accounting principle. A42 Investments in Associated Companies - ----------------------------------- (in millions - U.S. dollars) A43 GAAP-Generally Accepted Accounting Principles (a) Quoted market prices on Asarco's investments in MEDIMSA and SPCC are not available since the shares are not publicly traded. It is not cost effective to estimate fair value; however, in management's opinion, the fair value is equal to or exceeds the carrying amount. (b) Translated into U.S. dollars at the rate in effect at December 31, 1992 ($1 U.S. = MN$3.123). December 31, 1993 financial statements are not available. (c) Translated at the average exchange rates of $1 U.S. = MN$3.114 in 1993 (MN$3.089 - 1992; MN$2.949 - 1991). (d) Includes an adjustment of $(4.6) million in 1991 to reflect the differences between U.S. and Mexican accounting standards. Effective with the second quarter of 1991, MEDIMSA is accounted for using the cost method. (e) Investment classified as available-for-sale security, and is reported at fair value, including unrealized gain of $172.3 million. Fair value is based on the December 31, 1993 closing market price of MIM's shares on the Sydney (Australia) Stock Exchange. Fair value is not necessarily indicative of an amount realizable in the event of a sale. (f) Includes $26.4 million of previously unrecognized equity earnings and $86.3 million (Asarco share) relating to the adoption of SFAS 109 by SPCC. (g) Includes $165 million relating to the adoption of SFAS 109 by SPCC. (h) $31.4 million from pro-rata repurchase of shares by SPCC in 1991. Asarco reduced its carrying value in SPCC by the amount of these proceeds. (7) Property - ------------- Property is stated at cost and consists of the following: Accumulated depreciation applicable to capitalized leases amounted to $39.9 million in 1993, $27.0 million in 1992 and $16.5 million in 1991, including depreciation charged to earnings of $13.4 million in 1993, $11.1 million in 1992 and $6.5 million in 1991. An increase in the proven and probable ore reserves at the Ray mine resulting from normal reassessments had the effect of lowering depreciation by $3.7 million in 1992. In the fourth quarter of 1993, the Company recorded a pre-tax charge of $13.2 million to provide for the closure and sale of a secondary metal processing plant, a zinc plant, and its pipe business. In 1992, the Company recorded a pre-tax charge of $31.9 million to reduce the carrying value of certain facilities, primarily at the El Paso, Texas smelter, which were unlikely to be used following the completion of the modernization and expansion program at the copper smelter in 1993. (8) Contingencies and Litigation - --------------------------------- The Company is a defendant in a lawsuit brought on behalf of classes of persons who live or have lived within a two mile radius from the site of the Company's former smelter located in Tacoma, Washington, seeking damages and medical monitoring due to substances allegedly emitted from the smelter. A44 The Company and two subsidiaries, as of December 31, 1993, are defendants in 726 lawsuits brought by 13,940 primary and 11,329 secondary plaintiffs seeking substantial actual and punitive damages for personal injury or death allegedly caused by exposure to asbestos as well as four lawsuits for removal or containment of asbestos-containing products in structures. In addition, the Company and certain subsidiaries are defendants in product liability lawsuits involving various other products, including metals. The Company is a defendant in lawsuits in Arizona brought by Indian Tribes and some other Arizona water users contesting the right of the Company and numerous other individuals and entities to use water and, in some cases, seeking damages for water usage and contamination of ground water. The lawsuits could potentially affect the Company's use of water at its Ray Complex, Mission Complex and other Arizona operations. The Company and certain of its subsidiaries have received notices from the United States Environmental Protection Agency ("EPA") that they and in most cases numerous other parties are potentially responsible to remediate alleged hazardous substance releases at certain sites under the Comprehensive Environmental Response, Compensation and Liability Act of 1980 ("CERCLA" or "Superfund"). In addition, the Company and certain of its subsidiaries are defendants in lawsuits brought under CERCLA or state laws which seek substantial damages and remediation. Remedial action is being undertaken by the Company at some of the sites. In connection with the sites referred to above, as well as at other closed plants and sites where the Company is working with the EPA and state agencies to resolve environmental issues, the Company has made reasonable estimates, where possible, of the extent and cost of necessary remedial action and damages. As a result of feasibility studies, public hearings, engineering studies and discussions with the EPA and similar state agencies, for sites where it is probable that a liability has been incurred and the amount of cost could be reasonably estimated, the Company recorded pre-tax charges to earnings in 1990 of $75.5 million and in 1992 of $72.4 million. Recorded reserves for these matters total $116.1 million at December 31, 1993. The Company anticipates that expenditures relating to these reserves will be made over the next several years. Net cash expenditures charged to these reserves were $44.3 million in 1993, $35.6 million in 1992 and $32.2 million in 1991. Future environmental related expenditures cannot be reliably determined in many circumstances due to the early stages of investigation, the uncertainties relating to specific remediation and clean-up methods and therefore the related costs, the possible participation of other potentially responsible parties, insurance coverage issues and changing environmental laws and interpretations. It is the opinion of management that the outcome of the legal proceedings and environmental contingencies mentioned, and other miscellaneous litigation and proceedings now pending, will not materially adversely affect the financial position of Asarco and its consolidated subsidiaries. However, it is possible that future environmental contingencies could have a material effect on quarterly or annual operating results, when they are resolved in future periods. This opinion is based on considerations including experience related to previous court judgments and settlements and remediation costs and terms. The financial viability of other potentially responsible parties has been considered when relevant and no credit has been assumed for any potential insurance recoveries when the availability of insurance has not been determined. A45 (9) Debt and Available Credit Facilities - ----------------------------------------- The fair value of the debt instruments was determined using quoted market prices of publicly traded securities, or securities of similar maturities and credit ratings. Maturities of debt instruments and future minimum payments under capital leases as of December 31, 1993 are as follows: Total interest paid (excluding amounts capitalized of $4.0 million in 1993, $7.4 million in 1992 and $12.3 million in 1991) was $51.1 million in 1993, $52.6 million in 1992 and $41.7 million in 1991. Debt securities in the amount of $250 million were issued in 1993 including $100 million of 7 3/8% Notes due in 2003, $100 million of 7 7/8% Debentures due in 2013 and $50 million of 7% Notes due in 2001. The Company has two revolving credit agreements that permit borrowings of up to $686.7 million, of which approximately $339 million was available at December 31, 1993. One facility allows the Company to borrow up to $366.7 million as of December 31, 1993, after which the facility will decline by $36.7 million quarterly until 1996. The second facility expires in March 1998. Borrowings under these agreements bear interest based on LIBOR, the CD or the prime rate, and averaged 3.8% at December 31, 1993. Rates may vary based upon the Company's debt rating. A commitment fee of 1/8% per annum is payable on the unused portion of the $366.7 facility in addition to a 1/8% per annum fee on the full amount of the facility. A commitment fee of 1/4% per annum is payable on the unused portion of the other facility. A46 The highest level of revolving credit borrowings during 1993 was $535.0 million (1992-$535.0 million; 1991-$450.0 million). Borrowings under these agreements averaged $397.7 million for 1993 (1992-$465.4 million; 1991-$390.3 million), with a weighted average interest rate of 3.7% in 1993 (1992-4.2%; 1991-6.5%). Under the most restrictive terms of the agreements, the Company must maintain a tangible net worth, as defined, of at least $1 billion. Tangible net worth was $1.4 billion at December 31, 1993. The ratio of current assets to current liabilities cannot be less than 125% and at December 31, 1993 this ratio was 153%. During 1991 the Company entered into two sale and leaseback transactions for mobile mining equipment and railroad rolling stock. Proceeds from these transactions were used principally to replace interim financing which was used to fund property additions. In January 1994, the Company prepaid its 9 3/4% Sinking Fund Debentures at par value plus a premium of .9%, using a portion of the proceeds of the 7% Notes issued in December 1993. The Company has two agreements expiring in 1994 which fix the rate on a notional $7.0 million of its variable-rate debt. During 1993, agreements covering $105.4 million of notional debt expired. The effect of the remaining agreements is to limit the interest rate exposure to 12.7% and is recorded as an adjustment to interest expense which resulted in 1993 in a $2.4 million charge (1992-$5.3 million; 1991-$2.5 million). The Company has exposure to credit risk but does not anticipate nonperformance by the counterparties to these agreements. (10) Stockholders' Equity - -------------------------- The Company purchased 5,393 of its common shares in 1993 (1992-5,649 shares; 1991-67,314 shares). In 1993, 256,620 common shares (1992-223,568 shares; 1991- 211,163 shares) were used for savings, stock option and incentive plans. The effect on the calculations of net earnings per common share of the Company's common stock equivalents (shares under option) was insignificant. Retained earnings at December 31, 1993, included undistributed earnings of $260.2 million for nonconsolidated subsidiaries and $263.0 million for all other investments. Retained earnings has been increased by cumulative foreign currency adjustments of $1.6 million at December 31, 1993 ($0.1 million in 1992; $6.6 million in 1991). In 1993, a charge of $0.6 million was transferred from cumulative foreign currency adjustments and used to determine the gain on the sale and dilution of ownership interest in Asarco Australia. Stockholders' equity at December 31, 1993 has been increased by $112.7 million for the unrealized gains on securities classified as available-for-sale (net of deferred taxes of $60.7 million). Stock Options: The Company has a stockholder-approved Stock Incentive Plan and a Stock Option Plan. The Stock Incentive Plan replaces the Stock Option Plan. No additional options will be granted under the Stock Option Plan and unexpired options continue to be governed by, and exercised under, the Stock Option Plan. The Stock Incentive Plan provides for the granting of nonqualified or incentive stock options, as defined under current provisions of the Internal Revenue Code, as well as for the award of restricted stock and bonuses payable in stock. The option price for options granted under the Stock Incentive Plan shall not be less than 100% of the fair market value of the Common Stock on the date of grant in the case of incentive stock options, or 50% in the case of other options. In general, options expire after 10 years and are not exercisable for six months from the date of grant. A47 Options granted may provide for "Stock Appreciation Rights" (SARs). An SAR permits an optionee, in lieu of exercising the option, to receive from the Company payment in an amount equal to the difference between the market value of the stock on the date of exercise of the SAR and the purchase price of the stock under the terms of the option. At December 31, 1993, twenty individuals held SARs covering options for 550,882 shares, ranging in price from $18.00 to $29.69 per share, exercisable as either regular stock options or SARs. The authorized number of shares under the Stock Incentive Plan is 2,000,000 of which 300,000 shares may be awarded as restricted stock. As of December 31, 1993, 1,029,050 shares are available for future grants under the Stock Incentive Plan. Stock option activity over the past three years under the Stock Incentive Plan and Stock Option Plan is summarized as follows: In 1989, the Company adopted a Shareholder Rights plan and declared a dividend of one Right for each of its Common Shares. In certain circumstances, if a person or group becomes the beneficial owner of 15% or more of the outstanding common shares (or in the case of MIM, more than 33 1/3%), with certain exceptions, these rights vest and entitle the holder to certain share purchase rights. In connection with the Rights dividend, 800,000 shares of Junior Participating Preferred Stock were authorized for issuance upon exercise of the Rights. (11) BENEFIT PLANS - ------------------- The Company maintains several noncontributory, defined benefit pension plans covering substantially all employees. Benefits for salaried plans are based on salary and years of service. Hourly plans are based on negotiated benefits and years of service. The Company's funding policy is to contribute amounts to the plans sufficient to meet the minimum funding requirements set forth in the Employee Retirement Income Security Act of 1974, plus such additional amounts as the Company may determine to be appropriate from time to time. Plan assets are invested principally in commingled stock funds and United States government securities. A48 Net pension costs consist of: The funded status of the plans using the projected unit credit method is presented below: The actuarial computations presented above are based upon a discount rate on benefit obligations of 7% in 1993 and 8% in 1992 and 1991; an expected long-term rate of return on plan assets of 10%; and annual salary increases of 4% in 1993 and 5% in 1992 and 1991. Noncontributory postretirement health care coverage under the Asarco Health Plan is provided to substantially all retirees not eligible for Medicare. A cost sharing Medicare supplement plan is available for retired salaried employees and life insurance coverage is provided to substantially all retirees. In 1992 the Company adopted SFAS 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions". The effect of adopting the new standard increased 1992 net periodic postretirement benefit cost by $3.2 million and decreased 1992 net income by $2.1 million. Postretirement benefit costs for 1991 of $5.1 million which were recorded on a cash basis, have not been restated. In addition, the projected benefit obligation of $54.0 million (net of tax benefit of $27.8 million) related to prior service cost was recognized as the cumulative effect of a change in accounting principle as of January 1, 1992. A49 The following sets forth the plan's status reconciled with amounts reported in the Company's Consolidated Balance Sheet: Net periodic postretirement benefit cost included the following components: The weighted-average annual assumed rate increase in the per capita cost of covered benefits (i.e., health cost trend rate) is 10% for 1993 (11% for 1992) and is assumed to decrease gradually to 5% for 1999 and remain at that level thereafter. The health care cost trend rate assumption has a significant effect on the amounts reported. For example, increasing the assumed health care cost trend rates by one percentage point in each year would increase the accumulated postretirement benefit obligation as of December 31, 1993 by $7.0 million, and the aggregate of the service and interest cost components of net periodic postretirement benefit cost for 1993 by $.8 million. The weighted-average discount rate used in determining the accumulated postretirement benefit obligation was 7% at December 31, 1993 (8 1/2%-1992). The plans are currently unfunded. (12) BUSINESS SEGMENTS - ----------------------- The Company operates principally in the nonferrous metals industry, involving mining, smelting, refining and selling of copper, silver, lead, and gold and mining and selling zinc and molybdenum in the form of concentrates. The Company is also engaged in specialty chemicals for metals plating and electronics industries and in minerals comprising limestone, sand and gravel operations. Included in the caption Other are the Company's polyvinyl chloride pipe and cement pipe businesses and its environmental services operations. Foreign operations are conducted by affiliates in Australia, Asia, Europe and North and South America. A50 General corporate administrative expenses are allocated among the segments generally in proportion to their operating expenses. Exploration expenses are attributable to the metals segment, while research expenses are attributable to metals and specialty chemicals. Identifiable assets are those directly used in the operations of each segment. Corporate assets are principally cash and investments. Export sales from the United States to unaffiliated customers were $278.3 million in 1993, $297.7 million in 1992 and $246.3 million in 1991. There can be no assurance that operations and assets of the Company and nonconsolidated associated companies that are subject to the jurisdiction of foreign governments may not be affected adversely by future actions by such governments. METAL SALES, EXCLUDING INTERSEGMENT SALES - ----------------------------------------- BUSINESS SEGMENTS AND LINES OF BUSINESS - --------------------------------------- A51 A52 Unaudited Quarterly Data - ------------------------ Accounting For Investments In Peru ---------------------------------- The following presents the 1993 and 1992 quarterly earnings (losses) of SPCC and Nor Peru including the cumulative effect of the change in accounting principle by SPCC, which were recognized by ASARCO as part of the $104.5 million recorded in the fourth quarter of 1993. The balance of $0.9 million relates to the period 1988 to 1991. Dividends received prior to the resumption of equity accounting were recorded as dividend income. A53 REPORT OF INDEPENDENT ACCOUNTANTS To the Board of Directors and Stockholders of ASARCO Incorporated We have audited the accompanying consolidated balance sheets of ASARCO Incorporated and Consolidated Subsidiaries as of December 31, 1993 and 1992, and the related consolidated statements of earnings, cash flows, and changes in common stockholders' equity for each of the three years in the period ended December 31, 1993. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of ASARCO Incorporated and Consolidated Subsidiaries as of December 31, 1993 and 1992, and the consolidated results of their operations and their cash flows for each of the three years in the period ended December 31, 1993, in conformity with generally accepted accounting principles. As discussed in Note 6 to the financial statements, the Company changed its method of accounting for investments classified as available-for-sale, as of December 31, 1993 and its equity investee Southern Peru Copper Corporation changed its method of accounting for income taxes as of January 1, 1993. In addition, in 1992, as discussed in Note 11 to the financial statements, the Company changed its method of accounting for postretirement benefits other than pensions. COOPERS & LYBRAND 1301 Avenue of The Americas New York, New York January 25, 1994 A54 ITEM 9.

ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND - ------------------------------------------------------------------------ FINANCIAL DISCLOSURE -------------------- None PART III ITEMS 10, 11, 12 and 13 - ----------------------- Reference is made to Executive Officers of Asarco and Business Experience During the Past Five Years on page A24. Information in response to the disclosure requirements specified by these items appears under the captions and pages of the 1993 Proxy Statement indicated below: The information referred to above is incorporated herein by reference. A55 PART IV ------- ITEM 14.

ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K. - -------------------------------------------------------------------------- (a) The following documents are filed as part of this report: 1. Financial Statements The following financial statements of ASARCO Incorporated and its subsidiaries are included at the indicated pages of the document as stated below: 2. Financial Statement Schedules The following schedules are included at indicated pages in this Annual Report on Form 10K: Schedules other than those listed above are omitted, as they are not required or are not applicable, or the required information is shown in the financial statements or notes thereto. Columns omitted from schedules filed have been omitted because the information is not applicable. Any other information omitted from schedules filed has been omitted due to immateriality. A56 3. Exhibits A57 A58 Item 14 Exhibit 23 REPORT OF INDEPENDENT ACCOUNTANTS ON FINANCIAL STATEMENT SCHEDULES To the Board of Directors and Stockholders of ASARCO Incorporated Our report on the consolidated financial statements of ASARCO Incorporated and consolidated subsidiaries has been included in this Form 10-K on page A53. In connection with our audits of such financial statements, we have also audited the related financial statement schedules which appear on pages B1 through B8 of this Form 10-K. In our opinion, the financial statement schedules referred to above, when considered in relation to the basic financial statements taken as a whole, present fairly, in all material respects, the information required to be included therein. New York, New York January 25, 1994 COOPERS & LYBRAND CONSENT OF INDEPENDENT ACCOUNTANTS We consent to the incorporation by reference in the Prospectuses constituting part of the Registration Statements on Form S-3 (File No. 33-45631) and Form S-8 (File Nos. 2-83782, 2-67732 and 33-34606) of ASARCO Incorporated of our report dated January 25, 1994, appearing on page A53 of this Annual Report on Form 10- K. Our report includes an explanatory paragraph that describes the change in the method of accounting for investments classified as available-for-sale and its equity investee Southern Peru Copper Corporation's change in method of accounting for income taxes. In addition, in 1992, the Company changed its method of accounting for postretirement benefits other than pensions. We also consent to the incorporation by reference of our report on the financial statement schedules, which appears above. New York, New York January 25, 1994 COOPERS & LYBRAND A59 SIGNATURES Pursuant to the requirements of Section 13 or 15(d) 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: February 23, 1994 ASARCO Incorporated (Registrant) By /s/ Richard de J. Osborne ----------------------------- (Richard de J. Osborne, Chairman of the Board, Chief Executive Officer and President) Pursuant to requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated. Date: February 23, 1994 B1 B2 B3 B4 B5 B6 B7 B8 C1 SOUTHERN PERU COPPER CORPORATION AND CONSOLIDATED SUBSIDIARIES INDEX TO FINANCIAL STATEMENTS AND FINANCIAL STATEMENT SCHEDULES Report of Independent Accountants C2 Consolidated Balance Sheets as of December 31, 1993 and 1992 C3-4 Consolidated Statements of Operations for the years ended December 31, 1993, 1992 and 1991 C5 Consolidated Statements of Cash Flows for the years ended December 31, 1993, 1992 and 1991 C6-7 Consolidated Statements of Stockholders' Equity for the years ended December 31, 1993, 1992 and 1991 C8 Notes to Consolidated Financial Statements C9-15 FINANCIAL STATEMENT SCHEDULES V - Property, plant and equipment for the years ended December 31, 1993, 1992 and 1991 C16 VI - Accumulated depreciation, depletion and amortization of property, plant and equipment for the years ended December 31, 1993 1992 and 1991 C17 X - Supplementary income statement information for the years ended December 31, 1993, 1992 and 1991 C18 NOTES Financial statement schedules other than the above are omitted because they are either not applicable, not required or the information is included in the notes to the financial statements. The individual financial statements of Southern Peru Copper Corporation have been omitted since the Company is primarily an operating company and the subsidiaries included in the consolidation are wholly owned. The financial statements and the related financial statement schedules referred to above are as submitted to the Registrant by Southern Peru Copper Corporation. C2 REPORT OF INDEPENDENT ACCOUNTANTS - -------------------------------------------------------------------------------- To the Board of Directors and Stockholders of Southern Peru Copper Corporation: We have audited the consolidated balance sheets of SOUTHERN PERU COPPER CORPORATION and CONSOLIDATED SUBSIDIARIES as of December 31, 1993 and 1992, and the related consolidated statements of operations, changes in stockholders' equity and cash flows for each of the three years in the period ended December 31, 1993. We have also audited the financial statement schedules (pages C16 to C18, inclusive). These financial statements and financial statement schedules are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements and financial statement schedules based on our audits. We conducted our audits in accordance with generally accepted auditing standards. These standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of Southern Peru Copper Corporation and Consolidated Subsidiaries at December 31, 1993 and 1992, and the consolidated results of their operations, and their cash flows for each of the three years in the period ended December 31, 1993 in conformity with generally accepted accounting principles. In addition, in our opinion, the financial statement schedules referred to above, when considered in relation to the basic financial statements taken as a whole, present fairly, in all material respects, the information required to be included therein. As described in Note 2 to the consolidated financial statements, the Company changed its method of accounting for income taxes in 1993. New York, New York February 4, 1994 COOPERS & LYBRAND C3 See accompanying notes to consolidated financial statements. C4 See accompanying notes to consolidated financial statements. C5 See accompanying notes to consolidated financial statements. C6 C7 See accompanying notes to consolidated financial statements. C8 SOUTHERN PERU COPPER CORPORATION AND CONSOLIDATED SUBSIDIARIES CONSOLIDATED STATEMENTS of CHANGES IN STOCKHOLDERS' EQUITY FOR THE YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 See accompanying notes to consolidated financial statements. C9 SOUTHERN PERU COPPER CORPORATION AND CONSOLIDATED SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - ------------------------------------------------------------------------------- 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES: Principles of Consolidation: Southern Peru Copper Corporation (the Company) is a Delaware Corporation which prepares its financial statements in accordance with generally accepted accounting principles in the United States. The Company operates two copper mines and a smelter in Peru (Peruvian Branch) and substantially all of its assets are located there. The consolidated financial statements include the accounts of the Company and its wholly owned subsidiaries. Certain reclassifications have been made in prior years' financial statements to conform to the 1993 presentation. Net Sales: Net sales represent the invoiced value of products containing copper, silver and molybdenum after deducting Peruvian sales and export taxes, commissions, insurance, freight, toll refining charges and hedging costs. Price estimates used for provisionally priced shipments are based on the Company's judgment of the current price level and its susceptibility to decline during the settlement period. Cash Equivalents: The Company considers all highly liquid investments with a maturity of three months or less when purchased to be cash equivalents. Marketable Securities: Marketable securities include liquid investments with a maturity of more than three months when purchased and are carried at cost, which approximates market value. Peruvian Tax Credits: Excess Peruvian tax credits are classified as prepaid expenses on the balance sheet and are utilized to either pay Peruvian taxes or are sold. The carrying value of the Peruvian tax credits approximates their market value. Inventories: Inventories are carried at the lower of average cost or market value. Property: Maintenance, repairs and gains or losses on assets retired or sold are reflected in earnings as incurred. The cost of renewals is capitalized and the property unit being replaced is retired. The cost of betterments is capitalized. Buildings and equipment are depreciated on the straight-line method over estimated lives from 5 to 34 years, or the estimated life of the mine if shorter. Mine development cost and the cost of Toquepala and Cuajone mineral lands are capitalized and charged to earnings on the unit-of-production method using economic ore reserves. Income Taxes: The Company adopted Statement of Financial Accounting Standards No. 109 "Accounting for Income Taxes" (SFAS No. 109) effective January 1, 1993. SFAS No. 109, issued in February 1992, requires the adoption of the "liability" method of calculating deferred taxes. Prior to the adoption of SFAS No. 109, the Company provided for income taxes under the provisions of APB No. 11. Deferred income taxes reflect the future tax consequences of differences between the tax bases of assets and liabilities and their financial reporting amounts at each year-end. C10 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, CONTINUED - ------------------------------------------------------------------------------- 2. CHANGE IN ACCOUNTING PRINCIPLE: The Company adopted SFAS No. 109 effective January 1, 1993. The cumulative effect of this change in accounting principle was a credit to income of $165.1 million and is shown separately on the Company's Consolidated Statement of Operations for the year ended December 31, 1993. The adoption of the new method resulted in an additional charge to 1993 net earnings of $4.1 million. 3. FOREIGN EXCHANGE CONTROL: All income, except for dividend and interest income of $1.5 million, $1.3 million and $7.4 million earned in the United States in 1993, 1992 and 1991, respectively, is derived from operations conducted by the Company's Peruvian Branch. Export proceeds are deposited directly to the Company's accounts, which can be maintained either in Peru or abroad. 4. PERUVIAN AND U.S. TAXES: Taxes on income represent Peruvian income taxes, except for provision (benefit) for U.S. taxes of ($1.5) million, $0.4 million and $2.5 million in 1993, 1992 and 1991, respectively, on income earned in the United States. United States taxes on foreign source income have been eliminated through the utilization of foreign taxes as either credits or deductions from taxable income. At December 31, 1993, the foreign tax credit carry forward available to reduce possible future U.S. income taxes amounted to approximately $67.8 million of which $23.8 million expires in 1994, $9.3 million expires in 1996 and $34.7 million expires in 1998. In addition, the Company has $0.2 million in Alternative Minimum Tax (AMT) credits which have no expiration dates. The Company has not recognized the benefit of existing foreign tax credits and AMT credits, since it is unlikely that realization will occur. The components of the Peruvian deferred tax liabilities (assets) are: *After the adoption of SFAS No. 109. Peruvian source income is taxed at graduated rates up to a maximum of 37% with monthly payments required. Income generated by the Cuajone mine, however, was subjected to a contract rate of 54.5% during the post-investment recovery period which concluded in October 1993. The results of the Cuajone mine were taxed at the lower general rate of 37% following the conclusion of the recovery period. Income taxes paid were $47.7 million, $60.0 million and $21.6 million in 1993, 1992 and 1991, respectively. C11 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, CONTINUED - ------------------------------------------------------------------------------- The Peruvian income tax at the maximum statutory rate is reconciled to the actual tax provisions as follows: Pursuant to a contract which expires in the year 2000, the Company delivers blister copper to Empresa Minera del Peru (Minero Peru), the Peruvian Government-owned Ilo refinery, for refining on toll. In 1993, the Company delivered 202,364 short tons of blister to Minero Peru for toll refining. 6. LABOR SHARES: Peruvian law in effect through 1991 provided that all employees in mining companies have increasing participation (up to a maximum of 33 1/3%) in profits, proceeds from liquidation and "management committees" of Peruvian branches of foreign companies. Employees participated in 10% of Branch results in two principal ways: (a) 4.5% of pre-tax profits payable in cash, hereafter referred to as liquid participation; and (b) 5.5% of pre-tax results, patrimonial participation, in the form of ownership shares and general debt obligations of the Branch. In October 1991, a legislative decree was issued changing the workers' participation law so that, effective 1992, workers had an 8% cash participation in pre-tax profits and no longer received patrimonial participation. Labor shares represented 17.5% of the Branch capital for the years 1993 and 1992, and 16.5% for 1991. C12 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, CONTINUED - ------------------------------------------------------------------------------- 7. DEBT AND AVAILABLE CREDIT FACILITIES: At December 31, 1993, the Company had $15.6 million outstanding in long-term debt, pursuant to various loan agreements described below, and no outstanding short-term borrowings. Lines of credit available for export financing at December 31, 1993, amounted to $28 million. Interest paid for short-term borrowings was $0.6 million, $1.7 million and $8.6 million in 1993, 1992 and 1991, respectively. The carrying value of the debt approximates its fair market value, since the interest rates are variable. The total amount of fees and interest paid relating to the long-term debt was $621,000. At December 31, 1993, the Company had three loan agreements that permit borrowings of up to $85 million, of which $69.4 million was available at December 31, 1993. One facility allows the Company to borrow up to $60.0 million until May 1995. The other two facilities allow for draw downs through December 31, 1994. Borrowings under these agreements bear interest based on LIBOR, Prime or other indices and averaged 8.01% at December 31, 1993. In addition, there are commitment fees ranging from approximately 0.37% to 0.75% on the unused balances of the Company's loan agreements. Aggregate maturities of the notes outstanding at December 31, 1993 are as follows: In addition to the loan agreements mentioned above, the Company has signed two additional loan agreements subsequent to December 31, 1993. On January 21, 1994, the Company signed a credit agreement to borrow up to $115 million. On January 25, 1994, the Company signed a second loan agreement for $50 million. The latter loan will be effective upon approval of the Japanese Ministry of International Trade and Industry (MITI). Under the most restrictive terms of the agreements, the Company must maintain a debt to equity ratio, as defined, which cannot exceed 80%. This ratio was 3% at December 31, 1993. In addition, the ratio of current assets to current liabilities, as defined, cannot be less than 150% and at December 31, 1993, this ratio was 497%. Dividends are limited to a portion of net income, as defined, and by debt service coverage ratios, as defined. One of the agreements, signed in January of 1994, may require the Company to hedge up to 130,000 metric tons of its annual production based on defined conditions. As of December 31, 1993 the Company had purchased put options with an exercise price of $0.70 per pound in compliance with the loan agreement. These options are accounted for as hedges and the cost of these options and any gains are reported as a component of the related sales transactions. 8. PENSION BENEFIT PLAN: The Company has a noncontributory, defined benefit pension plan covering the salaried employees in the United States and the expatriate employees in Peru. Benefits are based on salary and years of service. The Company's funding policy is to contribute amounts to the plan sufficient to meet the minimum funding requirements set forth in the Employee Retirement Income Security Act of 1974, plus such additional amounts as the Company may determine to be appropriate from time to time. Plan assets are primarily invested in guaranteed investment contracts with the Metropolitan Life Insurance Company of New York. The net pension costs consist of: C13 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, CONTINUED - -------------------------------------------------------------------------------- The funded status of the plan using the projected unit credit method is: The actuarial computations are based upon a discount rate on benefit obligations of 7%, an expected long-term rate of return on plan assets of 8%, and annual salary increases of 4%. The pension information for 1992 is not presented due to immateriality. C14 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, CONTINUED - -------------------------------------------------------------------------------- 9. Common Stock: At December 31, 1993, the stockholders of the Company were as follows: The Company declared and paid cash dividends of $18 million and $15 million in 1993 and 1992, respectively. Additionally, in 1991, the Company purchased 13.8 percent of its previously outstanding shares from its stockholders pro rata for an aggregate purchase price of $60 million. The repurchased shares are held in the Company's treasury and are available for issuance for general corporate purposes. 10. RELATED PARTY TRANSACTIONS: ASARCO Incorporated (ASARCO), a stockholder of the Company, provides various support services to the Company. In 1993 and 1992, these activities were principally related to legal, tax and treasury support services. In 1991, these services also included the purchase and shipment of materials to the Company's operations in Peru. The amounts paid to ASARCO for these services were $0.4 million, $0.2 million and $1.0 million in 1993, 1992 and 1991, respectively. Sales to ASARCO and other affiliates are disclosed in Note 5. Fomenta, S.A., a wholly owned Peruvian subsidiary, holds a 19% interest in the capital of Metalurgica Peruana S.A., (MEPSA). MEPSA, a Peruvian company, is engaged in the manufacture of metallurgical products used in the mining industry. The Company purchases grinding media from MEPSA for use at the Company's concentrators. Purchases were $5.3 million, $6.7 million and $9.7 million in 1993, 1992 and 1991, respectively. 11. CUAJONE JOINT VENTURER: In September 1991, the Company purchased the Joint Venture interest in the Cuajone mine from Billiton, B.V. for $15.2 million, to be paid in annual installments through 1996. Provision exists, however, for acceleration of these payments as stockholder dividends are made. Under the terms of this agreement, $4.3 million, $4.2 million and $2.5 million were paid in 1993, 1992 and 1991, respectively. The 1993 and 1992 amounts include acceleration payments of the entire 1996 installment and part of the 1995 installment. Therefore, as of December 31, 1993, only the 1994 and 1995 installments remain outstanding. Prior to the purchase, the participation of the Joint Venturer in the net earnings of the Company represented a pro rata allocation of Cuajone net earnings based on the percentage of equity contribution made by the Joint Venturer to the Cuajone operation. Cash distributions were made in accordance with terms of the Joint Venture agreement, and were consequently determined by other factors as well as net earnings. 12. COMMITMENTS AND CONTINGENCIES: Refining Assessment: In 1986 and 1987, Minero Peru claimed additional refining charges for the period 1981 through March 1987 from the Company and two of its blister customers. The Company negotiated with Minero Peru on behalf of all parties and agreed to reimburse the two blister customers involved for their pro rata portion of any negotiated settlement. Claims for all years concern the application of escalator clauses in toll refining contracts. Claims for the period 1983 through March 1987 were settled in 1988. During 1993, the assessment claims relating to the 1981 and 1982 years was settled by arbitration in the Company's favor. This resulted in the reversal of prior years' accruals of $11.1 million which is included in 1993's earnings. C15 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, CONTINUED - ------------------------------------------------------------------------------- CUAJONE INVESTMENT RECOVERY: In December 1991, the Company and the Government of Peru entered an agreement resolving all open issues concerning the conclusion of the investment recovery contract which governed the development and operation of the Cuajone mine. The Company agreed to undertake a $300 million investment program over the five years 1992-1996, and the Peruvian Government agreed not to discriminate against the Company in comparison with treatment given to other mining companies. As part of this agreement, in 1991 the Company transferred $55 million from its accounts in New York to an account with the Central Reserve Bank of Peru, to be withdrawn by the Company at its discretion solely for application to the $300 million investment program. At December 31, 1993, the balance of this account with the Central Reserve Bank of Peru was $58.3 million. The projects specified in the investment program are in various stages. External financing, as described in Note 7 above, has been obtained by the Company for use in the investment program. Litigation: On February 26, 1993, the Mayor of Tacna brought a lawsuit against the Company seeking $100 million in damages from alleged harmful deposition of tailings and slag, and smelter emissions. In another lawsuit previously brought by the Mayor of Tacna, also relating to the disposal of mine tailings, the Peruvian Supreme Court has ruled that the Company must cease its current method of disposal. The Company has submitted plans to the Ministry of Mines and Energy and is awaiting the Ministry's approval for modifying the tailings disposal. Adoption of the modified tailings disposal plan should, in the Company's belief, resolve this matter. In another pending lawsuit, a group named the Association of Retired Employees of Southern Peru Copper Corporation has challenged the accounting of the Company's Peruvian branch and its allocations of financial results to the Mining Community in the 1970's. It is the opinion of the Company's management that the outcome of the legal proceedings mentioned, and other miscellaneous litigation and proceedings now pending, will not materially adversely affect the financial position of the Company and its consolidated subsidiaries. C16 C17 (a) Does not include $5,534 relating to the amortization of goodwill. C18 D1 Form 10K ASARCO Incorporated EXHIBIT INDEX Exhibit Indexed No. Description on page - ------- ----------- ------- 3. Certificate of Incorporation and By-Laws (a) Certificate of Incorporation - restated, filed May 4, 1970 (Filed as an Exhibit to the Company's 1980 Annual Report on Form 10-K and incorporated herein by reference) (b) Certificate of Amendment to the Certificate of Incorporation effective April 23, 1975 (Filed as an Exhibit to the Company's 1980 Annual Report on Form 10-K and incorporated herein by reference) (c) Certificate of Amendment of Certificate of Incorporation executed April 14, 1981 (Filed as an Exhibit to the Post-Effective Amendment No. 8 to Registration Statement No. 2-47616, filed April 30, 1981 and incorporated herein by reference) (d) Certificate of Amendment of Restated Certificate of Incorporation filed on May 6, 1985 (Filed as an Exhibit to the Company's Quarterly Report on Form 10-Q for the quarter ended March 31, 1985 and incorporated herein by reference) (e) Certificate of Amendment of Certificate of Incorporation filed July 21, 1986 (Filed as an Exhibit to the Company's Quarterly Report on Form 10-Q for the quarter ended June 30, 1986 and incorporated herein by reference) (f) Certificate of Amendment of Restated Certificate of Incorporation, as amended filed April 22, 1987 (Filed as an Exhibit to the Company's 1987 Annual Report on Form 10-K and incorporated herein by reference) (g) Statement of Cancellation filed July 31, 1987 whereby 155,000 shares of Series A Cumulative Preferred Stock and 862,500 shares of $9.00 Convertible Exchangeable Preferred Stock were cancelled (Filed as an Exhibit to the Company's 1987 Annual Report on Form 10-K and incorporated herein by reference) (h) Statement of Cancellation filed November 20, 1987 whereby 1,026,900 shares of Series A Cumulative Preferred Stock were cancelled (Filed as an Exhibit to the Company's 1987 Annual Report on Form 10-K and incorporated herein by reference) (i) Statement of Cancellation filed December 18, 1987 whereby 1,250,000 shares of Series B Cumulative Convertible Preferred Stock were cancelled (Filed as an Exhibit to the Company's 1987 Annual Report on Form 10-K and incorporated herein by reference) (j) Statement of Cancellation filed March 3, 1988 whereby 27,000 shares of Series A Cumulative Preferred Stock were cancelled (Filed as an Exhibit to the Company's 1987 Annual Report on Form 10-K and incorporated herein by reference) D2 Form 10K ASARCO Incorporated EXHIBIT INDEX (Continued) Exhibit Indexed No. Description on page - ------- ----------- ------- (k) Certificate of Amendment of Restated Certificate of Incorporation, as amended, filed August 7, 1989 (Filed as an Exhibit to the Company's Quarterly Report on Form 10-Q for the quarter ended June 30, 1989 and incorporated herein by reference) (l) By-Laws as last amended on June 26, 1991 (Filed as an Exhibit to the Company's 1991 Annual Report on Form 10-K and incorporated herein by reference.) 4. Instruments defining the rights of security holders, including indentures (a) There are currently various separate indentures, agreements or similar instruments under which long-term debt of Asarco is currently outstanding. The Registrant hereby agrees to furnish to the Commission, upon request, a copy of any of the instruments which define the rights of holders of long-term debt securities. None of the outstanding instruments represents long-term debt securities in excess of 10% of the total assets of Asarco as of December 31, 1993 (b) Form of Rights Agreement dated as of July 26, 1989, between the Company and First Chicago Trust Company of New York, as Rights Agent, defining the rights of shareholders under a July 1989 Shareholders' Rights plan and dividend declaration (Filed as an Exhibit to the Company's report on Form 8-K filed on July 28, 1989 and incorporated herein by reference) (c) Rights Agreement Amendment dated as of September 24, 1992, between the Company and The Bank of New York, as Successor Rights Agent under the Rights Agreement listed above (Filed as an Exhibit to the Company's 1992 Annual Report on Form 10-K and incorporated herein by reference) (d) Indenture Agreement dated as of February 1, 1993 between the Company and Bankers Trust Company, as Trustee, covering the issuance of debt securities registered by the Company in April 1992, not to exceed $250 million (Filed as an Exhibit to the Company's 1992 Annual Report on form 10-K and incorporated herein by reference) 10. (a) Stock Option Plan as amended through November 24, 1987 (Filed as an Exhibit to the Company's 1988 Annual Report on Form 10-K and incorporated herein by reference) (b) Form of Employment Agreement entered into in 1985, as amended in March and April 1989, among the Company and currently 12 of its executive officers, including Messrs. R. de J. Osborne, F.R. McAllister, A.B. Kinsolving, R.J. Muth and R.M. Novotny (Filed as an Exhibit to the Company's Quarterly Report on Form 10-Q for the quarter ended June 30, 1989 and incorporated herein by reference) (c) Deferred Fee Plan for Directors, as amended through D9-D13 January 26, 1994 (d) Supplemental Pension Plan for Designated Mid-Career Officers, as amended through January 31, 1990 (Filed as an Exhibit to the Company's 1989 Annual Report on Form 10-K and incorporated herein by reference) D3 ASARCO Incorporated EXHIBIT INDEX (Continued) Exhibit Indexed No. Description on page - ------- ----------- ------- (e) Retirement Plan for Non-Employee Directors, as amended through January 25, 1989 (Filed as an Exhibit to the Company's 1988 Annual Report on Form 10-K and incorporated herein by reference) (f) Directors' Stock Award Plan, as amended through January 27, 1993 (Filed as an Exhibit to the Company's 1992 Annual Report on Form 10-K and incorporated herein by reference) (g) Stock Incentive Plan adopted by the Company's Shareholders on April 25, 1990 (Filed as an Exhibit to the Company's 1990 Annual Report on Form 10-K and incorporated herein by reference) 11. Statement re Computation of Earnings Per Share D-4 21. Subsidiaries of the registrant D-5 - D-8 23. Report of Independent Accountants on Financial Statement Schedules and Consent of Independent Accountants are included on page A58 of this Annual Report on Form 10-K. Report on Form 11-K relating to the Savings Plan for Salaried Employees of ASARCO Incorporated and Participating Subsidiaries is to be filed by amendment on Form 8. Copies of exhibits may be acquired upon written request to the Treasurer and the payment of processing and mailing costs.

25600_1993.txt

25600

1993

Item 1. Business. GENERAL American General Finance, Inc. (AGFI) is a financial services holding company whose principal subsidiaries are American General Finance Corporation (AGFC) and American General Financial Center (AGF-Utah). AGFC is also a holding company with subsidiaries that are engaged primarily in the consumer finance and credit insurance business. The credit insurance operations are conducted by Merit Life Insurance Co. (Merit) and Yosemite Insurance Company (Yosemite) as a part of the Company's consumer finance business. AGF-Utah is an industrial loan company engaged primarily in the consumer finance business with funding for its operations including public deposits insured by the Federal Deposit Insurance Corporation. Unless the context otherwise indicates, references to the Company relate to AGFI and its subsidiaries, whether directly or indirectly owned. At December 31, 1993, the Company had 1,204 offices in 39 states, Puerto Rico, and the Virgin Islands. In January 1994, a purchasing office was opened in Texas increasing the total number of states in which the Company operates to 40. Total finance receivables net of unearned finance charges as of December 31, 1993, were $6.6 billion. At December 31, 1993, the Company employed approximately 7,300 persons. The Company's executive offices are located in Evansville, Indiana. AGFI was incorporated under the laws of the State of Indiana in 1974 to become the parent holding company of AGFC. AGFC was incorporated under the laws of the State of Indiana in 1927 as successor to a business started in 1920. Since 1982, AGFI has been a direct or indirect wholly-owned subsidiary of American General Corporation (American General), a consumer financial services organization incorporated in the State of Texas in 1980 as the successor to American General Insurance Company, a Texas insurance company incorporated in 1926. Certain amounts in the 1992 and 1991 information presented herein have been reclassified to conform to the 1993 presentation. Item 1. Continued Selected Financial Statistics The following table sets forth certain selected financial information and ratios of the Company and illustrates certain aspects of the Company's business for the years indicated: 1993 1992 1991 (dollars in thousands) Average finance receivables net of unearned finance charges (ANR) $6,387,044 $5,939,417 $5,904,893 Average borrowings $5,693,080 $5,317,836 $5,261,270 Finance charges as a percentage of ANR (yield) 16.9% 16.7% 16.6% Interest expense as a percentage of average borrowings (borrowing cost) 6.7% 7.5% 8.4% Spread between yield and borrowing cost 10.2% 9.2% 8.2% Insurance revenues as a percentage of ANR 2.2% 2.0% 1.9% Operating expenses as a percentage of ANR 5.2% 5.2% 4.9% Allowance for finance receivable losses as a percentage of net finance receivables 2.8% 2.6% 2.5% Net charge-offs as a percentage of ANR (charge-off ratio) 2.2% 2.2% 2.3% Delinquency ratio - 60 days or more (defined in Finance Receivable Loss and Delinquency Experience in Item 1. herein.) 2.5% 2.2% 2.6% Debt to equity ratio 5.3 5.3 5.2 Return on average assets 2.6% 2.3% 2.0% Return on average assets before deducting cumulative effect of accounting changes 2.8% 2.3% 2.0% Item 1. Continued 1993 1992 1991 Return on average equity 18.1% 15.7% 12.8% Return on average equity before deducting cumulative effect of accounting changes 19.2% 15.7% 12.8% Ratio of earnings to fixed charges (refer to Exhibit 12 in Item 14. herein for calculations) 1.9 1.6 1.5 CONSUMER FINANCE OPERATIONS Through its subsidiaries, the Company makes loans directly to individuals, purchases retail sales contract obligations of individuals, and offers credit card services. In its lending operations, the Company generally takes a security interest in real property and/or personal property of the borrower. Of the loans outstanding at December 31, 1993, 89% were secured by such property. At December 31, 1993, mortgage loans (generally second mortgages) accounted for 11% of the total number of loans outstanding and 53% of the aggregate dollar amount of loans outstanding; compared to 13% and 58%, respectively, at December 31, 1992. Loans secured by real property generally have maximum original terms of 180 months. Loans secured by personal property or that are unsecured generally have maximum original terms of 60 months. The Company purchases retail sales contracts arising from the retail sale of consumer goods and services. Retail sales contracts are secured by the real property or personal property giving rise to the contract. Retail sales contracts generally have a maximum original term of 60 months. Through AGF-Utah, the Company provides various credit card services, including the issuance of MasterCard and Visa credit cards to individuals through branch and direct mail solicitation programs, and manages private label credit card programs for various business entities. Credit card receivables are all unsecured and require minimum monthly payments based on current balances. Finance Receivables All data in this report on finance receivables (except as otherwise indicated) are calculated on a net basis -- that is, after deduction of unearned finance charges but before deduction of an allowance for finance receivable losses. Item 1. Continued The following table sets forth certain information concerning finance receivables of the Company: Years Ended December 31, 1993 1992 1991 Originated, renewed and purchased: Amount (in thousands): Real estate loans $ 939,769 $ 841,898 $ 825,067 Non-real estate loans 2,499,113 1,969,564 1,647,277 Retail sales contracts 1,172,089 917,108 711,206 Credit cards 797,373 633,617 471,325 Total originated and renewed 5,408,344 4,362,187 3,654,875 Purchased (net of sales) 31,501 259,492 213,925 Total originated, renewed, and purchased $5,439,845 $4,621,679 $3,868,800 Number: Real estate loans 58,163 48,778 45,425 Non-real estate loans 1,280,639 915,311 742,728 Retail sales contracts 1,037,858 810,088 568,383 Average size (to nearest dollar): Real estate loans $16,158 $17,260 $18,163 Non-real estate loans 1,951 2,152 2,218 Retail sales contracts 1,129 1,132 1,251 Balance at end of period: Amount (in thousands): Real estate loans $2,641,879 $2,782,297 $2,953,272 Non-real estate loans 2,318,102 2,054,380 1,817,076 Retail sales contracts 922,856 871,503 791,003 Credit cards 691,151 491,506 383,541 Total $6,573,988 $6,199,686 $5,944,892 Number: Real estate loans 153,562 153,621 154,430 Non-real estate loans 1,270,167 1,074,511 914,468 Retail sales contracts 888,632 756,887 582,173 Credit cards 441,263 360,796 293,216 Total 2,753,624 2,345,815 1,944,287 Average size (to nearest dollar): Real estate loans $17,204 $18,111 $19,124 Non-real estate loans 1,825 1,912 1,987 Retail sales contracts 1,039 1,151 1,359 Credit cards 1,566 1,362 1,308 Item 1. Continued ANR The following table details ANR by type of finance receivable for the years indicated: 1993 1992 1991 (dollars in thousands) Loans $4,942,508 $4,736,611 $4,755,033 Retail sales contracts 895,288 781,701 793,401 Credit cards 549,248 421,105 356,459 Total $6,387,044 $5,939,417 $5,904,893 Yield The following table details yield for the years indicated: 1993 1992 1991 Loans 17.0% 16.6% 16.4% Retail sales contracts 15.7% 16.0% 15.5% Credit cards 18.0% 19.3% 21.5% Total 16.9% 16.7% 16.6% Geographic Distribution See Note 4. of the Notes to Consolidated Financial Statements in Item 8. herein for information on geographic distribution of finance receivables. Item 1. Continued Finance Receivable Loss and Delinquency Experience The finance receivable loss experience for the Company for the periods indicated is set forth in the net charge-off and charge-off ratio(a) information below: Years Ended December 31, 1993 1992 1991 (dollars in thousands) Real estate loans: Net charge-offs $ 20,325 $ 21,403 $ 19,087 Charge-off ratio .7% .8% .6% Non-real estate loans: Net charge-offs $ 79,016 $ 71,052 $ 72,341 Charge-off ratio 3.7% 4.0% 4.4% Total loans: Net charge-offs $ 99,341 $ 92,455 $ 91,428 Charge-off ratio 2.0% 2.0% 1.9% Retail sales contracts: Net charge-offs $ 17,049 $ 11,887 $ 14,220 Charge-off ratio 1.9% 1.5% 1.8% Credit cards: Net charge-offs $ 24,358 $ 24,738 $ 28,236 Charge-off ratio 4.5% 5.9% 8.0% Total: Net charge-offs $140,748 $129,080 $133,884 Charge-off ratio 2.2% 2.2% 2.3% Allowance for finance receivable losses (b) $183,756 $161,678 $151,091 Allowance ratio (b) 2.8% 2.6% 2.5% (a) The charge-off ratio represents charge-offs net of recoveries as a percentage of the average of the amount of net finance receivables at the beginning of each month during the period. (b) The amount shown for allowance for finance receivable losses represents the balance at the end of the period. The allowance ratio represents the allowance for finance receivable losses at the end of the period as a percentage of net finance receivables. The allowance for finance receivable losses is maintained at a level based on management's periodic evaluation of the finance receivable portfolio and reflects an amount that, in management's opinion, is adequate to absorb losses in the existing portfolio. In evaluating the portfolio, management takes into consideration numerous factors, including current economic conditions, prior finance receivable loss and delinquency experience, the composition of the finance receivable portfolio, and management's estimate of anticipated finance receivable losses. Item 1. Continued AGFI's basic policy is to charge off each month loan accounts, except those secured by real estate, on which little or no collections were made in the prior six-month period. Retail sales contracts are charged off when four installments are past due. Credit card accounts are charged off when 180 days past due. In the case of loans secured by real estate, foreclosure proceedings are instituted when four monthly installments are past due. When foreclosure is completed and the Company has obtained title to the property, the real estate is established as an asset valued at market value, and any loan value in excess of that amount is charged off. Exceptions are made to the charge-off policies when, in the opinion of management, such treatment is warranted. Based upon contract terms in effect at the respective dates, delinquency(a) was as follows: December 31, 1993 1992 1991 (dollars in thousands) Real estate loans $ 48,426 $ 53,046 $ 64,064 % of related receivables 1.8% 1.8% 2.1% Non-real estate loans $102,855 $ 75,449 $ 75,731 % of related receivables 3.8% 3.2% 3.6% Total loans $151,281 $128,495 $139,795 % of related receivables 2.8% 2.4% 2.7% Retail sales contracts $ 14,887 $ 10,770 $ 11,672 % of related receivables 1.4% 1.0% 1.2% Credit cards $ 15,396 $ 13,273 $ 14,822 % of related receivables 2.2% 2.7% 3.9% Total $181,564 $152,538 $166,289 % of related receivables 2.5% 2.2% 2.6% (a) Finance receivables any portion of which was 60 days or more past due (including unearned finance charges and excluding deferred origination costs, a fair value adjustment on finance receivables and accrued interest). Sources of Funds AGFI funds its consumer finance operations principally through net cash flows from operating activities, issuances of long-term debt, short-term borrowings in the commercial paper market, and borrowings from banks. The spread between the rates charged in consumer finance operations and the cost of borrowed funds is one of the major factors determining the Company's earnings. The Company is limited by statute in most states to a maximum rate which it may charge in its lending operations. A relatively high ratio of borrowings to invested capital is customary in the consumer finance industry and is an important element in profitable operations. Item 1. Continued Average Borrowings The following table details average borrowings by type of debt for the years indicated: 1993 1992 1991 (dollars in thousands) Long-term debt $3,856,328 $3,181,509 $2,566,305 Short-term debt 1,781,165 1,889,874 1,923,684 Investment certificates 55,587 246,453 771,281 Total $5,693,080 $5,317,836 $5,261,270 Borrowing Cost The following table details interest expense as a percentage of average borrowings by type of debt for the years indicated: 1993 1992 1991 Long-term debt 7.9% 8.7% 9.2% Short-term debt 4.1% 5.6% 7.5% Investment certificates 4.7% 6.3% 7.8% Total 6.7% 7.5% 8.4% Contractual Maturities Contractual maturities of loans and retail sales contracts, and debt as of December 31, 1993 were as follows: Loans and Retail Sales Contracts Debt (dollars in thousands) Due in: 1994 $2,079,612 $2,489,678 1995 1,219,180 938,565 1996 758,336 562,853 1997 375,914 352,361 1998 224,437 243,130 1999 and thereafter 1,225,358 1,256,577 Total $5,882,837 $5,843,164 See Note 4. of the Notes to Consolidated Financial Statements in Item 8. herein for further information on principal cash collections of finance receivables. Item 1. Continued INSURANCE OPERATIONS Merit is a life and health insurance company domiciled in Indiana and currently licensed in 43 states and the District of Columbia. Merit writes or assumes (through affiliated and non-affiliated insurance companies) credit life, credit accident and health, and ordinary insurance coverages. Yosemite is a property and casualty insurance company domiciled in California and licensed in 41 states which principally underwrites credit- related property and casualty coverages. Both Merit and Yosemite market their products through the consumer finance network of the Company. The credit life insurance policies typically cover the life of the borrower in an amount equal to the unpaid balance of the obligation and provide for payment in full to the lender of the insured's obligation in the event of death. The credit accident and health insurance policies provide for the payment of the installments on the insured's obligation to the lender coming due during a period of unemployment or disability due to illness or injury. The credit-related property and casualty insurance is written to protect property pledged as security for the obligation. The purchase by the borrower of credit life, credit accident and health, and credit property and casualty insurance is voluntary with the exception of property damage coverage for automobiles, dwellings, and commercial real estate pledged as collateral. In these instances, property damage coverage is provided under the terms of the lending agreement if the borrower does not provide evidence of coverage with another insurance carrier. Premiums for insurance products are financed as part of the insured's obligation to the lender. Merit has from time to time entered into reinsurance agreements with other insurance companies, including certain American General subsidiaries, for assumptions of various shares of annuities and ordinary, group, and credit life insurance on a coinsurance basis. The reserves attributable to this business fluctuate over time and in certain instances are subject to recapture by the ceding company. At December 31, 1993, life reserves on the books of Merit attributable to this business amounted to $74.2 million. The following tables set forth information concerning the insurance operations: Life Insurance in Force December 31, 1993 1992 1991 (dollars in thousands) Credit life $2,547,784 $2,221,940 $1,955,560 Ordinary life 2,373,685 2,208,685 2,189,817 Total $4,921,469 $4,430,625 $4,145,377 Item 1. Continued Premiums Earned Years Ended December 31, 1993 1992 1991 (dollars in thousands) Insurance premiums earned in connection with affiliated finance and loan activities: Credit life $ 35,711 $ 30,324 $ 28,794 Credit accident and health 42,978 34,222 29,968 Property 25,686 18,594 15,370 Other insurance premiums earned: Ordinary life 20,823 19,344 22,177 Premiums assumed under coinsurance agreements 12,318 6,984 5,783 Total $137,516 $109,468 $102,092 Premiums Written Years Ended December 31, 1993 1992 1991 (dollars in thousands) Insurance premiums written in connection with affiliated finance and loan activities: Credit life $ 41,036 $ 36,605 $ 27,975 Credit accident and health 56,839 44,029 36,695 Property 47,358 19,344 18,250 Other insurance premiums written: Ordinary life 20,823 23,968 20,233 Premiums assumed under coinsurance agreements 12,318 6,984 5,035 Total $178,374 $130,930 $108,188 Investments and Investment Results The investment portfolio of the Company's insurance subsidiaries is subject to state insurance laws and regulations which prescribe the nature, quality and percentage of various types of investments which may be made by insurance companies. Item 1. Continued The following table summarizes the investment results of the Company's insurance subsidiaries for the periods indicated: Years Ended December 31, 1993 1992 1991 (dollars in thousands) Net investment revenue (a) $ 55,654 $ 54,134 $ 51,023 Average invested assets $666,982 $597,631 $549,359 Return on invested assets (a) 8.3% 9.1% 9.3% Net realized investment gains (losses) (b) $ 7,101 $ 1,937 $ (1,694) (a) Net investment revenue and return on invested assets are after deduction of investment expense but before net realized investment gains (losses) and provision for income taxes. (b) Includes net realized investment gains (losses) on marketable securities and other invested assets before provision for income taxes. REGULATION Consumer Finance The Company operates under various state laws which regulate the consumer lending and retail sales financing businesses. The degree and nature of such regulation varies from state to state. In general, the laws under which a substantial amount of the Company's business is conducted provide for state licensing of lenders, impose maximum term, amount, interest rate and other charge limitations, and enumerate whether and under what circumstances insurance and other ancillary products may be sold in connection with a lending transaction. In addition, certain of these laws prohibit the taking of liens on real estate except liens resulting from judgments. The Company also is subject to various types of federal regulation, including the Federal Consumer Credit Protection Act, the Equal Credit Opportunity Act, the Fair Credit Reporting Act, and certain Federal Trade Commission rules. AGF-Utah, which engages in the consumer finance business and accepts insured deposits, is subject to regulation by and reporting requirements of the Federal Deposit Insurance Corporation and is subject to regulatory codes in the state of Utah. It is difficult for the Company to predict to what extent its business will be affected by changes in economic, competitive, political and international conditions, state and federal laws and regulations, judicial or administrative interpretations, and taxation. Item 1. Continued Insurance The operations of the Company's insurance subsidiaries are subject to regulation and supervision by state authorities. The extent of such regulation varies but relates primarily to conduct of business, types of products offered, standards of solvency, payment of dividends, licensing, nature of and limitations on investments, deposits of securities for the benefit of policyholders, the approval of policy forms and premium rates, periodic examination of the affairs of insurers, form and content of required financial reports and establishment of reserves required to be maintained for unearned premiums, losses and other purposes. Substantially all of the states in which the Company operates regulate the rates of premiums charged for credit life and credit accident and health insurance issued with respect to all credit transactions by the Company in those states. COMPETITION Consumer Finance The consumer finance business in which the Company engages is highly competitive. The Company competes with other consumer finance companies, industrial banks, industrial loan companies, commercial banks, sales finance companies, savings and loan associations, credit unions, mutual or cooperative agencies and others. See Competitive Factors in Item 7. herein for more information. Insurance The Company's insurance business generally operates as an ancillary business to the consumer lending operations. As such, the competition for this business is relatively limited. Item 2.

Item 2. Properties. Due to the nature of the Company's business, its investment in real estate and tangible property is not significant in relation to its total assets. AGFI and certain of its subsidiaries own real estate on which AGFI and other affiliates conduct business. Branch office operations are generally conducted in leased premises. Leases are ordinarily entered into for three- to five-year terms. The Company's exposure to environmental regulation arises from its ownership of such properties. The properties are monitored for compliance with federal and local guidelines. Potential costs related to environmental clean-up are estimated to be immaterial. Item 3.

Item 3. Legal Proceedings. The Company is a defendant in various lawsuits arising in the normal course of business. The Company believes it has valid defenses in these lawsuits and is defending them vigorously. The Company also believes that the total amounts that would ultimately have to be paid, if any, arising from these lawsuits would have no material effect on its consolidated financial position or its consolidated results of operations. PART II Item 5.

Item 5. Market for Registrant's Common Equity and Related Stockholder Matters. There is no trading market for AGFI's common stock, all of which is owned by American General. The frequency and amount of cash dividends declared on AGFI's common stock for the years indicated were as follows: Quarter Ended 1993 1992 (dollars in thousands) March 31 $ 26,000 $ 58,000 June 30 42,100 33,240 September 30 52,900 - December 31 48,198 41,600 $169,198 $132,840 See Management's Discussion and Analysis of Financial Condition and Results of Operations in Item 7. herein, as well as Note 13. of Notes to Consolidated Financial Statements in Item 8. herein, with respect to limitations on the ability of AGFI to pay dividends. Item 6.

Item 6. Selected Financial Data. The following selected financial data are derived from the consolidated financial statements of the Company. The data should be read in conjunction with the consolidated financial statements, related notes, and other financial information included herein. Selected Financial Data Years Ended December 31, 1993(a) 1992 1991 1990 1989 (dollars in thousands) Total revenues $1,288,777 $1,170,371 $1,141,662 $1,114,068 $1,072,817 Net income (b) 195,741 161,908 135,020 121,925 86,107 December 31, 1993(a) 1992 1991 1990 1989 (dollars in thousands) Total assets $7,658,775 $7,210,763 $6,906,025 $6,802,524 $6,534,341 Long-term debt 4,018,797 3,604,371 2,819,045 2,239,448 2,348,158 Item 6. Continued (a) The Company adopted three new accounting standards through cumulative adjustments as of January 1, 1993, resulting in a one-time reduction of net income of $12.7 million. See Note 2. of the Notes to Consolidated Financial Statements in Item 8. herein for information on the adoption of new accounting standards. (b) Per share information is not included because all of the common stock of AGFI is owned by American General. Item 7.

Item 7. Continued Factors which specifically affected the Company's operating results are as follows: Finance Charges. Changes in finance charge revenues, the principal component of total revenues, are a function of period to period changes in the levels of ANR, the yield, and the number of days in the periods compared. ANR for 1993 and 1992 increased when compared to the respective previous year. The increases resulted from receivables originated or renewed by the Company due to business development efforts and the continuance of the Company's historical practice of purchasing portfolios of receivables. The yield for 1993 and 1992 increased when compared to the respective previous year primarily due to increased emphasis on higher-rate non-real estate secured loans during 1993 and 1992 and higher yield on retail sales contracts for 1992. The additional day in 1992 also increased finance charge revenues for 1992 when compared to 1993 and 1991. Insurance Revenues. There was an increase in insurance premiums earned for 1993 when compared to 1992 primarily due to the increase in premiums written in 1992 when compared to 1991. Insurance premiums written also increased for 1993 when compared to 1992 primarily due to an increase in the sale of the core credit and credit-related insurance products that resulted from increased loan volume, insurance product roll-outs, and the assumption of additional reinsurance business. Insurance premiums earned increased in 1992 when compared to 1991 primarily due to the increase in premiums written in 1991 when compared to 1990. Other Revenues. Other revenues increased for 1993 and 1992 when compared to the respective previous year primarily due to an increase in investment revenue. The increase in investment revenue is due to the increased amount of investments in marketable securities and realized investment gains partially offset by a decline in investment yields. The decline in investment yields is primarily due to the low interest rate environment which caused some higher-yielding investments to be called. The proceeds of the called investments were reinvested at then current rates. Interest Expense. Changes in interest expense are a function of period to period changes in the borrowing cost, average borrowings, and the number of days in the periods compared. The borrowing cost for 1993 and 1992 decreased when compared to the respective previous year due to the decline in short-term interest rates and the issuance of long-term debt at rates lower than the rates on fixed-rate obligations maturing, redeemed or that remain outstanding. Average borrowings for 1993 and 1992 increased when compared to the respective previous year primarily to fund asset growth. Operating Expenses. Operating expenses increased for 1993 and 1992 when compared to the respective previous period. The increases were primarily due to increases in salaries, benefits, and occupancy costs. These expenses increased primarily due to an increase in the number of consumer finance offices in the third quarter of 1992 and the additional employees required to operate such offices. The increase in operating expenses for 1993 and 1992 when compared to the respective previous year was partially offset by the increase in deferral of finance receivable origination costs. Operating expenses also increased for 1993 when compared to 1992 due to a major branch office automation program. Item 7. Continued Provision for Finance Receivable Losses. Provision for finance receivable losses for 1993 increased when compared to 1992 due to an increase in net charge-offs and amounts provided for the allowance for finance receivable losses. Provision for finance receivable losses for 1992 decreased when compared to 1991 due to a decrease in net charge-offs partially offset by an increase in the amounts provided for the allowance for finance receivable losses. Net charge-offs for 1993 increased when compared to 1992 primarily due to the increase in ANR. The allowance for finance receivable losses for 1993 and 1992 increased when compared to the respective previous year primarily due to the increase in net finance receivables and to bring the balance to appropriate levels based upon the economic climate, portfolio mix, levels of delinquency, and net charge- offs. Insurance Losses and Loss Adjustment Expenses. Insurance losses and loss adjustment expenses for 1993 increased when compared to 1992 primarily due to an increase in premiums written and the assumption of additional reinsurance business, slightly offset by a decrease in loss ratios. Insurance losses and loss adjustment expenses for 1992 also increased when compared to 1991. This increase was primarily due to an increase in premiums written and annuity payments that were made beginning in 1992 on annuity business which was acquired in 1991. Cumulative Effect of Accounting Changes. The adoption of three new accounting standards resulted in a cumulative adjustment effective January 1, 1993 consisting of a one-time charge to earnings of $12.7 million. Other than the cumulative effect, adoption of these new accounting standards did not have a material effect on 1993 net income and is not expected to have a material impact in the future. See Note 2. of the Notes to Consolidated Financial Statements in Item 8.

Item 8. Financial Statements and Supplementary Data. The Report of Independent Auditors and the related consolidated financial statements are presented on the following pages. REPORT OF INDEPENDENT AUDITORS The Board of Directors American General Finance, Inc. We have audited the accompanying consolidated balance sheets of American General Finance, Inc. (a wholly-owned subsidiary of American General Corporation) as of December 31, 1993 and 1992, and the related consolidated statements of income, shareholder's equity and cash flows for each of the three years in the period ended December 31, 1993. Our audit also included the financial statement schedule listed in the Index at Item 14(a). These financial statements and schedule are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements and schedule based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the consolidated financial position of American General Finance, Inc. and subsidiaries at December 31, 1993 and 1992, and the consolidated results of their operations and their cash flows for each of the three years in the period ended December 31, 1993, in conformity with generally accepted accounting principles. Also, in our opinion, the related financial statement schedule, when considered in relation to the basic financial statements taken as a whole, presents fairly, in all material respects, the information set forth therein. As discussed in Note 2. of the Notes to Consolidated Financial Statements, in 1993 the Company changed its method of accounting for postretirement benefits other than pensions, income taxes, postemployment benefits, reinsurance, loan impairments, and certain investments in debt and equity securities, as a result of adopting recently promulgated accounting standards governing the accounting treatment for these items. ERNST & YOUNG Nashville, Tennessee February 14, 1994 American General Finance, Inc. and Subsidiaries Consolidated Balance Sheets December 31, Assets 1993 1992 (dollars in thousands) Finance receivables, net of unearned finance charges (Note 4.): Loans $4,959,981 $4,836,677 Retail sales contracts 922,856 871,503 Credit cards 691,151 491,506 Net finance receivables 6,573,988 6,199,686 Deduct allowance for finance receivable losses (Note 5.) 183,756 161,678 Net finance receivables, less allowance for finance receivable losses 6,390,232 6,038,008 Marketable securities (Note 3.) 699,697 585,811 Cash and cash equivalents 48,374 43,584 Goodwill (Note 6.) 299,653 310,736 Other assets (Note 6.) 220,819 232,624 Total assets $7,658,775 $7,210,763 December 31, Liabilities and Shareholder's Equity 1993 1992 (dollars in thousands) Long-term debt (Note 11.) $4,018,797 $3,604,371 Short-term notes payable (Notes 7. and 8.) Commercial paper 1,643,961 1,708,281 Banks and other 171,000 150,558 Investment certificates (Note 9.) 9,406 73,528 Insurance claims and policyholder liabilities 415,488 363,174 Other liabilities 231,737 225,847 Accrued taxes 57,686 34,117 Total liabilities 6,548,075 6,159,876 Shareholder's equity (Notes 3., 12., and 13.) Common stock 1,000 1,000 Additional paid-in capital 616,021 615,874 Net unrealized investment gains 33,740 617 Retained earnings 459,939 433,396 Total shareholder's equity 1,110,700 1,050,887 Total liabilities and shareholder's equity $7,658,775 $7,210,763 See Notes to Consolidated Financial Statements. American General Finance, Inc. and Subsidiaries Consolidated Statements of Income Years Ended December 31, 1993 1992 1991 (dollars in thousands) Revenues Finance charges $1,082,660 $ 994,296 $ 977,166 Insurance 142,856 119,272 110,069 Other 63,261 56,803 54,427 Total revenues 1,288,777 1,170,371 1,141,662 Expenses Interest expense 379,764 398,168 440,086 Operating expenses 330,122 307,782 286,781 Provision for finance receivable losses 162,847 135,102 136,885 Insurance losses and loss adjustment expenses 79,214 66,603 59,410 Total expenses 951,947 907,655 923,162 Income before provision for income taxes and cumulative effect of accounting changes 336,830 262,716 218,500 Provision for Income Taxes (Note 10.) 128,437 100,808 83,480 Income before cumulative effect of accounting changes 208,393 161,908 135,020 Cumulative Effect of Accounting Changes (Note 2.) 12,652 - - Net Income $ 195,741 $ 161,908 $ 135,020 See Notes to Consolidated Financial Statements. American General Finance, Inc. and Subsidiaries Consolidated Statements of Shareholder's Equity Years Ended December 31, 1993 1992 1991 (dollars in thousands) Preferred Stock Balance at beginning of year $ - $ - $ 495,500 Retired - - 495,500 Balance at end of year - - - Common Stock Balance at beginning of year 1,000 1,000 1,000 Balance at end of year 1,000 1,000 1,000 Additional Paid-in Capital Balance at beginning of year 615,874 615,874 120,374 Capital contribution from parent and other 147 - 495,500 Balance at end of year 616,021 615,874 615,874 Net Unrealized Investment Gains Balance at beginning of year 617 655 427 Change in non-redeemable preferred stock investments (318) (38) 228 Effect of accounting change on fixed-maturity investments 33,441 - - Balance at end of year 33,740 617 655 Retained Earnings Balance at beginning of year 433,396 404,328 442,113 Net income 195,741 161,908 135,020 Cash dividends: Preferred stock - - (48,311) Common stock (169,198) (132,840) (124,494) Balance at end of year 459,939 433,396 404,328 Total Shareholder's Equity $1,110,700 $1,050,887 $1,021,857 See Notes to Consolidated Financial Statements. American General Finance, Inc. and Subsidiaries Notes to Consolidated Financial Statements December 31, 1993 Note 1. Summary of Significant Accounting Policies Principles of Consolidation The consolidated financial statements include the accounts of American General Finance, Inc. (AGFI) and all of its subsidiaries (the Company) including American General Finance Corporation (AGFC) and American General Financial Center (AGF-Utah). The subsidiaries are all wholly-owned and all intercompany items have been eliminated. AGFI is a wholly-owned subsidiary of American General Corporation (American General). Reclassifications Certain amounts in the 1992 and 1991 financial statements have been reclassified to conform to the 1993 presentation. Finance Receivable Revenue Revenue on finance receivables is accounted for as follows: (1) Finance charges on discounted finance receivables and interest on interest-bearing finance receivables are recognized as revenue on the accrual basis using the interest method. The accrual of revenue is suspended when the fourth contractual payment becomes past due for loans and retail sales contracts and when the sixth contractual payment becomes past due for credit cards. (2) Extension fees and late charges are recognized as revenue when received. (3) Nonrefundable points and fees on loans and retail sales contracts are recognized on the accrual basis using the interest method over the lesser of the contractual term or the estimated life based upon prepayment experience. Effective January 1, 1992, the Company changed, on a prospective basis, the estimated life over which nonrefundable points and fees are amortized to finance charges to the lesser of the contractual term or 50 months for real estate secured finance receivables and 19 months for non-real estate secured finance receivables. This change did not have a material impact on the results of operations of the Company. For loans and retail sales contracts originated prior to January 1, 1992, the estimated life over which nonrefundable points and fees are amortized to finance charges continues to be 36 months. If a loan or retail sales contract liquidates before amortization is completed, any unamortized fees are recognized as revenue at the date of liquidation. Deferred annual fees on credit cards are not material. Notes to Consolidated Financial Statements, Continued Finance Receivable Origination Costs The Company defers costs associated with the origination of loans and credit card receivables. Deferred loan origination costs are included in finance receivables and are required to be amortized to finance charges using the interest method over the contractual term or the estimated economic life of the loans. In 1992, the Company changed, on a prospective basis, the method used to amortize deferred loan origination costs to revenue, and the term over which such deferred costs are amortized. Effective January 1, 1992, deferred costs on loans originated are amortized to finance charges using the interest method over the lesser of the contractual term or 50 months for real estate secured loans and 19 months for non-real estate secured loans. This change did not have a material impact on the results of operations of the Company. For loans originated prior to January 1, 1992, the Company amortizes these deferred costs over the contractual term or 24 months on a straight-line basis; which produces a result not materially different from the interest method over 36 months, which was the estimated life based upon prepayment experience. If a loan liquidates before amortization is completed, any unamortized costs are charged to revenue at the date of liquidation. Deferred costs for the origination of credit cards are not material. Allowance For Finance Receivable Losses The allowance for finance receivable losses is maintained at a level based on management's periodic evaluation of the finance receivable portfolio and reflects an amount that, in management's opinion, is adequate to absorb losses in the existing portfolio. In evaluating the portfolio, management takes into consideration numerous factors, including current economic conditions, prior finance receivable loss and delinquency experience, the composition of the finance receivable portfolio, and management's estimate of anticipated finance receivable losses. AGFI's basic policy is to charge off each month loan accounts, except those secured by real estate, on which little or no collections were made in the prior six-month period. Retail sales contracts are charged off when four installments are past due. Credit card accounts are charged off when 180 days past due. In the case of loans secured by real estate, foreclosure proceedings are instituted when four monthly installments are past due. When foreclosure is completed and the Company has obtained title to the property, the real estate is established as an asset valued at market value and any loan value in excess of that amount is charged off. Exceptions are made to the charge-off policies when, in the opinion of management, such treatment is warranted. Cash Equivalents The Company considers all short-term investments with a maturity at date of purchase of three months or less to be cash equivalents. Notes to Consolidated Financial Statements, Continued Marketable Securities Prior to December 31, 1993, the Company reported marketable securities in accordance with the then-existing accounting standards. Investments in bonds and redeemable preferred stocks were considered held for investment purposes and were carried at cost, adjusted where appropriate for amortization of premiums or discounts. Investments in non-redeemable preferred stocks were stated at fair value and net unrealized gains or losses on revaluation of these stocks were credited or charged to shareholder's equity. Effective with the adoption of Statement of Financial Accounting Standards 115 (see Note 2.), management determines the appropriate classification of marketable securities at the time of purchase and re-evaluates such designation as of each balance sheet date. All marketable securities are currently classified as available-for-sale and recorded at fair value. The fair value adjustment, net of deferred taxes, is recorded in net unrealized investment gains within shareholder's equity. Interest Conversion Agreements The interest differential to be paid or received on interest conversion agreements is accrued as interest rates change and is recognized over the life of the agreements as an adjustment to interest expense. Realized Gains or Losses The difference between the selling price and cost of an investment is recorded as a gain or loss (using the specific identification method) and is included in other revenues. If the fair value of an investment declines below its cost or amortized cost and this decline is considered to be other than temporary, the investment is reduced to its fair value, and the reduction is recorded as a realized loss. Insurance Operations The Company's insurance subsidiaries are engaged in writing credit life and credit accident and health insurance, ordinary life insurance, and property and casualty insurance. Premiums on credit life insurance are recognized as revenue using using the sum-of-the-digits or actuarial methods, except in the case of level-term contracts, which are recognized as revenue using the straight-line method over the lives of the policies. Premiums on credit accident and health insurance are recognized as revenue using an average of the sum-of-the-digits and the straight-line methods. Ordinary life insurance premiums are reported as earned when collected but not before their due dates. Premiums on property and casualty insurance are recognized as revenue using the straight-line method over the terms of the policies or appropriate shorter periods. Notes to Consolidated Financial Statements, Continued Policy reserves for credit life and credit accident and health insurance are equal to related unearned premiums, and claim reserves are based on company experience. Liabilities for future life insurance policy benefits associated with ordinary life contracts are accrued when premium revenue is recognized and are computed on the basis of assumptions as to investment yields, mortality, and withdrawals. Annuity reserves are computed on the basis of assumptions as to investment yields and mortality. Reserves for losses and loss adjustment expenses of the property and casualty insurance company are based upon estimates of claims reported plus estimates of incurred but not reported claims. Ordinary life, group annuity, and accident and health insurance reserves assumed under coinsurance agreements are established on the bases of various tabular and unearned premium methods. Insurance acquisition costs, principally commissions, reinsurance fees, and premium taxes, are deferred and charged to expense over the terms of the related policies or reinsurance agreements. The Company's insurance subsidiaries enter into reinsurance agreements among themselves and other insurers, including insurance subsidiaries of American General. The life reserves attributable to this business with the subsidiaries of American General were $62.6 million and $63.4 million at December 31, 1993 and 1992, respectively. In 1993, the Company's insurance subsidiaries assumed from and ceded to other insurers $42.5 million and $3.7 million of reinsurance premiums, respectively. Liabilities for unpaid claims and claim adjustment expenses and receivables for reinsurance credits are included in the balance sheet at their respective gross amounts. The Company's insurance subsidiaries remain liable to the extent reinsurers do not meet their obligations. Statutory accounting practices differ from generally accepted accounting principles, primarily in the following respects: credit life insurance reserves are maintained on the basis of mortality tables; ordinary life and group annuity insurance reserves are based on statutory requirements; insurance acquisition costs are expensed when incurred rather than expensed over the related contract period; deferred income taxes are not recorded on temporary differences in the recognition of revenue and expense for tax versus statutory reporting purposes; certain intangible assets resulting from a purchase and the related amortization are not reflected in statutory financial statements; and a security valuation reserve is required for Merit Life Insurance Co. (Merit), which is a wholly-owned subsidiary of AGFC. The following compares net income and shareholder's equity determined under statutory accounting practices with those determined under generally accepted accounting principles: Net Income Shareholder's Equity Years Ended December 31, December 31, 1993 1992 1991 1993 1992 (dollars in thousands) Statutory accounting practices $31,080 $32,128 $22,837 $245,175 $221,233 Generally accepted accounting principles 39,363 38,164 34,991 386,821 317,636 Notes to Consolidated Financial Statements, Continued Effective December 31, 1991, an indirect insurance subsidiary of American General was purchased by a subsidiary of AGFI. Total assets at the time of purchase were $12.3 million. The cash paid for the affiliate as shown in the Consolidated Statements of Cash Flows was $1.0 million. Fair Value of Financial Instruments Fair values are based on estimates using discounted cash flows when quoted market prices are not available. Those techniques are significantly affected by the assumptions used, including the discount rate and estimates of future cash flows. In that regard, the derived fair value estimates cannot be substantiated by comparison to independent markets and, in many cases, could not be realized in immediate settlement of the instrument. The fair value amounts presented can be misinterpreted, and care should be exercised in drawing conclusions from such data. Cash and Cash Equivalents. The carrying amounts reported in the Consolidated Balance Sheets for cash and cash equivalents approximate those assets' fair values. Marketable Securities. Fair values for investment securities are based on quoted market prices, where available. For investments not actively traded, fair values were estimated using values obtained from independent pricing services or, in the case of private placements, by discounting expected future cash flows using a current market rate applicable to yield, credit quality, and maturity of the investment. Finance Receivables. The fair values for fixed-rate finance receivables are estimated using discounted cash flow analysis, using interest rates currently being offered for finance receivables with similar terms to borrowers of similar credit quality. For variable-rate finance receivables that reprice frequently and with no significant change in credit risk, fair values are based on carrying values. Interest Conversion Agreements. Fair values for the Company's interest conversion agreements are based on estimates, obtained from the individual counterparties, of the cost or benefit of terminating the agreements. Unused Customer Credit Lines. The unused credit lines available to the Company's customers are considered to have no fair value. The interest rates charged on these facilities are either variable and reprice frequently, such as for revolving lines of credit, or can be changed at the Company's discretion, such as for credit cards. Furthermore, these amounts, in part or in total, may be cancelled at the discretion of the Company. Credit Facilities. The Company's committed credit facilities are substantially short-term, and therefore no fair value is determined. Long-term Debt. The fair values of the Company's long-term borrowings are estimated using discounted cash flows based on current borrowing rates. Notes to Consolidated Financial Statements, Continued Short-term Notes Payable. The carrying value of short-term notes payable approximates the fair value. Investment Certificates. Fair values for fixed-rate time deposits are estimated using a discounted cash flow calculation that applies interest rates currently being offered on time deposits to a schedule of aggregated expected monthly maturities on time deposits. The carrying amounts for variable-rate time deposits approximate their fair values at the reporting date. The fair values disclosed for demand deposits are, by definition, equal to the amount payable on demand at the reporting date. Note 2. New Accounting Standards During 1993, the Company adopted six new Statements of Financial Accounting Standards (SFAS) issued by the Financial Accounting Standards Board. The Company adopted SFAS 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions," through a cumulative adjustment, effective January 1, 1993, resulting in a one-time reduction of net income of $2.9 million ($4.4 million pretax). This standard requires accrual of a liability for postretirement benefits other than pensions. Other than the cumulative effect, adoption of SFAS 106 did not have a material impact on 1993 net income and is not expected to have a material impact in the future. The Company adopted SFAS 109, "Accounting for Income Taxes," through a cumulative adjustment, effective January 1, 1993, resulting in a one-time reduction of net income of $8.6 million. This standard changes the way income tax expense is determined for financial reporting purposes. Other than the cumulative effect, adoption of SFAS 109 did not have a material impact on 1993 net income and is not expected to have a material impact in the future. The Company adopted SFAS 112, "Employers' Accounting for Postemployment Benefits," through a cumulative adjustment, effective January 1, 1993, resulting in a one-time reduction of net income of $1.2 million ($1.8 million pretax). This standard requires the accrual of a liability for benefits provided to employees after employment but before retirement. Other than the cumulative effect, adoption of SFAS 112 did not have a material impact on 1993 net income and is not expected to have a material impact in the future. The Company adopted SFAS 113, "Accounting and Reporting for Reinsurance of Short-Duration and Long-Duration Contracts," effective January 1, 1993. This standard, which does not have a material impact on the consolidated financial statements, requires that reinsurance receivables and prepaid reinsurance premiums be reported as assets, rather than netted against the related insurance liabilities. Notes to Consolidated Financial Statements, Continued The Company adopted SFAS 114, "Accounting by Creditors for Impairment of a Loan," effective January 1, 1993. This standard requires that certain impaired loans be reported at the present value of expected future cash flows, the loan's observable market price, or the fair value of underlying collateral. The adoption of SFAS 114 did not have a material impact on 1993 net income and is not expected to have a material impact in the future. The Company adopted SFAS 115, "Accounting for Certain Investments in Debt and Equity Securities," at December 31, 1993. This statement requires that debt and equity securities be carried at fair value unless the Company has the positive intent and ability to hold these investments to maturity. Marketable securities must be classified into one of three categories: 1) held-to-maturity, 2) available-for-sale, or 3) trading securities. Upon adoption of SFAS 115, the Company classified all marketable securities as available-for-sale and, accordingly, recorded them at fair value. The corresponding unrealized gain, net of deferred taxes, was credited directly to shareholder's equity. The adjustment increased marketable securities by $51.4 million, deferred income taxes by $18.0 million, and shareholder's equity by $33.4 million. Note 3. Marketable Securities At December 31, 1993, all marketable securities were classified as available-for-sale and reported at fair value due to the adoption of SFAS 115 (see Note 2.). Previously, fixed-maturity marketable securities were classified as held-to-maturity and reported at amortized cost. Marketable securities were as follows at December 31: Fair Value Amortized Cost 1993 1992 1993 1992 (dollars in thousands) Fixed-maturity marketable securities: Bonds: Corporate securities $313,174 $307,156 $290,153 $289,186 Mortgage-backed securities 234,062 183,988 223,868 176,627 States and political subdivisions 102,438 70,301 94,540 64,499 Other 40,766 51,328 30,736 44,247 Redeemable preferred stocks 7,486 8,877 7,180 8,913 Total 697,926 621,650 646,477 583,472 Non-redeemable preferred stocks 1,771 2,339 1,313 2,339 Total marketable securities $699,697 $623,989 $647,790 $585,811 Notes to Consolidated Financial Statements, Continued At December 31, the gross unrealized gains and losses were as follows: Gross Gross Unrealized Gains Unrealized Losses 1993 1992 1993 1992 Fixed-maturity marketable (dollars in thousands) securities: Bonds: Corporate securities $23,836 $19,597 $ 815 $ 1,627 Mortgage-backed securities 11,681 7,916 1,487 555 State and political subdivisions 8,031 5,865 133 63 Other 10,032 7,141 2 60 Redeemable preferred stocks 315 111 9 147 Total 53,895 40,630 2,446 2,452 Non-redeemable preferred stocks 458 - - - Total marketable securities $54,353 $40,630 $ 2,446 $ 2,452 During the years ended December 31, 1993, 1992, and 1991, marketable securities with a fair value of $141.4 million, $127.9 million, and $61.7 million, respectively, were sold or redeemed. The gross realized gains on such sales or redemptions totaled $7.4 million, $3.1 million, and $.9 million, respectively. The gross realized losses totaled $.1 million, $.5 million and $2.8 million, respectively. The contractual maturities of fixed-maturity securities at December 31, 1993 were as follows: Fair Amortized Value Cost Fixed maturities, excluding (dollars in thousands) mortgage-backed securities: Due in 1 year or less $ 11,298 $ 11,146 Due after 1 year through 5 years 75,474 69,644 Due after 5 years through 10 years 232,320 215,818 Due after 10 years 144,772 126,001 463,864 422,609 Mortgage-backed securities 234,062 223,868 Total $697,926 $646,477 Actual maturities may differ from contractual maturities since borrowers may have the right to call or prepay obligations. Company requirements and investment strategies may result in the sale of investments before maturity. Certain of the bonds were on deposit with regulatory authorities. The carrying value of such bonds was $18.6 million and $21.2 million at December 31, 1993 and 1992, respectively. Notes to Consolidated Financial Statements, Continued Note 4. Finance Receivables Loans collateralized by security interests in real estate generally have maximum original terms of 180 months. Loans collateralized by consumer goods, automobiles or other chattel security, and loans that are unsecured, generally have maximum original terms of 60 months. Retail sales contracts are collateralized principally by consumer goods and automobiles, and generally have maximum original terms of 60 months. Credit card receivables are all unsecured and require minimum monthly payments based upon current balances. Of the loans and retail sales contracts outstanding at December 31, 1993, 91% were secured by the real or personal property of the borrower. At December 31, 1993, mortgage loans (generally second mortgages) accounted for 11% of the total number of loans outstanding and 53% of the aggregate dollar amount of loans outstanding. Contractual maturities of loans and retail sales contracts were as follows: December 31, 1993 Net Receivables Percent of Amount Net Receivables (dollars in thousands) 1994 $2,079,612 35.4% 1995 1,219,180 20.7 1996 758,336 12.9 1997 375,914 6.4 1998 224,437 3.8 Thereafter 1,225,358 20.8 Total $5,882,837 100.0% Experience of the Company has shown that a substantial portion of loans and retail sales contracts will be renewed, converted, or paid in full prior to maturity. Accordingly, the preceding information as to contractual maturities should not be considered as a forecast of future cash collections. Principal cash collections and such collections as a percentage of average net finance receivables were as follows: 1993 1992 (dollars in thousands) Loans: Principal cash collections $2,100,565 $1,903,077 Percent of average net finance receivables 42.5% 40.2% Retail sales contracts: Principal cash collections $1,123,098 $ 887,115 Percent of average net finance receivables 125.5% 113.5% Credit cards: Principal cash collections $ 573,176 $ 501,885 Percent of average net receivables 104.4% 119.2% Notes to Consolidated Financial Statements, Continued Unused credit limits on credit card receivables extended by the Company to its customers were $1.8 billion and $1.4 billion at December 31, 1993 and 1992, respectively. Unused credit limits on revolving lines of credit extended by the Company to its customers were $188.3 million and $128.8 million at December 31, 1993 and 1992, respectively. These amounts, in part or in total, can be cancelled at the discretion of the Company, and are not indicative of the amount expected to be funded. Geographic diversification of finance receivables reduces the concentration of credit risk associated with a recession in any one region. The largest concentrations of finance receivables, net of unearned finance charges, are as follows: December 31, 1993 December 31, 1992 Location Amount Percent Amount Percent (dollars in thousands) (dollars in thousands) California $ 750,772 11% $ 838,163 14% N. Carolina 581,754 9 512,109 8 Florida 502,977 8 503,980 8 Illinois 409,032 6 386,795 6 Indiana 364,706 6 361,442 5 Virginia 353,397 5 325,395 5 Ohio 341,179 5 284,013 5 Georgia 264,260 4 244,284 4 Other 3,005,911 46 2,743,505 44 $6,573,988 100% $6,199,686 100% The fair values determined for finance receivables at December 31, 1993 and 1992 approximate the carrying amounts reported in the Consolidated Balance Sheets net of the allowance for finance receivable losses. Care should be exercised in drawing conclusions based on the estimated fair values at the end of the year, since such fair value estimates are based only on the value of the finance receivables and do not reflect the value of the underlying customer relationships or the related distribution system. Notes to Consolidated Financial Statements, Continued Note 5. Allowance for Finance Receivable Losses The changes in the allowance for finance receivable losses are detailed below: 1993 1992 1991 (dollars in thousands) Balance at beginning of year $161,678 $151,091 $148,127 Provision for finance receivable losses 162,847 135,102 136,885 Allowance related to net acquired receivables and other (21) 4,565 (37) Charge-offs: Finance receivables charged off (169,758) (158,781) (160,205) Recoveries 29,010 29,701 26,321 Net charge-offs (140,748) (129,080) (133,884) Balance at end of year $183,756 $161,678 $151,091 Note 6. Costs In Excess of Net Assets Acquired Goodwill, resulting from the excess of the purchase price paid over the value of separately identified tangible and intangible assets acquired, amounted to $299.7 million and $310.7 million at December 31, 1993 and 1992, respectively, and is being amortized on a straight-line basis over periods of twenty or forty years. Accumulated amortization amounted to $48.4 million and $39.3 million at December 31, 1993 and 1992, repectively. Included in other assets is a customer base valuation of $23.2 million and $24.8 million at December 31, 1993 and 1992, respectively, which is being amortized to operating expenses on a straight-line basis over a twenty-five year period. Note 7. Short-term Notes Payable and Credit Facilities AGFC issues commercial paper with terms ranging from 1 to 270 days. Information concerning short-term notes payable for commercial paper and to banks was as follows: 1993 1992 1991 (dollars in thousands) Maximum borrowings at any month end $1,886,426 $2,096,961 $2,143,947 Average borrowings $1,780,732 $1,887,408 $1,904,245 Weighted average interest rate (total interest expense divided by average borrowings) 3.2% 3.9% 6.3% Weighted average interest rate, giving effect to commitment fees and interest conversion agreements 4.1% 5.6% 7.5% Weighted average interest rate, at December 31, 3.3% 3.5% 4.9% Notes to Consolidated Financial Statements, Continued Credit facilities are maintained to support the issuance of commercial paper and as an additional source of funds for operating requirements. At December 31, 1993 and 1992, the Company had committed credit facilities of $390.0 million and $365.0 million, respectively, and was an eligible borrower under a $2.1 billion committed credit facility and $2.6 billion of committed credit facilities, respectively, extended to American General and certain of its subsidiaries. The annual commitment fees for all committed facilities range from .075% to .1875%. At December 31, 1993 and 1992, the Company also had $496.0 million and $451.0 million, respectively, of uncommitted credit facilities and was an eligible borrower under $240.0 million and $220.0 million, respectively, of uncommitted credit facilities extended to American General and certain of its subsidiaries. Available borrowings under all facilities are reduced by any amounts outstanding thereunder. At December 31, 1993 and 1992, Company short-term borrowings outstanding under all credit facilities were $171.0 million and $148.3 million, respectively, and Company long-term borrowings outstanding under all credit facilities were $147.0 million and $117.2 million, respectively, with remaining availability to the Company of $2.4 billion and $2.9 billion, respectively, in committed facilities and $461.0 million and $425.5 million, respectively, in uncommitted facilities. Interest conversion agreements in which the Company contracted to pay interest at fixed rates and receive interest at floating rates were $290.0 million, $415.0 million, and $765.0 million in notional amounts at December 31, 1993, 1992, and 1991, respectively. The fair value of these agreements was $29.4 million and $19.9 million at December 31, 1993 and 1992, respectively, which would have been the cost to the Company of termination of the agreements. The weighted average interest rate was 8.75%, 8.83%, and 8.87% at December 31, 1993, 1992, and 1991, respectively. These agreements mature at various dates and have various fixed rates as shown in the table below: Weighted Average Notional Interest Maturity Amount Rate (dollars in thousands) 1994 $100,000 8.71% 1996 50,000 8.38 1998 90,000 9.06 2000 50,000 8.64 $290,000 8.75% Options on interest conversion agreements at December 31, 1993, 1992, and 1991, in aggregate notional amounts were $200.0 million, $250.0 million, and $350.0 million, respectively. The fair value of these agreements was $33.3 million and $20.7 million at December 31, 1993 and 1992, respectively, which would have been the cost to the Company of termination of the agreements. The option agreements at December 31, 1993, if exercised by the counterparty, will commit the Company to pay interest at Notes to Consolidated Financial Statements, Continued fixed rates. The related option fees received are being amortized as a reduction of interest expense over the aggregate of the option period and interest conversion period. Interest conversion agreements involve credit risk due to possible non- performance by the counterparties. The Company manages the credit risk of counterparty defaults in these transactions by limiting the total amount of arrangements outstanding, both by individual counterparty and in the aggregate, by monitoring the size and maturity structure of the off-balance-sheet portfolio, and by applying uniform credit standards. The Company does not anticipate non-performance by the counterparties, and any such non-performance would not have a material impact on net income. Notional amounts represent amounts on which interest payments to be exchanged are calculated. The credit risk to the Company is limited to the interest differential based on the interest rates contained in the agreements. Note 8. Short-term Notes Payable - Parent Borrowings from American General are primarily to provide overnight operating liquidity when American General is in a surplus cash position. All such borrowings are made on a due on demand basis at short-term rates based on American General's commercial paper rates. At December 31, 1993, 1992 and 1991, AGFI had no borrowings outstanding with American General. Information concerning such borrowings was as follows: 1993 1992 1991 (dollars in thousands) Maximum borrowings at any month end $ 178 $29,200 $86,000 Average borrowings $ 433 $ 2,466 $19,439 Weighted average interest rate (total interest expense divided by average borrowings) 3.2% 4.0% 7.4% The information above excludes $2.3 million in borrowings from American General by the Company's insurance subsidiaries at December 31, 1992, which are not material. At December 31, 1993 and 1991, the Company's insurance subsidiaries had no borrowings outstanding from American General. Notes to Consolidated Financial Statements, Continued Note 9. Investment Certificates At December 31, 1993, AGF-Utah was the Company's only active industrial loan company with investment certificates outstanding. AGF-Utah and other previously active industrial loan companies derived a portion of their operating funds from various types of investment certificates issued under provisions of the laws in the states in which they operate. Information concerning investment certificates was as follows: 1993 1992 1991 (dollars in thousands) Weighted average interest rate (total interest expense divided by average borrowings) 4.7% 6.3% 7.8% Weighted average interest rate, as of December 31, 5.5% 5.1% 6.9% Balances at year end by type: Demand deposits $ 633 $ 18,866 $ 71,987 Time deposits 8,773 54,662 372,101 Total $ 9,406 $ 73,528 $444,088 The fair value of the investment certificates at December 31, 1993 and 1992 was $.6 million and $18.9 million, respectively, for demand deposits and $9.0 million and $55.9 million, respectively, for time deposits. 1993 1992 1991 Balances at year end, by maturity, (dollars in thousands) for time deposits: 3 months or less $ 1,381 $ 10,998 $ 93,919 over 3 months through 6 months 1,365 10,239 57,946 over 6 months through 12 months 2,404 15,838 85,499 over 12 months 3,623 17,587 134,737 Total $ 8,773 $ 54,662 $372,101 Note 10. Income Taxes AGFI and all of its subsidiaries file a consolidated federal income tax return with American General and its subsidiaries. AGFI and its subsidiaries provide for federal income taxes as if filing a separate tax return, and pay such amounts to American General in accordance with a tax sharing agreement. Beginning in 1993, income taxes have been provided in accordance with SFAS 109 (see Note 2.). Under this method, deferred tax assets and liabilities are calculated using the differences between the financial reporting basis and the tax basis of assets and liabilities, using the enacted tax rate. The effect of a tax rate change is recognized in income in the period of enactment. Before 1993, the Company recognized deferred taxes on timing differences between financial reporting income and taxable income. Deferred taxes were not adjusted for tax rate changes. Notes to Consolidated Financial Statements, Continued As a result of this accounting change, 1993 income tax disclosures are not comparable to prior years. Provision for income taxes is summarized as follows: Years Ended December 31, 1993 1992 1991 (dollars in thousands) Federal Current $124,295 $ 86,942 $68,006 Deferred (7,617) 759 5,390 Total federal 116,678 87,701 73,396 State 11,759 13,107 10,084 Total $128,437 $100,808 $83,480 Provision for deferred federal income taxes is summarized as follows: Years Ended December 31, 1992 1991 (dollars in thousands) Finance receivable losses $(5,370) $ 2,656 Other, net 6,129 2,734 Total $ 759 $ 5,390 The U.S. statutory federal income tax rate differs from the effective income tax rate as follows: Years Ended December 31, 1993 1992 1991 Statutory federal income tax rate 35.0% 34.0% 34.0% State income taxes 2.3 3.3 3.1 Amortization of goodwill 1.2 1.1 1.3 Nontaxable investment income (.6) (.6) (.8) Other, net .2 .6 .6 Effective income tax rate 38.1% 38.4% 38.2% The net deferred tax liability of $25.5 million is net of deferred tax assets totalling $80.9 million. The most significant deferred tax assets relate to the provision for finance receivable losses and insurance premiums recorded for financial reporting purposes. No valuation allowance on deferred tax assets is considered necessary at December 31, 1993. Notes to Consolidated Financial Statements, Continued On August 10, 1993, the Revenue Reconciliation Act of 1993 was enacted, which increased the corporate tax rate from 34% to 35%, retroactive to January 1, 1993. The additional 1% tax on earnings for first and second quarter 1993 was $1.6 million, and the effect of the 1% increase in the tax rate used to value existing deferred tax liabilities, as required by SFAS 109, was $.6 million. In accordance with SFAS 109, this total one-time charge of $2.2 million was included in provision for income taxes for the quarter ended September 30, 1993. Note 11. Long-term Debt Long-term debt outstanding at December 31, is summarized as follows: Senior Maturity Senior Subordinated Total (dollars in thousands) 1994 $ 468,337 $196,974 $ 665,311 1995 663,986 274,579 938,565 1996 562,853 - 562,853 1997 352,361 - 352,361 1998 243,130 - 243,130 1999-2003 958,866 - 958,866 2004-2009 297,711 - 297,711 Total $3,547,244 $471,553 $4,018,797 Certain debt issues of the Company are redeemable prior to maturity at par, at the option of the holders. If these issues were so redeemed, the senior amounts above would increase $150.0 million in 1994 and 1996 and would decrease $150.0 million in 1999 and 2009. Carrying Value Fair Value Type of Debt 1993 1992 1993 1992 (dollars in thousands) Senior $3,547,244 $3,155,194 $3,776,820 $3,299,964 Senior subordinated 471,553 449,177 486,806 478,470 Total $4,018,797 $3,604,371 $4,263,626 $3,778,434 The senior subordinated debt at December 31, 1992 included $50 million held by certain subsidiaries of American General. Notes to Consolidated Financial Statements, Continued The weighted average interest rates on long-term debt outstanding by type were as follows: Years Ended December 31, December 31, 1993 1992 1993 1992 Senior 7.6% 8.4% 7.4% 8.1% Senior subordinated 8.7 9.4 7.1 9.0 Total 7.9 8.7 7.3 8.2 The agreements under which certain of the Company's long-term debt was issued contain provisions for optional prepayments after a specified period of time. Certain debt agreements also contain restrictions on consolidated retained earnings for certain purposes (see Note 13.). Note 12. Capital Stock AGFI has two classes of capital stock: special shares (without par value, 25 million shares authorized) which may be issued in series with such dividend, liquidation, redemption, conversion, voting and other rights as the board of directors may determine prior to issuance; and common shares ($.50 par value, 25 million shares authorized). Issued shares were as follows: Special Shares - As of December 31, 1993 and 1992, there were no shares issued and outstanding. Common Shares - As of December 31, 1993 and 1992, there were 2 million shares issued and outstanding. Note 13. Consolidated Retained Earnings The ability of AGFI to pay dividends is substantially dependent on the receipt of dividends or other funds from its subsidiaries. The Company's insurance subsidiaries are restricted by state laws as to the amounts they may pay as dividends without prior notice to, or in some cases prior approval from, their respective state insurance departments. The maximum amount of dividends which can be paid by the Company's insurance subsidiaries in 1994 without prior approval is $29.6 million. The Company's insurance subsidiaries had statutory capital and surplus of $245.2 million at December 31, 1993. The amount of dividends which may be paid by AGFC is limited by provisions of certain of its debt agreements. Under the most restrictive provisions of such agreements, $38.9 million of the consolidated retained earnings of AGFC at December 31, 1993, was free from such restrictions. At that same date, $24.6 million of the retained earnings of AGFI's industrial loan company subsidiaries was unrestricted as to the payment of dividends. Notes to Consolidated Financial Statements, Continued At December 31, 1993, Merit had $52.7 million of accumulated earnings for which no federal income tax provisions have been required. Federal income taxes will become payable only to the extent such earnings are distributed as dividends or exceed limits prescribed by tax laws. No distributions are presently contemplated from these earnings. If such earnings were to become taxable at December 31, 1993, the federal income tax would approximate $18.4 million. Note 14. Benefit Plans Retirement Income Plans The Company participates in the American General Retirement Plans (AGRP), which are noncontributory defined benefit pension plans covering most employees. Pension benefits are based on the participant's average monthly compensation and length of credited service. American General's funding policy is to contribute annually no more than the maximum amount that can be deducted for federal income tax purposes. American General uses the projected unit credit method to compute pension expense. The plans' assets include primarily readily marketable stocks and bonds. The pension plans purchased annuity contracts from several of American General's life insurance subsidiaries that provide benefits to certain retirees. These annuity contracts provided $2 million for benefits to the Company's retirees for the years ended December 31, 1993 and 1992. AGFI's participation in the AGRP is accounted for as if AGFI had its own plan. The following table sets forth AGFI's portion of the plans' funded status: Years Ended December 31, 1993 1992 1991 (dollars in thousands) Actuarial present value of benefit obligation: Accumulated benefit obligation $35,868 $22,400 $39,249 Vested benefits (included in accumulated benefit obligation) $35,639 $21,985 $38,810 Projected benefit obligation $43,212 $29,278 $42,686 Plan assets at fair value 49,767 44,678 63,090 Plan assets in excess of projected benefit obligation 6,555 15,400 20,404 Unrecognized prior service cost (659) (821) (984) Unrecognized net loss (gain) 3,485 (4,320) (9,295) Unrecognized net asset at January 1, net of amortization (2,747) (3,925) (5,118) Prepaid pension expense $ 6,634 $ 6,334 $ 5,007 Notes to Consolidated Financial Statements, Continued Net pension expense included the following components for the years ended December 31: 1993 1992 1991 (dollars in thousands) Service cost $ 2,375 $ 1,881 $ 1,349 Interest on projected benefit obligation 2,791 3,687 3,373 Actual return on plan assets (6,112) (5,000) (8,926) Amortization of prior service costs (157) (163) (157) Amortization of unrecognized net asset existing at date of initial application (1,190) (1,193) (562) Deferral of net asset (loss) gain 2,224 (631) 3,093 Total pension expense (income) $ (69) $(1,419) $(1,830) Additional assumptions concerning the determination of net pension costs is as follows: 1993 1992 1991 Weighted average discount rate 7.25% 8.00% 8.50% Expected long-term rate of return on plan assets 10.00 10.00 10.00 Rate of increase in compensation levels 4.00 5.00 5.00 Postretirement Benefits Other Than Pensions The Company participates in American General's life, medical and dental plans for certain retired employees. Most plans are contributory, with retiree contributions adjusted annually to limit employer contributions to predetermined amounts. For individuals retiring after December 31, 1992, the cost of the supplemental major medical plan is borne entirely by retirees. American General and its subsidiaries have reserved the right to change or eliminate these benefits at any time. American General's retiree medical and dental plans are unfunded and self- insured. The life plans are fully insured. Notes to Consolidated Financial Statements, Continued AGFI's participation in the plans is accounted for as if AGFI had its own plans. The following table sets forth AGFI's portion of the plans' combined funded status and the accrued postretirement benefit cost included in other liabilities in the Company's Consolidated Balance Sheet at December 31, 1993: Accumulated postretirement benefit obligation (dollars in thousands): Retirees $2,223 Fully eligible active plan participants 1,804 Other active plan participants 2,341 Accumulated postretirement benefit obligation 6,368 Unrecognized net gain (226) Accrued postretirement benefit cost $6,142 Postretirement benefit expense for the year ended December 31, 1993 included the following components (dollars in thousands): Service cost-benefits attributed to service during the period $ 184 Interest cost on accumulated postretirement benefit obligation 403 Postretirement benefit expense $ 587 For measurement purposes, a 13.5% annual rate of increase in the per capita cost of covered health care benefits was assumed in 1994; the rate was assumed to decrease gradually to 6% for 2009 and remain at that level. A 1% increase in the assumed annual rate of increase in per capita cost of health care benefits results in an immaterial increase in the accumulated postretirement benefit obligation and postretirement benefit expense. The discount rate used in determining the accumulated postretirement benefit obligation was 7.25%. Note 15. Lease Commitments, Rent Expense and Contingent Liabilities The approximate annual rental commitments for leased office space, automobiles and data processing and related equipment accounted for as operating leases, excluding leases on a month-to-month basis and those with a remaining term of one year or less, are as follows: 1994, $21.9 million; 1995, $17.3 million; 1996, $12.9 million; 1997, $8.4 million; 1998, $4.4 million; and subsequent to 1998, $19.3 million. Notes to Consolidated Financial Statements, Continued Taxes, insurance and maintenance expenses are obligations of the Company under certain leases. It is expected that, in the normal course of business, leases that expire will be renewed or replaced by leases on other properties; therefore, it is believed that future minimum annual rental commitments will not be less than the amount of rental expense incurred in 1993. Rental expense incurred for the years ended December 31, 1993, 1992, and 1991, was $31.4 million, $25.9 million, and $26.2 million, respectively. The Company is a defendant in various lawsuits arising in the normal course of business. The Company believes it has valid defenses in these lawsuits and is defending the cases vigorously. The Company also believes that the total amounts that would ultimately have to be paid, if any, arising from these lawsuits would have no material effect on its consolidated financial position. Note 16. Interim Financial Information (Unaudited) Unaudited interim information for 1993 and 1992 is summarized below: Income Before Provision for Income Taxes and Cumulative Effect of Total Revenues Accounting Changes Three Months Ended 1993 1992 1993 1992 (dollars in thousands) March 31 $ 310,915 $ 286,463 $ 77,317 $ 58,314 June 30 322,485 284,052 89,793 60,033 September 30 328,277 294,384 86,797 69,931 December 31 327,100 305,472 82,923 74,438 Total $1,288,777 $1,170,371 $336,830 $262,716 Net Income Three Months Ended 1993 1992 (dollars in thousands) March 31 $ 35,761(a) $ 35,962 June 30 56,391 36,989 September 30 51,642(b) 43,295 December 31 51,947 45,662 Total $195,741 $161,908 (a) Includes cumulative charge of $12.7 million due to adoption of accounting changes: SFAS 106, SFAS 109, and SFAS 112. Amounts previously reported in the 1993 first quarter Form 10-Q have been restated above for SFAS 112. (b) Includes corporate tax rate increase enacted in the third quarter, retroactive to January 1, 1993 (see Note 10.). PART IV Item 14.

Item 14. Exhibits, Financial Statement Schedules, and Reports on Form 8-K (a) (1) and (2) The following consolidated financial statements of American General Finance, Inc. and subsidiaries are included in Item 8: Consolidated Balance Sheets, December 31, 1993 and 1992 Consolidated Statements of Income, years ended December 31, 1993, 1992, and 1991 Consolidated Statements of Shareholder's Equity, years ended December 31, 1993, 1992, and 1991 Consolidated Statements of Cash Flows, years ended December 31, 1993, 1992, and 1991 Notes to Consolidated Financial Statements Schedule III--Condensed Financial Information of Registrant is included in Item 14(d). All other schedules for which provision is made in the applicable accounting regulations of the Securities and Exchange Commission have been omitted, because they are inapplicable, or the information required therein is included in the consolidated financial statements or notes. (3) Exhibits: Exhibits are listed in the Exhibit Index beginning on page 58 herein. (b) Reports on Form 8-K No Current Reports on Form 8-K were filed during the last quarter of 1993. (c) Exhibits The exhibits required to be included in this portion of Item 14. are submitted as a separate section of this report. Item 14(d). Schedule III - Condensed Financial Information of Registrant American General Finance, Inc. Condensed Balance Sheets December 31, 1993 1992 (dollars in thousands) Assets Cash $ 217 $ 248 Credit card finance receivables 587,404 417,780 Deduct allowance for credit card finance receivable losses 26,143 22,615 Net credit card finance receivables 561,261 395,165 Investments in subsidiaries 1,268,775 1,186,904 Other assets 79,534 56,508 Total assets $1,909,787 $1,638,825 Liabilities and Shareholder's Equity Senior long-term debt, 5.0% - 13.0%, due 1994-2000 $ 53,025 $ 45,970 Notes payable to banks 120,000 120,000 Notes payable to subsidiaries 573,256 378,671 Other liabilities 52,806 43,297 Total liabilities 799,087 587,938 Shareholder's equity: Common stock 1,000 1,000 Additional paid-in capital 616,021 615,874 Other equity 33,740 617 Retained earnings 459,939 433,396 Total shareholder's equity 1,110,700 1,050,887 Total liabilities and shareholder's equity $1,909,787 $1,638,825 See Notes to Condensed Financial Statements. Schedule III, Continued American General Finance, Inc. Condensed Statements of Income Years Ended December 31, 1993 1992 1991 (dollars in thousands) Revenues Dividends received from subsidiaries $152,555 $171,139 $147,842 Finance charges - credit cards 84,367 25,043 - Interest and other 3,517 3,369 1,608 Total revenues 240,439 199,551 149,450 Expenses Provision for credit card finance receivable losses 24,429 6,868 - Interest expense 40,122 22,821 15,979 Operating expenses 24,967 6,569 1,446 Total expenses 89,518 36,258 17,425 Income before federal income taxes, equity in undistributed net income of subsidiaries, and cumulative effect of accounting changes 150,921 163,293 132,025 Federal Income Tax Credit 584 10,260 5,390 Income before equity in undistributed net income of subsidiaries and cumulative effect of accounting changes 151,505 173,553 137,415 Equity in Undistributed Net Income of Subsidiaries 56,888 (11,645) (2,395) Income before cumulative effect of accounting changes 208,393 161,908 135,020 Cumulative Effect of Accounting Changes Parent company 65 - - Subsidiaries (12,717) - - Net Income $195,741 $161,908 $135,020 See Notes to Condensed Financial Statements. Schedule III, Continued American General Finance, Inc. Condensed Statements of Cash Flows Years ended December 31, 1993 1992 1991 (dollars in thousands) Cash Flows from Operating Activities Net Income $195,741 $161,908 $135,020 Reconciling adjustments to net cash provided by operating activities: Provision for credit card finance receivable losses 24,429 6,868 - Change in dividends receivable (11,239) 14,842 (36,115) Equity in undistributed net income of subsidiaries (44,171) 11,645 2,395 Other, net 10,616 (13,107) (1,149) Net cash provided by operating activities 175,376 182,156 100,151 Cash Flows from Investing Activities Participation in credit card finance receivables (677,847) (586,151) - Cash collections on credit card finance receivables participation 487,200 161,853 - Return of capital from subisidiary - 23,537 - Capital contribution to subsidiary (4,577) (17,267) (9,248) Preferred stock redemption of subsidiary - 4,000 - Other, net (18,040) (8,604) - Net cash used for investing activities (213,264) (422,632) (9,248) Cash Flows from Financing Activities Proceeds from issuance of long-term debt 17,320 16,043 11,605 Repayment of long-term debt (11,448) (14,108) (16,874) Change in notes receivable or payable with parent and subsidiaries 194,585 254,733 62,160 Change in notes payable to banks - 120,000 - Common stock dividends paid (162,600) (124,740) (101,844) Preferred stock dividends paid - (12,078) (48,311) Other, net - - 2,441 Net cash provided by (used for) financing activities 37,857 239,850 (90,823) (Decrease) increase in cash (31) (626) 80 Cash at beginning of year 248 874 794 Cash at end of year $ 217 $ 248 $ 874 See Notes to Condensed Financial Statements. Schedule III, Continued American General Finance, Inc. Notes to Condensed Financial Statements December 31, 1993 Note 1. Accounting Policies In the financial statements of the registrant, AGFI's investments in subsidiaries are stated at cost plus the equity in undistributed net income of subsidiaries since the date of the acquisition. The condensed financial statements of the registrant should be read in conjunction with AGFI's consolidated financial statements. Note 2. Long-Term Debt The aggregate amounts of long-term senior debt maturities for the five years subsequent to December 31, 1993, are as follows: 1994, $11.2 million; 1995, $12.4 million; 1996, $6.5 million; 1997, $11.2 million; 1998, $10.8 million; and thereafter, $.9 million. Note 3. Participation Agreement On May 1, 1992, AGFI entered into a credit card participation agreement whereby AGFI purchases credit card finance receivables from a subsidiary. The servicing fee expense for the participation transaction for the years ended December 31, 1993 and 1992 was $18.2 million and $5.1 million, respectively. Signatures Pursuant to the requirements of Section 13 or 15(d) 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. AMERICAN GENERAL FINANCE, INC. (Registrant) By /s/ Philip M. Hanley (Philip M. Hanley) Date: March 23, 1994 Senior Vice President and Chief Financial Officer Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated. Signature Title Date /s/ Daniel Leitch III President and Chief Executive March 23, 1994 (Daniel Leitch III) Officer and Director (Principal Executive Officer) /s/ Philip M. Hanley Senior Vice President and Chief March 23, 1994 (Philip M. Hanley) Financial Officer and Director (Principal Financial Officer) /s/ George W. Schmidt Controller and Assistant March 23, 1994 (George W. Schmidt) Secretary (Principal Accounting Officer) /s/ Wayne D. Baker Director March 23, 1994 (Wayne D. Baker) /s/ Robert M. Devlin Director March 23, 1994 (Robert M. Devlin) /s/ Bennie D. Hendrix Director March 23, 1994 (Bennie D. Hendrix) /s/ Harold S. Hook Director March 23, 1994 (Harold S. Hook) /s/ James R. Jerwers Director March 23, 1994 (James R. Jerwers) /s/ Larry R. Klaholz Director March 23, 1994 (Larry R. Klaholz) /s/ David C. Seeley Director March 23, 1994 (David C. Seeley) /s/ James R. Tuerff Director March 23, 1994 (James R. Tuerff) /s/ Peter V. Tuters Director March 23, 1994 (Peter V. Tuters) SUPPLEMENTAL INFORMATION TO BE FURNISHED WITH REPORTS FILED PURSUANT TO SECTION 15(D) OF THE SECURITIES EXCHANGE ACT OF 1934 BY REGISTRANTS WHICH HAVE NOT REGISTERED SECURITIES PURSUANT TO SECTION 12 OF THE SECURITIES EXCHANGE ACT OF 1934. No annual report to security-holders or proxy material has been sent to security-holders. Exhibit Index Exhibits Page (3) a. Restated Articles of Incorporation of American General Finance, Inc. (formerly Credithrift Financial, Inc.) dated May 27, 1988 and amendments thereto dated September 7, 1988 and March 20, 1989. Incorporated by reference to Exhibit (3)a filed as a part of the Company's Annual Report on Form 10-K for the year ended December 31, 1988 (File No. 1-7422). b. By-laws of American General Finance, Inc. Incorporated by reference to Exhibit (3)b filed as a part of the Company's Annual Report on Form 10-K for the year ended December 31, 1992 (File No. 1-7422). (4) a. The following instruments are filed pursuant to Item 601(b)(4)(ii) of Regulation S-K, which requires with certain exceptions that all instruments be filed which define the rights of holders of long-term debt of the Company and its consolidated subsidiaries. In the aggregate, the issuances of debt under each Indenture referred to under items (1), (2) and (3) below exceed 10% of the total assets of the Company on a consolidated basis. (1) Indenture dated as of January 1, 1988 from American General Finance Corporation (formerly Credithrift Financial Corporation) to Continental Bank, N.A. (formerly Continental Illinois National Bank and Trust Company of Chicago). Incorporated by reference to Exhibit 4(c) filed as a part of American General Finance Corporation's Annual Report on Form 10-K for the year ended December 31, 1987 (File No. 1-6155). (a) Resolutions and form of note for senior note, 8 3/8% due January 15, 1995. Incorporated by reference to Exhibits 4(a)(1) and 4(a)(2) filed as a part of American General Finance Corporation's Current Report on Form 8-K dated January 21, 1988 (File No. 1-6155). (b) Resolutions and forms of notes for (senior) Medium- Term Notes, Series A. Incorporated by reference to Exhibits 4(a), 4(b), 4(c), 4(d), and 4(e) filed as a part of American General Finance Corporation's Current Report on Form 8-K dated July 12, 1988 (File No. 1-6155). (c) Resolutions and form of note for senior note, 8 1/2% due June 15, 1999. Incorporated by reference to Exhibits 4(a)(1) and 4(a)(2) filed as a part of American General Finance Corporation's Current Report on Form 8-K dated June 12, 1989 (File No. 1-6155). Exhibit Index, Continued Exhibits Page (d) Consent and form of note for senior note, 8 1/8% due August 15, 2009. Incorporated by reference to Exhibits 4(a)(1) and 4(a)(2) filed as a part of American General Finance Corporation's Current Report on Form 8-K dated August 3, 1989 (File No. 1-6155). (e) Resolutions and form of note for senior note, 8.45% due October 15, 2009. Incorporated by reference to Exhibits 4(a)(1) and 4(a)(2) filed as a part of American General Finance Corporation's Current Report on Form 8-K dated October 24, 1989 (File No. 1-6155). (f) Resolutions and form of note for senior note, 9 1/4% due July 1, 1994. Incorporated by reference to Exhibits 4(a)(1) and 4(a)(2) filed as a part of American General Finance Corporation's Current Report on Form 8-K dated June 28, 1990 (File No. 1-6155). (2) Indenture dated as of December 1, 1985 from American General Finance Corporation (formerly Credithrift Financial Corporation) to The Chase Manhattan Bank (National Association). Incorporated by reference to Exhibit 4(a) filed as a part of Credithrift Financial Corporation's Current Report on Form 8-K dated February 4, 1986 (File No. 1-6155). (a) Resolutions and form of note for senior note, 7 3/4% due January 15, 1997. Incorporated by reference to Exhibit 4 filed as a part of Credithrift Financial Corporation's Current Report on Form 8-K dated January 22, 1987 (File No. 1-6155). (b) Resolutions and form of note for (senior) Medium-Term Notes, Series B. Incorporated by reference to Exhibits 4(a) and 4(b) filed as a part of American General Finance Corporation's Current Report on Form 8-K dated September 10, 1990 (File No. 1-6155). (c) Resolutions and form of note for senior note, 8 7/8% due March 15, 1996. Incorporated by reference to Exhibits 4(a) and 4(b) filed as a part of American General Finance Corporation's Current Report on Form 8-K dated March 7, 1991 (File No. 1-6155). Exhibit Index, Continued Exhibits Page (d) Resolutions for (senior) Medium-Term Notes, Series B. Incorporated by reference to Exhibit 4 filed as a part of American General Finance Corporation's Current Report on Form 8-K dated March 18, 1991 (File No. 1-6155). (e) Resolutions and form of note for senior note, 8.10% due August 15, 1995. Incorporated by reference to Exhibits 4(a) and 4(b) filed as a part of American General Finance Corporation's Current Report on Form 8-K dated July 31, 1991 (File No. 1-6155). (f) Resolutions and form of note for senior note, 8 1/2% due August 15, 1998. Incorporated by reference to Exhibits 4(a) and 4(b) filed as a part of American General Finance Corporation's Current Report on Form 8-K dated August 6, 1991 (File No. 1-6155). (g) Resolutions for (senior) Medium-Term Notes, Series B. Incorporated by reference to Exhibit 4 filed as a part of American General Finance Corporation's Current Report on Form 8-K dated November 20, 1991 (File No. 1-6155). (3) Senior Indenture dated as of November 1, 1991 from American General Finance Corporation to Morgan Guaranty Trust Company of New York. Incorporated by reference to Exhibit 4(a) filed as part of American General Finance Corporation's Current Report on Form 8-K dated November 6, 1991 (File No. 1-6155). (a) Resolutions and form of note for senior note, 7 3/8% due November 15, 1996. Incorporated by reference to Exhibits 4(c) and 4(d) filed as part of American General Finance Corporation's Current Report on Form 8-K dated November 6, 1991 (File No. 1-6155). (b) Resolutions and form of note for senior note, 7.15% due May 15, 1997. Incorporated by reference to Exhibits 4(a) and 4(b) filed as part of American General Finance Corporation's Current Report on Form 8-K dated May 13, 1992 (File No. 1-6155). (c) Resolutions and form of note for senior note, 7.45% due July 1, 2002. Incorporated by reference to Exhibits 4(a) and 4(b) filed as a part of American General Finance Corporation's Current Report on Form 8-K dated July 2, 1992 (File No. 1-6155). Exhibit Index, Continued Exhibits Page (d) Resolutions and form of note for senior note, 5% due September 1, 1995. Incorporated by reference to Exhibits 4(a) and 4(b) filed as a part of American General Finance Corporation's Current Report on Form 8-K dated August 20, 1992 (File No. 1-6155). (e) Resolutions and form of note for senior note, 7 1/8% due December 1, 1999. Incorporated by reference to Exhibits 4(a) and 4(b) filed as a part of American General Finance Corporation's Current Report on Form 8-K dated December 1, 1992 (File No. 1-6155). (f) Resolutions and forms of notes for (senior) Medium- Term Notes, Series C. Incorporated by reference to Exhibits 4(a), 4(b) and 4(c) filed as a part of American General Finance Corporation's Current Report on Form 8-K dated December 10, 1992 (File No. 1- 6155). (g) Resolutions and form of note for senior note, 6 7/8% due January 15, 2000. Incorporated by reference to Exhibits 4(a) and 4(b) filed as a part of American General Finance Corporation's Current Report on Form 8-K dated January 11, 1993 (File No. 1-6155). b. In accordance with Item 601(b)(4)(iii) of Regulation S-K, certain other instruments defining the rights of holders of long-term debt of the Company and its subsidiaries have not been filed as exhibits to this Annual Report on Form 10-K because the total amount of securities authorized under each such instrument does not exceed 10% of the total assets of the Company on a consolidated basis. The Company hereby agrees to furnish a copy of each such instrument to the Securities and Exchange Commission upon request therefor. (12) Computation of ratio of earnings to fixed charges. 62 (23) Consent of Ernst & Young 63

34285_1993.txt

34285

1993

Item 1. Business. (a) GENERAL DEVELOPMENT OF BUSINESS. Reliability Incorporated ("Reliability") and its subsidiaries are principally engaged in the manufacture of equipment used to condition and test integrated circuits ("ICs"). The Company and its subsidiaries also operate testing laboratories which condition and test integrated circuits as a service to others and manufacture power sources, primarily a line of DC to DC power converters which convert direct current voltage into a higher or lower voltage. The following table shows the active subsidiaries of the Company as of the date of this report: Reliability Incorporated (a Texas corporation) ------------------------ RICR de Costa Rica, S.A. Reliability Singapore Pte Ltd. (a Costa Rica corporation) (a Singapore corporation) Reliability Japan Incorporated(1) (a Japanese corporation) (1) This subsidiary has discontinued operations and is in the process of being dissolved. As used in this report, the terms "Company" and "Registrant" refer to Reliability, its present subsidiaries and their predecessors, unless a different meaning is stated or indicated. The Company was incorporated under the laws of Texas in 1953. All subsidiaries are incorporated under a variant of the "Reliability" name. The Company's business was started in 1971 when substantially all of the assets of a testing laboratory owned by Texas Instruments Incorporated were acquired by Reliability, Inc. Reliability, Inc. was not at the time owned by the Registrant. The Registrant, in 1974, acquired Reliability, Inc. and began providing conditioning and testing services. In 1984, this separate company was merged into Reliability Incorporated. Reliability Singapore Pte Ltd. began operations during 1978 and provides conditioning services and manufactures certain conditioning products at a facility in Singapore. Reliability Singapore also manufactured power sources until 1993, when the power sources manufacturing operations were transferred to Costa Rica. RICR de Costa Rica, S.A. began operating in 1990, and manufactures and sells power sources. The companies described in this paragraph have discontinued operations and have been or are in the process of being dissolved. Reliability Nederland B.V. began operations in 1974 in the Republic of Ireland and manufactured power sources until 1991, when the company permanently closed the facility in Ireland. Reliability Nederland B.V. was chartered in the Netherlands and also functioned as a holding company for certain of the Company's foreign subsidiaries until December 1993, when it was dissolved, at which time subsidiaries owned by Reliability Nederland B.V. became subsidiaries of the Company. Reliability Europe Ltd. was incorporated in England in 1984 to serve as a sales representative and product demonstration facility for the Company in Europe; from 1988 to 1990 it also manufactured conditioning systems. In 1992, this company ceased operations completely. Reliability International, Inc., a U.S. Virgin Islands corporation, was incorporated in 1984 as a foreign sales corporation and ceased operations on December 31, 1992. Reliability Japan Incorporated, located in Tokyo, Japan, was incorporated in 1987 and served as a sales and technology center for conditioning and testing systems which were manufactured by the Company. Operations of the Japanese subsidiary were discontinued during 1993 and the subsidiary will be dissolved in 1994. The Company operates in three industry segments as discussed below. CONDITIONING AND TESTING PRODUCTS. ("Conditioning Products") Under current semiconductor technology and manufacturing processes, manufacturers are unable to consistently produce batches of ICs which are completely free of defects. An IC may be defective at the time it is produced, or it may have a latent defect which permits it to operate according to specifications for a period of time but eventually causes it to fail. An IC with such a defect will almost always fail during the first 500 to 1,000 hours of normal use. Accordingly, it has become customary to "condition" ICs, i.e., to subject them, during a relatively short period of time, to controlled stresses which simulate the first several hundred hours of operation in an effort to uncover defects. Such stresses may include maximum rated temperature, voltage and electrical signals and are also commonly referred to as "burn-in". Following conditioning, an IC is tested to determine whether it operates as intended. There are two general types of electrical tests to which an IC may be subjected. Parametric testing determines whether the electrical characteristics of the IC fall within certain specified limits. Functional testing determines whether the IC performs its specified function. The Company's products condition and functionally test ICs. The Company manufactures conditioning systems which are marketed under the names CRITERIA(R) and TITAN(tm); these products can perform most burn- in conditioning processes, but they do not test the ICs during conditioning. CRITERIA systems were originally designed for internal use in the Company's test labs ("TLs") but, since 1974, these systems have been sold to outside customers. Conditioning systems generally are used on new IC production lines, but may also be added to existing production lines. There are a number of different models within the product lines, each with a different capacity and conditioning capability. The CRITERIA models condition relatively large numbers of similar ICs at one time. The TITAN burn-in products provide wide range flexibility to users with relatively small quantities and multiple types of ICs to be conditioned. The TITAN products are designed primarily for IC users, but may also be used by IC manufacturers. CRITERIA products are purchased primarily by companies that manufacture large volumes of similar ICs, but they are also purchased by companies that use ICs. The Company manufactures, under the trade name INTERSECT(tm), systems which functionally test ICs during conditioning. This represents a significant difference in the way most ICs are tested. Most functional testing is performed sequentially, that is, one IC is tested at a time after the IC is conditioned; INTERSECT systems perform parallel functional testing, a process by which more than one IC is tested at a time. INTERSECT systems test ICs during the conditioning process, resulting in substantial time savings. INTERSECT systems are computer controlled for high volume burn-in and testing of semiconductor devices. The Company's INTERSECT systems can vary in their capacities and testing capabilities. The Company also produces and sells other conditioning and testing products and related equipment. The Company manufactures the RI Automatic Loader/Unloader(tm) which is appropriate for handling surface mount and dual inline IC packages. The Company also manufactures IDEA Automatic Loader and Unloader products which use a load/unload technique that is appropriate for dual inline and surface mount IC packages requiring high volume throughput. Conditioning systems and INTERSECT products are the principal products marketed and sold by the Company. The other conditioning and testing products represent options available to customers to enhance the performance of the Company's principal products. Conditioning and testing products are manufactured at the Company's Texas facility and certain limited manufacturing is also done at the Company's facility in Singapore. CONDITIONING AND TESTING SERVICES. ("Services") The Company provides conditioning and testing Services through its TLs to companies that manufacturer integrated circuits. Services revenues also include revenues from the sale of certain conditioning products, purchased by Services customers, which are used by the Company to provide services to the customers. The Company has TLs at its Durham, North Carolina and Singapore facilities, although only conditioning services are available in Singapore. The Durham TL provides conditioning and testing services to a customer in the Research Triangle area of North Carolina. The Company uses CRITERIA systems and burn-in boards to provide conditioning Services. Sequential testing equipment manufactured by other vendors is utilized by the Company in certain testing procedures. Services are generally sold on a long-term, non-binding purchase order basis. POWER SOURCES. The operating components of electronic equipment frequently have varying electrical requirements. Rather than provide electricity to each component separately, specialized devices, called DC- DC converters, or power sources, are used to convert a given electrical input into an electrical output of different voltage. By using small DC- DC converters, electronic equipment can operate from a single output power supply yet provide a specific, and different, voltage to operating components. These DC-DC converters allow a designer of electronic equipment to localize power requirements, increase modularity in the product design, and expand equipment without having to redefine power needs. The Company specializes in the one watt to twenty-five watt DC-DC converter market and manufactures a wide range of power sources classified into various product series. The Company introduced its initial product series, the V-PAC(R), in 1972. The V-PAC is a DC-DC converter compatible with electronic equipment assembly operations. The Company also manufactures the Z-PAC(R), which is a high efficiency DC-DC power source, the S-PAC(tm), a smaller one watt unit which is similar to the V-PAC, the TELECOM-PAC(R) and the ISDN-PAC(tm), which are power sources designed for the telecommunications industry, and the LAN, a power source designed to operate with Local Area Network computer applications. The Company's power sources are sold primarily to companies that manufacture computers and peripheral equipment for computers, and secondarily to companies that manufacture industrial control systems, pipeline sensing and control products, and telecommunications and telephone circuits. The Company has a power sources manufacturing facility in San Jose, Costa Rica. In 1991, the Company closed a power sources manufacturing facility in Ireland and shifted production of power sources for the European market to Costa Rica. During 1993 the power sources manufacturing capacity in Singapore was also transferred to Costa Rica. (b) FINANCIAL INFORMATION ABOUT INDUSTRY SEGMENTS. The Company's business is divided into three industry segments - (i) manufacture of conditioning products (Conditioning Products), (ii) conditioning services which condition and test ICs for others (Services), and (iii) manufacture of power sources (Power Sources). The table included in Note 2 of the Company's Consolidated Financial Statements provides certain information regarding the Company's industry segments. (c) NARRATIVE DESCRIPTION OF BUSINESS. The business of the Company is generally described in part (a) of this Item 1. The following paragraphs provide additional information concerning various aspects of the Company's business. Unless otherwise indicated, the information provided is applicable to all industry segments in which the Company operates. (i) PRINCIPAL PRODUCTS. Information as to the principal products and services of the Company is given in part (a) of this Item 1. The Conditioning Products segment of the Company's business is the dominant segment. The following table sets forth the percentage of the Company's total revenues by business segment: Years Ended December 31, ---------------------- Business Segment 1993 1992 1991 - ---------------- ---- ---- ---- Conditioning Products 53% 54% 45% Services 27 24 25 Power Sources 20 22 30 --- --- --- Total revenues 100% 100% 100% === === === Reference is made to Note 2 of the Company's Consolidated Financial Statements for additional information. (ii) NEW PRODUCTS. During 1993, Reliability began development of the INNOVATION(r) 2000 which further enhances the RI Automatic Loader/Unloader product line. The INNOVATION 2000 provides additional automation features such as device media and burn-in board handling. These additional features will significantly improve productivity by providing continuous and unattended device loading and unloading for approximately forty-five minutes, allowing one operator to handle multiple machines or operations. Delivery of the INNOVATION 2000 is scheduled for the first quarter of 1994. During 1993, Reliability introduced a burn-in board screener which allows INTERSECT 30 customers to prescreen and functionally test both 16 and 64 Meg DRAMs. The machine improves the utilization of the INTERSECT system and, in some cases, eliminates the need for a pre-test on a more expensive serial test system. The Company also introduced a software product called Burn-In Board Management ("BIB Management(tm)") which allows customers to track the usage, history, and defect rate of burn-in boards ("BIBs"). Using reports generated by the program, a customer can make decisions about the cost compared to performance of sockets and BIBs and will know when the BIBs become unreliable and need to be replaced. In addition, the BIB Management software can be used in conjunction with Reliability's Interactive System Controller to prevent an operator from loading an inappropriate board into a system or running an incorrect test plan. The Company, during 1993, continued to investigate the use of surface mount technology in the process of manufacturing power source products. Surface mount technology removes the human element from certain manufacturing processes thereby enhancing the reliability of the power sources. The technology also enables products to be assembled in smaller packages and therefore provides higher power output from smaller units. The Company introduced, in 1993, a new 15 watt DC-DC converter adding another higher wattage unit to the product line and continued development efforts related to reducing the cost of manufacturing power sources. (iii) RAW MATERIALS AND INVENTORY. The Company's products are designed by its engineers and are manufactured, assembled, and tested at its facilities in Houston, Texas; San Jose, Costa Rica; and to a limited degree in Singapore. The Company's products utilize certain parts which it manufactures and components purchased from others. Certain metal fabrications and subassembly functions are performed by others for the Company. The Company maintains an inventory of components and parts for its manufacturing activities. There are many sources for most of the raw materials needed for the Company's manufacturing activities, although a few components come from sole sources. The Company has not experienced any significant inability to obtain components or parts, but does experience occasional delays in receiving certain items. (iv) PATENTS, TRADEMARKS. The Company has patents and pending patent applications in the United States and certain other countries which cover key components of the CRITERIA and INTERSECT systems, and components of certain other conditioning and testing products. The Company considers its patent for the EX-SERT(tm) backplane system to be material. This patent, which was granted in the United States in February 1983, and will expire in February 2000, covers the use of a cavity at the rear wall of the burn-in chamber to isolate power and signal connectors from the harsh environment of the burn-in chamber. In many burn- in systems, the power and signal connectors are subjected to intense heat generated within the burn-in chamber, resulting in shortened connector life. The connection assembly disclosed in the patent reduces connector maintenance problems. A patent with respect to the backplane connection assembly has also been granted in Japan. The Company also considers its patents covering a method of IC extraction during the process of unloading burn-in boards and a patent for a floating head mechanism related to the loading of ICs onto burn-in boards to be significant. These patents expire in 2001 and 2005, respectively. The Company believes that its other patents and patent applications are useful, but their loss would not be material to the business of the Company. The Company believes that the rapidly changing technology in the electronics industry makes the Company's future success dependent more on the quality of its products, services, and performance and the technical skills of its personnel and its ability to adapt to the changing technological environment than upon any patents which it has or may be able to obtain. The Company has certain trademarks which are registered with the U.S. Patent & Trademark Office for use in connection with its products and services, including "ri (plus design)", "RELIABILITY", "CRITERIA", "V-PAC", "Z-PAC", "INNOVATION", "TELECOM-PAC" and "RI STINGRAY". In addition, the Company uses certain other trade names which are not presently registered, including "TITAN", "INTERSECT", "INTERACT", "INTERNET", "EX-SERT", "UNLOADER", "S-PAC", "ISDN-PAC" and "RI Automatic Loader/Unloader" and others not listed here which are used less frequently. The Company has in the past and will in the future protect vigorously all of its patents and trademarks as well as its other proprietary rights. (v) SEASONALITY. The Company's business is not seasonal, but is cyclical depending on the electronics manufacturing and semiconductor industries. (vi) WORKING CAPITAL. The Company finances its inventory and other working capital needs out of internally generated funds and periodic borrowings. The Company has short-term credit facilities on which the Company could draw additional funds as of December 31, 1993. Reference is made to Note 3 of the Company's Consolidated Financial Statements for additional information as to credit agreements under which working capital is or could be available if required. (vii) MAJOR CUSTOMERS. In 1993 and 1992, four customers accounted for 73% and 67% of the Company's consolidated revenues. The four customers are Intel Corporation, International Business Machines Corporation, Mitsubishi Semiconductor America, Inc. and Texas Instruments Incorporated. In 1993 and 1992, two of the customers accounted for approximately 52% and 45% and 46% and 49% of revenues, respectively, in the Services segment. In addition in 1993 and 1992 two other customers accounted for 46% and 44% and 24% and 57% of revenues, respectively, in the Conditioning Products segment. Note 2 to the Company's Consolidated Financial Statements discloses information concerning customers that accounted for more than 10% of consolidated revenues. In the Conditioning Products and Power Sources segments, decreased business from one customer may be replaced by new or increased business from other customers, but there is no assurance that this will occur. The Company believes that its relationships with its customers are good. The loss of or reduction in orders from a major customer and the failure of the Company to obtain other sources of revenue could have a material adverse impact on the Company. (viii) BACKLOG. The following table sets forth the Company's backlog at the dates indicated: December 31, ------------- Business Segment 1993 1992 - ---------------- ---- ---- (In thousands) Conditioning Products $ 3,653 $ 7,091 Services 649 1,517 Power Sources 1,022 824 ------ ------ Total $ 5,324 $ 9,432 ====== ====== Backlog for sales of Conditioning Products and Power Sources represents orders for delivery within twelve months from the date on which backlog is reported. Backlog for Services represents orders for services where the ICs to be conditioned have been delivered to the Company and orders for Conditioning Products that are directly related to providing services to customers. The Company's backlog as of December 31, 1993, is believed to be firm, although portions of the backlog are not subject to legally binding agreements. Orders included in backlog of the Conditioning Products segment totaling $694,000 are not currently scheduled for delivery, but management projects that the products will be scheduled for delivery in 1994. (ix) GOVERNMENTAL BUSINESS. The Company does not carry on a material amount of business with any governmental agency. (x) COMPETITION. The markets for the Company's products and services are subject to intense competition. The Company's primary competitors in the manufacture of Conditioning Products are other independent manufacturers of such systems and manufacturers of ICs who design their own equipment. The primary methods of competition in the manufacturing market are quality, service, delivery, price, and product features. The Company believes that its service after the sale, including its ability to provide installation, maintenance service, and spare parts, enhances its competitiveness. The world market for power sources is divided into the merchant and the captive markets. There are less than one thousand competitors in the merchant market of the power source manufacturing business, most of which target a particular application for their business. The Company believes there are approximately twenty significant competitors whose products compete directly with those of the Company in its U.S. and foreign markets. Competition in the power sources market is based primarily on the specific features of the power sources, price and quality. The primary areas of competition for the Company's Services are price, service level, and geographic location. The Singapore TL provides services to companies in southeast Asia that manufacture and use ICs, and the Durham TL provides services to a major IC manufacturer in the Research Triangle area of North Carolina. (xi) RESEARCH. The demand of the semiconductor industry for increasingly complex and sophisticated equipment results in the Company's continuing development of new products and review and modification of its existing products to adapt to technology changes in the industry. The Company also focuses on the development of peripheral equipment and options for its CRITERIA, INTERSECT and TITAN lines. In 1993, 1992 and 1991, the Company spent $889,000, $2,639,000 and $3,105,000, respectively, on research and development activities. Substantially all of the Company's research and development resources, during 1991 and 1992, were devoted to an INTERSECT project and other conditioning products. The Company completed development of the INTERSECT 30 in 1992. Other developmental projects, which are primarily related to the Conditioning Products segment, were undertaken in 1993. (xii) ENVIRONMENTAL MATTERS. The business of the Company is not expected to be affected by zoning, environmental protection, or other similar laws or ordinances. (xiii) EMPLOYEES. On December 31, 1993, the Company had 409 employees. Continued growth of the Company is dependent upon the Company's ability to attract and retain its technical staff and skilled employees. During recent years, the Company has experienced a low turnover rate among its employees, except that due to the very low unemployment rates in Singapore and Costa Rica, turnover at these facilities has been high. (d) FINANCIAL INFORMATION ABOUT FOREIGN AND DOMESTIC OPERATIONS AND EXPORT SALES. See Note 2 to the Company's Consolidated Financial Statements for a table showing information about foreign and domestic operations of the Company for the last three years. Item 2.

Item 2. Properties The corporate headquarters of the Company are located in a 131,000 square foot facility on a seven acre tract of land in Park 10, an office and industrial park on Interstate Highway 10 located on the west side of Houston. The Company occupies 101,000 square feet in the facility and the remaining 30,000 square feet has been sub-leased. This facility also includes manufacturing operations for conditioning products, research and development activities, and sales and marketing of power sources for the U.S. market. The lease for this facility will expire in 1995, and the Company has an option to renew for five additional years. A subsidiary of the Registrant occupies 18,200 square feet of leased space in Singapore. The Singapore facility is devoted to an TL and manufacture of burn-in boards. The Durham TL is located in 15,300 square feet of leased space in North Carolina. A subsidiary of the Registrant occupies 18,900 square feet of leased space in San Jose, Costa Rica. The plant in Costa Rica manufactures and sells power sources. See Note 7 to the Company's Consolidated Financial Statements. Item 3.

Item 3. Legal Proceedings. Not applicable. Item 4.

Item 4. Submission of Matters to a Vote of Security Holders. Not applicable. Item 4A. Executive Officers of the Registrant. The following table sets out certain information regarding each executive officer of the Company: Officer of Reliability Position currently Incorporated held with Name Age Since Reliability Incorporated ---- --- ------------ ------------------------ Larry Edwards 52 1981 President and Chief Executive Officer Max T. Langley 47 1978 Senior Vice President and Chief Financial Officer/ Secretary/Treasurer Robert W. Hildenbrand, Jr. 45 1984 Vice President J.E. (Jim) Johnson 48 1984 Vice President James M. Harwell 39 1993 Vice President Paul Nesrsta 37 1993 Vice President Mr. Edwards became the chief executive officer of the Company in March 1993. He was president and chief operating officer of the Company from April 1990 to March 1993 and was executive vice president and chief operating officer of the Company for more than five years prior to becoming the president in 1990. Mr. Harwell has been a vice president of the Company since July 1993. Mr. Harwell was the division manager of the automation equipment division of the Company from February 1991 to July 1993 and held positions as managing director of two of the Company's foreign subsidiaries for more than five years prior to February 1991. Mr. Nesrsta has been a vice president of the Company since July 1993. Mr. Nesrsta was manager of the test systems division of the Company for more than five years prior to becoming a vice president in 1993. Each other person named above has held his present position for more than five years. PART II Item 5.

Item 5. Market for the Registrant's Common Stock and Related Stockholder Matters. The Common Stock of Reliability trades on The Nasdaq Stock Market under the stock symbol REAL. The high and low last trade prices for 1993 and 1992, as reported by The Nasdaq Stock Market, are set forth below. These quotations represent prices between dealers without retail mark-up, mark- down, or commission, and do not necessarily reflect actual transactions. First Second Third Fourth Quarter Quarter Quarter Quarter ------- ------- ------- ------ - - - ---- High $2.50 $1.28 $4.88 $5.63 Low .81 .69 .94 2.50 - ---- High $2.13 $2.13 $2.88 $2.00 Low 1.00 1.25 1.38 1.25 A covenant in a working capital financing agreement restricts the Company's ability to pay dividends if certain criteria are not met. The Company could pay a dividend at December 31, 1993. The Company paid no dividends in 1993 or 1992. The Company intends to retain any earnings for use in its business and therefore does not anticipate paying dividends in the foreseeable future. See Note 3 to the Company's Consolidated Financial Statements. Reliability had approximately 920 shareholders of record as of February 18, 1994. Item 6.

Item 6. Selected Financial Data. The following table sets out certain selected financial data for the years indicated: Years Ended December 31, ------------------------------------ 1993 1992 1991 1990 1989 ------ ------ ------ ------ ------ (In thousands, except per share data) Revenues $27,022 $31,413 $29,612 $34,311 $38,073 Costs and expenses: Operating costs 24,269 32,587 32,617 38,499 37,693 Provision for restructuring 288 1,392 1,000 - - Interest expense (income), net 43 125 83 78 (21) ------ ------ ------ ------ ------ Total costs and expenses 24,600 34,104 33,700 38,577 37,672 ------ ------ ------ ------ ------ Income (loss) before income taxes 2,422 (2,691) (4,088) (4,266) 401 Provision (benefit) for income taxes 53 (46) 101 (543) 309 ------ ------ ------ ------ ------ Net income (loss) (1) $ 2,369 $(2,645) $(4,189) $(3,723) $ 92 ====== ====== ====== ====== ====== Average shares outstanding 4,243 4,243 4,242 4,213 4,211 ====== ====== ====== ====== ====== Net income (loss) per share (1) $ .56 $ (.62) $ (.99) $ (.88) $ .02 ====== ====== ====== ====== ====== Dividends per share $ .00 $ .00 $ .00 $ .00 $ .00 ====== ====== ====== ====== ====== Total assets $11,018 $14,693 $13,615 $17,320 $23,696 Long-term debt - - - - 600 Working capital 5,846 2,413 4,298 6,661 9,561 Property and equipment, net 2,257 3,312 3,758 5,810 7,474 Stockholders' equity 8,114 5,745 8,390 12,564 16,276 - ----- (1) The net loss and net loss per share for 1992 originally reflected the tax benefit of a net operating loss carryforward as an extraordinary item. The tax benefit of the net operating loss carryforward has been reclassified and netted against the income tax provision, as explained in Note 5 to the Consolidated Financial Statements. Item 7.

Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations. FINANCIAL CONDITION. Management considers cash provided by operations and retained earnings to be primary sources of capital. The Company maintains lines of credit to supplement these primary sources of capital and has leased its major facilities, reducing the need to expend capital on such items. Changes in the Company's financial condition, liquidity, and capital requirements during the three year period ended December 31, 1993 are attributable to significant operating losses through the first quarter of 1993 and a return to profitability in the periods subsequent to the March 1993 quarter. The return to profitability resulted in a significant improvement in the Company's financial condition. The losses resulted from a general decline in demand for products sold by the Company, significant expenses to maintain certain foreign subsidiaries, costs associated with excess capacity and costs related to restructuring of operations. The reduction in expenses resulting from the restructuring of operations, which was completed in the first quarter of 1993, resulted in the Company returning to profitability in 1993. Certain ratios and amounts monitored by management in evaluating the Company's financial resources and performance are presented in the following chart: 1993 1992 1991 -------- -------- -------- Working capital: Working capital (thousands of dollars) $ 5,846 $ 2,413 $ 4,298 Current ratio 3.1 to 1 1.3 to 1 1.9 to 1 Profitability ratios: Gross profit 43 % 42 % 39 % Return on revenues 9 % ( 8)% (14)% Return on assets 22 % (18)% (31)% Return on equity 29 % (46)% (50)% Equity ratios: Total liabilities to equity 0.4 1.6 0.6 Assets to equity 1.4 2.6 1.6 The Company's financial condition improved significantly during 1993. Working capital increased to $5.8 million at December 31, 1993 from $2.4 million at December 31, 1992, and the ratio of current assets to current liabilities increased to 3.1 at the end of 1993, compared to 1.3 at the end of 1992. The improvement is attributable to a return to profitability resulting from expense reductions which included reductions in personnel levels and restructuring of operations, reduction in excess leased space and a general reduction in most expense items. Net cash provided by operating activities was $5.2 million in 1993, contrasted with $1.5 million used by operations in 1992. The principal items contributing to the cash provided by operations in 1993 are net income of $2.4 million, depreciation and amortization of $1.3 million, and decreases in accounts receivable and inventories. Cash provided by operations was used to reduce debt under financing agreements by $2.4 million in the 1993 period. Cash flows from operations were also used to reduce accounts payable and accrued liabilities by a total of $2.3 million and provided cash of $1.7 million which was used to substantially complete restructuring of operations. Accounts receivable were unusually high at December 31, 1992 due to shipment of conditioning products during the latter part of the fourth quarter of 1992. The decrease in inventories in 1993 resulted from shipment of conditioning products in the first quarter of 1993 that were partially completed at December 31, 1992 and a decrease in raw materials inventory resulting from a decrease in demand for products sold by the Company. The decrease in the current ratio and working capital in 1992 compared to 1991 resulted principally from the $2.6 million loss reported in 1992 and an increase in inventories and accounts receivable. The inventory increase resulted from an increase in work-in-progress inventory related to products that were shipped in 1993. Short-term borrowing and an increase in accounts payable were used to support cash used by operations and to purchase $1.4 million of capital equipment in 1992. Capital expenditures during 1993 totaled $492,000, a decrease from expenditures of $1.4 million in 1992. A change in product mix and volume increases at the Company's Service facilities will require additional equipment during 1994. Management currently projects that 1994 expenditures may exceed $1.0 million. The lease on the Company's corporate headquarters expires in 1995. The Company will decide during the first half of 1994 whether to continue to lease or purchase the existing facility, or to relocate to a different facility. The Company maintains bank lines of credit to provide funds to support periodic changes in liquidity. Bank debt decreased $2.4 million in 1993 after increasing $2.0 million in 1992. Cash flow from operations was used to pay off all bank debt in 1993. Borrowings under loan agreements during 1992 were used to support cash used by operations and to finance capital expenditures. The U.S. Company's working capital line of credit is evidenced by demand notes and credit availability is limited to 80% of eligible accounts receivable. The Company's Singapore subsidiary has an overdraft facility; continuation of the facility is at the discretion of the bank. The Company could borrow an additional $1.4 million under its lines of credit at December 31, 1993. Current projections indicate that cash generated by operations supplemented by incidental bank borrowing under existing agreements will be sufficient to meet the cash requirements of the Company during 1994. Effective January 1, 1993, the Company changed its method of accounting for income taxes from the deferred method to the liability method required by Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes." The adoption of this standard did not have a material effect on the Company's Financial Statements. Reliability's revenue is dependent on conditions within the semiconductor industry and profitability is dependent on revenues and controlling expenses. Semiconductor manufacturers experienced good sales growth during 1992 and 1993 and current forecasts indicate an increase in revenues for the industry in 1994. The Company has net operating loss carryforwards available to reduce income taxes on a portion of future taxable income. RESULTS OF OPERATIONS. OVERVIEW. Revenues from products sold by the Company declined during the three year period ending in 1993 except that an increase in revenues in the Conditioning Products segment in 1992 was attributable to revenues from the sale of INTERSECT 30 systems. Delivery of these high unit price systems began in the second quarter of 1992 and continued throughout 1993. A decline in revenues during the three year period in the Power Sources segment resulted from price competition, resulting in a significant decrease in unit prices and a decrease in unit volume. Customer requirements for conditioning Services decreased slightly in 1993. A small decrease in Services revenues in 1992 resulted from a revenue decrease at one of the Company's services facilities. REVENUES. Revenues decreased 14% in 1993 to $27 million, reflecting decreases in all business segments. Revenues in the Central America geographical segment increased while the U.S., Asia and Pacific and Western Europe segments declined. The increase in the Central America segment is attributable to shifting Power Sources manufacturing to Costa Rica from Ireland and Singapore. The overall decrease in the U.S. segment is related to volume and unit price decreases. A substantial portion of the decrease in the Asia Pacific segment is related to shifting Power Sources manufacturing from Singapore to Costa Rica and to shut-down of the Japanese operation. In 1992, revenues were $31.4 million, an increase of 6% over 1991, reflecting an increase in the Conditioning Products segment, a decrease in the Power Sources segment and a small decrease in the Services segment. Conditioning Products revenues decreased 16% in 1993 to $14.2 million after increasing 27% in 1992. A decrease in the unit volume of older models of burn-in chambers and loader and unloader products and lower average unit prices contributed to the decline. The increase in 1992 is attributable to a significant increase in revenues from the sale of INTERSECT 30 products. Revenues in the Conditioning Products segment overall, excluding INTERSECT products, declined during the three year period due to changes in requirements by the semiconductor industry for burn-in and other conditioning products and to product mix changes. Domestic conditioning and testing product shipments increased due to shipment of INTERSECT 30 systems beginning in the second quarter of 1992. Revenues from the sale of conditioning and testing products in Japan decreased significantly in 1992 due to a reduction in capital spending by Japanese semiconductor manufacturers. Revenues in the Power Sources segment decreased in 1993 to $5.4 million after decreasing 20% to $7.0 million in 1992. The decrease, in both years, resulted principally from price competition resulting in average unit sale price and volume decreases. The decline in revenues appeared to be stabilizing during the latter part of 1993. Revenues in the Services segment decreased 3% in 1993 to $7.4 million after decreasing only $6,000 in 1992. The 1993 decrease in revenues is attributable to product mix changes and unit price decreases resulting from lower operating costs being passed through to customers. Average unit prices increased during the latter part of 1993 due to a shift in product mix. Revenues included in the Services segment from the sale of conditioning products to Services customers increased during 1993 due to a change in product mix. Revenues at the Durham services facility decreased in 1992 due to volume decreases caused by product mix changes. Revenues at the Singapore facility increased in 1992 due to volume increases and increases in average unit sales prices due to product mix changes. INFLATION. The overall impact of inflation on revenues has been minimal. Salaries and wages have increased at rates less than the general inflation rate during the three year period due to salary reductions and wages freezes during 1991 and 1992. The cost of raw materials and purchased parts increased at rates somewhat greater than the general inflation rate due to general increases in demand. COSTS AND EXPENSES. Changes in costs and expenses during the three year period are primarily related to various cost reduction and restructuring measures, changes in revenue levels and the changes in research and development expenditures. Total costs and expenses, excluding the provision for restructuring, decreased $8.3 million in 1993 compared to the revenue decrease of $4.4 million. Cost of revenues decreased $2.7 million; marketing, general and administrative expenses decreased $3.8 million; and research and development expenses decreased $1.8 million. The overall decrease in expenses, in 1993, related to restructuring of operations, expense reduction programs and a decrease in revenue and volume related expenses. Total costs and expenses, excluding the provision for restructuring, decreased $30,000 in 1992 to $32.6 million, compared to a revenue increase of $1.8 million. In general, costs and expenses decreased in 1992 due to a reduction in personnel levels and various cost reduction programs. The decreases were offset in some instances by volume related expenses associated with revenues from the sale of the INTERSECT 30 products. Costs and expenses were also affected by certain operations operating below levels necessary to absorb fixed overhead costs. The Company's gross profit, as a percent of revenues, was 43%, 42% and 39% in 1993, 1992 and 1991, respectively. The 1993 increase is related to an increase in the Conditioning Products segment. The increase in the Conditioning Products segment resulted from a decrease in both fixed and variable manufacturing costs and changes in product mix. The increase also resulted from a reduction in expenses due to shut-down of the Japanese operation. A small decline in the gross profit in the Services segment is due principally to an increase in revenues from the sale of conditioning products to Services customers, because the gross profit on these products is traditionally low due to price competition. Revenues in the Power Sources segment declined 22% in 1993, but the gross profit in the segment was basically unchanged compared to 1992. Total manufacturing costs declined significantly due to the restructuring of operations and shifting of all production capacity for this segment to Costa Rica. A significant portion of the benefit of the change took effect in the third quarter of 1993. The overall 1992 gross profit increase is principally related to an increase in the Conditioning Products segment and to a lesser extent to an increase in the Service segment, reduced by a decrease in the Power Sources segment. The increase in the Conditioning Products segment resulted from a reduction in overhead expenses, including personnel and expense reductions, and a higher absorption of fixed overhead by certain operations. The increase in the Services segment in 1992 results from product mix changes and a reduction in overhead expense. Expense controls at both of the Company's services facilities and a reduction in overhead expense also contributed to the increase. The 1992 decrease in the Power Sources segment relates to volume and price decreases and the cost of carrying excess production capacity. Marketing, general, and administrative expenses decreased $3.8 million in 1993 in comparison to a $4.4 million decrease in revenues. Expenses were reduced throughout 1993 by stringent expense reduction programs, reductions in personnel levels and discontinuation of operations at two foreign facilities. Approximately 45% of the decrease is due to shut-down of the UK and Japanese operations in late 1992 and consolidation of Power Sources manufacturing in Costa Rica. In addition, expenses decreased in the Conditioning Products segment due to a decrease in revenue related expenses such as commissions and warranty and installation costs. The increase of $459,000 in 1992 is related to an increase in revenue related expenses, such as commissions, royalties and similar expenses, in the Conditioning Products segment resulting from shipment of INTERSECT systems. Expenses in the Power Sources and Services segments decreased in 1992. The decrease in expenses in the Services segment resulted from stringent expense control measures. Expenses in the Power Sources segment decreased in 1992 due to volume decreases and the shut-down of the Irish power sources facility in 1991. Expenses at the Costa Rica and Singapore power sources operations increased, but at rates less than the decrease related to the Irish operation. Expense controls and personnel reductions at most facilities during 1992 resulted in a decrease in marketing, general and administrative expenses. The expense reductions were offset by the revenue related expenses associated with the increase in INTERSECT revenues, but expenses in the Conditioning Products segment increased only 16% while revenues increased 27%. Research and development expenditures totaled $889,000 in 1993, compared to $2.6 and $3.1 million in 1992 and 1991, respectively. A significant portion of expenditures in each of the three years related to development of conditioning and testing products, with a substantial portion of these expenditures being related to development of the INTERSECT 30 line of burn- in and test systems. The decrease in 1992 and 1993 results from completion of the INTERSECT 30 development project in 1992. Costs associated with development of conditioning products increased in 1993 after declining in 1992. Development costs in the Power Sources segment declined in 1993 and also in 1992. The Company recorded in 1993 a provision for restructuring of operations totaling $288,000. The provision was composed of $319,000 related to retirement and severance pay for U.S. employees who were terminated in March 1993 and a $31,000 reduction of the 1992 restructuring provision related to downsizing power sources production capacity in Singapore. The Company recorded a $1.4 million provision for restructuring of operations in 1992. The provision was composed of $1.0 million for curtailment of operations in Japan, $216,000 related to closing of the U.K. facility, $325,000 related to reduction of power sources manufacturing capacity in Singapore and a $149,000 reduction of the 1991 provision for closing of the Irish power sources facility. The Company recorded a $1.0 million provision for shut- down of its Irish power sources facility in the third quarter of 1991. The shut-down was completed during 1992 at a cost which was $149,000 less than the original estimate. Net interest expense decreased significantly in 1993 due to a reduction in debt balances during the last half of 1993. Interest expense increased in 1992 compared to 1991 due to an increase in debt balances, reduced somewhat by a decline in interest rates. Interest income declined in 1993 and 1992 due to a decrease in investable cash balances and a decrease in interest rates in 1992. INCOME TAX EXPENSE (BENEFIT). The Company's income tax expense (benefit) was $53,000, $(46,000) and $101,000, in 1993, 1992 and 1991, respectively. This equated to an effective tax rate of 2% in 1993 and a negative 2% in 1992. The 1991 provision of $101,000 was recorded on a loss of $4.1 million. The Company's effective tax rates differed from the U.S. tax rate of 34% due to tax benefits of net operating loss carryforwards in 1993 and 1992; tax provided on a dividend from a foreign subsidiary in 1992; tax benefits, in 1993, related to expenses incurred in shutting down a foreign subsidiary; expenses of foreign subsidiaries for which tax benefits were not available in 1992 and 1991; and in 1991 tax benefits were not available to the U.S. Company due to net operating loss carryback limitations. Item 8.

Item 8. Consolidated Financial Statements and Supplementary Data. INDEX TO CONSOLIDATED FINANCIAL STATEMENTS AND FINANCIAL STATEMENT SCHEDULES Page ---- Report of independent public accountants. . . . . . . . . . . . . . . . . Consolidated balance sheets at December 31, 1993 and 1992 . . . . . . . . For each of the three years in the period ended December 31, 1993: Consolidated statements of operations . . . . . . . . . . . . . . . . . Consolidated statements of cash flows . . . . . . . . . . . . . . . . . Consolidated statements of stockholders' equity . . . . . . . . . . . . Notes to consolidated financial statements. . . . . . . . . . . . . . . . Supplementary financial information: Quarterly results of operations (unaudited) . . . . . . . . . . . . . . S-1 Schedules for each of the three years in the period ended December 31, 1993: V - Property, plant and equipment. . . . . . . . . . . . . . . . . . S-2 VI - Accumulated depreciation of property, plant and equipment . . . . . . . . . . . . . . . . . . . . . . . S-3 VIII - Valuation and qualifying accounts and reserves . . . . . . . . . S-4 IX - Short-term borrowings. . . . . . . . . . . . . . . . . . . . . . S-5 X - Supplementary income statement information . . . . . . . . . . . S-6 All other schedules are omitted since the required information is not present, or is not present in amounts sufficient to require submission of the schedule, or because the information required is included in the consolidated financial statements and notes thereto. REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS The Board of Directors and Stockholders Reliability Incorporated We have audited the accompanying consolidated balance sheets of Reliability Incorporated as of December 31, 1993 and 1992, and the related consolidated statements of operations, cash flows and stockholders' equity for each of the three years in the period ended December 31, 1993. Our audits also included the financial statement schedules listed in the Index on page F- 1. These financial statements and schedules are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements and schedules based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the consolidated financial position of Reliability Incorporated at December 31, 1993 and 1992, and the consolidated results of its operations and its cash flows for each of the three years in the period ended December 31, 1993, in conformity with generally accepted accounting principles. Also, in our opinion, the related financial statement schedules, when considered in relation to the basic financial statements taken as a whole, present fairly in all material respects the information set forth therein. BY/s/ERNST & YOUNG Houston, Texas February 11, 1994 RELIABILITY INCORPORATED CONSOLIDATED BALANCE SHEETS ASSETS December 31, -------------- 1993 1992 ---- ---- (In thousands) Current assets: Cash $ 2,882 $ 362 Accounts receivable (Note 3) 3,074 4,103 Inventories (Note 3) 2,356 5,939 Deferred income taxes (Note 5) - 60 Other 314 519 ------ ------ Total current assets 8,626 10,983 Property and equipment, at cost (Note 3): Machinery and equipment 11,994 12,884 Leasehold improvements 2,543 2,588 ------ ------ 14,537 15,472 Less accumulated depreciation 12,280 12,160 ------ ------ 2,257 3,312 Other assets 135 398 ------ ------ $11,018 $14,693 ====== ====== LIABILITIES AND STOCKHOLDERS' EQUITY Current liabilities: Accounts payable $ 524 $ 1,878 Short-term borrowings (Note 3) - 2,408 Accrued liabilities (Note 8) 2,016 2,951 Current maturities on long-term debt (Note 3) 58 - Income taxes payable (Note 5) 18 53 Liability for restructuring (Note 6) 164 1,280 ------ ------ Total current liabilities 2,780 8,570 Deferred income taxes (Note 5) 124 153 Liability for restructuring (Note 6) - 225 Commitments and contingencies (Note 7) - - Stockholders' equity (Notes 3 and 4): Common stock, without par value; 20,000,000 shares authorized; 4,242,848 shares issued 5,926 5,926 Retained earnings (deficit) 2,188 (181) ------ ------ Total stockholders' equity 8,114 5,745 ------ ------ $11,018 $14,693 ====== ====== See accompanying notes. RELIABILITY INCORPORATED CONSOLIDATED STATEMENTS OF OPERATIONS (In thousands, except per share data) Years Ended December 31, ------------------------ 1993 1992 1991 ---- ---- ---- Revenues: Product sales $19,651 $23,834 $22,027 Services 7,371 7,579 7,585 ------ ------ ------ 27,022 31,413 29,612 Costs and expenses: Cost of product sales 10,986 13,759 13,245 Cost of services 4,419 4,376 4,913 Marketing, general and administrative 7,975 11,813 11,354 Research and development 889 2,639 3,105 Provision for restructuring (Note 6) 288 1,392 1,000 ------ ------ ------ 24,557 33,979 33,617 ------ ------ ------ Operating income (loss) 2,465 (2,566) (4,005) Interest expense, net (Note 3) 43 125 83 ------ ------ ------ Income (loss) before income taxes 2,422 (2,691) (4,088) Provision (benefit) for income taxes (Note 5) 53 (46) 101 ------ ------ ------ Net income (loss) $ 2,369 $(2,645) $(4,189) ====== ====== ====== Net income (loss) per share $ .56 $ (.62) $ (.99) ====== ====== ====== See accompanying notes. RELIABILITY INCORPORATED CONSOLIDATED STATEMENTS OF CASH FLOWS (In thousands) Years Ended December 31, ------------------------ 1993 1992 1991 ---- ---- ---- Cash flows from operating activities: Net income (loss) $ 2,369 $(2,645) $(4,189) Adjustments to reconcile net income (loss) to cash provided by operating activities: Depreciation and amortization 1,258 1,761 2,407 Provisions for restructuring 288 1,392 1,000 Deferred income taxes 31 (51) (58) Loss (gain) on disposal of fixed assets 352 131 (1) Provision for inventory obsolescence 262 636 347 Provision for bad debts - (12 ) (30) Exchange (gain) loss (49) 62 (14) Change in assets and liabilities: (Increase) decrease in assets: Short-term investment - 100 (100) Accounts receivable 1,042 (1,498) 1,360 Inventories 3,338 (2,066) (164) Refundable income taxes - 120 703 Other assets 457 354 14 Increase (decrease) in liabilities: Accounts payable (1,366) 720 88 Accrued liabilities (978) 274 (52) Income taxes payable (35) (241) 56 Liability for restructuring (1,744) (491) (396) ------ ------ ------ Total adjustments 2,856 1,191 5,160 ------ ------ ------ Net cash provided (used) by operating activities 5,225 (1,454) 971 ------ ------ ------ Cash flows from investing activities: Expenditures for plant and equipment (492) (1,436) (665) Proceeds from sale of equipment 15 27 54 ------ ------ ------ Net cash (used) in investing activities (477) (1,409) (611) ------ ------ ------ Cash flows from financing activities: Borrowings (payments) under loan agreements (2,457) 2,035 (53) Conversion of note payable to long-term debt 393 - - Payments and current maturities on long-term debt (335) - - Issuance of common stock - - 15 ------ ------ ------ Net cash (used) provided by financing activities (2,399) 2,035 (38) ------ ------ ------ Effect of exchange rate changes on cash 171 (36) (13) ------ ------ ------ Net increase (decrease) in cash 2,520 (864) 309 Cash at beginning of year 362 1,226 917 ------ ------ ------ Cash at end of year $ 2,882 $ 362 $ 1,226 ====== ====== ====== See accompanying notes. RELIABILITY INCORPORATED CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY Years Ended December 31, 1993, 1992 and 1991 (In thousands) Common Stock ------------ Retained Earnings Total Shares Amount (Deficit) Amount ------ ------ -------- ------ Balance at December 31, 1990 4,223 $5,911 $6,653 $12,564 Net (loss) (4,189) (4,189) Shares issued to employee stock savings plan 20 15 15 ----- ----- ------ ------ Balance at December 31, 1991 4,243 5,926 2,464 8,390 Net (loss) (2,645) (2,645) ----- ----- ------ ------ Balance at December 31, 1992 4,243 5,926 (181) 5,745 Net income 2,369 2,369 ----- ----- ------ ------ Balance at December 31, 1993 4,243 $5,926 $ 2,188 $ 8,114 ===== ===== ====== ====== See accompanying notes. RELIABILITY INCORPORATED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS December 31, 1993 1. BASIS OF PRESENTATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES The consolidated financial statements include the accounts of the Company and its subsidiaries, all of which are majority owned. All significant intercompany balances and transactions have been eliminated in consolidation. Certain amounts in the consolidated financial statements for the years ended December 31, 1992 and 1991 have been reclassified to conform to the 1993 presentation. CASH EQUIVALENTS For the purposes of the statements of cash flows, the Company considers all highly liquid cash investments with maturities of three months or less to be cash equivalents. INVENTORIES Inventories are stated at the lower of standard cost (which approximates first-in, first-out) or market (replacement cost or net realizable value) and include: 1993 1992 ---- ---- (In thousands) Raw materials $1,702 $2,924 Work-in-progress 553 2,553 Finished goods 101 462 ----- ----- $2,356 $5,939 ===== ===== PROPERTY, PLANT AND EQUIPMENT For financial statement purposes, depreciation is computed principally on the straight-line method using lives from 4 to 10 years for leasehold improvements and the straight-line and double-declining balance methods using lives from 2 to 8 years for machinery and equipment. INCOME TAXES The provision for income taxes includes Federal, foreign, and state income taxes. Deferred income taxes are provided for temporary differences between financial statement and income tax reporting. RELIABILITY INCORPORATED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued) December 31, 1993 FOREIGN CURRENCY TRANSLATION The financial statements of foreign subsidiaries are translated into U.S. dollar equivalents in accordance with Statement of Financial Accounting Standards No. 52. The Company's primary functional currency is the U.S. dollar. Accordingly, translation adjustments and transaction gains or losses for foreign subsidiaries that use the U.S. dollar as their functional currency are recognized in consolidated income in the year of occurrence. The remaining entity used the local currency as its functional currency and translation adjustments were immaterial. 2. INFORMATION ON BUSINESS SEGMENTS AND GEOGRAPHIC AREAS The Company operates in three industry segments: (1) manufacture of conditioning products which are used in conditioning and testing of integrated circuits; (2) conditioning services which condition and test integrated circuits and (3) manufacture of power sources. Financial information by industry segment is as follows: 1993 1992 1991 ---- ---- ---- (In thousands) Revenues from unaffiliated customers: Conditioning products $14,218 $16,840 $13,241 Conditioning services 7,371 7,579 7,585 Power sources 5,433 6,994 8,786 ------ ------ ------ $27,022 $31,413 $29,612 ====== ====== ====== Operating income (loss): Conditioning products $ 1,892 $(1,910) $(3,649) Conditioning services 1,384 1,854 1,218 Power sources (190) (849) (276) Provision for restructuring of operations: Conditioning product (280) (1,108) - Power sources (8) (284) (1,000) General corporate expenses (333) (269) (298) ------ ------ ------ $ 2,465 $(2,566) $(4,005) ====== ====== ====== Identifiable assets: Conditioning products $ 5,718 $ 8,922 $ 7,014 Conditioning services 2,905 2,634 2,057 Power sources 2,395 3,077 4,066 General corporate assets - 60 478 ------ ------ ------ $11,018 $14,693 $13,615 ====== ====== ====== RELIABILITY INCORPORATED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued) December 31, 1993 Financial information by industry segment is as follows (Continued): 1993 1992 1991 ---- ---- ---- (In thousands) Depreciation: Conditioning products $ 341 $ 627 $ 706 Conditioning services 597 762 1,231 Power sources 271 336 401 ------ ------ ------ $ 1,209 $ 1,725 $ 2,338 ====== ====== ====== Capital expenditures: Conditioning products $ 248 $ 422 $ 301 Conditioning services 191 933 342 Power sources 53 81 46 ------ ------ ------ $ 492 $ 1,436 $ 689 ====== ====== ====== Financial information by geographical area is as follows: 1993 1992 1991 ---- ---- ---- (In thousands) Revenues from unaffiliated customers: United States $19,469 $23,018 $20,136 Asia and Pacific 4,755 6,459 6,958 Central America 2,798 1,895 20 Western Europe - 41 2,498 Intergeographic revenues: United States 120 956 678 Asia and Pacific 408 1,453 1,816 Central America 911 935 834 Western Europe - - 6 Eliminations (1,439) (3,344) (3,334) ------ ------ ------ $27,022 $31,413 $29,612 ====== ====== ====== RELIABILITY INCORPORATED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued) December 31, 1993 Financial information by geographical area is as follows (Continued): 1993 1992 1991 ---- ---- ---- (In thousands) Operating income (loss): United States $ 2,798 $ (200) $(2,660) Asia and Pacific 197 (812) 341 Central America 95 105 (479) Western Europe - 2 91 Provision for restructuring of operations: United States (318) - - Asia and Pacific 30 (1,325) - Western Europe - (67) (1,000) General corporate expenses (337) (269) (298) ------ ------ ------ $ 2,465 $(2,566) $(4,005) ====== ====== ====== Identifiable assets: United States $ 7,349 $ 8,948 $ 8,681 Asia and Pacific 2,100 4,497 3,255 Central America 1,569 1,131 778 Western Europe - 117 901 ------ ------ ------ $11,018 $14,693 $13,615 ====== ====== ====== The Company provides products and services to companies in the electronics and semiconductor industries, many of which are industry leaders. There are a limited number of companies which purchase conditioning products and services sold by the Company. The Company's four largest customers accounted for approximately 73%, 67% and 47% of consolidated revenues in 1993, 1992 and 1991, respectively. Accounts receivable are generally due within 30 days and collateral is not required except that export sales from the United States generally require letters of credit. Historically, the Company's bad debts have been very low, an indication of the credit worthiness of the customers to which the Company sells. Intersegment sales, which are not material, and intergeographic sales of manufactured products are priced at cost plus a reasonable profit. The Company had export revenues from its United States operation to the following geographical areas: 1993 1992 1991 ---- ---- ---- (In thousands) Asia and Pacific $2,165 $2,605 $2,517 Europe 3,140 4,331 583 North America and other 457 726 934 ----- ----- ----- $5,762 $7,662 $4,034 ===== ===== ===== RELIABILITY INCORPORATED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued) December 31, 1993 Revenues from major customers, as a percent of total revenues and industry segments, are as follows: Total Conditioning Conditioning Power Revenues Products Services Sources -------- ------------ ------------ ------- ---- Customer A 24% 46% -% -% Customer B 23 44 - - Customer C 14 - 52 - Customer D 12 - 45 - ---- Customer A 13 24 - 1 Customer B 31 57 - - Customer C 11 - 46 - Customer D 12 - 49 - ---- Customer A 18 39 - 1 Customer B 5 11 - - Customer C 9 4 32 - Customer D 15 - 62 - 3. SHORT-TERM BORROWINGS AND LONG-TERM DEBT The Company maintains a working capital financing agreement with NationsBank of Texas, N.A. Under the agreement, the Company may request loan advances, evidenced by demand notes, up to $2,500,000. Credit availability is limited to 80% of eligible accounts receivable of the U.S. Company. Interest is payable monthly at the bank's base rate plus 2 1/2% (8 1/2% at December 31, 1993). There were no balances outstanding at December 31, 1993. The loan is collaterized by the U.S. Company's accounts receivable, inventories, fixed assets and certain other assets. The Company had credit availability of $1,206,000 at December 31, 1993. The agreement limits the Company's annual capital expenditures. The financing agreement was amended in July 1993. The amended agreement provides that if the tangible net worth, as defined, of the U.S. Company is less than $3,000,000, the U.S. Company may not pay dividends or make certain advances or loans without the written approval of the bank and becomes subject to certain other defined restrictions. The financial requirements of the financing agreement were met at December 31, 1993. The Company's Singapore subsidiary maintains an agreement with a Singapore bank to provide an overdraft facility to the Company at the bank's prime rate plus 1% (6% at December 31, 1993). The line of credit was reduced, in August 1993, from 1,500,000 Singapore dollars (U.S. $938,000) RELIABILITY INCORPORATED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued) December 31, 1993 to 500,000 Singapore dollars (U.S. $313,000). There were no balances outstanding at December 31, 1993, and amounts utilized under credit commitments totalled $125,000, resulting in credit availability of $188,000 at December 31, 1993. The loan is collateralized by all assets of the subsidiary and requires maintenance of a minimum net worth of the Singapore subsidiary. Payment of dividends requires written consent from the bank, and continuation of the credit facility is at the discretion of the bank. The Company's Japanese subsidiary entered into an agreement with a related party of the subsidiary, in December 1990, to provide a credit facility to the subsidiary. The related party of the subsidiary obtained a line of credit from a Japanese bank and made the amount available to the Company. The interest rate is the rate paid on the underlying loan plus 20%, which totalled 6% at December 31, 1993. In April 1993, the loan was converted to a term loan payable in monthly installments of $9,900, plus interest paid quarterly. The Company has made certain advance payments, and the loan is currently scheduled to be paid in full in June 1994. The subsidiary may not borrow additional amounts as of December 31, 1993. At December 31, 1993, the total loan balance was $58,000, and amounts due under this agreement have been classified as current maturities on long-term debt. Interest paid on debt during 1993, 1992 and 1991 was $82,000, $134,000 and $126,000, respectively. Interest expense is presented net as follows: 1993 1992 1991 ---- ---- ---- (In thousands) Interest expense $ 58 $ 147 $ 131 Interest (income) (15) (22) (48) ---- ---- ---- Interest expense, net $ 43 $ 125 $ 83 ==== ==== ==== 4. EMPLOYEE STOCK PLAN The Company sponsors an Employee Stock Savings Plan and Trust (the "Plan"). United States employees of the Company who have completed at least one year of service become participants in the Plan. The Plan allows an employee to contribute up to 15% of defined compensation to the Plan and to elect to have contributions not be subject to Federal income taxes under Section 401(k) of the Internal Revenue Code. The Company contributes a matching amount to the Plan equal to 50% of the employee's contribution, to a maximum of 2%, for employees who contribute 2% or more. The Company also contributes, as a voluntary contribution, an amount equal to 1% of the defined compensation of all participants. The Company's contribution for matching and voluntary contributions amounted to $105,000 in 1993, $121,000 in 1992 and $116,000 in 1991. Employee contributions may be invested in Company stock or other investment options offered by the Plan. The Company's contributions vest with the employee over seven years and are invested solely in Company stock. RELIABILITY INCORPORATED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued) December 31, 1993 The Company, during 1992, registered and reserved 500,000 shares of common stock for sale to the Plan. The Plan purchased, in the open market, 64,115 and 78,288 shares during 1993 and 1992, for an aggregate purchase price of $150,000 and $143,000, respectively. At December 31, 1993, 357,597 reserved shares remain unissued under the registration. The Company had previously registered and reserved 100,000 shares of common stock for sale to the Plan. At December 31, 1993 and 1992, all 100,000 of the shares had been sold to the Plan. The purchase price per share was the closing price on the day prior to purchase by the Plan. During 1991, the Plan purchased 20,000 shares of stock from the Company for an aggregate purchase price of $15,000. The Plan purchased, in the open market, 97,000 shares during 1991 for an aggregate purchase price of $146,000. The Plan did not purchase any stock from the Company during 1993 or 1992. 5. INCOME TAXES Effective January 1, 1993, the Company changed its method of accounting for income taxes and adopted Statement of Financial Accounting Standards ("SFAS") No. 109, "Accounting for Income Taxes" which requires an asset and liability approach to financial accounting and reporting for income taxes. The difference between the financial statement and tax basis of assets and liabilities is determined annually. Deferred income tax assets and liabilities are computed for those differences that have future tax consequences using the currently enacted tax laws and rates that apply to the periods in which they are expected to affect taxable income. Valuation allowances are established, if necessary, to reduce the deferred tax asset to the amount that will more likely than not be realized. Income tax expense is the current tax payable or refundable for the period plus or minus the net change in the deferred tax assets and liabilities. The cumulative effect of adopting SFAS 109 on the Company's financial position and results of operations was not material. As permitted under the new rules, prior period financial statements have not been restated except that the tax benefit from utilization of a net operating loss carryforward in 1992 has been reclassified to the provision for income taxes. This reclassification results in income tax for 1992 being presented in a manner consistent with the presentation required under SFAS 109. RELIABILITY INCORPORATED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued) December 31, 1993 The provision (benefit) for income taxes is based on income (loss) before income taxes as follows: Geographic area 1993 1992 1991 --------------- ---- ---- ---- (In thousands) United States $ 2,187 $( 442) $(2,502) Foreign 145 (2,192) (1,664) Eliminations and corporate items 90 (57) 78 ------ ------ ------ $ 2,422 $(2,691) $(4,088) ====== ====== ====== The components of the provision (benefit) for income taxes are as follows: Current Deferred Total ------- -------- ----- (In thousands) ---- Federal $ - $ - $ - Foreign 17 31 48 State 5 - 5 ---- ---- ---- $ 22 $ 31 $ 53 1992 ==== ==== ==== ---- Federal - Provision $ 344 $ - $ 344 Federal Tax Benefit from utilization of net operating loss carryforward (316) - (316) Foreign (28) (51) (79) State 5 - 5 ---- ---- ---- $ 5 $ (51) $ (46) 1991 ==== ==== ==== ---- Federal $ (87) $ 45 $ (42) Foreign 240 (103) 137 State 6 - 6 ---- ---- ---- $ 159 $ (58) $ 101 ==== ==== ==== RELIABILITY INCORPORATED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued) December 31, 1993 The differences between the effective rate reflected in the provision (benefit) for income taxes on income (loss) before income taxes and the amounts determined by applying the statutory U.S. tax rate of 34% are analyzed below: 1993 1992 1991 ---- ---- ---- (In thousands) Provision (benefit) at statutory rate $ 823 $(915) $(1,390) Tax benefit of net operating loss carryforward (245) (316) - Tax effects of: Foreign expenses for which a tax benefit (is available) is not available (495) 778 715 Foreign income taxed at rates less than U.S. rate (11) (19) (10) U.S. Federal tax on dividend from foreign subsidiary - 486 - Alternative minimum tax - 29 7 Benefits not recorded due to net loss carryforward position - - 759 Other (19) (89) 20 ---- ---- ------ $ 53 $ (46) $ 101 ==== ==== ====== The components of the provision (benefit) for deferred income taxes for the years ended December 31, 1992 and 1991 are as follows: 1992 1991 ---- ---- (In thousands) Depreciation $ (8) $(215) Benefits not recorded due to net loss carryforward position 170 101 Distributions of former DISC (29) (29) (Benefit) associated with restructuring charge (98) - Inventory and other reserves (79) 45 Timing difference in recognition of intercompany transfers (29) 24 Other 22 16 ---- ---- $ (51) $ (58) ==== ==== The Company's cash requirements made it necessary for the Singapore subsidiary to remit a cash dividend to the Company during the second quarter of 1992. U.S. income taxes of $486,000 were provided on the remittance. RELIABILITY INCORPORATED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued) December 31, 1993 The significant components of the Company's net deferred tax liabilities and assets are as follows: 1993 1992 ---- ---- (In thousands) Deferred tax liabilities: Depreciation $ 103 $ 96 Domestic international sales corp. dividend 21 42 Other - 15 ----- ------ Total deferred tax liabilities 124 153 ----- ------ Deferred tax assets: Reserves not currently deductible (416) (559) Foreign tax credits (490) (531) Net operating loss carryforwards (255) (370) Business tax credits (253) (253) Provision for restructuring - (98) Other (21) (18) ----- ------ Total deferred tax assets (1,435) (1,829) Valuation allowance 1,435 1,769 ----- ------ Net deferred tax assets - (60) ----- ------ Net deferred tax liability $ 124 $ 93 ===== ====== SFAS 109 requires that the tax benefit of net operating losses, temporary differences and credit carryforwards be recorded as an asset to the extent that management assesses that realization is more likely than not. Realization of the future tax benefits is dependent on the Company's ability to generate sufficient taxable income within the carryforward period. Because of the Company's history of operating losses, management believes that recognition of the deferred tax assets arising from the above- mentioned future tax benefits is currently not appropriate and, accordingly, has provided a valuation allowance. The Company completed a restructuring of its foreign operations in 1993. As part of the restructuring the Company changed its policy and began providing United States taxes on unremitted foreign earnings. Earnings on which United States taxes have been provided total $1,700,000 at December 31, 1993. Net income for 1992 included income of a subsidiary operating in Costa Rica under an export processing tax exemption. The subsidiary is exempt from Costa Rica income tax through 1998 and is 50% exempted from 1999 through 2002. Except for 1992, the subsidiary has operated at a loss. A 1992 tax benefit of $19,000 related to income of the subsidiary. Net cash payments (refunds) for income taxes during 1993, 1992 and 1991 were $54,000, $100,000 and $(606,000), respectively. RELIABILITY INCORPORATED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued) December 31, 1993 At December 31, 1993, the Company had a domestic net operating loss carryforward for financial reporting purposes of approximately $2,170,000. Such carryforward for income tax purposes is $750,000 and will expire in 2007 and 2008. The net operating loss carryforward for alternative minimum tax purposes is $640,000. In addition, the Company has alternative minimum tax credit carryforwards of $73,000, which can be carried forward indefinitely, and research and development and foreign tax credit carryforwards of $743,000, expiring in various years from 1994 through 2007. 6. PROVISION FOR RESTRUCTURING The Company recorded in 1993 a provision for restructuring totaling $288,000. The provision is composed of $319,000 related to retirement and severance pay for U.S. employees who were terminated in March 1993 and a $31,000 reduction of the 1992 restructuring provision related to downsizing production capacity for power sources in Singapore. The Company recorded restructuring charges of $1,392,000 and $1,000,000 in 1992 and 1991, respectively. The 1991 charge related to costs associated with the closure of the Company's power sources facility located in Ireland. The Company completed the shut-down in 1992. The provision for shut-down was reduced by $149,000 in 1992. The 1992 amount represents a $1,000,000 provision for curtailment of operations of the Company's Japanese subsidiary, and a charge of $541,000, reduced by a $149,000 credit applicable to Irish closure, related to downsizing of the Company's UK marketing operation, downsizing production capacity for power sources in Singapore and shifting production to Costa Rica. The charge is related principally to the remaining lease obligations and associated costs at the two facilities, severance liabilities and write off of fixed assets. The provision for curtailment of operations of the Japanese subsidiary relates to estimated losses on disposal of certain assets, severance pay, estimated expenses to be incurred in curtailing operations and settling lease obligations related to the subsidiary's facility. 7. COMMITMENTS The Company leases manufacturing and office facilities under noncancelable operating lease agreements, expiring through 1998. Rental expense for 1993, 1992 and 1991 was $1,234,000, $1,627,000 and $1,636,000, respectively. Future minimum rental payments under leases in effect at December 31, 1993 are: 1994 - $1,166,000; 1995 - $654,000; 1996 - $420,000; 1997 - $297,000; 1998 - $18,000; subsequent to 1998 - None. The Company entered into an agreement in August 1993 to sub-lease manufacturing and office space in its U.S. facility. Rental income for 1993 was $41,000. Future income under the sub-lease will be: 1994 - $108,000; and 1995 - $38,000. RELIABILITY INCORPORATED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued) December 31, 1993 8. ACCRUED LIABILITIES Accrued liabilities consist of the following: 1993 1992 ---- ---- (In thousands) Payroll $ 950 $1,091 Advanced payments 341 845 Warranty 453 291 Other 272 724 ----- ----- $2,016 $2,951 ===== ===== The advanced payments balance at December 31, 1993 relates principally to payments for conditioning products which are included in the Company's backlog at December 31, 1993. Advanced payments are refundable if the Company does not meet the terms of the orders. Revenues related to advanced payments are recognized when the products are shipped. 9. RELATED PARTY TRANSACTIONS The husband of an employee of the Company has an ownership interest in a company that provides computer software development and technical assistance for certain products sold by the Company. The net expense accrued related to these transactions, including royalties, amounted to $454,000, $964,000 and $417,000 during 1993, 1992 and 1991, respectively. The amounts payable to such Company were $1,000 and $117,000 at December 31, 1993 and 1992, respectively, and the accounts are settled in the ordinary course of business. RELIABILITY INCORPORATED SUPPLEMENTARY FINANCIAL INFORMATION QUARTERLY RESULTS OF OPERATIONS (Unaudited) (In thousands, except per share data) First Second Third Fourth Quarter Quarter Quarter Quarter ------- ------- ------- ------- ---- Net sales $ 6,752 $ 6,540 $ 7,239 $ 6,491 Gross profit 2,585 2,672 3,417 2,943 Net income (loss) (545)(1) 848 1,198 868(2) Net income (loss) per share (.13) .20 .28 .21 1992(3) ---- Net sales $ 6,520 $10,351 $ 8,453 $ 6,089 Gross profit 2,764 4,856 3,616 2,042 Net income (loss) (906)(4) 777 160 (2,676)(5) Net income (loss) per share (.21) .18 .04 (.63) - ---- (1) The net loss for the first quarter of 1993 includes a $319,000 provision for restructuring of U.S. operations. (2) The net income for the fourth quarter of 1993 is increased by a $31,000 reduction in cost associated with restructuring of operations in Asia. (3) The net income (loss) and net income (loss) per share for the second, third and fourth quarters of 1992 originally presented the tax benefit of a net operating loss carryforward as an extraordinary item. The tax benefit of the net operating loss carryforward has been netted against the income tax provision. See Note 5 to Consolidated Financial Statements. (4) The net loss for the first quarter of 1992 is reduced by a $120,000 decrease in a provision for restructuring of operations that was recorded in 1991. (5) The net loss for the fourth quarter of 1992 includes a $1,529,000 provision for restructuring of operations in Europe and Asia. S-1 RELIABILITY INCORPORATED SCHEDULE V - PROPERTY, PLANT AND EQUIPMENT Years Ended December 31, 1993, 1992 and 1991 (In thousands) Building Machinery and and Land Improvements Equipment Total ---- ------------ --------- ----- ---- Balance at beginning of year $ - $2,588 $12,884 $15,472 Additions - 43 449 492 Retirements - (88) (1,339) (1,427) --- ----- ------ ------ Balance at end of year $ - $2,543 $11,994 $14,537 === ===== ====== ====== ---- Balance at beginning of year $ - $2,613 $12,230 $14,843 Additions - 52 1,384 1,436 Retirements - (77) (730) (807) --- ----- ------ ------ Balance at end of year $ - $2,588 $12,884 $15,472 === ===== ====== ====== ---- Balance at beginning of year $ 5 $2,977 $12,661 $15,643 Additions - 88 601 689 Retirements (5) (452) (1,032) (1,489) --- ----- ------ ------ Balance at end of year $ - $2,613 $12,230 $14,843 === ===== ====== ====== S-2 RELIABILITY INCORPORATED SCHEDULE VI - ACCUMULATED DEPRECIATION OF PROPERTY, PLANT AND EQUIPMENT Years Ended December 31, 1993, 1992 and 1991 (In thousands) Building Machinery and and Improvements Equipment Total ------------ --------- ----- ---- Balance at beginning of year $1,768 $10,392 $12,160 Additions 267 942 1,209 Retirements (54) (1,035) (1,089) ----- ------ ------ Balance at end of year $1,981 $10,299 $12,280 ===== ====== ====== ---- Balance at beginning of year $1,557 $ 9,528 $11,085 Additions 284 1,441 1,725 Retirements (73) (577) (650) ----- ------ ------ Balance at end of year $1,768 $10,392 $12,160 ===== ====== ====== ---- Balance at beginning of year $1,458 $ 8,375 $ 9,833 Additions 291 2,047 2,338 Retirements (192) (894) (1,086) ----- ------ ------ Balance at end of year $1,557 $ 9,528 $11,085 ===== ====== ====== S-3 RELIABILITY INCORPORATED SCHEDULE VIII - VALUATION AND QUALIFYING ACCOUNTS AND RESERVES Years Ended December 31, 1993, 1992 and 1991 (In thousands) 1993 1992 1991 ---- ---- ---- Inventory reserves at beginning of year $1,092 $ 753 $1,034 Additions charged to costs and expenses 262 636 347 Amounts charged to reserve (751) (297) (628) ----- ----- ----- Inventory reserves at end of year $ 603 $1,092 $ 753 ===== ===== ===== S-4 RELIABILITY INCORPORATED SCHEDULE X - SUPPLEMENTARY INCOME STATEMENT INFORMATION Years Ended December 31, 1993, 1992 and 1991 (In thousands) 1993 1992 1991 ---- ---- ---- Maintenance and repairs $413 $523 $517 Taxes other than payroll and income taxes $311 $431 $506 Royalties $291 $300 $ - S-6 RELIABILITY INCORPORATED Item 9.

Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure. Not applicable. PART III In accordance with paragraph (3) of General Instruction G to Form 10-K, Part III of this Report is omitted because the Company will file with the Securities and Exchange Commission not later than 120 days after the end of 1993 a definitive proxy statement pursuant to Regulation 14A involving the election of directors. PART IV Item 14. Exhibits, Financial Statement Schedules and Reports on Form 8-K. (a) The following financial statements are filed as part of this report: 1. Consolidated Financial Statements and Supplementary Data. Listed in the Index to Financial Statements provided in response to Item 8 hereof (see p. for Index). 2. Financial Statement Schedules. Listed in the Index to Financial Statements provided in response to Item 8 hereof (see p. for Index). (b) The following exhibits are filed as part of this report: 3.1 Restated Articles of Incorporation (with amendment). Reference is made to Exhibit 3.1 to the Company's Registration Statement on Form S-1, Registration No. 2- 90034. 3.2 Restated and Amended Bylaws. Reference is made to Exhibit 3 to the Company's Quarterly Report on Form 10- Q for the quarter ended June 30, 1990. 3.3 Amendment to Bylaws. Reference is made to Exhibit 3 to the Company's Quarterly Report on Form 10-Q for the quarter ended March 31, 1993. 4. Capital and Surplus Retention Agreement. Reference is made to Exhibit 4 to the Company's report on Form 10-Q for the quarter ended September 30, 1993. 22. List of subsidiaries. 24. Consent of Independent Public Accountants dated March 18, 1994. (c) No reports on Form 8-K were required to be filed by the Company during the last quarter of the fiscal year covered by this report. RELIABILITY INCORPORATED SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Company has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. RELIABILITY INCORPORATED (Registrant) DATE: March 21, 1994 BY/s/Max T. Langley, Senior Vice President Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Company and in the capacities and on the dates indicated. BY/s/Larry Edwards, President and DATE: March 21, 1994 Chief Executive Officer BY/s/Max T. Langley, Senior Vice President, DATE: March 21, 1994 Chief Financial Officer, Principal Accounting Officer Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Company and in the capacities and on the dates indicated. BY/s/W. L. Hampton, Director DATE: March 21, 1994 BY/s/Everett Hanlon, Director DATE: March 21, 1994 BY/s/John R. Howard, Director DATE: March 21, 1994 BY/s/Thomas L. Langford, Director DATE: March 21, 1994 BY/s/A. C. Lederer, Jr., Director DATE: March 21, 1994 RELIABILITY INCORPORATED INDEX TO EXHIBITS Exhibit Page Number Description of Exhibits Number - ------- ----------------------- ------ 3.1 Restated Articles of Incorporation (with amendment). Reference is made to Exhibit 3.1 to the Company's Registration Statement on Form S-1, Registration No. 2-90034. 3.2 Restated and Amended Bylaws. Reference is made to Exhibit 3 to the Company's Quarterly Report on Form 10-Q for the quarter ended June 30, 1990. 3.3 Amendment to Bylaws. Reference is made to Exhibit 3 to the Company's Quarterly Report on Form 10-Q for the quarter ended March 31, 1993. 4. Capital and Surplus Retention Agreement. Reference is made to Exhibit 4 to the Company's report on Form 10-Q for the quarter ended September 30, 1993. 22. List of Subsidiaries. Page 24 24. Consent of Independent Public Accountants Page 25 dated March 18, 1994. RELIABILITY INCORPORATED Exhibit 22 LIST OF SUBSIDIARIES Subsidiary Jurisdiction of Incorporation ---------- ----------------------------- Reliability Singapore Pte Ltd. Singapore Reliability Japan Incorporated (1) Japan RICR de Costa Rica, S.A. Costa Rica Each subsidiary does business under its respective corporate name. (1) Inactive as of December 31, 1993 RELIABILITY INCORPORATED Exhibit 24 CONSENT OF INDEPENDENT PUBLIC ACCOUNTANTS We consent to the incorporation by reference in the Registration Statement (Form S-8 No. 33-47803) pertaining to the Reliability Incorporated Employee Stock Savings Plan and Trust and in the related Prospectus of our report dated February 11, 1994, with respect to the consolidated financial statements and schedules of Reliability Incorporated included in this Annual Report (Form 10-K) for the year ended December 31, 1993. BY/s/ERNST & YOUNG Houston, Texas March 18, 1994

Item 14. Exhibits, Financial Statement Schedules and Reports on Form 8-K. (a) The following financial statements are filed as part of this report: 1. Consolidated Financial Statements and Supplementary Data. Listed in the Index to Financial Statements provided in response to Item 8 hereof (see p. for Index). 2. Financial Statement Schedules. Listed in the Index to Financial Statements provided in response to Item 8 hereof (see p. for Index). (b) The following exhibits are filed as part of this report: 3.1 Restated Articles of Incorporation (with amendment). Reference is made to Exhibit 3.1 to the Company's Registration Statement on Form S-1, Registration No. 2- 90034. 3.2 Restated and Amended Bylaws. Reference is made to Exhibit 3 to the Company's Quarterly Report on Form 10- Q for the quarter ended June 30, 1990. 3.3 Amendment to Bylaws. Reference is made to Exhibit 3 to the Company's Quarterly Report on Form 10-Q for the quarter ended March 31, 1993. 4. Capital and Surplus Retention Agreement. Reference is made to Exhibit 4 to the Company's report on Form 10-Q for the quarter ended September 30, 1993. 22. List of subsidiaries. 24. Consent of Independent Public Accountants dated March 18, 1994. (c) No reports on Form 8-K were required to be filed by the Company during the last quarter of the fiscal year covered by this report. RELIABILITY INCORPORATED SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Company has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. RELIABILITY INCORPORATED (Registrant) DATE: March 21, 1994 BY/s/Max T. Langley, Senior Vice President Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Company and in the capacities and on the dates indicated. BY/s/Larry Edwards, President and DATE: March 21, 1994 Chief Executive Officer BY/s/Max T. Langley, Senior Vice President, DATE: March 21, 1994 Chief Financial Officer, Principal Accounting Officer Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Company and in the capacities and on the dates indicated. BY/s/W. L. Hampton, Director DATE: March 21, 1994 BY/s/Everett Hanlon, Director DATE: March 21, 1994 BY/s/John R. Howard, Director DATE: March 21, 1994 BY/s/Thomas L. Langford, Director DATE: March 21, 1994 BY/s/A. C. Lederer, Jr., Director DATE: March 21, 1994 RELIABILITY INCORPORATED INDEX TO EXHIBITS Exhibit Page Number Description of Exhibits Number - ------- ----------------------- ------ 3.1 Restated Articles of Incorporation (with amendment). Reference is made to Exhibit 3.1 to the Company's Registration Statement on Form S-1, Registration No. 2-90034. 3.2 Restated and Amended Bylaws. Reference is made to Exhibit 3 to the Company's Quarterly Report on Form 10-Q for the quarter ended June 30, 1990. 3.3 Amendment to Bylaws. Reference is made to Exhibit 3 to the Company's Quarterly Report on Form 10-Q for the quarter ended March 31, 1993. 4. Capital and Surplus Retention Agreement. Reference is made to Exhibit 4 to the Company's report on Form 10-Q for the quarter ended September 30, 1993. 22. List of Subsidiaries. Page 24 24. Consent of Independent Public Accountants Page 25 dated March 18, 1994. RELIABILITY INCORPORATED Exhibit 22 LIST OF SUBSIDIARIES Subsidiary Jurisdiction of Incorporation ---------- ----------------------------- Reliability Singapore Pte Ltd. Singapore Reliability Japan Incorporated (1) Japan RICR de Costa Rica, S.A. Costa Rica Each subsidiary does business under its respective corporate name. (1) Inactive as of December 31, 1993 RELIABILITY INCORPORATED Exhibit 24 CONSENT OF INDEPENDENT PUBLIC ACCOUNTANTS We consent to the incorporation by reference in the Registration Statement (Form S-8 No. 33-47803) pertaining to the Reliability Incorporated Employee Stock Savings Plan and Trust and in the related Prospectus of our report dated February 11, 1994, with respect to the consolidated financial statements and schedules of Reliability Incorporated included in this Annual Report (Form 10-K) for the year ended December 31, 1993. BY/s/ERNST & YOUNG Houston, Texas March 18, 1994

4310_1993.txt

4310

1993

ITEM 1. BUSINESS ALZA Corporation ("ALZA") was incorporated under the laws of the state of California on June 11, 1968, and changed its legal domicile from California to Delaware in 1987. On February 7, 1992, ALZA acquired all outstanding shares of Bio-Electro Systems, Inc. ("BES") in a merger; ALZA was the surviving corporation. ALZA's mailing address is 950 Page Mill Road, P.O. Box 10950, Palo Alto, CA 94303-0802. ALZA develops a broad range of pharmaceutical products based on ALZA's proprietary therapeutic systems technologies. ALZA's therapeutic systems are designed to provide controlled, predetermined rates of drug release for extended time periods. By administering drugs in preset patterns, ALZA's products can increase both the medical and the economic value of drugs, by minimizing their unpleasant or harmful side effects while optimizing their beneficial actions. In addition, ALZA's therapeutic systems can simplify drug therapy and increase patient compliance by decreasing the frequency with which medication must be administered. Among the ALZA-developed products commercialized to date by client companies are Procardia XL (registered trademark) for the treatment of angina and hypertension, Transderm-Nitro (registered trademark) for the prevention and treatment of angina, Nicoderm (registered trademark), an aid in smoking cessation, and Duragesic (registered trademark) for the management of chronic pain. In addition, more than 60 products based on ALZA's therapeutic systems are in various stages of development and clinical evaluation, a number of which are awaiting marketing approval in the United States and other countries. During 1993, ALZA continued to apply its broad-based drug delivery technologies to the development of new pharmaceutical products incorporating many of the important drugs available today, as well as new molecular entities. Most of ALZA's product development activities have been undertaken pursuant to joint development and commercialization agreements, including agreements with many of the world's largest pharmaceutical companies. These agreements normally provide for the pharmaceutical company client to reimburse ALZA for costs incurred in product development and clinical evaluation. The client receives marketing rights to the product, and ALZA receives payments based on the client's sales of the product. In some cases ALZA manufactures all or a portion of the client's requirements of the product; in other cases the client manufactures the product. In June 1993, ALZA distributed a special dividend of "Units" to ALZA stockholders. Each Unit consisted of one share of Class A Common Stock of Therapeutic Discovery Corporation ("TDC") and one warrant to purchase one-eighth of one share of ALZA Common Stock. TDC was formed for the purpose of selecting and developing new human pharmaceutical products combining ALZA's proprietary drug delivery technologies with drug compounds, and commercializing such products, most likely through licensing to ALZA. TDC was funded with $250 million in cash contributed by ALZA. TDC and ALZA have entered into a research and development contract for the selection and development of such products. ALZA has the option to license each product developed by TDC, and to purchase all of the outstanding shares of TDC Class A Common Stock, at a purchase price based on a predetermined formula. The formation of TDC, and the development of products with TDC, are intended to result in a potential pipeline of products for marketing by ALZA. Over the last several years, ALZA has expanded its manufacturing capacity. ALZA is also in the process of expanding its marketing activities. ALZA expects its marketing activities to increase in the future as a result of the marketing and co-promotion rights ALZA has retained under certain product development and other agreements, and as a result of ALZA's arrangements with TDC. ALZA has announced that ALZA Pharmaceuticals will commence marketing the Testoderm (registered trademark) testosterone transdermal system in April 1994. In late March 1994, ALZA announced that the Actisite (registered trademark) (tetracycline HCl) Periodontal Fiber had been cleared for marketing in the United States, where it will be marketed by a partnership of ALZA and the Procter & Gamble Company. TECHNOLOGIES AND PRODUCTS TRANSDERMAL SYSTEMS. ALZA's transdermal therapeutic systems provide for the controlled delivery of drugs directly into the bloodstream through intact skin. Transdermal systems are well-suited for the delivery of potent drugs that are poorly absorbed and/or extensively metabolized when administered orally. ALZA's transdermal products are thin multilayer systems, in the form of small adhesive patches, that combine a drug reservoir with a polymer membrane or other mechanism for the control of drug release to the surface of intact skin, and hence into the bloodstream. The transdermal products developed by ALZA and presently marketed in the United States and other countries include: - TRANSDERM SCOP (REGISTERED TRADEMARK) (scopolamine) - Applied once every three days to prevent motion sickness. - TRANSDERM-NITRO (nitroglycerin) - Applied once a day for the prevention and treatment of angina pectoris. - CATAPRES-TTS (REGISTERED TRADEMARK) (clonidine) - Applied once a week for the treatment of high blood pressure. - DURAGESIC (fentanyl) - Applied once every three days for the management of chronic pain in patients requiring opioid analgesia. - NICODERM (nicotine) - Applied once a day to aid in smoking cessation. A number of additional transdermal products are in various stages of development and clinical testing. The Testoderm product, which is applied once a day for testosterone replacement in hypogonadal males, will be introduced by ALZA Pharmaceuticals in the United States in April 1994. The product was developed by ALZA on behalf of ALZA TTS Research Partners Ltd., a limited partnership, which will receive royalties from ALZA based on sales of the product. ALZA plans to market the product outside the United States through distributors. OSMOTIC SYSTEMS. ALZA's OROS (registered trademark) therapeutic systems deliver compounds to the gastrointestinal tract at predetermined controlled rates. These systems resemble conventional tablets or capsules in appearance, but use osmosis to provide pre-programmed, controlled drug delivery. An OROS system is comprised of a polymer membrane with one or more laser-drilled holes surrounding a core containing the drug or drugs, with or without osmotic or other agents. Water from the gastrointestinal tract diffuses through the membrane at a controlled rate into the drug core, causing the drug to be released in solution or suspension at a predetermined controlled rate out of the laser-drilled hole(s). OROS systems are well suited for delivering drug compounds throughout the gastrointestinal tract in programmed delivery for local treatment or systemic absorption. The OROS products developed by ALZA and presently marketed in the United States and other countries include: - PROCARDIA XL/ADALAT OROS (REGISTERED TRADEMARK) - A once a day formulation of the calcium channel blocker nifedipine for the treatment of both angina and hypertension. - MINIPRESS XL (REGISTERED TRADEMARK)/ALPRESS LP (REGISTERED TRADEMARK) - A once a day formulation of prazosin for the treatment of hypertension (marketed in France and approved for marketing in the United States). - VOLMAX (REGISTERED TRADEMARK) - A twice daily dosage form of albuterol for the treatment of asthma. - EFIDAC/24 (REGISTERED TRADEMARK) - The first over-the-counter once a day nasal decongestant product, introduced in the United States in the second half of 1993. Two additional OROS products have received "approvable" letters from the FDA, and a number of OROS products are in various stages of development and testing or are awaiting regulatory approval. In addition to the OROS systems described above, ALZA is currently utilizing other osmotic technologies in the development of products. These technologies include: - CHRONSET (REGISTERED TRADEMARK). ALZA's Chronset therapeutic system, currently in development for oral delivery of proteins and peptides, provides for a predetermined delay in the release of active compounds from an orally administered capsule. - MUCOSAL ORAL THERAPEUTIC SYSTEMS. ALZA's Mucosal Oral Therapeutic System (MOTS) is designed to provide controlled delivery of drugs to the oral cavity for either local or systemic therapy and is designed to be retained in the mouth for the duration of administration. - PUSH-PILL SYSTEMS. ALZA's push-pill systems are designed to deliver large quantities of insoluble drugs on a once-a-day basis, either at a constant rate, or in a programmed drug release profile for delayed, patterned or pulsatile release. - HUMAN IMPLANTABLE THERAPEUTIC SYSTEMS. ALZA's Human Implantable Therapeutic Systems (HITS) are designed to deliver low molecular weight compounds by diffusion, and low to high molecular weight, water labile compounds by osmosis. ACTISITE (TETRACYCLINE HCL) PERIODONTAL FIBER. The Actisite (tetracycline HCl) periodontal fiber utilizes ALZA's proprietary diffusional technology and was developed jointly with On-Site Therapeutics, Inc. The thread-like polymeric fibers are designed to treat periodontal disease by providing rate-controlled delivery of tetracycline for ten days after placement in the periodontal pocket by a dental practitioner. In late March 1994, ALZA announced that the product had been cleared for marketing in the United States, where it will be marketed by a partnership of ALZA and Procter & Gamble. ALZA has the rights to market the Actisite product in most countries outside of the United States, and the product has been approved in France, Italy, Luxembourg, the United Kingdom, Germany, Denmark, Sweden and Belgium. ALZA is marketing the product in Italy through a distributor and is in the process of arranging for distributors to market the product in other European countries. The product is manufactured by ALZA. BAXTER (REGISTERED TRADEMARK) INFUSOR. The Baxter (registered trademark) Infusor is a lightweight, disposable device for intravenous therapy which resulted from a joint development arrangement between ALZA and Baxter International Inc. ("Baxter"). The product is manufactured and marketed by Baxter in the United States, Europe and Asia for the delivery of chemotherapeutic agents and analgesics. Baxter also markets a light-weight patient controlled analgesic unit in combination with the Baxter Infusor. OTHER ALZA PRODUCTS. ALZA has three products developed in its earlier years which are marketed directly by ALZA in the United States, and in other countries under distribution agreements with third parties. Those products are: - OCUSERT (REGISTERED TRADEMARK) - ALZA'S OCUSERT (PILOCARPINE) Pilo-20 and Pilo-40 ocular therapeutic systems for the treatment of glaucoma. - PROGESTASERT (REGISTERED TRADEMARK) - The Progestasert (progesterone) intrauterine contraceptive device provides a contraceptive effect for one year by releasing the natural hormone progesterone. - ALZET (REGISTERED TRADEMARK) - Alzet mini-osmotic pumps are transplantable, capsule-shaped units that can deliver solutions containing a wide range of agents in laboratory animals at controlled rates for up to four weeks. ELECTROTRANSPORT. Electrotransport systems transport drugs across intact skin through the use of an electrical potential gradient. ALZA's electrotransport therapeutic systems ("ETS") are thin, flexible devices similar in size and appearance to ALZA's transdermal systems. ETS consist of an adhesive, a drug reservoir, electrodes and a power source/controller. The systems are designed for the delivery of large molecules (including proteins and peptides) and potent drugs that are poorly absorbed or extensively metabolized in the gastrointestinal tract. ALZA has several products utilizing this technology under development with client companies, including an ETS-fentanyl product with Janssen Pharmaceutica. OTHER TECHNOLOGIES. ALZA has a number of other technologies in various stages of development, including: - INTRAVENOUS THERAPY. Pursuant to a licensing agreement with ALZA, Baxter has developed a MainStream (trademark) in-line drug delivery system for the intravenous delivery of drugs. Baxter is now in the process of preparing and filing Abbreviated New Drug Applications for various drugs to be incorporated in the MainStream system. ALZA's IVOS (registered trademark) system is designed to incorporate the solid dosage form of the drug into an intravenous system and to provide extended duration controlled delivery of the drug, without the need to premix or reformulate drugs prior to use. ALZA has licensed its IVOS technology on a worldwide basis to a major health care concern for final product development and future manufacturing and marketing. - BIOERODIBLE POLYMERS. ALZA has under development therapeutic systems based on bioerodible polymers. After placement in the body, the polymer platform erodes and is absorbed. These polymers can be used for the controlled delivery of therapeutic agents that are physically mixed within the polymer matrix by the process of polymer erosion, dissolution or diffusion through the polymer matrix, pore formation in the matrix, or a combination of these mechanisms. - VETERINARY PRODUCTS. ALZA has under development for client companies a number of veterinary products based on its various technologies. These technologies include ruminal bolus osmotic systems, implantable osmotic systems and various site-specific systems that provide either constant or pulsatile drug delivery. Ivomec-SR (registered trademark), a product combining Merck & Co., Inc.'s antiparasitic agent ivermectin with ALZA's ruminal bolus technology to control internal and external parasites in cattle on pasture for an entire grazing season following a single administration, has been introduced by Merck in the United Kingdom. Regulatory applications for approval to market the product in the United States and other countries are on file. Other veterinary products under development include systems for the administration of an estrus suppressing agent, and, under an agreement with Monsanto, growth hormones for cattle and other food producing animals. THERAPEUTIC DISCOVERY CORPORATION On June 11, 1993, ALZA completed the distribution of a special dividend of "Units" to ALZA stockholders. Each Unit consists of one share of TDC Class A Common Stock and one warrant to purchase one-eighth of one share of ALZA Common Stock. Holders of record of ALZA Common Stock received one Unit for every 10 shares of ALZA Common Stock owned on May 28, 1993, with cash distributed in lieu of fractional Units. The Units trade on the Nasdaq Stock Market (under the trading symbol TDCAZ), and will trade only as Units until the earlier of June 11, 1996 or the date on which ALZA exercises the Purchase Option (as defined below) (the "Separation Date"), at which time the warrants and TDC Class A Common Stock will trade separately. The warrants will be exercisable at a per-share exercise price of $65 at any time after the Separation Date and will expire, if not previously exercised, on December 31, 1999. In connection with the dividend, ALZA contributed $250 million in cash to TDC. TDC was formed for the purpose of selecting and developing new human pharmaceutical products combining ALZA's proprietary drug delivery technology with various drug compounds, and commercializing such products, most likely through licensing to ALZA. ALZA and TDC have entered into a development agreement (the "Development Contract") pursuant to which ALZA conducts research and development activities on behalf of TDC. ALZA has granted to TDC a royalty-free, nonexclusive, perpetual license to use ALZA's proprietary drug delivery technology to develop and commercialize specified TDC products. ALZA has an option to license any products developed by TDC, on a product-by-product basis, providing ALZA with access to a potential pipeline of products for worldwide commercialization. If ALZA exercises its license option for any product, ALZA will make royalty payments to TDC with respect to such product if the product is sold by ALZA (up to a maximum of 5% of ALZA's net sales) or, if the product is sold by a third party, sublicensing fees of up to 50% of ALZA's sublicensing revenues with respect to the product. ALZA has an option, exercisable on a product-by-product basis, to buy out its royalty obligation to TDC by making a one-time payment that is a multiple of royalties and sublicensing fees paid in specified periods. ALZA also has an option to purchase, according to a predetermined formula, all (but not less than all) of the outstanding shares of TDC Class A Common Stock (the "Purchase Option"). The Purchase Option is exercisable at any time until December 31, 1999 (or later under certain circumstances). However, the Purchase Option will expire, in any event, on the 60th day after TDC files with the Securities and Exchange Commission a Report on Form 10-K or Form 10-Q containing a balance sheet showing less than an aggregate of $5 million in cash, cash equivalents, short-term investments and long-term investments. If ALZA exercises the Purchase Option, the exercise price will be the greatest of: (a) the greater of (i) 25 times the worldwide royalties and sublicensing fees paid by ALZA to TDC during four specified calendar quarters or (ii) 100 times such royalties and sublicensing fees during a specified calendar quarter; in either case, less any amounts previously paid by ALZA to exercise a buy-out option with respect to any product; (b) the fair market value of one million shares of ALZA Common Stock; (c) $325 million less all amounts paid by TDC under the Development Contract; or (d) $100 million. The purchase price may be paid in cash, in ALZA Common Stock, or any combination of the two, at the election of ALZA. ALZA performs certain administrative services for TDC under an administrative services agreement which is terminable at the option of TDC, and for which ALZA is reimbursed its direct costs, plus certain overhead expenses. For the year ended December 31, 1993, reimbursement to ALZA under this agreement was approximately $120,000. BIO-ELECTRO SYSTEMS, INC. In February 1992, ALZA acquired all the outstanding shares of BES for $23 per share, paid in ALZA Common Stock. BES was formed in 1988 through a subscription offering to ALZA stockholders to develop drug delivery systems incorporating ALZA's proprietary electrotransport and bioerodible polymer drug delivery technologies. ALZA had an option to acquire all BES Class A Common Stock, which ALZA exercised on November 11, 1991. The acquisition was effected through a merger of BES into ALZA on February 7, 1992. In the merger, an aggregate of approximately 1.9 million ALZA shares were issued to BES stockholders in exchange for all outstanding BES shares, and ALZA assumed all BES liabilities. RESEARCH AND DEVELOPMENT ALZA had research revenues of $46.8 million during 1993, $39.1 million during 1992 and $41.7 million during 1991 from clients with which ALZA has joint research and product development agreements (including $4.9 million from TDC in 1993 and $14.7 million from BES in 1991). ALZA's research revenues represent the clients' reimbursement to ALZA of related costs, including an allocation of general and administrative expenses, and therefore do not contribute significantly to current income. ALZA spent $16.8 million on ALZA-sponsored research and development activities during 1993 ($18.3 million and $11.6 million in 1992 and 1991, respectively) and $36.4 million on client-sponsored research and development activities during 1993 ($33.8 million and $29.5 million in 1992 and 1991, respectively), excluding related reimbursable general and administrative costs. Research and development costs are expensed as incurred. MANUFACTURING ALZA manufactures some or all of the product requirements for certain client companies, including Nicoderm for Marion Merrell Dow, Duragesic for Janssen, Procardia XL and Minipress XL for Pfizer, Catapres-TTS for Boehringer Ingelheim, Transderm Scop and Efidac/24 for Ciba, and IVOMEC-SR for Merck. ALZA also manufactures its Progestasert, Alzet, Ocusert and Testoderm products. ALZA's 220,000 square foot commercial manufacturing facility is in Vacaville, California. Some of the materials used in manufacturing ALZA-developed products are unique and may be available only from one or a limited number of suppliers. ALZA attempts, where appropriate, to negotiate long-term supply arrangements for some of these materials. In December 1993, ALZA wrote off approximately $28.1 million related primarily to ALZA's manufacturing activities. This write-off resulted from both non-recurring expenses and allowances related to scale-up of the production of certain products and to excess transdermal manufacturing capacity and equipment resulting from ALZA's facilities expansion in Vacaville, California. The facilities expansion was followed by lower than anticipated Nicoderm production requirements reflecting the decline in Nicoderm sales in 1993. A portion of the write-off also related to the Duragesic product. In late 1993, ALZA learned that certain 25 microgram and 50 microgram Duragesic systems manufactured by ALZA may release fentanyl at a somewhat higher rate than the designated dose. For a short period, only limited quantities of the product were available on a "compassionate need" basis from Janssen Pharmaceuticals. The $28.1 million write-off included $10.1 million of inventory write-downs, $6.8 million of equipment write-offs, $4.6 million of allowances reducing sales and receivables, and $6.6 million of anticipated future cash outlays related to contractual product supply issues. The effect of the write-off was to increase costs of products shipped by approximately $22.0 million and reduce net sales by $6.1 million for the year ended December 31, 1993. GOVERNMENTAL REGULATION Under the United States Food, Drug, and Cosmetic Act, "new drugs" must obtain approval from the FDA before they lawfully can be marketed in the United States. Applications for approval must be based on extensive clinical and other testing, the cost of which is very substantial. The packaging and labeling of all new drug products are also subject to FDA regulation. Approvals are required from health regulatory authorities in foreign countries before marketing of pharmaceutical products may commence in those countries. Requirements for approval may differ from country to country, and can involve additional testing. There can be substantial delays in obtaining required approvals from both the FDA and foreign regulatory authorities after applications are filed. Even after approvals are obtained, further delays may be encountered before the products become commercially available. Veterinary products are subject to similar, although in some cases less extensive, approval procedures. All facilities and manufacturing techniques used for the manufacture of products for clinical use or for sale must conform with "Good Manufacturing Practices," the FDA regulations governing the production of pharmaceutical products. From time to time, the FDA and other federal, state and local government agencies may adopt regulations that affect the manufacturing and marketing of ALZA-developed products. Environmental regulations may also affect the manufacturing process. As a pharmaceutical company, ALZA uses in its business chemicals and materials which may be classified from time to time as hazardous or toxic materials and which require special handling and disposal. In addition, ALZA undertakes to minimize releases to the environment and exposure of its employees and the public to such materials, and the costs of these activities have increased substantially in recent years. While the cost of compliance, prevention and clean-up have not been material to date, it is possible that such costs may increase significantly in the future. See "Legal Proceedings" below. PATENTS AND PATENT APPLICATIONS As of December 31, 1993, ALZA owned more than 500 United States patents and more than 150 pending United States patent applications relating to its products and other technologies. ALZA has in excess of 2,000 foreign patents and pending patent applications covering its various technologies and products. Patents have been issued, or are expected to be issued, covering ALZA's current technologies and products, as well as products under development. Patent protection generally has been important in the pharmaceutical industry. ALZA believes that its current patents, and patents that may be obtained in the future, are important to future operations. There can be no assurance that ALZA's currently existing patents will cover future products, that additional patents will be issued, or that any patents now or hereafter issued will be of commercial benefit. In the United States, patents generally are granted for a period of seventeen years. Some of ALZA's earlier patents covering various aspects of certain OROS and TTS dosage forms have begun to expire, or will expire, over the next several years; however, ALZA technologies and products are generally covered by multiple patents. Although a patent has a statutory presumption of validity in the United States, the issuance of a patent is not conclusive as to such validity or as to the enforceable scope of the claims of the patent. There can be no assurance that patents of ALZA will not be successfully challenged in the future. The validity or enforceability of a patent after its issuance by the patent office can be challenged in litigation. If the outcome of the litigation is adverse to the owner of the patent, third parties may then be able to use the invention covered by the patent, in some cases without payment. There can be no assurance that ALZA patents will not be infringed or successfully avoided through design innovation. It is also possible that third parties may obtain patent or other proprietary rights that may be necessary or useful to ALZA. In cases where third parties are first to invent a particular product or technology, it is possible that those parties will obtain patents that will be sufficiently broad so as to prevent ALZA from using certain technology or from further developing or commercializing certain products. If licenses from third parties are necessary but cannot be obtained, commercialization of the related products would be delayed or prevented. As ALZA expands its direct marketing of products, ALZA may choose to license-in compounds or technologies for use in those products. In addition, ALZA utilizes significant unpatented proprietary technology, and there can be no assurance that others will not develop similar technology. For a description of certain legal proceedings relating to patents, see "Legal Proceedings" below. COMPETITION All of ALZA's current and future products will face competition both from more traditional forms of drug delivery and from advanced delivery systems being developed by others. This competition potentially includes all of the pharmaceutical companies in the world, including current ALZA clients. Many of these other pharmaceutical companies have greater financial resources, technical staff and manufacturing and marketing capabilities than does ALZA. A number of smaller companies also are developing drug delivery technologies. Competition in drug delivery systems is generally based on performance characteristics and price. Acceptance by hospitals, physicians and patients is crucial to the success of a product. Health care reimbursement policies of government agencies and insurers will continue to exert pressure on pricing, and various federal and state agencies have enacted regulations requiring rebates of a portion of the purchase price of many pharmaceutical products. Price competition may become increasingly important as a result of the federal government administration's stated intention to focus on the containment of health care costs. The health care industry has continued to change rapidly as the public, government, medical practitioners and the pharmaceutical industry focus on ways to expand medical coverage while controlling the growth in health care costs. Congress is working on comprehensive legislative changes which, if enacted, could significantly affect health care companies. The President of the United States has made this reform a top priority. The changes are expected to put pressures on the prices charged for pharmaceutical products. While ALZA believes the changing health care environment may increase the value of ALZA's drug delivery products over the long term, it is impossible to predict the impact any such legislative changes may have on ALZA. REVENUES In 1993, ALZA received royalty income from 12 products in the marketplace. Approximately 60% of ALZA's 1993 royalty income has been the result of sales of Procardia XL by Pfizer in the United States. Because the drug nifedipine incorporated in the Procardia XL (registered trademark) product is no longer covered by a patent, other companies may attempt to develop products similar to Procardia XL. To date no product has been introduced which is bio-equivalent to Procardia XL. If such a product were to be developed and introduced, its marketing could have a significant impact on Procardia XL sales, and therefore ALZA's royalties. Information as to ALZA's revenues is presented below: Pfizer accounted for 35% of ALZA's total revenues in 1993, 29% in 1992 and 27% in 1991; Ciba accounted for 13% of ALZA's total revenues in 1993, 10% in 1992 and 14% in 1991; and Marion Merrell Dow accounted for 10% of ALZA's total revenues in 1993, 26% in 1992 and 10% in 1991. The loss of these revenues would have a material adverse effect on ALZA's profitability. Research revenue from TDC during 1993 was approximately $4.9 million (2% of total revenues). BES accounted for 9% of ALZA's total revenues in 1991. INDUSTRY SEGMENTS; EXPORTS ALZA's business comprises one industry segment. Export sales were $18.1 million during 1993, $12.1 million during 1992 and $2.9 million in 1991, principally to distributors in Europe and client companies in Europe and Canada. EMPLOYEES On December 31, 1993, ALZA had 1,078 employees, of whom approximately 500 were engaged in research and product development activities, approximately 340 were engaged in manufacturing activities and the remainder were working in general, administrative and marketing areas. ITEM 2.

ITEM 2. PROPERTIES ALZA's corporate offices and its initial research and development campus are located in Palo Alto, California. During 1993, ALZA continued to develop its second research and development campus in Mountain View, California, and its commercial manufacturing facility in Vacaville, California. ALZA also occupies a small research facility in Spring Lake Park, Minnesota. ALZA believes that its facilities and equipment are sufficient to meet its current operating requirements. In addition, ALZA expects to continue to develop its Mountain View Campus and to purchase or lease available facilities or properties to support its long-term expansion, if and when they become available on acceptable terms. ITEM 3.

ITEM 3. LEGAL PROCEEDINGS In the ordinary course of business, various suits and claims are filed against ALZA. In the past, ALZA's liability claims (including product liability) have not been significant, and ALZA is not aware of any material asserted or unasserted claims pending against ALZA. ALZA is not involved in any legal proceedings which, in the opinion of the management, either alone or in the aggregate, will have a material adverse effect on ALZA's financial position or results of operations. Two patent infringement suits were filed in late 1991 against both Marion Merrell Dow and ALZA in connection with the commercialization of Nicoderm. One of the suits was filed by Elan Corporation in the United States District Court for the Northern District of California. In May 1992, this suit was withdrawn and, under the settlement, ALZA and Marion Merrell Dow agreed to withdraw their countersuit. The settlement had no impact on the financial statements of any of the parties. The other suit was filed in the United States District Court for the District of New Jersey by Ciba Corporation. Ciba's motion for preliminary injunction against the marketing of Nicoderm was denied in December 1991. The suit is in the discovery phase. During the second quarter of 1993, two securities class action lawsuits were filed against ALZA and certain of its officers and directors in the United States District Court for the Northern District of California. The lawsuits have been consolidated into one suit. The consolidated lawsuit claims that ALZA issued and allowed to be issued various public statements that were materially false and misleading, primarily with respect to the Nicoderm product. Under a recent court order, ALZA's outside directors are to be removed as defendants in the suit. ALZA believes that the lawsuit is without merit and is vigorously defending it. In July 1993, a derivative suit was filed against certain officers and all of the directors of ALZA in the United States District Court for the Northern District of California. The lawsuit claims that some or all of the named persons engaged in the mismanagement of the company and improperly obtained profits from the sale of ALZA securities. The suit has been assigned to the same judge as the consolidated case described above. Activities on the derivative suit have been stayed pursuant to a stipulation and a court order. ALZA believes that the lawsuit is without merit. ALZA has been named as a potentially responsible party ("PRP") in connection with the cleanup of certain waste disposal or "superfund" sites. One of these actions is the cleanup of the Hillview Porter site near ALZA's Palo Alto facilities. ALZA believes that it did not discharge any of the chemicals of concern at this site. Other actions in which ALZA has been named as a PRP involve the disposal of small quantities of waste at disposal sites which were later named as cleanup sites. ALZA does not believe that its liability in these matters, either individually or in the aggregate, will be material. However, because the actions involve many parties and multiple regulatory authorities, and the cleanup and allocation of financial responsibility can take many years, it is impossible to predict the timing or amount of ALZA's potential liability. Subsequent to year end, a suit was filed against ALZA by Cygnus Therapeutics Corporation in the United States District Court for the Northern District of California, seeking a declaration of unenforceability and invalidity of an ALZA patent relating to transdermal administration of fentanyl and alleging violation of antitrust laws. ALZA believes the suit to be without merit and has filed a motion to dismiss the suit. ITEM 4.

ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS None. EXECUTIVE OFFICERS OF THE REGISTRANT PART II ITEM 5.

ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS ALZA incorporates by reference the information concerning the market for its common stock and related stockholder matters set forth at page 38 in the Annual Report to Stockholders (the "Annual Report") attached as Exhibit 13. ITEM 6.

ITEM 6. SELECTED FINANCIAL DATA ALZA incorporates by reference the selected consolidated financial data set forth at page 37 in the Annual Report. ITEM 7.

ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS ALZA incorporates by reference Management's Discussion and Analysis of Financial Condition and Results of Operations set forth at pages 20 to 22 in the Annual Report. ITEM 8.

ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA ALZA incorporates by reference the Consolidated Financial Statements and notes thereto set forth at pages 23 to 35 and the Report of Independent Auditors at page 36 in the Annual Report. ITEM 9.

ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE Not applicable. PART III ITEM 10.

ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT ALZA incorporates by reference the information concerning its directors set forth under the heading "Election of Directors" on pages 1-4 in ALZA's definitive proxy statement dated March 14, 1994 for its Annual Meeting of Stockholders to be held on April 26, 1994 (the "Proxy Statement"). Information concerning ALZA's executive officers appears at the end of Part I of this report on pages 16 and 17. ITEM 11.

ITEM 11. EXECUTIVE COMPENSATION ALZA incorporates by reference the information ("Summary Compensation Table," "1993 Option Grants" and "1993 Aggregated Option Exercises and Fiscal Year-End Option Values") set forth under the heading "Executive Compensation" on pages 4 through 10 in the Proxy Statement. ITEM 12.

ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT ALZA incorporates by reference the information set forth under the heading "Beneficial Stock Ownership" on pages 11 and 12 in the Proxy Statement. ITEM 13.

ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS ALZA incorporates by reference the information set forth under the heading "Certain Transactions" on page 14 in the Proxy Statement. PART IV ITEM 14.

ITEM 14. EXHIBITS, FINANCIAL STATEMENTS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K (a) Documents filed as part of this Annual Report on Form 10-K: 1. Consolidated Financial Statements: Incorporated by reference to the Annual Report (see accompanying Index to Consolidated Financial Statements). 2. Consolidated Financial Statement Schedules: See accompanying Index to Consolidated Financial Statement Schedules. 3. Exhibits: 3.1 Restated Certificate of Incorporation of ALZA Corporation filed with the Delaware Secretary of State on February 14, 1994. 3.2 Restated By-laws of ALZA Corporation as restated on February 10, 1994. 10.1 Technology License Agreement between ALZA and Therapeutic Discovery Corporation(1) 10.2 Development Agreement between ALZA and Therapeutic Discovery Corporation(2) 10.3 License Option Agreement between ALZA and Therapeutic Discovery Corporation(3) 10.4 Restated Certificate of Incorporation of Therapeutic Discovery Corporation(4) ___________________________ (1) Incorporated by Reference to Exhibit 10.1 of the Form 10 of Therapeutic Discovery Corporation (Commission File No. 0-21478) dated March 31, 1993, as amended. (2) Incorporated by Reference to Exhibit 10.2 of the Form 10 of Therapeutic Discovery Corporation (Commission File No. 0-21478) dated March 31, 1993, as amended. (3) Incorporated by Reference to Exhibit 10.3 of the Form 10 of Therapeutic Discovery Corporation (Commission File No. 0-21478) dated March 31, 1993, as amended. (4) Incorporated by Reference to Exhibit 3.2 of the Form 10 of Therapeutic Discovery Corporation (Commission File No. 0-21478) dated March 31, 1993, as amended. 10.5 364-Day Credit Agreement dated November 4, 1993 among ALZA Corporation, the participating banks and The Chase Manhattan Bank (National Association) as agent for the participating banks. 10.6 3-Year Credit Agreement dated November 4, 1993 among ALZA Corporation, the participating banks and The Chase Manhattan Bank (National Association) as agent for the participating banks. EXECUTIVE COMPENSATION PLANS AND ARRANGEMENTS 10.7 1994 PACE Plan 10.8 Executive Deferral Plan Amendments 11 Statement regarding weighted average common and common equivalent shares used in the computation of per share earnings 13 Portions of Annual Report to Stockholders expressly incorporated by reference herein 20 Proxy Statement (not to be deemed filed except as expressly incorporated by reference herein)(5) 21 Subsidiaries 23 Consent of Ernst & Young, Independent Auditors (b) No reports on Form 8-K were filed during the quarter ended December 31, 1993. ____________________ (5) Incorporated by Reference to the definitive Proxy Statement, dated March 14, 1994. ALZA CORPORATION INDEX TO CONSOLIDATED FINANCIAL STATEMENTS, REPORT OF INDEPENDENT AUDITORS AND CONSOLIDATED FINANCIAL STATEMENT SCHEDULES (Item 14(a)) PAGE NUMBER REFERENCE ----------------------- ANNUAL REPORT FORM TO STOCKHOLDERS 10-K --------------- ---- Consolidated statement of operations for the years ended December 31, 1993, 1992 and 1991 23 Consolidated balance sheet at December 31, 1993 and 1992 24 Consolidated statement of stockholders' equity for the years ended December 31, 1993, 1992 and 1991 25 Consolidated statement of cash flows for the years ended December 31, 1993, 1992 and 1991 26 Notes to consolidated financial statements 27-35 Report of Ernst & Young, Independent Auditors 36 The following consolidated financial statement schedules of ALZA Corporation are included: I - Marketable securities - other 23-24 investments II - Amounts receivable from related parties, 25 and underwriters, promoters, and employees other than related parties V - Consolidated property, plant and 26 equipment VI - Consolidated accumulated depreciation 27 and amortization of property, plant and equipment VIII - Consolidated valuation and qualifying 28 accounts IX - Short-term borrowings 29 X - Consolidated supplementary income 30 statement information All other schedules have been omitted because the required information is not present or is not present in amounts sufficient to require submission of the schedule, or because the information required is included in the consolidated financial statements, including the notes thereto. SCHEDULE I ALZA CORPORATION MARKETABLE SECURITIES - OTHER INVESTMENTS DECEMBER 31, 1993 SCHEDULE II ALZA CORPORATION AMOUNTS RECEIVABLE FROM RELATED PARTIES AND UNDERWRITERS, PROMOTERS AND EMPLOYEES OTHER THAN RELATED PARTIES DECEMBER 31, 1993 SCHEDULE V ALZA CORPORATION CONSOLIDATED PROPERTY, PLANT AND EQUIPMENT YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 SCHEDULE VI ALZA CORPORATION CONSOLIDATED ACCUMULATED DEPRECIATION AND AMORTIZATION OF PROPERTY, PLANT AND EQUIPMENT YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 SCHEDULE VIII ALZA CORPORATION CONSOLIDATED VALUATION AND QUALIFYING ACCOUNTS YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 SCHEDULE IX ALZA CORPORATION SHORT-TERM BORROWINGS DECEMBER 31, 1993 SCHEDULE X ALZA CORPORATION CONSOLIDATED SUPPLEMENTARY INCOME STATEMENT INFORMATION YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 Amount for advertising costs and depreciation and amortization of intangible assets are not presented as such amounts are less than 1% of total sales and revenues in each of the years presented. SIGNATURES Pursuant to the requirements of Section 13 or 15(d) 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. ALZA CORPORATION By [DR. ERNEST MARIO] --------------------------------- Dr. Ernest Mario Chief Executive Officer Date: March 29, 1994 Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated. [DR. ALEJANDRO ZAFFARONI] [RUDOLPH A. PETERSON] - ------------------------------ -------------------------------- Dr. Alejandro Zaffaroni Rudolph A. Peterson Co-Chairman of the Board of Director Directors Date: March 29, 1994 Date: March 29, 1994 [DR. ERNEST MARIO] [DR. JANE E. SHAW] - ------------------------------ -------------------------------- Dr. Ernest Mario Dr. Jane E. Shaw Co-Chairman of the Board of Director Directors, Director and Chief Date: March 29, 1994 Executive Date: March 29, 1994 [WILLIAM G. DAVIS] [ISAAC STEIN] - ------------------------------ -------------------------------- William G. Davis Isaac Stein Director Director Date: March 29, 1994 Date: March 29, 1994 [JULIAN N. STERN] - ------------------------------ -------------------------------- Martin S. Gerstel Julian N. Stern Director Director Date: Date: March 29, 1994 [DR. ROBERT J. GLASER] [BRUCE C. COZADD] - ------------------------------ -------------------------------- Dr. Robert J. Glaser Bruce C. Cozadd Director Vice President, Chief Date: March 29, 1994 Financial Officer and Principal Accounting Officer Date: March 29, 1994 [DEAN O. MORTON] - ------------------------------ Dean O. Morton Director Date: March 29, 1994 - 32 - EXHIBIT INDEX

351979_1993.txt

351979

1993

ITEM 1. BUSINESS and ITEM 2.

ITEM 2. PROPERTIES Burlington Northern Inc. (BNI) was incorporated in Delaware in 1981 as part of a holding company reorganization. BNI and its majority-owned subsidiaries (collectively BN) are primarily engaged in the rail transportation business. The principal subsidiary is Burlington Northern Railroad Company (Railroad). BN Leasing Corporation, a wholly owned subsidiary of BNI, was formed during 1989 to acquire railroad rolling stock and other equipment necessary for the transportation and other business affairs of BN. Railroad transportation Railroad operates the largest railroad system in the United States based on miles of road and second main track, with approximately 24,500 total miles at December 31, 1993. The principal cities served include Chicago, Minneapolis-St. Paul, Fargo-Moorhead, Billings, Spokane, Seattle, Portland, St. Louis, Kansas City, Des Moines, Omaha, Lincoln, Cheyenne, Denver, Fort Worth, Dallas, Houston, Galveston, Tulsa, Wichita, Springfield (Missouri), Memphis, Birmingham, Mobile and Pensacola. During 1993, BN refined Railroad's customer oriented business units by creating smaller, more focused business units. The following table presents BN's revenue information by Railroad business unit, and includes reclassification of prior-year information to conform to current year presentation. Percent of revenues was calculated before consideration of shortline payments and other miscellaneous revenues. The principal contributors to rail transportation revenues were as follows (revenues and revenue ton miles in millions, carloadings in thousands): Coal The transportation of coal is Railroad's largest source of revenues, accounting for approximately one-third of the total. Based on carloadings and tons hauled, Railroad is the largest transporter of Western low-sulfur coal in the United States. Over 90 percent of Railroad's coal traffic originated in the Powder River Basin of Montana and Wyoming during the three years ended December 31, 1993. These coal shipments were destined for coal-fired electric generating stations primarily in the North Central, South Central and Mountain regions of the United States with smaller quantities exported. Railroad also handles increasing amounts of low-sulfur coal from the Powder River Basin for delivery to markets in the eastern and southeastern portion of the United States. The low-sulfur coal from the Powder River Basin is abundant, inexpensive to mine and clean-burning. Since the Clean Air Act of 1990 requires power plants to reduce harmful emissions either by burning coal with a lower sulfur content or by installing expensive scrubbing units, opportunities for increased shipments of this low-sulfur coal still exist. Agricultural Commodities Based on carloadings and tons hauled, Railroad is the largest rail transporter of grain in North America. Railroad's system is strategically located to serve the Midwest and Great Plains grain producing regions where Railroad serves most major terminal, storage, feeding and food-processing locations. Additionally, Railroad has access to major export markets in the Pacific Northwest, western Great Lakes and Texas Gulf regions as well as direct entry to consuming markets in southern Mexico through its Protexa Burlington International affiliate. Intermodal Intermodal transportation moves traffic on specially designed flatcars or doublestack equipment which competes with motor carriers. Railroad's intermodal transportation system integrates the movement of approximately 46 daily trains operating between 30 rail hubs and 28 satellite rail hubs (Railroad-operated marshalling points for trailer/container movements). These operations are strategically located across Railroad's rail network and also serve major distribution centers outside BN's system. Strategic alliances have been formed to enhance Railroad's market access both with other railroads and with major truck transportation providers. Forest Products The Forest Products business unit is primarily comprised of lumber, plywood, pulpmill feedstock, wood pulp and paper products. These products primarily come from the Pacific Northwest, upper Midwest and Southeast areas of the United States. Chemicals The Chemicals business unit is comprised of fertilizer, petroleum and chemical commodities as well as Railroad's environmental logistics business. Primary origin markets for Railroad include the Gulf Coast, the Pacific Northwest, and various Canadian ports of entry. Environmental logistics is an area of significant opportunity as municipalities exhaust their traditional disposal sources and must increasingly transport their waste longer distances. Consumer Products Products included in Railroad's Consumer Products business unit represent a wide variety of commodities. Some of the major products in this group are food products, beverages, frozen foods, canned foods, appliances and electronics. Because this business unit handles a wide variety of consumer goods, the business unit performance typically mirrors the country's economy. Minerals Processors Commodities in this group include clays, cements, sands and other minerals and aggregates. This group services both the oil and construction industries. Iron & Steel The Iron & Steel business unit handles virtually all of the commodities included in or resulting from the production of steel. Taconite, an iron ore derivative produced in northern Minnesota, scrap steel and coal coke are the business unit's primary input products, while finished steel products range from structural beams and coil to wire and nails. Vehicles & Machinery The Vehicles & Machinery business unit is responsible for both domestic and international vehicle manufacturers as well as an assortment of primary and secondary markets for heavy machinery. Through the development and implementation of Autostack technology (using containers to move motor vehicles), Railroad is redefining transit time and ride quality. Heavy machinery includes primary markets for aircraft, construction, farm and railroad equipment and secondary markets for used equipment. The business unit is also responsible for military and other miscellaneous traffic for the United States government. Aluminum, Non-Ferrous Metals & Ores The Aluminum, Non-Ferrous Metals & Ores business unit handles alumina and aluminum products, petroleum coke and a variety of other metals and ores such as zinc, copper and lead. Operating factors Certain significant operating statistics were as follows: - --------------- * Beginning in 1990, BN reduced revenues and mileage for the effects of shortline railroads, which complete hauls for BN. In prior years, payments to shortline railroads were classified in operating expenses. Properties In 1993, approximately 96 percent of the total ton miles, both revenue and non-revenue generating, carried by Railroad were handled on its main lines. At December 31, 1993, approximately 18,828 miles of Railroad's track consisted of 112-lb. per yard or heavier rail, including approximately 10,461 track miles of 132-lb. per yard or heavier rail. Additions and replacements to properties were as follows: Equipment BN owned or leased, under both capital and operating leases, with an initial lease term in excess of one year, the following units of railroad rolling stock at December 31, 1993: In addition to the owned and leased locomotives identified above, BN operates 199 freight locomotives under power purchase agreements. The average age of locomotives and freight cars was 14.5 years and 18.6 years, respectively, at December 31, 1993, compared with 13.5 years and 18.4 years, respectively, at December 31, 1992. The average percentage of BN's locomotives and freight cars awaiting repairs during 1993 was 7.4 and 3.3, respectively, compared with 7.4 and 4.1, respectively, in 1992. The average time between locomotive failures was 67.9 days in 1993 compared with 71 days in 1992. During 1993, BN entered into an agreement to acquire 350 new-technology alternating current traction motor locomotives. BN anticipates reduced locomotive operating costs as well as an increase in both horsepower and traction, meaning fewer locomotives will be needed for many freight operations. BN accepted delivery of one locomotive during 1993 and anticipates delivery of between approximately 60 and 100 each year from 1994 through 1997. Employees BN employed an average of 30,502 employees in 1993 compared with 31,204 in 1992 and 31,760 in 1991. BN's payroll and employee benefits costs, including capitalized labor costs, were approximately $1.9 billion for each of the years ended December 31, 1993, 1992 and 1991. Almost 90 percent of BN's employees are covered by collective bargaining agreements with 14 different labor organizations. In October 1991, Railroad entered into an agreement (Crew Consist Agreement No. 1) with the United Transportation Union (UTU) covering the southern portion of Railroad's system. Crew Consist Agreement No. 1 provided for crews on most through-freight trains to consist of one conductor and one engineer and for crews on all other trains to consist of one brakeman, one conductor and one engineer. Under the terms of Crew Consist Agreement No. 1, Railroad offered the opportunity for voluntary separation from employment in return for severance payments of up to $60,000 per employee. Remaining conductors or brakemen who, as a result of Crew Consist Agreement No. 1, were unable to hold a position in active service, due to relative seniority, were placed on a reserve board. Employees in reserve status received compensation at a rate equal to either 75 percent of their previous 12-month earnings, or 75 percent of the basic five-day yard helper rate of pay, whichever is greater, and are required to be available for return to active service on 15 days' notice. Each UTU member on the southern portion of Railroad's system received a lump-sum payment of $1,000 upon ratification of Crew Consist Agreement No. 1. In May 1993, Railroad entered into an agreement (Crew Consist Agreement No. 2) with the UTU covering approximately 3,400 UTU members in the northern portion of Railroad's system. Crew Consist Agreement No. 2 provides for crews on most through-freight trains to consist of one conductor and one engineer and for crews on all other trains to consist of one brakeman, one conductor and one engineer. It is similar to Crew Consist Agreement No. 1, covering the southern portion of Railroad's system. Each UTU member on the northern portion of Railroad's system received a one-time lump-sum payment of $5,000, pursuant to Crew Consist Agreement No. 2. Under the terms of Crew Consist Agreement No. 2, Railroad offered the opportunity for voluntary separation from employment in return for severance payments of up to $80,000 per employee. Conductors and brakemen who choose not to accept the voluntary separation offer can elect volunteer surplus status pursuant to which they will receive $60,000 to be paid out over a period of 18 to 48 months, as each selects. If such employee has not been recalled to active service by the time such payments cease upon expiration of the selected period, such employee will remain in volunteer surplus status, without further compensation or benefits, until recalled to active service. Employees in volunteer surplus status may be called back to service only after the individuals in reserve status, within their own subdivided seniority district, have been recalled. Remaining conductors and brakemen who, as a result of Crew Consist Agreement No. 2, are not needed in train service, and who do not elect one of the above severance options, will be placed on a reserve board. Employees in reserve status will receive compensation equal to either 75 percent of their previous 12-month earnings, or 75 percent of the basic five-day yard helper rate of pay, whichever is greater, and are required to be available for return to active service on 15 days' notice. In October 1993, the UTU elected to adopt Crew Consist Agreement No. 2 for those southern portion UTU members who were previously covered by Crew Consist Agreement No. 1. Crew Consist Agreement No. 2 was implemented on the southern portion of the Railroad's system during the fourth quarter of 1993. Upon implementation, each of the approximately 3,300 UTU members on the southern portion of Railroad's system received a one-time lump-sum payment of $4,000, which was the incremental difference between the $1,000 lump-sum payment received following ratification of Crew Consist Agreement No. 1 and the amount received by UTU members following adoption of Crew Consist Agreement No. 2. Railroad will continue to remove excess positions from train service through the implementation of Crew Consist Agreement No. 2. Approximately 1,350 excess positions have been removed as a result of employees accepting severance or voluntary surplus payments. Other excess positions have been eliminated and personnel formerly in those positions have been assigned to reserve boards, absorbed through additional train starts and/or utilized in quality and safety initiatives. Based upon its experience under Crew Consist Agreement No. 1, Railroad anticipates that the number of employees on reserve status will decline over time. In July 1993, the American Train Dispatchers Association ratified an April agreement which will facilitate the consolidation of all dispatching functions into a centralized train dispatching office in Fort Worth, Texas by the end of 1995. Competition The general environment in which BN operates remains highly competitive. Depending on the specific market, deregulated motor carriers, other railroads and river barges exert pressure on various price and service combinations. The presence of advanced, high service truck lines with expedited delivery, subsidized infrastructure and minimal empty mileage continues to impact the market for non-bulk, time sensitive freight. The potential expansion of long combination vehicles could further encroach upon markets traditionally served by railroads. In order to remain competitive, BN and other railroads continue to develop and implement technologically supported operating efficiencies to improve productivity. As railroads streamline, rationalize and otherwise enhance their franchises, competition among rail carriers intensifies. BN's primary rail competitors in the western region of the United States consist of Atchison, Topeka & Santa Fe Railway Company; Chicago & Northwestern Transportation Company (C&NW); Southern Pacific Transportation Company; and Union Pacific Railroad Company (UP). Coal, one of BN's primary commodities, has experienced significant pressure on rates due to competition from the joint effort of C&NW/UP and BN's efforts to penetrate into new markets. In addition to the railroads discussed above, numerous regional railroads and motor carriers operate in parts of the same territory served by BN. Environmental BN's operations, as well as those of its competitors, are subject to extensive federal, state and local environmental regulation. In order to comply with such regulation and to be consistent with BN's corporate environmental policy, BN's operating procedures include practices to protect the environment. Amounts expended relating to such practices are inextricably contained in the normal day-to-day costs of BN's business operations. ITEM 3.

ITEM 3. LEGAL PROCEEDINGS Wheat and barley transportation rates In September 1980 a class action lawsuit was filed against Railroad in United States District Court for the District of Montana (District Court) challenging the reasonableness of Railroad's export wheat and barley rates. The class consists of Montana grain producers and elevators. The plaintiffs sought a finding that Railroad's single car export wheat and barley rates for shipments moving from Montana to the Pacific Northwest were unreasonably high and requested damages in the amount of $64 million. In March 1981 the District Court referred the rate reasonableness issue to the Interstate Commerce Commission (ICC). Subsequently, the State of Montana filed a complaint at the ICC challenging Railroad's multiple car rates for Montana wheat and barley movements occurring after October 1, 1980. The ICC issued a series of decisions in this case from 1988 to 1991. Under these decisions, the ICC applied a revenue to variable cost test to the rates and determined that Railroad owed $9,685,918 in reparations plus interest. In its last decision, dated November 26, 1991, the ICC found Railroad's total reparations exposure to be $16,559,012 through July 1, 1991. The ICC also found that Railroad's current rates were below a reasonable maximum and vacated its earlier rate prescription order. Railroad appealed to the United States Court of Appeals for the District of Columbia Circuit (D.C. Circuit) those portions of the ICC's decisions concerning the post-October 1, 1980 rate levels. Railroad's primary contention on appeal was that the ICC erred in using the revenue to variable cost rate standard to judge the rates instead of Constrained Market Pricing/Stand Alone Cost principles. The limited portions of decisions that cover pre-October 1, 1980 rates were appealed to the Montana District Court. On March 24, 1992, the Montana District Court dismissed plaintiffs' case as to all aspects other than those relating to pre-October 1, 1980 rates. On February 9, 1993, the D.C. Circuit served its decision regarding the appeal of the several ICC decisions in this case. The Court held that the ICC did not adequately justify its use of the revenue to variable cost standard as Railroad had argued and remanded the case to the ICC for further administrative proceedings. On July 22, 1993, the ICC served an order in response to the D.C. Circuits' February 9, 1993 decision. In its order, the ICC stated it would use the Constrained Market Pricing/Stand Alone Cost standards in assessing the reasonableness of BN wheat and barley rates moving from Montana to Pacific Coast ports from 1978 forward. The ICC assigned the case to the Office of Hearings to develop a procedural schedule. The parties are now engaged in discovery. ITEM 4.

ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS During the fourth quarter of 1993, no matters were submitted to a vote of security holders. EXECUTIVE OFFICERS OF THE REGISTRANT AND PRINCIPAL SUBSIDIARY The following information concerning executive officers is as of February 14, 1994: GERALD GRINSTEIN, 61 Chairman and Chief Executive Officer Burlington Northern Inc. July 1991 to Present Director October 1985 to Present Chairman and Chief Executive Officer Burlington Northern Railroad Company July 1991 to Present Chairman, President and Chief Executive Officer, October 1990 to July 1991, Burlington Northern Inc.; Chairman, President and Chief Executive Officer, February 1990 to July 1991, Burlington Northern Railroad Company; President and Chief Executive Officer, January 1989 to October 1990, Burlington Northern Inc.; Chief Operating Officer, February 1989 to February 1990, Burlington Northern Railroad Company. Mr. Grinstein is a Director of Delta Air Lines, Inc., Browning Ferris Industries, Inc., Seafirst Corporation and Sunstrand Corporation. WILLIAM E. GREENWOOD, 55 Chief Operating Officer Burlington Northern Railroad Company February 1990 to Present Executive Vice President, Marketing and Sales, January 1987 to January 1990, Burlington Northern Railroad Company. DAVID C. ANDERSON, 52 Executive Vice President, Chief Financial Officer and Chief Accounting Officer Burlington Northern Inc. October 1991 to Present Executive Vice President, Chief Financial Officer Burlington Northern Railroad Company October 1991 to Present Senior Vice President and Chief Financial Officer, July 1983 to September 1991, Federal Express Corporation. Mr. Anderson is a Director of Concord EFS, Inc. JOHN Q. ANDERSON, 42 Executive Vice President, Marketing and Sales Burlington Northern Railroad Company February 1990 to Present Principal, January 1982 to January 1990, McKinsey & Company, Inc. DOUGLAS J. BABB, 41 Vice President and General Counsel Burlington Northern Railroad Company December 1986 to Present EDMUND W. BURKE, 45 Executive Vice President, Law and Secretary Burlington Northern Inc. August 1989 to Present Executive Vice President, Law and Government Affairs Burlington Northern Railroad Company February 1990 to Present Executive Vice President, Law and Government Affairs and Secretary, September 1989 to February 1990, Burlington Northern Railroad Company; Senior Vice President, Law and Secretary, January 1989 to July 1989, Burlington Northern Inc.; Senior Vice President, Law and Government Affairs and Secretary, December 1986 to August 1989, Burlington Northern Railroad Company. MARK S. CANE, 38 Vice President, Intermodal Burlington Northern Railroad Company September 1992 to Present Vice President, Equipment Management, March 1991 to September 1992; Vice President, Service Design, December 1989 to March 1991; Assistant Vice President, Marketing Resources, May 1988 to December 1989, Burlington Northern Railroad Company. JOHN T. CHAIN, JR., 59 Executive Vice President, Safety and Corporate Support Burlington Northern Railroad Company March 1993 to Present Executive Vice President, Operations, February 1991 to February 1993, Burlington Northern Railroad Company. Commander in Chief of the Strategic Air Command, June 1986 to January 1991. Mr. Chain is a Director of Kemper Corporation, Northrop Corporation and R.J.R. Nabisco. JAMES B. DAGNON, 54 Executive Vice President, Employee Relations Burlington Northern Inc. January 1992 to Present Executive Vice President, Employee Relations Burlington Northern Railroad Company January 1992 to Present Senior Vice President, Human Resources, August 1991 to January 1992; Senior Vice President, Labor Relations, June 1987 to August 1991, Burlington Northern Railroad Company. WILLIAM W. FRANCIS, 53 Executive Vice President, Network Management Burlington Northern Railroad Company February 1993 to Present Senior Vice President, Network Management, July 1990 to January 1993; Vice President, Northern Region, October 1988 to July 1990, Burlington Northern Railroad Company. DAVID L. HULL, 46 Vice President, Revenue Management Burlington Northern Railroad Company April 1992 to Present Vice President, Financial Planning, December 1989 to April 1992; Vice President, Revenue and Cost Accounting, March 1988 to September 1989, Burlington Northern Railroad Company. FRANCIS T. KELLY, 46 Securities and Finance Counsel Burlington Northern Railroad Company November 1989 to Present SEC Counsel, December 1988 to November 1989, Burlington Northern Railroad Company. RICHARD L. LEWIS, 53 Senior Vice President, Corporate Development Burlington Northern Railroad Company February 1993 to Present Vice President, Strategic Planning, February 1991 to January 1993; Vice President, Freight Equipment and Strategic Planning, January 1989 to January 1991; Vice President, Strategic Planning, May 1988 to January 1989, Burlington Northern Railroad Company. ROBERT F. MCKENNEY, 40 Senior Vice President and Treasurer Burlington Northern Inc. October 1991 to Present Senior Vice President and Treasurer Burlington Northern Railroad Company October 1991 to Present Senior Vice President, Treasurer, Acting Chief Financial Officer and Acting Chief Accounting Officer, April 1991 to October 1991, Burlington Northern Inc.; Senior Vice President, Treasurer and Acting Chief Financial Officer, April 1991 to October 1991, Burlington Northern Railroad Company; Vice President and Treasurer, October 1989 to April 1991, Burlington Northern Inc. and Burlington Northern Railroad Company; Vice President, September 1985 to September 1989, D'Accord Incorporated and D'Accord Financial Services, Inc. RICHARD A. RUSSACK, 55 Vice President, Communications Burlington Northern Railroad Company October 1991 to Present Managing Director, October 1989 to September 1991, Ogilvy, Adams & Rinehart, Inc.; Executive Vice President, September 1985 to September 1989, Gavin Anderson & Co., Inc. DON S. SNYDER, 45 Vice President, Controller and Chief Accounting Officer Burlington Northern Railroad Company April 1990 to Present Vice President, Controller, December 1987 to March 1990, Burlington Northern Railroad Company. PHILIP F. WEAVER, 53 Vice President, Agricultural Commodities Burlington Northern Railroad Company July 1990 to Present Acting Assistant Vice President, Marketing Resources, December 1989 to July 1990; Assistant Vice President Agricultural Products, August 1987 to July 1990, Burlington Northern Railroad Company. PART II ITEM 5.

ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS BNI's common stock is traded on the New York, Chicago and Pacific Stock Exchanges. At January 31, 1994, the number of common stockholders of record was 28,131. Information on quarterly dividends and common stock prices is shown on page 46. ITEM 6.

ITEM 6. SELECTED FINANCIAL DATA The selected financial data shown below should be read in conjunction with the consolidated financial statements and related notes. (1) Beginning in 1990, shortline expenses were reported as a reduction of revenues. Prior to 1990, these expenses had been included in purchased services expense. The reclassification had no effect on net income. Previously issued consolidated financial statements were not restated to reflect the reclassification. (2) The 1991 pre-tax special charge relates to: (i) restructuring costs for reducing surplus crew positions and a management separation pay program, (ii) increases in estimated personal injury costs and (iii) increases in estimated environmental clean-up costs. (3) During 1991, BN extinguished debt through an early redemption resulting in an extraordinary loss, net of income taxes, of $14 million, or $.18 per common share. During 1990, BN extinguished debt through note exchange agreements and the purchase of certain debentures. The net income for the year ended December 31, 1990 includes a resulting extraordinary gain, net of income taxes, of $14 million, or $.18 per common share. (4) Results for 1992 reflect the cumulative effect of the change in accounting method for revenue recognition, and the cumulative effect of the implementation of the accounting standard for postretirement benefits (Statement of Financial Accounting Standards (SFAS) No. 106). The cumulative effect of the change in accounting method for revenue recognition decreased 1992 net income by $11 million, or $.13 per common share. The cumulative effect of the change in accounting method for postretirement benefits decreased 1992 net income by $10 million, or $.11 per common share, and had no immediate effect on cash flows. (5) Results for 1993 include the effects of the Omnibus Budget Reconciliation Act of 1993 (the Act) which was signed into law on August 10, 1993. The Act increased the corporate federal income tax rate by one percent, effective January 1, 1993, which reduced net income by $29 million, or $.32 per common share, through the date of enactment. (6) Beginning in November 1991, shares used in computation of earnings (loss) per common share reflect a November 1991 public offering of 10,350,000 shares. (7) During 1993, BN adopted SFAS No. 109, "Accounting for Income Taxes." The effect of the adoption was to increase the current portion of the deferred income tax asset with a corresponding increase in the noncurrent deferred income tax liability of $26 million at January 1, 1993. Certain 1992 balance sheet data was reclassified to conform to the 1993 presentation. These reclassifications had no effect on previously reported net income, stockholders' equity or cash flows. (8) The 1991 operating ratio excludes the special charge discussed in note (2) above. (9) Net income used to calculate return on average stockholders' equity excludes, in the year of occurrence, the special charge, extraordinary items and the cumulative effect of accounting changes. ITEM 7.

ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Management's discussion and analysis relates to the financial condition and results of operations of Burlington Northern Inc. (BNI) and its majority-owned subsidiaries (collectively BN). The principal subsidiary is Burlington Northern Railroad Company (Railroad). CAPITAL RESOURCES AND LIQUIDITY Cash from operations and other resources Cash generated from operations is BN's principal source of liquidity and is primarily used for dividends and capital expenditures. Operating activities provided cash of $578 million in 1993, compared with $680 million in 1992 and $368 million in 1991. The decrease in cash from operations in 1993 compared with 1992 was primarily attributable to an $81 million increase in labor-related payments, a decline in the level of accounts receivables sold and a one-time settlement agreement payment received in 1992. These items were partially offset by a decrease in interest paid during 1993. The increase in cash from operations in 1992 over 1991 was primarily due to increased profitability, a smaller decline in the level of accounts receivable sold and the one-time settlement agreement payment received in 1992. While operating cash flows for 1993 and 1991 were sufficient to fund dividends, such cash flows were not sufficient to completely fund capital expenditures. In 1992, operating cash flows were sufficient to fund both dividends and capital expenditures. Cash shortfalls as a result of these cash outlays are generally financed with debt. Sources available for such financing are discussed below. During the first quarter of 1993, BN entered into an agreement to acquire 350 new-technology alternating current traction motor locomotives. BN accepted delivery of one locomotive during 1993 and anticipates delivery of between approximately 60 and 100 each year from 1994 through 1997. Future cash from operations during this strategic investment period may not, at times, be sufficient to completely fund dividends as well as capital expenditures and strategic investments. Therefore, these requirements will likely be financed using a combination of sources including, but not limited to, cash from operations, operating leases, debt issuances and other miscellaneous sources. Each financing decision will be based upon the most appropriate alternative available. During December 1993, BNI filed a registration statement with the Securities and Exchange Commission for the issuance, from time to time, of up to $500 million aggregate principal amount of debt securities. Net proceeds from the sale of the debt securities, if any are offered and sold, will be used to pay down debt or for other general corporate purposes. BNI acquired equipment which was financed in December 1993 through the issuance of $78 million of 6.32 percent notes due 1994 to 2012. In July 1993, BNI issued $150 million of 7 1/2 percent senior unsecured debentures due 2023 and used the proceeds for general corporate purposes, including working capital. These debentures were the final borrowing under the registration statement filed on September 24, 1991 covering the issuance, from time to time, of up to $500 million aggregate principal amount of debt securities. Railroad maintains an effective program for the issuance, from time to time, of commercial paper. These borrowings are supported by Railroad's bank credit agreement, thus outstanding commercial paper balances reduce available borrowings under this agreement. The bank credit agreement allows borrowings of up to $500 million on a short-term basis. The agreement is currently scheduled to expire in November 1994. At Railroad's option, borrowing rates are based on prime, certificate of deposit or London Interbank Offered rates. Annual facility fees are 0.25 percent. The maturity value of commercial paper outstanding at December 31, 1993 was $27 million, leaving a total of $473 million of the credit agreement available, while no commercial paper was outstanding at December 31, 1992. Railroad has an agreement to sell, on a revolving basis, an undivided percentage ownership interest in a designated pool of accounts receivable with limited recourse. As of December 31, 1993, the agreement allowed for the sale of accounts receivable up to a maximum of $175 million. The agreement expires not later than December 1994. At December 31, 1993 and 1992, accounts receivable were net of $100 million and $189 million, respectively, representing receivables sold. In November 1992, BNI completed a public offering of 6,900,000 shares of 6 1/4 percent cumulative convertible preferred stock at $50 per share. Most of the $337 million net proceeds from the offering were placed in trust to fund the redemption of BNI's $300 million 9 5/8 percent notes due 1996. Under the terms of the indenture, the 9 5/8 percent notes were redeemable at par, commencing February 1, 1993. The notification for redemption of the 9 5/8 percent notes was issued to holders of the notes in December 1992 with a redemption date of February 1, 1993. The debt was considered to be extinguished as of December 31, 1992, because BNI had irrevocably placed assets in trust, prior to such date, to be used solely to satisfy scheduled payments of both the interest on and principal of the $300 million 9 5/8 percent notes. The difference between BNI's redemption price and the net carrying value resulted in an immaterial loss which was recorded in other income (expense), net in 1992. In July 1992, BNI issued $150 million of 7 percent senior unsecured notes due 2002. The proceeds were used to retire $100 million of 14 3/4 percent notes due August 15, 1992 and to reduce outstanding commercial paper balances. In February 1992, BNI issued $200 million of 8 3/4 percent senior unsecured debentures due 2022 and used the proceeds to reduce outstanding commercial paper balances. These debt instruments provided favorable long-term interest rates and matched long-term borrowing to the long-lived assets of BN's capital program. In November 1991, BNI completed a public offering of 10,350,000 shares of common stock. The transaction resulted in net proceeds of $359 million which were used primarily to retire $250 million of 11 5/8 percent subordinated debentures. Capital expenditures and resources A breakdown of capital expenditures is set forth in the following table (in millions): Equipment expenditures for 1993 increased primarily as a result of acquiring freight cars through purchases rather than through operating leases and increased information system purchases. Capital roadway expenditures for 1993 increased compared with 1992 primarily due to spending related to the severe flooding in the Midwest. Spending for signal and communication projects and new strategic initiatives for transportation network management further contributed to this increase. The average age of locomotives and freight cars at year-end 1993 was 14.5 years and 18.6 years compared to 13.5 years and 18.4 years at year-end 1992. Capital roadway spending in 1992 reflects an increase in track programs in the Powder River Basin to support BN's coal unit train service, as well as additional signal and communication projects. Equipment expenditures were lower in 1992 primarily due to the 1991 purchase of 50 high horsepower locomotives at a cost of $76 million. BN projects capital spending for the next few years to be higher than in previous years partially as a result of certain strategic investments, with a projection for 1994 of approximately $650 million. As discussed in "Cash from operations and other resources," BN has a commitment to acquire 350 new-technology alternating current traction motor locomotives through 1997. Also, BN will continue its implementation of several strategic initiatives for transportation network management using information systems technology. In addition to capital expenditures, BN continues to utilize operating leases to fulfill certain equipment requirements. In 1994, BN anticipates financing approximately $200 million of equipment through operating leases. The method used to finance this equipment will depend upon current market conditions and other factors. During 1993, BN renewed leases primarily for intermodal doublestack cars and containers, and locomotives. In 1992, renewals were primarily for covered hoppers, locomotives and coal cars. Dividends Common stock dividends declared have remained constant at $1.20 per common share for 1993, 1992 and 1991. Dividends paid on common and preferred stock during these periods were $125 million, $106 million and $92 million, respectively. The increase in 1993 dividends was primarily attributable to the issuance of 6,900,000 shares of 6 1/4 percent cumulative convertible preferred stock in November 1992. The increase in 1992 was due in large part to the issuance of 10,350,000 shares of common stock in November 1991. BNI expects to continue its current policy of paying regular quarterly dividends on its common and preferred stock, however, dividends are declared by the Board of Directors based on profitability, capital expenditure requirements, debt service and other factors. Capital structure BN's ratio of total debt to total capital, excluding redeemable preferred stock, was 48 percent at the end of both 1993 and 1992 and 62 percent at the end of 1991. In 1992, the total debt to total capital ratio improved from 1991 because debt was reduced, the 6 1/4 percent cumulative convertible preferred stock was issued and net income exceeded dividend requirements. RESULTS OF OPERATIONS Year ended December 31, 1993 compared with year ended December 31, 1992 BN had net income of $296 million, or $3.06 per common share, on 89.7 million shares for 1993 compared with net income of $278 million, or $3.11 per common share, on 88.6 million shares for 1992. Results for 1993 included the effects of severe flooding in the Midwest, most notably in the third quarter. The floods slowed and often halted operations, forced extensive detours, increased car, locomotive and crew costs and resulted in extensive rebuilding of damaged track and bridges. BN estimated that the third quarter flooding reduced revenues during 1993 by $44 million and increased operating expenses by $35 million, for a combined reduction of $79 million or $.55 per common share. Net income for 1993 included the retroactive effects of the Omnibus Budget Reconciliation Act of 1993 (the Act), which was passed into law during August 1993. The Act increased the corporate federal income tax rate by one percent, effective January 1, 1993, which reduced net income by $29 million, or $.32 per common share, through the date of enactment. BN recognized a one-time, non-cash charge of $28 million to income tax expense to adjust deferred taxes as of the enactment date and a charge of $1 million to current income tax expense. Net income for 1992 included settlement payments received for the reimbursement of attorneys' fees and costs incurred by BN in connection with litigation filed by Energy Transportation Systems, Inc., and others, and reimbursement of a portion of the amount paid by BN in settlement of that action. The pre-tax amount recorded in other income (expense), net was approximately $47 million. Also during 1992, BN's net income included a $21 million, or $.24 per common share, cumulative effect of changes in accounting methods and a $17 million, or $.19 per common share, favorable tax settlement with the Internal Revenue Service (IRS). Revenues During 1993, BN refined Railroad's customer oriented business units by creating smaller, more focused business units. The following table presents BN's revenue information by Railroad business unit, and includes reclassification of prior-year information to conform to current year presentation: Coal revenues improved $12 million compared with 1992, primarily as a result of increased traffic caused by a rise in the demand for electricity. Higher revenues resulting from volume increases were partially offset by lower yields arising from competitive pricing pressures in contract renegotiations, traffic mix and other factors. Additionally, BN estimated lost coal revenues of approximately $35 million for the third quarter of 1993 as a result of flood-related problems in July and August which interrupted service to several utilities. Agricultural Commodities revenues were $7 million higher than 1992 as stronger yields were partially offset by lower volumes. Improved yields resulted from a traffic mix with a greater portion of wheat traffic in 1993. Stronger export demand, for high-quality wheat grown in regions served by BN, contributed to a $74 million improvement in wheat revenues. Reduced crop quality and production problems, stemming from poor planting and growing conditions, resulted in lower corn volumes and produced a year-over-year decline in corn revenues of $45 million. Intermodal revenues were $19 million higher in 1993 compared with 1992. BN AMERICA (BNA) revenues in 1993 surpassed revenues in 1992 as a result of continued escalating demand for containerized transportation and an increased demand for intermodal service due generally to a shortage in truck capacity. As import traffic expanded and shifted from ports in California to ports served by BN in the Pacific Northwest, intermodal-international revenues increased. Domestic trailer revenues declined as trailer traffic continued to convert to containers, partially offsetting other Intermodal increases. Chemicals revenues for 1993 were $17 million greater than in 1992. Increased plastics shipments for existing customers led improvements in overall Chemicals revenues. Environmental logistics and fertilizer traffic in 1993 surpassed 1992 levels, also contributing to the higher revenues for Chemicals. Revenues for Minerals Processors increased $15 million compared with 1992. As drilling activity increased, export traffic for clays and aggregates expanded, contributing to greater revenues in 1993 than in 1992. Glass minerals and cement revenues exceeded 1992 levels. This increase was due to expanded sand traffic, which also benefited from increased drilling activity, and increased cement traffic, related to certain highway and airport construction projects. Vehicles & Machinery revenues were $21 million greater than in 1992. This improvement was due in part to growth in production and sales of light vehicles which increased domestic traffic volumes. A rise in demand for heavy machinery also contributed to greater revenues. Yields increased in 1993 primarily as a result of a decline in the average length of haul. Forest Products, Iron & Steel and Aluminum, Non-Ferrous Metals & Ores had lower revenues in 1993 compared with 1992. Current year Forest Products revenues were $6 million less than in 1992 because of reduced lumber traffic, resulting from a weak timber industry market, which was partially offset by increased particle and construction board traffic. Iron & Steel revenues declined $6 million compared with 1992, primarily due to lower taconite traffic caused by labor strikes at two large customers. Aluminum, Non-Ferrous Metals & Ores revenues decreased by $5 million as aluminum production declined. Revenues for Consumer Products were relatively flat compared with 1992. Expenses Total operating expenses for 1993 were $4,038 million compared with $4,033 million for 1992. Despite the adverse effects of the Midwest flooding on operating expenses during the third quarter of 1993, BN's year-to-date operating ratio improved one percentage point, to 86 percent, compared with 87 percent for 1992. Overall compensation and benefits expenses for 1993 remained constant with 1992. Cost of living allowances (COLAs) for union employees were $24 million lower during 1993 compared with 1992 due to timing differences of vesting periods. Work force reductions and a decrease in railroad unemployment taxes lowered expenses in 1993. These savings were offset by increases in incentive compensation, wages and salaries, and higher costs for union health, welfare and life insurance benefits. Increased wages were partially caused by a scheduled three percent basic wage increase effective July 1993 and inefficiencies associated with the Midwest flooding during 1993. Fuel expenses were $14 million higher during 1993 compared with 1992, primarily due to weather-related reductions in fuel efficiency. Increased fuel consumption due to higher traffic volume was substantially offset by the decrease in the average price paid for diesel fuel, 61.5 cents per gallon in 1993 compared with 62.2 cents per gallon in 1992. Included in the 1993 average price per gallon is a 4.3 cents per gallon increase in the federal fuel tax effective October 1, 1993, as part of the Omnibus Budget Reconciliation Act of 1993. This increased tax added approximately $7 million to expense in the fourth quarter. Materials expenses for 1993 increased $5 million compared with 1992. The combination of flood-related problems and a larger fleet size increased materials costs for locomotive repairs. Also, safety and protective equipment expenditures were higher due to continued emphasis of BN's safety programs. Offsetting these increases were lower car materials expenses. Equipment rents expenses were $6 million higher in 1993 compared with 1992 due to increases in both car-hire expenses and locomotive rentals. A reduction in car-hire expenses during the first half of 1993, due to improved utilization of equipment, was more than offset by flood-related inefficiencies which increased car-hire expenses during the second half of 1993. Purchased services expenses for 1993 were $8 million higher than in 1992. Contributing to this increase were cost increases for intermodal logistics, training, moving and derailments. Lower trackage rights credits, which reduces purchased services expenses, were received from the Southern Pacific Transportation Company (SPTC) as the floods reduced SPTC volumes over BN track. These increases were partially offset by decreases in contracted locomotive repairs and consultant fees. Depreciation expense for 1993 was $14 million higher compared with 1992 primarily due to an increase in the asset base. The $42 million decrease in other operating expenses compared with 1992 was primarily due to a $35 million decline in costs associated with personal injury claims. BN has introduced a number of programs to improve worker safety and counter increasing personal injury costs. Reductions in bad debt expense and various other costs were partially offset by losses on property retired due to flood damages and increased moving expenses. Interest expense declined $41 million in 1993 compared with 1992. This decline was mainly due to a lower average long-term debt balance outstanding during 1993 and the refinancing of higher interest rate debt throughout 1992. Other income (expense), net was $36 million lower in 1993 than in 1992. The higher 1992 income was due to a first quarter net gain of $47 million for payments and reimbursements received for the settlement of prior litigation. This decline was partially offset by an increase in the net gain on property dispositions in 1993 compared with 1992. The effective tax rate was 43.2 percent for 1993 compared with 33.8 percent for 1992. This increase resulted primarily from the retroactive increase, effective January 1, 1993, in tax rates as part of the Omnibus Budget Reconciliation Act of 1993. Excluding the retroactive effect of the tax rate change on deferred tax balances at January 1, 1993, BN's effective tax rate was 38.2 percent for 1993. Additionally, a favorable tax settlement with the IRS reduced the 1992 effective tax rate by 3.8 percent. Year ended December 31, 1992 compared with year ended December 31, 1991 BN had net income of $278 million, or $3.11 per common share, on 88.6 million shares for 1992 compared with a net loss of $320 million, or $4.14 per common share, on 77.5 million shares for 1991. Results for 1992 were reduced by $11 million, or $.13 per common share, net of tax, cumulative effect of an accounting change in revenue recognition method and $10 million, or $.11 per common share, net of tax, cumulative effect of an accounting change for postretirement benefits. Results for 1991 included an after-tax special charge of $442 million, or $5.79 per common share, related to railroad restructuring costs and increases in liabilities for casualty and environmental clean-up costs, and an extraordinary loss of $14 million, or $.18 per common share, net of tax benefits, as a result of early retirement of debt. The 1991 special charge included the following pre-tax components (in millions): Revenues During 1993, BN refined Railroad's customer oriented business units by creating smaller, more focused business units. The following table presents BN's revenue information by Railroad business unit, and includes reclassification of prior-year information to conform to current year presentation: Coal revenues in 1992 were $34 million below 1991. The decrease included the effects of a two-day work stoppage during the second quarter. The effects of the work stoppage were not recovered later in 1992 because of continued weak demand. Mild weather during the first three quarters of 1992 decreased demand for coal and slowed traffic compared with the prior year. In addition, competitive pricing pressures in contract renegotiations and declining cost indices, on which many coal contract rates are based, also contributed to lower 1992 revenues. Revenues for Agricultural Commodities were $1 million less in 1992 than in 1991. The decrease was primarily due to weak export demand for corn in the latter three quarters of 1992 which contributed to a $36 million reduction compared with 1991. This decrease was substantially offset by a $34 million increase in wheat that resulted from strong export shipments during 1992. The $24 million increase in Intermodal revenues was driven by a $59 million increase in BNA traffic that was attributable to increased demand for containerized transportation. A portion of the increase in containerized transportation was due to a conversion from trailer transportation which decreased by $24 million compared with 1991. Forest Products revenues increased $20 million compared with 1991. The increase reflects an improvement in lumber revenues that resulted from good spring building conditions, favorable movements because of product pricing pressures and increased demand caused by Hurricane Andrew's destruction. Pulpmill feedstock revenues also increased because of higher demand for woodchips. These increases were slightly offset by a decreased demand for paper and paper products during 1992, partly due to excess supplies of newsprint. Revenues for Chemicals were $42 million greater in 1992 than in 1991. The increase was primarily due to increased plastics shipments from new contracts. Higher fertilizer and petroleum products revenues were also contributing factors. Fertilizer traffic improved due to a strong spring application season and increased shipments at the beginning of the year to replenish low inventory levels from the fall of 1991. Petroleum products benefited from a stronger economy in 1992 than in 1991. Revenues in 1992 for Consumer Products and Iron & Steel both improved by $8 million compared with 1991. The improvement for Consumer Products resulted from higher bulk food products revenues, due largely from an increased movement of sugar, and higher frozen foods revenues. Frozen foods revenues improved over the prior year due largely to increased french fry traffic resulting from favorable product prices. Iron & Steel revenues improved due to increased traffic because of two new pipe projects. Revenues for Minerals Processors, Vehicles & Machinery and Aluminum, Non-Ferrous Metals & Ores were relatively flat in 1992 compared with 1991. While Vehicles & Machinery revenues were flat overall, automotive revenues increased as higher traffic volume more than offset lower yields. Declining yields reflect the rates used in late 1991 and 1992 long-term contract renewals, which were influenced by competitive pricing pressures. This increase in automotive revenues was offset by declines in heavy machinery and government traffic revenues. The slight decrease in Minerals Processors revenues was attributable to a weaker demand for glass minerals and cement products related to the construction and automobile industries. Aluminum, Non-Ferrous Metals & Ores benefited from a stronger economy in 1992 than in 1991. Expenses Total operating expenses for 1992 were $4,033 million compared with expenses of $4,090 million, excluding a $708 million special charge, in 1991. The operating ratio for 1992 was 87 percent compared with the 1991 ratio, excluding the special charge, of 90 percent. The improvement in operating expenses was primarily attributable to savings in compensation and benefits and fuel costs. Compensation and benefits expenses decreased by $47 million compared with 1991. During 1991, BN recorded a $77 million accrual for union employees' signing bonuses and for COLAs. The 1992 COLA accruals were $58 million. Current-year savings of $22 million were also noted in health, welfare and life insurance benefits due to union contract modifications. Smaller crew sizes and a full year of reduced pay rates for employees on reserve boards, which were established in the second half of 1991, also contributed to lower wages and salaries in 1992. These combined savings were somewhat offset by increases in mechanical, maintenance crew and other wages. Also, increasing use of the wage continuation program for injured employees, which was phased in during 1991, served to further offset the savings. Fuel expenses were $20 million lower than in 1991. In 1992, BN paid 62.2 cents per gallon compared with 65.5 cents in 1991. This lower average fuel price per gallon resulted in approximately $19 million of the overall savings. Reduced consumption also contributed slightly to the overall decrease. Materials expenses for 1992 were $12 million higher than in 1991. Materials costs were higher due to increased locomotive repairs during 1992. Increasing track repair cost and related work equipment repair cost also contributed to the overall increase. The $12 million decrease in equipment rents expenses compared with 1991 was largely due to a decline in locomotive related expenses. Locomotive cost savings resulted from a renegotiated purchased power agreement and the expiration, during 1992, of several locomotive leases which were not renewed. These cost savings were somewhat offset by an increase in car-hire expenses due to lower 1992 than 1991 recoveries for prior period car-hire overpayments, which offset car-hire expenses in the period recovered. Purchased services expenses increased $7 million in 1992 compared with 1991. The increases over 1991 were a result of higher expenses related to computer programming costs associated with the implementation of several strategic initiatives, the expansion of a BNA customer service center due to increased BNA traffic, payments for car repairs and intermodal logistics costs. These increases were somewhat offset by lower environmental clean-up expenses, decreased relocation costs, fewer locomotive overhauls and increased payments from SPTC for trackage rights. Depreciation expense for 1992 was $9 million lower than in 1991. The decrease was primarily attributable to reduced depreciation for rail subsequent to the current-year implementation of an Interstate Commerce Commission required service life study for rail. The effect of the study on rail depreciation was to reduce 1992 expense by $28 million. This decrease was partially offset by increased depreciation, due to a larger asset base. Other expenses for 1992 was $12 million greater than in 1991. Although reported injury claims decreased, personal injury expense, excluding wage continuation costs discussed in compensation and benefits, increased by approximately $18 million as settlement costs for claims settled increased, and hearing loss claims continued to develop. Bad debt accruals also contributed to this increase. Lower derailment expenses and a decline in moving expenses partially offset this increase. Interest expense decreased $40 million in 1992 compared with 1991. Lower market interest rates and reduced commercial paper balances were significant contributors to this decrease. The reduction of long-term debt and the refinancing of high interest rate debt, during 1992 and late 1991, added to the current-year savings. Also, 1991 interest expense included an interest accrual related to a rate litigation case. In 1992, BN recorded other income, net of expense, of $41 million versus other expense, net of income, of $25 million in 1991. The 1992 income is due primarily to a first quarter net gain of $47 million for payments and reimbursements received for the settlement of prior litigation. Loss on investment and loss on sale of receivables were also lower in 1992 than in 1991. The effective tax rate was 33.8 percent and 37.6 percent in 1992 and 1991, respectively. The lower 1992 rate was the result of a fourth quarter Appeals Division settlement of IRS audits for the years 1981 through 1985. The total tax benefit recorded in 1992 was $17 million which reduced the effective tax rate by 3.8 percent. OTHER MATTERS In October 1991, Railroad entered into an agreement (Crew Consist Agreement No. 1) with the United Transportation Union (UTU) covering the southern portion of Railroad's system. Crew Consist Agreement No. 1 provided for crews on most through-freight trains to consist of one conductor and one engineer and for crews on all other trains to consist of one brakeman, one conductor and one engineer. Under the terms of Crew Consist Agreement No. 1, Railroad offered the opportunity for voluntary separation from employment in return for severance payments of up to $60,000 per employee. Remaining conductors or brakemen who, as a result of Crew Consist Agreement No. 1, were unable to hold a position in active service, due to relative seniority, were placed on a reserve board. Employees in reserve status received compensation at a rate equal to either 75 percent of their previous 12-month earnings, or 75 percent of the basic five-day yard helper rate of pay, whichever is greater, and are required to be available for return to active service on 15 days' notice. Each UTU member on the southern portion of Railroad's system received a lump-sum payment of $1,000 upon ratification of Crew Consist Agreement No. 1. In May 1993, Railroad entered into an agreement (Crew Consist Agreement No. 2) with the UTU covering approximately 3,400 UTU members in the northern portion of Railroad's system. Crew Consist Agreement No. 2 provides for crews on most through-freight trains to consist of one conductor and one engineer and for crews on all other trains to consist of one brakeman, one conductor and one engineer. It is similar to Crew Consist Agreement No. 1, covering the southern portion of Railroad's system. Each UTU member on the northern portion of Railroad's system received a one-time lump-sum payment of $5,000, pursuant to Crew Consist Agreement No. 2. Under the terms of Crew Consist Agreement No. 2, Railroad offered the opportunity for voluntary separation from employment in return for severance payments of up to $80,000 per employee. Conductors and brakemen who choose not to accept the voluntary separation offer can elect volunteer surplus status pursuant to which they will receive $60,000 to be paid out over a period of 18 to 48 months, as each selects. If such employee has not been recalled to active service by the time such payments cease upon expiration of the selected period, such employee will remain in volunteer surplus status, without further compensation or benefits, until recalled to active service. Employees in volunteer surplus status may be called back to service only after the individuals in reserve status, within their own subdivided seniority district, have been recalled. Remaining conductors and brakemen who, as a result of Crew Consist Agreement No. 2, are not needed in train service, and who do not elect one of the above severance options, will be placed on a reserve board. Employees in reserve status will receive compensation equal to either 75 percent of their previous 12-month earnings, or 75 percent of the basic five-day yard helper rate of pay, whichever is greater, and are required to be available for return to active service on 15 days' notice. In October 1993, the UTU elected to adopt Crew Consist Agreement No. 2 for those southern portion UTU members who were previously covered by Crew Consist Agreement No. 1. Crew Consist Agreement No. 2 was implemented on the southern portion of the Railroad's system during the fourth quarter of 1993. Upon implementation, each of the approximately 3,300 UTU members on the southern portion of Railroad's system received a one-time lump-sum payment of $4,000, which was the incremental difference between the $1,000 lump-sum payment received following ratification of Crew Consist Agreement No. 1 and the amount received by UTU members following adoption of Crew Consist Agreement No. 2. Railroad will continue to remove excess positions from train service through the implementation of Crew Consist Agreement No. 2. Approximately 1,350 excess positions have been removed as a result of employees accepting severance or voluntary surplus payments. Other excess positions have been eliminated and personnel formerly in those positions have been assigned to reserve boards, absorbed through additional train starts and/or utilized in quality and safety initiatives. Based upon its experience under Crew Consist Agreement No. 1, Railroad anticipates that the number of employees on reserve status will decline over time. In July 1993, the American Train Dispatchers Association ratified an April agreement which will facilitate the consolidation of all dispatching functions into a centralized train dispatching office in Fort Worth, Texas by the end of 1995. Since 1935, BN has participated in the national railroad retirement system which is separate from the national social security system. Under this system, an independent Railroad Retirement Board administers the determination and payment of benefits to all railroad workers. Both BN and its employees are subject to a tax on employee earnings which is above the normal social security rate assessed to those who are employed outside the railroad industry. Personal injury claims, including work-related injuries to employees, are a significant expense for the railroad industry. Employees of BN are compensated for work-related injuries according to the provisions of the Federal Employers' Liability Act (FELA). FELA's system of requiring finding of fault, coupled with unscheduled awards and reliance on the jury system, has resulted in significant increases in expense. The result has been a trend during the last several years of significant increases in BN's personal injury expense which reflects the combined effects of increasing medical expenses, legal judgments and settlements. To improve worker safety and counter increasing costs, BN has introduced a number of programs to reduce the number of personal injury claims and the dollar amount of claims settlements which helped reduce cost in 1993. If these efforts continue to be successful, future expenses could be further reduced. The total amount of personal injury expenses (including wage continuation payments) were $216 million, $253 million and $224 million in 1993, 1992 and 1991, respectively. BN is also working with others through the Association of American Railroads to seek changes in legislation to provide a more equitable program for injury compensation in the railroad industry. BN's operations, as well as those of its competitors, are subject to extensive federal, state and local environmental regulation. In order to comply with such regulation and to be consistent with BN's corporate environmental policy, BN's operating procedures include practices to protect the environment. Amounts expended relating to such practices are inextricably contained in the normal day-to-day costs of BN's business operations. Under the requirements of the Federal Comprehensive Environmental Response, Compensation and Liability Act of 1980 (Superfund) and certain other laws, BN is potentially liable for the cost of clean-up of various contaminated sites identified by the U.S. Environmental Protection Agency and other agencies. BN has been notified that it is a potentially responsible party (PRP) for study and clean-up costs at a number of sites and, in many instances, is one of several PRPs. BN generally participates in the clean-up of these sites through cost-sharing agreements with terms that vary from site to site. Costs are typically allocated based on relative volumetric contribution of material, the amount of time the site was owned or operated, and/or the portion of the total site owned or operated by each PRP. However, under Superfund and certain other laws, as a PRP, BN can be held jointly and severally liable for all environmental costs associated with a site. Environmental costs include initial site surveys and environmental studies of potentially contaminated sites as well as costs for remediation and restoration of sites determined to be contaminated. Liabilities for environmental clean-up costs are initially recorded when BN's liability for environmental clean-up is both probable and a reasonable estimate of associated costs can be made. Adjustments to initial estimates are recorded as necessary based upon additional information developed in subsequent periods. BN conducts an ongoing environmental contingency analysis, which considers a combination of factors, including independent consulting reports, site visits, legal reviews, analysis of the likelihood of participation in and ability to pay for clean-up by other PRPs, and historical trend analysis. BN is involved in a number of administrative and judicial proceedings in which it is being asked to participate in the clean-up of sites contaminated by material discharged into the environment. BN paid $27 million, $20 million and $21 million during 1993, 1992 and 1991, respectively, relating to mandatory clean-up efforts, including amounts expended under federal and state voluntary clean-up programs. At this time, BN expects to spend approximately $120 million in future years to remediate and restore these sites. Liabilities for environmental costs represent BN's best estimates for remediation and restoration of these sites and include asserted and unasserted claims. BN's best estimate of unasserted claims was approximately $5 million as of the end of 1993. Although recorded liabilities include BN's best estimates of all costs, without reduction for anticipated recovery from insurance, BN's total clean-up costs at these sites cannot be predicted with certainty due to various factors such as the extent of corrective actions that may be required, evolving environmental laws and regulations, advances in environmental technology, the extent of other PRPs participation in clean-up efforts, developments in ongoing environmental analyses related to sites determined to be contaminated, and developments in environmental surveys and studies of potentially contaminated sites. As a result, charges to income for environmental liabilities could possibly have a significant effect on results of operations in a particular quarter or fiscal year as individual site studies and remediation and restoration efforts proceed or as new sites arise. However, expenditures associated with such liabilities are typically paid out over a long period, in some cases up to 40 years, and are therefore not expected to have a material adverse effect on BN's consolidated financial position, cash flow or liquidity. In November 1992, the Financial Accounting Standards Board (FASB) issued Statement of Financial Accounting Standards (SFAS) No. 112, "Employers' Accounting for Postemployment Benefits." This standard requires employers to recognize benefits provided to former or inactive employees after employment but before retirement, if certain conditions are met. In the first quarter of 1994, BN will adopt SFAS No. 112. The principal effect of adopting this standard will be to establish liabilities for long-term and short-term disability plans. The effect upon earnings to adopt this standard is expected to be approximately $15 to $20 million. The initial effect of applying this standard will be reported as the effect of a change in accounting method and previously issued financial statements will not be restated. In May 1993, the FASB issued SFAS No. 115, "Accounting for Certain Investments in Debt and Equity Securities." SFAS No. 115 addresses the accounting and reporting requirements for investments in equity securities that have readily determinable fair values and for all investments in debt securities, and is effective for fiscal years beginning after December 15, 1993. The initial effect of applying this standard is to be reported as the effect of a change in accounting method and previously issued financial statements may not be restated. No material effect on BN's financial condition or results of operations is anticipated from the adoption of SFAS No. 115. ITEM 8.

ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA CONSOLIDATED STATEMENTS OF OPERATIONS BURLINGTON NORTHERN INC. AND SUBSIDIARIES (DOLLARS IN MILLIONS, EXCEPT PER SHARE DATA) See accompanying notes to consolidated financial statements. CONSOLIDATED BALANCE SHEETS BURLINGTON NORTHERN INC. AND SUBSIDIARIES (DOLLARS IN MILLIONS) See accompanying notes to consolidated financial statements. CONSOLIDATED STATEMENTS OF CASH FLOWS BURLINGTON NORTHERN INC. AND SUBSIDIARIES (DOLLARS IN MILLIONS) See accompanying notes to consolidated financial statements. CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS' EQUITY BURLINGTON NORTHERN INC. AND SUBSIDIARIES (DOLLARS IN MILLIONS, EXCEPT PER SHARE DATA) See accompanying notes to consolidated financial statements. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS BURLINGTON NORTHERN INC. AND SUBSIDIARIES 1. ACCOUNTING POLICIES Principles of consolidation The consolidated financial statements include the accounts of Burlington Northern Inc. (BNI) and its majority-owned subsidiaries (collectively BN). The principal subsidiary is Burlington Northern Railroad Company (Railroad). All significant intercompany accounts and transactions have been eliminated. Property and equipment Main line track is depreciated on a group basis using a units-of-production method. All other property and equipment are depreciated on a straight-line basis over estimated useful lives. Interstate Commerce Commission (ICC) regulations require periodic formal studies of ultimate service lives for all railroad assets. Resulting service life estimates are subject to review and approval by the ICC. An annual review of rates and accumulated depreciation is performed and appropriate adjustments are recorded. Significant premature retirements are recorded as gains or losses at the time of their occurrence, which would include major casualty losses, abandonments, sales and obsolescence of assets. Expenditures which significantly increase asset values or extend useful lives are capitalized. Repair and maintenance expenditures are charged to operating expense when the work is performed. All properties are stated at cost. Materials and supplies Materials and supplies consist mainly of diesel fuel, repair parts for equipment and other railroad property and are valued at average cost. Revenue recognition Transportation revenues are recognized proportionately as a shipment moves from origin to destination. Income taxes Income taxes are provided based on earnings reported for tax return purposes in addition to a provision for deferred income taxes. The provision for income taxes includes deferred taxes determined by the change in the deferred tax liability, which is computed based on the differences between the financial statement and tax basis of assets and liabilities as measured by applying enacted tax laws and rates. Deferred tax expense is the result of changes in the net liability for deferred taxes. Investment tax credits were accounted for under the "flow-through" method. Earnings (loss) per common share Earnings (loss) per common share are determined by dividing net income, after deduction of preferred stock dividends, by the weighted average number of common shares outstanding and common share equivalents. Common share equivalents were not included in the computation of the loss per common share in 1991 since their effect would have been antidilutive. Cash and cash equivalents All short-term investments which mature in less than 90 days when purchased are considered cash equivalents for purposes of disclosure in the consolidated balance sheets and consolidated statements of cash flows. Cash equivalents are stated at cost, which approximates market value. Reclassifications Certain prior year data has been reclassified to conform to the current year presentation. These reclassifications had no effect on previously reported net income, stockholders' equity or cash flows. 2. ACCOUNTS RECEIVABLE, NET Railroad has an agreement to sell, on a revolving basis, an undivided percentage ownership interest in a designated pool of accounts receivable with limited recourse. As of December 31, 1993, the agreement allowed for the sale of accounts receivable up to a maximum of $175 million. The agreement expires not later than December 1994. Average monthly proceeds from the sale of accounts receivable were $182 million, $190 million and $269 million in 1993, 1992 and 1991, respectively. At December 31, 1993 and 1992, accounts receivable were net of $100 million and $189 million, respectively, representing receivables sold. Included in other income (expense), net were expenses of $9 million, $11 million and $20 million in 1993, 1992 and 1991, respectively, relating to the sale. BN maintains an allowance for doubtful accounts based upon the expected collectibility of all trade accounts receivable, including receivables sold with recourse. Allowances for doubtful accounts and recourse on receivables sold of $17 million and $16 million have been recorded at December 31, 1993 and 1992. 3. PROPERTY AND EQUIPMENT, NET Property and equipment, net was as follows (in millions): Certain noncancellable leases were classified as capital leases and were included in property and equipment. The consolidated balance sheets at December 31, 1993 and 1992 included $36 million and $35 million, respectively, of property and equipment under capital leases. The related depreciation was included in depreciation expense. Accumulated depreciation for property and equipment under capital leases was $31 million and $29 million at December 31, 1993 and 1992, respectively. Main line track is depreciated on a group basis using a units-of-production method. The accumulated depreciation and annual depreciation accrual rates for railroad assets other than main line track are calculated using a straight-line method and statistical group measurement techniques, which closely approximate unit depreciation. The group techniques project depreciation expense and estimated accumulated depreciation utilizing historical experience and expected future conditions relating to the timing of asset retirements, cost of removal, salvage proceeds, maintenance practices and technological changes. In this manner, the net book value of reported assets reflects estimated remaining asset utility on a historical cost basis. Due to the imprecision of annual reviews using statistical group measurement techniques for long-term asset retirement, replacement and deterioration patterns, BN adjusts accumulated depreciation for significant differences between recorded accumulated depreciation and computed requirements. Differences between recorded accumulated depreciation and computed requirements are recognized prospectively on a straight-line basis. Under ICC regulations, BN conducts service life studies on an annual basis. Results of service life studies are recorded over the remaining life of the asset group studied. During 1993, BN completed service life studies of equipment and road property. During 1992, the service life studies consisted of rail. The effect of implementing the results of new service life studies and similar rate adjustments were to decrease depreciation expense in 1993 by $2 million compared with 1992 and to decrease depreciation expense in 1992 by $28 million compared with 1991. In future periods, service life studies will be conducted on other asset groups as well as these same assets under ICC requirements. However, the impact of such studies is not determinable at this time. In 1993, capitalization of certain software development costs increased as a result of new strategic initiatives. Capitalization of software development costs begins upon establishment of technological feasibility. The establishment of technological feasibility is based upon completion of planning, design and other technical performance requirements. Capitalized software development costs are amortized over a seven-year estimated useful life using the straight-line method. No amortization was recorded for the year ended December 31, 1993. Unamortized capitalized software costs were $6 million as of December 31, 1993. 4. DEBT Debt outstanding was as follows (in millions): Railroad maintains an effective program for the issuance, from time to time, of commercial paper. These borrowings are supported by Railroad's bank credit agreement, thus outstanding commercial paper balances reduce available borrowings under this agreement. The bank credit agreement allows borrowings of up to $500 million on a short-term basis. The agreement is currently scheduled to expire in November 1994. At Railroad's option, borrowing rates are based on prime, certificate of deposit or London Interbank Offered rates. Annual facility fees are 0.25 percent. The maturity value of commercial paper outstanding at December 31, 1993 was $27 million, leaving a total of $473 million of the credit agreement available, while no commercial paper was outstanding at December 31, 1992. The financial covenants of the bank credit agreement require that Railroad's consolidated tangible net worth, as defined in the agreement, be at least $1.4 billion, and its debt, as defined in the agreement, cannot exceed the lesser of 140 percent of its consolidated tangible net worth or $2.5 billion. The agreement contains an event of default arising out of the occurrence and continuance of a "Change in Control." A "Change in Control" is generally defined as the acquisition of more than 50 percent of the voting securities of BNI, which has not been approved by the BNI Board of Directors, a change in the control relationship between BNI and Railroad, and finally, a "Change in Control" is deemed to occur when a majority of the seats on the BNI Board of Directors is occupied by persons who are neither nominated by BNI management nor appointed by directors so nominated. The commercial paper program is further summarized as follows (dollars in millions): Maturities of commercial paper averaged 4 and 14 days in 1993 and 1992, respectively. During December 1993, BNI filed a registration statement with the Securities and Exchange Commission for the issuance, from time to time, of up to $500 million aggregate principal amount of debt securities. Net proceeds from the sale of the debt securities, if any are offered and sold, will be used to pay down debt or for other general corporate purposes. BNI acquired equipment which was financed in December 1993 through the issuance of $78 million of 6.32 percent notes due 1994 to 2012. In July 1993, BNI issued $150 million of 7 1/2 percent senior unsecured debentures due 2023 and used the proceeds for general corporate purposes, including working capital. These debentures were the final borrowing under the registration statement filed on September 24, 1991 covering the issuance, from time to time, of up to $500 million aggregate principal amount of debt securities. In November 1992, BNI completed a public offering of 6,900,000 shares of 6 1/4 percent cumulative convertible preferred stock at $50 per share. Most of the $337 million net proceeds from the offering were placed in trust to fund the redemption of BNI's $300 million 9 5/8 percent notes due 1996. Under the terms of the indenture, the 9 5/8 percent notes were redeemable at par, commencing February 1, 1993. The notification for redemption of the 9 5/8 percent notes was issued to holders of the notes in December 1992 with a redemption date of February 1, 1993. The debt was considered to be extinguished as of December 31, 1992, because BNI had irrevocably placed assets in trust, prior to such date, to be used solely to satisfy scheduled payments of both the interest on and principal of the $300 million 9 5/8 percent notes. The difference between BNI's redemption price and the net carrying value resulted in an immaterial loss which was recorded in other income (expense), net in 1992. In July 1992, BNI issued $150 million of 7 percent senior unsecured notes due 2002. The proceeds were used to retire $100 million of 14 3/4 percent notes due August 15, 1992 and to reduce outstanding commercial paper balances. In February 1992, BNI issued $200 million of 8 3/4 percent senior unsecured debentures due 2022 and used the proceeds to reduce outstanding commercial paper balances. Aggregate long-term debt scheduled maturities for 1994 through 1998 and thereafter are $185 million, $31 million, $25 million, $248 million, $24 million and $1,266 million, respectively. Substantially all Railroad properties and certain other assets are pledged as collateral to or are otherwise restricted under the various Railroad long-term debt agreements. 5. DISCLOSURES ABOUT FAIR VALUE OF FINANCIAL INSTRUMENTS The estimated fair values of BN's financial instruments at December 31, 1993 and 1992 and the methods and assumptions used to estimate the fair value of each class of financial instruments held by BN, were as follows: Cash and short-term investments The carrying amount approximated fair value because of the short maturity of these instruments. Notes receivable The fair value of notes receivable was estimated by discounting the anticipated cash flows. Discount rates of 8.7 percent and 10 percent at December 31, 1993 and 1992, were determined to be appropriate when considering current U.S. Treasury rates and the credit risk associated with these notes. Accrued interest payable The carrying amount approximated fair value as the majority of interest payments are made semiannually. Long-term debt and commercial paper The fair value of BN's long-term debt, excluding unamortized discount, was primarily based on secondary market indicators. For those issues not actively quoted, estimates were based on each obligation's characteristics. Among the factors considered were the maturity, interest rate, credit rating, collateral, amortization schedule, liquidity and option features such as optional redemption or optional sinking funds. These features were compared to other similar outstanding obligations to determine an appropriate increment or spread, above U.S. Treasury rates, at which the cash flows were discounted to determine the fair value. The carrying amount of commercial paper approximated fair value because of the short maturity of these instruments. Redeemable preferred stock The fair value of BN's redeemable preferred stock represented the market value as shown on the New York Stock Exchange at December 31, 1992. Recourse liability from sale of receivables It is unlikely that BN would be able to pay a second entity to assume its recourse obligation. Therefore, the carrying value of the allowance for doubtful accounts on receivables sold approximated the fair value of the recourse liability related to those receivables. The carrying amount and estimated fair values of BN's financial instruments were as follows (in millions): BN also holds investments in, and has advances to, several unconsolidated transportation affiliates. It was not practicable to estimate the fair value of these financial instruments, which were carried at their original cost of $19 million and $22 million in the December 31, 1993 and 1992 consolidated balance sheets. There were no quoted market prices available for the shares held in the affiliated entities, and the cost of obtaining an independent valuation would have been excessive considering the materiality of these investments to BN. In addition, BN has a note receivable, from a shortline railroad, that has principal payments which are based on traffic volume over a segment of line. The carrying value of the note was $5 million at December 31, 1993 and 1992. As it is not practicable to forecast the traffic volume over the remaining life of the note, it was not included in the notes receivable amount shown above. In May 1993, the Financial Accounting Standards Board (FASB) issued Statement of Financial Accounting Standards (SFAS) No. 115, "Accounting for Certain Investments in Debt and Equity Securities." SFAS No. 115 addresses the accounting and reporting requirements for investments in equity securities that have readily determinable fair values and for all investments in debt securities, and is effective for fiscal years beginning after December 15, 1993. The initial effect of applying this standard is to be reported as the effect of a change in accounting method and previously issued financial statements may not be restated. No material effect on BN's financial condition or results of operations is anticipated from the adoption of SFAS No. 115. 6. INCOME TAXES Effective January 1, 1993, BN adopted SFAS No. 109, "Accounting for Income Taxes." SFAS No. 109 modifies SFAS No. 96, which established the liability method of accounting for income taxes, and had been adopted by BN effective January 1, 1986. BN adopted SFAS No. 109 consistent with the transitional guidelines of SFAS No. 109. The effect of the adoption was to increase the current portion of the deferred income tax asset with a corresponding increase in the noncurrent deferred income tax liability of $26 million at January 1, 1993. There was no effect on net income, stockholders' equity or cash flows. Income tax expense (benefit), excluding the effect of the extraordinary item and the cumulative effect of changes in accounting methods, was as follows (in millions): Reconciliation of the federal statutory income tax rate to the effective tax rate, excluding the extraordinary item and the cumulative effect of changes in accounting methods, was as follows: The components of deferred tax assets and liabilities were as follows (in millions): As of December 31, 1993, approximately $5 million of alternative minimum tax credit carryovers with no expiration date are available to offset future tax liabilities. The alternative minimum tax credits have been fully recognized for financial accounting purposes. In 1993, tax benefits of $4 million related to the adjustment to recognize a minimum pension liability were allocated directly to stockholders' equity. On August 10, 1993, the Omnibus Budget Reconciliation Act of 1993 (the Act) was signed into law. The Act increased the corporate federal income tax rate by one percent, effective January 1, 1993, which reduced net income by $29 million, or $.32 per common share, through the date of enactment. A one-time, non-cash charge of $28 million to income tax expense was recorded as an adjustment to deferred taxes as of the enactment date and a charge of $1 million to income tax expense was recorded as an adjustment to current income taxes. In December 1992, BN received notification that an Appeals Division settlement of the Internal Revenue Service audits for the years 1981 through 1985 had been approved by the Joint Committee on Taxation. This action settled all unagreed issues for those years. The tax effect of the settlement was included in the 1992 tax provision as shown below (in millions, except per share data): 7. REDEEMABLE PREFERRED STOCK On July 15, 1993, BNI redeemed all of the outstanding shares of its $10 Par Value 5 1/2 percent Cumulative Redeemable Preferred Stock. BNI purchased the shares for $10.067222 per share or for a total of $9 million, representing the redemption price of $10 per share plus accrued dividends for the period from June 2, 1993 to July 15, 1993. Redeemable preferred stock activity was as follows (dollars in millions): 8. PREFERRED CAPITAL STOCK No Par Value Preferred Stock, authorized 25,000,000 shares -- 6,900,000 shares issued In November 1992, BNI issued 6,900,000 shares of 6 1/4 percent Cumulative Convertible Preferred Stock, Series A No Par Value. The convertible preferred stock is not redeemable prior to December 26, 1995. Thereafter, the shares may be redeemed at BNI's option, in whole or in part, during the twelve months beginning November 24 of each year except for 1995 which commences December 26, at the following redemption prices per share: $52.1875 in 1995, $51.875 in 1996, $51.5625 in 1997, $51.25 in 1998, $50.9375 in 1999, $50.625 in 2000, $50.3125 in 2001, and $50 in 2002 and thereafter. The convertible preferred stock may be converted, at the option of the holder at any time, into the number of shares of BNI's common stock equal to the liquidation preference of each share of convertible preferred stock, $50, divided by the conversion price of $47 per share of common stock. The convertible preferred stockholders have no voting rights unless six quarterly dividend payments are in default. In a default, such stockholders may vote separately as a class with all other series of the No Par Value Preferred Stock to elect two additional directors. Voting rights will continue until all arrearages have been paid. As of December 31, 1993, there had been no such defaults. Class A Preferred Stock Without Par Value, authorized 50,000,000 shares -- unissued At December 31, 1993, BNI had available for issuance 50,000,000 shares of Class A Preferred Stock Without Par Value. The Board of Directors has the authority to issue such stock in one or more series, to fix the number of shares and to fix the designations and the powers. On July 10, 1986, the Board of Directors designated a series of 800,000 shares of Class A Preferred Stock Without Par Value as Series A Junior Participating Class A Preferred Stock. On December 19, 1991, the Board of Directors increased the Series A Junior Participating Class A Preferred Stock designation to 3,000,000 shares. Each one one-hundredth of a share will have dividend and voting rights approximately equal to those of one share of common stock of BNI. In addition, on July 10, 1986, the Board of Directors declared a dividend distribution of one right for each outstanding share of common stock of BNI. The rights become exercisable if, without BNI's prior consent, a person or group acquires securities having 20 percent or more of the voting power of all of BNI's voting securities or announces a tender offer which would result in such ownership. Each right, when exercisable, entitles the registered holder to purchase from BNI one one-hundredth of a share of Series A Junior Participating Class A Preferred Stock at a price of $190 per one one-hundredth of a share, subject to adjustment. If, after the rights become exercisable, BNI were to be acquired through a merger, each right would permit the holder to purchase, for the exercise price, stock of the acquiring company having a value of twice the exercise price. In addition, if any person acquires 25 percent or more of BNI (other than as a result of a cash offer for all shares), each right not owned by the holder of such 25 percent would permit the purchase, for the exercise price, of stock of BNI having a value of twice the exercise price. The rights may be redeemed by BNI under certain circumstances until their expiration date for $.05 per right. 9. COMMON STOCK AND ADDITIONAL PAID-IN CAPITAL BNI is authorized to issue 300,000,000 shares of Common Stock Without Par Value. At December 31, 1993, there were 88,796,139 shares of common stock outstanding. Each holder of common stock is entitled to one vote per share in the election of directors and on all matters submitted to a vote of stockholders. Subject to the rights and preferences of the convertible preferred stock and any future issuance of additional preferred stock, each share of common stock is entitled to receive dividends as may be declared by the Board of Directors out of funds legally available and to share ratably in all assets available for distribution to stockholders upon dissolution or liquidation. No holder of common stock has any preemptive right to subscribe for any securities of BNI. Effective December 1991, the Board of Directors of BNI authorized the transfer, to additional paid-in capital, of $1,343 million representing capital in excess of the stated value of common stock. 10. STOCK OPTIONS AND OTHER CAPITAL STOCK Stock options Under BN's stock option plans, options may be granted to officers and key salaried employees at fair market value on the date of grant. All options expire within ten years after the date of grant. BN may also grant stock appreciation rights (SARs) in tandem with stock options which would be exercisable during the same period as the options. SARs entitle an option holder to receive a payment equal to the difference between the option price and the fair market value of the common stock at the date of exercise of the SAR. To the extent the SAR is exercised, the related option is cancelled and to the extent the option is exercised the related SAR is cancelled. Any change in the current market value over the SARs exercise price would be recognized at such time as an adjustment to compensation expense. During the third quarter of 1991, following a change in rules 16(a) and 16(b) promulgated under the Securities and Exchange Act of 1934, as amended, substantially all holders of SARs relinquished those rights. As a result, there were no further adjustments to compensation expense in times of changing market prices after the year ended December 31, 1991. Adjustments to compensation expense during the year ended December 31, 1991 were not significant. Activity in stock option plans was as follows: Shares issued upon exercise of options may be issued from treasury shares or from authorized but unissued shares. Other capital stock BN has restricted stock award plans under which up to 1,700,000 common shares may be awarded to eligible employees and directors of BN. No cash payment is required by the individual. Shares awarded under the plan may not be sold, transferred or used as collateral by the holder until the shares awarded become free of the restrictions, generally by one-thirds on the third, fourth and fifth anniversaries of the date of grant. All shares still subject to restrictions are generally forfeited and returned to the plan if the employee or director's relationship with BN is terminated. If the employee or director retires, becomes disabled or dies, the restrictions will lapse at that time. The compensation expense resulting from the award of restricted stock is valued at the average of the high and low market prices of BNI common stock on the date of the award, recorded as a reduction of stockholders' equity, and charged to expense evenly over the service period. Restricted stock awards under these plans, net of forfeitures, were 232,354, 214,475 and 223,850 shares in 1993, 1992 and 1991, respectively. A total of 870,525, 824,877 and 757,565 restricted common shares were outstanding at December 31, 1993, 1992 and 1991, respectively. Compensation expense was not significantly affected for all periods presented. BN also has a stock award plan which provides for grants of shares of BNI's common stock to full-time employees, excluding officers, based upon performance. A total of 100,000 shares of common stock has been authorized for these awards. The shares awarded contain no restrictions and the recipients have full shareholder rights and privileges. Compensation expense is based upon the average of the high and low market prices of BNI common stock on the date of grant. During the years ended December 31, 1993, 1992 and 1991, 5,540, 11,720 and 7,790 shares were awarded under this plan. The related compensation expense was not significant. An employee stock purchase plan was adopted in 1992 effective in 1993 as a means to encourage employee ownership of BNI common stock. A total of 500,000 shares of common stock were authorized for distribution under this plan. The plan allows eligible BN employees to use the proceeds of incentive compensation awards to purchase shares of BNI common stock at a discount, as determined by the BNI Board of Directors, from the market price and may require that the shares purchased be held for a specific time period as also determined by the Board of Directors. The difference between the market price and the employees' purchase price is recorded as additional compensation expense. During the year ended December 31, 1993, 34,629 shares were awarded under this plan. The related compensation expense was not significant. 11. RETIREMENT PLANS BN has non-contributory defined benefit pension plans covering substantially all non-union employees. The benefits are based on years of credited service and the highest five-year average compensation levels. Contributions to the plans are based upon the projected unit credit actuarial funding method and are limited to amounts that are currently deductible for tax purposes. Contributions are intended to provide not only for benefits attributed to service to date but also for those expected to be earned in the future. The funded status of BN plans and the net accrued pension cost reflected in the consolidated balance sheets were as follows (in millions): Components of the net pension cost were as follows (in millions): Net pension cost for 1993 was lower than 1992 primarily due to a decrease in the rate of future compensation growth from 6 percent to 5.5 percent. The changes in pension cost for the two years ended December 31, 1992 were primarily attributable to the expected year-to-year changes in the discount rates. The discount rate and rate of increase in future compensation levels used in determining the actuarial present value of the benefit obligations were 7 percent and 5.5 percent at December 31, 1993 and 8.5 percent and 5.5 percent at December 31, 1992. The expected long-term rate of return on assets was 9.5 percent for 1993 and 10 percent for the other years presented. BN sponsors a 401(k) thrift and profit sharing plan which covers substantially all non-union employees. BN matches 35 percent of the first 6 percent of the employees' contributions, which is subject to certain percentage limits of the employees' earnings, at the end of each quarter. Depending on BN's performance, an additional matching contribution of 20 to 40 percent can be made at the end of the year. BN's expense was $6 million, $4 million and $6 million in 1993, 1992 and 1991, respectively. Effective January 1, 1994, BN also sponsors a 401(k) retirement savings plan covering substantially all union employees which is non-contributory on the part of BN. 12. OTHER BENEFIT PLANS Postretirement benefits Effective January 1, 1992, BN adopted SFAS No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions." BN provides certain postretirement health care benefits, payable until age 65, for a small number of retirees who retired on or before March 1986. Both the accumulated postretirement benefits obligation and cost associated with this plan were insignificant. Life insurance benefits are provided for eligible non-union employees. BN adopted accrual accounting for the expense of these plans in 1992 by taking a $16 million cumulative effect charge to income in order to establish a liability for those benefits. BN pays benefits as claims are processed. The following table presents the status of the plans and the accrued postretirement benefit cost reflected in the consolidated balance sheets (in millions): Components of the postretirement benefit cost were as follows (in millions): The discount rate used in determining the benefit obligation was 7 percent at December 31, 1993 and 8.5 percent at December 31, 1992. The health care cost trend rate is assumed to decrease gradually from 15 percent in 1994 to 6 percent in 2003 and thereafter. Increasing the assumed health care cost trend rate by one percentage point in each year would have an insignificant effect on the accumulated postretirement benefit obligation at December 31, 1993 and 1992 as well as the aggregate of the service and interest cost components in 1993 and 1992. Under collective bargaining agreements, Railroad participates in multi-employer benefit plans which provide certain postretirement health care and life insurance benefits for eligible union employees. Insurance premiums attributable to retirees, which are expensed as incurred, were $10 million in 1993 and $11 million in both 1992 and 1991. Postemployment benefits In November 1992, the FASB issued SFAS No. 112, "Employers' Accounting for Postemployment Benefits." This standard requires employers to recognize benefits provided to former or inactive employees after employment but before retirement, if certain conditions are met. In the first quarter of 1994, BN will adopt SFAS No. 112. The principal effect of adopting this standard will be to establish liabilities for long-term and short-term disability plans. The effect upon earnings to adopt this standard is expected to be approximately $15 to $20 million. The initial effect of applying this standard will be reported as the effect of a change in accounting method and previously issued financial statements will not be restated. 13. CASUALTY AND ENVIRONMENTAL RESERVES Casualty reserves consist primarily of personal injury claims, including work-related injuries to employees. Employees of BN are compensated for work-related injuries according to the provisions of the Federal Employers' Liability Act. Liabilities for personal injury claims are estimated through an actuarial model that considers historical data and trends and is designed to record those costs in the period of occurrence. BN conducts an ongoing review and analysis of claims and other information to ensure the continued adequacy of casualty reserves. To the extent costs exceed recorded accruals they will not materially affect BN's financial condition, results of operations or liquidity. Under the requirements of the Federal Comprehensive Environmental Response, Compensation and Liability Act of 1980 (Superfund) and certain other laws, BN is potentially liable for the cost of clean-up of various contaminated sites identified by the U.S. Environmental Protection Agency and other agencies. BN has been notified that it is a potentially responsible party (PRP) for study and clean-up costs at a number of sites and, in many instances, is one of several PRPs. BN generally participates in the clean-up of these sites through cost-sharing agreements with terms that vary from site to site. Costs are typically allocated based on relative volumetric contribution of material, the amount of time the site was owned or operated, and/or the portion of the total site owned or operated by each PRP. However, under Superfund and certain other laws, as a PRP, BN can be held jointly and severally liable for all environmental costs associated with a site. Environmental costs include initial site surveys and environmental studies of potentially contaminated sites as well as costs for remediation and restoration of sites determined to be contaminated. Liabilities for environmental clean-up costs are initially recorded when BN's liability for environmental clean-up is both probable and a reasonable estimate of associated costs can be made. Adjustments to initial estimates are recorded as necessary based upon additional information developed in subsequent periods. BN conducts an ongoing environmental contingency analysis, which considers a combination of factors, including independent consulting reports, site visits, legal reviews, analysis of the likelihood of participation in and ability to pay for clean-up by other PRPs, and historical trend analysis. Liabilities for environmental costs represent BN's best estimates for remediation and restoration of these sites and include asserted and unasserted claims. BN's best estimate of unasserted claims was approximately $5 million as of the end of 1993. Although recorded liabilities include BN's best estimates of all costs, without reduction for anticipated recovery from insurance, BN's total clean-up cost at these sites cannot be predicted with certainty due to various factors such as the extent of corrective actions that may be required, evolving environmental laws and regulations, advances in environmental technology, the extent of other PRPs participation in clean-up efforts, developments in ongoing environmental analyses related to sites determined to be contaminated, and developments in environmental surveys and studies of potentially contaminated sites. As a result, charges to income for environmental liabilities could possibly have a significant effect on results of operations in a particular quarter or fiscal year as individual site studies and remediation and restoration efforts proceed or as new sites arise. However, expenditures associated with such liabilities are typically paid out over a long period, in some cases up to 40 years, and are therefore not expected to have a material adverse effect on BN's consolidated financial position, cash flow or liquidity. 14. COMMITMENTS AND CONTINGENCIES Lease commitments BN has substantial lease commitments for railroad, highway and data processing equipment, office buildings and a taconite dock facility. Most of these leases provide the option to purchase the equipment at fair market value at the end of the lease. However, some provide fixed purchase price options. Lease rental expense for operating leases was $175 million, $189 million and $195 million for the years ended December 31, 1993, 1992 and 1991, respectively. Minimum annual rental commitments were as follows (in millions): In addition to the above, BN also receives and pays rents for railroad equipment on a per diem basis, which is included in equipment rents. Other commitments and contingencies During 1993, BN entered into an agreement to acquire 350 new-technology alternating current traction motor locomotives. BN accepted delivery of one locomotive in 1993 and anticipates delivery of between approximately 60 and 100 each year from 1994 through 1997. BN has two locomotive electrical power purchase agreements, expiring in 1998 and 2001, that currently involve 199 locomotives. Payments required by the agreements are based upon the number of megawatt hours of energy consumed, subject to specified take-or-pay minimums. The rates specified in the two agreements are renegotiable every two years. BN's 1994 minimum commitment obligation is $48 million. Based on projected locomotive power requirements, BN's payments in 1994 are expected to be in excess of the minimum. Payments under the agreements totaled $53 million, $56 million and $55 million in 1993, 1992 and 1991, respectively, which exceeded the applicable minimums in each year. In 1990, BN entered into a letter of credit for the benefit of a vendor. This letter of credit is a performance guarantee for up to $15 million in major overhauls to be performed on the power purchase equipment. In connection with its program to transfer certain rail lines to independent operators, BN has agreed to make certain payments for services performed by the operators in connection with traffic that involves the shortlines and Railroad as carriers. These payments are not fixed in amount, will vary with such factors as traffic volumes and shortline costs and are not expected to exceed normal business requirements for services received. These payments are reflected as reductions to revenue to conform with reporting to the ICC. Revenues for these joint moves, including amounts applicable to the independent operator portion of the line haul, are reflected by BN as revenue from operations. There are no other commitments or contingent liabilities which BN believes would have a material adverse effect on the consolidated financial position, results of operations or liquidity. 15. OTHER INCOME (EXPENSE), NET Other income (expense), net includes the following (in millions): In the first quarter of 1992, BN entered into a settlement agreement relating to the reimbursement of attorneys' fees and costs incurred by BN in connection with litigation filed by Energy Transportation Systems, Inc., and others, and reimbursement of a portion of the amount paid in prior years by BN in settlement of that action. Under the terms of the settlement, BN received approximately $50 million before legal fees. 16. ACCOUNTING CHANGES Effective January 1, 1993, BN adopted SFAS No. 109, "Accounting for Income Taxes." SFAS No. 109 modifies SFAS No. 96, which established the liability method of accounting for income taxes, and had been adopted by BN effective January 1, 1986. BN adopted SFAS No. 109 consistent with the transitional guidelines of SFAS No. 109. The effect of the adoption was to increase the current portion of the deferred income tax asset with a corresponding increase in the noncurrent deferred income tax liability of $26 million at January 1, 1993. There was no effect on net income, stockholders' equity or cash flows. In January 1992, the Emerging Issues Task Force of the FASB reached a consensus that origination of service revenue recognition was not an acceptable method beginning in 1992 for the freight services industry. Accordingly, effective January 1, 1992, BN changed its method of revenue recognition from one which recognized transportation revenue at the origination point, to a method whereby transportation revenue is recognized proportionately as a shipment moves from origin to destination. The cumulative effect, net of a $7 million income tax benefit, of the change on the prior year's revenue, at the time of adoption, decreased 1992 net income by $11 million, or $.13 per common share. In the fourth quarter of 1992, effective January 1, 1992, BN adopted SFAS No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions," and elected immediate recognition of the $16 million transition obligation. The cumulative effect, net of a $6 million income tax benefit, of the change on prior years', at the time of adoption, decreased 1992 net income by $10 million, or $.11 per common share. Financial results for the first quarter of 1992 have previously been restated for the cumulative effect of the change in accounting method for revenue recognition, which had previously been reported in other income (expense), net and for the cumulative effect of the implementation of the accounting standard for postretirement benefits. There was no material effect on the second and third quarter, and those quarters were not restated for the adoption of SFAS No. 106. 17. 1991 SPECIAL CHARGE Included in 1991 results was a pre-tax special charge of $708 million related to railroad restructuring costs and increases in liabilities for casualty claims and environmental clean-up costs. The 1991 special charge included the following components: Restructuring This program provided for work force reduction of employees. The restructuring program and related charge had two components: - $185 million to provide for employee related costs for the elimination of surplus crew positions. - $40 million to provide for employee related costs for a separation program. Other - $350 million to increase casualty reserves based on an actuarial valuation and escalations in both the cost and number of projected hearing loss claims. - $133 million to increase environmental reserves based on studies and analyses of potential environmental clean-up and restoration costs. The special charge reduced 1991 net income by $442 million, or $5.79 per common share. 18. EXTRAORDINARY ITEM The extraordinary loss for 1991 of $14 million, $.18 per common share, resulted from the loss on redemption of 11 5/8 percent debentures, net of an $8 million income tax benefit. The 1991 redemption of the 11 5/8 percent debentures was completed using proceeds from the issuance of common stock. REPORT OF MANAGEMENT To the Stockholders and Board of Directors of Burlington Northern Inc. and Subsidiaries The accompanying consolidated financial statements have been prepared by management in conformity with generally accepted accounting principles. The fairness and integrity of these financial statements, including any judgments and estimates, are the responsibility of management, as is all other information presented in this Annual Report on Form 10-K. In the opinion of management, the financial statements are fairly stated, and, to that end, BN maintains a system of internal control which: provides reasonable assurance that transactions are recorded properly for the preparation of financial statements; safeguards assets against loss or unauthorized use; maintains accountability for assets; and requires proper authorization and accounting for all transactions. Management is responsible for the effectiveness of internal controls. This is accomplished through accounting and other control systems, policies and procedures, employee selection and training, appropriate delegation of authority and segregation of responsibilities, and an established code of ethics for employees. To further ensure compliance with established standards and related control procedures, BN conducts a substantial corporate audit program. Our independent accountants provide an objective independent review through their audit of BN's financial statements. Their audit includes a review of internal accounting controls to the extent deemed necessary for the purposes of their audit. The Audit Committee of the Board of Directors, composed solely of outside directors, meets regularly with the independent accountants, management and corporate audit to review the work of each and to ensure that each is properly discharging its financial reporting and internal control responsibilities. To ensure complete independence, the independent accountants and the corporate audit department have full and free access to the Audit Committee to discuss the results of their audits, the adequacy of internal accounting controls and the quality of financial reporting. David C. Anderson Executive Vice President, Chief Financial Officer and Chief Accounting Officer January 17, 1994 REPORT OF INDEPENDENT ACCOUNTANTS To the Stockholders and Board of Directors of Burlington Northern Inc. and Subsidiaries We have audited the consolidated financial statements and financial statement schedules of Burlington Northern Inc. and Subsidiaries listed in Item 14 of this Form 10-K. These consolidated financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these consolidated financial statements and financial statement schedules based on our audits. We conducted our audits according to generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the consolidated financial position of Burlington Northern Inc. and Subsidiaries as of December 31, 1993 and 1992, and the consolidated results of their operations and their cash flows for each of the three years in the period ended December 31, 1993 in conformity with generally accepted accounting principles. In addition, in our opinion, the financial statement schedules referred to above, when considered in relation to the basic financial statements taken as a whole, present fairly, in all material respects, the information required to be included therein. As discussed in Note 16 to the consolidated financial statements, the Company changed its method of accounting for income taxes in 1993 and for revenue recognition and postretirement benefits other than pensions in 1992. COOPERS & LYBRAND Fort Worth, Texas January 17, 1994 QUARTERLY FINANCIAL DATA-UNAUDITED (DOLLARS IN MILLIONS, EXCEPT PER SHARE DATA) - --------------- (1) Results for the third quarter of 1993 include the effects of the Omnibus Budget Reconciliation Act of 1993 (the Act) which was signed into law on August 10, 1993. The Act increased the corporate federal income tax rate by one percent, effective January 1, 1993, which reduced net income by $29 million, or $.32 per common share, through the date of enactment. Results for the third quarter of 1993 also include the effects of the severe flooding in the Midwest. BN estimates the flooding reduced revenues and operating income during the quarter by $44 million and $79 million, respectively, and reduced net income by $49 million, or $.55 per common share. (2) Amounts may not total to the annual earnings per share because each quarter and the year are calculated separately based on average outstanding shares and common share equivalents during that period. (3) The higher of average or end of period market price is used to determine common share equivalents for fully diluted earnings per share. In addition, the if-converted method is used for convertible preferred stock when computing fully diluted earnings per common share. (4) Results for 1992 reflect the cumulative effect of the change in accounting method for revenue recognition, and the cumulative effect of the implementation of the accounting standard for postretirement benefits (Statement of Financial Accounting Standards No. 106). The cumulative effect of the change in accounting method for revenue recognition decreased 1992 net income by $11 million, or $.13 per common share. The cumulative effect of the change in accounting method for postretirement benefits decreased 1992 net income by $10 million, or $.11 per common share, and had no immediate effect on cash flows. (5) Results for the fourth quarter of 1992 include a $17 million reduction in income tax expense as a result of a favorable Internal Revenue Service settlement which allowed BN to recognize additional depreciation deductions for income taxes. ITEM 9.

ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE None PART III ITEM 10.

ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT and ITEM 11.

ITEM 11. EXECUTIVE COMPENSATION A definitive proxy statement of Burlington Northern Inc. will be filed not later than 120 days after the end of the fiscal year with the Securities and Exchange Commission. The information set forth therein under "Election of Directors" and "Executive Compensation" will be incorporated herein by reference. Executive Officers of Burlington Northern Inc. and the principal subsidiary are listed on pages 8-11 of this Form 10-K. ITEM 12.

ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT Information required is set forth under the caption "Election of Directors" in the Proxy Statement for the 1994 Annual Meeting of Stockholders and will be incorporated herein by reference. ITEM 13.

ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS Information required is set forth under the caption "Executive Compensation" in the Proxy Statement for the 1994 Annual Meeting of Stockholders and will be incorporated herein by reference. PART IV ITEM 14.

ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K Schedules other than those listed above are omitted for the reason that they are not required or not applicable, or the required information is included in the consolidated financial statements or related notes. EXHIBIT INDEX The following exhibits are filed as part of this report. EXHIBIT INDEX (CONTINUED) - --------------- * Exhibit is incorporated by reference as indicated. ** Exhibit is filed with Form 10-K for the year ended December 31, 1993. REPORTS ON FORM 8-K During the fourth quarter of 1993, there were no reports filed on Form 8-K. SIGNATURES REQUIRED FOR FORM 10-K Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, Burlington Northern Inc. has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. BURLINGTON NORTHERN INC. /s/ GERALD GRINSTEIN Gerald Grinstein Chairman, Chief Executive Officer and Director Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of Burlington Northern Inc. and in the capacities and on the dates indicated. DIRECTORS OF BURLINGTON NORTHERN INC. SCHEDULE II BURLINGTON NORTHERN INC. AND SUBSIDIARIES AMOUNTS RECEIVABLE FROM RELATED PARTIES AND UNDERWRITERS, PROMOTERS, AND EMPLOYEES OTHER THAN RELATED PARTIES FOR THE YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 - --------------- NOTE: Mr. Gerald Grinstein, Chairman of the Board, received noninterest-bearing loans, payable upon demand, in the principal amount of $1,600,000 and $880,000 in 1993 and 1992, respectively. Both loans are secured by shares of BNI common stock. SCHEDULE V BURLINGTON NORTHERN INC. AND SUBSIDIARIES PROPERTY, PLANT AND EQUIPMENT FOR THE YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 (IN MILLIONS) - --------------- (1) Relates primarily to reused track materials from Materials and Supplies inventory used for additions to property. See accompanying notes to consolidated financial statements for information regarding depreciation methods and other matters. SCHEDULE VI BURLINGTON NORTHERN INC. AND SUBSIDIARIES ACCUMULATED DEPRECIATION, DEPLETION, AND AMORTIZATION OF PROPERTY, PLANT AND EQUIPMENT FOR THE YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 (IN MILLIONS) - --------------- (1) Relates primarily to estimated net book value of retirements plus the cost to remove property before determination of excess depreciation on assets retained. See accompanying notes to consolidated financial statements for information regarding depreciation methods and other matters. SCHEDULE VIII BURLINGTON NORTHERN INC. AND SUBSIDIARIES VALUATION AND QUALIFYING ACCOUNTS FOR THE YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 (IN MILLIONS) - --------------- Notes: (1) Principally represents cash payments. (2) Classified in the consolidated balance sheets as follows: SCHEDULE X BURLINGTON NORTHERN INC. AND SUBSIDIARIES SUPPLEMENTARY INCOME STATEMENT INFORMATION FOR THE YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 (IN MILLIONS) - --------------- Note: Items omitted are either less than one percent of consolidated revenues or are disclosed elsewhere in the consolidated financial statements or notes thereto. EXHIBIT INDEX

31986_1993.txt

31986

1993

ITEM 3. LEGAL PROCEEDINGS In El Paso Natural Gas Company and Meridian Oil Gathering Inc. v. Amoco Production Company, filed in Delaware Chancery Court on May 8, 1991, Amoco Production Company ("Amoco") alleged breaches by EPG and a then affiliated company, Meridian Oil Gathering Inc. ("MOGI"), of certain gas purchase, gathering and transportation agreements pertaining to natural gas produced by Amoco in the San Juan Basin. Amoco alleged breach of "favored nations" contractual provisions regarding services to be performed by EPG, including those relating to transportation capacity and rates, and has sought a court order requiring specific performance by EPG and MOGI with respect to future transportation services and an award of monetary damages of an undetermined amount for alleged past breaches of contract. On March 4, 1992, the Court issued a Memorandum Opinion which, among other things, denied Amoco's motion for partial summary judgment and concluded that the Amoco contracts at issue do not contain the general "favored nations" rights claimed by Amoco. The court further concluded that EPG's and MOGI's motions for summary judgment, seeking dismissal of Amoco's counterclaim against MOGI, should be granted. Conoco Inc. ("Conoco") asserted claims similar to Amoco's original claims, involving lesser quantities of gas, in a separate Delaware Chancery Court proceeding filed on December 30, 1991, Conoco Inc. v. El Paso Natural Gas Company. In August 1992, the Amoco and Conoco cases were consolidated, MOGI was dismissed as a party, and Amoco and Conoco filed amended pleadings to restate their claims in lights of the court's March 4, 1992 ruling. EPG and Conoco concluded a settlement agreement which resulted in dismissal of the Conoco claims. Trial of the Amoco claims concluded on July 15, 1993; however, the court's decision has not yet been issued. Post-trial briefing and oral arguments concluded in early November 1993, and the decision of the court is expected in early 1994. Management does not expect the outcome of this matter to have a materially adverse effect on the Company's financial condition. The Company is a named defendant in numerous lawsuits and a named party in numerous governmental proceedings arising in the ordinary course of business. While the outcome of such lawsuits or other proceedings against the Company cannot be predicted with certainty, management does not expect these matters to have a materially adverse effect on the Company's financial condition. ITEM 4.

ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS During the fourth quarter of 1993, no matters were submitted to a vote of security holders. PART II ITEM 5.

ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS All outstanding common stock of EPG was owned by BR until March 1992. In March 1992, EPG completed the Offering. On June 30, 1992, BR distributed its 31.4 million shares of EPG common stock, which represented approximately 85 percent of EPG's outstanding common stock, to BR shareholders. As a result, BR no longer retains an ownership interest in EPG. EPG's common stock is traded on the New York Stock Exchange. As of January 14, 1994 the approximate number of holders of record of common stock was 25,673. This does not include individual participants on whose behalf a clearing agency or its nominee holds EPG's common stock. The following table reflects the high and low sales prices for and cash dividends declared on EPG's common stock based on the daily composite listing of stock transactions for the New York Stock Exchange. On January 14, 1994, EPG's Board of Directors declared a quarterly dividend of $0.3025 per share on EPG's common stock, payable on April 4, 1994 to shareholders of record on March 11, 1994. ITEM 6.

ITEM 6. SELECTED FINANCIAL DATA - ------------ (a) Earnings per share of common stock is based on 37,212,192 weighted average shares of common stock outstanding for 1993, 36,049,135 weighted average shares of common stock outstanding for 1992 and 31,421,731 shares of common stock outstanding for the years 1989 through 1991. (b) Represents dividends declared subsequent to the Offering. (c) In May 1991, EPG declared and paid a dividend of $175 million to its then parent company, The El Paso Company ("TEPCO"). In September 1991, EPG declared a dividend of all its Oil and Gas Operations Segment to TEPCO. The total amount of that dividend was $925 million. In addition, EPG declared and paid dividends to BR totaling $55 million in 1991 and $274 million prior to the Offering in 1992. (d) Excludes current maturities. (e) MPC has been consolidated for the months of May 1993 through December 1993. ITEM 7.

ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS FINANCIAL CONDITION AND LIQUIDITY Cash provided by operating activities was $236 million for 1993 compared with $334 million for 1992. The decrease from the previous year was primarily due to proceeds received in 1992 from the sale of the direct bill portion of the take-or-pay receivables, lower take-or-pay collections in 1993, rate refund payments resulting from the settlement agreement and costs incurred to repair flood damaged pipelines (see Other of this section), partially offset by decreased tax payments in 1993. Cash provided by continuing operating activities was $334 million for 1992 compared with $249 million for 1991. The increase was primarily due to proceeds from the sale of the direct bill portion of the take-or-pay receivables, the 1991 net cash payments made in connection with the August 14, 1991 FERC order (see Rates and Regulatory Matters of this section), the decrease in take-or-pay expenditures and a decrease in interest payments. The increase was partially offset by a reduction in volumetric take-or-pay receivable collections and a decrease in accruals for regulatory issues. Acquisition On June 1, 1993, the Company acquired from a wholly owned subsidiary of Enron Corp., that subsidiary's 50 percent interest in MPC, for approximately $40 million in cash, representing the approximate book value of the investment. The acquisition, which was funded by internally generated cash flow, gives the Company 100 percent ownership of MPC. The acquisition was accounted for using the purchase method. In conjunction with the acquisition, the following liabilities were assumed: The following MPC balances are included in the December 31, 1993 Consolidated Balance Sheet of the Company: The operating results of MPC are included in the Company's consolidated results of operations for the months of May 1993 through December 1993. The Company's previously owned 50 percent equity interest in MPC is included in other-net in the accompanying Consolidated Statement of Income. The following pro forma summary presents the consolidated results of operations of the Company as if the acquisition had occurred as of January 1, 1993 and January 1, 1992. These pro forma results have been prepared for comparative purposes only and do not purport to be indicative of what may have resulted had the acquisition occurred as of those dates or of results which may occur in the future. Gathering and Production Area Facilities On January 14, 1994, EPG filed an application with FERC seeking an order which would terminate, effective January 1, 1996, certificates applicable to certain gathering and production area facilities owned by EPG on the basis that such facilities are not subject to FERC jurisdiction. EPG intends, effective January 1, 1996, to transfer all of its nonjurisdictional gathering and production area facilities to a wholly owned subsidiary of EPG. Such facilities are used for gathering and other nonjurisdictional functions and are an inherent part of EPG's current gathering operations. The facilities to be transferred consist of approximately 6,700 miles of various sized pipelines, compressors with horsepower of 40,600 and various treating and processing plants. These nonjurisdictional facilities, together with the facilities included in the January 14, 1994 FERC application, constitute all of EPG's gathering and production area facilities. Rates and Regulatory Matters On July 1, 1991, EPG filed for FERC approval of new system rates and placed the proposed new rates into effect on January 1, 1992, subject to refund. On July 31, 1992, EPG again filed for new system rates to recover increased costs and return on rate base associated with EPG's expansion and modernization projects. These rates became effective on February 1, 1993, subject to refund. In the July 1992 filing, EPG's rate base increased from $752 million to approximately $1.2 billion. EPG made its compliance filing on December 31, 1992 in accordance with the Restructuring Rules. In January 1993, EPG, certain of its customers and FERC staff reached a settlement agreement which led to the resolution of the above mentioned rate and restructuring proceedings. The settlement agreement was filed in January 1993 to supersede EPG's December 31, 1992 compliance filing. As required by FERC order, EPG filed revised rates on September 14, 1993, which implemented the settlement agreement effective October 1, 1993. Under the settlement agreement, EPG refunded a total of approximately $56 million, inclusive of interest, in the fourth quarter of 1993. EPG had provided for these rate refunds as revenues were collected. The settlement agreement provides for the accelerated recovery of a substantial portion of EPG's investment in its underground storage facility. This is being recovered by a demand charge mechanism over the period from October 1, 1993 through December 31, 1996. The amount to be recovered was approximately $56.7 million plus interest accruing beginning February 1, 1993 at the FERC allowed rate, which approximates the prime rate. The amount recovered through December 31, 1993 was $19 million. The outstanding balance at December 31, 1993 was $37 million, of which $12 million is included in other current assets and $25 million is included in other assets in the accompanying Consolidated Balance Sheet. The settlement agreement also established new depreciation rates for certain of EPG's facilities effective January 1, 1992. On August 14, 1991, FERC approved an order resolving all of the issues in EPG's December 1987 rate case filing and certain other pending matters which became effective on September 1, 1991. The order provided for: (i) the establishment of revised rate levels for the period July 1, 1988 through the effective date of EPG's next rate change, which occurred on January 1, 1992; and (ii) payment of certain refunds for the period July 1, 1988 through August 31, 1991. EPG disbursed to its customers $252 million in October 1991 in accordance with the order. The total refund obligation at September 1, 1991 was $369 million before certain offsets, including an unbilled portion of the $169 million of recoverable excess gas costs. The net refund obligation and the remaining balance of the recoverable excess gas costs, $25 million, were recorded against previously established accruals. Pursuant to the Restructuring Rules, MPC filed its restructuring plan on November 3, 1992. On March 2, 1993, FERC issued an order essentially approving MPC's compliance filing, subject to changes, which were made in an amended restructuring plan on March 29, 1993. Several of MPC's customers filed protests and requests for rehearing of the March 2, 1993 FERC order. The rehearing requests were denied, and FERC approved the amended restructuring plan on July 9, 1993, with an effective date of August 1, 1993. On October 15, 1993, FERC issued an order which denied requests for rehearing of the July 9, 1993 order. Several of MPC's customers have filed petitions for review of the March 2, 1993, July 9, 1993 and October 15, 1993 orders with the United States Court of Appeals which are currently pending. The primary issues on appeal pertain to FERC's requirement that MPC's rates for firm transportation service be based upon SFV rate design rather than MFV rate design. The application of SFV rates requires MPC's existing firm shippers to pay a higher proportion of their total transportation rate in the reservation component of the rate, and this increases aggregate transportation charges for low load factor shippers. Such shippers have contended that FERC's application of SFV rate design to MPC unlawfully abrogates the rate provisions of MPC's service agreements and constitutes an unlawful rate increase. MPC believes the United States Court of Appeals will uphold SFV rates as applied to MPC. Take-or-Pay Settlements Since 1987, EPG has made, or has committed to make, buy-out and buy-down payments totaling $1.5 billion to resolve past and future take-or-pay exposure, to terminate and reform gas purchase contracts, to amend pricing and take provisions of gas purchase contracts and to settle related litigation. In certain cases, EPG resolved claims by making recoupable prepayments. At December 31, 1993 and December 31, 1992, the recoupable prepayment balances were $9 million and $19 million, respectively. These payments resolved virtually all the outstanding producer claims asserted against EPG and terminated or prospectively reformed substantially all of EPG's remaining gas purchase contracts, with the result that EPG no longer has any material take-or-pay exposure. EPG has filed to recover $1.1 billion of its buy-out and buy-down costs under FERC cost recovery procedures. The collection period for the direct bill portion of the take-or-pay buy-out and buy-down costs extends through May 1994. The collection period for the volumetric surcharge portion of such costs extends through March 1996. Through December 31, 1993, EPG had recovered approximately $1.0 billion; of that recovery, $361 million was collected by direct bill and $682 million by volumetric surcharge. EPG has established a reserve for that portion of the volumetric surcharge receivables balance which is unlikely to be collected over the period through March 1996, based on current throughput projections. The balance of this reserve was $19 million at December 31, 1993. Under FERC procedures, take-or-pay cost recovery filings may be challenged by pipeline customers on prudence and certain other grounds. In October 1992, FERC approved an order, subject to rehearing, resolving all but one of the outstanding issues regarding EPG's take-or-pay proceedings. The remaining issue involves the claim by several customers that EPG has sought to recover an excessive amount for the value of certain production properties which were transferred to a producer as part of a 1989 take-or-pay settlement. On March 8, 1993, an initial decision from the presiding ALJ was rendered which, if adopted without changes by FERC, would require EPG to refund to or forgo collection from its customers of up to $30 million, plus interest. Exceptions to this initial decision were filed with FERC by both parties on April 7, 1993. On April 27, 1993, briefs opposing exceptions were filed by the same parties as well as by FERC staff. EPG has established adequate reserves for this issue and does not believe that the ultimate outcome will have a materially adverse effect on the Company's financial condition or results of operations. On January 14, 1992, EPG completed a sale of substantially all of its remaining take-or-pay buy-out and buy-down receivables. The sale totaled $325 million, including $305 million of cash received at closing, which was used to repay $300 million of a payable to BR. The receivables sold in this transaction included $104 million which was recovered through direct bill and $221 million to be recovered through volumetric surcharge. The volumetric surcharge portion of the sale has been accounted for as a financing transaction because EPG is subject to certain recourse provisions related to such receivables. At December 31, 1993 and December 31, 1992, $87 million and $125 million, respectively, of the volumetric surcharge portion of the receivables sold remained outstanding. Amounts collected related to the take-or-pay receivables sold are remitted to the purchasers of the receivables. Restructuring and Financing Transactions In February 1992, EPG established a $300 million revolving credit facility with a group of banks which expires in March 1996. As of December 31, 1993, there were no borrowings outstanding under this facility. Approximately $1 million of commercial paper was outstanding as of December 31, 1993. During 1992 and 1991, EPG completed several transactions in preparation for its separation from BR. Among these transactions was the transfer of the net assets of El Paso Production Company ("EPPC") and Meridian Oil Hydrocarbons Inc. ("Hydrocarbons"), collectively, the Company's Oil and Gas Operations Segment, which is reported as discontinued operations. In December 1991, EPG declared and paid a dividend to BR of $55 million. In January and February 1992, EPG declared and paid dividends totaling $274 million to BR. These dividends were paid from the balance owed to EPG under an intercorporate cash management arrangement. In March 1992, EPG completed the Offering. The proceeds from the Offering, net of related costs, totaled approximately $96 million. On June 30, 1992, BR distributed its 31.4 million shares of EPG's common stock to BR shareholders, which represented approximately 85 percent of EPG's outstanding common stock. As a result, BR no longer retains an ownership interest in EPG. EPG had a Commitment Agreement with BR under which it could borrow up to $300 million and Loan Agreements for borrowings up to $500 million. At December 31, 1991, outstanding borrowings under the Commitment and Loan Agreements were $300 million and $325 million, respectively. In January 1992, additional borrowings of $109 million were made under the Loan Agreements to purchase the notes and debentures described below. EPG also undertook certain transactions to establish an appropriate capital structure for its post-separation operations. In December 1991 and January 1992, EPG purchased notes and debentures totaling $253 million and $134 million, respectively. Funds were provided by proceeds from borrowings under the BR Loan Agreements. In addition, all of the outstanding 9 5/8% debentures were called for redemption at 106.84 percent of their principal amount. In January 1992, EPG received net proceeds of $569 million from the issuance of new debt securities. The proceeds were used for repayment of borrowings under the Loan Agreements with BR, redemption of debentures and payment of general corporate costs. EPG repaid its outstanding commercial paper in December 1991 with borrowings under the Commitment Agreement with BR. The proceeds from the sale of the take-or-pay receivables, previously discussed herein, were used to repay the borrowings under the Commitment Agreement with BR. The Commitment Agreement and the Loan Agreements with BR were terminated prior to the completion of the Offering. Competition Currently, EPG faces competition from other companies which transport natural gas to the California market. Competition generally occurs on the basis of price, quality and reliability of service. The total present interstate pipeline capacity for delivering natural gas to the California border is approximately 6.9 Bcf/d. In addition to EPG, three other major interstate pipelines presently deliver natural gas to California. Transwestern has the capacity to deliver approximately 1.1 Bcf/d from Permian, Anadarko and San Juan Basin supply sources; PGT has the capacity to deliver about 1.8 Bcf/d of Canadian gas; and Kern River has the capacity to deliver approximately 700 MMcf/d from Rocky Mountain supply sources. PGT completed a 755 MMcf/d expansion of its California capacity on November 1, 1993. In 1992, Kern River held an open season to determine interest in expanding capacity to California by 200 MMcf; however, no planned expansions have since been announced. Demand for natural gas in the California market is projected to be less than capacity for some time to come. EPG maintains a strong competitive position in the market by virtue of the fact that its pipeline is, and expects to remain, the lowest-cost transporter of natural gas to California and the principal means of moving gas from the San Juan Basin to the California border. EPG's pipeline capacity to California is fully subscribed under long-term contracts which provide for the payment of fixed reservation charges. EPG's largest single contract for interstate capacity to California is its 1,450 MMcf/d contract with SoCal, which has a primary term ending August 31, 2006. In 1992, SoCal relinquished 300 MMcf/d pursuant to this contract (out of an original contract demand quantity of 1,750 MMcf/d), all of which was subsequently subscribed by new firm shippers under long-term contracts. Pursuant to this contract, SoCal has the option to relinquish an additional 300 MMcf/d of capacity during the first quarter of 1996. PG&E has a contract for 1,140 MMcf/d of firm capacity rights on EPG's system. This contract has a primary term ending December 31, 1997. CPUC has directed PG&E to maintain 600 MMcf/d of capacity on EPG's system to service PG&E's core and core subscription service customers. EPG expects to offset potential future reductions in capacity commitments through new contracts with various natural gas users in California which are now served indirectly through SoCal and PG&E, as well as through the development of additional East-of-California and northern Mexico markets. In general, natural gas faces varying degrees of competition from electricity, coal and oil. Competitive pressure from alternative fuels is less prevalent in EPG's market area due to strict environmental regulations in California. Environmental Accruals for environmental compliance costs are established when environmental assessments and/or remediation are probable, and when costs can be reasonably estimated. As of December 31, 1993, EPG had a reserve of $38 million for the following environmental contingencies with income statement impact: 1 -- EPG has been conducting remediation of PCB contamination at its facilities. The majority of the required PCB remediation has been completed. Future PCB remediation costs are estimated to range between $8 million and $11 million over the next five years. 2 -- EPG executed an Administrative Order on Consent with EPA on June 25, 1993 to conduct a RI/FS for a BI site located in Statesville, North Carolina, that has been identified for cleanup. BI and EPG have entered into an agreement to jointly fund the RI/FS for the site. EPG's share of the potential remediation costs is estimated to be between $17 million and $20 million over a 30 year period. 3 -- On November 2, 1993, in accordance with an EPA order, EPG and ARCO submitted work plans for remediation of the subsurface at the Prewitt Refinery in McKinley County, New Mexico. EPG and ARCO have a cost sharing agreement to each pay one-half of any remediation costs at this site. EPG's share of the remediation costs is estimated to be between $10 million and $20 million over a 30 year period. 4 -- EPG is involved in other environmental assessment and remediation activities which include two additional CERCLA sites (Fountain Inn, South Carolina and Odessa, Texas) and one state Superfund site (Etowah, Tennessee). The amount reserved as of December 31, 1993 will cover these and other small environmental assessments and other remediation projects. EPG also has potential expenditures, of a capital nature, for the following environmental projects: 1 -- EPG has analyzed CAAA, and believes that these rules will impact the Company's operations primarily in the following areas: (i) potential required reductions in the emissions of NOx in non-attainment areas; (ii) the requirement for air emissions permitting of existing facilities; and (iii) enhanced monitoring of air emissions. The Company anticipates capitalizing the equipment costs associated with complying with CAAA and estimates that approximately $5 million to $27 million will be spent during the 1995 through 1997 time frame. However, EPA's proposed enhanced monitoring rules, when finalized, could potentially impose greater costs to the Company. 2 -- EPG has been conducting remediation of mercury contamination at certain facilities and is replacing mercury containing meters with dry flow devices. The remaining remediation costs are estimated to be between $8 million and $12 million, most of which will be incurred over the next two years. EPG will close and retire about 5,400 earthen siphon/dehydration pits in the San Juan Basin as recently required by certain environmental regulations. EPG estimates costs of approximately $17 million to $25 million to retire these pits over the next two years. The mercury remediation and pit closure costs, which are associated with the retirement of equipment, will be recorded as adjustments to accumulated depreciation, as required by regulatory accounting. On December 21, 1993, EPA issued EPG a Notice of Liability for the CSMRI site in Golden, Colorado. Because EPA has not yet determined the volume of hazardous substances sent to the site by all parties, there is no way to estimate EPG's potential share of remediation costs. However, based on the volumes EPA presently lists as contributed by EPG and other potentially responsible parties, it appears that EPG is a minor contributor. It is possible that new information or future developments could require the Company to reassess its potential exposure related to environmental matters. As such information or developments occur, contingency amounts will be adjusted accordingly. Common Stock Transactions Subsequent to the Offering For the year ended December 31, 1993, EPG paid approximately $40 million in dividends. On January 14, 1994, EPG's Board of Directors declared a quarterly dividend of $0.3025 per share on EPG's common stock, payable on April 4, 1994 to shareholders of record on March 11, 1994. On October 22, 1992, EPG's Board of Directors authorized the repurchase of up to two million shares of EPG's outstanding common stock from time to time in the open market. Shares repurchased are held in EPG's treasury and are expected to be used in connection with employee stock option plans to minimize dilution to existing shareholders. During 1992, EPG acquired 812,773 shares of its common stock for an aggregate value of $24 million and in the fourth quarter reissued, in connection with employee stock option plans, 628,258 shares of common stock out of treasury stock for an aggregate value of $11 million. The 184,515 remaining shares were reissued through April 1993, in connection with employee stock option plans, for an aggregate value of $5 million. During 1993, EPG acquired 509,095 shares of its common stock for an aggregate value of $18 million and subsequently reissued, in connection with employee stock option plans, 22,734 shares of its common stock out of treasury stock for an aggregate value of $0.5 million. As of December 31, 1993, EPG had 486,361 shares of treasury stock. In addition, from April 1993 through December 1993, EPG issued 43,394 shares of common stock in connection with employee stock option plans. A total of 2,300 and 132,700 restricted shares of EPG's common stock were granted to certain employees for 1993 and 1992, respectively. The market value of such shares awarded was approximately $0.1 million and $2.8 million in 1993 and 1992, respectively. Capital Expenditures The Company's planned capital expenditures for 1994 of approximately $210 million are primarily for maintenance of business, system expansion and system enhancement. These expenditures are expected to be financed through internally generated funds. Capital expenditures for 1993 were $164 million compared to $246 million for 1992. The decrease was due primarily to the 1992 completion of system expansion and enhancement projects. On July 7, 1992, EPG filed an application with FERC, which was amended on November 27, 1992, to expand the delivery capacity of its system in the vicinity of Yuma, Arizona and, through an extension of its system south to San Luis Rio Colorado, Sonora, Mexico, to serve northern Mexican markets. The proposed expansion would provide shippers the opportunity to deliver natural gas to Mexican markets in northern Baja California via new pipeline capacity of 348 MMcf/d. This project is expected to cost approximately $71 million and will be financed through internally generated funds or through short-term borrowings. On November 29, 1993, FERC issued an order which approved the siting, construction and operation of facilities necessary for a border crossing facility in Yuma, Arizona which would connect the proposed extension with pipeline facilities in Mexico. The order also made a preliminary determination on environmental issues. FERC is deferring action on the remainder of the July 7, 1992 filing until EPG demonstrates that it has long-term executed contracts or binding precedent agreements for a substantial amount of the firm capacity of the proposed facilities. EPG is a member of a five-company consortium that plans to build the proposed Samalayuca II Power Plant near Ciudad Juarez, Mexico. On December 17, 1992, an award for construction was granted to the consortium by the Comision Federal de Electricidad, the Mexican government-owned utility. On March 16, 1993, EPG filed an application with FERC to expand its system in order to provide natural gas service to the proposed Samalayuca II Power Plant and to an existing power plant in the same location. The proposed expansion would provide an additional 300 MMcf/d of capacity at a cost of approximately $57 million and will be financed through internally generated funds or through short-term borrowings. In the November 29, 1993 order, FERC also approved the proposed border crossing facility south of Clint, Texas which would connect EPG's facilities with facilities in Mexico. FERC is deferring action on the remainder of the March 16, 1993 filing until EPG demonstrates that it has long-term executed contracts or binding precedent agreements for a substantial amount of the firm capacity of the proposed facilities. On December 29, 1993, PG&E, SoCal and the CPUC jointly filed a motion with FERC seeking clarification or rehearing of the November 29, 1993 FERC order for both the Yuma, Arizona and the Samalayuca II Power Plant projects discussed above. On March 17, 1993, MPC filed an application, which was amended on November 8, 1993, for a certificate of public convenience and necessity to build and operate a 475 MMcf/d expansion of its existing system. The proposed expansion will extend from MPC's existing east lateral located near Bakersfield, California approximately 352 miles northward to the vicinity of Sacramento and the East Bay area near San Francisco. The expansion will also include 56 miles of looping of the existing pipeline along with 207 miles of laterals. The estimated cost of the entire system is $467 million which is expected to be funded primarily through project financing. MPC expects to receive its FERC certificate in early 1994 and put the expansion into service in January 1996. On December 16, 1993, FERC held a public conference to examine a jurisdictional question raised by CPUC and PG&E regarding MPC's system expansion. The primary issue is whether FERC or CPUC should have jurisdiction over the proposed expansion. Written comments were filed by interested parties on January 10, 1994, with a final decision by FERC expected in early 1994. Other In January 1993, EPG experienced flood damage to its pipeline system in the Gila, Arizona area due to heavy rain. Since that time, EPG has been incurring costs for repairs and expects to be reimbursed through its property insurance policies once all repairs have been completed. RESULTS OF OPERATIONS Year Ended December 31, 1993 Compared to Year Ended December 31, 1992 Operating revenues for the year ended December 31, 1993 were $106 million higher than for the same period of 1992. New system rates and a new rate design placed into effect February 1, 1993, resulted in a $41 million increase in revenues which was comprised of an increase in reservation revenues of $111 million offset by a decrease in transportation revenues of $70 million. The consolidation of MPC contributed $27 million to the increase. Higher production area rates and volumes increased revenues by $3 million and $7 million, respectively. Higher sales rates increased revenues by $34 million; however, lower sales volumes offset that increase by $5 million. In addition, the sale of gas in storage contributed $18 million to the increase in revenues; this increase is offset in operating charges. Offsetting the increase in operating revenues was a decrease of $13 million due to lower transportation volumes, a decrease in return on take-or-pay receivables of $4 million and a decrease in liquid revenues of $2 million. Operating charges were $62 million higher for the year ended December 31, 1993 compared to the same period for 1992. Higher average cost of gas contributed $39 million to the increase. In addition, the sale of gas in storage contributed $18 million to the increase in operating charges; this increase is offset in operating revenues. Higher operation and maintenance costs of $26 million were due primarily to an accrual for estimated take-or-pay undercollections, the consolidation of MPC and increases in employee benefit costs and outside contractors fees, primarily related to environmental clean-up. This increase is partially offset by lower stock related benefit costs. An increase of $3 million in other taxes is primarily due to the consolidation of MPC and an increase in ad valorem taxes. The increase in operating charges was partially offset by lower depreciation rates after giving effect to the rate settlement. Additionally, lower gas sales volumes resulted in a decrease in operating charges of $4 million. EPG's throughput for 1993 was 1,306 Bcf compared to 1,357 Bcf in 1992. This decrease is due to lower deliveries to the utility electric generation market resulting from the availability of excess hydroelectric power in the California markets. The lower deliveries to California were partially offset by higher throughput to off-system markets. Interest and debt expense for the year ended December 31, 1993 was $7 million higher than for the same period of 1992 due primarily to the consolidation of MPC. Allowance for funds used during construction ("AFUDC") was $2 million lower for the year ended December 31, 1993 than for the same period in 1992 due to a decrease in expansion project expenditures during 1993. Other-net was $6 million higher for the year ended December 31, 1993 compared to the same period for 1992. Contributing to the higher expense was a $6 million increase related to environmental accruals; a $4 million reduction in direct bill interest income; and a $4 million reduction in partnership earnings due to the consolidation of MPC. The increase was offset by lower interest expense of $4 million on tax adjustments and $3 million of interest income related to the recovery of EPG's investment in its underground storage facility. Year Ended December 31, 1992 Compared to Year Ended December 31, 1991 Operating revenues for 1992 were $68 million higher than 1991. The overall increase in revenues was due primarily to new rates placed into effect on January 1, 1992. The new rates resulted in a $156 million increase in reservation revenues, which reflects the shift from firm sales service to firm transportation service. By unbundling its sales service, the Company's sales occur at the mainline receipt point as opposed to the delivery point. Lower accruals for regulatory issues resulted in an increase in revenues of $42 million. Higher sales volumes resulted in increased revenues of $88 million; however, lower sales rates offset that increase by $23 million. Also offsetting the increases were lower transportation rates which resulted in decreased revenues of $113 million. Other decreases affecting the improved 1992 results were a $30 million decrease in production area revenues resulting from the sale of certain gathering and processing facilities and lower rates, a $28 million decrease in return on take-or-pay receivables, an $11 million decrease in liquid revenues and a $6 million decrease in interest on receivables from customers. Operating charges were $68 million higher for 1992 compared to 1991. The increase was primarily due to higher purchased gas costs. Higher sales volumes resulted in a $72 million increase in purchased gas costs; however, this increase was partially offset by a $15 million decrease due to lower gas purchase prices. A $12 million increase in depreciation and a $7 million increase in taxes, other than income taxes, both resulting from system expansions, also contributed to the increase in operating charges. An $8 million decrease in operation and maintenance costs was principally due to reductions in fees paid to outside operators and contractors, partially offset by additional costs allocated to the Company from BR resulting from the separation of the two companies. Throughput for 1992 was 1,357 Bcf compared to 1,409 Bcf in 1991. The decrease in throughput was principally due to increased competition in the California markets. Lower deliveries to California were partially offset by higher throughput to the East-of-California and off-system markets. Interest and debt expense was $68 million for 1992 compared with $98 million for 1991. The decrease was primarily due to a $18 million reduction in interest on commercial paper, which balance was repaid in December 1991, and a $17 million reduction in interest on rate refund, which refund was made in October 1991. These decreases were partially offset by an $8 million increase resulting from the cost of the take-or-pay receivables sale. Interest income from BR was $2 million for 1992 compared with $38 million for 1991. This decrease was due to the dividends declared and paid to BR in December 1991 and in January and February 1992, from the balance owed by BR to EPG under the intercorporate cash management arrangement. Reported as other-net was $2 million expense for 1992 compared with $12 million income for 1991. Contributing to lower income in 1992 was a $5 million decrease in net gains on dispositions of facilities; a $7 million reduction in MPC partnership earnings resulting from a non-recurring income adjustment in 1991; and a $6 million increase in other interest. A $6 million increase in income from temporary investments and other interest income partially offset the lower income. OTHER The Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 106 ("SFAS 106") requiring companies to account for other post-retirement employee benefits ("OPEBs") (principally retiree medical costs) on an accrual basis versus the pay-as-you-go basis traditionally followed by most United States companies. The Company adopted SFAS 106 effective January 1, 1993. The Company provides a non-contributory defined benefit postretirement medical plan that covers employees who retired on or before March 1, 1986 and limited postretirement life insurance for employees who retire after January 1, 1985. As such, the Company's obligation to accrue for OPEBs is primarily limited to the fixed population of retirees who retired on or before March 1, 1986. The medical plan is funded to the extent employer contributions are recoverable through rates. EPG began recovering through its rates the OPEB costs included in the settlement agreement. To the extent actual OPEB costs exceed the amounts reflected in the settlement agreement, a regulatory asset has been recorded. Management expects such amounts to be fully recovered through its rates. The Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 112 ("SFAS 112") which requires companies to account for benefits to former or inactive employees after employment but before retirement (referred to in SFAS 112 as "postemployment benefits"). SFAS 112 is effective for the fiscal years beginning after December 15, 1993. Postemployment benefits include every form of benefit provided to former or inactive employees, their beneficiaries and covered dependents. Benefits include, but are not limited to salary continuation, supplemental unemployment benefits, severance benefits, disability-related benefits (including workers' compensation), job training and counseling and continuation of benefits such as health care benefits and life insurance coverage. The cumulative effect at January 1, 1994 of adopting SFAS 112 is estimated to be approximately $8 million. Management expects to fully recover its postemployment benefit costs through rates. The Revenue Reconciliation Act of 1993, enacted in August 1993, changed the corporate income tax rate from 34 to 35 percent effective January 1, 1993. As a result, the Company's current year provision for income tax expense was adjusted in the third quarter of 1993 by approximately $1 million, of which $0.5 million is related to the balance of deferred income taxes at December 31, 1992. In addition, the balance of accumulated deferred income taxes at January 1, 1993 was increased $5 million in accordance with Statement of Financial Accounting Standards No. 109 ("SFAS 109"), and a corresponding regulatory asset was recorded. Management expects such amounts to be fully recovered through its rates. Deferred credits, in the accompanying Consolidated Balance Sheet, include excess deferrals resulting from the reduction of the statutory federal tax rate from 46 to 34 percent on July 1, 1987. ITEM 8.

ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA EL PASO NATURAL GAS COMPANY CONSOLIDATED STATEMENT OF INCOME (IN THOUSANDS, EXCEPT PER COMMON SHARE AMOUNTS) See accompanying Accounting Policies and Notes to Consolidated Financial Statements. EL PASO NATURAL GAS COMPANY CONSOLIDATED BALANCE SHEET (IN THOUSANDS, EXCEPT PER SHARE AMOUNT) ASSETS See accompanying Accounting Policies and Notes to Consolidated Financial Statements. EL PASO NATURAL GAS COMPANY CONSOLIDATED STATEMENT OF CASH FLOWS (IN THOUSANDS) See accompanying Accounting Policies and Notes to Consolidated Financial Statements. EL PASO NATURAL GAS COMPANY CONSOLIDATED STATEMENT OF STOCKHOLDERS' EQUITY (DOLLARS IN THOUSANDS, EXCEPT PER SHARE AMOUNTS) See accompanying Accounting Policies and Notes to Consolidated Financial Statements. EL PASO NATURAL GAS COMPANY ACCOUNTING POLICIES PRESENTATION AND PRINCIPLES OF CONSOLIDATION The consolidated financial statements include the accounts of the Company. All significant intercompany transactions of continuing operations are accounted for at market prices and have been eliminated in consolidation. The financial statements for previous periods include certain reclassifications that were made to conform to the current presentation. Such reclassifications have no impact on reported income or stockholders' equity. On June 1, 1993, the Company acquired from a wholly owned subsidiary of Enron Corp., that subsidiary's 50 percent interest in MPC, a general partnership. This acquisition gives the Company 100 percent ownership of MPC. The operating results of MPC are included in the Company's consolidated results of operations for the months of May 1993 through December 1993. The Company's previously owned 50 percent equity interest in MPC is included in other-net in the accompanying Consolidated Statement of Income. In September 1991, a dividend of the common stock of EPG's Oil and Gas Operations Segment was made by EPG to its then parent company, TEPCO. The accompanying financial statements and notes reflect the discontinuance of the Oil and Gas Operations Segment. CASH AND TEMPORARY CASH INVESTMENTS Short-term investments purchased with an original maturity of three months or less are considered cash equivalents. Through December 31, 1991, cash and temporary cash investments also included excess cash advanced by the Company to its then parent company, BR, under an intercorporate cash management arrangement. ACCUMULATED PROVISION FOR UNCOLLECTIBLE ACCOUNTS RECEIVABLE The Company has established a provision for losses on trade accounts receivable which may become uncollectible. Collectibility of trade receivables is reviewed regularly, and the allowance for bad debts is adjusted as necessary under the specific identification method. The balance of this provision at December 31, 1993 and 1992 was $3.9 million and $5.1 million, respectively. ACCOUNTING FOR REGULATED OPERATIONS EPG and MPC are subject to the regulations and accounting procedures of FERC and therefore, continue to follow the reporting and accounting requirements of Statement of Financial Accounting Standards No. 71 ("SFAS 71"). Accounting methods for companies subject to cost-of-service regulation may differ from those used by non-regulated companies. However, when the accounting method prescribed by the regulatory authority is used for rate-making, such accounting conforms to the generally accepted accounting principle of matching costs against the revenues to which they apply. Transactions which have been recorded differently than a non-regulated entity include the following: (i) take-or-pay payments recoverable from customers, based upon transportation volumes, have been recorded as an asset, net of allowance; (ii) losses on reacquired debt have been recorded in other assets and are being amortized over the life of the original or replacement debt; (iii) revenue related to the implementation of SFAS 109 has been recorded as a deferred credit and is being amortized into income; (iv) adjustment to reflect the increase in the federal income tax rate has been recorded in other regulatory assets to be recovered in future rates; (v) excess amounts of OPEB costs have been recorded in other regulatory assets to be recovered in future rates; (vi) a portion of EPG's investment in its underground storage facility has been recorded as an asset and is being recovered in accordance with the settlement agreement; (vii) the cost of equity funds used during construction has been capitalized; (viii) MPC's excess amounts due to straight-line depreciation rates versus approved depreciation rates have been recorded as other regulatory assets to be EL PASO NATURAL GAS COMPANY ACCOUNTING POLICIES (CONTINUED) recovered in future rates and (ix) MPC's deferred taxes on the equity portion of AFUDC have been recorded in other regulatory assets to be recovered in future rates. ACCOUNTING FOR GAS IMBALANCES EPG currently accounts for gas imbalances due to or due from shippers and operators. Gas imbalance payables and receivables are maintained at a net legal entity basis in accordance with Statement of Financial Accounting Standards No. 105. Gas imbalances prior to October 1, 1993 are valued at the 1992 average El Paso System index price as prescribed in EPG's tariff. Gas imbalances subsequent to October 1, 1993 are valued at the current quarterly average El Paso System index price. The Company has established a provision for gas imbalances which may become uncollectible. Collectibility of gas imbalances is reviewed regularly and the provision is adjusted as necessary under the specific identification method. The balance of the provision at December 31, 1993 and 1992 was $5.6 million and $12.1 million, respectively. INCOME TAXES Income taxes are based on income reported for tax return purposes and a provision for deferred income taxes. Deferred income taxes are provided to reflect the tax consequences in future years of differences between the financial statement and tax bases of assets and liabilities at each year end. Tax credits are accounted for under the flow-through method, which reduces the provision for income taxes in the year the tax credits first become available. Pursuant to a tax sharing agreement between EPG and BR covering periods prior to July 1992, EPG is responsible for its tax liabilities and those of its subsidiaries. EPG is required to pay BR its allocable portion of the consolidated federal tax liability and combined state income tax liability. PROPERTY, PLANT AND EQUIPMENT Included in the Company's property, plant and equipment is construction work in progress of approximately $53 million and $93 million at December 31, 1993 and 1992, respectively. An allowance for both debt and equity funds used during construction is included in the cost of the Company's property, plant and equipment. EPG's properties are depreciated using the composite method. Straight-line depreciation rates for 1993 and 1991 were 1.6 percent for transmission facilities. For 1992, the depreciation rate for transmission facilities was 2.67 percent adjusted to 1.6 percent in accordance with the settlement agreement. The depreciation rate for gathering facilities was 3.5 percent for 1993, 1992 and 1991. MPC's depreciation rates reflect a levelized cost-of-service approach and a 25-year depreciation life. MPC's depreciation rate for its plant during the first 15 years increases gradually from 1.48 percent in 1992 to 8.76 percent in 2007. The depreciation rates are designed to recover approximately 80 percent of MPC's plant balance by March 1, 2007. The depreciation rate related to years 16 through 25 will be determined in future rate proceedings. (See "Accounting for Regulated Operations" of Accounting Policies.) Additional acquisition cost assigned to utility plant represents EPG's portion of the excess of allocated acquisition cost over historical cost that resulted from the 1983 acquisition of EPG's former parent, TEPCO, by BR's former parent, BNI. These costs are being amortized on a straight-line basis over the estimated remaining life of the properties. EL PASO NATURAL GAS COMPANY ACCOUNTING POLICIES (CONTINUED) Costs of properties that are not operating units, as defined by FERC, which are retired, sold or abandoned are charged or credited, net of salvage, to accumulated depreciation and amortization. Gains or losses on sales of operating units are credited or charged to income. INVENTORIES Inventories are carried on either the first-in first-out or average cost method at the lower of cost or market. Gas in storage inventories at December 31, 1992 were carried at cost determined on a last-in first-out basis. During 1993, EPG sold its gas in storage inventory in accordance with the settlement agreement with EPG's customers and FERC staff. Inventories at December 31, 1993 and 1992 consist of the following components: RECOVERABLE EXCESS GAS COSTS The cash flow statement for 1991 shows recoveries of recoverable excess gas costs. These costs represent the cumulative excess of actual purchased gas costs over the average of these costs included in EPG's gas sales rates. FERC's August 14, 1991 order provided for a portion of the September 1, 1991 recoverable excess gas costs balance to be offset against refund obligations. The remainder of the costs, $25 million, was recorded against previously established accruals. Effective with the implementation of the 1991 order, EPG no longer records recoverable excess gas costs. TAKE-OR-PAY SETTLEMENTS Assets resulting from the resolution of take-or-pay obligations include recoupable take-or-pay prepayments and take-or-pay buy-out and buy-down receivables. Recoupable prepayments result when EPG pays for, but does not physically receive, gas and retains the right to take such gas in the future, generally over five years. Take-or-pay buy-outs and buy-downs represent costs paid to natural gas producers for the termination or modification of gas purchase contracts. In exchange for EPG's agreement to absorb 25 percent of its take-or-pay buy-out and buy-down costs, FERC regulations provide for the direct billing of 25 percent of such costs to EPG's customers. In addition, such regulations allow EPG to recover the remaining 50 percent of its buy-out and buy-down costs through a surcharge added to its transportation rates. EARNINGS PER SHARE Earnings per share of common stock is based on the weighted average number of shares of common stock outstanding during the year. The weighted average number of shares of common stock outstanding for 1993, 1992 and 1991 were 37,212,192, 36,049,135 and 31,421,731, respectively. Stock options are the only common stock equivalents and are currently not dilutive. EL PASO NATURAL GAS COMPANY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 1. RATES AND REGULATORY MATTERS General Rate Filings and Other On July 1, 1991, EPG filed for FERC approval of new system rates and placed the proposed new rates into effect on January 1, 1992, subject to refund. On July 31, 1992, EPG again filed for new rates to recover increased costs and return on rate base associated with EPG's expansion and modernization projects. These rates were effective on February 1, 1993, subject to refund. In the July 1992 filing, EPG's rate base increased from $752 million to approximately $1.2 billion. EPG made its compliance filing on December 31, 1992, in accordance with the Restructuring Rules. In January 1993, EPG, certain of its customers and FERC staff reached a settlement agreement which led to the resolution of the above mentioned rate and restructuring proceedings. The settlement agreement was filed in January 1993 to supersede EPG's December 31, 1992 compliance filing. As required by FERC order, EPG filed revised rates on September 14, 1993, which implemented the settlement agreement effective October 1, 1993. Under the settlement agreement, EPG refunded a total of approximately $56 million, inclusive of interest, in the fourth quarter of 1993. EPG had provided for these rate refunds as revenues were collected. The settlement agreement provides for the accelerated recovery of a substantial portion of EPG's investment in its underground storage facility. This is being recovered by a demand charge mechanism over the period from October 1, 1993 through December 31, 1996. The amount to be recovered was approximately $56.7 million plus interest accruing beginning February 1, 1993 at the FERC allowed rate, which approximates the prime rate. The amount recovered through December 31, 1993 was $19 million. The outstanding balance at December 31, 1993 was $37 million, of which $12 million is included in other current assets and $25 million is included in other assets in the accompanying Consolidated Balance Sheet. The settlement agreement also established new depreciation rates for certain of EPG's facilities effective January 1, 1992. On August 14, 1991, FERC approved an order resolving all of the issues in EPG's December 1987 rate case filing and certain other pending matters which became effective on September 1, 1991. The order provided for: (i) the establishment of revised rate levels for the period July 1, 1988 through the effective date of EPG's next rate change, which occurred on January 1, 1992; and (ii) payment of certain refunds for the period July 1, 1988 through August 31, 1991. EPG disbursed to its customers $252 million in October 1991 in accordance with the order. The total refund obligation at September 1, 1991 was $369 million before certain offsets, including an unbilled portion of the $169 million of recoverable excess gas costs. The net refund obligation and the remaining balance of the recoverable excess gas costs, $25 million, were recorded against previously established accruals. Pursuant to the Restructuring Rules, MPC filed its restructuring plan on November 3, 1992. On March 2, 1993, FERC issued an order essentially approving MPC's compliance filing, subject to changes, which were made in an amended restructuring plan on March 29, 1993. Several of MPC's customers filed protests and requests for rehearing of the March 2, 1993 FERC order. The rehearing requests were denied, and FERC approved the amended restructuring plan on July 9, 1993, with an effective date of August 1, 1993. On October 15, 1993, FERC issued an order which denied requests for rehearing of the July 9, 1993 order. Several of MPC's customers have filed petitions for review of the March 2, 1993, July 9, 1993, and October 15, 1993 orders with the United States Court of Appeals which are currently pending. The primary issues on appeal pertain to FERC's requirement that MPC's rates for firm transportation service be based upon SFV rate design rather than MFV rate design. The application of SFV rates requires MPC's existing firm shippers to pay a higher proportion of their total transportation rate in the reservation component of the rate, and this increases aggregate transportation charges for low load factor shippers. Such EL PASO NATURAL GAS COMPANY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) shippers have contended that FERC's application of SFV rate design to MPC unlawfully abrogates the rate provisions of MPC's service agreements and constitutes an unlawful rate increase. MPC believes the United States Court of Appeals will uphold SFV rates as applied to MPC. Take-or-Pay Settlements Since 1987, EPG has made, or has committed to make, buy-out and buy-down payments totaling $1.5 billion to resolve past and future take-or-pay exposure, to terminate and reform gas purchase contracts, to amend pricing and take provisions of gas purchase contracts and to settle related litigation. In certain cases, EPG resolved claims by making recoupable prepayments. At December 31, 1993 and December 31, 1992, the recoupable prepayment balances were $9 million and $19 million, respectively. These payments resolved virtually all the outstanding producer claims asserted against EPG and terminated or prospectively reformed substantially all of EPG's remaining gas purchase contracts, with the result that EPG no longer has any material take-or-pay exposure. EPG has filed to recover $1.1 billion of its buy-out and buy-down costs under FERC cost recovery procedures. The collection period for the direct bill portion of the take-or-pay buy-out and buy-down costs extends through May 1994. The collection period for the volumetric surcharge portion of such costs extends through March 1996. Through December 31, 1993, EPG had recovered approximately $1.0 billion; of that recovery, $361 million was collected by direct bill and $682 million by volumetric surcharge. EPG has established a reserve for that portion of the volumetric surcharge receivables balance which is unlikely to be collected over the period through March 1996, based on current throughput projections. The balance of this reserve was $19 million at December 31, 1993. Under FERC procedures, take-or-pay cost recovery filings may be challenged by pipeline customers on prudence and certain other grounds. In October 1992, FERC approved an order, subject to rehearing, resolving all but one of the outstanding issues regarding EPG's take-or-pay proceedings. The remaining issue involves the claim by several customers that EPG has sought to recover an excessive amount for the value of certain production properties which were transferred to a producer as part of a 1989 take-or-pay settlement. On March 8, 1993, an initial decision from the presiding ALJ was rendered which, if adopted without changes by FERC, would require EPG to refund to or forgo collection from its customers of up to $30 million, plus interest. Exceptions to this initial decision were filed with FERC by both parties on April 7, 1993. On April 27, 1993, briefs opposing exceptions were filed by the same parties as well as by FERC staff. EPG has established adequate reserves for this issue and does not believe that the ultimate outcome will have a materially adverse effect on the Company's financial condition or results of operations. On January 14, 1992, EPG completed a sale of substantially all of its remaining take-or-pay buy-out and buy-down receivables. The sale totaled $325 million, including $305 million of cash received at closing, which was used to repay $300 million of a payable to BR. The receivables sold in this transaction included $104 million which was recovered through direct bill and $221 million to be recovered through volumetric surcharge. The volumetric surcharge portion of the sale has been accounted for as a financing transaction because EPG is subject to certain recourse provisions related to such receivables. At December 31, 1993 and December 31, 1992, $87 million and $125 million, respectively, of the volumetric surcharge portion of the receivables sold remained outstanding. Amounts collected related to the take-or-pay receivables sold are remitted to the purchasers of the receivables. 2. ACQUISITION On June 1, 1993, the Company acquired from a wholly owned subsidiary of Enron Corp., that subsidiary's 50 percent interest in MPC for approximately $40 million in cash, representing the approximate book value of EL PASO NATURAL GAS COMPANY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) the investment. The acquisition, which was funded by internally generated cash flow, gives the Company 100 percent ownership of MPC. The acquisition was accounted for using the purchase method. In conjunction with the acquisition, the following liabilities were assumed: The following MPC balances are included in the December 31, 1993 Consolidated Balance Sheet of the Company: The operating results of MPC are included in the Company's consolidated results of operations for the months of May 1993 through December 1993. The Company's previously owned 50 percent equity interest in MPC is included in other-net in the accompanying Consolidated Statement of Income. The following pro forma summary presents the consolidated results of operations of the Company as if the acquisition had occurred as of January 1, 1993 or January 1, 1992. These pro forma results have been prepared for comparative purposes only and do not purport to be indicative of what may have resulted had the acquisition occurred as of those dates or of results which may occur in the future. EL PASO NATURAL GAS COMPANY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) 3. LONG-TERM DEBT Long-term debt outstanding is as follows: The following are aggregate maturities of long-term debt for the next five years and in total thereafter: On December 5, 1991, EPG commenced a tender offer with respect to the 9.45% Notes and 8 5/8% Debentures. Pursuant to the tender offer, in December 1991, EPG purchased $207 million aggregate principal amount of the 9.45% Notes for $228 million and $93 million aggregate principal amount of 8 5/8% Debentures for $93 million. In January 1992, EPG purchased an additional $46 million and $41 million of aggregate principal amounts of the 9.45% Notes and 8 5/8% Debentures, respectively. Funds for these purchases were provided by proceeds from borrowings under the BR Loan Agreements described below. In addition, on December 19, 1991, EPG called for redemption, on January 23, 1992, of all the outstanding 9 5/8% Debentures ($100 million aggregate principal amount) at a price equal to 106.84 percent of their principal amount. EPG had a Commitment Agreement with BR under which it could borrow up to $300 million. EPG also maintained Loan Agreements with BR under which it could borrow up to $500 million. As of December 31, 1991, $300 million was outstanding under the Commitment Agreement and $325 million was outstanding under the Loan Agreements. In January 1992, EPG borrowed an additional $109 million under the Loan Agreements. Borrowings under the Loan Agreements were used to pay for the purchase of the 9.45% Notes and the 8 5/8% Debentures in December 1991 and January 1992 and the payment of related transaction costs. In January 1992, EPG issued $575 million principal amount of new debt securities consisting of $100 million of 6.90% Notes due 1997, $215 million of 7 3/4% Notes due 2002 and $260 million of 8 5/8% Debentures EL PASO NATURAL GAS COMPANY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) due 2022. The net proceeds of $569 million received from such issuance were used to repay $434 million of borrowings under the Loan Agreements with BR, to redeem $107 million of 9 5/8% Debentures and for general corporate purposes ($28 million) including costs related to the transactions discussed above. EPG repaid its outstanding commercial paper in December 1991 with borrowings under the Commitment Agreement with BR. The proceeds from the sale of the take-or-pay receivables were used to repay the borrowings under the Commitment Agreement with BR. The Commitment Agreement and the Loan Agreements with BR were terminated prior to the completion of the Offering. In February 1992, EPG established a $300 million revolving credit facility with a group of banks which facility expires in March 1996. As of December 31, 1993, there were no borrowings outstanding under this facility. Approximately $1 million of commercial paper was outstanding as of December 31, 1993. EPG must comply with various restrictive covenants contained in its debt agreements which include, among others, maintaining consolidated tangible net worth (as defined in the agreements) of at least $400 million. Also, EPG's consolidated debt and guaranties to capitalization ratio cannot exceed 70 percent. Furthermore, certain EPG subsidiaries (other than any project financing subsidiary, as defined in the agreements) may not incur debt obligations which would exceed $75 million in the aggregate. As of December 31, 1993, EPG's consolidated tangible net worth exceeded the minimum restrictive covenant requirement by $298 million, its consolidated debt and guaranties to capitalization ratio was 47 percent and there were no subsidiary debt obligations of those subsidiaries limited by the debt agreements. On September 30, 1991, MPC entered into a credit agreement ("Credit Agreement") with a group of banks which provided a 15 year project financing loan to MPC of up to $180 million. Total outstanding loan balances under the Credit Agreement were $165 million and $170 million at December 31, 1993 and 1992, respectively. The loan is repayable in semiannual installments over the period to March 31, 2007. Interest on the loan is payable quarterly. MPC has entered into interest rate swap agreements which effectively convert $114.3 million of the current loan balance from floating-rate debt to fixed-rate debt. MPC makes payments to counterparties at fixed rates and in return receives payments at floating rates. Substantially all of the remaining $50.5 million of loan principal had interest rates ranging from 3.9 percent to 4.3 percent during 1993. With the impact of the interest rate swap agreements, the overall effective rate on the loan was approximately 7.6 percent during 1993 and 1992. Borrowings under the Credit Agreement are collateralized by a priority interest in the Company's partnership interests and certain other distributed and undistributed partnership property. The Credit Agreement also contains covenants relating to, among other things, partnership distributions and additional indebtedness. EL PASO NATURAL GAS COMPANY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) 4. ENVIRONMENTAL Accruals for environmental compliance costs are established when environmental assessments and/or remediation are probable, and when costs can be reasonably estimated. As of December 31, 1993, EPG had a reserve of $38 million for the following environmental contingencies with income statement impact: 1 -- EPG has been conducting remediation of PCB contamination at its facilities. The majority of the required PCB remediation has been completed. Future PCB remediation costs are estimated to range between $8 million and $11 million over the next five years. 2 -- EPG executed an Administrative Order on Consent with EPA on June 25, 1993 to conduct a RI/FS for a BI site located in Statesville, North Carolina, that has been identified for cleanup. BI and EPG have entered into an agreement to jointly fund the RI/FS for the site. EPG's share of the potential remediation costs is estimated to be between $17 million and $20 million over a 30 year period. 3 -- On November 2, 1993, in accordance with an EPA order, EPG and ARCO submitted work plans for remediation of the subsurface at the Prewitt Refinery in McKinley County, New Mexico. EPG and ARCO have a cost sharing agreement to each pay one-half of any remediation costs at this site. EPG's share of the remediation costs is estimated to be between $10 million and $20 million over a 30 year period. 4 -- EPG is involved in other environmental assessment and remediation activities which include two additional CERCLA sites (Fountain Inn, South Carolina and Odessa, Texas) and one state Superfund site (Etowah, Tennessee). The amount reserved as of December 31, 1993 will cover these and other small environmental assessments and other remediation projects. EPG also has potential expenditures, of a capital nature, for the following environmental projects: 1 -- EPG has analyzed CAAA, and believes that these rules will impact the Company's operations primarily in the following areas: (i) potential required reductions in the emissions of NOx in non-attainment areas; (ii) the requirement for air emissions permitting of existing facilities; and (iii) enhanced monitoring of air emissions. The Company anticipates capitalizing the equipment costs associated with complying with CAAA and estimates that approximately $5 million to $27 million will be spent during the 1995 through 1997 time frame. However, EPA's proposed enhanced monitoring rules, when finalized, could potentially impose greater costs to the Company. 2 -- EPG has been conducting remediation of mercury contamination at certain facilities and is replacing mercury containing meters with dry flow devices. The remaining remediation costs are estimated to be between $8 million and $12 million, most of which will be incurred over the next two years. EPG will close and retire about 5,400 earthen siphon/dehydration pits in the San Juan Basin as recently required by certain environmental regulations. EPG estimates costs of approximately $17 million to $25 million to retire these pits over the next two years. The mercury remediation and pit closure costs, which are associated with the retirement of equipment, will be recorded as adjustments to accumulated depreciation, as required by regulatory accounting. On December 21, 1993, EPA issued EPG a Notice of Liability for the CSMRI site in Golden, Colorado. Because EPA has not yet determined the volume of hazardous substances sent to the site by all parties, there is no way to estimate EPG's potential share of remediation costs. However, based on the volumes EPA presently lists as contributed by EPG and other potentially responsible parties, it appears that EPG is a minor contributor. It is possible that new information or future developments could require the Company to reassess its potential exposure related to environmental matters. As such information or developments occur, contingency amounts will be adjusted accordingly. EL PASO NATURAL GAS COMPANY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) 5. CORPORATE REORGANIZATION During 1992 and 1991, EPG completed several transactions in preparation for its separation from BR. Among these transactions was the transfer of the net assets of the Company's Oil and Gas Operations Segment to TEPCO, which is reported as discontinued operations. In May 1991, EPG declared and paid a dividend of $175 million to TEPCO. Effective August 31, 1991, EPG contributed its oil and gas cost-of-service production properties to EPPC. In September 1991, EPG declared a dividend of all its Oil and Gas Operations Segment to TEPCO. The total amount of that dividend was $925 million, $500 million of which was a return of capital and, accordingly, reduced additional paid-in-capital. TEPCO declared a dividend of 100 percent of the common stock of EPG to BR, TEPCO's parent company, effective September 2, 1991. In December 1991, EPG declared and paid a dividend to BR of $55 million. In January and February 1992, EPG declared and paid dividends totaling $274 million to BR. These dividends were paid from the balance owed to EPG under an intercorporate cash management arrangement. In March 1992, EPG completed the Offering. The proceeds from the Offering, net of related costs, totaled approximately $96 million. On June 30, 1992, BR distributed its 31.4 million shares of EPG's common stock, which represented approximately 85 percent of EPG's outstanding common stock, to BR shareholders. As a result, BR no longer retains an ownership interest in EPG. Discontinued Operations The following results of operations of the Oil and Gas Operations Segment are presented as income from discontinued operations, net of income taxes, in the accompanying Consolidated Statement of Income: The operations of EPG's cost-of-service production properties that were contributed to EPPC on August 31, 1991, were reflected in the Company's Natural Gas Operations Segment and are therefore not included in income from discontinued operations. The net book value of the production properties was $197 million on August 31, 1991. The earnings related to the cost-of-service production properties are included in income from continuing operations and are not material. 6. CAPITAL STOCK Under EPG's employee stock option plans, options may be granted to officers and key employees at fair market value on the date of grant, exercisable in whole or part by the optionee after completion of one to three years of continuous employment from the grant date. Options are also granted to Directors at fair market value on the date of grant and are exercisable immediately. Under the terms of these plans, EPG may grant stock appreciation rights ("SARs") to certain holders of stock options. SARs are subject to the same terms and conditions as the related stock options. The stock option holder who has been granted tandem SARs can elect to exercise either an option or a SAR. SARs entitle an option holder to receive a payment equal to the difference between the option price and the fair market value of the common stock of EPG at the date of EL PASO NATURAL GAS COMPANY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) exercise of the SAR. To the extent a SAR is exercised, the related option is cancelled, and to the extent an option is exercised, the related SAR is cancelled. On January 15, 1992, the Board of Directors of EPG granted options exercisable for 722,300 shares of common stock effective upon the closing of the Offering. One-third of the options became exercisable on December 19, 1992; one-third became exercisable on January 15, 1994; and one-third will become exercisable on January 15, 1995. On January 12, 1993, EPG's Board of Directors granted stock options exercisable for 554,000 shares of common stock at $30.81 per share. The stock options vested on January 12, 1994. On March 18, 1993, 3,000 stock options were granted at $36.19 per share and became exercisable immediately. On May 1, 1993, 3,000 stock options were granted at $38.19 per share and became exercisable immediately. On July 22, 1993, 15,000 stock options were granted at $37.25 per share and vested on January 22, 1994. On January 14, 1994, EPG's Board of Directors granted stock options exercisable for 655,100 shares of common stock at $36.875 per share which will vest on January 14, 1995. In addition, stock options were granted for 3,000 shares of common stock at $36.875 per share, which became exercisable immediately. After the Offering, 597,838 BR stock options and 100,730 BR SARs, at prices ranging from $25.50 to $44.75 per share, were converted to EPG stock options and SARs at prices ranging from $13.51 to $22.91 per share. Activity in EPG's stock option plans for 1992 and 1993 was as follows: At December 31, 1993, 321,286 stock options and 70,154 SARs were exercisable at prices ranging from $13.51 to $38.19 per share. At December 31, 1992, 568,422 stock options and 105,203 SARs were exercisable at prices ranging from $13.51 to $25.69 per share. SARs shown as cancelled in the table above were cancelled when the underlying stock options were exercised. Stock options shown as cancelled in the table above may be a result of the tandem SAR being exercised. The maximum number of shares for which stock options may be granted under EPG's stock option plans are approximately seven million shares of common stock, to be issued from shares held in EPG's treasury or out of authorized but unissued shares of EPG's common stock, or partly out of each, as shall be determined by EPG's Board of Directors. On October 22, 1992, EPG's Board of Directors authorized the repurchase of up to two million shares of EPG's outstanding shares of common stock from time to time in the open market. Shares repurchased are held in EPG's treasury and are expected to be used in connection with EPG employee stock option plans to minimize dilution to existing shareholders. During 1992, EPG acquired 812,773 shares of its common stock EL PASO NATURAL GAS COMPANY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) for an aggregate value of $24 million and in the fourth quarter reissued, in connection with EPG's employee stock option plans, 628,258 shares of common stock out of treasury stock for an aggregate value of $11 million. The 184,515 remaining shares were reissued through April 1993, in connection with employee stock option plans, for an aggregate value of $5 million. During 1993, EPG acquired 509,095 shares of its common stock for an aggregate value of $18 million and subsequently reissued, in connection with employee stock option plans, 22,734 shares of its common stock out of treasury stock for an aggregate value of $0.5 million. As of December 31, 1993, EPG had 486,361 shares of treasury stock. In addition, from April 1993 through December 1993, EPG issued 43,394 shares of common stock in connection with EPG's employee stock option plans. A total of 2,300 and 132,700 restricted shares of EPG's common stock were granted to certain employees for 1993 and 1992 respectively. The market value of such shares awarded was approximately $0.1 million and $2.8 million in 1993 and 1992, respectively. EPG has 25,000,000 shares of authorized preferred stock, par value $0.01 per share, none of which have been issued. For the year ended December 31, 1993, primary earnings per share of common stock was $2.46 per share. If stock options exercised in 1993 had been exercised on January 1, 1993, earnings per share would have remained at the same level. For the year ended December 31, 1992, primary earnings per share of common stock was $2.12 per share. If stock options exercised in December 1992 had been exercised on January 1, 1992, earnings per share of common stock for 1992 would have been $2.08. 7. PROPERTY, PLANT AND EQUIPMENT Property, plant and equipment consists of the following: The December 31, 1993 balance of property, plant and equipment, net includes $224 million for MPC. EL PASO NATURAL GAS COMPANY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) 8. INCOME TAXES The following table reflects the components of income tax expense. Investment tax credit as shown above is net of estimated recapture, if any, provided for during each year. The following table reflects the components of deferred tax expense (benefit): The following table reflects the components of the net deferred tax liability: EL PASO NATURAL GAS COMPANY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) Tax expense of the Company differs from the amount computed by applying the statutory federal income tax rate to income from continuing operations before income taxes. The reasons for this difference are as follows: The Revenue Reconciliation Act of 1993, enacted in August 1993, changed the corporate income tax rate from 34 to 35 percent effective January 1, 1993. As a result, the Company's current year provision for income tax expense was adjusted in the third quarter of 1993 by approximately $1 million, of which $0.5 million is related to the balance of deferred income taxes at December 31, 1992. In addition, the balance of accumulated deferred income taxes at January 1, 1993 was increased $5 million in accordance with SFAS 109, and a corresponding regulatory asset was recorded. Management expects such amounts to be fully recovered through its rates. Deferred credits, in the accompanying Consolidated Balance Sheet, include excess deferrals resulting from the reduction of the statutory federal tax rate from 46 to 34 percent on July 1, 1987. 9. PENSION PLANS The Company previously participated in BR's pension plans, which were non-contributory defined benefit plans covering substantially all employees. The benefits were based on the number of years of credited service and the highest five-year average compensation levels. Contributions to the plans were determined by BR and were limited to amounts that were deductible for tax purposes. In January 1992, the Company established its own pension plans with provisions similar to those of the BR plans. Upon separation from BR, the Company's qualified pension plan received assets equal to the accumulated benefit obligation relating to the Company's employees. EL PASO NATURAL GAS COMPANY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) The following table sets forth the qualified plan's funded status and amounts recognized in the Company's Consolidated Balance Sheet at December 31, 1993 and December 31, 1992: The following table reflects the components of net periodic pension cost: The 1993 weighted average discount rate and rate of increase in future compensation levels used in determining the actuarial present value of the projected benefit obligation were 7.5 percent and 5.0 percent, respectively. The 1993 weighted average expected long-term rate of return on plan assets was 9.0 percent. The 1992 weighted average discount rate and rate of increase in future compensation levels used in determining the actuarial present value of the projected benefit obligation were 8.5 percent and 5.0 percent, respectively. The 1992 weighted average expected long-term rate of return on plan assets was 9.0 percent. Contributions to the plans are limited to amounts currently deductible for tax purposes. The accumulated vested benefit obligation is the actuarial present value of the vested benefits to which the employee is currently entitled, but it is based on the employee's expected date of termination. 10. POSTRETIREMENT AND POSTEMPLOYMENT BENEFITS OTHER THAN PENSIONS The Financial Accounting Standards Board issued SFAS 106 requiring companies to account for OPEBs, (principally retiree medical costs) on an accrual basis versus the pay-as-you-go basis traditionally followed by most United States companies. The Company adopted SFAS 106 effective January 1, 1993. The Company provides a non-contributory defined benefit postretirement medical plan that covers employees who retired on or before March 1, 1986 and limited postretirement life insurance for employees who retire after January 1, 1985. As such, the Company's obligation to accrue for OPEBs is primarily limited to the fixed population of retirees who retired on or before March 1, 1986. The medical plan is funded to the extent employer contributions are recoverable through rates. EL PASO NATURAL GAS COMPANY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) EPG began recovering through its rates the OPEB costs included in the settlement agreement. To the extent actual OPEB costs exceed the amounts reflected in the settlement agreement, a regulatory asset has been recorded. Management expects such amounts to be fully recovered through its rates. The following table sets forth the plan's funded status and amounts recognized in the Company's Consolidated Balance Sheet at December 31, 1993: The following table reflects the components of net periodic postretirement benefit cost for the twelve months ended December 31, 1993: A 13.5 percent annual rate of increase in the per capita costs of covered health care benefits was assumed for 1994, gradually decreasing to 6 percent by the year 2002. Increasing the assumed health care cost trend rates by one percentage point in each year would increase the accumulated postretirement benefit obligation as of December 31, 1993 by approximately $13.9 million and increase the interest cost components of net periodic postretirement benefit cost for 1993 by approximately $1 million. A discount rate of 7.5 percent was used to determine the accumulated postretirement benefit obligation. The Financial Accounting Standards Board issued SFAS 112 which requires companies to account for benefits to former or inactive employees after employment but before retirement (referred to in SFAS 112 as "postemployment benefits"). SFAS 112 is effective for the fiscal years beginning after December 15, 1993. Postemployment benefits include every form of benefit provided to former or inactive employees, their beneficiaries and covered dependents. Benefits include, but are not limited to salary continuation, supplemental unemployment benefits, severance benefits, disability-related benefits (including workers' compensation), job training and counseling, and continuation of benefits such as health care benefits and life insurance coverage. The cumulative effect at January 1, 1994 of adopting SFAS 112 is estimated to be approximately $8 million. Management expects to fully recover its postemployment benefits costs through rates. 11. COMMITMENTS AND CONTINGENT LIABILITIES See Note 1 and 4 of Notes to Consolidated Financial Statements, Item 1 and 2 -- Business and Properties, El Paso Natural Gas Company, Master Separation Agreement and Item 3 -- Legal Proceedings for discussions of litigation and other contingencies. EL PASO NATURAL GAS COMPANY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) Minimum annual rental commitments at December 31, 1993, are as follows: Rental expense for operating leases was $8 million in 1993 and 1992, and $7 million in 1991. EPG has a lease agreement for approximately 391,207 square feet of space which is currently used as the Company headquarters and its gas control center. The lease expires on May 31, 2007, and grants EPG two ten year options to extend the term of the lease. Management is not aware of other commitments or contingent liabilities which would have a materially adverse effect on the Company's financial condition or results of operations. 12. SIGNIFICANT CUSTOMERS The Company had gross revenues equal to or in excess of 10 percent of consolidated operating revenues from the following customers: 13. SUPPLEMENTAL CASH FLOW INFORMATION The following provides additional information concerning supplemental disclosures of cash flow activities: 14. RELATED PARTY TRANSACTIONS In 1991 and for the first six months of 1992, BR and Meridian were considered related parties of EPG. Through February 1992, EPG participated in an intercorporate cash management arrangement with BR, pursuant to which excess cash balances from each of BR's operating subsidiaries were advanced to BR on a daily basis and cash requirements of BR's operating subsidiaries were funded daily through advances from BR. Balances under the arrangement accrued interest at rates approximating short-term market rates. In January and February 1992, EPG declared and paid dividends totaling $274 million to BR from the balance owed to EPG under the intercorporate cash management arrangement. On April 8, 1992, EPG's Board of Directors declared a quarterly dividend on common stock of $0.25 per share to the June 1, 1992 stockholders of record. EPG paid the dividend on June 19, 1992, in the amount of $9.3 million, $8 million of which was paid to BR. EL PASO NATURAL GAS COMPANY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) Revenues associated with the transportation of gas for Meridian by EPG were $15 million for the six months ended June 30, 1992, and $47 million for the year ended December 31, 1991. Operating revenues include $26 million related to transactions with the discontinued Oil and Gas Operations Segment in 1991. Operating charges related to transactions with the discontinued segment were less than $1 million in 1991. In May 1991, EPG declared and paid a dividend to TEPCO of $175 million and in December 1991 declared and paid a $55 million dividend to BR. Certain BR corporate overhead expenses were allocated to EPG. The allocated amounts were not material and management believes the allocation methodology was appropriate. 15. FINANCIAL INSTRUMENTS Fair Value The following disclosure of the estimated fair value of financial instruments was made in accordance with the requirements of Statement of Financial Accounting Standards No. 107 ("SFAS 107"). The estimated fair value amounts have been determined by the Company using available market information and valuation methodologies. As of December 31, 1993, the carrying amounts of the various financial instruments employed by the Company, including cash, cash equivalents, short-term borrowings, and trade receivables and payables are representative of fair value because of the short maturity of these instruments. The carrying amounts and estimated fair values of the Company's other financial instruments at December 31, 1993 are as follows: The fair value of the Company's long-term debt has been estimated based on quoted market prices for the same or similar issues. The fair value of interest rate swap agreements is the amount at which they could be settled, based on estimates obtained from dealers. Off-Balance Sheet Risk During 1993, EPG and EPGM entered into certain price swap agreements to, in effect, hedge the market risk caused by fluctuations in the price of natural gas. The agreements call for EPG and EPGM to make payments to or receive payments from the other parties based upon the differential between a fixed and a variable price for natural gas as specified by the contract. The current price swap agreements run for periods of up to five years and had a notional contract amount of approximately $30 million at December 31, 1993. While EPG and EPGM's notional contract amounts are used to express the magnitude of price swap agreements, the amounts potentially subject to credit risk, in the event of non-performance by the other parties, are substantially smaller. EPG and EPGM do not anticipate non-performance by the other parties. MPC has entered into interest rate swap agreements which effectively convert $114.3 million of floating-rate debt to fixed-rate debt. MPC makes payments to counterparties at fixed rates and in return receives payments at floating rates. REPORT OF INDEPENDENT ACCOUNTANTS To the Board of Directors and Stockholders El Paso Natural Gas Company We have audited the consolidated financial statements and the financial statement schedules of El Paso Natural Gas Company listed in Item 14(a) of this Form 10-K. These financial statements and financial statement schedules are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements and financial statement schedules based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of El Paso Natural Gas Company as of December 31, 1993 and 1992, and the consolidated results of its operations and its cash flows for each of the three years in the period ended December 31, 1993, in conformity with generally accepted accounting principles. In addition, in our opinion, the financial statement schedules referred to above, when considered in relation to the basic financial statements taken as a whole, present fairly, in all material respects, the information required to be included therein. COOPERS & LYBRAND El Paso, Texas January 21, 1994 EL PASO NATURAL GAS COMPANY CONSOLIDATED QUARTERLY INFORMATION YEARS ENDED DECEMBER 31, 1993 AND 1992 (IN THOUSANDS, EXCEPT PER SHARE AMOUNTS) (UNAUDITED) SCHEDULE IV EL PASO NATURAL GAS COMPANY INDEBTEDNESS OF AND TO RELATED PARTIES -- NOT CURRENT YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 (IN THOUSANDS) SCHEDULE V EL PASO NATURAL GAS COMPANY PROPERTY, PLANT AND EQUIPMENT YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 (IN THOUSANDS) For depreciation rates and methods, see Accounting Policies. (a) Primarily from system enhancement and maintenance projects. (b) Primarily the consolidation of MPC's $242 million of property, plant and equipment and reclassification of $46 million of underground storage facility. (c) Primarily from major system expansion and enhancement projects. (d) Primarily reclassification of $31 million of gas in storage inventory consistent with the August 14, 1991 FERC order. SCHEDULE VI EL PASO NATURAL GAS COMPANY ACCUMULATED DEPRECIATION, DEPLETION AND AMORTIZATION OF PROPERTY, PLANT AND EQUIPMENT YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 (IN THOUSANDS) SCHEDULE VIII EL PASO NATURAL GAS COMPANY VALUATION AND QUALIFYING ACCOUNTS YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 (IN THOUSANDS) - --------------- (a) Presentation of prior years has been changed to conform to current year presentation. (b) Primarily accounts charged off. (c) Primarily accounts recovered. SCHEDULE X EL PASO NATURAL GAS COMPANY SUPPLEMENTARY INCOME STATEMENT INFORMATION YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 (IN THOUSANDS) - ------------ Note -- Items omitted are either less than 1 percent of consolidated revenues or are disclosed elsewhere in the consolidated financial statements or notes thereto. ITEM 9.

ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE None PART III ITEM 10.

ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT The information appearing under the caption "Proposal No. 1 -- Election of Directors" in the Company's proxy statement for the 1994 Annual Meeting of Stockholders (the "Proxy Statement") is incorporated herein by reference. Information regarding executive officers of the Company is presented in Items 1 and 2 of this Form 10-K under the caption "Executive Officers of the Registrant." ITEM 11.

ITEM 11. EXECUTIVE COMPENSATION Information appearing under the caption "Executive Compensation" in the Proxy Statement is incorporated herein by reference. ITEM 12.

ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT Information appearing under the caption "Security Ownership of a Certain Beneficial Owner and Management" in the Proxy Statement is incorporated herein by reference. ITEM 13.

ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS None. PART IV ITEM 14.

ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K (A) THE FOLLOWING DOCUMENTS ARE FILED AS A PART OF THIS REPORT: 1. Financial statements. The following consolidated financial statements of the Company are included in Part II, Item 8 of this report: 2. Financial statement schedules and supplementary information required to be submitted. (B) REPORTS ON FORM 8-K: No reports on Form 8-K were filed by the Registrant during the quarter ended December 31, 1993. EL PASO NATURAL GAS COMPANY EXHIBIT LIST DECEMBER 31, 1993 Each exhibit identified on this Exhibit List is filed as a part of this report. Exhibits not incorporated by reference to a prior filing are designated by an asterisk; all exhibits not so designated are incorporated herein by reference to a prior filing as indicated. SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, El Paso Natural Gas Company has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. EL PASO NATURAL GAS COMPANY Registrant By /s/ WILLIAM A. WISE William A. Wise Chairman of the Board, President and Chief Executive Officer Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of El Paso Natural Gas Company and in the capacities and on the date indicated: INDEX TO EXHIBITS Each exhibit set forth below is filed as part of this report.

722079_1993.txt

722079

1993

ITEM 3. LEGAL PROCEEDINGS. Various legal proceedings are pending against Terra Industries and its subsidiaries. Management of Terra Industries considers that the aggregate liability, if any, resulting from these proceedings will not be material to Terra Industries. ITEM 4.

ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS. No items were submitted to a vote of security holders of Terra Industries during the fourth quarter of the 1993 fiscal year. EXECUTIVE OFFICERS OF TERRA INDUSTRIES The following paragraphs set forth the name, age and offices with Terra Industries of each present executive officer of Terra Industries, the period during which each executive officer has served as such and each executive officer's business experience during the past five years: There are no family relationships among the executive officers and directors of Terra Industries or arrangements or understandings between any executive officer and any other person pursuant to which any executive officer was selected as such. Officers of Terra Industries are elected annually to serve until their respective successors are elected and qualified. PART II ITEM 5.

ITEM 5. MARKET FOR TERRA INDUSTRIES' COMMON EQUITY AND RELATED STOCKHOLDER MATTERS. Information with respect to the market for Terra Industries' common equity and related stockholder matters contained in Terra Industries' 1993 Annual Report to Stockholders under the caption "Quarterly Financial and Stock Market Data (Unaudited)" is incorporated herein by reference. ITEM 6.

ITEM 6. SELECTED FINANCIAL DATA. Information with respect to selected financial data contained in Terra Industries' 1993 Annual Report to Stockholders under the caption "Financial Summary" is incorporated herein by reference. ITEM 7.

ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS. Information with respect to management's discussion and analysis of financial condition and results of operations contained in Terra Industries' 1993 Annual Report to Stockholders under the caption "Financial Review" is incorporated herein by reference. ITEM 8.

ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA. The consolidated financial statements, together with the report of independent accountants thereon, the information contained under the caption "Quarterly Financial and Stock Market Data (Unaudited)" contained in Terra Industries' 1993 Annual Report to Stockholders are incorporated herein by reference. ITEM 9.

ITEM 9. DISAGREEMENTS ON ACCOUNTING AND FINANCIAL DISCLOSURE. Not Applicable. PART III ITEM 10.

ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF TERRA INDUSTRIES. Information with respect to directors of Terra Industries under the caption "Election of Directors" in the Proxy Statement for the Annual Meeting of Stockholders of Terra Industries to be held on May 3, 1994, is incorporated herein by reference. Information with respect to executive officers who are not also directors of Terra Industries appears under the caption "Executive Officers of Terra Industries" in Part I hereof and is incorporated herein by reference. ITEM 11.

ITEM 11. EXECUTIVE COMPENSATION. Information with respect to executive compensation under the caption "EXECUTIVE COMPENSATION AND OTHER INFORMATION" in the Proxy Statement for the Annual Meeting of Stockholders of Terra Industries to be held on May 3, 1994, is incorporated herein by reference. ITEM 12.

ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT. Information with respect to security ownership of certain beneficial owners and management under the caption "Equity Security Ownership" in the Proxy Statement for the Annual Meeting of Stockholders of Terra Industries to be held on May 3, 1994, is incorporated herein by reference. ITEM 13.

ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS. Information with respect to certain relationships and related transactions under the caption "CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS" in the Proxy Statement for the Annual Meeting of Stockholders of Terra Industries to be held on May 3, 1994, is incorporated herein by reference. PART IV ITEM 14.

ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K. (a) FINANCIAL STATEMENTS AND FINANCIAL STATEMENT SCHEDULES 1. Consolidated Financial Statements of Terra Industries and its subsidiaries (incorporated herein by reference to Terra Industries' 1993 Annual Report to Stockholders). Consolidated Statements of Financial Position at December 31, 1993 and 1992. Consolidated Statements of Income for the years ended December 31, 1993, 1992 and 1991. Consolidated Statements of Cash Flows for the years ended December 31, 1993, 1992 and 1991. Consolidated Statements of Changes in Stockholders' Equity for the years ended December 31, 1993, 1992 and 1991. Notes to the Consolidated Financial Statements. Independent Auditors' Report. Quarterly Production Data (Unaudited). Quarterly Financial and Stock Market Data (Unaudited). Stockholders and Dividends. Financial Summary. 2. Index to Financial Statement Schedules See Index to Financial Statement Schedules of Terra Industries and its subsidiaries at page S-1. 3. Other Financial Statements Individual financial statements of Terra Industries' subsidiaries are omitted because all such subsidiaries are included in the consolidated financial statements being filed. Individual financial statements of 50% or less owned persons accounted for on the equity method have been omitted because such 50% or less owned persons considered in the aggregate, as a single subsidiary, would not constitute a significant subsidiary. (b) EXECUTIVE COMPENSATION PLANS AND ARRANGEMENTS 1. Amended and Restated Deferred Compensation Agreement made as of May 1, 1991, by and between Terra Industries and R. F. Richards filed as Exhibit 10 to Terra Industries' Form 8-K dated September 30, 1991. 2. Resolution adopted by the Personnel Committee of the Board of Directors of Terra Industries with respect to supplemental retirement benefits for certain senior executive officers of Terra Industries, filed as Exhibit 10.4.2 to Terra Industries' Form 10-Q for the fiscal quarter ended March 31, 1991. 3. 1992 Executive Incentive Plan of Terra Industries filed as Exhibit 10.1.12 to Terra Industries' Form 10-K for the year ended December 31, 1991. 4. 1992 Stock Incentive Plan of Terra Industries filed as Exhibit 10.1.6 to Terra Industries' Form 10-K for the year ended December 31, 1992. 5. Form of Restricted Stock Agreement of Terra Industries under its 1992 Stock Incentive Plan filed as Exhibit 10.1.7 to Terra Industries' Form 10-K for the year ended December 31, 1992. 6. Form of Incentive Stock Option Agreement of Terra Industries under its 1992 Stock Incentive Plan filed as Exhibit 10.1.8 to Terra Industries' Form 10-K for the year ended December 31, 1992. 7. Form of Nonqualified Stock Incentive Agreement of Terra Industries under its 1992 Stock Incentive Plan filed as Exhibit 10.1.9 to Terra Industries' Form 10-K for the year ended December 31, 1992. 8. 1993 Incentive Award Program for Officers and Key Executives of Terra Industries filed as Exhibit 10.1.10 to Terra Industries' Form 10-K for the year ended December 31, 1992. 9. Excess Benefit Plan of Terra Industries as amended effective as of January 1, 1992, filed as Exhibit 10.1.13 to Terra Industries' Form 10-K for the year ended December 31, 1992. 10. Restricted Stock Agreement of Burton M. Joyce dated May 1, 1991, filed as Exhibit 10.1.14 to Terra Industries' Form 10-K for the year ended December 31, 1992. 11. Terra Industries Inc. Supplemental Deferred Compensation Plan effective as of December 20, 1993, filed as Exhibit 10.1.9 to Terra Industries' Form 10-K for the year ended December 31, 1993. 12. Retirement/Consulting Agreement, dated as of May 13, 1993 by and between Paul D. Foster and Terra International, filed as Exhibit 10.1.2 to Terra Industries' Form 10-K for the year ended December 31, 1993. 13. Consulting Agreement dated as of December 30, 1993, by and between Paul D. Foster and Terra International, filed as Exhibit 10.1.13 to Terra Industries' Form 10-K for the year ended December 31, 1993. 14. 1994 Incentive Award Program for Officers and Key Executives of Terra Industries filed as Exhibit 10.1.14 to Terra Industries' Form 10-K for the year ended December 31, 1993. (c) REPORTS ON FORM 8-K The following report on Form 8-K was filed during the fourth quarter of 1993: Form 8-K dated October 26, 1993, Item 5. (d) Exhibits 3.1.1 Articles of Restatement of Terra Industries filed with the State of Maryland on September 11, 1990, filed as Exhibit 3.1 to Terra Industries' Form 10-K for the year ended December 31, 1990, is incorporated herein by reference. [8 pages]. 3.1.2 Articles of Amendment of Terra Industries filed with the State of Maryland on May 6, 1992, filed as Exhibit 3.1.2 to Terra Industries' Form 10-K for the year ended December 31, 1992, is incorporated herein by reference. [2 pages]. 3.2 By-Laws of Terra Industries, as amended through August 7, 1991, filed as Exhibit 3 to Terra Industries' Form 8-K dated September 30, 1991, is incorporated herein by reference. [12 pages]. 4.1.1 Indenture dated as of May 31, 1987, from Terra Industries to Mellon Bank, N.A., as Trustee, including form of Debenture, filed as Exhibit 4 to Amendment No. 2 to the Registration Statement on Form S-3 (Registration No. 33-14171) filed by Terra Industries on June 11, 1987, is incorporated herein by reference. [105 pages]. 4.1.2 Revolving Credit Agreement dated as of November 24, 1992, among Terra International, Inc., CitiCorp USA, Inc., Mellon Bank, N.A., Continental Bank N.A., First Bank National Association, NationsBank of Texas, N.A. and Rabobank Nederland, filed as Exhibit 4.1.2 to Terra Industries' Form 10-K for the year ended December 31, 1992, is incorporated herein by reference. 4.1.3 First Amendment Agreement, dated as of March 26, 1993, by and between Terra International, Inc., the Lenders listed on the signature page thereto, and CitiCorp USA, Inc., as agent to Lenders. [17 pages]. 4.1.4 Second Amendment Agreement, dated as of December 30, 1993, by and between Terra International, Inc., the Lenders listed on the signature page thereto, and CitiCorp USA, Inc., as agent for the Lenders. [13 pages]. Other instruments defining the rights of holders of long-term debt of Terra Industries and its subsidiaries are not being filed because the total amount of securities authorized under any such instrument does not exceed 10 percent of the total assets of Terra Industries and its subsidiaries on a consolidated basis. Terra Industries agrees to furnish a copy of any instrument to the Securities and Exchange Commission upon request. 10.1.1 Amended and Restated Deferred Compensation Agreement made as of May 1, 1991, by and between Terra Industries and R. F. Richards filed as Exhibit 10 to Terra Industries' Form 8-K dated September 30, 1991, is incorporated herein by reference. [4 pages]. 10.1.2 Resolution adopted by the Personnel Committee of the Board of Directors of Terra Industries with respect to supplemental retirement benefits for certain senior executive officers of Terra Industries, filed as Exhibit 10.4.2 to Terra Industries' Form 10-Q for the fiscal quarter ended March 31, 1991, is incorporated herein by reference. [1 page] 10.1.3 1992 Executive Incentive Plan of Terra Industries filed as Exhibit 10.1.12 to Terra Industries' Form 10-K for the year ended December 31, 1991, is incorporated herein by reference. [3 pages]. 10.1.4 1992 Stock Incentive Plan of Terra Industries filed as Exhibit 10.1.6 to Terra Industries' Form 10-K for the year ended December 31, 1992, is incorporated herein by reference. [8 pages]. 10.1.5 Form of Restricted Stock Agreement of Terra Industries under its 1992 Stock Incentive Plan filed as Exhibit 10.1.7 to Terra Industries' Form 10-K for the year ended December 31, 1992, is incorporated. herein by reference. [4 pages]. 10.1.6 Form of Incentive Stock Option Agreement of Terra Industries under its 1992 Stock Incentive Plan, filed as Exhibit 10.1.8 to Terra Industries' Form 10-K for the year ended December 31, 1992, is incorporated herein by reference. [4 pages]. 10.1.7 Form of Nonqualified Stock Incentive Agreement of Terra Industries under its 1992 Stock Incentive Plan, filed as Exhibit 10.1.9 to Terra Industries' Form 10-K for the year ended December 31, 1992, is incorporated herein by reference. [4 pages]. 10.1.8 1993 Incentive Award Program for Officers and Key Executives of Terra Industries, filed as Exhibit 10.1.10 to Terra Industries' Form 10-K for the year ended December 31, 1992, is incorporated herein by reference. [3 pages]. 10.1.9 Terra Industries Inc. Supplemental Deferred Compensation Plan effective as of December 20, 1993. [19 pages.] 10.1.10 Excess Benefit Plan of Terra Industries as amended effective as of January 1, 1992, filed as Exhibit 10.1.13 to Terra Industries' Form 10-K for the year ended December 31, 1992, is incorporated herein by reference. [2 pages]. 10.1.11 Restricted Stock Agreement of Burton M. Joyce dated May 1, 1991, filed as Exhibit 10.1.14 to Terra Industries' Form 10-K for the year ended December 31, 1992, is incorporated herein by reference. [2 pages]. 10.1.12 Retirement/Consultant Agreement, dated as of May 13, 1993, by and between Paul D. Foster and Terra International. [4 pages]. 10.1.13 Consulting Agreement, dated as of December 30, 1993, by and between Paul D. Foster and Terra International. [2 pages]. 10.1.14 1994 Incentive Award Program for Officers and Key Executives of Terra Industries. [3 pages]. 10.2 Asset Sale and Purchase Agreement among Inspiration Consolidated Copper Company and Cyprus Miami Mining Corporation and Cyprus Christmas Mine Corporation dated as of June 30, 1989, filed as Exhibit 10.19 to Terra Industries' Form 10-Q for the quarter ended September 30, 1989, is incorporated herein by reference. [83 pages]. 10.3.1 Stock Purchase Agreement, dated as of June 14, 1991, among Minorco, Kirkdale Investments Limited, Terra Industries and Hudson Holdings Corporation, filed as Exhibit 2 to Terra Industries' Form 8-K dated June 14, 1991, is incorporated herein by reference. [55 pages]. 10.3.2 Amended and Restated Stock Purchase Agreement, dated as of July 31, 1991, among Minorco, Kirkdale Investments Limited, Terra Industries and Hudson Holdings Corporation, filed as Exhibit 1 to Terra Industries' Form 8-K dated July 31, 1991, is incorporated herein by reference. [62 pages]. 10.3.3 Option Agreement, dated as of June 14, 1991, among Kirkdale Investments Limited and Terra Industries, filed as Exhibit 3 to Terra Industries' Form 8-K dated June 14, 1991, is incorporated herein by reference. [16 pages]. 10.3.4 Amendment to Stock Option Agreement, dated July 31, 1991, among Minorco, Kirkdale Investments Limited and Terra Industries, filed as Exhibit 2 to Terra Industries' Form 8-K dated July 31, 1991, is incorporated herein by reference. [3 pages]. 10.4 Asset and Sale Purchase Agreement, dated as of April 8, 1993, by and between Terra International, Inc., Terra International (Canada) Inc. and ICI Canada Inc., filed as Exhibit A to Terra Industries' Form 8-K dated April 8, 1993, is incorporated herein by reference. [95 pages]. 10.5 Asset Purchase Agreement, dated as of December 30, 1993, by and between Terra International, Inc., The Upjohn Company and Asgrow Florida Company, filed as Exhibit A to Terra Industries' Form 8-K dated December 31, 1993, is incorporated herein by reference. [71 pages]. 10.6 Lease, dated as of April 8, 1993, between W. Patrick Moroney and Terra International (Canada) Inc. [42 pages]. 13 Financial Review and Consolidated Financial Statements as Contained in the Annual Report to Stockholders of Terra Industries for the fiscal year ended December 31, 1993. [32 pages]. 21 Subsidiaries of Terra Industries. [3 pages]. 24 Powers of Attorney [8 pages]. SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, Terra Industries has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. TERRA INDUSTRIES INC. By: /s/ George H. Valentine ------------------------- George H. Valentine Vice President, General Counsel and Corporate Secretary Date: March 3, 1994 Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of Terra Industries and in the capacities and on the dates indicated: INDEX TO FINANCIAL STATEMENT SCHEDULES, REPORTS AND CONSENTS Financial statement schedules not included in this report have been omitted because they are not applicable or the required information is shown in the consolidated financial statements or the notes thereto. S-1 INDEPENDENT AUDITORS' REPORT ON FINANCIAL STATEMENT SCHEDULES TO THE BOARD OF DIRECTORS AND STOCKHOLDERS OF TERRA INDUSTRIES INC.: We have audited the consolidated financial statements of Terra Industries Inc. as of December 31, 1993 and 1992, and for each of the two years then ended, and have issued our report thereon dated February 1, 1994; such financial statements and report are included in the 1993 Annual Report to Stockholders of Terra Industries Inc. and are incorporated herein by reference. Our audits also included the Financial Statement Schedules of Terra Industries Inc. listed in Item 14(a) of this Form 10-K. These Financial Statement Schedules are the responsibility of the management of Terra Industries Inc. Our responsibility is to express an opinion based on our audits. In our opinion, such Financial Statement Schedules, when considered in relation to the basic consolidated financial statements taken as a whole, present fairly in all material respects the information set forth therein. DELOITTE & TOUCHE Omaha, Nebraska February 1, 1994 INDEPENDENT AUDITORS' CONSENT We consent to the incorporation by reference in the Prospectuses constituting part of the Registration Statements on Form S-8 (Registration Nos. 33-46735, 33-46734, 33-30058 and 33-4939) and Registration Statements on Form S-3 (Registration Nos. 2-90808, 2-84876 and 2-84669) of Terra Industries Inc. of our report dated February 1, 1994, included in the 1993 Annual Report to Stockholders of Terra Industries Inc. which is incorporated by reference in this Form 10-K. We also consent to the incorporation by reference in such Prospectuses of our report on the Financial Statement Schedules, appearing above. DELOITTE & TOUCHE Omaha, Nebraska February 28, 1994 S-2 REPORT OF INDEPENDENT ACCOUNTANTS To the Board of Directors and Stockholders of Terra Industries Inc. In our opinion, the consolidated financial statements listed in the index under Item 14(a)(1) and (2) on page 11 of the 1993 Annual Report on Form 10-K present fairly, in all material respects, the results of operations, cash flows and changes in stockholders' equity of Terra Industries Inc. and its subsidiaries for the year ended December 31, 1991, in conformity with generally accepted accounting principles. These financial statements are the responsibility of the Company's management; our responsibility is to express an opinion on these financial statements based on our audit. We conducted our audit of these statements in accordance with generally accepted auditing standards which require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audit provides a reasonable basis for the opinion expressed above. We have not audited the consolidated financial statements of Terra Industries Inc. for any period subsequent to December 31,1991. PRICE WATERHOUSE February 13, 1992 New York, New York S-3 CONSENT OF INDEPENDENT ACCOUNTANTS We hereby consent to the incorporation by reference in the Prospectuses constituting part of the Registration Statements on Form S-3 (Registration Nos. 2-90808, 2-84876 and 2-84669) and Form S-8 (Registration Nos. 33-30058, 33-4939, 33-46734 and 33-46735) of Terra Industries Inc. of our report dated February 13, 1992 appearing on page S-3 of this Annual Report on Form 10-K. PRICE WATERHOUSE New York, New York March 1, 1994 S-4 SCHEDULE II TERRA INDUSTRIES INC. AMOUNTS RECEIVABLE FROM RELATED PARTIES AND UNDERWRITERS, PROMOTERS, AND EMPLOYEES OTHER THAN RELATED PARTIES Years Ended December 31, 1993, 1992, and 1991 --------------------------------------------- (in thousands) (a) For 1992 the Corporation reclassified the accounts receivable of Alloy Research, Inc. to Net Assets of Discontinued Operations. (b) Represents amounts collected. S-5 TERRA INDUSTRIES INC. (Parent Company) SCHEDULE III - CONDENSED FINANCIAL INFORMATION OF REGISTRANT STATEMENTS OF FINANCIAL POSITION See accompanying Notes to the Condensed Financial Statements. S-6 TERRA INDUSTRIES INC. (Parent Company) SCHEDULE III - CONDENSED FINANCIAL INFORMATION OF REGISTRANT CONDENSED STATEMENTS OF OPERATIONS AND ACCUMULATED DEFICIT See accompanying Notes to the Condensed Financial Statements. S-7 TERRA INDUSTRIES INC. (Parent Company) SCHEDULE III - CONDENSED FINANCIAL INFORMATION OF REGISTRANT STATEMENTS OF CASH FLOWS See accompanying Notes to the Condensed Financial Statements. S-8 TERRA INDUSTRIES INC. (Parent Company) SCHEDULE III - CONDENSED FINANCIAL INFORMATION OF REGISTRANT NOTES TO THE CONDENSED FINANCIAL STATEMENTS 1. BASIS OF PRESENTATION The Condensed Financial Statements include the Registrant only and reflect the equity method of accounting for its wholly owned subsidiary, Terra International, Inc. (International). Equity in International's 1992 earnings includes the deduction of $5.7 million for the cumulative effect of accounting changes to recognize the prior service cost of providing post-retirement medical benefits to International's employee's. Equity in the financial results of the base metals, coal, leasing and other discontinued businesses have been included in discontinued operations. 2. LONG-TERM DEBT Long-term debt at December 31, 1993 and 1992 consists of 8.5% Convertible Subordinated Debentures (Debentures) of $72,057,000 that is due 2012. Sinking fund payments of $5,175,000 per year begin in 1998. The fair value, based upon redemption provisions, at December 31, 1993 is $74.4 million and at December 31, 1992 was $75.3 million. The Debentures are convertible into Common Shares any time prior to maturity, unless previously redeemed, at a conversion price of $8.083 per share. The Debentures are subject to redemption, upon not less than 20 days notice by mail, at any time, as a whole or in part, at the election of the Registrant. The redemption price, expressed as a percent of the principal amount of the Debentures to be redeemed, is 103.40% until May 31, 1994, 102.55% until May 31, 1995 and decreasing yearly thereafter to 100% at June 1, 1997. 3. COMMITMENTS AND CONTINGENCIES The Registrant is committed to a non-cancelable office lease expiring in 1998. Total minimum rental payments, are: 1994, $3.1 million; 1995, $3.1 million; 1996, $3.2 million; 1997, $3.3 million and 1998, $1.7 million. These amounts are not reduced by sublease rentals, which in 1993 were $2.0 million. The Registrant is contingently liable for retiree medical benefits of employees of coal mining operations sold on January 12, 1993. Under the purchase agreement, the purchaser agreed to indemnify the Registrant against its obligations under certain employee benefit plans. Due to the Coal Industry Retiree Health Benefit Act of 1992, certain retiree medical benefits of union coal miners have become statutorily mandated, and all companies owning 50 percent or more of any company liable for such benefits as of certain specified dates becomes liable for such benefits if the company directly liable is unable to pay them. As a result, if the purchaser becomes unable to pay its retiree medical obligations assumed pursuant to the sale, the Registrant may have to pay such amount. The Registrant has estimated that the present value of liabilities for which it retains contingent responsibility approximates $12 million at December 31, 1993. In the event the Registrant would be required to assume this liability, mineral reserves associated with the sold coal subsidiary would revert to the Registrant. The Registrant had letters of credit outstanding totaling $13.0 million at December 31, 1993 and $14.1 million at December 31, 1992, guaranteeing various insurance and financing activities. Short-term investments of $13.0 million at December 31, 1993 and 1992 are restricted to collateralize certain of the letters of credit. 4. INCOME TAXES The Registrant files a consolidated U.S. federal tax return. The principal operating subsidiaries provide for federal income taxes according to tax sharing agreements which allocate the benefits of operating losses and differences between financial reporting and income tax basis results to the Registrant. S-9 SCHEDULE V TERRA INDUSTRIES INC. PROPERTY, PLANT & EQUIPMENT Years Ended December 31, 1993, 1992, and 1991 ---------------------------------------------- (in thousands) (a) Discontinued operations include the Leasing and Construction Materials segments in 1992 and the Base Metals segment in 1991. (b) Amounts included in related to acquisitions during 1993 are $12,301. S-10 SCHEDULE VI TERRA INDUSTRIES INC. ACCUMULATED DEPRECIATION, DEPLETION AND AMORTIZATION OF PROPERTY, PLANT AND EQUIPMENT Years Ended December 31, 1993, 1992, and 1991 (in thousands) (a) Discontinued operations included the Leasing and Construction Materials segments in 1992 and the Base Metals segment in 1991. S-11 SCHEDULE VIII TERRA INDUSTRIES INC. VALUATION AND QUALIFYING ACCOUNTS Years Ended December 31, 1993, 1992, and 1991 --------------------------------------------- (in thousands) (a) Write-offs, net of recoveries. S-12 SCHEDULE IX TERRA INDUSTRIES INC. SHORT-TERM BORROWINGS Years Ended December 31, 1993, 1992, and 1991 --------------------------------------------- (in thousands) (a) Based on number of days during the year. S-13 SCHEDULE X TERRA INDUSTRIES INC. SUPPLEMENTARY INCOME STATEMENT INFORMATION Years Ended December 31, 1993, 1992, and 1991 --------------------------------------------- (in thousands) (a) Less than one percent of total revenues. (b) Amounts have been restated to reflect discontinued operations. S-14 EXHIBIT INDEX 3.1.1 Articles of Restatement of Terra Industries filed with the State of Maryland on September 11, 1990, filed as Exhibit 3.1 to Terra Industries' Form 10-K for the year ended December 31, 1990, is incorporated herein by reference. [8 pages]. 3.1.2 Articles of Amendment of Terra Industries filed with the State of Maryland on May 6, 1992, filed as Exhibit 3.1.2 to Terra Industries' Form 10-K for the year ended December 31, 1992, is incorporated herein by reference. [2 pages]. 3.2 By-Laws of Terra Industries, as amended through August 7, 1991, filed as Exhibit 3 to Terra Industries' Form 8-K dated September 30, 1991, is incorporated herein by reference. [12 pages]. 4.1.1 Indenture dated as of May 31, 1987, from Terra Industries to Mellon Bank, N.A., as Trustee, including form of Debenture, filed as Exhibit 4 to Amendment No. 2 to the Registration Statement on Form S-3 (Registration No. 33-14171) filed by Terra Industries on June 11, 1987, is incorporated herein by reference. [105 pages]. 4.1.2 Revolving Credit Agreement dated as of November 24, 1992, among Terra International, Inc., CitiCorp USA, Inc., Mellon Bank, N.A., Continental Bank N.A., First Bank National Association, NationsBank of Texas, N.A. and Rabobank Nederland, filed as Exhibit 4.1.2 to Terra Industries' Form 10-K for the year ended December 31, 1992, is incorporated herein by reference. 4.1.3 First Amendment Agreement, dated as of March 26, 1993, by and between Terra International, Inc., the Lenders listed on the signature page thereto, and CitiCorp USA, Inc., as agent to Lenders. [17 pages]. 4.1.4 Second Amendment Agreement, dated as of December 30, 1993, by and between Terra International, Inc., the Lenders listed on the signature page thereto, and CitiCorp USA, Inc., as agent for the Lenders. [13 pages]. Other instruments defining the rights of holders of long-term debt of Terra Industries and its subsidiaries are not being filed because the total amount of securities authorized under any such instrument does not exceed 10 percent of the total assets of Terra Industries and its subsidiaries on a consolidated basis. Terra Industries agrees to furnish a copy of any instrument to the Securities and Exchange Commission upon request. 10.1.1 Amended and Restated Deferred Compensation Agreement made as of May 1, 1991, by and between Terra Industries and R. F. Richards filed as Exhibit 10 to Terra Industries' Form 8-K dated September 30, 1991, is incorporated herein by reference. [4 pages]. 10.1.2 Resolution adopted by the Personnel Committee of the Board of Directors of Terra Industries with respect to supplemental retirement benefits for certain senior executive officers of Terra Industries, filed as Exhibit 10.4.2 to Terra Industries' Form 10-Q for the fiscal quarter ended March 31, 1991, is incorporated herein by reference. [1 page] 10.1.3 1992 Executive Incentive Plan of Terra Industries filed as Exhibit 10.1.12 to Terra Industries' Form 10-K for the year ended December 31, 1991, is incorporated herein by reference. [3 pages]. 10.1.4 1992 Stock Incentive Plan of Terra Industries filed as Exhibit 10.1.6 to Terra Industries' Form 10-K for the year ended December 31, 1992, is incorporated herein by reference. [8 pages]. 10.1.5 Form of Restricted Stock Agreement of Terra Industries under its 1992 Stock Incentive Plan filed as Exhibit 10.1.7 to Terra Industries' Form 10-K for the year ended December 31, 1992, is incorporated. herein by reference. [4 pages]. 10.1.6 Form of Incentive Stock Option Agreement of Terra Industries under its 1992 Stock Incentive Plan, filed as Exhibit 10.1.8 to Terra Industries' Form 10-K for the year ended December 31, 1992, is incorporated herein by reference. [4 pages]. 10.1.7 Form of Nonqualified Stock Incentive Agreement of Terra Industries under its 1992 Stock Incentive Plan, filed as Exhibit 10.1.9 to Terra Industries' Form 10-K for the year ended December 31, 1992, is incorporated herein by reference. [4 pages]. 10.1.8 1993 Incentive Award Program for Officers and Key Executives of Terra Industries, filed as Exhibit 10.1.10 to Terra Industries' Form 10-K for the year ended December 31, 1992, is incorporated herein by reference. [3 pages]. 10.1.9 Terra Industries Inc. Supplemental Deferred Compensation Plan effective as of December 20, 1993. [19 pages.] 10.1.10 Excess Benefit Plan of Terra Industries as amended effective as of January 1, 1992, filed as Exhibit 10.1.13 to Terra Industries' Form 10-K for the year ended December 31, 1992, is incorporated herein by reference. [2 pages]. 10.1.11 Restricted Stock Agreement of Burton M. Joyce dated May 1, 1991, filed as Exhibit 10.1.14 to Terra Industries' Form 10-K for the year ended December 31, 1992, is incorporated herein by reference. [2 pages]. 10.1.12 Retirement/Consultant Agreement, dated as of May 13, 1993, by and between Paul D. Foster and Terra International. [4 pages]. 10.1.13 Consulting Agreement, dated as of December 30, 1993, by and between Paul D. Foster and Terra International. [2 pages]. 10.1.14 1994 Incentive Award Program for Officers and Key Executives of Terra Industries. [3 pages]. 10.2 Asset Sale and Purchase Agreement among Inspiration Consolidated Copper Company and Cyprus Miami Mining Corporation and Cyprus Christmas Mine Corporation dated as of June 30, 1989, filed as Exhibit 10.19 to Terra Industries' Form 10-Q for the quarter ended September 30, 1989, is incorporated herein by reference. [83 pages]. 10.3.1 Stock Purchase Agreement, dated as of June 14, 1991, among Minorco, Kirkdale Investments Limited, Terra Industries and Hudson Holdings Corporation, filed as Exhibit 2 to Terra Industries' Form 8-K dated June 14, 1991, is incorporated herein by reference. [55 pages]. 10.3.2 Amended and Restated Stock Purchase Agreement, dated as of July 31, 1991, among Minorco, Kirkdale Investments Limited, Terra Industries and Hudson Holdings Corporation, filed as Exhibit 1 to Terra Industries' Form 8-K dated July 31, 1991, is incorporated herein by reference. [62 pages]. 10.3.3 Option Agreement, dated as of June 14, 1991, among Kirkdale Investments Limited and Terra Industries, filed as Exhibit 3 to Terra Industries' Form 8-K dated June 14, 1991, is incorporated herein by reference. [16 pages]. 10.3.4 Amendment to Stock Option Agreement, dated July 31, 1991, among Minorco, Kirkdale Investments Limited and Terra Industries, filed as Exhibit 2 to Terra Industries' Form 8-K dated July 31, 1991, is incorporated herein by reference. [3 pages]. 10.4 Asset and Sale Purchase Agreement, dated as of April 8, 1993, by and between Terra International, Inc., Terra International (Canada) Inc. and ICI Canada Inc., filed as Exhibit A to Terra Industries' Form 8-K dated April 8, 1993, is incorporated herein by reference. [95 pages]. 10.5 Asset Purchase Agreement, dated as of December 30, 1993, by and between Terra International, Inc., The Upjohn Company and Asgrow Florida Company, filed as Exhibit A to Terra Industries' Form 8-K dated December 31, 1993, is incorporated herein by reference. [71 pages]. 10.6 Lease, dated as of April 8, 1993, between W. Patrick Moroney and Terra International (Canada) Inc. [42 pages]. 13 Financial Review and Consolidated Financial Statements as Contained in the Annual Report to Stockholders of Terra Industries for the fiscal year ended December 31, 1993. [32 pages]. 21 Subsidiaries of Terra Industries. [3 pages]. 24 Powers of Attorney [8 pages].

49588_1993.txt

49588

1993

ITEM 1. BUSINESS. I.C.H. Corporation ("ICH," the "Company," or "Registrant") is an insurance holding company that engages primarily in the business of life insurance, accident and health insurance and the sale of annuities through its subsidiary insurance companies (the "ICH Companies"). A chart illustrating ICH's holding company system and identifying each ICH Company as of March 18, 1994 is included under "ICH Holding Company System" at the end of this ITEM 1. ICH's business strategy has undergone significant change during the past five years. After pursuing a strategy of growth through leveraged acquisitions, ICH has, since 1989, sold a number of subsidiaries in transactions designed to reduce leverage. Primarily as a result of sales of subsidiaries, ICH's total consolidated assets declined from $9.3 billion at December 31, 1988 to $3.7 billion at year end 1993. In December 1989, ICH sold Great Southern Life Insurance Company, based in Dallas, Texas, to Financial Holding Corporation. In March 1990, ICH sold certain other subsidiaries, including Philadelphia Life Insurance Company, based in Dallas, Texas, and Massachusetts General Life Insurance Company, situated in Denver, Colorado, to Life Partners Group, Inc. In November 1992, ICH sold Bankers Life and Casualty Company ("Bankers") and Bankers' subsidiary, Certified Life Insurance Company ("Certified"), to Bankers Life Holding Corporation ("BLHC"), an affiliate of Conseco, Inc. ("Conseco"). These sales generated liquidity for the retirement of existing debt, and the transactions with Life Partners Group, Inc. and BLHC were structured so that ICH retained an interest in the subsidiaries sold, enabling it to benefit from their future performance and appreciation. With the November 1992 sale of control of Bankers and Certified, ICH also achieved the dual goals of balancing the mix of its life and health insurance business and positioning ICH to restructure its insurance operations. Since year end 1992, ICH has pursued a strategy of rebalancing and simplifying its capital structure. The debt reduction ICH had accomplished through December 1992 affected primarily the Company's senior secured loans, which carried the lowest interest rates. During 1993, the Company targeted the more expensive elements of its capital structure. On September 30, 1993, ICH sold its remaining interest in Bankers, represented by 13,316,168 shares of BLHC (approximately 24.4% of those outstanding) to Conseco and one of Conseco's subsidiaries for $287.6 million, resulting in a gain of $197.7 million. The sale of the BLHC stock enhanced the Company's common equity, generated substantial liquidity for use in the Company's capital restructuring and other corporate purposes, and enabled the Company to retire its $5.50 Redeemable Preferred Stock, Series 1987-A, stated value $50 million, held by Conseco's subsidiary. During the fourth quarter of 1993, ICH completed a voluntary exchange offer, pursuant to which it issued $91.2 million 11 1/4% Senior Subordinated Notes due 2003 to existing security holders, in exchange for outstanding notes and debentures; it called for redemption all of its 16 1/2% Senior Subordinated Debentures due 1994 that remained outstanding following the exchange offer; and it redeemed its $8.00 Redeemable Preferred Stock, Series 1987-C, stated value $50 million, that carried a 16% annual dividend rate. At year end 1993, ICH had reduced the amount of its long term debt to $418.0 million, from $1,412.8 million at December 31, 1988, and had a debt to equity ratio of .8 to 1. In February 1994, ICH retired its Class B Common Stock, a class of common equity that carried special voting rights in the election of directors. The Class B Common Stock was issued to Consolidated National Corporation ("CNC") in 1985, and enabled CNC to elect 75% of the Company's directors. Effective February 11, 1994, the Company repurchased, for $500,000, all of its Class B Common Stock from CNC, concurrently with CNC's sale of shares of ICH's Common Stock to Torchmark Corporation ("Torchmark") and Stephens Inc. ("Stephens"). The Company and CNC terminated the Management and Consulting Agreement, pursuant to which CNC, through its affiliates, Robert T. Shaw and C. Fred Rice, has provided management services to ICH since 1985, and ICH entered into ten year Independent Contractor and Services Agreements with each of Messrs. Shaw and Rice. As a result of these transactions, the Company now has only one class of common equity, Common Stock, and, as of February 11, 1994, no stockholder beneficially owned 10% or more of the outstanding Common Stock. Torchmark, a diversified insurance and financial services company headquartered in Birmingham, Alabama, and Stephens, an investment banking firm headquartered in Little Rock, Arkansas, are the largest stockholders of the Company, beneficially owning, respectively, 9.78% and 9.74% of the Common Stock of the Company as of February 11, 1994. A representative of each of Torchmark and Stephens has been added to the Company's Board of Directors, filling existing vacancies. During 1994, ICH intends to continue to investigate opportunities to improve its capital structure, to reduce the cost of its capital funds, and to strengthen and expand its insurance operations. By May 30, 1994, ICH intends to accomplish the termination of the reinsurance treaties that were entered into in connection with ICH's sale of Marquette National Life Insurance Company ("Marquette") to CNC in 1990, and reacquire Marquette as part of the assets transferred when the reinsured liabilities are recaptured, pursuant to the agreement, dated June 15, 1993, among ICH, CNC and Consolidated Fidelity Life Insurance Company ("CFLIC"), as amended. Upon the successful completion of the recaptures, ICH will retire its senior secured debt, with a $30 million outstanding principal balance, and its Series 1984-A Preferred Stock and Series 1987-B Preferred Stock that are held by CFLIC, the subsidiary of CNC that currently acts as reinsurer under the treaties, in exchange for the preferred stock of CFLIC that ICH acquired when the June 15, 1993 agreement was executed. See the discussion under the heading "Transactions With Consolidated Fidelity Life Insurance Company" appearing in ITEM 7 of this Report. After March 31, 1994, if the recaptures are not complete, CNC will have the right, subject to regulatory approval, to transfer to ICH all of the common stock of CFLIC in exchange for the assets of CFLIC that were to be retained by CNC upon completion of the recaptures. Upon completion of the transactions contemplated by the June 15, 1993 agreement, CNC and its principals, Messrs. Shaw and Rice, will beneficially own less than 3% of the Company's Common Stock, based on shares currently outstanding. At December 31, 1993, ICH had short-term investments and readily marketable fixed maturity investments totaling approximately $131.3 million, substantially all of which represents proceeds remaining from the September 1993 sale of BLHC common stock. ICH intends to ultimately deploy these remaining proceeds in its continuing capital restructuring program and for the strengthening and growth of its insurance business and general corporate purposes. The actual uses of the funds will be subject to a number of factors, including developments in the marketplace, regulatory and competitive conditions in the industry, the availability of capital resources and the interest rate environment. NOTE: The financial information presented in this Report includes the assets and results of operations of divested companies prior to their sale and, in the case of Bankers and Certified, includes the results of their operations from November 1992 through September 1993, based on the equity method of accounting. For this reason, the financial data presented for years before, during and after the years in which sales of subsidiaries occurred may not be comparable. See Note 2 of the Notes to Financial Statements included in ITEM 8 of this Report on Form 10-K. INSURANCE OPERATIONS The primary ICH Companies actively marketing insurance products are: SOUTHWESTERN LIFE INSURANCE COMPANY ("Southwestern"): Headquartered in Dallas, Texas, Southwestern concentrates on the sale of individual life insurance and annuities through general agents and brokers. On the basis of reporting as required by insurance regulatory authorities ("SAP"), Southwestern had total assets of $1,297.7 million at December 31, 1993, and markets products in 39 states, the District of Columbia and Guam. UNION BANKERS INSURANCE COMPANY ("Union Bankers"): Headquartered in Dallas, Texas, Union Bankers markets individual health and life insurance products and annuities in 45 states and the District of Columbia through general agents and brokers. It had total assets of $209.2 million at December 31, 1993, based on SAP. CONSTITUTION LIFE INSURANCE COMPANY ("Constitution"): Headquartered in Louisville, Kentucky, Constitution currently concentrates on the sale of annuity products through brokers. Licensed in 48 states and the District of Columbia, Constitution had total assets, including separate accounts, of $555.7 million at December 31, 1993, based on SAP. PHILADELPHIA AMERICAN LIFE INSURANCE COMPANY ("Philadelphia American"): Headquartered in Houston, Texas, Philadelphia American markets group life, health and disability insurance and provides fee-based third party administrative services to group plans. Philadelphia American had total assets based on SAP of $78.8 million at December 31, 1993, and conducts business in 47 states, the District of Columbia and the Virgin Islands. BANKERS LIFE AND CASUALTY COMPANY OF NEW YORK ("Bankers New York"): Headquartered in Woodbury, New York, this ICH Company concentrates on the sale of life insurance and annuities in eight states through general agents, special marketing groups and relationships with financial institutions. Bankers New York had total assets of $193.5 million at December 31, 1993, based on SAP. INTEGRITY NATIONAL LIFE INSURANCE COMPANY ("Integrity"): Headquartered in Louisville, Kentucky, Integrity markets home service life insurance and health insurance through general agents. It had total assets based on SAP of $39.5 million at December 31, 1993, and is licensed in 19 states and the District of Columbia. BANKERS MULTIPLE LINE INSURANCE COMPANY ("Bankers Multiple"): With operations based in both Louisville, Kentucky, and Dallas, Texas, Bankers Multiple offers errors and omissions insurance and group and individual health insurance through brokers and by direct mail. It is licensed in all 50 states and the District of Columbia, and had total assets based on SAP of $59.2 million at December 31, 1993. The following table summarizes the consolidated premium income and other considerations and the consolidated premium equivalents of ICH during the past three years. Pro forma information is also presented as if the sale of Bankers and Certified had occurred at the beginning of the period presented. Premium income represents gross receipts on the ICH Companies' traditional life and health insurance for individuals and groups, and other considerations consist of policy charges for the cost of insurance, policy administrative charges, surrender charges, and amortization of policy initiation fees relating to universal and interest sensitive life insurance and accumulation products such as guaranteed investment contracts and certain annuities. In contrast, premium equivalents represent gross receipts on universal and interest sensitive life insurance and on accumulation products, less other considerations. Additional information regarding ICH's industry segments is reflected in ITEM 7 and Note 17 of the Notes to Financial Statements and Schedules V and VI of the Financial Statement Schedules included in ITEM 8 of this Report on Form 10-K. Since 1990, market, economic and regulatory conditions have challenged ICH's strategy of significantly increasing the size of its accumulation business and expanding its life insurance business through internal growth. Investor and consumer confidence in the insurance industry was weakened during 1991 by the much publicized conservatorship proceedings involving Executive Life Insurance Company and Mutual Benefit Life Insurance Company. The commencement of these proceedings in April and July, 1991, respectively, was followed by a series of downgrades in the ratings of a number of insurers by nationally recognized statistical rating organizations. While ratings do not constitute recommendations to buy or sell, and are subject to change or withdrawal at any time, they are considered an important measurement in some markets. Combined with declining interest rates and weak economies in certain regions of the country, these developments inhibited internal growth in the accumulation and life insurance product lines, particularly affecting those insurers that did not have the highest ratings. They prompted state insurance agencies to more aggressively exercise regulatory jurisdiction over insurers and resulted in a national trend to impose stricter capital and surplus requirements and more conservative investment guidelines industrywide. The ICH Companies were susceptible to these market, economic and regulatory conditions. The amount of corporate debt remaining from ICH's prior acquisitions, the perceived interdependence of the ICH Companies created by a stacked holding company structure and losses incurred in connection with past investment strategies contributed to a series of ratings downgrades that began in 1991 and continued in 1993, with downgrades by Duff & Phelps Credit Rating Company ("Duff & Phelps") in January 1993, by A.M. Best Company ("A.M. Best") in February 1993 and by Moody's Investors Service ("Moody's") in June 1993. These factors also contributed to increased regulatory oversight of the ICH insurance holding company organization. As a result of these downgrades, ICH has a subordinated debt rating of B3 by Moody's and B- by Standard & Poor's Corporation, and a preferred stock rating of Caa by Moody's and CCC+ by Standard and Poor's Corporation (all of which are below investment grade). ICH's lead life insurance subsidiary, Southwestern, has a B++ rating by A.M. Best (very good) and a claims paying rating of A by Duff & Phelps (investment grade), BBB- by Standard & Poor's Insurance Rating Services (adequate financial security, but capacity to meet policyholder obligations is susceptible to adverse economic and underwriting conditions) and Ba2 by Moody's (questionable financial security). Integrity has been assigned a rating of B+ and the remaining ICH Companies have been assigned a rating of B++ by A.M. Best. Since the November 1992 sale of Bankers and Certified, ICH has concentrated on restructuring its corporate organization, rebalancing and simplifying its capital structure and reducing and refinancing its corporate debt to alleviate the concerns cited by the rating organizations and to restore to the ICH Companies the excellent claims paying ratings they have historically held. The ICH Companies have consolidated operationally, to reduce costs and increase efficiencies. They have redesigned the manner in which they develop and market products, targeting markets and products less sensitive to credit ratings, and they have restructured their insurance holding company organization, from a vertical to a substantially horizontal configuration. INDIVIDUAL LIFE INSURANCE The ICH Companies underwrite life insurance under a wide variety of conventional and special whole life and interest sensitive policies ("permanent insurance"), as well as ordinary term policies. The following table summarizes the life insurance operations during the past five years. Certain information is separately presented in the table below for the existing ICH Companies and for subsidiaries sold by ICH during the indicated periods. For purposes of the following table, the term "remaining subsidiaries" refers to insurance subsidiaries of ICH that were owned at the end of the specified period. The life insurance products issued by the ICH Companies consist of whole life insurance, which provides policyholders with permanent life insurance and fixed, guaranteed rates of return on the cash value element of policy premiums, and universal and interest-sensitive life insurance policies. The profitability of traditional whole life products and universal and interest-sensitive life policies is dependent on investment income earned, the ultimate underwriting experience and the realization of anticipated unit administrative costs. Although the ICH Companies experienced an increased demand for traditional products during 1993, most new individual life insurance sales by the ICH Companies, measured by premium volume, continue to be made under universal and interest-sensitive life policies that provide whole life insurance with adjustable rates of return based on current interest rates. The principal difference between universal and interest-sensitive life insurance policies centers on policy provisions affecting the amount and timing of premium payments. Universal life policies permit policyholders to vary the frequency and size of their premium payments, although policy benefits also may vary. Premium payments under the interest-sensitive whole life policies are not variable by the policyholders. The ICH Companies' universal and interest-sensitive life products are marketed to individuals directly and through qualified retirement plans, deferred compensation plans, and employer-sponsored payroll deduction plans. The principal traditional life insurance products sold by the ICH Companies consist of a series of specially designed whole life policies that are marketed primarily to insureds 50 years of age and older and a graded death benefit whole life policy. Total sales of individual life insurance by the ICH Companies declined approximately 6% in 1993, compared to declines of 33% in each of 1992 and 1991 (excluding Bankers and Certified). During 1993, the ICH Companies implemented a number of changes in the manner in which their individual life insurance products are developed and marketed to reverse the decline in sales. Southwestern and Union Bankers have created a combined distribution system for most of the ICH Companies' life and health insurance products that are marketed through general agents and brokers, promoting the cross marketing of products and coordinating broker compensation arrangements across product lines to increase the incentives for new life sales. New simplified issue life insurance products have been introduced targeting the senior citizen market and other markets less sensitive to credit ratings, and marketing trends are more closely integrated into the product development process. With these changes, the ICH Companies are focusing on a broader market where there is an increased demand for individual life insurance policies in smaller face amounts. In the future, ICH intends to increase the amount of its life insurance business through both internal growth and the acquisition of blocks of business or companies. Factors important in any acquisition transaction will include the synergistic opportunities offered, improved economies of scale, and the projected rate of return on the investment compared with the cost of the Company's capital funds. INDIVIDUAL HEALTH INSURANCE Substantially all of ICH's consolidated premium income and other considerations for individual health insurance are received from Medicare supplement plans, comprehensive and major medical (collectively, "comprehensive") health plans and long-term care plans. The following table sets forth, by policy type, the amounts and percentages of ICH's consolidated premium income and other considerations for individual health insurance during the indicated periods. The table also provides pro forma information as if the sale of Bankers and Certified had taken place at the beginning of 1992. As shown in the table, ICH sold a substantial portion of its health insurance business in the November 1992 sale of Bankers. The ICH Companies currently underwrite Medicare supplement plans, comprehensive health plans and long-term care plans, with an emphasis on the sale of Medicare supplement insurance. Medicare supplement plans provide coverage for the deductible and coinsured portions of Medicare and for major losses exceeding Medicare maximums, and automatically adjust coverages in accordance with changes in Medicare benefits. The comprehensive health plans provide coverage for hospital, medical, and surgical costs within various prescribed policy deductible and coinsurance limits and are marketed primarily to self-employed individuals, other workers who are not fully covered by group health insurance, and early retirees. In addition, cost containment products, which provide specific health insurance benefits up to certain limits, and dreaded disease policies have been designed for those who cannot afford comprehensive coverage or who seek supplemental coverage for specific risks. During 1993, the ICH Companies changed the commission structure and eliminated waiting periods for entry level customers for its Medicare supplement products to further penetrate the senior citizens market. In the "under age" market, the ICH Companies' product development efforts have concentrated on specified risk and cost containment products. The ICH Companies entered the long-term care business in late 1985 and market their products to all persons ages 50 through 84. These products are developed to meet the needs of all persons regardless of their stature or income status. To meet regulatory requirements adopted in various states, the ICH Companies developed new long term care plans during 1993, which resulted in an interruption of marketing efforts in some states. Introduced in late 1993, the ICH Companies' new long term care products now offer a full range of benefits for varying periods, including lifetime benefits. The comprehensive health plans currently offered by the ICH Companies in many states have certain built-in protections against rising policy claims due to escalating health care costs. Under each of these plans, premiums are increased automatically in accordance with government indices of cost escalation and based on actuarial tables that are keyed to the insured's age at each plan anniversary. In contrast, premiums on many traditional health plans issued by the ICH Companies may not be increased without notice to or approval by insurance regulatory authorities. In addition, as a part of their product development process, the ICH Companies constantly monitor actual claims experience and health medical loss ratios and, subject to regulatory constraints, adjustments are made to the terms of new products as they are developed and the availability of products. Product adjustments include changes to the underwriting criteria used, agent commissions paid, the premiums charged and levels of deductibles. Due to escalating health care costs and marginal profitability, management began deemphasizing sales of comprehensive health plans in late 1990 and has decreased the number of states in which these plans are marketed. Federal and state legislation and regulations impose minimum loss ratios with respect to Medicare supplement plans, restrict first year commissions payable to agents and require standardized benefits under and disclosure obligations for Medicare supplement plans. Changes to the Medicare law made by the Omnibus Budget Reconciliation Act of 1990 have had the effect of increasing the regulation of Medicare supplement plans in all states, requiring minimum loss ratios of at least 65%, standardizing benefits to promote comparability of plans, guaranteeing renewability and prohibiting those offering Medicare supplement plans from underwriting for health conditions or claims experience of those who first become eligible for Medicare. The health insurance industry faces increasing government regulation as a result of legislative efforts to increase access to health care coverage and adopt measures to contain, and control, escalating health care costs. Health insurance premium increases, selective underwriting procedures, the portability of insurance and exclusions for pre-existing conditions have been the target of many individual and group health insurance reform efforts, at both the state and national levels. See the discussion under "Regulation" appearing in this Item below. These reform efforts have created uncertainty in the health insurance industry, particularly among insurers offering comprehensive health insurance products. With their increased emphasis on supplemental and specified risk health insurance products, the ICH Companies believe they are pursuing a business strategy in their individual health insurance segment that coincides with the essential elements of many of the health care reform efforts currently under consideration. However, ICH currently cannot predict which, if any, of the health care reform proposals under consideration by Congress and the various states will be implemented, whether any additional health insurance measures will be adopted in the foreseeable future or the impact such reform measures ultimately would have on the ICH Companies' existing portfolio of products or their established distribution systems. ACCUMULATION PRODUCTS The ICH Companies' accumulation products include traditional annuities, which are sold primarily through independent agents and brokers. During 1993, the ICH Companies significantly increased their marketing efforts for annuity products, adopting the strategic goal of using annuities to represent their accumulations business segment. In the current interest rate environment, annuities have become attractive as replacements for certificates of deposit. The ICH Companies have promoted the sale of annuities through marketing relationships with established distribution systems targeting the senior citizen market. During 1993, annuities accounted for 94% of the ICH Companies' accumulation product premium equivalents, a trend management expects to continue. Substantially all of ICH's annuity considerations are attributable to sales of flexible premium deferred annuities and single premium deferred annuities. Generally, such flexible premium deferred annuities permit annual payments in such amounts as the holder deems appropriate, and the single premium deferred annuities underwritten by the ICH Companies require a one-time lump sum payment. While deciding to emphasize the sale of annuities, the ICH Companies, during 1993, decided to no longer pursue growth in their accumulations business through the sale of guaranteed investment contracts. Constitution, the ICH Company that had been positioned in 1990 to underwrite guaranteed investment contracts, was significantly downsized during 1993 as a part of the restructuring of the ICH insurance holding company reorganization, and no longer actively markets guaranteed investment contract products. A significant amount of Constitution's in force guaranteed investment contract business was terminated in 1992 and 1993, primarily as the result of scheduled maturities and the early termination of contracts. GROUP BUSINESS Group insurance is highly competitive. Most policies are written on a periodic basis, and competitive bids are often sought prior to renewal. Philadelphia American is the only ICH Company making any significant new sales to groups, although Bankers Multiple continues to underwrite health insurance under an established Association group plan. Many of the factors affecting the profitability of the individual comprehensive health insurance products are equally applicable to group health insurance plans. Philadelphia American also provides fee-based administrative services, processing comprehensive health insurance claims under diverse group plans. Philadelphia American does not assume any underwriting risk under its administrative-only arrangements, which are entered into with large and medium-sized employers. Instead, Philadelphia American merely processes and pays claims for an administrative fee, while the employer acts as a self-insurer and provides the policyholder benefits. Philadelphia American also provides groups with managed care plans, under which it develops a network of providers with negotiated cost controls and administers group claims and makes available stop loss coverage for group benefits. The total claims administered by Philadelphia American under these fee-based administrative arrangements increased from $288.9 million during 1992 to $310.7 million during 1993. Many states have considered and enacted small group insurance reform legislation. While the definitions used and requirements imposed vary significantly from state to state, typical components of legislation targeting small group insurance reform include community rating, limitations on underwriting, restrictions on exclusions for pre-existing conditions and restrictions on rate increases. If enacted by Congress, national health care reform legislation could significantly change the manner in which group business is conducted. Philadelphia American incurred significant losses in its group business during 1993, resulting in pre-tax operating losses of $12.9 million with respect to the ICH Companies' group and other business for the year. See the discussion under the subheading "Group and Other Insurance" under "Analysis of Operating Results by Industry Segment" in ITEM 7 of this Report, which discussion is incorporated herein by reference, for an analysis of the factors contributing to the losses. Due to the unprofitable performance of its group insurance plans during 1993 and the uncertainties created by the currently proposed national health care reform efforts, Philadelphia American intends to further de-emphasize the sale of fully insured traditional indemnity group plans in favor of fee-based administrative services and managed health care programs. MARKETING The ICH Companies are collectively licensed to sell their insurance products in all 50 of the United States and in certain protectorates of the United States. The following table identifies those states which accounted for 5% or more of the subsidiaries' 1993 combined direct premiums from life, health, and annuity sales to residents in such states. As of year end 1993, individual life and health insurance products offered by the ICH Companies are sold primarily through more than 11,000 independent agents. Substantially all independent agents selling insurance products for the ICH Companies also represent other insurers. Group insurance is sold principally through independent agencies that are assisted by group sales staffs employed by an ICH subsidiary, and alternate funded plans are marketed directly by employees of an ICH Company. The ICH Companies develop their marketing programs essentially on three levels. First, the ICH Companies design competitive insurance products for targeted markets that provide an appropriate return over the life of the product. Factors considered in designing insurance products include insurance regulatory requirements, underwriting limitations, federal income tax laws, and competitive features like premium rates, rates of return, and other policy benefits. Secondly, the subsidiaries develop facilities and support staffs designed to provide superior services to agents and policyholders. Thirdly, the ICH Companies adopt competitive agent compensation arrangements that are intended to provide incentives for the agents to increase their production of new insurance and to promote continued renewals of in-force insurance written through them. Historically, these incentives have involved awards, overrides, and compensation scales that escalate with production and provide additional commission payments for renewal business. During 1993, the ICH Companies centralized the marketing strategy for most of the ICH Company individual life and health insurance products that are distributed through general agents and brokers. Southwestern and Union Bankers now offer their products through shared distribution systems, with agent and broker compensation packages coordinated across product lines. Southwestern has terminated its exclusive marketing arrangements for individual life insurance products, and has eliminated broker compensation based solely on insurance in force, with no emphasis on new production. UNDERWRITING The ICH Companies employ professional underwriting staffs and have adopted and follow detailed underwriting procedures designed to assess and quantify insurance risks before issuing life and health insurance policies to individuals and groups. Except with respect to Medicare supplement insurance, which is heavily regulated, the underwriting practice of each ICH Company is to require medical examinations (including blood tests, where permitted) of applicants for certain health insurance and for life insurance in excess of prescribed policy amounts. These requirements vary according to the applicant's age and by policy type, and streamlined procedures have been developed based on the amount and type of coverage sought. The ICH Companies also rely on medical records and each potential policyholder's written application for insurance. In issuing health insurance, the ICH Companies use information from the application and, in some cases, inspection reports, physician statements, or medical examinations to determine whether a policy should be issued as applied for, issued with reduced coverage under a health rider, or rejected. Acquired Immunity Deficiency Syndrome ("AIDS") claims identified to date, as a percentage of total claims, have not been significant for ICH's subsidiaries. Evaluating the impact of future AIDS claims under the life and health insurance policies issued by ICH is extremely difficult, in part due to the insufficient and conflicting data regarding the number of persons now infected by the AIDS virus and uncertainty as to the speed at which the disease may spread through the general population. The ICH Companies have implemented, where legally permitted, underwriting procedures designed to assist in the detection of the AIDS virus in applicants. INVESTMENTS The ICH Companies derive a substantial portion of their income from investments. State insurance laws impose certain restrictions on the nature and extent of investments by insurance companies and, in some states, may require divestiture of assets contravening these restrictions. At December 31, 1993, based on statutory insurance accounting practices, intercompany investments in equity securities of ICH's subsidiaries constituted approximately 19.53% of the combined adjusted capital and surplus of ICH's insurance subsidiaries. These intercompany investments have been eliminated, in accordance with generally accepted accounting principles, in the financial statements appearing in this Form 10-K. The following table summarizes, for the indicated periods, certain results of the investments of ICH and its consolidated subsidiaries. See ITEM 7 for a description of factors affecting the comparability of the indicated periods. The investments of the ICH Companies are managed under the supervision of management and of each company's board of directors. See the discussion under the heading "Investment Portfolio" in ITEM 7, and Note 5 of the Notes to Financial Statements appearing elsewhere in this Form 10-K, which are incorporated herein by reference, for information about the composition and performance of ICH's investment portfolio. Diversification of risk, asset-liability management and reduction of the Company's exposure to losses arising from prepayments of collateralized mortgage obligations are key elements of the Company's investment policies. Beginning in 1992, the ICH Companies have relied increasingly on independent investment advisors in the management of their investments. Conseco Capital Management, Inc., the investment advisory subsidiary of Conseco, provides investment management services to the ICH Companies; it managed approximately $430 million of their investments during 1993. Westridge Capital Corporation managed the investment of approximately $42 million of the assets and hedged the risk for one of Constitution's accumulation products during 1993. New England Asset Management, Inc. provides advice in the management of substantially all of the remaining investment portfolios of the ICH Companies and advised the ICH Companies in connection with the sale of a substantial portion of their residual and interest-only collateralized mortgage obligations to, and the reinvestment of a portion of the proceeds from the sale in trust certificates sold by, Fund America Investors Corporation II in July 1993. REINSURANCE In keeping with industry practices, the ICH Companies reinsure with unaffiliated insurance companies and, to a lesser extent, other ICH Companies portions of the life and health insurance and annuities underwritten by them. Under most of the subsidiaries' reinsurance arrangements, new insurance and annuity sales are reinsured automatically rather than on bases that would require the reinsurer's prior approval. Generally, the ICH Companies enter into indemnity reinsurance arrangements to assist in diversifying their risks and to limit their maximum loss on large or unusually hazardous risks, including risks that exceed the ICH Companies' respective policy-retention limits currently ranging up to $500,000 per insured. Indemnity reinsurance does not discharge the ceding insurer's liability to meet policy claims on the reinsured business. The ceding insurer remains responsible for policy claims on the reinsured business to the extent the reinsurer fails to pay such claims. CFLIC, a subsidiary of CNC, reinsures certain annuity business written by Bankers and Southwestern, under reinsurance agreements that were entered into in connection with ICH's 1990 sale of Marquette to CNC. On June 15, 1993, ICH, CNC and CFLIC entered into an agreement that gives ICH the right, and under which ICH has the obligation, to negotiate the termination of these reinsurance agreements. See the discussion under the heading "Transactions With Consolidated Fidelity Life Insurance Company" appearing in ITEM 7 of this Form 10-K, which discussion is incorporated herein by reference. ICH, CNC and CFLIC have agreed with Torchmark and Stephens that the reinsurance agreements will be terminated by May 30, 1994, and CNC will have the right to transfer its ownership interest in CFLIC to ICH, in exchange for designated assets of CFLIC, if the recaptures are not completed by March 31, 1994. The termination of the reinsurance agreements is dependent on the completion of successful negotiations and the receipt of all required regulatory approvals. In a few instances, ICH's subsidiaries have reinsured blocks of insurance policies to provide funds for enhancing surplus, financing acquisitions and other purposes. Under these financing arrangements, statutorily determined profits on the reinsured business are accelerated through the reinsurer's payment of ceding commissions representing the present value of profits on the business over the reinsurance period. During 1993, the ICH Companies reduced by $13.1 million the financial reinsurance ICH Companies had obtained during 1991. In addition, a surplus relief treaty between an ICH Company and a third party reinsurer was terminated as a part of the restructuring of the ICH holding company organization that was completed September 29, 1993. Historically, reinsurance has not had a significant effect on ICH's consolidated results of operations, with net ceded premium income and other considerations representing 5% or less of total premium income and other considerations in each of the past three years. ADMINISTRATIVE OPERATIONS The administration operations of most of the ICH Companies are consolidated through Facilities Management Installation, Inc. ("FMI"), the service corporation subsidiary of ICH. Functioning as the employer of substantially all of the employees performing services in ICH's insurance operations, FMI provides management and administrative services to the ICH Companies directly and through arrangements with third parties. Claims administration, risk underwriting, regulatory compliance and development and marketing of insurance products are performed on the basis of function or business segment. A significant portion of the data processing services required in the administrative operations of the ICH Companies is provided by a third party vendor. Because of the operational interrelationships among the ICH Companies, the sales of subsidiaries in prior years have required changes in the administrative operations of various ICH Companies, including changes in executive responsibilities and personnel requirements. The complete separation of the operations of the ICH Companies and the subsidiaries previously sold occurred in 1993, with the expiration of the servicing arrangements that were entered into when the former subsidiaries were sold in 1989 and 1990. Following a full-scale review, the administrative operations of the ICH Companies have been reorganized to remove inefficiencies, redundancies and excess capacities, and the operations of several ICH Companies have been consolidated across product lines in a primary location under a common management team. COMPETITION The insurance industry is highly competitive, with approximately 2,000 life and health insurance companies in the United States. Certain large insurers and insurance holding company systems have substantially greater capital and surplus, larger and more diversified portfolios of life and health insurance policies, and larger agency sales operations than those of the ICH Companies. Financial and claims paying ratings assigned to insurers by the nationally recognized independent rating agencies, always a key ingredient, have in some markets become preemptive, especially in the area of accumulation products. The ICH Companies also are encountering increased competition from banks, securities brokerage firms, and other financial intermediaries marketing insurance products and other investments such as savings accounts and securities. The ICH Companies compete primarily on the basis of experience, size, accessibility, cost structure and pricing, claims responsiveness, product design and diversity, service and distribution. ICH believes that its insurance subsidiaries are generally competitive based on premium rates and service, have longstanding relationships with their agents, and offer a diverse portfolio of products. REGULATION STATE INSURANCE REGULATION. The discussion under the heading "Regulatory Environment" appearing under ITEM 7 of this Report on Form 10-K is incorporated herein by reference. In recent years, an increasing number of legislative proposals have been introduced or proposed in Congress and in some state legislatures that would effect major changes in the health care system, either nationally or at the state level. In addition, some states have already enacted health care and insurance reforms and others continue to consider additional reforms. Among the proposals under consideration in Congress and some state legislatures are insurance market reforms to increase the availability of group health insurance to small business and control the cost of insurance, requirements that all businesses offer health insurance coverage to their employees and the creation of a single government health insurance plan that would cover all citizens. Reform legislation proposed by the Clinton administration would ultimately guarantee universal access to health care coverage and create purchasing alliances for government established health care plans. Alternative legislative proposals that have been developed to reform the health care system have goals ranging from universal access to health care coverage through managed competition to health care cost containment through, among other things, health insurance reform. ICH currently cannot predict what impact health care reform proposals will have on the health insurance industry, whether any additional health insurance measures will be adopted in the foreseeable future or, if adopted, whether such reform proposals or measures will have a material effect on its operations. Certain subsidiaries of ICH have entered into agreements with state insurance departments which impose restrictions or reporting requirements in connection with their operation of business or their payment of dividends. In management's view, none of these regulatory agreements have adversely affected the insurance business of the ICH Companies. In conjunction with the receipt of the approval of the Texas Department of Insurance required for the restructuring of the ICH insurance holding company organization in September 1993, ICH and its Texas-based subsidiaries, Southwestern and Union Bankers, entered into an agreement with the Texas Department of Insurance, which superseded the regulatory agreement they had entered into on March 31, 1993. Among other things, the agreement with the Texas Department of Insurance requires ICH, Southwestern and Union Bankers to provide the Texas Department with designated information on an on-going basis; requires Southwestern to provide 30 days prior notice of any stockholder dividend, to limit the amount it invests in private placement securities, and to not invest in interest-only collateralized mortgage obligations; and requires 30 days prior notice of any financial reinsurance transaction or acquisition of business through assumption reinsurance by either Southwestern or Union Bankers. The agreement with the Texas Department also addresses the reinsurance agreements under which CFLIC reinsures business written by Southwestern, and provides that any recapture of the reinsured business by Southwestern can occur only after receipt of the written concurrence of the Texas Department. In March 1993, ICH had agreed with the Texas Department to develop a plan addressing the enhancement and diversification of the asset portfolio supporting the reserve liabilities reinsured by CFLIC, and in June 1993 ICH entered into an agreement with CFLIC and CNC giving ICH the authority, and responsibility, for negotiating the termination of CFLIC's reinsurance agreements. In connection with the restructuring of the ICH holding company organization in September 1993, Constitution and the Kentucky Department of Insurance terminated a stipulation that required Constitution to maintain adjusted surplus of at least $100 million or discontinue the sale of insurance. Primarily as a result of actions taken in connection with the restructuring, as reported in its annual statutory financial statements, Constitution had approximately $55.6 million in adjusted surplus (statutory capital and surplus plus the asset valuation reserve) as of December 31, 1993. ICH's subsidiary, Modern American Life Insurance Company ("Modern American"), signed an agreement with the Missouri Department of Insurance in December 1992 that, among other things, currently restricts Modern American's ability to invest in securities of affiliates and requires Modern American to obtain the consent of the Missouri Department before paying any stockholder dividends. During 1992, Modern American also agreed with the Florida Department of Insurance that it would suspend writing insurance and not enter into any reinsurance agreements in Florida. FEDERAL INCOME TAXATION. ICH's life insurance subsidiaries are taxed under the life insurance company provisions of the Internal Revenue Code of 1986, as amended (the "Code"). Under the Code, a life insurance company's taxable income incorporates income from all sources, including life and health premiums, investment income, and certain decreases in reserves. The Code currently establishes the maximum corporate tax rate of 35% and imposes a corporate alternative minimum tax at a 20% rate. SEE Note 13 of the Notes to Financial Statements included in ITEM 8 of this Report on Form 10-K. Beginning in 1992, ICH and its subsidiaries file life-nonlife consolidated federal income tax returns. Amendments to the Code adopted in 1990 require the capitalization and amortization over a ten year period of certain policy acquisition costs incurred in connection with the sale of certain insurance products. Prior tax laws permitted these costs to be deducted as they were incurred. This new rule applies to the life, health and annuity business issued by the ICH Companies. By deferring deductions, this new rule has the effect of increasing the current tax incurred, and decreasing deferred taxes payable by a corresponding amount. The lost after-tax earnings caused by accelerating the current tax liability is the primary effect of this provision on the statutory net income of ICH's insurance subsidiaries. Certain proposals to make additional changes in the federal income tax laws and regulations affecting insurance companies or insurance products continue to be considered at various levels in the United States Congress and the Internal Revenue Service. ICH currently cannot predict whether any additional tax reform measures will be adopted in the foreseeable future or, if adopted, whether such measures will have a material effect on its operations. RESERVES. In accordance with applicable insurance laws, ICH's insurance subsidiaries have established and carry as liabilities actuarial reserves to meet their respective policy obligations. Life insurance reserves, when added to interest thereon at certain assumed rates and premiums to be received on outstanding policies, are calculated to be sufficient to meet policy obligations. The actuarial factors used in determining such reserves are based on statutorily prescribed mortality and interest rates. Reserves maintained for health insurance include the unearned premiums under each policy, reserves for claims that have been reported but are not yet due, and reserves for claims that have been incurred but have not been reported. Furthermore, for all health policies under which renewability is guaranteed, additional reserves are maintained in recognition of the actuarially calculated probability that the frequency and amount of claims will increase as the attained age of the insured increases. The ICH Companies maintain reserves on reinsured business once it is assumed by them and take credit for reserves on reinsured business after it is ceded to other insurers by them. Reserves for the assumed reinsurance are computed on bases essentially comparable to direct insurance reserves. The reserves carried in the financial statements included elsewhere in this Form 10-K are calculated based on generally accepted accounting principles and may differ from those specified by the laws of the various states and carried in the statutory financial statements of the insurance subsidiaries. These differences arise from the use of different mortality and morbidity tables and interest assumptions, the introduction of lapse assumptions into the reserve calculation, and the use of the level premium reserve method on all insurance business. In addition, beginning in 1993, to the extent the ICH Companies remain primarily liable for benefits on policies which have been ceded to other insurers, the reserve credits taken for regulatory reporting purposes are eliminated under generally accepted accounting principles. See Note 1 of the Notes to Financial Statements included in ITEM 8 of this Report on Form 10-K for certain additional information regarding reserve assumptions under generally accepted accounting principles. EMPLOYEES At March 1, 1994, ICH and its subsidiaries employed a total of approximately 1,320 persons, excluding agents, who are not employees but are independent contractors. ICH HOLDING COMPANY SYSTEM ICH was organized in 1966 as a Missouri corporation and was reincorporated in Delaware during 1977. The following chart summarizes as of March 18, 1994 the relationships among ICH and its significant subsidiaries. Each percentage used in the chart represents the parent's percentage ownership interest in the outstanding voting securities of the respective subsidiary company. The years in which ICH formed, or acquired more than 50% of, the indicated subsidiaries are set forth parenthetically. [GRAPHIC] The above chart reflects the restructuring of the ICH insurance holding company system, from a vertical to a substantially horizontal structure, that was effected September 29, 1993. The restructuring was designed to increase the financial independence of the ICH Companies and reduce the effect of multi-jurisdictional regulation that results when insurance subsidiaries are held indirectly, through other insurance subsidiaries. - --------- *The following companies are direct or indirect subsidiaries of ICH, but do not have any significant operations: American MedCAP Inc.; BML Agency, Inc.; BML Agency, Inc. of Ohio; Dallas Insurance Services Company; I.C.H. Financial Services, Inc.; Independence National, Inc.; Investment Dissolution Corporation; Philadelphia American Property Company; Quail Creek Communications, Inc.; Quail Creek Recreation, Inc.; Quail Creek Water Company, Inc.; REO Holding Corporation; Southeast Title & Insurance Company; and Western Pioneer Corporation. Prior to the restructuring, Southwestern and Philadelphia American were held by ICH indirectly through Modern American, and Union Bankers, Bankers Multiple, Bankers New York, and Constitution were held by ICH indirectly through Southwestern. By virtue of the restructuring, which involved a series of transactions including the retirement of debt and equity securities, the payment of dividends, the termination of a reinsurance agreement between Modern American and Constitution, and the execution of a new reinsurance agreement between Modern American and Southwestern, Modern American eliminated its investment in securities of affiliates, Southwestern reduced its investment in insurance subsidiaries to Constitution and Bankers New York, and ICH made its ownership of its insurance subsidiaries more direct. The restructuring was completed following the receipt of approvals by the Missouri, Texas, Illinois, Kentucky and Pennsylvania Insurance Departments. See ITEM 2 of this Form 10-K for a description of an appeal of the approvals granted by the Missouri Department of Insurance. ITEM 1A.

ITEM 1A. EXECUTIVE OFFICERS OF REGISTRANT. Set forth below is certain information regarding the current executive officers of I.C.H. Corporation as of March 1, 1994. ROBERT L. BEISENHERZ, age 48. Chairman of the Board and Chief Executive Officer since October 1992, a director since March 1992 and President since February 1992. Mr. Beisenherz served as Executive Vice President of ICH from June, 1990, when he joined ICH, until February 1992. Throughout 1991 and until his election as President in February 1992, Mr. Beisenherz also served as an executive officer of subsidiaries of Consolidated National Corporation. For the previous 17 years, he was a consulting actuary with Lewis & Ellis, Inc., consulting actuaries, Dallas, Texas. JOSEPH P. CROWLEY, age 49. Senior Vice President -- Group Marketing and Claims since March 1993. Mr. Crowley has served as President of ICH's subsidiary, Philadelphia American Life Insurance Company, since 1984 and President and Chief Operating Officer since 1987. He is responsible for the group and managed care operations of Philadelphia American and, during 1993, he was also responsible for overseeing individual health claims. ROBERT C. GREVING, age 42. Senior Vice President and Chief Actuary since September 1992. Mr. Greving joined the ICH organization in 1990 and serves as Executive Vice President, Chief Actuary and a director of ICH's subsidiary, Southwestern Life Insurance Company, and as an officer of various other ICH subsidiaries. Mr. Greving was a Senior Vice President and Actuary of American Founders Life Insurance Company from January 1988 until July 1990. American Founders Life Insurance Company was placed under protective receivership by the Texas Insurance Department from April 14, 1989 until its release on September 19, 1989. The commencement of the supervisory proceedings was prompted by the Chapter 11 bankruptcy of its ultimate parent, American Continental Corporation. JOHN T. HULL, age 50. Executive Vice President since March 1993 and Treasurer since 1983. Mr. Hull served from 1983 to 1993 as Senior Vice President and from 1979 to 1982 as the chief accountant for ICH and certain of its affiliates. He has served since 1983 as Treasurer of several ICH subsidiaries. W. SHERMAN LAY, age 54. Executive Vice President -- Operating Companies since September 1993. Mr. Lay served as Senior Vice President from 1986 until 1993 and has served as an officer of various affiliates of ICH since 1971. Mr. Lay serves as an officer and a director of various ICH insurance subsidiaries, including the position of Chief Executive Officer of Philadelphia American, President of Constitution Life Insurance Company and, since October 1993, President of Southwestern. EDWARD R. MEKEEL, JR., age 47. Executive Vice President and Chief Financial Officer since September 1992. Mr. Mekeel also serves as a director and chief financial officer of various ICH subsidiaries. Before joining ICH in 1992, Mr. Mekeel was employed as the Senior Vice President and Chief Financial Officer and a director of First Capital Life Insurance Company from July 1989 until October 1991, and from August 1983 until June 1989, he was employed as the Senior Vice President and Controller of Mutual Benefit Life Insurance Company and served as an officer and director of various of its affiliates. In May 1991, the California Commissioner of Insurance commenced involuntary conservatorship proceedings against First Capital Life Insurance Company while Mr. Mekeel was still an executive officer and director. When the Commissioner was appointed Conservator, Mr. Mekeel was appointed one of the conservation managers, a function he performed until his employment relationship ended in October 1991. C. FRED RICE, age 55. Senior Executive Vice President--Marketing and Real Estate since 1985. A director since 1975 and a member of the Executive Committee, Investment Committee, Compensation Committee, and Stock Option Committee, Mr. Rice is an employee of CNC. Mr. Rice has served as Vice President, Secretary, and a director of CNC since 1984. He also has served since 1970 as an officer and director of various affiliates of ICH. Mr. Rice currently serves as a director of Financial Benefit Group, Inc. H. DON RUTHERFORD, age 57. Senior Vice President--Individual Marketing since March 1993. Mr. Rutherford joined Union Bankers Insurance Company in 1967, and serves as Senior Executive Vice President and Senior Marketing Officer of that subsidiary. Mr. Rutherford serves as Marketing Director for the individual life and health products of ICH's insurance organization. SHERYL G. SNYDER, age 47. Executive Vice President since March 1992 and General Counsel since December 1990. Mr. Snyder had been a partner of the law firm of Wyatt, Tarrant & Combs, Louisville, Kentucky since 1978 and associated with the firm since 1973. He has served as president of the Louisville and Kentucky State Bar Associations. Officers are elected by the Board of Directors of ICH and hold office until their respective successors are duly elected and qualified. All of the executive officers of ICH are employed by its wholly-owned subsidiary, Facilities Management Installation, Inc., except Mr. Rice. Set forth below is certain information regarding other former directors and/or executive officers of ICH. PHILLIP E. ALLEN, age 63. Vice Chairman of the Board and Secretary from April 1990 until his retirement in May 1993. Mr. Allen served as Secretary of ICH from 1986 and as an officer and director of various affiliates of ICH from 1983 until his retirement. He served as General Counsel of ICH and certain of its affiliates from 1978, and as Executive Vice President--Corporate Operations of ICH from 1983, until his election as Vice Chairman of the Board of ICH in April, 1990. Mr. Allen continues to provide services to the Company pursuant to the Retirement/Retainer Agreement he and the Company entered into at the time of his retirement. THOMAS J. BROPHY, age 58. Executive Vice President from 1986 until September 1993. Mr. Brophy served as President of Southwestern from June 1990, and as its Chief Operating Officer from 1987, until September 1993. From 1987 until 1990, he was Senior Executive Vice President of Southwestern. Mr. Brophy was employed by Great Southern Life Insurance Company from 1974 until the closing of ICH's sale of Great Southern in December 1989 and served as Senior Executive Vice President and Chief Operating Officer of Great Southern from 1983 until such closing. FMI had an administrative services agreement with Mutual Security Life Insurance Company ("MSL") when, on October 5, 1990, the Indiana Insurance Department placed MSL in rehabilitation. Under the agreement, FMI provided administrative services for a closed block of business written by MSL, and to facilitate the performance of these services, Mr. Brophy was appointed, in April 1990, a Vice President of MSL, to serve without compensation or other benefit. While the Indiana Office of Rehabilitation requested FMI to continue providing the administrative services after the rehabilitation proceedings were commenced, Mr. Brophy immediately resigned as an officer of MSL, effective October 9, 1990. ROBERT T. SHAW, age 59, served as Chairman of the Board from 1975 and Chief Executive Officer from 1975 to 1989 and from February 1992 until his resignation in October 1992. He also served from 1966 until 1992 as an officer and director of various affiliates of ICH. Mr. Shaw is an employee of CNC and has served as President, Treasurer, and a director of CNC since 1984. Throughout 1993, Mr. Shaw provided services to ICH by virtue of CNC's management and consulting agreement with ICH, and he currently provides services pursuant to a ten year Independent Contractor and Services Agreement he and the Company entered into February 11, 1994. ITEM 2.

ITEM 2. PROPERTIES. The following table sets forth certain information regarding the principal physical properties of I.C.H. Corporation and its subsidiaries as of March 1, 1994. A 2,600-acre residential and recreational real estate development in Perry Park, Kentucky is owned by ICH. ICH's subsidiaries own certain real estate located in Chicago, Illinois, which was acquired from Bankers Life and Casualty Company at the time of its sale in November 1992, and an office building with 129,000 square footage, at 2551 Elm Street, Dallas, Texas, where Union Bankers Insurance Company was formerly headquartered; they also hold, for investment purposes, certain real estate, none of which is included in the table below. ITEM 3.

ITEM 3. LEGAL PROCEEDINGS. Modern American Life Insurance Company is a Defendant in a class action lawsuit filed by William D. Castle and others on or about May 14, 1993 in the Circuit Court of Jackson County, Missouri, styled WILLIAM D. CASTLE, ET AL. V. MODERN AMERICAN LIFE INSURANCE COMPANY, CV93-10275 (the "CASTLE case"). The suit purports to be brought on behalf of a class of persons who own what Plaintiffs denominate as charter contracts, issued by life insurance companies merged into or acquired by Modern American Life Insurance Company and its predecessors. The petition alleges breach of contract, and seeks declaratory judgment, costs, expenses and such other relief as the Court deems appropriate. As an alternative, the petition seeks rescission. On or about October 12, 1993, the Plaintiffs in the CASTLE case also filed a lawsuit in the Circuit Court of Cole County, Missouri, naming Modern American and the Director of the Missouri Department of Insurance (the "Missouri Director") as Defendants. The second lawsuit, styled ROBERT J. MEYER, ET AL. V. JAY ANGOFF, DIRECTOR OF THE MISSOURI DEPARTMENT OF INSURANCE AND MODERN AMERICAN LIFE INSURANCE COMPANY, CV193-1331CC (the "MEYER case"), is an appeal from the regulatory proceedings before the Missouri Department of Insurance, by which Modern American received regulatory approvals required for it to participate in the restructuring of the ICH insurance holding company organization. The restructuring was completed on or about September 29, 1993. The Plaintiffs in the MEYER case are seeking reversal or remand of the Director's order of approval. The Cole Circuit Court has determined that it will review the Department's decision on the record pursuant to Missouri's administrative procedure act. Modern American believes it has meritorious defenses to both the CASTLE and MEYER cases and intends to defend both cases vigorously. A subsidiary of ICH, together with six other solvent parties, has been notified by the Texas Natural Resource Conservation Commission (formerly known as the Texas Water Commission) that it is a potentially responsible party under Texas environmental legislation with respect to certain property owned by that subsidiary and leased to a third party in Texas. That property is part of a tract of approximately 17 acres that allegedly has been contaminated with creosote. The potentially responsible parties have engaged an environmental consulting firm to investigate the extent of the contamination and develop a clean-up plan, after which the costs of the clean-up can be estimated. The Phase I Remedial Investigation was completed during the first half of 1993, and the Phase I Remedial Investigation Technical Memorandum (Phase I Report) was finalized by the end of 1993. Phase II of the Remedial Investigation and the risk assessment are to be performed during 1994. ICH's subsidiary has agreed to pay 6% of the cost of the investigation, and a former ICH subsidiary, which ICH has agreed to indemnify, has also agreed to pay 6% of the cost of the investigation. There is no agreement among the potentially responsible parties with regard to any responsibility for or the allocation of costs of any remedial action which may ultimately be determined necessary. A potentially responsible party brought an action, TOWNE SQUARE ASSOCIATES AND MILLENNIUM III REAL ESTATE CORPORATION V. GSV PROPERTIES, ET AL., Cause No. 91-15951, filed November 1991 in the 250th Judicial District, Travis County, Texas, naming the other potentially responsible parties defendants, including ICH's subsidiary and former subsidiary. ICH's subsidiary and former subsidiary asserted a counter-claim against the plaintiff as well as the other defendants, contesting their status as potentially responsible parties and seeking contribution and/or indemnity. The claims between the plaintiff and ICH's subsidiary and former subsidiary have now been resolved and the Texas Natural Resource Conservation Commission is contesting the Court's jurisdiction over the remaining claims. ICH and Robert L. Beisenherz, Chairman and Chief Executive Officer of the Company (collectively "the Company"), as well as Robert T. Shaw, former Chairman of the Company, and certain former affiliates of the Company, were added by an Amended Complaint, filed December 3, 1993, as Defendants in a lawsuit pending in Marion Circuit Court in Indianapolis, Indiana. MUTUAL SECURITY LIFE INSURANCE COMPANY, BY ITS LIQUIDATOR, JOHN F. MORTELL V. JAMES M. FAIL, EMILY S. FAIL, JACK A. GOCHENAUR, ALVIN R. TOWNSEND, SR., JANICE T. TOWNSEND, CHARLES D. CASPER, HARRY T. CARNEAL, CLIFFORD G. SMITH, KATHERYN F. SMITH, THOMAS K. PENNINGTON, MICHAEL BOEDEKER, MELVIN R. SCHOCK, LIFESHARES GROUP, INC., LSC-MARKETING, INC., LIFESHARES SERVICES COMPANY, MICHAEL S. LANG, LANG ASSOCIATES, INC., BETA FINANCIAL CORPORATION, THE OKLAHOMA BANK, ROBERT T. SHAW, CONSOLIDATED NATIONAL CORPORATION, I.C.H. CORPORATION, BANKERS LIFE AND CASUALTY COMPANY, MARQUETTE NATIONAL LIFE INSURANCE COMPANY, ROBERT L. BEISENHERZ, MARILYN BEISENHERZ, THEODORE L. KESSNER, AND CROSBY, GUENZEL, DAVIS, KESSNER & KUESTER (the "MUTUAL SECURITY case"). On January 3, 1994, the suit was removed to the United States District Court, the Southern District of Indiana at Indianapolis, Case No. IP94-0001 C. A motion to remand the MUTUAL SECURITY case back to State Court, filed by the Plaintiff Liquidator, is currently pending. The Plaintiff, the Commissioner of Insurance, who had been appointed Liquidator of Mutual Security Life Insurance Company ("MSL") pursuant to a Final Order of Liquidation, entered on December 6, 1991, alleges in the amended complaint that the Defendant Fail and others acquired control of MSL through a series of transactions, and misused assets of MSL to acquire control of Bluebonnet Savings Bank, FSB, thereby contributing to the insolvency of MSL. The allegations against the Company arise primarily from a loan that was made to James Fail in 1989 by Bankers Life and Casualty Company, at that time a subsidiary of the Company. The Plaintiff alleges that the Company and others are liable for the acts of James Fail under doctrines of joint venture and conspiracy, including alleged violations of the Racketeer Influenced & Corrupt Organizations Act ("RICO"), 18 U.S.C. Section 1961, ET SEQ. The complaint seeks unspecified compensatory damages, treble damages, costs, attorney fees and all other appropriate relief. Pleadings responsive to the Amended Complaint have not yet been filed, and discovery has not yet commenced. The Company believes it has meritorious defenses to the MUTUAL SECURITY case and intends to defend the suit vigorously. Except as described above, ICH and its subsidiaries are not parties, and their property is not subject, to any material pending legal proceedings other than ordinary routine litigation incidental to their respective businesses. SEE Note 12 of the Notes to Financial Statements included elsewhere in this Form 10-K. ITEM 4.

ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS. Not Applicable. PART II ITEM 5.

ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS. The Common Stock of I.C.H. Corporation is listed for trading on the American and Chicago Stock Exchanges under the symbol "ICH". The following table sets forth for the periods indicated the high and low sale prices per share of the Common Stock as reported by the American Stock Exchange. At March 18, 1994, 47,834,739 shares of Common Stock of ICH were outstanding and were owned of record by approximately 52,000 stockholders. No cash dividends have been declared by ICH on its Common Stock since 1985. ICH anticipates that it will continue for the foreseeable future to follow a policy of retaining substantially all its earnings, and that as a result no cash dividends on the Common Stock will be declared. Certain indentures currently restrict ICH from declaring or paying dividends on its capital stock in excess of specified amounts, and ICH's senior secured loan agreement prohibits the payment of cash dividends on Common Stock. See the discussion under the heading "Liquidity and Capital Resources--Parent Company" in ITEM 7 and Note 3 of the Notes to Financial Statements included in ITEM 8 in this Form 10-K. On February 11, 1994, ICH repurchased from Consolidated National Corporation 100,000 shares of the Class B Common Stock of ICH, representing all of the shares of that class authorized, issued and outstanding. As a result of that repurchase, ICH is no longer authorized to issue Class B Common Stock. No cash dividends had been declared on the shares of ICH's Class B Common Stock since 1985. ITEM 6.

ITEM 6. SELECTED FINANCIAL DATA. The following table sets forth for the indicated periods selected historical financial information for ICH and its consolidated subsidiaries. Such information should be read in conjunction with the consolidated financial statements of ICH, and the related notes and schedules, included elsewhere herein. Factors affecting the comparability of certain indicated periods are discussed under "Management's Discussion and Analysis of Financial Condition and Results of Operations" in ITEM 7.

ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS. The following is an analysis of the results of operations and financial condition of ICH and its consolidated subsidiaries. The consolidated financial statements and related notes and schedules included elsewhere in this Form 10-K should be read in conjunction with this analysis. RECENT EVENTS AND OTHER FACTORS During 1993, ICH successfully completed the sale for cash of its interest in Bankers Life Holding Corporation ("BLHC"), completed an exchange offer for a substantial portion of its debt scheduled to mature over the next several years, significantly reduced its and its subsidiaries' exposure to the risks associated with highly volatile mortgage-backed securities, and realized significant gains from the sale of investments in CCP Insurance, Inc. ("CCP Insurance"). These transactions resulted in a significant improvement in ICH's financial position, and the sale of the interest in BLHC provided ICH with substantial liquidity with which to meet its financial obligations. In addition, ICH completed the restructuring of its insurance holding company system, reduced its subsidiaries' dependence on financial reinsurance by in excess of 40%, and began the process of terminating significant reinsurance arrangements with an affiliated company. ICH utilized a portion of the proceeds from its sale of BLHC and cash remaining from its sale of Bankers Life and Casualty Company ("Bankers") in 1992 to further reduce some of the more expensive components of its capital structure. In management's opinion, ICH made significant progress in improving its relationship with regulatory authorities, and continued progress in consolidating the operations of its Texas-based insurance subsidiaries and in further reducing operating expenses. The successes in 1993 were offset, in part, by lower than anticipated earnings from continuing operations and additional losses and writedowns in the Company's investment portfolio. Subsequent to year-end, in February 1994, ICH purchased and retired its Class B Common Stock which had given its previous holders the ability to elect 75% of the members of ICH's Board of Directors. Following is an analysis of these various events and factors, including management's assessment of their impact on the financial position and liquidity of ICH, as well as management's future expectations. SALE OF INVESTMENT IN BANKERS LIFE HOLDING CORPORATION At year-end 1992, ICH's subsidiaries held direct and indirect common equity interests in BLHC totaling approximately 39.9%. Such interests had been acquired in conjunction with the sale of ICH's subsidiary, Bankers, in November 1992. During the first quarter of 1993, ICH acquired such interests from its subsidiaries. Effective March 31, 1993, BLHC completed an initial public offering of 19.55 million shares of its common stock, or an aggregate 35.8% interest in BLHC, at $22 per share. Proceeds of the offering, after underwriting expenses, approximated $405 million. Effective the same day, Conseco Capital Partners, L.P. ("CCP") announced a plan of dissolution and BLHC common shares held by CCP were subsequently distributed to the respective partners. ICH received 2,917,318 shares of BLHC common stock as a result of such distribution, increasing its direct ownership in BLHC common stock to 13,316,168 shares, or approximately 24.4% of BLHC's outstanding common shares following the offering. ICH reflected a pre-tax gain on the BLHC offering totaling approximately $99.4 million, primarily representing ICH's equity in the net proceeds of such offering. BLHC utilized a portion of the offering proceeds to redeem certain of its outstanding securities, including $50 million stated value of BLHC preferred stock and $34.7 million principal amount of BLHC junior subordinated notes held by ICH's subsidiaries. Because a portion of the purchase price paid for such investments had been allocated to ICH's common equity investments in BLHC, such redemptions resulted in additional pre-tax gains totaling approximately $8.3 million. On September 30, 1993, ICH sold its investment in BLHC to Conseco, Inc. ("Conseco") and one of Conseco's subsidiaries for $287.6 million cash. ICH utilized $50 million of the proceeds to redeem $50 million stated value of its Series 1987-A Preferred Stock held by a Conseco subsidiary. The sale of the BLHC shares resulted in a pre-tax gain totaling approximately $197.6 million. For financial reporting purposes, the gains resulting from BLHC's offering and the sale of ICH's remaining interest in BLHC totaling approximately $297.0 million have been reflected as a single line item in the 1993 statement of earnings. ICH continued to reflect its equity in the operating results of BLHC through the date of sale. Effective March 31, 1993, Bankers and an ICH subsidiary terminated a reinsurance agreement under which Bankers had previously ceded substantially all of its directly underwritten participating life insurance business to ICH's subsidiary. Assets, primarily fixed maturities and cash, with a fair value of approximately $163.6 million were transferred to Bankers and Bankers assumed policy liabilities on the reinsured business totaling approximately $186.2 million. ICH realized a gain on the termination of the reinsurance agreement totaling approximately $22.6 million which has been reflected in other income in the 1993 statement of earnings. CHANGES IN CAPITAL STRUCTURE During 1993, ICH completed an exchange offer for a portion of its outstanding debt and significantly reduced some of the more expensive components of its debt and equity structure. Subsequent to year-end, a significant transaction occurred affecting control of the Company. As discussed above, $50 million stated value of ICH's Series 1987-A Preferred Stock was redeemed in conjunction with the sale of the interest in BLHC. In addition, on December 2, 1993, ICH redeemed for $50 million cash all of its Series 1987-C Preferred Stock at its stated value. These redemptions reduced ICH's annual preferred dividend requirements by $13.5 million. Utilizing a portion of the proceeds from the sale of BLHC and cash remaining from the sale of Bankers in 1992, ICH retired all of the remaining $124.9 million principal amount of its 16 1/2% Senior Subordinated Debentures due 1994 ("Debentures") during 1993. Approximately $37.5 million of the Debentures were redeemed through a scheduled sinking fund payment in January 1993, an additional $37.5 million were called in March 1993 at a price of 101.84% of the amount redeemed, approximately $4.1 million were exchanged for new debt of the Company in November 1993, and the remaining Debentures were redeemed at par effective for financial reporting purposes as of December 30, 1993. Interest savings on the retired Debentures, excluding the exchanged debt, will approximate $20.2 million annually. In November 1993, ICH completed an exchange offer whereby $4.1 million of the Debentures and $87.1 million of its 11 1/4% Senior Subordinated Notes due 1996 ("Old Notes") were exchanged for $91.2 million of 11 1/4% Senior Subordinated Notes due 2003 ("New Notes"). See Note 3 of the Notes to Financial Statements for additional information regarding terms of the New Notes. Prior to the exchange offer, ICH and its subsidiaries held $46.8 million of the Old Notes which can, at ICH's option and upon repurchase of the $34.1 million of such Old Notes held by its subsidiaries, be utilized to partially satisfy its first $100 million sinking fund obligation relative to the Old Notes on December 1, 1994. The results of the exchange offer provided ICH additional flexibility in meeting such sinking fund obligation, since the amount of the Old Notes exchanged for New Notes can, also at ICH's option, be taken into consideration in determining what portion, if any, of the Old Notes it wishes to redeem through operation of the sinking fund. Assuming ICH utilizes its available Old Notes and defers sinking fund payments by an amount equivalent to the Old Notes which were exchanged, ICH would not have any sinking fund obligation in 1994 and its obligation in 1995 would total $66.1 million. Alternatively, and assuming its ability to generate the required liquidity, ICH may, at its option, determine to retire up to $100 million of the Old Notes at their par value through operation of the sinking fund in each of 1994 and 1995. ICH also has the option of calling any portion of the Old Notes at a 3% premium through November 30, 1994, and at a 2% premium during the following twelve month period. Thereafter, the Old Notes may be called at their par value. On February 11, 1994, ICH purchased all of the 100,000 shares of its Class B Common Stock from Consolidated National Corporation ("CNC") for total cash consideration of $500,000. The Class B Common Stock had entitled CNC to elect 75% of ICH's Board of Directors and, by virtue of such voting power, CNC was considered to be ICH's controlling shareholder. The Class B Common Stock was immediately cancelled and retired following ICH's purchase. Concurrently, Stephens Inc. ("Stephens") and Torchmark Corporation ("Torchmark") purchased 4,457,000 shares and 4,667,000 shares, respectively, of ICH Common Stock from CNC. Stephens is an investment banking firm with its principal offices located in Little Rock, Arkansas, and Torchmark is a diversified insurance and financial services company headquartered in Birmingham, Alabama. One officer each from Stephens and Torchmark was elected to fill vacancies on the ICH Board of Directors. In addition, a management and services agreement between ICH and CNC was cancelled, and new ten-year services agreements were entered into with the two principal shareholders of CNC. As a result of these transactions and the transactions with Consolidated Fidelity Life Insurance Company as described below, CNC's ownership in ICH will be reduced to approximately one million shares, or 2%, of ICH's outstanding Common Stock. Management believes these transactions are significant for various reasons. Most importantly, management believes that ICH's access to both debt and equity capital markets has previously been limited because of the control position held by CNC through the Class B stock, and that the retirement of the Class B stock and considerable reduction in CNC's holdings of ICH Common Stock could ultimately enhance ICH's ability to refinance its currently outstanding debt. TRANSACTIONS WITH CONSOLIDATED FIDELITY LIFE INSURANCE COMPANY Effective June 15, 1993, ICH entered into an agreement (the "Agreement") which initiated the process of terminating certain reinsurance arrangements involving Consolidated Fidelity Life Insurance Company ("CFLIC"), a subsidiary of CNC. The reinsurance arrangements involve certain annuity business with reserves totaling approximately $330.0 million as of December 31, 1993, which was transferred by a subsidiary of ICH, Southwestern Life Insurance Company ("Southwestern"), to an unaffiliated reinsurer in 1990. The unaffiliated reinsurer, in turn, transferred the business to another CNC subsidiary, Marquette National Life Insurance Company ("Marquette"). In 1991, Marquette transferred the annuity business to CFLIC. The reinsurance arrangements have been under review by the Texas Department of Insurance ("Texas Department") and, in March 1993, ICH and Southwestern agreed with the Texas Department that they would, among other things, develop a plan to enhance and diversify the assets supporting the liabilities reinsured by CFLIC, including possibly recapturing the reinsured annuity business. The recapture is subject to negotiations with the unaffiliated reinsurer and approval by the Texas Department. CNC and CFLIC agreed to structure the proposed recapture in a manner that will permit ICH to redeem or retire certain of its outstanding securities, provided that CFLIC would be allowed to retain certain assets following the recapture. CFLIC holds ICH's senior secured debt, with a current balance of $30 million, which it acquired in 1992 from ICH's bank lenders. In addition, CFLIC holds approximately $22.2 million stated value of ICH's Series 1984-A Preferred Stock, $7 million stated value of Series 1987-B Preferred Stock, and 620,423 shares of ICH's Common Stock. CFLIC also intends to terminate another reinsurance arrangement under which business written by Bankers is reinsured by CFLIC. Under terms of the Agreement, ICH is responsible for the negotiation on CFLIC's behalf of both the Southwestern and Bankers recaptures and the management of the affairs of CFLIC and Marquette, including management of their investments, until the recaptures are effected. Upon completion of the recaptures, CFLIC will have no remaining insurance business. To facilitate the recaptures of the reinsured business, ICH acquired $63 million of CFLIC preferred stock in exchange for its ownership interest in certain investments with an estimated fair value as of June 15, 1993, of $63 million, including its ownership in a limited partnership (HMC/Life Partners, L.P.) and 83% of ICH's ownership interest in I.C.H. Funding Corporation ("ICH Funding"). ICH Funding is a special purpose entity that was formed in 1992 to hold ICH's residual interest in a pool of mortgage-backed securities acquired from Bankers. The CFLIC preferred stock is non-redeemable and non-voting with cumulative 6% annual dividends that are payable "in-kind" until the recaptures are completed. ICH and CFLIC anticipate that the assets received by CFLIC from ICH in consideration for the preferred stock, along with other assets held by CFLIC, including its ownership in Marquette, will be transferred to Southwestern upon recapture of the annuity business. Following the recaptures, CFLIC is obligated to repurchase its preferred stock by transferring its ownership interest in the ICH debt and preferred securities and additional assets to ICH. Upon their receipt, ICH intends to retire the ICH securities. For financial reporting purposes, no gain or loss was recognized on the transfer of assets to CFLIC. The Agreement identifies the specific assets and liabilities plus, subject to certain conditions, an amount of cash that will be retained by CFLIC following the recaptures. All remaining assets held by CFLIC, including the ICH securities, will revert to ICH in redemption of CFLIC's preferred stock. As a consequence, ICH will benefit or suffer the consequences to the extent of any appreciation or depreciation in the value of the assets transferred to CFLIC. At December 31, 1993, ICH has reflected its investment in the CFLIC preferred stock at its approximate fair value of $54 million, or $9 million less than the value assigned to such preferred stock at June 15, 1993. The reduction in fair value between the two dates was primarily attributable to a decline in the fair value of the 83% interest in ICH Funding transferred to CFLIC. Management believes the transactions with CFLIC will be beneficial for several reasons. In addition to eliminating $30 million in scheduled debt principal requirements, the redemption or retirement of the ICH securities will reduce ICH's interest and preferred dividend requirements by approximately $5.4 million annually. Further, the recapture of the Southwestern annuity business will substantially eliminate the possibility for conflicts of interest between CNC and its subsidiaries and ICH. Management's present goal is to complete the transactions with CFLIC as soon as possible. RESTRUCTURING OF ICH HOLDING COMPANY SYSTEM In September 1993, ICH completed the restructuring of its insurance holding company system, from a vertical to a substantially horizontal structure. The restructuring was designed to increase the financial independence of ICH's subsidiary insurance companies and reduce the effect of multi-jurisdictional regulation that results when such subsidiaries are held indirectly, through other insurance subsidiaries. In the process of such restructuring, a surplus debenture due to ICH from a subsidiary with an outstanding principal balance of $105.8 million was retired and added to ICH's investment in its subsidiaries. As a consequence, there are no remaining surplus debentures due to ICH from its subsidiaries. The restructuring is expected to facilitate more accurate analysis and understanding of the Company by ratings agencies, securities analysts, and regulators, and will permit the direct payment of dividends from subsidiaries to ICH in future periods. Following such restructuring, ICH's subsidiaries affected by the restructuring have maintained risk-based capital levels substantially in excess of those required by applicable regulatory authorities. RATINGS ICH's subordinated debt and preferred stock are rated by various nationally recognized statistical rating organizations, such as Moody's Investors Service, Inc. ("Moody's") and Standard and Poor's Corporation ("S&P"). These agencies, along with Duff & Phelps Credit Rating Company ("Duff & Phelps"), have also rated the claims paying ability of certain of ICH's insurance subsidiaries. In addition, A.M. Best, an agency specializing in the rating of insurance companies, has assigned ratings to each of ICH's insurance subsidiaries. Over the last two years, substantially all of the ratings issued by these agencies have reflected ratings downgrades. Virtually all ratings downgrades experienced by ICH and its subsidiaries were attributed to high or continuing leverage at the parent company level. Moody's has rated ICH's subordinated debt at "B3" and its preferred stock at "Caa," both of which are below investment grade. S&P has rated ICH's debt at "B-" and its preferred stock at "CCC+," both of which are also below investment grade. Southwestern has been assigned claims paying ratings of "Ba2" by Moody's (questionable financial security), "BBB-" by S&P (adequate financial security, but capacity to meet policyholder obligations susceptible to adverse economic and underwriting conditions) and "A" by Duff & Phelps (high claims paying ability). A.M. Best has assigned "B++" ratings (very good) to all of ICH's significant insurance subsidiaries. The ratings assigned to ICH by ratings agencies have a significant effect on ICH's ability to borrow funds, as well as the interest rates that ICH must pay in order to borrow funds. The claims paying ratings assigned to ICH's subsidiaries could have a significant effect on a given subsidiary's ability to market its products, as well as its ability to retain its presently existing insurance in force. Except for an increase in the level of withdrawals of guaranteed investment contracts ("GICs") as discussed in "Liquidity and Capital Resources -Insurance Operations," management does not believe that ICH's insurance subsidiaries have experienced more than normal policy surrenders and withdrawals as a result of the ratings downgrades received in 1992 and 1993. In addition and notwithstanding such ratings downgrades, total new business produced by ICH's insurance subsidiaries, excluding GIC business, increased in 1993 as compared to 1992. Substantially all of ICH's and its subsidiaries' present ratings were issued prior to ICH's sale of its investment in BLHC, the restructuring of its insurance holding company system, the completion of its debt exchange offer, the retirement of its remaining Debentures, and the redemptions of $100 million in preferred stocks and the Class B Common Stock. Management believes, as a result of these previously discussed events, that the financial condition of ICH and its insurance subsidiaries has significantly improved and that, as a result, the possibility exists for upgrades in such financial and claims paying ratings. ICH has arranged for meetings with all applicable rating agencies in March 1994, but there can be no assurance that ICH's or its subsidiaries' ratings will be upgraded following such meetings. REGULATORY ENVIRONMENT ICH's insurance subsidiaries are subject to comprehensive regulation in the various states in which they are authorized to do business. The laws of these states establish supervisory agencies with broad administrative powers, among other things, to grant and revoke licenses for transacting business, to regulate trade practices, reserve requirements, the form and content of policies, and the type and amount of investments, and to review premium rates for fairness and adequacy. These supervisory agencies periodically examine the business and accounts of ICH's insurance subsidiaries and require them to file detailed annual financial statements and reports prepared in accordance with statutory accounting practices. In addition, as an insurance holding company, ICH is also subject to regulatory oversight in the states in which its insurance subsidiaries are domiciled. Primarily as a result of the failures of several large insurance holding companies during the past few years, increased scrutiny has been placed upon the insurance regulatory framework, and a number of state legislatures have enacted legislation that has altered, and in many cases increased, state authority to regulate insurance companies and their holding company systems. Further, some Congressional leaders have proposed legislation which could result in the federal government's assuming some role in the regulation of the insurance industry. In light of these developments, the National Association of Insurance Commissioners (the "NAIC") and state insurance regulators have also become involved in the process of re-examining existing laws and regulations and their application to insurance companies. In particular, this re-examination has focused on insurance company investment and solvency issues and, in some instances, has resulted in new interpretations of existing law, the development of new laws and the implementation of non-statutory guidelines. The NAIC has formed committees and appointed advisory groups to study and formulate regulatory proposals on such diverse issues as the use of surplus debentures, the accounting for reinsurance transactions, uniform investment laws and the adoption of risk-based capital requirements. In addition, in connection with its accreditation of states to conduct periodic examinations, the NAIC has encouraged and persuaded states to adopt model NAIC laws on specific topics, such as holding company regulations, the structure of reinsurance transactions, and the definition of extraordinary dividends. During 1992 and continuing in 1993, in part as a result of these activities, ICH's insurance subsidiaries became subject to substantially more oversight by insurance regulators, and such increased oversight will likely continue in 1994 and future periods. During 1992, a special working group (the "Group") of the NAIC, which included the representatives of seven states, conducted an extensive review of the operations and financial condition of ICH and CNC and their respective insurance subsidiaries. Retaining the services of an independent accounting firm, other than ICH's public accountants, the Group placed particular emphasis on reviewing transactions between related parties and major transactions with certain other unaffiliated companies, differences between GAAP and statutory reporting practices, cash flow projections, off-balance sheet risks and non-traditional investments, and the insurance subsidiaries' risk-based capital requirements. In December 1992, based on their review of the findings, the Group advised ICH they had material concerns about asset quality and the cash flow position of ICH. The asset quality concerns were discussed in detail in ICH's 1992 Annual Report on Form 10-K and, as indicated in such discussion, substantially all of the Group's concerns had already been addressed by ICH. Management believes that the Group's concerns regarding ICH's cash flow position were effectively overcome in 1993 by the sale of ICH's investment in BLHC and the successful completion of ICH's debt exchange offer. As a result of these events and the resolution of remaining asset quality concerns, the Group's utilization of other independent accountants to review the affairs of ICH and its subsidiaries has been effectively eliminated and management believes that regulators from the states in which ICH's insurance subsidiaries are domiciled were significantly more cooperative in granting the required approvals for ICH to accomplish the restructuring of its insurance holding company system. The Group has nevertheless indicated that it will likely continue to monitor, to the extent it deems appropriate, the activities and the operations of ICH and CNC and their respective insurance subsidiaries. However, based on the progress made to date in resolving concerns expressed by the Group, management does not anticipate that ICH will encounter any regulatory difficulty in proceeding with its corporate objective to grow its insurance operations through strategic acquisitions or other means. Life insurance companies are generally required under statutory accounting rules to maintain an asset valuation reserve ("AVR") which consists of two components: a "default component" to provide for future credit-related losses on fixed income investments and an "equity component" to provide for losses on all types of equity investments, including real estate. Life insurance companies are also required to maintain an interest maintenance reserve ("IMR"), which is credited with the portion of realized capital gains and losses from the sale of fixed maturity investments attributable to changes in interest rates. The IMR is required to be amortized against statutory earnings on a basis reflecting the remaining period to maturity of the fixed income securities sold and there are no limitations as to the amounts which can be accumulated in the IMR. At December 31, 1993, the AVR of ICH's insurance subsidiaries totaled $45.0 million. The IMR of such subsidiaries was insignificant. Increases in the AVR and the IMR do not reduce either statutory or GAAP operating income, but result in a reduction in the statutory surplus of ICH's insurance subsidiaries. Historically, insurance companies have been required to satisfy the minimum capital requirements of the states in which such companies were domiciled. Such minimum capital requirements tended to be relatively small, fixed dollar amounts that bore little, if any, reflection of the size of the company or the nature and diversification of the risks taken by the company. Over the past several years, the NAIC and various states have undertaken projects to develop risk-based capital ("RBC") requirements for insurance companies and model laws that would provide the framework for triggering a range of regulatory options in the event an insurance company failed to maintain adequate RBC levels. Effective with statutory annual statements filed for the year ending December 31, 1993 and thereafter, each life insurance company is required to calculate, utilizing NAIC formulas, their level of targeted adjusted capital. Such NAIC formulas focus on 1) asset impairment risks, 2) insurance risks, 3) interest rate risks, and 4) general business risks. A risk-based capital ratio ("RBC ratio") is then determined based on the company's level of adjusted capital and surplus, including AVR and other adjustments, to its targeted adjusted capital. In states which have adopted the NAIC regulations, the new RBC requirements provide for four different levels of regulatory attention depending on an insurance company's RBC ratio. The "Company Action Level" is triggered if a company's RBC ratio is less than 200% but greater than or equal to 150%, or if a negative trend has occurred (as defined by the regulations) and the company's RBC ratio is less than 250%. At the Company Action Level, the company must submit a comprehensive plan to the regulatory authority which discusses proposed corrective actions to improve its capital position. The "Regulatory Action Level" is triggered if a company's RBC ratio is less than 150% but greater than or equal to 100%. At the Regulatory Action Level, the regulatory authority will perform a special examination of the company and issue an order specifying corrective actions that must be followed. The "Authorized Control Level" is triggered if a company's RBC ratio is less than 100% but greater than or equal to 70%, and the regulatory authority may take any action it deems necessary, including placing the company under regulatory control. The "Mandatory Control Level" is triggered if a company's RBC ratio is less than 70%, and the regulatory authority is mandated to place the company under its control. Management believes that the levels of capital in ICH's insurance subsidiaries is sufficient to meet RBC requirements. Based on the NAIC's formulas, the RBC ratios for all but one of ICH's life insurance subsidiaries, based on financial statements as filed with regulatory authorities, exceeded 325% at December 31, 1993. One subsidiary's RBC ratio approximated 250% and management is in the process of evaluating alternatives to achieve at least a 300% RBC ratio for such subsidiary by year-end 1994. From time to time, assessments are levied on ICH's insurance subsidiaries by life and health guaranty associations in states in which they are licensed to do business. Such assessments are made primarily to cover the losses of policyholders of insolvent or rehabilitated insurers. In some states, these assessments can be partially recovered through a reduction in future premium taxes. ICH's insurance subsidiaries, other than Bankers and Certified, paid assessments of $3.2 million, $2.2 million and $1.2 million in the years 1993, 1992 and 1991, respectively. Bankers and Certified paid assessments of $.6 million and $1.7 million for the ten months ended October 31, 1992 and the year 1991, respectively. Although the economy and other factors have recently caused the number and size of insurance company failures to increase, based on information currently available, ICH believes that any future assessments are not reasonably likely to have a material adverse effect on its insurance subsidiaries. INVESTMENT PORTFOLIO ICH pursues an investment strategy principally designed to balance the duration of investment assets against the liabilities of its insurance subsidiaries for future policy and contract benefits and, under certain circumstances, to manage its exposure to changes in market interest rates. Over the past several years, ICH has taken steps to restructure its investment portfolio in order to improve the overall quality of the portfolio. While these actions have resulted in substantially reduced exposure to credit risks, average yields have decreased from 9.1% in 1991 to 8.3% in 1992 and 6.9% in 1993. As a result of the investment portfolio restructuring, substantial investments were made in mortgage-backed securities and collateralized mortgage obligations in 1991 which were highly sensitive to subsequent changes in market interest rates and which contributed to the decline in investment yields. Further, the overall decline in market interest rates over the past several years has had a significant impact on ICH's ability to maintain the level of earnings on its invested assets. In accordance with applicable insurance laws, ICH's insurance subsidiaries maintain substantial portfolios of investment assets that are held, in large part, to fund their future contractual obligations to policyholders. In structuring these portfolios, ICH has emphasized, and expects to continue to emphasize, investments in fixed maturities. In addition, ICH has maintained significant levels of short-term investments to meet its liquidity needs. Since 1991, fixed maturities and short-term investments have represented more than 75% of ICH's consolidated investments, while no other category of investment represented more than 10%. Additional information regarding the categories and amounts of ICH's investment assets is reflected in Note 5 of the Notes to Financial Statements. During 1993, the NAIC initiated the process of drafting a model investment act. In general, the currently drafted investment act is substantially more restrictive than the present investment laws of the states in which ICH's insurance subsidiaries are domiciled. Management cannot predict with any certainty whether or when such a model investment act will be adopted and whether such act will "grandfather" certain existing investments. However, if adopted, it is likely that such model investment act will significantly limit the types of investments that can be made by ICH's insurance subsidiaries in future periods, as well as the amounts that can be invested in various investment categories, and could result in an overall reduction in investment yields. Prior to 1992, ICH had carried all of its fixed maturities at amortized cost (less permanent declines), because management had stated its intent and believed ICH had the ability to hold all such investments to their ultimate maturities. If a determination was made to dispose of particular fixed maturity investments, the carrying values of such investments were adjusted to the lower of cost or market value. In 1992, management evaluated ICH's investment strategy, specifically in light of the sale of Bankers and ICH's need for liquidity. Based in part on ICH's decision to retain three independent investment advisors during 1992 to manage in excess of $1 billion of its investments, management determined that ICH's fixed maturities would be classified into three categories effective December 31, 1992. Fixed maturity investments which were determined to be readily marketable were classified as "actively managed" and adjusted to their fair value through an adjustment to unrealized investment gains and losses in stockholders' equity. Those investments which ICH intended to sell, primarily certain mortgage-backed securities, were classified as "held for sale" and were adjusted to their fair value (if lower than cost) through a charge to earnings. Certain private placement securities which were not readily marketable and which ICH had both the ability and the positive intent to hold to maturity were classified as "held to maturity" and carried at amortized cost. In April 1993, the Financial Accounting Standards Board adopted Statement of Financial Accounting Standards (SFAS) No. 115, "Accounting for Certain Investments in Debt and Equity Securities." SFAS No. 115 expands the use of fair value accounting for certain investments in debt and equity securities and requires that financial institutions classify their fixed maturity investments into three categories. Fixed maturity investments that an entity has the positive intent and ability to hold to maturity are to be classified as "held to maturity" and will continue to be reported at amortized cost. Fixed maturity and equity investments available for sale, which may or may not be traded before maturity, are to be marked to their current value, with any unrealized gains and losses reported as a separate component of stockholders' equity. Finally, fixed maturity and equity investments held only for trading must be marked to their current value, with any unrealized gains or losses reflected in earnings. SFAS No. 115 is required to be adopted for 1994 financial statements, but earlier adoption is encouraged. In 1993, ICH adopted the provisions of SFAS No. 115 and has categorized its fixed maturity and equity investments into two categories, available for sale and held to maturity. At year-end 1993, ICH and its subsidiaries did not hold any securities which would meet the criteria of being classified in a trading category. In its 1992 balance sheet, ICH has reclassified its "actively managed" and "held for sale" fixed maturities as available for sale. ICH's fixed maturity portfolio generally includes government and corporate debt securities and mortgage-backed securities. Historically, this portfolio has been structured in part to balance desirable yields with credit concerns. ICH has concentrated its fixed maturity investments within categories that are rated investment-grade, while in certain instances holding selected noninvestment-grade securities that provide higher yields. ICH classifies its high-yield securities as noninvestment-grade if they are unrated or are rated less than BBB-by S&P or Baa by Moody's. Based on such classifications, ICH's noninvestment-grade fixed maturities represented 4.0% of ICH's consolidated investment portfolio at year-end 1993 as compared to 3.8% at year-end 1992 and 4.7% at year end 1991. Following is a summary of fixed maturity investments segregated by investment quality based on S&P ratings and the two categories of such investments as reflected in ICH's consolidated balance sheet at December 31, 1993 (in millions): Investments in noninvestment-grade debt securities generally have greater risks than investment-grade securities. Risk of loss upon default by the borrower is greater with noninvestment-grade securities because these securities are generally unsecured and often are subordinated to other creditors of the issuers, and because the issuers have high levels of indebtedness and are more sensitive to adverse economic conditions, such as recessions or increasing interest rates, than are investment-grade issuers. ICH's subsidiaries hold substantial investments in mortgage-backed securities and collateralized mortgage obligations (collectively, "CMOs"). These investments generally offer relatively high yields and, because of the quality of the underlying collateral, are usually given the highest ratings by S&P and Moody's. Beginning in late 1990 and continuing through 1991 management utilized a strategy of investing in CMOs to enhance the credit quality of ICH's investment portfolio without incurring a reduction in investment yields. At year-end 1993, CMO's totaling $798.1 million represented 46.5% of ICH's fixed maturity investments and 30.2% of total invested assets. Of this amount, $709.2 million represented conventional CMO obligations with principal guarantees that are reflected as available for sale and carried at their fair value and $88.9 million primarily represented so-called derivative CMOs, such as residual interests in a pool or pools of mortgage loans, of which $72.7 million are reflected as available for sale at their fair value and $16.2 million are reflected as held to maturity and carried at amortized cost. As reflected in its year-end 1992 financial statements, ICH held mortgage-backed residual interests and interest-only certificates ("IOs") with a carrying value and fair value of $422.7 million. Such year-end values were reflected net of reserves for anticipated losses in 1993 totaling $34.9 million, which had been provided based on the prepayment experience incurred and expected on the mortgage loans underlying such residual interests and IOs through the first three months of 1993. At June 30, 1993, the carrying value and fair value of such investments had declined to $358.3 million as a result of principal repayments. Based on an analysis of subsequent prepayment experience, management believed that the reserves provided at year-end 1992 had been adequate and, as a consequence, ICH did not incur any significant additional losses on its residual interests and IOs during the first six months of 1993. Effective July 30, 1993, ICH and its subsidiaries, along with CFLIC, entered into a transaction designed to substantially reduce their exposure to the prepayment risks associated with their investments in residual interest and IO mortgage-backed securities, including liquidating a substantial portion of such investments. ICH's subsidiaries and CFLIC sold directly-owned residual interests and IOs with a carrying value of approximately $137.7 million and $26.5 million, respectively, to an unaffiliated third party, Fund America Investors Corporation II ("Fund America"). In addition, ICH and CFLIC sold to Fund America 75% of their rights with respect to residual interests in certain mortgage-backed securities which were acquired in conjunction with the sale of Bankers and are held in a special-purpose trust (the "Trust") to collateralize certain mortgage note obligations (see Note 3 of the Notes to Financial Statements included elsewhere in this Report). CFLIC had acquired its interest in the Trust as previously discussed under "Transactions With Consolidated Fidelity Life Insurance Company." Because ICH was deemed to be the Trust's sponsor and, with CFLIC, retained a majority ownership in the residual interest, the accounts of the Trust were included in ICH's consolidated balance sheet at year-end 1992 and at June 30, 1993. Following is a summary of the various accounts of the Trust as reflected in ICH's balance sheet at June 30, 1993, and ICH's net residual interest in the Trust (in millions): The net carrying value of the 75% interests in the Trust sold by ICH and CFLIC to Fund America approximated $7.0 million and $33.7 million, respectively, at the date of sale. Fund America sponsored the formation of a new trust (the "New Trust") into which it deposited the purchased securities. Interests in the New Trust aggregating $217 million, or 68.4% of its total outstanding securities, were sold to other unaffiliated parties. A portion of the sales proceeds were utilized to acquire additional securities which were deposited into the New Trust, including certain securities maturing in 2030 designed to assure the ultimate return of principal on the interests in the New Trust retained by ICH, its subsidiaries and CFLIC. The remaining proceeds, after underwriting expenses, were utilized to pay a portion of the purchase price for the securities purchased from ICH and its subsidiaries and CFLIC. The remainder of the purchase price was paid by issuing participation certificates representing residual interests in the pool of $101.0 million principal amount of securities placed in the New Trust. The participation certificates received in the transaction were valued for financial reporting purposes at their fair value, assuming an 11% annual return to maturity. Before the recognition of gains totaling approximately $14.3 million resulting from the disposal of certain securities utilized to hedge prepayment risks on the mortgage-backed securities, the transactions resulted in losses for ICH and CFLIC totaling approximately $23.1 million. ICH reflected its portion of the losses resulting from these transactions as realized investment losses in its 1993 results. Following is a summary of the effects of the above-described transactions: Because ICH and CFLIC no longer hold a direct or indirect majority interest in the Trust and have not guaranteed any portion of the collateralized mortgage note obligations, the accounts of the Trust have not been consolidated with those of the Company for periods subsequent to the sale to Fund America on July 30, 1993. Management had originally intended to reflect ICH's investments in the Fund America certificates, its remaining interest in the Trust, and its investments in certain other residual interests at their amortized cost in the held to maturity category of fixed maturities to eliminate the accounting volatility associated with these types of investments. In late 1993, the Emerging Issues Task Force ("EITF") of the Financial Accounting Standards Board addressed "Impairment Recognition for a Purchased Investment in a Collateralized Mortgage Obligation Investment or in a Mortgage-Backed Interest-Only Certificate", in their EITF Issue No. 98-13. The focus of the EITF issue involved the criteria to be used to determine when writedowns should be taken on these types of investments as a result of the issuance of SFAS No. 115. ICH had previously determined when writedowns would be taken, based on an earlier EITF consensus, utilizing the undiscounted expected future cash flows on these types of investments. The writedown required under this approach was the amount necessary to reduce the carrying value of an individual security to a zero expected future yield and was reflected as a realized investment loss. The EITF reached a tentative consensus that the criteria for determining when future writedowns were required should be based on the discounted expected future cash flows, utilizing a "risk-free" rate of return. If the discounted cash flows are less than the carrying value of the investment, a permanent impairment in the value of the investment is to be recognized. Under the provisions of SFAS No. 115, if impairment is indicated, an individual security should be written down to its fair value as a new cost basis and the writedown should be accounted for as a realized loss. ICH has implemented the provisions of EITF Issue No. 93-18 and, in conjunction with its adoption of SFAS No. 115 effective as of December 31, 1993, has reflected writedowns relative to certain residual interest mortgage-backed securities totaling $4.9 million, net of tax effects. Such writedowns have been reflected as the cumulative effect of a change in accounting method in the 1993 statement of earnings. The EITF is also expected to address at a meeting scheduled for March 24, 1994, whether, due to their nature, these types of investments can ever be classified as held to maturity under the provisions of SFAS No. 115. Authoritative sources have indicated that the EITF will likely require that these types of investments be classified as available for sale and be reflected at their fair value. Accordingly, at December 31, 1993, ICH has classified its investments in the Fund America certificates and its remaining investment in the Trust as available for sale and has reduced the carrying value of such investments from $95.5 million to their estimated fair value of $67.1 million. Such reduction, totaling $28.4 million, has been reflected as an unrealized investment loss through a charge to stockholder's equity. The fair value of these investments was estimated by an investment banking firm assuming an 11% annual return to maturity. At December 31, 1993, mortgage loans principally involving commercial real estate totaled $138.5 million, representing approximately 5.2% of ICH's investment portfolio. ICH has a stated policy of not directly initiating or making new mortgage loans, except under limited circumstances, including primarily loans to finance sales of company-owned real estate. New mortgage loans have totaled approximately $3.1 million, $17.0 million and $12.2 million during 1993, 1992 and 1991, respectively. Substantially all other mortgage loans owned by ICH and its subsidiaries were as a result of acquisitions of life insurance companies in 1986 and prior years. Delinquencies on mortgage loans in excess of 60 days represented approximately .2% of total mortgage loans outstanding, as compared to 4% at year-end 1992. Management believes that its mortgage loan portfolio is well seasoned and that the collateral underlying these mortgage loans is sufficient to recover the carrying value of such investments and, as a result, no significant losses should be incurred. Real estate investments totaling $67.5 million and home office real estate totaling $13.3 million represented 2.5% and .5% of ICH's investment portfolio, respectively, at December 31, 1993. ICH has a stated policy of not directly making real estate investments, except for foreclosures on its existing mortgage loans. Mortgage loan foreclosures totaled $3.2 million, $5.7 million and $20.9 million for the three years 1993, 1992 and 1991, respectively. During 1993, ICH completed its obligation to purchase certain real estate from former subsidiaries for approximately $19 million. In addition, in conjunction with the sale of Bankers in 1992, ICH purchased all of the real estate held by Bankers, primarily its home office real estate, for $9 million. Bankers has entered into a long-term lease for a portion of the property sold to ICH and ICH is attempting to sell the remaining properties. The Bankers real estate has been independently appraised at a value in excess of ICH's carrying value. At December 31, 1993, ICH and its subsidiaries held limited partnership interests in various partnerships with a carrying value totaling $43.6 million, as compared to $39.8 million at year-end 1992 and $36.9 million at year-end 1991. These investments were made primarily to participate in the potential appreciation resulting from certain leveraged buyouts and corporate reorganizations. In addition, included in such investments at year-end 1993 was a $25.0 million investment, representing a 49% limited partnership interest, in a partnership formed to acquire through auction certain mortgage loans and real estate formerly held by failed savings and loan associations for resale. ICH believes that on a selective basis these investments offer attractive risk-adjusted returns; however, such investments are not readily marketable and, in the event of a need for liquidity, ICH may be unable to quickly convert such investments into cash. See Note 6 of the Notes to Financial Statements for additional information regarding ICH's investments in limited partnerships. Included in the limited partnership investments at year-end 1991 was ICH's 21.4% interest in Conseco Capital Partners, L.P. ("Predecessor CCP") with a carrying value of $17.0 million. In 1992, Predecessor CCP formed a new insurance holding company, CCP Insurance, and completed an initial public offering of shares of CCP Insurance common stock. ICH's subsidiaries received 1,764,439 shares of CCP Insurance in exchange for their investment in Predecessor CCP and ICH's subsidiaries acquired an additional 525,000 shares of CCP Insurance through its offering. In September 1993, CCP Insurance completed an underwritten primary and secondary offering of shares of its common stock. ICH's subsidiaries sold all of their 1,764,439 shares of CCP insurance common stock in the offering and realized investment gains totaling $27.8 million. In addition, during 1993, ICH's subsidiaries sold 455,375 of the 525,000 shares of CCP Insurance acquired in its initial public offering and realized additional investment gains totaling $5.3 million. Included in the limited partnership investments at year-end 1992 and 1991 was ICH's investment in the HMC/Life Partners, L.P. with a carrying value of approximately $5.0 million. During March 1993, Life Partners Group, Inc. ("LPG"), the holding company formed to acquire certain subsidiaries from ICH in 1990, completed an initial public offering of 15.2 million shares of its common stock, or a 58.5% interest in LPG, at $17 per share. ICH had acquired a 31% interest in the HMC/Life Partners, L.P. at the time of the sale of such subsidiaries and the partnership, in turn, directly owned 5.1 million shares of the LPG common stock. Based on an assumed liquidation of the partnership and distribution of shares under provisions of the partnership agreement, the holder of ICH's partnership interest would be entitled to receive shares of LPG common stock with a fair value at December 31, 1993, of approximately $21.3 million, or $16.3 million more than the adjusted cost of ICH's investment in the partnership. As discussed earlier under "Transactions With Consolidated Fidelity Life Insurance Company," the investment in the HMC/Life Partners, L.P. was transferred to CFLIC in exchange for preferred stock as the first step in a series of transactions to terminate certain reinsurance arrangements involving CFLIC and Southwestern. During 1993, two other companies controlled by partnerships in which ICH's subsidiaries had ownership interests completed initial public offerings of shares of their common stock. Assuming a liquidation of the partnerships and a distribution of the shares of common stock held by the partnerships, ICH's subsidiaries would be entitled to receive shares of common stock with a fair value totaling $5.3 million in excess of their adjusted cost basis in such partnerships. At December 31, 1993, the carrying values of such partnership interests were adjusted to reflect the increase in value, with a corresponding increase in unrealized investment gains reflected in stockholders' equity. In addition, during 1993, ICH reflected a $5.0 million writeoff of a partnership interest through realized investment losses following the commencement of bankruptcy proceedings by the company controlled by such partnership. At December 31, 1993, ICH had pre-tax unrealized investment gains totaling $33.9 million, consisting of $21.4 million of unrealized gains related to available for sale fixed maturities, $7.2 million of unrealized gains attributable to equity securities, and $5.3 million of unrealized gains attributable to investments in limited partnerships. Such unrealized investment gains are reflected in stockholders' equity, net of a $10.4 million adjustment in deferred policy acquisition costs and other policy liabilities, a $5.2 million adjustment for the minority interest in certain unrealized investment losses and $8.2 million in deferred income tax effects. At December 31, 1992, pre-tax unrealized investment gains totaled $28.5 million, of which $24.1 million was attributable to ICH's equity investment in CCP Insurance, and were reflected in stockholders' equity, net of $9.7 million in deferred income tax effects. The unrealized gains related to available for sale fixed maturities are primarily as a result of declines in market interest rates between the two dates. Except as may be required to meet its liquidity requirements, ICH has no current plans over the near-term to liquidate a significant portion of such available for sale fixed maturities to realize such gains. The following table reflects investment writedowns which were included in realized investment gains or losses during each of the three years in the period ending December 31, 1993: The writedowns in fixed maturity investment in 1993 and 1991 were related to noninvestment-grade securities. As a result of reductions in market interest rates and a corresponding increase in mortgage loan refinancings, ICH incurred substantial writedowns related to its residual interests and interest-only CMOs in 1992. As previously discussed, ICH substantially reduced its exposure to such investments and, except for $7.6 million of writedowns taken in conjunction with the adoption of SFAS No. 115 reflected as a cumulative effect of a change in accounting method, there were no similar writeoffs during 1993. Investment real estate writedowns have increased over the three year period as a result of the general deterioration in real estate markets. Because of the factors discussed above, ICH's losses on its mortgage loan portfolio have been nominal during the three year period. The $18.4 million writedown in 1991 related to a reinsurance treaty with Executive Life Insurance Company. Such treaty was terminated in 1992 without further writedowns required. LIQUIDITY AND CAPITAL RESOURCES ICH reduced its reported indebtedness by $75.5 million in 1991, $162.8 million in 1992 and $125.3 million in 1993. Such reductions totaling $363.6 million were effected primarily through ICH's prepayment of $168.4 million of senior secured debt and subordinated debt with proceeds from the sale of Bankers in 1992 and BLHC in 1993, through a $45 million prepayment of senior secured indebtedness in 1992, and through the payment of $146 million of scheduled subordinated debt sinking fund and principal installments. The following table sets forth, for the periods indicated, certain ratio data regarding the operations of ICH and its consolidated subsidiaries. Pro forma ratio data is presented as if the sale of Bankers and ICH's investment in BLHC had occurred as of the beginning of each period presented and is based on the same assumptions utilized in preparing the pro forma results of operations reflected in Note 2 of the Notes to Financial Statements, including elimination of the after-tax gains on the sales of Bankers in 1992 and the Company's investment in BLHC in 1993. Realized investment losses (resulting primarily from writedowns) reduced operating earnings by $119.1 million and $26.4 million for 1992 and 1991, respectively. See "Insurance Operations" following for additional information regarding items of an infrequent and non-recurring nature which have affected ICH's operating results. INSURANCE OPERATIONS The primary sources of liquidity for ICH's insurance subsidiaries include operating cash flows and short-term investments. The net cash provided by operating activities and by policyholder contract deposits of ICH and its subsidiaries, after the payment of policyholder contract withdrawals and benefits, operating expenses, and interest requirements approximated $87.7 million in 1992 and $220.7 million in 1991. In 1993, such operating cash flows resulted in net cash requirements totaling approximately $205.5 million. Exclusive of withdrawals by holders of GICs as discussed below, cash provided by operating activities during 1993 totaled approximately $124.5 million. ICH believes that its short-term investments are readily marketable and can be sold quickly for cash. Cash and short-term investments totaled $366.9 million, or 14% of consolidated investments, at year-end 1993, compared to $421.8 million or 14% at year-end 1992 and $386.5 million or 9% at year-end 1991. The principal requirement for liquidity of ICH's insurance subsidiaries is their contractual obligations to policyholders, including policy loans and payments of benefits and claims. As a result of continued cash flows of its insurance subsidiaries, ICH believes that reserves maintained by such subsidiaries have been adequate to pay policy benefits and claims. Further, policy loans by ICH's subsidiaries have represented 7% or less of ICH's consolidated investment assets during the past three years. As previously discussed, the claims-paying ratings assigned to certain of ICH's subsidiaries by various nationally recognized statistical ratings organizations were lowered during 1992 and 1993. Except for withdrawals made by certain GIC holders, management believes ICH's subsidiaries have not experienced more than normal policy surrenders and withdrawals as a result of these ratings downgrades. For the year ended December 31, 1993, policyholder contract withdrawals, principally GICs, exceeded policyholder contract deposits by approximately $207.4 million. Withdrawals by GIC holders totaled $329.0 million. Approximately $184.3 million of such withdrawals represented scheduled maturities of GICs which were not reinvested with an ICH subsidiary. In addition, as a result of the previously discussed restructuring of ICH's holding company system, the surplus of such subsidiary was significantly reduced and, as a consequence, some policyholders became entitled to an early withdrawal of their GICs. The subsidiary also voluntarily offered certain other GIC holders the right of early withdrawal. Unscheduled and early GIC withdrawals totaled $144.7 million. Because of its available liquidity and readily marketable securities, the subsidiary has not encountered, and management does not anticipate that the subsidiary will encounter, any difficulty in meeting its obligations relative to such withdrawals. The substantial withdrawal of GICs during 1993 is expected to have a positive effect on ICH's future results of operations because the rates of interest being credited to such GICs exceeded the rates ICH's subsidiary was earning on the related invested assets. Certain of ICH's insurance subsidiaries have ceded blocks of insurance to unaffiliated reinsurers to provide funds for financing acquisitions and other purposes. These reinsurance transactions, or so-called "surplus relief reinsurance," represent financing arrangements and, in accordance with generally accepted accounting practices, are not reflected in the accompanying financial statements except for the risk fees paid to or received from reinsurers. Net statutory surplus provided by such treaties before tax effects totaled $51.5 million at December 31, 1993, or approximately 41% less than the $87.5 million of surplus relief at December 31, 1992. These arrangements are expected to terminate over the next several years through the recapture of the ceded blocks of business and such recaptures will result in a charge to the statutory earnings of the recapturing companies. During 1993, a treaty that had provided approximately $22.2 million of surplus relief for an ICH subsidiary as of year-end 1992 was recaptured in conjunction with ICH's restructuring of its insurance holding company system. PARENT COMPANY The primary sources of liquidity for ICH have historically included dividends and loans from its insurance subsidiaries and payments of principal and interest on surplus debentures issued by certain insurance subsidiaries. As previously discussed, in 1993, the sale of ICH's investment in BLHC provided a substantial amount of liquidity for the parent company. The unpaid principal balance of surplus debentures issued to ICH by its insurance subsidiaries totaled $247.6 million at December 31, 1992 and $607.2 million at December 31, 1991. Of the 1992 amount, surplus debentures in the aggregate unpaid principal amount of $141.8 million was payable by Southwestern and $105.8 million was payable by Modern American. In 1993, Southwestern repaid the remaining balance on its surplus debenture utilizing proceeds from its 1992 sale of Bankers. In the restructuring of ICH's insurance holding company system in 1993, the surplus debenture from Modern American was retired and added to ICH's investment in its subsidiaries. At December 31, 1993, there were no remaining surplus debentures due ICH by its subsidiaries. State insurance laws generally restrict the ability of insurance companies to make loans to affiliates or to pay cash dividends in excess of the greater of such companies' net gains from operations during the preceding year or 10% of their policyholder surplus determined in accordance with accounting practices prescribed by such states. These regulatory restrictions historically have not affected the ability of ICH to meet its liquidity requirements. However, certain states in which ICH's subsidiaries are domiciled, including New York and Kentucky, have adopted laws that have restricted the payment of cash dividends to the lesser of such companies' net gains from operations or 10% of their policyholder surplus. Other states may consider similar legislation in future periods or may consider legislation that would base the level of cash dividends which may be paid to the maintenance of specified risk-based capital levels. The adoption of such laws could significantly reduce the level of cash dividends that could be paid without regulatory approval. ICH received cash dividends from Modern American totaling $149 million in 1991, but received no cash dividends from its insurance subsidiaries in either 1993 or 1992. In 1992, Modern American agreed with the Missouri Department of Insurance that it would not pay any dividends without obtaining the prior approval from the Missouri Department and, in 1993, Southwestern agreed with the Texas Department that it would not pay any dividend without giving it thirty days prior notice. The restructuring of ICH's insurance holding company system in 1993 substantially reduced the size of Modern American and it no longer holds title to the common stock of any of ICH's insurance subsidiaries. Therefore, the restrictions on Modern American's ability to pay dividends are not expected to have a significant affect on future dividends to ICH from ICH's subsidiaries. In addition, as a result of the restructuring, all of ICH's insurance subsidiaries, other than Constitution Life Insurance Company and Bankers Life and Casualty Company of New York, are aligned horizontally beneath ICH and, as a consequence, are expected to be able to make direct payments of dividends to ICH in future periods. Prior to 1992, ICH had issued demand and collateralized notes to certain of its subsidiaries in order to meet short-term liquidity requirements. At December 31, 1991, ICH's obligations to its subsidiaries under such notes, including accrued interest thereon, totaled $47.6 million. Although management believed such loans met the investment criteria of the various states, during 1993 and 1992 ICH repaid all of such obligations to its subsidiaries. ICH does not intend to utilize such borrowings in future periods. ICH's principal needs for liquidity are debt service and, to a lesser extent, preferred dividend requirements. ICH's consolidated indebtedness totaled approximately $418.0 million at December 31, 1993, compared to $543.3 million at December 31, 1992, and $706.1 million at December 31, 1991. Substantially all indebtedness of ICH was incurred in the connection with acquisitions of subsidiaries in periods prior to 1987, including collateralized senior debt and unsecured subordinated debt, a portion of which was exchanged for new debt in 1993. See Note 3 of the Notes to Financial Statements for additional information regarding ICH's consolidated indebtedness, including annual maturities. Primarily as a result of the sale for cash of ICH's interest in BLHC in 1993, ICH believes that it has adequate resources to meet its existing commitments, including preferred stock dividends, for all of 1994. The following table reflects ICH's cash sources and requirements on a projected basis for 1994 and on an actual basis for 1993. Cash available at the end of 1993 includes approximately $60.3 million of readily marketable fixed maturity investments which were acquired for the purpose of obtaining higher yields than could be achieved through holdings in short-term investments. The 1994 projected cash requirements assume no sinking fund payments relative to ICH's Old Notes. See "Changes in Capital Structure" for a discussion of ICH's options relative to sinking fund requirements in 1994. In addition, the 1994 projections assume that the CFLIC transactions with ICH will be effected during the 1994 second quarter, including the redemption of CFLIC's preferred stock by the return to ICH of its $30 million senior secured loan and ICH's Series 1986-A and Series 1987-B preferred stocks. See "Transactions With Consolidated Fidelity Life Insurance Company." As a result of the acquisition and retirement of ICH's Class B Common Stock in early 1994, management now believes that ICH has improved its ability to refinance its presently outstanding debt at substantially reduced interest rates. Such a refinancing is, of course, dependent on numerous factors, such as an improvement in the ratings assigned by nationally recognized statistical rating organizations, market interest rates, a successful underwriting, and other factors. ICH intends to monitor these factors closely over the next several months to determine whether such a refinancing is possible. There can be no assurance that ICH will, in fact, attempt to restructure its presently outstanding debt; however, in the event that it does, the 1994 projected cash sources and requirements as reflected above could materially change. ICH's actual cash sources in 1993 were approximately $295.6 million more than were previously projected for 1993, substantially all of which were attributable to ICH's sale of its investment in BLHC for $287.6 million. Actual cash requirements in 1993 exceeded projected requirements by approximately $174.3 million. Significant items that were not included in the 1993 projections and that accounted for a substantial portion of the increase in cash requirements include ICH's redemption of $100 million of its outstanding preferred stock, an additional $45.9 million redemption of its Debentures, and intercompany income tax allocation payments to ICH's insurance subsidiaries totaling $15.0 million. The increase in tax allocation payments was a result of the BLHC transaction which resulted in a taxable gain and reimbursement to ICH's subsidiaries for utilization by ICH of their tax loss carryforwards. Primarily as a result of the increase in cash sources, which was not completely offset by an increase in cash requirements, available cash and marketable securities at the end of 1993 was approximately $121.3 million more than originally projected. RESULTS OF OPERATIONS ICH's results in 1993 and 1992 have been affected by numerous items of an infrequent and non-recurring nature. In 1993, ICH realized significant gains on the sale of its investment in BLHC, other invested assets, and the termination of a reinsurance arrangement with Bankers, and realized a benefit from the change in corporate income tax rates. In addition, significant writedowns of certain capitalized costs and operating facilities were taken in connection with the continuation of an operational consolidation and provisions were made for the costs associated with agreements entered into with ICH's former controlling shareholders and certain other contingencies. In 1992, ICH realized a gain on the sale of Bankers, which was offset by charges for significant losses on the portfolio of CMO residual interests and IOs, a litigation settlement, costs incurred to modify a data processing services arrangement, and costs incurred or accrued relative to an operational consolidation. The following table reflects the results of ICH's basic operations from 1991 through 1993 and the effects that the above described charges and credits had on ICH's operating results for each of the three years. The decline in pre-tax operating earnings from $59.6 million in 1991 to $47.7 million in 1992 was attributable, in part, to including Bankers' results for only the first ten months of 1992 compared to the full year in 1991. ICH was unable to effectively redeploy the proceeds from the sale of Bankers during the last two months of 1992 to replace the reduction in operating earnings resulting from such sale. In addition, a reduction in yields on invested assets between 1991 and 1992 contributed to a narrowing of the spreads between earnings on invested assets and interest credited to policyholders' accounts or required to meet policyholder obligations and further contributed to the reduction in operating earnings. The decline in the pre-tax operating earnings of $47.7 million to a pre-tax operating loss of $6.6 million in 1993 reflects, in part, the exclusion of Bankers' results for all of 1993. ICH did reflect its equity in the operating results of BLHC for the first nine months of 1993 totaling $29.1 million. However, ICH was still unable in 1993 to redeploy proceeds from the sale to fully replace the earnings of Bankers. Following the sale of its interest in BLHC in September 1993, ICH has methodically proceeded to utilize its available liquidity to further reduce the costs of its capital structure, but during the interim period has had to maintain larger than desirable amounts invested in lower-yielding short-term investments. In addition, interest spreads relative to ICH's insurance operations further narrowed in 1993 resulting in reduced operating earnings, and ICH incurred sizeable losses in its group health operations. ANALYSIS OF OPERATING RESULTS BY INDUSTRY SEGMENT ICH's major industry segments consist of individual life insurance, individual health insurance, group and other insurance, accumulation products, and corporate (including surplus investment). The following table sets forth the consolidated revenues, expenses, pre-tax operating earnings and product sales attributed or allocated to each industry segment. "Pre-tax operating earnings (loss)" reflected in the table represent ICH's consolidated operating earnings or loss before realized investment gains or losses, corporate interest expense, amortization of excess cost, provision for income taxes, the cumulative effect of accounting changes, and extraordinary gains and losses. See Note 17 of the Notes to Financial Statements and Schedule V of the Financial Statement Schedules for additional information regarding ICH's segment results. INDIVIDUAL LIFE. Revenues of the individual life insurance segment accounted for approximately 37.8% of consolidated revenues excluding corporate revenues and realized investment gains and losses in 1993, as compared to 20% in 1992 and 21% in 1991. Such increase in 1993 is directly attributable to the sale of Bankers in 1992. Bankers revenues had been derived predominantly from sales of individual health insurance products and, as a result of the sale, the relative proportion of ICH's revenues attributable to the individual life insurance segment increased significantly. Most individual life insurance sales over the last three years were of universal and interest-sensitive life insurance products, although several new traditional whole life products were introduced into the marketplace during 1993. Exclusive of sales by Bankers, individual life sales have declined from $21.0 million in 1991 to $14.0 million in 1992 to $13.1 million in 1993. Management believes these declines are attributable to the downgrade in the claims-paying rating of ICH's most significant life insurance subsidiary, Southwestern, and to slow market acceptance of several new products introduced during 1991. However, as a result of changes in marketing strategies to target sales in the senior citizen marketplace and the new products introduced in 1993, sales of individual life insurance products increased significantly in the latter half of 1993, exceeding sales during the comparable period in 1992. Pre-tax operating earnings of the individual life insurance segment decreased from $80.0 million in 1991 to $42.5 million in 1992, but increased to $45.1 million in 1993. Included in pre-tax operating earnings in 1993 was a non-recurring gain on the termination of a reinsurance arrangement between an ICH subsidiary and Bankers totaling $22.6 million. Excluding such gain, pre-tax operating earnings in 1993 totaled $22.5 million. Bankers derived substantial profits from its individual life insurance business and the sale of Bankers accounts for a significant portion of the decline in pre-tax operating earnings of this segment. Declining market interest rates and the reduced yields earned by ICH on its investment portfolio have also contributed to the decline in the operating profits of this segment. Over one-half of ICH's life insurance reserves represent reserves on traditional life insurance products having fixed contractual interest rates. Consequently, declining investment yields have resulted in significantly reduced profit margins on the traditional block of business. Remaining life insurance reserves consist primarily of reserves on interest-sensitive products and credited rates on such policies have been and are continuing to be reduced to correspond with the decline in yields on investments. Management expects to continue to emphasize growth in its individual life insurance segment and, barring a further decline in investment yields, believes the changes made in its marketing strategies and the introduction of new products in 1993 will result in increased sales of individual life insurance products and an improvement in the operating results of this segment in 1994. INDIVIDUAL HEALTH. Sales and revenues in the individual health segment declined significantly in 1993 as a result of the sale of Bankers. Individual health premiums earned by Bankers represented approximately 74.8% of total individual health premiums in 1992 and 75.7% in 1991. The individual health premiums earned in 1993 and the remaining premiums earned in each of 1992 and 1991 were primarily attributable to Union Bankers Insurance Company ("Union Bankers") and Bankers Multiple Line Insurance Company ("Bankers Multiple"), former Bankers subsidiaries which were retained by ICH when Bankers was sold. Union Bankers has emphasized the sale of Medicare supplement products through brokerage agencies. Bankers Multiple specializes in the sale of comprehensive health products through a large general agency. Another ICH subsidiary, Integrity National Life Insurance Company, sells individual health insurance products, primarily Medicare supplement business, in the home service market. Exclusive of Bankers in 1992, new sales of individual health products increased from $60.3 million in 1992 to $63.6 million in 1993 and premiums earned increased from $216.2 million in 1992 to $220.3 million in 1993. The ratio of policy benefits to premiums earned (exclusive of Bankers) declined from 68.4% in 1992 to 62.3% in 1993, resulting in an approximately $15.0 million improvement in the gross operating margins of ICH's insurance subsidiaries. Management expects to continue to emphasize growth in the individual health segment, primarily in the senior citizens market through the sales of Medicare supplement and long-term care, or nursing home, products. GROUP AND OTHER INSURANCE. New sales of group life and health insurance increased from $47.3 million in 1991 to $61.9 million in 1992, but declined to $41.2 million in 1993. All sales of new group business in 1993 were made by Philadelphia American Life Insurance Company ("Philadelphia American"), as were substantially all new sales in 1992. Several large group health cases were added at the end of 1992, increasing the volume of new 1992 sales; however, primarily as a result of competitive factors, Philadelphia American purposely did not attempt to achieve the same level of new sales during 1993. In addition to revenues from sales of group insurance products, Philadelphia American derives substantial revenues from administrative services only ("ASO") contracts whereby it process claims for non-affiliated groups without assuming underwriting risks. Bankers Multiple also underwrites a profitable real estate agents errors and omissions product, the results of which are included in the group and other insurance segment. While sales of new group business declined during 1993 as compared to 1992, earned premiums of this segment (excluding Bankers) increased from $103.8 million in 1992 to $136.5 million in 1993 as a result of sales in 1992. The related ratio of policy benefits to earned premiums of the group segment increased dramatically from 62.9% in 1992 to 74.8% in 1993 and contributed to a pre-tax operating loss of $12.9 million in 1993, as compared to pre-tax operating earnings of $5.1 million in 1992. During the last half of 1993, Philadelphia American encountered an unexpected increase in claim costs driven by an upswing in the utilization and cost of physician services and several large individual claims covered under group plans. Additionally, in the course of evaluating Philadelphia American's results for the fourth quarter of 1993, management determined that errors had been made in the second and third quarters of 1993 in accounting for certain reinsurance activities and had resulted in an approximate $7.4 million overstatement of Philadelphia American's pre-tax operating earnings for such periods. These errors contributed to an inadequate assessment of the need for premium rate increases on certain of Philadelphia American's group health cases, which, in turn, contributed to the adverse claims experience on these cases which continued into the 1993 fourth quarter. Management has taken several actions which are expected to rapidly reduce losses and return this segment to profitability in 1994. These actions include 1) terminating several large, but unprofitable group cases at or near the end of 1993, 2) identifying several additional group cases which will not be renewed during the first six months of 1994, and 3) implementing substantial rate increases to restore profitability to its remaining group business. In addition, internal controls at Philadelphia American have been strengthened and personnel changes have been made to prevent a future reoccurrence of accounting errors in reported results. Because of uncertainties regarding the potential impact of currently proposed national health care reforms, management does not believe that it would be prudent to presently invest additional capital resources to grow the group segment of its business. However, Philadelphia American intends to actively pursue new ASO business to more fully utilize its present claims processing capabilities without incurring additional underwriting risks. ACCUMULATION PRODUCTS. Sales of accumulation products, primarily GICs, declined significantly in 1993 as compared to prior periods. In 1993, new GIC sales totaled $5.3 million, as compared to $292.1 million in 1992. Such decline in GIC sales was offset, in part, by an increase in new annuity sales. ICH's subsidiaries produced $84.6 of annuity sales, principally single premium deferred annuities, in the accumulation segment in 1993, as compared to $27.2 million in 1992 (excluding Bankers). The substantial decline in GIC sales was directly attributable to a downgrade in the claims-paying ratings assigned to an ICH subsidiary as previously discussed. As a result of these ratings downgrades, ICH's subsidiaries redirected their marketing efforts in 1993 to sales of annuities in the less ratings-sensitive individual marketplace. The accumulation products segment reflected a pre-tax operating loss of $6.7 million in 1993, as compared to a slight profit in 1992. The loss was primarily attributable to the decline in yields earned on invested assets during 1993. Substantially all of the $329.0 million in GIC liabilities which were withdrawn in 1993 bore interest at guaranteed fixed rates which, in many cases, exceeded rates being earned on the related invested assets. At year-end 1993, approximately 75% of the remaining $377.7 million in GIC liabilities bear interest at floating rates and a substantial portion of the remaining fixed rated liabilities are expected to be withdrawn in 1994. As a consequence, and barring a further decline in investment yields, management anticipates that the accumulation segment will realize a return to profitability in 1994. Because of its present claims-paying ratings, ICH's insurance subsidiaries have effectively withdrawn from the GIC marketplace. Management expects to continue to emphasize sales of new annuities. CORPORATE. Revenues allocated to the corporate segment include investment income on the capital and surplus of ICH's insurance subsidiaries. In addition, such revenues also include gains on the sale of ICH's investment in BLHC in 1993 and its investment in Bankers in 1992. Historically, ICH has allocated all corporate overhead expenses to the various operating segments. In 1993, $45.6 million in expenses were allocated to the corporate segment, including $23.9 million in writeoffs of capitalized data processing costs and certain home office real estate, a $9.0 million provision for services agreements entered into with ICH's former controlling shareholders, an $9.3 million provision for anticipated costs of litigation and other contingencies, and $4.4 million of expenses associated with the restructuring of ICH's collateralized mortgage note obligation. In 1992, $41.5 million of expenses were allocated to this segment, including an $18.0 million litigation settlement, $12.6 million of costs associated with modifying its data processing servicing arrangements with Perot Systems, and $10.9 million in costs related to a planned operational consolidation of three of ICH's Texas-based insurance subsidiaries. INTEREST EXPENSE AND PREFERRED DIVIDEND REQUIREMENTS ICH's consolidated interest expense totaled $66.2 million in 1993, $79.0 million in 1992 and $98.6 million in 1991. The reductions in interest expense were primarily as a result of the principal reductions in ICH's long-term indebtedness made during the periods as previously discussed under "Liquidity and Capital Resources." The reductions in interest expense in 1993 and 1992 were offset, in part, by the interest expense incurred relative to collateralized mortgage note obligations totaling $6.0 million in 1993 and $2.3 million in 1992. The collateralized mortgage note obligations were initially incurred in conjunction with the sale of Bankers in 1992. As a result of the transactions entered into in July 1993 to reduce ICH's exposure to prepayment risks on certain mortgage-backed securities (see "Investment Portfolio"), the accounts of a special-purpose trust, which included the collateralized mortgage note obligations and the related interest expense, are no longer included in ICH's consolidated balance sheet or statement of earnings after July 30, 1993. Preferred dividend requirements totaled $28.8 million in 1993 and $30.8 million in each of 1992 and 1991. As the result of the redemption of $100 million stated value of ICH's preferred stocks in 1993, preferred dividend requirements are expected to be reduced to approximately $17.3 million in 1994. Assuming the completion of the transactions with CFLIC by March 31, 1994, as previously discussed under "Transactions With Consolidated Fidelity Life Insurance Company," ICH's preferred dividend requirements in 1994 would be reduced by an additional $2.5 million. INCOME TAX PROVISIONS AND DEFERRED INCOME TAX ASSETS In 1993, income tax expense represented approximately 31% of consolidated operating earnings before income taxes, or 4% less than the expected corporate income tax rate. During 1993, the corporate income tax rate was increased from 34% to 35%, retroactive to January 1, 1993. The effect of such rate increase on ICH's deferred income tax asset as of the beginning of 1993, a benefit totaling $3.5 million, has been included in the 1993 income tax provision. Other significant items affecting the 1993 effective income tax rate included a reduction in the valuation allowance for ICH's deferred income tax asset based on the utilization of available loss carryforwards to offset income taxes otherwise payable as a result of the BLHC sale and other investment gains and the utilization of capital loss carryforwards which had previously not been reflected for financial reporting purposes. In 1992, ICH reported an income tax credit totaling $69.2 million on a consolidated operating loss before income taxes of $18.4 million. This unusual relationship was primarily attributable to the significant tax basis gain on the sale of Bankers and a reduction in the Company's valuation allowance for its deferred tax asset as a result of utilizing available capital loss carryforwards to reduce taxes otherwise payable as a result of such gain. In 1991, income tax expense represented 24% of consolidated operating earnings before income taxes. The effective rate was approximately 10% lower than the expected rate, substantially all of which was attributable to a reduction in the deferred tax asset valuation allowance based on tax planning strategies for the utilization of a portion of ICH's capital loss carryforwards. See Note 13 of the Notes to Financial Statements for an analysis of the various components affecting ICH's income tax provisions. At December 31, 1993 and 1992, ICH reported deferred income tax assets totaling $53.0 million and $121.0 million, respectively. The substantial reduction in the deferred income tax asset between the periods is primarily as a result of the tax effects associated with the gains realized in 1993 from the sales of ICH's interest in BLHC and other capital gains. The tax assets were comprised of the tax benefit (cost) associated with the following types of temporary differences based on the respective 35% and 34% tax rates in effect at the end of 1993 and 1992: Operating and capital loss carryforwards have significantly different characteristics as to expiration dates and their usability. For federal income tax purposes, operating losses may be carried forward for a maximum of fifteen years from the year they are incurred; capital losses may be carried forward for a maximum of five years. In addition, ordinary loss carryforwards may be utilized to offset ordinary income or capital gains, whereas capital loss carryforwards can only be utilized to offset capital gains. As a consequence, taxpayers have substantially more flexibility in being able to utilize operating loss carryforwards than capital loss carryforwards. For federal income tax purposes, at December 31, 1993, ICH's subsidiaries had $39.0 million of ordinary loss carryforwards expiring in 2005 and $14.9 million of capital loss carryforwards expiring in 1998. Management has periodically assessed the ability of ICH's insurance subsidiaries to produce taxable income in future periods sufficient to fully utilize their operating book/tax temporary differences and tax loss carryforwards. These assessments have included actuarial projections under alternative scenarios of future profits on the existing insurance in force of ICH's insurance subsidiaries, including provisions for adverse deviation, adjusted to reflect ICH's anticipated debt service costs. While management believes that there will be sufficient future taxable income to realize substantially all of the benefit of ICH's remaining temporary differences, valuation allowances totaling $16.3 million and $24.2 million were provided against ICH's deferred tax assets at December 31, 1993 and 1992, respectively, to reflect the uncertainties of realizing all of the benefits of available tax loss carryforwards. Alternative minimum tax ("AMT") credit carryforwards result from the acceleration of income taxes under certain circumstances and can be carried forward for an indefinite period. The $13.9 million and $11.7 million component of ICH's deferred income tax assets at December 31, 1993 and 1992, respectively, represents taxes incurred under AMT provisions which are expected to be recovered through reduced income tax payments over the next several years. CUMULATIVE EFFECT OF ACCOUNTING CHANGES Effective January 1, 1993, ICH adopted SFAS No. 106, "Employers' Accounting for Postretirement Benefits Other than Pensions," and incurred a charge for the cumulative effect of the adoption of the accounting change as of that date totaling $1.8 million, after tax effects. In addition, effective December 31, 1993, ICH adopted SFAS No. 115, "Accounting for Certain Investments in Debt and Equity Securities" and incurred a charge for the cumulative effect of the adoption of the accounting change as of that date totaling $4.9 million, after tax effects. Effective January 1, 1991, ICH adopted SFAS No. 109, "Accounting for Income Taxes," and the benefit of the cumulative effect of the adoption of the accounting change as of that date totaled $8.8 million. EXTRAORDINARY LOSSES For the years 1993 and 1992, ICH incurred extraordinary losses, net of tax effects, totaling $1.9 million and $4.3 million, respectively. The extraordinary losses in both periods were related to early extinguishment of debt. See Note 15 of the Notes to Financial Statements for an analysis of the components of such losses. IMPACT OF INFLATION Medical cost inflation has had a significant impact on the individual health and group health lines of business. Benefit costs have continued to increase in recent years in excess of the Consumer Price Index and will likely continue. This impact, however, has been substantially offset by increases in premium rates. Management does not believe that inflation has otherwise had a significant impact on its results of operations over the past three years. KNOWN TRENDS AND UNCERTAINTIES WHICH MAY AFFECT FUTURE RESULTS PROPOSED HEALTH CARE REFORM President Clinton has targeted health care reform as a top domestic priority of his administration, and has proposed to Congress legislation, the American Health Security Act, that would significantly change the manner in which the entire health care industry operates. The reform legislation proposed by the Clinton administration would ultimately guarantee universal access to health care coverage and create purchasing alliances for government established health care plans. Alternative legislative proposals that have been developed to reform the health care system have goals ranging from universal access to health care coverage through managed competition to health care cost containment through, among other things, health insurance reform. ICH currently cannot predict what impact health care reform proposals will have on the health insurance industry, whether any health insurance measures will be adopted in the foreseeable future or, if adopted, whether such reform proposals or measures will have a material effect on its operations. FEDERAL INCOME TAX AUDIT ISSUES See Note 12 of the Notes to Financial Statement for a discussion of potential income tax audit issues. ITEM 8.

ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA. AND FINANCIAL STATEMENT SCHEDULES OF I.C.H. CORPORATION AND SUBSIDIARIES (ITEMS 8, 14(A), AND 14(C)) FINANCIAL STATEMENTS FINANCIAL STATEMENT SCHEDULES All other schedules for which provision is made in the applicable accounting regulations of the Securities and Exchange Commission are not required under the related instructions or are inapplicable and therefore have been omitted or the information is presented in the consolidated financial statements or related notes. REPORT OF INDEPENDENT ACCOUNTANTS To the Board of Directors and Stockholders I.C.H. Corporation We have audited the consolidated financial statements and financial statement schedules of I.C.H. Corporation and Subsidiaries as listed in the index on page 47 of this Form 10-K. These financial statements and financial statement schedules are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements and financial statement schedules based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of I.C.H. Corporation and Subsidiaries as of December 31, 1993 and 1992, and the consolidated results of their operations and their cash flows for each of the three years in the period ended December 31, 1993, in conformity with generally accepted accounting principles. In addition, in our opinion, the financial statement schedules referred to above, when considered in relation to the basic financial statements taken as a whole, present fairly, in all material respects, the information required to be included therein. As more fully described in Notes 14 and 5 to these consolidated financial statements, effective January 1, 1993 and December 31, 1993, the Company adopted Statements of Financial Accounting Standards No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions" and No. 115, "Accounting for Certain Investments in Debt and Equity Securities," respectively. COOPERS & LYBRAND Dallas, Texas March 14, 1994 I.C.H. CORPORATION AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS DECEMBER 31, 1993 AND 1992 (IN THOUSANDS) ASSETS The accompanying notes are an integral part of the financial statements. I.C.H. CORPORATION AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF EARNINGS FOR THE YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 (IN THOUSANDS, EXCEPT PER SHARE DATA) The accompanying notes are an integral part of the financial statements. I.C.H. CORPORATION AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY FOR THE YEARS ENDED DECEMBER 31, 1993, 1992, AND 1991 (IN THOUSANDS) The accompanying notes are an integral part of the financial statements. I.C.H. CORPORATION AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS FOR THE YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 (IN THOUSANDS) The accompanying notes are an integral part of the financial statements. I.C.H. CORPORATION AND SUBSIDIARIES NOTES TO FINANCIAL STATEMENTS 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (A) BASIS OF PRESENTATION The consolidated financial statements include the accounts of I.C.H. Corporation (Company) and its wholly-owned and majority-owned subsidiaries from date of acquisition or through date of divestiture. All significant intercompany accounts and transactions have been eliminated in consolidation. Previously reported amounts for 1992 and 1991 have in some instances been reclassified to conform to the 1993 presentation. See Note 2 for 1993 and 1992 organization changes. The Company's insurance subsidiaries maintain their accounts in conformity with accounting practices prescribed or permitted by state insurance regulatory authorities. In the accompanying financial statements such accounts have been adjusted to conform with generally accepted accounting principles (GAAP). (B) INVESTMENTS Fixed maturity investments include bonds and preferred stocks with mandatory redemption features. The Company classifies all fixed maturity investments into two categories as follows: - Available for sale securities, representing securities that are readily marketable and that may be sold prior to maturity due to changes that might occur in market interest rate risks, changes in the security's prepayment risk, the Company's management of its income tax position, its general liquidity needs, increases in loan demand, the need to increase regulatory capital, changes in foreign currency risk, or similar factors. Available for sale securities are carried at fair value. - Held to maturity securities, representing securities such as private placements which are not readily marketable and which the Company has the ability and positive intent to hold to maturity. Held to maturity securities are carried at amortized cost. The Company may dispose of such securities under certain unforeseen circumstances, such as issuer credit deterioration or regulatory requirements. Fixed maturity investments and related futures contracts which are denominated in or linked to foreign currencies are revalued to reflect changes in the exchange rate as of the balance sheet date. Anticipated prepayments on mortgage-backed securities are taken into consideration in determining estimated future yields on such securities. Equity securities include investments in common stocks and non-redeemable preferred stocks and are carried at fair value. Policy loans and collateral loans are stated at their current unpaid principal balance, net of unamortized discount and related liabilities for which the Company has the right to offset. Short-term investments include commercial paper, invested cash and other investments purchased with maturities generally less than three months and are carried at amortized cost. The Company considers all short-term investments to be cash equivalents. Mortgage loans are stated at the aggregate unpaid principal balances, less unamortized discount. Fees received and costs incurred with origination of mortgage loans are deferred and amortized as yield adjustments over the remaining lives of the mortgages. Real estate, substantially all of which was acquired through foreclosure, is recorded at the lower of fair value minus estimated costs to sell or cost. If the fair value of the foreclosed real estate minus estimated costs to sell is less than cost, a valuation allowance is provided for the deficiency. Increases or decreases in the valuation allowance are charged or credited to income. Investments in limited partnerships and 20% to 50% interests in the common stocks of other entities, whose affairs are not controlled by the Company (equity investees), are reflected on the I.C.H. CORPORATION AND SUBSIDIARIES NOTES TO FINANCIAL STATEMENTS--(CONTINUED) 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED) equity method, or at cost, adjusted for the Company's share, after allowance for possible dilution, of the undistributed earnings and losses (both realized and unrealized) since acquisition. At December 31, 1992 the carrying value of the Company's residual ownership interest in a divested subsidiary had been adjusted for (i) the excess of the sales proceeds received over (ii) the Company's basis in the 39.9% interest in the divested subsidiary retained by the Company. A portion of such excess of sales proceeds over the Company's basis was being amortized into earnings on a straight-line basis over ten years. The Company regularly evaluates investments based on current economic conditions, past credit loss experience and other circumstances. A decline in net realizable value that is other than temporary is recognized as a realized investment loss and a reduction in the cost basis of the investment. The Company discounts expected cash flow in the computation of net realizable value of its investments, other than certain mortgage-backed securities. In those circumstances where the expected cash flows of residual interest and interest-only mortgage-backed securities, discounted at a risk-free rate of return, result in an amount less than the carrying value, a realized loss is reflected in an amount sufficient to adjust the carrying value of a given security to its fair value. Net realized investment gains and losses, including gains and losses on foreign currency transactions and held for sale securities, are included in the determination of net earnings. Unrealized investment gains and losses on available for sale securities and marketable equity securities are charged or credited directly to stockholders' equity. The specific identification method is used to account for the disposition of investments. (C) DUE FROM REINSURERS At December 31, 1993, amounts recoverable from reinsurers, including amounts equal to the assets supporting insurance liabilities ceded to reinsurers and amounts due for the reimbursement of related benefit payments, are reflected as receivables due from reinsurers. Amounts due from reinsurers are evaluated as to their collectibility and, if appropriate, reserves for doubtful collectibility are established through a charge to earnings. (D) EXCESS COST OF INVESTMENT IN SUBSIDIARIES OVER NET ASSETS ACQUIRED The excess cost of investments in subsidiaries over net assets acquired is being amortized on the straight-line basis over a 40-year period. The Company periodically assesses the recoverability of its excess cost through an actuarial projection of undiscounted future earnings of the Company's insurance subsidiaries (excluding excess cost amortization) over the remaining life of such excess cost. Such projections are prepared under various interest rate scenarios, with anticipated levels of new business production for only a five-year period. (E) DEFERRED POLICY ACQUISITION COSTS AND PRESENT VALUE OF FUTURE PROFITS OF ACQUIRED BUSINESS Costs which vary with and are related to the acquisition of new business have been deferred to the extent that such costs are deemed recoverable through future revenues. These costs include commissions, certain costs of policy issuance and underwriting and certain variable agency expenses. For traditional life and health products deferred costs are amortized with interest over the premium paying period in proportion to the ratio of anticipated annual premium revenue to the anticipated total premium revenue. Deferred policy acquisition costs related to universal life, interest-sensitive and investment products are amortized in relation to the present value, using the assumed crediting rate, of expected gross profits on the products, and retrospective adjustments of these amounts are made whenever the Company revises its estimates of current or future gross profits to be realized from a group of policies. I.C.H. CORPORATION AND SUBSIDIARIES NOTES TO FINANCIAL STATEMENTS--(CONTINUED) 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED) The present value of future profits on business in force of acquired subsidiaries represents the portion of the cost to acquire such subsidiaries that is allocated to the value of the right to receive future cash flows from insurance contracts existing at the dates of acquisitions. Such value is the actuarially determined present value of the future cash flows from the acquired policies, based on projections of future premium collection, mortality, morbidity, surrenders, operating expenses, investment yields, and other factors. The account is amortized with interest over the estimated remaining life of the acquired policies. Recoverability of deferred policy acquisition costs and the present value of future profits of acquired business is evaluated annually by comparing the current estimate of discounted expected future cash flows to the unamortized asset balance by line of insurance business. If such current estimate indicates that the existing insurance liabilities, together with the present value of future cash flows from the business, will not be sufficient to recover the unamortized asset balance, the difference is charged to expense. Amortization is adjusted in future years to reflect the revised estimate of future profits. Anticipated returns, including realized and unrealized gains and losses, from the investment of policyholder balances are considered in determining the amortization of deferred policy acquisition costs. When fixed maturities are stated at their fair value, an adjustment is made to deferred policy acquisition costs and unearned revenue reserves equal to the changes in amortization that would have been recorded if those fixed maturities had been sold at their fair value and the proceeds reinvested at current yields. Furthermore, if future yields expected to be earned on fixed maturities decline, it may be necessary to increase certain insurance liabilities. Adjustments to such liabilities are required when their balances, in addition to future net cash flows including investment income, are insufficient to cover future benefits and expenses. (F) SEPARATE ACCOUNTS Separate accounts represent segregated assets whose values directly determine the amounts of the liabilities for variable products and separate account pension deposits. The insurance company does not have an investment risk with these assets and liabilities. The risk lies solely with the holder of the contract. (G) FUTURE POLICY BENEFITS The liability for future policy benefits of long duration contracts has been computed by the net level premium method based on estimated future investment yield, mortality, morbidity and withdrawal experience. Reserve interest assumptions are graded and range from 6% to 10%. Mortality, morbidity and withdrawal assumptions reflect the experience of the life insurance subsidiaries modified as necessary to reflect anticipated trends and to include provisions for possible unfavorable deviations. The assumptions vary by plan, year of issue and duration. The future policy benefit reserves include a provision for policyholder dividends based upon dividend scales assumed at the date of purchase of acquired companies or as presently contemplated. (H) POLICY AND CONTRACT CLAIMS Policy and contract claims include provisions for reported claims in process of settlement, valued in accordance with the terms of the related policies and contracts, as well as provisions for claims incurred and unreported based on prior experience of the Company. I.C.H. CORPORATION AND SUBSIDIARIES NOTES TO FINANCIAL STATEMENTS--(CONTINUED) 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED) (I) UNIVERSAL LIFE AND INVESTMENT CONTRACT LIABILITIES Benefit reserves for universal life, interest-sensitive and investment products are determined following the retrospective deposit method and consist principally of policy account values before any surrender charges, plus certain deferred policy fees which are amortized using the same assumptions and factors used to amortize deferred policy acquisition costs. (J) INCOME TAXES Deferred income taxes are recorded to reflect the tax consequences on future years of differences between the tax bases of assets and liabilities and their financial reporting amounts at each year-end. Excess cost of investment in subsidiaries over net assets acquired is reduced for the tax benefits obtained from the utilization of an acquired company's tax deductions. (K) RECOGNITION OF PREMIUM REVENUE AND RELATED EXPENSES Premium revenue for traditional life insurance products is reported as earned when due. Accident and health premiums are earned over the period for which premiums are paid. Benefits and expenses are associated with earned premiums so as to result in recognition of profits over the premium paying period. This association is accomplished by means of a provision for future policy benefit reserves and the amortization of deferred policy acquisition costs. (L) PARTICIPATING POLICIES Participating life insurance policies represent approximately 1% and 4% of the total individual life insurance in force at December 31, 1993 and 1992, respectively. The amount of dividends to be paid is determined annually by the boards of directors of the life insurance subsidiaries. A portion of the earnings of the Company is allocated to the participating policyholders and included in other policyholder funds. (M) FAIR VALUES OF FINANCIAL INSTRUMENTS The following methods and assumptions were used by the Company in estimating its fair value disclosures for financial instruments: CASH AND SHORT-TERM INVESTMENTS: The carrying amounts reported in the balance sheet for these instruments approximate their fair values. INVESTMENT SECURITIES: Fair values for fixed maturity securities (including mandatorily redeemable preferred stocks) are based on quoted market prices, where available. For fixed maturity securities not actively traded, fair values are estimated using values obtained from independent pricing services or are estimated based on expected future cash flows using a current market rate applicable to the yield, credit quality, and maturity of the investments. The fair values for equity securities are based on quoted market prices and are recognized in the balance sheet. MORTGAGE AND COLLATERAL LOANS: The fair values for mortgage and collateral loans are estimated using discounted cash flow analyses, based on interest rates currently being offered for similar loans to borrowers with similar credit ratings. Loans with similar characteristics are aggregated for purposes of the calculations. POLICY LOANS: The Company does not believe an estimate of the fair value of policy loans can be made without incurring excessive cost. Policy loans have no stated maturities and are usually repaid by reductions to benefits and surrenders. Because of the numerous assumptions which would have to be made to estimate fair value, the Company further believes that such information would not be meaningful. I.C.H. CORPORATION AND SUBSIDIARIES NOTES TO FINANCIAL STATEMENTS--(CONTINUED) 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED) INVESTMENTS IN LIMITED PARTNERSHIPS: Fair values for the Company's investments in limited partnerships are based on the estimated fair values of the partnership assets and liabilities, assuming a liquidation of the partnership and distribution of proceeds to the partners. OFF-BALANCE-SHEET INSTRUMENTS: Fair values for the Company's off-balance-sheet interest rate swaps are based on formulas using current assumptions. INVESTMENT CONTRACTS: Fair values for the Company's liabilities under investment-type insurance contracts are estimated using discounted cash flow calculations, based on interest rates currently being offered for similar contracts with maturities consistent with those remaining for the contracts being valued. NOTES PAYABLE: The fair value of the Company's long-term debt is estimated using discounted cash flow analyses, based on the Company's current incremental borrowing rates for similar types of borrowing arrangements. (N) EARNINGS PER SHARE CALCULATIONS Primary earnings per share are computed by dividing earnings, less preferred dividend requirements, by the weighted average number of common shares outstanding. In computing fully diluted earnings per share, the weighted average number of common shares outstanding is adjusted to reflect common stock equivalents resulting from stock options and the assumed conversion of the Company's Series 1984-A and 1986-A Preferred Stock into common shares, and preferred dividend requirements are adjusted to eliminate dividends on the shares assumed to have been converted. The computation of fully diluted earnings per share excludes the assumed conversion of such preferred shares for each period in which the assumed conversion would be antidilutive. 2. ACQUISITIONS AND DISPOSITIONS On November 9, 1992, the Company completed the sale of its wholly-owned subsidiary, Bankers Life and Casualty Company (Bankers), and Bankers' subsidiary, Certified Life Insurance Company (Certified), to an affiliate of Conseco, Inc. (Conseco) for $600 million cash, subject to final adjustment. Prior to the closing, Bankers transferred its ownership in all of its other subsidiaries to the Company, and the Company and its subsidiaries purchased certain other assets from Bankers, including primarily a residual interest in certain mortgage-backed securities, Bankers' home office real estate, and certain equity investments. The Company provided financing for the acquisition totaling $101.4 million and, in return, retained an approximate 29.7% interest in Bankers. The financing consisted of a $16.7 million common equity investment in Bankers Life Holding Corporation (BLHC), the Conseco entity formed for the purpose of making the acquisition, and the purchase of $34.7 million of BLHC 11% Junior Subordinated Debentures due 2003 and $50.0 million of a BLHC preferred stock yielding an 11% annual return. In addition, Conseco Capital Partners, L.P. (CCP) acquired a 52.6% interest in BLHC, and the Company, through one of its subsidiaries, made an additional $9.6 million investment to acquire a 19.3% ownership interest in CCP. As a result of the 29.7% interest in BLHC and the indirect investment through CCP, the Company retained a residual interest in Bankers totaling approximately 39.9%. The results of operations of Bankers and Certified were included in the Company's consolidated results of operations through October 31, 1992, the effective date of the sale for financial reporting purposes. Subsequent to that date, the Company reflected its proportionate share of the operating results of CCP and BLHC based on the equity method. Because of the significant ownership interest in Bankers retained by the Company, the sale of Bankers was accounted for as a step transaction in accordance with GAAP. Accordingly, the Company reflected its residual interest in Bankers on its historical accounting basis and reflected a gain on the approximate 60.1% interest in Bankers deemed to have been sold totaling $110,734,000 in the Company's consolidated statement of earnings for the year ended December 31, 1992. In conjunction with the sale of Bankers, the Company I.C.H. CORPORATION AND SUBSIDIARIES NOTES TO FINANCIAL STATEMENTS--(CONTINUED) 2. ACQUISITIONS AND DISPOSITIONS (CONTINUED) indemnified the purchasers against certain contingencies relating to taxes and other matters associated with Bankers and Certified in periods prior to the closing date. The Company believes its liability, if any, will not be material. Effective March 31, 1993, BLHC completed an initial public offering (Offering) of 19.55 million shares of its common stock, or an approximate 35.8% interest in BLHC at $22 per share. Proceeds of the Offering, after underwriting expenses, approximated $405 million. Effective the same day, CCP announced a plan of dissolution and BLHC shares held by CCP were subsequently distributed to the respective partners in accordance with that plan. The Company received 2,917,318 shares of BLHC common stock as a result of such distribution, increasing its direct ownership in BLHC common stock to 13,316,168 shares, or approximately 24.4% of BLHC's outstanding common shares following the Offering. The Company reflected a gain on the BLHC Offering totaling $99,376,000, primarily representing the Company's 24.4% equity in the net proceeds of such Offering. BLHC utilized a portion of the Offering proceeds to redeem certain of its outstanding securities, including the $50 million stated value of BLHC preferred stock and the $34.7 million principal amount of BLHC Junior Subordinated Notes held by the Company. Because a portion of the purchase price paid for such investments had been allocated to the Company's common equity investments in BLHC, such redemptions resulted in additional gains totaling $8,252,000, which have been included as a component of realized investment gains. On September 30, 1993, the Company sold its remaining investment in BLHC to Conseco and one of Conseco's subsidiaries for $287,639,000 cash. The Company utilized $50 million of the proceeds to redeem $50 million stated value of the Series 1987-A Preferred Stock of the Company from a Conseco subsidiary. The sale of the BLHC shares resulted in a gain totaling $197,665,000. The gains resulting from BLHC's Offering and the sale of the Company's remaining interest in BLHC totaling $297,041,000 have been reflected as a single line item in the consolidated statement of earnings for the year ended December 31, 1993. The Company continued to reflect its equity in the earnings of BLHC through the date of sale. In addition to the sales of Bankers and the Company's interest in BLHC and the subsequent application of the proceeds from such sales, other transactions occurred during 1993 or are expected to occur in 1994 that have had or are expected to have a significant effect on the Company's results of operations, including 1) the sale in 1993 of a 75% interest in a special purpose trust holding certain mortgage-backed securities and the deconsolidation of the accounts of such trust (see Note 3), 2) the sale in 1993 of the Company's investment in the common stock of CCP Insurance, Inc. (CCP Insurance) (see Note 6) and the reinvestment of the proceeds from such sale, and 3) the assumed completion in 1994 of the recapture of certain annuity business ceded to an affiliate under a reinsurance agreement and the related retirement of certain of the Company's debt and preferred stock upon completion of the recapture (see Note 4). Following is unaudited pro forma results of the Company with reported results adjusted to reflect the effects on operations of the above described transactions. The approximate after-tax gains realized on the sale of Bankers totaling $73.1 million in 1992 and the Company's interest in BLHC totaling $193.1 million in 1993 are included in the Company's historical results, but have been eliminated from the pro forma results. The $600 million of proceeds from the sale of Bankers in 1992 was utilized 1) to retire $75 million of the Company's 16 1/2% Senior Subordinated Debentures due 1994 (Debentures), 2) to retire $85 million of the Company's senior secured debt, 3) to purchase $84.7 million of BLHC debt and preferred stock, 4) to purchase $26.3 million of BLHC and CCP equity investments, and 5) to purchase assets from Bankers for $280.5 million. The remaining $48.5 million of proceeds from the sale of Bankers, along with the remaining proceeds from the sales of the Company's investments in BLHC and CCP Insurance, is assumed to have been invested at a new money rate of 6 1/4%. The Company utilized $100 million of the proceeds from the sale I.C.H. CORPORATION AND SUBSIDIARIES NOTES TO FINANCIAL STATEMENTS--(CONTINUED) 2. ACQUISITIONS AND DISPOSITIONS (CONTINUED) of BLHC to redeem the Company's Series 1986-A and 1986-C preferred stocks and approximately $45.9 million of its Debentures, and the remaining proceeds totaled approximately $141.7 million. The pro forma results further assume that all of the transactions occurred as of the first day of each period persented. Such pro forma results may not represent what the Company's results would have been had the assumed transactions occurred at the beginning of such periods and do not purport to project the Company's results for any future period. 3. NOTES PAYABLE AND COLLATERALIZED MORTGAGE NOTE OBLIGATION The carrying amount of notes payable at December 31, 1993 and 1992, and the fair value of notes payable at December 31, 1993, are summarized as follows: I.C.H. CORPORATION AND SUBSIDIARIES NOTES TO FINANCIAL STATEMENTS--(CONTINUED) 3. NOTES PAYABLE AND COLLATERALIZED MORTGAGE NOTE OBLIGATION (CONTINUED) The following summary sets forth the maturities and sinking fund requirements of notes payable during each of the five years following December 31, 1993 (in thousands): At December 31, 1993, the Company held $46,793,000 principal amount of the Old Notes which, at the Company's option, can be used to partially satisfy its first $100 million sinking fund obligation relative to such notes due December 1, 1994. In addition, at its option, the Company can defer the remainder of its sinking fund obligation in 1994 and a portion of its sinking fund obligation in 1995 based on the $87,106,000 of Old Notes which were exchanged for an equal amount of New Notes. Accordingly, in the above schedule of maturities and sinking fund requirements, it has been assumed that there is no sinking fund requirement relative to the Old Notes in 1994 and the sinking fund requirement in 1995 will total $66,101,000. At its option, the Company may alternatively determine to use sinking fund provisions in 1994 and 1995 to retire up to $100 million principal amount of the Old Notes at their par value in each year. At December 31, 1993 and 1992, the Company had notes receivable totaling $26,500,000 and $26,000,000, respectively, which were collateralized by the Company's note payable in the amount of I.C.H. CORPORATION AND SUBSIDIARIES NOTES TO FINANCIAL STATEMENTS--(CONTINUED) 3. NOTES PAYABLE AND COLLATERALIZED MORTGAGE NOTE OBLIGATION (CONTINUED) $20,340,000 and $19,780,000, respectively. The Company has the right to set off its obligation against the notes receivable. In the accompanying balance sheets, the Company's notes receivables have been reflected net of amounts due under the notes payable. Immediately prior to its sale, Bankers held certain mortgage-backed securities and other related securities used as hedges with a carrying value of $252,049,000. In conjunction with the sale of Bankers, these securities were placed in a special purpose trust (the Trust), organized by a new special purpose subsidiary, I.C.H. Funding Corporation (ICH Funding). Bankers was issued a $159,162,000 bond collateralized by the securities placed in the Trust. The Company retained a residual interest in the Trust totaling $91,797,000. All of the receipts on the securities placed in the Trust were to be applied first to repay the principal and interest on the bond retained by Bankers of 8.5%. The bond to Bankers with a carrying value of $157,231,000 at December 31, 1992, was reflected in the accompanying balance sheet as a collateralized mortgage note obligation. The Company was granted an option to purchase Bankers' interest in the bond at its remaining carrying value within ninety days following the sale of Bankers. On February 5, 1993, the Trust completed the sale to unaffiliated parties of interests in the trust totaling $171,000,000 and utilized $142,092,000 of the proceeds to retire the remaining obligation due Bankers. On July 30, 1993, the Company and its affiliate, CFLIC, sold 75% of their rights with respect to the Trust to an unaffiliated party and the accounts of the Trust, including the collateralized mortgage note obligations, were eliminated from the consolidated financial statements of the Company for periods subsequent to that date. 4. RELATED PARTY TRANSACTIONS Effective June 15, 1993, the Company entered into an agreement (the Agreement) with CNC and CFLIC, pursuant to which the Company acquired $63 million of a newly-issued preferred stock from CFLIC in exchange for the Company's ownership interest in certain investments with a carrying value and an estimated fair value as of that date of $63 million, including the Company's ownership in a limited partnership (the HMC/Life Partners, L.P.) and 83% of the Company's ownership in ICH Funding. The transactions with CFLIC were entered into as the first step in a series of transactions which are intended to terminate certain reinsurance arrangements involving CFLIC. The reinsurance arrangements involve certain annuity business with reserves totaling $330.0 million as of December 31, 1993, which was transferred by the Company's subsidiary, Southwestern Life Insurance Company (Southwestern), to an unaffiliated insurer in 1990. The unaffiliated insurer, in turn, transferred the business to another CNC subsidiary, Marquette National Life Insurance Company (Marquette), and, in 1991, Marquette transferred the annuity business to CFLIC. Under terms of the Agreement, upon termination of the reinsurance agreements involving CFLIC and Southwestern, along with the termination of other reinsurance arrangements involving CFLIC and Bankers, the CFLIC preferred stock is to be redeemed by the return of certain assets presently held by CFLIC to the Company, including the Company's senior secured debt totaling $30 million, the Company's 1984-A Preferred Stock with a stated value of $22,242,000, the Company's 1986-B Preferred Stock with a stated value of $7 million, and certain other assets to be determined. The CFLIC preferred stock is non-redeemable and non-voting, with 6% annual dividends that are payable "in-kind" until the reinsurance arrangements are terminated. The Company and CFLIC anticipate that the assets received by CFLIC from the Company as consideration for the preferred stock, along with other assets held by CFLIC, including its ownership in Marquette, will be transferred to Southwestern upon recapture of the annuity business. The termination of the reinsurance arrangements are subject to negotiations with the unaffiliated reinsurer and approval by regulatory authorities. After March 31, 1994, if the recaptures are not complete, CNC will have the right, subject to regulatory approval, to transfer to the Company all of the common stock of CFLIC in exchange for the assets of CFLIC that were to be retained by CNC upon completion of the recaptures. For financial reporting purposes, no gain or loss was recognized on the transfer of the assets to CFLIC. At December 31, 1993, the I.C.H. CORPORATION AND SUBSIDIARIES NOTES TO FINANCIAL STATEMENTS--(CONTINUED) 4. RELATED PARTY TRANSACTIONS (CONTINUED) Company has reflected its investment in the CFLIC preferred stock at its approximate fair value of $54 million, or less than the $63 million fair value initially assigned to such stock based primarily on the change in the fair value of the assets transferred to CFLIC subsequent to June 15, 1993. In addition, the Company has continued to include the accounts of ICH Funding in its consolidated financial statements, with CFLIC's ownership interest reflected as a minority interest in such investment. Experience refunds received from CFLIC under the Southwestern reinsurance arrangement totaled $4,851,000, $2,068,000 and $10,788,000 for the years ended December 31, 1993, 1992 and 1991, respectively. The Bankers business reinsured by CFLIC was not profitable in 1992 and 1991 due primarily to a loss incurred relative to certain reinsurance recoverables and, as a consequence, Bankers was not entitled to an experience refund in either 1992 or 1991. Bankers was a party to a service agreement with Marquette and CFLIC whereby it provided investment management, administrative, data processing, and general supervisory and management services related to business reinsured with CFLIC, in exchange for annual fees equal to .45% of reserves on the reinsured policies. Fees earned from providing such services totaled $1,593,000 for the ten months ended October 31, 1992 and $2,043,000 for the year ended December 31, 1991. Such fees were taken into consideration in the determination of profitability of the reinsured business. In addition, a subsidiary entered into a service agreement effective January 1992, whereby the subsidiary provided administrative services for Marquette. Fees earned from providing such services totaled $449,000 and $2,016,000 for the years ended December 31, 1993 and 1992, respectively. On February 11, 1994, the Company purchased all of the 100,000 shares of its Class B Common Stock held by CNC for total cash consideration of $500,000. The Class B Common Stock had entitled CNC to elect 75% of the Company's Board of Directors (see Note 10). Concurrently with the purchase of such stock, the Company entered into Independent Contractor and Services Agreements (Services Agreements) with Robert T. Shaw and C. Fred Rice, the controlling shareholders of CNC. The Services Agreements provide for a lump sum payment to Messrs. Shaw and Rice totaling $2 million as of the closing date and additional payments totaling $8,575,000 over a ten-year period. In addition, the Company agreed to provide customary employee benefits to Messrs. Shaw and Rice and their dependents. In the event of the deaths of Messrs. Shaw or Rice, any amounts not previously paid under the Services Agreements will become immediately payable to their estates. In consideration for the Services Agreements, Messrs. Shaw and Rice agreed that they would attempt to identify business opportunities in the insurance industry which may be suitable for the Company and to consult with the Company regarding such other matters as the Company may reasonably request. In addition, Mr. Rice will continue to serve as an executive officer of the Company and, if re-elected, will continue to serve on the Company's Board of Directors. The Services Agreements replaced a management and consulting contract with CNC that provided for annual payments to CNC totaling $2 million. In addition, Mr. Shaw was granted an option, exercisable within a six month period, to acquire certain aircraft equipment currently owned by the Company at its depreciated book value. At December 31, 1993, the Company has provided a liability for the present value of amounts payable under the Services Agreements totaling $9,050,000. I.C.H. CORPORATION AND SUBSIDIARIES NOTES TO FINANCIAL STATEMENTS--(CONTINUED) 4. RELATED PARTY TRANSACTIONS (CONTINUED) At December 31, 1993 and 1992, the Company held a $2 million promissory note from CNC bearing interest at 10% and payable in December 1995. The note and accrued interest were repaid on February 11, 1994. Through June 1993, FMI had leased office space under a ten-year lease in a building owned by Messrs. Shaw and Rice. Effective March 30, 1990, FMI had sublet substantially all of the office space to a former subsidiary which was sold as of that date. 5. INVESTMENTS Investment income by type of investment was as follows: Following is an analysis of realized gains (losses) on investments: Prior to 1992, all of the Company's fixed maturities were carried at amortized cost because management had stated its intent and believed ICH had the ability to hold all such investments to I.C.H. CORPORATION AND SUBSIDIARIES NOTES TO FINANCIAL STATEMENTS--(CONTINUED) 5. INVESTMENTS (CONTINUED) their ultimate maturities. During 1992, the Company retained the services of three independent investment advisors to manage in excess of $1 billion of the Company's fixed maturities and, as a result, at December 31, 1992, the Company had classified its fixed maturities into three categories, including actively managed, held for sale and held to maturity. In 1993, the Company adopted the provisions of SFAS No. 115, "Accounting for Certain Investments in Debt and Equity Securities," and has classified its fixed maturities into two categories, including available for sale and held to maturity. SFAS No. 115 also establishes criteria for the recognition of a permanent impairment in the carrying value of debt and equity securities. The Company reflected a charge for the cumulative effect of writedowns of certain mortgage-backed securities required under the provisions of SFAS No. 115 totaling $7,573,000. The cumulative charge has been reflected net of $2,651,000 in related income tax effects. The actively managed and held for sale securities in 1992 have been reclassified in the following tables as available for sale. The amortized cost of investments in fixed maturities, the cost of equity securities and the estimated values of such investments at December 31, 1993 and 1992 by categories of securities are as follows: I.C.H. CORPORATION AND SUBSIDIARIES NOTES TO FINANCIAL STATEMENTS--(CONTINUED) 5. INVESTMENTS (CONTINUED) The mortgage-backed securities held in trust at December 31, 1992, collateralized the Company's mortgage note obligation to Bankers (see Note 3). The Company held a residual interest in the securities held in trust with a carrying value at December 31, 1992, totaling $79,715,000. I.C.H. CORPORATION AND SUBSIDIARIES NOTES TO FINANCIAL STATEMENTS--(CONTINUED) 5. INVESTMENTS (CONTINUED) The amortized cost and estimated fair value of fixed maturities at December 31, 1993, by contractual maturity, are shown below. Expected maturities will differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties. Excluding scheduled maturities and sales related to reinsurance transactions, proceeds from sales of investments in debt securities during 1993, 1992 and 1991 and the related gross gains and gross losses realized on such sales were as follows: I.C.H. CORPORATION AND SUBSIDIARIES NOTES TO FINANCIAL STATEMENTS--(CONTINUED) 5. INVESTMENTS (CONTINUED) Following are changes in unrealized appreciation (depreciation) on investments (in thousands): The carrying value of nonaffiliated invested assets for which no investment income was recorded during the twelve months ended December 31, 1993, was as follows (in thousands): In addition, the Company owns preferred stock in CFLIC with a carrying value of $54 million at December 31, 1993 (see Note 4). There were no dividends declared on the CFLIC preferred stock during 1993. Other than the Company's investment in securities of Fund America Investors Corporation II with a carrying value and fair value of $58,577,000, the Company had no investments exceeding 10% of stockholders' equity. At December 31, 1993, the Company held unrated or noninvestment-grade corporate debt securities with a carrying value of $107,012,000 and an aggregate fair value of $106,197,000. These holdings amounted to 6.2% of the Company's fixed maturity investments and 4.0% of total cash and invested assets. The holdings of noninvestment-grade securities are widely diversified and include securities of 42 issuers. At December 31, 1993, the Company held residual interest mortgage-backed securities with a carrying value of $78,246,000 and a fair value of $75,590,000. The effective annual yield on such investments based on their carrying value approximated 12.6% at December 31, 1993. I.C.H. CORPORATION AND SUBSIDIARIES NOTES TO FINANCIAL STATEMENTS--(CONTINUED) 5. INVESTMENTS (CONTINUED) At December 31, 1993, the Company held mortgage loans principally involving commercial real estate with a carrying value and estimated fair value of $138,504,000 and $142,998,000, respectively. Approximately 62% of such mortgages involved property located in Texas, consisting of first mortgage liens on completed income-producing properties. Mortgages on individual properties do not exceed $8 million. The Company's life insurance subsidiaries are required to maintain certain amounts of assets on deposit with state regulatory authorities. Such assets had an aggregate carrying value of $301,971,000 at December 31, 1993, including securities of the Company with an estimated fair value of $19,491,000, which have been eliminated in consolidation in the accompanying balance sheet. 6. INVESTMENTS IN EQUITY INVESTEES AND LIMITED PARTNERSHIPS At December 31, 1992, the Company owned a 39.9% indirect equity interest in Bankers, consisting of a 29.7% equity interest in BLHC and 10.2% equity interest through its limited partnership investment in CCP. In addition, the Company owned $34.7 million principal amount of BLHC 11% Junior Subordinated Debentures due 2003 and $50.0 million of a BLHC 11% preferred stock. The 1992 sale of Bankers was accounted for as a "step transaction" in accordance with GAAP. Accordingly, gain recognition was limited to the 60.1% interest deemed to have been sold. The excess of the sales price over the Company's basis in Bankers on the 39.9% portion of the investment deemed to have been retained by the Company (excess of sales price over basis in retained interest) was reflected as a reduction in the carrying value of the Company's investments in BLHC and CCP. Effective March 31, 1993, the Company's ownership interest in BLHC was reduced to 24.4% as a result of BLHC's offering and on September 30, 1993, the Company sold its investment in BLHC (see Note 2). I.C.H. CORPORATION AND SUBSIDIARIES NOTES TO FINANCIAL STATEMENTS--(CONTINUED) 6. INVESTMENTS IN EQUITY INVESTEES AND LIMITED PARTNERSHIPS (CONTINUED) At December 31, 1992, CCP had no assets or liabilities, other than its investment in BLHC. Financial information of BLHC and the Company's carrying value and equity in earnings of BLHC as of and for the two months ended December 31, 1992, and the Company's equity in the earnings of BLHC for the nine months ended September 30, 1993, is as follows (in thousands): Following is an analysis of the Company's equity investments in BLHC and CCP (in thousands): I.C.H. CORPORATION AND SUBSIDIARIES NOTES TO FINANCIAL STATEMENTS--(CONTINUED) 6. INVESTMENTS IN EQUITY INVESTEES AND LIMITED PARTNERSHIPS (CONTINUED) Following is an analysis of the Company's investment in limited partnerships (excluding the Company's investment in CCP at December 31, 1992, which was reflected as an investment in equity investees): The fair value of the Company's investments in limited partnerships approximated their carrying value of $43,640,000 at December 31, 1993. Included in the limited partnership investments at December 31, 1991, was the Company's 21.4% interest in CCP (Predecessor CCP). On July 21, 1992, Predecessor CCP formed a new insurance holding company, CCP Insurance, Inc. and completed an initial public offering (IPO) of common stock in CCP Insurance. Predecessor CCP was liquidated and the Company received 1,764,439 shares of CCP Insurance common stock in exchange for its 21.4% interest in Predecessor CCP. At the date of exchange, the Company's carrying value in Predecessor CCP totaled $19,509,000, which became the Company's basis in the shares of CCP Insurance common stock. The Company subsequently reflected its investment in CCP Insurance, along with 525,000 shares of CCP Insurance purchased in the IPO, as marketable equity securities. Effective September 29, 1993, CCP Insurance completed an underwritten primary and secondary offering of shares of its common stock. The Company sold all of the 1,764,439 shares of the common stock of CCP Insurance in conjunction with the offering for $47,272,000 and realized investment gains totaling $27,758,000. In addition, during 1993, the Company sold 455,375 shares of CCP Insurance common stock in open market transactions and realized gains totaling $5,310,000. At December 31, 1993, the Company continues to hold 69,625 shares of CCP Insurance common stock with a fair value of approximately $1.9 million. Financial information of Predecessor CCP and the Company's equity in the earnings of Predecessor CCP is as follows (in thousands): I.C.H. CORPORATION AND SUBSIDIARIES NOTES TO FINANCIAL STATEMENTS--(CONTINUED) 6. INVESTMENTS IN EQUITY INVESTEES AND LIMITED PARTNERSHIPS (CONTINUED) Following is a summary of the equity in earnings of equity investees and limited partnerships: 7. FINANCIAL INSTRUMENTS WITH OFF-BALANCE SHEET RISK Certain of the Company's subsidiaries have entered into interest rate swap arrangements to convert the interest rate characteristics of certain investments to match those of related insurance liabilities. The agreements expire from 1994 to 1997 and exchange fixed-rate payments ranging from 5.45% to 8.44% for three month LIBOR-based interest payments on notional amounts of $43.9 million. The interest rate differential to be received or paid is recognized over the lives of the agreements as an adjustment to interest expense. The subsidiaries are exposed to credit risk in the event of default by counterparties to the extent of any amounts that have been recorded in the balance sheet and market risk as a result of potential future increases in LIBOR. The fair value of interest rate swap arrangements at December 31, 1993, approximated $2.5 million. I.C.H. CORPORATION AND SUBSIDIARIES NOTES TO FINANCIAL STATEMENTS--(CONTINUED) 8. INSURANCE LIABILITIES Insurance liabilities consist of the following: The estimated fair value of guaranteed investment contracts approximated their carrying value at December 31, 1993 because it is expected that substantially all of such contracts will be terminated during 1994. The estimated fair value of the liabilities for other investment contracts is approximately equal to their carrying value at December 31, 1993, because interest rates credited to account balances approximate current rates paid on similar investments and are generally not guaranteed beyond one year. Fair values for the Company's insurance liabilities other than those for investment-type insurance contracts are not required to be disclosed. However, the fair values of liabilities under all insurance contracts are taken into consideration in the Company's overall management of interest rate risk, which minimizes exposure to changing interest rates through the matching of investment maturities with amounts due under insurance contracts. 9. STOCKHOLDERS' EQUITY AND RESTRICTIONS At December 31, 1993, substantially all of consolidated stockholders' equity represented net assets of the Company's insurance subsidiaries that cannot be transferred to the Company in the form of dividends, loans or advances. Generally, the net assets of the Company's insurance subsidiaries available for transfer to the Company are limited to the greater of the subsidiaries' net gain from operations during the preceding year or 10% of the subsidiaries' net surplus as of the end of the preceding year as determined in accordance with accounting practices prescribed or permitted by insurance regulatory authorities. Payment of dividends in excess of such amounts would generally require approval by the regulatory authorities. At December 31, 1993, approximately $34.0 million was available under existing laws for the payment of dividends by insurance subsidiaries to the I.C.H. CORPORATION AND SUBSIDIARIES NOTES TO FINANCIAL STATEMENTS--(CONTINUED) 9. STOCKHOLDERS' EQUITY AND RESTRICTIONS (CONTINUED) Company during 1994 without prior approval; however, Modern American has agreed with its domiciliary state that it will not pay any stockholder dividends without obtaining prior regulatory approval. In addition, Southwestern has agreed with its domiciliary state that it will give 30 days prior notice before the payment of any stockholder dividends. On the basis of reporting as prescribed or permitted by insurance regulatory authorities, the consolidated insurance subsidiaries have audited combined stockholders' equity, after elimination of amounts attributable to investments in consolidated insurance subsidiaries, of approximately $259,856,000 and $227,003,000 as of December 31, 1993 and 1992, respectively, and audited combined net income (loss) as follows: Gains and losses relative to individual investments are generally reflected for statutory reporting purposes as unrealized investment gains or losses until such time as the specific investments are sold or otherwise disposed of. In addition, statutory investment gains and losses are reported net of related income tax effects. Statutory realized investment losses in 1992 include losses on the disposition of First Executive Corporation common stock totaling $118 million which were reflected prior to 1992 for financial reporting purposes. During 1992, certain employees who had previously purchased shares of the Company's Common Stock under a Restricted Stock Purchase Agreement pledged the shares of Common Stock to collateralize notes receivable which had been issued to a former affiliate in 1982, but which were subsequently acquired by the Company in 1985. The notes and accrued interest totaling $1,471,000 and $1,906,000 at December 31, 1993 and 1992, respectively, bear interest at 9%, mature in 1996 and were collateralized by 375,564 shares and 530,976 shares of the Company's Common Stock at each of the respective dates. In addition, the Company has other notes receivable with a carrying value of $258,000 at December 31, 1993 and 1992, which are collateralized by 51,534 shares of the Company's Common Stock. In the accompanying balance sheets, such notes and accrued interest have been reflected as reductions in stockholders' equity. 10. CAPITAL STOCK At December 31, 1993, the Company had three classes of capital stock, including Series Preferred Stock (no par value), Common Stock ($1.00 par value) and Class B Common Stock ($1.00 par value). At December 31, 1993, there were three series of Preferred Stock outstanding, the Series 1984-A Preferred Stock, the $1.75 Convertible Exchangeable Preferred Stock, Series 1986-A (Series 1986-A Preferred Stock), and the Series 1987-B Preferred Stock. The holder of each outstanding share of the Series 1984-A Preferred Stock is entitled to cumulative annual dividends of $4.93 and liquidating distributions of up to the $41.07 stated value. Such dividends and liquidating distributions are payable in preference to the Common Stock and Class B Common Stock. The Series 1984-A Preferred Stock may be converted, at the option of the holder, at any time into shares of Common Stock at the rate of one share of Common Stock for each .3160 shares of Series 1984-A Preferred Stock. The Series 1984-A Preferred Stock has the right to vote as a class with the Common Stock on all matters submitted to a vote of the holders of the Common Stock. The Company, at its option, may redeem all of the shares of the Series 1984-A Preferred Stock at their stated value. I.C.H. CORPORATION AND SUBSIDIARIES NOTES TO FINANCIAL STATEMENTS--(CONTINUED) 10. CAPITAL STOCK (CONTINUED) The holder of each outstanding share of Series 1986-A Preferred Stock is entitled to cumulative annual dividends of $1.75 and liquidating distributions of up to $25 per share. Such dividends and liquidating distributions are payable in preference to the Common Stock, Class B Common Stock and all other series of the Company's Preferred Stock currently outstanding. The Series 1986-A Preferred Stock may be converted, at the option of the holder, at any time into shares of Common Stock at the rate of .7692 shares of Common Stock for each share of Series 1986-A Preferred Stock. The Company may redeem, at its option, any or all shares of the Series 1986-A Preferred Stock at redemption prices declining annually to $25 per share after December 1, 1996 plus accrued and unpaid dividends. The Series 1986-A Preferred Stock is exchangeable, in whole but not in part, at the Company's option on any dividend payment date commencing December 1, 1988 for the Company's 7% Convertible Subordinated Debentures due 2011 at the rate of $25 principal amount of Debentures for each share of Series 1986-A Preferred Stock. The Series 1986-A Preferred Stock is nonvoting, except as required by law and except that, if six quarterly dividends are unpaid and past due, the holders of the Series 1986-A Preferred Stock may elect two directors to the Company's Board of Directors. The Series 1987-B Preferred Stock has a stated value of $50 per share, provides for cash liquidating distributions of up to such stated value and provides for cumulative annual dividends of $4.50 per share. Dividends and liquidating distributions on the 1987-B Preferred Stock are payable in preference to those payable on the Common Stock and Class B Common Stock, but are subordinated in right of payment to dividends and liquidating distributions payable on the Series 1986-A Preferred Stock. The 1987-B Preferred Stock ranks on parity with the Series 1984-A Preferred Stock. The 1987-B Preferred Stock is neither convertible nor entitled to any voting rights, except as required by law. The Company may redeem shares of the 1987-B Preferred Stock at any time at the $50 stated value. Through February 10, 1994, the Common Stock and Class B Common Stock were entitled to vote as separate classes on stockholder actions that directly or indirectly could effect a change in the aggregate number or par value of shares of Class B Common Stock or in the powers, preferences or rights of the holders of Class B Common Stock. The Company's Board of Directors was classified by its Certificate of Incorporation to require, so long as the Class B Common Stock was outstanding, that at least 50% of the Company's directors were to be independent, and that 75% of the directors were to be elected by the Class B Common Stock and the remaining 25% were to be elected by the Common Stock and voting Preferred Stock. The Class B Common Stock had the same rights to dividends and liquidating distributions as the Common Stock. On February 11, 1994, the Company purchased all of the outstanding shares of Class B Common Stock and immediately cancelled and retired such shares (see Note 4). On August 7, 1991, the Company's shareholders approved an amendment to the 1990 Stock Option Incentive Plan which increased the shares available for grant from 2.4 million shares to 2.9 million shares. In connection with the sale of the Company's remaining investment in BLHC on September 30, 1993 (see Note 2), the Company redeemed all of the outstanding shares of its Series 1987-A Preferred Stock at their $50 per share stated value. On December 2, 1993, the Company redeemed for cash all of the outstanding shares of its Series 1987-C Preferred Stock at their $50 per share stated value. Annual dividend requirements on the redeemed shares totaled $5.50 per share and $8.00 per share, respectively. I.C.H. CORPORATION AND SUBSIDIARIES NOTES TO FINANCIAL STATEMENTS--(CONTINUED) 10. CAPITAL STOCK (CONTINUED) Capital stock activity for the three years ended December 31, 1993, was as follows: I.C.H. CORPORATION AND SUBSIDIARIES NOTES TO FINANCIAL STATEMENTS--(CONTINUED) 10. CAPITAL STOCK (CONTINUED) Shares reserved for issuance at December 31, 1993: 11. REINSURANCE The life insurance subsidiaries have set their retention limit for acceptance of risk on life insurance policies at various levels currently up to $500,000. There are reinsurance agreements with various companies whereby insurance in excess of the respective subsidiaries' retention limits is reinsured. To the extent that reinsuring companies become unable to meet their obligations under these agreements, the subsidiaries remain contingently liable. Insurance in force ceded in 1993 and 1992 under risk sharing arrangements totaled approximately $5.7 billion and $5.4 billion, respectively. Through 1992, the liability for future policy benefits was stated after deductions for amounts applicable to such risk sharing reinsurance ceded. As of December 31, 1992, such amount totaled $251,911,000. In 1993, the Company adopted the provisions of SFAS No. 113, "Accounting and Reporting for Reinsurance of Short-Duration and Long-Duration Contracts," which changes the accounting and reporting for reinsurance contracts. SFAS No. 113 requires that when a reinsurance contract does not relieve the reinsurer from the legal liability to its policyholders, ceding insurers must report amounts recoverable from reinsurers as assets rather than as a reduction of the related policyholder liabilities. In addition, financial reporting disclosures were amended to require information relative to the volume of premiums ceded to and the benefits paid by reinsurers under related reinsurance arrangements. At December 31, 1993, the Company has reflected in its balance sheet an asset for amounts due from reinsurers totaling $388,083,000 and has correspondingly increased its insurance liabilities by the same amount. Following is information relative to premiums ceded to unaffiliated reinsurers and the related benefits incurred by such reinsurers for the year ended December 31, 1993 (in thousands): Amounts due from reinsurers at December 31, 1993, includes $334,633,000 due from Employers Reassurance Company (ERC) relative to certain annuity business which ERC has retroceded to CFLIC. The Company has begun the process of terminating the reinsurance arrangements with ERC and CFLIC (see Note 4). Certain of the Company's insurance subsidiaries have ceded blocks of insurance under reinsurance treaties to provide funds for financing acquisitions and other purposes. In addition, certain subsidiaries have assumed reinsurance from unaffiliated reinsurers under similar arrangements. These reinsurance transactions, generally known as "surplus relief reinsurance," represent financing arrangements and, in accordance with GAAP, are not reflected in the accompanying financial statements except for the risk fees paid to or received from reinsurers. Net statutory surplus provided by I.C.H. CORPORATION AND SUBSIDIARIES NOTES TO FINANCIAL STATEMENTS--(CONTINUED) 11. REINSURANCE (CONTINUED) such treaties totaled $51.5 million and $87.5 million at December 31, 1993 and 1992, respectively. Risk fees paid to or received from reinsurers generally range from 2% to 4% of the net amount of surplus provided. 12. COMMITMENTS, LITIGATION AND CONTINGENT LIABILITIES At December 31, 1993, the Company and its subsidiaries had long-term leases covering certain of their facilities and equipment. The net minimum rental commitments under noncancellable operating leases with lease terms in excess of one year are $6.3 million, $5.9 million, $.7 million, $.3 million and $.3 million for the years 1994, 1995, 1996, 1997, and 1998, respectively, and $.1 million for subsequent years. In addition, as a result of a judgement involving a mortgage loan foreclosure, a subsidiary is obligated under a real property lease for payments totaling $120,000 annually through November 2082. At December 31, 1993, the Company had an outstanding commitment to make limited partnership investments of up to $25 million in Conseco Capital Partners II, L.P. The partnership was formed to make corporate acquisitions of specialized annuity, life and health insurance companies and related businesses. The Company and its subsidiaries have been under examination by the Internal Revenue Service (IRS) for the tax years 1983 through 1992. The IRS has completed its examination for the years 1983 through 1985 and had previously issued Preliminary Notices of Deficiencies totaling approximately $17.5 million, before interest. The Company protested such assessed deficiencies and subsequently has tentatively reached an agreement with the IRS under which the Company and certain of its subsidiaries will incur approximately $4.6 million of additional taxes and interest. The IRS has not completed its examination for the years 1986 through 1992 and therefore has not issued Notices of Deficiencies for those years. Management believes that the ultimate liability for additional taxes and interest for these later years will not exceed amounts recorded in the Company's financial statements. In the course of their examination of the income tax returns of the Company and its subsidiaries for the years 1986 through 1989, the examining agent involved has submitted a Request for Technical Advice to the IRS Chief Counsel's Office regarding the deductibility of interest expense on the surplus debentures issued by the Company's insurance subsidiaries. The issue involves approximately $444 million of interest deductions claimed by the Company's subsidiaries during the periods under examination and, if disallowed as deductions, would result in additional income tax expense, before interest, of approximately $163 million. For years subsequent to the periods under examination, the Company's subsidiaries have claimed additional interest deductions totaling $190 million which, if likewise disallowed, would result in additional income tax expense, before interest, totaling approximately $65 million. Management believes the surplus debentures in question were legally enforceable debt instruments, as opposed to equity contributions, and that the related interest was properly deductible. In addition, the appropriate domiciliary states of the Company's insurance subsidiaries recognized such surplus debentures as valid debt instruments. Further, all existing case law has held in the favor of taxpayers with regard to the issue of whether surplus debentures represent debt, as opposed to equity and, as a consequence, management believes that the Company and its subsidiaries do not have significant exposure to additional taxes as a result of this Request for Technical Advice. From time to time, assessments are levied on the Company's insurance subsidiaries by life and health guaranty associations in states in which they are licensed to do business. Such assessments are made primarily to cover the losses of policyholders of insolvent or rehabilitated insurers. In some states, these assessments can be partially recovered through a reduction in future premium taxes. The Company's insurance subsidiaries paid assessments of $3.2 million, $2.8 million and $2.9 million in I.C.H. CORPORATION AND SUBSIDIARIES NOTES TO FINANCIAL STATEMENTS--(CONTINUED) 12. COMMITMENTS, LITIGATION AND CONTINGENT LIABILITIES (CONTINUED) the years 1993, 1992 and 1991, respectively. Based on information currently available, management believes that any future assessments are not reasonably likely to have a material adverse effect on the Company's insurance subsidiaries. Modern American is a defendant in a class action lawsuit filed on or about May 14, 1993 in the Circuit Court of Jackson County, Missouri, styled WILLIAM D. CASTLE, ET AL. V. MODERN AMERICAN LIFE INSURANCE COMPANY (the CASTLE case). The suit purports to be brought on behalf of a class of persons who own what plaintiffs denominate as charter contracts, issued by life insurance companies merged into or acquired by Modern American and its predecessors. The petition alleges breach of contract, and seeks declaratory judgment, costs, expenses and such other relief as the Court deems appropriate. As an alternative, the petition seeks rescission. On or about October 12, 1993, the plaintiffs in the CASTLE case also filed a lawsuit in the Circuit Court of Cole County, Missouri, naming Modern American and the Director of the Missouri Department of Insurance (the Missouri Director) as defendants. The second lawsuit, styled ROBERT J. MEYER, ET AL. V. JAY ANGOFF, DIRECTOR OF THE MISSOURI DEPARTMENT OF INSURANCE AND MODERN AMERICAN LIFE INSURANCE COMPANY (the MEYER case), is an appeal from the regulatory proceedings before the Missouri Department of Insurance, by which Modern American received regulatory approvals required for it to participate in a restructuring of the Company's insurance holding company organization. The restructuring was completed on or about September 29, 1993. The plaintiffs in the MEYER case are seeking reversal or remand of the Director's order of approval, declaratory judgment and such other relief to which they claim they are entitled. The Cole Circuit Court has determined that it will review the Missouri Department's decision on the record pursuant to Missouri's administrative procedure act. Modern American believes it has meritorious defenses to both the CASTLE and MEYER cases and intends to defend both cases vigorously. Various other lawsuits and claims are pending against the Company and its subsidiaries. Based in part upon the opinion of counsel as to the ultimate disposition of the above discussed and other matters, management believes that the liability, if any, will not be material. See Note 2 for a discussion regarding indemnifications made by the Company with respect to the sale of Bankers. 13. FEDERAL INCOME TAXES Effective January 1, 1991, the Company adopted SFAS No. 109, "Accounting for Income Taxes." The cumulative effect to January 1, 1991 of this statement on the Company's consolidated balance sheet was the recognition of a deferred tax asset totaling $43,880,000 and a reduction in excess cost resulting from the recognition of utilization of tax deductions of acquired companies totaling $35,097,000. The adjustment of these accounts resulted in a net cumulative effect totaling $8,783,000 which has been reflected as a separate line item in the consolidated statement of earnings. Through 1991, the Company filed a consolidated federal income tax return with its wholly-owned non-life insurance subsidiaries. The Company's life insurance subsidiaries also filed federal income tax returns as a consolidated group. Beginning in 1992, the Company and its non-life insurance subsidiaries joined with the Company's life insurance subsidiaries in filing a single consolidated tax return. ICH Funding will file a separate income tax return for periods subsequent to ICH's transfer of an 83% ownership interest to CFLIC in June 1993 (see Note 4). I.C.H. CORPORATION AND SUBSIDIARIES NOTES TO FINANCIAL STATEMENTS--(CONTINUED) 13. FEDERAL INCOME TAXES (CONTINUED) The Company's deferred federal income tax asset at December 31, 1993 and 1992, is comprised of the tax benefit (cost) associated with the following items based on 35% and 34% tax rates in effect at the end of each of the respective periods: As a result of the sale of Bankers, BLHC and other investment transactions in 1993 and 1992, the Company realized significant benefits from the utilization of capital temporary differences and, accordingly, reduced its deferred tax valuation allowances. The provision for income taxes is included in the statements of earnings as follows: The components of the provision for income taxes on operating earnings (loss) are as follows: I.C.H. CORPORATION AND SUBSIDIARIES NOTES TO FINANCIAL STATEMENTS--(CONTINUED) 13. FEDERAL INCOME TAXES (CONTINUED) A reconciliation of the income tax provisions based on the prevailing corporate tax rate of 35% in 1993 and 34% in 1992 and 1991 to the provision reflected in the consolidated financial statements is as follows: The benefit from the reduction in the deferred tax asset in 1993 as reflected in the above reconciliation exceeds the actual change in the valuation allowance as a result of the change in corporate tax rates during 1993. At December 31, 1993, the Company and its subsidiaries had the following income tax carryforwards available (in millions): The IRS is examining federal income tax returns of the Company and certain insurance subsidiaries through 1989. See Note 12 for a discussion of certain proposed deficiencies. 14. BENEFIT AND OPTION PLANS The Company has not established retirement benefit plans for its employees. However, Bankers had a noncontributory unfunded deferred compensation plan for qualifying members of its career agency force. Net pension costs included in other operating expenses included the following components (in thousands): The weighted-average discount rate and rate of increase in future compensation levels used in determining the actuarial present value of the projected benefit obligation were 8% and 5%, respectively. I.C.H. CORPORATION AND SUBSIDIARIES NOTES TO FINANCIAL STATEMENTS--(CONTINUED) 14. BENEFIT AND OPTION PLANS During 1993, the Company entered into agreements with certain employees providing for severance benefits supplemental to those available to all employees under the Company's welfare benefit plans. The agreements generally provide for a benefit of two times the annual salary of each covered employee upon the voluntary or involuntary termination of their employment for any reason other than gross misconduct, plus an additional benefit of up to one year's salary if, in the aggregate, shares of the Company's Common Stock acquired by such employees under the Company's incentive stock option plans or the stock purchase plan of a predecessor company are disposed of at less than a minimum specified price. For the year ended December 31, 1993, the Company reflected a charge for the total anticipated cost of providing benefits under the agreements totaling $2,820,000. Effective January 1, 1993, the Company adopted SFAS No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions." SFAS No. 106 requires that an enterprise accrue, during the years that an employee renders the necessary service, the expected cost of providing postretirement life and health care benefits to an employee and the employee's beneficiaries and covered dependents. The Company's transition obligation as of January 1, 1993, approximated $22,873,000. The Company had previously provided a liability totaling $20,127,000 at December 31, 1992, for postretirement benefits for retired employees of certain acquired companies through its purchase accounting relative to such companies. The Company reflected a charge for the cumulative effect to January 1, 1993, of providing postretirement benefits for its remaining employees totaling $2,746,000. The cumulative charge has been reflected net of $934,000 in related income tax effects. The Company's obligation for accrued postretirement benefits is unfunded. Following is an analysis of the change in the liability for accrued postretirement benefits for the year ended December 31, 1993 (in thousands): The liability for accrued postretirement benefits includes the following at December 31, 1993 (in thousands): For measurement purposes, a 10% annual rate of increase in the health care cost trend rate was assumed for 1993; the rate was assumed to decrease gradually to 5 1/2% for 2015 and remain at that level thereafter. The health care cost trend rate assumption has a significant effect on the amounts reported. To illustrate, increasing the assumed health care cost trend rates by 1 percentage point in each year would increase the accumulated postretirement benefit obligation as of January 1, 1993 by $2,099,000 and the aggregate of the service and interest components of net periodic postretirement benefit cost for 1993 by $382,000. The weighted average discount rate used in determining the accumulated postretirement benefit obligation was 7 1/2%. I.C.H. CORPORATION AND SUBSIDIARIES NOTES TO FINANCIAL STATEMENTS--(CONTINUED) 14. BENEFIT AND OPTION PLANS (CONTINUED) Southwestern and certain former subsidiaries provided certain health care and life insurance benefits for retired employees. Employees meeting certain age and length of service requirements become eligible for these benefits. The cost of providing these benefits and similar benefits for active employees is recognized as expenses as claims are incurred. These costs approximated $2,430,000 and $2,960,000 for 1992 and 1991, respectively. Under provisions of the 1990 Stock Option Incentive Plan the Company is authorized to grant options to certain key employees for the purchase of up to 2.9 million shares of the Company's Common Stock at a price not less than fair market value at date of grant. The options are exercisable for up to ten years from date of grant and become exercisable at various times ranging from six months to three years. The Company had previously granted options for the purchase of up to 156,780 shares of the Company's Common Stock exercisable through June 1993. Stock options granted are summarized as follows: 15. EXTRAORDINARY LOSSES For the years 1993 and 1992, the Company incurred extraordinary losses, all related to early extinguishment of debt, as follows: I.C.H. CORPORATION AND SUBSIDIARIES NOTES TO FINANCIAL STATEMENTS--(CONTINUED) 15. EXTRAORDINARY LOSSES (CONTINUED) Exclusive of scheduled sinking fund obligations, in 1993, the Company redeemed $83,379,000 of its 16 1/2% Debentures utilizing proceeds from the sales of Bankers and BLHC. In 1992, the Company prepaid $130 million of its senior secured loan utilizing proceeds from the sale of Bankers totaling $85 million and internally-generated funds totaling $45 million. 16. QUARTERLY FINANCIAL DATA (UNAUDITED) For the quarter ended March 31, 1993, the Company reported a non-operating gain totaling $79,459,000, net of tax effects, representing the Company's equity in the proceeds of BLHC's initial public offering. As a result of the Company's subsequent sale of its remaining interest in BLHC, such non-operating gain was reclassified as a component of revenues and operating earnings. Revenues and results of operations for the 1993 first quarter have accordingly been adjusted to reflect such reclassification. The results of operations for the quarters ended June 30, 1993 and September 30, 1993, have been restated to correct for accounting errors determined in the course of preparation of the Company's year-end financial statements. The errors involved the incorrect accounting for certain group I.C.H. CORPORATION AND SUBSIDIARIES NOTES TO FINANCIAL STATEMENTS--(CONTINUED) 16. QUARTERLY FINANCIAL DATA (UNAUDITED) (CONTINUED) health reinsurance activities and the correction of income tax provisions for a special purpose subsidiary which can no longer be included in the Company's consolidated income tax return. Following is a summary of the effect of these corrections on the reported results (in thousands, except per share amounts): Fully diluted earnings per share are independently calculated for each interim period. In those periods where the results of such calculations would be antidilutive, primary earnings per share are reflected in lieu of fully diluted earnings per share. Therefore, the sum of the quarterly earnings per share on a fully diluted basis will not necessarily equal fully diluted earnings per share for the entire year. Reporting results of insurance operations on a quarterly basis necessitates numerous estimates throughout the year, principally in the calculation of reserves and in the determination of the effective rate for federal income taxes. It is the Company's practice to review its estimates at the end of each quarter and, if necessary, make appropriate refinements, with the resulting effect being reported in current operations. Only at year-end is the Company able to retrospectively assess the precision of its previous quarterly estimates. The Company's fourth quarter results contain the effect of the difference between previous estimates and final year-end results and, therefore, the results of an interim period may not be indicative of the results for the entire year. 17. INDUSTRY SEGMENT DATA The Company and its subsidiaries are principally engaged in the sale and underwriting of individual life and health insurance, group insurance and accumulation products. Total revenues by segment reflect sales to unaffiliated customers. Operating earnings (loss) equal total revenues less operating expenses. Premium income and other considerations includes premium income, mortality and administration charges, surrender charges and amortization of deferred policy initiation fees. Net investment income and other income are allocated to the segments based on rates ranging from 6% to 10% related to reserves generated by each of the four insurance segments. Corporate revenues and operating earnings include gains (losses) on the sales of subsidiaries, equity in earnings (losses) of unconsolidated affiliates and limited partnerships, and the remaining net investment income considered to be income applicable to the investment of capital and surplus funds. Operating expenses are allocated to each segment based on a ratio of operating expenses to premiums and premium equivalents. I.C.H. CORPORATION AND SUBSIDIARIES NOTES TO FINANCIAL STATEMENTS--(CONTINUED) 17. INDUSTRY SEGMENT DATA (CONTINUED) 18. SUPPLEMENTAL DATA TO CONSOLIDATED STATEMENTS OF CASH FLOWS Cash payments (receipts) for interest expense and income taxes were as follows: The following reflects assets and liabilities disposed relative to the sales of subsidiaries and net cash flow relative to such sales during the year ended December 31, 1992 (in thousands): I.C.H. CORPORATION AND SUBSIDIARIES NOTES TO FINANCIAL STATEMENTS--(CONTINUED) 19. OTHER OPERATING INFORMATION Other operating costs and expenses for the three years ended December 31, 1993, are as follows: In October 1992, the Company entered into a settlement agreement and agreed to pay a $12.6 million settlement fee to Perot Systems, Inc. to modify an existing data processing services arrangement. Under the settlement agreement, Perot Systems agreed to eliminate minimum fee requirements totaling $15.6 million annually through July 1992, to lower its unit transaction charges, and to procure the release of the Company relative to its guarantee of certain equipment lease obligations. Bankers paid $6.3 million of the settlement fee and Conseco agreed to a reduction in Bankers' required capital and surplus as of the date of sale by a corresponding amount. For the years ended December 31, 1993 and 1992, the Company reflected consolidation and reorganization expenses totaling $23,870,000 and $10,885,000, respectively. The expenses were associated with the operational consolidation of three of the Company's Texas-based insurance subsidiaries. The 1993 expenses include a $10,757,000 writedown of certain home office real estate, a $9,760,000 writeoff of certain capitalized data processing costs and $3,353,000 in writeoffs of other property and equipment. The 1992 expense included an accrual for the expenses anticipated to be incurred relative to such consolidation and an $8,000,000 writedown of certain home office real estate. In addition, during 1993, the Company assessed its exposure to the costs associated with pending litigation and certain other contingencies and provided reserves totaling $9,320,000 for the costs anticipated to be incurred relative to such matters. The litigation settlement expense in 1992 related to a class action suit which had been filed by certain policyholders and which was settled in that year. I.C.H. CORPORATION AND SUBSIDIARIES NOTES TO FINANCIAL STATEMENTS--(CONTINUED) 19. OTHER OPERATING INFORMATION (CONTINUED) Changes in the present value of future profits of acquired business for the three years ended December 31, 1993, are as follows: Based on current conditions and assumptions as to future events on all policies in force, approximately 10% and 9% of the present value of future profits of acquired business as of December 31, 1993, are expected to be amortized in each of the next two years, respectively, and 8% in each of the succeeding three years. The interest accrual rate for the present value of future profits of acquired business ranged from 8% to 10% during each of the three years in the period ended December 31, 1993. SCHEDULE II I.C.H. CORPORATION AND SUBSIDIARIES AMOUNTS RECEIVABLE FROM RELATED PARTIES AND UNDERWRITERS, PROMOTERS AND EMPLOYEES OTHER THAN RELATED PARTIES FOR THE YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 (IN THOUSANDS) SCHEDULE III I.C.H. CORPORATION CONDENSED FINANCIAL INFORMATION OF REGISTRANT BALANCE SHEETS DECEMBER 31, 1993 AND 1992 (IN THOUSANDS) ASSETS The accompanying notes are an integral part of the financial statements. SCHEDULE III (CONTINUED) I.C.H. CORPORATION CONDENSED FINANCIAL INFORMATION OF REGISTRANT (CONTINUED) STATEMENTS OF EARNINGS FOR THE YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 (IN THOUSANDS) The accompanying notes are an integral part of the financial statements. SCHEDULE III (CONTINUED) I.C.H. CORPORATION CONDENSED FINANCIAL INFORMATION OF REGISTRANT (CONTINUED) STATEMENTS OF CASH FLOWS FOR THE YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 (IN THOUSANDS) The accompanying notes are an integral part of the financial statements. SCHEDULE III (CONTINUED) I.C.H. CORPORATION CONDENSED FINANCIAL INFORMATION OF REGISTRANT (CONTINUED) NOTES TO CONDENSED FINANCIAL STATEMENTS The accompanying condensed financial statements should be read in conjunction with the consolidated financial statements and notes thereto of I.C.H. Corporation and Subsidiaries. Notes payable at December 31, 1993 and 1992, are summarized as follows: The following summary sets forth the scheduled maturities and sinking fund requirements of notes payable during each of the five years following December 31, 1993 (in thousands): Dividends from subsidiaries and equity investees consist of the following: Prior to the sale of Bankers, the parent company acquired certain assets from Bankers at their fair value. The tax attributes related to such assets were likewise transferred to ICH and the income tax consequences which had been reflected for financial purposes have been reflected as a deemed dividend to the parent company. SCHEDULE V I.C.H. CORPORATION AND SUBSIDIARIES SUPPLEMENTARY INSURANCE INFORMATION FOR THE YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 (IN THOUSANDS) SCHEDULE VI I.C.H. CORPORATION AND SUBSIDIARIES REINSURANCE FOR THE YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 (DOLLARS IN THOUSANDS) These agreements will terminate during the next few years. SCHEDULE VIII I.C.H. CORPORATION AND SUBSIDIARIES VALUATION AND QUALIFYING ACCOUNTS AND RESERVES FOR THE YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 (IN THOUSANDS) ITEM 9.

ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE. Not applicable. PART III ITEM 10.

ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF REGISTRANT. The information appearing under ITEM 1A in Part I of this Form 10-K and the information appearing under the heading "Election of Directors" in the Registrant's definitive Proxy Statement to be filed pursuant to Regulation 14A under the Securities Exchange Act of 1934 in connection with the Registrant's 1994 Annual Meeting of Stockholders are incorporated herein by reference. ITEM 11.

ITEM 11. EXECUTIVE COMPENSATION. The information appearing under the heading "Executive Compensation" in the Registrant's definitive Proxy Statement to be filed pursuant to Regulation 14A under the Securities Exchange Act of 1934 in connection with the Registrant's 1994 Annual Meeting of Stockholders is incorporated herein by reference. ITEM 12.

ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT. The information appearing under the heading "Security Ownership" in the Registrant's definitive Proxy Statement to be filed pursuant to Regulation 14A under the Securities Exchange Act of 1934 in connection with the Registrant's 1994 Annual Meeting of Stockholders is incorporated herein by reference. ITEM 13.

ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS. The information appearing under the subheading "Certain Transactions" under "Executive Compensation" in the Registrant's definitive Proxy Statement to be filed pursuant to Regulation 14A under the Securities Exchange Act of 1934 in connection with the Registrant's 1994 Annual Meeting of Stockholders is incorporated herein by reference. PART IV ITEM 14.

ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K. 1. EXHIBITS. The exhibits listed on the Index to Exhibits appearing on pages 99-105 of this Form 10-K and the footnotes thereto are incorporated herein by reference. The exhibit descriptions incorporated by reference identify by asterisk (*) each management contract or compensatory plan or arrangement required to be filed as an exhibit to this Form 10-K pursuant to ITEM 14(C). 2. FINANCIAL STATEMENTS. The list of audited consolidated financial statements of ICH and the related auditor's report appearing under the heading "Financial Statements" in the Index to Financial Statements and Financial Statement Schedules of I.C.H. Corporation and Subsidiaries in ITEM 8 on page of this Form 10-K is incorporated herein by reference. 3. FINANCIAL STATEMENT SCHEDULES. The list of schedules appearing under the heading "Financial Statement Schedules" in the Index to Financial Statements and Financial Statement Schedules of I.C.H. Corporation and Subsidiaries in ITEM 8 on page 47 of this Form 10-K is incorporated herein by reference. 4. FORM 8-K. On October 1, 1993, the Registrant filed a Report on Form 8-K, dated September 30, 1993, to report, under ITEM 5 of that form, the closing of the Registrant's sale of 13,316,168 shares of common stock of Bankers Life Holding Corporation; the sale of shares of common stock of CCP Insurance, Inc. by subsidiaries of the Registrant in conjunction with an underwritten public offering; and the completion of the restructuring of the Registrant's insurance holding company organization, from a vertical to a substantially horizontal configuration and matters relating to the receipt of regulatory approvals in connection therewith. The Registrant filed a Report on Form 8-K, dated January 15, 1994, to report, under ITEM 5 of that form, the execution of Stock Purchase Agreements pursuant to which the Registrant agreed to repurchase its Class B Common Stock from Consolidated National Corporation ("CNC") and CNC agreed to sell shares of the Registrant's Common Stock to Torchmark Corporation and Stephens Inc.; and a Report on Form 8-K, dated February 11, 1994, to report, under ITEM 1 of that form, the closing of said Stock Purchase Agreements and the sales of Common Stock and Class B Common Stock and other transactions contemplated thereby. SIGNATURES Pursuant to the requirements of Section 13 or 15(d) 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. I.C.H. CORPORATION BY: /s/ ROBERT L. BEISENHERZ -------------------------------------- Robert L. Beisenherz CHAIRMAN OF THE BOARD, CHIEF EXECUTIVE OFFICER AND PRESIDENT Date: March 21, 1994 Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated. INDEX TO EXHIBITS The following documents are incorporated by reference or filed as Exhibits to the Annual Report on Form 10-K of I.C.H. Corporation for the year ended December 31, 1993:

732712_1993.txt

732712

1993

Item 1. Business GENERAL Bell Atlantic Corporation (the "Company" or "Bell Atlantic") is one of the seven regional holding companies ("RHCs") formed in connection with the court- approved divestiture (the "Divestiture"), effective January 1, 1984, of those assets of the American Telephone and Telegraph Company ("AT&T") related to exchange telecommunications, exchange access functions, printed directories and cellular mobile communications. Pursuant to the Divestiture, AT&T transferred to the Company, among other assets, its 100% ownership interest in seven Bell System operating companies ("BOCs"): New Jersey Bell Telephone Company; The Bell Telephone Company of Pennsylvania; The Diamond State Telephone Company; The Chesapeake and Potomac Telephone Company; The Chesapeake and Potomac Telephone Company of Maryland; The Chesapeake and Potomac Telephone Company of Virginia; and The Chesapeake and Potomac Telephone Company of West Virginia (collectively, the "Network Services Companies"). In January 1994, to facilitate the creation of a uniform "Bell Atlantic" brand name across the territories served by these seven telephone subsidiaries, the names of the Network Services Companies were changed to Bell Atlantic - New Jersey, Inc. ("Bell Atlantic - New Jersey"), Bell Atlantic - Pennsylvania, Inc. ("Bell Atlantic - Pennsylvania"), Bell Atlantic - Delaware, Inc. ("Bell Atlantic - Delaware"), Bell Atlantic - Washington, D.C., Inc. ("Bell Atlantic - Washington, D.C."), Bell Atlantic - Maryland, Inc. ("Bell Atlantic - Maryland"), Bell Atlantic - Virginia, Inc. ("Bell Atlantic - Virginia") and Bell Atlantic - West Virginia, Inc. ("Bell Atlantic - West Virginia"), respectively. The Company's business currently encompasses two segments: (1) Communications and Related Services, and (2) Financial, Real Estate, and Other Services. Financial information with respect to the Company's industry segments is set forth in Note 15 to the Consolidated Financial Statements incorporated by reference in this Annual Report on Form 10-K. The Communications and Related Services segment includes the Network Services Companies as well as subsidiaries which are engaged in the business of providing wireless communications products and services, including cellular mobile service; selling directory advertising and providing photocomposition services; servicing and repairing computers; and providing software for telecommunications and computer networking. During 1993, Bell Atlantic reorganized certain functions performed by each of the Network Services Companies into nine lines of business ("LOBs") organized across the Network Services Companies around specific market segments. See "Communications and Related Services - The Network Services Companies - Operations". The Financial, Real Estate, and Other Services segment is comprised of subsidiaries of the Company which are engaged in lease financing of commercial, industrial, medical and high-technology equipment, and other forms of financing; real estate investment and management; and the sale and distribution of liquefied petroleum gas. In line with its continuing de-emphasis of financial services businesses over the past several years and its intensified focus on core communications businesses, the Company announced in October 1993 that it had begun evaluating possible strategies for exiting its financial services businesses. In March 1994, the Company announced an agreement to sell a significant portion of its diversified leasing business to GFC Financial Corporation. This sale is expected to close in the second quarter of 1994, subject to the receipt of regulatory approvals. See "Financial, Real Estate, and Other Services". The communications industry is currently undergoing fundamental changes driven by the accelerated pace of technological innovation, the convergence of the telecommunications, cable television, information services and entertainment businesses, and a regulatory environment in which many traditional regulatory barriers are being lowered and competition permitted or encouraged. Although no definitive prediction can be made of the market opportunities these changes will present or whether Bell Atlantic will be able successfully to take advantage of these opportunities, the Company is positioning itself to be a leading communications, information services and entertainment company. The Company was incorporated in 1983 under the laws of the State of Delaware and has its principal executive offices at 1717 Arch Street, Philadelphia, Pennsylvania 19103 (telephone number 215-963-6000). LINE OF BUSINESS RESTRICTIONS The consent decree entitled "Modification of Final Judgment" ("MFJ") approved by the United States District Court for the District of Columbia (the "D.C. District Court") which, together with the Plan of Reorganization ("Plan") approved by the D.C. District Court, set forth the terms of Divestiture also established certain restrictions on the post-Divestiture activities of the RHCs, including Bell Atlantic. The MFJ's principal restrictions on post-Divestiture RHC activities included prohibitions on (i) providing interexchange telecommunications, (ii) providing information services, (iii) engaging in the manufacture of telecommunications equipment and customer premises equipment ("CPE"), and (iv) entering into any non-telecommunications businesses, in each case without the approval of the D.C. District Court. Since Divestiture, the D.C. District Court has retained jurisdiction over the construction, modification, implementation and enforcement of the MFJ. In September 1987, the D.C. District Court rendered a decision which eliminated the need for the RHCs to obtain its approval prior to entering into non-telecommunications businesses. However, the D.C. District Court refused to eliminate the restrictions relating to equipment manufacturing or providing interexchange services. With respect to information services, the Court issued a ruling in March 1988 which permitted the RHCs to engage in a number of information transport functions as well as voice storage and retrieval services, including voice messaging, electronic mail and certain information gateway services. However, the RHCs were generally prohibited from providing the content of the data they transmitted. As the result of an appeal of the D.C. District Court's September 1987 and March 1988 decisions by the RHCs and other parties, the United States Court of Appeals for the District of Columbia Circuit ordered the D.C. District Court to reconsider the RHCs' request to provide information content and determine whether removal of the restrictions thereon would be in the public interest. In July 1991, the D.C. District Court removed the remaining restrictions on RHC participation in information services, but imposed a stay pending appeal of that decision. In October 1991, the United States Court of Appeals for the District of Columbia Circuit vacated the stay, thereby permitting the RHCs to provide information services, and in May 1993 affirmed the D.C. District Court's July 1991 decision. The United States Supreme Court denied certiorari in November 1993. Several bills have been introduced in the current session of Congress pursuant to which the line of business restrictions established by the MFJ could be eliminated or modified. No definitive prediction can be made as to whether or when any such legislation will be enacted, the provisions thereof or their impact on the business or financial condition of the Company. COMMUNICATIONS AND RELATED SERVICES The Network Services Companies General The Network Services Companies presently serve a territory ("Territory") consisting of 19 Local Access and Transport Areas ("LATAs"). These LATAs are generally centered on a city or based on some other identifiable common geography and, with certain limited exceptions, each LATA marks the boundary within which a Network Services Company may provide telephone service. The Network Services Companies provide two basic types of telecommunications services. First, they transport telecommunications traffic between subscribers located within the same LATA ("intraLATA service"), including both local and toll services. Local service includes the provision of local exchange ("dial tone"), local private line and public telephone services (including dial tone service for pay telephones owned by the Company and other pay telephone providers). Among other local services provided are Centrex (telephone company central office-based switched telephone service enabling the subscriber to make both intercom and outside calls) and a variety of special and custom calling services. Toll service includes message toll service (calling service beyond the local calling area) within LATA boundaries, and intraLATA Wide Area Toll Service (WATS)/800 services (volume discount offerings for customers with highly concentrated demand). As permitted by the Plan, Bell Atlantic - New Jersey and Bell Atlantic - Pennsylvania also earn toll revenue from the provision of telecommunications service between LATAs ("interLATA service") in corridors between the cities (and certain surrounding counties) of (i) New York, New York and Newark, New Jersey and (ii) Philadelphia, Pennsylvania and Camden, New Jersey. Second, the Network Services Companies provide exchange access service, which links a subscriber's telephone or other equipment to the transmission facilities of interexchange carriers which, in turn, provide interLATA service to their customers. Bell Atlantic - Pennsylvania, Bell Atlantic -Delaware, Bell Atlantic - Maryland and Bell Atlantic - West Virginia also provide exchange access service to interexchange carriers which provide intrastate intraLATA long distance telecommunications service. See "Communications and Related Services -The Network Services Companies - Competition - IntraLATA Toll Competition". Operations Although the Network Services Companies remain responsible within their respective service areas for the provision of telephone services, financial performance and regulatory matters, during 1993, Bell Atlantic reorganized certain functions formerly performed by each of these companies relating to these telephone services into nine LOBs organized across the Network Services Companies around specific market segments. These nine LOBs are: The Consumer Services LOB markets communications services to residential ----------------- customers within the Territory (11 million households and 29 million people) and plans in the future to market information services and entertainment programming. 1993 revenues generated by consumer services were approximately $4 billion, representing approximately 34% of the Network Services Companies' aggregate revenues. These revenues were derived primarily from the provision of telephone services to residential users. The Carrier Services LOB markets (i) switched and special access to the ---------------- Network Services Companies' local exchange networks, and (ii) billing and collection services, including recording, rating, bill processing and bill rendering. 1993 revenues generated by the carrier market were approximately $2.5 billion, representing approximately 21% of the Network Services Companies' aggregate revenues. Approximately 93% of total carrier services revenues were derived from interexchange carriers; AT&T is the largest single customer. Most of the remaining revenues came from business customers and government agencies with their own special access network connections, wireless customers and other local exchange carriers ("LECs") which resell network connections to their own customers. The Small Business Services LOB markets communications and information ----------------------- services to small businesses (customers having up to 20 access lines or 100 Centrex lines). The Network Services Companies have approximately 1.2 million small business customers in the Territory which in 1993 generated approximately $1.7 billion in revenues, representing approximately 15% of the Network Services Companies' aggregate revenues. The Large Business Services LOB markets communications and information ----------------------- services to large businesses (customers having more than 20 access lines or more than 100 Centrex lines). These services include voice switching/processing services (e.g., dedicated private lines, custom Centrex, ---- call management and voice messaging), end-user networking (e.g., credit and ---- debit card transactions, and personal computer-based conferencing, including data and video), internetworking (establishing links between the geographically disparate networks of two or more companies or within the same company), network integration (integrating multiple geographically disparate networks into one system), network optimization (disaster avoidance, 911, intelligent vehicle highway systems), video services (distance learning, telemedicine, surveillance, videoconferencing) and integrated multi-media applications services. The Network Services Companies serve more than 18,000 primarily in-Territory large business customers in the commercial, state and local government and education markets. 1993 revenues from the large business market were approximately $1.5 billion, representing approximately 13% of the Network Services Companies' aggregate revenues. The Directory Services LOB manages the provision of (i) advertising and ------------------ marketing services to advertisers, and (ii) listing information (e.g., White ---- Pages and Yellow Pages). These services are currently provided primarily through print media, but the Company expects that use of electronic formats will increase in the future. In addition, the Directory Services LOB manages the provision of photocomposition, database management and other related products and services to publishers. 1993 revenues from directory services were approximately $1 billion, representing approximately 9% of the Network Services Companies' aggregate revenues. The Public and Operator Services LOB markets pay telephone and operator ---------------------------- services in the Territory to meet consumer needs for accessing public networks, locating and identifying network subscribers, providing calling assistance and arranging billing alternatives (e.g., calling card, collect and third party ---- calls). 1993 revenues from public and operator services were approximately $663 million, representing approximately 6% of the Network Services Companies' aggregate revenues. The Federal Systems LOB markets communications and information technology and --------------- services to departments, agencies and offices of the executive, judicial and legislative branches of the federal government. 1993 revenues from the federal government market were approximately $200 million, representing approximately 2% of the Network Services Companies' aggregate revenues. The Information Services LOB has been established to provide programming -------------------- services, including on-demand entertainment, transactions and interactive multimedia applications within the Territory and in selected other markets. See "Communications and Related Services - The Network Services Companies - FCC Regulation and Interstate Rates - Telephone Company Provision of Video Dial Tone and Video Programming". The Network LOB manages the technologies, services and systems platforms ------- required by the other eight LOBs and the Network Services Companies to meet the needs of their respective customers, including, without limitation, switching, feature development and on-premises installation and maintenance services. The Network Services Companies have been making and expect to continue to make significant capital expenditures on their networks to meet the demand for communications services and to further improve such services. Capital expenditures of the Network Services Companies were approximately $2.3 billion in 1991, $2.2 billion in 1992 and $2.1 billion in 1993. The total investment in plant, property and equipment decreased from approximately $30.7 billion at December 31, 1991 to approximately $29.6 billion at December 31, 1992, and increased to approximately $30.6 billion at December 31, 1993, in each case after giving effect to retirements, but before deducting accumulated depreciation at such date. The Network Services Companies as a whole are projecting construction expenditures for 1994 at approximately the same level as in the past several years. However, subject to regulatory approvals, the Network Services Companies plan to allocate capital resources to the deployment of broadband network platforms (technologies ultimately capable of providing a switched facility for access to and transport of high-speed data services, video-on-demand, and image and interactive multimedia applications). Most of the funds for these expenditures are expected to be generated internally. Some additional external financing may be necessary or desirable for some of the Network Services Companies. FCC Regulation and Interstate Rates The Network Services Companies are subject to the jurisdiction of the Federal Communications Commission ("FCC") with respect to interstate services and certain related matters. The FCC prescribes a uniform system of accounts for telephone companies, interstate depreciation rates and the principles and standard procedures used to separate plant investment, expenses, taxes and reserves between those applicable to interstate services under the jurisdiction of the FCC and those applicable to intrastate services under the jurisdiction of the respective state regulatory authorities ("separations procedures"). The FCC also prescribes procedures for allocating costs and revenues between regulated and unregulated activities. Interstate Access Charges The Network Services Companies provide intraLATA service and, with certain limited exceptions, do not participate in the provision of interLATA service except through offerings of exchange access service. See "Communications and Related Services - The Network Services Companies - General". The FCC has prescribed structures for exchange access tariffs to specify the charges ("Access Charges") for use and availability of the Network Services Companies' facilities for the origination and termination of interstate interLATA service. Access Charges are intended to recover the related costs of the Network Services Companies which have been allocated to the interstate jurisdiction ("Interstate Costs") under the FCC's separations procedures. In general, the tariff structures prescribed by the FCC provide that Interstate Costs of the Network Services Companies which do not vary based on usage ("non-traffic sensitive costs") are recovered from subscribers through flat monthly charges ("Subscriber Line Charges"), and from interexchange carriers through usage-sensitive Carrier Common Line ("CCL") charges. See "Communications and Related Services - The Network Services Companies - FCC Regulation and Interstate Rates - FCC Access Charge Pooling Arrangements". Traffic-sensitive Interstate Costs are recovered from carriers through variable access charges based on several factors, primarily usage. In May 1984, the FCC authorized the implementation of Access Charge tariffs for "switched access service" (access to the local exchange network) and of Subscriber Line Charges for multiple line business customers (up to $6.00 per month per line). In 1985, the FCC authorized Subscriber Line Charges for residential and single-line business customers at the rate of $1.00 per month per line, which increased in installments to $3.50 effective April 1, 1989. As a result of the phasing in of Subscriber Line Charges, a substantial portion of non-traffic sensitive Interstate Costs is now recovered directly from subscribers, thereby reducing the per-minute CCL charges to interexchange carriers. This significant reduction in CCL charges has tended to reduce the incentive for interexchange carriers and their high-volume customers to bypass the Network Services Companies' switched network via special access lines or alternative communications systems. However, competition for this access business has increased in recent years. See "Communications and Related Services - The Network Services Companies - Competition - Alternative Access and Local Services". FCC Access Charge Pooling Arrangements The FCC previously required that all LECs, including the Network Services Companies, pool revenues from CCL and Subscriber Line Charges that cover the non-traffic sensitive costs of the local exchange network, that is, the Interstate Costs associated with the lines from subscribers' premises to telephone company central offices. To administer such pooling arrangements, the FCC mandated the formation of the National Exchange Carrier Association, Inc. Some LECs received more revenue from the pool than they billed their interexchange carrier customers using the nationwide average CCL rate. Other companies, including all but one of the Network Services Companies, received substantially less from the pool than the amount billed to their interexchange carrier customers. By an order adopted in 1987, the FCC changed its mandatory pooling requirements. These changes, which became effective April 1, 1989, permitted all of the Network Services Companies as a group to withdraw from the pool and to charge CCL rates which more closely reflect their non-traffic sensitive costs. The Network Services Companies are still obligated to make contributions of CCL revenues to companies who choose to continue to pool non- traffic sensitive costs so that the pooling companies can charge a CCL rate no greater than the nationwide average CCL rate. In addition to this continuing obligation, the Network Services Companies have a transitional support obligation to high cost companies who left the pool in 1989 and 1990. This transitional support obligation phases out over five years. These long-term and transitional support requirements will be recovered in the Network Services Companies' CCL rates. Depreciation Depreciation rates provide for the recovery of the Network Services Companies' investment in telephone plant and equipment, and are revised periodically to reflect more current estimates of remaining service lives and future net salvage values. In October 1993, the FCC issued an order simplifying the depreciation filing process by reducing the information required for certain categories of plant and equipment whose remaining service life, salvage estimates and depreciation rates fall within an approved range. Petitions for reconsideration of that order were filed in December 1993. In November 1993, the FCC issued a further order inviting comments on proposed ranges for an initial group of categories of plant and equipment. Price Caps In September 1990, the FCC adopted "price cap" regulation to replace the traditional rate of return regulation of LECs. LEC price cap regulation became effective on January 1, 1991. The price cap system places a cap on overall prices for interstate services and requires that the cap decrease annually, in inflation-adjusted terms, by a fixed percentage which is intended to reflect expected increases in productivity. The price cap level can also be adjusted to reflect "exogenous" changes, such as changes in FCC separations procedures or accounting rules. LECs subject to price caps have somewhat increased flexibility to change the prices of existing services within certain groupings of interstate services, known as "baskets". Under price cap regulation, the FCC set an authorized rate of return of 11.25% for the years 1991 and beyond. To the extent that a company is able to earn a higher rate of return through improved efficiency, the FCC's price cap rules permit them to retain the full amount of this higher return up to 100 basis points above the authorized rate of return (currently, up to a 12.25% rate of return). If a company's rate of return is between 100 and 500 basis points above the authorized rate of return (that is, currently, between 12.25% and 16.25%), the company must share 50% of the earnings above the 100-basis-point level with customers by reducing rates prospectively. All earnings above the 500-basis-point level must be returned to customers in the form of prospective rate decreases. If, on the other hand, a company's rate of return is more than 100 basis points below the authorized rate of return (that is, currently, below 10.25%), the company is permitted to increase rates prospectively to make up the deficiency. Under FCC-approved tariffs, the Network Services Companies are charging uniform rates for interstate access services (with the exception of Subscriber Line Charges) throughout the Territory and are regarded as a single unit by the FCC for rate of return measurement. On February 16, 1994, the FCC initiated a rulemaking proceeding to determine the effectiveness of LEC price cap rules and decide what changes, if any, should be made to those rules. This rulemaking is expected to be concluded by the end of 1994. In January 1993, the FCC denied the Network Services Companies exogenous treatment of the increased expense for postretirement benefits required under Statement of Financial Accounting Standards No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions", which the Company adopted effective January 1, 1991. The Network Services Companies have appealed this decision. The appeal is likely to be decided during the second half of 1994. Computer Inquiry III In August 1985, the FCC initiated Computer Inquiry III to re-examine its regulations requiring that "enhanced services" (e.g., voice messaging services, ---- electronic mail, videotext gateway, protocol conversion) be offered only through a structurally separated subsidiary. In 1986, the FCC eliminated this requirement, permitting the Network Services Companies to offer enhanced services, subject to compliance with a series of nonstructural safeguards designed to promote an effectively competitive market. These safeguards include detailed cost accounting, protection of customer information and certain reporting requirements. In June 1990, the United States Court of Appeals for the Ninth Circuit vacated and remanded the Computer Inquiry III decisions to the FCC, finding that the FCC had not fully justified those decisions. In December 1991, the FCC adopted an order which reinstated relief from the separate subsidiary requirement upon a company's compliance with the FCC's Computer III Open Network Architecture ("ONA") requirements and strengthened some of the nonstructural safeguards. In the interim, the Network Services Companies had filed interstate tariffs implementing the ONA requirements. Those tariffs became effective in February 1992, subject to further investigation. That investigation was completed on December 15, 1993, when an order was released making minor changes to the Network Services Companies' ONA rates. In March 1992, the Network Services Companies certified to the FCC that they had complied with all initial ONA obligations and therefore should be granted structural relief for enhanced services. The FCC granted the Network Services Companies structural relief in June 1992. Other parties have appealed this decision, which remains in effect pending the outcome of the appeal. A decision on the appeal is likely by the end of 1994. The FCC's December 1991 order has been appealed to the United States Court of Appeals for the Ninth Circuit by several parties. Pending decision on those appeals, the FCC's decision remains in effect. If a court again reverses the FCC, the Network Services Companies' right to offer enhanced services could be impaired. FCC Cost Allocation and Affiliate Transaction Rules In 1987, the FCC adopted rules governing (i) the allocation of costs between the regulated and unregulated activities of a communications common carrier and (ii) transactions between the regulated and unregulated affiliates of a communications common carrier. The cost allocation rules apply to certain unregulated activities: activities that have never been regulated as communications common carrier offerings and activities that have been preemptively deregulated by the FCC. The costs of these activities are removed prior to the separations procedures process and are allocated to unregulated activities in the aggregate, not to specific services, for pricing purposes. Other activities must be accounted for as regulated activities, and their costs are subject to separations procedures. These activities include (i) those which have been deregulated by the FCC without preempting state regulation, (ii) those which have been deregulated by a state but not the FCC and (iii) "incidental activities," which cannot, in the aggregate, generate more than 1% of a company's revenues. Since the Network Services Companies engage in these types of activities, the Network Services Companies, pursuant to the FCC's cost allocation rules, filed a cost allocation manual, which manual has been approved by the FCC. The affiliate transaction rules govern the pricing of assets transferred to and services provided by affiliates. These rules generally require that assets be transferred between affiliates at "market price", if such price can be established through a tariff or a prevailing price actually charged to third parties. In the absence of a tariff or prevailing price, "market price" cannot be established, in which case (i) asset transfers from a regulated to an unregulated affiliate must be valued at the higher of cost or fair market value, and (ii) asset transfers from an unregulated to a regulated affiliate must be valued at the lower of cost or fair market value. The affiliate transaction rules require that a service provided by one affiliate to another affiliate, which service is also provided to unaffiliated entities, must be valued at tariff rates or market prices. If the affiliate does not also provide the service to unaffiliated entities, the price must be determined in accordance with the FCC's cost allocation principles. In October 1993, the FCC proposed new affiliate transaction rules which would essentially eliminate the different rules for the provision of services and apply the asset transfer rules to all affiliate transactions. The Network Services Companies have filed comments opposing the proposed rules. The FCC has not attempted to make its cost allocation or affiliate transaction rules preemptive. State regulatory authorities are free to use different cost allocation methods and affiliate transaction rules for intrastate ratemaking and to require carriers to keep separate allocation records. Telephone Company Provision of Video Dial Tone and Video Programming In 1987, the FCC initiated an inquiry into whether developments in the cable and telephone industries warranted changes in the rules prohibiting telephone companies such as the Network Services Companies from providing video programming in their respective service territories directly or indirectly through an affiliate. In November 1991, the FCC released a Further Notice of Proposed Rulemaking in these proceedings. In August 1992, the FCC issued an order permitting telephone companies such as the Network Services Companies to provide "video dial tone" service. Video dial tone permits telephone companies to provide video transport to multiple programmers on a non-discriminatory common carrier basis. The FCC has also ruled that neither telephone companies that provide video dial tone service, nor video programmers that use these services, are required to obtain local cable franchises. Other parties have appealed these orders, which remain in effect pending the outcome of the appeal. In late 1992, Bell Atlantic - New Jersey entered into agreements pursuant to which, pending regulatory approval, it would provide video dial tone transport services to two video programmers in New Jersey. As contemplated by its contract with Sammons Communications, Incorporated ("Sammons"), Bell Atlantic - New Jersey will deploy fiber optic technology that will enable Sammons and other video information providers to deliver video programming in three Morris County, New Jersey communities over a video dial tone platform. Bell Atlantic - New Jersey's contract with Future Vision of America Corporation ("Future Vision") contemplates that Bell Atlantic - New Jersey will deploy fiber optic technology in the Dover Township, New Jersey telephone network to establish a video dial tone platform that will allow Future Vision and other video information providers to deliver competitive video programming services in that community. Applications for approval to deploy these video dial tone systems are pending at the FCC. In December 1992, Bell Atlantic - Virginia and Bell Atlantic Video Services Company filed a lawsuit against the federal government in the United States District Court for the Eastern District of Virginia seeking to overturn the prohibition in the Cable Communications Policy Act of 1984 against LECs providing video programming in their respective service areas. In a decision rendered in August 1993 and clarified in October 1993, the court struck down this prohibition as a violation of the First Amendment's freedom of speech protections and enjoined its enforcement against the Company, the Network Services Companies and Bell Atlantic Video Services Company. This decision has been appealed to the United States Court of Appeals for the Fourth Circuit. In early 1993, the FCC granted the Company authority to test a new technology known as Asynchronous Digital Subscriber Line ("ADSL") for use in delivering video entertainment and information over existing copper telephone lines. Beginning in March 1993, the Company began a one-year technical trial of ADSL serving up to 400 Bell Atlantic employees in northern Virginia. In the Fall of 1993, Bell Atlantic petitioned the FCC for authorization to expand and convert this technical trial, upon its completion, into a six month market trial serving up to 2,000 customers. Bell Atlantic also requested authority to offer a commercial video dial tone service to customers served by 25 central offices in parts of northern Virginia and southern Maryland upon completion of the six month market trial. These applications are pending at the FCC. Interconnection and Collocation In October 1992, the FCC issued an order allowing third parties to collocate their equipment in telephone company offices to provide special access (private line) services to the public. The FCC's stated purpose was to encourage greater competition in the provision of interstate special access services. The order permits collocating parties to pay LECs an interconnection charge that is lower than the existing tariffed rates for similar non-collocated services; it allows LECs limited additional pricing flexibility for their own special access services when collocated interconnection is operational. In February 1993, the Network Services Companies filed interstate tariffs to allow collocation for special access services. These tariffs are currently effective. The Company and certain other parties have appealed the FCC's special access collocation order. Bell Atlantic expects the appeal to be decided in 1994. On September 2, 1993, the FCC extended collocation to switched access services. The terms and conditions for switched access collocation are similar to those for special access collocation. On November 18, 1993, the Network Services Companies filed interstate tariffs to allow collocation for switched access services. These tariffs became effective on February 16, 1994. The Company and certain other parties have appealed the FCC's switched access collocation order. Appeals of this order have been stayed pending a decision on the appeals of the special access collocation order. Increased competition through collocation will adversely affect the revenues of the Network Services Companies, although some of the lost revenues could be offset by increased demand of the Network Services Companies' own special access services as a result of the slightly increased pricing flexibility that the FCC has permitted. The Company does not expect the net revenue impact of special access collocation to be material. Revenue losses from switched access collocation, however, may be larger than from special access collocation. Intelligent Networks In December 1991, the FCC issued a Notice of Inquiry into the plans of the BOCs, including the Network Services Companies, to deploy new "modular" network architectures, such as Advanced Intelligent Network ("AIN") technology. The Notice of Inquiry asks what, if any, regulatory action the FCC should take to assure that such architectures are deployed in a manner that is "open, responsive, and procompetitive". On August 31, 1993, the FCC issued a Notice of Proposed Rulemaking proposing a schedule for AIN deployment. The proposals in that Notice of Proposed Rulemaking generally follow those that the Company proposed in its response to the Notice of Inquiry. The Company cannot estimate when the FCC will conclude this proceeding. The results of this proposed rulemaking could include a requirement that the Network Services Companies offer individual components of their services, such as switching and transport, to competitors who will provide the remainder of such services through their own facilities. Such increased competition could divert revenues from the Network Services Companies. However, deployment of AIN technology may also enable the Network Services Companies to respond more quickly and efficiently to customer requests for new services. This could result in increased revenues from new services that could at least partially offset losses resulting from increased competition. State Regulation and Intrastate Rates The communications services of the Network Services Companies are subject to regulation by the public utility commissions in the jurisdictions in which they operate with respect to intrastate rates and services and other matters. In 1993, there were a number of proceedings dealing with such issues as the various Network Services Companies' rates of return, the adoption of flexible regulation procedures and the introduction of competition for local exchange and local access services. Bell Atlantic - New Jersey, Inc. (formerly New Jersey Bell Telephone Company) In June 1987, the New Jersey Board of Regulatory Commissioners ("NJBRC") (which was then known as the Board of Public Utilities) issued an order approving a Rate Stability Plan ("RSP") that modified the way the NJBRC monitors Bell Atlantic - New Jersey's intrastate earnings. Rather than continue to monitor overall company financial performance, the RSP authorized financial performance surveillance only of less competitive services. The RSP also capped intrastate tariffed rates for its six year duration (July 1, 1987 through June 30, 1993), subject, however, to certain exceptions which would permit Bell Atlantic - New Jersey to seek increases in tariffed rates during the RSP's fourth through sixth years. The RSP separated Bell Atlantic - New Jersey's intrastate services into two categories: Group I (more competitive) services such as directory advertising, Centrex, pay telephone services, billing and collection services, high capacity channel and special access services, public data networks, central office local area networks, pay-per-view ordering service, high capacity digital hand-off service, Bellboy(R) paging service, 911 enhanced terminal equipment and Home Intercom; and Group II (less competitive) services such as local exchange service, local usage, message toll service, 800 data base complementary service and Repeat Call and Return Call. Only the Group II services were subject to financial performance monitoring by the NJBRC for the purpose of determining whether or not Bell Atlantic - New Jersey was earning the target rate of return for those services. In January 1989, the NJBRC issued an order which established a target rate of return on equity of 12.9% for the purpose of monitoring the financial performance of the Group II category of services. Under the RSP, Bell Atlantic - New Jersey was allowed to charge competitive rates for Group I services, without restriction and without financial performance monitoring. The New Jersey Telecommunications Act of 1992 (the "NJ Telecommunications Act") became effective in January 1992. The NJ Telecommunications Act authorized the NJBRC to adopt alternative regulatory frameworks that provide incentives to telecommunications companies for aggressive deployment of new technologies. It also deregulated services which the NJBRC has found to be competitive. Pursuant to that legislation, Bell Atlantic - New Jersey filed its Plan for Alternative Form of Regulation in March 1992, and a revised plan in May 1992. This revised plan was unanimously approved by the NJBRC in December 1992, with certain modifications; the written order reflecting that approval was issued on May 6, 1993. Bell Atlantic - New Jersey filed a plan conforming to the NJBRC's order (the "NJ PAR"), which became effective on May 20, 1993. Several parties have filed judicial appeals of the NJBRC's order. The briefing schedule for this appeal extends through the middle of August 1994. The NJ PAR, which supersedes the RSP, divides Bell Atlantic - New Jersey's services into Rate-Regulated Services (formerly Group II services) and Competitive Services (formerly Group I and services which have never been regulated by the NJBRC). Under this Plan, Bell Atlantic - New Jersey's Rate- Regulated Services are grouped in two categories: - "Protected Services": Basic residence and business service, Touch-Tone, access services, message toll services and the ordering, installation and restoration of these services. Rates for Protected Services, other than basic residence service, may be increased beginning January 1996 in an amount limited to the prior year's increase in the Gross National Product-Price Index ("GNP-PI") less a 2% productivity offset, as long as the return on equity for Rate-Regulated Services does not exceed 11.7%. Basic residence service rates are frozen through December 1999. - "Other Services": Custom calling, Custom Local Area Signaling Services ("CLASS" services which utilize Signaling System 7), operator services and 911 enhanced service. Rates for Other Services may be increased beginning January 1996 in an amount limited to the prior year's increase in the GNP-PI less a 2% productivity offset, as long as the return on equity for Rate-Regulated Services does not exceed 12.7%. All earnings above a return on equity of 13.7% for Rate-Regulated Services will be shared equally with customers. There is no point at which the earnings are capped. Competitive Services are deregulated under the NJ Telecommunications Act. Other services such as premises wire maintenance, Answer Call and electronic messaging, which have never been regulated by the NJBRC, continue to be deregulated under the NJ Telecommunications Act. Bell Atlantic - Pennsylvania, Inc. (formerly The Bell Telephone Company of Pennsylvania) Bell Atlantic - Pennsylvania continues to operate under traditional rate-of- return regulation, but is pursuing regulatory reform through regulatory channels. In October 1992, the Pennsylvania Public Utility Commission ("PPUC") adopted financial reporting rules that exclude revenues, expenses and investment associated with directory advertising from quarterly earnings surveillance reports, although these rules require Bell Atlantic - Pennsylvania to file an annual informational filing including directory advertising earnings. The PPUC made no finding relative to future ratemaking treatment for directory advertising. On July 8, 1993, legislation was enacted in Pennsylvania which enables Bell Atlantic - Pennsylvania to petition the PPUC to regulate Bell Atlantic - Pennsylvania under an alternative form of regulation other than rate-based rate of return. On October 1, 1993, Bell Atlantic - Pennsylvania filed its petition and plan with the PPUC which contained (i) six proposed competitive services (directory advertising, billing services, Centrex, Speed Call, Repeat Call and paging) for removal from price and earnings regulations, (ii) a price stability mechanism which caps revenue increases through tariff rate changes for other (noncompetitive) services in any year at the increase in the Gross Domestic Product - Price Index in the previous year less 2.25%, and (iii) a network deployment schedule which commits to universal broadband availability in its telecommunications network by 2015. Hearings on this petition and plan were held in February 1994. The PPUC must either approve or reject Bell Atlantic - Pennsylvania's plan as filed or suggest changes thereto no later than June 30, 1994. Bell Atlantic - Delaware, Inc. (formerly The Diamond State Telephone Company) In August 1992, Bell Atlantic - Delaware filed an intrastate rate case with the Delaware Public Service Commission ("DPSC") to increase intrastate net revenues by $14.3 million annually. In November 1993, the DPSC voted to award Bell Atlantic - Delaware a $3.8 million annual intrastate revenue increase based on the stipulated 10.58% overall rate of return. Bell Atlantic - Delaware then filed a petition for reargument of the decision, requesting that the DPSC increase Bell Atlantic - Delaware's revenue award by an additional $6.3 million annually. On December 6, 1993, Bell Atlantic - Delaware entered into an agreement with the Office of Public Advocate of the Delaware state government which stipulated an increase in Bell Atlantic - Delaware's revenue award of $1.5 million annually. The DPSC approved the stipulation and ordered a revised annual intrastate revenue increase of $5.3 million. Bell Atlantic - Delaware put final rates into effect on December 15, 1993. The Delaware Telecommunications Technology Investment Act of 1993 (the "Delaware Telecommunications Act") became effective on July 8, 1993. The Delaware Telecommunications Act modified telecommunications industry regulation for intrastate services and allows Bell Atlantic - Delaware to elect to be regulated under an alternative regulation plan instead of traditional rate of return regulation. The Delaware Telecommunications Act provides: -- that the prices of "Basic Telephone Services" (e.g., dial tone and ---- local usage) will remain regulated and cannot change in any one year by more than the rate of inflation, less 3%; -- that the prices of "Discretionary Services" (e.g., Identa Ring(SM) ---- and Call Waiting) cannot increase more than 15% per year per service, after an initial one-year cap; -- that the prices of "Competitive Services" (e.g., directory advertising ---- and message toll service) will not be subject to tariff; and -- that Bell Atlantic - Delaware develop a technology deployment plan with a commitment to invest a minimum of $250 million in Delaware's telecommunications network during the first five years of the plan. The Delaware Telecommunications Act also provides protections to ensure that competitors will not be unfairly disadvantaged, including a prohibition on cross-subsidization, imputation rules, service unbundling and resale service availability requirements, and a review by the DPSC during the fifth year of the plan. On July 20 1993, the DPSC initiated a rulemaking to develop regulations for the implementation of the Delaware Telecommunications Act. On March 24, 1994, Bell Atlantic - Delaware elected to be regulated under the alternative regulation provisions of the Delaware Telecommunications Act. On such date, Bell Atlantic - Delaware also filed a technology deployment plan consistent with such legislation pursuant to which it committed to (i) link public schools, major medical facilities and state government offices to the "information superhighway", (ii) digitize all of its telephone switches by 1998, and (iii) connect all of its central offices with fiber optic cable by 1998. Bell Atlantic - Washington, D.C., Inc. (formerly The Chesapeake and Potomac Telephone Company) In January 1993, as the outcome of a process begun by a Bell Atlantic - Washington, D.C. proposal to the District of Columbia Public Service Commission ("DCPSC") in 1988, the DCPSC adopted a regulatory reform plan for the intra- Washington, D.C. services of Bell Atlantic - Washington, D.C. Under the plan, the DCPSC adopted a banded rate of return on equity (based on earnings from all services) with 12.5% as the midpoint: Bell Atlantic - Washington, D.C. would be allowed to seek rate increases if its return on equity falls below 11.5% and would be required to share, through prospective rate cuts, 50% of any earnings in excess of a return on equity of 13.5%. Bell Atlantic - Washington, D.C.'s rates for most residential services were frozen at the levels set in the prior rate proceeding in March 1992. The DCPSC granted pricing flexibility, including custom contracting and 14-day tariffing, for all Centrex services and for high capacity private line services since these services were found to be subject to competition. The DCPSC also established a screen for determining what other services are competitive and therefore should be subject to flexible pricing in the future. The plan will be in effect for three years, after which the DCPSC will investigate Bell Atlantic - Washington, D.C.'s performance and determine what regulatory structure is appropriate at that time. Pursuant to the DCPSC's January 1993 regulatory reform plan, in December 1993, the DCPSC re-set Bell Atlantic - Washington, D.C.'s banded rate of return on equity to range from 10.45% to 12.45%, with a midpoint of 11.45%. However, the DCPSC also found that Bell Atlantic - Washington, D.C. was entitled to increased annual revenues of $15.8 million. The DCPSC increased the rates for public telephone service, increased the message unit rate for business customers and increased certain other business and residential rates to cover the increased revenue requirement. Rates for basic residential service remain frozen at the level set in March 1992. Under the plan, Bell Atlantic - Washington, D.C. also applied for and received pricing flexibility for several competitive services, including digital data services, paging services, speed calling, Repeat Call, Home Intercom and Home Intercom Extra. Bell Atlantic - Maryland, Inc. (formerly The Chesapeake and Potomac Telephone Company of Maryland) As the result of a process initiated by a joint petition of Bell Atlantic - Maryland, the Office of People's Counsel of the Maryland state government, and the Staff of the Public Service Commission of Maryland ("MPSC"), the MPSC in 1990 approved an agreement which instituted a regulatory reform plan (the "Reform Plan") for regulation of intrastate services provided by Bell Atlantic - Maryland. The Reform Plan provides for sharing of earnings on other-than- competitive services (e.g., basic business and residential dial tone line and ---- usage, pay telephone services and intraLATA toll services) within a prescribed rate-of-return range (12.7% to 14.5% return on equity), for the direct refund to ratepayers of all earnings above that range and for no sharing of earnings if earnings fall below that range. Earnings on competitive services (e.g., Centrex ---- intercom and high capacity, special access and private line services) are not subject to a rate of return limitation. In connection with its approval of the Reform Plan, the MPSC required Bell Atlantic - Maryland to initiate a rate proceeding to examine Bell Atlantic - Maryland's financial and operating results under the Reform Plan and to serve as a rate case for determining rates and rate structure on a going-forward basis for services that the MPSC has determined are other-than-competitive. On January 22, 1993, at the conclusion of this rate proceeding, the MPSC issued an order directing Bell Atlantic - Maryland to reduce rates prospectively in the aggregate amount of $28.6 million annually. Tariffs reducing rates by that amount became effective on January 23, 1993. Bell Atlantic - Maryland's application for a modification or rehearing of the order was denied in part and granted in part on March 30, 1993. Under the terms of the revised order, Bell Atlantic - Maryland's rate reduction was upheld, but it was permitted to accelerate the amortization of certain post-employment benefits obligations, eliminating any refund requirement for prior periods. The decision in this case is now final. On July 26, 1993, MFS-Intelenet of Maryland, Inc. ("MFS-Maryland"), a subsidiary of MFS Communications Company, Inc. ("MFS"), filed an application with the MPSC for authority to provide and resell local exchange and interexchange telecommunications services to business customers in areas served by Bell Atlantic - Maryland and for an order establishing policies and requirements for interconnection of competing local exchange networks. Hearings have been held and a final decision is expected in April 1994. On November 9, 1993, the MPSC instituted an investigation into legal and policy matters relevant to the regulation of firms, including current telecommunications providers and cable television firms, which may provide local exchange and exchange access services in Maryland in the future. A procedural schedule has been established and a final decision is expected this year. Bell Atlantic - Virginia, Inc. (formerly The Chesapeake and Potomac Telephone Company of Virginia) In December 1988, the Virginia State Corporation Commission ("VSCC") adopted an Experimental Plan for Alternative Regulation (the "Experimental Plan") of Virginia telephone companies. Bell Atlantic - Virginia elected to participate in the Experimental Plan effective January 1, 1989, and remained subject to it through the end of 1993. The Experimental Plan marked a departure from traditional regulation and classified services into four categories: actually competitive, potentially competitive, discretionary and basic. Combined earnings from potentially competitive, discretionary and basic services were capped at a 14% return on equity. Bell Atlantic - Virginia's financial results under the Experimental Plan for the years 1989 through 1992 have been filed with the VSCC. The VSCC's audit of Bell Atlantic - Virginia's 1989 and 1990 financial results found no refunds to be due. Bell Atlantic - Virginia's financial results for 1991 and 1992, which as filed with the VSCC indicate that no refunds are due, are still subject to VSCC audit. Following an evaluation of the Experimental Plan in 1993, the VSCC issued an order on December 17, 1993 adopting a Modified Plan for Alternative Regulation (the "Modified Plan"). The Modified Plan became effective January 1, 1994. Bell Atlantic - Virginia is deemed by the VSCC to be subject to this Modified Plan. The Modified Plan places Bell Atlantic - Virginia's services into one of three categories: - "Competitive" services, for which there are readily available substitutes which reasonably meet customer needs and for which competition in the marketplace effectively regulates the price (e.g., Centrex intercom services, ---- directory advertising). - "Discretionary" services, which can only be provided by the local exchange telephone company, but which are optional, nonessential enhancements to basic communications services or services which others are capable of providing but which do not conform to the competitive services definition (e.g., Caller ID and operator call completion services). ---- - "Basic" services, which are not discretionary and, due to their nature or legal/regulatory restraints, only the local exchange telephone companies can provide (e.g., residential and business local exchange telephone service and ---- operator directory assistance service). The latter two categories of services are subject to rate of return regulation. For 1994 the VSCC has established a permissible range for return on equity for these two regulated services of 10.55% to 12.55%. In assessing whether earnings have exceeded this permitted range, the VSCC will impute to regulated earnings an amount equal to 25% of the net profits of Yellow Pages advertising, which the VSCC will otherwise continue to treat as a competitive service under the Modified Plan. If Bell Atlantic - Virginia's earnings on this basis exceed the permitted range, refunds of the excess must be made. If Bell Atlantic - Virginia were to seek an increase in rates for Basic service that, taking into account rate changes in Discretionary services, results in an increase in overall regulated operating revenue, the financial performance considered by the VSCC would include results for all categories of services. Earnings from Competitive services are not otherwise regulated. In its Final Order of December 17, 1993, the VSCC also announced its intention to hold a proceeding in the first half of 1994 to consider further modifications to the Modified Plan or alternative regulatory plans that local exchange companies might offer. Under legislation passed in the 1993 session of the Virginia General Assembly, the VSCC is no longer statutorily required to regulate telephone companies on the basis of rate of return regulation; for example, the VSCC is free to adopt a price cap form of regulation. On February 8, 1994, Bell Atlantic - Virginia filed a proposal in this new proceeding to have its Discretionary and Basic services regulated on a price cap basis; competitive services would not be regulated. Bell Atlantic - Virginia's proposal will be discussed in hearings to begin in late April 1994. Bell Atlantic - West Virginia, Inc. (formerly The Chesapeake and Potomac Telephone Company of West Virginia) In April 1988, the Public Service Commission of West Virginia ("WVPSC") approved a stipulation among Bell Atlantic - West Virginia, AT&T, MCI Communications Corporation ("MCI"), Sprint Communications Company, L.P. ("Sprint"), the WVPSC Staff and the Consumer Advocate Division of the WVPSC which gave Bell Atlantic - West Virginia flexibility in the pricing of competitive services (e.g., intraLATA toll service, intraLATA "800" service, ---- intraLATA WATS service, billing and collection services and directory advertising) and provided for a freeze on rates for basic local exchange services through December 31, 1990 and a lifting, on January 1, 1989, of the moratorium on intraLATA toll competition. This "Flexible Regulation Plan" was subsequently extended through December 31, 1991. As part of the stipulation, Bell Atlantic - West Virginia invested in excess of $300 million dollars from 1988 through 1990 to modernize West Virginia's telecommunications infrastructure. In March 1990, the West Virginia legislature enacted legislation, which became effective on January 1, 1991, requiring the WVPSC to cease its regulation of the rates charged by a telephone utility for any service that the WVPSC finds to be subject to "workable competition", unless the WVPSC finds that to do so would adversely affect the continued availability of adequate, economical and reliable local telephone service. In December 1991, the WVPSC approved, with some modifications, a stipulation signed by Bell Atlantic - West Virginia, the Consumer Advocate Division of the WVPSC, the WVPSC Staff and AT&T which set forth a new "Incentive Regulation Plan". The Incentive Regulation Plan continues the major provisions of the Flexible Regulation Plan, including pricing flexibility for competitive services and a freeze on the rates for basic local exchange service. It also committed Bell Atlantic - West Virginia to invest an additional $450 million from 1991 through 1995 in West Virginia's telecommunications infrastructure. The Incentive Regulation Plan permitted Bell Atlantic - West Virginia to increase operator directory assistance and Call Waiting charges, provides Bell Atlantic - West Virginia some flexibility in setting depreciation rates and allows Bell Atlantic - West Virginia to petition for a surcharge to reflect changes in federally mandated separations procedures and accounting rules. The stipulation also provides for the phased elimination of Locality Rate Area charges, which are basic service charges paid by customers who are located farthest from the central office. Under the WVPSC's December 1991 order, the freeze on rates for basic service and the phase out of Locality Rate Area charges will end on December 31, 1994 instead of the July 1, 1996 date set forth in the stipulation. In January 1989, AT&T, MCI and Sprint filed petitions with the WVPSC to require Bell Atlantic - West Virginia to reduce intrastate access charges by $3 million annually. On June 29, 1993, the WVPSC approved a settlement agreement in which the parties agreed that access charges would be reduced by $1.5 million annually, that the interexchange carriers would not seek additional reductions until the year 2000 and that Bell Atlantic - West Virginia would not seek additional increases until the year 2000. New Products and Services Bell Atlantic(R) IQ(SM) Services All of the Network Services Companies have introduced the Bell Atlantic(R) IQ(SM) Services family of calling features (although not all features are available in all states). These features include Identa Ring(SM), which ----------- allows a single line to have multiple telephone numbers, each with a distinctive ring; Repeat Call, which allows customers automatically to redial busy phone ----------- numbers; Return Call, which allows customers automatically to return the last ----------- incoming call, even without knowing the number; Ultra Forward(SM), which ------------- customers can use to program call-forwarding instructions; and Home Intercom, ------------- which allows for phone-to-phone dialing within the home. All of the Network Services Companies except Bell Atlantic - Pennsylvania offer Caller ID service, --------- a Bell Atlantic IQ(SM) Service which displays the number of the calling party. It is anticipated that Caller ID will be tariffed and available in Pennsylvania in 1994. At the end of 1993, the Network Services Companies had over 600,000 subscribers to Caller ID. Data Services The Network Services Companies have introduced several high speed data transmission services. In 1993, Switched Multi-Megabit Data Service ("SMDS", a ----------------------------------- high-speed, public, packet-switched data transmission service) was available under tariff from all Network Services Companies except Bell Atlantic - New Jersey (which offers SMDS on a special rate authorization basis with informal approval of the NJBRC) and Bell Atlantic - Delaware; Fiber Distributed Data ---------------------- Interface Network Service was available under tariff in Washington, D.C., - ------------------------- Maryland and Virginia; and Frame Relay Service (which allows high-speed ------------------- interconnection of a customer's multiple locations) was available under tariff in Pennsylvania, Washington, D.C., Maryland and Virginia. Information Services The Network Services Companies offer various types of information services, such as message storage services, voice mail and electronic mail. Answer Call, ----------- a telephone answering service aimed at residential and small business customers, had more than 900,000 subscribers at the end of 1993. Competition Regulatory proceedings, as well as new technology, are continuing to expand the types of available communications services and equipment and the number of competitors offering such services. An increasing amount of this competition is from large companies which have substantial capital, technological and marketing resources, many of which do not face the same regulatory constraints as the Company. Alternative Access and Local Services A substantial portion of the Network Services Companies' revenues from business and government customers is derived from a relatively small number of large, multiple-line subscribers. The Network Services Companies face competition from alternative communications systems, constructed by large end users, interexchange carriers and alternative access vendors, which are capable of originating and/or terminating calls without the use of the local telephone company's plant. MFS has an optical fiber network which currently competes with Bell Atlantic - Pennsylvania and Bell Atlantic - Maryland in the Philadelphia, Pittsburgh and Baltimore metropolitan areas. In the Washington, D.C. metropolitan area, Institutional Communications Company, in which MFS has acquired a controlling interest, has deployed an optical fiber network to compete with Bell Atlantic - Washington, D.C., Bell Atlantic - Maryland and Bell Atlantic - Virginia in the provision of switched and special access services and local services. Eastern TeleLogic Corporation is currently providing service in the Philadelphia area over an optical fiber network, and Digital Direct of Pittsburgh, Inc. (dba Penn Access) has multiple fiber rings in service in the Pittsburgh metropolitan area, with additional fiber rings under construction. In July 1993, Virginia Metrotel Inc. was granted authority by the VSCC to compete against Bell Atlantic - Virginia in the provision of access services in the Richmond metropolitan area. Teleport Communications Group Inc. ("Teleport") provides competitive access service in the New York metropolitan area, including northern New Jersey. The ability of such alternative access providers to compete with the Network Services Companies has been enhanced by the FCC's orders requiring the Network Services Companies to offer collocated interconnection for special and switched access services. Other potential sources of competition are cable television systems, shared tenant services and other non-carrier systems which are capable of bypassing the Network Services Companies' local plant, either partially or completely, through substitution of special access for switched access or through concentration of telecommunications traffic on fewer of the Network Services Companies' lines. Well-financed competitors are seeking authority, or are likely soon to seek authority, to offer competing local exchange services, such as dial tone and local usage, in some of the most lucrative of the local telephone service areas of the Network Services Companies. Southwestern Bell Corporation ("Southwestern Bell") acquired existing cable television systems in Montgomery County, Maryland and Arlington, Virginia. Southwestern Bell could use these systems to compete with the Company's telephone services in these areas. Southwestern Bell also provides cellular service in the Washington metropolitan area. On July 26, 1993, MFS-Maryland filed an application with the MPSC for authority to provide and resell local exchange and interexchange telecommunications services to business customers in areas served by Bell Atlantic - Maryland and for an order establishing policies and requirements for interconnection of competing local exchange networks. Hearings have been held and a final decision is expected in April 1994. On November 9, 1993, the MPSC instituted an investigation into legal and policy matters relevant to the regulation of firms, including current telecommunications providers and cable television firms, which may provide local exchange and exchange access services in Maryland in the future. A procedural schedule has been established and a final decision is expected this year. On December 10, 1993, another MFS subsidiary asked the PPUC for authority to provide local exchange service to business customers in certain areas of Bell Atlantic - Pennsylvania's service territory. No procedural schedule has been set for action on this petition. Teleport and MFS both offer local exchange service in metropolitan New York and may seek to extend that service into northern New Jersey. The two largest long-distance carriers are also positioning themselves to begin to offer services that will compete with the Network Services Companies' local exchange services. In November 1992, AT&T announced its intention to acquire a controlling interest in McCaw Cellular Communications Inc. ("McCaw"), the largest cellular company in the United States, and to integrate McCaw's wireless local service network with AT&T's long distance network. In December 1993, MCI announced its intention to invest $2 billion to begin building competing local exchange and access networks in twenty major markets in the United States, several of which are likely to be in the Territory. In March 1994, MCI also announced its intention to acquire a substantial interest in Nextel Communications Inc. (formerly Fleet Call Inc.), and to integrate Nextel's wireless local service network with MCI's long distance network in at least 10 major markets, one or more of which might be in the Territory. The entry of these and other local exchange service competitors will almost certainly reduce the local exchange service revenues of the Network Services Companies, at least in the market segments and geographical areas in which the competitors operate. Depending on such competitors' success in marketing their services, and the conditions of interconnection established by the regulatory commissions, these reductions could be significant. These revenue reductions may be offset to some extent by revenues from interconnection charges to be paid to the Network Services Companies by these competitors. The Network Services Companies seek to meet such competition by establishing and/or maintaining competitive cost-based prices for local exchange services (to the extent the FCC and state regulatory authorities permit the Network Services Companies' prices to move toward costs), by keeping service quality high and by effectively implementing advances in technology. See "Communications and Related Services - The Network Services Companies - FCC Regulation and Interstate Rates - Interstate Access Charges" and "- FCC Access Charge Pooling Arrangements". Personal Communications Services Radio-based personal communications services ("PCS") also constitute potential sources of competition to the Network Services Companies and to Bell Atlantic's cellular communications companies. PCS consists of wireless portable telephone services which would allow customers to make and receive telephone calls from any location using small handsets, and which could also be used for data transmission. The FCC has authorized trials of such services, using a variety of technologies, by numerous companies, including the Company's cellular telecommunications subsidiaries (collectively, "Bell Atlantic Mobile"). In September 1993, the FCC issued a report and order allocating radio spectrum to be licensed for use in providing PCS. Under the order, seven separate bandwidths of spectrum, ranging in size from 10 MHz to 30 MHz, would be auctioned to potential PCS providers in each geographic area of the United States; five of the spectrum blocks would be auctioned by "basic trading area" and the remaining two would be auctioned by larger "major trading area" (as such trading areas are defined by Rand McNally). LECs and companies with LEC subsidiaries, such as the Company, are eligible to bid for PCS licenses, except that cellular carriers such as the Company are limited to obtaining only 10 MHz of PCS bandwidth in areas where they provide cellular service. Bidders other than cellular providers may obtain multiple licenses aggregating up to 40 MHz of bandwidth in any area. Bell Atlantic has stated that it intends to pursue PCS licenses in the auctions, which are expected to be held in 1994 or in early 1995. In December 1993, the FCC awarded pioneer's preference PCS licenses to, among other entities, American Personal Communications ("APC"), which is owned in part by The Washington Post Company, and Omnipoint Communications, Inc. ("Omnipoint"). APC's license authorizes it to provide PCS service in competition with the local exchange services of the Network Services Companies in all or large portions of Pennsylvania, the District of Columbia, Maryland, Virginia and West Virginia. APC has announced its intention to build out an operational system by the first quarter of 1995. Omnipoint's license authorizes it to provide service in the New York metropolitan area, which includes the northern New Jersey areas served by the Company. If implemented, PCS and other similar services would compete with services currently offered by the Company, and could result in losses of revenues, although the Company may be able to derive new revenues if it obtains authorization to provide PCS or similar new services. Centrex The Network Services Companies offer Centrex service, which is a telephone company central office-based communications system for business, government and other institutional customers consisting of a variety of integrated software- based features located in a centralized switch or switches and extended to the customer's premises primarily via local distribution facilities. In the provision of Centrex, the Network Services Companies are subject to significant competition from the providers of CPE systems, such as private branch exchanges ("PBXs"), which perform similar functions with less use of the Network Services Companies' switching facilities. Users of Centrex systems generally require more subscriber lines than users of PBX systems of similar capacity. The FCC increased the maximum Subscriber Line Charge on embedded Centrex lines to $6.00 per month per line effective April 1, 1989. Increases in Subscriber Line Charges result in Centrex users incurring higher charges than users of comparable PBX systems. Some of the state regulatory commissions having jurisdiction over the Network Services Companies have approved Centrex tariff revisions designed to offset the effects of such higher Subscriber Line Charges and to provide for stability of Centrex rates. The MPSC established a proceeding to consider the tariff for Centrex Extend service (multi-location Centrex intercom service for a closed end user group of a single Centrex customer), which Bell Atlantic - Maryland began offering in August 1993. A decision on the appropriateness of this tariff is expected this year. In Virginia and West Virginia, the intercom portion of Centrex service has been detariffed. IntraLATA Toll Competition The ability of interexchange carriers to engage in the provision of intrastate intraLATA toll service in competition with the Network Services Companies is subject to state regulation. Such competition is permitted in Pennsylvania, Delaware, Maryland and West Virginia; in addition, in Delaware, the DPSC has initiated a proceeding to determine whether to require presubscription and dialing parity ("1+ dialing") for intraLATA toll competitors of Bell Atlantic - Delaware. Intrastate intraLATA competition has not been permitted in New Jersey, but the NJBRC has initiated a proceeding in response to petitions filed by interexchange carriers to consider whether and on what terms to permit intraLATA competition. The issue is inapplicable to Washington, D.C. since intraLATA toll service is not offered within the District of Columbia. The VSCC has instituted a proceeding to consider whether, and on what terms, to permit intraLATA competition in Virginia. Directories The Network Services Companies continue to face significant competition from other providers of directories as well as competition from other advertising media. In particular, the former sales representative of the Network Services Companies (other than Bell Atlantic - New Jersey) publishes directories in competition with those published by the Network Services Companies in New Jersey, Pennsylvania, Delaware and the Washington, D.C. and Baltimore metropolitan areas. Public Telephone Services The Company faces increasing competition in the provision of pay telephone services from other pay telephone service providers. In addition, the growth of wireless communications negatively impacts usage of public telephones. Operator Services Alternative operator services providers have entered into competition with the Company's operator services product line. Other Communications and Related Services Domestic Wireless Communications Bell Atlantic Mobile provides cellular telecommunications service in certain portions of the Network Services Companies' Territory and in other parts of the United States. These entities market cellular telecommunications service and related equipment directly to consumers, wholesale such service to businesses which resell the service to consumers, and authorize agents to sell such service to consumers. They also resell paging service in some locations. On April 30, 1992, the Company acquired Metro Mobile CTS, Inc., then the second-largest independent provider of cellular telecommunications service in the United States. Cellular telecommunications service is subject to FCC regulation and licensing requirements. Some states also regulate the service. To assure competition, the FCC awarded two competitive licenses in each market. Many such competing cellular providers are substantial businesses with experience in broadcasting, telecommunications, cable television and radio common carrier services. Competition is based on the price of cellular service, the quality of the service and the size of the geographic area served. The FCC is in the process of authorizing additional providers of mobile services which will likely provide competition to existing cellular carriers. See "Communications and Related Services - The Network Services Companies - Competition - Personal Communications Services". Bell Atlantic Mobile has established cellular telecommunications service in the standard metropolitan statistical areas ("SMSAs") for Washington, D.C.; Wilmington, Delaware; Baltimore, Maryland; Allentown, Philadelphia, Pittsburgh and Reading, Pennsylvania; Trenton, Vineland and Atlantic City, New Jersey; Phoenix and Tucson, Arizona; Bridgeport, Hartford, New Haven, and New London, Connecticut; New Bedford, Pittsfield and Springfield, Massachusetts; Albuquerque and Las Cruces, New Mexico; Charlotte and Hickory, North Carolina; Providence, Rhode Island; Anderson, Columbia and Greenville, South Carolina; and El Paso, Texas. Bell Atlantic Mobile also has established service in the rural service areas of Kent (Dover), Delaware; Kent (Eastern Shore) and Frederick, Maryland; Ocean, Sussex and Hunterdon, New Jersey; Greene, Jefferson, Huntingdon, Lawrence and McKean, Pennsylvania; Madison, Caroline, Frederick (Fauquier) and Lee, Virginia; Wetzel and Mason, West Virginia; Windham, Connecticut; Cabarrus and Anson, North Carolina; Newport, Rhode Island; Cherokee, Lancaster and Oconee, South Carolina; and Gila, Arizona. Bell Atlantic Mobile also owns a significant minority interest in a partnership providing cellular telecommunications service in the New York City metropolitan area and the adjoining SMSAs of New Brunswick and Long Branch, New Jersey. Under reciprocal agreements between Bell Atlantic Mobile and certain other providers of cellular telecommunications service, the customers of Bell Atlantic Mobile may use the services of those other providers in areas where Bell Atlantic Mobile is not licensed to provide service. Bell Atlantic Paging, Inc. markets paging services in portions of the Network Services Companies' Territory. International Bell Atlantic International, Inc. and its subsidiaries ("International") serve as the Company's principal vehicle for new business development outside the United States. International provides telecommunications consulting and software systems integration services to telecommunications authorities in several countries, and has entered into business development agreements with various governmental authorities. In September 1990, wholly-owned New Zealand subsidiaries of International and Ameritech Corporation ("Ameritech") each purchased approximately 49% of the common shares of Telecom Corporation of New Zealand Limited ("TCNZ") for a purchase price of approximately $2.4 billion. Under the terms of the acquisition and subsequent agreements with the New Zealand government, International and Ameritech were required to sell equity interests in TCNZ such that their combined ownership would, within four years of the acquisition, be reduced to 49.9%. In furtherance of that requirement, International and Ameritech in 1991 sold a portion of their equity shares in TCNZ in a worldwide public offering, thereby reducing their combined ownership in TCNZ to approximately 68%. In March 1993 and September 1993, International privately sold an aggregate of 9.8% of TCNZ, reducing its ownership interest in TCNZ to approximately 24.8%, and, together with private sales by Ameritech, completing its sell-down obligations. International is also a shareholder in joint ventures, begun in November 1990, with a subsidiary of U S WEST, INC. and the telecommunications administrations of The Czech Republic and The Slovak Republic, to build and operate cellular and packet data networks in these republics. The cellular telecommunications system currently provides service to the public in, among other cities, Prague, Bratislava and Brno. In May 1991, International acquired, through a joint venture, approximately a 12.5% interest in Sky Network Television Limited, a provider of subscription television services in New Zealand. International, through a joint venture established in December 1992 with Societa Finanziaria Telefonica p.a. and Societa Italiana per L'Esercizio delle Telecomunicazioni p.a., develops operations support systems for telecommunications providers worldwide. In November 1993, International acquired for $520 million approximately 23% of the equity ownership interest in Grupo Iusacell, S.A. de C.V. ("Iusacell"), the second largest telecommunications company in Mexico and the primary business of which is the provision of cellular telephone service. Under the acquisition agreement, and provided certain conditions are met, International is obligated to purchase additional shares of Iusacell's capital stock representing 17%-23% of Iusacell's total outstanding shares of capital stock for up to an additional $520 million. In March 1994, a consortium in which International has the second largest interest (approximately 11.5%), was awarded the second cellular license for Italy. Business Systems Companies Bell Atlantic Business Systems Services, Inc. ("Business Systems Services"), which was formerly known as Sorbus Inc., is a computer services company which provides hardware and software maintenance, network support, disaster recovery and other services for more than 5,000 makes and models of computer equipment and associated peripherals. Business Systems Services provides service to more than 60,000 customer sites from over 200 locations in the United States and Canada. Business Systems Services' major competitors are computer equipment manufacturers which offer to service the equipment they sell as well as other vendors of computer maintenance and service. In some cases, Business Systems Services is dependent on computer manufacturers and distributors for spare parts necessary for the products it services. The Bell Atlantic Computer Technology Services Division of Business Systems Services provides parts repair and sales and refurbishment services for International Business Machines Corporation, Digital Equipment Corporation, Sun Microsystems, Inc. and other computer manufacturers' equipment to end users, manufacturers and service companies throughout the world. Bell Atlantic Business Systems International, Inc. provides computer maintenance and other end user computer services in the United Kingdom, France, Italy, Germany, Switzerland, Austria, The Netherlands and Finland through companies which are owned jointly with International Computers Limited. Business Systems International provides computer services in Australia and New Zealand through a partnership with Fujitsu Australia Limited. Other Bell Atlantic TeleProducts Corp. sells CPE to residential, work-at-home and small business customers and Integrated Services Digital Network CPE to a variety of business customers. Bell Atlantic Professional Services, Inc. recruits and contracts out temporary professional services and provides training services to suppliers and end users of computers and communications equipment. During 1993 the Company began to exit the customized software and systems businesses operated by subsidiaries of The Bell Atlantic Systems Group, Inc. The Company has sold the stock or substantially all the assets of Bell Atlantic Utilities Systems, Inc., Bell Atlantic Public Sector Systems, Inc. and Bell Atlantic Integrated Systems, Inc., and is pursuing the sale of Bell Atlantic Healthcare Systems, Inc. The Company continues to operate the operations support systems software business of Bell Atlantic Telecommunications Systems, Inc. as a subsidiary of International and the network integration business of Bell Atlantic Integrated Systems, Inc. through the Large Business Services LOB. FINANCIAL, REAL ESTATE, AND OTHER SERVICES The Financial, Real Estate, and Other Services segment comprises Bell Atlantic Capital Corporation ("Capital Corporation") and its subsidiaries, Bell Atlantic Properties, Inc. ("Properties") and its subsidiaries, and Vision Energy Resources, Inc. ("Vision Energy") and its subsidiaries. In line with its continuing de-emphasis of financial services businesses over the past several years and its intensified focus on core communications businesses, the Company announced in October 1993 that it had begun evaluating possible strategies for exiting its financial services businesses. Capital Corporation's wholly-owned subsidiary, Bell Atlantic TriCon Leasing Corporation ("TriCon"), engages in leasing of office, medical and other equipment sold by many vendors and also provides other types of financing. In addition, TriCon provides leasing of CPE to customers of other Bell Atlantic companies, and engages in a number of large leveraged leasing transactions. In March 1994, the Company announced an agreement to sell substantially all of Tricon's assets (other than its leveraged lease and project finance portfolios) to GFC Financial Corporation. This sale is expected to close in the second quarter of 1994, subject to the receipt of regulatory approvals. In 1992, Capital Corporation entered into a joint venture agreement with PacifiCorp Financial Services, Inc. ("PFS") with respect to both companies' computer leasing businesses. Prior to the formation of the joint venture, Capital Corporation's computer leasing business was operated by its subsidiary, Bell Atlantic Systems Leasing International, Inc. ("BASLI"). Under the joint venture, Capital Corporation and PFS established Pacific Atlantic Systems Leasing, Inc. ("PASLI"), 50% owned by each of the companies, which both companies use as their principal vehicle for domestic operating leases of computer equipment. Most of BASLI's employees have become employees of PASLI, and PASLI is responsible for the day-to-day management of BASLI's domestic computer leasing portfolio. The equipment financing market is highly competitive. Equipment financing companies must compete with substantial leasing companies which are affiliated with major equipment suppliers, and with other well established leasing companies, banks and other financial institutions. Properties invests in and manages commercial real estate properties. The Vision Energy companies are engaged in the sale and distribution of liquefied petroleum gas primarily in the midwestern United States and Florida. CERTAIN CONTRACTS AND RELATIONSHIPS Certain planning, marketing, procurement, financial, legal, accounting, technical support and other management services are provided on behalf of the Network Services Companies on a centralized basis by Bell Atlantic's wholly- owned subsidiary, Bell Atlantic Network Services, Inc. ("NSI"). Bell Atlantic Network Funding Corporation provides short-term financing and cash management services to the Network Services Companies. Certain corporate services also are provided to other subsidiaries on a centralized basis by NSI. Bell Atlantic Financial Services, Inc. provides short-, medium- and long-term financing services and cash management services to subsidiaries of the Company other than the Network Services Companies. The seven RHCs each own (directly or through subsidiaries) a one-seventh interest in Bell Communications Research, Inc. ("Bellcore"). Pursuant to the Plan, Bellcore furnishes the RHCs and their BOC subsidiaries with technical assistance such as network planning, engineering and software development, as well as various other consulting services that can be provided more effectively on a centralized basis. Bellcore is the central point of contact for coordinating the efforts of the RHCs in meeting the national security and emergency preparedness requirements of the federal government. It also helps to mobilize the combined resources of the RHCs in times of natural disasters. EMPLOYEE RELATIONS As of December 31, 1993, the Company and its subsidiaries employed approximately 73,600 persons, which represents approximately a three percent increase from the number of employees at December 31, 1992. This overall net increase reflects growth in certain non-Network Services Companies subsidiaries, the acquisition in 1993 of two companies which provide advertising and marketing services through the Directory Services LOB, and the hiring of some associates by the Network Services Companies to meet service requirements. Approximately 65% of the employees of the Company and its subsidiaries are represented by unions. Of those so represented, approximately 80% are represented by the Communications Workers of America, and approximately 20% are represented by the International Brotherhood of Electrical Workers, which are both affiliated with the American Federation of Labor - Congress of Industrial Organizations. Under the terms of the three-year contracts ratified in October 1992 by unions representing associate employees of the Network Services Companies and NSI, represented associates received a base wage increase of 3.74% in August 1993. Under the same contracts, associates received a Corporate Profit Sharing payment of $495 per person in 1994 based upon the Company's 1993 financial performance. Item 2.

Item 2. Properties The principal properties of the Company do not lend themselves to simple description by character and location. At December 31, 1993, the Company's investment in plant, property and equipment consisted of the following: "Connecting lines" consists primarily of aerial cable, underground cable, poles, conduit and wiring. "Central office equipment" consists of switching equipment, transmission equipment and related facilities. "Land and buildings" consists of land owned in fee and improvements thereto, principally central office buildings. "Telephone instruments and related equipment" consists primarily of public telephone instruments and telephone equipment (including PBXs) used by the Network Services Companies in their operations. "Other" property consists primarily of furniture, office equipment, vehicles and other work equipment, and plant under construction of the Network Services Companies, as well as the property of the Other Communications and Related Services companies. Financial, Real Estate, and Other Services property consists mainly of land and buildings owned by BAP. Not included in the above properties is $199.3 million of equipment under operating leases, net of accumulated depreciation of $652.4 million, owned primarily by TriCon and BASLI at December 31, 1993. Additional information with respect to the Company's plant, property and equipment is set forth in Schedule V on page of this report. The Company's central offices are served by various types of switching equipment. At December 31, 1993 and 1992, the number of local exchanges served and the percent of subscriber lines served by each type of equipment were as follows: Item 3.

Item 3. Legal Proceedings Pre-Divestiture Contingent Liabilities and Litigation The Plan provides for the recognition and payment by AT&T and the former BOCs (including the Network Services Companies) of liabilities that are attributable to pre-Divestiture events but do not become certain until after Divestiture. These contingent liabilities relate principally to litigation and other claims with respect to the former Bell System's rates, taxes, contracts and torts (including business torts, such as alleged violations of the antitrust laws). Except to the extent that affected parties otherwise agree, contingent liabilities that are attributable to pre-Divestiture events are shared by AT&T and the BOCs in accordance with formulas prescribed by the Plan, whether or not an entity was a party to the proceeding and regardless of whether an entity was dismissed from the proceeding by virtue of settlement or otherwise. Each company's allocable share of liability under these formulas depends on several factors, including the type of contingent liability involved and each company's relative net investment as of the effective date of Divestiture. Under the formula generally applicable to most of the categories of these contingent liabilities, the Network Services Companies' aggregate allocable share of liability is approximately 10.2%. AT&T and various of its subsidiaries and the BOCs (including in some cases one or more of the Network Services Companies) have been and are parties to various types of litigation relating to pre-Divestiture events, including actions and proceedings involving environmental claims and allegations of violations of equal employment laws. Damages, if any, ultimately awarded in the remaining actions relating to pre-Divestiture events could have a financial impact on the Company whether or not the Company is a defendant since such damages will be treated as contingent liabilities and allocated in accordance with the allocation rules established by the Plan. While complete assurance cannot be given as to the outcome of any contingent liabilities or litigation, in the opinion of the Company's management, any monetary liability or financial impact to which the Company would be subject after final adjudication of all of the remaining potential or actual pre- Divestiture claims would not be material in amount to the financial position of the Company. Other Pending Cases (1) On April 12, 1990, a letter was submitted to the Company's Board of Directors by a law firm, purportedly on behalf of a shareowner of the Company, requesting that the Company commence action against any present or former director, officer or employee of the Company or any of its subsidiaries who might be found to have violated any duty to the Company in connection with (i) certain litigation involving Bell Atlantic - Pennsylvania and (ii) a temporary suspension of the Company and Bell Atlantic - Washington, D.C. from eligibility for future federal government contracts (the "Treasury suspension"). As previously reported by the Company in its Quarterly Reports on Form 10-Q for the quarters ended March 31 and September 30, 1990 and its Annual Reports on Form 10-K for the years ended December 31, 1990 and 1991, the Bell Atlantic - Pennsylvania litigation involved allegations that this subsidiary had engaged in improper practices while selling certain optional services, and resulted in a settlement pursuant to which Bell Atlantic - Pennsylvania made payments and refunds aggregating approximately $42 million; the Treasury suspension involved allegations that the Company and Bell Atlantic - Washington, D.C. had misrepresented certain facts in connection with a bid for a particular government contract, and was terminated approximately one month later after the Company agreed to re-emphasize to employees the need to verify information provided to the government, including information supplied to the Company by sub-contractors. In response to the demand letter (a similar letter, purportedly on behalf of a different shareowner, was received shortly thereafter), the Board of Directors of the Company (the "Board) on April 24, 1990 appointed a committee of three outside directors (James H. Gilliam, Jr. (Chairman), William G. Copeland and John F. Maypole) to investigate these matters and present its recommendation to the Board (the "Special Committee"). On May 11, 1990, the Company was served with a complaint filed in the Court of Common Pleas of Philadelphia County, Pennsylvania, naming certain then-current directors and officers as defendants in a shareholder derivative suit. The complaint alleged that the defendants had breached their fiduciary duties to the Company and its shareowners by failing to implement and enforce adequate safeguards to prevent the activities which resulted in the Bell Atlantic - Pennsylvania litigation and the Treasury suspension referred to above. The Company is not a defendant in this litigation. The Special Committee retained independent outside counsel and conducted a five-month investigation. After completion of its investigation, the Special Committee concluded that it would not be in the best interest of the Company and its shareowners to assert claims or take any other action against any director or officer of the Company or any of its subsidiaries with respect to either the Bell Atlantic - Pennsylvania litigation or the Treasury suspension. Accordingly, the Special Committee recommended that the Board reject the demands expressed in the shareowner letters, and the Board on October 23, 1990 adopted this recommendation. Counsel for each of the demanding shareowners was advised of the Board's determination. The defendants' motion to dismiss the Court of Common Pleas litigation on jurisdictional grounds was denied and, as reported in the Company's Quarterly Report on Form 10-Q for the quarter ended September 30, 1991, in September 1991 the Pennsylvania Supreme Court refused to hear the defendants' appeal of the trial court's denial of their motion to dismiss the Court of Common Pleas litigation. A related case filed in the United States District Court for the Eastern District of Pennsylvania was settled and is discussed below under "Prior Cases." (2) In its Annual Reports on Form 10-K for the years ended December 31, 1990 and 1991, the Company reported that in January 1991, the Company, its Chief Executive Officer and its former Chief Financial Officer were named as defendants in several identical class action complaints. These complaints, which have been consolidated in a single proceeding in the United States District Court for the Eastern District of Pennsylvania and have subsequently been amended, allege that, during a class period from June 14, 1990 through January 22, 1991, the plaintiffs purchased shares of Bell Atlantic stock at inflated prices as a result of the defendants' alleged failure to disclose material information regarding certain aspects of the Company's financial performance and prospects. The trial court's earlier decision granting defendants' motion to dismiss this action has been reversed by the United States Court of Appeals for the Third Circuit upon appeal by the plaintiffs. Discovery in this action is in progress. While complete assurance cannot be given as to the outcome of any litigation, in the opinion of the Company's management, any monetary liability or financial impact to which the Company would be subject after final adjudication of the foregoing actions would not be material in amount to the financial position of the Company. Prior Cases On June 19, 1991, the Company was served with a complaint filed in the United States District Court for the Eastern District of Pennsylvania naming all of the then-current directors of the Company and one former officer as defendants in a shareowner class action and derivative suit. This lawsuit made allegations very similar to the Court of Common Pleas suit referenced above in "Other Pending Cases" with respect to the Bell Atlantic - Pennsylvania litigation and Treasury suspension matters and, in addition, alleged that the Company violated federal proxy rules and regulations and its duty of candor under state law by failing to disclose, in its 1987-1991 proxy materials, information about the Bell Atlantic - Pennsylvania litigation, the Treasury suspension, the appointment of the Special Committee and the Court of Common Pleas litigation referenced above. On March 25, 1992, the parties to the federal court action reached an agreement to settle that action, subject to court approval after notice to the Company's shareowners, without the payment of any damages but subject to payment of the plaintiffs' attorneys fees up to $450,000. In June 1992, this settlement agreement was approved by the United States District Court for the Eastern District of Pennsylvania. A single shareowner, who is also the plaintiff in the related Court of Common Pleas litigation, filed an appeal with the United States Court of Appeals for the Third Circuit challenging the approval of the settlement agreement by the lower court. On August 18, 1993, the Third Circuit affirmed the lower court approval of the settlement agreement. After expiration of the time in which to file an appeal of the Third Circuit affirmation, the Company paid the plaintiffs' attorneys fees stipulated by the settlement agreement and the federal court action was dismissed. Item 4.

Item 4. Submission of Matters to a Vote of Security Holders Not applicable EXECUTIVE OFFICERS OF THE REGISTRANT Set forth below is certain information with respect to the Company's executive officers. Prior to serving as an executive officer of the Company, each of the above officers, with the exception of Mr. Johnson, has held high level managerial positions with the Company or one of its subsidiaries for at least five years. From 1987 until joining the Company in 1992, Mr. Johnson served as President, GTE-Contel Federal Sector for GTE Corporation. Mr. Kelly is retiring on April 7, 1994. Officers are not elected for a fixed term of office but are removable at the discretion of the Board of Directors of the Company. PART II Item 5.

Item 5. Market for Registrant's Common Equity and Related Stockholder Matters The principal market for trading in the common stock of Bell Atlantic Corporation is the New York Stock Exchange. The common stock is also listed in the United States on the Boston, Chicago, Pacific, and Philadelphia stock exchanges. As of December 31, 1993, there were 1,026,371 shareowners of record. High and low stock prices, as reported on the New York Stock Exchange Composite Transactions, and dividend data are as follows: Item 6.

Item 6. Selected Financial Data The Selected Financial and Operating Data on page 6 of the Company's 1993 Annual Report to Shareowners is incorporated herein by reference. Item 7.

Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations The Management's Discussion and Analysis of Results of Operations and Financial Condition on pages 7 through 12 of the Company's 1993 Annual Report to Shareowners is incorporated herein by reference. Item 8.

Item 8. Financial Statements and Supplementary Data The Report of Independent Accountants, Consolidated Statements of Income, Consolidated Balance Sheets, Consolidated Statements of Cash Flows, and Notes to Consolidated Financial Statements on pages 14 through 39 of the Company's 1993 Annual Report to Shareowners are incorporated herein by reference. Item 9.

Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure None. PART III Item 10.

Item 10. Directors and Executive Officers of Registrant For information with respect to the executive officers of the Company, see "Executive Officers of the Registrant" at the end of Part I of this Report. For information with respect to the Directors of the Company, see "Election of Directors" on pages 1 through 5 of the Proxy Statement for the Company's 1994 Annual Meeting of Shareowners, which is incorporated herein by reference. Item 11.

Item 11. Executive Compensation For information with respect to executive compensation, see "Executive Compensation" on pages 9 through 14, "Stock Performance Graphs" on page 16, and "Employment Agreements" on page 17 of the Proxy Statement for the Company's 1994 Annual Meeting of Shareowners, which are incorporated herein by reference. Item 12.

Item 12. Security Ownership of Certain Beneficial Owners and Management For information with respect to the security ownership of the Directors and Executive Officers of the Company, see "Ownership of Bell Atlantic Common Stock" on page 15 of the Proxy Statement for the Company's 1994 Annual Meeting of Shareowners, which is incorporated herein by reference. Item 13.

Item 13. Certain Relationships and Related Transactions None. PART IV Item 14.

Item 14. Exhibits, Financial Statement Schedules, and Reports on Form 8-K (a) The following documents are filed as part of this report: (1) Financial Statements See Index to Financial Statements and Financial Statement Schedules appearing on Page. (2) Financial Statement Schedules See Index to Financial Statements and Financial Statement Schedules appearing on Page. (3) Exhibits Exhibits identified in parentheses below, on file with the Securities and Exchange Commission (SEC), are incorporated herein by reference as exhibits hereto. Exhibit Number - -------------- 3a Certificate of Incorporation of Bell Atlantic Corporation ("Bell Atlantic"), dated October 7, 1983. (Exhibit 3a to Registration Statement on Form S-1 No. 2-87842, File No. 1-8606.) 3b Certificate of Amendment of Certificate of Incorporation of Bell Atlantic, dated May 9, 1986 and filed May 16, 1986. (Exhibit 3b to Form SE dated March 27, 1987, File No. 1-8606.) 3c Certificate of Amendment of Certificate of Incorporation of Bell Atlantic, dated May 6, 1987 and filed May 8, 1987. (Exhibit 3c to Form SE dated March 28, 1988, File No. 1-8606.) 3d Certificate of Amendment of Certificate of Incorporation of Bell Atlantic, dated May 10, 1990 and filed June 29, 1990. (Exhibit 3d to Form SE dated March 28, 1991, File No. 1-8606.) 3e By-Laws of Bell Atlantic, as amended through June 23, 1992. (Exhibit 3e to Form SE dated March 29, 1993, File No. 1-8606.) 4 No instrument which defines the rights of holders of long and intermediate term debt, of the Company and all of its consolidated subsidiaries, is filed herewith pursuant to Regulation S-K, Item 601(b)(4)(iii)(A). Pursuant to this regulation, Bell Atlantic hereby agrees to furnish a copy of any such instrument to the SEC upon request. Exhibit Number - -------------- 10a Agreement Concerning Contingent Liabilities, Tax Matters and Termination of Certain Agreements among AT&T, Bell Atlantic, the Network Services Companies, and certain other parties, dated as of November 1, 1983. 10a(i) Agreement Concerning Allocation of Contingent Liabilities between AT&T and Bell Atlantic, dated as of January 28, 1985. (Exhibit 10h(i) to Form SE filed on March 28, 1985, File No. 1-8606.) 10b Agreement among Bell Atlantic Network Services, Inc. (formerly named Bell Atlantic Management Services, Inc.) and the Network Services Companies, dated November 7, 1983. 10c Bell Atlantic Senior Management Short Term Incentive Plan, as amended and restated effective as of January 1, 1993. (Exhibit 10c to Form SE dated March 29, 1993, File No. 1-8606.)* 10d Bell Atlantic Senior Management Long-Term Disability and Survivor Protection Plan, as amended. (Exhibit 10h to Form SE filed on March 27, 1986, File No. 1-8606.)* 10d(i) Resolutions amending the Plan, effective as of January 1, 1989. (Exhibit 10d to Form SE dated March 29, 1989, File No. 1-8606.)* 10e Bell Atlantic Senior Management Transfer Program. (Exhibit 10ee to 1983 Form 10-K, File No. 1-8606.)* 10e(i) Resolutions terminating the Program for transfers on or after November 1, 1992. (Exhibit 10e to Form SE dated March 29, 1993, File No. 1-8606.)* 10f Bell Atlantic Personal Financial Services Program for Senior and Executive Managers and Key Employees, effective as of July 1, 1990, as amended. (Exhibit 10f to Form SE dated March 28, 1991, File No. 1-8606.)* 10g Bell Atlantic Deferred Compensation Plan for Outside Directors, as amended and restated as of January 1, 1993. (Exhibit 10g to Form SE dated March 29, 1993, File No. 1-8606.)* 10h Bell Atlantic Insurance Plan for Directors. (Exhibit 10hh to Registration Statement on Form S-1 No. 2-87842, File No. 1-8606.)* 10i Description of Bell Atlantic Plan for Non-Employee Directors' Travel Accident Insurance. (Exhibit 10ii to Registration Statement on Form S-1 No. 2-87842, File No. 1-8606.)* 10j Article V from Bell Atlantic Management Pension Plan regarding limitations on payment of pension amounts which exceed the limitations contained in the Employee Retirement Income Security Act of 1974. (Exhibit 10j to Form SE dated March 26, 1992, File No. 1-8606.)* Exhibit Number - -------------- 10k Bell Atlantic Senior Management Retirement Income Plan, as amended and restated effective as of January 1, 1993. (Exhibit 10k to Form SE dated March 29, 1993, File No. 1-8606)* 10k(i) Resolutions amending the Bell Atlantic Senior Management Retirement Income Plan effective as of December 31, 1993.* 10l Bell Atlantic Deferred Compensation Plan (formerly the Bell Atlantic Senior Management Incentive Award Deferral Plan), as amended and restated effective as of January 1, 1993. (Exhibit 10l to Form SE dated March 29, 1993, File No. 1-8606)* 10l(i) Resolutions amending the Bell Atlantic Deferred Compensation Plan, effective October 25, 1993.* 10m Bell Atlantic Stock Incentive Plan, consisting of (1) The Bell Atlantic 1985 Performance Share Plan as amended and restated effective as of January 1, 1993 and (2) The Bell Atlantic 1985 Incentive Stock Option Plan as amended and restated effective as of January 1, 1993. (Exhibit 10m to Form SE dated March 29, 1993, File No. 1-8606)* 10m(i) Resolutions amending The Bell Atlantic 1985 Incentive Stock Option Plan, subject to the approval of the shareowners of the Company.* 10n Bell Atlantic Retirement Plan for Outside Directors, as amended and restated as of January 1, 1993. (Exhibit 10n to Form SE dated March 29, 1993, File No. 1-8606)* 10o Bell Atlantic Stock Compensation Plan for Outside Directors, as amended and restated as of January 1, 1993. (Exhibit 10o to Form SE dated March 29, 1993, File No. 1-8606)* 10p Bell Atlantic Corporation Directors' Charitable Giving Program. (Exhibit 10p to Form SE dated March 29, 1990, File No. 1-8606)* 10p(i) Resolutions amending and partially terminating the Program. (Exhibit 10p to Form SE dated March 29, 1993, File No. 1-8606)* 10q Employment Agreement dated January 24, 1994 between the Company and William O. Albertini.* 10r Employment Agreement dated January 24, 1994 among the Company, Bell Atlantic Enterprises International, Inc. and Lawrence T. Babbio, Jr.* 10s Resolution dated January 24, 1994 granting Lawrence T. Babbio, Jr. certain nonqualified stock options to purchase American Depositary Receipts representing Series L shares of the capital stock of Grupo Iusacell, S.A. de C.V.* Exhibit Number - -------------- 10t Employment Agreement dated January 24, 1994 between the Company and James G. Cullen.* 10u Non-Compete and Proprietary Information Agreement dated August 10, 1993 between the Company and James G. Cullen.* 10v Employment Agreement dated January 24, 1994 among the Company, Bell Atlantic Network Services, Inc. and Stuart C. Johnson.* 10w Non-Compete and Proprietary Information Agreement dated August 9, 1993 among the Company, Bell Atlantic Network Services, Inc. and Stuart C. Johnson.* 10x Employment Agreement dated January 24, 1994 between the Company and James R. Young.* 11 Computation of Earnings Per Common Share. 12 Computation of Ratio of Earnings to Fixed Charges. 13 1993 Annual Report to Shareowners (for the fiscal year ended December 31, 1993). Except for the portions of such Annual Report which are expressly incorporated herein by reference, such Annual Report is furnished for the information of the Securities and Exchange Commission and is not deemed to be "filed" as part of this Annual Report on Form 10-K . 21 List of subsidiaries of Bell Atlantic. 23 Consent of Coopers & Lybrand. 24 Powers of attorney. 99a Annual report on Form 11-K for the Bell Atlantic Savings Plan for Salaried Employees for the year ended December 31, 1993. (To be filed by amendment.) 99b Annual report on Form 11-K for the Bell Atlantic Savings and Security Plan (Non-Salaried Employees) for the year ended December 31, 1993. (To be filed by amendment.) ____________ * Indicates management contract or compensatory plan or arrangement. Shareowners may request a copy of any of the exhibits to this Annual Report on Form 10-K by writing to the Corporate Secretary, Bell Atlantic Corporation, 1717 Arch Street, Philadelphia, Pennsylvania 19103. (b) Current Reports on Form 8-K filed during the quarter ended December 31, 1993: A Current Report on Form 8-K, dated October 11, 1993, was filed reporting on Item 5 (Other Events) that the Company had formed a strategic partnership with Grupo Iusacell, S.A. de C.V. A Current Report on Form 8-K, dated October 12, 1993, was filed reporting on Item 5 (Other Events) and Item 7 (Financial Statements and Exhibits) that the Company, Tele-Communications, Inc. (TCI), and Liberty Media Corporation (Liberty) had entered into a letter of intent which sets forth the terms and conditions upon which the parties proposed to negotiate a combination of TCI and Liberty into the Company pursuant to a series of transactions. A Current Report on Form 8-K, dated October 19, 1993, was filed regarding the Company's third quarter 1993 financial results. This report contained unaudited condensed consolidated statements of income for the three- and nine-month periods ended September 30, 1993 and 1992. A Current Report on Form 8-K, dated December 15, 1993, was filed reporting on Item 5 (Other Events) and Item 7 (Financial Statements and Exhibits) regarding an amendment to the letter of intent among the Company, TCI, and Liberty. SIGNATURES Pursuant to the requirements of Section 13 or 15(d) 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. BELL ATLANTIC CORPORATION By /s/ William O. Albertini ----------------------------- William O. Albertini Vice President and Chief Financial Officer March 29, 1994 Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the date indicated. BELL ATLANTIC CORPORATION Index to Financial Statements and Financial Statement Schedules Schedules other than those listed above have been omitted because the required information is contained in the financial statements and the notes thereto, or because such schedules are not required or applicable. REPORT OF INDEPENDENT ACCOUNTANTS To the Board of Directors and Shareowners of Bell Atlantic Corporation Our report on the consolidated financial statements of Bell Atlantic Corporation and subsidiaries has been incorporated by reference in this Form 10- K from page 14 of the 1993 Annual Report to shareowners of Bell Atlantic Corporation and subsidiaries. In connection with our audits of such financial statements, we have also audited the related financial statement schedules listed in the index on page of this Form 10-K. In our opinion, the financial statement schedules referred to above, when considered in relation to the basic financial statements taken as a whole, present fairly, in all material respects, the information required to be included therein. /s/ COOPERS & LYBRAND 2400 Eleven Penn Center Philadelphia, Pennsylvania February 7, 1994 BELL ATLANTIC CORPORATION AND SUBSIDIARIES SCHEDULE II - AMOUNTS RECEIVABLE FROM RELATED PARTIES AND UNDERWRITERS, PROMOTERS AND EMPLOYEES OTHER THAN RELATED PARTIES For the Years Ended December 31, 1993, 1992, and 1991 (Dollars in Thousands) (a) Loans made in connection with the 1986 acquisition of Greyhound Capital Corporation, used for the employee's purchase of venture capital assets from Greyhound Corporation and continued portfolio management. (b) In February 1992, the term of this loan was extended to February 28, 1995. The loan bears interest at 7% per annum and is collateralized by certain securities, as well as by certain payments owed to the debtor by the Company. (c) In March 1992, the term of this loan was extended to February 28, 1995. The loan bears interest at 7% per annum and is collateralized by certain securities, as well as by certain payments owed to the debtor by the Company. (d) Note payable on demand, bearing interest at 8%. (e) During 1993, the loan was transferred to a 50%-owned joint venture and was collected in full. (f) Amounts settled in consideration of individuals foregoing entitlements to future long-term contingent compensation. BELL ATLANTIC CORPORATION AND SUBSIDIARIES SCHEDULE V - CONSOLIDATED PLANT, PROPERTY AND EQUIPMENT For the Year Ended December 31, 1993 (Dollars in Millions) The notes on Page are an integral part of this Schedule. BELL ATLANTIC CORPORATION AND SUBSIDIARIES SCHEDULE V - CONSOLIDATED PLANT, PROPERTY AND EQUIPMENT For the Year Ended December 31, 1992 (Dollars in Millions) The notes on Page are an integral part of this Schedule. BELL ATLANTIC CORPORATION AND SUBSIDIARIES SCHEDULE V - CONSOLIDATED PLANT, PROPERTY AND EQUIPMENT For the Year Ended December 31, 1991 (Dollars in Millions) The notes on Page are an integral part of this Schedule. BELL ATLANTIC CORPORATION AND SUBSIDIARIES NOTES TO SCHEDULE V - PLANT, PROPERTY AND EQUIPMENT _________ (a) These additions include (1) the original cost (estimated if not specifically determinable) of reused material, which is concurrently credited to material and supplies, and (2) allowance for funds used during construction. Transfers between Plant in Service, Plant under Construction and Other are included in Additions at Cost. (b) Items of plant, property and equipment are deducted from the property accounts when retired or sold at the amounts at which they are included therein, estimated if not specifically determinable. (c) The telephone subsidiaries' provision for depreciation is based on the remaining life method and straight-line composite rates prescribed by regulatory authorities. The remaining life method provides for the full recovery of the remaining net investment in plant, property and equipment. During 1993, 1992, and 1991, the telephone subsidiaries implemented changes in depreciation rates approved by the regulators. These changes will more closely align the recovery of the Company's investment in plant, property and equipment with current estimates of its remaining economic useful life. For the years 1993, 1992, and 1991, depreciation expressed as a percentage of average depreciable plant was 7.7%, 7.0%, and 6.4%, respectively. (d) For 1993, Other Changes includes $24.5 million related to the acquisition of certain Other Communications and Related Services businesses. (e) See Note 1 of the Notes to Consolidated Financial Statements in the 1993 Annual Report to shareowners for the Company's depreciation policies. BELL ATLANTIC CORPORATION AND SUBSIDIARIES SCHEDULE VI - ACCUMULATED DEPRECIATION For the Years Ended December 31, 1993, 1992, and 1991 (Dollars in Millions) BELL ATLANTIC CORPORATION AND SUBSIDIARIES SCHEDULE VIII - VALUATION AND QUALIFYING ACCOUNTS For the Years Ended December 31, 1993, 1992, and 1991 (Dollars in Millions) - -------- (a) In 1992, amounts include beginning balances for businesses acquired during the year. Allowance for Uncollectible Accounts Receivable includes (1) amounts previously written off which were credited directly to this account when recovered, and (2) accruals charged to accounts payable for anticipated uncollectible charges on purchases of accounts receivable from others which were billed by the Company. (b) Amounts written off as uncollectible or obsolete or transferred to other accounts. (c) Represents the valuation allowance at implementation of Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes," effective January 1, 1993. (d) Other Allowances include allowances for obsolete equipment and allowances for probable losses incurred in the directory businesses arising in the normal course of operations. BELL ATLANTIC CORPORATION AND SUBSIDIARIES SCHEDULE IX - SHORT-TERM BORROWINGS For the Years Ended December 31, 1993, 1992, and 1991 (Dollars in Millions) - ---------- (a) Represents average daily face amount. (b) Computed by dividing aggregate interest expense by average daily face amount. (c) Includes both domestic and international borrowings. BELL ATLANTIC CORPORATION AND SUBSIDIARIES SCHEDULE X - SUPPLEMENTARY INCOME STATEMENT INFORMATION For the Years Ended December 31, 1993, 1992, and 1991 (Dollars in Millions) - ----------- Amounts for royalties and for amortization of intangible assets are not presented as such amounts are less than 1% of total operating revenues. Amounts reported for 1992 and 1991 for maintenance and repairs have been revised to include certain additional costs. EXHIBITS TO FORM 10-K ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE YEAR ENDED DECEMBER 31, 1993 COMMISSION FILE NO. 1-8606 BELL ATLANTIC CORPORATION EXHIBIT INDEX Exhibit Number - -------------- 3a Certificate of Incorporation of Bell Atlantic Corporation ("Bell Atlantic"), dated October 7, 1983. (Exhibit 3a to Registration Statement on Form S-1 No. 2-87842, File No. 1-8606) 3b Certificate of Amendment of Certificate of Incorporation of Bell Atlantic, dated May 9, 1986 and filed May 16, 1986. (Exhibit 3b to Form SE dated March 27, 1987, File No. 1-8606) 3c Certificate of Amendment of Certificate of Incorporation of Bell Atlantic, dated May 6, 1987 and filed May 8, 1987. (Exhibit 3c to Form SE dated March 28, 1988, File No. 1-8606) 3d Certificate of Amendment of Certificate of Incorporation of Bell Atlantic, dated May 10, 1990 and filed June 29, 1990. (Exhibit 3d to Form SE dated March 28, 1991, File No. 1-8606) 3e By-Laws of Bell Atlantic, as amended through June 23, 1992. (Exhibit 3e to Form SE dated March 29, 1993, File No. 1-8606) 4 No instrument which defines the rights of holders of long and intermediate term debt, of the Company and all of its consolidated subsidiaries, is filed herewith pursuant to Regulation S-K, Item 601(b)(4)(iii)(A). Pursuant to this regulation, Bell Atlantic hereby agrees to furnish a copy of any such instrument to the SEC upon request. 10a Agreement Concerning Contingent Liabilities, Tax Matters and Termination of Certain Agreements among AT&T, Bell Atlantic, the Network Services Companies, and certain other parties, dated as of November 1, 1983. 10a(i) Agreement Concerning Allocation of Contingent Liabilities between AT&T and Bell Atlantic, dated as of January 28, 1985. (Exhibit 10h(i) to Form SE filed on March 28, 1985, File No. 1-8606) 10b Agreement among Bell Atlantic Network Services, Inc. (formerly named Bell Atlantic Management Services, Inc.) and the Network Services Companies, dated November 7, 1983. 10c Bell Atlantic Senior Management Short Term Incentive Plan, as amended and restated effective as of January 1, 1993. (Exhibit 10c to Form SE dated March 29, 1993, File No. 1-8606)* 10d Bell Atlantic Senior Management Long-Term Disability and Survivor Protection Plan, as amended. (Exhibit 10h to Form SE filed on March 27, 1986, File No. 1-8606)* Exhibit Number - -------------- 10d(i) Resolutions amending the Plan, effective as of January 1, 1989. (Exhibit 10d to Form SE dated March 29, 1989, File No. 1-8606)* 10e Bell Atlantic Senior Management Transfer Program. (Exhibit 10ee to 1983 Form 10-K, File No. 1-8606)* 10e(i) Resolutions terminating the Program for transfers on or after November 1, 1992. (Exhibit 10e to Form SE dated March 29, 1993, File No. 1-8606)* 10f Bell Atlantic Personal Financial Services Program for Senior and Executive Managers and Key Employees, effective as of July 1, 1990, as amended. (Exhibit 10f to Form SE dated March 28, 1991, File No. 1-8606)* 10g Bell Atlantic Deferred Compensation Plan for Outside Directors, as amended and restated as of January 1, 1993. (Exhibit 10g to Form SE dated March 29, 1993, File No. 1-8606)* 10h Bell Atlantic Insurance Plan for Directors. (Exhibit 10hh to Registration Statement on Form S-1 No. 2-87842, File No. 1-8606)* 10i Description of Bell Atlantic Plan for Non-Employee Directors' Travel Accident Insurance. (Exhibit 10ii to Registration Statement on Form S-1 No. 2-87842, File No. 1-8606)* 10j Article V from Bell Atlantic Management Pension Plan regarding limitations on payment of pension amounts which exceed the limitations contained in the Employee Retirement Income Security Act of 1974. (Exhibit 10j to Form SE dated March 26, 1992, File No. 1-8606)* 10k Bell Atlantic Senior Management Retirement Income Plan, as amended and restated effective as of January 1, 1993. (Exhibit 10k to Form SE dated March 29, 1993, File No. 1-8606)* 10k(i) Resolutions amending the Bell Atlantic Senior Management Retirement Income Plan effective as of December 31, 1993.* 10l Bell Atlantic Deferred Compensation Plan (formerly the Bell Atlantic Senior Management Incentive Award Deferral Plan), as amended and restated effective as of January 1, 1993. (Exhibit 10l to Form SE dated March 29, 1993, File No. 1-8606)* 10l(i) Resolutions amending the Bell Atlantic Deferred Compensation Plan, effective October 25, 1993.* 10m Bell Atlantic Stock Incentive Plan, consisting of (1) The Bell Atlantic 1985 Performance Share Plan as amended and restated effective as of January 1, 1993 and (2) The Bell Atlantic 1985 Incentive Stock Option Plan as amended and restated effective as of January 1, 1993. (Exhibit 10m to Form SE dated March 29, 1993, File No. 1-8606)* Exhibit Number - -------------- 10m(i) Resolutions amending The Bell Atlantic 1985 Incentive Stock Option Plan, subject to the approval of the shareowners of the Company.* 10n Bell Atlantic Retirement Plan for Outside Directors, as amended and restated as of January 1, 1993. (Exhibit 10n to Form SE dated March 29, 1993, File No. 1-8606)* 10o Bell Atlantic Stock Compensation Plan for Outside Directors, as amended and restated as of January 1, 1993. (Exhibit 10o to Form SE dated March 29, 1993, File No. 1-8606)* 10p Bell Atlantic Corporation Directors' Charitable Giving Program. (Exhibit 10p to Form SE dated March 29, 1990, File No. 1-8606)* 10p(i) Resolutions amending and partially terminating the Program. (Exhibit 10p to Form SE dated March 29, 1993, File No. 1-8606)* 10q Employment Agreement dated January 24, 1994 between the Company and William O. Albertini.* 10r Employment Agreement dated January 24, 1994 among the Company, Bell Atlantic Enterprises International, Inc. and Lawrence T. Babbio, Jr.* 10s Resolution dated January 24, 1994 granting Lawrence T. Babbio, Jr. certain nonqualified stock options to purchase American Depositary Receipts representing Series L shares of the capital stock of Grupo Iusacell, S.A. de C.V.* 10t Employment Agreement dated January 24, 1994 between the Company and James G. Cullen.* 10u Non-Compete and Proprietary Information Agreement dated August 10, 1993 between the Company and James G. Cullen.* 10v Employment Agreement dated January 24, 1994 among the Company, Bell Atlantic Network Services, Inc. and Stuart C. Johnson.* 10w Non-Compete and Proprietary Information Agreement dated August 9, 1993 among the Company, Bell Atlantic Network Services, Inc. and Stuart C. Johnson.* 10x Employment Agreement dated January 24, 1994 between the Company and James R. Young.* 11 Computation of Earnings Per Common Share. 12 Computation of Ratio of Earnings to Fixed Charges. Exhibit Number - -------------- 13 1993 Annual Report to Shareowners (for the fiscal year ended December 31, 1993). Except for the portions of such Annual Report which are expressly incorporated herein by reference, such Annual Report is furnished for the information of the Securities and Exchange Commission and is not deemed to be "filed" as part of this Annual Report on Form 10-K. 21 List of subsidiaries of Bell Atlantic. 23 Consent of Coopers & Lybrand. 24 Powers of attorney. 99a Annual report on Form 11-K for the Bell Atlantic Savings Plan for Salaried Employees for the year ended December 31, 1993. (To be filed by amendment.) 99b Annual report on Form 11-K for the Bell Atlantic Savings and Security Plan (Non-Salaried Employees) for the year ended December 31, 1993. (To be filed by amendment.) - ------------- * Indicates management contract or compensatory plan or arrangement.

722573_1993.txt

722573

1993

Item 1. Business -------- General ------- Maxicare Health Plans, Inc., a Delaware corporation (the "Company") is a managed health care company, with a combined enrollment of approximately 293,000 at January 1, 1994. The Company owns and operates a system of 7 health maintenance organizations ("HMOs") in 7 states including California, Indiana, Illinois, Louisiana, North Carolina, South Carolina, and Wisconsin and three preferred provider organizations ("PPOs") called Maxiselect. Through its HMO operations, the Company arranges for comprehensive health care services to its members for a predetermined prepaid fee. The Company provides these services by contracting on a prospective basis with physician groups for a fixed fee per member per month regardless of the extent and nature of services, and with hospitals and other providers under a variety of fee arrangements. The Company believes that an HMO offers certain advantages over traditional health insurance: - To the member, an HMO offers comprehensive and coordinated health care programs, including preventive services, generally without requiring claims forms. - To the employer, an HMO offers an opportunity to improve the breadth and quality of health benefit programs available to employees and their families without a significant increase in cost or administrative burdens. - To the health care provider, such as physician groups and hospitals, an HMO provides a more predictable revenue source. The Company's executive offices are located at 1149 South Broadway Street, Los Angeles, California 90015, and its telephone number is (213)765-2000. History ------- On December 5, 1990, Maxicare Health Plans, Inc., a California corporation whose shares were publicly traded and the former parent company of the Company's businesses ("MHP"), merged with and into HealthCare USA Inc., a Delaware corporation ("HealthCare"), one of its wholly-owned subsidiaries, for the purpose of reincorporating from the state of California into the state of Delaware. Except as expressly provided herein or where the context requires, references to "MHP" and the "Company" herein pertain to both pre- merger Maxicare Health Plans, Inc., a California corporation, and to post-merger Maxicare Health Plans, Inc., a Delaware corporation. The HMO business of the Company originated in California in 1973. The business was operated as a nonprofit corporation through 1980. The Company was incorporated in California on December 23, 1980, to serve as a holding company for the California HMO and related entities. At the end of 1980, the California HMO was converted to a for-profit corporation. The Company began multi-state operations in June 1982 by purchasing 100% of CNA Health Plans, Inc. As part of its expansion strategy, the Company acquired all of the stock of HealthCare and HealthAmerica Corporation ("HealthAmerica") in the fourth quarter of 1986. At that time, HealthCare owned or managed HMOs in three states and HealthAmerica owned or managed HMOs in 17 states, including 11 states not previously serviced by the Company. The business of the Company's corporate predecessor, HealthCare, commenced in December 1968 when, through a predecessor corporation, it opened its first hospital. HealthCare was initially incorporated in January 1981 under the name of Greatwest Hospitals Inc. HealthCare's first HMO was acquired on December 30, 1981 through a merger with General Medical Centers, Inc. The acquisitions of HealthCare and HealthAmerica were highly leveraged and resulted in a substantial increase in the Company's long-term debt. These acquisitions, combined with adverse industry conditions and inadequate pricing policies, produced a dramatic deterioration in the Company's operating performance and financial condition. These financial difficulties ultimately caused certain of the Company's HMOs to fall out of compliance with state regulations and its loan agreement with various banks (the "Bank Group") and to default under the terms of its public indebtedness. As a result of deteriorating financial, operational and regulatory situations, MHP and forty-seven affiliated entities filed for protection under Chapter 11 of the United States Bankruptcy Code (the "Bankruptcy Code") in March and April of 1989 (the "Petition Dates"). Hereinafter, all 48 entities which filed bankruptcy petitions may from time to time be referred to as the "Debtors". Under the Bankruptcy Code, substantially all pre-petition liabilities, contingencies and other contractual obligations of the Debtors, except those expressly assumed by them, were discharged upon emergence from Chapter 11 on December 5, 1990, the "Effective Date" of the plan of reorganization (the "Reorganization Plan"). On or shortly after the Effective Date, the Company transferred approximately $85.4 million of cash to be distributed under the Reorganization Plan to segregated bank accounts and issued global certificates evidencing $67.0 million principal amount of 13.5% Senior Notes due December 5, 2000 (the "Senior Notes"), 10,000,000 shares of Common Stock and warrants to purchase an additional 555,555 shares of Common Stock (the "Warrants") to be distributed to holders of allowed claims and interests under the Reorganization Plan. As of January 31, 1994, approximately $85.5 million in cash, $39.7 million principal amount of Senior Notes, $18.2 million of cash in lieu of the now redeemed Senior Notes (see "Item 8. Financial Statements and Supplementary Data - Note 3 to the Company's Consolidated Financial Statements"), 8.9 million shares of Common Stock and 8,858 Warrants to purchase Common Stock had been distributed to holders of allowed claims. The remaining amounts of cash and securities will be distributed to holders of allowed claims upon adjudication of the remaining disputed claims pursuant to a formula set forth in the Reorganization Plan. In addition to the foregoing, certain assets of the Debtors which were not retained by the reorganized Company were transferred to a distribution trust for liquidation on behalf of the creditors (the "Distribution Trust") after reimbursement of expenses of the Distribution Trust. As of January 31, 1994, $8.9 million has been disbursed by the Distribution Trust to the disbursing agent. The Company anticipates that future distributions will be made from the Distribution Trust. Pursuant to the Reorganization Plan, the Company is required to make distributions based on its consolidated net worth in excess of $2.0 million at December 31, 1991 and 1992 (the "Consolidated Net Worth Distribution"). In March 1992, the Company consummated the sale of $60 million of Series A Cumulative Convertible Preferred Stock (the "Series A Stock") (see "Item 8. Financial Statements and Supplementary Data - Note 6 to the Company's Consolidated Financial Statements"). The proceeds from this sale, plus internally generated cash, were utilized to redeem in April 1992 the entire outstanding Senior Notes. The sale of the Series A Stock had the effect of significantly increasing the net worth of the Company. The Company does not believe the Reorganization Plan contemplated either the issuance of the Series A Stock or the redemption of the Senior Notes, and accordingly, the Company believes the Consolidated Net Worth Distribution required by the Reorganization Plan should be calculated on a basis as if the sale of the Series A Stock had not been consummated and the Senior Notes had not been redeemed. As a result of the foregoing, the Company calculated the December 31, 1992 Consolidated Net Worth Distribution amount to be approximately $971,000, which was deposited for distribution to certain creditors under the Reorganization Plan in March 1993. In addition, the Company believes that any Consolidated Net Worth Distribution which under the Reorganization Plan is to be utilized to redeem the Senior Notes is no longer due as the Senior Notes have been fully redeemed. The committee representing the creditors (the "New Committee") has stated it does not agree with the Company's interpretation of the the Reorganization Plan and believes that additional amounts may be due under the Consolidated Net Worth Distribution provision of the Reorganization Plan. The Company has responded to various inquiries of the New Committee and may engage in future discussions in an attempt to resolve any disputed items. Notwithstanding the foregoing, the Company elected to accrue in its consolidated financial statements for the year ended December 31, 1992 the maximum potential liability of $7.2 million on this matter (see "Item 8. Financial Statements and Supplementary Data"). The Bankruptcy Court retains jurisdiction over implementation and interpretation of the Reorganization Plan and, pursuant to a stipulation with the South Carolina regulators, over the operations of the South Carolina HMO, until all regulatory approvals regarding this HMO have been obtained (see "Item 1. Business - Government Regulation"). The Managed Health Care Industry -------------------------------- The Company owns and operates a multi-state system of HMOs. An HMO is an organization that arranges for health care services to its members. For these services, the members' employers pay all or most of the predetermined fee that does not vary with the nature or extent of health care services provided to the member, and the member pays a relatively small copayment or deductible for certain services. The fixed payment distinguishes HMOs from conventional health insurance plans that contain customary copayment and deductible features and also require the submission of claims forms. An HMO receives a fixed amount from its members regardless of the nature and extent of health care services provided, and as a result, an HMO has an incentive to keep its members healthy and to manage its costs through strategies such as monitoring hospital admissions and reviewing specialist referrals by primary care physicians. The goal is to combine the delivery of and access to quality health care services with effective management controls to make the most cost- effective use of health care resources. Although HMOs have been operating in the United States for half a century, their popularity began increasing in the 1970's in response to rapidly escalating health care costs and enactment of the Federal Health Maintenance Organization Act of 1973, a federal statute designed to promote the establishment and growth of HMOs (see "Item 1. Business - Government Regulation"). There are four basic organizational models of HMOs which are the staff, group, independent practice association and network models. The distinguishing feature between models is the HMO's relationship with its physicians. In the staff model, the HMO employs the physicians directly at an HMO facility and compensates the physicians by salary and other incentive plans. In the group model, the HMO contracts with a multi-specialty physician group which provides services primarily for HMO members and receives a fixed monthly fee, known as capitation, for each HMO member, regardless of the number of physician visits. Under the independent practice association model, the HMO either contracts with a physicians' association, which in turn contracts directly with individual physicians, or contracts directly with individual physicians. In either case, these physicians provide care in their own offices. Under the network model of organization, the HMO contracts with numerous community multi-specialty physician groups, hospitals and other health care providers. The physician groups are paid on a capitation basis, as in the group model, but medical care is usually provided in the physician's own facilities. The Company's HMOs include only network, group and independent practice association models. For the year ended December 31, 1993, 58% of the Company's health care expenses represented capitation payments to providers. PPOs are generally a network of health care providers which offer their services to health care purchasers, such as employers. PPO members choose from among the various contracting physician groups and independent practice associations (the "Physician Groups") the particular group from which they desire to receive their medical care, or choose a noncontracting physician and are reimbursed on a traditional indemnity plan basis after reaching an annual deductible. Payment is based on some variation of fee-for-service reimbursement and health care services are determined by the terms of the contract. The Company's PPO business began in Indiana, California and Louisiana in the fourth quarters of 1989, 1990 and 1992, respectively. In the third quarter of 1993 the Company introduced a primary care physician network product ("PCPN") to a Louisiana employer group with a health care plan which is self- insured. Under the PCPN, eligible members of the employer group may choose the Company's contracted physician network for their primary care services for a period of one year. The Company's PPO and PCPN lines of business represent approximately five percent (5%) of the Company's combined enrollment at December 31, 1993. The Company believes that the PPO and PCPN products offered by Maxicare Life and Health Insurance Company, a wholly-owned subsidiary of the Company, expand the options for members, while maintaining the concept of managed health care and is exploring the possibility of offering the PPO business and additional products and indemnity services in other markets. Health Care Services -------------------- In exchange for a predetermined monthly payment, an HMO member is entitled to receive a broad range of health care services. Various state and federal regulations require an HMO to offer its members physician and hospital services, and permit an HMO to offer certain supplemental services such as dental care and prescription drug services at an additional cost (see "Item 1. Business - Government Regulation"). As of December 31, 1993, the Company's HMOs had contracts with approximately 300 hospitals in 7 states and the Company owns and operates 3 pharmacies in California. The Company's members generally receive the following range of health care services: Primary Care Physician Services - medical care provided by primary care physicians (typically family practitioners, general internists and pediatricians). Such care generally includes periodic physical examinations, well-baby care and other preventive health services, as well as the treatment of illnesses not requiring referral to a specialist. Specialist Physician Services - medical care provided by specialist physicians on referral from the responsible primary care physicians. The most commonly used specialist physicians include obstetrician-gynecologists, cardiologists, surgeons and radiologists. Hospital Care - inpatient and outpatient hospital care including room and board, diagnostic tests, and medical and surgical procedures. Diagnostic Laboratory Services - inpatient and outpatient laboratory tests. Diagnostic and Therapeutic Radiology Services - X-ray and nuclear medicine services, including CT scans and therapeutic radiological procedures. Home Health Services - medical and surgical procedures performed on an outpatient basis, including emergency room services where such services are medically necessary, outpatient surgical procedures, evaluation and crisis intervention, mental health services, physical therapy and other similar services in which hospitalization is not medically necessary or appropriate. Other Services - other related health care services such as ambulance, family planning and infertility services and health education (including prenatal nutritional counseling, weight- loss and stop-smoking programs). Additional optional services include in-patient psychiatric care, hearing aids, durable medical supplies and equipment, dental care, vision care, chiropractic care and prescription drug services. Delivery of Health Care Services -------------------------------- The Company's HMOs provide for a portion of the health care services to its members by contracting on a prepaid basis with physician groups. The Company's HMOs typically pay to the physician groups a monthly capitation fee for each member assigned to the group. The amount of the capitation fee does not vary with the nature or extent of services utilized. In exchange for the capitation fee, the physician groups provide professional services to members, including laboratory services and X-rays. Members choose from among the various contracting physician groups the particular group from which they desire to receive their medical care. Members select a primary care physician to serve as their personal physician from the physician group. This physician will oversee their medical care and refer them to a specialist when medically necessary. In order to attract new members and retain existing members, the Company's HMOs must retain a network of quality physician groups and develop agreements with new physician groups. The Company's HMOs contract for hospital services with various hospitals under a variety of arrangements, including fee-for- service, discounted fee-for-service, per diem and capitation. Hospitalization costs are not generally included in the capitation fee paid by the Company's HMOs to physician groups. Except in emergency situations, a member's hospitalization must be approved in advance by the utilization review committee of the member's physician group and must take place in hospitals affiliated with the Company's HMOs. When emergency situations arise, however, which require medical care by physicians or hospitals not affiliated with the Company's HMOs, the Company's HMOs assume financial responsibility for the cost of such care. In mid 1992 the Company began restructuring its provider network in the Indianapolis marketplace as a result of the termination of contract negotiations with MH Healthcare, Inc. ("MetroHealth"), a health care provider in that market. Pursuant to the contract which expired on December 31, 1992, the enrollees in Indianapolis who use the MetroHealth facilities, comprising approximately 8% of the Company's total enrollment at December 31, 1993, will continue to have access to MetroHealth providers through March 31, 1994. MetroHealth currently offers its own HMO in the Indianapolis area. The restructuring of the Company's relationships among health care providers in the Indiana marketplace contributed to an increase in health care expenses (see "Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations"). The provider network restructuring which began in mid 1992 has been substantially completed as of the first quarter of 1994. Total enrollment in the Indiana HMO decreased approximately 22% during the first quarter of 1994 from December 31, 1993 but the Company believes that it will ultimately be able to replace a substantial number of the members who remain with MetroHealth and that the restructuring of the provider network will not have a long-term adverse impact on the Company's operations. Premium Structure and Cost Control ---------------------------------- The Company generally sets its membership fees, or premiums, pursuant to a community rating system which means that it charges the same nominal premium per class of subscriber within a geographic area for like services; however, groups which meet certain enrollment requirements are charged premiums based on prior cost experience (see "Item 1. Business - Government Regulation"). The Company has attempted to develop uniform procedures and guidelines to manage medical care costs. These procedures and guidelines include the annual negotiation of the capitation fee paid to physician groups, hospitals, dentists and pharmacies, the negotiation of discount contracts with other health care providers and the placement of financial responsibility on the primary care physician for the initiation of specialist referrals and hospital utilization. In situations where the Company assumes the financial responsibility for specialist referrals and hospital utilization, health care providers are rewarded monetarily for specified levels of utilization through incentive programs. In addition to directing the Company's health care providers toward capitation arrangements, the Company has a variety of programs and procedures in place to effect cost containment. These programs are intended to address utilization of inpatient services, outpatient services and referral services which: (i) verify the medical necessity of inpatient nonemergency treatment or surgery, (ii) establish whether services must be performed in an inpatient setting or could be done on an outpatient basis; and (iii) determine the appropriate length of stay for inpatient services, which may involve concurrent and/or retrospective review. In addition, the Company revised the terms and procedures of its pharmacy plan which incorporates such cost containment features as drug formularies (a Company-developed listing of preferred, cost- effective drugs). The Company establishes an annual budget for each geographic area and determines the expected costs of providing services in such areas. The budget is calculated on a per member per month basis for specific components. These include professional care by the contracting Physician Groups; hospitals; prescription drug and dental care services; emergency care; other health care services; and administration. The Company budgets hospital costs on the basis of utilization experience, actual cost per member per month, expected inflation and anticipated changes in health care delivery. For further information, see "Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations" and "Item 8. Financial Statements and Supplementary Data-Consolidated Statements of Operations" included herein. Management Information Systems ------------------------------ All of the Company's HMOs are currently linked through a network of data lines to the corporate data center, allowing the Company to prepare and make available management and accounting reports including eligibility, capitation, billing and claims information on an ongoing basis. System generated reports contain budgeted and actual monthly cost and utilization statistics relating to physician initiated services and hospitalization. Hospital reports, which are available on a daily basis, are further analyzed by the type of service, days paid, and actual and average length and cost of stay by type of admission. The corporate data center is located in Los Angeles. Quality Assurance ----------------- As required by federal and state law, the Company evaluates the quality and appropriateness of the medical care delivered to its members by its independently contracted providers in a number of ways including performing periodic medical care evaluation studies, analyzing monthly utilization of certain services, conducting periodic member satisfaction studies and reviewing and responding to member and physician grievances. The Company compiles a variety of statistical information concerning the utilization of various services, including emergency room care, outpatient care, out-of-area services, hospital services and physician visits. Under-utilization as well as over- utilization is closely evaluated in an effort to monitor the quality of care provided to the Company's members by physician groups. The Company has a member services department which deals directly with members concerning their health care questions, comments, concerns or grievances. The Company conducts annual surveys questioning members about their level of satisfaction with the services they receive. Management reviews any problems that are presented by members concerning the delivery of medical care and receives periodic reports summarizing member grievances. Marketing --------- Primary responsibility for the Company's marketing efforts rests with a marketing director and sales representatives for each HMO operated by the Company. Members typically join the Company's HMOs through an employer, who pays all or most of the monthly premium. In most instances, employers offer employees a choice of traditional health insurance or membership with HMOs such as those operated by the Company. The Company's HMOs' agreements with employers are generally for a term of 12 months subject to renewal annually. Once the Company's relationship with the employer is established, marketing efforts are then focused on employees. During an annual "open enrollment period", employees may select their desired health care coverage. The primary annual open enrollment period occurs in the month of January. By the end of January, approximately 62% of the Company's members select their desired health care coverage for the ensuing annual period. New employees make their choices at the time of employment. The Company's HMO membership is widely diverse, with no employer group comprising 10% or more of the Company's total enrollment. As of December 31, 1993, the Company's HMOs were offered by more than 1,400 employer groups. The Company has also developed a multi-state account program which offers employers having multiple locations in areas served by the Company's HMOs the opportunity to deal with one primary account manager. Billing and enrollment procedures are handled at a plan level giving the multi-state employer the opportunity to monitor individual areas within his employer group. For certain multi- state employers, the Company develops individual marketing and benefit programs for separate divisions, locations or benefit classes within the same employer. The Company believes that attracting employers is only the first step toward increasing enrollment at each of its HMOs; ultimately, the Company's ability to retain and increase membership will depend upon how users of the health care system assess its benefit package, rates, quality of service, financial condition and responsiveness to user demands. Competition ----------- The health care industry is highly competitive and the managed health care industry is becoming increasingly competitive in all markets. The HMO industry continues to gain market share, particularly at the expense of the indemnity carriers. The Company competes in its regional markets for employers and members with other HMOs, conventional health insurers and PPOs as well as employers who elect to self-insure, and for quality physician groups with other HMOs and PPOs. Many of these competitors are larger or have greater financial resources than the Company. The level of competition varies from state to state depending on the variety and size of other conventional insurance, HMO and PPO health care services offered in each state. Competitors of the Company include such well known entities as Kaiser, Health Net and Pacificare (in California), MetroHealth (in Indiana), and HMO Illinois, Partners National Health Plan, Humana and Chicago HMO (in Illinois). The Company believes the principal competitive factors it faces are premium rates, the quality of contracted providers, the variety of health care coverage options offered and the quality of service to members and providers. Competition may result in pressure to reduce rates or limit the growth potential of HMOs in any particular market. Employers, for example, are increasingly cost sensitive in selecting health care providers for their employees, which provides an incentive for the Company to keep its rates competitive. In addition to the above, the Company has recently faced increased competition from health care providers which offer not only HMO services but PPO and indemnity health care services to employer groups. In an effort to remain competitive, the Company has begun to offer a variety of health care services, including PPOs, and is actively exploring offering additional PPO and indemnity services through joint ventures or other arrangements. Competition may also be affected by mergers and acquisitions in the managed care and general health care industries as companies respond to proposed health care reform and seek to expand their operating territories to gain economies of scale and market share. Government Regulation --------------------- The federal government and each of the states in which the Company's HMOs operate have enacted statutes regulating the activities of HMOs. The most important laws affecting the Company are the Federal Health Maintenance Organization Act of 1973, as amended (the "HMO Act"), and the regulations thereunder promulgated by the Secretary of Health and Human Services, and the various state regulations mandating compliance with certain net worth and other financial tests. Federal Regulations. All of the Company's HMOs are federally qualified under the HMO Act. The HMO Act and regulations provide that, with certain exceptions, each employer of at least 25 employees must permit two "qualified" HMOs to market a health benefits plan to its employees, with the employer contributing the same amount toward the employee's HMO enrollment fee as it would otherwise have paid for conventional health care insurance. Under federal regulations, services to members must be provided substantially on a fixed prepaid monthly basis, without regard to the actual level of utilization of services. Premiums established by HMOs may vary from employer to employer through composite rate factors and special treatment of certain broad classes of members, including geographical location ("community rating"). Experience rating of accounts (i.e., setting premiums for a group account based on that group's past use of health care services) is also permitted under federal regulations in certain circumstances. From time to time, modifications to the HMO Act have been considered by Congress. The Company is unable to predict what, if any, modifications to the HMO Act will be passed into law or what effect, if any, such legislation would have upon the operations, profitability or business prospects of the Company. Among other areas regulated by federal and state law, although not necessarily by each state, are the scope of benefits available to members, the manner in which premiums are structured, procedures for review of quality assurance, enrollment requirements, the relationship between the HMO and its health care providers, procedures for resolving grievances, licensure, expansion of service area, and financial condition. The HMOs are subject to periodic review by the federal and state licensing authorities which regulate the HMOs. State Regulations. With the exception of the Company's South Carolina HMO, all of the Company's operational HMOs are licensed by pertinent state authorities. The operations of the South Carolina HMO are currently under Bankruptcy Court jurisdiction pending a reorganization of that entity as a division of one of the Company's other HMOs. The Company believes that it will be able to ultimately resolve the South Carolina HMO's licensing situation by changing its legal structure to that of a division of another one of its operating HMOs, or as a separately licensed HMO in the state of South Carolina. Presently, the Company is discussing with the North Carolina Department of Insurance the possibility of operating the South Carolina HMO as a division of the North Carolina HMO. In any event, the Company does not believe that the resolution of this situation will have a materially adverse effect on the Company taken as a whole. All of the Company's HMOs are subject to extensive state regulations which require the HMO to comply with certain net worth and other financial tests. A number of states have recently enacted legislation which increases these financial tests. To the extent an HMO fails to satisfy these regulatory requirements, MHP may need to infuse the HMO with additional capital in order to maintain the good standing of the HMO in the state. Under the HMO's business plans and in order to ensure financial compliance with state regulators, the Company is currently operating under a decentralized and segregated cash management system. The Company has implemented administrative services agreements which provide for MHP to furnish various management, financial, legal, computer and telecommunication services to the HMOs pursuant to the terms of the agreement with each HMO. The Company believes that it is currently operating in compliance with the state regulations and has obtained regulatory approval of the operational and financial plans and related administrative services agreements for its HMOs. The issue of health care reform continues to undergo intense discussion and examination by the public and private sectors. A number of proposals for health care reform have been introduced by both state and federal governments which include such concepts as universal coverage, comprehensive benefits, quality in the delivery of health care at an affordable price and portability of coverage for the insured. Many proposals are still being developed. Though the role of managed care appears to be an integral part in most proposals, the Company cannot determine the effect, if any, these proposals may have on the business or operations of the Company, if adopted. Employees --------- As of December 31, 1993, the Company employed approximately 465 full-time employees. None of the Company's employees are represented by a labor union or covered by a collective bargaining arrangement and the Company believes its employee relations are good. Directors and Executive Officers of the Registrant -------------------------------------------------- The directors and executive officers of the Company at December 31, 1993 were as follows: Peter J. Ratican was appointed Chairman of the Board of Directors, Chief Executive Officer and President of the Company in August 1988. Prior to joining the Company, Mr. Ratican was a senior executive of DeLaurentiis Entertainment Group Inc. and MCA INC. Prior to joining MCA INC., Mr. Ratican was a Senior Audit Manager for the Los Angeles Office of Price Waterhouse, specializing in the entertainment and health care industries. He is a member of the California Knox-Keene Health Care Services Advisory Committee, which assists the California Department of Corporations in regulating prepaid health plans (HMOs). Mr. Ratican has been a director of the Company since August 1983. He received a Bachelor of Science degree in Accounting from the University of California at Los Angeles and is a certified public accountant. Eugene L. Froelich was appointed Chief Financial Officer, Executive Vice President - Finance and Administration and director in March 1989. From 1984 to March 1989, Mr. Froelich was President of GFE, Inc., where he engaged in financial and business consulting for a variety of industries. Previously, Mr. Froelich was Vice President of MCA INC. Mr. Froelich graduated from Adelphi University and is a certified public accountant. Alan D. Bloom has been Senior Vice President - Secretary and General Counsel to the Company since July 1987. Mr. Bloom joined the Company as General Counsel in 1981 and from 1983 to 1987, he was Secretary and General Counsel. Mr. Bloom received a Bachelor's degree in Biology from the University of Chicago, a Master of Public Health from the University of Michigan, and a J.D. degree from American University. Aivars L. Jerumanis was appointed Senior Vice President - Management Information Systems and Chief Information Officer of the Company in January 1990. From May 1989 to January 1990, Mr. Jerumanis was a private consultant in advising companies on management information services matters and from June 1973 to May 1989 he was with MCA INC., where he served as Director of Corporate Data Processing and Vice President of Universal Studios. He received a Masters in Business Administration from Columbia University, a Masters in Civil Engineering from Rensselaer Polytechnic Institute and a Bachelor's degree in Civil Engineering from Lafayette College. Richard A. Link was appointed Chief Accounting Officer and Senior Vice President - Accounting of the Company in September 1988. Previously, Mr. Link was in the Los Angeles offices of Price Waterhouse where he had been Senior Audit Manager with an emphasis in health care. He has a Bachelor's degree in Business Administration from the University of Southern California and is a certified public accountant. Samuel W. Warburton, M.D. has been Senior Vice President - Medical Affairs of the Company since December 1988. As of April 1993, Dr. Warburton serves in this position as well as medical director of the North Carolina ACCESS program, a primary care case management program for medicaid enrollees. He has also served as Vice President of Medical Affairs of Maxicare North Carolina, Inc. since May 1985. From January 1980 to April 1985, Dr. Warburton was Chief of the Division of Family Medicine at Duke University and a Director of the Duke-Watts Family Medicine Program. Dr. Warburton has had a number of teaching and clinical appointments and published numerous articles on family medicine. He received his Bachelor of Arts from John Hopkins University and his Medical degree from the University of Pennsylvania School of Medicine. William B. Caswell was appointed Vice President, General Manager of the California HMO in February 1992. From March 1988 to January 1992 Mr. Caswell served as President of VertiHealth, a subsidiary of UniHealth America. Prior to joining VertiHealth he was Senior Vice President of California Medical Center - Los Angeles. Mr. Caswell serves on the board of directors of the University of Southern California School of Nursing as well as the Southern California Chapter of the Arthritis Foundation. He received a Master's degree in Business Administration and a Master of Public Health from the University of California at Los Angeles. David J. Hammons was appointed Vice President - Administrative Services and Chief Actuary of the Company in August 1993. From January 1988 to July 1993 Mr. Hammons was Vice President and Chief Actuary of the Company. He has a Bachelor's degree in Mathematics from the State University of New York and is a Fellow of the Society of Actuaries and a member of the American Academy of Actuaries. Robert J. Landis has served as Treasurer since November 1988. Prior to this date, he served as Assistant Treasurer since December 1983. Mr. Landis received a Bachelor's degree in Business Administration from the University of Southern California, a Master's degree in Business Administration from California State University at Northridge and is a certified public accountant. Vicki F. Perry was appointed Vice President, General Manager of Maxicare Indiana, Inc. in January 1992. From January 1990 to December 1991 she served as Executive Vice President - Plan Operations Support of the Company. Ms. Perry, who has been with the Company since 1982, previously served as Executive Director of the Indiana HMO. Ms. Perry is a graduate of Indiana University. Claude S. Brinegar is currently Vice Chairman of the board of directors of Unocal Corporation and served as Executive Vice President of Administration and Planning until May 1992. In 1985, Mr. Brinegar was elected Executive Vice President of Unocal and he became Chief Financial Officer in 1986. In 1989, Mr. Brinegar was elected as Vice Chairman of Unocal and has been a director of the Company since December 20, 1991. He is also a member of the board of directors of Consolidated Rail Corporation and a visiting scholar at Stanford University. Leon M. Clements served as Chief Administrative Officer and Associate Director of the UCLA Medical Group Practice from April 1993 to October 1993. Mr. Clements is currently self-employed as a consultant. From July 1990 to October 1992 Mr. Clements served as Chief Administrative Officer of Cleveland Clinic in Fort Lauderdale Florida. From November 1986 to June 1990 Mr. Clements was Chief Executive Officer with Browne-McHardy Clinic, a major health care provider for the Company's HMO in New Orleans, Louisiana. Mr. Clements has a Bachelor of Science degree in Economics and Finance and a Masters of Business Administration from the University of Southwestern Louisiana and served as a director of the Company from August 31, 1990 to January 28, 1994. Mr. Clements was the chairman of the Official Committee of Unsecured Creditors (the "OCC") during the Company's bankruptcy reorganization proceedings. Florence F. Courtright has been a private investor for the last five years and was elected a director of the Company on November 5, 1993. She is a founding Limited Partner of Bainco International Investors, 1.p and a Trustee of Loyola Marymount University. Further, Ms. Courtright is a former co-owner of the Beverly Wilshire Hotel and the Beverly Hills Hotel. Thomas W. Field, Jr. was appointed the Chairman of the Board of ABCO Markets in December 1991. ABCO Markets is in the grocery business. He has been President of Field & Associates, a management consulting firm, since October 1989. From 1984 to September 1989 Mr. Field was with McKesson Corporation in a number of executive capacities, most recently as Chairman of the Board, President and Chief Executive Officer. Mr. Field has been a director of the Company since April 1, 1992. Mr. Field also holds directorships at Campbell Soup Company, Bromar Inc. and Hume Medical. Charles E. Lewis has been a Professor of Medicine, Public Health and Nursing at the University of California at Los Angeles, since 1970. As of July 1993, he was appointed Director of the Center of Health Promotion and Disease Prevention. He is a member of the Institute of Medicine, National Academy of Sciences and is a graduate of the Harvard Medical School and of the University of Cincinnati School of Public Health where he received a Doctorate of Science degree. Dr. Lewis is a Regent of the American College of Physicians and a member of the Board of Commissioners of the Joint Commission on Accreditation of Health Care Organizations. Dr. Lewis has been a director of the Company since August 1983. The Board of Directors (the "Board") is classified into Class I, Class II and Class III directors. Class I directors include Dr. Lewis and Mr. Brinegar and they will serve until the 1994 annual meeting of stockholders and until their successors are duly qualified and elected. Class II directors include Mr. Froelich and Ms. Courtright and they will serve until the 1995 annual meeting of stockholders and until their successors are duly qualified and elected. Class III directors include Mr. Ratican, Mr. Field and Mr. Clements and they will serve until the 1993 annual meeting of stockholders and until their successors are duly qualified and elected. Officers are elected annually and serve at the pleasure of the Board, subject to all rights, if any, under certain contracts of employment (see "Item 11. Executive Compensation"). Pursuant to the Reorganization Plan, Mr. Clements was added to the Board as a designee of the pre-petition creditors. Dr. Lewis was added to the Board as an independent director and Messrs. Ratican and Froelich continued to serve as directors. Messrs. Brinegar and Field and Ms. Courtright were appointed to the Board. On January 28, 1994 the Company's shareholders at the 1993 Annual Meeting of Stockholders elected Alan S. Manne as a Class I director, replacing Leon Clements, and re-elected Peter Ratican and Thomas Field each for three year terms ending at the 1996 Annual Meeting of Stockholders or until his successor is duly qualified and elected. Mr. Manne is currently a professor emeritus and from 1961 to 1992 was a professor of operations research at Stanford University. He is an author, or co-author, of seven books and received his Ph.D. in economics from Harvard University. He is co- organizer of the International Energy Workshop. Item 2.

Item 2. Properties ---------- The Company's operating facilities are held through leaseholds. At December 31, 1993, the Company or its HMOs leased approximately 222,000 square feet at 21 locations with an aggregate current monthly rental of approximately $250,000. These leases have remaining terms of up to eight years. In August 1990, the Company entered into a lease for new corporate office space in Los Angeles. The lease commenced in February 1991 and is for a term of sixty-four (64) months. The lease is for approximately 83,000 square feet with a monthly base rental expense of approximately $98,500 excluding the Company's percentage share of all increases in the landlord's operating cost of the building. At December 31, 1993 the Company leased other properties including administrative locations, 3 pharmacies, and other miscellaneous facilities. The Company has subleased approximately 11,000 square feet to contracting medical groups, with current monthly rentals totaling $16,000 and monthly subrental revenue of $17,000. Item 3.

Item 3. Legal Proceedings ----------------- a. JURISDICTIONAL CHALLENGES AND APPEALS TO THE CHAPTER 11 REORGANIZATION PROCEEDINGS Immediately after the filing of the petitions, the Debtors were faced with several motions challenging the jurisdiction of the Bankruptcy Court over the Debtors' Chapter 11 cases. As of March 11, 1994, the only remaining jurisdictional appeals are the appeals filed by the State of Wisconsin (the "Wisconsin Appeals"), which affect the Maxicare Health Insurance Company, ("MHIC") one of the Company's HMO subsidiaries. The Wisconsin Appeals challenge MHIC's eligibility to be a debtor under the Bankruptcy Code. The Bankruptcy Court, the District Court and the United States Court of Appeals for the Ninth Circuit denied the State of Wisconsin's motions for a stay of consummation of the Reorganization Plan pending determination of the Wisconsin Appeals. On July 9, 1992, the United States District Court for the Central District of California entered a Ruling on Appeal (the "Ruling") concerning this matter. In its Ruling, the District Court held that MHIC is a domestic insurance company under Wisconsin state law and MHIC was therefore not eligible for relief under the Bankruptcy Code which excludes domestic insurance companies from entities eligible for relief thereunder. The District Court remanded the matter back to the Bankruptcy Court and ordered the Bankruptcy Court to take action consistent with the Ruling. The Company, MHIC and other affiliates filed a motion for rehearing of the Ruling and on August 27, 1992, the District Court denied the motion for rehearing. The Company has appealed the Ruling and the District Court's denial of the motion for rehearing to the United States Court of Appeals for the Ninth Circuit. In addition, the Company, MHIC and other affiliates have filed a motion in the District Court to stay implementation of the Ruling while the Ruling is on appeal. A hearing on the motion to stay the Ruling has been set for June 23, 1994. The Company has reached a settlement agreement in principle with the State of Wisconsin memorialized in a written memorandum of understanding. Pursuant to the agreement, a reorganization plan for MHIC, in accordance with Wisconsin state law, will be submitted without prejudice for approval by the Wisconsin State Court. Under the terms of the agreement in principle, the reorganization of MHIC must be on terms consistent with the Reorganization Plan. The implementation of the agreement in principle will have no material adverse impact on the Company's business or its operations. The agreement is subject to approval by the Bankruptcy Court and the non-occurrence of certain contingencies. The United States Court of Appeals for the Ninth Circuit has issued an order extending the time for the filing of briefs in connection with the Company's appeal of the Ruling in order to allow the parties an opportunity to implement and consummate the settlement. In the event the settlement cannot be fully implemented, the Company may pursue the appeal. If prosecution of the appeal resumes and the Ruling is upheld after MHIC's appellate rights have been exhausted, creditors of MHIC will likely only have the protections and recoveries afforded under applicable state law. In addition to the Wisconsin Appeals, twenty-four appeals were filed challenging various aspects of the Reorganization Plan's confirmation order. As of March 1, 1993, twenty-one of these appeals have been withdrawn or dismissed, two have been stayed subject to Bankruptcy Court and U.S. District Court approval of settlement agreements with the class action appellants discussed below and one has been stayed subject to Bankruptcy Court and United States District Court approval of the class action settlement agreements and the non-occurrence of certain other conditions. The Company believes it has a meritorious position and will prevail on its appeal of the Ruling or on the stayed appeals if prosecution of these appeals resumes. b. CLASS ACTION LITIGATIONS On July 15, 1988, a class action complaint alleging various violations of federal and state securities law arising from the purchase of the Company's old common stock was filed by Gerald D. Mirkin in the Superior Court for the County of Los Angeles against the Company, its former and current officers and directors, including Peter Ratican, and others including the Company's former accountants and investment bankers (Mirkin and Miller, et al. v. Fred W. Wasserman, et al. (Superior Court, Los Angeles County, CA) (Case No. CA 01122)). This action has been consolidated with two other actions. These other actions include (i) a class action lawsuit filed by Charles Miller against the Company and its former and current officers in the Superior Court of the State of California for the County of Los Angeles for violation of the California Corporations Code and California State common law arising from the purchase and sale of the Company's old common stock or the Company's 11 3/4% Notes, and (ii) a class action filed by William Steiner, on behalf of himself and other Company shareholders, against former and current officers and directors, and others including the Company's former accountants and investment bankers in the Superior Court of the State of California for the County of Los Angeles alleging violation of federal and state securities laws arising from the purchase and sale of the Company's old common stock. No class was certified in this consolidated action. In January, 1990, the trial court dismissed the action without leave to file an amended complaint, and the plaintiffs appealed the dismissal. In March, 1991, the Court of Appeals upheld the trial court dismissal. The plaintiffs subsequently appealed the Court of Appeals' ruling to the California Supreme Court. On September 19, 1993 the California Supreme Court affirmed the Court of Appeals' order precluding the Plaintiffs from pursuing the consolidated actions. The Plaintiffs did not seek review of the California Supreme Court's decision by the United States Supreme Court within the requisite time, rendering the California Supreme Court's decision final. Accordingly, the Company will no longer be reporting on this matter. On May 4, 1988, a class action complaint alleging violations of federal and state securities laws was filed by Murray Zucker on behalf of himself and other Company shareholders in the United States District Court for the Central District of California. Murray Zucker, et al. v. Maxicare Health Plans, Inc., et al. (United States District Court, Central District of CA) (Case No. 88 02499 LEW (TX)) (the "Zucker Action"). A class has been certified in the Zucker Action. The Company and certain of its current and former directors and officers who are named defendants have entered into a settlement agreement with respect to all of the claims in the aforementioned actions. Amounts to be paid under the settlement agreement have been funded entirely by the Company's directors and officers insurance policy with First State Insurance Company. The settlement agreement has been approved by the United States District Court, the class members and the Bankruptcy Court. The non-settling defendants appealed certain aspects of the District Court's approval of the settlement agreement (the "Zucker Appeal") which would preclude such non-settling defendants from seeking indemnification or contribution from the settling defendants, and the investment bankers appealed their exclusion from the class, to the United States Court of Appeals for the Ninth Circuit. On January 26, 1994, the Ninth Circuit Court of Appeals dismissed the Zucker Appeal for lack of jurisdiction over the appeal. Under the Reorganization Plan, former officers and directors who may have pre-petition claims against the Company for indemnification for damages in excess of insurance coverage are general unsecured creditors. An agreement has been executed between the non-settling defendants and the settling defendants, pursuant to which the non-settling defendants have agreed to waive their right to appeal the portion of the District Court's order approving the settlement agreement that precludes the non-settling defendants from seeking contribution or indemnification from the settling defendants. Under the agreement, the non-settling defendants retain the right to appeal their exclusion by the District Court from membership in the settling class. The Company does not believe that the ultimate resolution of any subsequent appeal by the non-settling defendants of their exclusion from membership in the settling class by the District Court, will impact the settlement of the Zucker Action. c. PENN HEALTH During the period from March 1, 1986 through June 30, 1989, Penn Health Corporation ("Penn Health"), a subsidiary of the Company, contracted with the Commonwealth of Pennsylvania through the Pennsylvania Department of Public Welfare (the "DPW") to provide a full range of health care services to Medicaid enrollees under the Pennsylvania Medical Assistance Program known as the HealthPass Program. The DPW was the sole subscriber group of Penn Health. These services were rendered by providers pursuant to contracts with Penn Health ("Penn Health Providers"). In consideration for these services, subject to certain adjustments, the DPW was obligated to pay to Penn Health a fixed monthly fee per enrollee based upon Penn Health's fee-for-service costs and a charge for administration. In addition, for the first two years of the contract, the DPW agreed to reimburse Penn Health for any financial losses in excess of $2 million. Under the applicable provisions of the contract, at the Petition Dates, the Company believes that the DPW owed Penn Health in excess of $24 million plus accrued interest, for reimbursement and adjustment of the cost of pre- petition services, an amount which the DPW disputes. After the Petition Dates, the DPW advanced funds directly to the Penn Health Providers for pre-petition services performed under the contracts with Penn Health. In certain cases the amount of the advanced funds may have been in excess of the amounts due to the Provider for such services. The payments made by the DPW approximated $16 million. The Penn Health Providers filed proofs of claim against Penn Health and other subsidiaries of the Company, without making deductions for the payments made by the DPW, although they noted receipt of such funds on their proofs of claim. In February, 1990, the Company filed a proceeding in the Bankruptcy Court against the DPW and the major Penn Health Providers to recover preferential transfers, to compel the turnover of property and to raise all objections to the proofs of claim of the Penn Health Providers, including that the claims asserted therein were overstated (the "Bankruptcy Action"). The disputes with the DPW and the major Penn Health Providers, in the Bankruptcy Action constitute the majority of the claims filed against Penn Health. On December 13, 1990, the Bankruptcy Court entered an order dismissing the Bankruptcy Action as against the DPW on jurisdictional grounds (the "Dismissal Order"). The Company filed an appeal of the Dismissal Order to the United States District Court for the Central District of California, which was subsequently resolved by a stipulation approved by the District Court. Pursuant to the stipulation, the jurisdictional issue was remanded to the Bankruptcy Court for redetermination in light of developments in the case law. On February 27, 1991 the Company filed a petition against the DPW in the Pennsylvania Board of Claims, seeking damages in excess of $24 million (the "Board Action"). In July 1992, the Pennsylvania Board of Claims (the "Board") denied DPW's preliminary objections to the Company's petition. In August 1992, the DPW answered the Company's petition and asserted counterclaims to recover (i) $16 million of payments that the DPW made to HealthPass healthcare providers purportedly to satisfy Penn Health's obligations to the providers; (ii) the costs the DPW incurred in processing and mailing the payments to the healthcare providers; and (iii) $6 million which the DPW alleges was distributed by Penn Health to the Company, but should have been retained by Penn Health to satisfy healthcare providers' claims. In the Company's October 14, 1992 answer to the counterclaim, the Company denied the allegations set forth in the counterclaim. The Company also asserted as an affirmative defense that Penn Health's discharge in bankruptcy under the Reorganization Plan is a complete bar to the DPW's counterclaim. In the event the DPW is successful in its counterclaims, all of which arose out of pre-petition activities of the Company and Penn Health, any recovery would be paid out of the Reorganization Plan funds and there will be no impact on the Company's cash resources. The Company believes that it has a meritorious defense to the counterclaim and will prevail on the counterclaim. On October 4, 1993 Penn Health filed a remand motion with the Bankruptcy Court for a determination that the DPW waived its sovereign immunity by asserting an offset against Penn Health. DPW opposed the remand motion and subsequently filed a motion with the Bankruptcy Court requesting that the Court abstain from adjudicating the Bankruptcy Action and require that Penn Health's claims against DPW be adjudicated by the Board in the Board Action. Pursuant to an order of the Bankruptcy Court entered on February 24, 1994, Penn Health's remand motion was granted in all respects and the Dismissal Order was vacated. Under an order entered by the Bankruptcy Court on January 24, 1994, the Court abstained on a preliminary basis from adjudicating the Bankruptcy Action and stayed all proceedings in the action until September 1, 1994 to allow the Board an opportunity to adjudicate the Board Action. The Bankruptcy Court retains jurisdiction over the Bankruptcy Action to try or hear the action on the merits in the event that the Board Action is not tried or heard by September 1, 1994, or no significant progress is made in trying or hearing the Board Action. In an order dated December 21, 1993 the Board consolidated the Board Action and two separate actions filed by Penn Health Providers against DPW to recover payment from DPW for services rendered to HealthPass members (the "Provider Actions") and set trial dates in the consolidated actions. Contractual issues pertaining to the DPW's liability to Penn Health in the Board Action and to Penn Health providers in the Provider Actions will be tried by the Board in a trial scheduled to commence on July 6, 1994. A trial to determine damages will be held by the Board on December 12, 1994. The Company has, in the past, engaged in settlement discussions with the DPW and representatives of the major Penn Health Providers but an agreement was not reached. The pre-petition amounts due to Penn Health Providers will be treated as unsecured class 11 claims under the Reorganization Plan. The Company is currently holding approximately $225,000 in an escrow account, which the Company believes will be sufficient to satisfy any remaining post-petition claims of Penn Health Providers. d. OTHER LITIGATION On March 12, 1993, MH Healthcare, Affiliate of Methodist Hospital of Indiana, Inc. ("MH") submitted a demand (the "Demand") to the American Arbitration Association (the "AAA") for arbitration of a contractual dispute between MH and Maxicare Indiana, Inc. ("Indiana") concerning interpretation of the provisions of a Master Agreement dated February 8, 1988, as subsequently amended, (the "Agreement") by and among MHP, Indiana and MH. MH Healthcare, Affiliate of Methodist Hospital of Indiana, Inc. v. Maxicare Indiana, Inc. Under the terms of the Agreement MH agreed to provide designated healthcare services to members of the health care plan operated by Indiana in exchange for the rates and fees designated in the Agreement. In the Demand MH: (i) contends that it was not paid the appropriate amounts due under the Agreement for 1992; (ii) disputes certain of the premium rates upon which Indiana based its calculation of payments made to MH under the Agreement; and (iii) contends that in accordance with the Agreement changes made by Indiana to the covered services provided to plan members have materially impacted the actuarial value of the payments due under the Agreement, entitling MH to an upward adjustment in the rates specified in the Agreement. Based on the Pre-Hearing Statement which MH submitted to the Arbitrator, the Company has been advised that MH is seeking a damage award of approximately $7.9 million plus interest. In the event MH prevails in the arbitration, there may be additional amounts due to MH for the 1993 contract year. Indiana disputes the allegations of the Demand and MH's damages computation and has asserted a counterclaim to the Demand to recover overpayments erroneously made to MH under the Agreement. The parties are currently engaged in arbitration of the allegations of the Demand by the AAA which commenced on March 21, 1994. The Company believes that Indiana has meritorious defenses to the Demand and that Indiana will prevail in the arbitration. The Company is a defendant in a number of other lawsuits arising in the ordinary course from the operations of its HMOs, including cases in which the plaintiffs assert claims against the Company or third parties that might assert indemnity or contribution claims against the Company for malpractice, negligence, bad faith in the failure to pay claims on a timely basis or denial of coverage. The Company does not believe that adverse determination in any one or more of these cases would have a material, adverse effect on the Company's business and operations. Item 4.

Item 4. Submission of Matters to a Vote of Security Holders --------------------------------------------------- No matter was submitted to a vote of security holders during the three months ended December 31, 1993. PART II ------- Item 5.

Item 5. Market for the Registrant's Common Stock and Related ---------------------------------------------------- Stockholder Matters ------------------- The Company emerged from Chapter 11 on December 5, 1990. Pursuant to the Reorganization Plan, its pre-petition creditors were entitled to receive 98% of the 10 million shares of Common Stock authorized for distribution under the Reorganization Plan; the remaining 2% of the Common Stock is to be distributed to equity and interest holders. (a) Market Information The Company's Common Stock appears on the National Association of Securities Dealers Automated Quotation National Market Systems ("NASDAQ-NMS") under the trading symbol MAXI. The following table sets forth the range of high and low bid and asked quotations of the Common Stock as reported by the National Quotation Bureau, Incorporated from January 1, 1992 to April 6, 1992. Thereafter, the table sets forth the high and low sale prices per share on the NASDAQ-NMS. The quotations are interdealer prices without retail mark-ups, markdowns, or commissions, and may not represent actual transactions. (b) Holders The number of holders of record of the Company's Common Stock on December 31, 1993 was 17,892. As of such date, the Company held 1,164,778 shares of Common Stock (the "Unallocated Shares") as disbursing agent for the benefit of creditors and holders of interests and equity claims under the Reorganization Plan. Of the Unallocated Shares held as of December 31, 1993, 752,236 were held for the benefit of creditors of the Company's operating subsidiaries (Reorganization Plan classes 5A through 5H), 118,400 shares were held for bank group creditors (Reorganization Plan class 7), 97,272 shares were held for bondholder creditors (Reorganization Plan classes 8A through 8D), and 196,870 were held for former stockholders (Reorganization Plan class 12). As of December 31, 1993, no shares were being held for the benefit of Maxicare Health Plans, Inc. creditors (Reorganization Plan class 9), however, certain of the shares held for the benefit of Reorganization Plan classes 7 and 8A through 8D will be reallocated to Reorganization Plan class 9 pursuant to a formula set forth in the Reorganization Plan. The Reorganization Plan provides that until such time as any share of Common Stock reserved for a holder of an allowed claim or allowed interest under the Reorganization Plan is allocated, the disbursing agent shall deliver an irrevocable proxy to vote the Unallocated Shares to the independent directors of the Board (as such term is defined by the Reorganization Plan). Currently, the independent directors are Messrs. Brinegar and Lewis (the "Independent Directors"). The Reorganization Plan provides that the Unallocated Shares shall be voted in the following manner: (i) 949,106 shares which were held in the claims reserves as of December 31, 1993 for the holders of Reorganization Plan classes 5A through 5H and Reorganization Plan class 9 allowed claims and Reorganization Plan class 12 allowed interests and equity holder claims, shall (a) as to proposals made by the Company, be voted in the same manner and the same degree as all of the allocated shares of Common Stock; and (b) as to proposals made by any person or entity other than the Company, be voted in accordance with the vote of a majority of the Independent Directors; and (ii) 215,672 shares which were held in the claims reserves as of December 31, 1993 for holders of Reorganization Plan class 7 and Reorganization Plan classes 8A through 8D allowed claims, shall be voted in the same manner and the same degree as all of the allocated shares of Common Stock. (c) Dividends The Company has not paid any cash dividends on its Common Stock. Item 6.

Item 6. Selected Financial Data ----------------------- Notes to Selected Financial Data (1) Expenses were offset by $5,218 and $3,055 of investment income for the years ended December 31, 1990 and 1989, respectively, that was estimated would not have been earned but for the Chapter 11 reorganization proceedings. Subsequent to the Effective Date, investment income is no longer offset against reorganization expenses. (2) Includes a 1992 write-off of unamortized original issue discount and unamortized issuance costs on the Senior Notes that were redeemed and a 1992 accrual of a distribution payable pursuant to the Reorganization Plan based on the Company's consolidated net worth as of December 31, 1992. Includes a 1991 accrual of a distribution payable pursuant to the Reorganization Plan based on the Company's consolidated net worth as of December 31, 1991 and a write- off of original issue discount on Senior Notes that were to be redeemed. Includes a 1990 gain with respect to the Independence Health Plan of Southeastern Michigan, Inc. settlement and the discharge of pre-petition liabilities pursuant to the Reorganization Plan (see "Item 8. Financial Statements and Supplementary Data - Note 3 to the Company's Consolidated Financial Statements"). (3) As provided in the Reorganization Plan, previously outstanding common stock was cancelled, and 10,000 shares of Common Stock were issued. Accordingly, per share information for 1990 was calculated by using the 10,000 shares plus common equivalent shares of stock options and Warrants when dilutive. Net loss per common and common equivalent share previously reported for 1989 was calculated based on 34,640 shares of old common stock. Therefore, the net loss per common and common equivalent share amount for 1989 is not comparable to 1993, 1992, 1991 and 1990 and, accordingly, has been omitted. (4) Includes long-term liabilities of $504, $1,015, $63,177, $63,388 and $12,323 in 1993, 1992, 1991, 1990 and 1989, respectively, and in 1989 pre-petition liabilities of $843,713. Item 7.

Item 7. Management's Discussion and Analysis of Financial Condition ----------------------------------------------------------- and Results of Operations ------------------------- The year ended December 31, 1993 compared to the year ended December -------------------------------------------------------------------- 31, 1992. --------- Maxicare Health Plans, Inc. (the "Company") reported net income of $5.6 million for the year ended December 31, 1993, compared to a net loss of $3.1 million, including extraordinary charges of $14.2 million, for the same period of 1992. Net income per common share available to common shareholders increased to $.02 for the year ended December 31, 1993 compared to a net loss per common share available to common shareholders of $.71 for the same period in 1992. For the year ended December 31, 1993, the Company reported operating revenues of $440.2 million, a 6% increase over the $414.5 million reported for the year ended December 31, 1992. The increase in revenues primarily results from the Company experiencing an increase in membership and modest premium rate increases. The increase in year-to-date operating revenues for 1993 was more than offset by an increase in health care expenses, contributing to a decrease in income from operations to $413,000 from $7.8 million for fiscal year 1992. Health care expenses increased for the year ended December 31, 1993 primarily because of a $7.0 million one-time charge reported in the third quarter of 1993 for previously unanticipated actual and projected health care costs. These costs primarily resulted from changes in the Indiana marketplace, the restructuring of relationships among the Company and its health care providers as well as unanticipated increases in high cost health care procedures. The provider network restructuring which began in mid 1992 has been substantially completed as of the first quarter of 1994. Marketing, general and administrative expenses increased $2.2 million to $41.0 million for the year ended December 31, 1993 as compared to 1992; however, these expenses have decreased as a percentage of operating revenues. The Company's consummation of the sale of $60 million of Series A preferred stock on March 11, 1992 and the redemption on April 13, 1992 of the entire outstanding principal, plus accrued interest on, the Senior Notes resulted in the Company reporting a $14.2 million extraordinary loss in the first quarter of 1992, the payment of $5.4 million in preferred stock dividends in 1993 and a decrease in year- to-date interest expense of $2.7 million for 1993 (see "Item 8.

Item 8. Financial Statements and Supplementary Data ------------------------------------------- REPORT OF INDEPENDENT ACCOUNTANTS --------------------------------- To the Board of Directors and Shareholders of Maxicare Health Plans, Inc. In our opinion, the consolidated financial statements listed in the index appearing under Part IV Item 14(a)(1) and (2) on page 70 present fairly, in all material respects, the financial position of Maxicare Health Plans, Inc. and its subsidiaries at December 31, 1993 and 1992, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 1993, in conformity with generally accepted accounting principles. These financial statements are the responsibility of the Company's management; our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits of these statements in accordance with generally accepted auditing standards which require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for the opinion expressed above. As discussed in Note 2 to the consolidated financial statements, the Company changed its method of accounting for income taxes in 1991. PRICE WATERHOUSE Los Angeles, California March 4, 1994 MAXICARE HEALTH PLANS, INC. AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS (Amounts in thousands except par value) See notes to consolidated financial statements. MAXICARE HEALTH PLANS, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF OPERATIONS (Amounts in thousands except per share data) See notes to consolidated financial statements. MAXICARE HEALTH PLANS, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS (Amounts in thousands) See notes to consolidated financial statements. MAXICARE HEALTH PLANS, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS' EQUITY (Amounts in thousands) See notes to consolidated financial statements. MAXICARE HEALTH PLANS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE 1 - BUSINESS DESCRIPTION Maxicare Health Plans, Inc., a Delaware corporation ("MHP"), is a holding company which owns various subsidiaries, primarily health maintenance organizations ("HMOs"). MHP operates HMOs in California, Indiana, Illinois, Louisiana, North Carolina, South Carolina and Wisconsin. All of MHP's HMOs are federally qualified by the United States Department of Health and Human Services and are generally regulated by the Department of Insurance of the state in which they are domiciled (except Maxicare, which is regulated by the California Department of Corporations). Maxicare Life and Health Insurance Company ("MLH"), a licensed insurance company and wholly-owned subsidiary of MHP, operates preferred provider organizations ("PPOs") or primary care provider network products in Indiana, Louisiana and California and represents approximately five percent (5%) of the consolidated enrollment of MHP and subsidiaries (the "Company") at December 31, 1993. In addition, MLH writes policies for group life and accidental death and dismemberment insurance; however, these lines of business make up less than one percent (1%) of the Company's operating revenues for the year ended December 31, 1993. NOTE 2-SIGNIFICANT ACCOUNTING POLICIES Basis of Consolidation The accompanying consolidated financial statements include the accounts of the Company. All significant inter-company balances and transactions have been eliminated. Cash and Cash Equivalents For purposes of the Consolidated Statements of Cash Flows, the Company considers all highly liquid investments that are both readily convertible into known amounts of cash and mature within 90 days from their date of purchase to be cash equivalents. Cash and cash equivalents consist of the following at December 31: Marketable Securities Marketable securities are stated at the lower of amortized cost, which typically approximates market, or market value. Market value is estimated using published or broker quoted prices. Gains or losses on disposal of marketable securities are determined on a specific identification basis and are included in investment income in the Consolidated Statements of Operations. Included in investment income for the year ended December 31, 1993 is $375,000 of gains recognized on the sale of marketable securities. Marketable securities consist of the following at December 31: All bonds in which the Company has invested are rated A or better by Moody's or Standard and Poor's rating agencies. Accounts Receivable Accounts receivable consist of the following at December 31: Property and Equipment Property and equipment are recorded at cost and include assets acquired through capital leases and improvements that significantly add to the productive capacity or extend the useful life of the asset. Costs of maintenance and repairs are charged to expense as incurred. Depreciation for financial reporting purposes is provided on the straight-line method over the estimated useful lives of the assets. The costs of major remodeling and improvements are capitalized as leasehold improvements. Leasehold improvements are amortized using the straight-line method over the shorter of the remaining term of the applicable lease or the life of the asset. Statutory Deposits Statutory deposits include cash investments that are limited to specific purposes as required by federal regulations, regulations in states in which the Company operates or employer groups with which the Company contracts. The Company had $12.6 million and $11.4 million in such investments limited by federal or state regulations at December 31, 1993 and 1992, respectively, and $850,000 and $500,000 in such investments limited by employer groups at December 31, 1993 and 1992, respectively. These investments are stated at the lower of amortized cost, which approximates market, or market value. Market value is estimated using published or broker quoted prices. Intangible Assets Intangible assets are amortized using the straight-line method over five years. Accumulated amortization of intangible assets at December 31, 1993 and 1992 is $1.7 million and $1.6 million, respectively. Long-term Liabilities Long-term liabilities include reserves for various legal matters, including reserves for medical malpractice claims, and various other miscellaneous long-term liabilities. Reorganization Accounting Costs incurred relating to the reorganization of the Company under Chapter 11 of Title 11 of the United States Bankruptcy Code are reflected in the accompanying consolidated financial statements as reorganization expenses. These costs consisted primarily of legal, accounting, compensatory and financial consulting expenses. Revenue Recognition Premiums are recorded as revenue in the month for which the enrollees are entitled to health care service. Premiums collected in advance are deferred. A portion of premiums is subject to possible retroactive adjustment. Provision has been made for estimated retroactive adjustments to the extent the probable outcome of such adjustments can be determined. Any other revenues are recognized as services are rendered. Cost Recognition The cost of health care services is expensed in the period the Company is obligated to provide such services. Estimated claims payable includes claims reported as of the balance sheet date and estimated (based upon utilization trends and projections of historical developments) costs of health care services rendered but not reported. Reserves are continually monitored and reviewed and as settlements are made or reserves adjusted, differences are reflected in current operations. Insurance Due to the high costs of insurance coverages, the Company's operating entities, except in South Carolina, are self-insured for risks on certain medical and hospital claims incurred by their members. The Indiana operations were reinsured through August 31, 1991 by a wholly-owned subsidiary of MHP and have been self-insured for such risks subsequent to this date. The North Carolina HMO maintained reinsurance coverage with a third party insurance carrier through December 31, 1992 but subsequently has been reinsured through MLH. The South Carolina HMO continues to maintain reinsurance coverage with a third party insurance carrier. In addition, the Company's operating entities are self-insured for medical malpractice claims. Premium Deficiencies Estimated future health care costs and maintenance expenses under a group of contracts in excess of estimated future premiums and reinsurance recoveries on those contracts are recorded as a loss when determinable. Income Taxes In February 1992, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes" ("FAS 109"). The Company elected to adopt the Statement for the year ended December 31, 1991. This Statement requires, among other things, recognition of future tax benefits measured by enacted tax rates, attributable to deductible temporary differences between financial statement and income tax bases of assets and liabilities and to net operating loss carryforwards ("NOLs") to the extent that realization of such benefits is more likely than not. Net Income (Loss) Per Common and Common Equivalent Share Primary earnings per share is computed by adjusting the net income (loss) for the preferred stock dividends in order to determine net income (loss) attributable to common shareholders. This amount is then divided by the weighted average number of common shares and common equivalent shares for stock options and warrants (when dilutive) outstanding during the period. Earnings per share assuming full dilution is reported when the assumption that the preferred stock is converted to Common Stock is dilutive. Earnings per share assuming full dilution is determined by dividing net income (loss) by the weighted average number of common shares and common stock equivalents for stock options and warrants and for preferred stock assumed converted to Common Stock (when dilutive). Stock Options With respect to stock options granted at an exercise price which is less than the fair market value on the date of grant, the difference between the option exercise price and market value at date of grant is charged to operations over the period the options vest. Income tax benefits attributable to stock options are credited to additional paid-in capital when exercised. Restriction on Fund Transfers Certain of the Company's operating subsidiaries are subject to state regulations which require compliance with certain deposit, reserve and net worth requirements. To the extent the operating subsidiaries must comply with these regulations, they may not have the financial flexibility to transfer funds to MHP. MHP's proportionate share of net assets (after inter-company eliminations) which, at December 31, 1993, may not be transferred to MHP by subsidiaries in the form of loans, advances or cash dividends without the consent of a third party is referred to as "Restricted Net Assets". Total Restricted Net Assets of these operating subsidiaries is $23.7 million at December 31, 1993, with deposit and reserve requirements representing $13.5 million of the Restricted Net Assets and net worth requirements, in excess of deposit and reserve requirements, representing the remaining $10.2 million. Total Restricted Net Assets at December 31, 1993 of $23.9 million includes restricted cash of $225,000 held by a non-operating subsidiary of MHP. Reclassifications Certain amounts for 1992 and 1991 have been reclassified to conform to the 1993 presentation. NOTE 3 - EXTRAORDINARY ITEMS On December 5, 1990 (the "Effective Date") the Company emerged from protection under Chapter 11 pursuant to the Company's joint plan of reorganization, as modified (the "Reorganization Plan") which provides that on December 31, 1991 and 1992 or within 90 days thereafter, the Company will make additional distributions, not to exceed $20.0 million in the aggregate, in an amount equal to its then consolidated net worth (as determined in the Company's audited consolidated financial statements) less $2.0 million (the "Consolidated Net Worth Distribution"). The Consolidated Net Worth Distribution will be distributed and applied in the following manner: 40% of the Consolidated Net Worth Distribution will be distributed ratably to the holders of certain allowed claims in accordance with the terms of the Reorganization Plan and the remaining 60% will be applied ratably against mandatory redemptions of the 13.5% Senior Notes due December 5, 2000 (the "Senior Notes") as set forth in the indenture governing the Senior Notes (the "Indenture"). On March 12, 1992, MHP noticed the redemption of the Senior Notes for April 13, 1992. In anticipation of this redemption, a $7.0 million extraordinary loss was recorded in the first quarter of 1992 for the write-off of unamortized original issue discount and unamortized issuance costs on the Senior Notes and an accrual for Senior Notes redemption costs. Also, a $7.2 million extraordinary loss ($20 million * 40% less $781,000 previously recorded) was reported in the first quarter of 1992 to accrue payments which may be made pursuant to the Reorganization Plan, based on the Company's consolidated net worth at December 31, 1992, to certain holders of allowed claims. The Company does not believe the Reorganization Plan contemplated either the issuance of convertible preferred stock (see Note 6) or the redemption of the Senior Notes, and accordingly, the Company believes the Consolidated Net Worth Distribution required by the Reorganization Plan should be calculated on a basis as if the sale of convertible preferred stock had not been consummated and the Senior Notes had not been redeemed. The Company has thus determined the December 31, 1992 Consolidated Net Worth Distribution amount to be approximately $971,000, which has been deposited for distribution to certain creditors under the Reorganization Plan. In addition, the Company believes that any Consolidated Net Worth Distribution which under the Reorganization Plan is to be utilized to redeem the Senior Notes is no longer due as the Senior Notes have been fully redeemed. Notwithstanding the foregoing, the Company has elected to accrue in its consolidated financial statements the maximum potential liability pending clarification of this matter. The amount that may be ultimately payable pursuant to this Reorganization Plan provision, if any, could be less than the amount accrued. The Consolidated Net Worth Distribution will be made from the Company's available cash. The Company's consolidated net worth of $4.0 million at December 31, 1991, before the recognition of the Consolidated Net Worth Distribution, resulted in an approximate $2.0 million Consolidated Net Worth Distribution payable being recorded in the fourth quarter of 1991 ($1.2 million representing the redemption of Senior Notes and $781,000 representing the distribution to holders of certain allowed claims). Payment of the December 31, 1991 Consolidated Net Worth Distribution was made in March 1992. The $781,000 distribution to holders of certain allowed claims, along with the write-off of $124,000 in original issue discount on the Senior Notes to be redeemed, was recorded as an extraordinary item in December 1991. NOTE 4 - LITIGATION The Company has reached a settlement agreement in principle with the State of Wisconsin regarding its appeal challenging confirmation of the Reorganization Plan on jurisdictional grounds. Pursuant to the agreement, a reorganization plan for Maxicare Health Insurance Company, a Wisconsin HMO subsidiary of MHP ("MHIC"), in accordance with Wisconsin state law, will be submitted without prejudice for approval by the Wisconsin State Court. Under the terms of the agreement in principle, MHIC's reorganization under Wisconsin law must be on terms consistent with the Reorganization Plan. The Company believes the implementation of the agreement in principle will have no material adverse impact on the Company's business or its operations. The agreement is subject to approval by the United States Bankruptcy Court and the non-occurence of certain contingencies. In the event the settlement cannot be implemented, the Company may pursue the appeal. If prosecution of the appeal resumes and the United States District Court's ruling is upheld after MHIC's appellate rights have been exhausted, creditors of MHIC will likely only have the protections and recoveries afforded under applicable state law. The Company believes that it has a meritorious position and will prevail on its appeal of the United States District Court's ruling, if prosecution of the appeal resumes. On March 12, 1993, MH Healthcare, Affiliate of Methodist Hospital of Indiana, Inc. ("MH") submitted a demand (the "Demand") to the American Arbitration Association (the "AAA") for arbitration of a contractual dispute between MH and Maxicare Indiana, Inc. ("Indiana") concerning interpretation of the provisions of a Master Agreement dated February 8, 1988, as subsequently amended, (the "Agreement") by and among MHP, Indiana and MH. Based on the Pre- Hearing Statement which MH submitted to the Arbitrator and communications with MH, the Company has been advised that MH is seeking a damage award of approximately $7.9 million plus interest. In the event MH prevails in the arbitration, there may be an additional amount due to MH for the 1993 contract year. Indiana disputes the allegations of the Demand and MH's damages computation and has asserted a counterclaim to the Demand to recover overpayments erroneously made to MH under the Agreement. The Company believes that Indiana has meritorious defenses to the Demand and that Indiana will prevail in the arbitration. In the event MH is awarded damages in an amount which proximates the damages MH contends it is entitled to, and such award is upheld on review, the award could have an adverse financial impact on Indiana and the Company. The Company is involved in litigation arising in the normal course of business, which, in the opinion of management, will not adversely affect the Company's consolidated financial position. NOTE 5 - COMMITMENTS AND OTHER CONTINGENCIES Excluded Cash Claims Reserve On the Effective Date, the Company estimated that payments to administration creditors and holders of allowed priority tax claims, allowed claims of secured creditors, enrollee claims, allowed priority employee claims and allowed convenience claims (the "Excluded Cash claims") would not exceed $10.3 million; however, if required the Reorganization Plan further provides for the payment of up to $16.0 million of such claims. Pursuant to a stipulation, the creditor committees agreed, provided the creditors have received the full amount of minimum cash pursuant to the Reorganization Plan ($77.3 million), to make up to the $5.7 million differential out of cash proceeds from the sales of assets or the settlement of litigation which were transferred to a trust established for the benefit of creditors pursuant to the Distribution Trust Agreement in order to provide for the payment of these claims in excess of $10.3 million. In the event that the Company's exposure to these claims significantly exceeds $16.0 million, this could have a material adverse effect on the viability of the Reorganization Plan and the Company's business and operations. The Company believes that reserves for the Excluded Cash claims will be adequate to satisfy these claims. Leases The Company has operating leases, some of which provide for initial free rent and all of which provide for subsequent rent increases. Rental expense is recognized on a straight-line basis with rental expense of $2.7 million, $2.8 million and $2.8 million reported for the years ended December 31, 1993, 1992 and 1991, respectively. Sublease rental revenue of $209,000, $198,000, $191,000 is reported for the years ended December 31, 1993, 1992 and 1991, respectively. Assets held under capital leases at December 31, 1993 and 1992 of $153,000 and $761,000, respectively, (net of $1.6 million and $1.1 million, respectively, of accumulated amortization) are comprised primarily of equipment leases. Amortization expense for capital leases is included in depreciation expense. Future minimum lease commitments for noncancelable leases at December 31, 1993 were as follows: Total future minimum rentals to be received under noncancelable operating subleases at December 31, 1993 were as follows: NOTE 6 - CAPITAL STOCK On March 9, 1992 the shareholders voted to amend MHP's current Restated Certificate of Incorporation to increase the authorized Capital Stock of the Company from 18 million shares to 45 million shares through: (i) an increase in the amount of authorized Common Stock of the Company, par value $.01, from 18 million shares to 40 million shares, and (ii) the authorization of 5 million shares of Preferred Stock of which 2.5 million shares will be designated Series A Cumulative Convertible Preferred Stock, par value $.01, ("Series A Stock"). Preferred Stock MHP entered into Stock Purchase Agreements dated December 17, 1991 and January 31, 1992 (the "Purchase Agreements"), pursuant to which, MHP issued an aggregate of 2,400,000 shares of Series A Stock to certain institutional investors in a private placement at a purchase price of $25.00 per share. Each share of Series A Stock accrues quarterly cash dividends at an annual rate of $2.25 per share and is currently convertible into approximately 2.7548 shares of Common Stock. The stock conversion ratio is subject to adjustment upon the occurrence of certain events. The transactions contemplated by the Purchase Agreements were consummated on March 11, 1992. Upon any liquidation, dissolution or winding up of the Company, holders of the Series A Stock are entitled to receive a preferential payment equal to $25.00 per share, plus all accrued and unpaid dividends. In the event of a sale of all or substantially all of the Company's stock or assets, or under certain circumstances, if the Company merges or combines with another entity, holders of the Series A Stock, at the election of holders of at least 75% of the Series A Stock then outstanding, may request to have their Series A Stock redeemed in which case they will receive a redemption price equal to the liquidation preference amount described above. In certain circumstances, the Company will have the right to redeem the Series A Stock at a redemption price of $25.00 per share, plus all accrued and unpaid dividends. Additionally, the Company may not create, issue, or increase the authorized number of shares of any class or series of stock which will rank senior to the Series A Stock as to liquidation rights without the affirmative vote or consent of holders of at least sixty-six and two-thirds percent (66 2/3%) of the outstanding shares of Series A Stock. Common Stock On the Effective Date, the Company issued 10.0 million shares of Common Stock to itself, as disbursing agent for the benefit of holders of allowed claims, interest and equity claims under the Reorganization Plan. The shares of Common Stock will be validly issued, fully paid and nonassessable upon issuance pursuant to the Reorganization Plan in accordance with the terms thereof. The Common Stock has been recorded at a value equal to the book value of the old common stock, less issuance costs. The Certificate of Incorporation of the Company prohibits the issuance of certain non- voting equity securities as required by the United States Bankruptcy Code. Stock Option Plans Pursuant to the Reorganization Plan, Messrs. Ratican and Froelich ("Senior Management") each received options to purchase up to 277,778 shares of Common Stock at a price of $6.54 per option share. At December 31, 1991, 100% of these options were fully vested. The difference of $905,000 between the option exercise price and market value at date of grant was charged to operations and accrued as a liability during 1991. As of January 1, 1992, the Company entered into employment agreements with Senior Management. Under the terms of these employment agreements, each member of Senior Management received on February 25, 1992 options to purchase up to 150,000 shares of Common Stock at a price of $8.00 per option share. One third of the options vested on the date of grant and one third of the options vest on both the first and second anniversaries of the date of grant. In December of 1990, the Company approved the 1990 Stock Option Plan (the "Stock Option Plan"). Under the terms of the Stock Option Plan, as amended, the Company may issue up to an aggregate of 1,000,000 stock options to directors, officers and other employees. Warrants In accordance with the Reorganization Plan, the Company issued warrants to itself, as disbursing agent for the allowed interests and equity holder claims. Upon issuance of the warrants (the "Warrants"), to these holders pursuant to the terms of the Reorganization Plan, the registered holders thereof will be entitled to purchase, in the aggregate, 555,555 shares of Common Stock. Such Warrants (i) are exercisable for the period commencing 180 days after the first distribution date and ending on December 5, 1995, (ii) bear an exercise price of $9.98 per Warrant, and (iii) have such other terms and conditions (including the right of the Company, at its option, to redeem the Warrants). As of December 31, 1993, 12 Warrants have been exercised for the purchase of Common Stock. NOTE 7 - INCOME TAXES The benefit for income taxes at December 31 consisted of the following: The federal and state deferred tax liabilities (assets) are comprised of the following at December 31: The differences between the benefit for income taxes at the federal statutory rate of 34% and that shown in the Consolidated Statements of Operations are summarized as follows for the years ended December 31: Upon the Effective Date of the Reorganization Plan, the Company experienced a "change of ownership" pursuant to applicable provisions of the Internal Revenue Code. As a result of the ownership change, the Company's utilization of pre-change NOLs is limited to $6.3 million per year. In the event the annual amount is not fully utilized, the Company is allowed to carryover such amount to subsequent years during the carryover period. Should the Company experience a second "change of ownership", the annual limitations on NOLs would be recalculated. FAS 109 requires that the tax benefit of such NOLs be recorded as an asset to the extent that management assesses the utilization of such NOLs to be more likely than not. Management has estimated, based on the Company's recent history of operating results and its expectations for the future, that future taxable income of the Company will more likely than not be sufficient to utilize a minimum of approximately $15 million of NOLs. Accordingly, the Company recorded an increase of $2.8 million in 1993 to its deferred tax asset, from $3.2 million recorded as of December 31, 1992, resulting in an aggregate deferred tax asset of $6.0 million recorded as of December 31, 1993 for the recognition of anticipated future utilization of NOLs. The maximum amount of remaining NOLs that may be utilized in future years before expiring in the years 2002 to 2006 is limited to approximately $87 million. The Company's income before taxes for financial statement purposes for the period of 1991 to 1993 was impacted by the incurrence of reorganization expenses and interest expense on the Senior Notes. The Company incurred reorganization expenses of $3.7 million and $895,000 in 1991 and 1992, respectively. The Company incurred interest expense related to the Senior Notes, which were issued in December of 1990 and redeemed in March of 1992, in the amounts of $9.5 million and $2.7 million in 1991 and 1992, respectively. Excluding reorganization expenses and interest expense on the Senior Notes, the Company's cumulative pre-tax income for the period of 1991 to 1993 would have been approximately $29.4 million on a pro forma basis after reflecting these adjustments. Quarterly Results of Operations (Unaudited) The following is a tabulation of the quarterly results of operations for the years ended December 31: (1) Includes a $2.8 million tax benefit from the recording of a deferred tax asset in the fourth quarter of 1993 (see "Item 8. Financial Statements and Supplementary Data - Note 7 to the Company's Consolidated Financial Statements"). (2) Earnings per share are computed on a primary basis for the three months ended March 31, June 30 and September 30, 1993 due to the anti-dilutive effect of the assumed conversion of the Company's Preferred Stock to Common Stock. Earnings per share assuming full dilution are reported for the three months ended December 31, 1993 due to the dilutive effect of assuming conversion of the Company's Preferred Stock to Common Stock for that period. (3) Includes a $3.2 million tax benefit from the recording of a deferred tax asset in the fourth quarter of 1992 (see "Item 8. Financial Statements and Supplementary Data - Note 7 to the Company's Consolidated Financial Statements"). (4) A $7.0 million extraordinary loss was recorded in the first quarter of 1992 for the write-off of unamortized original issue discount and unamortized issuance costs on the Senior Notes and an accrual for the Senior Notes redemption costs. Also, a $7.2 million extraordinary loss was reported in the first quarter of 1992 to accrue payments which may be made pursuant to the Reorganization Plan, based on the Company's consolidated net worth at December 31, 1992, to certain holders of allowed claims (see "Item 8. Financial Statements and Supplementary Data - Note 3 to the Company's Consolidated Financial Statements"). Item 9.

Item 9. Changes in and Disagreements with Accountants on ------------------------------------------------ Accounting and Financial Disclosures ------------------------------------ None PART III -------- Item 10.

Item 10. Directors, Executive Officers, Promoters and Control ---------------------------------------------------- Persons of the Registrant ------------------------- The information set forth in the table, the notes thereto and the paragraphs thereunder, in Part I, Item 1. of this Form 10-K under the caption "Directors and Executive Officers of the Registrant" is incorporated herein by reference. During 1993, a report required by Section 16(a) of the Securities Exchange Act of 1934 covering the initial statement of beneficial ownership of the Company's securities for Florence F. Courtright was not filed on a timely basis; however, such report was subsequently filed. In making this statement, the Company has relied on the written representations of its incumbent directors and officers and copies of the reports that they have filed with the Commission. Item 11.

Item 11. Executive Compensation ---------------------- Shown below is information concerning the annual and long-term compensation for services in all capacities to the Company for the years ended December 31, 1993, 1992 and 1991, of those persons who were, at December 31, 1992 (i) the chief executive officer and (ii) the other four most highly compensated executive officers of the Company (collectively the "Named Officers"): (1) Excludes distributions received during the year ended December 31, 1992 paid with respect to claims for pre-petition compensation paid pursuant to the Reorganization Plan. (2) These amounts are bonuses payable pursuant to the Reorganization Plan and were paid from funds held by the Disbursing Agent in a segregated account and were not paid out of the Company's available cash. (3) These amounts include contributions made by the Company on behalf of the Named Officer under the Company's 401(k) Savings Incentive Plan. (4) In accordance with the transitional provisions applicable to the revised rules on executive officer and director compensation disclosure adopted by the Securities and Exchange Commission, as informally interpreted by the Commission's Staff, amounts of Other Annual Compensation and All Other Compensation are excluded for the Company's 1991 fiscal year. (5) William B. Caswell's employment at the Company began in February 1992. Option Grants ------------- Shown below is further information on grants of stock options pursuant to the 1990 Incentive Stock Option Plan during the year ended December 31, 1993, to the Named Officers which are reflected in the Summary Compensation Table. (1) The options were granted as of December 20, 1993 and vest in one- third installments on the first, second and third anniversaries of the date of grant. If the grantee's employment is terminated under certain circumstances or there is a restructuring of the Company (as set forth in the option agreement) these options would become immediately exercisable. (2) The option exercise price is subject to adjustment in the event of a stock split or dividend, recapitalization or certain other events. (3) The actual value, if any, the Named Officer may realize will depend on the excess of the stock price over the exercise price on the date the option is exercised, so that there is no assurance the value realized by the Named Officer will be at or near the value estimated. This amount is net of the option exercise price. Option Exercises and Fiscal Year-End Values ------------------------------------------- Shown below is information with respect to the unexercised options to purchase the Company's Common Stock granted in fiscal 1993 and prior years under employment agreements and the 1990 Incentive Stock Option Plan to the Named Officers and held by them at December 31, 1993. None of the Named Officers exercised any stock options during fiscal 1993. (1) Based on the closing price on the NASDAQ-NMS on that date ($9.75), net of the option exercise price. Employment Agreements --------------------- As of January 1, 1992, the Company has entered into five-year employment agreements with Peter J. Ratican and Eugene L. Froelich ("Senior Management"). These employment agreements provide for annual base compensation of $425,000 for Mr. Ratican and $325,000 for Mr. Froelich, subject to increases and bonuses, as may be determined by the Board based on annual reviews. The employment agreements provide that upon the termination of either member of Senior Management by the Company without Cause or reasons other than death or incapacity or the voluntary termination by either member of Senior Management for certain reasons as set forth in their employment agreements, the terminated member will be entitled to receive (i) a payment equal to the balance of the terminated member's annual base salary which would have been paid over the remainder of the term of the employment agreement; (ii) an additional one year's annual base salary; (iii) payment of any performance bonus amounts which would have otherwise been payable over the remainder of the term of the agreement; (iv) immediate vesting of all stock options; (v) the continuation of the right to participate in any profit sharing, bonus, stock option, pension, life, health and accident insurance, or other employee benefits plans including a car allowance through December 31, 1996. Cause is defined as: (i) the willful or habitual failure to perform requested duties commensurate with his employment without good cause; (ii) the willful engaging in misconduct or inaction materially injurious to the Company; or (iii) the conviction for a felony or of a crime involving moral turpitude, dishonesty or theft. In the event of a Change in Control of the Company, either member may elect to terminate the employment contract in which case the electing member will be entitled to receive a payment equal to 2.99 times that member's average annualized compensation from the Company over a certain period. Change of Control is defined as: (i) any transaction or occurence which results in the Company ceasing to be publically owned with at least 300 stockholders; (ii) any person or group becoming beneficial owner of more than forty percent (40%) of the combined voting power of the Company's outstanding securities; (iii) a change in the composition of the Board, as set forth in the employment agreement; (iv) the merger or consolidation of the Company with or into any other non-affiliated entity whereby the Company's equity security holders, immediately prior to such transaction, own less than sixty percent (60%) of the equity; or (v) the sale or transfer of all or substantially all of its assets. In the event of death or incapacity, the member, or his estate, shall receive the equivalent of ninety (90) days base salary and in the case of incapacity, the continuation of health and disability benefits. The employment agreements also provide that in the event either member of Senior Management does not receive an offer for a new employment agreement containing terms at least as favorable as those contained in the existing employment agreements before the expiration of such employment agreements, such member will be entitled to receive a payment equal to one year's base salary under the terminating agreement. Under these agreements, each member of Senior Management will be entitled to receive an annual performance bonus calculated using a formula, as set forth in the employment agreements, which is based on the Company's annual pre-tax earnings, before extraordinary items, over $10 million. In addition, upon the sale of the Company, a sale of substantially all of its assets or a merger where the Company shareholders cease to own a majority of the outstanding voting capital stock, Senior Management will be entitled to a sale bonus calculated using a formula which is based on a percentage of the excess value of the Company over an initial value as set forth in the employment agreements. In addition, Senior Management remains entitled to receive certain additional compensation out of funds set aside for distribution under the Reorganization Plan on the Effective Date or from the proceeds of assets liquidated on behalf of pre-petition creditors under the Reorganization Plan. As of January 1, 1993 the Company entered into an employment agreement, effective through December 31, 1994, with Richard A. Link. As of January 1, 1994 the Company entered into an employment agreement, effective through December 31, 1994, with Alan D. Bloom and an employment agreement, effective through December 31, 1995, with William B. Caswell. The contracts provide a minimum base salary of $197,500, $203,000 and $195,000 for Messrs. Link, Bloom and Caswell, respectively, subject to increases and bonuses, as may be determined from time to time by the Chief Executive Officer of the Company. The contract with Mr. Caswell also provides that: (i) should he die, his estate shall receive the equivalent of thirty (30) days base salary; (ii) should the Company terminate his employment prior to the first anniversary of the contract for any reason other than death, incapacity, or Cause, he shall receive the equivalent of his annual base salary; (iii) should the Company terminate his employment on or after the first anniversary of the contract for any reason other than death, incapacity, or Cause, he shall receive the amount of the remainder of his annual base salary as would have been paid had the contract not been terminated which amount shall in no event be less than the equivalent of six (6) months base salary; and (iv) should his employment be terminated for any reason other than death, voluntary resignation, incapacity or Cause within six (6) months of a Change of Control, he shall receive the equivalent of his annual base salary. Cause is defined as (i) the willful and continued failure to perform duties pursuant to the employment agreement without good cause; (ii) the willful engaging in misconduct or inaction materially injurious to the Company; or (iii) the conviction of a felony or of a crime involving moral turpitude. Change of Control is defined as (i) the merger or consolidation of the Company with or into any other non- affiliated entity whereby the Company's equity security holders, immediately prior to such transaction, own less than fifty percent (50%) of the equity; or (ii) the sale or transfer of all or substantially all of its assets. The contracts with Messrs. Link and Bloom provide that should their employment be terminated under certain circumstances, they would receive up to the equivalent of four (4) months base salary. Compensation of Directors ------------------------- During 1993, certain members of the Board received compensation for their services as directors. These members included Claude Brinegar, Leon Clements, Florence Courtright, Thomas Field, Jr., Walter Filkowski and Charles Lewis and they received cash payments of $33,000, $29,250, $6,000, $31,500, $6,000 and $30,750, respectively. During 1994, current directors, excluding directors who are also officers of the Company, will receive compensation for their services in the amount of $24,000 per year, plus $750 per meeting. In addition, these directors are entitled to be reimbursed for all of their reasonable out-of-pocket expenses incurred in connection with their services as directors of the Company. Non-employee directors of the Company have received options to purchase shares of Common Stock which are immediately exercisable at an exercise price equal to the market price at the date of grant. Set forth below is a schedule of the outstanding options at December 31, 1993 held by each of the current and former directors, the date of grant and the exercise price of such options: Provided these directors continue to serve as directors of the Company, the exercise term of these options is five years. If the directorship is terminated, the options expire thirty (30) days from the date of such termination. Upon the expiration of his term as a director on February 10, 1993, the Board voted to extend the period in which Mr. Filkowski could exercise his options to one year from the termination date of his directorship. In February 1994, Mr. Filkowski exercised all options held. Compensation Committee Interlocks and Insider Participation ----------------------------------------------------------- Peter Ratican, the Company's President and Chief Executive Officer, served as an ex-officio member of the Compensation Committee of the Company for the year ended December 31, 1993. Although Mr. Ratican served as an ex-officio member of this Compensation Committee, he did not participate in any decisions regarding his own compensation as an executive officer. The Company's Board of Directors as a whole determines Mr. Ratican's total compensation package. Item 12.

Item 12. Security Ownership of Certain Beneficial Owners and --------------------------------------------------- Management ---------- The following table sets forth the number and percentage of the outstanding shares of Common Stock and Series A Stock owned beneficially as of December 31, 1993 by each director or nominee for director as of such date, by the Company's chief executive officer ("CEO"), by the four other most highly compensated executive officers other than the CEO, by all directors and executive officers as a group, and by each person who, to the knowledge of the Company, beneficially owned more than 5% of any class of the Company's voting stock on such date. ------------------------- * - Less than one percent ------------------------- * - less than one percent (1) Except as otherwise set forth herein, all information pertaining to the holdings of persons who beneficially own more than 5% of any class of the Company's voting stock (other than the Company or its executive officers and directors) is based on filings with the Securities and Exchange Commission and information provided by the record holders. (2) In setting forth "beneficial" ownership, the rules of the Securities and Exchange Commission require that shares underlying currently exercisable options or issuable upon conversion of the Series A Stock, including options which become exercisable within 60 days, held by a described person be treated as "beneficially" owned and further require that every person who has or shares the power to vote or to dispose of shares of stock be reported as a "beneficial" owner of all shares as to which any such sole or shared power exists. As a consequence, shares which are not yet outstanding are, if obtainable upon exercise of an option which is exercisable or will become exercisable within sixty (60) days or upon conversion of the Series A Stock, nevertheless treated as "beneficially" owned by the designated person, and several persons may be deemed to be the "beneficial" owners of the same securities if they share the power to vote or dispose of them. (3) In the event that a tender offer for the Company's shares of Common Stock is commenced prior to the final distribution of the Company's Common Stock pursuant to the Reorganization Plan, the committee elected to oversee the implementation of the Reorganization Plan after the Effective Date (the "New Committee") will have certain rights to direct the tender of the Unallocated Shares. The New Committee disclaims beneficial ownership over any such shares. (4) Assumes 10,033,345 shares of Common Stock outstanding, the conversion of all 2,400,000 shares of Series A Stock outstanding (or 6,611,520 shares) and, with respect to each listed beneficial owner, the exercise or conversion of any option, warrant or right held by each such owner exercisable or convertible within 60 days. (5) These shares are held by the Company, as disbursing agent for the benefit of holders of Reorganization Plan classes 5A through 5H, 7 and 8A through 8D allowed claims and Reorganization Plan class 12 allowed interests and equity holder claims. The Company disclaims beneficial ownership of these shares. For information concerning the voting of these shares, see "General Information - Outstanding Shares and Voting Rights". (6) Cede & Co. holds these shares as a nominee for the Depository Trust Company, which is the securities depository for various segments of the financial industry. None of these shares are owned beneficially by Cede & Co. Includes 1,228,725 shares beneficially owned by Chilmark Capital Corp. and Neil Jonathan Weisman; for further information with respect to these shares, see footnote (7), below. (7) Includes 40,000 shares of Common Stock held by the Chilmark Capital Corp. ("Chilmark") profit sharing plan, and 755,100 shares of Common Stock held in a partnership, of which, Chilmark is general partner and 433,625 shares of Common Stock held for two managed accounts for which Chilmark has investment discretion. Neil Jonathan Weisman is president and sole shareholder of Chilmark. (8) Includes 427,778 shares which are subject to options which are currently exercisable or will become exercisable within 60 days. (9) On December 5, 1990, the effective date of the Reorganization Plan, Messrs. Ratican, Lewis, Bloom and Clements held 350; 490; 150 and 2,000 shares, respectively, of common stock of Maxicare Health Plans, Inc., a California corporation ("MHP"), the Company's predecessor in interest; Mr. Ratican's shares were held in his individual retirement account. These shares were cancelled as of that date in accordance with the terms of the Reorganization Plan. As a result, Messrs. Ratican, Lewis, Bloom and Clements each holds a class 12 claim under the Reorganization Plan which will entitle Mr. Ratican to receive 2 shares of Common Stock and 5 warrants, Dr. Lewis to receive 2 shares of Common Stock and 8 warrants, Mr. Bloom to receive 2 warrants and Mr. Clements to receive 11 shares of Common Stock and 32 warrants. The total number of shares of Common Stock and warrants which these individuals will receive are excluded from the shares disclosed as beneficially owned. (10) All shares (and the calculation of the percentage owned assumes such shares are outstanding) are subject to options which are currently exercisable. (11) Includes 6,666 shares which are subject to options which are currently exercisable or will become exercisable within 60 days. (12) Includes 46,664 shares which are subject to options which are currently exercisable or will become exercisable within 60 days. (13) Includes 16,667 shares which are subject to options which are currently exercisable or will become exercisable within 60 days. (14) Includes 20,000 shares which are subject to options which are currently exercisable or will become exercisable within 60 days. (15) Does not include the Unallocated Shares, held of record by the Company. Under certain circumstances, the Independent Directors, currently Messrs. Brinegar and Lewis and Ms. Courtright, have rights to vote the Unallocated Shares. The Independent Directors disclaim beneficial ownership of these shares. For further information on the voting of these shares, see "General Information - Outstanding Shares and Voting Rights", above. (16) Dr. Lewis, a director of the Company, is employed by a creditor and/or affiliate of a creditor which have filed claims under the Reorganization Plan which may entitle such creditor, or affiliate thereof, to receive distributions of Common Stock. The total number of shares of Common Stock which these creditors will receive has not yet been determined. Dr. Lewis disclaims beneficial ownership of these shares. (17) The shares of Common Stock and Series A Stock are held by Mellon Bank, N.A., acting as trustee (the "Trustee") under two separate trust agreements for the General Motors employee pension trusts (the "Trusts"). The Trustee may act for the Trusts with respect to such shares only pursuant to direction of one of the Trusts' applicable investment managers. General Motors Investment Management Corporation ("GMIMCo") is the investment manager with respect to 200,000 shares (in the aggregate) of Series A Stock. The shares of Series A Stock are convertible into an aggregate of 819,002 shares of Common Stock; the shares of Common Stock issuable upon conversion of the Series A Stock are included in the number of shares of Common Stock attributable to these holders. Investment and disposition decisions regarding the shares of Series A Stock and Common Stock managed by the Trusts' other investment managers are made by the personnel of such managers, who act independently of GMIMCo, although the continued engagement of such managers as investment managers for the Trusts is subject to the authorization of GMIMCo. Because of the Trustee's limited role, beneficial ownership of the shares of Series A Stock and Common Stock by the Trustee is disclaimed. (18) Includes 12,200 shares of Common Stock and 190,000 shares of Series A Stock held in a fiduciary capacity by J.P. Morgan and Co. Incorporated through its subsidiaries J.P. Morgan Investment Management, Inc. and Morgan Guaranty Trust Company of New York. All shares of Common Stock and Series A Stock are subject to the sole dispositive authority of these subsidiaries of J.P. Morgan and Co. Incorporated and the shares of Series A Stock are subject to the sole voting authority of these entities. The shares of Series A Stock are convertible into an aggregate of 523,412 shares of Common Stock; the shares of Common Stock issuable upon conversion of the Series A Stock are included in the number of shares of Common Stock attributable to these holders. (19) The shares of Common Stock issuable upon conversion of the Series A Stock are included in the number of shares of Common Stock attributable to these holders. None of the holders currently hold shares of Common Stock. (20) All shares are held on behalf of institutional investors and are subject to the sole voting and dispositive authority of Froley, Revy Investment Co., Inc. (21) Mutual Series Fund Inc. (the "Fund") is an investment company consisting of four separate series of stock. Two of the series, namely, Mutual Beacon Fund and Mutual Qualified Fund, are the beneficial owners of 58,000 shares and 130,100 shares, respectively, of Series A Stock. The shares owned by these funds are registered in nominee name. Pursuant to investment advisory contracts with each of the series, Heine Securities Corporation ("Heine"), an investment advisor, and Michael F. Price, president of Heine, have sole investment and voting power over the securities beneficially owned by the series. However, Heine and Mr. Price disclaim any beneficial ownership in such shares owned by the Fund. (22) Linder Fund, Inc. ("Linder") is an investment company which beneficially owns 507,500 shares of Common Stock and 193,500 shares of Series A Stock. The shares owned by Linder are registered in nominee name. Pursuant to an investment advisory contract with Linder, Ryback Management Corporation, an investment advisor, shares investment and voting power over the securities beneficially owned by Linder. The shares of Series A Stock are convertible into an aggregate of 533,054 shares of Common Stock; the shares of Common Stock issuable upon conversion of the Series A Stock are included in the number of shares of Common Stock attributable to these holders. (23) Includes 568,000 shares of Common Stock and 100,000 shares of Series A Stock held in a fiduciary capacity by Snyder Capital Management, Inc. ("Snyder"), an investment advisor for a number of investors. No individual investor beneficially owns more than 5% of any class of the Company's voting stock. Snyder has sole voting power over 47,000 shares of Common Stock and 63,600 shares of Series A Stock. Voting power is shared by Snyder on 442,000 shares of Common Stock and 31,500 shares of Series A Stock. The shares of Series A Stock are convertible into an aggregate of 275,480 shares of Common Stock; the shares of Common Stock issuable upon conversion of the Series A Stock are included in the number of shares of Common Stock attributable to this holder. (24) Includes 92,199 shares of Common Stock and 328,500 shares of Series A Stock held in a fiduciary capacity by Smith Barney Shearson Inc. ("SBS"), a registered broker/dealer. Smith Barney Shearson Holdings Inc. ("SBH") is the sole common shareholder of SBS and The Travelers Inc. ("TRV") is the sole shareholder of SBH. However, SBH and TRV disclaim any beneficial ownership in such shares. The shares of Series A Stock are convertible into an aggregate of 904,952 shares of Common Stock; the shares of Common Stock issuable upon conversion of the Series A Stock are included in the number of shares of Common Stock attributable to this holder. SBS has sole voting power over approximately 915,315 shares, including those shares issuable upon conversion of Series A Stock. (25) Bear Stearns Securities Corp. is the record holder of these shares; however, all shares are held on behalf of investors. Bear Stearns Securities Corp. disclaims beneficial ownership of all shares. (26) Includes 1,093,880 shares which are subject to options which are currently exercisable or will become exercisable within 60 days. Also, on December 5, 1990, the Effective Date of the Reorganization Plan, certain officers and directors of the Company held an aggregate of 3,790 shares of common stock of MHP, the Company's predecessor in interest. These shares were cancelled as of that date in accordance with the terms of the Reorganization Plan. As a result, these executive officers and directors each holds a class 12 claim under the Reorganization Plan which entitle them to receive an aggregate of 19 shares of Common Stock and 60 warrants to purchase Common Stock. The total number of shares of Common Stock and warrants which these individuals will receive are excluded from the shares disclosed as beneficially owned. Item 13.

Item 13. Certain Relationships and Related Transactions ---------------------------------------------- None. PART IV ------- Item 14.

Item 14. Exhibits, Financial Statement Schedules, and Reports on ------------------------------------------------------- Form 8-K -------- (a) 1. Financial Statements The following consolidated financial statements of Maxicare Health Plans, Inc. and subsidiaries are included in this report in response to Item 8. Report of Independent Accountants Consolidated Balance Sheets - At December 31, 1993 and 1992 Consolidated Statements of Operations - Years ended December 31, 1993, 1992 and 1991 Consolidated Statements of Cash Flows - Years ended December 31, 1993, 1992 and 1991 Consolidated Statements of Changes in Shareholders' Equity - Years ended December 31, 1993, 1992 and 1991 Notes to Consolidated Financial Statements (a) 2. Financial Statement Schedules Schedule I - Marketable Securities and Other Investments at December 31, 1993 Schedule III - Condensed Financial Information of Registrant - Condensed Balance Sheets at December 31, 1993 and 1992, Condensed Statements of Operations and Condensed Statements of Cash Flows for the years ended December 31, 1993, 1992 and 1991, Notes to Condensed Financial Information of Registrant Schedule V - Property, Plant and Equipment for the years ended December 31, 1993, 1992 and 1991 Schedule VI - Accumulated Depreciation, Depletion and Amortization of Property, Plant and Equipment for the years ended December 31, 1993, 1992 and 1991 Schedule VIII - Valuation and Qualifying Accounts for the years ended December 31, 1993, 1992 and 1991 (a) 3. Exhibits 2.1 Joint Plan of Reorganization dated May 14, 1990, as modified on May 24 and July 12, 1990 (without schedules)* 2.2 Order Confirming Joint Plan of Reorganization dated May 14, 1990, as Modified, entered on August 31, 1990 (without exhibits or schedules)* 2.3 Amendment to Order Confirming Joint Plan of Reorganization dated May 14, 1990, as Modified, entered on August 31, 1990* 2.4 Stipulation and Order Re Conditions to Effectiveness of the Plan, entered on December 3, 1990* 2.5 Notice That The Conditions to Effectiveness of the Plan Have Been Met or Waived, filed on December 4, 1990* 2.6 Agreement and Plan of Merger of Maxicare Health Plans, Inc. and HealthCare USA Inc., dated as of December 5, 1990 (without exhibits or schedules)* 3.1 Charter of Maxicare Health Plans, Inc., a Delaware corporation* 3.3 Amendment to Charter of Maxicare Health Plans, Inc., a Delaware corporation@ 3.4 Amended Bylaws of Maxicare Health Plans, Inc., a Delaware corporation 4.1 Form of Certificate of New Common Stock of Maxicare Health Plans, Inc.* 4.2 Form of Certificate of Warrant of Maxicare Health Plans, Inc.* 4.4 Warrant Agreement by and between Maxicare Health Plans, Inc. and American Stock Transfer & Trust Company, dated as of December 5, 1990* 4.5 Stock Transfer Agent Agreement by and between Maxicare Health Plans, Inc., and American Stock Transfer & Trust Company, dated as of December 5, 1990* 4.6 Registration Undertaking by Maxicare Health Plans, Inc., dated as of December 5, 1990* 4.8 Portions of Charter of Maxicare Health Plans, Inc., relating to the rights of holders of the New Common Stock, the Warrants, or the New Senior Notes* 4.9 Portions of Bylaws of Maxicare Health Plans, Inc., relating to the rights of holders of the New Common Stock, the Warrants, or the New Senior Notes* 4.10 Series A Cumulative Convertible Preferred Stock Purchase Agreement dated as of December 17, 1991** 4.11 Series A Cumulative Convertible Preferred Stock Purchase Agreement dated as of January 31, 1992** 4.12 Form of Certificate of Preferred Stock of Maxicare Health Plans, Inc.@ 10.1 Management Incentive Program* 10.2 Incentive Compensation Agreement* 10.3b Employment and Indemnification Agreement by and between Maxicare Health Plans, Inc. and Peter J. Ratican, dated as of January 1, 1992@ 10.4b Employment and Indemnification Agreement by and between Maxicare Health Plans, Inc. and Eugene L. Froelich dated January 1, 1992@ 10.5b Employment Agreement by and between Maxicare Health Plans, Inc. and Samuel W. Warburton, dated as of January 1, 1993@@ 10.7c Employment and Indemnification Agreement by and between Maxicare Health Plans, Inc. and Vicki F. Perry, dated as of January 1, 1993@@ 10.7d Employment and Indemnification Agreement by and between Maxicare Health Plans, Inc. and Vicki F. Perry, dated as of January 1, 1994 10.8b Employment and Indemnification Agreement by and between Maxicare Health Plans, Inc. and Alan D. Bloom, dated as of January 1, 1993@@ 10.8c Employment and Indemnification Agreement by and between Maxicare Health Plans, Inc. and Alan D. Bloom, dated as of January 1, 1994 10.9c Form of Employment and Indemnification Agreement by and between Maxicare Health Plans, Inc. and Richard A. Link, dated as of January 1, 1993@@ 10.12c Employment and Indemnification Agreement by and between Maxicare Health Plans, Inc. and Aivars Jerumanis, dated as of January 1, 1993@@ 10.12d Employment and Indemnification Agreement by and between Maxicare Health Plans, Inc. and Aivars Jerumanis, dated as of January 1, 1994 10.14 Stock Option Agreement by and between Maxicare Health Plans, Inc. and Peter J. Ratican, dated as of December 5, 1990* 10.15 Stock Option Agreement by and between Maxicare Health Plans, Inc. and Eugene L. Froelich, dated as of December 5, 1990* 10.16 Form of Stock Option Agreement by and between Maxicare Health Plans, Inc. and Samuel Warburton, dated as of December 5, 1990* 10.18 Form of Stock Option Agreement by and between Maxicare Health Plans, Inc. and Vicki F. Perry, dated as of December 5, 1990* 10.19 Stock Option Agreement by and between Maxicare Health Plans, Inc. and Alan D. Bloom, dated as of December 5, 1990* 10.20 Stock Option Agreement by and between Maxicare Health Plans, Inc. and Richard A. Link, dated as of December 5, 1990* 10.23 Stock Option Agreement by and between Maxicare Health Plans, Inc. and Aivars Jerumanis, dated as of December 5, 1990* 10.28 Form of Distribution Trust Agreement* 10.29 Lease by and between Maxicare Health Plans, Inc. and Transamerica Occidental Life Insurance Company, dated as of June 1, 1990* 10.30 Maxicare Health Plans, Inc. 401(k) Plan* 10.32 Stock Option Agreement by and between Maxicare Health Plans, Inc. and Leon M. Clements, dated as of May 20, 1991@ 10.33 Stock Option Agreement by and between Maxicare Health Plans, Inc. and Walter J. Filkowski, dated as of May 20, 1991@ 10.35 Stock Option Agreement by and between Maxicare Health Plans, Inc. and Charles E. Lewis, dated as of May 20, 1991@ 10.36 Stock Option Agreement by and between Maxicare Health Plans, Inc. and Claude S. Brinegar, dated as of July 18, 1991@ 10.38 Stock Option Agreement by and between Maxicare Health Plans, Inc. and Richard A. Link, dated as of December 20, 1991@ 10.40 Stock Option Agreement by and between Maxicare Health Plans, Inc. and Aivars Jerumanis, dated as of December 20, 1991@ 10.41 Stock Option Agreement by and between Maxicare Health Plans, Inc. and Samuel W. Warburton, dated as of December 20, 1991@ 10.42 Stock Option Agreement by and between Maxicare Health Plans, Inc. and Peter J. Ratican, dated as of February 25, 1992@ 10.43 Stock Option Agreement by and between Maxicare Health Plans, Inc. and Eugene L. Froelich, dated as of February 25, 1992@ 10.44 Amended Maxicare Health Plans, Inc. 1990 Stock Option Plan@ 10.48 Employment and Indemnification Agreement by and between Maxicare Health Plans, Inc. and William B. Caswell, dated as of January 8, 1992@@ 10.48a Employment and Indemnification Agreement by and between Maxicare Health Plans, Inc. and William B. Caswell, dated as of January 1, 1994 10.49 Stock Option Agreement by and between Maxicare Health Plans, Inc. and William B. Caswell, dated as of February 3, 1992@@ 10.50 Stock Option Agreement by and between Maxicare Health Plans, Inc. and Thomas W. Field, Jr., dated as of April 1, 1992@@ 10.51b Employment and Indemnification Agreement by and between Maxicare Health Plans, Inc. and Robert Landis, dated as of January 1, 1993@@ 10.51c Employment and Indemnification Agreement by and between Maxicare Health Plans, Inc. and Robert Landis, dated as of January 1, 1994 10.52 Stock Option Agreement by and between Maxicare Health Plans, Inc. and Robert Landis, dated as of December 5, 1990@@ 10.53 Stock Option Agreement by and between Maxicare Health Plans, Inc. and Robert Landis, dated as of December 20, 1991@@ 10.54 Stock Option Agreement by and between Maxicare Health Plans, Inc. and Florence Courtright, dated as of November 5, 1993 10.55 Stock Option Agreement by and between Maxicare Health Plans, Inc. and Vicki F. Perry, dated as of December 20, 10.56 Stock Option Agreement by and between Maxicare Health Plans, Inc. and Alan D. Bloom, dated as of December 20, 10.57 Stock Option Agreement by and between Maxicare Health Plans, Inc. and Richard Link, dated as of December 20, 10.58 Stock Option Agreement by and between Maxicare Health Plans, Inc. and Aivars Jerumanis, dated as of December 20, 1993 10.59 Stock Option Agreement by and between Maxicare Health Plans, Inc. and Robert Landis, dated as of December 20, 10.60 Stock Option Agreement by and between Maxicare Health Plans, Inc. and William Caswell, dated as of December 20, 10.61 Stock Option Agreement by and between Maxicare Health Plans, Inc. and Thomas W. Field, Jr., dated as of December 20, 1993 10.62 Stock Option Agreement by and between Maxicare Health Plans, Inc. and Dr. Charles E. Lewis, dated as of December 20, 1993 10.63 Stock Option Agreement by and between Maxicare Health Plans, Inc. and Claude S. Brinegar, dated as of December 20, 1993 10.64 Employment and Indemnification Agreement by and between Maxicare Health Plans, Inc. and David Hammons, dated as of January 1, 1994 10.65 Stock Option Agreement by and between Maxicare Health Plans, Inc. and David J. Hammons, dated as of May 20, 10.66 Stock Option Agreement by and between Maxicare Health Plans, Inc. and David J. Hammons, dated as of December 20, 1991 10.67 Stock Option Agreement by and between Maxicare Health Plans, Inc. and David Hammons, dated as of December 20, 21 List of Subsidiaries 23.1 Consent of Independent Accountants 28.1 Notice That The Conditions to Effectiveness of the Plan Have Been Met or Waived*** 28.2 Stipulation and Order Regarding Conditions to Effectiveness of Joint Plan of Reorganization*** ------------------- * Incorporated by reference from the Company's Registration Statement on Form 10, declared effective March 18, 1991, in which these exhibits bore the same exhibit numbers. ** Incorporated by reference from the Company's Reports on Form 8-K dated December 17, 1991 and January 31, 1992, in which these exhibits bore the same exhibit numbers. *** Incorporated by reference from the Company's Report on Form 8-K dated December 5, 1990, in which these exhibits bore the same exhibit numbers. @ Incorporated by reference from the Company's Annual Report on Form 10-K for the year ended December 31, 1991, in which these exhibits bore the same exhibit numbers. @@ Incorporated by reference from the Company's Annual Report on Form 10-K for the year ended December 31, 1992, in which these exhibits bore the same exhibit numbers. (b) Reports on Form 8-K None. SIGNATURES Pursuant to the requirements of Section 13 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. March 25, 1994 /s/ PETER J. RATICAN -------------- ------------------------ Date Peter J. Ratican Chief Executive Officer March 25, 1994 /s/ EUGENE L. FROELICH -------------- ------------------------ Date Eugene L. Froelich Chief Financial Officer March 25, 1994 /s/ RICHARD A. LINK -------------- ------------------------ Date Richard A. Link Principal Accounting Officer Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated. Signatures Title Date ---------- ----- ---- /s/ PETER J. RATICAN Chairman and Director March 25, 1994 -------------------- Peter J. Ratican /s/ EUGENE L. FROELICH Director March 25, 1994 ---------------------- Eugene L. Froelich Director March __, 1994 ---------------------- Claude S. Brinegar /s/ FLORENCE F. COURTRIGHT Director March 25, 1994 -------------------------- Florence F. Courtright /s/ THOMAS W. FIELD, JR. Director March 25, 1994 ------------------------ Thomas W. Field, Jr. /s/ CHARLES E. LEWIS Director March 25, 1994 -------------------- Charles E. Lewis /s/ ALAN S. MANNE Director March 25, 1994 ----------------- Alan S. Manne MAXICARE HEALTH PLANS, INC. AND SUBSIDIARIES SCHEDULE I - MARKETABLE SECURITIES AND OTHER INVESTMENTS (Amounts in thousands) At December 31, 1993 MAXICARE HEALTH PLANS, INC. SCHEDULE III - CONDENSED FINANCIAL INFORMATION OF REGISTRANT CONDENSED BALANCE SHEETS (Amounts in thousands) See notes to condensed financial information of registrant. MAXICARE HEALTH PLANS, INC. SCHEDULE III - CONDENSED FINANCIAL INFORMATION OF REGISTRANT CONDENSED STATEMENTS OF OPERATIONS (Amounts in thousands) See notes to condensed financial information of registrant. MAXICARE HEALTH PLANS, INC. SCHEDULE III - CONDENSED FINANCIAL INFORMATION OF REGISTRANT CONDENSED STATEMENTS OF CASH FLOWS (Amounts in thousands) See notes to condensed financial information of registrant. MAXICARE HEALTH PLANS, INC. SCHEDULE III - CONDENSED FINANCIAL INFORMATION OF REGISTRANT NOTES TO CONDENSED FINANCIAL INFORMATION OF REGISTRANT Note 1 - General ---------------- The condensed financial information of the registrant ("MHP") should be read in conjunction with the consolidated financial statements and the notes to consolidated financial statements which are included elsewhere herein. Note 2 - Transactions with Affiliates ------------------------------------- The Company is operating on a post-Effective Date basis under a decentralized and segregated cash management system. The operating subsidiaries currently pay monthly fees to MHP pursuant to administrative services agreements. Effective January 1, 1991 MHP acquired the stock of Maxicare Southeast Health Plans, Inc. from Maxicare (a California corporation and wholly-owned subsidiary of MHP) for $2.8 million through the issuance of a two year, 9% promissory note with principal and interest payable semi-annually. Effective July 1, 1991 MHP acquired the stock of Maxicare Health Plans of the Midwest, Inc. from Maxicare for $4.2 million through the issuance of a two year, 9% promissory note with principal and interest payable semi-annually. On October 1, 1992 MHP and HCS Computer, Inc. (a wholly-owned subsidiary of MHP that provides computer and telecommunications services to the Company) merged their operations. Accordingly, MHP's Condensed Statement of Operations for the year ended December 31, 1992 includes the results of operations of the computer and telecommunications operations for the three months ended December 31, 1992. Note 3 - Commitments and Other Contingencies -------------------------------------------- MHP's assets held under capital leases at December 31, 1993 and 1992 of $145,000 and $745,000, respectively, (net of $1.6 million and $1.1 million, respectively, of accumulated amortization) are comprised primarily of equipment leases. Future minimum lease commitments of $97,000 for noncancelable leases at December 31, 1993 are all payable in 1994; therefore, there are no long-term lease obligations. MAXICARE HEALTH PLANS, INC. AND SUBSIDIARIES SCHEDULE V - PROPERTY, PLANT AND EQUIPMENT (Amounts in thousands) For the Year Ended December 31, 1993 For the Year Ended December 31, 1992 (1) Adjustments as a result of physical inventory. MAXICARE HEALTH PLANS, INC. AND SUBSIDIARIES SCHEDULE V - PROPERTY, PLANT AND EQUIPMENT (Amounts in thousands) For the Year Ended December 31, 1991 (1) Adjustments as a result of physical inventory. MAXICARE HEALTH PLANS, INC. AND SUBSIDIARIES SCHEDULE VI - ACCUMULATED DEPRECIATION, DEPLETION AND AMORTIZATION OF PROPERTY, PLANT AND EQUIPMENT (Amounts in thousands) For the Year Ended December 31, 1993 For the Year Ended December 31, 1992 (1) Adjustments as a result of physical inventory. MAXICARE HEALTH PLANS, INC. AND SUBSIDIARIES SCHEDULE VI - ACCUMULATED DEPRECIATION, DEPLETION AND AMORTIZATION OF PROPERTY, PLANT AND EQUIPMENT (Amounts in thousands) For the Year Ended December 31, 1991 (1) Reclassifications as a result of physical inventory. MAXICARE HEALTH PLANS, INC. AND SUBSIDIARIES SCHEDULE VIII - VALUATION AND QUALIFYING ACCOUNTS (Amounts in thousands) For the Year Ended December 31, 1993 For the Year Ended December 31, 1992 (1) Reduction in premium revenue. (2) Write-off of aged retroactive billing adjustments. (3) Write-off of notes receivable reserve. MAXICARE HEALTH PLANS, INC. AND SUBSIDIARIES SCHEDULE VIII - VALUATION AND QUALIFYING ACCOUNTS (Amounts in thousands) For the Year Ended December 31, 1991 (1) Write-off of aged retroactive billing adjustments. (2) Write-off of fully reserved notes receivable. INDEX TO EXHIBITS Exhibit Sequential Number Description Page Number ------ ---------------------------------------- ----------- 2.1 Joint Plan of Reorganization dated May 14, 1990, as modified on May 24 and July 12, 1990 (without schedules)* 2.2 Order Confirming Joint Plan of Reorganization dated May 14, 1990, as Modified, entered on August 31, 1990 (without exhibits or schedules)* 2.3 Amendment to Order Confirming Joint Plan of Reorganization dated May 14, 1990, as Modified, entered on August 31, 1990* 2.4 Stipulation and Order Re Conditions to Effectiveness of the Plan, entered on December 3, 1990* 2.5 Notice That The Conditions to Effectiveness of the Plan Have Been Met or Waived, filed on December 4, 1990* 2.6 Agreement and Plan of Merger of Maxicare Health Plans, Inc. and HealthCare USA Inc., dated as of December 5, 1990 (without exhibits or schedules)* 3.1 Charter of Maxicare Health Plans, Inc., a Delaware corporation* 3.3 Amendment to Charter of Maxicare Health Plans, Inc., a Delaware corporation@ 3.4 Amended Bylaws of Maxicare Health 95 of 319 Plans, Inc., a Delaware corporation 4.1 Form of Certificate of New Common Stock of Maxicare Health Plans, Inc.* 4.2 Form of Certificate of Warrant of Maxicare Health Plans, Inc.* ------------------------- * Incorporated by reference from the Company's Registration Statement on Form 10, declared effective March 18, 1991, in which these exhibits bore the same exhibit numbers. @ Incorporated by reference from the Company's Annual Report on Form 10-K for the year ended December 31, 1991, in which these exhibits bore the same exhibit numbers. Exhibit Sequential Number Description Page Number ------ ---------------------------------------- ----------- 4.4 Warrant Agreement by and between Maxicare Health Plans, Inc. and American Stock Transfer & Trust Company, dated as of December 5, 1990* 4.5 Stock Transfer Agent Agreement by and between Maxicare Health Plans, Inc., and American Stock Transfer & Trust Company, dated as of December 5, 1990* 4.6 Registration Undertaking by Maxicare Health Plans, Inc., dated as of December 5, 1990* 4.8 Portions of Charter of Maxicare Health Plans, Inc., relating to the rights of holders of the New Common Stock, the Warrants, or the New Senior Notes* 4.9 Portions of Bylaws of Maxicare Health Plans, Inc., relating to the rights of holders of the New Common Stock, the Warrants, or the New Senior Notes* 4.10 Series A Cumulative Convertible Preferred Stock Purchase Agreement dated as of December 17, 1991** 4.11 Series A Cumulative Convertible Preferred Stock Purchase Agreement dated as of January 31, 1992** 4.12 Form of Certificate of Preferred Stock of Maxicare Health Plans, Inc.@ 10.1 Management Incentive Program* 10.2 Incentive Compensation Agreement* 10.3b Employment and Indemnification Agreement by and between Maxicare Health Plans, Inc. and Peter J. Ratican, dated as of January 1, 1992@ ------------------------- * Incorporated by reference from the Company's Registration Statement on Form 10, declared effective March 18, 1991, in which these exhibits bore the same exhibit numbers. ** Incorporated by reference from the Company's Reports on Form 8-K dated December 17, 1991 and January 31, 1992, in which these exhibits bore the same exhibit numbers. @ Incorporated by reference from the Company's Annual Report on Form 10-K for the year ended December 31, 1991, in which these exhibits bore the same exhibit numbers. Exhibit Sequential Number Description Page Number ------ ---------------------------------------- ----------- 10.4b Employment and Indemnification Agreement by and between Maxicare Health Plans, Inc. and Eugene L. Froelich dated January 1, 1992@ 10.5b Employment Agreement by and between Maxicare Health Plans, Inc. and Samuel W. Warburton, dated as of January 1, 1993@@ 10.7c Employment and Indemnification Agreement by and between Maxicare Health Plans, Inc. and Vicki F. Perry, dated as of January 1, 1993@@ 10.7d Employment and Indemnification Agreement by 115 of 319 and between Maxicare Health Plans, Inc. and Vicki F. Perry, dated as of January 1, 1994 10.8b Employment and Indemnification Agreement by and between Maxicare Health Plans, Inc. and Alan D. Bloom, dated as of January 1, 1993@@ 10.8c Employment and Indemnification Agreement 125 of 319 by and between Maxicare Health Plans, Inc. and Alan D. Bloom, dated as of January 1, 10.9c Form of Employment and Indemnification Agreement by and between Maxicare Health Plans, Inc. and Richard A. Link, dated as of January 1, 1993@@ 10.12c Employment and Indemnification Agreement by and between Maxicare Health Plans, Inc. and Aivars Jerumanis, dated as of January 1, 1993@@ 10.12d Employment and Indemnification Agreement by 135 of 319 and between Maxicare Health Plans, Inc. and Aivars Jerumanis, dated as of January 1, ------------------------- @ Incorporated by reference from the Company's Annual Report on Form 10-K for the year ended December 31, 1991, in which these exhibits bore the same exhibit numbers. @@ Incorporated by reference from the Company's Annual Report on Form 10-K for the year ended December 31, 1992, in which these exhibits bore the same exhibit numbers. Exhibit Sequential Number Description Page Number ------ ---------------------------------------- ----------- 10.14 Stock Option Agreement by and between Maxicare Health Plans, Inc. and Peter J. Ratican, dated as of December 5, 1990* 10.15 Stock Option Agreement by and between Maxicare Health Plans, Inc. and Eugene L. Froelich, dated as of December 5, 1990* 10.16 Form of Stock Option Agreement by and between Maxicare Health Plans, Inc. and Samuel Warburton, dated as of December 5, 1990* 10.18 Form of Stock Option Agreement by and between Maxicare Health Plans, Inc. and Vicki F. Perry, dated as of December 5, 1990* 10.19 Stock Option Agreement by and between Maxicare Health Plans, Inc. and Alan D. Bloom, dated as of December 5, 1990* 10.20 Stock Option Agreement by and between Maxicare Health Plans, Inc. and Richard A. Link, dated as of December 5, 1990* 10.23 Stock Option Agreement by and between Maxicare Health Plans, Inc. and Aivars Jerumanis, dated as of December 5, 1990* 10.28 Form of Distribution Trust Agreement* 10.29 Lease by and between Maxicare Health Plans, Inc. and Transamerica Occidental Life Insurance Company, dated as of June 1, 1990* 10.30 Maxicare Health Plans, Inc. 401(k) Plan* 10.32 Stock Option Agreement by and between Maxicare Health Plans, Inc. and Leon M. Clements, dated as of May 20, 1991@ 10.33 Stock Option Agreement by and between Maxicare Health Plans, Inc. and Walter J. Filkowski, dated as of May 20, 1991@ ------------------------- * Incorporated by reference from the Company's Registration Statement on Form 10, declared effective March 18, 1991, in which these exhibits bore the same exhibit numbers. @ Incorporated by reference from the Company's Annual Report on Form 10-K for the year ended December 31, 1991, in which these exhibits bore the same exhibit numbers. Exhibit Sequential Number Description Page Number ------ ---------------------------------------- ----------- 10.35 Stock Option Agreement by and between Maxicare Health Plans, Inc. and Charles E. Lewis, dated as of May 20, 1991@ 10.36 Stock Option Agreement by and between Maxicare Health Plans, Inc. and Claude S. Brinegar, dated as of July 18, 1991@ 10.38 Stock Option Agreement by and between Maxicare Health Plans, Inc. and Richard A. Link, dated as of December 20, 1991@ 10.40 Stock Option Agreement by and between Maxicare Health Plans, Inc. and Aivars Jerumanis, dated as of December 20, 1991@ 10.41 Stock Option Agreement by and between Maxicare Health Plans, Inc. and Samuel W. Warburton, dated as of December 20, 1991@ 10.42 Stock Option Agreement by and between Maxicare Health Plans, Inc. and Peter J. Ratican, dated as of February 25, 1992@ 10.43 Stock Option Agreement by and between Maxicare Health Plans, Inc. and Eugene L. Froelich, dated as of February 25, 1992@ 10.44 Amended Maxicare Health Plans, Inc. 1990 Stock Option Plan@ 10.48 Employment and Indemnification Agreement by and between Maxicare Health Plans, Inc. and William B. Caswell, dated as of January 8, 1992@@ 10.48a Employment and Indemnification Agreement 145 of 319 by and between Maxicare Health Plans, Inc. and William B. Caswell, dated as of January 1, 1994 10.49 Stock Option Agreement by and between Maxicare Health Plans, Inc. and William B. Caswell, dated as of February 3, 1992@@ ------------------------- @ Incorporated by reference from the Company's Annual Report on Form 10-K for the year ended December 31, 1991, in which these exhibits bore the same exhibit numbers. @@ Incorporated by reference from the Company's Annual Report on Form 10-K for the year ended December 31, 1992, in which these exhibits bore the same exhibit numbers. Exhibit Sequential Number Description Page Number ------ ---------------------------------------- ----------- 10.50 Stock Option Agreement by and between Maxicare Health Plans, Inc. and Thomas W. Field, Jr., dated as of April 1, 1992@@ 10.51b Employment and Indemnification Agreement by and between Maxicare Health Plans, Inc. and Robert Landis, dated as of January 1, 1993@@ 10.51c Employment and Indemnification Agreement 155 of 319 by and between Maxicare Health Plans, Inc. and Robert Landis, dated as of January 1, 10.52 Stock Option Agreement by and between Maxicare Health Plans, Inc. and Robert Landis, dated as of December 5, 1990@@ 10.53 Stock Option Agreement by and between Maxicare Health Plans, Inc. and Robert Landis, dated as of December 20, 1991@@ 10.54 Stock Option Agreement by and between 165 of 319 Maxicare Health Plans, Inc. and Florence Courtright, dated as of November 5, 1993 10.55 Stock Option Agreement by and between 176 of 319 Maxicare Health Plans, Inc. and Vicki F. Perry, dated as of December 20, 1993 10.56 Stock Option Agreement by and between 187 of 319 Maxicare Health Plans, Inc. and Alan D. Bloom, dated as of December 20, 1993 10.57 Stock Option Agreement by and between 198 of 319 Maxicare Health Plans, Inc. and Richard Link, dated as of December 20, 1993 10.58 Stock Option Agreement by and between 209 of 319 Maxicare Health Plans, Inc. and Aivars Jerumanis, dated as of December 20, 1993 10.59 Stock Option Agreement by and between 220 of 319 Maxicare Health Plans, Inc. and Robert Landis, dated as of December 20, 1993 10.60 Stock Option Agreement by and between 231 of 319 Maxicare Health Plans, Inc. and William Caswell, dated as of December 20, 1993 ------------------------- @@ Incorporated by reference from the Company's Annual Report on Form 10-K for the year ended December 31, 1992, in which these exhibits bore the same exhibit numbers. Exhibit Sequential Number Description Page Number ------ ---------------------------------------- ----------- 10.61 Stock Option Agreement by and between 242 of 319 Maxicare Health Plans, Inc. and Thomas W. Field, Jr., dated as of December 20, 10.62 Stock Option Agreement by and between 253 of 319 Maxicare Health Plans, Inc. and Dr. Charles E. Lewis, dated as of December 20, 1993 10.63 Stock Option Agreement by and between 264 of 319 Maxicare Health Plans, Inc. and Claude S. Brinegar, dated as of December 20, 1993 10.64 Employment and Indemnification Agreement 275 of 319 by and between Maxicare Health Plans, Inc. and David Hammons, dated as of January 1, 1994 10.65 Stock Option Agreement by and between 285 of 319 Maxicare Health Plans, Inc. and David J. Hammons, dated as of May 20, 1991 10.66 Stock Option Agreement by and between 296 of 319 Maxicare Health Plans, Inc. and David J. Hammons, dated as of December 20, 1991 10.67 Stock Option Agreement by and between 307 of 319 Maxicare Health Plans, Inc. and David Hammons, dated as of December 20, 1993 21 List of Subsidiaries 318 of 319 23.1 Consent of Independent Accountants 319 of 319 28.1 Notice That The Conditions to Effectiveness of the Plan Have Been Met or Waived*** 28.2 Stipulation and Order Regarding Conditions to Effectiveness of Joint Plan of Reorganization*** ------------------------- *** Incorporated by reference from the Company's Report on Form 8-K dated December 5, 1990, in which these exhibits bore the same exhibit numbers. Exhibit 3.4 MAXICARE HEALTH PLANS, INC. BYLAWS As Amended through January 28, 1994 Page ARTICLE I. OFFICES. . . . . . . . . . . . . . . . . . 4 Section 1. PRINCIPAL OFFICE. . . . . . . . . . . . 4 Section 2. OTHER OFFICES . . . . . . . . . . . . . 4 ARTICLE II. MEETINGS OF STOCKHOLDERS . . . . . . . . . 4 Section 1. PLACE OF MEETINGS. . . . . . . . . . . 4 Section 2. ANNUAL MEETINGS OF STOCKHOLDERS. . . . 4 Section 3. SPECIAL MEETINGS . . . . . . . . . . . 4 Section 4. NOTICE OF STOCKHOLDERS' MEETINGS . . . 4 Section 5. MANNER OF GIVING NOTICE; AFFIDAVIT OF NOTICE. . . . . . . . . . . . . . . 5 Section 6. QUORUM . . . . . . . . . . . . . . . . 5 Section 7. ADJOURNED MEETING AND NOTICE THEREOF . 5 Section 8. ORGANIZATION . . . . . . . . . . . . . 5 Section 9. VOTING . . . . . . . . . . . . . . . . 6 Section 10. WAIVER OF NOTICE OR CONSENT BY ABSENT STOCKHOLDERS . . . . . . . . . . . . . 6 Section 11. RECORD DATE. . . . . . . . . . . . . . 6 Section 12. PROXIES. . . . . . . . . . . . . . . . 7 Section 13. INSPECTORS OF ELECTION . . . . . . . . 7 Section 14. NOTICE OF STOCKHOLDER BUSINESS AND NOMINATIONS. . . . . . . . . . . . . . 8 ARTICLE III. DIRECTORS. . . . . . . . . . . . . . . . . 10 Section 1. POWERS . . . . . . . . . . . . . . . . 10 Section 2. NUMBERS OF DIRECTORS . . . . . . . . . 10 Section 3. RESIGNATIONS; VACANCIES. . . . . . . . 10 Section 4. PLACE OF MEETINGS AND TELEPHONIC MEETINGS . . . . . . . . . . . . . . . 11 Section 5. ANNUAL MEETINGS . . . . . . . . . . . 11 Section 6. OTHER REGULAR MEETINGS . . . . . . . . 11 Section 7. SPECIAL MEETINGS . . . . . . . . . . . 11 Section 8. DISPENSING WITH NOTICE . . . . . . . . 12 Section 9. QUORUM . . . . . . . . . . . . . . . . 12 Section 10. ADJOURNMENT. . . . . . . . . . . . . . 12 Section 11. ACTION WITHOUT MEETING . . . . . . . . 12 Section 12. FEES AND COMPENSATION OF DIRECTORS . . 12 ARTICLE IV. COMMITTEES . . . . . . . . . . . . . . . . 12 Section 1. COMMITTEES OF DIRECTORS. . . . . . . . 12 Section 2. MEETINGS AND ACTION OF COMMITTEES. . . 13 ARTICLE V. OFFICERS . . . . . . . . . . . . . . . . . 13 Section 1. OFFICERS . . . . . . . . . . . . . . . 13 Section 2. ELECTION OF OFFICERS . . . . . . . . . 13 Section 3. SUBORDINATE OFFICERS, ETC. . . . . . . 14 Section 4. REMOVAL AND RESIGNATION OF OFFICERS. . 14 Section 5. VACANCIES IN OFFICES . . . . . . . . . 14 Section 6. CHAIRMAN OF THE BOARD. . . . . . . . . 14 Section 7. VICE CHAIRMAN OF THE BOARD . . . . . . 14 Section 8. PRESIDENT. . . . . . . . . . . . . . . 14 Section 9. VICE PRESIDENTS. . . . . . . . . . . . 15 Section 10. SECRETARY. . . . . . . . . . . . . . . 15 Section 11. TREASURER. . . . . . . . . . . . . . . 15 ARTICLE VI. RECORDS AND REPORTS. . . . . . . . . . . . 16 Section 1. MAINTENANCE AND INSPECTION OF SHARE REGISTER . . . . . . . . . . . . . . . 16 Section 2. MAINTENANCE AND INSPECTION OF BYLAWS . 16 Section 3. MAINTENANCE AND INSPECTION OF OTHER CORPORATE RECORDS. . . . . . . . . . . 16 Section 4. INSPECTION BY DIRECTORS. . . . . . . . 17 ARTICLE VII. GENERAL CORPORATE MATTERS. . . . . . . . . 17 Section 1. CHECKS, DRAFTS, EVIDENCES OF INDEBTEDNESS . . . . . . . . . . . . . 17 Section 2. CORPORATE CONTRACTS AND INSTRUMENTS; HOW EXECUTED . . . . . . . . . . . . . 17 Section 3. CERTIFICATES FOR SHARES. . . . . . . . 17 Section 4 LOST CERTIFICATES. . . . . . . . . . . 17 Section 5. TRANSFER OF SHARES . . . . . . . . . . 18 Section 6. TRANSFER AND REGISTRY AGENTS . . . . . 18 Section 7. REGULATIONS. . . . . . . . . . . . . . 18 Section 8. RESTRICTION ON TRANSFER OF STOCK . . . 18 Section 9. REPRESENTATION OF SHARES OF OTHER CORPORATIONS . . . . . . . . . . . . . 19 Section 10. DIVIDENDS, SURPLUS, ETC. . . . . . . . 19 ARTICLE VIII. GENERAL. . . . . . . . . . . . . . . . . . 19 Section 1. CONSTRUCTION AND DEFINITIONS . . . . . 19 Section 2. SEAL . . . . . . . . . . . . . . . . . 19 Section 3. FISCAL YEAR. . . . . . . . . . . . . . 20 ARTICLE IX. AMENDMENTS . . . . . . . . . . . . . . . . 20 Section 1. AMENDMENT BY STOCKHOLDERS. . . . . . . 20 Section 2. AMENDMENT BY DIRECTORS . . . . . . . . 20 BYLAWS OF MAXICARE HEALTH PLANS, INC. ARTICLE I. OFFICES Section 1. PRINCIPAL OFFICE. The Board of Directors shall fix the location of the principal executive office of the Corporation at any place within or outside the State of Delaware. Section 2. OTHER OFFICES. The Board of Directors may at any time establish branch or subordinate offices at any place or places where the Corporation shall determine. ARTICLE II. MEETINGS OF STOCKHOLDERS Section 1. PLACE OF MEETINGS. Meetings of stockholders shall be held at any place within or outside the State of Delaware designated by the Board of Directors. In the absence of any such designation, stockholders' meetings shall be held at the principal executive office of the Corporation. Section 2. ANNUAL MEETINGS OF STOCKHOLDERS. The annual meeting of stockholders shall be held each year on a date and at a time designated by the Board of Directors. At each annual meeting directors shall be elected and any other proper business may be transacted. Section 3. SPECIAL MEETINGS. A special meeting of the stockholders may be called at any time for any purpose or purposes by the Board of Directors, the Chairman or Vice-President of the Board, the President of the Corporation or by a committee of the Board which has been duly designated by the Board and whose powers and authority, as provided in a resolution of the Board or in these bylaws, include the power to call such meetings, and such special meetings shall be called by the President of the Corporation at the request in writing of stockholders owning at least a majority in amount of the entire capital stock of the Corporation issued and outstanding and entitled to vote. Such stockholders' request shall state the purpose or purposes of the proposed meeting. Business transacted at any special meeting shall be limited to matters relating to the purpose or purposes stated in the notice of meeting. Section 4. NOTICE OF STOCKHOLDERS' MEETINGS. All notices of meetings of stockholders shall be sent or otherwise given in accordance with Section 5 of this Article II not less than ten (10) nor more than sixty (60) days before the date of the meeting being noticed. The notice shall specify the place, date and hour of the meeting and in the case of a special meeting, the purpose(s) for which the meeting is called. The notice of any meeting at which directors are to be elected shall include the name of any nominee or nominees. Section 5. MANNER OF GIVING NOTICE; AFFIDAVIT OF NOTICE. Notice of any meeting of stockholders shall be given either personally or by first-class mail or telegraphic or other written communication, charges prepaid, addressed to the stockholder at the address of such stockholder appearing on the books of the Corporation. If mailed, notice is given when deposited in the United States mail, postage prepaid, directed to the stockholder at his address as it appears on the records of the Corporation. An affidavit of the mailing or other means of giving an notice of any stockholders' meeting shall be executed by the Secretary, Assistant Secretary or any transfer agent of the Corporation giving such notice, and shall be filed and maintained in the minute books of the Corporation. Section 6. QUORUM. At all meetings of stockholders, except as otherwise required by statute or by the Certificate of Incorporation, the presence in person or by proxy of the holders of a majority of the shares of stock outstanding and entitled to vote at any meeting of stockholders shall constitute a quorum for the transaction of business. The stockholders present at a duly called or held meeting at which a quorum is present may continue to do business until adjournment, notwithstanding the withdrawal of enough stockholders to leave less than a quorum, if any action taken (other than adjournment) is approved by at least a majority of the shares required to constitute a quorum. Section 7. ADJOURNED MEETING AND NOTICE THEREOF. Any stockholders' meeting, annual or special, whether or not a quorum is present, may by adjourned from time to time by the vote of the majority of the shares represented at such meeting, either in person or by proxy. When any meeting of stockholders, either annual or special, is adjourned to another time or place, notice need not be given of the adjourned meeting if the time and place thereof are announced at the meeting at which the adjournment is taken, unless a new record date for the adjourned meeting is fixed, or unless the adjournment is for more than thirty (30) days from the date set for the original meeting, in which case the Board of Directors shall set a new record date. Notice of any such adjourned meeting, if required, shall be given to each stockholder of record entitled to vote at the adjourned meeting in accordance with the provisions of Sections 4 and 5 of this Article II. At any adjourned meeting the Corporation may transact any business which might have been transacted at the original meeting. Section 8. ORGANIZATION. At every meeting of stockholders, the President, or in his absence the Chairman or Vice Chairman of the Board, shall act as chairman of the meeting and the Secretary shall act as secretary of the meeting. In case none of the officers designated above to act as chairman or secretary of the meeting, respectively, shall be present, a chairman or a secretary of the meeting, as the case may be, may be chosen by a majority of the votes cast at such meeting by the holders of shares present in person or represented by proxy and entitled to vote at the meeting. Section 9. VOTING. The stockholders entitled to vote at any meeting of stockholders shall be determined in accordance with the provisions of Section 11 of this Article II, subject to the provisions of Section 217 the Delaware General Corporation Law (relating to voting rights of fiduciaries, pledgors and joint owners of stock). Any stockholder entitled to vote on any matter (other than the election of directors) may vote part of the shares in favor of the proposal and refrain from voting the remaining shares or vote them against the proposal but, if the stockholder fails to specify the number of shares such stockholder is voting affirmatively, it will be conclusively presumed that the stockholder's approving vote is with respect to all shares such stockholder is entitled to vote. If a quorum is present, the affirmative vote of the majority of the shares represented at the meeting and voting on any matter shall be the act of the stockholders, unless the vote of a greater number or voting by classes is required by these Bylaws, the Certificate of Incorporation or by statute. Directors shall be elected by a plurality of the votes of the shares represented at the meeting and entitled to vote on the election of directors. No stockholder shall be entitled to cumulate votes on any matter at any meeting of stockholders. Section 10. WAIVER OF NOTICE OR CONSENT BY ABSENT STOCKHOLDERS. Whenever notice is required to be given to the stockholders under any provision of the General Corporation Law or the Certificate of Incorporation or the Bylaws, a written waiver thereof, signed by a stockholder entitled to notice, whether before or after the time stated therein, shall be deemed equivalent to notice. Attendance of a stockholder at a meeting shall constitute a waiver of notice of such meeting, except when the stockholder attends a meeting for the express purpose of objecting, at the beginning of the meeting, to the transaction of any business because the meeting is not lawfully called or convened. Neither the business to be transacted at, nor the purpose of, any regular or special meeting of the stockholders need be specified in any written waiver of notice. Section 11. RECORD DATE. In order that the Corporation may determine the stockholders entitled to notice of or to vote at any meeting of stockholders or any adjournment thereof, or to express consent to corporate action in writing without a meeting, or entitled to receive payment of any dividend or other distribution or allotment of any rights, or entitled to exercise any rights in respect of any change, conversion or exchange of stock or for the purpose of any other lawful action, the Board of Directors may fix a record date, which record date shall not precede the date upon which the resolution fixing the record date is adopted by the Board of Directors and which record date: (1) in the case of determination of stockholders entitled to vote at any meeting of stockholders or adjournment thereof, shall not be more than sixty (60) nor less than ten (10) days before the date of such meeting; (2) in the case of determination of stockholders entitled to express consent to corporate action in writing without a meeting, shall not be more than ten (10) days from the date upon which the resolution fixing the record date is adopted by the Board of Directors; and (3) in the case of any such action, shall not be more than sixty (60) days prior to such other action. If no record date is fixed: (1) the record date for determining stockholders entitled to notice of or to vote at a meeting of stockholders shall be at the close of business on the day next preceding the day on which notice is given, or, if notice is waived, at the close of business on the day next preceding the day on which the meeting is held; (2) the record date for determining stockholders entitled to express consent to corporate action in writing without a meeting when no prior action of the Board of Directors is required by law, shall be the first date on which a signed written consent setting forth the action taken or proposed to be taken is delivered to the Corporation in accordance with applicable law, or, if prior action by the Board of Directors is required by law, shall be at the close of business on the day on which the Board of Directors adopts the resolution relating to taking such prior action; and (3) the record date for determining stockholders for any other purpose shall be at the close of business on the day on which the Board of Directors adopts the resolution relating thereto. A determination of stockholders of record entitled to notice of or to vote at a meeting of stockholders shall apply to any adjournment of the meeting; provided, however, that the Board of Directors may fix a new record date for the adjourned meeting. Section 12. PROXIES. Each stockholder entitled to vote at a meeting of stockholders may authorize another person or persons to act for him by proxy, but no such proxy shall be voted or acted upon after three years from its date, unless the proxy provides for a longer period. Section 13. INSPECTORS OF ELECTION. The Board, in advance of any meeting of stockholders, may appoint one or more inspectors to act at the meeting or any adjournment thereof. If inspectors are not so appointed, the person presiding at such meeting may, and on the request of any stockholder entitled to vote thereat shall, appoint one or more inspectors. In case any person appointed fails to appear or act, the vacancy may be filled by appointment made by the Board in advance of the meeting or at the meeting by the person presiding thereat. Each inspector, before entering upon the discharge of his duties, shall take and sign an oath faithfully to execute the duties of inspector at such meeting with strict impartiality and according to the best of his ability. The inspector or inspectors shall determine the number of shares outstanding and the voting power of each, the shares represented at the meeting, the existence of a quorum, the validity and effect of proxies, and shall receive votes or ballots, hear and determine all challenges and questions arising in connection with the right to vote, count and tabulate all votes or ballots, determine the result, and shall do such acts as are proper to conduct the election or vote with fairness to all stockholders. On request of the person presiding at the meeting or any stockholder entitled to vote thereat, the inspector or inspectors shall make a report in writing of any challenge, question or matter determined by him or them and execute a certificate of any fact found by him or them. Any report or certificate made by the inspector or inspectors shall be prima facie evidence of the facts stated and of the vote as certified by him or them. Section 14. NOTICE OF STOCKHOLDER BUSINESS AND NOMINATIONS. (A) ANNUAL MEETING OF STOCKHOLDERS (1) Nominations of persons for election to the Board of Directors of the corporation and the proposal of business to be considered by the stockholders may be made at an annual meeting of stockholders (a) pursuant to the Corporation's notice of meeting delivered pursuant to Section 4 of Article II of these bylaws, (b) by or at the direction of the Chairman of the Board of Directors, or (c) by any stockholder who is entitled to vote at the meeting, who complied with the notice procedures set forth in clauses (2) and (3) or this subsection (A) and this bylaw and who was a stockholder of record at the time such notice is delivered to the Secretary of the Corporation. (2) For nominations or other business to be properly brought before an annual meeting by a stockholder pursuant to clause (c) of the foregoing subsection (A) (1) of this bylaw, the stockholder must have given timely notice thereof in writing to the Secretary of the Corporation. To be timely, a stockholder's notice shall be delivered to the Secretary at the principal executive officers of the Corporation not less than seventy (70) days nor more than ninety (90) days prior to the first anniversary of the preceding year's annual meeting; provided, however, that in the event that the date of the annual meeting is advanced by more than twenty (20) days or delayed by more than seventy (70) days from such anniversary date, notice by the stockholder to be timely must be so delivered not earlier than the ninetieth (90th) day prior to such annual meeting and not later than the close of business on the later of the seventieth (70th) day prior to such annual meeting or the tenth (10th) day following the day on which public announcement of the date of such meeting is first made. Such stockholder's notice shall set forth (a) as to each person who the stockholder proposes to nominate for election or reelection as a director, all information relating to such person that is required to be disclosed in solicitations of proxies for election of directors, or is otherwise required, in each case pursuant to Regulation 14A under the Securities Exchange Act of 1934, as amended (the "Exchange Act"), including such person's written consent to being named in the proxy statement as a nominee and to serving as a director if elected; (b) as to any other business that the stockholder proposes to bring before the meeting, a brief description of the business desired to be brought before the meeting, the reasons for conducting such business at the meeting and any material interest in such business of such stockholder and the beneficial owner, if any on whose behalf the proposal is made, and (c) as to the stockholder giving the notice and the beneficial owner, if any, on whose behalf the nomination or proposal is made, (i) the name and address of such stockholder, as they appear on the Corporation's books, and of such beneficial owner, and (ii) the class and number of shares of the capital stock of the Corporation which are owned beneficially and of record by such stockholder and such beneficial owner. (3) Notwithstanding anything in the second sentence of subsection (a) (2) of this bylaw to the contrary, in the event that the number of directors to be elected to the Board of Directors of the Corporation is increased and there is no public announcement naming all of the nominees for director or specifying the size of the increased Board of Directors made by the Corporation at least eighty (80) days prior to the first anniversary of the preceding year's annual meeting, a stockholder's notice required by this bylaw shall also be considered timely, but only with respect to nominees for any new positions created by such increase, if it shall be delivered to the Secretary of the Corporation at the principal executive offices of the Corporation not later than the close of business on the tenth (10th) day following the day on which such public announcement is first made by the Corporation. (B) SPECIAL MEETINGS OF STOCKHOLDERS As set forth in Section 3 of Article II above, only such business shall be conducted at a special meeting of stockholders as shall have been brought before the meeting pursuant to Section 4 of Article II of these bylaws. Nominations of persons for election to the Board of Directors shall be made at a special meeting of stockholders at which directors are to be elected pursuant to the Corporation's notice of meeting (a) by or at the direction of the Board of Directors, or (b) by any stockholder of the Corporation who is entitled to vote at the meeting, who complies with the notice procedures set forth in this bylaw and who is a stockholder of record at the time such notice is delivered to the Secretary of the Corporation. Nominations by stockholders of person for election to the Board of Directors may be made at such a special meeting of stockholders if the stockholder's notice as required by subsection (A) (2) of this bylaw shall be delivered to the Secretary of the Corporation at the principal executive offices of the Corporation no later than the close of business on the thirtieth (30th) day prior to such special meeting or, if fewer than thirty (30) days notice of such meeting is given, no later than the fifth (5th) day following the day on which public announcement is first made of the date of the special meeting and of the nominees proposed by the Board of Directors to be elected at such meeting. (C) GENERAL (1) Only persons who are nominated in accordance with the procedures set forth in this bylaw shall be eligible to serve as directors and only such business shall be conducted at a meeting of stockholders as shall have been brought before the meeting in accordance with the procedures set forth in this bylaw. Except as otherwise provide by law, the Restated Certificate of Incorporation of the Corporation, as amended, or these bylaws, the chairman of the meeting shall have the power and duty to determine whether a nomination or any business proposed to be brought before the meeting was made in accordance with the procedures set forth in this bylaw and, if any proposed nomination or business is not in compliance with this bylaw, to declare that such defective proposal or nomination shall be disregarded. (2) For purposes of this bylaw, "public announcement" shall mean disclosure in a press release reported by the Dow Jones News Service Associated Press or comparable national news service or in a document publicly filed by the Corporation with the Securities and Exchange Commission pursuant to Section 13, 14 or 15 (d) of the Exchange Act. (3) Notwithstanding the foregoing provisions of this bylaw, a stockholder shall also comply with all applicable requirements of the Exchange Act and the rules and regulations thereunder with respect to the matters set forth in this bylaw. Nothing in this bylaw shall be deemed to affect any rights of stockholders to request inclusion of proposals in the Corporation's proxy statement pursuant to Rule 14a-8 under the Exchange Act. ARTICLE III. DIRECTORS Section 1. POWERS. The Board of Directors shall exercise all of the powers of the Corporation except such as are by law, or by the Certificate of Incorporation of the Corporation or by these Bylaws, conferred upon or reserved to the stockholders. Section 2. NUMBER OF DIRECTORS. The number of directors which shall constitute the Board of Directors of the Corporation shall initially be nine (9). The number of directors may from time to time by changed, by resolution of the Board of Directors or a majority vote of the outstanding shares entitled to vote thereon. The directors shall, except for filling vacancies (whether resulting from an increase in the number of directors, resignations, removals or otherwise), be elected at the annual meeting of the stockholders and each director shall be elected to serve until his successor is elected and qualifies. Directors need not be stockholders. Section 3. RESIGNATIONS; VACANCIES. Any director or member of a committee may resign at any time. Such resignation shall be made in writing, and shall take effect at the time specified therein, and if no time be specified, at the time of its receipt by the President or Secretary. The acceptance of a resignation shall not be necessary to make it effective. Vacancies in the Board of Directors may be filled in the manner provided in the Certificate of Incorporation. A vacancy or vacancies in the Board of Directors shall be deemed to exist in the case of the death, resignation or removal of any director, or if the authorized number of directors be increased, or if the stockholders fail, at any meeting of stockholders at which any director or directors are elected, to elect the full authorized number of directors to be voted for that meeting. No reduction of the authorized number of directors shall have the effect of removing any director prior to the expiration of his term of office. Section 4. PLACE OF MEETING AND TELEPHONIC MEETINGS. Regular meetings of the Board of Directors may be held at any place within or without the State of Delaware that has been designated from time to time by resolution of the Board of Directors. In the absence of such designation, regular meetings shall be held at the principal executive office of the Corporation. Special meetings of the Board of Directors shall be held at any place within or without the State of Delaware that has been designated in the notice of the meeting or, if not stated in the notice or there is no notice, at the principal executive office of the Corporation. Any meeting, regular or special, may be held by conference, telephone or similar communication equipment, so long as all directors participating in such meeting can hear one another, and all such directors shall be deemed to be present in person at such meeting. Section 5. ANNUAL MEETINGS. Immediately following each annual meeting of stockholders, the Board of Directors shall hold a regular meeting for the purpose of organization, any desired election of officers and the transaction of other business. Notice of this meeting shall not be required. Section 6. OTHER REGULAR MEETINGS. Other regular meetings of the Board of Directors shall be held without call at such time as shall from time to time be fixed by the Board of Directors. Such regular meetings may be held without notice. Section 7. SPECIAL MEETINGS. Special meetings of the Board of Directors for any purpose or purposes may be called at any time by the Chairman of the Board or the President or any Vice President or the Secretary or any two directors. Notice of the time and place of special meetings shall be delivered personally or by telephone to each director or sent by first-class mail, telegram or facsimile, charges prepaid, addressed to each director at his or her address as it is shown upon the records of the Corporation. In case such notice is mailed, it shall be deposited in the United States mail at least four (4) days prior to the time of the holding of the meeting. In case such notice is delivered personally, or by telephone, telegram or facsimile, it shall be delivered personally or by telephone or the telegraph company at least forty-eight (48) hours prior to the time of the holding of the meeting. Any oral notice given personally or by telephone may be communicated to either the director or to a person at the office of the director who the person giving the notice has reason to believe will promptly communicate it to the director. The notice need not specify the purpose of the meeting nor the place if the meeting is to be held at the principal executive office of the Corporation. Section 8. DISPENSING WITH NOTICE. The transaction of any business at any meeting of the Board of Directors, however called and noticed or wherever held, shall be as valid as though had at a meeting duly held after regular call and notice if a quorum be present and if, either before or after the meeting, each of the directors not present signs a written waiver of notice, a consent to holding the meeting or an approval of the minutes thereof. The waiver of notice or consent need not specify the purpose of the meeting. All such waivers, consents and approvals shall be filed with the corporate records or made a part of the minutes of the meeting. Notice of a meeting need not be given to any director who attends the meeting without protesting, prior thereto or at its commencement, the lack of notice to such director. Section 9. QUORUM. A majority of the authorized number of directors shall constitute a quorum for the transaction of business, except to adjourn as hereinafter provided. Every act or decision done or made by a majority of the directors present at a meeting duly held at which a quorum is present shall be regarded as the act of the Board of Directors, subject to the provisions of Section 144 of the Delaware General Corporation Law (approval of contracts or transactions in which a director has a financial interest), Section 141(c) (appointment of committees), and Section 145 (indemnification of directors). A meeting at which a quorum is initially present may continue to transact business notwithstanding the withdrawal of directors, if any action taken is approved by at least a majority of the required quorum of such meeting. Section 10. ADJOURNMENT. A majority of the directors present, whether or not constituting a quorum, may adjourn any meeting to another time and place. Section 11. ACTION WITHOUT MEETING. Any action required or permitted to be taken by the Board of Directors may be taken without a meeting, if all members of the Board of Directors shall individually or collectively consent in writing to such action. Such action by written consent shall have the same force and effect as a unanimous vote of the Board of Directors. Such written consent or consents shall be filed with the minutes of the proceedings of the Board of Directors. Section 12. FEES AND COMPENSATION OF DIRECTORS. Directors and members of committees may receive such compensation, if any, for their services, and such reimbursement of expenses, as may be fixed or determined by resolution of the Board of Directors. Nothing contained in these Bylaws shall be construed to preclude any director from serving the Corporation in any other capacity as an officer, agent, employee, or otherwise, and receiving compensation for such services. ARTICLE IV. COMMITTEES Section 1. COMMITTEES OF DIRECTORS. The Board of Directors may, by resolution adopted by a majority of the authorized number of directors, designate one or more committees, each consisting of two or more directors, to serve at the pleasure of the Board of Directors. The Board of Directors may designate one or more directors as alternate members of any committee, who may replace any absent member at any meeting of the committee. Any such committee, to the extent provided in the resolution of the Board of Directors, shall have all the authority of the Board of Directors, except with respect to the power or authority in reference to amending the Certificate of Incorporation, adopting an agreement of merger or consolidation, recommending to the stockholders the sale, lease or exchange of all or substantially all the Corporations's property and assets, recommending to the stockholders a dissolution of the Corporation or a revocation of a dissolution, or amending the Bylaws of the Corporation; and, unless the resolution designating such committee or the Certificate of Incorporation expressly so provide, no such committee shall have the power of authority to declare a dividend or to authorize the issuance of stock. Such committee or committees shall have such name or names as may be determined from time to time by resolution adopted by the Board of Directors. Section 2. MEETINGS AND ACTION OF COMMITTEES. Meetings and action of committees shall be governed by, and held and taken in accordance with, the provisions of Article III of these Bylaws, Section 4 (place of meetings), 6 (regular meetings), 7 (special meetings and notice), 8 (dispensing with notice), 9 (quorum), 10 (adjournment), and 11 (action without meeting), with such changes in the context of those Bylaws as are necessary to substitute the committee and its members for the Board of Directors and its members, except that the time of regular meetings of committees may be determined by resolution of the Board of Directors as well as the committee, special meetings of committees may also be called by resolution of the Board of Directors and notice of special meetings of committees shall also be given to alternate members, who shall have the right to attend all meetings of the committee. The Board of Directors and any committee may adopt rules for the government of any committee not inconsistent with the provisions of these Bylaws. ARTICLE V. OFFICERS Section 1. OFFICERS. The officers of the Corporation shall be a President, a Secretary and a Treasurer. The Corporation may also have, at the discretion of the Board of Directors, a Chairman and/or Vice Chairman of the Board, one or more Vice- Presidents, one or more Assistant Secretaries, one or more Assistant Treasurers, and such other officers as may be appointed in accordance with the provisions of Section 3 of this Article V. Any number of offices may be held by the same person. Section 2. ELECTION OF OFFICERS. The officers of the Corporation, except such officers as may be appointed in accordance with the provisions of Section 3 of this Article V, shall be chosen by the Board of Directors, and each shall serve at the pleasure of the Board of Directors, subject to the rights, if any, of an officer under any contract of employment. Section 3. SUBORDINATE OFFICERS, ETC. The Board of Directors may appoint, and may empower the President to appoint, such other officers as the business of the Corporation may require, each of whom shall hold office for such period, have such authority and perform such duties as are provided in these Bylaws or as the Board of Directors may from time to time determine. Section 4. REMOVAL AND RESIGNATION OF OFFICERS. Subject to the rights, if any, of an officer under any contract of employment, any officer may be removed, either with or without cause, by the Board of Directors, at any regular or special meeting thereof, or, except in case of an officer chosen by the Board of Directors, by any officer upon whom such power of removal may be conferred by the Board of Directors. Any officer may resign at any time by giving written notice to the Corporation. Any such resignation shall take effect at the date of the receipt of such notice or at any later time specified therein; and, unless otherwise specified therein, the acceptance of such resignation shall not be necessary to make it effective. Any such resignation is without prejudice to the rights, if any, of the Corporation under any contract to which the officer is a party. Section 5. VACANCIES IN OFFICES. A vacancy in any office because of death, resignation, removal, disqualification or any other cause shall be filled in the manner prescribed in these Bylaws for regular appointments to such office. Section 6. CHAIRMAN OF THE BOARD. The Chairman of the Board, if such an officer be elected, shall, if present, preside at all meetings of the Board of Directors and exercise and perform such other powers and duties as may be from time to time assigned to him by the Board of Directors or prescribed by these Bylaws. If there is no President, the Chairman of the Board shall in addition be the Chief Executive Officer of the Corporation and shall have the powers and duties prescribed in Section 8 of this Article V. Section 7. VICE CHAIRMAN OF THE BOARD. The Vice Chairman of the Board, if such an officer is elected shall, in the absence or disability of the Chairman, perform all the duties of the Chairman, and when so acting, shall have all the powers of, and be subject to all the restrictions upon the Chairman. The Vice Chairman shall exercise and perform such other powers and duties as may be from time to time assigned to him by the Board of Directors or prescribed by these Bylaws. Section 8. PRESIDENT. Subject to such supervisory powers, if any, as may be given by the Board of Directors to the Chairman or Vice Chairman of the Board, if there be such an officer or officers, the President shall be the Chief Executive Officer of the Corporation and shall, subject to the control of the Board of Directors, have general supervision, direction and control of the business and the officers of the Corporation. He shall preside at all meetings of the stockholders and, in the absence of the Chairman or Vice Chairman of the Board, or if there be none, at all meetings of the Board of Directors. He shall have the general powers and duties of management usually vested in the office of President of a corporation and shall have such other powers and duties as may be prescribed by the Board of Directors or these Bylaws. Section 9. VICE PRESIDENTS. In the absence or disability of the President, the Vice Presidents, if any, in order of their rank as fixed by the Board of Directors or, if not ranked, a Vice President designated by the Board of Directors, shall perform all the duties of the President, and when so acting shall have all the powers of, and be subject to all the restrictions upon, the President. The Vice Presidents shall have such other powers and perform such other duties as from time to time may be prescribed for them respectively by the Board of Directors, these Bylaws, or the President or the Chairman or Vice Chairman of the Board if there is no President. Section 10. SECRETARY. The Secretary shall keep or cause to be kept, at the principal executive office or such other place as the Board of Directors may order, a book of minutes of all meetings and actions of directors, committees of directors and stockholders, with the time and place of holding, whether regular or special, and, if special, how authorized, the notice thereof given, the names of those present at director's and committee meetings, the number of shares present or represented at stockholders' meetings, and the proceedings thereof. The Secretary shall keep, or cause to be kept, at the principal executive office or at the office of the Corporation's transfer agent or registrar, as determined by resolution of the Board of Directors, a share register, or a duplicate share register, showing the names of all stockholders and their addresses, the number and classes of shares held by each, the number and date of certificates issued for the same, and the number and date of cancellation of every certificate surrendered for cancellation. The Secretary shall give, or cause to be given, notice of all meetings of the stockholders and of the Board of Directors required by these Bylaws or by law to be given, and he shall keep the seal of the Corporation in safe custody, and shall have such other powers and perform such other duties as may be prescribed by the Board of Directors or by these Bylaws. Section 11. TREASURER. The Treasurer shall keep and maintain, or cause to be kept and maintained, adequate and correct books and records of accounts of the properties and business transactions of the Corporation, including accounts of its assets, liabilities, receipts, disbursements, gains, losses, capital, retained earnings and shares. The books of account shall be open at all reasonable times to inspection by any director. The Treasurer shall deposit all moneys and other valuables in the name and to the credit of the Corporation with such depositories as may be designated by the Board of Directors. He shall disburse the funds of the Corporation as may be ordered by the Board of Directors, shall render to the President and directors, whenever they request it, an account of all of his transactions as Treasurer and of the financial condition of the Corporation, and shall have other powers and perform such other duties as may be prescribed by the Board of Directors or these Bylaws. ARTICLE VI. RECORDS AND REPORTS Section 1. MAINTENANCE AND INSPECTION OF SHARE REGISTER. The Corporation shall keep at its principal executive office, or at the office of its transfer agent or registrar, if either be appointed and as determined by resolution of the Board of Directors, a record of its stockholders, giving the names and addresses of all stockholders and the number and class of shares held by each stockholder. Any stockholder, in person or by attorney or other agent, shall, upon written demand under oath stating the purpose thereof, have the right during the usual hours for business to inspect for any proper purpose the Corporation's stock ledger and a list of its stockholders and to make copies or extracts therefrom. A proper purpose shall mean a purpose reasonably related to such person's interest as a stockholder. In every instance where an attorney or other agent shall be the person who seeks the right to inspection, the demand under oath shall be accompanied by a power of attorney or such other writing which authorizes the attorney or other agent to so act on behalf of the stockholder. The demand under oath shall be directed to the Corporation at its registered office in the State of Delaware or at its principal place of business. Section 2. MAINTENANCE AND INSPECTION OF BYLAWS. The Corporation shall keep at its principal executive office the original or a copy of these Bylaws as amended to date, which shall be open to inspection by the stockholders at all reasonable times during usual business hours. Section 3. MAINTENANCE AND INSPECTION OF OTHER CORPORATE RECORDS. The accounting books and records and minutes of proceedings of the stockholders and the Board of Directors and any committee or committees of the Board of Directors shall be kept at such place or places designated by the Board of Directors, or, in the absence of such designation, at the principal executive office of the Corporation. The minutes shall be kept in written form and the accounting books and records shall be kept either in written form in any other form capable of being converted into written form. Such minutes, accounting books and records shall be open to inspection upon the written demand of any stockholder in the same manner and subject to the same limitations specified in Section 1 of this Article VI with respect to the identities of stockholders. Section 4. INSPECTION BY DIRECTORS. Any director shall have the right to examine the Corporation's stock ledger, a list of its stockholders and its books and records for a purpose reasonably related to his position as a director. ARTICLE VII. GENERAL CORPORATE MATTERS Section 1. CHECKS, DRAFTS, EVIDENCE OF INDEBTEDNESS. All checks, drafts or other orders for payment of money, notes or other evidences of indebtedness, issued in the name of or payable by the Corporation, shall be signed or endorsed by such person or persons and in such manner as, from time to time, shall be determined by resolution of the Board of Directors. Section 2. CORPORATE CONTRACTS AND INSTRUMENTS; HOW EXECUTED. The Board of Directors, except as otherwise provided in these Bylaws, may authorize any officer or officers, agent or agents, to enter into any contract or execute any instrument in the name of and on behalf of the Corporation, and such authority may be general or confined to specific instances; and, unless so authorized or ratified by the Board of Directors or within the agency power of an officer, no officer, agent or employee shall have any power or authority to bind the Corporation by any contract or engagement or to pledge its credit or to render it liable for any purpose or to any amount. Section 3. CERTIFICATES FOR SHARES. A certificate or certificates for shares of the Common Stock of the Corporation shall be issued to each stockholder when any such shares are fully paid, and the Board of Directors may authorize the issuance of certificates or shares as partly paid provided that such certificates shall state the amount of the consideration to be paid therefor and the amount paid thereon. All certificates shall be signed in the name of the Corporation by the Chairman or Vice Chairman of the Board or the President or Vice President and by the Treasurer or an Assistant Treasurer or the Secretary or any Assistant Secretary. Any or all of the signatures on the certificate may be facsimile, if the certificate is countersigned by a transfer agent or registered by a registrar other than the Corporation itself or its employee. In case any officer, transfer agent or registrar who has signed or whose facsimile signature has been placed upon a certificate shall have ceased to be such officer, transfer agent or registrar before such certificate is issued, it may be issued by the Corporation with the same effect as if such person were an officer, transfer agent or registrar at the date of issue. Section 4. LOST CERTIFICATES. Except as hereinafter in this Section 5 provided, no new certificate for shares shall be issued in lieu of an old certificate unless the latter is surrendered to the Corporation and cancelled at the same time. The Board of Directors may in case any share certificate or certificate for any other security is lost, stolen or destroyed, authorize the issuance of a new certificate in lieu thereof, upon such terms and conditions as the Board of Directors may require, including provision for indemnification of the Corporation secured by a bond or other adequate security sufficient to protect the Corporation against any claim that may be made against it, including any expense or liability, on account of the alleged loss, theft or destruction of such certificate or the issuance of such new certificate. Section 5. TRANSFER OF SHARES. Transfers of shares of capital stock of the Corporation shall be made only on the books of the Corporation by the holder thereof or by his duly authorized attorney appointed by a power of attorney duly executed and filed with the Secretary or a transfer agent of the Corporation, and on surrender of the certificate or certificates representing such shares of capital stock properly endorsed for transfer and upon payment of all necessary transfer taxes. Every certificate exchanged, returned or surrendered to the Corporation shall be marked "Cancelled," with the date of cancellation, by the Secretary or an Assistant Secretary or the transfer agent of the Corporation. A person in whose name shares of capital stock shall stand on the books of the Corporation shall be deemed the owner thereof to receive dividends, to vote as such owner and for all other purposes as respects the Corporation, its stockholders and creditors for any purpose, until such transfer shall have been entered on the books of the Corporation by an entry showing from and to whom transferred. Section 6. TRANSFER AND REGISTRY AGENTS. The Corporation may from time to time maintain one or more transfer offices or agents and registry offices or agents at such place or places as may be determined from time to time by the Board. Section 7. REGULATIONS. The Board may make rules and regulations as it may deem expedient, not inconsistent with the Bylaws or with the Certificate of Incorporation, concerning the issue, transfer and registration of certificates representing shares of its capital stock. Section 8. RESTRICTION ON TRANSFER OF STOCK. A written restriction on the transfer or registration of transfer of capital stock of the Corporation, if permitted by Section 202 of the General Corporation Law and noted conspicuously on the certificate representing such capital stock, may be enforced against the holder of the restricted capital stock of any successor or transferee of the holder including an executor, administrator, trustee, guardian or other fiduciary entrusted with like responsibility for the person or estate of the holder. A restriction on the transfer or registration of transfer of capital stock of the Corporation may be imposed either by the Certificate of Incorporation or by an agreement among any number of stockholders or among such stockholders and the Corporation. No restriction so imposed shall be binding with respect to capital stock issued prior to the adoption of the restriction unless the holders of such capital stock are parties to an agreement or voted in favor of the restriction. Section 9. REPRESENTATION OF SHARES OF OTHER CORPORATIONS. The Chairman of the Board, the President, or any Vice President, or any other person authorized by resolution of the Board of Directors or by any of the foregoing designated officers, is authorized to vote on behalf of the Corporation any and all shares of any other corporation or corporations, foreign or domestic, standing in the name of the Corporation. The authority herein granted to said officers to vote or represent on behalf of the Corporation any and all shares held by the Corporation in any other corporation or corporations may be exercised by any such officer in person or by any person authorized to do so by proxy duly executed by said officer. Section 10. DIVIDENDS, SURPLUS, ETC. Subject to the provisions of the Certificate of Incorporation and of applicable law, the Board of Directors: (a) may declare and pay dividends or make other distributions on the outstanding shares of capital stock in such amounts and at such time or times as, in its discretion, the conditions of the affairs of the Corporation shall render advisable; (b) may use and apply, in its discretion, any of the surplus of the Corporation in purchasing or acquiring any shares of capital stock of the Corporation, or purchase warrants therefor, in accordance with law, or any of its bonds, debentures, notes, scrip or other securities or evidences indebtedness; (c) may set aside from time to time out of such surplus or net profits such sum or sums as, in its discretion, it may think proper, as a reserve fund to meet contingencies, or for equalizing dividends or for the purpose of maintaining or increasing the property or business of the Corporation, or for any other purpose it may think conducive to the best interests of the Corporation. ARTICLE VIII. GENERAL Section 1. CONSTRUCTION AND DEFINITIONS. Unless the context requires otherwise, the general provisions, rules of construction, and definitions in the Delaware General Corporation Law shall govern the construction of these Bylaws. Without limiting the generality of the foregoing, the singular number includes the plural, the plural number includes the singular, and the term "person" includes both a corporation and a natural person. Section 2. SEAL. The corporate seal of the Corporation shall bear the name of the Corporation and the words "Delaware [year]." The Corporation may also have such other seals as the Board of Directors shall deem appropriate, including "OFFICIAL CORPORATE SEAL." A corporate seal may be used by causing it or a facsimile thereof to be impressed or affixed or reproduced. Section 3. FISCAL YEAR. The fiscal year of the Corporation shall be determined, and may be changed, by resolution of the Board of Directors. ARTICLE IX. AMENDMENTS Section 1. AMENDMENT BY STOCKHOLDERS. New Bylaws may be adopted or these Bylaws may be amended or repealed by the vote of holders of a majority of the outstanding shares entitled to vote, unless, as to a particular provision, a higher vote is required by the Certificate of Incorporation or by statute; provided, however, that Section 3 of Article II, and Sections 1 and 2 of Article IX of these Bylaws may not be amended or repealed in any respect except by the affirmative vote of the holders of not less than eighty percent (80%) of the outstanding shares entitled to vote thereon ("Voting Shares"), regardless of class and voting class, and, where such action is proposed by an Interested Stockholder or by an Associate or Affiliate of an Interested Stockholder (as such capitalized terms are defined in the Certificate of Incorporation of the Corporation), the affirmative vote of the holders of a majority of all Voting Shares, regardless of class and voting together as a single class, other than shares held by the Interested Stockholder which proposed (or the Affiliate or Associate of which proposed) such action, or any Affiliate or Associate of such Interested Stockholder; provided, however, that where such action is approved by a majority of the Disinterested Directors (as defined in the Certificate of Incorporation of the Corporation), the affirmative vote of a majority of the Voting Shares, regardless of class and voting class, shall be required for approval of such action. Section 2. AMENDMENT BY DIRECTORS. Subject to the rights of the Stockholders as provided in Section 1 of this Article IX to adopt, amend or repeal bylaws, bylaws may be adopted, amended or repealed by the Board of Directors. Exhibit 10.7d EMPLOYMENT AGREEMENT This Employment Agreement ("Agreement"), dated as of January 1, 1994, is made by and between Maxicare Health Plans, Inc., a Delaware corporation (the "Company"), and Vicki F. Perry, an individual ("Employee"). R E C I T A L S --------------- WHEREAS, Employee is knowledgeable and skillful in the Company's business; WHEREAS, the Company wishes to retain the services of Employee as Vice President/General Manager of the Company and Employee has agreed to render services as such; WHEREAS, Employee is willing to be employed by the Company under the terms and conditions set forth herein; NOW, THEREFORE, in consideration of the terms and conditions hereinafter set forth, and for other good and valuable consideration, the receipt of which is hereby acknowledged the parties hereto agree as follows: 1. DEFINITIONS. As used in this Agreement, the following capitalized terms shall have the following meanings, unless otherwise expressly provided or unless the context otherwise requires: (a) "Board of Directors" means the Board of Directors of the Company. (b) "Cause" means, as used with respect to the involuntary termination of Employee: (i) The willful and continued failure by Employee to substantially perform his duties pursuant to the terms of this Agreement without good cause; or (ii) The willful engaging by Employee in misconduct or inaction materially injurious to the Company; or (iii) The conviction of Employee for a felony or of a crime involving moral turpitude. No act, or failure to act, on the Employee's part shall be considered "willful" if done or omitted to be done by the Employee in good faith and with reasonable belief that the Employee's action or omission was in the best interest of the Company. (c) "Change of Control" means (i) the merger or consolidation of the Company with or into any other person or entity other than an affiliate or subsidiary of the Company if upon the consummation of the transaction, holders of the Company's equity securities, immediately prior to such transaction own less than fifty percent (50%) of the equity; or (ii) the sale or transfer by the Company of all or substantially all of its assets. (d) "Incapacity" means the absence of the Employee from his employment or the inability of Employee to perform his duties pursuant to this Agreement by reason of mental or physical illness, disability or incapacity for a period of thirty (30) consecutive days and such determination is based upon a certificate as to such mental or physical disability issued by a licensed physician and/or psychiatrist, as the case may be, employed by the Company. 2. EMPLOYMENT, SERVICES AND DUTIES. The Company hereby employs Employee as Vice President/General Manager. Subject to his continued employment as such by the Board of Directors, Employee shall have and perform the duties and have the powers, authority and responsibilities ordinarily associated with a person in such position and shall be subject to the direction of the Company's Board of Directors. Employee shall render his services at such locations as the Company's Board of Directors may designate. 3. ACCEPTANCE OF EMPLOYMENT. Employee hereby accepts employment hereunder and agrees to devote his full time to the Company's business and shall in no way be involved in any activities whatsoever which might interfere with his employment with the Company. 4. COMPENSATION. As compensation for all services to be rendered by Employee hereunder, the Company agrees to provide Employee with the following: (a) BASE SALARY. The Company shall pay to Employee a base salary at the rate of $160,000.00 per annum, with such increases and bonuses, as may be determined from time to time by the Chief Executive Officer of the Company. Said salary shall be payable in equal semi-monthly installments or in such other installments as may be agreed upon between the parties. (b) STOCK OPTIONS. The Company shall grant to Employee an option (the "Stock Option") to purchase 7,500 shares of the Company's Common Stock. The Stock Option shall be granted pursuant to the terms of the Company's 1990 Stock Option Plan and a Stock Option Agreement in the form attached hereto as Exhibit A. Employee acknowledges that he is entitled to only one such Stock Option grant pursuant to this Agreement. Employee's interest in and rights to the Stock Option shall vest in accordance with the terms of the Stock Option Agreement. 5. BENEFITS. In addition to the compensation provided for in Section 4 of this Agreement, Employee shall have the right to participate in any profit-sharing, pension, life, health and accident insurance, or other employee benefit plans presently adopted or which hereafter may be adopted by the Company in a manner comparable to those offered or available to other employees of the Company. Employee shall be entitled to four (4) weeks annual vacation time, during which time his compensation will be paid in full. Unused vacation days in any year(s) may be carried over to a subsequent year(s) provided, however, the cumulative number of vacation days which may be carried over in any one year shall not exceed four (4) weeks. 6. EXPENSES. The Company shall promptly reimburse Employee for all reasonable travel, hotel, entertainment and other expenses incurred by Employee in the discharge of Employee's duties hereunder, upon receipt from Employee of vouchers, receipts or other reasonable substantiation of such expenses acceptable to the Company. 7. TERM OF EMPLOYMENT. The term of employment hereunder shall be for a period of one (1) year, commencing as of the date of this Agreement, unless earlier terminated as herein provided. This Agreement shall terminate upon the occurrence of any of the following events: (a) The death of Employee; (b) Employee voluntarily leaves the employ of the Company, with or without the consent of the Company; (c) The Incapacity of Employee; (d) The Company terminates this Agreement for Cause; (e) The Company terminates this Agreement for any reason other than as set forth in Sections 7(a), 7(c) or 7(d) hereof; or (f) The appointment of a trustee for the Company for the purpose of liquidating and winding up the Company pursuant to Chapter 7 of the Federal Bankruptcy Code. 8. COMPENSATION UPON TERMINATION. In the event this Agreement is terminated pursuant to Section 7, the Company shall pay to Employee such compensation as Employee is entitled to receive pursuant to Section 4, prorated through the date of said termination. In the event that such termination arises under Section 7(a), Employee's estate shall be entitled to receive severance compensation equal to such amount of Employee's annual base salary as would have been paid over a thirty (30) day period. In the event that such termination arises under Section 7(e), Employee shall be entitled to receive severance compensation in an amount equal to such amount of Employee's annual base salary as would have been paid over a four (4) month period. In the event that this Agreement is terminated by the Company or its successor in interest in connection with, or as a result of, a Change in Control or for any reason other than as set forth in Sections 7(a) - (d) hereof within six (6) months of a Change in Control, Employee shall, in lieu of any severance compensation payable pursuant to the immediately preceding sentence, be entitled to receive severance compensation in an amount equal to such amount of Employee's annual base salary as would have been paid over a four (4) month period. Any and all severance amounts paid pursuant to the provisions of this Section 8 shall be paid in one lump sum installment. The treatment of Employee's Stock Options shall be governed by the terms of the Company's 1990 Stock Option Plan and the Stock Option Agreement. 9. COVENANT NOT TO COMPETE. Employee covenants and agrees that during the term of his employment by the Company pursuant to this Agreement he will not, directly or indirectly, own, manage, operate, join, control or become employed by, or render any services of any advisory nature or otherwise, or participate in the ownership, management, operation or control of, any business which competes with the business of the Company or any of its affiliates. Notwithstanding the foregoing, Employee shall not be prevented from investing his assets in such form or manner as will not require any services on the part of Employee in the operation of the affairs of a company in which investments are made, provided such company is not engaged in a business competitive to the Company, or if it is in competition with the Company, provided its stock is publicly traded and Employee owns less than one percent (1%) of the outstanding stock of that company. 10. CONFIDENTIALITY. Employee covenants and agrees that he will not at any time during or after the termination of his employment by the Company reveal, divulge or make known to any person, firm or corporation any information, knowledge or data of a proprietary nature relating to the business of the Company or any of its affiliates which is not or has not become generally known or public. Employee shall hold, in a fiduciary capacity, for the benefit of the Company, all information, knowledge or data of a proprietary nature, relating to or concerned with, the operations, customers, developments, sales, business and affairs of the Company and its affiliates which is not generally known to the public and which is or was obtained by the Employee during his employment by the Company. Employee recognizes and acknowledges that all such information, knowledge or data is a valuable and unique asset of the Company and accordingly he will not discuss or divulge any such information, knowledge or data to any person, firm, partnership, corporation or organization other than to the Company, its affiliates, designees, assignees or successors or except as may otherwise be required by the law, as ordered by a court or other governmental body of competent jurisdiction, or in connection with the business and affairs of the Company. 11. EQUITABLE REMEDIES. In the event of a breach or threatened breach by Employee of any of his obligations under Sections 9 and 10 hereof, Employee acknowledges that the Company may not have an adequate remedy at law and therefore it is mutually agreed between Employee and the Company that in addition to any other remedies at law or in equity which the Company may have, the Company shall be entitled to seek in a court of law and/or equity a temporary and/or permanent injunction restraining Employee from any continuing violation or breach of this Agreement. 12. MISCELLANEOUS. (a) This Agreement shall be binding upon and inure to the benefit of the Company and any successor of the Company. This Agreement shall not be terminated by the voluntary or involuntary dissolution of the Company or by any merger, reorganization or other transaction in which the Company is not the surviving or resulting corporation or upon any transfer of all or substantially all of the assets of Company in the event of any such merger, or transfer of assets. The provisions of this Agreement shall be binding upon and shall inure to the benefit of the surviving business entity or the business entity to which such assets shall be transferred in the same manner and to the same extent that the Company would be required to perform as if no such transaction had taken place. Neither this Agreement nor any rights arising hereunder may be assigned or pledged by Employee. Employee's rights to the compensation provided for under Section 4 of this Agreement (as may be limited by Section 8 of the Agreement) and to the reimbursement for expenses under Section 6 hereof, shall continue, despite the fact that Employee may cease to be employed by the Company, and shall survive the termination of this Agreement regardless of cause. This Agreement shall inure to the benefit of and be enforceable by Employee's personal or legal representatives, executors, administrators, successors, heirs, distributees, devisees and legatees. (b) Except as otherwise provided by law or elsewhere herein, Employee shall be entitled to all benefits as set forth herein notwithstanding the occurrence of the following events: (i) any act of force majeure which materially and adversely affect the Company's business and operations, including but not limited to, the Company having sustained a material loss, whether or not insured, by reason of fire, earthquake, flood, epidemic, explosion, accident, calamity or other act of God; (ii) any strike or labor dispute or court or government action, order or decree; (iii) a banking moratorium having been declared by federal or state authorities; (iv) an outbreak of major armed conflict, blockade, embargo, or other international hostilities or restraints or orders of civic, civil defense, or military authorities, or other national or international calamity having occurred; (v) any act of public enemy, riot or civil disturbance or threat thereof; or (vi) a pending or threatened legal or governmental proceeding or action relating generally to the Company's business, or a notification having been received by the Company of the threat of any such proceeding or action, which could materially adversely affect the Company. (c) Except as expressly provided herein, this Agreement contains the entire understanding between the parties with respect to the subject matter hereof, and may not be modified, altered or amended except by an instrument in writing signed by the parties hereto. This Agreement supersedes all prior agreements of the parties with respect to the subject matter hereof. In the event of termination of employment of Employee pursuant to this Agreement, the arrangements provided for by this Agreement, by any Stock Option Agreement or other written agreement between the Company or any of its affiliates and Employee in effect at the time, and by any other applicable benefit plan of the Company or any of its affiliates, will constitute the entire obligation of the Company to the Employee and performance thereof by the Company will constitute full settlement of any and all claims, whether in contract or tort, that Employee might otherwise assert against the Company or any of its affiliates on account of such termination. (d) This Agreement shall be construed in accordance with the laws of the State of California applicable to agreements made and to be performed entirely within such state and without regard to the conflict of law principals thereof. (e) Nothing in the Agreement is intended to require or shall be construed as requiring the Company to do or fail to do any act in violation of applicable law. The Company's inability pursuant to court order to perform its obligations under this Agreement shall not constitute a breach of this Agreement. If any provision of this Agreement is invalid or unenforceable, the remainder of this Agreement shall nevertheless remain in full force and effect. If any provision is held invalid or unenforceable with respect to particular circumstances, it shall, nevertheless, remain in full force and effect in all other circumstances. (f) With the exception of disputes arising under or with respect to Sections 9 or 10 hereof, any and all disputes hereunder shall be resolved by arbitration. Any party hereto electing to commence an action shall give written notice to the other parties hereto of such election. The dispute shall be settled by arbitration in accordance with the then rules of the American Arbitration Association; provided, however, in the event the parties are unable to agree on an arbitrator within twenty (20) days after receipt of the aforementioned notice of arbitration, a single arbitrator shall be selected by the Chief Judge of the Superior Court of the State of California for the County of Los Angeles. The award of such arbitrator may be confirmed or enforced in any court of competent jurisdiction. The costs and expenses of the arbitrator, including the attorney's fees and costs of each of the parties, shall be apportioned between the parties by such arbitrator, based upon such arbitrator's determination of the merits of their respective positions. With respect to such arbitration, the parties shall have those rights of discovery as may be granted by the arbitrator in accordance with California law. (g) Any notice to the Company required or permitted hereunder shall be given in writing to the Company, either by personal service, telex, telecopier or, if by mail, by registered or certified mail return receipt requested, postage prepaid, duly addressed to the Secretary of the Company at its then principal place of business. Any such notice to Employee shall be given in a like manner, and if mailed shall be addressed to Employee at Employee's home address then shown in the files of the Company. For the purpose of determining compliance with any time limit herein, a notice shall be deemed given on the fifth day following the postmarked date, if mailed, or the date of delivery if personally delivered. (h) A waiver by either party of any term or condition of this Agreement or any breach thereof, in any one instance, shall not be deemed or construed to be a waiver of such term or condition or of any subsequent breach thereof. (i) The paragraph and subparagraph headings contained in this Agreement are solely for convenience and shall not be considered in its interpretation. (j) This Agreement may be executed in one or more counterparts, each of which shall constitute an original. IN WITNESS WHEREOF, the parties hereto have executed this Employment Agreement as of the day and year first written above. COMPANY: MAXICARE HEALTH PLANS, INC., a Delaware corporation By: /s/ Peter J. Ratican Title: Chairman, President and Chief Executive Officer EMPLOYEE: /s/ Vicki F. Perry Exhibit 10.8c EMPLOYMENT AGREEMENT This Employment Agreement ("Agreement"), dated as of January 1, 1994, is made by and between Maxicare Health Plans, Inc., a Delaware corporation (the "Company"), and Alan D. Bloom, an individual ("Employee"). R E C I T A L S --------------- WHEREAS, Employee is knowledgeable and skillful in the Company's business; WHEREAS, the Company wishes to retain the services of Employee as Senior Vice President, Secretary and General Counsel of the Company and Employee has agreed to render services as such; WHEREAS, Employee is willing to be employed by the Company under the terms and conditions set forth herein; NOW, THEREFORE, in consideration of the terms and conditions hereinafter set forth, and for other good and valuable consideration, the receipt of which is hereby acknowledged the parties hereto agree as follows: 1. DEFINITIONS. As used in this Agreement, the following capitalized terms shall have the following meanings, unless otherwise expressly provided or unless the context otherwise requires: (a) "Board of Directors" means the Board of Directors of the Company. (b) "Cause" means, as used with respect to the involuntary termination of Employee: (i) The willful and continued failure by Employee to substantially perform his duties pursuant to the terms of this Agreement without good cause; or (ii) The willful engaging by Employee in misconduct or inaction materially injurious to the Company; or (iii) The conviction of Employee for a felony or of a crime involving moral turpitude. No act, or failure to act, on the Employee's part shall be considered "willful" if done or omitted to be done by the Employee in good faith and with reasonable belief that the Employee's action or omission was in the best interest of the Company. (c) "Change of Control" means (i) the merger or consolidation of the Company with or into any other person or entity other than an affiliate or subsidiary of the Company if upon the consummation of the transaction, holders of the Company's equity securities, immediately prior to such transaction own less than fifty percent (50%) of the equity; or (ii) the sale or transfer by the Company of all or substantially all of its assets. (d) "Incapacity" means the absence of the Employee from his employment or the inability of Employee to perform his duties pursuant to this Agreement by reason of mental or physical illness, disability or incapacity for a period of thirty (30) consecutive days and such determination is based upon a certificate as to such mental or physical disability issued by a licensed physician and/or psychiatrist, as the case may be, employed by the Company. 2. EMPLOYMENT, SERVICES AND DUTIES. The Company hereby employs Employee as Senior Vice President, Secretary and General Counsel. Subject to his continued employment as such by the Board of Directors, Employee shall have and perform the duties and have the powers, authority and responsibilities ordinarily associated with a person in such position and shall be subject to the direction of the Company's Board of Directors. Employee shall render his services at such locations as the Company's Board of Directors may designate. 3. ACCEPTANCE OF EMPLOYMENT. Employee hereby accepts employment hereunder and agrees to devote his full time to the Company's business and shall in no way be involved in any activities whatsoever which might interfere with his employment with the Company. 4. COMPENSATION. As compensation for all services to be rendered by Employee hereunder, the Company agrees to provide Employee with the following: (a) BASE SALARY. The Company shall pay to Employee a base salary at the rate of $203,000.00 per annum, with such increases and bonuses, as may be determined from time to time by the Chief Executive Officer of the Company. Said salary shall be payable in equal semi-monthly installments or in such other installments as may be agreed upon between the parties. (b) STOCK OPTIONS. The Company shall grant to Employee an option (the "Stock Option") to purchase 7,500 shares of the Company's Common Stock. The Stock Option shall be granted pursuant to the terms of the Company's 1990 Stock Option Plan and a Stock Option Agreement in the form attached hereto as Exhibit A. Employee acknowledges that he is entitled to only one such Stock Option grant pursuant to this Agreement. Employee's interest in and rights to the Stock Option shall vest in accordance with the terms of the Stock Option Agreement. 5. BENEFITS. In addition to the compensation provided for in Section 4 of this Agreement, Employee shall have the right to participate in any profit-sharing, pension, life, health and accident insurance, or other employee benefit plans presently adopted or which hereafter may be adopted by the Company in a manner comparable to those offered or available to other employees of the Company. Employee shall be entitled to four (4) weeks annual vacation time, during which time his compensation will be paid in full. Unused vacation days in any year(s) may be carried over to a subsequent year(s) provided, however, the cumulative number of vacation days which may be carried over in any one year shall not exceed four (4) weeks. 6. EXPENSES. The Company shall promptly reimburse Employee for all reasonable travel, hotel, entertainment and other expenses incurred by Employee in the discharge of Employee's duties hereunder, upon receipt from Employee of vouchers, receipts or other reasonable substantiation of such expenses acceptable to the Company. 7. TERM OF EMPLOYMENT. The term of employment hereunder shall be for a period of one (1) year, commencing as of the date of this Agreement, unless earlier terminated as herein provided. This Agreement shall terminate upon the occurrence of any of the following events: (a) The death of Employee; (b) Employee voluntarily leaves the employ of the Company, with or without the consent of the Company; (c) The Incapacity of Employee; (d) The Company terminates this Agreement for Cause; (e) The Company terminates this Agreement for any reason other than as set forth in Sections 7(a), 7(c) or 7(d) hereof; or (f) The appointment of a trustee for the Company for the purpose of liquidating and winding up the Company pursuant to Chapter 7 of the Federal Bankruptcy Code. 8. COMPENSATION UPON TERMINATION. In the event this Agreement is terminated pursuant to Section 7, the Company shall pay to Employee such compensation as Employee is entitled to receive pursuant to Section 4, prorated through the date of said termination. In the event that such termination arises under Section 7(a), Employee's estate shall be entitled to receive severance compensation equal to such amount of Employee's annual base salary as would have been paid over a thirty (30) day period. In the event that such termination arises under Section 7(e), Employee shall be entitled to receive severance compensation in an amount equal to such amount of Employee's annual base salary as would have been paid over a four (4) month period. In the event that this Agreement is terminated by the Company or its successor in interest in connection with, or as a result of, a Change in Control or for any reason other than as set forth in Sections 7(a) - (d) hereof within six (6) months of a Change in Control, Employee shall, in lieu of any severance compensation payable pursuant to the immediately preceding sentence, be entitled to receive severance compensation in an amount equal to such amount of Employee's annual base salary as would have been paid over a four (4) month period. Any and all severance amounts paid pursuant to the provisions of this Section 8 shall be paid in one lump sum installment. The treatment of Employee's Stock Options shall be governed by the terms of the Company's 1990 Stock Option Plan and the Stock Option Agreement. 9. COVENANT NOT TO COMPETE. Employee covenants and agrees that during the term of his employment by the Company pursuant to this Agreement he will not, directly or indirectly, own, manage, operate, join, control or become employed by, or render any services of any advisory nature or otherwise, or participate in the ownership, management, operation or control of, any business which competes with the business of the Company or any of its affiliates. Notwithstanding the foregoing, Employee shall not be prevented from investing his assets in such form or manner as will not require any services on the part of Employee in the operation of the affairs of a company in which investments are made, provided such company is not engaged in a business competitive to the Company, or if it is in competition with the Company, provided its stock is publicly traded and Employee owns less than one percent (1%) of the outstanding stock of that company. 10. CONFIDENTIALITY. Employee covenants and agrees that he will not at any time during or after the termination of his employment by the Company reveal, divulge or make known to any person, firm or corporation any information, knowledge or data of a proprietary nature relating to the business of the Company or any of its affiliates which is not or has not become generally known or public. Employee shall hold, in a fiduciary capacity, for the benefit of the Company, all information, knowledge or data of a proprietary nature, relating to or concerned with, the operations, customers, developments, sales, business and affairs of the Company and its affiliates which is not generally known to the public and which is or was obtained by the Employee during his employment by the Company. Employee recognizes and acknowledges that all such information, knowledge or data is a valuable and unique asset of the Company and accordingly he will not discuss or divulge any such information, knowledge or data to any person, firm, partnership, corporation or organization other than to the Company, its affiliates, designees, assignees or successors or except as may otherwise be required by the law, as ordered by a court or other governmental body of competent jurisdiction, or in connection with the business and affairs of the Company. 11. EQUITABLE REMEDIES. In the event of a breach or threatened breach by Employee of any of his obligations under Sections 9 and 10 hereof, Employee acknowledges that the Company may not have an adequate remedy at law and therefore it is mutually agreed between Employee and the Company that in addition to any other remedies at law or in equity which the Company may have, the Company shall be entitled to seek in a court of law and/or equity a temporary and/or permanent injunction restraining Employee from any continuing violation or breach of this Agreement. 12. MISCELLANEOUS. (a) This Agreement shall be binding upon and inure to the benefit of the Company and any successor of the Company. This Agreement shall not be terminated by the voluntary or involuntary dissolution of the Company or by any merger, reorganization or other transaction in which the Company is not the surviving or resulting corporation or upon any transfer of all or substantially all of the assets of Company in the event of any such merger, or transfer of assets. The provisions of this Agreement shall be binding upon and shall inure to the benefit of the surviving business entity or the business entity to which such assets shall be transferred in the same manner and to the same extent that the Company would be required to perform as if no such transaction had taken place. Neither this Agreement nor any rights arising hereunder may be assigned or pledged by Employee. Employee's rights to the compensation provided for under Section 4 of this Agreement (as may be limited by Section 8 of the Agreement) and to the reimbursement for expenses under Section 6 hereof, shall continue, despite the fact that Employee may cease to be employed by the Company, and shall survive the termination of this Agreement regardless of cause. This Agreement shall inure to the benefit of and be enforceable by Employee's personal or legal representatives, executors, administrators, successors, heirs, distributees, devisees and legatees. (b) Except as otherwise provided by law or elsewhere herein, Employee shall be entitled to all benefits as set forth herein notwithstanding the occurrence of the following events: (i) any act of force majeure which materially and adversely affect the Company's business and operations, including but not limited to, the Company having sustained a material loss, whether or not insured, by reason of fire, earthquake, flood, epidemic, explosion, accident, calamity or other act of God; (ii) any strike or labor dispute or court or government action, order or decree; (iii) a banking moratorium having been declared by federal or state authorities; (iv) an outbreak of major armed conflict, blockade, embargo, or other international hostilities or restraints or orders of civic, civil defense, or military authorities, or other national or international calamity having occurred; (v) any act of public enemy, riot or civil disturbance or threat thereof; or (vi) a pending or threatened legal or governmental proceeding or action relating generally to the Company's business, or a notification having been received by the Company of the threat of any such proceeding or action, which could materially adversely affect the Company. (c) Except as expressly provided herein, this Agreement contains the entire understanding between the parties with respect to the subject matter hereof, and may not be modified, altered or amended except by an instrument in writing signed by the parties hereto. This Agreement supersedes all prior agreements of the parties with respect to the subject matter hereof. In the event of termination of employment of Employee pursuant to this Agreement, the arrangements provided for by this Agreement, by any Stock Option Agreement or other written agreement between the Company or any of its affiliates and Employee in effect at the time, and by any other applicable benefit plan of the Company or any of its affiliates, will constitute the entire obligation of the Company to the Employee and performance thereof by the Company will constitute full settlement of any and all claims, whether in contract or tort, that Employee might otherwise assert against the Company or any of its affiliates on account of such termination. (d) This Agreement shall be construed in accordance with the laws of the State of California applicable to agreements made and to be performed entirely within such state and without regard to the conflict of law principals thereof. (e) Nothing in the Agreement is intended to require or shall be construed as requiring the Company to do or fail to do any act in violation of applicable law. The Company's inability pursuant to court order to perform its obligations under this Agreement shall not constitute a breach of this Agreement. If any provision of this Agreement is invalid or unenforceable, the remainder of this Agreement shall nevertheless remain in full force and effect. If any provision is held invalid or unenforceable with respect to particular circumstances, it shall, nevertheless, remain in full force and effect in all other circumstances. (f) With the exception of disputes arising under or with respect to Sections 9 or 10 hereof, any and all disputes hereunder shall be resolved by arbitration. Any party hereto electing to commence an action shall give written notice to the other parties hereto of such election. The dispute shall be settled by arbitration in accordance with the then rules of the American Arbitration Association; provided, however, in the event the parties are unable to agree on an arbitrator within twenty (20) days after receipt of the aforementioned notice of arbitration, a single arbitrator shall be selected by the Chief Judge of the Superior Court of the State of California for the County of Los Angeles. The award of such arbitrator may be confirmed or enforced in any court of competent jurisdiction. The costs and expenses of the arbitrator, including the attorney's fees and costs of each of the parties, shall be apportioned between the parties by such arbitrator, based upon such arbitrator's determination of the merits of their respective positions. With respect to such arbitration, the parties shall have those rights of discovery as may be granted by the arbitrator in accordance with California law. (g) Any notice to the Company required or permitted hereunder shall be given in writing to the Company, either by personal service, telex, telecopier or, if by mail, by registered or certified mail return receipt requested, postage prepaid, duly addressed to the Secretary of the Company at its then principal place of business. Any such notice to Employee shall be given in a like manner, and if mailed shall be addressed to Employee at Employee's home address then shown in the files of the Company. For the purpose of determining compliance with any time limit herein, a notice shall be deemed given on the fifth day following the postmarked date, if mailed, or the date of delivery if personally delivered. (h) A waiver by either party of any term or condition of this Agreement or any breach thereof, in any one instance, shall not be deemed or construed to be a waiver of such term or condition or of any subsequent breach thereof. (i) The paragraph and subparagraph headings contained in this Agreement are solely for convenience and shall not be considered in its interpretation. (j) This Agreement may be executed in one or more counterparts, each of which shall constitute an original. IN WITNESS WHEREOF, the parties hereto have executed this Employment Agreement as of the day and year first written above. COMPANY: MAXICARE HEALTH PLANS, INC., a Delaware corporation By: /s/ Peter J. Ratican Title: Chairman, President and Chief Executive Officer EMPLOYEE: /s/ Alan D. Bloom Exhibit 10.12d EMPLOYMENT AGREEMENT This Employment Agreement ("Agreement"), dated as of January 1, 1994, is made by and between Maxicare Health Plans, Inc., a Delaware corporation (the "Company"), and Aivars Jerumanis, an individual ("Employee"). R E C I T A L S --------------- WHEREAS, Employee is knowledgeable and skillful in the Company's business; WHEREAS, the Company wishes to retain the services of Employee as Senior Vice President, Chief Information Officer of the Company and Employee has agreed to render services as such; WHEREAS, Employee is willing to be employed by the Company under the terms and conditions set forth herein; NOW, THEREFORE, in consideration of the terms and conditions hereinafter set forth, and for other good and valuable consideration, the receipt of which is hereby acknowledged the parties hereto agree as follows: 1. DEFINITIONS. As used in this Agreement, the following capitalized terms shall have the following meanings, unless otherwise expressly provided or unless the context otherwise requires: (a) "Board of Directors" means the Board of Directors of the Company. (b) "Cause" means, as used with respect to the involuntary termination of Employee: (i) The willful and continued failure by Employee to substantially perform his duties pursuant to the terms of this Agreement without good cause; or (ii) The willful engaging by Employee in misconduct or inaction materially injurious to the Company; or (iii) The conviction of Employee for a felony or of a crime involving moral turpitude. No act, or failure to act, on the Employee's part shall be considered "willful" if done or omitted to be done by the Employee in good faith and with reasonable belief that the Employee's action or omission was in the best interest of the Company. (c) "Change of Control" means (i) the merger or consolidation of the Company with or into any other person or entity other than an affiliate or subsidiary of the Company if upon the consummation of the transaction, holders of the Company's equity securities, immediately prior to such transaction own less than fifty percent (50%) of the equity; or (ii) the sale or transfer by the Company of all or substantially all of its assets. (d) "Incapacity" means the absence of the Employee from his employment or the inability of Employee to perform his duties pursuant to this Agreement by reason of mental or physical illness, disability or incapacity for a period of thirty (30) consecutive days and such determination is based upon a certificate as to such mental or physical disability issued by a licensed physician and/or psychiatrist, as the case may be, employed by the Company. 2. EMPLOYMENT, SERVICES AND DUTIES. The Company hereby employs Employee as Senior Vice President, Chief Information Officer. Subject to his continued employment as such by the Board of Directors, Employee shall have and perform the duties and have the powers, authority and responsibilities ordinarily associated with a person in such position and shall be subject to the direction of the Company's Board of Directors. Employee shall render his services at such locations as the Company's Board of Directors may designate. 3. ACCEPTANCE OF EMPLOYMENT. Employee hereby accepts employment hereunder and agrees to devote his full time to the Company's business and shall in no way be involved in any activities whatsoever which might interfere with his employment with the Company. 4. COMPENSATION. As compensation for all services to be rendered by Employee hereunder, the Company agrees to provide Employee with the following: (a) BASE SALARY. The Company shall pay to Employee a base salary at the rate of $185,000.00 per annum, with such increases and bonuses, as may be determined from time to time by the Chief Executive Officer of the Company. Said salary shall be payable in equal semi-monthly installments or in such other installments as may be agreed upon between the parties. (b) STOCK OPTIONS. The Company shall grant to Employee an option (the "Stock Option") to purchase 5,000 shares of the Company's Common Stock. The Stock Option shall be granted pursuant to the terms of the Company's 1990 Stock Option Plan and a Stock Option Agreement in the form attached hereto as Exhibit A. Employee acknowledges that he is entitled to only one such Stock Option grant pursuant to this Agreement. Employee's interest in and rights to the Stock Option shall vest in accordance with the terms of the Stock Option Agreement. 5. BENEFITS. In addition to the compensation provided for in Section 4 of this Agreement, Employee shall have the right to participate in any profit-sharing, pension, life, health and accident insurance, or other employee benefit plans presently adopted or which hereafter may be adopted by the Company in a manner comparable to those offered or available to other employees of the Company. Employee shall be entitled to three (3) weeks annual vacation time, during which time his compensation will be paid in full. Unused vacation days in any year(s) may be carried over to a subsequent year(s) provided, however, the cumulative number of vacation days which may be carried over in any one year shall not exceed three (3) weeks. 6. EXPENSES. The Company shall promptly reimburse Employee for all reasonable travel, hotel, entertainment and other expenses incurred by Employee in the discharge of Employee's duties hereunder, upon receipt from Employee of vouchers, receipts or other reasonable substantiation of such expenses acceptable to the Company. 7. TERM OF EMPLOYMENT. The term of employment hereunder shall be for a period of one (1) year, commencing as of the date of this Agreement, unless earlier terminated as herein provided. This Agreement shall terminate upon the occurrence of any of the following events: (a) The death of Employee; (b) Employee voluntarily leaves the employ of the Company, with or without the consent of the Company; (c) The Incapacity of Employee; (d) The Company terminates this Agreement for Cause; (e) The Company terminates this Agreement for any reason other than as set forth in Sections 7(a), 7(c) or 7(d) hereof; or (f) The appointment of a trustee for the Company for the purpose of liquidating and winding up the Company pursuant to Chapter 7 of the Federal Bankruptcy Code. 8. COMPENSATION UPON TERMINATION. In the event this Agreement is terminated pursuant to Section 7, the Company shall pay to Employee such compensation as Employee is entitled to receive pursuant to Section 4, prorated through the date of said termination. In the event that such termination arises under Section 7(a), Employee's estate shall be entitled to receive severance compensation equal to such amount of Employee's annual base salary as would have been paid over a thirty (30) day period. In the event that such termination arises under Section 7(e), Employee shall be entitled to receive severance compensation in an amount equal to such amount of Employee's annual base salary as would have been paid over a four (4) month period. In the event that this Agreement is terminated by the Company or its successor in interest in connection with, or as a result of, a Change in Control or for any reason other than as set forth in Sections 7(a) - (d) hereof within six (6) months of a Change in Control, Employee shall, in lieu of any severance compensation payable pursuant to the immediately preceding sentence, be entitled to receive severance compensation in an amount equal to such amount of Employee's annual base salary as would have been paid over a four (4) month period. Any and all severance amounts paid pursuant to the provisions of this Section 8 shall be paid in one lump sum installment. The treatment of Employee's Stock Options shall be governed by the terms of the Company's 1990 Stock Option Plan and the Stock Option Agreement. 9. COVENANT NOT TO COMPETE. Employee covenants and agrees that during the term of his employment by the Company pursuant to this Agreement he will not, directly or indirectly, own, manage, operate, join, control or become employed by, or render any services of any advisory nature or otherwise, or participate in the ownership, management, operation or control of, any business which competes with the business of the Company or any of its affiliates. Notwithstanding the foregoing, Employee shall not be prevented from investing his assets in such form or manner as will not require any services on the part of Employee in the operation of the affairs of a company in which investments are made, provided such company is not engaged in a business competitive to the Company, or if it is in competition with the Company, provided its stock is publicly traded and Employee owns less than one percent (1%) of the outstanding stock of that company. 10. CONFIDENTIALITY. Employee covenants and agrees that he will not at any time during or after the termination of his employment by the Company reveal, divulge or make known to any person, firm or corporation any information, knowledge or data of a proprietary nature relating to the business of the Company or any of its affiliates which is not or has not become generally known or public. Employee shall hold, in a fiduciary capacity, for the benefit of the Company, all information, knowledge or data of a proprietary nature, relating to or concerned with, the operations, customers, developments, sales, business and affairs of the Company and its affiliates which is not generally known to the public and which is or was obtained by the Employee during his employment by the Company. Employee recognizes and acknowledges that all such information, knowledge or data is a valuable and unique asset of the Company and accordingly he will not discuss or divulge any such information, knowledge or data to any person, firm, partnership, corporation or organization other than to the Company, its affiliates, designees, assignees or successors or except as may otherwise be required by the law, as ordered by a court or other governmental body of competent jurisdiction, or in connection with the business and affairs of the Company. 11. EQUITABLE REMEDIES. In the event of a breach or threatened breach by Employee of any of his obligations under Sections 9 and 10 hereof, Employee acknowledges that the Company may not have an adequate remedy at law and therefore it is mutually agreed between Employee and the Company that in addition to any other remedies at law or in equity which the Company may have, the Company shall be entitled to seek in a court of law and/or equity a temporary and/or permanent injunction restraining Employee from any continuing violation or breach of this Agreement. 12. MISCELLANEOUS. (a) This Agreement shall be binding upon and inure to the benefit of the Company and any successor of the Company. This Agreement shall not be terminated by the voluntary or involuntary dissolution of the Company or by any merger, reorganization or other transaction in which the Company is not the surviving or resulting corporation or upon any transfer of all or substantially all of the assets of Company in the event of any such merger, or transfer of assets. The provisions of this Agreement shall be binding upon and shall inure to the benefit of the surviving business entity or the business entity to which such assets shall be transferred in the same manner and to the same extent that the Company would be required to perform as if no such transaction had taken place. Neither this Agreement nor any rights arising hereunder may be assigned or pledged by Employee. Employee's rights to the compensation provided for under Section 4 of this Agreement (as may be limited by Section 8 of the Agreement) and to the reimbursement for expenses under Section 6 hereof, shall continue, despite the fact that Employee may cease to be employed by the Company, and shall survive the termination of this Agreement regardless of cause. This Agreement shall inure to the benefit of and be enforceable by Employee's personal or legal representatives, executors, administrators, successors, heirs, distributees, devisees and legatees. (b) Except as otherwise provided by law or elsewhere herein, Employee shall be entitled to all benefits as set forth herein notwithstanding the occurrence of the following events: (i) any act of force majeure which materially and adversely affect the Company's business and operations, including but not limited to, the Company having sustained a material loss, whether or not insured, by reason of fire, earthquake, flood, epidemic, explosion, accident, calamity or other act of God; (ii) any strike or labor dispute or court or government action, order or decree; (iii) a banking moratorium having been declared by federal or state authorities; (iv) an outbreak of major armed conflict, blockade, embargo, or other international hostilities or restraints or orders of civic, civil defense, or military authorities, or other national or international calamity having occurred; (v) any act of public enemy, riot or civil disturbance or threat thereof; or (vi) a pending or threatened legal or governmental proceeding or action relating generally to the Company's business, or a notification having been received by the Company of the threat of any such proceeding or action, which could materially adversely affect the Company. (c) Except as expressly provided herein, this Agreement contains the entire understanding between the parties with respect to the subject matter hereof, and may not be modified, altered or amended except by an instrument in writing signed by the parties hereto. This Agreement supersedes all prior agreements of the parties with respect to the subject matter hereof. In the event of termination of employment of Employee pursuant to this Agreement, the arrangements provided for by this Agreement, by any Stock Option Agreement or other written agreement between the Company or any of its affiliates and Employee in effect at the time, and by any other applicable benefit plan of the Company or any of its affiliates, will constitute the entire obligation of the Company to the Employee and performance thereof by the Company will constitute full settlement of any and all claims, whether in contract or tort, that Employee might otherwise assert against the Company or any of its affiliates on account of such termination. (d) This Agreement shall be construed in accordance with the laws of the State of California applicable to agreements made and to be performed entirely within such state and without regard to the conflict of law principals thereof. (e) Nothing in the Agreement is intended to require or shall be construed as requiring the Company to do or fail to do any act in violation of applicable law. The Company's inability pursuant to court order to perform its obligations under this Agreement shall not constitute a breach of this Agreement. If any provision of this Agreement is invalid or unenforceable, the remainder of this Agreement shall nevertheless remain in full force and effect. If any provision is held invalid or unenforceable with respect to particular circumstances, it shall, nevertheless, remain in full force and effect in all other circumstances. (f) With the exception of disputes arising under or with respect to Sections 9 or 10 hereof, any and all disputes hereunder shall be resolved by arbitration. Any party hereto electing to commence an action shall give written notice to the other parties hereto of such election. The dispute shall be settled by arbitration in accordance with the then rules of the American Arbitration Association; provided, however, in the event the parties are unable to agree on an arbitrator within twenty (20) days after receipt of the aforementioned notice of arbitration, a single arbitrator shall be selected by the Chief Judge of the Superior Court of the State of California for the County of Los Angeles. The award of such arbitrator may be confirmed or enforced in any court of competent jurisdiction. The costs and expenses of the arbitrator, including the attorney's fees and costs of each of the parties, shall be apportioned between the parties by such arbitrator, based upon such arbitrator's determination of the merits of their respective positions. With respect to such arbitration, the parties shall have those rights of discovery as may be granted by the arbitrator in accordance with California law. (g) Any notice to the Company required or permitted hereunder shall be given in writing to the Company, either by personal service, telex, telecopier or, if by mail, by registered or certified mail return receipt requested, postage prepaid, duly addressed to the Secretary of the Company at its then principal place of business. Any such notice to Employee shall be given in a like manner, and if mailed shall be addressed to Employee at Employee's home address then shown in the files of the Company. For the purpose of determining compliance with any time limit herein, a notice shall be deemed given on the fifth day following the postmarked date, if mailed, or the date of delivery if personally delivered. (h) A waiver by either party of any term or condition of this Agreement or any breach thereof, in any one instance, shall not be deemed or construed to be a waiver of such term or condition or of any subsequent breach thereof. (i) The paragraph and subparagraph headings contained in this Agreement are solely for convenience and shall not be considered in its interpretation. (j) This Agreement may be executed in one or more counterparts, each of which shall constitute an original. IN WITNESS WHEREOF, the parties hereto have executed this Employment Agreement as of the day and year first written above. COMPANY: MAXICARE HEALTH PLANS, INC., a Delaware corporation By: /s/ Peter J. Ratican Title: Chairman, President and Chief Executive Officer EMPLOYEE: /s/ Aivars Jerumanis Exhibit 10.48a EMPLOYMENT AGREEMENT This Employment Agreement ("Agreement"), dated as of January 1, 1994, is made by and between MAXICARE, a California corporation (the "Company"), and William B. Caswell, an individual ("Employee"). R E C I T A L S --------------- WHEREAS, Employee is knowledgeable and skillful in the Company's business; WHEREAS, the Company wishes to retain the services of Employee as Vice President - General Manager of the Company and Employee has agreed to render services as such; WHEREAS, Employee is willing to be employed by the Company under the terms and conditions set forth herein; NOW, THEREFORE, in consideration of the terms and conditions hereinafter set forth, and for other good and valuable consideration, the receipt of which is hereby acknowledged the parties hereto agree as follows: 1. DEFINITIONS. As used in this Agreement, the following capitalized terms shall have the following meanings, unless otherwise expressly provided or unless the context otherwise requires: (a) "Board of Directors" means the Board of Directors of the Company. (b) "Cause" means, as used with respect to the involuntary termination of Employee: (i) The willful and continued failure by Employee to substantially perform his duties pursuant to the terms of this Agreement without good cause; or (ii) The willful engaging by Employee in misconduct or inaction materially injurious to the Company; or (iii) The conviction of Employee for a felony or of a crime involving moral turpitude. No act, or failure to act, on the Employee's part shall be considered "willful" if done or omitted to be done by the Employee in good faith and with reasonable belief that the Employee's action or omission was in the best interest of the Company. (c) "Change of Control" means (i) the merger or consolidation of the Company or the Company's parent, Maxicare Health Plans, Inc., a Delaware corporation ("Maxicare") with or into any other person or entity other than an affiliate or subsidiary of the Company or Maxicare, as the case may be, if upon the consummation of the transaction, holders of Maxicare's or the Company's equity securities, as the case may be, immediately prior to such transaction own less than fifty percent (50%) of the equity securities of the surviving or consolidated entity; or (ii) the sale or transfer by the Company or Maxicare of all or substantially all of their respective assets. (d) "Incapacity" means the absence of the Employee from his employment or the inability of Employee to perform his duties pursuant to this Agreement by reason of mental or physical illness, disability or incapacity for a period of forty-five (45) consecutive days and such determination is based upon a certificate as to such mental or physical disability issued by a licensed physician and/or psychiatrist, as the case may be, employed by the Company. 2. EMPLOYMENT, SERVICES AND DUTIES. The Company hereby employs Employee as Vice President - General Manager. Subject to his continued employment as such by the Board of Directors or the President of the Company, Employee shall have and perform the duties and have the powers, authority and responsibilities ordinarily associated with a person in such position and shall be subject to the direction of the Company's Board of Directors and the President of the Company or such other person(s) as they may designate. Employee shall render his services at such locations as the Company's Board of Directors or the President of the Company may designate. 3. ACCEPTANCE OF EMPLOYMENT. Employee hereby accepts employment hereunder and agrees to devote his full time to the Company's business and shall in no way be involved in any activities whatsoever which might interfere with his employment with the Company. 4. COMPENSATION. As compensation for all services to be rendered by Employee hereunder, the Company agrees to provide Employee with the following: (a) BASE SALARY. The Company shall pay to Employee an initial base salary at the rate of $195,000 per annum, with such increases and bonuses, as may be determined from time to time by the Board of Directors of the Company. Said salary shall be payable in equal semi-monthly installments or in such other installments as may be agreed upon between the parties. (b) STOCK OPTIONS. The Company shall grant to Employee an option (the "Stock Option") to purchase 10,000 shares of Maxicare's Common Stock. The Stock Option shall be granted pursuant to the terms of Maxicare's 1990 Stock Option Plan and a Stock Option Agreement in the form attached hereto as Exhibit A. Employee acknowledges that he is entitled to only one such Stock Option grant pursuant to this Agreement. Employee's interest in and rights to the Stock Option shall vest in accordance with the terms of the Stock Option Agreement. 5. BENEFITS. In addition to the compensation provided for in Section 4 of this Agreement, Employee shall receive an automobile allowance in the amount of $275.00 per month and shall have the right to participate in any profit-sharing, pension, life, health and accident insurance, or other employee benefit plans presently adopted or which hereafter may be adopted by the Company in a manner comparable to those offered or available to other comparatively situated executives of the Company. Employee shall be entitled to three (3) weeks annual vacation time, during which time his compensation will be paid in full. Unused vacation days in any year(s) may be carried over to a subsequent year(s) provided, however, the cumulative number of vacation days which may be carried over in any one year shall not exceed three (3) weeks. 6. EXPENSES. The Company shall promptly reimburse Employee for all reasonable travel, hotel, entertainment and other expenses incurred by Employee in the discharge of Employee's duties hereunder, including parking, the cost of purchase, installation and operation of a car phone, upon receipt from Employee of vouchers, receipts or other reasonable substantiation of such expenses acceptable to the Company. 7. TERM OF EMPLOYMENT. The term of employment hereunder shall be for a period of two (2) years, commencing as of the date of this Agreement, unless earlier terminated as herein provided. This Agreement shall terminate upon the occurrence of any of the following events: (a) The death of Employee; (b) Employee voluntarily leaves the employ of the Company, with or without the consent of the Company; (c) The Incapacity of Employee; (d) The Company terminates this Agreement for Cause; (e) The Company terminates this Agreement for any reason other than as set forth in Sections 7(a), 7(c) or 7(d) hereof; or (f) The appointment of a trustee for the Company for the purpose of liquidating and winding up the Company pursuant to Chapter 7 of the Federal Bankruptcy Code. Subject to the provisions of 7(a) through (f) above, in the event the Company, in its sole discretion, wishes to engage Employee's services beyond the term of this Agreement, the Company agrees to notify Employee, in writing, no less than 120 days prior to the expiration of the term hereof, of the terms and conditions of such proposed ongoing employment. 8. COMPENSATION UPON TERMINATION. In the event this Agreement is terminated pursuant to Section 7, the Company shall pay to Employee such compensation as Employee is entitled to receive pursuant to Section 4 and vacation benefits pursuant to Section 5, prorated through the date of said termination. In the event that such termination arises under Section 7(a), Employee's estate shall be entitled to receive severance compensation equal to such amount of Employee's annual base salary as would have been paid over a thirty (30) day period. In the event that such termination arises under Section 7(e), (i) prior to the first anniversary of the date of this Agreement, Employee shall be entitled to receive severance compensation in an amount equal to Employee's annual base salary; or (ii) on or after the first anniversary of the date of this Agreement, Employee shall be entitled to receive severance compensation equal to the amount of the remainder of Employee's annual base salary as would have been paid had this Agreement not been terminated which amount shall in no event be less than Employee's annual base for a six (6) month period. In the event that this Agreement is terminated by the Company or its successor in interest in connection with, or as a result of, a Change in Control or for any reason other than as set forth in Sections 7(a) - (d) hereof within six (6) months of a Change in Control, Employee shall be entitled to receive severance compensation in an amount equal to Employee's annual base salary. Any and all severance amounts paid pursuant to the provisions of this Section 8 shall be paid in one lump sum installment. The treatment of Employee's Stock Options shall be governed by the terms of Maxicare's 1990 Stock Option Plan and the Stock Option Agreement. 9. COVENANT NOT TO COMPETE. Employee covenants and agrees that during the term of this Agreement he will not, directly or indirectly, own, manage, operate, join, control or become employed by, or render any services of any advisory nature or otherwise, or participate in the ownership, management, operation or control of, any business which competes with the business of the Company or any of its affiliates. Notwithstanding the foregoing, Employee shall not be prevented from investing his assets in such form or manner as will not require any services on the part of Employee in the operation of the affairs of a company in which investments are made, provided such company is not engaged in a business competitive to the Company, or if it is in competition with the Company, provided its stock is publicly traded and Employee owns less than one percent (1%) of the outstanding stock of that company. 10. CONFIDENTIALITY. Employee covenants and agrees that he will not at any time during or after the termination of his employment by the Company reveal, divulge or make known to any person, firm or corporation any information, knowledge or data of a proprietary nature relating to the business of the Company or any of its affiliates which is not or has not become generally known or public. Employee shall hold, in a fiduciary capacity, for the benefit of the Company, all information, knowledge or data of a proprietary nature, relating to or concerned with, the operations, customers, developments, sales, business and affairs of the Company and its affiliates which is not generally known to the public and which is or was obtained by the Employee during his employment by the Company. Employee recognizes and acknowledges that all such information, knowledge or data is a valuable and unique asset of the Company and accordingly he will not discuss or divulge any such information, knowledge or data to any person, firm, partnership, corporation or organization other than to the Company, its affiliates, designees, assignees or successors or except as may otherwise be required by the law, as ordered by a court or other governmental body of competent jurisdiction, or in connection with the business and affairs of the Company. 11. EQUITABLE REMEDIES. In the event of a breach or threatened breach by Employee of any of his obligations under Sections 9 and 10 hereof, Employee acknowledges that the Company may not have an adequate remedy at law and therefore it is mutually agreed between Employee and the Company that in addition to any other remedies at law or in equity which the Company may have, the Company shall be entitled to seek in a court of law and/or equity a temporary and/or permanent injunction restraining Employee from any continuing violation or breach of this Agreement. 12. MISCELLANEOUS. (a) This Agreement shall be binding upon and inure to the benefit of the Company and any successor of the Company. This Agreement shall not be terminated by the voluntary or involuntary dissolution of the Company or by any merger, reorganization or other transaction in which the Company is not the surviving or resulting corporation or upon any transfer of all or substantially all of the assets of Company in the event of any such merger, or transfer of assets. The provisions of this Agreement shall be binding upon and shall inure to the benefit of the surviving business entity or the business entity to which such assets shall be transferred in the same manner and to the same extent that the Company would be required to perform it if no such transaction had taken place. Neither this Agreement nor any rights arising hereunder may be assigned or pledged by Employee. Employee's rights to the compensation provided for under Section 4 of this Agreement (as may be limited by Section 8 of the Agreement) and to the reimbursement for expenses under Section 6 hereof, shall continue, despite the fact that Employee may cease to be employed by the Company, and shall survive the termination of this Agreement regardless of cause. This Agreement shall inure to the benefit of and be enforceable by Employee's personal or legal representatives, executors, administrators, successors, heirs, distributees, devisees and legatees. (b) Except as otherwise provided by law or elsewhere herein, Employee shall be entitled to all benefits as set forth herein notwithstanding the occurrence of the following events: (i) any act of force majeure which materially and adversely affect the Company's business and operations, including but not limited to, the Company having sustained a material loss, whether or not insured, by reason of fire, earthquake, flood, epidemic, explosion, accident, calamity or other act of God; (ii) any strike or labor dispute or court or government action, order or decree; (iii) a banking moratorium having been declared by federal or state authorities; (iv) an outbreak of major armed conflict, blockade, embargo, or other international hostilities or restraints or orders of civic, civil defense, or military authorities, or other national or international calamity having occurred; (v) any act of public enemy, riot or civil disturbance or threat thereof; or (vi) a pending or threatened legal or governmental proceeding or action relating generally to the Company's business, or a notification having been received by the Company of the threat of any such proceeding or action, which could materially adversely affect the Company. (c) Except as expressly provided herein, this Agreement contains the entire understanding between the parties with respect to the subject matter hereof, and may not be modified, altered or amended except by an instrument in writing signed by the parties hereto. This Agreement supersedes all prior agreements of the parties with respect to the subject matter hereof. In the event of termination of employment of Employee pursuant to this Agreement, the arrangements provided for by this Agreement, by any Stock Option Agreement or other written agreement between the Company or any of its affiliates and Employee in effect at the time, and by any other applicable benefit plan of the Company or any of its affiliates, will constitute the entire obligation of the Company to the Employee and performance thereof by the Company will constitute full settlement of any and all claims, whether in contract or tort, that Employee might otherwise assert against the Company or any of its affiliates on account of such termination. (d) This Agreement shall be construed in accordance with the laws of the State of California applicable to agreements made and to be performed entirely within such state and without regard to the conflict of law principals thereof. (e) Nothing in the Agreement is intended to require or shall be construed as requiring the Company to do or fail to do any act in violation of applicable law. The Company's inability pursuant to court order to perform its obligations under this Agreement shall not constitute a breach of this Agreement. If any provision of this Agreement is invalid or unenforceable, the remainder of this Agreement shall nevertheless remain in full force and effect. If any provision is held invalid or unenforceable with respect to particular circumstances, it shall, nevertheless, remain in full force and effect in all other circumstances. (f) With the exception of disputes arising under or with respect to Sections 9 or 10 hereof, any and all disputes hereunder shall be resolved by arbitration. Any party hereto electing to commence an action shall give written notice to the other parties hereto of such election. The dispute shall be settled by arbitration in accordance with the then rules of the American Arbitration Association; provided, however, in the event the parties are unable to agree on an arbitrator within twenty (20) days after receipt of the aforementioned notice of arbitration, a single arbitrator shall be selected by the Chief Judge of the Superior Court of the State of California for the County of Los Angeles. The award of such arbitrator may be confirmed or enforced in any court of competent jurisdiction. The costs and expenses of the arbitrator, including the attorney's fees and costs of each of the parties, shall be apportioned between the parties by such arbitrator, based upon such arbitrator's determination of the merits of their respective positions. With respect to such arbitration, the parties shall have those rights of discovery as may be granted by the arbitrator in accordance with California law. (g) Any notice to the Company required or permitted hereunder shall be given in writing to the Company, either by personal service, telex, telecopier or, if by mail, by registered or certified mail return receipt requested, postage prepaid, duly addressed to the Secretary of the Company at its then principal place of business. Any such notice to Employee shall be given in a like manner, and if mailed shall be addressed to Employee at Employee's home address then shown in the files of the Company. For the purpose of determining compliance with any time limit herein, a notice shall be deemed given on the fifth day following the postmarked date, if mailed, or the date of delivery if personally delivered. (h) A waiver by either party of any term or condition of this Agreement or any breach thereof, in any one instance, shall not be deemed or construed to be a waiver of such term or condition or of any subsequent breach thereof. (i) The paragraph and subparagraph headings contained in this Agreement are solely for convenience and shall not be considered in its interpretation. (j) This Agreement may be executed in one or more counterparts, each of which shall constitute an original. IN WITNESS WHEREOF, the parties hereto have executed this Employment Agreement as of the day and year first written above. COMPANY: MAXICARE, a California Corporation By: /s/ Peter J. Ratican Title: Chairman, President and Chief Executive Officer EMPLOYEE: /s/ William B. Caswell Exhibit 10.51c EMPLOYMENT AGREEMENT This Employment Agreement ("Agreement"), dated as of January 1, 1994, is made by and between Maxicare Health Plans, Inc., a Delaware corporation (the "Company"), and Robert Landis, an individual ("Employee"). R E C I T A L S --------------- WHEREAS, Employee is knowledgeable and skillful in the Company's business; WHEREAS, the Company wishes to retain the services of Employee as Treasurer of the Company and Employee has agreed to render services as such; WHEREAS, Employee is willing to be employed by the Company under the terms and conditions set forth herein; NOW, THEREFORE, in consideration of the terms and conditions hereinafter set forth, and for other good and valuable consideration, the receipt of which is hereby acknowledged the parties hereto agree as follows: 1. DEFINITIONS. As used in this Agreement, the following capitalized terms shall have the following meanings, unless otherwise expressly provided or unless the context otherwise requires: (a) "Board of Directors" means the Board of Directors of the Company. (b) "Cause" means, as used with respect to the involuntary termination of Employee: (i) The willful and continued failure by Employee to substantially perform his duties pursuant to the terms of this Agreement without good cause; or (ii) The willful engaging by Employee in misconduct or inaction materially injurious to the Company; or (iii) The conviction of Employee for a felony or of a crime involving moral turpitude. No act, or failure to act, on the Employee's part shall be considered "willful" if done or omitted to be done by the Employee in good faith and with reasonable belief that the Employee's action or omission was in the best interest of the Company. (c) "Change of Control" means (i) the merger or consolidation of the Company with or into any other person or entity other than an affiliate or subsidiary of the Company if upon the consummation of the transaction, holders of the Company's equity securities, immediately prior to such transaction own less than fifty percent (50%) of the equity; or (ii) the sale or transfer by the Company of all or substantially all of its assets. (d) "Incapacity" means the absence of the Employee from his employment or the inability of Employee to perform his duties pursuant to this Agreement by reason of mental or physical illness, disability or incapacity for a period of thirty (30) consecutive days and such determination is based upon a certificate as to such mental or physical disability issued by a licensed physician and/or psychiatrist, as the case may be, employed by the Company. 2. EMPLOYMENT, SERVICES AND DUTIES. The Company hereby employs Employee as Treasurer. Subject to his continued employment as such by the Board of Directors, Employee shall have and perform the duties and have the powers, authority and responsibilities ordinarily associated with a person in such position and shall be subject to the direction of the Company's Board of Directors. Employee shall render his services at such locations as the Company's Board of Directors may designate. 3. ACCEPTANCE OF EMPLOYMENT. Employee hereby accepts employment hereunder and agrees to devote his full time to the Company's business and shall in no way be involved in any activities whatsoever which might interfere with his employment with the Company. 4. COMPENSATION. As compensation for all services to be rendered by Employee hereunder, the Company agrees to provide Employee with the following: (a) BASE SALARY. The Company shall pay to Employee a base salary at the rate of $150,000.00 per annum, with such increases and bonuses, as may be determined from time to time by the Chief Executive Officer of the Company. Said salary shall be payable in equal semi-monthly installments or in such other installments as may be agreed upon between the parties. (b) STOCK OPTIONS. The Company shall grant to Employee an option (the "Stock Option") to purchase 10,000 shares of the Company's Common Stock. The Stock Option shall be granted pursuant to the terms of the Company's 1990 Stock Option Plan and a Stock Option Agreement in the form attached hereto as Exhibit A. Employee acknowledges that he is entitled to only one such Stock Option grant pursuant to this Agreement. Employee's interest in and rights to the Stock Option shall vest in accordance with the terms of the Stock Option Agreement. 5. BENEFITS. In addition to the compensation provided for in Section 4 of this Agreement, Employee shall have the right to participate in any profit-sharing, pension, life, health and accident insurance, or other employee benefit plans presently adopted or which hereafter may be adopted by the Company in a manner comparable to those offered or available to other employees of the Company. Employee shall be entitled to four (4) weeks annual vacation time, during which time his compensation will be paid in full. Unused vacation days in any year(s) may be carried over to a subsequent year(s) provided, however, the cumulative number of vacation days which may be carried over in any one year shall not exceed four (4) weeks. 6. EXPENSES. The Company shall promptly reimburse Employee for all reasonable travel, hotel, entertainment and other expenses incurred by Employee in the discharge of Employee's duties hereunder, upon receipt from Employee of vouchers, receipts or other reasonable substantiation of such expenses acceptable to the Company. 7. TERM OF EMPLOYMENT. The term of employment hereunder shall be for a period of one (1) year, commencing as of the date of this Agreement, unless earlier terminated as herein provided. This Agreement shall terminate upon the occurrence of any of the following events: (a) The death of Employee; (b) Employee voluntarily leaves the employ of the Company, with or without the consent of the Company; (c) The Incapacity of Employee; (d) The Company terminates this Agreement for Cause; (e) The Company terminates this Agreement for any reason other than as set forth in Sections 7(a), 7(c) or 7(d) hereof; or (f) The appointment of a trustee for the Company for the purpose of liquidating and winding up the Company pursuant to Chapter 7 of the Federal Bankruptcy Code. 8. COMPENSATION UPON TERMINATION. In the event this Agreement is terminated pursuant to Section 7, the Company shall pay to Employee such compensation as Employee is entitled to receive pursuant to Section 4, prorated through the date of said termination. In the event that such termination arises under Section 7(a), Employee's estate shall be entitled to receive severance compensation equal to such amount of Employee's annual base salary as would have been paid over a thirty (30) day period. In the event that such termination arises under Section 7(e), Employee shall be entitled to receive severance compensation in an amount equal to such amount of Employee's annual base salary as would have been paid over a four (4) month period. In the event that this Agreement is terminated by the Company or its successor in interest in connection with, or as a result of, a Change in Control or for any reason other than as set forth in Sections 7(a) - (d) hereof within six (6) months of a Change in Control, Employee shall, in lieu of any severance compensation payable pursuant to the immediately preceding sentence, be entitled to receive severance compensation in an amount equal to such amount of Employee's annual base salary as would have been paid over a four (4) month period. Any and all severance amounts paid pursuant to the provisions of this Section 8 shall be paid in one lump sum installment. The treatment of Employee's Stock Options shall be governed by the terms of the Company's 1990 Stock Option Plan and the Stock Option Agreement. 9. COVENANT NOT TO COMPETE. Employee covenants and agrees that during the term of his employment by the Company pursuant to this Agreement he will not, directly or indirectly, own, manage, operate, join, control or become employed by, or render any services of any advisory nature or otherwise, or participate in the ownership, management, operation or control of, any business which competes with the business of the Company or any of its affiliates. Notwithstanding the foregoing, Employee shall not be prevented from investing his assets in such form or manner as will not require any services on the part of Employee in the operation of the affairs of a company in which investments are made, provided such company is not engaged in a business competitive to the Company, or if it is in competition with the Company, provided its stock is publicly traded and Employee owns less than one percent (1%) of the outstanding stock of that company. 10. CONFIDENTIALITY. Employee covenants and agrees that he will not at any time during or after the termination of his employment by the Company reveal, divulge or make known to any person, firm or corporation any information, knowledge or data of a proprietary nature relating to the business of the Company or any of its affiliates which is not or has not become generally known or public. Employee shall hold, in a fiduciary capacity, for the benefit of the Company, all information, knowledge or data of a proprietary nature, relating to or concerned with, the operations, customers, developments, sales, business and affairs of the Company and its affiliates which is not generally known to the public and which is or was obtained by the Employee during his employment by the Company. Employee recognizes and acknowledges that all such information, knowledge or data is a valuable and unique asset of the Company and accordingly he will not discuss or divulge any such information, knowledge or data to any person, firm, partnership, corporation or organization other than to the Company, its affiliates, designees, assignees or successors or except as may otherwise be required by the law, as ordered by a court or other governmental body of competent jurisdiction, or in connection with the business and affairs of the Company. 11. EQUITABLE REMEDIES. In the event of a breach or threatened breach by Employee of any of his obligations under Sections 9 and 10 hereof, Employee acknowledges that the Company may not have an adequate remedy at law and therefore it is mutually agreed between Employee and the Company that in addition to any other remedies at law or in equity which the Company may have, the Company shall be entitled to seek in a court of law and/or equity a temporary and/or permanent injunction restraining Employee from any continuing violation or breach of this Agreement. 12. MISCELLANEOUS. (a) This Agreement shall be binding upon and inure to the benefit of the Company and any successor of the Company. This Agreement shall not be terminated by the voluntary or involuntary dissolution of the Company or by any merger, reorganization or other transaction in which the Company is not the surviving or resulting corporation or upon any transfer of all or substantially all of the assets of Company in the event of any such merger, or transfer of assets. The provisions of this Agreement shall be binding upon and shall inure to the benefit of the surviving business entity or the business entity to which such assets shall be transferred in the same manner and to the same extent that the Company would be required to perform as if no such transaction had taken place. Neither this Agreement nor any rights arising hereunder may be assigned or pledged by Employee. Employee's rights to the compensation provided for under Section 4 of this Agreement (as may be limited by Section 8 of the Agreement) and to the reimbursement for expenses under Section 6 hereof, shall continue, despite the fact that Employee may cease to be employed by the Company, and shall survive the termination of this Agreement regardless of cause. This Agreement shall inure to the benefit of and be enforceable by Employee's personal or legal representatives, executors, administrators, successors, heirs, distributees, devisees and legatees. (b) Except as otherwise provided by law or elsewhere herein, Employee shall be entitled to all benefits as set forth herein notwithstanding the occurrence of the following events: (i) any act of force majeure which materially and adversely affect the Company's business and operations, including but not limited to, the Company having sustained a material loss, whether or not insured, by reason of fire, earthquake, flood, epidemic, explosion, accident, calamity or other act of God; (ii) any strike or labor dispute or court or government action, order or decree; (iii) a banking moratorium having been declared by federal or state authorities; (iv) an outbreak of major armed conflict, blockade, embargo, or other international hostilities or restraints or orders of civic, civil defense, or military authorities, or other national or international calamity having occurred; (v) any act of public enemy, riot or civil disturbance or threat thereof; or (vi) a pending or threatened legal or governmental proceeding or action relating generally to the Company's business, or a notification having been received by the Company of the threat of any such proceeding or action, which could materially adversely affect the Company. (c) Except as expressly provided herein, this Agreement contains the entire understanding between the parties with respect to the subject matter hereof, and may not be modified, altered or amended except by an instrument in writing signed by the parties hereto. This Agreement supersedes all prior agreements of the parties with respect to the subject matter hereof. In the event of termination of employment of Employee pursuant to this Agreement, the arrangements provided for by this Agreement, by any Stock Option Agreement or other written agreement between the Company or any of its affiliates and Employee in effect at the time, and by any other applicable benefit plan of the Company or any of its affiliates, will constitute the entire obligation of the Company to the Employee and performance thereof by the Company will constitute full settlement of any and all claims, whether in contract or tort, that Employee might otherwise assert against the Company or any of its affiliates on account of such termination. (d) This Agreement shall be construed in accordance with the laws of the State of California applicable to agreements made and to be performed entirely within such state and without regard to the conflict of law principals thereof. (e) Nothing in the Agreement is intended to require or shall be construed as requiring the Company to do or fail to do any act in violation of applicable law. The Company's inability pursuant to court order to perform its obligations under this Agreement shall not constitute a breach of this Agreement. If any provision of this Agreement is invalid or unenforceable, the remainder of this Agreement shall nevertheless remain in full force and effect. If any provision is held invalid or unenforceable with respect to particular circumstances, it shall, nevertheless, remain in full force and effect in all other circumstances. (f) With the exception of disputes arising under or with respect to Sections 9 or 10 hereof, any and all disputes hereunder shall be resolved by arbitration. Any party hereto electing to commence an action shall give written notice to the other parties hereto of such election. The dispute shall be settled by arbitration in accordance with the then rules of the American Arbitration Association; provided, however, in the event the parties are unable to agree on an arbitrator within twenty (20) days after receipt of the aforementioned notice of arbitration, a single arbitrator shall be selected by the Chief Judge of the Superior Court of the State of California for the County of Los Angeles. The award of such arbitrator may be confirmed or enforced in any court of competent jurisdiction. The costs and expenses of the arbitrator, including the attorney's fees and costs of each of the parties, shall be apportioned between the parties by such arbitrator, based upon such arbitrator's determination of the merits of their respective positions. With respect to such arbitration, the parties shall have those rights of discovery as may be granted by the arbitrator in accordance with California law. (g) Any notice to the Company required or permitted hereunder shall be given in writing to the Company, either by personal service, telex, telecopier or, if by mail, by registered or certified mail return receipt requested, postage prepaid, duly addressed to the Secretary of the Company at its then principal place of business. Any such notice to Employee shall be given in a like manner, and if mailed shall be addressed to Employee at Employee's home address then shown in the files of the Company. For the purpose of determining compliance with any time limit herein, a notice shall be deemed given on the fifth day following the postmarked date, if mailed, or the date of delivery if personally delivered. (h) A waiver by either party of any term or condition of this Agreement or any breach thereof, in any one instance, shall not be deemed or construed to be a waiver of such term or condition or of any subsequent breach thereof. (i) The paragraph and subparagraph headings contained in this Agreement are solely for convenience and shall not be considered in its interpretation. (j) This Agreement may be executed in one or more counterparts, each of which shall constitute an original. IN WITNESS WHEREOF, the parties hereto have executed this Employment Agreement as of the day and year first written above. COMPANY: MAXICARE HEALTH PLANS, INC., a Delaware corporation By: /s/ Peter J. Ratican Title: Chairman, President and Chief Executive Officer EMPLOYEE: /s/ Robert Landis Exhibit 10.54 MAXICARE HEALTH PLANS, INC. STOCK OPTION AGREEMENT Maxicare Health Plans, Inc., a Delaware corporation (the "Company"), hereby grants as of this 5th day of November, 1993, to Florence Courtright (the "Optionee"), an option to purchase a maximum of 10,000 shares of its common stock (the "Common Stock"), at a price per share (the "Exercise Price") of $10.88 per share (the "Option"), on the following terms and conditions: 1. GRANT UNDER 1990 STOCK PLAN. The Option is granted pursuant to and is governed by the Company's 1990 Stock Option Plan (the "Plan") and, unless the context otherwise requires, terms used and/or defined herein shall have the same meaning as in the Plan. Determinations made in connection with this Option pursuant to the Plan shall be governed by the Plan as it exists on this date. This Option is not intended to be and shall not be treated as an incentive stock option under Section 422 of the Internal Revenue Code. 2. EXTENT OF OPTION. As an officer, employee, or director with the Company, the Optionee's rights in and to the Option shall vest as of the date hereof, and the Optionee may, subject to Section 13 hereof, exercise this Option immediately for up to the total number of shares set forth in the first sentence of this Agreement. While the Optionee continues to serve as an officer, director or employee of the Company (or a subsidiary thereof, as the case may be), the Option may be exercised up to and including the earlier of the date which is five years from the date this Option is granted (the "Fifth Anniversary Date"). For purposes of this Agreement, any accrued installment shall be referred to as an "Accrued Installment". All of the foregoing rights are subject to Sections 3 and 4 hereof, as appropriate, if the Optionee ceases to serve as an officer, director or employee of the Company (or a subsidiary thereof, as the case may be) or becomes disabled or dies while serving as an officer, director or employee of the Company (or a subsidiary thereof, as the case may be). 3. TERMINATION OF BUSINESS RELATIONSHIP. If the Optionee ceases to remain an officer, director or employee of the Company (or subsidiary thereof, as the case may be), other than by reason of death or disability as defined in Section 4, any unexercised Accrued Installments of the Option shall expire and become unexercisable as of the earlier of (i) the Fifth Anniversary Date, or (ii) thirty (30) days following the termination of Optionee's employment or termination of Optionee's directorship. No further installments of this Option shall become exercisable. The Board of Directors of the Company may extend such thirty (30) day period for a period not to exceed one (1) year following the Termination Date (as defined in the Plan), but in no event beyond the applicable Fifth Anniversary Date. In such a case, the Optionee's only rights hereunder shall be those which are properly exercised before the termination of this Option. Any portion of an Option that expires hereunder shall remain unexercisable and be of no effect whatsoever after such expiration notwithstanding that such Optionee may be reemployed by, or again become a director of, the Company (or a subsidiary thereof, as the case may be). 4. DEATH OR DISABILITY. In the event of the death of the Optionee while an officer, employee or director of the Company (or a subsidiary thereof, as the case may be), or in the event of termination of employment or directorship by reason of the Optionee's Disability (as defined in the Plan), any unexercised Accrued Installments of the Option granted to Optionee shall expire and become unexercisable as of the earlier of (i) the Fifth Anniversary Date, or (ii) the first anniversary date of the Optionee's death (if applicable) or (iii) the first anniversary date of the termination of employment or directorship by reason of Disability (if applicable). Any such Accrued Installments of a deceased Optionee may be exercised prior to their expiration by (and only by) the person or persons to whom the Optionee's Option rights shall pass by will or by the laws of descent and distribution. Any installments under a deceased Optionee's Option that have not accrued as of the date of his death shall expire and become unexercisable as of said date of death. For purposes of this Agreement, the Optionee shall be deemed employed by the Company (or a subsidiary thereof, as the case may be) during any period of leave of absence from active employment as authorized by the Company (or a subsidiary thereof, as the case may be). 5. PARTIAL EXERCISE. Exercise of this Option up to the extent above stated may be in part at any time and from time to time with the above limits, except that this Option may not be exercised for a fraction of a share. Upon the exercise of the final installment of this Option, the Optionee shall be entitled to receive cash with respect to the value of any fraction of a share (in lieu of any said fractional share). 6. PAYMENT OF EXERCISE PRICE. The Exercise Price is payable in United States dollars and may be paid in cash or by certified or cashier's check, or any combination of the foregoing, equal in amount to the Exercise Price. 7. INVESTMENT REPRESENTATIONS; RESTRICTIONS ON TRANSFER. (a) The Optionee represents, warrants and covenants to the Company that: (i) Any Common Stock acquired by the Optionee upon exercise of the Option will be acquired for the Optionee's own account and not with a view to resale on distribution in violation of the Securities Act of 1933, as amended (the "1933 Act"). (ii) The Optionee has such knowledge and experience in business and financial matters as to be capable of utilizing the information which is available to the Optionee to evaluate the merits and risks of an investment in the Common Stock, and is able to bear the economic risks of any Common Stock or other securities which the Optionee may acquire upon exercise of the Option. (iii) The Optionee understands that the Option has not been registered under the Securities Act of 1933, as amended (the "1933 Act"), that the Option has been issued in reliance upon certain exemptions contained therein. The Optionee further understands that because the Option has not been registered under the 1933 Act or registered or qualified pursuant to applicable "blue sky" statutes, the Optionee may not, and Optionee covenants and agrees that Optionee will not, sell, offer to sell or otherwise dispose of any such Option in violation of the 1933 Act or any applicable "blue sky" or securities law of any state. The Optionee acknowledges and understands that Optionee has no independent right to require the Company to register the Option. 8. METHOD OF EXERCISING OPTION. Subject to the terms and conditions of this Agreement, this Option may be exercised by written notice to the Company, at the principal executive office of the Company, or to such transfer agent as the Company shall designate. Such notice shall state the election to exercise this Option and the number of shares in respect of which it is being exercised and shall be signed by the Optionee or person or persons entitled to so exercise this Option. Such notice shall be accompanied by payment of the full Exercise Price of such shares, and the Company shall deliver a certificate or certificates representing such shares as soon as practicable after the notice is received. The certificate or certificates for the shares as to which this Option shall have been so exercised shall be registered in the name of the person or persons so exercising this Option (or, if this Option shall be exercised by the Optionee and if the Optionee shall so request in the notice exercising this Option, shall be registered in the name of the Optionee and another person jointly, with right of if Optionee is entitled to exercise any unexercised if Optionee is entitled to exercise any unexercised survivorship) and shall be delivered to or upon the written order of the person or persons exercising this Option. In the event this Option shall be exercised, pursuant to Section 4 hereof, by any person or persons other than the Optionee, such notice shall be accompanied by appropriate proof of the right of such person or persons to exercise this Option. All shares that shall be purchased upon the exercise of this Option as provided herein shall be fully paid and non-assessable. 9. OPTION NOT TRANSFERABLE; TRANSFER OF STOCK. This Option is not transferable or assignable except by will or by the laws of descent and distribution. During the Optionee's lifetime, only the Optionee may exercise this Option. 10. NO OBLIGATION TO EXERCISE OPTION. The grant and acceptance of this Option imposes no obligation on the Optionee to exercise it. 11. NO OBLIGATION TO CONTINUE EMPLOYMENT. Neither the Company nor any subsidiary thereof is by the Plan or this Option obligated to continue to employ Optionee and neither the Plan nor this Option shall otherwise interfere with the Company's or any of the Company's subsidiary's right to discharge or retire any employee, including Optionee, at any time. 12. NO RIGHTS AS STOCKHOLDER UNTIL EXERCISE. The Optionee shall have no rights as a stockholder with respect to shares subject to this Agreement until a stock certificate therefore has been issued to the Optionee and is fully paid for. Except as is expressly provided in the Plan with respect to certain changes in the capitalization of the Company, no adjustment shall be made for dividends or similar rights for which the record date is prior to the date such stock certificate is issued. 13. REORGANIZATION OF COMPANY. (a) Upon the dissolution or liquidation of the Company, or upon a reorganization, merger or consolidation of the Company as a result of which the Company's outstanding Common Stock is changed into or exchanged for cash or property or securities not of the Company's issue, or upon a sale of all or substantially all property of the Company to, or the acquisition of all or substantially all of the stock of the Company then outstanding by, another corporation or person, the Plan shall terminate, and the Option granted hereunder shall terminate; provided, however, Optionee shall be entitled, at such time prior to the consummation of the transaction causing such termination as the Company shall designate, to exercise the unexercised installments of the Option. (b) In addition to and not in lieu of those rights granted pursuant to subsection 13(a) above, if provisions shall be made in writing in connection with such transaction for the continuance of the Plan and/or the assumption of options theretofore granted, or the substitution for such options of options covering the stock of the successor corporation, or a parent or subsidiary thereof with appropriate adjustments as to the number and kind of shares and prices, the unexercised Option shall continue in the manner and under the terms so provided. (c) The Company shall have no obligation to provide for the continuance, assumption or substitution of the Plan or the Option by any successor corporation or parent or subsidiary thereof. 14. WITHHOLDING TAXES. The Optionee hereby agrees that the Company (or a subsidiary thereof, as the case may be) may withhold from the Optionee's wages or other remuneration the appropriate amount of federal, state and local taxes attributable to the Optionee's exercise of any installment of this Option. The Optionee further agrees that, if the Company (or a subsidiary thereof, as the case may be) does not withhold an amount from the Optionee's wages or other remuneration sufficient to satisfy the Company's (or any such subsidiary's) withholding obligation, the Optionee will reimburse the Company (or any such subsidiary) on demand, in cash, for the amount underwithheld. 15. GOVERNING LAW. This Agreement shall be governed by and interpreted in accordance with the laws of the State of California applicable to agreements made and to be performed entirely within such State and without regard to the conflict of law principals thereof. 16. AMENDMENTS. No amendment, modification, termination or waiver of any provision of this Agreement shall be effective unless the same shall be in writing signed by all parties hereto. 17. COUNTERPARTS. This Agreement may be signed in one or more counterparts, each of which shall be deemed to be an original, but all of which together shall constitute one and the same instrument. 18. SURVIVAL OF REPRESENTATIONS. All representations, covenants and warranties of the parties hereto shall survive the execution of this Agreement. IN WITNESS WHEREOF the Company and the Optionee have caused this instrument to be executed as of the date first written above, and the Optionee whose signature appears below acknowledges receipt of a copy of the Plan and acceptance of an original copy of this Agreement. THE COMPANY: MAXICARE HEALTH PLANS, INC. By: /s/ Peter J. Ratican Chairman, President and Chief Executive Officer OPTIONEE: /s/ Florence Courtright Exhibit 10.55 MAXICARE HEALTH PLANS, INC. STOCK OPTION AGREEMENT Maxicare Health Plans, Inc., a Delaware corporation (the "Company"), hereby grants as of this 20th day of December, 1993, to Vicki F. Perry (the "Optionee"), an option to purchase a maximum of 7,500 shares of its common stock (the "Common Stock"), at a price per share (the "Exercise Price") of $9.63 per share (the "Option"), on the following terms and conditions: 1. GRANT UNDER 1990 STOCK PLAN. The Option is granted pursuant to and is governed by the Company's 1990 Stock Option Plan (the "Plan") and, unless the context otherwise requires, terms used and/or defined herein shall have the same meaning as in the Plan. Determinations made in connection with this Option pursuant to the Plan shall be governed by the Plan as it exists on this date. This Option is not intended to be and shall not be treated as an incentive stock option under Section 422 of the Internal Revenue Code. 2. EXTENT OF OPTION. If the Optionee has continued to serve in the capacity of an officer, employee, or director with the Company (or a subsidiary thereof, as the case may be) on the following dates, the Optionee may, subject to Section 13 hereof, exercise this Option for the portion of the total number of shares subject to this Option set opposite the applicable date: Less than one year from the - 0 shares date hereof One year but less than two years - 2,500 shares from the date hereof Two years but less than three - 2,500 shares years from the date hereof Three years but less than four - 2,500 shares years from the date hereof The foregoing rights are cumulative and, while the Optionee continues to serve as an officer, director or employee of the Company (or a subsidiary thereof, as the case may be), may be exercised up to and including the earlier of the date which is five years from the date this Option is granted (the "Fifth Anniversary Date"). For purposes of this Agreement, any accrued installment shall be referred to as an "Accrued Installment". All of the foregoing rights are subject to Sections 3 and 4 hereof, as appropriate, if the Optionee ceases to serve as an officer, director or employee of the Company (or a subsidiary thereof, as the case may be) or becomes disabled or dies while serving as an officer, director or employee of the Company (or a subsidiary thereof, as the case may be). 3. TERMINATION OF BUSINESS RELATIONSHIP. If the Optionee ceases to remain an officer, director or employee of the Company (or subsidiary thereof, as the case may be), other than by reason of death or disability as defined in Section 4, any unexercised Accrued Installments of the Option shall expire and become unexercisable as of the earlier of (i) the Fifth Anniversary Date, or (ii) thirty (30) days following the termination of Optionee's employment or termination of Optionee's directorship. No further installments of this Option shall become exercisable. The Board of Directors of the Company may extend such thirty (30) day period for a period not to exceed one (1) year following the Termination Date (as defined in the Plan), but in no event beyond the applicable Fifth Anniversary Date. In such a case, the Optionee's only rights hereunder shall be those which are properly exercised before the termination of this Option. Any portion of an Option that expires hereunder shall remain unexercisable and be of no effect whatsoever after such expiration notwithstanding that such Optionee may be reemployed by, or again become a director of, the Company (or a subsidiary thereof, as the case may be). 4. DEATH OR DISABILITY. In the event of the death of the Optionee while an officer, employee or director of the Company (or a subsidiary thereof, as the case may be), or in the event of termination of employment or directorship by reason of the Optionee's Disability (as defined in the Plan), any unexercised Accrued Installments of the Option granted to Optionee shall expire and become unexercisable as of the earlier of (i) the Fifth Anniversary Date, or (ii) the first anniversary date of the Optionee's death (if applicable) or (iii) the first anniversary date of the termination of employment or directorship by reason of Disability (if applicable). Any such Accrued Installments of a deceased Optionee may be exercised prior to their expiration by (and only by) the person or persons to whom the Optionee's Option rights shall pass by will or by the laws of descent and distribution. Any installments under a deceased Optionee's Option that have not accrued as of the date of his death shall expire and become unexercisable as of said date of death. For purposes of this Agreement, the Optionee shall be deemed employed by the Company (or a subsidiary thereof, as the case may be) during any period of leave of absence from active employment as authorized by the Company (or a subsidiary thereof, as the case may be). 5. PARTIAL EXERCISE. Exercise of this Option up to the extent above stated may be in part at any time and from time to time with the above limits, except that this Option may not be exercised for a fraction of a share. Upon the exercise of the final installment of this Option, the Optionee shall be entitled to receive cash with respect to the value of any fraction of a share (in lieu of any said fractional share). 6. PAYMENT OF EXERCISE PRICE. The Exercise Price is payable in United States dollars and may be paid in cash or by certified or cashier's check, or any combination of the foregoing, equal in amount to the Exercise Price. 7. INVESTMENT REPRESENTATIONS; RESTRICTIONS ON TRANSFER. (a) The Optionee represents, warrants and covenants to the Company that: (i) Any Common Stock acquired by the Optionee upon exercise of the Option will be acquired for the Optionee's own account and not with a view to resale on distribution in violation of the Securities Act of 1933, as amended (the "1933 Act"). (ii) The Optionee has such knowledge and experience in business and financial matters as to be capable of utilizing the information which is available to the Optionee to evaluate the merits and risks of an investment in the Common Stock, and is able to bear the economic risks of any Common Stock or other securities which the Optionee may acquire upon exercise of the Option. (iii) The Optionee understands that the Option has not been registered under the Securities Act of 1933, as amended (the "1933 Act"), that the Option has been issued in reliance upon certain exemptions contained therein. The Optionee further understands that because the Option has not been registered under the 1933 Act or registered or qualified pursuant to applicable "blue sky" statutes, the Optionee may not, and Optionee covenants and agrees that Optionee will not, sell, offer to sell or otherwise dispose of any such Option in violation of the 1933 Act or any applicable "blue sky" or securities law of any state. The Optionee acknowledges and understands that Optionee has no independent right to require the Company to register the Option. 8. METHOD OF EXERCISING OPTION. Subject to the terms and conditions of this Agreement, this Option may be exercised by written notice to the Company, at the principal executive office of the Company, or to such transfer agent as the Company shall designate. Such notice shall state the election to exercise this Option and the number of shares in respect of which it is being exercised and shall be signed by the Optionee or person or persons entitled to so exercise this Option. Such notice shall be accompanied by payment of the full Exercise Price of such shares, and the Company shall deliver a certificate or certificates representing such shares as soon as practicable after the notice is received. The certificate or certificates for the shares as to which this Option shall have been so exercised shall be registered in the name of the person or persons so exercising this Option (or, if this Option shall be exercised by the Optionee and if the Optionee shall so request in the notice exercising this Option, shall be registered in the name of the Optionee and another person jointly, with right of survivorship) and shall be delivered to or upon the written order of the person or persons exercising this Option. In the event this Option shall be exercised, pursuant to Section 4 hereof, by any person or persons other than the Optionee, such notice shall be accompanied by appropriate proof of the right of such person or persons to exercise this Option. All shares that shall be purchased upon the exercise of this Option as provided herein shall be fully paid and non-assessable. 9. OPTION NOT TRANSFERABLE; TRANSFER OF STOCK. This Option is not transferable or assignable except by will or by the laws of descent and distribution. During the Optionee's lifetime, only the Optionee may exercise this Option. 10. NO OBLIGATION TO EXERCISE OPTION. The grant and acceptance of this Option imposes no obligation on the Optionee to exercise it. 11. NO OBLIGATION TO CONTINUE EMPLOYMENT. Neither the Company nor any subsidiary thereof is by the Plan or this Option obligated to continue to employ Optionee and neither the Plan nor this Option shall otherwise interfere with the Company's or any of the Company's subsidiary's right to discharge or retire any employee, including Optionee, at any time. 12. NO RIGHTS AS STOCKHOLDER UNTIL EXERCISE. The Optionee shall have no rights as a stockholder with respect to shares subject to this Agreement until a stock certificate therefore has been issued to the Optionee and is fully paid for. Except as is expressly provided in the Plan with respect to certain changes in the capitalization of the Company, no adjustment shall be made for dividends or similar rights for which the record date is prior to the date such stock certificate is issued. 13. REORGANIZATION OF COMPANY. (a) Upon the dissolution or liquidation of the Company, or upon a reorganization, merger or consolidation of the Company as a result of which the Company's outstanding Common Stock is changed into or exchanged for cash or property or securities not of the Company's issue, or upon a sale of all or substantially all property of the Company to, or the acquisition of all or substantially all of the stock of the Company then outstanding by, another corporation or person, the Plan shall terminate, and the Option granted hereunder shall terminate; provided, however, Optionee shall be entitled, at such time prior to the consummation of the transaction causing such termination as the Company shall designate, to exercise the unexercised installments of the Option including all unaccrued installments thereof which would, but for this subsection 13(a), not yet be exercisable. Notwithstanding the foregoing, in the event that any transaction causing such termination is not consummated, any unexercised unaccrued installments that had become exercisable solely by reason of the provisions of this subsection 13(a) shall again become unaccrued and unexercisable as of said termination of such transaction, subject, however, to such installments accruing pursuant to the normal accrual schedule provided in the terms under which the Option was granted. (b) In addition to and not in lieu of those rights granted pursuant to subsection 13(a) above, if provisions shall be made in writing in connection with such transaction for the continuance of the Plan and/or the assumption of options theretofore granted, or the substitution for such options of options covering the stock of the successor corporation, or a parent or subsidiary thereof with appropriate adjustments as to the number and kind of shares and prices, the unexercised Option shall continue in the manner and under the terms so provided. (c) The Company shall have no obligation to provide for the continuance, assumption or substitution of the Plan or the Option by any successor corporation or parent or subsidiary thereof. 14. WITHHOLDING TAXES. The Optionee hereby agrees that the Company (or a subsidiary thereof, as the case may be) may withhold from the Optionee's wages or other remuneration the appropriate amount of federal, state and local taxes attributable to the Optionee's exercise of any installment of this Option. The Optionee further agrees that, if the Company (or a subsidiary thereof, as the case may be) does not withhold an amount from the Optionee's wages or other remuneration sufficient to satisfy the Company's (or any such subsidiary's) withholding obligation, the Optionee will reimburse the Company (or any such subsidiary) on demand, in cash, for the amount underwithheld. 15. GOVERNING LAW. This Agreement shall be governed by and interpreted in accordance with the laws of the State of California applicable to agreements made and to be performed entirely within such State and without regard to the conflict of law principals thereof. 16. AMENDMENTS. No amendment, modification, termination or waiver of any provision of this Agreement shall be effective unless the same shall be in writing signed by all parties hereto. 17. COUNTERPARTS. This Agreement may be signed in one or more counterparts, each of which shall be deemed to be an original, but all of which together shall constitute one and the same instrument. 18. SURVIVAL OF REPRESENTATIONS. All representations, covenants and warranties of the parties hereto shall survive the execution of this Agreement. IN WITNESS WHEREOF the Company and the Optionee have caused this instrument to be executed as of the date first written above, and the Optionee whose signature appears below acknowledges receipt of a copy of the Plan and acceptance of an original copy of this Agreement. THE COMPANY: MAXICARE HEALTH PLANS, INC. By: /s/ Peter J. Ratican Chairman, President and Chief Executive Officer OPTIONEE: /s/ Vicki F. Perry Exhibit 10.56 MAXICARE HEALTH PLANS, INC. STOCK OPTION AGREEMENT Maxicare Health Plans, Inc., a Delaware corporation (the "Company"), hereby grants as of this 20th day of December, 1993, to Alan D. Bloom (the "Optionee"), an option to purchase a maximum of 7,500 shares of its common stock (the "Common Stock"), at a price per share (the "Exercise Price") of $9.63 per share (the "Option"), on the following terms and conditions: 1. GRANT UNDER 1990 STOCK PLAN. The Option is granted pursuant to and is governed by the Company's 1990 Stock Option Plan (the "Plan") and, unless the context otherwise requires, terms used and/or defined herein shall have the same meaning as in the Plan. Determinations made in connection with this Option pursuant to the Plan shall be governed by the Plan as it exists on this date. This Option is not intended to be and shall not be treated as an incentive stock option under Section 422 of the Internal Revenue Code. 2. EXTENT OF OPTION. If the Optionee has continued to serve in the capacity of an officer, employee, or director with the Company (or a subsidiary thereof, as the case may be) on the following dates, the Optionee may, subject to Section 13 hereof, exercise this Option for the portion of the total number of shares subject to this Option set opposite the applicable date: Less than one year from the - 0 shares date hereof One year but less than two years - 2,500 shares from the date hereof Two years but less than three - 2,500 shares years from the date hereof Three years but less than four - 2,500 shares years from the date hereof The foregoing rights are cumulative and, while the Optionee continues to serve as an officer, director or employee of the Company (or a subsidiary thereof, as the case may be), may be exercised up to and including the earlier of the date which is five years from the date this Option is granted (the "Fifth Anniversary Date"). For purposes of this Agreement, any accrued installment shall be referred to as an "Accrued Installment". All of the foregoing rights are subject to Sections 3 and 4 hereof, as appropriate, if the Optionee ceases to serve as an officer, director or employee of the Company (or a subsidiary thereof, as the case may be) or becomes disabled or dies while serving as an officer, director or employee of the Company (or a subsidiary thereof, as the case may be). 3. TERMINATION OF BUSINESS RELATIONSHIP. If the Optionee ceases to remain an officer, director or employee of the Company (or subsidiary thereof, as the case may be), other than by reason of death or disability as defined in Section 4, any unexercised Accrued Installments of the Option shall expire and become unexercisable as of the earlier of (i) the Fifth Anniversary Date, or (ii) thirty (30) days following the termination of Optionee's employment or termination of Optionee's directorship. No further installments of this Option shall become exercisable. The Board of Directors of the Company may extend such thirty (30) day period for a period not to exceed one (1) year following the Termination Date (as defined in the Plan), but in no event beyond the applicable Fifth Anniversary Date. In such a case, the Optionee's only rights hereunder shall be those which are properly exercised before the termination of this Option. Any portion of an Option that expires hereunder shall remain unexercisable and be of no effect whatsoever after such expiration notwithstanding that such Optionee may be reemployed by, or again become a director of, the Company (or a subsidiary thereof, as the case may be). 4. DEATH OR DISABILITY. In the event of the death of the Optionee while an officer, employee or director of the Company (or a subsidiary thereof, as the case may be), or in the event of termination of employment or directorship by reason of the Optionee's Disability (as defined in the Plan), any unexercised Accrued Installments of the Option granted to Optionee shall expire and become unexercisable as of the earlier of (i) the Fifth Anniversary Date, or (ii) the first anniversary date of the Optionee's death (if applicable) or (iii) the first anniversary date of the termination of employment or directorship by reason of Disability (if applicable). Any such Accrued Installments of a deceased Optionee may be exercised prior to their expiration by (and only by) the person or persons to whom the Optionee's Option rights shall pass by will or by the laws of descent and distribution. Any installments under a deceased Optionee's Option that have not accrued as of the date of his death shall expire and become unexercisable as of said date of death. For purposes of this Agreement, the Optionee shall be deemed employed by the Company (or a subsidiary thereof, as the case may be) during any period of leave of absence from active employment as authorized by the Company (or a subsidiary thereof, as the case may be). 5. PARTIAL EXERCISE. Exercise of this Option up to the extent above stated may be in part at any time and from time to time with the above limits, except that this Option may not be exercised for a fraction of a share. Upon the exercise of the final installment of this Option, the Optionee shall be entitled to receive cash with respect to the value of any fraction of a share (in lieu of any said fractional share). 6. PAYMENT OF EXERCISE PRICE. The Exercise Price is payable in United States dollars and may be paid in cash or by certified or cashier's check, or any combination of the foregoing, equal in amount to the Exercise Price. 7. INVESTMENT REPRESENTATIONS; RESTRICTIONS ON TRANSFER. (a) The Optionee represents, warrants and covenants to the Company that: (i) Any Common Stock acquired by the Optionee upon exercise of the Option will be acquired for the Optionee's own account and not with a view to resale on distribution in violation of the Securities Act of 1933, as amended (the "1933 Act"). (ii) The Optionee has such knowledge and experience in business and financial matters as to be capable of utilizing the information which is available to the Optionee to evaluate the merits and risks of an investment in the Common Stock, and is able to bear the economic risks of any Common Stock or other securities which the Optionee may acquire upon exercise of the Option. (iii) The Optionee understands that the Option has not been registered under the Securities Act of 1933, as amended (the "1933 Act"), that the Option has been issued in reliance upon certain exemptions contained therein. The Optionee further understands that because the Option has not been registered under the 1933 Act or registered or qualified pursuant to applicable "blue sky" statutes, the Optionee may not, and Optionee covenants and agrees that Optionee will not, sell, offer to sell or otherwise dispose of any such Option in violation of the 1933 Act or any applicable "blue sky" or securities law of any state. The Optionee acknowledges and understands that Optionee has no independent right to require the Company to register the Option. 8. METHOD OF EXERCISING OPTION. Subject to the terms and conditions of this Agreement, this Option may be exercised by written notice to the Company, at the principal executive office of the Company, or to such transfer agent as the Company shall designate. Such notice shall state the election to exercise this Option and the number of shares in respect of which it is being exercised and shall be signed by the Optionee or person or persons entitled to so exercise this Option. Such notice shall be accompanied by payment of the full Exercise Price of such shares, and the Company shall deliver a certificate or certificates representing such shares as soon as practicable after the notice is received. The certificate or certificates for the shares as to which this Option shall have been so exercised shall be registered in the name of the person or persons so exercising this Option (or, if this Option shall be exercised by the Optionee and if the Optionee shall so request in the notice exercising this Option, shall be registered in the name of the Optionee and another person jointly, with right of survivorship) and shall be delivered to or upon the written order of the person or persons exercising this Option. In the event this Option shall be exercised, pursuant to Section 4 hereof, by any person or persons other than the Optionee, such notice shall be accompanied by appropriate proof of the right of such person or persons to exercise this Option. All shares that shall be purchased upon the exercise of this Option as provided herein shall be fully paid and non-assessable. 9. OPTION NOT TRANSFERABLE; TRANSFER OF STOCK. This Option is not transferable or assignable except by will or by the laws of descent and distribution. During the Optionee's lifetime, only the Optionee may exercise this Option. 10. NO OBLIGATION TO EXERCISE OPTION. The grant and acceptance of this Option imposes no obligation on the Optionee to exercise it. 11. NO OBLIGATION TO CONTINUE EMPLOYMENT. Neither the Company nor any subsidiary thereof is by the Plan or this Option obligated to continue to employ Optionee and neither the Plan nor this Option shall otherwise interfere with the Company's or any of the Company's subsidiary's right to discharge or retire any employee, including Optionee, at any time. 12. NO RIGHTS AS STOCKHOLDER UNTIL EXERCISE. The Optionee shall have no rights as a stockholder with respect to shares subject to this Agreement until a stock certificate therefore has been issued to the Optionee and is fully paid for. Except as is expressly provided in the Plan with respect to certain changes in the capitalization of the Company, no adjustment shall be made for dividends or similar rights for which the record date is prior to the date such stock certificate is issued. 13. REORGANIZATION OF COMPANY. (a) Upon the dissolution or liquidation of the Company, or upon a reorganization, merger or consolidation of the Company as a result of which the Company's outstanding Common Stock is changed into or exchanged for cash or property or securities not of the Company's issue, or upon a sale of all or substantially all property of the Company to, or the acquisition of all or substantially all of the stock of the Company then outstanding by, another corporation or person, the Plan shall terminate, and the Option granted hereunder shall terminate; provided, however, Optionee shall be entitled, at such time prior to the consummation of the transaction causing such termination as the Company shall designate, to exercise the unexercised installments of the Option including all unaccrued installments thereof which would, but for this subsection 13(a), not yet be exercisable. Notwithstanding the foregoing, in the event that any transaction causing such termination is not consummated, any unexercised unaccrued installments that had become exercisable solely by reason of the provisions of this subsection 13(a) shall again become unaccrued and unexercisable as of said termination of such transaction, subject, however, to such installments accruing pursuant to the normal accrual schedule provided in the terms under which the Option was granted. (b) In addition to and not in lieu of those rights granted pursuant to subsection 13(a) above, if provisions shall be made in writing in connection with such transaction for the continuance of the Plan and/or the assumption of options theretofore granted, or the substitution for such options of options covering the stock of the successor corporation, or a parent or subsidiary thereof with appropriate adjustments as to the number and kind of shares and prices, the unexercised Option shall continue in the manner and under the terms so provided. (c) The Company shall have no obligation to provide for the continuance, assumption or substitution of the Plan or the Option by any successor corporation or parent or subsidiary thereof. 14. WITHHOLDING TAXES. The Optionee hereby agrees that the Company (or a subsidiary thereof, as the case may be) may withhold from the Optionee's wages or other remuneration the appropriate amount of federal, state and local taxes attributable to the Optionee's exercise of any installment of this Option. The Optionee further agrees that, if the Company (or a subsidiary thereof, as the case may be) does not withhold an amount from the Optionee's wages or other remuneration sufficient to satisfy the Company's (or any such subsidiary's) withholding obligation, the Optionee will reimburse the Company (or any such subsidiary) on demand, in cash, for the amount underwithheld. 15. GOVERNING LAW. This Agreement shall be governed by and interpreted in accordance with the laws of the State of California applicable to agreements made and to be performed entirely within such State and without regard to the conflict of law principals thereof. 16. AMENDMENTS. No amendment, modification, termination or waiver of any provision of this Agreement shall be effective unless the same shall be in writing signed by all parties hereto. 17. COUNTERPARTS. This Agreement may be signed in one or more counterparts, each of which shall be deemed to be an original, but all of which together shall constitute one and the same instrument. 18. SURVIVAL OF REPRESENTATIONS. All representations, covenants and warranties of the parties hereto shall survive the execution of this Agreement. IN WITNESS WHEREOF the Company and the Optionee have caused this instrument to be executed as of the date first written above, and the Optionee whose signature appears below acknowledges receipt of a copy of the Plan and acceptance of an original copy of this Agreement. THE COMPANY: MAXICARE HEALTH PLANS, INC. By: /s/ Peter J. Ratican Chairman, President and Chief Executive Officer OPTIONEE: /s/ Alan D. Bloom Exhibit 10.57 MAXICARE HEALTH PLANS, INC. STOCK OPTION AGREEMENT Maxicare Health Plans, Inc., a Delaware corporation (the "Company"), hereby grants as of this 20th day of December, 1993, to Richard Link (the "Optionee"), an option to purchase a maximum of 5,000 shares of its common stock (the "Common Stock"), at a price per share (the "Exercise Price") of $9.63 per share (the "Option"), on the following terms and conditions: 1. GRANT UNDER 1990 STOCK PLAN. The Option is granted pursuant to and is governed by the Company's 1990 Stock Option Plan (the "Plan") and, unless the context otherwise requires, terms used and/or defined herein shall have the same meaning as in the Plan. Determinations made in connection with this Option pursuant to the Plan shall be governed by the Plan as it exists on this date. This Option is not intended to be and shall not be treated as an incentive stock option under Section 422 of the Internal Revenue Code. 2. EXTENT OF OPTION. If the Optionee has continued to serve in the capacity of an officer, employee, or director with the Company (or a subsidiary thereof, as the case may be) on the following dates, the Optionee may, subject to Section 13 hereof, exercise this Option for the portion of the total number of shares subject to this Option set opposite the applicable date: Less than one year from the - 0 shares date hereof One year but less than two years - 1,667 shares from the date hereof Two years but less than three - 1,667 shares years from the date hereof Three years but less than four - 1,666 shares years from the date hereof The foregoing rights are cumulative and, while the Optionee continues to serve as an officer, director or employee of the Company (or a subsidiary thereof, as the case may be), may be exercised up to and including the earlier of the date which is five years from the date this Option is granted (the "Fifth Anniversary Date"). For purposes of this Agreement, any accrued installment shall be referred to as an "Accrued Installment". All of the foregoing rights are subject to Sections 3 and 4 hereof, as appropriate, if the Optionee ceases to serve as an officer, director or employee of the Company (or a subsidiary thereof, as the case may be) or becomes disabled or dies while serving as an officer, director or employee of the Company (or a subsidiary thereof, as the case may be). 3. TERMINATION OF BUSINESS RELATIONSHIP. If the Optionee ceases to remain an officer, director or employee of the Company (or subsidiary thereof, as the case may be), other than by reason of death or disability as defined in Section 4, any unexercised Accrued Installments of the Option shall expire and become unexercisable as of the earlier of (i) the Fifth Anniversary Date, or (ii) thirty (30) days following the termination of Optionee's employment or termination of Optionee's directorship. No further installments of this Option shall become exercisable. The Board of Directors of the Company may extend such thirty (30) day period for a period not to exceed one (1) year following the Termination Date (as defined in the Plan), but in no event beyond the applicable Fifth Anniversary Date. In such a case, the Optionee's only rights hereunder shall be those which are properly exercised before the termination of this Option. Any portion of an Option that expires hereunder shall remain unexercisable and be of no effect whatsoever after such expiration notwithstanding that such Optionee may be reemployed by, or again become a director of, the Company (or a subsidiary thereof, as the case may be). 4. DEATH OR DISABILITY. In the event of the death of the Optionee while an officer, employee or director of the Company (or a subsidiary thereof, as the case may be), or in the event of termination of employment or directorship by reason of the Optionee's Disability (as defined in the Plan), any unexercised Accrued Installments of the Option granted to Optionee shall expire and become unexercisable as of the earlier of (i) the Fifth Anniversary Date, or (ii) the first anniversary date of the Optionee's death (if applicable) or (iii) the first anniversary date of the termination of employment or directorship by reason of Disability (if applicable). Any such Accrued Installments of a deceased Optionee may be exercised prior to their expiration by (and only by) the person or persons to whom the Optionee's Option rights shall pass by will or by the laws of descent and distribution. Any installments under a deceased Optionee's Option that have not accrued as of the date of his death shall expire and become unexercisable as of said date of death. For purposes of this Agreement, the Optionee shall be deemed employed by the Company (or a subsidiary thereof, as the case may be) during any period of leave of absence from active employment as authorized by the Company (or a subsidiary thereof, as the case may be). 5. PARTIAL EXERCISE. Exercise of this Option up to the extent above stated may be in part at any time and from time to time with the above limits, except that this Option may not be exercised for a fraction of a share. Upon the exercise of the final installment of this Option, the Optionee shall be entitled to receive cash with respect to the value of any fraction of a share (in lieu of any said fractional share). 6. PAYMENT OF EXERCISE PRICE. The Exercise Price is payable in United States dollars and may be paid in cash or by certified or cashier's check, or any combination of the foregoing, equal in amount to the Exercise Price. 7. INVESTMENT REPRESENTATIONS; RESTRICTIONS ON TRANSFER. (a) The Optionee represents, warrants and covenants to the Company that: (i) Any Common Stock acquired by the Optionee upon exercise of the Option will be acquired for the Optionee's own account and not with a view to resale on distribution in violation of the Securities Act of 1933, as amended (the "1933 Act"). (ii) The Optionee has such knowledge and experience in business and financial matters as to be capable of utilizing the information which is available to the Optionee to evaluate the merits and risks of an investment in the Common Stock, and is able to bear the economic risks of any Common Stock or other securities which the Optionee may acquire upon exercise of the Option. (iii) The Optionee understands that the Option has not been registered under the Securities Act of 1933, as amended (the "1933 Act"), that the Option has been issued in reliance upon certain exemptions contained therein. The Optionee further understands that because the Option has not been registered under the 1933 Act or registered or qualified pursuant to applicable "blue sky" statutes, the Optionee may not, and Optionee covenants and agrees that Optionee will not, sell, offer to sell or otherwise dispose of any such Option in violation of the 1933 Act or any applicable "blue sky" or securities law of any state. The Optionee acknowledges and understands that Optionee has no independent right to require the Company to register the Option. 8. METHOD OF EXERCISING OPTION. Subject to the terms and conditions of this Agreement, this Option may be exercised by written notice to the Company, at the principal executive office of the Company, or to such transfer agent as the Company shall designate. Such notice shall state the election to exercise this Option and the number of shares in respect of which it is being exercised and shall be signed by the Optionee or person or persons entitled to so exercise this Option. Such notice shall be accompanied by payment of the full Exercise Price of such shares, and the Company shall deliver a certificate or certificates representing such shares as soon as practicable after the notice is received. The certificate or certificates for the shares as to which this Option shall have been so exercised shall be registered in the name of the person or persons so exercising this Option (or, if this Option shall be exercised by the Optionee and if the Optionee shall so request in the notice exercising this Option, shall be registered in the name of the Optionee and another person jointly, with right of survivorship) and shall be delivered to or upon the written order of the person or persons exercising this Option. In the event this Option shall be exercised, pursuant to Section 4 hereof, by any person or persons other than the Optionee, such notice shall be accompanied by appropriate proof of the right of such person or persons to exercise this Option. All shares that shall be purchased upon the exercise of this Option as provided herein shall be fully paid and non-assessable. 9. OPTION NOT TRANSFERABLE; TRANSFER OF STOCK. This Option is not transferable or assignable except by will or by the laws of descent and distribution. During the Optionee's lifetime, only the Optionee may exercise this Option. 10. NO OBLIGATION TO EXERCISE OPTION. The grant and acceptance of this Option imposes no obligation on the Optionee to exercise it. 11. NO OBLIGATION TO CONTINUE EMPLOYMENT. Neither the Company nor any subsidiary thereof is by the Plan or this Option obligated to continue to employ Optionee and neither the Plan nor this Option shall otherwise interfere with the Company's or any of the Company's subsidiary's right to discharge or retire any employee, including Optionee, at any time. 12. NO RIGHTS AS STOCKHOLDER UNTIL EXERCISE. The Optionee shall have no rights as a stockholder with respect to shares subject to this Agreement until a stock certificate therefore has been issued to the Optionee and is fully paid for. Except as is expressly provided in the Plan with respect to certain changes in the capitalization of the Company, no adjustment shall be made for dividends or similar rights for which the record date is prior to the date such stock certificate is issued. 13. REORGANIZATION OF COMPANY. (a) Upon the dissolution or liquidation of the Company, or upon a reorganization, merger or consolidation of the Company as a result of which the Company's outstanding Common Stock is changed into or exchanged for cash or property or securities not of the Company's issue, or upon a sale of all or substantially all property of the Company to, or the acquisition of all or substantially all of the stock of the Company then outstanding by, another corporation or person, the Plan shall terminate, and the Option granted hereunder shall terminate; provided, however, Optionee shall be entitled, at such time prior to the consummation of the transaction causing such termination as the Company shall designate, to exercise the unexercised installments of the Option including all unaccrued installments thereof which would, but for this subsection 13(a), not yet be exercisable. Notwithstanding the foregoing, in the event that any transaction causing such termination is not consummated, any unexercised unaccrued installments that had become exercisable solely by reason of the provisions of this subsection 13(a) shall again become unaccrued and unexercisable as of said termination of such transaction, subject, however, to such installments accruing pursuant to the normal accrual schedule provided in the terms under which the Option was granted. (b) In addition to and not in lieu of those rights granted pursuant to subsection 13(a) above, if provisions shall be made in writing in connection with such transaction for the continuance of the Plan and/or the assumption of options theretofore granted, or the substitution for such options of options covering the stock of the successor corporation, or a parent or subsidiary thereof with appropriate adjustments as to the number and kind of shares and prices, the unexercised Option shall continue in the manner and under the terms so provided. (c) The Company shall have no obligation to provide for the continuance, assumption or substitution of the Plan or the Option by any successor corporation or parent or subsidiary thereof. 14. WITHHOLDING TAXES. The Optionee hereby agrees that the Company (or a subsidiary thereof, as the case may be) may withhold from the Optionee's wages or other remuneration the appropriate amount of federal, state and local taxes attributable to the Optionee's exercise of any installment of this Option. The Optionee further agrees that, if the Company (or a subsidiary thereof, as the case may be) does not withhold an amount from the Optionee's wages or other remuneration sufficient to satisfy the Company's (or any such subsidiary's) withholding obligation, the Optionee will reimburse the Company (or any such subsidiary) on demand, in cash, for the amount underwithheld. 15. GOVERNING LAW. This Agreement shall be governed by and interpreted in accordance with the laws of the State of California applicable to agreements made and to be performed entirely within such State and without regard to the conflict of law principals thereof. 16. AMENDMENTS. No amendment, modification, termination or waiver of any provision of this Agreement shall be effective unless the same shall be in writing signed by all parties hereto. 17. COUNTERPARTS. This Agreement may be signed in one or more counterparts, each of which shall be deemed to be an original, but all of which together shall constitute one and the same instrument. 18. SURVIVAL OF REPRESENTATIONS. All representations, covenants and warranties of the parties hereto shall survive the execution of this Agreement. IN WITNESS WHEREOF the Company and the Optionee have caused this instrument to be executed as of the date first written above, and the Optionee whose signature appears below acknowledges receipt of a copy of the Plan and acceptance of an original copy of this Agreement. THE COMPANY: MAXICARE HEALTH PLANS, INC. By: /s/ Peter J. Ratican Chairman, President and Chief Executive Officer OPTIONEE: /s/ Richard Link Exhibit 10.58 MAXICARE HEALTH PLANS, INC. STOCK OPTION AGREEMENT Maxicare Health Plans, Inc., a Delaware corporation (the "Company"), hereby grants as of this 20th day of December, 1993, to Aivars Jerumanis (the "Optionee"), an option to purchase a maximum of 5,000 shares of its common stock (the "Common Stock"), at a price per share (the "Exercise Price") of $9.63 per share (the "Option"), on the following terms and conditions: 1. GRANT UNDER 1990 STOCK PLAN. The Option is granted pursuant to and is governed by the Company's 1990 Stock Option Plan (the "Plan") and, unless the context otherwise requires, terms used and/or defined herein shall have the same meaning as in the Plan. Determinations made in connection with this Option pursuant to the Plan shall be governed by the Plan as it exists on this date. This Option is not intended to be and shall not be treated as an incentive stock option under Section 422 of the Internal Revenue Code. 2. EXTENT OF OPTION. If the Optionee has continued to serve in the capacity of an officer, employee, or director with the Company (or a subsidiary thereof, as the case may be) on the following dates, the Optionee may, subject to Section 13 hereof, exercise this Option for the portion of the total number of shares subject to this Option set opposite the applicable date: Less than one year from the - 0 shares date hereof One year but less than two years - 1,667 shares from the date hereof Two years but less than three - 1,667 shares years from the date hereof Three years but less than four - 1,666 shares years from the date hereof The foregoing rights are cumulative and, while the Optionee continues to serve as an officer, director or employee of the Company (or a subsidiary thereof, as the case may be), may be exercised up to and including the earlier of the date which is five years from the date this Option is granted (the "Fifth Anniversary Date"). For purposes of this Agreement, any accrued installment shall be referred to as an "Accrued Installment". All of the foregoing rights are subject to Sections 3 and 4 hereof, as appropriate, if the Optionee ceases to serve as an officer, director or employee of the Company (or a subsidiary thereof, as the case may be) or becomes disabled or dies while serving as an officer, director or employee of the Company (or a subsidiary thereof, as the case may be). 3. TERMINATION OF BUSINESS RELATIONSHIP. If the Optionee ceases to remain an officer, director or employee of the Company (or subsidiary thereof, as the case may be), other than by reason of death or disability as defined in Section 4, any unexercised Accrued Installments of the Option shall expire and become unexercisable as of the earlier of (i) the Fifth Anniversary Date, or (ii) thirty (30) days following the termination of Optionee's employment or termination of Optionee's directorship. No further installments of this Option shall become exercisable. The Board of Directors of the Company may extend such thirty (30) day period for a period not to exceed one (1) year following the Termination Date (as defined in the Plan), but in no event beyond the applicable Fifth Anniversary Date. In such a case, the Optionee's only rights hereunder shall be those which are properly exercised before the termination of this Option. Any portion of an Option that expires hereunder shall remain unexercisable and be of no effect whatsoever after such expiration notwithstanding that such Optionee may be reemployed by, or again become a director of, the Company (or a subsidiary thereof, as the case may be). 4. DEATH OR DISABILITY. In the event of the death of the Optionee while an officer, employee or director of the Company (or a subsidiary thereof, as the case may be), or in the event of termination of employment or directorship by reason of the Optionee's Disability (as defined in the Plan), any unexercised Accrued Installments of the Option granted to Optionee shall expire and become unexercisable as of the earlier of (i) the Fifth Anniversary Date, or (ii) the first anniversary date of the Optionee's death (if applicable) or (iii) the first anniversary date of the termination of employment or directorship by reason of Disability (if applicable). Any such Accrued Installments of a deceased Optionee may be exercised prior to their expiration by (and only by) the person or persons to whom the Optionee's Option rights shall pass by will or by the laws of descent and distribution. Any installments under a deceased Optionee's Option that have not accrued as of the date of his death shall expire and become unexercisable as of said date of death. For purposes of this Agreement, the Optionee shall be deemed employed by the Company (or a subsidiary thereof, as the case may be) during any period of leave of absence from active employment as authorized by the Company (or a subsidiary thereof, as the case may be). 5. PARTIAL EXERCISE. Exercise of this Option up to the extent above stated may be in part at any time and from time to time with the above limits, except that this Option may not be exercised for a fraction of a share. Upon the exercise of the final installment of this Option, the Optionee shall be entitled to receive cash with respect to the value of any fraction of a share (in lieu of any said fractional share). 6. PAYMENT OF EXERCISE PRICE. The Exercise Price is payable in United States dollars and may be paid in cash or by certified or cashier's check, or any combination of the foregoing, equal in amount to the Exercise Price. 7. INVESTMENT REPRESENTATIONS; RESTRICTIONS ON TRANSFER. (a) The Optionee represents, warrants and covenants to the Company that: (i) Any Common Stock acquired by the Optionee upon exercise of the Option will be acquired for the Optionee's own account and not with a view to resale on distribution in violation of the Securities Act of 1933, as amended (the "1933 Act"). (ii) The Optionee has such knowledge and experience in business and financial matters as to be capable of utilizing the information which is available to the Optionee to evaluate the merits and risks of an investment in the Common Stock, and is able to bear the economic risks of any Common Stock or other securities which the Optionee may acquire upon exercise of the Option. (iii) The Optionee understands that the Option has not been registered under the Securities Act of 1933, as amended (the "1933 Act"), that the Option has been issued in reliance upon certain exemptions contained therein. The Optionee further understands that because the Option has not been registered under the 1933 Act or registered or qualified pursuant to applicable "blue sky" statutes, the Optionee may not, and Optionee covenants and agrees that Optionee will not, sell, offer to sell or otherwise dispose of any such Option in violation of the 1933 Act or any applicable "blue sky" or securities law of any state. The Optionee acknowledges and understands that Optionee has no independent right to require the Company to register the Option. 8. METHOD OF EXERCISING OPTION. Subject to the terms and conditions of this Agreement, this Option may be exercised by written notice to the Company, at the principal executive office of the Company, or to such transfer agent as the Company shall designate. Such notice shall state the election to exercise this Option and the number of shares in respect of which it is being exercised and shall be signed by the Optionee or person or persons entitled to so exercise this Option. Such notice shall be accompanied by payment of the full Exercise Price of such shares, and the Company shall deliver a certificate or certificates representing such shares as soon as practicable after the notice is received. The certificate or certificates for the shares as to which this Option shall have been so exercised shall be registered in the name of the person or persons so exercising this Option (or, if this Option shall be exercised by the Optionee and if the Optionee shall so request in the notice exercising this Option, shall be registered in the name of the Optionee and another person jointly, with right of survivorship) and shall be delivered to or upon the written order of the person or persons exercising this Option. In the event this Option shall be exercised, pursuant to Section 4 hereof, by any person or persons other than the Optionee, such notice shall be accompanied by appropriate proof of the right of such person or persons to exercise this Option. All shares that shall be purchased upon the exercise of this Option as provided herein shall be fully paid and non-assessable. 9. OPTION NOT TRANSFERABLE; TRANSFER OF STOCK. This Option is not transferable or assignable except by will or by the laws of descent and distribution. During the Optionee's lifetime, only the Optionee may exercise this Option. 10. NO OBLIGATION TO EXERCISE OPTION. The grant and acceptance of this Option imposes no obligation on the Optionee to exercise it. 11. NO OBLIGATION TO CONTINUE EMPLOYMENT. Neither the Company nor any subsidiary thereof is by the Plan or this Option obligated to continue to employ Optionee and neither the Plan nor this Option shall otherwise interfere with the Company's or any of the Company's subsidiary's right to discharge or retire any employee, including Optionee, at any time. 12. NO RIGHTS AS STOCKHOLDER UNTIL EXERCISE. The Optionee shall have no rights as a stockholder with respect to shares subject to this Agreement until a stock certificate therefore has been issued to the Optionee and is fully paid for. Except as is expressly provided in the Plan with respect to certain changes in the capitalization of the Company, no adjustment shall be made for dividends or similar rights for which the record date is prior to the date such stock certificate is issued. 13. REORGANIZATION OF COMPANY. (a) Upon the dissolution or liquidation of the Company, or upon a reorganization, merger or consolidation of the Company as a result of which the Company's outstanding Common Stock is changed into or exchanged for cash or property or securities not of the Company's issue, or upon a sale of all or substantially all property of the Company to, or the acquisition of all or substantially all of the stock of the Company then outstanding by, another corporation or person, the Plan shall terminate, and the Option granted hereunder shall terminate; provided, however, Optionee shall be entitled, at such time prior to the consummation of the transaction causing such termination as the Company shall designate, to exercise the unexercised installments of the Option including all unaccrued installments thereof which would, but for this subsection 13(a), not yet be exercisable. Notwithstanding the foregoing, in the event that any transaction causing such termination is not consummated, any unexercised unaccrued installments that had become exercisable solely by reason of the provisions of this subsection 13(a) shall again become unaccrued and unexercisable as of said termination of such transaction, subject, however, to such installments accruing pursuant to the normal accrual schedule provided in the terms under which the Option was granted. (b) In addition to and not in lieu of those rights granted pursuant to subsection 13(a) above, if provisions shall be made in writing in connection with such transaction for the continuance of the Plan and/or the assumption of options theretofore granted, or the substitution for such options of options covering the stock of the successor corporation, or a parent or subsidiary thereof with appropriate adjustments as to the number and kind of shares and prices, the unexercised Option shall continue in the manner and under the terms so provided. (c) The Company shall have no obligation to provide for the continuance, assumption or substitution of the Plan or the Option by any successor corporation or parent or subsidiary thereof. 14. WITHHOLDING TAXES. The Optionee hereby agrees that the Company (or a subsidiary thereof, as the case may be) may withhold from the Optionee's wages or other remuneration the appropriate amount of federal, state and local taxes attributable to the Optionee's exercise of any installment of this Option. The Optionee further agrees that, if the Company (or a subsidiary thereof, as the case may be) does not withhold an amount from the Optionee's wages or other remuneration sufficient to satisfy the Company's (or any such subsidiary's) withholding obligation, the Optionee will reimburse the Company (or any such subsidiary) on demand, in cash, for the amount underwithheld. 15. GOVERNING LAW. This Agreement shall be governed by and interpreted in accordance with the laws of the State of California applicable to agreements made and to be performed entirely within such State and without regard to the conflict of law principals thereof. 16. AMENDMENTS. No amendment, modification, termination or waiver of any provision of this Agreement shall be effective unless the same shall be in writing signed by all parties hereto. 17. COUNTERPARTS. This Agreement may be signed in one or more counterparts, each of which shall be deemed to be an original, but all of which together shall constitute one and the same instrument. 18. SURVIVAL OF REPRESENTATIONS. All representations, covenants and warranties of the parties hereto shall survive the execution of this Agreement. IN WITNESS WHEREOF the Company and the Optionee have caused this instrument to be executed as of the date first written above, and the Optionee whose signature appears below acknowledges receipt of a copy of the Plan and acceptance of an original copy of this Agreement. THE COMPANY: MAXICARE HEALTH PLANS, INC. By: /s/ Peter J. Ratican Chairman, President and Chief Executive Officer OPTIONEE: /s/ Aivars Jerumanis Exhibit 10.59 MAXICARE HEALTH PLANS, INC. STOCK OPTION AGREEMENT Maxicare Health Plans, Inc., a Delaware corporation (the "Company"), hereby grants as of this 20th day of December, 1993, to Robert Landis (the "Optionee"), an option to purchase a maximum of 10,000 shares of its common stock (the "Common Stock"), at a price per share (the "Exercise Price") of $9.63 per share (the "Option"), on the following terms and conditions: 1. GRANT UNDER 1990 STOCK PLAN. The Option is granted pursuant to and is governed by the Company's 1990 Stock Option Plan (the "Plan") and, unless the context otherwise requires, terms used and/or defined herein shall have the same meaning as in the Plan. Determinations made in connection with this Option pursuant to the Plan shall be governed by the Plan as it exists on this date. This Option is not intended to be and shall not be treated as an incentive stock option under Section 422 of the Internal Revenue Code. 2. EXTENT OF OPTION. If the Optionee has continued to serve in the capacity of an officer, employee, or director with the Company (or a subsidiary thereof, as the case may be) on the following dates, the Optionee may, subject to Section 13 hereof, exercise this Option for the portion of the total number of shares subject to this Option set opposite the applicable date: Less than one year from the - 0 shares date hereof One year but less than two years - 3,333 shares from the date hereof Two years but less than three - 3,333 shares years from the date hereof Three years but less than four - 3,334 shares years from the date hereof The foregoing rights are cumulative and, while the Optionee continues to serve as an officer, director or employee of the Company (or a subsidiary thereof, as the case may be), may be exercised up to and including the earlier of the date which is five years from the date this Option is granted (the "Fifth Anniversary Date"). For purposes of this Agreement, any accrued installment shall be referred to as an "Accrued Installment". All of the foregoing rights are subject to Sections 3 and 4 hereof, as appropriate, if the Optionee ceases to serve as an officer, director or employee of the Company (or a subsidiary thereof, as the case may be) or becomes disabled or dies while serving as an officer, director or employee of the Company (or a subsidiary thereof, as the case may be). 3. TERMINATION OF BUSINESS RELATIONSHIP. If the Optionee ceases to remain an officer, director or employee of the Company (or subsidiary thereof, as the case may be), other than by reason of death or disability as defined in Section 4, any unexercised Accrued Installments of the Option shall expire and become unexercisable as of the earlier of (i) the Fifth Anniversary Date, or (ii) thirty (30) days following the termination of Optionee's employment or termination of Optionee's directorship. No further installments of this Option shall become exercisable. The Board of Directors of the Company may extend such thirty (30) day period for a period not to exceed one (1) year following the Termination Date (as defined in the Plan), but in no event beyond the applicable Fifth Anniversary Date. In such a case, the Optionee's only rights hereunder shall be those which are properly exercised before the termination of this Option. Any portion of an Option that expires hereunder shall remain unexercisable and be of no effect whatsoever after such expiration notwithstanding that such Optionee may be reemployed by, or again become a director of, the Company (or a subsidiary thereof, as the case may be). 4. DEATH OR DISABILITY. In the event of the death of the Optionee while an officer, employee or director of the Company (or a subsidiary thereof, as the case may be), or in the event of termination of employment or directorship by reason of the Optionee's Disability (as defined in the Plan), any unexercised Accrued Installments of the Option granted to Optionee shall expire and become unexercisable as of the earlier of (i) the Fifth Anniversary Date, or (ii) the first anniversary date of the Optionee's death (if applicable) or (iii) the first anniversary date of the termination of employment or directorship by reason of Disability (if applicable). Any such Accrued Installments of a deceased Optionee may be exercised prior to their expiration by (and only by) the person or persons to whom the Optionee's Option rights shall pass by will or by the laws of descent and distribution. Any installments under a deceased Optionee's Option that have not accrued as of the date of his death shall expire and become unexercisable as of said date of death. For purposes of this Agreement, the Optionee shall be deemed employed by the Company (or a subsidiary thereof, as the case may be) during any period of leave of absence from active employment as authorized by the Company (or a subsidiary thereof, as the case may be). 5. PARTIAL EXERCISE. Exercise of this Option up to the extent above stated may be in part at any time and from time to time with the above limits, except that this Option may not be exercised for a fraction of a share. Upon the exercise of the final installment of this Option, the Optionee shall be entitled to receive cash with respect to the value of any fraction of a share (in lieu of any said fractional share). 6. PAYMENT OF EXERCISE PRICE. The Exercise Price is payable in United States dollars and may be paid in cash or by certified or cashier's check, or any combination of the foregoing, equal in amount to the Exercise Price. 7. INVESTMENT REPRESENTATIONS; RESTRICTIONS ON TRANSFER. (a) The Optionee represents, warrants and covenants to the Company that: (i) Any Common Stock acquired by the Optionee upon exercise of the Option will be acquired for the Optionee's own account and not with a view to resale on distribution in violation of the Securities Act of 1933, as amended (the "1933 Act"). (ii) The Optionee has such knowledge and experience in business and financial matters as to be capable of utilizing the information which is available to the Optionee to evaluate the merits and risks of an investment in the Common Stock, and is able to bear the economic risks of any Common Stock or other securities which the Optionee may acquire upon exercise of the Option. (iii) The Optionee understands that the Option has not been registered under the Securities Act of 1933, as amended (the "1933 Act"), that the Option has been issued in reliance upon certain exemptions contained therein. The Optionee further understands that because the Option has not been registered under the 1933 Act or registered or qualified pursuant to applicable "blue sky" statutes, the Optionee may not, and Optionee covenants and agrees that Optionee will not, sell, offer to sell or otherwise dispose of any such Option in violation of the 1933 Act or any applicable "blue sky" or securities law of any state. The Optionee acknowledges and understands that Optionee has no independent right to require the Company to register the Option. 8. METHOD OF EXERCISING OPTION. Subject to the terms and conditions of this Agreement, this Option may be exercised by written notice to the Company, at the principal executive office of the Company, or to such transfer agent as the Company shall designate. Such notice shall state the election to exercise this Option and the number of shares in respect of which it is being exercised and shall be signed by the Optionee or person or persons entitled to so exercise this Option. Such notice shall be accompanied by payment of the full Exercise Price of such shares, and the Company shall deliver a certificate or certificates representing such shares as soon as practicable after the notice is received. The certificate or certificates for the shares as to which this Option shall have been so exercised shall be registered in the name of the person or persons so exercising this Option (or, if this Option shall be exercised by the Optionee and if the Optionee shall so request in the notice exercising this Option, shall be registered in the name of the Optionee and another person jointly, with right of survivorship) and shall be delivered to or upon the written order of the person or persons exercising this Option. In the event this Option shall be exercised, pursuant to Section 4 hereof, by any person or persons other than the Optionee, such notice shall be accompanied by appropriate proof of the right of such person or persons to exercise this Option. All shares that shall be purchased upon the exercise of this Option as provided herein shall be fully paid and non-assessable. 9. OPTION NOT TRANSFERABLE; TRANSFER OF STOCK. This Option is not transferable or assignable except by will or by the laws of descent and distribution. During the Optionee's lifetime, only the Optionee may exercise this Option. 10. NO OBLIGATION TO EXERCISE OPTION. The grant and acceptance of this Option imposes no obligation on the Optionee to exercise it. 11. NO OBLIGATION TO CONTINUE EMPLOYMENT. Neither the Company nor any subsidiary thereof is by the Plan or this Option obligated to continue to employ Optionee and neither the Plan nor this Option shall otherwise interfere with the Company's or any of the Company's subsidiary's right to discharge or retire any employee, including Optionee, at any time. 12. NO RIGHTS AS STOCKHOLDER UNTIL EXERCISE. The Optionee shall have no rights as a stockholder with respect to shares subject to this Agreement until a stock certificate therefore has been issued to the Optionee and is fully paid for. Except as is expressly provided in the Plan with respect to certain changes in the capitalization of the Company, no adjustment shall be made for dividends or similar rights for which the record date is prior to the date such stock certificate is issued. 13. REORGANIZATION OF COMPANY. (a) Upon the dissolution or liquidation of the Company, or upon a reorganization, merger or consolidation of the Company as a result of which the Company's outstanding Common Stock is changed into or exchanged for cash or property or securities not of the Company's issue, or upon a sale of all or substantially all property of the Company to, or the acquisition of all or substantially all of the stock of the Company then outstanding by, another corporation or person, the Plan shall terminate, and the Option granted hereunder shall terminate; provided, however, Optionee shall be entitled, at such time prior to the consummation of the transaction causing such termination as the Company shall designate, to exercise the unexercised installments of the Option including all unaccrued installments thereof which would, but for this subsection 13(a), not yet be exercisable. Notwithstanding the foregoing, in the event that any transaction causing such termination is not consummated, any unexercised unaccrued installments that had become exercisable solely by reason of the provisions of this subsection 13(a) shall again become unaccrued and unexercisable as of said termination of such transaction, subject, however, to such installments accruing pursuant to the normal accrual schedule provided in the terms under which the Option was granted. (b) In addition to and not in lieu of those rights granted pursuant to subsection 13(a) above, if provisions shall be made in writing in connection with such transaction for the continuance of the Plan and/or the assumption of options theretofore granted, or the substitution for such options of options covering the stock of the successor corporation, or a parent or subsidiary thereof with appropriate adjustments as to the number and kind of shares and prices, the unexercised Option shall continue in the manner and under the terms so provided. (c) The Company shall have no obligation to provide for the continuance, assumption or substitution of the Plan or the Option by any successor corporation or parent or subsidiary thereof. 14. WITHHOLDING TAXES. The Optionee hereby agrees that the Company (or a subsidiary thereof, as the case may be) may withhold from the Optionee's wages or other remuneration the appropriate amount of federal, state and local taxes attributable to the Optionee's exercise of any installment of this Option. The Optionee further agrees that, if the Company (or a subsidiary thereof, as the case may be) does not withhold an amount from the Optionee's wages or other remuneration sufficient to satisfy the Company's (or any such subsidiary's) withholding obligation, the Optionee will reimburse the Company (or any such subsidiary) on demand, in cash, for the amount underwithheld. 15. GOVERNING LAW. This Agreement shall be governed by and interpreted in accordance with the laws of the State of California applicable to agreements made and to be performed entirely within such State and without regard to the conflict of law principals thereof. 16. AMENDMENTS. No amendment, modification, termination or waiver of any provision of this Agreement shall be effective unless the same shall be in writing signed by all parties hereto. 17. COUNTERPARTS. This Agreement may be signed in one or more counterparts, each of which shall be deemed to be an original, but all of which together shall constitute one and the same instrument. 18. SURVIVAL OF REPRESENTATIONS. All representations, covenants and warranties of the parties hereto shall survive the execution of this Agreement. IN WITNESS WHEREOF the Company and the Optionee have caused this instrument to be executed as of the date first written above, and the Optionee whose signature appears below acknowledges receipt of a copy of the Plan and acceptance of an original copy of this Agreement. THE COMPANY: MAXICARE HEALTH PLANS, INC. By: /s/ Peter J. Ratican Chairman, President and Chief Executive Officer OPTIONEE: /s/ Robert Landis Exhibit 10.60 MAXICARE HEALTH PLANS, INC. STOCK OPTION AGREEMENT Maxicare Health Plans, Inc., a Delaware corporation (the "Company"), hereby grants as of this 20th day of December, 1993, to William Caswell (the "Optionee"), an option to purchase a maximum of 10,000 shares of its common stock (the "Common Stock"), at a price per share (the "Exercise Price") of $9.63 per share (the "Option"), on the following terms and conditions: 1. GRANT UNDER 1990 STOCK PLAN. The Option is granted pursuant to and is governed by the Company's 1990 Stock Option Plan (the "Plan") and, unless the context otherwise requires, terms used and/or defined herein shall have the same meaning as in the Plan. Determinations made in connection with this Option pursuant to the Plan shall be governed by the Plan as it exists on this date. This Option is not intended to be and shall not be treated as an incentive stock option under Section 422 of the Internal Revenue Code. 2. EXTENT OF OPTION. If the Optionee has continued to serve in the capacity of an officer, employee, or director with the Company (or a subsidiary thereof, as the case may be) on the following dates, the Optionee may, subject to Section 13 hereof, exercise this Option for the portion of the total number of shares subject to this Option set opposite the applicable date: Less than one year from the - 0 shares date hereof One year but less than two years - 3,333 shares from the date hereof Two years but less than three - 3,333 shares years from the date hereof Three years but less than four - 3,334 shares years from the date hereof The foregoing rights are cumulative and, while the Optionee continues to serve as an officer, director or employee of the Company (or a subsidiary thereof, as the case may be), may be exercised up to and including the earlier of the date which is five years from the date this Option is granted (the "Fifth Anniversary Date"). For purposes of this Agreement, any accrued installment shall be referred to as an "Accrued Installment". All of the foregoing rights are subject to Sections 3 and 4 hereof, as appropriate, if the Optionee ceases to serve as an officer, director or employee of the Company (or a subsidiary thereof, as the case may be) or becomes disabled or dies while serving as an officer, director or employee of the Company (or a subsidiary thereof, as the case may be). 3. TERMINATION OF BUSINESS RELATIONSHIP. If the Optionee ceases to remain an officer, director or employee of the Company (or subsidiary thereof, as the case may be), other than by reason of death or disability as defined in Section 4, any unexercised Accrued Installments of the Option shall expire and become unexercisable as of the earlier of (i) the Fifth Anniversary Date, or (ii) thirty (30) days following the termination of Optionee's employment or termination of Optionee's directorship. No further installments of this Option shall become exercisable. The Board of Directors of the Company may extend such thirty (30) day period for a period not to exceed one (1) year following the Termination Date (as defined in the Plan), but in no event beyond the applicable Fifth Anniversary Date. In such a case, the Optionee's only rights hereunder shall be those which are properly exercised before the termination of this Option. Any portion of an Option that expires hereunder shall remain unexercisable and be of no effect whatsoever after such expiration notwithstanding that such Optionee may be reemployed by, or again become a director of, the Company (or a subsidiary thereof, as the case may be). 4. DEATH OR DISABILITY. In the event of the death of the Optionee while an officer, employee or director of the Company (or a subsidiary thereof, as the case may be), or in the event of termination of employment or directorship by reason of the Optionee's Disability (as defined in the Plan), any unexercised Accrued Installments of the Option granted to Optionee shall expire and become unexercisable as of the earlier of (i) the Fifth Anniversary Date, or (ii) the first anniversary date of the Optionee's death (if applicable) or (iii) the first anniversary date of the termination of employment or directorship by reason of Disability (if applicable). Any such Accrued Installments of a deceased Optionee may be exercised prior to their expiration by (and only by) the person or persons to whom the Optionee's Option rights shall pass by will or by the laws of descent and distribution. Any installments under a deceased Optionee's Option that have not accrued as of the date of his death shall expire and become unexercisable as of said date of death. For purposes of this Agreement, the Optionee shall be deemed employed by the Company (or a subsidiary thereof, as the case may be) during any period of leave of absence from active employment as authorized by the Company (or a subsidiary thereof, as the case may be). 5. PARTIAL EXERCISE. Exercise of this Option up to the extent above stated may be in part at any time and from time to time with the above limits, except that this Option may not be exercised for a fraction of a share. Upon the exercise of the final installment of this Option, the Optionee shall be entitled to receive cash with respect to the value of any fraction of a share (in lieu of any said fractional share). 6. PAYMENT OF EXERCISE PRICE. The Exercise Price is payable in United States dollars and may be paid in cash or by certified or cashier's check, or any combination of the foregoing, equal in amount to the Exercise Price. 7. INVESTMENT REPRESENTATIONS; RESTRICTIONS ON TRANSFER. (a) The Optionee represents, warrants and covenants to the Company that: (i) Any Common Stock acquired by the Optionee upon exercise of the Option will be acquired for the Optionee's own account and not with a view to resale on distribution in violation of the Securities Act of 1933, as amended (the "1933 Act"). (ii) The Optionee has such knowledge and experience in business and financial matters as to be capable of utilizing the information which is available to the Optionee to evaluate the merits and risks of an investment in the Common Stock, and is able to bear the economic risks of any Common Stock or other securities which the Optionee may acquire upon exercise of the Option. (iii) The Optionee understands that the Option has not been registered under the Securities Act of 1933, as amended (the "1933 Act"), that the Option has been issued in reliance upon certain exemptions contained therein. The Optionee further understands that because the Option has not been registered under the 1933 Act or registered or qualified pursuant to applicable "blue sky" statutes, the Optionee may not, and Optionee covenants and agrees that Optionee will not, sell, offer to sell or otherwise dispose of any such Option in violation of the 1933 Act or any applicable "blue sky" or securities law of any state. The Optionee acknowledges and understands that Optionee has no independent right to require the Company to register the Option. 8. METHOD OF EXERCISING OPTION. Subject to the terms and conditions of this Agreement, this Option may be exercised by written notice to the Company, at the principal executive office of the Company, or to such transfer agent as the Company shall designate. Such notice shall state the election to exercise this Option and the number of shares in respect of which it is being exercised and shall be signed by the Optionee or person or persons entitled to so exercise this Option. Such notice shall be accompanied by payment of the full Exercise Price of such shares, and the Company shall deliver a certificate or certificates representing such shares as soon as practicable after the notice is received. The certificate or certificates for the shares as to which this Option shall have been so exercised shall be registered in the name of the person or persons so exercising this Option (or, if this Option shall be exercised by the Optionee and if the Optionee shall so request in the notice exercising this Option, shall be registered in the name of the Optionee and another person jointly, with right of survivorship) and shall be delivered to or upon the written order of the person or persons exercising this Option. In the event this Option shall be exercised, pursuant to Section 4 hereof, by any person or persons other than the Optionee, such notice shall be accompanied by appropriate proof of the right of such person or persons to exercise this Option. All shares that shall be purchased upon the exercise of this Option as provided herein shall be fully paid and non-assessable. 9. OPTION NOT TRANSFERABLE; TRANSFER OF STOCK. This Option is not transferable or assignable except by will or by the laws of descent and distribution. During the Optionee's lifetime, only the Optionee may exercise this Option. 10. NO OBLIGATION TO EXERCISE OPTION. The grant and acceptance of this Option imposes no obligation on the Optionee to exercise it. 11. NO OBLIGATION TO CONTINUE EMPLOYMENT. Neither the Company nor any subsidiary thereof is by the Plan or this Option obligated to continue to employ Optionee and neither the Plan nor this Option shall otherwise interfere with the Company's or any of the Company's subsidiary's right to discharge or retire any employee, including Optionee, at any time. 12. NO RIGHTS AS STOCKHOLDER UNTIL EXERCISE. The Optionee shall have no rights as a stockholder with respect to shares subject to this Agreement until a stock certificate therefore has been issued to the Optionee and is fully paid for. Except as is expressly provided in the Plan with respect to certain changes in the capitalization of the Company, no adjustment shall be made for dividends or similar rights for which the record date is prior to the date such stock certificate is issued. 13. REORGANIZATION OF COMPANY. (a) Upon the dissolution or liquidation of the Company, or upon a reorganization, merger or consolidation of the Company as a result of which the Company's outstanding Common Stock is changed into or exchanged for cash or property or securities not of the Company's issue, or upon a sale of all or substantially all property of the Company to, or the acquisition of all or substantially all of the stock of the Company then outstanding by, another corporation or person, the Plan shall terminate, and the Option granted hereunder shall terminate; provided, however, Optionee shall be entitled, at such time prior to the consummation of the transaction causing such termination as the Company shall designate, to exercise the unexercised installments of the Option including all unaccrued installments thereof which would, but for this subsection 13(a), not yet be exercisable. Notwithstanding the foregoing, in the event that any transaction causing such termination is not consummated, any unexercised unaccrued installments that had become exercisable solely by reason of the provisions of this subsection 13(a) shall again become unaccrued and unexercisable as of said termination of such transaction, subject, however, to such installments accruing pursuant to the normal accrual schedule provided in the terms under which the Option was granted. (b) In addition to and not in lieu of those rights granted pursuant to subsection 13(a) above, if provisions shall be made in writing in connection with such transaction for the continuance of the Plan and/or the assumption of options theretofore granted, or the substitution for such options of options covering the stock of the successor corporation, or a parent or subsidiary thereof with appropriate adjustments as to the number and kind of shares and prices, the unexercised Option shall continue in the manner and under the terms so provided. (c) The Company shall have no obligation to provide for the continuance, assumption or substitution of the Plan or the Option by any successor corporation or parent or subsidiary thereof. 14. WITHHOLDING TAXES. The Optionee hereby agrees that the Company (or a subsidiary thereof, as the case may be) may withhold from the Optionee's wages or other remuneration the appropriate amount of federal, state and local taxes attributable to the Optionee's exercise of any installment of this Option. The Optionee further agrees that, if the Company (or a subsidiary thereof, as the case may be) does not withhold an amount from the Optionee's wages or other remuneration sufficient to satisfy the Company's (or any such subsidiary's) withholding obligation, the Optionee will reimburse the Company (or any such subsidiary) on demand, in cash, for the amount underwithheld. 15. GOVERNING LAW. This Agreement shall be governed by and interpreted in accordance with the laws of the State of California applicable to agreements made and to be performed entirely within such State and without regard to the conflict of law principals thereof. 16. AMENDMENTS. No amendment, modification, termination or waiver of any provision of this Agreement shall be effective unless the same shall be in writing signed by all parties hereto. 17. COUNTERPARTS. This Agreement may be signed in one or more counterparts, each of which shall be deemed to be an original, but all of which together shall constitute one and the same instrument. 18. SURVIVAL OF REPRESENTATIONS. All representations, covenants and warranties of the parties hereto shall survive the execution of this Agreement. IN WITNESS WHEREOF the Company and the Optionee have caused this instrument to be executed as of the date first written above, and the Optionee whose signature appears below acknowledges receipt of a copy of the Plan and acceptance of an original copy of this Agreement. THE COMPANY: MAXICARE HEALTH PLANS, INC. By: /s/ Peter J. Ratican Chairman, President and Chief Executive Officer OPTIONEE: /s/ William Caswell Exhibit 10.61 MAXICARE HEALTH PLANS, INC. STOCK OPTION AGREEMENT Maxicare Health Plans, Inc., a Delaware corporation (the "Company"), hereby grants as of this 20th day of December, 1993, to Thomas W. Field, Jr. (the "Optionee"), an option to purchase a maximum of 10,000 shares of its common stock (the "Common Stock"), at a price per share (the "Exercise Price") of $9.63 per share (the "Option"), on the following terms and conditions: 1. GRANT UNDER 1990 STOCK PLAN. The Option is granted pursuant to and is governed by the Company's 1990 Stock Option Plan (the "Plan") and, unless the context otherwise requires, terms used and/or defined herein shall have the same meaning as in the Plan. Determinations made in connection with this Option pursuant to the Plan shall be governed by the Plan as it exists on this date. This Option is not intended to be and shall not be treated as an incentive stock option under Section 422 of the Internal Revenue Code. 2. EXTENT OF OPTION. As an officer, employee, or director with the Company, the Optionee's rights in and to the Option shall vest as of the date hereof, and the Optionee may, subject to Section 13 hereof, exercise this Option immediately for up to the total number of shares set forth in the first sentence of this Agreement. While the Optionee continues to serve as an officer, director or employee of the Company (or a subsidiary thereof, as the case may be), the Option may be exercised up to and including the earlier of the date which is five years from the date this Option is granted (the "Fifth Anniversary Date"). For purposes of this Agreement, any accrued installment shall be referred to as an "Accrued Installment". All of the foregoing rights are subject to Sections 3 and 4 hereof, as appropriate, if the Optionee ceases to serve as an officer, director or employee of the Company (or a subsidiary thereof, as the case may be) or becomes disabled or dies while serving as an officer, director or employee of the Company (or a subsidiary thereof, as the case may be). 3. TERMINATION OF BUSINESS RELATIONSHIP. If the Optionee ceases to remain an officer, director or employee of the Company (or subsidiary thereof, as the case may be), other than by reason of death or disability as defined in Section 4, any unexercised Accrued Installments of the Option shall expire and become unexercisable as of the earlier of (i) the Fifth Anniversary Date, or (ii) thirty (30) days following the termination of Optionee's employment or termination of Optionee's directorship. No further installments of this Option shall become exercisable. The Board of Directors of the Company may extend such thirty (30) day period for a period not to exceed one (1) year following the Termination Date (as defined in the Plan), but in no event beyond the applicable Fifth Anniversary Date. In such a case, the Optionee's only rights hereunder shall be those which are properly exercised before the termination of this Option. Any portion of an Option that expires hereunder shall remain unexercisable and be of no effect whatsoever after such expiration notwithstanding that such Optionee may be reemployed by, or again become a director of, the Company (or a subsidiary thereof, as the case may be). 4. DEATH OR DISABILITY. In the event of the death of the Optionee while an officer, employee or director of the Company (or a subsidiary thereof, as the case may be), or in the event of termination of employment or directorship by reason of the Optionee's Disability (as defined in the Plan), any unexercised Accrued Installments of the Option granted to Optionee shall expire and become unexercisable as of the earlier of (i) the Fifth Anniversary Date, or (ii) the first anniversary date of the Optionee's death (if applicable) or (iii) the first anniversary date of the termination of employment or directorship by reason of Disability (if applicable). Any such Accrued Installments of a deceased Optionee may be exercised prior to their expiration by (and only by) the person or persons to whom the Optionee's Option rights shall pass by will or by the laws of descent and distribution. Any installments under a deceased Optionee's Option that have not accrued as of the date of his death shall expire and become unexercisable as of said date of death. For purposes of this Agreement, the Optionee shall be deemed employed by the Company (or a subsidiary thereof, as the case may be) during any period of leave of absence from active employment as authorized by the Company (or a subsidiary thereof, as the case may be). 5. PARTIAL EXERCISE. Exercise of this Option up to the extent above stated may be in part at any time and from time to time with the above limits, except that this Option may not be exercised for a fraction of a share. Upon the exercise of the final installment of this Option, the Optionee shall be entitled to receive cash with respect to the value of any fraction of a share (in lieu of any said fractional share). 6. PAYMENT OF EXERCISE PRICE. The Exercise Price is payable in United States dollars and may be paid in cash or by certified or cashier's check, or any combination of the foregoing, equal in amount to the Exercise Price. 7. INVESTMENT REPRESENTATIONS; RESTRICTIONS ON TRANSFER. (a) The Optionee represents, warrants and covenants to the Company that: (i) Any Common Stock acquired by the Optionee upon exercise of the Option will be acquired for the Optionee's own account and not with a view to resale on distribution in violation of the Securities Act of 1933, as amended (the "1933 Act"). (ii) The Optionee has such knowledge and experience in business and financial matters as to be capable of utilizing the information which is available to the Optionee to evaluate the merits and risks of an investment in the Common Stock, and is able to bear the economic risks of any Common Stock or other securities which the Optionee may acquire upon exercise of the Option. (iii) The Optionee understands that the Option has not been registered under the Securities Act of 1933, as amended (the "1933 Act"), that the Option has been issued in reliance upon certain exemptions contained therein. The Optionee further understands that because the Option has not been registered under the 1933 Act or registered or qualified pursuant to applicable "blue sky" statutes, the Optionee may not, and Optionee covenants and agrees that Optionee will not, sell, offer to sell or otherwise dispose of any such Option in violation of the 1933 Act or any applicable "blue sky" or securities law of any state. The Optionee acknowledges and understands that Optionee has no independent right to require the Company to register the Option. 8. METHOD OF EXERCISING OPTION. Subject to the terms and conditions of this Agreement, this Option may be exercised by written notice to the Company, at the principal executive office of the Company, or to such transfer agent as the Company shall designate. Such notice shall state the election to exercise this Option and the number of shares in respect of which it is being exercised and shall be signed by the Optionee or person or persons entitled to so exercise this Option. Such notice shall be accompanied by payment of the full Exercise Price of such shares, and the Company shall deliver a certificate or certificates representing such shares as soon as practicable after the notice is received. The certificate or certificates for the shares as to which this Option shall have been so exercised shall be registered in the name of the person or persons so exercising this Option (or, if this Option shall be exercised by the Optionee and if the Optionee shall so request in the notice exercising this Option, shall be registered in the name of the Optionee and another person jointly, with right of if Optionee is entitled to exercise any unexercised if Optionee is entitled to exercise any unexercised survivorship) and shall be delivered to or upon the written order of the person or persons exercising this Option. In the event this Option shall be exercised, pursuant to Section 4 hereof, by any person or persons other than the Optionee, such notice shall be accompanied by appropriate proof of the right of such person or persons to exercise this Option. All shares that shall be purchased upon the exercise of this Option as provided herein shall be fully paid and non-assessable. 9. OPTION NOT TRANSFERABLE; TRANSFER OF STOCK. This Option is not transferable or assignable except by will or by the laws of descent and distribution. During the Optionee's lifetime, only the Optionee may exercise this Option. 10. NO OBLIGATION TO EXERCISE OPTION. The grant and acceptance of this Option imposes no obligation on the Optionee to exercise it. 11. NO OBLIGATION TO CONTINUE EMPLOYMENT. Neither the Company nor any subsidiary thereof is by the Plan or this Option obligated to continue to employ Optionee and neither the Plan nor this Option shall otherwise interfere with the Company's or any of the Company's subsidiary's right to discharge or retire any employee, including Optionee, at any time. 12. NO RIGHTS AS STOCKHOLDER UNTIL EXERCISE. The Optionee shall have no rights as a stockholder with respect to shares subject to this Agreement until a stock certificate therefore has been issued to the Optionee and is fully paid for. Except as is expressly provided in the Plan with respect to certain changes in the capitalization of the Company, no adjustment shall be made for dividends or similar rights for which the record date is prior to the date such stock certificate is issued. 13. REORGANIZATION OF COMPANY. (a) Upon the dissolution or liquidation of the Company, or upon a reorganization, merger or consolidation of the Company as a result of which the Company's outstanding Common Stock is changed into or exchanged for cash or property or securities not of the Company's issue, or upon a sale of all or substantially all property of the Company to, or the acquisition of all or substantially all of the stock of the Company then outstanding by, another corporation or person, the Plan shall terminate, and the Option granted hereunder shall terminate; provided, however, Optionee shall be entitled, at such time prior to the consummation of the transaction causing such termination as the Company shall designate, to exercise the unexercised installments of the Option. (b) In addition to and not in lieu of those rights granted pursuant to subsection 13(a) above, if provisions shall be made in writing in connection with such transaction for the continuance of the Plan and/or the assumption of options theretofore granted, or the substitution for such options of options covering the stock of the successor corporation, or a parent or subsidiary thereof with appropriate adjustments as to the number and kind of shares and prices, the unexercised Option shall continue in the manner and under the terms so provided. (c) The Company shall have no obligation to provide for the continuance, assumption or substitution of the Plan or the Option by any successor corporation or parent or subsidiary thereof. 14. WITHHOLDING TAXES. The Optionee hereby agrees that the Company (or a subsidiary thereof, as the case may be) may withhold from the Optionee's wages or other remuneration the appropriate amount of federal, state and local taxes attributable to the Optionee's exercise of any installment of this Option. The Optionee further agrees that, if the Company (or a subsidiary thereof, as the case may be) does not withhold an amount from the Optionee's wages or other remuneration sufficient to satisfy the Company's (or any such subsidiary's) withholding obligation, the Optionee will reimburse the Company (or any such subsidiary) on demand, in cash, for the amount underwithheld. 15. GOVERNING LAW. This Agreement shall be governed by and interpreted in accordance with the laws of the State of California applicable to agreements made and to be performed entirely within such State and without regard to the conflict of law principals thereof. 16. AMENDMENTS. No amendment, modification, termination or waiver of any provision of this Agreement shall be effective unless the same shall be in writing signed by all parties hereto. 17. COUNTERPARTS. This Agreement may be signed in one or more counterparts, each of which shall be deemed to be an original, but all of which together shall constitute one and the same instrument. 18. SURVIVAL OF REPRESENTATIONS. All representations, covenants and warranties of the parties hereto shall survive the execution of this Agreement. IN WITNESS WHEREOF the Company and the Optionee have caused this instrument to be executed as of the date first written above, and the Optionee whose signature appears below acknowledges receipt of a copy of the Plan and acceptance of an original copy of this Agreement. THE COMPANY: MAXICARE HEALTH PLANS, INC. By: /s/ Peter J. Ratican Chairman, President and Chief Executive Officer OPTIONEE: /s/ Thomas W. Field, Jr. Exhibit 10.62 MAXICARE HEALTH PLANS, INC. STOCK OPTION AGREEMENT Maxicare Health Plans, Inc., a Delaware corporation (the "Company"), hereby grants as of this 20th day of December, 1993, to Dr. Charles E. Lewis (the "Optionee"), an option to purchase a maximum of 10,000 shares of its common stock (the "Common Stock"), at a price per share (the "Exercise Price") of $9.63 per share (the "Option"), on the following terms and conditions: 1. GRANT UNDER 1990 STOCK PLAN. The Option is granted pursuant to and is governed by the Company's 1990 Stock Option Plan (the "Plan") and, unless the context otherwise requires, terms used and/or defined herein shall have the same meaning as in the Plan. Determinations made in connection with this Option pursuant to the Plan shall be governed by the Plan as it exists on this date. This Option is not intended to be and shall not be treated as an incentive stock option under Section 422 of the Internal Revenue Code. 2. EXTENT OF OPTION. As an officer, employee, or director with the Company, the Optionee's rights in and to the Option shall vest as of the date hereof, and the Optionee may, subject to Section 13 hereof, exercise this Option immediately for up to the total number of shares set forth in the first sentence of this Agreement. While the Optionee continues to serve as an officer, director or employee of the Company (or a subsidiary thereof, as the case may be), the Option may be exercised up to and including the earlier of the date which is five years from the date this Option is granted (the "Fifth Anniversary Date"). For purposes of this Agreement, any accrued installment shall be referred to as an "Accrued Installment". All of the foregoing rights are subject to Sections 3 and 4 hereof, as appropriate, if the Optionee ceases to serve as an officer, director or employee of the Company (or a subsidiary thereof, as the case may be) or becomes disabled or dies while serving as an officer, director or employee of the Company (or a subsidiary thereof, as the case may be). 3. TERMINATION OF BUSINESS RELATIONSHIP. If the Optionee ceases to remain an officer, director or employee of the Company (or subsidiary thereof, as the case may be), other than by reason of death or disability as defined in Section 4, any unexercised Accrued Installments of the Option shall expire and become unexercisable as of the earlier of (i) the Fifth Anniversary Date, or (ii) thirty (30) days following the termination of Optionee's employment or termination of Optionee's directorship. No further installments of this Option shall become exercisable. The Board of Directors of the Company may extend such thirty (30) day period for a period not to exceed one (1) year following the Termination Date (as defined in the Plan), but in no event beyond the applicable Fifth Anniversary Date. In such a case, the Optionee's only rights hereunder shall be those which are properly exercised before the termination of this Option. Any portion of an Option that expires hereunder shall remain unexercisable and be of no effect whatsoever after such expiration notwithstanding that such Optionee may be reemployed by, or again become a director of, the Company (or a subsidiary thereof, as the case may be). 4. DEATH OR DISABILITY. In the event of the death of the Optionee while an officer, employee or director of the Company (or a subsidiary thereof, as the case may be), or in the event of termination of employment or directorship by reason of the Optionee's Disability (as defined in the Plan), any unexercised Accrued Installments of the Option granted to Optionee shall expire and become unexercisable as of the earlier of (i) the Fifth Anniversary Date, or (ii) the first anniversary date of the Optionee's death (if applicable) or (iii) the first anniversary date of the termination of employment or directorship by reason of Disability (if applicable). Any such Accrued Installments of a deceased Optionee may be exercised prior to their expiration by (and only by) the person or persons to whom the Optionee's Option rights shall pass by will or by the laws of descent and distribution. Any installments under a deceased Optionee's Option that have not accrued as of the date of his death shall expire and become unexercisable as of said date of death. For purposes of this Agreement, the Optionee shall be deemed employed by the Company (or a subsidiary thereof, as the case may be) during any period of leave of absence from active employment as authorized by the Company (or a subsidiary thereof, as the case may be). 5. PARTIAL EXERCISE. Exercise of this Option up to the extent above stated may be in part at any time and from time to time with the above limits, except that this Option may not be exercised for a fraction of a share. Upon the exercise of the final installment of this Option, the Optionee shall be entitled to receive cash with respect to the value of any fraction of a share (in lieu of any said fractional share). 6. PAYMENT OF EXERCISE PRICE. The Exercise Price is payable in United States dollars and may be paid in cash or by certified or cashier's check, or any combination of the foregoing, equal in amount to the Exercise Price. 7. INVESTMENT REPRESENTATIONS; RESTRICTIONS ON TRANSFER. (a) The Optionee represents, warrants and covenants to the Company that: (i) Any Common Stock acquired by the Optionee upon exercise of the Option will be acquired for the Optionee's own account and not with a view to resale on distribution in violation of the Securities Act of 1933, as amended (the "1933 Act"). (ii) The Optionee has such knowledge and experience in business and financial matters as to be capable of utilizing the information which is available to the Optionee to evaluate the merits and risks of an investment in the Common Stock, and is able to bear the economic risks of any Common Stock or other securities which the Optionee may acquire upon exercise of the Option. (iii) The Optionee understands that the Option has not been registered under the Securities Act of 1933, as amended (the "1933 Act"), that the Option has been issued in reliance upon certain exemptions contained therein. The Optionee further understands that because the Option has not been registered under the 1933 Act or registered or qualified pursuant to applicable "blue sky" statutes, the Optionee may not, and Optionee covenants and agrees that Optionee will not, sell, offer to sell or otherwise dispose of any such Option in violation of the 1933 Act or any applicable "blue sky" or securities law of any state. The Optionee acknowledges and understands that Optionee has no independent right to require the Company to register the Option. 8. METHOD OF EXERCISING OPTION. Subject to the terms and conditions of this Agreement, this Option may be exercised by written notice to the Company, at the principal executive office of the Company, or to such transfer agent as the Company shall designate. Such notice shall state the election to exercise this Option and the number of shares in respect of which it is being exercised and shall be signed by the Optionee or person or persons entitled to so exercise this Option. Such notice shall be accompanied by payment of the full Exercise Price of such shares, and the Company shall deliver a certificate or certificates representing such shares as soon as practicable after the notice is received. The certificate or certificates for the shares as to which this Option shall have been so exercised shall be registered in the name of the person or persons so exercising this Option (or, if this Option shall be exercised by the Optionee and if the Optionee shall so request in the notice exercising this Option, shall be registered in the name of the Optionee and another person jointly, with right of if Optionee is entitled to exercise any unexercised if Optionee is entitled to exercise any unexercised survivorship) and shall be delivered to or upon the written order of the person or persons exercising this Option. In the event this Option shall be exercised, pursuant to Section 4 hereof, by any person or persons other than the Optionee, such notice shall be accompanied by appropriate proof of the right of such person or persons to exercise this Option. All shares that shall be purchased upon the exercise of this Option as provided herein shall be fully paid and non-assessable. 9. OPTION NOT TRANSFERABLE; TRANSFER OF STOCK. This Option is not transferable or assignable except by will or by the laws of descent and distribution. During the Optionee's lifetime, only the Optionee may exercise this Option. 10. NO OBLIGATION TO EXERCISE OPTION. The grant and acceptance of this Option imposes no obligation on the Optionee to exercise it. 11. NO OBLIGATION TO CONTINUE EMPLOYMENT. Neither the Company nor any subsidiary thereof is by the Plan or this Option obligated to continue to employ Optionee and neither the Plan nor this Option shall otherwise interfere with the Company's or any of the Company's subsidiary's right to discharge or retire any employee, including Optionee, at any time. 12. NO RIGHTS AS STOCKHOLDER UNTIL EXERCISE. The Optionee shall have no rights as a stockholder with respect to shares subject to this Agreement until a stock certificate therefore has been issued to the Optionee and is fully paid for. Except as is expressly provided in the Plan with respect to certain changes in the capitalization of the Company, no adjustment shall be made for dividends or similar rights for which the record date is prior to the date such stock certificate is issued. 13. REORGANIZATION OF COMPANY. (a) Upon the dissolution or liquidation of the Company, or upon a reorganization, merger or consolidation of the Company as a result of which the Company's outstanding Common Stock is changed into or exchanged for cash or property or securities not of the Company's issue, or upon a sale of all or substantially all property of the Company to, or the acquisition of all or substantially all of the stock of the Company then outstanding by, another corporation or person, the Plan shall terminate, and the Option granted hereunder shall terminate; provided, however, Optionee shall be entitled, at such time prior to the consummation of the transaction causing such termination as the Company shall designate, to exercise the unexercised installments of the Option. (b) In addition to and not in lieu of those rights granted pursuant to subsection 13(a) above, if provisions shall be made in writing in connection with such transaction for the continuance of the Plan and/or the assumption of options theretofore granted, or the substitution for such options of options covering the stock of the successor corporation, or a parent or subsidiary thereof with appropriate adjustments as to the number and kind of shares and prices, the unexercised Option shall continue in the manner and under the terms so provided. (c) The Company shall have no obligation to provide for the continuance, assumption or substitution of the Plan or the Option by any successor corporation or parent or subsidiary thereof. 14. WITHHOLDING TAXES. The Optionee hereby agrees that the Company (or a subsidiary thereof, as the case may be) may withhold from the Optionee's wages or other remuneration the appropriate amount of federal, state and local taxes attributable to the Optionee's exercise of any installment of this Option. The Optionee further agrees that, if the Company (or a subsidiary thereof, as the case may be) does not withhold an amount from the Optionee's wages or other remuneration sufficient to satisfy the Company's (or any such subsidiary's) withholding obligation, the Optionee will reimburse the Company (or any such subsidiary) on demand, in cash, for the amount underwithheld. 15. GOVERNING LAW. This Agreement shall be governed by and interpreted in accordance with the laws of the State of California applicable to agreements made and to be performed entirely within such State and without regard to the conflict of law principals thereof. 16. AMENDMENTS. No amendment, modification, termination or waiver of any provision of this Agreement shall be effective unless the same shall be in writing signed by all parties hereto. 17. COUNTERPARTS. This Agreement may be signed in one or more counterparts, each of which shall be deemed to be an original, but all of which together shall constitute one and the same instrument. 18. SURVIVAL OF REPRESENTATIONS. All representations, covenants and warranties of the parties hereto shall survive the execution of this Agreement. IN WITNESS WHEREOF the Company and the Optionee have caused this instrument to be executed as of the date first written above, and the Optionee whose signature appears below acknowledges receipt of a copy of the Plan and acceptance of an original copy of this Agreement. THE COMPANY: MAXICARE HEALTH PLANS, INC. By: /s/ Peter J. Ratican Chairman, President and Chief Executive Officer OPTIONEE: /s/ Dr. Charles E. Lewis Exhibit 10.63 MAXICARE HEALTH PLANS, INC. STOCK OPTION AGREEMENT Maxicare Health Plans, Inc., a Delaware corporation (the "Company"), hereby grants as of this 20th day of December, 1993, to Claude S. Brinegar (the "Optionee"), an option to purchase a maximum of 10,000 shares of its common stock (the "Common Stock"), at a price per share (the "Exercise Price") of $9.63 per share (the "Option"), on the following terms and conditions: 1. GRANT UNDER 1990 STOCK PLAN. The Option is granted pursuant to and is governed by the Company's 1990 Stock Option Plan (the "Plan") and, unless the context otherwise requires, terms used and/or defined herein shall have the same meaning as in the Plan. Determinations made in connection with this Option pursuant to the Plan shall be governed by the Plan as it exists on this date. This Option is not intended to be and shall not be treated as an incentive stock option under Section 422 of the Internal Revenue Code. 2. EXTENT OF OPTION. As an officer, employee, or director with the Company, the Optionee's rights in and to the Option shall vest as of the date hereof, and the Optionee may, subject to Section 13 hereof, exercise this Option immediately for up to the total number of shares set forth in the first sentence of this Agreement. While the Optionee continues to serve as an officer, director or employee of the Company (or a subsidiary thereof, as the case may be), the Option may be exercised up to and including the earlier of the date which is five years from the date this Option is granted (the "Fifth Anniversary Date"). For purposes of this Agreement, any accrued installment shall be referred to as an "Accrued Installment". All of the foregoing rights are subject to Sections 3 and 4 hereof, as appropriate, if the Optionee ceases to serve as an officer, director or employee of the Company (or a subsidiary thereof, as the case may be) or becomes disabled or dies while serving as an officer, director or employee of the Company (or a subsidiary thereof, as the case may be). 3. TERMINATION OF BUSINESS RELATIONSHIP. If the Optionee ceases to remain an officer, director or employee of the Company (or subsidiary thereof, as the case may be), other than by reason of death or disability as defined in Section 4, any unexercised Accrued Installments of the Option shall expire and become unexercisable as of the earlier of (i) the Fifth Anniversary Date, or (ii) thirty (30) days following the termination of Optionee's employment or termination of Optionee's directorship. No further installments of this Option shall become exercisable. The Board of Directors of the Company may extend such thirty (30) day period for a period not to exceed one (1) year following the Termination Date (as defined in the Plan), but in no event beyond the applicable Fifth Anniversary Date. In such a case, the Optionee's only rights hereunder shall be those which are properly exercised before the termination of this Option. Any portion of an Option that expires hereunder shall remain unexercisable and be of no effect whatsoever after such expiration notwithstanding that such Optionee may be reemployed by, or again become a director of, the Company (or a subsidiary thereof, as the case may be). 4. DEATH OR DISABILITY. In the event of the death of the Optionee while an officer, employee or director of the Company (or a subsidiary thereof, as the case may be), or in the event of termination of employment or directorship by reason of the Optionee's Disability (as defined in the Plan), any unexercised Accrued Installments of the Option granted to Optionee shall expire and become unexercisable as of the earlier of (i) the Fifth Anniversary Date, or (ii) the first anniversary date of the Optionee's death (if applicable) or (iii) the first anniversary date of the termination of employment or directorship by reason of Disability (if applicable). Any such Accrued Installments of a deceased Optionee may be exercised prior to their expiration by (and only by) the person or persons to whom the Optionee's Option rights shall pass by will or by the laws of descent and distribution. Any installments under a deceased Optionee's Option that have not accrued as of the date of his death shall expire and become unexercisable as of said date of death. For purposes of this Agreement, the Optionee shall be deemed employed by the Company (or a subsidiary thereof, as the case may be) during any period of leave of absence from active employment as authorized by the Company (or a subsidiary thereof, as the case may be). 5. PARTIAL EXERCISE. Exercise of this Option up to the extent above stated may be in part at any time and from time to time with the above limits, except that this Option may not be exercised for a fraction of a share. Upon the exercise of the final installment of this Option, the Optionee shall be entitled to receive cash with respect to the value of any fraction of a share (in lieu of any said fractional share). 6. PAYMENT OF EXERCISE PRICE. The Exercise Price is payable in United States dollars and may be paid in cash or by certified or cashier's check, or any combination of the foregoing, equal in amount to the Exercise Price. 7. INVESTMENT REPRESENTATIONS; RESTRICTIONS ON TRANSFER. (a) The Optionee represents, warrants and covenants to the Company that: (i) Any Common Stock acquired by the Optionee upon exercise of the Option will be acquired for the Optionee's own account and not with a view to resale on distribution in violation of the Securities Act of 1933, as amended (the "1933 Act"). (ii) The Optionee has such knowledge and experience in business and financial matters as to be capable of utilizing the information which is available to the Optionee to evaluate the merits and risks of an investment in the Common Stock, and is able to bear the economic risks of any Common Stock or other securities which the Optionee may acquire upon exercise of the Option. (iii) The Optionee understands that the Option has not been registered under the Securities Act of 1933, as amended (the "1933 Act"), that the Option has been issued in reliance upon certain exemptions contained therein. The Optionee further understands that because the Option has not been registered under the 1933 Act or registered or qualified pursuant to applicable "blue sky" statutes, the Optionee may not, and Optionee covenants and agrees that Optionee will not, sell, offer to sell or otherwise dispose of any such Option in violation of the 1933 Act or any applicable "blue sky" or securities law of any state. The Optionee acknowledges and understands that Optionee has no independent right to require the Company to register the Option. 8. METHOD OF EXERCISING OPTION. Subject to the terms and conditions of this Agreement, this Option may be exercised by written notice to the Company, at the principal executive office of the Company, or to such transfer agent as the Company shall designate. Such notice shall state the election to exercise this Option and the number of shares in respect of which it is being exercised and shall be signed by the Optionee or person or persons entitled to so exercise this Option. Such notice shall be accompanied by payment of the full Exercise Price of such shares, and the Company shall deliver a certificate or certificates representing such shares as soon as practicable after the notice is received. The certificate or certificates for the shares as to which this Option shall have been so exercised shall be registered in the name of the person or persons so exercising this Option (or, if this Option shall be exercised by the Optionee and if the Optionee shall so request in the notice exercising this Option, shall be registered in the name of the Optionee and another person jointly, with right of if Optionee is entitled to exercise any unexercised if Optionee is entitled to exercise any unexercised survivorship) and shall be delivered to or upon the written order of the person or persons exercising this Option. In the event this Option shall be exercised, pursuant to Section 4 hereof, by any person or persons other than the Optionee, such notice shall be accompanied by appropriate proof of the right of such person or persons to exercise this Option. All shares that shall be purchased upon the exercise of this Option as provided herein shall be fully paid and non-assessable. 9. OPTION NOT TRANSFERABLE; TRANSFER OF STOCK. This Option is not transferable or assignable except by will or by the laws of descent and distribution. During the Optionee's lifetime, only the Optionee may exercise this Option. 10. NO OBLIGATION TO EXERCISE OPTION. The grant and acceptance of this Option imposes no obligation on the Optionee to exercise it. 11. NO OBLIGATION TO CONTINUE EMPLOYMENT. Neither the Company nor any subsidiary thereof is by the Plan or this Option obligated to continue to employ Optionee and neither the Plan nor this Option shall otherwise interfere with the Company's or any of the Company's subsidiary's right to discharge or retire any employee, including Optionee, at any time. 12. NO RIGHTS AS STOCKHOLDER UNTIL EXERCISE. The Optionee shall have no rights as a stockholder with respect to shares subject to this Agreement until a stock certificate therefore has been issued to the Optionee and is fully paid for. Except as is expressly provided in the Plan with respect to certain changes in the capitalization of the Company, no adjustment shall be made for dividends or similar rights for which the record date is prior to the date such stock certificate is issued. 13. REORGANIZATION OF COMPANY. (a) Upon the dissolution or liquidation of the Company, or upon a reorganization, merger or consolidation of the Company as a result of which the Company's outstanding Common Stock is changed into or exchanged for cash or property or securities not of the Company's issue, or upon a sale of all or substantially all property of the Company to, or the acquisition of all or substantially all of the stock of the Company then outstanding by, another corporation or person, the Plan shall terminate, and the Option granted hereunder shall terminate; provided, however, Optionee shall be entitled, at such time prior to the consummation of the transaction causing such termination as the Company shall designate, to exercise the unexercised installments of the Option. (b) In addition to and not in lieu of those rights granted pursuant to subsection 13(a) above, if provisions shall be made in writing in connection with such transaction for the continuance of the Plan and/or the assumption of options theretofore granted, or the substitution for such options of options covering the stock of the successor corporation, or a parent or subsidiary thereof with appropriate adjustments as to the number and kind of shares and prices, the unexercised Option shall continue in the manner and under the terms so provided. (c) The Company shall have no obligation to provide for the continuance, assumption or substitution of the Plan or the Option by any successor corporation or parent or subsidiary thereof. 14. WITHHOLDING TAXES. The Optionee hereby agrees that the Company (or a subsidiary thereof, as the case may be) may withhold from the Optionee's wages or other remuneration the appropriate amount of federal, state and local taxes attributable to the Optionee's exercise of any installment of this Option. The Optionee further agrees that, if the Company (or a subsidiary thereof, as the case may be) does not withhold an amount from the Optionee's wages or other remuneration sufficient to satisfy the Company's (or any such subsidiary's) withholding obligation, the Optionee will reimburse the Company (or any such subsidiary) on demand, in cash, for the amount underwithheld. 15. GOVERNING LAW. This Agreement shall be governed by and interpreted in accordance with the laws of the State of California applicable to agreements made and to be performed entirely within such State and without regard to the conflict of law principals thereof. 16. AMENDMENTS. No amendment, modification, termination or waiver of any provision of this Agreement shall be effective unless the same shall be in writing signed by all parties hereto. 17. COUNTERPARTS. This Agreement may be signed in one or more counterparts, each of which shall be deemed to be an original, but all of which together shall constitute one and the same instrument. 18. SURVIVAL OF REPRESENTATIONS. All representations, covenants and warranties of the parties hereto shall survive the execution of this Agreement. IN WITNESS WHEREOF the Company and the Optionee have caused this instrument to be executed as of the date first written above, and the Optionee whose signature appears below acknowledges receipt of a copy of the Plan and acceptance of an original copy of this Agreement. THE COMPANY: MAXICARE HEALTH PLANS, INC. By: /s/ Peter J. Ratican Chairman, President and Chief Executive Officer OPTIONEE: /s/ Claude S. Brinegar Exhibit 10.64 EMPLOYMENT AGREEMENT This Employment Agreement ("Agreement"), dated as of January 1, 1994, is made by and between Maxicare Health Plans, Inc., a Delaware corporation (the "Company"), and David Hammons, an individual ("Employee"). R E C I T A L S --------------- WHEREAS, Employee is knowledgeable and skillful in the Company's business; WHEREAS, the Company wishes to retain the services of Employee as Vice President, Administrative Services of the Company and Employee has agreed to render services as such; WHEREAS, Employee is willing to be employed by the Company under the terms and conditions set forth herein; NOW, THEREFORE, in consideration of the terms and conditions hereinafter set forth, and for other good and valuable consideration, the receipt of which is hereby acknowledged the parties hereto agree as follows: 1. DEFINITIONS. As used in this Agreement, the following capitalized terms shall have the following meanings, unless otherwise expressly provided or unless the context otherwise requires: (a) "Board of Directors" means the Board of Directors of the Company. (b) "Cause" means, as used with respect to the involuntary termination of Employee: (i) The willful and continued failure by Employee to substantially perform his duties pursuant to the terms of this Agreement without good cause; or (ii) The willful engaging by Employee in misconduct or inaction materially injurious to the Company; or (iii) The conviction of Employee for a felony or of a crime involving moral turpitude. No act, or failure to act, on the Employee's part shall be considered "willful" if done or omitted to be done by the Employee in good faith and with reasonable belief that the Employee's action or omission was in the best interest of the Company. (c) "Change of Control" means (i) the merger or consolidation of the Company with or into any other person or entity other than an affiliate or subsidiary of the Company if upon the consummation of the transaction, holders of the Company's equity securities, immediately prior to such transaction own less than fifty percent (50%) of the equity; or (ii) the sale or transfer by the Company of all or substantially all of its assets. (d) "Incapacity" means the absence of the Employee from his employment or the inability of Employee to perform his duties pursuant to this Agreement by reason of mental or physical illness, disability or incapacity for a period of thirty (30) consecutive days and such determination is based upon a certificate as to such mental or physical disability issued by a licensed physician and/or psychiatrist, as the case may be, employed by the Company. 2. EMPLOYMENT, SERVICES AND DUTIES. The Company hereby employs Employee as Senior Vice President, Administrative Services. Subject to his continued employment as such by the Board of Directors, Employee shall have and perform the duties and have the powers, authority and responsibilities ordinarily associated with a person in such position and shall be subject to the direction of the Company's Board of Directors. Employee shall render his services at such locations as the Company's Board of Directors may designate. 3. ACCEPTANCE OF EMPLOYMENT. Employee hereby accepts employment hereunder and agrees to devote his full time to the Company's business and shall in no way be involved in any activities whatsoever which might interfere with his employment with the Company. 4. COMPENSATION. As compensation for all services to be rendered by Employee hereunder, the Company agrees to provide Employee with the following: (a) BASE SALARY. The Company shall pay to Employee a base salary at the rate of $134,000.00 per annum, with such increases and bonuses, as may be determined from time to time by the Chief Executive Officer of the Company. Said salary shall be payable in equal semi-monthly installments or in such other installments as may be agreed upon between the parties. (b) STOCK OPTIONS. The Company shall grant to Employee an option (the "Stock Option") to purchase 5,000 shares of the Company's Common Stock. The Stock Option shall be granted pursuant to the terms of the Company's 1990 Stock Option Plan and a Stock Option Agreement in the form attached hereto as Exhibit A. Employee acknowledges that he is entitled to only one such Stock Option grant pursuant to this Agreement. Employee's interest in and rights to the Stock Option shall vest in accordance with the terms of the Stock Option Agreement. 5. BENEFITS. In addition to the compensation provided for in Section 4 of this Agreement, Employee shall have the right to participate in any profit-sharing, pension, life, health and accident insurance, or other employee benefit plans presently adopted or which hereafter may be adopted by the Company in a manner comparable to those offered or available to other employees of the Company. Employee shall be entitled to four (4) weeks annual vacation time, during which time his compensation will be paid in full. Unused vacation days in any year(s) may be carried over to a subsequent year(s) provided, however, the cumulative number of vacation days which may be carried over in any one year shall not exceed four (4) weeks. 6. EXPENSES. The Company shall promptly reimburse Employee for all reasonable travel, hotel, entertainment and other expenses incurred by Employee in the discharge of Employee's duties hereunder, upon receipt from Employee of vouchers, receipts or other reasonable substantiation of such expenses acceptable to the Company. 7. TERM OF EMPLOYMENT. The term of employment hereunder shall be for a period of one (1) year, commencing as of the date of this Agreement, unless earlier terminated as herein provided. This Agreement shall terminate upon the occurrence of any of the following events: (a) The death of Employee; (b) Employee voluntarily leaves the employ of the Company, with or without the consent of the Company; (c) The Incapacity of Employee; (d) The Company terminates this Agreement for Cause; (e) The Company terminates this Agreement for any reason other than as set forth in Sections 7(a), 7(c) or 7(d) hereof; or (f) The appointment of a trustee for the Company for the purpose of liquidating and winding up the Company pursuant to Chapter 7 of the Federal Bankruptcy Code. 8. COMPENSATION UPON TERMINATION. In the event this Agreement is terminated pursuant to Section 7, the Company shall pay to Employee such compensation as Employee is entitled to receive pursuant to Section 4, prorated through the date of said termination. In the event that such termination arises under Section 7(a), Employee's estate shall be entitled to receive severance compensation equal to such amount of Employee's annual base salary as would have been paid over a thirty (30) day period. In the event that such termination arises under Section 7(e), Employee shall be entitled to receive severance compensation in an amount equal to such amount of Employee's annual base salary as would have been paid over a four (4) month period. In the event that this Agreement is terminated by the Company or its successor in interest in connection with, or as a result of, a Change in Control or for any reason other than as set forth in Sections 7(a) - (d) hereof within six (6) months of a Change in Control, Employee shall, in lieu of any severance compensation payable pursuant to the immediately preceding sentence, be entitled to receive severance compensation in an amount equal to such amount of Employee's annual base salary as would have been paid over a four (4) month period. Any and all severance amounts paid pursuant to the provisions of this Section 8 shall be paid in one lump sum installment. The treatment of Employee's Stock Options shall be governed by the terms of the Company's 1990 Stock Option Plan and the Stock Option Agreement. 9. COVENANT NOT TO COMPETE. Employee covenants and agrees that during the term of his employment by the Company pursuant to this Agreement he will not, directly or indirectly, own, manage, operate, join, control or become employed by, or render any services of any advisory nature or otherwise, or participate in the ownership, management, operation or control of, any business which competes with the business of the Company or any of its affiliates. Notwithstanding the foregoing, Employee shall not be prevented from investing his assets in such form or manner as will not require any services on the part of Employee in the operation of the affairs of a company in which investments are made, provided such company is not engaged in a business competitive to the Company, or if it is in competition with the Company, provided its stock is publicly traded and Employee owns less than one percent (1%) of the outstanding stock of that company. 10. CONFIDENTIALITY. Employee covenants and agrees that he will not at any time during or after the termination of his employment by the Company reveal, divulge or make known to any person, firm or corporation any information, knowledge or data of a proprietary nature relating to the business of the Company or any of its affiliates which is not or has not become generally known or public. Employee shall hold, in a fiduciary capacity, for the benefit of the Company, all information, knowledge or data of a proprietary nature, relating to or concerned with, the operations, customers, developments, sales, business and affairs of the Company and its affiliates which is not generally known to the public and which is or was obtained by the Employee during his employment by the Company. Employee recognizes and acknowledges that all such information, knowledge or data is a valuable and unique asset of the Company and accordingly he will not discuss or divulge any such information, knowledge or data to any person, firm, partnership, corporation or organization other than to the Company, its affiliates, designees, assignees or successors or except as may otherwise be required by the law, as ordered by a court or other governmental body of competent jurisdiction, or in connection with the business and affairs of the Company. 11. EQUITABLE REMEDIES. In the event of a breach or threatened breach by Employee of any of his obligations under Sections 9 and 10 hereof, Employee acknowledges that the Company may not have an adequate remedy at law and therefore it is mutually agreed between Employee and the Company that in addition to any other remedies at law or in equity which the Company may have, the Company shall be entitled to seek in a court of law and/or equity a temporary and/or permanent injunction restraining Employee from any continuing violation or breach of this Agreement. 12. MISCELLANEOUS. (a) This Agreement shall be binding upon and inure to the benefit of the Company and any successor of the Company. This Agreement shall not be terminated by the voluntary or involuntary dissolution of the Company or by any merger, reorganization or other transaction in which the Company is not the surviving or resulting corporation or upon any transfer of all or substantially all of the assets of Company in the event of any such merger, or transfer of assets. The provisions of this Agreement shall be binding upon and shall inure to the benefit of the surviving business entity or the business entity to which such assets shall be transferred in the same manner and to the same extent that the Company would be required to perform as if no such transaction had taken place. Neither this Agreement nor any rights arising hereunder may be assigned or pledged by Employee. Employee's rights to the compensation provided for under Section 4 of this Agreement (as may be limited by Section 8 of the Agreement) and to the reimbursement for expenses under Section 6 hereof, shall continue, despite the fact that Employee may cease to be employed by the Company, and shall survive the termination of this Agreement regardless of cause. This Agreement shall inure to the benefit of and be enforceable by Employee's personal or legal representatives, executors, administrators, successors, heirs, distributees, devisees and legatees. (b) Except as otherwise provided by law or elsewhere herein, Employee shall be entitled to all benefits as set forth herein notwithstanding the occurrence of the following events: (i) any act of force majeure which materially and adversely affect the Company's business and operations, including but not limited to, the Company having sustained a material loss, whether or not insured, by reason of fire, earthquake, flood, epidemic, explosion, accident, calamity or other act of God; (ii) any strike or labor dispute or court or government action, order or decree; (iii) a banking moratorium having been declared by federal or state authorities; (iv) an outbreak of major armed conflict, blockade, embargo, or other international hostilities or restraints or orders of civic, civil defense, or military authorities, or other national or international calamity having occurred; (v) any act of public enemy, riot or civil disturbance or threat thereof; or (vi) a pending or threatened legal or governmental proceeding or action relating generally to the Company's business, or a notification having been received by the Company of the threat of any such proceeding or action, which could materially adversely affect the Company. (c) Except as expressly provided herein, this Agreement contains the entire understanding between the parties with respect to the subject matter hereof, and may not be modified, altered or amended except by an instrument in writing signed by the parties hereto. This Agreement supersedes all prior agreements of the parties with respect to the subject matter hereof. In the event of termination of employment of Employee pursuant to this Agreement, the arrangements provided for by this Agreement, by any Stock Option Agreement or other written agreement between the Company or any of its affiliates and Employee in effect at the time, and by any other applicable benefit plan of the Company or any of its affiliates, will constitute the entire obligation of the Company to the Employee and performance thereof by the Company will constitute full settlement of any and all claims, whether in contract or tort, that Employee might otherwise assert against the Company or any of its affiliates on account of such termination. (d) This Agreement shall be construed in accordance with the laws of the State of California applicable to agreements made and to be performed entirely within such state and without regard to the conflict of law principals thereof. (e) Nothing in the Agreement is intended to require or shall be construed as requiring the Company to do or fail to do any act in violation of applicable law. The Company's inability pursuant to court order to perform its obligations under this Agreement shall not constitute a breach of this Agreement. If any provision of this Agreement is invalid or unenforceable, the remainder of this Agreement shall nevertheless remain in full force and effect. If any provision is held invalid or unenforceable with respect to particular circumstances, it shall, nevertheless, remain in full force and effect in all other circumstances. (f) With the exception of disputes arising under or with respect to Sections 9 or 10 hereof, any and all disputes hereunder shall be resolved by arbitration. Any party hereto electing to commence an action shall give written notice to the other parties hereto of such election. The dispute shall be settled by arbitration in accordance with the then rules of the American Arbitration Association; provided, however, in the event the parties are unable to agree on an arbitrator within twenty (20) days after receipt of the aforementioned notice of arbitration, a single arbitrator shall be selected by the Chief Judge of the Superior Court of the State of California for the County of Los Angeles. The award of such arbitrator may be confirmed or enforced in any court of competent jurisdiction. The costs and expenses of the arbitrator, including the attorney's fees and costs of each of the parties, shall be apportioned between the parties by such arbitrator, based upon such arbitrator's determination of the merits of their respective positions. With respect to such arbitration, the parties shall have those rights of discovery as may be granted by the arbitrator in accordance with California law. (g) Any notice to the Company required or permitted hereunder shall be given in writing to the Company, either by personal service, telex, telecopier or, if by mail, by registered or certified mail return receipt requested, postage prepaid, duly addressed to the Secretary of the Company at its then principal place of business. Any such notice to Employee shall be given in a like manner, and if mailed shall be addressed to Employee at Employee's home address then shown in the files of the Company. For the purpose of determining compliance with any time limit herein, a notice shall be deemed given on the fifth day following the postmarked date, if mailed, or the date of delivery if personally delivered. (h) A waiver by either party of any term or condition of this Agreement or any breach thereof, in any one instance, shall not be deemed or construed to be a waiver of such term or condition or of any subsequent breach thereof. (i) The paragraph and subparagraph headings contained in this Agreement are solely for convenience and shall not be considered in its interpretation. (j) This Agreement may be executed in one or more counterparts, each of which shall constitute an original. IN WITNESS WHEREOF, the parties hereto have executed this Employment Agreement as of the day and year first written above. COMPANY: MAXICARE HEALTH PLANS, INC., a Delaware corporation By: /s/ Peter J. Ratican Title: Chairman, President and Chief Executive Officer EMPLOYEE: /s/ David Hammons Exhibit 10.65 MAXICARE HEALTH PLANS, INC. STOCK OPTION AGREEMENT Maxicare Health Plans, Inc., a Delaware corporation (the "Company"), hereby grants as of this 20th day of May, 1991, to Dave Hammons (the "Optionee"), an option to purchase a maximum of 10,000 shares of its common stock (the "Common Stock"), at a price per share (the "Exercise Price") equal to the weighted average price per share for the first twenty trading days after December 5, 1990, of (i) the closing bid price of the Company's Common stock in the principal national securities exchange in which the Common Stock is traded, or (ii) if the Company's Common Stock is not traded on a national securities exchange, the last reported sale price of the Common Stock on the NASDAQ National Market List, or (iii) if the common stock is not reported on the NASDAQ National Market List, the closing bid price (or average of bid prices) last quoted by an established quotation service for over-the-counter securities (the "Option"), on the following terms and conditions: 1. GRANT UNDER 1990 STOCK PLAN. This Option is granted pursuant to and is governed by the Company's 1990 Stock Option Plan (the "Plan") and, unless the context otherwise requires, terms used and/or defined herein shall have the same meaning as in the Plan. Determinations made in connection with this Option pursuant to the Plan shall be governed by the Plan as it exists on this date. 2. EXTENT OF OPTION. If the Optionee has continued to serve the Company in the capacity of an officer, employee, or director with the Company on the following dates, the Optionee may, subject to Section 13 hereof, exercise this Option for the portion of the total number of shares set forth opposite the applicable date: December 5, 1992 One-third (1/3) of the total number of shares subject to this option December 5, 1993 An additional one third (1/3) of the total number of shares subject to this option December 5, 1994 An additional one-third (1/3) of the total number of shares subject to this option The foregoing right are cumulative and, while the Optionee continues to serve as an officer, director or employee of the Company, may be exercised up to and including the earlier of the date which is 5 years from December 5, 1990 or the expiration date of the Plan (the earlier of such dates being hereinafter referred to as the "Option Expiration Date"). For purposes of this Agreement, any accrued installment shall be referred to as "Accrued Installment". All of the foregoing rights are subject to Sections 3 and 4 hereof, as appropriate, if the Optionee ceases to serve as an officer, director or employee of the Company or becomes disabled or dies while serving as an officer, director or employee of the Company. 3. TERMINATION OF BUSINESS RELATIONSHIP. If the Optionee ceases to remain an officer, director or employee of the Company, other than by reason of death or disability as defined in Section 4, any unexercised Accrued Installments of the Option shall expire and become unexercisable as of the earlier of (i) the Option Expiration Date, or (ii) thirty (30) days following the termination of Optionee's employment or termination of Optionee's directorship. No further installment of this Option shall become exercisable. The Board of Directors of the Company may extend such thirty (30) day period for a period not to exceed one (1) year following the Termination Date, (as defined in the Plan), but in no event beyond the applicable Option Expiration Date. In such a case, the Optionee's only rights hereunder shall be those which are properly exercised before the termination of this Option. Any portion of an Option that expires hereunder shall remain unexercisable and be of no effect whatsoever after such expiration notwithstanding that such Optionee may be reemployed by, or again become a director of, the Company. 4. DEATH OR DISABILITY. In the event of the death of the Optionee while an officer, employee or director of the Company, or in the event of termination of employment or directorship by reason of the Optionee's Disability (as defined in the Plan), any unexercised Accrued Installments of the Option granted to the Optionee shall expire and become unexercisable as of the earlier of (i) the Option Expiration Date, or (ii) the first anniversary date of the Optionee's death (if applicable) or (iii) the first anniversary date of the termination of employment or directorship by reason of Disability (if applicable). Any such Accrued Installments of a deceased Optionee may be exercised prior to their expiration by (and only by) the person or persons to whom the Optionee's Option rights shall pass by will or by the laws of descent and distribution. Any installments under a deceased Optionee's Option that have not accrued as of the date of his/her death shall expire and become unexercisable as of said date of death. For purposes of this Agreement, the Optionee shall be deemed employed by the Company during any period of leave of absence from active employment as authorized by the Company. 5. PARTIAL EXERCISE. Exercise of this Option up to the extent above stated may be made in part at any time and from time to time with the above limits, except that this Option may be exercised for a fraction of a share. Upon the exercise of the final installment of this Option, the Optionee shall be entitled to receive cash with respect to the value of any fraction of a share (in lieu of any said fractional share). 6. PAYMENT OF EXERCISE PRICE. The Exercise Price is payable in United States Dollars and may be paid in cash or by certified or cashier's check, or any combination of the foregoing, equal in the amount to the Exercise Price. 7. INVESTMENT REPRESENTATIONS; RESTRICTIONS ON TRANSFER. (a) The Optionee represents, warrants and covenants to the Company that: (i) Any Common Stock acquired by the Optionee upon exercise of the Option will be acquired of the Optionee's own account and not with a view of resale or distribution in violation of the Securities Act of 1933, as amended (the "1933 Act"). (ii) The Optionee has such knowledge and experience in business and financial matters as to be capable of utilizing the information which is available to the Optionee to evaluate the merits and risks of an investment in the Common Stock, and is able to tear the economic risks of any Common Stock or other securities which the Optionee may acquire upon exercise of the Option. (iii) The Optionee understands that neither the Option nor the Common Stock to be issued upon exercise of the Option have been registered under the Securities Act of 1933, as amended (the "1933 Act"), that the Option has been, and the shares of Common Stock issuable upon exercise of the Option will be, issued in reliance upon certain exemptions contained therein, and that the Company's reliance on such exemption is predicated on Optionee's representations set forth herein. The Optionee further understands that because neither the Option nor the shares of Common Stock to be issued up on exercise of the Option have been registered under the 1993 Act, the Optionee may not and Optionee covenants and agrees that Optionee will not, sell, offer to sell or otherwise dispose of any such securities in violation of the 1933 Act or any applicable "blue sky" or securities law of any state. The Optionee acknowledges and understands that Optionee has no independent right to require the Company to register the Option or the Common Stock to be issued upon exercise of the Option. (b) The Optionee consents to the placing of restrictive legends in substantially the following form on any stock certificate(s) representing Common Stock issued upon exercise of the Option: "The Shares represented by this Certificate have not been registered under the Securities Act of 1933, as amended, or the blue sky laws of any state. These shares have been acquired for investment and not with a view to distribution or resale, and may not be sold, mortgaged, pledged, hypothecated or otherwise transferred without an effective registration statement for such shares under the Securities Act of 1933, as amended, or until the issuer has been furnished with an opinion of counsel for the registered owner of these shares, reasonably satisfactory to counsel for the issurer, that such sale, transfer or disposition is exempt from the registration or qualification provisions of the Securities Act of 1933, as amended, or the blue sky laws of any state having jurisdiction." (c) The Optionee also hereby consents and agrees to the placing of stop transfer instructions against any subsequent transfer(s) of shares of Common Stock issued upon exercise of the Option. The Company hereby agrees to remove the legend and stop transfer instructions upon receipt of an opinion of counsel from the registered owner of the shares of Common Stock issued upon exercises of the Option, in form and substance acceptable to counsel for the Company, to the effect that such shares may be transferred without violation of the 1933 Act or the blue sky laws of any state having jurisdiction. 8. METHOD OF EXERCISING OPTION. No Option may be exercised in whole or in part until two (2) years after December 5, 1990. Subject to the terms and conditions of this Agreement, this Option may be exercised by written notice to the Company, at the principal executive office of the Company, or to such transfer agent as the Company shall designate. Such notice shall state the election to exercise this Option and the number of shares in respect of which it is being exercised and shall be signed by the Optionee or person or persons entitled to so exercise this Option. Such notice shall be accompanied by payment of the full Exercise Price of such shares, and the Company shall deliver a certificate or certificates representing such shares as soon as practicable after the notice is received. The certificate or certificates for the shares as to which this Option shall have been so exercised shall be registered in the name of the person or persons so exercising this Option (or, if this Option shall be exercised by the Optionee and if the Optionee shall so request in the notice exercising this Option, shall be registered in the name of the Optionee and another person jointly, with right of survivorship) and shall be delivered to or upon the written order of the person or persons exercising this Option. In the event this Option shall be exercised, pursuant to Section 4 hereof, by any person or persons other than the Optionee, such notice shall be accompanied by appropriate proof of the right of such person or persons to exercise this Option. All shares that shall be purchased upon the exercise of this Option as provided herein shall be fully paid and non-assessable. 9. OPTION NOT TRANSFERABLE; TRANSFER OF STOCK. This Option is not transferable or assignable except by will or by the laws of descent and distribution. During the Optionee's lifetime, only the Optionee may exercise this Option. Common Stock issued pursuant to the exercise of this Option or any interest in such Common Stock, may be sold, assigned, gifted, pledged, hypothecated, encumbered or otherwise transferred to alienated in any manner by the holder(s) thereof, subject, however, to the provisions of the Plan, including any representations or warranties requested under Section 22 thereof, and also subject to compliance with any applicable federal, state, local or other law, regulations or rule governing the sale or transfer of stock or securities, and provided, further than in all cases, the Optionee may not sell or otherwise transfer shares acquired upon the exercise of an Option for a period of six (6) months following the date of acquisition (within the meaning of Section 16-b (3) of the Security Exchange Act of 1934) of such Option without the prior written consent of the Board. 10. NO OBLIGATION TO EXERCISE OPTION. The grant and acceptance of this Option imposes no obligation on the Optionee to exercise it. 11. NO OBLIGATION TO CONTINUE EMPLOYMENT. The Company is not by the Plan or this Option obligated to continue to employ Optionee and neither the Plan nor this Option shall otherwise interfere with the Company's right to discharge or retire any employee, including Optionee, at any time. 12. NO RIGHTS AS STOCKHOLDER UNTIL EXERCISE. The Optionee shall have no rights as a stockholder with respect to shares subject to this Agreement until a stock certificate therefore has been issued to the Optionee and is fully paid for. Except as is expressly provided in the Plan with respect to certain changes in the capitalization of the Company, no adjustment shall be made for dividends or similar rights for which the record date is prior to the date such stock certificate is issued. 13. REORGANIZATION OF COMPANY. (a) Upon the dissolution or liquidation of Company, or upon a reorganization, merger or consolidation of the Company as a result of which the Company's outstanding Common Stock is changed into or exchanged for cash or property or securities not of the Company's issue, or upon a sale of all or substantially all property of the Company to, or the acquisition of all or substantially all of the stock of the Company then outstanding by, another corporation or person, the Plan shall terminate, and the Option granted hereunder shall terminate; provided, however, if Optionee is entitled to exercise any unexercised installment of the Option then outstanding, then Optionee may, at such time prior to the consummation of the transaction causing such termination as the Company shall designate, exercise the unexercised installments of the Option including all unaccrued installments thereof which would, but for this subsection 13(a), not yet be exercisable. Notwithstanding the foregoing, in the event that any transaction causing such termination is not consummated, any unexercised unaccrued installments that had become exercisable solely by reason of the provisions of this subsection 13(a) shall again become unaccrued and unexercisable as of said termination of such transaction, subject, however, to such installments accruing pursuant to the normal accrual schedule provided in the terms under which the Option was granted. (b) In addition to and not in lieu of those rights granted pursuant to subsection 13(a) above, if provisions shall be made in writing in connection with such transaction for the continuance of the Plan and/or the assumption of options theretofore granted, or the substitution for such options of options covering the stock of the successor corporation, or a parent or subsidiary thereof with appropriate adjustments as to the number and kind of shares and prices, the unexercised Option shall continue in the manner and under the terms so provided. (c) The Company shall have no obligation to provide for the continuance, assumption or substitution of the Plan or the Option by any successor corporation or parent or subsidiary thereof. 14. WITHHOLDING TAXES. The Optionee hereby agrees that the Company may withhold from the Optionee's wages or other remuneration the appropriate amount of federal, state and local taxes attributable to the Optionee's exercise of any installment of this Option. The Optionee further agrees that, if the Company does not withhold an amount from the Optionee's wages or other remuneration sufficient to satisfy the Company's withholding obligation, the Optionee will reimburse the Company on demand, in cash, for the amount underwithheld. 15. GOVERNING LAW. This Agreement shall be governed by and interpreted in accordance with the laws of the State of California applicable to agreements made and to be performed entirely within such State and without regard to the conflict of law principals thereof. 16. AMENDMENTS. No amendment, modification, termination or waiver of any provision of this Agreement shall be effective unless the same shall be in writing signed by all parties hereto. 17. COUNTERPARTS. This Agreement may be signed in one or more counterparts, each of which shall be deemed to be an original, but all of which together shall constitute one and the same instrument. 18. SURVIVAL OF REPRESENTATIONS. All representations, covenants and warranties of the parties hereto shall survive the execution of this Agreement. IN WITNESS WHEREOF the Company and the Optionee have caused this instrument to be executed as of the date first written above, and the Optionee whose signature appears below acknowledges receipt of a copy of the Plan and acceptance of an original copy of this Agreement. THE COMPANY: MAXICARE HEALTH PLANS, INC. By: /s/ Peter J. Ratican President and Chief Executive Officer OPTIONEE: /s/ Dave Hammons Exhibit 10.66 MAXICARE HEALTH PLANS, INC. STOCK OPTION AGREEMENT Maxicare Health Plans, Inc., a Delaware corporation (the "Company"), hereby grants as of this 20th day of December, 1991, to Dave Hammons (the "Optionee"), an option to purchase a maximum of 5,000 shares of its common stock (the "Common Stock"), at a price per share (the "Exercise Price") of $8.25 per share (the "Option"), on the following terms and conditions: 1. GRANT UNDER 1990 STOCK PLAN. This Option is granted pursuant to and is governed by the Company's 1990 Stock Option Plan (the "Plan") and, unless the context otherwise requires, terms used and/or defined herein shall have the same meaning as in the Plan. Determinations made in connection with this Option pursuant to the Plan shall be governed by the Plan as it exists on this date. This Option is not intended to be and shall not be treated as an incentive stock option under Section 422 of the Internal Revenue Code. 2. EXTENT OF OPTION. If the Optionee has continued to serve the Company in the capacity of an officer, employee, or director with the Company (or a subsidiary thereof, as the case may be) on the following dates, the Optionee may, subject to Section 13 hereof, exercise this Option for the portion of the total number of shares set opposite the applicable date: Less than one year from the date hereof - 0 One year but less than two years from the date hereof - 1,667 Two years but less than three years from the date hereof - 1,667 Three years but less than four years from the date hereof - 1,666 The foregoing right are cumulative and, while the Optionee continues to serve as an officer, director or employee of the Company (or a subsidiary thereof, as the case may be), may be exercised up to and including the earlier of the date which is five years from the date this Option is granted (the "Fifth Anniversary Date"). For purposes of this Agreement, any accrued installment shall be referred to as "Accrued Installment". All of the foregoing rights are subject to Sections 3 and 4 hereof, as appropriate, if the Optionee ceases to serve as an officer, director or employee of the Company (or a subsidiary thereof, as the case may be) or becomes disabled or dies while serving as an officer, director or employee of the Company (or a subsidiary thereof, as the case may be). 3. TERMINATION OF BUSINESS RELATIONSHIP. If the Optionee ceases to remain an officer, director or employee of the Company (or a subsidiary thereof, as the case may be), other than by reason of death or disability as defined in Section 4, any unexercised Accrued Installments of the Option shall expire and become unexercisable as of the earlier of (i) the Option Expiration Date, or (ii) thirty (30) days following the termination of Optionee's employment or termination of Optionee's directorship. No further installment of this Option shall become exercisable. The Board of Directors of the Company may extend such thirty (30) day period for a period not to exceed one (1) year following the Termination Date (as defined in the Plan), but in no event beyond the applicable Option Expiration Date. In such a case, the Optionee's only rights hereunder shall be those which are properly exercised before the termination of this Option. Any portion of an Option that expires hereunder shall remain unexercisable and be of no effect whatsoever after such expiration notwithstanding that such Optionee may be reemployed by, or again become a director of, the Company (or a subsidiary thereof, as the case may be). 4. DEATH OR DISABILITY. In the event of the death of the Optionee while an officer, employee or director of the Company (or a subsidiary thereof, as the case may be), or in the event of termination of employment or directorship by reason of the Optionee's Disability (as defined in the Plan), any unexercised Accrued Installments of the Option granted to Optionee shall expire and become unexercisable as of the earlier of (i) the Fifth Anniversary Date, or (ii) the first anniversary date of the Optionee's death (if applicable) or (iii) the first anniversary date of the termination of employment or directorship by reason of Disability (if applicable). Any such Accrued Installments of a deceased Optionee may be exercised prior to their expiration by (and only by) the person or persons to whom the Optionee's Option rights shall pass by will or by the laws of descent and distribution. Any installments under a deceased Optionee's Option that have not accrued as of the date of his/her death shall expire and become unexercisable as of said date of death. For purposes of this Agreement, the Optionee shall be deemed employed by the Company (or a subsidiary thereof, as the case may be) during any period of leave of absence from active employment as authorized by the Company (or a subsidiary thereof, as the case may be). 5. PARTIAL EXERCISE. Exercise of this Option up to the extent above stated may be made in part at any time and from time to time with the above limits, except that this Option may be exercised for a fraction of a share. Upon the exercise of the final installment of this Option, the Optionee shall be entitled to receive cash with respect to the value of any fraction of a share (in lieu of any said fractional share). 6. PAYMENT OF EXERCISE PRICE. The Exercise Price is payable in United States Dollars and may be paid in cash or by certified or cashier's check, or any combination of the foregoing, equal in the amount to the Exercise Price. 7. INVESTMENT REPRESENTATIONS; RESTRICTIONS ON TRANSFER. (a) The Optionee represents, warrants and covenants to the Company that: (i) Any Common Stock acquired by the Optionee upon exercise of the Option will be acquired of the Optionee's own account and not with a view of resale or distribution in violation of the Securities Act of 1933, as amended (the "1933 Act"). (ii) The Optionee has such knowledge and experience in business and financial matters as to be capable of utilizing the information which is available to the Optionee to evaluate the merits and risks of an investment in the Common Stock, and is able to tear the economic risks of any Common Stock or other securities which the Optionee may acquire upon exercise of the Option. (iii) The Optionee understands that neither the Option nor the Common Stock to be issued upon exercise of the Option have been registered under the Securities Act of 1933, as amended (the "1933 Act"), that the Option has been, and the shares of Common Stock issuable upon exercise of the Option will be, issued in reliance upon certain exemptions contained therein, and that the Company's reliance on such exemption is predicated on Optionee's representations set forth herein. The Optionee further understands that because neither the Option nor the shares of Common Stock to be issued up on exercise of the Option have been registered under the 1993 Act, the Optionee may not and Optionee covenants and agrees that Optionee will not, sell, offer to sell or otherwise dispose of any such securities in violation of the 1933 Act or any applicable "blue sky" or securities law of any state. The Optionee acknowledges and understands that Optionee has no independent right to require the Company to register the Option or the Common Stock to be issued upon exercise of the Option. (b) The Optionee consents to the placing of restrictive legends in substantially the following form on any stock certificate(s) representing Common Stock issued upon exercise of the Option: "The Shares represented by this Certificate have not been registered under the Securities Act of 1933, as amended. These shares have been acquired for investment and not with a view to distribution or resale, and may not be sold, mortgaged, pledged, hypothecated or otherwise transferred without an effective registration statement for such shares under the Securities Act of 1933, as amended, or until the issuer has been furnished with an opinion of counsel for the registered owner of these shares, reasonably satisfactory to counsel for the issuer, that such sale, transfer or disposition is exempt from the registration or qualification provisions of the Securities Act of 1933, as amended." (c) The Optionee also hereby consents and agrees to the placing of stop transfer instructions against any subsequent transfer(s) of shares of Common Stock issued upon exercise of the Option. The Company hereby agrees to remove the legend and stop transfer instructions upon receipt of an opinion of counsel from the registered owner of the shares of Common Stock issued upon exercises of the Option, in form and substance acceptable to counsel for the Company, to the effect that such shares may be transferred without violation of the 1933 Act. 8. METHOD OF EXERCISING OPTION. Subject to the terms and conditions of this Agreement, this Option may be exercised by written notice to the Company, at the principal executive office of the Company, or to such transfer agent as the Company shall designate. Such notice shall state the election to exercise this Option and the number of shares in respect of which it is being exercised and shall be signed by the Optionee or person or persons entitled to so exercise this Option. Such notice shall be accompanied by payment of the full Exercise Price of such shares, and the Company shall deliver a certificate or certificates representing such shares as soon as practicable after the notice is received. The certificate or certificates for the shares as to which this Option shall have been so exercised shall be registered in the name of the person or persons so exercising this Option (or, if this Option shall be exercised by the Optionee and if the Optionee shall so request in the notice exercising this Option, shall be registered in the name of the Optionee and another person jointly, with right of survivorship) and shall be delivered to or upon the written order of the person or persons exercising this Option. In the event this Option shall be exercised, pursuant to Section 4 hereof, by any person or persons other than the Optionee, such notice shall be accompanied by appropriate proof of the right of such person or persons to exercise this Option. All shares that shall be purchased upon the exercise of this Option as provided herein shall be fully paid and non-assessable. 9. OPTION NOT TRANSFERABLE; TRANSFER OF STOCK. This Option is not transferable or assignable except by will or by the laws of descent and distribution. During the Optionee's lifetime, only the Optionee may exercise this Option. Common Stock issued pursuant to the exercise of this Option or any interest in such Common Stock, may be sold, assigned, gifted, pledged, hypothecated, encumbered or otherwise transferred to alienated in any manner by the holder(s) thereof, subject, however, to the provisions of the Plan, including any representations or warranties requested under Section 22 thereof, and also subject to compliance with any applicable federal, state, local or other law, regulations or rule governing the sale or transfer of stock or securities, and provided, further than in all cases, the Optionee may not sell or otherwise transfer shares acquired upon the exercise of an Option for a period of six (6) months following the date of acquisition (within the meaning of Section 16-b (3) of the Security Exchange Act of 1934) of such Option without the prior written consent of the Board. 10. NO OBLIGATION TO EXERCISE OPTION. The grant and acceptance of this Option imposes no obligation on the Optionee to exercise it. 11. NO OBLIGATION TO CONTINUE EMPLOYMENT. Neither the Company nor any subsidiary thereof is by the Plan or this Option obligated to continue to employ Optionee and neither the Plan nor this Option shall otherwise interfere with the Company's right to discharge or retire any employee, including Optionee, at any time. 12. NO RIGHTS AS STOCKHOLDER UNTIL EXERCISE. The Optionee shall have no rights as a stockholder with respect to shares subject to this Agreement until a stock certificate therefore has been issued to the Optionee and is fully paid for. Except as is expressly provided in the Plan with respect to certain changes in the capitalization of the Company, no adjustment shall be made for dividends or similar rights for which the record date is prior to the date such stock certificate is issued. 13. REORGANIZATION OF COMPANY. (a) Upon the dissolution or liquidation of Company, or upon a reorganization, merger or consolidation of the Company as a result of which the Company's outstanding Common Stock is changed into or exchanged for cash or property or securities not of the Company's issue, or upon a sale of all or substantially all property of the Company to, or the acquisition of all or substantially all of the stock of the Company then outstanding by, another corporation or person, the Plan shall terminate, and the Option granted hereunder shall terminate; provided, however, if Optionee is entitled to exercise any unexercised installment of the Option then outstanding, then Optionee may, at such time prior to the consummation of the transaction causing such termination as the Company shall designate, exercise the unexercised installments of the Option including all unaccrued installments thereof which would, but for this subsection 13(a), not yet be exercisable. Notwithstanding the foregoing, in the event that any transaction causing such termination is not consummated, any unexercised unaccrued installments that had become exercisable solely by reason of the provisions of this subsection 13(a) shall again become unaccrued and unexercisable as of said termination of such transaction, subject, however, to such installments accruing pursuant to the normal accrual schedule provided in the terms under which the Option was granted. (b) In addition to and not in lieu of those rights granted pursuant to subsection 13(a) above, if provisions shall be made in writing in connection with such transaction for the continuance of the Plan and/or the assumption of options theretofore granted, or the substitution for such options of options covering the stock of the successor corporation, or a parent or subsidiary thereof with appropriate adjustments as to the number and kind of shares and prices, the unexercised Option shall continue in the manner and under the terms so provided. (c) The Company shall have no obligation to provide for the continuance, assumption or substitution of the Plan or the Option by any successor corporation or parent or subsidiary thereof. 14. WITHHOLDING TAXES. The Optionee hereby agrees that the Company (or a subsidiary thereof, as the case may be) may withhold from the Optionee's wages or other remuneration the appropriate amount of federal, state and local taxes attributable to the Optionee's exercise of any installment of this Option. The Optionee further agrees that, if the Company (or a subsidiary thereof, as the case may be) does not withhold an amount from the Optionee's wages or other remuneration sufficient to satisfy the Company's (or any such subsidiary's) withholding obligation, the Optionee will reimburse the Company (or any such subsidiary) on demand, in cash, for the amount underwithheld. 15. GOVERNING LAW. This Agreement shall be governed by and interpreted in accordance with the laws of the State of California applicable to agreements made and to be performed entirely within such State and without regard to the conflict of law principals thereof. 16. AMENDMENTS. No amendment, modification, termination or waiver of any provision of this Agreement shall be effective unless the same shall be in writing signed by all parties hereto. 17. COUNTERPARTS. This Agreement may be signed in one or more counterparts, each of which shall be deemed to be an original, but all of which together shall constitute one and the same instrument. 18. SURVIVAL OF REPRESENTATIONS. All representations, covenants and warranties of the parties hereto shall survive the execution of this Agreement. IN WITNESS WHEREOF the Company and the Optionee have caused this instrument to be executed as of the date first written above, and the Optionee whose signature appears below acknowledges receipt of a copy of the Plan and acceptance of an original copy of this Agreement. THE COMPANY: MAXICARE HEALTH PLANS, INC. By: /s/ Peter J. Ratican Chairman, Chief Executive Officer and President OPTIONEE: /s/ Dave Hammons Exhibit 10.67 MAXICARE HEALTH PLANS, INC. STOCK OPTION AGREEMENT Maxicare Health Plans, Inc., a Delaware corporation (the "Company"), hereby grants as of this 20th day of December, 1993, to David Hammons (the "Optionee"), an option to purchase a maximum of 5,000 shares of its common stock (the "Common Stock"), at a price per share (the "Exercise Price") of $9.63 per share (the "Option"), on the following terms and conditions: 1. GRANT UNDER 1990 STOCK PLAN. The Option is granted pursuant to and is governed by the Company's 1990 Stock Option Plan (the "Plan") and, unless the context otherwise requires, terms used and/or defined herein shall have the same meaning as in the Plan. Determinations made in connection with this Option pursuant to the Plan shall be governed by the Plan as it exists on this date. This Option is not intended to be and shall not be treated as an incentive stock option under Section 422 of the Internal Revenue Code. 2. EXTENT OF OPTION. If the Optionee has continued to serve in the capacity of an officer, employee, or director with the Company (or a subsidiary thereof, as the case may be) on the following dates, the Optionee may, subject to Section 13 hereof, exercise this Option for the portion of the total number of shares subject to this Option set opposite the applicable date: Less than one year from the - 0 shares date hereof One year but less than two years - 1,667 shares from the date hereof Two years but less than three - 1,667 shares years from the date hereof Three years but less than four - 1,666 shares years from the date hereof The foregoing rights are cumulative and, while the Optionee continues to serve as an officer, director or employee of the Company (or a subsidiary thereof, as the case may be), may be exercised up to and including the earlier of the date which is five years from the date this Option is granted (the "Fifth Anniversary Date"). For purposes of this Agreement, any accrued installment shall be referred to as an "Accrued Installment". All of the foregoing rights are subject to Sections 3 and 4 hereof, as appropriate, if the Optionee ceases to serve as an officer, director or employee of the Company (or a subsidiary thereof, as the case may be) or becomes disabled or dies while serving as an officer, director or employee of the Company (or a subsidiary thereof, as the case may be). 3. TERMINATION OF BUSINESS RELATIONSHIP. If the Optionee ceases to remain an officer, director or employee of the Company (or subsidiary thereof, as the case may be), other than by reason of death or disability as defined in Section 4, any unexercised Accrued Installments of the Option shall expire and become unexercisable as of the earlier of (i) the Fifth Anniversary Date, or (ii) thirty (30) days following the termination of Optionee's employment or termination of Optionee's directorship. No further installments of this Option shall become exercisable. The Board of Directors of the Company may extend such thirty (30) day period for a period not to exceed one (1) year following the Termination Date (as defined in the Plan), but in no event beyond the applicable Fifth Anniversary Date. In such a case, the Optionee's only rights hereunder shall be those which are properly exercised before the termination of this Option. Any portion of an Option that expires hereunder shall remain unexercisable and be of no effect whatsoever after such expiration notwithstanding that such Optionee may be reemployed by, or again become a director of, the Company (or a subsidiary thereof, as the case may be). 4. DEATH OR DISABILITY. In the event of the death of the Optionee while an officer, employee or director of the Company (or a subsidiary thereof, as the case may be), or in the event of termination of employment or directorship by reason of the Optionee's Disability (as defined in the Plan), any unexercised Accrued Installments of the Option granted to Optionee shall expire and become unexercisable as of the earlier of (i) the Fifth Anniversary Date, or (ii) the first anniversary date of the Optionee's death (if applicable) or (iii) the first anniversary date of the termination of employment or directorship by reason of Disability (if applicable). Any such Accrued Installments of a deceased Optionee may be exercised prior to their expiration by (and only by) the person or persons to whom the Optionee's Option rights shall pass by will or by the laws of descent and distribution. Any installments under a deceased Optionee's Option that have not accrued as of the date of his death shall expire and become unexercisable as of said date of death. For purposes of this Agreement, the Optionee shall be deemed employed by the Company (or a subsidiary thereof, as the case may be) during any period of leave of absence from active employment as authorized by the Company (or a subsidiary thereof, as the case may be). 5. PARTIAL EXERCISE. Exercise of this Option up to the extent above stated may be in part at any time and from time to time with the above limits, except that this Option may not be exercised for a fraction of a share. Upon the exercise of the final installment of this Option, the Optionee shall be entitled to receive cash with respect to the value of any fraction of a share (in lieu of any said fractional share). 6. PAYMENT OF EXERCISE PRICE. The Exercise Price is payable in United States dollars and may be paid in cash or by certified or cashier's check, or any combination of the foregoing, equal in amount to the Exercise Price. 7. INVESTMENT REPRESENTATIONS; RESTRICTIONS ON TRANSFER. (a) The Optionee represents, warrants and covenants to the Company that: (i) Any Common Stock acquired by the Optionee upon exercise of the Option will be acquired for the Optionee's own account and not with a view to resale on distribution in violation of the Securities Act of 1933, as amended (the "1933 Act"). (ii) The Optionee has such knowledge and experience in business and financial matters as to be capable of utilizing the information which is available to the Optionee to evaluate the merits and risks of an investment in the Common Stock, and is able to bear the economic risks of any Common Stock or other securities which the Optionee may acquire upon exercise of the Option. (iii) The Optionee understands that the Option has not been registered under the Securities Act of 1933, as amended (the "1933 Act"), that the Option has been issued in reliance upon certain exemptions contained therein. The Optionee further understands that because the Option has not been registered under the 1933 Act or registered or qualified pursuant to applicable "blue sky" statutes, the Optionee may not, and Optionee covenants and agrees that Optionee will not, sell, offer to sell or otherwise dispose of any such Option in violation of the 1933 Act or any applicable "blue sky" or securities law of any state. The Optionee acknowledges and understands that Optionee has no independent right to require the Company to register the Option. 8. METHOD OF EXERCISING OPTION. Subject to the terms and conditions of this Agreement, this Option may be exercised by written notice to the Company, at the principal executive office of the Company, or to such transfer agent as the Company shall designate. Such notice shall state the election to exercise this Option and the number of shares in respect of which it is being exercised and shall be signed by the Optionee or person or persons entitled to so exercise this Option. Such notice shall be accompanied by payment of the full Exercise Price of such shares, and the Company shall deliver a certificate or certificates representing such shares as soon as practicable after the notice is received. The certificate or certificates for the shares as to which this Option shall have been so exercised shall be registered in the name of the person or persons so exercising this Option (or, if this Option shall be exercised by the Optionee and if the Optionee shall so request in the notice exercising this Option, shall be registered in the name of the Optionee and another person jointly, with right of survivorship) and shall be delivered to or upon the written order of the person or persons exercising this Option. In the event this Option shall be exercised, pursuant to Section 4 hereof, by any person or persons other than the Optionee, such notice shall be accompanied by appropriate proof of the right of such person or persons to exercise this Option. All shares that shall be purchased upon the exercise of this Option as provided herein shall be fully paid and non-assessable. 9. OPTION NOT TRANSFERABLE; TRANSFER OF STOCK. This Option is not transferable or assignable except by will or by the laws of descent and distribution. During the Optionee's lifetime, only the Optionee may exercise this Option. 10. NO OBLIGATION TO EXERCISE OPTION. The grant and acceptance of this Option imposes no obligation on the Optionee to exercise it. 11. NO OBLIGATION TO CONTINUE EMPLOYMENT. Neither the Company nor any subsidiary thereof is by the Plan or this Option obligated to continue to employ Optionee and neither the Plan nor this Option shall otherwise interfere with the Company's or any of the Company's subsidiary's right to discharge or retire any employee, including Optionee, at any time. 12. NO RIGHTS AS STOCKHOLDER UNTIL EXERCISE. The Optionee shall have no rights as a stockholder with respect to shares subject to this Agreement until a stock certificate therefore has been issued to the Optionee and is fully paid for. Except as is expressly provided in the Plan with respect to certain changes in the capitalization of the Company, no adjustment shall be made for dividends or similar rights for which the record date is prior to the date such stock certificate is issued. 13. REORGANIZATION OF COMPANY. (a) Upon the dissolution or liquidation of the Company, or upon a reorganization, merger or consolidation of the Company as a result of which the Company's outstanding Common Stock is changed into or exchanged for cash or property or securities not of the Company's issue, or upon a sale of all or substantially all property of the Company to, or the acquisition of all or substantially all of the stock of the Company then outstanding by, another corporation or person, the Plan shall terminate, and the Option granted hereunder shall terminate; provided, however, Optionee shall be entitled, at such time prior to the consummation of the transaction causing such termination as the Company shall designate, to exercise the unexercised installments of the Option including all unaccrued installments thereof which would, but for this subsection 13(a), not yet be exercisable. Notwithstanding the foregoing, in the event that any transaction causing such termination is not consummated, any unexercised unaccrued installments that had become exercisable solely by reason of the provisions of this subsection 13(a) shall again become unaccrued and unexercisable as of said termination of such transaction, subject, however, to such installments accruing pursuant to the normal accrual schedule provided in the terms under which the Option was granted. (b) In addition to and not in lieu of those rights granted pursuant to subsection 13(a) above, if provisions shall be made in writing in connection with such transaction for the continuance of the Plan and/or the assumption of options theretofore granted, or the substitution for such options of options covering the stock of the successor corporation, or a parent or subsidiary thereof with appropriate adjustments as to the number and kind of shares and prices, the unexercised Option shall continue in the manner and under the terms so provided. (c) The Company shall have no obligation to provide for the continuance, assumption or substitution of the Plan or the Option by any successor corporation or parent or subsidiary thereof. 14. WITHHOLDING TAXES. The Optionee hereby agrees that the Company (or a subsidiary thereof, as the case may be) may withhold from the Optionee's wages or other remuneration the appropriate amount of federal, state and local taxes attributable to the Optionee's exercise of any installment of this Option. The Optionee further agrees that, if the Company (or a subsidiary thereof, as the case may be) does not withhold an amount from the Optionee's wages or other remuneration sufficient to satisfy the Company's (or any such subsidiary's) withholding obligation, the Optionee will reimburse the Company (or any such subsidiary) on demand, in cash, for the amount underwithheld. 15. GOVERNING LAW. This Agreement shall be governed by and interpreted in accordance with the laws of the State of California applicable to agreements made and to be performed entirely within such State and without regard to the conflict of law principals thereof. 16. AMENDMENTS. No amendment, modification, termination or waiver of any provision of this Agreement shall be effective unless the same shall be in writing signed by all parties hereto. 17. COUNTERPARTS. This Agreement may be signed in one or more counterparts, each of which shall be deemed to be an original, but all of which together shall constitute one and the same instrument. 18. SURVIVAL OF REPRESENTATIONS. All representations, covenants and warranties of the parties hereto shall survive the execution of this Agreement. IN WITNESS WHEREOF the Company and the Optionee have caused this instrument to be executed as of the date first written above, and the Optionee whose signature appears below acknowledges receipt of a copy of the Plan and acceptance of an original copy of this Agreement. THE COMPANY: MAXICARE HEALTH PLANS, INC. By: /s/ Peter J. Ratican Chairman, President and Chief Executive Officer OPTIONEE: /s/ David Hammons Exhibit 21 SUBSIDIARIES OF THE REGISTRANT Exhibit 23.1 CONSENT OF INDEPENDENT ACCOUNTANTS We hereby consent to the incorporation by reference in the Registration Statement on Form S-8 (No. 33-50508) of Maxicare Health Plans, Inc. of our report dated March 4, 1994 appearing on page 37 of this Form 10-K. PRICE WATERHOUSE Los Angeles, California March 25, 1994

64803_1993.txt

64803

1993

Item 1. Business Melville Corporation, a New York corporation (in this Item 1 called the "Company"), is one of the largest diversified specialty retailers in the United States. On December 31, 1993, the Company, through its subsidiaries (which together with the Company throughout this Item 1 are collectively called the "Companies"), operated a total of 7,282 retail stores and leased departments throughout the United States, Puerto Rico, the U.S. Virgin Islands, Canada, the Czech Republic and Slovakia. During 1993 the Companies also manufactured men's and women's footwear in two factories and furniture in five factories. The Companies market products in chains of specialty retail stores operating under various trade names. Prescription drugs, health and beauty aids are sold in chains of stores operated under the "CVS", "Peoples", "Standard Drug" and "Austin Drug" trade names. Apparel and accessories are sold in chains of stores under the "Marshalls", "Wilsons Suede & Leather", "Wilsons The Leather Experts", "Bermans", "Bermans The Leather Experts", "Pelle Cuir", "Tannery West", "Snyder Leather Outlets", "Georgetown Leather Design" and "Bob's" trade names. Footwear is sold in chains of stores operated under the "FootAction USA", "FootAction For Kids", "Fan Club", "Thom McAn" and "B.O.Q." trade names and in leased departments in Kmart discount department stores and Pay Less Drug Stores. Toy and hobby products are sold in chains of stores operating under the "Kay-Bee Toys", "Circus World", "K & K Toys", "Toy Works" and "Play Things" trade names. Domestics are sold in a chain of stores operated under the "Linens 'n Things" trade name. Furniture is sold in a chain of stores under the "This End Up" and "Wood's End" trade names. In general, the retailing business is seasonal in nature with each particular business of the Company affected, to varying degrees, by certain peak selling periods. The peak selling periods are characterized by inventory build-ups prior to such periods. The build-ups are financed, in part, with the issuance of commercial paper and bank loan participation notes, which are repaid from internally generated funds. To maintain financial flexibility, the Company also has on file with the Securities and Exchange Commission a shelf registration statement for the issuance of up to $300 million in debt securities, including medium term notes. No debt securities have been issued to date, and the Company does not currently have any plans to issue such debt securities under this shelf registration because its capital resources are sufficient to sustain current operations and provide for future growth. The Christmas holiday is the most significant seasonal selling period for the Company overall and the peak selling period for its toy and leather apparel businesses. The peak selling periods, other than the Christmas holiday, for the Company's non-leather apparel and footwear businesses coincide with the Easter holiday and the opening of school in the fall. Competition is based upon such factors as price, style, quality and design of product and the layout and location of stores. The Company's principal office is located in Rye, New York. As of December 31, 1993, the Companies had approximately 111,000 full and part-time associates. BUSINESS SEGMENT INFORMATION The Company is principally a specialty retailer conducting business in four major segments: - Prescription drugs, health and beauty aids retailing. - Apparel retailing, which includes men's and women's specialty and leather apparel, brand name and private label apparel for men, women and children. - Footwear, which includes retailing of both discount and popular-priced shoes; retailing of brand name shoes and athletic footwear for men, women and children; and footwear manufacturing. - Toys and household furnishings, which include retailing of toys, domestics and furniture (as well as furniture manufacturing). The financial information concerning industry segments required by Item 101(b) of Regulation S-K is set forth on page 47 of the Company's Annual Report to Shareholders for the year ended December 31, 1993, and is incorporated herein by reference. PRESCRIPTION DRUGS, HEALTH AND BEAUTY AIDS RETAILING On December 31, 1993, the Companies operated 1,284 prescription drugs, health and beauty aids stores in 15 states and the District of Columbia under the names "CVS", "Peoples", "Standard Drug" and "Austin Drug", 1,081 of which have pharmacies. Net sales for these stores for 1993 represented approximately 38% of the Companies' consolidated net sales. These stores are considered "destination" stores and are located primarily in "strip" shopping centers and freestanding units. In the prescription drugs, health and beauty aids retailing business, the Company counts itself among the largest retailers in terms of number of stores in its primary marketing territories, which is the mid-Atlantic and Northeast United States. The monthly business periodical entitled "Chain Drug Review" has ranked CVS fourth in number of stores and fifth in dollar volume and among the top ten drug store chains in the United States based upon dollar volume and store count. These stores also compete with general merchandise stores, supermarkets and mail order pharmacies. APPAREL RETAILING On December 31, 1993, the Companies operated 448 off-price quality brand name family apparel stores in 40 states under the name "Marshalls". These stores are located primarily in "strip" shopping centers in which Marshalls is an "anchor" tenant. Marshalls' net sales for 1993 represented approximately 25% of the Companies' consolidated net sales. On December 31, 1993, the Companies operated 631 men's and women's leather and suede apparel and accessory stores, which are located primarily in regional shopping malls, in 45 states and the District of Columbia under the names "Wilsons Suede & Leather", "Wilsons The Leather Experts", "Tannery West", "Bermans The Leather Experts", "Bermans", "Snyder Leather Outlets", "Pelle Cuir" and "Georgetown Leather Design". Net sales for 1993 in these stores represented approximately 5% of the Companies' consolidated net sales. On December 31, 1993, the Companies operated 16 stores selling casual clothing and footwear for the entire family under the name "Bob's" principally in "strip" shopping centers located in Connecticut, Massachusetts, New York and Rhode Island. Net sales at Bob's stores for 1993 represented approximately 2% of the Companies' consolidated net sales. In the apparel retailing business, the Company believes it has a significant presence in the markets for the products which it carries; however, such products represent only a small portion of the total apparel market. FOOTWEAR On December 31, 1993, the Companies operated 2,771 leased footwear departments, 391 stores under the names "FootAction USA", "FootAction For Kids" and "Fan Club" and 337 stores under the names "Thom McAn" and "B.O.Q.". Collectively, these leased departments and retail stores are located in all 50 states, Puerto Rico, the U.S. Virgin Islands, the Czech Republic and Slovakia. Each of the leased departments is operated by the Company's Meldisco division which sells footwear for the entire family. All but 334 of the leased departments operated during the fiscal year ended December 31, 1993 were located in Kmart discount department stores in the United States, Puerto Rico, the Czech Republic and Slovakia. These 334 leased departments were located in Pay Less Drug Stores, which are owned by Pay Less Drug Stores Northwest, Inc. ("Pay Less"). Pursuant to an agreement between the Company and Kmart Corporation ("Kmart" then known as S.S. Kresge Company) entered into as of January 1, 1975, and an agreement between the Company and Pay Less dated October 10, 1988, all license agreements relating to such leased departments have terms of 25 years, subject to certain performance standards. Rental payments under all such license agreements are based on a percentage of sales, with additional payments to be made under certain of the license agreements with Kmart based on profits. The Company has a 51% equity interest, and Kmart has a 49% equity interest, in all the subsidiaries which operate leased departments in Kmart stores, with the exception of 42 such subsidiaries in which the Company has a 100% equity interest. The Company has a 100% equity interest in all the subsidiaries which operate leased departments in Pay Less Drug Stores. Aggregate net sales for 1993 of Meldisco leased departments represented approximately 12% of the Companies' consolidated net sales. FootAction stores (including Fan Club stores operated as part of the FootAction division) are located primarily in regional shopping malls. These stores specialize in brand name casual and athletic footwear and related apparel for the entire family. FootAction's net sales for 1993 represented approximately 3% of the Companies' consolidated net sales. A majority of the Thom McAn stores are also located in regional shopping malls and substantially all of such stores sell footwear and related items for men and women. Excluded from the operating results of the Thom McAn chain were stores designated to be closed or redeployed under the Company's strategic realignment program announced in 1992. Of the stores excluded, over 200 were closed or redeployed in 1993. Thom McAn's net sales for 1993 represented approximately 2% of the Companies' consolidated net sales. The Companies' footwear retailing is primarily in the discount and popular-price categories. However, with the growth of its FootAction division, the Company continues to increase its presence in brand name casual and athletic footwear. During 1993, substantially all of the footwear, as well as all hosiery, handbags and accessories sold in these stores, was purchased from unrelated third parties. In the footwear retailing business the Companies, through their retail stores and leased departments, compete with footwear chain store operators and many other types of footwear retailers, e.g., general merchandise stores, traditional department stores, mail order businesses and apparel stores. According to research data provided to the Company by Footwear Market Insights, a management consulting and marketing research company specializing in footwear, the seven largest footwear chain store and leased department operators in the United States, ranked according to the number of pairs of footwear sold and number of retail outlets, account for approximately 40.1% of total footwear pair sales, and the Companies are among such seven largest operators. Manufacturing As of December 31, 1993, the Company operated two factories in the Southeast United States which produce shoes and contain facilities for product development, product testing and quality control. During 1993, the manufactured footwear represented an insignificant percentage of the total footwear sold by the Companies. The two factories which produce footwear for the Companies' retail stores will be closed in 1994. The costs associated with the shutdown of the operations were provided for as a part of the strategic realignment charge recorded in 1992. TOYS AND HOUSEHOLD FURNISHINGS On December 31, 1993, the Companies operated 1,026 toy and hobby stores in all 50 states and Puerto Rico under the names "Kay-Bee Toys", "Circus World", "K & K Toys", "Toy Works" and "Play Things". The "Kay-Bee Toys", "Circus World", "Play Things" and "K & K Toys" stores are located primarily in regional shopping malls. The "Toy Works" stores are located primarily in "strip" shopping centers and freestanding units. Excluded from operating results were stores that the Company designated to close or not renew under its strategic realignment program announced in 1992. Of the stores excluded, over 70 were closed in 1993. Net sales in toy and hobby stores for 1993 represented approximately 9% of the Companies' consolidated net sales. On December 31, 1993, the Companies operated 143 quality brand name linens, towels, bath and other household items stores, which are located primarily in "strip" shopping centers in 27 states under the name "Linens 'n Things". Linens 'n Things' net sales for 1993 represented approximately 3% of the Companies' consolidated net sales. On December 31, 1993, the Companies operated 235 stores retailing a distinctive line of casual crate-designed furniture and coordinated accessories for residential and commercial use, located primarily in regional shopping malls in 33 states and Canada, under the names "This End Up", and "Wood's End". Net sales of furniture for 1993 represented approximately 1% of the Companies' consolidated net sales. In the toy retailing business, the Company is among the largest toy and hobby chain store operators in the United States in terms of sales, as well as number of retail outlets. Based upon sales volume, the business periodical "Discount Store News" has ranked Kay-Bee among the top toy specialty chains in the United States. In the household furnishings retailing business, the Company believes itself to be a significant factor in the markets for the products which it carries. Based on total revenues, This End Up has been ranked by "Furniture Today", a weekly business periodical, among the top 25 furniture retailers in the United States. Manufacturing During 1993, the Company, through This End Up Furniture Company, manufactured a distinctive line of casual furniture in five factories located in the Southeast United States. Approximately 99% of the furniture manufactured is sold through the Company's This End Up division. The Company believes that these factories have the capacity to supply all of the sales volume requirements of its "This End Up" and "Wood's End" retail stores and currently these factories supply substantially all of such requirements. This End Up Furniture Company manufactures a large portion of its furniture from southern yellow pine, which is in plentiful supply in the Southeastern United States. Southern yellow pine is a renewable resource and most producers have reforestation programs in effect. ACQUISITIONS During 1993, the Company acquired 59 prescription drugs, health and beauty aids stores, 31 leather apparel stores and 10 stores selling branded athletic footwear and apparel. DISPOSITIONS Effective May 17, 1993, the Company completed the sale of all 487 of its Chess King stores; effective May 29, 1993, the Company completed the sale of all of its 103 Prints Plus stores, and effective October 16, 1993, the Company completed the sale of all of its 114 Accessory Lady stores. Net sales for each of these chains in 1993 through their date of disposition represented less than 1% of the Companies' consolidated net sales. Item 2.

Item 2. Properties The registrant and its subsidiaries lease various retail stores and warehouse, plant and office facilities. Most of these leases contain initial terms ranging from 5 to 25 years and many have options for extension beyond the initial term ranging from 5 to 15 years. Retail stores and office facilities are leased in nearly all cases. In the fiscal year ended December 31, 1993, the registrant and its subsidiaries operated fifty-three distribution centers, located in 18 states, containing an aggregate of approximately 10,106,000 square feet. All such distribution centers are leased with the exception of sixteen distribution centers containing an aggregate of approximately 5,053,000 square feet which are owned by the registrant or one of its subsidiaries. Sixteen distribution centers (comprising approximately 3,340,000 square feet) are used in the prescription drugs, health and beauty aids business; ten distribution centers (comprising approximately 3,356,000 square feet) are used in the apparel businesses; ten distribution centers (comprising approximately 1,923,000 square feet) are used in the footwear businesses; and seventeen distribution centers (comprising approximately 1,487,000 square feet) are used in the toys and household furnishings businesses. In the fiscal year ended December 31, 1993, the registrant and its subsidiaries operated seven factories, all of which are located in North Carolina. Two are footwear factories, one with the capacity to produce over 1,500,000 pairs of shoes annually. (As discussed above, these two factories will be closed in 1994). Five are furniture factories with the total capacity to produce approximately 780,000 pieces of furniture annually. The registrant or one of its subsidiaries own all of such factories. Item 3.

Item 3. Legal Proceedings There are no material pending legal proceedings, other than ordinary routine litigation incidental to the business, to which the registrant or any of its subsidiaries is a party or of which any of its or their property is the subject. Item 4.

Item 4. Submission of Matters to a Vote of Security Holders There were no matters submitted to a vote of security holders, through solicitation of proxies or otherwise, during the fourth quarter of the fiscal year ending December 31, 1993. EXECUTIVE OFFICERS OF THE REGISTRANT The following is included as an unnumbered item in Part I of this report since the registrant did not furnish such information in its definitive proxy statement dated March 14, 1994. Date Date First Appointed Appointed an to Present Officer of Name/Office Age Office the Registrant - ----------- --- ---------- -------------- James E. Alward 50 3/17/92 3/17/92 Vice President Norman Axelrod 41 3/07/88 3/07/88 Vice President (President of Linens 'n Things) Warren D. Feldberg 44 10/18/91 10/18/91 Vice President (Chairman and Chief Executive Officer of Marshalls) Michael A. Friedheim 50 1/01/94 7/14/82 Vice President (Chairman and Chief Executive Officer of Bob's) Philip C. Galbo 43 8/01/89 8/01/89 Treasurer Date Date First Appointed Appointed an to Present Officer of Name/Office Age Office the Registrant - ----------- --- ---------- -------------- Stanley P. Goldstein 59 1/01/87 4/13/71 Chairman of the Board and Chief Executive Officer Thomas E. Harms 47 3/10/94 3/10/94 Vice President Robert G. House 47 9/11/91 9/11/91 Vice President Robert D. Huth 48 4/06/87 4/06/87 Executive Vice President and Chief Financial Officer Daniel B. Katz 48 2/19/91 3/12/86 Senior Vice President (President of Melville Realty Company, Inc.) William C. Kingsford 47 3/12/86 7/13/79 Vice President Jerald L. Maurer 51 1/01/94 1/01/94 Senior Vice President Larry A. McVey 52 3/14/84 3/14/84 Vice President (President of Thom McAn) John I. Mitchell, Jr. 54 10/12/88 10/12/88 Vice President and Chief Information Officer Ralph T. Parks 48 3/10/94 3/10/94 Vice President (President of FootAction) Jerald S. Politzer 48 10/09/91 6/21/89 Executive Vice President (Acting President of Kay-Bee) Date Date First Appointed Appointed an to Present Officer of Name/Office Age Office the Registrant - ----------- --- ---------- -------------- Shahid Quraeshi 45 7/13/88 7/13/88 Vice President and Controller (Principal Accounting Officer) Arthur V. Richards 55 9/13/89 4/12/77 Vice President and Secretary J. M. Robinson 47 7/13/88 7/13/88 Vice President (President of Meldisco) Harvey Rosenthal 51 1/01/94 10/17/84 President and Chief Operating Officer Thomas M. Ryan 41 1/01/94 1/01/94 Vice President (President and Chief Executive Officer of CVS) Joel N. Waller 53 3/11/87 3/11/87 Vice President (Chairman of Wilsons) In each case the term of office extends to the date of the board of directors meeting following the next annual meeting of shareholders of the registrant. In addition to the office(s) which they hold in the registrant as shown above, each of the individuals listed (with the exception of Messrs. Harms, Kingsford, Maurer and House) hold various offices in certain subsidiaries of the registrant. Previous positions and responsibilities held by each of the above officers with the registrant and for each of the above officers who have not held the same office(s) with the same responsibilities for more than the past five years, are indicated below: James E. Alward - Director of Taxation (January, 1979 to Present) of the registrant. Warren D. Feldberg - President (January, 1991 to November, 1991) of Target Stores, a division of Dayton Hudson Corporation, Executive Vice President (December, 1988 to January, 1991) of Target Stores, Senior Vice President (March, 1988 to December, 1988) of Target Stores. Michael A. Friedheim - Executive Vice President (February, 1986 to January, 1994) of the registrant. Philip C. Galbo - Assistant Treasurer (October, 1988 to July, 1989) of the registrant. Thomas E. Harms - Vice President Human Resources (July, 1993 to March, 1994) and Director Human Resources (September, 1990 to July, 1993) of the CVS division of the registrant; Director of Personnel of Marshall Field's (August, 1988 to August, 1990). Robert G. House - Consultant (January, 1988 to July, 1991) Temple, Barker & Sloane, general management consultants. Daniel B. Katz - Vice President (March, 1986 to February, 1991) of the registrant; President (March, 1978 to Present) of Melville Realty Company, Inc., a subsidiary of the registrant. Jerald L. Maurer - Corporate Vice President of Strategic Human Resource Management of Aetna Life and Casualty Company (January, 1992 to January, 1994); Vice President of Human Resources (January, 1991 to January 1992) of Medstat Systems, Inc.; Senior Vice President of Human resources (1988 to January, 1990) of John Wiley & Sons, Inc. Ralph T. Parks - President of the FootAction division of the registrant (November, 1991 to Present); Executive Vice President and Chief Operating Officer of FootAction, Inc. (March, 1987 to November, 1991). Jerald S. Politzer - Group Vice President (June, 1989 to October, 1991) of the registrant; President and Chief Executive Officer (November, 1986 to June, 1989) of G. Fox & Company, a division of The May Department Stores Company. Arthur V. Richards - Secretary (April, 1977 to Present), General Counsel (September, 1989 to October, 1990) and General Attorney (April, 1977 to September, 1989) of the registrant. Harvey Rosenthal - President and Chief Executive Officer (October, 1984 to January, 1994) of the CVS division of the registrant. Thomas M. Ryan - Executive Vice President (January, 1990 to January, 1994) and Senior Vice President-Pharmacy (January, 1988 to January, 1990) of the CVS division of the registrant. Part II Item 5.

Item 5. Market Price of and Dividends on the Registrant's Common Equity and Related Stockholder Matters The number of holders of the registrant's Common Stock, based upon the number of record holders, was 7,600 as of December 31, 1993. All other information required by this item is included in the registrant's Annual Report to Shareholders for the year ended December 31, 1993 on pages 1 and 46 and is incorporated herein by reference. Item 6.

Item 6. Selected Financial Data The information required by this item is included in the registrant's Annual Report to Shareholders for the year ended December 31, 1993 on page 48 and is incorporated herein by reference. Item 7.

Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations The information required by this item is included in the registrant's Annual Report to Shareholders for the year ended December 31, 1993 on pages 30 through 33 and is incorporated herein by reference. Item 8.

Item 8. Financial Statements and Supplementary Data The information required by this item is included in the registrant's Annual Report to Shareholders for the year ended December 31, 1993 on pages 35 through 47, and is incorporated herein by reference. Item 9.

Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure During the registrant's two most recent fiscal years or any subsequent interim period, no event occurred which would require disclosure under this item. PART III Item 10.

Item 10. Directors and Executive Officers of the Registrant Information regarding the executive officers is furnished under the heading "EXECUTIVE OFFICERS OF THE REGISTRANT" in Part I of this report since the registrant did not furnish such information in its definitive proxy statement dated March 14, 1994. The other information required by this item is included in the registrant's definitive proxy statement dated March 14, 1994 on pages 1 through 3 and is incorporated herein by reference. Item 11.

Item 11. Executive Compensation The information required by this item is included in the registrant's definitive proxy statement dated March 14, 1994 on pages 7 through 13 and is incorporated herein by reference. Item 12.

Item 12. Security Ownership of Certain Beneficial Owners and Management The information required by this item is included in the registrant's definitive proxy statement dated March 14, 1994 on pages 1 through 5 and is incorporated herein by reference. Item 13.

Item 13. Certain Relationships and Related Transactions No information is required to be reported by this item. PART IV Item 14.

Item 14. Exhibits, Financial Statement Schedules and Reports on Form 8-K (a) Documents filed as part of this report: l. and 2. Financial Statements and Financial Statement Schedules. The consolidated financial statements of Melville Corporation and its subsidiary companies incorporated herein by reference to the Annual Report to Shareholders for the fiscal year ended December 31, 1993 and the related consolidated financial statement schedules are set forth in the index to consolidated financial statements and consolidated schedules on page 26 hereof. 3. Exhibits (a) The Exhibits filed as part of this report are listed below: Exhibit Table Number: - ------- 3 (a) Restated Certificate of Incorporation, as amended as of April 18, 1990 (incorporated by reference to Exhibit 3 filed with the registrant's Quarterly Report on Form 10-Q for the fiscal quarter ended June 30, 1990). 3 (b) By-Laws, as amended through December 8, 1993. 4 No instrument which defines the rights of holders of long and intermediate debt of the registrant and its subsidiaries is filed herewith pursuant to Regulation S-K, Item 601(b)(4)(iii)(A) other than the June 23, 1989 amendment to the Restated Certificate of Incorporation defining the rights of the holders of the Series One ESOP Convertible Preference Stock (see above exhibit table number 3(a)). The registrant hereby agrees to furnish a copy of any such instrument to the Securities and Exchange Commission upon request. EXECUTIVE COMPENSATION PLANS AND ARRANGEMENTS 10 (iii)(A) (i) 1973 Stock Option Plan (incorporated by reference to Exhibit (10) (iii) (A) (i) to the registrant's Annual Report on Form 10-K for the fiscal year ended December 31, 1987). Exhibit Table Number: - ------- (ii) 1987 Stock Option Plan (incorporated by reference to Exhibit (10) (iii) (A) (iii) to the registrant's Annual Report on Form 10-K for the fiscal year ended December 31, 1987). (iii) 1989 Directors Stock Option Plan (incorporated by reference to Exhibit B to the registrant's Annual Report on Form 10-K for the fiscal year ended December 31, 1988). (iv) Melville Corporation Omnibus Stock Incentive Plan (incorporated by reference to Exhibit B to the registrant's Annual Report on Form 10-K for the fiscal year ended December 31, 1989). (v) Directors Retirement Plan (incorporated by reference to Exhibit 10(iii)(A)(vi) to registrant's Annual Report on Form 10-K for year ended December 31, 1992). (vi) Profit Incentive Plan of Melville Corporation (incorporated by reference to Exhibit A to registrant's definitive Proxy Statement dated March 14, 1994). 11 Statement re: Computation of Per Share Earnings. 12 Statement re: Computation of Ratios. Exhibit Table Number: - ------- 13 Annual Report to Shareholders for the year ended December 31, 1993. (Except for the portions incorporated herein by reference, such report is furnished for the information of the SEC and is not deemed "filed" as part of this Form 10-K report.) 18 Letter re: Change in Accounting Principle. 22 Subsidiaries of the registrant. (b) No reports on Form 8-K were filed in the last fiscal quarter ending December 31, 1993. SIGNATURES Pursuant to the requirements of Section 13 or 15(d) 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. MELVILLE CORPORATION By /S/ ARTHUR V. RICHARDS ------------------------------- Arthur V. Richards Vice President and Secretary March 30, 1994 Pursuant to the requirements of the Securities Exchange Act of 1934, this report has also been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated. Signature Title Date --------- ----- ---- Chairman of the Board and Director (Chief Executive /S/ STANLEY P. GOLDSTEIN Officer) March 28, 1994 - ---------------------------- (Stanley P. Goldstein) Executive Vice President and Director /S/ ROBERT D. HUTH (Chief Financial Officer) March 28, 1994 - ----------------------------- (Robert D. Huth) Vice President and Corporate Controller (Principal Accounting /S/ SHAHID QURAESHI Officer) March 28, 1994 - ----------------------------- (Shahid Quraeshi) /S/ HYMAN L. BATTLE, JR. Director March 28, 1994 - ----------------------------- (Hyman L. Battle, Jr.) /S/ ALLAN J. BLOOSTEIN Director March 28, 1994 - ----------------------------- (Allan J. Bloostein) /S/ JOHN J. CREEDON Director March 28, 1994 - ----------------------------- (John J. Creedon) Signature Title Date --------- ----- ---- Vice President /S/ MICHAEL A. FRIEDHEIM and Director March 29, 1994 - ----------------------------- (Michael A. Friedheim) /S/ MICHAEL H. JORDAN Director March 28, 1994 - ----------------------------- (Michael H. Jordan) /S/ TERRY R. LAUTENBACH Director March 28, 1994 - ----------------------------- (Terry R. Lautenbach) /S/ THEODORE LEVITT Director March 28, 1994 - ----------------------------- (Theodore Levitt) /S/ DONALD F. MCCULLOUGH Director March 28, 1994 - ----------------------------- (Donald F. McCullough) /S/ FRANK MELVILLE Director March 28, 1994 - ----------------------------- (Frank Melville) Executive Vice President and Director March __, 1994 - ----------------------------- (Jerald S. Politzer) President, Chief Operating Officer /S/ HARVEY ROSENTHAL and Director March 28, 1994 - ----------------------------- (Harvey Rosenthal) /S/ IVAN G. SEIDENBERG Director March 29, 1994 - ----------------------------- (Ivan G. Seidenberg) /S/ PATRICIA CARRY STEWART Director March 27, 1994 - ----------------------------- (Patricia Carry Stewart) /S/ M. CABELL WOODWARD, JR. Director March 28, 1994 - ----------------------------- (M. Cabell Woodward, Jr.) MELVILLE CORPORATION AND SUBSIDIARY COMPANIES Index to Consolidated Financial Statements and Schedules The consolidated financial statements of Melville Corporation and Subsidiary Companies together with the report on such consolidated financial statements of KPMG Peat Marwick dated February 10, 1994, except as to the subsequent event note, which is as of March 1, 1994, which appear on the pages listed below of the 1993 Annual Report to shareholders, are incorporated by reference in this Annual Report on Form 10-K. Page Number in 1993 Annual Report to Shareholders --------------- Independent Auditors' Report .............................. 34 Consolidated Statements of Earnings for the years ended December 31, 1993, 1992 and 1991 ................ 35 Consolidated Balance Sheets as of December 31, 1993 and 1992 ..........................................36-37 Consolidated Statements of Shareholders' Equity for the years ended December 31, 1993, 1992 and 1991 ..........................................38 Consolidated Statements of Cash Flows for the years ended December 31, 1993, 1992 and 1991 ...........39 Notes to Consolidated Financial Statements .................40-47 Included in Part IV of this report: Page Consent of Independent Auditors ---- for Melville Corporation and Subsidiary Companies ...............................F-1 Independent Auditors' Report on Consolidated Financial Statement Schedules of Melville Corporation and Subsidiary Companies ...............................F-2 Consolidated Financial Statement Schedules of Melville Corporation and Subsidiary Companies for the years ended December 31, 1993, 1992 and 1991: V - Property, Plant and Equipment ...................S-1 VI - Accumulated Depreciation and Amortization of Property, Plant and Equipment ..............S-2 VIII - Valuation and Qualifying Accounts ...............S-3 IX - Short-Term Borrowings ...........................S-4 X - Supplementary Consolidated Statements of Earnings Information ..........................S-5 Schedules not included above have been omitted because they are not applicable or the required information is shown in the consolidated financial statements or related notes. S-1 S-2 Schedule VIII ------------- MELVILLE CORPORATION AND SUBSIDIARY COMPANIES Valuation and Qualifying Accounts Years ended December 31, 1993, 1992 and 1991 ($ in Thousands) Additions Balance at Charged to Balance at Beginning Costs and End Description of Year Expenses Deductions(1) of Year ------------ ----------- ----------- ------------- --------- Accounts Receivable: Allowance for Doubtful Accounts: Year Ended December 31, 1993 $ 25,131 $ 23,173 $ 15,770 $ 32,534 ======== ======== ======== ======== Year Ended December 31, 1992 $ 21,717 $ 12,087 $ 8,673 $ 25,131 ======== ======== ======== ======== Year Ended December 31, 1991 $ 15,170 $ 17,642 $ 11,095 $ 21,717 ======== ======== ======== ======== (1) Write-offs, net of recoveries S-3 S-4 Schedule X ---------- MELVILLE CORPORATION AND SUBSIDIARY COMPANIES Supplementary Consolidated Statement of Earnings Information Years ended December 31, 1993, 1992 and 1991 ($ in Thousands) Amount Charged to Costs and Expenses Item 1993 1992 1991 ---- ---- ---- ---- Taxes, other than payroll and income taxes $ 113,922 $ 108,536 $ 101,762 ======= ======= ======= Advertising costs $ 174,297 $ 154,839 $ 131,092 ======= ======= ======= Amounts for maintenance and repairs, depreciation and amortization of intangible assets, pre-opening costs and similar deferrals and royalties are not presented as such amounts are less than 1% of sales. S-5 CONSENT OF INDEPENDENT AUDITORS The Board of Directors and Shareholders Melville Corporation: We consent to incorporation by reference in the Registration Statements Numbers 33-40251, 33-17181 and 2-97913 on Form S-8 and Numbers 33-62664 and 33-34946 on Form S-3 of Melville Corporation and subsidiary companies of our report dated February 10, 1994, except as to the Subsequent Event note, which is as of March 1, 1994, related to the consoldiated balance sheets of Melville Corporations and subsidiary companies as of December 31, 1993 and 1992, and the related consolidated statements of earnings, shareholders' equity and cash flows and related financial statement schedules for each of the years in the three-year period ended December 31, 1993, which reports appear (or are incorporated by reference) in the December 31, 1993 annual report on Form 10-K of Melville Corporation and subsidiary companies. Our reports refer to the adoption of the Financial Accounting Standards Board's Statement of Financial Accounting Standards No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions," in 1992 and to a change in the method of determining retail price indices used in the valuation of LIFO inventories in 1993. Very truly yours, /s/KPMG PEAT MARWICK KPMG Peat Marwick New York, New York March 30, 1994 INDEPENDENT AUDITORS' REPORT The Board of Directors and Shareholders Melville Corporation: Under date of February 10, 1994, except as to the Subsequent Event note, which is as of March 1, 1994, we reported on the consolidated balance sheets of Melville Corporation and subsidiary companies as of December 31, 1993 and 1992, and related consolidated statements of earnings, shareholders' equity and cash flows for each of the years in the three-year period ended December 31, 1993, as contained in the 1993 annual report to shareholders. These consolidated financial statements and our report thereon are incorporated by reference in the annual report on Form 10-K for the year 1993. In connection with our audits of the aforementioned consolidated financial statements, we also have audited the related financial statement schedules listed in the accompanying index. These financial statement schedules are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statement schedules based on our audits. In our opinion, such financial statement schedules, when considered in relation to the basic consolidated financial statements taken as a whole, present fairly, in all material respects, the information set forth therein. As discussed on page 44 of the Annual Report to Stockholders, the Company adopted the provisions of the Financial Accounting Standards Board's Statement of Financial Accounting Standards No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions," in 1992. Also, as discussed on page 41, the Company changed its method of determining retail price indices used in the valuation of LIFO inventories in 1993. /s/KPMG PEAT MARWICK KPMG Peat Marwick New York, New York February 10, 1994, except as to the Subsequent Event note, which is as of March 1, 1994 INDEX TO EXHIBITS Exhibit Table Number: - --------- 3 (a) Restated Certificate of Incorporation, as amended as of April 18, 1990 (incorporated by reference to Exhibit 3 filed with the registrant's Quarterly Report on Form 10-Q for the fiscal quarter ended June 30, 1990). * 3(b) By-Laws, as amended through December 8, 1993. 4 No instrument which defines the rights of holders of long and intermediate debt of the registrant and its subsidiaries is filed herewith pursuant to Regulation S-K, Item 601(b)(4)(iii)(A) other than the June 23, 1989 amendment to the Restated Certificate of Incorporation defining the rights of the holders of the Series One ESOP Convertible Preference Stock (see above exhibit table number 3 (a)). The registrant hereby agrees to furnish a copy of any such instrument to the Securities and Exchange Commission upon request. EXECUTIVE COMPENSATION PLANS AND ARRANGEMENTS Exhibit Table Number : - ------------ 10(iii)(A) (i) 1973 Stock Option Plan (incorporated by reference to Exhibit (10) (iii) (A) (i) to the registrant's Annual Report on Form 10-K for the fiscal year ended December 31, 1987). (ii) 1987 Stock Option Plan (incorporated by reference to Exhibit (10) (iii) (A) (iii) to the registrant's Annual Report on Form 10-K for the fiscal year ended December 31, 1987). (iii) 1989 Directors Stock Option Plan (incorporated by reference to Exhibit B to the registrant's Annual Report on Form 10-K for the fiscal year ended December 31, 1988). (iv) Melville Corporation Omnibus Stock Incentive Plan (incorporated by reference to Exhibit B to the registrant's Annual Report on Form 10-K for the fiscal year ended December 31, 1989). (v) Directors Retirement Plan (incorporated by reference to Exhibit 10 (iii) (A) (vi) to registrant's Annual Report on Form 10-K for year ended December 31, 1992). (vi) Profit Incentive Plan of Melville Corporation (incorporated by reference to Exhibit A to registrant's definitive Proxy Statement dated March 14, 1994). Exhibit Table Number: - ----------- * 11 Statement re: Computation of Per Share Earnings. * 12 Statement re: Computation of Ratios. * 13 Annual Report to Shareholders for the year ended December 31, 1993. (Except for the portions incorporated herein by reference, such report is furnished for the information of the SEC and is not deemed "filed" as part of this Form 10-K report.) * 18 Letter re: Change in Accounting Principle. * 22 Subsidiaries of the registrant.

817473_1993.txt

817473

1993

ITEM 1. BUSINESS OF THE COMPANY BACKGROUND American Capital Strategies, Ltd., a Delaware corporation (the "Company"), was incorporated in 1986 to provide financial advisory services to and invest in small and medium sized businesses. On August 29, 1997, the Company completed an initial public offering ("IPO") of 10,382,437 shares of its common stock ("Common Stock") and became a non-diversified, closed end investment company that has elected to be treated as a business development company ("BDC") under the Investment Company Act of 1940, as amended ("1940 Act"). On October 1, 1997, the company began operations so as to qualify to be taxed as a regulated investment company (RIC) as defined in Subtitle A, Chapter 1, under Subchapter M of the Internal Revenue Code of 1986 as amended (the "Code"). As contemplated by these transactions, the Company materially changed its business plan and format from structuring and arranging financing for buyout transactions on a fee for services basis to primarily being a lender to and investor in small and medium sized companies. The Company continues to provides financial advisory services to businesses through ACS Capital Investments Corporation ("CIC"), a wholly-owned subsidiary. The Company had established itself as a leading firm in structuring and obtaining funding for management and employee buyouts of subsidiaries, divisions and product lines being divested by larger corporations through the use of an employee stock ownership plans ("ESOPs"). From its formation in 1986 through the IPO, the Company arranged 29 financing transactions aggregating over $400 million. BUSINESS The Company is a buyout and specialty finance company that is principally engaged in providing senior debt, subordinated debt and equity to companies in need of capital for employee buyouts, management buyouts, growth, acquisitions, liquidity and restructuring. The Company invests up to $20 million in each transaction and through its subsidiary, CIC, will arrange and secure capital for larger transactions. The Company's primary business objectives are to increase its net operating income and net asset value by investing its assets in senior debt, subordinated debt with detachable warrants and equity of small to medium sized businesses with attractive current yields and potential for equity appreciation. The Company's loans typically range from $1 million to $20 million, mature in five to ten years, and require monthly or quarterly interest payments at variable rates based on the prime rate plus a margin. The Company prices its debt and equity investments based on its analysis of each transaction. As of December 31, 1997 the weighted average effective interest on the Company's debt investments was 14.5% and dividend rate on the Company's preferred stock investment was 15% The Company also invests in common stock which may not provide a current yield but would share in the appreciation of the investment. At December 31, 1997, common stock investments represented 6.0% of the Company's portfolio and common stock investments excluding CIC was 7.6% of the Company's investment in non-publicly traded securities. The Company expects common stock investments to represent the smallest percentage of its portfolio. The Company's equity interests in small and medium sized businesses are purchased with the goal of disposing of such interests and realizing a gain within three to seven years. The opportunity to realize such gain may occur if the business recapitalizes its equity, either through a sale to new owners or makes a public offering of its equity. The Company generally does not have the right to require that a business undergo an initial public offering by registering securities under the Securities Act of 1933, but the Company generally does have the right to sell its equity interests in a public offering by the business to the extent permitted by underwriters. In most cases, the Company also receives the right to require the business to purchase the warrants or stock held by the Company ("Put Rights") under various circumstances including, typically, the repayment of the Company's loans or debt securities. When no public offering is available, the Company may use its Put Rights to dispose of its equity interest in a business, although the Company's ability to exercise Put Rights may be limited or nonexistent if a business is illiquid. The Company makes available significant managerial assistance to its portfolio companies. Such assistance typically involves closely monitoring the operations of the company, participating in its board and management meetings, being available for consultation with its officers and providing organizational and financial guidance. Providing assistance to its borrowers serves as a control for the Company as well as provides an opportunity for the Company to assist in maximizing the operations of the borrower. Prior to the IPO, the Company established itself as a leading firm in structuring and obtaining funding for management and employee buyouts of subsidiaries, divisions and product lines being divested by larger corporations through the use of an ESOP. The selling entities have included Sunbeam Corporation, the U.S. Office of Personnel Management, American Premier Underwriters, Inc. (formerly Penn Central Corporation), Campbell Soup Company, Union Carbide Corporation, National Forge Company, Inc., Air Products Company, Ampco-Pittsburgh Corporation and British Petroleum Company. In most of the ESOP transactions structured by the Company, the employees agree to restructure their wages and benefits so that overall cash compensation is reduced while contributions of stock are made to an ESOP. The resulting company is structured so that the fair market value of stock contributed to the ESOP can be deducted from corporate income before paying taxes. Restructuring employee compensation together with the ESOP tax advantages has the effect of improving the cash flow of the ESOP company. The Company believes that its ESOP knowledge and experience and its ability to fund transactions positions the Company favorably in the market place. The Company continues providing financial advisory services and structuring of transactions through its wholly-owned subsidiary CIC. The typical advisory engagement includes a monthly retainer and a performance fee contingent upon closing of the transaction or event which is the subject of the engagement. Management believes that future growth of CIC is attainable through adding additional professionals, by gaining additional market share and by realizing the benefits of what is expected to be an increasing client base, which should expand as a result of its relationship with the Company. The Company believes that, through the structuring and advisory business, it has established an extensive referral network comprised of venture capitalists, investment bankers, attorneys, commercial bankers and business and financial brokers. CIC is continuing the relationships with the referral network and the Company utilizes the referral network and CIC's client base as its primary sources of investment opportunities. LENDING AND INVESTMENT DECISION CRITERIA The Company reviews certain criteria in order to make investment decisions. The criteria listed below provide a general guide for the Company's lending and investment decisions, although not all criteria are required to be favorable in order for the Company to make an investment. Operating History. The Company focuses on target companies that have stable operating histories and are profitable or near profitable at existing operating levels. The Company reviews the target companies ability to service and repay debt based on its historical results of operations. The Company does not expect to lend or invest in start-up or other early stage companies. Growth. In addition to generating sufficient cash flow to service its debt, a potential recipient of the Company's financing generally is required to establish its ability to grow its cash flow. Anticipated growth will be a key factor in determining the value ascribed to any warrants and equity interests acquired by the Company. Liquidation Value of Assets. Although the Company does not operate as an asset-based lender, liquidation value of the assets collateralizing the Company's loans is an important factor in each credit decision. Emphasis is placed both on tangible assets (accounts receivable, inventory, plant, property and equipment) as well as intangible assets such as customer lists, networks, databases and recurring revenue streams. Experienced Management Team. The Company requires that each borrower have or promptly obtain a management team that is experienced and properly incentivized through a significant ownership interest in the borrower. The Company requires that a potential recipient of the Company's financing have a management team who have demonstrated the ability to execute the company's objectives and implement its business plan. Exit Strategy. Prior to making an investment, the Company analyzes the potential for the target company to experience a liquidity event that will allow the Company to realize value for its equity position. Liquidity events include, among other things, an initial public offering, a private sale of the Company's financial interest, a sale of the company, or a purchase by the company or one of its stockholders of the Company's equity position. OPERATIONS Marketing and Origination Process. The Company and CIC have thirteen professionals responsible for originating loans and investments and providing financial assistance to small and medium sized businesses and intends to hire an additional five professionals by year end. To originate financing opportunities, these professionals use an extensive referral network comprised of venture capitalists, investment bankers, unions, attorneys, accountants, commercial bankers, unions, business brokers and prospective or existing ESOP companies. The Company also has an extensive set of internet sites that it uses to attract financing opportunities. Approval Process. The Company's financial professionals review informational packages in search of potential financing opportunities and conduct a due diligence investigation of each applicant that passes an initial screening process. This due diligence investigation generally includes one or more on-site visits, a review of the company's historical and prospective financial information, interviews with management, employees, customers and vendors of the applicant, and background checks and research on the applicant's product, service or particular industry. Upon completion of the due diligence investigation, the financial professional creates a profile summarizing the target company's historical financial statements, industry and management team and analyzing its conformity to the Company's general investment criteria. The financial professional then presents this profile to the Company's Credit Committee, which is comprised of David Gladstone, Malon Wilkus and Adam Blumenthal, the Chairman, President and Executive Vice President, respectively, of the Company. The Company's Credit Committee and the Company's Board of Directors must approve each financing. Support Services. A commercial bank provides certain loan accounting and administrative services for the Company's investments and also acts as the custodian of the Company's portfolio assets pursuant to and in accordance with the 1940 Act. COMPETITION The Company's primary competitors include financial institutions and venture capital firms and other nontraditional lenders. Many of these entities have greater financial and managerial resources than the Company. Nevertheless, the Company believes that it competes effectively with these entities through, among other means, its responsiveness to the needs of its customers and its flexibility in structuring transactions. EMPLOYEES As of March 20, 1998, the Company had twenty-two employees, thirteen of whom are professionals working on financings for small and medium sized businesses. The Company believes that its relations with its employees are excellent. The Company intends to continue maintaining a relatively low overhead by outsourcing many functions not directly related to marketing or underwriting its investments and the executive management of the Company. THE COMPANY'S OPERATIONS AS A BDC AND RIC As a BDC, the Company may not acquire any asset other than Qualifying Assets unless, at the time the acquisition is made, Qualifying Assets represent at least 70% of the value of the Company's total assets. The principal categories of Qualifying Assets relevant to the business of the Company are the following: (i) securities purchased in transactions not involving any public offering from the issuer of such securities, which issuer is an eligible portfolio company. An eligible portfolio company is defined as any issuer that (a) is organized and has its principal place of business in the United States, (b) is not an investment company other than a small business investment company wholly-owned by the BDC and (c) does not have any class of publicly-traded securities with respect to which a broker may extend credit; (ii) securities received in exchange for or distributed with respect to securities described above, or pursuant to the exercise of options, warrants or rights relating to such securities; and (iii) cash, cash items, Government securities, or high quality debt securities maturing in one year or less from the time of investment. The Company may not change the nature of its business so as to cease to be, or withdraw its election as, a BDC unless authorized by vote of a majority, as defined in the 1940 Act, of the Company's shares. Since the Company made its BDC election, it has not made any substantial change in its structure or in the nature of its business. The Company operates so as to qualify as a RIC under the Internal Revenue Code of 1986 as amended. Generally in order to qualify as a RIC, the Company must distribute to shareholders in a timely manner, at least 90% of its "investment company taxable income" and 98% of its capital gain net income as defined by the code. The Company must derive at least 90% of its gross income from dividends, interest, payments with respect to securities loans, gain from the sale of stock or other securities, or other income derived with respect to its business of investing in such stock or securities as defined by the code. Additionally, the Company must diversify its holdings so that (i) at least 50% of the value of the Company's assets consists of cash, cash items, government securities and other securities if such other securities of any one issuer do not represent more than 5% of the Company's assets and 10% of the outstanding voting securities of the issuer and (ii) no more than 25% of the value of the Company's assets are invested in the securities of one issuer (other than U.S. government securities), or of two or more issuers that are controlled by the Company and are engaged in the same or similar or related trades or businesses. TEMPORARY INVESTMENTS Pending investment in other types of Qualifying Assets, the Company has invested its otherwise uninvested cash primarily in cash, cash items, government securities, agency paper or high quality debt securities maturing in one year or less from the time of investment in such high quality debt investments ("Temporary Investments") so that at least seventy percent (70%) of its assets are Qualifying Assets. Typically, the Company invests in U.S. Treasury bills or in repurchase obligations of a "primary dealer" in government securities (as designated by the Federal Reserve Bank of New York) or of any other dealer whose credit has been established to the satisfaction of the Board of Directors. There is no percentage restriction on the proportion of the Company's assets that may be invested in such repurchase agreements. A repurchase agreement involves the purchase by an investor, such as the Company, of a specified security and the simultaneous agreement by the seller to repurchase it at an agreed upon future date and at a price which is greater than the purchase price by an amount that reflects an agreed-upon interest rate. Such interest rate is effective for the period of time during which the investor's money is invested in the arrangement and is related to current market interest rates rather than the coupon rate on the purchased security. The Company requires the continual maintenance by its custodian or the correspondent in its account with the Federal Reserve/Treasury Book Entry System of underlying securities in an amount at least equal to the repurchase price. If the seller were to default on its repurchase obligation, the Company might suffer a loss to the extent that the proceeds from the sale of the underlying securities were less than the repurchase price. A seller's bankruptcy could delay or prevent a sale of the underlying securities. LEVERAGE For the purpose of making investments other than Temporary Investments and to take advantage of favorable interest rates, the Company intends to issue in the future senior debt securities, up to the maximum amount permitted by the 1940 Act, which currently permits the Company, as a BDC, to issue senior debt securities and preferred stock (collectively, "Senior Securities") in amounts such that the Company's asset coverage, as defined in the 1940 Act, is at least 200% after each issuance of Senior Securities. Such indebtedness may also be incurred for the purpose of effecting share repurchases. As a result, the Company would become exposed to the risks of leverage. Although the Company has no current intention to do so, it has retained the right to issue preferred stock. As permitted by the 1940 Act, the Company may, in addition, borrow amounts up to five percent (5%) of its total assets for temporary or emergency purposes. ITEM 2.

ITEM 2. PROPERTIES Neither the Company nor any of its subsidiaries owns any real estate or other physical properties materially important to the operation of the Company or any of its subsidiaries. The Company leases an aggregate of approximately 10,000 square feet of office space in four locations for terms ranging up to seven years. ITEM 3.

ITEM 3. LEGAL PROCEEDINGS Although the Company may, from time to time, be involved in litigation and claims arising out of its operations in the normal course of business, as of December 31, 1997, the Company was not presently a party to any material legal proceedings. ITEM 4.

ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS During the fourth quarter of the fiscal year ended December 31, 1997, there were no matters submitted to a vote of the Company's security holders through the solicitation of proxies or otherwise. PART II ITEM 5.

ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS Since the IPO the Company has distributed and currently intends to continue to distribute 90% of its net operating income and net realized short-term capital gains, if any, on a quarterly basis to its stockholders. Net realized long-term capital gains may be retained to supplement the Company's equity capital and support growth in its portfolio, unless the Board of Directors determines in certain cases to make a distribution. There is no assurance that the Company will achieve investment results or maintain a tax status that will permit any specified level of cash distributions or year-to-year increases in cash distributions. The Common Stock is quoted on the Nasdaq Stock Market under the symbol ACAS. As of March 25, 1998, the Company had 49 stockholders of record and approximately 1300 beneficial owners. The following table sets forth the range of high and low bid prices of the Company's Common Stock as reported on the Nasdaq Stock Market and the dividends declared by the Company for the period from August 29, 1997, when public trading of the Common Stock commenced, through March 25, 1998. ITEM 6.

ITEM 6. SELECTED FINANCIAL DATA [Furnish the information required by Item 301 of Regulation S-K.] ITEM 7.

ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATION [Furnish the information required in Item 303 of Regulation S-K.] ITEM 7A.

ITEM 7A. QUALITATIVE AND QUANTITATIVE DISCLOSURES ABOUT MARKET RISK [Furnish the information required by Item 305 of Regulation S-K.] ITEM 8.

ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA [Furnish the financial statements meeting the requirements of Regulation S-X, except ss. 210.3-05 and Article 11 thereof, and the supplementary financial information required by Item 302 of Regulation S-K. Financial statements of the registrant and its subsidiaries consolidated (as required by Rule 14a-3(b)) shall be filed under this Item. Other financial statements and schedules required under Regulation S-X may be filed as "Financial Statement Schedules" pursuant to Item 13, Exhibits, Financial Statement Schedules, and Reports on Form 8-K, of this Form.] ITEM 9.

ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE [Furnish the information required by Item 302 of Regulation S-K.] PART III ITEM 10.

ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT Information in response to this Item is incorporated herein by reference to the information provided in the Company's Proxy Statement for its Annual Meeting of Shareholders to be held May 14, 1998 (the "1998 Proxy Statement") under the heading "Directors and Executive Officers of the Registrant." ITEM 11.

ITEM 11. EXECUTIVE COMPENSATION Information in response to this Item is incorporated herein by reference to the information provided in the 1998 Proxy Statement under the heading "Compensation of Directors and Executive Officers." ITEM 12.

ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT Information in response to this Item is incorporated herein by reference to the information provided in the 1998 Proxy Statement under the heading "Security Ownership of Management and Certain Beneficial Owners." ITEM 13.

ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS Information in response to this Item is incorporated herein by reference to the information provided in the 1998 Proxy Statement under the heading "Certain Transactions." PART IV ITEM 14.

ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K [(a) List the following: (1) all financial statements; (2) financial statement schedules required by Item 8 and paragraph (d) below; and (3) those exhibits required by Item 601 of Regulation S-K and paragraph (c) below. Identify in the list each management contract or compensatory plan or arrangement required to be filed as an exhibit to this Form pursuant to Item 149c) of this report (b) State whether any reports on Form 8-K have been filed during the last quarter of the period covered by this report. (c) File as exhibits those exhibits required by Item 601 of Regulation S-K. (d) Registrants shall file, as financial statement schedules to this Form, the financial statements required by Regulation S-X which are excluded from the annual report to shareholders by Rule 14a-3(b), including: (1) separate financial statements of subsidiaries not consolidated and fifty percent or less owned persons; (2) separate financial statements of affiliates whose securities are pledged as collateral; and (3) schedules.] SIGNATURES Pursuant to the requirements of Section 13 or 15(d) 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. AMERICAN CAPITAL STRATEGIES, LTD. By: /s/ John R. Erickson -------------------------- John R. Erickson Chief Financial Officer (Principal Financial and Accounting Officer) Date: March 31, 1998 Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated. EXHIBIT INDEX

52485_1993.txt

52485

1993

Item 2. Properties The Company's principal electric generating stations at December 31, 1993, are as follows: Net Kilowatts Accredited Major Generating Name and Location of Station Fuel Type Capability Duane Arnold Energy Center, Palo, Iowa Nuclear 371,000 (1) Ottumwa Generating Station, Ottumwa, Iowa Coal 339,840 (2) Prairie Creek Station, Cedar Rapids, Iowa Coal 234,000 Sutherland Station, Marshalltown, Iowa Coal 145,500 Sixth Street Station, Cedar Rapids, Iowa Coal 66,000 Peaking Turbines, Marshalltown, Iowa Oil 210,000 Diesel Stations, all in Iowa Oil 12,200 Burlington Generating Station, Burlington, Iowa Coal 211,800 Grinnell Station, Grinnell, Iowa Gas 47,200 George Neal Unit 3, Sioux City, Iowa Coal 144,200 (3) Total generating capability 1,781,740 (1) The capability represents the Company's 70% ownership interest in the 530,000 Kw generating station. The other owners are Central Iowa Power Cooperative (20%) and Corn Belt Power Cooperative (10%). The plant is operated by the Company. (2) The Company owns 48% of this 708,000 Kw generating station. The plant is operated by the Company. (3) This represents the Company's 28% ownership interest in this 515,000 Kw generating station which is operated by an unaffiliated utility. At December 31, 1993, the transmission lines of the Company, operating from 34,000 to 345,000 volts, approximated 4,259 circuit miles (all located in Iowa). The Company owned 107 transmission substations (all located in Iowa) with a total installed capacity of 8,426.4 MVa and 464 distribution substations (all located in Iowa) with a total installed capacity of 2,445.3 MVa. The Company's principal properties are suitable for their intended use and are held subject to liens of indentures relating to its First Mortgage Bonds. Item 3.

Item 3. Legal Proceedings On December 24, 1990, IS filed in the United States Federal District Court (Court) for the Southern District of Iowa, a Complaint for Declaratory and Other Relief against the Iowa Department of Transportation (IDOT) for declaratory relief and contribution under CERCLA to recover costs that have been and will be incurred by IS (subsequently the Company) in connection with FMGP clean-up costs related to certain real property located in the City of Burlington, Iowa, and nearby areas, including the Mississippi River. On February 11, 1991, IDOT filed an Answer and Counterclaim against IS pursuant to CERCLA, alleging that it had incurred costs and expenses in excess of $1.3 million responding to the release of contamination and requesting judgment against IS for such costs and for all such future costs. Subsequently, in correspondence to IS's counsel, IDOT alleged that it had incurred in excess of $4.7 million in response costs. On June 3, 1993, the Court approved a Settlement Agreement and Order Confirming Settlement between IS (subsequently the Company) and IDOT. Under the terms of the agreement, the Company and IDOT agreed to dismiss the suit and countersuit discussed above. Additionally, the Company and IDOT have agreed to a cost-sharing arrangement for future investigation and clean-up costs at the Burlington site, whereby the Company will absorb the next $15 million of such costs and 75% of additional costs thereafter, to the extent any such costs are incurred pursuant to clean-up plans acceptable to regulatory agencies. The Company will also supervise the investigation and clean-up activities. Reference is made to Notes 4 and 12 of the Notes to Financial Statements for a discussion of the Company's rate proceedings and environmental matters. Also see Item 1. "Business - Environmental Matters." Item 4.

Item 4. Submission of Matters to a Vote of Security Holders At a special meeting of the IE preferred shareholders held on October 22, 1993, the proposed merger of IE and IS was voted upon and approved. A summary of the results of the vote is as follows: Shares Eligible Shareholder Class to Vote For Against Abstain 4.30% preferred 120,000 110,917 - 308 4.80% preferred 146,406 91,625 267 2,535 6.10% preferred 100,000 63,174 - 2,853 The Company's sole common shareholder, Industries, approved the merger on May 4, 1993. PART II Item 5.

Item 5. Market for the Registrant's Common Stock and Related Stockholder Matters All outstanding common stock of the Company is held by its parent (Industries) and is not publicly traded. The amounts of dividends declared for the last two years are as follows: Quarter Dividends Declared (000's) First Quarter $ 10,000 Second Quarter 5,700 Third Quarter 3,800 Fourth Quarter 11,800 $ 31,300 First Quarter $ 13,231 Second Quarter 3,000 Third Quarter 4,462 Fourth Quarter 4,028 $ 24,721 Under terms of the Fifty-fifth and Fifty-sixth Supplemental Indentures relating to Series W and Series X First Mortgage Bonds, the Company has agreed that no cash dividends shall be paid or declared, nor shall any distribution be made on any capital stock, nor shall any shares of such stock be purchased, redeemed or otherwise acquired for any consideration by the Company or any subsidiary of the Company, if after immediately giving effect to such payment, distribution or retirement, (A) the principal amount of all outstanding defined Unsecured Indebtedness exceeds 20% of defined Total Capitalization, or (B) the aggregate amount of all such payments, distributions and retirements made since December 31, 1987 exceeds net income since December 31, 1987 plus $50,000,000. Pursuant to these terms, at December 31, 1993, $18,209,000 of retained earnings was restricted as to the payment of cash dividends. The Company may periodically pay cash dividends on any shares of its preferred or preference stock at any time issued and outstanding, provided that all such payments shall be included in the above payments as determined since December 31, 1987. Item 6.

Item 6. Selected Financial Data The following selected financial data, in the opinion of the Company, includes adjustments, which are normal and recurring in nature, necessary for the fair presentation of the results of operations and financial position. See Item 7.

Item 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF THE RESULTS OF OPERATIONS AND FINANCIAL CONDITION The following discussion analyzes significant changes in the components of net income and financial condition during the years 1993 and 1992. See Note 1 of the Notes to Financial Statements for a discussion of the merger of Iowa Electric Light and Power Company (IE) and Iowa Southern Utilities Company (IS), effective December 31, 1993, that formed the Company. RESULTS OF OPERATIONS The Company's net income increased $23.5 million during 1993 and decreased $1.8 million during 1992. The 1993 results reflect the acquisition of the Iowa service territory of Union Electric Company (UE) (as discussed in Note 3 of the Notes to Financial Statements) and a return to more normal weather conditions in the Company's service territory. The floods in Iowa in 1993 did not significantly affect the Company's results of operations. The 1992 results were adversely affected by extremely cool summer weather and a mild winter in the Company's service territory. The Company's operating income increased $25.0 million and $0.6 million during 1993 and 1992, respectively, as compared to prior years. Reasons for the changes in the results of operations are explained in the following discussion. ELECTRIC REVENUES Electric revenues and Kwh sales (excluding off-system sales) increased $87.5 million and 25%, respectively, during 1993. In 1992, electric revenues and Kwh sales decreased $19.6 million and 1.5%, respectively. The 1993 sales increase is attributable to the acquisition of the UE territory and a return to more normal weather conditions. After adjusting for these items, underlying electric sales increased 6% in 1993, which reflects the economic growth in the industrial and commercial customer base. The 1992 Kwh sales decrease reflects unusually mild weather conditions in the Company's service territory. Residential sales, which are the most weather sensitive, decreased 9.5%. However, industrial sales, which are less sensitive to weather, increased approximately 5.5%. Adjusting for the effects of weather, Kwh sales increased 2.7%, reflecting economic growth in the Company's service territory. The Company's electric tariffs include energy adjustment clauses (EAC) that are designed to currently recover the costs of fuel and the energy portion of purchased power billings to customers. See Note 2(g) of the Notes to Financial Statements for discussion of the EAC. The increase in electric revenues for 1993 is primarily because of the sales increase and increased recovery of fuel costs through the EAC. The revenue decrease in 1992 was primarily related to the lower Kwh sales discussed above and lower off-system sales to other utilities. A rate decrease in the former IS service territory that became effective in September 1991 contributed to the revenue decrease to a lesser extent. These items were partially offset by the effect of the rate increase in the former IE service territory that became effective in December 1991. See Note 4(b) of the Notes to Financial Statements for a discussion of the electric rate case in the former IE service territory. GAS REVENUES Gas revenues increased $14.9 million and $8.4 million during 1993 and 1992, respectively. Gas sales in therms (including transported volumes) increased 5.3% in 1993 and were flat in 1992. Gas sales also reflect the effects of weather. Adjusting for the effects of weather, gas sales decreased 1.5% in 1993 and increased 1.5% in 1992. The Company's tariffs include purchased gas adjustment clauses (PGA) that are designed to currently recover the cost of gas sold. See Note 2(g) of the Notes to Financial Statements for discussion of the PGA. Gas revenues increased in 1993 and 1992 substantially because of increased costs of gas recovered through the PGA and the effect of gas rate increases in the former service territory of both IE and IS, that became effective in September 1992. The 1993 sales increase also contributed to the revenue increase for that year. See Note 4(a) of the Notes to Financial Statements for a discussion of the gas rate increases. STEAM REVENUES Steam revenues increased $1.1 million during 1993 and decreased $0.6 million during 1992, primarily related to fluctuations in sales volumes among large industrial customers. OPERATING EXPENSES Fuel for production increased $14.3 million in 1993 because of increased availability of the Company's fossil-fueled generating stations, which experienced extended maintenance outages in 1992, and because of increased sales. Fuel for production decreased $17.8 million during 1992 primarily because of a nuclear refueling outage at the Duane Arnold Energy Center (DAEC), maintenance outages at the fossil-fueled generating stations and the lower electric sales. There were refueling outages in 1993 and 1992, but no such outage in 1991. The decrease in Kwh generation during the refueling and maintenance outages was substantially replaced by purchased power. Purchased power increased $18.7 million in 1993, of which approximately $14.7 million represents increased energy purchases and approximately $4.0 million is a net increase in capacity charges. The increase in energy purchases is because of the increased Kwh sales. The increased capacity costs reflect the contracts associated with the acquisition of the UE service territory, partially offset by the expiration, in April 1993, of the purchase power agreement with the City of Muscatine. (See Note 12(b) of the Notes to Financial Statements). Purchased power increased $4.5 million in 1992 because of increased purchases during the refueling and maintenance outages, partially offset by lower purchases related to lower off-system sales. Gas purchased for resale increased $7.5 million and $5.1 million during 1993 and 1992, respectively. The increases are primarily because of increased per unit gas costs, and in 1993, increased sales. Other operating expenses increased $3.6 million in 1993 and decreased $5.2 million during 1992. The 1993 increase is primarily because of increased labor and benefit costs and higher electric and gas transmission and distribution costs, partially offset by lower non-labor costs at the DAEC. The 1992 decrease was substantially related to a regulatory disallowance of $3.9 million recorded in April 1991, after the Iowa Utilities Board (IUB) denied recovery of previously deferred former manufactured gas plant (FMGP) clean-up costs. Lower non-labor costs at the DAEC and lower Nuclear Regulatory Commission fees, partially offset by increased labor and benefit costs, also affected 1992. Maintenance expenses increased $6.6 million during 1993 and were flat in 1992. The 1993 increase is primarily because of increased maintenance at the Company's fossil-fueled generating stations and the DAEC. The 1992 maintenance expenses reflect increased maintenance at fossil-fueled generating stations, substantially offset by lower maintenance costs at the DAEC. Depreciation and amortization increased during both years primarily because of increases in utility plant in service, including the acquisition of the UE territory on December 31, 1992. An increase in the average gas utility property depreciation rate, resulting from an updated depreciation study, also contributed to the 1993 increase. Depreciation and amortization expenses for both years include $5.5 million for the DAEC decommissioning provision, which is collected through rates. Property taxes increased $4.8 million during 1993, primarily because of the acquisition of the UE service territory and increases assessed values. Federal and state income taxes included in operating expenses increased $18.0 million in 1993 primarily because of increases in taxable income and an increase of 1% in the Federal statutory income tax rate. Such income taxes decreased $1.9 million in 1992 primarily because of adjustments of $1.5 million recorded in the second quarter of 1992 to previously recorded tax reserves and a reduction in taxable income. INTEREST EXPENSE Interest expense (long-term debt and other combined) increased in 1993 and 1992 primarily because of an increase in the average amount of debt outstanding. A reduction in the average interest rate in 1993 substantially offset the effect of the higher average outstanding debt. The lower average interest rate reflects the refinancing of certain long-term debt issues at lower rates and lower-cost short-term borrowings outstanding for interim periods between the redemption of certain long-term debt series and the issuance of their long-term replacements. Interest expense related to the Company's reserves for rate refunds also contributed to the increase in 1992. LIQUIDITY AND CAPITAL RESOURCES The Company's capital requirements are primarily attributable to its construction programs and debt maturities. Cash and temporary cash investments increased $16.6 million during 1993. In 1993, cash flows from operating activities were $149 million. These funds were primarily used for construction and acquisition expenditures and to pay dividends. It is anticipated that the Company's future capital requirements will be met by cash generated from operations and external financing. The level of cash generated from operations is partially dependent upon economic conditions, legislative activities, environmental matters and timely rate relief. (See Notes 4 and 12 of the Notes to Financial Statements). Access to the long-term and short-term capital and credit markets is necessary for obtaining funds externally. The Company's liquidity and capital resources will be affected by environmental and legislative issues, including the ultimate disposition of remediation issues surrounding the FMGP issue, the Clean Air Act as amended, the National Energy Policy Act of 1992, and Federal Energy Regulatory Commission (FERC) Order 636, as discussed in Note 12 of the Notes to Financial Statements. Consistent with rate making principles of the IUB, management believes that the costs incurred for the above matters will not have a material adverse effect on the financial position or results of operations of the Company. The IUB has adopted rules which require the Company to spend 2% of electric and 1.5% of gas gross retail operating revenues annually for energy efficiency programs. Energy efficiency costs in excess of the amount in the most recent electric and gas rate cases are being recorded as regulatory assets. At December 31, 1993, the Company had $18.5 million of such costs recorded as regulatory assets. The Company will make its initial filing for recovery of the costs in 1994. CONSTRUCTION AND ACQUISITION PROGRAM The Company's construction and acquisition program anticipates expenditures of $150 million for 1994, of which approximately 44% represents expenditures for electric transmission and distribution facilities, 18% represents fossil-fueled generation expenditures and 10% represents nuclear generation expenditures. Substantial commitments have been made in connection with such expenditures. The Company's levels of construction and acquisition expenditures are projected to be $149 million in 1995, $144 million in 1996, $149 million in 1997 and $160 million in 1998. It is estimated that approximately 80% of construction expenditures will be provided by cash from operating activities (after payment of dividends) for the five year period 1994-1998. Capital expenditure and investment and financing plans are subject to continual review and change. The capital expenditure and investment program may be revised significantly as a result of many considerations including changes in economic conditions, variations in actual sales and load growth compared to forecasts, requirements of environmental, nuclear and other regulatory authorities, acquisition opportunities, the availability of alternate energy and purchased power sources, the ability to obtain adequate and timely rate relief, escalations in construction costs and conservation and energy efficiency programs. LONG-TERM FINANCING Other than periodic sinking fund requirements which the Company intends to meet by pledging additional property, $124 million of long-term debt, including four series of First Mortgage Bonds aggregating $123 million, will mature prior to December 31, 1998. The Company intends to refinance the majority of the debt maturities with long-term debt. In order to provide an up-to-date instrument for the issuance of bonds, notes or other evidence of indebtedness, the Company has entered into an Indenture of Mortgage and Deed of Trust dated September 1, 1993 (New Mortgage). The lien of the New Mortgage is subordinate to the lien of the Company's first mortgages until such time as all bonds issued under the first mortgages have been retired and such mortgages satisfied. The New Mortgage provides for, among other things, the issuance of Collateral Trust Bonds upon the basis of First Mortgage Bonds being issued. Accordingly, to the extent that the Company issues Collateral Trust Bonds on the basis of First Mortgage Bonds, it must comply with the requirements for the issuance of First Mortgage Bonds under the Company's first mortgages. Under the terms of the New Mortgage, the Company has covenanted not to issue any additional First Mortgage Bonds under its first mortgages except to provide the basis for issuance of Collateral Trust Bonds. In November 1993, the Company entered into arrangements with various cities in the State of Iowa (Cities), whereby the Cities issued an aggregate of $19.4 million of pollution control revenue refunding bonds (PCRRBs), all at 5.5%, due 2023. Each series of the PCRRBs is secured, in part, by payments on a corresponding principal amount of Collateral Trust Bonds, at 5.5%, due 2023. The proceeds received by the Company in the transaction were used to redeem $10.2 million of Pollution Control Obligations, 5.75%, due serially 1995-2003 and an aggregate of $9.2 million of First Mortgage Bonds, Series P & Q, 6.7%, due 2006. In October 1993, the Company sold $100 million aggregate principal amount of Collateral Trust Bonds, 6% Series, due 2008, and 7% Series, due 2023. A portion of the proceeds from the Collateral Trust Bonds was used to retire short-term debt, with the balance used for general corporate purposes, including support of the Company's construction program. In May 1993, the Company redeemed First Mortgage Bonds Series K, 8-5/8%, principal amount of $20 million, and Series R, 8-1/4%, principal amount of $25 million and First Mortgage Bonds Series 8-3/4%, principal amount of $15 million. The redemptions were completed with proceeds from short-term borrowings and, as discussed above, long-term debt was ultimately issued to replace the short-term borrowings. The Indentures pursuant to which the Company issues First Mortgage Bonds constitute direct first mortgage liens upon substantially all tangible public utility property and contain covenants which restrict the amount of additional bonds which may be issued. At December 31, 1993, such restrictions would have allowed the Company to issue $258 million of additional First Mortgage Bonds. The Company intends to file in the first quarter of 1994 with the FERC for authority to issue $250 million of long-term debt. The Company is currently authorized by the SEC to issue $50 million of long-term debt under an existing registration statement. The Company expects to issue up to $150 million in 1994. The proceeds are expected to be used for the early redemption of three series of First Mortgage Bonds aggregating $55 million, which have not yet been called, and for general corporate purposes, including support of its construction program. The Articles of Incorporation of the Company authorize and limit the aggregate amount of additional shares of Cumulative Preferred Stock and Cumulative Preference Stock which may be issued. At December 31, 1993, the Company could have issued an additional 700,000 shares of Cumulative Preference Stock and 100,000 additional shares of Cumulative Preferred Stock. The Company's capitalization ratios at year-end were as follows: 1993 1992 Long-term debt 48% 50% Preferred stock 2 2 Common equity 50 48 100% 100% SHORT-TERM FINANCING For interim financing, the Company is authorized by the FERC to issue, through 1994, up to $125 million of short-term notes. This availability of short-term financing provides the Company flexibility in the issuance of long-term securities. At December 31, 1993, the Company had outstanding short-term borrowings of $24 million. The Company has two agreements, both of which expire in 1994, with separate financial institutions to sell up to $65 million of its utility accounts receivable. The Company intends to consolidate the agreements into one new agreement in 1994. At December 31, 1993, the Company had sold $53.2 million under the agreements. At December 31, 1993, the Company had bank lines of credit aggregating $67.7 million and was using $19.0 million of its lines to support commercial paper and $7.7 million to support certain pollution control obligations. Commitment fees are paid to maintain these lines and there are no conditions which restrict the unused lines of credit. In addition to the above, the Company has an uncommitted credit facility with a financial institution whereby it can borrow up to $50 million. Rates are set at the time of borrowing and no fees are paid to maintain this facility. At December 31, 1993, $5.0 million was borrowed at 3.4% under this facility. The Company also has a letter of credit in the amount of $3.4 million supporting two of its variable rate pollution control obligations. EFFECTS OF INFLATION Under the rate making principles prescribed by the regulatory commissions to which the Company is subject, only the historical cost of plant is recoverable in revenues as depreciation. As a result, the Company has experienced economic losses equivalent to the current year's impact of inflation on utility plant. In addition, the regulatory process imposes a substantial time lag between the time when operating and capital costs are incurred and when they are recovered. The Company does not expect the effects of inflation at current levels to have a significant effect on its results of operations. Selected Quarterly Financial Data (unaudited) The following unaudited quarterly data, in the opinion of the Company, includes adjustments, which are normal and recurring in nature, necessary for the fair presentation of the results of operations and financial position. Quarter Ended March June September December 31 30 30 31 (in thousands) Operating revenues $193,784 $148,919 $187,392 $183,655 Operating income 24,100 18,095 36,095 25,629 Net income 14,422 10,491 26,213 16,844 Net income available for common stock 14,193 10,262 25,985 16,616 Operating revenues $166,494 $132,843 $145,003 $165,922 Operating income 17,721 15,755 26,034 19,429 Net income 9,522 7,501 17,561 10,707 Net income available for common stock 9,022 7,002 17,059 10,479 The above amounts were affected by seasonal weather conditions and the timing of utility rate changes. Rate activities are discussed in Note 4 of the Notes to Financial Statements. The 1993 results were affected by the acquisition of the Iowa service territory from Union Electric Company, as discussed in Note 3 of the Notes to Financial Statements. Refer to Management's Discussion and Analysis for discussion of the adverse effect of weather upon 1992 results, primarily in the third quarter. Item 8.

Item 8. Financial Statements and Supplementary Data Information required by Item 8. begins on page 48. MANAGEMENT'S RESPONSIBILITY FOR FINANCIAL STATEMENTS The Company's management has prepared and is responsible for the presentation, integrity and objectivity of the financial statements and related information included in this report. The financial statements have been prepared in conformity with generally accepted accounting principles applied on a consistent basis and, in some cases, include estimates that are based upon management's judgment and the best available information, giving due consideration to materiality. Financial information contained elsewhere in this report is consistent with that in the financial statements. The Company maintains a system of internal accounting controls which it believes is adequate to provide reasonable assurance that assets are safeguarded, transactions are executed in accordance with management authorization and the financial records are reliable for preparing the financial statements. The system of internal accounting controls is supported by written policies and procedures, by a staff of internal auditors and by the selection and training of qualified personnel. The internal audit staff conducts comprehensive audits of the Company's system of internal accounting controls. Management strives to maintain an adequate system of internal controls, recognizing that the cost of such a system should not exceed the benefits derived. In accordance with generally accepted auditing standards, the independent public accountants (Arthur Andersen & Co.), obtained a sufficient understanding of the Company's internal controls to plan their audit and determine the nature, timing and extent of other tests to be performed. No material internal control weaknesses have been reported to management, nor is management aware of any such weaknesses. The Board of Directors, through its Audit Committee comprised entirely of outside directors, meets periodically with management, the internal auditor and Arthur Andersen & Co. to discuss financial reporting matters, internal control and auditing. To ensure their independence, both the internal auditor and Arthur Andersen & Co. have full and free access to the Audit Committee. /s/ Lee Liu (Signature) Lee Liu Chairman of the Board, President & Chief Executive Officer /s/ Blake O. Fisher, Jr. (Signature) Blake O. Fisher, Jr. Executive Vice President & Chief Financial Officer /s/ Richard A. Gabbianelli (Signature) Richard A. Gabbianelli Controller & Chief Accounting Officer ARTHUR ANDERSEN & CO. REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS To the Board of Directors of IES Utilities Inc.: We have audited the accompanying balance sheets and statements of capitalization of IES UTILITIES INC. (an Iowa corporation) as of December 31, 1993 and 1992, and the related statements of income, retained earnings and cash flows for each of the three years in the period ended December 31, 1993. These financial statements and the financial statement schedules referred to below are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements and financial statement schedules based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of IES Utilities Inc. as of December 31, 1993 and 1992, and the results of its operations and its cash flows for each of the three years in the period ended December 31, 1993, in conformity with generally accepted accounting principles. Our audits were made for the purpose of forming an opinion on the basic financial statements taken as a whole. The financial statement schedules listed in Item 14(a)2 are presented for purposes of complying with the Securities and Exchange Commission's rules and are not part of the basic financial statements. These schedules have been subjected to the auditing procedures applied in the audits of the basic financial statements and, in our opinion, fairly state in all material respects the financial data required to be set forth therein in relation to the basic financial statements taken as a whole. As discussed in Note 8 to the financial statements, effective January 1, 1993, IES Utilities Inc. changed its method of accounting for postretirement benefits other than pensions. /s/ Arthur Andersen & Co. (Signature) ARTHUR ANDERSEN & CO. Chicago, Illinois, January 28, 1994 IES UTILITIES INC. STATEMENTS OF INCOME Year Ended December 31 1993 1992 1991 (in thousands) Operating revenues: Electric $550,521 $462,999 $482,578 Gas 154,318 139,455 131,019 Steam 8,911 7,808 8,396 713,750 610,262 621,993 Operating expenses: Fuel for production 87,702 73,368 91,182 Purchased power 93,449 74,794 70,245 Gas purchased for resale 109,122 101,605 96,504 Other operating expenses 123,210 119,607 124,855 Maintenance 46,219 39,573 39,571 Depreciation and amortization 69,407 64,107 61,466 Property taxes 36,426 31,586 31,770 Federal and state income taxes 39,411 21,422 23,307 Miscellaneous taxes 4,885 5,261 4,800 609,831 531,323 543,700 Operating income 103,919 78,939 78,293 Other income and deductions: Allowance for equity funds used during construction 824 1,831 820 Miscellaneous, net 2,248 2,803 3,950 3,072 4,634 4,770 Interest: Long-term debt 34,926 35,689 31,171 Other 5,243 3,939 5,595 Allowance for debt funds used during construction (1,148) (1,346) (1,266) 39,021 38,282 35,500 Net income 67,970 45,291 47,563 Preferred and preference dividend requirements 914 1,729 2,170 Net income available for common stock $ 67,056 $ 43,562 $ 45,393 The accompanying Notes to Financial Statements are an integral part of these statements. IES UTILITIES INC. STATEMENTS OF RETAINED EARNINGS Year Ended December 31 1993 1992 1991 (in thousands) Balance at beginning of year $153,106 $134,822 $134,750 Add: Net income 67,970 45,291 47,563 221,076 180,113 182,313 Deduct: Cash dividends declared - Common stock 31,300 24,721 45,321 Preferred stock, at stated rates 914 1,665 1,956 Preference stock, at stated rates - 64 214 Preferred stock redemption premiums - 557 - 32,214 27,007 47,491 Balance at end of year ($18,209,000 restricted as to payment of cash dividends) $188,862 $153,106 $134,822 The accompanying Notes to Financial Statements are an integral part of these statements. IES UTILITIES INC. BALANCE SHEETS December 31 1993 1992 (in thousands) ASSETS Utility plant, at original cost: Plant in service - Electric $1,707,278 $1,641,536 Gas 147,956 137,227 Other 75,845 73,970 1,931,079 1,852,733 Less - Accumulated depreciation 813,312 759,754 1,117,767 1,092,979 Leased nuclear fuel, net of amortization 51,681 48,505 Construction work in progress 41,937 30,324 1,211,385 1,171,808 Current assets: Cash and temporary cash investments 18,313 1,743 Accounts receivable - Customer, less reserve 22,679 24,517 Other 10,330 10,429 Income tax refunds receivable 8,767 - Production fuel, at average cost 14,338 19,418 Materials and supplies, at average cost 26,861 28,765 Adjustment clause balances - 1,217 Regulatory assets 6,421 3,636 Prepayments and other 31,502 26,085 139,211 115,810 Other assets: Regulatory assets 149,978 118,215 Nuclear decommissioning trust funds 28,059 21,327 Deferred charges and other 18,345 13,731 196,382 153,273 $1,546,978 $1,440,891 CAPITALIZATION AND LIABILITIES Capitalization (See Statements of Capitalization): Common stock $ 33,427 $ 33,427 Paid-in surplus 279,042 229,042 Retained earnings 188,862 153,106 Total common equity 501,331 415,575 Cumulative preferred stock 18,320 18,320 Long-term debt 480,074 441,522 999,725 875,417 Current liabilities: Short-term borrowings 24,000 92,000 Notes payable - associated companies - 560 Capital lease obligations 15,345 13,211 Sinking funds and maturities 224 224 Accounts payable 47,179 45,384 Dividends payable 5,229 229 Accrued interest 9,438 9,247 Accrued taxes 39,763 41,987 Accumulated refueling outage provision 2,660 7,549 Adjustment clause balances 5,149 - Provision for rate refund liability 8,670 9,020 Other 27,038 17,848 184,695 237,259 Long-term liabilities: Capital lease obligations 36,336 35,294 Liability under National Energy Policy Act of 1992 11,984 12,054 Environmental liabilities 9,130 9,815 Other 25,197 17,645 82,647 74,808 Deferred credits: Accumulated deferred income taxes 237,464 206,099 Accumulated deferred investment tax credits 42,447 47,308 279,911 253,407 Commitments and contingencies (Note 12) $1,546,978 $1,440,891 The accompanying Notes to Financial Statements are an integral part of these statements. IES UTILITIES INC. STATEMENTS OF CAPITALIZATION December 31 1993 1992 (in thousands) Common equity: Common stock - par value $2.50 per share - authorized 24,000,000 shares; outstanding 13,370,788 shares $ 33,427 $ 33,427 Paid-in surplus 279,042 229,042 Retained earnings 188,862 153,106 501,331 415,575 Cumulative preferred stock - par value $50 per share - authorized 466,406 shares; outstanding 366,406 shares - 6.10% - Outstanding 100,000 shares 5,000 5,000 4.80% - Outstanding 146,406 shares 7,320 7,320 4.30% - Outstanding 120,000 shares 6,000 6,000 18,320 18,320 Long-term debt: Collateral trust bonds - 6% series, due 2008 50,000 - 7% series, due 2023 50,000 - 5.5% series, due 2023 19,400 - 119,400 - First mortgage bonds - Series J, 6-1/4%, due 1996 15,000 15,000 Series K, 8-5/8%, retired in 1993 - 20,000 Series L, 7-7/8%, due 2000 15,000 15,000 Series M, 7-5/8%, due 2002 30,000 30,000 Series P & Q, 6.70%, retired in 1993 - 9,200 Series R, 8-1/4%, retired in 1993 - 25,000 Series W, 9-3/4%, due 1995 50,000 50,000 Series X, 9.42%, due 1995 50,000 50,000 Series Y, 8-5/8%, due 2001 60,000 60,000 Series Z, 7.60%, due 1999 50,000 50,000 6-1/8% series, due 1997 8,000 8,000 9-1/8% series, due 2001 21,000 21,000 7-3/8% series, due 2003 10,000 10,000 7-1/4% series, due 2007 30,000 30,000 8-3/4% series, retired in 1993 - 15,000 339,000 408,200 Pollution control obligations - 5.75%, retired in 1993 - 10,200 4.90% to 5.75%, due serially 1994 to 2003 3,920 4,144 5.95%, due 2007, secured by First mortgage bonds 10,000 10,000 Variable rate (3.15% at December 31, 1993), due 2000 to 2010 11,100 11,100 25,020 35,444 Unamortized debt premium and (discount), net (3,122) (1,898) 480,298 441,746 Less - Amount due within one year 224 224 480,074 441,522 $ 999,725 $ 875,417 The accompanying Notes to Financial Statements are an integral part of these statements. IES UTILITIES INC. STATEMENTS OF CASH FLOWS Year Ended December 31 1993 1992 1991 (in thousands) Cash flows from operating activities: Net income $67,970 $45,291 $47,563 Adjustments to reconcile net income to net cash flows from operating activities - Depreciation and amortization 69,407 64,107 61,466 Principal payments under capital lease obligations 11,429 11,725 15,471 Deferred taxes and investment tax credits 10,531 (2,406) (13,068) Amortization of deferred charges 860 961 7,778 Refueling outage provision (4,889) (5,503) 11,553 Allowance for equity funds used during construction (824) (1,831) (820) (Gain) loss on disposition of assets, net (655) - 30 Other (1,321) (4,742) (4,026) Other changes in assets and liabilities - Accounts receivable (8,553) (571) (3) Sale of utility accounts receivable 10,490 7,710 (5,000) Accounts payable 5,620 345 569 Accrued taxes (10,991) 6,118 3,375 Production fuel 5,080 2,579 1,234 Adjustment clause balances 6,366 (4,122) 184 Deferred energy efficiency costs (9,747) (6,877) (1,905) Provision for rate refunds (350) 7,528 (197) Other (1,281) (4,519) 2,307 Net cash flows from operating activities 149,142 115,793 126,511 Cash flows from financing activities: Dividends declared on common stock (31,300) (24,721) (45,321) Dividends on preferred and preference stock (914) (1,729) (2,170) Proceeds from issuance of long-term debt 119,400 83,400 88,700 Equity infusion from parent company 50,000 - 40,000 Net change in short-term borrowings (68,560) 51,660 (55,750) Sinking fund requirements and reductions in long-term debt and preferred and preference stock (79,624) (39,429) (31,589) Principal payments under capital lease obligations (11,276) (12,337) (14,738) Dividends payable 5,000 - - Other (1,295) 476 (500) Net cash flows from financing activities (18,569) 57,320 (21,368) Cash flows from investing activities: Construction and acquisition expenditures (113,212) (171,013) (105,009) Nuclear decommissioning trust funds (5,532) (5,532) (5,505) Proceeds from disposition of assets 837 - 203 Other 3,904 (246) (620) Net cash flows from investing activities (114,003) (176,791) (110,931) Net increase (decrease) in cash and temporary cash investments 16,570 (3,678) (5,788) Cash and temporary cash investments at beginning of year 1,743 5,421 11,209 Cash and temporary cash investments at end of year $ 18,313 $ 1,743 $ 5,421 Supplemental cash flow information: Cash paid during the year for - Interest $ 39,747 $ 36,503 $ 36,932 Income taxes $ 40,130 $ 23,640 $ 32,925 Noncash investing and financing activities - Capital lease obligations incurred $ 14,605 $ 1,973 $ 11,874 The accompanying Notes to Financial Statements are an integral part of these statements. NOTES TO FINANCIAL STATEMENTS (1) GENERAL: IES Utilities Inc. (the Company) is a wholly-owned subsidiary of IES Industries Inc. (Industries) and is subject to regulation by the Iowa Utilities Board (IUB) and the Federal Energy Regulatory Commission (FERC). On June 4, 1993, Industries announced that its wholly-owned utility subsidiaries, Iowa Electric Light and Power Company (IE) and Iowa Southern Utilities Company (IS), filed applications for regulatory authority to merge. The merger became effective December 31, 1993, following receipt of all necessary Boards of Directors, shareholder and regulatory approvals. IE is the surviving corporation and has been renamed IES Utilities Inc. The separate existence of IS has ceased. The Company serves a total of 325,000 electric and 170,000 natural gas retail customers as well as 32 resale customers in more than 550 Iowa communities. The merger was accounted for under a method of accounting similar to pooling of interests, which combined the ownership interests of IE and IS. The assets and liabilities of IE and IS were combined at their recorded amounts as of the merger date. (2) SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES: (a) Regulatory Assets - The Company is subject to the provisions of Statement of Financial Accounting Standards No. 71 "Accounting for the Effects of Certain Types of Regulation" (SFAS 71). The regulatory assets represent probable future revenue associated with certain incurred costs as these costs are recovered through the ratemaking process. At December 31, 1993, regulatory assets were comprised of the following items, and were reflected in the Balance Sheets as follows: Regulatory Assets (in millions) Deferred income taxes (Note 2(b)) $ 88.6 Energy efficiency programs 18.5 Employee pension and benefit costs (Note 8) 14.1 Environmental liabilities (Note 12(f)) 12.9 National Energy Policy Act of 1992 (Note 12(h)) 12.5 FERC Order No. 636 transition costs (Note 12(i)) 5.0 Cancelled plant costs 3.3 Regulatory study costs 1.5 156.4 Less current amounts 6.4 $150.0 Refer to the individual footnotes referenced above for a discussion of the specific items reflected in regulatory assets. The amounts reflected for energy efficiency programs are a result of an IUB mandate whereby 2% of electric and 1.5% of gas gross retail operating revenues are to be expended annually for energy efficiency programs. Under this mandate, the Company will make its initial filing for recovery of the costs in 1994. (b) Income Taxes - The Company follows the liability method of accounting for deferred income taxes, which requires the establishment of deferred tax liabilities and assets, as appropriate, for all temporary differences between the tax basis of assets and liabilities and the amounts reported in the financial statements. Deferred taxes are recorded using currently enacted tax rates. Except as noted below, income tax expense includes provisions for deferred taxes to reflect the tax effects of temporary differences between the time when certain costs are recorded in the accounts and when they are deducted for tax return purposes. As temporary differences reverse, the related accumulated deferred income taxes are reversed to income. Investment tax credits have been deferred and are subsequently credited to income over the average lives of the related property. Consistent with ratemaking practices, deferred tax expense is not recorded for certain temporary differences (primarily related to utility property, plant and equipment). Accordingly, the Company has recorded deferred tax liabilities and regulatory assets, as discussed in Note 2(a). (c) Temporary Cash Investments - Temporary cash investments are stated at cost which approximates market value and are considered cash equivalents for the Statements of Cash Flows. These investments consist of short-term liquid investments which have maturities of less than 90 days from the date of acquisition and at December 31, 1993, include $15 million invested with affiliated companies. (d) Depreciation of Utility Property, Plant and Equipment - The average rates of depreciation for electric and gas properties, including the Company's nuclear generating station, the Duane Arnold Energy Center (DAEC), which is being depreciated over a 36 year life using a remaining life method, were as follows: 1993 1992 1991 Electric 3.5% 3.5% 3.5% Gas 3.5% 3.0% 3.0% Based on the most recent site specific study, completed in 1992, the Company's 70% share of the estimated cost to decommission the DAEC and return the underlying property to its original state approximated $223 million in 1992 dollars. The study is based on the prompt removal and dismantling decommissioning alternative and is assumed to begin at the end of the DAEC's operating license in 2014. The level of annual recovery through rates of decommissioning costs is $5.5 million, which is deposited in external trust funds, and is based on a remaining life recovery method. The annual recovery level is reviewed and, if necessary, adjusted in each rate case. Decommissioning costs, at the level collected through rates, are included in "Depreciation and amortization" expense in the Statements of Income. In addition to the $28.1 million invested in the external trust funds as indicated in the Balance Sheets, the Company has an internal decommissioning reserve of $21.7 million recorded as accumulated depreciation. Earnings on the external funds are recognized as income and a corresponding amount of interest expense is recorded for the reinvestment of the earnings. (e) Allowance for Funds Used During Construction - The allowance for funds used during construction (AFC), which represents the cost during the construction period of funds used for construction purposes, is capitalized as a component of the cost of utility plant. The amount of AFC applicable to debt funds and to other (equity) funds, a non-cash item, is computed in accordance with the prescribed FERC formula. The aggregate gross rates used for 1993-1991 were 5.7%, 9.2% and 8.5%, respectively. (f) Operating Revenues - The Company accrues revenues for services rendered but unbilled at month-end in order to more properly match revenues with expenses. (g) Adjustment Clauses - The Company's tariffs provide for subsequent adjustments to its electric and natural gas rates for changes in the cost of fuel and purchased energy and in the cost of natural gas purchased for resale. Changes in the under/over collection of these costs are reflected in "Fuel for production" and "Gas purchased for resale" in the Statements of Income. The cumulative effects are reflected in the Balance Sheets as a current asset or current liability, pending automatic reflection in future billings to customers. (h) Accumulated Refueling Outage Provision - The IUB allows the Company to collect, as part of its base revenues, funds to offset other operating and maintenance expenditures incurred during refueling outages at the DAEC. As these revenues are collected, an equivalent amount is charged to other operating and maintenance expenses with a corresponding credit to a reserve. During a refueling outage, the reserve is reversed to offset the refueling outage expenditures. (i) Reclassifications - Certain prior period amounts have been reclassified on a basis consistent with the 1993 presentation. (3) ACQUISITION OF IOWA SERVICE TERRITORY OF UNION ELECTRIC COMPANY: Effective December 31, 1992, the Company acquired the Iowa distribution system and a portion of the Iowa transmission facilities of Union Electric Company (UE) for $65.0 million in cash. The acquisition was accounted for as a purchase. The net book value of the acquired assets was approximately $34.4 million and the amount of the purchase price in excess of the book value ($30.6 million) has been recorded as an acquisition adjustment. The acquisition adjustment is being amortized over the life of the property and is included in "Other income and deductions - Miscellaneous, net" in the Statements of Income. Recovery of the acquisition adjustment through rates will be addressed in future rate proceedings. See Note 12(b) for a discussion of the purchase power contracts with UE associated with this acquisition. (4) RATE MATTERS: (a) Gas Rate Cases - Former IE Service Territory In July 1992, IE applied to the IUB for an increase in gas rates of $6.3 million annually, or 5.9%. Effective September 30, 1992, the IUB authorized an interim increase of $5.4 million, subject to refund. On April 30, 1993, the IUB issued its "Final Decision and Order," which approved stipulations between IE and certain intervenors providing for an annual increase in revenues of $5.5 million. IE did not have any refund liability as a result of the Order. Former IS Service Territory In July 1992, IS applied to the IUB for an increase in gas rates of $2.3 million annually, or 6.2%. Effective September 30, 1992, the IUB authorized an interim increase of $1.9 million, subject to refund. In February 1993, the IUB approved stipulations between IS and certain intervenors in the proceeding that provided for an annual increase in revenues of $1.6 million. As a result of the Order, IS refunded approximately $0.2 million, including interest, in the second quarter of 1993. (b) 1991 Electric Rate Case - In October 1991, IE applied to the IUB for an increase in interim and final retail electric rates of $18.9 million annually, or 6.0%. The IUB approved an interim rate increase of $15.6 million, annually, which became effective in December 1991, subject to refund. In July 1992, the IUB issued its "Final Decision and Order" approving an annual electric rate increase of $7.9 million. The application of double leverage ratemaking theory to IE's capital structure accounted for approximately $4 million of the difference between the interim rate level and the amount allowed in the Order. After a limited rehearing of the double leverage issue, the IUB issued its "Order On Rehearing" in December 1992, which affirmed the original decision. IE appealed the IUB's Order to the Iowa District Court (Court). In December 1993, the Court issued its decision, which upholds the IUB's Order. The Company did not appeal the Court's decision to the Iowa Supreme Court. In the second quarter of 1993, IE refunded approximately $4.1 million, including interest, which represented a refund down to the level of revenues that would have resulted had it won the appeal. An additional refund, including interest, of $8.7 million is required at December 31, 1993, as a result of the Court's decision. The refund is expected to be completed in the second quarter of 1994. There will be no effect on electric revenues and net income when the additional refund is made because the Company has been reserving for the effect of the additional refund. (5) LEASES: The Company has a capital lease covering its 70% undivided interest in nuclear fuel purchased for the DAEC. Future purchases of fuel may also be added to the fuel lease. This lease provides for annual one year extensions and the Company intends to exercise such extensions through the DAEC's operating life. Interest costs under the lease are based on commercial paper costs incurred by the lessor. The Company is responsible for the payment of taxes, maintenance, operating cost, risk of loss and insurance relating to the leased fuel. The lessor has an $80 million credit agreement with a bank supporting the nuclear fuel lease. The agreement continues on a year to year basis, unless either party provides at least a three year notice of termination; no such notice of termination has been provided by either party. Annual nuclear fuel lease expenses include the cost of fuel, based on the quantity of heat produced for the generation of electric energy, plus the lessor's interest costs related to fuel in the reactor and administrative expenses. These expenses (included in "Fuel for production" in the Statements of Income) for 1993-1991 were $12.4 million, $12.9 million and $17.5 million, respectively. The Company's operating lease rental expenses for 1993-1991 were $8.4 million, $6.8 million and $7.0 million, respectively. The Company's future minimum lease payments by year are as follows: Capital Operating Year Lease Leases (in thousands) 1994 $ 16,994 $ 6,511 1995 11,970 6,353 1996 10,784 4,865 1997 9,940 3,420 1998 4,145 3,549 1999-2003 4,111 12,130 57,944 $ 36,828 Less: Amount representing interest 6,263 Present value of net minimum capital lease payments $ 51,681 (6) UTILITY ACCOUNTS RECEIVABLE: Customer accounts receivable, including unbilled revenues, arise primarily from the sale of electricity and natural gas. At December 31, 1993, the Company was serving a diversified base of residential, commercial and industrial customers consisting of approximately 325,000 electric and 170,000 gas customers. The Company has entered into two agreements, one with limited recourse, to sell undivided fractional interests of an aggregate of $65 million in its pool of utility accounts receivable. At December 31, 1993, $53.2 million was sold under the agreements. The agreements expire in June and December 1994. The Company intends to consolidate the agreements into one new agreement in 1994. (7) INCOME TAXES: The components of federal and state income taxes for the years ended December 31, were as follows: 1993 1992 1991 (in millions) Classified as Federal and State Income Taxes: Current tax expense $ 28.4 $ 24.0 $ 36.3 Deferred tax expense 15.9 0.2 (10.1) Amortization and adjustment of investment tax credits (4.9) (2.8) (2.9) 39.4 21.4 23.3 Included in Miscellaneous, net: Current tax expense (0.9) (0.8) 0.4 Deferred tax expense (0.5) 0.1 (0.2) (1.4) (0.7) 0.2 Total income tax expense $ 38.0 $ 20.7 $ 23.5 The overall effective income tax rates shown below were computed by dividing total income tax expense by income before income taxes. Year Ended December 31 1993 1992 1991 Statutory Federal income tax rate 35.0% 34.0% 34.0% Add (deduct): Amortization of investment tax credits (2.5) (4.2) (4.0) State income taxes, net of Federal benefits 5.8 5.6 6.4 Property basis and other temporary differences for which deferred taxes are not provided under ratemaking principles 1.5 0.5 2.1 Reversal through tariffs of deferred taxes provided at rates in excess of the current statutory Federal income tax rate (1.7) (2.7) (3.7) Adjustment of prior period taxes (2.0) (2.0) (1.3) Other items, net (0.3) 0.2 (0.4) Overall effective income tax rate 35.8% 31.4% 33.1% The accumulated deferred income taxes as set forth below and in the Balance Sheets arise from the following temporary differences: December 31 1993 1992 (in millions) Property related $ 272 $ 256 Decommissioning related (12) (11) Investment tax credit related (30) (32) Other 7 (7) $ 237 $ 206 (8) BENEFIT PLANS: The Company has one contributory and two non-contributory retirement plans which, collectively, cover substantially all of its employees. Plan benefits are generally based on years of service and compensation during the employees' latter years of employment. Payments made from the pension funds to retired employees and beneficiaries during 1993 totaled $10.4 million. In addition to these payments, the Company purchased annuities totaling $6.3 million for all previous employees who had retired as of January 1993, under one of the plans. The cost of the annuities and the reduction in the projected benefit obligation were substantially equivalent. The Company's policy is to fund the pension cost at an amount which is at least equal to the minimum funding requirements mandated by the Employee Retirement Income Security Act (ERISA) and which does not exceed the maximum tax deductible amount for the year. Pursuant to the provisions of SFAS 71, certain adjustments to the Company's pension provision are necessary to reflect the accounting for pension costs allowed in the most recent rate cases. The components of the pension provision are as follows: Year Ended December 31 1993 1992 1991 (in thousands) Service cost $ 4,275 $ 4,439 $ 4,517 Interest cost on projected benefit obligation 11,131 9,999 8,959 Assumed return on plans' assets (12,177) (11,640) (10,026) Amortization of unrecognized gain (763) (135) (19) Amortization of prior service cost 1,195 938 775 Amortization of unrecognized plans' assets as of January 1, 1987 (384) (382) (392) Pension cost 3,277 3,219 3,814 Adjustment to funding level (2,867) 301 (228) Total pension costs paid to the Trustees $ 410 $ 3,520 $ 3,586 Actual return on plans' assets $ 12,718 $ 8,861 $ 37,085 A reconciliation of the funded status of the plans to the amounts recognized in the Balance Sheets is presented below: December 31 1993 1992 (in thousands) Fair market value of plans' assets $ 174,133 $ 177,514 Actuarial present value of benefits rendered to date - Accumulated benefits based on compensation to date, including vested benefits of $100,905,000 and $91,303,000, respectively 110,676 100,288 Additional benefits based on estimated future salary levels 42,938 31,324 Projected benefit obligation 153,614 131,612 Plans' assets in excess of projected benefit obligation 20,519 45,902 Remaining unrecognized net asset existing at January 1, 1987, being amortized over 20 years (4,109) (5,256) Unrecognized prior service cost 16,708 14,961 Unrecognized net gain (28,830) (52,709) Prepaid pension cost recognized in the Balance Sheets $ 4,288 $ 2,898 Assumed rate of return, all plans 8.00% 8.00% Weighted average discount rate of projected benefit obligation, all plans 7.50% 8.25% Range of assumed rates of increase in future compensation levels for the plans 4.00-5.75% 4.00-5.75% The decrease in the discount rate used to compute the projected benefit obligation, from 8.25% at December 31, 1992 to 7.50% at December 31, 1993, accounted for a significant portion of the reduction in the unrecognized net gain between periods and, similarly, contributed to the increase in the projected benefit obligation at December 31, 1993. The Company provides certain benefits to retirees (primarily health care benefits). Through 1992, the Company expensed such costs as benefits were paid, which was consistent with ratemaking practices. Such costs totaled $2.2 million for 1992 and $1.9 million for 1991. Effective January 1, 1993, the Company adopted SFAS 106, which requires the accrual of the expected cost of postretirement benefits other than pensions during the employees' years of service. The IUB has adopted rules stating that postretirement benefits other than pensions will be included in rates pursuant to the provisions of SFAS 106. The rules permit the Company to amortize the transition obligation as of January 1, 1993 over 20 years and require that all amounts collected are to be funded into an external trust to pay benefits as they become due. Beginning in 1993, the gas portion of these costs is being recovered in the Company's gas rates, and are funded in external trust funds; recovery of the electric portion will be addressed in future electric proceedings. The IUB has adopted a rule that permits a deferral of the incremental electric SFAS 106 costs until the earlier of: 1) an order in an electric rate case, or 2) December 31, 1995. Accordingly, pursuant to the provisions of SFAS 71, the Company had deferred $2.9 million of such costs at December 31, 1993, and it expects to file electric rate cases seeking recovery of the deferred costs before December 31, 1995. The components of postretirement benefit costs for the year ended December 31, 1993, are as follows: (in thousands) Service cost $ 1,685 Interest cost on accumulated postretirement benefit obligation 3,247 Amortization of transition obligation existing at January 1, 1993 2,024 Postretirement benefit costs 6,956 Less: Deferred postretirement benefit costs 2,858 Net postretirement benefit costs $ 4,098 A reconciliation of the funded status of the plans to the amounts recognized in the Balance Sheets is presented below: December 31, January 1, 1993 1993 (in thousands) Fair market value of plans' assets $ 1,171 $ - Accumulated postretirement benefit obligation - Active employees not yet eligible 18,325 18,232 Active employees eligible 4,130 3,698 Retirees 20,140 18,558 Total accumulated postretirement benefit obligation 42,595 40,488 Accumulated postretirement benefit obligation in excess of plans' assets (41,424) (40,488) Unrecognized transition obligation 38,463 40,488 Unrecognized net gain (1,167) - Accrued postretirement benefit cost in the Balance Sheets $ (4,128) $ - Assumed rate of return 8.0% - Weighted average discount rate of accumulated postretirement benefit obligation 7.5% 8.25% Medical trend on paid charges: Initial trend rate 12.0% 13.0% Ultimate trend rate 6.5% 8.0% The assumed medical trend rates are critical assumptions in determining the service cost and accumulated postretirement benefit obligation related to postretirement benefit costs. A 1% change in the medical trend rates, holding all other assumptions constant, would have changed the 1993 service cost by $1.1 million (22%) and the accumulated postretirement benefit obligation at December 31, 1993 by $6.7 million (16%). The Company will adopt the provisions of SFAS 112 "Employers' Accounting for Postemployment Benefits" as of January 1, 1994 and its adoption will not have a material effect on the Company's financial position or results of operations. This statement requires that benefits offered to former or inactive employees after termination of employment, but before retirement, be accrued over the service lives of the employees if all of the following conditions are met: 1) the obligation relates to services already performed, 2) the employees' rights vest, 3) the payments are probable, and 4) the amounts are reasonably determinable. Otherwise, such obligations are to be recognized at the time they become probable and reasonably determinable. The Company has generally accounted for these obligations as they were paid. (9) PREFERRED AND PREFERENCE STOCK: The Company has 466,406 shares of Cumulative Preferred Stock, $50 par value, authorized for issuance at December 31, 1993, of which the 6.10%, 4.80% and 4.30% Series had 100,000, 146,406 and 120,000 shares, respectively, outstanding at both December 31, 1993 and 1992. These shares are redeemable at the Company's option upon 30 days notice at $51.00, $50.25 and $51.00 per share, respectively, plus accrued dividends. The Company also has 700,000 shares of Cumulative Preference Stock ($100 par value) authorized for issuance, of which none were outstanding at December 31, 1993. (10) DEBT: (a) Long-Term Debt - In November 1993, the Company entered into arrangements with various cities in the State of Iowa (Cities), whereby the Cities issued an aggregate of $19.4 million of pollution control revenue refunding bonds (PCRRBs), all at 5.5%, due 2023. Each series of the PCRRBs is secured, in part, by payments on a corresponding principal amount of Collateral Trust Bonds, at 5.5%, due 2023. The proceeds received by the Company in the transaction were used to redeem $10.2 million of Pollution Control Obligations, 5.75%, due serially 1995-2003 and an aggregate of $9.2 million of First Mortgage Bonds, Series P & Q, 6.7%, due 2006. In October 1993, the Company sold $100 million aggregate principal amount of Collateral Trust Bonds, 6% Series, due 2008, and 7% Series, due 2023. A portion of the proceeds from the Collateral Trust Bonds was used to retire short-term debt, with the balance used for general corporate purposes, including support of its construction program. In May 1993, the Company redeemed First Mortgage Bonds Series K, 8-5/8%, principal amount of $20 million, and Series R, 8-1/4%, principal amount of $25 million and First Mortgage Bonds Series 8-3/4%, principal amount of $15 million. The redemptions were completed with proceeds from short-term borrowings and, as discussed above, long-term debt was ultimately issued to replace the short-term borrowings. The Company's Indentures and Deeds of Trust securing its First Mortgage Bonds constitute direct first mortgage liens upon substantially all tangible public utility property. The Company's Indenture and Deed of Trust securing its Collateral Trust Bonds constitutes a second lien on substantially all tangible public utility property while First Mortgage Bonds remain outstanding. Total sinking fund requirements, which the Company intends to meet by pledging additional property under the terms of the Company's Indentures and Deeds of Trust, and debt maturities for 1994-1998 are as follows: Debt maturities (in thousands) Debt Issue 1994 1995 1996 1997 1998 Sinking Fund Requirements $ 780 $ 780 $ 630 $ 550 $ 550 Pollution Control 224 140 140 140 140 Series W - 50,000 - - - Series X - 50,000 - - - Series J - - 15,000 - - 6 1/8% Series - - - 8,000 - $1,004 $100,920 $ 15,770 $ 8,690 $ 690 The Company intends to refinance the majority of the debt maturities with long-term debt. (b) Short-Term Debt - At December 31, 1993, the Company had bank lines of credit aggregating $67.7 million and was using $19.0 million to support commercial paper and $7.7 million to support certain pollution control obligations. Commitment fees are paid to maintain these lines and there are no conditions which restrict the unused lines of credit. In addition to the above, the Company has an uncommitted credit facility with a financial institution whereby it can borrow up to $50 million. Rates are set at the time of borrowing and no fees are paid to maintain this facility. At December 31, 1993, $5.0 million was borrowed at 3.4% under this facility. The Company also has a letter of credit in the amount of $3.4 million supporting two of its variable rate pollution control obligations. (11) ESTIMATED FAIR VALUE OF FINANCIAL INSTRUMENTS: The estimated fair values of financial instruments at December 31, 1993, and the basis upon which they were estimated are as follows: Current assets and current liabilities - The carrying amount approximates fair value because of the short maturity of such financial instruments. Nuclear decommissioning trust funds - The estimated fair value of these trust funds, as reported by the trustee based upon current market values, is $29.5 million. Cumulative preferred stock - The estimated fair value of this stock of $12.8 million is based upon quoted market prices. Long-term debt - The carrying amount of long-term debt was $480 million compared to estimated fair value of $507 million. The estimated fair value of long-term debt is based upon quoted market prices. Since the Company is subject to regulation, any gains or losses related to the difference between the carrying amount and the fair value of financial instruments may not be realized by the Company's parent. (12) COMMITMENTS AND CONTINGENCIES: (a) Construction Program - The Company's construction and acquisition program anticipates expenditures of approximately $150 million, for which substantial commitments have been made. (b) Purchase Power Contracts - The Company has a purchase power contract with Terra Comfort Company (Terra Comfort), a wholly-owned subsidiary of Industries, for annual capacity purchases of 114 Mw that expires on December 31, 1994. In connection with the acquisition of the UE properties discussed in Note 3, the Company is purchasing power from UE under a five-year firm capacity contract with a 1994 requirement of 120 Mw of delivered capacity declining to 60 Mw in 1997. The Company will also purchase an additional maximum interruptible capacity of up to 54 Mw of 25 Hz power. This 25 Hz power purchase will extend through 1998 and will continue thereafter unless either party gives a three-year notice of cancellation. The costs of capacity purchases for these contracts are reflected in "Purchased power" in the Statements of Income. Total capacity charges under all existing contracts will approximate $21.0 million, $14.7 million, $11.4 million, $8.7 million and $0.3 million for the years 1994-1998, respectively. (c) Coal Contract Commitments - The Company has entered into coal supply contracts which expire between 1994 and 2001 for its fossil-fueled generating stations. At December 31, 1993, the contracts cover approximately $147 million of coal over the life of the contracts, which includes $34 million expected to be incurred in 1994. The Company expects to supplement these coal contracts with spot market purchases to fulfill its future fossil fuel needs. (d) Information Technology Services - In 1992, the Company entered into an agreement with Electronic Data Systems Corporation (EDS) for information technology services. The term of the contract is twelve years and the contract is subject to declining termination fees. The Company's anticipated expenditures under the agreement for 1994 are estimated to be approximately $8.9 million. Future costs under the agreement are variable and are dependent upon the Company's level of usage of technological services from EDS, as well as inflation. (e) Nuclear Insurance Programs - The Price-Anderson Amendments Act of 1988 (1988 Act) provides the Company with the benefit of $9.4 billion of public liability coverage consisting of $200 million of insurance and $9.2 billion of potential retroactive assessments from the owners of nuclear power plants. Under the 1988 Act, the Company could be assessed a maximum of $79 million per nuclear incident, with a maximum of $10 million per year (of which the Company's 70% ownership portion would be $55 million and $7 million, respectively) if losses relating to the incidents exceeded $200 million. These limits are subject to adjustments for inflation in future years. Pursuant to provisions in various nuclear insurance policies, the Company could be assessed retroactive premiums in connection with future accidents at a nuclear facility owned by a utility participating in the particular insurance plan. With respect to excess property damage and replacement power coverages, the Company could be assessed annually a maximum of $8.5 million and $1 million, respectively, if the insurer's losses relating to accidents exceeded its reserves. While assessments may also be made for losses in certain prior years, the Company is not aware of any losses in such years that it believes are likely to result in an assessment. (f) Environmental Liabilities - At December 31, 1993, the Company's Balance Sheet reflects $13.1 million (including $4.0 million as current) of environmental liabilities, which, pursuant to generally accepted accounting principles, represents the minimum amount of the estimated range of such costs that the Company expects to incur. The minimum amount of the range is used because no amount within the range represents a better estimate. These estimates are subject to continuing review. The Company has been named as a Potentially Responsible Party (PRP) for certain former manufactured gas plant (FMGP) sites by either the Iowa Department of Natural Resources (IDNR) or the Environmental Protection Agency (EPA). The Company is working with the IDNR and EPA to investigate its 27 sites and to determine the appropriate remediation activities that may be needed to mitigate health and environmental concerns. Such investigations are expected to be completed by 1999 and site-specific remediations are anticipated to be completed within 3 years after the completion of the investigations of each site. The Company may be required to monitor these sites for a number of years upon completion of remediation. The Company is investigating the possibility of insurance and third party cost sharing for FMGP clean-up costs. The amount of shared costs, if any, can not be reasonably determined and, accordingly, no potential sharing has been recorded. Regulatory assets of $12.9 million have been recorded in the Balance Sheets, which reflects the future recovery that is being provided through the Company's rates (See Note 2(a)). Considering the recorded reserves for environmental liabilities and the past rate treatment allowed by the IUB, management believes that the clean-up costs incurred by the Company for these FMGP sites will not have a material adverse effect on its financial position or results of operations. (g) Clean Air Act - The Clean Air Act Amendments of 1990 (Act) requires emission reductions of sulfur dioxide and nitrogen oxides to achieve reductions of atmospheric chemicals believed to cause acid rain. The provisions of the Act will be implemented in two phases with Phase I affecting two of the Company's units beginning in 1995 and Phase II affecting all units beginning in the year 2000. The Company expects to meet the requirements of the Act by switching to lower sulfur fuels and through capital expenditures primarily related to fuel burning equipment and boiler modifications. The Company estimates capital expenditures at approximately $28 million, including $4 million in 1994, in order to meet these requirements of the Act. (h) National Energy Policy Act of 1992 - The National Energy Policy Act of 1992 requires owners of nuclear power plants to pay a special assessment into a "Uranium Enrichment Decontamination and Decommissioning Fund." The assessment is based upon prior nuclear fuel purchases and, for the DAEC, averages $1.3 million annually through 2007, of which the Company's 70% share is $0.9 million. The Company is recovering the costs associated with this assessment through its electric fuel adjustment clauses over the period the costs are assessed. The Company's 70% share of the future assessment, $12.7 million payable through 2007, has been recorded as a liability in the Balance Sheets, including $0.7 million included in "Current liabilities - other," with a related regulatory asset for the unrecovered amount (See Note 2(a)). (i) FERC Order No. 636 - The FERC issued Order No. 636 (Order 636) in 1992. Order 636 as modified on rehearing, (1) requires the Company's pipeline suppliers to unbundle their services so that gas supplies are obtained separately from transportation service, and transportation and storage services are operated and billed as separate and distinct services, (2) requires the pipeline suppliers to offer "no notice" transportation service under which firm transporters (such as the Company) can receive delivery of gas up to their contractual capacity level on any day without prior scheduling, (3) allows pipelines to abandon long-term (one year or more) transportation service to a customer whenever the customer fails to match the highest rate and longest term (up to 20 years) offered to the pipeline by other customers for the particular capacity, and (4) provides for a mechanism under which pipelines can recover prudently incurred transition costs associated with the restructuring process. The Company may benefit from enhanced access to competitively priced gas supply and more flexible transportation services as a result of Order 636. However, the Company will be required to pay certain transition costs passed on from its pipeline suppliers as they implement Order 636. The Company's three pipeline suppliers have filed new tariffs with the FERC implementing Order 636 and the pipelines have also made filings with the FERC to begin collecting their respective transition costs. The Company began paying the transition costs in November 1993, and has recorded a liability of $5.0 million for such transition costs that have been incurred by the pipelines to date, including $1.7 million expected to be billed in 1994. While the magnitude of the total transition costs to be charged to the Company cannot yet be determined, the Company believes any transition costs the FERC would allow the pipelines to collect would be recovered from its customers, based upon past regulatory treatment of similar costs by the IUB. Accordingly, regulatory assets, in amounts corresponding to the liabilities, have been recorded to reflect the anticipated recovery. (13) JOINTLY-OWNED ELECTRIC UTILITY PLANT: Under joint ownership agreements with other Iowa utilities, the Company has undivided ownership interests in jointly-owned electric generating stations and related transmission facilities. Each of the respective owners is responsible for the financing of its portion of the construction costs. Kilowatt-hour generation and operating expenses are divided on the same basis as ownership with each owner reflecting its respective costs in its Statements of Income. Information relative to the Company's ownership interest in these facilities at December 31, 1993 is as follows: Ottumwa Neal DAEC Unit 1 Unit 3 ($ in millions) Utility plant in service $ 484 $ 179 $ 43 Accumulated depreciation $ 221 $ 69 $ 22 Construction work in progress $ 7 $ - $ - Plant capacity - Mw 530 708 515 Percent ownership 70% 48% 28% In-service date 1974 1981 1975 (14) SEGMENTS OF BUSINESS: The principal business segments of the Company are the generation, transmission, distribution and sale of electric energy and the purchase, distribution and sale of natural gas. Certain financial information relating to the Company's significant segments of business is presented below: Year Ended December 31 1993 1992 1991 (in thousands) Operating results: Revenues - Electric $ 550,521 $ 462,999 $ 482,578 Gas 154,318 139,455 131,019 Operating income (pre-tax) - Electric 128,994 90,891 100,402 Gas 13,750 8,367 (360)* Other information: Depreciation and amortization - Electric 63,832 59,707 57,612 Gas 5,186 4,024 3,480 Construction and acquisition expenditures - Electric 84,720 154,902 77,646 Gas 12,582 17,308 21,100 Assets - Identifiable assets - Electric 1,288,505 1,226,614 1,115,310 Gas 164,773 141,801 108,851 1,453,278 1,368,415 1,224,161 Other corporate assets 93,700 72,476 79,949 Total assets $1,546,978 $1,440,891 $1,304,110 * Includes a $3.9 million pre-tax write-off of previously deferred FMGP clean-up costs pursuant to disallowance of recovery in an IUB order. Item 9.

Item 9. Changes and Disagreements with Accountants on Accounting and Financial Disclosure. None. PART III Item 10.

Item 10. Directors, Executive Officers, Promoters and Control Persons of the Registrant Information regarding the identification of directors is included in Exhibit 99 and is incorporated herein by reference. Exhibit 99 is primarily an excerpt from IES Industries Inc. definitive proxy statement prepared for the 1994 annual meeting of stockholders, which will be filed on or about April 4, 1994. The executive officers of the registrant are as follows: Executive Officers of the Registrant (Effective February 1, 1994) Lee Liu, 60, Chairman of the Board, President & Chief Executive Officer. First elected officer in 1975. Larry D. Root, 57, President and Group Executive, Energy Delivery and Nuclear Group and Director. First elected officer in 1979. Rene H. Males, 61, President and Group Executive, Generation and Engineering Group and Director. First elected officer in 1991. (i) Blake O. Fisher, Jr., 49, Executive Vice President & Chief Financial Officer and Director. First elected officer in 1991. (ii) Dr. Robert J. Latham, 51, Senior Vice President, Finance and Corporate Affairs, & Treasurer. First elected officer in 1985. Stephen W. Southwick, 47, Vice President & General Counsel. First elected officer in 1982. John F. Franz, Jr., 54, Vice President, Nuclear. First elected officer in 1992. (iii) Phillip D. Ward, 53, Vice President, Engineering. First elected officer in 1990. Harold W. Rehrauer, 56, Vice President, Field Operations. First elected officer in 1987. Thomas R. Seldon, 55, Vice President, Human Resources. First elected officer in 1987. Robert J. Kucharski, 61, Vice President, Administration & Secretary. First elected officer in 1976. Richard A. Gabbianelli, 37, Controller & Chief Accounting Officer. First elected officer in 1994. Officers are elected annually by the Board of Directors and each of the officers named above, except Rene H. Males, Blake O. Fisher, Jr. and John F. Franz, Jr., have been employed by the Company (or IS) as an officer or in other responsible positions at such companies for at least five years. There are no family relationships among these officers. There are no arrangements or understandings with respect to election of any person as an officer. (i) Prior to the appointment of Rene H. Males as an officer of IS in 1990, he was President of Joy Environment Equipment Company of Monrovia, California. He was Senior Vice President for Wisconsin Electric Power Company from 1987 to 1989. (ii) Prior to the appointment of Blake O. Fisher, Jr. as Executive Vice President & Chief Financial Officer of the Company in January 1991, he was employed by Consumers Power Company as Vice President Finance and Treasurer. (iii) Prior to the appointment of John F. Franz, Jr. as Vice President, Nuclear in 1992, he was employed by Philadelphia Electric Company as Plant Manager, Peach Bottom Atomic Power Station. Item 11.

Item 11. Executive Compensation Information regarding executive compensation is included in Exhibit 99 and is incorporated herein by reference. Item 12.

Item 12. Security Ownership of Certain Beneficial Owners and Management Information regarding security ownership of certain beneficial owners and management is included in Exhibit 99 and is incorporated herein by reference. Item 13.

Item 13. Certain Relationships and Related Transactions Information regarding certain relationships and related transactions is included in Exhibit 99 and is incorporated herein by reference. PART IV Item 14.

Item 14. Exhibits, Financial Statement Schedules and Reports on Form 8-K Page No. (a) 1. Financial Statements - Included in Part II of this report - Management's Responsibility for Financial Statements. 45 - 46 Report of Independent Public Accountants. 47 Statements of Income for the years ended December 31, 1993, 1992 and 1991. 48 Statements of Retained Earnings for the years ended December 31, 1993, 1992 and 1991. 49 Balance Sheets at December 31, 1993 and 1992. 50 - 51 Statements of Capitalization at December 31, 1993 and 1992. 52 Statements of Cash Flows for the years ended December 31, 1993, 1992 and 1991. 53 Notes to Financial Statements. 54 - 81 (a) 2. Financial Statement Schedules - Included in Part IV of this report - Schedule II - Amounts Receivable from Related Parties and Underwriters, Promoters and Employees Other Than Related Parties for the years ended December 31, 1993, 1992 and 1991. 87 Schedule V - Utility Plant for the years ended December 31, 1993, 1992 and 1991. 88 - 90 Schedule VI - Accumulated Depreciation for the years ended December 31, 1993, 1992 and 1991. 91 Schedule VII - Guarantees of Securities of Other Issuers as of December 31, 1993. 92 Schedule VIII - Valuation and Qualifying Accounts and Reserves for the years ended December 31, 1993, 1992 and 1991. 93 Schedule IX - Short-term Borrowings for the years ended December 31, 1993, 1992 and 1991. 94 Other schedules are omitted as not required under Rules of Regulation S-X. (a) 3. Exhibits - See Exhibit Index beginning on page 97. (b) Reports on Form 8-K and Form 8-K/A - Items Financial Reported Statements Date of Report File No. 5,7 None December 9, 1993 0-4117-1 (1) 5,7 None December 9, 1993 0-849 (2) 2,5,7 None January 7, 1994 0-4117-1 (3) 2,7 None January 7, 1994 0-849 (3) 7 (4) March 2, 1994 0-4117-1 (4) Notes: (1) Form 8-K filed by Iowa Electric Light and Power Company. (2) Form 8-K filed by Iowa Southern Utilities Company. (3) Form 8-K filed by IES Utilities Inc. subsequent to the merger of Iowa Electric Light and Power Company and Iowa Southern Utilities Company effective December 31, 1993. (4) Form 8-K/A filed by IES Utilities Inc. amending Form 8-K filed on January 7, 1994, File No. 0-4117-1, providing the audited financial statements of the Company for the year ended December 31, 1993. IES UTILITIES INC. SCHEDULE II - AMOUNTS RECEIVABLE FROM RELATED PARTIES AND UNDERWRITERS, PROMOTERS AND EMPLOYEES OTHER THAN RELATED PARTIES BALANCE AT DECEMBER 31 (in thousands) Affiliated Company 1991 1992 1993 Cedar Rapids and Iowa City Railway Company $ 54 $ 46 $ 19 IES Industries Inc. 842 613 985 IES Diversified Inc. - - 48 Industrial Energy Applications, Inc. 41 130 21 Total $ 937 $ 789 $1,073 NOTE: All receivables are collected from the affiliated companies within one month, thus all amounts are current and are recorded in the Balance Sheets as Current Assets - Accounts Receivable - Other. IES UTILITIES INC. SCHEDULE VIII--VALUATION AND QUALIFYING ACCOUNTS AND RESERVES FOR THE YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 Column A Column B Column E Balance Balance Description January 1 December 31 (in thousands) 1993: Accumulated provision for uncollectible accounts $ 567 $ 268 Accumulated provision for rate refunds $ 9,020 $ 8,670 1992: Accumulated provision for uncollectible accounts $ 804 $ 567 Accumulated provision for rate refunds $ 1,492 $ 9,020 1991: Accumulated provision for uncollectible accounts $ 727 $ 804 Accumulated provision for rate refunds $ 2,022 $ 1,492 IES UTILITIES INC. SCHEDULE IX--SHORT-TERM BORROWINGS FOR THE YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 Column A Column B Column C Column D Column E Column F Average Weighted Category of Weighted Maximum Daily Daily Aggregate Average Amount Amount Average Short-term Balance Interest Outstanding Outstanding Interst Rate Borrowings December 31 Rate During During During the Period the Period the Period 1993: Commercial paper $19,000,000 3.50% $92,000,000 $39,182,000 3.33% Uncommitted Credit Facility $ 5,000,000 3.40% $ 5,000,000 $ 1,027,000 3.30% 1992: Commercial paper $92,000,000 3.71% $92,000,000 $ 9,160,000 4.14% 1991: Commercial paper $40,900,000 5.02% $51,000,000 $30,298,000 6.43% SIGNATURES Pursuant to the requirements of Section 13 or 15(d) 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, on the 29th day of March 1994. IES UTILITIES INC. By /s/ Blake O. Fisher, Jr. Blake O. Fisher, Jr. Executive Vice President & Chief Financial Officer and Director Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons in the capacities indicated on March 29, 1994: /s/ Lee Liu Chairman of the Board, President & Lee Liu Chief Executive Officer (Principal Executive Officer) /s/ Blake O. Fisher, Jr. Executive Vice President & Chief Blake O. Fisher, Jr. Financial Officer and Director (Principal Financial Officer) /s/ Richard A. Gabbianelli Controller & Chief Accounting Officer Richard A. Gabbianelli (Principal Accounting Officer) /s/ C.R.S. Anderson Director C.R.S. Anderson /s/ J. Wayne Bevis Director J. Wayne Bevis /s/ Robert F. Brewer Director Robert F. Brewer /s/ Dr. George Daly Director Dr. George Daly /s/ G. Sharp Lannom, IV Director G. Sharp Lannom, IV /s/ Salomon Levy Director Dr. Salomon Levy /s/ Rene H. Males Director Rene H. Males /s/ Robert D. Ray Director Robert D. Ray /s/ David Q. Reed Director David Q. Reed /s/ Larry D. Root Director Larry D. Root /s/ Henry Royer Director Henry Royer /s/ Robert W. Schlutz Director Robert W. Schlutz /s/ Anthony R. Weiler Director Anthony R. Weiler EXHIBIT INDEX The Exhibits designated by an asterisk are filed herewith and all other Exhibits as stated to be filed are incorporated herein by reference. Exhibit 2(a) Agreement and Plan of Merger between IE and IS dated as of June 4, 1993 (Agreement and Plan of Merger) (Filed as Exhibit 2 to the Company's Current Report on Form 8-K, dated June 4, 1993 (File No. 0-4117-1). 2(b) Amendment 1 dated June 16, 1993, to the Agreement and Plan of Merger (Filed as Exhibit 2(b) to the IE Registration Statement on Form S-3, dated September 14, 1993 (File No. 33-68796)). 2(c) Amendment 2 dated September 8, 1993, to the Agreement and Plan of Merger (Filed as Exhibit 2(c) to the IE Registration Statement on Form S-3, dated September 14, 1993 (File No. 33-68796)). 2(d) Amendment 3 dated September 27, 1993, to the Agreement and Plan of Merger (Filed as Exhibit 2(d) to the IE Current Report on Form 8-K, dated December 9, 1993 (File No. 0-4117-1)). 3(a) Articles of Incorporation of the Registrant, Amended and Restated as of January 6, 1994. (Filed as Exhibit 4(b) to the Company's Current Report on Form 8-K, dated January 7, 1994 (File No. 0-4117-1)). * 3(b) Bylaws of Registrant, Amended as of February 1, 1994. 4(a) Indenture of Mortgage and Deed of Trust, dated as of September 1, 1993, between the Company (formerly IE) and the First National Bank of Chicago, as Trustee (Mortgage) (Filed as Exhibit 4(c) to IE's Form 10-Q for the quarter ended September 30, 1993). 4(b) Supplemental Indentures to the Mortgage: IE File Number Dated as of Reference Exhibit First October 1, 1993 Form 10-Q, 11/12/93 4(d) Second November 1, 1993 Form 10-Q, 11/12/93 4(e) 4(c) Indenture of Mortgage and Deed of Trust, dated as of August 1, 1940, between the Company (formerly IE) and the First National Bank of Chicago, Trustee (1940 Indenture) (Filed as Exhibit 2(a) to IE's Registration Statement File No. 2-25347). 4(d) Supplemental Indentures to the 1940 Indenture: Number Dated as of IE File Reference Exhibit First March 1, 1941 2-25347 2(a) Second July 15, 1942 2-25347 2(a) Third August 2, 1943 2-25347 2(a) Fourth August 10, 1944 2-25347 2(a) Fifth November 10, 1944 2-25347 2(a) Sixth August 8, 1945 2-25347 2(a) Seventh July 1, 1946 2-25347 2(a) Eighth July 1, 1947 2-25347 2(a) Ninth December 15, 1948 2-25347 2(a) Tenth November 1, 1949 2-25347 2(a) Eleventh November 10, 1950 2-25347 2(a) Twelfth October 1, 1951 2-25347 2(a) Thirteenth March 1, 1952 2-25347 2(a) Fourteenth November 5, 1952 2-25347 2(a) Fifteenth February 1, 1953 2-25347 2(a) Sixteenth May 1, 1953 2-25347 2(a) Seventeenth November 3, 1953 2-25347 2(a) Eighteenth November 8, 1954 2-25347 2(a) Nineteenth January 1, 1955 2-25347 2(a) Twentieth November 1, 1955 2-25347 2(a) Twenty-first November 9, 1956 2-25347 2(a) Twenty-second November 6, 1957 2-25347 2(a) Twenty-third November 4, 1958 2-25347 2(a) Twenty-fourth November 3, 1959 2-25347 2(a) Twenty-fifth November 1, 1960 2-25347 2(a) Twenty-sixth January 1, 1961 2-25347 2(a) Twenty-seventh November 7, 1961 2-25347 2(a) Twenty-eighth November 6, 1962 2-25347 2(a) Twenty-ninth November 5, 1963 2-25347 2(a) Thirtieth November 4, 1964 2-25347 2(a) Thirty-first November 2, 1965 2-25347 2(a) Thirty-second September 1, 1966 Form 10-K, 1966 4.10 Thirty-third November 30, 1966 Form 10-K, 1966 4.10 Thirty-fourth November 7, 1967 Form 10-K, 1967 4.10 Thirty-fifth November 5, 1968 Form 10-K, 1968 4.10 Thirty-sixth November 1, 1969 Form 10-K, 1969 4.10 Thirty-seventh December 1, 1970 Form 8-K, 12/70 1 Thirty-eighth November 2, 1971 2-43131 2(g) Thirty-ninth May 1, 1972 Form 8-K, 5/72 1 Fortieth November 7, 1972 2-56078 2(i) Forty-first November 7, 1973 2-56078 2(j) Forty-second September 10, 1974 2-56078 2(k) Forty-third November 5, 1975 2-56078 2(l) Forty-fourth July 1, 1976 Form 8-K, 7/76 1 Forty-fifth November 1, 1976 Form 8-K, 12/76 1 Forty-sixth December 1, 1977 2-60040 2(o) Forty-seventh November 1, 1978 Form 10-Q, 6/30/79 1 Forty-eighth December 1, 1979 Form S-16, 2-65996 2(q) Forty-ninth November 1, 1981 Form 10-Q,3/31/82 2 Fiftieth December 1, 1980 Form 10-K, 1981 4(s) Fifty-first December 1, 1982 Form 10-K, 1982 4(t) Fifty-second December 1, 1983 Form 10-K, 1983 4(u) Fifty-third December 1, 1984 Form 10-K, 1984 4(v) Fifty-fourth March 1, 1985 Form 10-K, 1984 4(w) Fifty-fifth March 1, 1988 Form 10-Q, 5/12/88 4(b) Fifty-sixth October 1, 1988 Form 10-Q, 11/10/88 4(c) Fifty-seventh May 1, 1991 Form 10-Q, 8/31/91 4(d) Fifty-eighth March 1, 1992 Form 10-K, 1991 4(c) Fifty-ninth October 1, 1993 Form 10-Q, 11/12/93 4(a) Sixtieth November 1, 1993 Form 10-Q, 11/12/93 4(b) 4(e) Indenture or Deed of Trust dated as of February 1, 1923, between the Company (successor to IS as result of merger of IS and IE) and The Northern Trust Company (The First National Bank of Chicago, successor) and Harold H. Rockwell (Richard D. Manella, successor), as Trustees (1923 Indenture) (Filed as Exhibit B-1 to File No. 2- 1719). 4(f) Supplemental Indentures to the 1923 Indenture: IS File Dated as of Reference Exhibit May 1, 1940 2-4921 B-1-k May 2, 1940 2-4921 B-1-l October 1, 1945 2-8053 7(m) October 2, 1945 2-8053 7(n) January 1, 1948 2-8053 7(o) September 1, 1950 33-3995 4(e) February 1, 1953 2-10543 4(b) October 2, 1953 2-10543 4(q) August 1, 1957 2-13496 2(b) September 1, 1962 2-20667 2(b) June 1, 1967 2-26478 2(b) February 1, 1973 2-46530 2(b) February 1, 1975 2-53860 2(aa) July 1, 1975 2-54285 2(bb) September 2, 1975 2-57510 2(bb) March 10, 1976 2-57510 2(cc) February 1, 1977 2-60276 2(ee) January 1, 1978 0-849 2 March 1, 1979 0-849 2 March 1, 1980 0-849 2 May 31, 1986 33-3995 4(g) July 1, 1991 0-849 4(h) September 1, 1992 0-849 4(m) 10(a) Agreement dated December 15, 1971 between Central Iowa Power Cooperative and IE. (Filed as Exhibit 5(a) to IE's Registration Statement File No. 2-43131). 10(b) Duane Arnold Energy Center Ownership Participation Agreement dated June 1, 1970 between Central Iowa Power Cooperative, Corn Belt Power Cooperative and IE. (Filed as Exhibit 5(kk) to IE's Registration Statement, File No. 2-38674). 10(c) Duane Arnold Energy Center Operating Agreement dated June 1, 1970 between Central Iowa Power Cooperative, Corn Belt Power Cooperative and IE. (Filed as Exhibit 5(ll) to IE's Registration Statement, File No. 2-38674). 10(d) Duane Arnold Energy Center Agreement for Transmission, Transformation, Switching, and Related Facilities dated June 1, 1970 between Central Iowa Power Cooperative, Corn Belt Power Cooperative and IE. (Filed as Exhibit 5(mm) to IE's Registration Statement, File No. 2-38674). 10(e) Basic Generating Agreement dated April 16, 1975 between Iowa Public Service Company, Iowa Power and Light Company, Iowa- Illinois Gas and Electric Company and IS for the joint ownership of Ottumwa Generating Station-Unit 1 (OGS-1). (Filed as Exhibit 1 to IE's Form 10-K for the year 1977). 10(f) Addendum Agreement to the Basic Generating Agreement for OGS-1 dated December 7, 1977 between Iowa Public Service Company, Iowa-Illinois Gas and Electric Company, Iowa Power and Light Company, IS and IE for the purchase of 15% ownership in OGS-1. (Filed as Exhibit 3 to IE's Form 10-K for the year 1977). 10(g) Fuel Lease dated August 21, 1973, as amended by Amendment No. 1 dated August 29, 1973, and by Amendment dated September 17, 1987, between Arnold Fuel, Inc. and IE for the procurement and financing of nuclear fuel. (Filed as Exhibit 10(l) to IE's Form 10-K for the year 1984). 10(h) Amendment dated as of September 17, 1987 to the Fuel Lease dated as of August 21, 1973 between Arnold Fuel, Inc. and IE. (Filed as Exhibit 10(i) to IE's Form 10-K for the year 1987). 10(i) Second Amended and Restated Credit Agreement dated as of September 17, 1987 between Arnold Fuel, Inc. and the First National Bank of Chicago and the Amended and Restated Consent and Agreement dated as of September 17, 1987 by IE. (Filed as Exhibit 10(j) to IE's Form 10-K for the year 1987). MANAGEMENT CONTRACTS AND/OR COMPENSATORY PLANS (EXHIBITS 10(j) THROUGH 10(u)) 10(j) Service Contract between S. Levy, Incorporated and IE. (Filed as Exhibit 10(m) to IE's Form 10-K for the year 1985). 10(k) Supplemental Retirement Plan. (Filed as Exhibit 10(l) to Industries' Form 10-K for the year 1987). 10(l) Management Incentive Compensation Plan. (Filed as Exhibit 10(m) to Industries' Form 10-K for the year 1987). 10(m) Key Employee Deferred Compensation Plan. (Filed as Exhibit 10(n) to Industries' Form 10-K for the year 1987). 10(n) Long-Term Incentive Plan. (Filed as Exhibit 10(o) to Industries' Form 10-K for the year 1987). 10(o) Executive Guaranty Plan. (Filed as Exhibit 10(p) to Industries' Form 10-K for the year 1987). 10(p) Executive Change of Control Severance Agreement. (Filed as Exhibit 10(s) to Industries' Form 10-K for the year 1989). 10(q) Amendments to Key Employee Deferred Compensation Agreement for Directors. (Filed as Exhibit 10(u) to Industries' Form 10-Q for the quarter ended March 31, 1990). 10(r) Amendments to Key Employee Deferred Compensation Agreement for Key Employees. (Filed as Exhibit 10(v) to Industries' Form 10-Q for the quarter ended March 31, 1990). 10(s) Amendments to Management Incentive Compensation Plan. (Filed as Exhibit 10(y) to Industries' Form 10-Q for the quarter ended March 31, 1990). 10(t) Director Retirement Plan. (Filed as Exhibit 10(t) to Industries' Form 10-K for the year 1993). 10(u) Copy of Supplemental Retirement Income Plan and Form of Supplemental Retirement Income Agreement. (Filed as Exhibit 10-A-6 to File No. 33-3995). 10(v) Agreement for Purchase and Sale of Certain Assets and Real Estate and Assignment of Easements, Leases and Licenses between Union Electric Company (Seller) and IE (Buyer). Filed as exhibit 10(t) to IE's Form 10-K for the year 1991. 10(w) Copy of Coal Supply Agreement, dated July 27, 1977, between IS and Sunoco Energy Development Co., and letter memorandum thereto, dated October 29, 1984, relating to the purchase of coal supplies for the fuel requirements at the Ottumwa Generating Station. (Filed as Exhibit 10-A-4 to File No. 33-3995). 10(x) Receivables Purchase and Sale Agreement. (Filed as Exhibit 10(a) to IE's Form 10-Q for the quarter ended June 30, 1989). 10(y) Terra Comfort Capacity and Energy Agreement dated August 14, 1989 between IE and Terra Comfort Corporation. (Filed as Exhibit 10(n) to IE's Form 10-K for the year 1989). 10(z) Capacity and Energy Agreement dated December 20, 1990 between Terra Comfort Corporation and IE. 10(aa) Operating and Transmission Agreement between Central Iowa Power Cooperative and IE. 10(ab) Capacity and Energy Agreement dated April 3, 1991 between Terra Comfort Corporation and IE. (Filed as Exhibit 10(r) to IE's Form 10-Q for the quarter ended March 31, 1991). *12 Ratio of Earnings to Fixed Charges. *23 Consent of Independent Public Accountants. *99 Director and Officer Information. Note: Pursuant to (b)(4)(iii)(A) of Item 601 of Regulation S-K, the Company has not filed as an exhibit to this Form 10-K certain instruments with respect to long-term debt that has not been registered if the total amount of securities authorized thereunder does not exceed 10% of total assets of the Company but hereby agrees to furnish to the Commission on request any such instruments.

310569_1993.txt

310569

1993

ITEM 1. BUSINESS Anheuser-Busch Companies, Inc. (the "Company") is a Delaware corporation that was organized in 1979 as the holding company parent of Anheuser-Busch, Incorporated ("ABI"), a Missouri corporation whose origins date back to 1875. In addition to ABI, which is the world's largest brewer of beer, the Company is also the parent corporation to a number of subsidiaries that conduct various other business operations, including those related to the brewing of beer, the manufacture of metal beverage containers, the recycling of metal and glass beverage containers, the production and sale of food and food-related products, and the operation of theme parks. Financial information with respect to the Company's business segments appears in financial statement note 15, "Business Segments," on page 57 of the 1993 Annual Report to Shareholders, which note hereby is incorporated by reference. BEER AND BEER-RELATED OPERATIONS The Company's principal product is beer, produced and distributed by its subsidiary, ABI, in a variety of containers primarily under the brand names Budweiser, Bud Light, Bud Dry Draft, Michelob, Michelob Light, Michelob Dry, Michelob Golden Draft, Michelob Golden Draft Light, Michelob Classic Dark, Busch, Busch Light, Natural Light, Natural Pilsner, King Cobra, and O'Doul's (a non-alcoholic malt beverage). Additionally, ABI imports Carlsberg and Carlsberg Light beers and Elephant Malt Liquor in U.S. markets as part of an agreement with the Denmark based Carlsberg A/S (formerly United Breweries, Ltd.), brewer of the brands. A new brand, Ice Draft from Budweiser, was introduced in the fourth quarter of 1993. Sales of beer by the Company aggregated 87.3 million barrels in 1993 as compared with 86.8 million barrels in 1992 and accounted for approximately 66% of consolidated net sales dollars in 1993. In 1992 and 1991 the percentage was 67%. Budweiser, Bud Light, Bud Dry Draft, Ice Draft from Budweiser, Michelob, Michelob Light, Michelob Dry, Michelob Golden Draft, Michelob Golden Draft Light, Michelob Classic Dark, Busch, Busch Light, Natural Light, Carlsberg, Elephant Malt Liquor, and O'Doul's are sold in both draught and packaged form. Natural Pilsner, King Cobra, and Carlsberg Light are sold only in packaged form. Budweiser, Bud Light, Bud Dry Draft, Ice Draft from Budweiser, Michelob, Michelob Light, Michelob Dry, Michelob Classic Dark, Natural Light, and O'Doul's are distributed and sold on a nationwide basis. Busch and Busch Light are distributed in 46 states, Natural Pilsner in 6 states, and King Cobra is distributed in 45 states. Michelob Golden Draft and Michelob Golden Draft Light are sold in 13 states. ABI's imported beer, Carlsberg is distributed in 45 states, Carlsberg Light in 28 states, and Elephant Malt Liquor is distributed in 38 states. Normally, due to the seasonality of the industry, sales of ABI's beers are at their lowest volume level in the first and fourth quarters of each year and at their highest in the second and third quarters. In 1993 the barrels sold in the lowest quarter (first quarter) differed by almost 19% from the barrels sold in the highest quarter (third quarter). ABI's 1994 quarterly sales to wholesalers volume growth is not expected to follow a consistent pattern; first quarter shipments in 1994 increased more significantly due to the roll-out of Ice Draft from Budweiser and higher planned inventory levels. ABI has developed a system of thirteen breweries, strategically located across the country, to economically serve its distribution system. (See Item 2

ITEM 2. PROPERTIES ABI has thirteen breweries in operation at the present time, located in St. Louis, Missouri; Newark, New Jersey; Los Angeles and Fairfield, California; Jacksonville and Tampa, Florida; Houston, Texas; Columbus, Ohio; Merrimack, New Hampshire; Williamsburg, Virginia; Baldwinsville, New York; Fort Collins, Colorado; and Cartersville, Georgia. Title to the Baldwinsville, New York brewery is held by the Onondaga County Industrial Development Agency ("OCIDA") pursuant to a Sale and Agency Agreement with ABI, which enabled OCIDA to issue tax exempt pollution control and industrial development revenue notes and bonds to finance a portion of the cost of the purchase and modification of the brewery. The brewery is not pledged or mortgaged to secure any of the notes or bonds, and the Sale and Agency Agreement with OCIDA gives ABI the unconditional right to require at any time that title to the brewery be transferred to ABI. ABI's breweries operated at approximately 94% of capacity in 1993. The Company, through wholly-owned subsidiaries, operates malt plants in Manitowoc, Wisconsin, Moorhead, Minnesota and Idaho Falls, Idaho; rice mills in Jonesboro, Arkansas and Woodland, California; a wild rice processing facility in Clearbrook, Minnesota; can manufacturing plants in Jacksonville, Florida, Columbus, Ohio, Arnold, Missouri, Windsor, Colorado, Carson, California, Newburgh, New York, Ft. Atkinson, Wisconsin, and Rome, Georgia; can lid manufacturing plants in Gainesville, Florida, Oklahoma City, Oklahoma, and Riverside, California; refillable bottle sorting facilities in Marion, Ohio and Nashua, New Hampshire; and snack food production plants in Robersonville, North Carolina, Hyannis, Massachusetts, Fayetteville, Tennessee, Visalia, California, and York, Pennsylvania. BEC operates its principal family entertainment facilities in Tampa, Florida; Williamsburg, Virginia; San Diego, California; Aurora, Ohio; Orlando, Florida; San Antonio, Texas; and Winter Haven, Florida. The Tampa facility is 265 acres, Williamsburg is 364 acres, San Diego is 165 acres, Aurora is 90 acres, Orlando is 224 acres, San Antonio is 496 acres, and the Winter Haven facility is 223 acres. The Company's wholly-owned subsidiary, CTI, through its domestic subsidiaries, operates 41 bakeries and 11 manufacturing plants in 19 states. CTI's international subsidiaries own and operate eight bakeries in Spain and a refrigerated dough manufacturing plant in France. CTI's domestic bakeries operate at approximately 75% of capacity, which is about average for the baking industry. Except for the Baldwinsville brewery, the can manufacturing plants in Carson, California and in Newburgh, New York, eleven CTI facilities, one ESI plant, and the Sea World park in San Diego, California, all of the Company's principal properties are owned in fee. The lease for the land used by the Sea World park in San Diego, California expires in 2033. Title to eight CTI facilities is currently held by development authorities for the jurisdictions in which the facilities are located pursuant to Industrial Development Bonds; the remaining CTI facilities are leased. The Company considers its buildings, improvements, and equipment to be well maintained and in good condition, irrespective of dates of initial construction, and adequate to meet the operating demands placed upon them. The production capacity of each of the manufacturing facilities is adequate for current needs and, except as described above, substantially all of each facility's capacity is utilized. ITEM 3.

ITEM 3. LEGAL PROCEEDINGS The Company is not a party to any pending or threatened litigation, the outcome of which would be expected to have a material adverse effect upon its financial condition or its operations. ITEM 4.

ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS There were no matters submitted to a vote of security holders, through the solicitation of proxies or otherwise, during the fourth quarter ended December 31, 1993. EXECUTIVE OFFICERS OF THE REGISTRANT AUGUST A. BUSCH III (age 56) is presently Chairman of the Board and President, and Director of the Company and has served in such capacities since 1977, 1974, and 1963, respectively. Since 1979 he has also served as Chairman of the Board and Chief Executive Officer of the Company's subsidiary, Anheuser-Busch, Incorporated. During the past five years he also served as President of that subsidiary (1987-1990). JERRY E. RITTER (age 59) is presently Executive Vice President-Chief Financial and Administrative Officer of the Company and was appointed to serve in such capacity in 1990. He is also Vice President-Finance of the Company's subsidiary, Anheuser-Busch, Incorporated, and has served in such capacity since 1982. During the past five years he also served as Vice President and Group Executive of the Company (1984-1990). MICHAEL J. ROARTY (age 65) is presently Executive Vice President- Corporate Marketing and Communications of the Company and was appointed to serve in such capacity in 1990. He is also presently Chairman of the Board of the Company's subsidiary, Busch Media Group, Inc., and Chairman of the Board and Chief Executive Officer of the Company's subsidiary, Busch Creative Services Corporation, and was appointed to serve in each such capacity in 1990. During the past five years he also served as Vice President of the Company (1988-1990) and Executive Vice President-Marketing of the Company's subsidiary, Anheuser-Busch, Incorporated (1983-1990). Mr. Roarty has elected to retire from his positions with the Company and its subsidiaries in September 1994. Details of Mr. Roarty's retirement are set forth on page 18 in the Company's Proxy Statement for the Annual Meeting of Shareholders on April 27, 1994. PATRICK T. STOKES (age 51) is presently Vice President and Group Executive of the Company and has served in such capacity since 1981. He is also presently President of the Company's subsidiary, Anheuser- Busch, Incorporated, and was appointed to serve in such capacity in 1990. During the past five years he also served as Chairman of the Board and Chief Executive Officer of the Company's subsidiary, Campbell Taggart, Inc. (1985-1990) and Chairman of the Board and President of the Company's subsidiary, Eagle Snacks, Inc. (1987-1990). BARRY H. BERACHA (age 52) is presently Vice President and Group Executive of the Company and has served in such capacity since 1976. He is also presently Chairman of the Board and Chief Executive Officer of the Company's subsidiary, Campbell Taggart, Inc. and has served in such capacity since September 1993. He is also Chairman of the Board of the Company's subsidiary, Metal Container Corporation and has served in such capacity since 1976. During the past five years he also served as Chief Executive Officer of Metal Container Corporation (1976-September 1993) and Chairman of the Board and Chief Executive Officer of the Company's subsidiary, Anheuser-Busch Recycling Corporation (1978-1993). JOHN H. PURNELL (age 52) is presently Vice President and Group Executive of the Company and has served in such capacity since January 1991. He is also Chairman of the Board and Chief Executive Officer of the Company's subsidiary, Anheuser-Busch International, Inc., and has served as Chairman since 1980 and as Chief Executive Officer since January 1991. During the past five years he also served as Senior Vice President-Corporate Planning and Development (1987-1991). W. RANDOLPH BAKER (age 47) is presently Vice President and Group Executive of the Company and has served in such capacity since 1982. During the past five years he also served as Chairman of the Board and President of the Company's subsidiaries, Busch Properties, Inc. and Busch Entertainment Corporation (1978-1991). STEPHEN K. LAMBRIGHT (age 51) is presently Vice President and Group Executive of the Company and has served in such capacity since 1984. STUART F. MEYER (age 60) is presently Vice President and Group Executive of the Company and has served in such capacity since April 1991 and has also served as Vice President-Corporate Human Resources of the Company (1984-March 1991). He was appointed President and Chief Executive Officer of the Company's subsidiary, St. Louis National Baseball Club, Inc., in January 1992 and prior to that served as Executive Vice President and Chief Operating Officer (April 1991-December 1991). He is also President and Chief Executive Officer of the Company's subsidiary, Civic Center Corporation, and has served in such capacity since April 1991. RAYMOND E. GOFF (age 48) is presently Vice President and Group Executive of the Company and has served in such capacity since 1986. He is also presently Chairman of the Board and Chief Executive Officer of the Company's subsidiary, Busch Agricultural Resources, Inc., and has served in such capacity since 1986. JAIME IGLESIAS (age 63) is presently Chairman of the Board and Senior Vice President-Europe of the Company's subsidiary, Anheuser-Busch Europe, Inc. ("ABEI") and was appointed to these positions in January 1993. Prior to that he served as Chief Executive Officer (1989-January 1993) and as President (1988-January 1993) of ABEI. He was appointed President-International Operations of the Company's subsidiary, Campbell Taggart, Inc. ("CTI"), in 1991 and prior to that served as Vice President-International (1983-1991). He is also Chairman of CTI's subsidiary, Bimbo S.A., and President and Senior Vice President-Europe of the Company's subsidiary, Anheuser-Busch International, Inc. ("ABII"), and has served in such capacities since 1978 and January 1993, respectively. He also served as President and Managing Director- Europe of ABII (1988-January 1993). ALOYS H. LITTEKEN (age 53) is presently Vice President-Corporate Engineering of the Company and has served in such capacity since 1981. WILLIAM L. RAMMES (age 52) is presently Vice President-Corporate Human Resources of the Company and has served in such capacity since June 1992. During the past five years he also served as Vice President- Operations of the Company's subsidiary, Anheuser-Busch Incorporated (1990-June 1992) and Vice President-Administration (1986-1989). JOHN B. ROBERTS (age 49) is presently Chairman of the Board and President of the Company's subsidiary, Busch Entertainment Corporation, and has served in such capacities since June 1992 and May 1991, respectively. During the past five years he also served as Executive Vice President and General Manager of Busch Entertainment Corporation (1990-May 1991) and Vice President and General Manager (1987-1990) and Vice President-Operations (1979-1987). JOSEPH L. GOLTZMAN (age 52) is presently Vice President and Group Executive of the Company and has served in such capacity since September 1993. He is also presently Chairman, Chief Executive Officer and President of the Company's subsidiary, Anheuser-Busch Recycling Corporation, President and Chief Executive Officer of the Company's subsidiary, Metal Container Corporation, and President of the Company's subsidiary, Metal Label Corporation, and has served in such capacities since January 1993, September 1993, and 1988, respectively. During the past five years he also served as President of Anheuser-Busch Recycling Corporation (1988-December 1992) and Vice President-Recycling and Metals Planning (January 1992-September 1993) and Director-Metals Planning and Recycling (1988-December 1991) of the Company. PART II The information required by Items 5, 6, 7, and 8 of this Part II are hereby incorporated by reference from pages 32 through 65 of the Company's 1993 Annual Report to Shareholders. ITEM 5.

ITEM 5. MARKET FOR THE REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS ITEM 6.

ITEM 6. SELECTED FINANCIAL DATA ITEM 7.

ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS ITEM 8.

ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA ITEM 9.

ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE There have been no disagreements with Price Waterhouse, the Company's independent accountants since 1961, on accounting principles or practices or financial statement disclosures. PART III ITEM 10.

ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT The information required with respect to Directors is hereby incorporated by reference from pages 3 through 5 of the Company's Proxy Statement for the Annual Meeting of Shareholders on April 27, 1994. The information required by this Item with respect to Executive Officers is presented on pages 6 through 8 of this Form 10-K. ITEM 11.

ITEM 11. EXECUTIVE COMPENSATION The information required by this Item is hereby incorporated by reference from page 7 and pages 15 through 21 of the Company's Proxy Statement for the Annual Meeting of Shareholders on April 27, 1994. ITEM 12.

ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT The information required by this Item is hereby incorporated by reference from pages 2 and 6 of the Company's Proxy Statement for the Annual Meeting of Shareholders on April 27, 1994. ITEM 13.

ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS The information required by this Item is hereby incorporated by reference from pages 21 through 23 of the Company's Proxy Statement for the Annual Meeting of Shareholders on April 27, 1994. PART IV 3. Exhibits Exhibit 3.1 - Amendment to Article Fourth of the Restated Certificate of Incorporation of the Company dated June 10, 1992. (Restated Certificate of Incorporation with amendments previously filed and incorporated by reference to Exhibit 3.1 to Form 10-K for the fiscal year ended December 31, 1987.) Exhibit 3.2 - Certificate of Designation, Rights and Preferences of the Series C Convertible Preferred Stock of the Company dated November 3, 1989. (Incorporated by reference to Exhibit 3.2 to Form 10-K for the fiscal year ended December 31, 1990.) Exhibit 3.3 - By-Laws of the Company (as amended and restated October 27, 1993). (Incorporated by reference to Exhibit 3 to Form 10-Q for the quarter ended September 30, 1993.) Exhibit 4.1 - Form of Rights Agreement, dated as of December 18, 1985 between Anheuser-Busch Companies, Inc. and Centerre Trust Company of St. Louis (now Boatmen's Trust Company), as amended and restated as of December 17, 1986. Exhibit 4.2 - Indenture between the Company and Manufacturers Hanover Trust Company. (Incorporated by reference to Exhibit 4 to Registration Statement on Form S-3, Registration No. 33-14685, filed with the Commission on June 3, 1987.) (Other indentures are not filed, but the Company agrees to furnish copies of such instruments to the Securities and Exchange Commission upon request.) [FN] - - - ----- *Incorporated by reference from the indicated pages of the 1993 Annual Report to Shareholders. Exhibit 10.1 - Anheuser-Busch Companies, Inc. Deferred Compensation Plan for Non-Employee Directors (as amended and restated February 22, 1989.) (Incorporated by reference to Exhibit 10.1 to Form 10-K for the fiscal year ended December 31, 1988.)* Exhibit 10.2 - First Amendment to Anheuser-Busch Companies, Inc. Deferred Compensation Plan for Non-Employee Directors (as amended and restated February 22, 1989) effective April 24, 1991. (Incorporated by reference to Exhibit 10.2 to Form 10-K for the fiscal year ended December 31, 1991.)* Exhibit 10.3 - Second Amendment to Anheuser-Busch Companies, Inc. Deferred Compensation Plan for Non-Employee Directors (as amended and restated February 22, 1989) effective January 1, 1994.* Exhibit 10.4 - Anheuser-Busch Companies, Inc. Retirement Program for Non-Employee Directors. (Incorporated by reference to Exhibit 10.1 to Registration Statement on Form S-14 filed September 14, 1982.)* Exhibit 10.5 - Anheuser-Busch Companies, Inc. 1981 Incentive Stock Option/Non-Qualified Stock Option Plan (as amended December 18, 1985, December 16, 1987, December 20, 1988 and July 22, 1992.) (Incorporated by reference to Exhibit 10.4 to Form 10-K for the fiscal year ended December 31, 1992.)* Exhibit 10.6 - Excerpts from resolutions adopted by the Anheuser-Busch Companies, Inc. Board of Directors on September 22, 1993 amending the Anheuser-Busch Companies, Inc. 1981 Incentive Stock Option/Non-Qualified Stock Option Plan.* Exhibit 10.7 - Anheuser-Busch Companies, Inc. 1981 Non- Qualified Stock Option Plan (as amended December 18, 1985, June 24, 1987, December 20, 1988 and July 22, 1992.) (Incorporated by reference to Exhibit 10.5 to Form 10-K for the fiscal year ended December 31, 1992.)* Exhibit 10.8 - Anheuser-Busch Companies, Inc. 1989 Incentive Stock Plan (as amended December 20, 1989, December 19, 1990 and December 15, 1993.)* Exhibit 10.9 - Anheuser-Busch Companies, Inc. Excess Benefit Plan.* Exhibit 10.10- First Amendment to Anheuser-Busch Companies, Inc. Excess Benefit Plan.* Exhibit 10.11- Second Amendment to Anheuser-Busch Companies, Inc. Excess Benefit Plan effective as of July 1, 1989. (Incorporated by reference to Exhibit 10.10 to Form 10-K for the fiscal year ended December 31, 1989.)* Exhibit 10.12- Excerpts from resolutions adopted by the Anheuser-Busch Companies, Inc. Board of Directors on September 22, 1993 amending the Anheuser-Busch Companies, Inc. Excess Benefit Plan.* Exhibit 10.13- Anheuser-Busch Companies, Inc. Supplemental Executive Retirement Plan Amended and Restated as of July 1, 1989. (Incorporated by reference to Exhibit 10.11 to Form 10-K for the fiscal year ended December 31, 1989.)* Exhibit 10.14- First Amendment to Anheuser-Busch Companies, Inc. Supplemental Executive Retirement Plan. (Incorporated by reference to Exhibit 10.11 to Form 10-K for the fiscal year ended December 31, 1990.)* Exhibit 10.15- Excerpts from resolutions adopted by the Anheuser-Busch Companies, Inc. Board of Directors on September 22, 1993 amending the Anheuser-Busch Companies, Inc. Supplemental Executive Retirement Plan.* Exhibit 10.16- Anheuser-Busch Executive Deferred Compensation Plan effective January 1, 1994.* Exhibit 10.17- Anheuser-Busch 401(k) Restoration Plan effective January 1, 1994.* Exhibit 10.18- Form of Indemnification Agreement with Directors and Executive Officers.* Exhibit 10.19- Investment Agreement By and Among Anheuser-Busch Companies, Inc., Anheuser-Busch International, Inc. and Anheuser-Busch International Holdings, Inc. and Grupo Modelo, S.A. de C.V., Diblo, S.A. de C.V. and certain shareholders thereof, dated as of June 16, 1993. Exhibit 10.20- Letter agreement between Anheuser-Busch Companies, Inc. and the Controlling Shareholders regarding Section 5.5 of the Investment Agreement filed as Exhibit 10.19 of this report. Exhibit 13 - Pages 32 through 65 of the Anheuser-Busch Companies, Inc. 1993 Annual Report to Shareholders, a copy of which is furnished for the information of the Securities and Exchange Commission. Portions of the Annual Report not incorporated herein by reference are not deemed "filed" with the Commission. Exhibit 21 - Subsidiaries of the Company Exhibit 23 - Consent of Independent Accountants, filed as page 16 of this report. [FN] - - - ----- * A management contract or compensatory plan or arrangement required to be filed by Item 14(c) of this report. (b) Reports on Form 8-K No reports on Form 8-K were filed during the fourth quarter of 1993. SIGNATURES Pursuant to the requirements of Section 13 or 15(d) 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. ANHEUSER-BUSCH COMPANIES, INC. ................................... (Registrant) By AUGUST A. BUSCH III ................................... August A. Busch III Chairman of the Board and President Date: March 23, 1994 All other schedules are omitted because they are not applicable or the required information is shown in the financial statements or notes thereto. Separate financial statements of subsidiaries not consolidated have been omitted because, in the aggregate, the proportionate share of their profit before income taxes and total assets are less than 20% of the respective consolidated amounts, and investments in such companies are less than 20% of consolidated total assets. REPORT OF INDEPENDENT ACCOUNTANTS ON FINANCIAL STATEMENT SCHEDULES To the Board of Directors of Anheuser-Busch Companies, Inc. Our audits of the consolidated financial statements referred to in our report dated February 7, 1994 appearing on page 41 of the 1993 Annual Report to Shareholders of Anheuser-Busch Companies, Inc. (which report and consolidated financial statements are incorporated by reference in this Annual Report on Form 10-K) also included an audit of the Financial Statement Schedules listed in Item 14(a) of this Form 10-K. In our opinion, these Financial Statement Schedules present fairly, in all material respects, the information set forth therein when read in conjunction with the related consolidated financial statements. PRICE WATERHOUSE St. Louis, Missouri February 7, 1994 CONSENT OF INDEPENDENT ACCOUNTANTS We hereby consent to the incorporation by reference in the Prospectuses constituting part of the Registration Statements on Forms S-3 (No. 33-31735 and No. 33-49051) and in the Registration Statements on Forms S-8 (No. 2-71762, No. 2-77829, No. 33-4664, No. 33-36132, No. 33-39714, No. 33-39715, and No. 33-46846) of Anheuser-Busch Companies, Inc. of our report dated February 7, 1994 appearing on page 41 of the Annual Report to Shareholders which is incorporated in this Annual Report on Form 10-K. We also consent to the incorporation by reference of our report on the Financial Statement Schedules, which appears on page 15 of this Form 10-K. PRICE WATERHOUSE St. Louis, Missouri March 23, 1994

859119_1993.txt

859119

1993

Item 1. Business BACKGROUND Illinois Central Corporation (the "Company") was incorporated under the laws of Delaware on January 27, 1989. The Company, through its wholly- owned subsidiary, Illinois Central Railroad Company (the "Railroad"), traces its origin to 1851, when the Railroad was incorporated as the nation's first land grant railroad. Today, the Railroad operates 2,700 miles of main line track between Chicago and the Gulf of Mexico, primarily carrying chemicals, coal and paper north, with coal, grain and milled grain products moving south along its lines. The Railroad has been significantly downsized and restructured from its peak of nearly 10,000 miles of track operated in 13 states, rebuilding its main line and converting to a single-track main line with a centralized traffic control system and divesting major east-west segments. In addition to the Railroad, the Company's other direct subsidiary conducts railroad related financing operations. In 1989, the Company was acquired by The Prospect Group, Inc. ("Prospect") by means of a public tender offer that resulted in the Company becoming highly leveraged. Prospect distributed the stock of the Company to Prospect's stockholders in 1990, and the Company again became publicly owned. Improved operating performance, combined with sales of non-operating assets and proceeds from equity and lower-cost debt financings since 1990 have resulted in a substantial reduction in the Company's leverage. Between December 31, 1989 and December 31, 1993, the Company reduced its debt to capitalization ratio from 89% to approximately 50%. The principal executive office of the Company is located at 455 North Cityfront Plaza Drive, Chicago, Illinois 60611-5504 and its telephone number is (312) 755-7500. GENERAL The Company is in the midst of a four year plan designed to increase its revenues and lower its operating ratio and interest costs. The plan is in sharp contrast to the Company's primary focus for the four years ended December 31, 1992 of significantly reducing costs and improving service offerings. With 1992 as its base, the plan will focus on capitalizing on the Company's leading operating ratio among Class I railroads (operating expenses divided by operating revenues) which was 68.2% at December 31, 1993. The components of the plan are: - increase annual revenues by $100 million by the end of 1996 - reduce the operating ratio by one percentage point per year for a total of four (4) points below the 1992 base - reduce annual interest expense by $10 million To accomplish this plan, revenues must grow at a compounded rate of 4.3% per year while operating expenses must not exceed a compounded annual growth rate of 2.5% per year. Management has identified the sources of planned revenue growth as economic expansion, new and expanded plants on line and market share growth. Economic expansion is the combination of industrial production improvement and freight rate increases. Market share growth is volume gained from competition, (i.e., other railroads, trucklines and barges) facilitated by being a low cost producer. See "Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations" for a discussion of the progress made in 1993. To foster achievement of these goals, the Railroad reorganized its marketing and sales effort (see below), restructured its safety and claims group into a Risk Management Group and streamlined the operating organization. The latter effectively created teams of engineering, maintenance and transportation experts who share the common goal of moving trains safely and efficiently. As a result of these changes, decision-making authority and accountability are now at lower and more localized levels, in line with the Company's systematic efforts to examine and refine all aspects of its service offering to customers. COMMODITIES AND CUSTOMERS The Railroad's customers are engaged in a wide variety of businesses and ship a number of different products that can be classified into commodity groups: chemicals, coal, grain, paper, grain mill and food products and other commodities. In 1993, two customers accounted for approximately 7% and 6%, respectively, of revenues (no other customer exceeded 5%) and the ten largest customers accounted for approximately 37% of revenues. In order to address more effectively the diversity of the Company's customer base and move toward attainment of the four year growth plan, the Railroad's marketing department was re-organized in 1993 along major commodity groups. The new business units are chemicals and bulk, grain and grain mill, forest products, coal and coke and metals, and intermodal. The formation of separate units enables a fully integrated sales and marketing effort. Specialization allows employees to anticipate and respond to customer needs more quickly, to attract customers who previously used trucks or barges for their service needs, and to establish business relationships with new shippers. These new units work with current and prospective customers to develop customized shipping solutions. Management believes that this commitment to improved customer service has enhanced relations with shippers. The formation of the Intermodal Business Unit underscores the Company's commitment to intermodal through long-term relationships with major participants in this strategic market. By forming a separate business unit, the Railroad has fully integrated its intermodal hub operation with sales and marketing for unmatched control of this highly specialized, customer-oriented service. In 1993, the Railroad invested in 800 new trailers and upgraded facilities to position itself for intermodal growth, dedicated its newest, state- of-the-art terminal, just south of Chicago at the intersections of major expressways, and initiated a major expansion at the Memphis facility with completion anticipated for the first quarter of 1994. To enhance service within its corridor, the Railroad entered into several joint operating agreements in 1992 and 1993 with trucklines and other intermodal carriers. Management anticipates that these relationships will provide better service to customers and seamless transportation of goods for shippers and customers. In 1993, approximately 75% of the Railroad's freight traffic originated on its own lines, of which approximately 29% was forwarded to other carriers. Approximately 20% of the Railroad's freight traffic was received from other carriers for final delivery by the Railroad, and the balance of approximately 5% represented bridge or through traffic. The respective percentage contributions by principal commodity group to the Railroad's freight revenues and revenue ton miles during the past five years are set forth below: CONTRIBUTION TO REVENUE TON MILES BY COMMODITY GROUP(1) COMMODITY GROUP 1993 1992 1991 Chemicals...................... 15.9% 15.1% 16.0% Coal........................... 15.1 18.2 17.0 Grain.......................... 27.9 27.3 27.7 Paper.......................... 9.6 9.0 8.4 Grain mill & food products .... 9.9 9.0 8.3 Intermodal..................... 3.7 3.1 2.9 All other ..................... 17.9 18.3 19.7 ------ ------ ------ Total.......................... 100.0% 100.0% 100.0% ====== ====== ====== - ------------------- (1) A new car tracking system installed in late 1990 affects the comparability of 1993's, 1992's and 1991's ton mile data with that of the prior years, thus prior years are not presented. Some of the elements contained in these commodity groupings are as follows: CHEMICALS ................... A wide variety of chemicals and related products such as chlorine, caustic soda, potash, soda ash, vinyl chloride monomer, carbon dioxide, synthetic resins, alcohols, glycols, styrene monomer, plastics, sulfuric acid, muriatic acid, anhydrous ammonia, phosphates, mixed fertilizer compounds and carbon blacks. COAL......................... Bituminous and metallurgical coal. GRAIN ....................... Corn, wheat, soybeans, sorghum, barley and oats. PAPER........................ Pulpboard, fiberboard, woodpulp, printing paper, newsprint and scrap or waste paper. GRAIN MILL & FOOD PRODUCTS .. Products obtained by processing grain and other farm products such as feed, soybean meal, corn syrup, flour and middlings, animal packinghouse by-products (tallow), canned food, corn oil, soybean oil, vegetable oils, malt liquors, sugar and molasses. INTERMODAL................... A wide variety of products shipped either in containers or trailers on specially designed cars. OTHER........................ Pulpwood and chips, lumber and other wood products; sand, gravel and stone, coke and petroleum products, metallic ores and other bulk commodities; primary and scrap metals, machinery and metal products, appliances, automobiles and parts, transportation equipment and farm machinery; glass and clay products, ordnance and explosives, rubber and plastic products, and general commodities. - ---------------------- (1) Ton mile data for years subsequent to December 31, 1990, are not comparable with prior years because of the installation of a new car tracking system in late 1990. As a result, this information is not meaningful (NM) for 1990 and 1989. (2) Freight train miles equals the total number of miles traveled by the Railroad's trains in the movement of freight. (3) Revenue ton miles of freight traffic equals the product of the weight in tons of freight carried for hire and the distance in miles between origin and destination. (4) Revenue per ton mile equals net freight revenue divided by revenue ton miles of freight traffic. (5) Gallons per ton mile equals the amount of fuel required to move one ton of freight one mile. The following tables summarize operating expense-to-revenue ratios of the Company for each of the past four years, excluding the effect of the $8.9 million pretax special charge in 1992. The ratios for 1989 are not comparable to subsequent years because of the March 17, 1989, change in control and are not presented. The first table analyzes the various components of operating expenses based on the line items appearing on the income statements, whereas the second table is based on functional groupings. - --------------------------- (1) Operating ratio means the ratio of operating expenses before special charge over operating revenues. (2) Transportation ratio means the ratio of transportation expenses (such as expenses of operating, servicing, inspecting, weighing, assembling and switching trains) over operating revenues. (3) Maintenance of way ratio means the ratio of maintenance of way expenses (such as the expense of repairing, maintaining, leasing, depreciating and retiring right- of-way and trackage structures, buildings and facilities) over operating revenues. (4) Maintenance of equipment ratio means the ratio of maintenance of equipment expenses (such as the expense of repairing, maintaining, leasing, depreciating and retiring transportation and other operating equipment) over operating revenues. EMPLOYEES; LABOR RELATIONS Railroad industry personnel are covered by the Railroad Retirement System instead of Social Security. Employer contribution rates under the Railroad Retirement System are currently more than double those in other industries, and may rise further because of the increasing proportion of retired employees receiving benefits relative to the shrinking number of working employees. Labor relations in the railroad industry are subject to extensive governmental regulation under the Railway Labor Act. Railroad industry personnel are also covered by the Federal Employer's Liability Act ("FELA") rather than by state no- fault workmen's compensation systems. FELA is a fault-based system, with compensation for injuries determined by individual negotiation or litigation. The Railroad is a party to several national collective bargaining agreements which establish the wages and benefits of its union workers -- 90% of all Railroad employees. These agreements are subject to renegotiation beginning November 1, 1994, however, cost of living allowance provisions and other terms in each agreement continue until new agreements are reached. Despite being part of a national bargaining group, the Railroad has expressed a desire to negotiate separate distinct agreements with each of its unions on a local basis. Management has been exploring that position and has held several discussions with representatives from most of its unions. It is too early to determine if separate agreements will be reached. Thus, the Railroad has not taken steps to withdraw formally from the national bargaining group. The following table shows the average annual employment levels of the Railroad: 1993 1992 1991 1990 1989 Total employees.. 3,306 3,421 3,611 3,688 3,942 A significant portion of the decline from the 1992 level is the result of a separate agreement between the Railroad and the United Transportation Union, reached in November 1991. This agreement permits the Railroad to reduce the size of all crews on all trains operated. In accordance with this agreement, 158 crew members were severed at a cost of $9.6 million to date. No further dramatic reductions in the current crew size of approximately 2.75 at December 31, 1993 is anticipated. Management believes that additional jobs in all areas may be eliminated over the next several years primarily through attrition and retirements though additional severances are possible. REGULATORY MATTERS; FREIGHT RATES; ENVIRONMENTAL Considerations The Railroad is subject to significant governmental regulation by the ICC and other federal, state and local regulatory authorities with respect to rates, service, safety and operations. The jurisdiction of the ICC encompasses, among other things, rates charged for certain transportation services, issuance of securities, assumption of certain liabilities by railroads, mergers or the acquisition of control of one carrier by another carrier and extension or abandonment of rail lines or services. The Federal Railroad Administration, the Occupational Safety and Health Administration and certain state transportation agencies have jurisdiction over railroad safety matters. These agencies prescribe and enforce regulations concerning car and locomotive safety equipment, track safety standards, employee work conditions and other operating practices. The amount of coal transported by the Railroad is expected to decline somewhat as the Clean Air Act is fully implemented. Much of the coal from mines currently served by the Railroad will not meet the environmental standards of the Clean Air Act without blending or installation of air scrubbers. On the other hand, the Railroad expects to participate in additional movements of Western coal. Overall, management believes that implementation of the Clean Air Act is unlikely to have a material adverse effect on the results of the Company. The Company is and will continue to be subject to extensive regulation under environmental laws and regulations concerning, among other things, discharges into the environment and the handling, storage, transportation and disposal of waste and hazardous materials. Inherent in the operations and real estate activities of the Railroad and other railroads is the risk of environmental liabilities. As discussed in Item 3. "Legal Proceedings," several properties on which the Railroad currently or formerly conducted operations are subject to governmental action in connection with environmental degradation. Additional expenditures by the Railroad may be required in order to comply with existing and future environmental and health and safety laws and regulations or to address other sites which may be discovered. Environmental regulations and remediation processes are subject to future change and cannot be determined at this time. Based on present information, in the opinion of management, the Company has adequate reserves for the costs of environmental investigation and remediation. However, there can be no assurance that environmental conditions will not be discovered which might individually or in the aggregate have a material adverse effect on the Company's financial condition. COMPETITION The Railroad faces intense competition for freight traffic from motor, water, and pipeline carriers and, to a lesser degree, from other railroads. Competition with other railroads and other modes of transportation is generally based on the quality and reliability of the service provided and the rates charged. Declining fuel prices disproportionately benefit trucking operations over railroad operations. The trucking industry frequently is more cost and transit-time competitive than railroads, particularly for distances of less than 500 miles. While deregulation of freight rates under the Staggers Act has greatly increased the ability of railroads to compete with each other and alternate forms of transportation, changes in governmental regulations (particularly changes to the Staggers Act) could significantly affect the Company's competitive position. To a greater degree than other rail carriers the Railroad is vulnerable to barge competition because its main routes are parallel to the Mississippi River system. The use of barges for some commodities, particularly coal and grain, sometimes represents a lower cost mode of transportation. As a result, the Railroad's revenue per ton-mile has generally been lower than industry averages for these commodities. Barge competition and barge rates are affected by navigational interruptions from ice, floods and droughts. These interruptions cause widely fluctuating rates. The Railroad's ability to maintain its market share of the available freight has traditionally been affected by its response to the navigational conditions on the river. Most of the Railroad's operations are conducted between points served by one or more competing carriers. The consolidation in recent years of major midwestern and eastern rail systems has resulted in strong competition in the service territory of the Railroad. LIENS ON PROPERTIES Most of the locomotives and rail cars owned by the Company's financing/leasing subsidiaries are subject to liens. See Note 8 of Notes to Consolidated Financial Statements. LIABILITY INSURANCE The Company is self-insured for the first $5 million of each loss. The Company carries $295 million of liability insurance per occurrence, subject to an annual cap of $370 million in the aggregate for all losses. This coverage is considered by the Company's management to be adequate in light of the Company's safety record and claims experience. ITEM 2.

ITEM 2. PROPERTIES - ------------------- PHYSICAL PLANT AND EQUIPMENT System. As of December 31, 1993, the Railroad's total system consisted of approximately 4,700 miles of track comprised of 2,700 miles of main line, 300 miles of secondary main line and 1,700 miles of passing, yard and switching track. The Railroad owns all of the track except for 190 miles operated by agreements over track owned by other railroads. Track Structures. During the five years ended December 31, 1993, the Railroad has spent $305.3 million on track structure to maintain its rail lines, as follows ($ in millions): Capital Expenditures Maintenance Total 1993 ......... $ 50.3 $ 25.1 $ 75.4 1992 ......... 46.4 23.0 69.4 1991 ......... 36.3 20.7 57.0 1990 ......... 34.6 20.0 54.6 1989 ......... 19.1 29.8 48.9 ------ ------ ------ Total......... $186.7 $118.6 $305.3 ====== ====== ====== These expenditures concentrated primarily on track roadway and bridge rehabilitation in 1993 and 1992. Approximately 1,300 miles and 1,400 miles of road were resurfaced in 1993 and 1992, respectively. Over the last two years, a total of $8.4 million was spent to construct new or expanded intermodal facilities in Chicago and Memphis. Expenditures in 1991 and 1990 benefited from the use of reclaimed rail, cross ties, ballast and other track materials from the second main line when the Railroad's double-track mainline was converted to a single-track mainline with centralized traffic control. Most reclaimed material has now been used and future expenditures will reflect the purchase of new materials. The reduced number of miles of track and the general good condition of the track structure should result in future expenditures approximately equal to the average of 1993 and 1992. Fleet. The Railroad's fleet has undergone significant rationalization and upgrading from its peak in 1985 of 862 locomotives and 28,616 freight cars. Over the last two years older, less efficient locomotives were replaced with newer larger horsepower and more efficient equipment. In 1993, the Company implemented a program to increase ownership of freight cars and locomotives and become less dependent on the leasing market as a source of equipment. Over the last three years the Company, through wholly-owned financing/leasing subsidiaries, has acquired a total of sixty-one (61) 15 to 16 year- old SD-40-2 locomotives and 1,522 freight cars. The 61 locomotives are leased to the Railroad for seven and one-half years. Approximately 650 of the cars acquired are leased to the Railroad as well. The remaining cars are leased to other non- affiliated railroads. When those leases expire, the Railroad has first right of refusal to lease the equipment. As these cars are leased to the Railroad other leased equipment will be returned to the independent, third-party lessors or short-term car hire agreements will be terminated. In 1993, the Railroad acquired 4 SD-40-2 locomotives and also upgraded its highway trailer fleet with 800 newly built trailers which replaced 880 older leased trailers. The following is the overall fleet at December 31: Total Units: 1993 1992 1991 1990 1989 ---- ---- ---- ---- ---- Locomotives(1) 468 449 470 471 516 Freight cars.. 16,634 15,877 16,381 16,526 17,141 Work equipment. 745 902 881 934 1,000 Highway trailers .898 203 124 67 70 (2) - ----------------------- (1) Approximately 100 locomotives need repair before they can be returned to service. This equipment is repaired if needed on an ongoing basis or sold. In 1993 and 1992, the Railroad sold 23 and 66 surplus locomotives, respectively. The active fleet is 322 as of December 31, 1993. (2) Excludes trailers being accumulated for return to lessors. The components of the fleet by subsidiary and in total for 1993 and in total for 1992 are shown below: (1) In addition, approximately 2,735 freight cars and 696 highway trailers were being used by the Railroad under short-term car hire agreements. (2) May be subject to Conditional Sales Agreements. (3) Excludes equipment listed under Leasing Subsidiaries. (4) Excludes trailers being accumulated for return to lessor. Item 3.

Item 3. Legal Proceedings - -------------------------- State of Alabama, et al. v. Alabama Wood Treating Corporation, Inc., et al., S.D. Ala. No. 85-0642-C The State of Alabama and Alabama State Docks ("ASD") filed suit in 1985 seeking damages for alleged pollution of land in Mobile, Alabama, stemming from creosoting operations over several decades. Defendants include the Railroad, which owned the land until 1976, Alabama Wood Treating Corporation, Inc., and Reilly Industries, Inc. ("RII"), which leased the land from the Railroad and conducted creosote operations on the site. In December 1976, the Railroad sold the premises to ASD. The complaint sought payment for the clean-up cost together with punitive and other damages. In 1986, ASD, RII and the Railroad agreed to form a joint technical committee to clean the site sharing equally the cost of clean-up, and in October 1986, the court stayed further proceedings in the suit. Under the agreement the joint technical committee has spent approximately $6.6 million and has been authorized to expend up to a total of $6.9 million. The Railroad has contributed $2.2 million and has agreed to increase its contribution to a total of $2.3 million. Further clean-up activities are anticipated. Under the agreement, if any party disagrees with the amount determined by the joint technical committee to be expended or otherwise disagrees with any aspect of the clean-up, such party may decline further participation and recommence legal proceedings. However, amounts already contributed by any party will be credited against that party's eventual liability and may not be recovered from any other party. Iselin Yard, Jackson, Tennessee In 1991, the Iselin Rail Yard in Jackson, Tennessee was placed on the Tennessee Superfund list. In May 1993, the United States Environmental Protection Agency ("EPA") proposed to add a number of sites, including Iselin Rail Yard to the National Priorities List. The Railroad operated a rail yard and locomotive repair facility at the site. The shop facility was sold in 1986 and the rail yard was sold in 1988. Trichloroethylene ("TCE") has been found in several municipal water wells near the site. TCE is a common component of solvents similar to those believed to have been used at the Iselin shop. In addition, concentrations of metals and organic chemicals have been identified on the surface of the site. No order has been issued by any regulatory agency but the State of Tennessee is monitoring work at the site. The Railroad expects to cooperate with the agencies and other Potentially Responsible Parties to conduct any necessary studies and clean-up activities. The Railroad has commenced a remedial investigation and feasibility study of the site. McComb, Mississippi Elevated levels of lead and other soil contamination has been discovered at the Railroad's facility in McComb, Mississippi. The site was used for many years for sandblasting lead-based paint off freight cars. The Railroad has commenced a formal site investigation under the supervision of the Mississippi Department of Environmental Quality. The Remedial Investigation has disclosed the presence of lead in the soil and further testing of the surface and subsurface soil and groundwater is underway to assess the scope of the contamination. No order has been issued by any regulatory agency. The Railroad expects to cooperate with the State of Mississippi to conduct any necessary studies and clean-up activities. Waste Oil Generation The Railroad was notified in September 1992 that it had been identified as a Potentially Responsible Party at a federal superfund site in West Memphis, Arkansas. The Railroad is alleged to have generated waste oil which was collected by a waste oil refiner who in turn disposed of sludge at the West Memphis landfill. In December 1992, the successor to the refiner initiated legal proceedings to preserve testimony in anticipation of a future contribution action against multiple Potentially Responsible Parties including the Railroad. Similar actions have been taken by the EPA or third parties with respect to waste oil allegedly generated by the Railroad and disposed of in landfills at Livingston, LA, Griffith, IN and Nashville, TN. Based on information currently available, the Railroad believes it has substantial defenses to liability for any contamination at these sites, and that any contribution to the contamination by the Railroad was de minimis. Item 4.

Item 4. Submission of Matters to a Vote of Security Holders ---------------------------------- No matters were submitted to a vote of security holders during the Company's fourth quarter. Item 4A. Executive Officers of the Registrant - ---------------------------------------------- The executive officers of the Company are identified in the table below. Each executive officer of the Company currently holds an identical position with the Railroad. Executive officers of the Company and the Railroad serve at the pleasure of the respective Boards of Directors. Name Age Position(s) ---- --- ----------- Gilbert H. Lamphere 41 Chairman of the Board of Directors E. Hunter Harrison 49 President and Chief Executive Officer, Director Gerald F. Mohan 53 Senior Vice President - Marketing John D. McPherson 47 Vice President - Operations James M. Harrell 41 Vice President - Human Resources David C. Kelly 49 Vice President - Maintenance Ronald A. Lane 43 Vice President and General Counsel and Secretary Dale W. Phillips 39 Vice President and Chief Financial Officer John V. Mulvaney 43 Controller BIOGRAPHICAL INFORMATION The following sets forth the periods during which the executive officers of the Company and the Railroad have served as such and a brief account of the business experience of such persons during the past five years. Mr. Lamphere was elected Chairman of the Board of Directors of the Company and the Railroad in February 1993. He has been a director of the Company and the Railroad since 1989 and Chairman of the Executive Committee of the Board since July 1990. Mr. Lamphere has been Co-Chairman and Chief Executive Officer of The Noel Group, Inc. ("Noel"), a diversified operating company since 1991, and a director of Noel since March 1990. Mr. Lamphere also is the Chairman, Chief Executive Officer and a director of Prospect, for which he has served in various capacities since becoming a director in 1983. Mr. Harrison was appointed President, Chief Executive Officer and a Director of the Company and the Railroad in February 1993. He joined the Company and the Railroad as Vice President and Chief Transportation Officer in 1989. In November 1991 he was appointed Senior Vice President - Transportation and was named Senior Vice President - - Operations in July 1992. He was employed by Burlington Northern Railway in various vice presidential positions from 1985 to 1989. Mr. Mohan was appointed Senior Vice President - - Marketing of the Railroad in 1986. In April 1993 he was elected a Director of the Railroad. He was appointed to his present position with the Company in December 1989. Mr. McPherson joined the Company and the Railroad in his current position in July 1993. Prior to joining the Company and the Railroad, he held various positions with the Atchison, Topeka and Santa Fe Railway Company from 1966 to 1993, most recently as Assistant Vice President - Safety. Mr. Harrell joined the Company and the Railroad in his current position in 1992. He served as Director of Labor Relations for The Atchison, Topeka and Santa Fe Railway Company from 1989 to 1992. From 1974 to 1989 he held various positions with The Atchison, Topeka and Santa Fe Railway Company. Mr. Kelly joined the Company and the Railroad as Vice President and Chief Engineer in 1989. In January 1994, he was appointed Vice President - Maintenance. He served as Assistant Chief Engineer - - Systems of CSX Transportation from 1987 to 1989. Mr. Lane joined the Company and the Railroad as Vice President and General Counsel and Secretary in 1990. In April 1993 he was elected a Director of the Railroad. He was previously employed by The Atchison, Topeka and Santa Fe Railway Company and Santa Fe Pacific Corporation serving as Assistant Vice President - Personnel and Labor Relations, 1987 to 1990. Mr. Phillips has been employed by the Railroad since February 1988, serving as Director of Taxes & Property Accounting from February to October 1988, as Assistant Controller from October 1988 to April 1989, and Controller from April 1989 to April 1990. He was appointed to his present position in the Company and the Railroad in April 1990. In April 1993 he was elected a Director of the Railroad. Mr. Phillips also serves as a director of Rail Association Insurance, Ltd. Mr. Mulvaney joined the Company and the Railroad as Controller in June 1990. He was previously employed by Navistar International Transportation Corp., serving as Director of Accounting, 1987 to 1990. No family relationship exists among the officers of the Company or the Railroad. PART II ------- ITEM 5.

ITEM 5. MARKET FOR THE REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS - -------------------------------------------------- The following table sets forth, for the periods indicated, (i) the high and low sale prices of the Common Stock as reported on the New York Stock Exchange Composite Tape, adjusted for the February 1992 3-for-2 stock split, and (ii) the per share amount of dividends paid. STOCK PRICE DIVIDENDS HIGH LOW PER SHARE First Quarter.. $25.500 $21.083 $ - Second Quarter. 24.875 20.250 .10 Third Quarter.. 22.375 16.500 .10 Fourth Quarter. 25.625 18.250 .15 First Quarter.. $27.250 $23.625 $ .15 Second Quarter. 30.125 25.375 .15 Third Quarter.. 32.750 26.625 .17 Fourth Quarter. 36.000 29.250 .17 First Quarter $38.625 $33.500 $ .21 (through March 1) As of March 1, 1994, there were approximately 11,000 stockholders based on estimates of beneficial ownership. The closing price of the Common Stock as reported on the New York Stock Exchange Composite Tape on March 1, 1994 was $35.75 per share. On February 10, 1994, the Board declared a dividend of $.21 per share payable April 7, 1994, to stockholders of record on March 24, 1994. Prior to April 1992, the Company had not previously paid cash dividends on its Common Stock. See "Management's Discussion and Analysis of Financial Condition and Results of Operations - Liquidity and Capital Resources," for a discussion of the restrictions on the Railroad's ability to transfer funds as dividends to the Company. The Common Stock is listed on the New York Stock Exchange, Inc. under the symbol "IC." ITEM 6.

ITEM 6. SELECTED FINANCIAL DATA - -------------------------------- The following table sets forth selected historical consolidated financial data of the Company for the four years ended December 31, 1993, and for the period January 27, 1989 the date on which the Company was incorporated, through December 31, 1989, and selected historical consolidated financial data of the Railroad as predecessor of the Company for the period January 1, 1989, through March 16, 1989, all derived from the consolidated financial statements of the Company which were audited by Arthur Andersen & Co. This summary should be read in conjunction with the consolidated financial statements included elsewhere in this Report and the schedules and notes thereto. The purchase method of accounting was used to record the assets acquired and liabilities assumed by the Company in 1989. The following notes are an integral part of the consolidated financial statements. The following notes are an integral part of the consolidated financial statements. The following notes are an integral part of the consolidated financial statements. The following notes are an integral part of the consolidated financial statements. 1. THE COMPANY Illinois Central Corporation, a holding company, (hereinafter, the "Company") was incorporated under the laws of Delaware. The Company was formed originally for the purpose of acquiring, through a wholly-owned subsidiary, the outstanding common stock of Illinois Central Transportation Company ("ICTC"). Following a tender offer and several mergers, the Illinois Central Railroad Company ("Railroad") is the surviving corporation and the successor to ICTC and now a wholly-owned subsidiary of the Company. 2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES PRINCIPLES OF CONSOLIDATION The consolidated financial statements include the accounts of the Company and its subsidiaries. Significant investments in affiliated companies are accounted for by the equity method. Transactions between consolidated companies have been eliminated in the accompanying consolidated financial statements. PROPERTIES Depreciation is computed by the straight-line method and includes depreciation on properties under capital leases. The depreciation rates for the equipment owned by the Company's finance subsidiary are based on estimated useful life and anticipated salvage value. Lives used range from 18 to 20 years. At the Railroad, depreciation for track structure, other road property, and equipment is calculated using the composite method. In the case of routine retirements, removal cost less salvage recovery is charged to accumulated depreciation. Expenditures for maintenance and repairs are charged to operating expense. The Interstate Commerce Commission ("ICC") approves the depreciation rates used by the Railroad. In 1991, the Railroad completed a study which resulted in revised depreciation rates for road properties (excluding track properties) and equipment. The revised rates did not and will not have a significant effect on operating results. The approximate ranges of annual depreciation rates for major property classifications are as follows: Road properties .................1% - 8% Transportation equipment ........1% - 7% In 1989, the Company initiated a program to convert approximately 500 miles of double track main line to a single track main line, with a centralized traffic control system. This program was completed successfully in 1991. REVENUES Revenues are recognized based on services performed and include estimated amounts relating to movements in progress for which the settlement process is not complete. Estimated revenue amounts for movements in progress are not significant. INCOME TAXES Effective January 1, 1992, the Company adopted the Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes" ("SFAS No. 109"). Under SFAS No. 109, deferred income taxes are accounted for on the asset and liability method by applying enacted statutory tax rates to differences ("temporary differences") between the financial statement carrying amounts and the tax bases of assets and liabilities. The resulting deferred tax assets and liabilities represent taxes to be collected or paid in the future when the related assets and liabilities are recovered and settled, respectively. See Note 10 for discussion of the 1992 impact of adopting SFAS No. 109. CASH AND TEMPORARY CASH INVESTMENTS Cash in excess of operating requirements is invested in certain funds having original maturities of three months or less. These investments are stated at cost, which approximates market value. INCOME PER SHARE Income per common share of the Company is based on the weighted average number of shares of common stock and common stock equivalents outstanding for the period. Dilution, which could result if all outstanding common stock equivalents were exercised, is not significant. FUTURES, OPTIONS, CAPS, FLOORS AND FORWARD CONTRACTS In March 1990, the FASB issued Statement of Financial Accounting Standards No. 105 "Disclosure of Information about Financial Instruments with Off Balance Sheet Risk and Financial Instruments with Concentration of Credit Risk" ("SFAS 105"). Disclosures required by SFAS 105 are found in various notes where the financial instruments or related risks are discussed. See specifically Notes 6, 7, 8, and 13. CASUALTY AND FREIGHT CLAIMS The Company accrues for injury and damage claims outstanding based on actual claims filed and estimates of claims incurred but not filed. Estimated amounts expected to be settled within one year are classified as current liabilities in the accompanying Consolidated Balance Sheets. EMPLOYEE BENEFIT PLANS All employees of the Railroad are covered under the Railroad Retirement Act. In addition, management employees of the Railroad are covered under a defined contribution plan. Contribution costs of the plan are funded currently. Mr. E. L. Moyers, former Chairman, President and Chief Executive Officer ("Mr. Moyers") is covered by a supplemental plan which is discussed in Note 9. Effective January 1, 1993, the Company adopted both the Statement of Financial Accounting Standards No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions" ("SFAS No. 106") and the Statement of Financial Accounting Standards No. 112, "Employers' Accounting for Postemployment Benefits" ("SFAS No. 112"). SFAS No. 106 requires that future costs associated with providing postretirement benefits be recognized as expense over the employees' requisite service period. The pay-as-you-go method used prior to 1993 recognized the expense on a cash basis. SFAS No. 112 establishes accounting standards for employers who provide postemployment benefits and clarifies when the expense is to be recognized. In accordance with the provisions of these standards, years prior to 1993 have not been restated. See Note 9 for discussion of the impact of adopting SFAS No. 106 and SFAS No. 112. RECLASSIFICATIONS Certain items relating to prior years have been reclassified to conform to the presentation in the current year. 3. EXTRAORDINARY ITEM AND REFINANCING The 1993 extraordinary loss resulted from the retirement of the Railroad's 14-1/8% Senior Subordinated Debentures (the "Debentures") and refinancing the Permanent Facility. The loss was $23.4 million, net of tax benefits of $12.6 million. The loss resulted from the premium paid, the write-off of unamortized financing fees and debt discount and costs associated with the calling of the $10.3 million of Debentures not tendered. The net proceeds of the 6.75% Notes (see Note 8), borrowings under the $180 million Revolving Credit Facility and other available cash were used to fund the retirement of the Debentures. 4. OTHER INCOME, NET Other Income, Net consisted of the following ($ in millions): Years Ended December 31, 1993 1992 1991 Income, net.............. $ 3.9 $ 3.8 $ 3.0 Net gains on real estate sales................... .8 .4 .7 Net gain (loss) on disposal of rolling stock........ (2.3) - - Equity in undistributed earnings of affiliates.. .5 .3 .4 Net gain on Series K..... - - 3.6 Other, net............... (1.2) (2.5) (2.0) ------ ------ ------ Other Income, Net....... $ 1.7 $ 2.0 $ 5.7 5. SUPPLEMENTAL CASH FLOW INFORMATION Cash changes in components of working capital, exclusive of Current Maturities of Long-Term Debt, included in the Consolidated Statements of Cash Flows were as follows ($ in millions): Years Ended December 31, 1993 1992 1991 Receivables, net.... $ (3.9) $ 4.7 $ (2.6) Materials and supplies (1.4) (3.2) (.6) Other current assets.. (1.5) .3 1.0 Accounts payable... 1.1 (5.7) (5.0) Income taxes payable 13.6 .5 (5.4) Accrued redundancy reserves............ (2.6) (11.0) (11.7) Other current liabilities......... (6.1) (1.4) (.4) ------- -------- -------- $ (.8) $ (15.8) $ (24.7) Included in changes in Other Liabilities and Reserves is approximately $6.3 million and $23.4 million for the years ended December 31, 1993 and 1992, respectively, reflecting proceeds from the settlement of casualty claims with numerous insurance carriers. In 1993, the Railroad entered into a capital lease for 200 covered hoppers. The lease expires in 2003. See Note 7 for a recap of the present value of the minimum lease payments. In 1991, the Railroad retired several Long- Term Debt obligations, most significantly its $150 million 15.5% Series K First Mortgage Bonds ("Series K"). These retirements resulted in non- cash reductions of debt balances of $4.6 million. Also, in 1991 the balance of a long term investment was reduced by $2.5 million. 6. MATERIALS AND SUPPLIES Materials and Supplies, valued using the average cost method, consist of track material, switches, car and locomotive parts and fuel. The Railroad entered into various hedge agreements designed to mitigate significant changes in fuel prices. As a result, approximately 93% of the short-term diesel fuel requirements through March 1995 and 46% through June 1995 are protected against significant price changes based on the average near-by contract for Heating Oil #2 traded on the New York Mercantile Exchange. 7. LEASES As of December 31, 1993, the Company leased 6,709 of its cars and 166 of its locomotives. The majority of these leases have original terms of 15 years and expire between 1994 and 2001. Under the terms of the majority of its leases, the Company has the right of first refusal to purchase, at the end of the lease terms, certain cars and locomotives at fair market value. Other leases include office and computer equipment, vehicles and office facilities. Net obligations under capital leases at December 31, 1993 and 1992, included in the Consolidated Balance Sheets are $5.4 million and $.2 million, respectively. At December 31, 1993, minimum rental payments under capital and operating leases that have initial or remaining noncancellable terms in excess of one year were as follows ($ in millions): Capital Operating Leases Leases 1994 ............................$ .9 $ 34.6 1995 ............................ .9 28.4 1996 ............................ .8 19.3 1997 ............................ .8 7.8 1998 ............................ .8 4.2 Thereafter ...................... 3.1 17.4 ---- ------ Total minimum lease payments... 7.3 $111.7 Less: Imputed interest .......... 1.9 Present value of minimum ---- payments..................... $5.4 Total rent expense applicable to noncancellable operating leases amounted to $45.2 million in 1993, $46.2 million for 1992 and $48.5 million for 1991. Most of the leases provide that the Company pay taxes, maintenance, insurance and certain other operating expenses. 8. LONG-TERM DEBT AND INTEREST EXPENSE Long-Term Debt at December 31, consisted of the following ($ in millions): At December 31, 1993, the aggregate annual maturities and sinking fund requirements for debt payments for 1994 through 1999 and thereafter are $24.3 million (includes bridge financing of $21.7 million (see below)), $2.3 million, $80.6 million, $2.7 million, $57.6 million, $61.2 million and $155.9 million, respectively. The weighted- average interest rate for 1993 and 1992 on total debt excluding the effect of discounts, premiums and related amortization was 9.1% and 10.8%, respectively. In November 1993, the Railroad initiated a public commercial paper program. The commercial paper is rated A2 by S&P, by Fitch and P3 by Moody's and is supported by a new $100 million Revolver with the Railroad's bank lending group. The Railroad views this program as a significant long-term funding source and intends to issue replacement notes as maturities occur. Therefore, the $38.1 million outstanding at December 31, 1993 has been classified as long-term. In connection with the commercial paper program, the bank lending group agreed to replace the $180 million Revolving Credit Facility (see below) with (i) a new $100 million Revolver, due 1996 and (ii) a $50 million 364-day facility due October 1994 ("Bank Line"). The new Revolver will be used primarily for backup for the commercial paper but can be used for general corporate purposes. The available amount is reduced by the outstanding amount of commercial paper borrowings and any letters of credit issued on behalf of the Railroad under the facility. No amounts have been drawn under the Revolver. The $100 million was limited to $57.9 million because $38.1 million in commercial paper was outstanding and $4.0 million in letters of credit had been issued. The Bank Line was structured as a 364-day renewable instrument and the Company intends to renew it on an on-going basis. The $40 million outstanding at December 31, 1993, has therefore been classified as long-term. The Company's financing/leasing subsidiaries have approximately $13.0 million in long-term borrowing agreements which were used to acquire a total of 61 locomotives during 1993 and 1991. Such borrowings are secured by equipment which is leased to the Railroad. These agreements mature in 1999 and 2000. One subsidiary used a short- term bridge financing of $21.7 million to acquire 1,522 box cars in December 1993. The bridge financing must be repaid or refinanced prior to March 3, 1994. The Company expects to refinance this debt with either a seven year floating or fixed rate term loan or a combination revolving facility and term loan also with a floating or fixed rate. During April 1993, the Company and the Railroad reached an agreement with its bank lending group and the holders of the privately placed $160 million Senior Secured Notes ("Senior Notes") for a release of all collateral and those instruments are now unsecured. The bank agreed to replace the Permanent Facility with a $180 million Revolving Credit Facility. This was done in connection with the tender offer made by the Railroad for all of the Debentures. The tender offer was funded by issuance of new $100 million 6.75% Notes, due 2003 (the "Notes"), borrowing under a $180 million Revolving Credit Facility negotiated with the banks which replaced the Permanent Facility and cash on hand. See Note 3 for discussion of the extraordinary loss incurred upon tender for the Debentures. The Railroad irrevocably placed $12.6 million on deposit with a trustee to cover principal, a 6% premium and interest through the first call date of October 1, 1994, for the untendered Debentures. The Notes (issued at a slight discount 1.071%) pay interest semiannually in May and November and are covered by an Indenture. Of the Senior Notes, $109.8 million bears interest at a rate of 10.02% and $50 million at 10.4%. Principal payments of $55 million are due in each of 1998 and 1999, and $25 million in each of 2000 and 2001. The Senior Notes are governed by a Note Purchase Agreement. Various borrowings of the Company's subsidiaries are governed by agreements which contain certain affirmative and negative covenants customary for facilities of this nature including restrictions on additional indebtedness, investments, guarantees, liens, distributions, sales and leasebacks, and sales of assets and capital stock. Some also require the Railroad to satisfy certain financial tests, including a leverage ratio, an earnings before interest and taxes to interest charges ratio, debt service coverage, and minimum consolidated tangible net worth requirements. The Railroad may be required to apply 100% of net after-tax proceeds of sales aggregating $2.5 million or greater of certain assets to reduce Revolver commitments. The holders of the Senior Notes can elect to receive a pro-rata share of after-tax proceeds. Interest Expense, Net consisted of the following ($ in millions): Years Ended December 31, 1993 1992 1991 ---- ---- ---- Interest expense........ $35.2 $46.2 $59.7 Less: Interest capitalized..... .8 .6 .4 Interest income..... 1.3 2.0 4.2 ----- ----- ----- Interest Expense, Net... $33.1 $43.6 $55.1 9. EMPLOYEE BENEFIT PLANS Retirement Plans. All employees of the Railroad are covered under the Railroad Retirement Act. In addition, management employees of the Railroad are covered under a defined contribution plan. Contributions under the plan vest immediately. Expenses relating to the defined contribution plan were $.4 million for each of the years ended December 31, 1993, 1992 and 1991. Mr. Moyers is covered by a non-qualified, unfunded supplemental retirement benefit agreement which provides for a defined benefit payable annually, commencing upon death, permanent disability or retirement (with benefits arising from retirement commencing upon his attaining age 65 and compliance with certain non-competition agreements), in the amount of $250,000 per year for a maximum of 15 years. In accordance with the term of the agreement, no payments will be made while Mr. Moyers is employed by another Class I railroad. The present value of this agreement was included in the 1992 special charge. See Note 15. Postretirement Plans. In addition to the Company's defined contribution plan for management employees, the Company has three benefit plans which provide some postretirement benefits to most former full-time salaried employees and selected former union represented employees. The medical plan for salaried retirees is contributory, with retiree contributions adjusted annually if expected inflation rate exceeds 9.5%, and contains other cost sharing features such as deductibles and co-payments. The Company's contribution will be fixed at the 1999 year end rate for all subsequent years. Salaried retirees are covered by a life insurance plan which provides a nominal death benefit and is non-contributory. The medical plan for locomotive engineers who retired under a special early retirement program in 1987 provides non-contributory coverage until age 65. All benefits under this plan terminate in 1998. There are no plan assets and the Company will continue to fund these benefits as claims are paid as was done in prior years. Postemployment Benefit Plans. The Company provides certain postemployment benefits such as long-term salary continuation and waiver of medical and life insurance co-payments while on long-term disability. SFAS No. 106 and SFAS No.112. As described in Note 2 effective January 1, 1993 the Company adopted SFAS No. 106 and SFAS No. 112. With respect to SFAS No. 106, the Company elected to immediately recognize the transition asset associated with adoption which resulted because the Company had previously recorded an amount under purchase accounting to reflect the estimated liability for such benefits as of the acquisition date of ICTC. As a result of adopting these two standards, the Company recorded a decrease to net income of $84,000 (net of taxes of $46,000) as a cumulative effect of changes in accounting principles ($ in millions): Postretirement Benefits (SFAS No. 106): APBO at January 1, 1993: Medical......................... $36.5 Life............................ 2.3 ----- Total APB................. 38.8 Liability previously recorded..... (40.3) ----- Transition Asset.......... 1.5 Postemployment Benefits Obligation at January 1, 1993 (SFAS 112)..... (1.6) ----- Pre-tax Cumulative Effect of Changes in Accounting Principles.......... (.1) Related tax benefit.................. - ----- Cumulative Effect of Changes in Accounting Principles.......... $ (.1) ===== Per Share Impact..................... $ - ===== In accordance with each standard, years prior to 1993 have not been restated. For 1993, the adoption of these two standards had no significant effect on income before cumulative effect of changes in accounting principles as compared to the Company's prior pay-as-you-go method of accounting for such benefits. The accumulated postretirement benefit obligations ("APBO") of the postretirement plans were as follows ($ in millions): January December 31, 1993 1, 1993 Medical Life Total Total Accumulated post- retirement benefit obligation: Retirees....... $26.4 $ 2.4 $28.8 $33.4 Fully eligible active plan participants.. .7 - .7 .7 Other active plan participants.. 4.7 - 4.7 4.7 ----- ----- ----- ----- Total APBO.... $31.8 $ 2.4 34.2 38.8 Unrecognized net gain.......... 5.0 - Accrued liability for post- retirement benefits....... $39.2 $38.8 ===== ===== The weighted-average discount rate used in determining the accumulated post-retirement benefit obligation was 8.0% at January 1, 1993. As a result of the Company's improved financial condition and recognizing the overall shift in the financial community, the Company lowered the weighted-average discount rate to 7.25% as of December 31, 1993. The change in rates resulted in approximately $2.0 million actuarial loss. The loss was offset by actual experience gains, primarily fewer claims and lower medical rate inflation, which resulted in a $5.0 million unrecognized net gain as of December 31, 1993. The components of the net periodic postretirement benefits cost for 1993 were as follows ($ in millions): Service costs........................ $ .1 Interest costs....................... 3.0 Net amortization of Corridor excess.. - ----- Net periodic postretirement benefit costs...................... $ 3.1 The weighted-average annual assumed rate of increase in the per capital cost of covered benefits (e.g., health care cost trend rate) for the medical plans is 14.0% for 1993 and is assumed to decrease gradually to 6.25% by 2001 and remain at that level thereafter. The health care cost trend rate assumption normally has a significant effect on the amounts reported; however, as discussed, the plan limits annual inflation for the Company's portion of such costs to 9.5% each year. Therefore, an increase in the assumed health care cost trend rates by one percentage point in each year would have no impact on the Company's accumulated postretirement benefit obligation for the medical plans as of December 31, 1993, or the aggregate of the service and interest cost components of net periodic postretirement benefit expense in future years. 10. PROVISION FOR INCOME TAXES Effective January 1, 1992, the Company adopted the Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes" ("SFAS No. 109"). As a result, the Company recorded a $23.4 million ($.55 per share) reduction in its accrued net deferred income tax liability as of January 1, 1992. The gain recorded upon adoption could not be recognized previously in accordance with SFAS No. 96 which the Company had adopted in 1988. The Company elected to report this change as the cumulative effect of a change of accounting principle. Therefore, prior year amounts were not restated. On August 10, 1993, the Omnibus Budget Reconciliation Act of 1993, which contains a deficit reduction package, became law. Certain aspects of the Act directly affect the Company. Most significantly, the new law increased the maximum corporate federal income tax rate from 34% to 35% retroactive to January 1, 1993. This change required the Company to record additional deferred income tax expense of approximately $3.1 million to reflect the new tax rate's impact on net deferred income tax liability as of January 1, 1993. The higher corporate rate is not anticipated to significantly affect the Company's cash flow. The Provision for Income Taxes for continuing operations consisted of the following ($ in millions): Years Ended December 31, 1993 1992 1991 ---- ---- ---- Current income tax: Federal............. $23.6 $14.4 $ 9.4 State............... .9 1.6 1.0 Deferred income taxes. 31.9 21.4 20.4 ----- ----- ----- Provision for Income Taxes............... $56.4 $37.4 $30.8 The effective income tax rates for the years ended December 31, 1993, 1992 and 1991, were 38%, 34% and 32%, respectively. See Note 3 for the tax benefits associated with the extraordinary loss. The items which gave rise to differences between the income taxes provided for continuing operations in the Consolidated Statements of Income and the income taxes computed at the statutory rate are summarized below ($ in millions): Temporary differences between book and tax income arise because the tax effects of transactions are recorded in the year in which they enter into the determination of taxable income. As a result, the book provisions for taxes differ from the actual taxes reported on the income tax returns. The net results of such differences are included in Deferred Income Taxes in the Consolidated Balance Sheets. The Company has an Alternative Minimum Tax ("AMT") carryforward credit of $.1 million at December 31, 1993. This excess of AMT over regular tax can be carried forward indefinitely to reduce future U.S. Federal income tax liabilities. At December 31, 1993, this credit was used to reduce the recorded deferred tax liability. At December 31, 1993, the Company, for tax or financial statement reporting purposes, had no net operating loss carryovers. Deferred Income Taxes consisted of the following ($ in millions): December 31, ----------------------- 1993 1992 Deferred tax assets... $ 82.2 $ 114.4 Less: Valuation allowance. (2.2) (3.3) Deferred tax assets, net of valuation allowance 80.0 111.1 Deferred tax liabilities. (259.5) (258.2) --------- --------- - - Deferred Income Taxes.... $ (179.5) $ (147.1) The valuation allowance is comprised of the portion of state tax net operating loss carryforwards expected to expire before they are utilized and non-deductible expenses incurred with the previous merger of wholly-owned subsidiaries. Major types of deferred tax assets are: reserves not yet deducted for tax purposes ($64.0 million) and safe harbor leases ($11.8 million). Major types of deferred tax liabilities are: accelerated depreciation ($206.2 million), land basis differences ($10.3 million) and debt marked to market ($2.1 million). The Company and the Railroad have a tax sharing agreement whereby the Railroad's federal tax liability and combined state tax liabilities (if any) are the lesser of (i) the Railroad's separate consolidated liability as if it were not a member of the Company's consolidated group or (ii) the Company's consolidated liability computed without regard to any other subsidiaries of the Company. The Company and its financing/leasing subsidiaries have a tax sharing agreement whereby the subsidiary's federal income tax and state income tax liabilities are determined on a consolidated, or combined state income tax basis as if it were not a member of the Company's consolidated group, with no benefit for prior net operating losses or credit carryovers from prior years. 11. COMMON STOCK AND DIVIDENDS The Company is authorized to issue 65,000,000 shares of Common Stock, par value $.001. At December 31, 1993, there were 42,614,566 shares of Common Stock outstanding. Each holder of Common Stock is entitled to one vote per share in the election of directors and on all matters submitted to a vote of stockholders. Subject to the rights and preferences of redeemable preferred stock, if any, each share of Common Stock is entitled to receive dividends as may be declared by the Board of Directors out of funds legally available and to share ratably in all assets available for distribution to stockholders upon dissolution or liquidation. No holder of Common Stock has any preemptive right to subscribe for any securities of the Company. No shares of preferred stock were outstanding at December 31, 1993 and 1992. On February 4, 1992, the Board of Directors authorized a three-for-two stock split on Common Stock. The split was in the form of a stock dividend and was paid on February 28, 1992. Fractional shares were settled for cash. A total of 14,132,058 shares were issued from authorized but unissued shares. In 1992, the Board of Directors initiated a policy of quarterly dividends on the Common Stock of the Company. Future dividends may be dependent on the ability of the Railroad to pay dividends to the Company. Certain covenants of the Railroad's debt restrict the level of dividends it may pay to the Company. At December 31, 1993, approximately $76 million was free of such restrictions. The Company awarded 25,000 shares and 150,000 shares of restricted stock to eligible employees of the Railroad in 1993 and 1992, respectively. No cash payments are required by the individuals. Shares awarded under the plans may not be sold, transferred, or used as collateral by the holders until the shares awarded become free of the restrictions. Restrictions lapse over a four-year period. All shares still subject to restrictions will be forfeited and returned to the plan if the employee's relationship with the Railroad is terminated. A total of 13,500 shares were forfeited in 1993. If the employee becomes disabled, or dies, or a change in control occurs during the vesting period, the restrictions will lapse at that time. The compensation expense resulting from the award of restricted stock is valued at the closing market price of the Company's Common Stock on the date of the award, recorded as a reduction of Stockholders' Equity, and charged to expense evenly over the service period. Compensation expense was $.8 million and $.5 million in 1993 and 1992, respectively. In 1992, the Company awarded 200,000 shares to Mr. Moyers as well. Of this amount, 133,000 were vested upon his retirement in 1993. The remaining 67,000 were forfeited in 1993 when Mr. Moyers was employed by another Class I railroad. See Note 15. 12. COMPENSATION AND STOCK OPTIONS Stock Purchase Plan. Under the Company's 1990 Stock Purchase Plan (the "Stock Plan"), 736,380 shares (post split) of Common Stock were made available from shares held by Prospect for sale to key employees and officers of the Company other than Mr. Moyers, as determined by the Company's Board of Directors. Shares so awarded were sold at a price of $.10 per share (post split)(which was Prospect's approximate original per share cost for such stock as adjusted for the 3 for 2 stock split in February 1992). In general, shares awarded pursuant to the Stock Purchase Plan are restricted for a period of four years and vest at a rate of 25% per year. At December 31, 1993, only 130,313 shares are restricted. All shares will vest prior to June 30, 1994, with 126,563 vesting on or before April 1, 1994. Unvested shares are subject to repurchase by the Company at a price of $.267 per share upon the termination of the participant's employment, other than as a result of death or permanent disability. The unawarded shares (63,270) and those repurchased in 1991 are now classified as Treasury Stock. Long-Term Incentive Plan. Under the Company's 1990 Long-Term Incentive Plan (the "Long-Term Incentive Plan") shares of Common Stock are available for issuance upon the exercise of incentive options that may be awarded by the Compensation Committee to directors and selected salaried employees of the Company and its affiliates and to certain other individuals who possess the potential to contribute to the future success of the Company. The Compensation Committee also has the authority under the Long- Term Incentive Plan to award stock appreciation rights, restricted stock and restricted stock units, dividend equivalents and other stock-based awards, and to determine the consideration to be paid by the participant for any awards, any limits on transfer of awards, and, within certain limits, other terms of awards. In the case of options (other than options granted to directors who are not full-time employees of the Company ("Outside Directors"), as described below) granted under the Long-Term Incentive Plan, the Committee has the power to determine the exercise price of the option (which cannot be less than 50% of the fair market value on the date of grant of the shares subject to the option), the term of the option, the time and method of exercise and whether the options are intended to qualify as "incentive stock options" pursuant to Section 422A of the Internal Revenue Code. Outside Directors of the Company also participate in the Long-Term Incentive Plan and are granted an option to purchase 15,000 shares of Common Stock upon initial appointment or election. In addition, Outside Directors as of November 1990 were granted options to purchase an additional 10,000 shares, which grants were approved at the 1991 Annual Meeting of Stockholders. Also on the date of each Annual Meeting, each Outside Director of IC who serves immediately prior to such date and who will continue to serve after such date (whether as a result of such director's re- election or by reason of the continuation of such director's term), will be granted an option to purchase 1,500 shares of Common Stock. Options granted to Outside Directors entitle such persons to purchase Common Stock at the fair market value of such Common Stock on the date the option was granted. Options held by Outside Directors expire 10 years from the date of grant, or, if earlier, one year following termination of service as a director for any reason other than death or disability. Such options become exercisable in full six months after their date of grant. At the 1993 Annual Meeting, the stockholders authorized an additional one million shares to be available for issuance under the Long-Term Incentive Plan. The following table summarizes the shares available for award under the Incentive Plan for the year ended December 31, 1993: Reserved shares at beginning of year........... 904,000 Options exercised............ (49,500) Restricted stock awarded..... (25,000) (74,500) -------- -------- Subtotal.................. 829,500 Increase in authorized shares. 1,000,000 Shares of restricted stock forfeited.................... 80,500 Change in options outstanding during year.................. (482,500) --------- Shares available for award at end of year............... 1,427,500 The following table summarizes changes in shares under option for the year ended December 31, 1993: Last Date Exercisable 4-21-2003 11-23-2003 The Compensation Committee awarded stock options to employees under the Long-Term Incentive Plan for the first time in 1993. Awards, all at fair market value, vest ratably over four years and expire 10 years from date of grant. In 1993, Outside Directors exercised 7,500 options at $12.00 per share when the market price was $25.625 per share, 7,500 options at $12.00 per share when the market price was $27.875 per share and a total of 34,500 options at prices ranging from $8.000 per share to $27.750 per share when the market price was approximately $33.00 per share. See Notes 11 and 15 for a discussion of the restricted stock issued under the Long-Term Incentive Plan. 13. CONTINGENCIES, COMMITMENTS AND CONCENTRATION OF RISKS The Company has unconditionally guaranteed its finance subsidiary's $32.1 million obligations. The Company is self-insured for the first $5 million of each loss. The Company carries $295 million of liability insurance per occurrence, subject to an annual cap of $370 million in the aggregate for all losses. This coverage is considered by the Company's management to be adequate in light of the Company's safety record and claims experience. As of December 31, 1993, the Company had $4.0 million of letters of credit outstanding as collateral primarily for surety bonds executed on behalf of the Company. Such letters of credit expire in 1994 and are automatically renewable for one year. The letters of credit reduced the maximum amount that could be borrowed under the Revolver (see Note 8). The Company has guaranteed repayment of certain indebtedness of a jointly owned company aggregating $7.8 million. The Company's primary share is $1.0 million; the remainder is a primary obligation of other unrelated owner companies. There are various regulatory proceedings, claims and litigation pending against the Company. While the ultimate amount of liability that may result cannot be determined, in the opinion of the Company's management, based on present information, adequate provisions for liabilities have been recorded. See "Management's Discussion and Analysis - Other" for a discussion of environmental matters. 14. DISCLOSURES ABOUT FAIR VALUE OF FINANCIAL INSTRUMENTS The following methods and assumptions were used to estimate the fair value of each class of financial instruments for which it is practicable to estimate that value: Cash and temporary cash investments. The carrying amount approximates fair value because of the short maturity of those instruments. Investments. The Company has investments of $10.3 million in 1993 and $11.1 million in 1992 for which there are no quoted market prices. These investments are in joint railroad facilities, railroad terminal associations, switching railroads and other transportation companies. For these investments, the carrying amount is a reasonable estimate of fair value. The Company's remaining investments ($5.4 million in 1993 and $3.9 million in 1992) are accounted for by the equity method. Long-term debt. The fair value of the Company's long-term debt is estimated based on the quoted market prices for the same or similar issues or on the current rates offered to the Company for debt of the same remaining maturities. Fuel hedge agreements. The fair value of fuel hedging agreements is the estimated amount that the Company would receive or pay to terminate the agreements as of year end, taking into account the current credit worthiness of the agreement counterparties. At December 31, 1993 and 1992, the fair value was a liability of $4.6 million and less than $.1 million, respectively. The estimated fair values of the Company's financial instruments at December 31, are as follows ($ in millions): 15. SPECIAL CHARGE In 1992, the Company recorded a pretax special charge of $8.9 million as part of operating expense. The special charge reduced Net Income by $5.9 million or $.13 per share. The special charge consisted of $7 million for various costs associated with the retirement of Mr. Moyers and the related organizational changes. The costs associated with Mr. Moyers' retirement include the present value of his pension, accelerated vesting of a portion of his restricted stock award and certain costs of a non- competition agreement. The remaining $1.9 million was for the disposition costs of railcars and a building and its adjacent land. 16. SELECTED QUARTERLY FINANCIAL DATA - (UNAUDITED)($ IN MILLIONS, EXCEPT SHARES DATA: Per share amounts in 1991 have been restated to reflect the 3-for-2 stock split that occurred in February 1992. - ----------------------- (a) Includes the special charge recorded in the fourth quarter of 1992, see Note 15. ILLINOIS CENTRAL CORPORATION AND SUBSIDIARIES -------------------- ----------------------------- F O R M 10-K FINANCIAL STATEMENT SCHEDULES SUBMITTED IN RESPONSE TO ITEM 14(a) ILLINOIS CENTRAL CORPORATION AND SUBSIDIARIES ------------- ------------- I N D E X T O FINANCIAL STATEMENT SCHEDULES SUBMITTED IN RESPONSE TO ITEM 14(a) Schedules for the three years ended December 31, 1993: II-Amounts receivable from related parties, and underwriters, promoters and employees other than related parties... III-Condensed financial information........ V-Property, plant and equipment.......... VI-Accumulated depreciation and amortization of property, plant and equipment....... VII-Guarantees of securities of other issuers............................... VIII-Valuation and qualifying accounts...... Pursuant to Rule 5.04 of General Rules of Regulation S-X, all other schedules are omitted because they are not required or because the required information is set forth in the financial statements or related notes thereto. ------------- ------------- ILLINOIS CENTRAL CORPORATION AND SUBSIDIARIES SCHEDULE II--AMOUNTS RECEIVABLE FROM RELATED PARTIES, AND UNDERWRITERS, PROMOTERS, AND EMPLOYEES OTHER THAN RELATED PARTIES ($ in millions) Balance at end of year Balance ----------- at begin- Non- Name of ning of Addi- Deduc- Curr- Curr- Debtor year tions tions ent ent - ------ --------- ----- ------ ---- ----- E. L. Moyers $.7 - - $.2 $.5 - ----------------- Pursuant to a four-year note dated May 15, 1992, bearing interest at the rate of 7.1%, Mr. Moyers became indebted to the Company in the principal amount of $1,000,000. In connection with Mr. Moyers' decision to retire and resign from the Board, Mr. Moyers repaid $238,500 of principal and interest and the Compensation Committee forgave an additional $200,000 principal amount of the loan. The May 15, 1992 note was cancelled in favor of a new note (the "Note") to be repaid in four annual installments of principal and interest, commencing on February 18, 1994. The Note provides that unpaid principal, including any accrued interest thereon, is to be accelerated in the event of a breach of the non-competition covenant contained in Mr. Moyers' consulting and non-competition agreement with the Company. The Note bears interest at a rate of 6.22% per annum and is prepayable in whole or in part at any time. Any unpaid principal, including any accrued interest thereon, is to be forgiven in the event of Mr. Moyers' death or disability. The Notes to Consolidated Financial Statements beginning on page are an integral part of this schedule. (a) Reflects 3-for-2 stock split in February 1992. The Notes to Consolidated Financial Statements beginning on page are an integral part of this schedule. (a) Reflects 3-for-2 stock split in February 1992. The Notes to Consolidated Financial Statements beginning on page are an integral part of this schedule. (1) Reclassification of properties from "Other Assets." (2) Reclassification of properties from "Assets Held For Disposition." ILLINOIS CENTRAL CORPORATION AND SUBSIDIARIES SCHEDULE VII--GUARANTEES OF SECURITIES OF OTHER ISSUERS AS OF DECEMBER 31, 1993, 1992 AND 1991 ($ IN MILLIONS) Column A Column B Column C Column D - -------- -------- -------- -------- Name of Title of Total Amount Nature of Issuer of Issue of Guaranteed Guarantee Securities Class of and Guaranteed Securities Outstanding by Person Guaranteed for Which Statement is Filed - ----------- ---------- ------------ -------- Terminal Refunding $7.8 Principal Railroad and and Association Improvement annual of St. Mortgage 4% interest Louis Bonds, St. Louis Series "C", due 7/1/2019 ILLINOIS CENTRAL CORPORATION AND SUBSIDIARIES EXHIBIT INDEX Exhibit Sequential No. Descriptions Page No. - ------- ------------ ---------- 3.1 Articles of Incorporation of Illinois Central Railroad Company, as amended. (Incorporated by reference to Exhibit 3.1 to the Registration Statement of Illinois Central Railroad Company on Form S-1. (SEC File No. 33-29269)) 3.2 By-Laws of Illinois Central Railroad Company, as amended. (Incorporated by reference to Exhibit 3.2 to the Registration Statement of Illinois Central Railroad Company on Form S-1. (SEC File No. 33-29269)) 3.3 Restated Articles of Incorporation of Illinois Central Corporation. (Incorporated by reference to Exhibit 3.1 to the Quarterly Report of the Illinois Central Corporation on Form 10-Q for the three months ended September 30, 1991. (SEC File No. 1-10720)) 3.4 By-Laws of Illinois Central Corporation, as amended. (Incorporated by reference to Exhibit 3.4 to the Registration Statement of Illinois Central Corporation and Illinois Central Railroad Company on Form S-1. (SEC File Nos. 33-36321 and 33-36321- 01)) 3.5 Certificate of Retirement of Illinois Central Corporation (Incorporated by reference to Exhibit 3.3 to the Registration Statement of Illinois Central Corporation and Illinois Central Railroad Company on Form S-1, as amended. (SEC File No. 33- 40696 and Post-Effective Amendments to Registration Statement Nos. 33-36321 and 33-36321-01)) 3.6 Certificate of Elimination of Illinois Central Corporation. (Incorporated by reference to Exhibit 3.2 to the Quarterly Report of the Illinois Central Corporation on Form 10-Q for the three months ended September 30, 1991. (SEC File No. 1-10720)) - -------------------- * Used herein to identify management contracts or compensation plans or arrangements as required by Item 14 of Form 10-K. ILLINOIS CENTRAL CORPORATION AND SUBSIDIARIES EXHIBIT INDEX Exhibit Sequential No. Descriptions Page No. - ------- ------------ ---------- 4.1 Form of 14-1/8% Senior Subordinated Debenture Indenture dated as of September 15, 1989 (the "Senior Subordinated Debenture Indenture") between Illinois Central Railroad Company and United States Trust Company of New York, Trustee (including the form of 14-1/8% Senior Subordinated Debenture included as Exhibit A therein). (Incorporated by reference to Exhibit 4.1 to the Registration Statement of Illinois Central Railroad Company on Form S-1, as amended. (SEC File No. 33- 29269)) 4.2 Restated Articles of Incorporation of Illinois Central Corporation (included in Exhibit 3.3) 4.3 Form of the Amended and Restated Revolving Credit and Term Loan Agreement dated as of September 22, 1989, and amended and restated as of July 23, 1991, among Illinois Central Railroad Company and the Banks named therein (including the Form of the Restated Revolving Credit Note, the Form of the Restated Term Note, the Form of the Intercreditor Agreement, the Form of the Security Agreement and the Form of the Bond Pledge Agreement included as Exhibits A, B, G, H and I, respectively, therein). (Incorporated by reference to Exhibit 4.1 to the Quarterly Report of Illinois Central Railroad Company on Form 10-Q for the three months ended September 30, 1991. (SEC File No. 1-7092)) 4.4 Amendment No. 1 dated as of February 28, 1992, to the Amended and Restated Revolving Credit and Term Loan Agreement dated as of September 22, 1989, and amended and restated as of July 23, 1991, among Illinois Central Railroad Company and the Banks named therein. (Incorporated by reference to Exhibit 4.3 to the Annual Report on Form 10-K for the year ended December 31, 1991, for the Illinois Central Railroad Company filed March 12, 1992. (SEC File No. 1-7092)) 4.5 Form of Guaranty dated as of September 22, 1989, and amended and restated as of July 23, 1991, among Illinois Central Corporation and the Banks named therein that are or may become parties to the Amended and Restated Revolving Credit and Term Loan Agreement dated as of September 22, 1989, and amended and restated as of July 23, 1991, among the Illinois Central Railroad Company and the Banks named therein. (Incorporated by reference to Exhibit 4.3 to the Quarterly Report of Illinois Central Corporation on Form 10-Q for the three months ended September 30, 1991. (SEC File No. 1-10720)) 4.6 Form of Pledge Agreement dated as of September 22, 1989, and amended and restated as of July 23, 1991, among Illinois Central Corporation and the Banks named therein that are or may become parties to the Amended and Restated Revolving Credit and Term Loan Agreement dated as of amended and restated as of July 23, 1991, among the Illinois Central Railroad Company and the Banks named therein and the Senior Note Purchasers that are parties to the Note Purchase Agreement dated as of July 23, 1991. (Incorporated by reference to Exhibit 4.4 to the Quarterly Report of Illinois Central Corporation on Form 10-Q for the three months ended September 30, 1991. (SEC File No. 1-10720)) 4.7 Form Supplemental Indenture dated July 23, 1991, between Illinois Central Railroad Company and Morgan Guaranty Trust Company of New York relating to First Mortgage Adjustable Rate Bonds, Series M. (Incorporated by reference to Exhibit 4.2 to the Quarterly Report of Illinois Central Railroad Company on Form 10-Q for the three months ended September 30, 1991. (SEC File No. 1-7092)) 4.8 Form of Note Purchase Agreement dated as of July 23, 1991, among Illinois Central Railroad Company, as issuer, and Illinois Central Corporation, as guarantor, for 10.02% Guaranteed Senior Secured Series A Notes due 1999 and for 10.4% Guaranteed Senior Secured Series B Notes due 2001 (including the Form of Series A Note and Series B Note included as Exhibits A-1 and A-2, respectively, therein). (Incorporated by reference to Exhibit 4.3 to the Quarterly Report of the Illinois Central Railroad Company on Form 10-Q for the three months ended September 30, 1991. (SEC File No. 1-7092)) 4.9 Form of the Loan and Security Agreement dated as of December 6, 1991, between IC Leasing Corporation I and Hitachi Credit America Corp. (including the Form of the Initial Funding Credit Note, the Form of the Refurbishing Credit Note, the Form of Assignment of Lease and Agreement, the Form of the Pledge Agreement between IC Financial Services Corporation and Hitachi Credit America Corp. and the Form of the Guaranty Agreement between Illinois Central Corporation and Hitachi Credit America Corp. included as Exhibits D, E, F, G and H, respectively, therein). (Incorporated by reference to Exhibit 4.9 to the Annual Report on Form 10-K for the year ended December 31, 1991, for the Illinois Central Corporation filed March 12, 1992. (SEC File No. 1-10720)) 4.10 Form of the Trust Agreement dated as of March 30, 1993, between IC Leasing Corporation II and Wilmington Trust Company. (Incorporated by reference to Exhibit 4.10 to the Current Report of Illinois Central Corporation on Form 8- K dated May 7, 1993. (SEC File No. 1-10720)) 4.11 Form of the Security Agreement and Mortgage dated as of March 30, 1993, between IC Leasing Trust II and UNUM Life Insurance Company of America (Including the Form of the Promissory Note between IC Leasing Trust II and UNUM Life Insurance Company of America included as Exhibit A, therein). (Incorporated by reference to Exhibit 4.11 to the Current Report of Illinois Central Corporation on Form 8- K dated May 7, 1993. (SEC File No. 1-10720)) 4.12 Assignment of Lease and Conveyance dated March 30, 1993, between IC Leasing Corporation II and IC Leasing Trust II. (Incorporated by reference to Exhibit 4.12 to the Current Report of Illinois Central Corporation on Form 8- K dated May 7, 1993. (SEC File No. 1-10720)) 4.13 Assignment of Lease and Conveyance dated March 30, 1993, between IC Leasing Trust II and UNUM Life Insurance Company of America. (Incorporated by reference to Exhibit 4.13 to the Current Report of Illinois Central Corporation on Form 8-K dated May 7, 1993. (SEC File No. 1- 10720)) 4.14 Form of the Amended and Restated Demand Promissory Note between IC Leasing Corporation III and The First National Bank of Boston dated December 3, 1993, and amended and restated as of January 3, 1994. 4.15 Form of the Guaranty dated as of December 3, 1993, between Illinois Central Corporation and The First National Bank of Boston. ILLINOIS CENTRAL CORPORATION AND SUBSIDIARIES EXHIBIT INDEX Exhibit Sequential No. Descriptions Page No. - ------- ------------ ---------- 4.16 Security Agreement dated as of December 3, 1993, between IC Leasing Corporation III and The First National Bank of Boston and Amendment No. 1 to the Security Agreement dated as of January 3, 1994. 4.17 Form of the Revolving Credit Agreement dated as of October 27, 1993, among Illinois Central Railroad Company and the Banks named therein (including the Form of the Note, the Form of the Competitive Bid Request, Form of the Notice of Competitive Bid Request, Form of the Competitive Bid and Form of the Competitive Bid Accept/Reject Letter included as Exhibits A, B-1, B-2, B-3 and B-4, respectively, therein). (Incorporated by reference to Exhibit 4.8 to the Annual Report on Form 10-K for the year ended December 31, 1993, for Illinois Central Railroad Company filed March 16, 1994. (SEC File No. 1-7092)) 4.18 Form of the Amended and Restated Revolving Credit Agreement dated as of October 27, 1993, among Illinois Central Railroad Company and the Banks named therein (including the Form of the Note, the Form of the Competitive Bid Request, Form of the Notice of Competitive Bid Request, Form of the Competitive Bid and Form of the Competitive Bid Accept/Reject Letter included as Exhibits A, B-1, B-2, B-3 and B-4, respectively, therein). (Incorporated by reference to Exhibit 4.8 to the Annual Report on Form 10-K for the year ended December 31, 1993, for Illinois Central Railroad Company filed March 16, 1994. (SEC File No. 1-7092)) ILLINOIS CENTRAL CORPORATION AND SUBSIDIARIES EXHIBIT INDEX Exhibit Sequential No. Descriptions Page No. - ------- ------------ ---------- 4.19 Form of Commercial Paper Dealer Agreement between Illinois Central Railroad Company and Lehman Commercial Paper, Inc. dated as of November 19, 1993. (Incorporated by reference to Exhibit 4.10 to the Annual Report on Form 10-K for the year ended December 31, 1993 for Illinois Central Railroad Company filed March 16, 1994. (SEC File No. 1-7092)) 4.20 Form of Issuing and Paying Agency Agreement of the Illinois Central Railroad Company related to the Commercial Paper Program between Illinois Central Railroad Company and Bank America National Trust Company dated as of November 19, 1993, (including Exhibit A the Form of Certificated Commercial Paper Note included therein). (Incorporated by reference to Exhibit 4.11 to the Annual Report on Form 10-K for the year ended December 31, 1993 for Illinois Central Railroad Company filed March 16, 1994. (SEC File No. 1-7092)) 10.1 * Form of supplemental retirement and savings plan. (Incorporated by reference to Exhibit 10C to the Registration Statement of Illinois Central Transportation Co. on Form 10 filed on October 7, 1988, as amended. (SEC File No. 1- 10085)) ILLINOIS CENTRAL CORPORATION AND SUBSIDIARIES EXHIBIT INDEX Exhibit Sequential No. Descriptions Page No. - ------- ------------ ---------- 10.2 * Form of management incentive compensation plan. (Incorporated by reference to Exhibit 10D to the Registration Statement of Illinois Central Transportation Co. on Form 10 filed on October 7, 1988, as amended. (SEC File No. 1- 10085)) 10.3 Consolidated Mortgage dated November 1, 1949 between Illinois Central Railroad Company and Guaranty Trust Company of New York, Trustee, as amended. (Incorporated by reference to Exhibit 10.8 to the Registration Statement of Illinois Central Railroad Company on Form S-1, as amended. (SEC File No. 33- 29269)) 10.4 Form of indemnification agreement dated as of January 29, 1991, between Illinois Central Corporation and certain officers and directors. (Incorporated by reference to Exhibit 10.9 to the Annual Report on Form 10-K for the year ended December 31, 1990, for the Illinois Central Corporation filed on April 1, 1991. (SEC File No. 1-10720)) 10.5 * Form of IC 1990 Stock Purchase Plan. (Incorporated by reference to Exhibit 10.6 to the Registration Statement of Illinois Central Corporation on Form 10 filed on January 5, 1990, as amended. (SEC File No. 1-10720)) ILLINOIS CENTRAL CORPORATION AND SUBSIDIARIES EXHIBIT INDEX Exhibit Sequential No. Descriptions Page No. - ------- ------------ ---------- 10.6 * Form of IC Long-Term Incentive Option Plan. (Incorporated by reference to Exhibit 10.17 to the Registration Statement of Illinois Central Corporation and Illinois Central Railroad Company on Form S-1. (SEC File Nos. 33-36321 and 33- 36321-01)) 10.7 * Amendments No. 1 and No. 2 to the IC Long-Term Incentive Plan. (Incorporated by reference to the Proxy Statement of Illinois Central Corporation in connection with its 1992 Annual Meeting of Stockholders. (SEC File No. 1- 10720)) 10.8 Railroad Locomotive Lease Agreement between IC Leasing Corporation I and Illinois Central Railroad Company dated as of September 5, 1991. (Incorporated by reference to Exhibit 10.9 to the Annual Report on Form 10-K for the year ended December 31, 1991 for the Illinois Central Railroad Company filed March 12, 1992. (SEC File No. 1- 7092)) 10.9 Railroad Locomotive Lease Agreement between IC Leasing Corporation II and Illinois Central Railroad Company dated as of January 14, 1993. (Incorporated by reference to Exhibit 10.6 to the Annual Report on Form 10-K for the year ended December 31, 1992, for the Illinois Central Railroad Company filed March 5, 1993. (SEC File No. 1- 7092)) ILLINOIS CENTRAL CORPORATION AND SUBSIDIARIES EXHIBIT INDEX Exhibit Sequential No. Descriptions Page No. - ------- ------------ ---------- 10.10 * Form of Consulting and Non- Competition Agreement between Illinois Central Corporation and Edward L. Moyers dated as of February 18, 1993. (Incorporated by reference to Exhibit 10.10 to Annual Report on Form 10-K for the year ended December 31, 1992, for the Illinois Central Corporation filed March 5, 1993. (SEC File No. 1-10720)) 10.11 * Form of the Note Agreement between the Illinois Central Corporation and Edward L. Moyers dated February 18, 1993. (Incorporated by reference to Exhibit 10.11 to Annual Report on Form 10-K for the year ended December 31, 1992, for the Illinois Central Corporation filed March 5, 1993. (SEC File No. 1- 10720)) 10.12 * Form of a Supplemental Retirement Benefit Agreement dated as of August 20, 1992 between Illinois Central Corporation and Edward L. Moyers. (Incorporated by reference to Exhibit 10.3 to the Quarterly Report of the Illinois Central Corporation on Form 10-Q for the three month ended September 30, 1992. (SEC File No. 1-10720)) 10.13 The Asset Sale Agreement between Allied Railcar Company and IC Leasing Corporation III dated December 3, 1993, (including the Bill of Sale Agreement and Assumption of Liabilities included as Exhibits C and D, respectively, therein). ILLINOIS CENTRAL CORPORATION AND SUBSIDIARIES EXHIBIT INDEX Exhibit Sequential No. Descriptions Page No. - ------- ------------ ---------- 10.15 The Purchase Agreement between IC Leasing Corporation III and The First National Bank of Maryland dated December 29, 1993. 11 Computation of Income Per Common Share (Included at E-9) 21 Subsidiaries of Registrant (Included at E-10) 24.1 Consent of Arthur Andersen & Co. (A) --------------------- (A) Included herein but not reproduced. (1) Shares for 1991 restated to reflect February 1992 3 for 2 stock split. (2) Such items are included in primary calculation. Additional shares represent difference between average price of Common Stock for the period and the end of period price.

78066_1993.txt

78066

1993

Item 3. Legal Proceedings I. In October 1980, the Corporation, the American Mining Congress, and several mining and energy development companies filed a petition in the U.S. Court of Appeals for the District of Columbia for review of EPA's August 1980 regulations (45 Fed. Reg. 52,729 and 52,735) relating to the prevention of significant deterioration (PSD) of air quality. In February 1982, the industry petitioners and EPA entered into a settlement agreement pursuant to which EPA would propose amendments to the PSD and particulate matter regulations. The court of appeals stayed the petition for review, pending implementation of the settlement agreement. In August 1983, EPA proposed regulations (48 Fed. Reg. 38,742) which, if adopted, would have substantially implemented the settlement agreement dealing with fugitive emissions, but on October 26, 1984, EPA promulgated final regulations inconsistent with the August 1983 proposal. In December 1984, the Corporation, the American Mining Congress and several mining and energy development companies filed a petition (No. 84-1609) in the U.S. Court of Appeals for the District of Columbia for review of the October 26, 1984, regulations, asserting that the terms of the February 1982 settlement agreement had not been carried out. The court stayed the petition pending the outcome of further EPA rulemakings. The further EPA rulemakings also have been challenged by the American Mining Congress and others in federal court actions filed in 1989 and 1993. All of the pre-1993 cases are being held in abeyance at the request of the parties. Currently before the court in the 1993 case is a joint motion by the American Mining Congress and EPA to hold that case in abeyance while the parties engage in settlement discussions that could resolve some of the contested issues. Also, on October 7, 1993, the American Mining Congress filed with the Administrator of EPA a petition for reconsideration of yet another related rulemaking (58 Fed. Reg. 31,622). EPA's response to the petition also could resolve some of the contested issues in the stayed lawsuits. II. Reference is made to the discussion of "Copper Operations" in this report for information regarding proceedings that pertain to water used by the Corporation's Morenci, Arizona operations. A. The following state water rights adjudication proceedings are pending in Arizona Superior Court: 1. In re the General Adjudication of All Rights to Use Water in the Little Colorado River System and Source, No. 6417 (Superior Court of Arizona, Apache County). (a) Petition was filed by the Corporation on or about February 17, 1978, and process has been served on all potential claimants. Virtually all statements of claimant have been filed. (b) The principal parties, in addition to the Corporation, are the State of Arizona, the Navajo Tribe of Indians, the Hopi Indian Tribe, the San Juan Southern Paiute group of Indians and the United States on its own behalf and on behalf of those Indian tribes. In this adjudication and in the adjudications reported in items 2.(a), (b) and (c) below, the United States and the Indian tribes seek to have determined and quantified their rights to use water arising under federal law on the basis that, when the Indian reservations and other federal reservations were established by the United States, water was reserved from appropriation under state law for the use of those reservations. (c) This proceeding could affect, among other things, the Corporation's rights to impound water in Show Low Lake and Blue Ridge Reservoir and to transport this water into the Salt River and Verde River watersheds for exchange with the Salt River Valley Water Users' Association. The Corporation has filed statements of claimant for these and other water claims. The legal issues and procedures in this adjudication are presently being defined. Trial of the Corporation's Show Low Lake water rights under state law will likely be held during 1994. 2. In re the General Adjudication of All Rights to Use Water in the Gila River System and Source, Nos. W-1 (Salt River), W-2 (Verde River), W-3 (Gila River) and W-4 (San Pedro River) (Superior Court of Arizona, Maricopa County). As a result of consolidation proceedings, this action now includes general adjudication proceedings with respect to the following three principal river systems and sources: (a) The Gila River System and Source Adjudication: (i) Petition was filed by the Corporation on February 17, 1978. Process has been served on water claimants in the upper and lower reaches of the watershed and virtually all statements of claimant have been filed. (ii) The principal parties, in addition to the Corporation, are the Gila Valley Irrigation District, the San Carlos Irrigation and Drainage District, the State of Arizona, the San Carlos Apache Tribe, the Gila River Indian Community and the United States on its own behalf and on behalf of the tribe and the community. (iii) This proceeding could affect, among other things, the Corporation's claim to the approximately 3,000 acre-feet of water that it diverts annually from Eagle Creek, Chase Creek or the San Francisco River and its claims to percolating groundwater that is pumped from wells located north of its Morenci Branch operations in the Mud Springs and Bee Canyon areas and in the vicinity of the New Cor- nelia Branch at Ajo. The Corporation has filed statements of claimant with respect to waters that it diverts from these sources. (iv) By a letter agreement dated September 7, 1990, the Corporation and the San Carlos Apache Tribe agreed upon principles to settle the water claims of that Tribe. Legislation authorizing that settlement was enacted into law on October 30, 1992. A comprehensive settlement agreement is presently being negotiated. The settlement will become effective if it is approved by the Arizona Superior Court and certain conditions are met by December 31, 1994. (b) The Salt River System and Source Adjudication: (i) Petition was filed by the Salt River Valley Water Users' Association on or about April 25, 1974. Process has been served, and statements of claimant have been filed by virtually all claimants. (ii) Principal parties, in addition to the Corporation, include the petitioner, the State of Arizona and the United States, on its own behalf and on behalf of various Indian tribes and communities including the White Mountain Apache Tribe, the San Carlos Apache Tribe, the Fort McDowell Mohave-Apache Indian Community, the Salt River Pima-Maricopa Indian Community and the Gila River Indian Community. (iii) The Corporation has filed a statement of claimant to assert its interest in the water exchange agreement with the Salt River Valley Water Users' Association by virtue of which it diverts from the Black River water claimed by the Association and repays the Association with water impounded in Show Low Lake and Blue Ridge Reservoir on the Little Colorado River Watershed, and to assert its interest in "water credits" to which the Corporation is entitled as a result of its construction of the Horseshoe Dam on the Verde River. (iv) The Salt River Pima-Maricopa Indian Community, Salt River Valley Water Users' Association, the principal Salt River Valley Cities, the State of Arizona and others have negotiated a settlement as among themselves for the Verde and Salt River system. The settlement has been approved by Congress, the President and the Arizona Superior Court. Under the settlement, the Salt River Pima-Maricopa Indian Community waived all water claims it has against all other water claimants (including the Corporation) in Arizona. (v) Active proceedings with respect to other claimants have not yet commenced in this adjudication. (c) The Verde River System and Source Adjudication: (i) Petition was filed by the Salt River Valley Water Users' Association on or about February 24, 1976, and process has been served. Virtually all statements of claimant have been filed. (ii) The principal parties, in addition to the Corporation, are the petitioner, the Fort McDowell Mohave-Apache Indian Community, the Payson Community of Yavapai Apache Indians, the Salt River Pima-Maricopa Indian Community, the Gila River Indian Community, the United States on its own behalf and on behalf of those Indian com- munities, and the State of Arizona. (iii) This proceeding could affect, among other things, the Corporation's Horseshoe Dam "water credits" with the Salt River Valley Water Users' Association resulting from its construction of the Horseshoe Dam on the Verde River. (See the Black River water exchange referred to in Paragraph II.A. 2.(b)(iii) above.) The Corporation has filed statements of claimant with respect to Horseshoe Dam and water claims associated with the former operations of the United Verde Branch. (iv) The Fort McDowell Mohave-Apache Indian Community, Salt River Valley Water Users' Association, the principal Salt River Valley Cities, the State of Arizona and others have negotiated a settlement as among themselves for the Verde River system. This settlement has been approved by Congress, the President and the Arizona Superior Court. Under this settlement, the Fort McDowell Mohave-Apache Indian Community waived all water claims it has against all other water claimants (including the Corporation) in Arizona. B. The following proceedings involving water rights adjudication are pending in the U.S. District Court for the District of Arizona: 1. On June 29, 1988, the Gila River Indian Community filed a complaint-in-intervention in United States v. Gila Valley Irrigation District, et al., Globe Equity No. 59 (D. Ariz.). The underlying action was initiated by the United States in October 1925 to determine conflicting claims to water rights in certain portions of the Gila River watershed. Although the Corporation was named and served as a defendant in that action, it was dismissed without prejudice as a de- fendant in March 1935. In June 1935, the Court entered a decree setting forth the water rights of numerous parties, but not those of the Corporation. The Court retained, and still has, jurisdiction of the case. The complaint-in-intervention does not name the Corporation as a defendant; however, it does name the Gila Valley Irrigation District as a defendant. Therefore, the complaint-in-intervention could affect the approximately 3,000 acre-feet of water that the Corporation diverts annually from Eagle Creek, Chase Creek or the San Francisco River pursuant to the agreement between the Corporation and the Gila Valley Irrigation District. In April 1990, the Court entered Findings of Fact and Conclusions of Law on four of the counts in the complaint-in-intervention. Trial on additional issues (primarily is- sues raised by plaintiff-in-intervention San Carlos Apache Tribe) was conducted in November 1991. In November 1992, after submission of post-trial briefs, the Court entered a judgment on the additional issues. The Corporation believes that neither the Findings of Fact or the Conclusions of Law entered in 1990 nor the judgment entered in 1992 should affect the 3,000 acre feet of water that the Corporation diverts annually pursuant to the agreement with the Gila Valley Irrigation District. An appeal of the 1992 judgment, however, has been noticed by the Gila Valley Irrigation District and others. The major users on the mainstream of the Gila River (decreed right holders) are engaged in continuing mandatory settlement discussions under the supervision of the Court. It will be several months before the likelihood of any comprehensive settlement can be ascertained. 2. On December 30, 1982, the Gila River Indian Community initiated an action styled Gila River Indian Community v. Gila Valley Irrigation District, et al., No. CIA 82-2185 (D. Ariz.), complaining about allegedly improper uses by approximately 17,000 named defendants of "water from within the Gila River watershed." The Corporation was named as a defendant in the complaint, but it has not yet been served with process. The complaint seeks an injunction restraining future uses of water that interfere with the alleged prior rights of the Gila River Indian Community as well as compensatory and punitive damages in an unspecified amount. 3. Prior to December 1982, various Indian tribes filed several suits in the U.S. District Court for the District of Arizona claiming prior and paramount rights to use waters which are presently being used by many water users, including the Corporation, and claiming damages for prior use in derogation of their allegedly paramount rights. These federal proceedings have been stayed pending final adjudication in the state courts. III. Prior to the mid-1960s, a predecessor of Phelps Dodge Industries, Inc. (PDI), a subsidiary of the Corporation, manufactured and sold some cable and wire products that were insulated with material containing as- bestos. PDI believes that the use of these products did not result in sig- nificant releases of airborne asbestos fibers. PDI and the Corporation are collectively referred to herein as PDI. Since October 1991, PDI has been served with 26 complaints naming it as a defendant in the Ingalls Shipyard asbestos litigation pending in Pasca- goula, Mississippi. These cases involved about 12,503 claimants, each seeking from $2 million to $20 million in compensatory and punitive damages from approximately 100 to 150 defendants. By Order dated April 21, 1993, PDI was dismissed without prejudice from the consolidated action encaptioned Abrams, et al. v. GAF Corporation, et al., No. 88-5422(2). As a result, ap- proximately 6,562 of the claims against PDI were dismissed. Subsequently, PDI was dismissed from another 14 lawsuits pending in Mississippi during 1993, thus bringing to 9,806 the total number of claims dismissed in that jurisdiction during 1993. In addition to the claims dismissed in Mississippi, 605 other claims against PDI brought in federal and state courts in Alabama, Arkansas, California, Louisiana, Michigan, New Jersey, Ohio, Pennsylvania and Washington were dismissed during 1993. As of December 31, 1993, approximately 2,697 claims were pending against PDI in Mississippi. In addition, PDI is currently defending 347 claims in 12 other jurisdictions. In these various proceedings, plaintiffs allege bodily injury or death from exposure to asbestos and claim damages based on theories of strict liability and negligence. PDI is vigorously contesting and defending these cases. IV. Claims under CERCLA and related state acts involving the Corporation have been raised with respect to the remediation of 34 waste disposal and other sites. Most are sites where the Corporation has received information requests or other indications that the Corporation may be a Potentially Responsible Party (PRP) under CERCLA. CERCLA is intended to expedite the remediation of hazardous substances without regard to fault. Responsible parties for each site include present and former owners, operators, transporters, and generators of the substances at the site. Liability is strict, joint and several. Because of the ambiguity of the regulations, the difficulty of identifying the responsible parties for any particular site, the complexity of allocating the remediation costs among them, the uncertainty as to the most desirable remediation techniques and the amount of remediation costs, and the time period during which such costs may be incurred, the Corporation is unable to reasonably estimate the full cost of compliance with CERCLA or equivalent state statutes. With respect to these 34 sites, based on currently available information, which in many cases is preliminary and incomplete, the Corporation has no reason to believe that its ultimate responsibility for remediation costs will exceed $0.5 million at any site and believes most will be substantially under $0.1 million. Item 4.

Item 4. Submission of Matters to a Vote of Security Holders No matters were submitted during the fourth quarter of 1993 to a vote of security holders, through the solicitation of proxies or otherwise. Executive Officers of Phelps Dodge Corporation The executive officers of Phelps Dodge Corporation are elected to serve at the pleasure of its Board of Directors. As of March 1, 1994, the executive officers of Phelps Dodge Corporation were as follows: Except as stated below, all of the above have been officers of Phelps Dodge Corporation for the past five years. Mr. Rethore was elected Senior Vice President in July 1989. Prior to joining Phelps Dodge he had been associated with Microdot Inc., a diversified manufacturer of industrial components, for 16 years, serving as President and Chief Executive Officer of Microdot Industries (the manufacturing division of Microdot Inc.) since 1984. Mr. St. Clair was elected Senior Vice President and Chief Financial Officer in May 1989. Prior to joining Phelps Dodge he had been associated with Koppers Company, Inc., a producer of road materials and chemicals, for 30 years, serving as Vice President, Treasurer and Chief Financial Officer since 1984. Part II Item 5.

Item 5. Market for the Registrant's Common Equity and Related Stockholder Matters The information called for by Item 5 appears in Management's Discussion and Analysis. Item 7.

Item 7. Management's Discussion and Analysis The information called for by Item 7 appears in Management's Discussion and Analysis. Item 8.

Item 8. Financial Statements and Supplementary Data The information called for by Item 8 appears in the Consolidated Financial Statements and Notes thereto. Item 9.

Item 9. Disagreements on Accounting and Financial Disclosure Not applicable. MANAGEMENT'S DISCUSSION AND ANALYSIS Phelps Dodge reported 1993 consolidated net income of $187.9 million, or $2.66 per common share, including after-tax revenues of $26.0 million, or 37 cents per common share, from copper price protection arrangements. Net income in 1993 was adversely affected by the passage of the Omnibus Budget Reconciliation Act of 1993 in the third quarter that retroactively raised the maximum corporate income tax rate from 34 percent to 35 percent effective January 1, 1993. The Corporation raised its 1993 tax provision by approximately $9.0 million, or 13 cents per common share, including $3.0 million for the effect of the tax rate increase on 1993 earnings and an additional $6.0 million for deferred taxes at December 31, 1992. All per share amounts in this report reflect average shares outstanding for the respective periods after giving effect to a two-for-one stock split in May 1992. The Corporation reported 1992 income of $301.6 million, or $4.28 per common share, before the cumulative effect of accounting changes. This 1992 income included a non-taxable gain of $36.4 million, or 52 cents per common share, on a subsidiary's stock issuance from two Sumitomo companies' acquisition of a 20 percent interest in the La Candelaria copper-gold project in Chile. Income taxes were not provided by Phelps Dodge on the $36.4 million book gain because the proceeds were indefinitely reinvested in the Chilean company. Consolidated net income for 1992 was $221.7 million, or $3.15 per common share, after recognizing the cumulative effect of accounting changes with respect to postretirement and postemployment benefits and income taxes. The Corporation reported net income of $272.9 million, or $3.93 per common share, in 1991. The Corporation's consolidated financial results for the last three years are summarized below (in millions except per common share amounts): Any material change in the price the Corporation receives for copper, or in its unit production costs, has a significant effect on the Corporation's results. The Corporation's present share of annual production is approximately 1.1 billion pounds of copper. Accordingly, each 1 cent per pound change in the average annual copper price received by the Corporation, or in average annual unit production costs, causes a variation in annual operating income before taxes of approximately $11 million. The New York Commodity Exchange (COMEX) spot price per pound of copper cathode, upon which the Corporation bases its selling price, averaged 85 cents in 1993, compared with $1.03 in 1992 and $1.05 in 1991. The COMEX price averaged 85 cents per pound for the first two months of 1994, closing at 87 cents per pound on March 2, 1994. The Corporation enters into price protection arrangements from time to time, depending on market circumstances, to ensure a minimum price for a portion of its expected future mine production. With respect to 1993 production, the Corporation entered into contracts with several financial institutions that provided for a minimum average annual realized price of 95 cents per pound for 475 million pounds of copper cathode, about 44 percent of 1993 production. These contracts were based on the average London Metal Exchange (LME) price for the entire year. During 1993, the Corporation recognized revenues of $39.4 million before taxes ($26.0 million, or 37 cents per common share, after taxes) from these arrangements. With respect to 1994 production, as of December 31, 1993, the Corporation had entered into contracts with several financial institutions that provide for minimum 1994 quarterly average prices of 75 cents per pound for 214 million pounds of copper cathode. As of March 2, 1994, total production covered by such contracts had been increased to 244 million pounds of copper cathode, approximately 22 percent of the Corporation's anticipated production for 1994. These contracts are based on the average LME price each quarter. Consolidated 1993 revenues were $2,595.9 million, compared with $2,579.3 million in 1992. Sales decreases in 1993 that resulted from lower average copper prices were more than offset by a higher volume of copper sold (including copper purchased for resale), a higher volume of wheels and rims sold, and increased sales by the international wire and cable operations (principally reflecting a late 1992 acquisition in Venezuela). A 6 percent increase in consolidated revenues from $2,434.3 million in 1991 to $2,579.3 million in 1992 also resulted from a higher volume of copper sold (including copper purchased for resale) and a higher volume of wheels and rims sold. In addition, the sales volume of wire and cable products increased in 1992 over 1991. Three new accounting standards adopted by the Corporation in the 1992 fourth quarter were treated as though they were in effect since the beginning of that year. As a result of its decision to elect early adoption of Statement of Financial Accounting Standards (SFAS) No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions," No. 109, "Accounting for Income Taxes," and No. 112, "Employers' Accounting for Postemployment Benefits," the Corporation recorded a non-recurring, after- tax transition charge of $79.9 million that was reflected in revised 1992 first quarter results. More information on the effects of these new accounting standards is included later in Management's Discussion and Analysis, and in Notes 5, 16 and 17 to the Consolidated Financial Statements. The adoption of these new standards had no effect on cash flow. Phelps Dodge's results for 1993, 1992 and 1991 can be meaningfully compared by separate reference to its reporting segments, Phelps Dodge Mining Company and Phelps Dodge Industries. Phelps Dodge Mining Company includes the Corporation's worldwide copper operations from mining through rod production, marketing and sales, other mining operations and invest- ments, and worldwide exploration and development programs. Phelps Dodge Industries includes the Corporation's carbon black and synthetic iron oxide operations, its wheel and rim business, and its magnet wire, specialty conductor and cable operations. Within each such segment, significant events and transactions have occurred which, as indicated in the separate discussions presented below, are material to an understanding of the particular year's results and to a comparison with results of the other periods. Note 21 to the Consolidated Financial Statements contains further information to which reference should be made for a fuller understanding of the following discussion and analysis. Statistics on reserves and production can be found in "Copper Operations" and "Ore Reserves." RESULTS OF PHELPS DODGE MINING COMPANY Phelps Dodge Mining Company is an international business comprising a group of companies involved in vertically integrated copper operations including mining, concentrating, electrowinning, smelting and refining, rod production, marketing and sales, and related activities. Copper is sold primarily to others as rod, cathode or concentrates, and to the Phelps Dodge Industries segment. In addition, Phelps Dodge Mining Company at times smelts and refines copper and produces copper rod for others on a toll basis. Phelps Dodge Mining Company also produces gold, silver, molybdenum and copper chemicals, principally as by-products, and sulfuric acid from its air quality control facilities. This segment also includes the Corporation's other mining operations and investments (including gold, fluorspar, silver, lead and zinc operations) and its worldwide exploration and development programs. Phelps Dodge Mining Company recorded 1993 earnings from operations of $223.6 million, compared with $363.8 million in 1992 and $367.5 million in 1991. The decrease in operating earnings in 1993 resulted from lower average copper prices, offset in part by increased copper sales volume and the effect of price protection arrangements. Unit production costs of copper in 1993 were slightly higher than in 1992, principally as a result of increased depreciation charges from recent capital projects, slightly increased mining expenses associated with longer and steeper haulage requirements, and weather-related costs in the 1993 first quarter. Earnings in 1992 compared with 1991 were affected by slightly lower average realized copper prices and volumes of copper sold, partially offset by lower unit costs of copper production. The stability of unit production costs for the three-year period primarily have resulted from additional production of low-cost cathode copper at solvent extraction/electrowinning (SX/EW) plants in Morenci, Arizona; Tyrone, New Mexico; and Santa Rita, New Mexico, and from the clo- sure of the higher cost concentrator operations at Tyrone. Copper produced by SX/EW accounted for 47 percent of the Corporation's total production in 1993, compared with 45 percent in 1992 and 36 percent in 1991. The SX/EW method of copper production results in lower unit costs than conventional concentrating, smelting and refining, and is a major factor in the Corporation's continuing efforts to maintain internationally competitive costs. Annual production capacity at Chino's SX/EW facility at Santa Rita was raised to 60,000 tons of cathode copper, an increase of 15,000 tons, by an expansion project completed in April 1993. Substantial capital programs completed in 1992 also assisted in con- taining the escalation of unit production costs. Phelps Dodge Mining Company completed construction on the Northwest Extension mining project in May 1992. This project added 70,000 tons of SX/EW production capacity per year from a copper deposit adjacent to and north of the existing Morenci mine. Morenci now has an annual production capacity of 170,000 tons of cathode copper. In addition, reentry into the Metcalf area of the Morenci mine continued during the year, and the Corporation successfully completed an extension and relocation of the in-pit ore crushing and conveying systems. Each of these projects was designed and implemented to enable Phelps Dodge Mining Company to maintain its low-cost production levels. Concentrate production at Tyrone, which historically approximated 100,000 tons of copper annually, was indefinitely suspended in February 1992 because the higher grade sulfide copper ore reserves were substantially depleted. However, in order to operate the Burro Chief SX/EW plant near Ty- rone at capacity, a mine-for-leach operation will continue. In early 1992, the Corporation completed a fourth expansion of the SX/EW plant, increasing its production capacity to 70,000 tons of cathode copper per year. The Corporation expects to operate the plant for the next 10 years or more. Phelps Dodge Mining Company continued construction at its La Candelaria project throughout 1993. La Candelaria is a major copper-gold deposit lo- cated three miles southwest of Ojos del Salado near Copiapo in the Atacama desert of northern Chile. Discovered in 1987 by the Phelps Dodge exploration group, La Candelaria has estimated ore reserves of 403.3 million tons at an average grade of 1.09 percent copper and containing 3 million ounces of gold. Phelps Dodge owns an 80 percent interest in La Candelaria, and a jointly owned subsidiary of Sumitomo Metal Mining Co., Ltd. and Sumitomo Corporation, both of Japan, owns a 20 percent interest. In 1993, final agreements were executed for $290 million in limited- recourse debt project financing for La Candelaria with four lenders: the Export-Import Bank of Japan with $200 million; the Overseas Private In- vestment Corporation (OPIC) with $50 million; Banco de Chile with $30 million; and Kreditanstalt fur Wiederaufbau with $10 million. The initial loan draw-down under these agreements was made in September. These borrowings are limited recourse to the Corporation prior to satisfaction of certain completion tests, and non-recourse thereafter. Construction and pre-stripping at La Candelaria are on schedule and full production is anticipated for 1995. When completed, the $550 million project will consist of an open-pit mine, concentrator, port and associated facilities. La Candelaria, which will be operated by Phelps Dodge, is expected to produce more than 100,000 tons of copper and 80,000 ounces of gold annually over the 34-year mine life. The Corporation has additional sources of copper that could be placed in production should market circumstances warrant. Permitting and significant capital expenditures would be required, however, to develop such additional production capacity. In 1993, Phelps Dodge Mining Company's Santa Gertrudis gold project in Mexico produced 38,221 ounces of gold, a 27 percent reduction from 1992's already reduced production levels. The 1993 production shortfalls primarily resulted from lower-than-expected ore grades and recoveries, and production losses caused by heavy rains during the first quarter. Phelps Dodge is currently evaluating alternatives for the sale of its interest in Santa Gertrudis. RESULTS OF PHELPS DODGE INDUSTRIES Phelps Dodge Industries is a business segment comprising a group of international companies that manufacture engineered products principally for the transportation and electrical sectors worldwide. Its operations are characterized by products with significant market share, internationally competitive cost and quality, and specialized engineering capabilities. This business segment includes the Corporation's carbon black and synthetic iron oxide operations through Columbian Chemicals Company and its subsidiaries (Columbian Chemicals); its wheel and rim operations through Accuride Corporation and its subsidiaries (Accuride); its magnet wire operations through Phelps Dodge Magnet Wire Company and its subsidiaries; its U.S. specialty conductor operations through Hudson International Conductors (Hudson); and its international wire and cable manufacturing operations through Phelps Dodge International Corporation. Phelps Dodge Industries recorded earnings from operations of $120.6 million in 1993, compared with $75.2 million in 1992 and $76.3 million in 1991. Earnings increases in 1993 were attributable to economic recovery in North America, particularly in the automotive sector, offsetting continued weakness in the European economies. Over 80 percent of the improvement came from the wheel and rim, magnet wire and carbon black businesses. Columbian Chemicals' 1993 earnings were higher than in 1992 primarily because of higher margins in North America that offset weak sales volumes in Europe. Columbian Chemicals' 1992 earnings were lower than in 1991 pri- marily because of lower industrial carbon black margins and lower earnings in Europe. Demand for rubber carbon black in the United States, however, strengthened in 1992. The 1991 results of Columbian Chemicals reflected weak demand in the North American automotive sector in the form of lower margins for carbon black, especially for rubber applications. In late 1993, Columbian Chemicals and its joint venture partner, Tiszai Vegyi Kombinat (TVK), began operation through Columbian Tiszai Carbon Ltd. (CTC) of the first carbon black manufacturing plant in Hungary. Located in the northeastern Hungarian city of Tiszaujvaros, CTC has an annual production capacity of 55,000 tons of carbon black, more than enough to supply the entire Hungarian carbon black market. The remaining production, nearly 70 percent, will be exported. Financing for CTC was arranged through the Overseas Private Investment Corporation (OPIC) and the European Bank for Reconstruction and Development (EBRD). It is the first project in Hungary to benefit from a direct loan by OPIC. Columbian Chemicals holds a 60 percent interest in CTC; TVK, Hungary's largest petrochemical company, holds the remaining 40 percent interest. Accuride increased its 1993 sales volume of steel wheels, rims and components by 18 percent over 1992 as a result of strong North American demand for medium and heavy trucks and trailers. In addition, Accuride experienced higher margins in 1993 resulting from improved productivity and lower unit production costs. Accuride's 1992 earnings also reflected both improved demand and improved margins over the prior year. Accuride's 1992 sales of wheels and rims were up approximately 22 percent as the truck and trailer industry began to recover from the 10-year lows experienced in 1991. The margin improvement resulted from productivity increases and cost reductions attributable to the company's $48 million modernization program initiated in 1990. This margin improvement was achieved notwithstanding lower average selling prices for steel wheels and rims resulting from con- tinued competitive pricing pressures in an industry that still has some excess capacity. Phelps Dodge Magnet Wire Company's 1993 earnings exceeded its 1992 earnings as a result of sales volume increases and improved margins in North America. Phelps Dodge Magnet Wire Company experienced steady volume growth during 1992 over 1991, and benefited from productivity gains and cost savings initiatives. Operating margins in 1992, however, were relatively flat as a result of intense competitive pressures. In March 1993, Phelps Dodge Magnet Wire Company expanded its international presence with the acquisition of Elektrodraht Mureck, Phelps Dodge Eldra GmbH. The magnet wire joint venture with Eldra Elektrodraht- Erzeugung GmbH, a leading European magnet wire manufacturer, is located in Mureck, Austria. Phelps Dodge holds a 51 percent interest in the company; Eldra Elektrodraht-Erzeugung GmbH holds the remaining 49 percent. In March 1994, Phelps Dodge Magnet Wire Company acquired a fine wire manufacturing plant in Laurinburg, North Carolina, from Rea Magnet Wire Company, Inc., and a magnet wire manufacturing plant in El Paso, Texas, from Texas Magnet Wire Company, an affiliate of Rea and Fujikura International, Inc. In 1993, the Corporation's international wire and cable business experienced increased earnings, primarily from the integration of a group of Venezuelan wire and cable manufacturing companies acquired in late 1992, and the continued growth of telephone and power cable and commercial wire sales in other markets. These increases in 1993 earnings were offset in part by lower sales volumes in Thailand where certain large-scale utility projects were delayed by the Thai government. In 1992, the Corporation's international wire and cable business enjoyed improved operating earnings over 1991 primarily because of volume improvements in Chile and Thailand and an expanding telephone service installation business in Central and South America. Some margin deterioration was experienced, however, resulting from tariff reductions and increased competition. The 1991 results of the Corporation's majority-owned international wire and cable manufacturing com- panies benefited from continued recovery in international markets for wire and cable, especially in Chile and Thailand where these affiliates showed significant increases in sales. In December 1992, Phelps Dodge, through its 87 percent owned Venezuelan associate company, Alambres y Cables Venezolanos, C.A. (ALCAVE), acquired three Venezuelan companies. These companies, which operate as a group, together with ALCAVE constitute one of the largest manufacturers of electrical and telecommunication copper and aluminum wires and cables in Venezuela and the Andean Region. Phelps Dodge Industries' 1992 earnings reflected a $5.0 million reserve at Hudson for the consolidation of its conductor operations in Ossining and Walden, New York, into its expanded Inman, South Carolina, facility. The consolidation, which was initiated in response to changes in market conditions, especially in the defense sector, was completed in 1993. Continued weak market conditions in the defense sector resulted in a 1993 earnings performance at Hudson that was below expectations. In 1993, operations outside the United States provided 51 percent of Phelps Dodge Industries' sales, compared with 48 percent in 1992 and 45 percent in 1991. During the year, operations outside the United States con- tributed 63 percent of the segment's earnings from operations, compared with 82 percent in 1992 and 69 percent in 1991. OTHER MATTERS RELATING TO THE STATEMENT OF CONSOLIDATED OPERATIONS The Corporation reported net interest expense in 1993 of $37.0 million, com- pared with $39.5 million in 1992 and $39.1 million in 1991. Reported net interest expense has remained relatively constant over the three-year period despite a $158.7 million increase in debt in 1993. This has resulted from the capitalization of interest charges during the construction and development of two major projects -- the La Candelaria copper-gold project in Chile and the carbon black project in Hungary. The Corporation's 1993 miscellaneous income, net of miscellaneous expense, was $16.4 million, compared with $10.7 million in 1992 and $28.4 million in 1991. A major factor in miscellaneous income and expense fluctuations over the past three years has been the receipt of dividends from the Corporation's 16.25 percent minority interest in Southern Peru Copper Corporation. The Corporation received pre-tax dividends of $2.9 million in 1993, $2.4 million in 1992, and $9.8 million in 1991. For the year ended December 31, 1993, the Corporation recorded a provision for taxes of $105.9 million (an effective rate of approximately 36.0 percent). This compares with a 1992 provision for taxes of $114.4 million (an effective rate of approximately 27.5 percent) and a 1991 provision of $131.4 million (an effective rate of approximately 32.5 percent). The 1993 effective rate was adversely affected by the passage of the Omnibus Budget Reconciliation Act of 1993 that retroactively raised the maximum corporate tax rate from 34 percent to 35 percent effective January 1, 1993. In addition to the effect of the increase in the maximum tax rate, the Corporation provided an additional $6.0 million for deferred taxes on temporary differences existing at December 31, 1992. The principal factor in the lower 1992 effective rate was a non-taxable gain of $36.4 million on a subsidiary's stock issuance from two Sumitomo companies' acquisition of a 20 percent interest in the La Candelaria copper-gold project in Chile. (See Note 5 to the Consolidated Financial Statements for a reconciliation of the Corporation's effective tax rates to statutory rates.) On February 15, 1994, the Corporation received an examination report from the Internal Revenue Service proposing increases to the Corporation's federal income tax liabilities for the years 1988 and 1989. The Corporation is currently preparing its response to this report and intends to protest all material unagreed adjustments. Management believes it has made adequate provision so that the final resolution of the issues involved, including their application to subsequent periods, will not have a material adverse effect on the consolidated financial position or operating results of the Corporation. On January 25, 1993, the U.S. Supreme Court ruled in favor of the government in U.S. vs. Hill, U.S. Supreme Court, No. 91-1421, reversing a decision that had permitted a favorable approach to the computation of the depletion preference for purposes of determining the alternative minimum tax liability. As a result of this decision, the Corporation amended its 1991 tax return and paid additional federal income taxes of approximately $26.6 million in February 1993. This ruling does not affect the net income of the Corporation, but does affect the timing of its tax payments. Under current financial accounting standards, any significant year-to- year movement in the rate of interest on long-term, high-quality corporate bonds necessitates a change in the discount rate used to calculate the actuarial present value of the Corporation's accumulated pension and other postretirement benefit obligations. As a result of the 1993 decline in long-term interest rates, the Corporation reduced its discount rate from 8.5 percent at December 31, 1992, to 7.25 percent at December 31, 1993. The Corporation's estimated pension obligations increased by a net $60 million primarily as a result of this discount rate reduction offset in part by a reduction in the assumed rate of increase in compensation levels from 5 percent to 4 percent. Other estimated postretirement benefit obligations of the Corporation increased by a net $14 million. The effect of the reduced discount rate on this estimated obligation was mostly offset by a 1 percentage point reduction for each year in the assumed annual rate of increase in the per capita cost of covered health care benefits. The increases in these estimated obligations did not affect the earnings reported by the Corporation in 1993. In accordance with applicable accounting standards, the Corporation will amortize such increases beginning in 1994 and continuing in subsequent years. The combined incremental expense will not be significant in 1994. For a further discussion of these issues, please see Notes 15 and 16 to the Consolidated Financial Statements. CHANGES IN FINANCIAL CONDITION; CAPITALIZATION At the end of 1993, the Corporation had cash and short-term investments of $255.8 million, compared with $251.2 million at the beginning of the year. The Corporation's operating activities provided $385.0 million of cash during the year which was more than adequate to cover dividend payments on its common stock and its routine investing activities. The cash used for the Corporation's capital expenditures at its La Candelaria copper-gold project ($189.8 million) and its carbon black project in Hungary ($33.6 million) were mostly provided by limited-recourse debt project financings ($198.2 million). Investing activities during 1993 included capital expenditures of $387.2 million, compared with $270.8 million in 1992, and acquisitions and investments in subsidiaries of $3.8 million, compared with $58.6 million in 1992. The $116.4 million increase in capital expenditures principally resulted from the Corporation's La Candelaria copper-gold project and Hungarian carbon black project. The decrease in investment in subsidiaries primarily reflected the 1992 acquisition of a group of wire and cable manufacturing companies in Venezuela. Investing activities in 1993 included cash proceeds of $6.7 million from the 1992 acquisition by two Sumitomo companies of a 20 percent interest in La Candelaria; that transaction also resulted in $41.9 million in cash proceeds in 1992 (see Note 3 to the Consolidated Financial Statements). The Corporation's total debt was $647.2 million at December 31, 1993 (including $82.7 million of foreign short-term borrowings), compared with $488.5 million at the end of 1992 (including $72.5 million of foreign short- term borrowings). The increase in total debt during the year principally resulted from limited-recourse project financings for La Candelaria, $164.7 million, and the carbon black project in Hungary, $33.5 million. The ratio of total debt to total capitalization was 23.7 percent at the end of 1993, compared with 19.4 percent at the end of 1992. On May 6, 1992, the Board of Directors declared a two-for-one stock split and a 10 percent increase in the Corporation's quarterly cash dividend, to 41.25 cents per share from 37.5 cents per share on a post-stock split basis (equivalent to 82.5 cents per share from 75 cents per share on a pre-stock split basis). The stock split, in the form of a 100 percent stock dividend, and the cash dividend were both payable June 8, 1992, to common shareholders of record at the close of business on May 18, 1992. As a result of the stock split, the Corporation's outstanding shares increased from approximately 35 million to approximately 70 million. This was reflected on the Consolidated Balance Sheet as an increase in "Common shares, par value $6.25" of approximately $219 million, with an offsetting charge to "Capital in excess of par value." The $3.1 million increase in dividend payments on the Corporation's common shares, from $113.0 million in 1992 to $116.1 million in 1993, principally resulted from the 10 percent increase in the dividend rate in the 1992 second quarter (from a quarterly rate of 37.5 cents per share to 41.25 cents per share). During the second quarter of 1993, final agreements were executed with a group of lenders for $290 million of 13-year debt financing for the La Candelaria project. These borrowings are limited recourse to the Corporation prior to satisfaction of certain completion tests, and non- recourse thereafter. The $290 million includes $200 million of floating rate dollar debt, $60 million of fixed rate dollar debt, and $30 million of floating rate debt denominated in Chilean pesos. The agreements provide for a three and one-half year draw-down period and a nine and one-half year repayment period. As of December 31, 1993, $205.7 million had been drawn down under these agreements. As the Corporation consolidates its interest in majority owned mining joint ventures using the proportional consolidation method, only 80 percent of this debt and related financing charges have been reflected in the Corporation's consolidated financial statements. The Corporation also caused the project to enter into an interest rate protection agreement with certain financial institutions to limit the effect of increases in the cost of the $200 million of floating rate debt. Under the terms of the agreement, the project will receive payments from these institutions if the six-month London Interbank Offered Rate (LIBOR) exceeds 9 percent prior to December 31, 2001, and 11 percent during the two years ending December 31, 2003. During 1993, the Corporation's 60 percent owned Hungarian subsidiary, Columbian Tiszai Carbon Ltd., borrowed $33.5 million under facilities from the Overseas Private Investment Corporation (OPIC) and the European Bank for Reconstruction and Development (EBRD) to finance construction of a carbon black manufacturing plant. Both facilities are with recourse to the Corporation prior to satisfaction of certain completion tests, and non- recourse thereafter. The OPIC facility is a $24.5 million fixed rate dollar borrowing bearing interest rates of between 8.01 percent and 9.15 percent, while the EBRD $9.0 million loan is a floating rate dollar borrowing. These borrowings mature in the years 1995 through 2001. In February 1993, the Corporation sold $90 million of 6.5 percent refunding bonds due April 1, 2013. The proceeds from the sale of these bonds were used to repay the Corporation's 7 percent Installment Sale Obligations due in the years 1993 through 2003 ($90.0 million) on April 1, 1993. The Corporation filed a shelf registration statement with the Securities and Exchange Commission on December 6, 1991, for up to $250 million of debt securities to be issued from time to time in one or more se- ries to refinance debt and for general corporate purposes. During the 1992 first quarter, the Corporation sold $100 million of 10-year notes bearing a coupon of 7.75 percent, maturing January 1, 2002, and $50 million of 7.96 percent notes due in the years 1998 through 2000. The proceeds from the sales of these notes, together with a small amount of cash from the Corporation, were used to retire $154.8 million of higher interest rate debt of the Corporation during the 1992 first quarter. On January 19, 1994, the Corporation issued $81.1 million of 5.45 percent obligations due in 2009. The proceeds from the issue are being used to retire the Corporation's 5.75 percent to 6.25 percent Series A and B notes due in the years 1994 through 2004. The Corporation entered into a new revolving credit agreement with several lenders on June 30, 1993, at which time it terminated its then existing credit agreement. The new agreement permits borrowings of up to $200 million from time to time until its maturity on June 30, 1998. Interest is payable at a fluctuating rate based on the agent bank's prime rate or a fixed rate, based on the Eurodollar Interbank Offered Rate or at fixed rates offered independently by the several lenders, for maturities of from seven to 360 days. This agreement provides for a facility fee of three-sixteenths of 1 percent of total commitments. The agreement requires the Corporation to maintain a minimum consolidated tangible net worth of $1.1 billion and limits indebtedness to 40 percent of total consolidated capitalization. There were no borrowings under the current or the previous agreement at either December 31, 1993, or December 31, 1992. The Corporation has other lines of credit totaling $90.5 million that are subject to agreement as to availability, terms and amount. The Corporation pays a fee at the rate of three-eighths of 1 percent for $12.5 million of these lines. There were no borrowings outstanding under these lines of credit at either December 31, 1993, or December 31, 1992. Accuride Canada Inc. has a revolving credit facility that permits borrowings of up to U.S. $25.0 million. Interest on these borrowings is payable at a fluctuating rate based on the agent bank's Base Rate Canada, or a fixed rate based on LIBOR, for maturities of one to six months. The $25.0 million commitment under this facility extends through June 1994, afterwhich the commitment is determined using a specified borrowing base calculation. At December 31, 1993, borrowings outstanding under this facility totaled $6.0 million, compared with $28.7 million at the beginning of the year. The current portion of the Corporation's long-term debt, scheduled for payment in 1994, is $17.2 million, including $13.7 million for its international manufacturing operations and $3.5 million on its air quality control obligations. During 1993, net working capital (exclusive of cash and short-term investments and current debt) decreased $7.3 million. This decrease principally resulted from a $20.6 million decrease in accrued income taxes and a $2.8 million increase in deferred income tax assets, partially offset by a $16.1 million net increase in accounts payable and accrued expenses. The $20.6 million decrease in accrued income taxes in 1993 was the result of approximately $26.6 million in additional federal income taxes paid with the Corporation's amended 1991 income tax return. The $16.1 million net increase in accounts payable and accrued expenses in 1993 principally resulted from improved vendor credit terms and increased accruals resulting from improved business in North America. During 1992, net working capital (exclusive of cash and short-term investments and current debt) increased $20.3 million. This increase principally resulted from a $40.4 million increase in accounts receivable, partially offset by a $20.2 million increase in accrued expenses. The $40.4 million increase in accounts receivable in 1992 was the result of approximately $16.0 million of acquired receivables from the acquisition of a group of Venezuelan wire and cable manufacturing companies, approximately $11.0 million due from the minority participants in the La Candelaria project for their portion of certain development costs, and generally higher sales in November and December of 1992 compared with the same period in 1991. The $20.2 million increase in accrued expenses in 1992 principally resulted from increased activity at La Candelaria, the acquisition of a group of Venezuelan wire and cable manufacturing companies, and the adoption of new accounting standards for postretirement and postemployment benefits. The Corporation expects capital outlays in 1994 to be approximately $215.0 million for Phelps Dodge Mining Company, including $110.0 million for the Corporation's 80 percent share of the La Candelaria project, and approximately $75.0 million for Phelps Dodge Industries. The La Candelaria outlays will be funded from the debt commitments for this project referred to above and by Phelps Dodge and the Sumitomo companies. The other capital outlays will be funded from cash reserves and operating cash flow or, if necessary, from other borrowings. The Corporation is subject to federal, state and local environmental laws, rules and regulations, including the Comprehensive Environmental Response, Compensation and Liability Act of 1980 (CERCLA or Superfund), as amended by the Superfund Amendments and Reauthorization Act of 1986. Under Superfund, the Environmental Protection Agency (EPA) has identified approximately 35,000 sites throughout the United States for review, ranking and possible inclusion on the National Priorities List (NPL) for possible response. Among the sites identified, EPA has included 13 sites owned by the Corporation. The Corporation believes that most, if not all, of its sites so identified will not qualify for listing on the NPL. In addition, the Corporation may be required to remove hazardous waste or remediate the alleged effects of hazardous waste on the environment associated with past disposal practices at sites not owned by the Corpora- tion. The Corporation has received notice that it is a Potentially Responsible Party (PRP) from EPA and/or individual states under CERCLA or a state equivalent and is participating in environmental assessment and remediation activity at 34 sites. For further information about these proceedings, see Item 3. Legal Proceedings, Part IV. At December 31, 1993, the Corporation had reserves of $74.0 million for remediation of certain of the sites referred to above and other environmental costs in accordance with its policy to record liabilities for environmental expenditures when it is probable that obligations have been incurred and the costs can reasonably be estimated. The Corporation's estimates of these costs are based upon currently available facts, existing technology, and presently enacted laws and regulations. Where the available information is sufficient to estimate the amount of liability, that estimate has been used; where the information is only sufficient to establish a range of probable liability and no point within the range is more likely than any other, the lower end of the range has been used. The amounts of these liabilities are very difficult to estimate due to such factors as the unknown extent of the remedial actions that may be re- quired and, in the case of sites not owned by the Corporation, the unknown extent of the Corporation's probable liability in proportion to the probable liability of other parties. Moreover, the Corporation has other probable environmental liabilities that cannot in its judgment reasonably be estimated, and losses attributable to remediation costs are reasonably possible at other sites. The Corporation cannot now estimate the total additional loss it may incur for such environmental liabilities, but such loss could be substantial. The possibility of recovery of some of the environmental remediation costs from insurance companies or other parties exists; however, the Corporation does not recognize these recoveries in its financial statements until they become probable. The Corporation's operations are subject to myriad environmental laws and regulations in jurisdictions both in the United States and in other countries in which it does business. For further discussion of these laws and regulations, please see "Environmental and Other Regulatory Matters" and "Environmental Matters." The estimates given in those discussions of the capital expenditures for programs to comply with applicable environmental laws and regulations in 1994 and 1995, and the expenditures for those programs in 1993, are separate from the reserves and estimates described above. Bills have been proposed in both the U.S. House of Representatives and the U.S. Senate that would amend the Mining Law of 1872. The proposed amendments would impose royalties on mining operations on unpatented lands; restrict access to public lands for exploration, development and mining activities; and impose more stringent environmental protection requirements. While the effect on Phelps Dodge's current operations and other currently owned mineral resources would be minimal, adoption of either of the proposed bills in their current form would result in significant additional capital expenditures and operating expenses in the development and operation of new mines on federal lands. The resulting additional restrictions and delays in the development of such mines would seriously impact future exploration and development on federal lands in the United States. In 1993, the New Mexico legislature passed the New Mexico Mining Act. The Act requires that operators of new and existing mining operations, as well as exploration activities, submit permit applications and reclamation plans for their operations and provide sufficient financial assurance until reclamation or post-mining land use goals are met. Regulations to implement the Act are due by June 18, 1994. The Act will increase the Corporation's regulatory and compliance costs for its New Mexico operations, but until the implementing regulations are adopted it is not possible to determine the impact of the new requirements on the Corporation. During 1993, the Corporation purchased 130,000 of its common shares under its current 4 million common share buy-back program initiated in September 1989 (numbers of shares have been revised to give effect to the two-for-one stock split in May 1992). Under this program, the Corporation from time to time makes purchases in the open market and also considers purchasing common shares in negotiated transactions. From November 1988 through December 31, 1993, the Corporation purchased a total of 6,945,000 common shares -- 2,373,000 shares under the current program and the balance under the now superseded program begun in November 1988. These purchased shares were restored to the treasury. There were 70,531,081 common shares outstanding at December 31, 1993. During 1992, the Corporation elected early adoption of Statement of Financial Accounting Standards (SFAS) No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions," No. 109, "Accounting for Income Taxes," and No. 112, "Employers' Accounting for Postemployment Benefits." All three standards have been treated as though they were in effect since January 1, 1992. The cumulative effects of the accounting changes required by these standards have been reflected in revised 1992 first quarter results. Adoption of the standards also requires recognition of certain ongoing operating costs in excess of those recorded under previously used accounting methods. For example, as a result of the new tax standard, Phelps Dodge increased the book value of certain purchased assets at Chino Mines Company, Columbian Chemicals Company, Accuride Corporation and Hudson International Conductors by $90.9 million as of January 1, 1992, with a corresponding increase in deferred tax liabilities. As a result, earnings from operations were reduced by $7.3 million for incremental 1992 depreciation and other expenses; net income was not affected because the tax provision was reduced by a corresponding amount. The combined cumulative effect of accounting changes from the adoption of these three new accounting standards was a one-time transition charge of $111.1 million before taxes ($79.9 million, or $1.13 per common share, after taxes). With respect to the Corporation's liability for postretirement benefits, if the Corporation's inflation assumptions prove to be incorrect, its estimates could be significantly different (for example, an increase in the medical inflation rate of 1 percent could result in an increase of as much as $12 million in the obligation). The adoption of these standards has had no effect on cash flow and has not affected adversely in any material respect the position of the Corporation under its debt agreements. The disclosures for these accounting changes are included in Note 16 for SFAS No. 106, Note 5 for SFAS No. 109 and Note 17 for SFAS No. 112. CAPITAL OUTLAYS The Corporation's capital outlays in each of the past three years are set forth in the following table. These capital outlays are exclusive of capitalized interest and the portions of the expenditures at Morenci, Chino and La Candelaria payable by minority interest holders. DIVIDENDS AND MARKET PRICE RANGES Phelps Dodge's common shares are listed on the New York Stock Exchange, the principal market on which they are traded. At March 2, 1994, there were 9,606 holders of record of the Corporation's common shares. The Corporation paid quarterly dividends of 37.5 cents on each common share throughout 1991 and in the 1992 first quarter (dividend amounts have been revised to give effect to the May 1992 two-for-one stock split). In the 1992 second quarter, the quarterly dividend was increased 10 percent to 41.25 cents on each common share and has continued at that rate. The table below sets forth the high and low prices per common share (composite quotation) in the periods indicated. INFLATION During the last three years, the principal impact of general inflation upon the financial results of the Corporation has been on unit production costs, especially energy and supply costs, at the Corporation's mining and industrial operations. In considering the impact of changing prices on the financial results of the Corporation, it is important to recognize that the selling price of the Corporation's principal product, copper, does not necessarily parallel the rate of inflation or deflation. PHELPS DODGE CORPORATION AND CONSOLIDATED SUBSIDIARIES INDEX TO CONSOLIDATED FINANCIAL STATEMENTS - ---------------------------------------------------------------------------- The consolidated balance sheet at December 31, 1993 and 1992, and the related consolidated statements of operations and of cash flows for each of the three years in the period ended December 31, 1993, and notes thereto, together with the report thereon of Price Waterhouse dated January 24, 1994, appear in this report. The additional financial data referred to below should be read in conjunction with these financial statements. Schedules not included with these additional financial data have been omitted because they are not applicable or the required information is shown in the financial statements or notes thereto. The individual financial statements of the Corporation have been omitted because the Corporation is primarily an operating company and all subsidiaries included in the consolidated financial statements, in the aggregate, do not have minority equity interests and/or indebtedness to any person other than the Corporation or its consolidated subsidiaries in amounts which together exceed 5 percent of total consolidated assets at December 31, 1993. Separate financial statements of subsidiaries not consolidated and 50 percent or less owned persons accounted for by the equity method, other than those for which summarized financial information is provided in Note 2 to the Consolidated Financial Statements, have been omitted because, if considered in the aggre- gate, such subsidiaries and 50 percent or less owned persons would not constitute a significant subsidiary. ADDITIONAL FINANCIAL DATA Financial statement schedules for the years ended December 31, 1993, 1992 and 1991: V - Property, plant and equipment VI - Accumulated depreciation, depletion and amortization of property, plant and equipment VII - Guarantees of securities of other issuers VIII - Valuation and qualifying accounts and reserves IX - Short-term borrowings X - Supplementary income statement information REPORT OF INDEPENDENT ACCOUNTANTS ON FINANCIAL STATEMENT SCHEDULES To the Board of Directors of Phelps Dodge Corporation Our audits of the consolidated financial statements referred to in our report dated January 24, 1994, appearing in this report also included an audit of the Financial Statement Schedules listed in the foregoing index titled "Additional Financial Data." In our opinion, these Financial Statement Schedules present fairly, in all material respects, the information set forth therein when read in conjunction with the related con- solidated financial statements. PRICE WATERHOUSE Phoenix, Arizona January 24, 1994 REPORT OF MANAGEMENT The management of Phelps Dodge Corporation is responsible for preparing the consolidated financial statements presented in this annual report and for their integrity and objectivity. The statements have been prepared in accordance with generally accepted accounting principles appropriate in the circumstances, and include amounts that are based on management's best estimates and judgments. Management has also prepared the other information in this annual report and is responsible for its accuracy and consistency with the financial statements. Management maintains a system of internal controls, including internal accounting controls, which in management's opinion provides reasonable assurance that assets are safeguarded and that transactions are properly recorded and executed in accordance with management's authorization. The system includes formal policies and procedures that are communicated to em- ployees with significant roles in the financial reporting process and updated as necessary. The system also includes the careful selection and training of qualified personnel, an organization that provides a segregation of responsibilities and a program of internal audits that independently assesses the effectiveness of internal controls and recommends possible improvements. The Audit Committee, consisting of six non-employee directors, meets at least three times a year to review, among other matters, internal control conditions and internal and external audit plans and results. It meets periodically with senior officers, internal auditors and independent accoun- tants to review the adequacy and reliability of the Corporation's ac- counting, financial reporting and internal controls. The consolidated financial statements have also been audited by Price Waterhouse, our independent accountants, whose appointment was ratified by the shareholders. The Price Waterhouse examination included a study and evaluation of internal accounting controls to establish a basis for reliance thereon in determining the nature, extent and timing of audit tests applied in the examination of the financial statements. Management also recognizes its responsibility for fostering a strong ethical climate so that the Corporation's affairs are conducted according to the highest standards of personal and corporate conduct. This responsibility is characterized and reflected in the Corporation's code of business ethics and policies, which is distributed throughout the Corporation. The code of conduct addresses, among other things, the necessity of ensuring open communication within the Corporation; potential conflicts of interest; compliance with all applicable laws, including those relating to financial disclosure; and the confidentiality of proprietary in- formation. The Corporation maintains a systematic program to assess com- pliance with these policies. REPORT OF INDEPENDENT ACCOUNTANTS To the Board of Directors and Shareholders of Phelps Dodge Corporation In our opinion, the accompanying consolidated balance sheet and the related consolidated statements of operations, of retained earnings and of cash flows present fairly, in all material respects, the financial position of Phelps Dodge Corporation and its subsidiaries at December 31, 1993 and 1992, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 1993, in conformity with generally accepted accounting principles. These financial statements are the responsibility of the Corporation's management; our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits of these statements in accordance with generally accepted auditing standards which require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant esti- mates made by management, and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for the opinion expressed above. As described in Note 1 to the Consolidated Financial Statements, the Corporation changed its method of accounting for postretirement and postemployment benefits and income taxes effective January 1, 1992. PRICE WATERHOUSE Phoenix, Arizona January 24, 1994 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Dollar amounts in tables stated in thousands except as noted) 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES Accounting and Reporting Changes. In 1992, the Corporation elected early adoption of Statement of Financial Accounting Standards (SFAS) No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions," No. 109, "Accounting for Income Taxes," and No. 112, "Employers' Accounting for Postemployment Benefits." All three standards were treated as though they were in effect since January 1, 1992. The cumulative effects of the accounting changes required by these standards were reflected in revised 1992 first quarter results. Adoption of the standards also required recognition of certain ongoing operating costs in excess of those recorded under previously used accounting methods. These costs have been allocated to each quarter of 1992 and were reflected in revised quarterly results. The adoption of these standards has had no effect on cash flow and has not affected adversely in any material respect the position of the Corporation under its debt agreements. The combined cumulative effect of accounting changes from the adoption of these three new accounting standards was a one-time transition charge of $111.1 million before taxes ($79.9 million, or $1.13 per common share, after taxes). The disclosures for these accounting changes are included in Note 16 for SFAS No. 106, Note 5 for SFAS No. 109 and Note 17 for SFAS No. 112. On May 6, 1992, the Board of Directors declared a two-for-one stock split effected in the form of a 100 percent stock dividend payable June 8, 1992, to common shareholders of record at the close of business on May 18, 1992. As a result of the stock split, the Corporation's outstanding shares increased from approximately 35 million to approximately 70 million. This was reflected on the Consolidated Balance Sheet as an increase in "Common shares, par value $6.25" of approximately $219 million, with an offsetting charge to "Capital in excess of par value." Per share amounts and the average number of shares outstanding have been retroactively revised for all periods presented. Basis of Consolidation. The consolidated financial statements include the accounts of the Corporation and its majority-owned subsidiaries. Interests in mining joint ventures in which the Corporation owns more than 50 percent are reported using the proportional consolidation method. Interests in other majority-owned subsidiaries are reported using the full consolidation method; the consolidated financial statements include 100 percent of the as- sets and liabilities of these subsidiaries and the ownership interests of minority participants are recorded as "Minority interest in subsidiaries" (minority interest in the net income of these subsidiaries was not sig- nificant). All material intercompany balances and transactions are eliminated. Investments in unconsolidated companies owned 20 percent or more are recorded on an equity basis. Investments in companies less than 20 percent owned are carried at cost. Foreign Currency Translation. Except as noted below, the assets and liabilities of foreign subsidiaries are translated at current exchange rates while revenues and expenses are translated at average rates in effect for the period. The related translation gains and losses are included in a separate component of common shareholders' equity. For the translation of the financial statements of certain foreign subsidiaries dealing pre- dominantly in U.S. dollars and for those affiliates operating in highly inflationary economies, assets and liabilities receivable or payable in cash are translated at current exchange rates, and inventories and other non- monetary assets and liabilities are translated at historical rates. Gains and losses resulting from translation of such financial statements are in- cluded in operating results, as are gains and losses incurred on foreign currency transactions. Statement of Cash Flows. For the purpose of preparing the Consolidated Statement of Cash Flows, the Corporation considers all highly liquid investments with a maturity of three months or less when purchased to be cash equivalents. Inventories and Supplies. Inventories and supplies are stated at the lower of cost or market. Cost for substantially all inventories is determined by the last-in, first-out method (LIFO). Cost for substantially all supplies is determined by a moving-average method. Property, Plant and Equipment. Property, plant and equipment are carried at cost. Cost of significant assets includes capitalized interest incurred during the construction and development period. Expenditures for replacements and betterments are capitalized; maintenance and repair expenditures are charged to operations as incurred. The principal depreciation methods used are the units of production method for mining, smelting and refining operations and, for other operations, the straight-line method based upon the estimated lives of spe- cific classes or groups of depreciable assets. Upon disposal of assets depreciated on a group basis, cost less salvage is charged to accumulated depreciation. Values for mining properties represent mainly acquisition costs or pre- 1932 engineering valuations. Depletion of mines is computed on the basis of an overall unit rate applied to the pounds of principal products sold from mine production. Mine exploration costs and development costs to maintain production of operating mines are charged to operations as incurred. Mine development expenditures at new mines and major development expenditures at operating mines that are expected to benefit future production are capitalized and amortized on the units of production method over the estimated commercially recoverable minerals. Environmental Expenditures. Environmental expenditures are expensed or capitalized depending upon their future economic benefits. Liabilities for such expenditures are recorded when it is probable that obligations have been incurred and the costs can be reasonably estimated. The Corporation's estimates of these costs are based upon currently available facts, existing technology, and presently enacted laws and regulations. Where the available information is sufficient to estimate the amount of liability, that estimate has been used; where the information is only sufficient to establish a range of probable liability and no point within the range is more likely than any other, the lower end of the range has been used. The possibility of recovery of some of these costs from insurance companies or other parties exists; however, the Corporation does not recognize these recoveries in its financial statements until they become probable. Goodwill. Included in "Other assets and deferred charges" are costs in excess of the net assets of businesses acquired. These amounts are amortized on a straight-line basis over periods of 20 to 40 years. Price Protection Programs. The Corporation may periodically use various price protection programs to ameliorate the effect of declining prices on a portion of its copper production. The costs of programs that guarantee a minimum price over a specified period are amortized on a straight-line basis over that period. Gains and losses from programs that effectively establish price ranges for future production are recognized in income during the periods affected. Income Taxes. In addition to charging income for taxes actually paid or payable, the provision for taxes reflects deferred income taxes resulting from temporary differences in 1993 and 1992 and timing differences in 1991 between financial and taxable income. Beginning with the 1992 adoption of SFAS No. 109, the effect on deferred income taxes of a change in tax rates is recognized in income in the period that includes the enactment date. Under the accounting method used in 1991, deferred income taxes were recognized using the tax rate applicable to the year of the calculation and were not adjusted for subsequent changes in tax rates. Pension Plans. The Corporation has trusteed, non-contributory pension plans covering substantially all of its U.S. employees and in some cases employees of international subsidiaries. The benefits are based on, in the case of certain plans, final average salary and years of service and, in the case of other plans, a fixed amount for each year of service. The Corporation's funding policy provides that payments to the pension trusts shall be at least equal to the minimum funding requirements of the Employee Retirement Income Security Act of 1974 for U.S. plans or, in the case of international subsidiaries, the minimum legal requirements in that particular country. Additional payments may also be provided by the Corporation from time to time. Postretirement Benefits Other Than Pensions. The Corporation has several postretirement health care and life insurance benefit plans covering most of its U.S. employees and in some cases employees of international subsidiaries. Postretirement benefits vary among plans and many plans require contributions from employees. Effective January 1, 1992, the Corporation began accounting for these benefits on an accrual basis. The Corporation's funding policy provides that payments shall be at least equal to its cash basis obligation, plus additional amounts that may be approved by the Corporation from time to time to the extent that they are deductible for income tax purposes. Postemployment Benefits. The Corporation has certain postemployment benefit plans covering most of its U.S. employees and in some cases employees of international subsidiaries. The benefit plans may provide severance, disability, supplemental health care, life insurance or other welfare benefits. Effective January 1, 1992, the Corporation began accounting for these benefits on an accrual basis. The Corporation's funding policy provides that payments shall be at least equal to its cash basis obligation, plus additional amounts that may be approved by the Corporation from time to time to the extent that they are deductible for income tax purposes. Earnings per Share. Earnings per share amounts are computed based on the weighted average number of shares actually outstanding during the period plus the shares that would be outstanding assuming the exercise of dilutive stock options, which are considered to be common stock equivalents. The number of equivalent shares that would be issued from the exercise of stock options is computed using the treasury stock method. Reclassification. For comparative purposes, certain prior year amounts have been reclassified to conform with the current year presentation. 2. EQUITY EARNINGS AND INVESTMENTS AND LONG-TERM RECEIVABLES Equity earnings (losses) were as follows: Dividends were received as follows: Investments and long-term receivables were as follows: Retained earnings of the Corporation include undistributed earnings of equity investments of (in millions): 1993 - $54.3; 1992 - $54.7; 1991 - $59.9. Condensed financial information for companies in which the Corporation has equity basis investments together with majority-owned foreign subsidiaries previously accounted for on an equity basis is as follows: 3. GAIN FROM SUBSIDIARY'S STOCK ISSUANCE In September 1992, a subsidiary of Sumitomo Metal Mining Co., Ltd. and Sumitomo Corporation, both of Japan, acquired a 20 percent interest in Compania Contractual Minera Candelaria, the Chilean contractual mining company that holds and is developing the La Candelaria project, for $52.8 million. Phelps Dodge, formerly the sole owner of the company, holds the remaining 80 percent interest. Phelps Dodge's share of the Sumitomo proceeds included a $40 million purchase price plus $1.9 million in closing adjustments. Deferred income taxes were not provided by Phelps Dodge on the $36.4 million book gain because the proceeds were indefinitely reinvested in the Chilean company to help fund construction and development of the project. 4. MISCELLANEOUS INCOME AND EXPENSE, NET Interest income totaled $10.9 million in 1993, principally from the Corporation's short-term investments, compared with $10.4 million and $12.0 million in 1992 and 1991, respectively. Miscellaneous income in 1993 also included a pre-tax $2.9 million dividend on its 16.25 percent minority interest in Southern Peru Copper Corporation, compared with $2.4 million and $9.8 million in 1992 and 1991, respectively. 5. INCOME TAXES As discussed in Note 1 to the Consolidated Financial Statements, the Corporation elected early adoption of SFAS No. 109, "Accounting for Income Taxes," as of January 1, 1992. SFAS No. 109 mandates an asset and liability approach for financial accounting and reporting of income taxes. One of the principal requirements of the new standard is that changes in tax rates and laws be reflected in income from operations in the period such changes are enacted. Under the Corporation's previous accounting method such changes were reflected over time. The new standard also requires balance sheet classification of deferred income taxes according to the balance sheet classification of the asset or liability to which the temporary difference is related. The cumulative effect on prior years of this change in accounting principle was a one-time transition charge of $10.0 million, or 14 cents per share. This charge was combined with the cumulative effect of other accounting changes (see Notes 16 and 17) and reported separately in the Consolidated Statement of Operations for the year ended December 31, 1992. One of the more significant effects of the new standard on the Corporation is the treatment of deferred income taxes resulting from prior business combinations. As a result of the new standard, Phelps Dodge in- creased the book value of certain purchased assets at Chino Mines Company, Columbian Chemicals Company, Accuride Corporation and Hudson International Conductors by $90.9 million as of January 1, 1992, with a corresponding increase in deferred income tax liabilities. Geographic sources of income before taxes and cumulative effect of accounting changes for the years ended December 31 were as follows: The provisions for income taxes for the years ended December 31 were as follows: A reconciliation of the U.S. statutory tax rate to the Corporation's effective tax rate is as follows: The Corporation paid federal, state, local and foreign income taxes of approximately $113 million in 1993, compared with approximately $85 million in 1992 and approximately $100 million in 1991. As of December 31, 1993, the Corporation had alternative minimum tax credits of approximately $110 million available for carryforward for federal income tax purposes. These credits can be carried forward indefinitely, but may only be used to the extent the regular tax exceeds the alternative minimum tax. The Corporation also has regular foreign tax credit and alternative minimum foreign tax credit carryforwards for federal income tax purposes of approximately $6 million and $34 million, which begin to expire in 1994. The Corporation's federal income tax returns for the years 1988 through 1989 and Arizona state income tax returns for the years 1988 through 1992 are currently under examination. The Corporation also has received a proposed assessment from the state of New Mexico relating to the Corporation's New Mexico state income tax liability for the years 1989 through 1990. Management believes that it has made adequate provision so that the final resolution of the issues involved, including application of those determinations to subsequent open years, will not have a material adverse effect on the consolidated financial condition or results of operations of the Corporation. Deferred income tax assets and (liabilities) comprised the following at December 31: Income taxes have not been provided on the Corporation's share ($198 million) of undistributed earnings of those manufacturing and mining interests abroad over which the Corporation has sufficient influence to control the distribution of such earnings and has determined that such earnings have been reinvested indefinitely. These earnings could become subject to additional tax if they were remitted as dividends, if foreign earnings were lent to the Corporation or a U.S. affiliate, or if the Corporation should sell its stock in the subsidiaries. It is not practicable to estimate the amount of additional U.S. tax that might be payable on the foreign earnings; however, the Corporation believes that U.S. foreign tax credits would largely eliminate any U.S. tax. Additional foreign withholding taxes which would be payable if all of the earnings were remitted as dividends are estimated to be $25.5 million. 6. INVENTORIES AND SUPPLIES Inventories are as follows (in millions): Inventories valued by the last-in, first-out method would have been greater if valued at current costs by approximately $101 million and $106 million at December 31, 1993 and 1992, respectively. Supplies in the amount of $103.3 million and $101.5 million at December 31, 1993 and 1992, respectively, are stated net of a reserve for obsolescence of $12.7 million and $16.7 million, respectively. 7. PROPERTY, PLANT AND EQUIPMENT Property, plant and equipment comprise the following (in millions): The net increases in property, plant and equipment of $231.6 million in 1993 and $214.1 million in 1992 are summarized below (in millions): 8. OTHER ASSETS AND DEFERRED CHARGES Other assets and deferred charges are as follows (in millions): 9. ACCOUNTS PAYABLE AND ACCRUED EXPENSES Accounts payable and accrued expenses are as follows (in millions): 10. OTHER LIABILITIES AND DEFERRED CREDITS Other liabilities and deferred credits are as follows (in millions): 11. LONG-TERM DEBT AND OTHER FINANCING Long-term debt due after one year is summarized below (in millions): Annual maturities of debt outstanding at December 31, 1993, are as follows (in millions): 1994 - $17.2; 1995 - $11.1; 1996 - $5.0; 1997 - $33.5; 1998 - $38.5. The Corporation filed a shelf registration statement with the Securities and Exchange Commission on December 6, 1991, for up to $250 million of debt securities to be issued from time to time in one or more se- ries to refinance debt and for general corporate purposes. During the 1992 first quarter, the Corporation sold $100 million of 10-year notes bearing a coupon of 7.75 percent, maturing January 1, 2002, and $50 million of 7.96 percent notes due in the years 1998 through 2000. The proceeds from the sales of these notes, together with a small amount of cash from the Corporation, were used to retire $154.8 million of higher interest rate debt of the Corporation during the 1992 first quarter. During 1993, the Corporation refunded its 7 percent installment sale obligations due in the years 1994 through 2004 through the issuance of $90 million of 6.50 percent obligations due 2013. On January 19, 1994, the Corporation issued $81.1 million of 5.45 percent obligations due 2009; the proceeds from the issue are being used to retire its 5.75 percent to 6.25 percent Series A and B notes due in the years 1994 through 2004 on March 1, 1994. The Corporation entered into a new revolving credit agreement with several lenders on June 30, 1993, at which time it terminated its then existing credit agreement. The new agreement permits borrowings of up to $200 million from time to time until its maturity on June 30, 1998. Interest is payable at a fluctuating rate based on the agent bank's prime rate or a fixed rate, based on the Eurodollar Interbank Offered Rate or at fixed rates offered independently by the several lenders, for maturities of from seven to 360 days. This agreement provides for a facility fee of three-sixteenths of 1 percent of total commitments. The agreement requires the Corporation to maintain a minimum consolidated tangible net worth of $1.1 billion and limits indebtedness to 40 percent of total consolidated capitalization. There were no borrowings under the previous or the current agreement at either December 31, 1992, or December 31, 1993. The Corporation has other lines of credit totaling $90.5 million which are subject to agreement as to availability, terms and amount. The Corporation pays a fee at the rate of three-eighths of 1 percent for $12.5 million of these lines. There were no borrowings outstanding under these lines of credit at either December 31, 1993, or December 31, 1992. The Corporation had $82.7 million in short-term debt at December 31, 1993, compared with $72.5 million at December 31, 1992, reflecting borrowings by its international mining and manufacturing operations. As of December 31, 1993, the Corporation's 80 percent owned Compania Contractual Minera Candelaria subsidiary had drawn down $205.7 million under limited-recourse debt project financing agreements to finance construction of the La Candelaria copper-gold project in Chile. Under the proportional consolidation method, the Corporation reflects $164.7 million of this amount in its financial statements. These borrowings are limited recourse to the Corporation prior to satisfaction of certain completion tests, and non- recourse thereafter. The financing arrangements for La Candelaria provide for a total of $290 million of 13-year financing including $200 million of floating rate dollar debt (with a rate based on the six-month London Interbank Offered Rate (LIBOR)), $60 million of fixed rate dollar debt, and $30 million of floating rate debt denominated in Chilean pesos (with a rate based on the 90-day Tasa Activa Bancaria), with a three and one-half year draw-down period and a nine and one-half year repayment period. These agreements were executed in June 1993, and the initial draw-down was made in September 1993. The Corporation also caused the project to enter into an interest rate protection agreement with certain financial institutions to limit the effect of increases in the cost of the $200 million of floating rate dollar debt. Under the terms of the agreement, the project will receive payments from these institutions if the six-month LIBOR exceeds 9 percent prior to December 31, 2001, and 11 percent during the two years ending December 31, 2003. The Corporation's 60 percent owned Hungarian subsidiary, Columbian Tiszai Carbon Ltd., has borrowed $33.5 million under facilities from the Overseas Private Investment Corporation (OPIC) and the European Bank for Reconstruction and Development (EBRD) to finance construction of a carbon black manufacturing plant. Both facilities are with recourse to the Corporation prior to satisfaction of certain completion tests, and non- recourse thereafter. The OPIC facility is a $24.5 million fixed rate dollar borrowing bearing interest rates of between 8.01 percent and 9.15 percent, while the EBRD $9 million loan is a floating rate dollar borrowing. These borrowings mature in the years 1995 through 2001. 12. SHAREHOLDERS' EQUITY Changes in common shareholders' capital accounts are summarized below: In 1988, the Corporation adopted a Preferred Share Purchase Rights Plan and declared a dividend of one right on each of its common shares. In certain circumstances, if a person or group of persons acquires or tenders for 20 percent or more of the Corporation's outstanding common shares, these rights vest and entitle the holder to certain share purchase rights. Until 10 days after vesting, the rights may be modified or redeemed by the Board of Directors. During 1993, the Corporation purchased 130,000 of its common shares under its current 4 million common share buy-back program initiated in September 1989 (numbers of shares have been revised to give effect to the two-for-one stock split in May 1992). Under this program the Corporation from time to time makes purchases in the open market and also considers purchasing common shares in negotiated transactions. From November 1988 through December 31, 1993, the Corporation purchased a total of 6,945,000 common shares -- 2,373,000 shares under the current program and the balance under the now superseded program begun in November 1988. These purchased shares were restored to the treasury. The Corporation has 6,000,000 authorized preferred shares with a par value of $1.00 each; no shares were outstanding at either December 31, 1993, or December 31, 1992. 13. STOCK OPTION PLANS; RESTRICTED STOCK Executives and other key employees have been granted options to purchase common shares under stock option plans adopted in 1979, 1987 and 1993. In each case, the option price equals the fair market value of the common shares on the day of the grant. Some of the options include limited stock appreciation rights under which an optionee has the right, in the event common shares are purchased pursuant to a third party tender offer or in the event a merger or similar transaction in which the Corporation shall not survive as a publicly held corporation is approved by the Corporation's shareholders, to relinquish the option and to receive from the Corporation an amount per share equal to the excess of the price payable for a common share in such offer or transaction over the option price per share. The 1993 plan provides (and the 1987 plan provided) for "reload" option grants to executives and other key employees. If an optionee exercises an option under the 1993 or 1987 plan with already-owned shares of the Corporation, the optionee receives a reload option that restores the option opportunity on a number of common shares equal to the number of shares used to exercise the original option. A reload option has the same terms as the original option except that it has an exercise price per share equal to the fair market value of a common share on the date the reload option is granted and is exercisable six months after the date of grant. The 1993 plan provides (and the 1987 plan provided) for the issuance to executives and other key employees, without any payment by them, of common shares subject to certain restrictions (Restricted Stock). The 1993 plan limits the award of Restricted Stock to 1,000,000 shares. Under a stock option plan adopted in 1989, options to purchase common shares have been granted to directors who have not been employees of the Corporation or its subsidiaries for one year or are not eligible to participate in any plan of the Corporation or its subsidiaries entitling participants to acquire stock, stock options or stock appreciation rights. At December 31, 1993, options for 5,812 shares, 944,110 shares, 27,160 shares and 1,950 shares were exercisable under the 1979 plan, the 1987 plan, the 1989 plan and the 1993 plan, respectively, at average prices of $10.35, $37.16, $31.42 and $44.81 per share. In addition, 49,200 shares of Restricted Stock issued under the 1987 plan and 51,000 shares of Restricted Stock issued under the 1993 plan were outstanding at December 31, 1993. Also at December 31, 1993, 4,257,004 shares were available for option grants (including 949,000 shares as restricted stock awards) under the 1993 plan (plus an additional 939,110 shares that may be issued as reload options) and 113,067 shares were available for option grants under the 1989 plan. These amounts are subject to future adjustment. No further options may be granted under the 1987 plan or the 1979 plan. Changes during 1991, 1992 and 1993 in options outstanding for the combined plans were as follows: Changes during 1991, 1992 and 1993 in Restricted Stock were as follows: 14. CUMULATIVE TRANSLATION ADJUSTMENTS Changes in the cumulative translation adjustments account during 1991, 1992 and 1993 are summarized below (in millions): 15. PENSION PLANS The Corporation has several non-contributory employee defined benefit pension plans covering substantially all U.S. employees. Employees covered under the salaried defined benefit pension plans are eligible to participate upon the completion of one year of service, and benefits are based upon final average salary and years of service. Employees covered under the remaining plans are generally eligible to participate at the time of em- ployment, and benefits are generally based on a fixed amount for each year of service. All employees are vested in the plans after five years of service. The Corporation also maintains pension plans for certain employees of international subsidiaries following the legal requirements in those countries. In a number of these plans, the plan assets exceed the projected benefit obligations (overfunded plans) and in the remainder of the plans, the projected benefit obligations exceed the plan assets (underfunded plans). The status of employee pension benefit plans at December 31 is summarized below (in millions): The Corporation's pension plans were valued between November 1, 1992, and January 1, 1993, and the obligations were projected to, and the assets were valued as of, the end of 1993. The majority of plan assets are invested in a diversified portfolio of stocks, bonds and cash or cash equivalents. A small portion of the plan assets is invested in pooled real estate and other private corporate investment funds. The components of net periodic pension cost (credit) were as follows (in millions): Assumptions used to develop the net periodic pension cost included an 8.5 percent discount rate in 1993 and 1992, compared with a discount rate of 9 percent in 1991. An expected long-term rate of return on assets of 10 percent and a rate of increase in compensation levels of 5 percent were used for all three years. For the valuation of pension obligations, the discount rate at the end of 1993 was 7.25 percent, reduced from 8.5 percent in 1992 and 1991, and the rate of increase in compensation levels was 4 percent, reduced from 5 percent in 1992 and 1991. The Corporation recognizes a minimum liability in its financial statements for its underfunded plans. "Other liabilities and deferred credits" at December 31, 1993, included $43 million relating to this minimum liability, compared with $23 million at December 31, 1992. This amount was offset by a $17 million intangible asset, a $16 million reduction in "Common Shareholders' Equity" and a $10 million deferred tax benefit at December 31, 1993, compared with a $17 million intangible asset, a $4 million reduction in "Common Shareholders' Equity" and a $2 million deferred tax benefit at December 31, 1992. The Corporation intends to fund at least the minimum amount required under the Employee Retirement Income Security Act of 1974 for U.S. plans or, in the case of international subsidiaries, the minimum legal requirements in that particular country. The excess of amounts accrued over minimum funding requirements, together with such excess amounts accrued in prior years, have been included in "Other liabilities and deferred credits." The anticipated funding for the current year is included in "Accounts payable and accrued expenses." 16. POSTRETIREMENT BENEFITS OTHER THAN PENSIONS As discussed in Note 1 to Consolidated Financial Statements, the Corporation elected early adoption of SFAS No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions," as of January 1, 1992. SFAS No. 106 requires recognition of postretirement medical and life insurance benefits on an accrual rather than cash basis. One of the principal requirements of the method is that the expected cost of providing such postretirement benefits be accrued during the years employees render the necessary service. Under the Corporation's previous accounting method, such benefits were accounted for on a cash basis. In 1992, the Corporation elected to recognize immediately the cumulative obligation for benefits attributable to service of retired and active employees prior to 1992 rather than amortizing the cumulative obligation over future service periods. This election resulted in a one-time 1992 transition charge of $105.5 million before taxes ($66.4 million, or 94 cents per common share, after taxes). This charge was combined with the cumulative effect of other accounting changes (see Notes 5 and 17) and reported separately in the Consolidated Statement of Operations for the year ended December 31, 1992. Substantially all of the Corporation's U.S. employees who retire from active service on or after normal retirement age of 65 are eligible for life insurance benefits. The Corporation also provides postretirement life insurance for employees of international subsidiaries in some cases. Life insurance benefits are also available under certain early retirement programs or pursuant to the terms of certain collective bargaining agree- ments. The majority of the costs of such benefits were paid out of a previously established fund maintained by an insurance company, however, a portion was paid through an insured contract. Health care insurance benefits are also provided for many employees retiring from active service. The coverage is provided on a non-contributory basis for certain groups of employees and on a contributory basis for other groups. The majority of these benefits are paid by the Corporation. The status of employee postretirement benefit plans at December 31 is summarized below (in millions): The components of net periodic postretirement benefit cost (credit) were as follows (in millions): For 1993 measurement purposes, annual rates of increase in the per capita cost of covered health care benefits were assumed to average 11 percent for 1994 decreasing gradually to 5.3 percent by 2010 and remaining at that level thereafter. For 1992 measurement purposes, annual rates of increase in the per capita cost of covered health care benefits were assumed to average 13 percent for 1993 decreasing gradually to 6.3 percent by 2010 and remaining at that level thereafter. The health care cost trend rate assumption has a significant effect on the amounts reported. To illustrate, increasing the assumed health care cost trend rates by 1 percentage point in each year would increase the accumulated postretirement benefit obligation as of December 31, 1993, by approximately $12 million and the aggregate of the service and interest cost components of net periodic postretirement benefit cost for the year then ended by approximately $1 million. The weighted-average discount rate used in determining the accumulated postretirement benefit obligation was 7.25 percent for 1993, compared with 8.5 percent used for 1992. The expected long-term rate of return on plan assets was 8 percent for both years. 17. POSTEMPLOYMENT BENEFITS As discussed in Note 1 to the Consolidated Financial Statements, the Corporation elected early adoption of SFAS No. 112, "Employers' Accounting for Postemployment Benefits," as of January 1, 1992. SFAS No. 112 prescribes accounting methods for employers who provide certain benefits to former or inactive employees after employment but before retirement. Adoption of this standard resulted in a one-time 1992 transition charge of $5.6 million before taxes ($3.5 million, or 5 cents per common share, after taxes). 18. COMMITMENTS Rent expense for the years 1993, 1992 and 1991 was (in millions): $26.6, $25.1 and $26.4, respectively. Future minimum lease payments for all noncancelable operating leases having a remaining term in excess of one year totaled $72.1 million at December 31, 1993. These commitments for future periods are as follows (in millions): 1994 - $17.1; 1995 - $12.8; 1996 - $9.8; 1997 - $7.3; 1998 - $6.1; 1999 and thereafter - $19.0 million. The Corporation enters into price protection arrangements from time to time, depending on market circumstances, to ensure a minimum price for a portion of its expected future mine production. With respect to 1994 production, as of December 31, 1993, the Corporation had entered into contracts with several financial institutions that provide for a minimum average quarterly realized price of 75 cents per pound for 214 million pounds of copper cathode. 19. CONTINGENCIES The Corporation is from time to time involved in various legal proceedings of a character normally incident to its past and present businesses. Management does not believe that the outcome of these proceedings will have a material adverse effect on the financial condition or results of operations of the Corporation on a consolidated basis. The Corporation is subject to federal, state and local environmental laws, rules and regulations, including the Comprehensive Environmental Response, Compensation and Liability Act of 1980 (CERCLA or Superfund), as amended by the Superfund Amendments and Reauthorization Act of 1986. Under Superfund, the Environmental Protection Agency (EPA) has identified approximately 35,000 sites throughout the United States for review, ranking and possible inclusion on the National Priorities List (NPL) for possible response. Among the sites identified, EPA has included 13 sites owned by the Corporation. The Corporation believes that most, if not all, of its sites so identified will not qualify for listing on the NPL. In addition, the Corporation may be required to remove hazardous waste or remediate the alleged effects of hazardous waste on the environment associated with past disposal practices at sites not owned by the Corpora- tion. The Corporation has received notice that it is a Potentially Responsible Party (PRP) from EPA and/or individual states under CERCLA or a state equivalent and is participating in environmental assessment and remediation activity at 34 sites. At December 31, 1993, the Corporation had reserves of $74.0 million for remediation of certain of the sites referred to above and other environmental costs in accordance with its policy to record liabilities for environmental expenditures when it is probable that obligations have been incurred and the costs can reasonably be estimated. The Corporation's estimates of these costs are based upon currently available facts, existing technology, and presently enacted laws and regulations. Where the available information is sufficient to estimate the amount of liability, that estimate has been used; where the information is only sufficient to establish a range of probable liability and no point within the range is more likely than any other, the lower end of the range has been used. The amounts of these liabilities are very difficult to estimate due to such factors as the unknown extent of the remedial actions that may be re- quired and, in the case of sites not owned by the Corporation, the unknown extent of the Corporation's probable liability in proportion to the probable liability of other parties. Moreover, the Corporation has other probable environmental liabilities that cannot in its judgment reasonably be estimated, and losses attributable to remediation costs are reasonably possible at other sites. The Corporation cannot now estimate the total additional loss it may incur for such environmental liabilities, but such loss could be substantial. The possibility of recovery of some of the environmental remediation costs from insurance companies or other parties exists; however, the Corporation does not recognize these recoveries in its financial statements until they become probable. As part of the Corporation's 1986 acquisition of Kennecott Santa Fe Corporation (now called Phelps Dodge Chino, Inc.), The Standard Oil Company agreed to perform the obligation of Phelps Dodge Chino, Inc. to pay the debt service on $58.5 million of pollution control bonds due 2015, issued by the Town of Hurley, New Mexico. Accordingly, the Corporation views this obligation as contingent. The Corporation has guaranteed the debt facility undertaken by 49 percent owned Compania Minera Santa Gertrudis, S.A. de C.V. (Santa Gertrudis) to finance the development of a gold property located in Sonora, Mexico. The debt facility allows Santa Gertrudis to borrow gold under a commitment that reduces quarterly and terminates in 1996. At December 31, 1993, the available commitment stood at 38,000 ounces of gold, and this entire amount was outstanding. 20. FAIR VALUE OF FINANCIAL INSTRUMENTS The methods and assumptions used to estimate the fair value of each class of financial instrument for which it is practicable to estimate a value are as follows: Cash and short-term investments -- the carrying amount is a reasonable estimate of the fair value because of the short matur- ity of those instruments. Investments and long-term receivables -- the fair values of some investments are estimated based on quoted market prices for those or similar investments. The fair values of other types of loans are estimated by discounting the future cash flows using the current rates at which similar loans would be made with similar credit ratings and for the same remaining maturities. For those investments for which there are no quoted market prices, a reasonable estimate of fair value is not practicable. Additional information pertinent to the value of unquoted investments is provided below. Long-term debt -- the fair value of the Corporation's long-term debt is estimated based on the quoted market prices for the same or similar issues or on the current notes offered to the Corporation for debt of the same remaining maturities. Standby letters of credit and financial guarantees -- the fair values of guarantees and letters of credit are based on fees currently charged for similar agreements or on the estimated cost to terminate them or otherwise settle the obligations with the counterparties at the reporting date. The Corporation has guaranteed the borrowings of certain subsidiaries totaling $213.1 million. These guarantees include project financings for the La Candelaria copper-gold project in Chile and the Hungarian carbon black project; upon the satisfaction of completion requirements, those borrowings become non-recourse to the Corporation. There is no market for these guarantees and they were issued without explicit cost. Therefore, it is not practicable to establish their fair value. The estimated fair values of the Corporation's financial instruments as of December 31, 1993, are as follows (in millions): It is not practicable to estimate the fair value of investments in certain untraded foreign companies carried at historic cost. The Corporation's largest cost basis investment is its 16.25 percent interest in Southern Peru Copper Corporation, which is carried at a book value of $13.2 million. For the year ended December 31, 1993, that company reported total assets of $731.4 million, common stockholders' equity of $565.0 million, revenues of $474.0 million and net income of $194.2 million after including a $165.1 million gain from the cumulative effect of accounting changes for income taxes. 21. BUSINESS SEGMENT DATA The Corporation's business consists of two segments, Phelps Dodge Mining Company and Phelps Dodge Industries. The principal activities of each segment are described below, and the accompanying table presents results of operations and other financial information by segment. Phelps Dodge Mining Company is an international business comprising a group of companies involved in vertically integrated copper operations including mining, concentrating, electrowinning, smelting and refining, rod production, marketing and sales, and related activities. Copper is sold primarily to others as rod, cathode or concentrates, and to the Phelps Dodge Industries segment. In addition, Phelps Dodge Mining Company at times smelts and refines copper and produces copper rod for others on a toll basis, and produces gold, silver, molybdenum and copper chemicals, prin- cipally as by-products, and sulfuric acid from its air quality control facilities. This segment also includes the Corporation's other mining operations and investments (including gold, fluorspar, silver, lead and zinc operations) and its worldwide exploration and development programs. Phelps Dodge Industries is a business segment comprising a group of international companies that manufacture engineered products principally for the transportation and electrical sectors worldwide. Its operations are characterized by products with significant market share, internationally competitive cost and quality, and specialized engineering capabilities. This business segment includes the Corporation's carbon black and synthetic iron oxide operations through Columbian Chemicals Company and its subsidiaries; its wheel and rim operations through Accuride Corporation and its subsidiaries; its magnet wire operations through Phelps Dodge Magnet Wire Company and its subsidiaries; its U.S. specialty conductor operations through Hudson International Conductors; and its international wire and cable manufacturing operations through Phelps Dodge International Corpora- tion. The major portion of the sales of this segment is to customers primarily involved in the transportation industry ($602.3 million or 47 percent in 1993, compared with $528.0 million or 45 percent in 1992 and $473.6 million or 43 percent in 1991) and the electrical industry ($566.2 million or 44 percent in 1993, compared with $544.3 million or 46 percent in 1992 and $526.6 million or 47 percent in 1991). The Corporation's total 1993 sales include exports of $60.3 million from U.S. operations to unaffiliated foreign customers, including products sold through U.S. brokers, compared with $86.5 million in 1992 and $108.6 million in 1991. Intersegment sales reflect the transfer of copper from Phelps Dodge Mining Company to Phelps Dodge Industries at the same prices charged to outside customers. While the Corporation has foreign operations in several geographic areas, none is significant in itself. Sales by foreign operations to unaffiliated customers totaled $677.2 million in 1993, compared with $617.2 million in 1992 and $546.7 million in 1991; intercompany sales were $72.2 million in 1993, compared with $55.0 million in 1992 and $43.3 million in 1991. Earnings from operations from foreign subsidiaries were $47.1 million in 1993 (including $0.8 million of foreign equity losses), compared with $61.1 million in 1992 (including $1.1 million of foreign equity earnings) and $48.1 million in 1991 (including $3.7 million of foreign equity earn- ings). Identifiable foreign assets totaled $1,161.9 million at year-end 1993, compared with $846.2 million at year-end 1992 and $644.6 million at year-end 1991. Part III Items 10, 11, 12 and 13. The information called for by Part III (Items 10, 11, 12 and 13) is incorporated herein by reference from the material included under the captions "Election of Directors," "Beneficial Ownership of Securities," "Executive Compensation" and "Other Matters" in Phelps Dodge Corporation's definitive proxy statement (to be filed pursuant to Regulation 14A) for its Annual Meeting of Shareholders to be held May 4, 1994 (the 1994 Proxy Statement), except that the information regarding executive officers called for by Item 401 of Regulation S-K is included in Part I of this report. The 1994 Proxy Statement is being prepared and will be filed with the Securities and Exchange Commission and furnished to shareholders on or about April 1, 1994. Part IV Item 14.

Item 14.Exhibits, Financial Statement Schedules, and Reports on Form 8-K. (a) 1. Financial Statements: Index. 2. Financial Statement Schedules: Index. 3. Exhibits: 3.1 Restated Certificate of Incorporation of the Corporation, effective June 16, 1987 (incorporated by reference to Exhibit 3.1 to the Corporation's Form 10-Q for the quarter ended June 30, 1987 (SEC File No. 1-82)). Certificate of Amendment of such Restated Certificate of Incorporation, effective August 4, 1988, and Certificate of Amendment of such Restated Certificate of Incorporation, effective August 9, 1988 (incorporated by reference to Exhibits 3.1 and 3.2 to the Corporation's Form 10-Q for the quarter ended September 30, 1988 (SEC File No. 1-82)). Complete composite copy of the Certificate of Incorporation of the Corporation as amended to date (incorporated by reference to Exhibit 3.1 to the Corporation's 1992 Form 10-K (SEC File No. 1-82)). 3.2 By-Laws of the Corporation, as amended to and including July 31, 1992 (incorporated by reference to Exhibit 3 to the Corporation's Form 10-Q for the quarter ended September 30, 1992 (SEC File No. 1-82)). 4.1 Reference is made to Exhibits 3.1 and 3.2 above. 4.2 Credit and Guaranty Agreement and Gold Overdraft Agreement, each dated as of August 9, 1990, and Amendment No. 1 to Credit and Guaranty Agreement, dated as of September 21, 1990, among Compania Minera Santa Gertrudis, S.A. de C.V. as Borrower, the Corporation as Guarantor, and Morgan Guaranty Trust Company of New York (incorporated by reference to Exhibit 4.1 to the Corporation's Form 10-Q for the quarter ended September 30, 1990 (SEC File No. 1-82)). Note: Certain instruments with respect to long- term debt of the Corporation have not been filed as Exhibits to this Report since the total amount of securities authorized under any such instrument does not exceed 10 percent of the total assets of the Corporation and its subsidiaries on a consolidated basis. The Corporation agrees to furnish a copy of each such instrument upon request of the Securities and Exchange Commission. 4.3 Rights Agreement, dated as of July 29, 1988 and Amended and Restated as of December 6, 1989, between the Corporation and Chemical Bank (formerly Manufacturers Hanover Trust Company), which includes the form of Certificate of Amendment setting forth the terms of the Junior Participating Cumulative Preferred Shares, par value $1.00 per share, as Exhibit A, the form of Right Certificate as Exhibit B and the Summary of Rights to Purchase Preferred Shares as Exhibit C (incorporated by reference to Exhibit 1 to the Corporation's Current Report on Form 8- K filed on December 7, 1989 (SEC File No. 1- 82)). 10. Management contracts and compensatory plans and agreements. 10.1 The Corporation's 1979 Stock Option Plan (the 1979 Plan), as amended to and including June 3, 1992 (incorporated by reference to Exhibit 10.1 to the Corporation's Form 10-Q for the quarter ended June 30, 1992 (SEC File No. 1-82)). Form of Stock Option Agreements under the 1979 Plan (incorporated by reference to the Corporation's Registration Statement on Form S-8 (Reg. No. 33- 34363)). Forms of amendments dated February 12, 1991 (incorporated by reference to the Corporation's 1990 10-K (SEC File No. 1-82)) and dated June 25, 1992, to Stock Option Agreements under the 1979 Plan (incorporated by reference to Exhibit 10.1 to the Corporation's 1992 Form 10-K (SEC File No. 1-82)). 10.2 The Corporation's 1987 Stock Option and Restricted Stock Plan (the 1987 Plan), as amended to and including June 3, 1992, and form of Stock Option Agreement and form of Reload Option Agreement as modified through June 3, 1992 (incorporated by reference to Exhibit 10.2 of the Corporation's Form 10-Q for the quarter ended June 30, 1992 (SEC File No. 1-82)). Form of Restricted Stock letter under the 1987 Plan (incorporated by reference to Exhibit 10.1 to the Corporation's 1990 10-K (SEC File No. 1-82)) and the amendment thereto dated June 25, 1992 (incorporated by reference to Exhibit 10.2 to the Corporation's 1992 Form 10-K (SEC File No. 1-82)). 10.3 The Corporation's 1989 Directors Stock Option Plan (the Plan), as amended to and including June 3, 1992 (incorporated by reference to Exhibit 10.3 to the Corporation's Form 10-Q for the quarter ended June 30, 1992 (SEC File No. 1- 82)). Form of Stock Option Agreement under the Plan (incorporated by reference to the Cor- poration's Registration Statement on Form S-8 (Reg. No. 33-34363)). Note: Omitted from filing pursuant to the Instruction to Item 601(b) (10) are actual Stock Option Agreements between the Corporation and certain officers under the Plans and certain Directors under the 1989 Directors Plan, which contain substantially similar provisions to Ex- hibits 10.1, 10.2 and 10.3 above. 10.4 The Corporation's 1993 Stock Option and Restricted Stock Plan (the 1993 Plan), as amended to and including December 1, 1993, and forms of Stock Option Agreement, Reload Option Agreement and Restricted Stock letter as currently in use under the 1993 Plan. 10.5 Description of the Corporation's Incentive Compensation Plan. 10.6 Deferred Compensation Agreement dated January 27, 1989 with Dr. Patrick J. Ryan (incorporated by reference to Exhibit 10.6 to the Corporation's 1987 Form 10-K (SEC File No. 1- 82)) and amendment to such agreement dated March 17, 1989 (incorporated by reference to Exhibit 10.7 to the Corporation's 1988 Form 10-K (SEC File No. 1-82)). 10.7 Deferred Compensation Plan for the Directors of the Corporation, amended and restated as of July 31, 1992 (incorporated by reference to Exhibit 10 to the Corporation's Form 10-Q for the quarter ended September 30, 1992 (SEC File No. 1-82)). 10.8 Form of Change-of-Control Agreement between the Corporation and certain executives, including all of the current executive officers to be listed in the summary compensation table to the 1994 Proxy Statement (incorporated by reference to Exhibit 10.7 to the Corporation's 1992 Form 10-K (SEC File No. 1-82)). 10.9 Form of Severance Agreement between the Corporation and certain executives, including all of the current executive officers to be listed in the summary compensation table to the 1994 Proxy Statement (incorporated by reference to Exhibit 10.11 to the Corporation's 1988 Form 10-K (SEC File No. 1-82)). 10.10 The Corporation's 1991 - 1993 Long-Term Performance Plan (incorporated by reference to Exhibit 10.12 to the Corporation's 1990 Form 10- K (SEC File No. 1-82)). 10.11 The Corporation's 1992 - 1994 Long-Term Performance Plan (incorporated by reference to Exhibit 10.14 to the Corporation's 1991 Form 10- K (SEC File No. 1-82)). 10.12 The Corporation's Retirement Plan for Directors, effective January 1, 1988 (incorporated by reference to Exhibit 10.13 to the Corporation's 1987 Form 10-K (SEC File No. 1-82)). 10.13 The Corporation's Comprehensive Executive Nonqualified Retirement and Savings Plan (the Nonqualified Plan), as amended November 7, 1990 (incorporated by reference to Exhibit 10.14 to the Corporation's 1990 Form 10-K (SEC File No. 1-82)). Amendment, effective January 1, 1991, to the Nonqualified Plan (incorporated by ref- erence to Exhibit 10.2 to the Corporation's Form 10-Q for the quarter ended June 30, 1991 (SEC File No. 1-82)). Two amendments, one effective as of January 1, 1991, and one effective as of November 15, 1993, to the Nonqualified Plan. 11 Statement re computation of per share earnings. 12 Statement re computation of ratios of total debt to total capitalization. 21 List of Subsidiaries and Investments. 23 Consent of Price Waterhouse. 24 Powers of Attorney executed by certain officers and directors who signed this Annual Report on Form 10-K. Note: Shareholders may obtain copies of Exhibits by making written request to the Secretary of the Corporation and paying copying costs of 10 cents per page, plus postage. (b) Reports on Form 8-K: No current Reports on Form 8-K were filed by the Corporation during the quarter ended December 31, 1993. Schedule VII PHELPS DODGE CORPORATION AND CONSOLIDATED SUBSIDIARIES GUARANTEES OF SECURITIES OF OTHER ISSUERS - ---------------------------------------------------------------------------- (In thousands) Name of issuer of securities Title of issue Amount owned guaranteed by of each class Total amount by person or person for which of securities guaranteed person for which statement is filed guaranteed & outstanding statement is filed - ------------------ ------------ ------------- ------------------ 1. Town of Hurley, Unit Priced Demand $58,500 - New Mexico; Adjustable Pollution The Standard Control Bonds, due Oil Company 2015; agreement by subsidiary of the Corporation to pay debt service assumed by The Standard Oil Company 2. Compania Minera Santa Gertrudis, S.A. de C.V. Gold Overdraft Agreement $14,887 - NOTE: A subsidiary of the Corporation has agreed to pay the debt service on item 1 but the obligation is viewed as the equivalent of a guarantee because the primary obligation has been assumed by The Standard Oil Company. See Note 19 to the Consolidated Financial Statements. Nature of any default by issuer of Amount in securities guaranteed treasury of in principal, interest, issuer of sinking fund or securities Nature of redemption provisions guaranteed guarantee or repayment of dividends ---------- --------- ------------------------- 1. Town of Hurley, - Bonds - New Mexico; The Standard Oil Company 2. Compania Minera Santa Gertrudis, S.A. de C.V. - Gold loan - SIGNATURES Pursuant to the requirements of Section 13 or 15(d) 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. PHELPS DODGE CORPORATION ------------------------ (Registrant) March 21, 1994 By: Thomas M. St. Clair ------------------- Thomas M. St. Clair Senior Vice President and Chief Financial Officer Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated. Chairman of the Board, President, Chief Executive Officer and Director Douglas C. Yearley (Principal Executive Officer) March 21, 1994 - ------------------ Douglas C. Yearley Senior Vice President and Chief Financial Officer Thomas M. St. Clair (Principal Financial Officer) March 21, 1994 - ------------------- Thomas M. St. Clair Vice President and Controller Thomas M. Foster (Principal Accounting Officer) March 21, 1994 - ---------------- Thomas M. Foster Edward L. Addison, Robert N. Burt, ) George C. Dillon, Cleveland E. Dodge, Jr., ) Paul W. Douglas, William A. Franke, Paul Hazen, ) Robert D. Krebs, Southwood J. Morcott, ) George B. Munroe, George L. Shinn, Directors ) March 21, 1994 By: Thomas M. St. Clair ------------------- Thomas M. St. Clair Attorney-in-fact

277509_1993.txt

277509

1993

Item 1. Business. Federal Signal Corporation, founded in 1901, was reincorporated as a Delaware Corporation in 1969. The company is a manufacturer and worldwide supplier of public safety, signaling and communications equipment, fire trucks and emergency vehicles, street sweeping, vacuum loader and catch basin cleaning vehicles, parking control equipment, custom on-premise signage, cutting tools, precision punches and related die components. Products produced and services rendered by Registrant and its subsidiaries (referred to collectively as "Registrant" herein, unless context otherwise indicates) are divided into groups (business segments) as follows: Signal, Sign, Tool and Vehicle. This classification of products and services is based upon Registrant's historical divisional structure established by management for the purposes of internal control, marketing and accounting. Developments, including acquisitions of businesses, considered significant to the company or individual segments are described under the following discussions of the applicable groups. The Financial Review sections, "Consolidated Results of Operations," "Group Operations" and "Financial Position and Cash Flow," and Note N - Segment Information contained in the annual report to shareholders for the year ended December 31, 1993 are incorporated herein by reference. On February 3, 1994, the Registrant's Board of Directors declared a 4-for-3 common stock split distributed March 1, 1994 to shareholders of record on February 14, 1994. The 554,088 post-split treasury shares held on February 14, 1994 were used to partially effect the split. Previously reported financial information has been restated to give effect to the stock split. Signal Group Signal Group products manufactured by Registrant consist of (1) a variety of visual and audible warning and signaling devices used by private industry, federal, state and local governments, building contractors, police, fire and medical fleets, utilities and civil defense and (2) parking, revenue control, and access control equipment and systems for parking facilities, commercial businesses, bridge and pier installation and residential developments. The visual and audible warning and signaling devices include emergency vehicle warning lights, electromechanical and electronic vehicle sirens and industrial signal lights, sirens, horns, bells and solid state audible signals, audio/visual emergency warning and evacuation systems, including weather and nuclear power plant warning notification systems and fire alarm system panels and devices. Parking, revenue control, and access control equipment and systems includes parking and security gates, card access readers, ticket issuing devices, coin and token units, fee computers, various forms of electronic control units and personal computer-based revenue and access control systems. Warning and signaling products, which account for the principal portion of the group's business, are marketed to both industrial and governmental users. Products are sold to industrial customers through manufacturers' representatives who sell to approximately 1,400 wholesalers. Products are also sold to governmental customers through more than 900 active independent distributors as well as through original equipment manufacturers and direct sales. International sales are made through the Registrant's independent foreign distributors or on a direct basis. Because of the large number of Registrant's products, Registrant competes with a variety of manufacturers and suppliers and encounters varying competitive conditions among its different products and encounters different classes of customers. Because of the variety of such products and customers, no meaningful estimate of either the total number of competitors or Registrant's overall competitive position can be made. Generally, competition is intense as to all of Registrant's products and, as to most such products, is based on price, including competitive bidding, on product reputation and performance, and on product servicing. Although some competitors in certain product lines are larger than Registrant, the Registrant believes it is the leading supplier of particular products. In May 1992, the Registrant acquired all of the outstanding shares of Aplicaciones Tecnologicas VAMA S.L. for cash and an earnout to be based upon future profitability of the company for a five-year period. VAMA is a leading European manufacturer of emergency vehicular signaling products located in Barcelona, Spain. The acquisition accelerates the Signal Group's strategic objective of increasing international market penetration, particularly in Europe. The backlogs of orders of Signal Group products believed to be firm at December 31, 1993 and 1992 were $9.7 million and $8.4 million, respectively. Almost all of the backlogs of orders at December 31, 1993, are reasonably expected to be filled within the current fiscal year. Sign Group The Sign Group, operating principally under the name "Federal Sign" designs, engineers, manufactures, installs and maintains illuminated and non- illuminated sign displays, for both sale and lease. Registrant additionally provides sign repair services and also enters into maintenance service contracts, usually over three-year to five-year periods, for signs it manufactures as well as for signs produced by other manufacturers. Its operations are oriented to custom designing and engineering of commercial and industrial signs or groups of signs for its customers. The sale and lease of signs and the sale of maintenance contracts are conducted primarily through Registrant's direct sale organization which operates from its twenty-two principal sales and manufacturing facilities located strategically throughout the continental U.S. Customers for sign products and services consist of local commercial businesses, as well as major national and multi-national companies. The Sign Group's markets stabilized during 1993, while the Registrant continued with aggressive, strategic restructuring programs. The group focused on reducing nonvalue-added tasks, redesigned work flow and emphasized training programs to empower employees and to improve quality and customer service. These programs, combined with a marketing effort targeted at more sophisticated, higher value-added projects, resulted in a return to profitability in 1993. A large number of Registrant's displays are leased to customers for terms of typically three to five years with both the lease and the maintenance portions of many such contracts then renewed for successive periods. Registrant is nationally a principal producer of custom-designed signs, but has numerous competitors (estimated at about 3,500 in total), most of whom are localized in their operations. Competition for sign products and services is intense and competitive factors consist largely of prices, terms, aesthetic and design considerations, and maintenance services. In some instances, smaller and more localized operations may enjoy some cost advantages which may permit lower pricing for particular displays. However, Registrant's reputation for creative design, quality manufacture and complete nationwide service together with its financial ability to maintain customer leasing programs and to undertake large project commitments in many cases offset competitors' price advantages. Total backlog at December 31, 1993, applicable to sign products and services was approximately $54.2 million compared to approximately $54.6 million at December 31, 1992. A significant part of Registrant's sign products and services backlog relates to sign maintenance contracts since such contracts are usually performed over long periods of time. At December 31, 1993, the Sign Group had a backlog of approximately $41.5 million compared to approximately $41.3 million at December 31, 1992, represented by in-service sign maintenance contracts. With the exception of the sign maintenance contracts, most of the backlog orders at December 31, 1993 are reasonably expected to be filled within the current fiscal year. Tool Group Tool Group products are produced by the Registrant's wholly-owned sub- sidiaries including: Dayton Progress Corporation, Schneider Stanznormalien GmbH, acquired in 1992, Container Tool Corp., acquired in 1991, Manchester Tool Company, Dico Corporation, acquired in 1992, Bassett Rotary Tool Company and Jamestown Punch and Tooling, Inc. Dayton Progress Corporation manufactures and purchases for resale an extensive variety of consumable die components for the metal stamping industry. These components consist of piercing punches, matched die matrixes, punch holders or retainers and many other products related to the metal stamper's needs. Registrant also produces a large variety of consumable precision metal products for customers' nonstamping needs, including special heat exchanger tools, beverage container tools, powder compacting units and molding components. In March 1992, Dayton Progress Corporation acquired for cash the assets of Schneider Stanznormalien GmbH, a German manufacturer of precision punch and die components. This acquisition gives Dayton Progress manufacturing capabilities on the European continent and provides greater access to European markets. In October 1991, Dayton Progress Corporation acquired for cash and stock all of the outstanding shares of Container Tooling Corporation. Container Tool manufactures and distributes body punch tooling used in the production of aluminum and steel beverage cans. The product complements Dayton Progress' tab-top tooling product line. In July 1989, Dayton Progress Corporation acquired for cash all of the outstanding stock of Electro Diecraft, a Canadian tool manufacturer. The name of the corporation was changed to Dayton Progress Canada, Ltd. Manchester Tool Company manufactures consumable carbide insert tooling for cutoff and deep grooving metal cutting applications. In November 1992, Manchester Tool Company acquired for cash all of the outstanding shares of Dico Corporation, a manufacturer of polycrystalline diamond and cubic boron nitride cutting tools. This product line complements Manchester Tool's carbide insert products and allows for entry into new market niches within general business areas already served. Bassett Rotary Tool Company is a manufacturer of consumable carbide cutting tools. Its products are medium to high precision in their manufacture and at times are quite complex in their configuration. The products represent a narrow band of the much broader cutting tool industry and require a high level of manufacturing skill. Jamestown Punch and Tooling, Inc. (previously known as Jamestown Perforators, Inc.) manufactures an extensive line of consumable special die components for the metal stamping and plastic molding industries in addition to a variety of precision ground high alloy parts. The markets served are located primarily east of the Mississippi River and price is an important purchasing factor in this highly competitive market. Sales are made on both a direct basis and through a limited distributor organization. Because of the nature of and market for the Registrant's products, competition is great at both domestic and international levels. Many customers have some ability to produce the product themselves, but at a cost disadvantage. Major market emphasis is placed on quality of product and level of service. Tool Group products are labor intensive with the only significant outside cost being the purchase of the tool steel, carbide and diamond raw material, as well as items necessary for manufacturing. Inventories are maintained to assure prompt service to the customer with the average order for standard tools filled in less than one week for domestic shipments and within two weeks for international shipments. Tool Group customers include metal and plastic fabricators and tool and die shops throughout the world. Because of the nature of the products, volume depends mainly on repeat orders from customers numbering in the thousands. These products are used in the manufacturing process of a broad range of items such as automobiles, appliances, construction products, electrical motors, switches and components and a wide variety of other household and industrial goods. Almost all business is done with private industry. Registrant's products are marketed in the United States, Japan and Europe principally through industrial distributors. Foreign sales and distribution offices are maintained in Weston, Ontario; Sagamihara and Tokyo, Japan; Kenilworth, England and Oberursel, Germany. Foreign manufacturing facilities are located in Weston, Ontario, Sagamihara, Japan and Oberursel, Germany. Sales to nondomestic customers are made through five wholly-owned subsidiaries: Dayton Progress Canada, Ltd., Dayton Progress International Corporation, Dayton Progress (UK) Ltd., Nippon Dayton Progress K.K. and Schneider Stanznormalien GmbH. Order backlogs of the Tool Group as of December 31, 1993 and December 31, 1992 were $7.5 million and $6.7 million, respectively. Almost all of the backlogs of orders at December 31, 1993 are expected to be filled within the current fiscal year. Vehicle Group The Vehicle Group is composed of Emergency One, Inc., Superior Emergency Vehicles, Ltd., acquired in 1991, Elgin Sweeper Company, Guzzler Manufacturing, Inc., acquired in 1993, and Ravo International, acquired in 1990. Emergency One, Inc. is the leading manufacturer of custom-designed fire trucks and rescue vehicles including four and six-wheel drive rescue trucks, tankers, pumpers, aerial ladder trucks, and airport rescue and fire fighting vehicles (each of aluminum construction for rust-free operation and energy efficiency). In December 1991, Emergency One acquired for cash all of the outstanding shares of Frontline Corporation, a manufacturer and distributor of ambulances, rescue trucks and mobile communication vehicles. The acquisition of Frontline Corporation complemented Emergency One's product line and enabled Emergency One to provide a complete product line of fire trucks, fire apparatus, emergency support and ambulance vehicles for distribution through Emergency One's domestic and international dealer network. During 1993, the company's ambulance operations were relocated to Emergency One's facilities in Ocala, Florida and the mobile communications vehicles product line was sold. The company was merged into Emergency One in January 1994. In December 1991, Emergency One acquired for cash, Superior Emergency Vehicles, Ltd., a manufacturer and distributor of a full range of fire truck bodies primarily for the Canadian market. In addition to increased manufacturing capacity, the acquisition of Superior Emergency Vehicles, Ltd. provides greater access to the Canadian market. In October 1989, Emergency One acquired for cash, American Eagle Fire Apparatus Company, Inc., a manufacturer of a full range of bodies for fire apparatus vehicles. The acquisition of American Eagle provided Emergency One with additional capacity to accommodate its rapid growth. This company was merged into Emergency One in June 1992. Elgin Sweeper Company is the leading manufacturer in the United States of self-propelled street cleaning vehicles. Utilizing three basic cleaning methods (mechanical sweeping, vacuuming and recirculating air), Elgin's products are primarily designed for large-scale cleaning of curbed streets and other paved surfaces. In March 1993, Elgin Sweeper Company acquired, principally for cash, all of the outstanding shares of Guzzler Manufacturing, Inc. Guzzler is an Alabama-based manufacturer and marketer of waste removal vehicles, using state-of-the-art vacuum technology, for worldwide industrial, environmental and municipal markets. The acquisition of Guzzler Manufacturing, Inc. complements Elgin Sweeper Company's product distribution and provides for increased exposure to the industrial and municipal marketplaces for Elgin and Guzzler, respectively. In December 1990, the Registrant, through Federal Signal Europe BV, acquired all of the outstanding shares of Van Raaij Holdings BV (which, along with its subsidiaries, is referred to herein as Ravo International), a Netherlands-based street sweeper manufacturer, for cash and an earnout to be based upon future profitability of the company for a five-year period. Ravo International is a leading European manufacturer and marketer of self- propelled street and sewer cleaning vehicles. Utilizing the vacuuming cleaning method, Ravo's products are primarily designed for cleaning of curbed streets and other paved surfaces. Both Ravo International and Elgin Sweeper Company also sell accessories and replacement parts for their sweepers. Ravo International also provides after market service and support for its products in the Netherlands. Some products and components thereof are not manufactured by Registrant but are purchased for incorporation with products of Registrant's manufacture. A majority of Vehicle Group sales are made to domestic and overseas municipalities and other governmental units, although in the street sweeper market and with the 1993 acquisition of Guzzler Manufacturing, Inc., there is an emerging trend towards commercial, industrial and private customers. Worldwide sales are principally conducted by domestic and international dealers, in most areas, with some sales being made on a direct-to-user basis. Registrant competes with several domestic and foreign manufacturers and due to the diversity of products offered, no meaningful estimate of either the number of competitors or Registrant's relative position within the market can be made, although Registrant does believe it is a major supplier within these product lines. Registrant competes with numerous foreign manufacturers principally in international markets. At December 31, 1993, the Vehicle Group backlogs were $150.3 million compared to $128.2 million at December 31, 1992. The backlogs at December 31, 1993, included approximately $3.2 million of backlog attributable to Guzzler Manufacturing, Inc., which was acquired in March 1993. A substantial majority of the orders in the backlogs at December 31, 1993 are reasonably expected to be filled within the current fiscal year. Approximately $34.3 million of the backlogs at December 31, 1993 and $30.3 million of the backlogs at December 31, 1992 represent the funded portion of a subcontract to build P-23 airport rescue and fire fighting vehicles for the U.S. Air Force, about half of which is expected to be produced and shipped after December 31, 1994. Additional Information Registrant's sources and availability of materials and components are not materially dependent upon either a single vendor or very few vendors. Registrant owns a number of patents and possesses rights under others to which it attaches importance, but does not believe that its business as a whole is materially dependent upon any such patents or rights. Registrant also owns a number of trademarks which it believes are important in connection with the identification of its products and associated goodwill with customers, but no material part of Registrant's business is dependent on such trademarks. Registrant's business is not materially dependent upon research activities relating to the development of new products or services or the improvement of existing products and services, but such activities are of importance as to some of Registrant's products. Expenditures for research and development by the Registrant were approximately $5.6 million in 1993, $5.2 million in 1992 and $5.1 million in 1991. Note N - Segment Information, presented in the annual report to shareholders for the year ended December 31, 1993, contains information concerning the Registrant's foreign sales, export sales and operations by geographic area, and is incorporated herein by reference. No material part of the business of Registrant is dependent either upon a single customer or very few customers. There are no significant seasonal aspects to Registrant's business or any material portion thereof. The Registrant is in substantial compliance with federal, state and local provisions which have been enacted or adopted regulating the discharge of materials into the environment, or otherwise relating to the protection of the environment. These provisions have had no material adverse impact upon capital expenditures, earnings or competitive position of the Registrant and its subsidiaries. The Registrant employed 4,426 people in ongoing businesses at the close of 1993. The Registrant believes relations with its employees have been satisfactory. Item 2.

Item 2. Properties. As of March 1, 1994, the Registrant utilized twenty-four principal manufacturing plants located primarily throughout North America, as well as six in Europe and one in the Far East. In addition, there were thirty-six sales and service/warehouse sites, with thirty being domestically based and six located overseas. The majority of the manufacturing plants are owned, whereas all the sales and service/warehouse sites are leased. In total, the Registrant devoted approximately 1,202,000 square feet to manufacturing and 788,000 square feet to service, warehousing and office space, as of March 1, 1994. Of the total square footage, approximately 23% is devoted to the Signal Group, 19% to the Sign Group, 13% to the Tool Group and 45% to the Vehicle Group. Not included in the manufacturing square footage is approximately 37,000 square feet of unutilized manufacturing space that resulted from the rearrangement of the Registrant's manufacturing operations, mostly in the Sign Group. This space is presently being marketed for sale or lease to nonaffiliates. Approximately 71% of the total square footage is owned by the Registrant, with the remaining 29% being leased. All of the Registrant's properties, as well as the related machinery and equipment, are considered to be well-maintained, suitable and adequate for their intended purposes. In the aggregate, these facilities are of sufficient capacity for the Registrant's current business needs. Capital expenditures for the years ended December 31, 1993, 1992, and 1991 were $10.1 million, $8.8 million, and $12.0 million, respectively. Capital expenditures in 1991 included expenditures relating to the airport rescue and fire fighting vehicle manufacturing facility at Emergency One. Registrant anticipates total capital expenditures in 1994 will not be significantly greater than 1993 amounts. Item 3.

Item 3. Legal Proceedings. The Registrant is subject to various claims, other pending and possible legal actions for product liability and other damages and other matters arising out of the conduct of the Registrant's business. The Registrant believes, based on current knowledge and after consultation with counsel, that the outcome of such claims and actions will not have a material adverse effect on the Registrant's consolidated financial position or the results of operations. On May 3, 1993, a Texas federal court jury rendered a verdict of $17,745,000 against Federal Sign, a division of the company, for alleged violation of the Texas Deceptive Trade Practices Act and misrepresentations to Duravision, Inc. and Manufacturers Product Research Group of North America, Inc. in connection with a 1988 research and development project for indoor advertising signs. The company believes the court erroneously excluded important evidence and that the verdict was against the weight of the evidence. Both inside and outside counsel that initially handled the case opined at the time of the verdict that the likelihood of a substantially unfavorable result to the company on appeal was remote. Trial counsel has turned the case over to new appellate counsel and has stated they cannot currently give an opinion on the appeal because they are no longer handling the case. Appellate counsel now handling the appeal of the case has not issued an opinion on its outcome. However, if the company loses its appeal of this case, there would be a charge to earnings for this verdict, plus interest and attorney fees. The company believes that the ultimate resolution of this contingency will not have a material effect on its financial condition, and accordingly, the company has not recorded any accruals for potential losses resulting from this judgment. Item 4.

Item 4. Submission of Matters to a Vote of Security Holders. No matters were submitted to a vote of security holders through the solicitation of proxies or otherwise during the three months ended December 31, 1993. PART II Item 5.

Item 5. Market for the Registrant's Common Stock and Related Security Holder Matters. Federal Signal Corporation's Common Stock is listed and traded on the New York Stock Exchange under the symbol FSS. Per share data listed in Note O -Selected Quarterly Data (Unaudited) contained in the 1993 annual report to shareholders is incorporated herein by reference. As of March 1, 1994, there were 4,818 holders of record of the Registrant's common stock. Certain long-term debt agreements impose restrictions on Registrant's ability to pay cash dividends on its common stock. All of the retained earnings at December 31, 1993, were free of any restrictions. Item 6.

Item 6. Selected Financial Data. Selected Financial Data contained in the 1993 annual report to shareholders is incorporated herein by reference. Item 7.

Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations. The Financial Review sections "Consolidated Results of Operations," "Group Operations" and "Financial Position and Cash Flow" contained in the 1993 annual report to shareholders are incorporated herein by reference. Note M - Contingency, contained in the annual report to shareholders for the year ended December 31, 1993, is incorporated herein by reference. Item 8.

Item 8. Financial Statements and Supplementary Data. The consolidated financial statements and accompanying footnotes of the Registrant and the report of the independent auditors set forth in the Registrant's 1993 annual report to shareholders are incorporated herein by reference. Item 9.

Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure. None. PART III Item 10.

Item 10. Directors and Executive Officers of the Registrant. The information under the caption "Election of Directors" contained in the Registrant's Proxy Statement for the Annual Meeting of Shareholders to be held on April 18, 1994 is incorporated herein by reference. The following is a list of the Registrant's executive officers, their ages, their business experience and their positions and offices as of March 1, 1994: Joseph J. Ross, age 48, was elected Chairman, President and Chief Executive Officer in February, 1990. Previously he served as President and Chief Executive Officer since December 1987 and as Chief Operating Officer since July 1986. Charles R. Campbell, age 54, was elected Senior Vice President and Chief Financial and Administrative Officer in July 1986. John A. DeLeonardis, age 46, was elected Vice President-Taxes in January 1992. He first joined the company as Director of Tax in November 1986. Theodore S. Fries, age 49, was elected President of Emergency One, Inc. in August 1984. Richard G. Gibb, age 50, was appointed President of the Signal Products Division in February 1985. Roger B. Parsons, age 53, was elected President of Elgin Sweeper Company in January 1983. Jesse N. Polan, age 44, was appointed President of Federal APD in February 1985. Robert W. Racic, age 45, was elected Vice President and Treasurer in April 1984. Richard L. Ritz, age 40, was elected Vice President and Controller in January 1991. He was appointed Controller effective November 1985. Richard R. Thomas, age 60, was appointed President of the Tool Group in January 1983. Kim A. Wehrenberg, age 42, was elected Vice President, General Counsel and Secretary effective October 1986. These officers hold office until the next annual meeting of the respective Boards following their election and until their successors shall have been elected and qualified. There are no family relationships among any of the foregoing executive officers. Item 11.

Item 11. Executive Compensation. The information contained under the caption "Executive Compensation" of Registrant's Proxy Statement for the Annual Meeting of Shareholders to be held April 18, 1994 is incorporated herein by reference. Item 12.

Item 12. Security Ownership of Certain Beneficial Owners and Management. The information contained under the caption "Security Ownership of Certain Beneficial Owners" of Registrant's Proxy Statement for the Annual Meeting of Shareholders to be held April 18, 1994 is incorporated herein by reference. Item 13.

Item 13. Certain Relationships and Related Transactions. The information contained under the caption "Executive Compensation" of Registrant's Proxy Statement for the Annual Meeting of Shareholders to be held April 18, 1994 is incorporated herein by reference. PART IV Item 14.

Item 14. Exhibits, Financial Statement Schedules and Reports on Form 8-K. (a)1. Financial Statements The following consolidated financial statements of Federal Signal Corporation and Subsidiaries included in the 1993 annual report of the Registrant to its shareholders are filed as a part of this report and are incorporated by reference in Item 8: Consolidated Balance Sheets -- December 31, 1993 and 1992 Consolidated Statements of Income -- Years ended December 31, 1993, 1992 and 1991 Consolidated Statements of Cash Flows -- Years ended December 31, 1993, 1992 and 1991 Notes to Consolidated Financial Statements 2. Financial Statement Schedules The following consolidated financial statement schedules of Federal Signal Corporation and Subsidiaries, for the three years ended December 31, 1993, are filed as a part of this report in response to Item 14(d): Schedule II -- Amounts receivable from related parties and underwriters, promoters and employees other than related parties Schedule VIII -- Valuation and qualifying accounts Schedule IX -- Short-term borrowings All other schedules for which provision is made in the applicable accounting regulations of the Securities and Exchange Commission are not required under the related instructions or are inapplicable, and therefore, have been omitted. 3. Exhibits 3. a. Restated Certificate of Incorporation of Registrant and Certificate of Amendment, filed as Exhibit (3)(a) to Registrant's Form 10-K for the year ended December 31, 1991, is incorporated herein by reference. b. By-laws of Registrant, filed as Exhibit (3)(b) to Registrant's Form 10-K for the year ended December 31, 1991, is incorporated herein by reference. 4. a. Rights Agreement. b. The Registrant has no long-term debt agreements for which the related outstanding debt exceeds 10% of consolidated total assets as of December 31, 1993. Copies of debt instruments for which the related debt is less than 10% of consolidated total assets will be furnished to the Commission upon request. 10. a. 1988 Stock Benefit Plan, filed as Exhibit (10)(a) to Registrant's Form 10-K for the year ended December 31, 1991, is incorporated herein by reference. b. Corporate Management Incentive Bonus Plan, filed as Exhibit (10)(b) to Registrant's Form 10-K for the year ended December 31, 1990, is incorporated herein by reference. c. Subsidiaries, Division and Other Designated Profit Centers Management Incentive Bonus Plan, filed as exhibit (10)(c) to Registrant's Form 10-K for the year ended December 31, 1989, is incorporated herein by reference. d. Supplemental Pension Plan, filed as Exhibit (10)(d) to Registrant's Form 10-K for the year ended December 31, 1990, is incorporated herein by reference. e. Executive Disability, Survivor and Retirement Plan, filed as Exhibit (10)(e) to Registrant's Form 10-K for the year ended December 31, 1990, is incorporated herein by reference. f. Supplemental Savings and Investment Plan. g. Employment Agreement with Charles R. Campbell, filed as Exhibit (10)(g) to Registrant's Form 10-K for the year ended December 31, 1989, is incorporated herein by reference. h. Employment Agreement with Joseph J. Ross, filed as Exhibit (10)(h) to Registrant's Form 10-K for the year ended December 31, 1989, is incorporated herein by reference. i. Change of Control Agreement with Kim A. Wehrenberg, filed as Exhibit (10)(i) to Registrant's Form 10-K for the year ended December 31, 1989, is incorporated herein by reference. j. Director Deferred Compensation Plan, filed as Exhibit (10)(j) to Registrant's Form 10-K for the year ended December 31, 1992, is incorporated herein by reference. k. Director Retirement Plan, filed as Exhibit (10)(k) to Registrant's Form 10-K for the year ended December 31, 1992, is incorporated herein by reference. 11. Computation of net income per common share 13. 1993 Annual Report to Shareholders of Federal Signal Corporation. Such report, except for those portions thereof which are expressly incorporated by reference in this Form 10-K, is furnished for the information of the Commission only and is not to be deemed "filed" as part of this filing. 21. Subsidiaries of the Registrant 23. Consent of Independent Auditors (b) Reports on Form 8-K No reports on Form 8-K were filed for the three months ended December 31, 1993. (c) and (d) The response to this portion of Item 14 is being submitted as a separate section of this report. Other Matters For the purposes of complying with the amendments to the rules governing Form S-8 (effective July 13, 1990) under the Securities Act of 1933, the undersigned Registrant hereby undertakes as follows, which undertaking shall be incorporated by reference into Registrant's Registration Statements on Form S-8 Nos. 33-12876, 33-22311, 33-38494, 33-41721 and 33-49476, dated April 14, 1987, June 26, 1988, December 28, 1990, July 15, 1991 and June 9, 1992, respectively: Insofar as indemnification for liabilities arising under the Securities Act of 1933 may be permitted to directors, officers and controlling persons of the Registrant pursuant to the foregoing provisions, or otherwise, the Registrant has been advised that in the opinion of the Securities and Exchange Commission such indemnification is against public policy as expressed in the Act and is, therefore, unenforceable. In the event that a claim for indemnification against such liabilities (other than the payment by the Registrant of expenses incurred or paid by a director, officer or controlling person of the Registrant in the successful defense of any action, suit or proceeding) is asserted by such director, officer or controlling person in connection with the securities being registered, the Registrant will, unless in the opinion of its counsel the matter has been settled by controlling precedent, submit to a court of appropriate jurisdiction the question whether such indemnification by it is against public policy as expressed in the Act and will be governed by the final adjudication of such issue. Signatures Pursuant to the requirements of Section 13 or 15 (d) 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. FEDERAL SIGNAL CORPORATION By: /s/ Joseph J. Ross March 25, 1994 Chairman, President, Chief Executive Officer and Director Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below, on March 25, 1994, by the following persons on behalf of the Registrant and in the capacities indicated. /s/ Charles R. Campbell /s/ Walter R. Peirson Senior Vice President and Chief Director Financial and Administrative Officer /s/ Richard L. Ritz /s/ J. Patrick Lannan, Jr. Vice President and Controller Director /s/ James A. Lovell, Jr. Director /s/ Thomas N. McGowen, Jr. Director

64908_1993.txt

64908

1993

893958_1993.txt

893958

1993

ITEM 1. BUSINESS Each Capital Auto Receivables Asset Trust, (each a "Trust") was formed pursuant to a Trust Agreement, between Capital Auto Receivables, Inc. (the "Seller") and Bankers Trust (Delaware), as Owner Trustee of the related Trust. The Trusts have issued Asset-Backed Notes (the "Notes"). The Notes are issued and secured pursuant to Indentures, between the related Trust and The First National Bank of Chicago as Indenture Trustee. Each Trust has also issued Asset-Backed Certificates. CAPITAL AUTO RECEIVABLES ASSET TRUSTS ------------------------------------- CAPITAL AUTO RECEIVABLES ASSET TRUST 1992-1 CAPITAL AUTO RECEIVABLES ASSET TRUST 1993-1 CAPITAL AUTO RECEIVABLES ASSET TRUST 1993-2 CAPITAL AUTO RECEIVABLES ASSET TRUST 1993-3 ___________________________ PART II ITEM 7.

ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Each of the Trusts was formed pursuant to a trust agreement between Capital Auto Receivables, Inc. (the "Seller") and Bankers Trust (Delaware), as Owner Trustee, and issued the following asset-backed notes and certificates. Each Trust acquired retail finance receivables from the Seller in the aggregate amount as shown below in exchange for asset-backed notes and asset-backed certificates representing undivided interests in each of the Trusts. Each Trust's property includes a pool of retail instalment sale contracts for new and used automobiles and light trucks, certain monies due thereunder, security interests in the vehicles financed thereby and certain other property. Retail Finance Date of Sale Receivables and Servicing Aggregate Asset-Backed Asset-Backed Trust Agreement Amount Notes Certificates - ---------- ----------------- --------- ---------------- ------------ (Millions) (Millions) (Millions) Capital December 17, 1992 $1,607.1 Class A-1 $ 657.7 $ 56.2 Auto Class A-2 $ 641.6 Receivables Class A-3 $ 251.6 Asset Trust 1992-1 Capital February 11, 1993 $2,912.9 Class A-1 $ 322.0 $ 101.9 Auto Class A-2 $ 225.0 Receivables Class A-3 $ 125.0 Asset Trust Class A-4 $ 478.0 1993-1 Class A-5 $1,147.0 Class A-6 $ 318.0 Class A-7 $ 196.0 Capital June 2, 1993 $2,009.3 Class A-1 $ 750.0 $ 58.6 Auto Class A-2 $ 100.0 Receivables Class A-3 $ 641.0 Asset Trust Class A-4 $ 403.0 1993-2 Capital October 21, 1993 $2,504.9 Class A-1 $ 430.0 $ 81.4 Auto Class A-2 $ 59.0 Receivables Class A-3 $ 63.0 Asset Trust Class A-4 $ 210.0 1993-3 Class A-5 $ 484.3 Class A-6 $1,177.2 (Private Placement) General Motors Acceptance Corporation (GMAC), the originator of the retail receivables, continues to service the receivables for the aforementioned Trusts and receives compensation and fees for such services. Investors receive periodic payments of principal and interest for each class of notes and certificates as the receivables are liquidated. ____________________ II-1 ITEM 8.

ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA CROSS REFERENCE SHEET Caption Page - ------------------------------------------------- ------ Capital Auto Receivables Asset Trust 1992-1, Independent Auditors' Report, Financial Statements II-3 and Selected Quarterly Data for the Year Ended December 31, 1993. Capital Auto Receivables Asset Trust 1993-1, Independent Auditors' Report, Financial Statements II-9 and Selected Quarterly Data for the period from February 11, 1993 to December 31, 1993. Capital Auto Receivables Asset Trust 1993-2, Independent Auditors' Report, Financial Statements II-15 and Selected Quarterly Data for the period from June 2, 1993 to December 31, 1993. Capital Auto Receivables Asset Trust 1993-3, Independent Auditors' Report, Financial Statements II-21 and Selected Quarterly Data for the period from October 21, 1993 to December 31, 1993. _____________________ II-2 INDEPENDENT AUDITORS' REPORT March 22, 1994 The Capital Auto Receivables Asset Trust 1992-1, its Noteholders and Certificateholders, Capital Auto Receivables, Inc., Bankers Trust (Delaware), Owner Trustee, and The First National Bank of Chicago, Indenture Trustee: We have audited the accompanying Statement of Assets, Liabilities and Equity of the Capital Auto Receivables Asset Trust 1992-1 as of December 31, 1993 and 1992, and the related Statement of Distributable Income for the year ended December 31, 1993. These financial statements are the responsibility of the Trust's management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audits to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. As described in Note 1 to the financial statements, these financial statements are prepared on the basis of cash receipts and disbursements, which is a comprehensive basis of accounting other than generally accepted accounting principles. In our opinion, such financial statements present fairly, in all material respects, the assets, liabilities and equity of the Capital Auto Receivables Asset Trust 1992-1 at December 31, 1993 and 1992 and its distributable income and distributions for the year ended December 31, 1993, on the basis of accounting described in Note 1. s\ DELOITTE & TOUCHE - ----------------------- DELOITTE & TOUCHE 600 Renaissance Center Detroit, Michigan 48243 II-3 CAPITAL AUTO RECEIVABLES ASSET TRUST 1992-1 STATEMENT OF ASSETS, LIABILITIES AND EQUITY (in millions of dollars) Dec. 31 Dec. 31 1993 1992 ------- ------- ASSETS $ $ Receivables (Note 2) ................... 759.3 1,607.1 ------- ------- TOTAL ASSETS ........................... 759.3 1,607.1 ======= ======= LIABILITIES AND EQUITY (Notes 2 and 3) Asset-backed Notes ..................... 709.7 1,550.9 ------- ------- Asset-backed Certificates (Equity) ..... 49.6 56.2 ------- ------- TOTAL LIABILITIES AND EQUITY............ 759.3 1,607.1 ======= ======= Reference should be made to the Notes to Financial Statements. II-4 CAPITAL AUTO RECEIVABLES ASSET TRUST 1992-1 STATEMENT OF DISTRIBUTABLE INCOME For the year ended December 31, 1993 (in millions of dollars) ------- $ Distributable Income Allocable to Principal ...................... 847.8 Allocable to Interest ...................... 53.3 ------- Distributable Income .......................... 901.1 ======= Income Distributed ............................ 901.1 ======= Reference should be made to the Notes to Financial Statements. II-5 CAPITAL AUTO RECEIVABLES ASSET TRUST 1992-1 NOTES TO FINANCIAL STATEMENTS NOTE 1. BASIS OF ACCOUNTING The financial statements of Capital Auto Receivables Asset Trust 1992-1 (the "Trust") are prepared on the basis of cash receipts and cash disbursements. Such financial statements differ from financial statements prepared in accordance with generally accepted accounting principles in that interest income and the related assets are recognized when received rather than when earned and distributions to noteholders and certificateholders are recognized when paid rather than when the respective obligation is incurred. Certain expenses of the Trust are paid by Capital Auto Receivables, Inc. (the "Seller"). NOTE 2. SALE OF NOTES AND CERTIFICATES On December 17, 1992, Capital Auto Receivables Asset Trust 1992-1 acquired retail finance receivables aggregating approximately $1,607.1 million from the Seller in exchange for three classes of Asset-Backed Notes representing indebtedness of the Trust of $657.7 million Class A-1, $641.6 million Class A-2 and $251.6 million Class A-3, and $56.2 million of Asset-Backed Certificates representing equity interests in the Trust. The Trust property includes a pool of retail instalment sale contracts for new and used automobiles and light trucks, certain monies due or received thereunder, security interests in the vehicles financed thereby and certain other property. The Servicer has the option to repurchase the remaining receivables and certain other property as of the last day of any month on or after which the principal balance declines to 10% or less of the aggregate amount financed. NOTE 3. PRINCIPAL AND INTEREST PAYMENTS Payments of interest and principal (including prepayments) on the Notes are made on the fifteenth day of March, June, September and December or, if any such day is not a Business Day, on the next succeeding Business Day, commencing March 15, 1993 (each, a "Payment Date"). Principal of the Notes will be payable on each Payment Date in an amount equal to the sum of the Noteholders' Principal Distributable Amounts for each of the three Monthly Periods preceding such Payment Date, to the extent of funds available therefor. Payments of principal on the Notes are made (i) on the Class A-1 Notes until they are paid in full, (ii) then on the Class A-2 Notes until they are paid in full and (iii) then on the Class A-3 Notes until they are paid in full. The principal balance of the Class A-1 Notes was paid in full on September 15, 1993, the then-unpaid principal balance of the Class A-2 Notes will be payable on September 15, 1995 and the then-unpaid principal balance of the Class A-3 Notes will be payable on December 15, 1997. The final scheduled Distribution Date for the Certificates will be December 15, 1997. On each Distribution Date on and after the date on which the Class A-1 Notes have been paid in full, Certificateholders will receive, in respect of the certificate balance, an amount equal to the Certficateholders' Principal Distributable Amount for the Monthly Period preceding such Distribution Date, to the extent of funds available therefor. II-6 CAPITAL AUTO RECEIVABLES ASSET TRUST 1992-1 NOTES TO FINANCIAL STATEMENTS (concluded) NOTE 3. PRINCIPAL AND INTEREST PAYMENTS (concluded) Interest on the outstanding principal amount of the Notes accrues from December 15, 1992 or, in the case of the Class A-2 Notes, December 17, 1992, or from the most recent Payment Date on which interest has been paid to but excluding the following Payment Date. During 1993, the Class A-1 Notes received interest at the rate of 3.73% per annum (calculated on the basis of a 360-day year of twelve 30-day months). The Class A-2 Notes receive a floating rate of interest which is reset for each Payment Date to be a rate equal to the lesser of (i) LIBOR plus 0.25% and (ii) 10% (calculated on the basis of actual days elapsed and a 360-day year). The Class A-2 Notes received or will receive interest at the following rates per annum for the following periods: 3.8750% for the period from January 1, 1993 through March 14, 1993 3.5000% for the period from March 15, 1993 through June 14, 1993 3.6250% for the period from June 15, 1993 through September 14, 1993 3.4375% for the period from September 15, 1993 through December 14, 1993 3.6250% for the period from December 15, 1993 through March 14, 1994 4.1250% for the period from March 15, 1994 through June 14, 1994 The Class A-3 Notes will bear interest at the rate of 5.75% per annum (calculated on the basis of a 360-day year of twelve 30-day months). On each Distribution Date, the Owner Trustee will distribute pro rata to Certificateholders accrued interest at the pass through rate of 6.20% per annum on the outstanding Certificate Balance. NOTE 4. FEDERAL INCOME TAX The Trust is classified as a grantor trust, and therefore is not taxable as a corporation for federal income tax purposes. Each Noteholder and Certificateholder, by the acceptance of a Note or Certificate, agrees to treat the Notes as indebtedness and the Certificates as equity interests in the Trust for federal, state and local income and franchise tax purposes. __________________________ II-7 CAPITAL AUTO RECEIVABLES ASSET TRUST 1992-1 SUPPLEMENTARY FINANCIAL DATA (unaudited) SUMMARY OF QUARTERLY DISTRIBUTABLE INCOME (in millions of dollars) 1993 Quarters Principal Interest Total - ------------------------------------ --------- -------- ----- $ $ $ First quarter ...................... 225.4 16.7 242.1 Second quarter ..................... 226.9 14.3 241.2 Third quarter ...................... 210.0 12.3 222.3 Fourth quarter ..................... 185.5 10.0 195.5 --------- -------- ----- Total ......................... 847.8 53.3 901.1 ========= ======== ===== II-8 INDEPENDENT AUDITORS' REPORT March 22, 1994 The Capital Auto Receivables Asset Trust 1993-1, its Noteholders and Certificateholders, Capital Auto Receivables, Inc., Bankers Trust (Delaware), Owner Trustee, and The First National Bank of Chicago, Indenture Trustee: We have audited the accompanying Statement of Assets, Liabilities and Equity of the Capital Auto Receivables Asset Trust 1993-1 as of December 31, 1993, and the related Statement of Distributable Income for the period February 11, 1993 (inception) through December 31, 1993. These financial statements are the responsibility of the Trust's management. Our responsibility is to express an opinion on these financial statements based on our audit. We conducted our audit in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audit provides a reasonable basis for our opinion. As described in Note 1 to the financial statements, these financial statements are prepared on the basis of cash receipts and disbursements, which is a comprehensive basis of accounting other than generally accepted accounting principles. In our opinion, such financial statements present fairly, in all material respects, the assets, liabilities and equity of the Capital Auto Receivables Asset Trust 1993-1 at December 31, 1993 and its distributable income and distributions for the period February 11, 1993 (inception) through December 31, 1993, on the basis of accounting described in Note 1. s\ DELOITTE & TOUCHE - ----------------------- DELOITTE & TOUCHE 600 Renaissance Center Detroit, Michigan 48243 II-9 CAPITAL AUTO RECEIVABLES ASSET TRUST 1993-1 STATEMENT OF ASSETS, LIABILITIES AND EQUITY (in millions of dollars) Dec. 31 ------- ASSETS $ Receivables (Note 2) ................... 1,660.8 ------- TOTAL ASSETS ........................... 1,660.8 ======= LIABILITIES AND EQUITY (Notes 2 and 3) Asset-backed Notes ..................... 1,565.8 ------- Asset-backed Certificates (Equity) ..... 95.0 ------- TOTAL LIABILITIES AND EQUITY............ 1,660.8 ======= Reference should be made to the Notes to Financial Statements. II-10 CAPITAL AUTO RECEIVABLES ASSET TRUST 1993-1 STATEMENT OF DISTRIBUTABLE INCOME For the period February 11, 1993 (inception) through December 31, 1993 (in millions of dollars) ------- $ Distributable Income Allocable to Principal ...................... 1,252.1 Allocable to Interest ...................... 72.5 ------- Distributable Income .......................... 1,324.6 ======= Income Distributed ............................ 1,324.6 ======= Reference should be made to the Notes to Financial Statements. II-11 CAPITAL AUTO RECEIVABLES ASSET TRUST 1993-1 NOTES TO FINANCIAL STATEMENTS NOTE 1. BASIS OF ACCOUNTING The financial statements of Capital Auto Receivables Asset Trust 1993-1 (the "Trust") are prepared on the basis of cash receipts and cash disbursements. Such financial statements differ from financial statements prepared in accordance with generally accepted accounting principles in that interest income and the related assets are recognized when received rather than when earned and distributions to noteholders and certificateholders are recognized when paid rather than when the respective obligation is incurred. Certain expenses of the Trust are paid by Capital Auto Receivables, Inc. (the "Seller"). NOTE 2. SALE OF NOTES AND CERTIFICATES On February 11, 1993, Capital Auto Receivables Asset Trust 1993-1 acquired retail finance receivables aggregating approximately $2,912.9 million from the Seller in exchange for seven classes of Asset-Backed Notes representing indebtedness of the Trust of $322.0 million Class A-1; $225.0 million Class A-2; $125.0 million Class A-3; $478.0 million Class A-4; $1,147.0 million Class A-5; $318.0 million Class A-6; $196.0 million Class A-7 and $101.9 million of Asset-Backed Certificates representing equity interests in the Trust. The Trust property includes a pool of retail instalment sale contracts for new and used automobiles and light trucks, certain monies due or received thereunder, security interests in the vehicles financed thereby, the interest rate cap and certain other property. The Servicer has the option to repurchase the remaining receivables and certain other property as of the last day of any month on or after which the principal balance declines to 10% or less of the aggregate amount financed. NOTE 3. PRINCIPAL AND INTEREST PAYMENTS Payments of interest and principal (including prepayments) on the Notes are made on the fifteenth day of February, May, August and November or, if any such day is not a Business Day, on the next succeeding Business Day, commencing May 17, 1993 (each, a "Payment Date"). Principal of the Notes will be payable on each Payment Date in an amount equal to the sum of the Noteholders' Principal Distributable Amounts for each of the three Monthly Periods preceding such Payment Date, to the extent of funds available therefor. Payments of principal on the Notes are payable by class in the priorities set forth in the Indenture (previously filed by Form 8-K). The principal balance of the Class A-1 Notes was paid in full on May 17, 1993; the principal balance of the Class A-2 Notes was paid in full on August 16, 1993; the principal balance of the Class A-3 Notes was paid in full on November 15, 1993; the principal balance of the Class A-4 Notes was paid in full on November 15, 1993; the then-unpaid principal balance of the Class A-5 Notes will be payable on November 15, 1995; and the then-unpaid principal balance of the Class A-6 Notes and the Class A-7 Notes will be payable on February 17, 1998. Payment of principal to the Certificateholders in respect of the Certificate Balance was initiated in 1993, subsequent to the full payment of the Class A-1, Class A-2, Class A-3, and Class A-4 Notes. On each Distribution Date, the Certificateholders receive an amount equal to the Certificateholders' Principal Distributable Amount for the Monthly Period preceding such Distribution Date, to the extent of funds available therefor. The final scheduled Distribution Date for the Certificates is February 17, 1998. II-12 CAPITAL AUTO RECEIVABLES ASSET TRUST 1993-1 NOTES TO FINANCIAL STATEMENTS (concluded) NOTE 3. PRINCIPAL AND INTEREST PAYMENTS (concluded) Interest on the outstanding principal amount of the Notes accrues from February 11, 1993 or, from the most recent Payment Date on which interest has been paid to but excluding the following Payment Date. The Class A-1 Notes received interest at the rate of 3.1875% per annum. The Class A-2 Notes received interest at the rate of 3.3125% per annum. The Class A-3 Notes received interest at the rate of 3.4375% per annum. The Class A-4 Notes received a floating rate of interest which was reset for each Payment Date to be equal to LIBOR, as follows: 3.3125% for the period from February 11, 1993 through May 16, 1993 3.1875% for the period from May 17, 1993 through August 15, 1993 3.2500% for the period from August 16, 1993 through November 14, 1993 The Class A-5 Notes receive a floating rate of interest which is reset for each Payment Date to be equal to LIBOR plus 0.15% (calculated on the basis of actual days elapsed and a 360-day year). The Class A-5 Notes received or will receive interest at the following rates per annum for the following periods: 3.4625% for the period from February 11, 1993 through May 16, 1993 3.3750% for the period from May 17, 1993 through August 15, 1993 3.4500% for the period from August 16, 1993 through November 14, 1993 3.6500% for the period from November 15, 1993 through February 14, 1994 3.7125% for the period from February 15, 1994 through May 15, 1994 The Class A-6 Notes bear interest at the rate of 4.90% per annum. The Class A-7 Notes bear interest at the rate of 5.35% per annum. On each Distribution Date, the Owner Trustee distributes pro rata to Certificateholders accrued interest at the pass-through rate of 5.85% per annum on the outstanding Certificate Balance. NOTE 4. FINANCIAL INSTRUMENT WITH OFF-BALANCE SHEET RISK The Trust is the holder of an interest rate cap agreement for the purpose of managing its floating interest rate exposure. An interest rate cap agreement provides the holder protection against interest rate movements above an established rate. The notional amount of this interest rate cap at December 31, 1993 was $956.1 million. NOTE 5. FEDERAL INCOME TAX The Trust is classified as a grantor trust, and therefore is not taxable as a corporation for federal income tax purposes. Each Noteholder and Certificateholder, by the acceptance of a Note or Certificate, agrees to treat the Notes as indebtedness and the Certificates as equity interests in the Trust for federal, state and local income and franchise tax purpose II-13 CAPITAL AUTO RECEIVABLES ASSET TRUST 1993-1 SUPPLEMENTARY FINANCIAL DATA (unaudited) SUMMARY OF QUARTERLY DISTRIBUTABLE INCOME (in millions of dollars) 1993 Quarters Principal Interest Total - ------------------------------------ --------- -------- ------- $ $ $ First quarter ..................... 0.0 1.0 1.0 Second quarter ..................... 523.8 28.8 552.6 Third quarter ...................... 391.3 22.9 414.2 Fourth quarter ..................... 337.0 19.8 356.8 --------- -------- ------- Total ......................... 1,252.1 72.5 1,324.6 ========= ======== ======= II-14 INDEPENDENT AUDITORS' REPORT March 22, 1994 The Capital Auto Receivables Asset Trust 1993-2, its Noteholders and Certificateholders, Capital Auto Receivables, Inc., Bankers Trust (Delaware), Owner Trustee, and The First National Bank of Chicago, Indenture Trustee: We have audited the accompanying Statement of Assets, Liabilities and Equity of the Capital Auto Receivables Asset Trust 1993-2 as of December 31, 1993, and the related Statement of Distributable Income for the period June 2, 1993 (inception) through December 31, 1993. These financial statements are the responsibility of the Trust's management. Our responsibility is to express an opinion on these financial statements based on our audit. We conducted our audit in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audit provides a reasonable basis for our opinion. As described in Note 1 to the financial statements, these financial statements are prepared on the basis of cash receipts and disbursements, which is a comprehensive basis of accounting other than generally accepted accounting principles. In our opinion, such financial statements present fairly, in all material respects, the assets, liabilities and equity of the Capital Auto Receivables Asset Trust 1993-2 at December 31, 1993, and its distributable income and distributions for the period June 2, 1993 (inception) through December 31, 1993, on the basis of accounting described in Note 1. s\ DELOITTE & TOUCHE - ----------------------- DELOITTE & TOUCHE 600 Renaissance Center Detroit, Michigan 48243 II-15 CAPITAL AUTO RECEIVABLES ASSET TRUST 1993-2 STATEMENT OF ASSETS, LIABILITIES AND EQUITY (in millions of dollars) Dec. 31 ------- ASSETS $ Receivables (net of $58.5 million of discount)(Note 2) 1,423.2 ------- TOTAL ASSETS ........................................ 1,423.2 ======= LIABILITIES AND EQUITY (Notes 2 and 3) Asset-backed Notes .................................. 1,364.6 ------- Asset-backed Certificates (Equity) .................. 58.6 ------- TOTAL LIABILITIES AND EQUITY......................... 1,423.2 ======= Reference should be made to the Notes to Financial Statements. II-16 CAPITAL AUTO RECEIVABLES ASSET TRUST 1993-2 STATEMENT OF DISTRIBUTABLE INCOME For the period June 2, 1993 (inception) through December 31, 1993 (in millions of dollars) ------- $ Distributable Income Allocable to Principal ...................... 529.4 Allocable to Interest ...................... 37.4 ------- Distributable Income .......................... 566.8 ======= Income Distributed ............................ 566.8 ======= Reference should be made to the Notes to Financial Statements. II-17 CAPITAL AUTO RECEIVABLES ASSET TRUST 1993-2 NOTES TO FINANCIAL STATEMENTS NOTE 1. BASIS OF ACCOUNTING The financial statements of Capital Auto Receivables Asset Trust 1993-2 (the "Trust") are prepared on the basis of cash receipts and cash disbursements. Such financial statements differ from financial statements prepared in accordance with generally accepted accounting principles in that interest income and the related assets are recognized when received rather than when earned and distributions to noteholders and certificateholders are recognized when paid rather than when the respective obligation is incurred. Certain expenses of the Trust are paid by Capital Auto Receivables, Inc. (the "Seller"). NOTE 2. SALE OF NOTES AND CERTIFICATES On June 2, 1993, Capital Auto Receivables Asset Trust 1993-2 acquired retail finance receivables aggregating approximately $2,009.3 million at a discount of $56.7 million from the Seller in exchange for four classes of Asset-Backed Notes representing indebtedness of the Trust of $750.0 million Class A-1, $100.0 million Class A-2, $641.0 million Class A-3, $403.0 million Class A-4, and $58.6 million of Asset-Backed Certificates representing equity interests in the Trust. The Trust property includes a pool of retail instalment sale contracts for new and used automobiles and light trucks, certain monies due or received thereunder, security interests in the vehicles financed thereby and certain other property. Substantially all of the Receivables comprising the Trust property were acquired by GMAC under special incentive rate financing programs. The Servicer has the option to repurchase the remaining receivables and certain other property as of the last day of any month on or after which the principal balance declines to 10% or less of the aggregate amount financed. NOTE 3. PRINCIPAL AND INTEREST PAYMENTS Payments of interest and principal (including prepayments) on the Notes are made on the fifteenth day of each month or, if any such day is not a Business Day, on the next succeeding Business Day, commencing June 15, 1993 (each, a "Distribution Date"). Principal of the Notes is payable on each Distribution Date in an amount equal to the sum of the Noteholders' Principal Distributable Amounts for the related Monthly Period to the extent of funds available therefor. Payments of principal on the Notes are payable by class in the priorities set forth in the Indenture (previously filed by Form 8-K). The unpaid principal balance of the Class A-1 Notes will be payable on June 15, 1994; the then-unpaid principal balance of the Class A-2 Notes will be payable on August 15, 1994; the then-unpaid principal balance of the Class A-3 Notes will be payable on November 15, 1995; and the then-unpaid principal balance of the Class A-4 Notes will be payable on May 15, 1997. II-18 CAPITAL AUTO RECEIVABLES ASSET TRUST 1993-2 NOTES TO FINANCIAL STATEMENTS (concluded) NOTE 3. PRINCIPAL AND INTEREST PAYMENTS (concluded) On each Distribution Date on and after the date on which the Class A-1 and Class A-2 Notes have been paid in full, Certificateholders will receive, in respect of the certificate balance, an amount equal to the Certificateholders' Principal Distributable Amount for the Monthly Period preceding such Distribution Date, to the extent of funds available therefor. The final scheduled Distribution Date for the Certificates is May 15, 1997. Interest on the outstanding principal amount of the Notes accrues from June 2, 1993 or, from the most recent Distribution Date on which interest has been paid to but excluding the following Distribution Date. The Class A-1 Notes bear interest at the rate of 3.35% per annum (calculated on the basis of actual days elapsed and a 360-day year). The Class A-2 Notes bear interest at the rate of 3.71% per annum (calculated on the basis of actual days elapsed and a 360-day year). The Class A-3 Notes bear interest at the rate of 4.20% per annum (calculated on the basis of a 360-day year of twelve 30-day months). The Class A-4 Notes bear interest at the rate of 4.70% per annum (calculated on the basis of a 360-day year of twelve 30-day months). On each Distribution Date, the Owner Trustee distributes pro rata to Certificateholders accrued interest at the pass-through rate of 4.70% per annum on the outstanding Certificate Balance. NOTE 4. FEDERAL INCOME TAX The Trust is classified as a partnership, and therefore is not taxable as a corporation for federal income tax purposes. Each Noteholder and Certificateholder, by the acceptance of a Note or Certificate, has agreed to treat the Notes as indebtedness and the Certificates as equity interests in the Trust for federal, state and local income and franchise tax purposes. __________________________ II-19 CAPITAL AUTO RECEIVABLES ASSET TRUST 1993-2 SUPPLEMENTARY FINANCIAL DATA (unaudited) SUMMARY OF QUARTERLY DISTRIBUTABLE INCOME (in millions of dollars) 1993 Quarters Principal Interest Total - ------------------------------------ --------- -------- ----- $ $ $ Second quarter ..................... 77.5 2.9 80.4 Third quarter ...................... 227.0 18.3 245.3 Fourth quarter ..................... 224.9 16.2 241.1 --------- -------- ----- Total ......................... 529.4 37.4 566.8 ========= ======== ===== II-20 INDEPENDENT AUDITORS' REPORT March 22, 1994 The Capital Auto Receivables Asset Trust 1993-3, its Noteholders and Certificateholders, Capital Auto Receivables, Inc., Bankers Trust (Delaware), Owner Trustee, and The First National Bank of Chicago, Indenture Trustee: We have audited the accompanying Statement of Assets, Liabilities and Equity of the Capital Auto Receivables Asset Trust 1993-3 as of December 31, 1993, and the related Statement of Distributable Income for the period October 21, 1993 (inception) through December 31, 1993. These financial statements are the responsibility of the Trust's management. Our responsibility is to express an opinion on these financial statements based on our audit. We conducted our audit in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audit provides a reasonable basis for our opinion. As described in Note 1 to the financial statements, these financial statements are prepared on the basis of cash receipts and disbursements, which is a comprehensive basis of accounting other than generally accepted accounting principles. In our opinion, such financial statements present fairly, in all material respects, the assets, liabilities and equity of the Capital Auto Receivables Asset Trust 1993-3 at December 31, 1993 and its distributable income and distributions for the period October 21, 1993 (inception) through December 31, 1993, on the basis of accounting described in Note 1. s\ DELOITTE & TOUCHE - ----------------------- DELOITTE & TOUCHE 600 Renaissance Center Detroit, Michigan 48243 II-21 CAPITAL AUTO RECEIVABLES ASSET TRUST 1993-3 STATEMENT OF ASSETS, LIABILITIES AND EQUITY (in millions of dollars) Dec. 31 ------- ASSETS $ Receivables (Note 2) ................... 2,438.7 ------- TOTAL ASSETS ........................... 2,438.7 ======= LIABILITIES AND EQUITY (Notes 2 and 3) Asset-backed Notes ..................... 2,357.3 ------- Asset-backed Certificates (Equity) ..... 81.4 ------- TOTAL LIABILITIES AND EQUITY............ 2,438.7 ======= Reference should be made to the Notes to Financial Statements. II-22 CAPITAL AUTO RECEIVABLES ASSET TRUST 1993-3 STATEMENT OF DISTRIBUTABLE INCOME For the period October 21, 1993 (inception) through December 31, 1993 (in millions of dollars) ------- $ Distributable Income Allocable to Principal ...................... 66.2 Allocable to Interest ...................... 5.4 ------- Distributable Income .......................... 71.6 ======= Income Distributed ............................ 71.6 ======= Reference should be made to the Notes to Financial Statements. II-23 CAPITAL AUTO RECEIVABLES ASSET TRUST 1993-3 NOTES TO FINANCIAL STATEMENTS NOTE 1. BASIS OF ACCOUNTING The financial statements of Capital Auto Receivables Asset Trust 1993-3 (the "Trust") are prepared on the basis of cash receipts and cash disbursements. Such financial statements differ from financial statements prepared in accordance with generally accepted accounting principles in that interest income and the related assets are recognized when received rather than when earned and distributions to noteholders and certificateholders are recognized when paid rather than when the respective obligation is incurred. Certain expenses of the Trust are paid by Capital Auto Receivables, Inc. (the "Seller"). NOTE 2. SALE OF NOTES AND CERTIFICATES On October 21, 1993, Capital Auto Receivables Asset Trust 1993-3 acquired retail finance receivables aggregating approximately $2,504.9 million from the Seller in exchange for six classes of Asset-Backed Notes representing indebtedness of the Trust of $430.0 million Class A-1; $59.0 million Class A-2; $63.0 million Class A-3; $210.0 million Class A-4; $484.3 million Class A-5; $1,177.2 million Class A-6; and $81.4 million of Asset-Backed Certificates representing equity interests in the Trust. The Trust property includes a pool of retail instalment sale contracts for new and used automobiles and light trucks, monies due or received thereunder, security interests in the vehicles financed thereby and certain other property. The Servicer has the option to repurchase the remaining receivables and certain other property as of the last day of any month on or after which the principal balance declines to 10% or less of the aggregate amount financed. NOTE 3. PRINCIPAL AND INTEREST PAYMENTS Payments of interest on the Class A-1 Notes and the Class A-5 Notes will be made on the fifteenth day of each month or, if any such day is not a Business Day, on the next succeeding Business Day, commencing on November 15, 1993 (each a "Distribution Date"). Payments of interest on the Class A- 2 Notes, the Class A-3 Notes, the Class A-4 Notes, and the Class A-6 Notes are made on the fifteenth day of January, April, July and October or, if any such day is not a Business Day, on the next succeeding Business Day, commencing January 18, 1994 (each, a "Payment Date"). Principal of the Notes will be payable by class in the priorities and in the amounts as set forth in the Indenture (previously filed by Form 8-K), equal to the sum of the Aggregate Noteholders' Principal Distributable Amounts to the extent of funds available therefor. II-24 CAPITAL AUTO RECEIVABLES ASSET TRUST 1993-3 NOTES TO FINANCIAL STATEMENTS (concluded) NOTE 3. PRINCIPAL AND INTEREST PAYMENTS (concluded) The unpaid principal balance of the Class A-1 Notes will be payable on November 15, 1994; the principal balance of the Class A-2 Notes was paid in full on January 18, 1994; the then-unpaid principal balance of the Class A- 3 Notes will be payable on April 15, 1994; the then-unpaid principal balance of the Class A-4 Notes will be payable on October 17, 1994; the then-unpaid principal balance of the Class A-5 Notes will be payable on October 16, 1995; and the then-unpaid principal balance of the Class A-6 Notes will be payable on October 15, 1998. On each Distribution Date on and after the date on which the Class A-2 Notes, the Class A-3 Notes and the Class A-4 Notes have been paid (or provided for) in full, Certificateholders will receive, in respect of the certificate balance, an amount equal to the Certificateholders' Principal Distributable Amount for the Monthly Period preceding such Distribution Date, to the extent of funds available therefor. The final scheduled Distribution Date for the Certificates will be October 15, 1998. Interest on the outstanding principal amount of the Notes accrues from October 21, 1993 or, from the most recent Distribution Date or Payment Date, as applicable, on which interest has been paid to but excluding the following Payment Date. The Class A-1 Notes bear interest at the rate of 3.30% per annum (calculated on the basis of actual days elapsed and a 360- day year). The Class A-2 Notes received interest at the rate of 3.25% per annum (calculated on the basis of actual days elapsed and a 360-day year). The Class A-3 Notes bear interest at the rate of 3.25% per annum (calculated on the basis of actual days elapsed and a 360-day year). The Class A-4 Notes bear interest at the rate of 3.30% per annum (calculated on the basis of actual days elapsed and a 360-day year). The Class A-5 Notes bear interest at the rate of 3.65% per annum (calculated on the basis of a 360-day year of twelve 30-day months). The Class A-6 Notes bear interest at the rate of 4.60% per annum (calculated on the basis of a 360-day year of twelve 30-day months). On each Distribution Date, the Owner Trustee distributes pro rata to Certificateholders accrued interest at the pass- through rate of 4.60% per annum on the outstanding Certificate Balance. NOTE 4. FEDERAL INCOME TAX The Trust is classified as a grantor trust, and therefore is not taxable as a corporation for federal income tax purposes. Each Noteholder and Certificateholder, by the acceptance of a Note or Certificate, agrees to treat the Notes as indebtedness and the Certificates as equity interests in the Trust for federal, state and local income and franchise tax purposes. __________________________ II-25 CAPITAL AUTO RECEIVABLES ASSET TRUST 1993-3 SUPPLEMENTARY FINANCIAL DATA (unaudited) SUMMARY OF QUARTERLY DISTRIBUTABLE INCOME (in millions of dollars) 1993 Quarters Principal Interest Total - ------------------------------------ --------- -------- ----- $ $ $ Fourth quarter ..................... 66.2 5.4 71.6 ========= ======== ===== II-26 PART IV ITEM 14.

ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8K (a) (1) FINANCIAL STATEMENTS. Included in Part II, Item 8, of Form 10-K. (a) (2) FINANCIAL STATEMENT SCHEDULES. All schedules have been omitted because they are inapplicable or because the information called for is shown in the financial statements or notes thereto. (a) (3) EXHIBITS (Included in Part II of this report). -- Capital Auto Receivables Asset Trust 1992-1, Financial Statements for the Year Ended December 31, 1993. -- Capital Auto Receivables Asset Trust 1993-1 Financial Statements for the period February 11, 1993 through December 31, 1993. -- Capital Auto Receivables Asset Trust 1993-2 Financial Statements for the period June 2, 1993 through December 31, -- Capital Auto Receivables Asset Trust 1993-3 Financial Statements for the period from October 21, 1993 through December 31, 1993. (b) REPORTS ON FORM 8-K. A current report on Form 8-K dated November 12, 1993 reporting matters under Item 7, Financial Statements and Exhibits, was filed during the fourth quarter ended December 31, 1993. ITEMS 2, 3, 4, 5, 6, 9, 10, 11, 12 and 13 are inapplicable and have been omitted. IV-1 SIGNATURE Pursuant to the requirements of Section 13 of the Securities Exchange Act of 1934, the Trustees have duly caused this report to be signed on their behalf by the undersigned thereunto duly authorized. CAPITAL AUTO RECEIVABLES ASSET TRUST 1992-1 CAPITAL AUTO RECEIVABLES ASSET TRUST 1993-1 CAPITAL AUTO RECEIVABLES ASSET TRUST 1993-2 CAPITAL AUTO RECEIVABLES ASSET TRUST 1993-3 by: Bankers Trust (Delaware) -------------------------------------- (Owner Trustee, not in its individual capacity but solely as Owner Trustee on behalf of the Issuer.) s\ Louis Bodi --------------------------------- (Louis Bodi, Assistant Treasurer) Date: March 30, 1994 -------------- IV-2

868482_1993.txt

868482

1993

Item 1. Business The Sears Credit Account Trust 1990 D (the "Trust") was formed pursuant to the Pooling and Servicing Agreement dated as of October 15, 1990 (the "Pooling and Servicing Agreement") among Sears, Roebuck and Co. ("Sears") as Servicer, its wholly-owned subsidiary, Sears Receivables Financing Group, Inc. ("SRFG") as Seller, and Continental Bank, National Association as trustee (the "Trustee"). The Trust's only business is to act as a passive conduit to permit investment in a pool of retail consumer receivables. Item 2.

Item 2. Properties The property of the Trust includes a portfolio of receivables (the "Receivables") arising in selected accounts under open-end credit plans of Sears (the "Accounts") and all monies received in payment of the Receivables. At the time of the Trust's formation, Sears sold and contributed to SRFG, which in turn conveyed to the Trust, all Receivables existing under the Accounts as of the end of certain of Sears regular billing cycles ending in September, 1990 and all Receivables arising under the Accounts from time to time thereafter until the termination of the Trust. Information related to the performance of the Receivables during 1993 is set forth in the ANNUAL STATEMENT filed as Exhibit 21 to this Annual Report on Form 10-K. Item 3.

Item 3. Legal Proceedings None Item 4.

Item 4. Submission of Matters to a Vote of Security Holders None PART II Item 5.

Item 5. Market for Registrant's Common Equity and Related Stockholder Matters Investor Certificates are held and delivered in book-entry form through the facilities of The Depository Trust Company ("DTC"), a "clearing agency" registered pursuant to the provisions of Section 17A of the Securities Exchange Act of 1934, as amended. All outstanding definitive Investor Certificates are held by CEDE and Co., the nominee of DTC. Item 9.

Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure None PART III Item 12.

Item 12. Security Ownership of Certain Beneficial Owners and Management As of March 15, 1994, 100% of the Investor Certificates were held in the nominee name of CEDE and Co. for beneficial owners. SRFG, as of March 15, 1994, owned 100% of the Seller Certificate, which represented beneficial ownership of a residual interest in the assets of the Trust as provided in the Pooling and Servicing Agreement. Item 13.

Item 13. Certain Relationships and Related Transactions None PART IV Item 14.

Item 14. Exhibits, Financial Statement Schedules, and Reports on Form 8-K (a) Exhibits: 21. 1993 ANNUAL STATEMENT prepared by the Servicer. 28. ANNUAL INDEPENDENT AUDITOR'S REPORTS pursuant to Section 3.06 of the Pooling and Servicing Agreement. (a) Review of servicing procedures. (b) Annual Servicing Letter. (b) Reports on Form 8-K: Current reports on Form 8-K are filed on, or before the Distribution Date each month (on, or the first business day after, the 15th of the month). The reports include as an exhibit, the MONTHLY INVESTOR CERTIFICATEHOLDERS' STATEMENT. Current Reports on Form 8-K were filed on October 15, 1993, November 15, 1993 and December 15, 1993. SIGNATURES Pursuant to the requirements of Section 13 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. Sears Credit Account Trust 1990 D (Registrant) By: Sears Receivables Financing Group, Inc. (Originator of the Trust) By: /S/ALICE M. PETERSON _____________________________________ Alice M. Peterson President and Chief Executive Officer Dated: March 30, 1994 EXHIBIT INDEX Page number in sequential Exhibit No. number system 21. 1993 ANNUAL STATEMENT prepared by the Servicer. 28. ANNUAL INDEPENDENT AUDITOR'S REPORTS pursuant to Section 3.06 of the Pooling and Servicing Agreement. (a) Review of servicing procedures. (b) Annual Servicing Letter. Exhibit 21 SEARS CREDIT ACCOUNT TRUST 1990 D 9.35% CREDIT ACCOUNT PASS-THROUGH CERTIFICATES 1993 ANNUAL STATEMENT Pursuant to the terms of the letter issued by the Securities and Exchange Commission dated February 19, 1991 (granting relief to the Trust from certain reporting requirements of the Securities Exchange Act of 1934, as amended), aggregated information regarding the performance of Accounts and payments to Investor Certificateholders in respect of the Due Periods related to the twelve Distribution Dates which occurred in 1993 is set forth below. 1) The total amount of the distribution to Investor Certificateholders during 1993, per $1,000 interest..$93.50 2) The amount of the distribution set forth in paragraph 1 above in respect of interest on the Investor Certificates, per $1,000 interest....................$93.50 3) The amount of the distribution set forth in paragraph 1 above in respect of principal on the Investor Certificates, per $1,000 interest.....................$0.00 4) The aggregate amount of Collections of Principal Receivables processed during the related Due Periods.................................$709,943,487.00 5) The aggregate amount of Collections of Finance Charge Receivables processed during the related Due Periods.................................$186,427,500.13 6) The aggregate amount of Collections of Principal Receivables processed during the related Due Periods which were allocated in respect of the Investor Certificates................................$535,263,045.94 7) The aggregate amount of Collections of Finance Charge Receivables processed during the related Due Periods which were allocated in respect of the Investor Certificates................................$140,882,596.21 8) The aggregate amount of Collections of Principal Receivables processed during the related Due Periods which were allocated in respect of the Seller Certificate.................................$174,680,441.06 9) The aggregate amount of Collections of Finance Charge Receivables processed during the related Due Periods which were allocated in respect of the Seller Certificate..................................$45,544,903.92 10) The excess of the Investor Charged-Off Amount over the sum of (i) payments in respect of the Available Subordinated Amount and (ii) Excess Servicing, if any (an "Investor Loss"), per $1,000 interest............ $0.00 11) The aggregate amount of Investor Losses in the Trust as of the end of the day on December 15, 1993, per $1,000 interest...................................... $0.00 12) The total reimbursed to the Trust from the sum of the Available subordinated Amount and Excess Servicing, if any, in respect of Investor Losses, per $1,000 interest............................................. $0.00 13) The amount of the Investor Monthly Servicing Fee payable by the Trust to the Servicer.........$14,947,916.67 14) The aggregate amount which was deposited in the Principal Funding Account in respect of Collections of Principal Receivables during the related Due Periods..................................$62,500,000.00 15) The aggregate amount of Investment Income during the related Due Periods..........................$81,567.22 16) The total amount on deposit in the Principal Funding Account in respect of Collections of Principal Receivables, as of the end of the reportable year..............................$62,500,000.00 17) The Deficit Accumulation Amount, as of the end of the reportable year................................$0.00 18) The aggregate amount which was deposited in the Interest Funding Account in respect of Certificate Interest during the related Due Periods...............$70,125,000.00 19) The total amount on deposit in the Interest Funding Account in respect of Certificate Interest, as of the end of the reportable year...................$11,687,500.00 Exhibit 28(a) February 11, 1994 Ms. Alice M. Peterson Ms. Cynthia K. Duncan Vice President and Treasurer Trust Officer Sears, Roebuck and Co. as Servicer Continental Bank, National Sears Tower Association as Trustee Chicago, Illinois 60684 231 South La Salle Street Chicago, Illinois 60697 We have applied the procedures listed below to the accounting records of Sears, Roebuck and Co. ("Sears") relating to the servicing procedures performed by Sears as Servicer under Section 3.06(b) of the Pooling and Servicing Agreement (the "Agreement") for the following Trusts: Date of Pooling and Trust Servicing Agreement Sears Credit Account Trust 1989E November 13, 1989 Sears Credit Account Trust 1990A January 12, 1990 Sears Credit Account Trust 1990B February 22, 1990 Sears Credit Account Trust 1990C July 31, 1990 Sears Credit Account Trust 1990D October 15, 1990 Sears Credit Account Trust 1990E December 1, 1990 It is understood that this report is solely for your information and is not to be referred to or distributed for any purpose to anyone other than Continental Bank, National Association as Trustee, Investor Certificateholders or the management of Sears. The procedures we performed are as follows: Compared the mathematical calculations of each amount set forth in each monthly certificate forwarded by the Servicer, pursuant to Section 3.04(b) of the Agreement, during the calendar year 1993 to the Servicer's computer-generated Portfolio Monitoring and Monthly Cash Flow Allocations Report. We found such amounts to be in agreement. February 11, 1994 Ms. Alice M. Peterson Ms. Cynthia K. Duncan Vice President and Treasurer Trust Officer Sears, Roebuck and Co. as Servicer Continental Bank, National Association as Trustee Because the above procedures do not constitute an audit conducted in accordance with generally accepted auditing standards, we do not express an opinion on any of the items referred to above. As a result of the procedures performed, no matters came to our attention that caused us to believe that the amounts in the monthly certificates require adjustment. Had we performed additional procedures or had we conducted an audit of the monthly certificates in accordance with generally accepted auditing standards, matters might have come to our attention that would have been reported to you. This report relates only to the items specified above and does not extend to any financial statements of Sears taken as a whole.

765813_1993.txt

765813

1993

ITEM 1. BUSINESS All references to "Notes" are to Notes to Consolidated Financial Statements contained in this report. The registrant, JMB Income Properties, Ltd. - XII (the "Partnership"), is a limited partnership formed in 1984 and currently governed under the Revised Uniform Limited Partnership Act of the State of Illinois to invest in improved income-producing commercial and residential real property. On August 23, 1985, the Partnership commenced an offering to the public of $100,000,000 (subject to increase by up to $150,000,000) in Limited Partnership Interests (the "Interests") pursuant to a Registration Statement on Form S-11 under the Securities Act of 1933 (Registration No. 2-96716). A total of 189,679 Interests were sold to the public at $1,000 per Interest and were issued to Investors in fiscal 1986. The offering closed on January 17, 1986. No Investor has made any additional capital contribution after such date. The Investors in the Partnership share in their portion of the benefits of ownership of the Partnership's real property investments according to the number of Interests held. The Partnership is engaged solely in the business of the acquisition, operation and sale and disposition of equity real estate investments. Such equity investments are held by fee title and/or through joint venture partnership interests. The Partnership's real estate investments are located throughout the nation and it has no real estate investments located outside of the United States. A presentation of information about industry segments, geographic regions, raw materials, or seasonality is not applicable and would not be material to an understanding of the Partnership's business taken as a whole. Pursuant to the Partnership agreement, the Partnership is required to terminate on or before October 31, 2035. Accordingly, the Partnership intends to hold the real properties it acquires for investment purposes until such time as sale or other disposition appears to be advantageous. Unless otherwise described, the Partnership expects to hold its properties for long- term investment where, due to current market conditions, it is impossible to forecast the expected holding period. At sale of a particular property, the proceeds, if any, are generally distributed or reinvested in existing properties rather than invested in acquiring additional properties. The Partnership has made the real property investments set forth in the following table: The Partnership's real property investments are subject to competition from similar types of properties (including in certain areas properties owned or advised by affiliates of the General Partners) in the respective vicinities in which they are located. Such competition is generally for the retention of existing tenants. Additionally, the Partnership is in competition for new tenants in markets where significant vacancies are present. Reference is made to Item 7 below for a discussion of competitive conditions and future renovation and capital improvement plans of the Partnership and certain of its significant investment properties. Approximate occupancy levels for the properties are set forth in the table in Item 2

ITEM 2. PROPERTIES The Partnership owns directly or through joint venture partnerships the properties or interests in the properties referred to under Item 1 above to which reference is hereby made for a description of said properties. The following is a listing of principal businesses or occupations carried on in and approximate occupancy levels by quarter during fiscal years 1993 and 1992 for the Partnership's investment properties owned during 1993: ITEM 3.

ITEM 3. LEGAL PROCEEDINGS The Partnership is not subject to any material pending legal proceedings. ITEM 4.

ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS There were no matters submitted to a vote of holders of Interests during 1992 and 1993. PART II ITEM 5.

ITEM 5. MARKET FOR THE PARTNERSHIP'S LIMITED PARTNERSHIP INTERESTS AND RELATED SECURITY HOLDER MATTERS As of December 31, 1993, there were 16,270 record holders of Interests of the Partnership. There is no public market for Interests and it is not anticipated that a public market for Interests will develop. Upon request, the Managing General Partner may provide information relating to a prospective transfer of Interests to an investor desiring to transfer his Interests. The price to be paid for the Interests, as well as any economic aspects of the transaction, will be subject to negotiation by the investor. Reference is made to Item 6

ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS LIQUIDITY AND CAPITAL RESOURCES On August 23, 1985, the Partnership commenced an offering to the public of $100,000,000, subject to increase by up to $150,000,000, pursuant to a Registration Statement on Form S-11 under the Securities Act of 1933. On January 17, 1986, the initial and final closing of the offering was consummated with the dealer manager of the public offering (an affiliate of which is a limited partner of one of the Associate General Partners of the Partnership), and 189,679 Interests were issued by the Partnership, from which the Partnership received gross proceeds of $189,679,000. After deducting selling expenses and other offering costs, the Partnership had approximately $171,306,000 with which to make investments in income-producing commercial real property, to pay legal fees and other costs (including acquisition fees) related to such investments and for working capital reserves. A portion of such proceeds was utilized to acquire the properties described in Item 1 above. At December 31, 1993, the Partnership had cash and cash equivalents of approximately $1,471,000. Such funds and short-term investments of approximately $21,966,000 are available for working capital requirements including the funding of the Partnership's share of releasing costs and capital improvements at the San Jose, California, New York, New York and Encino, California real property investments. The Partnership and its consolidated ventures have currently budgeted in 1994 approximately $4,271,000 for tenant improvements and other capital expenditures, not including the improvements or additions related to the renovation of Topanga Plaza to be funded through the existing loan as discussed below and in Note 3(c). Such budgeted amounts also exclude the Partnership's share of the January 17, 1994 earthquake repair costs at Topanga Plaza which are estimated to be approximately $2,100,000 (as discussed below and in Note 10(b)). The Partnership's share of such items and its share of similar items for its unconsolidated ventures in 1994 is currently budgeted to be approximately $3,056,000. Actual amounts expended in 1994 may vary depending on a number of factors including actual leasing activity, results of property operations, liquidity considerations and other market conditions over the course of the year. Due to these commitments, the Partnership has reduced the operating distribution beginning with the first quarter 1993. Additionally, as more fully described in Notes 5 and 8, distributions to the General Partners have been deferred in accordance with the subordination requirements of the Partnership agreement. The source of capital for such items and for both short-term and long-term future liquidity and distributions is expected to be through cash generated by the Partnership's investment properties and through the sale of such investments. To the extent that a property does not produce adequate amounts of cash to meet its needs, the Partnership may withdraw funds from the working capital reserve which it maintains. The Partnership's and its ventures' mortgage obligations are all non-recourse. Therefore, the Partnership and its Ventures are not obligated to pay mortgage indebtedness unless the related property produces sufficient net cash flow from operations or sale. On January 30, 1992, the Partnership through JMB/Mid Rivers Mall Associates, sold its interest in Mid Rivers Mall located in St. Peters, Missouri to an affiliate of an unaffiliated joint venture partner. The Partnership received, in connection with the sale, after all fees, expenses, and joint venture participation, net cash of $13,250,000. See Note 6 for a further description of the transaction. Overall cash flow returns at Broad Street for the next few years are expected to be lower than originally projected because an additional 13% of the space currently leased and occupied expires during the next two years. In addition, a tenant, occupying approximately 37,000 square feet (approximately 15% of the building), did not renew its lease when it expired in September 1993. However, subtenants occupying approximately 21,000 square feet whose leases also expired in September 1993 have held over while Broad Street continues to negotiate leases with them. Furthermore, Broad Street has renewed and expanded another tenant, effective July 1, 1993, whose lease was scheduled to expire in December 1994. This tenant has expanded from approximately 18,000 square feet to approximately 35,000 square feet at a market effective rental rate which is lower than its previous lease. The Partnership will continue its aggressive leasing program; however, the downtown New York City market remains extremely competitive due to the significant amount of space available primarily resulting from the layoffs, cutbacks and consolidations by financial service companies and related businesses which dominated this market. In addition to competition for tenants in the downtown Manhattan market from other buildings in the area, there is increasing competition from less expensive alternatives to Manhattan. In order to enhance the building's competitive position in the marketplace, the joint venture partners have recently completed certain modest upgrades to the building's main lobby and elevators. Rental rates in the downtown market are currently at depressed levels and this can be expected to continue for the foreseeable future while the current vacant space is gradually absorbed. Little, if any, new construction is planned for downtown over the next few years and it is expected that the building will continue to be adversely affected by the lower than originally projected effective rental rates now achieved upon releasing of existing leases which expire over the next few years. Therefore, the JMB/Broad Street joint venture recorded a provision for value impairment at December 31, 1991 to reduce the net book value of 40 Broad Street to $30,000,000 due to the uncertainty of JMB/Broad Street joint venture's ability to recover the net carrying value of the investment property through future operations or sale. An additional provision for value impairment was recorded at December 31, 1992 to further reduce the net book value of the property to the then estimated valuation of $7,800,000. Reference is made to Notes 1 and 3(d) for further discussion of the current status of this investment property. During 1991, the JMB/Broad Street joint venture was required to pay approximately $1,800,000 in transfer taxes (and related amounts) relating to the original acquisition of this investment property. See Note 3(d). In January 1992, the Partnership advanced $575,000 to the JMB/San Jose joint venture for the payment of certain other operating expenses. These monies were paid back to the Partnership by the end of 1992. The venture partners notified the tenants in and invitees to the complex that some of the buildings, particularly the 100-130 Park Center Plaza Buildings and the garage below them, could pose a life safety hazard under certain unusually intense earthquake conditions. While the buildings and the garage were designed to comply with the applicable codes for the period in which they were constructed, and there is no legal requirement to upgrade the buildings for seismic purposes, the venture partners are working with consultants to analyze ways in which such a potential life safety hazard could be eliminated. However, since the costs of both re-leasing space and any seismic program could be substantial, the Partnership has commenced discussions with the appropriate lender for additional loan proceeds to pay for all or a portion of these costs. The Partnership is also continuing to discuss terms for a possible loan extension with the mortgage lender on the 150 Almaden and 185 Park Avenue buildings and certain parking areas as the mortgage loan secured by this portion of the complex matured on October 1, 1993 and was extended to December 1, 1993. However, the Partnership and the lender have not been able to agree upon mutually acceptable terms for a loan extension and the lender has accelerated the loan. Should an agreement not be reached and as the Partnership does not have its share of the outstanding loan balance in its reserves in order to retire the loan, it is possible that the lender would exercise its remedies and seek to acquire title to this portion of the complex. Furthermore, should lender assistance be required to fund significant costs at the 100-130 Park Center Plaza buildings but not be obtained, the Partnership has decided not to commit any additional amounts to this portion of the complex since the likelihood of recovering such funds through increased capital appreciation is remote. The result would be that the Partnership would no longer have an ownership interest in this portion of the complex. As a result, there is uncertainty about the ability to recover the net carrying value of the property through future operations and sale and accordingly, the JMB/San Jose joint venture has made a provision for value impairment on the 150 Almaden and 185 Park Avenue buildings and certain parking areas of $15,549,935. Such provision at December 31, 1993 is recorded to reduce the net carrying value of these buildings to the then outstanding balance of the related non-recourse financing. Due to the uncertainty of the JMB/San Jose joint venture's ability to recover the net carrying value of those buildings within the investment property through future operations or sale, the JMB/San Jose joint venture had recorded a provision for value impairment at December 31, 1991 of $21,175,127 to reduce the net book value of the 100-130 Park Center Plaza buildings and a certain parking area to an amount equal to the then outstanding balance of the related non-recourse financing. Additionally, at December 31, 1992, the JMB/San Jose joint venture recorded a provision for value impairment of $8,142,152 on certain other portions of the complex to amounts equal to the then outstanding balances of the related non-recourse financing. In the event the lender on any portion of the complex exercised its remedies as discussed above, the result would likely be that JMB/San Jose joint venture would no longer have an ownership interest in such portion. See Note 3(b) for further discussion of this investment property. Tenants occupying approximately 110,000 square feet (approximately 26% of the buildings) of the Park Center Plaza investment property have leases that expire in 1995, for which there can be no assurance of renewals. On January 17, 1994, an earthquake occurred in Los Angeles, California. The epicenter was located in the town of Northridge which is approximately 6 miles from Topanga Plaza Shopping Center. Consequently, the entire mall, including the 4 major department stores who own their own buildings, suffered some casualty damage. The approximately 360,000 sq. ft. of mall shops owned by the Topanga Partnership did not suffer major structural damage. The estimated cost of the repairs at Topanga for which the joint venture is responsible is approximately $8.8 million. The majority of this cost will be subject to recovery under the joint venture's earthquake insurance policy after payment of the required deductible. The deductible on the building improvements, furniture and fixtures, and business interruption coverages due to loss of rents is approximately $2.1 million. The Partnership anticipates that it will pay for its share of insurance deductibles from its reserves without any material effect on its projected operations for 1994. As of the date of this report, 97 of the malls 114 shops have opened, and the remaining shops are expected to open during the upcoming weeks as tenants complete their repairs. Only one of the four major department stores has been able to open and it may take several weeks or months before the entire center is open and operating. The earthquake will result in some adverse effect on the operations of the center in the near term; the extent and length of which is not presently determinable. The Partnership and its joint venture partner completed a renovation at the Topanga Plaza Shopping Center during 1992 of approximately $40,000,000. In conjunction with this renovation and remerchandising, the Partnership secured an extension of the operating covenant for the Nordstrom's department store to the year 2000 from an original expiration date in 1994. In addition, the Broadway store has also committed to operate in the center until the year 2000. The Partnership and its joint venture partner have refinanced the existing mortgage notes with replacement financing from the existing mortgage holder in the aggregate amount of approximately $59,000,000 which was funded in four stages. See Note 4(b) for further discussion of the refinancing of this loan. The Plaza Hermosa Shopping Center was developed with proceeds raised through a municipal bond financing. This financing is secured by a letter of credit facility which is ultimately secured by a deed of trust on the property. The letter of credit facility expired December 31, 1993; however, the Partnership signed an agreement with the holder of the letter of credit to extend its expiration date to June 30, 1994. The Partnership is currently evaluating its alternatives, including seeking an extension of the existing letter of credit, replacing the bond financing with a conventional mortgage or retiring the debt with current cash reserves. The existing bond financing is due and payable upon the expiration of the letter of credit, and accordingly, has been classified as a current liability at December 31, 1993. There can be no assurance that any such replacement financing will be secured. This property did not sustain any significant damage in connection with the January 17, 1994 Los Angeles earthquake. In 1995, the leases of tenants occupying approximately 33,000 square feet (approximately 35% of the property) at the Plaza Hermosa Shopping Center expire. Although the Partnership has received indications that some of these tenants will renew, there can be no assurance that such renewals will take place. In July 1993, at the First Financial Plaza office building, a tenant, Mitsubishi vacated its approximate 8,100 square feet prior to its lease expiration of January 1997 and continues to pay rent pursuant to its lease obligation. In 1994, leases representing approximately 20% of the leasable square footage are scheduled to expire. Although renewal discussions with the majority of these tenants have been favorable, there can be no assurance that these tenants will review their leases upon expiration. The Los Angeles office market in general and the Encino submarket in particular have become extremely competitive resulting in higher rental concession granted to tenants and flat or decreasing market rental rates. Furthermore, due to the recession in southern California and to concern regarding tenants' ability to perform under current lease terms, the venture has granted rent deferrals and other forms of rent relief to several tents including First Financial Housing, an affiliate of the unaffiliated venture partner. The property incurred minimal damage as a result of the earthquake in southern California on January 17, 1994. There are certain risks associated with the Partnership's investments made through joint ventures including the possibility that the Partnership's joint venture partners in an investment might become unable or unwilling to fulfill their financial or other obligations, or that such joint venture partners may have economic or business interests or goals that are inconsistent with those of the Partnership. In response to the weakness of the economy and the limited amount of available real estate financing in particular, the Partnership is taking steps to preserve its working capital. Therefore, the Partnership is carefully scrutinizing the appropriateness of any discretionary expenditures, including the possible reduction of future distributions, particularly in relation to the amount of working capital it has available. By conserving working capital, the Partnership will be in a better position to meet future needs of its properties without having to rely on external financing sources. RESULTS OF OPERATIONS The increase in short-term investments, long-term debt and advances from affiliate and the decrease in construction costs payable and other long-term liabilities at December 31, 1993 as compared to December 31, 1992 is primarily due to the receipt of the funds advanced of approximately $735,000 by the joint venture partner at the Topanga Plaza and the receipt and use of the refinancing proceeds of the long-term debt related to the renovation at the Topanga Plaza as discussed above. The third funding of the refinancing of $18,400,000 was received on February 2, 1993, of which approximately $9,900,000 was used to payoff the other long-term liabilities and approximately $7,001,000 was used to paydown construction payables. The increase in rents and other receivables at December 31, 1993 as compared to December 31, 1992 is primarily due to the timing of payment of certain tenant receivables of $292,000 at the Los Angeles, California investment property. The increase in escrow deposits at December 31, 1993 as compared to December 31, 1992 is primarily due to the escrowing of funds for improvements as a result of a renewal and expansion of a certain tenant's space at 40 Broad Street. The increase in buildings and improvements at December 31, 1993 as compared to December 31, 1992 is primarily due to additions and expansion of a certain tenant's space of approximately $1,552,000 at 40 Broad Street, approximately $663,000 at the Topanga Plaza as a result of the renovation and re-merchandising of the property and approximately $430,000 at the First Financial Plaza. The decrease in investment in unconsolidated ventures at December 31, 1993 as compared to December 31, 1992 and the decrease in the Partnership's share of operations of unconsolidated ventures for the twelve months ended December 31, 1993 as compared to the twelve months ended December 31, 1992 is primarily due to the JMB/San Jose joint venture recording at September 30, 1993 a provision for value impairment of $15,549,935 (of which the Partnership's share is $7,774,968) to reduce the net carrying value of the 150 Almaden and 185 Park Avenue buildings and certain parking areas to the then outstanding balance of the related non-recourse financing. The increase in the Partnership's share of operations of unconsolidated ventures for the twelve months ended December 31, 1992 as compared to the twelve months ended December 31, 1991 was primarily due to the Partnership's share of the provisions for value impairment recorded in 1991 at the San Jose, California investment property, partially offset in 1992 by the effect of an additional provision for value impairment recorded at December 31, 1992. See note 3(b). The increase in accrued rents receivable at December 31, 1993 as compared to December 31, 1992 is primarily due to rents accrued ratably over the term of the lease rather than as paid at Topanga Plaza. The increase in deferred expenses, and the corresponding increase of amortization of deferred expense for the twelve months ended and at December 31, 1993 as compared to December 31, 1992 is primarily due to the capitalization of certain expenses related to the renovation of Topanga Plaza. The decrease in accrued interest at December 31, 1993 as compared to December 31, 1992 is primarily due to the new loan of $59,000,000 effective June 1, 1993 at the Topanga Plaza (see Note 3(c)). The decrease in rental income for the twelve months ended December 31, 1993 as compared to the twelve months ended December 31, 1992 and 1991 is primarily due to decreased effective rents at the New York, New York investment property, lower occupancy at Plaza Hermosa and First Financial in 1993 and due to lower occupancy in 1992 at Topanga Plaza caused by the renovation as discussed in Note 3(c). The decrease in interest income for the twelve months ended December 31, 1993 as compared to December 31, 1992 is primarily due to a decrease in the interest rates earned on U.S. Government obligations in 1993. Interest income increased for the twelve months ended December 31, 1992 as compared to the twelve months ended December 31, 1991 primarily due to the investment of the Mid Rivers sale proceeds in U.S. Government obligations in 1992. Mortgage and other interest expense increased for the twelve months ended December 31, 1993 as compared to 1992 primarily due to the fundings by the Topanga mortgage lender of $16,000,000 in December 1992, $18,400,000 in February 1993 and $14,000,000 in June 1993 as more fully described in Note 4(b). Depreciation expense increased for the twelve months ended December 31, 1993 as compared to 1992 due to the increase in building and improvements at 40 Broad Street, Topanga Plaza and First Financial Plaza. Depreciation expense decreased for the twelve months ended December 31, 1992 as compared to December 31, 1991 primarily due to the lower basis of assets at the New York, New York investment property due to the $28,870,198 provision for value impairment recorded at December 31, 1991. Venture partners' share of consolidated ventures' operations decreased for the twelve months ended December 31, 1993 as compared to the twelve months ended December 31, 1992 primarily due to decreased earnings at the Topanga Plaza as a result of the renovation and re-merchandising as discussed above. Partnership's share of gain on sale of interest in investment property of $5,655,876 decreased for the twelve months ended December 31, 1993 as compared to the twelve months ended December 31, 1992 due to the sale of the Partnership's interest in Mid Rivers in January, 1992 (see Note 6). INFLATION Due to the decrease in the level of inflation in recent years, inflation generally has not had a material effect on rental income or property operating expenses. To the extent that inflation in future periods does have an adverse impact on property operating expenses, the effect will generally be offset by amounts recovered from tenants as many of the long-term leases at the Partnership's commercial properties have escalation clauses covering increases in the cost of operating and maintaining the properties as well as real estate taxes. Therefore, there should be little effect on operating earnings if the properties remain substantially occupied. In addition, substantially all of the leases at the Partnership's shopping center investments contain provisions which entitle the Partnership to participate in gross receipts of tenants above fixed minimum amounts. Future inflation may also cause capital appreciation of the Partnership's investment properties over a period of time to the extent that rental rates and replacement costs of properties increase. ITEM 8.

ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA JMB INCOME PROPERTIES, LTD. - XII (A LIMITED PARTNERSHIP) AND CONSOLIDATED VENTURES INDEX Independent Auditors' Report Consolidated Balance Sheets, December 31, 1993 and 1992 Consolidated Statements of Operations, years ended December 31, 1993, 1992 and 1991 Consolidated Statements of Partners' Capital Accounts, years ended December 31, 1993, 1992 and 1991 Consolidated Statements of Cash Flows, years ended December 31, 1993, 1992 and 1991 Notes to Consolidated Financial Statements Schedule -------- Supplementary Income Statement Information X Consolidated Real Estate and Accumulated Depreciation XI Schedules not filed: All schedules other than those indicated in the index have been omitted as the required information is inapplicable or the information is presented in the consolidated financial statements or related notes. JMB/SAN JOSE ASSOCIATES (A GENERAL PARTNERSHIP) INDEX Independent Auditors' Report Balance Sheets, December 31, 1993 and 1992 Statements of Operations, years ended December 31, 1993, 1992 and 1991 Statements of Partners' Capital Accounts, years ended December 31, 1993, 1992 and 1991 Statements of Cash Flows, years ended December 31, 1993, 1992 and 1991 Notes to Financial Statements. Schedule -------- Supplementary Income Statement Information X Real Estate and Accumulated Depreciation XI Schedules not filed: All schedules other than those indicated in the index have been omitted as the required information is inapplicable or the information is presented in the consolidated financial statements or related notes. INDEPENDENT AUDITORS' REPORT The Partners JMB INCOME PROPERTIES, LTD. - XII: We have audited the consolidated financial statements of JMB Income Properties, Ltd. - XII (a limited partnership) and consolidated ventures as listed in the accompanying index. In connection with our audits of the consolidated financial statements, we also have audited the financial statement schedules as listed in the accompanying index. These consolidated financial statements and financial statement schedules are the responsibility of the General Partners of the Partnership. Our responsibility is to express an opinion on these consolidated financial statements and financial statement schedules based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by the General Partners of the Partnership, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of JMB Income Properties, Ltd. - XII and consolidated ventures at December 31, 1993 and 1992, and the results of their operations and their cash flows for each of the years in the three-year period ended December 31, 1993, in conformity with generally accepted accounting principles. Also in our opinion, the related financial statement schedules, when considered in relation to the basic consolidated financial statements taken as a whole, present fairly, in all material respects, the information set forth therein. KPMG PEAT MARWICK Chicago, Illinois March 25, 1994 JMB INCOME PROPERTIES, LTD. - XII (A LIMITED PARTNERSHIP) AND CONSOLIDATED VENTURES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 (1) BASIS OF ACCOUNTING The accompanying consolidated financial statements include the accounts of the Partnership and its ventures, Topanga Plaza Partnership ("Topanga"), JMB-40 Broad Street Associates ("Broad Street"), JMB First Financial Associates ("First Financial") and First Financial's venture, JMB Encino Partnership, ("Encino") (note 3). The effect of all transactions between the Partnership and its ventures have been eliminated in the consolidated financial statements. The equity method of accounting has been applied in the accompanying consolidated financial statements with respect to the Partnership's venture interests in JMB/San Jose Associates ("San Jose"), JMB/Mid Rivers Mall Associates ("JMB/Rivers") and JMB/Rivers' venture, Mid Rivers Mall Associates, L.P. ("Mid Rivers"). Accordingly, the accompanying consolidated financial statements do not include the accounts of San Jose, JMB/Rivers and Mid Rivers. The Partnership, through JMB/Rivers sold its interest in Mid Rivers mall in January 1992. Certain amounts in the 1992 and 1991 consolidated financial statements have been reclassified to conform with the 1993 presentation. The Partnership's records are maintained on the accrual basis of accounting as adjusted for Federal income tax reporting purposes. The accompanying consolidated financial statements have been prepared from such records after making appropriate adjustments to present the Partnership's accounts in accordance with generally accepted accounting principles ("GAAP") and to consolidate the accounts of the ventures as described above. Such adjustments are not recorded on the records of the Partnership. The net effect of these items for the years ended December 31, 1993 and 1992 is summarized as follows: JMB INCOME PROPERTIES, LTD. - XII (A LIMITED PARTNERSHIP) AND CONSOLIDATED VENTURES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED The net earnings (loss) per limited partnership interest is based upon the number of limited partnership interests outstanding at the end of each period (189,684). Statement of Financial Accounting Standards No. 95 requires the Partnership to present a statement which classifies receipts and payments according to whether they stem from operating, investing or financing activities. The required information has been segregated and accumulated according to the classifications specified in the pronouncement. Partnership distributions from its unconsolidated ventures are considered cash flow from operating activities to the extent of the Partnership's cumulative share of net earnings. In addition, the Partnership records amounts held in U.S. Government obligations at cost, which approximates market. For the purposes of these financial statements, the Partnership's policy is to consider all such amounts held with original maturities of three months or less ($0 and $1,985,253 at December 31, 1993 and 1992, respectively) as cash equivalents with any remaining amounts reflected as short-term investments. Deferred expenses consist primarily of commitment fees and loan related costs which are amortized over the term of the related mortgage loans, and lease commissions which are amortized over the term of the related leases, using the straight-line method. Also included in deferred expenses are certain other charges which are amortized over the expected recovery period. Although certain leases of the Partnership provide for tenant occupancy during periods for which no rent is due and/or increases in the minimum lease payments over the term of the lease, rental income is accrued for the full period of occupancy on a straight-line basis. Statement of Financial Accounting Standards No. 107 ("SFAS 107"), "Disclosures about Fair Value of Financial Instruments", requires entities with total assets exceeding $150 million at December 31, 1993 to disclose the SFAS 107 value of all financial assets and liabilities for which it is practicable to estimate. Value is defined in the Statement as the amount at which the instrument could be exchanged in a current transaction between willing parties, other than in a forced or liquidation sale. The Partnership believes the carrying amount of its financial instruments classified as current assets and liabilities (excluding current portion of long-term debt) approximates SFAS 107 value due to the relatively short maturity of these instruments. There is no quoted market value available for any of the Partnership's other instruments. The debt, with a carrying balance of $94,585,440, has been calculated to have an SFAS 107 value of $101,959,833 by discounting the scheduled loan payments to maturity. Due to restrictions on transferability and prepayment and the inability to obtain comparable financing due to current levels of debt, previously modified debt terms or other property specific competitive conditions, the Partnership would be unable to refinance these properties to obtain such calculated debt amounts reported. (See note 4.) The Partnership has no other significant financial instruments. In response to the significant vacancy levels coupled with the depressed rental rates in the downtown New York market, the JMB/Broad Street joint venture, as a matter of prudent accounting practice, has recorded provisions for value impairment on 40 Broad Street Office Building of $28,870,198 and $22,908,606 at December 31, 1991 and 1992, respectively. Such provisions were recorded to reduce the net basis of the investment property to $7,800,000 at December 31, 1992. Reference is made to note 3(d) for further discussion of the current status of this investment property. JMB INCOME PROPERTIES, LTD. - XII (A LIMITED PARTNERSHIP) AND CONSOLIDATED VENTURES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED Additionally, in response to the uncertainties relating to the JMB/San Jose joint venture's ability to recover the net carrying value of certain buildings within the Park Center Plaza investment property through future operations or sale, the JMB/San Jose joint venture, as a matter of prudent accounting practice, has recorded a provision for value impairment on certain parcels within the complex of $21,175,127. Such provision, made as of December 31, 1991, was recorded to reduce the net basis of the 100 Park Center Plaza Buildings and a certain parking area to the then outstanding balance of the related non-recourse debt. Additionally, a provision for value impairment of $8,142,152 was recorded at December 31, 1992 on certain other portions of the complex to reduce the net basis of these portions to the outstanding balance of the related non-recourse debt at December 31, 1992. Furthermore, a provision for value impairment on the 150 Almaden and 185 Park Avenue buildings and certain parking areas of $15,549,935 was recorded at September 30, 1993 to reduce the net to the then outstanding balance of the related non-recourse debt. Reference is made to note 3(b) for further discussion of the current status of this investment property. No provision for State or Federal income taxes has been made as the liability for such taxes is that of the investors rather than the Partnership. However, in certain circumstances, the Partnership has been required under applicable law to remit directly to the tax authorities amounts representing withholding from distributions paid to partners. (2) INVESTMENT PROPERTIES (a) General The Partnership has acquired, either directly or through joint ventures (note 3), three shopping centers, two office buildings and an office complex. The Partnership sold, through JMB/Rivers, its interest in Mid Rivers Mall in January 1992. All of the remaining properties were in operation at December 31, 1993. The cost of the investment properties represents the total cost to the Partnership or its consolidated ventures plus miscellaneous acquisition costs. Depreciation on the properties has been provided over the estimated useful lives of the various components as follows: YEARS ----- Building and improvements -- straight-line 30 Personal property -- straight-line . . . . 5 == Maintenance and repairs are generally charged to operations as incurred. Significant betterments and improvements are capitalized and depreciated over their estimated useful lives. Certain investment properties are pledged as security for the long-term debt, for which there is no recourse to the Partnership, as described in note 4. JMB INCOME PROPERTIES, LTD. - XII (A LIMITED PARTNERSHIP) AND CONSOLIDATED VENTURES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED (b) Plaza Hermosa Shopping Center During September 1986, the Partnership acquired a multi-building neighborhood shopping center in Hermosa Beach, California. The Partnership's purchase price for the shopping center was $18,290,000, of which $11,890,000 was paid in cash at closing. The balance of the purchase price is represented by bond financing in the amount of $6,400,000 (note 4). This financing is secured by a letter of credit facility which is ultimately secured by a deed of trust on the property. The letter of credit facility expired December 31, 1993; however, the Partnership signed an agreement with the issuer of the letter of credit to extend its expiration date to June 30, 1994. The Partnership is currently evaluating its alternatives, including seeking an extension of the existing letter of credit, replacing the bond financing with a conventional mortgage or retiring the debt with current cash reserves. The existing bond financing is due and payable upon the expiration of the letter of credit, and accordingly, has been classified as a current liability at December 31, 1993. There can be no assurance that any such replacement financing will be secured. The property is managed by an affiliate of the General Partners of the Partnership for a fee calculated as 4% of gross receipts of the property. (3) VENTURE AGREEMENTS (a) General The Partnership at December 31, 1993 is a party to four operating venture agreements (the Partnership, through JMB/Rivers, sold its interest in Mid Rivers Mall in January 1992) and has made capital contributions to the respective ventures as discussed below. Under certain circumstances, either pursuant to the venture agreements or due to the Partnership's obligations as a General Partner, the Partnership may be required to make additional cash contributions to the ventures. There are certain risks associated with the Partnership's investments made through joint ventures including the possibility that the Partnership's joint venture partners in an investment might become unable or unwilling to fulfill their financial or other obligations, or that such joint venture partners may have economic or business interests or goals that are inconsistent with those of the Partnership. (b) San Jose The Partnership has acquired, through San Jose, an interest in an existing office building complex in San Jose, California (Park Center Financial Plaza). San Jose acquired nine office buildings and two parking garage structures in June 1985 for a purchase price of approximately $32,472,000 subject to long-term indebtedness of approximately $6,347,000. All of the properties were in operation when acquired. In addition, in May 1986, San Jose purchased an additional office building (150 Almaden) and a parking and retail building (185 Park Avenue) in the Park Center Financial Plaza complex for a total purchase price of approximately $47,476,000. In conjunction with the acquisitions, San Jose reserved approximately $31,590,000 to fund debt service, leasing commissions, and capital and tenant improvements. JMB INCOME PROPERTIES, LTD. - XII (A LIMITED PARTNERSHIP) AND CONSOLIDATED VENTURES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED In September 1986, San Jose obtained a mortgage loan in the amount of $25,000,000 secured by the 150 Almaden and 185 Park Avenue buildings and certain parking areas. The outstanding principal balance, which is non-amortizing, bears interest at the rate of 9.5% per annum and had a scheduled maturity in October 1993 and was extended to December 1, 1993. The property is managed by an affiliate of the General Partners of the Partnership for a fee calculated as 3% of gross receipts. The partners of San Jose are the Partnership and JMB Income Properties, Ltd.-XI, another partnership sponsored by the Managing General Partner of the Partnership ("JMB-XI"). The terms of San Jose's partnership agreement generally provide that contributions, distributions, cash flow, sale or refinancing proceeds and profits and losses will be distributed or allocated to the Partnership in their respective 50% ownership percentages. In 1991, all remaining amounts originally set aside by the Partnership to fund debt service, leasing commissions and capital and tenant improvement costs at Park Center Financial Plaza were utilized. In January 1992, the Partnership advanced $575,000 to the JMB/San Jose joint venture for the payment of certain operating expenses. These monies were paid back to the Partnership by the end of 1992. However, since the costs of both re-leasing space and any seismic program could be substantial, the Partnership has commenced discussions with the appropriate lender for additional loan proceeds to pay for all or a portion of these costs. The venture is also continuing to discuss terms for a possible loan extension with the mortgage lender on the 150 Almaden and 185 Park Avenue buildings and certain parking areas as the mortgage loan secured by this portion of the complex matured in October 1993 and was extended to December 1, 1993. However, the Partnership and the lender have not been able to agree upon mutually acceptable terms for a loan extension and the lender has accelerated the loan. Should an agreement not be reached and as the venture does not have its share of the outstanding loan balance in its reserves in order to retire the loan, it is possible that the lender would exercise its remedies and seek to acquire title to this portion of the complex. Furthermore, should lender assistance be required to fund significant costs at the 100-130 Park Center Plaza buildings but not be obtained, the venture has decided not to commit any additional amounts to this portion of the complex since the likelihood of recovering such funds through increased capital appreciation is remote. The result would be that the Partnership would no longer have an ownership interest in this portion of the complex. As a result, there is uncertainty about the ability to recover the net carrying value of the property through future operations and sale and accordingly, the JMB/San Jose joint venture has made a provision for value impairment on the 150 Almaden and 185 Park Avenue buildings and certain parking areas of $15,549,935. Such provision at September 30, 1993 was recorded to reduce the net carrying value of these buildings to the then outstanding balance of the related non-recourse financing. Due to the uncertainty of the JMB/San Jose joint venture's ability to recover the net carrying value of those buildings within the investment property through future operations or sale, the JMB/San Jose joint venture recorded a provision for value impairment at December 31, 1991 of $21,175,127 to reduce the net book value of the 100-130 Park Center Plaza buildings and a certain parking area to an amount equal to the then outstanding balance of the related non- recourse financing. Additionally, at December 31, 1992, the JMB/San Jose joint venture recorded a provision for value impairment of $8,142,152 on certain other portions of the complex to amounts equal to the then outstanding balances of the related non-recourse financing. In the event the lender on any portion of the complex exercised its remedies as discussed above, the result would likely be that JMB/San Jose joint venture would no longer have an ownership interest in such portion. JMB INCOME PROPERTIES, LTD. - XII (A LIMITED PARTNERSHIP) AND CONSOLIDATED VENTURES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED (c) Topanga In December 1985, the Partnership acquired, through a joint venture partnership with an affiliate of the developer, a 58% interest in an existing two-level enclosed mall regional shopping center known as Topanga Plaza in the Woodland Hills area of Los Angeles, California. The aggregate purchase price for the Partnership's interest in the venture was approximately $25,263,000, which was paid in cash at closing. Under the terms of the joint venture agreement, the Partnership generally will be allocated or distributed 58% of profits and losses, cash flow from operations and sale or refinancing proceeds. The shopping center is subject to a long-term management agreement with an affiliate of the joint venture partner. Under the terms of the management agreement, the manager is entitled to receive a management fee based on a formula which relates to direct and general overhead costs and expenses incurred in the operation of the property. In 1990, the Topanga joint venture reached an agreement with an existing major department store to lease approximately 24,600 square feet of the department store owned retail space for a minimum term of ten years. Subleases have been executed with retail tenants for all of the leasable area within this space. Topanga paid approximately $1,600,000 (all of which was funded by December 31, 1991) for tenant improvements, leasing costs and other expenditures related to the sublease space. Topanga has funded these costs through advances by an affiliate of the venture partner which bore interest at approximately 9% as of December 31, 1991. In 1991, $272,367 of this interest was capitalized as construction period interest. Such advances were repaid in connection with the initial funding of the new mortgage, see note 4(b) for further discussion. The Partnership and its joint venture partner completed a renovation of the Topanga Plaza Shopping Center during 1992. In conjunction with this renovation, the Partnership secured an extension of the operating covenant for the Nordstrom's department store to the year 2000 from an original expiration date in 1994. In addition, the Broadway store has also committed to operate in the center until the year 2000. The Partnership and its joint venture partner have refinanced the existing mortgage notes with replacement financing from the existing mortgage holder in the amount of approximately $59,000,000 which was funded in four stages. See Note 4(b) for a discussion of such refinancing. The joint venture partner has agreed to advance the joint venture funds for expenses incurred for certain redevelopment costs related to the expansion of Topanga Plaza. The balance of these advances was $735,000 at December 31, 1993. Such advances will be repaid to the joint venture partner as funds are made available from operations. Construction period interest of approximately $130,620 and $1,035,000, has been capitalized for the years ended December 31, 1993 and 1992, respectively. The shopping center is subject to fire, life and safety code and ordinance requirements, which have changed since the property's original construction. Accordingly, the Partnership intends to comply with such revised regulations and fund such retrofit costs. In conjunction with the renovation, a substantial portion of such retrofit costs have been completed. The Partnership will fund any remaining costs from operations over the next several years, as tenant leases expire, until the entire building conforms to such requirements. JMB INCOME PROPERTIES, LTD. - XII (A LIMITED PARTNERSHIP) AND CONSOLIDATED VENTURES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED (d) Broad Street During December 1985, the Partnership acquired, through Broad Street, a joint venture with JMB Income Properties, Ltd.-X, a partnership sponsored by an affiliate of the Managing General Partner, a 68.56% interest in an existing 24-story office building located at 40 Broad Street in New York, New York. Broad Street's purchase price for the building, which was paid in cash at closing, was approximately $65,100,000 of which the Partnership provided approximately $44,630,000. The Partnership will be allocated or distributed profits and losses, cash flow from operations and sale or refinancing proceeds in the ratio of its capital contributions to Broad Street which is 68.56%. During 1991, Broad Street was required to pay $1,797,827 for an assessed transfer tax related to the original acquisition of the investment property. Of this amount, the Partnership funded $1,232,560. A portion of the amount, $990,000, was capitalized in 1991. The remaining amount, $807,827, was reflected in the results of operations as penalty and interest. The downtown New York City market remains extremely competitive due to the significant amount of space available primarily resulting from the layoffs, cutbacks and consolidations by financial service companies and related businesses which dominated this market. Rental rates in the downtown market are currently at depressed levels and this can be expected to continue for the foreseeable future while the current vacant space is gradually absorbed. Little, if any, new construction is planned for downtown over the next few years and it is expected that the building will continue to be adversely affected by the lower than originally projected effective rental rates now achieved upon releasing of existing leases which expire over the next few years. Therefore, the JMB/Broad Street joint venture recorded a provision for value impairment at December 31, 1991 to reduce the net book value of 40 Broad Street to $30,000,000 due to the uncertainty of JMB/Broad Street joint venture's ability to recover the net carrying value of the investment property through future operations or sale. An additional provision for value impairment was recorded at December 31, 1992 to further reduce the net book value of the property to the then estimated valuation of $7,800,000. The property is managed by an affiliate of the General Partners of the Partnership for a fee calculated as 2% of gross receipts of the property. (e) JMB/Rivers In December 1986, the Partnership and JMB Income Properties, Ltd.-XIII (a partnership sponsored by an affiliate of the Managing General Partner, "JMB- XIII") formed JMB/Rivers, which entered into a joint venture ("Mid Rivers") with an affiliate of the developer ("Venture Partner") and acquired an interest in an enclosed regional shopping center then under construction in St. Peters, Missouri, known as Mid Rivers Mall. Under the terms of the venture agreement, JMB/Rivers contributed approximately $39,400,000, of which the Partnership's share was approximately $19,700,000. During January 1992, JMB/Rivers sold its interest in Mid Rivers Mall (see note 6). The ultimate ownership percentages for JMB/Rivers and Venture Partner were established as 80% and 20%, respectively. Operating profits and losses were generally allocated in proportion to and to the extent of distributions as described above and, to the extent profits and losses exceeded such distributions, to the Partners in accordance with their respective ownership percentages. The terms of the JMB/Rivers agreement generally provided that JMB INCOME PROPERTIES, LTD. - XII (A LIMITED PARTNERSHIP) AND CONSOLIDATED VENTURES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED the Partnership was allocated or distributed, as the case may be, profits and losses, cash flow from operations and sale or refinancing proceeds in the ratio of its respective capital contributions to JMB/Rivers. The shopping center was managed by an affiliate of the Venture Partner for a fee calculated as 4% of gross receipts of the property through the date of sale. (f) First Financial On May 20, 1987, the Partnership, through First Financial, a joint venture with JMB-XIII, acquired an interest in a general partnership ("Encino") with an affiliate of the developer ("Venture Partner") which owns an office building in Encino (Los Angeles), California. First Financial is obligated to make an initial investment in the aggregate amount of $49,850,000 of which approximately $49,812,000 of such contributions have been made to Encino. The Partnership's share of the remaining amounts, approximately $24,000, will be contributed when the Venture Partner complies with certain requirements. In November 1987, First Financial caused Encino to obtain a third party first mortgage loan in the amount of $30,000,000. The proceeds of such loan were distributed to First Financial to reduce its contribution and to the Venture Partner who subsequently repaid a $15,500,000 loan from First Financial. Thus, the total cash investment of First Financial for its interest in the office building, after consideration of the funding of the $30,000,000 permanent financing, is approximately $20,000,000, of which the Partnership's share is approximately $12,500,000. The outstanding principal balance of the third party first mortgage loan as of December 31, 1993 is $29,394,848. The Encino partnership agreement generally provides that First Financial is entitled to receive (after any participating amounts due to Pepperdine University pursuant to its tenant lease) from cash flow from operations (as defined) an annual cumulative preferred return equal to 9.05% through April 30, 1995 (and 8.9% thereafter) of its capital contributions. Any remaining cash flow is to be split equally between First Financial and the Venture Partner. Pepperdine University, under its tenant lease, is entitled to an amount based on 6.6% of the Venture Partner's share of the office building's net operating profit and net sale profit (as defined). All of Encino's operating profits and losses before depreciation have been allocated to First Financial in 1993, 1992 and 1991. The Encino partnership agreement also generally provides that net sale proceeds and net refinancing proceeds (as defined), after any amounts due to Pepperdine University pursuant to its tenant lease, are to be distributed: first, to First Financial in an amount equal to its deficiency, if any, in its cumulative preferred return as described above; next, to First Financial in the amount of its capital contributions; next, to the Venture Partner in an amount equal to $600,000; any remaining proceeds are to be split equally between First Financial and the Venture Partner. The terms of the First Financial partnership agreement provide that annual cash flow, net sale or refinancing proceeds, and tax items will be distributed or allocated, as the case may be, to the Partnership in proportion to its 62.5% share of capital contributions. The office building is managed by an affiliate of the Venture Partner for a fee based upon a percentage of rental receipts (as defined) of the property. JMB INCOME PROPERTIES, LTD. - XII (A LIMITED PARTNERSHIP) AND CONSOLIDATED VENTURES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED (b) Debt Refinancing In January 1992, the Partnership and its joint venture partner finalized the refinancing of the existing mortgage notes at Topanga Plaza with replacement financing from the existing mortgage holder in the aggregate amount of $59,000,000 which was funded in four stages. Included in the initial funding was the $1,600,000 repayment of advances by an affiliate of the venture partner, the $1,500,000 refinancing of a portion of the existing mortgage and $2,300,000 representing a return to the Partnership of prior contributions used to fund previous costs incurred relating to fire, life and safety regulations and certain releasing costs. The second funding occurred on December 2, 1992 in the amount of $16,000,000, which was used to paydown interim lines of credit used for certain renovation costs and operational capital expenditures as described below. The third funding of $18,400,000 occurred on February 1, 1993, a portion of which was used to paydown interim lines of credit used for certain renovation costs and the remainder to fund additional renovation costs. The fourth stage refinanced the remaining portion of the existing mortgage of $14,000,000 upon its maturity in June 1993. The loan, aggregating $59,000,000, represents the new loan of $43,500,000 and the refinancing of the existing loans of $15,500,000. The term of the new loan began June 1, 1993 with monthly principal and interest payments and matures January 31, 2002. It carries an interest rate of 10.125%. The Topanga joint venture has funded certain renovation costs through a line of credit bearing interest at 10.125% with various maturity dates. The line of credit had a balance of $9,650,000 at December 31, 1992 and was paid by the additional loan funding discussed above. Five year maturities of long-term debt are summarized as follows: 1994 . . . . . . . . . $ 6,972,571 1995 . . . . . . . . . 29,535,960 1996 . . . . . . . . . 414,577 1997 . . . . . . . . . 458,557 1998 . . . . . . . . . 507,202 =========== (5) PARTNERSHIP AGREEMENT Pursuant to the terms of the Partnership Agreement, net profits or losses of the Partnership from operations are allocated 96% to the Limited Partners and 4% to the General Partners. Profits from the sale or refinancing of investment properties will be allocated to the General Partners: (i) in an amount equal to the greater of 1% of such profits or the amount of cash distributable to the General Partners from any such sale or refinancing (as described below); and (ii) in order to reduce deficits, if any, in the General Partners' capital accounts to a level consistent with the gain anticipated to be realized from the sale of properties. Losses from the sale or refinancing of investment properties will be allocated 1% to the General Partners. The remaining sale or refinancing profits and losses will be allocated to the Limited Partners. The General Partners are not required to make any capital contributions except under certain limited circumstances upon termination of the Partnership. In general, distributions of cash from operations will be made 90% to the Limited Partners and 10% to the General Partners. However, a portion of such distributions to the General Partners is subordinated to the Limited Partners' receipt of a stipulated return on capital. JMB INCOME PROPERTIES, LTD. - XII (A LIMITED PARTNERSHIP) AND CONSOLIDATED VENTURES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED The Partnership Agreement provides that the General Partners shall receive as a distribution from the sale of a real property by the Partnership amounts equal to the cumulative deferrals of any portion of their 10% cash distribution and 2-1/2% of the selling price, and that the remaining proceeds (net after expenses and retained working capital) be distributed 85% to the Limited Partners and 15% to the General Partners. However, the Limited Partners shall receive 100% of such net sale proceeds until the Limited Partners (i) have received cash distributions of sale or refinancing proceeds in an amount equal to the Limited Partners' aggregate initial capital investment in the Partnership, (ii) have received cumulative cash distributions from the Partnership's operations which, when combined with sale or refinancing proceeds previously distributed, equal a 6% annual return on the Limited Partners' average capital investment for each year (their initial capital investment as reduced by sale or refinancing proceeds previously distributed) commencing with the second fiscal quarter of 1986 and (iii) have received cash distributions of sale and refinancing proceeds and of the Partnership's operations, in an amount equal to the Limited Partners' initial capital investment in the Partnership plus a 10% annual return on the Limited Partners' average capital investment. Accordingly, approximately $773,000 of sale proceeds from the sale of the Partnership's interest in Mid Rivers Mall has been deferred by the General Partners (note 6). (6) SALE OF INTEREST IN INVESTMENT PROPERTY On January 30, 1992, the Partnership through JMB/Rivers sold its interest in Mid Rivers Mall located in St. Peters, Missouri to an affiliate of an unaffiliated joint venture partner. The sale price of the interest was $26,500,000 (before closing costs and prorations) plus the outstanding balance of the mortgages of which JMB/Rivers share was $35,318,171 as of the date of closing. The Partnership received, in connection with the sale, after all fees, expenses, and joint venture partner's participation, net cash of $13,250,000. For financial reporting purposes, JMB/Rivers has recognized a gain of approximately $12,022,000 in 1992, of which, the Partnership's share was approximately $5,656,000. (7) LEASES At December 31, 1993, the Partnership and its consolidated ventures' principal assets are two shopping centers and two office buildings. The Partnership has determined that all leases relating to these properties are properly classified as operating leases; therefore, rental income is reported when earned and the cost of the properties, excluding the cost of the land, is depreciated over the estimated useful lives. Leases with tenants range in term from month-to-month to twenty-five years and provide for fixed minimum rent and partial reimbursement of operating costs. In addition, leases with shopping center tenants provide for additional rent based upon percentages of tenants' sales volumes. With respect to the Partnership's shopping center investments, a substantial portion of the ability of retail tenants to honor their leases is dependent on the retail economic sector. JMB INCOME PROPERTIES, LTD. - XII (A LIMITED PARTNERSHIP) AND CONSOLIDATED VENTURES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED Cost and accumulated depreciation of the leased assets are summarized as follows at December 31, 1993: Office Buildings: Cost . . . . . . . . . . . . . . . $ 69,607,308 Accumulated depreciation . . . . . (21,553,857) ------------ 48,053,451 ------------ Shopping Centers: Cost . . . . . . . . . . . . . . . 129,886,662 Accumulated depreciation . . . . . (20,170,896) ------------ 109,715,766 ------------ $157,769,217 ============ Minimum lease payments, including amounts representing executory costs (e.g. taxes, maintenance, insurance) and any related profit, to be received in the future under the operating leases are as follows: 1994 . . . . . . . . . . . . . . . . $ 19,229,112 1995 . . . . . . . . . . . . . . . . 18,680,561 1996 . . . . . . . . . . . . . . . . 17,610,704 1997 . . . . . . . . . . . . . . . . 14,586,577 1998 . . . . . . . . . . . . . . . . 13,216,074 Thereafter . . . . . . . . . . . . . 65,231,296 ------------ Total. . . . . . . . . . . . . . $148,554,324 ============ Contingent rent (based on sales by property tenants) included in rental income was as follows: 1991 . . . . . . . . . . . . . . . . $450,316 1992 . . . . . . . . . . . . . . . . 309,934 1993 . . . . . . . . . . . . . . . . 427,809 ======== (8) TRANSACTIONS WITH AFFILIATES Fees, commissions and other expenses required to be paid by the Partner- ship to the General Partners and their affiliates as of December 31, 1993 and for the years ended December 31, 1993, 1992 and 1991 are as follows: JMB INCOME PROPERTIES, LTD. - XII (A LIMITED PARTNERSHIP) AND CONSOLIDATED VENTURES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED In accordance with the subordination requirements of the Partnership Agreement, the General Partners have deferred receipt of their distributions (see note 5) of net cash flow from the Partnership. The cumulative amount of such deferred distributions aggregated $7,254,766 at December 31, 1993. These amounts or amounts currently payable do not bear interest and may be paid in future periods. The Topanga venture has incurred approximately $130,620 and $1,035,000 of interest costs relating to affiliated venture partner advances (note 3(c)) in 1993 and 1992, respectively, all of which was paid to an affiliate of the venture partner as of December 31, 1993. (9) INVESTMENT IN UNCONSOLIDATED VENTURES Summary of combined financial information for San Jose and JMB/Rivers (sold January 30, 1992) as of and for the years ended December 31, 1993 and 1992 is as follows: 1993 1992 ------------ ------------ Current assets . . . . . . . . . . $ 1,094,449 2,789,789 Current liabilities. . . . . . . . (25,841,373) (25,782,960) ------------ ------------ Working capital (deficit). . (24,746,924) (22,993,171) Investment property, net . . . . . 33,218,816 49,511,546 Other assets, net. . . . . . . . . 3,180,985 731,574 Long-term debt . . . . . . . . . . (3,784,508) (4,157,064) Other liabilities. . . . . . . . . (70,297) (74,275) Venture partners' equity . . . . . (4,077,776) (11,688,045) ------------ ------------ Partnership's capital. . . . $ 3,720,296 11,330,565 ============ ============ Represented by: Invested capital . . . . . . . . $ 45,976,774 45,976,774 Cumulative distributions . . . . (20,652,500) (19,652,500) Cumulative loss. . . . . . . . . (21,603,978) (14,993,709) ------------ ------------ $ 3,720,296 11,330,565 ============ ============ Total income . . . . . . . . . . . $ 10,369,335 11,573,574 ============ ============ Expenses applicable to operating loss . . . . . . . . . . . . . . $ 23,589,873 17,846,170 ============ ============ Operating loss . . . . . . . . . . $ 13,220,538 6,272,596 ============ ============ Gain on sale of investment property $ -- 12,022,449 ============ ============ Net earnings (loss). . . . . . . . $(13,220,538) 5,749,853 ============ ============ Reference is made to note 3(b) regarding the provision for value impairments of $15,549,935 and $8,142,152 which were recorded in 1993 and 1992, respectively, by the JMB/San Jose joint venture. Total income, expenses related to operating earnings and net loss for the above-mentioned ventures for the year ended December 31, 1991 were $18,717,268, $39,749,915 and $21,032,647, respectively. JMB INCOME PROPERTIES, LTD. - XII (A LIMITED PARTNERSHIP) AND CONSOLIDATED VENTURES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONCLUDED (10) SUBSEQUENT EVENTS (a) Distribution to Partners In February 1994, the Partnership paid a distribution of $476,581 ($2.50 per Interest) to the Limited Partners. (b) Topanga On January 17, 1994, an earthquake occurred in Los Angeles, California. The epicenter was located in the town of Northridge which is approximately 6 miles from Topanga Plaza Shopping Center. Consequently, the entire mall, including the 4 major department stores who own their own buildings, suffered some casualty damage. The approximately 360,000 sq. ft. of mall shops owned by the Topanga Partnership did not suffer major structural damage. The estimated cost of the repairs at Topanga for which the joint venture is responsible is approximately $8.8 million. The majority of this cost will be subject to recovery under the joint venture's earthquake insurance policy after payment of the required deductible. The deductible on the building improvements, furniture and fixtures, and business interruption coverages due to loss of rents is approximately $2.1 million. The Partnership anticipates that it will pay for its share of insurance deductibles from its reserves without any material effect on its projected operations for 1994. As of the date of this report, 97 of the malls 114 shops have opened, and the remaining shops are expected to open during the upcoming weeks as tenants complete their repairs. Only one of the four major department stores has been able to open and it may take several weeks or months before the entire center is open and operating. The earthquake will result in some adverse effect on the operations of the center in the near term; the extent and length of which is not presently determinable. SCHEDULE X JMB INCOME PROPERTIES, LTD. - XII (A LIMITED PARTNERSHIP) AND CONSOLIDATED VENTURES SUPPLEMENTARY INCOME STATEMENT INFORMATION YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 CHARGED TO COSTS AND EXPENSES ---------------------------------------------- 1993 1992 1991 ------------ ------------ ------------ Maintenance and repairs. $3,055,489 3,108,903 3,139,142 Depreciation . . . . . . 5,739,255 4,811,235 5,684,994 Amortization of deferred expenses . . . . . . . 787,304 456,673 499,231 Real estate taxes. . . . 3,643,702 3,896,555 3,985,659 ========== ========= ========= INDEPENDENT AUDITORS' REPORT The Partners JMB/SAN JOSE ASSOCIATES: We have audited the financial statements of JMB/San Jose Associates (a general partnership) as listed in the accompanying index. In connection with our audits of the financial statements, we also have audited the financial statement schedules as listed in the accompanying index. These financial statements are the responsibility of the General Partners of the Partnership. Our responsibility is to express an opinion on these financial statements and financial statement schedules based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by the General Partners of the Partnership, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of JMB/San Jose Associates at December 31, 1993 and 1992, and the results of its operations and its cash flows for each of the years in the three-year period ended December 31, 1993, in conformity with generally accepted accounting principles. Also in our opinion, the related financial statement schedules, when considered in relation to the basic financial statements taken as a whole, present fairly, in all material respects, the information set forth therein. As discussed in note 3(b) of Notes to Consolidated Financial Statements of JMB Income Properties, LTD - XII, the mortgage loan secured by the 150 Almaden and 185 Park Avenue buildings and certain related parking improvements matured December 1, 1993. Should an agreement not be reached to extend the loan, it is possible that the lender would exercise its remedies and seek to acquire title to these properties. Also, the Venture has commenced discussions with the lender on the 100-130 Park Center Plaza properties for additional loan proceeds to cover re-leasing and seismic program costs. Should the lender assistance required to fund these costs not be obtained, the Partnership has decided not to commit additional funds to these properties. The result would be that the Partnership would no longer have an ownership interest in these properties. The Venture has recorded provisions for value impairment to reduce the net book value of such properties to the outstanding balance of the related non-recourse financing. KPMG PEAT MARWICK Chicago, Illinois March 25, 1994 JMB/SAN JOSE ASSOCIATES (A GENERAL PARTNERSHIP) NOTES TO FINANCIAL STATEMENTS YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 (1) BASIS OF ACCOUNTING The accompanying financial statements have been prepared for the purpose of complying with Rule 3.09 of Regulation S-X of the Securities and Exchange Commission. They include the accounts of the unconsolidated joint venture, JMB/San Jose joint venture ("Venture"), in which JMB Income Properties, Ltd.- XII ("JMB Income-XII") and JMB Income Properties, Ltd.-XI are the partners. The Venture's records are maintained on the accrual basis of accounting as adjusted for Federal income tax reporting purposes. The accompanying financial statements have been prepared from such records after making appropriate adjustments to present the Venture's accounts in accordance with generally accepted accounting principles ("GAAP"). Such adjustments are not recorded on the records of the Venture. The net effect of these items for the years ended December 31, 1993 and 1992 is summarized as follows: JMB/SAN JOSE ASSOCIATES (a general partnership) Notes to Financial Statements - Continued Statement of Financial Accounting Standards No. 95 requires the Venture to present a statement which classifies receipts and payments according to whether they stem from operating, investing or financing activities. The required information has been segregated and accumulated according to the classifications specified in the pronouncement. In addition, the Venture records amounts held in U.S. Government obligations at cost, which approximates market. For purposes of these statements, the Venture's policy is to consider all such amounts held with original maturities of three months or less cash equivalents with any remaining amounts reflected as short-term investments. None of the Partnership's investments in U.S. Government obligations were classified as cash equivalents at December 31, 1993 and December 31, 1992. Certain amounts in the 1992 and 1991 financial statements have been reclassified to conform to the 1993 presentation. Depreciation on buildings and improvements has been provided over the estimated useful lives of the assets (5 to 30 years) using the straight-line method. Deferred expenses consist primarily of loan fees and lease commissions which are amortized over the terms stipulated in the related loan agreements or over the terms of the related leases using the straight-line method. Although certain leases of the Venture provide for tenant occupancy during periods for which no rent is due and/or increases in the minimum lease payments over the term of the lease, rental income is accrued for the full period of occupancy on a straight-line basis. Maintenance and repair expenses are charged to operations as incurred. Significant betterments and improvements are capitalized and depreciated over their estimated useful lives. The Venture recorded in 1993, as a matter of prudent accounting practice, a provision for value impairment of $15,549,935 on the 150 Almaden and 185 Park Avenue building and certain parking areas. In 1992, the Venture recorded a provision for value impairment of $8,142,152 on certain portions of the complex. In 1991, the Venture recorded a provision for value impairment of $21,175,127 to reduce the net basis of the 100 Park Center Plaza Buildings and a certain parking area to the then outstanding balance of the related non- recourse debt. No provision for State or Federal income taxes has been made as the liability for such taxes is that of the venture partners rather than the Venture. (2) VENTURE AGREEMENT A description of the acquisition of the property is contained in Note 3(b) of JMB Income - XII. Such note is incorporated herein by reference. JMB/SAN JOSE ASSOCIATES (A GENERAL PARTNERSHIP) NOTES TO FINANCIAL STATEMENTS - CONTINUED (3) LONG-TERM DEBT Long-term debt consists of the following at December 31, 1993 and 1992: 1993 1992 ---------- ---------- 7.75% mortgage note; secured by the 100 Park Center Plaza Buildings, and certain related parking improvements in San Jose, California; principal and interest payments of $34,023 are due monthly through September 2000; additional interest payments of 2% per annum of gross income (total interest not to exceed 9.875%), which amounted to $55,034 in 1993 and $53,936 in 1992. $ 2,377,511 2,592,398 10% mortgage note; secured by the 100 Park Center Plaza Buildings, and certain related parking improvements in San Jose, California; principal and interest payments of $10,353 are due monthly through September 2000. . . 608,178 667,948 7.85% mortgage note; secured by the 170 Almaden Building in San Jose, California; principal and interest payments of $13,537 are due monthly through June 2003 . . . . . . . . . . . 1,170,903 1,239,278 9.5% mortgage note; secured by the 150 Almaden and 185 Park Avenue buildings, and certain related parking improvements in San Jose, California; interest only payments of $197,917 are due monthly through December 1993 when the entire principal was due (currently in default (1)). . . . . . . . . . . . . . 25,000,000 25,000,000 ----------- ---------- Total debt . . . . . . . . . . . 29,156,592 29,499,624 Less current portion of long-term debt. . . . . . . . . 25,372,084 25,342,560 ----------- ---------- Total long-term debt . . . . . . $ 3,784,508 4,157,064 ============ ========== Five year maturities of long-term debt are as follows: 1994 . . . . . . . . . $25,372,084 1995 . . . . . . . . . 403,174 1996 . . . . . . . . . 437,407 1997 . . . . . . . . . 474,656 1998 . . . . . . . . . 515,062 =========== (1) A description of the discussions between JMB/San Jose and the mortgage lender on the 150 Almaden and 185 Park Avenue buildings is contained in Note 3(b) of Notes to Consolidated Financial Statements of JMB Income - XII. Such note is hereby incorporated herein by reference. JMB/SAN JOSE ASSOCIATES (A GENERAL PARTNERSHIP) NOTES TO FINANCIAL STATEMENTS - CONTINUED (4) LEASES As Property Lessor At December 31, 1993, the Venture's principal asset is an office building complex. The Venture has determined that all leases relating to this property are properly classified as operating leases; therefore, rental income is reported when earned and the cost of the property, excluding the cost of the land, is depreciated over the estimated useful life. Leases with tenants range in term from one to twenty-five years and provide for fixed minimum rent and partial reimbursement of operating costs. Minimum lease payments, including amounts representing executory costs (e.g. taxes, maintenance, insurance) and any related profit, to be received in the future under the operating leases are as follows: 1994. . . . . . . . . . . . . $ 7,563,161 1995. . . . . . . . . . . . . 6,626,946 1996. . . . . . . . . . . . . 5,573,226 1997. . . . . . . . . . . . . 4,508,323 1998. . . . . . . . . . . . . 4,187,855 Thereafter. . . . . . . . . . 15,736,333 ----------- $44,195,844 =========== (5) TRANSACTIONS WITH AFFILIATES Fees, commissions and other expenses required to be paid by the Venture to the General Partners and their affiliates as of December 31, 1993 and for the years ended December 31, 1993, 1992 and 1991 were as follows: SCHEDULE X JMB/SAN JOSE ASSOCIATES (A GENERAL PARTNERSHIP) SUPPLEMENTARY INCOME STATEMENT INFORMATION YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 CHARGED TO COSTS AND EXPENSES ---------------------------------------------- 1993 1992 1991 ------------ ------------ ------------ Maintenance and repairs. $ 973,276 1,029,913 965,927 Depreciation . . . . . . 1,063,616 1,898,286 2,369,699 Amortization of deferred expenses. . . . . . . . 243,694 243,229 193,526 Taxes: Real estate. . . . . . 991,781 755,041 724,758 Other. . . . . . . . . 4,792 5,375 5,410 Advertising. . . . . . . 17,484 -- 57,048 ========== ========= ========= ITEM 9.

ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE There were no changes of or disagreements with accountants during 1992 and 1993. PART III ITEM 10.

ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE PARTNERSHIP The Managing General Partner of the Partnership is JMB Realty Corporation ("JMB"), a Delaware corporation. JMB has responsibility for all aspects of the Partnership's operations, subject to the requirement that sales of real property must be approved by the Associate General Partner of the Partnership, Income Associates-XII, L.P., an Illinois limited partnership with JMB as the sole general partner. The Associate General Partner shall be directed by a majority in interest of its limited partners (who are generally officers, directors and affiliates of JMB or its affiliates) as to whether to provide its approval of any sale of real property (or any interest therein) of the Partnership. Various relationships of the Partnership to the Managing General Partner and its affiliates are described under the caption "Conflicts of Interest" at pages 12-17 of the Prospectus, which description is hereby incorporated herein by reference. The names, positions held and length of service therein of each director and executive officer and certain officers of the Managing General Partner of the Partnership are as follows: SERVED IN NAME OFFICE OFFICE SINCE - ---- ------ ------------ Judd D. Malkin Chairman 5/03/71 Director 5/03/71 Neil G. Bluhm President 5/03/71 Director 5/03/71 Jerome J. Claeys III Director 5/09/88 Burton E. Glazov Director 7/01/71 Stuart C. Nathan Executive Vice President 5/08/79 Director 3/14/73 A. Lee Sacks Director 5/09/88 John G. Schreiber Director 3/14/73 H. Rigel Barber Chief Executive Officer 8/01/93 Jeffrey R. Rosenthal Chief Financial Officer 8/01/93 Gary Nickele Executive Vice President 1/01/92 General Counsel 2/27/84 Ira J. Schulman Executive Vice President 6/01/88 Gailen J. Hull Senior Vice President 6/01/88 Howard Kogen Senior Vice President 1/02/86 Treasurer 1/01/91 There is no family relationship among any of the foregoing directors or officers. The foregoing directors have been elected to serve one-year terms until the annual meeting of the Managing General Partner to be held on June 7, 1994. All of the foregoing officers have been elected to serve one-year terms until the first meeting of the Board of Directors held after the annual meeting of the Managing General Partner to be held on June 7, 1994. There are no arrangements or understandings between or among any of said directors or officers and any other person pursuant to which any director or officer was elected as such. JMB is the corporate general partner of Carlyle Real Estate Limited Partnership-VII ("Carlyle-VII"), Carlyle Real Estate Limited Partnership-IX ("Carlyle-IX"), Carlyle Real Estate Limited Partnership-X ("Carlyle-X"), Carlyle Real Estate Limited Partnership-XI ("Carlyle-XI"), Carlyle Real Estate Limited Partnership-XII ("Carlyle-XII"), Carlyle Real Estate Limited Partnership-XIII ("Carlyle-XIII"), Carlyle Real Estate Limited Partnership-XIV ("Carlyle-XIV"), Carlyle Real Estate Limited Partnership-XV ("Carlyle-XV"), Carlyle Real Estate Limited Partnership-XVI ("Carlyle-XVI"), Carlyle Real Estate Limited Partnership-XVII ("Carlyle-XVII"), JMB Mortgage Partners, Ltd. ("Mortgage Partners"), JMB Mortgage Partners, Ltd.-II ("Mortgage Partners-II") and JMB Mortgage Partners, Ltd.-III ("Mortgage Partners-III"), JMB Mortgage Partners, Ltd.-IV ("Mortgage Partners-IV"), Carlyle Income Plus, Ltd. ("Carlyle Income Plus") and Carlyle Income Plus, Ltd.-II ("Carlyle Income Plus-II"), and the managing general partner of JMB Income Properties, Ltd.-IV ("JMB Income-IV"), JMB Income Properties, Ltd.-V ("JMB Income-V"), JMB Income Properties, Ltd.-VI ("JMB Income-VI"), JMB Income Properties, Ltd.-VII ("JMB Income-VII"), JMB Income Properties, Ltd.-VIII ("JMB Income-VIII"), JMB Income Properties, Ltd.-IX ("JMB Income-IX"), JMB Income Properties, Ltd.-X ("JMB Income-X"), JMB Income Properties, Ltd.-XI ("JMB Income-XI") and JMB Income Properties, Ltd.-XIII ("JMB Income-XIII"). Most of the foregoing directors and officers are also officer and/or directors of various affiliated companies of Arvida/JMB Managers, Inc. (the general partner Arvida/JMB Partners, L.P. ("Arvida")), Arvida/JMB Managers-II, Inc. (the general partner Arvida/JMB Partners, L.P.-II ("Arvida-II")) and Income Growth Managers, Inc. (the corporate general partner of IDS/JMB Balanced Income Growth, Ltd. ("IDS/BIG")). Most of such directors and officers are also partners of certain partnerships which are associate general partners in the following real estate limited partnerships: Carlyle-VII, Carlyle-IX, Carlyle-X, Carlyle-XI, Carlyle-XII, Carlyle-XIII, Carlyle-XIV, Carlyle-XV, Carlyle-XVI, Carlyle-XVII, JMB Income-VI, JMB Income-VII, JMB Income-VIII, JMB Income-IX, JMB Income-X, JMB Income-XI, JMB Income-XIII, Mortgage Partners, Mortgage Partners-II, Mortgage Partners-III, Mortgage Partners-IV, Carlyle Income Plus, Carlyle Income Plus-II and IDS/BIG. The business experience during the past five years of each such director and officer of the Managing General Partner of the Partnership in addition to that described above is as follows: Judd D. Malkin (age 56) is an individual general partner of JMB Income-IV and JMB Income-V. Mr. Malkin has been associated with JMB since October, 1969. He is a Certified Public Accountant. Neil G. Bluhm (age 56) is an individual general partner of JMB Income-IV and JMB Income-V. Mr. Bluhm has been associated with JMB since August, 1970. He is a member of the Bar of the State of Illinois and a Certified Public Accountant. Jerome J. Claeys III (age 51) (Chairman and Director of JMB Institutional Realty Corporation) has been associated with JMB since September, 1977. He holds a Masters degree in Business Administration from the University of Notre Dame. Burton E. Glazov (age 55) has been associated with JMB since June, 1971 and served as an Executive Vice President of JMB until December 1990. He is a member of the Bar of the State of Illinois and a Certified Public Accountant. Stuart C. Nathan (age 52) has been associated with JMB since July, 1972. He is a member of the Bar of the State of Illinois. A. Lee Sacks (age 60) (President and Director of JMB Insurance Agency, Inc.) has been associated with JMB since December, 1972. John G. Schreiber (age 47) has been associated with JMB since December, 1970 and served as an Executive Vice President of JMB until December 1990. He holds a Masters degree in Business Administration from Harvard University Graduate School of Business. H. Rigel Barber (age 44) has been associated with JMB since March, 1982. He holds a J.D. degree from the Northwestern Law School and is a member of the Bar of the State of Illinois. Jeffrey R. Rosenthal (age 42) has been associated with JMB since December, 1987. He is a Certified Public Accountant. Gary Nickele (age 41) has been associated with JMB since February, 1984. He holds a J.D. degree from the University of Michigan Law School and is a member of the Bar of the State of Illinois. Ira J. Schulman (age 42) has been associated with JMB since February, 1983. He holds a Masters degree in Business Administration from the University of Pittsburgh. Gailen J. Hull (age 45) has been associated with JMB since March, 1982. He holds a Masters degree in Business Administration from Northern Illinois University and is a Certified Public Accountant. Howard Kogen (age 58) has been associated with JMB since March, 1973. He is a Certified Public Accountant. ITEM 11.

ITEM 11. EXECUTIVE COMPENSATION The Partnership has no officers or directors. The General Partners of the Partnership are entitled to receive a share of cash distributions, when and as cash distributions are made to the Investors, and a share of profits or losses as described under the caption "Compensation and Fees" at pages 8-12, "Cash Distributions" at pages 61-63, "Allocation of Profits or Losses for Tax Purposes" at pages 63 and 64 and "Cash Distributions; Allocations of Profits and Losses" at pages A-8 to A-12 of the Partnership Agreement included as an exhibit to the Prospectus, which descriptions are hereby incorporated herein by reference. Reference is also made to Notes 5 and 8 for a description of such transactions, distributions and allocations. No such cash distributions were paid to the General Partners in 1993, 1992 and 1991. An affiliate of the Managing General Partner provided property management services to the Partnership for 1993 for the Plaza Hermosa Shopping Center in Hermosa Beach, California at a fee calculated at 4% of the gross receipts of the property and to the 40 Broad Street office building in New York, New York at a fee calculated at 2% of the gross receipts of the property. In 1993, such affiliate earned property management and leasing fees amounting to $221,843 all of which were paid at December 31, 1993. As set forth in the Prospectus of the Partnership, the Managing General Partner must negotiate such agreements on terms no less favorable to the Partnership than those customarily charged for similar services in the relevant geographical area and such agreements must be terminable by either party thereto, without penalty, upon 60 days' notice. The General Partners of the Partnership may be reimbursed for their direct expenses relating to the administration of the Partnership and the operation of the Partnership's real property investments. In 1993, the Managing General Partner received reimbursement for such expenses and salaries in the amount of $92,243 of which $72,561 was unpaid at December 31, 1993. The Managing General Partner received no disbursement agent and data processing fees in 1993. JMB Insurance Agency, Inc., an affiliate of the Managing General Partner of the Partnership, earned and received insurance brokerage commissions in 1993 aggregating $84,976 in connection with the providing of insurance coverage for the real property investments of the Partnership. Such commissions are at rates set by insurance companies for the classes of coverage involved. The Partnership is permitted to engage in various transactions involving affiliates of the Managing General Partner of the Partnership, as described under the captions "Compensation and Fees" at pages 8-12, "Conflicts of Interest" at pages 12-17 and "Rights, Powers and Duties of General Partners" at pages A-12 to A-22 of the Partnership Agreement, included as an exhibit to the Prospectus, which descriptions are hereby incorporated herein by reference. The relationship of the Managing General Partner (and its directors and officers) to its affiliates is set forth above in Item 10 above and Exhibit 21 hereto. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS There were no significant transactions or business relationships with the Managing General Partner, affiliates or their management other than those described in Items 10 and 11 above. PART IV ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K (a) The following documents are filed as part of this report: 1. Financial Statements (See Index to Financial Statements filed with this annual report). 2. Exhibits. 3-A. The Prospectus of the Partnership dated August 23, 1985 as supplemented December 9, 1985 and January 10, pursuant to Rules 424 (b) and 424 (c), as filed with the Commission is hereby incorporated herein by reference. Copies of pages 8-12, 61-64 and A-8 to A-12 are hereby incorporated herein by reference to Exhibit 3-A to the Partnership's Report on Form 10-K for December 31, 1992 (File No. 0-16108) dated March 19, 1993. 3-B. Amended and Restated Agreement of Limited Partnership set forth as Exhibit A to the Prospectus, which agreement is hereby incorporated herein by reference to Exhibit 3-B to the Partnership's Report on Form 10-K for December 31, 1992 (File No. 0-16108) dated March 19, 1993. 4-A. Mortgage loan agreement between Topanga and Connecticut General Life Insurance Company dated January 31, 1992 relating to Topanga Plaza in Los Angeles, California is hereby incorporated herein by reference to Exhibit 4-A to the Partnership's Report on Form 10-K for December 31, 1992 (File No. 0-16108) dated March 19, 1993. 4-B. Mortgage loan agreement between First Financial and The Prudential Insurance Company of America dated November 2, 1987 relating to First Financial Plaza in Encino, California is hereby incorporated herein by reference to Exhibit 4-B to the Partnership's Report on Form 10-K for December 31, 1992 (File No. 0-16108) dated March 19, 1993. 4-C. Mortgage loan modification agreement between Topanga and Connecticut General Life Insurance dated January 31, 1993 relating to Topanga Plaza in Los Angeles, California is hereby incorporated herein by reference to Exhibit 4 of the Partnership's Report on Form 10-Q (File No. 0- 16108) dated November 11, 1993. 10-A.Acquisition documents including the venture agreement relating to the purchase by the Partnership of Topanga Plaza in Los Angeles, California, are hereby incorporated by reference to the Partnership's Report on Form 8-K (File No. 0-16108) dated December 31, 1985. 10-B.Acquisition documents including the venture agreement relating to the purchase by the Partnership of First Financial Plaza in Encino, California are hereby incorporated by reference to the Partnership's Report on Form 8-K (File No. 0-16108) dated June 3, 1987. 10-C.Acquisition documents including the venture agreement relating to the purchase by the Partnership of 40 Broad Street in New York, New York, are hereby incorporated by reference to the Partnership's Report on Form 8-K (File No. 0-16108) dated December 31, 1985. 10-D.Sale documents and exhibits thereto relating to the sale of the Partnership's interest in Mid Rivers Mall in St. Peters (St. Louis), Missouri are hereby incorporated by reference to the Partnership's Report on Form 8-K (File No. 0-16108) dated February 18, 1992. 21. List of Subsidiaries 24. Powers of Attorney - ---------------- Although certain additional long-term debt instruments of the Registrant have been excluded from Exhibit 4 above, pursuant to Rule 601(b)(4)(iii), the Registrant commits to provide copies of such agreements to the Securities and Exchange Commissions upon request. (b) No Reports on Form 8-K were required or filed since the beginning of the last quarter of the period covered by this report. No annual report or proxy material for 1993 has been sent to the Partners of the Partnership. An annual report will be sent to the Partners subsequent to this filing. SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Act of 1934, the Partnership has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. JMB INCOME PROPERTIES, LTD. - XII By: JMB Realty Corporation Managing General Partner GAILEN J. HULL By: Gailen J. Hull Senior Vice President Date:March 25, 1994 Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated. By: JMB Realty Corporation Managing General Partner JUDD D. MALKIN* By: Judd D. Malkin, Chairman and Director Date:March 25, 1994 NEIL G. BLUHM* By: Neil G. Bluhm, President and Director Date:March 25, 1994 H. RIGEL BARBER* By: H. Rigel Barber, Chief Executive Officer Date:March 25, 1994 JEFFREY R. ROSENTHAL* By: Jeffrey R. Rosenthal, Chief Financial Officer Principal Financial Officer Date:March 25, 1994 GAILEN J. HULL By: Gailen J. Hull, Senior Vice President Principal Accounting Officer Date:March 25, 1994 A. LEE SACKS* By: A. Lee Sacks, Director Date:March 25, 1994 By: STUART C. NATHAN* Stuart C. Nathan, Executive Vice President and Director Date:March 25, 1994 *By:GAILEN J. HULL, Pursuant to a Power of Attorney GAILEN J. HULL By: Gailen J. Hull, Attorney-in-Fact Date:March 25, 1994 JMB INCOME PROPERTIES, LTD. - XII EXHIBIT INDEX DOCUMENT INCORPORATED BY REFERENCE PAGE ------------- ---- 3-A. Pages 8-12, 61-64 and A-8 to A-12 of the Prospectus of the Partnership dated August 23, 1985, as supple- mented on December 9, 1985 and January 10, 1986 Yes 3-B. Amended and Restated Agreement of Limited Partnership Yes 4-A. Mortgage loan agreement related to Topanga Plaza Yes 4-B. Mortgage loan agreement related to First Financial Plaza Yes 4-C. Mortgage loan modification agreement related to Topanga Plaza Yes 10-A. Acquisition documents related to Topanga Plaza Yes 10-B. Acquisition documents related to First Financial Plaza Yes 10-C. Acquisition documents related to 40 Broad Street Yes 10-D. Sale documents related to Mid Rivers Mall Yes 21. List of Subsidiaries No 24. Powers of Attorney No

ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS There were no significant transactions or business relationships with the Managing General Partner, affiliates or their management other than those described in Items 10 and 11 above. PART IV ITEM 14.

ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K (a) The following documents are filed as part of this report: 1. Financial Statements (See Index to Financial Statements filed with this annual report). 2. Exhibits. 3-A. The Prospectus of the Partnership dated August 23, 1985 as supplemented December 9, 1985 and January 10, pursuant to Rules 424 (b) and 424 (c), as filed with the Commission is hereby incorporated herein by reference. Copies of pages 8-12, 61-64 and A-8 to A-12 are hereby incorporated herein by reference to Exhibit 3-A to the Partnership's Report on Form 10-K for December 31, 1992 (File No. 0-16108) dated March 19, 1993. 3-B. Amended and Restated Agreement of Limited Partnership set forth as Exhibit A to the Prospectus, which agreement is hereby incorporated herein by reference to Exhibit 3-B to the Partnership's Report on Form 10-K for December 31, 1992 (File No. 0-16108) dated March 19, 1993. 4-A. Mortgage loan agreement between Topanga and Connecticut General Life Insurance Company dated January 31, 1992 relating to Topanga Plaza in Los Angeles, California is hereby incorporated herein by reference to Exhibit 4-A to the Partnership's Report on Form 10-K for December 31, 1992 (File No. 0-16108) dated March 19, 1993. 4-B. Mortgage loan agreement between First Financial and The Prudential Insurance Company of America dated November 2, 1987 relating to First Financial Plaza in Encino, California is hereby incorporated herein by reference to Exhibit 4-B to the Partnership's Report on Form 10-K for December 31, 1992 (File No. 0-16108) dated March 19, 1993. 4-C. Mortgage loan modification agreement between Topanga and Connecticut General Life Insurance dated January 31, 1993 relating to Topanga Plaza in Los Angeles, California is hereby incorporated herein by reference to Exhibit 4 of the Partnership's Report on Form 10-Q (File No. 0- 16108) dated November 11, 1993. 10-A.Acquisition documents including the venture agreement relating to the purchase by the Partnership of Topanga Plaza in Los Angeles, California, are hereby incorporated by reference to the Partnership's Report on Form 8-K (File No. 0-16108) dated December 31, 1985. 10-B.Acquisition documents including the venture agreement relating to the purchase by the Partnership of First Financial Plaza in Encino, California are hereby incorporated by reference to the Partnership's Report on Form 8-K (File No. 0-16108) dated June 3, 1987. 10-C.Acquisition documents including the venture agreement relating to the purchase by the Partnership of 40 Broad Street in New York, New York, are hereby incorporated by reference to the Partnership's Report on Form 8-K (File No. 0-16108) dated December 31, 1985. 10-D.Sale documents and exhibits thereto relating to the sale of the Partnership's interest in Mid Rivers Mall in St. Peters (St. Louis), Missouri are hereby incorporated by reference to the Partnership's Report on Form 8-K (File No. 0-16108) dated February 18, 1992. 21. List of Subsidiaries 24. Powers of Attorney - ---------------- Although certain additional long-term debt instruments of the Registrant have been excluded from Exhibit 4 above, pursuant to Rule 601(b)(4)(iii), the Registrant commits to provide copies of such agreements to the Securities and Exchange Commissions upon request. (b) No Reports on Form 8-K were required or filed since the beginning of the last quarter of the period covered by this report. No annual report or proxy material for 1993 has been sent to the Partners of the Partnership. An annual report will be sent to the Partners subsequent to this filing. SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Act of 1934, the Partnership has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. JMB INCOME PROPERTIES, LTD. - XII By: JMB Realty Corporation Managing General Partner GAILEN J. HULL By: Gailen J. Hull Senior Vice President Date:March 25, 1994 Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated. By: JMB Realty Corporation Managing General Partner JUDD D. MALKIN* By: Judd D. Malkin, Chairman and Director Date:March 25, 1994 NEIL G. BLUHM* By: Neil G. Bluhm, President and Director Date:March 25, 1994 H. RIGEL BARBER* By: H. Rigel Barber, Chief Executive Officer Date:March 25, 1994 JEFFREY R. ROSENTHAL* By: Jeffrey R. Rosenthal, Chief Financial Officer Principal Financial Officer Date:March 25, 1994 GAILEN J. HULL By: Gailen J. Hull, Senior Vice President Principal Accounting Officer Date:March 25, 1994 A. LEE SACKS* By: A. Lee Sacks, Director Date:March 25, 1994 By: STUART C. NATHAN* Stuart C. Nathan, Executive Vice President and Director Date:March 25, 1994 *By:GAILEN J. HULL, Pursuant to a Power of Attorney GAILEN J. HULL By: Gailen J. Hull, Attorney-in-Fact Date:March 25, 1994 JMB INCOME PROPERTIES, LTD. - XII EXHIBIT INDEX DOCUMENT INCORPORATED BY REFERENCE PAGE ------------- ---- 3-A. Pages 8-12, 61-64 and A-8 to A-12 of the Prospectus of the Partnership dated August 23, 1985, as supple- mented on December 9, 1985 and January 10, 1986 Yes 3-B. Amended and Restated Agreement of Limited Partnership Yes 4-A. Mortgage loan agreement related to Topanga Plaza Yes 4-B. Mortgage loan agreement related to First Financial Plaza Yes 4-C. Mortgage loan modification agreement related to Topanga Plaza Yes 10-A. Acquisition documents related to Topanga Plaza Yes 10-B. Acquisition documents related to First Financial Plaza Yes 10-C. Acquisition documents related to 40 Broad Street Yes 10-D. Sale documents related to Mid Rivers Mall Yes 21. List of Subsidiaries No 24. Powers of Attorney No

351825_1993.txt

351825

1993

ITEM 1. BUSINESS First National Bancorp (Registrant) was incorporated as a Georgia business corporation in 1980. In July 1981, through a plan of reorganization, the Registrant acquired all of the issued and outstanding common stock of The First National Bank of Gainesville (FNBG), Gainesville, Georgia in exchange for Registrant's common stock. Because of its ownership of all the issued and outstanding shares of common stock of the following banks, Registrant is a "bank holding company" as that term is defined under Federal law in the Bank Holding Company Act of 1956, as amended, and under the bank holding company laws of the State of Georgia. As a bank holding company, the Registrant is subject to the applicable provisions of the Federal Reserve System and the Georgia State Department of Banking and Finance. The Registrant's primary business as a bank holding company is to manage the business and affairs of its banking subsidiaries. The Registrant's subsidiary banks provide a full range of banking and mortgage banking services to their customers. Since its formation in 1980 through December 31, 1993, the Registrant has acquired fourteen banks in addition to the founding bank, FNBG. Those banks which have been acquired and some information about each is presented in the "Acquisition Schedule, Properties, and Other Information" table below. The following table lists the Registrant and subsidiaries, disclosing information pertinent to Part I, Item 1 and properties information disclosure as required in Part I, Item 2

ITEM 2. PROPERTIES Registrant's fifteen subsidiary banks operate as autonomously as is possible under a holding company structure within their particular counties and maintain separate banking facilities, which each subsidiary bank owns or leases. In addition, Registrant owns a main office building, used as its corporate offices, and several other offices used to house banking support operations. See Item 1. Business for additional information concerning properties. ITEM 3.

ITEM 3. LEGAL PROCEEDINGS The nature of the business of Registrant and its subsidiaries ordinarily results in a certain amount of litigation. Accordingly, Registrant and its subsidiaries are parties (both as plaintiff and defendant) to a limited number of lawsuits incidental to their business and, in certain of such suits, claims or counterclaims have been asserted. In the opinion of management and counsel for Registrant, these lawsuits generally may be considered ordinary litigation incidental to the conduct of business and in none of these cases should the ultimate outcome have a material adverse effect on Registrant's financial position. ITEM 4.

ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS There were no matters submitted to a vote of security holders during the fourth quarter of 1993. PART II ITEM 5.

ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS The market, stock price, and dividend information which appears on page 35 of Registrant's 1993 Annual Report to shareholders, is incorporated by reference in this Form 10-K Annual Report. The discussion of source of dividends and restrictions on dividends, which may be declared by the subsidiary banks, appearing on page 53, Note 14, of Registrant's 1993 Annual Report to shareholders, is incorporated by reference in this Form 10-K Annual Report. ITEM 6.

ITEM 6. SELECTED FINANCIAL DATA The Selected Financial Data which appears as a part of Management's Discussion and Analysis of Financial Condition and Results of Operations on page 20 of Registrant's 1993 Annual Report to shareholders, is incorporated by reference in this Form 10-K Annual Report. ITEM 7.

ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Management's Discussion and Analysis of Financial Condition and Results of Operations, which appears on pages 19 through 35 of Registrant's 1993 Annual Report to shareholders, is incorporated by reference in this Form 10-K Annual Report. ITEM 8.

ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA The Consolidated Financial Statements and Notes to Consolidated Financial Statements, together with the report thereon of KPMG Peat Marwick, dated January 28, 1994, appearing on pages 37 through 56 of Registrant's 1993 Annual Report to shareholders, are incorporated by reference in this Form 10-K Annual Report. Consolidated quarterly financial information appearing on page 56 of the Registrant's 1993 Annual Report to shareholders, is incorporated by reference in this Form 10-K Annual Report. ITEM 9.

ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE Within the twenty-four month period prior to the date of Registrant's most recent financial statements, and for the year ended December 31, 1993, Registrant did not change accountants and had no disagreements with its accountants on any matter of accounting principles, practices, or financial statement disclosure. PART III ITEM 10.

ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT The information concerning directors is presented on pages 2 through 6 of the Proxy Statement for Annual Meeting of Shareholders, to be held April 20, 1994, which information is incorporated by reference in this Form 10-K Annual Report. Information concerning executive officers of Registrant is set forth under the caption "Executive Officers of the Registrant" in Item 1. Business, hereof. ITEM 11.

ITEM 11. EXECUTIVE COMPENSATION Executive Compensation is shown under Compensation of Executive Officers on pages 9 through 18 of the Proxy Statement for Annual Meeting of Shareholders, to be held April 20, 1994, which is incorporated by reference in this Form 10- K Annual Report. Compensation of Directors is shown under Compensation of Directors on page 18 of the Proxy Statement For Annual Meeting of Shareholders, to be held April 20, 1994, which is incorporated by reference in this Form 10-K Annual Report. ITEM 12.

ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT Principal Shareholders of Registrant which appears on page 9 of the Proxy Statement For Annual Meeting of Shareholders, to be held April 20, 1994, is incorporated by reference in this Form 10-K Annual Report. Security Ownership of Directors, Nominees, Executive Officers, and Directors and Executive Officers, as a group, which appears on pages 7 through 9 of the Proxy Statement For Annual Meeting of Shareholders, to be held April 20, 1994, is incorporated by reference in this Form 10-K Annual Report. ITEM 13.

ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS Transactions with Management which appears on page 19 of the Proxy Statement For Annual Meeting of Shareholders, to be held April 20, 1994, is incorporated by reference in this Form 10-K Annual Report. PART IV ITEM 14.

ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K (a)1.FINANCIAL STATEMENTS The following consolidated financial statements of Registrant and its subsidiaries and independent auditors' report, incorporated herein by reference from pages 37 through 56 of Registrant's 1993 Annual Report to shareholders, have been filed as Item 8 in Part II of this report: Independent Auditors' Report Consolidated Balance Sheets - December 31, 1993 and 1992 Consolidated Statements of Income - Years ended December 31, 1993, 1992, and 1991 Consolidated Statements of Shareholders' Equity - Years ended December 31, 1993, 1992, and 1991 Consolidated Statements of Cash Flows - Years ended December 31, 1993, 1992, and 1991 Notes to Consolidated Financial Statements (a)2.FINANCIAL STATEMENT SCHEDULES Financial statement schedules are omitted as the required information is not applicable. (a)3.EXHIBITS LIST See Exhibit Index included as page 13 of this report, which is incorporated herein by reference. (b) REPORTS ON FORM 8-K Current Report on Form 8-K, dated December 28, 1993, was filed on December 31, 1993, pertaining to the issuance of 63,676, $1.00 par value common stock shares of Registrant, used in the acquisition of First Citizens Bancorp of Cherokee County, Inc., which was the parent company of Citizens Bank, Cherokee County. Current Report on Form 8-K, dated October 20, 1993, was filed on October 27, 1993, pertaining to the promotion of J. Reid Moore to the Controller's position with Registrant. Current Report on Form 8-K, dated October 14, 1993, was filed on October 14, 1993, pertaining to the signing of an Agreement of Reorganization and Plan of Merger, by Registrant and Metro, whereby Registrant will merge with Metro and acquire all of the outstanding shares of Metro's subsidiary bank, The Commercial Bank of Douglasville, Georgia. SIGNATURES Pursuant to the requirements of Section 13 or 15 (d) of the Securities Exchange Act of 1934, First National Bancorp has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. FIRST NATIONAL BANCORP By: /s/ Richard A. McNeece --------------------------------------------- Richard A. McNeece, Chairman and Chief Executive Officer By: /s/ Peter D. Miller --------------------------------------------- Peter D. Miller, President, Chief Administrative and Chief Financial Officer By: /s/ J. Reid Moore --------------------------------------------- J. Reid Moore Group Vice President and Controller Date: March 28, 1994 Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of First National Bancorp and in the capacities and on the dates indicated. EXHIBITS INDEX

64782_1993.txt

64782

1993

ITEM 1. BUSINESS Description of Business Mellon Bank Corporation (the "Corporation") is a multibank holding company incorporated under the laws of Pennsylvania in August 1971 and registered under the Federal Bank Holding Company Act of 1956, as amended. The Corporation provides a comprehensive range of financial products and services in domestic and selected international markets. The Corporation's banking subsidiaries are located in the states of Pennsylvania, Massachusetts, Delaware and Maryland, while other subsidiaries are located in key business centers throughout the United States and abroad. At December 31, 1993, the Corporation was the twenty-third largest bank holding company in the United States in terms of assets. The Corporation's principal wholly owned subsidiaries are Mellon Bank, N.A. ("Mellon Bank"), The Boston Company, Inc. ("TBC"), Mellon Bank (DE) National Association, Mellon Bank (MD) and a number of companies known as Mellon Financial Services Corporations. The Corporation's banking subsidiaries engage in domestic retail banking, worldwide commercial banking, trust banking, investment management and other financial services and various securities-related activities. Mellon Bank, which has its executive offices in Pittsburgh, Pennsylvania, became a subsidiary of the Corporation in November 1972. With its predecessors, Mellon Bank has been in business since 1869. Mellon Bank is comprised of six operating regions: Mellon Bank-Western Region, which includes Mellon Bank's Pittsburgh-based executive offices, serves consumer and small to mid-sized commercial markets in western Pennsylvania, as well as large commercial and financial institution markets throughout the United States and selected international markets. Mellon Bank-Central Region, headquartered in State College, Pennsylvania, serves consumer and small to mid-sized commercial markets in central Pennsylvania. Mellon Bank-Commonwealth Region, headquartered in Harrisburg, Pennsylvania, serves consumer and small to mid-sized commercial markets in south central Pennsylvania. Mellon Bank-Northern Region, headquartered in Erie, Pennsylvania, serves consumer and small to mid-sized commercial markets in northwestern Pennsylvania. Mellon Bank - Northeastern Region, headquartered in Wilkes-Barre, Pennsylvania, serves consumer and small to mid-sized commercial markets in northeastern Pennsylvania. Mellon PSFS, headquartered in Philadelphia, Pennsylvania, serves consumer and small commercial markets in eastern Pennsylvania and mid-sized commercial customers in eastern Pennsylvania and portions of New Jersey. On December 21, 1993, the Corporation completed its acquisition of AFCO Credit Corporation (AFCO) and CAFO, Inc. AFCO is headquartered in New York, New York, while CAFO is headquartered in Toronto, Canada. These companies provide property and casualty insurance premium financing to small, mid-size and large companies. AFCO is a subsidiary of Mellon Bank, N.A. CAFO is a subsidiary of Mellon Bank Canada. TBC, through Boston Safe Deposit and Trust Company and other subsidiaries, engages in the business of mutual fund administration, institutional trust and custody, institutional asset management and private banking services. TBC is headquartered in Boston, Massachusetts. Description of Business (continued) Mellon Bank (DE) National Association, headquartered in Wilmington, Delaware, serves consumer and small to mid-sized commercial markets throughout Delaware, and provides nationwide cardholder processing services. Mellon Bank (MD) is headquartered in Rockville, Maryland, and serves consumer and small to mid-sized commercial markets throughout Maryland. Mellon Bank (MD) has a Maryland state charter and is a member of the Federal Reserve System. The Corporation's banking subsidiaries operate 631 domestic retail banking locations, including 432 branch offices. The deposits of the national banking subsidiaries, Boston Safe Deposit and Trust and Mellon Bank (MD) are insured by the Federal Deposit Insurance Corporation ("FDIC") to the extent provided by law. Other subsidiaries of the Corporation provide a broad range of bank-related services -- including commercial financial services, equipment leasing, residential real estate loan financing, commercial loan financing, stock transfer services, cash management, mortgage servicing, numerous trust and investment management services and real estate investment management services. The types of financial products and services offered by the Corporation's subsidiaries are subject to ongoing change. For analytical purposes, management has focused the Corporation into four business sectors: Wholesale Banking, Retail Financial Services and Service Products, which comprise the core business sectors, and Real Estate Banking. Further information regarding the Corporation's designated business sectors is presented in the Business Sectors section on pages 20 through 22 of the Corporation's 1993 Annual Report to Shareholders, which pages are incorporated herein by reference. A brief discussion of the business sectors is presented below. There is considerable interrelationship among these sectors. Wholesale Banking The Corporation provides lending and other wholesale banking services to domestic and selected international markets through its Corporate Banking, Capital Markets and Leasing departments. These markets generally include large domestic commercial and industrial customers, U.S. operations of foreign companies, multinational corporations and various financial institutions--including banks, securities broker/dealers, insurance companies, finance companies and mutual funds. The Corporation also offers corporate finance and rate/risk management products; syndicates, participates out and sells loans; offers a variety of capital markets products and services, including private placements and money market and foreign exchange transactions; and provides equipment leasing, financing and lease advisory services. The Corporation maintains foreign offices in London, Tokyo, Hong Kong, Toronto, and Grand Cayman, British West Indies. Through these offices, the Corporation conducts trade finance activities, engages in correspondent banking, provides corporate banking and capital markets services, and engages in funding and trading activities. As part of the Corporation's Wholesale Banking sector, Middle Market Banking serves companies in the Central Atlantic region with annual sales between $10 million and $250 million and provides specialized lending expertise to state and local governments in its regional markets and health care on a national basis. It also operates a nationwide asset-based lending division which provides secured lending, principally through accounts receivable and inventory financing. The Middle Market Banking department sells the Corporation's full complement of banking products and services to its customers. Retail Financial Services Retail financial products and services are offered through the Corporation's banking subsidiaries in the Central Atlantic region. Description of Business (continued) Retail Financial Services This banking network provides a full range of products to individuals and small businesses including short and long-term credit facilities, mortgages, credit cards, investment products, checking, savings, and time deposits, money market accounts, money transfer, safe deposit facilities, access to automated teller machines and cash management services. These services are delivered through a combination of the Corporation's 402 branch offices, 29 supermarket facilities, 586 ATMs, 7 loan sales offices and a telephone banking center. Service Products The Corporation offers a number of service products through its various subsidiaries. These fee-based businesses generally are not as asset or capital intensive as are the Wholesale and Retail Financial Services sectors. The Corporation's subsidiaries provide a wide variety of trust and investment management services operating under the umbrella name "Mellon Trust". These include corporate trust, master trust, personal trust, investment-related services, mutual fund administration, custody and account administration services. The Corporation also owns a number of subsidiaries that provide a variety of active and passive equity and fixed income investment management services, including management of international securities and real estate assets; security transfer agency services; and accounting and processing related services. Through these functions, the Corporation serves the employee benefit, institutional and individual markets. On May 21, 1993, the Corporation completed its acquisition of TBC. The Corporation now ranks among the largest national competitors in each of these major trust and investment businesses: mutual fund administration; institutional trust and custody; institutional asset management; and private banking management. In December 1993, the Corporation entered into a definitive agreement to merge with The Dreyfus Corporation (Dreyfus). Completion of the merger is subject to the approval of the shareholders of the Corporation and Dreyfus, various regulatory approvals and certain approvals by the shareholders of the mutual funds advised by Dreyfus. Upon completion of the merger with Dreyfus, the Corporation expects to substantially increase its trust and investment management fee revenue and become the largest bank manager of mutual funds. Further information regarding these transactions is presented in the Corporation's 1993 Annual Report to Shareholders in the Significant events in 1993 section on page 19 and in note 21 of Notes to Financial Statements on pages 71 and 72, which portions are incorporated herein by reference. The Global Cash Management department provides a broad range of cash management services, including check collections and disbursements, remittance processing, electronic funds transfer services, information reporting and automated investment services. Also included in the service products sector are the core servicing functions of the Corporation's mortgage banking operations, located in Houston, Denver and Cleveland, through which the Corporation originates and services residential and commercial mortgages for institutional investors and makes residential mortgage loans. Real Estate Banking Real estate banking consists of the Corporation's commercial real estate lending activities, through which it originates financing for residential, commercial, multifamily and other projects. Description of Business (continued) The 1993 Annual Report to Shareholders summarizes principal locations and operating entities on pages 78 through 80, which pages are incorporated herein by reference. Exhibit 21.1 to this Annual Report on Form 10-K presents a list of the subsidiaries of the Corporation as of December 31, 1993. Supervision and Regulation The Corporation, as a bank holding company, is regulated under the Bank Holding Company Act of 1956, as amended (the "Act"), and is subject to the supervision of the Board of Governors of the Federal Reserve System (the "Federal Reserve Board"). Generally, the Act limits the business of bank holding companies to banking, managing or controlling banks, performing certain servicing activities for subsidiaries, and engaging in such other activities as the Federal Reserve Board may determine to be closely related to banking and a proper incident thereto. Certain of the Corporation's subsidiaries are themselves bank holding companies under the Act. The Corporation's national banking subsidiaries are subject to primary supervision, regulation and examination by the Office of the Comptroller of the Currency (the "OCC"); Boston Safe Deposit and Trust Company ("BSDT") is subject to supervision, regulation and examination by the Federal Deposit Insurance Corporation (the "FDIC") and the Massachusetts Office of the Commissioner of Banks; and Mellon Bank (MD) is subject to supervision, regulation and examination by the Federal Reserve Board and the State of Maryland. Mellon Securities Trust Company and Boston Safe Deposit and Trust Company of New York are New York trust companies and are supervised by the New York State Department of Banking. Boston Safe Deposit and Trust Company of California is a California trust company and is supervised by the State of California Banking Department. The Corporation's securities-related subsidiaries are regulated by the Securities and Exchange Commission (the "SEC"). InvestNet, a subsidiary of the Corporation, conducts a brokerage operation and Mellon Investment Products Company, a subsidiary of Mellon Bank, engages in the sale, as agent, of certain mutual fund and unit investment trust products. Both InvestNet and Mellon Investment Products Company are registered broker/dealers and members of the National Association of Securities Dealers, Inc., a securities industry self-regulatory organization. Certain subsidiaries of the Corporation are registered investment advisers under the Investment Advisers Act of 1940 and, as such, are supervised by the SEC. Certain of the Corporation's public finance activities are regulated by the Municipal Securities Rulemaking Board. Mellon Bank and certain of the Corporation's other subsidiaries are registered with the Commodity Futures Trading Commission (the "CFTC") as commodity pool operators or commodity trading advisors and, as such, are subject to CFTC regulation. The Corporation and its subsidiaries are subject to an extensive scheme of banking laws and regulations that are intended primarily for the protection of the customers and depositors of the Corporation's subsidiaries rather than holders of the Corporation's securities. These laws and regulations govern such areas as permissible activities, loans and investments, rates of interest that can be charged on loans and reserves. The Corporation and its subsidiaries also are subject to general U.S. federal laws and regulations and to the laws and regulations of the states or countries in which they conduct their business. Set forth below are brief descriptions of selected laws and regulations applicable to the Corporation and its subsidiaries. Pennsylvania legislation authorizes bank holding companies in any state to acquire Pennsylvania banks or bank holding companies provided that Pennsylvania bank holding companies enjoy reciprocal privileges in those jurisdictions. Most states outside the Southeast currently have such reciprocal laws. As a result, the Corporation can acquire banks in any state which has a reciprocal law. There are certain restrictions on the ability of the Corporation and certain of its non-bank affiliates to borrow from, and engage in other transactions with, its banking subsidiaries and on the ability of such banking subsidiaries to pay dividends to the Corporation. These restrictions are discussed in note 16 of the Notes to Financial Statements on page 62 of the Corporation's 1993 Annual Report to Shareholders. This note is incorporated herein by reference. Supervision and Regulation (continued) The OCC has authority under the Financial Institutions Supervisory Act to prohibit national banks from engaging in any activity which, in the OCC's opinion, constitutes an unsafe or unsound practice in conducting their businesses. The Federal Reserve Board has similar authority with respect to the Corporation, its Maryland banking subsidiary and its non-bank subsidiaries, including Mellon Securities Trust Company, a member of the Federal Reserve System. The FDIC has similar authority with respect to BSDT. The deposits of each of the banking subsidiaries are insured up to applicable limits by the FDIC and are subject to deposit insurance assessments to maintain the Bank Insurance Fund ("BIF") of the FDIC. The FDIC has adopted a risk-based assessment system to replace the previous flat-rate system. The risk-based system imposes insurance premiums based upon a matrix that takes into account a bank's capital level and supervisory rating. Under this risk-based system, the assessment rate imposed on banks ranges from 23 cents for each $100 of domestic deposits for the healthiest institutions to 31 cents for each $100 of domestic deposits for the weakest institutions. The Financial Institutions Reform, Recovery and Enforcement Act ("FIRREA") contains a "cross-guarantee" provision which could result in any insured depository institution owned by the Corporation being assessed for losses incurred by the FDIC in connection with assistance provided to, or the failure of, any other depository institution owned by the Corporation. Also, under Federal Reserve Board policy, the Corporation may be expected to act as a source of financial strength to each of its banking subsidiaries and to commit resources to support each such bank in circumstances where such bank might not be in a financial position to support itself. The Federal Deposit Insurance Corporation Improvement Act of 1991 ("FDICIA") substantially revised the depository institution regulatory and funding provisions of the Federal Deposit Insurance Act and made revisions to several other federal banking statutes. Among other things, federal banking regulators are required to take prompt corrective action in respect of depository institutions that do not meet minimum capital requirements. FDICIA identifies the following capital tiers for financial institutions: well capitalized, adequately capitalized, undercapitalized, significantly undercapitalized and critically undercapitalized. Rules adopted by the federal banking agencies under FDICIA provide that an institution is deemed to be: "well capitalized" if the institution has a Total risk-based capital ratio of 10.0% or greater, a Tier I risk-based ratio of 6.0% or greater, and a leverage ratio of 5.0% or greater, and the institution is not subject to an order, written agreement, capital directive, or prompt corrective action directive to meet and maintain a specific level for any capital measure; "adequately capitalized" if the institution has a Total risk-based capital ratio of 8.0% or greater, a Tier I risk-based capital ratio of 4.0% or greater, and a leverage ratio of 4.0% or greater (or a leverage ratio of 3.0% or greater if the institution is rated composite 1 in its most recent report of examination, subject to appropriate Federal banking agency guidelines), and the institution does not meet the definition of a well capitalized institution; "undercapitalized" if the institution has a Total risk-based capital ratio that is less than 8.0%, a Tier I risk-based capital ratio that is less than 4.0% or a leverage ratio that is less than 4.0% (or a leverage ratio that is less than 3.0% if the institution is rated composite 1 in its most recent report of examination, subject to appropriate Federal banking agency guidelines) and the institution does not meet the definition of a significantly undercapitalized or critically undercapitalized institution; "significantly undercapitalized" if the institution has a Total risk-based capital ratio that is less than 6.0%, a Tier I risk-based capital ratio that is less than 3.0%, or a leverage ratio that is less than 3.0% and the institution does not meet the definition of a critically undercapitalized institution; and "critically undercapitalized" if the institution has a ratio of tangible equity to total assets that is equal to or less than 2.0%. FDICIA imposes progressively more restrictive constraints on operations, management and capital distributions, depending on the capital category in which an institution is classified. At December 31, 1993, the Corporation and all of the Corporation's banking subsidiaries fell into the well capitalized category based on the ratios and guidelines noted above. The appropriate Federal banking agency may, under certain circumstances, reclassify a well capitalized insured depository institution as adequately capitalized. The appropriate agency is also permitted to require an adequately Supervision and Regulation (continued) capitalized or undercapitalized institution to comply with the supervisory provisions as if the institution were in the next lower category (but not treat a significantly undercapitalized institution as critically undercapitalized) based on supervisory information other than the capital levels of the institution. The statute provides that an institution may be reclassified if the appropriate Federal banking agency determines (after notice and opportunity for hearing) that the institution is in an unsafe or unsound condition or deems the institution to be engaging in an unsafe or unsound practice. Legislation enacted in August 1993 provides that deposits and certain claims for administrative expenses and employee compensation against an insured depository institution would be afforded a priority over other general unsecured claims against such an institution in the "liquidation or other resolution" of such an institution by any receiver. During 1993, regulatory guidelines were adopted, and legislation was proposed in Congress, to address concerns regarding retail sales by banks of various nondeposit investment products, including mutual funds. Legislative and regulatory attention to these matters is likely to continue, and may intensify, in the future. Although existing statutory and regulatory requirements in this regard have not had a significant effect on the Corporation's business, there can be no assurance that future requirements will not have such an effect on the Corporation's business, as currently conducted or as proposed to be conducted after the proposed merger with The Dreyfus Corporation. Various other legislation, including proposals to restructure the banking regulatory system, provide for nationwide interstate banking and to limit the investments that a depository institution may make with insured funds, are from time to time introduced in Congress. The Corporation cannot determine the ultimate effect that any such potential legislation, if enacted, would have upon its financial condition or operations. Competition The Corporation and its subsidiaries continue to be subject to intense competition in all aspects and areas of their businesses from banks; other domestic and foreign financial institutions, such as savings and loan associations, savings banks, finance companies and credit unions; and other providers of financial services, such as money market funds, brokerage firms, investment companies, credit companies and insurance companies. The Corporation also competes with nonfinancial institutions, including retail stores and manufacturers of consumer products that maintain their own credit programs, as well as governmental agencies that make available loans to certain borrowers. Also, in the Service Products business sector, the Corporation competes with a wide range of technologically capable service providers. In terms of domestic deposits, Mellon Bank is the largest commercial banking institution in Pennsylvania where it competes with approximately 260 commercial banks, 140 thrifts and numerous credit unions and consumer finance institutions. Mellon Bank competes with approximately 30 commercial banks and 40 thrifts in the six-county Pittsburgh area of Western Pennsylvania. Mellon Bank competes with approximately 45 commercial banks and 50 thrifts in the five-county Philadelphia area, one of the largest metropolitan areas in the United States. In most of the markets in which the Corporation's banking subsidiaries operate, they compete with large regional and other banking organizations in making commercial, industrial and consumer loans, and in providing products and services. Competition has continued to increase in recent years in many areas in which the Corporation and its subsidiaries operate, in substantial part because other types of financial institutions and other entities are increasingly engaging in activities traditionally engaged in by commercial banks. Commercial banks face significant competition in acquiring quality assets due to such factors as the increase in commercial paper and long-term debt issued by industrial companies, increased activities by foreign banks and credit unions, and the increased lending powers granted to and Competition (continued) employed by many types of thrift institutions and credit unions. Commercial banks also face competition in attracting deposits at reasonable prices due to the activities of money market funds; increased activities of non-bank deposit takers, including brokerage firms; alternatives presented by foreign banks; and the increased availability of demand deposit type accounts at thrift institutions and credit unions. Unlike the Corporation, many of these competitors, with the particular exception of thrift institutions, are not subject to regulation as extensive as that described under the "Supervision and Regulation" section and, as a result, they may have a competitive advantage over the Corporation in certain respects. Employees The Corporation and its subsidiaries had approximately 21,400 full-time equivalent employees in December 1993. Statistical Disclosure by Bank Holding Companies I. Distribution of Assets, Liabilities and Stockholders' Equity; Interest Rates and Interest Differential Information required by this section of Securities Act Industry Guide 3, or Exchange Act Industry Guide 3, ("Guide 3") is presented in the Rate/Volume Variance Analysis on page 11. Required information is also presented in the Financial Section of the Corporation's 1993 Annual Report to Shareholders in the Consolidated Balance Sheet -- Average Balances and Interest Yields/Rates on pages 76 and 77, and in Net Interest Revenue, on page 22, which is incorporated herein by reference. Statistical Disclosure by Bank Holding Companies (continued) RATE/VOLUME VARIANCE ANALYSIS Note: Amounts are calculated on a taxable equivalent basis where applicable, at tax rates approximating 35% in 1993 and 34% in 1992 and 1991, and are before the effect of reserve requirements. Changes in interest revenue or interest expense arising from the combination of rate and volume variances are allocated proportionally to rate and volume based on their relative absolute magnitudes. Statistical Disclosure by Bank Holding Companies (continued) II. Securities Portfolio A. Book values of securities at year end are as follows: B. Maturity Distribution of Securities Information required by this section of Guide 3 is presented in the Financial Section of the Corporation's 1993 Annual Report to Shareholders in note 3 of Notes to Financial Statements on Securities on pages 50 through 52, which note is incorporated herein by reference. Statistical Disclosure by Bank Holding Companies (continued) III. Loan Portfolio A. Types of Loans Information required by this section of Guide 3 is presented in the Credit Risk and Asset Quality section of the Financial Section of the Corporation's 1993 Annual Report to Shareholders on pages 31 through 40 which portions are incorporated herein by reference. B. Maturities and Sensitivities of Loans to Changes in Interest Rates Maturity distribution of loans at December 31, 1993: Note: Maturity distributions are based on remaining contractual maturities. * Includes demand loans and loans with no stated maturity. ** Excludes consumer mortgages, other consumer credit and lease finance assets. Sensitivity of loans at December 31, 1993 to Changes in Interest Rates: Note: Maturity distributions are based on remaining contractual maturities. * Excludes consumer mortgages, other consumer credit and lease finance assets. ** Includes demand loans and loans with no stated maturity. C. Risk Elements Information required by this section of Guide 3 is presented in the Financial Section of the Corporation's 1993 Annual Report to Shareholders in the Credit Risk and Asset Quality section on pages 31 through 40, which portions are incorporated herein by reference. Statistical Disclosure by Bank Holding Companies (continued) IV. Summary of Loan Loss Experience The Corporation employs various estimation techniques in developing the credit loss reserve. Management reviews the specific circumstances of individual loans subject to more than the customary potential for exposure to loss. In establishing the level of the reserve, management also identifies market concentrations, changing business trends, industry risks and general economic conditions that may adversely affect loan collectibility. In addition, management assesses volatile factors such as interest rates and real estate market conditions that may significantly alter loss potential. Based on this evaluation, management believes that the credit loss reserve is adequate to absorb future losses inherent in the portfolio. The reserve is not specifically associated with individual loans or portfolio segments. Thus, the reserve is available to absorb credit losses arising from any individual loan or portfolio segment. When losses on specific loans are identified, management charges off the portion deemed uncollectible. In view of the fungible nature of the reserve and management's practice of charging off known losses, the Corporation does not maintain truly specific reserves on any loan. However, management has developed a loan loss reserve methodology designed to provide procedural discipline in assessing the adequacy of the reserve. The allocation of the Corporation's reserve for credit losses presented below is based on this loan loss reserve methodology. Further information on the Corporation's credit policies, the factors that influenced management's judgment in determining the level of the reserve for credit losses, and the analyses of the credit loss reserve for the years 1989-1993 are set forth in the Financial Section of the Corporation's 1993 Annual Report to Shareholders in the Credit Management section on page 31, the Reserve for Credit Losses and Review of Net Credit Losses section on pages 39 and 40, in note 1 of Notes to Financial Statements under Reserve for Credit Losses on page 48 and in note 5 on page 52; which portions are incorporated herein by reference. Statistical Disclosure by Bank Holding Companies (continued) IV. Summary of Loan Loss Experience (continued) For each category on the prior page, the ratio of loans to consolidated total loans is as follows: V. Deposits Maturity distribution of domestic time deposits at December 31, 1993 The majority of foreign deposits of approximately $1.2 billion at December 31, 1993 were in amounts in excess of $100,000. Additional information required by this section of Guide 3 is set forth in the Financial Section of the Corporation's 1993 Annual Report to Shareholders in Consolidated Balance Sheet -- Average Balances and Interest Yields/Rates on pages 76 and 77, which portions are incorporated herein by reference. Statistical Disclosure by Bank Holding Companies (continued) VI. Return on Equity and Assets (a) Computed on a daily average basis. (b) Computed using net income applicable to common stock after adding back Series D preferred stock dividends. (c) The Series A redeemable preferred stock was redeemed by the Corporation in July 1991. VII. Short-Term Borrowings Information required by this section of Guide 3 is contained in the Financial Section of the Corporation's 1993 Annual Report to Shareholders in the Consolidated Balance Sheet on page 44, and in note 9 of Notes to Financial Statements on Short-term borrowings on pages 53 and 54, which portions are incorporated herein by reference. ITEM 2.

ITEM 2. PROPERTIES Pittsburgh properties In 1983, Mellon Bank entered into a long-term lease of One Mellon Bank Center, a 54-story office building in Pittsburgh, Pennsylvania. At December 31, 1993, Mellon Bank occupied approximately 59% of the building's 1,525,000 square feet of rentable space and subleased substantially all of the remaining space to third parties. During 1984, Mellon Bank entered into a sale/leaseback arrangement of the Union Trust Building in Pittsburgh, Pennsylvania, also known as Two Mellon Bank Center, while retaining title to the land thereunder. At December 31, 1993, Mellon Bank occupied approximately 74% of this building's approximately 595,000 square feet of rentable space and subleased substantially all of the remaining space to third parties. Mellon Bank owns the 41-story office building in Pittsburgh, Pennsylvania, known as Three Mellon Bank Center. At December 31, 1993, Mellon Bank occupied approximately 96% of the approximately 943,000 square feet of rentable space, with the remainder leased to third parties. Philadelphia properties Mellon Bank owns a building known as One Mellon Bank Center located at the corner of Broad and Chestnut Streets in the Center City area of Philadelphia, Pennsylvania. At December 31, 1993, Mellon Bank occupied all of One Mellon Bank Center's approximately 63,700 square feet of rentable space. Mellon Bank also leases a large portion of a building in Philadelphia, Pennsylvania, known as Mellon Independence Center. At December 31, 1993, Mellon Bank leased approximately 74% of Mellon Independence Center's approximately 881,700 square feet of rentable space. Of the space leased by Mellon Bank, approximately 200,000 square feet was subleased to third parties at December 31, 1993. In 1987, Mellon Bank entered into a 25-year lease for a portion of a 53-story office building known as Mellon Bank Center, at the corner of 18th and Market Streets in the Center City area of Philadelphia, Pennsylvania. At December 31, 1993, Mellon Bank leased approximately 19% of the building's approximately 1,245,000 square feet of rentable space. Boston properties The Boston Company leases space in two downtown Boston office buildings: 41-story One Boston Place located at the corner of Court Street and Washington Street and 41-story Exchange Place located at 53 State Street. As of December 31, 1993, The Boston Company leased approximately 30% of One Boston Place's 769,150 square feet of rentable space and approximately 26% of Exchange Place's 1,063,750 square feet of rentable space. Of The Boston Company's leased space at Exchange Place, 141,900 square feet is subleased to third parties. The Boston Company also leases 82,900 square feet in the Park Square Building, 31 St. James Avenue, Boston. As of December 31, 1993, The Boston Company also occupies space in two office buildings in the Wellington Business Center located in Medford, MA, about two miles north of downtown Boston. The Boston Company owns a substantial interest in and fully occupies the 117,000 square foot building known as Client Services Center II. Across the street, The Boston Company leases 100% of the 319,600 square foot facility known as Client Services Center III. Approximately 40% of Client Services Center III is subleased to a third party. Other properties Mellon Bank owns and occupies 100% of an office building in State College, Pennsylvania, which serves as the headquarters for Mellon Bank-Central Region. Mellon Bank owns and occupies 100% of two small office buildings in Erie, Pennsylvania which serves as the headquarters of Mellon Bank-Northern Region. PROPERTIES (continued) Mellon Bank owns its five-story Mellon Bank-Commonwealth Region headquarters building, which includes a banking office in Harrisburg, Pennsylvania. Mellon Bank occupies approximately 80% of the approximately 75,000 square feet of rentable space in this building. Mellon Bank owns the Mellon Bank-Northeastern Region headquarters building in Wilkes-Barre, Pennsylvania. Mellon Bank occupies approximately 9% of this building's approximately 142,000 square feet, with the remainder leased to third parties. Mellon Bank (DE) owns a three-story office building known as the Pike Creek Building in New Castle County, Delaware, and currently occupies the building's entire 84,000 square feet of available floor space. Mellon Bank (DE) also leases approximately 16%, or 34,000 square feet, of an 18-story office building in Wilmington, Delaware. Mellon Bank (MD) leases approximately 40% of an office building in Rockville, Maryland, which is used for its headquarters. The banking subsidiaries' branches are located in 33 counties in western, northwestern, central, northeastern and eastern Pennsylvania, all three of Delaware's counties, four Maryland counties in the northern suburbs of Washington, D.C. and a single retail branch in Boston, Massachusetts. At December 31, 1993, the banking subsidiaries of the Corporation owned 215 of the Corporation's 432 bank branch buildings and leased the remainder with leases expiring at various times through 2020. Other subsidiaries of the Corporation lease office space primarily for their operations at many of the locations listed on pages 78 through 80 of the Principal Locations and Operating Entities Section of the Corporation's 1993 Annual Report, which pages are incorporated herein by reference. For additional information on the Corporation's premises and equipment, see note 6 of Notes to Financial Statements on page 52 of the Corporation's 1993 Annual Report, which note is incorporated herein by reference. ITEM 3.

ITEM 3. LEGAL PROCEEDINGS Various legal actions and proceedings are pending or are threatened against the Corporation and its subsidiaries, some of which seek relief or damages in amounts that are substantial. These actions and proceedings arise in the ordinary course of the Corporation's businesses and include suits relating to its lending, collections, servicing, investments and trust activities. Due to the complex nature of some of these actions and proceedings, it may be a number of years before such matters ultimately are resolved. After consultation with legal counsel, management believes that the aggregate liability, if any, resulting from such pending and threatened actions and proceedings will not have a material adverse effect on the Corporation's financial condition. On February 12, 1991, a jury in Colorado rendered a verdict in a lender liability lawsuit in which the Corporation is one of the defendants. The jury awarded actual damages of $42 million and punitive damages of $23 million in favor of the plaintiffs. In the lawsuit, the plaintiffs contended that the Corporation breached certain obligations and failed to disclose certain information in connection with its lending relationships with the plaintiffs. On June 6, 1991, a district judge in Colorado entered a judgment reducing the award to $16 million in actual damages, plus interest, and $12 million in punitive damages. On January 27, 1994, the Colorado Court of Appeals affirmed the judgment for plaintiffs for compensatory damages in the reduced amount of $5.36 million, plus interest since November 1, 1989, and vacated the judgment for punitive damages and remanded to the trial court with the direction to reconsider the amount, if any, of punitive damages. By Colorado law, the amount of punitive damages cannot exceed the amount of the compensatory damages. The Corporation intends to petition the Colorado Court of Appeals for rehearing and it is possible that the other parties may also appeal. Because of the uncertainty as to the ultimate resolution, no provision has been made in the financial statements for this matter. On August 7, 1992, a judge in the United States District Court for the Eastern District of Pennsylvania entered a judgment ordering Mellon Bank to reimburse certain of its trust customers the amount of sweep fees which were charged Legal Proceedings (continued) to their trust accounts since 1981, plus interest. In this class-action proceeding, the plaintiffs claimed that Mellon Bank, and other banks, breached their fiduciary duties with regard to the provision of sweep services, alleging that the banks charged unreasonable fees, failed to disclose fully their fees for sweep services and wrongfully invested sweep funds in internal or affiliated accounts or investment vehicles. The court found that the total amount of sweep fees collected by Mellon Bank since 1981 for both fiduciary and non-fiduciary accounts was approximately $55 million. On May 18, 1993, the Third Circuit Court of Appeals vacated the judgment entered by the district court and remanded the case for dismissal. On June 18, 1993, the Third Circuit Court of Appeals denied plaintiff's Petition for Rehearing. The district court ordered the case dismissed on July 6, 1993. On September 13, 1993, the plaintiffs petitioned the United States Supreme Court for a writ of certiorari, and on November 8, 1993, the Supreme Court denied this petition. On July 28, 1993, a second lawsuit arising out of Mellon Bank's sweep fees practices was filed with the United States District Court for the Eastern District of Pennsylvania against Mellon Bank and its directors. On August 30, 1993, a third lawsuit, similar to the second, was filed in the same court and was consolidated with the second. On December 16, 1993, these suits also were dismissed. Plaintiffs initially appealed this dismissal but the appeals have been withdrawn. On September 10, 1993, the Corporation filed complaints in the United States District Court for the Western District of Pennsylvania against four financial services companies. The complaints involved claims arising from the breach of the contract under which the Corporation purchased The Boston Company, as well as violations of other obligations to the Corporation. The claims related to administration services the Corporation provides to a family of mutual funds then known as the Smith Barney Shearson Funds. The defendant companies were: Smith Barney, Harris Upham & Co. Incorporated (Smith Barney); its parent organization, Primerica Corporation (now The Travelers Inc.); Lehman Brothers Inc. (formerly Shearson Lehman Brothers); and its parent organization, American Express Company. The Corporation's mutual funds administration services are provided through The Boston Company. In its complaint against Smith Barney and Primerica (which purchased Shearson's mutual fund and brokerage businesses in 1993), the Corporation asserted that, despite expressly agreeing that they were bound by, and would comply with, the terms and provisions of the contract between Shearson and the Corporation, Smith Barney and Primerica violated that contract. The Corporation sought money damages against each of the defendants and further sought a court order requiring that Smith Barney and Primerica cease their unlawful conduct and honor the contract between the Corporation and Shearson. A hearing was held in November 1993. As a result, the Corporation was granted injunctive relief preventing Smith Barney, for a period of seven years, from competing with Mellon in providing administration services to funds in the Smith Barney Shearson family, other than Smith Barney funds that existed prior to Smith Barney's March 12, 1993, agreement to purchase Shearson Lehman Brothers' mutual fund and brokerage businesses. The injunction covered all new funds created or underwritten by Smith Barney, however named, after March 12, 1993, and obligated Smith Barney to recommend Mellon as the provider of administration services. Effective January 1, 1994, Mellon and Smith Barney Shearson Inc. settled their litigation. Under the terms of the settlement agreement, which will remain in effect through May 2000, the companies will work together to provide administration services to certain funds affiliated with Smith Barney. Smith Barney will seek to be appointed administrator for certain of its affiliated funds, in addition to its current roles as investment advisor and distributor. Smith Barney would, in turn, enter into sub-administration agreements with Mellon for certain administration services. Incorporated in the settlement agreement are certain Smith Barney Shearson funds that existed prior to Smith Barney's March 12, 1993, agreement to purchase Shearson Lehman Brothers' mutual fund and brokerage businesses, as well as certain Smith Barney Shearson sponsored funds covered by the above injunction. In connection with such settlement, actions against all defendants were dismissed. Subsequent to the announcement of the proposed merger with Dreyfus described in Item 1 above, plaintiffs who claim to be shareholders of Dreyfus commenced six purported class action suits in the Supreme Court of the State of New York, Legal Proceedings (continued) County of New York, naming Dreyfus, the individual directors of Dreyfus and (in two of the cases) the Corporation as defendants. In these complaints, the plaintiffs, among other things, object to the terms of the proposed merger and seek injunctive relief against its consummation, as well as compensatory and punitive damages. The Corporation believes that these complaints lack merit and intends to defend them vigorously. ITEM 4.

ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS No matters were submitted to security holders for vote during the fourth quarter of 1993. EXECUTIVE OFFICERS OF THE REGISTRANT The name and age of, and the positions and offices held by, each executive officer of the Corporation as of December 31, 1993, together with the offices held by each such person during the last five years, are listed below. Certain of the executive officers have executed employment contracts with the Corporation. All other executive officers serve at the pleasure of their appointing authority. No executive officer has a family relationship to any other listed executive officer. (continued) Executive Officers of the Registrant (continued) (1) From June 1987 to January 1990, Mr. Cahouet was Chairman and Chief Executive Officer of the Corporation and of Mellon Bank. In January 1990, he assumed the additional title of President. Mr. Cahouet has executed an employment contract with the Corporation which terminates May 31, 1997. (2) From August 1987 to January 1990, Mr. Elliott was Executive Vice President and head of the Finance Department of Mellon Bank. From February 1988 to January 1990, Mr. Elliott was Assistant Treasurer of Mellon Bank Corporation. From January 1990 to June 1992, Mr. Elliott was Executive Vice President, Chief Financial Officer and Treasurer of the Corporation and Executive Vice President and Chief Financial Officer of Mellon Bank. (3) From July 1985 to January 1990, Mr. Gaugh was Executive Vice President and head of Retail Banking of Mellon Bank. From January 1990 to November 1993, Mr. Gaugh was Vice Chairman, Retail Bank of the Corporation and of Mellon Bank. (4) From February 1988 to January 1990, Mr. McGuinn was General Counsel and Secretary of the Corporation and General Counsel of Mellon Bank. From January 1990 to October 1990, he assumed the additional title of Vice Chairman, Administration of the Corporation and of Mellon Bank. From November 1990 to October 1992, Mr. McGuinn was Vice Chairman, Real Estate Finance, General Counsel and Secretary of the Corporation and Vice Chairman, Real Estate Finance and General Counsel of Mellon Bank. From October 1992 to November 1993, Mr. McGuinn was Vice Chairman, Special Banking Services of the Corporation and of Mellon Bank. (5) From June 1988 to January 1990, Mr. Morby was a special consultant to the Chairman and to the President of Mellon Bank. (6) From 1983 to August 1991, Mr. Russell was President and Chief Operating Officer of GLENFED/Glendale Federal Bank. From September 1991 to November 1991, Mr. Russell was Executive Vice President, Information Management and Research, Technology Products and Mortgage Banking of Mellon Bank. From November 1991 to June 1992, Mr. Russell was Executive Vice President, Credit Policy of the Corporation and of Mellon Bank. (7) From July 1987 to January 1990, Mr. Smith was Vice Chairman, Chief Financial Officer and Treasurer of the Corporation and Vice Chairman and Chief Financial Officer of Mellon Bank. From January 1990 to November 1993, Mr. Smith was Vice Chairman, Service Products of the Corporation and of Mellon Bank. Mr. Smith has executed an employment contract with the Corporation which terminates on July 31, 1996. (8) From 1986 to 1990, Mr. Hughey was Senior Vice President and Director of Taxes of Mellon Bank. PART II ITEM 5.

ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS The information required by this Item is set forth in the Financial Section of the Corporation's 1993 Annual Report to Shareholders in Liquidity and Dividends on pages 28 and 29, in Selected Quarterly Data on page 42, in note 16 of Notes to Financial Statements on page 62 and in Corporate Information on page 84, which portions are incorporated herein by reference. In August 1989, the Corporation adopted a Shareholder Protection Rights Plan under which each shareholder receives one Right for each share of common stock or Series D Junior Preferred Stock of the Corporation (together, the "voting stock") held. The Rights are currently represented by the certificates for, and trade only with, the voting stock. The Rights would separate from the voting stock and become exercisable only if a person or group acquires 20 percent or more of the voting power of the voting stock or ten days after a person or group commences a tender offer that would result in ownership of 20 percent or more of such voting power. At that time, each Right would entitle the holder to purchase for $200 (the "exercise price") one one-hundredth of a share of participating preferred stock. Each share of such preferred stock would be entitled to cumulative dividends equal to 1 percent per annum, plus the amount of dividends that would be payable on 100 shares of the Corporation's common stock, and would have a liquidation preference of the greater of 100 times the exercise price or the amount to be distributed in liquidation to a holder of 100 shares of the Corporation's common stock. Should a person or group actually acquire 20 percent or more of the voting power of the voting stock, each Right held by the acquiring person or group (or their transferees) would become void and each Right held by the Corporation's other shareholders would entitle those holders to purchase for the exercise price a number of shares of the Corporation's common stock having a market value of twice the exercise price. Should the Corporation be involved in a merger or similar transaction with a 20 percent owner or sell more than 50 percent of its assets or assets generating more than 50 percent of its operating income or cash flow to any person or group, each outstanding Right would then entitle its holder to purchase for the exercise price a number of shares of such other company having a market value of twice the exercise price. In addition, if any person or group acquires between 20 percent and 50 percent of the voting power of the voting stock, the Corporation may, at its option, exchange one share of common stock for each outstanding Right. The Rights are not exercisable until the above events occur and will expire on August 15, 1999 unless earlier exchanged or redeemed by the Corporation. The Corporation may redeem the Rights for $.01 per Right under certain circumstances. The distribution of the Rights was not a taxable event. Common shares outstanding or issuable at December 31, 1993 ITEM 6.

ITEM 6. SELECTED FINANCIAL DATA The information required by this Item is set forth in the Corporation's 1993 Annual Report to Shareholders in the Financial Summary on page 17, in the Overview of 1993 results on pages 18 and 19, in the Significant events in 1993 on ITEM 6. SELECTED FINANCIAL DATA (continued) page 19, in note 1 of Notes to Financial Statements on pages 47 through 49, and in the Consolidated Balance Sheet -- Average Balances and Interest Yields/Rates on pages 76 and 77, which portions are incorporated herein by reference. ITEM 7.

ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The information required by this Item is set forth in the Corporation's 1993 Annual Report to Shareholders in the Financial Review on pages 17 through 42 and in note 16 of Notes to Financial Statements on page 62, which portions are incorporated herein by reference. ITEM 8.

ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA Reference is made to Item 14 on page 25 hereof for a detailed listing of the items under Financial Statements, Financial Statement Schedules, and Other Financial Data which are incorporated herein by reference. ITEM 9.

ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE NONE. PART III ITEM 10.

ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT The information required by this Item pertaining to directors of the Corporation is included in the Corporation's proxy statement for its 1994 Annual Meeting of Shareholders (the "1994 Proxy Statement") in the Election of Directors-Biographical Summaries of Nominees section on pages 3 through 5, and is incorporated herein by reference. The information required by this Item pertaining to executive officers of the Corporation has been included in Part I of this Form 10-K under the heading "Executive Officers of the Registrant." ITEM 11.

ITEM 11. EXECUTIVE COMPENSATION The information required by this Item is included in the 1994 Proxy Statement in the Directors' Compensation section on pages 7 and 8 and in the Executive Compensation section on pages 13 through 21, and is incorporated herein by reference. ITEM 12.

ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT The information required by this Item is included in the 1994 Proxy Statement in the Beneficial Ownership of Stock section on pages 10 through 12, and is incorporated herein by reference. ITEM 13.

ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS The information required by this Item is included in the 1994 Proxy Statement in the Business Relationships; Related Transactions and Certain Legal Proceedings section on pages 8 and 9, and is incorporated herein by reference. PART IV ITEM 14.

ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K (a) The financial statements and schedules required for the Annual Report of the Corporation on Form 10-K are included, attached or incorporated by reference as indicated in the following index. Page numbers below refer to pages of the Financial Section of the Corporation's 1993 Annual Report to Shareholders: (b) Current Reports on Form 8-K during the fourth quarter of 1993: A report dated October 12, 1993, which included the Corporation's press release regarding third quarter and year-to-date 1993 financial results. A report dated October 19, 1993, which included the Corporation's press release announcing the redemption of the Corporation's Series B Preferred Stock and 8.6% Debentures Due 2009. Also included in this filing was a second press release announcing the Corporation's expectation to repurchase up to 1 million shares of its common stock. A report dated November 16, 1993, which included the Corporation's press release announcing the increase in the Corporation's common stock dividend and the elimination of the discount offered on purchases made under the Corporation's Dividend Reinvestment and Common Stock Purchase Plan. A report dated December 1, 1993, which included the Corporation's press release announcing that an injunction had been granted to the Corporation against Smith Barney Shearson Inc. in its mutual fund administration case. Also included in this filing was a second press release announcing that the Corporation completed the sale of two of its outsourcing businesses to FIserv, Inc. A report dated December 2, 1993, which included a joint press release of the Corporation and Electronic Payment Services, Inc. (EPS) announcing that the Corporation intends to become an equity partner in EPS. A report dated December 6, 1993, which included a joint press release of the Corporation and The Dreyfus Corporation announcing the definitive agreement to merge the two entities. (c) Exhibits The exhibits listed on the Index to Exhibits on pages 27 through 31 hereof are incorporated by reference or filed herewith in response to this item. SIGNATURE Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Corporation has duly caused this Annual Report to be signed on its behalf by the undersigned, thereunto duly authorized. Mellon Bank Corporation By: /s/ Frank V. Cahouet -------------------------- Frank V. Cahouet Chairman, President and Chief Executive Officer DATED: March 23, 1994 Pursuant to the requirements of the Securities Exchange Act of 1934, this Annual Report has been signed below by the following persons on behalf of the Corporation and in the capacities and on the dates indicated: Index to Exhibits Index to Exhibits (continued) * Management contract or compensatory plan arrangement. Index to Exhibits (continued) * Management contract or compensatory plan arrangement. Index to Exhibits (continued) Index to Exhibits (continued) The documents identified below, which define the rights of holders of long-term debt of the Corporation, are not filed herewith as the total amount of securities authorized under each of them does not exceed 10% of the total assets of the Corporation and its subsidiaries on a consolidated basis. The Corporation hereby agrees to furnish a copy of such documents to the Securities and Exchange Commission upon request. 1 Indenture dated as of September 10, 1987, between the Corporation and Bank of New York, as Trustee, relating to 7-1/4% Convertible Subordinated Capital Notes Due 1999. 2 Indenture dated as of May 2, 1988, as supplemented by the First Supplemental Indenture dated as of November 29, 1990, among Mellon Financial Company, the Corporation and The Chase Manhattan Bank (National Association), as Trustee, providing for the issuance of debt securities in series from time to time. 3 Fiscal Agency Agreement dated as of July 14, 1989, between the Corporation, as Issuer, and Chemical Bank, as Fiscal Agent, relating to U.S. $200,000,000 Floating Rate Notes Due July 1994. 4 Indenture dated as of April 15, 1991, as supplemented by the First Supplemental Indenture dated as of November 24, 1992, among Mellon Financial Company, the Corporation and Continental Bank, National Association, providing for the issuance of subordinated debt securities in series from time to time. 5 Fiscal and Paying Agency Agreement dated as of May 17, 1993, between Mellon Bank, N.A. as Issuer, and The Chase Manhattan Bank (National Association), as Fiscal and Paying Agent relating to 6-1/2% Subordinated Notes due August 1, 2005 and 6-3/4% Subordinated Notes due June 1, 2003.

75527_1993.txt

75527

1993

ITEM 1. BUSINESS PACIFIC ENTERPRISES Pacific Enterprises is a Los Angeles-based utility holding company primarily engaged in supplying natural gas throughout most of Southern and portions of Central California. These operations are conducted through Southern California Gas Company, the nation's largest natural gas distribution utility, serving 4.7 million meters and 535 communities throughout a 23,000-square mile service territory with a population of approximately 16 million. Through other subsidiaries, Pacific Enterprises is also engaged in interstate and offshore natural gas transmission and in alternate energy development. STRATEGIC PLAN AND RECENT RESTRUCTURING Pacific Enterprises returned to profitability in 1993 and resumed dividends on its Common Stock. This was accomplished through the completion of a strategic restructuring and the continued strong performance of gas utility operations conducted through Southern California Gas Company, which has achieved or exceeded its authorized rate of return on rate base for the last 11 consecutive years. The restructuring was part of a new strategic plan to refocus on natural gas utility operations. It was adopted in 1992 in response to increasingly unsatisfactory financial performance and shareholder returns attributable to non-utility operations. Non-utility operations had been greatly expanded in 1986 with the initial acquisition of retailing operations and, to a lesser extent, again in 1988 with additional acquisitions in retailing and in oil and gas exploration and production. The profitability of gas utility operations could not offset declines in non-utility operations and earnings per share increasingly declined beginning in 1988 and substantial and increasing losses were incurred beginning in 1990. As a result, non-utility related indebtedness increased substantially and dividends on Common Stock were reduced in 1991 and suspended in 1992. During 1992 and early 1993, retailing and oil and gas exploration and production operations were sold with the sale proceeds applied to reduce non-utility related debt and the remaining debt was refinanced. Corporate staff and other expenses also were reduced. In addition, a quasi-reorganization for financial reporting purposes was effected on December 31, 1992 restating assets and liabilities to their fair value and eliminating an accumulated deficit in retained earnings. In mid-1993, Pacific Enterprises completed a public offering of 8 million shares of its Common Stock and applied a portion of the proceeds of the offering to the repayment of substantially all remaining non-utility debt. Cash dividends on Common Stock were then resumed at an initial annual rate of $1.20 per share. The restructuring was completed later in 1993 by establishing common membership for the Boards of Directors of Pacific Enterprises and Southern California Gas Company and electing several officers in common between the two companies. These include Willis B. Wood, Jr., Chairman and Chief Executive Officer of Pacific Enterprises, who was elected as Presiding Director of Southern California Gas Company and Richard D. Farman, Chief Executive Officer of Southern California Gas Company, who was elected as President of Pacific Enterprises. ------------------------------ Pacific Enterprises was incorporated in California in 1907 as the successor to a corporation organized in 1886. Its principal executive offices are located at 633 West Fifth Street, Los Angeles, California 90071-2006 and its telephone number is (213) 895-5000. SOUTHERN CALIFORNIA GAS COMPANY Pacific Enterprises' principal subsidiary is Southern California Gas Company ("SoCalGas"), a public utility owning and operating a natural gas transmission, storage and distribution system that supplies natural gas in 535 cities and communities throughout most of Southern California and parts of Central California. SoCalGas is the nation's largest natural gas distribution utility, providing gas service to approximately 16 million residential, commercial, industrial, utility electric generation and wholesale customers through approximately 4.7 million meters in a 23,000-square mile service area. SoCalGas is subject to regulation by the California Public Utilities Commission (CPUC) which, among other things, establishes rates SoCalGas may charge for gas service, including an authorized rate of return on investment. SoCalGas' future earnings and cash flow will be determined primarily by the allowed rate of return on common equity, growth in rate base, noncore pricing and the variance in gas volumes delivered to these noncore customers versus CPUC-adopted forecast deliveries, the recovery of gas and contract restructuring costs if the Comprehensive Settlement (see "Recent Developments - Comprehensive Settlement of Regulatory Issues") is not approved and the ability of management to control expenses and investment in line with the amounts authorized by the CPUC to be collected in rates. Also, SoCalGas' ability to earn revenues in excess of its authorized return from noncore customers due to volume increases will be substantially eliminated for the five years of the Comprehensive Settlement referenced above. This is because forecasted deliveries in excess of the 1991 throughput levels used to establish rates were contemplated in estimating the costs of the Comprehensive Settlement, and are reflected in current year liabilities. In addition, the impact of any future regulatory restructuring and increased competitiveness in the industry, including the continuing threat of customers bypassing SoCalGas' system and obtaining service directly from interstate pipelines, can affect SoCalGas' performance. For 1994, the CPUC has authorized SoCalGas to earn a rate of return on rate base of 9.22 percent and a 11.00 percent rate of return on common equity compared to 9.99 percent and 11.90 percent, respectively, in 1993. Growth in rate base for 1993 was approximately 1.8 percent and rate base is expected to increase by approximately 4 percent to 5 percent in 1994. SoCalGas has achieved or exceeded its authorized return on rate base for the last eleven consecutive years and its authorized rate of return on equity for the last nine consecutive years. RECENT DEVELOPMENTS REGULATORY ACTIVITY On December 17, 1993, the CPUC issued its decision in SoCalGas' 1994 general rate case which authorized a net $97 million rate reduction. SoCalGas plans to adjust its operations with the intention of operating within the amounts authorized in rates. Approximately $21 million of the rate reduction represents productivity improvements. Other items include non-operational issues, primarily reductions in marketing programs and income tax effects of the rate reduction. The decision also includes the effects of the reduction of SoCalGas' rate of return authorized in its 1994 cost of capital proceeding, which increased the total reduction in rates to $132 million. New rates emanating from the CPUC decision became effective January 1, 1994. RESTRUCTURING OF GAS SUPPLY CONTRACTS SoCalGas and the Company's gas supply subsidiaries have reached agreements with suppliers of California offshore and Canadian gas for a restructuring of long-term gas supply contracts. The cost of these supplies to SoCalGas has been substantially in excess of its average delivered cost of gas. During 1993, these excess costs totaled approximately $125 million. The new agreements substantially reduce the ongoing delivered costs of these gas supplies and provide lump sum settlement payments of $375 million to the suppliers. The expiration date for the Canadian gas supply contract has been shortened from 2012 to 2003, and the supplier of California offshore gas continues to have an option to purchase related gas treatment and pipeline facilities owned by the Company's gas supply subsidiary. The agreement with the suppliers of Canadian gas is subject to certain Canadian regulatory and other approvals. COMPREHENSIVE SETTLEMENT OF REGULATORY ISSUES SoCalGas and a number of interested parties, including the Division of Ratepayer Advocates ("DRA") of the CPUC, large noncore customers and ratepayer groups, have filed for CPUC approval a comprehensive settlement (the "Comprehensive Settlement") of a number of pending regulatory issues including partial rate recovery of restructuring costs associated with the gas supply contracts discussed above. The Comprehensive Settlement, if approved by the CPUC, would permit SoCalGas to recover in utility rates approximately 80 percent of its contract restructuring costs of $375 million and accelerated depreciation of related pipeline assets of its gas supply affiliates of approximately $130 million, together with interest, over a period of approximately five years. SoCalGas has filed a financing application with the CPUC primarily for the borrowing of $425 million to provide for funds needed under the Comprehensive Settlement. See "Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations - Comprehensive Settlement of Regulatory Issues" for a discussion of the regulatory issues, in addition to the gas supply issues, addressed in the Comprehensive Settlement. OPERATING STATISTICS The following table sets forth certain operating statistics of SoCalGas from 1989 through 1993. OPERATING STATISTICS - 11 - SERVICE AREA SoCalGas distributes natural gas throughout a 23,000 - square mile service territory with a population of approximately 16 million people. As indicated by the following map, its service territory includes most of Southern California and portions of Central California. [MAP] Natural gas service is also provided on a wholesale basis to the distribution systems of the City of Long Beach, San Diego Gas & Electric Company and Southwest Gas Company. - 12 - UTILITY SERVICES SoCalGas' customers are divided, for regulatory purposes, into core and noncore customers. Core customers are primarily residential and small commercial and industrial customers, without alternative fuel capability. Noncore customers are primarily electric utilities, wholesale and large commercial and industrial customers, with alternative fuel capability. SoCalGas offers two basic utility services, sale of gas and transmission of gas. Residential customers and most other core customers purchase gas directly from SoCalGas. Noncore customers and large core customers have the option of purchasing gas either from SoCalGas or from other sources (such as brokers or producers) for delivery through SoCalGas' transmission and distribution system. Smaller customers are permitted to aggregate their gas requirements and also to purchase gas directly from brokers or producers, up to a limit of 10 percent of SoCalGas' core market. SoCalGas generally earns the same contribution to earnings whether a particular customer purchases gas from SoCalGas or utilizes SoCalGas' system for transportation of gas purchased from others. (See "Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations - Ratemaking Procedures.") SoCalGas continues to be obligated to purchase reliable supplies of natural gas to serve the requirements of its core customers. However, the only gas supplies that SoCalGas may offer for sale to noncore customers are the same supplies that it purchases to serve its core customers. Noncore customers that elect to purchase gas supplies from SoCalGas must for a two-year period agree to take-or-pay for 75 percent of the gas that they contract to purchase. SoCalGas also provides a gas storage service for noncore customers on a bid basis. The storage service program provides opportunities for customers to store gas on an "as available" basis during the summer to reduce winter purchases when gas costs are generally higher, or to reduce their level of winter curtailment in the event temperatures are unusually cold. During 1993, SoCalGas stored approximately 24 billion cubic feet of customer-owned gas. - 13 - DEMAND FOR GAS Natural gas is a principal energy source in SoCalGas' service area for residential, commercial and industrial uses as well as utility electric generation (UEG) requirements. Gas competes with electricity for residential and commercial cooking, water heating and space heating uses, and with other fuels for large industrial, commercial and UEG uses. Demand for natural gas in Southern California is expected to continue to increase but at a slower rate due primarily to a slowdown in housing starts, new energy efficient building construction and appliance standards and general recessionary business conditions. During 1993, 97 percent of residential energy customers in SoCalGas' service territory used natural gas for water heating and 94 percent for space heating. Approximately 78 percent of those customers used natural gas for cooking and over 72 percent for clothes drying. Demand for natural gas by large industrial and UEG customers is very sensitive to the price of alternative competitive fuels. These customers number only approximately 1,000; however, during 1993, accounted for approximately 19 percent of total revenues, 65 percent of total gas volumes delivered and 15 percent of the authorized gas margin. Changes in the cost of gas or alternative fuels, primarily fuel oil, can result in significant shifts in this market, subject to air quality regulations. Demand for gas for UEG use is also affected by the price and availability of electric power generated in other areas and purchased by SoCalGas' UEG customers. Since the completion of the Kern River/Mojave Interstate Pipeline (Mojave) in February 1992, SoCalGas' throughput to customers in the Kern County area who use natural gas to produce steam for enhanced oil recovery projects has decreased significantly because of the bypass of SoCalGas' system. Mojave now delivers to customers formerly served by SoCalGas 350 to 400 million cubic feet of gas per day. The decrease in revenues from enhanced oil recovery customers is subject to full balancing account treatment, except for a five percent incentive to SoCalGas for attaining certain throughput levels, and therefore, does not have a material impact on earnings. However, bypass of other Company markets also may occur as a result of plans by Mojave to extend its pipeline north to Sacramento through portions of SoCalGas' service territory. The effect of bypass is to increase SoCalGas' rates to other customers and thus make its natural gas service less competitive with that of competing pipelines and available alternate fuels. - 14 - In response to bypass, SoCalGas has received authorization from the CPUC for expedited review of price discounts proposed for long-term gas transportation contracts with some noncore customers. In addition, in December 1992, the CPUC approved changes in the methodology for allocating SoCalGas' costs between core and noncore customers to reduce the subsidization of core customer rates by noncore customers. Effective in June 1993, these new rate changes implemented the CPUC's policy known as "long-run marginal cost." The revised methodologies have resulted in a reduction of noncore rates and a corresponding increase in core rates that better reflect the cost of serving each customer class and, together with price discounting authority, has enabled SoCalGas to better compete with interstate pipelines for noncore customers. In addition, in August 1993 a capacity brokering program was implemented. Under the program, for a fee, SoCalGas provides to noncore customers, or others, a portion of its control of interstate pipeline capacity to allow more direct access to producers. Also, the Comprehensive Settlement (see "Recent Developments - Comprehensive Settlement of Regulatory Issues") will help SoCalGas' competitiveness by reducing the cost of transportation service to noncore customers. SUPPLIES OF GAS In 1993, SoCalGas delivered slightly less than 1 trillion cubic feet of natural gas through its system. Approximately 64 percent of these deliveries were customer-owned gas for which SoCalGas provided transportation services, compared to 65 percent in 1992. The balance of gas deliveries was gas purchased by SoCalGas and resold to customers. Most of the natural gas delivered by SoCalGas is produced outside of California. These supplies are delivered to the California border by interstate pipeline companies (primarily El Paso Natural Gas Company and Transwestern Natural Gas Company) that produce or purchase the supplies or provide transportation services for supplies purchased from other sources by SoCalGas or its transportation customers. These supplies enter SoCalGas' intrastate transmission system at the California border for delivery to customers. SoCalGas currently has paramount rights to daily deliveries of up to 2,200 million cubic feet of natural gas over the interstate pipeline systems of El Paso Natural Gas Company (up to 1,450 million cubic feet) and Transwestern Pipeline Company (up to 750 million cubic feet). The rates that interstate pipeline companies may charge for gas and transportation services and other terms of service are regulated by the Federal Energy Regulatory Commission (FERC). - 15 - The following table sets forth the sources of gas deliveries by SoCalGas from 1989 through 1993. - 16 - SOUTHERN CALIFORNIA GAS COMPANY SOURCES OF GAS Market sensitive gas supplies (supplies purchased on the spot market as well as under longer-term contracts and ranging from one month to ten years based on spot prices) accounted for approximately 66 percent of total gas volumes purchased by SoCalGas during 1993, as compared with 61 percent and 69 percent, respectively, during 1992 and 1991. These supplies were generally purchased at prices significantly below those for other long-term sources of supply. See "Item 7. "Management's Discussion and Analysis of Financial Condition and Results of Operations - Comprehensive Settlement of Regulatory Issues" for a discussion of the contemplated gas cost incentive mechanism. On March 16, 1994, the CPUC issued its decision approving the gas cost incentive mechanism for implementation for a three year trial period beginning April 1, 1994. SoCalGas estimates that sufficient natural gas supplies will be available to meet the requirements of its customers into the next century. Because of the many variables upon which estimates of future service are based, however, actual levels of service may vary significantly from estimated levels. RATES AND REGULATION SoCalGas is regulated by the CPUC. The CPUC consists of five commissioners appointed by the Governor of California for staggered six-year terms. It is the responsibility of the CPUC to determine that utilities operate in the best interest of the ratepayer with a reasonable profit. The regulatory structure is complex and has a very substantial impact on the profitability of SoCalGas. The return that SoCalGas is authorized to earn is the product of the authorized rate of return on rate base and the amount of rate base. Rate base consists primarily of net investment in utility plant. Thus, SoCalGas' earnings are affected by changes in the authorized rate of return on rate base and the growth in rate base and by SoCalGas' ability to control expenses and investment in rate base within the amounts authorized by the CPUC in setting rates. SoCalGas' ability to achieve its authorized rate of return is affected by other regulatory and operating factors. See "Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations - Ratemaking Procedures." SoCalGas' operating and fixed costs, including return on rate base, are allocated between core and noncore customers under a methodology that is based upon the costs incurred in serving these customer classes. For 1994, approximately 87 percent of the CPUC-authorized gas margin has been allocated to core customers and 13 percent to noncore customers, including wholesale customers. Under the current regulatory framework, costs may be reallocated between the core and the noncore markets once every other year in a biennial cost allocation proceeding (BCAP). PROPERTIES At December 31, 1993, SoCalGas owned approximately 3,280 miles of transmission and storage pipeline, 42,250 miles of distribution pipeline and 42,406 miles of service piping. It also owned twelve transmission compressor stations and six underground storage reservoirs (with a combined working storage capacity of approximately 116 billion cubic feet) and general office buildings, shops, service facilities, and certain other equipment necessary in the conduct of its business. Southern California Gas Tower, a wholly owned subsidiary of SoCalGas, has a 15% limited partnership interest in a 52-story office building in downtown Los Angeles. SoCalGas occupies about half of the building. See also "Item 2.

ITEM 2. PROPERTIES Pacific Library Tower, a wholly-owned subsidiary of Pacific Enterprises, has a 25% ownership interest in a 72-story office building in downtown Los Angeles that was completed in late 1990. Pacific Enterprises and its subsidiaries occupy twelve floors of the building. Information with respect to the properties of other Pacific Enterprises' subsidiaries is set forth in Item 1 of this Annual Report. ITEM 3.

ITEM 3. LEGAL PROCEEDINGS Except for the matters referred to in the financial statements filed with or incorporated by reference in Item 8 or referred to elsewhere in this Annual Report, neither Pacific Enterprises nor any of its subsidiaries is a party to, nor is their property the subject of, any material pending legal proceedings other than routine litigation incidental to its businesses. Pacific Enterprises and certain of its directors and former directors are defendants in seven shareholder actions. Three of the actions are substantially identical shareholder derivative actions in which Pacific Enterprises is named only as a nominal defendant. The derivative actions seek recovery from the defendant directors on behalf of Pacific Enterprises for damages asserted to have been suffered by Pacific Enterprises by alleged breaches of fiduciary duties by the directors in connection with Pacific Enterprises' diversification program. The remaining four actions are shareholder class actions filed on behalf of shareholders who purchased shares of Pacific Enterprises between June 5, 1990 and February 4, 1992 and seek recovery from Pacific Enterprises and the defendant directors for damages asserted to have been suffered as a result of allegedly improper disclosures under the federal securities laws. In January 1994, Pacific Enterprises announced an agreement had been reached to settle the shareholder lawsuits which were originally filed in February 1992. The settlement, which is subject to court approval, totals $45 million. The settlement and related legal costs, after giving effect to amounts paid by other parties, had been fully provided in liabilities established in prior years. Pacific Enterprises is a defendant in various lawsuits arising in the normal course of business; however, management believes that the resolution of these pending claims and legal proceedings will not have a material adverse effect on Pacific Enterprises' financial statements. ITEM 4.

ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS No matters were submitted during the fourth quarter of 1993 to a vote of Pacific Enterprises' security holders. PART II ITEM 5.

ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS Pacific Enterprises' Common Stock is traded on the New York and Pacific Stock Exchanges. Information as to the high and low sales prices for such stock as reported on the composite tape for stocks listed on the New York Stock Exchange and dividends paid for each quarterly period during the two years ended December 31, 1993 is set forth under the captions "Range of Market Prices of Capital Stock" and "Quarterly Financial Data" in Pacific Enterprises' 1993 Annual Report to Shareholders filed as Exhibit 13.01 to this Annual Report. Such information is incorporated herein by reference. At December 31, 1993, there were 45,414 holders of record of Pacific Enterprises' Common Stock. ITEM 6.

ITEM 6. SELECTED FINANCIAL DATA The information required by this Item is set forth under the caption "Financial Review - Selected Financial Data and Comparative Statistics 1983-1993" in Pacific Enterprises' 1993 Annual Report to Shareholders filed as Exhibit 13.01 to this Annual Report. Such information is incorporated herein by reference. ITEM 7.

ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The information required by this Item is set forth under the caption "Financial Review - Management's Discussion and Analysis" in Pacific Enterprises' 1993 Annual Report to Shareholders filed as Exhibit 13.01 to this Annual Report. Such information is incorporated herein by reference. ITEM 8.

ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA Pacific Enterprises' consolidated financial statements and schedules required by this Item are listed in Item 14(a)1 and 2 in Part IV of this Annual Report. The consolidated financial statements listed in Item 14(a)1 are incorporated herein by reference. ITEM 9.

ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE No change in the Company's accountants has taken place. PART III ITEM 10.

ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT Information required by this Item with respect to the Company's directors is set forth under the caption "Election of Directors" in the Company's Proxy Statement for its Annual Meeting of Shareholders scheduled to be held on May 5, 1994. Such information is incorporated herein by reference. Information required by this Item with respect to the Company's executive officers is set forth in Item 1 of this Annual Report. ITEM 11.

ITEM 11. EXECUTIVE COMPENSATION Information required by this Item is set forth under the caption "Election of Directors", "Executive Compensation" and "Employee Benefit Plans" in the Company's Proxy Statement for its Annual Meeting of Shareholders scheduled to be held on May 5, 1994. Such information is incorporated herein by reference. ITEM 12.

ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT Information required by this Item is set forth under the caption "Election of Directors" in the Company's Proxy Statement for its Annual Meeting of Shareholders scheduled to be held on May 5, 1994. Such information is incorporated herein by reference. ITEM 13.

ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS Not applicable. PART IV ITEM 14.

ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K (a) DOCUMENTS FILED AS PART OF THIS REPORT: 1.01 Report of Deloitte & Touche, Independent Auditors (Contained in Exhibit 13.01). 1.02 Consolidated Balance Sheet at December 31, 1993 and 1992 (Contained in Exhibit 13.01). 1.03 Statement of Consolidated Income for the years ended December 31, 1993, 1992 and 1991 (Contained in Exhibit 13.01). 1.04 Statement of Consolidated Shareholders' Equity for the years ended December 31, 1993, 1992 and 1991 (Contained in Exhibit 13.01). 1.05 Statement of Consolidated Cash Flows for the years ended December 31, 1993, 1992 and 1991 (Contained in Exhibit 13.01). 1.06 Statement of Business Segment Information for the years ended December 31, 1993, 1992 and 1991 (Contained in Exhibit 13.01). 1.07 Notes to Consolidated Financial Statements (Contained in Exhibit 13.01). 2. SUPPLEMENTAL FINANCIAL STATEMENT SCHEDULES: 2.01 Report of Deloitte & Touche, Independent Auditors 2.02 Pacific Enterprises and Subsidiary Companies - Property, Plant and Equipment for the years ended December 31, 1993, 1992 and 1991 - Schedule V 2.03 Pacific Enterprises and Subsidiary Companies - Accumulated Depreciation, and Amortization of Property, Plant and Equipment for the years ended December 31, 1993, 1992, and 1991 - Schedule VI 2.04 Pacific Enterprises and Subsidiary Companies - Short-Term Borrowings, December 31, 1993, 1992 and 1991 - Schedule IX 2.05 Pacific Enterprises and Subsidiary Companies - Supplementary Income Statement Information December 31, 1993, 1992 and 1991 - Schedule X 3. ARTICLES OF INCORPORATION AND BY-LAWS: 3.01 Articles of Incorporation of Pacific Enterprises (Note 22; Exhibit 4.1) 3.02 Bylaws of Pacific Enterprises (Note 21; Exhibit 3.02) 4. INSTRUMENTS DEFINING THE RIGHTS OF SECURITY HOLDERS: (Note: As permitted by Item 601(b)(4)(iii) of Regulation S-K, certain instruments defining the rights of holders of long-term debt for which the total amount of securities authorized thereunder does not exceed ten percent of the total assets of Southern California Gas Company and its subsidiaries on a consolidated basis are not filed as exhibits to this Annual Report. The Company agrees to furnish a copy of each such instrument to the Commission upon request.) 4.01 Specimen Common Stock Certificate of Pacific Enterprises (Note 16; Exhibit 4.01). 4.02 Specimen Preferred Stock Certificates of Pacific Enterprises (Note 8; Exhibit 4.02) 4.03 Specimen Remarketed Preferred Stock Certificate (Note 17; Exhibit 4.03) 4.04 First Mortgage Indenture of Southern California Gas Company to American Trust Company dated October 1, 1940 (Note 1; Exhibit B-4). 4.05 Supplemental Indenture of Southern California Gas Company to American Trust Company dated as of July 1, 1947 (Note 2; Exhibit B-5). 4.06 Supplemental Indenture of Southern California Gas Company to American Trust Company dated as of August 1, 1955 (Note 3; Exhibit 4.07). 4.07 Supplemental Indenture of Southern California Gas Company to American Trust Company dated as of June 1, 1956 (Note 4; Exhibit 2.08). 4.08 Supplemental Indenture of Southern California Gas Company to Wells Fargo Bank, National Association dated as of August 1, 1972 (Note 6; Exhibit 2.19). 4.09 Supplemental Indenture of Southern California Gas Company to Wells Fargo Bank, National Association dated as of May 1, 1976 (Note 5; Exhibit 2.20). 4.10 Supplemental Indenture of Southern California Gas Company to Wells Fargo Bank, National Association dated as of September 15, 1981 (Note 9; Exhibit 4.25). 4.11 Supplemental Indenture of Southern California Gas Company to Manufacturers Hanover Trust Company of California, successor to Wells Fargo Bank, National Association, and Crocker National Bank as Successor Trustee dated as of May 18, 1984 (Note 11; Exhibit 4.29). 4.12 Supplemental Indenture of Southern California Gas Company to Bankers Trust Company of California, N.A., successor to Wells Fargo Bank, National Association dated as of January 15, 1988 (Note 13; Exhibit 4.11). 4.13 Supplemental Indenture of Southern California Gas Company to First Trust of California, National Association, successor to Bankers Trust Company of California, N.A. (Note 18; Exhibit 4.37) 4.14 Rights Agreement dated as of March 7, 1990 between Pacific Enterprises and Security Pacific National Bank, as Rights Agent (Note 19; Exhibit 4). 10. MATERIAL CONTRACTS 10.01 Sale and Purchase Agreement, dated as of May 22, 1992, as amended between TCH Corporation and Pacific Enterprises (Note 19; Exhibit 1). 10.02 Sale and Purchase Agreement, dated as of May 22, 1992, as amended, among Big 5 Holdings, Inc., Pacific Enterprises and Thrifty Corporation (Note 19; Exhibit 2). 10.03 Sale and Purchase Agreement, dated as of October 11, 1992 by and between Hunt Oil Company and Pacific Enterprises Oil Company (USA) (Note 19; Exhibit 1). 10.04 Sale and Purchase Agreement, dated as of October 11, 1992 by and between Hunt Oil Company and Pacific Enterprises Mineral Company (Note 20; Exhibit 2). 10.05 Sale and Purchase Agreement, dated as of October 11, 1992 by and between Hunt Oil Company and Pacific Enterprises Oil Company (Western) (Note 20; Exhibit 3). 10.06 Sale and Purchase Agreement, dated as of October 11, 1992 by and between Hunt Oil Company and Pacific Gas Gathering Company (Note 6; Exhibit 4). 10.07 Form of Indemnification Agreement between Pacific Enterprises and each of its directors and officers (Note 21; Exhibit 10.07) 10.08 Credit Agreement dated as of March 4, 1993 among Pacific Enterprises, Morgan Guaranty Trust Company of New York and the other banks named therein. (Note 21; Exhibit 10.08) EXECUTIVE COMPENSATION PLANS AND ARRANGEMENTS 10.09 Restatement and Amendment of Pacific Enterprises 1979 Stock Option Plan (Note 7; Exhibit 1.1). 10.10 Pacific Enterprises Supplemental Medical Reimbursement Plan for Senior Officers (Note 8; Exhibit 10.24). 10.11 Pacific Enterprises Financial Services Program for Senior Officers (Note 8; Exhibit 10.25). 10.12 Pacific Enterprises Supplemental Retirement and Survivor Plan (Note 11; Exhibit 10.36). 10.13 Pacific Enterprises Stock Payment Plan (Note 11; Exhibit 10.37). 10.14 Pacific Enterprises Pension Restoration Plan (Note 8; Exhibit 10.28). 10.15 Southern California Gas Company Pension Restoration Plan For Certain Management Employees (Note 8; Exhibit 10.29). 10.16 Pacific Enterprises Executive Incentive Plan (Note 13; Exhibit 10.13). 10.17 Pacific Enterprises Deferred Compensation Plan for Key Management Employees (Note 12; Exhibit 10.41). 10.18 Pacific Enterprises Employee Stock Ownership Plan and Trust Agreement as amended in toto effective October 1, 1992. (Note 21; Exhibit 10.18). 10.19 Pacific Enterprises Stock Incentive Plan (Note 15; Exhibit 4.01). 10.20 Pacific Enterprises Retirement Plan for Directors (Note 21; Exhibit 10.20). 10.21 Pacific Enterprises Director's Deferred Compensation Plan (Note 21; Exhibit 10.21). 11. STATEMENT RE COMPUTATION OF EARNINGS PER SHARE 11.01 Pacific Enterprises Computation of Earnings per Share (see Statement of Consolidated Income contained in Exhibit 13.01). 13. ANNUAL REPORT TO SECURITY HOLDERS 13.01 Pacific Enterprises 1993 Annual Report to Shareholders. (Such report, except for the portions thereof which are expressly incorporated by reference in this Annual Report, is furnished for the information of the Securities and Exchange Commission and is not to be deemed "filed" as part of this Annual Report). 22. SUBSIDIARIES OF THE REGISTRANT 22.01 List of subsidiaries of Pacific Enterprises 24. CONSENTS OF EXPERTS AND COUNSEL 24.01 Consent of Deloitte & Touche, Independent Auditors. 25. POWER OF ATTORNEY 25.01 Power of Attorney of Certain Officers and Directors of Pacific Enterprises (contained on signature pages). (b) REPORTS ON FORM 8-K: The following reports on Form 8-K were filed during the last quarter of 1993. REPORT DATE ITEM REPORTED Nov. 3, 1993 Item 5 Dec. 9, 1993 Item 5 Dec. 17, 1993 Item 5 _________________________ NOTE: Exhibits referenced to the following notes were filed with the documents cited below under the exhibit or annex number following such reference. Such exhibits are incorporated herein by reference. Note Reference Document 1 Registration Statement No. 2-4504 filed by Southern California Gas Company on September 16, 1940. 2 Registration Statement No. 2-7072 filed by Southern California Gas Company on March 15, 1947. 3 Registration Statement No. 2-11997 filed by Pacific Lighting Corporation on October 26, 1955. 4 Registration Statement No. 2-12456 filed by Southern California Gas Company on April 23, 1956. 5 Registration Statement No. 2-56034 filed by Southern California Gas Company on April 14, 1976. 6 Registration Statement No. 2-59832 filed by Southern California Gas Company on September 6, 1977. 7 Registration Statement No. 2-66833 filed by Pacific Lighting Corporation on March 5, 1980. 8 Annual Report on Form 10-K for the year ended December 31, 1980, filed by Pacific Lighting Corporation. 9 Annual Report on Form 10-K for the year ended December 31, 1981, filed by Pacific Lighting Corporation. 10 Annual Report on Form 10-K for the year ended December 31, 1983 filed by Pacific Lighting Corporation. 11 Annual Report on Form 10-K for the year ended December 31, 1984 filed by Pacific Lighting Corporation. 12 Annual Report on Form 10-K for the year ended December 31, 1985 filed by Pacific Lighting Corporation. 13 Annual Report on Form 10-K for the year ended December 31, 1987, filed by Pacific Enterprises. 14 Current Report on Form 8-K dated March 7, 1990 filed by Pacific Enterprises. 15 Registration Statement No. 33-21908 filed by Pacific Enterprises on May 17, 1988. 16 Annual Report on Form 10-K for the year ended December 31, 1988 filed by Pacific Enterprises. 17 Annual Report on form 10-K for the year ended December 31, 1989 filed by Pacific Enterprises. 18 Registration Statement No. 33-50826 filed by Southern California Gas Company on August 13, 1992. 19 Current Report on Form 8-K dated September 25, 1992 filed by Pacific Enterprises. 20 Current Report on Form 8-K dated January 5, 1993 filed by Pacific Enterprises. 21 Annual Report on Form 10-K for the year ended December 31, 1992 filed by Pacific Enterprises. 22 Registration Statement No. 33-61278 filed by Pacific Enterprises on April 20, 1993. SIGNATURES Pursuant to the requirements of Section 13 or 15(d) 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. PACIFIC ENTERPRISES By: /s/ WILLIS B. WOOD, JR. -------------------------------- Name: Willis B. Wood, Jr. Title: Chairman of the Board and Chief Executive Officer Dated: March 28, 1994 Each person whose signature appears below hereby authorizes Willis B. Wood, Jr. and Lloyd A. Levitin, and each of them, severally, as attorney-in-fact, to sign on his or her behalf, individually and in each capacity stated below, and file all amendments to this Annual Report. Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated. SIGNATURE TITLE DATE /s/ WILLIS B. WOOD, JR. Chairman of the Board, March 28, 1994 - ----------------------------- Chief Executive (Willis B. Wood, Jr.) Officer and Director (Principal Executive Officer) /s/ LLOYD A. LEVITIN Executive Vice - March 28, 1994 - ----------------------------- President and Chief (Lloyd A. Levitin) Financial Officer (Principal Financial Officer) /s/ HYLA H. BERTEA Director March 28, 1994 - ---------------------------- (Hyla H. Bertea) /s/ HERBERT L. CARTER Director March 28, 1994 - ---------------------------- (Herbert L. Carter) /s/ JAMES F. DICKASON Director March 28, 1994 - ---------------------------- (James F. Dickason) /s/ RICHARD D. FARMAN Director March 28, 1994 - ---------------------------- (Richard D. Farman) /s/ WILFORD D. GODBOLD, JR. Director March 28, 1994 - ---------------------------- (Wilford D. Godbold, Jr.) /s/ IGNACIO E. LOZANO, JR. Director March 28, 1994 - ---------------------------- (Ignacio E. Lozano, Jr.) /s/ HAROLD M. MESSMER, JR. Director March 28, 1994 - ---------------------------- (Harold M. Messmer, Jr.) /s/ PAUL A. MILLER Director March 28, 1994 - ---------------------------- (Paul A. Miller) /s/ JOSEPH N. MITCHELL Director March 28, 1994 - ---------------------------- (Joseph N. Mitchell) /s/ JOSEPH R. RENSCH Director March 28, 1994 - ---------------------------- (Joseph R. Rensch) /s/ ROCCO C. SICILIANO Director March 28, 1994 - ---------------------------- (Rocco C. Siciliano) /s/ LEONARD H. STRAUS Director March 28, 1994 - ---------------------------- (Leonard H. Straus) /s/ DIANA L. WALKER Director March 28, 1994 - ---------------------------- (Diana L. Walker)

821480_1993.txt

821480

1993

Item 1. Regulation and Legislation. Generally, the franchising authority can decide not to renew a franchise only if it finds that the cable operator has not substantially complied with the material terms of the franchise, has not provided reasonable service in light of the community's needs, does not have the financial, legal and technical ability to provide the services being proposed for the future, or has not presented a reasonable proposal for future service. A final decision of non-renewal by the franchising authority is appealable in court. The General Partner and its affiliates recently have experienced lengthy negotiations with some franchising authorities for the granting of franchise renewals and transfers. Some of the issues involved in recent renewal negotiations include rate reregulation, customer service standards, cable plant upgrade or replacement and shorter terms of franchise agreements. The inability of a Partnership to renew a franchise, or lengthy negotiations or litigation involving the renewal process could have an adverse impact on the business of a Partnership. The inability of a Partnership to transfer a franchise could have an adverse impact on the ability of a Partnership to accomplish its investment objectives. COMPETITION. The Systems face competition from a variety of alternative entertainment media, such as: Multichannel Multipoint Distribution Service ("MMDS"), which is often called a "wireless cable service" and is a microwave service authorized to transmit television signals and other communications on a complement of channels, which when combined with instructional fixed television and other channels, is able to provide a complement of television signals potentially competitive with cable television systems; Satellite Master Antenna Television System ("SMATV"), commonly called a "private" cable television system, which is a system wherein one central antenna is used to receive signals and deliver them to, for example, an apartment complex; and Television Receive-Only Earth Stations ("TVRO"), which are satellite receiving antenna dishes that are used by "backyard users" to receive satellite delivered programming directly in their homes. Programming services sell their programming directly to owners of TVROs as well as through third parties. The competition from MMDS and TVRO potentially diminishes the pool of subscribers to the Systems because persons who subscribe to MMDS services or who own backyard satellite dishes are not likely to subscribe to all of the Systems' cable television services. In the near future, the Systems will also face competition from direct satellite to home transmission ("DBS"). DBS can provide to individuals on a wide-scale basis premium channel services and specialized programming through the use of high-powered DBS satellites that transmit such programming to a rooftop or side-mounted antenna. There are currently no DBS operators in the areas served by the Systems. DBS systems' ability to compete with the cable television industry will depend on, among other factors, the ability to obtain access to programming and the availability of reception equipment at reasonable prices. The first DBS satellite was recently launched, and it is anticipated that DBS services will become available throughout the United States during 1994. The Systems also face competition from video cassette rental outlets and movie theaters in the Systems' service areas. The General Partner believes the preponderance of video cassette recorder ("VCR") ownership in the Systems' service areas may be a positive rather than a negative factor because households that have VCRs are attracted to non-commercial programming delivered by the Systems, such as movies and sporting events on cable television, that they can tape at their convenience. Cable television franchises are not exclusive, so that more than one cable television system may be built in the same area (known as an "overbuild"), with potential loss of revenues to the operator of the original cable television system. The Systems currently face no direct competition from other cable television operators. Although the Partnerships have not yet encountered competition from a telephone company entering into the cable television business, the Partnerships' Systems could potentially face competition from telephone companies doing so. Bell Atlantic, a regional Bell operating company ("RBOC"), has announced its intention, if permitted by the courts, to build a cable television system in Alexandria, Virginia, and has won a lawsuit to obtain such authority. The case is on appeal. The General Partner currently owns and manages the cable television system in Alexandria, Virginia. Another RBOC, Ameritech, has also indicated its intention to build and operate a cable television system in Naperville, Illinois, a location where the General Partner manages a system on behalf of one of its managed limited partnerships. Other RBOCs have indicated their intention to enter the cable television market, and have filed lawsuits similar to the one being pursued by Bell Atlantic and Ameritech. Widespread competition through overbuilds by RBOCs could have a negative impact on companies like the General Partner that are already established cable television system operators. COMPETITION FOR SUBSCRIBERS IN THE PARTNERSHIPS' SYSTEMS. Following is a summary of competition from MMDS, SMATV and TVRO operators in the Partnerships' franchise areas: REGULATION AND LEGISLATION. The cable television industry is regulated through a combination of the Federal Communications Commission ("FCC"), some state governments, and most local governments. In addition, the Copyright Act of 1976 imposes copyright liability on all cable television systems. Cable television operations are subject to local regulation insofar as systems operate under franchises granted by local authorities. Cable Television Consumer Protection and Competition Act of 1992. On October 5, 1992, Congress enacted the Cable Television Consumer Protection and Competition Act of 1992 (the "1992 Cable Act"), which became effective on December 4, 1992. This legislation effected significant changes to the regulatory environment in which the cable television industry operates. The 1992 Cable Act generally allows for a greater degree of regulation of the cable television industry. Under the 1992 Cable Act's definition of effective competition, nearly all cable television systems in the United States, including those owned and managed by the General Partner, are subject to rate regulation of basic cable services. In addition, the 1992 Cable Act allows the FCC to regulate rates for non-basic service tiers other than premium services in response to complaints filed by franchising authorities and/or cable subscribers. In April 1993, the FCC adopted regulations governing rates for basic and non-basic services and ordered an interim freeze on these rates effective on April 15, 1993. The rate freeze recently was extended by the FCC until the earlier of May 15, 1994, or the date on which a cable system's basic service rate is regulated by a franchising authority. The FCC's rate regulations became effective on September 1, 1993. On February 22, 1994, the FCC announced a revision of its rate regulations which it believes will generally result in a further reduction of rates for basic and non-basic services. The 1992 Cable Act encourages competition with existing cable systems by allowing municipalities, which are otherwise legally qualified, to own and operate their own cable systems without having to obtain a franchise; prevents franchising authorities from granting exclusive franchises; or unreasonably refusing to award additional franchises covering an existing cable system's service area. The 1992 Cable Act also makes several procedural changes to the process under which a cable operator seeks to enforce renewal rights which could make it easier in some cases for a franchising authority to deny renewal. The 1992 Cable Act prohibits the common ownership of cable systems and co-located MMDS or SMATV systems, and absent certain exceptions, the sale or transfer of ownership of a cable system within 36 months after its acquisition or initial construction. The 1992 Cable Act also precludes video programmers affiliated with cable companies from favoring cable operators over competitors and requires such programmers to sell their programs to other multichannel video distributors. This provision may limit the ability of cable program suppliers to offer exclusive programming arrangements with cable companies and could affect the volume discounts that program suppliers currently offer to the General Partner in its capacity as a multiple system operator. The 1992 Cable Act has eliminated the latitude of operators to set rates for commercially leased access channels and requires that leased access rates be set according to a formula determined by the FCC. The 1992 Cable Act contains new broadcast signal carriage requirements, and the FCC has adopted regulations implementing the statutory requirements. These new rules allow a local commercial broadcast television station to elect whether to demand that a cable television system carry its signal, or to require the cable television system to negotiate with the station for "retransmission consent." A cable television system is generally required to devote up to one-third of its activated channel capacity for the mandatory carriage of local commercial broadcast television stations, and non-commercial television stations are also given mandatory carriage rights, although such stations are not given the option to negotiate retransmission consent for the carriage of their signals by cable television systems. Additionally, cable television systems also are required to obtain retransmission consent from all "distant" commercial television stations (except for commercial satellite-delivered independent "superstations"), commercial radio stations and certain low-power television stations carried by cable television systems. See Item 1. Cable Television Services. There have been several lawsuits filed by cable television operators and programmers in Federal court challenging various aspects of the 1992 Cable Act, including provisions relating to mandatory broadcast signal carriage, retransmission consent, access to cable programming, rate regulation, commercial leased channels and public access channels. On April 8, 1993, a three-judge Federal district court panel issued a decision upholding the constitutional validity of the mandatory signal carriage requirements of the 1992 Cable Act. That decision has been appealed directly to the United States Supreme Court. Appeals have been filed in the Federal appellate court challenging the validity of the FCC's retransmission consent rules. Ownership and Market Structure. The FCC rules and federal law generally prohibit the direct or indirect common ownership, operation, control or interest in a cable television system, on the one hand, and a local television broadcast station whose television signal reaches any portion of the community served by the cable television system, on the other hand. The FCC recently lifted its ban on the cross-ownership of cable television systems by broadcast networks. The FCC revised its regulations to permit broadcast networks to acquire cable television systems serving up to 10% of the homes passed in the nation, and up to 50% of the homes passed in a local market. Neither the Partnerships nor the General Partner has any direct or indirect ownership, operation, control or interest in a television broadcast station, or a telephone company, and they are thus presently unaffected by the cross-ownership rules. The Cable Communications Policy Act of 1984 (the "1984 Cable Act") and FCC regulations generally prohibit the common operation of a cable television system and a telephone company within the same service area. Until recently, a provision of a Federal court antitrust consent decree also prohibited the regional Bell operating companies ("RBOCs") from engaging in cable television operations. This prohibition was recently removed when the court retaining jurisdiction over the consent decree ruled that the RBOCs could provide information services over their facilities. This decision permits the RBOCs to acquire or construct cable television systems outside of their own service areas. The 1984 Cable Act prohibited local exchange carriers, including the RBOCs, from providing video programming directly to subscribers within their local exchange telephone service areas, except in rural areas or by specific waiver of FCC rules. This statutory provision has recently been challenged on constitutional grounds by Bell Atlantic, one of the RBOCs. The court held that the 1984 Cable Act cross-ownership provision is unconstitutional, and it issued an order enjoining the United States Justice Department from enforcing the cross-ownership ban. The National Cable Television Association, an industry group of which the General Partner is a member, has appealed this landmark decision, and the case could ultimately be reviewed by the United States Supreme Court. This federal cross-ownership rule is particularly important to the cable industry since these telephone companies already own certain facilities needed for cable television operation, such as poles, ducts and associated rights-of-way. The FCC has conducted a comprehensive proceeding examining whether and under what circumstances telephone companies should be allowed to provide cable television services, including video programming, to their customers. The FCC has concluded that under the 1984 Cable Act interexchange carriers (such as AT&T, which provide long distance services) are not subject to the restrictions which bar the provision of cable television service by local exchange carriers. In addition, the FCC concluded that neither a local exchange carrier providing a video dialtone service nor its programming suppliers leasing the dialtone service are required to obtain a cable television franchise. This determination has been appealed. If video dialtone services become widespread in the future, cable television systems could be placed at a competitive disadvantage because cable television systems are required to obtain local franchises to provide cable television service and must comply with a variety of obligations under such franchises. The FCC has tentatively concluded that construction and operation of technologically advanced, integrated broadband networks by carriers for the purpose of providing video programming and other services would constitute good cause for waiver of the cable/telephone cross-ownership prohibitions. In July 1989, the FCC granted a California telephone company a waiver of the cross-ownership restrictions based on a showing of "good cause," but the FCC's decision was reversed on appeal, and as a result of this decision, the FCC may be required to follow a stricter policy in granting such waivers in the future. As part of the same proceeding, the FCC recommended that Congress amend the 1984 Cable Act to allow Local Exchange Carriers ("LECs") to provide their own video programming services over their facilities. The FCC recently decided to loosen ownership and affiliation restrictions currently applicable to telephone companies, and has proposed to increase the numerical limit on the population of areas qualifying as "rural" and in which LECs can provide cable service without a FCC waiver. Legislation is pending in Congress which would permit the LECs to provide cable television service within their own operating areas conditioned on establishing separate video programming affiliates. The legislation would generally prohibit, however, telephone companies from acquiring cable systems within their own operating areas. The legislation would also enable cable television companies and others, subject to regulatory safeguards, to offer telephone services by eliminating state and local barriers to entry. ITEM 2.

ITEM 2. PROPERTIES The cable television systems owned at December 31, 1993 by the Partnerships are described below. The following tables set forth (i) the monthly basic plus service rates charged to subscribers, (ii) the number of basic subscribers and pay units, (iii) the number of homes passed by cable plant, (iv) the miles of cable plant and (v) the range of franchise expiration dates for the cable television systems owned and operated by the Partnerships. The monthly basic plus service rates set forth herein represent, with respect to systems with multiple headends, the basic plus service rate charged to the majority of the subscribers within the system. While the charge for basic plus service may have increased in some cases as a result of the FCC's rate regulations, overall revenues to the Partnerships may have decreased due to the elimination of charges for additional outlets and certain equipment. In cable television systems, basic subscribers can subscribe to more than one pay TV service. Thus, the total number of pay services subscribed to by basic subscribers are called pay units. Figures for numbers of subscribers, miles of cable plant and homes passed are compiled from the General Partner's records and may be subject to adjustments. CABLE TV FUND 14-A, LTD. As of December 31, 1993, the number of homes passed and the miles of cable plant were 43,400 and 726, respectively. Franchise expiration dates range from July 1995 to January 2003. As of December 31, 1993, the number of homes passed and the miles of cable plant were 19,266 and 409, respectively. Franchise expiration date for all franchises is September 1999. As of December 31, 1993, the number of homes passed and the miles of cable plant were 34,921 and 452, respectively. Franchise expiration dates range from December 1999 to April 2001. As of December 31, 1993, the number of homes passed and the miles of cable plant were 22,400 and 679, respectively. Franchise expiration dates range from July 1999 to January 2001. As of December 31, 1993, the number of homes passed and the miles of cable plant were 24,570 and 314, respectively. Franchise expiration dates range from April 1994 to September 2004. Any franchise that expires in 1994 is in the process of franchise renewal negotiations. CABLE TV FUND 14-B, LTD. At December 31, --------------- Surfside, South Carolina 1993 1992 1991 - ------------------------ ---- ---- ---- Monthly rate basic plus service $ 23.25 $ 20.60 $ 18.95 Basic subscribers 17,770 17,275 17,665 Pay units 10,168 10,422 11,748 As of December 31, 1993, the number of homes passed and the miles of cable plant were 32,100 and 489, respectively. Franchise expiration dates range from June 2006 to December 2013. At December 31, --------------- Little Rock, California 1993 1992 1991 - ----------------------- ---- ---- ---- Monthly rate basic plus service $ 21.77 $ 20.00 $ 17.95 Basic subscribers 4,875 4,859 4,338 Pay units 4,171 3,717 3,553 As of December 31, 1993, the number of homes passed and the miles of cable plant were 6,910 and 192, respectively. Franchise expiration date is October 2000. CABLE TV FUND 14-A/B VENTURE At December 31, --------------- BROWARD COUNTY, FLORIDA 1993 1992 1991 - ----------------------- ---- ---- ---- Monthly basic plus service rate $ 24.00 $ 23.95 $ 19.50 Basic subscribers 45,515 42,945 41,153 Pay units 37,684 33,735 33,950 As of December 31, 1993, the number of homes passed and the miles of cable plant were 89,000 and 938, respectively. Franchise expiration dates range from July 1994 to December 2024. Any franchise that expires in 1994 is in the process of franchise renewal negotiations. PROGRAMMING SERVICES Programming services provided by the Systems include local affiliates of the national broadcast networks, local independent broadcast channels, the traditional satellite services (e.g., American Movie Classics (AMC), Arts & Entertainment (ARTS), Black Entertainment Network (BET), C-SPAN, The Discovery Channel (DISC), Lifetime (LIFE), Entertainment Sports Network (ESPN), Home Shopping Network (HSN), Mind Extension University (MEU), Music Television (MTV), Nickelodeon (NICK), Turner Network Television (TNT), The Nashville Network (TNN), Video Hits One (VH-1), and superstations WOR, WGN and TBS. The Partnerships' Systems also provide a selection, which varies by system, of premium channel programming (e.g., Bravo (BRVO), Cinemax (CMAX), The Disney Channel (DISN), Encore (ENC), Home Box Office (HBO), Showtime (SHOW) and The Movie Channel (TMC)). ITEM 3.

ITEM 3. LEGAL PROCEEDINGS In April 1989, a few months after it had acquired the Surfside System, Fund 14-B acquired a small cable television system in the Surfside Beach area from Tritek/Southern Communications, Ltd. At the time of the acquisition, this system served approximately 1,450 subscribers in the same area as the Surfside System. In May 1990, the Federal Trade Commission ("FTC") commenced an investigation into the effect of this acquisition on competition in the Surfside Beach area. Fund 14-B submitted its response to the FTC's request for information concerning the acquisition in July 1990. The FTC conducted recorded interviews with certain employees of the General Partner in September 1991. No further action has been taken by the FTC, although to the best of the General Partner's knowledge the investigation is still pending. ITEM 4.

ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS None. PART II. ITEM 5.

ITEM 5. MARKET FOR THE REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS While the Partnerships are publicly held, there is no public market for the limited partnership interests and it is not expected that a market will develop in the future. As of March 1, 1994, the approximate number of equity security holders was: Item 6.

Item 6. Selected Financial Data * Cable TV Fund 14-B's selected financial data includes 100 percent of the Cable TV Fund 14-A/B accounts on a consolidated basis. Item 7.

Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations CABLE TV FUND 14-B Results of Operations The results of operations for Cable TV Fund 14-B ("Fund 14-B") are summarized below: 1993 Compared to 1992 - Partnership owned - Revenues in Fund 14-B's wholly-owned cable television systems increased $319,096, or approximately 3 percent, from $9,347,000 in 1992 to $9,666,096 in 1993. Basic service rate adjustments as well as increases in revenues from advertising sales and pay-per-view were primarily responsible for the increase in revenues. Such increases were offset, in part, by decreases in premium service revenue. In addition, the increase in revenues would have been greater but for the reduction in basic rates due to new basic rate regulations issued by the FCC in May 1993 with which Fund 14-B complied effective September 1, 1993. In addition, on February 22, 1994, the FCC announced a further rulemaking which, when implemented, could reduce rates further. Operating, general and administrative expenses increased $180,421, or approximately 4 percent, from $5,130,821 in 1992 to $5,311,242 in 1993. Operating, general and administrative expenses represented 55 percent of revenue in both 1993 and 1992. Increases in programming fees were primarily responsible for the increase in operating, general and administrative expense. No other individual factor significantly affected the increase in operating, general and administrative expenses. Management fees and allocated overhead from the General Partner increased $54,980, or approximately 4 percent, from $1,270,685 in 1992 to $1,325,665 in 1993 due to the increase in revenues, upon which such fees and allocations are based, and an increase in allocated expense from the General Partner. Depreciation and amortization expense decreased $213,407, or approximately 3 percent, from $6,673,468 in 1992 to $6,460,061 in 1993. This decrease is due to the maturation of Fund 14-B's asset base. Operating loss decreased $297,102, or approximately 8 percent, from $3,727,974 in 1992 to $3,430,872 in 1993. This decrease is due to the increase in revenues exceeding the increases in operating, general and administrative and management fees and allocated overhead from the General Partner as well as the decrease in depreciation and amortization expense. Operating income before depreciation and amortization expense increased $83,695, or approximately 3 percent, from $2,945,494 in 1992 to $3,029,189 in 1993 due to the increase in revenues exceeding the increases in operating, general and administrative expenses and management fees and allocated overhead from the General Partner. Interest expense decreased $164,771, or approximately 18 percent, from $923,922 in 1992 to $759,151 in 1993. This decrease is due to lower effective interest rates and lower outstanding balances on interest bearing obligations. Net loss decreased $471,996, or approximately 10 percent, from $4,673,447 in 1992 to $4,201,451 in 1993. These losses were primarily the result of the factors discussed above and are expected to continue in the future. Venture owned - In addition to its wholly owned systems, Fund 14-B owns an approximate 73 percent interest in the Venture. Revenues of the Venture's Broward County System increased $1,856,065, or approximately 9 percent, from $20,212,867 in 1992 to $22,068,952 in 1993. Increases in basic and premium subscribers accounted for approximately 48 percent of the increase in revenue. Basic and premium subscribers increased 6 percent and 14 percent, respectively, during 1993. Advertising sales accounted for approximately 19 percent of the increase in revenues. Basic service rate adjustments accounted for approximately 15 percent of the increase in revenues. The increase in revenues would have been greater but for the reduction in basic rates due to the new basic rate regulations issued by the FCC in May 1993 with which the Venture complied effective September 1, 1993. In addition, on February 22, 1994, the FCC announced a further rulemaking which, when implemented, could reduce rates further. No other individual factor significantly affected the increase in revenues. Operating, general and administrative expense increased $1,287,088, or approximately 12 percent, from $11,052,427 in 1992 to $12,339,515 in 1993. Operating, general and administrative expenses represented 56 percent of revenue in 1993, compared to 55 percent in 1992. The increase in operating, general and administrative expenses was due primarily to increases in programming fees and marketing expenses. No other individual factor significantly affected the increase in operating, general and administrative expense. Management fees and allocated overhead from Jones Intercable, Inc. increased $219,910, or approximately 9 percent, from $2,481,658 in 1992 to $2,701,568 in 1993 due to the increase in revenues, upon which such fees and allocations are based, and an increase in allocated expenses from Jones Intercable, Inc. Depreciation and amortization expense decreased $619,107, or approximately 6 percent, from $9,971,915 in 1992 to $9,352,808 in 1993. The decrease in depreciation and amortization expense is attributable to the maturation of the Venture's intangible asset base. Operating loss decreased $968,164, or approximately 29 percent, from $3,293,133 in 1992 to $2,324,939 in 1993. This decrease is due to the increase in revenues exceeding the increases in operating, general and administrative expenses and management fees and allocated overhead from Jones Intercable, Inc. as well as the decrease in depreciation and amortization expense. Operating income before depreciation and amortization expense increased $349,087, or approximately 5 percent, from $6,678,782 in 1992 to $7,027,869 in 1993 due to the increase in revenues exceeding the increases in operating, general and administrative expenses and management fees and allocated overhead from Jones Intercable, Inc. Interest expense decreased $114,318, or approximately 4 percent, from $2,564,990 in 1992 to $2,450,672 in 1993 due to lower effective interest rates and lower outstanding balances on interest bearing obligations. Net loss decreased $1,472,607, or approximately 24 percent, from $6,186,107 in 1992 to $4,713,500 in 1993. The decrease was primarily attributable to the decrease in operating loss and the decrease in interest expense. These losses were primarily the result of the factors discussed above and are expected to continue in the future. 1992 Compared to 1991 - Partnership owned - Revenues in Fund 14-B's wholly-owned cable television systems increased $686,278, or approximately 8 percent, from $8,660,722 in 1991 to $9,347,000 in 1992. Service rate adjustments implemented in each of Fund 14-B's systems accounted for approximately 54 percent of the increase in revenues. Increases in basic subscribers accounted for approximately 19 percent of the increase in revenues. Increases in basic commercial customers accounted for approximately 11 percent of the increase in revenues. No other individual factor significantly affected the increase in revenues. Operating, general and administrative expenses decreased $160,732, or approximately 3 percent, from $5,291,553 in 1991 to $5,130,821 in 1992. Operating, general and administrative expenses represented 55 percent of revenue in 1992 compared to 61 percent in 1991. The decrease in operating, general and administrative expense was due primarily to decreases in copyright fees and professional service fees. In 1991, the Partnership incurred fees relating to a Federal Trade Commission investigation initiated in May 1990, but no such fees were incurred in 1992. These decreases were partially offset by increases in personnel related costs and programming fees. No other individual factor significantly affected the increase in operating, general and administrative expenses. Management fees and allocated overhead from the General Partner increased $125,886, or approximately 11 percent, from $1,144,799 in 1991 to $1,270,685 in 1992 due to the increase in revenues, upon which such fees and allocations are based, and an increase in allocated expense from the General Partner. Depreciation and amortization expense increased $159,250, or approximately 2 percent, from $6,514,218 in 1991 to $6,673,468 in 1992. This increase in depreciation and amortization expense is attributable to additions in the depreciable asset base. Operating loss decreased $561,874, or approximately 13 percent, from $4,289,848 in 1991 to $3,727,974 in 1992. This decrease was due to the increase in revenues and the decrease in operating, general and administrative expenses exceeding the increases in management fees and allocated overhead from the General Partner and depreciation and amortization expense. Operating income before depreciation and amortization expense increased $721,124, or approximately 32 percent, from $2,224,370 in 1991 to $2,945,494 in 1992 due to the increase in revenues and the decrease in operating, general and administrative expenses exceeding the increase in management fees and allocated overhead from the General Partner. Interest expense decreased $351,475, or approximately 28 percent, from $1,275,397 in 1991 to $923,922 in 1992. This decrease was due to lower effective interest rates on interest bearing obligations. Net loss decreased $874,390, or approximately 16 percent, from $5,547,837 in 1991 to $4,673,447 in 1992. These losses were primarily the result of the factors discussed above. Venture owned - Revenues of the Venture's Broward County System increased $1,845,986, or approximately 10 percent, from $18,366,881 in 1991 to $20,212,867 in 1992. Basic service rate adjustments accounted for approximately 51 percent of the increase in revenues. Increases in basic commercial customers and customer late fees accounted for approximately 22 percent and 7 percent, respectively, of the increase in revenues. No other individual factor significantly affected the increase in revenues. Operating, general and administrative expense increased $987,683, or approximately 10 percent, from $10,064,744 in 1991 to $11,052,427 in 1992. Operating, general and administrative expenses represented 55 percent of revenue in 1992 and 1991. The increase in operating, general and administrative expenses was due to increases in personnel related costs and programming fees, which were partially offset by decreases in marketing expenses. No other individual factor significantly affected the increase in operating, general and administrative expense. Management fees and allocated overhead from the General Partner increased $290,942, or approximately 13 percent, from $2,190,716 in 1991 to $2,481,658 in 1992 due to the increase in revenues, upon which such fees and allocations are based, and an increase in allocated expenses from the General Partner. Depreciation and amortization expense decreased $500,706, or approximately 5 percent, from $10,472,621 in 1991 to $9,971,915 in 1992. The decrease in depreciation and amortization expense was attributable to the maturation of the Venture's intangible asset base. Operating loss decreased $1,068,067, or approximately 24 percent, from $4,361,200 in 1991 to $3,293,133 in 1992. This decrease was due to the increase in revenues exceeding the increases in operating, general and administrative expenses, management fees and allocated overhead from the General Partner, as well as the decrease in depreciation and amortization expense. Operating income before depreciation and amortization expense increased $567,361, or approximately 9 percent, from $6,111,421 in 1991 to $6,678,782 in 1992 due to the increase in revenues exceeding the increases in operating, general and administrative expenses and management fees and allocated overhead from the General Partner. Interest expense decreased $1,078,926, or approximately 30 percent, from $3,643,916 in 1991 to $2,564,990 in 1992 due to lower effective interest rates on interest bearing obligations. Net loss before minority interest in consolidated net loss decreased $1,852,613, or approximately 23 percent, from $8,038,720 in 1991 to $6,186,107 in 1992. The decrease was primarily attributable to the decrease in operating loss and the decrease in interest expense. These losses were primarily the result of the factors discussed above. Financial Condition In addition to the Surfside System and the Little Rock System owned exclusively by it, Fund 14-B owns an approximate 73 percent interest in the Venture. The accompanying consolidated financial statements include 100 percent of the accounts of Fund 14- B and those of the Venture reduced by Fund 14-A's 27 percent minority interest in the Venture. See discussion of the Venture's financial condition. Fund 14-B expended approximately $1,638,000 on capital additions during 1993 in its Surfside System and Little Rock System. Approximately 32 percent of these expenditures were for the construction of cable plant extensions. Approximately 23 percent and 17 percent of the expenditures were for the construction of drops to subscribers homes and cable plant upgrades, respectively. The remainder of the expenditures were for various enhancements in Fund 14-B's cable television systems. Funding for these expenditures was provided by cash generated by operations. Anticipated capital expenditures for 1994 are approximately $1,500,000. Approximately 37 percent of these expenditures are expected to be used for new plant construction in Fund 14-B's systems. Approximately 21 percent are for service drops to homes. The remainder of these expenditures are for various enhancements in each of Fund 14-B's systems. The actual level of capital expenditures will depend, in part, upon the General Partner's determination as to the proper scope and timing of such expenditures in light of the FCC's announcement of a further rulemaking regarding the 1992 Cable Act on February 22, 1994 and Fund 14-B's liquidity position. Funding for these improvements will be provided by cash generated from operations and borrowings under Fund 14-B's credit facility. Fund 14-B's credit agreement had an original commitment of $20,000,000. Such commitment consisted of a $10,000,000 reducing revolving credit facility and a $10,000,000 term loan. The reducing revolving credit commitment reduced to $9,500,000 on December 31, 1993, reduces to $8,500,000 on December 31, 1994 and is payable in full at December 31, 1995. At December 31, 1993, $5,600,000 was outstanding under this agreement, leaving $3,900,000 of borrowings available until December 31, 1994 for the needs of Fund 14-B. The $10,000,000 term loan is payable in quarterly installments which began March 31, 1993 and the term loan matures December 31, 1995. As of December 31, 1993, $9,750,000 was outstanding on this term loan due to installment payments made during 1993 totalling $250,000. Installments due during 1994 total $500,000. Currently, interest on the outstanding principal balance on each loan is at Fund 14-B's option of prime plus .20 percent, LIBOR plus 1.20 percent or CD rate plus 1.325 percent. The effective interest rates on amounts outstanding as of December 31, 1993 and 1992 were 4.71 percent and 4.98 percent, respectively. In January 1993, the Partnership entered into an interest rate cap agreement covering outstanding debt obligations of $8,000,000. The Partnership paid a fee of $77,600. The agreement protected the Partnership from interest rates that exceeded seven percent for three years from the date of the agreement. The General Partner believes that Fund 14-B has sufficient sources of capital to service its presently anticipated needs, subject to the regulatory matters discussed below. As a result of the climate of the cable industry in recent years and the regulatory matters discussed below, the fair market values of Fund 14-B's cable television systems have declined on a per subscriber basis since acquired by Fund 14-B. Fund 14- B has no intention to sell the systems in the near term; however, it can not predict whether market conditions will improve in the future or whether the systems ultimately will appreciate in value. Regulation and Legislation On October 5, 1992, Congress enacted the Cable Television Consumer Protection and Competition Act of 1992 (the "1992 Cable Act") which became effective on December 4, 1992. This legislation has effected significant changes to the regulatory environment in which the cable television industry operates. The 1992 Cable Act generally allows for a greater degree of regulation of the cable television industry. Under the 1992 Cable Act's definition of effective competition, nearly all cable television systems in the United States, including those owned and managed by the General Partner, are subject to rate regulation of basic cable services. In addition, the 1992 Cable Act allows the FCC to regulate rates for non-basic service tiers other than premium services in response to complaints filed by franchising authorities and/or cable subscribers. In April 1993, the FCC adopted regulations governing rates for basic and non-basic services. These regulations, with which Fund 14-B complied, became effective on September 1, 1993. See Item 1 for further discussion of the provisions of the 1992 Cable Act. Based on the General Partner's assessment of the FCC's rulemakings concerning rate regulation under the 1992 Cable Act, Fund 14-B reduced the rates it charged for certain regulated services. On an annualized basis, such rate reductions will result in an estimated reduction in Fund 14-B's revenue of approximately $700,000, or approximately 7 percent, and a decrease in operating income before depreciation and amortization of approximately $620,000, or approximately 13 percent. In addition, on February 22, 1994, the FCC announced a further rulemaking which, when implemented, could reduce rates further. Based on the foregoing, the General Partner believes that the new rate regulations will have a negative effect on Fund 14-B's revenues and operating income before depreciation and amortization. The General Partner has undertaken actions to mitigate a portion of these reductions primarily through (a) new service offerings, (b) product re-marketing and re-packaging and (c) marketing efforts directed at non- subscribers. To the extent such reductions are not mitigated, the values of Fund 14-B's cable television systems, which are calculated based on cash flow, could be further adversely impacted. The 1992 Cable Act contains new broadcast signal carriage requirements, and the FCC has adopted regulations implementing the statutory requirements. These new rules allow a local commercial broadcast television station to elect whether to demand that a cable system carry its signal or to require the cable system to negotiate with the station for "retransmission consent." Additionally, cable systems also are required to obtain retransmission consent from all "distant" commercial television stations (except for commercial satellite-delivered independent "superstations"), commercial radio stations and certain low-power television stations carried by the cable systems. The retransmission consent rules went into effect October 6, 1993. In the cable television systems owned by Fund 14-B, no broadcast stations withheld their consent to retransmission of their signal. Certain broadcast signals are being carried pursuant to extensions offered to the General Partner by broadcasters, including a one-year extension for carriage of the CBS station owned and operated by the CBS network in Los Angeles. The General Partner expects to conclude retransmission consent negotiations with those stations whose signals are being carried pursuant to extensions without having to terminate the distribution of any of those signals. However, there can be no assurance that such will occur . If any broadcast station currently being carried pursuant to an extension is dropped, there could be a negative effect on the system if a significant number of subscribers were to disconnect their service. CABLE TV FUND 14-A/B VENTURE Results of Operations 1993 Compared to 1992- Revenues of the Venture's Broward County System increased $1,856,065, or approximately 9 percent, from $20,212,867 in 1992 to $22,068,952 in 1993. Increases in basic and premium subscribers accounted for approximately 48 percent of the increase in revenue. Basic and premium subscribers increased 6 percent and 14 percent, respectively, during 1993. Advertising sales accounted for approximately 19 percent of the increase in revenues. Basic service rate adjustments accounted for approximately 15 percent of the increase in revenues. The increase in revenues would have been greater but for the reduction in basic rates due to the new basic rate regulations issued by the FCC in May 1993 with which the Venture complied effective September 1, 1993. In addition, on February 22, 1994, the FCC announced a further rulemaking which, when implemented, could reduce rates further. No other individual factor significantly affected the increase in revenues. Operating, general and administrative expense increased $1,287,088, or approximately 12 percent, from $11,052,427 in 1992 to $12,339,515 in 1993. Operating, general and administrative expenses represented 56 percent of revenue in 1993, compared to 55 percent in 1992. The increase in operating, general and administrative expenses was due primarily to increases in programming fees and marketing expenses. No other individual factor significantly affected the increase in operating, general and administrative expense. Management fees and allocated overhead from Jones Intercable, Inc. increased $219,910, or approximately 9 percent, from $2,481,658 in 1992 to $2,701,568 in 1993 due to the increase in revenues, upon which such fees and allocations are based, and an increase in allocated expenses from Jones Intercable, Inc. Depreciation and amortization expense decreased $619,107, or approximately 6 percent, from $9,971,915 in 1992 to $9,352,808 in 1993. The decrease in depreciation and amortization expense is attributable to the maturation of the Venture's tangible asset base. Operating loss decreased $968,164, or approximately 29 percent, from $3,293,133 in 1992 to $2,324,939 in 1993. This decrease is due to the increase in revenues exceeding the increases in operating, general and administrative expenses and management fees and allocated overhead from Jones Intercable, Inc. as well as the decrease in depreciation and amortization expense. Operating income before depreciation and amortization expense increased $349,087, or approximately 5 percent, from $6,678,782 in 1992 to $7,027,869 in 1993 due to the increase in revenues exceeding the increases in operating, general and administrative expenses and management fees and allocated overhead from Jones Intercable, Inc. Interest expense decreased $114,318, or approximately 4 percent, from $2,564,990 in 1992 to $2,450, 672 in 1993 due to lower effective interest rates and lower outstanding balances on interest bearing obligations. Net loss decreased $1,472,607, or approximately 24 percent, from $6,186,107 in 1992 to $4,713,500 in 1993. The decrease was primarily attributable to the decrease in operating loss and the decrease in interest expense. These losses were primarily the result of the factors discussed above and are expected to continue in the future. 1992 Compared to 1991- Revenues of the Venture's Broward County System increased $1,845,986, or approximately 10 percent, from $18,366,881 in 1991 to $20,212,867 in 1992. Basic service rate adjustments accounted for approximately 51 percent of the increase in revenues. Increases in basic commercial customers and customer late fees accounted for approximately 22 percent and 7 percent, respectively, of the increase in revenues. No other individual factor significantly affected the increase in revenues. Operating, general and administrative expense increased $987,683, or approximately 10 percent, from $10,064,744 in 1991 to $11,052,427 in 1992. Operating, general and administrative expenses represented 55 percent of revenue in 1992 and 1991. The increase in operating, general and administrative expenses was due primarily to increases in personnel related costs and programming fees, which were partially off set by decreases in marketing expenses. No other individual factor significantly affected the increase in operating, general and administrative expense. Management fees and allocated overhead from Jones Intercable, Inc. increased $290,942, or approximately 13 percent, from $2,190,716 in 1991 to $2,481,658 in 1992 due to the increase in revenues, upon which such fees and allocations are based, and an increase in allocated expenses from Jones Intercable, Inc. Depreciation and amortization expense decreased $500,706, or approximately 5 percent, from $10,472,621 in 1991 to $9,971,915 in 1992. The decrease in depreciation and amortization expense was attributable to the maturation of the Venture's intangible asset base. Operating loss decreased $1,068,067, or approximately 24 percent, from $4,361,200 in 1991 to $3,293,133 in 1992. This decrease was due to the increase in revenues exceeding the increase in operating, general and administrative expenses, management fees and allocated overhead from Jones Intercable, Inc. as well as the decrease in depreciation and amortization expense. Operating income before depreciation and amortization expense increased $567,361, or approximately 9 percent, from $6,111,421 in 1991 to $6,678,782 in 1992 due to the increase in revenues exceeding the increases in operating, general and administrative expenses and management fees and allocated overhead from Jones Intercable, Inc. Interest expense decreased $1,078,926, or approximately 30 percent, from $3,643,916 in 1991 to $2,564,990 in 1992 due to lower effective interest rates on interest bearing obligations. Net loss decreased $1,852,613, or approximately 23 percent, from $8,038,720 in 1991 to $6,186,107 in 1992. The decrease was primarily attributable to the decrease in operating loss and the decrease in interest expense. These losses were primarily the result of the factors discussed above. Financial Condition The Venture expended approximately $3,040,000 on capital additions during 1993. Cable television plant extensions accounted for approximately 27 percent of these expenditures. The construction of service drops to homes and the purchase of converters accounted for approximately 25 percent and 12 percent, respectively, of the expenditures. The remainder of these expenditures related to various enhancements in the Broward County System. These capital expenditures were funded from cash on hand and cash generated from operations. The Venture plans to expend approximately $3,125,000 for capital additions in 1994. Of this total, approximately 24 percent is for cable television plant extensions. Approximately 26 percent will relate to the construction of service drops to homes. Approximately 14 percent will relate to upgrades and rebuild of the Broward County System. The remainder of the anticipated expenditures are for various enhancements in the Broward County System. These capital expenditures are expected to be funded from cash on hand and cash generated from operations and, if necessary, borrowings under a renegotiated credit facility, as discussed below. On December 31, 1992, the then outstanding balance of $46,800,000 on the Venture's revolving credit facility converted to a term loan. The balance outstanding on the term loan at December 31, 1993 was $43,290,000. The term loan is payable in quarterly installments which began March 31, 1993 and is payable in full by December 31, 1999. Installments paid during 1993 totalled $3,510,000. Installments due during 1994 total $3,510,000. Funding for these installments is expected to come from cash on hand and cash generated from operations. The General Partner is currently negotiating to reduce principal payments (to provide liquidity for capital expenditures) and to adjust certain leverage covenants. Interest is at the Venture's option of prime plus 1/2 percent, LIBOR plus 1-1/2 percent or CD rate plus 1-5/8 percent. The effective interest rates on amounts outstanding as of December 31, 1993 and 1992 were 5.0 percent and 5.48 percent, respectively. In January 1993, the Venture entered into an interest rate cap agreement covering outstanding debt obligations of $25,000,000. The Venture paid a fee of $246,250. The agreement protects the Venture from interest rates that exceeded 7 percent for three years from the date of the agreement. Subject to regulatory matters discussed below and the General Partner's ability to successfully renegotiate the Venture's credit facility, the General Partner believes that the Venture has sufficient sources of capital to service its presently anticipated needs. Regulation and Legislation On October 5, 1992, Congress enacted the Cable Television Consumer Protection and Competition Act of 1992 (the "1992 Cable Act") which became effective on December 4, 1992. This legislation has effected significant changes to the regulatory environment in which the cable television industry operates. The 1992 Cable Act generally allows for a greater degree of regulation of the cable television industry. Under the 1992 Cable Act's definition of effective competition, nearly all cable television systems in the United States, including those owned and managed by the General Partner, are subject to rate regulation of basic cable services. In addition, the 1992 Cable Act allows the FCC to regulate rates for non-basic service tiers other than premium services in response to complaints filed by franchising authorities and/or cable subscribers. In April 1993, the FCC adopted regulations governing rates for basic and non-basic services. These regulations, with which the Venture complied, became effective on September 1, 1993. See Item 1 for further discussion of the provisions of the 1992 Cable Act. Based on the General Partner's assessment of the FCC's rulemakings concerning rate regulation under the 1992 Cable Act, the Venture reduced the rates it charged for certain regulated services. On an annualized basis, such rate reductions will result in an estimated reduction in the Venture's revenue of approximately $1,800,000, or approximately 8 percent, and a decrease in operating income before depreciation and amortization of approximately $1,100,000, or approximately 10 percent. In addition, on February 22, 1994, the FCC announced a further rulemaking which, when implemented, could reduce rates further. Based on the foregoing, the General Partner believes that the new rate regulations will have a negative effect on the Venture's revenues and operating income before depreciation and amortization. The General Partner has undertaken actions to mitigate a portion of these reductions primarily through (a) new service offerings, (b) product re-marketing and re-packaging and (c) marketing efforts directed at non-subscribers. To the extent such reductions are not mitigated, the values of the Venture's cable television systems, which are calculated based on cash flow, could be adversely impacted. In addition, the FCC's rulemakings may have an adverse effect on the Venture's ability to renegotiate its credit facility. Item 8.

Item 8. Financial Statements CABLE TV FUND 14 FINANCIAL STATEMENTS AS OF DECEMBER 31, 1993 and 1992 INDEX REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS To the Partners of Cable TV Fund 14-B: We have audited the accompanying consolidated balance sheets of CABLE TV FUND 14-B (a Colorado limited partnership) and subsidiary as of December 31, 1993 and 1992, and the related consolidated statements of operations, partners' capital (deficit) and cash flows for each of the three years in the period ended December 31, 1993. These financial statements and the schedules referred to below are the responsibility of the General Partner's management. Our responsibility is to express an opinion on these financial statements and schedules based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of Cable TV Fund 14-B and subsidiary as of December 31, 1993 and 1992, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 1993, in conformity with generally accepted accounting principles. Our audits were made for the purpose of forming an opinion on the basic financial statements taken as a whole. The schedules listed in the index of financial statements are presented for purposes of complying with the Securities and Exchange Commission's rules and are not part of the basic financial statements. These schedules have been subjected to the auditing procedures applied in the audits of the basic financial statements and, in our opinion, fairly state in all material respects the financial data required to be set forth therein in relation to the basic financial statements taken as a whole. /s/ ARTHUR ANDERSEN & CO. ARTHUR ANDERSEN & CO Denver, Colorado, March 11, 1994. CABLE TV FUND 14-B (A Limited Partnership) CONSOLIDATED BALANCE SHEETS The accompanying notes to consolidated financial statements are an integral part of these consolidated balance sheets. CABLE TV FUND 14-B (A Limited Partnership) CONSOLIDATED BALANCE SHEETS The accompanying notes to consolidated financial statements are an integral part of these consolidated balance sheets. CABLE TV FUND 14-B (A Limited Partnership) CONSOLIDATED STATEMENTS OF OPERATIONS The accompanying notes to consolidated financial statements are an integral part of these consolidated statements. CABLE TV FUND 14-B (A Limited Partnership) CONSOLIDATED STATEMENTS OF PARTNERS' CAPITAL (DEFICIT) The accompanying notes to consolidated financial statements are an integral part of these consolidated statements. CABLE TV FUND 14-B (A Limited Partnership) CONSOLIDATED STATEMENTS OF CASH FLOWS The accompanying notes to consolidated financial statements are an integral part of these consolidated statements. CABLE TV FUND 14-B (A Limited Partnership) NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (1) ORGANIZATION AND PARTNERS' INTERESTS Formation and Business Cable TV Fund 14-B ("Fund 14-B"), a Colorado limited partnership, was formed on September 9, 1987, under a public program sponsored by Jones Intercable, Inc. ("Intercable"). Fund 14-B was formed to acquire, construct, develop and operate cable television systems. Intercable is the "General Partner" and manager of Fund 14-B. The General Partner and its subsidiaries also own and operate cable television systems. In addition, the General Partner manages cable television systems for other limited partnerships for which it is general partner and, also, for other affiliated entities. Contributed Capital, Commissions and Syndication Costs The capitalization of Fund 14-B is set forth in the accompanying statements of partners' capital (deficit). No limited partner is obligated to make any additional contribution to partnership capital. The General Partner purchased its interest in Fund 14-B by contributing $1,000 to partnership capital. An affiliate of the General Partner, Jones International Securities, Ltd., received a commission of 10 percent of capital contributions of the limited partners, from which the affiliate paid all commissions of participating broker-dealers which sold the partnership interests. The General Partner was reimbursed 3.75 percent of capital contributions of the limited partners for all offering costs. Commission costs and reimbursements to the General Partner for costs of raising partnership capital were charged to limited partners' capital. All profits and losses of Fund 14-B are allocated 99 percent to the limited partners and 1 percent to the General Partner, except for income or gain from the sale or disposition of cable television properties, which will be allocated to the partners based upon the formula set forth in the Partnership Agreement and interest income earned prior to the first acquisition by Fund 14-B of a cable television system, which was allocated 100 percent to the limited partners. Formation of Joint Venture and Partnership Acquisitions Formation of Joint Venture On January 8, 1988, Cable TV Fund 14-A and Fund 14-B formed Cable TV Fund 14-A/B Venture (the "Venture"), to acquire the cable television system serving areas in and around Broward County, Florida (the "Broward County System"). Cable TV Fund 14-A contributed $18,975,000 to the capital of the Venture for an approximate 27 percent ownership interest and Fund 14-B contributed $51,025,000 of its net contributed capital for an approximate 73 percent ownership interest. Cable Television System Acquisitions Fund 14-B, acquired the cable television system serving Surfside, South Carolina (the "Surfside System") in 1988 and the cable television system serving Little Rock, California (the "Little Rock System") in 1989. The above acquisitions were accounted for as purchases with the individual purchase prices allocated to tangible and intangible assets based upon an independent appraisal. The method of allocation of purchase price was as follows: first, to the fair value of net tangible assets acquired; second, to the value of subscriber lists and noncompete agreements with previous owners; third, to franchise costs; and fourth, to costs in excess of interests in net assets purchased. Brokerage fees paid to an affiliate of the General Partner (Note 3) and other system acquisition costs were capitalized and included in the cost of intangible assets. (2) SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES Accounting Records The accompanying financial statements have been prepared on the accrual basis of accounting in accordance with generally accepted accounting principles. Fund 14-B's tax returns are also prepared on the accrual basis. Principles of Consolidation As a result of Fund 14-B's ownership interest in the Venture of approximately 73 percent, the accompanying financial statements present Fund 14-B's and the Venture's financial condition and results of operations on a consolidated basis with the ownership interest of Cable TV Fund 14-A in the Venture shown as a minority interest. The Venture does not have any ownership interest in the Surfside System or Little Rock System. These systems are owned 100 percent by Fund 14-B. All interpartnership accounts and transactions have been eliminated. Property, Plant and Equipment Depreciation is provided using the straight-line method over the following estimated service lives: Replacements, renewals, and improvements are capitalized and maintenance and repairs are charged to expense as incurred. Intangible Assets Costs assigned to franchises, subscriber lists, noncompete agreement and costs in excess of interests in net assets purchased are amortized using the straight-line method over the following remaining estimated useful lives: Revenue Recognition Subscriber prepayments are initially deferred and recognized as revenue when earned. (3) TRANSACTIONS WITH THE GENERAL PARTNER AND AFFILIATES Brokerage Fees The Jones Group, Ltd., an affiliate of the General Partner, performs brokerage services for Fund 14-B. For brokering the acquisition of the Surfside System for Fund 14-B, The Jones Group, Ltd. earned a fee totalling $1,920,000, or 4 percent of the purchase price, during the year ended December 31, 1988. Approximately $920,000 of such fee has been deferred until the sale of the Surfside System. For brokering the acquisition of an SMATV system in the Broward County System for the Venture, The Jones Group, Ltd. was paid a fee of $2,456, or 4 percent of the purchase price, in 1992. There were no brokerage fees paid in 1991 or 1993. Management Fees, Distribution Ratios and Reimbursements The General Partner manages Fund 14-B and the Venture and receives a fee for its services equal to five percent of the gross revenues of Fund 14-B and the Venture, excluding revenues from the sale of cable television systems or franchises. Management fees paid to the General Partner by Fund 14-B and the Venture for the years ended December 31, 1993, 1992 and 1991 were $1,586,750, $1,477,993 and $1,351,380, respectively. Any partnership distributions made from cash flow (defined as cash receipts derived from routine operations, less debt principal and interest payments and cash expenses) are allocated 99 percent to the limited partners and 1 percent to the General Partner. Any distributions other than interest income on limited partner subscriptions earned prior to the acquisition of the partnership's first cable television system or from cash flow, such as from the sale or refinancing of a system or upon dissolution of the partnership, will be made as follows: first, to the limited partners in an amount which, together with all prior distributions, will equal 125 percent of the amount initially contributed to the partnership capital by the limited partners; the balance, 75 percent to the limited partners and 25 percent to the General Partner. Fund 14-B and the Venture reimburse the General Partner for certain allocated overhead and administrative expenses. These expenses include salaries and benefits paid for corporate personnel, rent, data processing services and other corporate facilities costs. Such personnel provide engineering, marketing, accounting, administrative, legal, and investor relations services to Fund 14-B and to the Venture. Allocations of personnel costs are based primarily on actual time spent by employees of the General Partner with respect to each partnership managed. Remaining overhead costs are allocated based on revenues and/or the cost of assets managed for the partnership. Systems owned by the General Partner and all other systems owned by partnerships for which Intercable is the general partner are also allocated a proportionate share of these expenses. The General Partner believes that the methodology used in allocating overhead and administrative expense is reasonable. Reimbursements made to the General Partner for allocated overhead and administrative expenses during the years ended December 31, 1993, 1992 and 1991 were $2,440,481, $2,274,350 and $1,984,135, respectively. Fund 14-B and the Venture were charged interest during 1993 at an average interest rate of 10.61 percent on the amounts due the General Partner, which approximated the General Partner's weighted average cost of borrowing. Total interest charged Fund 14-B and the Venture by the General Partner was $2,361, $7,219 and $5,512 for the years ended December 31, 1993, 1992 and 1991, respectively. Payments to Affiliates for Programming Services Fund 14-B and the Venture receive programming from Superaudio and The Mind Extension University, affiliates of the General Partner. Payments to Superaudio totalled approximately $46,177, $45,603 and $40,707, in 1993, 1992 and 1991, respectively. Payments to The Mind Extension University totalled approximately $26,824, $26,131 and $25,005 in 1993, 1992 and 1991, respectively. (4) DEBT On December 31, 1992, the then outstanding balance of $46,800,000 on the Venture's revolving credit facility converted to a term loan. The balance outstanding on the term loan at December 31, 1993 was $43,290,000 . The term loan is payable in quarterly installments which began March 31, 1993 and is payable in full by December 31, 1999. Installments paid during 1993 totalled $3,510,000. Installments due during 1994 total $3,510,000. Funding for these installments is expected to come from cash on hand and cash generated from operations. The General Partner is currently negotiating to reduce principal payments to provide liquidity for capital expenditures. Interest is at the Venture's option of prime plus 1/2 percent, LIBOR plus 1-1/2 percent or CD rate plus 1-5/8 percent. The effective interest rates on amounts outstanding as of December 31, 1993 and 1992 were 5.0 percent and 5.48 percent, respectively. In January 1993, the Venture entered into an interest rate cap agreement covering outstanding debt obligations of $25,000,000. The Venture paid a fee of $246,250. The agreement protects the Venture from interest rates that exceeded 7 percent for three years from the date of the agreement. The fee is being charged to interest expense over the life of the agreement using the straight-line method. Fund 14-B's credit agreement had an original commitment of $20,000,000. Such commitment consisted of a $10,000,000 reducing revolving credit facility and a $10,000,000 term loan. The reducing revolving credit commitment reduced to $9,500,000 on December 31, 1993, reduces to $8,500,000 on December 31, 1994 and is payable in full at December 31, 1995. At December 31, 1993, $5,600,000 was outstanding under this revolving credit agreement, leaving $3,900,000 of borrowings available until December 31, 1994 for the needs of Fund 14-B. The $10,000,000 term loan is payable in quarterly installments which began March 31, 1993 and matures on December 31, 1995. As of December 31, 1993, $9,750,000 was outstanding on this term loan due to installment payments made during 1993 totalling $250,000. Currently, interest is payable on each loan at Fund 14-B's option of prime plus .20 percent, LIBOR plus 1.20 percent or CD Rate plus 1.325 percent. The effective interest rates on amounts outstanding on Fund 14-B's credit facility as of December 31, 1993 and 1992 were 4.71 percent and 4.98 percent, respectively. In January 1993, the Partnership entered into an interest rate cap agreement covering outstanding debt obligations of $8,000,000. The Partnership paid a fee of $77,600. The agreement protected the Partnership from interest rates that exceeded 7 percent for three years from the date of the agreement. The fee is being charged to interest expense over the life of this agreement using the straight-line method. Installments due on debt principal for each of the five years in the period ending December 31, 1998 and thereafter, respectively, are: At December 31, 1993, substantially all of Fund 14-B's and the Venture's property, plant and equipment secured the above indebtedness. (5) INCOME TAXES Income taxes have not been recorded in the accompanying financial statements because they accrue directly to the partners. The Federal and state income tax returns of Fund 14-B are prepared and filed by the General Partner. Fund 14-B's tax returns, the qualification of Fund 14-B as such for tax purposes, and the amount of distributable Partnership income or loss are subject to examination by Federal and state taxing authorities. If such examinations result in changes with respect to Fund 14-B's qualification as such, or in changes with respect to Fund 14-B's recorded income or loss, the tax liability of the general and limited partners would likely be changed accordingly. Taxable loss reported to the partners is different from that reported in the statements of operations due to the difference in depreciation recognized under generally accepted accounting principles and the expense allowed for tax purposes under the Modified Accelerated Cost Recovery System (MACRS). There are no other significant differences between taxable loss and the net loss reported in the consolidated statements of operations. (6) COMMITMENTS AND CONTINGENCIES On October 5, 1992, Congress enacted the Cable Television Consumer Protection and Competition Act of 1992 (the "1992 Cable Act:") which became effective on December 4, 1992. The 1992 Cable Act generally allows for a greater degree of regulation in the cable television industry. In April 1993, the FCC adopted regulations governing rates for basic and non-basic services. These regulations became effective on September 1, 1993. Such regulations caused reductions in the rates for certain regulated services. On February 22, 1994, the FCC announced a further rulemaking which, when implemented could reduce rates further. The General Partner plans to mitigate a portion of these reductions primarily through (a) new service offerings, (b) product re-marketing and re-packaging and (c) marketing efforts directed at non-subscribers. The 1992 Cable Act contains new broadcast signal carriage requirements, and the FCC has adopted regulations implementing the statutory requirements. These new rules allow a local commercial broadcast television station to elect whether to demand that a cable system carry its signal or to require the cable system to negotiate with the station for "retransmission consent." Additionally, cable systems also are required to obtain retransmission consent from all "distant" commercial television stations (except for commercial satellite-delivered independent "superstations"), commercial radio stations and certain low-power television stations carried by the cable systems. The retransmission consent rules went into effect October 6, 1993. In the cable television systems owned by Fund 14-B, no broadcast stations withheld their consent to retransmission of their signal. Certain broadcast signals are being carried pursuant to extensions offered to the General Partner by broadcasters, including a one-year extension for carriage of the CBS station owned and operated by the CBS network in Los Angeles. The General Partner expects to conclude retransmission consent negotiations with those stations whose signals are being carried pursuant to extensions without having to terminate the distribution of any of those signals. However, there can be no assurance that such will occur . If any broadcast station currently being carried pursuant to an extension is dropped, there could be a negative effect on the system if a significant number of subscribers were to disconnect their service. Office and other facilities are rented under various long-term lease arrangements. Rent paid under such lease arrangements totalled $97,288, $86,704 and $93,928, respectively, for the years ended December 31, 1993, 1992 and 1991. Minimum commitments under operating leases for each of the five years in the period ending December 31, 1998 and thereafter are as follows: (7) SUPPLEMENTARY PROFIT AND LOSS INFORMATION Supplementary profit and loss information for the respective periods is presented below: (8) OPERATING RESULTS OF SURFSIDE AND LITTLE ROCK SYSTEMS The results of operations of Fund 14-B's wholly owned Surfside System and Little Rock System on a stand-alone basis are presented below. Fund 14-B's share of the Venture owned Broward County System operations is also presented. CABLE TV FUND 14-B SCHEDULE V - PROPERTY, PLANT AND EQUIPMENT FOR THE YEARS ENDED DECEMBER 31, 1993,1992 and 1991 CABLE TV FUND 14-B SCHEDULE VI - ACCUMULATED DEPRECIATION OF PROPERTY, PLANT AND EQUIPMENT FOR THE YEARS ENDED DECEMBER 31, 1993, 1992 and 1991 REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS To the Partners of Cable TV Fund 14-A/B Venture: We have audited the accompanying balance sheets of CABLE TV FUND 14-A/B VENTURE (a Colorado general partnership) as of December 31, 1993 and 1992, and the related statements of operations, partners' capital and cash flows for each of the three years in the period ended December 31, 1993. These financial statements and the schedules referred to below are the responsibility of the General Partner's management. Our responsibility is to express an opinion on these financial statements and schedules based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of Cable TV Fund 14-A/B Venture as of December 31, 1993 and 1992, and the results of its operations and its cash flows for each of the three years in the period ended December 31, 1993, in conformity with generally accepted accounting principles. Our audits were made for the purpose of forming an opinion on the basic financial statements taken as a whole. The schedules listed in the index of financial statements are presented for purposes of complying with the Securities and Exchange Commission's rules and are not part of the basic financial statements. These schedules have been subjected to the auditing procedures applied in the audits of the basic financial statements and, in our opinion, fairly state in all material respects the financial data required to be set forth therein in relation to the basic financial statements taken as a whole. /s/ ARTHUR ANDERSEN & CO. ARTHUR ANDERSEN & CO. Denver, Colorado, March 11,1994. CABLE TV FUND 14-A/B VENTURE (A General Partnership) BALANCE SHEETS The accompanying notes to financial statements are an integral part of these balance sheets. CABLE TV FUND 14-A/B VENTURE (A General Partnership) BALANCE SHEETS The accompanying notes to financial statements are an integral part of these balance sheets. CABLE TV FUND 14-A/B VENTURE (A General Partnership) STATEMENTS OF OPERATIONS The accompanying notes to financial statements are an integral part of these statements. CABLE TV FUND 14-A/B VENTURE (A General Partnership) STATEMENTS OF PARTNERS' CAPITAL The accompanying notes to financial statements are an integral part of these statements. CABLE TV FUND 14-A/B VENTURE (A General Partnership) STATEMENTS OF CASH FLOWS The accompanying notes to financial statements are an integral part of these statements. CABLE TV FUND 14-A/B VENTURE (A General Partnership) NOTES TO FINANCIAL STATEMENTS (1) ORGANIZATION AND PARTNERS' INTERESTS Formation and Business On January 8, 1988, Cable TV Funds 14-A and 14-B (the "Venture Partners") formed a Colorado general partnership known as Cable TV Fund 14-A/B Venture (the "Venture") by contributing $18,975,000 and $51,025,000, respectively, for approximate 27 percent and 73 percent ownership interests, respectively. The Venture was formed for the purpose of acquiring the cable television system serving areas in and around Broward County, Florida (the "Broward County System"). Jones Intercable, Inc., ("Intercable") general partner of each of the Venture Partners, manages the Venture. Intercable and its subsidiaries also own and operate cable television systems. In addition, Intercable manages cable television systems for other limited partnerships for which it is general partner and for other affiliated entities. Contributed Capital The capitalization of the Venture is set forth in the accompanying statements of partners' capital. All Venture distributions, including those made from cash flow, from the sale or refinancing of Venture property and on dissolution of the Venture, shall be made to the Venture Partners in proportion to their approximate 27 and 73 percent interests in the Venture. Cable Television System Acquisition The Broward County System acquisition was accounted for as a purchase with the purchase price allocated to tangible and intangible assets based upon an independent appraisal. The method of allocation of purchase price was as follows: first, to the fair value of net tangible assets acquired; second, to the value of subscriber lists and noncompete agreements with previous owners; third, to franchise costs; and fourth, to costs in excess of interests in net assets purchased. Brokerage fees paid to an affiliate of the General Partner and other system acquisition costs were capitalized and included in the cost of intangible assets. (2) SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES Accounting Records The accompanying financial statements have been prepared on the accrual basis of accounting in accordance with generally accepted accounting principles. The Venture's tax returns are also prepared on the accrual basis. Property, Plant and Equipment Depreciation is provided using the straight-line method over the following estimated service lives: Replacements, renewals, and improvements are capitalized and maintenance and repairs are charged to expense as incurred. Intangible Assets Costs assigned to franchises, subscriber lists, noncompete agreement and costs in excess of interests in net assets purchased are amortized using the straight-line method over the following remaining estimated useful lives: Revenue Recognition Subscriber prepayments are initially deferred and recognized as revenue when earned. (3) TRANSACTIONS WITH AFFILIATES Brokerage Fees The Jones Group, Ltd., an affiliate of the General Partner, performs brokerage services in connection with the acquisition of systems for the Venture. For brokering the acquisition of a SMATV system in the Broward County System for the Venture, The Jones Group, Ltd. was paid a fee of $2,456, or 4 percent of the purchase price, during 1992. There were no brokerage fees paid in 1993 or 1991. Management Fees and Reimbursements Intercable manages the Venture and receives a fee for its services equal to five percent of the gross revenues of the Venture, excluding revenues from the sale of cable television systems or franchises. Management fees paid to Intercable by the Venture for the years ended December 31, 1993, 1992 and 1991 were $1,103,448, $1,010,643 and $918,344, respectively. The Venture reimburses Intercable for allocated overhead and administrative expenses. These expenses include salaries and related benefits paid for corporate personnel, rent, data processing services and other corporate facilities costs. Such personnel provide engineering, marketing, accounting, administrative, legal, and investor relations services to the Venture. Allocations of personnel costs are based primarily on actual time spent by employees of the General Partner with respect to each entity managed. Remaining overhead costs are allocated based on revenues and/or the cost of assets managed for the entity. Systems owned by Intercable and all other systems owned by partnerships for which Intercable is the general partner are also allocated a proportionate share of these expenses. Intercable believes that the methodology used in allocating overhead and administrative expenses is reasonable. Reimbursements made to Intercable by the Venture for allocated overhead and administrative expenses during the years ended December 31, 1993, 1992 and 1991 were $1,598,120, $1,471,015 and $1,272,372, respectively. The Venture was charged interest during 1993 at an average interest rate of 10.61 percent on the amounts due Intercable, such rate approximated Intercable's weighted average cost of borrowing. Total interest charged the Venture by Intercable was $2,361, 10,475 and $4,131 for the years ended December 31, 1993, 1992 and 1991, respectively. Payments to Affiliates for Programming Services The Venture receives programming from Superaudio and The Mind Extension University, affiliates of Intercable. Payments to Superaudio totalled $30,018, $28,679 and $25,872 in 1993, 1992 and 1991, respectively. Payments to The Mind Extension University totalled $17,451, $16,434 and $15,882 in 1993, 1992 and 1991, respectively. (4) DEBT On December 31, 1992, the then outstanding balance of $46,800,000 on the Venture's revolving credit facility converted to a term loan. The balance outstanding on the term loan at December 31, 1993 was $43,290,000. The term loan is payable in quarterly installments which began March 31, 1993 and is payable in full by December 31, 1999. Installments paid during 1993 totalled $3,510,000. Installments due during 1994 total $3,510,000. Funding for these installments is expected to come from cash on hand and cash generated from operations. Intercable is currently negotiating to reduce principal payments to provide liquidity for capital expenditures. Interest is at the Venture's option of prime plus 1/2 percent, LIBOR plus 1-1/2 percent or CD rate plus 1-5/8 percent. The effective interest rates on amounts outstanding as of December 31, 1993 and 1992 were 5.0 percent and 5.48 percent, respectively In January 1993, the Venture entered into an interest rate cap agreement covering outstanding debt obligations of $25,000,000. The Venture paid a fee of $246,250. The agreement protects the Venture from interest rates that exceed 7 percent for three years from the date of the agreement. The fee is being charged to interest expense over the life of the agreement using the straight-line method. On August 22, 1988, the Venture entered into an interest rate cap agreement covering outstanding debt obligations of $20,000,000. The Venture paid a fee of $310,000. The agreement protected the Venture from interest rates that exceeded ten percent for three years from the date of the agreement. The fee was charged to interest expense over the life of this agreement using the straight-line method. Installments due on debt principal for each of the five years in the period ending December 31, 1998 and thereafter, respectively, are: $3,561,519, $4,731,519 , $5,901,519, $8,207,173, $9,360,000 and $11,700,000 . At December 31, 1993, substantially all of the Venture's property, plant and equipment secured the above indebtedness. (5) INCOME TAXES Income taxes have not been recorded in the accompanying financial statements because they accrue directly to the partners of Cable TV Funds 14-A and 14-B, which are general partners in the Venture. The Venture's tax returns, the qualification of the Venture as such for tax purposes, and the amount of distributable Venture income or loss are subject to examination by Federal and state taxing authorities. If such examinations result in changes with respect to the Venture's qualification as such, or in changes with respect to the Venture's recorded income or loss, the tax liability of the Venture's general partners would likely be changed accordingly. Taxable loss reported to the partners is different from that reported in the statements of operations due to the difference in depreciation recognized under generally accepted accounting principles and the expense allowed for tax purposes under the Modified Accelerated Cost Recovery System (MACRS). There are no other significant differences between taxable loss and the net loss reported in the statements of operations. (6) COMMITMENTS AND CONTINGENCIES On October 5, 1992, Congress enacted the Cable Television Consumer Protection and Competition Act of 1992 (the "1992 Cable Act:") which became effective on December 4, 1992. The 1992 Cable Act generally allows for a greater degree of regulation in the cable television industry. In April 1993, the FCC adopted regulations governing rates for basic and non-basic services. These regulations became effective on September 1, 1993. Such regulations caused reductions in the rates for certain regulated services. On February 22, 1994, the FCC announced a further rulemaking which, when implemented could reduce rates further. The General Partner plans to mitigate a portion of these reductions primarily through (a) new service offerings, (b) product re-marketing and re-packaging and (c) marketing efforts directed at non-subscribers. Office and other facilities are rented under various long-term lease arrangements. Rent paid under such lease arrangements totalled $46,521, $45,406 and $54,702 respectively for the years ended December 31, 1993, 1992 and 1991. Minimum commitments under operating leases for each of the five years in the period ending December 31, 1998 and thereafter are as follows: 1994 $ 46,520 1995 46,520 1996 28,507 1997 5,724 1998 1,431 Thereafter - -------- $128,702 ======== (7) SUPPLEMENTARY PROFIT AND LOSS INFORMATION Supplementary profit and loss information for the respective periods is presented below: CABLE TV FUND 14-A/B VENTURE SCHEDULE V - PROPERTY, PLANT AND EQUIPMENT FOR THE YEARS ENDED DECEMBER 31, 1993, 1992 and 1991 CABLE TV FUND 14-A/B VENTURE SCHEDULE VI - ACCUMULATED DEPRECIATION OF PROPERTY, PLANT AND EQUIPMENT FOR THE YEARS ENDED DECEMBER 31, 1993, 1992 and 1991 ITEM 9.

ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE None. PART III. ITEM 10.

ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT The Partnerships themselves have no officers or directors. Certain information concerning directors and executive officers of the General Partner is set forth below. Mr. Glenn R. Jones has served as Chairman of the Board of Directors and Chief Executive Officer of the General Partner since its formation in 1970, and he was President from June 1984 until April 1988. Mr. Jones was elected a member of the Executive Committee of the Board of Directors in April 1985. He is also Chairman of the Board of Directors and Chief Executive Officer of Jones Spacelink, Ltd., a publicly held cable television company that is a subsidiary of Jones International, Ltd. and the parent of the General Partner. Mr. Jones is the sole shareholder, President and Chairman of the Board of Directors of Jones International, Ltd. He is also Chairman of the Board of Directors of the subsidiaries of the General Partner and of certain other affiliates of the General Partner. Mr. Jones has been involved in the cable television business in various capacities since 1961, is a past member of the Board of Directors of the National Cable Television Association and is a former member of its Executive Committee. Mr. Jones is a past director and member of the Executive Committee of C-Span. Mr. Jones has been the recipient of several awards including the Grand Tam Award in 1989, the highest award from the Cable Television Administration and Marketing Society, the Chairman's Award from the Investment Partnership Association, which is an association of sponsors of public syndications; the cable television industry's Public Affairs Association President's Award in 1990; the Donald G. McGannon award for the advancement of minorities and women in cable; the STAR Award from American Women in Radio and Television, Inc., for exhibition of a commitment to the issues and concerns of women in television and radio; and the Women in Cable Accolade in 1990 in recognition of support of this organization. Mr. Jones is also a founding member of the James Madison Council of the Library of Congress, is on the Board of Governors of the American Society of Training and Development and is a director of the National Alliance of Business. Mr. James B. O'Brien, the General Partner's President, joined the General Partner in January 1982 as System Manager, Brighton, Colorado, and was later promoted to the position of General Manager, Gaston County, North Carolina. Prior to being elected President and a Director of the General Partner in December 1989, Mr. O'Brien served as a Division Manager, Director of Operations Planning/Assistant to the CEO, Fund Vice President and Group Vice President/Operations. As President, he is responsible for the day-to-day operations of the cable television systems managed and owned by the General Partner. Mr. O'Brien is also President and a Director of Jones Cable Group, Ltd., Jones Global Funds, Inc., and Jones Global Management, Inc., all affiliates of the General Partner. Mr. O'Brien is a board member of Cable Labs, Inc., the research arm of the cable television industry. He also serves as a director of the Cable Television Administration and Marketing Association and as a director of the Walter Kaitz Foundation. Ms. Ruth E. Warren joined the General Partner in August 1980 and served in various capacities, including system manager and Fund Vice President, since then. Ms. Warren was elected Group Vice President/Operations of the General Partner in September 1990. Ms. Warren also serves as Vice President/Operations of Jones Spacelink, Ltd. Mr. Kevin P. Coyle joined The Jones Group, Ltd. in July 1981 as Vice President/Financial Services. In September 1985, he was appointed Senior Vice President/Financial Services. He was elected Treasurer of the General Partner in August 1987, Vice President/Treasurer in April 1988 and Group Vice President/Finance in October 1990. Mr. Christopher J. Bowick joined the General Partner in September 1991 as Group Vice President/Technology and Chief Technical Officer. Previous to joining the General Partner, Mr. Bowick worked for Scientific Atlanta's Transmission Systems Business Division in various technical management capacities since 1981, and as Vice President of Engineering since 1989. Mr. Timothy J. Burke joined the General Partner in August 1982 as corporate tax manager, was elected Vice President/Taxation in November 1986 and Group Vice President/Taxation/Administration in October 1990. He is also a member of the Board of Directors of Jones Spacelink, Ltd. Mr. Raymond L. Vigil joined the General Partner in April 1993 as Group Vice President/Human Resources and was elected a Director of the General Partner in November 1993. Previous to joining the General Partner, Mr. Vigil served as Executive Director of Learning with USWest from September 1989 to April 1993. Prior to that, Mr. Vigil worked in various human resources posts over a 14-year term with the IBM Corporation. Mr. James J. Krejci joined Jones International, Ltd. in March 1985 as Group Vice President. He was elected Group Vice President and Director of the General Partner in August 1987. He is also an officer of Jones Futurex, Inc., a subsidiary of Jones Spacelink, Ltd. engaged in manufacturing and marketing data encryption devices, Jones Information Management, Inc., a subsidiary of Jones International, Ltd. providing computer data and billing processing facilities and Jones Lightwave, Ltd., a company owned by Jones International, Ltd. and Mr. Jones, and several of its subsidiaries engaged in the provision of telecommunications services. Prior to joining Jones International, Ltd., Mr. Krejci was employed by Becton Dickinson and Company, a medical products manufacturing firm. Ms. Elizabeth M. Steele joined the General Partner in August 1987 as Vice President/General Counsel and Secretary. Ms. Steele also is an officer of Jones Spacelink, Ltd. From August 1980 until joining the General Partner, Ms. Steele was an associate and then a partner at the Denver law firm of Davis, Graham & Stubbs, which serves as counsel to the General Partner. Mr. Michael J. Bartolementi joined the General Partner in September 1984 as an accounting manager and was promoted to Assistant Controller in September 1985. He was named Controller in November 1990. Mr. George J. Feltovich was elected a Director of the General Partner in March 1993. Mr. Feltovich has been a private investor since 1978. Prior to 1978, Mr. Feltovich served as an administrative and legal consultant to various private and governmental housing programs. Mr. Feltovich was admitted to practice law in California, Pennsylvania and the District of Columbia and is a member of the California Bar Association. Mr. Patrick J. Lombardi has been a Director of the General Partner since February 1984 and has served as a member of the Audit Committee of the Board of Directors since February 1985. In September 1985, Mr. Lombardi was appointed Vice President of The Jones Group, Ltd., and in June 1989 was elected President of Jones Global Group, Inc., both affiliates of the General Partner. Mr. Lombardi is President and a director of Jones Financial Group, Ltd., an affiliate of the General Partner, and Group Vice President/Finance and a director of Jones International, Ltd. Mr. Howard O. Thrall was elected a Director of the General Partner in December 1988 and serves as a member of the Audit Committee and the special Stock Option Committee, which was established in August of 1992. From 1984 until August 1993, Mr. Thrall was associated with Douglas Aircraft Company, an aircraft manufacturing firm, most recently as Regional Vice President Marketing. In September 1993, Mr. Thrall joined World Airways, Inc. as Vice President of Sales, Asian Region. ITEM 11.

ITEM 11. EXECUTIVE COMPENSATION The Partnerships have no employees; however, various personnel are required to operate the cable television systems owned by the Partnerships. Such personnel are employed by the General Partner and, pursuant to the terms of the limited partnership agreements of the Partnerships, the cost of such employment is charged by the General Partner to the Partnerships as a direct reimbursement item. See Item 13. ITEM 12.

ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGERS No person or entity owns more than 5 percent of the limited partnership interests in either of the Partnerships. ITEM 13.

ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS The General Partner and its affiliates engage in certain transactions with the Partnerships as contemplated by the limited partnership agreements of the Partnerships and as disclosed in the Prospectus for the Partnerships. The General Partner believes that the terms of such transactions, which are set forth in the Partnerships' limited partnership agreements, are generally as favorable as could be obtained by the Partnerships from unaffiliated parties. This determination has been made by the General Partner in good faith, but none of the terms were or will be negotiated at arm's-length and there can be no assurance that the terms of such transactions have been or will be as favorable as those that could have been obtained by the Partnerships from unaffiliated parties. The General Partner charges the Partnerships for management fees, and the Partnerships reimburse the General Partner for certain allocated overhead and administrative expenses in accordance with the terms of the limited partnership agreements of the Partnerships. These expenses consist primarily of salaries and benefits paid to corporate personnel, rent, data processing services and other facilities costs. Such personnel provide engineering, marketing, administrative, accounting, legal and investor relations services to the Partnerships. Allocations of personnel costs are based primarily on actual time spent by employees of the General Partner with respect to each Partnership managed. Remaining overhead costs are allocated based on revenues and/or the costs of assets managed for the Partnerships. Systems owned by the General Partner and all other systems owned by partnerships for which Jones Intercable, Inc. is the General Partner, are also allocated a proportionate share of these expenses. The General Partner also advances funds and charges interest on the balance payable from the Partnerships. The interest rate charged the Partnerships approximates the General Partner's weighted average cost of borrowing. Affiliates of the General Partner have received amounts from the Partnerships for performing brokerage services. The Systems receive stereo audio programming from Superaudio, a joint venture owned 50% by an affiliate of the General Partner and 50% by an unaffiliated party, for a fee based upon the number of subscribers receiving the programming. These systems also receive educational video programming from Mind Extension University, Inc., an affiliate of the General Partner, for a fee based upon the number of subscribers receiving the programming. The charges to the Partnerships for related transactions are as follows for the periods indicated: * Cable TV Fund 14-B's consolidation includes 100% of the Venture. PART IV. ITEM 14.

ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K SIGNATURES Pursuant to the requirements of Section 13 or 15(d) 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. CABLE TV FUND 14-A, LTD. CABLE TV FUND 14-B, LTD. Colorado limited partnerships By: Jones Intercable, Inc., their general partner By: /s/ GLENN R. JONES Glenn R. Jones Chairman of the Board and Chief Dated: March 25, 1994 Executive Officer Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated.

793548_1993.txt

793548

1993

ITEM 1 - BUSINESS a) Description of Business Introduction Midlantic Corporation ("MC") is a regional bank holding company headquartered in Edison, New Jersey. MC's principal activity consists of managing, controlling and providing services and capital funds to its direct and indirect subsidiaries. MC directly or indirectly owns Midlantic National Bank ("MNB"), headquartered in Newark, New Jersey and Continental Bank ("CB"), headquartered in Norristown, Pennsylvania. The activities of MC and certain of its subsidiaries are significantly restricted by law (see "Supervision and Regulation"). Divestitures and Internal Mergers In 1991, MC announced a major restructuring program (the "Restructuring Program"), which encompassed a strategy of selling assets and subsidiaries located outside of New Jersey and southeastern Pennsylvania in order to strengthen its capital position and focus upon its core market. The following actions have been taken pursuant to the Restructuring Program: - MC's New Jersey bank subsidiaries, MNB and Midlantic National Bank/North were merged on September 30, 1991. - On November 15, 1991, the trust assets, branch facilities and $20.9 million of private banking and home equity loans of Midlantic National Bank and Trust Co./Florida ("MNB/Florida") were sold for $24.2 million. In late 1993, MNB/Florida was dissolved. - On December 31, 1991, MC sold The York Bank and Trust Company of York, Pennsylvania, for $129.0 million and United Penn Bank and UniPenn Realty Co., of Wilkes-Barre, Pennsylvania, for $90.2 million, respectively. - On March 24, 1992, Midlantic Home Mortgage Corporation ("MHMC") a mortgage banking subsidiary, was sold for $44.6 million. - On July 1, 1992, MC sold Central Trust Company and Endicott Trust Company for an aggregate sales price of $114.8 million of cash and other consideration and on December 31, 1992, MC sold the Merchants National Bank & Trust Company of Syracuse and Union National Bank of Albany for an aggregate sales price of $93.3 million of cash and other consideration. Prior to the announcement of the Restructuring Program, MC caused its wholly- owned subsidiary, Continental Bancorp, Inc., to be merged with and into MC. Midlantic National Bank and Continental Bank As of December 31, 1993, MNB operated 262 bank offices in twenty counties of New Jersey and one bank office in Philadelphia, Pennsylvania. MNB has an offshore branch in Grand Cayman, British West Indies. Its main office is in Newark, New Jersey and its principal executive offices are in Edison, New Jersey. CB operated 62 bank offices in Bucks, Chester, Delaware, Montgomery and Philadelphia counties in Pennsylvania at December 31, 1993. Its headquarters is located in Norristown, Pennsylvania and its executive offices are located in Philadelphia, Pennsylvania. MNB and CB operate six regional trust offices (five in New Jersey and one in Pennsylvania). According to "The American Banker," based upon total deposits, at December 31, 1993, MNB was the second largest commercial bank in New Jersey and CB was the seventh largest commercial bank in Pennsylvania. The following table provides information about MNB and CB as of December 31, 1993: MNB and CB are engaged in commercial and retail banking activities. Banking services are extended to individual, business, governmental and institutional customers, and to correspondent banks. Such services include all the usual deposit functions of commercial banks with demand and time account services; the making of commercial, industrial, real estate and consumer loans; the furnishing of collection and foreign exchange services; and rental of safe deposit boxes. In addition, MNB and CB furnish financial and data processing services to customers and other banks and provide cash management facilities to commercial customers. Offshore deposit acceptances and placements are conducted by MNB at facilities in Grand Cayman. MNB and CB provide complete personal and corporate trust services, including administration of estates and trusts, pension and other employee benefit plans, investment advisory and agency accounts, and a full range of other fiduciary, corporate fiduciary, and agency services. Nonbank Activities MC's major nonbank activities are conducted through the following direct or indirect subsidiaries: Midlantic Securities Corp., a discount broker/dealer located in Philadelphia, Pennsylvania; Lenders Life Insurance Co., an Arizona- based affiliate, which acts as a reinsurer in connection with credit-related insurance; and Lease and Go, Inc., which engages in the leasing of motor vehicles. At December 31, 1993, less than five percent of the consolidated assets of MC were employed in nonbank activities. Employees As of December 31, 1993, 5,863 persons were employed full-time or part-time by MC and its subsidiaries. Management of MC considers relations with its employees to be satisfactory. Competition The banking business is highly competitive and the bank subsidiaries ("Subsidiary Banks") of MC compete not only with New Jersey, New York and Pennsylvania commercial banks, but also with savings banks, savings and loan associations, money market and mutual funds, insurance companies, consumer finance companies, credit unions and other lending and deposit-gathering institutions. Effect of Government Monetary Policies The earnings of MC and the Subsidiary Banks are affected by domestic and foreign economic conditions and by the monetary and fiscal policies of the United States government and its agencies. The monetary policies of the Board of Governors of the Federal Reserve System (the "FRB") have had, and will probably continue to have, an important impact on the operating results of commercial banks through the FRB's power to implement national monetary policy in order to, among other things, curb inflation or combat a recession. The policies of the FRB have a major effect upon the levels of bank loans, investments and deposits through the FRB's open market operations in United States government securities, through its regulation of, among other things, the discount rate on borrowings of depository institutions, and the reserve requirements against depository institution deposits. Recently, lower interest rates resulting from the FRB's monetary policies have generally benefited depository institutions. It is not possible to predict the nature and impact of future changes in monetary and fiscal policies and their impact on MC and the Subsidiary Banks. Supervision and Regulation General - As a bank holding company registered under the Bank Holding Act of 1956, as amended (the "Act"), MC is subject to substantial regulation and supervision by the FRB. The Subsidiary Banks are subject to regulation and supervision by federal and state bank regulatory agencies, including the Office of the Comptroller of the Currency ("OCC") and the Federal Deposit Insurance Corporation ("FDIC"). Federal banking and other laws impose a number of requirements and restrictions on the operations and activities of depository institutions. In addition, the federal banking agencies periodically take regulatory actions to implement legislation and regulatory initiatives that might result in additional substantial restrictions on operations and activities and increase operating costs. Holding Company Activities - Under the Act, bank holding companies may engage directly, or indirectly through subsidiaries, in activities which the FRB determines to be so closely related to banking or managing or controlling banks as to be a proper incident thereto. Acquisitions of existing companies and engaging in activities which the FRB has not theretofore determined to be permissible for bank holding companies normally require specific FRB approval. MC, as well as its subsidiaries, is prohibited from engaging in certain tie-in arrangements in connection with any extension of credit, lease or provision of any property or services. Generally, the Act prohibits a bank holding company from acquiring more than five percent of the voting shares or substantially all of the assets of any bank without prior approval of the FRB. Subject to limited exceptions, the FRB is prohibited from approving an application by a bank holding company to acquire voting shares of any commercial bank in another state unless such acquisition of a bank is specifically authorized by the laws of such other state. Subject to certain restrictions, New Jersey law permits bank holding companies which are located in New Jersey, such as MC, to acquire commercial banks located outside of New Jersey. Pennsylvania law permits New Jersey bank holding companies, like MC, to acquire commercial banks in Pennsylvania, subject to the prior approval of the acquisition by the Pennsylvania Department of Banking and certain other limitations. In accordance with the restrictions in the New Jersey and Pennsylvania laws and subject to certain limitations, MC may acquire banks or bank holding companies in any state permitting such an acquisition. MC may, subject to approval by the FRB, also acquire savings associations. Dividends - The principal sources of income for MC are dividends and management fees from the Subsidiary Banks. The limitations on the Subsidiary Banks' ability to pay dividends to MC are described under the consolidated financial note caption "30. Lending and dividend limitations" and the consolidated financial note caption "31. Regulatory matters" on pages 68 and 69, respectively, of MC's Annual Report to Shareholders for the fiscal year ended December 31, 1993, which consolidated financial notes are incorporated herein by reference. Regulatory agreements with the FRB and OCC that restricted MC's and MNB's ability to declare and pay dividends were terminated in March 1994. Capital Requirements - Federal law currently requires MC and the Subsidiary Banks to meet certain minimum leverage and risk-based capital ratios, and empowers the bank regulatory agencies to take a number of enforcement actions against MC or the Subsidiary Banks if they fail to achieve the mandated ratios. MC and the Subsidiary Banks currently meet or exceed the minimum regulatory capital standards. The federal bank regulatory agencies have proposed incorporating an interest rate risk component and concentrations of credit and nontraditional activities risk components into existing risk-based capital standards. Under the proposals, banks and bank holding companies with greater than "normal" levels of such risks would be required to hold additional capital. Such proposals, if adopted, are not expected to have a material impact on MC or the Subsidiary Banks. Holding Company Liability - FRB policy requires bank holding companies to serve as a source of strength to their subsidiary banks by standing ready to use available resources to provide adequate capital funds to subsidiary banks during periods of financial stress or adversity. A bank holding company also could be liable under certain provisions of the Federal Deposit Insurance Corporation Improvement Act of 1991 ("FDICIA") for the capital deficiencies of an undercapitalized bank subsidiary. In the event of a bank holding company's bankruptcy under Chapter 11 of the U.S. Bankruptcy Code, the trustee will be deemed to have assumed and is required to cure immediately any deficit under any commitment by the debtor to any of the federal banking agencies to maintain the capital of an insured depository institution, and any claim for a breach of such obligation will generally have priority over most other unsecured claims. Transactions with Subsidiary Banks - The Subsidiary Banks are subject to certain restrictions imposed by law on extensions of credit to, and certain other transactions with, MC and certain other subsidiaries, as described under the consolidated financial note caption "30. Lending and dividend limitations" on pages 68 and 69 of MC's Annual Report to Shareholders for the fiscal year ended December 31, 1993, which consolidated financial note is incorporated herein by reference. A regulatory agreement with the OCC that restricted MNB's ability to declare and pay dividends was terminated in March 1994. The Subsidiary Banks are also subject to certain restrictions on investments in MC securities and on the taking of such securities as collateral for loans to any borrower. Unsafe or Unsound Practices - The appropriate federal bank regulatory authorities also have authority to prohibit a bank or bank holding company from engaging in any activity or transaction deemed by the federal bank regulatory authority to be an unsafe or unsound practice. The payment of dividends could, depending upon the financial condition of the bank or bank holding company, be such an unsafe or unsound practice. The amount of other payments by Subsidiary Banks to MC (including management fees) is subject to review by bank regulatory authorities. Federal law also grants to federal banking agencies the power to issue cease and desist orders when a depository institution or a bank holding company or an officer or director thereof is engaged in or is about to engage in unsafe and unsound practices. The FRB may require a bank holding company to discontinue certain of its activities or activities of its nonbank subsidiaries or divest itself of such nonbank subsidiaries if such activities cause serious risk to a bank subsidiary and are inconsistent with the Act or other applicable federal banking laws. Under certain circumstances, engaging in an unsafe or unsound practice could be grounds for the appointment of a receiver or conservator for an insured bank. Other Regulatory Matters - The Subsidiary Banks are also subject to other laws and regulations relating to required reserves, investments, loans, the opening and closing of branches and other aspects of their operations. Certain other regulatory matters that had affected MC and the Subsidiary Banks in recent years are described under the heading "Regulatory Agreements" in Management's Discussion and Analysis and the consolidated financial note caption "31. Regulatory matters" on pages 42 and 69, respectively of MC's Annual Report to Shareholders for the fiscal year ended December 31, 1993, each of which is incorporated herein by reference. In March 1994, the FRB and OCC terminated the regulatory agreements under which MC and MNB had been operating in recent years. New Banking Regulations - Pursuant to the provisions of FDICIA, which was enacted in late 1991 and which provides for significant changes in the bank regulatory system, the bank regulatory agencies have adopted or proposed for adoption regulations that impose significant restrictions on the activities of insured financial institutions and their holding companies. Among other things, such regulations impose uniform standards for real estate lending, adopt truth-in-savings disclosure requirements and prohibit or limit the acceptance of brokered deposits by insured financial institutions that do not meet the banking agencies' definition of "well-capitalized." The bank regulatory agencies are also actively considering proposals that affect a wide range of operational and managerial matters, including asset quality, earnings, stock valuation and employee compensation, limitations on activities of state- chartered banks, and new reporting and audit requirements. Deposit Insurance - The deposits of the Subsidiary Banks are insured by the FDIC through the Bank Insurance Fund ("BIF") to the extent provided by law. Effective January 1, 1993, the FDIC implemented a risk-based insurance system that assesses premiums of between 23 and 31 basis points per $100 of deposits depending upon the capital and supervisory group within which the institution falls. The Subsidiary Banks initially paid premiums at the higher end of this range. However, premiums were reduced somewhat during 1993 and are expected to decline again in 1994. The FDIC is considering other modifications to the assessment system which could result in a further increase in deposit insurance premium rates. Community Reinvestment and Fair Lending - Pursuant to federal law, federal regulatory authorities review the performance of MC and its Subsidiary Banks in meeting the credit needs of the communities served by the Subsidiary Banks. The applicable federal regulatory authority considers compliance with this law in connection with applications for, among other things, approval of branches, branch relocations and acquisitions of banks and bank holding companies. Federal regulatory authorities also review the performance of MC and its Subsidiary Banks with respect to compliance with laws prohibiting discriminatory practices in lending including the Equal Credit Opportunity Act and the Fair Housing Act. Under current law, federal regulators that have reason to believe that a bank has engaged in a pattern or practice of violating the Equal Credit Opportunity Act are required to refer the matter to the United States Department of Justice. Prompt Corrective Action - FDICIA prescribes the supervisory and regulatory actions that will be taken against undercapitalized insured depository institutions for the purposes of promptly resolving problems at such institutions at the least possible long-term loss to the FDIC. Five categories of depository institutions have been established by FDICIA in accordance with their capital levels: "well-capitalized," "adequately capitalized," "undercapitalized," "significantly undercapitalized" and "critically undercapitalized." The federal banking agencies have adopted uniform regulations to implement the prompt regulatory action provision of FDICIA. Under the uniform regulations, a well-capitalized institution has a minimum tier 1 capital-to-total risk-based assets ratio of 6 percent, a minimum total capital-to-total risk-based assets ratio of 10 percent and a minimum leverage ratio of 5 percent and is not subject to any written capital order or directive. An adequately capitalized institution meets all of its minimum capital requirements under the existing capital adequacy guidelines. An undercapitalized institution is one that fails to meet any one of the three minimum capital requirements. A significantly undercapitalized institution has a tier 1 capital-to-total risk-based assets ratio of less than 3 percent, a tier 1 leverage ratio of less than 3 percent or a total capital-to-total risk- based assets ratio of less than 6 percent. A critically undercapitalized institution has a tier 1 leverage ratio of 2 percent or less. An institution whose capital ratios meet the criteria for a well-capitalized institution may be classified as an adequately capitalized institution due to qualitative and/or quantitative factors other than capital adequacy. An adequately capitalized institution or undercapitalized institution, may under certain circumstances, be required to comply with supervisory actions as if it were in the next lower category. Based upon MC's understanding of the uniform regulations and of publicly available interpretations thereof by the bank regulatory agencies, MC believes that each of the Subsidiary Banks currently qualifies as a "well-capitalized" institution. The categorization of depository institutions under the uniform regulations is solely for the purpose of applying the prompt corrective action provision of FDICIA and is not intended to be, and should not be interpreted as, a representation of the depository institution's overall financial condition or prospects. An undercapitalized institution is required to submit a capital restoration plan for acceptance by the appropriate federal banking agency and will be subject to close monitoring of both its condition and compliance with, and progress made pursuant to, its capital restoration plan. The capital restoration plan will be accepted only if (i) it specifies the steps that will be taken to become adequately capitalized and the activities in which the institution will engage, (ii) it is based upon realistic assumptions and is likely to succeed in restoring the institution's capital, (iii) it does not appreciably increase the institution's risk exposure and (iv) each holding company that controls the institution provides appropriate assurances of performance and guarantees that the institution will comply with the plan until the institution is adequately capitalized on an average basis for each of four consecutive quarters. Liability under the guaranty is the lesser of (i) five percent of the institution's total assets at the time it became undercapitalized and (ii) the amount necessary to bring the institution into compliance with all applicable capital standards as of the time the institution fails to comply with the plan. An institution that fails to submit an acceptable plan may be placed into conservatorship or receivership unless its capital restoration plan is accepted. An undercapitalized institution will also be subject to restrictions on asset growth, acquisitions, branching, new activities, capital distributions and the payment of management fees. FDICIA requires the appropriate regulatory agencies to take one or more specific actions against significantly undercapitalized institutions and undercapitalized institutions that fail to submit capital restoration plans or fail to implement in a material respect their capital restoration plans, which actions include but are not limited to (i) requiring the institution to sell shares or other obligations to raise capital, (ii) limiting deposit interest rates, (iii) requiring the election of a new board of directors and/or dismissing senior executive officers and directors who held such positions for more than 180 days before the institution became undercapitalized, (iv) prohibiting receipt of deposits from correspondent banks, (v) requiring divestiture or liquidation of one or more subsidiaries and (vi) requiring the parent company to divest the institution if such divestiture will improve the institution's financial condition and future prospects. In addition, an insured institution that receives a less-than-satisfactory rating for asset quality, management, earnings or liquidity may be deemed by its appropriate federal banking regulator to be engaging in an unsafe or unsound practice for purposes of issuing an order to cease and desist or to take certain affirmative actions. If the unsafe or unsound practice is likely to weaken the institution, cause insolvency or substantial dissipation of assets or earnings or otherwise seriously prejudice the interest of depositors or the FDIC, a receiver or conservator could be appointed. Finally, subject to certain exceptions, FDICIA requires critically undercapitalized institutions to be placed into receivership or conservatorship within 90 days after becoming critically undercapitalized. The FRB has indicated that it will consult with each federal banking agency regulating the bank subsidiaries of a holding company to monitor required supervisory actions and, based on an assessment of these developments, will take appropriate action at the holding company level. Conservatorship and Receivership Powers of Federal Banking Agencies - FDICIA significantly expanded the authority of the federal banking regulators to place depository institutions into conservatorship or receivership to include, among other things, appointment of the FDIC as conservator or receiver of an undercapitalized institution under certain circumstances. In the event a bank is placed into conservatorship or receivership, the FDIC is required, subject to certain exceptions, to choose the method for resolving the institution that is least costly to the BIF, such as liquidation. In any event, if either of the Subsidiary Banks were placed into conservatorship or receivership, because of the cross-guarantee provisions of the Federal Deposit Insurance Act, as amended, MC as the sole stockholder of the Subsidiary Banks would likely lose its investment in the Subsidiary Banks. The FDIC may provide federal assistance to a "troubled institution" without placing the institution into conservatorship or receivership. In such case, pre-existing debtholders and stockholders may be required to make substantial concessions and, insofar as practical, the FDIC will succeed to their interests in proportion to the amount of federal assistance provided. Enforcement Actions and Administrative Sanctions - Failure to comply with applicable laws, regulations and supervisory agreements could subject MC, the Subsidiary Banks and officers, directors and institution-affiliated parties to administrative sanctions and potentially substantial civil money penalties. Proposed Legislation From time to time various proposals are made in the United States Congress as well as state legislatures which would alter the powers of, and place restrictions on, different types of bank organizations as well as bank and nonbank activities. Such legislative proposals include interstate branching, expansion of bank powers, amendment of the Community Reinvestment Act, and regulation of bank sales of mutual funds. It is impossible to predict whether any of the proposals will be adopted, therefore, it is not practical to predict the impact of such adoption on the business of MC or its subsidiaries. b) Statistical Information and Analysis The following tables set forth on a consolidated basis certain statistical data concerning MC and its wholly-owned subsidiaries ("Midlantic"). I. Distribution of Assets, Liabilities and Shareholders' Equity; Interest Rates and Interest Differential A. Average Balances MC responds to this segment by incorporating by reference the material for the years 1991 through 1993 under the heading "Comparative Consolidated Average Balance Sheet with Resultant Interest and Average Rates" on pages 72 and 73 of MC's Annual Report to Shareholders for the fiscal year ended December 31, 1993. B. Average Rates Earned and Paid MC responds to this segment by incorporating by reference the material for the years 1991 through 1993 under the caption "Comparative Consolidated Average Balance Sheet with Resultant Interest and Average Rates" on pages 72 and 73 of MC's Annual Report to Shareholders for the fiscal year ended December 31, 1993. C. Analysis of Year-to-Year Changes in Net Interest Earnings MC responds to this segment by incorporating by reference the material in "Table VI - Analysis of Changes in Net Interest Income" on page 20 of MC's Annual Report to Shareholders for the fiscal year ended December 31, 1993. II. Investment Portfolio A. Book Values MC responds to this item by incorporating by reference the amounts for 1993 and 1992 appearing in the columns labeled "Book Value" under the consolidated financial note caption "4. Investment securities" on pages 52 and 53 of MC's Annual Report to Shareholders for the fiscal year ended December 31, 1993. At December 31, 1991, Midlantic's investment securities portfolio, which totalled $2.656 billion, was stratified as follows: United States Treasury securities $1.926 billion; obligations of United States government agencies $383.665 million; obligations of states and political subdivisions $204.835 million; and Other securities $141.220 million. B. Maturities and Weighted Average Interest Yields MC responds to this item by incorporating by reference the material contained in the maturity distribution table under the consolidated financial note caption "4. Investment securities" on page 53 of MC's Annual Report to Shareholders for the fiscal year ended December 31, 1993. C. Securities of a Single Issuer Exceeding Ten Percent of Shareholders' Equity At December 31, 1993, Midlantic had aggregate investments with the Federal Home Loan Mortgage Corporation and the Federal National Mortgage Association, which comprised 61 percent and 34 percent of shareholders' equity, respectively. III. Loan Portfolio A. Types of Loans The following table shows the amount of each type of loan of Midlantic at the end of each of the past five years: B. Maturities and Sensitivities of Loans to Changes in Interest Rates MC responds to this segment by incorporating by reference the material in "Table XXIX Loan Portfolio - Maturities and Sensitivity to Changes in Interest Rates" on page 39 of MC's Annual Report to Shareholders for the fiscal year ended December 31, 1993. C. Risk Elements 1. Nonaccrual, Past Due and Restructured Loans MC responds to this item by incorporating by reference the material under the subcaptions "Nonaccrual Loans," "Renegotiated Loans" and "Accruing Past Due Loans" including the material for 13 1of2 the years 1989 through 1993 in "Table XVII - Nonaccrual Loans, Other Real Estate Owned, Net and Past Due Loans" on pages 31 through 33 of MC's Annual Report to Shareholders for the fiscal year ended December 31, 1993. 2. Potential Problem Loans MC responds to this item by incorporating by reference the material under the subcaption "Potential Problem Loans" on page 34 of MC's Annual Report to Shareholders for the fiscal year ended December 31, 1993. 3. Foreign Outstandings At December 31, 1993, Midlantic's foreign outstandings (dollar denominated credits owed or guaranteed by foreign countries, foreign banks and other foreign persons) amounted to $637.9 million or 4.6 percent of total consolidated assets as compared with $753.1 million or 5.2 percent of total assets at year-end 1992 and $315.4 million or 1.7 percent of total assets at year- end 1991. The rise in foreign outstandings since year-end 1991 primarily reflects an increase in short-term money market investments with domestic subsidiaries of foreign banks. The following table relates individual country exposures as a percent of total assets for those individual country exposures that exceeded .75 percent of total assets during any period-end covering the three years ended December 31, 1993. 13 2of2 The following is an analysis of the changes in the aggregate outstandings to Japan and France: 4. Loan Concentrations At December 31, 1993, there were no additional significant loan concentrations other than those disclosed pursuant to section III.A. of this report. D. Other Interest-bearing Assets MC responds to this item by incorporating by reference the material under the subcaption "Other Real Estate Owned" on pages 34 and 35 and the material relating to other real estate owned for the years 1989 through 1993 reported in "Table XVII - Nonaccrual Loans, Other Real Estate Owned, Net and Past Due Loans on page 31 of MC's Annual Report to Shareholders for the fiscal year ended December 31, 1993. IV. Summary of Loan Loss Experience A. Analysis of Loan Loss Experience MC responds to this item by incorporating by reference the material under the subcaption "Allowance for Loan Losses" including the material for the years 1989 through 1993 in "Table XVI - Summary of Loan Loss Experience" on pages 29 through 31 of MC's Annual Report to Shareholders for the fiscal year ended December 31, 1993. B. Allocation of Allowance for Loan Losses and the Percentage of Loans to Total Loans The following table provides the allocation of the allowance for loan losses at the end of each of the past five years as required by Securities and Exchange Commission Industry Guide # 3. The methodology used to allocate reserves is heavily weighted by loan charge-off history. The level of Midlantic's charge-offs in recent years may not be indicative of future losses and, therefore, may result in higher allocations to certain loan categories. Midlantic considers the entire allowance as available for the entire loan portfolio. The following table provides the percentage of loans to total loans of Midlantic at the end of each of the past five years: V. Deposits MC responds to this item by incorporating by reference the material for the years 1991 through 1993 in "Table XXV - Average Funding Sources - Balances and Rates Paid" and under the consolidated financial note caption "13. Deposits" on pages 36 and 56, respectively, of MC's Annual Report to Shareholders for the fiscal year ended December 31, 1993. VI. Return on Equity and Assets MC responds to this item by incorporating by reference the return on assets, return on equity, and equity to assets ratio as well as other key information presented for the years 1991 through 1993 under the caption "Consolidated Statistical Information" on page 75 of MC's Annual Report to Shareholders for the fiscal year ended December 31, 1993. During 1993, 1992 and 1991 MC did not pay dividends to its common shareholders and consequently had no dividend payout ratio on its common stock. VII. Short-term Borrowings MC responds to this item by incorporating by reference the material under the consolidated financial note caption "14. Short-term borrowings" on page 56 of MC's Annual Report to Shareholders for the fiscal year ended December 31, 1993. ITEM 2

ITEM 2 - PROPERTIES The corporate headquarters of MC are located in the Metro Park commercial complex in Edison, New Jersey. MNB's principal executive offices are also located in the Metro Park complex while CB's principal executive offices are located at Centre Square in Philadelphia, Pennsylvania. MC, through its subsidiary, Parkway Management Inc., in a joint venture with an unaffiliated party, has a 50 percent interest in the ownership and operation of a 12-story 264,000 square foot building on land leased from an unaffiliated third party under a long-term lease at the Metro Park commercial complex in Edison, New Jersey. Approximately 213,000 square feet of the building have been rented by MNB for its use and the use of MC, at a minimum annual rental of $3.129 million. The building is encumbered by a mortgage securing a nonrecourse 32-year loan made by an unrelated third party (which loan may be called in 1996). CB leases approximately 101,000 square feet of the Centre Square building, of which approximately 10,000 square feet are utilized as a branch facility, with the remainder housing its executive offices and certain operations. The Centre Square lease is in the 20th year of an initial 30-year lease, of which the minimum annual rental amounts to $994 thousand. Such lease contains five ten- year renewal options which commence at the initial expiration date of March 31, 2004. At December 31, 1993, the Subsidiary Banks occupied 326 bank offices (198 were owned in fee and 128 were leased) in 20 counties of New Jersey, 5 counties of Pennsylvania, and in Grand Cayman. The Subsidiary Banks also lease additional office space from various unrelated firms. MNB owns a computer and operations center comprising approximately 110,000 square feet in West Orange, New Jersey and, through its wholly-owned subsidiary, Iron Investments Corp., in a joint venture with an unaffiliated party, owns and operates a 70,500 square foot building in Morris County, New Jersey, of which approximately 36,000 square feet are utilized by MNB primarily for certain data processing operations. MNB also owns a 10-story office building in West Paterson, New Jersey with approximately 200,000 square feet of space and a four-story office building in Edison, New Jersey (located in the Metro Park commercial complex) with approximately 40,000 square feet of space, portions of which are utilized for operational functions. CB utilizes two buildings in Norristown, Pennsylvania, which are owned in fee and encompass approximately 87,000 square feet, for certain operations and administrative functions. A substantial portion of CB's accounting and data processing operations is conducted in four buildings, owned in fee, comprising approximately 141,000 square feet in Fort Washington, Pennsylvania. At December 31, 1993, the nonbank subsidiaries of MC had four offices, all of which were leased. Total consolidated occupancy rental expense of Midlantic, net of rental income and intercompany leasing arrangements, was $17.723 million in 1993. ITEM 3

ITEM 3 - LEGAL PROCEEDINGS As MC reported in "Item 1 - Legal Proceedings" of its quarterly reports on Form 10-Q for the quarters ended March 31, 1993, June 30, 1993 and September 30, 1993, MC and various directors and former officers of MC are defendants in a consolidated action, initially commenced in March 1990, pending in Federal District Court in New Jersey (the "Action"). The Action has been instituted by shareholders of MC, either on behalf of MC against various directors and former officers of MC, or directly against MC and various directors and former officers of MC. In general, the Action seeks damages payable either to MC or to the shareholders and holders of certain debt securities because of alleged discrepancies between certain public statements made by MC and later results of MC's operations. In their pleadings, plaintiffs do not seek damages in a stated dollar amount. The Action includes claims that certain actions of MC are void. The claims are based upon alleged violations of the United States securities laws and New Jersey common law. In June 1990, the plaintiffs filed a motion for class certification. The defendants moved to dismiss the complaint on July 31, 1990. On October 11, 1990, the Court filed an opinion denying the defendants' motion to dismiss the complaint. On December 3, 1990, an answer to the complaint was served on behalf of those defendants who had been served with the complaint. The parties have stipulated to the certification of a plaintiff class, which stipulation was reflected in an order entered by the Court on March 6, 1991. On May 6, 1991, the Court entered a consent order setting forth a discovery schedule. At present, documents are being produced and depositions are proceeding. ITEM 4

ITEM 4 - SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS There were no matters submitted to a vote of security holders during the fourth quarter of 1993. EXECUTIVE OFFICERS OF THE REGISTRANT The following is a list of all the executive officers of MC who serve as such at the pleasure of the Board of Directors of MC as of March 23, 1994: Age at 1/1/94 Position ______ ________ GARRY J. SCHEURING 54 Chairman of the Chairman of the Board, President and Chief Board, President Executive Officer of MC since 1991; and Chief Chairman of the Board, President and Chief Executive Executive Officer of Midlantic National Officer Bank since 1992; Chairman of the Board and Chief Executive Officer of Continental Bank since 1992; Vice Chairman of Continental Bank Corporation (1988-1991) HOWARD I. ATKINS 42 Executive Vice Executive Vice President and Chief Financial President and Officer of MC since 1991; Corporate Treasurer Chief Financial and Treasury Executive of Chase Manhattan Bank, Officer N.A. (1988-1991) DONALD W. EBBERT, JR. 48 Senior Vice Senior Vice President and Treasurer President and (since 1992) and Senior Vice President Treasurer and Director of Investor Relations (1990-1992) of MC; Senior Vice President and Treasurer of Southeast Banking Corporation (1988-1989) MARY ELLEN GRAY 45 Executive Vice Executive Vice President and Director of Real President and Estate Lending of MC since 1992; Executive Vice Director of President for Real Estate (1989-1992) of Chemical Real Estate Bank, N.A. of New Jersey Lending JEFFREY S. GRIFFIE 49 Executive Vice Executive Vice President and Director of Corporate President and Operations of MC since 1992; Executive Vice Director of President of Midlantic National Bank since 1985 Corporate Operations JAMES E. KELLY 49 Controller Controller of MC since 1992; Executive Vice President of Continental Bank since 1988 JOSEPH H. KOTT 45 Executive Vice Executive Vice President and General Counsel (since President and 1993) and Senior Vice President and General Counsel General Counsel (1991-1993) of MC; Partner, Pitney, Hardin, Kipp & Szuch (1982-1991) Age at 1/1/94 Position ______ ________ R. RAY LOCKHART 54 Senior Vice Senior Vice President and Auditor of MC President and since 1987 Auditor JAMES J. LYNCH 43 Executive Vice Executive Vice President and Director of President and Commercial Banking-Pennsylvania of MC since 1992; Director of President (since 1992) and Vice Chairman (1986-1992) Commercial Banking- of Continental Bank Pennsylvania EUGENE J. MCNAMARA 61 Senior Vice Senior Vice President and Director of Human President and Resources of MC since 1992; Senior Vice Director of President and Northern Region Senior Operations Human Resources Officer of Midlantic National Bank (1991-1992); Executive Vice President and Senior Operations Officer of Midlantic National Bank/North (1984-1991) BARBARA Z. PARKER 44 Executive Vice Executive Vice President and Director of Trust and President and Investment Management (since 1993) and Senior Vice Director of Trust President and Director of Trust and Investment and Investment Management (1992-1993) of MC; Senior Vice President, Management Corporate Banking (1991-1992) and Vice President, Corporate Banking (1985-1991) of Midlantic National Bank ALFRED J. SCHIAVETTI, JR. 54 Executive Vice Executive Vice President and Chief Credit Officer President and of MC since 1991; Managing Director, Realty Group Chief Credit of Chemical Bank (1987-1991) Officer ALAN M. SILBERSTEIN 46 Executive Vice Executive Vice President and Director of Retail President and Banking of MC since 1992; Executive Vice Director of President, Consumer Banking Group (1990-1991) Retail Banking and Senior Vice President, Consumer Banking (1986-1990) of Chemical Bank FRANK T. VAN GROFSKI 49 Executive Vice Executive Vice President and Director of Corporate President and Banking and Commercial Banking-New Jersey of MC since Director of 1992; Senior Vice President, Corporate Banking of Corporate Banking Midlantic National Bank (1987-1992) and Commercial Banking-New Jersey PART II ITEM 5

ITEM 5 - MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS The table below sets forth for the periods indicated the range of highest and lowest actual transactions per share and the closing price of Midlantic Corporation common stock, as reported by NASDAQ. The price quotations set forth herein do not include retail markups, markdowns or commissions. The number of common shareholders of record at January 28, 1994 was 30,722. Midlantic Corporation did not declare any dividends on its common stock during 1992 or 1993. MC also responds to this item by incorporating by reference the information under the consolidated financial note caption "16. Capital stock - preferred stock," the consolidated financial note caption "30. Lending and dividend limitations" and the consolidated financial note caption "31. Regulatory matters" on pages 57, 68 and 69, respectively, of MC's Annual Report to Shareholders for the fiscal year ended December 31, 1993. (See also "Supervision and Regulation"). A regulatory agreement with the FRB that restricted MC's ability to declare and pay cash dividends was terminated in March 1994. ITEM 6

ITEM 6 - SELECTED FINANCIAL DATA MC responds to this item by incorporating by reference the material appearing in the columns 1989 through 1993 under the caption "Selected Supplemental Financial Data" and accompanying footnote on page 43 of MC's Annual Report to Shareholders for the fiscal year ended December 31, 1993. ITEM 7

ITEM 7 - MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS MC responds to this item by incorporating by reference the material under the section heading "Management's Analysis of the Results of Operations and Financial Condition" and the consolidated supplementary financial and statistical information on pages 16 through 43 and pages 71 through 75, respectively, of MC's Annual Report to Shareholders for the fiscal year ended December 31, 1993. The FRB Agreement and the OCC Agreement referred to in "Regulatory Agreements" on page 42 of MC's Annual Report to Shareholders for the year ended December 31, 1993, were terminated in March 1994. ITEM 8

ITEM 8 - FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA MC responds to this item by incorporating by reference the material on pages 44 through 70 of MC's Annual Report to Shareholders for the fiscal year ended December 31, 1993. ITEM 9

ITEM 9 - CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE During the past two fiscal years, there was neither a change in independent accountants nor any disagreements with independent accountants on any matter of accounting principles or practices, financial statement disclosure, or auditing scope or procedure. PART III ITEM 10

ITEM 10 - DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT MC responds to this item by incorporating by reference the material on pages 2 through 4 under the caption "Information About Nominees For Directors of the Company" in MC's definitive proxy statement respecting its 1994 Annual Shareholders' Meeting. Information regarding executive officers is included in this report under the caption "Executive Officers of the Registrant." ITEM 11

ITEM 11 - EXECUTIVE COMPENSATION MC responds to this item by incorporating by reference the material under the caption "Executive Compensation and Other Information" on pages 6 through 15 in MC's definitive proxy statement respecting its 1994 Annual Shareholders' Meeting. Such incorporation by reference shall not be deemed to specifically incorporate by reference the information referred to in Item 402(a)(8) of Regulation S-K. ITEM 12

ITEM 12 - SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT MC responds to this item by incorporating by reference the material under the captions "Principal Shareholders" on page 17 and "Securities Ownership of Management" on pages 4 through 6 in MC's definitive proxy statement respecting its 1994 Annual Shareholders' Meeting, except that the percentage owned by all directors and executive officers as a group is hereby amended to be 3.43%. ITEM 13

ITEM 13 - CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS MC responds to this item by incorporating by reference the material under the captions "Compensation Committee Interlocks and Insider Participation" on page 11 and "Interest of Management in Certain Transactions" on page 15 in MC's definitive proxy statement respecting its 1994 Annual Shareholders' Meeting. PART IV ITEM 14

ITEM 14 - EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K a) FINANCIAL STATEMENTS, SCHEDULES AND EXHIBITS 1. FINANCIAL STATEMENTS Midlantic Corporation and Subsidiaries Consolidated Financial Statements* Consolidated Statement of Income for each of the Three Years in the Period Ended December 31, 1993 Consolidated Balance Sheet at December 31, 1993 and 1992 Consolidated Statement of Changes in Shareholders' Equity for each of the Three Years in the Period Ended December 31, 1993 Consolidated Statement of Cash Flows for each of the Three Years in the Period Ended December 31, 1993 Notes to Consolidated Financial Statements Independent Auditor's Report *Incorporated by reference to pages 44 through 70 of Midlantic Corporation's Annual Report to Shareholders for the fiscal year ended December 31, 1993. 2. SCHEDULES Schedules are omitted because they are not required or are not applicable. 3. EXHIBITS (3) (a) Certificate of Incorporation of Midlantic Corporation, as amended through March 12, 1990 incorporated by reference to Exhibit 3(a) to Form 10-K of Midlantic Corporation for the fiscal year ended December 31, 1989 (b) By-Laws of Midlantic Corporation as amended and restated through September 16, 1992 incorporated by reference to Exhibit 3(b) to Form 10-K of Midlantic Corporation for the fiscal year ended December 31, 1992 (4) (a) Agreement to file instruments regarding long-term debt (b) Rights Agreement dated as of February 23, 1990 between Midlantic Corporation and Midlantic National Bank (including as Exhibit A thereto Midlantic Corporation's Certificate of Amendment of Certificate of Incorporation covering its Series B Junior Participating Preferred Stock and including as Exhibit B thereto the form of Rights Certificate) incorporated by reference to Exhibit 2 to the Registration Statement on Form 8-A of Midlantic Corporation dated February 26, 1990 (10) (a) Purchase Agreement dated as of June 5, 1990 among Midlantic National Bank, Midlantic Corporation, Midlantic National Bank/Delaware and Manufacturers Hanover Trust Company incorporated by reference to Exhibit 28(b) to Form 8-K of Midlantic Corporation dated June 30, 1990 (b) Agreement by and between Midlantic National Bank, Newark, New Jersey and the Office of the Comptroller of the Currency dated December 20, 1990 incorporated by reference to Exhibit 28(a) to Form 8-K of Midlantic Corporation dated December 21, (c) Letter dated January 17, 1991 from Midlantic National Bank to the Office of the Comptroller of the Currency amending an Agreement dated December 20, 1990 between Midlantic National Bank and the Office of the Comptroller of the Currency incorporated by reference to Exhibit 19(a) to Form 10-Q of Midlantic Corporation for the quarter ended June 30, 1991 (d) Amendment dated July 23, 1991 to an Agreement dated December 20, 1990 between Midlantic National Bank and the Office of the Comptroller of the Currency incorporated by reference to Exhibit 19(b) to Form 10-Q of Midlantic Corporation for the quarter ended June 30, 1991 (e) Acquisition Agreement dated as of September 25, 1991 among Midlantic Corporation, United Penn Bank and Mellon Bank, N.A. incorporated by reference to Exhibit 28 to Form 8-K of Midlantic Corporation dated October 1, 1991 (f) Amendment and Supplement dated December 18, 1991 to Acquisition Agreement dated as of September 25, 1991 among Midlantic Corporation, United Penn Bank and Mellon Bank, N.A. incorporated by reference to Exhibit 28(d) to Form 8-K of Midlantic Corporation dated December 31, 1991 (g) Stock Purchase Agreement dated as of February 21, 1992 between Midlantic Corporation and ONBANCORP, Inc. incorporated by reference to Exhibit 28(b) to Form 8-K of Midlantic Corporation dated February 21, 1992 (h) Written Agreement dated as of May 16, 1991 between Midlantic Corporation and the Federal Reserve Bank of New York incorporated by reference to Exhibit 28 to Form 8-K of Midlantic Corporation dated May 16, 1991 (i) Stock Purchase Agreement dated as of March 23, 1992 by and among CHMC Mortgage Company Acquisition, Inc., Midlantic Banks Inc. and Midlantic Corporation incorporated by reference to Exhibit 10 to Form 10-K of Midlantic Corporation for the year ended December 31, 1991 (j) Agreement dated as of July 21, 1992 between Midlantic Corporation and The Bank of New York Company, Inc. incorporated by reference to Exhibit 28 to Form 8-K of Midlantic Corporation dated July 22, 1992 Executive Compensation Plans and Arrangements _____________________________________________ (k) Midlantic Incentive Stock and Stock Option Plan (1986), as amended, incorporated by reference to Exhibit 4 to Midlantic Corporation's Registration Statement on Form S-8, No. 33-50952 (l) Midlantic Incentive Plan, as amended, incorporated by reference to Exhibit 4(c) to Midlantic Corporation's Post- Effective Amendment No. 1 to Registration Statement on Form S-8, No. 33-16256 (m) Continental Bancorp, Inc. 1982 Stock Option Plan, as amended, incorporated by reference to Exhibit 4(f) to Midlantic Corporation's Post-Effective Amendment No. 1 to Registration Statement on Form S-8, No. 33-16256 (n) Rules and Regulations Relating to the Payment in Shares of Common Stock for the Exercise Price of Stock Options incorporated by reference to Exhibit 10(o) to Form 10-K of Midlantic Corporation for the fiscal year ended December 31, (o) Rules and Regulations - Stock Awards incorporated by reference to Exhibit 10(p) to Form 10-K of Midlantic Corporation for the fiscal year ended December 31, 1992 (p) Rules and Regulations Relating to the Exercise of Stock Appreciation Rights incorporated by reference to Exhibit 10(q) to Form 10-K of Midlantic Corporation for the fiscal year ended December 31, 1992 (q) Rules and Regulations Relating to the Payment in Shares of Common Stock of Taxes in Connection with the Vesting of an Award incorporated by reference to Exhibit 10(r) to Form 10-K of Midlantic Corporation for the fiscal year ended December 31, 1992 (r) Rules and Regulations Relating to the Payment in Shares of Common Stock of Taxes in Connection with the Exercise of a Non-Qualified Stock Option incorporated by reference to Exhibit 10(s) to Form 10-K of Midlantic Corporation for the fiscal year ended December 31, 1992 (s) Continental Bancorp, Inc. Survivor Benefit Plan incorporated by reference to Exhibit 10(t) to Form 10-K of Midlantic Corporation for the fiscal year ended December 31, 1992 (t) Midlantic Corporation Executive Supplemental Retirement Plan incorporated by reference to Exhibit 19(a) to Form 10-Q of Midlantic Corporation for the quarter ended June 30, 1989 (u) Midlantic Corporation Excess Benefit Plan and Amendment No. 1 dated March 20, 1991 thereto incorporated by reference to Exhibit 19(a) to Form 10-Q of Midlantic Corporation for the quarter ended March 31, 1991 (v) Midlantic Corporation Severance Pay Policy incorporated by reference to Exhibit 19(c) to Form 10-Q of Midlantic Corporation for the quarter ended September 30, 1991 (w) Form of Change of Control Agreement of Midlantic Corporation incorporated by reference to Exhibit 10(y) to Form 10-K of Midlantic Corporation for the fiscal year ended December 31, (x) Employment Agreement dated and effective as of April 23, 1991 between Midlantic Corporation and Garry J. Scheuring incorporated by reference to Exhibit 28 to Form 8-K of Midlantic Corporation dated April 11, 1991 (y) Employment Agreement dated as of July 1, 1991 between Midlantic Corporation and Alfred J. Schiavetti, Jr. incorporated by reference to Exhibit 19(g) to Form 10-Q of Midlantic Corporation for the quarter ended June 30, 1991 (z) Employment Agreement dated as of September 12, 1991 between Midlantic Corporation and Howard I. Atkins incorporated by reference to Exhibit 19(a) to Form 10-Q of Midlantic Corporation for the quarter ended September 30, 1991 (aa) Employment Agreement dated as of January 27, 1992 between Midlantic Corporation and Alan M. Silberstein incorporated by reference to Exhibit 10 to Form 10-K of Midlantic Corporation for the year ended December 31, 1991 (bb) Change of Control Agreement dated as of January 1, 1993 between Midlantic Corporation and James J. Lynch incorporated by reference to Exhibit 10(dd) to Form 10-K of Midlantic Corporation for the fiscal year ended December 31, 1992 (cc) Description of tax consultation plan of Midlantic Banks Inc. incorporated by reference to Exhibit 10(ee) to Form 10-K of Midlantic Corporation for the fiscal year ended December 31, (dd) Midlantic Annual Incentive and Bonus Plan (11) Statement regarding computation of income (loss) per common share (13) Annual Report to Shareholders for the fiscal year ended December 31, (21) Subsidiaries of Midlantic Corporation (23) Consent of Independent Accountants (24) Powers of Attorney Copies of the foregoing Exhibits will be furnished upon request and payment. b) REPORTS ON FORM 8-K No reports on Form 8-K were filed during the last quarter of the period covered by this report. SIGNATURES Pursuant to the requirements of Section 13 or 15(d) 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. MIDLANTIC CORPORATION (Registrant) Signature Title Date _________________________________________________________________________ By GARRY J. SCHEURING ___________________________ Chairman of the Board, March 23, 1994 Garry J. Scheuring President and Chief Executive Officer By HOWARD I. ATKINS ___________________________ Executive Vice President March 23, 1994 Howard I. Atkins and Chief Financial Officer By JAMES E. KELLY ___________________________ Controller March 23, 1994 James E. Kelly Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated. Signature Title Date _________________________________________________________________________ .............................. Chairman of the Board, March 23, 1994 (Garry J. Scheuring) President and Chief Executive Officer * .............................. Director March 23, 1994 (Charles E. Ehinger) * .............................. Director March 23, 1994 (David F. Girard-diCarlo) * .............................. Director March 23, 1994 (Frederick C. Haab) * .............................. Director March 23, 1994 (Kevork S. Hovnanian) Signature Title Date _________________________________________________________________________ * .............................. Director March 23, 1994 (Arthur J. Kania) * .............................. Director March 23, 1994 (Aubrey C. Lewis) * .............................. Director March 23, 1994 (David F. McBride) * .............................. Director March 23, 1994 (Desmond P. McDonald) * .............................. Director March 23, 1994 (William E. McKenna) * .............................. Director March 23, 1994 (Marcy Syms Merns) * .............................. Director March 23, 1994 (Ralph H. O'Brien) * .............................. Director March 23, 1994 (Roy T. Peraino) * .............................. Director March 23, 1994 (Ernest L. Ransome, III) * .............................. Director March 23, 1994 (Ronald Rubin) * .............................. Director March 23, 1994 (B. P. Russell) * .............................. Director March 23, 1994 (Fred R. Sullivan) * .............................. Director March 23, 1994 (Harold L. Yoh, Jr.) *Joseph H. Kott, by signing his name hereto, does sign this document on behalf of each of the persons named above pursuant to powers of attorney duly executed by such persons which are filed with the Securities and Exchange Commission. By JOSEPH H. KOTT _____________________________ Joseph H. Kott Attorney-in-fact

63073_1993.txt

63073

1993

Item 1. BUSINESS THE SYSTEM SYSTEM ORGANIZATION New England Electric System (NEES) is a voluntary association created under Massachusetts law on January 2, 1926, and is a registered holding company under the Public Utility Holding Company Act of 1935 (the 1935 Act). NEES owns voting stock in the amounts indicated of the following companies, which together constitute the System. % Voting Securities State of Type of Owned by Name of Company Organization Business NEES --------------- ------------ --------- ---------- Subsidiaries: Granite State Electric Company N.H. Retail 100 (Granite State) Electric Massachusetts Electric Company Mass. Retail 100 (Mass. Electric) Electric The Narragansett Electric Company R.I. Retail 100 (Narragansett) Electric Narragansett Energy Resources R.I. Wholesale 100 Company (Resources) Electric Generation New England Electric Resources, Inc. Mass. Consulting 100 (NEERI) Services New England Electric Transmission N.H. Electric 100 Corporation (NEET) Transmission New England Energy Incorporated Mass. Oil and Gas 100 (NEEI) Exploration & Development New England Hydro-Transmission N.H. Electric 53.97(a) Corporation (N.H. Hydro) Transmission New England Hydro-Transmission Mass. Electric 53.97(a) Electric Company, Inc. Transmission (Mass. Hydro) New England Power Company (NEP) Mass. Wholesale 98.80(b) Electric Generation & Transmission New England Power Service Company Mass. Service 100 (Service Company) Company (a) The common stock of these subsidiaries is owned by NEES and certain participants (or their parent companies) in Phase II of the Hydro-Quebec project. See Interconnection with Quebec, page 21. (b) Holders of common stock and 6% Cumulative Preferred Stock of NEP have general voting rights. The 6% Cumulative Preferred Stock represents 1.20% of the total voting power. In 1993, the System was realigned into two strategic business units, a wholesale business unit and a retail business unit. The facilities of NEES' three retail electric subsidiaries, Mass. Electric, Narragansett, and Granite State (collectively referred to as the Retail Companies), and of its principal wholesale electric subsidiary, NEP, constitute a single integrated electric utility system that is directly interconnected with other utilities in New England and New York State, and indirectly interconnected with utilities in Canada. See ELECTRIC UTILITY OPERATIONS, page 3. NEET owns and operates a portion of an international transmission interconnection between the electric systems of Hydro-Quebec and New England. Mass. Hydro and N.H. Hydro own and operate facilities in connection with an expanded second phase of this interconnection. See Interconnection with Quebec, page 21. NEEI is engaged in various activities relating to fuel supply for the System. These activities presently include participation (principally through a partnership with a non-affiliated oil company) in domestic oil and gas exploration, development, and production (see OIL AND GAS OPERATIONS, page 43) and the sale to NEP of fuel purchased in the open market. Resources is a general partner, with a 20% interest, in each of two partnerships formed in connection with the Ocean State Power project. See Ocean State Power, page 21. The Service Company has contracted with NEES and its subsidiaries to provide, at cost, such administrative, engineering, construction, legal, and financial services as the companies request. The Service Company also provides maintenance and construction services under contract to certain non-affiliated utility customers. Profits from these contracts are used to reduce the cost of services to affiliated companies. NEERI is a wholly-owned, non-utility subsidiary of NEES which provides consulting services domestically and internationally to non-affiliates. EMPLOYEES As of December 31, 1993, NEES subsidiaries had approximately 5,000 employees. As of that date, the total number of employees was approximately 840 at NEP, 1,800 at Mass. Electric, 760 at Narragansett, 80 at Granite State, and 1,500 at the Service Company. Of the 5,000 employees, approximately 3,300 are members of labor organizations. Collective bargaining agreements with the Brotherhood of Utility Workers of New England, Inc., the International Brotherhood of Electrical Workers, and the Utility Workers Union of America, AFL-CIO expire in May 1995. FINANCIAL INFORMATION ABOUT BUSINESS SEGMENTS The business of the System is conducted in two primary business segments, electric utility operations and oil and gas operations. The financial information with respect to Electric Utility Operations is as follows: Year Ended December 31 (thousands of dollars) 1993 1992 1991 - ---------------------- ---- ---- ---- Operating revenues $2,187,040 $2,138,302 $2,056,798 Operating income 332,843 341,650 317,487 Total assets 4,460,652 4,177,781 3,964,569 Capital expenditures 304,659 241,872 209,674 The financial information with respect to Oil and Gas Operations is as follows: Year Ended December 31 (thousands of dollars) 1993 1992 1991 - ---------------------- ---- ---- ---- Operating revenues $ 46,938 $ 43,374 $ 37,580 Pre-tax loss passed (46,355) (54,607) (39,303) on to customers Total assets 335,226 407,015 485,508 Capital expenditures 18,965 21,262 32,969 ELECTRIC UTILITY OPERATIONS GENERAL NEP's business is principally generating, purchasing, transmitting, and selling electric energy in wholesale quantities. In 1993, 95% of NEP's revenue from the sale of electricity was derived from sales for resale to affiliated companies and 5% from sales for resale to municipal and other utilities. NEP is the wholesale supplier of the electric energy requirements of the Retail Companies. Narragansett, however, receives credits against its purchases of power from NEP for the cost of generation from its Providence units, which are integrated with NEP's facilities to achieve maximum economy and reliability. Discussions of NEP's generating properties, load growth, energy mix, and fuel supplies include the related properties of Narragansett. For details of sales of energy and operating revenue for the last five years, see OPERATING STATISTICS on page 28 of the New England Power Company 1993 Annual Report to Stockholders (the NEP 1993 Annual Report). The combined service area of the Retail Companies constitutes the retail service area of the System and covers more than 4,400 square miles with a population of about 3,000,000 (1990 census). See Map, page 17. The largest cities served are Worcester, Mass. (population 170,000) and Providence, R.I. (population 161,000). Mass. Electric and Narragansett are engaged principally in the distribution and sale of electricity at retail. Mass. Electric provides approximately 930,000 customers with electric service at retail in a service area comprising approximately 43% of the area of The Commonwealth of Massachusetts. The population of the service area is about 2,160,000 or 36% of the total population of the Commonwealth (1990 Census). Mass. Electric's territory consists of 149 cities and towns including rural, suburban, and urban communities with Worcester, Lawrence, Lowell, and Quincy being the largest cities served. The economy of the area is diversified. Principal industries served by Mass. Electric include electrical and industrial machinery, computer manufacturing and related products, plastic goods, fabricated metals and paper, and chemical products. In addition, a broad range of professional, banking, high-technology, medical, and educational concerns is served. During 1993, 41% of Mass. Electric's revenue from the sale of electricity was derived from residential customers, 36% from commercial customers, 22% from industrial customers, and 1% from others. In 1993, the 20 largest customers of Mass. Electric accounted for less than 8% of its electric revenue. For details of sales of energy and operating revenue for the last five years, see OPERATING STATISTICS on page 26 of Mass. Electric's 1993 Annual Report to Stockholders (the Mass. Electric 1993 Annual Report). Narragansett provides approximately 323,000 customers with electric service at retail. Its service territory, which includes urban, suburban, and rural areas, covers about 839 square miles or 80% of the area of Rhode Island, and encompasses 27 cities and towns including the cities of Providence, East Providence, Cranston, and Warwick. The population of the area is about 725,000 (1990 Census) which represents about 72% of the total population of the state. The economy of the territory is diversified. Principal industries served by Narragansett produce fabricated metal products, jewelry, silverware, electrical and industrial machinery, transportation equipment, textiles, and chemical and allied products. In addition, a broad range of professional, banking, medical, and educational institutions is served. During 1993, 42% of Narragansett's revenue from the sale of electricity was derived from residential customers, 40% from commercial customers, 16% from industrial customers, and 2% from others. In 1993, the 20 largest customers of Narragansett accounted for approximately 11% of its electric revenue. For details of sales of energy and operating revenue for the last five years see OPERATING STATISTICS on page 23 of Narragansett's 1993 Annual Report to Stockholders (the Narragansett 1993 Annual Report). Granite State provides approximately 35,000 customers with electric service at retail in the State of New Hampshire in an area having a population of about 73,000 (1990 Census), including the city of Lebanon and the towns of Hanover, Pelham, Salem and surrounding communities. During 1993, 48% of Granite State's revenue from the sale of electricity was derived from commercial customers, 39% from residential customers, 12% from industrial customers, and 1% from others. In 1993, the 10 largest customers of Granite State accounted for about 20% of its electric revenue. Granite State is not subject to the reporting requirements of the Securities Exchange Act of 1934, and its financial impact on the System is relatively small. Information on Granite State is provided herein solely for the purpose of furnishing a more complete description of System operations. The electric utility business of NEP and the Retail Companies is not highly seasonal. For NEP and the Retail Companies, industrial customers are broadly distributed among standardized industrial classifications. No single industrial classification exceeds 4% of operating revenue, and no single customer of the System contributes more than 1% of operating revenue. Kilowatthour (KWH) sales billed to ultimate customers in 1993 increased by 1.4% over 1992. A return to more normal weather conditions in 1993 was largely offset by the fact that 1992 included an extra day for leap year. KWH sales billed to ultimate customers increased 0.4% in 1992. COMPETITIVE CONDITIONS The electric utility business is being subjected to increasing competitive pressures, stemming from a combination of increasing electric rates, improved technologies and new regulations, and legislation intended to foster competition. Recently, this competition has been most prominent in the bulk power market in which non-utility generating sources have noticeably increased their market share. For example, in 1984, less than 1% of NEP's capacity was supplied by non-utility generation sources. By the end of 1993, non-utility power purchases accounted for 380 MW or 7% of NEP's total capacity. In addition to competition from non- utility generators, the presence of excess generating capacity in New England has resulted in the sale of bulk power by utilities at prices less than the total costs of owning and operating such generating capacity. Electric utilities are also facing increased competition in the retail market. Currently, retail competition comes from alternative fuel suppliers (principally natural gas companies) for heating and cooling, customer-owned generation to displace purchases from electric utilities, and direct competition among electric utilities to attract major new manufacturing facilities to their service territories. In the future, the potential exists for electric utilities and non-utility generators to sell electricity to retail customers of other electric utilities. The NEES companies are responding to current and anticipated competitive pressures in a variety of ways including cost control and a corporate reorganization into separate retail and wholesale business units. The wholesale business unit is positioning itself for increased competition through such means as terminating certain purchased power contracts, past and future shutdowns of uneconomic generating stations, and rapid amortization of certain plant assets. NEP's rates currently include approximately $100 million per year associated with the recovery of certain Seabrook Nuclear Generating Station Unit 1 (Seabrook 1) costs under a 1988 rate settlement and coal conversion expenditures at NEP's Salem Harbor station. The recovery of these costs will be completed prior to the end of 1995. The retail business unit's response to competition includes the development of value-added services for customers and the offering of economic development rates to encourage businesses to locate in our service territory. In its recent rate settlement, Mass. Electric was able to change the standard terms under which it offers service to commercial and industrial customers to extend the notice period a customer must give from one to two years before purchasing electricity from others or generating any additional electricity for the customer's own use. In addition, Mass. Electric began offering a discount from base rates in return for a contract requiring the customer to provide five years written notice before purchasing electricity from others or generating any additional electricity for the customer's own use. The discount is available to customers with average monthly peak demands over 500 kilowatts. Electric utility rates are generally based on a utility's costs. Therefore, electric utilities are subject to certain accounting standards that are not applicable to other business enterprises in general. These accounting rules allow regulated entities, in appropriate circumstances, to establish regulatory assets and to defer the income statement impact of certain costs that are expected to be recovered in future rates. The effects of competition could ultimately cause the operations of the NEES companies, or a portion thereof, to cease meeting the criteria for application of these accounting rules. While the NEES companies do not expect to cease meeting these criteria in the near future, if this were to occur, accounting standards of enterprises in general would apply and immediate recognition of any previously deferred costs would be necessary in the year in which these criteria were no longer applicable. RATES General In 1993, 74% of the System's electric utility revenues was attributable to NEP, whose rates are subject to regulation by the Federal Energy Regulatory Commission (FERC). The rates of Mass. Electric, Narragansett, and Granite State are subject to the respective jurisdictions of the state regulatory commissions in Massachusetts, Rhode Island, and New Hampshire. The rates of each of the Retail Companies contain a purchased power cost adjustment clause (PPCA). The PPCA is designed to allow the Retail Companies to pass on to their customers increases in purchased power expense resulting from increases allowed by the FERC in NEP's rates. The Retail Companies are also required to reflect rate decreases or refunds. PPCA changes become effective on the dates specified in the filing of the adjustments with the state regulatory commission (not earlier than 30 days after such filing) unless the state regulatory commission orders otherwise. There have been, on occasion, regulatory delays in permitting PPCA increases. Effective March 1, 1993, Narragansett and Granite State received approval for PPCA clauses that fully reconcile on an annual basis purchased power expenses incurred by the companies against purchased power related revenues. Under the doctrine of Narragansett v. Burke, a case decided by the Rhode Island Supreme Court in 1977, NEP's wholesale rates must be accepted as allowable expenses for rate-making purposes by state commissions in retail rate proceedings. In 1986 and 1988 the U.S. Supreme Court reaffirmed this doctrine in two cases that did not involve NEP. However, the Narragansett v. Burke doctrine has been indirectly challenged by a number of state regulatory commissions which have held that federal preemption of the regulation of wholesale electric rates does not preclude the state commission from reviewing the prudence of a utility's decision to purchase power under a FERC-approved rate, and from disallowing costs if it finds that the purchase was an imprudent choice among alternative sources. In a 1985 opinion, the New Hampshire Supreme Court took this position on the issue of state regulation of wholesale power purchases. Also, legislation has been filed from time to time in Congress that would have eroded or repealed the doctrine. If state commissions were to refuse to allow the Retail Companies to include the full cost of power purchased from NEP in their rates, System earnings could be adversely affected. The rates of NEP and the Retail Companies contain fuel adjustment clauses that allow the rates to be adjusted to reflect changes in the cost of fuel. NEP's fuel clause is on a current basis. Mass. Electric has a fuel clause billing procedure that provides for monthly billing of estimated quarterly fuel costs, while Narragansett's and Granite State's fuel costs are estimated on a semi-annual basis. Billings are adjusted in the subsequent period for any excess or deficiency in fuel cost recovery. The FERC rules allow up to 50% of construction work in progress (CWIP) to be included in rate base in addition to CWIP already allowed in rate base for fuel conversion projects or pollution control facilities. This rule allows NEP the option of recovering currently through rates a portion of the costs of financing its construction program, rather than recording allowance for funds used during construction (AFDC) on that portion. The FERC rules with regard to canceled plants provide that utilities may recover in rates only 50% of prudently incurred canceled plant costs. However, the FERC allows utilities to include the recoverable amount in rate base and earn a return on the unamortized balance. NEP is recovering the cost of the conversion to coal of three units at Salem Harbor Station by means of an oil conservation adjustment (OCA), a FERC-approved rate. The OCA is designed to amortize the conversion costs by the mid-1990s. Through 1993, NEP has recovered approximately 84% of the conversion costs. The Retail Companies have OCA provisions designed to pass on to their customers amounts billed through NEP's OCA, which totaled $24.6 million for 1993. NEP Rates No NEP rate cases were filed with the FERC during 1993. Seabrook 1 Nuclear Unit NEP owns approximately 10% of Seabrook 1, a 1,150 MW nuclear generating unit, that entered commercial service on June 30, 1990. NEP's rate recovery of its investment in Seabrook 1 was resolved through two separate rate settlement agreements. The pre-1988 portion of NEP's investment is being recovered over a period of seven years and five months ending in July 1995. NEP's investment in Seabrook 1 since January 1, 1988, which amounts to approximately $50 million at December 31, 1993, is being recovered over its useful life. W-92 Rate Case In May 1992, the FERC approved a settlement of NEP's W-92 rate case under which base rates were increased by $39.7 million, effective March 1992. The entire increase was attributable to costs associated with the commercial operation of Unit 2 of the Ocean State Power (OSP) generating facility. These costs had been collected through NEP's fuel clause since the unit entered service in late 1991. The settlement also incorporated new depreciation rates proposed in NEP's filing, which reduced NEP's overall revenue requirement by $18 million. Mass. Electric Rates Rate schedules applicable to electric services rendered by Mass. Electric are on file with the Massachusetts Department of Public Utilities (MDPU). In November 1993, the MDPU approved a rate agreement filed by Mass. Electric, the Massachusetts Attorney General, and two groups of large commercial and industrial customers. Under the agreement, Mass. Electric began implementing an 11- month general rate decrease effective December 1, 1993 of $26 million (on an annual basis) from the level of rates then in effect. This rate reduction will continue in effect until October 31, 1994, after which rates will increase to the previously approved levels. The agreement also provided for rate discounts of up to $4 million available for the period ending October 31, 1994 for large commercial and industrial customers who agree to give a five-year notice to Mass. Electric before they purchase power from another supplier or generate any additional power themselves. These discounts will increase after October 31, 1994 to a level of $11 million per year if all eligible customers participate. Mass. Electric also agreed not to increase its base rates above currently approved levels before October 1, 1995. The decrease in revenues will be offset by the recognition for accounting purposes of revenues for electricity delivered but not yet billed. The agreement also resolved all issues associated with providing funds and securing rate recovery for environmental cleanup costs of Massachusetts manufactured gas waste sites formerly owned by Mass. Electric and its affiliates, as well as certain other Mass. Electric environmental cleanup costs (see Hazardous Substances, page 30). The rate agreement allows for these costs to be met by establishing a special interest bearing fund on Mass. Electric's books. On a consolidated basis, the fund's initial balance of $30 million comes from previously recorded environmental reserves and is not recoverable from customers. The establishment of the fund's initial balance at Mass. Electric resulted in a one-time charge to fourth quarter earnings of $9 million, before tax. Annual contributions of $3 million, adjusted for inflation, will be added to the fund by Mass. Electric and will be recoverable in rates. In addition, any shortfalls in the fund will be paid by Mass. Electric and be recovered through rates over seven years, without interest. Lastly, the agreement provided for the rate recovery of $8 million of certain storm restoration and other costs previously charged to expense. Effective October 1992, the MDPU authorized a $45.6 million annual increase in rates for Mass. Electric. This general rate increase included $2.5 million representing the first step of a four-year phase-in of Mass. Electric's tax deductible costs associated with post-retirement benefits other than pensions (PBOPs). A second $2.5 million increase took effect October 1, 1993. Narragansett Rates Rate schedules applicable to electric services rendered by Narragansett are on file with the Rhode Island Public Utilities Commission (RIPUC) and the Rhode Island Division of Public Utilities and Carriers. Effective March 1993, Narragansett implemented a new rate design which reallocated costs among its various rate classes, but which are not expected to affect total revenues over a twelve month period. Among other things, the new rates reduced the seasonality of the rates applicable to Narragansett's larger commercial and industrial customers. This change will result in lower revenues in summer months and higher revenues in other months when compared to Narragansett's prior rate design. Effective May 1992, the RIPUC authorized a $3.5 million annual increase in rates for Narragansett. In addition, effective January 1993, the RIPUC approved a $1.5 million increase in rates for Narragansett representing the first step of a three-year phase-in of Narragansett's recovery of costs associated with PBOPs. A second $1.5 million increase took effect in January 1994. Effective April 1991, the RIPUC approved Narragansett's settlement of a $13 million rate increase. Granite State Rates Effective March 1993, the New Hampshire Public Utilities Commission (NHPUC) authorized a $2.0 million rate increase for Granite State, with a retroactive adjustment to September 15, 1992 to reflect the difference between the authorized amount and the $1.4 million Granite State had been collecting on an interim basis since September 15, 1992. Effective July 1, 1993, the NHPUC approved a $0.7 million increase in rates for Granite State to recover costs associated with PBOPs. Recovery of Demand-Side Management Expenditures The three Retail Companies offer conservation and load management programs, usually referred to in the industry as Demand- Side Management (DSM) programs, which are designed to help customers use electricity efficiently, as a part of meeting the System's future resource needs and customers' needs for energy services. See RESOURCE PLANNING, page 36. The Retail Companies file their DSM programs regularly with their respective regulatory agencies and have received approval to recover in rates estimated DSM expenditures on a current basis. The rates provide for reconciling estimated expenditures to actual DSM expenditures, with interest. Mass. Electric's expenditures subject to the reconciliation mechanism were $47 million, $44 million, and $55 million in 1993, 1992, and 1991, respectively. Narragansett's expenditures subject to the reconciliation mechanism were $12 million, $12 million, and $19 million in 1993, 1992, and 1991, respectively. Since 1990, the Retail Companies have been allowed to earn incentives based on the results of their DSM programs. The Retail Companies must be able to demonstrate the electricity savings produced by their DSM programs to their respective state regulatory agencies before incentives are recorded. Mass. Electric recorded $6.7 million, $8.6 million, and $6.0 million of before-tax incentives in 1993, 1992, and 1991, respectively. Narragansett recorded $0.5 million, $1.3 million, and $1.6 million of before-tax incentives in 1993, 1992, and 1991, respectively. The Retail Companies have received regulatory approvals that will give them the opportunity to continue to earn incentives based on 1994 DSM program results. GENERATION Energy Mix The following table displays the contributions of various fuel sources and other generation to total net generation of electricity by NEP during the past three years, as well as an estimate for 1994: % of Net Generation -------------------------- Estimated Actual --------- ---------------- 1994 1993 1992 1991 ---- ---- ---- ---- Coal 37 38 41 44 Nuclear 18 18 18 18 Gas (1) 16 16 15 11 Oil 11 11 10 11 Hydroelectric 6 6 6 7 Hydro-Quebec 6 5 4 3 Renewable Non-Utility Generation (2) 6 6 6 6 --- --- --- --- 100 100 100 100 (1) Gas includes both utility and non-utility generation. (2) Waste to energy and hydro. Electric Utility Properties The electric utility properties of the System companies consist of NEP's and Narragansett's fossil-fuel base load and intermediate load steam generating units, conventional and pumped storage hydroelectric stations, internal combustion peaking units, portions of fossil fuel and nuclear generating units, the ownership interests of NEET, Mass. Hydro, and N.H. Hydro in the Hydro-Quebec Interconnection, and an integrated system of transmission lines, substations, and distribution facilities. See MAP - ELECTRIC UTILITY PROPERTIES, page 17. NEP's integrated system consists of 2,290 circuit miles of transmission lines, 116 substations with an aggregate capacity of 13,265,588 kVA, and 7 pole or conduit miles of distribution lines. The properties of Mass. Electric and Narragansett include substations and distribution and transmission lines, which are interconnected with transmission and other facilities of NEP. At December 31, 1993, Mass. Electric owned 282 substations, which had an aggregate capacity of 2,859,309 kVA, 147,090 line transformers with the capacity of 7,489,447 kVA, and 15,948 pole or conduit miles of distribution lines. Mass. Electric also owns 81 circuit miles of transmission lines. At December 31, 1993, Narragansett owned 248 substations, which had an aggregate capacity of 2,838,927 kVA, 53,100 line transformers with the capacity of 2,239,554 kVA, and 4,492 pole or conduit miles of distribution lines. Narragansett, in addition, owns 325 circuit miles of transmission lines. Substantially all of the properties and franchises of Mass. Electric, Narragansett, and NEP are subject to the liens of indentures under which mortgage bonds have been issued. For details of the mortgage liens on these properties see the long-term debt note in Notes to Financial Statements in each of these companies' respective 1993 Annual Report. The properties of NEET are subject to a mortgage under its financing arrangements. (a) These units currently burn coal, but are also capable of burning oil. (b) For a discussion of the Manchester Street Station repowering project, see Manchester Street Station Repowering on page 37. (c) Includes (i) an interest in a jointly owned oil-fired unit in Yarmouth, Maine, and (ii) diesel units at various locations. (d) See Hydroelectric Project Licensing, page 28. (e) See Nuclear Units, page 21. (f) Capability includes contracted purchases (1,312 MW) less contract sales (164 MW). Net generation includes the effects of the above contracted purchases and economy interchanges through the New England Power Exchange (including Hydro-Quebec purchases and purchases from non-utility generation). For further information see Non-Utility Generation Sources, page 20. NEP and Narragansett are members of the New England Power Pool (NEPOOL), a group of over 90 New England utilities that comprises virtually all of New England's electric generation. Mass. Electric and Granite State participate in NEPOOL through NEP. The NEPOOL Agreement provides for coordination of the planning and operation of the generation and transmission facilities of its members. The NEPOOL Agreement incorporates generating capacity reserve obligations, provisions regarding the use of major transmission lines, and provisions for payment for facilities usage. The NEPOOL Agreement further provides for New England-wide central dispatch of generation through the New England Power Exchange. Through NEPOOL, operating and capital economies are achieved and reserves are established on a region-wide rather than an individual company basis. The electric energy available to NEES subsidiaries and other members is determined by the aggregate available to NEPOOL. The 1993 NEPOOL peak demand of 19,570 MW occurred on July 8, 1993. The maximum demand to date of 19,742 MW occurred on July 19, 1991. The 1993 summer peak for the System of 4,081 MW occurred on July 8, 1993. This was below the previous all time peak load of 4,250 MW which occurred on July 19, 1991. The 1993-1994 winter peak of 4,121 MW occurred on January 19, 1994. For a discussion of resource planning, see RESOURCE PLANNING, page 36. MAP (Displays electric utility properties of NEES subsidiaries) Fuel for Generation NEP burned the following amounts of coal, residual oil, and gas during the past three years: 1993 1992 1991 ---- ---- ---- Coal (in millions of tons) 3.2 3.3 3.6 Oil (in millions of barrels) 5.0 4.9 6.4 Natural Gas (in billions of cubic feet) 0.7 3.2 1.7 Coal Procurement Program Depending on coal-fired generating unit availability and the degree to which the units are dispatched, NEP's 1994 coal requirements should range between 3.0 and 3.2 million tons. NEP obtains its domestic coal under contracts of varying lengths and on a spot basis from domestic coal producers in Kentucky, West Virginia, and Pennsylvania, and from mines in Colombia and Venezuela. Three different rail systems (CSX, Norfolk Southern, and Conrail) transport coal from domestic sources to loading ports on the east coast. NEP's coal is transported from east coast ports by ocean-going collier to Brayton Point and Salem Harbor. NEP has a term charter with the Energy Independence, a self-unloading collier, which carries all of NEP's U.S. coal and a portion of foreign coal. NEP also charters other coal-carrying vessels for the balance of foreign coal. As protection against interruptions in coal deliveries, NEP maintained coal inventories at its generating stations during 1993 in the range of 40 to 60 days. A United Mine Workers strike lasting the second half of 1993 interrupted one long-term contract which was replaced prior to its 1994 expiration. To meet environmental requirements, NEP uses coal with a relatively low sulphur and ash content. NEP's average price for coal burned, including transportation costs, calculated on a 26 million Btu per ton basis, was $44.72 per ton in 1991, $44.15 in 1992, and $43.53 per ton in 1993. Based on a 42 gallon barrel of oil producing 6.3 million Btu's, these coal prices were equivalent to approximately $10.83 per barrel of oil in 1991, $10.70 in 1992 and $10.57 per barrel of oil in 1993. Oil Procurement Program The System's 1994 oil requirements are expected to be approximately 5.0 million barrels. The System obtains its oil requirements through contracts with oil suppliers and purchases on the spot market. Current contracts provide for minimum annual purchases of 2.6 million barrels at market related prices. The System currently has a total storage capacity for approximately 2.3 million barrels of residual and diesel fuel oil. The System's average cost of oil burned, calculated on a 6.3 million Btu per barrel basis, was $11.82 in 1991, $12.68 in 1992, and $13.30 in 1993. Natural Gas NEP uses natural gas at both Brayton 4 and Manchester Street Stations when gas is priced less than residual fuel oil. At Brayton 4, natural gas currently displaces 2.2% sulphur residual fuel oil. At Manchester Street Station, gas currently displaces 1.0% sulphur residual fuel oil. In 1993, approximately 0.7 billion cubic feet of gas were consumed at an average cost of $2.58 per thousand cubic feet excluding pipeline demand charges. This gas price was equivalent to approximately $16.25 per barrel of oil. Firm year-round gas deliveries to Manchester Street Station are planned as part of its repowering project. The repowered facility would use up to 95 million cubic feet of natural gas per day. See Manchester Street Station Repowering, page 37. NEP has contracted with six pipeline companies for transportation of natural gas from supply regions to these two generating stations: (1) 60 million cubic feet per day from Western Canada via TransCanada PipeLines, Ltd. (TransCanada), Iroquois Gas Transmission System, Tennessee Gas Pipeline Company and Algonquin Gas Transmission Company, and (2) 60 million cubic feet per day from the U.S. Mid-Continent region via ANR Pipeline Company, Columbia Gas Transmission Company and Algonquin. (a) NEP has entered into a firm service agreement with TransCanada. Service commenced on November 1, 1992. (b) NEP has entered into a firm service agreement with Iroquois. Service commenced on November 1, 1993. (c) NEP has entered into a firm service agreement with Tennessee. Service commenced on November 1, 1993. (d) NEP has entered into a firm service agreement with Algonquin for delivery of Canadian gas. Service commenced on November 1, 1993. Additional service for a portion of the domestic gas is expected to commence in December 1994. NEP has also entered into a firm service agreement for deliveries of gas to its Brayton Point Station. All facilities for this service have been constructed and in service since December of 1991. (e) ANR has constructed substantially all facilities necessary to serve NEP. NEP has entered into a firm service agreement with ANR. Service is expected to commence in December 1994. (f) Columbia has received and accepted a FERC certificate to construct facilities for service to NEP. NEP has entered into a firm service agreement with Columbia. Service is expected to commence in December 1994. NEP has also signed contracts with four Canadian gas suppliers for a total of 60 million cubic feet per day. NEP has not yet signed supply arrangements with Mid-Continent producers. The pipeline agreements require minimum fixed payments. NEP's minimum net payments are currently estimated to be approximately $45 million in 1994, $65 million in 1995, and $70 million each in 1996, 1997, and 1998. The amount of the fixed payments are subject to FERC regulation and will depend on FERC actions affecting the rates on each of the pipelines. As part of its W-12 rate settlement, NEP is recovering 50% of the fixed pipeline capacity payments through its current fuel clause and deferring the recovery of the remaining 50% until the Manchester Street repowering project is completed. NEP has deferred payments of approximately $13 million as of December 31, 1993. Nuclear Fuel Supply As noted above, NEP participates with other New England utilities in the ownership of several nuclear units. See Nuclear Units, page 21. The utilities responsible for supply for these units are not experiencing any difficulty in obtaining commitments for the supply of each element of the nuclear fuel cycle. Non-Utility Generation Sources The System companies purchase a portion of the electricity generated by, or provide back-up or standard service to, 139 small power producers or cogenerators (a total of 3,185,101 MWh of purchases in 1993). As of December 31, 1993, these non-utility generation sources include 32 low-head hydroelectric plants, 51 wind or solar generators, seven waste to energy facilities, and 49 cogenerators. The total capacity of these sources is as follows: In Service Future Projects (12/31/93) Under Contract Source (MW) (MW) ------ ---------- --------------- Hydro 43 - Wind - 20 Waste to Energy 169 33 Cogeneration 303 40 Independent Power Producers - 83* ---- --- Total 515 176 * Milford Power was accepted for dispatch by NEPOOL on January 20, 1994. The in-service amount includes 377 MW of capacity and 138 MW treated as load reductions and excludes the Ocean State Power contracts discussed below. Ocean State Power Ocean State Power (OSP) and Ocean State Power II (OSP II) are general partnerships that own and operate a two unit gas-fired combined cycle electric power plant in Burrillville, R.I. Resources is a general partner with a 20% interest in both OSP and OSP II and had an equity investment of approximately $40 million at December 31, 1993. The first unit began commercial operation on December 31, 1990 and the second unit went into service on October 1, 1991. The two units have a combined winter net electrical capability of approximately 562 MW. Each unit's capacity and energy output is sold under 20-year unit power agreements to a group of New England utilities, including NEP, which has contracts for 48.5% of the output of each unit. NEP is required to make certain minimum fixed payments to cover capital and fixed operating costs of these units in amounts estimated to be $70 million per year. Interconnection with Quebec NEET, Mass. Hydro, and New Hampshire Hydro own and operate, on behalf of NEPOOL participants in the project, a 450 kV direct current (DC) transmission line and related terminals to interconnect the New England and Quebec transmission systems (the Interconnection). The transfer capability of the Interconnection is 2,000 MW. NEPOOL members purchase from and sell energy to Hydro-Quebec pursuant to several agreements. The principal agreement calls for NEPOOL members to purchase 7 billion KWH of energy each year for ten years (the Firm Energy Contract). Purchases under the Firm Energy Contract totaled over 6.4 billion KWH in 1993. NEP is a participant in both the Phase I and Phase II projects of the Interconnection. NEP's participation percentage in both projects is approximately 18%. NEP and the other participants have entered into support agreements that end in 2020, to pay monthly their proportionate share of the total cost of constructing, owning, and operating the transmission facilities. NEP accounts for these support agreements as capital leases and accordingly recorded approximately $78 million in utility plant at December 31, 1993. Under the support agreements, NEP has agreed, in conjunction with any Phase II project debt financing, to guarantee its share of project debt. At December 31, 1993, NEP had guaranteed approximately $34 million. In the event any Interconnection facilities are abandoned for any reason, each participant is contractually committed to pay its pro-rata share of the net investment in the abandoned facilities. Nuclear Units General NEP is a stockholder of Yankee Atomic Electric Company (Yankee Atomic), Vermont Yankee Nuclear Power Corporation (Vermont Yankee), Maine Yankee Atomic Power Company (Maine Yankee), and Connecticut Yankee Atomic Power Company (Connecticut Yankee). Each of these companies (collectively referred to as the Yankee Companies) owns a single nuclear generating unit. In addition, NEP is a joint owner of the Millstone 3 nuclear generating unit in Connecticut and the Seabrook 1 nuclear generating unit in New Hampshire. Millstone 3 and Seabrook 1 are operated by subsidiaries of Northeast Utilities (NU). NEP pays its proportionate share of costs and receives its proportionate share of each unit's output. NEP's interest and investment in each of the Yankee Companies, Millstone 3, and Seabrook 1 and the net capability of each plant are as follows: Equity Net Investment Capability (12/31/93) Interest (MW) (in millions) -------- ---------- ------------- Yankee Atomic 30.0% * $ 7 Vermont Yankee 20.0% 93 10 Maine Yankee 20.0% 158 14 Connecticut Yankee 15.0% 87 15 ---- ---- Subtotal 338 $ 46 Net Investment in Plant** (12/31/93) (in millions) ------------- Millstone 3 12.2% 140 $405 Seabrook 1 9.9% 115 149 ---- Subtotal 255 ---- Total 593 ==== *Operations ceased **Excludes nuclear fuel NEP has a 30% ownership interest in Yankee Atomic which owns a 185 megawatt nuclear generating station in Rowe, Massachusetts. The station began commercial service in 1960. In February 1992, the Yankee Atomic board of directors decided to permanently cease power operation of, and in time, decommission the facility. In March 1993, the FERC approved a settlement agreement that allows Yankee Atomic to recover all but $3 million of its approximately $50 million remaining investment in the plant over the period extending to July 2000, when the plant's Nuclear Regulatory Commission (NRC) operating license would have expired. Yankee Atomic recorded the $3 million before-tax write-down in 1992. The settlement agreement also allows Yankee Atomic to earn a return on the unrecovered balance during the recovery period and to recover other costs, including an increased level of decommissioning costs, over this same period. Decommissioning cost recovery increased from $6 million per year to $27 million per year for the period 1993 to 1995. This level of recovery is subject to review in 1996. NEP has recorded an estimate of its entire future payment obligations to Yankee Atomic as a liability on its balance sheet and an offsetting regulatory asset reflecting its expected future rate recovery of such costs. This liability and related regulatory asset amounted to approximately $104 million each at December 31, 1993. NEP purchases the output of the other Yankee nuclear electric generating plants in the same percentages as its stock ownership of the Yankee Companies, less small entitlements taken by municipal utilities for Maine Yankee and Vermont Yankee. NEP has power contracts with each Yankee Company that require NEP to pay an amount equal to its share of total fixed and operating costs (including decommissioning costs) of the plant plus a return on equity. The stockholders of three Yankee Companies (Vermont Yankee, Maine Yankee and Connecticut Yankee) have agreed, subject to regulatory approval, to provide capital requirements in the same proportion as their ownership percentages of the particular Yankee Company. Pursuant to the terms of a lending agreement, Yankee Atomic will not pay dividends to its shareholders, including NEP, until such lender is paid in full. There is widespread concern about the safety of nuclear generating plants. The NRC regularly reviews the adequacy of its comprehensive requirements for nuclear plants. Many local, state, and national public officials have expressed their opposition to nuclear power in general and to the continued operation of nuclear power plants. It is possible that this controversy will result in cost increases and modifications to, or premature shutdown of, the operating nuclear units in which NEP has an interest. On three occasions (most recently in 1987), referenda appeared on the ballot in Maine that, if passed, would have required the prompt shutdown of Maine Yankee. All the referenda were defeated. There is no assurance that similar measures will not appear on future ballots. Pending before FERC is an initial decision of an administrative law judge disallowing full rate recovery for the unamortized portion of a nuclear plant to be retired before the end of its operating license. The decision, if affirmed, would result in rate recovery of less than the full investment in a nuclear plant retired from service prior to the end of its operating license. The amount of the disallowance would depend upon the plant's historic capacity factor and the number of years remaining on its operating license. Decommissioning Each of the Yankee Companies includes charges for all or a portion of decommissioning costs in its cost of energy. These charges vary depending upon rate treatment, the method of decommissioning assumed, economic assumptions, site and unit specific variables, and other factors. Any increase in these charges is subject to FERC approval. Each of the operating nuclear units has established decommissioning trust funds or escrow funds into which payments are being made to meet the projected cost of decommissioning its plant. If any of the units were shut down prior to the end of its operating license, the funds collected for decommissioning to that point would be insufficient. Estimates of NEP's pro-rata share (based on ownership) of decommissioning costs, NEP's share of the actual book values of decommissioning fund balances set aside for each unit at December 31, 1993 (in millions of dollars), and the expiration date of the operating license of each plant are as follows: NEP's share of ----------------------------- Estimated Decommissioning Fund License Costs Balances (1) Expiration Unit (in 1993 $) (12/31/93) Date ---- --------------- ------------ ---------- Yankee Atomic (2) $78 $26 -- Connecticut Yankee $49 $18 2007 Maine Yankee $63 $19 2008 Vermont Yankee $57 $20 2012 Millstone 3 $50 $10 2025 Seabrook 1 $36 $ 3 2026 (1) Certain additional amounts are anticipated to be available through tax deductions. (2) The estimated cost of decommissioning for Yankee Atomic does not reflect the benefit of the component removal project (CRP) for which decommissioning funds were spent in 1993. Additional expenditures for CRP will be made in 1994. NEP is currently collecting through rates amounts for decommissioning based upon cost estimates and funding methodologies authorized by FERC. Such estimates are determined periodically for each plant and may not reflect the current projected cost of decommissioning. There is no assurance that decommissioning costs actually incurred by the Yankee Companies, Millstone 3 or Seabrook 1 will not substantially exceed these amounts. For example, current decommissioning cost estimates assume the availability of permanent repositories for both low-level and high-level nuclear waste which do not currently exist. NRC rules require that reasonable assurance be provided that adequate funds will be available for the decommissioning of commercial nuclear power plants. The rule establishes minimum funding levels that licensees must satisfy. Each of the units in which NEP has an interest has filed a report with the NRC providing assurance that funds will be available to decommission the facility. A Maine statute provides that if both Maine Yankee and its decommissioning trust fund have insufficient assets to pay for the plant decommissioning, the owners of Maine Yankee are jointly and severally liable for the shortfall. The definition of owner under the statute covers NEP and may cover companies affiliated with it. NEP and the Retail Companies cannot determine, at this time, the constitutionality, applicability, or effect of this statute. If NEP or the Retail Companies were required to make payments under this statute, they would assess their legal remedies at that time. In any event, NEP and the Retail Companies would attempt to recover through rates any payments required. If any claim in excess of NEP's ownership share were enforced against a NEES company, that company would seek reimbursement from any other Maine Yankee stockholder which failed to pay its share of such costs. The Energy Policy Act of 1992 assesses the domestic nuclear power industry for a portion of costs associated with the decontamination and decommissioning of the Department of Energy's (DOE) uranium enrichment facilities. An annual assessment of $150 million (escalated for inflation) on the domestic nuclear power industry will be allocated to each plant based upon the amount of DOE uranium enrichment services utilized in the past. The total DOE assessment, which began in October 1992, will remain in place for up to 15 years and will amount to $2.25 billion (escalated). The Yankees, Millstone 3 and Seabrook have been assessed and initial billings indicate NEP's obligation for such costs over the next 14 years will be approximately $29 million. In accordance with the provisions of the Energy Policy Act, these costs are being recovered through NEP's fuel clause. High-Level Waste Disposal The Nuclear Waste Policy Act of 1982 provides a framework and timetable for selection of sites for repositories of high-level radioactive waste (spent nuclear fuel) from United States nuclear plants. The DOE has entered into contracts with the Yankee Companies, the Millstone 3 joint owners, and the Seabrook 1 joint owners for acceptance of title to, and transportation and storage of, this waste. Under these contracts, each operating unit will pay fees to the DOE to cover the development and creation of waste repositories. Fees for fuel burned since April 1983 have been collected by the DOE on an ongoing basis at the rate of one tenth of a cent per KWH of net generation. Fees for generation up through April 1983 were determined by the DOE as follows: $13.2 million for Yankee Atomic, $48.7 million for Connecticut Yankee, $50.4 million for Maine Yankee, and $39.3 million for Vermont Yankee. Neither Millstone 3 nor Seabrook 1 has been assessed any fees for fuel burned through April 1983, because they did not enter commercial operation until 1986 and 1990, respectively. The Yankee Companies had several options to pay these fees. Yankee Atomic paid its fee to the DOE for the period through April 1983. The other three Yankee Companies elected to defer payment until a future date, thereby incurring interest expense. However, payment to the DOE must occur prior to the first delivery of spent fuel. Connecticut, Maine, and Vermont Yankee have segregated a portion of their respective DOE obligations in external accounts. The remainder of the funds have been used to support general capital requirements. All expect to separately fund in full in external accounts their DOE obligation (including accrued interest) prior to payment to the DOE. To the extent that any of the three Yankee Companies is unable to fully meet its DOE obligation at the prescribed time, NEP might be required to provide additional funds. Prior to such time that the DOE takes delivery of a plant's spent nuclear fuel, it is stored on site in spent fuel pools. Connecticut Yankee and Maine Yankee have adequate existing storage through the late 1990's. Millstone 3 will be able to maintain a full core discharge capability through the end of its current license. Seabrook 1's current licensed storage capacity is adequate until at least 2010. Vermont Yankee is able to maintain a full core discharge capability until 2001. Yankee Atomic has adequate on-site storage capacity for all its spent fuel. Federal legislation enacted in December 1987 directed the DOE to proceed with the studies necessary to develop and operate a permanent high-level waste disposal site at Yucca Mountain, Nevada. There is local opposition to development of this site. Although originally scheduled to open in 1998, the DOE announced in November 1989 that the permanent disposal site is not expected to open before 2010, a date the DOE has defined as optimistic. The legislation also provides for the development of a Monitored Retrievable Storage (MRS) facility and abandons plans to identify and select a second, permanent disposal site. An MRS facility would provide temporary storage for high-level waste prior to eventual permanent disposal. It is not known when an MRS facility would begin accepting deliveries. Additional delays due to political and technical problems are likely. It is extremely unlikely deliveries would be accepted prior to 1999. Federal authorities have deferred indefinitely the commercial reprocessing of spent nuclear fuel. Low-Level Waste Disposal In 1986, the Low-Level Radioactive Waste Policy Amendments Act was enacted by Congress. This statute sets a time limit of December 31, 1992, beyond which disposal of low-level waste at any of the three existing sites is impermissible. Under the statute, individual states are responsible for finding local sites for disposal or forming regional disposal compacts by defined milestone dates. As of December 1991, all of the states in which NEP holds an interest in a nuclear facility had met the 1990 milestone which required the filing of a facility operating license application or Governor's certification that the state will provide for storage, disposal, and management of waste generated after 1992. Although New Hampshire met the 1990 milestone, the arrangements made by the state did not encompass low-level waste generated by Seabrook 1 and it is currently prohibited from shipping its low-level waste out of the state. Connecticut Yankee, Millstone 3, Vermont Yankee, Maine Yankee and Yankee Atomic are currently allowed to ship low-level radioactive waste to the existing disposal site in South Carolina. The 1992 milestone required each state to file a facility operating license application. None of the states in which NEP holds an interest in a nuclear facility has met this milestone. Failure to meet this milestone means that those states may be subject to surcharges on waste shipped out of state. Disposal costs could increase significantly. Since January 1, 1993, the South Carolina low-level waste disposal site has been the only site open to accept low-level waste from NEP's units. The South Carolina site will remain open until June 30, 1994 to generators whose states are making progress toward developing their own disposal facilities. Effective June 30, 1994, the South Carolina low-level waste disposal site will be closed permanently to non- regional wastes. However, all of the nuclear facilities in which NEP has an interest have temporary storage facilities on site to meet short-term low-level radioactive waste storage requirements. Price-Anderson Act The Price-Anderson Act limits the amount of liability claims that would have to be paid in the event of a single incident at a nuclear plant to $9.2 billion (based upon 114 licensed reactors). The maximum amount of commercially available insurance coverage to pay such claims is only $200 million. The remaining $9.0 billion would be provided by an assessment of up to $79.3 million per incident levied on each of the nuclear units in the United States, subject to a maximum assessment of $10 million per incident per nuclear unit in any year. The maximum assessment, which was most recently calculated in 1993, is to be adjusted at least every five years to reflect inflationary changes. NEP's current interest in the Yankees, Millstone 3, and Seabrook 1 would subject NEP to an $81.8 million maximum assessment per incident. NEP's payment of any such assessment would be limited to a maximum of $10.3 million per incident per year. As a result of the permanent cessation of power operation of the Yankee Atomic plant, Yankee Atomic has petitioned the NRC for an exemption from obligations under the Price-Anderson Act. Other Items Federal legislation requires emergency response plans, approved by federal authorities, for nuclear generating units. The Yankee Companies, Seabrook 1, and Millstone 3 are not currently experiencing difficulty in maintaining approval of their emergency response plans. REGULATORY AND ENVIRONMENTAL MATTERS Regulation Numerous activities of NEES and its subsidiaries are subject to regulation by various federal agencies. Under the 1935 Act, many transactions of NEES and its subsidiaries are subject to the jurisdiction of the Securities and Exchange Commission (SEC). Under the Federal Power Act, certain electric subsidiaries of NEES are subject to the jurisdiction of the FERC with respect to rates, accounting, and hydroelectric facilities. In addition, the NRC has broad jurisdiction over nuclear units and federal environmental agencies have broad jurisdiction over environmental matters. The electric utility subsidiaries of NEES are also subject to the jurisdiction of regulatory bodies of the states and municipalities in which they operate. For more information, see: RATES, page 8, Nuclear Units, page 21, RESOURCE PLANNING, page 36, Fuel for Generation, page 18, Environmental Requirements, page 29, and OIL AND GAS OPERATIONS, page 43. Hydroelectric Project Licensing NEP is the largest operator of conventional hydroelectric facilities in New England. NEP's hydroelectric projects are licensed by the FERC. These licenses expire periodically and the projects must be relicensed at that time. NEP's present licenses expire over a period from 2001 to 2020 excluding the Deerfield River Project discussed below. Upon expiration of a FERC license for a hydro project, the project may be taken over by the United States or licensed to the existing, or a new licensee. If the project were taken over, the existing licensee would receive an amount equal to the lesser of (i) fair value of the project or (ii) original cost less depreciation and amounts held in amortization reserves, plus in either case severance damages. The net book value of NEP's hydroelectric projects was $245 million as of December 31, 1993. In the event that a new license is not issued when the existing license expires, FERC must issue annual licenses to the existing licensee which will allow the project to continue operation until a new license is issued. A new license for a project may incorporate operational restrictions and requirements for additional non-power facilities (e.g., recreational facilities) that could affect operation of the project, and may also require additional capital investment. For example, NEP has previously received new licenses for projects on the Connecticut River that involved construction of an extensive system of fish ladders. The license for the 84 MW Deerfield River Project expired at the end of 1993. NEP filed an application for a new license in 1991, which is still under review. Several advocacy groups have intervened proposing operational modifications which would reduce the energy output of the project substantially. FERC has issued NEP an annual license to continue operation of the project under the terms and conditions of the expired license until a new license issues or other disposition of the project takes place. The next NEP project to require a new license will be the 368 MW Fifteen Mile Falls Project on the Connecticut River in New Hampshire and Vermont. This license expires in 2001. The formal process of preparing an application for a new license will begin in 1996. FERC has recently issued a Notice of Inquiry regarding the decommissioning of licensed hydroelectric projects. Responses to this notice are still under review at FERC. Some parties have advocated positions in this docket that would draw into question recovery of investment and severance damages in the event of project decommissioning. Depending upon the scope of any project decommissioning regulations, the associated costs could be substantial. Environmental Requirements Existing Operations The NEES subsidiaries are subject to federal, state, and local environmental regulation of, among other things: wetlands and flood plains; air and water quality; storage, transportation, and disposal of hazardous wastes and substances; underground storage tanks; and land-use. It is likely that the stringency of environmental regulation affecting the System and its operations will increase in the future. Siting and Construction Activities for New Facilities All New England states require, in certain circumstances, regulatory approval for site selection or construction of electric generating and major transmission facilities. Connecticut, Maine, Massachusetts, New Hampshire, and Rhode Island also have programs of coastal zone management that might restrict construction of power plants and other electrical facilities in, or potentially affecting, coastal areas. All agencies of the federal government must prepare a detailed statement of the environmental impact of all major federal actions significantly affecting the quality of the environment. The New England states have environmental laws which require project proponents to prepare reports of the environmental impact of certain proposed actions for review by various agencies. Except for the planned Manchester Street Repowering Project, the System is not currently constructing generating plants or major transmission facilities. Environmental Expenditures Total System capital expenditures for environmental protection facilities have been substantial. System capital expenditures for such facilities amounted to approximately $29 million in 1991, $31 million in 1992, and $23 million in 1993, including expenditures by NEP of $25 million, $28 million, and $14 million, respectively, for those years. The System estimates that total capital expenditures for environmental protection facilities will be approximately $65 million in 1994 ($50 million by NEP) and $25 million in 1995 ($15 million by NEP). Hazardous Substances The United States Environmental Protection Agency (EPA) has established a comprehensive program for the management of hazardous waste. The program allows individual states to establish their own programs in coordination with the EPA; Massachusetts, New Hampshire, Vermont, and Rhode Island have established such programs. Both the EPA and Massachusetts regulations cover certain operations at Brayton Point and Salem Harbor. Other System activities, including hydroelectric and transmission and distribution operations, also involve some wastes that are subject to EPA and state hazardous waste regulation. In addition, numerous System facilities are subject to federal and state underground storage tank regulations. The EPA regulates the manufacture, distribution, use, and disposal of polychlorinated biphenyls (PCB), which are found in dielectric fluid used in some electrical equipment. The System has completed the removal from service of all PCB transformers and capacitors. Some electrical equipment contaminated with PCBs remains in service. At sites where PCB equipment has been operated, removal, disposal, and replacement of contaminated soils may be required. The Federal Comprehensive Environmental Response, Compensation and Liability Act, more commonly known as the "Superfund" law, imposes strict, joint and several liability, regardless of fault, for remediation of property contaminated with hazardous substances. Parties liable include past and present site owners and operators, transporters that brought wastes to the site, and entities that generated or arranged for disposal or treatment of wastes ultimately disposed of at the site. A number of states, including Massachusetts, have enacted similar laws. The electric utility industry typically utilizes and/or generates in its operations a range of potentially hazardous products and by-products. These products or by-products may not have previously been considered hazardous, and may not currently be considered hazardous, but may be identified as such by federal, state, or local authorities in the future. NEES subsidiaries currently have in place an environmental audit program intended to enhance compliance with existing federal, state, and local requirements regarding the handling of potentially hazardous products and by-products. Federal and state environmental agencies, as well as private parties, have contacted or initiated legal proceedings against NEES and certain subsidiaries regarding liability for cleanup of sites alleged to contain hazardous waste or substances. NEES and/or its subsidiaries have been named as a potentially responsible party (PRP) by either the EPA or the Massachusetts Department of Environmental Protection (DEP) for 18 sites (6 for NEP, 13 for Mass. Electric, and 2 for Narragansett) at which hazardous waste is alleged to have been disposed. NEES and its subsidiaries are also aware of other sites which they may be held responsible for remediating and it is likely that, in the future, NEES and its subsidiaries will become involved in additional proceedings demanding contribution for the cost of remediating additional hazardous waste sites. The most prevalent types of hazardous waste sites that NEES and its subsidiaries have been connected with are former manufactured gas locations. Until the early 1970s, NEES was a combined electric and gas holding company system. Gas was manufactured from coal and oil until the early 1970s to supply areas in which natural gas was not yet available or for peaking purposes. Among the waste byproducts of that process were coal and oil tars. The NEES companies are currently aware of approximately 40 locations at which gas may have been manufactured and/or stored. Of the manufactured gas locations, 17 have been listed for investigation by the DEP. Two manufactured gas plant locations that have been the subject of extensive litigation are discussed in more detail below: the Pine Street Canal Superfund site in Burlington, Vermont and a site located in Lynn, Massachusetts. Approximately 18 parties, including NEES, have been notified by the EPA that they are PRPs for cleanup of the Pine Street Canal site, at which coal tar and other materials were deposited. Between 1931 and 1951, NEES and its predecessor owned all of the common stock of Green Mountain Power Corporation. Prior to, during, and after that time, gas was manufactured at the Pine Street Canal site. The EPA had brought a lawsuit against NEES and other parties to recover all of the EPA's past and future response costs at this site. In 1990, the litigation ended with the filing of a final consent decree with the court. Under the terms of the settlement, to which 14 entities were party, the EPA recovered its past response costs. NEES recorded its share of these costs in 1989. NEES remains a PRP for ongoing and future response costs. In November 1992, the EPA proposed a cleanup plan estimated by the EPA to cost $50 million. In June 1993, the EPA withdrew this cleanup plan in response to public concern about the plan and the cost. It is not known at this time what the ultimate cleanup plan will be, how much it will cost, or what portion NEES will have to pay. On May 26, 1993, the United States Court of Appeals for the First Circuit affirmed on appeal an earlier adverse decision against NEES and two of its subsidiaries, Mass. Electric and New England Power Service Company, with respect to the Lynn, Massachusetts site which was once owned by an electric and gas utility formerly owned by NEES. The electric operations of this subsidiary were merged into Mass. Electric. The decision held NEES and these subsidiaries liable for cleanup of the properties involved in the case. Although the circumstances differ from location to location, the Court of Appeals opinion has adverse implications for the potential liability of NEES and its subsidiaries with respect to other gas manufacturing locations operated by gas utilities once owned by NEES. In November 1993, the MDPU approved a rate agreement filed by Mass. Electric (see RATES, page 8) that resolved all rate recovery issues related to Massachusetts manufactured gas sites formerly owned by NEES or its subsidiaries as well as certain other Massachusetts hazardous waste sites. The agreement allows for these costs to be met by establishing a special fund on Mass. Electric's books. On a consolidated basis, the fund's initial balance of $30 million comes from previously recorded environmental reserves and is not recoverable from customers. NEES had previously established approximately $40 million of reserves related to Massachusetts manufactured gas locations earlier in 1993 and in prior years. The establishment of the fund's initial balance at Mass. Electric resulted in a one-time charge to fourth quarter earnings of $9 million, before tax. The agreement also provides that contributions of $3 million, adjusted for inflation, be added to the fund each year by Mass. Electric and be recoverable in rates. Under the agreement, any shortfalls in the fund will be paid by Mass. Electric and be recovered through rates over seven years, without interest. Predicting the potential costs to investigate and remediate hazardous waste sites continues to be difficult. Factors such as the evolving nature of remediation technology and regulatory requirements and the particular characteristics of each site, including, for example the size of the site, the nature and amount of waste disposed at the site, and the surrounding geography and land use, make precise estimates difficult. There are also significant uncertainties as to the portion, if any, of the investigation and remediation costs of any particular hazardous waste site that may ultimately be borne by NEES or its subsidiaries. At year end 1993, NEES had total reserves for environmental response costs of $56 million and a related regulatory asset of $19 million. NEES and each of its subsidiaries believe that hazardous waste liabilities for all sites of which each is aware, and which are not covered by a rate agreement, will not be material (10% of common equity) to their respective financial positions. Where appropriate, the NEES companies intend to seek recovery from their insurers and from other PRPs, but it is uncertain whether, and to what extent, such efforts would be successful. NEP, in burning coal and oil to produce electricity, produces approximately 308,000 tons per year of coal ash and other coal combustion by-products and 18,500 tons per year of oil ash. In August 1993, the EPA determined that coal combustion byproducts would not be regulated as a hazardous waste. The EPA is expected to issue regulations regarding oil ash treatment in 1997. The EPA and the New England states in which System companies operate regulate the removal and disposal of material containing asbestos. Asbestos insulation is found extensively on power plant equipment and, to a lesser extent, in buildings and underground electric cable. System companies routinely remove and dispose of asbestos insulation during equipment maintenance. Electric and Magnetic Fields (EMF) In recent years, concerns have been raised about whether EMF, which occur near transmission and distribution lines as well as near household wiring and appliances, cause or contribute to adverse health effects. Numerous studies on the effects of these fields, some of them sponsored by electric utilities (including NEES companies), have been conducted and are continuing. Some of the studies have suggested associations between certain EMF and various types of cancer, while other studies have not substantiated such associations. In February 1993, the EPA called for significant additional research on EMF. It is impossible to predict the ultimate impact on NEES subsidiaries and the electric utility industry if further investigations were to demonstrate that the present electricity delivery system is contributing to increased risk of cancer or other health problems. Several state courts have recognized a cause of action for damage to property values in transmission line condemnation cases based on the fear that power lines cause cancer. It is difficult to predict what impact there would be on the NEES companies if this cause of action is recognized in the states in which NEES companies operate and in contexts other than condemnation cases. Bills have been introduced in the Rhode Island Legislature to require transmission lines to be placed underground. In July 1993, two bills passed by the legislature restricting the construction of overhead transmission lines were vetoed by the governor. EMF- related legislation has also been introduced in Massachusetts. Air Under federal regulations, each New England state has issued a state implementation plan that limits air pollutants emitted from facilities such as generating stations. These implementation plans are intended to ensure continued maintenance of national and state ambient air quality standards, where such standards are currently met. The plans are also intended to bring areas not currently meeting standards into compliance. In 1985, the Massachusetts legislature enacted an acid rain law that requires that sulphur dioxide (SO2) emissions from fossil fuel generating stations be reduced. Regulations implementing the statute were adopted in 1989. Emission reductions required by the regulations must be fully implemented by January 1, 1995, and will require NEP to use more costly lower sulphur oil and coal and make capital expenditures. Use of natural gas at Brayton 4 is one of NEP's methods for helping to meet the requirements of the acid rain law. See Fuel for Generation - Natural Gas, page 19. NEP may also use emission credits for conservation from non-combustion energy sources and cogeneration technology toward meeting the law's requirements. NEP produces approximately 50% of its electricity at eight older thermal generating units located in Massachusetts. The 1990 amendments to the federal Clean Air Act require a significant reduction in the nation's SO2 and nitrogen oxide (NOx) emissions by the year 2000. Under the amendments, NEP is not subject to Phase 1 of the acid rain provisions of the federal law that will become effective in 1995. However, NEP is subject to the Massachusetts SO2 acid rain law that will become effective in 1995. Phase 2 of the federal acid rain requirements, effective in 2000, will apply to NEP and its units. Under the federal Clean Air Act, state environmental agencies in ozone non-attainment areas were required to develop regulations (also known as Reasonably Available Control Technology requirements, or RACT) that will become effective in 1995 to address the first phase of ozone air quality attainment. These regulations were adopted in Massachusetts in September 1993. The RACT regulations require control technologies (such as low NOx burners) to reduce NOx emissions, an ozone precursor. Additional control measures may be necessary to ensure attainment of the ozone standard. These measures would have to be developed by the states in 1994 and fully implemented no later than 1999. The extent of these additional control measures is unknown at this time, but could range from minor additions to the RACT requirements to extensive emission reduction requirements, such as costly add-on controls or fuel switching. To date, NEP has expended approximately $7 million of one-time operation and maintenance costs and $50 million of capital costs in connection with Massachusetts and federal Clean Air Act compliance requirements. NEP expects to incur additional one-time operation and maintenance costs of approximately $18 million and capital costs of approximately $70 million in 1994 and 1995 to comply with the federal and state clean air requirements that will become effective in 1995. In addition, as a result of federal and state clean air requirements, NEP will begin incurring increased fuel costs which are estimated to reach an annual level of $13 million by 1995. The generation of electricity from fossil fuels may emit trace amounts of hazardous air pollutants as defined in the Clean Air Act Amendments of 1990. The Act mandates a study of the potential dangers of hazardous air pollutant emissions from electric utility plants. Such research is currently under way and is expected to be complete in 1995. The study conclusions could result in new emission standards and the need for additional costly controls on NEP plants. At this time, NEES and its subsidiaries cannot estimate the impact that findings of this research might have on operations. The federal Clean Air Act Amendments of 1990 and the Rio Convention on global climate change have increased the public focus on industrial emissions to the air. Electric utilities' use of fossil fuels is a significant source of emissions which evoke concerns about such issues as acid rain, ozone levels, global warming, small particulates, and hazardous air pollutants. Should the 1999 ozone attainment requirements be extensive or additional Clean Air Act Amendments or other environmental requirements be imposed, continued operation of certain existing generating units of NEP beyond 1999 could be uneconomical. NEP believes that premature retirement of substantially all of its older thermal generating units would cause substantial rate increases. Water The federal Clean Water Act prohibits the discharge of any pollutant (including heat), except in compliance with a discharge permit issued by the states or the EPA for a term of no more than five years. NEP and Narragansett have received required permits for all their steam-generating plants. NEET has received its required surface water discharge permits for all of its current operations. Occasional violations of the terms of these permits have occurred. NEES facilities store substantial amounts of oil and are required to have spill prevention control and counter-measure (SPCC) plans. Currently, major System facilities such as Brayton Point and Salem Harbor have up-to-date SPCC plans. A comprehensive study of smaller facilities has been completed to determine the appropriate plans for these facilities and a five-year implementation plan has been developed. Nuclear The NRC, along with other federal and state agencies, has extensive regulations pertaining to environmental aspects of nuclear reactors. Safety aspects of nuclear reactors, including design controls and inspection programs to mitigate any possibility of nuclear accidents and to reduce any damages therefrom, are also subject to NRC regulation. See Nuclear Units, page 21. RESOURCE PLANNING Load Forecasts and History The Retail Companies currently forecast an increase in KWH sales of 1.4% in 1994. The System has been projecting that, in the absence of significant energy conservation by its customers, annual weather-normalized peak load growth over the next 15 years will average approximately 2.3%. Peak load growth would be limited to about 1.1% annually over this period if planned DSM programs described below are successfully implemented. These projections are being updated. During the late 1980s unusually high load growth caused a tight capacity situation to develop for both the System and the New England region. More recently, the sluggish regional economy plus the addition of new generating facilities in the region alleviated concerns about inadequate resources for the next several years. Future resource additions from the Manchester Street repowering project described below and contracts with non-utility generators along with the continued demand-side management programs are expected to meet NEP's resource needs until approximately 2000. Additional new capacity may be required in that time frame. A return to the high load growth of the late 1980s, the cancellation of future planned capacity, or the shutdown of existing capacity could necessitate additional generation or power purchase contracts on the supply-side, or demand-side conservation and load management programs, in order to meet customer demands. Corporate Plans NEES has a history of planning for change to meet resource requirements and other goals. NEES' current plan, called NEESPLAN 4, was completed in 1993. NEESPLAN 4 attempts to reconcile the increasing importance and cost of environmental impact mitigation and utilities' traditional obligation to serve, with growing competition at all levels in the industry. NEESPLAN 4 also addresses planning methodology and implements a resource strategy that restricts commitments to those necessary to meet highly certain loads, and develops options on future resources to meet less certain loads and meet future fuel diversity needs. The new plan also strengthens the emission reduction goals previously established by the System and calls for CO2, SOx, and NOx reductions by 2000 to 20%, 60%, and 60%, respectively, below 1990 levels. Most of this reduction will come from current plans and commitments, including demand-side management, the Manchester Street repowering, increased use of natural gas and lower sulphur fuels, the installation of emission control equipment, low NOx burners, combustion controls, and other new power sources entering the energy mix through the year 2000. Many of these actions are being taken to comply with state and federal environmental laws. See Environmental Requirements, page 29. The remaining improvement will come from actions beyond current commitments. They may include further fuel conversions or efficiency improvements in power plants and the transmission and distribution system, as well as competitively acquired renewable resources and greenhouse gas offsets. NEP is currently participating in an experimental project investigating greenhouse gas offsets which involves funding the use of improved forestry techniques in Malaysia to limit unnecessary destruction of forests. Past NEES plans have concerned similar challenging issues the System faced and continues to address. In 1979, NEES instituted NEESPLAN, the key objectives of which were to keep customer costs to a minimum and to reduce the System's reliance on foreign oil. In 1985, NEES announced an updated plan, NEESPLAN II, the objectives of which were to provide an adequate supply of electricity to customers at the lowest possible cost and to encourage customers to use electricity efficiently. NEESPLAN 3, announced in 1990, continued these objectives and directly addressed the environmental impacts of providing electricity service. Demand-Side Management As mentioned above, the System believes that DSM programs are an important part of meeting its resource goals. Since 1987, the System has put in place a series of customer programs for encouraging electric conservation and load management. Through these DSM programs, the System has achieved over 825,000 MWh of annual energy savings. During 1993, the System spent a total of $76 million on DSM programs and related expenses. The System has budgeted to spend up to $103 million in 1994. Recovery of these expenditures through rates on a current, as incurred, basis has been approved by the various regulatory commissions. See RATES, page 8. Manchester Street Station Repowering The NEES subsidiaries' major construction project is the repowering of the Manchester Street Station, a 140 MW electric generating station in Providence, R.I. During 1993, construction continued on the joint Narragansett/NEP project. The project began in 1992 and remains on schedule and within budget, with an expected in-service date of late 1995. Narragansett and NEP operate three steam electric generating units of approximately 50 MW each which went into service at Manchester Street Station in the 1940s. During 1992, NEP acquired a 90% interest in the site and the Station in anticipation of the repowering project. As part of the repowering project, three new combustion turbines and heat recovery steam generators will be added to the Station, replacing the existing boilers. The existing steam turbines will be replaced with new and more efficient turbines of slightly larger capacity. The fuel for generation, which is now primarily residual oil, will be replaced with natural gas, using distillate oil as an emergency backup. See Fuel for Generation, page 18. Repowering will more than triple the power generation capacity of Manchester Street Station, and substantially increase the plant's thermal efficiency. It is expected that the plant's capacity factor will also increase. Certain air emissions are projected to decrease relative to historical levels because of the change in fuels and the increase in efficiency. Substantial additions to Narragansett's high voltage transmission network will be necessary in order to accommodate the output of the plant. Two 7-mile 115 kV underground transmission cables (located primarily in public ways) are under construction to connect the repowered station to existing 115 kV lines at a new substation. Total cost for the generating station, scheduled for completion in late 1995, is estimated to be approximately $525 million, including AFDC. In addition, related transmission work, which is principally the responsibility of Narragansett, is estimated to cost approximately $75 million and is scheduled for completion in late 1994. At December 31, 1993, $161 million, including AFDC, has been spent on the project which includes the related transmission work. Substantial commitments have been made relative to future planned expenditures for this project. Regulation The activities and specific projects in the System's resource plans are subject to regulation by state and federal authorities. Approval by these agencies is necessary to site and license new facilities and to recover the costs for new DSM programs and non- utility resources. See Regulation, page 28. Research and Development Expenditures for the System's research and development activities totaled $9.5 million, $8.9 million, and $8.8 million in 1993, 1992, and 1991, respectively. Total expenditures are expected to be about $12 million in 1994. About 50% of these expenditures support the Electric Power Research Institute, which conducts research and development activities on behalf of its sponsors and provides NEES companies with access to a wide range of relevant research results at minimum cost. The System also directly funds research projects of a more site-specific concern to the System and its customers. These projects include: - creating options to allow the use of economically-priced fossil fuels without adversely affecting plant performance, and to insure safe, reliable and environmentally sound production of electric energy at the lowest cost; - developing and assessing new information and methods to understand and reduce the environmental impacts of System operations including investigation of offset methods for counterbalancing greenhouse gas emissions away from the source; - developing, assessing and demonstrating new generation technologies and fuels that will ensure economic, efficient and environmentally sound production of electric energy in the future; - creating options to maintain electric service quality and reliability for customers at the lowest cost; and - developing conservation, load control, and rate design measures that will help customers use electric energy more efficiently. Construction and Financing Estimated construction expenditures (including nuclear fuel) for the System's electric utility companies are shown below for 1994 through 1996. The System conducts a continuing review of its construction and financing programs. These programs and the estimates shown below are subject to revision based upon changes in assumptions as to System load growth, rates of inflation, receipt of adequate and timely rate relief, the availability and timing of regulatory approvals, new environmental and legal or regulatory requirements, total costs of major projects, and the availability and costs of external sources of capital. The anticipated capital requirements for oil and gas operations are not included in the table below. See OIL AND GAS OPERATIONS page 43. Estimated Construction Expenditures ----------------------------------- 1994 1995 1996 Total ---- ---- ---- ----- (In Millions - excluding AFDC) NEP - --- Manchester St. Station Generation $145 $ 95 $ 40 $ 280 Manchester St. Station Substation 10 0 0 10 Other Generation (1) 70 50 60 180 Other Transmission 15 15 20 50 ---- ---- ---- ------ Total NEP $240 $160 $120 $ 520 ---- ---- ---- ------ Mass. Electric - -------------- Distribution $ 90 $ 90 $ 95 $ 275 Narragansett - ------------ Manchester St. Station Generation $ 15 $ 15 $ 5 $ 35 Manchester St. Station Transmission/ 30 0 0 30 Substation Other Transmission 15 15 15 45 Distribution 20 25 25 70 ---- ---- ---- ------ Total Narragansett $ 80 $ 55 $ 45 $ 180 ---- ---- ---- ------ Granite State - ------------- Distribution $ 5 $ 5 $ 5 $ 15 ---- ---- ---- ------ Other $ 10 $ 0 $ 0 $ 10 - ----- ---- ---- ---- ------ Combined Total - -------------- Manchester St. Station Generation $160 $110 $ 45 $ 315 Manchester St. Station Transmission/ 40 0 0 40 Substation Other Generation (1) 70 50 60 180 Other Transmission 40 30 35 105 Distribution 115 120 125 360 ---- ---- ---- ------ Grand Total $425 $310 $265 $1,000 ---- ---- ---- ------ (1) Includes Nuclear Fuel Financing The proportion of construction expenditures estimated to be financed by internally generated funds during the period from 1994 to 1996 is: NEP 80% Mass. Electric 80% Narragansett 70% Granite State 80% The general practice of the operating subsidiaries of NEES has been to finance construction expenditures in excess of internally generated funds initially by issuing unsecured short-term debt. This short-term debt is subsequently reduced through sales by such subsidiaries of long-term debt securities and preferred stock, and through capital contributions from NEES to the subsidiaries. NEES, in turn, generally has financed capital contributions to the operating subsidiaries through retained earnings and the sale of additional NEES shares. Since April 1991, NEES has been meeting all of the requirements of its dividend reinvestment and common share purchase plan and employee share plans through open market purchases. Under these plans, NEES may revert to the issuance of new common shares at any time. The ability of NEP and the Retail Companies to issue short-term debt is limited by regulatory restrictions, by provisions contained in their charters, and by certain debt and other instruments. Under the charters or by-laws of NEP, Mass. Electric, and Narragansett, short-term debt is limited to 10% of capitalization. The preferred stockholders authorized these limitations to be increased to 20% of capitalization until the late 1990's, at which time the limits will revert to 10% of capitalization. The following table summarizes the short-term debt limits at December 31, 1993, and the amount of outstanding short-term debt at such date. ($ millions) Limit Outstanding ----- ----------- NEP 315 51 Mass. Electric 139 38 Narragansett 75 20 Granite State 10 - In order to issue additional long-term debt and preferred stock, NEP and the Retail Companies must comply with earnings coverage requirements contained in their respective mortgages, note agreements, and preference provisions. The most restrictive of these provisions in each instance generally requires (1) for the issuance of additional mortgage bonds by NEP, Mass. Electric, and Narragansett, for purposes other than the refunding of certain outstanding mortgage bonds, a minimum earnings coverage (before income tax) of twice the pro forma annual interest charges on mortgage bonds, and (2) for the issuance of additional preferred stock by NEP, Mass. Electric, and Narragansett, minimum gross income coverage (after income tax) of one and one-half times pro forma annual interest charges and preferred stock dividends, in each case for a period of twelve consecutive calendar months within the fifteen calendar months immediately preceding the proposed new issue. The respective long-term debt and preferred stock coverages of NEP and the Retail Companies under their respective mortgage indentures, note agreements, and preference provisions, are stated in the following table for the past three years: Coverage ----------------------- 1993 1992 1991 ---- ---- ---- NEP - --- General and Refunding Mortgage Bonds 4.66 4.15 4.02 Preferred Stock 2.76 2.80 2.71 Mass. Electric - -------------- First Mortgage Bonds 3.15 3.60 3.07 Preferred Stock 2.02 2.14 2.12 Narragansett - ------------ First Mortgage Bonds 2.47 3.79 2.98 Preferred Stock 1.78 2.52 2.06 Granite State - ------------- Notes (1) 2.41 2.53 1.98 (1) As defined under the most restrictive note agreement. OIL AND GAS OPERATIONS GENERAL Since 1974, NEEI has engaged in oil and gas exploration and development, primarily through a partnership with Samedan Oil Corporation (Samedan), a subsidiary of Noble Affiliates, Inc. NEEI's oil and gas activities are regulated by the SEC under the 1935 Act. Under the terms of the Samedan-NEEI partnership agreement, Samedan is the managing partner and oversees all partnership operations including the sale of production. Effective January 1, 1987, NEEI decided not to acquire new oil and gas prospects due to prevailing and expected oil and natural gas market conditions. This decision did not affect NEEI's interests and commitments in oil and gas properties owned as of December 31, 1986 by the Samedan-NEEI partnership. Samedan continues to explore, develop, and manage these properties on behalf of the partnership. Thus, the results of NEEI's operations are substantially affected by the performance of Samedan. Samedan may elect to terminate the partnership at the end of any calendar year upon one year's prior notice. NEEI is required to obtain SEC approval for further investment in these oil and gas properties. On December 21, 1993, the SEC issued an order authorizing NEEI to invest up to $10 million in its partnership with Samedan during 1994. The SEC has reserved jurisdiction over an additional $5 million of spending authority. NEEI is winding down its oil and gas program. The level of expenditures for exploration and development of existing properties has declined as a result of the decision not to acquire new oil and gas prospects after December 31, 1986. NEEI's activities are primarily rate-regulated and consist of all prospects entered into prior to 1984. Savings and losses from this rate-regulated program are being passed on to NEP and ultimately to retail customers, under an intercompany pricing policy (Pricing Policy) approved by the SEC. Due to precipitate declines in oil and gas prices, NEEI has incurred operating losses since 1986 and expects to generate substantial additional losses in the future. NEP's ability to pass such losses on to its customers was favorably resolved in NEP's 1988 FERC rate settlement. This settlement covered all costs incurred by or resulting from commitments made by NEEI through March 1, 1988. Other subsequent costs incurred by NEEI are subject to normal regulatory review. NEEI follows the full cost method of accounting for its oil and gas operations, under which capitalized costs (including interest paid to banks) relating to wells and leases determined to be either commercial or non-commercial are amortized using the unit of production method. Due to the Pricing Policy, NEEI's rate-regulated program has not been subject to certain SEC accounting rules, applicable to non-rate-regulated companies, which limit the costs of oil and gas property that can be capitalized. The Pricing Policy has allowed NEEI to capitalize all costs incurred in connection with fuel exploration activities of its rate regulated program, including interest paid to banks of which $9 million, $14 million, and $22 million was capitalized in 1993, 1992, and 1991, respectively. In the absence of the Pricing Policy, the SEC's full cost "ceiling test" rule requires non-rate regulated companies to write-down capitalized costs to a level which approximates the present value of their proved oil and gas reserves. Based on NEEI's 1993 average oil and gas selling prices and NEEI's proved reserves at December 31, 1993, if this test were applied, it would have resulted in a write-down of approximately $138 million after-tax. RESULTS OF OPERATIONS Revenues from natural gas sales were approximately 13% higher in 1993 than 1992 even though NEEI's natural gas production declined by about 9%. NEEI expects 1994 natural gas revenues to be slightly higher than 1993 revenues on slightly lower total production. NEEI's 1993 oil and gas exploration and development expenditures were $9 million. NEEI's estimated proved reserves decreased from 17.3 million barrels of oil and gas equivalent at December 31, 1992, to 15.1 million barrels of oil and gas equivalent at December 31, 1993. Production, primarily from offshore Gulf properties, decreased reserves by 3.8 million equivalent barrels. Additions and revisions primarily on offshore Gulf properties increased reserves by 1.6 million equivalent barrels. Prices received by NEEI for its natural gas varied considerably during 1993, from approximately $1.31/MCF to $2.90/MCF, due principally to seasonal fluctuations and regional variations in gas prices. NEEI's overall average gas price in 1993 was $1.96/MCF. The results of NEEI's oil and gas program will continue to be affected by developments in the world oil market and the domestic market for natural gas, including actions by the federal government and by foreign governments, which may affect the price of oil and gas, the terms of contracts under which gas is sold, and changes in regulation of the domestic interstate gas pipelines. The following table summarizes NEEI's crude oil and condensate production in barrels, natural gas production in MCF, and the average sales price per barrel of oil and per MCF of natural gas produced by NEEI during the years ended December 1993, 1992, and 1991, and the average production (lifting) cost per dollar of gross revenues. Years Ended December 31, ---------------------------------- 1993 1992 1991 ---- ---- ---- Crude oil and condensate production (barrels) 477,545 506,428 435,890 Natural gas production 19,696,944 21,514,986 17,904,015 (MCF) Average sales price per barrel of oil and $17.05 $19.34 $22.80 condensate Average sales price per MCF of natural gas $1.96 $1.59 $1.61 Average production cost (including severance taxes) per dollar of gross revenue $0.14 $0.17 $0.18 OIL AND GAS PROPERTIES During 1993, principal producing properties, representing 58% of NEEI's 1993 revenues, were (i) a 50% working interest in Brazos Blocks A-52, A-53, A-65, and A-37 located in federal waters offshore Texas, (ii) a 12% working interest in Main Pass Blocks 107 and 108, located in federal waters offshore Louisiana, (iii) a 25% working interest in Main Pass Blocks 93, 102, and 90, located in federal waters offshore Louisiana, (iv) a 20% working interest in Matagorda Island 587, located in federal waters offshore Texas, and (v) a 15% working interest in Eugene Island Block 28, located in federal waters offshore Louisiana. Other major producing properties during 1993 included a 20% working interest in Vermilion Block 114, located in federal waters offshore Louisiana, a 15% working interest in High Island Blocks 21, 22, and 34, located in federal waters offshore Texas, and a 15% working interest in West Delta 18/33, located in federal waters offshore Louisiana. As used in the tables below, (i) a productive well is an exploratory or a development well that is not a dry well, (ii) a dry well is an exploratory or development well found to be incapable of producing either oil or gas in commercial quantities, (iii) "gross" refers to the total acres or wells in which NEEI has a working interest, and (iv) "net," as applied to acres or wells, refers to gross acres or wells multiplied by the percentage working interest owned by NEEI. The following table shows the approximate undeveloped acreage held by NEEI as of December 31, 1993. Undeveloped acreage is acreage on which wells have not been drilled or completed to a point that would permit the production of commercial quantities of oil and gas, regardless of whether such acreage contains proved reserves. Location Gross Acres Net Acres -------- ----------- --------- Offshore-Gulf of Mexico 124,209 21,676 Other 278,203 49,756 ------- ------ Total 402,412 71,432 During the years ended December 31, 1993, 1992, and 1991 NEEI participated in the completion of the following net exploratory and development wells: Net Exploratory Wells Net Development Wells --------------------- --------------------- Year Ended Productive* Dry Productive* Dry ---------- ---------- --- ---------- --- December 31, 1993 0 2 0 0 December 31, 1992 2 0 0 0 December 31, 1991 1 4 3 5 * Includes depleted wells The following table summarizes the total gross and net productive wells and the approximate total gross and net developed acres, both as of December 31, 1993: Oil Gas Developed Acres --- --- --------------- Gross Net Gross Net Gross Net ----- --- ----- --- ----- --- 139 16 557 64 312,492 57,400 At December 31, 1993, NEEI was in the process of drilling or completing 4 gross and 0 net wells. CAPITAL REQUIREMENTS AND FINANCING Estimated expenditures in 1994 for NEEI's exploration and development program are approximately $10 million which is the amount authorized by the SEC. In addition, NEEI's estimated 1994 interest costs are approximately $10 million. Internal funds are expected to provide 100% of NEEI's capital requirements for 1994. In 1989, NEEI refinanced its outstanding borrowings through a credit agreement which currently provides for borrowings of up to $275 million. Borrowings under this credit agreement are principally secured by a pledge of NEEI's rights with respect to NEP under the Pricing Policy covering the rate-regulated program. The amount available for borrowing under the revolving credit agreement decreases by varying amounts annually, beginning December 31, 1995 and expiring December 31, 1998. NEEI MAP Major Oil and Gas Properties EXECUTIVE OFFICERS NEES - ---- All executive officers are elected to continue in office subject to Article 19 of the Agreement and Declaration of Trust until the first meeting of the Board of Directors following the next annual meeting of shareholders, or the special meeting of shareholders held in lieu of such annual meeting, and until their successors are chosen and qualified. The executive officers also serve as officers and/or directors of various subsidiary companies. John W. Rowe - Age: 48 - President and Chief Executive Officer since 1989 - Elected Chairman of NEP in 1993 - President of NEP from 1991 to 1993 - Chairman of NEP from 1989 to 1991 - President and Chief Executive Officer of Central Maine Power Company from 1984 to 1989. Frederic E. Greenman - Age: 57 - Senior Vice President since 1987 - General Counsel since 1985 - Secretary since 1984 - Vice President of NEP since 1979. Alfred D. Houston - Age: 53 - Elected Executive Vice President in 1994 - Senior Vice President-Finance from 1987 to 1994 - Vice President-Finance from 1985 to 1987 - Vice President of NEP since 1987 - Vice President of Narragansett since 1976 - Treasurer of Narragansett since 1977. John W. Newsham - Age 61 - Vice President since 1991 - Executive Vice President of NEP since 1993 - Vice President of NEP and Director of Thermal Production from 1987 to 1993. Richard P. Sergel - Age: 44 - Vice President since 1992 - Treasurer from 1990 to 1991 - Chairman of Mass. Electric and Narragansett since 1993 - Treasurer of NEP and Mass. Electric from 1990 to 1991 - Vice President of the Service Company since 1988 - Director of Rates from 1982 to 1990. Jeffrey D. Tranen - Age: 47 - Vice President since 1991 - President of NEP since 1993 - Vice President of NEP from 1984 to 1993 - Vice President of Mass. Hydro, N.H. Hydro, and NEET from 1987 to 1991 - President of Mass. Hydro, N.H. Hydro, and NEET since 1991. Michael E. Jesanis - Age: 37 - Treasurer since 1992 - Director of Corporate Finance from 1990 to 1991 - Manager, Financial Planning from 1986 to 1990. NEP - --- The Treasurer is elected by the stockholders to hold office until the next annual meeting of stockholders and until the successor is duly chosen and qualified. The other executive officers are elected by the Board of Directors to hold office subject to the pleasure of the directors and until the first meeting of directors after the next annual meeting of stockholders and until their successors are duly chosen and qualified. Certain officers of NEP are, or at various times in the past have been, officers and/or directors of the System companies with which NEP has entered into contracts and had other business relations. Jeffrey D. Tranen* - President since 1993 - Vice President from 1984 to 1993. John W. Rowe* - Chairman since 1993 - President from 1991 to 1993 - Chairman from 1989 to 1991. John W. Newsham* - Executive Vice President since 1993 - Vice President from 1987 to 1993. Lawrence E. Bailey - Age: 50 - Vice President since 1989 - Plant Manager of Brayton Point Station from 1987 to 1991. Jeffrey A. Donahue - Age: 35 - Vice President since 1993 - various engineering positions with the Service Company since 1983 - Director of Construction since 1992 - Chief Electrical Engineer since 1991. Frederic E. Greenman* - Vice President since 1979. Alfred D. Houston* - Vice President since 1987 - Treasurer from 1983 to 1987. John F. Malley - Age: 45 - Vice President since 1992 - Manager of Generation Planning for the Service Company from 1986 to 1991. Arnold H. Turner - Age: 53 - Vice President since 1989 - Director of Planning and Power Supply since 1985. Jeffrey W. VanSant - Age: 40 - Vice President since 1993 - Manager of Oil and Gas Exploration and Development for the Service Company from 1985 to 1993 - Manager of Oil and Gas Procurement from 1992 to 1993 - Manager of Natural Gas Supply from 1989 to 1992. Michael E. Jesanis* - Treasurer since 1992. Howard W. McDowell - Age: 50 - Controller since 1987 - Controller of Mass. Electric and Narragansett since 1987 - Treasurer of Granite State since 1984. *Please refer to the material supplied under the caption EXECUTIVE OFFICERS - NEES for other information regarding this officer. Mass. Electric - -------------- The Treasurer is elected by the stockholders to hold office until the next annual meeting of stockholders and until the successor is duly chosen and qualified. The other executive officers are elected by the board of directors to hold office subject to the pleasure of the directors and until the first meeting of the directors after the next annual meeting of stockholders. Certain officers of Mass. Electric are, or at various times in the past have been, officers and directors of System companies with which Mass. Electric has entered into contracts and had other business relations. Richard P. Sergel - Chairman since 1993 - Reference is made to the material supplied under the caption EXECUTIVE OFFICERS - NEES for other information regarding Mr. Sergel. John H. Dickson - Age: 51 - President since 1990 - Treasurer from 1985 to 1990 - Treasurer of NEES from 1985 to 1990 - Treasurer of NEP from 1987 to 1990 - Vice President of NEEI from 1982 to 1990 - Treasurer of NEEI from 1983 to 1990. David L. Holt - Age: 45 - Executive Vice President since 1993 - Vice President of NEP from 1992 to 1993 - Chief Engineer and Director of Engineering for the Service Company since 1991 - Chief Electrical Engineer for the Service Company from 1986 to 1991. John C. Amoroso - Age: 55 - Vice President since 1993 - District Manager, Southeast District from 1992 to 1993 - Manager, Southeast District from 1985 to 1992. Gregory A. Hale - Age: 43 - Vice President since 1993 - Senior Counsel for the Service Company from 1988 to 1993. Cheryl A. LaFleur - Age: 39 - Vice President since 1993 - Vice President of the Service Company from 1992 to 1993 - Assistant to the NEES Chairman and President from 1990 to 1991 - Senior Counsel for the Service Company from 1989 to 1991. Charles H. Moser - Age: 53 - Vice President since 1993 - Chief Protection and Planning Engineer for the Service Company from 1984 to 1993. Lydia M. Pastuszek - Age: 40 - Vice President since 1993 - Vice President of NEP from 1990 to 1993 - President of Granite State since 1990 - Assistant to the President of Granite State from 1989 to 1990 - Director of Demand Planning for the Service Company from 1985 to 1989. Anthony C. Pini - Age: 41 - Vice President since 1993 - Assistant Controller for the Service Company from 1985 to 1993. Nancy H. Sala - Age: 42 - Vice President since 1992 - Central District Manager since 1992 - Assistant to the President of Mass. Electric from 1990 to 1992 - Manager of the Central District for Mass. Electric from 1989 to 1990 - Manager of Petroleum Supply and NEEI Shipping for the Service Company from 1986 - 1989. Dennis E. Snay - Age: 52 - Vice President and Merrimack Valley District Manager since 1990 - Assistant to President of Mass. Electric from 1984 to 1990. Michael E. Jesanis - Treasurer since 1992 - Reference is made to the material supplied under the caption EXECUTIVE OFFICERS - NEES for other information regarding Mr. Jesanis. Howard W. McDowell - Controller since 1987 and Assistant Treasurer since 1977 - Reference is made to the material supplied under the caption EXECUTIVE OFFICERS - NEP for other information regarding Mr. McDowell. Narragansett - ------------ Officers are elected by the board of directors or appointed, as appropriate, to serve until the meeting of directors following the annual meeting of stockholders, and until their successors are chosen and qualified. Officers other than the President, Treasurer, and Secretary, serve also at the pleasure of the directors. Certain officers of Narragansett are, or at various times in the past have been, officers and directors of System companies with which Narragansett has entered into contracts and had other business relations. Richard P. Sergel - Chairman since 1993 - Reference is made to the material supplied under the caption EXECUTIVE OFFICERS - NEES for other information regarding Mr. Sergel. Robert L. McCabe - Age: 53 - President since 1986. William Watkins, Jr. - Age 61 - Executive Vice President since 1992 - Vice President of the Service Company from 1981 to 1992. Francis X. Beirne - Age: 50 - Vice President since 1993 - Manager, Southern District from 1988 to 1993 - District Manager, Customer Service from 1983 - 1988. Richard W. Frost - Age: 54 - Vice President since 1993 - Division Superintendent of Transmission and Distribution from 1986 to 1990 - District Manager - Southern District from 1990 to 1993. Alfred D. Houston - Vice President since 1976 - Treasurer since 1977 - Reference is made to the material supplied under the caption EXECUTIVE OFFICERS - NEES for other information regarding Mr. Houston. James V. Mahoney - Age: 48 - Vice President and Director of Business Services since 1993 - President of NEEI from 1992 to 1993 - Vice President of the Service Company from 1989 to 1993 - Director of Fuel Supply for the Service Company from 1985 to 1993. Howard W. McDowell - Controller since 1987 - Reference is made to the material supplied under the caption EXECUTIVE OFFICERS - NEP for other information regarding Mr. McDowell. Item 2.

Item 2. PROPERTIES See Item 1. Business - ELECTRIC UTILITY PROPERTIES, page 13 and OIL AND GAS PROPERTIES, page 45. Item 3.

Item 3. LEGAL PROCEEDINGS In February 1993, a jury in Salem Massachusetts Superior Court assessed damages of $7.5 million, including interest, against Mass. Electric in a case arising from the installation by Mass. Electric of an allegedly undersized transformer for the plaintiff's manufacturing facility. Mass. Electric settled this case with its general liability insurance carrier and the plaintiff in 1993. See Item 1. RATES, page 8; Nuclear Units, page 21; Hydro Electric Project Licensing, page 28; Environmental Requirements, page 29; OIL AND GAS OPERATIONS, page 43. Item 4.

Item 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS No matters were submitted to a vote of security holders during the last quarter of 1993. PART II Item 5.

Item 5. MARKET FOR THE REGISTRANT'S COMMON EQUITY AND RELATED SECURITY HOLDER MATTERS NEES information in response to the disclosure requirements specified by this Item 5. appears under the captions in the NEES Annual Report indicated below: Required Information Annual Report Caption -------------------- --------------------- (a) Market Information Shareholder Information (b) Holders Shareholder Information (c) Dividends Financial Highlights The information referred to above is incorporated by reference in this Item 5. NEP, Mass. Electric, and Narragansett - The information required by this item is not applicable as the common stock of all these companies is held solely by NEES. Information pertaining to payment of dividends and restrictions on payment of dividends is incorporated herein by reference to each company's 1993 Annual Report. Item 6.

Item 6. SELECTED FINANCIAL DATA NEES ---- The information required by this item is incorporated herein by reference to page 21 of the NEES 1993 Annual Report. NEP --- The information required by this item is incorporated herein by reference to page 29 of the NEP 1993 Annual Report. Mass. Electric -------------- The information required by this item is incorporated herein by reference to page 27 of the Mass. Electric 1993 Annual Report. Narragansett ------------ The information required by this item is incorporated herein by reference to page 24 of the Narragansett 1993 Annual Report. Item 7.

Item 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS. NEES ---- The information required by this item is incorporated herein by reference to pages 12 through 20 of the NEES 1993 Annual Report. NEP --- The information required by this item is incorporated herein by reference to pages 4 through 9 of the NEP 1993 Annual Report. Mass. Electric -------------- The information required by this item is incorporated herein by reference to pages 4 through 10 of the Mass. Electric 1993 Annual Report. Narragansett ------------ The information required by this item is incorporated herein by reference to pages 4 through 9 of the Narragansett 1993 Annual Report. Item 8.

Item 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA NEES ---- The information required by this item is incorporated herein by reference to pages 21 through 40 of the NEES 1993 Annual Report. NEP --- The information required by this item is incorporated herein by reference to pages 3, 10 through 27, and 29 of the NEP 1993 Annual Report. Mass. Electric -------------- The information required by this item is incorporated herein by reference to pages 3, 11 through 25, and 27 of the Mass. Electric 1993 Annual Report. Narragansett ------------ The information required by this item is incorporated herein by reference to pages 3, 10 through 22, and 24 of the Narragansett 1993 Annual Report. Item 9.

Item 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE NEES, NEP, Mass. Electric, and Narragansett - None. PART III Item 10.

Item 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT NEES ---- The information required by this item is incorporated herein by reference to the material under the caption ELECTION OF DIRECTORS in the definitive proxy statement of NEES, dated March 10, 1994, for the 1994 Annual Meeting of Shareholders, provided that the information under the headings "Compensation Committee Report on Executive Compensation" and "Corporate Performance" are not so incorporated. Reference is also made to the information under the caption EXECUTIVE OFFICERS - NEES in Part I of this report. NEP --- The names of the directors of NEP, their ages, and a brief account of their business experience during the past five years appear below. Information required by this item for Executive Officers is provided under the caption EXECUTIVE OFFICERS - NEP in Part I of this report. Directors are elected to hold office until the next annual meeting of stockholders or special meeting held in lieu thereof and until their respective successors are chosen and qualified. Joan T. Bok - Director since 1979 - Age: 64 - Chairman of the Board of NEES - Vice Chairman of the Company from 1993 to 1994 - Chairman or Vice Chairman of the Company from 1988 to 1994 - Vice Chairman of the Company from 1989 to 1991 - Chairman of NEES from 1984 to 1994 (Chairman, President, and Chief Executive Officer from July 26, 1988 until February 13, 1989). Directorships of NEES System companies: New England Electric System, Massachusetts Electric Company, The Narragansett Electric Company, Narragansett Energy Resources Company, New England Electric Resources, Inc., New England Electric Transmission Corporation, New England Energy Incorporated, New England Hydro Finance Company, Inc., New England Hydro-Transmission Corporation, New England Hydro-Transmission Electric Company, Inc., and New England Power Service Company. Other directorships: Avery Dennison Corporation, John Hancock Mutual Life Insurance Company, Monsanto Company, and the Federal Reserve Bank of Boston. Frederic E. Greenman* - Director since 1986. Directorships of NEES System companies and affiliates: Narragansett Energy Resources Company, New England Electric Resources, Inc., New England Electric Transmission Corporation, New England Energy Incorporated, New England Hydro Finance Company, Inc., New England Hydro-Transmission Corporation, New England Hydro-Transmission Electric Company, Inc., New England Power Service Company, Yankee Atomic Electric Company, Connecticut Yankee Atomic Power Company, Maine Yankee Atomic Power Company, and Vermont Yankee Nuclear Power Corporation. Alfred D. Houston* - Director since 1984. Directorships of NEES System companies: Narragansett Energy Resources Company, New England Electric Transmission Corporation, New England Energy Incorporated, New England Hydro Finance Company, Inc., New England Hydro-Transmission Corporation, New England Hydro-Transmission Electric Company, Inc., and New England Power Service Company. John W. Newsham* - Director since 1991. Directorships of NEES System companies: Narragansett Energy Resources Company, New England Electric Resources, Inc., and New England Power Service Company. John W. Rowe* - Director since 1989. Directorships of NEES System companies and affiliates: New England Electric System, Massachusetts Electric Company, The Narragansett Electric Company, Narragansett Energy Resources Company, New England Electric Resources, Inc., New England Electric Transmission Corporation, New England Energy Incorporated, New England Hydro Finance Company, Inc., New England Hydro-Transmission Corporation, New England Hydro-Transmission Electric Company, Inc., New England Power Service Company, and Maine Yankee Atomic Power Company. Other directorships: Bank of Boston Corporation and UNUM Corporation. Jeffrey D. Tranen* - Director since 1991. Directorships of NEES System affiliates: Narragansett Energy Resources Company, New England Electric Resources, Inc., New England Electric Transmission Corporation, New England Energy Incorporated, New England Hydro Finance Company, Inc., New England Hydro-Transmission Corporation, New England Hydro-Transmission Electric Company, Inc., and New England Power Service Company. *Please refer to the material supplied under the caption EXECUTIVE OFFICERS - NEES and EXECUTIVE OFFICERS - NEP in Part I of this report for other information regarding this director. Mass. Electric -------------- The names of the directors of Mass. Electric, their ages, and a brief account of their business experience during the past five years appear below. Information required by this item for Executive Officers is provided under the caption EXECUTIVE OFFICERS - - Mass. Electric in Part I of this report. Directors are elected to hold office until the next annual meeting of stockholders or special meeting held in lieu thereof and until their respective successors are chosen and qualified. Urville J. Beaumont - Director since 1984 - Age: 61 - Treasurer and Director, law firm of Beaumont & Campbell, P.A. Joan T. Bok* - Director since 1979. Sally L. Collins - Director since 1976 - Age: 58 - Health Services Administrator at Kollmorgen Corporation EOD since January 1989 - Former Director of Medical Services at Oxbow Health Associates, Inc., Hadley, Mass. - Former member of Mass. Electric Customer Advisory Council. John H. Dickson - Director since 1990 - Reference is made to material supplied under the caption EXECUTIVE OFFICERS - Mass. Electric for other information regarding Mr. Dickson. Other directorship: Worcester Business Development Corporation. Charles B. Housen - Director since 1979 - Age: 61 - Chairman, President, and Director of Erving Industries, Inc., Erving, Mass. Dr. Kathryn A. McCarthy - Director since 1973 - Age: 69 - Research Professor of Physics at Tufts University, Medford, Mass. - Senior Vice President and Provost at Tufts from 1973 to 1979 - Other directorships: State Mutual Life Assurance Company of America. Patricia McGovern - Elected Director in 1994 - Age: 52 - Of Counsel to law firm of Goulston & Storrs, P.C. since 1993 - Massachusetts State Senator and Chair of the Senate Ways and Means Committee from 1984 to 1992. John F. Reilly - Director since 1988 - Age: 61 - President and CEO of Fred C. Church, Inc., Lowell, Mass. - Other as directorships: Colonial Gas Company and NE Insurance Co., Ltd. John W. Rowe* - Director since 1989. Richard P. Sergel* - Director since 1993. Richard M. Shribman - Director since 1979 - Age: 68 - Treasurer of Norick Realty Corporation, Salem, Mass. - President of Norick Realty Corporation until 1992 - Other directorships: Eastern Bank. Roslyn M. Watson - Director since 1992 - Age: 44 - President of Watson Ventures (commercial real estate development and management) Boston, Mass. - Vice President of the Gunwyn Company (commercial real estate development) Cambridge, Mass. from 1990 - 1993 and Project Manager from 1986 - 1990 - Other directorships: The Boston Company Funds. *Please refer to the material supplied under the caption EXECUTIVE OFFICERS - NEES in Part I of this report and/or the material supplied under the caption DIRECTORS AND OFFICERS OF THE REGISTRANT - NEP in this Item for other information regarding this director. Narragansett ------------ The names of the directors of Narragansett, their ages, and a brief account of their business experience during the past five years appear below. Information required by this item for Executive Officers is provided under the caption EXECUTIVE OFFICERS - - Narragansett in Part I of this report. Directors are elected to hold office until the next annual meeting of stockholders or special meeting held in lieu thereof and until their respective successors are chosen and qualified. Joan T. Bok* - Director since 1979. Stephen A. Cardi - Director since 1979 - Age: 52 - Treasurer and Director of Cardi Corporation (construction), Warwick, R.I. Frances H. Gammell - Director since 1992 - Age: 44 - Director, Vice President of Finance, and Secretary of Original Bradford Soap Works, Inc. Joseph J. Kirby - Director since 1988 - Age: 62 - President of Washington Trust Bancorp, Inc., Westerly, R.I. and President and Director of the Washington Trust Company. Robert L. McCabe - President and Director of Narragansett since 1986 - Other directorship: Citizens Savings Bank - Please refer to the material supplied under the caption EXECUTIVE OFFICERS - Narragansett in Part I of this report for other information regarding Mr. McCabe. John W. Rowe* - Director since 1989. Richard P. Sergel* - Chairman and Director since 1993. William E. Trueheart - Director since 1989 - Age: 50 - President of Bryant College, Smithfield, Rhode Island - Executive Vice President of Bryant College from 1986 to 1989 - Other directorships: Fleet National Bank. John A. Wilson, Jr. - Director since 1971 - Age: 62 - Former Consultant to and President of Wanskuck Co., Providence, R.I., - Former Consultant to Hinckley, Allen, Snyder & Comen (attorneys), Providence, R.I. *Please refer to the material supplied under the caption DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT - NEP in this Item for other information regarding this director. Section 16(a) of the Securities Exchange Act of 1934 requires the System's officers and directors, and persons who own more than 10% of a registered class of the System's equity securities, to file reports on Forms 3, 4, and 5 of share ownership and changes in share ownership with the SEC and the New York Stock Exchange and to furnish the System with copies of all Section 16(a) forms they file. Based solely on Mass. Electric's and Narragansett's review of the copies of such forms received by them, or written representations from certain reporting persons that such forms were not required for those persons, Mass. Electric and Narragansett believe that, during 1993, all filing requirements applicable to its officers, directors, and 10% beneficial owners were complied with, except that one report on Form 3 was filed late for each of Mr. Beirne, Mr. Frost, and Mr. Mahoney. Item 11.

Item 11. EXECUTIVE COMPENSATION NEES ---- The information required by this item is incorporated herein by reference to the material under the captions BOARD STRUCTURE AND COMPENSATION, EXECUTIVE COMPENSATION, PAYMENTS UPON A CHANGE IN CONTROL, PLAN SUMMARIES, and RETIREMENT PLANS in the definitive proxy statement of NEES, dated March 10, 1994, for the 1994 Annual Meeting of Shareholders, provided that the information under the headings "Compensation Committee Report on Executive Compensation" and "Corporate Performance" are not so incorporated. NEP, MASS. ELECTRIC, AND NARRAGANSETT ------------------------------------- EXECUTIVE COMPENSATION The following tables give information with respect to all compensation (whether paid directly by NEP, Mass. Electric, or Narragansett or billed to it as hourly charges) for services in all capacities for NEP, Mass. Electric, or Narragansett for the years 1991 through 1993 to or for the benefit of the Chief Executive Officer and the four other most highly compensated executive officers for each company. NEP SUMMARY COMPENSATION TABLE Long-Term Compensa- Annual Compensation (b) tion -------------------------- --------- Other Name and Annual Restricted All Other Principal Compensa- Share Compensa- Position Year Salary Bonus tion Awards tion (a) ($) ($)(c) ($)(d) ($)(e) ($)(f) - ---------- ---- ------- ------ --------- ---------- --------- John W. 1993 181,269 112,095 2,318 54,256 2,386(g) Rowe 1992 184,532 69,205 2,318 56,479 2,340 Chairman 1991 160,202 67,618 2,188 58,394 2,153 Joan T. 1993 154,428 92,949 3,323 46,245 3,444(h) Bok 1992 157,705 59,310 2,899 48,274 3,326 Vice 1991 155,392 66,005 3,135 56,641 3,615 Chairman Jeffrey D. 1993 159,936 112,105 2,974 32,753 3,563(i) Tranen 1992 120,843 52,286 2,307 23,732 2,670 President 1991 129,725 45,832 2,240 20,970 2,595 Frederic E. 1993 123,648 75,058 2,131 22,811 3,110(j) Greenman 1992 133,223 50,258 2,361 26,960 3,298 Vice 1991 125,237 43,804 2,516 24,028 3,145 President Lawrence E. 1993 135,123 61,283 101 21,286 3,790(k) Bailey 1992 129,711 47,737 101 20,985 2,594 Vice 1991 122,928 32,588 102 14,474 2,459 President (a) Certain officers of NEP are also officers of NEES and various other System companies. (b) Includes deferred compensation in category and year earned. (c) The bonus figure represents cash bonuses under an incentive compensation plan, special bonuses, the goals program award, and the variable portion of the incentive thrift plan match by NEP. See description under Plan Summaries. (d) Includes amounts reimbursed by NEP for the payment of taxes. (e) These shares receive the same dividends as the other common shares of NEES. The shares become unrestricted after five years. See also Payments Upon a Change in Control, below. As of December 31, 1993, the following executive officers held the amount of restricted shares with the value indicated: Mr. Rowe 11,807 shares, $461,949 value; Mrs. Bok 10,241 shares, $400,679 value; Mr. Greenman 3,220 shares, $125,983 value; Mr. Tranen 2,193 shares, $85,019 value; and Mr. Bailey 1,369 shares, $53,562 value. These amounts do not include the restricted share awards for 1993 which were not determined until February 1994. The value was calculated by multiplying the closing market price on December 31, 1993 by the number of shares. (f) Includes NEP contributions to life insurance and the incentive thrift plan that are not bonus contributions. See description under Plan Summaries. The life insurance contribution is calculated based on the value of term life insurance for the named individuals. The premium costs for most of these policies have been or will be recovered by NEP. (g) For Mr. Rowe, the amount and type of compensation in 1993 is as follows: $1,879 for contributions to the thrift plan and $507 for life insurance. (h) For Mrs. Bok, the amount and type of compensation in 1993 is as follows: $1,937 for contributions to the thrift plan and $1,507 for life insurance. (i) For Mr. Tranen, the amount and type of compensation in 1993 is as follows: $3,198 for contributions to the thrift plan and $365 for life insurance. (j) For Mr. Greenman, the amount and type of compensation in 1993 is as follows: $2,478 for contributions to the thrift plan and $637 for life insurance. (k) For Mr. Bailey, the amount and type of compensation in 1993 is as follows: $2,702 for contributions to the thrift plan and $1,088 for life insurance. MASS. ELECTRIC SUMMARY COMPENSATION TABLE Long-Term Compensa- Annual Compensation (b) tion -------------------------- --------- Other Name and Annual Restricted All Other Principal Compensa- Share Compensa- Position Year Salary Bonus tion Awards tion (a) ($) ($)(c) ($)(d) ($)(e) ($)(f) - ---------- ---- ------- ------ --------- ---------- --------- Richard P. 1993 93,628 71,187 1,657 20,713 2,036(h) Sergel (g) Chairman John H. 1993 156,900 116,399 3,005 28,103 3,623(i) Dickson 1992 150,469 61,561 3,087 27,801 3,442 President 1991 141,720 51,451 2,389 23,606 3,255 and CEO Nancy H. 1993 102,860 43,386 103 13,370 2,378(j) Sala (g) 1992 96,785 20,508 103 8,326 1,936 Vice President Dennis E. 1993 105,768 29,175 101 11,173 3,025(k) Snay 1992 101,208 28,448 103 12,207 2,024 Vice 1991 94,862 23,320 103 10,001 1,897 President Cheryl A. 1993 71,488 43,373 68 13,206 1,575(l) LaFleur (g) Vice President (a) Certain officers of Mass. Electric are also officers of NEES and various other System companies. (b) Includes deferred compensation in category and year earned. (c) The bonus figure represents cash bonuses under an incentive compensation plan, special bonuses, the goals program award, and the variable portion of the incentive thrift plan match by Mass. Electric. See description under Plan Summaries. (d) Includes amounts reimbursed by Mass. Electric for the payment of taxes. (e) These shares receive the same dividends as the other common shares of NEES. The shares become unrestricted after five years. See also Payments Upon a Change in Control, below. As of December 31, 1993, the following executive officers held the amount of restricted shares with the value indicated: Mr. Sergel 2,022 shares, $79,110 value; Mr. Dickson 2,190 shares, $85,683 value; Ms. Sala 360 shares, $14,085 value; Mr. Snay 859 shares, $33,608 value; and Ms. LaFleur 824 shares, $32,239 value. These amounts do not include the restricted share awards for 1993 which were not determined until February 1994. The value was calculated by multiplying the closing market price on December 31, 1993 by the number of shares. (f) Includes Mass. Electric contributions to life insurance and the incentive thrift plan that are not bonus contributions. See description under Plan Summaries. The life insurance contribution is calculated based on the value of term life insurance for the named individuals. The premium costs for most of these policies have been or will be recovered by Mass. Electric. (g) Mr. Sergel and Ms. LaFleur were elected as officers of Mass. Electric in 1993, and Ms. Sala was elected in 1992. Compensation data is provided for the years in which they have served as officers. (h) For Mr. Sergel, the type and amount of compensation in 1993 is as follows: $1,873 for contributions to the thrift plan and $163 for life insurance. (i) For Mr. Dickson, the type and amount of compensation in 1993 is as follows: $3,138 for contributions to the thrift plan and $485 for life insurance. (j) For Ms. Sala, the type and amount of compensation in 1993 is as follows: $2,057 for contributions to the thrift plan and $321 for life insurance. (k) For Mr. Snay, the type and amount of compensation in 1993 is as follows: $2,115 for contributions to the thrift plan and $910 for life insurance. (l) For Ms. LaFleur, the type and amount of compensation in 1993 is as follows: $1,430 for contributions to the thrift plan and $145 for life insurance. NARRAGANSETT SUMMARY COMPENSATION TABLE Long-Term Compensa- Annual Compensation (b) tion -------------------------- --------- Other Name and Annual Restricted All Other Principal Compensa- Share Compensa- Position Year Salary Bonus tion Awards tion (a) ($) ($)(c) ($)(d) ($)(e) ($)(f) - ---------- ---- ------- ------ --------- ---------- --------- Richard P. 1993 48,207 36,653 854 10,665 1,048(h) Sergel (g) Chairman Robert L. 1993 139,632 98,654 2,408 22,617 3,771(i) McCabe 1992 134,536 54,109 2,041 25,076 2,603 President 1991 128,863 40,428 1,306 18,024 2,388 and CEO William 1993 118,501 39,403 101 13,370 5,847(j) Watkins, 1992 65,586 17,315 66 7,350 1,312 Jr. (g) Executive Vice President Richard W. 1993 96,408 28,667 103 11,211 2,628(k) Frost (g) Vice President Francis X. 1993 87,300 10,580 113 2,462 1,859(l) Beirne (g) Vice President (a) Certain officers of Narragansett are also officers of NEES and various other System companies. (b) Includes deferred compensation in category and year earned. (c) The bonus figure represents cash bonuses under an incentive compensation plan, special bonuses, the goals program award, and the variable portion of the incentive thrift plan match by Narragansett. See description under Plan Summaries. (d) Includes amounts reimbursed by Narragansett for the payment of taxes. (e) These shares receive the same dividends as the other common shares of NEES. The shares become unrestricted after five years. See also Payments Upon a Change in Control, below. As of December 31, 1993, the following executive officers held the amount of restricted shares with the value indicated: Mr. Sergel 2,022 shares, $79,110 value; Mr. McCabe 2,082 shares, $81,458 value; Mr. Watkins 954 shares, $37,325 value; Mr. Frost 942 shares, $36,855 value; and Mr. Beirne 206 shares, $8,059 value. These amounts do not include the restricted share awards for 1993 which were not determined until February 1994. The value was calculated by multiplying the closing market price on December 31, 1993 by the number of shares. (f) Includes Narragansett contributions to life insurance and the incentive thrift plan that are not bonus contributions. See description under Plan Summaries. The life insurance contribution is calculated based on the value of term life insurance for the named individuals. The premium costs for most of these policies have been or will be recovered by Narragansett. (g) Messrs. Sergel, Frost, and Beirne were elected as officers of Narragansett in 1993, and Mr. Watkins was elected in 1992. Compensation data is provided for the years in which they have served as officers. (h) For Mr. Sergel, the type and amount of compensation in 1993 is as follows: $964 for contributions to the thrift plan and $84 for life insurance. (i) For Mr. McCabe, the type and amount of compensation in 1993 is as follows: $2,682 for contributions to the thrift plan and $1,089 for life insurance. (j) For Mr. Watkins, the type and amount of compensation in 1993 is as follows: $2,370 for contributions to the thrift plan and $3,477 for life insurance. (k) For Mr. Frost, the type and amount of compensation in 1993 is as follows: $1,928 for contributions to the thrift plan and $700 for life insurance. (l) For Mr. Beirne, the type and amount of compensation in 1993 is as follows: $1,746 for contributions to the thrift plan and $113 for life insurance. Directors' Compensation Members of the Mass. Electric and Narragansett Boards of Directors, except Dickson, McCabe, Rowe, and Sergel receive a quarterly retainer of $1,250, a meeting fee of $600 plus expenses, and 50 NEES common shares each year. Since all members of the NEP Board are employees of NEES System companies, no fees are paid for service on the Board except as noted below for Mrs. Bok. Mrs. Bok retired as an employee of the NEES companies on January 1, 1994 (remaining as Chairman of NEES and a director for NEES subsidiaries). Mrs. Bok has agreed to waive the normal fees and annual retainers otherwise payable for services by non- employees on NEES subsidiary boards and will receive in lieu thereof a single annual stipend of $60,000. Mrs. Bok also became a consultant to NEES as of January 1, 1994. Under the terms of her contract, she will receive an annual retainer of $100,000. No payments were made in 1993 pursuant to these arrangements. Mass. Electric and Narragansett permit directors to defer all or a portion of their retainers and meeting fees. Special accounts are maintained on Mass. Electric's and Narragansett's books showing the amounts deferred and the interest accrued thereon. Other NEP, Mass. Electric, and Narragansett do not have any share option plans. The NEES Compensation Committee administers certain of the incentive compensation plans, and the Management Committee administers the others (including the incentive share plan). Retirement Plans The following table shows estimated annual benefits payable to executive officers under the qualified pension plan and the supplemental retirement plan, assuming retirement at age 65 in 1994. PENSION TABLE Five-Year Average 15 Years 20 Years 25 Years 30 Years 35 Years 40 Years Compensa- of of of of of of tion Service Service Service Service Service Service - --------- -------- -------- -------- -------- -------- -------- $100,000 28,000 36,600 45,000 53,400 58,900 61,600 $150,000 43,000 56,300 69,300 82,200 90,300 94,800 $200,000 58,000 76,000 93,500 111,000 122,100 128,100 $250,000 73,000 95,700 117,800 139,800 153,800 161,300 $300,000 88,100 115,400 142,000 168,600 185,500 194,500 $350,000 103,100 135,100 166,300 197,400 217,200 227,700 $400,000 118,100 154,800 190,500 226,200 249,000 261,000 $450,000 133,100 174,500 214,800 255,000 280,700 294,200 For purposes of the retirement plans, Messrs. Rowe, Tranen, Greenman, and Bailey currently have 16, 24, 30, and 25 credited years of service, respectively. Mr. Sergel, Mr. Dickson, Ms. Sala, Mr. Snay, and Ms. LaFleur currently have 15, 20, 24, 30, and 7 credited years of service, respectively. Messrs. McCabe, Watkins, Frost, and Beirne currently have 25, 21, 31, and 22 credited years of service, respectively. At the time she retired from NEP, Mrs. Bok had 38 credited years of service, and she commenced receiving the described benefits under the pension plans and the life insurance program. As a non-employee, she no longer accrues service credit or additional benefits under these plans. Benefits under the pension plans are computed using formulae based on percentages of highest average compensation computed over five consecutive years. The compensation covered by the pension plan includes salary, bonus, and restricted share awards. The benefits listed in the pension table are not subject to deduction for Social Security and are shown without any joint and survivor benefits. The Pension Table above does not include annuity payments to be received in lieu of life insurance. The policies are described above under Plan Summaries. In February 1993, NEP announced a voluntary early retirement program available to all non-union employees over age 55 with 10 or more years of service as of June 30, 1993. Mrs. Bok accepted the offer. The program offered either an annuity or a lump sum equal to the greater value of either one week's base pay times the number of years of service plus two weeks base pay or an additional five years of service and five years of age. In accordance with the terms of the offer, Mrs. Bok received an additional annuity of $12,611 from a supplemental pension plan and a lump sum of $110,896 from the qualified plan. Mrs. Bok had not been eligible for a bonus under the prior incentive compensation plan. In lieu thereof she will receive a limited cost of living (consumer price index) adjustment to her benefits from the qualified pension plan and the supplemental retirement plan. Since this plan serves to adjust the pension benefit only after retirement, there will be no supplement paid under the plan until at least 1995. Senior executives receive the same post-retirement health benefits as those offered non-union employees who retire with a combination of age and years of service equal to 85. PAYMENTS UPON A CHANGE OF CONTROL The incentive compensation plans would provide a payment of 40% of base compensation in the event of a "change in control" as defined in the plans. This payout would be made in lieu of any cash bonuses under the plans for the year in which the "change in control" occurs. A similar payment is provided for the previous plan year if awards for that year had not yet been distributed. A "change in control" is defined, generally, as an occurrence of certain events that either evidence a merger or acquisition of NEES or cause a significant change in the makeup of the NEES board of directors over a short period of time. Upon the occurrence of a "change in control," restrictions on all shares issued to participants under the incentive share plan would cease and the participants would receive an award of shares for that year, determined in the usual manner, based upon the cash awards described in the preceding paragraph. NEP, MASS. ELECTRIC, AND NARRAGANSETT PLAN SUMMARIES A brief description of the various plans through which compensation and benefits are provided to the named executive officers is presented below to better enable shareholders to understand the information presented in the tables shown earlier. The amounts of compensation and benefits provided to the named executive officers under the plans described below (and charged to NEP, Mass. Electric, or Narragansett) are presented in the Summary Compensation Tables. Goals Program The goals program covers all employees who have completed one year of service with any NEES subsidiary. Goals are established annually. For 1993, these goals related to earnings per share, customer costs, safety, absenteeism, conservation, generating station availability, transmission reliability, environmental and OSHA compliance, and customer favorability attitudes. Some goals apply to all employees, while others apply to particular functional groups. Depending upon the number of goals met, and provided the minimum goal for earnings per share is met, employees may earn a cash bonus of 1% to 4-1/2% of their compensation. Incentive Thrift Plan The incentive thrift plan (a 401(k) program) provides for a match of one-half of up to the first 4% of base compensation contributed to the System's incentive thrift plan (shown under All Other Compensation in the Summary Compensation Tables) and, based on an incentive formula tied to earnings per share, may fully match the first 4% of base compensation contributed (the additional amount, if any, is shown under Bonus in the Summary Compensation Tables). Under Federal law, contributions to these plans are restricted. In 1993, the salary reduction amount was limited to $8,994. Life Insurance NEES has established for certain senior executives life insurance plans funded by individual policies. The combined death benefit under these insurance plans is three times the participant's annual salary. After termination of employment, participants may elect, commencing at age 55 or later, to receive an annuity income equal to 40% of annual salary. In that event, the life insurance is reduced over fifteen years to an amount equal to the participant's final annual salary. Due to changes in the tax law, this plan was closed to new participants, and an alternative was established with only a life insurance benefit. The individuals listed in the NEP summary compensation table are in one or the other of these plans. Mass. Electric and Narragansett each have two executive officers eligible to participate in one or the other of these plans. Item 12.

Item 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT NEES ---- The information required by this item is incorporated herein by reference to the material under the caption TOTAL COMMON EQUITY BASED HOLDINGS in the definitive proxy statement of NEES, dated March 10, 1994, for the 1994 Annual Meeting of Shareholders, provided that the information under the headings "Compensation Committee Report on Executive Compensation" and "Corporate Performance" are not so incorporated. NEP, Mass. Electric, and Narragansett ------------------------------------- NEES owns 100% of the voting securities of Mass. Electric and Narragansett. NEES owns 98.80% of the voting securities of NEP. SECURITY OWNERSHIP The following tables list the holdings of NEES common shares as of March 10, 1994 by NEP, Mass. Electric, and Narragansett directors, the executive officers named in the Summary Compensation Tables, and all directors and executive officers, as a group. NEP --- Name Shares Beneficially Owned (a) ---- ----------------------------- Lawrence E. Bailey 1,953 Joan T. Bok 25,162 Frederic E. Greenman 10,632 Alfred D. Houston 10,953 John W. Newsham 10,270 John W. Rowe 20,419 Richard P. Sergel 6,702 Jeffrey D. Tranen 6,604 All directors and executive officers, as a group (13 persons) 115,340 (b) (a) Includes restricted shares and allocated shares in employee benefit plans. (b) This is less than 1% of the total number of shares of NEES outstanding. Mass. Electric -------------- Name Shares Beneficially Owned ---- ------------------------- Urville J. Beaumont 104 (a) Joan T. Bok 25,162 (b) Sally L. Collins 105 John H. Dickson 7,883 (b) Charles B. Housen 52 Cheryl A. LaFleur 1,796 (b) Kathryn A. McCarthy 100 Patricia McGovern 0 John F. Reilly 105 John W. Rowe 20,419 (b) Nancy H. Sala 5,459 (b),(c) Richard P. Sergel 6,702 (b) Richard M. Shribman 105 Dennis E. Snay 3,720 (b) Roslyn M. Watson 205 All directors and executive officers, as a group (23 persons) 105,713 (d) (a) Mr. Beaumont disclaims a beneficial ownership interest in these shares held under an irrevocable trust. (b) Includes restricted shares and allocated shares in employee benefit plans. (c) Ms. Sala disclaims a beneficial ownership interest in 205 shares held under the Uniform Gift to Minors Act. (d) This is less than 1% of the total number of shares of NEES outstanding. Narragansett ------------ Name Shares Beneficially Owned ---- ------------------------- Francis X. Beirne 2,956 (a) Joan T. Bok 25,162 (a) Stephen A. Cardi 104 Richard W. Frost 4,521 (a) Frances H. Gammell 105 Joseph J. Kirby 105 Robert L. McCabe 7,671 (a) John W. Rowe 20,419 (a) Richard P. Sergel 6,702 (a) William E. Trueheart 105 William Watkins, Jr. 7,143 (a) John A. Wilson, Jr. 508 All directors and executive officers, as a group (15 persons) 95,477 (b) (a) Includes restricted shares and allocated shares in employee benefit plans. (b) This is less than 1% of the total number of shares of NEES outstanding. Item 13.

Item 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS The construction company of Mr. Stephen A. Cardi, a director of Narragansett, was awarded two contracts by New England Power Company for construction work at its Brayton Point Station. The contract amounts totalled $600,000 and $1,000,000, respectively. Reference is made to Item 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT and Item 11. EXECUTIVE COMPENSATION. PART IV Item 14.

Item 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K List of Exhibits Unless otherwise indicated, the exhibits listed below are incorporated by reference to the appropriate exhibit numbers and the Commission file numbers indicated in parentheses. NEES ---- (3) Agreement and Declaration of Trust dated January 2, 1926, as amended through April 28, 1987 (Exhibit 3 to 1987 Form 10-K, File No. 1-3446). (4) Instruments Defining the Rights of Security Holders (a) Massachusetts Electric Company First Mortgage Indenture and Deed of Trust, dated as of July 1, 1949, and twenty supplements thereto (Exhibit 7-A, File No. 1-8019; Exhibit 7-B, File No. 2-8836; Exhibit 4-C, File No. 2-9593; Exhibit 4 to 1980 Form 10-K, File No. 2-8019; Exhibit 4 to 1982 Form 10-K, File No. 0-5464; Exhibit 4 to 1986 Form 10-K, File No. 0-5464; Exhibit 4(a) to 1988 Form 10-K, File No. 1-3446; Exhibit 4(a) to 1989 Form 10-K, File No. 1-3446; Exhibit 4(a) to 1992 Form 10-K, File No. 1-3446; Twentieth Supplemental Indenture dated as of September 1, 1993 (filed herewith). (b) The Narragansett Electric Company First Mortgage Indenture and Deed of Trust, dated as of September 1, 1944, and twenty-one supplements thereto (Exhibit 7-1, File No. 2-7042; Exhibit 7-B, File No. 2-7490; Exhibit 4-C, File No. 2-9423; Exhibit 4-D, File No. 2-10056; Exhibit 4 to 1980 Form 10-K, File No. 0-898; Exhibit 4 to 1982 Form 10-K, File No. 0-898; Exhibit 4 to 1983 Form 10-K, File No. 0-898; Exhibit 4 to 1985 Form 10-K, File No. 0-898; Exhibit 4 to 1986 Form 10-K, File No. 0-898; Exhibit 4 to 1987 Form 10-K, File No. 0-898; Exhibit 4 to 1991 Form 10-K, File No. 0-898); Exhibit 4(b) to 1992 Form 10-K, File No. 1-3446; Twenty-First Supplemental Indenture dated as of October 1, 1993 (filed herewith). (c) The Narragansett Electric Company Preference Provisions, as amended, dated March 23, 1993 (filed herewith). (d) New England Power Company Indentures General and Refunding Mortgage Indenture and Deed of Trust dated as of January 1, 1977 and nineteen supplements thereto (Exhibit 4(b) to 1980 Form 10-K, File No. 0-1229; Exhibit 4(b) to 1982 Form 10-K, File No. 0-1229; Exhibit 4(b) to 1983 Form 10-K, File No. 0-1229; Exhibit 4(b) to 1985 Form 10-K, File No. 0-1229; Exhibit 4(b) to 1986 Form 10-K, File No. 0-1229; Exhibit 4(c)(ii) to 1988 Form 10-K, File No. 1-3446; Exhibit 4(c)(ii) to 1989 Form 10-K, File No. 1-3446; Exhibit 4(c)(ii) to 1990 Form 10-K, File No. 1-3446; Exhibit 4(c)(ii) to 1991 Form 10-K, File No. 1-3446; Exhibit 4(c)(ii) to 1992 Form 10-K, File No. 1-3446; Nineteenth Supplemental Indenture dated as of August 1, 1993 (filed herewith). (10) Material Contracts (a) Boston Edison Company et al. and New England Power Company: Amended REMVEC Agreement dated August 12, 1977 (Exhibit 5-4(d), File No. 2-61881). (b) The Connecticut Light and Power Company et al. and New England Power Company: Sharing Agreement for Joint Ownership, Construction and Operation of Millstone Unit No. 3 dated as of September 1, 1973, and Amendment dated as of August 1, 1974 (Exhibit 10-5, File No. 2-52820); Amendments dated as of December 15, 1975 and April 1, 1986; (Exhibit 10(b), to 1990 Form 10-K, File No. 1-3446). Transmission Support Agreement dated August 9, 1974; Instrument of Transfer to NEP with respect to the 1979 Connecticut Nuclear Unit, and Assumption of Obligations, dated December 17, 1975 (Exhibit 10-6(b), File No. 2-57831). (c) Connecticut Yankee Atomic Power Company et al. and New England Power Company: Stockholders Agreement dated July 1, 1964 (Exhibit 13-9-A, File No. 2-23006); Power Purchase Contract dated July 1, 1964 (Exhibit 13-9-B, File No. 2-23006); Supplementary Power Contract dated as of April 1, 1987 (Exhibit 10(c) to 1987 Form 10-K, File No. 1-3446); Capital Funds Agreement dated September 1, 1964 (Exhibit 13-9-C, File No. 2-23006); Transmission Agreement dated October 1, 1964 (Exhibit 13-9-D, File No. 2-23006); Agreement revising Transmission Agreement dated July 1, 1979 (Exhibit to 1979 Form 10-K, File No. 1-3446); Guarantee Agreement dated as of November 13, 1981 (Exhibit 10(d) to 1981 Form 10-K, File No. 1-3446); Guarantee Agreement dated as of August 1, 1985 (Exhibit 10(c) to 1985 Form 10-K, File No. 1-3446). (d) Maine Yankee Atomic Power Company et al. and New England Power Company: Capital Funds Agreement dated May 20, 1968 and Power Purchase Contract dated May 20, 1968 (Exhibit 4-5, File No. 2-29145); Amendments dated as of January 1, 1984, March 1, 1984 (Exhibit 10(d) to 1983 Form 10-K, File No. 1-3446), October 1, 1984, and August 1, 1985 (Exhibit 10(d) to 1985 Form 10-K, File No. 1-3446); Stockholders Agreement dated May 20, 1968 (Exhibit 10-20, File No. 2-34267); Additional Power Contract dated as of February 1, 1984 (Exhibit 10(d) to 1985 Form 10-K, File No. 1-3446); Guarantee Agreement dated as of September 23, 1985 (Exhibit 10(d) to 1985 Form 10-K, File No. 1-3446). (e) New England Energy Incorporated Contracts (i) Capital Funds Agreement with NEES dated November 1, 1974 (Exhibit 10-29(b), File No. 2-52969); Amendment dated July 1, 1976, and Amendment dated July 26, 1979 (Exhibit 10(g)(i) to 1980 Form 10-K, File No. 1-3446); Amendment dated August 26, 1981 (Exhibit 10(f)(i) to 1981 Form 10-K, File No. 1-3446); Amendment dated March 26, 1985 (Exhibit 10(e)(i) to 1985 Form 10-K, File No. 1-3446); Amendment dated as of April 28, 1989 (Exhibit 10 (e)(i) to 1989 Form 10-K, File No. 1-3446); Amendment dated as of June 1, 1990 (Exhibit 10(e)(i) to 1990 Form 10-K, File No. 1-3446). (ii) Loan Agreement with NEES dated July 19, 1978 and effective November 1, 1974, and Amendment dated July 26, 1979 (Exhibit 10(g)(iii) to 1980 Form 10-K, File No. 1-3446); Amendment dated August 26, 1981 (Exhibit 10(f)(ii) to 1981 Form 10-K, File No. 1-3446); Amendment dated March 26, 1985 (Exhibit 10(e)(ii) to 1985 Form 10-K, File No. 1-3446); Amendment dated as of April 28, 1989 (Exhibit 10(e)(ii) to 1989 Form 10-K, File No. 1-3446); Amendment dated as of June 1, 1990 (Exhibit 10(e)(ii) to 1990 Form 10-K, File No. 1-3446). (iii) Fuel Purchase Contract with New England Power Company dated July 26, 1979, and Amendment dated August 26, 1981 (Exhibit 10(f)(iii) to 1981 Form 10-K, File No. 1-3446); Amendment dated March 26, 1985, and Amendment effective January 1, 1984 (Exhibit 10(e)(iii) to 1985 Form 10-K, File No. 1-3446); Amendment dated as of April 28, 1989 (Exhibit 10(e)(iii) to 1989 Form 10-K, File No. 1-3446). (iv) Partnership Agreement with Samedan Oil Corporation as Amended and Restated on February 5, 1985 (Exhibit 10(e)(iv) to 1984 Form 10-K, File No. 1-3446); Amendment dated as of January 14, 1992 (Exhibit 10(e)(iv) to 1991 Form 10-K, File No. 1-3446). (v) Credit Agreement dated as of April 28, 1989 (Exhibit 10(e)(v) to 1989 Form 10-K, File No. 1-3446); Amendment dated as of June 1, 1990 (Exhibit 10(e)(v) to 1990 Form 10-K, File No. 1-3446); Amendment dated as of August 1, 1992 (Exhibit 10(e)(v) to 1992 Form 10-K, File No. 1-3446). (vi) Capital Maintenance Agreement dated November 15, 1985, and Assignment and Security Agreement dated November 15, 1985 (Exhibit 10(e)(vi) to 1985 Form 10-K, File No. 1-3446); Amendment dated as of April 28, 1989 (Exhibit 10(e)(vi) to 1989 Form 10-K, File No. 1-3446). (f) New England Power Company and New England Electric Transmission Corporation et al.: Phase I Terminal Facility Support Agreement dated as of December 1, 1981 (Exhibit 10(g) to 1981 Form 10-K, File No. 1-3446); Amendments dated as of June 1, 1982, and November 1, 1982 (Exhibit 10(f) to 1982 Form 10-K, File No. 1-3446); Agreement with respect to Use of the Quebec Interconnection dated as of December 1, 1981 (Exhibit 10(g) to 1981 Form 10-K, File No. 1-3446); Amendments dated as of May 1, 1982, and November 1, 1982 (Exhibit 10(f) to 1982 Form 10-K, File No. 1-3446); Amendment dated as of January 1, 1986 (Exhibit (10)(f) 1986 Form 10-K, File No. 1-3446); Agreement for Reinforcement and Improvement of New England Power Company's Transmission System dated as of April 1, 1983 (Exhibit 10(f) to 1983 Form 10-K, File No. 1-3446); Lease dated as of May 16, 1983 (Exhibit 10(f) to 1983 Form 10-K, File No. 1-3446); Upper Development - Lower Development Transmission Line Support Agreement dated as of May 16, 1983 (Exhibit 10(f) to 1983 Form 10-K, File No. 1-3446). (g) New England Electric Transmission Corporation and PruCapital Management, Inc. et al: Note Agreement dated as of September 1, 1986 (Exhibit 10(g) to 1986 Form 10-K, File No. 1-3446); Mortgage, Deed of Trust and Security Agreement dated as of September 1, 1986 (Exhibit 10(g) to 1986 Form 10-K, File No. 1-3446); Equity Funding Agreement with New England Electric System dated as of December 1, 1985 (Exhibit 10(g) to 1991 Form 10-K, File No. 1-3446). (h) Vermont Electric Transmission Company, Inc. et al. and New England Power Company: Phase I Vermont Transmission Line Support Agreement dated as of December 1, 1981; Amendments dated as of June 1, 1982, and November 1, 1982 (Exhibit 10(g) to 1982 Form 10-K, File No. 1-3446); Amendment dated as of January 1, 1986 (Exhibit 10(h) to 1986 Form 10-K, File No. 1-3446). (i) New England Power Pool Agreement: (Exhibit 4(e), File No. 2-43025); Amendments dated July 1, 1972, and March 1, 1973 (Exhibit 10-15, File No. 2-48543); Amendment dated March 15, 1974 (Exhibit 10-5, File No. 2-52775); Amendment dated June 1, 1975 (Exhibit 10-14, File No. 2-57831); Amendment dated September 1, 1975 (Exhibit 10-13, File No. 2-59182); Amendments dated December 31, 1976, January 31, 1977, July 1, 1977, and August 1, 1977 (Exhibit 10-16, File No. 2-61881); Amendments dated August 15, 1978, January 3, 1980, and February 1980 (Exhibit 10-3, File No. 2-68283); Amendment dated September 1, 1981 (Exhibit 10(h) to 1981 Form 10-K, File No. 1-3446); Amendment dated as of December 1, 1981 (Exhibit 10(h) to 1982 Form 10-K, File No. 1-3446); Amendments dated June 1, 1982, June 15, 1983, and October 1, 1983 (Exhibit 10(i) to 1983 Form 10-K, File No. 1-3446); Amendments dated August 1, 1985, August 15, 1985, September 1, 1985, and January 1, 1986 (Exhibit 10(i) to 1985 Form 10-K, File No. 1-3446); Amendment dated September 1, 1986 (Exhibit 10(i) to 1986 Form 10-K, File No. 1-3446); Amendment dated April 30, 1987 (Exhibit 10(i) to 1987 Form 10-K, File No. 1-3446); Amendments dated March 1, 1988 and May 1, 1988 (Exhibit 10(i) to 1988 Form 10-K, File No. 1-3446); Amendment dated March 15, 1989 (Exhibit 10(i) to 1989 Form 10-K, File No. 1-3446); Amendment dated October 1, 1990 (Exhibit 10(i) to 1990 Form 10-K, File No. 1-3446); Amendment dated as of September 15, 1992 (Exhibit 10(i) to 1992 Form 10-K, File No. 1-3446). (j) Public Service Company of New Hampshire et al. and New England Power Company: Agreement for Joint Ownership, Construction and Operation of New Hampshire Nuclear Units dated as of May 1, 1973; Amendments dated May 24, 1974, June 21, 1974, September 25, 1974 and October 25, 1974 (Exhibit 10-18(b), File No. 2-52820); Amendment dated January 31, 1975 (Exhibit 10-16(b), File No. 2-57831); Amendments dated April 18, 1979, April 25, 1979, June 8, 1979, October 11, 1979, December 15, 1979, June 16, 1980, December 31, 1980 (Exhibit 10(i) to 1980 Form 10-K, File No. 1-3446); Amendments dated June 1, 1982, April 27, 1984, June 15, 1984 (Exhibit 10(j) to 1984 Form 10-K, File No. 1-3446); Amendments dated March 8, 1985, March 14, 1986, May 1, 1986 and September 19, 1986 (Exhibit 10(j) to 1986 Form 10-K, File No. 1-3446); Amendment dated November 12, 1987 (Exhibit 10(j) to 1987 Form 10-K, File No. 1-3446); Amendment dated January 13, 1989 (Exhibit 10(j) to 1989 Form 10-K, File No. 1-3446); Amendment dated as of November 1, 1990 (Exhibit 10(j) to 1991 Form 10-K, File No. 1- 3446). Transmission Support Agreement dated as of May 1, 1973 (Exhibit 10-23, File No. 2-49184); Instrument of Transfer to NEP with respect to the New Hampshire Nuclear Units and Assumptions of Obligations dated December 17, 1975 and Agreement Among Participants in New Hampshire Nuclear Units, certain Massachusetts Municipal Systems and Massachusetts Municipal Wholesale Electric Company dated May 28, 1976 (Exhibit 10-16(c), File No. 2-57831); Seventh Amendment To and Restated Agreement for Seabrook Project Disbursing Agent (Exhibit 10(j) to 1991 Form 10-K, File No. 1-3446); Amendments dated as of June 29, 1992 (Exhibit 10(j) to 1992 Form 10-K, File No. 1-3446); Seabrook Project Managing Agent Operating Agreement dated as of June 29, 1992, and amendment to Seabrook Project Managing Agent Agreement dated as of June 29, 1992 (Exhibit 10(j) to 1992 Form 10-K, File No. 1-3446). (k) Vermont Yankee Nuclear Power Corporation et al. and New England Power Company: Capital Funds Agreement dated February 1, 1968, Amendment dated March 12, 1968, and Power Purchase Contract dated February 1, 1968 (Exhibit 4-6, File No. 2-29145); Amendments dated as of June 1, 1972 and April 15, 1983 (Exhibit 10(k) to 1983 Form 10-K, File No. 1-3446) and April 24, 1985 (Exhibit 10(k) to 1985 Form 10-K, File No. 1-3446); Amendment dated as of June 1, 1985 (Exhibit 10(k) to 1987 Form 10-K, File No. 1-3446); Amendments dated as of May 6, 1988 (Exhibit 10(k) to 1988 Form 10-K, File No. 1-3446); Amendment dated as of June 15, 1989 (Exhibit 10(k) to 1989 Form 10-K, File No. 1-3446); Additional Power Contract dated as of February 1, 1984 (Exhibit 10(k) to 1983 Form 10-K, File No. 1-3446); Guarantee Agreement dated as of November 5, 1981 (Exhibit 10(j) to 1981 Form 10-K, File No. 1-3446). (l) Yankee Atomic Electric Company et al. and New England Power Company: Amended and Restated Power Contract dated April 1, 1985 (Exhibit 10(l) to 1985 Form 10-K, File No. 1-3446); Amendment dated May 6, 1988 (Exhibit 10(l) to 1988 Form 10-K, File No. 1-3446); Amendments dated as of June 26, 1989 and July 1, 1989 (Exhibit 10 (l) to 1989 Form 10-K, File No. 1-3446); Amendment dated as of February 1, 1992 (Exhibit 10(l) to 1992 Form 10-K, File No. 1- 3446). *(m) New England Electric Companies' Deferred Compensation Plan as amended dated December 8, 1986 (Exhibit 10(m) to 1986 Form 10-K, File No. 1-3446). *(n) New England Electric System Companies Retirement Supplement Plan as amended dated April 1, 1991 (Exhibit 10(n) to 1991 Form 10-K, File No. 1-3446). *(o) New England Electric Companies' Executive Supplemental Retirement Plan as amended dated April 1, 1991 (Exhibit 10(o) to 1991 Form 10-K, File No. 1-3446). *(p) New England Electric Companies' Incentive Compensation Plan as amended dated January 1, 1992 (Exhibit 10(q) to 1992 Form 10-K, File No. 1-3446). *(q) New England Electric Companies' Senior Incentive Compensation Plan as amended dated November 26, 1991 (Exhibit 10(q) to 1991 Form 10-K, File No. 1- 3446). *(r) New England Electric Companies' Incentive Compensation Plan II as amended dated September 3, 1992 (Exhibit 10(r) to 1992 Form 10-K, File No. 1-3446). *(s) New England Electric System Directors Deferred Compensation Plan as amended dated November 24, 1992 (Exhibit 10(s) to 1992 Form 10-K, File No. 1-3446). *(t) Forms of Life Insurance Program (Exhibit 10(s) to 1986 Form 10-K, File No. 1-3446); and Form of Life Insurance (Collateral Assignment) (Exhibit 10(t) to 1991 Form 10-K, File No. 1-3446). (u) New England Power Company and New England Hydro-Transmission Electric Company, Inc. et al: Phase II Massachusetts Transmission Facilities Support Agreement dated as of June 1, 1985 (Exhibit 10(t) to 1986 Form 10-K, File No. 1-3446); Amendment dated as of May 1, 1986 (Exhibit 10(t) to 1986 Form 10-K, File No. 1-3446); Amendments dated as of February 1, 1987, June 1, 1987, September 1, 1987, and October 1, 1987 (Exhibit 10(u) to 1987 Form 10-K, File No. 1-3446); Amendment dated as of August 1, 1988 (Exhibit 10(u) to 1988 Form 10-K, File No. 1-3446); Amendment dated January 1, 1989 (Exhibit 10(u) to 1990 Form 10-K, File No. 1-3446). (v) New England Power Company and New England Hydro-Transmission Corporation et al: Phase II New Hampshire Transmission Facilities Support Agreement dated as of June 1, 1985 (Exhibit 10(u) to 1986 Form 10-K, File No. 1-3446); Amendment dated as of May 1, 1986 (Exhibit 10(u) to 1986 Form 10-K, File No. 1-3446); Amendments dated as of February 1, 1987, June 1, 1987, September 1, 1987, and October 1, 1987 (Exhibit 10(v) to 1987 Form 10-K, File No. 1-3446); Amendment dated as of August 1,1988 (Exhibit 10(v) to 1988 Form 10-K, File No. 1-3446); Amendments dated January 1, 1989 and January 1, 1990 (Exhibit 10(v) to 1990 Form 10-K, File No. 1-3446). (w) New England Power Company et al: Phase II New England Power AC Facilities Support Agreement dated as of June 1, 1985 (Exhibit 10(v) to 1986 Form 10-K, File No. 1-3446); Amendment dated as of May 1, 1986 (Exhibit 10(v) to 1986 Form 10-K, File No. 1-3446); Amendments dated as of February 1, 1987, June 1, 1987, and September 1, 1987 (Exhibit 10(w) to 1987 Form 10-K, File No. 1-3446); Amendment dated as of August 1, 1988 (Exhibit 10(w) to 1988 Form 10-K, File No. 1-3446). (x) New England Hydro-Transmission Electric Company, Inc. and New England Electric System et al: Equity Funding Agreement dated as of June 1, 1985 (Exhibit 10(w) to 1986 Form 10-K, File No. 1-3446); Amendment dated as of May 1, 1986 (Exhibit 10(w) to 1986 Form 10-K, File No. 1-3446); Amendment dated as of September 1, 1987 (Exhibit 10(x) to 1987 Form 10-K, File No. 1-3446); Amendment dated as of August 1, 1988 (Exhibit 10(x) to 1988 Form 10-K, File No. 1-3446). (y) New England Hydro-Transmission Corporation and New England Electric System et al: Equity Funding Agreement dated as of June 1, 1985 (Exhibit 10(x) to 1986 Form 10-K, File No. 1-3446); Amendment dated as of May 1, 1986 (Exhibit 10(x) to 1986 Form 10-K, File No. 1-3446); Amendment dated as of September 1, 1987 (Exhibit 10(y) to 1987 Form 10-K, File No. 1-3446); Amendment dated as of August 1, 1988 (Exhibit 10(y) to 1988 Form 10-K, File No. 1-3446). (aa) Ocean State Power, et al., and Narragansett Energy Resources Company: Equity Contribution Agreement dated as of December 29, 1988 (Exhibit 10(aa) to 1988 Form 10-K, File No. 1-3446); Amendment dated as of September 29, 1989 (Exhibit 10 (aa) to 1989 Form 10-K File No. 1-3446); Ocean State Power, et al., and New England Electric System: Equity Contribution Support Agreement dated as of December 29, 1988 (Exhibit 10(aa) to 1988 Form 10-K, File No. 1-3446); Amendment dated as of September 29, 1989 (Exhibit 10 (aa) to 1989 Form 10-K, File No. 1-3446); Ocean State Power II, et al., and Narragansett Energy Resources Company:Equity Contribution Agreement dated as of September 29, 1989 (Exhibit 10 (aa) to 1989 Form 10-K File No. 1-3446); Ocean State Power II, et al., and New England Electric System: Equity Contribution Support Agreement dated as of September 29, 1989 (Exhibit 10 (aa) to 1989 Form 10-K File No. 1-3446). *(bb) New England Power Service Company and Joan T. Bok: Service Credit Letter dated October 21, 1982 (Exhibit 10(cc) to 1992 Form 10-K, File No. 1-3446). *(cc) New England Electric System and John W. Rowe: Service Credit Letter dated December 5, 1988 (Exhibit 10(dd) to 1992 Form 10-K, File No. 1-3446). *(dd) New England Power Service Company and the Company: Form of Supplemental Pension Service Credit Agreement (Exhibit 10(ee) to 1992 Form 10-K, File No. 1-3446). * Compensation related plan, contract, or arrangement. (13) 1993 Annual Report to Shareholders (filed herewith). (18) Coopers & Lybrand Preferability Letter dated February 25, 1994 (filed herewith). (22) Subsidiary list appears in Part I of this document. (25) Power of Attorney (filed herewith). NEP --- (3) (a) Articles of Organization as amended through June 27, 1987 (Exhibit 3(a) to 1988 Form 10-K, File No. 0-1229). (b) By-laws of the Company as amended June 25, 1987 (Exhibit 3 to 1987 Form 10-K, File No. 0-1229). (4) General and Refunding Mortgage Indenture and Deed of Trust dated as of January 1, 1977 and nineteen supplements thereto (Exhibit 4(b) to 1980 Form 10-K, File No. 0-1229; Exhibit 4(b) to 1982 Form 10-K, File No. 0-1229; Exhibit 4(b) to 1983 Form 10-K, File No. 0-1229; Exhibit 4(b) to 1985 Form 10-K, File No. 0-1229; Exhibit 4(b) to 1986 Form 10-K, File No. 0-1229; Exhibit 4(b) to 1986 Form 10-K, File No. 0-1229; Exhibit 4(b) to 1988 Form 10-K, File No. 0-1229; Exhibit 4(c)(ii) to 1989 NEES Form 10-K, File No. 1-3446; Exhibit 4(c)(ii) to 1990 NEES Form 10-K, File No. 1-3446; Exhibit 4(c)(ii) to 1991 NEES Form 10-K, File No. 1-3446; Exhibit 4(c)(ii) to 1992 NEES Form 10-K, File No. 1-3446; Exhibit 4(c) to 1993 NEES Form 10-K, File No. 1-3446). (10) Material Contracts (a) Boston Edison Company et al. and the Company: Amended REMVEC Agreement dated August 12, 1977 (Exhibit 5-4(d), File No. 2-61881). (b) The Connecticut Light and Power Company et al. and the Company: Sharing Agreement for Joint Ownership, Construction and Operation of Millstone Unit No. 3 dated as of September 1, 1973, and Amendment dated as of August 1, 1974 (Exhibit 10-5, File No. 2-52820); Amendments dated as of December 15, 1975 and April 1, 1986 (Exhibit 10(b) to NEES' 1990 Form 10-K File No. 1-3446). Transmission Support Agreement dated August 9, 1974; Instrument of Transfer to the Company with respect to the 1979 Connecticut Nuclear Unit, and Assumption of Obligations, dated December 17, 1975 (Exhibit 10-6(b), File No. 2-57831). (c) Connecticut Yankee Atomic Power Company et al. and the Company: Stockholders Agreement dated July 1, 1964 (Exhibit 13-9-A, File No. 2-2006); Power Purchase Contract dated July 1, 1964 (Exhibit 13-9-B, File No. 2-23006); Supplementary Power Contract dated as of April 1, 1987 (Exhibit 10(c) to 1987 Form 10-K, File No. 0-1229); Capital Funds Agreement dated September 1, 1964 (Exhibit 13-9-C, File No. 2-23006); Transmission Agreement dated October 1, 1964 (Exhibit 13-9-D, File No. 2-23006); Agreement revising Transmission Agreement dated July 1, 1979 (Exhibit to NEES' 1979 Form 10-K, File No. 1-3446); Five Year Capital Contribution Agreement dated November 1, 1980 (Exhibit 10(e) to NEES' 1980 Form 10-K, File No. 1-3446); Guarantee Agreement dated as of November 13, 1981 (Exhibit 10(d) to NEES' 1981 Form 10-K, File No. 1-3446); Guarantee Agreement dated as of August 1, 1985 (Exhibit 10(c) to NEES' 1985 Form 10-K, File No. 1-3446). (d) Maine Yankee Atomic Power Company et al. and the Company: Capital Funds Agreement dated May 20, 1968 and Power Purchase Contract dated May 20, 1968 (Exhibit 4-5, File No. 2-29145); Amendments dated as of January 1, 1984, March 1, 1984 (Exhibit 10(d) to NEES' 1983 Form 10-K, File No. 1-3446); October 1, 1984, and August 1, 1985 (Exhibit 10(d) to NEES' 1985 Form 10-K, File No. 1-3446); Stockholders Agreement dated May 20, 1968 (Exhibit 10-20; File No. 2-34267); Additional Power Contract dated as of February 1, 1984 (Exhibit 10(d) to NEES' 1985 Form 10-K, File No. 1-3446); Guarantee Agreement dated as of September 23, 1985 (Exhibit 10(d) to NEES' 1985 Form 10-K, File No. 1-3446). (e) Mass. Electric and the Company: Primary Service for Resale dated February 15, 1974 (Exhibit 5-17(a), File No. 2-52969); Amendment of Service Agreement dated June 22, 1983 (Exhibit 10(b) to Mass. Electric's 1986 Form 10-K, File No. 0-5464); Amendment of Service Agreement effective November 1, 1993 (filed herewith). (f) The Narragansett Electric Company and the Company: Primary Service for Resale dated February 15, 1974 (Exhibit 4-1(b), File No. 2-51292); Amendment of Service Agreement dated July 26, 1990 (Exhibit 4(f) to New England Power Company's 1990 Form 10-K, File No. 0-1229). Amendment of Service Agreement dated July 24, 1991 (Exhibit 10(f) to 1991 Form 10-K, File No. 0-1229); Amendment of Service Agreement effective November 1, 1993 (filed herewith). (g) Time Charter between Intercoastal Bulk Carriers, Inc., and New England Power Company dated as of December 27, 1989 (Exhibit 10(g) to 1989 Form 10-K, File No. 1-3446). (h) New England Electric Transmission Corporation et al. and the Company: Phase I Terminal Facility Support Agreement dated as of December 1, 1981 (Exhibit 10(g) to NEES' 1981 Form 10-K, File No. 1-3446); Amendments dated as of June 1, 1982 and November 1, 1982 (Exhibit 10(f) to NEES' 1982 Form 10-K, File No. 1-3446); Agreement with respect to Use of the Quebec Interconnection dated as of December 1, 1981 (Exhibit 10(g) to NEES' 1981 Form 10-K, File No. 1-3446); Amendments dated as of May 1, 1982 and November 1, 1982 (Exhibit 10(f) to NEES' 1982 Form 10-K, File No. 1-3446); Amendment dated as of January 1, 1986 (Exhibit 10(f) to NEES' 1986 Form 10-K, File No. 1-3446); Agreement for Reinforcement and Improvement of the Company's Transmission System dated as of April 1, 1983 (Exhibit 10(f) to NEES' 1983 Form 10-K, File No. 1-3446); Lease dated as of May 16, 1983 (Exhibit 10(f) to NEES' 1983 Form 10-K, File No. 1-3446); Upper Development-Lower Development Transmission Line Support Agreement dated as of May 16, 1983 (Exhibit 10(f) to NEES' 1983 Form 10-K, File No. 1-3446). (i) Vermont Electric Transmission Company, Inc. et al. and the Company: Phase I Vermont Transmission Line Support Agreement dated as of December 1, 1981; Amendments dated as of June 1, 1982 and November 1, 1982 (Exhibit 10(g) to NEES' 1982 Form 10-K, File No. 1-3446); Amendment dated as of January 1, 1986 (Exhibit 10(h) to NEES' 1986 Form 10-K, File No. 1-3446). (j) New England Energy Incorporated and the Company: Fuel Purchase Contract dated July 26, 1979, and Amendment dated August 26, 1981 (Exhibit 10(f)(iii) to NEES' 1981 Form 10-K, File No. 1-3446); Amendment dated March 26, 1985, and Amendment effective January 1, 1984 (Exhibit 10(e)(iii) to NEES' 1985 Form 10-K, File No. 1-3446); Amendment dated as of April 28, 1989 (Exhibit 10(e)(iii) to 1989 NEES Form 10-K, File No. 1-3446). (k) New England Power Pool Agreement: (Exhibit 4(e), File No. 2-43025); Amendments dated July 1, 1972, March 1, 1973 (Exhibit 10-15, File No. 2-48543);Amendment dated March 15, 1974 (Exhibit 10-5, File No. 2-52775); Amendment dated June 1, 1975 (Exhibit 10-14, File No. 2-57831); Amendment dated September 1, 1975 (Exhibit 10-13, File No. 2-59182); Amendments dated December 31, 1976, January 31, 1977, July 1, 1977, and August 1, 1977 (Exhibit 10-16, File No. 2-61881); Amendments dated August 15, 1978, January 3, 1980, and February 1980 (Exhibit 10-3, File No. 2-68283); Amendment dated September 1, 1981 (Exhibit 10(h) to NEES' 1981 Form 10-K, File No. 1-3446); Amendment dated December 1, 1981 (Exhibit 10(h) to NEES' 1982 Form 10-K, File No. 1-3446); Amendments dated June 1, 1982, June 15, 1983, and October 1, 1983 (Exhibit 10(i) to NEES' 1983 Form 10-K, File 1-3446); Amendments dated August 1, 1985, August 15, 1985, September 1, 1985, and January 1, 1986 (Exhibit 10(i) to NEES' 1985 Form 10-K, File No. 1-3446); Amendment dated September 1, 1986 (Exhibit 10(i) to NEES' 1986 Form 10-K, File No. 1-3446); Amendment dated April 30, 1987 (Exhibit 10(i) to NEES' 1987 Form 10-K, File No. 1-3446); Amendments dated March 1, 1988 and May 1, 1988 (Exhibit 10(i) to NEES' 1988 Form 10-K, File No. 1-3446); Amendment dated March 15, 1989 (Exhibit 10(i) to 1989 NEES Form 10-K, File No. 1-3446); Amendment dated October 1, 1990 (Exhibit 10 (i) to 1990 NEES Form 10-K, File No. 1-3446); Amendment dated October 1, 1990 Exhibit 10(i) to 1990 NEES Form 10-K, File No. 1-3446); Amendment dated as of September 15, 1992 (Exhibit 10(i) to 1992 NEES Form 10-K, File No. 1-3446). (l) New England Power Service Company and the Company: Specimen of Service Contract (Exhibit 10(l) to 1988 Form 10-K, File No. 0-1229). (m) Public Service Company of New Hampshire et al. and the Company: Agreement for Joint Ownership, Construction and Operation of New Hampshire Nuclear Units dated as of May 1, 1973; Amendments dated May 24, 1974, June 21, 1974, September 25, 1974 and October 25, 1974 (Exhibit 10-18(b), File No. 2-52820); Amendment dated January 31, 1975 (Exhibit 10-16(b), File No. 2-57831); Amendments dated April 18, 1979, April 25, 1979, June 8, 1979, October 11, 1979, December 15, 1979, June 16, 1980, and December 31, 1980 (Exhibit 10(i) to NEES' 1980 Form 10-K, File No. 1-3446); Amendments dated June 1, 1982, April 27, 1984, and June 15, 1984 (Exhibit 10(j) to NEES' 1984 Form 10-K, File No. 1-3446); Amendments dated March 8, 1985, March 14, 1986, May 1, 1986, and September 19, 1986 (Exhibit 10(j) to NEES' 1986 Form 10-K, File No. 1-3446); Amendment dated November 12, 1987 (Exhibit 10(j) to NEES' 1987 Form 10-K, File No. 1-3446); Amendment dated January 13, 1989 (Exhibit 10(j) to NEES' 1990 Form 10-K, File No. 1-3446); Seventh Amendment as of November 1, 1990 (Exhibit 10(m) to NEES' 1991 Form 10-K, File No. 1-3446). Transmission Support Agreement dated as of May 1, 1973 (Exhibit 10-23, File No. 2-49184); Instrument of Transfer to the Company with respect to the New Hampshire Nuclear Units and Assumptions of Obligations dated December 17, 1975 and Agreement Among Participants in New Hampshire Nuclear Units, certain Massachusetts Municipal Systems and Massachusetts Municipal Wholesale Electric Company dated May 28, 1976 (Exhibit 16(c), File No. 2-57831); Seventh Amendment To and Restated Agreement for Seabrook Project Disbursing Agent dated as of November 1, 1990 (Exhibit 10(m) to NEES' 1991 Form 10-K, File No. 1-3446); Amendments dated as of June 29, 1992 (Exhibit 10(j) to NEES' 1992 Form 10-K, File No. 1- 3446). Settlement Agreement dated as of July 19, 1990 between Northeast Utilities Service Company and the Company (Exhibit 10(m) to NEES' 1991 Form 10-K, File No. 1-3446). Seabrook Project Managing Agent Operating Agreement dated as of June 29, 1992, Amendment to Seabrook Project Managing Agent Operating Agreement dated as of June 29, 1992 (Exhibit 10(j) to NEES' 1992 Form 10-K, File No. 1- 3446). (n) Vermont Yankee Nuclear Power Corporation et al. and the Company: Capital Funds Agreement dated February 1, 1968, Amendment dated March 12, 1968 and Power Purchase Contract dated February 1, 1968 (Exhibit 4-6, File No. 2-29145); Amendments dated as of June 1, 1972, April 15, 1983 (Exhibit 10(k) to NEES' 1983 Form 10-K, File No. 0-1229) and April 24, 1985 (Exhibit 10(n) to NEES' 1985 Form 10-K, File No. 1-3446); Amendment dated as of June 1, 1985 (Exhibit 10(n) to 1988 Form 10-K, File No. 0-1229); Amendments dated May 6, 1988 (Exhibit 10(n) to 1988 Form 10-K, File No. 0-1229); Amendment dated as of June 15, 1989 (Exhibit 10(k) to 1989 NEES Form 10-K, File No. 1-3446); Additional Power Contract dated as of February 1, 1984 (Exhibit 10(k) to NEES' 1983 Form 10-K, File No. 1-3446); Guarantee Agreement dated as of November 5, 1981 (Exhibit 10(j) to NEES' 1981 Form 10-K, File No. 1-3446). (o) Yankee Atomic Electric Company et al. and the Company: Amended and Restated Power Contract dated April 1, 1985 (Exhibit 10(l) to NEES' 1985 Form 10-K, File No. 1-3446); Amendment dated May 6, 1988 (Exhibit 10(l) to NEES' 1988 Form 10-K, File No. 1-3446); Amendments dated as of June 26, 1989 and July 1, 1989 (Exhibit 10(l) to 1989 NEES Form 10-K, File No. 1-3446); Amendment dated as of February 1, 1992 (Exhibit 10(l) to 1992 NEES Form 10-K, File No. 1-3446). *(p) New England Electric Companies' Deferred Compensation Plan as amended dated December 8, 1986 (Exhibit 10(m) to NEES' 1986 Form 10-K, File No. 1-3446). *(q) New England Electric System Companies Retirement Supplement Plan as amended dated April 1, 1991 (Exhibit 10(n) to NEES' 1991 Form 10-K, File No. 1-3446). *(r) New England Electric Companies' Executive Supplemental Retirement Plan as amended dated April 1, 1991 (Exhibit 10(o) to NEES' 1991 Form 10-K, File No. 1-3446). *(s) New England Electric Companies' Incentive Compensation Plan as amended dated January 1, 1992 (Exhibit 10(p) to NEES' 1992 Form 10-K, File No. 1-3446); New England Electric Companies' Senior Incentive Compensation Plan as amended dated November 26, 1991 (Exhibit 10(q) to NEES' 1991 Form 10-K, File No. 1-3446). *(t) Forms of Life Insurance Program: (Exhibit 10(s) to NEES' 1986 Form 10-K, File No. 1-3446); and Form of Life Insurance (Collateral Assignment) (Exhibit 10(t) to NEES' 1991 Form 10-K, File No. 1-3446). *(u) New England Electric Companies' Incentive Compensation Plan II as amended dated September 1, 1992 (Exhibit 10 (r) to NEES' 1992 Form 10-K, File No. 1-3446). (v) New England Hydro-Transmission Electric Company, Inc. et al. and the Company: Phase II Massachusetts Transmission Facilities Support Agreement dated as of June 1, 1985 (Exhibit 10(t) to NEES' 1986 Form 10-K, File No. 1-3446); Amendment dated as of May 1, 1986 (Exhibit 10(t) to NEES' 1986 Form 10-K, File No. 1-3446); Amendments dated as of February 1, 1987, June 1, 1987, September 1, 1987, and October 1, 1987 (Exhibit 10(u) to NEES' 1987 Form 10-K, File No. 1-3446); Amendment dated as of August 1, 1988 (Exhibit 10(u) to NEES' 1988 Form 10-K, File No. 1-3446); Amendment dated January 1, 1989 (Exhibit 10 (u) to NEES' 1990 Form 10-K, File No. 1-3446). (w) New England Hydro-Transmission Corporation et al. and the Company: Phase II New Hampshire Transmission Facilities Support Agreement dated as of June 1, 1985 (Exhibit 10(u) to NEES' 1986 Form 10-K, File No. 1-3446); Amendment dated as of May 1, 1986 (Exhibit 10(u) to NEES' 1986 Form 10-K, File No. 1-3446); Amendments dated as of February 1, 1987, June 1, 1987, September 1, 1987, and October 1, 1987 (Exhibit 10(v) to NEES' 1987 Form 10-K, File No. 1-3446). Amendment dated as of August 1, 1988 (Exhibit 10(v) to NEES' 1988 Form 10-K, File No. 1-3446); Amendments dated January 1, 1989 and January 1, 1990 (Exhibit 10 (v) to NEES' 1990 Form 10-K, File No. 1-3446). (x) Vermont Electric Power Company et al. and the Company: Phase II New England Power AC Facilities Support Agreement dated as of June 1, 1985 (Exhibit 10(v) to NEES' 1986 Form 10-K, File No. 1-3446); Amendment dated as of May 1, 1986 (Exhibit 10(v) to NEES' 1986 Form 10-K, File No. 1-3446). Amendments dated as of February 1, 1987, June 1, 1987, and September 1, 1987 (Exhibit 10(w) to NEES' 1987 Form 10-K, File No. 1-3446); Amendment dated as of August 1, 1988 (Exhibit 10(w) to NEES' 1988 Form 10-K, File No. 1-3446). (y) TransCanada Pipelines Limited and the Company: Firm Service Contract for Firm Transportation Service for natural gas dated as of January 6, 1992; Amendments dated as of March 2, 1992 and October 30, 1992 (Exhibit 10(y) to 1992 Form 10-K, File No. 0-1229). (z) TransCanada Pipelines Limited and the Company: Firm Service Contract for Firm Transportation Service for natural gas dated as of October 30, 1992 (Exhibit 10(z) to 1992 Form 10-K, File No. 0-1229). (aa) Algonquin Gas Transmission Company and the Company: X-38 Service Agreement for Firm Transportation of natural gas dated July 3, 1992; Amendment dated July 31, 1992 (Exhibit 10(aa) to 1992 Form 10-K, File No. 0-1229). (bb) ANR Pipeline Company and the Company: Gas Transportation Agreement dated July 18, 1990 (Exhibit 10(bb) to 1992 Form 10-K, File No. 0-1229). (cc) Columbia Gas Transmission Corporation and the Company: Service Agreement for Service under FTS Rate Schedule dated June 13, 1991 (filed herewith). (dd) Iroquois Gas Transmission System, L.P. and the Company: Gas Transportation Contract for Firm Reserved Service dated as of June 5, 1991 (Exhibit 10(dd) to 1992 Form 10-K, File No. 0-1229). (ee) Tennessee Gas Pipeline Company and the Company: Firm Natural Gas Transportation Agreement dated July 9, 1992 (Exhibit 10(ee) to 1992 Form 10-K, File No. 0-1229). *(ff) New England Power Service Company and Joan T. Bok: Service Credit Letter dated October 21, 1982 (Exhibit 10(cc) to 1992 NEES Form 10-K, File No. 1-3446). *(gg) New England Electric System and John W. Rowe: Service Credit Letter dated December 5, 1988 (Exhibit 10(dd) to 1992 NEES Form 10-K, File No. 1-3446). *(hh) New England Power Service Company and the Company: Form of Supplemental Pension Service Credit Agreement (Exhibit 10(ee) to 1992 NEES Form 10-K, File No. 1-3446). * Compensation related plan, contract, or arrangement. (12) Statement re computation of ratios for incorporation by reference into NEP registration statements on Form S-3, Commission File Nos. 33-48257, 33-48897, and 33-49193 (filed herewith). (13) 1993 Annual Report to Stockholders (filed herewith). (22) Subsidiary list (filed herewith). (25) Power of Attorney (filed herewith). Mass. Electric -------------- (3) (a) Articles of Organization of the Company as amended March 5, 1993, August 11, 1993, September 20, 1993, and November 15, 1993 (filed herewith). (b) By-Laws of the Company as amended February 4, 1993, July 30, 1993, and September 15, 1993 (filed herewith). (4) First Mortgage Indenture and Deed of Trust, dated as of July 1, 1949, and twenty supplements thereto (Exhibit 7-A, File No. 1-8019; Exhibit 7-B, File No. 2-8836; Exhibit 4-C, File No. 2-9593; Exhibit 4 to 1980 Form 10-K, File No. 2-8019; Exhibit 4 to 1982 Form 10-K, File No. 0-5464; Exhibit 4 to 1986 Form 10-K, File No. 0-5464); Exhibit 4 to 1988 Form 10-K, File No. 0-5464; Exhibit 4(a) to 1989 NEES Form 10-K, File No. 1-3446; Exhibit 4(a) to 1992 NEES Form 10-K, File No. 1-3446; Exhibit 4(a) to 1993 NEES Form 10-K, File No. 1-3446). (10) Material Contracts (a) Boston Edison Company et al. and Company: Amended REMVEC Agreement dated August 12, 1977 (Exhibit 5-4(d), File No. 2-61881). (b) New England Power Company and the Company: Primary Service for Resale dated February 15, 1974 (Exhibit 5-17(a), File No. 2-52969); Amendment of Service Agreement dated July 22, 1983 (Exhibit 10(b) to 1986 Form 10-K, File No. 0-5464); Amendment of Service Agreement effective November 1, 1993 (Exhibit 10(e) to 1993 NEP Form 10-K, File No. 0- 1229). (c) New England Power Pool Agreement: (Exhibit 4(e), File No. 2-43025); Amendments dated July 1, 1972, and March 1, 1973 (Exhibit 10-15, File No. 2-48543); Amendment dated March 15, 1974 (Exhibit 10-5, File No. 2-52775); Amendment dated June 1, 1975 (Exhibit 10-14, File No. 2-57831); Amendment dated September 1, 1975 (Exhibit 10-13, File No. 2-59182); Amendments dated December 31, 1976, January 31, 1977, July 1, 1977, and August 1, 1977 (Exhibit 10-16, File No. 2-61881); Amendments dated August 15, 1978, January 3, 1980, and February 1980 (Exhibit 10-3, File No. 2-68283); Amendment dated September 1, 1981 (Exhibit 10(h) to NEES' 1981 Form 10-K, File No. 1-3446); Amendment dated as of December 1, 1981 (Exhibit 10(h) to NEES' 1982 Form 10-K, File No. 1-3446); Amendments dated June 1, 1982, June 15, 1983, and October 1, 1983 (Exhibit 10(i) to NEES' 1983 Form 10-K, File No. 1-3446); Amendments dated August 1, 1985, August 15, 1985, September 1, 1985, and January 1, 1986 (Exhibit 10(i) to NEES' 1985 Form 10-K, File No. 1-3446); Amendment dated September 1, 1986 (Exhibit 10(i) to NEES' 1986 Form 10-K, File No. 1-3446); Amendments dated April 30, 1987 (Exhibit 10(i) to NEES' 1987 Form 10-K, File No. 1-3446); Amendments dated March 1, 1988 and May 1, 1988 (Exhibit 10(i) to NEES' 1988 Form 10-K, File No. 1-3446); Amendment dated March 15, 1989 (Exhibit 10(i) to 1989 NEES Form 10-K, File No. 1-3446). Amendment dated October 1, 1990 (Exhibit 10(i) to 1990 NEES Form 10-K, File No. 1-3446); Amendment dated as of September 15, 1992 (Exhibit 10(i) to 1992 NEES Form 10-K, File No. 1-3446). (d) New England Power Service Company and the Company: Specimen of Service Contract (Exhibit 10(d) to 1988 Form 10-K, File No. 0-5464). (e) New England Telephone and Telegraph Company and the Company: Specimen of Joint Ownership Agreement for Wood Poles (Exhibit 4(e), File No. 2-24458). *(f) New England Electric Companies' Deferred Compensation Plan as amended dated December 8, 1986 (Exhibit 10(m) to NEES' 1986 Form 10-K, File No. 1-3446). *(g) New England Electric System Companies Retirement Supplement Plan as amended dated April 1, 1991 (Exhibit 10(n) to NEES' 1991 Form 10-K, File No. 1-3446). *(h) New England Electric Companies' Executive Supplemental Retirement Plan as amended dated April 1, 1991 (Exhibit 10(o) to NEES' 1991 Form 10-K, File No. 1-3446). *(i) New England Electric Companies' Incentive Compensation Plan as amended dated January 1, 1992 (Exhibit 10(p) to NEES' 1992 Form 10-K, File No. 1-3446). *(j) New England Electric Companies' Form of Deferred Compensation Agreement for Directors (Exhibit 10(p) to NEES' 1980 Form 10-K, File No. 1-3446). *(k) New England Electric Companies' Senior Incentive Compensation Plan as amended dated November 26, 1991 (Exhibit 10(q) to NEES' 1991 Form 10-K, File No. 1-3446). *(l) Forms of Life Insurance Program: (Exhibit 10(s) to NEES' 1986 Form 10-K, File No. 1-3446); and Form of Life Insurance (Collateral Assignment) (Exhibit 10(t) to NEES' 1991 Form 10-K, File No. 1-3446). *(m) New England Electric Companies' Incentive Compensation Plan II as amended dated September 1, 1992 (Exhibit 10(r) to NEES' 1992 Form 10-K, File No. 1-3446). *(n) New England Power Service Company and the Company: Form of Supplemental Pension Service Credit Agreement (Exhibit 10(ee) to 1992 NEES Form 10-K, File No. 1-3446). * Compensation related plan, contract, or arrangement. (12) Statement re computation of ratios for incorporation by reference into the Mass. Electric registration statement on Form S-3, Commission File No. 33-49251 (filed herewith). (13) 1993 Annual Report to Stockholders (filed herewith). (18) Coopers & Lybrand Preferability Letter dated February 25, 1994 (Exhibit 18 to 1993 NEES Form 10-K, File No. 1-3446). (25) Power of Attorney (filed herewith). Narragansett ------------ (3) (a) Articles of Incorporation as amended June 9, 1988 (Exhibit 3(a) to 1988 Form 10-K, File No. 0-898). (b) By-Laws of the Company (Exhibit 3 to 1980 Form 10-K, File No. 0-898). (4) (a) First Mortgage Indenture and Deed of Trust, dated as of September 1, 1944, and twenty-one supplements thereto (Exhibit 7-1, File No. 2-7042; Exhibit 7-B, File No. 2-7490; Exhibit 4-C, File No. 2-9423; Exhibit 4-D, File No. 2-10056; Exhibit 4 to 1980 Form 10-K, File No. 0-898; Exhibit 4 to 1982 Form 10-K, File No. 0-898; Exhibit 4 to 1983 Form 10-K, File No. 0-898; Exhibit 4 to 1985 Form 10-K, File No. 0-898; Exhibit 4 to 1986 Form 10-K, File No. 0-898; Exhibit 4 to 1987 Form 10-K, File No. 0-898; Exhibit 4(b) to 1991 NEES Form 10-K, File No. 1-3446; Exhibit 4(b) to 1992 NEES Form 10-K, File No. 1-3446; Exhibit 4(b) to 1993 NEES Form 10-K, File No. 1-3446). (b) The Narragansett Electric Company Preference Provisions, as amended, dated March 23, 1993 (Exhibit 4(c) to 1993 NEES Form 10-K, File No. 1- 3446). (10) Material Contracts (a) Boston Edison Company et al. and the Company: Amended REMVEC Agreement dated August 12, 1977 (Exhibit 5-4(d), File No. 2-61881). (b) New England Power Company and the Company: Primary Service for Resale dated February 15, 1974 (Exhibit 4-1(b), File No. 2-51292); Amendment of Service Agreement dated July 26, 1990 (Exhibit 10(f) to 1990 NEP Form 10-K, File No. 0-1229); Amendment of Service Agreement dated July 24, 1991 (Exhibit 4(f) to 1991 NEP Form 10-K, File No. 0-1229); Amendment of Service Agreement effective November 1, 1993 (Exhibit 10(f) to 1993 NEP Form 10-K, File No. 0-1229). (c) New England Power Pool Agreement: (Exhibit 4(e), File No. 2-43025); Amendments dated July 1, 1972, and March 1, 1973 (Exhibit 10-15, File No. 2-48543); Amendment dated March 15, 1974 (Exhibit 10-5, File No. 2-52775); Amendment dated June 1, 1975 (Exhibit 10-14, File No. 2-57831); Amendment dated September 1, 1975 (Exhibit 10-13, File No. 2-59182); Amendments dated December 31, 1976, January 31, 1977, July 1, 1977, and August 1, 1977 (Exhibit 10-16, File No. 2-61881); Amendments dated August 15, 1978, January 3, 1980, and February 1980 (Exhibit 10-3, File No. 2-68283); Amendment dated September 1, 1981 (Exhibit 10(h) to NEES' 1981 Form 10-K, File No. 1-3446); Amendment dated December 1, 1981 (Exhibit 10(h) to NEES' 1982 Form 10-K, File No. 1-3446); Amendments dated June 1, 1982, June 15, 1983, and October 1, 1983 (Exhibit 10(i) to NEES' 1983 Form 10-K, File No. 1-3446); Amendments dated August 1, 1985, August 15, 1985, September 1, 1985, and January 1, 1986 (Exhibit 10 (i) to NEES' 1985 Form 10-K, File No. 1-3446); Amendment dated September 1, 1986 (Exhibit 10(i) to NEES' 1986 Form 10-K, File No. 1-3446); Amendment dated April 30, 1987 (Exhibit 10(i) to NEES' 1987 Form 10-K, File No. 1-3446); Amendments dated March 1, 1988 and May 1, 1988 (Exhibit 10(i) to NEES' 1988 Form 10-K, File No. 1-3446); Amendment dated March 15, 1989 (Exhibit 10(i) to 1989 NEES Form 10-K, File No. 1-3446). Amendment dated October 1, 1990 (Exhibit 10(i) to 1990 NEES' Form 10-K, File No. 1-3446); Amendment dated as of September 15, 1992 (Exhibit 10(i) to NEES' 1992 Form 10-K, File No. 1-3446. (d) New England Power Service Company and the Company: Specimen of Service Contract (Exhibit 10(d) to 1989 Form 10-K, File No. 0-898). (e) New England Telephone and Telegraph Company and the Company: Specimen of Joint Ownership Agreement for Wood Poles (Exhibit 3(d), File No. 2-24458). *(f) New England Electric Companies' Deferred Compensation Plan for Officers, as amended December 8, 1986 (Exhibit 10(m) to NEES' 1986 Form 10-K, File No. 1-3446). *(g) New England Electric System Companies Retirement Supplement Plan, as amended April 1, 1991 (Exhibit 10(n) to NEES' 1991 Form 10-K, File No. 1-3446). *(h) New England Electric Companies' Executive Supplemental Retirement Plan, as amended dated April 1, 1991 (Exhibit 10(o) to NEES' 1991 Form 10-K, File No. 1-3446). *(i) New England Companies' Incentive Compensation Plan, as amended dated January 1, 1992 (Exhibit 10(p) to NEES' 1992 Form 10-K, File No. 1-3446). *(j) New England Electric Companies' Form of Deferred Compensation Agreement for Directors (Exhibit 10(p) to NEES' 1980 Form 10-K, File No. 1-3446). *(k) New England Electric Companies' Senior Incentive Compensation Plan as amended dated November 26, 1991 (Exhibit 10(q) to NEES' 1991 Form 10-K, File No. 1-3446). *(l) Forms of Life Insurance Program (Exhibit 10(s) to NEES' 1986 Form 10-K, File No. 1-3446); and Form of Life Insurance (Collateral Assignment) (Exhibit 10(t) to NEES' 1991 Form 10-K, File No. 1-3446). *(m) New England Electric Companies' Incentive Compensation Plan II as amended dated September 1, 1992 (Exhibit 10(r) to NEES' 1992 Form 10-K, File No. 1-3446). *(n) New England Power Service Company and the Company: Form of Supplemental Pension Service Credit Agreement (Exhibit 10(ee) to 1992 NEES Form 10-K, File No. 1-3446). * Compensation related plan, contract, or arrangement. (12) Statement re computation of ratios for incorporation by reference into the Narragansett registration statement on Form S-3, Commission File No. 33-45052 (filed herewith). (13) 1993 Annual Report to Stockholders (filed herewith). (25) Power of Attorney (filed herewith). Financial Statement Schedules See Index to Financial Statements and Financial Statement Schedules for NEES, NEP, Mass. Electric, and Narragansett on pages 100, 109, 115, and 121, respectively. Reports on Form 8-K NEES ---- NEES filed reports on Form 8-K dated October 14, 1993 and November 30, 1993, both of which contained Item 5. NEP --- None. Mass. Electric -------------- Mass. Electric filed reports on Form 8-K dated October 14, 1993 and November 30, 1993, both of which contained Item 5. Narragansett ------------ None. NEW ENGLAND ELECTRIC SYSTEM SIGNATURES Pursuant to the requirements of Section 13 or 15(d) 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. NEW ENGLAND ELECTRIC SYSTEM* s/John W. Rowe John W. Rowe President and Chief Executive Officer March 28, 1994 Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the date indicated. (Signature and Title) Principal Executive Officer s/John W. Rowe John W. Rowe President and Chief Executive Officer Principal Financial Officer s/Alfred D. Houston Alfred D. Houston Executive Vice President and Chief Financial Officer Principal Accounting Officer s/Michael E. Jesanis Michael E. Jesanis Treasurer Directors (a majority) Joan T. Bok Paul L. Joskow John M. Kucharski Edward H. Ladd Joshua A. McClure s/John G. Cochrane Malcolm McLane All by: Felix A. Mirando, Jr. John G. Cochrane John W. Rowe Attorney-in-fact George M. Sage Charles E. Soule Anne Wexler James Q. Wilson James R. Winoker Date (as to all signatures on this page) March 28, 1994 *The name "New England Electric System" means the trustee or trustees for the time being (as trustee or trustees but not personally) under an agreement and declaration of trust dated January 2, 1926, as amended, which is hereby referred to, and a copy of which as amended has been filed with the Secretary of the Commonwealth of Massachusetts. Any agreement, obligation or liability made, entered into or incurred by or on behalf of New England Electric System binds only its trust estate, and no shareholder, director, trustee, officer or agent thereof assumes or shall be held to any liability therefor. NEW ENGLAND POWER COMPANY SIGNATURES Pursuant to the Requirements of Section 13 or 15(d) 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. The signature of the undersigned company shall be deemed to relate only to matters having reference to such company. NEW ENGLAND POWER COMPANY s/Jeffrey D. Tranen Jeffrey D. Tranen President Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the date indicated. The signature of each of the undersigned shall be deemed to relate only to matters having reference to the above-named company. (Signature and Title) Principal Executive Officer s/Jeffrey D. Tranen Jeffrey D. Tranen President Principal Financial Officer s/Michael E. Jesanis Michael E. Jesanis Treasurer Principal Accounting Officer s/Howard W. McDowell Howard W. McDowell Controller Directors (a majority) Joan T. Bok Frederic E. Greenman Alfred D. Houston s/John G. Cochrane John W. Newsham All by: John W. Rowe John G. Cochrane Jeffrey D. Tranen Attorney-in-fact Date (as to all signatures on this page) March 28, 1994 MASSACHUSETTS ELECTRIC COMPANY SIGNATURES Pursuant to the Requirements of Section 13 or 15(d) 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. The signature of the undersigned company shall be deemed to relate only to matters having reference to such company. MASSACHUSETTS ELECTRIC COMPANY s/John H. Dickson John H. Dickson President Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the date indicated. The signature of each of the undersigned shall be deemed to relate only to matters having reference to the above-named company. (Signature and Title) Principal Executive Officer s/John H. Dickson John H. Dickson President Principal Financial Officer s/Michael E. Jesanis Michael E. Jesanis Treasurer Principal Accounting Officer s/Howard W. McDowell Howard W. McDowell Controller Directors (a majority) Urville J. Beaumont Joan T. Bok Sally L. Collins John H. Dickson s/John G. Cochrane Charles B. Housen All by: Kathryn A. McCarthy John G. Cochrane Patricia McGovern Attorney-in-fact John F. Reilly John W. Rowe Richard P. Sergel Richard M. Shribman Roslyn M. Watson Date (as to all signatures on this page) March 28, 1994 THE NARRAGANSETT ELECTRIC COMPANY SIGNATURES Pursuant to the Requirements of Section 13 or 15(d) 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. The signature of the undersigned company shall be deemed to relate only to matters having reference to such company. THE NARRAGANSETT ELECTRIC COMPANY s/Robert L. McCabe Robert L. McCabe President Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the date indicated. The signature of each of the undersigned shall be deemed to relate only to matters having reference to the above-named company. (Signature and Title) Principal Executive Officer s/Robert L. McCabe Robert L. McCabe President Principal Financial Officer s/Alfred D. Houston Alfred D. Houston Vice President and Treasurer Principal Accounting Officer s/Howard W. McDowell Howard W. McDowell Controller Directors (a majority) Joan T. Bok Stephen A. Cardi Frances H. Gammell s/John G. Cochrane Joseph J. Kirby All by: Robert L. McCabe John G. Cochrane John W. Rowe Attorney-in-fact Richard P. Sergel William E. Trueheart John A. Wilson, Jr. Date (as to all signatures on this page) March 28, 1994 CONSENT OF INDEPENDENT ACCOUNTANTS We consent to the incorporation by reference in the registration statements of New England Electric System on Form S-3 of the Dividend Reinvestment and Common Share Purchase Plan (File No. 33-12313) and on Forms S-8 of the New England Electric System Companies Employees' Share Ownership Plan (File No. 2-89648), the New England Electric System Companies Incentive Thrift Plan (File No. 33-26066), the New England Electric System Companies Incentive Thrift Plan II (File No. 33-35470), the NEES Goals Program (File No. 2-94447) and the Yankee Atomic Electric Company Thrift Plan (File No. 2-67531) of our reports dated February 25, 1994 on our audits of the consolidated financial statements and financial statement schedules of New England Electric System and subsidiaries as of December 31, 1993 and 1992 and for each of the three years in the period ended December 31, 1993, which reports are incorporated by reference or included in this Annual Report on Form 10-K. We also consent to the incorporation by reference in the registration statements of New England Power Company on Forms S-3 (File Nos. 33-48257, 33-48897, and 33-49193), Massachusetts Electric Company on Form S-3 (File No. 33-49251) and The Narragansett Electric Company on Form S-3 (File No. 33-45052) of our reports dated February 25, 1994 on our audits of the financial statements and financial statement schedules of New England Power Company, Massachusetts Electric Company and The Narragansett Electric Company, respectively, as of December 31, 1993 and 1992 and for each of the three years in the period ended December 31, 1993, which reports are incorporated by reference or included in this Annual Report on Form 10-K. s/ Coopers & Lybrand Boston, Massachusetts COOPERS & LYBRAND March 25, 1994 REPORT OF INDEPENDENT ACCOUNTANTS Our reports on the consolidated financial statements of New England Electric System and subsidiaries and on the financial statements of certain of its subsidiaries, listed in item 14 herein, which financial statements and reports are included in the respective 1993 Annual Reports to Shareholders, have been incorporated by reference in this Form 10K. In connection with our audits of such financial statements, we have also audited the related financial statement schedules listed in Item 14 herein. In our opinion, the financial statement schedules referred to above, when considered in relation to the corresponding basic financial statements taken as a whole, present fairly, in all material respects, the information required to be included therein. s/ Coopers & Lybrand Boston, Massachusetts COOPERS & LYBRAND February 25, 1994 NEW ENGLAND ELECTRIC SYSTEM AND SUBSIDIARIES CONSOLIDATED --------------------------------------------------------- SCHEDULE X - SUPPLEMENTARY INCOME STATEMENT INFORMATION Year Ended December 31, 1993, 1992, and 1991

36672_1993.txt

36672

1993

Item 1. Business. THE CORPORATION Bank of Boston Corporation (the "Corporation") is a registered bank holding company, organized in 1970 under Massachusetts law with both national and international operations. Through its subsidiaries, the Corporation is engaged in providing a wide variety of financial services to individuals, corporate and institutional customers, governments and other financial institutions. These services include individual and community banking, consumer finance, mortgage origination and servicing, domestic corporate and investment banking, leasing, international banking, commercial real estate lending, private banking, trust, correspondent banking, and securities and payments processing. The Corporation's principal subsidiary is The First National Bank of Boston ("FNBB"), a national banking association with its headquarters in Massachusetts. Other major banking subsidiaries of the Corporation are Casco Northern Bank, N.A. ("Casco") in Maine, Bank of Boston Connecticut ("BKB Connecticut"), Rhode Island Hospital Trust National Bank ("Hospital Trust"), Bank of Vermont, and in Massachusetts, South Shore Bank, Mechanics Bank and Multibank West. As of December 31, 1993, approximately 78% of the Corporation's total loan volume consisted of domestic loans and leases, with the balance overseas. The Corporation's banking subsidiaries maintain approximately 320 branches in Massachusetts, Rhode Island, Connecticut, Maine and Vermont. The Corporation, through its subsidiaries, has a presence in approximately 33 states of the United States and in approximately 23 foreign countries. As of December 31, 1993, the Corporation's subsidiaries employed in the aggregate approximately 18,600 full-time equivalent employees in their domestic and foreign operations. The executive office of the Corporation and the head office of FNBB are located at 100 Federal Street, Boston, Massachusetts 02110 (Telephone (617) 434-2200). BUSINESS OF THE CORPORATION The Corporation's business is generally focused in the areas of retail banking, corporate banking and international banking. In October of 1993, the Corporation announced certain organizational and management changes, including the creation of a new Chairman's Office and the establishment of a twenty-nine member Corporate Working Committee. The Chairman's Office consists of Chairman and Chief Executive Officer Ira Stepanian, President and Chief Operating Officer Charles K. Gifford, Vice Chairman, Chief Financial Officer and Treasurer William J. Shea, and Vice Chairman Edward A. O'Neal. The Corporation's businesses were previously organized into five major groups and a number of other major centralized functions. This group structure was replaced by fifteen core business and ten corporate-wide support areas, each led by an executive with authority to operate and manage his or her respective area. These twenty-five executives and the members of the Chairman's Office comprise the Corporate Working Committee. These core business and corporate wide support areas work closely with one another and each is linked to one of the members of the Chairman's Office. For discussions of the Corporation's business activities, including its lending activities, its cross-border outstandings, and the management of its foreign currency exposure, see "Management's Financial Review," "Cross-Border Outstandings," and "Off-Balance-Sheet Financial Markets Instruments" on pages 32 through 51, 86 and 87, and 47 and 48, respectively, of the Corporation's 1993 Annual Report to Stockholders, which pages are included in Exhibit 13 hereto and which discussions are incorporated herein by reference. Activities in which the Corporation and its subsidiaries are presently engaged or which they may undertake in the future are subject to certain statutory and regulatory restrictions. Banks and bank holding companies are extensively regulated under both federal and state law. There are various legal limitations upon the extent to which banking subsidiaries of the Corporation can finance or otherwise supply funds to the Corporation or certain of its affiliates. See "Supervision and Regulation." COMPETITION AND INDUSTRY CONSOLIDATION The Corporation's subsidiaries compete with other major financial institutions, including commercial banks, investment banks, mutual savings banks, savings and loan associations, credit unions, consumer finance companies, money market funds and other non-banking institutions, such as insurance companies, major retailers, brokerage firms, and investment companies in New England, throughout the United States, and internationally. One of the principal methods of competing effectively in the financial services industry is to improve customer service through the quality and range of services available, easing access to facilities and pricing. See "Supervision and Regulation" with respect to the impact of legislation upon the Corporation and its subsidiaries. One outgrowth of the competitive environment discussed above has been a significant number of consolidations in the banking industry both on a national and regional level. The Corporation engages on an ongoing basis in reviewing and discussing possible acquisitions of financial institutions, as well as banking and other assets in order to expand its business incident to the implementation of its business strategy. The Corporation intends to continue to explore acquisition opportunities as they arise in order to take advantage of the continuing consolidation in the banking industry. In July 1993, the Corporation completed its acquisitions of Society for Savings Bancorp, Inc., a $2.4 billion registered bank holding company based in Hartford, Connecticut ("Bancorp") and Multibank Financial Corp., a $2.4 billion registered bank holding company based in Dedham, Massachusetts ("Multibank"). In addition, in September 1993, the Corporation announced that it had reached a definitive agreement to acquire BankWorcester Corporation ("BankWorcester") for $34.00 for each share of BankWorcester common stock outstanding, subject to an upward adjustment if the transaction is not consummated on or before June 30, 1994. It is expected that the total purchase price will be approximately $247 million. BankWorcester, the holding company for Worcester County Institution for Savings, had approximately $1.5 billion of assets, approximately $1.3 billion of deposits and 28 branches at December 31, 1993. The transaction has been approved by the boards of directors of both companies and by BankWorcester's stockholders. In March 1994, the Corporation announced that it had reached a definitive agreement to acquire Pioneer Financial, A Co-operative Bank ("Pioneer Bank") for $118 million in cash. Pioneer Bank, which is based in Middlesex County, Massachusetts had approximately $773 million in assets, $720 million in deposits and 20 branches at December 31, 1993. The Pioneer Bank transaction has been approved by the boards of directors of both companies. Both pending transactions are subject to the approval of the Office of the Comptroller of the Currency (the "OCC") and the Board of Bank Incorporation of the Commonwealth of Massachusetts (the "Massachusetts BBI"), and applications for approval for the BankWorcester acquisition have been submitted to the OCC and the Massachusetts BBI. Neither transaction may be consummated until the 30th day after OCC approval is received, during which time the United States Department of Justice may challenge the transactions on antitrust grounds. The Corporation's objective is to consummate the BankWorcester transaction by mid-year 1994 and the Pioneer Bank transaction in the fall of 1994 although no assurances can be given that the requisite regulatory approvals will be granted or, if granted, that such approvals will be received within these time frames. SUPERVISION AND REGULATION The business in which the Corporation and its subsidiaries are engaged is subject to extensive supervision, regulation and examination by various bank regulatory authorities and other agencies of federal and state governments. The Corporation and its subsidiaries are engaged on a regular basis in discussions with such regulators and agencies on a variety of matters which arise in connection with this regulatory and supervisory process. The supervisory or regulatory activities may, but need not, be directly related to the financial services provided by the Corporation and its subsidiaries. The supervision, regulation and examination to which the Corporation and its subsidiaries are subject are often intended by the regulators primarily for the protection of depositors or are aimed at carrying out broad public policy goals rather than for the protection of security holders. Several of the more significant regulatory provisions applicable to banks and bank holding companies to which the Corporation and its subsidiaries are subject are noted below along with certain current regulatory matters concerning the Corporation and its banking subsidiaries. To the extent that the following information describes statutory or regulatory provisions, it is qualified in its entirety by reference to the particular statutory provisions. Any change in applicable law or regulation may have a material effect on the business and prospects of the Corporation. The Corporation The Corporation, as a bank holding company under the Bank Holding Company Act of 1956, as amended, (the "BHCA"), is registered with the Board of Governors of the Federal Reserve System (the "Federal Reserve Board") and is regulated under the provisions of the BHCA. Under the BHCA, the Corporation is prohibited, with certain exceptions, from acquiring direct or indirect ownership or control of more than 5% of the voting shares of any company which is not a bank and from engaging in any business other than that of banking, managing or controlling banks or furnishing services to, or acquiring premises for, its affiliated banks. The Corporation may, however, engage in, and own voting shares of companies engaging in, certain activities determined by the Federal Reserve Board, by order or by regulation, to be so closely related to banking or to managing or controlling banks "as to be a proper incident thereto." The location of such "non-bank" subsidiaries of the Corporation is not restricted geographically under the BHCA. The Corporation is required by the BHCA to file with the Federal Reserve Board periodic reports and such additional reports as the Federal Reserve Board may require. The Federal Reserve Bank of Boston (the "Federal Reserve") performs examinations of the Corporation and certain of its subsidiaries. The BHCA requires every bank holding company to obtain the prior approval of the Federal Reserve Board before it may acquire substantially all of the assets of any bank, or ownership or control of any voting shares of any bank, if, after such acquisition, it would own or control, directly or indirectly, more than 5% of the voting shares of such bank. Since the Corporation is also a bank holding company under the laws of Massachusetts, the Commissioner of Banks for the Commonwealth of Massachusetts (the "Massachusetts Commissioner") has authority to require certain reports from the Corporation from time to time and to examine the Corporation and each of its subsidiaries other than national banking associations. Prior approval of the Massachusetts BBI also may be required before the Corporation may acquire any additional commercial banks located in Massachusetts. Acquisitions by the Corporation of non-Massachusetts banks or bank holding companies may be subject to the prior approval by both the Massachusetts and the applicable state or federal banking regulators. Massachusetts has an interstate bank acquisition law which permits banking organizations outside Massachusetts to acquire Massachusetts banking organizations if the state law of the acquirer permits acquisitions of banking organizations in that state by Massachusetts-based banking organizations. In addition, Massachusetts has a business combinations law which provides that if any acquirer buys 5% or more of a target company's stock without the prior approval of the target company's board of directors, it generally may not (i) complete the acquisition through a merger, (ii) pledge or sell any assets of the target company, or (iii) engage in other self-dealing transactions with the target company for a period of three years. The prior board approval requirement does not apply if the acquirer buys at least 90% of the target company's outstanding stock in the transaction in which it crosses the 5% threshold or if the acquirer, after crossing the threshold, obtains the approval of the target company's board and two-thirds of the target company's stock held by persons other than the acquirer. This legislation automatically applies to Massachusetts corporations, including the Corporation, which did not elect to "opt out" of the statute. Massachusetts law also provides for classified boards of directors for most public companies incorporated in Massachusetts, unless the company elected to "opt out" of the law. As a result of this law, the Corporation's Board of Directors is divided into three classes of Directors and the three-year terms of the classes are staggered. Other Massachusetts legislation exists which is intended to provide limited anti-takeover protection to certain Massachusetts corporations by preventing an acquirer of certain percentages of such corporation's stock from obtaining voting rights in such stock unless the corporation's other stockholders authorize such voting rights. The legislation automatically applies to certain Massachusetts corporations which have not elected to "opt out" of the statute. The Corporation, by vote of its Board of Directors, has "opted out" of the statute's coverage. In June 1990, the Board of Directors of the Corporation adopted a stockholder rights plan providing for a dividend of one preferred stock purchase right for each outstanding share of common stock of the Corporation (the "Rights"). Under certain circumstances, the Rights would enable stockholders to purchase common stock of the Corporation or of an acquiring Corporation at a substantial discount. The dividend was distributed on July 12, 1990 to stockholders of record on that date. Holders of shares of the Corporation's common stock issued subsequent to that date receive the Rights with their shares. The Rights trade automatically with shares of the Corporation's common stock and become exercisable only under certain circumstances. The purpose of the Rights is to encourage potential acquirers to negotiate with the Corporation's Board of Directors prior to attempting a takeover and to provide the Board with leverage in negotiating on behalf of all stockholders the terms of any proposed takeover. The Rights may have certain anti-takeover effects. The Rights should not interfere, however, with any merger or other business combination approved by the Board of Directors. For a further discussion of the Corporation's stockholder rights plan see the description of the Rights set forth in the Corporation's registration statement on Form 8-A relating to the Rights (including the Rights Agreement, dated as of June 28, 1990, between the Corporation and FNBB, as Rights Agent, which is attached as an exhibit to the Form 8-A), which is incorporated herein by reference. The Banking Subsidiaries General The Corporation's banking subsidiaries that are national banks are subject to the supervision of, and are regularly examined by, the OCC. The Corporation's state-chartered banking subsidiaries are subject to the supervision of, and are regularly examined by, the Federal Deposit Insurance Corporation (the "FDIC") as well as by their respective state regulators. The Corporation's domestic subsidiary banks' deposits are insured by the FDIC to the extent allowed by law and, accordingly, the banks are subject to the regulations of the FDIC. As members of the Federal Reserve System, the nationally chartered banks are also subject to regulation by the Federal Reserve Board. Bank of Vermont and Hospital Trust, as members of the Federal Home Loan Bank of Boston, are also subject to the regulations of the Federal Housing Finance Board. FIRREA Under the Financial Institutions Reform, Recovery, and Enforcement Act of 1989 ("FIRREA"), an FDIC insured institution can be held liable for any loss incurred by, or reasonably expected to be incurred by, the FDIC in connection with (i) the default of a commonly controlled FDIC-insured depository institution or (ii) any assistance provided by the FDIC to a commonly controlled FDIC-insured depository institution in danger of default. The term "default" is defined to mean the appointment of a conservator or receiver for such institution and "in danger of default" is defined generally as the existence of certain conditions indicating that a "default" is likely to occur in the absence of regulatory assistance. In addition, FIRREA broadened the enforcement powers of the federal banking agencies, including the power to impose fines and penalties over all financial institutions. Further, under FIRREA the failure to meet capital guidelines could subject a financial institution to a variety of regulatory actions, including the termination of deposit insurance by the FDIC. FDICIA The Federal Deposit Insurance Corporation Improvement Act of 1991 ("FDICIA"), also provides for expanded regulation of financial institutions. Under FDICIA, banks are placed in one of five capital categories, for which the federal banking agencies have established specific capital ratio levels. Pursuant to the agencies' regulations, an institution is considered "well capitalized" if it has a total risk-based capital ratio of at least 10%, a tier 1 risk-based capital ratio of at least 6% and a leverage capital ratio of at least 5%. In addition, regardless of a bank's capital level, a bank is not considered "well capitalized" if it is subject to a cease and desist order, formal agreement, capital directive, or prompt corrective action directive that requires it to achieve or maintain a higher level of capital. An institution is considered "adequately capitalized" if it has a total risk-based capital ratio of at least 8%, a tier 1 risk-based capital ratio of at least 4% and a leverage capital ratio of at least 4%. Institutions with capital levels below those necessary to qualify as "adequately capitalized" are deemed to be either "undercapitalized," "significantly undercapitalized" or "critically undercapitalized," depending on their specific capital levels. FDICIA, through its prompt corrective action ("PCA") system, imposes significant operational and management restrictions on banks that are not considered at least "adequately capitalized". At December 31, 1993, FNBB satisfied the requirements of the "well capitalized" category and the Corporation's other banking subsidiaries satisfied the requirements of the "adequately capitalized" or "well capitalized" categories. The capital categories of the Corporation's banking subsidiaries are determined solely for purposes of applying FDICIA's PCA provisions, and such capital categories may not constitute an accurate representation of the overall financial condition or prospects of any of the Corporation's banking subsidiaries. Under FDICIA's PCA system, a bank in the "undercapitalized" category must submit a capital restoration plan guaranteed by its parent company. The liability of the parent company under any such guarantee is limited to the lesser of 5% of the bank's assets at the time it became undercapitalized, or the amount needed to comply with the plan. A bank in the "undercapitalized" category also is subject to limitations in numerous areas including, but not limited to: asset growth; acquisitions; branching; new business lines; acceptance of brokered deposits; and borrowings from the Federal Reserve. Progressively more burdensome restrictions are applied to banks in the "undercapitalized" category that fail to submit or implement a capital plan and to banks that are in the "significantly undercapitalized" or "critically undercapitalized" categories. In addition, a bank's primary federal banking agency is authorized to downgrade the bank's capital category to the next lower category upon a determination that the bank is in an unsafe or unsound condition or is engaged in an unsafe or unsound practice. An unsafe or unsound practice can include receipt by the institution of a rating on its most recent examination of three or worse (on a scale of 1 (best) to 5 (worst)), with respect to its asset quality, management, earnings or liquidity. The FDIC's deposit insurance assessments have moved under FDICIA from a flat-rate system to a risk-based system. The risk-based system places a bank in one of nine risk categories, principally on the basis of its capital level and an evaluation of the bank's risk to the Bank Insurance Fund, and bases premiums on the probability of loss to the FDIC with respect to each individual bank. During 1993, the FDIC's risk-based system provided that the highest and lowest premiums assessable per $100 of insured deposits were $.31 and $.23, respectively, with a greater difference between the rates possible in 1994 or 1995. FDICIA and the regulations issued thereunder also have (i) limited the use of brokered deposits to well capitalized banks, and adequately capitalized banks that have received waivers from the FDIC; (ii) established restrictions on the permissible investments and activities of FDIC-insured state chartered banks and their subsidiaries; (iii) implemented uniform real estate lending rules; (iv) prescribed standards to limit the risks posed by credit exposure between banks; (v) revised risk-based capital rules to include components for measuring the risk posed by interest rate changes; (vi) amended various consumer banking laws; (vii) increased restrictions on loans to a bank's insiders; (viii) established standards in a number of areas to assure bank safety and soundness; and (ix) implemented additional requirements for institutions that have $500 million or more in total assets with respect to annual independent audits, audit committees, and management reports related to financial statements, internal controls and compliance with designated laws and regulations. The Corporation continues to analyze the effect of, and address its ongoing compliance with, the various regulations issued under FDICIA. It is anticipated that FDICIA, and the regulations enacted thereunder, will continue to result in more limitations on banking activities generally, and increased costs for the Corporation and the banking industry because of higher FDIC assessments and higher costs of compliance, documentation and record keeping. Other Regulatory Restrictions The Corporation's domestic subsidiary banks and the subsidiaries of such banks are subject to a large number of other regulatory restrictions, including certain restrictions upon: (i) any extensions of credit by such banks to, from or for the benefit of the Corporation and the Corporation's non-banking affiliates (collectively with the Corporation, the "Affiliates"), (ii) the purchase of assets or services from or the sale of assets or the provision of services to Affiliates, (iii) the issuance of a guarantee, acceptance or letter of credit on behalf of or for the benefit of Affiliates, (iv) the purchase of securities of which an Affiliate is a principal underwriter during the existence of the underwriting and (v) investments in stock or other securities issued by Affiliates or acceptance thereof as collateral for an extension of credit. The Corporation and all its subsidiaries, including FNBB, are also subject to certain restrictions with respect to engaging in the issue, flotation, underwriting, public sale or distribution of certain types of securities. In addition, under both the BHCA and regulations which have been issued by the Federal Reserve Board, the Corporation and its subsidiaries are prohibited from engaging in certain tie-in arrangements in connection with any extension of credit, lease or sale of any property or the furnishing of any service. In operations in other countries, the Corporation and FNBB are also subject to restrictions imposed by the laws and banking authorities of such countries. The Corporation's banking subsidiaries are also required to maintain cash reserves against deposits and are subject to restrictions, among others, upon (i) the nature and amount of loans which they may make to a borrower; (ii) the nature and amount of securities in which they may invest; (iii) the portion of their respective assets which may be invested in bank premises; (iv) the geographic location of their branches; and (v) the nature and extent to which they can borrow money. Dividends The payment of dividends by the Corporation is determined by the Board of Directors based on the Corporation's liquidity, asset quality profile, capital adequacy, and recent earnings history (excluding significant non-recurring transactions) as well as economic conditions and other factors, including applicable government regulations and policies and the amount of dividends payable to the Corporation by its subsidiary banks. In 1993, the aggregate dividends declared by the Corporation on its common stock and preferred stock were approximately $73 million. For each quarter of 1993, a dividend of $.10 per share was declared and paid on the Corporation's common stock. In the first quarter of 1994, the Corporation declared a dividend on its common stock of $.22 per share. The declaration and payment of dividends on the Corporation's common stock was previously subject to the prior approval of the Federal Reserve and the Division of Banking Supervision and Regulation of the Federal Reserve Board pursuant to an agreement between the Corporation and the Federal Reserve entered into in 1991. In October 1993, the Federal Reserve terminated the agreement. The Corporation is a legal entity separate and distinct from its subsidiary banks and its other non-bank subsidiaries. The Corporation's revenues (on a parent company only basis) result primarily from interest and dividends paid to the Corporation by its subsidiaries. The right of the Corporation, and consequently the right of creditors and stockholders of the Corporation, to participate in any distribution of the assets or earnings of any subsidiary through the payment of such dividends or otherwise is necessarily subject to the prior claims of creditors of the subsidiary (including depositors, in the case of banking subsidiaries), except to the extent that claims of the Corporation in its capacity as a creditor may be recognized. It is the policy of the OCC and the Federal Reserve Board that banks and bank holding companies, respectively, should pay dividends only out of current earnings and only if after paying such dividends the bank or bank holding company would remain adequately capitalized. Federal banking regulators also have authority to prohibit banks and bank holding companies from paying dividends if they deem such payment to be an unsafe or unsound practice. In addition, it is the position of the Federal Reserve Board that a bank holding company is expected to act as a source of financial strength to its subsidiary banks. Various federal and state laws, regulations and policies limit the ability of the Corporation's banking subsidiaries to pay dividends to the Corporation. Federal banking law requires the approval of the OCC if the aggregate total of the dividends declared by any of the Corporation's national banking subsidiaries in any calendar year will exceed the bank's net profits, as defined by applicable regulation, for that year combined with retained net profits for the preceding two years. Also, state law requires the approval of state bank regulatory authorities if the dividends declared by state banks exceed certain prescribed limits. In 1993, approximately $7 million of dividends were declared by one of the Corporation's banking subsidiaries. The payment of any future dividends by the Corporation's banking subsidiaries will be determined based on a number of factors, including the subsidiary's liquidity, asset quality profile, capital adequacy and recent earnings history. In addition, as discussed below, two of the Corporation's banking subsidiaries, BKB Connecticut and South Shore Bank, are subject to regulatory agreements which require prior regulatory approval and prior notice, respectively, for the payment of dividends. See the related discussions set forth below in "Capital," "Legislation" and "Regulatory Agreements." Capital Information concerning the Corporation and its banking subsidiaries with respect to capital is set forth in the discussion of "Capital Management" contained in the Corporation's 1993 Annual Report to Stockholders on pages 49 and 50, which pages are included in Exhibit 13 hereto and which discussion is incorporated herein by reference. See also "Legislation" and "Regulatory Agreements" discussed below and "Dividends" discussed above. Legislation In addition to extensive existing government regulation, federal and state statutes and regulations can change in unpredictable ways, often with significant effects on the way in which financial institutions may conduct business. Legislation which has been enacted in recent years has substantially increased the level of competition among commercial banks, thrift institutions and non-banking institutions, including insurance companies, brokerage firms, mutual funds, investment banks and major retailers. Similarly, the enactment of banking legislation such as FIRREA and FDICIA has affected the banking industry by, among other things, broadening the powers of the federal banking agencies in a number of areas. Other legislation, which is considered from time to time, such as interstate branching, could, if enacted, significantly affect the business of the Corporation. See also "Supervision and Regulation -- the Corporation" discussed above. Regulatory Matters During 1993, certain regulatory agreements between the Corporation or its banking subsidiaries and their respective banking agencies were terminated by the agencies as a result of improvements in the areas addressed in those agreements. Information on the terminated and remaining agreements is set forth below. As previously reported, in 1989, FNBB entered into an agreement with the OCC to address certain areas, and the Corporation entered into a similar memorandum of understanding with the Federal Reserve. In 1991 the Corporation entered into a written agreement with the Federal Reserve that was essentially a formalization of the then existing memorandum of understanding. In February 1993 and October 1993, respectively, the OCC and the Federal Reserve terminated the agreements as a result of the progress made by FNBB and the Corporation in the areas addressed by the agreements. As previously reported, in 1991 Casco and Hospital Trust entered into agreements with the OCC that were substantially similar to the OCC's agreement with FNBB. In February 1993, the OCC terminated the agreements with Casco and Hospital Trust as a result of the progress made by Casco and Hospital Trust in the areas addressed in their respective agreements. As previously reported, Bank of Vermont and its regulators, the FDIC and the Commissioner of Banking, Insurance and Securities of the State of Vermont (the "Vermont Commissioner"), entered into a memorandum of understanding in 1992. In October 1993, the FDIC and the Vermont Commissioner terminated the memorandum as a result of Bank of Vermont's compliance with its provisions. As previously reported, in 1992 Bancorp and Multibank entered into written agreements with the Federal Reserve. In September 1993, the Federal Reserve terminated the agreements with Bancorp and Multibank as a result of the progress made by Bancorp and Multibank in the areas addressed in their respective agreements. As previously reported, in connection with the acquisition of Bancorp, BKB Connecticut was merged with and into Bancorp's subsidiary bank, Society for Savings ("Society"), and Society changed its name to "BKB Connecticut" following the merger. The resulting bank remains subject to a stipulation and agreement entered into by BKB Connecticut with the Connecticut Banking Commissioner in 1991 pursuant to which BKB Connecticut is required, among other things, to reduce the level of its classified assets, to maintain appropriate reserves, and to maintain its tier 1 leverage capital ratio in excess of minimum regulatory requirements. As of December 31, 1993, BKB Connecticut's tier 1 leverage capital ratio was above the minimum required under its agreement. The agreement requires the prior written consent of the Connecticut Banking Commissioner and the Regional Director of the FDIC for the payment of dividends by BKB Connecticut. The agreement, as amended, also requires BKB Connecticut to submit semiannual progress reports to the regulators of actions taken under the agreement. BKB Connecticut has implemented or is implementing improvements in the various areas addressed in its agreement. As previously reported, Mechanics Bank entered into a memorandum of understanding with the FDIC and the Massachusetts Commissioner in 1991. In January 1994, the FDIC and the Massachusetts Commissioner terminated the agreement with Mechanics Bank as a result of the progress made by Mechanics Bank in the areas addressed in the agreement. As previously reported, South Shore Bank entered into a memorandum of understanding with the FDIC and the Massachusetts Commissioner in 1992, which incorporated the terms of an earlier memorandum of understanding entered into in 1991. The memorandum of understanding addresses certain areas, including management, asset quality, reserves, profitability, capital ratios, and dividends. South Shore Bank is also subject to the ongoing conditions of the FDIC's approval order relating to the merger of two other banks into South Shore Bank. The conditions of the approval order require, among other things, a plan to reduce classified asset levels and that South Shore Bank have, as of December 31, 1993, a minimum tier 1 leverage capital ratio of at least 6.0%. As of December 31, 1993, South Shore Bank was in compliance with the capital ratio aspects of, and had adopted or was implementing improvements in the various areas addressed in, the agreement and approval order. As previously reported, as part of the 1991 merger of two of Multibank's banking subsidiaries, the FDIC issued an approval order which requires that the resulting bank, Multibank West, comply with certain conditions. The approval order addresses, among other things, uniform policies and procedures, risk ratings, asset quality, reserves and funds management, and requires that Multibank West maintain an equity-to-assets ratio of at least 5%. Multibank West, which is required to file periodic progress reports with the FDIC, has complied with all of the aspects of the approval order. The Corporation is currently in the process of seeking regulatory approval to merge Mechanics Bank, South Shore Bank and Multibank West into FNBB. While it is anticipated that the mergers will be consummated by mid-year 1994, there can be no assurances that the requisite regulatory approvals will be granted or, if granted, that such approvals will be received within this time frame. As previously reported, in January 1994, the Securities and Exchange Commission (the "Commission") commenced an administrative proceeding against the Corporation. The administrative proceeding relates to the Commission's claim that the Corporation's second quarter 1989 Form 10-Q did not disclose known trends or uncertainties with respect to the Corporation's credit portfolio and specifically its domestic commercial real estate portfolio. The Corporation reported a significant loss in the third quarter of 1989 as a result of adding to its reserve for credit losses, primarily due to deterioration in the credit quality of its domestic commercial real estate portfolio. Management believes that the disclosures made in its second quarter 1989 Form 10-Q were appropriate and intends to defend the action vigorously. Although management cannot predict the outcome of this proceeding, an unfavorable outcome will not result in any monetary penalties to the Corporation. GOVERNMENTAL POLICIES AND ECONOMIC CONDITIONS The earnings and business of the Corporation and its subsidiaries are affected by a number of external influences. The economic and political conditions in which the Corporation and its subsidiaries operate can vary greatly. Such conditions include volatile foreign exchange markets and, in certain countries, high rates of inflation and foreign exchange liquidity problems. In 1993, the economies of New England and the United States reflected modest improvement and for most of 1993, the Corporation experienced improved domestic loan demand. The economic downturn in New England, however, predated the national recession and since the state of the regional economy reflects structural as well as cyclical forces, New England's economic recovery may be slower and more uneven than for the country as a whole. The Corporation's earnings and business are also affected by the policies of various government and regulatory authorities in New England and throughout the United States, as well as foreign governments and international agencies, including, in the United States, the Federal Reserve Board. Important functions of the Federal Reserve Board, in addition to those enumerated under "Supervision and Regulation," are to regulate the supply of money and of bank credit, to deal with general economic conditions within the United States and to be responsive to international economic conditions. From time to time, the Federal Reserve Board and the central banks of foreign countries have taken specific steps to effect changes in the value of the United States dollar in foreign currency markets as well as to control domestic inflation and to control the country's money supply. The instruments of monetary policy employed by the Federal Reserve Board for these purposes (including interest rates and the level of cash reserves banks are required to maintain against deposits) influence in various ways the interest rates paid on interest bearing liabilities and the interest received on earning assets, as well as the overall level of bank loans, investments and deposits. Inflation has generally had a minimal impact on the Corporation because substantially all of its assets and liabilities are of a monetary nature and a large portion of its operations are based in the United States, where inflation has been low. As discussed in "Management's Financial Review," a currency position maintained by the Corporation in Brazil, a country with a hyperinflationary economy, has had an effect on the levels of net interest revenue, noninterest income and net interest margin, while modestly benefiting total revenue. Prospective domestic and international economic and political conditions and the policies of the Federal Reserve Board, as well as other domestic and international regulatory authorities, may effect the future business and earnings of the Corporation. This section should be read in conjunction with "Management's Financial Review" contained in the Corporation's 1993 Annual Report to Stockholders on pages 32 through 51, which pages are included in Exhibit 13 hereto and which discussion is incorporated herein by reference. CONSOLIDATED STATISTICAL INFORMATION The "Consolidated Statistical Information" is incorporated herein by reference from the following pages of the Corporation's 1993 Annual Report to Stockholders, which pages are included in Exhibit 13 hereto. This information should be read in conjunction with the financial statements incorporated by reference in Item 8 of this Report. Page of 1993 Annual Report to Stockholders Average Balances and Interest Rates: Consolidated 79 United States Operations 80 International Operations 81 Change in Net Interest Revenue-Volume and Rate Analysis: 1993 compared with 1992 82 1992 compared with 1991 83 Geographic Segment Information 84 Cross-border Outstandings 86 and 87 Loans and Lease Financing 88 Nonaccrual Loans and Leases 89 Reserve for Credit Losses: Allocation of Reserve for Credit Losses 90 Analysis of Reserve for Credit Losses 91 Securities 92 Deposits 92 Short-term Borrowings 93 Consolidated Selected Financial Data-Selected Ratios 31 Item 2.

Item 2. Properties. The head offices of the Corporation and FNBB are located in a 37-story building at 100 Federal Street, Boston, Massachusetts. In 1993, FNBB leased approximately 70% of the building's approximately 1.3 million square feet. FNBB's securities and payments processing center is located in Canton, Massachusetts, where FNBB leases approximately 85% of the Canton office building's approximately 275,000 square feet. FNBB's data processing and record keeping operations are located at Columbia Park in Boston. The Columbia Park facility, comprising approximately 405,000 square feet, and the land on which it is situated are owned by FNBB. In addition, FNBB leases Multibank's former operations facility in Dedham, Massachusetts, which comprises approximately 158,000 square feet. The headquarters for FNBB's operations in Argentina and Brazil are located in a 10-story building in Buenos Aires and a 20-story building in Sao Paulo, respectively. The Buenos Aires and Sao Paulo facilities, comprising approximately 256,000 and 187,000 square feet, respectively, are owned by FNBB. Hospital Trust owns a 30-story building and a building adjacent thereto at One Hospital Trust Plaza, Providence, Rhode Island. Hospital Trust occupies approximately 40% of the complex's approximately 546,000 square feet. In addition, Hospital Trust maintains an operations center in East Providence, Rhode Island that also serves as the primary backup for FNBB's Columbia Park facility. The East Providence operations center, which consists of approximately 141,000 square feet, is owned by Hospital Trust. BKB Connecticut has recently moved its headquarters to Hartford, Connecticut where it has offices at 31 Pratt Street and 100 Pearl Street. BKB Connecticut owns and occupies approximately 50,000 square feet at the Pratt Street location, which was the former Bancorp headquarters. BKB Connecticut owns an undivided one-half interest in the Pearl Street location and currently occupies approximately 54,000 square feet. BKB Connecticut also maintains regional offices in Connecticut, the largest of which is in Waterbury and comprises approximately 157,000 square feet of owned space in three interconnected buildings. Casco's headquarters are located at One and Two Monument Square in Portland, Maine. Casco leases approximately 135,000 square feet of the complex and currently occupies approximately 76,000 square feet of that space. Bank of Vermont's headquarters in Burlington, Vermont consist of approximately 77,000 square feet of owned space in four interconnected buildings. None of these properties is subject to any material encumbrance. The Corporation's subsidiaries also own or lease numerous other premises used in domestic and foreign operations. Item 3.

Item 3. Legal Proceedings. The Corporation and its subsidiaries in 1993 were or currently are parties to a number of legal proceedings that have arisen in connection with the normal course of business activities of the Corporation, FNBB and the Corporation's other subsidiaries, including the following matters: Arnold/Society for Savings Bancorp, Inc. As previously reported, in March, 1993, a complaint was filed in Delaware Chancery Court against the Corporation, Bancorp and Bancorp's directors who voted in favor of the Corporation's acquisition of Bancorp. The action was brought by a Bancorp stockholder, individually and as a class action on behalf of all Bancorp stockholders of record on the date the acquisition was announced, and sought an injunction with respect to the proposed acquisition and damages in an unspecified amount. In May 1993, the Chancery Court denied the plaintiff's motion for a preliminary injunction and in July 1993, the Corporation acquired Bancorp. In December 1993, the Chancery Court granted summary judgment in favor of the Corporation, Bancorp and Bancorp's former directors. The plaintiff has appealed that decision to the Delaware Supreme Court, where the matter is currently pending. Bancorp Class Action. As previously reported, a class action complaint was filed in U.S. District Court for the District of Connecticut against Bancorp, two of its then senior officers and one former officer. The complaint, as subsequently amended, alleges that Bancorp's financial reports for fiscal years 1988, 1989, and the first half of 1990 contained material misstatements or omissions concerning its real estate loan portfolio and other matters, in violation of Connecticut common law and of Sections 10(b) and 20 of the Securities Exchange Act of 1934. The action was brought by a Bancorp shareholder, individually and as a class action on behalf of purchasers of Bancorp's stock from January 19, 1989 through November 30, 1990 and seeks damages in an unspecified amount. Bancorp and the defendant officers have denied the allegations of the amended complaint and intend to defend the action vigorously. Lender Liability Litigation. The Corporation's subsidiaries, in the normal course of their business in collecting outstanding obligations, are named as defendants in complaints or counterclaims filed in various jurisdictions by borrowers or others who allege that lending practices by such subsidiaries have damaged the borrowers or others. Such claims, commonly referred to as lender liability claims, frequently request not only relief from repayment of the debt obligation, but also recovery of actual, consequential, and punitive damages, some in very large dollar amounts. During 1991, one such claim resulted in a judgment being entered against Hospital Trust for approximately $4.0 million, plus interest. The judgment against Hospital Trust remains on appeal. Stranway/Elmendorf Case. As previously reported, in June 1985 a complaint was filed against FNBB in the U.S. District Court for the District of New Hampshire by private plaintiffs on behalf of the United States in a qui tam action under 3l U.S.C. # 3729, known as the False Claims Act. The complaint alleges that FNBB failed to disclose, or made false statements, to the Farmer's Home Administration ("FmHA") in connection with securing and inducing payment on guarantees from the FmHA on loans by FNBB and certain investors to Stranway Corporation and its subsidiary Elmendorf Board Corporation. Damages are alleged in the amount of $50,000,000, plus interest, costs and attorneys fees. The United States, which must decide at the outset whether to take over civil prosecution of a False Claims Act suit initiated by a private plaintiff, has declined to enter an appearance in and take over the action. The action was transferred to the District of Massachusetts. In 1986, FNBB filed a motion to dismiss the suit for lack of subject matter jurisdiction and the motion was denied by the District Court in 1988. Discovery has been essentially completed in the case. FNBB denies the allegations in the complaint and intends to continue to defend the action vigorously. Management, after reviewing all actions and proceedings pending against the Corporation and its subsidiaries, considers that the aggregate loss, if any, resulting from the final outcome of these proceedings will not be material. Item 3A. Executive Officers of the Corporation. Information with respect to the executive officers of the Corporation, as of March 1, 1994, is set forth below. Executive Officers are generally elected annually by the Board of Directors and hold office until the following year and until their successors are chosen and qualified, unless they sooner resign, retire, die or are removed. Except where otherwise noted, the positions listed for the officers are for both the Corporation and FNBB. All of the foregoing individuals have been officers of the Corporation or one of its subsidiaries for the past five years except for Ms. Haney and Messrs. Blake, Champion, Gallery, O'Neal, Ott and Shea. Prior to joining the Corporation in 1990, Ms. Haney was Senior Vice President/Manager of Portfolio Accounting for The Boston Company since 1988 and Mr. Champion was Senior Vice President and Department Head, General Services for Continental Bank from 1976. Mr. Gallery came to the Corporation in 1991 from The First National Bank of Chicago where he was Division Manager, Midwest since 1989. Prior to joining the Corporation in 1992, Mr. O'Neal was employed by Chemical Banking Corporation as Senior Executive Vice President, Operating Services and Nationwide Consumer in 1992, Vice Chairman and Director from 1990 to 1991 and Group Executive Consumer Banking Group from 1987 to 1990. Mr. Blake also joined the Corporation in 1992 and prior to that time was Vice President of the MAC Group/Gemini Consulting since 1988. Mr. Ott also came to the Corporation in 1992 from Constellation Bancorp where he served as Executive Vice President, Community Banking Division, and prior to that time was an Associate at TAC Associates from 1991 to 1992, Senior Vice President, Community Banking Division of Fleet Bank from 1990 to 1991 and Vice President of Bank of America from 1975 to 1990. Mr. Shea joined the Corporation in 1993 from Coopers & Lybrand, where he had served as a partner since 1983 and as Vice Chairman since 1991. Item 4.

Item 4. Submission of Matters to a Vote of Security Holders. Not applicable. PART II Item 5.

Item 5. Market for Registrant's Common Equity and Related Stockholder Matters. The information required by this Item is presented on pages 30, 31 and 95 of the Corporation's 1993 Annual Report to Stockholders, which pages are included in Exhibit 13 hereto, and such information is hereby incorporated by reference. Item 6.

Item 6. Selected Financial Data. The "Consolidated Selected Financial Data" of the Corporation for the six years ended December 31, 1993 appears on pages 30 and 31 of the Corporation's 1993 Annual Report to Stockholders, which pages are included in Exhibit 13 hereto, and such information is hereby incorporated by reference. Item 7.

Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations. The information in response to this Item is included in "Management's Financial Review" on pages 32 through 51 of the Corporation's 1993 Annual Report to Stockholders, which pages are included in Exhibit 13 hereto, and such information is hereby incorporated by reference. Item 8.

Item 8. Financial Statements and Supplementary Data. Item 9.

Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure. Not applicable. PART III Item 10.

Item 10. Directors and Executive Officers of the Registrant. Information concerning the Executive Officers of the Corporation which responds to this Item is contained in the response to Item 3A contained in Part I of this Report and is hereby incorporated by reference herein. The information that responds to this Item with respect to Directors, is contained under the heading "Election of Directors" in the Corporation's definitive proxy statement for its 1994 Annual Meeting of Stockholders, which is required to be filed pursuant to Regulation 14A of the Exchange Act and which will be filed with the Commission not later than 120 days after the end of the Corporation's fiscal year (the "Proxy Statement"). Information with respect to compliance by the Corporation's directors and executive officers with Section 16(a) of the Exchange Act is contained under the heading "Compliance with Section 16(a) of the Exchange Act" in the Proxy Statement. Pursuant to General Instruction G(3) to Form 10-K, the foregoing information from the Proxy Statement is hereby incorporated by reference. Item 11.

Item 11. Executive Compensation. The information required in response to this Item is contained under the heading "Compensation of Executive Officers" in the Proxy Statement. Pursuant to General Instruction G(3) to Form 10-K, the foregoing information from the Proxy Statement, with the exception of the sections entitled "Compensation Committee Report on Executive Compensation" and "Five-Year Stockholder Return Comparison," is hereby incorporated by reference. Item 12.

Item 12. Security Ownership of Certain Beneficial Owners and Management. The information required in response to this Item is contained under the heading "Beneficial Ownership of Securities" in the Proxy Statement. Pursuant to General Instruction G(3) to Form 10-K, the foregoing information from the Proxy Statement is hereby incorporated by reference. Item 13.

Item 13. Certain Relationships and Related Transactions. The information required in response to this Item is contained under the heading "Indirect Interest of Directors and Executive Officers in Certain Transactions" in the Proxy Statement. Pursuant to General Instruction G(3) to Form 10-K, the foregoing information from the Proxy Statement is hereby incorporated by reference. PART IV Item 14.

Item 14. Exhibits, Financial Statement Schedules, and Reports on Form 8-K. (a)(1) The financial statements required in response to this Item are listed in response to Item 8 of this Report and are incorporated herein by reference. (a)(2) Financial Statement Schedules. Schedules have been omitted because the information is either not required, not applicable, or is included in the financial statements or notes thereto. (a)(3) Exhibits 3(a) - Restated Articles of Organization of the Corporation, as amended through November 24, 1993. 3(b) - By-Laws of the Corporation, as amended through October 28, 1993. 4(a) - Indenture dated as of January 15, 1986 defining rights of holders of the Corporation's 7 3/4% Convertible Subordinated Debentures Due 2011, incorporated herein by reference to Exhibit 4(b) to the Corporation's Annual Report on Form 10-K for the year ended December 31, 1985 (File No. 1-6522). 4(b) - Fiscal and Paying Agency Agreement dated as of February 10, 1986 defining rights of holders of the Corporation's Subordinated Floating Rate Notes Due 2001, incorporated herein by reference to Exhibit 4(d) to the Corporation's Annual Report on Form 10-K for the year ended December 31, 1985 (File No. 1-6522). 4(c) - Fiscal and Paying Agency Agreement dated as of August 26, 1986 defining rights of holders of the Corporation's Floating Rate Subordinated Equity Commitment Notes Due 1998 incorporated herein by reference to Exhibit 4(e) to the Corporation's Annual Report on Form 10-K for the year ended December 31, 1986 (File No. 1-6522). Item 14. Exhibits, Financial Statement Schedules, and Reports on Form 8-K (cont'd). (a)(3) Exhibits (cont'd) 4(d) - Indenture dated as of June 15, 1987 defining the rights of holders of the Corporation's 9 1/2% Subordinated Equity Contract Notes due 1997, incorporated herein by reference to Exhibit 4(g) to the Corporation's Annual Report on Form 10-K for the year ended December 31, l987 (File No. 1-6522). 4(e) - Indenture dated as of July 15, 1988 and form of note defining rights of the holders of the Corporation's 10.30% Subordinated Notes due September 1, 2000, incorporated herein by reference to Exhibit 4(i) to the Corporation's Annual Report on Form 10-K for the year ended December 31, 1988 (File No. 1-6522). 4(f) - Fiscal and Paying Agency Agreement dated as of September 12, 1985 defining rights of holders of the Corporation's Floating Rate Notes Due 2000, incorporated herein by reference to Exhibit 4(c) to the Corporation's Annual Report on Form 10-K for the year ended December 31, 1985 (File No. 1-6522). 4(g) - Subordinated Indenture dated as of June 15, 1992, as amended by the First Supplemental Indenture dated as of June 24, 1993, and forms of notes defining rights of the holders of the Corporation's 6 7/8% Subordinated Notes due 2003, the 6 5/8% Subordinated Notes due 2005, and the 6 5/8% Subordinated Notes due 2004, incorporated herein by reference to Exhibit 4(d) to the Corporation's Registration Statement on Form S-3 (Registration Number 33-48418), to Exhibits 4(e) and 4(f) to the Corporation's Current Report on Form 8-K dated June 24, 1993, to Exhibit 4 to the Corporation's Current Report on Form 8-K dated November 15, 1993 and to Exhibit 4 to the Corporation's Current Report on Form 8-K dated January 5, 1994 (File No. 1-6522). Item 14. Exhibits, Financial Statement Schedules, and Reports on Form 8-K (cont'd). (a)(3) Exhibits (cont'd) 4(h) - Rights Agreement, dated as of June 28, 1990, between the Corporation and FNBB, as Rights Agent, and the description of the Rights, incorporated herein by reference to the Corporation's registration statement on Form 8-A relating to the Rights and to Exhibit 1 of such registration statement (File No. 1-6522). 4(i) - Deposit Agreement, dated August 13, 1992 between the Corporation and FNBB, as Depositary, relating to the Corporation's Depositary Shares, each representing a one-tenth interest in the Corporation's 8.60% Cumulative Preferred Stock, Series E, incorporated herein by reference to Exhibit 4(b) to the Corporation's Current Report on Form 8-K dated August 13, 1992 (File No. 1-6522). 4(j) - Deposit Agreement, dated as of June 30, 1993 between the Corporation and FNBB, as Depositary, relating to the Corporation's Depositary Shares, each representing a one-tenth interest in the Corporation's 7 7/8% Cumulative Preferred Stock, Series F, incorporated herein by reference to Exhibit 4(b) to the Corporation's Current Report on Form 8-K dated June 24, 1993 (File No. 1-6522). 10(a) Bank of Boston Corporation 1982 Stock Option Plan as amended through August 24, 1989, incorporated herein by reference to Exhibit 10(a) to the Corporation's Annual Report on Form 10-K for the year ended December 31, 1989 (File No. 1-6522).* ____________________________________________________________ * Indicates that document is a management contract or compensatory plan or arrangement that is required to be filed as an exhibit to this Report pursuant to Item 14(c) of Form 10-K. Item 14. Exhibits, Financial Statement Schedules, and Reports on Form 8-K (cont'd). (a)(3) Exhibits (cont'd) 10(b) Bank of Boston Corporation 1986 Stock Option Plan as amended through August 24, 1989, incorporated herein by reference to Exhibit 10(b) to the Corporation's Annual Report on Form 10-K for the year ended December 31, 1989 (File No. 1-6522).* 10(c) Bank of Boston Corporation and its Subsidiaries Performance Recognition Opportunity Plan, as amended effective January 27, 1994.* 10(d) Bank of Boston Corporation Executive Non-Qualified Deferred Compensation Plan, as amended through March 12, 1991, incorporated herein by reference to Exhibit 10(d) to the Corporation's Annual Report on Form 10-K for the year ended December 31, 1992 (File No. 1-6522).* 10(e) The First National Bank of Boston Bonus Supplemental Employee Retirement Plan, as amended through September 13, 1990, incorporated herein by reference to Exhibit 10(e) to the Corporation's Annual Report on Form 10-K for the year ended December 31, 1990 (File No. 1-6522).* 10(f) Description of the Corporation's Supplemental Life Insurance Plan, incorporated herein by reference to Exhibit 10(h) to the Corporation's Annual Report on Form 10-K for the year ended December 31, 1988 (File No. 1-6522).* 10(g) The First National Bank of Boston Excess Benefit Supplemental Employee Retirement Plan, effective as of January 1, 1989, incorporated herein by reference to Exhibit 10(g) to the Corporation's Annual Report on Form 10-K for the year ended December 31, 1989 (File No. 1-6522).* ____________________________________________________________ * Indicates that document is a management contract or compensatory plan or arrangement that is required to be filed as an exhibit to this Report pursuant to Item 14(c) of Form 10-K. Item 14. Exhibits, Financial Statement Schedules, and Reports on Form 8-K (cont'd). (a)(3) Exhibits (cont'd) 10(h) Bank of Boston Corporation 1991 Long-Term Stock Incentive Plan, as amended through January 27, 1994.* 10(i) Employment Agreement dated July 7, 1992 between The First National Bank of Boston and Edward A. O'Neal, incorporated herein by reference to Exhibit 10(k) to the Corporation's Annual Report on Form 10-K for the year ended December 31, 1992 (File No. 1-6522).* 10(j) Employment Agreement dated December 4, 1992 between The First National Bank of Boston and William J. Shea, incorporated herein by reference to Exhibit 10(l) to the Corporation's Annual Report on Form 10-K for the year ended December 31, 1992 (File No. 1-6522).* 10(k) Bank of Boston Corporation Relocation Policy, as amended through October, 1990, incorporated herein by reference to Exhibit 10(j) to the Corporation's Annual Report on Form 10-K for the year ended December 31, 1990 (File No. 1-6522).* 10(l) - Description of the Corporation's Supplemental Long-Term Disability Plan effective as of February 10, 1994.* 10(m) Bank of Boston Corporation's Director Stock Award Plan effective as of May 1, 1993.* 10(n) Lease dated as of September 1, 1991 between The First National Bank of Boston and The Equitable Federal Street Realty Company Limited Partnership, incorporated herein by reference to Exhibit 10(l) to the Corporation's Annual Report on Form 10-K for the year ended December 31, 1991 (File No. 1-6522). _____________________________________________________________ * Indicates that document is a management contract or compensatory plan or arrangement that is required to be filed as an exhibit to this Report pursuant to Item 14(c) of Form 10-K. Item 14. Exhibits, Financial Statement Schedules, and Reports on Form 8-K (cont'd). (a)(3) Exhibits (cont'd) 11 - Computation of earnings per common share. 12(a) Computation of the Corporation's Consolidated Ratio of Earnings to Fixed Charges (excluding interest on deposits). 12(b) Computation of the Corporation's Consolidated Ratio of Earnings to Fixed Charges (including interest on deposits). 12(c) Computation of the Corporation's Consolidated Ratio of Earnings to Combined Fixed Charges and Preferred Stock Dividend Requirements (excluding interest on deposits). 12(d) Computation of the Corporation's Consolidated Ratio of Earnings to Combined Fixed Charges and Preferred Stock Dividend Requirements (including interest on deposits). 13 - Pages 30 through 51, 53 through 93 and 95 of the Corporation's 1993 Annual Report to Stockholders. 21 - List of subsidiaries of Bank of Boston Corporation. 23 - Consent of Independent Accountants. 24 - Power of attorney of certain officers and directors (included on pages II-1 through II-2). Item 14. Exhibits, Financial Statement Schedules, and Reports on Form 8-K (cont'd). (a)(3) Exhibits (cont'd) 99 - Notice of Annual Meeting and Proxy Statement for the Annual Meeting of the Corporation's Stockholders to be held April 28, 1994. (Pursuant to General Instruction G(3) to Form 10-K, the information required to be filed by Part III hereof is incorporated by reference from the Corporation's definitive proxy statement which is required to be filed pursuant to Regulation 14A and which will be filed with the Commission not later than 120 days after the end of the Corporation's fiscal year.) (b) During the fourth quarter of 1993, the Corporation filed three Current Reports on Form 8-K. The current reports, dated October 28, 1993, November 2, 1993 and November 15, 1993, contained information pursuant to Items 5 and 7 of Form 8-K. The Corporation also filed one Current Report on Form 8-K, dated January 5, 1994, which contained information pursuant to Items 5 and 7 of Form 8-K. SIGNATURES Pursuant to the requirements of Section 13 or 15(d) 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, in the City of Boston, and Commonwealth of Massachusetts, on the 4th day of March, 1994. BANK OF BOSTON CORPORATION By /s/ IRA STEPANIAN ------------------------------- (Ira Stepanian) (Chief Executive Officer) Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed by the following persons in the capacities and on the dates listed below. By so signing, each of the undersigned, in his or her capacity as a director or officer, or both, as the case may be, of the Corporation, does hereby appoint Ira Stepanian, Charles K. Gifford, William J. Shea, Bradford H. Warner, Robert T. Jefferson and Gary A. Spiess, and each of them severally, or if more than one acts, a majority of them, his or her true and lawful attorneys or attorney to execute in his or her name, place and stead, in his or her capacity as a director or officer or both, as the case may be, of the Corporation, any and all amendments to said report and all instruments necessary or incidental in connection therewith, and to file the same with the Securities and Exchange Commission. Each of said attorneys shall have full power and authority to do and perform in the name and on behalf of each of the undersigned, in any and all capacities, every act whatsoever requisite or necessary to be done in the premises as fully and to all intents and purposes as each of the undersigned might or could do in person, hereby ratifying and approving the acts of said attorneys and each of them. II-1 II-2

879209_1993.txt

879209

1993

Item 1. Business The Sears Credit Account Trust 1991 D (the "Trust") was formed pursuant to the Pooling and Servicing Agreement dated as of September 15, 1991 (the "Pooling and Servicing Agreement") among Sears, Roebuck and Co. ("Sears") as Servicer, its wholly-owned subsidiary, Sears Receivables Financing Group, Inc. ("SRFG") as Seller, and Continental Bank, National Association as trustee (the "Trustee"). The Trust's only business is to act as a passive conduit to permit investment in a pool of retail consumer receivables. Item 2.

Item 2. Properties The property of the Trust includes a portfolio of receivables (the "Receivables") arising in selected accounts under open-end credit plans of Sears (the "Accounts") and all monies received in payment of the Receivables. At the time of the Trust's formation, Sears sold and contributed to SRFG, which in turn conveyed to the Trust, all Receivables existing under the Accounts as of the end of certain of Sears regular billing cycles ending in August, 1991 and all Receivables arising under the Accounts from time to time thereafter until the termination of the Trust. Information related to the performance of the Receivables during 1993 is set forth in the ANNUAL STATEMENT filed as Exhibit 21 to this Annual Report on Form 10-K. Item 3.

Item 3. Legal Proceedings None Item 4.

Item 4. Submission of Matters to a Vote of Security Holders None PART II Item 5.

Item 5. Market for Registrant's Common Equity and Related Stockholder Matters Investor Certificates are held and delivered in book-entry form through the facilities of The Depository Trust Company ("DTC"), a "clearing agency" registered pursuant to the provisions of Section 17A of the Securities Exchange Act of 1934, as amended. All outstanding definitive Investor Certificates are held by CEDE and Co., the nominee of DTC. Item 9.

Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure None PART III Item 12.

Item 12. Security Ownership of Certain Beneficial Owners and Management As of March 15, 1994, 100% of the Investor Certificates were held in the nominee name of CEDE and Co. for beneficial owners. SRFG, as of March 15, 1994, owned 100% of the Seller Certificate, which represented beneficial ownership of a residual interest in the assets of the Trust as provided in the Pooling and Servicing Agreement. Item 13.

Item 13. Certain Relationships and Related Transactions None PART IV Item 14.

Item 14. Exhibits, Financial Statement Schedules, and Reports on Form 8-K (a) Exhibits: 21. 1993 ANNUAL STATEMENT prepared by the Servicer. 28. ANNUAL INDEPENDENT AUDITOR'S REPORTS pursuant to Section 3.06 of the Pooling and Servicing Agreement. (a) Review of servicing procedures. (b) Annual Servicing Letter. (b) Reports on Form 8-K: Current reports on Form 8-K are filed on, or before the Distribution Date each month (on, or the first business day after, the 15th of the month). The reports include as an exhibit, the MONTHLY INVESTOR CERTIFICATEHOLDERS' STATEMENT. Current Reports on Form 8-K were filed on October 15, 1993, November 15, 1993 and December 15, 1993. SIGNATURES Pursuant to the requirements of Section 13 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. Sears Credit Account Trust 1991 D (Registrant) By: Sears Receivables Financing Group, Inc. (Originator of the Trust) By: /S/ALICE M. PETERSON _____________________________________ Alice M. Peterson President and Chief Executive Officer Dated: March _____, 1994 EXHIBIT INDEX Page number in sequential Exhibit No. number system 21. 1993 ANNUAL STATEMENT prepared by the Servicer. 28. ANNUAL INDEPENDENT AUDITOR'S REPORTS pursuant to Section 3.06 of the Pooling and Servicing Agreement. (a) Review of servicing procedures. (b) Annual Servicing Letter. Exhibit 21 SEARS CREDIT ACCOUNT TRUST 1991 D 7.75% CREDIT ACCOUNT PASS-THROUGH CERTIFICATES 1993 ANNUAL STATEMENT Pursuant to the terms of the letter issued by the Securities and Exchange Commission dated March 31, 1992 (granting relief to the Trust from certain reporting requirements of the Securities Exchange Act of 1934, as amended), aggregated information regarding the performance of Accounts and payments to Investor Certificateholders in respect of the Due Periods related to the twelve Distribution Dates which occurred in 1993 is set forth below. 1) The total amount of the distribution to Investor Certificateholders during 1993, per $1,000 interest..$77.50 2) The amount of the distribution set forth in paragraph 1 above in respect of interest on the Investor Certificates, per $1,000 interest....................$77.50 3) The amount of the distribution set forth in paragraph 1 above in respect of principal on the Investor Certificates, per $1,000 interest.....................$0.00 4) The aggregate amount of Collections of Principal Receivables processed during the related Due Periods.....................................$505,369,770.21 5) The aggregate amount of Collections of Finance Charge Receivables processed during the related Due Periods.....................................$136,046,490.08 6) The aggregate amount of Collections of Principal Receivables processed during the related Due Periods which were allocated in respect of the Investor Certificates...............................$349,762,639.71 7) The aggregate amount of Collections of Finance Charge Receivables processed during the related Due Periods which were allocated in respect of the Investor Certificates................................$94,270,723.54 8) The aggregate amount of Collections of Principal Receivables processed during the related Due Periods which were allocated in respect of the Seller Certificate................................$155,607,130.50 9) The aggregate amount of Collections of Finance Charge Receivables processed during the related Due Periods which were allocated in respect of the Seller Certificate.................................$41,775,766.54 10) The excess of the Investor Charged-Off Amount over the sum of (i) payments in respect of the Available Subordinated Amount and (ii) Excess Servicing, if any (an "Investor Loss"), per $1,000 interest............$0.00 11) The aggregate amount of Investor Losses in the Trust as of the end of the day on December 15, 1993, per $1,000 interest......................................$0.00 12) The total reimbursed to the Trust from the sum of the Available subordinated Amount and Excess Servicing, if any, in respect of Investor Losses, per $1,000 interest.............................................$0.00 13) The amount of the Investor Monthly Servicing Fee payable by the Trust to the Servicer.........$9,999,999.96 14) The aggregate amount which was deposited in the Principal Funding Account in respect of Collections of Principal Receivables during the related Due Periods..............................................$0.00 15) The aggregate amount of Investment Income during the related Due Periods..................................$0.00 16) The total amount on deposit in the Principal Funding Account in respect of Collections of Principal Receivables, as of the end of the reportable year....$0.00 17) The Deficit Accumulation Amount, as of the end of the reportable year......................................$0.00 18) The aggregate amount which was deposited in the Interest Funding Account in respect of Certificate Interest during the related Due Periods..............$38,750,000.04 19) The total amount on deposit in the Interest Funding Account in respect of Certificate Interest, as of the end of the reportable year...................$9,687,500.01 Exhibit 28(a) February 11, 1994 Ms. Alice M. Peterson Ms. Cynthia K. Duncan Vice President and Treasurer Trust Officer Sears, Roebuck and Co. as Servicer Continental Bank National Sears Tower Association as Trustee Chicago, Illinois 60684 231 South La Salle Street Chicago, Illinois 60697 We have applied the procedures listed below to the accounting records of Sears, Roebuck and Co. ("Sears") relating to the servicing procedures performed by Sears as Servicer under Section 3.06(b) of the Pooling and Servicing Agreement (the "Agreement") for the following Trusts: Date of Pooling and Trust Servicing Agreement Sears Credit Account Trust 1991A March 1, 1991 Sears Credit Account Trust 1991B May 15, 1991 Sears Credit Account Trust 1991C July 1, 1991 Sears Credit Account Trust 1991D September 15, 1991 Sears Credit Account Master Trust I November 18, 1992 It is understood that this report is solely for your information and is not be referred to or distributed for any purpose to anyone other than Continental Bank, National Association as Trustee, Investor Certificateholders or the management of Sears. The procedures we performed are as follows: Compared the mathematical calculations of each amount set forth in each monthly certificate forwarded by the Servicer, pursuant to Section 3.04(b) of the Agreement, during the calendar year 1993 to the Servicer's computer-generated Portfolio Monitoring and Monthly Cash Flow Allocations report. We found such amounts to be in agreement. Because the above procedures do not constitute an audit conducted in accordance with generally accepted auditing standards, we do not express an opinion on any of the items referred to above. February 11, 1994 Ms. Alice M. Peterson Ms. Cynthia K. Duncan Vice President and Treasurer Trust Officer Sears, Roebuck and Co. as Servicer Continental Bank National Association as Trustee As a result of the procedures performed, no matters came to our attention that caused us to believe that the amounts in the monthly certificates require adjustment. Had we performed additional procedures or had we conducted an audit of the monthly certificates in accordance with generally accepted auditing standards, matters might have come to our attention that would have been reported to you. This report relates only to the items specified above and does not extend to any financial statements of Sears taken as a whole.

705752_1993.txt

705752

1993

ITEM 1. BUSINESS. Century Properties Fund XIX (hereinafter referred to either as "Fund", "Partnership" or "Registrant") was organized in August 1982, as a California limited partnership under the Uniform Limited Partnership Act of the California Corporations Code. Fox Partners II, a California general partnership, is the general partner of the Fund. The general partners of Fox Partners II are Fox Capital Management Corporation ("Fox"), a California corporation, Fox Realty Investors ("FRI"), a California general partnership, and Fox Partners 83, a California general partnership. The Fund's Registration Statement, filed pursuant to the Securities Act of 1933 (No. 2-79007), was declared effective by the Securities and Exchange Commission on September 20, 1983. Registrant marketed its securities pursuant to its Prospectus dated September 20, 1983, which was amended on June 13, 1984, and thereafter supplemented (hereinafter the "Prospectus"). This Prospectus was filed with the Securities and Exchange Commission pursuant to Rule 424(b) of the Securities Act of 1933. The principal business of the Fund is and has been to acquire, hold for investment and ultimately sell income-producing multi-family residential properties. The Fund is a "closed" limited partnership real estate syndicate formed to acquire multi-family residential properties. Beginning in September 1983 through October 1984, the Fund offered $90,000,000 in Limited Partnership Units and sold $89,292,000. The net proceeds of this offering were used to acquire thirteen income-producing real properties. The Fund's original property portfolio was geographically diversified with properties acquired in seven states. The Fund's acquisition activities were completed in June 1985 and since then the principal activity of the Fund has been managing its portfolio. One property was sold in each of the years, 1988, 1992 and 1993 and in February 1994. In addition one property was foreclosed on in 1993. See Item 2

ITEM 2. PROPERTIES. A description of the multi-family residential properties in which the Fund has or has had an ownership interest is as follows: All Registrant's properties are or were owned in fee. See the financial statements in Item 8 for information regarding any encumbrances to which the properties of the Fund are subject. An occupancy summary is set forth on the chart following: CENTURY PROPERTIES FUND XIX OCCUPANCY SUMMARY AVERAGE OCCUPANCY RATE(%) FOR THE YEAR ENDED DECEMBER 31, 1993 1992 1991 Wood Lake Apartments . . . . . . . . . 91 92 89 Greenspoint Apartments . . . . . . . . 97 94 93 Sandspoint Apartments . . . . . . . . . 90 91 91 Wood Ridge Apartments . . . . . . . . . 94 92 90 Plantation Crossing Apartments . . . . 97 97 96 Plantation Forest Apartments . . . 94 95 95 Sunrunner Apartments . . . . . . . . . 91 92 92 McMillan Place Apartments . . . . . . . 93 93 93 Misty Woods Apartments . . . . . . . . 93 95 93 Parkside Village Apartments . . . 95 95 95 The Cove Apartments . . . . . . . - - 88 Property was sold in May 1993. 1993 average occupancy rate covers the periods from January 1993 through May 1993. Placed into receivership in 1992 and acquired by lender through foreclosure in July 1993. Property was sold in February 1994. NET PROJECT OPERATIONS INTRODUCTION The Net Project Operations tables reflect the components of net project operations for each property in which the Fund had an ownership interest that was included in the Fund's Consolidated Financial Statements for the years then ended. Net project operations should not be considered as an alternative to net loss (as presented in the consolidated financial statements) as an indicator of the Fund's operating performance or to cash flows as a measure of liquidity. The tables present: Project operations are the rental revenues less operating expenses (subtotal) less the related debt service (principal and interest on an accrual basis, excluding deferred interest). Net project operations are the amounts that were included in the consolidated statements of operations in Item 8, except that net project operations are net of principal reductions (exclusive of balloon payments). To determine net project operations, project operations may have been adjusted for the following items: Decreased for amortization of notes payable discount. Decreased for deferred interest recognized as an interest expense in the Consolidated Statements of Operations. A reconciliation of Net Project Operations to Loss Before Extraordinary Item is included. ITEM 3.

ITEM 3. LEGAL PROCEEDINGS. There are no material pending legal proceedings to which the Fund is a party or to which any of its assets are subject. ITEM 4.

ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS. No matter was submitted to a vote of security holders during the period covered by this Report. PART II ITEM 5.

ITEM 5. MARKET FOR THE REGISTRANT'S EQUITY AND RELATED SECURITY HOLDER MATTERS. The Limited Partnership Unit holders are entitled to certain distributions as provided in the Partnership Agreement. No market for Limited Partnership Units exists, nor is expected to develop. For Unit Holders, distributions from operations to date have been approximately $25 for each $1,000 of original investment. As of December 31, 1993, the approximate number of holders of Limited Partnership Units was as follows: NUMBER OF RECORD TITLE OF CLASS HOLDERS* Limited Partnership Units 9,395 *Number of Investments. ITEM 6.

ITEM 6. SELECTED FINANCIAL DATA. The following represents selected financial data for the Fund for the years ended December 31, 1993, 1992, 1991, 1990 and 1989. The data should be read in conjunction with the consolidated financial statements included elsewhere herein. This data is not covered by the independent auditors' report. ITEM 7.

ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS. This Item should be read in conjunction with Consolidated Financial Statements and other Items contained elsewhere in this Report. RESULTS OF OPERATIONS In 1993, some of the Fund's properties experienced an improvement in operations as a result of slight increases in the rental and lease rates due, in part, to improvements in the local economies in which the properties operate. However, the operating results of certain of the Fund's properties continue to be affected by highly competitive market conditions combined with the continued sluggish economy. Markets in some areas remained depressed due, in part, to overbuilding which continued to depress rental rates at some of the Fund's properties. Markets in which the Fund's properties are located are discussed below: Phoenix The Phoenix economy remains stable. It is anticipated that several companies will be relocating to the area causing increased economic growth. Construction continues to decline, allowing absorption of vacant apartment units and rental rate increases. Occupancy increased and rental revenue improved at Greenspoint Apartments due to selective rental rate increases. Occupancy and revenue remained stable at Sandspoint Apartments. St. Petersburg/Tampa The recession still lingers within the St. Petersburg/Tampa economy. The defense cutbacks and the partial closing of MacDill Airforce Base have kept job growth to a minimum. However, job growth is expected to come from corporate relocations to the area due to lower rents and cost of living. The apartment market is competitive, resulting in stable occupancy and operations at Sunrunner Apartments. Dallas The Dallas economy is relatively diversified; however, the recession still lingers where continued defense cutbacks have slowed the growth in employment. These job losses were partially offset by major corporations relocating to the area near the Dallas/Fort Worth International Airport causing a recent increase in economic growth in certain submarkets. The apartment market remains competitive due to affordability of new single family homes and recent job losses as described above. Occupancy at McMillan Place Apartments remained stable and selective rental rate increases were implemented during the year due, in part, to a strong submarket. Atlanta Atlanta's economy appears to be recovering although it remains very weak. Relocating corporations, the 1996 Summer Olympic Games, health services and the Fighter contract awarded to Lockheed are expected to be major sources of job growth. In addition, UPS has relocated its headquarters to Atlanta. The apartment market remains competitive due to oversupply of available rental units. However, curtailment of apartment construction and continued corporate migration combined with a decline in single family home construction are expected to increase occupancy in the next year. The Partnership's properties operate in competitive submarkets. However, occupancy and rental revenue were relatively stable at Wood Lake, Plantation Forest, Plantation Crossing and Wood Ridge Apartments. Charlotte The economy is slowly recovering due to job losses in the dominant manufacturing industry. However, these job losses were offset, in part, by job growth in health care and financial services industries as Charlotte continues its transition from a manufacturing economy to a service economy. Abatement of construction in some areas has allowed occupancy to stabilize. However, the market remains competitive and rental concessions are common. Occupancy and operations at Misty Woods Apartments have remained stable. 1993 Compared to 1992 Loss before extraordinary item decreased $5,624,000 in 1993 compared to 1992 primarily due to the $3,846,000 provision for impairment of value and loss on sale recognized in 1992 and to a decrease in interest, operating and depreciation expenses, offset, in part, by decreased rental revenues, due to the sale of Parkside Village Apartments and the foreclosure of The Cove Apartments in 1993, and the sale of the Shadow Lake Apartments in December 1992. The decrease in rental revenue was offset, in part, by the increased rental revenue at certain of the Fund's properties due to increased occupancy. In addition, the decrease in interest expense is also due to lower interest rates obtained from the replacement financing of the Sandspoint and Greenspoint Apartments in June 1992 and Wood Lake, Wood Ridge and Plantation Crossing Apartments in June 1993 which is offset, in part, by the prepayment penalties paid in connection with the Wood Lake, Wood Ridge and Plantation Crossing Apartments refinancing. General and administrative expenses increased due to financing costs incurred in 1993 on refinancings which were not finalized. The gain on sale of property of $576,000 relates to the sale of Parkside Village Apartments and the loss on sale of $44,000 relates to the foreclosure of The Cove Apartments. 1992 Compared to 1991 Loss before extraordinary item increased $3,053,000 in 1992 compared to 1991 primarily due to the $1,694,000 and $1,895,000 provisions for impairment of value recognized in 1992 on The Cove Apartments and Parkside Village Apartments, respectively, and the $257,000 loss on sale of Shadow Lake Apartments recognized in 1992. Rental revenues, operating expenses and interest expenses decreased, in part, as a result of cessation of recording the operating results of Shadow Lake and The Cove Apartments since these properties were placed into receivership in 1992; however, operating expenses increased at most of the remaining properties. Depreciation expense decreased due to depreciation no longer being recorded on Shadow Lake and The Cove Apartments when a receiver was placed on the properties. Interest and other income decreased due to a decrease in interest rates and cash available for investments. The $7,022,000 extraordinary item - gain on extinguishment of debt recognized in 1992 relates to the debt -forgiveness by the lenders from the sale of Shadow Lake Apartments and the refinancing on Sandspoint and Greenspoint Apartments in 1992. FUND LIQUIDITY AND CAPITAL RESOURCES Introduction The results of project operations are determined by rental revenues less operating expenses (exclusive of depreciation and amortization) and debt service (see Item 2, Properties). Seven of the Fund's ten properties operating during all or part of 1993 generated positive project operations while Parkside Village, McMillan Place and Misty Woods Apartments experienced negative project operations. The Fund, after taking into account results of project operations, interest and other income and general and administrative expenses, incurred negative results from operations for the period, as defined herein. Negative results are also anticipated to occur in 1994. Cash distributions from operations were suspended since 1987. It is anticipated that cash distributions will remain suspended in 1994. Net project operations should not be considered as an alternative to net loss (as presented in the consolidated financial statements) as an indicator of the Fund's operating performance or to cash flows as a measure of liquidity. As presented in the Consolidated Statement of Cash Flows, cash was used by operating activities. Cash was provided by investing activities from proceeds from sale of rental property and used for additions and improvements to rental properties, an increase in restricted cash and cost of sale of rental property. Cash was used by financing activities primarily for notes payable principal payments and repayments of notes payable to affiliate of the general partner and provided primarily by notes payable proceeds on the refinancing of Wood Lake, Wood Ridge and Plantation Crossing Apartments. As a result of scheduled pay rate increases in 1990 in accordance with the Greenspoint and Sandspoint Apartments debt modification agreements, the Fund approached the lender on these notes requesting further debt relief or a discounted prepayment on the loans. The Fund received approval from the lender for discounted prepayments. The discounted prepayments were contingent upon receiving proceeds from replacement financing on the properties, which the Fund obtained in June 1992, as discussed in Note 7 to the consolidated financial statements. The Fund had been negotiating debt modification or a discounted payoff with the lender of the loan on Shadow Lake Apartments but was unsuccessful. In an effort to obtain debt modification, the Fund did not make the June 1992 debt service payment. The lender issued a notice of default and placed a receiver on the property on July 31, 1992. As discussed in Note 7 to the consolidated financial statements, the property was sold in December 1992. The net loss on sale was $257,000. The total consideration for the property was $11,724,000, including mortgage financing of $8,000,000 when acquired in November 1983. The Fund approached the lender on McMillan Place Apartments requesting an extension of the modification agreement which expired in October 1991 and, as discussed in Note 4 to the consolidated financial statements, finalized an agreement in July 1992. The Fund borrowed an additional $291,000 in 1993 from an affiliate of the general partner to provide cash for working capital needs. The Fund repaid $1,309,000 in principal and $86,000 in interest to an affiliate of the general partner in 1993. As of December 31, 1993 the Partnership had outstanding borrowings of $370,000 from an affiliate of the general partner as discussed in Note 5 to the consolidated financial statements. The Fund had been attempting to refinance the Wood Lake, Wood Ridge and Plantation Crossing Apartments loans in the amount of $6,850,000, $6,371,000 and $4,361,000, respectively, due in 1993 and 1994. As discussed in Note 4 to the consolidated financial statements, the Fund finalized an agreement with a new lender for replacement financing in June 1993. The new financing has a variable interest rate and matures in 1998. A wholly owned subsidiary was formed in October 1992 into which the properties were transferred in June 1993 as a condition of the refinancing. The Fund had not made the debt service payments since July 1992 on The Cove Apartments note payable. Consequently, the lender issued a notice of default and placed a receiver on the property on September 1, 1992. As discussed in Note 8 to the consolidated financial statements, the property was acquired through foreclosure by the first lender in July 1993. The net loss on property disposition after the $1,694,000 provision for impairment of value recognized in 1992 was $44,000. The total consideration for the property was $23,732,000, including mortgage financing of $14,546,000 when acquired in December 1984. The Fund placed Parkside Village Apartments, located in Aurora, Colorado, on the market for sale due to working capital needs for the Fund and continued improvement in the Denver market. As a result, as discussed in Note 8 to the consolidated financial statements, the Fund sold the property in May 1993 for $11,259,000. Net gain on the sale after the provision for impairment of value of $1,895,000 recognized in 1992 was $576,000. A substantial portion of the proceeds received from this sale was used to replenish working capital reserves, pay down the notes due to an affiliate of the general partner and pay down $500,000 on the Sunrunner Apartments note payable which was a condition of the sale of Parkside Village Apartments. The total consideration for the Parkside Village Apartments was $17,262,000, including mortgage financing of $10,000,000 when acquired in November 1983. The two remaining letters of credit on Misty Woods Apartments were scheduled to expire in June 1993. However, the Fund obtained a one year extension to June 1994. Upon expiration the lender will re-evaluate the requirements for such letters of credit, but could determine that all or part of these amounts be drawn to pay down the loan. As discussed in Note 3 to the consolidated financial statements, the Fund has cash reserved for this purpose should payment be required by the lender. The Fund approached the lender of the $5,804,000 first loan on Misty Woods Apartments for debt modification and an extension of the May 1996 maturity date. The lender is currently reviewing the proposal. The Fund has a balloon payment on McMillan Place Apartments of $10,800,000 due in December 1994. To meet this obligation, the Fund is currently negotiating with the lender for debt modification. In October 1993, Greenspoint Apartments sustained flood damage as a result of heavy rainfall. The Fund incurred $45,000 in damage, which was paid for by the Fund's insurance carrier. As discussed in Note 9 to the consolidated financial statements, in February 1994 the Fund sold Plantation Forest Apartments for $2,450,000. The estimated loss on the sale was $149,000 which will be recognized in the first quarter of 1994. Total consideration paid for the property was $3,429,000 including mortgage financing of $1,760,000 when acquired in June 1984. Net proceeds realized from the sale were, in part, used to fully repay the demand notes held by an affiliate of the general partner. In 1993, the Fund spent $658,000 on additions and improvements to properties, the majority of which was spent at Sandspoint, Sunrunner and Wood Ridge Apartments. In 1994, the Fund anticipates spending approximately $781,000 on property additions and improvements, the majority of which will be spent at Sandspoint, Wood Lake, Wood Ridge and McMillan Place Apartments. However, due to the limited cash available only improvements necessary to maintain occupancy or to meet safety requirements will be made in 1994. Conclusion At this time, it appears that the investment objective of capital growth will not be attained and that a significant portion of invested capital will not be returned to investors. The extent to which invested capital is returned to investors is dependent upon the success of the Fund's strategy as set forth herein, as well as upon significant improvement in the performance of the Fund's remaining properties and the markets in which such properties are located and on the sales price of the remaining properties. In this regard, the remaining properties will be held longer than originally expected. The ability to hold and operate these properties is dependent on the Fund's ability to obtain additional financing, refinancing, or debt restructuring as required. Since January 1991, the Fund's working capital reserves have been depleted and insufficient funds have been available to meet ongoing operating requirements. Subsequently, after periodically notifying the general partner of the Fund's need for capital to maintain operations, short-term loans have been obtained from an affiliate of the general partner. A substantial portion of the proceeds received from the sale of Parkside Village Apartments was used to pay down these borrowings. In order to meet capital and operating requirements and to hold and operate its properties, the Fund sold Parkside Village Apartments in May 1993 and Plantation Forest in February 1994 and obtained refinancing on the Wood Lake, Wood Ridge and Plantation Crossing Apartments. Proceeds received from the sale were used to replenish working capital reserves, pay off the notes payable to an affiliate of the general partner and pay down the Sunrunner Apartments note payable. If the Fund is unable to obtain additional debt modification or refinancing, the Fund may be required to dispose of additional properties now operating at a deficit or with significant balloon payments, through sale or transfer to lenders. The Fund believes this strategy, combined with cash generated from the Fund's properties with positive operations, will allow the Partnership to meet its capital and operating requirements. Although inflation impacts the Fund's expenses, the Fund has the ability to attempt to offset expense increases through rent increases. It is impossible to predict the future impact of inflation on the operations of the Fund's properties, the Fund's ability to successfully pass increased costs through to tenants or the impact of inflation on the ultimate sales price of remaining properties. ITEM 8.

ITEM 8. FINANCIAL STATEMENTS AND FINANCIAL STATEMENT SCHEDULES. CENTURY PROPERTIES FUND XIX (A LIMITED PARTNERSHIP) PAGE Independent Auditors' Report 15 Consolidated Financial Statements: Balance Sheets at December 31, 1993 and 1992 16 Statements of Operations for the Years Ended December 31, 1993, 1992 and 1991 17 Statements of Partners' Equity (Deficiency) for the Years Ended December 31, 1993, 1992 and 1991 18 Statements of Cash Flows for the Years Ended December 31, 1993, 1992 and 1991 19 Notes to Consolidated Financial Statements 20 Financial Statement Schedules: Schedule X - Consolidated Statements of Operations Information for the Years Ended December 31, 1993, 1992 and 1991 26 Schedule XI - Real Estate and Accumulated Depreciation at December 31, 1993 27 Consolidated financial statements and financial statement schedules not included have been omitted because of the absence of conditions under which they are required or because the information is included elsewhere in the consolidated financial statements. INDEPENDENT AUDITORS' REPORT Century Properties Fund XIX: We have audited the consolidated financial statements of Century Properties Fund XIX (a limited partnership) ("Partnership") and its wholly- owned subsidiaries listed in the accompanying table of contents. Our audits also included the financial statement schedules of the Partnership listed in the accompanying table of contents. These financial statements and financial statement schedules are the responsibility of the Partnership's management. Our responsibility is to express an opinion on these financial statements and financial statement schedules based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, such consolidated financial statements present fairly, in all material respects, the financial position of the Partnership at December 31, 1993 and 1992, and the results of its operations and its cash flows for each of the three years in the period ended December 31, 1993 in conformity with generally accepted accounting principles. Also, in our opinion, such financial statement schedules, when considered in relation to the basic consolidated financial statements taken as a whole, present fairly in all material respects the information shown therein. The accompanying consolidated financial statements have been prepared assuming that the Partnership will continue as a going concern. As discussed in Note 1 to the consolidated financial statements, the Partnership has experienced negative cash flow from operations and has a balloon payment of $10,800,000 due in December 1994, which raises substantial doubt about the Partnership's ability to continue as a going concern. Management's plans in regard to these matters are also described in Note 1. The consolidated financial statements do not include any adjustments that might result from the outcome of these uncertainties. DELOITTE & TOUCHE San Francisco, California March 18, 1994 CENTURY PROPERTIES FUND XIX (A LIMITED PARTNERSHIP) NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 1. ORGANIZATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES Organization - Century Properties Fund XIX ("Partnership") is a limited partnership organized under the laws of the State of California to acquire, hold for investment, and ultimately sell income-producing real estate. The general partner of the Partnership is Fox Partners II, a California general partnership. The general partners of Fox Partners II are Fox Capital Management Corporation ("Fox", formerly known as Fox & Carskadon Financial Corporation), a California corporation, Fox Realty Investors ("FRI") (formerly known as Century Partners), a California general partnership, and Fox Partners 83, a California general partnership. The capital contributions of $89,292,000 ($1,000 per unit) were made by the limited partners, including 100 Limited Partnership Units purchased by Fox. On December 6, 1993, NPI Equity Investments II, Inc. ("NPI Equity II") became the managing partner of FRI and acquired voting control and assumed operational control over Fox. As a result, NPI Equity II became responsible for the operation and management of the business and affairs of the Partnership. Basis of Presentation and Operating Strategy - The accompanying consolidated financial statements have been prepared on a going concern basis which contemplates the realization of assets and satisfaction of liabilities in the normal course of business. The Partnership, after taking into account accrued but unpaid interest on certain notes payable for which the Partnership had suspended debt service payments, has experienced cash flow deficiencies during recent years. At December 31, 1993, the Partnership had borrowed a total of $370,000 from affiliates of the general partner for working capital needs. The Partnership holds investments in and operates properties in real estate markets that are experiencing unfavorable economic conditions. Many of the Partnership's properties are or were located in oil industry related and other weakened markets and have experienced operating difficulties. In addition, markets in some areas remained depressed due in part to overbuilding which continued to depress residential rental rates. The level of sales of existing properties have been affected by the limited availability of financing in real estate markets. As disclosed in Note 4, the Partnership has a balloon payment of $10,800,000 on McMillan Place Apartments due in December 1994. To meet this obligation the Partnership is negotiating with the lender for an extension and modification of the loan. The Partnership's ability to hold and operate its remaining properties is dependent on obtaining refinancing or debt restructuring as required. If the Partnership is unable to obtain debt modification or refinancing, it is likely that dispositions of properties now operating at a deficit or with significant balloon payments will occur through sale, foreclosure or transfer to the lenders. The Partnership sold Plantation Forest in February 1994 and with the proceeds from the sale paid off the remaining loans from an affiliate of the general partner. The Partnership believes this strategy, combined with cash generated from the Partnership's properties with positive operations are expected to allow the Partnership to meet its capital and operating requirements. The outcome of these uncertainties cannot presently be determined. The consolidated financial statements do not include any adjustments that might result from the ultimate outcome of these uncertainties. Distributions - Cash distributions have been suspended since 1987. It is anticipated that cash distributions will remain suspended in 1994. Consolidation - The consolidated financial statements include the statements of the Partnership and its wholly owned subsidiaries, one of which was formed in April 1992 into which Sandspoint and Greenspoint Apartments were transferred. Another subsidiary was formed in October 1992 into which Wood Lake, Wood Ridge and Plantation Crossing Apartments were transferred in June 1993. An additional subsidiary was formed in May 1993 into which Sunrunner Apartments was transferred. All significant intercompany transactions and balances have been eliminated. New Accounting Pronouncements - In December 1991, the Financial Accounting Standards Board (FASB) issued Statement No. 107, "Disclosures About Fair Value of Financial Instruments". This Statement will not affect the financial position or results of operations of the Partnership but will require additional disclosure on the fair value of certain financial instruments for which it is practicable to estimate fair value. Disclosures under this statement will be required in the 1995 financial statements. Cash and Cash Equivalents - The Partnership considers cash investments, principally commercial paper, with an original maturity date of three months or less at the time of purchase to be cash equivalents. Rental Properties - Rental properties are stated at cost. A provision for impairment of value is recorded when a decline in value of property is determined to be other than temporary as a result of one or more of the following: (1) a property is offered for sale at a price below its current carrying value, (2) a property has significant balloon payments due within the foreseeable future for which the Partnership does not have the resources to meet, anticipates it will be unable to obtain replacement financing or debt modification sufficient to allow a continued hold of the property over a reasonable period of time, (3) a property has been, and is expected to continue, generating significant operating deficits and the Partnership is unable or unwilling to sustain such deficit results of operations, and has been unable to, or anticipates it will be unable to, obtain debt modification, financing or refinancing sufficient to allow a continued hold of the property for a reasonable period of time or, (4) a property's value has declined based on management's expectations with respect to projected future operational cash flows and prevailing economic conditions. An impairment loss is indicated when the undiscounted sum of estimated future cash flows from an asset, including estimated sales proceeds, and assuming a reasonable period of ownership up to five years, is less than the carrying amount of the asset. The impairment loss is measured as the difference between the estimated fair value and the carrying amount of the asset. In the absence of the above circumstances, rental properties and improvements are stated at cost. Depreciation - Depreciation is computed by the straight-line method over estimated useful lives of 30 years for buildings and improvements and six years for furnishings. Properties for which a provision for impairment of value has been recorded and are expected to be disposed of within the next year are not depreciated. Properties in Receivership - When a property has been placed in receivership and the Partnership does not expect to regain control of such property, the Partnership no longer records operating revenues and expenses, depreciation or other non cash expenses subsequent to the date of receivership. In addition, interest is no longer accrued on such property's notes payable as the Partnership does not expect to pay such interest. Deferred Financing Costs - Financing costs are deferred and amortized over the lives as interest expense of the related loans, which range from three to ten years, or expensed if financing is not obtained. Net Loss Per Limited Partnership Unit - The net loss per limited partnership unit is computed by dividing the net loss allocated to the limited partners by 89,292 units outstanding. Income Taxes - No provision for Federal and state income taxes has been made in the consolidated financial statements because income taxes are the obligation of the partners. Reclassification - Certain amounts have been reclassified to conform to the 1993 presentation. 2. TRANSACTIONS WITH THE GENERAL PARTNER AND AFFILIATES In accordance with the Partnership Agreement, the Partnership may be charged by the general partners and affiliates for services provided to the Partnership. From March 1988 to December 1992 such amounts were assigned pursuant to a services agreement by the general partner and affiliates to Metric Realty Services, L.P., which performed partnership management and other services for the Partnership. On January 1, 1993, Metric Management, Inc., a company which is not affiliated with the general partner, commenced providing certain property and portfolio management services to the Partnership under a new services agreement. As provided in the new services agreement effective January 1, 1993, no reimbursements were made to the general partner and affiliates during 1993. Subsequent to December 31, 1992, reimbursements were made to Metric Management, Inc. On December 16, 1993, the services agreement with Metric Management, Inc. was modified and, as a result thereof, the Partnership's general partner assumed responsibility for cash management of the Partnership as of December 23, 1993 and assumed responsibility for day-to-day management of the Partnership's affairs, including portfolio management, accounting and investor relations services as of April 1, 1994. In addition, interest was charged on borrowings from affiliates of the general partner to the Partnership. Related party expenses are as follows: 1993 1992 1991 Property management fees $ - $ 886,000 $ 878,000 Reimbursement of operational expenses: Accounting - 269,000 269,000 Investor services - 66,000 41,000 Professional services - 39,000 44,000 ------ ---------- ---------- Total $ - $1,260,000 $1,232,000 ====== ========== ========== Interest expense $57,000 $69,000 $26,000 ======= ======= ======= In accordance with the Partnership Agreement, the general partner received a Partnership management incentive allocation equal to ten percent of net and taxable income (losses) before gains on property dispositions. The general partner was also allocated its two percent continuing interest in the Partnership's net and taxable income (loss) after the preceding allocation. The general partner is also allocated gain on property dispositions to the extent it is entitled to receive distributions and then 12 percent of remaining gain. 3. RESTRICTED CASH Restricted cash at December 31, 1993 represents $160,000 in restricted tenant security deposits, $700,000 required to be maintained in accordance with the new financing agreement on Wood Lake, Wood Ridge and Plantation Crossing Apartments in order to meet future capital requirements, and $656,000 security for letters of credit totalling $600,000 which the Partnership provided the lender in connection with the purchase of Misty Woods Apartments. These letters of credit may be drawn upon by the lender under certain conditions. They are subject to annual review and renewal by the lender, and will be released upon satisfaction of the conditions per the agreement, principally the attainment of certain rental income levels at the property. The letters of credit were due June 15, 1993. However, the Partnership obtained an extension for an additional year to June 1994. Upon expiration the lender will re-evaluate the requirements for such letters of credit, but could determine that all or part of these amounts be drawn on to pay down the loan. Restricted cash of $656,000 has been invested in commercial paper and matured in January 1994 at an interest rate of 3.35 percent per annum. 4. NOTES PAYABLE Individual rental properties are pledged as collateral for the related notes payable. Interest rates range from 7.6 percent to 10.9 percent at December 31, 1993. Generally, the difference between the pay rates and contract rates was accrued and bore interest at the contract rate. The notes are generally payable monthly, mature between 1994 and 1998 and require balloon payments. Plantation Forest Apartments was sold in February 1994 and the related note payable was paid at sale. See Note 9. After reflecting the property sale as discussed above, principal payments at December 31, 1993 are required as follows: 1994 $13,562,000 1995 17,611,000 1996 6,083,000 1997 3,536,000 1998 19,077,000 ----------- Total $59,869,000 =========== Amortization of the deferred financing costs totalled $349,000, $256,000 and $213,000 for 1993, 1992 and 1991, respectively. The Fund approached the lender on McMillan Place Apartments requesting an extension of the current modification agreement which expired in October 1991 and finalized an agreement in July 1992. Monthly interest only payments will be made at 9.625 percent per annum from October 1, 1991 through November 1992, 10.250 percent from December 1992 through November 1993 and 10.875 percent from December 1993 through the loan's maturity date of December 1, 1994. The difference between the contract rate of 10.875 percent per annum and the modified pay rate is deferred and accrues interest at the contract rate. The Fund has a balloon payment on McMillan Place Apartments of $10,800,000 due in December 1994. To meet this obligation, the Fund is negotiating with the lender for debt modification and an extension of the loan. In June 1993 the Partnership finalized an agreement for replacement financing on Wood Lake, Wood Ridge and Plantation Crossing Apartments. The existing notes of $6,850,000, $6,371,000 and $4,361,000, respectively, with contract interest rates ranging from 11.75 percent to 13.98 percent and scheduled to mature in 1993 and 1994, were prepaid. The new loan in the amount of $20,375,000 with a variable interest rate of 4.125 percent over a 90 day LIBOR rate not to exceed 11.50 percent in the first three years, is due in June 1998. The loan interest rate was 7.6 percent at December 31, 1993. The note requires a minimum pay rate ranging from 8.5 percent to 9.5 percent. The difference between the loan interest rate and the minimum pay rate is credited to principal. The new financing agreement requires a $700,000 working capital reserve to be maintained by the Partnership. In connection with this refinancing, the Partnership was required to pay $540,000 in related costs, in addition to $199,000 in prepayment penalties. The agreement also required the Partnership to transfer the properties into a separate wholly owned subsidiary and to cross-collateralize the properties as security for the loan. Prepaid financing costs of $523,000 were refunded in 1993 when the original lender rejected the loan. In connection with the Parkside Village Apartments sale, the note payable on Sunrunner Apartments was paid down by $500,000. 5. NOTES PAYABLE TO AFFILIATE OF THE GENERAL PARTNER The Partnership borrowed an additional $291,000 in 1993 from an affiliate of the general partner to provide cash for working capital needs. The Partnership repaid $1,309,000 in principal and $86,000 in interest to an affiliate of the general partner in 1993. As of December 31, 1993 the Partnership had outstanding borrowings of $370,000 from an affiliate of the general partner to provide cash for working capital needs. These remaining notes bear interest at the prime rate plus one percent (prime rate was six percent at December 31, 1993) and are payable upon demand. Accrued interest payable to an affiliate of the general partner was $65,000 as of December 31, 1993. In February 1994 the Partnership paid off all remaining and outstanding borrowings owed to an affiliate of the general partner. Interest charged on the notes was $57,000, $69,000 and $26,000 for the year ended December 31, 1993, 1992 and 1991, respectively. 6. PROVISION FOR IMPAIRMENT OF VALUE AND LOSS ON SALE In 1992, the Partnership determined that it would allow The Cove Apartments, located in Tampa, Florida to be acquired by the lender through foreclosure. Accordingly, a provision for impairment of value of $1,694,000 was recognized in 1992 to reduce the carrying value of the property based on the estimated economic loss to the Partnership. Carrying value includes the cost of the property less accumulated depreciation and unamortized deferred financing costs. The Partnership had placed Parkside Village Apartments, located in Aurora, Colorado on the market for sale at a price less than its current carrying value. Accordingly, a provision for impairment of value of $1,895,000 was recognized in 1992 to reduce the carrying value based on the estimated economic loss to the Partnership. Carrying value includes cost of the property less accumulation depreciation and unamortized deferred financing costs. In July 1993, the Partnership disposed of The Cove Apartments through foreclosure, as discussed in Note 8, and recognized a $44,000 loss on disposition in 1993. 7. EXTRAORDINARY ITEM - GAIN ON EXTINGUISHMENT OF DEBT In June 1992, the Partnership obtained replacement financing on the Sandspoint and Greenspoint Apartments. The existing notes of $11,750,000 and $10,000,000 with an interest rate of 10 percent at June 30, 1992, which had been due in 1995, were prepaid at a discounted amount totalling $17,721,000. The replacement financing on the Sandspoint and Greenspoint Apartments totalled $9,820,000 and $8,430,000, respectively. In connection with the financing, the Partnership paid $727,000 in refinancing costs. The new financing agreement provides for a variable interest rate at 4.50 percent over a 90 day LIBOR interest rate. The current interest rate is 7.75 percent with a minimum pay rate of 10 percent. The notes will mature in 1995 with an option to extend the maturity date an additional two years. The agreement also required the Fund to transfer the properties into a separate wholly owned subsidiary and to cross-collateralize the properties as security for the loans. The discount amount of $4,029,000 plus accrued interest of $886,000 forgiven by the lender upon prepayment of the original financing, net of unamortized loan fees of $113,000 was recognized by the Partnership as extraordinary item - gain on extinguishment of debt in the 1992 consolidated financial statements. The Partnership had been negotiating debt modification or a discounted payoff with the lender of the loan on Shadow Lake Apartments but was unsuccessful. In an effort to obtain debt modification, the Partnership did not make the June 1992 debt service payment. The lender issued a notice of default and placed a receiver on the property on July 31, 1992. In December 1992, the Partnership sold Shadow Lake Apartments, located in Little Rock, Arkansas for $6,443,000. As part of the sale, a portion of the existing loan in the amount of $6,300,000 was repaid at the time of the sale. The lender forgave the remaining principal balance and accrued interest of $2,330,000. In connection with the property disposition, the Partnership incurred closing costs of $10,000. The net loss on sale was $257,000 which was recognized in 1992. The $2,330,000 amount forgiven by the lender net of unamortized financing costs of $110,000, was recognized as extraordinary item - gain on extinguishment of debt in the 1992 consolidated financial statements. 8. DISPOSITION OF RENTAL PROPERTIES In May 1993, the Partnership sold Parkside Village Apartments, located in Aurora, Colorado for $11,259,000. After payment of the existing loan of $7,667,000 and costs of the sale of $728,000 (including $281,000 real estate commission paid to an outside broker and $400,000 prepayment penalty on the existing loan), the net proceeds to the Partnership were $2,864,000. The carrying value of the property at the time of sale, net of the $1,895,000 provision for impairment of value recognized in 1992, was $9,955,000. The net gain on the sale was $576,000. In July 1993, the Partnership allowed The Cove Apartments, located in Tampa, Florida, to be acquired through foreclosure by the holder of the first loan. Accordingly, the Partnership was relieved of the first note payable of $16,000,000 (which had been due September 1994), $18,000 in accrued property taxes and $619,000 of accrued and unpaid interest. In addition, the expenses of disposition were $52,000. The carrying value of the property at the time of foreclosure, net of the $1,694,000 provision for impairment of value recognized in 1992, was $16,629,000. The net loss on disposition was $44,000 and was recognized in 1993. See Note 6. 9. SUBSEQUENT EVENT - SALE OF RENTAL PROPERTY In February 1994 the Partnership sold Plantation Forest Apartments, located in Atlanta, Georgia for $2,450,000. After payment of the existing loan of $1,965,000 and expenses of sale of $3,000, the proceeds to the Partnership were $482,000. The estimated loss on the sale of $149,000 will be recognized in the first quarter of 1994. A portion of the proceeds was used to fully repay the remaining and outstanding borrowings owed to an affiliate of the general partner. 10. RECONCILIATION TO INCOME TAX METHOD OF ACCOUNTING The differences between the accrual method of accounting for income tax reporting and the accrual method of accounting used in the consolidated financial statements are as follows: As to items omitted, amounts did not exceed one percent of total revenues. 1. COLUMN A - Description 2. COLUMN B - Encumbrances 3. COLUMN C - Initial cost to Partnership - Land 4. COLUMN C - Initial cost to Partnership - Buildings and Improvements 5. COLUMN D - Cost Capitalized Subsequent to Acquisition - Improvements 6. COLUMN D - Cost Capitalized Subsequent to Acquisition - Carrying Costs 7. COLUMN E - Gross Amount at Which Carried at Close of Period - Land 8. COLUMN E - Gross Amount at Which Carried at Close of Period - Buildings and Improvements 9. COLUMN E - Gross Amount at Which Carried at Close of Period - Total 10. COLUMN F - Accumulated Depreciation 11. COLUMN G - Year of Construction 12. COLUMN H - Date of Acquisition SCHEDULE XI CENTURY PROPERTIES FUND XIX (A LIMITED PARTNERSHIP) REAL ESTATE AND ACCUMULATED DEPRECIATION DECEMBER 31, 1993 NOTES: The aggregate cost for Federal income tax purposes is $91,986,000. Depreciation is computed on lives ranging from six to 30 years. Balance, January 1, 1991 $146,079,000 Improvements capitalized subsequent to acquisition 654,000 ------------ Balance, December 31, 1991 146,733,000 Improvements capitalized subsequent to acquisition 557,000 Cost of rental property disposed of (9,462,000) ------------ Balance, December 31, 1992 137,828,000 Improvements capitalized subsequent to acquisition 658,000 Cost of rental property disposed of (41,050,000) ------------ Balance, December 31, 1993 $ 97,436,000 ============ Balance, January 1, 1991 $ 32,499,000 Additions charged to expense 4,535,000 ------------ Balance, December 31, 1991 37,034,000 Additions charged to expense 3,784,000 Provision for impairment of value 3,589,000 Accumulated depreciation on rental property disposed of (2,772,000) ------------ Balance, December 31, 1992 41,635,000 Additions charged to expense 2,840,000 Accumulated depreciation on rental property disposed of (11,012,000) Allowance for impairment of value on rental properties disposed of (3,589,000) ------------ Balance, December 31, 1993 $29,874,000 =========== ITEM 9.

ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURES. Not applicable. PART III ITEM 10.

ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT. The Fund has no directors or executive officers. The following are the names and additional information relating to the directors and executive officers of NPI Equity II. On December 6, 1993, NPI Equity II became managing partner of FRI and acquired voting control and assumed operational control of Fox, thereby obtaining management and control of the general partner. By virtue of their positions with NPI Equity II, the listed individuals control the business affairs of the Fund. FRI, Fox and their affiliates, including NPI, serve directly or indirectly as general partner of 30 public partnerships. MICHAEL L. ASHNER (age 41) has been President and a Director of NPI since 1984, President and a Director of NPI Equity II since 1993 and President and a Director of Fox since December 6, 1993. Since 1991, Mr. Ashner has also served as a Director and President of NPI Equity Investments, Inc. ("NPI Equity I"), an affiliate of NPI Equity II, which serves as the general partner of the seven public NPI real estate limited partnerships. In addition, since 1981 Mr. Ashner has been President and sole shareholder of Exeter Capital Corporation, a firm which has organized and administered real estate limited partnerships. He received his A.B. degree cum laude from Cornell University and received a J.D. degree magna cum laude from the University of Miami School of Law, where he was an editor of the law review. Mr. Ashner is a member of the New Jersey, New York and Florida bar associations and is a member of the Executive Council of the Board of Directors of the National Multi Housing Council. MARTIN LIFTON (age 61) has been the Chairman and a Director of NPI since 1991 and NPI Equity II since 1993 and the Chairman and a Director of Fox since December 6, 1993. In addition, since 1991, Mr. Lifton has served as the Chairman and a Director of NPI Equity I. Mr. Lifton is also Chairman and President of Lifton Company, a real estate investment firm. Since entering the real estate business 35 years ago, Mr. Lifton has engaged in a wide range of real estate activities, including the purchase and construction of apartment complexes in the New York metropolitan area and in the southeastern and midwestern United States. Mr. Lifton was also one of the founders of the Bank of Great Neck of which he is Chairman and a major stockholder. Mr. Lifton received his B.S. degree from the New York University School of Commerce where he majored in real estate. ARTHUR N. QUELER (age 47) was a co-founder of NPI, of which he has been Executive Vice President and a Director since 1984. Mr. Queler has also been Executive Vice President and a Director of NPI Equity II since 1993 and of Fox since December 6, 1993. Since 1991, Mr. Queler has been Executive Vice President and a Director of NPI Equity I. In addition, since 1983 Mr. Queler has been President of ANQ Securities, Inc., a NASD registered broker-dealer firm which has been responsible for supervision of licensed brokers and coordination with a nationwide broker-dealer network for the marketing of NPI investment programs. Prior to 1983, Mr. Queler was a managing general partner of Berg Harquel Associates, a real estate syndication firm, in which capacity he was involved in the acquisition, syndication and management of 23 properties. Mr. Queler is a certified public accountant. He received B.B.A. and M.B.A. degrees from the City College of New York. Messrs. Ashner, Lifton and Queler currently are the beneficial owners of all of the outstanding stock of NPI. ITEM 11.

ITEM 11. EXECUTIVE COMPENSATION The Fund does not pay or employ any directors or officers. Compensation to the directors and officers of Fox, the managing general partner of the general partner, and to the partners of FRI, a general partner of the general partner, is paid directly by Fox and FRI, as the case may be. The Fund has not established any plans pursuant to which plan or non-plan compensation has been paid or distributed during the last fiscal year or is proposed to be paid or distributed in the future, nor has the Fund issued or established any options or rights relating to the acquisition of its securities or any plans relating to such options or rights. However, the general partner of the Fund has received and is expected to receive certain allocations, distributions and other amounts pursuant to the Fund's limited partnership agreement. ITEM 12.

ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT. There is no person known to the Fund who owns beneficially or of record more than five percent of the voting securities of the Fund. Other than the 100 Limited Partnership Units which Fox purchased at or prior to the closing date, the Fund's general partners have not contributed any capital to the Fund. With respect to the ownership of 100 Limited Partnership Units, Fox has the same rights and entitlement as all other limited partners. However, the general partner has discretionary control over most of the decisions made by or for the Fund pursuant to the terms of the Fund's limited partnership agreement. The Fund has no directors or officers. The directors and executive officers of Fox and the partners of FRI, as a group, own less than one percent of the Fund's voting securities. There are no arrangements known to the Fund, the operation of which may, at a subsequent date, result in a change in control of the Fund. ITEM 13.

ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS. The Fund borrowed an additional $291,000 in 1993 from an affiliate of the general partner to provide cash for working capital needs. The Fund repaid $1,309,000 in principal and $86,000 in interest to an affiliate of the general partner in 1993. On December 6, 1993 an affiliate of NPI Equity II purchased the remaining and outstanding loans owed to an affiliate of the general partner. As of December 31, 1993 the Partnership had outstanding borrowings of $370,000 from an affiliate of the general partner to provide cash for working capital needs. These remaining notes bear interest at the prime rate plus one percent (prime rate was six percent at December 31, 1993) and are payable upon demand. In February 1994 the Partnership paid off all remaining and outstanding borrowings owed to an affiliate of the general partner. Interest charged on the notes was $57,000, $69,000 and $26,000 for the year ended December 31, 1993, 1992 and 1991, respectively. PART IV ITEM 14.

ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K. (a) 1., 2. and 3. See Item 8 of this Form 10-K for the Financial Statements of the Fund, Notes thereto, and Financial Statement Schedules. (A table of contents to Consolidated Financial Statements and Financial Statement Schedules is included in Item 8 and incorporated herein by reference.) (b) The following report on Form 8-K was required to be filed during the last quarter covered by this Report: DATE OF ITEM MONTH SUCH NUMBERS FILED REPORT REPORTED DESCRIPTION December 12/6/93 1 Changes in Control of Registrant (c) Financial Statement Schedules, if required by Regulation S-K, are included in Item 8. SIGNATURES Pursuant to the requirements of Section 13 or 15(d) 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. CENTURY PROPERTIES FUND XIX By: FOX PARTNERS II Its General Partner By: FOX CAPITAL MANAGEMENT CORPORATION A General Partner ("FOX") By: /s/ Michael L. Ashner ------------------------ Michael L. Ashner President Date: March 18, 1994 Pursuant to the requirements of the Securities Exchange Act of 1934, this Report has been signed below by the following persons on behalf of the registrant and in the capacities and on the date indicated. By: /s/ Michael L. Ashner By: /s/ Arthur N. Queler ---------------------- ---------------------- Michael L. Ashner Arthur N. Queler President and Director of Executive Vice President (Principal FOX Financial and Accounting Officer) and Director of FOX By: /s/ Martin Lifton -------------------- Martin Lifton Chairman and Director of FOX Date: March 18, 1994

4515_1993.txt

4515

1993

ITEM 1. BUSINESS American Airlines, Inc. (American or the Company), the principal subsidiary of AMR Corporation (AMR), was founded in 1934. For financial reporting purposes, American's operations fall within two major lines of business: the Air Transportation Group and the Information Services Group. AIR TRANSPORTATION GROUP The Air Transportation Group consists primarily of American's Passenger and Cargo divisions. AMERICAN'S PASSENGER DIVISION is one of the largest scheduled passenger airlines in the world. At the end of 1993, American provided scheduled jet service to 106 cities in the U.S. mainland and Hawaii, 28 in Latin America, 14 in Europe and 24 other destinations worldwide, including service to six cities provided through cooperative agreements with other airlines. AMERICAN'S CARGO DIVISION provides a full range of freight and mail services to shippers throughout the airline's system. In addition, through cooperative agreements with other carriers, it has the ability to transport shipments to virtually any country in the world. INFORMATION SERVICES GROUP The Information Services Group consists of three divisions of American: SABRE Travel Information Network (STIN), SABRE Computer Services (SCS) and SABRE Development Services (SDS). STIN provides travel reservation services through its computer reservation system, SABRE -- one of the largest privately owned, real-time computer systems in the world. SCS manages AMR's data processing centers, voice and data communications networks and local-area computer networks worldwide. SDS provides applications development, software solutions, consulting, and other technology services to other AMR units. Additional information regarding business segments is included in Note 11 to the consolidated financial statements. ROUTES AND COMPETITION AIR TRANSPORTATION Service over almost all of American's routes is highly competitive. Currently, any carrier deemed fit by the U.S. Department of Transportation (DOT) is free to operate scheduled passenger service between any two points within the U.S. and its possessions. On most of its routes, American competes with at least one, and usually more than one, major domestic airline including: America West Airlines, Continental Airlines, Delta Airlines, Northwest Airlines, Southwest Airlines, Trans World Airlines, United Airlines, and USAir. American also competes with national, regional, all-cargo, and charter carriers and, particularly on shorter segments, ground transportation. Most major air carriers have developed hub-and-spoke systems and schedule patterns in an effort to maximize revenue potential of their service. American currently operates six domestic hubs: Dallas/Fort Worth, Chicago O'Hare, Miami, Raleigh/Durham, Nashville, and San Juan, Puerto Rico. During 1993, American closed its hub operation at San Jose, California. United Airlines and Delta Airlines have large operations at American's Chicago and Dallas/Fort Worth hubs, respectively. The four American Eagle carriers owned by AMR Eagle, an AMR subsidiary, increase the number of markets the Air Transportation Group serves by providing connections to American at its hubs and certain other major airports. Simmons Airlines, Inc. serves Dallas/Fort Worth and Chicago. Flagship Airlines, Inc. serves Miami, Raleigh/Durham, Nashville, and New York John F. Kennedy International Airport. Executive Airlines, Inc. serves San Juan, Puerto Rico. Wings West Airlines, Inc. serves Los Angeles, Orange County and selected other airports in the western U.S. American's competitors also own, and have marketing agreements with, regional carriers which provide service at their major hubs. In addition to its extensive domestic service, American provides service to and from cities in various other countries, primarily across North, Central and South America and Europe. In 1991, American added service to 20 cities in 15 countries in Latin America with the acquisition of route authorities from Eastern Air Lines. In 1992, American added service from several U.S. gateway cities to London's Heathrow Airport with the acquisition of Trans World Airlines' route authorities. American's operating revenues from foreign operations were approximately $3.9 billion in 1993, $3.7 billion in 1992 and $2.7 billion in 1991. Additional information about the Company's foreign operations is included in Note 10 to the consolidated financial statements. Competition in international markets is generally subject to more extensive government regulation than domestic markets. In these markets, American competes with foreign-investor owned and national flag carriers and U.S. carriers that have been granted authority to provide scheduled passenger and cargo service between the U.S. and various overseas locations. American's operating authority in these markets is subject to aviation agreements between the U.S. and the respective countries, and in some cases, fares and schedules require the approval of the DOT and the relevant foreign governments. Because international air transportation is governed by bilateral or other agreements between the U.S. and the foreign country or countries involved, changes in U.S. or foreign government aviation policy could result in the alteration or termination of such agreements, diminish the value of such route authorities, or otherwise affect American's international operations. Bilateral relations between the U.S. and various foreign countries served by American are currently being renegotiated. On all of its routes, American's pricing decisions are affected by competition from other airlines, some of which have cost structures significantly lower than American's and can therefore operate profitably at lower fare levels. American and its principal competitors use inventory and yield management systems that permit them to vary the number of discount seats offered on each flight in an effort to maximize revenues. American believes that it has several advantages relative to its competition. Its fleet is young, efficient and quiet. It has a comprehensive domestic and international route structure, anchored by efficient hubs, which permit it to take full advantage of whatever traffic growth occurs. The Company believes American's AAdvantage frequent flyer program, which is the largest program in the industry, and its superior service also give it a competitive advantage. The major domestic carriers have some advantage over foreign competitors in their ability to generate traffic from their extensive domestic route systems. In many cases, however, U.S. carriers are limited in their rights to carry passengers beyond designated gateway cities in foreign countries. Some of American's foreign competitors are owned and subsidized by foreign governments. To improve their access to each others markets, various U.S. and foreign carriers have made substantial equity investments in, or established marketing relationships with, other carriers. COMPUTER RESERVATION SYSTEMS The complexity of the various schedules and fares offered by air carriers has fostered the development of electronic distribution systems. Travel agents and other subscribers access travel information and book airline, hotel and car rental reservations and issue airline tickets using these systems. American developed the SABRE computer reservation system (CRS), which is the one of the largest CRSs in the world. Competition among the CRS vendors is strong. Services similar to those offered through SABRE are offered by several air carriers and other companies in the U.S. and abroad, including: the Covia Partnership, owned by United Airlines, USAir and various foreign carriers; Worldspan, owned by Delta Airlines, Northwest Airlines, Trans World Airlines, and ABACUS Distribution Systems; and System One, owned by Continental Airlines. The SABRE CRS has several advantages relative to its competition. The Company believes that SABRE ranks first in market share among travel agents in the U.S. The SABRE CRS is furthering its expansion into international markets and continues to be in the forefront of technological innovation in the CRS industry. REGULATION GENERAL The Airline Deregulation Act of 1978 (Act) and various other statutes amending the Act, eliminated most domestic economic regulation of passenger and freight transportation. However, the DOT and the Federal Aviation Administration (FAA) still exercise certain regulatory authority over air carriers under the Federal Aviation Act of 1958, as amended. The DOT maintains jurisdiction over international route authorities and certain consumer protection matters, such as advertising, denied boarding compensation, baggage liability, and computer reservations systems. The DOT issued certain rules governing the CRS industry which became effective on December 7, 1992, and expire on December 31, 1997. The FAA regulates flying operations generally, including establishing personnel, aircraft and security standards. In addition, the FAA has implemented a number of requirements that the Air Transportation Group is incorporating into its maintenance program. These matters relate to, among other things, inspection and maintenance of aging aircraft, corrosion control, collision avoidance and windshear detection. Based on its current implementation schedule, the Air Transportation Group expects to be in compliance with the applicable requirements within the required time periods. The U.S. Department of Justice has jurisdiction over airline antitrust matters. The U.S. Postal Service has jurisdiction over certain aspects of the transportation of mail and related services. Labor relations in the air transportation industry are regulated under the Railway Labor Act, which vests in the National Mediation Board certain regulatory powers with respect to disputes between airlines and labor unions arising under collective bargaining agreements. FARES Airlines are permitted to establish their own domestic fares without governmental regulation, and the industry is characterized by substantial price competition. The DOT maintains authority over international fares, rates and charges. International fares and rates are also subject to the jurisdiction of the governments of the foreign countries which American serves. While air carriers are required to file and adhere to international fare and rate tariffs, many international markets are characterized by substantial commissions, overrides, and discounts to travel agents, brokers and wholesalers. Fare discounting by competitors has historically had a negative effect on American's financial results because American is generally required to match competitors' fares to maintain passenger traffic. During recent years, a number of new low-cost airlines have entered the domestic market and several major airlines have begun to implement efforts to lower their cost structures. Further fare reductions, domestic and international, may occur in the future. If fare reductions are not offset by increases in passenger traffic or changes in the mix of traffic that improves yields, the Air Transportation Group's operating results will be negatively impacted. AIRPORT ACCESS The FAA has designated four of the nation's airports -- Chicago O'Hare, New York Kennedy, New York LaGuardia, and Washington National - -- as "high density traffic airports" and has limited the number of take-offs and landings per hour, known as slots, during peak demand time periods at these airports. Currently, the FAA permits the purchasing, selling and trading of these slots by airlines and others, subject to certain restrictions. During 1993, the DOT issued final rules allowing air carriers to convert up to 50 percent of their commuter slots at Chicago O'Hare for use by jets with fewer than 110 seats. Certain foreign airports, including London Heathrow, a major European destination for American, also have slot allocations. The Air Transportation Group currently has sufficient slot authorizations to operate its existing flights and has generally been able to obtain slots to expand its operations and change its schedules. There is no assurance, however, that the Air Transportation Group will be able to obtain slots for these purposes in the future, because, among other factors, slot allocations are subject to changes in government policies. ENVIRONMENTAL MATTERS The Company is subject to various laws and government regulations concerning environmental matters and employee safety and health in the U.S. and other countries. U.S. federal laws that have a particular impact on the Company include the Airport Noise and Capacity Act of 1990 (ANCA), the Clean Air Act, and the Comprehensive Environmental Response, Compensation and Liability Act (CERCLA or the Superfund). The Company is also subject to the oversight of Occupational Safety and Health Administration (OSHA) concerning employee safety and health matters. The U.S. Environmental Protection Agency (EPA), OSHA, and other federal agencies have been authorized to promulgate regulations that have an impact on the Company's operations. In addition to these federal activities, various states have been delegated certain authorities under the aforementioned federal statutes. Many state and local governments have adopted environmental and employee safety and health laws and regulations, some of which are similar to federal requirements. As a part of its continuing environmental program, the Company has maintained compliance with such requirements without any material adverse effect on its business. The ANCA requires the phase-out by December 31, 1999, of Stage II aircraft operations, subject to certain exceptions. Under final regulations issued by the FAA in 1991, air carriers are required to reduce, by modification or retirement, the number of Stage II aircraft in their fleets 25 percent by December 31, 1994; 50 percent by December 31, 1996; 75 percent by December 31, 1998, and 100 percent by December 31, 1999. Alternatively, a carrier may satisfy the regulations by operating a fleet that is at least 55 percent, 65 percent, 75 percent, and 100 percent Stage III by the dates set forth in the preceding sentence, respectively. The ANCA recognizes the rights of airport operators with noise problems to implement local noise abatement programs so long as they do not interfere unreasonably with interstate or foreign commerce or the national air transportation system. Authorities in several cities have promulgated aircraft noise reduction programs, including the imposition of night-time curfews. The ANCA generally requires FAA approval of local noise restrictions on Stage III aircraft first effective after October 1990, and establishes a regulatory notice and review process for local restrictions on Stage II aircraft first proposed after October 1990. At December 31, 1993, approximately 83 percent of American's fleet was Stage III. While American has had sufficient scheduling flexibility to accommodate local noise restrictions imposed to date, American's operations could be adversely affected if locally- imposed regulations become more restrictive or widespread. The Clean Air Act provides that state and local governments may not adopt or enforce aircraft emission standards unless those standards are identical to the federal standards. The engines on American's aircraft meet the EPA's turbine engine emissions standards. American has been identified by the EPA as a potentially responsible party (PRP) with respect to the following Superfund Sites: Operating Industries, Inc., California; Cannons, New Hampshire; Byron Barrel and Drum, New York; Palmer PSC, Massachusetts; Frontier Chemical, New York and Duffy Brothers, Massachusetts. American has settled the Operating Industries, Cannons and Byron Barrel and Drum matters, and all that remains to complete these matters are administrative tasks. With respect to the Palmer PSC, Frontier Chemical and Duffy Brothers sites, American is one of several PRPs named at each site. Although they are Superfund Sites, American's alleged waste disposal is minor compared to the other PRPs. American does not expect these matters, individually or collectively, to have a material impact on its financial condition, operating results or cash flows. LABOR The airline business is labor intensive. On December 31, 1993, American had approximately 95,800 employees. Wages, salaries and benefits represented nearly 35 percent of American's consolidated operating expenses for the year ended December 31, 1993. To improve its competitive position, American has undertaken various steps to reduce its unit labor costs, including workforce reductions. The majority of American's employees are represented by labor unions and covered by collective bargaining agreements. American's relations with such labor organizations are governed by the Railway Labor Act. Under this act, the collective bargaining agreements among American and these organizations become amendable upon the expiration of their stated term. If either party wishes to modify the terms of any such agreement, it must notify the other party before the contract becomes amendable. After receipt of such notice, the parties must meet for direct negotiations, and if no agreement is reached, either party may request that a federal mediator be appointed. If no agreement is reached in mediation, the National Mediation Board may determine, at any time, that an impasse exists and may proffer arbitration. Either party may decline to submit to arbitration. If arbitration is rejected, a 30-day "cooling-off" period commences, following which the labor organization may strike and the airline may resort to "self-help," including the imposition of its proposed amendments and the hiring of replacement workers. American's collective bargaining agreement with the Association of Professional Flight Attendants became amendable on December 31, 1992. The National Mediation Board declared a cooling-off period in the negotiations in September 1993, following a long period of negotiation and mediation. After enduring a five-day strike by the union in November, American agreed to resolve the remaining issues through binding arbitration. American imposed certain contract amendments after the union declared the strike. The arbitration process is expected to be complex and will likely not be decided for several months. While the ultimate outcome is uncertain, the new contract will likely result in higher unit labor costs in 1994. American's collective bargaining agreements with the Allied Pilots Association and Flight Engineers International Association become amendable on August 31, 1994. American's collective bargaining agreement with the Transport Workers Union becomes amendable on March 1, 1995. FUEL American's operations are significantly affected by the availability and price of jet fuel. American's fuel costs and consumption for the years 1989 through 1993 were: Based upon American's 1993 fuel consumption, a one-cent change in the average annual price-per-gallon of jet fuel caused a change of approximately $2.5 million in American's monthly fuel costs. American's fuel cost in 1993 decreased 2.4 percent over the prior year, primarily due to a 4.9 percent decrease in the average price per gallon, offset by a 2.7 percent increase in gallons consumed. Changes in fuel prices have industry-wide impact and benefit or harm American's competitors as well as American. Accordingly, lower fuel prices may be offset by increased price competition and lower revenues for all air carriers. Fuel prices may increase in the future. There can be no assurance that American will be able to pass such cost increases on to its customers by increasing fares in the future. Most of American's fuel is purchased pursuant to contracts which, by their terms, may be terminated upon short notice. While American does not anticipate a significant reduction in fuel availability, dependency on foreign imports of crude oil and the possibility of changes in government policy on jet fuel production, transportation and marketing make it impossible to predict the future availability of jet fuel. If there were major reductions in the availability of jet fuel, American's business would be adversely affected. FREQUENT FLYER PROGRAM American established the AAdvantage frequent flyer program (AAdvantage) to develop passenger loyalty by offering awards to travelers for their continued patronage. AAdvantage members earn mileage credits for flights on American, American Eagle, or certain flights on participating airlines, or by utilizing services of other program participants, including hotels, car rental companies, and bank credit card issuers. In addition, American periodically offers special short-term promotions which allow members to earn additional free travel awards or mileage credits. American reserves the right to change the AAdvantage program rules, regulations, travel awards and special offers at any time. American may initiate changes impacting, for example, participant affiliations, rules for earning mileage credit, mileage levels and awards, blackout dates and limited seating for travel awards, and the features of special offers. American reserves the right to end the AAdvantage program with six months notice. Mileage credits can be redeemed for free, discounted or upgraded travel on American, American Eagle or participating airlines, or for other travel industry awards. Once a member accrues sufficient mileage for an award, the member may request an award certificate from American. Award certificates may be redeemed up to one year after issuance. Most travel awards are subject to blackout dates and capacity control seating. All miles earned after July 1989 must be redeemed within three years or they expire. American accounts for its frequent flyer obligation on an accrual basis using the incremental cost method. American's frequent flyer liability is accrued each time a member accumulates sufficient mileage in his or her account to claim the lowest level of free travel award (20,000 miles) and such award is expected to be used for free travel on American. American includes fuel, food, and reservations/ticketing costs, but not a contribution to overhead or profit, in the calculation of incremental cost. The cost for fuel is estimated based on total fuel burn traced by day by various categories of markets, with an amount allocated to each passenger. Food costs are tracked monthly by market category, with an amount allocated to each passenger. Reservation/ticketing costs are based on the total number of passengers (including those traveling on free awards) divided into American's total expense for these costs. No accounting is performed for non-travel awards redeemed since the cost to American, if any, is de minimis. At December 31, 1993 and 1992, American estimated that approximately 3.9 million and 3.7 million free travel awards, respectively, were eligible for redemption. At December 31, 1993 and 1992, American estimated that approximately 3.6 million and 3.4 million free travel awards, respectively, were expected to be redeemed for free travel on American. In making this estimate, American has excluded mileage in inactive accounts, mileage related to accounts that have not yet reached the lowest level of free travel award, mileage that is not expected to ever be redeemed for free travel, and mileage related to accounts that have reached the lowest level of free travel award but are estimated based on historical data to be redeemed for discounts and upgrades, free travel on participating airlines other than American, or services other than free travel, for which American has no obligation to pay the provider of those services. The liability for the program mileage that has reached the lowest level of free travel award and is expected to be redeemed for free travel on American and deferred revenues for mileage sold to others participating in the program was $380 million and $285 million, representing 9.0 percent and 5.6 percent of American's total current liabilities, at December 31, 1993 and 1992, respectively. The number of free travel awards used for travel on American during the years ended December 31, 1993, 1992 and 1991 was approximately 2,163,000, 1,474,000, and 1,237,000, respectively, representing 9.5 percent, 6.0 percent and 5.3 percent of total revenue passenger miles for each period, respectively. American believes displacement of revenue passengers is insignificant given American's load factors, its ability to manage frequent flyer seat inventory and the relatively low ratio of free award usage to revenue passenger miles. Effective February 1, 1995, the lowest level of free travel award will increase from 20,000 to 25,000 miles. OTHER MATTERS SEASONALITY AND OTHER FACTORS The Air Transportation Group's results of operations for any interim period are not necessarily indicative of those for the entire year, since the air transportation business is subject to seasonal fluctuations. Higher demand for air travel has traditionally resulted in more favorable operating results for the second and third quarters of the year than for the first and fourth quarters. The results of operations in the air transportation business have also significantly fluctuated in the past in response to general economic conditions. In addition, fare initiatives, fluctuations in fuel prices, labor strikes and other factors could impact this seasonal pattern. Unaudited quarterly financial data for the two-year period ended December 31, 1993, is included in Note 12 to the consolidated financial statements. No material part of the business of American and its subsidiaries is dependent upon a single customer, or very few customers. Consequently, the loss of the Company's largest few customers would not have a materially adverse effect upon American. INSURANCE American carries insurance for public liability, passenger liability, property damage and all-risk coverage for damage to its aircraft, in amounts which, in the opinion of management, are adequate. OTHER GOVERNMENT MATTERS In time of war or during an unlimited national emergency or civil defense emergency, American and other major air carriers may be required to provide airlift services to the Military Airlift Command under the Civil Reserve Air Fleet program. ITEM 2.

ITEM 2. PROPERTIES FLIGHT EQUIPMENT Owned and leased aircraft operated by American at December 31, 1993, included: For information concerning the estimated useful lives and residual values for owned aircraft, lease terms and amortization relating to aircraft under capital leases, and acquisitions of aircraft, see Notes 1, 3 and 4 to the consolidated financial statements. See Management's Discussion and Analysis for discussion of the retirement of certain widebody aircraft from the fleet. Lease expirations for American's leased aircraft included in the above table as of December 31, 1993, were: The table excludes leases for 15 Boeing 767-300 Extended Range aircraft which can be canceled with 30 days' notice during the first 10 years of the lease term. At the end of that term in 1998, the leases can be renewed for periods ranging from 10 to 12 years. The table also excludes one Boeing 737-200 and four Boeing 737-300 aircraft which have been subleased and one McDonnell Douglas DC-10-30 aircraft which has been grounded. Substantially all of American's aircraft leases include an option to purchase the aircraft or to extend the lease term, or both, with the purchase price or renewal rental to be based essentially on the market value of the aircraft at the end of the term of the lease or at a predetermined fixed rate. GROUND PROPERTIES American leases, or has built as leasehold improvements on leased property, most of its airport and terminal facilities; certain corporate office, maintenance and training facilities in Fort Worth, Texas; its principal overhaul and maintenance base and computer facility at Tulsa International Airport, Tulsa, Oklahoma; its regional reservation offices; and local ticket and administration offices throughout the system. American has entered into agreements with the Tulsa Municipal Airport Trust; the Alliance Airport Authority, Fort Worth, Texas; and the Dallas/Fort Worth, Chicago O'Hare, Raleigh/Durham, Nashville, San Juan, New York, and Los Angeles airport authorities to provide funds for, among other things, additional facilities and equipment, and improvements and modifications to existing facilities, which equipment and facilities are or will be leased to American. American also utilizes public airports for its flight operations under lease arrangements with the municipalities or governmental agencies owning or controlling them and leases certain other ground equipment for use at its facilities. For information concerning the estimated lives and residual values for owned ground properties, lease terms and amortization relating to ground properties under capital leases, and acquisitions of ground properties, see Notes 1, 3 and 4 to the consolidated financial statements. ITEM 3.

ITEM 3. LEGAL PROCEEDINGS In December 1992, the U.S. Department of Justice filed an antitrust lawsuit in the U.S. District Court for the District of Columbia under Section 1 of the Sherman Act against several airlines, including the Company, alleging price fixing based upon the industry's exchange of fare information through the Airline Tariff Publishing Company. In March 1994, the Company and the remaining defendants in the case agreed to settle the lawsuit without admitting liability by entering into a stipulated final judgment that prohibits or restricts certain pricing practices including the announcement of fare increases before their effective date. The proposed final judgment is subject to approval by the Court following a public notice and comment period prescribed by statute. The Company does not anticipate a material financial impact from the settlement or compliance with the stipulated judgment. Private class action claims with similar allegations were settled by the Company and other airlines which became final in March 1993. Prior to the private class action settlement becoming final, the Company and several other airlines voluntarily altered certain pricing practices at issue in the lawsuits to avoid exposure to additional claims. American has been sued in two class action cases that have been consolidated in the Circuit Court of Cook County, Illinois, in connection with certain changes made to American's AAdvantage frequent flyer program in May, 1988. (Wolens, et al v. American Airlines, Inc., No. 88 CH 7554, and Tucker v. American Airlines, Inc., No. 89 CH 199.) In both cases, the plaintiffs seek to represent all persons who joined the AAdvantage program before May 1988. The complaints allege that, on that date, American implemented changes that limited the number of seats available to participants traveling on certain awards and established holiday blackout dates during which no AAdvantage seats would be available for certain awards. The plaintiffs allege that these changes breached American's contracts with AAdvantage members and were in violation of the Illinois Consumer Fraud and Deceptive Business Practices Act (Consumer Fraud Act). Plaintiffs seek money damages of an unspecified sum, punitive damages, costs, attorneys fees and an injunction preventing the Company from making any future changes that would reduce the value of AAdvantage benefits. American moved to dismiss both complaints, asserting that the claims are preempted by the Federal Aviation Act and barred by the Commerce Clause of the U.S. Constitution. The trial court denied American's preemption motions, but certified its decision for interlocutory appeal. In December 1990, the Illinois Appellate Court held that plaintiffs' claims for an injunction are preempted by the Federal Aviation Act, but that plaintiffs' claims for money damages could proceed. On March 12, 1992, the Illinois Supreme Court affirmed the decision of the Appellate Court. American sought a writ of certiorari from the U.S. Supreme Court; and on October 5, 1992, that Court vacated the decision of the Illinois Supreme Court and remanded the cases for reconsideration in light of the U.S. Supreme Court's decision in Morales v. TWA, et al, which interpreted the preemption provisions of the Federal Aviation Act very broadly. On December 16, 1993, the Illinois Supreme Court rendered its decision on remand, holding that plaintiffs' claims seeking an injunction were preempted, but that identical claims for compensatory and punitive damages were not preempted. On February 8, 1994, American filed petition for a writ of certiorari in the U.S. Supreme Court. The Illinois Supreme Court granted American's motion to stay the state court proceeding pending disposition of American's petition in the U.S. Supreme Court. AMR and American are vigorously defending all of the above claims. ITEM 4.

ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS Omitted under the reduced disclosure format pursuant to General Instruction J(2)(c) of Form 10-K. PART II ITEM 5.

ITEM 5. MARKET FOR REGISTRANT'S COMMON STOCK AND RELATED STOCKHOLDER MATTERS American is a wholly-owned subsidiary of AMR Corporation and there is no market for the Registrant's Common Stock. ITEM 6.

ITEM 6. SELECTED CONSOLIDATED FINANCIAL DATA Omitted under the reduced disclosure format pursuant to General Instruction J(2)(a) of Form 10-K. ITEM 7.

ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (Abbreviated pursuant to General Instruction J(2)(a) of Form 10-K). HIGHLIGHTS SUMMARY American's net income in 1993 was $23 million. The 1993 results reflect the negative impact of a five-day strike by the union representing American's flight attendants in November. The results also include a $125 million charge ($79 million after tax) for the retirement of certain DC-10 aircraft and a positive $115 million adjustment to revenues ($67 million net of related commission expense and taxes) for a change in estimate related to certain earned passenger revenues. In 1992, American recorded a net loss of $735 million. The loss for 1992, before the effect of the adoption of two new mandatory accounting standards, was $274 million. The Company's 1993 operating income was $564 million, compared to an operating loss of $77 million in 1992. In the first quarter of 1993, AMR created and began implementing a new strategic framework, known as the Transition Plan. The Plan has three parts, each intended to improve results. First, make AMR's core airline business bigger and stronger where economically justified. Second, and conversely, shrink the airline where it cannot compete profitably. Third, reallocate resources and effort to AMR and American's growing information and management services businesses which are more profitable than the airline. Major events relating to the Transition Plan in 1993 included: . The SABRE Technology Group -- later renamed The SABRE Group -- was formed during the second quarter of 1993. . American announced its decision to retire 42 widebody DC-10 jets to reduce the airline's capacity and lower operating expenses. . American shifted domestic capacity to its major hubs in Dallas/Fort Worth and Miami. The AMR Eagle carriers added or increased service in certain other markets as American reduced or withdrew jet service. . American significantly reduced service at San Jose, California. . To provide increased value to business customers, American expanded its successful three-class transcontinental service to new markets, added more frequent flights on business routes such as Dallas/Fort Worth - Chicago, and added more first class seats on some narrowbody aircraft. . American increased capacity in Latin America by 17.5 percent over 1992. American's 1993 results benefited from strengthened domestic revenues in comparison to 1992. American's 1992 domestic revenues suffered from competitive fare reductions below the levels American established in its Value Pricing Plan in April 1992. European revenues, however, were negatively impacted in 1993 by aggressive fare discounting by competitors, weak European economies and a stronger U.S. dollar. The Company's 1993 results also reflect the dramatic adverse impact of a five-day strike by American's flight attendants' union in November. The strike's after-tax impact on fourth quarter results, estimated at $190 million, offset earnings generated earlier in the year. With the downsizing of unprofitable operations, American's workforce began to decline following years of double-digit percentage increases. In 1993, American provided $25 million for employee severance, primarily management/specialist and operations employees. REVENUES 1993 COMPARED TO 1992 American's operating revenues increased 8.4 percent to $14.7 billion in 1993, compared to $13.6 billion in 1992. Passenger revenues rose 8.4 percent, $1.0 billion, primarily as a result of an 8.8 percent increase in passenger yield (the average amount one passenger pays to fly one mile), partially offset by a 0.3 percent decline in passenger traffic. American's passenger yield in 1993 increased to 13.28 cents, primarily as a result of a very weak comparison base of 1992, when revenues were negatively impacted by competitors' drastic discounting of domestic fares. For the year, domestic yield increased 13.5 percent. International yield was mixed, increasing 13.9 percent in the Pacific, unchanged in Latin America and declining 10.1 percent in Europe. In 1993, American derived 73.8 percent of its passenger revenues from domestic operations and 26.2 percent from international operations. Although American's system capacity, as measured by available seat miles (ASMs), increased 5.2 percent, its traffic, as measured by revenue passenger miles (RPMs), decreased 0.3 percent. The drastic fare discounting drove traffic up to record levels in 1992. Traffic suffered in 1993 from American's inability to carry passengers during the flight attendants' union strike in November and the adverse effect of the strike on passenger demand during the month of December. American's domestic traffic decreased 3.5 percent, to 69.7 billion RPMs, while domestic capacity grew 2.9 percent. International traffic grew 9.1 percent, to 27.5 billion RPMs on capacity growth of 12.1 percent. The increase in international traffic was led by a 14.7 percent increase in Latin America on capacity growth of 17.5 percent, and a 7.4 percent increase in Europe on capacity growth of 10.8 percent. Cargo revenues increased 10.4 percent, $60 million, driven by a 22.5 percent increase in American's domestic and international cargo volumes, partially offset by decreasing yields brought about by strong price competition resulting from excess industry capacity. Other revenues, consisting of service fees, liquor revenues, duty-free sales, tour marketing and miscellaneous other revenues, increased 5.2 percent, $26 million, primarily as a result of increased traffic. Information Services Group revenues increased 7.3 percent, $79 million, primarily due to increased booking fees resulting from growth in booking volumes and average fees collected from participating vendors. EXPENSES 1993 COMPARED TO 1992 Operating expenses increased 3.8 percent, $515 million. American's capacity increased 5.2 percent, to 160.9 billion ASMs, due primarily to the addition of new aircraft. American's Passenger Division cost per ASM decreased by 2.0 percent, to 8.25 cents. Wages, salaries and benefits rose 5.1 percent, $237 million, due to wage and salary adjustments for existing employees and rising health-care costs. In addition, during the fourth quarter, American recorded a $25 million severance provision in conjunction with layoffs and voluntary terminations of management/specialist and operations personnel. Aircraft fuel expense decreased 2.4 percent, $44 million, due to a 4.9 percent decrease in the average price per gallon, partially offset by a 2.7 percent increase in gallons consumed. The average price per gallon decreased from $0.65 per gallon in 1992 to $0.62 per gallon in 1993. American consumed an average of 245 million gallons of fuel each month. A one-cent decline in fuel prices saves approximately $2.5 million per month. Commissions to agents increased 10.3 percent, $130 million, due principally to increased passenger revenues and increased incentives for travel agents. Depreciation and amortization increased 16.4 percent, $157 million, primarily due to the addition of 44 owned jet aircraft and other capital equipment. Food service cost was flat, reflecting the 9.1 percent increase in international traffic, where food costs are greater, offset by the 3.5 percent decrease in domestic traffic. Maintenance materials and repairs expense decreased 8.9 percent, $53 million, due principally to the retirement of older aircraft and increased operational efficiencies. Other operating expenses (including crew travel expenses, booking fees, purchased services, communications charges, credit card fees and advertising) increased 2.4 percent, $54 million, primarily due to the increase in capacity and an increase in fees paid to affiliates for passengers connecting with American flights. Interest capitalized decreased 50.0 percent, $49 million, as a result of the decrease in the average balance during the year of purchase deposits for flight equipment and the decline in interest rates. Miscellaneous - net for 1993 includes a $125 million charge related to the retirement of 31 DC-10 aircraft. Included in Miscellaneous - net for 1992 is a $14 million provision for a cash payment representing American's share of a multi-carrier antitrust settlement. OTHER INFORMATION DEFERRED TAX ASSETS As of December 31, 1993, the Company had deferred tax assets aggregating approximately $2.0 billion, including approximately $337 million of alternative minimum tax (AMT) credit carryforwards. The Company believes substantially all the deferred tax assets, other than the AMT credit carryforwards, will be realized through reversal of existing taxable temporary differences. The Company anticipates using its AMT credit carryforwards, which are available for an indefinite period of time, against its future regular tax liability within the next 10 years for several reasons. Although the Company incurred net losses in 1990 through 1993, it recorded substantial income before taxes and taxable income during the seven-year period 1983 through 1989 of approximately $3.2 billion and $1.8 billion, respectively. The Company is aggressively pursuing revenue enhancement and cost reduction initiatives to restore profitability. The Company has also substantially curtailed its planned capital spending program, which will accelerate the reversal of depreciation differences between financial and tax income, thus increasing taxable income. ENVIRONMENTAL MATTERS American has been notified of potential liability with regard to several environmental cleanup sites. At sites where remedial litigation has commenced, potential liability is joint and several. American's alleged volumetric contributions at the sites are minimal. American does not expect these actions, individually or collectively, to have a material impact on its financial condition, operating results or cash flows. DISCOUNT RATE Due to the decline in interest rates during 1993, the discount rate used to determine the Company's pension obligations as of December 31, 1993 and the related expense for 1994, has been reduced. The impact on 1994 pension expense of the change in the discount rate will be substantially offset by the significant appreciation in the market value of pension plan assets experienced during 1993. PROPOSED SETTLEMENT OF LITIGATION During 1992, American and certain other carriers agreed to settle various class action claims, subject to approval by the U.S. District Court for the Northern District of Georgia. Under the terms of the agreement, the carriers paid a total of approximately $50 million in cash and will jointly issue and distribute approximately $408 million in face amount of certificates for discounts of approximately 10 percent on future air travel on any of the carriers. A liability has not been established for the certificate portion of the settlement since American expects that, in the aggregate, future revenues received upon redemption of the certificates will exceed the related cost of providing the air travel. American anticipates that the share of the certificates redeemed on American may represent, but is not limited to, American's 26 percent market share among the carriers. The ultimate impact of the settlement on American's revenues, operating margins and earnings is not reasonably estimable since both the portion of certificates to be redeemed on American and the stimulative or depressive effect of the certificate redemption on revenues is not known. OUTLOOK FOR 1994 During 1993, AMR completed a comprehensive review of the competitive realities of its businesses and determined that it must change significantly in order to generate sufficient earnings. The fundamental problems of the airline -- increasing competition from low- cost, low-fare carriers, its inability to reduce labor costs to competitive levels, and the changing values of its customers -- demand new solutions. As an initial response to that need, AMR created and began implementing a new strategic framework known as the Transition Plan. The plan has three parts, each intended to improve AMR's results. First, make the core airline business bigger and stronger where economically justified. Second, and conversely, shrink the airline where it cannot compete profitably. Third, reallocate resources and effort to the growing information and management services businesses, which are more profitable than the airline. An integral part of the Transition Plan is the expansion of the business activities of The SABRE Group. The SABRE Group was formed as a business unit during 1993, integrating reporting relationships among American's STIN, SCS and SDS divisions and AMR's other information technology businesses. AMR plans to more fully develop and market its distinct information technology expertise through The SABRE Group and continues to investigate opportunities for further expanding its information technology businesses. These opportunities may include the combination of marketing and/or developmental functions of The SABRE Group businesses and/or a formal reorganization of The SABRE Group into one or more subsidiaries of AMR. This formal reorganization, if concluded, would likely involve the transfer to AMR, by means of a dividend, of American's STIN, SCS and SDS divisions. In addition, a formal reorganization would also result in the Company's compliance with a recent directive from the European Community Council of Ministers that, in effect, requires that a CRS operating in the European Community have a legal status that is separate and apart from its affiliated airline. Further, the Transition Plan recognizes the unfavorable and uncertain economics which have characterized the core airline business in recent years, acknowledges the airline cost problem and seeks to maximize the contribution of the Company's more profitable businesses. In 1994, AMR will continue the course of change initiated in 1993 under the Transition Plan. Over the long term, AMR will continue its best efforts to reduce airline costs and to restore the airline operations to profitability. Based on the success or failure of those efforts, AMR will make ongoing determinations as to the appropriate degree of reallocation of resources from the airline operations to its other businesses, which may include, if the airline cannot be run profitably, the disposition or termination, over the long term, of a substantial part or all of the airline operations. AIR TRANSPORTATION GROUP During 1993, American closed its hub and dramatically reduced operations at San Jose, California, and expanded its Dallas/Fort Worth and Miami hubs. The airline will continue to reduce or eliminate service where it cannot operate profitably. American's regional airline affiliates, subsidiaries of AMR Eagle, have added turboprop service on some routes where jet service has been canceled, and they will continue to pursue these opportunities in 1994. In 1993, American removed 21 McDonnell Douglas DC-10 and 28 Boeing 727 aircraft from service. In 1994, an additional 14 DC- 10s and 31 727s will be retired. As a result, in 1994 American's available seat miles are expected to decrease by almost five percent. Domestic capacity will drop by almost seven percent, while international capacity will increase slightly. The capacity reduction will be the first at American since 1981. Aircraft retirements have necessitated the furlough of about 3,700 American employees since late 1992. The Company anticipates further workforce reductions in 1994 and, accordingly, made a provision for the cost of these reductions in 1993. Fewer aircraft deliveries will also translate into lower capital spending. American's revenue plan for 1994 reflects continued emphasis on producing premium yields by attracting more full fare passengers than its competitors. As part of this plan, American will expand its successful three-class domestic transcontinental service, add more first class seats on some narrowbody aircraft and increase frequencies in business-oriented markets. In addition, American will seek to grow its cargo revenues again in 1994. In 1993, American's Passenger Division cost per available seat mile declined by 2.0 percent, largely due to a 4.9 percent drop in the cost of jet fuel. In 1994, though American will continue its rigorous program of cost control, it expects units costs, excluding fuel, to rise modestly. This increase will be driven by higher unit labor costs due to pay scale and average seniority escalations. On August 10, 1993, the Omnibus Budget Reconciliation Act was signed into law, imposing a new 4.3 cents per gallon tax on commercial aviation jet fuel for use in domestic operations. The new tax will become effective October 1, 1995, and is scheduled to continue until October 1, 1998. American estimates the resulting annual increase in fuel taxes will be approximately $90 million. AMR instituted a program in the latter half of 1993 to reduce interest costs. At year-end interest rates, the Company anticipates that this program, which involves such things as interest rate swaps, will produce significant interest cost savings. This savings is expected to largely offset the additional interest cost of new financings in 1994. In November 1993, American endured a five-day strike by its flight attendants' union; the strike ended when both sides agreed to binding arbitration. The arbitration process is expected to be complex and will likely not be decided for several months. While the ultimate outcome is uncertain, the new contract will likely result in higher unit labor costs in 1994. American's labor contract with its pilots' union becomes amendable in August 1994. The Company and the union leadership are pursuing opportunities to streamline the negotiation and settlement process. The ultimate outcome of these negotiations cannot be estimated at this time. INFORMATION SERVICES GROUP The integration of AMR's information services businesses will continue in 1994 with the integration of American Airlines Decision Technologies, which is a subsidiary of AMR, SDS and other units in The SABRE Group into SABRE Decision Technologies (SDT). SDT will develop and market The SABRE Group's expanding array of information systems products and services to a growing list of airline and other customers throughout the world. STIN will seek to sustain its revenue growth through continued geographical expansion of the SABRE computerized reservation system and the sale of its leading-edge automated reservations products such as SABRExpress, SABRExpress Ticketing and SABRE TravelBase, a new travel agency accounting system. ITEM 8.

ITEM 8. CONSOLIDATED FINANCIAL STATEMENTS Page ---- Report of Independent Auditors 17 Consolidated Statement of Operations 18 Consolidated Balance Sheet 19 Consolidated Statement of Cash Flows 21 Consolidated Statement of Stockholder's Equity 22 Notes to Consolidated Financial Statements 23 REPORT OF INDEPENDENT AUDITORS The Board of Directors and Stockholder American Airlines, Inc. We have audited the accompanying consolidated balance sheets of American Airlines, Inc. as of December 31, 1993 and 1992, and the related consolidated statements of operations, stockholder's equity, and cash flows for each of the three years in the period ended December 31, 1993. Our audits also included the financial statement schedules listed in Item 14(a) on page 40. These financial statements and schedules are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements and schedules based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of American Airlines, Inc. at December 31, 1993 and 1992, and the consolidated results of its operations and its cash flows for each of the three years in the period ended December 31, 1993, in conformity with generally accepted accounting principles. Also, in our opinion, the related financial statement schedules, when considered in relation to the basic financial statements taken as a whole, present fairly in all material respects the information set forth therein. As discussed in Notes 7 and 8 to the consolidated financial statements, effective January 1, 1992, the Company changed its method of accounting for income taxes and postretirement benefits other than pensions. ERNST & YOUNG 2121 San Jacinto Dallas, Texas 75201 February 15, 1994 AMERICAN AIRLINES, INC. CONSOLIDATED STATEMENT OF OPERATIONS (in millions) The accompanying notes are an integral part of these financial statements. AMERICAN AIRLINES, INC. CONSOLIDATED BALANCE SHEET (in millions) The accompanying notes are an integral part of these financial statements. AMERICAN AIRLINES, INC. CONSOLIDATED BALANCE SHEET (in millions, except shares and par value) The accompanying notes are an integral part of these financial statements. AMERICAN AIRLINES, INC. CONSOLIDATED STATEMENT OF CASH FLOWS (in millions) The accompanying notes are an integral part of these financial statements. AMERICAN AIRLINES, INC. CONSOLIDATED STATEMENT OF STOCKHOLDER'S EQUITY (in millions) The accompanying notes are an integral part of these financial statements. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 1. SUMMARY OF ACCOUNTING POLICIES BASIS OF CONSOLIDATION American Airlines, Inc. (American or the Company) is a wholly-owned subsidiary of AMR Corporation (AMR). The consolidated financial statements include the accounts of American and its wholly-owned subsidiaries. All significant intercompany transactions have been eliminated. Certain amounts from prior years have been reclassified to conform with the 1993 presentation. TRANSACTIONS WITH AFFILIATES Transactions with affiliates are on a basis determined by the parties. American invests funds of affiliates in a combined short-term investment portfolio and passes through interest income on such funds at the average rate earned on the portfolio. To the extent funds transferred to American exceed the invested portfolio, such amounts are converted to Long-Term Debt due to Parent under a subordinated note agreement with AMR. To the extent American invests its excess cash flows in the short-term investment portfolio, Long-Term Debt due to Parent is reduced with a corresponding increase in Payables to Affiliates. The subordinated promissory note bears interest based on the London Interbank Offered Rate (LIBOR), 3.5 percent at December 31, 1993, and the interest rate is reset every six months. The note is due May 1, 2001; however, American may prepay the note without penalty at any time. Under the provisions of this note agreement, approximately $3.86 billion and $3.06 billion was included in Long-Term Debt due to Parent as of December 31, 1993 and 1992, respectively. Payables to Affiliates includes approximately $514 million and $801 million at December 31, 1993 and 1992, respectively, representing funds of affiliates transferred to American for investment and invested in the portfolio. Interest paid to affiliates in addition to interest income passed through on invested funds was approximately $132 million, $106 million and $93 million for the years ended December 31, 1993, 1992 and 1991, respectively. Interest expense includes $16 million for the years ended December 31, 1993 and 1992, and $15 million for the year ended December 31, and 1991, relating to debentures held by AMR calculated at a 9.03 percent effective interest rate. During 1991, AMR contributed $1.0 billion of capital to American by reducing American's obligation to AMR for invested funds. American paid affiliates $138 million, $110 million and $73 million in 1993, 1992 and 1991, respectively, for ground handling services provided at selected airports, data processing services, consulting services and investment management and advisory services with respect to short-term investments and the assets of its retirement benefit plans. American issues tickets for flights on AMR Eagle. As a result, the revenue collected for such tickets is prorated between American and AMR Eagle based on the segments flown by the respective carriers. In addition, in 1993, 1992 and 1991, American paid fees of $261 million, $213 million and $111 million, respectively, included in Other Operating Expenses, to AMR Eagle primarily for passengers connecting with American flights. American paid commissions of $4 million and $19 million to AMR Foreign Sales Corporation, Ltd., a subsidiary of AMR, in 1992 and 1991, respectively, for arranging certain aircraft sale and leaseback transactions. The commissions were recognized as adjustments to the deferred gains on these sales. American charges AMR affiliates for the use of its communications, accounting and information processing systems, as well as for other services. American recognizes compensation expense associated with certain AMR common stock-based awards for employees of American. INVENTORIES Spare parts, materials and supplies relating to flight equipment are carried at average cost and are expensed when used in operations. Allowances for obsolescence are provided, over the estimated useful life of the related aircraft and engines, for spare parts expected to be on hand at the date aircraft are retired from service. EQUIPMENT AND PROPERTY The provision for depreciation of operating equipment and property is computed on the straight-line method applied to each unit of property, except that spare assemblies are depreciated on a group basis. The depreciable lives and residual values used for the principal depreciable asset classifications are: * In connection with a review of its fleet plan, American changed, effective October 1, 1991, the estimated useful lives of its Boeing 727-200 aircraft and engines from a common retirement date of December 31, 1994, to projected retirement dates by aircraft, which results in an average depreciable life of approximately 21 years. ** During 1993, American announced its intention to retire a total of 36 McDonnell Douglas DC-10-10 and six McDonnell Douglas DC-10-30 aircraft. At December 31, 1993, 21 of those aircraft had been grounded. *** Approximate common retirement date. Equipment and property under capital leases are amortized over the term of the leases and such amortization is included in depreciation and amortization. Lease terms vary but are generally 10 to 25 years for aircraft and 7 to 40 years for other leased equipment and property. MAINTENANCE AND REPAIR COSTS Maintenance and repair costs for owned and leased flight equipment are charged to operating expense as incurred. INTANGIBLE ASSETS The Company continually evaluates intangible assets to determine whether current events and circumstances warrant adjustment of the carrying values or amortization periods. Route acquisition costs and airport operating and gate lease rights represent the purchase price attributable to route authorities, airport take-off and landing slots and airport gate leasehold rights acquired and are being amortized on a straight-line basis over 10 to 40 years. PASSENGER REVENUES Passenger ticket sales are initially recorded as a current liability. Revenue derived from the sale is recognized at the time transportation is provided. FREQUENT FLYER PROGRAM The estimated incremental cost of providing free travel awards is accrued when such award levels are reached. Revenues received for miles sold to others participating in the program are deferred and recognized over a period approximating the time transportation is provided. INCOME TAXES AMR and its eligible subsidiaries, including American, file a consolidated federal income tax return. Deferred income taxes reflect the net tax effects of temporary differences between the financial reporting carrying amounts of assets and liabilities and the income tax amounts. DEFERRED GAINS Gains on the sale and leaseback of equipment and property are deferred and amortized over the terms of the related leases as a reduction of rent expense. FOREIGN EXCHANGE CONTRACTS American enters into foreign exchange contracts as a hedge against certain amounts payable or receivable in foreign currencies. Market value gains or losses are recognized and offset against foreign exchange gains or losses on those obligations or receivables. FUEL SWAP CONTRACTS American enters into swap contracts to hedge against market price fluctuations of jet fuel. Gains or losses on these contracts are included in fuel expense when the underlying fuel being hedged is used. STATEMENT OF CASH FLOWS Short-term investments, without regard to remaining maturity at acquisition, are not considered as cash equivalents for purposes of the statement of cash flows. 2. SHORT-TERM INVESTMENTS Short-term investments consisted of (in millions): The fair value of short-term investments at December 31, 1993, by contractual maturity was (in millions): All short-term investments were classified as available-for-sale and stated at fair value. 3. COMMITMENTS AND CONTINGENCIES The Company has on order 36 jet aircraft - 16 Boeing 757-200s, seven Boeing 767-300ERs and 13 Fokker 100s scheduled for delivery through 1996. Deposits of $313 million have been made toward the purchase of these aircraft. Future payments, including estimated amounts for price escalation through anticipated delivery dates for these aircraft and related equipment will be approximately $600 million in 1994, $450 million in 1995 and $150 million in 1996, a portion of which is payable in foreign currencies. In addition to these commitments for aircraft, the Company has authorized expenditures of approximately $1.1 billion for aircraft modifications, renovations of, and additions to, airport and office facilities and various other equipment and assets. American expects to spend approximately $750 million of this amount in 1994. American has included an event risk covenant in approximately $2.9 billion of lease agreements. The covenant permits the holders of such instruments to receive a higher rate of return (between 50 and 700 basis points above the stated rate) if a designated event, as defined, should occur and the credit rating of the debentures or the debt obligations underlying the lease agreements is downgraded below certain levels. 3. COMMITMENTS AND CONTINGENCIES (CONTINUED) In July 1991, American entered into a five-year agreement whereby American transfers, on a continuing basis and with recourse to the receivables, an undivided interest in a designated pool of receivables. Undivided interests in new receivables are transferred daily as collections reduce previously transferred receivables. At December 31, 1993 and 1992, Receivables are presented net of approximately $300 million of such transferred receivables. American maintains an allowance for uncollectible receivables based upon expected collectibility of all receivables, including the receivables transferred. Special facility revenue bonds have been issued by certain municipalities, primarily to purchase equipment and improve airport facilities which are leased by American. In certain cases, the bond issue proceeds were loaned to American and are included in Long-Term Debt. Certain bonds have rates that are periodically reset and are remarketed by various agents. In certain circumstances, American may be required to purchase up to $413 million of the special facility revenue bonds prior to maturity, in which case American has the right to resell the bonds or to use the bonds to offset its lease or debt obligations. American may borrow the purchase price of these bonds under standby letter-of-credit agreements. At American's option, these letters of credit are secured by funds held by bond trustees and by approximately $448 million of short-term investments. 4. LEASES American leases various types of equipment and property, including aircraft, passenger terminals, equipment and various other facilities. The future minimum lease payments required under capital leases, together with the present value of net minimum lease payments, and future minimum lease payments required under operating leases that have initial or remaining non-cancelable lease terms in excess of one year as of December 31, 1993, were (in millions): * Future minimum payments required under capital leases and operating leases include $384 million and $6.0 billion, respectively, guaranteed by AMR relating to special facility revenue bonds issued by municipalities. ** The present value of future minimum lease payments includes $132 million guaranteed by American. At December 31, 1993, the Company had 235 jet aircraft under operating leases and 80 jet aircraft under capital leases. 4. LEASES (CONTINUED) The aircraft leases can generally be renewed at rates based on fair market value at the end of the lease term for one to five years. Most aircraft leases have purchase options at or near the end of the lease term at fair market value, but generally not to exceed a stated percentage of the defined lessor's cost of the aircraft. Of the aircraft American has under operating leases, 15 Boeing 767-300ERs are cancelable upon 30 days' notice during the initial 10-year lease term. At the end of that term in 1998, the leases can be renewed for periods ranging from 10 to 12 years. In 1993, American agreed to forfeit its right to cancel leases for 25 Airbus A300-600R aircraft upon 30 days' notice and extended the terms of the leases for periods ranging from 18 to 19 years. Rent expense, excluding landing fees, was $1.2 billion, $1.1 billion and $925 million for the years ended December 31, 1993, 1992 and 1991, respectively. 5. INDEBTEDNESS Short-term borrowings at December 31, 1992, consisted of commercial paper. Long-term debt (excluding amounts maturing within one year) consisted of (in millions): Maturities of long-term debt (including sinking fund requirements) for the next five years are: 1994 - $70 million; 1995 - $44 million; 1996 - $47 million; 1997 - $44 million; 1998 - $53 million. Certain debt is secured by aircraft, engines, equipment and other assets having a net book value of approximately $1.5 billion. American has a $500 million short-term credit facility agreement which expires in 1995 and a $1.0 billion credit facility expiring in 1994. American expects to replace the $1.0 billion credit facility with a $750 million credit agreement. American also has $335 million available under a multiple option facility which expires in 1995. Interest on these agreements is calculated at floating rates based upon LIBOR. At December 31, 1993, no borrowings were outstanding and approximately $1.8 billion was available under these facilities. As of February 15, 1994, borrowings of $400 million were outstanding under the credit facilities. American's debt and credit facility agreements contain certain restrictive covenants, including a cash flow coverage test, a minimum net worth requirement and limitations on indebtedness and the declaration of dividends on shares of its capital stock. At December 31, 1993, under the most restrictive provisions of those agreements, approximately $1.3 billion of American's retained earnings were available for payment of cash dividends to AMR. 6. FINANCIAL INSTRUMENTS The fair values of the Company's long-term debt were estimated using quoted market prices, where available. For long-term debt not actively traded, fair values were estimated using discounted cash flow analyses, based on the Company's current incremental borrowing rates for similar types of borrowing arrangements. The fair values of the Company's long-term debt, including current maturities, at December 31, 1993, were (in millions): During 1993, American entered into interest-rate swap agreements with a number of major financial institutions. Under these swap agreements, American receives fixed-rate payments (4.25% to 6.44%) in exchange for floating-rate payments (3.25% to 4.00% at December 31, 1993) on a total notional principal amount of $1.4 billion. The swap agreements expire over three to 15 years. American is exposed to credit risk in the event of default by the counterparties; however, American does not anticipate such default. Under agreements with certain counterparties, American or the counterparty may be required to post collateral based on certain credit limits and ratings. As of December 31, 1993, no collateral was required under these agreements. The fair value of the Company's interest-rate swap agreements is estimated based on the market prices for similar agreements. The net fair values of the Company's interest rate swap agreements at December 31, 1993, representing the estimated net amount the Company would have to pay to terminate the agreements, was $6 million. To hedge against the risk of future currency exchange rate fluctuations on certain lease obligations and related interest payable in foreign currencies, American has entered into various foreign currency exchange agreements. Changes in the value of the agreements due to exchange rate fluctuations are offset by changes in the value of the foreign currency denominated lease obligations translated at the current rate. In the event of default by the counterparties, American is exposed to risk for periodic settlements due under the agreements; however, American does not anticipate such default. At December 31, 1993, American had agreements to purchase 20.3 billion Japanese yen at rates ranging from 104.50 to 137.26 yen per U.S. dollar. The fair value of the Company's foreign currency exchange agreements is estimated based on quoted market prices of comparable agreements. The net fair value of the Company's foreign currency exchange agreements at December 31, 1993, representing the estimated net amount that American would receive to terminate the agreements, was approximately $18 million. American has sold options enabling two major banks to put Dutch guilders to American at a fixed rate of guilders per U.S. dollar at periodic intervals through 1994. At December 31, 1993, approximately 680 million guilders remain subject to the put options. The market risk associated with the put options is offset by American's ability, under a purchase agreement, to pay for certain equipment in U.S. dollars or, at American's option, in Dutch guilders, at the same exchange rate as the put options. At dates where American does not have a liability under the equipment purchase agreement due to changes in delivery schedules, American has purchased options to put approximately 50 million guilders to a major bank at the same rate of exchange. American's credit risk is limited to failure of the manufacturer to perform under the purchase agreement or the failure of the bank to perform under the purchased put option agreement; however, American does not anticipate non-performance. The proceeds from the sales of the put options, net of the cost of the put options purchased, were deferred and are being offset against the cost of the equipment acquired under the purchase agreement. The net fair value of these guilder put options was de minimis at December 31, 1993. 7. INCOME TAXES American, as a wholly-owned subsidiary, is included in AMR's consolidated tax return. American's provision (benefit) for income taxes has been computed on the basis that American files separate consolidated income tax returns with its subsidiaries. Effective January 1, 1992, AMR adopted Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes," (FAS 109), changing its method of accounting for income taxes. American was required to simultaneously adopt the methodology used in FAS 109 in accordance with its tax sharing agreement with AMR. As permitted under the new rules, prior years' financial statements have not been restated to reflect the change in accounting method. The cumulative effect of adopting FAS 109 decreased the net loss for the year ended December 31, 1992, by $132 million The significant components of the income tax provision (benefit) were (in millions): The income tax provision (benefit) includes a provision of $43 million in 1993 and benefit of $114 million and $67 million in 1992 and 1991, respectively, for federal taxes. In addition, a deferred tax benefit of $320 million was recognized in the year ended December 31, 1992, upon adoption of Statement of Financial Accounting Standards No. 106, "Employers' Accounting for Postretirement Benefits Other than Pensions" (FAS 106). The income tax provision (benefit) differed from amounts computed at the statutory federal income tax rate as follows (in millions): 7. INCOME TAXES (CONTINUED) The components of American's deferred tax assets and liabilities were (in millions): At December 31, 1993, American had available for federal income tax purposes approximately $337 million of alternative minimum tax credit carryforwards available for an indefinite period, and approximately $1.2 billion of net operating loss carryforwards for regular tax purposes, with $640 million expiring in 2007 and $585 million expiring in 2008. The sources of deferred income taxes and the tax effect of each for the year ended December 31, 1991, before American adopted FAS 109, were (in millions): 8. RETIREMENT BENEFITS Substantially all employees of American are eligible to participate in pension plans. The defined benefit plans provide benefits for participating employees based on years of service and average compensation for a specified period of time before retirement. Airline pilots and flight engineers also participate in defined contribution plans for which company contributions are determined as a percentage of participant compensation. Costs for all pension plans were approximately $288 million, $247 million and $187 million in 1993, 1992 and 1991, respectively. 8. RETIREMENT BENEFIT PLANS (CONTINUED) Net periodic pension cost of the defined benefit plans was (in millions): The funded status and actuarial present value of benefit obligations of the defined benefit plans were (in millions): * American's funding policy is to make contributions equal to, or in excess of, the minimum funding requirements of the Employee Retirement Income Security Act of 1974. Plan assets consist primarily of government and corporate debt securities, marketable equity securities, and money market fund and mutual fund shares, of which approximately $99 million and $86 million of plan assets at December 31, 1993 and 1992, respectively, were invested in shares of mutual funds managed by a subsidiary of AMR. The projected benefit obligation was calculated using weighted average discount rates of 7.50%, 9.00% and 9.25% at December 31, 1993, 1992 and 1991, respectively; rates of increase for compensation of 4.40% at December 31, 1993, and 4.90% at December 31, 1992 and 1991; and the 1983 Group Annuity Mortality Table. The weighted average expected long-term rate of return on assets was 10.50% in 1993 and 11.25% in 1992 and 1991. The vested benefit obligation and plan assets at fair value at December 31, 1993, for plans whose benefits are guaranteed by the Pension Benefit Guaranty Corporation are $3.1 billion and $3.5 billion, respectively. Pension costs for defined contribution plans were approximately $118 million, $108 million and $90 million in 1993, 1992 and 1991, respectively. 8. RETIREMENT BENEFITS (CONTINUED) In addition to pension benefits, other postretirement benefits, including certain health care and life insurance benefits, are also provided to retired employees. The amount of health care benefits is limited to lifetime maximums as outlined in the plan. Substantially all employees of American and employees of certain other subsidiaries may become eligible for these benefits if they satisfy eligibility requirements during their working lives. Effective January 1, 1990, American's non-union employees that are covered by the health care and life insurance plan, as well as employees who are represented by the Transport Workers Union, began making contributions toward funding a portion of their retiree health care benefits during their working lives. American funds benefits as incurred and began, effective January 1993, to match employee prefunding. Effective January 1, 1992, American adopted FAS 106, changing the method of accounting for these benefits. Prior to 1992, other postretirement benefit expense was recognized by expensing health care claims incurred and annual life insurance premiums. Such expense was $31 million in 1991 and has not been restated. The cumulative effect of adopting FAS 106 as of January 1, 1992, was a charge of $913 million ($593 million after tax). This change also increased other postretirement benefit expense by approximately $89 million ($57 million after tax) for the year ended December 31, 1992. Net other postretirement benefit cost was (in millions): The funded status of the plan, reconciled to the accrued other postretirement benefit cost recognized in American's balance sheet, was (in millions): Plan assets consist primarily of shares of a mutual fund managed by a subsidiary of AMR. 8. RETIREMENT BENEFITS (CONTINUED) For 1993, future benefit costs were estimated assuming per capita cost of covered medical benefits would increase at an 11% annual rate, decreasing gradually to a 4% annual growth rate in 2000 and thereafter. A 1% increase in this annual trend rate would have increased the accumulated other postretirement benefit obligation at December 31, 1993, by approximately $118 million and 1993 other postretirement benefit cost by approximately $17 million. In 1992, future benefit costs were estimated assuming per capita cost of covered medical benefits would increase at a 12% annual rate, decreasing gradually to a 5% annual growth rate in 1999 and thereafter. The weighted average discount rate used in estimating the accumulated other postretirement benefit obligation was 7.50% and 9.00% at December 31, 1993 and 1992, respectively. 9. REVENUE AND OTHER EXPENSE ITEMS Revenues for the second quarter of 1993 include a $115 million positive adjustment resulting from a change in estimate relating to certain earned passenger revenues. Miscellaneous - net in 1993 includes a $125 million charge related to the retirement of 31 McDonnell Douglas DC-10 aircraft. The charge represents the Company's best estimate of the expected loss based upon the anticipated method of disposition. However, should the ultimate method of disposition differ, the actual loss could be different than the amount estimated. Miscellaneous - net for 1991 includes a provision of $42 million for the anticipated cost of lease terminations and aircraft dispositions relating to the retirement of American's Boeing 737 and British Aerospace BAe 146 aircraft fleets. Also included in 1991 is a $26 million charge for the retirement of American's Boeing 747SP aircraft. 10. FOREIGN OPERATIONS American conducts operations in various foreign countries. American's operating revenues from foreign operations were (in millions): 11. OTHER FINANCIAL INFORMATION American's operations fall within two industry segments: the Air Transportation Group and the Information Services Group. For a description of each of these groups, refer to Business on page 1. Following are financial highlights for these two groups for each of the three years in the period ended December 31, 1993 (in millions): The adoption of FAS 106 reduced the 1992 operating income of the Air Transportation Group and the Information Services Group by $85 million and $4 million, respectively. Intergroup revenues consist of revenues earned by the Information Services Group from the Air Transportation Group. Identifiable assets of the industry segments were (in millions): Identifiable assets are gross assets used by a business segment, including an allocated portion of assets used jointly by more than one segment. General corporate and other consists primarily of income tax assets. 11. OTHER FINANCIAL INFORMATION (CONTINUED) Supplemental disclosures of cash flow information and non-cash activities (in millions): 12. QUARTERLY FINANCIAL DATA (UNAUDITED) Unaudited summarized financial data by quarter for 1993 and 1992 (in millions): * Results for the first quarter of 1992 have been restated for the cumulative effect of the adoption of FAS 106 and FAS 109 which resulted in a net charge of $461 million after tax. Results for the first three quarters of 1992 have also been restated by the ratable portion of the $89 million current year effect of the accounting change for FAS 106, net of tax benefit. Results for the second quarter of 1993 include a $125 million charge related to the retirement of 31 McDonnell Douglas DC-10 aircraft. Results for the fourth quarter of 1993 reflect the adverse impact of a five-day strike by American's flight attendants' union and a $25 million charge for the cost of severance of certain employees. Results for the second quarter of 1992 include a $14 million provision for a cash payment representing American's share of a multi-carrier antitrust settlement. Results for the fourth quarter of 1992 include a $22 million charge for the cost of severance of certain employees. ITEM 9.

ITEM 9. DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE None. PART III ITEM 10.

ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT Omitted under the reduced disclosure format pursuant to General Instruction J(2)(c) of Form 10-K. ITEM 11.

ITEM 11. EXECUTIVE COMPENSATION Omitted under the reduced disclosure format pursuant to General Instruction J(2)(c) of Form 10-K. ITEM 12.

ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT Omitted under the reduced disclosure format pursuant to General Instruction J(2)(c) of Form 10-K. ITEM 13.

ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS Omitted under the reduced disclosure format pursuant to General Instruction J(2)(c) of Form 10-K. PART IV ITEM 14.

ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K (a) (1) The financial statements listed in the accompanying index to financial statements and schedules are filed as part of this report. (2) The schedules listed in the accompanying index to financial statements and schedules are filed as part of this report. (3) Exhibits required to be filed by Item 601 of Regulation S-K. (Where the amount of securities authorized to be issued under any of American's long-term debt agreements does not exceed ten percent of American's assets, pursuant to paragraph (b)(4) of Item 601 of Regulation S-K, in lieu of filing such as an exhibit, American hereby agrees to furnish to the Commission upon request a copy of any agreement with respect to such long-term debt.) EXHIBIT 3(a) Composite of the Certificate of Incorporation of American, incorporated by reference to Exhibit 3(a) to American's report on Form 10-K for the year ended December 31, 1982, file number 1-2691. 3(b) Amended Bylaws of American, incorporated by reference to Exhibit 3(b) to American's report on Form 10-K for the year ended December 31, 1990, file number 1-2691. 10(a) Purchase Agreement, dated as of February 12, 1979, between American and the Boeing Company, relating to the purchase of Boeing Model 767-323 aircraft, incorporated by reference to Exhibit 10(b)(3) to American's Registration Statement No. 2-76709. 10(b) Description of American's Split Dollar Insurance Program, dated December 28, 1977, incorporated by reference to Exhibit 10(c)(1) to American's Registration Statement No. 2-76709. 10(c) American's 1992 Incentive Compensation Plan. 10(d) 1979 American Airlines (AMR) Stock Option Plan, as amended, incorporated by reference to Exhibit 10(d) to American's report on Form 10-K for the year ended December 31, 1982, file number 1-2691. 10(e) 1979 American Airlines (AMR) Stock Option Plan, as amended, incorporated by reference to Exhibit 10(e) to American's report on Form 10-K for the year ended December 31, 1982, file number 1-2691. 10(f) Form of Stock Option Agreement for Corporate Officers under the 1979 American Airlines (AMR) Stock Option Plan, incorporated by reference to Exhibit 10(c)(5) to American's Registration Statement No. 2-76709. 10(g) Form of Stock Option Agreement under the 1974 and 1979 American Airlines (AMR) Stock Option Plans, incorporated by reference to Exhibit 10(c)(6) to American's Registration Statement No. 2-76709. 10(h) Deferred Compensation Agreement, dated April 14, 1973, as amended March 1, 1975, between American and Robert L. Crandall, incorporated by reference to Exhibit 10(c)(7) to American's Registration Statement No. 2-76709. 10(i) Deferred Compensation Agreement, dated October 18, 1972, as amended March 1, 1975, between American and Gene E. Overbeck, incorporated by reference to Exhibit 10(c)(9) to American's Registration Statement No. 2-76709. 10(j) Deferred Compensation Agreement, dated June 3, 1970, between American and Francis H. Burr, incorporated by reference to Exhibit 11(d) to American's Registration Statement No. 2-39380. 10(k) Description of informal arrangement relating to deferral of payment of directors' fees, incorporated by reference to Exhibit 10(c)(11) to American's Registration Statement No. 2-76709. 10(l) Purchase Agreement, dated as of February 29, 1984, between American and the McDonnell Douglas Corporation, relative to the purchase of McDonnell Douglas Super 80 aircraft, incorporated by reference to Exhibit 10(l) to American's report on Form 10-K for the year ended December 31, 1983, file number 1-2691. 10(m) Purchase Agreement, dated as of June 27, 1983, between American and the McDonnell Douglas Corporation, relative to the purchase of McDonnell Douglas Super 80 aircraft, incorporated by reference to Exhibit 4(a)(8) to American's Registration Statement No. 2-84905. 10(n) Form of Executive's Termination Benefits Agreement incorporated by reference to Exhibit 10(p) to American's report on Form 10-K for the year ended December 31, 1985, file number 1-2691. 10(o) Amendment, dated June 4, 1986, to Purchase Agreement in Exhibit 10(l) above, incorporated by reference to Exhibit 10(l) to American's report on Form 10-K for the year ended December 31, 1986, file number 1-2691. 10(p) Acquisition Agreement, dated as of March 1, 1987, between American and Airbus Industrie relative to the lease of Airbus A300-600R aircraft, incorporated by reference to Exhibit 10(p) to American's report on Form 10-K for the year ended December 31, 1986, file number 1-2691. 10(q) Acquisition Agreement, dated as of March 1, 1987, between American and the Boeing Company relative to the lease of Boeing 767-323ER aircraft, incorporated by reference to Exhibit 10(q) to American's report on Form 10-K for the year ended December 31, 1986, file number 1-2691. 10(r) Acquisition Agreement, dated as of July 21, 1988, between American and the Boeing Company relative to the purchase of Boeing Model 757-223 aircraft, incorporated by reference to Exhibit 10(r) to American's report on Form 10-K for the year ended December 31, 1988, file number 1-2691. 10(s) Acquisition Agreement, dated as of February 4, 1989, among American and Delta Airlines, Inc. and others relative to operation of a computerized reservations system incorporated by reference to Exhibit 10(s) to American's report on Form 10-K for the year ended December 31, 1988, file number 1-2691. 10(t) Purchase Agreement, dated as of May 5, 1989, between American and the Boeing Company relative to the purchase of Boeing 757-223 aircraft, incorporated by reference to Exhibit 10(t) to American's report on Form 10-K for the year ended December 31, 1989, file number 1-2691. 10(u) Purchase Agreement, dated as of June 9, 1989, between American and Fokker Aircraft U. S. A., Inc. relative to the purchase of Fokker 100 aircraft, incorporated by reference to Exhibit 10(u) to American's report on Form 10-K for the year ended December 31, 1989, file number 1-2691. 10(v) Purchase Agreement, dated as of June 23, 1989, between American and the Boeing Company relative to the purchase of Boeing 767-323ER aircraft, incorporated by reference to Exhibit 10(v) to American's report on Form 10-K for the year ended December 31, 1989, file number 1-2691. 10(w) Purchase Agreement, dated as of August 3, 1989, between American and the McDonnell Douglas Corporation relative to the purchase of MD-11 aircraft, incorporated by reference to Exhibit 10(w) to American's report on Form 10-K for the year ended December 31, 1989, file number 1-2691. 10(x) Amendment, dated as of August 3, 1989, to the Purchase Agreement in Exhibit 10(l) above, incorporated by reference to Exhibit 10(x) to American's report on Form 10-K for the year ended December 31, 1989, file number 1-2691. 10(y) Purchase Agreement, dated as of October 25, 1989, between American and AVSA, S. A. R. L. relative to the purchase of Airbus A300-600R aircraft, incorporated by reference to Exhibit 10(y) to American's report on Form 10-K for the year ended December 31, 1989, file number 1-2691. 10(z) Amendment, dated as of November 16, 1989, to Employment Agreement among AMR Corporation, American Airlines and Robert L. Crandall, incorporated by reference to Exhibit 10(z) to American's report on Form 10-K for the year ended December 31, 1989, file number 1-2691. 10(aa) Management Severance Allowance, dated as of February 23, 1990, for levels 1-4 employees of American Airlines, Inc., incorporated by reference to Exhibit 10(aa) to American's report on Form 10-K for the year ended December 31, 1989, file number 1-2691. 10(bb) Management Severance Allowance, dated as of February 23, 1990, for level 5 and above employees of American Airlines, Inc., incorporated by reference to Exhibit 10(bb) to American's report on Form 10-K for the year ended December 31, 1989, file number 1-2691. 10(cc) Amendment, dated as of December 3, 1990, to Employment Agreement among AMR Corporation, American Airlines and Robert L. Crandall incorporated by reference to Exhibit 10(cc) to American's report on Form 10-K for the year ended December 31, 1990, file number 1-2691. 10(dd) Amendment, dated as of May 1, 1992, to Employment Agreement among American, American Airlines and Robert L. Crandall incorporated by reference to Exhibit 10(dd) to American's report on Form 10-Q for the period ended June 30, 1992, file number 1-2691. 12 Computation of ratio of earnings to fixed charges for the years ended December 31, 1989, 1990, 1991, 1992 and 1993. 19 The 1974 and 1979 American Airlines (AMR) Stock Option plans as amended March 16, 1983, incorporated by reference to Exhibit 19 to American's report on Form 10-K for the year ended December 31, 1983, file number 1- 2691. Refer to Exhibits 10(d) and 10(e). 23 Consent of Independent Auditors appears on page 41 hereof. (b) Reports on Form 8-K: None. AMERICAN AIRLINES, INC. INDEX TO FINANCIAL STATEMENTS AND SCHEDULES COVERED BY REPORT OF INDEPENDENT AUDITORS (ITEM 14(A)) All other schedules are omitted since the required information is included in the financial statements or notes thereto, or since the required information is either not present or not present in sufficient amounts. Exhibit 23 CONSENT OF INDEPENDENT AUDITORS We consent to the incorporation by reference in Post Effective Amendment No. 2 to the Registration Statement (Form S-3 No. 33-42998) of American Airlines, Inc., and in the related Prospectus, of our report dated February 15, 1994, with respect to the consolidated financial statements and schedules of American Airlines, Inc. included in this Annual Report (Form 10-K) for the year ended December 31, 1993. ERNST & YOUNG 2121 San Jacinto Dallas, Texas 75201 March 29, 1994 AMERICAN AIRLINES, INC. Schedule IV - Indebtedness of and to Related Parties - Not Current Year ended December 31, 1993 (in millions) (a) See Note 1 to consolidated financial statements included in this Form 10-K for a description of the terms of this indebtedness. AMERICAN AIRLINES, INC. Schedule IV - Indebtedness of and to Related Parties - Not Current Year ended December 31, 1992 (in millions) (a) See Note 1 to consolidated financial statements included in this Form 10-K for a description of the terms of this indebtedness. AMERICAN AIRLINES, INC. Schedule IV - Indebtedness of and to Related Parties - Not Current Year ended December 31, 1991 (in millions) (a) See Note 1 to consolidated financial statements included in this Form 10-K for a description of the terms of this indebtedness. AMERICAN AIRLINES, INC. Schedule V - Property, Plant and Equipment Year ended December 31, 1993 (in millions) Additions to Flight Equipment includes amounts transferred from Purchase Deposits upon delivery of aircraft. AMERICAN AIRLINES, INC. Schedule V - Property, Plant and Equipment Year ended December 31, 1992 (in millions) Additions to Flight Equipment includes amounts transferred from Purchase Deposits upon delivery of aircraft. Net Transfers and Other Adjustments includes the sale and subsequent leaseback of two Boeing 757 aircraft, six Boeing 767 aircraft, three Fokker 100 aircraft and one McDonnell Douglas MD-80 aircraft. Seven of these agreements were accounted for as capital leases. AMERICAN AIRLINES, INC. Schedule V - Property, Plant and Equipment Year ended December 31, 1991 (in millions) Additions to Flight Equipment includes amounts transferred from Purchase Deposits upon delivery of aircraft. Net Transfers and Other Adjustments includes the sale and subsequent leaseback of thirteen Boeing 757 aircraft, two Boeing 767 aircraft, six Fokker 100 aircraft and 29 McDonnell Douglas MD-80 aircraft. Six of these agreements were accounted for as capital leases. AMERICAN AIRLINES, INC. Schedule VI - Accumulated Depreciation, Amortization and Obsolescence of Property, Plant and Equipment Year ended December 31, 1993 (in millions) AMERICAN AIRLINES, INC. Schedule VI - Accumulated Depreciation, Amortization and Obsolescence of Property, Plant and Equipment Year ended December 31, 1992 (in millions) (a) Includes accumulated depreciation related to sale and subsequent leaseback transactions. See Schedule V. AMERICAN AIRLINES, INC. Schedule VI - Accumulated Depreciation, Amortization and Obsolescence of Property, Plant and Equipment Year ended December 31, 1991 (in millions) (a) Includes accumulated depreciation related to sale and subsequent leaseback transactions. See Schedule V. AMERICAN AIRLINES, INC. Schedule VII - Guarantees of Securities of Other Issuers December 31, 1993 (in millions) AMERICAN AIRLINES, INC. Schedule VIII - Valuation and Qualifying Accounts and Reserves (deducted from asset to which applicable) Year ended December 31, 1993 (in millions) (a) See Schedule VI. (b) Transfer to allowance for obsolescence of inventories. AMERICAN AIRLINES, INC. Schedule VIII - Valuation and Qualifying Accounts and Reserves (deducted from asset to which applicable) Year ended December 31, 1992 (in millions) (a) See Schedule VI. AMERICAN AIRLINES, INC. Schedule VIII - Valuation and Qualifying Accounts and Reserves (deducted from asset to which applicable) Year ended December 31, 1991 (in millions) (a) See Schedule VI. AMERICAN AIRLINES, INC. Schedule IX - Short-Term Borrowings Year ended December 31, 1993 (in millions) (a) Computed based on monthly amount outstanding during the year. (b) Computed by dividing total interest expense by the average amount outstanding during the year. (c) Commercial paper generally matures within 120 days after issue with no provisions for renewal. AMERICAN AIRLINES, INC. Schedule IX - Short-Term Borrowings Year ended December 31, 1992 (in millions) (a) Computed based on monthly amount outstanding during the year. (b) Computed by dividing total interest expense by the average amount outstanding during the year. (c) Commercial paper generally matures within 120 days after issue with no provisions for renewal. AMERICAN AIRLINES, INC. Schedule IX - Short-Term Borrowings Year ended December 31, 1991 (in millions) (a) Computed based on monthly amount outstanding during the year. (b) Computed by dividing total interest expense by the average amount outstanding during the year. (c) Commercial paper generally matures within 120 days after issue with no provisions for renewal. Facility agreement borrowings generally mature within 100 days after issue, with a renewal option available over the term of the facility agreement. American also borrows additional funds from various institutions on a short-term basis at the lenders' prevailing rates. AMERICAN AIRLINES, INC. Schedule X - Supplementary Income Statement Information Years ended December 31, 1993, 1992 and 1991 (in millions) 1993 1992 1991 ------ ------ ------ Advertising expense $ 197 $ 198 $ 241 ====== ====== ====== Exhibit 12 AMERICAN AIRLINES COMPUTATION OF RATIO OF EARNINGS TO FIXED CHARGES SIGNATURES Pursuant to the requirements of Section 13 or 15(d) 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. AMERICAN AIRLINES, INC. /s/ Robert L. Crandall Robert L. Crandall Chairman, President and Chief Executive Officer (Principal Executive Officer) /s/ Michael J. Durham Michael J. Durham Senior Vice President and Chief Financial Officer (Principal Financial and Accounting Officer) Date: March 16, 1994 Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates noted: Directors: /s/ Howard P. Allen /s/ William Lyon Howard P. Allen William Lyon /s/ Edward A. Brennan /s/ Ann D. McLaughlin Edward A. Brennan Ann D. McLaughlin /s/ Christopher F. Edley /s/ Charles H. Pistor, Jr. Christopher F. Edley Charles H. Pistor, Jr. /s/ Antonio Luis Ferre' /s/ Joe M. Rodgers Antonio Luis Ferre' Joe M. Rodgers /s/ Charles T. Fisher, III /s/ Maurice Segall Charles T. Fisher, III Maurice Segall /s/ Dee J. Kelly /s/ Eugene F. Williams, Jr. Dee J. Kelly Eugene F. Williams, Jr. Date: March 16, 1994

18230_1993.txt

18230

1993

ITEM 1. BUSINESS. Principal Business Segments Caterpillar Inc. together with its consolidated subsidiaries (the "Company") operates in three principal business segments: (1) Machinery--Design, manufacture, and marketing of earthmoving, construction, and materials handling machinery--track and wheel tractors, track and wheel loaders, lift trucks, self-guided materials handling vehicles, pipelayers, motor graders, wheel tractor-scrapers, track and wheel excavators, backhoe loaders, log skidders, log loaders, off-highway trucks, articulated trucks, paving products, and related parts. (2) Engines--Design, manufacture, and marketing of engines for earthmoving and construction machines, on-highway trucks, and locomotives; marine, petroleum, agricultural, industrial, and other applications; electric power generation systems; and related parts. Caterpillar diesel and spark-ignited engines meet power needs ranging from 54 to 8,000 horsepower. Turbines range from 1,340 to 15,000 horsepower (1000 to 10 500 kilowatts). (3) Financial Products--Provides financing alternatives for Caterpillar and noncompetitive related equipment, and extends loans to Caterpillar customers and dealers. Also provides various forms of insurance for Caterpillar dealers and customers to help support their purchase and financing of Caterpillar equipment. Note 22 of the Notes to Consolidated Financial Statements on pages A-21 through A-22 of the Appendix to the Company's 1994 Annual Meeting Proxy Statement contains additional information regarding the Company's business segments and geographic segments and is incorporated herein by reference. Company Operations The Company conducts operations in the Machinery and Engines segments of its business under highly competitive conditions, including intense price competition. It places great emphasis upon the high quality and performance of its products and the service support for such products which is supplied by its dealers. Although no one competitor is believed to produce all of the same types of machines and engines produced by the Company, there are numerous companies, large and small, which compete with the Company in the sale of each of its products. Machines are distributed principally through a worldwide organization of independent full-line dealers, and one company-owned dealership; 65 located in the United States and 118 located outside the United States. Worldwide, these dealers have more than 1,250 places of business. Diesel and spark-ignited engines are sold through the worldwide dealer organization and to other manufacturers for use in products manufactured by them. Caterpillar dealers do not deal exclusively in the Company's products, although in most cases sales and servicing of the Company's products are the dealers' principal business. Turbines are sold through a sales force employed by Solar Turbines Incorporated, a wholly owned subsidiary, or its subsidiaries and associated companies. These employees are from time to time assisted by independent sales representatives. Financial Products consists primarily of Caterpillar Financial Services Corporation and its subsidiaries, and Caterpillar Insurance Co. Ltd. Further information concerning the Company's operations in 1993 and its outlook for 1994 appears under the caption "Management's Discussion and Analysis" on pages A-26 through A-35 of the Appendix to the Company's 1994 Annual Meeting Proxy Statement, which pages are incorporated herein by reference. Patents and Trademarks The Company's products are sold primarily under the marks "Caterpillar," "Cat," "Solar," and "Barber-Greene." The Company owns a number of patents and trademarks relating to the products manufactured by it, which have been obtained over a period of years. These patents and trademarks have been of value in the growth of the Company's business and may continue to be of value in the future. The Company does not regard any segment of the Company's business as being dependent upon any single patent or group of patents. Research and Development The Company has always placed strong emphasis on product-oriented research and engineering relating to the development of new or improved machines, engines and major components thereof, and to the development of new and improved machine tools and processes for use in manufacturing. In 1993, 1992 and 1991, the Company expended $455 million, $446 million and $441 million, respectively, on its research and engineering program. Of these amounts, $319 million in 1993, $310 million in 1992 and $272 million in 1991 were attributable to new prime products and major component development and major improvements to existing products. The remainders were attributable to engineering costs incurred during the early production phase as well as ongoing efforts to improve existing products. During 1993 the Company announced several new products, such as the 3406E truck engine, as well as improvements to existing products. The Company expects to continue the development of new products and improvements to existing products in the future. Employment At December 31, 1993, the Company employed 51,250 persons of whom 13,147 were located outside the United States. Sales Sales outside the United States were 49% of consolidated sales in 1993, compared with 55% in 1992 and 59% in 1991 . Environmental Matters The Company's facilities and products are subject to extensive environmental laws and regulations. Research, engineering, and operating expenses relating to environmental protection totaled approximately $126 million in 1993, and are expected to remain relatively constant for 1994. Such expenses include depreciation expenses of approximately $10 million, but exclude reserves described hereinafter. Capital expenditures for pollution abatement and control for 1993 were approximately $11 million, approximately 2.5% of total capital expenditures. For 1994, the Company estimates that such capital expenditures will approximate $17 million. It is expected that these expenditure levels will continue and may increase over time. However, the ultimate cost of future compliance is uncertain due to a number of factors such as the evolving nature and interpretation of environmental laws and regulations, the extent of remediation which may be required at sites identified by the Environmental Protection Agency (EPA), or comparable state authorities, and evolving technologies. The 1990 Amendments to the Clean Air Act provide, among other things, for more stringent air emission standards which may require significant expenditures to bring the Company's facilities into compliance and to redesign certain of the Company's products. The 1990 Amendments are scheduled to be implemented throughout the 1990s and the first decade of the 21st century. However, a large number of the regulations which will be required to achieve that implementation have not yet been proposed or promulgated. In 1993, capital and operating expenditures attributed to compliance with the 1990 Amendments were approximately $15 million. Expenditures for 1994 are expected to be approximately $19 million. Based on a preliminary environmental assessment, during 1992 Solar Turbines Incorporated (Solar), a subsidiary of the Company since 1981, estimated that assessment, remediation and preventative expenditures for contamination of its Harbor Drive facility in San Diego, California will be approximately $30 to $50 million expended over the next 25 years, a significant portion of which will be capital expenditures. The contamination of Harbor Drive, a manufacturing facility for over 60 years, involves cleaning solvents, petroleum products, and metal products, which have been found in both soil and groundwater samples. Solar has been working closely with the state and local agencies on this issue. While subject to further analysis, Solar believes that a substantial portion of the expenditures may be recoverable from third parties who previously conducted manufacturing or other operations on or adjacent to the site. A reserve of $13 million was recorded in the third quarter of 1992 with respect to this matter. Remediation expenses with respect to Harbor Drive were $3 million in 1993. Also in 1992, a reserve of $5 million was recorded with respect to estimated costs of remediation of soil and groundwater contamination at other facilities. This reserve includes $4 million for estimated costs to remediate potential groundwater contamination at a former Company facility located in San Leandro, California. Remediation efforts have been ongoing, and the Company has been working closely with the California Department of Toxic Substances Control in its remediation efforts. Remediation expenses with respect to San Leandro were less than $1 million in 1993. As of December 31, 1993, the Company, in conjunction with numerous other parties, has been identified as a potentially responsible party (PRP) at 18 active sites identified by the EPA, or similar state authorities for remediation under the Comprehensive Environmental Response, Compensation, and Liability Act of 1980 (CERCLA), or comparable federal or state statutes (CERCLA sites). Lawsuits and claims involving additional environmental matters are likely to arise from time to time. CERCLA and facility sites are in varying stages of investigation and remediation. As a result, management's assessment of potential liability and remediation costs have been based on currently available facts, the stage of the proceedings, the number of PRPs identified, documentation available, currently anticipated and reasonably identifiable remediation costs, amounts contributed by the Company on a pro-rata basis toward investigation and remediation costs, existing technology, presently enacted laws and regulations, and other factors. While the Company may have rights of contribution or reimbursement from other parties or coverage under insurance policies, such issues are not factors in management's estimation of liability. Based on the foregoing factors, management believes that it is unlikely that any identified matters, either individually or in the aggregate, will have a material adverse effect on the Company's consolidated financial position, results of operations or capital expenditures. Remediation and monitoring expenses actually incurred in 1993 in respect of CERCLA sites and soil and groundwater contamination at Company facilities (including Harbor Drive and San Leandro sites noted above) were approximately $4 million. ITEM 1a.

ITEM 1a. EXECUTIVE OFFICERS OF THE REGISTRANT AS OF DECEMBER 31, 1993. ITEM 2.

ITEM 2. PROPERTIES. The Company's operations are highly integrated. Although the majority of the Company's plants are involved primarily in the production of either machines or engines, several of the Company's plants are involved in the manufacture of both machines and engines. In addition, several plants are involved in the manufacture of components which are used in the assembly of both machines and engines. The Company's distribution centers and regional distribution centers are involved in the storage and distribution of parts for machines and engines. Also, the research and development activities carried on at the Technical Center involve both machines and engines. The corporate headquarters for the Company are located in Peoria, Illinois. Additional marketing headquarters are located both inside and outside the United States. All square footage and acreage provided herein is approximated as of December 31, 1993. Total Properties Total properties owned or leased by the Company consist of 65,330,072 square feet of building area, of which 90.6% is owned in fee and 9.4% is leased. Owned Properties Properties owned in fee by the Company consist of 59,221,322 square feet of building area and 19,288 acres of land. Properties owned by the Company are believed to be generally well maintained and adequate for the purposes for which they are presently used. Through planned capital expenditures, the Company expects these properties to remain adequate for future needs. Consolidations/Closures/Sales Over the last five years, in the ordinary course of business, the Company has consolidated operations and / or closed a number of its facilities. The Company continues to own closed properties totaling 3,956,839 square feet of building area and 6,900 acres of land which are no longer utilized in current operations. These closed properties have been declared surplus and are for sale. In December, 1991, the Company announced the probable closure of its manufacturing facility in York, Pennsylvania and consolidation of its Brazilian operations (including manufacturing, parts distribution, and office functions) at the Company's existing Piracicaba facility. The timing of the closure of the York facility is still pending. The consolidation of Brazilian operations was completed in 1993 and the manufacturing, distribution and office facilities located in Sao Paulo, Brazil were closed and sold. Previously closed facilities located in Brampton, Ontario and Mentor, Ohio were also sold in 1993. The Company's distribution facility in New Orleans, Louisiana, was closed in 1993 and its sale is pending for 1994. Leased Properties Properties leased by the Company consist of 6,108,750 square feet of building area. These properties are covered by leases expiring over terms of generally 1 to 10 years. The Company anticipates no difficulty in retaining occupancy of any of its leased facilities, either by renewing leases prior to expiration or by replacing them with equivalent leased facilities. Manufacturing Manufacturing activities are conducted at 24 locations inside the United States and 11 locations outside the United States. Remanufacturing and Overhaul activities are conducted at 3 locations inside the United States and 3 locations outside the United States. These facilities have a total building area of 42,422,585 square feet, of which 98.5% is used for manufacturing and 1.5% is used for remanufacturing and overhaul. These facilities are believed to be suitable for their intended purposes with adequate capacities for current and projected needs for existing Company products. A list of the Company's manufacturing, remanufacturing and overhaul facilities follows with principal use indicated: Plant Locations inside the U.S. Principal Use ------------------------------- ------------- Gardena, California ................... Manufacturing San Diego, California ................. Manufacturing Jacksonville, Florida ................. Manufacturing Aurora, Illinois ...................... Manufacturing Decatur, Illinois ..................... Manufacturing DeKalb, Illinois ...................... Manufacturing Dixon, Illinois ....................... Manufacturing East Peoria, Illinois ................. Manufacturing Joliet, Illinois ...................... Manufacturing Mapleton, Illinois .................... Manufacturing Mossville, Illinois ................... Manufacturing Peoria, Illinois ...................... Manufacturing Pontiac, Illinois ..................... Manufacturing Lafayette, Indiana .................... Manufacturing Wamego, Kansas ........................ Manufacturing Menominee, Michigan ................... Manufacturing Minneapolis, Minnesota ................ Manufacturing New Ulm, Minnesota .................... Manufacturing Corinth, Mississippi .................. Remanufacturing Boonville, Missouri ................... Manufacturing Clayton, North Carolina ............... Manufacturing Leland, North Carolina ................ Manufacturing Dallas, Oregon ........................ Manufacturing York, Pennsylvania .................... Manufacturing DeSoto, Texas ......................... Overhaul Houston, Texas ........................ Manufacturing Mabank, Texas ......................... Overhaul Plant Locations outside the U.S. Principal Use -------------------------------- ------------- Melbourne, Australia .................. Manufacturing Gosselies, Belgium .................... Manufacturing Piracicaba, Brazil .................... Manufacturing Edmonton, Canada ...................... Overhaul Leicester, England .................... Manufacturing Grenoble, France ...................... Manufacturing Rantigny, France ...................... Manufacturing Vernon, France ........................ Manufacturing Godollo, Hungary ...................... Manufacturing Jakarta, Indonesia .................... Manufacturing Bazzano, Italy ........................ Manufacturing Monterrey, Mexico ..................... Manufacturing Nuevo Laredo, Mexico .................. Remanufacturing Tijuana, Mexico ....................... Overhaul Financial Products A majority of the activity of the Financial Products Division is conducted from its leased headquarters located in Nashville, Tennessee. The Financial Products Division also leases 5 other office locations inside the United States and 7 office locations outside the United States and shares other office space with other Company entities. Distribution The Company's distribution activities are conducted at 10 Distribution Center locations (3 inside the United States and 7 outside the United States) and 13 Regional Distribution Center locations (12 inside the United States and 1 outside the United States). These locations have a total building area of 8,502,793 square feet and are used for the distribution of Company products. Caterpillar Logistics Services, Inc. distributes other companies' products utilizing certain of the Company's distribution facilities as well as other non- Company facilities located both inside and outside the United States. The Company also owns or leases other storage facilities which support distribution activities. Technical Center, Training/Demonstration Areas and Proving Grounds The Company owns a Technical Center located in Mossville, Illinois and various other training/demonstration areas and proving grounds located both inside and outside the United States. Capital Expenditures During the five years ended December 31, 1993, changes in investment in land, buildings, machinery and equipment of the Company were as follows (stated in millions of dollars): At December 31, 1993, the net book value of properties located outside the United States represented 25.7% of the net properties on the consolidated financial position. Further information concerning the Company's investment in land, buildings, machinery and equipment appears under Notes 1D and 12 of the "Notes to Consolidated Financial Statements" on pages A-10 and A-16 , respectively, of the Appendix to the 1994 Annual Meeting Proxy Statement, which Notes are incorporated herein by reference. ITEM 3.

ITEM 3. LEGAL PROCEEDINGS. The Company is a party to litigation matters and claims which are normal in the course of its operations, and, while the results of such litigation and claims cannot be predicted with certainty, management believes, based on the advice of counsel, the final outcome of such matters will not have a materially adverse effect on the consolidated financial position. As previously reported, on July 18, 1990 and July 20, 1990, two class action complaints were filed against the Company and certain of its officers and directors in United States District Court for the Central District of Illinois ("District Court") on behalf of all persons (other than the defendants) who purchased or otherwise acquired common stock of the Company and certain options relating to common stock of the Company between January 19, 1990 and June 26, 1990 (the "Class Period"), alleging, among other things, violations of certain provisions of the federal securities laws. The two cases were consolidated on April 2, 1991 ("Consolidated Class Actions"). The consolidated complaint alleged that the defendants fraudulently issued public statements and reports during the Class Period which were misleading in that they failed to disclose material adverse information relating to the Company's Brazilian operations, its factory modernization program and its reorganization plan. The plaintiffs and the defendants, with the active participation and approval of the Company's directors and officers liability insurer (the "Insurer"), have reached an agreement regarding settlement of the Consolidated Class Actions. The settlement is contingent upon approval by the District Court and certain other contingencies. Pursuant to the directors and officers liability policy (the "Policy"), the Company has requested that the Insurer acknowledge that 100% of the amount to be paid under the settlement agreement, beyond the Company's self-insured retention under the Policy, is covered by the Policy. Because the Company is named as a co-defendant in the Consolidated Class Actions, the insurer has denied coverage for a portion of the settlement amount, claiming that some liability must be attributable to the Company and not covered under the Policy. The Company has been advised that the position of the Insurer is contrary to applicable law and the Company has brought an action in the District Court against the Insurer for breach of contract and declaratory relief ("Declaratory Judgment Action"). The Company believes a successful recovery against the Insurer is likely in this Declaratory Judgment Action. If that recovery is obtained, the Company believes that its cost with respect to the settlement of the Consolidated Class Actions will approximate costs necessary to litigate the Consolidated Class Actions to a successful conclusion at trial. Regardless of whether the Company is successful in the Declaratory Judgment Action, the Company does not believe the settlement of the Consolidated Class Actions will have a materially negative impact on the Company's financial condition or results of operations. On May 12, 1993, a Statement of Objections ("Statement") was filed by the Commission of European Communities against Caterpillar Inc. and certain overseas subsidiaries ("Company"). The Statement alleges that certain service fees payable by dealers, certain dealer recordkeeping obligations, a restriction which prohibits a European Community ("EC") dealer from appointing subdealers, and certain export pricing practices and parts policies violate EC competition law under Article 85 of the European Economic Community Treaty. The Statement seeks injunctive relief and unspecified fines. Based on an opinion of counsel, the Company believes it has strong defenses to each allegation set forth in the Statement. On November 19, 1993, the Commission of European Communities informed the Company that a new complaint has been received by it alleging that certain export parts policies violate Article 85 and Article 86 of the European Economic Community Treaty. The Commission advised the Company that it intends to deal with the new complaint within the framework of the proceedings initiated on May 12, 1993. Based on an opinion of counsel, the Company believes it has strong defenses to the allegations set forth in the new complaint. ITEM 4.

ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS. Not applicable. PART II ITEM 5.

ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS. The information required by Item 5 is incorporated by reference from under the caption "Common Stock Price Range" and the first paragraph under the caption "Number of Stockholders" appearing on page A-36 and under the caption "Dividends" on page A-31 of the Appendix to the Company's 1994 Annual Meeting Proxy Statement. ITEM 6.

ITEM 6. SELECTED FINANCIAL DATA. The information required by Item 6 is incorporated by reference from pages A-24 and A-25 of the Appendix to the Company's 1994 Annual Meeting Proxy Statement under the caption "Eleven-year Financial Summary" but only for the years 1989-1993, inclusive, and then only with respect to the information set forth for each of such years under the following captions: "Sales and revenues," "Profit (loss) before effects of accounting changes(1)" (including the footnote indicated), "Effects of accounting changes (note 2)" (including the note indicated), "Profit (loss)," "Profit (loss) per share of common stock: (1) (2) Profit (loss) before effects of accounting changes(1)" (including the footnotes indicated), "Profit (loss) per share of common stock:(1) (2) Effects of accounting changes (note 2)" (including the footnotes and note indicated), "Profit (loss) per share of common stock:(1) (2) Profit (loss)" (including the footnotes indicated), "Dividends declared per share of common stock," "Total assets: Machinery and Engines," "Total assets: Financial Products," "Long-term debt due after one year: Machinery and Engines," and "Long-term debt due after one year: Financial Products." ITEM 7.

ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS. The information required by Item 7 is incorporated by reference from under the caption "Management's Discussion and Analysis" on pages A-26 through A-35 of the Appendix to the Company's 1994 Annual Meeting Proxy Statement. ITEM 8.

ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA. The information required by Item 8 is incorporated by reference from the Report of Independent Accountants appearing on page A-3, and the Financial Statements and Notes to Consolidated Financial Statements appearing on pages A-4 through A-23 of the Appendix to the Company's 1994 Annual Meeting Proxy Statement. ITEM 9.

ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE. Not applicable. PART III ITEM 10.

ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT. The information required by Item 10 relating to identification of directors is incorporated by reference from pages 3 through 7 of the Company's 1994 Annual Meeting Proxy Statement under the captions "Nominees for Election as Directors for Terms Expiring in 1997," "Directors Continuing in Office in the Class of 1995," and "Directors Continuing in Office in the Class of 1996." Identification of executive officers appears herein under Item 1a. There are no family relationships between the officers and directors of the Company. All officers serve at the pleasure of the Board of Directors and are regularly elected at a meeting of the Board of Directors in April of each year. Information required under Item 405 of Regulation S-K is incorporated by reference from under the caption "Filings Pursuant to Section 16 of the Securities Exchange Act of 1934" appearing on page 25 of the Company's 1994 Annual Meeting Proxy Statement. ITEM 11.

ITEM 11. EXECUTIVE COMPENSATION. The information required by Item 11 is incorporated by reference from under the caption "Compensation of Directors" which appears on page 9, from under the caption "Report of the Compensation Committee" on pages 11 through 15, from under the caption "Performance Graph" on page 16, from under the caption "Executive Compensation" and the tables thereunder which appear on pages 17 through 19, from under the caption "Pension Program" (including footnote) and the table thereunder which appear on pages 19 and 20, and from under the caption "Compensation Committee Interlocks and Insider Participation" which appears on page 16 of the Company's 1994 Annual Meeting Proxy Statement. ITEM 12.

ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT. The information required by Item 12 is incorporated by reference from pages 10 and 11 of the Company's 1994 Annual Meeting Proxy Statement under the caption "Equity Security Ownership of Management and Certain Other Beneficial Owners (as of December 31, 1993)." ITEM 13.

ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS. The information required by Item 13 is incorporated by reference from the Company's 1994 Annual Meeting Proxy Statement from under the caption "Certain Relationships and Related Transactions" appearing on page 20 and from under the caption "Compensation Committee Interlocks and Insider Participation" on page 16. PART IV ITEM 14.

ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K. (a) The following documents are filed as part of this report: 1. Financial Statements: Report of Independent Accountants (p. A-3)* Statement 1 Consolidated Results of Operations for the Years Ended December 31 (p. A-4)* Statement 2 Changes in Consolidated Stockholders' Equity for the Years Ended December 31 (p. A-5)* Statement 3 Financial Position at December 31 (p. A-6 and p. A-7)* Statement 4 Statement of Cash Flows for the Years Ended December 31 (p. A-8 and p. A-9)* Notes to Consolidated Financial Statements (pp. A-10 through A-23)* 2. Financial Statement Schedules: Report of Independent Accountants on Financial Statement Schedules Schedule V Property, Plant and Equipment Schedule VI Accumulated Depreciation of Property, Plant and Equipment Schedule VIII Valuation and Qualifying Accounts Schedule IX Short-term Borrowings All other schedules are omitted because they are not applicable or the required information is shown in the financial statements or the notes thereto incorporated by reference. (b) No reports on Form 8-K were filed during the last quarter of 1993. (c) Exhibits: 3 (a) Restated Certificate of Incorporation, Certificate of Amendment of Certificate of Incorporation, and Certificate of Designation, Preferences and Rights of the Terms of the Series A Junior Participating Preferred Stock (incorporated by reference from Exhibit 3(a) to Form 10-K for the year ended December 31, 1991, Commission File No. 1-768). (b) Bylaws (incorporated by reference from Exhibit 3(b) to Form 10-K for the year ended December 31, 1990, Commission File No. 1-768). 4 (a) Rights Agreement dated as of November 12, 1986, between Caterpillar Inc., the Registrant hereunder, and First Chicago Trust Company of New York (formerly Morgan Shareholder Services Trust Company) (incorporated by reference from Exhibit 10(a) to Form 10-K for the year ended December 31, 1990, Commission File No. 1-768) and First Amendment to Rights Agreement dated December 9, 1992 (incorporated by reference from Exhibit 10(a) to Form 10-K for the year ended December 31, 1992, Commission File No. 1-768). 10 (a) 1977 Stock Option Plan as amended (incorporated by reference from Exhibit 10(b) to Form 10-K for the year ended December 31, 1984, Commission File No. 1-768).** (b) 1987 Stock Option Plan as amended and Long Term Incentive Supplement.** (c) Supplemental Pension Benefit Plan, as amended and restated.** (d) Supplemental Employees' Investment Plan (incorporated by reference from Exhibit 10(e) to Form 10-K for the year ended December 31, 1987, Commission File No. 1-768).** (e) Caterpillar Inc. 1993 Corporate Incentive Compensation Plan Management and Salaried Employees, as amended and restated.** (f) Directors' Deferred Compensation Plan, as amended and restated.** (g) Directors' Retirement Plan (incorporated by reference from Exhibit 10(i) to Form 10-K for the year ended December 31, 1991, Commission File No. 1-768).** (h) Directors' Charitable Award Program.** 11 Computations of Earnings Per Share 12 Statement Setting Forth Computation of Ratios of Profit to Fixed Charges (The ratio of profit to fixed charges for the year ended December 31, 1993 was 2.4. Because of pretax losses for the years ended December 31, 1992 and 1991, profit was not sufficient to cover fixed charges. The coverage deficiencies were approximately $341 million and $529 million, respectively.) 21 Subsidiaries and Affiliates of the Registrant 23 Consent of Independent Accountants 99 (a) Form 11-K for Employees' Investment Plan. (b) Form 11-K for Caterpillar Foreign Service Employees' Stock Purchase Plan. (c) Form 11-K for the Savings and Investment Plan for eligible employees of Solar Turbines Incorporated. (d) Form 11-K for the Tax Deferred Savings Plan for eligible employees of Caterpillar Inc. (e) Appendix to the Company's 1994 Annual Meeting Proxy Statement (furnished for the information of the Commission and not deemed to be filed except for those portions expressly incorporated by reference herein). - -------- *Incorporated by reference from the indicated pages of the Appendix to the 1994 Annual Meeting Proxy Statement. **Compensatory plan or arrangement required to be filed as an exhibit pursuant to Item 14(c) of this Form 10-K. SIGNATURES PURSUANT TO THE REQUIREMENTS OF SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT OF 1934, THE COMPANY HAS DULY CAUSED THIS REPORT TO BE SIGNED ON ITS BEHALF BY THE UNDERSIGNED, THEREUNTO DULY AUTHORIZED. CATERPILLAR INC. (Registrant) By: R. R. Atterbury III ------------------------------- Date: March 2, 1994 R. R. Atterbury III, Secretary PURSUANT TO THE REQUIREMENTS OF THE SECURITIES EXCHANGE ACT OF 1934, THIS REPORT HAS BEEN SIGNED BELOW BY THE FOLLOWING PERSONS ON BEHALF OF THE COMPANY AND IN THE CAPACITIES AND ON THE DATES INDICATED. March 2, 1994 DONALD V. FITES Chairman of the Board, Director -------------------------- and Chief Executive Officer (Donald V. Fites) March 2, 1994 JAMES W. WOGSLAND Vice Chairman and Director -------------------------- (James W. Wogsland) March 2, 1994 GLEN A. BARTON Group President -------------------------- (Glen A. Barton) March 2, 1994 GERALD S. FLAHERTY Group President -------------------------- (Gerald S. Flaherty) March 2, 1994 JAMES W. OWENS Vice President and -------------------------- Chief Financial Officer (James W. Owens) March 2, 1994 ROBERT R. GALLAGHER Controller and -------------------------- Chief Accounting Officer (Robert R. Gallagher) _______, 1994 Director -------------------------- (Lilyan H. Affinito) March 2, 1994 JOHN W. FONDAHL Director -------------------------- (John W. Fondahl) March 2, 1994 DAVID R. GOODE Director -------------------------- (David R. Goode) March 2, 1994 JAMES P. GORTER Director -------------------------- (James P. Gorter) March 2, 1994 WALTER H. HELMERICH, III Director -------------------------- (Walter H. Helmerich, III) March 2, 1994 JERRY R. JUNKINS Director -------------------------- (Jerry R. Junkins) _______, 1994 Director -------------------------- (Charles F. Knight) March 2, 1994 PETER A. MAGOWAN Director -------------------------- (Peter A. Magowan) March 2, 1994 GEORGE A. SCHAEFER Director -------------------------- (George A. Schaefer) March 2, 1994 JOSHUA I. SMITH Director -------------------------- (Joshua I. Smith) March 2, 1994 CLAYTON K. YEUTTER Director -------------------------- (Clayton K. Yeutter) REPORT OF INDEPENDENT ACCOUNTANTS ON FINANCIAL STATEMENT SCHEDULES To the Board of Directors of Caterpillar Inc.: Our audits of the consolidated financial statements of Caterpillar Inc. referred to in our report dated January 21, 1994 appearing on page A-3 of the Appendix to the 1994 Annual Meeting Proxy Statement (which report and consolidated financial statements are incorporated by reference in this Annual Report on Form 10-K) also included an audit of the Financial Statement Schedules listed in Item 14(a) of this Form 10-K. In our opinion, these Financial Statement Schedules present fairly, in all material respects, the information set forth therein when read in conjunction with the related consolidated financial statements. PRICE WATERHOUSE Peoria, Illinois January 21, 1994 CATERPILLAR INC. AND CONSOLIDATED SUBSIDIARY COMPANIES SCHEDULE V -- PROPERTY, PLANT AND EQUIPMENT (Millions of dollars) YEARS ENDED DECEMBER 31, - ---------------- (1) The principal lives and depreciation methods used for the above asset classifications are: (2) Includes effects of changes to the Provision for plant closing and consolidation costs. See Schedule VIII. CATERPILLAR INC. AND CONSOLIDATED SUBSIDIARY COMPANIES SCHEDULE VI - ACCUMULATED DEPRECIATION OF PROPERTY, PLANT AND EQUIPMENT (Millions of dollars) YEARS ENDED DECEMBER 31, CATERPILLAR INC. AND CONSOLIDATED SUBSIDIARY COMPANIES SCHEDULE VIII - VALUATION AND QUALIFYING ACCOUNTS (Millions of dollars) YEARS ENDED DECEMBER 31, CATERPILLAR INC. AND CONSOLIDATED SUBSIDIARY COMPANIES SCHEDULE IX - SHORT-TERM BORROWINGS (Millions of dollars) YEARS ENDED DECEMBER 31, - --------------- /(1)/ The weighted average interest rates were computed by relating interest expense for the year to average daily or monthly borrowings. /(2)/ High inflation countries include borrowings in Brazil. The Weighted Average Interest Rate is not considered meaningful because rate reflects effect of significant inflation. /(3)/ Commercial paper supported by revolving credit agreements of $455 million, $795 million, and $790 million at December 31, 1993, 1992, and 1991, respectively, was classified as noncurrent in the consolidated financial position. In this Schedule, the commercial paper balances include the noncurrent portion.

812427_1993.txt

812427

1993

ITEM 1. BUSINESS THE COMPANY The Company was formed in 1918 and was renamed Hoechst Celanese Corporation in February 1987. The Company manufactures and sells, principally to industrial customers, a diversified line of products including textile and technical fibers; acetate cigarette filter tow; specialty and bulk chemicals and pharmaceuticals; prescription drugs; crop protection products; veterinary pharmaceuticals and animal-feed additives; engineering plastics; polyethylene; presensitized offset printing plates; dyes and pigments; and polyester film. The Company's operations are currently segmented as follows: Chemicals; Fibers and Film; Specialties and Advanced Materials (comprised of the Advanced Materials Group and Specialty Chemicals Group); Life Sciences and Advanced Technology. The Company is wholly owned by Hoechst Corporation, which in turn is wholly owned by Hoechst Aktiengesellschaft ("Hoechst AG"), a large chemical company headquartered in Frankfurt, Federal Republic of Germany. Hoechst AG and its consolidated entities (the "Hoechst Group") consist of over 270 companies. The Hoechst Group operates in more than 120 countries. The Hoechst Group's sales in 1993 were approximately $27.7 billion. See "Certain Relationships and Related Transactions." The Hoechst Group is one of the largest manufacturers of prescription drugs and one of the four largest producers and marketers of chemicals and chemical-related products in the world. Beginning January 1, 1991, the Company consolidated Celanese Mexicana, S.A. ("Celmex"), a 40-percent-owned affiliate, in its financial statements. Hoechst Celanese with Hoechst AG owns 51 percent of the outstanding voting shares of Celmex. The Company previously accounted for Celmex under the equity method. In November 1993, the Company acquired 52.96 percent of the outstanding shares of Copley Pharmaceutical, Inc. ("Copley"), a generic drug manufacturer, in a tender offer for an aggregate purchase price of $546 million. The Company's principal executive offices are located at 1041 Route 202-206, Bridgewater, New Jersey 08807; its mailing address is Route 202-206, Post Office Box 2500, Somerville, New Jersey 08876-1258; and its telephone number is (908) 231-2000. DESCRIPTION OF BUSINESS SEGMENTS CHEMICALS SEGMENT This segment consists of Hoechst Celanese Chemical Group, Inc., the chemical operations of Celmex and the chemical operations of Celanese Canada Inc. ("Celanese Canada"), approximately 56% owned by the Company. The Company entered the petrochemical field in the United States in 1945, primarily to obtain supplies of acetic acid and related chemical raw materials for its fibers operations. As its internal chemical usage expanded and additional products were developed, the segment began selling chemicals to others. This segment employs approximately 4,100 people and produces more than 60 different chemicals. The segment produces chemicals by upgrading hydrocarbons such as ethylene, propylene, natural gas and butane. The hydrocarbon raw materials are purchased on the open market, principally under long-term contracts. The major chemicals produced fall into two broad product groups: (1) methyl chemicals, oxo-alcohols and solvents; and (2) acetyl chemicals, monomers and ethylene oxide/glycol. Methyl chemicals are principally used in plastics, polyesters, adhesives, solvents, synthetic lubricants, fuel additives and coatings. Ethylene oxide/glycol, oxo-alcohols and solvents are principally used in surfactants, coatings, rocket propellants, antifreeze, herbicides and polyesters. Monomers and acetyl chemicals are primarily used in water-based paints, adhesives, textile finishes, paper coatings, manufactured fibers, pharmaceuticals, herbicides and plastics. With respect to substantially all of its major products, this segment is either the largest or second largest United States merchant market supplier. Other major United States producers are: of methyl chemicals, Borden, Inc., E.I. duPont de Nemours & Co., Inc. ("duPont"), Georgia-Pacific Corporation and Hercules Incorporated; of alcohols, duPont, Eastman Chemical Products, Inc. ("Eastman"), Shell and Union Carbide Corporation; and of monomers and acetyl chemicals, BASF, duPont, Eastman, Quantum Chemical Corporation, Rohm and Haas Co. and Union Carbide Corporation. Celmex is the sole or a major Mexican producer of a variety of products including vinyl acetate, acetic acid, acetic anhydride, acrylates, and phthalic anhydride. A substantial portion of the chemical production of Celmex is sold in the export market, in competition with world producers. Celanese Canada is the sole or a major Canadian producer of acetic acid, acetic anhydride, formaldehyde, pentaerythritol and vinyl acetate monomer. A substantial portion of the chemical production of Celanese Canada is sold in the export market, in competition with world producers. Celanese Canada operates a world scale methanol unit at its Edmonton plant site in Alberta. The methanol operation is owned by Celanese Canada and the Company. Other major Canadian producers of methanol are Nova Corporation of Alberta and Methanex Corporation (formerly Ocelot Industries Ltd.). Utilizing both acquired and internally developed technology, the segment is continually working to upgrade its chemical processes to improve energy, raw material and capital utilization. By producing a number of its major chemicals at different plant locations, the segment attempts to avoid or minimize the effect of production disruptions at any one location. FIBERS AND FILM SEGMENT This segment is comprised of the following business areas: Textile Fibers, Technical Fibers and Polyester Resins and Films. The Fibers and Film segment employs approximately 17,200 people and operates plants in the United States and abroad. The major product lines include: polyester staple, filament, resins, monofilament, spunbond and film; acetate filament and tow; purified terephthalic acid ("PTA"); dimethylterephthalate ("DMT") and polybenzimidazole ("PBI"). The Company is one of the largest producers of manufactured fibers in the United States. It is also one of the leading producers of polyester film. The Company conducts research and development, manufactures, markets and sells a combination of branded and unbranded fibers and film products for a wide variety of end uses. The Company sells most of its fibers and yarns directly to textile mills, tire manufacturers, cigarette makers and other intermediate processors. Among the internationally registered trademarks are: Trevira(R), Celebrate!(R), Hostaphan(R) and Trespaphan(R). Polyester staple and filament, commonly recognized by their Trevira(R) trademark, are principally used in wearing apparel, upholstery, floor coverings, home furnishings, and woven and non-woven fabrics. Polyester staple and filament are also used in tires, belts, hoses, thread and plastic reinforcement. The Company is one of the largest producers in the United States of cellulose acetate products. Cellulose acetate flake is produced for sale or conversion to acetate tow for use in cigarette filters and to filament used in apparel and industrial applications. Polyester monofilament is used in zippers, conveyor belting and dryer and forming screen applications in the paper industry. Roofing and geotextile applications are the primary end uses for polyester spunbond. Polyester resins are primarily used in beverage, pharmaceutical and other containers and for the manufacture of polyester fibers. In 1991, the Company entered into a worldwide joint venture agreement with Hoechst AG and certain Mitsubishi companies to establish a joint venture for the production, marketing and sale of polyester film. The joint venture has regional centers in the United States, Germany and Japan. As provided by the joint venture agreement, the Company's polyester film business, in January 1992, was transferred to a partnership, the partners of which are subsidiaries of the Company and Mitsubishi. Hostaphan(R) polyester film, manufactured by the Company, is used in many consumer products including audio, video and computer tape; food packaging; solar window film; labels and decals; graphic arts film; photoresist; and other electronics applications. Trespaphan(R) polypropylene film is imported for resale from other companies in the Hoechst Group and is used in packaging, capacitors, pressure sensitive tape and electric motor insulators. The key raw materials used by the Fibers and Film segment in production are either supplied internally or purchased on the open market, generally under long-term contracts. Polyester fibers are produced from PTA or DMT, which are either purchased from other suppliers or produced by Cape Industries, 100% owned by the Company, and ethylene glycol which is purchased from other suppliers and is also produced by the Company. Acetate fibers are made principally from acetic anhydride produced mainly by the Company and from wood pulp purchased by the Company. See "Business-Raw Materials and Energy." Major manufactured polyester and acetate fibers competitors include: Allied- Signal, Inc., duPont, Eastman, ICI Americas, Inc. ("ICI"), Rhodia AG and Wellman, Inc. Major United States and foreign polyester film producers include: duPont, ICI, Toray Industries (America), Inc. and Teijin America, Inc. Competing producers of PTA and DMT in the United States are Amoco Chemicals Corporation and duPont, respectively. Celmex is the sole or a major Mexican producer of a variety of products including polyester high denier industrial yarn, industrial staple, textile staple and filament, carpet staple, textile nylon filament, industrial nylon filament, cellulose acetate flake, yarn, and cigarette filter tow, polyester bottle resin, laminated and printed film and bioriented polypropylene. Celanese Canada is the sole or a major Canadian producer of a variety of products including polyester, textile staple, carpet staple, cellulose acetate filament yarn, cellulose acetate flake and cigarette filter tow. A substantial portion of the fibers production of both Celmex and Celanese Canada is sold in export markets in competition with world producers. The Company (owning approximately a 30% interest) and China National Tobacco Company are involved in a joint venture that manufactures cellulose acetate tow for cigarette filters at a facility in Nantong, People's Republic of China. Two more joint venture manufacturing sites for the same product are under construction and expected to come on stream in late 1995. They are located at Kunming and Zhuhai, People's Republic of China. SPECIALTIES AND ADVANCED MATERIALS SEGMENT This segment consists of the Advanced Materials Group and Specialty Chemicals Group. This segment employs approximately 4,000 people and produces, imports and sells a wide variety of specialty products. Advanced Materials Group. The Advanced Materials Group produces a variety of high-performance engineering thermoplastics, including acetal copolymer sold under the trademarks Celcon(R) and Hostaform(R), Celanese(R) nylon 6/6 resins, thermoplastic polyester sold under the trademarks Celanex(R) and Impet(R), liquid crystal polymers sold under the trademark Vectra(R), long fiber- reinforced thermoplastics sold under the trademark Celstran(R) and thermo- plastic alloys sold under the trademark Vandar(R), as replacements for metals and other plastics in a wide variety of end uses. The Group's product lines also include Hostalen(R) GUR, ultra high molecular weight polyethylene. The Company produces the basic raw materials for Celcon(R), Celanex(R), Impet(R) and Vandar(R) resins and purchases them for Celanese(R) nylon 6/6 and Vectra(R) and Celstran(R) resins. Other major United States producers of one or more similar engineering thermoplastics are duPont, General Electric Company and BASF. The Group also resells Hostaflon(R) fluoropolymers manufactured by Hoechst AG.The Company participates in Fortron Industries, a joint venture (with a 50% interest; Kureha Chemical Industry Co., Ltd. ("Kureha") having a 50% interest). The joint venture has completed the construction of a plant to manufacture Fortron(R) polyphenylene sulfide. Since 1987 the Company has marketed Fortron(R) which is manufactured by Kureha. The Company participates in Polyplastics Co., Ltd. (with a 45% interest; Daicel Chemical Industries, Ltd. having a 55% interest) which produces and sells acetal copolymer, thermoplastic polyester resins and other polymeric products and in Ticona Polymerwerke GmbH (with a 41% interest; Hoechst AG having a 59% interest) which produces acetal copolymer resins marketed by both Hoechst AG and the Company. The Company also participates in Taiwan Engineering Plastics Co., Ltd. (with a 12% interest; Polyplastics Co., Ltd. having a 30% interest; Hoechst AG a 32% interest; Hoechst Taiwan Co., Ltd. a 1% interest; and Chang Chun Group a 25% interest) which produces and markets acetal copolymer resins. Specialty Chemicals Group. This Group's product lines include: textile dyes, organic pigments, colorant and additive masterbatches, resins, sodium hydrosulfite, surfactants, and other specialty chemicals which are mainly used in the textile, ink, pulp and paper, paint, coatings, plastics, personal care, detergent and food processing industries; organic intermediates used for synthesis of dyes, pigments, pharmaceuticals, cosmetics, agricultural chemicals, photochemicals, plastics, adhesives, and other chemical products; inorganic chemicals sold for broad industrial use, including pharmaceuticals, electrical and battery equipment and oil drilling; superabsorbent polymers used in personal care products; waxes and lubricants used for polish and plastics processing applications; a complete range of color and liquid photoresists and ancillaries used in the manufacture of internationally registered trademarks are: Remazol(R) dyes; Genapol(R) and Hostapon(R) surfactants; Sanwet(R) superabsorbent polymers (a registered trademark of Sanyo Chemical Industries, Ltd. licensed to the Company); and AZ(R) liquid photoresist. The Group also produces and sells Enco(R) printing systems which include presensitized printing plates, pre-press color proofing films and a complementary line of processing chemistry and equipment used by the graphic arts industry. The Group is among the leading suppliers of presensitized offset printing plates in the United States. Major U.S. competitors in offset printing plates are Minnesota Mining and Manufacturing Company, Polychrome Corporation, Eastman Kodak Co., duPont and Fuji Photo Film Company, Ltd. Aluminum for printing plates is purchased on the open market from a limited number of suppliers. The Group's product lines also include Sunette(R) (acesulfame K) a new high- intensity sweetener, Celgard(R) microporous membranes, Separex(R) gas membrane systems, and ultra fine polyolefin powders. LIFE SCIENCES SEGMENT This segment consists of Hoechst-Roussel Pharmaceuticals Incorporated ("HRPI"), Bulk Pharmaceuticals and Intermediates ("BPI") which includes the Pharmaceutical Production Division ("PPD"), Hoechst-Roussel Agri-Vet Company ("HRAVC") and Copley. This segment employs approximately 2,700 people. Its operations encompass the research and development, production and marketing of branded and generic prescription drugs, bulk pharmaceutical chemicals, veterinary pharmaceutical products, animal-feed additives and crop protection products. HRPI. The Company's prescription drug business is conducted through HRPI, a majority owned subsidiary. HRPI has two classes of common stock: Class R and Class H Common Stock. Class R Common Stock has 20% of the total voting rights and is owned entirely by Roussel-Uclaf, S.A. ("RU"), a French pharmaceutical company which is majority owned by Hoechst AG. Class H Common Stock has 80% of the total voting rights and is owned entirely by the Company. RU also owns warrants which, if exercised, would increase RU's interest in HRPI to 50% by 1994. The major products of HRPI are prescription drugs which are promoted by its field sales force to health professionals in physicians' offices, pharmacies, hospitals, group purchasing organizations and managed care organizations. Major products include: Altace(TM) (ramipril), Claforan(R) (cefotaxime sodium), DiaBeta(R) (glyburide), Lasix(R) (furosemide), Loprox(R) (ciclopirox olamine), Topicort(R) (desoximetasone), Dermatop(R) (prednicarbate) and Trental(R) (pentoxifylline). Altace(TM) is an ACE-inhibitor antihypertensive. Claforan(R) is an antibiotic used in the treatment of serious infectious diseases. DiaBeta(R) is an oral antidiabetic. Lasix(R) is a diuretic used for the mobilization of edema of varied origin. Loprox(R) is a topical antifungal. Topicort(R) is a high potency topical corticosteriod anti-inflammatory. Dermatop(R) is a mid-potency topical corticosteroid anti-inflammatory. Trental(R) is a hemorrheologic agent to relieve intermittent claudication (leg cramping pain associated with peripheral arterial disease). HRPI's major competitors include: for ACE-inhibitor antihypertensive, Merck & Co., Inc. and Bristol Myers Squibb; for diuretics, Merck & Co., Inc., SmithKline Beecham PLC and Hoffman-LaRoche Inc.; for oral antidiabetics, The Upjohn Company and Pfizer Inc.; for vasotherapeutics, Sandoz Corporation; for third generation cephalosporin antibiotics, Hoffman-LaRoche Inc., Glaxo, Inc., and Eli Lilly & Company; and for dermatologicals, Syntex Laboratories, Inc. and Schering-Plough Corporation. Active ingredients for HRPI's major products are produced by PPD or imported from Hoechst AG or RU. Formulation and packaging of most products are performed in the United States by HRPI under strict manufacturing practices governed by the United States Food and Drug Administration (the "FDA"). Other products are imported from companies in the Hoechst Group and are subject to the same FDA regulations. HRPI conducts research concentrated on the discovery of compounds which act on the central nervous system (e.g., Alzheimer's disease and schizophrenia) and those which treat diseases of the skin. At this time, HRPI is awaiting approval from the FDA of one new drug product. Approximately 22 additional products are in clinical investigation under FDA Investigational New Drug Applications. In addition, HRPI has the right of first refusal to market all future new Hoechst AG and RU pharmaceutical products in the United States. Copley. The company's generic drug business is conducted through its participation in Copley. Copley develops, manufactures and markets a broad range of off-patent prescription and over-the counter pharmaceuticals. BPI is a supplier of bulk analgesics, pharmaceutical bulk actives and pharmaceutical intermediates. The Company participates in BHC Company (with a 50% interest: Boots Company PLC having a 50% indirect interest) which manufactures and markets bulk ibuprofen. BHC's major competitor is Ethyl Corporation. BPI also manufactures acetaminophen for which its major competitors include Mallinckrodt Corporation and Rhone-Poulenc Corporation. PPD produces and supplies HRPI with active ingredients for DiaBeta(R), Lasix(R), Topicort(R) and Trental(R) products. HRAVC. HRAVC is a partnership between a wholly owned subsidiary of the Company (50%) and Uclaf Corporation (50%), which is indirectly wholly owned by RU. HRAVC is involved in developing and marketing animal health and crop protection products. It is anticipated that in 1994 the crop protection activities of HRAVC will be merged with NOR-AM Chemical Company, Inc. a wholly owned subsidiary of Schering Berlin Inc. The resulting partnership will be 60% owned by a wholly owned subsidiary of the Company. HRAVC's animal health products consist primarily of veterinary pharmaceuticals and animal-feed additives. HRAVC's crop protection products are used with four of the five major United States crops: wheat, soybeans, cotton and rice. HRAVC's products are promoted by a field sales force and primarily marketed through distributors. Animal health products are manufactured under tolling arrangements with HRPI and in some cases other toll manufacturers. The active ingredients for these products are imported from other companies in the Hoechst Group. ADVANCED TECHNOLOGY SEGMENT This segment consists of the Advanced Technology Group and includes research and development costs to seed and develop new businesses. These costs are not borne by any group and are shown separately beginning in 1993. Prior to 1993 this group was included in the Specialities and Advanced Materials segment. Emerging businesses are primarily based on products or processes that have been developed by the Company or other companies in the Hoechst Group. This segment employs 1,000 people. RESEARCH AND DEVELOPMENT The Company conducts research and development both independently and jointly with Hoechst AG and, additionally, has been a party to a broad research and development cost-sharing agreement with Hoechst AG since January 1, 1988. The Company is continuing to expand its own research and development activities in areas where specific developments for the United States market increase the Company's competitiveness. Research and development costs are included in expenses as incurred. The Company's research and development costs for 1993, 1992 and 1991 were $258 million, $262 million and $261 million, respectively. Management intends to maintain the Company's research and development expenditures in 1994 at approximately the same level as 1993. At December 31, 1993, approximately 2,000 employees, including approximately 1,000 professionals, were engaged in basic and applied research and development at the Company. These individuals work in coordination with the Hoechst Group's research and development personnel in the Federal Republic of Germany and other parts of the world. The Hoechst Group in turn has access to a significant portion of the Company's technology, know-how and patent rights. The Hoechst Group is one of the leading research-oriented chemical companies in the world, employing approximately 15,300 persons in its various research and development laboratories. Research and development expenditures of the Hoechst Group amounted to approximately $1.8 billion in 1993. Based on individual license agreements and the cost-sharing agreement, the Company has access to a significant portion of the Hoechst Group's technology, know-how and patent rights for the United States and other markets, including licenses for new developments. The Company's United States research and development facilities are located in Auburn Hills, Michigan (automotive plastic applications); Branchburg, New Jersey (photoresists); Bridgewater, New Jersey (pharmaceuticals); Charlotte, North Carolina (textile and technical fibers, specialty chemicals, separations products and polyester resins); Corpus Christi, Texas (chemicals, pharmaceutical intermediates and bulk actives); Coventry, Rhode Island (organic intermediates, dyes, pigments and specialty chemicals); Greer, South Carolina (polyester film); Winona, Minnesota (advanced materials); Florence, Kentucky (advanced materials); Portsmouth, Virginia (superabsorbent polymers) and Summit, New Jersey (advanced materials, polymers and engineering plastics). MARKETING AND COMPETITION The Company's products are generally sold in the United States directly or through distributors or agents. Foreign subsidiaries and affiliates sell principally through local sales personnel or agents. With the exception of products sold by the Life Sciences segment, the principal customers worldwide are other manufacturers which use the Company's products in a wide variety of industrial and consumer products. Products sold by the Life Sciences segment are primarily sold through wholesalers and distributors. In general, the Company sells its products in highly competitive worldwide markets. The number of competitors in a market or country and the Company's competitive position vary widely with the products and countries involved. See specific discussion of competitors in "Description of Business Segments" above. There is growing competition from private and state-owned industries in certain foreign countries in which there is an abundance of low-cost labor or raw materials. This competition has a direct or indirect effect on many product lines. For example, in the area of textile fibers, business is impacted by fabric and apparel imports into the United States, Canada and Mexico, particularly from the Far East. Depending upon the characteristics of the particular market, the Company competes on the basis of price, product quality and performance, technical support and customer service. Within the Chemicals and Fibers and Film segments, the Company competes primarily on the basis of price, product quality and performance. In general, Specialties and Advanced Materials products are sold based on product performance, technical support and, to a lesser extent, price. Life Sciences products compete based on product performance as well as technical support and expertise. The Company's business is affected to some degree by seasonality in the industries of its customers such as automotive, housing, agriculture, printing and textiles. The business is also sensitive to changes in the world economy, including changes in currency exchange rates. Operations outside the United States are subject to the economic and political risks inherent in the countries in which they operate. Additionally, the export and domestic markets can be affected significantly by import laws and regulations and energy cost differentials. During 1993, the Company's export sales from the United States were 12.3% of consolidated net sales. Indirect marketing activities of the Company are extended through technical and educational services, advertising and promotion. These activities reach each level of the manufacturing and distribution system, as well as consumers of apparel, home furnishings and industrial products. Product development and technical service personnel supplement direct sales efforts by assisting customers in using existing products and developing new ones. RAW MATERIALS AND ENERGY Most of the Company's products are made by chemically processing and upgrading several basic types of raw materials including petroleum hydrocarbons and derivatives, natural gas, wood pulp and aluminum. These derivatives include ethylene and paraxylene, which are primarily supplied by major United States and Canadian oil companies. Raw materials are purchased from affiliated and non- affiliated suppliers throughout the world. The Company's production facilities rely largely on coal, fuel oil, natural gas and electricity for energy. The Company currently has adequate supplies or access to sources of all purchased raw materials and energy for the foreseeable future. The Company does not consider itself dependent upon any one supplier for a material amount of its raw material or fuel purchases. However, in the United States, wood pulp (a raw material for cellulosics) is largely obtained from two suppliers, and Cape Industries is the sole supplier of DMT and is one of two suppliers of PTA used in the production of polyester. Celmex purchases the majority of its raw materials from Petroleos de Mexico. In addition, some active ingredients and other raw materials used by the Life Sciences segment, as well as the Specialty Chemicals and Advanced Technology Groups, are supplied by other companies in the Hoechst Group. GOVERNMENT REGULATIONS The pharmaceutical, agricultural and veterinary industries in the United States have for many years been subject to extensive regulations by the Federal government and to an increasing extent by state agencies, primarily as to product efficacy, safety, advertising and labeling. The general trend is toward more stringent regulations. Such regulations affect the cost of developing and marketing products. The Company believes it is in substantial compliance with all environmental, health and safety regulations and continues to devote attention to the health and safety of its employees and the protection of the public health and the environment in the regions where it operates. Such compliance has not had an adverse effect on the Company's competitive position or business. The Company cannot predict the effect of regulations which may be adopted in the future by governmental bodies responsible for air, water and solid waste pollution controls and employee and community health and safety. In November 1990, Congress passed, as part of the Omnibus Budget Reconciliation Act, legislation requiring pharmaceutical manufacturers to extend rebates to state Medicaid agencies based on each state's reimbursement of pharmaceutical products under the Medicaid program effective January 1, 1991. Medicaid rebates and related state programs reduced net sales and operating income by $26 million in 1993, $24 million in 1992 and $12 million in 1991. PATENTS AND LICENSES The Company owns, or is licensed under, more than 4,500 patents relating to its products and manufacturing processes, some of which are important to specific commercial operations. No single patent or group of patents is considered material to the business as a whole. The Company's principal licenses are either continuing licenses from third parties or relate to patents and know- how owned by other companies in the Hoechst Group. Generally in the latter cases, the licenses require no specific payment because, overall, the research and development costs have been shared. In cases where license fees are involved with the Hoechst Group, they are generally based on percentages of sales and do not require minimum payments. Management believes that the terms of such license agreements are similar to those competitively negotiated between unrelated parties. The Company has developed and acquired technical information and owns patents in the chemicals, fibers, life sciences, specialties and advanced materials fields, some of which have been licensed to affiliates and others worldwide. EMPLOYEES At December 31, 1993, worldwide employment for the Company was approximately 29,900. The Company employed about 9,000 persons outside the United States. In the United States, fewer than one-fourth of the plants and employees are organized by labor unions. Most labor agreements are for terms of three years. The Company offers comprehensive benefit plans for employees and their families and believes relations with employees are satisfactory. ENVIRONMENT The Company's worldwide operations are subject to environmental laws and regulations which impose limitations on the discharge of pollutants into the air and water and establish standards for the treatment, storage and disposal of solid and hazardous wastes. The Company believes that it is in substantial compliance with all applicable environmental laws and regulations. In 1993, combined worldwide expenditures, including third party and divested sites, for compliance with environmental control regulations and internal Company initiatives totaled $294 million, of which $149 million was for capital projects. In both 1994 and 1995, total annual environmental expenditures are expected to be approximately $300 million, of which $125 million is for capital projects. It is anticipated that stringent environmental regulations will continue to be imposed on the Company and the industry in general. Although the Company cannot predict expenditures beyond 1995, management believes that the current spending trends will continue. The Company may be subject to claims brought by Federal or state regulatory agencies or private individuals pursuant to statutory authority or common law. In particular, the Company has a potential liability under the Federal Comprehensive Environmental Response Compensation and Liability Act ("Superfund") and related state laws for investigation and cleanup costs at approximately 100 sites. At most of these sites, numerous companies, including either the Company or one of its predecessor companies, have been notified that the United States Environmental Protection Agency ("EPA"), state governing body or private individuals consider such companies to be potentially responsible parties under Superfund or related laws. The proceedings relating to these sites are in various stages. The cleanup process has not been completed at most sites and the status of the insurance coverage for most of these proceedings is in litigation. The Company has accrued its best estimate of its ultimate liability for investigation or cleanup costs, but, due to the many variables involved in such estimation, the ultimate liability may vary. Expenditures for investigation, clean up and related activities have been $31 million for the three years ended December 31, 1993 with expenditures in no year greater than $13 million. SEGMENT AND GEOGRAPHICAL INFORMATION See Note (14) of Notes to Consolidated Financial Statements for Segment and Geographical Information. ITEM 2.

ITEM 2. PROPERTIES The Company owns and operates various manufacturing facilities within the United States and abroad. It also owns or leases facilities related to its operations such as warehouses, pipelines, tolling operations, research and development and sales offices. The Company's principal manufacturing facilities, which are owned by the Company (unless otherwise indicated), are summarized below: CHEMICALS SEGMENT: - ---------- *The methanol operation is owned by Celanese Canada and the Company. **Polyester film assets are owned by a partnership. See "Business--Description of Business Segments"(Item 1). Management believes that the Company's properties are suitable for its business and have adequate productive capacities to meet current and future business requirements. ITEM 3.

ITEM 3. LEGAL PROCEEDINGS The Company is a defendant in a number of lawsuits, including environmental, product liability and personal injury actions. Certain of these lawsuits are or purport to be class actions. In some of these cases, claimed damages are substantial. While it is impossible at this time to determine with certainty the ultimate outcome of these lawsuits, management believes, based on the advice of legal counsel, that adequate provisions have been made for probable - ---------- * This facility is leased. losses with respect thereto and that the ultimate outcome will not have a material adverse effect on the financial position of the Company, but may have a material effect upon the results of operations in any given year. The Company was named in 1986, 1987, 1988 and 1991 as one of numerous defendants in fourteen lawsuits in the Twenty-First Judicial District Court, Parish of Livingston, Louisiana. These lawsuits arose out of shipments of allegedly toxic waste to a waste oil processing site in Livingston Parish, Louisiana. Claims totalling approximately $20 billion are being made against the defendants for property damages, personal injury and psychological and other damages. While a class consisting of approximately 3,000 plaintiffs has been certified by the court, it is difficult to assess the extent to which the Company may be liable, if at all, since individualized claims of class members are involved. However, considering the number of potentially responsible parties (over 80 defendants in each case), many of which are substantial corporations, and the Company's small proportion of the total volume of waste sent to the site (well under one percent), management believes, based on the advice of legal counsel, that its portion of such liability (including any site clean up costs) would not have a material adverse effect on the financial position of the Company or results of operations. Trial is expected to begin in late 1994. The Company is defending itself vigorously in these proceedings. In February 1990, Region IV of the EPA issued a notice of violation to the Company at its Rock Hill, South Carolina plant alleging that the plant is subject to the benzene fugitive emission standard promulgated by the EPA under the Clean Air Act in 1984. The Company learned in September 1990 that Region IV referred the matter to the United States Department of Justice ("DOJ") for consideration of the appropriateness of enforcement. Although the Company has voluntarily agreed to meet the fugitive emissions standard at this facility as soon as possible, it is the Company's position that the facility properly determined in 1984 that it qualified for an exemption from the standard and, therefore, enforcement and sanctions are not appropriate. The DOJ and the EPA filed a complaint in July, 1992 in U.S. District Court in Columbia, South Carolina, asking the Court to set a penalty of not more than $25,000 per violation per day. The Company asked the EPA and the DOJ to consider an Alternate Dispute Resolution ("ADR") and they rejected ADR. The Company is defending itself vigorously. In November 1993, the DOJ filed a complaint similar to the complaint described above with regard to the Company's plant in Narrows, Virginia. It is the Company's position that the Narrows plant also qualified for the same exemption that applied to the Rock Hill plant. The Company is defending itself vigorously. During the second quarter of 1991, it was discovered that the Aston, Pennsylvania facility of Custom Compounding, Inc., a company acquired in December 1990, required an air permit. The Company in December 1993 voluntarily entered into an Administrative Consent Order with the Pennsylvania Department of Environmental Resources that would require the payment over a period of time of a penalty of $300 thousand. In late June 1991, the Company entered into an agreement with the EPA to participate in a voluntary program known as the "Toxic Substances Control Act - Section 8 (e) CAP Program." Under this program, the EPA is allowing participating companies to conduct voluntary, retrospective self-audits, to submit newly discovered 8 (e) studies to the EPA and to pay a penalty of $6 thousand for each unreported study. Under the program, however, the total penalties to the Company cannot exceed $1 million. Based on the number of studies the Company's self-audit had identified by the end of August, 1992, it is now clear the Company's penalty, which is expected to be payable in mid to late 1995, will be the program's $1 million maximum amount. Under the terms of a December 1991 consent order with the City of Mount Holly, North Carolina (the "Consent Order"), the Company agreed with respect to its Mount Holly plant to meet certain effluent limits for its discharges to the City's water treatment plant and to upgrade its Mount Holly plant's pretreatment facility. The Consent Order establishes a date to "begin construction" of the pretreatment facility upgrade and requires the Company to pay a stipulated sum for each day it fails to comply with the schedule. The City has taken the position that the Company began construction late and has requested payment of $137 thousand. The Company disagrees with this position and, therefore, has not made such payment. The Company is a named defendant in twenty putative class actions, two of which have been certified as class actions as well as defendant in other non- class actions filed in nine states ("the Plumbing Actions"). In these lawsuits the plaintiffs typically seek recovery for alleged property damage to housing units, mental anguish from the alleged failure of plumbing systems, punitive damages, and, in certain cases, additional damages under the Texas Deceptive Trade Practices Act. The other defendants include United States Brass Corporation ("U.S. Brass")(formerly a wholly owned subsidiary of Household International, Inc.), Vanguard Plastics, Inc. ("Vanguard"), Shell Oil Company ("Shell") and E.I. duPont deNemours & Co., Inc. ("duPont"). Damage amounts are not specified. The plumbing systems were designed and manufactured primarily by U.S. Brass and Vanguard. The pipe was made from polybutylene resin supplied by Shell. The Company sold acetal copolymer resin and duPont sold acetal polymer resin to other companies who manufactured the fittings used in the plumbing systems. The class actions and the purported class actions are in the Superior Court of the State of Arizona in and for the County of Maricopa (two cases), in the Superior Court of the State of California for the Counties of San Diego (thirteen cases) and Stanislaus (one case), in the District Court of Clark County, Nevada (one case) and in the 2nd Judicial District Court of Washoe County, Nevada (one case), in the 164th Judicial District Court, Harris County, Texas (one case) and in the United States District Court for the Southern District of Texas (one case; filed, but not served). The Company does not believe its acetal copolymer was defective or caused the plumbing systems to fail. In many cases the Company's exposure may be limited by the fact that the other defendants and other responsible parties may be found liable in whole or substantial part or by invocation of the statute of limitations. The Company is defending itself vigorously in these actions. The Company has also commenced litigation against Household International, Inc. to recover, among other things, the portion of Plumbing Action judgements, settlements and expenses that are attributable to its former subsidiary, U.S. Brass. The Company and certain of its codefendants are currently involved in a nonbinding voluntary mediation effort relating to the plumbing claims with attorneys representing substantially all the plaintiffs in Texas cases and two uncertified nationwide class actions. This mediation seeks to settle the individual claims currently asserted in these Texas cases and to establish a nationwide framework for resolving future claims. However, it is currently too early to determine whether there will be any settlement of any of these pending or future claims, and, if there is a settlement, the manner in which it will be finally allocated among all the potentially responsible parties. Management believes that the Plumbing Actions are substantially covered by insurance. In September 1989, after being sued by one of its insurers in New York, the Company filed suit in the Superior Court of the State of Delaware in and for New Castle County against National Union Fire Insurance Co. of Pittsburgh, Pennsylvania, the primary general liability insurance carrier for the Company from April 1985 to May 1989 and a majority of the excess/umbrella carriers insuring the Company from 1978 to 1989, seeking a declaration that insurance coverage exists for these product liability claims. The insurers' New York action has been stayed and the Company's Delaware suit is proceeding. Negotiations with several of the carriers have resulted in settlement or agreements in principle to settle, resulting in substantial continuing coverage of the plumbing actions or cash payments for claims. There are ongoing discussions with several of the remaining insurers. Outside counsel believes that the Company has a substantial probability of prevailing in its litigation against the carriers. Management believes that the Plumbing Actions will not have a material adverse effect on the financial position of the Company, but may have a material effect upon the results of operations in any given year. See Note (15) of Notes to the Consolidated Financial Statements. In 1988 the Company was sued in Texas State Court by persons alleging injuries as a result of an explosion at the Pampa plant in November 1987. At various times since then the suit has been amended to add additional plaintiffs and to allege injuries resulting from exposure to chemicals either at the plant or in the surrounding environment as a result of plant activities. All explosion claims were settled in December 1990, but there remain approximately 900 "exposure" plaintiffs. Although many plaintiffs have not specified their alleged damages, those that have done so total in excess of $1.3 billion (including exemplary damages). The Santa Fe Railroad, also named as a defendant, has settled with plaintiffs for an undisclosed amount. The parties agreed on a case management order which provided for an initial trial of the claims of three families, chosen by plaintiffs as test cases, but with the agreement that any factual decisions in those cases would not have any effect on later cases. The claims of those families were abandoned by plaintiffs during a trial in the fall of 1993. A similar suit was filed by approximately 100 individuals ("Kingsmill" case) including many of the same plaintiffs, making similar exposure claims and claiming unspecified damages in Texas State court in Sweetwater (Nolan County) in September 1992. An agreement in principle to settle the remaining claims along with the Kingsmill claims has been negotiated with plaintiffs' lawyers. Management is of the opinion that any potential liability ultimately will be covered by insurance. The Company's insurance coverage for environmental matters is currently in litigation. A suit instituted by the Company, in February 1989, against certain of the Company's insurance carriers in the Superior Court, Somerset County, of the State of New Jersey, seeking coverage for environmental matters has been stayed in favor of a March 1989 suit in the Superior Court, Cleveland County, of the State of North Carolina, initiated by such insurance carriers. Both suits seek a determination whether certain of the Company's environmental liabilities are covered by insurance. Management believes that the Texas actions will not have a material adverse effect on the financial position of the Company or results of operations. ITEM 4.

ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS Not applicable. PART II ITEM 5.

ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS Not applicable. ITEM 6.

ITEM 6. SELECTED FINANCIAL DATA Note: This table should be read in conjunction with Management's Discussion and Analysis of Financial Condition and Results of Operations and the Financial Statements and Supplementary Schedules. ITEM 7.

ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The following sections should be read in conjunction with Note (14) of Notes to Consolidated Financial Statements for Segment and Geographical Information. RESULTS OF OPERATIONS 1993 COMPARED TO 1992 Net sales of $6,899 million in 1993 were 2%, or $145 million, below 1992 sales. Life Sciences sales were slightly higher than in 1992, but sales declined in all other operating segments. Chemicals segment sales were lower than 1992 as increased volumes were offset by lower selling prices as a result of continued overcapacity. Fibers and Film segment sales declined from 1992 as reduced export volumes and selling prices were slightly offset by improved domestic volumes. Textile Fibers sales were level compared to 1992. Higher acetate filament sales volumes and prices reflect continuing strength in the fashion industry. These improvements were offset by lower volumes in North American polyester filament and lower selling prices for polyester staple that resulted from increased competitive pressures. In Technical Fibers, sales volumes and prices were lower than in 1992 as filter product shipments to the Far East decreased and overall selling prices declined due to excess worldwide capacity and the strengthening of the dollar in Europe. Tire and MRG (mechanical rubber goods) volumes were lower as a result of the weak European economy, while increased spunbond sales reflected a stronger domestic roofing market. Polyester Resins and Films sales increased marginally over 1992 as packaging resin volumes increased due to higher demand, particularly in the Mexican market. After adjusting for the disposition of the high density polyethylene ("HDPE") business in 1992, Specialties and Advanced Materials sales improved as increased volumes offset lower selling prices. Specialty Chemicals sales were virtually unchanged as reduced selling prices, due to worldwide competitive pressures, and lower volumes, primarily in fine chemicals and printing products, were offset by increased selling prices and improved product mix for pigments and improved volumes for surfactants, electronic products, waxes, and superabsorbent materials. Within Advanced Materials, sales were higher as volumes increased for both high performance polymers and engineering thermoplastics due to general economic growth in their end use markets. Life Sciences sales were slightly higher as both price and volume improvements in crop protection and animal health, in part the result of new product introductions, offset lower full year pharmaceutical volumes. Fourth quarter pharmaceutical sales were higher than the prior 1993 quarters due to wholesaler purchases that normally would have occurred in the first quarter of 1994. Selling, General and Administrative expenses ("SG&A") for 1993 remained virtually the same as 1992 as improvements in Chemicals, Specialty Chemicals, and Advanced Materials offset unfavorable expenses in Fibers and Film. In addition, Fibers and Film SG&A includes a $50 million receipt in settlement of a litigation. Research and Development expenses of $258 million were slightly lower than in 1992. During 1993, the Company charged $29 million to operating income for restructuring (principally Mexican chemical operations), $19 million of which related to the write-down of property, plant and equipment. As part of an ongoing Fibers and Film Segment North American strategy, the company restructured its North American polyester fibers operations. During 1992, the Company charged $87 million to operating income for restructuring, $34 million of which related to the write-down of property, plant and equipment. An additional $15 million was charged to operations in 1992 for restructuring and regionalization of certain other businesses. Operating income of $360 million was $38 million, or 10%, lower than 1992. Improvements in the Fibers and Film and the Specialty and Advanced Materials segments were offset by lower Chemicals and Life Sciences segments operating income. Chemicals segment operating income declined from $210 million in 1992 to $88 million in 1993 due to several nonrecurring items. Operating income from continuing operations improved as manufacturing costs and product mix were favorable compared to the prior year. Operating income was reduced, however, due to 1993 restructuring charges and costs associated with a toxic tort suit involving the Pampa, Texas plant. Also, during 1992, Chemicals segment recorded income of $68 million related to the settlement of its Pampa insurance claims. Fibers and Film operating income improved by $117 million from $298 million in 1992 to $415 million in 1993. Textile Fibers operating income was relatively flat compared to 1992 as an increase in sales volume was offset by higher manufacturing costs. Technical Fibers operating income was lower than in 1992 primarily due to reduced shipments and lower selling prices of filter products. The decrease in Polyester Resins and Films operating income was due to increased manufacturing costs and higher raw material costs principally in Mexico. In addition, Fibers and Film 1993 operating income includes a $50 million receipt in settlement of a litigation while 1992 operating income included $87 million in restructuring costs. The Specialties and Advanced Materials segment operating income improved from $26 million to $58 million primarily due to higher volumes and lower selling and marketing expenses. Specialty Chemicals operating income was lower primarily due to increased manufacturing costs. Operating income increased significantly for Advanced Materials due to improved volumes and favorable manufacturing costs resulting from higher efficiencies and reduced maintenance expenses. Operating income in Life Sciences declined from $60 million in 1992 to $17 million in 1993 primarily due to reduced pharmaceutical sales and to research and development expenditures associated with strategic initiatives within the pharmaceuticals business. Beginning in 1993, the Company has segregated sales and costs associated with the Advanced Technology segment from segment sales and operating income of its operating segments. The Advanced Technology segment represents research and development costs to seed and develop new businesses. Prior to 1993 this group was included in the Specialties and Advanced Materials segment.These costs and results have not been borne by any operating group. When projects and/or businesses become viable, they are transferred to the appropriate operating segment. Equity in Net (Loss) Earnings of Affiliates declined by $12 million compared to 1992 primarily due to lower earnings by Japanese and German affiliates which reflect the continued sluggish economic conditions in those countries. Interest expense decreased $5 million, or 6%, primarily due to lower interest rates, particularly in Mexico. Interest and Other Income, net, was $22 million lower than in 1992 primarily due to lower interest income in 1993, the result of lower interest rates. In 1992, Interest and Other Income included a gain on the sale of the HDPE facility. The effective tax rate decreased to 35% in 1993 compared to 47% in 1992. The decrease is mainly attributable to the accounting change required by the Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes" ("FAS 109"). The Company implemented Statement of Financial Accounting Standards No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions" ("FAS 106"), effective January 1, 1992, and FAS 109 and Statement of Financial Accounting Standards No. 112, "Employers' Accounting for Postemployment Benefits" (FAS 112), January 1, 1993. FAS 106, requires the Company to accrue the current cost of those benefits and resulted in a net after-tax cumulative charge of $141 million in the first quarter of 1992. FAS 109, which requires the asset and liability method of accounting for income taxes and the calculation of deferred taxes using enacted tax rates, resulted in a net after-tax cumulative charge of $31 million in 1993. In addition, by applying FAS 109, pre-tax operating income was reduced by $40 million due to the increase in depreciation and amortization expense resulting from the increased carrying amounts of assets and liabilities acquired in a purchase business combination. The increase in operating expense was offset by a lower deferred tax provision. FAS 112 requires recognition of postemployment benefits on an accrual basis and resulted in a net after-tax cumulative charge of $8 million in 1993. The effect of this change on 1993 earnings before the cumulative effect of accounting changes was not material. On November 11,1993, the Company purchased 52.96% of the outstanding shares of Copley Pharmaceutical, Inc. ("Copley") for approximately $546 million. Copley develops, manufactures and markets a broad range of off-patent prescription and over-the-counter pharmaceuticals. The acquisition was accounted for under the purchase method of accounting. Accordingly, the purchase price will be allocated to the assets acquired and liabilities assumed based on their estimated respective fair values as of the date of acquisition. The allocation of the purchase price will be finalized during 1994. The excess of cost over net assets acquired was approximately $510 million and is being amortized over its estimated life. The Company financed the acquisition through a revolving credit agreement with its parent, Hoechst Corporation. Copley's results of operations have been included in the Company's consolidated financial statements as of the date of acquisition. Copley's operations are not material in relation to the Company's consolidated financial statements and pro forma financial information, therefore, has not been presented. Copley is included in the Life Sciences segment. The following discussions and analyses of "1992 Compared to 1991" and "1991 Compared to 1990" have been restated to reflect Advanced Technology as a separate segment. 1992 COMPARED TO 1991 Net sales of $7,044 million for 1992 represented an increase of 3.7%, or $250 million, over 1991. Improvements in the Fibers and Film, Specialties and Advanced Materials and Life Sciences segments more than offset a decline in the Chemicals segment. Chemicals segment sales declined due to continued unfavorable selling prices, principally methanol and ethylene glycol/oxide, partially offset by domestic and export volume improvements, mostly acrylates and vinyl acetate monomer. In the Fibers and Film segment, 1992 full year sales increased due to improved volumes and, to a lesser extent, higher selling prices. Textile fibers sales were higher due to an increase in polyester staple, acetate filament and polyester textile filament prices. Volume improvements, primarily in polyester staple and spunbond, were partially offset by unfavorable acetate filament export volumes. Spunbond prices were lower due to increased competitive pressures. Strong fourth quarter sales contributed to 1992 increases in Technical Fibers. The improvement is attributable to higher sales volumes from filter products and the polyester high denier industrial fibers business units resulting from increased market demands. In Film and Fiber Intermediates, sales increased as a result of favorable pricing and higher volumes in polyethylene terephthalate film and packaging resins. Specialties and Advanced Materials segment sales were slightly higher, primarily due to volume improvements in superabsorbents, dyes and pigments, the last two increasing due to stronger apparel and automotive markets. Advanced Materials sales increased due to higher volumes in engineering thermoplastics and high performance polymers, the result of a general strengthening of the U.S. economy. These volume increases were partially offset by unfavorable selling prices due to competitive pressures. Life Sciences segment sales increased due to a strong fourth quarter. The heavy sales volumes were the result of significant wholesaler purchases which normally would have occurred in the first quarter of 1993. New product introductions in the crop protection and animal health area also contributed to the increase. Selling, general and administrative expenses were $946 million, an increase of $56 million, or 6.3%, from 1991. Selling, general and administrative expenses were higher as increased expenses within Life Sciences were partially offset by declines in the Fibers and Film and Specialties and Advanced Materials segments. Life Sciences expenses increased due to a field force expansion and higher costs to support new marketing programs. Research and Development expenses of $262 million were flat across all segments and unchanged from 1991 levels. The Company is restructuring its North American polyester fibers operations. As part of an ongoing North American strategy, Hoechst Celanese will install additional staple fiber capacity within Celanese Mexicana, S.A. This expansion should not result in a net increase in North American staple fiber capacity. The realignment of other polyester facilities in Canada and the United States is currently being studied. During 1992, $87 million has been charged to Fibers and Film operating income for restructuring, $34 million of which related to the write-down of property, plant and equipment. An additional $15 million has been established for restructuring and regionalization of certain other businesses. Operating income was $398 million, a decrease of $75 million, or 15.9%, from 1991. Excluding the effects of restructuring costs, all business areas within the Fibers and Film segment showed improvements in operating income and offset a decline in the Chemicals segment operating income. The favorability in operating income experienced by Textile Fibers was mainly due to sales improvements. Technical Fibers registered a modest improvement in operating income from increased sales. Film and Fiber Intermediates operating income was higher due to substantially improved sales volumes and, to a lesser extent, favorable raw materials costs (paraxylene and ethylene glycol). Although raw material costs were somewhat lower, Chemicals segment operating income declined as competitive pressures in the commodity chemicals market continued to have an adverse impact on selling prices and profit margins. Specialties and Advanced Materials segment operating income improved primarily due to higher sales volumes. In Specialty Chemicals, strong sales volumes were the main contributor to improved operating income. Improvements were also realized in Advanced Materials, which was aided by a strengthening in the automotive and electronics markets. Life Sciences segment operating income was relatively flat as fourth quarter sales volume improvements were offset by higher selling, general and administrative expenses. In addition to higher volumes of Trental(R) (pentoxifylline), Diabeta (R)(glyburide) and Altace(TM) (ramipril), earnings benefited from improved performance in the animal health and crop protection businesses. Equity in Net Earnings of Affiliates was $4 million, a decline of $14 million from the comparable 1991 period. The reduction is due, in part, to start up costs related to the Company's participation in a joint venture to manufacture and market bulk ibuprofen. In addition, lower volumes and increased price competition contributed to lower earnings by Japanese and German affiliates reflecting continued sluggish economic conditions in those countries. Interest expense declined $13 million to $81 million due primarily to lower interest rates, particularly in Mexico. Interest and other income, net, rose slightly to $74 million. The increase is predominantly due to gains realized on the sale of the HDPE facility and certain other cost investments, partially offset by lower 1992 interest income, the result of lower interest rates. The effective tax rate was 47.1% and 47.4% for 1992 and 1991, respectively. In November 1987, an explosion and fire caused severe damage resulting in the shutdown of the Chemical segment's Pampa, Texas plant. Rebuilding of the plant production facilities was completed in April 1989 with ancillary and support facilities completed in June of 1991. In 1989, the Company established a valuation allowance for any potential shortfall between the insurance claims and the ultimate insurance settlement. During the fourth quarter of 1992, the Company agreed to a settlement with its insurance carriers covering the explosion and business interruption claims. As a result of the settlement, approximately $68 million was credited to operating income. Effective January 1, 1992, the Company adopted the provisions of Statement of Financial Accounting Standards No. 106 "Employers' Accounting for Postretirement Benefits Other than Pensions" ("FAS 106") which decreased net income by $141 million, net of tax. See Note (12) of Notes to Consolidated Financial Statements. In the following discussion and analysis of "1991 Compared to 1990," 1990 is presented on a pro forma basis as if Celmex had been consolidated at January 1, 1990. 1991 COMPARED TO PRO FORMA 1990 FOR THE INCLUSION OF CELMEX Net sales of $6,794 million for 1991 increased $262 million, or 4%, from 1990 net sales. Sales increased in the Chemicals and Life Sciences segments, but were flat in the Fibers and Film and Specialties and Advanced Materials segments. Chemical segment sales improved due to higher selling prices and strong export sales volumes. However, sales prices have generally declined throughout the year, influenced by the decline in prices for purchased hydrocarbon feedstocks. Full year sales volumes were level as export volume improvement offset a decline in the domestic area. In the Fibers and Film segment, sales increased marginally as higher volumes offset lower selling prices. In Textile Fibers, polyester staple and filament volumes increased versus the prior year reflecting improved market conditions. Acetate filament and Trevira(R) Spunbond polyester geotextile and roofing products continued to operate at capacity levels. However, polyester staple selling prices were lower due to competitive and recessionary market conditions. Technical Fibers sales were level as higher filter products sales were offset by reductions in other product lines, particularly tire yarn and fabrics. Filter products sales improved in 1991 as strong worldwide demand for cigarette tow and acetate flake resulted in both higher sales prices and volumes. Although pricing improved marginally, sales volumes were lower for tire yarn and fabrics due to the continued sluggish economy, particularly in the automotive sector. In Film and Fiber Intermediates, higher volumes for polyester intermediates and packaging resins were offset by lower volumes for polyester film. Prices were lower for both film and intermediates. Specialty and Advanced Materials 1991 segment sales increased primarily due to increased sales in Specialty Chemicals. Specialty Chemicals experienced strong demand for fiber reactive dyes, superabsorbent materials and specialty and paper chemicals. Advanced Materials sales were slightly higher than the prior year due to higher sales of fluoropolymers. This increase was partially offset by slightly lower Engineering Plastics sales resulting from a weak domestic economy especially in the depressed automotive, electrical/electronics and housing industries. Life Sciences segment sales increased due predominantly to the continued strong sales of Diabeta(R) (glyburide), Trental(R) (pentoxifylline) and Claforan(R) (cefotaxime sodium) as well as sales from new products Altace/TM/ (ramipril) and Prokine/TM/ (sargramostim). Selling, general and administrative expenses (including research and development) were $1,151 million, an increase of $94 million, or 8.9%, from the comparable 1990 period. Selling, general and administrative expenses increased in all segments, but predominantly within Life Sciences and Specialties and Advanced Materials. Life Sciences expenses increased due to higher advertising and marketing expenses related to new products, Altace/TM /and Prokine/TM/, as well as additional personnel costs to support higher sales levels. Specialty and Advanced Materials segments expenses increased due to new business development and higher development costs. Operating income was $473 million, an increase of $37 million, or 8.5%, from the comparable 1990 period. Operating income improved significantly for the Chemicals and Life Sciences segments, remained flat for the Fibers and Film segment and declined in the Specialties and Advanced Materials segment. Chemicals segment operating income increased as higher sales and lower hydrocarbon feedstock costs more than offset higher manufacturing costs. Fibers and Film segment operating income was virtually unchanged from the prior year as improvement in the Celmex fibers and film businesses offset declines in the domestic businesses. Textile Fibers operating income declined as higher sales revenue was offset by higher manufacturing costs. Technical Fibers operating income was off slightly as unfavorable tire yarn results and higher manufacturing costs offset improvements in the filter products business. Film and Fiber Intermediates operating income improved due principally to lower hydrocarbon feedstock costs. Specialty and Advanced Materials segment operating income declined due to increased manufacturing costs. Life Sciences segment operating income improved as net sales more than offset increased selling, general and administrative and manufacturing costs. Equity in Net Earnings of Affiliates ($18 million) was virtually unchanged from 1990. Interest expense decreased $8 million to $94 million due primarily to a decline in Celmex's debt. Interest and other income, net, of $69 million represents a decrease of $62 million from 1990. The decrease resulted predominantly from a $20 million gain on the sales of businesses recognized during 1990 and a $28 million decrease in Celmex interest income in 1991. The effective tax rate for the full year 1991 was 47.4% compared to 45.8% for the comparable 1990 period. ENVIRONMENTAL In 1993, combined worldwide expenditures, including third party and divested sites, for compliance with environmental regulations and internal Company initiatives totaled $294 million of which $149 million was for capital projects. In both 1994 and 1995 total annual environmental expenditures are expected to be approximately $300 million of which $125 million is for capital projects. It is anticipated that stringent environmental regulations will continue to be imposed on the Company and the industry in general. Although the Company cannot predict expenditures beyond 1995, management believes that the current spending trends will continue. In 1993, 1992 and 1991 the total environmental costs charged to operations for remediation efforts amounted to $34 million, $46 million and $24 million, respectively. As of December 31, 1993 and 1992 the Company's total environmental liability recognized in the financial statements is $149 million and $156 million, respectively. The amounts are neither reduced for anticipated insurance recovery nor discounted from the anticipated payment date. In the opinion of management, environmental expenditures will not have a material adverse effect upon the Company's competitive position. INFLATION In recent years, inflation has not had a material impact on the Company's costs due principally to price competition among suppliers of raw materials. However, in certain segments of the Company's businesses, changes in the prices of raw materials, particularly petroleum derivatives, could have a significant impact on the Company's costs, which the Company may not be able to reflect fully in its pricing structure. RATIO OF EARNINGS TO FIXED CHARGES Ratio of earnings to fixed charges for 1993 was 3.6 compared to 4.0 for 1992. The ratio declined due to the decrease in operating income. For the purpose of calculating the ratio of earnings to fixed charges, earnings consist of earnings from operations before fixed charges, minority interests, income taxes and cumulative effect of accounting changes. Fixed charges consist of interest and debt expense, capitalized interest, interest on obligations under capital leases, the estimated interest portion of rents under operating leases and the majority-owned preferred stock dividend requirement. LIQUIDITY AND CAPITAL RESOURCES OF THE COMPANY Cash and cash equivalents of $171 million at December 31, 1993 represented a decrease of $42 million from 1992. The decrease primarily resulted from net cash used in investing activities of $978 million, partially offset by net cash provided by operating and financing activities of $537 million and $400 million, respectively. Investing activities in 1993 included expenditures for capital projects of $556 million compared with $592 million in 1992. In addition, as discussed above, the Company acquired 52.96% of the outstanding shares of Copley for approximately $546 million. The Company funded the purchase price with a loan under a revolving credit agreement with Hoechst Corporation ("Parent"). In 1993, the Company increased its commercial paper program from $250 million to $600 million to provide an additional source of financing flexibility. At December 31, 1993, there was no commercial paper outstanding. The Company has $600 million of committed domestic credit facilities, all of which were unused at December 31, 1993. These credit lines provide backup to the Company's commercial paper program. The Company also has a $750 million revolving credit agreement with its Parent. At December 31, 1993, the outstanding balance on this credit facility was $679 million, primarily the result of the Copley acquisition. In addition, the Company prepaid its 13% senior promissory notes and 8% notes in the amounts of $15 million and $7 million, respectively. In February 1993, the Company paid its Parent an $85 million dividend. The Company also declared a 1993 dividend of $70 million which was paid during the first quarter of 1994. The Company intends to continue its practice of paying a dividend to its Parent at the discretion of the Company's Board of Directors. On January 10, 1994, the Securities and Exchange Commission declared effective the Company's registration statement covering the offer and sale from time to time of its unsecured debt securities at an aggregate initial public offering price of not more than $650 million. On January 26, 1994, the Company issued $250 million of 6-1/8% Notes due February 2004. In March 1994, the Company also sold $100 million of its medium-term notes. The net proceeds from these transactions were used to repay a portion of the amount borrowed by the Company from its Parent. The Company may sell from time to time up to an additional $300 million of medium-term notes. The proceeds from any medium-term notes to be sold will be used for general corporate purposes. The Company expects that its capital expenditures, investments and working capital requirements will continue to be met primarily from internally generated funds from operations. However, the Company may, due to the timing of funding requirements or investments supplement its liquidity from external or affiliated sources. Such sources include the Company's medium-term note shelf registration, its commercial paper program or loans from its Parent or Hoechst AG and affiliates. ITEM 8.

ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY SCHEDULES Index to Consolidated Financial Statements HOECHST CELANESE CORPORATION CONSOLIDATED BALANCE SHEETS See accompanying notes to consolidated financial statements. HOECHST CELANESE CORPORATION CONSOLIDATED STATEMENTS OF EARNINGS See accompanying notes to consolidated financial statements. HOECHST CELANESE CORPORATION CONSOLIDATED STATEMENTS OF STOCKHOLDER'S EQUITY See accompanying notes to consolidated financial statements. HOECHST CELANESE CORPORATION CONSOLIDATED STATEMENTS OF CASH FLOWS See accompanying notes to consolidated financial statements. HOECHST CELANESE CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (1) SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (A) PRINCIPLES OF CONSOLIDATION Hoechst Celanese Corporation (the "Company") is wholly owned by Hoechst Corporation ("Parent"), a holding company, itself a wholly owned subsidiary of Hoechst Aktiengesellschaft ("Hoechst AG"). The consolidated financial statements include the accounts of the Company and its majority owned subsidiaries, Celanese Mexicana, S.A. ("Celmex"), joint ventures and partnerships. All significant intercompany balances and transactions have been eliminated in consolidation. Certain reclassifications have been made in the 1992 consolidated financial statements to conform to the classifications used in 1993. Substantially all of the Company's minority interests are comprised of Celmex, Celanese Canada Inc. and Copley Pharmaceutical, Inc. On November 11, 1993, the Company purchased 52.96% of the outstanding shares of Copley Pharmaceutical, Inc. ("Copley") for approximately $546 million. Copley develops, manufactures and markets a broad range of off- patent prescription and over-the-counter pharmaceuticals. The acquisition has been accounted for under the purchase method of accounting. Accordingly, the Company will allocate the purchase price to the assets acquired and liabilities assumed based on their estimated respective fair values as of the date of acquisition. The allocation of the purchase price will be completed during 1994. The excess of costs over net assets acquired was approximately $510 million and is being amortized over its estimated life. The Company financed the acquisition through a revolving credit agreement with its Parent. Copley's results of operations have been included in the Company's consolidated financial statements as of the date of acquisition. Copley's operations are not material in relation to the Company's consolidated financial statements and pro forma financial information has therefore not been presented. (B) CASH EQUIVALENTS The Company considers all highly liquid investments with a maturity of three months or less to be cash equivalents. (C) INVENTORIES Inventories are stated at the lower of cost (first-in, first-out ["FIFO"] or last-in, first-out ["LIFO"]) or market. (D) INVESTMENTS AND EQUITY IN NET (LOSS) EARNINGS OF AFFILIATES In general, the Company's share of net earnings or losses of companies in which it owns at least 20% and less than a majority, and does not exercise management control, is included in the Consolidated Statements of Earnings as "Equity in net (loss) earnings of affiliates." (E) PROPERTY, PLANT AND EQUIPMENT Property, plant and equipment is stated at cost. Depreciation and amortization are computed on a straight-line basis over estimated useful lives. HOECHST CELANESE CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (1) SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED) (E) PROPERTY, PLANT AND EQUIPMENT (CONTINUED) Amortization of leasehold improvements is provided on a straight-line basis over the estimated useful lives of the related assets or lease terms, whichever is shorter. Expenditures for maintenance and repairs are charged against operations; major replacements, renewals and significant improvements are capitalized. (F) INTANGIBLES Excess of cost over fair value of net assets of businesses acquired ("Goodwill") is being amortized using the straight-line method principally over periods of twenty-five and forty years. It is the Company's policy to review that the forecast cumulative, undiscounted cash flow of those acquired businesses is greater than the carrying value of the Goodwill. Amortization expense charged against operations amounted to $39 million in 1993, $37 million in 1992 and $38 million in 1991. Patents and trademarks are being amortized on a straight-line basis over their estimated useful or legal lives, whichever is shorter. Amortization expense charged against operations amounted to $15 million in 1993, $11 million in 1992 and $12 million in 1991. (G) INCOME TAXES The Company's consolidated results of operations are included in the consolidated Federal income tax return of its Parent. The Company's Parent allocates a provision for Federal income taxes equivalent to the tax effect on the operations of the Company as if a separate return were filed. Deferred income taxes have been provided to recognize the effect of temporary differences between financial statement and income tax accounting. The Company implemented Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes" ("FAS 109"), effective January 1, 1993, which requires the asset and liability method of accounting for income taxes and the calculation of deferred taxes using the enacted tax rates in effect at the implementation date. HOECHST CELANESE CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (1) SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED) (H) BENEFIT PLANS Pension costs for defined-benefit pension plans are computed in accordance with Statement of Financial Accounting Standards No. 87, "Employers' Accounting for Pensions" ("FAS 87"). Effective January 1, 1992, the Company adopted the provisions of Statement of Financial Accounting Standards No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions" ("FAS 106"), which requires the Company to accrue the current cost of those benefits. Effective January 1, 1993, the Company adopted the provisions of Statement of Financial Accounting Standards No. 112, "Employers' Accounting for Postemployment Benefits" ("FAS 112"). FAS 112 requires recognition of postemployment benefits on an accrual basis. (I) RESEARCH AND DEVELOPMENT COSTS Research and development costs are included in expenses as incurred. (J) FUNCTIONAL CURRENCIES In general, local currencies have been designated as the functional currencies for the Company's foreign operations. In Mexico, prior to 1993, the United States dollar was the functional currency. (K) NEW ACCOUNTING PRONOUNCEMENT Effective for years beginning after December 15, 1993, the Company is required to adopt the provisions of Statement of Financial Accounting Standards No. 115, "Accounting for Certain Investments in Marketable Equity and Debt Securities" ("FAS 115"). FAS 115 establishes standards of financial accounting and reporting for investments in equity securities that have readily determinable market values and for all investments in debt securities. The Company does not believe that the adoption of this standard will have a material impact on its financial position or results of operations. (2) RELATED PARTY TRANSACTIONS Purchases from Hoechst AG and its affiliates aggregated $495 million in 1993, $516 million in 1992 and $421 million in 1991. Net sales to Hoechst AG and its affiliates aggregated $216 million in 1993, $217 million in 1992 and $186 million in 1991. The Company's principal licenses are under patents owned by Hoechst AG and its affiliates. License fees, relating to license agreements between the Company and Hoechst AG and its affiliates, charged to operations, aggregated $48 million in 1993, $48 million in 1992 and $41 million in 1991. The Company has a revolving credit agreement with its Parent under which it may borrow up to $750 million. The Company has agreed to pay interest at 30 day LIBOR plus .0625 of 1%. During 1993 and 1992, HOECHST CELANESE CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (2) RELATED PARTY TRANSACTIONS (CONTINUED) respectively, the Company borrowed $768 million and $90 million under this agreement. Repayments on the revolving credit agreements for 1993 and 1992, respectively, were $89 million and $90 million. Interest charges related to such borrowings aggregated $2 million in 1993 and $1 million in 1992. The outstanding balance on this credit facility was $679 million at December 31, 1993. There was no outstanding balance under this credit facility at December 31, 1992 and 1991. Note obligations payable to Parent aggregated $156 million at December 31, 1993 and $86 million at December 31, 1992. In 1991, the Company had note obligations payable to an affiliate of Hoechst AG which aggregated $8 million at December 31, 1991. Interest expense on these obligations aggregated $7 million in 1993, $2 million in 1992 and $1 million in 1991. Short-term note obligations payable to Parent aggregated $100 million at December 31, 1992. This obligation was repaid during 1993. No such obligations were outstanding at December 31, 1993. Interest expense on this obligation aggregated $6 million in 1993 and $2 million in 1992. As of December 31, 1992, the Company had an outstanding short-term loan to its Parent in the amount of $176 million. No such loan existed at December 31, 1993. Interest income on this loan was not material in 1992. (3) INVESTMENTS AND EQUITY IN NET EARNINGS (LOSS) OF AFFILIATES (IN MILLIONS, EXCEPT NUMBER OF AFFILIATES) HOECHST CELANESE CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (4) INCOME TAXES Effective January 1, 1993, the Company adopted FAS 109 which requires the asset and liability method of accounting for income taxes, and deferred taxes are calculated using enacted tax rates. In addition, FAS 109 significantly changes the accounting for purchase business combinations. The provisions of FAS 109 have been applied without restating prior years' financial statements. Prior to FAS 109, acquired assets and liabilities in a purchase business combination were shown net of tax. Under FAS 109, these assets and liabilities are assigned their fair value and deferred taxes are provided on the difference between such value and their tax bases. Accordingly, in adopting FAS 109, the Company adjusted the carrying amount of the assets acquired and liabilities assumed in connection with the 1987 Celanese Corporation acquisition. The noncash effects from the application of FAS 109 were to increase Property, plant and equipment, $178 million; Investments in affiliates, $34 million; Other assets, $10 million and Other liabilities, $64 million. Pretax operating income for the year ended December 31, 1993 was reduced by $40 million due to the increase in depreciation and amortization expense resulting from the higher carrying amounts. The increase in operating expense was offset by a lower deferred tax provision. HOECHST CELANESE CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (4) INCOME TAXES (CONTINUED) HOECHST CELANESE CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (4) INCOME TAXES (CONTINUED) The tax effects of the temporary differences which give rise to a significant portion of deferred tax assets and liabilities as of December 31, 1993 are as follows: The cumulative effect of adopting FAS 109 as of January 1, 1993 amounted to $31 million and is included as part of the increase to deferred income taxes on the Consolidated Balance Sheets and a charge to the Consolidated Statement of Earnings as of December 31, 1993. The net adjustment represents the establishment of deferred taxes primarily due to differences between the book and tax bases of LIFO inventories and the adjustment of deferred taxes to reflect the currently enacted tax rate. A valuation allowance is provided when it is more likely than not that some portion or all of the deferred tax assets will not be realized. Based on the Company's historical and current pretax earnings, management believes it is more likely than not that the Company will realize the benefit of the deferred tax assets existing at December 31, 1993. Further, management believes the existing deductible temporary differences will reverse during periods in which the Company generates net taxable income. The financial reporting basis of investments in certain non-U.S. subsidiaries differs from their tax basis. In accordance with FAS 109, a deferred tax liability is not recorded on this temporary difference because the investments are essentially permanent in duration. A reversal of the Company's plans to permanently reinvest in these operations would cause such temporary differences to become taxable. At December 31, 1993 these temporary differences were approximately $424 million. A determination of the amount of unrecognized deferred tax liability related to these investments is not practicable. HOECHST CELANESE CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (5) NET RECEIVABLES As of December 31, 1993 and 1992, the Company had no significant concentrations of credit risk. Concentrations of credit risk with respect to trade receivables are limited since the Company's customer base is dispersed across many different industries and geographies. In November 1987, an explosion and fire caused severe damage resulting in the shutdown of the Company's Pampa, Texas plant. Rebuilding of the plant production facilities was completed in April, 1989 with ancillary and support facilities completed in June, 1991. In 1992, as part of the rebuilding process, approximately $46 million was capitalized for safety and environmental enhancements. In 1989, the Company established a valuation allowance for any potential shortfall between the insurance claims and the ultimate insurance settlement. During the fourth quarter of 1992, the Company agreed to a settlement with its insurance carriers covering the explosion and business interruption claims. As a result of the settlement, approximately $68 million was credited to the operations of the Chemicals segment in the accompanying Consolidated Financial Statements. (6) INVENTORIES At December 31, 1993, $518 million ($566 million at December 31, 1992) of total inventories were valued by the LIFO method. During the first quarter of 1993, the Company changed its method of accounting for Celmex inventory from LIFO to FIFO. The impact of this change was to reduce the LIFO reserve by $16 million and increase net earnings by $4 million. The effect of this change is not material and prior years' financial statements have, therefore, not been restated. HOECHST CELANESE CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (7) PROPERTY, PLANT AND EQUIPMENT, NET Interest costs capitalized in 1993, 1992 and 1991 were $21 million, $14 million and $10 million, respectively. (8) ACCOUNTS PAYABLE AND ACCRUED LIABILITIES (9) NOTES PAYABLE AND LONG-TERM DEBT HOECHST CELANESE CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (9) NOTES PAYABLE AND LONG-TERM DEBT (CONTINUED) The Company has a commercial paper program aggregating $600 million. Included in "Commercial paper, notes payable and current installments of long-term debt" in the Consolidated Balance Sheet at December 31, 1992 is $135 million due to holders of commercial paper. There was no balance due at December 31, 1993. The Company has revolving credit agreements with banks that provide for loans up to $50 million through October, 1996. Under these agreements, the Company pays a commitment fee of 3/16 of 1% per annum based on unused amounts. The Company has additional revolving credit agreements with several banks that provide for loans up to $550 million for a renewable term of 364 days. The Company pays a commitment fee of 1/16 of 1% per annum on unused amounts. The above described credit lines provide the credit backup for the Company's commercial paper program. The credit lines were unused at December 31, 1993 and 1992. The Company had standby and trade letters of credit outstanding amounting to $105 million at December 31, 1993 and $101 million at December 31, 1992. The Company periodically enters into forward exchange contracts as hedges against foreign currency transactions and does not engage in speculative contracts. There were no significant foreign exchange contracts outstanding at December 31, 1993 and 1992. The Company has an interest rate conversion agreement. Under the terms of the agreement, the Company has fixed the interest rate on $12 million of debt at 6.27% through 1996. The Company's debt instruments include covenants, as defined in the loan agreements, that require maintenance of consolidated net worth of not less than $2.3 billion, and the limitation of dividends and other restricted payments. At December 31, 1993, $688 million was available for dividends or other restricted payments under existing loan agreements. The Company intends to continue its current policy to pay dividends to its Parent at the discretion of the Company's Board of Directors. Such dividends will be used by the Parent to service acquisition debt pertaining to the acquisition of Celanese Corporation. Annual maturities of long-term debt each year for the next five years are: $7 million in 1994; $10 million in 1995; $6 million in 1996; $336 million in 1997; and $76 million in 1998. (10) OTHER LIABILITIES HOECHST CELANESE CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (11) BENEFIT PLANS The Company has several defined-benefit pension plans covering substantially all employees. Benefit formulas are based on years of service and compensation levels or years of service and negotiated benefits. The pension plans in the United States are being funded in accordance with the requirements of the Employee Retirement Income Security Act of 1974. Net periodic pension cost for defined-benefit pension plans consists of the following: The actuarial computations, based on the projected unit credit method, assumed a discount rate of 7.5%, 8.5% and 8.5% in 1993, 1992 and 1991, respectively. The assumed rate of return was 9.0%, 8.5% and 8.5% in 1993, 1992 and 1991, respectively. The assumed rate of increase in compensation levels was 4.5%, 5.6% and 6.0% in 1993, 1992 and 1991, respectively. The following table sets forth the funded status of the Company's qualified plans and the amounts recognized in the Company's Consolidated Balance Sheets at December 31, 1993 and 1992: HOECHST CELANESE CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (11) BENEFIT PLANS (CONTINUED) Assets of the Company's pension plans consist of equity and fixed income securities, real estate and deposit administration contracts maintained in master trust funds, which are managed by various investment managers appointed by the Company. The Company has various investment savings plans for certain employees, some of which qualify under Section 401(k) of the Internal Revenue Code. The Company's contributions to the plans are based on specified percentages of employee contributions and aggregated $33 million in 1993, $31 million in 1992 and $30 million in 1991. The Company provides certain of its employees with non-qualified supplemental retirement benefits. The accumulated benefit obligation of these benefits totalled $96 million in 1993 and $87 million in 1992. (12) OTHER POSTRETIREMENT BENEFITS Under various employer sponsored plans, the Company provides certain health care and life insurance benefits for retired employees and their dependents. Substantially all of the Company's employees are eligible for health care benefits after reaching normal retirement age with 10 years of service. Benefits, eligibility and cost sharing provisions for union employees vary by location. Generally, the medical plans pay a stated percentage, based upon years of service, of most medical expenses reduced for any deductible and payments made by government programs and other group coverage. The Company is generally self-insured for these costs and has no plan assets. The plans' provisions include a cap which limits future Company contributions for medical coverage under these plans. It was the Company's policy to fund and account for these benefits on a cash basis. Amounts paid related to such benefits aggregated $19 million in 1993, $17 million in 1992 and $16 million in 1991. Effective January 1, 1992, the Company adopted the provisions of FAS 106 for all its plans. Under this statement, the Company accrues the current cost of those benefits. The Company previously had expensed the cost of these benefits as claims were paid, except for the portion related to unfunded actuarial liability of retiree health care benefits accrued as part of the acquisition of Celanese Corporation in 1987. In addition, the Company elected to recognize immediately the transition obligation measured as of January 1, 1992. This resulted in a one-time after-tax charge of $141 million (after a reduction for income taxes of $90 million and the effect of minority interests of $3 million). The effect of this change on operating results, after recording the cumulative effect for years prior to 1992, was to recognize an additional pretax expense of $23 million. The pro forma effect of the change on years prior to 1992 was not determinable. HOECHST CELANESE CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (12) OTHER POSTRETIREMENT BENEFITS (CONTINUED) Net Periodic Postretirement Benefit Cost included the following components: The following table sets forth the unfunded status of the plans, which represents the accrued postretirement benefit cost recognized in the Company's Consolidated Balance Sheets at December 31, 1993 and 1992: For measuring the expected postretirement benefit obligation, the Company assumed a 10.6 percent rate of increase in the per capita claims cost in 1993 and assumed that the rate would decrease gradually over an eight year period to 6.0 percent and remain at that level thereafter. The weighted-average discount rate used in determining the accumulated postretirement benefit obligation was 7.5 and 8.5 percent at December 31, 1993 and December 31, 1992, respectively. If the health care cost trend were increased 1.0 percent, the accumulated postretirement benefit obligation as of December 31, 1993 would have increased by approximately $27 million, or 6.7 percent. The effect of the change on the aggregate of service and interest cost for 1993 would be an increase of approximately $2 million, or 6.1 percent. Effective January 1, 1993, the Company adopted the provisions of Statement of Financial Accounting Standards No. 112, "Employers' Accounting for Postemployment Benefits" ("FAS 112"). This Statement requires an accrual method of recognizing postemployment benefits such as disability-related benefits. The cumulative effect at January 1, 1993 of adopting FAS 112 reduced net income by $8 million, net of $4 million of income tax benefits. The effect of this change on 1993 income before cumulative effect of accounting changes was not material. HOECHST CELANESE CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (13) LEASED ASSETS AND LEASE COMMITMENTS At December 31, 1993, minimum lease commitments under long-term operating leases are as follows: Total minimum rent charged to operations under all operating leases was $68 million in 1993, $64 million in 1992 and $66 million in 1991. Effective December 31, 1992, the Parent increased its investment in the Company by contributing to the Company property, plant and equipment that had been leased under capital leases from its Parent. Rental payments made under such lease obligations amounted to $10 million for the period ended December 31, 1992, and $13 million for the period ended December 31, 1991. The effect of the transaction was to increase additional paid-in capital by $49 million, reverse $10 million of previously existing deferred income taxes and decrease debt (obligations under capital leases) by $59 million. Management expects that, in the normal course of business, leases that expire will be renewed or replaced by other leases. HOECHST CELANESE CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (14) SEGMENT AND GEOGRAPHICAL INFORMATION /(a)/ Beginning in 1993, the Company segregated amounts associated with Advanced Technology. This new segment represents research and development costs to seed and develop new businesses. When projects or businesses become viable, they are transferred to the appropriate operating segment. The prior years' segment results have been restated to reflect this change. /(b)/ Includes $15 million of depreciation and a $4 million reserve for asset impairment related to the 1993 restructuring program (see note 16). /(c)/ Includes $29 million of assets related to the purchase of Copley and $3 million of assets related to the purchase of certain other businesses (see note (1)(a)). /(d)/ Includes a $30 million reserve for asset impairment related to 1992 restructuring program for North American Fibers (see note 16). HOECHST CELANESE CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (14) SEGMENT AND GEOGRAPHICAL INFORMATION (CONTINUED) The following table presents financial information based on the geographic location of the manufacturing facilities of the Company: - ---------- /(a)/ Included in United States net sales are export sales of $845 million in 1993, $877 million in 1992 and $932 million in 1991. /(b)/ Product transfers between geographic areas are priced on a basis intended to reflect, as nearly as practicable, the prevailing market value of the products transferred. HOECHST CELANESE CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (15) COMMITMENTS AND CONTINGENCIES The Company is a defendant in a number of lawsuits, including environmental, product liability and personal injury actions (see footnote 18 for discussion of environmental). Certain of these lawsuits are or purport to be class actions. In some of these cases, claimed damages are substantial. While it is impossible at this time to determine with certainty the ultimate outcome of these lawsuits, management believes, based on the advice of legal counsel, that adequate provisions have been made for probable losses with respect thereto and that the ultimate outcome will not have a material adverse effect on the financial position of the Company, but may have a material effect upon the results of operations in any given year. The Company is named a defendant in twenty putative class actions, two of which have been certified as class actions as well as a defendant in other non-class actions filed in nine states ("the Plumbing Actions"). In these lawsuits the plaintiffs typically seek recovery for alleged property damage to housing units, mental anguish from the alleged failure of plumbing systems, and punitive damages and, in certain cases, additional damages under the Texas Deceptive Trade Practices Act. The other defendants include United States Brass Corporation ("U.S. Brass")(formerly a wholly owned subsidiary of Household International, Inc.), Vanguard Plastics, Inc. ("Vanguard"), Shell Oil Company ("Shell") and E.I. duPont deNemours & Co., Inc ("duPont"). Damage amounts are not specified. The plumbing systems were designed and manufactured primarily by U.S. Brass and Vanguard. The pipe was made from polybutylene resin supplied by Shell. The Company sold acetal copolymer resin and duPont sold acetal polymer resin to other companies who manufactured the fittings used in the plumbing systems. Based on, among other things, the findings of outside experts and the successful use of the Company's acetal copolymer in similar applications, the Company does not believe that its acetal copolymer was defective or caused the plumbing systems to fail. In many cases the Company's exposure may be limited by the fact that the other defendants and other responsible parties may be found liable in whole or substantial part or by invocation of the statute of limitations since the Company ceased selling the resin for use in the plumbing systems in site built homes during 1986 and in manufactured homes during 1989. In order to mitigate the potential exposure to and cost of litigation, the Company, together with Shell and duPont, has established a company, Plumbing Claims Group ("PCG"), to assess individual repair requests and pay for certain repairs. The amount that each company contributes toward those repairs will ultimately be determined based on an allocation mechanism which the companies are currently negotiating. The Company believes that PCG repairs limit its exposure to future litigation. The Company has accrued its best estimate of its liability, asserted and unasserted, for the plumbing product liability and repair claims, taking into consideration anticipated insurance recoveries, but excluding other recoveries that may result from lawsuits against other parties to the Plumbing Actions. The Company has commenced litigation against Household International, Inc. to recover, among other things, the portion of Plumbing Action judgements, settlements and expenses that are attributable to its former subsidiary, U.S. Brass. Due to the many variables involved in the estimation process, as facts and circumstances change, the estimate will be adjusted. Since the Company was one of the suppliers of the resin used in the plumbing systems and not a manufacturer or marketer of these systems, the Company does not know the number of units that contain the plumbing fittings, the number of systems that will fail, if any, or the extent of any failures. Accordingly, it is impossible to estimate with any degree of certainty the level of unasserted plumbing claims. Due to the many variables, the timing of payments, which will be offset by any insurance proceeds, cannot be predicted with any certainty. HOECHST CELANESE CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (15) COMMITMENTS AND CONTINGENCIES (CONTINUED) The Company and certain of its codefendants are currently involved in a nonbinding voluntary mediation effort relating to the plumbing claims with attorneys representing substantially all the plaintiffs in Texas cases and two uncertified nationwide class actions. This mediation seeks to settle the individual claims currently asserted in these Texas cases and to establish a nationwide framework for resolving future claims. However, it is currently too early to determine whether there will be any settlement of any of these pending or future claims, and, if there is a settlement, the manner in which it will be finally allocated among all the potentially responsible parties. Management believes that the Plumbing Actions, legal expenses and the Company's contributions to the PCG repair payments are substantially covered by insurance. The Company has initiated litigation seeking a declaration that insurance coverage exists for these product liability claims. Negotiations with several of the carriers have resulted in settlements or agreements in principle to settle, resulting in substantial continuing coverage of the Plumbing Actions or cash payments for claims. There are ongoing discussions with several of the remaining insurers. Outside counsel believes that the Company has a substantial probability of prevailing in its litigation against the carriers. Management believes that the plumbing claims will not have a material adverse effect on the financial position of the Company, but may have a material effect upon the results of operations in any given year. Copley is a defendant in numerous lawsuits alleging injury from the use of Albuterol Sulfate Inhalation Solution 0.5%. On January 5, 1994 Copley announced a voluntary nationwide recall of the product. Although the ultimate outcome of these lawsuits cannot be determined, in the opinion of the Company's management, these actions will not have a material adverse effect on the financial position of the Company or results of operations. At December 31, 1993, there were outstanding commitments relating to capital projects of approximately $118 million. (16) RESTRUCTURING The Company is restructuring its North American, principally Mexican, chemicals operations. During 1993, $29 million has been charged to Chemical operating income for restructuring, $19 million of which related to the write-down of property, plant and equipment. The Company is restructuring its North American polyester fibers operations. As part of an ongoing North American strategy, the Company will install additional staple fiber capacity within Celmex. This expansion should not result in a net increase in North American staple fiber capacity. The realignment of other polyester facilities in Canada and the United States is currently being studied. During 1992, $87 million was charged to Fibers and Film operating income for restructuring, $34 million of which related to the write-down of property, plant and equipment. An additional $15 million was established for restructuring and regionalization of certain other businesses. (17) FAIR VALUE OF FINANCIAL INSTRUMENTS In accordance with the provisions of Statement of Financial Accounting Standards No. 107, "Disclosures about Fair Value of Financial Instruments" ("FAS 107"), the Company is required to disclose the fair value of certain financial instruments as of the balance sheet dates. The fair value represents the Company's estimate and, therefore, should not be construed as the value that the Company would receive or give up for a financial instrument. The fair values of the Company's significant financial instruments are discussed below. HOECHST CELANESE CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (17) FAIR VALUE OF FINANCIAL INSTRUMENTS (CONTINUED) The book value of cash and cash equivalents, marketable securities, net receivables, commercial paper, notes payable, and trade payables approximates fair market value due to the short maturity of these instruments. Included in other assets are certain investments accounted for under the cost method. In general, the investments are not publicly traded and, therefore, fair market values are not readily determinable. The Company believes that the carrying value of $43 million approximates the fair market value. The fair value of the Company's long-term debt is estimated based on quotations from investment bankers and on current rates of debt for similar types of issues. At December 31, 1993, the estimated fair value was $946 million versus the carrying value of $879 million. At December 31, 1992, the estimated fair value was $900 million versus the carrying value of $830 million. The carrying value of the current installments of long-term debt approximates the fair value. (18) ENVIRONMENTAL The Company's worldwide operations are subject to environmental laws and regulations which impose limitations on the discharge of pollutants into the air and water and establish standards for the treatment, storage and disposal of solid and hazardous wastes. The Company believes that it is in substantial compliance with all applicable environmental laws and regulations. The Company reviews the effects of any new laws and regulations on each of its locations; determines whether a liability exists based on that review; and records a liability, as appropriate. The company expenses all expenditures mandated by law or Company policy to ameliorate existing conditions. Liabilities that are established represent the company's best estimate based on all the available facts and are adjusted as facts and circumstances change. The Company may be subject to substantial claims brought by Federal or state regulatory agencies or private individuals pursuant to statutory authority or common law. In particular, the Company has a potential liability under the Federal Comprehensive Environmental Response compensation and Liability Act ("Superfund") and related state laws for investigation and cleanup costs at approximately 100 sites. At most of these sites, numerous companies, including either the Company or one of its predecessor companies, have been notified that the United States Environmental Protection Agency ("EPA"), state governing body or private individuals consider such companies to be potentially responsible parties (PRPs) under Superfund or related laws. The proceedings relating to these sites are in various stages. The cleanup process has not been completed at most sites and the status of the insurance coverage for most of these proceedings is uncertain. Consequently, the Company cannot determine accurately its ultimate liability for investigation or cleanup costs at these sites. Expenditures (including third party and divested sites) for investigation, clean up and related activities have been $31 million for the three years ended December 31, 1993 with expenditures in no year greater than $13 million. As events progress at each site for which it has been named a PRP, the Company accrues, as appropriate, a liability for site cleanup. Such liabilities include all costs that are probable and can be reasonably estimated. In establishing these liabilities, the Company considers: its shipments of waste to a site; its percentage of total waste shipped to the site; the types of wastes involved; the conclusions of any studies; the magnitude of any remedial actions that may be necessary; and the number and viability of other PRPs. Often HCC will join with other PRPs to sign joint defense agreements that will settle, among the PRPs, each party's percent allocation of HOECHST CELANESE CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (18) ENVIRONMENTAL (CONTINUED) costs at the site. Although the ultimate liability may differ from the estimate, the Company routinely reviews the liabilities and revises the estimate, as appropriate, based on the most current information available. In 1993, 1992 and 1991 the total environmental costs charged to operations for remediation efforts amounted to $34 million, $46 million and $24 million, respectively. As of December 31, 1993 and 1992 the Company's total environmental liability recognized in the financial statements is $149 million and $156 million. The amounts are neither reduced for anticipated insurance recovery nor discounted from the anticipated payment date. Moreover, environmental liabilities are paid over an extended period and the timing of such payments cannot be predicted with certainty. Management believes that environmental costs will not have a material adverse effect on the financial position of the Company or results of operations. (19) OTHER MATTERS Fibers and Film 1993 operating income includes a $50 million receipt in settlement of a litigation. The amount has been included in selling, general and administrative expenses. HOECHST CELANESE CORPORATION SCHEDULE V--PROPERTY, PLANT AND EQUIPMENT AT DECEMBER 31, 1993, 1992 AND 1991 - ---------- /(a)/ Includes $29 million of assets related to the purchase of Copley and $3 million of assets related to the purchase of certain other businesses (see note (1)(a)). /(b)/ Includes $92 million of assets related to the 1993 restructuring program (see note 16). /(c)/ Includes $20 million of assets related to the 1992 restructuring program for North American Fibers (see note 16). /(d)/ Includes $46 million of additions related to Pampa settlement (see note 5). /(e)/ Includes Celmex opening balances of $42 million in "Land and improvements," $55 million in "Buildings, improvements and leasehold improvements," $279 million in "Machinery and equipment," and $62 million in "Construction in progress." (see note (1)(a)). HOECHST CELANESE CORPORATION SCHEDULE VI--ACCUMULATED DEPRECIATION AND AMORTIZATION OF PROPERTY, PLANT AND EQUIPMENT AT DECEMBER 31, 1993, 1992 AND 1991 - ---------- /(a)/ Includes $15 million of depreciation and a $4 million reserve for asset impairment related to the 1993 restructuring program (see note 16). /(b)/ Includes $92 million of assets related to the 1993 restructuring program (see note 16). /(c)/ Includes $30 million reserve for asset impairment related to the 1992 restructuring program for North American Fibers (see note 16). /(d)/ Includes $16 million of assets related to the 1992 restructuring program for North American Fibers (see note 16). /(e)/ Includes $5 million of additions related to Pampa settlement (see note 5). /(f)/ Includes Celmex opening balances of $9 million in "Land improvements," $9 million in "Buildings, improvements and leasehold improvements," and $221 million in "Machinery and equipment." (see note (1)(a)), HOECHST CELANESE CORPORATION SCHEDULE IX--SHORT-TERM BORROWINGS FOR THE YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 - ---------- /(a)/ Payable to banks consists predominantly of obligations of non-U.S. operations with a variety of interest rates and maturities. In 1993, includes $679 million payable to Parent. /(b)/ Amounts for payable to banks represents the maximum aggregate outstanding at any quarter end. Amounts for commercial paper represent the maximum outstanding at any time during the year. /(c)/ Represents the average quarterly amount outstanding for payable to banks and the average monthly outstanding for commercial paper. /(d)/ Computed by dividing appropriate interest expense by the weighted average amounts outstanding. HOECHST CELANESE CORPORATION SCHEDULE X--SUPPLEMENTARY INCOME STATEMENT INFORMATION YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 - -------------------------------------------------------------------------------- REPORT OF INDEPENDENT AUDITORS - -------------------------------------------------------------------------------- The Board of Directors Hoechst Celanese Corporation: We have audited the accompanying consolidated balance sheets of Hoechst Celanese Corporation as of December 31, 1993 and 1992, and the related consolidated statements of earnings, stockholder's equity, and cash flows for each of the years in the three-year period ended December 31, 1993. In connection with our audits of the consolidated financial statements, we also have audited the financial statement schedules listed in Item 14(a)(2) as of and for each of the years in the three-year period ended December 31, 1993. These consolidated financial statements and financial statement schedules are the responsibility of the Company's management. Our responsibility is to express an opinion on these consolidated financial statements and financial statement schedules based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Hoechst Celanese Corporation as of December 31, 1993 and 1992, and the results of its operations and its cash flows for each of the years in the three-year period ended December 31, 1993, in conformity with generally accepted accounting principles. Also in our opinion, the related financial statement schedules, when considered in relation to the basic consolidated financial statements taken as a whole, present fairly, in all material respects, the information set forth therein. As discussed in Notes 4 and 12 to the consolidated financial statements, the Company adopted the provisions of the Financial Accounting Standards Board's Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes" and No. 112, "Employers' Accounting for Postemployment Benefits" in 1993. As discussed in Note 12 to the consolidated financial statements, the Company adopted the provisions of the Financial Accounting Standards No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions" in 1992. KPMG PEAT MARWICK Short Hills, New Jersey January 28, 1994 ITEM 9.

ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE There has been no change of accountants or reported disagreement on any matter of accounting principles or procedures or financial statement disclosure in 1993. PART III ITEM 10.

ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT The directors and executive officers of Hoechst Celanese are as follows: - ---------- /(1)/ Member of Executive Committee, a committee of the Board of Directors. All directors of the Company have been appointed for a term commencing November 23, 1993. All terms of directors will end on the date of the next annual stockholder meeting. All executive officers were appointed for a term commencing December 6, 1993. All terms of executive officers will end at the first meeting of the Board following the next annual stockholder meeting. Mr. Dormann has been a Director and Chairman of the Company since January 1, 1990. Mr. Dormann has also served as Chairman of the Board of Directors of Hoechst Corporation since March 31, 1987 and from February 1987 until January 1988 he served as Chairman and Chief Executive Officer of the Company. Prior to that, he served as Director of American Hoechst Corporation ("AHC") from 1980 to February 1987 and as Chairman of AHC from October 1984 to February 1987. He is a member of the Board of Management and Chief Financial Officer of Hoechst AG and is responsible for all Hoechst Group activities in North America. Mr. Dormann has been with Hoechst AG for 31 years and is a resident of the Federal Republic of Germany. Dr. Drew has been President and Chief Executive Officer of the Company since January 1988. Prior to that, he was President and Chief Operating Officer from February 1987 until January 1988. He has been a Director of the Company since February 1987. He was formerly a Group Vice President with Celanese Corporation ("Celanese") from June 1985 to February 1987. He served as President of Celanese Fibers Operations and a Vice President of Celanese from June 1984 until June 1985 and was President and Chief Executive Officer of Celanese Canada Inc. from May 1982 until June 1984. Dr. Drew was a Director of Celanese from April 1986 to February 1987. He is also Director of Manville Corporation, Riverwood International Corporation, Thomas & Betts Corporation and Public Service Enterprise Group Incorporated. On January 1, 1991, Dr. Drew also assumed management responsibility within the Hoechst Group for certain areas of the Far East, including China, Hong Kong, Taiwan and Singapore. Mr. Benz has been Senior Vice President--Finance and Chief Financial Officer of the Company since April 1992 and Director of the Company since February 1987. From February 1987 to March 1992 he was Vice President--Finance and Chief Financial Officer of the Company. He was a Director and Chief Financial Officer with AHC from October 1980 to February 1987. Prior to 1980 he served as AHC's Treasurer for nine years. He also had responsibility for AHC's Petrochemicals and Plastics Group. Prior to joining AHC, he was employed by Peat, Marwick, Mitchell & Co. for 10 years. Mr. Engels has been Senior Vice President of the Company since April 1992 and director of the Company since September 1991. From September 1991 to March 1992 he was Vice President of the Company. He was Vice President--Marketing and Sales of the Fibers Division of Hoechst AG from November 1986 until August 1991. From January 1985 to October 1986 he was Director of Personnel and Social Policies for the Hoechst Group. From 1981 to December 1984, he was Divisional Director and head of the Staff Department of Hoechst AG, coordinating the Hoechst Group affiliates outside the Federal Republic of Germany. Mr. Engels has been with Hoechst AG for 21 years. Mr. Kennedy has been Executive Vice President of the Company since April 1992 and Director of the Company since March 1989. He was Group President of the Chemical Group from July 1989 to March 1992. From March 1989 to March 1992 he was Vice President of the Company. Prior to that, he was President of the Chemical Group from March 1989 to June 1989, Executive Vice President of the Chemical Group from January 1988 to February 1989 and Executive Vice President of Celanese Chemical Company, Inc. from September 1986 until December 1987. He previously served as Vice President and General Manager of Filter Products from October 1984 to September 1986. Prior to that, he was Business Director of Celanese Chemical Company, Inc. Dr. Patterson has been Executive Vice President of the Company since April 1992 and Director of the Company since January 1988. He has also been Chairman of the Board of Directors of HRPI since December 1992. From January 1988 to March 1992 he was Vice President of the Company. He was Group President of the Advanced Materials Group from November 1991 to March 1992, Group President of the Advanced Technology Group from May 1991 to March 1992 and Group President of the Fibers and Film Group form June 1989 to March 1992. Prior to that, he was President of Technical Fibers from March 1988 to May 1989, President of Industrial Fibers from January 1988 to March 1988, Vice President and General Manager of Celanese Industrial Fibers from December 1984 until January 1988 and Vice President, Technical of Celanese Fibers Operations from May 1984 until December 1984. He was Corporate Director of Planning of Celanese from March 1982 to May 1984. Dr. Patterson is a Director of Copley since November 1993. Mr. Harris has been Vice President of the Company since January 1988 and President, Textile Fibers Group since January 1990. He served as Treasurer of the Company from January 1988 until March 1989 and Executive Vice President, Textile Fibers Group from April 1989 until December 1989. He was formerly President of Celanese Fibers Operations, Ltd. from September 1986 until January 1988 and Vice President and General Manager of Polymer and Filter Products from September 1986 until December 1987. He served as Vice President, Administration of Celanese Fibers from November 1984 until August 1986. From May 1984 he was Executive Vice President of Celanese Canada Inc. and from November 1982 until April 1984 he was Vice President, Finance of Celanese Canada Inc. Mr. Jenkins has been Vice President--General Counsel of the Company since January 1989 and a Director since April 1989. Prior to that, he was Senior Vice President and General Counsel of The Pullman Company from January 1988 to December 1988. He served as Deputy General Counsel of the Company from June 1987 to December 1987 and as Vice President and General Counsel of the Hoechst Celanese Advanced Technology Company from August 1986 to June 1987. He was Secretary of Celanese from June 1984 to August 1986 and General Attorney of Celanese from September 1976 to August 1986. Dr. Langston has been Vice President of the Company since January 1991. Prior to that, he was Vice President, Human Resources of the Life Sciences Group from March 1989 to December 1990. From July 1987 to February 1989 he was the Company's Director of Compensation. From September 1982 to June 1987 he was Director, Human Resources of the Specialty Chemicals Group. Mr. Schmieder has been Vice President and Treasurer of the Company since January 1, 1992. He was Regional Manager for the Asia/Pacific Region of Hoechst AG from January 1990 to December 1991. From 1987 to December 1989 he worked on various assignments in the Central Staff and Legal Departments of Hoechst AG. From 1977 to 1987 he was in the Legal Department of Hoechst AG. Mr. Schmieder has been with Hoechst AG for 17 years. Mr. Schuele has been Vice President of the Company since February 1987 and responsible for Canadian Operations since May 1991. Prior to that, he was President of Specialty Products Group from February 1989 to April 1991 and Vice President--Quality and Communications from January 1988 to January 1989. He served as Treasurer from 1981 until January 1988 and became a Vice President in 1985. He joined AHC in 1980 as Assistant Treasurer after having been with The Chase Manhattan Bank, N.A. for 10 years. Mr. Smedley has been Vice President and Controller of the Company since February 1987. Prior to that, he served as Controller of AHC from 1975 and Vice President and Controller from 1980. Prior to joining AHC in 1972, he was with Price Waterhouse & Co. for 10 years. He is a Certified Public Accountant. ITEM 11.

ITEM 11. EXECUTIVE COMPENSATION The following tables set forth the compensation paid during the past three years and, in the case of pensions, payable in the future to the Chief Executive Officer and the four next most highly compensated executive officers of the Company. COMPENSATION TABLE The following table sets forth the total amount of cash compensation paid to the named executives in 1993, 1992 and 1991. - ---------- /(1)/ Bonus paid early in the following year for services rendered in each of the listed years. /(2)/ Company contribution to Savings Plan. /(3)/ Amounts for 1991 reflect compensation for services performed from September through December of that year. 1993 LONG-TERM INCENTIVE AWARDS TABLE The following table sets forth the awards made under the Company's Long-Term Incentive Award Plan to the named executives in 1993. LONG-TERM INCENTIVE PLANS - AWARDS IN LAST FISCAL YEAR Payments and awards are tied to achieving specified levels of Return on Capital Employed (ROCE), both absolute and relative to a competitive group of other companies. The target amount will be earned if 100% of the targeted ROCE is achieved. If threshold levels are not achieved, no payments will be made from the Plan. If threshold levels are achieved but target levels are not achieved, payments as low as 25% of the target amounts will be made. If certain stretch goals beyond target levels are achieved, payments as high as 150% of the target amounts will be made. PENSION TABLE The following table sets forth estimated annual retirement benefits for the named executives under the Hoechst Celanese Retirement Plan and the Hoechst Celanese Executive Pension Plan. PENSION PLAN TABLE/(1)/ BENEFITS FOR REPRESENTATIVE YEARS OF CREDITED SERVICE/(2)/ ----------------------------------------------------------- - ---------- /(1)/ This table represents total benefits payable from both the Hoechst Celanese Retirement Plan and the Hoechst Celanese Executive Pension Plan. Drs. Drew and Patterson and Messrs. Kennedy and Benz are participants in both these plans. Mr. Engels is covered by the Hoechst AG Pension Plan. Benefits from the Executive Pension Plan are only payable in the event the executive retires directly from employment with the Company. /(2)/ Amounts shown assume the executive retires at age 65 (or earlier if certain years of service requirements with the Company are met) and are paid annually for the remainder of the executive's life regardless of marital status. Benefits listed in the table are not subject to any deduction for Social Security. /(3)/ Final Average Earnings are defined in the plans as the average of the three highest years' earnings (base salary plus bonus) out of the last 10 years before retirement. The current Final Average Earnings for Dr. Drew, Dr. Patterson, Mr. Kennedy and Mr. Benz are approximately $1,043,000; $504,700; $501,700 and $473,400, respectively. The approximate years of Credited Service of the executives covered by the plans are: Dr. Drew, 27 years; Dr. Patterson, 26 years; Mr. Kennedy, 27 years; Mr. Benz 22 years. Employment contract with Hoechst AG. Mr. Engels has a special contract with Hoechst AG that covers certain aspects of his assignment in the United States in the nature of foreign relocation allowances, such as moving and travel expenses, vacation, home leaves, contributions to the German health insurance system while employed in the United States, emergency home leaves, etc. His salary and benefits are provided by the Company as long as he is employed in the United States by the Company. ITEM 12.

ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT Collectively, the directors and executive officers of the Company beneficially own less than 1% of the outstanding capital stock of Hoechst AG. Each of Messrs. Benz, Harris, Kennedy, Schuele and Mr. John A. Downard, President of Technical Fibers Group, serves on the Board of Directors of Celanese Canada Inc. Each of Messrs. Benz, Downard, Drew, Harris, Kennedy and Schuele owns 100 shares of its common stock. ITEM 13.

ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS RELATIONSHIP WITH HOECHST AG The Company is wholly owned by Hoechst Corporation, which in turn is wholly owned by Hoechst AG, a large chemical company headquartered in Frankfurt, Federal Republic of Germany. Hoechst AG is a publicly held company whose shares are listed and traded on the Tokyo stock exchange in Japan and on a number of major stock exchanges in Europe including the Frankfurt, Federal Republic of Germany; London, United Kingdom; and Geneva, Switzerland stock exchanges. The Company and Hoechst AG are parties to a broad research and development cost-sharing agreement. In most cases, licenses between the Company and Hoechst AG under patents owned by Hoechst AG require no specific payment because overall research and development costs have been shared. However, when license agreements are negotiated and utilized between the Company and Hoechst AG, they are on terms that are as favorable to the Company as could be obtained by third parties from Hoechst AG. The Company, from time to time, has entered into various financing agreements with its parent, Hoechst Corporation, and affiliates of Hoechst AG at competitive rates. See Note (2) of Notes to Consolidated Financial Statements. The Company has, from time to time, contracted for various plant and equipment design and consulting services from companies in the Hoechst Group on terms at least as favorable as could be obtained from third parties. The Company purchases from companies in the Hoechst Group many chemical raw materials at competitive prices for use in manufacturing chemically-related products. Several finished chemicals, which are resold in the United States, are also purchased from companies in the Hoechst Group. See Note (2) of Notes to Consolidated Financial Statements. The Company intends to continue its current policy of paying dividends to Hoechst Corporation at the discretion of the Company's Board of Directors. Payment of dividends by the Company is restricted by its public debt instruments, when there is, or a payment would result in, a default under these instruments or if the payments (when aggregated with other "Restricted Payments" as defined therein) would exceed a formula amount based on the total of $250 million plus Consolidated Net Income (as defined therein) plus certain Net Cash Proceeds from the sale, conversion or exchange of stock (as specified therein). Certain of the Company's employees, including a director, have employment contracts with Hoechst AG. See "Executive Compensation." PART IV ITEM 14.

ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K (A)(1) FINANCIAL STATEMENTS The Consolidated Financial Statements of the Company and the Report of Independent Auditors of KPMG Peat Marwick are set forth in the Financial Statements and Supplementary Data (Item 8) and are filed as part of this report. (A)(2) FINANCIAL STATEMENT SCHEDULES The following additional financial information is filed as part of this report and should be read in conjunction with the Consolidated Financial Statements: Schedules not included with this additional financial information have been omitted either because they are not applicable or because the required information is shown in the financial statements or notes thereto. (A)(3) EXHIBITS The following Exhibits are filed as part of this report: (B) REPORTS ON FORM 8-K During the quarter ended December 31, 1993, no reports on Form 8-K were filed. SIGNATURES Pursuant to the requirements of Section 15(d) of the Securities Exchange Act of 1934, Hoechst Celanese has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. Hoechst Celanese Corporation By: /s/ Ernest H. Drew ------------------------------------- Ernest H. Drew President and Chief Executive Officer March 28, 1994 Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed on March 28, 1994, by the following persons on behalf of the registrant and in the capacities indicated. - ---------- * Ernest H. Drew, by signing his name hereto, does sign this document on behalf of each of the persons indicated above pursuant to powers of attorney duly executed by such persons, filed with the Securities and Exchange Commission. By: /s/ Ernest H. Drew ------------------------------------- Ernest H. Drew Attorney-in-Fact SUPPLEMENTAL INFORMATION TO BE FURNISHED WITH REPORTS FILED PURSUANT TO SECTION 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 (THE "ACT") BY REGISTRANTS WHICH HAVE NOT REGISTERED SECURITIES PURSUANT TO SECTION 12 OF THE ACT: Hoechst Celanese Corporation is a wholly owned subsidiary of Hoechst Corporation. Accordingly, no annual report or proxy material has been sent to security holders. EXHIBITS TO 1993 ANNUAL REPORT ON FORM 10-K -------------------------------------------

68813_1993.txt

68813

1993

Item 1. Business. Multimedia, Inc. (the "Company") is a diversified media company with corporate headquarters in Greenville, South Carolina. The Company is a South Carolina corporation which began using its current name in 1968; however, its predecessor newspaper and broadcasting companies date back as early as 1888. The Company publishes 11 daily and approximately 50 non-daily newspaper publications; owns and operates five television and five radio stations; serves approximately 417,000 cable television subscribers in five states; monitors approximately 52,000 security alarm customers; and produces and syndicates television programming. The Company's industry segments are newspaper publishing, broadcasting, cable television, entertainment and security alarms. Financial information for these segments is presented in Note 14 of the Notes to Consolidated Financial Statements in the 1993 Annual Report, which material is incorporated herein by reference. Further information relating to the development of the business since the beginning of the fiscal year covered by this report is included in Management's Discussion and Analysis of Financial Condition and Results of Operations set forth on pages 16 through 23 in the 1993 Annual Report and in the Notes to Consolidated Financial Statements in the 1993 Annual Report, which material is incorporated herein by reference. RECAPITALIZATION MERGER On September 20, 1985, the Company's shareholders approved a Recapitalization Agreement and Plan of Merger providing for the merger of MM Acquiring Corp., a new corporation which had been organized for purposes of the merger, with and into the Company (the "Recapitalization Merger"). The purpose of the Recapitalization Merger was to recapitalize the Company and thereby provide the Company's shareholders with an opportunity to receive a premium over historical prices for a significant portion of their shares while retaining an ongoing equity interest in the Company and to provide performance incentives to members of senior management of the Company by providing them with increased equity participation in the Company. The Recapitalization Merger was consummated on October 1, 1985. Further information relating to the Recapitalization Merger is included in Note 2 of the Notes to Consolidated Financial Statements in the 1993 Annual Report, which material is incorporated herein by reference. NEWSPAPER OPERATIONS The Company publishes the only daily newspapers in Greenville, South Carolina; Asheville, North Carolina; Montgomery, Alabama; Clarksville, Tennessee; Gallipolis and Pomeroy, Ohio; Point Pleasant, West Virginia; Staunton, Virginia; Moultrie, Georgia; and Mountain Home, Arkansas. It also publishes Sunday newspapers in each market except Moultrie, Point Pleasant and Mountain Home. The Company also publishes approximately 50 non-daily publications in Alabama, Arkansas, Georgia, North Carolina, Ohio, South Carolina, Virginia and Tennessee, including the monthly MUSIC CITY NEWS and THE GOSPEL VOICE. In April 1993, the Company's Montgomery newspaper merged its morning and afternoon newspapers. Prior year linage comparisons have not been restated. However, if restated, billed advertising linage would have increased 2.2% from 1992 to 1993. The increase is primarily due to a strong rebound in classified advertising. Substantially all of the Company's newspaper revenues are obtained from advertising and circulation. Advertising rates and rate structures vary depending upon circulation and type of advertising (local, classified, national, etc.). The following table indicates billed newspaper advertising linage and advertising revenues for 1993, 1992 and 1991. 1993 1992 1991 Advertising linage 144,928,000 146,172,000 155,199,000 Advertising revenues $99,173,000 $98,254,000 $98,127,000 The Company's newspapers are primarily home-delivered and are generally sold by independent carriers and circulation dealers. Certain non-daily publications are distributed free of charge, using both mail and carrier delivery. The following table indicates total paid newspaper circulation at year-end and circulation revenues for 1993, 1992 and 1991. 1993 1992 1991 Circulation: Daily 323,000 325,000 318,000 Sunday 352,000 351,000 344,000 Non-daily 202,000 159,000 159,000 Circulation revenues $30,233,000 $28,491,000 $26,024,000 The percentages of the Company's newspaper revenues contributed by advertising, circulation and other operating revenues for the five years ended December 31, 1993, were: 1993 1992 1991 1990 1989 Advertising revenues 73% 74% 76% 78% 79% Circulation revenues 22 22 20 19 19 Other operating revenues 5 4 4 3 2 100% 100% 100% 100% 100% Newsprint represents approximately 20% of the newspaper division's operating expenses. The basis weight of newsprint used by the Company is 30 pound paper. The price of newsprint remains volatile, and it is difficult to predict any significant price increase or decrease. The average cost per ton may vary depending upon the competitive discount allowance throughout the year. Two newsprint suppliers provide the majority of the Company's newsprint. The Company believes that its newsprint supply sources under existing arrangements are adequate. The Company's newspapers compete for advertising principally on the basis of readership and compete for circulation principally on the basis of content. The Company's daily newspapers do not compete directly with any other general circulation daily newspaper published in that community. Most of the Company's newspapers compete with other newspapers published in nearby cities and towns, or with free distribution advertising weeklies. Further, all of the Company's newspapers compete with newspapers having national or regional circulation, as well as with magazines, radio, television, outdoor and other advertising media. BROADCASTING OPERATIONS The Company wholly owns and operates four VHF television stations located in St. Louis, Missouri (KSDK, an NBC affiliate); Cincinnati, Ohio (WLWT, an NBC affiliate); Knoxville, Tennessee (WBIR-TV, an NBC affiliate); and Macon, Georgia (WMAZ-TV, a CBS affiliate). In addition, the Company owns a 51% majority interest in WKYC-TV (an NBC affiliate) Cleveland, Ohio, and has operating control of the station. Television stations operate under network affiliation contracts running from two to five years. The network provides programs to its affiliated stations and sells commercial time in the programs to national advertisers. The stations also sell commercial time in the programs to national and local advertisers. Generally, a network affiliation agreement can be cancelled prior to the expiration of the contract by either party with 180 days notice. The Company has experienced no difficulties in the past with such affiliation renewals. The Company's television stations' affiliation renewal dates follow: Television Station Network Affiliation Renewal KSDK May 1, 1994 WLWT September 1, 1994 WBIR September 10, 1994 WKYC December 26, 1994 WMAZ February 1, 1995 Each television station transmits live, filmed or taped programs purchased from others or produced by the station. For both television and radio, the Company endeavors to present a balanced schedule of programs, including entertainment, news, public affairs, sports and other programs of public service and public interest. The Company owns and operates AM and FM radio broadcasting stations in Greenville, South Carolina, and Macon, Georgia, and an AM station in Spartanburg, South Carolina. Each of these stations is authorized to operate 24 hours per day, and each maintains a daily operating schedule of at least 18 hours. The principal sources of the Company's television and radio revenues consist of payments from national, regional and local advertisers or agencies for program time or advertising announcements, payments from the networks for broadcasting network programming and payments by advertisers and other broadcasters for services such as the production of films or the taping of advertising material. The percentages of the Company's broadcasting revenues contributed by television and radio and other for the five years ended December 31, 1993, were: 1993 1992 1991 1990 1989 Television revenues 94% 91% 91% 89% 89% Radio and other revenues 6 9 9 11 11 100% 100% 100% 100% 100% In January 1993, the Company sold its mobile video production business for $4.5 million, which resulted in a gain of approximately $2.3 million before taxes. Revenues from the mobile video production business are included in the above table under other revenues. During the first quarter of 1994, the Company sold its radio stations in Milwaukee, Wisconsin, and Shreveport, Louisiana, for a total of $7.2 million, which resulted in a gain of approximately $3.6 million before taxes. Excluding the results of the properties sold during 1993 and the first quarter of 1994, broadcasting revenues would have decreased approximately 1% and operating profit would have increased approximately 5% from 1992 to 1993. The market size, rank and share for the Company's television stations are presented below: Rank Share WKYC (Market #12) 1993 2 17 1992 3 17 1991 3 17 KSDK (Market #18) 1993 1 26 1992 1 24 1991 1 24 WLWT (Market #31) 1993 2 19 1992 3 17 1991 2 21 WBIR (Market #62) 1993 1 28 1992 1 27 1991 1 27 WMAZ (Market #120) 1993 1 42 1992 1 43 1991 1 44 Note: Information represents station ADI TV Household share sign-on/sign-off for the November Arbitron or Nielsen of the respective period. Source for market size: "Arbitron Television - 1993" The Company's television and radio stations compete for revenues principally on the basis of ratings. The Company's television and radio stations compete for revenues with other advertising media such as newspapers, magazines and other television and radio stations. Other sources of present and potential competition include cable television ("CATV"), pay cable and subscription TV operations. CATV systems currently operate in most of the market areas served by the Company's communications media. In addition, franchises for CATV systems have been granted by various communities in these market areas, and additional CATV franchises may be considered and granted from time to time. The future of broadcasting depends on a number of factors, including the general strength of the economy, population growth, overall advertising revenues, relative efficiency compared to other competing advertising media and existing and future governmental regulations and policies. The business strategy of the Company's broadcasting division focuses on providing quality local programming and service to each of its respective communities. The most important local programming segment to the Company's broadcasting division is local news programming. Local news programming typically has the highest rating of any local programming segment, and television stations usually receive a significant portion of their advertising revenues from the local news segments. Quality local news coverage is also important in establishing a local station's public service reputation. Further information regarding the Company's broadcasting operations is presented under "Federal Regulation of Broadcasting". CABLE OPERATIONS The Company operates cable television systems serving subscribers in Kansas, Oklahoma, Illinois, Indiana and North Carolina. The following table shows homes passed, basic and pay subscribers, basic penetration, pay-to-basic ratio and average monthly revenue per cable subscriber at the end of 1993, 1992 and 1991. 1993 1992 1991 Homes passed 694,000 688,000 623,000 Basic subscribers 417,000 410,000 365,000 Pay subscribers 323,000 333,000 312,000 Basic penetration 60.1% 59.6% 58.6% Pay-to-basic ratio 77.5% 81.2% 85.5% Average monthly revenue per cable subscriber $33.29 $32.13 $30.36 The majority of the increase in basic subscribers from 1991 to 1992 was due to the purchase of 33,000 cable television subscribers in Indiana and Illinois. Cable television is the distribution of television signals and special information programs to subscribers within the community by means of a coaxial cable system. A cable system may also offer pay television services which provide, for an extra charge, special programs such as recently released movies, entertainment programs or selected sports events. Subscribers receive these programs on a designated channel of the cable system which is restricted with electronic security devices to isolate the pay television signal so that only subscribers to the service can receive it. The Company holds approximately 140 franchises from local governing authorities which permit the Company to operate a CATV system in the granting community (see Federal Regulation of Cable Television). These franchises, which expire at varying dates ranging from one to 20 years, are generally non-exclusive and may be terminated for failure to comply with specified conditions. In most cases, the Company is required to pay fees generally ranging from three to five percent of the system's revenues to the particular local governing authority granting the franchise. At the end of 1993, approximately 52 systems, which account for more than 68% of the Company's subscribers, have franchise agreements expiring in the year 2000 and beyond. During 1993, the Company began a five-year $150 million investment in the technological upgrade of its cable television operations. The investment includes approximately $45 million in each of the next two years to replace the coaxial wire in our cable systems with fiber. The majority of the remaining portion of the $150 million program will include the integration of digital compression and the installation of interactive converter boxes in the homes of approximately 50% of our customers, being the percent of the existing customers that we expect will want the new interactive services. The Company believes the technological upgrade will prepare it for new competitors and potential revenue opportunities. The Company may compete with other companies and individuals in the submission of applications for additional franchises, the renewal of existing franchises and in seeking to acquire operating CATV systems and under-developed franchises. Since most franchises are granted on a non-exclusive basis, other applicants may obtain franchises in areas where the Company presently operates systems or holds franchises. The Company's cable television division competes for revenues principally on the basis of quality of service, a variety of programming options and pricing. The Company's strategy is to develop clusters of cable television systems in suburban communities of major metropolitan markets and other areas with favorable demographics. Management believes that the clustering of cable systems produces operating, marketing and servicing efficiencies. On February 22, 1994, the Federal Communications Commission ("FCC" or "Commission") announced several decisions relating to cable rates (see Federal Regulation of Cable Television). Wireless Cable Service The Company operates wireless cable systems in the Oklahoma City, Oklahoma, and Wichita, Kansas, metropolitan areas. Wireless cable is over-the-air distribution to consumers' residences of video programming by means of microwave radio channels. It combines standard broadcast television reception equipment with microwave reception equipment and uses a combination downconverter and channel selector to provide a composite of broadcast and non- broadcast signals to subscribers. In this regard, wireless cable may provide an alternative programming delivery service to that offered by a traditional cable television system. The frequencies allocated by the FCC for this use are those in the multichannel multipoint distribution service ("MMDS"), Private Operational Fixed Microwave Service ("OFS") and, on a part-time basis, the Instructional Television Fixed Service ("ITFS"). The Company holds several licenses issued by the FCC for use of frequencies in its Oklahoma City systems. For both the Oklahoma City and Wichita systems, the Company has entered into lease agreements with the FCC license-holders for various MMDS and ITFS frequencies. Terms of these agreements vary from one year to five years with provision for renewal. In 1990 and 1991, the Commission simplified its regulations and procedures applicable to the wireless cable business in order to allow wireless cable systems to compete more effectively with traditional cable systems. Among other things, the Commission eliminated its rules restricting the number of wireless cable channels a single entity can control in a market and modified interference requirements and processing practices to accelerate the application process. The Commission also limited the future ownership or lease of wireless cable channels by cable television operators within their local franchise areas, while grandfathering existing wireless cable operations owned by cable television operators. Further, the Commission modified restrictions on lease terms for MMDS use of ITFS frequencies and increased power limitations and channel assignment standards. The Cable Television Consumer Protection and Competition Act of 1992 (the "1992 Act") prohibits common ownership of cable television and wireless cable operations in a franchise area. However, existing operations, such as those of the Company, are grandfathered, and the FCC is authorized to grant waivers of the cross-ownership restriction in other situations. Wireless cable operators that include local or distant television stations in their service offerings traditionally have relied upon the compulsory broadcast retransmission license established by the Copyright Act to cover their use of copyrighted material contained in such signals. The Copyright Office has ruled that the compulsory license does not cover wireless cable operations. The wireless cable industry is expected to seek legislation to clarify that wireless cable operators are eligible for the license. The provisions of the 1992 Act governing mandatory carriage of television broadcast signals (see Federal Regulation of Broadcasting) do not apply to wireless cable operations. However, those provisions dealing with retransmission consent are applicable. Consequently, wireless cable operators are required to obtain the consent of local broadcast stations prior to utilizing microwave frequencies to distribute such stations. The Company does not use microwave frequencies to distribute local over-the-air television stations in its Oklahoma City operations, but it does in Wichita, and it has obtained the requisite consents for distribution of those local stations. SECURITY ALARM OPERATIONS The Company sells or leases and installs residential and commercial alarm equipment and provides monitoring services for the alarm owner or lessee. These accounts are monitored through a central computer located in Wichita, Kansas. At year-end, the Company provided security monitoring services for approximately 52,000 customers (both residential and commercial) primarily located in the midwest and western United States. These accounts were obtained through acquisitions and through in-house sales efforts. The following table shows the number of subscribers and the average recurring monthly revenue per security subscriber at the end of 1993, 1992 and 1991. 1993 1992 1991 Number of subscribers 52,000 35,000 26,000 Average recurring monthly revenue per subscriber $25.13 $23.09 $21.94 The Company's security alarm division generates revenues from the installation, monitoring and servicing of security alarm systems. Monitoring fees, which represent approximately 80% of the division's revenues, consist of payments from customers for the surveillance of the security devices in their home or business. These devices transmit a signal through telephone lines or radio waves to the monitoring station whenever the customer's alarm is triggered. Generally, monitoring contracts between the Company and alarm customers are for at least three years. There are many security companies competing in the same markets with the Company. The Company may also compete with other companies in the acquisition of existing security accounts. The Company's security division competes for revenues with many other security companies on the basis of quality of service, ability to monitor and service security systems and price. ENTERTAINMENT OPERATIONS The Company's entertainment division produces television programming for broadcast both in the U.S. and internationally. The division derives virtually all of its operating profits and approximately 50% and 25%, respectively, of its revenues from the production and syndication of two daytime television talk shows, the "DONAHUE" and "SALLY JESSY RAPHAEL" shows. Both of these shows are primarily distributed via satellite to the stations for showing. A significant portion of operating profit for the division is contributed by the "DONAHUE" show. The Company's syndication activities continue to be an important source of revenues, particularly the "DONAHUE" show. The Company contracts with television stations for exclusive rights to air these programs in their respective markets. The length of these contracts generally range from one to three years. Fees from these sales to stations and the sale of advertising in these shows are the principal sources of revenue for the Company's entertainment division. In addition, the Company produces other talk shows, and special dramas, movies and docudramas for first-run syndication, the networks, cable, PBS and the international marketplace. The "DONAHUE" show, hosted by Phil Donahue, is in its twenty-sixth year of production and syndication. The show is currently seen in 189 U.S. markets and in 50 foreign countries. Phil Donahue is currently under contract with the Company through August 31, 1995. The "SALLY JESSY RAPHAEL" show is currently in its eleventh season of production and syndication and is broadcast in 186 U.S. markets and in 30 foreign countries. The show's revenues have grown significantly over the last five years, due to increased ratings and clearances. Sally Jessy Raphael is currently under contract with the Company through September 1998. In September 1991, the Company purchased certain television and first-run syndicated television assets from Carolco Pictures, Inc.'s wholly owned subsidiary, Orbis Communications, now named Multimedia Motion Pictures, Inc. ("MMP"). MMP's primary objective is to produce made-for-television movies or miniseries for the networks, syndication and cable marketplace. The number of hours of programming produced and sold to various networks increased from six hours in 1992 to 16 hours in 1993. The Company expects to curtail this activity in the future to concentrate its resources on more profitable programming opportunities. The Company introduced a talk show, "JERRY SPRINGER", in September 1991 on four stations and began nationwide syndication in September 1992. The "Jerry Springer" show is currently seen in 145 U.S. markets. Jerry Springer is currently under contract with the Company through September 1997. "RUSH LIMBAUGH, THE TELEVISION SHOW", a late-night talk show, premiered in September 1992 and is currently seen in 223 U.S. markets. "RUSH LIMBAUGH, THE TELEVISION SHOW" is a joint venture between Ailes Communications, Rush Limbaugh and the Company. Rush Limbaugh is currently under contract with the Company through August 1995. The Company plans to launch a news-oriented all talk channel for cable in the fall of 1994. The Company's entertainment division competes for revenues with numerous other syndicated programming principally on the basis of ratings. EMPLOYEE RELATIONS The Company employs approximately 3,500 full-time employees and has contracts with local collective bargaining agents representing approximately 5% of its employees. Employees of the Company receive various supplemental benefits including group life and health insurance, pension and salary deferral thrift plans. The Company considers its relationship with employees excellent. REGULATION OF BROADCASTING AND CABLE OPERATIONS Federal Regulation of Broadcasting The Company's television and radio broadcasting operations are subject to the jurisdiction of the FCC under the Communications Act of 1934 as amended (the "Act"). The Act empowers the FCC, among other things, to issue, revoke or modify broadcasting licenses, to assign frequency bands, to determine the location of stations, to regulate the apparatus used by stations, to establish areas to be served, to adopt such regulations as may be necessary to carry out the provisions of the Act and to impose certain penalties for violation of its regulations. Under the Act, radio and television broadcast licenses may be granted for maximum periods of seven and five years, respectively. Upon application, and in the absence of conflicting applications or adverse findings as to the licensee's qualifications, existing radio and television licenses will be renewed without hearing by the FCC for additional seven and five year terms, respectively. If a competing application is filed against a licensee's renewal application, the Act requires a full comparative hearing. The U.S. Court of Appeals for the District of Columbia Circuit affirmed a significant FCC decision in a comparative television renewal proceeding which recognized an incumbent licensee's "renewal expectancy" based on substantial service to its community. The Court's decision indicated that a renewal expectancy, if proven by sound past performance, should be considered by the FCC along with other standard comparative factors applicable to both the incumbent and the competing applicants such as (i) the applicants' other media holdings (in this context, FCC policy disfavors owners of multiple properties); (ii) the applicants' plans for management of the facility by their respective owners (which is normally not required in the case of a publicly owned broadcasting company); and (iii) other factors, including local residency, civic involvement and provision of signals to under-served populations. The FCC has established procedures placing strict limitation on settlement payments made to competing applicants in return for dismissal of their applications. These rules were intended to reduce the potential for abuse of the FCC's renewal procedures. The FCC currently has pending a rulemaking and inquiry proceeding to develop specific standards for determining whether an incumbent is entitled to a renewal expectancy and for comparing incumbent licensees with competing applicants as well as to establish procedures regarding the order of proof for determining entitlement to renewal expectancy. Petitions to deny broadcast station license renewal applications (as well as other types of broadcast applications) have been filed in recent years by various parties asserting programming, employment and other complaints. Most such petitions have been denied by the FCC on the basis of pleadings and without formal hearings. The Company's applications for the renewal of its broadcast licenses for the regular term have heretofore been granted without hearing; however, there is no assurance that this experience will be repeated in the future. The Company's television stations' FCC license renewal dates follow: Television Station FCC License Renewal WMAZ April 1, 1997 WBIR August 1, 1997 WKYC October 1, 1997 WLWT October 1, 1997 KSDK February 1, 1998 The Act also prohibits the assignment of a license or the transfer of control of a license or significant modification of broadcast transmission facilities without prior approval of the FCC. Moreover, FCC multiple ownership regulations prohibit the common ownership or control of most communications media (i.e., television and radio, television and daily newspapers, radio and daily newspapers or television and cable television operations ("Cable")) serving common or overlapping market areas. The Company owns daily newspapers and AM and FM radio stations in Greenville, South Carolina; and AM and FM radio stations and a television station in Macon, Georgia. These ownership interests pre-dated the FCC's multiple ownership rules and thus are "grandfathered", and divestiture by the Company is not required. In the case of a sale or transfer of control (other than a "pro forma" or non-substantial transfer of control), however, the buyer or transferee would not be able to continue the common ownership of the relevant properties absent a waiver of the FCC's rules. In addition, FCC multiple ownership regulations generally limit the number of cognizable broadcast interests which may be owned by an entity or individual. Cognizable interests under FCC multiple ownership rules include 5% or greater voting stockholder interests (10% or more for investment companies, bank trust departments and insurance companies), general (and some types of limited) partnership interests and official positions as officers or directors. FCC multiple ownership regulations generally permit the common ownership of up to 12 television stations (without regard to whether they are in the UHF or VHF band), provided the total audience reach of commonly owned television stations is less than 25% of the nation's television households. (For purposes of calculating the total percentage of national television households, only 50% of each UHF station's audience reach is counted.) A rulemaking proceeding currently pending before the FCC proposes to liberalize both the local and national limits on television ownership. It is unlikely that this rulemaking will be concluded before the end of 1994, and there can be no assurance that any of these rules will be changed. In any event, the Company's broadcast operations will continue to be subject to the FCC's ownership rules and any changes the agency may adopt. The Company does not believe that the FCC multiple ownership regulations for television stations will restrict its growth except in areas with overlapping coverage to its existing properties. In 1992 the FCC relaxed its "duopoly" rule governing ownership by a single entity of multiple radio stations in the same market. In local markets with 15 or more stations, one entity is permitted to own two AM and two FM stations, so long as the combined audience share of these stations does not exceed 25% of the market at the time of acquisition. In markets with fewer than 15 stations, ownership of up to three radio stations is permitted, no more than two of which may be in the same service (AM or FM), provided that the total number of stations owned comprises less than 50% of the total number of stations in the market. The FCC also increased the number of stations which may be owned by a single entity on a national basis to 18 AM and 18 FM stations; in 1994 this will increase to 20 AM and 20 FM stations. The 1992 Act contains two provisions that fundamentally alter the relationship that has existed in recent years between cable television systems and television broadcast stations whose signals are distributed to cable subscribers. The first deals with the rights of "local" commercial and non-commercial television broadcasters to mandatory carriage of their signals on cable systems ("must-carry"). The second, in certain defined circumstances, prohibits cable operators from carrying the signals of television stations without first obtaining their consent ("retransmission consent"). The two provisions are related in that, with respect to local cable carriage, broadcasters must make a choice once every three years on a system by system basis whether to proceed under the must-carry rules or whether to insist upon retransmission consent in order for their signal to be carried. The FCC's implementing regulations required broadcasters to elect between must-carry and retransmission consent by June 17, 1993, with the choice binding for three years. A broadcast station has the right to choose must-carry, assuming it can deliver a signal of specified strength, with regard to cable systems in its Area of Dominant Influence as defined by the audience measurement service Arbitron. Stations electing to grant retransmission authority were expected to conclude their consent agreements with cable systems by October 6, 1993, the date on which system's authority to carry broadcast signals without consent expired. In June 1993, the Company elected retransmission consent on the majority of cable systems that carry the signals of the stations in the stations' markets. Must-carry was elected on a small percentage of systems. Pending negotiation of long-term retransmission agreements, the stations have entered into interim agreements (currently scheduled to expire June 30, 1994) with all of the affected cable system operators. The must-carry provisions of the 1992 Act have been challenged as unconstitutional. A special three-judge district court rejected the challenge. That decision has been appealed, and the Supreme Court of the United States heard oral arguments in the case on January 12, 1994. Its decision is expected later this year. The Company cannot predict the outcome of the case. A separate challenge to the retransmission consent provision of the 1992 Act was rejected by a Federal district court. An appeal of that decision is pending. The FCC's syndicated exclusivity and network non-duplication rules enable television broadcast stations, that have obtained exclusive distribution rights for programming in their market, to require cable systems (with more than 1,000 subscribers) to delete or "black-out" such programming from other television stations which are carried by the cable system. The FCC is studying whether to relax or abolish the geographic limitations on program exclusivity contained in its rules so as to allow parties to set by contract the geographic scope of exclusive distribution rights. In addition to full service television broadcast stations, the FCC, under its rules, provides for authorization of low power television stations ("LPTV"), subscription television stations ("STV"), multipoint distribution services ("MDS"), multichannel multipoint distribution services ("MMDS") and direct satellite-to-home broadcast services ("DBS"). These services have the technical capability to distribute television programming to viewers' homes and, thus, to compete with conventional full service television stations. Technological developments in broadcasting and related fields, such as High Definition Television ("HDTV"), Digital Audio Broadcasting ("DAB") as well as changes in FCC regulations, may affect the competitiveness of new and existing alternatives to conventional radio and television services or otherwise affect the market for radio and television broadcast services. For example, the FCC favors relaxation of the cross-ownership ban on telephone companies providing cable television services in their telephone service area and has authorized telephone companies to provide cable service on a "video dial tone" basis. (See Federal Regulation of Cable Television.) In this regard, the United States District Court for the Eastern District of Virginia recently held that the provision of the Communications Act that prohibits telephone companies from providing video programming to subscribers within their service area is unconstitutional. Although the court's ruling only applied to the operations of Bell Atlantic (the regional Bell Operating Company ["RBOC"] that brought the suit) and its subscribers, other RBOCs have brought suit in other courts seeking to have the provision declared unconstitutional. Congressional legislation to eliminate or modify this cross- ownership ban has also been proposed. The FCC also has proposed the establishment of a local multipoint distribution service ("LMDS") that could offer multiple channels of video programming using very high-frequency microwave signals in the 28 GHz band. Under the proposal, two service providers in each of 489 markets across the country would be licensed to distribute video, data and other telecommunications services. In January 1994, the FCC announced that it would issue a Second Notice of Proposed Rulemaking in this proceeding designed to determine whether it should implement a Negotiated Rulemaking Proceeding to allow participants to determine whether the 28 GHz band could be shared by terrestrial LMDS and satellite users. The Company cannot predict the outcome of the FCC's proceeding, nor can the Company assess the effect which future technological developments or changes in FCC regulations or policies may have on the Company's operations. There are additional FCC regulations and policies, and regulations and policies of other federal agencies, regulating network- affiliate relations, political broadcasts, advertising practices, program content, equal employment opportunities, application procedures and other areas affecting the business or operation of broadcast stations. Proposals for additional or revised regulations or legislation are pending and considered by federal regulatory agencies and Congress from time to time. The Company cannot predict the effect of existing and proposed federal regulations, legislation and policies on its broadcasting business. The foregoing does not purport to be a complete summary of all the provisions of the Act or the regulations and policies of the FCC thereunder. Federal Regulation of Cable Television The cable television industry is subject to extensive government regulation at the federal and local levels and, in some cases, at the state level. The relationship of various levels of government in regulating cable television and the extent of such regulation is established by the Cable Communications Policy Act of 1984 (the "1984 Act") and the recent amendment thereto, the 1992 Act. The FCC has had and will continue to have principal federal responsibility for regulating cable television. The 1992 Act has greatly expanded the regulatory framework of the FCC within which cable operators must operate. Under this new framework, the FCC was required to adopt new regulations implementing Congressional policies for such aspects of cable operations as rates, customer service obligations, carriage of television broadcast signals and other types of programming, technical matters, leased access, franchise issues, consumer electronics equipment standards, ownership and employment practices. During the past year, the FCC completed initial rulemaking proceedings in accordance with timetables imposed by the 1992 Act; however, many of the new rules remain under reconsideration by the FCC. In addition, provisions of the 1992 Act and some of the FCC's implementing regulations have been challenged in court. Thus, there remains an element of uncertainty as to the ultimate nature and scope of the new requirements. A. Television Signal Carriage and Programming. The 1992 Act contains two elements that fundamentally alter the relationship between cable systems and television broadcast stations. The first reinstates the mandatory carriage of certain local over-the-air television stations ("must-carry" rules). Such rules have previously been held unconstitutional as violative of cable operators' First Amendment Rights. The second element provides that in certain circumstances television stations may prohibit the carriage by cable systems absent consent ("retransmission consent"). The two provisions are related in that broadcast stations must elect either must-carry or retransmission consent on local cable systems. Election must be made every three years. For the current three-year election period, the Company's cable systems have succeeded in maintaining desirable channel line-ups by accommodating those stations electing mandatory carriage and entering into retransmission consent agreements with others. The U.S. Supreme Court recently heard arguments on an appeal of the 1992 Act's must-carry provisions and is expected to rule on their constitutionality later this year. In addition, the FCC is reconsidering certain aspects of its recently-adopted regulations governing must-carry and retransmission consent. (See also, Federal Regulation of Broadcasting, above.) The FCC's syndicated exclusivity and network non-duplication rules enable television broadcast stations, that have obtained exclusive distribution rights for programming in their market, to require cable systems (with more than 1,000 subscribers) to delete or "black-out" such programming from other television stations which are carried by the cable system. The extent of such deletions varies from market to market but generally makes distant broadcast signals less attractive sources of programming. The FCC also is studying whether to relax or abolish the geographic limitations on program exclusivity contained in its rules so as to allow parties to set by contract the geographic scope of exclusive distribution rights. This could result in even more extensive program black- outs. The FCC has recommended to Congress that it repeal at least part of the cable industry's compulsory copyright license which Congress established in 1976 to serve as a means of compensating program suppliers for cable retransmission of broadcast signals. (See Copyright discussion, below.) The FCC determined that the statutory compulsory copyright license for distant broadcast signals no longer served the public interest and that private negotiations between the applicable parties would better serve the public. The FCC has deferred a decision on whether to recommend the repeal of the statutory compulsory copyright license for retransmission of local broadcast signals. Legislation has been proposed to repeal the compulsory copyright license law. Without the compulsory license, cable operators might need to negotiate rights from the copyright owners for each program carried on each broadcast station in the channel lineup. Such negotiated agreements could increase the cost to cable operators of carrying broadcast signals. The exact relationship between the compulsory license and the 1992 Act's retransmission consent provision is unclear, and it is expected that additional legislation will be introduced to address this issue. The FCC requires that non-broadcast cable origination programming comply with FCC standards similar to those imposed on broadcasters. These standards include regulations governing political advertising and programming, advertising during children's programming, prohibition of lottery information and sponsorship identification requirements. The 1992 Act imposes certain restrictions on cable operators which have an attributable ownership interest in satellite programming services. Vertically-integrated companies are prohibited from unreasonably refusing to deal with a multichannel distributor and from discriminating in price, terms and conditions in the sale of programming to multichannel distributors if the effect is to hinder or prevent competition. As required by the 1992 Act, the FCC issued rules governing distribution practices and contractual relationships between vertically-integrated programmers and cable systems in an effort to promote competition and diversity in the programming market and to increase its availability to consumers. However, the rules allow programmers to: establish credit, financial or technical qualifications; establish different prices, terms and conditions based on actual and reasonable differences; and enter into exclusive arrangements if in the public interest. This provision has withstood judicial challenge, but an appeal of the court's decision is pending. In addition, the FCC is reconsidering the rules it adopted to implement statutory policy. B. Cable Television Ownership. As a result of the 1984 Act, the FCC is, with a few exceptions, the only governmental agency authorized to prescribe rules relating to cable system ownership or control by persons with interest in other mass media communications. The 1984 Act prohibits common ownership or control of a television station and a cable system in the station's Grade B signal coverage area (typically an area approximately 15-75 miles from the station's transmitting antenna). The 1992 Act imposes restrictions on common ownership or control of MMDS and Satellite Master Antenna Television ("SMATV") operations in a cable service area. (SMATV is a video delivery system that receives programming through a satellite earth station for distribution to viewers (without using public rights of way) in multiple dwelling complexes such as apartment buildings and hotels.) Existing ownership interests of MMDS or SMATV services are unaffected. The 1992 Act directed the FCC to implement horizontal and vertical ownership limitations on cable operators. With regard to horizontal ownership, the FCC adopted rules limiting the number of subscribers a cable operator is authorized to reach to no more than 30 percent of all homes passed by cable nationwide. The horizontal ownership limits were invalidated by a federal court, and the FCC has stayed its rule pending further judicial appeal. The FCC's new vertical integration rules limit to 40 percent of a system's capacity the number of channels that can be occupied by a commonly-owned programmer. These rules are undergoing FCC reconsideration. The 1992 Act grants local franchising authorities certain rights to deny franchise awards or transfer approvals upon a finding of common ownership by the applicant of another system in the same service area or that competition would be reduced or eliminated by such award or transfer. Except for rural telephone companies as defined by the FCC, federal law restricts the ability of telephone companies to engage in cable television operations within their local service areas. Specifically, local telephone companies may not provide video programming, channels of communication, pole or conduit space or other rental arrangements to an affiliate. The FCC favors relaxation of this ban and authorizes telephone companies to provide cable service on a "video dial tone" basis by furnishing transmission facilities to customers who would distribute programming. In the FCC's view, neither the phone company nor its programmer/customer would be subject to local franchise requirements that would apply to a conventional cable operator. Legislation which would eliminate or modify this ownership ban has also been proposed. If the restrictions are relaxed or removed, cable television companies could face increased competition. Recently, Bell Atlantic was successful in overturning the 1984 Cable Act cable-telco cross-ownership restrictions on constitutional grounds. The decision, which is limited in applications to Bell Atlantic and its subsidiaries, has been appealed, but other regional Bell Operating Companies have brought similar challenges in other jurisdictions. (See also Federal Regulation of Broadcasting, above.) Other measures that would eliminate barriers to telephone companies' entry into the cable television business are being considered by Congress. In 1992 the FCC modified its regulations governing common ownership or control of cable systems with national television networks. The new rules allow national television networks to own cable systems if such a system (when aggregated with all other cable systems in which the network holds such an interest) does not pass (i) more than 10 percent of homes passed on a nationwide basis, and (ii) 50 percent of the homes passed within any one Arbitron area of dominant influence (ADI). The 1992 Act prohibits, with some exceptions, cable operators from selling a system within 36 months of acquisition or construction. Franchise authorities must act within a certain time period to act on a request for transfer by a cable operator. The FCC has adopted rules dealing with both of these matters and has them under consideration. C. Leased Access. Cable systems with more than 36 activated channels are required by the 1984 Act to make a certain number of those channels available for commercial leased access by third parties unaffiliated with the system operator. (This provision does not, however, require a system in operation on or before December 29, 1984, to delete existing programming that was on the system before July 1, 1984, to accommodate potential lessees.) Under the 1992 Act, the FCC must determine maximum reasonable rates for commercial use of designated channel capacity and establish reasonable terms and conditions for such use. Parties who believe they have been denied access wrongfully may petition the FCC for relief or seek relief in Federal Court. Under the 1992 Act, Cable operators may prohibit the carriage of any material deemed to be obscene or otherwise patently offensive on commercial access channels. Alternatively, cable operators may place all "indecent" leased access programming on a single channel and must block the channel unless otherwise requested by a subscriber. FCC implementing rules allowing cable operators to ban such programming from access channels were struck down by the court, which remanded to the FCC regulations dealing with operators' rights and obligations to sequester certain programming on a separate channel. The FCC has asked the court for a rehearing and has stayed enforcement of its rules in the meanwhile. D. Other Non-Programming Requirements. The 1992 Act mandates that the FCC modify and adopt new rules regarding frequency utilization standards for cable systems. The FCC has preempted, except upon a FCC-granted waiver, state and local authorities from enforcing technical standards which are more stringent than the FCC's guidelines. The 1992 Act requires the FCC to issue regulations to ensure compatibility between cable systems and television receivers and video cassette recorders ("VCR"). Regulations shall include, among other things, requirements that cable operators notify subscribers if certain functions of television receivers and VCRs are not compatible with converter boxes. Regulations must also be adopted to promote the commercial availability of converter boxes and remote control devices. The FCC will also determine whether, and under what circumstances, to permit cable operators to scramble signals. The FCC issues licenses for microwave relay stations, mobile radios and receive-only earth stations, all of which are commonly used in the operation of cable systems. A cable system's failure to comply with any FCC requirements may result in a variety of sanctions including monetary fines or revocation or suspension of licenses for stations used in connection with the system. A cable system's inability to use a microwave relay station or a mobile radio due to license revocation could adversely affect system operations, particularly if the relay microwave is used to provide service to distant communities or to relay distant television signals to the system. The FCC rules contain signal leakage monitoring standards which must be complied with by all cable systems annually. These requirements pertain to cable operators' use of certain frequencies at specified power levels and involve specific testing which must be completed each year to test for signal leakage. The FCC currently regulates the rates and conditions imposed by public utilities for use of their poles, unless under the Federal Pole Attachments Act state public service commissions are able to demonstrate that they regulate the cable television pole attachment rates. Nineteen states (including Illinois among those served by the Company) have certified to the FCC that they regulate the rates, terms and conditions for pole attachments. In the absence of state regulation, the FCC administers such pole attachment rates through use of a formula which it has devised. The validity of this FCC function was upheld by the U.S. Supreme Court. The 1992 Act and FCC implementing rules expand the cable industry's Equal Employment Opportunity obligations by requiring cable companies to provide additional information on race, sex, hiring, promotion and recruitment practices for six employment positions that the FCC has identified as performing key management functions. E. Rate Regulation. The 1992 Act establishes a mechanism for regulation of the rates charged by a cable operator for its service. Local regulation of basic (that level of service which includes broadcast signals) cable rates will be permitted for those cable systems not subject to "effective competition". The definition of "effective competition" (fewer than 30 percent of the households in the service area subscribe; or at least 50 percent of the households in the service area are served by two multichannel video programming distributors and at least 15 percent subscribe to the smaller operator; or a franchising authority serves as a multichannel video programming distributor and offers service to at least 50 percent of the households) ensures that virtually all cable systems are now subject to rate regulation. In order to regulate rates for the basic tier of service and related equipment, local officials must request FCC certification and must follow detailed FCC guidelines and procedures to determine whether the rates in question conform to a highly complex, FCC-approved "benchmark" or, if rates exceed the benchmark, whether the operator can justify them with a cost-of-service showing. FCC rules also limit related rates, including those for set-top converters, additional outlets and home wiring, to cost, plus a modest element of profit. Rates for expanded tiers of service (other than pay channels or pay-per-view) are subject to the same benchmark or cost-of-service standards as basic rates, but compliance is enforced by the FCC in response to complaints by subscribers or the local franchising authority. Although the new rules eventually will permit cable companies periodic rate increases for inflation and certain external costs, a rate freeze imposed by the FCC in May 1993 has been extended several times and continues in effect. On February 22, 1994, the FCC announced several decisions relating to cable rates including revisions to its "benchmark" approach. New benchmark formulas will be issued to reflect a new competitive differential -- that is, the average amount by which rates charged by cable operators not subject to effective competition exceeds "reasonable" rates - of 17 percent, rather than the 10 percent previously found by the FCC. In addition, the FCC altered its treatment of packages of a la carte channels. New rules will be issued setting forth factors that will be used, on a case-by-case basis, to determine whether an a la carte package "enhances subscriber choice" or "evades" rate regulation. Procedures for adding channels were adopted to permit operators to recover their programming costs, a markup of 7.5 percent on the programming, and some portion of the benchmark per channel rate. The FCC also adopted "interim" rules to govern cable operator cost-of-service showings, based on principles similar to those used in the telephone regulatory context. It set an interim industry-wide rate of return of 11.25 percent. The new rules also will include "streamlined" cost-of-service showings for upgrades and an experimental incentive upgrade plan. Taken as a whole, the new regulations have compelled significant changes in the Company's operations including restructuring of the Company's service offerings and reduced rates for the reconstituted basic service. Additional changes are likely as a result of the February 1994 decisions. The ultimate impact of these regulations cannot be predicted at this time because many aspects of the regulatory scheme are under reconsideration by the FCC, are under judicial challenge, or have yet to be adopted by the FCC. F. Franchise Fees and Access. Although franchising authorities may impose franchise fees under the 1984 Act, such payments cannot exceed five percent of system revenues per year. Franchising authorities are also empowered to require that the operator provide certain cable-related facilities, equipment and services to the public and to enforce operator compliance with franchise requirements and voluntary commitments. The 1992 Act permits cable operators to itemize on its subscriber bills amounts assessed as a franchise fee or dedicated to certain franchisor- imposed requirements. When changed circumstances render compliance with such requirements commercially impracticable, the 1984 Act requires franchising authorities to renegotiate performance standards and, under certain conditions, permits the operator to make changes in program commitments without local approval. Although franchising authorities are permitted to require and enforce the dedication of system channels for non-commercial public, educational and governmental access use, they must permit the operator to make other use of such channels until the demand for use of designated access purposes is sufficient to occupy the dedicated capacity. In addition, if the franchising authority requires or the operator volunteers to provide free services or financial support for non-commercial access users, the value of such commitments must be credited toward the franchise fee payment. G. Local Franchising. Because a cable distribution system uses local streets and rights-of-way, cable television systems have been subject to state and local regulation, typically imposed through the franchising process. State and local officials have been involved in franchisee selection, system design and construction, safety, service rates, consumer relations and billing practices and community-related programming and services. Except for cable systems lawfully operating without a franchise on or before July 1, 1984, the 1984 Act requires that a cable operator obtain a franchise prior to instituting service. Under the 1992 Act, franchising authorities may not award an exclusive franchise or unreasonably deny a competitive franchise. Local authorities may, without obtaining a franchise, operate their own cable system, notwithstanding the granting of one or more franchises by a local authority. The FCC has adopted rules which establish minimum customer service requirements. However, the 1992 Act permits local franchising authorities to establish, in excess of or in addition to those of the FCC, certain customer service requirements regarding such matters as office hours, telephone availability and service calls. H. Renewal. The 1992 Act did not significantly alter the procedures for the renewal of cable television franchises which provide an incumbent franchisee certain protections against having its franchise renewal application denied. These procedures are designed to provide the incumbent franchisee with a fair hearing on past performance, an opportunity to present a renewal proposal and to have it fairly and carefully considered, and a right of appeal if the franchising authority either fails to follow the procedures or denies renewal unfairly. Nevertheless, renewal is not assured, as the franchisee must meet certain statutory and franchise standards. Moreover, even if a franchise is renewed, the franchising authority may attempt to impose new and more onerous requirements such as significant upgrading of facilities and services or higher franchise fees as a condition of renewal. I. Theft of Cable Service and Unauthorized Reception of Satellite Programming. The 1984 Act addresses the problem of unauthorized connections to cable systems and the use of private earth stations capable of receiving many of the attractive satellite-delivered program services offered by cable systems without payment to or authorization of the program owner. Both of these practices are potential sources of significant revenue loss for cable systems. The 1992 Act has raised the penalties for engaging in theft of service and the manufacturing or sale of devices used to assist theft of service. However, it is not a violation to receive satellite-delivered programming by private earth stations without permission, if the program signal in question is not scrambled (transmitted in an encoded form which cannot be received without special decoding equipment), and the program owner has no specific marketing arrangement in place for granting such user permission. J. Copyright. Cable television systems are subject to a federal copyright licensing scheme covering carriage of television broadcast signals. In exchange for contributing a percentage of their revenues to a federal copyright royalty pool, cable operators receive blanket permission (a "compulsory license") to retransmit copyrighted material in broadcast signals. The amount of this royalty payment varies depending on the amount of system revenues from certain sources, the number of distant signals carried and the location of the cable system with respect to over-the-air television markets. Royalty rates paid by operators are subject to periodic adjustment by a copyright arbitration royalty panel, which can be convened by the Librarian of Congress when necessary in order to compensate for the effects of national monetary inflation and for FCC rule changes that increase the amount of television broadcast signals that cable systems carry. Legislative proposals have been and continue to be made to simplify or eliminate the compulsory license. The FCC has recommended to Congress that the compulsory license for the carriage of distant broadcast signals be eliminated. In addition, the full impact of the 1992 Act's retransmission consent provision is unclear. Therefore, the nature or amount of future payments for broadcast signal carriage cannot be predicted at this time. For the copyrighted materials they use in carriage or origination of non-broadcast programming, cable systems, like broadcasters, must have the permission of each copyright holder. System compliance with both the statutory copyright license and provisions of the Copyright Act of 1976 requiring private clearance is enforced through copyright infringement litigation brought by either the copyright holder or its representative or, in the case of violations of the statutory copyright license, by a local broadcaster or the copyright holder. K. Regulatory Change. Since its adoption in 1984, the Cable Act has been shaped by FCC regulations and by judicial interpretation. The 1992 Act has resulted in significant changes in the operation of cable television systems. As discussed above, the FCC has been charged with adopting rules and regulations and implementing the new provisions, although at present it is difficult to predict the ultimate course of such rules and regulations. Additionally, major provisions of the 1992 Act have been challenged in the courts, most significantly, the must-carry, retransmission consent and rate regulation provisions. It is likely that FCC regulations will also be challenged in court. Until the FCC has concluded its rule-making proceedings and the courts have adjudicated the issues presented to them, it would be premature to assess the full impact of the 1992 Act on the Company. The foregoing does not purport to be a complete summary of all present and proposed federal, state and local regulations relating to the cable industry. Item 2.

Item 2. Properties. The Company owns all of its newspaper publishing plants and properties; 222,000 square feet in Greenville, South Carolina; 124,000 square feet in Montgomery, Alabama; 91,000 square feet in Asheville, North Carolina; 65,000 square feet in Clarksville, Tennessee; 27,000 square feet in Staunton, Virginia; 19,000 square feet in Gallipolis, Ohio; 11,000 square feet in Moultrie, Georgia; and 14,000 square feet in Mountain Home, Arkansas. In addition, the Company leases approximately 30,000 square feet of newspaper production and office space in Alabama, North Carolina, South Carolina and Tennessee. The Company's Montgomery, Alabama, newspaper has begun a $15 million capital project to purchase a new press and upgrade its production plant with $4 million to be invested in 1994. In its broadcasting operations, the Company owns buildings with approximately 68,000 square feet in St. Louis, Missouri; 12,000 square feet in Cincinnati, Ohio; 39,000 square feet in Knoxville, Tennessee; 10,000 square feet in Greenville, South Carolina; and 28,000 square feet in Macon, Georgia. The Company leases its studio buildings in Cincinnati and Cleveland. The Company owns all of its cable television systems and equipment. The Company leases certain offices and tower sites. The Company owns the offices in Wichita, Great Bend and McPherson, Kansas; Edmond and Bixby, Oklahoma; Oak Lawn and Harvey, Illinois; Rocky Mount, New Bern, Greenville, Washington and Kinston, North Carolina; and Laporte, Indiana. In its entertainment operations, the Company leases approximately 16,000 square feet in New York, New York, and 13,000 square feet in Los Angeles, California. In its security operations, the Company leases office space in Oklahoma City, Oklahoma; Dallas and Houston, Texas; Miami, Florida; Chicago, Illinois; and St. Louis, Missouri. The central monitoring station is located in the Company's cable television headquarters in Wichita, Kansas. Except as noted above, the Company generally owns the equipment used in its newspaper, broadcasting, cable, entertainment and security operations. The Company believes that all of its properties are in good condition, well maintained and adequate for its current operations. Item 3.

Item 3. Legal Proceedings. The Company from time to time becomes involved in litigation incidental to its business, including libel actions. In the opinion of management, the Company carries adequate insurance against any judgments of material amounts which are likely to be recovered in such actions. At the present time, the Company is not a party to any litigation in which it is anticipated that the amount of any likely recovery would have a material adverse effect on its financial position. Item 4.

Item 4. Submission of Matters to a Vote of Security Holders. Not applicable. PART II. Item 5.

Item 5. Market for Registrant's Common Equity and Related Stockholder Matters. The Company's Common Stock is traded in the National Market System over-the-counter market and appears on The National Association of Securities Dealers Automated Quotation ("NASDAQ") under the symbol MMEDC. The following table sets forth the range of closing high and low bid prices for the Company's Common Stock in the over-the-counter market by quarter since January 1, 1992. The prices were reported by The NASDAQ Information Exchange System. These prices represent prices between dealers in securities and, as such, do not include retail mark-ups, mark-downs, or commissions and do not necessarily represent actual transactions. Low Bid High Bid 1993: First Quarter $32.00 $36.25 Second Quarter $32.00 $38.00 Third Quarter $30.75 $36.75 Fourth Quarter $33.50 $39.00 1992: First Quarter $23.00 $28.00 Second Quarter $26.00 $29.00 Third Quarter $23.50 $28.75 Fourth Quarter $24.00 $32.00 The Company's Credit and Note Agreements limit the payment of dividends on any capital stock of the Company. Currently the most restrictive of these limits the annual payment of dividends to 25% of annualized net income. No dividends were declared or paid during 1993 or 1992. The Company has no intention of paying any cash dividends in the foreseeable future. (See Note 6 to the Consolidated Financial Statements included in the 1993 Annual Report, which material is incorporated herein by reference.) As of March 3, 1994, there were approximately 1,200 record holders of the Company's Common Stock. Item 6.

Item 6. Selected Financial Data. The required information is set forth on pages 18 and 19 of the accompanying 1993 Annual Report, which material is incorporated herein by reference. Item 7.

Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations. The required information is set forth on pages 16 through 23 of the accompanying 1993 Annual Report, which material is incorporated herein by reference. Item 8.

Item 8. Financial Statements and Supplementary Data. The following information is set forth in the accompanying 1993 Annual Report, which material is incorporated herein by reference: All Consolidated Financial Statements of Multimedia, Inc. and Subsidiaries (pages 24 through 27); all Notes to Consolidated Financial Statements (pages 28 through 41); and the "Independent Auditors' Report" (page 42). With the exception of the information herein expressly incorporated by reference, the 1993 Annual Report of the Registrant is not deemed filed as part of this Annual Report on Form 10-K. Item 9.

Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure. None. PART III. Item 10.

Item 10. Directors and Executive Officers of the Registrant. The required information is incorporated herein by reference from the information in the Company's definitive proxy statement dated March 15, 1994, for the Annual Meeting of Shareholders to be held April 20, 1994, under the headings "Election of Directors" and "Executive Officers". Item 11.

Item 11. Executive Compensation. The required information is incorporated herein by reference from the information in the Company's definitive proxy statement dated March 15, 1994, for the Annual Meeting of Shareholders to be held April 20, 1994, under the headings "Management Compensation" and "Compensation Committee Interlocks and Insider Participation". Item 12.

Item 12. Security Ownership of Certain Beneficial Owners and Management. The required information is incorporated herein by reference from the information in the Company's definitive proxy statement dated March 15, 1994, for the Annual Meeting of Shareholders to be held April 20, 1994, under the headings "Election of Directors", "Principal Shareholders of the Company" and "Executive Officers". Item 13.

Item 13. Certain Relationships and Related Transactions. The required information is incorporated herein by reference from the information in the Company's definitive proxy statement dated March 15, 1994, for the Annual Meeting of Shareholders to be held April 20, 1994, under the headings "Election of Directors", "Management Compensation" and "Compensation Committee Interlocks and Insider Participation". PART IV. Item 14.

Item 14. Exhibits, Financial Statement Schedules, and Reports on Form 8-K. (a) (1) The following consolidated financial statements are incorporated by reference from the 1993 Annual Report attached hereto: Consolidated Statements of Earnings, years ended December 31, 1993, 1992 and 1991 Consolidated Statements of Stockholders' Equity (Deficit), years ended December 31, 1993, 1992 and 1991 Consolidated Statements of Cash Flows, years ended December 31, 1993, 1992 and 1991 Consolidated Balance Sheets, December 31, 1993 and 1992 Notes to Consolidated Financial Statements Independent Auditors' Report (a) (2) The following auditors' report and financial schedules for years ended December 31, 1993, 1992 and 1991 are submitted herewith: Independent Auditors' Report on 10-K Schedules Schedule V - Property, Plant and Equipment Schedule VI - Accumulated Depreciation - Property, Plant and Equipment Schedule VIII - Valuation and Qualifying Accounts Schedule X - Supplementary Income Statement Information All other schedules are omitted as the required information is inapplicable or the information is presented in the financial statements or related notes. (a) (3) Exhibits: (2) See Exhibit 10.8. (3.1) Restated Articles of Incorporation of the Company filed on December 22, 1967, in the office of the Secretary of State of South Carolina: Incorporated by reference to Exhibit 4.4 to the Company's Registration Statement on Form S-3, No. 33-9622. (3.2) Amendments to the Company's Restated Articles of Incorporation filed on June 27, 1969; April 20, 1972; April 25, 1978; May 1, 1980; and May 13, 1983, in the office of the Secretary of State of South Carolina: Incorporated by reference to Exhibit 4.5 to the Company's Registration Statement on Form S-3, No. 33-9622. (3.3) Amendment to the Company's Restated Articles of Incorporation attached as Annex B to Articles of Merger filed on October 1, 1985, in the office of the Secretary of State of South Carolina: Incorporated by reference to Exhibit 4.6 to the Company's Registration Statement on Form S-3, No. 33-9622. (3.4) Articles of Amendment filed February 8, 1990, in the office of the Secretary of State of South Carolina: Incorporated by reference to Exhibit 3.4 to the Company's Annual Report on Form 10-K for the year ended December 31, 1989 ("1989 Form 10-K") (File No. 0-6265). (3.5) Articles of Amendment to the Company's Restated Articles of Incorporation filed April 18, 1991, in the office of the Secretary of State of South Carolina: Incorporated by reference to Exhibit 4.1.4 to the Company's Registration Statement on Form S-8, File No. 33-40050 ("S-8 No. 33-40050"). (3.6) By-laws of the Company: Incorporated by reference to Exhibit 3.3 to the Company's Annual Report on Form 10-K for the year ended December 31, 1985 ("1985 Form 10-K") (File No. 0-6265). (3.6.1) Amendment to By-laws of the Company, effective April 23, 1992: Incorporated by reference to Exhibit 4.2.1 to the Company's Registration Statement on Form S-3, File No. 33-46557. (3.6.2) Amendment to By-laws of the Company, effective December 10, 1993. (4.1) See Exhibits 3.1, 3.2, 3.3, 3.4, 3.5, 3.6, 3.6.1, 3.6.2, 10.5 and 10.7. (4.2) Form of Certificates for Common Stock: Incorporated by reference to Exhibit 4.2 to the Company's Form 10-K for the year ended December 31, 1992 ("1992 Form 10-K") (File No. 0-6265). (4.3) Rights agreement, dated as of September 6, 1989, by and between the Company and South Carolina National Bank, Rights agent: Incorporated by reference to Exhibit 1 to Form 8-K of the Company dated September 6, 1989. (4.4) The Company hereby agrees to furnish to the Securities and Exchange Commission, upon request of the Commission, a copy of any instrument with respect to long-term debt not being registered in a principal amount less than 10% of the total assets of the Company and its subsidiaries on a consolidated basis. (10.1)* Restricted Option Plan of the Company: Incorporated by reference to Exhibit 10.1 to the Company's 1985 Form 10-K. (10.2)* Performance Stock Option Plan of the Company: Incorporated by reference to Exhibit 10.2 to the Company's Form 10-K for the year ended December 31, 1987 (File No. 0-6265). (10.2.1)* Amendment of Performance Stock Option Plan: Incorporated by reference to Exhibit 10.2.1 to the Company's Form 10-K for the year ended December 31, 1988 ("1988 Form 10-K") (File No. 0-6265). (10.3)* Key Executive Stock Option Plan of the Company: Incorporated by reference to Exhibit 28.1 to the Company's Registration Statement on Form S-8, No. 33-17234. (10.4)* Director Stock Option Plan: Incorporated by reference to Exhibit 10.20 to 1992 Form 10-K. (10.5) Credit Agreement between the Company and the Chase Manhattan Bank (National Association) and Citibank, N.A. as Lead Agents, the First National Bank of Chicago, First Union National Bank of North Carolina and the Toronto- Dominion Bank, Cayman Islands Branch, as Co-Agents and the Chase Manhattan Bank (National Association), as Administrative Agent, and various banks (excluding schedules and certain exhibits); the Registrant agrees to furnish supplementally to the Securities and Exchange Commission a copy of any omitted Schedule or Exhibit upon request of the Commission: Incorporated by reference to Exhibit 4.1 of the Company's 1990 second quarter Form 10-Q (File No. 0-6265). (10.5.1) List of Lenders under Credit Agreement as of March 3, 1994. (10.6) Contract for Services between Multimedia Entertainment, Inc. and Phillip J. Donahue, dated as of April 15, 1982, as amended by letter agreements dated April 15, 1982, February 10, 1984, and August 6, 1985: Incorporated by reference to Exhibit 10.6 to the Company's 1985 Form 10-K. Portions of this exhibit have been omitted and are the subject of an order of the United States Securities and Exchange Commission granting the Company's request for confidential treatment. (10.6.1) Amendment to Contract for Services: Incorporated by reference to Exhibit 10.6.1 to the Company's 1988 Form 10-K. Portions of this exhibit have been omitted and are the subject of an order of the United States Securities and Exchange Commission granting the Company's request for confidential treatment. (10.6.2) Amendment to Contract for Services: Incorporated by reference to Exhibit 10.6.2 to the Company's quarterly report on Form 10-Q for the quarter ended June 30, 1991. Portions of this exhibit have been omitted and are the subject of an order of the United States Securities and Exchange Commission granting the Company's request for confidential treatment. (10.6.3) 1993 Amendment to Contract for services: Incorporated by reference to Exhibit 10.6.3 to the Company's quarterly report on Form 10-Q for the quarter ended June 30, 1993. Portions of this exhibit have been omitted and are the subject of an order of the United States Securities and Exchange Commission granting the Company's request for confidential treatment. (10.7) Form of Note Agreement between the Company and various institutional holders (excluding schedules and certain exhibits); the Registrant agrees to furnish supplementally to the Securities and Exchange Commission a copy of any omitted schedule or exhibit upon request of the Commission: Incorporated by reference to Exhibit 4.2 of the Company's 1990 second quarter Form 10-Q. (10.8) Recapitalization Agreement and Plan of Merger, dated May 1, 1985, as amended and restated between MM Acquiring Corp. and the Company: Incorporated by reference to Exhibit 2 to the Company's Registration Statement on Form S-14 dated August 20, 1985 (Registration No. 2-99786). (10.9)* Executive Salary Protection Plan: Incorporated by reference to Exhibit 10.15 to the Company's Form 10-K for the year ended December 31, 1986. (10.10)* Executive Salary Protection Agreement - First Amendment: Incorporated by reference to Exhibit 10.10 to the Company's Form 10-K for the year ended December 31, 1991 ("1991 Form 10-K"). (10.11) Purchase Agreement by and between Multimedia, Inc. and National Broadcasting Company, Inc.: Incorporated by reference to Exhibit 10.1 to the Company's Form 10-Q for the quarter ended September 30, 1990. (10.12) Exchange Agreement between National Broadcasting Company, Inc. and Multimedia, Inc.: Incorporated by reference to Exhibit 10.2 to the Company's Form 10-Q for the quarter ended September 30, 1990 (File No. 0-6265). (10.13)* 1991 Stock Option Plan: Incorporated by reference to Exhibit 10.15 to the Company's Form 10-K for the year ended December 31, 1990 (File No. 0-6265). (10.13.1)* Amendment to 1991 Stock Option Plan: Incorporated by reference to Exhibit 28.2 to S-8 No. 33-40050. (10.13.2)* Amendments to 1991 Stock Option Plan, dated as of February 24, 1993: Incorporated by reference to Exhibit 10.13.2 to the 1992 Form 10-K. (10.14)* Management Committee Incentive Plan: Incorporated by reference to Exhibit 10.14 to 1991 Form 10-K. (10.15)* Executive Incentive Plan: Incorporated by reference to Exhibit 10.15 to 1991 Form 10-K. (10.16)* Summary of Supplemental Retirement Program for Messrs. Bartlett and Sbarra: Incorporated by reference to Exhibit 10.16 to 1991 Form 10-K. (10.17)* Agreements between Multimedia, Inc. and J. William Grimes dated August 6 and September 20, 1991: Incorporated by reference to Exhibit 10.16 to the Company's quarterly report on Form 10-Q for the quarter ended September 30, 1991 (File No. 0-6265). (10.17.1)* Resolution of Board of Directors relating to J. William Grimes, adopted April 23, 1992: Incorporated by reference to Exhibit 10.7.1 to the Company's Form 10-Q for the quarter ended March 31, 1992. (10.17.2)* Resolution of Board of Directors relating to J. William Grimes, adopted December 18, 1992: Incorporated by reference to Exhibit 10.17.2 to 1992 Form 10-K. (10.17.3)* Resignation and release agreement between Multimedia, Inc. and J. William Grimes dated December 9, 1993. (10.18)* Agreement with Robert L. Turner, dated January 29, 1991: Incorporated by reference to Exhibit 10.18 to 1991 Form 10-K. (10.19) Contract for Services between Multimedia Entertainment, Inc. and Rabbit Ears Enterprises, f/s/o Sally Jessy Raphael, dated as of April 26, 1989, as amended by letter dated December 4, 1990: Incorporated by reference to Exhibit 10.19 to 1991 Form 10-K. Portions of this exhibit have been omitted and are the subject of an order of the United States Securities and Exchange Commission granting the Company's request for confidential treatment. (10.19.1) Agreement between Multimedia Entertainment, Inc. and Wonderland Entertainment, f/s/o Sally Jessy Raphael, dated as of August 17, 1993: Incorporated by reference to Exhibit 10.19.1 to the Company's Form 10-Q for the quarter ended September 30, 1993. Portions of this exhibit have been omitted and are the subject of an order of the United States Securities and Exchange Commission granting the Company's request for confidential treatment. (10.20) Asset Purchase and Sale Agreement by and between Prime Cable Income Partners, L.P., as seller and Tar River Communications, Inc., as buyer, relating to Valparaiso and Laporte, Indiana systems dated as of July 30, 1992, as amended by letter supplement dated as of December 3, 1992: Incorporated by reference to Exhibits to Form 8-K dated December 16, 1992. (11) Computation of Primary and Fully Diluted Earnings per Share. (13) 1993 Annual Report. (21) Subsidiaries of the Registrant. (23) Accountants' Consent to incorporate by reference in Registration Statements No. 2-68069, 33-17234, 33-40050, 33-40253, 33-61574 and 33-61462, on Form S-8, and in Registration Statements No. 33-42179 and 33-46557 on Form S-3. (99) Proxy Statement dated March 15, 1994. ________________________ * This is a management contract or compensatory plan or arrangement. (b) Reports on Form 8-K. Items reported on Form 8-K dated December 10, 1993: (5) Other Events (7) Exhibits SIGNATURES Pursuant to the requirements of Section 13 or 15(d) 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. MULTIMEDIA, INC. By: Signature Title Date /s/ Walter E. Bartlett Chairman, Chief March 28, 1994 Walter E. Bartlett Executive Officer and President /s/ Robert E. Hamby, Jr. Senior Vice President March 28, 1994 Robert E. Hamby, Jr. Finance and Administration and Chief Financial Officer /s/ Thomas L. Magaha Vice President March 28, 1994 Thomas L. Magaha Finance and Development/ Controller Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities as of the dates indicated. By: /s/ Walter E. Bartlett Director March 28, 1994 Walter E. Bartlett /s/ Rhea T. Eskew Director March 28, 1994 Rhea T. Eskew /s/ David L. Freeman Director March 28, 1994 David L. Freeman /s/ Robert E. Hamby, Jr. Director March 28, 1994 Robert E. Hamby, Jr. /s/ Donald D. Sbarra Director March 28, 1994 Donald D. Sbarra /s/ Elizabeth P. Stall Director March 28, 1994 Elizabeth P. Stall INDEPENDENT AUDITORS' REPORT ON 10-K SCHEDULES The Board of Directors and Stockholders Multimedia, Inc.: Under the date of February 11, 1994, we reported on the consolidated balance sheets of Multimedia, Inc. and subsidiaries as of December 31, 1993 and 1992 and the related consolidated statements of earnings, stockholders' equity (deficit), and cash flows for each of the years in the three-year period ended December 31, 1993, as contained in the 1993 annual reports to stockholders. These consolidated financial statements and our report thereon are incorporated by reference in the annual report on Form 10-K for the year 1993. In connection with our audits of the aforementioned consolidated financial statements, we also have audited the financial statement schedules as listed in Item 4(a)(2). These financial statement schedules are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statement schedules based on our audits. In our opinion, such financial statement schedules, when considered in relation to the basic consolidated financial statement taken as a whole, present fairly, in all material respects, the information set forth therein. (signature of KPMG Peat Marwick appears here) Greenville, South Carolina February 11, 1994 Schedule V MULTIMEDIA, INC. AND SUBSIDIARIES Property, Plant and Equipment Years ended December 31, 1993, 1992 and 1991 Schedule VI MULTIMEDIA, INC. AND SUBSIDIARIES Accumulated Depreciation - Property, Plant and Equipment Years ended December 31, 1993, 1992 and 1991 Schedule VIII MULTIMEDIA, INC. AND SUBSIDIARIES Valuation and Qualifying Accounts Years ended December 31, 1993, 1992 and 1991 Schedule X MULTIMEDIA, INC. AND SUBSIDIARIES Supplementary Income Statement Information Years ended December 31, 1993, 1992 and 1991 Charged directly to Costs and Expenses 1993 1992 1991 Amortization of intangible assets $14,778,000 11,272,000 9,308,000 ========== ========== ========= Advertising costs $11,099,000 9,669,000 8,785,000 ========== ========== ========= All other information is inapplicable or less than one percent of total revenue.

352510_1993.txt

352510

1993

ITEM 1 BUSINESS (A) GENERAL DEVELOPMENT OF BUSINESS North Fork Bancorporation, Inc. (the "Registrant") located in Mattituck, New York, is a commercial bank holding company incorporated under the laws of Delaware and registered under the Federal Bank Holding Company Act of 1956, as amended. The Company's primary subsidiary, North Fork Bank (the "Bank"), is the result of the October 1, 1992 merger of the Registrant's banking subsidiaries, The North Fork Bank & Trust Company ("Bank & Trust") and Southold Savings Bank ("Southold"). Bank & Trust was merged into Southold; Southold then converted its charter from that of a state savings bank to a state commercial bank and changed its name to North Fork Bank. The Bank provides a wide range of commercial banking services through 35 branch locations throughout Suffolk, Nassau, Westchester and Rockland Counties, New York. The Registrant was organized in 1980 and in 1981 acquired Bank & Trust, a commercial bank operating primarily on eastern Long Island, New York. Bank & Trust was chartered on April 26, 1905 under the name Mattituck Bank and in 1950 changed its name to The North Fork Bank & Trust Company. During the 1950's, three other banks located on the north fork of eastern Long Island were merged into Bank & Trust. Since then, Bank & Trust had expanded its branch network to other areas of Long Island primarily through de novo branching. Prior to 1988, the Registrant's principal asset was Bank & Trust and its business consisted primarily of the ownership and operation of Bank & Trust. On August 1, 1988, the Registrant completed the acquisition of Southold, a New York State chartered savings bank under the regulation of the New York State Banking Department ("Banking Department") and the Federal Deposit Insurance Corporation ("FDIC"). Southold, established in 1858, was Suffolk County's oldest savings institution. Its focus had traditionally been to develop a stable core deposit base and invest those funds in residential real estate loans. Southold expanded its branch network through the June 28, 1991 acquisition of Eastchester Financial Corporation, ("Eastchester"). Eastchester's primary asset was Eastchester Savings Bank, a $500.8 million savings bank which operated through seven branch locations throughout Westchester and Rockland Counties, New York. Immediately upon consummation of the acquisition, Eastchester was dissolved and its operations consolidated into those of Southold. Additionally, the Registrant has four non-bank subsidiaries, none of which accounted for a significant portion of the Registrant's consolidated assets, nor contributed significantly to the Registrant's consolidated results of operations, at and for the year ended December 31, 1993. At December 31, 1993, the Registrant had assets of $1.9 billion, deposits of $1.4 billion and stockholder's equity of $154.5 million. A more detailed discussion concerning the Registrant's financial condition and results of operations is contained in Part II of this report. PART I (CONTINUED) ITEM 1 BUSINESS (CONTINUED) (B) FINANCIAL INFORMATION ABOUT INDUSTRY SEGMENTS. Not applicable. (C) NARRATIVE DESCRIPTION OF BUSINESS GENERAL The Registrant operates primarily through the Bank, which attracts deposits through thirty five (35) retail banking facilities throughout Suffolk, Nassau, Westchester and Rockland Counties, New York. The Bank's business consists principally of attracting demand, savings and time deposits from the general public and investing those deposits, together with funds generated from operations, in commercial loans to small and medium sized businesses, residential one to four family mortgage loans, commercial mortgage loans, consumer loans and construction and land development loans. The Bank can also obtain funds through short term borrowings, such as repurchase agreements, utilizing its unpledged portfolio of agency guaranteed mortgage backed securities as collateral. A portion of the Bank's assets are invested in securities such as U.S. treasury securities, U.S. government agency obligations, state and municipal obligations and agency guaranteed mortgage backed securities. During 1993, the Bank undertook a balance sheet leverage strategy to utilize excess capital and enhance operating results while benefitting from the existing steepness in the yield curve. By obtaining funds through short term repurchase agreement borrowings, the Bank invested in 7 and 15 year maturity agency guaranteed mortgage backed securities, realizing almost 200 basis points on the assets. COMPETITION The Bank's major competitors across the entire line of its products and services are local branches of large money-center banks which are headquartered in New York City and banks headquartered in other sections of New York State. Additionally, this subsidiary also competes for loans and deposits with other independent commercial banks in its marketplace; for deposits and mortgage loans with local savings and loan associations and savings banks; for deposits and consumer loans with credit unions; for deposits with insurance companies and money market funds; and for consumer loans with local consumer finance organizations and the financing affiliates of consumer goods manufacturers, especially automobile manufacturers. In setting rate structures for the Bank's loan and deposit products, management refers to a wide variety of financial information and indices, including the rates charged or paid by the major money-center banks, both locally and in the commercial centers, and the rates fixed periodically by smaller, local competitors. ITEM 1 BUSINESS (CONTINUED) SUPERVISION AND REGULATION GENERAL The Registrant, as a bank holding company, is regulated under the Bank Holding Company Act of 1956, as amended (the "Act"), and is subject to the supervision of the Board of Governors of the Federal Reserve System (the "Federal Reserve Board"). Generally, the Act limits the business of bank holding companies to banking, or managing or controlling banks, performing certain servicing activities for subsidiaries, and engaging in such other activities as the Federal Reserve Board may determine to be closely related to banking. The Federal Reserve Board has formal capital guidelines which bank holding companies are required to meet. These guidelines include the "risk-based" capital ratios and the leverage ratios, discussed below. The risk-based capital guidelines are designed to make regulatory capital requirements more sensitive to differences in risk profile among banks and bank holding companies, to account for off-balance sheet exposure and to minimize disincentives for holding liquid assets. Under these guidelines, assets and off-balance sheet items are assigned to broad risk categories, each with appropriate weights. The resulting capital ratios will represent capital as a percentage of total risk-weighted assets and off-balance sheet items. The guidelines currently require all bank holding companies to maintain a minimum ratio of total capital to risk-weighted assets of 8.00%, including a minimum ratio of Tier 1 capital to risk-weighted assets of 4.00%. The Federal Deposit Insurance Corporation has adopted comparable capital guidelines for state banks which are not members of the Federal Reserve System. Tier 1 capital consists of common equity, qualifying perpetual preferred equity and minority interests in the equity accounts of unconsolidated subsidiaries, less goodwill and other non-qualifying intangibles. After December 31, 1992, the allowance for loan losses qualifies only as supplementary capital and then only to the extent of 1.25% of total risk-weighted assets. Other elements of supplementary capital, which is limited overall to 100% of Tier 1 capital, include perpetual preferred equity not qualifying for Tier 1, mandatory convertible debt and subordinated and other qualifying securities. The Registrant's bank subsidiary, as a state chartered and FDIC insured depository institution, is subject to the supervision, regulation and examination of the Banking Department and the FDIC. The FDIC has formal capital guidelines which banks are required to meet which are similar to those imposed by the Federal Reserve Bank. There are certain restrictions on the ability of the Bank to pay dividends to the Registrant. Dividends from the Bank to the parent company are limited by the regulations of the New York State Banking Department to the Bank's current year's earnings plus it's prior two years' retained net profits. Based on the parameters of this regulation, the Bank's dividend capability at January 1, 1994 includes it's 1994 earnings plus approximately $24.3 million in priors years retained net profits. ITEM 1 BUSINESS (CONTINUED) SUPERVISION AND REGULATION (CONTINUED) HOLDING COMPANY LIABILITY Federal Reserve Board policy requires bank holding companies to serve as a source of financial strength to their subsidiary banks by standing ready to use available resources to provide adequate capital funds to subsidiary banks during periods of financial stress or adversity. A bank holding company also could be liable under certain provisions of a new banking law for the capital deficiencies of an undercapitalized bank subsidiary. In the event of a bank holding company's bankruptcy under Chapter 11 of the U.S. Bankruptcy Code, the trustee will be deemed to have assumed and is required to cure immediately any deficit under any commitment by the debtor to any of the federal banking agencies to maintain the capital of an insured depository institution, and any claim for a subsequent breach of such obligation will generally have priority over most other unsecured claims. TRANSACTIONS WITH AFFILIATES The Bank is subject to restrictions under federal law which limit a bank's extensions of credit to, and certain other transactions with, affiliates. Such transactions by the Bank with any one affiliate are limited in amount to 10 percent of such subsidiary bank's capital and surplus and with all affiliates to 20 percent of such subsidiary bank's capital and surplus. Furthermore, such loans and extensions of credit, as well as certain other transactions, are required to be secured in accordance with specific statutory requirements. The purchase of low quality assets from affiliates is generally prohibited. Federal law also provides that certain transactions with affiliates, including loans and asset purchases, must be on terms and under circumstances, including credit standards, that are substantially the same, or at least as favorable to the institution as those prevailing at the time for comparable transactions involving other non-affiliated companies or, in the absence of comparable transactions, on terms and under circumstances, including credit standards, that in good faith would be offered to, or would apply to, non-affiliated companies. FIRREA The deposits of the Bank are insured up to applicable limits by the FDIC. Recent federal legislation that affects the competitive environment for the Registrant includes the Financial Institutions Reform, Recovery and Enforcement Act of 1989 ("FIRREA") which, among other things, provides for the acquisition of thrift institutions by bank holding companies, increases deposit insurance assessments for insured banks, broadens the enforcement power of federal bank regulatory agencies, and provides that any FDIC-insured depository institution may be liable for any loss incurred by the FDIC, or any loss which the FDIC reasonably anticipates incurring, in connection with the default of any commonly controlled FDIC-insured depository institution or any assistance provided by the FDIC to any such institution in danger of default. ITEM 1 BUSINESS (CONTINUED) SUPERVISION AND REGULATION (CONTINUED) FDICIA On December 19, 1991, the President signed into law the Federal Deposit Insurance Corporation Improvement Act of 1991 ("FDICIA"). FDICIA substantially revises the depository institution regulatory and funding provisions of the Federal Deposit Insurance Act and makes revisions to several other federal banking statutes. Among other things, FDICIA requires the federal banking regulators to take prompt corrective action in respect of depository institutions that do not meet minimum capital requirements. FDICIA establishes five capital categories: "well capitalized," "adequately capitalized," "undercapitalized," "significantly undercapitalized," and "critically undercapitalized." Under the regulations, a "well capitalized" institution has a minimum total capital to total risk-weighted assets ratio of at least 10 percent, a minimum Tier 1 capital to total risk-weighted assets ratio of at least 6 percent, a minimum leverage ratio of at least 5 percent and is not subject to any written order, agreement, or directive; an "adequately capitalized" institution has a total capital to total risk-weighted assets ratio of at least 8 percent, a Tier I capital to total risk-weighted assets ratio of at least 4 percent, and a leverage ratio of at least 4 percent (3 percent if given the highest regulatory rating and not experiencing significant growth), but does not qualify as "well capitalized." An "undercapitalized" institution fails to meet any one of the three minimum capital requirements. A "significantly undercapitalized" institution has a total capital to total risk-weighted assets ratio of less than 6 percent, a Tier I capital to total risk-weighted assets ratio of less than 3 percent or a Tier I leverage ratio of less than 3 percent. A "critically undercapitalized" institution has a Tier I leverage ratio of 2 percent or less. Under certain circumstances, a "well capitalized" "adequately capitalized" or "undercapitalized" institution may be required to comply with supervisory actions as if the institution was in the next lowest capital category. FDICIA generally prohibits a depository institution from making any capital distribution (including payment of a dividend) or paying any management fee to its holding company if the depository institution would thereafter be undercapitalized. Undercapitalized depository institutions are subject to restrictions on borrowing from the Federal Reserve System, effective December 19, 1993. In addition, undercapitalized depository institutions are subject to growth and activity limitations and are required to submit "acceptable" capital restoration plans. Such a plan will not be accepted unless, among other things, the depository institution's holding company guarantees the capital plan, up to an amount equal to the lesser of five percent of the depository institution's assets at the time it becomes undercapitalized or the amount of the capital deficiency as of the time the institution fails to comply with the plan. The federal banking agencies may not accept a capital plan without determining, among other things, ITEM 1 BUSINESS (CONTINUED) SUPERVISION AND REGULATION (CONTINUED) FDICIA that the plan is based on realistic assumptions and is likely to succeed in restoring the depository institution's capital. If adepository institution fails to submit an acceptable plan, it is treated as if it is significantly undercapitalized and may be placed into conservatorship or receivership. Significantly undercapitalized depository institutions may be subject to a number of requirements and restrictions, including orders to sell sufficient voting stock to become adequately capitalized, more stringent requirements to reduce total assets, cessation of receipt of deposits from correspondent banks, further activity restricting prohibitions on dividends to the holding company and requirements that the holding company divest its bank subsidiary, in certain instances. Subject to certain exceptions, critically undercapitalized depository institutions must have a conservator or receiver appointed for them within a certain period after becoming critically undercapitalized. FDIC regulations adopted under FDICIA prohibit a bank from accepting, renewing or rolling-over brokered deposits unless (i) it is well capitalized, or (ii) it is adequately capitalized and receives a waiver from the FDIC. For purposes of this regulation, a bank is defined to be well capitalized if it maintains a leverage ratio of at least 5 percent, a risk-adjusted Tier I capital ratio of at least 6 percent and a risk-adjusted total capital ratio of at least 10 percent and is not otherwise in a "troubled condition" as specified by its appropriate federal regulatory agency. A bank that is adequately capitalized and has been granted an FDIC waiver to accept, renew or roll-over brokered deposits may not pay an interest rate on any such deposits in excess of 75 basis points over prevailing market rates on comparable deposits in specified market areas. There are no such restrictions on a bank that is well capitalized. The Registrant anticipates that these regulations will not have a material adverse effect on its operations. For the capital ratios of the Registrant, see page 16 of the Registrant's Annual Report to Shareholders for the year ended December 31, 1993 included herein as Exhibit 13, and incorporated herein by reference. FDIC INSURANCE ASSESSMENTS The Bank is subject to FDIC deposit insurance assessments. Pursuant to FDICIA, the FDIC adopted a transition risk-based system for determining deposit insurance assessments that became effective on January 1, 1993. Under the risk-based system, an insured institution will be assessed at rates in the range of .23 percent to .31 percent depending on its capital and supervisory classifications, as assigned by its primary federal regulator. The insurance assessment rate for the Bank in 1993 was .26 percent, as it was considered a "well capitalized" institution in a Tier II supervisory classification. The FDIC has proposed, in substance, that the transitional risk-based assessment system be adopted, with minor modifications, as the permanent risk-based assessment system that must be made effective by January 1, 1994. ITEM 1 BUSINESS (CONTINUED) SUPERVISION AND REGULATION (CONTINUED) CONSERVATORSHIP AND RECEIVERSHIP POWERS OF FEDERAL BANKING AGENCIES FDICIA significantly expanded the authority of the federal banking regulators to place depository institutions into conservatorship or receivership to include, among other things, appointment of the FDIC as conservator or receiver of an undercapitalized institution under certain circumstances. In the event a bank is placed into conservatorship or receivership, the FDIC is required, subject to certain exceptions, to choose the method for resolving the institution that is least costly to the bank insurance fund of the FDIC, such as liquidation. The FDIC may provide federal assistance to a "troubled institution" - without placing the institution into conservatorship or receivership. In such case, pre-existing debtholders and shareholders may be required to make substantial concessions and, insofar as practical, the FDIC will succeed to their interests in proportion to the amount of federal assistance provided. Various other legislation, including proposals to overhaul the banking regulatory system and to limit the investments that a depository institution may make with insured funds are from time to time introduced in Congress. The Registrant cannot determine the ultimate effect that FDICIA and the implementing regulations to be adopted thereunder, or any other potential legislation, if enacted, would have upon its financial condition or results of operations. MEMORANDA OF UNDERSTANDINGS On February 17, 1994, the Federal Deposit Insurance Corporation (the "FDIC") notified the Bank that based on the improvement in it's financial condition, the FDIC was terminating the Memorandum of Understanding (the "MOU") dated August 25, 1993 between the Bank, the FDIC and the New York State Banking Department (the "NYSBD"). The Bank received similar notification from the NYSBD on February 23, 1994. The MOU required the Bank to, among other things, (i) maintain a Tier I leverage ratio of 5.50%; (ii) reduce the level of classified assets as a ratio of capital and reserves and (iii) charge off all assets classified "Loss" and 50% of those classified "Doubtful" in the FDIC and NYSBD Reports on Examination. On February 1, 1994, the Federal Reserve Bank of New York notified the Registrant that in light of the noticeable improvement in it's financial condition the Memorandum of Understanding dated October 22, 1992 was terminated. The Federal Reserve Bank memorandum prohibited the Registrant from, among other things, the payment of dividends and the renewal or modification of the terms of existing indebtedness without prior regulatory approval. EMPLOYEES As of December 31, 1993, the Registrant and its subsidiaries employed 503 full time and 152 part time employees. ITEM 1 BUSINESS (CONTINUED) STATISTICAL DISCLOSURE BY BANK HOLDING COMPANIES Information required by the Securities Act Industry Guide 3, or Exchange Act Guide 3 is presented on pages 6 through 14 inclusive under the caption Management's Discussion and Analysis, and Quarterly Financial Information located on page 17 in the Registrant's Annual Report to Shareholders for the year ended December 31, 1993 included herein as Exhibit 13, and incorporated herein by reference. (D) FINANCIAL INFORMATION ABOUT FOREIGN AND DOMESTIC OPERATIONS AND EXPORT SALES Not applicable. ITEM 2

ITEM 2 PROPERTIES The Registrant's principal corporate offices are in a 28,300 square foot facility located at 9025 Main Road, Mattituck, New York. This facility is owned by the Bank and leased to the Registrant. The Registrant's banking subsidiary owns nineteen (19) buildings and occupies twenty-seven (27) other facilities under lease arrangements. All but three of the facilities are utilized by the banking subsidiary for branch banking offices. Of these three, one is an owned facility used by the loan servicing and operations departments of the Registrant, one is the headquarters facilities and the other is utilized by the Company's Special Asset Division. The premises occupied or leased by the Registrant and its subsidiaries are considered to be well located and suitably equipped to serve as banking facilities. ITEM 3

ITEM 3 LEGAL PROCEEDINGS Information required by this item can be found under the caption "Note 13 - Other Commitments and Contingent Liabilities - (b) Other Matters", on page 40 of the Registrant's Annual Report to Shareholders included herein as Exhibit 13 and incorporated herein by reference. ITEM 4

ITEM 4 SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS EXECUTIVE OFFICERS OF THE REGISTRANT The names and ages of the executive officers of the Registrant and positions held by them and their backgrounds are presented in the following table. The officers are elected annually by the Board of Directors. PART II ITEM 5

ITEM 5 MARKET FOR THE REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDERS' MATTERS The Registrant's common stock is traded on the New York Stock Exchange under the symbol NFB. As of February 14, 1994, there were 5,300 shareholders of record of the Registrant's common stock. The Registrant has not declared dividends in 1993 or 1992. The Registrant intends to commence shareholder dividends in 1994. For information regarding other dividend and liquidity restrictions, see the "Liquidity" section of Management's Discussion and Analysis located on page 11, the paragraph below the table in Note 7 on page 29 and the sixth paragraph of Note 10 on page 35 of the Registrant's Annual Report to Shareholders for the year ended December 31, 1993 located herein as exhibit 13 and incorporated herein by reference. ITEM 6

ITEM 6 SELECTED FINANCIAL DATA Pages 1 and 2 of the Registrant's Annual Report to Shareholders for the year ended December 31, 1993 included herein as exhibit 13 is incorporated herein by reference. ITEM 7

ITEM 7 MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Pages 2 through 17 inclusive in the Registrant's Annual Report to Shareholders for the year ended December 31, 1993 included herein as exhibit 13 are incorporated herein by reference. ITEM 8

ITEM 8 FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA Pages 18 through 44 inclusive in the Registrant's Annual Report to Shareholders for the year ended December 31, 1993 included herein as exhibit 13 are incorporated herein by reference. ITEM 9

ITEM 9 CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURES None PART III ITEM 10

ITEM 10 DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT The information required by this item will appear under the caption "Nominee for Director and Directors Continuing in Office" on page 3 of the Registrant's Proxy Statement for its Annual Meeting of Stockholders to be held April 26, 1994, included herein as exhibit 23 and is incorporated herein by reference. ITEM 11

ITEM 11 EXECUTIVE COMPENSATION The information required by this item will appear under the caption "Executive Compensation" on pages 8 through 11, and under the caption "Retirement Plan" on page 17 of the Registrant's Proxy Statement for its Annual Meeting of Stockholder's to be held April 26, 1994, included herein as exhibit 23 and is incorporated herein by reference. ITEM 12

ITEM 12 SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT The information required by this item will appear under the caption "Certain Beneficial Ownership" and "Nominees for Director and Directors Continuing in Office" on pages 2 through 6 of the Registrant's Proxy Statement for its Annual Meeting of Stockholder's to be held April 26, 1994, included herein as exhibit 23 and is incorporated herein by reference. ITEM 13

ITEM 13 CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS The information required by this item will appear under the caption "Transactions with Directors, Executive Officers and Associates" on page 18 of the Registrant's Proxy Statement for its Annual Meeting of Stockholders to be held April 26, 1994 included herein as exhibit 23 and is incorporated herein by reference. PART IV ITEM 14

ITEM 14 EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K (a) The following consolidated financial statements of the Registrant, its bank subsidiary and its other subsidiaries, and the independent auditors' report thereon, included on Pages 18 through 44, inclusive, of Registrant's Annual Report to Stockholders for the fiscal year ended December 31, 1993, included herein as exhibit 13 are incorporated herein by reference. 1. Consolidated Financial Statements: Statements of Operations - For the years ended December 31, 1993, 1992 and 1991; Balance Sheets - December 31, 1993, and 1992; Statements of Cash Flows - For the years ended December 31, 1993, 1992 and 1991; Statements of Changes in Stockholders' Equity - For the years ended December 31, 1993, 1992 and 1991; Notes to Consolidated Financial Statements. ITEM 14 EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K, CONTINUED 2. There are no financial statement schedules required to be filed by the Registrant. 3. The following exhibits are incorporated herein by reference: Exhibit Prior Number Description Filing 3(a) Articles of Incorporation Previously filed on Form S-3 dated 8/16/91 as Exhibit 4(b) (Registration No.33-42294) and incorporated herein by reference. 4(a) Rights Agreement dated Incorporated by reference to 2/28/89, between North Fork Form 8-A Registration Bancorporation,Inc. and statement dated 3/21/89. The North Fork Bank & Trust Company, as rights agent. 4(b) Warrant Agreement Previously filed on Form S-3 as Exhibit 4(e) to Amendment No. 3 filed 7/14/92 (Registration No. 33-42294) and incorporated herein by reference. 4(c) Warrant Agreement Previously filed on Form S-3 dated 10/7/92 (Registration No. 33-53058) and incorporated herein by reference. 10(a) North Fork Bancorporation, Inc. Previously filed on Form S-3 Dividend Reinvestment and Stock dated 11/3/82 (Registration No. Purchase Plan 2-80166) and incorporated herein by reference. 10(b) North Fork Bancorporation, Inc. Previously filed on Form S-8 1982 Incentive Stock Option Plan dated 12/1/82 (Registration No. 2-80676) and incorporated herein by reference. 10(c) North Fork Bancorporation, Inc. Previously filed on Form S-8 1982 Stock Purchase Plan dated 12/1/82. (Registration for Employees No. 2-80677) and incorporated herein by reference. 10(d) North Fork Bancorporation, Inc. Previously filed on Form S-8 1982 Employee Stock Option Plan dated 8/25/89 (Registration No. 33-30751 and incorporated herein by reference. ITEM 14 EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K (CONTINUED) 10(e) North Fork Bancorporation, Inc. Previously filed on Form S-8 1985 Incentive Stock Option Plan dated 8/29/85. (Registration No.2-99984) and incorporated herein by reference. 10(f) North Fork Bancorporation, Inc. Previously filed on Form S-8 1987 Long Term Incentive Plan dated 6/12/87 (Registration No. 33-14903) and incorporated herein by reference. 10(g) North Fork Bancorporation, Inc. Previously filed on Form S-8 1989 Executive Management dated 4/17/90 (Registration No. Compensation Plan 33-34372) and incorporated herein by reference. 10(h) North Fork Bancorporation, Inc. Previously filed on Form S-8 1991 Stock Purchase Plan dated 3/15/91 (Registration No. for Employees 33-39449) and incorporated herein by reference. 10(i) North Fork Bancorporation, Inc. Previously filed on Form S-8 401(k) Retirement Savings Plan dated 9/28/92 (Registration No. 33-52504) and incorporated herein by reference. The following exhibits are submitted herewith: Exhibit Number Description 3(b) By Laws 11 Statement re: Computation of earnings per share. 13 Annual Report to Shareholders for the year ended December 31, 1993. 21 Subsidiaries of Registrant 22 Registrant's Proxy Statement for its Annual Meeting of Stockholders' 23 Accountants' Consent (b) Reports on Form 8-K filed during the quarter ended December 31, 1993: None. For the purposes of complying with the amendments to the rules governing Form S-8 (effective July 13, 1990) under the Securities Act of 1933 (the "Act"), the undersigned Registrant hereby undertakes as follows, which undertaking shall be incorporated by reference into Registrant's Registration Statements on Form S-8 No. 2-80676 (filed December 1, 1982), No. 2-80677 (filed December 1, 1982), No. 2-99984 (filed August 29, 1985), No. 33-14903 (filed June 12, 1987), No. 33-30751 (filed August 25, 1989), No. 33-34372 (filed April 17, 1990), No. 33-39449 (filed March 5, 1991), and No. 33-52504 (filed September 28, 1992). ITEM 14 EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K (CONTINUED) Insofar as indemnification for liabilities arising under the Act may be permitted to directors, officers and controlling persons of the Registrant pursuant to the foregoing provisions, or otherwise, the Registrant has been advised that in the opinion of the Securities and Exchange Commission such indemnification is against public policy as expressed in the Act and is, therefore, unenforceable. In the event that a claim for indemnification against such liabilities (other than the payment by the Registrant of expenses incurred or paid by a director, officer or controlling person of the Registrant in the successful defense of any action, suit, or proceeding) is asserted by such director, officer or controlling person in connection with the securities being registered, the Registrant will, unless in the opinion of its counsel the matter has been settled by controlling precedent, submit to a court of appropriate jurisdiction the question whether such indemnification by it is against public policy as expressed in the act and will be governed by the final adjudication of such issue. Pursuant to the requirements of Section 13 or 15(d) of this Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. NORTH FORK BANCORPORATION, INC. Dated: March 9, 1994 BY:/s/ John A. Kanas -------------------------- JOHN A. KANAS, President (Principal Executive Officer) BY: /s/Daniel M. Healy ------------------------ DANIEL M. HEALY, Executive Vice President & Chief Financial Officer (Principal Accounting Officer) Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the date indicated. Signature Title Date /s/John A. Kanas President and March 9, 1994 - -------------------------- Chairman of the Board John A. Kanas Director - -------------------------- John Bohlsen Director - -------------------------- Malcolm J. Delaney /s/Allan C. Dickerson Director March 9, 1994 - -------------------------- Allan C. Dickerson Director - -------------------------- Lloyd A. Gerard Director - -------------------------- James F. Reeve /s/James H. Rich, Jr. Director March 9, 1994 - -------------------------- James H. Rich, Jr. /s/George H. Rowsom Director March 9, 1994 - -------------------------- George H. Rowsom /s/Raymond W. Terry, Jr. Director March 9, 1994 - -------------------------- Raymond W. Terry, Jr. EXHIBIT INDEX Exhibit Number Description - ------- ----------- 3(b) By Laws 11 Statement re: Computation of earnings per share. 13 Annual Report to Shareholders for the year ended December 31, 1993. 21 Subsidiaries of Registrant 22 Registrant's Proxy Statement for its Annual Meeting of Stockholders' 23 Accountants' Consent

701811_1993.txt

701811

1993

Item 1. Business General Mentor Graphics Corporation (Mentor Graphics or Company), an Oregon corporation organized in 1981, is headquartered in Wilsonville, Oregon. The Company's common stock is traded in the NASDAQ National Market System under the symbol MENT. Products and Services The Company designs, manufactures, markets and supports electronic design automation (EDA) software for the integrated circuit (IC) and systems design markets. The Company provides a broad range of EDA tools developed either by the Company or together with third parties to support the entire electronic design process. The Company's software products enable engineers and designers to design, analyze, place and route, and test custom ICs, application specific ICs (ASICs), printed circuit boards, multichip modules and other electronic systems and subsystems. The Company^s Falcon Framework software provides a common foundation for the Company's EDA software products. Falcon Framework software also allows for the integration of third party software tools developed by other commercial EDA vendors and by customers for their own internal use. The Company's products help customers reduce development time while producing innovative hardware products of high quality. In addition to software products, Mentor Graphics' Value Added Services division also offers consulting, support and training services to enhance customers' success in the design and manufacture of hardware products. Platforms The Company's software runs on UNIX workstations in a broad range of price and performance levels, including workstations manufactured by Hewlett-Packard Company, Sun Microsystems, Inc., Digital Equipment Corporation, NEC Corporation and International Business Machines Corporation. The above major computer manufacturers have a substantial installed base of workstations, and make frequent introductions of new products with significant price/performance improvements. The Company has written virtually all of its software in the high level languages C++, C, Pascal, or Fortran to facilitate its portability to other platforms in the future, should availability of the Company's software on such platforms prove desirable. Marketing and Sales The Company's marketing strategy emphasizes customer support, Value Added Services, a strong direct sales force and large corporate account penetration in the semiconductor, aerospace, computer, telecommunications and consumer electronics industries. Customers use the Company's products in the design of such diverse products as supercomputers, automotive electronics, missile guidance systems, signal processors, personal computers, gallium arsenide circuits, microprocessors and telecommunication switching systems. Mentor Graphics sells and licenses its products primarily through its direct sales force in the United States, through the direct sales forces of its wholly-owned subsidiaries in Asia and Europe and through distributors. During 1993, the Company transitioned from direct sales to distributorships in some Asian markets by assisting former employees to set up distributorship businesses for Company products. The Company is considering making similar transitions to distributorships in other geographies. During the years ended December 31, 1993 and 1992, sales outside of North America accounted for 46 and 48 percent, respectively, of total sales. Additional information relating to foreign and domestic operations is contained in Note 15 of Notes to Consolidated Financial Statements on pages 34-35 of the 1993 Annual Report to Shareholders and is incorporated by this reference. Fluctuating exchange rates and other factors beyond the Company's control, such as tariff and trade policies, domestic and foreign tax and economic policies and the relative stability of international economic and monetary conditions should continue to affect the level and profitability of sales outside the United States. The Company's OpenDoor program coordinates and supports the integration of commercial EDA products and customers' internal products into the Company's EDA environment. Under this program, the Company enables OpenDoor participant companies to develop interfaces from their products to the Company's products. OpenDoor participants can select from a range of integration technologies to achieve an optimal degree of integration for their products. There are now approximately 115 OpenDoor participants. No material portion of the Company's business is dependent on a single customer. The Company has traditionally experienced some seasonal fluctuations in receipt of orders, which are typically stronger in the second and fourth quarters of the year. As is typical of many other companies in the electronics industry, the Company generally ships its products to customers within 10 to 90 days after receipt of an order, and a substantial portion of quarterly shipments tend to be made in the last month of each quarter. The Company believes that the dollar amount of its backlog is not material to an understanding of the Company's business. The Company sells and licenses its products and some third-party products pursuant to purchase orders and master purchase and license agreements. The Company has corporate agreements providing the general terms and conditions of sales and discounts to certain of its customers. The Company schedules deliveries only after receipt of purchase orders under these agreements. Manufacturing Operations The Company's manufacturing operations primarily consist of reproduction of the Company's software and documentation. In North America, manufacturing occurs at the Company's facility in Wilsonville, Oregon. Software and documentation distribution centers in The Netherlands, Japan and Singapore serve their respective regions. The Company generally does not integrate Company software with hardware from suppliers. The Company uses a manufacturing resource planning system which integrates purchasing, inventory control and accounting in all regions. Product Development The EDA market is competitive and characterized by rapid technological change, which requires continuous high expenditures for the enhancement of existing products and the development of new products. The Company is committed to the creation of new products and intends to continue to enhance its existing products. During the years ended December 31, 1993, 1992 and 1991, the Company expensed approximately $77,598,000, $73,947,000 and $79,539,000 respectively, and capitalized approximately $3,609,000, $6,120,000, and $9,917,000, respectively, related to product development. Substantially all of these costs were related to the development of the Company's proprietary application software. Suppliers The Company contracts with several suppliers who provide software products which the Company integrates into its product line, allowing the Company to both concentrate its development efforts on its core product line and offer its customers a more complete design solution. The Company no longer integrates and resells computer hardware with the Company's products. The Company believes that its customers realize little value in purchasing hardware through the Company. As a service to its customers in Europe and Japan, where some customers prefer to purchase both hardware and software from one source, the Company will continue to accept orders for hardware which is shipped directly from the supplier to customers. Customer Support and Professional Services The Company has a worldwide organization to meet its customers' needs for software support, training, consulting, custom IC design and documentation. The Company offers support contracts providing software updates and support. Most of the Company's customers are covered by software support contracts. Some hardware support is provided to customers under subcontract by third-party hardware suppliers, although the Company will not be entering into any new hardware support agreements with customers in 1994. The Company provides technical support for its products through a direct telephone support line and an electronic communications system. Additional professional services are offered through the Company's Value Added Services division which provides consulting and training to help the Company's customers improve their design processes and make the most efficient use of their EDA software tools. Competition The EDA industry is competitive and has been characterized by rapid technological advances in application software, operating systems and hardware. The Company's principal competitors are Cadence Design Systems Inc., Synopsys Inc., Viewlogic Systems, Inc., COMPASS Design Automation, Inc., Zuken Incorporated, Racal Redac, Ltd., Intergraph Corporation, and Seiko Corporation. The Company believes that other companies may be developing EDA systems. Some of the Company's competitors and potential competitors may have greater financial and marketing resources than Mentor Graphics. However, the Company believes the main competitive factors in the EDA industry are breadth and quality of application software, product integration, ability to respond to technological change, quality of a company's sales force, price, size of the installed base, level of customer support and value added services. The Company believes that it generally competes favorably in these areas. The Company can give no assurance, however, that it will have the financial resources, marketing, distribution and service capability, depth of key personnel or technological knowledge to compete successfully in the EDA market. Employees The Company and its subsidiaries employed approximately 2,100 persons full time as of December 31, 1993 compared with approximately 2,200 persons at the end of 1992. The Company's success will depend in part on its ability to attract and retain employees who are in great demand. The Company continues to enjoy good employee relations. No Company employees are represented by a collective bargaining unit. Patents and Licenses The Company owns United States and Canadian patents covering the technology underlying several of its software products. The Company has also filed other patent applications on technology it has developed and intends to file additional patent applications in the future. While the Company believes the pending applications relate to patentable devices, there can be no assurance that any patent will be issued or that any patent can be successfully defended. The Company believes that patents are less significant to the success of its business than technical competence, management ability, marketing capability and customer support. The Company regards its application software as proprietary and attempts to protect it with copyrights, trade secret laws, and internal non-disclosure safeguards, as well as patents, when appropriate, as noted above. The Company typically incorporates restrictions on disclosure, usage and transferability into its agreements with customers and other third parties. Item 2.

Item 2. Properties The Company's Wilsonville, Oregon facilities are located in six owned buildings of approximately 570,000 total square feet located on about 90 acres. All corporate functions, as well as a majority of research and development and domestic activities, operate from this site. In January 1993, the Company entered into a five-year lease with a third party covering the Company's former manufacturing and warehouse building on its Wilsonville site. The building size is approximately 150,000 square feet. The Company leases additional space in San Jose, California, and in various locations throughout the United States and in foreign countries, primarily for sales and customer service operations. The Company believes that it will be able to renew or replace its existing leases as they expire and that its current facilities will be adequate through at least 1994. Item 3.

Item 3. Legal Proceedings There are no material legal proceedings pending against the Company. Item 4.

Item 4. Submission of Matters to a Vote of Security Holders No matters were submitted to a vote of the security holders of the Company during the fourth quarter of the fiscal year ended December 31, 1993. Executive Officers of Registrant The following are the executive officers of the Company: Name Position Age Has Served As An Officer of Company Since Walden C.Rhines President, Chief 47 1993 Executive Officer and Director R. Douglas Norby Senior Vice 58 1993 President and Chief Financial Officer Waldo J Richards Senior Vice President, 54 1993 Product Operations Frank S. Delia Vice President, Chief 47 1983 Administrative Officer, General Counsel and Secretary James J.Luttenbacher Corporate Controller 38 1993 and Chief Accounting Officer Patricia J.O'Connor Vice President, Human 38 1990 Resources The officers are elected by the Board of Directors of the Company at its annual meeting. Officers hold their positions until they resign, are terminated or their successors are elected. There are no arrangements or understandings between the officers or any other person pursuant to which officers were elected and none of the officers are related. All of the officers named have been employed by Mentor Graphics for the last five years except: 1) Mr. Rhines, who was employed from 1972 to 1993 by Texas Instruments, Incorporated where he held a variety of technical and management positions and was most recently Executive Vice President of Texas Instruments Semiconductor Group; 2) Mr. Norby, who was employed from 1992 to 1993 by Pharmetrix Corporation as President and Chief Executive Officer and from 1985 to 1992 by Lucasfilm, Ltd. where he last held the position of President and Chief Operating Officer; 3) Mr. Richards, who was employed from 1989 to 1993 by Sequent Computer Systems Inc. in a variety of engineering management positions; and 4) Mr. Luttenbacher, who was employed from 1981 to 1992 by Hewlett-Packard Company in a variety of accounting positions, the most recent of which was Manager of the North American Financial Services Group. PART II Item 5.

Item 5. Market for the Registrant's Common Equity and Related Stockholder Matters The Company paid a quarterly dividend of $0.06 per share during 1992 and during the first three quarters of 1993. The Company ceased payment of the dividend in the fourth quarter of 1993 and does not intend to pay dividends in the foreseeable future. Additional information required by this item is included under "Management's Discussion and Analysis of Results of Operations and Financial Condition" on pages 17-22, under "Quarterly Financial Information" on page 36 and under the shareholder information included on page 38 of the Company's 1993 Annual Report to Shareholders. Item 6.

Item 6. Selected Financial Data The information required by this item is included under "Selected Consolidated Financial Data" on page 16 of the Company's 1993 Annual Report to Shareholders. Item 7.

Item 7. Management's Discussion and Analysis of Results of Operations and Financial Condition The information required by this item is included under "Management's Discussion and Analysis of Financial Condition and Results of Operations" on pages 17-22 of the Company's 1993 Annual Report to Shareholders. Item 8.

Item 8. Financial Statements and Supplementary Data The financial statements are included in the Company's 1993 Annual Report to Shareholders on pages 23-37 and are indexed here under Item 14(a)(1). The supplementary data required by this item is included under "Quarterly Financial Information" on page 36 of the Company's 1993 Annual Report to Shareholders. See also the financial statement schedules appearing here as indexed under Item 14(a)(2). Item 9.

Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure None. PART III Item 10.

Item 10. Directors and Executive Officers of Registrant The information required by this item concerning the Company's Directors is included under "Election of Directors" in the Company's 1994 Proxy Statement and is incorporated herein by reference. The information concerning the Company's Executive Officers is included herein on page 6 under the caption "Executive Officers of the Registrant." No information is included in response to Item 405 of Regulation S-K. Item 11.

Item 11. Executive Compensation The information required by this item is included under "Compensation of Directors," "Information Regarding Executive Officer Compensation" and "Certain Transactions" in the Company's 1994 Proxy Statement and is incorporated herein by reference. Item 12.

Item 12. Security Ownership of Certain Beneficial Owners and Management The information required by this item is included under "Election of Directors" and "Information Regarding Beneficial Ownership of Principal Shareholders and Management" in the Company's 1994 Proxy Statement and is incorporated herein by reference. Item 13.

Item 13. Certain Relationships and Related Transactions The information required by this item is included under "Certain Transactions" in the Company's 1994 Proxy Statement and is incorporated herein by reference. PART IV Item 14.

Item 14. Exhibits, Financial Statement Schedules, and Reports on Form 8-K (a) (1) Financial Statements The documents listed are included on pages indicated in the Company's 1993 Annual Report to Shareholders: Page Consolidated Statements of Operations 23 Consolidated Balance Sheets 24 Consolidated Statements of Cash Flows 25 Consolidated Statements of Stockholders' Equity 26 Notes to Consolidated Financial Statements 27-35 Independent Auditors' Report 37 (2) Financial Statement Schedules The documents and schedules listed below are filed as part of this report on the pages indicated: Schedule Page I Marketable Securities 11 II Amounts Receivable from Related Parties and Underwriters, Promoters, and Employees other than Related Parties 12-13 V Property, Plant and Equipment 14 VI Accumulated Depreciation and Amortization of Property, Plant and Equipment 15 VIII Valuation and Qualifying Accounts 16 IX Short-Term Borrowings 17 X Supplementary Income Statement Information 18 Independent Auditors^ Report on Financial Statement Schedules 19 All other financial statement schedules have been omitted since they are not required, not applicable or the information is included in the consolidated financial statements or notes. (3) Exhibits 3. A. 1987 Restated Articles of Incorporation. Incorporated by reference to Exhibit 24 to the Company's Registration Statement on Form S-3 (Registration No. 33- 23024). B. Bylaws of the Company. 10. *A. 1982 Stock Option Plan. Incorporated by reference to Exhibit 10.A to the Company's Annual Report on Form 10-K for the fiscal year ended December 31, 1991 (1991 10-K). *B. Nonqualified Stock Option Plan. Incorporated by reference to Exhibit 10.C to the Company's Annual Report on Form 10-K for the fiscal year ended December 31, 1989 (1989 10-K). *C. 1986 Stock Plan. Incorporated by reference to Exhibit 10.D to the Company's 1989 10-K. *D. 1987 Non-Employee Directors' Stock Option Plan. Incorporated by reference to Exhibit 10.E. to the Company's 1989 10-K. *E. Stock Option Agreement under the 1986 Stock Plan dated October 15, 1993 between the Company and Walden C. Rhines. *F. Form of Indemnity Agreement entered into between the Registrant and each of its officers and directors. Incorporated by reference to Exhibit B to the Company's 1987 Proxy Statement. G. Lease dated November 20, 1991, for 999 Ridder Park Drive and 1051 Ridder Park Drive, San Jose, California. Incorporated by reference to Exhibit 10.M to the Company's Form SE dated March 25, 1992. H. Amended and Restated Loan Agreement between Mentor Graphics Corporation and First Interstate Bank of Oregon, N.A. dated December 31, 1992 as amended. Incorporated by reference to Exhibit 10.J to the Company's Form SE dated March 25, 1993. 13. Portions of the 1993 Annual Report to Shareholders that are incorporated herein by reference. 21. List of Subsidiaries of the Company. 23. Consent of Accountants. ___________________ * Management contract or compensatory plan or arrangement (b) No reports on Form 8-K have been filed during the last quarter of the period covered by this Report. SIGNATURES Pursuant to the requirements of Section 13 or 15(d) 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, on March 30, 1994. MENTOR GRAPHICS CORPORATION By _________________________ Walden C. Rhines President and Chief Executive Officer Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed by the following persons on behalf of the registrant on March 30, 1994 in the capacities indicated. Signature Title (1) Principal Executive Officer: ____________________________ President, Chief Executive Walden C. Rhines Officer and Director (2) Principal Financial Officer: ____________________________ Senior Vice President and R. Douglas Norby Chief Financial Officer (3) Principal Accounting Officer: _____________________________ Corporate Controller and James J. Luttenbacher Chief Accounting Officer (4) Directors: _____________________________ Chairman of the Board and Thomas H. Bruggere Director _____________________________ Director Marsha B. Congdon _____________________________ Director David R. Hathaway _____________________________ Director Fontaine K. Richardson _____________________________ Director Jon A. Shirley _____________________________ Director David N. Strohm SCHEDULE I MENTOR GRAPHICS CORPORATION AND SUBSIDIARIES MARKETABLE SECURITIES (1) (In Thousands) Amount of Issue Carried in the Market Value Consolidated Name of Title of Cost of of Issue Balance Sheet Issuer Issue Issue at 12/31/93 at 12/31/93 Various Certificates $ 14,105 $14,105 $14,105 of Deposit Bank of Certificate 12,510 12,510 12,510 Tokyo of Deposit Various Euro CDs 10,477 10,477 10,477 Paper Various Commercial 5,458 5,458 5,458 Various Money Market 5,000 5,000 5,000 Note Various Corporate 1,515 1,515 1,515 Notes Citibank Floating Rate 995 995 995 Notes Various Money Funds 329 329 329 $ 50,389 ________________________________ (1) Individual issues not exceeding 2% of total assets were grouped according to type of security. This schedule includes $36,779 of investments classified as cash equivalents on the consolidated balance sheet. SCHEDULE II MENTOR GRAPHICS CORPORATION AND SUBSIDIARIES AMOUNTS RECEIVABLE FROM RELATED PARTIES AND UNDERWRITERS, PROMOTERS, AND EMPLOYEES OTHER THAN RELATED PARTIES (In Thousands) Beginning Ending Balance Additions Deductions Balance Year ended December 31, 1991: Richard Anderson(1) $ 170 $ 0 $ 0 $ 170 John Goldsworthy(2) 100 0 100 0 Michael Burstein(3) 150 0 150 0 Marvin Wolfson(4) 332 0 186 146 James Hammock(5) 505 0 505 0 Kathleen Herder(6) 140 0 140 0 James Painter(7) 150 0 30 120 Wendell Roberts(8) 100 0 100 0 Gary Geaslen (9) 0 110 0 110 Dottie Wanat (10) 0 125 0 125 Donald Ramble (11) 0 250 0 250 $ 1,647 $ 485 $ 1,211 $ 921 Year ended December 31, 1992: Richard Anderson $ 170 $ 0 $ 170 $ 0 Marvin Wolfson 146 0 146 0 James Painter 120 0 30 90 Gary Geaslen 110 0 110 0 Dottie Wanat 125 0 125 0 Donald Ramble 250 0 50 200 James Luttenbacher (12) 0 100 100 0 Garry Burt (13) 0 150 0 150 $ 921 $ 250 $ 731 $ 440 Year ended December 31, 1993: James Painter $ 90 0 90 $ 0 Donald Ramble 200 0 50 150 Garry Burt 150 0 0 150 $ 440 $ 0 $ 140 $ 300 (1) Interest rate was 9% per annum. Note was secured by shares of the Company's common stock, covered by various stock options granted to debtor and a second trust deed on real property owned by debtor. Payment was made in full on February 26, 1992. Individual is no longer employed by the Company. (2) Interest rate was 8% per annum. Note was secured by a second trust deed on real property owned by debtor. The employee was terminated and note was forgiven as part of the restructure in August 1991. (3) Interest rate was 8.34% per annum. Note was secured by shares of the Company's common stock. Payment was made in full on May 2, 1991. (4) Interest rate was 10.5% per annum (with no interest payable for the last six months of 1990). Notes were secured by shares of the Company's common stock. Payment of $186 was received January 29, 1991. The remaining balance of $146 was paid in full on March 17, 1992. (5) Interest rate was 10% per annum. Note was secured by shares of the Company's common stock. Payment was made in full on February 13, 1991. (6) Interest rate was 10% per annum. The Relocation Bridge Note was secured by a second trust deed on real property owned by debtor. Payment was made in full on February 14, 1991. (7) Interest rate was 8.36% per annum. Note was secured by a second trust deed on real property owned by debtor. Loan was to be forgiven at a rate of 20% per year, as long as employee remained employed by the Company on September 14 of each year through 1995. Employee was terminated on January 15, 1993 and $40 was forgiven by the Company at that time. The promissory note was revised to $50. Payment was made in full on June 29, 1993. (8) Interest rate was 10% per annum. Note was secured by a second trust deed on real property owned by debtor. The employee was terminated and note was forgiven as part of the restructure in August 1991. (9) Interest rate was 9% per annum. Notes were secured by various stock options granted to debtor. Individual is no longer employed by the Company. Payment of $12 was received March 14, 1992. The remaining balance of $98 was paid on September 1, 1992. (10) Interest rate was 8.5% per annum. Note was secured by a second trust deed on real property owned by debtor. Payment was made in full on January 24, 1992. (11) Interest rate is 8.5% per annum. Note is secured by a second trust deed on real property owned by debtor. Loan shall be forgiven a rate of 20% per year, as long as the employee remains employed by the Company on July 1 of each year through 1996. (12) Interest rate was 6% per annum. The Relocation Bridge Note was secured by a second trust deed on real property owned by debtor. Payment of $71 was made on December 2, 1992. The remaining balance of $29 was paid in full on December 19, 1992. (13) Interest rate is 6.5% per annum. Note is secured by a second trust deed on real property owned by debtor. A replacement note was made on December 31, 1993 which requires payment of net proceeds upon exercise of the Company's common stock and four annual installments of $20, plus accrued interest through December 31, 1997. Upon payment of these amounts, remaining obligations under this note including principal and interest will be forgiven. SCHEDULE V MENTOR GRAPHICS CORPORATION AND SUBSIDIARIES PROPERTY, PLANT AND EQUIPMENT (In Thousands) Effect of Beginning Additions Currency Ending Classification Balance at Cost Retirements Changes Balance Year ended December 31, 1991: Computer equipment and furniture $108,450 $ 33,652 $(28,518) $ (75) $113,509 Buildings and building equipment 0 51,815 (14) 0 51,801 Land and improvements 5,121 9,101 0 0 14,222 Leasehold improvements 15,942 1,400 (9,141) 40 8,241 Service spare parts 9,123 1,001 (7,820) 179 2,483 $138,636 $ 96,969 $(45,493) $ 144 $190,256 Year ended December 31, 1992: Computer equipment and furniture $113,509 $ 16,988 $ (9,505) $ (2,464) $118,528 Buildings and building equipment 51,801 1,328 0 0 53,129 Land and improvements 14,222 345 0 0 14,567 Leasehold improvements 8,241 4,054 (1,918) (320) 10,057 Service spare parts 2,483 2,021 (1,542) 36 2,998 $190,256 $ 24,736 $(12,965) $ (2,748) $199,279 Year ended December 31, 1993: Computer equipment and furniture $118,528 $ 24,893 $ (20,345) $ (1,101) $121,975 Buildings and building equipment 53,129 320 (123) 0 53,326 Land and improvements 14,567 74 0 0 14,641 Leasehold improvements 10,057 58 (483) (19) 9,613 Service spare parts 2,998 1,284 (702) 277 3,857 $199,279 $ 26,629 $(21,653) $ (843) $203,412 SCHEDULE VI MENTOR GRAPHICS CORPORATION AND SUBSIDIARIES ACCUMULATED DEPRECIATION AND AMORTIZATION OF PROPERTY, PLANT AND EQUIPMENT (In Thousands) Additions Charged to Effect of Beginning Costs and Currency Ending Classification Balance Expenses Retirements Changes Balance Year ended December 31, 1991: Computer equipment and furniture $ 57,676 $ 25,212 $(16,251) $ (5) $ 66,632 Buildings and building equipment 0 1,411 0 0 1,411 Land and improvements 0 332 0 0 332 Leasehold improvements 12,897 1,468 (8,844) 51 5,572 Service spare parts 5,625 1,278 (4,943) 136 2,096 $ 76,198 $ 29,701 $(30,038) $ 182 $ 76,043 Year ended December 31, 1992: Computer equipment and furniture $ 66,632 $ 21,434 $ (7,402) $(1,552) $ 79,112 Buildings and building equipment 1,411 1,578 0 0 2,989 Land and improvements 332 357 0 0 689 Leasehold improvements 5,572 1,316 (1,499) (201) 5,188 Service spare parts 2,096 1,065 (1,388) (52) 1,721 $ 76,043 $ 25,750 $(10,289) $(1,805) $ 89,699 Year ended December 31, 1993: Computer equipment and furniture $ 79,112 $ 23,230 $(17,202) $ (733) $ 84,407 Buildings and building equipment 2,989 1,578 (29) 0 4,538 Land and improvements 689 361 0 0 1,050 Leasehold improvements 5,188 1,398 (379) (11) 6,196 Service spare parts 1,721 1,033 (595) 150 2,309 $ 89,699 $ 27,600 $(18,205) $ (594) $ 98,500 SCHEDULE VIII MENTOR GRAPHICS CORPORATION AND SUBSIDIARIES VALUATION AND QUALIFYING ACCOUNTS (In Thousands) Additions Charged to Beginning Cost & Ending Description Balance Expenses Deductions Balance Year ended December 31, 1991: Allowance for deferred tax assets $ 0 $ 0 $ 0 $ 0 Allowance for doubtful accounts $ 3,155 $ 1,224 $ 643 (1) $ 3,736 Allowance for obsolete inventory $ 7,392 $11,198 $ 2,951 (2) $15,639 Accrued restructure costs $ 0 $27,100 $16,867 (3) $10,233 Year ended December 31, 1992: Allowance for deferred tax assets $ 0 $ 0 $ 0 $ 0 Allowance for doubtful accounts $ 3,736 $ 1,282 $ 642 (1) $ 4,376 Allowance for obsolete inventory $15,639 $ 2,665 $ 5,868 (2) $12,436 Accrued restructure costs $10,233 $14,500 $12,463 (3) $12,270 Year ended December 31, 1993: Allowance for deferred tax assets $ 0 $58,495(4) $ 0 $58,495 Allowance for doubtful accounts $ 4,376 $ 508 $ 956 (1) $ 3,928 Allowance for obsolete inventory $12,436 $ 1,924 $ 6,346 (2) $ 8,014 Accrued restructure costs $12,270 $26,200 $10,096 (3) $28,374 (1) Deductions primarily represent accounts written off during the period. (2) Deductions primarily represent inventory scrapped during the period. (3) Deductions primarily represent payments made to carry out restructure plans and reversals of accrued restructure charges due to changes in estimates of $1,400 and $1,600 for the years ended December 31, 1993 and 1992, respectively. (4) Addition represents adoption of Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes" on January 1, 1993 and increases to the valuation allowance during the year. As such, the Company established a valuation allowance for certain deferred tax assets, including net operating loss and tax credit carryforwards. Statement No. 109 requires that such a valuation allowance be recorded when it is more likely than not that some portion of the deferred tax assets will not be realized. SCHEDULE IX MENTOR GRAPHICS CORPORATION AND SUBSIDIARIES SHORT-TERM BORROWINGS (1) (In Thousands) Weighted Maximum Average Average Category of Weighted Amount Amount Interest Aggregate Average Outstanding Outstanding Rate Short-Term Ending Interest During the During the During the Borrowings Balance Rate Period Period (3) Period (4) Year ended December 31, 1991: Lines of credit (2) $ 4,459 8.88% $14,087 $ 8,612 9.13% Year ended December 31, 1992: Lines of credit (2) $ 5,457 8.48% $11,462 $ 6,825 8.65% Year ended December 31, 1993: Lines of credit (2) $ 2,843 7.66% $ 6,839 $ 5,160 7.92% ________________ (1) Short-term borrowings on the consolidated balance sheets consist of drawings on various multi-currency unsecured line of credit agreements as well as the current portion of long-term debt of $3,521, $91, and $52 for the years ended 1993, 1992, and 1991, respectively. See note 8 in the 1993 Annual Report to Shareholders for a more complete description of the Company's long-term debt. (2) The lines of credit generally have terms of one or two years and are subject to renewal upon expiration. (3) The average amount outstanding was computed by using the average monthly balances during the period. (4) The weighted average interest rates were computed by dividing the actual interest expense by the total of the average balance for each month for which an amount was outstanding, and then multiplying the result by twelve months to obtain an annual rate. SCHEDULE X MENTOR GRAPHICS CORPORATION AND SUBSIDIARIES SUPPLEMENTARY INCOME STATEMENT INFORMATION (In Thousands) Charged to Costs and Expenses Year Ended December 31 1991 1992 1993 Item (1) Advertising Costs $ 6,820 $ 8,084 $ 6,868 Maintenance & Repair $ 5,756 $ 6,296 $ 6,407 Royalty Costs $10,139 $ 9,854 $ 9,815 ________________________ (1) Items not presented did not exceed 1% of revenues in any of the above periods. Independent Auditors' Report The Board of Directors and Stockholders Mentor Graphics Corporation: Under date of February 1, 1994, we reported on the consolidated balance sheets of Mentor Graphics Corporation and subsidiaries as of December 31, 1993 and 1992, and the related consolidated statements of operations, cash flows and stockholders' equity for each of the years in the three-year period ended December 31, 1993, which are included in the 1993 annual report to stockholders. These consolidated financial statements and our report thereon are incorporated by reference in the annual report on Form 10-K for the year 1993. In connection with our audits of the aforementioned consolidated financial statements, we also have audited the related consolidated financial statement schedules as listed in the accompanying index. These financial statement schedules are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statement schedules based on our audits. In our opinion, such financial statement schedules, when considered in relation to the basic consolidated financial statements taken as a whole, present fairly, in all material respects, the information set forth therein. As discussed in Notes 1 and 4 to the consolidated financial statements, the Company adopted the provisions of the Financial Accounting Standards Board's Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes" in 1993. KPMG PEAT MARWICK Portland, Oregon February 1, 1994

4969_1993.txt

4969

1993

Item 1. BUSINESS. Introduction American Express Credit Corporation (including its subsidiaries, where appropriate, "Credco") was incorporated in Delaware in 1962 and was acquired by American Express Company ("American Express") in December 1965. On January 1, 1983, Credco became a wholly-owned subsidiary of American Express Travel Related Services Company, Inc. (including its subsidiaries, where appropriate, "TRS"), a wholly-owned subsidiary of American Express. Credco is primarily engaged in the business of purchasing most Cardmember receivables arising from the use of the American Express R Card, including the American Express R Gold Card, Platinum Card R and Corporate Card issued in the United States, and certain related extended payment plan receivables, and in designated currencies outside the United States. Credco also purchases certain receivables arising from the use of the Optima sm Card. The American Express Card and the Optima Card are referred to herein as the "Card". American Express Card Business The Card is issued by TRS. Cards are currently issued in 32 currencies. The Card, which is issued to individuals for their personal account or through a corporate account established by their employer, permits Cardmembers to charge purchases of goods and services in the United States and in most countries around the world at establishments that have agreed to accept the Card. As of December 31, 1993, there were 3.6 million establishments worldwide that have agreed to accept the Card. TRS accepts from each participating establishment the charges arising from Cardmember purchases at a discount that varies with the type of participating establishment, the volume of charges, the timing and method of payment to the establishment and the method of submission. At December 31, 1993 there were 35.4 million American Express Cards in force worldwide. In 1993, Card billed business was $124 billion. Except in the case of the Optima Card, the Card is primarily designed for use as a method of payment and not as a means of financing purchases of goods and services and carries no pre-set spending limit. Charges are approved based on a Cardmember's past spending and payment patterns, credit history and personal resources. Except in the case of the Optima Card and certain extended payment plans such as the Sign & Travel R account, payment of the full amount billed each month is due from the Cardmember upon receipt of the bill, and no finance charges are assessed. Card accounts that are past due by a given number of days are subject, in most cases, to a delinquency assessment. The Optima Card is a revolving credit card which is marketed to individuals in the United States and several other countries. The American Express Card and consumer lending businesses are subject to extensive regulation in the United States under a number of federal laws and regulations. Federal legislation regulates abusive debt collection practices. In addition, a number of states and foreign countries also have similar consumer credit protection and disclosure laws. Outside the United States, certain countries similarly regulate the provision of credit and protection of Cardmembers' rights. These laws and regulations have not had, and are not expected to have, a material adverse effect on the Card and consumer lending businesses, either in the United States or on a worldwide basis. General Nature of Credco's Business Credco purchases certain Cardmember receivables arising from the use of the Card throughout the world pursuant to agreements (the "Receivables Agreements") with TRS. Net income primarily depends on the volume of receivables arising from the use of the Card purchased by Credco, the discount rates applicable thereto, the relationship of total discount to Credco's interest expense and the collectibility of the receivables purchased. The average life and collectibility of accounts receivable generated by the use of the Card are affected by factors such as general economic conditions, overall levels of consumer debt and the number of new Cards issued. Credco purchases Cardmember receivables without recourse. Amounts resulting from unauthorized charges (for example, those made with a lost or stolen Card) are excluded from the definition of "receivables" under the Receivables Agreements and are not eligible for purchase by Credco. If the unauthorized nature of the charge is discovered after purchase by Credco, the charge is repurchased from Credco. Credco generally purchases non-interest-bearing Cardmember receivables at face amount less a specified discount agreed upon from time to time and interest-bearing Cardmember receivables at face amount. The Receivables Agreements generally require that non-interest-bearing receivables be purchased at discount rates which yield to Credco earnings of not less than 1.25 times its fixed charges on an annual basis. The Receivables Agreements also provide that consideration will be given from time to time to revising the discount rate applicable to purchases of new receivables to reflect changes in money market rates or significant changes in the collectibility of receivables. Since January 1, 1989, the annual average discount rates have varied between 1.04 and 1.78 percent, and averaged 1.04 percent for 1993. New groups of Cardmember receivables are generally purchased net of reserve balances applicable thereto. Extended payment plan receivables are primarily funded by subsidiaries of TRS other than Credco; however, Credco purchases certain extended payment plan receivables. At both December 31, 1993 and 1992, extended payment plan receivables owned by Credco totalled $1.1 billion, representing 8.8 percent and 9.6 percent, respectively, of all receivables owned by Credco. These extended payment plan receivables consist of deferred merchandise receivables and certain interest-bearing extended payment plan receivables comprised principally of Optima and Sign & Travel accounts. In August 1992, a trust was formed by TRS to purchase certain Cardmember receivables as part of an asset securitization program. In September 1993 and August 1992, Credco sold back to TRS $1 billion and $2.4 billion, respectively, of gross receivables that arose from designated domestic Cardmember accounts. TRS conveyed, through a subsidiary, American Express Receivables Financing Corporation ("RFC"), these receivables, together with the right to receive subsequent receivables arising from such Cardmember accounts, to a Master Trust. In 1993 and 1992, Credco purchased $380 million and $1.3 billion, respectively, of gross participation interests in RFC's seller's interest, representing an undivided interest in the securitized receivables owned by the Trust. Participation interests in securitized receivables represented 15.4 percent and 13.5 percent of Credco's total accounts receivable at December 31, 1993 and 1992, respectively. The Card Issuers, at their expense and as agents for Credco, perform accounting, clerical and other services necessary to bill and collect all Cardmember receivables owned by Credco. The Receivables Agreements provide that, without prior written consent of Credco, the credit standards used to determine whether a Card is to be issued to an applicant may not be materially reduced and that the policy as to the cancellation of Cards for credit reasons may not be materially liberalized. The Receivables Agreements may be terminated at any time by the parties thereto. Alternatively, such parties may agree to reduce the required 1.25 fixed charge coverage ratio, which could result in lower discount rates and, consequently, lower revenue and net income of Credco. Volume of Business The following table shows the volume of Cardmember receivables purchased by Credco net of Cardmember receivables sold to affiliates during each of the years indicated, together with the receivables owned by Credco at the end of such years (in millions): Volume of Cardmember Cardmember Receivables Owned Receivables Purchased at December 31, Year Domestic Foreign Total Domestic Foreign Total - ---- -------- ------- -------- -------- ------- ------- 1993 $80,202 $14,635 $ 94,837 $10,758 $2,210 $12,968 1992 81,311 13,041 94,352 10,412 1,287 11,699 1991 80,844 18,934 99,778 10,581 1,639 12,220 1990 87,323 16,117 103,440 11,278 1,790 13,068 1989 76,432 14,152 90,584 10,089 644 10,733 The transactions in connection with TRS's asset securitization program described above reduced the volume of domestic Cardmember receivables purchased and the amount owned by Credco at December 31, 1993 and 1992. In July 1993, Credco began purchasing certain foreign currency Cardmember receivables which had been sold to an affiliate during the period from December 1991 through June 1993. In December 1993, Credco repurchased participation interests in a portion of its receivables which had previously been sold to an affiliate during the period from December 1991 through November 1993. These transactions increased the volume of foreign Cardmember receivables purchased and the amount owned by Credco at December 31, 1993. The average life of Cardmember receivables owned by Credco for each of the five years ending December 31, 1993 (based upon the ratio of the average amount of both billed and unbilled receivables owned by Credco at the end of each month during the years indicated to the volume of Cardmember receivables purchased by Credco, net of Cardmember receivables sold to affiliates) was 43 days. The following table shows the aging of billed Cardmember receivables: December 31, ----------------------- 1993 1992 ------------------------------------------------------- Current 80.5% 77.8% 30 to 59 days 14.0 15.5 60 to 89 days 2.0 2.3 90 days and over 3.5 4.4 Loss Experience Credco generally writes off against its reserve for doubtful accounts the total balance in an account for which any portion remains unpaid 12 months from the date of original billing. Accounts are written off earlier if deemed uncollectible. The following table sets forth Credco's write-offs, net of recoveries for the year, expressed as a percentage of the volume of Cardmember receivables purchased by Credco, net of Cardmember receivables sold to affiliates, in each of the years indicated: Year - ----------------------------------------------------------------------------- 1993 1992 1991 1990 1989 ---- ---- ---- ---- ---- .57% .70% .81% .70% .57% Sources of Funds Credco's business is financed by short-term borrowings consisting principally of commercial paper, borrowings under bank lines of credit and sales of medium- and long-term debt, as well as through operations. The weighted average interest costs on an annual basis of all borrowings, after giving effect to commitment fees under lines of credit and the cost of interest rate swaps, during the following years were: Weighted Average Year Interest Cost ---- ---------------- 1993 4.61% 1992 5.80 1991 7.54 1990 8.85 1989 9.44 From time to time, American Express and certain of its subsidiaries purchase Credco's commercial paper at prevailing rates, enter into variable rate note agreements at interest rates generally above the 13-week treasury bill rate and provide lines of credit. The largest amount of borrowings from American Express or its subsidiaries at any month end during the five years ended December 31, 1993 was $2.5 billion. At December 31, 1993, the amount borrowed was $588 million. See notes 4 and 5 in "Notes to Consolidated Financial Statements" appearing herein for information about Credco's debt, including Credco's lines of credit from various banks and long-term debt. Foreign Operations See notes 2, 7 and 10 in "Notes to Consolidated Financial Statements" appearing herein for information about Credco's foreign exchange risks and operations in different geographical regions. Employees On December 31, 1993, Credco had 60 employees. Item 2.

Item 2. PROPERTIES. Credco neither owns nor leases any material physical properties. Item 3.

Item 3. LEGAL PROCEEDINGS. There are no material pending legal proceedings to which Credco or its subsidiaries is a party or of which any of their property is the subject. Credco knows of no such proceedings being contemplated by government authorities or other parties. Item 4.

Item 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS. Omitted pursuant to General Instruction J(2)(c) to Form l0-K. PART II Item 5.

Item 5. MARKET FOR REGISTRANT'S COMMON STOCK AND RELATED STOCKHOLDER MATTERS. American Express, through a wholly-owned subsidiary, TRS, owns all of the outstanding common stock of Credco. Therefore, there is no market for Credco's common stock. Credco paid a dividend of $125 million and $250 million to TRS in December, 1993 and 1992, respectively. For information about limitations on Credco's ability to pay dividends, see note 6 in "Notes to Consolidated Financial Statements" herein. Item 6.

Item 6. SELECTED FINANCIAL DATA. The following summary of certain consolidated financial information of Credco was derived from audited financial statements for the five years ended December 31, 1993. 1993 1992 1991 1990 1989 ---- ---- ---- ---- ---- (dollars in millions) Income Statement Data Revenues 1,282 1,605 2,070 2,131 1,731 Interest expense 599 728 946 1,022 898 Provision for doubtful accounts, net of recoveries 475 661 855 811 565 Income tax provision 64 70 87 99 71 Extraordinary charge net of taxes 22 - - - - Net income 115 138 174 191 190 Balance Sheet Data Accounts receivable 12,968 11,699 12,220 13,068 10,733 Reserve for doubtful accounts (542) (603) (731) (719) (550) Total assets 14,943 13,631 14,127 14,222 12,610 Short-term debt 9,738 7,581 7,918 7,450 5,506 Current portion of long-term debt 692 969 768 823 771 Long-term debt 1,776 2,303 3,136 3,403 3,795 Shareholder's equity 1,662 1,672 1,784 1,610 1,422 Dividends Cash Dividends 125 250 - - - Item 7.

Item 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS. Liquidity and Capital Resources Credco's receivables portfolio consists of charge card receivables, participation interests in charge card receivables and extended payment plan receivables purchased without recourse from American Express Travel Related Services Company, Inc. and certain of its subsidiaries ("TRS") throughout the world. At December 31, 1993 and 1992, respectively, Credco owned $11.8 billion and $10.6 billion of charge card receivables and participations in charge card receivables, representing 91.2 percent and 90.4 percent of the total receivables owned, and $1.1 billion of extended payment plan receivables, representing 8.8 percent and 9.6 percent of the total receivables owned. At December 31, 1993 and 1992, $2 billion of variable rate loans made to American Express Centurion Bank ("Centurion Bank") were outstanding, which are secured by Optima receivables owned by Centurion Bank. The loan agreements require Centurion Bank to maintain, as collateral, Optima receivables equal to the outstanding loan balance plus an amount equal to three times the receivable reserve as applicable to such Optima receivables. Credco's assets are financed through a combination of short-term debt, long- term senior notes, equity capital and retained earnings. Daily funding requirements are met primarily by the sale of commercial paper. Credco has readily sold the volume of commercial paper necessary to meet its funding needs as well as to cover the daily maturities of commercial paper issued. The average amount of commercial paper outstanding was $8.7 billion for 1993 and $7.7 billion for 1992. An alternate source of borrowing consists of committed credit line facilities. The aggregate commitment of these facilities is generally maintained at 50 percent of short-term debt, net of short-term investments and cash equivalents. At December 31, 1993 and 1992, Credco, through its wholly-owned subsidiary, American Express Overseas Credit Corporation Limited ("AEOCC"), had outstanding borrowings of $58.4 million and $9.7 million, respectively, under these committed lines of credit. In addition, Credco, through AEOCC, had short-term borrowings under uncommitted lines of credit totalling $65 million and $37.2 million at December 31, 1993 and 1992, respectively. During 1993, Credco issued $606 million of medium- and long-term debt. The proceeds were used to reduce short-term debt incurred primarily in connection with the purchase of Cardmember receivables. During 1993, 1992 and 1991, the average long-term debt outstanding was $2.8 billion, $3.7 billion and $4.0 billion, respectively. At December 31, 1993, Credco had $810 million of medium- and long-term debt which may be issued under shelf registrations filed with the Securities and Exchange Commission. Credco has realigned its long-term debt financing strategy to better match its its liabilities with its assets. In connection with this realigned strategy, during 1993 Credco reduced its high coupon long-term debt through the defeasance of $498 million of long-term debt and the retirement of an additional $153.8 million of long-term debt through a series of open market purchases. These transactions resulted in an extraordinary charge net of income tax, of $22 million. In addition, Credco canceled an interest rate swaption resulting in additional interest expense of $13 million. Credco paid dividends to TRS of $125 million and $250 million in December, 1993 and 1992, respectively. Results of Operations Credco purchases Cardmember receivables without recourse from TRS. Non-interest-bearing Cardmember receivables are purchased at face amount less a specified discount agreed upon from time to time, and interest-bearing Cardmember receivables are purchased at face amount. Non-interest-bearing receivables are purchased under Receivables Agreements that generally provide that the discount rate shall not be lower than a rate that yields earnings of at least 1.25 times fixed charges on an annual basis. The ratio of earnings to fixed charges was 1.34, 1.29 and 1.28 in 1993, 1992 and 1991, respectively. The ratio of earnings to fixed charges in 1993 calculated in accordance with the Receivables Agreements after the impact of the extraordinary charge was 1.28. The Receivables Agreements also provide that consideration will be given from time to time to revising the discount rate applicable to purchases of new receivables to reflect changes in money market interest rates or significant changes in the collectibility of receivables. Pretax income depends primarily on the volume of Cardmember receivables purchased, the discount rates applicable thereto, the relationship of total discount to Credco's interest expense and the collectibility of the receivables purchased. The average life of Cardmember receivables was 43 days for each of the years ended December 31, 1993, 1992 and 1991. During 1993 and 1992 Credco sold participation interests in a portion of its receivables to an affiliate. These transactions were partly responsible for the decreased revenues from purchased Cardmember receivables which was offset by decreased interest expense and provision for doubtful accounts. Credco's operating results for the year ended December 31, 1993 include a $6 million one-time benefit from the change in the U.S. federal income tax rate (from 34 percent to 35 percent) in Credco's deferred tax assets. The following is an analysis of the (decrease) increase in key revenue and expense accounts (in millions): - ----------------------------------------------------------------------------- 1993 1992 1991 - ----------------------------------------------------------------------------- Revenue earned from purchased accounts receivable-changes attributable to: Volume of receivables purchased $ 24 $ (89) $ (50) Discount rate (334) (333) (29) - ----------------------------------------------------------------------------- Total $(310) $(422) $ (79) - ----------------------------------------------------------------------------- Interest income from affiliates-changes attributable to: Average loan $ (7) $ 19 $ 28 Interest rates (14) (51) (49) - ----------------------------------------------------------------------------- Total $ (21) $ (32) $ (21) - ----------------------------------------------------------------------------- Interest income from investments-changes attributable to: Average investments $ 14 $ 34 $ 65 Interest rates (11) (40) (27) - ----------------------------------------------------------------------------- Total $ 3 $ (6) $ 38 - ----------------------------------------------------------------------------- Interest expense-changes attributable to: Average debt $ 24 $ 1 $ 88 Interest rates (153) (219) (164) - ----------------------------------------------------------------------------- Total $(129) $(218) $ (76) - ----------------------------------------------------------------------------- Provision for doubtful accounts-changes attributable to: Volume of receivables purchased $ 9 $ (57) $ (27) Provision rates and volume of recoveries (195) (137) 71 - ----------------------------------------------------------------------------- Total $(186) $(194) $ 44 - ----------------------------------------------------------------------------- Item 8.

Item 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA. 1. Financial Statements. See "Index to Financial Statements" at page hereof. 2. Supplementary Financial Information. (a) Selected quarterly financial data. See note 11 in "Notes to Consolidated Financial Statements." Item 9.

Item 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE. None. PART III Item 10.

Item 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT. Omitted pursuant to General Instruction J(2)(c) to Form 10-K. Item 11.

Item 11. EXECUTIVE COMPENSATION. Omitted pursuant to General Instruction J(2)(c) to Form 10-K. Item 12.

Item 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT. Omitted pursuant to General Instruction J(2)(c) to Form 10-K. Item 13.

Item 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS. Omitted pursuant to General Instruction J(2)(c) to Form 10-K. PART IV Item 14.

Item 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K. (a) 1. Financial Statements: See "Index to Financial Statements" at page hereof. 2. Financial Statement Schedules: See "Index to Financial Statements" at page hereof. 3. Exhibits: See "Exhibit Index" hereof. (b) Reports on Form 8-K: None. SIGNATURES Pursuant to the requirements of Section 13 or 15(d) 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. AMERICAN EXPRESS CREDIT CORPORATION (Registrant) DATE March 30, 1994 /s/ Vincent P. Lisanke -------------- ------------------------------- Vincent P. Lisanke President and Chief Executive Officer Pursuant to the requirement of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated. DATE March 30, 1994 /s/ Vincent P. Lisanke -------------- -------------------------------- Vincent P. Lisanke President, Chief Executive Officer and Director DATE March 30, 1994 /s/ Walter S. Berman -------------- -------------------------------- Walter S. Berman Chairman of the Board and Director (principal financial officer) DATE March 30, 1994 /s/ C. J. Martin -------------- -------------------------------- C. J. Martin Vice President-Finance (principal accounting officer) DATE March 30, 1994 /s/ Michael P. Monaco -------------- -------------------------------- Michael P. Monaco Director AMERICAN EXPRESS CREDIT CORPORATION COVERED BY REPORT OF INDEPENDENT AUDITORS (Item 14(a)) Page Number -------------------------- Form 10-K Financial Statements Report of independent auditors............... F - 2 Consolidated statements of income for the three years ended December 31, 1993 ......... F - 3 Consolidated statements of retained earnings for the three years ended December 31, 1993 . F - 3 Consolidated balance sheets at December 31, 1993 and 1992 ............................... F - 4 Consolidated statements of cash flows for the three years ended December 31, 1993...... F - 5 Notes to consolidated financial statements .. F - 6 to F - 14 Schedules: VIII - Valuation and qualifying accounts for the years ended December 31, 1993, 1992 and 1991 ....................... F - 15 IX - Short-term borrowings at and for the years ended December 31, 1993, 1992 and 1991 ............................. F - 16 All other schedules are omitted since the required information is not present or not present in amounts sufficient to require submission of the schedule, or because the information required is included in the consolidated financial statements or notes thereto. F - 1 REPORT OF INDEPENDENT AUDITORS - ------------------------------------------------------------------------------- The Board of Directors American Express Credit Corporation We have audited the accompanying consolidated balance sheets of American Express Credit Corporation as of December 31, 1993 and 1992, and the related consolidated statements of income, retained earnings and cash flows for each of the three years in the period ended December 31, 1993. Our audits also included the financial statement schedules listed in the Index at Item 14(a). These financial statements and schedules are the responsibility of American Express Credit Corporation's management. Our responsibility is to express an opinion on these financial statements and schedules based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of American Express Credit Corporation at December 31, 1993 and 1992, and the consolidated results of its operations and its cash flows for each of the three years in the period ended December 31, 1993, in conformity with generally accepted accounting principles. Also, in our opinion, the related financial statement schedules, when considered in relation to the basic financial statements taken as a whole, present fairly in all material respects the information set forth therein. Ernst & Young New York, New York February 3, 1994 F - 2 AMERICAN EXPRESS CREDIT CORPORATION CONSOLIDATED STATEMENTS OF INCOME (millions) Year Ended December 31, 1993 1992 1991 Revenues Revenue earned from purchased accounts receivable $1,139 $1,449 $1,871 Interest income from affiliates 70 91 123 Interest income from investments 67 64 70 Other income 6 1 6 Total $1,282 1,605 2,070 Expenses Interest 599 728 946 Provision for doubtful accounts, net of recoveries of $175, $201 and $217 475 661 855 Operating expenses 7 8 8 Total 1,081 1,397 1,809 Income before taxes 201 208 261 Income tax provision 64 70 87 Income before extraordinary charges 137 138 174 Extraordinary charges for early retirement of debt (net of income taxes of $12 million) 22 - - Net income $ 115 $ 138 $ 174 CONSOLIDATED STATEMENTS OF RETAINED EARNINGS (millions) Year Ended December 31, 1993 1992 1991 Retained earnings at beginning of year $1,542 $1,654 $1,480 Dividend paid to TRS (125) (250) - Net income 115 138 174 Retained earnings at end of year $1,532 $1,542 $1,654 See notes to consolidated financial statements. F - 3 AMERICAN EXPRESS CREDIT CORPORATION CONSOLIDATED BALANCE SHEETS (millions) December 31, 1993 1992 Assets Cash and cash equivalents $ 257 $ 126 Accounts receivable 12,968 11,699 Less reserve for doubtful accounts 542 603 12,426 11,096 Loans and deposits with affiliates 2,000 2,140 Deferred charges and other assets 260 269 Total assets $14,943 $13,631 Liabilities and Shareholder's Equity Short-term debt $ 9,738 $ 7,581 Current portion of long-term debt 692 969 Long-term debt 1,776 2,303 Due to affiliates 932 895 Accrued interest and other liabilities 97 140 Total liabilities 13,235 11,888 Deferred discount revenue 46 71 Shareholder's equity: Common stock-authorized 3,000,000 shares of $.10 par value; issued and outstanding 1,504,938 shares 1 1 Capital surplus 129 129 Retained earnings 1,532 1,542 Total shareholder's equity 1,662 1,672 Total liabilities and shareholder's equity $14,943 $13,631 See notes to consolidated financial statements. F - 4 AMERICAN EXPRESS CREDIT CORPORATION CONSOLIDATED STATEMENTS OF CASH FLOWS (millions) Year Ended December 31, 1993 1992 1991 Cash Flows From Operating Activities: Net Income $ 115 $ 138 $ 174 Adjustments to reconcile net income to net cash provided by operating activities: Extraordinary charge for early retirement of debt 34 - - Provision for doubtful accounts, net of recoveries 475 661 855 Amortization of deferred underwriting fees and bond discount/premium 5 4 8 (Decrease) in deferred discount revenue (26) (23) (14) Decrease (increase) in deferred tax assets 46 6 (37) (Increase) decrease in interest receivable and operating assets (33) 24 (13) (Decrease) in accrued interest and other liabilities (43) (1) (9) (Decrease) increase in due to affiliates (16) (5) 50 Net cash provided by operating activities 557 804 1,014 Cash Flows From Investing Activities: Proceeds from maturities of investments - - 10 Increase in accounts receivable (2,488) (1,874) (489) Sale of participation interests in accounts receivable to an affiliate - 297 292 Sale of net accounts receivable to an affiliate 914 2,202 - Repurchase of participation interests from affiliates (435) (1,207) - Recoveries of accounts receivable previously written off 175 201 217 Repayment from affiliates of loans and deposits 141 - 168 Loans and deposits made to affiliates - (140) (660) Increase (decrease) in due to affiliates 62 692 (451) Net cash (used in) provided by investing activities (1,631) 171 (913) Cash Flows From Financing Activities: Increase (decrease) in short-term debt, net 6 197 (806) Proceeds from issuance of debt 9,071 4,750 6,103 Redemption of debt (7,747) (5,871) (5,166) Dividend paid to TRS (125) (250) - Net cash provided by (used in) financing activities 1,205 (1,174) 131 Effect of exchange rate changes on cash and cash equivalents - (2) - Net increase (decrease) in cash equivalents 131 (201) 232 Cash and cash equivalents at beginning of year 126 327 95 Cash and cash equivalents at end of year $ 257 $ 126 $ 327 See notes to consolidated financial statements. F - 5 AMERICAN EXPRESS CREDIT CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 1. Basis of Presentation American Express Credit Corporation and its subsidiaries ("Credco") is a wholly-owned subsidiary of American Express Travel Related Services Company, Inc. ("TRS"), which is a wholly-owned subsidiary of American Express Company ("American Express"). American Express Overseas Credit Corporation Limited and its subsidiaries ("AEOCC") and Credco Receivables Corp. ("CRC") are wholly owned subsidiaries of Credco. 2. Summary of Significant Accounting Policies Principles of Consolidation The accompanying consolidated financial statements include the accounts of Credco and all its subsidiaries. All significant intercompany transactions have been eliminated. Revenue Earned from Purchased Accounts Receivable A portion of discount revenue earned on purchases of non-interest-bearing Cardmember receivables equal to the provision for doubtful accounts is recognized as income at the time of purchase; the remaining portion is deferred and recorded as income ratably over the period that the receivables are outstanding. Finance charge income on interest-bearing extended payment plan receivables is recognized as it is earned. Credco ceases accruing this income after six contractual payments are past due, or earlier, if deemed uncollectible. Accruals that cease generally are not resumed. Reserve for Doubtful Accounts The reserve for doubtful accounts is established at the time receivables are purchased and is based on historical collection experience and evaluation of the current status of existing receivable balances. Credco generally writes off against its reserve for doubtful accounts the total balance in an account for which any portion remains unpaid twelve months from the date of original billing for non-interest-bearing Cardmember receivables and after six contractual payments are past due for interest-bearing Cardmember receivables. Accounts are written off earlier if deemed uncollectible. Fair Values of Financial Instruments The fair values of financial instruments are estimates based upon current market conditions and perceived risks at December 31, 1993 and 1992 and require varying degrees of management judgment. The fair values of long-term debt and off-balance sheet financial instruments are included in the related footnotes. For all other financial instruments, the carrying amounts in the Consolidated Balance Sheets approximate the fair values. Interest Rate Transactions Credco enters into various interest rate agreements as a means of hedging its interest rate exposure. The net interest receivable or payable in these agreements is recorded as an adjustment to interest expense and is recognized in earnings over the life of the agreements. Foreign Currency Foreign currency assets and liabilities are translated into their U.S. dollar equivalents based on rates of exchange prevailing at the end of each year. Revenue and expense accounts are translated at exchange rates prevailing during the year. Credco enters into various foreign exchange transactions as a means of hedging foreign exchange exposure. Foreign exchange contracts generally are marked-to-market, with the unrealized gain or loss offset by the gain or loss on the hedged position. The net foreign exchange losses for 1993, 1992 and 1991 were not significant. Cash and Cash Equivalents Credco has defined cash and cash equivalents as cash and short-term investments with a maturity of ninety days or less at the time of purchase. 3. Accounts Receivable At December 31, 1993 and 1992, respectively, Credco owned $11.8 billion and $10.6 billion of charge card receivables and participations in charge card receivables, representing 91.2 percent and 90.4 percent of the total receivables owned. In 1992, Credco purchased participation interests in the seller's interest in Cardmember receivables owned by a Master Trust which was formed by TRS as part of an asset securitization program. In September 1993, Credco purchased additional participation interests. At December 31, 1993 and 1992, Credco owned approximately $2 billion and $1.6 billion, respectively, of participation interests in receivables, representing 15.4 percent and 13.5 percent, respectively, of its total accounts receivable. Credco purchases certain billed and unbilled Cardmember receivables arising from extended payment plans from certain TRS subsidiaries. Credco owned $1.1 billion of these receivables as of December 31, 1993 and 1992, representing 8.8 percent and 9.6 percent, respectively, of its total accounts receivable. Finance charges on such interest-bearing extended payment plan receivables ranged from .75 percent to 1.75 percent per month of the unpaid receivable balance as of December 31, 1993. These finance charges, which are included in revenues, were $136 million, $149 million and $140 million for 1993, 1992 and 1991, respectively. 4. Short-term Debt At December 31, short-term debt consisted of (millions): 1993 1992 Commercial paper $8,810 $6,977 Borrowings from affiliates 588 390 Borrowings under lines of credit 123 47 Borrowing agreements with bank trust departments and others 217 167 Total short-term debt $9,738 $7,581 Credco has various facilities available to obtain short-term credit, including the issuance of commercial paper and agreements with banks. Credco had unused committed credit lines totalling $4.4 billion and $3.4 billion at December 31, 1993 and 1992, respectively. Credco pays fees to the financial institutions that provide these credit line facilities. The fair value of the unused lines of credit is not significant at December 31, 1993 and 1992. At December 31, 1993 and 1992, Credco, through AEOCC, had short-term borrowings under uncommitted lines of credit totalling $65 million and $37.2 million, respectively, and borrowings under committed lines of credit totalling $58.4 million and $9.7 million, respectively. Credco's annual weighted average short-term interest rate was 3.57 percent, 4.73 percent and 6.75 percent for the years ended December 31, 1993, 1992 and 1991, respectively. These rates include the cost of maintaining credit line facilities for the periods and the effect of interest rate swaps. Credco paid $347 million, $354 million and $590 million of interest on short-term debt obligations in 1993, 1992 and 1991, respectively. 5. Long-term Debt At December 31, long-term debt consisted of (millions): 1993 1992 Senior notes, 6.125% to 11.625% due through 2005 $1,287 $1,714 Japanese yen senior bonds and loans, 4.9% to 8% due through 1996 218 252 Pound sterling note, 10% due 1994 - 60 Canadian dollar note, 9% due 1994 - 47 Borrowing agreements with bank trust departments - 10 Other senior notes 7 10 Medium-term notes 270 218 Net unamortized bond discount (6) (8) Total long-term debt $1,776 $2,303 Current portion: Senior notes, 7.375% to 11.625% $ 400 $ 481 Canadian dollar notes, 9% to 11.7% 45 74 Pound sterling notes, 9.625% to 10% 60 75 Japanese yen bonds, 5.875% to 6.9 33 110 Other senior notes - 2 Medium-term notes 154 227 Total current portion of long-term debt $ 692 $ 969 The book value of variable rate long-term debt that reprices within a year approximates fair value. The fair value of other long-term debt is based on quoted market price or discounted cash flow. The aggregate fair value of Credco's long-term debt including the current portion outstanding at December 31, 1993 and 1992 was $2.6 billion and $3.4 billion, respectively. Aggregate annual maturities of debt for the five years ending December 31, 1998 are as follows (millions): 1994, $692; 1995, $403; 1996, $409; 1997, $211; 1998, $753. Credco paid $290 million, $332 million and $358 million of interest on long-term debt obligations in 1993, 1992 and 1991, respectively. During 1993, Credco issued the following long- and medium-term debt: $300 million 6 1/8 percent Senior Notes due June 15, 2000; $100 million Step-up Senior Notes due August 10, 2005, which are callable on August 10, 2000, bearing interest at 6.25 percent for the first seven years and 7.45 percent for the remaining five years; and $206 million of medium-term notes at various rates and maturities. Credco has realigned its long-term debt financing strategy to better match its liabilities with its assets. In connection with this realigned strategy, during 1993 Credco reduced its high coupon long-term debt through the defeasance of $498 million of long-term debt and the retirement of an additional $153.8 million of long-term debt through a series of open market purchases. These transactions resulted in an extraordinary charge net of income tax, of $22 million. In addition, Credco canceled an interest rate swaption resulting in additional interest expense of $13 million. 6. Restrictions as to Dividends and Limitations on Indebtedness The most restrictive limitation on dividends imposed by the debt instruments issued by Credco is the requirement that Credco maintain a minimum consolidated net worth of $50 million. There are no limitations on the amount of debt that can be issued by Credco. The most restrictive of the debt instruments issued by AEOCC and its subsidiaries requires that AEOCC maintain a minimum consolidated net worth of $50 million. The net worth of AEOCC included in the December 31, 1993 Consolidated Balance Sheet was $404 million. 7. Commitments and Contingencies Credco uses certain financial instruments with off-balance sheet market risks in order to hedge market risks inherent in the valuation of items reflected in the Consolidated Balance Sheet. Credco utilizes a variety of financial instruments to achieve this objective. These instruments include interest rate swap agreements, forward interest rate agreements, foreign exchange forward contracts, and foreign currency interest rate swap agreements. The fair values of the financial instruments are estimates based upon current market conditions and perceived risks and require varying degrees of management judgment. If the counterparty in any of these transactions fails to perform its obligations, Credco's exposure to market risk is limited to the movement of interest and foreign exchange rates. The creditworthiness of the counterparties is monitored on an ongoing basis. Interest rate swap agreements generally involve the exchange of fixed or floating rate interest payment obligations on a specified principal amount without the exchange of the underlying notional amount. The notional amount of interest rate swaps outstanding as of December 31, 1993 and 1992, respectively, was $2.7 billion and $2.3 billion, ($502 million and $1.3 billion of which was with an affiliate). The fair value of these interest rate swaps was a net liability of $36 million and $48 million (net liability of $11.6 million and $25 million with an affiliate) at December 31, 1993 and 1992, respectively. These agreements have varying maturities through August 2000. The following is a summary of notional amounts of interest rate swaps with varying expirations over the next seven years (billions): 1993 1992 Short-term debt converted from variable to fixed $1.7 $1.7 Short-term variable rate debt converted to different variable rates - 0.1 Long-term debt converted from fixed to variable 1.0 0.5 Forward interest rate agreements are contracts to receive or pay the difference between a specific agreed upon interest rate and the reference rate for a specified period of time in the future. The notional amount of forward rate agreements outstanding at December 31, 1992 was $113 million. The fair value of these forward interest rate agreements was a net liability of $1.1 million at December 31, 1992. There were no forward interest rate agreements outstanding at December 31, 1993. Foreign exchange forward contracts are agreements entered into, generally with a bank, to buy or sell foreign currency on a future date at a specified foreign exchange rate. Credco had foreign exchange forward contracts totalling $750 million and $701 million ($237 million and $332 million of which was with an affiliate) outstanding at December 31, 1993 and 1992, respectively. The fair value of these foreign exchange forward contracts was not significant at December 31, 1993 and 1992. These agreements have varying maturities through March 1994. Foreign currency interest rate swap agreements are contracts to exchange currency and interest payments for a specific period of time. These swaps result in effective borrowing rates different from the stated rates on the debt which they hedge. The contract amounts of these swaps outstanding at December 31, 1993 and 1992 totalled $706 million and $900 million, respectively. The fair value of these foreign currency interest rate swaps was a $2 million net liability and a $19 million net liability at December 31, 1993 and 1992, respectively. These agreements have varying maturities through October 1998. 8. Transactions with Affiliates In 1993, 1992 and 1991 Credco purchased Cardmember receivables without recourse from TRS and certain of its subsidiaries totalling approximately $95 billion, $94 billion and $100 billion, respectively. Receivables Agreements for non-interest-bearing receivables generally provide that Credco purchase such receivables at a discount rate which yields earnings to Credco equal to at least 1.25 times its fixed charges on an annual basis. The agreements require TRS, at its expense, to perform accounting, clerical and other services necessary to bill and collect all Cardmember receivables owned by Credco. Since settlements under the agreements occur monthly, an amount due from, or payable to, such affiliates may arise at the end of the month. In August 1992, a trust was formed by TRS to purchase certain Cardmember receivables as part of an asset securitization program. In September 1993 and August 1992, Credco sold back to TRS $1 billion and $2.4 billion, respectively, of gross receivables that arose from designated domestic Cardmember accounts. TRS conveyed, through a subsidiary, American Express Receivables Financing Corporation ("RFC"), these receivables, together with the right to receive subsequent receivables arising from such Cardmember accounts, to a Master Trust. In 1993 and 1992, Credco, through a subsidiary, purchased $380 million and $1.3 billion, respectively, of participation interests in the seller's interest in the trust, representing an undivided interest in the securitized receivables conveyed to the trust. In July 1993, Credco began repurchasing certain foreign currency Cardmember receivables which had been sold to an affiliate during the period from December 1991 through June 1993. In December 1993 Credco repurchased the participation interests in a portion of its receivables which had been previously sold to an affiliate during the period from December 1991 through November 1993. In 1992, TRS entered into an agreement with Credco to indemnify Credco for unrealized losses related to certain foreign exchange and interest rate swap agreements, arising out of a decision by TRS to fund certain related foreign currency receivables through affiliates other than Credco. In 1993, Credco reduced its interest expense by $9.8 million for its recovered losses. As a result of the repurchase of the foreign currency Cardmember receivables and the participation interests in receivables described above, this agreement between Credco and TRS was terminated in December 1993. Other transactions with American Express and its subsidiaries for the years ended December 31 were as follows (millions): 1993 1992 1991 Cash and cash equivalents at December 31 3 $ 27 $ 227 Maximum month-end level of cash and cash equivalents during the year 229 475 440 Secured loans to American Express Centurion Bank at December 31 2,000 2,000 2,000 Other loans and deposits to TRS subsidiaries at December 31 - 140 - Maximum month-end level of loans and deposits to TRS subsidiaries during the year 2,001 2,140 2,000 Borrowings at December 31 588 390 173 Maximum month-end level of borrowings during the year 2,451 1,439 1,435 Interest income 70 91 123 Other income 6 7 6 Interest expense 48 78 37 At December 31, 1993, 1992 and 1991 Credco held $2 billion of variable rate secured loans from American Express Centurion Bank ("Centurion Bank"), a wholly-owned subsidiary of TRS. These loans are secured by certain interest - -bearing extended payment plan receivables owned by Centurion Bank. Interest income from these variable rate loans was $67 million, $81 million and $110 million for 1993, 1992 and 1991, respectively. Credco's employees are covered by benefit plans of American Express, which adopted SFAS No. 106, "Employer's Accounting for Postretirement Benefits Other Than Pensions," using the immediate recognition transition option, effective as of January 1, 1992. Adoption of SFAS No. 106 had no material effect on Credco's financial statements. In 1994, American Express announced a plan to spin-off Lehman Brothers Holdings Inc. ("Lehman") to its shareholders as a special dividend. References to an affiliate contained in the footnotes include subsidiaries of Lehman. 9. Income Taxes The Financial Accounting Standards Board issued SFAS No. 109, "Accounting for Income Taxes," which supersedes SFAS No. 96. Credco adopted SFAS No. 109 as of January 1, 1992. The adoption of SFAS No. 109 did not materially affect Credco's results. The taxable income of Credco is included in the consolidated U.S. federal income tax return of American Express. Under an agreement with TRS, taxes are recognized on a stand-alone basis. If benefits for all future tax deductions, foreign tax credits and net operating losses cannot be recognized on a stand-alone basis, such benefits are then recognized based upon a share, derived by formula, of those deductions and credits that are recognizable on a TRS consolidated reporting basis. Deferred income tax assets and liabilities result from the recognition of temporary differences. Temporary differences are differences between the tax bases of assets and liabilities and their reported amounts in the financial statements that will result in differences between income for tax purposes and income for financial statement purposes in future years. The current and deferred components of the provision (benefit) for income taxes consist of the following (millions): 1993 1992 1991 Current $ 18 $64 $124 Deferred 46 6 (37) --- --- --- Total income tax provision before extraordinary item $ 64 $70 $ 87 Income tax benefit from extraordinary item (12) - - --- --- --- Total income tax provision $ 52 $70 $87 The components of the provision for deferred income taxes for the year ended December 31, 1991 is provision for losses of $(8) million, net income from affiliates of $(32) million and cash basis adjustment and other, net, of $3 million. Credco's net deferred tax assets consisted of the following (million): 1993 1992 Gross deferred tax assets: Reserve for loan losses $181 $226 Total gross deferred tax assets 181 226 Gross deferred tax liabilities: Foreign exchange contacts (5) (3) Other (2) (3) Total gross deferred tax liabilities (7) (6) Net deferred tax assets $174 $220 Credco has not recorded a valuation allowance. Federal tax overpayments of $14 million and accrued federal taxes payable of $1 million at December 31, 1993 and 1992, respectively, are included in Due to affiliates. Income taxes paid to TRS during 1993, 1992 and 1991 were approximately $21 million, $75 million and $73 million, respectively. The U.S. statutory tax rate and effective tax rate for 1992 and 1991 was approximately 34 percent. In 1993, the U.S. federal tax rate increased from 34 percent to 35 percent, resulting in a one-time benefit of $6 million in Credco's deferred tax assets. As a result of this one-time benefit, the income tax provision for continuing operations for 1993 is different than that computed using the U.S. statutory tax rate of 35 percent. 10. Geographic Segments Credco is principally engaged in the business of purchasing Cardmember receivables arising from the use of the American Express Card in the United States and foreign locations. The following presents information about operations in different geographic areas (millions): 1993 1992 1991 Revenues United States $ 1,134 $ 1,425 $ 1,706 International 148 180 364 Consolidated $ 1,282 $ 1,605 $ 2,070 Income before taxes United States $ 173 $ 192 $ 187 International 28 16 74 Consolidated $ 201 $ 208 $ 261 Identifiable assets United States $12,787 $12,233 $12,242 International 2,156 1,398 1,885 Consolidated $14,943 $13,631 $14,127 11. Quarterly Financial Data (Unaudited) Summarized quarterly financial data is as follows (millions): Quarter Ended 12/31 9/30 6/30 3/31 Revenues $295 $321 $336 $330 Income before taxes 40 64 39 58 Net income 26 35 25 29 Revenues $340 $389 $431 $445 Income before taxes 50 46 54 58 Net income 33 30 36 39 AMERICAN EXPRESS CREDIT CORPORATION SCHEDULE VIII - VALUATION AND QUALIFYING ACCOUNTS YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 (in millions) 1993 1992 1991 ---- ---- ---- Reserve for doubtful accounts: Balance at beginning of year $ 603 $ 731 $ 719 Additions: Provision for doubtful accounts charged to income (1) 650 862 1,072 Other credits (2) 55 121 10 Deductions: Accounts written off 704 864 1,023 Other charges (3) 62 240 47 Foreign translation - 7 - ----- ----- ----- Balance at end of year $ 542 $ 603 $ 731 ===== ===== ===== Reserve for doubtful accounts as a percentage of Cardmember receivables owned at year end 4.18% 5.15% 5.98% ===== ===== ===== (1) Before recoveries on accounts previously written off of (millions): 1993-$175, 1992-$201 and 1991-$217. (2) Reserve balances applicable to new groups of Cardmember receivables purchased from TRS and certain of its subsidiaries. (3) Reserve balances applicable to certain groups of Cardmember receivables and participation interests sold to affiliates. AMERICAN EXPRESS CREDIT CORPORATION SCHEDULE IX - SHORT-TERM BORROWINGS YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 (millions) Maximum Average Year-end amount out- amount Weighted weighted standing at out- average Balance average any month- standing interest at end interest end during during the rate during of period rate the period period(1) the period(2) --------- -------- ----------- ---------- ------------- Commercial paper 1993 $8,810 4.13% $9,302 $8,707 3.58% 1992 6,977 3.85 8,340 7,733 4.77 1991 7,504 5.15 9,181 8,211 6.65 Interest-bearing borrowings from affiliates 1993 $ 588 3.24% $2,451 $1,207 3.29% 1992 390 3.47 1,414 853 3.88 1991 173 5.17 1,215 112 6.39 Borrowings under lines of credit(3) 1993 $ 123 5.59% $ 174 $ 149 6.25% 1992 47 7.89 135 100 9.78 1991 153 8.71 220 112 11.71 Borrowing agreements with bank trust departments and others 1993 $ 217 3.21% $ 227 $ 155 3.28% 1992 167 3.43 167 121 3.80 1991 88 4.05 150 133 5.90 (1) The average borrowings were computed using the daily amounts outstanding. (2) Interest rates were determined by dividing the actual interest expense for the year by the average daily debt outstanding. (3) AEOCC borrowings under foreign lines of credit including borrowings with an affiliate. EXHIBIT INDEX Pursuant to Item 601 of Regulation S-K Exhibit No. Description 3(a) Registrant's Certificate of Incorporated by Incorporation, as amended reference to Exhibit 3(a) to Registrant's Registration Statement on Form S-1 dated February 25, 1972 (File No. 2-43170). 3(b) Registrant's By-Laws, amended Incorporated by and restated as of November 24, reference to Exhibit 1980 3(b) to Registrant's Annual Report on Form 10-K for the year ended December 31, 1985. 4(a) Registrant's Debt Securities Incorporated by ref- Indenture dated as of erence to Exhibit 4(s) September 1, 1987 to Registrant's Registration Statement on Form S-3 dated September 2, 1987 (File No. 33-16874). 4(b) Form of Note with optional Incorporated by redemption provisions reference to Exhibit 4(t) to Registrant's Registration Statement on Form S-3 dated September 2, 1987 (File No. 33-16874). 4(c) Form of Debenture with Incorporated by optional redemption and reference to Exhibit sinking fund provisions 4(u) to Registrant's Registration Statement on Form S-3 dated September 2, 1987 (File No. 33-16874). 4(d) Form of Original Issue Incorporated by Discount Note with reference to Exhibit optional redemption 4(v) to Registrant's provision Registration Statement on Form S-3 dated September 2, 1987 (File No. 33-16874). 4(e) Form of Zero Coupon Note Incorporated by with optional redemption reference to Exhibit provisions 4(w) to Registrant's Registration Statement on Form S-3 dated September 2, 1987 (File No. 33-16874). 4(f) Form of Variable Rate Note Incorporated by with optional redemption and reference to Exhibit repayment provisions 4(x) to Registrant's Registration Statement on Form S-3 dated September 2, 1987 (File No. 33-16874). 4(g) Form of Extendible Note Incorporated by with optional redemption reference to Exhibit and repayment provisions 4(y) to Registrant's Registration Statement on Form S-3 dated September 2, 1987 (File No. 33-16874). 4(h) Form of Fixed Rate Incorporated by Medium-Term Note reference to Exhibit 4(z) to Registrant's Registration Statement on Form S-3 dated September 2, 1987 (File No. 33-16874). 4(i) Form of Floating Rate Incorporated by Medium-Term Note reference to Exhibit 4(aa) to Registrant's Registration Statement on Form S-3 dated September 2, 1987 (File No. 33-16874). 4(j) Form of Warrant Agreement Incorporated by reference to Exhibit 4(bb) to Registrant's Registration Statement on Form S-3 dated September 2, 1987 (File No. 33-16874). 4(k) Form of Supplemental Indenture Incorporated by reference to Exhibit 4(cc) to Registrant's Registration Statement on Form S-3 dated September 2, l987 (File No. 33-16874). 4(l) The Registrant hereby agrees to furnish the Commission, upon request, with copies of the instruments defining the rights of holders of each issue of long-term debt of the Registrant for which the total amount of securities authorized thereunder does not exceed 10% of the total assets of the Registrant 10(a) Receivables Agreement Incorporated by dated as of January 1, 1983 reference to Exhibit between the Registrant and 10(b) to Registrant's American Express Travel Annual Report on Form Related Services Company, 10-K for the year Inc. ended December 31, 1987. 10(b) Secured Loan Agreement Incorporated by dated as of June 30, 1988 reference to Exhibit between the Registrant 10(b) to Registrant's and American Express Annual Report on Centurion Bank Form 10-K for the year ended December 31, 1988. 10(c) Participation Agreement Incorporated by dated as of August 3, 1992 reference to Exhibit between American Express 10(c) to Registrant's Receivables Financing Annual Report on Corporation and Credco Form 10-K for the year Receivables Corp. ended December 31, 1992. 12 Statement re computation of ratios Electronically filed herewith. 23 Consent of Independent Auditors Electronically filed herewith.

91767_1993.txt

91767

1993

ITEM 1. BUSINESS The Company The Company, a South Carolina corporation founded in Hartsville, South Carolina, in 1899, is a major multinational manufacturer of paperboard-based and plastic-based packaging products. The Company is also vertically integrated into paperboard production and recovered-paper collection. The paperboard utilized in the Company's packaging products is produced substantially from recovered paper. The Company operates an extensive network of plants in the United States and has subsidiaries in Europe, Canada, Mexico, South America, Australia and Asia, and affiliates in the United Kingdom, Canada, Japan and France. The Company's business is organized by global product lines in order to leverage its U.S. customer base, to take advantage of synergies from its worldwide operations and to serve its customers worldwide on a timely basis and with consistent quality. The Company serves a wide variety of industrial and consumer markets. Industrial markets, which represented approximately 58% of the Company's sales in 1993, include paper manufacturers, chemical and pharmaceutical producers, textile manufacturers, automotive manufacturers, and the building and construction industry. Consumer markets, which represented approximately 42% of the Company's sales in 1993, include food and beverage processors, the personal and health care industries, grocery store chains, household good manufacturers and consumer electronics. The Company believes that it is a leading producer in most markets served. One of the Company's strategic goals is to increase the proportion of consumer markets product sales in order to change the business mix between industrial and consumer markets to 50/50. The Company's operations are divided into four segments (three domestic and one international) for financial reporting purposes. Domestic segments include Converted Products, Paper and Miscellaneous. The Financial Reporting For Business Segments Table as shown in the Company's 1993 Annual Report to Shareholders, which is included as Exhibit 13, presents selected financial data by major lines of business or segments for each of the past three fiscal years. This table is hereby incorporated by reference and should be read in conjunction with the Management's Discussion and Analysis of the 1993 Annual Report to Shareholders, which is also hereby incorporated by reference. Acquisitions/Dispositions Acquisitions and business combinations have been, and are expected to continue to be, an important part of the Company's strategy for growth. Significant acquisitions during the past five years include the 1989 merger of the Company's plastic bottle operations with those of Graham Container Corporation and Graham Engineering Corporation to form a partnership, Sonoco Graham Company. The Company subsequently sold its 40% interest in Sonoco Graham Company to the other partners in 1991. Also in 1989, the Company acquired Hilex Poly Co., Inc. This company operated two plants and manufactured plastic bags for the grocery and retail markets. In 1990, as part of the Company's restructuring program, one of these plants, the Los Angeles operation, was closed. During 1990, the Company acquired Lhomme S.A. in France, which was the leading French manufacturer of paperboard, tubes and cores. In January 1992, the Company purchased the Trent Valley paper mill in Trenton, Ontario, Canada. This purchase provided Sonoco with a modern machine that allows for the production of higher grades of paper. In January 1993, the Company purchased all of the outstanding stock of Crellin Holding, Inc., an international manufacturer, designer and marketer of molded plastic products. I-1 SONOCO PRODUCTS COMPANY AND CONSOLIDATED SUBSIDIARIES ------------------------- Acquisitions/Dispositions, Continued In January 1993, the Company also completed the acquisition of the OPV/Durener Group, Germany's second largest manufacturer of tubes and cores. In October 1993, the Company acquired Engraph, Inc. following the successful conclusion of a cash-tender offer and merger transaction. Engraph markets pressure-sensitive labels and package inserts, flexible packaging, screen process printing and paperboard cartons and specialties. Engraph, with approximately 1,600 employees, has 17 plants in the United States, one in Mexico and one in Puerto Rico. The acquisition of Engraph is an important strategic step in the Company's long-range goal to achieve a 50/50 mix in its industrial and consumer market sales. The availability of Engraph's product lines to the Company's existing customers is expected to provide new opportunities for expanding Engraph's consumer markets-based products, both domestically and internationally. Competition The Company believes it has several competitive advantages in the industrial and consumer Converted Products markets it serves. First, the Company sells many products within the Converted Products segment globally. As a result, the Company believes it has the capability to respond effectively to customers seeking national or international supply agreements. Secondly, the Company believes its technological leadership, reputation for quality and vertical integration has enabled the Company to coordinate its product development and global expansion with the rapidly changing needs of its major customers, who demand high-quality, state-of-the-art, environmentally compatible packaging. Thirdly, the Company and its customers have developed international standards to reduce costs and increase quality. Finally, the Company believes that its strategy of vertical integration, via the Paper segment, increases its control over the availability and quality of raw materials used in its products. With the 1993 acquisition of Engraph, the Company entered into a major new business that expands the Company's opportunities for growth in new packaging fields. Having operated internationally for more than 70 years, the International segment has been important in the Company's ability to serve and retain many of its customers that have international packaging requirements. The Company considers its ability to serve its customers worldwide in a timely, consistent and cost-effective manner a competitive advantage. The Company expects its international activities to provide an increasing portion of its future growth. The Company is the largest United States producer of high-density, high-molecular weight plastic carry-out grocery bags and maintains approximately a 40% share of the market. The Company sponsors recycling programs for the plastic carrier bag industry and has relationships with what it believes to be approximately one-half of all participating U.S. supermarkets offering a bag recycling program. Other similar products produced by the Company include roll bags for produce and bakery requirements, plastic bags for convenience stores and high-volume retail outlets and agricultural film. The Company's products are sold in highly competitive market environments. Within each of these markets, supply and demand are the major factors controlling the market environment. Additionally, and to a lesser degree, these markets are influenced by the overall rate of economic activity. Throughout the year, the Company remained highly competitive within each of the markets served. None of the Company's segments are seasonal to any significant degree. I-2 SONOCO PRODUCTS COMPANY AND CONSOLIDATED SUBSIDIARIES ------------------------------ ITEM 1. BUSINESS, Continued Raw Materials The principal raw materials used by the Company are plastic resins, metal, pulpwood, recovered paper and paper. With the exception of pulpwood, recovered paper and paper, the Company's raw materials and supplies are purchased from a number of outside sources; however, the supply is considered adequate to meet the Company's requirements. Company-owned timberlands, timber-cutting rights and suppliers are believed to be sufficient to assure the future availability of pulpwood. Recovered paper used in the manufacture of paperboard is purchased either directly from suppliers near manufacturing operations or through the Company's subsidiary, Paper Stock Dealers, Inc. Although the Company considers the supply of raw materials to be adequate to meet its needs, the majority of raw materials are subject to some price volatility. Backlog Most customer orders are manufactured with a lead time not to exceed approximately three weeks. Long-term contracts, primarily for composite cans, exist for approximately 16% of trade sales (no one contract exceeds 3%). These contracts, which are for a specific duration, generally include price escalation provisions for raw materials, labor and overhead costs. There are no significant long-term purchase contracts as the Company considers the supply of raw materials adequate to meet its needs. Patents, Trademarks and Related Contracts No segment of the business is materially dependent upon the existence of patents, trademarks or related contracts. Research and Development The Company has 132 employees engaged in new product development and technical support for existing product lines. Company sponsored spending in this area was $12.9 million, $11.7 million and $9.9 million in 1993, 1992 and 1991, respectively. Spending focused on projects related to Sonoco's primary businesses and reflects a commitment to ensure that the Company is the technology leader in markets served. Customer-sponsored spending has been immaterial for the past three years. Environmental Protection The Company is subject to various federal, state and local environmental laws and regulations concerning, among other matters, wastewater effluent and air emissions. Compliance costs have not been significant due to the nature of the materials and processes used in manufacturing operations. The Company has been named as a potentially responsible party at five sites in the Northeast. These sites are believed to represent the Company's largest potential environmental problems. The Company has presently accrued $3.1 million as of December 31, 1993, with respect to these sites. Due to the complexity of determining clean-up costs associated with the sites, an estimate of the ultimate cost to the Company cannot be determined; however, costs will be accrued once reasonable estimates are determined. Employees The number of employees at December 31, 1993, was 16,472. I-3 SONOCO PRODUCTS COMPANY AND CONSOLIDATED SUBSIDIARIES ------------------------- ITEM 1. BUSINESS, Continued Financial Information about Foreign and Domestic Operations and Export Sales The Company has subsidiaries and affiliates operating in 24 countries. The primary operations of the international subsidiaries are similar in products and markets served to our domestic businesses. The Management's Discussion and Analysis, the Financial Reporting for Business Segments, and Note 15 to the Financial Statements of the Annual Report to Shareholders are hereby incorporated by reference. United States export sales are immaterial. ITEM 2.

ITEM 2. PROPERTIES The main plant and corporate offices are located in Hartsville, South Carolina. The Company has 170 branch or manufacturing operations in the United States, 26 in Canada and 66 in 22 other international countries. There are 119 manufacturing operations in the converting segment, 33 in the paper segment, 92 in the international segment, and 18 in the miscellaneous segment at December 31, 1993. One hundred and one (101) domestic plants are owned in fee simple; sixty-five (65) are leased for terms up to ten years with options to renew for additional terms and four (4) have lease purchase agreements. The Company believes that its properties are suitable and adequate for current needs and that the total productive capacity is adequately utilized. ITEM 3.

ITEM 3. LEGAL PROCEEDINGS In the normal course of business, the Company is a party to various legal proceedings incidental to its business and is subject to a variety of environmental and pollution control laws and regulations in all jurisdictions in which it operates. Although the level of future expenditures for legal and environmental matters is impossible to determine with any degree of probability, it is management's opinion that such costs when finally determined, will not have a material adverse effect on the consolidated financial position of the Company. ITEM 4.

ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS None. I-4 SONOCO PRODUCTS COMPANY AND CONSOLIDATED SUBSIDIARIES ------------------------ PART II ITEM 5.

ITEM 5. MARKET FOR THE REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS Market and Market Prices of Common Stock Sonoco Products Company common stock is traded on the NASDAQ National Market System. The Comparative Highlights in the 1993 Annual Report to Shareholders (Exhibit 13 of this report) shows, by quarter, the high and low price on this market for the latest two years, and is hereby incorporated by reference. Approximate Number of Security Holders There were approximately 33,000 shareholder accounts as of March 9, 1994. Dividends The Comparative Highlights in the 1993 Annual Report to Shareholders is hereby incorporated by reference. There are certain restrictions with respect to the maintenance of financial ratios and the disposition of assets in several of the Company's loan agreements which may limit the Company's ability to pay cash dividends. The most restrictive covenant currently requires that tangible net worth at the end of each fiscal quarter be greater than $200 million through April 3, 1994, and $365 million thereafter. The Company is prohibited from paying cash dividends if these requirements are not met. Additionally, the terms of the Company's Series A Cumulative Convertible Preferred Stock prohibits payment of dividends on any junior class of stock, including the Company's Common Stock, unless full cumulative dividends on the Series A Cumulative Convertible Preferred Stock have been paid or declared and set aside for payment for all past Dividend payment periods. ITEM 6.

ITEM 6. SELECTED FINANCIAL DATA The Selected Eleven-Year Financial Data in the 1993 Annual Report to Shareholders provides the required data, and is hereby incorporated by reference. ITEM 7.

ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The information presented under Management's Discussion and Analysis of the 1993 Annual Report to Shareholders is hereby incorporated by reference. ITEM 8.

ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA Report of Independent Accountants. II-1 REPORT OF INDEPENDENT ACCOUNTANTS --------------------------------- To the Shareholders and Directors Sonoco Products Company: We have audited the consolidated financial statements of Sonoco Products Company as of December 31, 1993 and 1992, and for each of the three years in the period ended December 31, 1993, which financial statements are included on pages 28 through 37 of the 1993 Annual Report to Shareholders of Sonoco Products Company and incorporated by reference herein. We have also audited the financial statement schedules listed in Item 14 of this form 10-K. These consolidated financial statements and financial statement schedules are the responsibility of the Company's management. Our responsibility is to express an opinion on these consolidated financial statements and financial statement schedules based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of Sonoco Products Company as of December 31, 1993 and 1992, and the consolidated results of its operations and its cash flows for each of the three years in the period ended December 31, 1993, in conformity with generally accepted accounting principles. In addition, in our opinion, the financial statement schedules referred to above, when considered in relation to the basic financial statements taken as a whole, present fairly, in all material respects, the information required to be included therein. As discussed in Notes 12 and 13 to the consolidated financial statements, the Company changed its method of accounting for postretirement benefits other than pensions and income taxes in 1992. /s/ Coopers & Lybrand ------------------------- COOPERS & LYBRAND Charlotte, North Carolina January 28, 1994 II-2 SONOCO PRODUCTS COMPANY AND CONSOLIDATED SUBSIDIARIES ------------------------- ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA, Continued Consolidated Financial Statements The consolidated financial statements and notes to consolidated financial statements for Sonoco Products Company included in the 1993 Annual Report to Shareholders (Exhibit 13 of this Report) are hereby incorporated by reference. Supplementary Financial Data The Comparative Highlights in the 1993 Annual Report to Shareholders is hereby incorporated by reference. ITEM 9.

ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE On July 15, 1992, the Company filed an 8-K pertaining to the Company's change in certifying accountant of Sonoco U.K. Ltd. Inc., a significant wholly owned subsidiary of Sonoco Products Company. The Company disengaged Wheawill and Sudworth and retained Coopers & Lybrand as independent accountants for Sonoco U.K. Ltd. Inc. The Form 8-K is incorporated herein by reference. II-3 SONOCO PRODUCTS COMPANY AND CONSOLIDATED SUBSIDIARIES -------------------------- PART III ITEM 10.

ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT Identification of Directors The Directors of Sonoco Products Company and Compliance with the Securities Exchange Act of 1934 are shown on pages 6 through 12 and page 25, respectively, of the Definitive Proxy Statement (included as Exhibit 99-1 of this report) and are hereby incorporated by reference. Identification of Executive Officers III-1 SONOCO PRODUCTS COMPANY AND CONSOLIDATED SUBSIDIARIES --------------------------- ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT, Continued Identification of Executive Officers, Continued III-2 SONOCO PRODUCTS COMPANY AND CONSOLIDATED SUBSIDIARIES ------------------------- ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT, Continued Family Relationships C. W. Coker and F. L. H. Coker are brothers and the first cousins of J. L. Coker and P. C. Coggeshall, Jr. ITEM 11.

ITEM 11. EXECUTIVE COMPENSATION Executive Compensation - Directors and Officers as shown on pages 14 - 20 and 22 of the Proxy Statement included as Exhibit 99-1 of this report is hereby incorporated by reference. ITEM 12.

ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT The security ownership of management as shown on page 13 of the Proxy Statement, Exhibit 99-1 of this report, is hereby incorporated by reference. ITEM 13.

ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS Transactions with management as shown on page 23 of the Proxy Statement included as Exhibit 99-1 of this report is hereby incorporated by reference. III-3 SONOCO PRODUCTS COMPANY AND CONSOLIDATED SUBSIDIARIES ------------------------- PART IV ITEM 14.

ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K Data incorporated by reference from the 1993 Annual Report to Shareholders (included as Exhibit 13 of this report): Comparative Highlights (Selected Quarterly Financial Data) Management's Discussion and Analysis of Financial Condition and Results of Operations Shareholders' Information (Selected Financial Data) Consolidated Balance Sheets as of December 31, 1993 and 1992 Consolidated Statements of Income for the years ended December 31, 1993, 1992 and 1991 Consolidated Statements of Changes Shareholders' Equity for the years ended December 31, 1993, 1992 and 1991 Consolidated Statements of Cash Flows for the years ended December 31, 1993, 1992 and 1991 Notes to Consolidated Financial Statements In response to Item 9 of this Form 10-K Annual Report, the Company's Current Report on Form 8-K filed on July 20, 1992 and Form 8-K/A filed on July 28, 1992 is incorporated by reference. Data submitted herewith: Report of Independent Accountants Financial Statement Schedules: Schedule V - Property, Plant and Equipment Schedule VI - Accumulated Depreciation, Depletion and Amortization of Property, Plant and Equipment IV-1 SONOCO PRODUCTS COMPANY AND CONSOLIDATED SUBSIDIARIES ---------------------------- ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K, Continued *Incorporated by reference to the Registrant's Form S-3 (File No. 33-50501) IV-2 SONOCO PRODUCTS COMPANY AND CONSOLIDATED SUBSIDIARIES ---------------------- ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K, Continued Reports on Form 8-K The Company filed a Current Report on Form 8-K on October 1, 1993, pertaining to the acquisition of Engraph, Inc. The items included in the Form 8-K were Item 5 (Other Events) describing the Agreement and Plan of Merger and Item 7 (Financial Statements, Pro Forma Financial Information and Exhibits). The Company filed a Current Report on Form 8-K on October 29, 1993, and a Form 8-K/A on November 4, 1993, pertaining to the acquisition of Engraph, Inc. The items included in the Form 8-K and Form 8-K/A were Item 2 (Acquisition or Disposition of Assets) and Item 7 (Financial Statements, Pro Forma Financial Information and Exhibits). IV-3 SONOCO PRODUCTS COMPANY AND CONSOLIDATED SUBSIDIARIES ---------------------------- SCHEDULE V - PROPERTY, PLANT AND EQUIPMENT for the years ended December 31, 1993, 1992 and 1991 (DOLLARS IN THOUSANDS) (A) Includes fixed assets written off as part of the 1992 and 1990 restructuring reserve. (B) Primarily relates to acquisitions and translation adjustments for foreign subsidiary assets. IV-4 SONOCO PRODUCTS COMPANY AND CONSOLIDATED SUBSIDIARIES ---------------------------- SCHEDULE VI - ACCUMULATED DEPRECIATION, DEPLETION AND AMORTIZATION OF PROPERTY, PLANT AND EQUIPMENT for the years ended December 31, 1993, 1992 and 1991 (DOLLARS IN THOUSANDS) -------------------- (A) Includes accumulated depreciation on fixed assets reserved for write off as part of the 1992 and 1990 restructuring reserve. (B) Includes translation adjustment of accumulated depreciation for foreign subsidiary companies. IV-5 SONOCO PRODUCTS COMPANY AND CONSOLIDATED SUBSIDIARIES ------------------------------- SCHEDULE VIII - VALUATION AND QUALIFYING ACCOUNTS for the years ended December 31, 1993, 1992 and 1991 (Dollars in thousands) (1) Includes amounts written off, translation adjustments and payments. (2) Increase in additions charged to costs and expenses in 1993 is related to acquisitions. IV-6 SONOCO PRODUCTS COMPANY AND CONSOLIDATED SUBSIDIARIES ---------------------- SCHEDULE IX - SHORT-TERM BORROWINGS for the years ended December 31, 1993, 1992 and 1991 (Dollars in thousands) (1) Represents borrowings consisting primarily of foreign denominated debt, under revolving lines of credit and term notes, excluding commercial paper borrowings which are classified as long-term. (2) Based on daily loan balances outstanding during the year. (3) Based on actual interest rates in effect during the year weighted by the loan balances outstanding. IV-7 SONOCO PRODUCTS COMPANY AND CONSOLIDATED SUBSIDIARIES ---------------------- SCHEDULE X - SUPPLEMENTARY INCOME STATEMENT INFORMATION for the years ended December 31, 1993, 1992 and 1991 (Dollars in thousands) Amounts for depreciation and amortization of intangible assets, pre-operating costs and similar deferrals, taxes other than payroll and income taxes, royalties and advertising costs are not presented as such amounts are less than 1% of total sales. IV-8 SONOCO PRODUCTS COMPANY AND CONSOLIDATED SUBSIDIARIES ------------------------- SIGNATURES Pursuant to the requirements of Section 13 or 15(d) 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, on this 29th day of March 1994. SONOCO PRODUCTS COMPANY /s/ C. W. Coker ---------------------------- C. W. Coker Chief Executive Officer Pursuant to the requirements of the Securities Exchange Act of 1934, this report is signed below by the following persons on behalf of the Registrant and in the capacities indicated on this 29th day of March 1994. /s/ F. T. Hill, Jr. ------------------- F. T. Hill, Jr. Vice President - Finance (Principal Accounting Officer) IV-9 SONOCO PRODUCTS COMPANY AND CONSOLIDATED SUBSIDARES ---------------------------- SIGNATURES, Continued IV-10

27984_1993.txt

27984

1993

ITEM 3 LEGAL PROCEEDINGS In the action styled GARCIA V. DELTONA ET. AL, Case No. 86-03542, filed in the Circuit Court for Dade County, Florida, on January 30, 1986, the plaintiff had sought to recover $2,000,000 allegedly paid to the Company on four installment land sales contracts, claiming fraud and misrepresentation on the part of one of the Company's independent sales representatives and other violations of law. The Company had cancelled the contracts in question according to their terms for default of the payment obligations by the purchaser. Although the Company negotiated a settlement of this action which provides for the Company to convey to the plaintiff property which has a value equivalent to the monies paid by the plaintiff to the Company under the cancelled contracts, the plaintiff has asserted that the Company has breached the settlement agreement by failing to convey sufficient property which meets the criteria of the settlement agreement. The Company is of the belief that the property conveyed complies with such criteria. The parties are currently attempting to resolve the dispute by reaching an agreement as to alternative property that may be used for settlement purposes. In the action styled FIVE POINTS LIMITED V. THE DELTONA CORPORATION, Case No. 93-22877, filed in the Circuit Court for Dade County, Florida and served upon the Company on December 8, 1993, the plaintiff is seeking damages against the Company for an alleged breach of the lease for its office building. The complaint alleges that the Company has defaulted in its obligation to make payments under the lease and seeks damages in excess of $272,000 for additional past due rent, plus damages for acceleration of lease payments in excess of $4,000,000. On February 17, 1994 the Court entered an Order requiring the Company to pay uncontested back rent of approximately $240,000, plus uncontested monthly rents of approximately $48,000, commencing on March 1, 1994. As of August 31, 1994, approximately $41,500 had been garnished by the Court under this Order. The Plaintiff has obtained multiple judgments in the amount of $647,000 as of August 31, 1994. These judgments have been recorded in certain of the Company's communities. On September 1, 1994 the Company entered into a settlement agreement with plaintiff to be consummated on or before October 17, 1994. New financing is essential for the Company to consummate the settlement agreement. Failure to fund this agreement will result in continued litigation and a likely substantial judgment against the Company. As part of the settlement agreement, the Company will be evicted from the premises and must vacate its occupancy by January 6, 1995. In the action styled LEE, ET.AL. V. THE DELTONA CORPORATION, Case No. 94-3808, filed in the Circuit Court for Dade County, Florida and served upon the Company on February 28, 1994, the plaintiff had alleged that the liquidated damages provision in the Company's contracts for the sale of its properties is unenforceable under Florida law and contests the method utilized by the Company to calculate actual damages in the event of contract cancellations. As part of its complaint, the plaintiff was seeking certification as a class action, as well as unspecified compensatory damages, together with interest, costs and fees. The Company has reached a settlement with the plaintiff and proceedings have been dismissed. In the action styled BRUCE WEINER V. THE DELTONA CORPORATION, the plaintiff, Bruce Weiner, prior Executive Vice President of the Company, has sued the Company on April 28, 1994 for alleged breach of employment contract seeking damages of approximately $750,000.00 and unspecified employee benefits. The proceeding is pending in the Circuit Court of Dade County, Florida, Case No. 94-7825-04. The Company has filed a response to the plaintiff's complaint and discovery is pending. No final hearing has been set. The Company believes that it has defenses to the claim. In the event that the Company is not successful in its defenses or a settlement is not reached, a substantial judgment may be entered against the Company in favor of the plaintiff. The Company at the present time is unable to predict the ultimate outcome of the litigation. Although settlement discussions have commenced, no resolution of the matter has been consummated. Any ultimate settlement will require the Company to obtain financing for payment. In the action styled JOSEPH MANCILLA, JR. V. THE DELTONA CORPORATION, the plaintiff, Joseph Mancilla, Jr., prior Senior Vice President of the Company, has sued the Company on May 17, 1994 for alleged breach of employment contract seeking damages in excess of $391,000,000 plus unspecified employee benefits, costs and other claims. The proceeding is pending in the Circuit Court of Dade County, Florida, Case No. 94-09116. The Company has filed a responsive pleading and no final hearing has been set. If a settlement is not reached and the Company is not successful in its defenses, a substantial portion of the plaintiff's claim may be entered as a judgment against the Company. The Company at the present time is unable to predict the ultimate outcome. The Company intends to begin settlement discussions with plaintiff. Any settlement funding would require the Company to obtain financing to meet settlement commitment. In the action styled MICHELLE GARBIS V. THE DELTONA CORPORATION, the plaintiff, Michelle Garbis, prior Senior Vice President and Corporate Secretary of the Company, has sued the Company on August 18, 1994 for alleged breach of employment contract seeking damages of approximately $280,000.00. The Company disputes the plaintiff's claim which is pending in the Circuit Court of Dade County, Florida, Case No. 94-15531 CA (11). The Company and plaintiff have reached a resolution and settlement of the claim and have entered into a stipulation requiring installment payments through December 1994. Failure of the Company to obtain financing and perform under the stipulation, would result in continued litigation and potential judgment against the Company for the unpaid portion of the settlement amount. The Company is subject to various litigation involving claims by certain trade creditors. The Company has entered into individual compromise and settlement agreements or stipulations, for payments at discounted amounts on or before September 30, 1994. Failure to obtain financing to make the committed payments may result in judgments of up to $500,000.00. The Company is also a party to certain other legal and administrative proceedings arising in the ordinary course of its business. The outcome will not, in the opinion of the Company, have a material adverse effect on the business or financial condition of the Company. ITEM 5

ITEM 5 PRICE RANGE OF COMMON STOCK AND DIVIDENDS The Company's Common Stock was traded on the New York and Pacific Stock Exchanges under the ticker symbol DLT until trading was suspended on April 6, 1994. The following table sets forth the reported high and low sales prices for the Company's Common Stock during the periods indicated as reported in the record of composite transactions for NYSE listed securities. QUARTER HIGH LOW - - ------- ------ ----- 1992 - First Quarter........................................ 1-1/2 5/8 Second Quarter....................................... 2-3/4 7/8 Third Quarter........................................ 2-1/4 1-7/8 Fourth Quarter....................................... 4-1/8 1-3/4 1993 - First Quarter........................................ 3-3/8 2-1/2 Second Quarter....................................... 3-1/2 1-7/8 Third Quarter........................................ 2-7/8 1-7/8 Fourth Quarter....................................... 3 1-7/8 On March 18, 1994 the last reported sales price of the shares of Common Stock on the NYSE was 1-1/4. There were 1,704 holders of record of the Company's Common Stock. On April 6, 1994, both the New York and Pacific Stock Exchanges suspended the Company's Common Stock from trading and instituted procedures to delist the Company's Common Stock. On June 16, 1994, the Company's Common Stock was formally removed from listing and registration on the New York Stock Exchange. As of August 31, 1994, the Company's Common Stock was traded on a limited basis in the over-the-counter markets. The high bid was 12-1/2(cent) and the low ask price was 50(cent) at September 6, 1994 on the over-the-counter markets. The Company has never paid any cash dividends on its Common Stock. The Company's loan agreements contain certain restrictions which currently prohibit the Company from paying dividends on its Common Stock. ITEM 6

ITEM 6 SELECTED CONSOLIDATED FINANCIAL INFORMATION The following table summarizes selected consolidated financial information and should be read in conjunction with the Consolidated Financial Statements. See "Management's Discussion and Analysis of Financial Condition and Results of Operations". CONSOLIDATED INCOME STATEMENT DATA (IN THOUSANDS EXCEPT PER SHARE AMOUNTS) CONSOLIDATED BALANCE SHEET DATA (IN THOUSANDS) ITEM 7

ITEM 7 MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS On June 19, 1992, the Company completed a transaction with Selex, which resulted in a change in control of the Company. Under the transaction, Selex loaned the Company $3,000,000 collateralized by a first mortgage on certain of the Company's property in its St. Augustine Shores, Florida community (the "First Selex Loan"). The First Selex Loan initially bears interest at the rate of 10% per annum with a term of four years and payment of interest deferred for the first 18 months. Accrued interest due under the First Selex Loan in the amount of $604,312 (including $463,562 due December 31, 1993) was unpaid and in default as of August 31, 1994. In conjunction with the First Selex Loan: (i) Empire sold Selex its 2,220,066 shares of the Company's Common Stock and assigned Selex its $1,000,000 Note from the Company, with $225,000 of interest accrued thereon; (ii) Maurice A. Halperin, Chairman of the Board of Empire and former Chairman of the Board of the Company, forgave payment of the $200,000 salary due him for the period of April, 1990 through April, 1991, which was in arrears; and (iii) certain changes occurred in the composition of the Company's Board of Directors. Namely, the six directors serving on the Company's Board who were previously designated by Empire resigned and four Selex designees (Messrs. Marcellus H.B. Muyres, Antony Gram, Cornelis van de Peppel and Cornelis L.J.J. Zwaans) were elected to serve as directors in their stead. Marcellus H.B. Muyres was appointed Chairman of the Board and Chief Executive Officer of the Company. These directors, as well as Leonardus G.M. Nipshagen, a Selex designee, were then elected as directors at the Company's 1992 Annual Meeting and re-elected at the Company's 1993 Annual Meeting. As part of the Selex transaction, Selex was granted an option, approved by the holders of a majority of the outstanding shares of the Company's Common Stock at the Company's 1992 Annual Meeting, to convert the Selex Loan, or any portion thereof, into a maximum of 850,000 shares of the Company's Common Stock at a per share conversion price equal to the greater of (i) $1.25 or (ii) 95% of the market price of the Company's Common Stock at the time of conversion, but in no event greater than $4.50 per share (the "Option"). However, on September 14, 1992, Selex formally waived and relinquished its right to exercise the Option as to 250,000 shares of the Company's Common Stock to enable the Company to settle certain litigation involving the Company through the issuance of approximately 250,000 shares of the Company's Common Stock to the claimants, without jeopardizing the utilization of the Company's net operating loss carryforward. On February 17, 1994, Selex exercised the remaining full 600,000 share Option at a conversion price of $1.90 per share, such that $1,140,000 in principal was repaid under the First Selex Loan through such conversion. As a consequence of such conversion, Selex holds 2,820,066 shares of the Company's Common Stock (43.1% of the outstanding shares of Common Stock of the Company based upon the number of shares of the Company's Common Stock outstanding as of March 18, 1994. Pursuant to the Selex transaction, $1,000,000 of the proceeds from the First Selex Loan was used by the Company to acquire certain commercial and multi-family properties at the Company's St. Augustine Shores community at their net appraised value, from Mr. Muyres and certain entities affiliated with Messrs. Zwaans and Muyres. Namely, (i) $416,000 was used to acquire 48 undeveloped condominium units (twelve 4 unit building sites) and 4 completed (and rented) condominium units from Conquistador, in which Messrs. Zwaans and Muyres serve as directors, as well as President and Secretary/Treasurer, respectively; (ii) $485,000 was used to acquire 4 commercial lots from Swan, in which Messrs. Zwaans and Muyres also serve as directors, as well as President and Secretary, respectively; and (iii) approximately $99,000 was used to reacquire, from Mr. Muyres, all of his rights, title and interest in that certain contract with the Company for the purchase of a commercial tract in St. Augustine Shores, Florida. None of the commercial land and multi-family property acquired by the Company from Mr. Muyres and certain entities affiliated with Messrs. Zwaans and Muyres collateralizes the First Selex Loan. In March, 1994, Conquistador exercised its right to repurchase certain of the multi-family property from the Company (which right had been granted in connection with the June, 1992 transaction) at a price of $312,000, of which $260,000 was paid in cash to the Company and $52,000 was applied to reduce interest due to Selex under the Third Selex Loan. In December, 1992, Mr. Gram, a director of the Company and beneficial owner of the Common Stock of the Company held by Selex, acquired all of the Company's outstanding bank debt and then assigned same to Yasawa, of which Mr. Gram is also the beneficial owner. Yasawa simultaneously completed a series of transactions with the Company which involved the transfer of certain assets to Yasawa or its affiliated companies, the acquisition by Yasawa of 289,637 shares of the Company's Common Stock through the exercise of warrants previously held by the banks, the provision of a $1,500,000 line of credit to the Company and the restructuring of the remaining debt as a $5,106,000 Yasawa Loan. Principal repayments aggregating $341,000 were made in 1993 and 1994 to reduce the Yasawa Loan to $4,765,000. On April 30, 1993, Selex loaned the Company an additional amount of $1,000,000 pursuant to the Second Selex Loan and since July 1, 1993 made further loans to the Company aggregating $4,400,000 under the Third Selex Loan. Principal of $33,000 had been repaid under the Second Selex Loan through August 31, 1994. As of August 31, 1994, Yasawa has loaned the Company an additional sum of $l,200,000 pursuant to the Second Yasawa Loan. As a consequence of these transactions, the Company had loans outstanding from Selex, Yasawa and their affiliates on August 31, 1994 in the aggregate amount of approximately $17,976,000, including interest. The loans from Selex, Yasawa and their affiliates are secured by substantially all of the assets of the Company. See Note 5 to Consolidated Financial Statements. The Company has stated in previous filings with the Commission that the obtainment of additional funds to implement its marketing program and achieve the objectives of its business plan is essential to enable the Company to maintain operations and continue as a going concern. Since December, 1992, the Company has been dependent on loans and advances from Selex, Yasawa and their affiliates in order to implement its marketing program and assist in meeting its working capital requirements. As stated above, during the last six months of 1993, Selex, Yasawa and their affiliates loaned the Company an aggregate of $4,400,000 pursuant to Third Selex Loan. Funds advanced under the Third Selex Loan enabled the Company to commence implementation of the majority of its marketing program in the third quarter of 1993. The full benefits were not realized in 1993 and the Company was unable to secure financing in 1994 to meet its working capital requirements. On March 10, 1994, the Company was advised that Selex filed Amendment No. 2 dated February 17, 1994 to its Schedule 13D (the "Amendment") with the Commission. In the Amendment, Selex reported that it, together with Yasawa and their affiliates were uncertain as to whether they would provide any further funds to the Company. The Amendment further stated that Selex, Yasawa and their affiliates, were seeking third parties to provide financing for the Company and that as part of any such transaction, they would be willing to sell or restructure all or a portion of their loans and Common Stock in the Company. Inasmuch as funding is not presently available to the Company from external sources and, as stated in their Amendment, Selex, Yasawa and their affiliates have not determined whether they will provide any further funds to the Company, the Company is facing a severe cash shortfall. As a consequence of its liquidity position, the Company has defaulted on certain obligations, including its escrow obligations to the Division pursuant to the Company's 1992 Consent Order, its obligation under its lease for its corporate offices and its obligation to make required interest payments under loans from Selex, Yasawa and their affiliates. Furthermore, the Company has not paid certain real estate taxes which are approximately $1,549,000 at August 31, 1994 and is also subject to certain pending litigation by former employees and others, which may adversely affect the financial condition of the Company. See "Legal Proceedings." The Company is continuing to seek third parties to provide financing. As part of any such transaction, Selex, Yasawa and their affiliates have indicated that they are willing to sell or restructure all or a portion of their loans and Common Stock in the Company. They have also indicated that they are willing to sell their interests in the Company at a significant discount. Consummation of any such transaction may result in a change in control of the Company. There can be no assurance, however, that any such transaction will result or that any financing will be obtained. Accordingly, the Company's Board of Directors is also considering other appropriate action given the severity of the Company's liquidity position including but not limited to filing under the federal bankruptcy laws. Alternatively, the Company could be subject to the filing of an involuntary bankruptcy proceeding in the event it is unable to resolve and settle pending litigation, satisfy settlement commitments and other unpaid creditor claims. See "Business: Recent Developments", "Legal Proceedings" and Notes 1, 5 and 8 to Consolidated Financial Statements. RESULTS OF OPERATIONS YEARS ENDED DECEMBER 31, 1993 AND DECEMBER 25, 1992 REVENUES Total revenues were $12,099,000 for 1993 compared to $12,217,000 for 1992. Included in 1992 revenues is a third quarter gain of $448,000 from the sale of the administration building at the Company's Citrus Springs community. Gross land sales were $3,170,000 for 1993 versus $2,515,000 for 1992. Net land sales (gross land sales less estimated uncollectible installment sales and contract valuation discount) increased to $2,432,000 for 1993 from $2,092,000 for 1992. The modest increase in sales reflects the introduction of the Company's marketing program which was delayed until the third quarter of the year. Retail land sales increased to $3,057,000 from $2,289,000, a 33.5% increase. The Company had a 90.6% increase in retail land sales contracts entered into in 1993 over 1992. This increase was due to the third quarter introduction of the Company's marketing program and reflects increased spending on advertising and promotional programs to strengthen the Company's marketing organization, rebuild its retail land sales business and re-enter the single-family home business. Bulk land sales were $113,000 in 1993 as compared to bulk land sales of $226,000 in 1992. In light of the Company's diminished bulk land sales inventory and the properties transferred to the Company's lenders on October 11, 1991, it is anticipated that 1994 will also produce a low volume of bulk land sales. See "Liquidity and Capital Resources: Mortgages and Similar Debt". The Company re-entered the single-family housing business in December, 1992. Since revenues are not recognized from housing sales until the completion of construction and passage of title, no significant housing revenues will be recognized in 1994. The Company recognized revenues from housing sales of $344,000 for 1993, primarily during the fourth quarter of the year, and had a backlog of housing sales of $899,000 as of December 31, 1993. The following table reflects the Company's real estate product mix for 1993 and 1992 (in thousands): - - -------------------- * New retail land sales contracts entered into, including deposit sales on which the Company has received less than 20% of the sales price, net of cancellations, for the years ended December 31, 1993 and December 25, 1992 were $4,106,000 and $2,154,000, respectively. Such contracts are not included in retail land sales until the applicable rescission period has expired and the Company has received payments totalling 20% of the contract sales prices. See Note 1 to the Consolidated Financial Statements. Improvement revenues result from the recognition of revenue deferred from prior period sales. Recognition occurs as development work proceeds on previously sold property. Improvement revenues totalled $4,725,000 in 1993 as compared to $2,404,000 for 1992. The increase was due to the Company's resumption of development work in the third quarter of 1992. Interest income was $1,197,000 for 1993 compared to $3,584,000 for 1992. This decrease is the result of lower contracts receivable balances. Other revenues were $3,401,000 for 1993 compared to $4,137,000 in 1992. Included in other revenues for 1992 is the previously mentioned gain of $448,000 on the sale of the administration building at the Company's Citrus Springs community, as well as revenues from the Company's Sunny Hills golf and country club which was sold in the first quarter of 1993. COSTS AND EXPENSES Costs and expenses were $20,871,000 for 1993 compared to $18,935,000 in 1992. Cost of sales totalled $6,441,000 for 1993 versus $4,605,000 for 1992, primarily due to the resumption of development work in the third quarter of 1992. Gross profit margins decreased from 46.7% to 40.9% The 1993 results include a provision for contract cancellations of $2,400,000. Included in the provision is $1,400,000 for contracts sold in prior years to third parties which the Company is obligated to repurchase. Commissions, advertising and other selling expenses totalled $6,008,000 for 1993 versus $3,917,000 for 1992. Advertising and promotional expenditures increased from $580,000 in 1992 to $1,521,000 in 1993, reflecting the Company's implementation of its marketing program. General and administrative expenses were $3,790,000 in 1993 versus $5,844,000 for 1992. General and administrative expenses have decreased primarily due to overhead reductions, as part of the Company's efforts to stabilize its liquidity situation. Interest expense was $1,257,000 for 1993, as compared to $3,356,000 for 1992, or a 62.5% decrease. Total interest costs (including capitalized interest) were $1,421,000 and $3,456,000 for 1993 and 1992, respectively. The decrease in interest cost is due to lower debt balances. NET INCOME The Company reported a net loss of $8,772,000 for 1993, compared to a net income of $7,336,000 for 1992. The 1993 results include a provision for contract cancellations of $2,400,000. The 1992 results include a gain of $448,000 on the sale of the administration building at the Company's Citrus Springs community, as well as a $10,161,000 extraordinary gain from debt restructuring and a $3,983,000 extraordinary gain from the settlement related to the Company's Marco refund obligation. RESULTS OF OPERATIONS YEARS ENDED DECEMBER 25, 1992 AND DECEMBER 27, 1991 REVENUES Total revenues were $12,217,000 for 1992 compared to $10,784,000 for 1991. Included in 1992 revenues is a third quarter gain of $448,000 from the sale of the administration building at the Company's Citrus Springs community. Gross land sales were $2,515,000 for 1992 versus $1,539,000 for 1991. Net land sales (gross land sales less estimated uncollectible installment sales and contract valuation discount) increased to $2,092,000 for 1992 from $1,154,000 for 1991. Retail land sales contracts written increased $851,000 from $1,438,000 in 1991 to $2,289,000 in 1992, a 60% increase. The increase in sales is primarily due to the resale, during the first quarter of 1992, of property which was the subject of a previously cancelled contract; however, sales for the year reflected the economic slowdown and the Company's inability to bolster marketing efforts due to its liquidity situation. Bulk land sales were $226,000 in 1992 as compared to bulk land sales of $101,000 in 1991. See "Liquidity and Capital Resources: Mortgages and Similar Debt". Although the Company re-entered the single-family housing business in December, 1992, since revenues are not recognized from housing sales until the completion of construction and passage of title, no housing revenues were expected to be recognized until late 1993. The following table reflects the Company's real estate product mix for 1992 and 1991 (in thousands): Improvement revenues result from the recognition of revenue deferred from prior period sales. Recognition occurs as development work proceeds on previously sold property. Improvement revenues totalled $2,404,000 in 1992 as compared to $-0- for 1991. The increase was due to the Company's resumption of development work in the third quarter of 1992. Interest income was $3,584,000 for 1992 compared to $5,270,000 for 1991. This decrease is the result of lower contracts receivable balances. Other revenues were $4,137,000 for 1992 compared to $4,240,000 in 1991. Included in other revenues is the previously mentioned gain of $448,000 on the sale of the administration building at the Company's Citrus Springs community. COSTS AND EXPENSES Costs and expenses were $18,935,000 for 1992 compared to $30,313,000 in 1991. Included in costs and expenses for 1991 was a provision of $8,900,000 caused by an addition to the allowance for uncollectible contracts for previously recognized sales of $12,200,000. Cost of sales totalled $4,605,000 for 1992 versus $2,599,000 for 1991, primarily due to the resumption of development work in the third quarter of 1992. Gross profit margins decreased from 53.1% to 46.7%. Commissions, advertising and other selling expenses totalled $3,917,000 for 1992 versus $4,107,000 for 1991. Advertising expenditures increased from $259,000 in 1991 to $580,000 in 1992, reflecting the Company's efforts to stimulate sales and implement its marketing program. Additional working capital was expected to be allocated during the year for advertising and promotional purposes to strengthen the Company's marketing organization, rebuild its retail land sales business and re-enter the single-family home business. General and administrative expenses were $5,844,000 in 1992 versus $6,165,000 for 1991. General and administrative expenses decreased primarily due to overhead reductions, as part of the Company's efforts to stabilize its liquidity situation. Interest expense was $3,356,000 for 1992, as compared to $6,896,000 for 1991, or a 51% decrease. Total interest costs (including capitalized interest) were $3,456,000 and $6,896,000 for 1992 and 1991, respectively. The decrease in interest cost is due to substantially lower debt balances, as well as lower prime rates of interest charged by the Company's lenders. NET INCOME The Company reported net income of $7,336,000 for 1992, compared to a net loss of $26,629,000 for 1991. The 1992 results include a gain of $448,000 on the sale of the administration building at the Company's Citrus Springs community, as well as a $10,161,000 extraordinary gain from debt restructuring and a $3,983,000 extraordinary gain from the settlement related to the Company's Marco refund obligation. The 1991 results included a provision of approximately $8,900,000 related to a $12,200,000 addition to the allowance for uncollectible contracts, as well as a $7,100,000 extraordinary loss from debt restructuring related to the Sixth Restatement. Exclusive of the extraordinary items, the loss from operations for 1992 was $6,808,000, as compared to the prior year's loss of $19,529,000. REGULATORY DEVELOPMENTS WHICH MAY AFFECT FUTURE OPERATIONS In Florida, as in many growth areas, local governments have sought to limit or control population growth in their communities through restrictive zoning, density reduction, the imposition of impact fees and more stringent development requirements. Although the Company has taken such factors into consideration in its master plans, the increased regulation has lengthened the development process and added to development costs. On a statewide level, the Florida Legislature adopted and implemented the Florida Growth Management Act of 1985 (the "Act") to aid local governments efforts to discourage uncontrolled growth in Florida. The Act precludes the issuance of development orders or permits if public facilities such as transportation, water and sewer services will not be available concurrent with development. Development orders have been issued for, and development has commenced in, the Company's existing communities (with development being virtually completed in certain of these communities). Thus, such communities are less likely to be affected by the new growth management policies than future communities. Any future communities developed by the Company will be strongly impacted by new growth management policies. Since the Act and its implications are consistently being re-examined by the State, together with local governments and various state and local governmental agencies, the Company cannot further predict the timing or the effect of new growth management policies, but anticipates that such policies may increase the Company's permitting and development costs. In addition to Florida, other jurisdictions in which the Company's properties are offered for sale have recently strengthened, or are considering strengthening, their regulation of subdividers and subdivided lands in order to provide further assurances to the public, particularly given the adverse publicity surrounding the industry which existed in 1990. The Company has attempted to take appropriate steps to modify its marketing programs and registration applications in the face of such increased regulation, but has incurred additional costs and delays in the marketing of certain of its properties in certain states and countries. For example, the Company has complied with regulations of certain states which require that the Company sell its properties to residents of those states pursuant to a deed and mortgage transaction, regardless of the amount of the down payment. The Company intends to continue to monitor any changes in statutes or regulations affecting, or anticipated to affect, the sale of its properties and intends to take all necessary and reasonable action to assure that its properties and its proposed marketing programs are in compliance with such regulations, but there can be no assurance that the Company will be able to timely comply with all regulatory changes in all jurisdictions in which the Company's properties are presently offered for sale to the public. LIQUIDITY AND CAPITAL RESOURCES MORTGAGES AND SIMILAR DEBT Indebtedness under various purchase money mortgages and loan agreements is collateralized by substantially all of the Company's assets, including stock of certain wholly-owned subsidiaries. The following table presents information with respect to mortgages and similar debt (in thousands): Included in Mortgage Notes Payable is the $3,000,000 First Selex Loan ($1,860,000 as of August 31, 1994), the $1,000,000 Second Selex Loan ($967,000 as of August 31, 1994) the $4,384,000 Third Selex Loan and the $4,900,000 Yasawa Loan ($4,765,000 as of August 31, 1994). Other loans include the $1,000,000 Empire note and the $1,500,000 Scafholding Loan. These mortgage notes payable and other loans are in default as of August 31, 1994 due to the non-payment of interest and principal. The lenders have not taken any action as a result of these defaults. On June 19, 1992, the Company completed a transaction with Selex whereby, among other things, Selex loaned the Company $3,000,000 (the First Selex Loan). The First Selex Loan is collateralized by a first mortgage on certain of the Company's property in its St. Augustine Shores, Florida community. The Loan matures on June 15, 1996 and provides for principal to be repaid at 50% of the net proceeds per lot for lots requiring release from the mortgage, with the entire unpaid balance becoming due and payable at the end of the four year term. It initially bears interest at the rate of 10% per annum, with payment of interest deferred for the initial eighteen months of the Loan and interest payments due quarterly thereafter. On February 17, 1994, principal in the amount of $1,140,000 was repaid under the First Selex Loan when Selex exercised its previously described Option to convert a portion of the Loan into 600,000 shares of the Company's Common Stock at a conversion price of $1.90 per share. Accrued interest in the amount of $604,300 (including $463,600 due December 31, 1993) was unpaid and in default under the First Selex Loan as of August 31, 1994. The Company had defaulted on its bank debt in the third quarter of 1990, and was engaged in negotiating the repayment and restructuring of such debt through 1991 and the first half of 1992. As of December 27, 1991, the Company's bank debt had been reduced by the assignment of mortgages receivables and, on October 11, 1991, the transfer of certain properties to its principal lending banks pursuant to a Conveyance Agreement with such lenders. The Conveyance Agreement not only provided for the partial repayment of the bank debt, but also encompassed an agreement in principle providing for the restructuring and repayment of the remaining bank debt. On June 18, 1992, the Company completed the restructuring of its bank debt by entering into the Sixth Amended and Restated Credit and Security Agreement (the "Sixth Restatement") with its lenders. The terms of the Sixth Restatement provided for the Company's remaining debt in the principal amount of approximately $25,300,000 to be repaid by June 30, 1997, with specified interim repayments and benchmarks to be achieved. Among other things, the Sixth Restatement provided for: (i) interest to accrue on the remaining debt at Citibank's alternate base rate ("ABR") plus 4% per annum, subject to a minimum interest rate of 11% per annum and a maximum interest rate of 14% per annum, with no interest payments due until June 30, 1996; (ii) accrued, but unpaid interest on $10,000,000 of the restructured debt to be forgiven provided that the principal balance outstanding on the restructured debt as of June 30, 1996 was less than $9,000,000; and (iii) the issuance to the lenders of warrants to acquire up to 277,387 shares of the Company's Common Stock at a price of $1.00 per share. In conjunction with the completion of the Sixth Restatement, the lenders released or subordinated their lien on certain assets of the Company, to enable the Company to complete the First Selex Loan, to complete the $13,500,000 sale of contracts receivable described below, to enter into the 1992 Consent Order with the Division, and to secure working capital needed to pay real estate taxes which were, at the time, delinquent and meet its customer obligations for improvement work at certain of the Company's communities. During the third quarter of 1992, the lenders also released their lien on certain other contracts receivable to allow the Company to complete a sale of such receivables, which generated $600,000 in proceeds. These proceeds were, in turn, paid to the lenders, with the lenders allowing the Company $1,000,000 in debt reduction credit, and resulting in an extraordinary gain of $400,000. During the 1991 second quarter, the Company incurred extraordinary expenses of $3,500,000 for debt restructuring, based upon the transfer value of the assets involved in the first phase of its debt restructuring. During the fourth quarter of 1991, the Company provided for an additional $3,600,000 of extraordinary expenses for debt restructuring based upon the Company's assessment of the ultimate costs that would result from the restructuring of its debt pursuant to the Sixth Restatement. The fourth quarter addition included the anticipated professional fees, bank charges and other costs related to the Sixth Restatement, as well as the loss on the sale of contracts receivable discussed below. The completion of the Sixth Restatement was dependent upon the completion of the sale of contracts receivable; therefore, the loss on such sale was included as an extraordinary item. On December 2, 1992 the Company entered into various agreements relating to certain of its assets and the restructuring of its debt with Yasawa. The consummation of these agreements was conditioned upon the acquisition by Mr. Gram of the bank debt under the Sixth Restatement (the "Bank Loan") described above. On December 4, 1992, Gram acquired the Bank Loan of approximately $25,150,000 (including interest and fees) for a price of $10,750,000, as well as the warrants which the lenders held. Immediately thereafter, Gram transferred all of his interest in the Bank Loan, including the warrants, to Yasawa. See Notes 5 and 10 to Consolidated Financial Statements. On December 11, 1992 the Company consummated the December 2, 1992 agreements with Yasawa. Under these agreements, Yasawa, its affiliates and the Company agreed as follows: (i) the Company sold certain property at its Citrus Springs community to an affiliate of Yasawa in exchange for approximately $6,500,000 of debt reduction credit; (ii) an affiliate of Yasawa and the Company entered into a joint venture agreement with respect to the Citrus Springs property, providing for the Company to market such property and receive an administration fee from the venture (in March, 1994, the Company and the affiliate agreed to terminate the venture); (iii) the Company sold certain contracts receivable at face value to an affiliate of Yasawa for debt reduction credit of approximately $10,800,000; (iv) the Company sold the Marco Shores Country Club and Golf Course to an affiliate of Yasawa for an aggregate sales price of $5,500,000, with the affiliate assuming an existing first mortgage of approximately $1,100,000 and the Company receiving debt reduction credit of $2,400,000, such that the Company obtained cash proceeds from this transaction of $2,000,000, which amount was used for working capital; (v) an affiliate of Yasawa agreed to lease the Marco Shores Country Club and Golf Course to the Company for a period of approximately one year; (vi) an affiliate of Yasawa and the Company agreed to amend the terms of the warrants to increase the number of shares issuable upon their exercise from 277,387 shares to 289,637 shares and to adjust the exercise price to an aggregate of approximately $314,000; (vii) Yasawa exercised the warrants in exchange for debt reduction credit of approximately $314,000; (viii) Yasawa released certain collateral held for the Bank Loan; (ix) an affiliate of Yasawa agreed to make an additional loan of up to $1,500,000 to the Company, thus providing the Company with a future line of credit (all of which was drawn and outstanding as of August 31, 1994); and (x) Yasawa agreed to restructure the payment terms of the remaining $5,106,000 of the Bank Loan as a loan from Yasawa. The Yasawa Loan bears interest at the rate of 11% per annum, with payment of interest deferred until December 31, 1993, at which time only accrued interest became payable. Commencing January 31, 1994, principal and interest became payable monthly, with all unpaid principal and accrued interest being due and payable on December 31, 1997. A portion of the proceeds from a March, 1993 sale of contracts receivable was applied to reduce the Yasawa Loan to $4,900,000 during the first quarter of 1993 and the assignment of a mortgage receivable to Yasawa reduced the Yasawa Loan to $4,764,000 as of August 31, 1994. Accrued interest due under the Yasawa Loan in the amount of $355,196 was unpaid and in default as of August 31, 1994. In February, 1994, Yasawa loaned the Company an additional amount of $437,500 at an interest rate of 8% per annum (the "Second Yasawa Loan"). As of August 31, 1994, a total of $1,200,000 had been advanced under the Loan. On April 30, 1993 Selex loaned the Company an additional $1,000,000 collateralized by a first mortgage on certain of the Company's property in its Marion Oaks, Florida community (the "Second Selex Loan"). The Second Selex Loan bears interest at 11% per annum, with interest deferred until December 31, 1993. The Second Selex Loan provides for principal to be repaid at $3,000 per lot for lots requiring release from the mortgage, with the entire unpaid principal balance and interest accruing from January 1, 1994 to April 30, 1994 to be due and payable on April 30, 1994. Although Selex had certain conversion rights under the Second Selex Loan in the event the Company sold any Common Stock or Preferred Stock prior to payment in full of all amounts due to Selex under the Second Selex Loan, such rights were voided as of December 31, 1993 since the regulations set forth in proposed Treasury Decision CO-18-90 relative to Section 382 of the Internal Revenue Code were not adopted by such date. As of August 31, 1994, $33,000 in principal had been repaid under the Second Selex Loan, but accrued interest of $93,344 due under the Loan as of August 31, 1993 remained unpaid and in default. From July 9, 1993 through December 31, 1993, Selex loaned the Company an additional $4,400,000 collateralized by a second mortgage on certain of the Company's property on which Selex and/or Yasawa hold a first mortgage pursuant to a Loan Agreement dated July 14, 1993 and amendments thereto (the "Third Selex Loan"). The Third Selex Loan bears interest at 11% per annum, with interest deferred until December 31, 1993. Principal is to be repaid at $3,000 per lot for lots requiring release from the mortgage, with the entire unpaid principal balance and interest accruing from January 1, 1994 to April 30, 1994 becoming due and payable on April 30, 1994. As of August 31, 1994 accrued interest of $466,837 due under the Third Selex Loan was unpaid and in default. Interest due to Selex, Yasawa and their affiliates in the aggregate amount of $2,300,000 remained unpaid and in default as of August 31, 1994. From January 1, 1994 through August 31, 1994, $24,000 in principal was repaid under the Second Selex Loan and $1,140,000 in principal was repaid under the First Selex Loan through the exercise of the above described Option. After giving effect to such repayments of principal, the Company had loans outstanding from Selex, Yasawa and their affiliates on August 31, 1994 in the amount of approximately $17,976,000 including interest, of which approximately $9,867,000 is owed to Selex, (10% per annum on the First Selex Loan, 11% per annum on the Second and Third Selex Loans and 12% per annum on the $1,000,000 Empire Note assigned to Selex); approximately $6,349,000 is owed to Yasawa, including accrued and unpaid interest of approximately $384,500 (11% per annum on the Yasawa Loan and 8% per annum on the Second Yasawa Loan); and approximately $1,759,000 is owed to an affiliate of Yasawa, including accrued and unpaid interest of approximately $259,500 (12% per annum). The loans from Selex, Yasawa and their affiliates are secured by substantially all of the assets of the Company. On March 10, 1994, the Company was advised that Selex filed an Amendment to its Schedule 13D filed with the Commission. In the Amendment, Selex reported that it, together with Yasawa and their affiliates, were uncertain as to whether they would provide any further funds to the Company. The Amendment further stated that Selex, Yasawa and their affiliates were seeking third parties to provide financing for the Company and that as part of any such transaction, they would be willing to sell or restructure all or a portion of their loans and Common Stock in the Company. The Company has stated in previous filings with the Commission that the obtainment of additional funds to implement its marketing program and achieve the objectives of its business plan is essential to enable the Company to maintain operations and continue as a going concern. Since December, 1992, the Company has been dependent on loans and advances from Selex, Yasawa and their affiliates in order to implement its marketing program and assist in meeting its working capital requirements. As stated above, during the last six months of 1993, Selex, Yasawa and their affiliates loaned the Company an aggregate of $4,400,000 pursuant to Third Selex Loan. Funds advanced under the Third Selex Loan enabled the Company to commence implementation of the majority of its marketing program in the third quarter of 1993. The full benefits of the program could not be realized in 1993 and the Company was unable to secure financing in 1994 to meet its ongoing working capital requirements. Inasmuch as funding is not presently available to the Company from external sources and, as stated in their Amendment, Selex, Yasawa and their affiliates have not determined whether they will provide any further funds to the Company, the Company is facing a severe cash shortfall. As a consequence of its liquidity position, the Company has defaulted on certain obligations, including its escrow obligations to the Division pursuant to the Company's 1992 Consent Order, its obligation under its lease for its corporate offices and its obligation to make required interest payments under loans from Selex, Yasawa and their affiliates. Furthermore, the Company has not paid certain real estate taxes which aggregate approximately $1,549,000 as of August 31, 1994 and is also subject to certain pending litigation from former employees and others, which may adversely affect the financial condition of the Company. See "Legal Proceedings." The Company is continuing to seek third parties to provide financing. As part of any such transaction, Selex, Yasawa and their affiliates have indicated that they are willing to sell or restructure all or a portion of their loans and Common Stock in the Company. They have also indicated that they are willing to sell their interests in the Company at a significant discount. Consummation of any such transaction may result in a change in control of the Company. There can be no assurance, however, that any such transaction will result or that any financing will be obtained. Accordingly, the Company's Board of Directors is also considering other appropriate action given the severity of the Company's liquidity position including but not limited to protection under federal bankruptcy laws. Alternatively, the Company could be subject to the filing of an involuntary bankruptcy proceeding in the event it is unable to resolve and settle pending litigation, satisfy settlement commitments and other unpaid creditor claims. See "Business: Recent Developments", "Legal Proceedings" and Notes 1, 5 and 8 to Consolidated Financial Statements. CONTRACTS AND MORTGAGES RECEIVABLE SALES In December, 1992, as described above, the Company sold $10,800,000 of contracts and mortgages receivable to an affiliate of Yasawa at face value, applying the proceeds therefrom to reduce the Bank Loan acquired by Yasawa. In June, 1992, the Company completed a new financing through a $13,500,000 sale of contracts and mortgages receivable which generated approximately $8,000,000 in net proceeds to the Company and the creation of a holdback account in the amount of $3,100,000. The anticipated costs of this transaction were included in the extraordinary loss from debt restructuring for 1991. In conjunction with this sale, the February, 1990 sale described below and certain prior sales of receivables, the Company granted the purchaser a security interest in certain additional contracts receivable of approximately $2,700,000 and conveyed all of its rights, title and interest in the property underlying such contracts to a collateral trustee. Upon compliance with the conditions of the agreement with the purchaser, funds from the holdback account and property held by the collateral trustee will be released to the Company. In February, 1990, the Company completed a sale of $17,000,000 of receivables, generating approximately $13,900,000 in net proceeds and a loss of approximately $600,000. This transaction, as well as the June, 1992 sale described above, among other things, requires that the Company replace or repurchase any receivable that becomes 90 days delinquent upon the request of the purchaser. Such requirement can be satisfied from contracts in which the purchaser holds a security interest (approximately $1,200,000 as of August 31, 1993). The Company believes that it has established adequate reserves and guarantees in the event such replacement or repurchase becomes necessary. In addition to the above, the Company transferred $1,600,000 in contracts and mortgages receivable in March, 1993, to a third party generating $1,100,000 in proceeds to the Company and the creation of a holdback account in the amount $150,000. The Company was the guarantor of approximately $29,265,000 of contracts receivable sold or transferred as of December 31, 1993 and had $1,992,000 on deposit with the purchaser of the receivables as security to assure collectibility as of such date. The Company has been in compliance with all receivable transactions since the consummation of the June, 1992 sale. The Company anticipates that it will be necessary to complete additional sales and financings of a portion of its receivables in 1994 and 1995. There can be no assurance, however, that such sales and/or financings can be accomplished. OTHER OBLIGATIONS As a result of the delays in completing the land improvements to certain property sold in certain of its Central and North Florida communities, the Company fell behind in meeting its contractual obligations to its customers. In connection with these delays, the Company, in February, 1980, entered into a Consent Order with the Division which provided a program for notifying affected customers. The Consent Order, which was restated and amended, provided a program for notifying affected customers of the anticipated delays in the completion of improvements (or, in the case of purchasers of unbuildable lots in certain areas of the Company's Sunny Hills community, the transfer of development obligations to core growth areas of the community); various options which may be selected by affected purchasers; a schedule for completing certain improvements; and a deferral of the obligation to install water mains until requested by the purchaser. Under an agreement with Topeka, Topeka's utility companies have agreed to furnish utility service to the future residents of the Company's communities on substantially the same basis as such services were provided by the Company. The Consent Order also required the establishment of an improvement escrow account as assurance for completing such improvement obligations. In June, 1992, the Company entered into the 1992 Consent Order with the Division, which replaced and superseded the original Consent Order, as amended and restated. Among other things, the 1992 Consent Order consolidated the Company's development obligations and provided for a reduction in its required monthly escrow obligation to $175,000 from September, 1992 through December, 1993. Beginning January, 1994 and until development is completed or the 1992 Consent Order is amended, the Company is required to deposit $430,000 per month into the escrow account. To meet its current escrow and development obligations under the 1992 Consent Order, the Company is required to deposit into escrow $5,160,000 in 1994 and $3,519,000 in 1995. As part of the assurance program under the 1992 Consent Order, the Company and its lenders granted the Division a lien on certain contracts receivable (approximately $8,915,000 as of December 31, 1993) and future receivables. As previously stated, the Company is in default of its escrow obligations, and in accordance with the 1992 Consent Order, the collections on such receivables have been escrowed for the benefit of purchasers since March 1, 1994. At August 31, 1994, the amount collected on fully paid-for lots was approximately $1,340,000. Pursuant to the 1992 Consent Order, the Company has limited the sale of single-family lots to lots which front on a paved street and are ready for immediate building. Because of the Company's default, the Division could also exercise other available remedies under the 1992 Consent Order, which remedies entitle the Division, among other things, to halt all sales of registered property. As of December 31, 1993, the Company had estimated development obligations of approximately $2,825,000 on sold property, an estimated liability to provide title insurance costing $951,000 and an estimated cost of street maintenance, prior to assumption of such obligations by local governments, of $3,852,000, all of which are included in deferred revenue. The total cost, including the previously mentioned obligations, to complete improvements at December 31, 1993 to lots subject to the 1992 Consent Order and to lots in the St. Augustine Shores community was estimated to be approximately $18,574,000. The Company has in escrow approximately $1,664,000 specifically for land improvements at certain of its Central and North Florida communities. The Company's continuing liquidity problems have precluded the timely payment of the full amount of its 1992 and 1993 real estate taxes. The Company has paid real estate taxes on all properties sold on which it is solely obligated to pay real estate taxes and on all properties which are presently available for sale. On properties where customers have contractually assumed the obligation to pay into a tax escrow maintained by the Company, the Company has and will continue to pay real estate taxes as monies are collected from customers. Delinquent real estate taxes on certain of the Company's properties, none of which are presently being marketed, aggregated approximately $1,549,000 as of August 31, 1994. The Company's corporate performance bonds to assure the completion of development at its St. Augustine Shores community expired in March and June, 1993. Such bonds cannot be renewed due to a change in the policy of the Board of County Commissioners of St. Johns County which precludes allowing any developer to secure the performance of development obligations by the issuance of corporate bonds. In the event that St. Johns County elects to undertake and complete such development work, the Company would be obligated with respect to 1,000 improved lots at St. Augustine Shores in the amount of approximately $6,200,000. The Company intends to submit an alternative assurance program for the completion of such development and improvements to the County for its approval. On September 30, 1988, the Company entered into an agreement with Citrus County, Florida to establish the procedure for transferring final maintenance responsibilities for roads in the Company's Citrus Springs subdivision to Citrus County. The agreement obligated the Company to complete certain remedial work on previously completed improvements within the Citrus Springs subdivision by June 1, 1991. The Company was unable to complete this work by the specified date and is negotiating with Citrus County for the transfer of final maintenance responsibility for the roads to the County. Following the consummation of the Sixth Restatement, the Company conveyed certain properties to the landlord in satisfaction of its outstanding lease obligations for its executive office building in Miami, Florida. The Company also entered into a modification of its lease agreement, providing for a reduction of its rental expenses through June 30, 1994, at which time the Company would have the option of acquiring the leased premises or reinstating the lease according to its original terms. Should the landlord sell the leased premises to a third party at any time that the lease, or any modification thereof, is in effect, then the lease with the Company would be cancelled. In December, 1993, the landlord filed suit against the Company alleging that the Company defaulted in its obligation to make rental payments under the lease and seeking to accelerate lease payments. See "Business: Recent Developments" and "Legal Proceedings". The Company had placed certain properties in trust to meet its refund obligations to customers affected by the 1976 denial by the U.S. Army Corps of Engineers of permits to complete the development of the Company's Marco Island community and had provided in its financial statements for such obligations. Following the September, 1992 court approval of a settlement of certain class action litigation instituted by customers affected by the Marco permit denials, the Company, among other things, conveyed more than 120 acres of multi-family and commercial land that had been placed in trust to the trustee of the 809 member class, and listed 250,000 shares of restricted Common Stock of the Company to be issued to the class members. At December 31, 1993, $2,886,000 remained in the allowance for Marco permit costs, including $554,000 relating to interest accrued on such obligations. Based upon the Company's experience with affected customers, the Company believes that its total obligations to the remaining 1.3% of its affected customers will not materially exceed the amount provided for in its financial statements. See Note 9 to Consolidated Financial Statements. LIQUIDITY Since 1986, the Company has directed its marketing efforts to rebuilding retail land sales in an attempt to obtain a more stable income stream and achieve a balanced growth of retail land sales and bulk land sales. Retail land sales typically have a higher gross profit margin than bulk land sales and the contracts receivable generated from retail land sales provide a continuing source of income. However, retail land sales also have traditionally produced negative cash flow through the point of sale. This is because the marketing and selling expenses have generally been paid prior to or shortly after the point of sale, while the land is generally paid for in installments. The Company's ability to rebuild retail land sales has been substantially dependent on its ability to sell or otherwise finance contracts receivable and/or secure other financing sources to meet its cash requirements. To alleviate the negative cash flow impact arising from retail land sales while attempting to rebuild its sales volume, the Company implemented several new marketing programs which, among other things, adjusted the method of commission payments and required larger down payments. However, the nationwide economic recession, which has been especially pronounced in the real estate industry, adverse publicity surrounding the industry which existed in 1990, the resulting, more stringent regulatory climate, and worldwide economic uncertainties have severely depressed retail land sales beginning in mid-1990 and continuing thereafter, resulting in a continuing liquidity crisis. Because of this severe liquidity crisis, the Company ceased development work late in the third quarter of 1990 and did not resume development work until the third quarter of 1992. From September 29, 1990 through the fourth quarter of 1991, when the Company ceased selling undeveloped lots, sales of undeveloped lots were accounted for using the deposit method. Under this method, all payments were recorded as a customer deposit liability. In addition, because of the increasing trend in delinquencies during 1990, since the beginning of 1991, the Company has not recognized any sale until 20% of the contract sales price has been received. As a result, the reporting and recognition of revenues and profits on a portion of the Company's retail land sales contracts is being delayed. See Note 1 to Consolidated Financial Statements. The continued economic recession and the increasing adverse effects of such recession on the Florida real estate industry not only resulted in the Company's sales remaining at depressed levels, but caused greater contract cancellations in 1991, particularly in the second half of the year, than were anticipated. Such cancellations required the Company to record an additional provision to its allowance for uncollectible sales of approximately $12,200,000 in the 1991 third quarter, impacting net income by approximately $8,900,000. While the Company is making every effort to reduce its cancellations, should this trend continue, the Company could be required to record additional provisions in the future. The Company had defaulted on its bank debt in the third quarter of 1990, and was engaged in negotiating the repayment and restructuring of such debt through 1991 and the first half of 1992. On October 11, 1991, as described above, the Company completed the first phase of the restructuring of its bank debt by conveying to the lenders certain real estate assets which had been held for future development or bulk sales purposes, and on June 18, 1992, the Company finalized the restructuring of its remaining bank debt by entering into the Sixth Restatement. In December, 1992, such bank debt was acquired by Mr. Gram and assigned to Yasawa. Through the sale of certain assets to Yasawa and its affiliates, including certain contracts receivable, and the exercise of the warrants by Yasawa, the Company was able to reduce such remaining debt from approximately $25,150,000 (including interest and fees) to approximately $5,106,000. During 1993, the Yasawa Loan was reduced to $4,900,000. The agreement with Yasawa also provided the Company with a future line of credit of $1,500,000, all of which was drawn and outstanding as of August 31, 1994. During 1993, Selex loaned the Company an additional $5,400,000 pursuant to the Second and Third Selex Loans, of which $5,351,000 was outstanding as of August 31, 1994, and Yasawa loaned the Company an additional $1,200,000 in 1994 pursuant to the Second Yasawa Loan. The loans from Selex, Yasawa and their affiliates are collateralized by substantially all of the Company's assets. On March 10, 1994, the Company was advised that Selex filed an Amendment to its Schedule 13D with the Commission. In the Amendment, Selex reported that it, together with Yasawa and their affiliates, were uncertain as to whether they would provide any further funds to the Company. The Amendment further stated that Selex, Yasawa and their affiliates were seeking third parties to provide financing for the Company and that as part of any such transaction, they would be willing to sell or restructure all or a portion of their loans and Common Stock in the Company. The Company has stated in previous filings with the Commission and elsewhere herein that the obtainment of additional funds to implement its marketing program and achieve the objectives of its business plan is essential to enable the Company to maintain operations and continue as a going concern. Since December, 1992, the Company has been dependent on loans and advances from Selex, Yasawa and their affiliates in order to implement its marketing program and assist in meeting its working capital requirements. As previously stated, during the last six months of 1993, Selex, Yasawa and their affiliates loaned the Company an aggregate of $4,400,000 pursuant to Third Selex Loan. Funds advanced under the Third Selex Loan enabled the Company to commence implementation of the majority of its marketing program in the third quarter of 1993. The full benefits of the program were not realized in 1993 and the Company was unable to secure financing in 1994 to meet its working capital requirements. Inasmuch as funding is not presently available to the Company from external sources and, as stated in their Amendment, Selex, Yasawa and their affiliates have not determined whether they will provide any further funds to the Company, the Company is facing a severe cash shortfall. As a consequence of its liquidity position, the Company has defaulted on certain obligations, including its previously described escrow obligations to the Division pursuant to the Company's 1992 Consent Order, its obligation under its lease for its corporate offices and its obligation to make required interest payments under loans from Selex, Yasawa and their affiliates. Furthermore, the Company has not paid certain real estate taxes which aggregate approximately $1,549,000 as of August 31, 1994 and is also subject to certain pending litigation from former employees and others, which may adversely affect the financial condition of the Company. See "Legal Proceedings." The Company is continuing to seek third parties to provide financing. As part of any such transaction, Selex, Yasawa and their affiliates have indicated that they are willing to sell or restructure all or a portion of their loans and Common Stock in the Company. They have also indicated that they are willing to sell their interests in the Company at a significant discount. Consummation of any such transaction may result in a change in control of the Company. There can be no assurance, however, that such transaction will result or that any financing will be obtained. Accordingly, the Company's Board of Directors is also considering other appropriate action given the severity of the Company's liquidity position. Alternatively, the Company could be subject to the filing of an involuntary bankruptcy proceeding in the event it is unable to resolve and settle pending litigation, satisfy settlement commitments and other unpaid creditor claims. See "Business: Recent Developments", "Legal Proceedings" and Notes 1, 5 and 8 to Consolidated Financial Statements. ITEM 8

ITEM 8 INDEX TO CONSOLIDATED FINANCIAL STATEMENTS AND SUPPLEMENTAL DATA INDEPENDENT AUDITORS' REPORT TO THE BOARD OF DIRECTORS AND STOCKHOLDERS OF THE DELTONA CORPORATION: We have audited the consolidated balance sheets of The Deltona Corporation and subsidiaries (the "Company") as of December 31, 1993 and December 25, 1992 and the related statements of consolidated operations, consolidated stockholders' equity (deficiency) and consolidated cash flows for each of the three years in the period ended December 31, 1993. These consolidated financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free from material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, such consolidated financial statements referred to above present fairly, in all material respects, the financial position of the Company at December 31, 1993 and December 25, 1992 and the results of its operations and its cash flows for each of the three years in the period ended December 31, 1993 in conformity with generally accepted accounting principles. The accompanying consolidated financial statements have been prepared assuming the Company will continue as a going concern. As discussed in Note 1 to the consolidated financial statements, the Company incurred substantial operating losses during 1993, 1992 and 1991, has continued to experience severe liquidity crises, causing the Company to be unable to meet certain contractual obligations, in some cases resulting in litigation that may have a substantial impact on the Company, and has a stockholders' deficiency at December 31, 1993. These matters raise substantial doubt about the Company's ability to continue as a going concern. Management's plans concerning these matters are described in Note 1. The consolidated financial statements do not include any adjustments that might result from the outcome of this uncertainty. DELOITTE & TOUCHE LLP Certified Public Accountants Miami, Florida September 5, 1994 CONSOLIDATED BALANCE SHEETS THE DELTONA CORPORATION AND SUBSIDIARIES ASSETS (IN THOUSANDS) The accompanying notes are an integral part of the consolidated financial statements. CONSOLIDATED BALANCE SHEETS THE DELTONA CORPORATION AND SUBSIDIARIES LIABILITIES AND STOCKHOLDERS' EQUITY (DEFICIENCY) (IN THOUSANDS EXCEPT SHARE DATA) The accompanying notes are an integral part of the consolidated financial statements. STATEMENTS OF CONSOLIDATED OPERATIONS THE DELTONA CORPORATION AND SUBSIDIARIES (IN THOUSANDS EXCEPT SHARE DATA) The accompanying notes are an integral part of the consolidated financial statements. STATEMENTS OF CONSOLIDATED STOCKHOLDERS' EQUITY (DEFICIENCY) THE DELTONA CORPORATION AND SUBSIDIARIES (IN THOUSANDS) FOR THE YEARS ENDED DECEMBER 31, 1993, DECEMBER 25, 1992 AND DECEMBER 27, 1991 The accompanying notes are an integral part of the consolidated financial statements. STATEMENTS OF CONSOLIDATED CASH FLOWS THE DELTONA CORPORATION AND SUBSIDIARIES (IN THOUSANDS) The accompanying notes are an integral part of the consolidated financial statements. STATEMENTS OF CONSOLIDATED CASH FLOWS - (CONTINUED) THE DELTONA CORPORATION AND SUBSIDIARIES (IN THOUSANDS) RECONCILIATION OF NET INCOME (LOSS) TO NET CASH PROVIDED BY (USED IN) OPERATING ACTIVITIES: The accompanying notes are an integral part of the consolidated financial statements. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS THE DELTONA CORPORATION AND SUBSIDIARIES 1. BASIS OF PRESENTATION AND SIGNIFICANT ACCOUNTING POLICIES BASIS OF PRESENTATION - GOING CONCERN The accompanying financial statements of The Deltona Corporation and subsidiaries (the "Company") have been prepared on a going concern basis, which contemplates the realization of assets and satisfaction of liabilities in the normal course of business. During 1990, as a result of adverse publicity surrounding the Florida real estate industry, the Company could not complete the sale of $7,000,000 of contracts receivable. This created a severe liquidity crisis for the Company. The liquidity crisis was further impacted by declining sales and increasing delinquencies in the Company's contracts receivable portfolio caused by such adverse publicity and the national economic slowdown which was particularly severe in the real estate industry. These factors caused the Company to incur a loss from operations of $19,529,000 during 1991, to default on its bank debt and to defer development work at its communities. As a result of its 1991 loss, the Company had a stockholders' deficiency of $13,169,000 for the year ended December 27, 1991. Although the Company reported net income of $7,336,000 for 1992, primarily due to extraordinary gains of $10,161,000 from debt restructuring and $3,983,000 from a settlement related to the Marco refund obligation, such that it was able to reduce the stockholders' deficiency to $5,519,000 as of December 25, 1992, the Company incurred a loss from operations for 1992 of $6,808,000 and for 1993 of $8,772,000, resulting in a stockholders' deficiency of $14,291,000 as of December 31, 1993. The Company has continued to experience liquidity problems, causing it to be unable to fully implement its marketing program and to meet certain contractual obligations, primarily relating to the repayment of debt and the completion of improvements. The Company must obtain additional financing to accomplish the objectives of satisfying or substantially reducing its current debt obligations and provide the financial stability that will allow the Company to accomplish the objectives of a successful business plan. These matters raise substantial doubt about the Company's ability to continue as a going concern. Following the completion of the restructuring of its bank debt in 1992 (see Note 5), the Company commenced the implementation of its business plan by undertaking a new marketing program which included the Company's re-entry into the single-family housing business. To accomplish the objectives of its business plan required the Company to obtain financing during 1993 and will require the Company to obtain additional financing in 1994 and 1995. The transactions described in Note 5 with Selex International B.V., a Netherlands corporation ("Selex"), Yasawa Holding, N.V., a Netherlands Antilles corporation ("Yasawa"), and their affiliates provided the Company with a portion of its financing requirements enabling the Company to commence implementation of the marketing program and attempt to accomplish the objectives of its business plan, but additional financing will be required in 1994 and 1995. Selex, Yasawa and their affiliates are uncertain as to whether they will provide any further funds to the Company. While the Company, together with Selex, Yasawa and their affiliates, is seeking third parties to provide financing for the Company and, as part of any such transaction, Selex, Yasawa and their affiliates have indicated their willingness to sell or restructure all or a portion of their loans and Common Stock in the Company, such financing has not yet become available. As a consequence of its liquidity position, the Company has defaulted on certain obligations, including its escrow account obligations to the State of Florida, Department of Business Regulation, Division of Land Sales, Condominiums and Mobile Homes (the "Division") pursuant to the Company's 1992 Consent Order with the Division (the "1992 Consent Order"), its obligation under its lease for its corporate offices, its obligation to pay certain real estate taxes, and its obligation to make required interest payments under loans from Selex, Yasawa and their affiliates. Additionally, the Company is subject to certain pending litigation by former employees and NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED) THE DELTONA CORPORATION AND SUBSIDIARIES 1. BASIS OF PRESENTATION AND SIGNIFICANT ACCOUNTING POLICIES - (CONTINUED) others, which may adversely affect the financial condition of the Company (See Note 5 and 8). There can be no assurance that the Company will be able to timely secure the necessary financing to resolve its present liquidity situation, that the pending litigation will be favorably concluded, or that a new business plan will be successfully implemented. Consequently, there can be no assurance that the Company can continue as a going concern. In the event that these matters are not successfully addressed, the Company's Board of Directors will consider other appropriate action given the severity of the Company's liquidity position, including, but not limited to, filing for protection under the federal bankruptcy laws. Alternatively, the Company could be subject to the filing of an involuntary bankruptcy proceeding in the event it is unable to resolve and settle pending litigation, satisfy settlement commitments and other unpaid creditor claims. See "Legal Proceedings", "Management's Discussion and Analysis of Financial Condition and Results of Operations" and Notes 5 and 8 to Consolidated Financial Statements. The consolidated financial statements do not include any adjustments relating to the recoverability of asset amounts or the amounts of liabilities should the Company be unable to continue as a going concern. Significant Accounting Policies The Company's consolidated financial statements are prepared in accordance with generally accepted accounting principles. Material intercompany accounts and transactions are eliminated. Since 1986, the Company has used a 52-53 week fiscal year ending on the last Friday of the year. The year ended December 31, 1993 contained 53 weeks, and the years ended December 25, 1992 and December 27, 1991 contained 52 weeks. Commencing in 1994, the Company will return to a fiscal year ended December 31. The Company sells homesites under installment contracts which provide for payments over periods ranging from 2 to 10 years. Sales of homesites are recorded under the percentage-of-completion method in accordance with Statement of Financial Accounting Standards No. 66, "Accounting for Sales of Real Estate" ("FASB No. 66"). Since 1991, the Company has not recognized a sale until it has received 20% of the contract sales price. Because of the severe liquidity crisis faced by the Company as discussed above, the Company ceased development work late in the third quarter of 1990. From September 29, 1990 through the fourth quarter of 1991, all sales of undeveloped lots were accounted for using the deposit method. Since the fourth quarter of 1991 and in compliance with the 1992 Consent Order, the Company has been offering only developed lots for sale (see Note 8). At the time of recording a sale the Company records an allowance for the estimated cost to cancel the related contracts receivable through a charge to the provision for uncollectible sales. The amount of this provision and the adequacy of the allowance is determined by the Company's continuing evaluation of the portfolio and past cancellation experience. While the Company uses the best information available to make such evaluations, future adjustments to the allowance may be necessary as a result of future national and international economic and other conditions that may be beyond the Company's control. Changes in the Company's estimate of the allowance for previously recognized sales will be reported in earnings in the period in which they become NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(CONTINUED) THE DELTONA CORPORATION AND SUBSIDIARIES 1. BASIS OF PRESENTATION AND SIGNIFICANT ACCOUNTING POLICIES-(CONTINUED) estimable and are charged to the provision for uncollectible contracts. Land improvement costs are allocated to individual homesites based upon the relationship that the homesite's sales price bears to the total sales price of all homesites in the community. The estimated costs of improving homesites are based upon independent engineering estimates made in accordance with sound cost estimation and provide for anticipated cost-inflation factors. The estimates are systematically reviewed. When cost estimates are revised, the percentage relationship they bear to deferred revenues is recalculated on a cumulative basis to determine future income recognition as performance takes place. Bulk land sales are recorded and profit is recognized in accordance with FASB No. 66. Bulk land sales of approximately $113,000, $226,000 and $101,000 are included in gross land sales for the years ended December 31, 1993, December 25, 1992 and December 27, 1991, respectively. Sales of houses and vacation ownership units, as well as all related costs and expenses, are recorded at the time of closing. Interest costs directly related to, and incurred during, a project's construction period are capitalized. Such capitalized interest amounted to $164,000, $100,000 and $-0- for the years ended December 31, 1993, December 25, 1992 and December 27, 1991, respectively. Property, plant and equipment is stated at cost. Depreciation is provided by the straight-line method over the estimated useful lives of the respective assets. Additions and betterments are capitalized, and maintenance and repairs are charged to income as incurred. Generally, upon the sale or retirement of assets, the accounts are relieved of the costs and related accumulated depreciation and any gain or loss is reflected in income. When property exchanges and refund transactions are consummated under the Company's Marco Island-Marco Shores customer programs (see Note 9), any resulting loss is charged to the allowance for Marco permit costs. When property exchanges and refund transactions are consummated under the Consent Order (see Note 8), any resulting loss is charged against the allowance included in accrued expenses and other. The Company accrues interest on its refund obligations in accordance with the various customer refund programs. For the purposes of the statements of cash flows, the Company considers its investments, which are comprised of short term, highly liquid investments purchased with a maturity of three months or less, to be cash equivalents. Certain amounts in the 1991 and 1992 financial statements have been reclassified for comparative purposes to the 1993 presentation. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(CONTINUED) THE DELTONA CORPORATION AND SUBSIDIARIES 2. CONTRACTS AND MORTGAGES RECEIVABLE At December 31, 1993, interest rates on contracts receivable outstanding ranged from 6.0% to 12.0% per annum (weighted average approximately 8.4%). The approximate principal maturities of contracts receivable (including $65,000 restricted for use in the Marco refund program, see Note 9) were: DECEMBER 31, -------------- (IN THOUSANDS) 1994........................................................... $ 942 1995........................................................... 1,011 1996........................................................... 1,077 1997........................................................... 1,125 1998........................................................... 1,156 1999 and thereafter............................................ 2,570 ------- Total.................................................. $ 7,881 ======= If a regularly scheduled payment on a contract remains unpaid 30 days after its due date, the contract is considered delinquent. Aggregate delinquent contracts receivable at December 31, 1993 and December 25, 1992 approximate $1,717,000 and $2,104,000, respectively. Information with respect to interest rates and average contract lives used in valuing new contracts receivable generated from sales follows: AVERAGE AVERAGE STATED DISCOUNTED YEARS ENDED TERM INTEREST RATE TO YIELD ----------- ---------- -------------- ---------- December 31, 1993.................... 98 months 7.8% 13.5% December 25, 1992.................... 111 months 8.4% 13.5% December 27, 1991.................... 108 months 7.8% 13.5% In March, 1993 the Company transferred $1,600,000 of contracts and mortgages receivable, generating approximately $1,059,000 in proceeds to the Company, which was used for working capital, and the creation of a holdback account in the amount of $150,000. As of December 31, 1993, the balance of the holdback account was $126,000. In December, 1992 the Company sold $10,800,000 of contracts and mortgages receivable to an affiliate of Yasawa at face value, applying the proceeds therefrom to reduce the debt under the Sixth Amended and Restated Credit and Security Agreement (the "Sixth Restatement") which had been acquired by Yasawa (see Note 5). In June, 1992, the Company completed a $13,500,000 sale of contracts and mortgages receivable which generated approximately $8,000,000 in net proceeds to the Company and the creation of a holdback account in the amount of $3,100,000. The anticipated costs of this transaction were included in the extraordinary loss from debt restructuring for 1991 since the restructuring was dependent on the sale. In conjunction with this sale, the February, 1990 sale described below and certain prior sales of receivables, the Company granted the purchaser a security interest in certain additional contracts and mortgages receivable of approximately $2,700,000 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(CONTINUED) THE DELTONA CORPORATION AND SUBSIDIARIES 2. CONTRACTS AND MORTGAGES RECEIVABLE - (CONTINUED) and conveyed all of its rights, title and interest in the property underlying such contracts to a collateral trustee. Upon compliance with the conditions of the agreement with the purchaser, funds from the holdback account and property held by the collateral trustee will be released to the Company. The Company sold approximately $17,000,000 of contracts and mortgages receivable in February, 1990. Net proceeds from the sale were approximately $13,900,000 (see Note 8). The Company recorded a loss of $600,000 on the 1990 sale (see Note 12). This transaction, as well as the June, 1992 sale described above, among other things, requires that the Company replace or repurchase any receivable that becomes 90 days delinquent upon the request of the purchaser. Such requirement can be satisfied from contracts in which the purchaser holds a security interest (approximately $1,419,000 as of December 31, 1993). Since the sale of receivables in 1992, the Company has been in compliance with the requirements of its prior receivables transactions and believes that it has established adequate reserves in the event such replacement or repurchase becomes necessary. The Company was unable, however, to replace or repurchase approximately $1,946,000 of delinquent contracts in 1993, which amount was deducted from the deposit held by the purchaser of the receivables as security. The Company was the guarantor of approximately $29,265,000 of contracts receivable sold or transferred as of December 31, 1993 and had $1,992,000 on deposit with the purchasers of the receivables as security to assure collectibility as of such date. The Company has been in compliance with all receivable transactions since the consummation sales. On July 24, 1991, the Company assigned mortgages receivable, including accrued interest and payments collected thereon from December 1990 through July 1991, of approximately $6,400,000, to its principal lending banks to be applied to reduce its outstanding bank debt (see Note 5). At December 31, 1993, mortgages receivable were collectible over periods ranging from one to seven years at stated interest rates of 7% to 10%. Principal maturities (including approximately $619,000 restricted for use in the Marco refund program, see Note 9) were approximately: DECEMBER 31, -------------- (IN THOUSANDS) 1994......................................................... $ 1,139 1995......................................................... 5 1996......................................................... 4 1997......................................................... 3 1998......................................................... 3 1999 and thereafter.......................................... 8 ------- Total (included in mortgages and other receivables)...... $ 1,162 ======= NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(CONTINUED) THE DELTONA CORPORATION AND SUBSIDIARIES 3. INVENTORIES Information with respect to the classification of inventory of land and improvements including land held for sale or transfer is as follows: DECEMBER 31, DECEMBER 25, 1993 1992 ------------ ------------ (IN THOUSANDS) Unimproved land...................................... $ 444 $ 444 Land in various stages of development................ 4,888 7,168 Fully improved land.................................. 7,111 4,806 -------- -------- Total.................................... $ 12,443 $ 12,418 ======== ======== Land and land improvements include approximately $202,000 and $406,000 of land placed in the Marco Island and Marco Shores trusts for the Marco refund program as of December 31, 1993 and December 25, 1992, respectively (see Note 9). Other inventories consists primarily of multi-family units completed, as well as approximately $900,000 in 1992 of land assets previously classified as being held for sale or transfer to lenders. Land held for sale or transfer to lenders consists of land and land assets which were transferred to the Company's lenders or sold by the Company with proceeds therefrom used in repayment of outstanding debt (see Note 5). 4. PROPERTY, PLANT AND EQUIPMENT Property, plant and equipment and accumulated depreciation consist of the following: DECEMBER 31, 1993 DECEMBER 25, 1992 --------------------- ---------------------- ACCUMULATED ACCUMULATED COST DEPRECIATION COST DEPRECIATION ------ ------------ ------ ------------ (IN THOUSANDS) Land and land improvements...... $ 143 $ - $ 157 $ - Other buildings, improvements and furnishings.............. 1,954 1,250 2,223 1,414 Construction and other equipment.............. 1,661 1,543 1,654 1,496 Construction work in progress... 43 - 34 - ------- ------- ------- ------- Total...................... $ 3,801 $ 2,793 $ 4,068 $ 2,910 ======= ======= ======= ======= NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(CONTINUED) THE DELTONA CORPORATION AND SUBSIDIARIES 4. PROPERTY, PLANT AND EQUIPMENT - (CONTINUED) Depreciation charged to operations for the years ended December 31, 1993, December 25, 1992 and December 27, 1991 was approximately $104,000, $175,000 and $292,000, respectively. 5. MORTGAGES AND SIMILAR DEBT Indebtedness under various purchase money mortgages and loan agreements is collateralized by substantially all of the Company's assets, including stock of certain wholly-owned subsidiaries. The following table presents information with respect to mortgages and similar debt (in thousands): DECEMBER 31, DECEMBER 25, 1993 1992 ------------ ------------ Mortgage Notes Payable ........................ $ 13,284 $ 8,165 Other Loans.................................... 2,500 1,000 -------- -------- Total Mortgages and Similar Debt....... $ 15,784 $ 9,165 ======== ======== Included in Mortgage Notes Payable is the $3,000,000 First Selex Loan ($1,860,000 as of August 31, 1994), the $1,000,000 Second Selex Loan ($967,000 as of August 31, 1994) the $4,384,000 Third Selex Loan and the $4,900,000 Yasawa Loan ($4,765,000 as of August 31, 1994). Other loans include the $1,000,000 Empire note and the $1,500,000 Scafholding Loan. These mortgage notes payable and other loans are in default as of August 31, 1994 due to the non-payment of interest and principal. The lenders have not taken any action as a result of these defaults. On June 19, 1992, the Company completed a transaction with Selex whereby, among other things, Selex loaned the Company $3,000,000 (the "First Selex Loan"). The First Selex Loan is collateralized by a first mortgage on certain of the Company's property in its St. Augustine Shores, Florida community. The Loan matures on June 15, 1996 and provides for principal to be repaid at 50% of the net proceeds per lot for lots requiring release from the mortgage, with the entire unpaid balance becoming due and payable at the end of the four year term. It initially bears interest at the rate of 10% per annum, with payment of interest deferred for the initial eighteen months of the Loan and interest payments due quarterly thereafter. As discussed in Note 10, Selex was granted an Option to convert the First Selex Loan, or any portion thereof, into up to 600,000 shares of the Company's Common Stock. On February 17, 1994, principal in the amount of $1,140,000 was repaid under the First Selex Loan when Selex exercised such Option at a conversion price of $1.90 per share. Accrued interest in the amount of $604,300 (including $463,600 due December 31, 1993) was unpaid and in default under the First Selex Loan as of August 31, 1994. The Company had defaulted on its bank debt in the third quarter of 1990, and was engaged in negotiating the repayment and restructuring of such debt through 1991 and the first half of 1992. As of December 27, 1991, the Company's bank debt had been reduced by the assignment of mortgages receivables and, on October 11, 1991, the transfer of certain properties to its principal lending banks pursuant to a Conveyance Agreement with such lenders. The Conveyance Agreement not only provided for the partial repayment of the bank debt, but also encompassed an agreement in principle providing for the restructuring and repayment of the remaining bank debt. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(CONTINUED) THE DELTONA CORPORATION AND SUBSIDIARIES 5. MORTGAGES AND SIMILAR DEBT - (CONTINUED) On June 18, 1992, the Company completed the restructuring of its bank debt by entering into the Sixth Amended and Restated Credit and Security Agreement (the "Sixth Restatement") with its lenders. The terms of the Sixth Restatement provided for the Company's remaining debt in the principal amount of approximately $25,300,000 to be repaid by June 30, 1997, with specified interim repayments and benchmarks to be achieved. Among other things, the Sixth Restatement provided for: (i) interest to accrue on the remaining debt at Citibank's alternate base rate ("ABR") plus 4% per annum, subject to a minimum interest rate of 11% per annum and a maximum interest rate of 14% per annum, with no interest payments due until June 30, 1996; (ii) accrued, but unpaid interest on $10,000,000 of the restructured debt to be forgiven provided that the principal balance outstanding on the restructured debt as of June 30, 1996 was less than $9,000,000; and (iii) the issuance to the lenders of warrants to acquire up to 277,387 shares of the Company's Common Stock at a price of $1.00 per share. In conjunction with the completion of the Sixth Restatement, the lenders released or subordinated their lien on certain assets of the Company, to enable the Company to complete the First Selex Loan, to complete the $13,500,000 sale of contracts receivable described below, to enter into the 1992 Consent Order with the Division, and to secure working capital needed to pay real estate taxes which were, at the time, delinquent and meet its customer obligations for improvement work at certain of the Company's communities. During the third quarter of 1992, the lenders also released their lien on certain other contracts receivable to allow the Company to complete a sale of such receivables, which generated $600,000 in proceeds. These proceeds were, in turn, paid to the lenders, with the lenders allowing the Company $1,000,000 in debt reduction credit, and resulting in an extraordinary gain of $400,000. During the 1991 second quarter, the Company incurred extraordinary expenses of $3,500,000 for debt restructuring, based upon the transfer value of the assets involved in the first phase of its debt restructuring. During the fourth quarter of 1991, the Company provided for an additional $3,600,000 of extraordinary expenses for debt restructuring based upon the Company's assessment of the ultimate costs that would result from the restructuring of its debt pursuant to the Sixth Restatement. The fourth quarter addition included the anticipated professional fees, bank charges and other costs related to the Sixth Restatement, as well as the loss on the sale of contracts receivable discussed below. The completion of the Sixth Restatement was dependent upon the completion of the sale of contracts receivable; therefore, the loss on such sale was included as an extraordinary item. On December 2, 1992 the Company entered into various agreements relating to certain of its assets and the restructuring of its debt with Yasawa. The consummation of these agreements was conditioned upon the acquisition by Mr. Gram of the bank debt under the Sixth Restatement as described above. On December 4, 1992, Gram acquired the Bank Loan of approximately $25,150,000 (including interest and fees) for a price of $10,750,000, as well as the warrants which the lenders held. Immediately thereafter, Gram transferred all of his interest in the Bank Loan, including the warrants, to Yasawa. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(CONTINUED) THE DELTONA CORPORATION AND SUBSIDIARIES 5. MORTGAGES AND SIMILAR DEBT - (CONTINUED) On December 11, 1992, the Company consummated the December 2, 1992 agreements with Yasawa. Under these agreements, Yasawa, its affiliates and the Company agreed as follows: (i) the Company sold certain property at its Citrus Springs community to an affiliate of Yasawa in exchange for approximately $6,500,000 of debt reduction credit; (ii) an affiliate of Yasawa and the Company entered into a joint venture agreement with respect to the Citrus Springs property, providing for the Company to market such property and receive an administration fee from the venture (in March, 1994, the Company and the affiliate agreed to terminate the venture); (iii) the Company sold certain contracts receivable at face value to an affiliate of Yasawa for debt reduction credit of approximately $10,800,000; (iv) the Company sold the Marco Shores Country Club and Golf Course to an affiliate of Yasawa for an aggregate sales price of $5,500,000, with the affiliate assuming an existing first mortgage of approximately $1,100,000 and the Company receiving debt reduction credit of $2,400,000, such that the Company obtained cash proceeds from this transaction of $2,000,000, which amount was used for working capital; (v) an affiliate of Yasawa agreed to lease the Marco Shores Country Club and Golf Course to the Company for a period of approximately one year; (vi) an affiliate of Yasawa and the Company agreed to amend the terms of the warrants to increase the number of shares issuable upon their exercise from 277,387 shares to 289,637 shares and to adjust the exercise price to an aggregate of approximately $314,000; (vii) Yasawa exercised the warrants in exchange for debt reduction credit of approximately $314,000; (viii) Yasawa released certain collateral held for the bank loan; (ix) an affiliate of Yasawa agreed to make an additional loan of up to $1,500,000 to the Company, thus providing the Company with a future line of credit (all of which was drawn and outstanding as of August 31, 1994); and (x) Yasawa agreed to restructure the payment terms of the remaining $5,106,000 of the bank loan as a loan from Yasawa (the "Yasawa Loan"). The Yasawa Loan bears interest at the rate of 11% per annum, with payment of interest deferred until December 31, 1993, at which time only accrued interest became payable. Commencing January 31, 1994, principal and interest became payable monthly, with all unpaid principal and accrued interest being due and payable on December 31, 1997. A portion of the proceeds from a March, 1993 sale of contracts receivable was applied to reduce the Yasawa Loan to $4,900,000 during the first quarter of 1993 and the assignment of a mortgage receivable to Yasawa reduced the Yasawa Loan to $4,771,000 as of February 17, 1994. Accrued interest due under the Yasawa Loan in the amount of $355,200 was unpaid and in default as of August 31, 1994. In February, 1994, Yasawa loaned the Company an additional amount of $437,500 at an interest rate of 8% per annum (the "Second Yasawa Loan"). As of August 31, 1994 a total of $1,200,000 had been advanced under this loan. On April 30, 1993 Selex loaned the Company an additional $1,000,000 collateralized by a first mortgage on certain of the Company's property in its Marion Oaks, Florida community (the "Second Selex Loan"). The Second Selex Loan bears interest at 11% per annum, with interest deferred until December 31, 1993. The Second Selex Loan provides for principal to be repaid at $3,000 per lot for lots requiring release from the mortgage, with the entire unpaid principal balance and interest accruing from January 1, 1994 to April 30, 1994 to be due and payable on April 30, 1994. Although Selex had certain conversion rights under the Second Selex Loan in the event the Company sold any Common Stock or Preferred Stock prior to payment in full of all NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(CONTINUED) THE DELTONA CORPORATION AND SUBSIDIARIES 5. MORTGAGES AND SIMILAR DEBT - (CONTINUED) amounts due to Selex under the Second Selex Loan, such rights were voided as of December 31, 1993 since the regulations set forth in proposed Treasury Decision CO-18-90 relative to Section 382 of the Internal Revenue Code were not adopted by such date. As of August 31, 1994, $33,000 in principal had been repaid under the Second Selex Loan. Accrued interest of $93,300 due under the Loan as of August 31, 1993 remained unpaid and in default. From July 9, 1993 through December 31, 1993, Selex loaned the Company an additional $4,400,000 collateralized by a second mortgage on certain of the Company's property on which Selex and/or Yasawa hold a first mortgage pursuant to a Loan Agreement dated July 14, 1993 and amendments thereto (the "Third Selex Loan"). The Third Selex Loan bears interest at 11% per annum, with interest deferred until December 31, 1993. Principal is to be repaid at $3,000 per lot for lots requiring release from the mortgage, with the entire unpaid principal balance and interest accruing from January 1, 1994 to April 30, 1994 becoming due and payable on April 30, 1994. As of August 31, 1994 accrued interest of $466,800 due under the Third Selex Loan was unpaid and in default. Interest due to Selex, Yasawa and their affiliates in the aggregate amount of $2,300,000 remained unpaid and in default as of August 31, 1994. From January 1, 1994 through August 31, 1994, $24,000 in principal was repaid under the Second Selex Loan and $1,140,000 in principal was repaid under the First Selex Loan through the exercise of the above described Option. After giving effect to such repayments of principal, the Company had loans outstanding from Selex, Yasawa and their affiliates on August 31, 1994 in the amount of approximately $17,976,000 including interest, of which approximately $9,867,000 is owed to Selex, (10% per annum on the First Selex Loan, 11% per annum on the Second and Third Selex Loans and 12% per annum on the $1,000,000 Empire Note assigned to Selex); approximately $6,349,000 is owed to Yasawa, including accrued and unpaid interest of approximately $384,500 (11% per annum on the Yasawa Loan and 8% per annum on the Second Yasawa Loan); and approximately $1,759,000 is owed to an affiliate of Yasawa, including accrued and unpaid interest of approximately $259,500 (12% per annum). The loans from Selex, Yasawa and their affiliates are secured by substantially all of the assets of the Company. 6. INCOME TAXES Because the Company incurred a net loss for 1991 and is in a carryforward position for both book and tax purposes for such year, no tax provision was recorded for 1991. Since the Company had income before consideration of any net operating loss carryforwards for book purposes for 1992, deferred taxes were provided for alternative minimum tax. The deferred provision for 1992 for alternative minimum tax resulted from the enactment of the alternative minimum tax provisions under the Tax Reform Act of 1986. Under these federal income tax provisions, a corporation may offset only 90% of its alternative minimum taxable income with net operating loss carryovers. Prior to December 26, 1992, the Company accounted for income taxes in accordance with Accounting Principles Board Opinion No. 11. Effective December 26, 1992, the Company adopted Statement of Accounting Standard No. 109 "Accounting for Income Taxes." There was no effect from the adoption of this standard. Under this standard deferred income assets and liabilities are computed annually for the difference between financial statements and the tax bases of assets and liabilities that will result in taxable or deductible amounts in the future bases on enacted tax laws and rates applicable to periods in which the differences are expected to affect taxable NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(CONTINUED) THE DELTONA CORPORATION AND SUBSIDIARIES 6. INCOME TAXES - (CONTINUED) income. Income tax expense is the tax payable or refundable for the period plus or minus the change during the period in deferred assets and liabilities. For the year ended December 31, 1993, the Company had a net loss for tax purposes and, as a result, there was no tax payable or refundable and there was no change in the net deferred tax asset. Accordingly, there was no tax provision for the year ended December 31, 1993. As of December 31, 1993, the Company had a net deferred tax asset of approximately $25,564,000 which primarily resulted from the tax effect of the Company's net operating loss carryforward of $21,719,000 and losses on subsidiaries sold in prior years of $3,944,000. A valuation allowance of $25,564,000 has been established against the net deferred tax asset. The Company's regular net operating loss carryover for tax purposes is estimated to be $51,813,000 at December 31, 1993, of which $6,555,000 will be available through 1995, $4,733,000 through 1996, $11,022,000 through 1997, $364,000 through 2002, $9,189,000 through 2003, $9,780,000 through 2006, and the remainder through 2007. In addition to the net operating loss carryover, investment tax credit carryovers of approximately $259,000, which expire from 1994 through 2001, are available to reduce federal income tax liabilities only after the net operating loss carryovers have been utilized. The utilization of the Company's net operating loss and tax credit carryforwards would be impaired or reduced under certain circumstances, pursuant to changes in the federal income tax laws effected by the Tax Reform Act of 1986. Events which affect these carryforwards include, but are not limited to, cumulative stock ownership changes of 50% or more over a three-year period, as defined, and the timing of the utilization of the tax benefit carryforwards. 7. LIABILITY FOR IMPROVEMENTS The Company has an obligation to complete land improvements upon deeding which, depending on contractual provisions, typically occurs within 90 to 120 days after the completion of payments by the customer. The estimated cost to complete improvements to lots and tracts at December 31, 1993 and December 25, 1992 was approximately $18,574,000 and $24,600,000 (as adjusted for the 1992 Consent Order), respectively. The foregoing estimates reflect the Company's current development plans at its communities (see Note 8). These estimates include estimated development obligations applicable to sold lots of approximately $2,825,000 and $10,700,000, respectively, a liability to provide title insurance, costing $951,000 and $900,000, respectively, and an estimated cost of street maintenance, prior to assumption of such obligations by local governments, of $3,852,000 and $2,800,000, respectively, all of which are included in deferred revenue. Included in cash at December 31, 1993 and December 25, 1992, are escrow deposits of $1,664,000 and $4,998,000, respectively, restricted for completion of improvements in certain of the Company's communities. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(CONTINUED) THE DELTONA CORPORATION AND SUBSIDIARIES 7. LIABILITY FOR IMPROVEMENTS - (CONTINUED) The anticipated expenditures for land improvements to complete areas from which sales have been made through December 31, 1993 are as follows: DECEMBER 31, 1993 ----------------- (In Thousands) 1994.......................................... $ 1,000 1995.......................................... 5,200 1996.......................................... 5,200 1997.......................................... 5,200 1998.......................................... 1,974 ------- Total..................................... $18,574 ======= 8. COMMITMENTS AND CONTINGENT LIABILITIES Total rental expense for the years ended December 31, 1993, December 25, 1992 and December 27, 1991 was approximately $808,000, $1,164,000 and $1,684,000, respectively. Following is a schedule of future minimum rental payments required under operating leases that have initial or remaining noncancellable lease terms in excess of one year: DECEMBER 31, 1993 ----------------------------------- TOTAL REAL ESTATE EQUIPMENT ----- ----------- --------- (IN THOUSANDS) 1994.................... $ 982 $ 916 $ 66 1995.................... 1,305 1,236 69 1996.................... 1,258 1,227 31 1997.................... 1,276 1,276 - 1998.................... 322 322 - 1999 and thereafter..... - - - ------ ------ ---- Total............... $5,143 $4,977 $166 ====== ====== ==== The above commitments are not a forecast of future rental expenses and may not necessarily be the amount payable in the event of default and do not encompass the terms of the proposed settlement of the corporate office lease (see discussion below). During 1983 the Company entered into a sale-leaseback agreement on its executive office building. Included in the above schedule in the real estate category is approximately $5,860,000 in future minimum rental payments to be paid over the term of the lease which expires March 31, 1998. The profit on this agreement is included in deferred revenue and is being amortized as a reduction in rent expense over the term of the lease. At December 31, 1993 and December 25, 1992, $1,205,000 and $1,544,000, respectively, of the profit remained in deferred revenue. Following the consummation of the Sixth Restatement, the Company conveyed certain properties to the landlord in satisfaction of its outstanding lease obligations for its executive office building in Miami, Florida. The Company also entered into a modification of its lease agreement, providing for a reduction of its rental expenses through June 30, 1994, at which time the Company would have the option of acquiring the leased premises or NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(CONTINUED) THE DELTONA CORPORATION AND SUBSIDIARIES 8. COMMITMENTS AND CONTINGENT LIABILITIES - (CONTINUED) reinstating the lease according to its original terms. Should the landlord sell the leased premises to a third party at any time that the lease, or any modification thereof, is in effect, then the lease with the Company would be cancelled. In the action styled FIVE POINTS LIMITED V. THE DELTONA CORPORATION, Case No. 93-22877, filed in the Circuit Court for Dade County, Florida and served upon the Company on December 8, 1993, the plaintiff is seeking damages against the Company for an alleged breach of the lease for its office building. The complaint alleges that the Company has defaulted in its obligation to make payments under the lease and seeks damages in excess of $272,000 for additional past due rent, plus damages for acceleration of lease payments in excess of $4,000,000. On February 17, 1994 the Court entered an Order requiring the Company to pay uncontested back rent of approximately $240,000, plus uncontested monthly rents of approximately $48,000, commencing on March 1, 1994. As of August 31, 1994, the Company had paid approximately $41,500 to the Court under this Order. The plaintiff has obtained judgments in the amount of $647,000 as of August 31, 1994. These judgments have been recorded in certain of the Company's communities. On September 1, 1994 the Company entered into a Settlement Agreement with plaintiff to be consummated on or before October 17, 1994. New financing is essential for the Company to fund the settlement agreement. Failure to fund this agreement will result in continued litigation and a likely substantial judgment against the Company. As part of the settlement agreement, the Company will be evicted from the premises and must vacate its occupancy by January 6, 1995. Homesite sales contracts provide for the return of all monies paid in (including paid-in interest) should the Company be unable to meet its contractual obligations after the use of reasonable diligence. If a refund is made, the Company will recover the related homesite and any improvement thereto. The aggregate amount of all monies paid in (including paid-in interest) on all homesite contracts having outstanding contractual obligations (primarily to complete improvements) at December 31, 1993 was approximately $11,422,000. As a result of the delays in completing the land improvements to certain property sold in certain of its Central and North Florida communities, the Company fell behind in meeting its contractual obligations to its customers. In connection with these delays, the Company, in February, 1980, entered into a Consent Order with the Division which provided a program for notifying affected customers. The Consent Order, which was restated and amended, provided a program for notifying affected customers of the anticipated delays in the completion of improvements (or, in the case of purchasers of unbuildable lots in certain areas of the Company's Sunny Hills community, the transfer of development obligations to core growth areas of the community); various options which may be selected by affected purchasers; a schedule for completing certain improvements; and a deferral of the obligation to install water mains until requested by the purchaser. Under an agreement with Topeka, Topeka's utility companies have agreed to furnish utility service to the future residents of the Company's communities on substantially the same basis as such services were provided by the Company. The Consent Order also required the establishment of an improvement escrow account as assurance for completing such improvement obligations. In June, 1992, the Company entered into the 1992 Consent Order with the Division, which replaced and superseded the original Consent Order, as amended and restated. Among other things, the 1992 Consent Order consolidated the Company's development obligations and provided for a reduction in its required monthly escrow obligation to $175,000 from September, 1992 through December, 1993. Beginning January, 1994 and until development is completed or the 1992 Consent Order is amended, the Company is required to deposit $430,000 per month into the escrow account. To meet its current escrow and development obligations under the 1992 Consent Order, the Company is required to deposit into escrow $5,160,000 in 1994 and $3,519,000 in 1995. As part of the assurance program under the 1992 Consent Order, the Company and its lenders granted the Division a lien on certain contracts receivable (approximately $8,915,000 as of December 31, 1993) and future receivables. As previously stated, the Company is in default of its escrow obligations, and in NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(CONTINUED) THE DELTONA CORPORATION AND SUBSIDIARIES 8. COMMITMENTS AND CONTINGENT LIABILITIES - (CONTINUED) accordance with the 1992 Consent Order, the collections on such receivables have been escrowed for the benefit of purchasers since March 1, 1994. At December 31, 1993, the liability to complete improvements to fully paid-for lots was approximately $774,000. Pursuant to the 1992 Consent Order, the Company has limited the sale of single-family lots to lots which front on a paved street and are ready for immediate building. Because of the Company's default, the Division could also exercise other available remedies under the 1992 Consent Order, which remedies entitle the Division, among other things, to halt all sales of registered property. Based upon the Company's experience with affected customers, the Company believes that the total refunds arising from delays in completing such improvements will not materially exceed the amount provided for in the consolidated financial statements. Approximately $64,000 and $133,300 of the provision for the total refunds relating to the delays of improvements remained in accrued expenses and other at December 31, 1993 and December 25, 1992, respectively. The Company's corporate performance bonds to assure the completion of development at its St. Augustine Shores community expire in March and June, 1993. Such bonds cannot be renewed due to a change in the policy of the Board of County Commissioners of St. Johns County which precludes allowing any developer to secure the performance of development obligations by the issuance of corporate bonds. In the event that St. Johns County elects to undertake the completion of such development work, the Company would be obligated with respect to 1,000 improved lots at St. Augustine Shores in the amount of approximately $6,200,000. The Company intends to submit an alternative assurance program for the completion of such development and improvements to the County for its approval. In addition to the matters discussed above and in Note 9, the Company is a party to other litigation relating to the conduct of its business which is routine in nature and, in the opinion of management, should have no material effect upon the Company's operation. 9. MARCO ISLAND-MARCO SHORES PERMITS On April 16, 1976, the U.S. Army Corps of Engineers (the "Corps") denied the Company's application for dredge and fill permits required to complete development of the Marco Island community. These denials adversely affected the Company's ability to obtain the required permits for the Marco Shores community as originally platted. Following the denials, the Company instituted legal proceedings, implemented various programs to assist its customers affected by the Corps' action, and applied for permits from certain administrative agencies for other areas of the Company's Marco ownership. On July 20, 1982, the Company entered into an agreement with the State of Florida and various state and local agencies (the "Settlement Agreement"), endorsed by various environmental interest groups, to resolve pending litigation and administrative proceedings relative to the Marco permitting issues. The Settlement Agreement became effective when, pursuant thereto, approximately 12,400 acres of the Company's Marco wetlands were conveyed to the State in exchange for approximately 50 acres of State-owned property in Dade County, Florida. In October, 1987, the Company sold the Dade County property for $9,000,000. The Settlement Agreement also allowed the Company to develop as many as 14,500 additional dwelling units in the Marco vicinity. On October 11, 1991, 1,300 acres of Marco property (7,000 dwelling units) were conveyed to the Company's lenders pursuant to the Conveyance Agreement. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(CONTINUED) THE DELTONA CORPORATION AND SUBSIDIARIES 9. MARCO ISLAND-MARCO SHORES PERMITS - (CONTINUED) The Company had placed certain properties in trust to meet its refund obligation to affected customers. On September 14, 1992, the Circuit Court of Dade County, Florida approved a settlement of certain class action litigation instituted by customers affected by the Marco permit denials, under the terms of which the Company was required, among other things, to convey more than 120 acres of multi-family and commercial land that had been placed in trust to the trustee of the 809 member class. As part of the settlement, the Company guaranteed the amount to be realized from the sale of the conveyed property. This guaranteed amount shall not exceed $2,000,000. Such settlement enabled the Company to resolve the claims of an additional 12.7% of its affected customers and re-evaluate the allowance for Marco permit costs. As a result of such analysis, the Company was able to reduce such allowance by $12,200,000, resulting in a $3,983,000 extraordinary gain and a $500,000 credit to accrued expenses to be credited to paid-in capital following issuance of 250,000 shares of restricted Common Stock of the Company to the class members. At December 31, 1993, $2,886,000 remained in the allowance for Marco permit costs. Based upon the Company's experience with affected customers, the Company believes that its total obligations to the remaining 1.3% of its affected customers will not materially exceed the amount provided for in the accompanying Consolidated Financial Statements. Information with respect to the allowance for Marco permit costs follows: DECEMBER 31, DECEMBER 25, 1993 1992 ------------ ------------ (IN THOUSANDS) Refunds requested by affected customers............ $ 332 $ 905 Reserve for settlement guarantee................... 2,000 2,000 Accrued interest on actual and estimated refund obligation............................... 554 944 ------- ------- Total..................................... $ 2,886 $ 3,849 ======= ======= 10. COMMON STOCK AND EARNINGS PER SHARE INFORMATION Options to purchase Common Stock of the Company had been granted to employees of the Company under an incentive stock option plan. Such shares could be treasury or authorized but unissued shares, and were subject to adjustment resulting from stock dividends, splits, reorganizations, or other substitutions of securities for the present Common Stock of the Company. The option price could not be less than the market value of the Company's Common Stock on the date of the grant. All options were exercisable for a period of up to five years from the date of grant at an annual cumulative rate of 20%, except that no option could be exercised for a period of 60 days from grant. Since options could not be granted after ten years from the date the plan was adopted, options were not available for grant under the plan after March 1, 1992, and options to purchase an aggregate of 26,800 shares which were outstanding as of December 27, 1991 expired unexercised on December 9, 1992. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(CONTINUED) THE DELTONA CORPORATION AND SUBSIDIARIES 10. COMMON STOCK AND EARNINGS PER SHARE INFORMATION - (CONTINUED) Under the Company's 1987 Stock Incentive Plan (the "Stock Plan"), an aggregate of 500,000 shares of Common Stock have been reserved for the granting of non-qualified stock options and the award of incentive shares to such executive officers and other key employees of the Company as may be determined by the Committee administering the Stock Plan. The extent to which incentive shares are earned and charged to expense will be determined at the end of the three-year award cycle, based on the achievement of the Company' s net income goal for the award cycle. Payment of incentive shares earned may be made in shares of the Company's Common Stock and/or cash. If paid in cash, such payment will be based on the average daily closing price of the Company's Common Stock during the last month of the award cycle. The option features of the Stock Plan are substantially the same as the Company's incentive stock option plan described above. A total of 79,940 shares were issued and $233,412 was paid with respect to awards earned under the Stock Plan as of December 29, 1989. In March, 1993 an option to acquire 20,000 shares of the Company's Common Stock at an exercise price of $4.00 per share was granted under the Stock Plan; the 20,000 share option remained outstanding as of December 31, 1993. On June 18, 1992, in conjunction with the Sixth Restatement, the Company issued warrants to its lenders for the purchase of 277,387 shares of Common Stock at $1.00 per share (the Warrants"). The Warrants became exercisable on June 18, 1992, were subject to mandatory repurchase by the Company at the request of the holder at any time after December 18, 1993 at 75% of the market price of the Company's Common Stock (unless such repurchase would cause a default under the Sixth Restatement or unless the Company elected to effect an underwritten public offering on a firm commitment basis), and expired on the later of: (i) 30 days after payment in full of all debt under the Sixth Restatement; (ii) July 31, 1997, or (iii) such later date as to which the expiration date had been extended to implement the provisions applicable to the mandatory repurchase option. On December 2, 1992, the Company entered into a Warrant Exercise and Debt Reduction Agreement with Yasawa, providing for the number of shares issuable upon acquisition of the Warrants by Yasawa and the exercise of such Warrants by Yasawa to be increased from 277,387 shares of Common Stock to 289,637 shares of Common Stock, and adjusting the exercise price to an aggregate of approximately $314,000. On December 11, 1992, following the acquisition of the Bank Loan and the Warrants by Gram and the immediate transfer of the Bank Loan and the Warrants by Gram to Yasawa, Yasawa exercised the Warrants in exchange for debt reduction credit to the Company of approximately $314,000. As part of the Selex transaction, Selex was granted an option which was approved by the holders of a majority of the outstanding shares of the Company's Common Stock at the Company's 1992 Annual Meeting, to convert the Selex Loan, or any portion thereof, into a maximum of 850,000 shares of the Company's Common Stock at a per share conversion price equal to the greater of (i) $1.25 or (ii) 95% of the market price of the Company's Common Stock at the time of conversion, but in no event greater than $4.50 per share (the "Option"). However, on September 14, 1992, Selex formally waived and relinquished its right to exercise the Option as to 250,000 shares of the Company's Common Stock to enable the Company to settle certain litigation involving the Company through the issuance of approximately 250,000 shares of the Company's Common Stock to the claimants, without jeopardizing the utilization of the Company's net operating loss carryforward. On February 17, 1994, Selex exercised the remaining full 600,000 share Option at a conversion price of $1.90 per share, such that $1,140,000 in principal was repaid under the First Selex Loan through such conversion. As a consequence of such conversion, Selex holds 2,820,066 shares of the Company's Common Stock (43.1% of the outstanding shares of Common Stock of the Company based upon the number of shares of the Company's Common Stock outstanding as of March 18, 1994. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(CONTINUED) THE DELTONA CORPORATION AND SUBSIDIARIES 10. COMMON STOCK AND EARNINGS PER SHARE INFORMATION -(CONTINUED) Earnings (loss) per common and common equivalent share were computed by dividing net income (loss) by the weighted average number of shares of Common Stock and common stock equivalents outstanding during each period. The earnings (loss) and average number of shares of Common Stock and common stock equivalents used to calculate earnings per share for 1993, 1992 and 1991 were ($8,772,000) and 6,056,743, $7,336,000 and 5,694,236 and ($26,629,000) and 5,660,967, respectively. 11. OTHER OPERATIONS Through December 31, 1993, the Company operated country clubs and golf courses at certain of its communities. All such operations have been sold as of December 31, 1993. The following is a summary of its operations: YEARS ENDED ------------------------------------------ DECEMBER 31, DECEMBER 25, DECEMBER 27, 1993 1992 1991 ------------ ------------ ------------ (IN THOUSANDS) Revenues........................ $1,820 $1,823 $2,375 Costs of sales.................. 1,527 1,638 1,948 ------ ------ ------ Gross profit............... $ 293 $ 185 $ 427 ====== ====== ====== NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(CONTINUED) THE DELTONA CORPORATION AND SUBSIDIARIES 12. BUSINESS SEGMENTS SUPPLEMENTAL UNAUDITED QUARTERLY FINANCIAL DATA (IN THOUSANDS, EXCEPT PER SHARE AMOUNTS) ITEM 10, 11 AND 13 DIRECTORS AND EXECUTIVE OFFICERS DIRECTORS OF THE COMPANY The Board of Directors of the Company presently consists of eight individuals: Antony Gram, Chairman of the Board and Chief Executive Officer, and Neil E. Bahr, George W. Fischer, Marcellus M. B. Muyres, Thomas B. McNeill, Leonardus G.M. Nipshagen, Cornelis van de Peppel and Cornelis L.J.J. Zwaans. As previously discussed, in June, 1992, the Company completed a transaction with Selex, which resulted in the infusion of additional funds into the Company and in a change in control of the Company. In conjunction with the transaction with Selex, Messrs. Muyres, Gram, Nipshagen, Peppel and Zwaans were designated by Selex for election as directors of the Company. See "Business: Recent Developments" and "Management's Discussion and Analysis of Financial Condition and Results of Operations." The table below sets forth the names of the present directors of the Company, together with certain information with respect to each of them. Unless otherwise indicated, each such person has held the position shown, or has been associated with the named employer in the executive capacity shown, for more than the past five years. The entire Board of Directors is elected annually to hold office until the next Annual Meeting of Stockholders and until their respective successors are duly elected and qualified. Messrs. Bahr, Fischer and McNeill (Audit Committee) receive a fee of $1,000 per month for services as a Director of the Company and are reimbursed for travel and related costs incurred with respect to committee and board meetings. Messrs. Gram, Muyres, Nipshagen, van de Peppel and Zwaans do not receive a monthly Directors fee, however are reimbursed for travel and related costs incurred with respect to committee and board meetings and other Company business activities. In August 1994, the Directors with outstanding fees and/or expenses agreed to forgive 50% of the amounts due them. The following sets forth the amounts due those Directors at August 31, 1994 after the forgiveness. Neil E. Bahr $ 6,500 George Fischer 6,500 Thomas B. McNeill 6,500 Marcellus H.B. Muyres 9,585 Cornelis L.J.J. Zwaans 4,981 ------- Total $34,066 ======= Cornelis van de Peppel provided the Company consulting services periodically during the months of August 1993 through November 1993. Mr. van de Peppel was paid $22,500 in consulting fees for his services as well as $11,862 in expense reimbursement in conjunction with those services. COMPENSATION COMMITTEE INTERLOCKS AND INSIDER PARTICIPATION The Executive Compensation Committee (the "Committee") is comprised of Mr. Bahr, Chairman, and three of the Selex directors, namely, Messrs. Gram, Muyres and Zwaans. Mr. Bahr, Chairman of the Committee and Vice Chairman of the Board, retired from the Company in December, 1985. From the Company's incorporation in September, 1962 until his retirement, Mr. Bahr served as an officer of the Company and/or its subsidiaries. He presently does not serve as a director or as a member of the compensation committee of any other company. Mr. Gram, a member of the Committee, has served as Chairman of the Board and Chief Executive Officer of the Company, and thus, as an executive officer of the Company, since July 13, 1994. Additionally, Mr. Gram is deemed to be the beneficial owner of 46.7% of the Company's Common Stock since he is the beneficial owner of Yasawa (which holds 4.4% of the Common Stock of the Company as of August 19, 1994), as well as the holder of a seventy-four percent equity interest in Wilbury International N.V., a Netherlands Antilles corporation ("Wilbury"), which owns all of the issued and outstanding stock of Selex (which holds 42.3% of the Common Stock of the Company as of August 19, 1994). See "Ownership of Voting Securities of the Company." Mr. Muyres, Vice Chairman of the Board of the Company, and a member of the Committee, served as Chairman of the Board and Chief Executive Officer, and thus, as an officer of the Company, from June 19, 1992 through July 12, 1994. As previously stated, Mr. Muyres serves as a director and executive officer of Swan, Conquistador and M&M, companies of which Mr. Zwaans, also a member of the Committee, serves as a director and executive officer. Mr. Zwaans also serves as a Managing Director of Selex. As previously stated, all of the issued and outstanding stock of Selex is owned by Wilbury. Wilbury is, in turn, owned by Messrs. Gram and Muyres, with Mr. Gram, as the largest shareholder of Wilbury, being treated as the beneficial owner of all of the Company's Common Stock held by Selex. See "Ownership of Voting Securities of the Company." On June 19, 1992, Selex loaned the Company the sum of $3,000,000 pursuant to the First Selex Loan. The First Selex Loan is collateralized by a first mortgage on certain of the Company's unsold, undeveloped property in its St. Augustine Shores, Florida community. The Loan matures on June 15, 1996 and provides for principal to be repaid at 50% of the net proceeds per lot for lots requiring release from the mortgage, with the entire unpaid balance becoming due and payable at the end of the four year term. It initially bears interest at the rate of 10% per annum, with payment of interest deferred for the initial 18 months of the Loan and interest payments due quarterly thereafter. As part of the Selex transaction, Selex was granted an option, approved by the holders of a majority of the outstanding shares of the Company's Common Stock at the Company's 1992 Annual Meeting, which, as modified, enabled Selex to convert the First Selex Loan, or any portion thereof, into a maximum of 600,000 shares of the Company's Common Stock at a per share conversion price equal to the greater of (i) $1.25 or (ii) 95% of the market price of the Company's Common Stock at the time of conversion, but in no event greater than $4.50 per share (the "Option"). On February 17, 1994, Selex exercised the Option, in full, at a conversion price of $1.90 per share, such that $1,140,000 in principal was repaid under the First Selex Loan through such conversion. As of August 31, 1994, the Company was in default of the First Selex Loan inasmuch as accrued interest in the amount of $604,300 (including $463,500 due December 31, 1993) remained unpaid. One million dollars of the proceeds from the First Selex Loan was used by the Company to acquire certain commercial and multi-family properties at the Company's St. Augustine Shores community at their net appraised value, from Mr. Muyres and certain entities affiliated with Messrs. Zwaans and Muyres. Namely, (i) $416,000 was used to acquire 48 undeveloped condominium units (twelve 4 unit building sites) and 4 completed and rented) condominium units from Conquistador, in which Messrs. Zwaans and Muyres serve as directors, as well as President and Secretary/Treasurer, respectively; (ii) $485,000 was used to acquire 4 commercial lots from Swan, in which Messrs. Zwaans and Muyres also serve as directors, as well as President and Secretary, respectively; and (iii) approximately $99,000 was used to reacquire, from Mr. Muyres, all of his rights, title and interest in that certain contracts with the Company for the purchase of a commercial tract in St. Augustine Shores, Florida. None of the commercial and multi-family property acquired by the Company from Mr. Muyres and certain entities affiliated with Messrs. Zwaans and Muyres collateralizes the First Selex Loan. In March, 1994, Conquistador exercised its right to repurchase certain multi-family property from the Company (which right had been granted in connection with the June, 1992 Selex transaction) at a price of $312,000, of which $260,000 was paid in cash to the Company and $52,000 was applied to reduce interest due to Selex under the third Selex Loan. As previously stated, Messrs. Muyres and Zwaans also serve as directors and executive officers of M&M. The Company has leased certain office space to M&M at its St. Augustine Shores community pursuant to a Lease Agreement dated August 10, 1990. The aggregate annual rental payments under such Lease are less than $60,000. On December 2, 1992, the Company entered into various agreements relating to certain of its assets and the restructuring of its debt with Yasawa, which is beneficially owned by Mr. Gram. The consummation of these agreements, which are further described below, was conditioned upon the acquisition by Gram of the Company's outstanding bank loan. On December 4, 1992, Gram entered into an agreement with the lenders, pursuant to which he acquired the bank loan of approximately $25,150,000 (including interest and fees) for a price of $10,750,000. In conjunction with such transaction, the lenders transferred to Gram the warrants which they held that entitled the holder to purchase an aggregate of 277,387 shares of the Company's Common Stock at an exercise price of $1.00 per share. Immediately after the acquisition of the bank loan, Gram transferred all of his interest in the bank loan, including the warrants, to Yasawa. On December 11, 1992, the Company consummated the December 2, 1992 agreements with Yasawa. Under these agreements, Yasawa, its affiliates and the Company agreed as follows: (i) the Company sold certain property at its Citrus Springs community to an affiliate of Yasawa in exchange for approximately $6,500,000 of debt reduction credit; (ii) an affiliate of Yasawa and the Company entered into a joint venture agreement with respect to the Citrus Springs property, providing for the Company to market such property and receive an administration fee from the venture (in March, 1994, the Company and the affiliate agreed to terminate the venture); (iii) the Company sold certain contracts receivable at face value to an affiliate of Yasawa for debt reduction credit of approximately $10,800,000; (iv) the Company sold the Marco Shores Country Club and Golf Course to an affiliate of Yasawa for an aggregate sales price of $5,500,000, with the affiliate assuming an existing first mortgage of approximately $1,100,000 and the Company receiving debt reduction credit of $2,400,000, such that the Company obtained cash proceeds from this transaction of $2,000,000, which amount was used for working capital; (v) an affiliate of Yasawa agreed to lease the Marco Shores Country Club and Golf Course to the Company for a period of approximately one year; (vi) an affiliate of Yasawa and the Company agreed to amend the terms of the warrants to increase the number of shares issuable upon their exercise from 277,387 shares to 289,637 shares and to adjust the exercise price to an aggregate of approximately $314,000; (vii) Yasawa exercised the warrants in exchange for debt reduction credit of approximately $314,000; (viii) Yasawa released certain collateral held for the bank loan; (ix) an affiliate of Yasawa agreed to make an additional loan of up to $1,500,000 to the Company, thus providing the Company with a future line of credit (all of which was drawn and outstanding as of August 19, 1994); and (x) Yasawa agreed to restructure the payment terms of the remaining $5,106,000 of the bank loan as a loan from Yasawa (the "Yasawa Loan"). The Yasawa Loan bears interest at the rate of 11% per annum, with payment of interest deferred until December 31, 1993, at which time only accrued interest became payable. Commencing January 31, 1994, principal and interest became payable monthly, with all unpaid principal and accrued interest being due and payable on December 31, 1997. A portion of the proceeds from a March, 1993 sale of contracts receivable was applied to reduce the Yasawa Loan to $4,900,000 during the first quarter of 1993 and the assignment of a mortgage receivable to Yasawa reduced the Yasawa Loan to $4,771,600 as of December 31, 1993. Accrued interest due under the Yasawa Loan in the amount of $355,200 were unpaid and in default as of August 31, 1994. In February, 1994, Yasawa loaned the Company an additional amount of approximately $514,900 at an interest rate of 8% per annum (the "Second Yasawa Loan"). Since May, 1994, additional amounts were advanced to the Company under the Second Yasawa Loan to enable the Company to pay certain essential expenses and effectuate settlements with the Company's principal creditors. As of August 31, 1994, an aggregate amount of $1,200,000 had been advanced to the Company under the Second Yasawa Loan. On April 30, 1993 Selex loaned the Company an additional $1,000,000 collateralized by a first mortgage on certain of the Company's property in its Marion Oaks, Florida community (the "Second Selex Loan"). The Second Selex Loan bears interest at 11% per annum, with interest deferred until December 31, 1993. The Second Selex Loan provides for principal to be repaid at $3,000 per lot for lots requiring release from the mortgage, with the entire unpaid principal balance and interest accruing from January 1, 1994 to April 30, 1994 to be due and payable on April 30, 1994. Although Selex had certain conversion rights under the Second Selex Loan in the event the Company sold any Common Stock or Preferred Stock prior to payment in full of all amounts due to Selex under the Second Selex Loan, such rights were voided as of December 31, 1993 since the regulations set forth in proposed Treasury Decision CO-18-90 relative to Section 382 of the Internal Revenue Code were not adopted by such date. As of August 31, 1994, $33,000 in principal had been repaid under the Second Selex Loan, but accrued interest of 93,300 due under the Loan as of August 31, 1994, as well as the principal balance of $967,000, remained unpaid and in default. From July 9, 1993 through December 31, 1993, Selex loaned the Company an additional $4,400,000 collateralized by a second mortgage on certain of the Company's property on which Selex and/or Yasawa hold a first mortgage pursuant to a Loan Agreement dated July 14, 1993 and amendments thereto (the "Third Selex Loan"). The Third Selex Loan bears interest at 11% per annum, with interest deferred until December 31, 1993. Principal is to be repaid at $3,000 per lot for lots requiring release from the mortgage, with the entire unpaid principal balance and interest accruing from January 1, 1994 to April 30, 1994 becoming due and payable on April 30, 1994. As of August 31, 1994, accrued interest of $466,800 due under the Third Selex Loan as well as the principal balance of $4,384,200 remained unpaid and in default. Interest due to Selex, Yasawa and their affiliates in the aggregate amount of $2,300,000 remained unpaid and in default as of August 31, 1994. Through August 31, 1994 $33,000 in principal was repaid under the Second Selex Loan and $1,140,000 in principal was repaid under the First Selex Loan through the exercise of the above described Option; however, Selex, Yasawa and their affiliates were unpaid and in default as of August 31, 1994. Consequently, as of August 31, 1994, the Company had loans outstanding from Selex, Yasawa and their affiliates in the aggregate amount of approximately $17,976,000, including interest, of which approximately $9,867,000 is owed to Selex, including accrued and unpaid interest of approximately $1,656,000 (10% per annum on the First Selex Loan, 11% per annum on the Second and Third Selex Loans and 12% per annum on the $1,000,000 Empire Note assigned to Selex); approximately $6,349,200 is owed to Yasawa, including accrued and unpaid interest of approximately $384,500 (11% per annum on the Yasawa Loan and 8% per annum on the Second Yasawa Loan); and approximately $1,759,000 is owed to an affiliate of Yasawa, including accrued and unpaid interest of approximately $259,500 (12% per annum). The loans from Selex, Yasawa and their affiliates are secured by substantially all of the assets of the Company. See "Business: Recent Developments", "Management's Discussion and Analysis of Financial Condition and Results of Operations" and Note 5 to Consolidated Financial Statements. The lease between an affiliate of Yasawa and the Company with respect to the Marco Shores Country Club and Gold Course was terminated in December 31, 1993. At the time of termination, an amount of approximately $34,200 was due to the Company from the Yasawa affiliate, which amount was paid in 1994. In December 1992, the Company and Citony (an affiliate of Yasawa) entered into a joint venture agreement with respect to Citony's Citrus Springs property, providing for the Company to market the property and receive an administration fee from the venture. The Company and Citony agreed to terminate the joint venture agreement in March, 1994, however, the Company is providing certain assistance to Citony during the transition period. At the time of termination $265,000 was due to the Company by Citony for marketing costs incurred as well as administrative services provided, which amount was paid in 1994. M&M First Coast Realty, of which Messrs. Muyres and Zwaans are Directors leased office facilities from the Company in its St. Augustine Shores community. At December 31, 1993 $16,600 was due the Company for past rents, which amount was paid in 1994. Messrs. Muyres and Zwaans serve as officers and directors of Conquistador Development Corporation, which the Company owed $11,583 at December 31, 1993, principally for condominium fees advanced on behalf of the Company. This amount was paid in 1994. EXECUTIVE OFFICERS OF THE COMPANY The table below sets forth the executive officers of the Company as of August 19, 1994, their ages and their principal occupations during the past five years; they have been appointed to serve in the capacities indicated until their successors are appointed and qualified, subject to their earlier resignation or removal by the Board of Directors. On July 13, 1994, Marcellus H.B. Muyres, who had served as Chairman of the Board and Chief Executive Officer of the Company since June 19, 1992, agreed to serve, instead, as a Vice Chairman of the Board to facilitate the appointment of Antony Gram as Chairman and Chief Executive Officer. Additionally, since December 31, 1993, one executive officer (Stephen J. Diamond) resigned his position and four executive officers (Michelle R. Garbis, Joseph Mancilla, Jr., Theodore J. Maureau, III and Bruce M. Weiner) were removed from the positions in which they served. EXECUTIVE COMPENSATION Due to the Company's liquidity situation, Antony Gram has served as Chairman of the Board and Chief Executive since July 13, 1994 without compensation. Likewise, Marcellus H.B. Muyres served as Chairman of the Board and Chief Executive Officer without compensation from June, 1992 through July 12, 1994. The Commission's rules on executive compensation disclosure require, however, that the Summary Compensation Table which appears below, depict the compensation for the past three years of the Company's chief executive officer and its four most highly compensated executive officers whose annual salary and bonuses exceed $100,000. During the fiscal year ended December 31, 1993, four executive officers of the Company were paid an annual salary and bonus in excess of $100,000, with one of such officers not being employed by the Company until March 15, 1993 and one not being employed until July 15, 1992. Accordingly, the table set forth below discloses compensation paid to Mr. Weiner for the year ended December 31, 1993, to Mr. Muyres and Mr. Mancilla for the two years ended December 31, 1993 and to Mr. Cortright and Mrs. Garbis for the three years ended December 31, 1993. SUMMARY COMPENSATION TABLE -------------------------- OPTION/SAR GRANTS IN LAST FISCAL YEAR The only option granted during 1993 was the grant of an option to Mr. Weiner to acquire 20,000 shares under the provisions of the Stock Plan. The exercise price of $4.00 per share was above the market price of the Company's Common Stock (2 7/8) on the March 15, 1993 grant date. The option was not awarded with tandem stock appreciation rights, and it expired unexercised following Mr. Weiner's removal as an officer of the Company. EMPLOYMENT CONTRACTS In 1993, the Company recruited Bruce M. Weiner, an individual with over twenty years of experience in the sale and marketing of Florida real estate, to develop, implement and oversee a marketing program which would strengthen the Company's marketing organization, rebuild its retail land sales business and provide for the Company's successful re-entry into the single family housing business. Effective March 15, 1993, the Company entered into a three-year employment agreement with Mr. Weiner. The agreement provided for Mr. Weiner to be paid an annual salary of $350,000 (subject to reduction or repayment, as discussed below, in the event that the overall annual objectives of the Company's marketing program were not substantially achieved) and for the furnishing of certain benefits, such as payment of an automobile allowance. The agreement further provided for Mr. Weiner to be paid an annual bonus if the annual overall objectives of the marketing program were met in an amount equal to the greater of: (i) one half of one percent of the Company's net retail land sales were met in an amount equal to the greater of: (i) one half of one percent of the Company's net retail land sales revenue for the preceding fiscal year (pro-rated for the Company's 1993 fiscal year) and one quarter of one percent of revenues from house sale closings during the Company's preceding fiscal year; or (ii) five percent of the annual pre-tax profits of the Company for the preceding fiscal year. Such bonus was to have been payable, net of applicable taxes, in incentive shares or other form of stock equivalents as may be determined, valued at a price of $4.00 per share unit. On the other hand, if the annual overall objectives of the marketing program were not met by Mr. Weiner in any given year, he was responsible for either repaying to the Company an amount equal to five percent of the operating losses of the Company for the preceding year or subject to a fifty percent reduction in salary until an amount equal to five percent of the operating loss had been recovered by the Company. In the event, however, that Mr. Weiner was precluded from meeting the annual overall objectives due to strikes, unforeseen governmental action or intervention, war, hurricane striking employer's communities or other similar acts of God, or the failure of the Company to fund or otherwise fulfill its obligations under the marketing program, then no such repayment or salary adjustment would be required. Additionally, the maximum amount of salary repayment or adjustment was limited to $50,000 per year (pro-rated to $39,584 for the Company's 1993 fiscal year, based upon the salary payments made to Mr. Weiner during 1993). In conjunction with Mr. Weiner's employment and his agreement, Mr. Weiner was awarded an option to purchase 20,000 shares of the Company's Common Stock under the provisions of the 1987 Stock Incentive Plan described below. See "Compensation Committee Report." In the event that Mr. Weiner earned the bonus provided for in his agreement with respect to the Company's 1994 fiscal year, it was anticipated that any net bonus payable would first be applied by the Company to exercise the shares in respect of which Mr. Weiner was granted said option. Mr. Weiner's agreement further provided that if his employment were terminated without cause (defined as gross misconduct or the failure to achieve certain specific objectives set forth in his agreement), he would be entitled to receive a lump-sum payment upon termination equal to the salary remaining to be paid him for the term of his agreement, unless termination was due to death, in which case his beneficiary would be entitled to receive a sum equal to one month's salary for each month of his employment during the first twelve months of employment, and thereafter, a sum equal to the aggregate of one year's salary. Mr. Weiner failed to achieve both the specific objectives set forth in his agreement for 1993 and the annual overall objectives of the marketing program during 1993. Due to the Company's liquidity situation, the Company was unable to pay its executive officers the compensation due them for the months of March, 1994 and April, 1994. The executive officers employed pursuant to an employment agreement notified the Chairman of the Board, the Vice Chairmen of the Board and the Chairman of the Executive Compensation Committee, on April 1, 1994, that the Company's failure to remit the compensation due constituted a breach of their respective agreements and that while they were willing to continue their efforts, for a limited time, to assist the Company in resolving its problems, they were not waiving their rights to enforce any remedies available under their respective agreements. On April 28, 1994, Mr. Weiner filed suit against the Company for breach of his agreement by reason of non-payment of compensation, seeking damages under the agreement in excess of $744,000. He was subsequently removed as an officer of the Company and his employment was terminated for non-performance. See "Legal Proceedings." Mr. Mancilla, Jr., who was appointed Senior Vice President and General Counsel of the Company, effective July 15, 1992, was employed pursuant to an employment agreement with the Company which continued through July 15, 1994 (the initial term), was to be automatically renewed at that time for an additional year (the initial renewal term), and thereafter was subject to automatic renewal for successive one-year periods (subsequent renewal terms) unless notice of intent not to renew was given by the Company sixty days prior to the applicable expiration date. The agreement provided for Mr. Mancilla to be paid an annual salary of $150,000 (subject to such increases as might be mutually agreed upon), for the furnishing of certain benefits, such as payment of an automobile allowance, and for payment of a bonus (the "Bonus") of $50,000 upon the settlement of certain litigation. The Bonus was paid in 1992 following court approval of the settlement of such litigation, and is included in the Summary Compensation Table set forth above. The agreement further provided that if Mr. Mancilla's employment were terminated or constructively terminated by the Company, without cause (defined as gross misconduct), he would be entitled to receive a lump-sum payment at termination equal to two years' salary (one year's salary if termination occurred during the initial renewal term or any subsequent renewal term), together with any salary remaining to be paid for the contract term (but, in no event, more than for an additional year); he would also be entitled to payment of an automobile allowance and certain insurance benefits for a period of not less than one year. For the purposes of Mr. Mancilla's agreement, "constructive termination" was defined as the assignment of duties inconsistent with his status as Senior Vice President and General Counsel or a substantial alteration in his responsibilities. Mr. Mancilla's agreement with the Company further provided that if his employment were terminated due to death, his beneficiary would be entitled to receive a sum equal to the aggregate of one year's salary. In May, 1994, Mr. Mancilla filed suit against the Company for breach of his employment agreement by reason of non-payment of compensation, seeking damages under the agreement in excess of $391,500. He was subsequently removed as an officer of the Company and his employment was terminated for non-performance. See "Legal Proceedings." In June, 1992, the Company obtained $8,000,000 additional financing through a $13,500,000 sale of certain of the Company's contracts receivable. The agreement with respect to such sale requires that the Company maintain, in effect, certain employment agreements with Mr. Cortright, Mrs. Garbis, and certain other executive officers of the Company. Pursuant to the requirements of such agreement, Mr. Cortright entered into a five-year employment agreement which continues through June 19, 1997. Such agreement is subject to automatic renewal for successive one-year periods unless notice of intent not to renew is given by the Company 60 days prior to the end of the applicable contract term. The agreement provides for Mr. Cortright to be paid his current annual salary of $200,000 (subject to such increases as may be mutually agreed upon) and for the furnishing of certain benefits, such as payment of an automobile allowance. The agreement contains "non compete" provisions which preclude Mr. Cortright from engaging, in any manner, or from being employed, in any capacity, in any business which could be deemed to be competitive with the Company in Florida, New York, New Jersey and Ohio during the five year term of his agreement, if his employment is terminated or constructively terminated by the Company or if he resigns his employment from the Company. Because of such non-compete provisions and to compensate Mr. Cortright for his exceptional services in conjunction with the completion of the restructuring of the Company's bank debt and the securing of financing for the Company through the above-mentioned contracts receivable sale and the Selex Loan, Mr. Cortright's agreement also provides for the payment of a $200,000 bonus, $50,000 of which was paid upon the signing of his agreement and the completion of the foregoing transactions, $50,000 of which was paid in June, 1993 (and is included in the Summary Compensation Table set forth above), $50,000 of which was due in June, 1994, the payment of which is in default, and $50,000 being payable on June, 1995 so long as he continues to serve as President and Chief Operating Officer of the Company (the "Special Bonus"), with payment of the unpaid portion of the Special Bonus accelerated in the event of the termination or constructive termination of his employment or the agreement without cause or due to his death or medical disability. Additionally and as a consequence of such non-compete provisions, Mr Cortright's employment agreement provides that if his employment is terminated or constructively terminated by the Company, without cause (defined as gross misconduct), during its initial term or any renewal term, he is entitled to receive a lump sum payment at termination equal to any salary remaining to be paid him for the contract term (but, in no event, less than for an additional two years); in addition, he is entitled to payment of an automobile allowance and certain insurance benefits for such period. For purposes of Mr. Cortright's agreement, "constructive termination" includes, among other things: (i) the assignment of duties inconsistent with Mr. Cortright's status as President and Chief Operating Officer or a substantial alteration in his responsibilities if such assignment and/or alteration is not acceptable to him, (ii) relocation of the Company's principal place of business to a location other than Orlando, Florida (unless such other location is mutually agreed upon), (iii) failure of the Company to maintain compensation plans in which Mr. Cortright participates or to continue providing certain other existing employee benefits, or (iv) any disability commencing after a "change in control" which is continuous for six months. Mr. Cortright's agreement with the Company further provides that if his employment is terminated due to death or medical disability (as distinguished from a disability following a change in control), payment of salary to him or his beneficiary shall continue for two years following termination. Under this agreement, the agreement with Mrs. Garbis described below, and the benefit plans described in the Compensation Committee Report, a "change in control" is (a) an acquisition of 35% of the voting securities of the Company if the Board of Directors determines that a change in control has occurred or is likely to occur; or (b) a change in the majority of the Board of Directors of the Company which is not recommended or approved by the incumbent Board. On June 11, 1992, the Board determined that the acquisition by Selex of more than 35% of the Company's Common Stock from Empire, accompanied by its control of the Board, would constitute a change in control of the Company. Mrs. Garbis was employed pursuant to a renewal of her employment agreement with the Company which, as renewed, continues through December 31, 1994. Such agreement was subject to automatic renewal for successive one-year periods unless notice of intent not to renew is given by the Company sixty days prior to the end of each year. The agreement provides for Mrs. Garbis to be paid her current annual salary of $115,000 (subject to such increases as the Company may determine) and for the furnishing of certain benefits, such as payment of an automobile allowance. The agreement provided that if employment is terminated due to death, payment of salary to her beneficiary continues for one year following termination. In addition, if employment is terminated by the Company without cause, regardless of whether or not the agreement itself is effect, she is entitled to receive a lump sum payment at termination equal to two years' salary; she is also entitled to payment of an automobile allowance and certain insurance benefits for one year. Such payments and benefits would be due if employment is terminated by the Company at any time within a two-year period following a change in control of the Company (unless termination is due to gross misconduct). In August, 1994 Mrs. Garbis filed suit against the Company for breach of her employment agreement by reason of non-payment of compensation, seeking damages under the agreement in excess of $280,000. Mrs. Garbis and the Company have reached a resolution and settlement of the claim. Mrs. Garbis has been removed as an officer of the Company and her employment was terminated. See "Legal Proceedings." Two other executive officers, Mr. Harden and Mrs. Hummerhielm, are employed pursuant to employment agreements which provide that if their employment is terminated due to death, payment of salary to their beneficiary continues for six months and, if employment is otherwise terminated by the Company without cause (defined as gross misconduct), they are entitled to receive one year's salary, payable in twenty-four equal semi-monthly installments. Although, as discussed above, the Company is in default of certain compensation due Mr. Cortright, Mrs. Garbis, Mr. Harden and Mrs. Hummerhielm, none of such officers has, as of August 19, 1994, instituted legal action with respect to such defaults. Since May 1, 1994, the Company has, with the exception of the $50,000 installment payment of the Special Bonus due Mr. Cortright, met all compensation obligations on a current basis. Nevertheless, should the employment of Mr. Cortright, Mr. Harden and Mrs. Hummerhielm be determined to have been terminated without cause, then the amounts that would be payable, as of August 19, 1994 under the agreements described above, inclusive of compensation in default and certain benefits, but exclusive of insurance benefits, would be $804,166, $101,337, and $101,337, respectively. COMPENSATION COMMITTEE REPORT COMPENSATION PHILOSOPHY It is the goal of the Company and the Executive Compensation Committee (the "Committee") to align all compensation, including executive compensation, with business objectives and both individual and corporate performance, while simultaneously attracting and retaining employees who contribute to the long-term success of the Company. The Company attempts, within its resources, to pay competitively and for performance and management initiative, while striving for fairness in the administration of its compensation program. EXECUTIVE COMPENSATION PROGRAM Since it has been the policy of the Company to encourage and enable employees upon whom it principally depends to acquire a personal proprietary interest in the Company, the total executive compensation program of the Company historically, consisted of both cash and equity-based compensation, and has been comprised of three key elements: salary, an annual bonus and a long term incentive plan that provides for both incentive awards and stock options. While each of these elements is discussed below, it is important to note that due to the financial performance of the Company during the past four years and the fact that the Company has undergone two changes in control since January 1, 1990, no awards have been made under the Annual Executive Bonus Plan (the "Bonus Plan") since 1990 and, with the exception of one stock option grant in 1993, no awards have been made under the long term incentive program other than the initial awards which were fully earned at the end of 1989. In particular, the Committee has been reticent to grant additional equity-based awards, lest it jeopardize the utilization of the Company's net operating loss carryforward for federal income tax purposes. This situation is re-examined annually and the 1993 review made it feasible for the Committee to grant Mr. Weiner, the Company's newly recruited executive vice president, an option to acquire 20,000 shares of the Company's Common Stock. SALARY Salaries paid to executive officers (other than the Chief Executive Officer and the President) are based upon the recommendations of the President, derived from his subjective assessment of the nature of the position, competitive salaries and the contribution, experience and Company tenure of the executive officer. The President reviews all salary recommendations with the Committee, which is responsible for approving or disapproving such recommendations. Salaries paid to the Chief Executive Officer (if any) and the President are determined by the Committee, subject to ratification by the Board of Directors, and are based upon the Committee's subjective evaluation of their contribution to the Company, their performance, and salaries paid by competitors to their chief executive officer and chief operating officer. Prior to January 1, 1990, the President's assessment and the Committee's subsequent approval or disapproval also took into consideration data from comparable industry salary surveys, such as that prepared by Stephens & Associates. From 1990 through March 31, 1994, the only salary increases which were granted occurred in June, 1992, at which time Mr. Cortright, Mrs. Garbis and two other executive officers of the Company were granted salary increases. Such increases were granted in connection with the efforts of these officers in securing over $10,000,000 in new financing for the Company and resolving various regulatory matters with the State of Florida. ANNUAL INCENTIVE PROGRAM Although business exigencies and the Company's liquidity situation have required the Company to suspend the granting of awards under the Bonus Plan, and to award bonuses only in certain limited instances where the bonus directly relates to the accomplishment of certain specified corporate and financial objectives, it is the intention of the Committee that an executive's annual compensation consist of a base salary and an annual bonus such as that provided under the Bonus Plan. All executive officers of the Company (except those officers who are otherwise entitled to receive additional compensation) and all managerial employees who meet certain eligibility criteria determined by their level of responsibility are eligible to participate in the Bonus Plan. The Bonus Plan provides for executives to earn bonuses of up to 150% of the base bonus for which they are eligible (which generally ranges from 10% to 75% of annual salary, depending upon their position and anticipated contribution to the Company), with the maximum bonus payable to the President being limited to 100% of his annual salary. Such bonuses are earned based upon the success of the Company, or of the subsidiary or division for which the individual is responsible, in achieving its debt-to-equity and/or net income goals. Typically, under the Bonus Plan, awards are determined in advance of a fiscal year, at which time the net income and/or debt-to-equity goals for the year are also established. Thereafter, at the conclusion of the year, the awards are adjusted up or down and paid, based upon the achievements of the specified objectives and individual job performance. The Bonus Plan provides for the acceleration of the determination and payment of bonuses thereunder in the event of the termination of employment of a participant following a change in control of the Company. No bonuses were awarded, earned by, or paid to, any executive officer of the Company under the Bonus Plan during or in respect of 1993; further, since no bonus awards have been outstanding to any executive officer of the Company for the past three years, the change in control resulting from the Selex transaction did not result in the acceleration of the determination and payment of bonuses under the Bonus Plan. The only bonus paid in 1993 was to Mr. Cortright pursuant to his employment agreement described above. In 1992, Mr. Cortright was instrumental in securing over $10,000,000 in new financing for the Company through the sale of contracts receivable and the Selex transaction, as well as for resolving certain regulatory matters with the State of Florida. His contribution was recognized through the award of a $200,000 bonus (an amount equal to one year's salary). To avoid straining the Company's liquidity situation, it was determined that his employment agreement would provide for that bonus to be paid in four annual installments, the second of which was paid in 1993. The installment due to have been paid in June, 1994 is currently in default and the final remaining installment is due to be paid in June, 1995. See "Employment Contracts." LONG TERM INCENTIVE PROGRAM Additional long-term cash and equity incentives has been provided through the 1987 Stock Incentive Plan (the "Stock Plan"). The Stock Plan combines the features of a stock option plan and a performance unit plan by providing for the issuance of up to 500,000 shares of Common Stock through the granting of stock options and the award of incentive shares. Under the Stock Plan, incentive shares are awarded to those executive officers and other key employees who, in the opinion of the Committee, are in positions which enable them to make significant contributions to the long-term performance and growth of the Company. The extent to which incentive share awards are earned is determined at the end of the three-year award cycle, based upon the achievement of a net income goal set forth in the three-year business plan adopted by the Board of Directors of the Company prior to or during the first year of the cycle. Awards are paid, in the discretion of the Committee, in cash or in shares of Common Stock of the Company, on or before the May 1st following the end of the three-year cycle. The Stock Plan provides for the acceleration of the determination and payment of awards thereunder in the event of a change of control of the Company. Incentive shares awarded in November, 1986 were fully earned as of the end of 1989, and 79,940 shares were issued under the Stock Plan. Inasmuch as no additional awards have been granted or are outstanding under the Stock Plan, the change in control resulting from the Selex transaction did not result in the acceleration of the determination and payment of awards thereunder. The Stock Plan also provides for the granting of non-qualified stock options, such that the Committee has available a further vehicle for compensating executives through equity participation. The exercise price of options granted under the Stock Plan cannot be less than the fair market value of the Company's Common Stock on the date of the grant. Options are granted under the Stock Plan for periods of up to five years and become exercisable in 20% cumulative annual increments (but no option may be exercised within 60 days of its grant). The only option granted in 1993, as indicated above, was an option to Mr. Weiner to acquire 20,000 shares of Common Stock at a price of $4.00 per share, which was in excess of the market value of the Company's Common Stock on the grant date. Such option expired unexercised following Mr. Weiner's removal as an officer of the Company. CHIEF EXECUTIVE OFFICER COMPENSATION Marcellus H.B. Muyres, who served as Chairman of the Board and Chief Executive Officer of the Company from June 19, 1992 through July 12, 1994, served without compensation in accordance with his representation to the Committee and the Board that he would not draw a salary until the Company's liquidity situation permitted the payment of appropriate compensation. To date, Mr. Muyres has received no compensation for his services as Chairman of the Board and Chief Executive Officer. As a director and executive officer of the Company, Mr. Muyres is entitled to reimbursement of expenses, including travel and transportation expenses, incurred on the Company's behalf. From June, 1992 through August 19, 1994, Mr. Muyres incurred expenses aggregating approximately $39,112, none of which has been reimbursed, but which is being carried as a liability of the Company. On July 13, 1994, Antony Gram was appointed Chairman of the Board and Chief Executive Officer of the Company, with Mr. Muyres agreeing to serve as a Vice Chairman of the Board. As Chairman and Chief Executive Officer, Mr. Gram has been given the responsibility of resolving the financial and legal difficulties facing the Company and developing an alternative business plan to enable the Company to continue as a going concern. During the process of resolving such difficulties and developing such plan, Mr. Gram has agreed to serve without compensation, with the understanding that all ordinary, necessary and reasonable expenses incurred by him in the performance of his duties, including travel and temporary living expenses, will be reimbursed by the Company and with the further understanding that the Committee and the Board will thereafter consider establishing an appropriate salary to be paid him for his services. COMPLIANCE WITH INTERNAL REVENUE CODE SECTION 162(M) Section 162(m) of the Internal Revenue Code, enacted in 1993, generally disallows a tax deduction to public companies for compensation over $1,000,0000 paid to the corporation's Chief Executive Officer and four other mostly highly compensated executives officers. Qualifying performance-based compensation will not be subject to the deduction limit if certain requirements are met. The compensation currently paid to the Company's Chief Executive Officer and highly compensated executive officers does not approach the $1,000,000 threshold, and the Company does not anticipate approaching such threshold in the foreseeable future. Nevertheless, the Company intends to take the necessary action to comply with the Code limitations. FUTURE COMPENSATION TRENDS The Committee anticipates undertaking a review of all compensation programs and policies of the Company, and making appropriate modifications and revisions, in conjunction with the development of an alternative business plan for the Company. Executive Compensation Committee Neil E. Bahr, Chairperson Antony Gram Marcellus H.B. Muyres Cornelis L.J.J. Zwaans ITEM 12

ITEM 12 OWNERSHIP OF VOTING SECURITIES OF THE COMPANY Based upon information furnished to the Company or contained in filings made with the Commission, the Company believes that the only persons who beneficially own more than five percent (5%) of the Common Stock the Common Stock of the Company are Dimensional Fund Advisors Inc. (5.7%), Selex (42.3%), and Antony Gram, through his holdings in Selex and Yasawa (46.7%). Dimensional Fund Advisors Inc. ("Dimensional"), 1299 Ocean Avenue, 11th Floor, Santa Monica, California 90401, a registered investment advisor, is deemed to have beneficial ownership of 380,300 shares of the Company's Common Stock as of December 31, 1993, with sole dispositive power as to all of such shares and sole voting power as to 216,100 of such shares. All of such shares are held in portfolios of DFA Investment Dimensions Group Inc., a registered open-end investment company (the "Fund"), or in series of The DFA Investment Trust Company, a Delaware business trust, or the DFA Group Trust and the DFA Participating Group Trust, investment vehicles for qualified employee benefit plans, as to all of which Dimensional serves as investment manager. Dimensional disclaims beneficial ownership of all such shares. Persons who are officers of Dimensional also serve as officers of the Fund. In their capacity as officers of the Fund, these persons vote the 164,200 additional shares which are owned by the Fund. All of the issued and outstanding stock of Selex, Gerrit Van Den Veenstraat 70, Amsterdam, the Netherlands, is owned by Wilbury which is, in turn, owned by Messrs. Muyres and Gram. Antony Gram, Chairman of the Board of Directors and Chief Executive Officer of the Company, as the largest shareholder of Wilbury, holding a seventy-four percent equity interest in that corporation, is treated as the beneficial owner of all of the Company's Common Stock held by Selex. In addition, Mr. Gram beneficially owns Yasawa. Since Yasawa is the direct owner of 289,637 shares of the Common Stock of the Company, Mr. Gram is deemed to be the beneficial owner of an aggregate of 3,109,703 shares of Common Stock of the Company. The following table sets forth information, as of August 19, 1994, concerning the beneficial ownership by all directors, by each of the executive officers named in the Summary Compensation Table beginning on Page 69 (the "Summary Compensation Table") and by all directors and executive officers as a group. The number of shares beneficially owned by each director or executive officer is determined under the rules of the Commission, and the information is not necessarily indicative of beneficial ownership for any other purpose. COMPLIANCE WITH SECTION 16(A) OF THE SECURITIES EXCHANGE ACT OF 1934 The Securities Exchange Act of 1934 requires the Company's directors, its executive officers and any persons holding more than ten percent of the Company's Common Stock to report their initial ownership of the Company's Common Stock and any subsequent changes in that ownership to the Commission and the New York Stock Exchange. Under the Section 16(a) rules, the Company is required to disclose in this Annual Report on Form 10-K any failure to file such required reports by their prescribed due dates. To the Company's knowledge, based solely on a review of the copies of such reports furnished to the Company and written representations that no other reports were required during the fiscal year ended December 31, 1993, all Section 16(a) filing requirements were satisfied, except that Mr. Gram, as beneficial owner of Selex, failed to file a Form 4 with respect to the conversion rights in the Second Selex Loan, which rights lapsed unexercised, Mr. Fischer filed one Form 4 approximately one week late, and Messrs. Muyres, Nipshagen, van de Peppel and Zwaans have neither filed a Form 5 nor acknowledged that such filing was not necessary. PERFORMANCE GRAPH Set forth below is a line graph comparing the cumulative total shareholder return on the Company's Common Stock, based on the market price of the Common Stock, with the cumulative total return of companies on the Media General Financial Services Composite Index and the Media General Peer Group (real estate subdividers and developers) Index. COMPARE 5-YEAR CUMULATIVE TOTAL RETURN AMONG THE DELTONA CORPORATION, MEDIA GENERAL INDEX AND PEER GROUP INDEX [INSERT GRAPH] ITEM 14

ITEM 14 EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K (A) 1 FINANCIAL STATEMENTS See Item 8, Index to Consolidated Financial Statements and Supplemental Data. (A) 2 FINANCIAL STATEMENT SCHEDULES PAGE ---- Independent Auditors' Report...................................... 81 Schedule IV - Indebtedness to related parties - non current as of December 31, 1993............................. 82 Schedule VIII - Valuation and qualifying accounts for the three years ended December 31, 1993.................... 83 Schedule X - Supplementary income statement information for the three years ended December 31, 1993.......... 84 All other schedules are omitted because they are not applicable or not required, or because the required information is included in the Consolidated Financial Statements or Notes thereto. (A) 3 EXHIBITS See the Exhibit Index included herewith. (B) REPORTS ON FORM 8-K No reports on Form 8-K were filed during the year ended December 31, 1993; however, a report on Form 8-K dated February 17, 1994 responding to Item 5 "Other Events" was filed on March 14, 1994. INDEPENDENT AUDITORS' REPORT TO THE BOARD OF DIRECTORS AND STOCKHOLDERS OF THE DELTONA CORPORATION: We have audited the consolidated financial statements of The Deltona Corporation and subsidiaries (the "Company") as of December 31, 1993 and December 25, 1992, and for each of the three years in the period ended December 31, 1993, and have issued our report thereon dated September 5, 1994, included elsewhere in this Annual Report on Form 10-K. Our audits also included the financial statement schedules listed in Item 14(a)2 of this Annual Report on Form 10-K. These financial statement schedules are the responsibility of the Company's management. Our responsibility is to express an opinion based on our audits. In our opinion, such financial statement schedules, when considered in relation to the basic consolidated financial statements taken as a whole, present fairly in all material respects the information set forth therein. DELOITTE & TOUCHE LLP Certified Public Accountants Miami, Florida September 5, 1994 SCHEDULE IV THE DELTONA CORPORATION AND SUBSIDIARIES INDEBTEDNESS TO RELATED PARTIES - NON CURRENT SCHEDULE VIII THE DELTONA CORPORATION AND SUBSIDIARIES VALUATION AND QUALIFYING ACCOUNTS (IN THOUSANDS) SCHEDULE X THE DELTONA CORPORATION AND SUBSIDIARIES SUPPLEMENTARY INCOME STATEMENT INFORMATION CHARGES (IN THOUSANDS) TO COSTS AND EXPENSES SIGNATURES Pursuant to the requirements of Section 13 or 15 (d) of the Securities Act of 1934, the Company has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. THE DELTONA CORPORATION (Company) By /S/ EARLE D. CORTRIGHT, JR. DATE: August 30, 1994 --------------------------------------- Earle D. Cortright, Jr., PRESIDENT & CHIEF OPERATING OFFICER Pursuant to the requirements of the Securities Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities indicated on the date indicated. /S/ ANTONY GRAM /S/ CORNELIS VAN DE PEPPEL - - ---------------------------------- -------------------------------- Antony Gram, CHIEF EXECUTIVE Cornelis van de Peppel, DIRECTOR OFFICER & DIRECTOR /S/ EARLE D. CORTRIGHT, JR. /S/ CORNELIS L.J.J. ZWAANS - - ---------------------------------- -------------------------------- Earle D. Cortright, Jr., PRESIDENT Cornelis L.J.J. Zwaans, DIRECTOR & CHIEF OPERATING OFFICER (PRINCIPAL FINANCIAL AND ACCOUNTING OFFICER) /S/ NEIL E. BAHR - - ---------------------------------- Neil E. Bahr, DIRECTOR /S/ GEORGE W. FISCHER - - ---------------------------------- George W. Fischer, DIRECTOR /S/ THOMAS B. MCNEILL - - ---------------------------------- Thomas B. McNeill, DIRECTOR /S/ MARCELLUS H.B. MUYRES - - ---------------------------------- Marcellus H.B. Muyres, DIRECTOR /S/ LEONARDUS G.M. NIPSHAGEN - - ---------------------------------- Leonardus G.M. Nipshagen, DIRECTOR DATE: August 30, 1994

84792_1993.txt

84792

1993

ITEM 1. BUSINESS The information indicated below appears in the 1993 Annual Report to Stockholders (Stockholders' Report) and is incorporated by reference: PAGE OF STOCKHOLDERS' REPORT ------------- Business operations: Polymers, Resins and Monomers .......................... 12 Plastics ............................................... 14 Performance Chemicals .................................. 15 Agricultural Chemicals ................................. 17 Industry segment information for years 1991-93 ............. 42 Foreign operations for years 1991-93 ....................... 42 Employees .................................................. 54 Raw Materials The company uses a variety of commodity chemicals as raw materials in its operations. In most cases, these raw materials are purchased from multiple sources under long-term contracts. Most of these materials are hydrocarbon derivatives such as propylene, acetone and styrene. Competition The principal market segments in which the company competes are described in the company's Annual Report to Stockholders on pages 12 through 18. The company experiences vigorous competition in each of these segments. The company's competitors include many large multinational chemical firms based in Europe, Japan and the United States. In some cases, the company competes against firms which are producers of commodity chemicals which the company must purchase as the raw materials to make its products. The company, however, does not believe this places it at any significant competitive disadvantage. The company's products compete with products offered by other manufacturers on the basis of price, product quality and specifications, and customer service. Most of the company's products are specialty chemicals which are sold to customers who demand a high level of customer service and technical expertise from the company and its sales force. Research and Development The company maintains its principal research and development laboratories at Spring House, Pennsylvania. Research and development expenses, substantially all company sponsored, totaled $204,990,000, $199,520,000, and $182,963,000 in 1993, 1992 and 1991, respectively. Approximately 16% of the company's employees have been engaged in research and development activities in each of the past three years. Environmental Matters A discussion of environmental matters is incorporated herein by reference to pages 28 and 29 of the Stockholders' Report. ITEM 2.

ITEM 2. PROPERTIES The company, its subsidiaries and affiliates presently operate 47 manufacturing facilities in 21 countries. A list identifying those facilities is found on page 60 of the company's Annual Report to Stockholders which is hereby incorporated by reference. Additional information addressing the suitability, adequacy and productive capacity of the company's facilities is found on page 30 of the company's Stockholders' Report and throughout the various business discussions of the company's industry segments found on pages 12 through 18 of the Stockholders' Report. ITEM 3.

ITEM 3. LEGAL PROCEEDINGS A discussion of legal proceedings is incorporated herein by reference to page 52 of the Stockholders' Report. ITEM 4.

ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS There were no matters submitted to a vote of security holders during the fourth quarter of 1993. PART II ITEM 5.

ITEM 5. MARKET FOR THE REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS The company's common stock of $2.50 par value is traded on the New York Stock Exchange (Symbol: ROH). There were 4,973 registered common stockholders as of March 4, 1994. The 1993 and 1992 quarterly summaries of the high and low prices of the company's common stock and the amounts of dividends paid on common stock are presented on pages 32 and 33 of the Stockholders' Report and are incorporated in this Form 10-K by reference. ITEM 6.

ITEM 6. SELECTED FINANCIAL DATA The company's summary of selected financial data and related notes for the years 1989 through 1993 are incorporated in this Form 10-K by reference to pages 54 through 56 of the Stockholders' Report. ITEM 7.

ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Management's discussion and analysis of 1991 to 1993 results is incorporated herein by reference to pages 22 through 31 of the Stockholders' Report. These items should be read in conjunction with the consolidated financial statements presented on pages 34 through 53 of the Stockholders' Report. ITEM 8.

ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA The consolidated balance sheets as of December 31, 1993, and 1992, and the related statements of consolidated earnings and retained earnings and cash flows for the years ended December 31, 1993, 1992, and 1991, together with the report of KPMG Peat Marwick dated February 21, 1994, are incorporated in this Form 10-K by reference to pages 34 through 53 of the Stockholders' Report. Supplementary selected quarterly financial data is incorporated in this Form 10-K by reference to pages 32 and 33 of the Stockholders' Report. ITEM 9.

ITEM 9. DISAGREEMENTS ON ACCOUNTING AND FINANCIAL DISCLOSURE No reports on Form 8-K were filed during 1993 or 1992 relating to any disagreements with accountants on accounting and financial disclosure. PART III ITEM 10.

ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT AND ITEM 11.

ITEM 11. EXECUTIVE COMPENSATION The information called for by Items 10 and 11 of this Form 10-K report for the fiscal year ended December 31, 1993, has been omitted, except for the information presented below, because the company on or about March 28, 1994, will file with the Securities and Exchange Commission a definitive Proxy Statement pursuant to regulation 14(a) under the Securities Exchange Act of 1934. Executive Officers The company's executive officers along with their present position, offices held and activities during the past five years are presented below. All officers normally are elected annually and serve at the pleasure of the Board of Directors. The company's non-employee directors and their business experience during the past five years are listed in the company's definitive Proxy Statement. Paul J. Baduini, 46, vice president since 1993; business unit director for ion exchange resins since 1992; previously manager of the Southern Cone countries from 1990 to 1991 and general manager of Rohm and Haas Brazil form 1988 to 1991. Albert H. Caesar, 56, vice president since 1993: business unit director and president of AtoHaas North America Inc. since 1992; previously business unit director for performance plastics from 1989 to 1992. Nance K. Dicciani, 46, vice president since 1993; business unit director for petroleum chemicals since 1991; previously general manager for business development and technology, chemicals group for Air Products and Chemicals, Inc. from 1990 to 1991 and director commercial development and technology, specialty chemicals division for Air Products and Chemicals, Inc. from 1988 to 1990. Robert M. Downing, 51, vice president since 1993; operations director for the North American region since 1986. David T. Espenshade, 55, vice president since 1993; director of materials management since 1990; previously business unit director for formulation chemicals from 1989 to 1990. J. Michael Fitzpatrick, 47, vice president since 1993; director of research since 1993; previously general manager of Rohm and Haas (UK) Limited and business director for polymers and resins from 1990 to 1993 and general manager of Rohm and Haas Mexico from 1988 to 1990. Donald C. Garaventi, 57, vice president since 1982; business group executive for polymers, resins and monomers and business unit director for polymers and resins since 1989; previously corporate business director for industrial chemicals and polymers, resins and monomers from 1986 to 1989. Rajiv L. Gupta, 48, vice president since 1993; regional director of Pacific since 1993; previously business unit director for plastics additives from 1989 to 1993. Howard C. Levy, 50, vice president since 1993; business unit director for biocides since 1989. Phillip G. Lewis, 43, vice president since 1993; director of safety, health and environmental affairs and product integrity since 1993; previously director of safety, health and environmental affairs from 1989 to 1993 and corporate medical director from 1987 to 1993. Enrique F. Martinez, 56, vice president and regional director of Latin America since 1989. John P. Mulroney, 58, director since 1982; president and chief operating officer since 1986; director of Teradyne Inc. and Aluminum Company of America. Robert E. Naylor, Jr., 61, director since 1986; group vice president and regional director of North America since 1989; previously group vice president for research and corporate development from 1985 to 1989; director of Airgas, Inc. Richard G. Peterson, 55, vice president since 1987; business group executive for performance chemicals and business unit director for separations since 1989; previously corporate business director for agricultural chemicals from 1987 to 1989. Frank R. Robertson, 53, vice president since 1991; business director for polymers and resins, North America, since 1989; previously business director for polymers, resins and monomers, European region, from 1985 to 1989. Fred W. Shaffer, 61, vice president since 1977; chief financial officer since 1978; previously controller from 1972 to 1990. William H. Staas, 50, vice president since 1993; business unit director for monomers since 1990; previously president of TosoHaas from 1988 to 1990. John F. Talucci, 54, vice president and business group executive for agricultural chemicals since 1989; previously director of polymers, resins and monomers business group for the North America region from 1983 to 1989. Charles M. Tatum, 46, vice president since 1990; business unit director of plastics additives since 1993; previously director of research from 1989 to 1993 and business director of agricultural chemicals business group, North America, from 1988 to 1989. Basil A. Vassiliou, 59, vice president since 1986; regional director of Europe since 1985; business group executive for plastics since 1991. Robert P. Vogel, 49, vice president since 1993; general counsel responsible for legal, insurance, tax and regulatory matters since 1994; previously associate general counsel, regulatory counsel and director of safety, health and environment and product integrity from 1991 to 1993 and associate general counsel and regulatory counsel from 1983 to 1990. J. Lawrence Wilson, 58, director since 1977; chairman of the board and chief executive officer since 1988; director of The Vanguard Group of Investment Companies and Cummins Engine Company, Inc. ITEM 12.

ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT The security ownership of certain beneficial owners and management is incorporated in this Form 10-K by reference to pages 18 and 19 of the definitive Proxy Statement to be filed with the Securities and Exchange Commission on or about March 28, 1994. ITEM 13.

ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS The information called for by Item 13 is incorporated in this Form 10-K by reference to pages 18 and 19 of the definitive Proxy Statement to be filed with the Securities and Exchange Commission on or about March 28, 1994. PART IV ITEM 14.

ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K (a) Documents filed as part of this report: 1. Financial Statements The consolidated financial statements of Rohm and Haas Company and the accompanying report of KPMG Peat Marwick dated February 21, 1994, are incorporated in this Form 10-K by reference to pages 34 through 53 of the Stockholders' Report, a complete copy of which follows page 6 of this report: 2. Financial Statement Schedules The following supplementary financial information is filed in this Form 10-K and should be read in conjunction with the financial statements in the Stockholders' Report: PAGE ---- Independent Auditors' Report on Financial Statement Schedules ... 6 Schedules submitted: V -- Land, buildings and equipment for the years 1993, 1992 and 1991 ............................................ 7 VI -- Accumulated depreciation of buildings and equipment for the years 1993, 1992 and 1991 ........................ 8 VIII -- Valuation and qualifying accounts for the years 1993, 1992 and 1991 ............................................ 9 The schedules not included herein are omitted because they are not applicable or the required information is presented in the financial statements or related notes. 3. Exhibits Exhibit (10), Material Contracts. The following management compensatory plans, which are subject to stockholders' approval at the annual meeting on May 2, 1994, are incorporated in this Form 10-K by reference to Exhibits A, B and C of the definitive Proxy Statement to be filed with the Securities and Exchange Commission on or about March 28, 1993: (a) Rohm and Haas Top Executive Annual Performance Award (b) Rohm and Haas Top Executive Long-Term Award Plan (c) Amended Rohm and Haas Stock Option Plan of 1992 Exhibit (12), Computation of Ratio of Earnings to Fixed Charges for the company and subsidiaries, is attached as page 10 of this Form 10-K. Exhibit (22), Subsidiaries of the registrant, is attached as page 11 of this Form 10-K. Exhibit (24), Consent of independent certified public accountants, is attached as page 13 of this Form 10-K. (b) On October 18, 1993, the company filed Form 8-K for reporting and filing a copy of the company's press release dated October 15, 1993, disclosing that the company expected to report a loss for the quarter ended September 30, 1993, due to charges not related to ongoing operations totaling $50 million, after tax, or 74 cents per share. These charges included an accrual for a landfill in New Jersey and a writedown of a plastics manufacturing facility in Kentucky. The company also restated first quarter earnings to reflect an after-tax charge of $20 million related to the adoption of a new accounting standard. SIGNATURES Pursuant to the requirements of Section 13 of the Securities Exchange Act of 1934, Rohm and Haas Company has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. /s/ Fred W. Shaffer --------------------------------- Fred W. Shaffer Vice President and Chief Financial Officer March 25, 1994 Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed on March 25, 1994 by the following persons on behalf of the registrant and in the capacities indicated. - ------------------------------------------------------------------------------ SIGNATURE AND TITLE SIGNATURE AND TITLE - ------------------------------------------------------------------------------ /s/ J. Lawrence Wilson /s/ Sandra O. Moose - ----------------------------------- ----------------------------------- J. Lawrence Wilson Sandra O. Moose Director, Chairman of the Board and Director Chief Executive Officer /s/ Fred W. Shaffer /s/ John P. Mulroney - ----------------------------------- ----------------------------------- Fred W. Shaffer John P. Mulroney Vice President and Director Chief Financial Officer /s/ George B. Beitzel /s/ Robert E. Naylor, Jr. - ----------------------------------- ----------------------------------- George B. Beitzel Robert E. Naylor, Jr. Director Director /s/ Daniel B. Burke /s/ Gilbert S. Omenn - ----------------------------------- ----------------------------------- Daniel B. Burke Gilbert S. Omenn Director Director /s/ Earl G. Graves /s/ Ronaldo H. Schmitz - ----------------------------------- ----------------------------------- Earl G. Graves Ronaldo H. Schmitz Director Director /s/ James A. Henderson /s/ Alan Schriesheim - ----------------------------------- ----------------------------------- James A. Henderson Alan Schriesheim Director Director /s/ John H. McArthur /s/ Marna C. Whittington - ----------------------------------- ----------------------------------- John H. McArthur Marna C. Whittington Director Director /s/ Paul F. Miller, Jr. - ----------------------------------- Paul F. Miller, Jr. Director INDEPENDENT AUDITORS' REPORT The Board of Directors and Stockholders Rohm and Haas Company: Under date of February 21, 1994, we reported on the consolidated balance sheets of Rohm and Haas Company and subsidiaries as of December 31, 1993 and 1992, and the related statements of consolidated earnings and retained earnings, and cash flows for each of the years in the three-year period ended December 31, 1993, as contained in the 1993 Annual Report to Stockholders. These consolidated financial statements and our report thereon are incorporated by reference in the annual report on Form 10-K for the year 1993. In connection with our audits of the aforementioned consolidated financial statements, we also audited the related financial statement schedules as listed under the heading "Financial Statement Schedules" on page 4. These financial statement schedules are the responsibility of the company's management. Our responsibility is to express an opinion on these financial statement schedules based on our audits. In our opinion, such financial statement schedules, when considered in relation to the basic consolidated financial statements taken as a whole, present fairly, in all material respects, the information set forth therein. As discussed in Notes 5 and 16 to the consolidated financial statements, the company adopted the provisions of Financial Accounting Standards Board Statement No. 112, "Accounting for Postemployment Benefits" in 1993, and the provisions of Financial Accounting Standards Board Statements No. 106, "Accounting for Postretirement Benefits Other Than Pensions" and No. 109, "Accounting for Income Taxes," in 1992. /s/ KPMG PEAT MARWICK --------------------------------- KPMG PEAT MARWICK Philadelphia, PA February 21, 1994

7974_1993.txt

7974

1993

ITEM 1. BUSINESS. The following description of business is provided in accordance with General Instruction J.(2)(d). Associates First Capital Corporation ("First Capital" or the "Company"), a Delaware corporation, is an indirect subsidiary of Ford Motor Company ("Ford"). All the outstanding Common Stock of First Capital is owned by Ford Holdings, Inc. ("Holdings"). First Capital's principal operating subsidiary is Associates Corporation of North America ("Associates"), the second largest independent finance company in the United States as of September 30, 1993. Unless the context otherwise requires, reference to First Capital or Associates includes each parent company and all its subsidiaries. At December 31, 1993, First Capital had 1,390 branch offices in the United States and employed approximately 12,400 persons. Corporate headquarters are located in Irving, Texas. First Capital's primary business activities are consumer finance, commercial finance and insurance underwriting. See NOTE 17 to the consolidated financial statements for financial information by business segment. Consumer Finance Consumer finance consists of making and investing in residential real estate-secured loans to individuals, making secured and unsecured installment loans to individuals, purchasing consumer retail installment obligations, investing in credit card receivables, financing manufactured housing ("MHO") purchases, and providing other consumer financial services. In addition, First Capital offers insurance to its consumer finance customers. Loans made to individuals are secured by mortgages on real property, by liens on personal property (the realizable value of which may be less than the amount of the loans secured) or are unsecured. At December 31, 1993, 74% of the gross outstanding balance of residential real estate-secured receivables was secured by first mortgages. At December 31, 1993, the gross consumer finance receivables included credit card receivables ($3.3 billion) owned or originated by Associates National Bank (Delaware), a subsidiary of First Capital. The interest rates currently charged on all types of consumer finance receivables average approximately 16% simple interest per annum. At December 31, 1993, the interest rates charged on approximately 38% of the net consumer finance receivables outstanding varied during the term of the contract at specified intervals in relation to a base rate established at the time the loan was made. State laws establish maximum allowable finance charges for certain consumer loans; approximately 91% of the outstanding gross consumer finance receivables were either not subject to such state maximums, or if subject, such maximum finance charges did not, in most cases, materially restrict the interest rates charged. Original maturities of residential real estate-secured receivables average 147 months and original maturities of other consumer receivables, excluding credit card and manufactured housing receivables, average 35 months. Original maturities of manufactured housing receivables average 240 months. Commercial Finance Commercial finance consists of the purchase of time sales obligations and leases, direct leases and secured direct loans, and sales of other financial services, including automobile club, mortgage banking and relocation services. In addition, First Capital offers insurance to its commercial finance customers. The types of equipment financed or leased are heavy-duty trucks, truck trailers, autos and other transportation equipment, construction equipment, machinery used in various manufacturing and distribution processes and communications equipment. Except for lease transactions in which First Capital owns the equipment, liens on the equipment financed secure the receivables. In many cases, First Capital obtains the endorsement or a full or limited repurchase agreement of the seller or the manufacturer of the goods, and in some cases, a portion of the purchase price of the installment obligations is withheld as a reserve. At December 31, 1993, the interest rates charged on approximately 13% of the net commercial finance receivables were established to vary during the term of the contract in relation to a base rate. Commercial finance receivables are generally not subject to maximum finance charges established by state law, and where such restrictions apply, at the present time, they do not materially restrict the interest rates charged. The interest rates currently charged on all types of commercial finance receivables average approximately 9% simple interest per annum. Original maturities of the commercial receivables average 36 months. Volume of Financing The following tables set forth the gross volume of finance business by major categories and average size and number of accounts based on gross finance receivables volume (excluding wholesale receivables) for the periods indicated: During the year ended December 31, 1993, 23% of the total gross volume of consumer loans, excluding credit card receivables, was made to current creditworthy customers that requested additional funds. The average balance prior to making an additional advance was $9,115 and the average additional advance was $3,112. Finance Receivables The following tables set forth the amounts of gross finance receivables held at year end by major categories and average size and number of accounts held at year end for the years indicated: Gross Finance Receivables Held at End of Year Consumer Finance Commercial Finance Residential Installment, Heavy-Duty Truck Total Real Estate- MHO and and Industrial Gross Secured Credit Card Equipment Finance Receivables Receivables Receivables Receivables (Dollar Amounts in Millions) At December 31 1993 $10,626.0 $9,869.8 $9,077.2 $29,573.0 36% 33% 31% 100% 1992 $ 9,820.0 $8,122.6 $7,672.0 $25,614.6 38% 32% 30% 100% 1991 $ 8,146.0 $7,188.7 $7,209.7 $22,544.4 36% 32% 32% 100% 1990 $ 4,900.5 $5,236.1 $6,310.2 $16,446.8 30% 32% 38% 100% 1989 $ 3,766.4 $4,176.6 $6,144.1 $14,087.1 27% 29% 44% 100% Average Size and Number of Accounts Based on Gross Finance Receivables Held at End of Year Consumer Finance Commercial Finance Residential Installment, Heavy-Duty Truck Real Estate- MHO and and Industrial Secured Credit Card Equipment Receivables Receivables Receivables At December 31 1993 Average Size $37,787 $2,489 $31,218 Number of Accounts 281,206 3,965,781 290,765 1992 Average Size $36,725 $2,551 $27,792 Number of Accounts 267,394 3,183,747 276,055 1991 Average Size $33,829 $2,469 $27,506 Number of Accounts 240,798 2,910,995 262,110 1990 Average Size $33,928 $2,097 $28,002 Number of Accounts 144,438 2,496,411 225,349 1989 Average Size $32,310 $2,055 $28,357 Number of Accounts 116,570 2,032,490 216,670 The ten largest customer accounts at December 31, 1993, other than accounts with affiliates (as described in NOTE 14 to the consolidated financial statements), represented 0.8% of the total gross finance receivables outstanding. Of such ten accounts, five were secured by heavy- duty trucks or truck trailers, two were secured by construction equipment, two were secured by a manufacturer's endorsement and related to communications equipment and one was secured by auto leasing arrangements. At December 31, 1993, the largest gross balance outstanding in such accounts was $31.2 million and the average gross balance was $24.9 million. Credit Loss and Delinquency Experience The credit loss experience, net of recoveries, of the finance business for the years indicated is set forth in the following table (dollar amounts in millions): Year Ended or at December 31 1993 1992 1991 1990 1989 NET CREDIT LOSSES Consumer Finance Amount $371.3 $382.9 $354.2 $254.2 $186.1 % of Average Net Receivables 2.19% 2.64% 2.84% 3.06% 2.59% % of Receivables Liquidated 3.41 4.57 5.65 5.51 5.05 Commercial Finance Amount $ 22.4 $ 41.8 $ 34.6 $ 23.4 $ 11.7 % of Average Net Receivables .30% .64% .60% .44% .22% % of Receivables Liquidated .26 .61 .61 .41 .20 Total Net Credit Losses Amount $393.7 $424.7 $388.8 $277.6 $197.8 % of Average Net Receivables 1.61% 2.02% 2.13% 2.03% 1.59% % of Receivables Liquidated 2.03 2.80 3.24 2.69 2.09 ALLOWANCE FOR LOSSES Balance at End of Period $808.9 $699.2 $590.9 $449.7 $390.1 % of Net Receivables 3.07% 3.06% 2.93% 3.02% 3.07% The allowance for losses on finance receivables is based on percentages of net finance receivables established by management for each major category of receivables based on historical loss experience, plus an amount for possible adverse deviation from historical experience. Additions to the allowance are charged to the provision for losses on finance receivables. An analysis of changes in the allowance for losses is included in NOTE 4 to the consolidated financial statements. Finance receivables are charged to the allowance for losses when they are deemed to be uncollectible. Additionally, Company policy provides for charge-off of various types of accounts as follows: consumer direct installment receivables, except those collateralized by residential real estate, are charged to the allowance for losses when no cash payment has been received for six months; credit card receivables are charged to the allowance for losses when the receivable becomes contractually six months delinquent; all other finance receivables are charged to the allowance for losses when any of the following conditions occur: (i) the related security has been converted or destroyed; (ii) the related security has been repossessed and sold or held for sale for one year; or (iii) the related security has not been repossessed and the receivable has become contractually one year delinquent. Recoveries on losses previously charged to the allowance are credited to the allowance at the time the recovery is collected. Delinquency on consumer residential real estate-secured and direct installment and credit card receivables is determined by the date of the last cash payment received from the customer (recency of payment basis), a delinquent loan being one on which the customer has paid no cash whatsoever for a period of time. It is not First Capital's policy to accept token payments on delinquent accounts. A delinquent account on all types of receivables, other than consumer residential real estate-secured and direct installment and credit card receivables, is one on which the customer has not made payments as contractually agreed (contractual payment basis). Extensions are granted on receivables from customers with satisfactory credit and with prior approval of management. The following tables show (i) the gross account balances delinquent sixty through eighty-nine days, ninety days and more, and total gross balances delinquent sixty days and more; and (ii) total gross balances delinquent sixty days and more by type of business at the dates indicated (dollar amounts in millions): Insurance Underwriting First Capital is engaged in the property and casualty and accidental death and dismemberment insurance business through Associates Insurance Company ("AIC") and in the credit life, credit accident and health insurance business through Associates Financial Life Insurance Company ("AFLIC"), principally for customers of the finance operations of First Capital. At December 31, 1993, AIC was licensed to do business in 50 states, the District of Columbia and Canada, and AFLIC was licensed to do business in 49 states and the District of Columbia. In addition, First Capital receives compensation for certain insurance programs underwritten by other companies through marketing arrangements in a number of states. The operating income produced by the finance operations' sale of insurance products is included in the respective finance operations' operating income. The following table sets forth the net property and casualty insurance premiums written by major lines of business for the years indicated (in millions): Year Ended December 31 1993 1992 1991 1990 1989 Automobile Physical Damage $ 97.6 $ 79.9 $ 69.2 $ 86.8 $ 85.0 Fire and Extended Coverage 41.3 27.8 15.8 31.2 30.7 Other Liability (a) 20.1 25.0 23.6 17.0 14.5 Total Net Premiums Written $159.0 $132.7 $108.6 $135.0 $130.2 (a) Includes contractual liability for auto club road service program. The following table sets forth the aggregate premium income relating to credit life, credit accident and health and accidental death and dismemberment insurance for the years indicated, and the life insurance in force at the end of each respective year (in millions): The following table summarizes the revenue of the insurance operation for the years indicated (in millions): Year Ended December 31 1993 1992 1991 1990 1989 Premium Revenue (a) $242.2 $209.9 $202.5 $212.7 $196.9 Investment Income 38.4 41.5 53.3 58.4 56.3 Total Revenue $280.6 $251.4 $255.8 $271.1 $253.2 (a) Includes compensation for insurance programs underwritten by other companies through marketing arrangements. Competition and Regulation The interest rates charged for the various classes of receivables of First Capital's finance business vary with the type of risk and maturity of the receivable and are generally affected by competition, current interest rates and, in some cases, governmental regulation. In addition to competition with finance companies, competition exists with, among others, commercial banks, thrift institutions, credit unions and retailers. Consumer finance operations are subject to detailed supervision by state authorities under legislation and regulations which generally require finance companies to be licensed and which, in many states, govern interest rates and charges, maximum amounts and maturities of credit and other terms and conditions of consumer finance transactions, including disclosure to a debtor of certain terms of each transaction. Licenses may be subject to revocation for violations of such laws and regulations. In some states, the commercial finance operations are subject to similar laws and regulations. Customers may seek damages for violations of state and Federal statutes and regulations governing lending practices, interest rates and other charges. Federal legislation preempts state interest rate ceilings on first mortgage loans and state laws which restrict various types of alternative residential real estate-secured receivables, except in those states which have specifically opted out of such preemption. Certain Federal and state statutes and regulations, among other things, require disclosure of the finance charges in terms of an annual percentage rate, make credit discrimination unlawful on a number of bases, require disclosure of a maximum rate of interest on variable or adjustable rate mortgage loans, and limit the types of security that may be taken in connection with non-purchase money consumer loans. Federal and state legislation in addition to that mentioned above has been, and from time to time may be, introduced which seeks to regulate the maximum interest rate and/or other charges on consumer finance receivables, including credit cards. Associates National Bank (Delaware) (the "Bank"), is under the supervision of, and subject to examination by, the Office of the Comptroller of the Currency. In addition, the Bank is subject to the rules and regulations of the Federal Reserve Board and the Federal Deposit Insurance Corporation ("FDIC"). Associates Investment Corporation is regulated by the FDIC and the Utah Department of Financial Institutions. Areas subject to regulation by these agencies include capital adequacy, loans, deposits, consumer protection, the payment of dividends and other aspects of operations. The insurance business is subject to detailed regulation, and premiums charged on certain lines of insurance are subject to limitation by state authorities. Most states in which insurance subsidiaries of First Capital are authorized to conduct business have enacted insurance holding company legislation pertaining to insurance companies and their affiliates. Generally, such laws provide, among other things, limitations on the amount of dividends payable by any insurance company and guidelines and standards with respect to dealings between insurance companies and affiliates. It is not possible to forecast the nature or the effect on future earnings or otherwise of present and future legislation, regulations and decisions with respect to the foregoing, or other related matters. ITEM 2.

ITEM 2. PROPERTIES. The furniture, equipment and other physical property owned by First Capital and its subsidiaries represent less than 1% of total assets at December 31, 1993 and are therefore not significant in relation to total assets. The branch finance operations are generally conducted on leased premises under short-term operating leases normally not exceeding five years. ITEM 3.

ITEM 3. LEGAL PROCEEDINGS. Because the finance and insurance businesses involve the collection of numerous accounts, the validity and priority of liens, and loss or damage claims under many types of insurance policies, the finance and insurance subsidiaries of First Capital are plaintiffs and defendants in numerous legal proceedings, including class action lawsuits. Neither First Capital nor any of its subsidiaries is a party to, nor is the property thereof the subject of, any pending legal proceedings which depart from the ordinary routine litigation incident to the kinds of business conducted by First Capital and its subsidiaries or, if such proceedings constitute other than routine litigation, in which there is a reasonable possibility of an adverse decision which could have any material adverse effect upon the financial condition of First Capital. There are no proceedings pending or, to the Company's knowledge, threatened by or on behalf of any administrative board or regulatory body which would materially affect or impair the right of First Capital or any of its subsidiaries to carry on any of their respective businesses. PART II ITEM 4.

ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS. Omitted in accordance with General Instruction J.(2)(c) to Form 10-K. ITEM 5.

ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS. All of the outstanding Common Stock of First Capital is owned by Ford Holdings, Inc. There is no market for First Capital stock. Dividends on the Common Stock are paid when declared by the Board of Directors. Annual Common Stock dividends of $226.0 million and $190.0 million were paid during the years ended December 31, 1993 and 1992, respectively. Associates, First Capital's principal operating subsidiary, is subject to various limitations under the provisions of its outstanding debt and revolving credit agreements, including limitations on the payment of dividends. See Liquidity/Capital Resources under Item 7, herein, for a description of such limitations. ITEM 6.

ITEM 6. SELECTED FINANCIAL DATA. The information that follows is being provided in lieu of the information called for by Item 6 of Form 10-K, in accordance with General Instruction J.(2)(a) to Form 10-K. The following table sets forth selected consolidated financial information regarding the Company's financial position and operating results which has been extracted from the Company's consolidated financial statements for the five years ended December 31, 1993. The information should be read in conjunction with the Management's Discussion and Analysis of Financial Condition and Results of Operations and the consolidated financial statements and accompanying footnotes included elsewhere in this report (dollar amounts in millions): ITEM 7.

ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS. The following management's narrative analysis of the results of operations is provided in lieu of management's discussion and analysis, in accordance with General Instruction J.(2)(a) to Form 10-K. Results of Operations REVENUE - Total revenue for the year ended December 31, 1993 increased $359.0 million (11%), compared with the year ended December 31, 1992. The components of the increase were as follows: Finance charges increased $316.0 million (11%), primarily caused by an increase in average net finance receivables outstanding, which was partially offset by a decrease in average revenue rates. Average net finance receivables outstanding were $24.4 billion and $21.0 billion for the years ended December 31, 1993 and 1992, respectively, a 16% increase. Total net finance receivables increased by approximately $3.5 billion (15%) from December 31, 1992 to December 31, 1993. Of the total growth, 23% was in the residential real estate-secured portfolio, 20% was in the direct installment and credit card portfolios, 19% was in the manufactured housing and other portfolios, 23% was in the heavy-duty truck portfolio and 15% was in the industrial equipment portfolio. The growth was due, in part, to the acquisitions of finance businesses or finance receivables of Allied Finance Company (April 1993), and Mack Financial Corporation and Great Western Financial Corporation (September 1993) as described in NOTE 3 to the consolidated financial statements. The average revenue rates on aggregate net receivables were 13.4% and 14.1% for the years ended December 31, 1993 and 1992, respectively. The decline in the average revenue rates was principally due to changes in market conditions, including lower prevailing market rates affecting yields on new business and variable and adjustable rate loans, and a shift in the loan portfolio mix toward a higher percentage of commercial loans, which generally have lower yields than consumer loans. Insurance premiums increased $32.3 million (15%) as a result of increased sales of insurance products, primarily in the credit life and credit accident and health insurance programs. Investment and other income increased $10.7 million (6%), due to an increase in fee-based financial services revenue, which was partially offset by a decrease in interest income from loans to former foreign subsidiaries of First Capital as a result of decreased balances outstanding, and a general decrease in the interest rates on investments. EXPENSES - Total expenses for the year ended December 31, 1993 increased $213.6 million (8%), compared with the year ended December 31, 1992. The components of the increase were as follows: Interest expense increased $59.1 million (5%). This change was caused by an increase in average outstanding debt ($186.7 million) attributable to higher net finance receivables outstanding, which was partially offset by a decrease in average interest rates ($127.6 million). The annual average interest rates on total debt, including amortization of discount and issuance expense, were as follows: Year Ended December 31 1993 1992 Short-term Debt 3.11% 3.68% Long-term Debt 8.03 8.78 Total Debt 5.94 6.55 The net interest margin was 7.92% and 7.98% for the years ended December 31, 1993 and 1992, respectively. Operating expenses increased $176.1 million (21%), primarily as a result of increased salaries, employment benefits and other operating expenses generally related to increased volumes of business, including acquisitions. The provision for loan losses decreased by $36.5 million (7%), primarily due to decreased losses. Net credit losses, measured in dollars and as a percent of average net finance receivables, declined during the twelve-month period ended December 31, 1993, compared to the same period ended December 31, 1992. The allowance for losses increased $109.7 million (16%) to $808.9 million at December 31, 1993 from $699.2 million at December 31, 1992. The increase primarily relates to the growth in net finance receivables. The allowance for losses, measured as a percent of net finance receivables, remained at a relatively constant level at December 31, 1993 (3.07%) compared to December 31, 1992 (3.06%). The allowance for losses is maintained at a level which considers, among other factors, historical loss experience, possible deviations from historical loss experience and varying economic conditions. Insurance benefits paid or provided increased $14.9 million (15%) in 1993, primarily due to an increase in property and casualty insurance claims. EARNINGS BEFORE PROVISION FOR INCOME TAXES AND CUMULATIVE EFFECT OF CHANGES IN ACCOUNTING PRINCIPLES - As a result of the aforementioned changes, earnings before provision for income taxes and cumulative effect of changes in accounting principles increased $145.4 million (24%) during 1993. PROVISION FOR INCOME TAXES - The provision for income taxes represented 37.5% and 35.2% of earnings before provision for income taxes for the years ended December 31, 1993 and 1992, respectively. The increase in the effective tax rate is primarily related to an increase in the Federal statutory rate and the method of computing state taxes as described in NOTE 8 to the consolidated financial statements. EARNINGS BEFORE CUMULATIVE EFFECT OF CHANGES IN ACCOUNTING PRINCIPLES - Earnings before cumulative effect of changes in accounting principles increased $76.9 million (20%) during 1993. CUMULATIVE EFFECT OF CHANGES IN ACCOUNTING PRINCIPLES - In 1992, the Company recorded a one-time charge of $10.4 million relating to the adoption of two new accounting standards. See NOTE 2 to the consolidated financial statements for additional information. NET EARNINGS - As a result of the aforementioned changes, net earnings increased $87.3 million (23%) during 1993. Liquidity/Capital Resources The following sets forth liquidity and capital resources for First Capital and its subsidiaries other than Associates and its subsidiaries. First Capital's primary sources of funds have been (i) borrowings from both commercial banks and the public and (ii) borrowings and dividends from Associates. The amount of dividends which may be paid by Associates is limited by certain provisions of its outstanding debt and revolving credit agreements. A restriction contained in one series of debt securities maturing August 1, 1996, generally limits payments of cash dividends on Associates Common Stock in any one year to not more than 50% of Associates consolidated net earnings for such year, subject to certain exceptions, plus increases in contributed capital and extraordinary gains. Any such amounts available for the payment of dividends in such fiscal year and not so paid, may be paid in any one or more of the five subsequent fiscal years. In accordance with this provision, at December 31, 1993, $221.9 million was available for dividends. A restriction contained in certain revolving credit agreements requires Associates to maintain a minimum tangible net worth, as defined, of $1.5 billion. At December 31, 1993, Associates tangible net worth was approximately $2.9 billion. A debt agreement of Associates limits the total of all affiliate-related receivables, as defined, to 7% of the aggregate gross receivables owned by Associates. An affiliate within the meaning of affiliate-related receivables includes First Capital, its parent corporation, and any corporation, other than Associates and its subsidiaries, of which First Capital or its parent corporation owns or controls at least 50% of its stock. The net total of all affiliate-related receivables which Associates owned at December 31, 1993 and 1992, amounted to 1.5% and 1.2%, respectively, of its aggregate gross receivables as of those dates. At December 31, 1993, First Capital had contractually committed bank lines of credit of $75.0 million, and revolving credit facilities of $250.0 million, none of which was in use. During 1993, First Capital raised $209.3 million through public and private offerings of medium- and long-term debt. The following sets forth liquidity and capital resources for Associates: Associates endeavors to maximize its liquidity by diversifying its sources of funds, which include: (i) its operations; (ii) the issuance of commercial paper; (iii) the issuance of unsecured intermediate-term debt in the public and private markets; (iv) borrowings available from short-term and revolving credit facilities with commercial banks; and (v) receivables purchase facilities. Issuance of Short- and Intermediate-Term Debt Commercial paper, with maturities ranging from 1 to 270 days, is the primary source of short-term debt. The average commercial paper interest rate incurred during 1993 was 3.11%. Associates issues intermediate-term debt publicly and privately in the domestic and foreign markets. During the year ended December 31, 1993, Associates raised $3.6 billion through public and private offerings at a weighted average effective interest rate and a weighted average term of 5.64% and 6.5 years, respectively. Credit Facilities and Related Borrowings Associates policy is to maintain bank credit facilities in support of its net short-term borrowings consistent with market conditions. Bank credit facilities provide a means of refinancing maturing commercial paper obligations as needed. At December 31, 1993, short-term bank lines and revolving credit facilities with banks totaled $8.2 billion, none of which was in use at that date. These facilities represented 80% of net short-term borrowings outstanding at December 31, 1993. Bank lines and revolvers may be withdrawn only under certain standard conditions. Associates pays fees or maintains compensating balances or utilizes a combination of both to maintain the availability of its bank credit facilities. Fees are .05% to .25% of 1% per annum of the amount of the facilities. At December 31, 1993 and 1992, Associates short-term debt, as defined, as a percent of total debt was 52%. Short-term debt, for purposes of this computation, includes the current portion of long-term debt but excludes short-term investments. See NOTES 5, 6 and 7 to the consolidated financial statements for a description of credit facilities, notes payable and long- term debt, respectively. Recent Accounting Pronouncements Effective January 1, 1993, the Company adopted Statement of Financial Accounting Standards ("SFAS") No. 112, "Employers' Accounting for Postretirement Benefits" and SFAS No. 113, "Accounting and Reporting for Reinsurance of Short-Duration and Long-Duration Contracts". The adoption of these standards was not significant to the Company's consolidated financial statements. The Financial Accounting Standards Board has issued SFAS No. 114, "Accounting by Creditors for Impairment of a Loan" effective 1995, SFAS No. 115, "Accounting for Certain Investments in Debt and Equity Securities" effective 1994, and SFAS No. 116, "Accounting for Contributions Received and Contributions Made" effective 1995. Adoption of these pronouncements is not expected to be significant to the Company's consolidated financial statements. ITEM 8.

ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA. REPORT OF INDEPENDENT ACCOUNTANTS Board of Directors Associates First Capital Corporation We have audited the consolidated financial statements and the financial statement schedule listed in Item 14(a) of this Form 10-K of Associates First Capital Corporation (an indirect subsidiary of Ford Motor Company). These financial statements and financial statement schedule are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements and financial statement schedule based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of Associates First Capital Corporation as of December 31, 1993 and 1992 and the consolidated results of their operations and their cash flows for each of the three years in the period ended December 31, 1993, in conformity with generally accepted accounting principles. In addition, in our opinion, the financial statement schedule referred to above, when considered in relation to the basic financial statements taken as a whole, presents fairly, in all material respects, the information required to be included therein. As discussed in NOTE 2 to the consolidated financial statements, effective January 1, 1992, the Company changed its methods of accounting for postretirement benefit costs other than pensions and income taxes. COOPERS & LYBRAND Dallas, Texas February 1, 1994 ASSOCIATES FIRST CAPITAL CORPORATION CONSOLIDATED STATEMENT OF EARNINGS (In Millions) Year Ended December 31 1993 1992 1991 REVENUE Finance charges $3,276.3 $2,960.3 $2,786.9 Insurance premiums 242.2 209.9 202.5 Investment and other income 187.1 176.4 197.7 3,705.6 3,346.6 3,187.1 EXPENSES Interest expense 1,340.5 1,281.4 1,347.8 Operating expenses 1,022.3 846.2 773.6 Provision for losses on finance receivables - NOTE 4 476.1 512.6 434.2 Insurance benefits paid or provided 114.9 100.0 91.1 2,953.8 2,740.2 2,646.7 EARNINGS BEFORE PROVISION FOR INCOME TAXES AND CUMULATIVE EFFECT OF CHANGES IN ACCOUNTING PRINCIPLES 751.8 606.4 540.4 PROVISION FOR INCOME TAXES - NOTE 8 281.7 213.2 193.1 EARNINGS BEFORE CUMULATIVE EFFECT OF CHANGES IN ACCOUNTING PRINCIPLES 470.1 393.2 347.3 CUMULATIVE EFFECT OF CHANGES IN ACCOUNTING PRINCIPLES - NOTE 2 (10.4) NET EARNINGS $ 470.1 $ 382.8 $ 347.3 See notes to consolidated financial statements. The weighted average interest rate for total long-term debt was 7.54% for 1993 and 8.33% for 1992. The estimated fair value of long-term debt at December 31, 1993 was $14.5 billion. The fair value was determined by discounting expected cash flows at discount rates currently available to the Company for debt with similar terms and remaining maturities. Long-term borrowing maturities during the next five years, including the current portion of notes payable after one year are: 1994, $2,203.1 million; 1995, $2,097.6 million; 1996, $2,334.4 million; 1997, $2,029.6 million; 1998, $1,316.1 million; and 1999 and thereafter $3,620.0 million. Certain debt issues contain call provisions or may be subject to repayment provisions at the option of the holder on specified dates prior to the maturity date. At December 31, 1993, approximately 3,500 warrants were outstanding to purchase $154.8 million aggregate principal amount of senior notes at par with interest rates ranging from 7.00% to 10.50%. The warrants are exercisable at various dates through October 1, 1999 at prices ranging from $1,000 to $25,000,000 per warrant. All of the above issues are unsecured except for a $50 million, 8.25% Senior Note due August 15, 2001, which is collateralized by First Capital's corporate offices. NOTE 8 - PROVISION FOR INCOME TAXES On August 10, 1993, the Omnibus Budget Reconciliation Act of 1993 (the "Act") was enacted. Among other changes, the Act increased the Federal income tax rate for corporations by one percentage point to 35% effective January 1, 1993. Net income for 1993 included a reduction of $2.1 million in the provision for income taxes as a result of restating deferred tax balances. The favorable effect reflects the higher tax rate applied to the Company's net deferred tax assets. Effective January 1, 1992, the Company adopted SFAS No. 109, "Accounting for Income Taxes". The cumulative effect of the accounting change was recognized in the December 31, 1992 Consolidated Statement of Earnings as a one-time increase to net earnings in the amount of $29.8 million. The following table sets forth the components of the provision for U.S. Federal and State income taxes and deferred income tax (benefit) for the periods indicated (in millions): Federal State Total Year ended December 31, 1993 Current $337.1 $20.5 $357.6 Deferred: Leasing transactions 3.6 3.6 Finance revenue 3.9 3.9 Provision for losses on finance receivables and other (83.4) (83.4) $261.2 $20.5 $281.7 Year ended December 31, 1992 Current $226.0 $ 8.8 $234.8 Deferred: Leasing transactions 13.6 13.6 Finance revenue 12.9 12.9 Provision for losses on finance receivables and other (48.1) (48.1) $204.4 $ 8.8 $213.2 Year ended December 31, 1991 Current $182.7 $ 6.4 $189.1 Deferred: Leasing transactions 15.1 15.1 Finance revenue 16.8 16.8 Provision for losses on finance receivables and other (27.9) (27.9) $186.7 $ 6.4 $193.1 In 1993, the Company entered into a tax-sharing agreement with Ford whereby state income taxes are provided on a separate-return basis. Prior to 1993, state income taxes were provided on a consolidated-return basis. At December 31, 1993 and 1992, the components of the Company's net deferred tax asset were as follows (in millions): 1993 1992 Deferred tax assets: Provision for losses on finance receivables and other $ 368.8 $ 301.7 Postretirement and other employee benefits 68.1 45.8 436.9 347.5 Deferred tax liabilities: Leasing transactions (145.9) (143.4) Finance revenue and other (192.6) (182.6) (338.5) (326.0) Net deferred tax asset $ 98.4 $ 21.5 Due to the Company's earnings levels, no valuation allowance related to the deferred tax asset has been recorded. The effective tax rate differed from the statutory U.S. Federal income tax rate as follows: % of Pretax Income Year Ended December 31 1993 1992 1991 Statutory tax rate 35.0% 34.0% 34.0% State and other 2.5 1.2 1.7 Effective tax rate 37.5% 35.2% 35.7% NOTE 9 - DEBT RESTRICTIONS Associates, First Capital's principal operating subsidiary, is subject to various limitations under the provisions of its outstanding debt and revolving credit agreements. The most significant of these limitations are summarized as follows: LIMITATION ON PAYMENT OF DIVIDENDS A restriction contained in one series of debt securities maturing August 1, 1996, generally limits payments of cash dividends on Associates Common Stock in any year to not more than 50% of Associates consolidated net earnings for such year, subject to certain exceptions, plus increases in contributed capital and extraordinary gains. Any such amounts available for the payment of dividends in such fiscal year and not so paid, may be paid in any one or more of the five subsequent fiscal years. In accordance with this provision, at December 31, 1993, $221.9 million was available for dividends. LIMITATION ON MINIMUM TANGIBLE NET WORTH A restriction contained in certain revolving credit agreements requires Associates to maintain a minimum tangible net worth, as defined, of $1.5 billion. At December 31, 1993, Associates tangible net worth was approximately $2.9 billion. LIMITATION ON AFFILIATE RECEIVABLES A debt agreement of Associates limits the total of all affiliate-related receivables, as defined, to 7% of the aggregate gross receivables owned by Associates. An affiliate within the meaning of affiliate-related receivables includes First Capital, its parent corporation, and any corporation, other than Associates and its subsidiaries, of which First Capital or its parent corporation owns or controls at least 50% of its stock. The net total of all affiliate-related receivables which Associates owned at December 31, 1993 and 1992, amounted to 1.5% and 1.2%, respectively, of its aggregate gross receivables as of those dates. NOTE 10 - LEASE COMMITMENTS Leases are primarily short-term and generally provide for renewal options not exceeding the original term. Total rent expense for the years ended December 31, 1993, 1992 and 1991 was $43.9 million, $38.3 million, and $34.5 million, respectively. Minimum rental commitments as of December 31, 1993 for all noncancelable leases (primarily office leases) for the years ending December 31, 1994, 1995, 1996, 1997 and 1998, are $37.0 million, $29.8 million, $22.2 million, $11.4 million and $5.1 million, respectively, and $4.6 million thereafter. NOTE 11 - EMPLOYEE BENEFITS DEFINED BENEFIT PLANS The Company sponsors various qualified and nonqualified pension plans (the "Plan" or "Plans"), which together cover substantially all permanent employees who meet certain eligibility requirements. Net periodic pension cost for the years indicated includes the following components (in millions): December 31 (a) 1993 1992 1991 Service cost $ 10.0 $ 8.4 $ 6.6 Interest cost 18.1 16.1 13.9 Actual return on Plan assets (21.6) (10.0) (28.4) Net amortization 7.4 (2.5) 19.0 Net periodic pension cost $ 13.9 $ 12.0 $ 11.1 The funded status of the Plans is as follows (in millions): The projected benefit obligation at December 31, 1993 and 1992 was determined using a discount rate of 7.0% and 8.0%, respectively, projected compensation increases of 6.0% and expected return on plan assets of 9.5%. A determination of the Federal income tax status related to the qualified Pension Plan has not been requested because the Internal Revenue Service has only recently begun accepting certain qualified pension plan applications. An application is expected to be filed during 1994. If a favorable determination letter is not received, First Capital has agreed to make any changes required to receive a favorable determination letter. RETIREMENT SAVINGS AND PROFIT SHARING PLAN The Company sponsors a defined contribution plan intended to provide assistance in accumulating personal savings for retirement and is designed to qualify under Sections 401(a) and 401(k) of the Internal Revenue Code. The savings plan has not been submitted to the Internal Revenue Service for approval as a qualified tax-exempt plan. Consequently, the plan provisions are subject to issuance of a favorable determination letter by the Internal Revenue Service. For the years ended December 31, 1993, 1992 and 1991, the Company's pretax contributions to the plan were $14.0 million, $12.1 million and $9.9 million, respectively. EMPLOYERS' ACCOUNTING FOR POSTRETIREMENT BENEFITS OTHER THAN PENSIONS The Company provides certain postretirement benefits through unfunded plans sponsored by First Capital. These benefits are currently provided to substantially all permanent employees who meet certain eligibility requirements. The benefits or the plan can be modified or terminated at the discretion of the Company. The Company adopted SFAS No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions" in 1992. As of January 1, 1992, the Company recorded a one-time charge to net earnings of approximately $40.2 million, which represents the estimated accumulated postretirement benefit obligation on that date of $64.9 million, net of deferred income taxes of approximately $20.7 million and amounts recorded as purchase accounting adjustments of approximately $4.0 million. This amount has been reflected in the Consolidated Statement of Earnings as a component of the cumulative effect of changes in accounting principles. Prior to 1992, the cost of providing these benefits was recognized as a charge to income as claims were paid. The amount paid for postretirement benefits for the years ended December 31, 1993, 1992 and 1991 was approximately $1.5 million, $2.1 million and $1.2 million, respectively. Net periodic postretirement benefit cost for 1993 and 1992 includes the following components (in millions): December 31 1993 1992 Service cost $ 4.2 $3.2 Interest cost 6.3 5.8 Net amortization (0.7) Net periodic postretirement benefit cost $ 9.8 $9.0 Accrued postretirement benefit cost at December 31, 1993 and 1992 is composed of the following (in millions): December 31 1993 1992 Accumulated postretirement benefit obligation ("APBO"): Retired participants $ 33.6 $27.8 Fully eligible participants 21.1 15.6 Other active participants 30.7 32.8 total APBO 85.4 76.2 Unamortized amendments 11.5 Unrecognized actuarial loss (16.8) (4.4) Accrued postretirement benefit cost $ 80.1 $71.8 For measurement purposes, a 12.50% and 13.32% weighted average annual rate of increase in per capita cost of covered health care benefits was assumed for 1993 and 1992, respectively, decreasing gradually to 5.50% by the year 2009. Discount rates of 7.50% and 8.50% were used in measuring the APBO at December 31, 1993 and 1992, respectively. Increasing the assumed health care cost trend rate by one percentage point each year would increase the APBO as of December 31, 1993 and 1992 by $6.2 million and $5.1 million, respectively, and the aggregate of the service and interest cost components of the net periodic postretirement benefit cost for each year then ended by $0.8 million. NOTE 12 - COMMITMENTS AND CONTINGENCIES First Capital and its subsidiaries are defendants in various legal proceedings which arose in the normal course of business. In management's judgment (based upon the advice of counsel) the ultimate liabilities, if any, from such legal proceedings will not have a material adverse effect on the financial position of First Capital. NOTE 13 - OTHER ASSETS The components of Other Assets at December 31, 1993 and 1992 were as follows (in millions): December 31 1993 1992 Balances with related parties - NOTE 14 $ 167.5 $ 193.2 Goodwill 382.2 405.2 Other 666.0 589.9 Total other assets $1,215.7 $1,188.3 Other assets include residential real estate-secured receivables held for sale by Associates National Mortgage Corporation, a subsidiary of the Company. At December 31, 1993, the aggregate book value was $77.6 million, which approximates estimated fair value. The estimated fair value was determined by discounting expected cash flows from such receivables at current market rates. NOTE 14 - TRANSACTIONS AND BALANCES WITH RELATED PARTIES CAPITAL TRANSACTIONS Effective as of December 15, 1993, First Capital received from Ford Holdings a capital contribution of $200.0 million in the form of cash. OTHER TRANSACTIONS AND BALANCES First Capital, through Associates, provided debt financing to certain of its former foreign subsidiaries. At December 31, 1993 and 1992, amounts due from foreign affiliates totaled $167.5 million and $193.2 million, respectively, and were included in Other Assets. These receivables bear fluctuating interest rates and are payable on demand. Interest income related to these transactions was $21.3 million, $34.0 million and $47.5 million for the years ended December 31, 1993, 1992 and 1991, respectively. The estimated fair value of these receivables was $175.6 million at December 31, 1993. At December 31, 1992, the gross consumer finance receivables included a participation in consumer receivables of $142.0 million of First Nationwide Bank, FSB, an affiliate of First Capital. This balance was included in Finance Receivables. The Company provides certain services of an administrative nature, use of certain tangible and intangible assets, including trademarks, guarantees of debt and related interest, and other management services to certain of its foreign affiliates in Japan, Canada, Puerto Rico and the United Kingdom. Such services and usage are charged to the affiliates based on the nature of the service. Fees for such guarantees range from .25% to 1% of the average outstanding debt guaranteed. Management believes the percentages represent fair value. The amounts paid or accrued under these arrangements for the years ended December 31, 1993, 1992 and 1991 were $40.1 million, $35.5 million and $25.3 million, respectively. At December 31, 1993 and 1992, the Company was a guarantor on debt and related accrued interest of its foreign affiliates in Canada and Puerto Rico amounting to $256.7 million and $154.5 million, respectively. At December 31, 1993 and 1992, First Capital's current income taxes payable to Holdings amounted to $40.2 million and $45.1 million, respectively. NOTE 15 - FINANCIAL INSTRUMENTS WITH OFF-BALANCE-SHEET RISKS The Company maintains cash, cash equivalents, investments, and certain other financial instruments with various major financial institutions. To the extent such deposits exceed maximum insurance levels, they are uninsured. Currency swap contracts are entered into as part of the Company's funding strategy. The Company has an interest rate swap contract acquired as part of a business acquisition. Amounts under currency and interest rate swap contracts at December 31, 1993 were approximately $202.9 million. Should a counterparty to these contracts fail to meet the terms of the contracts, the Company could be at market risk for any currency and/or interest rate differentials. At December 31, 1993, the Company estimated its exposure to loss resulting from currency and interest rate differentials, in event of non-performance by all counterparties, was $14.0 million, which also approximated the estimated fair value of amounts under contract. Associates National Bank (Delaware) a subsidiary of First Capital, makes available credit lines to holders of their credit cards. The unused portion of the available credit is revocable by the bank under specified conditions. The unused portion of the available credit at December 31, 1993 approximated $8.2 billion. The potential risk associated with, and the estimated fair value of, the unused credit lines are not considered to be significant. The consumer operation grants revolving lines of credit to certain of its customers. At December 31, 1993, the unused portion of these lines aggregated approximately $712.4 million. The potential risk associated with, and the estimated fair value of, the unused credit lines are not considered to be significant. The commercial operation grants lines of credit to certain dealers of truck, construction equipment and manufactured housing. At December 31, 1993, the unused portion of these lines aggregated approximately $684.6 million. The potential risk associated with, and the estimated fair value of, the unused credit lines are not considered to be significant. NOTE 16 - INVESTMENTS IN MARKETABLE SECURITIES DEBT SECURITIES Debt security investments, principally bonds and notes, are intended to be held for the foreseeable future and are carried at amortized cost. However, if market conditions or other factors subsequently change, such securities may be sold prior to maturity with the realized gain or loss included in investment and other income. Amortized cost at December 31, 1993 and 1992 was $598.7 million and $480.0 million, respectively. The following table sets forth, by type of security issuer, the amortized cost, gross unrealized gains and estimated market value at December 31, 1993 (in millions): Gross Estimated Amortized Unrealized Market Cost Gains Value U.S. Government obligations $456.5 $12.4 $468.9 Corporate obligations 58.0 0.8 58.8 Mortgage-backed and other obligations 84.2 0.1 84.3 Total debt securities $598.7 $13.3 $612.0 The amortized cost and estimated market value of debt securities at December 31, 1993, by contractual maturity, are shown below (in millions): Estimated Amortized Market Cost Value Due in one year or less $ 52.3 $ 52.4 Due after one year through five years 370.1 378.2 Due after five years through ten years 168.5 172.9 Due after ten years 7.8 8.5 $598.7 $612.0 EQUITY SECURITIES Equity security investments, principally common stock held by the Company's insurance subsidiaries, are recorded at market value. Market value at December 31, 1993 and 1992 was $35.0 million and $27.3 million, respectively. Historical cost of these investments at December 31, 1993 and 1992 was $28.9 million and $21.8 million, respectively. Estimated market values of debt and equity securities are based on quoted market prices. NOTE 17 - BUSINESS SEGMENT INFORMATION First Capital's primary business activities are consumer finance, commercial finance and insurance underwriting. The consumer finance operation is engaged in making and investing in residential real estate-secured receivables, consumer direct installment and revolving credit receivables, including credit card receivables, primarily through a wholly-owned credit card bank, purchasing consumer retail installment obligations, and providing other consumer financial services. The commercial finance operation is principally engaged in financing sales of transportation and industrial equipment and leasing, and sales of other financial services, including automobile club, mortgage banking and relocation services. The insurance operation is engaged in underwriting credit life and credit accident and health, property, casualty and accidental death and dismemberment insurance, principally for customers of the finance operations, and such sales are the principal amounts included in the intersegment revenue shown below. The following table sets forth information by business segment (in millions): NOTE 18 - CONDENSED FINANCIAL INFORMATION OF REGISTRANT (PARENT COMPANY ONLY) Condensed unconsolidated financial information of Associates First Capital Corporation as of or for the years ended December 31, 1993, 1992 and 1991 were as follows (in millions): CONDENSED STATEMENT OF EARNINGS Year Ended December 31 1993 1992 1991 Revenue Interest and other income $ 6.7 $ 6.1 $ 20.9 Dividends from subsidiaries 242.7 191.6 201.3 249.4 197.7 222.2 Expenses Interest expense 51.1 56.5 78.5 Operating expenses 15.3 15.2 10.3 66.4 71.7 88.8 Income before credit for Federal income taxes and equity in net earnings of subsidiaries 183.0 126.0 133.4 Credit for Federal income taxes resulting from tax agreements with subsidiaries 21.2 21.7 23.1 Earnings before equity in undistributed earnings of subsidiaries 204.2 147.7 156.5 Equity in undistributed earnings of subsidiaries 265.9 235.1 190.8 Net earnings $470.1 $382.8 $347.3 CONDENSED BALANCE SHEET December 31 1993 1992 Assets Investment in and advances to subsidiaries, eliminated in consolidation, and other $3,198.9 $2,773.7 Total assets $3,198.9 $2,773.7 Liabilities and Stockholder's Equity Accounts payable and accruals $ 19.9 $ 26.4 Notes payable and long-term debt (1) 672.7 685.4 Stockholder's equity (2) 2,506.3 2,061.9 Total liabilities and stockholder's equity $3,198.9 $2,773.7 The estimated fair value of notes payable and long-term debt at December 31, 1993 was $685.3 million. Fair values were estimated by discounting expected cash flows at discount rates currently available to the Company for debt with similar terms and remaining maturities. See notes to condensed financial information. CONDENSED STATEMENT OF CASH FLOWS (In Millions) Year Ended December 31 1993 1992 1991 Cash Flows from Operating Activities Net earnings $ 470.1 $ 382.8 $ 347.3 Adjustments to net earnings for noncash items: Amortization and depreciation 0.1 0.1 0.1 (Decrease) increase in accounts payable and accruals (6.5) (13.7) 6.4 Equity in undistributed earnings of subsidiaries (265.9) (235.1) (190.8) Other (0.6) 1.0 2.9 Net cash provided from operating activities 197.2 135.1 165.9 Cash Flows from Investing Activities Cash dividends from subsidiaries (1) 242.7 191.6 201.3 Increase in investments in and advances to subsidiaries (402.7) (151.7) (96.2) Net cash provided from (used for) investing activities (160.0) 39.9 105.1 Cash Flows from Financing Activities Increase in notes payable and long-term debt (2) 231.6 241.8 23.2 Cash dividends paid (226.0) (190.0) (173.0) Retirement of long-term debt (244.2) (228.4) (271.0) Capital contribution from parent 200.0 154.0 Net cash used for financing activities (38.6) (176.6) (266.8) (Decrease) increase in cash and cash equivalents (1.4) (1.6) 4.2 Cash and cash equivalents at beginning of period 0.5 2.1 (2.1) Cash and cash equivalents at end of period $ (0.9) $ 0.5 $ 2.1 NOTES TO CONDENSED FINANCIAL INFORMATION: (1) The ability of the Company's subsidiaries to transfer funds to the Company in the form of cash dividends is restricted pursuant to the terms of certain debt agreements entered into by the Company's principal operating subsidiary, Associates Corporation of North America. See NOTE 9 to the consolidated financial statements for a summary of the most significant of these restrictions. (2) Notes payable and long-term debt bear interest at rates from 4.00% to 13.75%. The estimated maturities of the notes outstanding, at December 31, 1993, during subsequent years were as follows (in millions): 1994 $356.0 1995 120.5 1996 89.5 1997 60.3 1998 46.4 $672.7 ITEM 9.

ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE. Not Applicable. PART III ITEM 10.

ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT. ITEM 11.

ITEM 11. EXECUTIVE COMPENSATION. ITEM 12.

ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT. ITEM 13.

ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS. The information required by Items 10-13 has been omitted in accordance with General Instruction J.(2)(c) to Form 10-K. PART IV ITEM 14.

ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K. (a)(1) Financial Statements Page Report of Independent Accountants 16 Consolidated Statement of Earnings for the years ended December 31, 1993, 1992 and 1991 17 Consolidated Balance Sheet at December 31, 1993 and 1992 18 Consolidated Statement of Changes in Stockholder's Equity for the years ended December 31, 1993, 1992 and 1991 19 Consolidated Statement of Cash Flows for the years ended December 31, 1993, 1992 and 1991 20 Notes to consolidated financial statements 21 (2) Financial Statement Schedules II - Amounts Receivable from Related Parties and Underwriters, Promoters and Employees Other than Related Parties. All other schedules are omitted because either they are not applicable or the information required to be included therein is provided in the consolidated financial statements or related notes. (b) Reports on Form 8-K. During the quarter ended December 31, 1993, First Capital filed no Current Reports on Form 8-K. (c) Exhibits (3) (a) Certificate of Incorporation. Incorporated by reference to Exhibit 3(a) to the Company's Form 10-K for the fiscal year ended October 31, 1986. (b) By-laws. Incorporated by reference to Exhibit 3 to the Company's Form 10-K for the year ended December 31, 1990. (4) Instruments with respect to issues of long-term debt have not been filed as exhibits to this annual report on Form 10-K as the authorized principal amount of any one of such issues does not exceed 10% of the total assets of the registrant and its consolidated subsidiaries. Registrant agrees to furnish to the Commission a copy of each such instrument upon its request. (12) Computation of Ratio of Earnings to Fixed Charges. (22) Subsidiaries of the registrant. Omitted in accordance with General Instruction J.(2)(b) to Form 10-K. (24) Consent of Independent Accountants. (25) Powers of Attorney. SIGNATURES No annual report to security holders or proxy material has been or will be sent to security holders. Pursuant to the requirements of Section 13 or 15(d) 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. ASSOCIATES FIRST CAPITAL CORPORATION By /s/ ROY A. GUTHRIE Senior Vice President and Comptroller March 25, 1994 Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the date indicated. Signature Title Date REECE A. OVERCASH, JR.* Chairman of the Board, (Reece A. Overcash, Jr.) Principal Executive Officer and Director KEITH W. HUGHES* President, Chief Operating (Keith W. Hughes) Officer and Director JAMES E. JACK* Senior Executive Vice President and (James E. Jack) Principal Financial Officer ROY A. GUTHRIE* Senior Vice President, March 25, 1994 (Roy A. Guthrie) Comptroller and Principal Accounting Officer HAROLD D. MARSHALL* Director (Harold D. Marshall) JOSEPH M. McQUILLAN* Director (Joseph M. McQuillan) By signing his name hereto, Roy A. Guthrie signs this document on behalf of himself and each of the other persons indicated above pursuant to powers of attorney duly executed by such persons. *By /s/ ROY A. GUTHRIE Attorney-in-fact SCHEDULE II INDEX TO EXHIBITS Sequentially Exhibit Numbered Number Exhibit Page (3) (a) Certificate of Incorporation. Incorporated by reference to Exhibit 3(a) to the Company's Form 10-K for the fiscal year ended October 31, 1986. (b) By-laws. Incorporated by reference to Exhibit 3 to the Company's Form 10-K for the year ended December 31, 1990. (4) Instruments with respect to issues of long-term debt have not been filed as exhibits to this annual report on Form 10-K as the authorized principal amount of any one of such issues does not exceed 10% of the total assets of the registrant and its consolidated subsidiaries. Registrant agrees to furnish to the Commission a copy of each such instrument upon request. (12) Computation of Ratio of Earnings to Fixed Charges. (22) Subsidiaries of the registrant. Omitted in accordance with General Instruction J.(2)(b) to Form 10-K. (24) Consent of Independent Accounts. (25) Powers of Attorney. EXHIBIT 12 EXHIBIT 12 ASSOCIATES FIRST CAPITAL CORPORATION COMPUTATION OF RATIO OF EARNINGS TO FIXED CHARGES (Dollar Amounts In Millions) Year Ended December 31 1993 1992 1991 Fixed Charges (a) Interest expense $1,340.5 $1,281.4 $1,347.8 Implicit interest in rent 1.9 1.6 2.2 Total fixed charges $1,342.4 $1,283.0 $1,350.0 Earnings (b) $ 751.8 $ 606.4 $ 540.4 Fixed charges 1,342.4 1,283.0 1,350.0 Earnings, as defined $2,094.2 $1,889.4 $1,890.4 Ratio of Earnings to Fixed Charges 1.56 1.47 1.40 (a) For purposes of such computation, the term "Fixed Charges" represents interest expense and a portion of rentals representative of an implicit interest factor for such rentals. (b) For purposes of such computation, the term "Earnings" represents earnings before provision for income taxes and cumulative effect of changes in accounting principles, plus fixed charges. EXHIBIT 24 EXHIBIT 24 CONSENT OF INDEPENDENT ACCOUNTANTS We consent to the incorporation by reference in the registration statement of Associates First Capital Corporation on Form S-3 (No. 33-65752) of our report dated February 1, 1994, on our audits of the consolidated financial statements and financial statement schedule of Associates First Capital Corporation as of December 31, 1993 and 1992, and for the years ended December 31, 1993, 1992, and 1991, which report is included in this Annual Report on Form 10-K. COOPERS & LYBRAND Dallas, Texas March 25, 1994 EXHIBIT 25 POWER OF ATTORNEY KNOW ALL MEN BY THESE PRESENTS, that the undersigned, an officer and/or a director of ASSOCIATES FIRST CAPITAL CORPORATION (the "Company"), has made, constituted and appointed and by these presents does hereby make, constitute and appoint THOMAS E. DALE, ROY A. GUTHRIE, CHESTER D. LONGENECKER and REECE A. OVERCASH, JR., and each of them, his true and lawful attorneys, for him and in his name, place and stead, and in his office and capacity as aforesaid, to sign and file the Company's Annual Report on Form 10-K for the fiscal year ended December 31, 1993, and any and all amendments thereto and any and all other documents to be signed and filed with the Securities and Exchange Commission in connection therewith, hereby granting to said THOMAS E. DALE, ROY A. GUTHRIE, CHESTER D. LONGENECKER and REECE A. OVERCASH, JR., and each of them, full power and authority to do and perform each and every act and thing whatsoever requisite and necessary to be done in the premises, as fully, to all intents and purposes, as he might or could do if personally present, hereby ratifying and confirming in all respects all that said THOMAS E. DALE, ROY A. GUTHRIE, CHESTER D. LONGENECKER and REECE A. OVERCASH, JR., or any of them, as said attorneys, may or shall lawfully do or cause to be done by virtue hereof. IN WITNESS WHEREOF, the undersigned has set his hand this 28th day of February, 1994. SIGNATURE:/s/ Reece A. Overcash, Jr. Reece A. Overcash, Jr. OFFICE: Chairman of the Board, Principal Executive Officer and Director POWER OF ATTORNEY KNOW ALL MEN BY THESE PRESENTS, that the undersigned, an officer and/or a director of ASSOCIATES FIRST CAPITAL CORPORATION (the "Company"), has made, constituted and appointed and by these presents does hereby make, constitute and appoint THOMAS E. DALE, ROY A. GUTHRIE, CHESTER D. LONGENECKER and REECE A. OVERCASH, JR., and each of them, his true and lawful attorneys, for him and in his name, place and stead, and in his office and capacity as aforesaid, to sign and file the Company's Annual Report on Form 10-K for the fiscal year ended December 31, 1993, and any and all amendments thereto and any and all other documents to be signed and filed with the Securities and Exchange Commission in connection therewith, hereby granting to said THOMAS E. DALE, ROY A. GUTHRIE, CHESTER D. LONGENECKER and REECE A. OVERCASH, JR., and each of them, full power and authority to do and perform each and every act and thing whatsoever requisite and necessary to be done in the premises, as fully, to all intents and purposes, as he might or could do if personally present, hereby ratifying and confirming in all respects all that said THOMAS E. DALE, ROY A. GUTHRIE, CHESTER D. LONGENECKER and REECE A. OVERCASH, JR., or any of them, as said attorneys, may or shall lawfully do or cause to be done by virtue hereof. IN WITNESS WHEREOF, the undersigned has set his hand this 28th day of February, 1994. SIGNATURE:/s/ Keith W. Hughes Keith W. Hughes OFFICE: President, Chief Operating Officer and Director POWER OF ATTORNEY KNOW ALL MEN BY THESE PRESENTS, that the undersigned, an officer and/or a director of ASSOCIATES FIRST CAPITAL CORPORATION (the "Company"), has made, constituted and appointed and by these presents does hereby make, constitute and appoint THOMAS E. DALE, ROY A. GUTHRIE, CHESTER D. LONGENECKER and REECE A. OVERCASH, JR., and each of them, his true and lawful attorneys, for him and in his name, place and stead, and in his office and capacity as aforesaid, to sign and file the Company's Annual Report on Form 10-K for the fiscal year ended December 31, 1993, and any and all amendments thereto and any and all other documents to be signed and filed with the Securities and Exchange Commission in connection therewith, hereby granting to said THOMAS E. DALE, ROY A. GUTHRIE, CHESTER D. LONGENECKER and REECE A. OVERCASH, JR., and each of them, full power and authority to do and perform each and every act and thing whatsoever requisite and necessary to be done in the premises, as fully, to all intents and purposes, as he might or could do if personally present, hereby ratifying and confirming in all respects all that said THOMAS E. DALE, ROY A. GUTHRIE, CHESTER D. LONGENECKER and REECE A. OVERCASH, JR., or any of them, as said attorneys, may or shall lawfully do or cause to be done by virtue hereof. IN WITNESS WHEREOF, the undersigned has set his hand this 28th day of February, 1994. SIGNATURE:/s/ Harold D. Marshall Harold D. Marshall OFFICE: Director POWER OF ATTORNEY KNOW ALL MEN BY THESE PRESENTS, that the undersigned, an officer and/or a director of ASSOCIATES FIRST CAPITAL CORPORATION (the "Company"), has made, constituted and appointed and by these presents does hereby make, constitute and appoint THOMAS E. DALE, ROY A. GUTHRIE, CHESTER D. LONGENECKER and REECE A. OVERCASH, JR., and each of them, his true and lawful attorneys, for him and in his name, place and stead, and in his office and capacity as aforesaid, to sign and file the Company's Annual Report on Form 10-K for the fiscal year ended December 31, 1993, and any and all amendments thereto and any and all other documents to be signed and filed with the Securities and Exchange Commission in connection therewith, hereby granting to said THOMAS E. DALE, ROY A. GUTHRIE, CHESTER D. LONGENECKER and REECE A. OVERCASH, JR., and each of them, full power and authority to do and perform each and every act and thing whatsoever requisite and necessary to be done in the premises, as fully, to all intents and purposes, as he might or could do if personally present, hereby ratifying and confirming in all respects all that said THOMAS E. DALE, ROY A. GUTHRIE, CHESTER D. LONGENECKER and REECE A. OVERCASH, JR., or any of them, as said attorneys, may or shall lawfully do or cause to be done by virtue hereof. IN WITNESS WHEREOF, the undersigned has set his hand this 28th day of February, 1994. SIGNATURE:/s/ Joseph M. McQuillan Joseph M. McQuillan OFFICE: Director POWER OF ATTORNEY KNOW ALL MEN BY THESE PRESENTS, that the undersigned, an officer and/or a director of ASSOCIATES FIRST CAPITAL CORPORATION (the "Company"), has made, constituted and appointed and by these presents does hereby make, constitute and appoint THOMAS E. DALE, ROY A. GUTHRIE, CHESTER D. LONGENECKER and REECE A. OVERCASH, JR., and each of them, his true and lawful attorneys, for him and in his name, place and stead, and in his office and capacity as aforesaid, to sign and file the Company's Annual Report on Form 10-K for the fiscal year ended December 31, 1993, and any and all amendments thereto and any and all other documents to be signed and filed with the Securities and Exchange Commission in connection therewith, hereby granting to said THOMAS E. DALE, ROY A. GUTHRIE, CHESTER D. LONGENECKER and REECE A. OVERCASH, JR., and each of them, full power and authority to do and perform each and every act and thing whatsoever requisite and necessary to be done in the premises, as fully, to all intents and purposes, as he might or could do if personally present, hereby ratifying and confirming in all respects all that said THOMAS E. DALE, ROY A. GUTHRIE, CHESTER D. LONGENECKER and REECE A. OVERCASH, JR., or any of them, as said attorneys, may or shall lawfully do or cause to be done by virtue hereof. IN WITNESS WHEREOF, the undersigned has set his hand this 28th day of February, 1994. SIGNATURE:/s/ James E. Jack James E. Jack OFFICE: Senior Executive Vice President, Principal Financial Officer and Director POWER OF ATTORNEY KNOW ALL MEN BY THESE PRESENTS, that the undersigned, an officer and/or a director of ASSOCIATES FIRST CAPITAL CORPORATION (the "Company"), has made, constituted and appointed and by these presents does hereby make, constitute and appoint THOMAS E. DALE, ROY A. GUTHRIE, CHESTER D. LONGENECKER and REECE A. OVERCASH, JR., and each of them, his true and lawful attorneys, for him and in his name, place and stead, and in his office and capacity as aforesaid, to sign and file the Company's Annual Report on Form 10-K for the fiscal year ended December 31, 1993, and any and all amendments thereto and any and all other documents to be signed and filed with the Securities and Exchange Commission in connection therewith, hereby granting to said THOMAS E. DALE, ROY A. GUTHRIE, CHESTER D. LONGENECKER and REECE A. OVERCASH, JR., and each of them, full power and authority to do and perform each and every act and thing whatsoever requisite and necessary to be done in the premises, as fully, to all intents and purposes, as he might or could do if personally present, hereby ratifying and confirming in all respects all that said THOMAS E. DALE, ROY A. GUTHRIE, CHESTER D. LONGENECKER and REECE A. OVERCASH, JR., or any of them, as said attorneys, may or shall lawfully do or cause to be done by virtue hereof. IN WITNESS WHEREOF, the undersigned has set his hand this 28th day of February, 1994. SIGNATURE:/s/ Roy A. Guthrie Roy A. Guthrie OFFICE: Senior Vice President, Comptroller and Principal Accounting Officer

10427_1993.txt

10427

1993

ITEM 1. BUSINESS (a) GENERAL DEVELOPMENT OF BUSINESS Bausch & Lomb Incorporated is a world leader in the development, manufacture and marketing of products and services for the personal health, medical, biomedical and optics fields. Bausch & Lomb was incorporated in the State of New York in 1908 to carry on a business which was established in 1853. Its principal executive offices are located in Rochester, New York. Unless the context indicates otherwise, the terms "Bausch & Lomb" and "Company" as used herein refer to Bausch & Lomb Incorporated and its consolidated subsidiaries. Highlights of the general development of the business of Bausch & Lomb Incorporated during 1993 are discussed below. The Company experienced good progress in 1993. Sales increased to $1,872 million, 10% above the 1992 amount of $1,709 million. Including restructuring charges in 1993, earnings amounted to $156.5 million or $2.60 per share. Excluding these charges, earnings advanced to $193.0 million, or $3.21 per share, a 13% increase over the 1992 amounts of $171.4 million and $2.84 per share. (b) FINANCIAL INFORMATION ABOUT INDUSTRY SEGMENTS Information concerning sales, business segment earnings and identifiable assets attributable to each of Bausch & Lomb's reportable industry segments is set forth on pages 3440 and 51-52 of the Annual Report and is incorporated herein by reference. (c) NARRATIVE DESCRIPTION OF BUSINESS Bausch & Lomb's operations have been classified into two industry segments: Healthcare and Optics. Below is a description of each segment and information to the extent that it is material to an understanding of the Company's business taken as a whole. In addition, pages 22-32 of the Annual Report are incorporated herein by reference. Healthcare The Healthcare segment includes personal health, medical and biomedical products. In the personal health area, major lines include solutions used for the care of contact lenses and for the relief of eye irritation, contact lens accessories, Clear Choice mouthwash, certain over-the-counter pharmaceutical products, the Interplak power toothbrushes and other oral care products, and Curel and Soft Sense skin care products. Medical products include contact lenses and lens materials, prescription drugs, the Miracle- Ear line of hearing aids and Steri-Oss dental implants. Biomedical products include purpose-bred laboratory animals for biomedical research, products derived from specific pathogenfree eggs, and a variety of other biotechnical and professional services provided to the scientific research community. The Company markets its personal health products in the U.S. to practitioners through its own sales force and through drug stores, food stores, and mass merchandisers. Personal health products are also marketed through an extensive international marketing organization. Distribution in many other countries is accomplished through distributors or dealers. Medical products are marketed through the Company's sales force to eyecare and dental care practitioners, independent optical laboratories, and hospitals. Hearing aids are distributed through the Miracle-Ear franchise system. Sales to pharmacies are handled by drug wholesalers, while marketing of medical products outside the U.S. is accomplished through the Company's extensive international marketing organization. In some countries, distribution is handled through dealers or distributors. Biomedical products are sold primarily through the Company's sales force worldwide. The Company acquired Steri-Oss, Inc., a California manufacturer of dental implants, during the first quarter of 1993. The breadth and quality of its line of coated and uncoated titanium implants has earned Steri-Oss an excellent reputation among dental professionals. During the second quarter of 1993, Bausch & Lomb acquired the Curel and Soft Sense lines of skin care products from S. C. Johnson and Son, Inc. These lines are expected to benefit from the Company's marketing and distribution expertise. The acquisition of Dahlberg, Inc. during the third quarter of 1993 expanded Bausch & Lomb's participation in the hearing care field. Dahlberg is the maker of the Miracle-Ear line of hearing aids, a widely recognized hearing aid brand name, which has over 1,000 franchised locations in the U.S. During the fourth quarter of 1993, the Company received licenses to product several generic pharmaceuticals in its state- of-the-art, aseptic manufacturing plant in Tampa, Florida. Additional approvals are anticipated during 1994. The Company introduced the Occasions line of contact lenses in 1993. Occasions are worn only once before being discarded and will be especially beneficial in selected situations when contact lenses are preferred over spectacles. Vivivit Q10 vitamins were introduced in Germany by the Company's Dr. Mann Pharma subsidiary during the second half of 1993. Favorable trade acceptance of this product led to a successful launch. Optics The principal products of the Company's Optics segment include sunglasses, binoculars, riflescopes, telescopes and optical thin film applications and products. Optical products are distributed worldwide through distributors, wholesalers, manufacturers' representatives, and independent sales representatives. These products are also distributed through the Company's sales force to optical stores, department stores, catalog showrooms, mass merchandisers, sporting goods stores and, in the case of optical thin films, to a variety of industrial customers. During 1993, the Company launched the Ray-Ban Survivors line of sunglasses. These products feature DiamondHard lens coatings which render glass lenses more scratch resistant. These sunglasses met with good acceptance among active, outdoor oriented consumers. The Company also introduced the Bausch & Lomb Elite riflescope during the year. It features multi-coated optics, durable construction and proven accuracy. It is expected to meet with good aceptance among consumers who demand the highest quality riflescopes. Raw Materials and Parts; Customers Materials and components in both of the Company's industry segments are purchased from a wide variety of suppliers and the loss of any one supplier would not adversely affect the Company's business to a significant extent. No material part of the Company's business in either of its industry segments is dependent upon a single or a few customers. Patents, Trademarks & Licenses While in the aggregate the Company's patents are of material importance to its businesses taken as a whole, no single patent or patent license or group of patents or patent licenses relating to any particular product or process is material to either industry segment. The Company actively pursues technology development and acquisition as a means to enhance its competitive position in its business segments. In the healthcare segment, Bausch & Lomb has developed significant consumer, eye care professional and dental care professional recognition of products sold under the Bausch & Lomb, Sensitive Eyes, ReNu, Boston, SeeQuence, Medalist, The Boston Lens, Optima, Soflens, Charles River, VAF/Plus and Interplak trademarks. Bausch & Lomb, Ray-Ban, Wayfarer and Bushnell are trademarks receiving substantial consumer recognition in the optics segment. Seasonality and Working Capital Some seasonality exists for the Interplak line of power toothbrushes in the Healthcare segment and for sunglasses and sports optics products in the Optics segment. During some periods, the accumulation of inventories of such products in advance of expected shipments reflects the seasonal nature of the products. In general, the working capital practices followed in each of the Company's industry segments are typical of those businesses. Competition Each industry segment is highly competitive in both U.S. and non-U.S. markets. In both of its segments, Bausch & Lomb competes on the basis of product performance, quality, technology, price, service, warranty and reliability. In the Optics segment, the Company also competes on the basis of style. Research and Development Research and development constitutes an important part of Bausch & Lomb's activities. In 1993, the Company's research and development expenditures totaled $58 million, as compared to $53 million in 1992 and $49 million in 1991. Environment Although Bausch & Lomb is unable to predict what legislation or regulations may be adopted or enacted in the future with respect to environmental protection and waste disposal, existing legislation and regulations have had no material adverse effect on its capital expenditures, earnings or competitive position. Capital expenditures for property, plant and equipment for environmental control facilities were not material during 1993 and are not anticipated to be material in 1994 or 1995. Number of Employees Bausch & Lomb employed approximately 15,900 persons as of December 25, 1993. (d) FINANCIAL INFORMATION ABOUT FOREIGN AND DOMESTIC OPERATIONS AND EXPORT SALES Information as to sales, operating earnings and identifiable assets attributable to each of Bausch & Lomb's geographic regions, and the amount of export sales in the aggregate, is set forth on page 51 of the Annual Report and is incorporated herein by reference. ITEM 2.

ITEM 2. PROPERTIES The principal manufacturing, distribution and production facilities and other important physical properties of Bausch & Lomb at March 1, 1994 are listed hereafter and grouped under the principal industry segment to which they relate. Certain properties relate to more than one industry segment. Except where otherwise indicated by footnote, all properties shown are held in fee and are not subject to major encumbrances. HEALTHCARE Manufacturing Plants Distribution Centers Yorba Linda, CA (2) Yorba Linda, CA (2) Sarasota, FL (1) Tampa, FL Tampa, FL Tucker, GA (2) Wilmington, MA (2) Golden Valley, MN (1) Golden Valley, MN (1) Greenville, SC (2) Hauppauge, NY (2) Lynchburg, VA (2) Rochester, NY (1),(2) Turtle Lake, WI (1) (Optics Center) Greenville, SC Turtle Lake, WI (1) North Ryde, Australia (2) Porto Alegre, Brazil Rio de Janeiro, Brazil (2) Kitchener, Canada (2) Beijing, China (2) Berlin, Germany Bhiwadi, India Jakarta, Indonesia (2) Waterford, Ireland (2) Milan, Italy Umsong-Gun (Seoul), Korea Naucalcan, Mexico (2) Barcelona, Spain Madrid, Spain Hastings, United Kingdom Production Facilities Hollister, CA (2) Brussels, Belgium Lebanon, CT (2) St. Constant, Canada Preston, CT (2) Henfield, England Summerland Key, FL Margate, England Roanoke, IL (2) L'Arbresle Cedex, France Wilmington, MA (2) Lyons, France Windham, ME (2) St. Aubin-les- Elbeuf, France Portage, MI (2) Extertal, Germany O'Fallon, MO (2) Kisslegg, Germany Raleigh, NC (2) Sulzfeld, Germany Omaha, NE (2) Calco, Italy Pittsfield, NH (2) Monticello Brienza, Italy Newfield (Lakeview), NJ (2) Atsugi, Japan Stone Ridge (Kingston), NY Hino, Japan Reinholds, PA (2) Tskuba, Japan (2) Charleston, SC Someren, Netherlands Houston, TX Barcelona, Spain (2) Oregon, WI (2) OPTICS Manufacturing Plants Distribution Centers Mountain View, CA (2) Mountain View, CA (2) Oakland, MD Richmond Hill, Canada (2) Rochester, NY (1),(2) Broomfield, CO (Optics Center) Overland Park, KS (2) Rochester, NY Rochester, NY (1), (2) (Frame Center) (Optics Center) San Antonio, TX San Antonio, TX North Ryde, Australia (2) Rio de Janeiro, Brazil (2) Pforzheim, Germany New Territories, Hong Kong (2) Bhiwadi, India Waterford, Ireland (2) Naucalcan, Mexico (2) Nuevo Laredo, Mexico (2) CORPORATE FACILITIES Rochester, NY One Chase Square (23rd, 24th, 25th Floors) (2) Euclid Street (2) 42 East Avenue (2) Optics Center (1),(2) 1295 Scottsville Road (2) [FN] (1) This facility is financed under a tax-exempt financing agreement. (2) This facility is leased. Bausch & Lomb considers that its facilities are suitable and adequate for the operations involved. All facilities are being productively utilized. ITEM 3.

ITEM 3. LEGAL PROCEEDINGS 1. In June 1990, the Company was served with six "toxic tort" suits filed against it and approximately 80 other defendants in the 21st Judicial District Court of Louisiana. These suits, which have been certified as a class action, alleged claims for personal injury, property damage and "fear of cancer" from waste allegedly generated by the Company and others and transported to an oil reclamation site in Louisiana. Each suit alleges joint and several liability and claims actual and exemplary damages exceeding 10% of the current assets of the Company on a consolidated basis, the Company believes that if its waste is or was present at the site, such waste would have amounted to approximately 0.1% of the site's total waste, and that its share of liability, if any, would be de minimis relative to other defendants' potential liability and that is is not material to the financial condition of the Company. On January 25, 1993, the Company and ten other defendants were dismissed from the action without prejudice, by a motion of the plaintiffs. It is probable that either the plaintiffs or one or more of the defendants will seek to bring the Company back into the proceedings. 2. Since August 1993, the Company's wholly-owned subsidiary, Dahlberg, Inc., has been served with seven lawsuits by individuals seeking to represent a class of consumers, including one action in the United States District Court for the Northern District of California, five actions in the Fourth Judicial District for the State of Minnesota and one in the Circuit Court, Barbour County, Alabama. Each action has been brought on behalf of alleged purchasers of Miracle-Ear hearing aids equipped with the Clarifier circuitry, which were manufactured and distributed by Dahlberg. The complaints allege that Dahlberg induced plaintiffs and others similarly situated to purchase hearing aids through allegedly false and misleading statements concerning the performance capabilities of the Clarifier circuitry. Plaintiffs allege fraud, negligence, and violation of federal and state statutes and are seeking compensatory and punitive damages in an unstated amount. Dahlberg is vigorously contesting the claims of the plaintiffs, including their claim to be representatives of a class. 3. In January 1994, the Department of Justice, acting on behalf of the Federal Trade Commission, commenced an action in the United States District Court for the District of Minnesota against Dahlberg, Inc., a wholly-owned subsidiary of the Company. The FTC is seeking civil penalties and injunctive relief, claiming that certain intended use claims in advertisements for hearing aids equipped with the Clarifier circuitry violated a 1976 consent order between the FTC and Dahlberg. The action seeks penalties of up to $10,000 for each publication of the advertisements. Dahlberg is vigorously contesting both the FTC's authority to regulate intended use claims for hearing aids and the allegation that the subject advertising violated the 1976 consent order. ITEM 4.

ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SHAREHOLDERS Inapplicable. PART II ITEM 5.

ITEM 5. MARKET FOR BAUSCH & LOMB INCORPORATED'S COMMON STOCK AND RELATED SHAREHOLDER MATTERS The sections entitled "Dividends" and "Quarterly Stock Prices" and table entitled "Selected Financial Data" on pages 44, 45 and 64-65, respectively, of the Annual Report are incorporated herein by reference. ITEM 6.

ITEM 6. SELECTED FINANCIAL DATA The table entitled "Selected Financial Data" on pages 6465 of the Annual Report is incorporated herein by reference. ITEM 7.

ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The section entitled "Financial Review" on pages 34-45 of the Annual Report is incorporated herein by reference. ITEM 8.

ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA The financial statements, including the notes thereto, together with the sections entitled "Report of Independent Accountants" and "Quarterly Results" of the Annual Report included on pages 46-63, 63 and 45, respectively, are incorporated herein by reference. ITEM 9.

ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE Inapplicable. PART III ITEM 10.

ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF BAUSCH & LOMB INCORPORATED Information with respect to non-officer directors is included in the Proxy Statement on pages 3-7, and such information is incorporated herein by reference. Set forth below are the names, ages (as of March 1, 1994), positions and offices held by, and a brief account of the business experience during the past five years of, each executive officer. Name and Age Position Daniel E. Gill (57) Chairman since 1982, Chief Executive Officer since 1981 and Director since l978. Ronald L. Zarrella (44) President and Chief Operating Officer since February, 1993; Executive Vice President (1992February, 1993); Senior Vice President and President, International Division (1987-1993); Vice President and President, Subsidiary Operations, International Division (1986-1987), and Director since April, 1993. Henry L. Foster (68) Senior Vice President since 1988, and Chairman of the Board since 1947 of Charles River Laboratories, Inc., a subsidiary of the Company; President and Chief Executive Officer, Charles River Laboratories, Inc. (1947- 1991); Vice President (1986-1988). Jay T. Holmes (51) Senior Vice President, Corporate Affairs since 1983, Secretary since 1981 and Director since l986. Harold O. Johnson (59) Senior Vice President since l985 and President, Contact Lens Division since l987; President, International Operations (1985-1987). James E. Kanaley (52) Senior Vice President since l985 and President, Personal Products Division since l987; President, Professional Eye Care Products Group (l985-l987). Robert J. Palmisano (49) Senior Vice President since 1992 and President, Eyewear Division since 1988; Vice President (19841992); President, Sports Optics and Scientific Products Group (1986- 1988). Carl E. Sassano (44) Senior Vice President since 1992; Vice President (1986-1992); President, Polymer Technology Corporation, a subsidiary of the Company (1983-1992). Peter Stephenson (54) Senior Vice President - Finance since March 1994; Vice President and Controller (February 1993- February 1994); Vice President and Corporate Treasurer Warner Lambert Company (1990-1991); Vice President and Corporate Controller - Warner Lambert Company (1987-1990). Frank M. Stotz (63) Senior Vice President since March 1994; Senior Vice President, Finance 1991 to March 1994; Partner, Price Waterhouse (1966-1991). Omar Casal (44) Vice President and President - Western Hemisphere Division since 1992; General Manager, Bausch & Lomb IOM S.p.A. (1989-1992); General Manager, Bausch & Lomb Australia Pty., Ltd. (1985-1989). James C. Foster (43) Vice President, and President and Chief Executive Officer of Charles River Laboratories, Inc., a subsidiary of the Company, since 1991; Executive Vice President, Charles River Laboratories (19891991); Senior Vice President, Charles River Laboratories and President, Charles River Biotechnical Services (1987-1988); President, Charles River Biotechnical Services and Vice President, Biotechnical Group (1985-1987). James P. Greenawalt (44) Vice President, Human Resources since 1986. Diane C. Harris (51) Vice President, Corporate Development since 1981. Stephen A. Hellrung (46) Vice President and General Counsel since 1985. Alexander E. Izzard (56) Vice President and President - AsiaPacific Division since 1990; Area Vice President - Far East, International Division since 1985. Franklin T. Jepson (46) Vice President, Communications and Investor Relations since 1986. Barbara M. Kelley (47) Vice President, Public Affairs since April, 1993; Staff Vice President, Public Affairs (19911993); Director, Public Affairs (1986-1991). Alex Kumar (46) Vice President and President - Europe, Middle East and Africa Division since 1989; Vice President, Europe, Middle East and Africa, International Division since 1988; Vice President, European Subsidiary Operations, International Division (1987-1988); Area Vice President, Europe, International Division (1986-1987). Jon M. Larson (60) Vice President since 1981 and Vice President, Quality since 1987; Vice President, Regulatory Affairs (1989-1991); Vice President, Technical Services, International Operations (1986-1987). Stephen C. McCluski (41) Vice President and Controller since March 1994; President - Outlook Eyewear Company (1992February 1994); Vice President Controller, Eyewear Division (1989-1992). B. Joseph Messner (41) Vice President since 1989 and President, Sports Optics Division since 1988; Vice President Operations, Sports Optics Division (1987-1988); Vice President and Controller, Sunglass Division (1984-1987). Alan H. Resnick (50) Vice President and Treasurer since 1986. Thomas M. Riedhammer (45) Vice President and President Worldwide Pharmaceuticals since January 1994; Vice President and President Pharmaceutical Division (1992-1993); Vice President - Research and Development, Pharmaceutical Division (1991-1992); Vice President, Paco Pharmaceutical Services, Inc. and President, Paco Research Corp. (1986-1991). Robert F. Thompson (40) Vice President since December 1993 and President Polymer Technology Corporation, a subsidiary of the Company (1992-1993); Vice President - U.S. Business Operations, Polymer Technology Corporation (1991-1992); Vice President Marketing, Polymer Technology Corporation (19881991). James J. Ward (56) Vice President - Audit Services since February, 1993; Vice President (1984-1993); Controller (1985-1993). Except for Henry and James Foster, who are father and son, there are no family relationships among the persons named above. All officers serve on a year-to-year basis through the day of the annual meeting of shareholders of the Company, and there is no arrangement or understanding between any of the officers of the Company and any other persons pursuant to which such officer was selected as an officer. ITEM 11.

ITEM 11. EXECUTIVE COMPENSATION The portions of the "Executive Compensation" section entitled "Compensation Tables" and "Defined Benefit Retirement Plans", the second through fourth paragraphs of the section entitled "Board of Directors", and the second paragraph of the section entitled "Related Transactions and Employment Contracts" included in the Proxy Statement on pages 15-21, 1-2 and 21, respectively, are incorporated herein by reference. ITEM 12.

ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT The section entitled "Security Ownership of Certain Beneficial Owners and Management" in the Proxy Statement on pages 8-9 is incorporated herein by reference. ITEM 13.

ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS Page 5 and the first paragraph of the section entitled "Related Transactions and Employment Contracts" on page 21 of the Proxy Statement are incorporated herein by reference. PART IV ITEM 14.

ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K The following documents or the portions thereof indicated are filed as a part of this report. (a) INDEX TO FINANCIAL STATEMENTS AND FINANCIAL STATEMENT SCHEDULES COVERED BY REPORTS OF INDEPENDENT ACCOUNTANTS. 1. Data incorporated by reference in Page in Item 8 from the Annual Report Annual Report Report of Independent Accountants 63 Balance Sheet at December 25, 1993 and December 26, 1992 47 For the years ended December 25, 1993, December 26, 1992 and December 28, 1991: Statement of Earnings 46 Statement of Cash Flows Notes to Financial Statements 49-63 2. Filed herewith Report of Independent Accountants on Financial Statement Schedules Exhibit (24) For the years ended December 25, 1993, December 26, 1992 and December 28, 1991: SCHEDULE II-Amounts Receivable from Page S-1 Related Parties and Underwriters, Promoters and Employees Other Than Related Parties SCHEDULE V-Property, Plant and Page S-2 Equipment SCHEDULE VI-Accumulated Depreciation Page S-3 and Amortization of Property, Plant and Equipment SCHEDULE VIII-Valuation and Qualifying Page S-4 Accounts SCHEDULE X-Supplementary Income Page S-5 Statement Information All other schedules have been omitted because the required information is not present or not present in amounts sufficient to require submission of the schedule, or because the information required is included in the consolidated financial statements or the notes thereto. (b) REPORTS ON FORM 8-K No reports on Form 8-K were filed by the Company during the last quarter of 1993. (c) ITEM 601 EXHIBITS Those exhibits required to be filed by Item 601 of Regulation S-K are listed in the Exhibit Index immediately preceding the exhibits filed herewith and such listing is incorporated herein by reference. Each of Exhibits (10)-a through (10)-u is a management contract or compensatory plan or arrangement required to be filed as an exhibit to this form pursuant ot Item 14(c) of this report. SIGNATURES Pursuant to the requirements of Section 13 or 15(d) 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. BAUSCH & LOMB INCORPORATED Date: March 22, 1994 By:/s/ Daniel E. Gill Daniel E. Gill Chairman and Chief Executive Officer Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated. Principal Executive Officer Date: March 22, 1994 By:/s/Daniel E. Gill Daniel E. Gill Chairman, Chief Executive Officer and Director Principal Financial Officer Date: March 22, 1994 By:/s/ Peter Stephenson Peter Stephenson Senior Vice President, Finance Controller Date: March 22, By:/s/ Stephen C. McCluski Stephen C. McCluski, Vice President and Controller Directors Franklin E. Agnew William Baldersto n III Bradfo rd R. Boss Ruth R. McMull in John R. Purcel l Linda Johnso n Rice Robert L. Tarnow Alvin W. Trivel piece William H. Waltrip Kenneth L. Wolfe Ronald L. Zarrella Date: March 22, 1994 By:/s/Jay T. Holmes Jay T. Holmes Attorney-in-Fact and Director EXHIBIT INDEX S-K Item 601 No. Document (3)-a Certificate of Incorporation of Bausch & Lomb Incorporated (filed as Exhibit (3)-a to the Company's Annual Report on Form 10- K for the fiscal year ended December 29, 1985, File No. 1-4105, and incorporated herein by reference). (3)-b Certificate of Amendment of Bausch & Lomb Incorporated (filed as Exhibit (3)-b to the Company's Annual Report on Form 10-K for the fiscal year ended December 31, 1988, File No. 1-4105, and incorporated herein by reference). (3)-c Certificate of Amendment of Bausch & Lomb Incorporated (filed as Exhibit (3)-c to the Company's Annual report on Form 10-K for the fiscal year ended December 26, 1992, File No. 1-4105, and incorporated herein by reference). (3)-d By-Laws of Bausch & Lomb Incorporated, as amended, effective October 28, 1986 (filed as Exhibit (3)-b to the Company's Annual Report on Form 10-K for the fiscal year ended December 28, 1986, File No. 1- 4105, and incorporated herein by reference). (4)-a Certificate of Incorporation of Bausch & Lomb Incorporated (filed as Exhibit (4)-a to the Company's Annual Report on Form 10- K for the fiscal year ended December 29, 1985, File No. 1-4105, and incorporated herein by reference). (4)-b Certificate of Amendment of Bausch & Lomb Incorporated (filed as Exhibit (4)-b to the Company's Annual Report on Form 10-K for the fiscal year ended December 31, 1988, File No. 1-4105, and incorporated herein by reference). (4)-c Certificate of Amendment of Bausch & Lomb Incorporated (filed as Exhibit (4)-c to the Company's Annual report on Form 10-K for the fiscal year ended December 26, 1992, File No. 1-4105, and incorporated herein by reference). (4)-d Form of Indenture, dated as of September 1, 1991, between the Company and Citibank, N.A., as Trustee, with respect to the Company's Medium-Term Notes (filed as Exhibit 4-(a) to the Company's Registration Statement on Form S-3, File No. 33-42858, and incorporated herein by reference). (4)-e Rights Agreement between the Company and The First National Bank of Boston, as successor to Chase Lincoln First Bank, N.A. (filed as Exhibit 1 to the Company's Current Report on Form 8-K dated July 25, 1988, File No. 14105, and incorporated herein by reference). (4)-f Amendment to the Rights Agreement between the Company and The First National Bank of Boston, as successor to Chase Lincoln First Bank, N.A. (filed as Exhibit 1 to the Company's Current Report on Form 8-K dated July 31, 1990, File No. 1-4105, and incorporated herein by reference). (10)-a Change of Control Employment Agreement with certain executive officers of the Company (filed as Exhibit (10)-a to the Company's Annual Report on Form 10-K for the fiscal year ended December 29, 1990, File No. 1-4105, and incorporated herein by reference). (10)-b The Bausch & Lomb Incorporated Executive Incentive Compensation Plan as restated (filed herewith). (10)-c The Bausch & Lomb Supplemental Retirement Income Plan I, as restated (filed as Exhibit (10)-e to the Company's Annual Report on Form 10-K for the fiscal year ended December 29, 1990, File No. 14105, and incorporated herein by reference). (10)-d The Bausch & Lomb Supplemental Retirement Income Plan II, as restated (filed as Exhibit (10)-f to the Company's Annual Report on Form 10-K for the fiscal year ended December 29, 1990, File No. 14105, and incorporated herein by reference). (10)-e The Bausch & Lomb Supplemental Retirement Income Plan III (filed as Exhibit (10)-g to the Company's Annual Report on Form 10-K for the fiscal year ended December 26, 1992, File No. 1-4105, and incorporated herein by reference). (10)-f The Bausch & Lomb Incorporated Long Term Incentive Program, as restated (filed as Exhibit (10)-g to the Company's Annual Report on Form 10-K for the fiscal year ended December 29, 1985, File No. 14105, and incorporated herein by reference). (10)-g Amendment to the Bausch & Lomb Incorporated Long Term Incentive Program (filed as Exhibit (10)-i to the Company's Annual Report on Form 10-K for the fiscal year ended December 31, 1988, File No. 1-4105, and incorporated herein by reference). (10)-h The Bausch & Lomb Incorporated Long Term Performance Stock Plan I (filed herewith). (10)-i Bausch & Lomb Incorporated Long Term Performance Stock Plan II, as amended (filed herewith). (10)-j The 1982 Stock Incentive Plan of Bausch & Lomb Incorporated (filed as Exhibit III-F to the Company's Annual Report on Form 10-K for the fiscal year ended December 26, 1982, File No. 1-4105, and incorporated herein by reference). (10)-k Amendment to the 1982 Stock Incentive Plan of Bausch & Lomb Incorporated (filed as Exhibit (10)-l to the Company's Annual Report on Form 10-K for the fiscal year ended December 31, 1988, File No. 1-4105, and incorporated herein by reference). (10)-l Amendment to the 1982 Stock Incentive Plan of Bausch & Lomb Incorporated (filed as Exhibit (10)-k to the Company's Annual Report on Form 10-K for the fiscal year ended December 29, 1990, File No. 1-4105, and incorporated herein by reference). (10)-m The 1987 Stock Incentive Plan of Bausch & Lomb Incorporated (filed as Exhibit I.B to the Company's Registration Statement on Form S-8, File No. 33-15439, and incorporated herein by reference). (10)-n Amendment to the 1987 Stock Incentive Plan of Bausch & Lomb Incorporated (filed as Exhibit (10)-n to the Company's Annual Report on Form 10-K for the fiscal year ended December 31, 1988, File No. 1-4105, and incorporated herein by reference). (10)-o Amendment to the 1987 Stock Incentive Plan of Bausch & Lomb Incorporated (filed as Exhibit (10)-n to the Company's Annual Report on Form 10-K for the fiscal year ended December 29, 1990, File No. 1-4105, and incorporated herein by reference). (10)-p The 1990 Stock Incentive Plan of Bausch & Lomb Incorporated, as amended (filed as Exhibit (10)-o to the Company's Annual Report on Form 10-K for the fiscal year ended December 29, 1990, File No. 14105, and incorporated herein by reference). (10)-q The Bausch & Lomb Incorporated Director Deferred Compensation Plan, as restated (filed as Exhibit (10)-p to the Company's Annual Report on Form 10-K for the fiscal year ended December 28, 1991, File No. 1-4105, and incorporated herein by reference). (10)-r The Bausch & Lomb Incorporated Executive Deferred Compensation Plan, as restated (filed as Exhibit (10)-q to the Company's Annual Report on Form 10-K for the fiscal year ended December 28, 1991, File No. 1-4105, and incorporated herein by reference). (10)-s The Bausch & Lomb Incorporated Executive Benefit Plan, as amended (filed as Exhibit (10)-t to the Company's Annual Report on Form 10-K for the fiscal year ended December 29, 1990, File No. 1-4105, and incorporated herein by reference). (10)-t The Bausch & Lomb Incorporated Executive Security Program (filed as Exhibit (10)-s to the Company's Annual Report on Form 10-K for the fiscal year ended December 30, 1989, File No. 1-4105, and incorporated herein by reference). (10)-u The Bausch & Lomb Retirement Benefit Restoration Plan (filed as Exhibit (10)-t to the company's Annual Report on Form 10-K for the fiscal year ended December 28, 1991, File No. 1-4105, and incorporated herein by reference). (11) Statement Regarding Computation of Per Share Earnings (filed herewith). (12) Statement Regarding Computation of Ratio of Earnings to Fixed Charges (filed herewith). (13) The Bausch & Lomb 1993 Annual Report to Shareholders for the fiscal year ended December 25, 1993 (filed herewith). With the exception of the pages of the Annual Report specifially incorporated by reference herein, the Annual Report is not deemed to be filed as a part of this Report on Form 10-K. (22) Subsidiaries (filed herewith). (24) Report of Independent Accountants on Financial Statement Schedules and Consent of Independent Accountants (filed herewith). (25) Power of attorney with respect to the signatures of directors in this Report on Form 10-K (filed herewith). EXHIBIT (10)-b THE EXECUTIVE INCENTIVE COMPENSATION PLAN 1.0 INTRODUCTION The Executive Incentive Compensation Plan is established to provide incentive compensation in the form of a supplement to the base salaries of those officers, managers, and key employees who contribute significantly to the growth and success of the Company's business; to attract and to retain, in the employ of the Company, individuals of outstanding ability; and to align the interests of those who hold positions of major responsibility in the Company with the interests of the Company's shareholders. 2.0 ELIGIBILITY Those members of the executive management group whose duties and responsibilities contribute significantly to the growth and success of the Company's business are eligible. This generally includes all positions in the midmanagement/technical band and above, in Rochester based divisions or functions. The plan may be adopted by nonRochester based divisions. The participant must be on the payroll in an eligible position before July 1 of the plan year, to be eligible for an award. 3.0 DEFINITIONS 3.1 A standard incentive award has been established for each salary grade or job band and is expressed as a percentage of period salary (i.e., eligible base salary earnings for the year). Exhibit I defines standard percentage schedules. The standard incentive award is the award payout level which over time, participants, units and the corporation should average, and will be the amount which will be used for financial accrual purposes during the incentive year. 3.2 An approved incentive is the incentive which has been approved by the Chairman of the Board of directors and the Committee On Management of the Board to be paid by the company to the participant. Actual incentive award amounts, based upon individual and organizational performance, can vary from 0% for unacceptable performance, or from a minimum of 25% to a maximum of 175% of standard. In any event, an award cannot exceed the maximum. 4.0 MEASURES OF PERFORMANCE Each organizational unit and eligible participant will set performance measures. These will be applied for incentive plan purposes as follows: 4.1 The "Organizational Performance Management System" (OPMS) has been established to evaluate corporate, division, and profit center performance for Executive Incentive Compensation Plan purposes. The OPMS is based upon specific organizational objectives. These objectives are to be agreed upon at the beginning of the plan year. They must be measurable financial categories such as sales, operating earnings, earnings per share, DSO, inventory turns, or quantifiable strategic goals, for example product development, products introduction market share. Performance levels for 5, 4, 3, 2, and 1 ratings are to be defined at the beginning of the plan year for each goal. There will be a pre-determined weighting among the chosen objectives reflecting the priority of those objectives. In general, it is expected that the calculated organizational results will determine the performance rating for the unit. However, after calculation of year end OPMS results, the CEO and COO may make a modification of +20% to the calculated rating, if performance is not accurately reflected in performance measures (i.e., due to general economic, industry change, corporate strategy change, natural disaster). Adjustments must be made in 5% increments. 4.2 The "Individual Performance Management System" (IPMS) for use with the Executive Incentive Plan will consist of five or fewer specific individual objectives. These objectives are to be agreed upon at the beginning of the Plan year. They must be measurable and generally within the participant's control. Further, there will be a predetermined weighting among the objectives reflecting the priority of these objectives. Individual performance will be determined by the participants' supervisor and approved by the Division/Group Presidents or appropriate corporate staff function head. In general, it is expected that the calculated individual results will determine the performance rating. However, the unit or functional officer may make an adjustment of +20% to the calculated ratings if performance is not accurately reflected in performance measures. Adjustments must be made in 5% increments. 5.0 DEFINITION OF PERFORMANCE The following "definitions of performance" are to be utilized for the plan: 6.0 PROCEDURE FOR BONUS CALCULATION AND APPROVAL Each participant's total bonus will be calculated as follows: 1) The standard bonus (see Section 3.1) is divided into appropriate corporation/unit-individual components (as defined in Section 4.0). 2) For the organizational components; A. The final rating is converted to a percentage factor (see Attachment I conversion table). B. The factor is multiplied by the standard organizational bonus. C. There is no organizational award granted if final rating is below 2.0. 3) For the individual component; A. The final rating is converted to a percentage factor (see Attachment III conversion table). B. The factor is multiplied by the standard individual bonus. C. There is no individual award granted if final rating is below 2.0. 4) To calculate the total bonus, the components are added. The Division Presidents will submit their recommendations for individual incentive awards to their immediate superiors (in some cases only the Chief Operating Officer; in others Group Presidents and COO). In all instances the recommendations for the Corporate awards will be submitted to the Chief Executive Officer for concurrence. Corporate function heads will submit their recommendations for individual awards to their immediate superior who will then submit the recommendations to the Chief Executive Officer for concurrence. 7.0 REMOVAL, TRANSFERS AND TERMINATIONS 7.1 Participants whose employment with the Company is terminated because of retirement, death, or disability: - - After the close of the plan year, but prior to the actual distribution of awards for such year, may be awarded a full incentive award for the plan year. In the case of death, such payment will be made to a beneficiary. - - After the beginning, but prior to the end of the plan year, may receive an incentive award for that year based on a prorated calculation reflecting their employment with the Company and participation in the Plan during year. Awards will not be paid for any period less than six months participation in the plan year. 7.2 Participants who are terminated in the fourth quarter of the year due to a re-structuring which results in job elimination, may receive an incentive award for that year based on a prorated calculation reflecting their employment with the Company and participation in the Plan during that year. 7.3 Participants transferred during the plan year within the Company will be awarded an incentive payment through the division in which the participant is employed at the end of the plan year. It will be based on the contribution made in each division in which the participant was employed during the year. To this end a written evaluation and rating must be completed by the participant's superior upon transfer. The awarding division will be charged for the full amount of the bonus. 7.4 Notwithstanding the foregoing, a special prorated incentive award shall be paid to participants if, during the period between the date of a change in control and the next award date determined pursuant to Section 10: 1) the participant's employment is terminated involuntarily other than for good cause, or 2) the Plan is terminated. The amount of the award shall be calculated as a percentage of period earnings based upon standard performance and prorated through the date of termination of the participant or the Plan, as applicable. A change of control of the Company is defined as follows: A. The acquisition by any individual, entity or group (within the meaning of Section 13 (d) (3) or 14 (d) (2) of the Securities Exchange Act of 1934, as amended (the "Exchange Act")) (a "Person") of beneficial ownership (within the meaning of Rule 13d-3 promulgated under the Exchange Act) of 20% or more of either (i) the then outstanding shares of common stock of the Company (the "Outstanding Company Common Stock") or (ii) the combined voting power of the then outstanding voting securities of the Company entitled to vote generally in the election of directors (the "Outstanding Company Voting Securities"); provided, however, that the following acquisitions shall not constitute a Change of Control: (i) any acquisition directly from the Company (excluding an acquisition by virtue of the exercise of a conversion privilege unless the security being so converted was itself acquired directly from the Company), (ii) any acquisition by the Company, (iii) any acquisition by any employee benefit plan (or related trust) sponsored or maintained by the Company or any corporation controlled by the Company or (iv) any acquisition by any corporation pursuant to a reorganization, merger or consolidation, if, following such reorganization, merger or consolidation, the conditions described in clauses (i), (ii) and (iii) of paragraph C of this Section 7.0 are satisfied; or B. Individuals who, as of the date hereof, constitute the Board of Directors of the Company (the "Board" and, as of the date hereof, the "Incumbent Board") cease for any reason to constitute at least a majority of the Board; provided, however, that any individual becoming a director subsequent to the date hereof whose election, or nomination for election by the Company's shareholders, was approved by a vote of at least a majority of the directors then comprising the Incumbent Board shall be considered as though such individual were a member of the Incumbent Board, but excluding, for this purpose, any such individual whose initial assumption of office occurs as a result of either an actual or threatened election contest (as such terms are used in Rule 14a-11 of Regulation 14A promulgated under the Exchange Act) or other actual or threatened solicitation of proxies or consents by or on behalf of a Person other than the Board; or C. Approval by the shareholders of the Company of a reorganization, merger, binding share exchange or consolidation, in each case, unless, following such reorganization, merger, binding share exchange or consolidation, (i) more than 60% of, respectively, the then outstanding shares of common stock of the corporation resulting from such reorganization, merger, binding share exchange or consolidation and the combined voting power of the then outstanding voting securities of such corporation entitled to vote generally in the election of directors is then beneficially owned, directly or indirectly, by all or substantially all of the individuals and entities who were the beneficial owners, respectively, of the Outstanding Company Common Stock and Outstanding Company Voting Securities immediately prior to such reorganization, merger, binding share exchange or consolidation in substantially the same proportions as their ownership, immediately prior to such reorganization, merger, binding share exchange or consolidation, of the Outstanding Company Stock and Outstanding Company Voting Securities, as the case may be, (ii) no Person (excluding the Company, any employee benefit plan (or related trust) of the Company or such corporation resulting from such reorganization, merger, binding share exchange or consolidation and any Person beneficially owning, immediately prior to such reorganization, merger, binding share exchange or consolidation, directly or indirectly, 20% or more of the Outstanding Company Stock or Outstanding Company Voting Securities, as the case may be) beneficially owns, directly or indirectly, 20% or more of, respectively, the then outstanding shares of common stock of the corporation resulting from such reorganization, merger, binding share exchange or consolidation or the combined voting power of the then outstanding voting securities of such corporation entitled to vote generally in the election of directors and (iii) at least a majority of the members of the board of directors of the corporation resulting from such reorganization, merger, binding share exchange or consolidation were members of the Incumbent Board at the time of the execution of the initial agreement providing for such reorganization, merger, binding share exchange or consolidation; or D. Approval by the shareholders of the Company of (i) a complete liquidation or dissolution of the Company or (ii) the sale or other disposition of all or substantially all of the assets of the Company, other than to a corporation, with respect to which following such sale or other disposition, (a) more than 60% of, respectively, the then outstanding shares of common stock of such corporation and the combined voting power of the then outstanding voting securities of such corporation entitled to vote generally in the election of directors is then beneficially owned, directly or indirectly, by all or substantially all of the individuals and entities who were the beneficial owners, respectively, of the Outstanding Company Common Stock and Outstanding Company Voting Securities immediately prior to such sale or other disposition in substantially the same proportion as their ownership, immediately prior to such sale or other disposition, of the same Outstanding Company Common Stock and Outstanding Company Voting Securities, as the case may be, (b) no Person (excluding the Company and any employee benefit plan (or related trust) of the Company or such corporation and any Person beneficially owning, immediately prior to such sale or other disposition, directly or indirectly, 20% or more of the Outstanding Company Common Stock or Outstanding Company Voting Securities, as the case may be) beneficially owns, directly or indirectly, 20% or more of, respectively, the then outstanding shares of common stock of such corporation and the combined voting power of the then outstanding voting securities of such corporation entitled to vote generally in the election of directors and (c) at least a majority of the members of the board of directors of such corporation were members of the Incumbent Board at the time of the execution of the initial agreement or action of the Board providing for such sale or other disposition of assets of the Company. 7.5 Participants who leave the company or are terminated prior to the actual payment of award for reasons other than retirement, death, disability, termination in the fourth quarter due to a restructuring which results in job elimination, change in control, will forfeit the award for that plan year. 8.0 INCENTIVE AWARDS THROUGH CONTRACTUAL AGREEMENTS Incentive awards may be made to participants who do not meet the six month eligibility requirements only if the following conditions are met. (1) Award must be made through contractual agreement made upon hiring, re-assignment, or commencement of special project or assignment. These arrangements must be approved in writing by Division President, Corporate Compensation, Corporate V.P. Human Resources, and normal 1 over 1 approval matrix. 9.0 ADMINISTRATION OF THE PLAN The Committee On Management of the Board of Directors reserves the right to interpret, amend, modify or terminate the existing program in accordance with changing conditions. Further, no participant eligible to receive any payments shall have any rights to pledge, assign, or otherwise dispose of unpaid portion of such payments. The Committee On Management is responsible for overall administration of the Plan. It will determine who will receive incentives and the amount of each incentive. It may also review the standards and objectives for a particular year. The Committee On Management may change or terminate the Plan at any time and no person has any rights with respect to an incentive award until it has been paid. 10.0 INCENTIVE AWARD DISTRIBUTION Incentive awards, when payable, shall be paid in the latter part of the month of February following the close of the preceding fiscal year. Participants may also elect to defer all or part of an incentive award in accordance with the procedure set forth in the Company's Deferred Compensation Plan. EXHIBIT (10)-h LONG TERM PERFORMANCE STOCK PLAN - I I. PURPOSE The Long Term Performance Stock Plan - I (the "Plan") is designed to advance the interests of Bausch & Lomb Incorporated (the "Company") and its shareholders by (i) providing incentives for those key executives who have overall responsibility for the long term performance of the Company; (ii) reinforcing corporate long term financial goals; (iii) providing competitive levels of long term compensation for key executives; and (iv) aligning management and shareholder interests. II. ELIGIBILITY Participation in the Plan is limited to senior officers with overall responsibility for the long term performance of the Company. The Committee on Management of the Board of Directors (the "Committee") will designate executives to participate in the Plan ("Participants"). III. AWARD CYCLES Award cycles ("Award Cycles") will be measured over three year periods, with the performance award, if any, for each Award Cycle to be paid early in the fourth year. There will be a series of overlapping Award cycles with a new Award Cycle starting and an old Award Cycle finishing each year. IV. PERFORMANCE GOALS The chief executive officer of the Company, with approval of the Committee, will establish the performance goals for each Award Cycle, ensuring that the goals are equitable and compatible with the Company's major business objectives. The performance goals for each Award Cycle will be based upon a matrix of sales growth and return on equity ("ROE") for the Company. V. AWARDS If the performance goals of the Company are achieved for an Award Cycle, Participants in the Plan will be eligible for awards which are calculated using an adjusted salary midpoint equal to the Participant's salary midpoint in effect in the first year of the Award Cycle multiplied times 110% ("Adjusted Salary Midpoint"). The Adjusted Salary Midpoint is then multiplied by 50% to calculate the standard award ("Standard Award") for each salary grade. If a Participant's salary grade changes in the course of an Award Cycle, the Participant's Standard Award will be adjusted using the Adjusted Salary Midpoint for the new grade level which was in effect during the first year of that Award Cycle. Depending upon the level of performance achieved by the Company, the amount of a Participant's actual award will range from 50% to 200% of the Standard Award (the "Award"). Awards paid pursuant to this Plan will consist of cash and Bausch & Lomb Class B Stock granted pursuant to the 1990 Stock Incentive Plan or any successor plan (the "Stock Plan"). VI. PERFORMANCE UNITS At the February meeting of the Committee following the commencement of the Award Cycle, each Participant will receive performance units ("Performance Units") equal to the number of shares of Class B Stock which, as of the date of such meeting of the Committee, have an aggregate fair market value (as determined under the Stock Plan) equal to 50% of each Participant's Standard Award. During the Award Cycle, Participants will receive quarterly cash payments on their Performance Units equal to the dividends which would be payable on a like number of shares of Class B Stock. Participant's Standard Award calculation changes because of a salary grade change in the course of an Award Cycle, the number of Performance Units will be adjusted accordingly. VII. PAYOUTS At the end of each Award Cycle, the Standard Award will be adjusted by the Committee to reflect sales growth and ROE performance on the applicable payout matrix to determine the amount of the Award payable to each Participant. The Award payable to a Participant may also be modified by the Committee if the Award does not accurately reflect performance due to general economic conditions, industry changes, corporate strategy changes, natural disasters or any similar condition. One half of that amount shall be paid in cash. The Participant will also receive shares of Class B Stock(pursuant to the Stock Plan) equal to the number of Performance Units granted to the Participant; provided, however, that if the Award is based upon a percentage which is more than or less than 100% of the Standard Award, the number of shares of Class B Stock to be granted will be adjusted up or down by a like percentage. There will be no adjustments in the number of shares of Class B Stock for fluctuations up or down in the fair market value of Class B Stock from the date of grant of Performance Units at the beginning of the Award Cycle to the date of grant of the Class B Stock, if any, after the Award Cycle. Notwithstanding any other provision of this Plan, if a Participant's performance results in calculation of an Award which would be less than 50% of the Standard Award, the Participant will nonetheless be entitled to a minimum grant of Class B Stock equal to 50% of the Performance Units granted to the Participant. Whether or not an Award is paid for an Award Cycle, all Performance Units granted hereunder for an Award Cycle shall expire at the end of the Award Cycle, and Participants shall have no further rights with respect to such Units, except to the extent that their performance entitles them to an Award. Performance Units shall not give Participants any rights under the Stock Plan maintained by the Company. VIII. DEFERRAL Any or all of the cash portion of an Award may be deferred, at the option of the Participant, into the Company's Deferred Compensation Plan. Notice of such a deferral must be given to the Company at least 18 months prior to the end of each Award Cycle for which deferral is requested. IX. TERMINATION OF EMPLOYMENT If the Participant's employment with the Company terminates before the end of any Award Cycle due to death, disability, or retirement, the Participant or his/her beneficiary is entitled to a pro rata share of any Award paid at the end of the Award Cycle, unless the Committee, upon the recommendation of the Chief Executive Officer, decides that a prorated Award should be paid prior to the end of the Award Cycle. If the Participant's employment with the Company terminates before the end of any Award Cycle for any other reason, the Participant's Performance Units shall be forfeited and the Participant shall not be entitled to any Award hereunder. X. ADMINISTRATION OF THE PLAN The Committee is responsible for the overall administration of the Plan. The Committee will, by formal resolution: 1) approve the Performance Goals for the Award Cycle at the beginning of each Award Cycle; 2) set new or adjust previously set performance goals as appropriate to reflect major unforeseen events; and 3) administer the Plan in all respects to carry out its purposes and objectives including, but not limited to, responding to changes in tax laws, regulations or rulings, changes in accounting principles or practices, mergers, acquisitions or divestitures, major technical innovations, or extraordinary, nonrecurring, or unusual items, to preserve the integrity of the Plan's objectives. The Committee reserves the right, in its discretion, to pay any Awards hereunder entirely in cash. The effective date of each Award Cycle is January 1 of the first year of the performance period. XI. RECAPITALIZATION In the event there is any recapitalization in the form of a stock dividend, distribution, split, subdivision or combination of shares of common stock of the Company, resulting in an increase or decrease in the number of common shares outstanding, the number of Performance Units then granted under the Plan shall be increased or decreased proportionately, as the case may be. XII. REORGANIZATION If, pursuant to any reorganization, sale or exchange of assets, consolidation or merger, outstanding Class B Stock is or would be exchanged for other securities of the Company or of another company which is a party to such transaction, or for property, any grant of Performance Units under the Plan theretofore granted shall, subject to the provisions of this Plan for making Awards, apply to the securities or property into which the Class B Stock covered thereby would have been changed or for which such Class B Stock would have been exchanged had such Class B Stock been outstanding at the time. EXHIBIT (10)-i LONG TERM PERFORMANCE STOCK PLAN - II I. PURPOSE The Long Term Performance Stock Plan - II (the "Plan") is designed to advance the interests of Bausch & Lomb Incorporated (the "Company") and its shareholders by (i) providing incentives for those key executives who have a major impact on long term corporate performance; (ii) reinforcing corporate long term financial goals; (iii) providing competitive levels of long term compensation for key executives; and (iv) aligning management and shareholder interests. II. ELIGIBILITY Participation in the Plan is limited to officers and other selected key executives who have a major impact on the performance of the Company. The Company's chief executive officer or his designees will designate executives to participate in the Plan ("Participants"). III. AWARD CYCLES Award cycles ("Award Cycles") will be measured over three year periods, with the performance award, if any, for each Award Cycle to be paid early in the fourth year. Award Cycles will commence on January 1 of the first year of each performance period. IV. PERFORMANCE GOALS The chief executive officer or his designees will establish the performance goals for each Award Cycle, ensuring that the goals are equitable and are compatible with the Company's major business objectives. The performance goals for each Participant will relate to the Participant's area of responsibility and be consistent with the long term goals of the Company. For Participants who are part of the Company's corporate staff, their performance goals will be weighted twothirds based upon the Participant's individual goals and onethird based upon the corporate wide financial goals of return on equity and sales growth. The corporate wide goals will be established by the chief executive officer or his designees. V. AWARDS A. Officer Awards If a Participant who is an officer achieves his or her performance goals for an Award Cycle, such Participant will be eligible for an award which is calculated using an adjusted salary midpoint equal to the Participant's salary midpoint in effect in the first year of the Award Cycle multiplied times 110% ("Adjusted Salary Midpoint"). The Adjusted Salary Midpoint is then multiplied by the appropriate percentage set forth below to calculate the three year standard award ("Standard Award") for each salary grade: B. Non Officer Awards. If a Participant who is not an officer achieves his or her performance goals for an Award Cycle, such Participant will be eligible for an award which is calculated using the Participant's salary in effect in the first year of the Award Cycle multiplied times 110% ("Adjusted Salary"). The Adjusted Salary is then multiplied by 45% to calculate the Standard Award for a non-officer Participant. C. Adjustments to Award Calculation If an officer Participant's salary grade changes in the course of an Award Cycle, such Participant's Standard Award will be adjusted using the Adjusted Salary Midpoint for the new grade level which was in effect during the first year of that Award Cycle. For all non-officer Participants, the calculation of the Standard Award will be adjusted using each such Participant's actual salary in the third year of the Award Cycle. D. Award Amount Depending upon the level of performance achieved by each Participant, the amount of a Participant's actual award, if any, will range from 50% to 200% of the Standard Award as adjusted pursuant to Section V.C. above (the "Award"). Awards paid pursuant to this Plan will consist of cash and Bausch & Lomb Class B Stock granted pursuant to the 1990 Stock Incentive Plan or any successor plan (the "Stock Plan"). If a Participant's performance results in calculation of an Award which would be less than 50% of the Standard Award, the Participant will nonetheless be entitled to a minimum grant of Class B Stock equal to 50% of the Performance Units granted to the Participant pursuant to Section VI below. VI. PERFORMANCE UNITS In February following the commencement of an Award Cycle each Participant will receive performance units ("Performance Units") equal to the number of shares of Class B Stock which, as of the date of the February meeting of the Committee on Management of the Board of Directors (the "Committee"), have an aggregate fair market value (as determined under the Stock Plan) equal to 50% of each Participant's Standard Award. During the Award Cycle, Participants will receive quarterly cash payments on their Performance Units equal to the dividends which would be payable on a like number of shares of Class B Stock. If an officer Participant's Standard Award calculation changes because of a salary grade change due to a promotion in the course of an Award Cycle, the number of Performance Units will be adjusted accordingly at the end of the Award Cycle. For non-officer Participants the number of Performance Units will be adjusted at the end of the third year of the Award Cycle when the non-officer Participant's Standard Award is adjusted for actual salary increases pursuant to Section V.C. above. VII. PAYOUTS At the end of each Award Cycle, the Standard Award (as adjusted pursuant to Section V.C. above) will be modified by the chief executive officer or his designees to reflect performance against the applicable goals and determine the amount of the Award payable to each Participant. The Award payable to a Participant may also be modified by the chief executive officer or his designees if the Award does not accurately reflect performance due to general economic conditions, industry changes, corporate strategy changes, natural disasters or any similar condition. One half of the Award amount shall be paid in cash. The Participant will also receive shares of Class B Stock (pursuant to the Stock Plan) equal to the number of Performance Units granted to the Participant; provided, however, that if the Award is based upon a percentage which is more than or less than 100% of the Standard Award, the number of shares of Class B Stock to be granted will be adjusted up or down by a like percentage. There will be no adjustments in the number of shares of Class B Stock for fluctuations up or down in the fair market value of Class B Stock from the date of grant of Performance Units at the beginning of the Award Cycle to the date of grant of the Class B Stock, if any, after the Award Cycle. Whether or not an Award is paid for an Award Cycle, all Performance Units granted hereunder for an Award Cycle shall expire immediately after the Award Cycle, and Participants shall have no further rights with respect to such Units, except to the extent that their performance entitles them to an Award. Performance Units shall not give Participants any rights under the Stock Plan. VIII. DEFERRAL Any or all of the cash portion of an Award may be deferred, at the option of the Participant, into the Company's Deferred Compensation Plan. Notice of such a deferral must be given to the Company at least 18 months prior to the end of each Award Cycle for which deferral is requested. IX. TERMINATION OF EMPLOYMENT If the Participant's employment with the Company terminates before the end of any Award Cycle due to death, disability, or retirement, the Participant or his/her beneficiary is entitled to a pro rata share of any Award paid at the end of the Award Cycle, unless the chief executive officer or his designees decide that a pro rated Award should be paid prior to the end of the Award Cycle. If the Participant's employment with the Company terminates before the end of any Award Cycle for any other reason, the Participant's Performance Units shall be forfeited and the Participant shall not be entitled to any Award hereunder. X. ADMINISTRATION OF THE PLAN This Plan has been adopted by the Committee, and the Committee may amend, suspend or terminate the Plan or any portion thereof at any time. The Committee is responsible for the design of the Plan and the overall administration of the Plan. Notwithstanding any other provision of this Plan, all grants of Class B Stock made in connection with this Plan shall be subject to the discretion of the Committee which shall make any such grants pursuant to the Stock Plan. The Committee reserves the right, in its discretion, to pay any Awards hereunder entirely in cash. The chief executive officer or his designees will: 1) approve the Performance Goals for each Award Cycle at the beginning of the Award Cycle; 2) set new or adjust previously set performance goals or terminate current Award Cycles and commence new Award Cycles for individual Participants as appropriate to reflect major unforeseen events which are negatively affecting performance; and 3) administer the Plan to carry out its purposes and objectives such as, but not limited to, responding to changes in tax laws, regulations or rulings, changes in accounting principles or practices, mergers, acquisitions or divestitures, major technical innovations, or extraordinary, non-recurring, or unusual items, to preserve the integrity of the Plan's objectives. XI. RECAPITALIZATION In the event there is any recapitalization in the form of a stock dividend, distribution, split, subdivision or combination of shares of common stock of the Company, resulting in an increase or decrease in the number of common shares outstanding, the number of Performance Units then granted under the Plan shall be increased or decreased proportionately, as the case may be. XII. REORGANIZATION If, pursuant to any reorganization, sale or exchange of assets, consolidation or merger, outstanding Class B Stock is or could be exchanged for other securities of the Company or of another company which is a party to such transaction, or for property, any grant of Performance Units under the Program theretofore granted shall, subject to the provisions of this Program for making Awards, apply to the securities or property into which the Class B Stock covered thereby would have been changed or for which such Class B Stock would have been exchanged had such Class B Stock been outstanding at the time. EXHIBIT 22 EXHIBIT (24) REPORT OF INDEPENDENT ACCOUNTANTS ON FINANCIAL STATEMENT SCHEDULES To the Board of Directors of Bausch & Lomb Incorporated out audits of the consolidated financial statements referred to in our report dated January 25, 1994 appearing on page 63 of the 1993 Annual Report to Shareholders of Bausch & Lomb Incorporated (which report and consolidated financial statements are incorporated by reference in this Annual Report on Form 10-K) also included an audit of the Financial Statement Schedules listed in Item 14(a)2, of this Form 10-K. In our opinion, these Financial Statement Schedules present fairly, in all material respects, the information set forth therein when read in conjunction with the related consolidated financial statements. /s/ Price Waterhouse PRICE WATERHOUSE Rochester, New York January 25, 1994 CONSENT OF INDEPENDENT ACCOUNTANTS We hereby consent to the incorporation by reference in the Registration Statements on Form S-8 (Nos. 2-56066, 2-85158, 33- 15439 and 33-35667) and in the Prospectus constituting part of the Registration Statement on Form S-3 (No. 3351117) of Bausch & Lomb Incorporated of our report dated January 25, 1994 appearing on page 63 of the 1993 Annual Report to Shareholders of Bausch & Lomb Incorporated which is incorporated in this Annual Report on Form 10-K. We also consent to the incorporation by reference of our above report on the Financial Statement Schedules. /s/ Price Waterhouse PRICE WATERHOUSE Rochester, New York March 23, 1994 EXHIBIT (25) POWER OF ATTORNEY The undersigned directors of Bausch & Lomb Incorporated (the "Company"), each hereby constitutes and appoints Daniel E. Gill and Jay T. Holmes, or either of them, his or her respective true and lawful attorneys and agents, each with full power and authority to act as such without the other, to sign for and on behalf of the undersigned the Company's Annual Report on Form 10-K for the year ended December 25, 1993, to be filed with the Securities and Exchange Commission pursuant to the Securities Exchange Act of 1934 and the related rules and regulations thereunder, and any amendment or amendments thereto, the undersigned hereby ratifying and confirming all that said attorneys and agents, or either one of them, shall do or cause to be done by virtue hereof. IN WITNESS WHEREOF, this instrument has been executed by the undersigned as of this 22 day of March, 1994. /s/ Franklin E. Agnew /s/ Linda Johnson Rice Franklin E. Agnew Linda Johnson Rice /s/ William Balderson III /s/ Robert L. Tarnow William Balderston III Robert L. Tarnow /s/ Bradford R. Boss /s/ Alvin W. Trivelpiece Bradford R. Boss Alvin W. Trivelpiece /s/ Daniel E. Gill /s/ William H. Waltrip Daniel E. Gill William H. Waltrip /s/ Jay T. Holmes /s/ Kenneth L. Wolfe Jay T. Holmes Kenneth L. Wolfe /s/ Ruth R. McMullin /s/ Ronald L. Zarrella Ruth R. McMullin Ronald L. Zarrella John R. Purcell

78890_1993.txt

78890

1993

Item 3: Legal Proceedings For a description of the Evergreen Case, see Items 1 and 2: "Pittston Minerals Group -- Description of Businesses -- Coal Operations -- Evergreen Case." Item 4:

Item 4: Submission of Matters to a Vote of Security Holders Not applicable. Executive Officers of the Registrant The following is a list as of March 15, 1994, of the names and ages of the executive and other officers of Pittston and the names and ages of certain officers of its subsidiaries, indicating the principal positions and offices held by each. There is no family relationship between any of the officers named. Name Age Positions and Offices Held Held Since Executive Officers Joseph C. Farrell 58 Chairman, President and Chief 1991 Executive Officer David L. Marshall 55 Vice Chairman of the Board 1990 Garold R. Spindler 46 Senior Vice President 1990 James B. Hartough 46 Vice President - Corporate Finance 1988 and Treasurer Frank T. Lennon 52 Vice President - Human Resources 1985 and Administration Gary R. Rogliano 42 Vice President - Controllership 1991 and Taxes Other Officers Karl K. Kindig 42 Vice President - Corporate Development 1991 Jack D. McDaniel 64 Vice President 1979 Michael E. Odom 42 Vice President - Special Projects 1991 Austin F. Reed 42 Vice President, General Counsel and 1994 Secretary Arthur E. Wheatley 51 Vice President and Director of Risk 1986 Management Subsidiary Officers Michael T. Dan 43 President and Chief Executive Officer 1993 of Brink's, Incorporated Peter A. Michel 51 President and Chief Executive Officer 1988 of Brink's Home Security, Inc. Garold R. Spindler 46 President and Chief Executive Officer 1990 of Pittston Coal Company Executive and other officers of Pittston are elected annually and serve at the pleasure of its Board of Directors. Mr. Farrell was elected to his present position effective October 1, 1991. From July 1990 through September 1991, he served as President and Chief Operating Officer of Pittston, and from 1984 to 1990, he served as Executive Vice President of Pittston. Mr. Marshall was elected Vice Chairman and Chief Financial Officer in July 1990 and resigned as Chief Financial Officer in February 1994. He remains as Vice Chairman of the Board and a director of Pittston. From 1984 to 1990, he served as Executive Vice President and Chief Financial Officer of Pittston. Mr. Marshall served as Chairman of Burlington Air Express Inc. from 1985 to February 1994. Mr. Spindler was elected President and Chief Executive Officer of Pittston Coal Company in October 1990. From 1986 to 1990 he served as President of Pyxis Resources Company, a subsidiary of Pittston. He was elected a Vice President of Pittston in 1986 and a Senior Vice President in July 1990. Mr. Kindig was elected Vice President - Corporate Development in October 1991. From 1990 to 1991 he served as Vice President and General Counsel of Pittston Coal Management Company, and from 1986 to 1990 he served as Counsel to Coal Operations. Mr. Odom was elected to his present position in October 1991. He served Pittston Coal Group, Inc. as President and Chief Executive Officer from 1989 to 1991 and as Executive Vice President - Operations from 1986 to 1989. Mr. Reed has served as Vice President and Secretary since September 1993 and was elected General Counsel in March 1994. Since 1989 he has served as General Counsel to Brink's, Incorporated and Burlington Air Express Inc. Mr. Rogliano was elected to his present position in October 1991. From 1986 to 1991, he served as Vice President and Director of Taxes of Pittston. Messrs. Hartough, Lennon, McDaniel and Wheatley have served in their present positions for more than the past five years. Mr. Dan was elected President and Chief Executive Officer of Brink's, Incorporated in July 1993. From August 1992 to July 1993 he served as President of North American operations of Brink's, Incorporated and as Executive Vice President of Brink's, Incorporated from 1985 to 1992. Mr. Michel was elected President and Chief Executive Officer of Brink's Home Security, Inc. in April 1988. From 1985 to 1987 he served as President and Chief Executive Officer of Penn Central Technical Security Company. PART II Item 5:

Item 5: Market for Registrant's Common Equity and Related Shareholder Matters MARKET PRICES OF PITTSTON COMMON STOCK On July 26, 1993, the outstanding shares of the Company's common stock were redesignated as Services Stock on a share-for-share basis and a second class of common stock, designated as Minerals Stock, was distributed on a basis of one-fifth of one share of Minerals Stock for each share of the Company's common stock. The common stock prices represent the actual historical high and low market prices. When issued trading for Services Stock and Minerals Stock commenced on July 6, 1993. Services Stock and Minerals Stock are traded on the New York Stock Exchange under the ticker symbols "PZS" and "PZM", respectively. As of March 1, 1994, there were approximately 7,300 and 6,100 shareholders of record of Services Stock and Minerals Stock, respectively. Item 6:

Item 6: Selected Financial Data THE PITTSTON COMPANY AND SUBSIDIARIES SELECTED FINANCIAL DATA (a) For purposes of computing net income (loss) per common share and book value per share for Pittston Services Group ("Services Group") and Pittston Minerals Group ("Minerals Group") for the periods prior to July 1, 1993, the number of shares of Pittston Services Group Common Stock ("Services Stock") are assumed to be the same as the total corresponding number of shares of The Pittston Company's (the "Company") common stock. The number of shares of Pittston Minerals Group Common Stock ("Minerals Stock") are assumed to equal one-fifth of the number of shares of the Company's common stock (Note 9). The initial dividends on the Services Stock and Minerals Stock were paid on September 1, 1993. Dividends paid by the Company prior to September 1, 1993, have been attributed to the Services and Minerals Groups in relation to the initial dividends paid on the Services Stock and Minerals Stock. (b) As of January 1, 1992, Brink's Home Security, Inc. elected to capitalize categories of costs not previously capitalized for home security installations to more accurately reflect subscriber installation costs. The effect of this change in accounting principle was to increase income (loss) before extraordinary credit and cumulative effect of accounting changes and net income of the Company and the Services Group by $2,435,000 or $.07 per share of Services Stock in 1993 and by $2,596,000 or $.07 per share of Services Stock in 1992. (c) Calculated based on the number of shares outstanding at end of the period excluding shares outstanding under the Company's Employee Benefits Trust (Note 9). PITTSTON SERVICES GROUP SELECTED FINANCIAL DATA The following Selected Financial Data reflects the results of operations and financial position of the businesses which comprise Pittston Services Group ("Services Group") and should be read in connection with the Services Group's financial statements. The financial information of the Services Group and Pittston Minerals Group ("Minerals Group") supplements the consolidated financial information of The Pittston Company and Subsidiaries (the "Company") and, taken together, includes all accounts which comprise the corresponding consolidated financial information of the Company. (a) For purposes of computing net income per common share and book value per share for the Service Group for the periods prior to July 1, 1993, the number of shares of Pittston Services Group Common Stock ("Services Stock") are assumed to be the same as the total corresponding number of shares of the Company's common stock. The initial dividend on Services Stock was paid on September 1, 1993. Dividends paid by the Company prior to September 1, 1993, have been attributed to the Services Group in relation to the initial dividend paid on the Services Stock. Book value per share is calculated based on the number of shares outstanding at the end of the period excluding 3,853,778 and 3,951,033 shares outstanding under the Company's Employee Benefits Trust at December 31, 1993 and 1992, respectively. Shares outstanding under the Company's Employee Benefits Trust are evaluated for inclusion in the evaluation of net income per share and have no dilutive effect (Note 1). (b) As of January 1, 1992, Brink's Home Security, Inc. ("BHS") elected to capitalize categories of costs not previously capitalized for home security installations to more accurately reflect subscriber installation costs. The effect of this change in accounting principle was to increase income before extraordinary credit and cumulative effect of accounting changes and net income of the Services Group by $2,435,000 or $.07 per share of Services Stock in 1993 and by $2,596,000 or $.07 per share of Services Stock in 1992. PITTSTON MINERALS GROUP SELECTED FINANCIAL DATA The following Selected Financial Data reflects the results of operations and financial position of the businesses which comprise Pittston Minerals Group ("Minerals Group") and should be read in connection with the Minerals Group's financial statements. The financial information of Minerals Group and Pittston Services Group ("Services Group") supplements the consolidated financial information of The Pittston Company and Subsidiaries (the "Company") and, taken together, includes all accounts which comprise the corresponding consolidated financial information of the Company. -2- (a) For purposes of computing net income per common share and book value per share for the Minerals Group for the periods prior to July 1, 1993, the number of shares of Pittston Minerals Group Common Stock ("Minerals Stock") are assumed to equal one-fifth of the number of shares of the Company's common stock. The initial dividend on Minerals Stock was paid on September 1, 1993. Dividends paid by the Company prior to September 1, 1993 have been attributed to the Minerals Group in relation to the initial dividend paid on the Minerals Stock. Book value per share is calculated based on the number of shares outstanding at the end of the period excluding 770,301 and 790,207 shares outstanding under the Company's Employee Benefits Trust at December 31, 1993 and 1992, respectively. Shares outstanding under the Company's Employee Benefits Trust are evaluated for inclusion in the calculation of net income per share and have no dilutive effect (Note 1). Item 7:

Item 7: Management's Discussion and Analysis of Results of Operations and Financial Condition THE PITTSTON COMPANY AND SUBSIDIARIES MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION RESULTS OF OPERATIONS Net income for 1993 was $14.1 million compared with $49.1 million for 1992. Operating profit totalled $26.1 million for 1993 compared with $89.5 million for 1992. Net income and operating profit for 1993 included restructuring and other charges of $48.9 million and $78.6 million, respectively, impacting Coal and Mineral Ventures operations. Consequently, these operations each reported operating losses for 1993, while each of The Pittston Company's (the "Company") services businesses, which include the operations of Burlington Air Express Inc. ("Burlington"), Brink's, Incorporated ("Brink's") and Brink's Home Security, Inc. ("BHS"), reported improved operating earnings compared with 1992. Net income and operating profit for 1992 were positively impacted by a pension credit of $7.0 million and $11.1 million, respectively, relating to the amortization of the unrecognized initial net pension asset at the date of adoption of Statement of Financial Accounting Standards ("SFAS") No. 87, "Employers' Accounting for Pensions", which was recognized over the estimated remaining average service life of the Company's employees since the date of adoption which expired at the end of 1992. In 1991, the Company had a net loss of $151.9 million and an operating loss of $33.9 million. The operating loss in 1991 included restructuring charges in the Coal segment of $115.2 million. Excluding the 1991 restructuring charges, operating profit in the Coal segment increased $5.8 million in 1992 compared with 1991. The combined operating profit of the Company's services businesses increased $3.3 million for the same period, with increased results for home security operations partially offset by decreased results for air freight operations. As of January 1, 1992, BHS elected to capitalize categories of costs not previously capitalized for home security installations to more accurately reflect subscriber installation costs. The effect of this change in accounting principle was to increase net income in 1992 by $2.6 million. The net loss for 1991 was due to the coal restructuring charges and to the net effect of two accounting changes adopted in 1991. The Company adopted the provisions of SFAS No. 109, "Accounting for Income Taxes" and SFAS No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions". The cumulative effect of SFAS No. 109 increased net income by $10.1 million in 1991, while the cumulative effect of SFAS No. 106 decreased net income by $133.1 million in 1991. BURLINGTON Operating profit of Burlington increased $22.9 million to $38.0 million in 1993 from $15.1 million in 1992. Worldwide revenues increased $97.8 million or 11% to $998.1 million in 1993 from $900.3 million in 1992. The increase in revenues primarily reflects volume increases only partially offset by lower average yields (revenues per pound). Total weight shipped worldwide for 1993 increased 14% to 1,020.4 million pounds from 893.0 million pounds in 1992. Operating expenses increased $76.2 million in 1993, while selling, general and administrative expenses decreased $.5 million in 1993 compared with the prior year. Selling, general and administrative expenses in 1992 were adversely affected by charges for costs related to organizational downsizing in both domestic and foreign operations. Higher operating expenses resulting from the increased volume of business in 1993 were, however, favorably impacted by increased efficiency in private fleet operations achieved as a result of a fleet upgrade to DC8-71 aircraft replacing B707 aircraft, accomplished by lease transactions at year-end 1992 and in early 1993. Two additional DC8-71's were added to the fleet during the fourth quarter of 1993, replacing less fuel efficient DC8-63 freighters. These aircraft meet Stage III noise regulations and provide the company with a significant increase in its lift capacity. During the 1993 fourth quarter Burlington also completed a 30% expansion of its airfreight hub in Toledo, Ohio. This expansion assists in achieving continuing efficiency gains, including higher average weight shipped per container. The increase in operating profit for 1993 compared with 1992 is attributable to increased Americas' operating profit of $22.0 million and increased foreign operating profit of $.9 million. The increase in Americas' operating profit was largely due to increased domestic and export volume and lower transportation costs per pound, partially offset by decreased average yields. Intra-Americas' volume increases resulted from strong electronics industry shipments as well as increased shipments from the health care industry, retail businesses and local accounts. While average yields decreased in 1993 compared with 1992 reflecting a highly competitive pricing environment, market improvement was evident during the last quarter of the year as load factors reached record levels throughout the industry. Burlington's operating profit decreased $4.7 million to $15.1 million in 1992 from $19.8 million in 1991 even though worldwide revenues increased $69.4 million or 8%. The increase in revenues reflected significant company-wide volume increases occurring principally during the latter part of 1992, offset by weaker average yields. The 1992 volume gains reflected recovering economic conditions. Yield declines resulted from a change in customer mix, due to a loss of high-yielding business with volume gains in lower-yielding accounts, and a change in product mix to an increased proportion of second-day business. The decline in operating profit, resulting from increased operating expenses which exceeded increased revenues is principally attributable to decreased Americas' operating profit of $8.3 million, which was only partially offset by increased foreign operating profit of $3.6 million. Americas' operating profit was adversely affected by decreased yields in 1992, only partially offset by volume gains. Operating profit of foreign subsidiaries increased $3.6 million in the aggregate to $12.5 million from $8.9 million in 1991 as improved results in the Far East more than offset declines in Europe. Operating profit in the Far East benefitted from volume increases despite pressures on yields. Operating profit in Europe was adversely impacted by the weakening in foreign currencies in relation to the U.S. dollar. However, margins in local currencies were maintained due to strong volumes, despite lower yields. In 1991, although operating expenses were adversely affected by $2.8 million of costs related to the move of Burlington's freight sorting hub from Fort Wayne, Indiana to Toledo Express Airport in Ohio, station costs and corporate support group costs were positively impacted by productivity gains. BRINK'S Operating profit of Brink's totalled $35.0 million in 1993 compared with $30.4 million in 1992. Worldwide operating revenues increased 9% or $37.9 million to $481.9 million with increased operating expenses and selling, general and administrative expenses of $31.7 million. Revenues increased for North American operations largely as a result of new business, but were partially offset by weak securities volumes for U.S. air courier operations. Operating expenses increased largely as a result of new business expansion, while selling, general and administrative expenses increased only slightly compared with the prior year. Other operating income decreased $1.5 million in 1993 almost entirely due to a $1.2 million decrease in equity earnings of foreign affiliates. Improved operating results from North American ground operations, air courier operations and international subsidiaries in 1993 compared with 1992 were partially offset by decreased equity earnings of foreign affiliates. North American ground operations had a 25% or $3.6 million operating profit improvement in 1993 compared with 1992 with increases in ATM, armored car and coin wrapping results, partially offset by a decrease in currency processing results. Air courier results increased $.5 million in 1993 largely due to high volume of precious metals exports, foreign currency shipments and new money shipments, which more than offset lower diamond and jewelry margins and the continued decline in the domestic securities business. Operating results for international subsidiaries increased $1.2 million compared with 1992, while equity earnings of foreign affiliates, included in operating profit decreased $1.2 million to $6.9 million in 1993 from $8.1 million in 1992. The increased results for international subsidiaries were largely attributable to earnings reported for operations in Brazil, partially offset by decreased results from a U.K. subsidiary. Operations in Brazil reported a $1.4 million operating profit in 1993 compared with a $.3 million operating loss in 1992. Although results were positive during 1993, operational and inflationary problems caused by the Brazilian economy make it uncertain as to whether this favorable trend in earnings will continue. Results in the U.K. were affected by competitive price pressures and recessionary pressures and were impacted by the cost of a labor settlement which will reduce future labor rates. In 1993, equity earnings of foreign affiliates were negatively impacted by substantially lower earnings of a 20% owned affiliate in Mexico. Operations in Mexico have been affected by a recessionary economy, new competitive pressures, losses from new business ventures and severance costs incurred in streamlining the work force. In 1992, Brink's operating profit increased $.4 million to $30.4 million from $30.0 million in 1991. Worldwide operating revenues increased 7% or $28.7 million to $444.0 million with increased operating expenses and selling, general and administrative expenses of $27.3 million and decreased other operating income of $1.0 million. Revenues increased for domestic operations as a result of new business, expansion of service with existing customers and increased specials work as a result of Hurricane Andrew. U.S. revenue increases were partially offset by decreases from Canada as a result of competitive pricing pressures as well as recessionary pressures. Operating costs increased as a result of providing new and expanded service for domestic customers, rising foreign labor costs and costs incurred for expansion in foreign markets. These operating cost increases were partially offset by benefits gained from domestic operating efficiencies. Increased operating results from foreign and North American ground operations of $2.2 million and $.3 million, respectively, were offset by a $2.1 million reduction in air courier profits. Operating profit of North American ground operations in 1992 increased 2% to $14.3 million from $14.0 million in 1991. Canadian operations continued to be adversely impacted by the weak economy and significant competitive pressures. The slight increase in North American operating profits was attributable to increases in armored car and coin wrapping results, almost entirely offset by decreases in ATM and currency processing results. Operating profit of domestic and international air courier operations in the aggregate declined by 44% to $2.7 million in 1992 from $4.8 million in 1991, as increases in international diamond and jewelry business were more than offset by reduced Canadian profits. Foreign subsidiaries had operating profit of $7.2 million in 1992 compared with $3.7 million in the prior year as increased results in Brazil, Israel and Chile more than offset an earnings decline in the United Kingdom. Although the operating loss for Brazil decreased $3.3 million in 1992 compared with 1991, operations in Brazil, while nearly breaking even, continued to be adversely impacted by cost and pricing pressures caused by a hyperinflationary economy. Operations in Israel benefitted from a growing share of local diamond shipments. Operations in the United Kingdom were affected by competitive price pressures as well as recessionary pressures. Equity earnings of foreign affiliates included in operating profit increased by $.5 million in 1992 to $8.1 million primarily due to higher operating results reported by an affiliate in France. Results from Brink's Mexican affiliate were strong, although 1992 results fell short of prior year earnings. While results for both subsidiaries and equity affiliates increased over the prior year, overhead expenses increased $2.0 million principally for costs related to tighter management oversight and expansion in European markets. BHS Operating profit of BHS aggregated $26.4 million in 1993 compared with $16.5 million in 1992 and $8.9 million in 1991. The $9.9 million increase in operating profit in 1993 compared with 1992 reflects increased monitoring margin of $11.6 million, partially offset by increased installation expenses of $.9 million and increased overhead costs of $.8 million. The $7.6 million increase in operating profits in 1992 compared with 1991 reflects increased monitoring margin of $7.8 million and reduced installation expenses of $2.5 million, partially offset by increased overhead costs of $2.7 million. The increased monitoring margin in 1993 as in 1992 was largely attributable to an expanding subscriber base which resulted in improved economies of scale and other cost efficiencies achieved in servicing BHS's subscribers. Monitoring margin in 1993 also benefitted from higher per subscriber revenues. At year-end 1993, BHS had approximately 259,600 subscribers, 44% more than the year-end 1991 subscriber base. New subscribers totalled 59,700 in 1993 and 51,300 in 1992. As a result, BHS's average subscriber base increased by 20% in 1993 and in 1992 when compared with each year prior. The increased installation expenses in 1993 compared with 1992 largely resulted from the increase in new installations. The reduced installation expenses in 1992 reflect a change in the capitalization rate for home security installations. As of January 1, 1992, BHS elected to capitalize categories of costs not previously capitalized for home security installations to more accurately reflect subscriber installation costs included as capitalized installation costs, which added $4.1 million and $4.3 million to operating profit in 1993 and 1992, respectively. The additional costs not previously capitalized consisted of costs for installation labor and related benefits for supervisory, installation scheduling, equipment testing and other support personnel (in the amount of $2.6 million and $2.3 million in 1993 and 1992, respectively) and costs incurred in maintaining facilities and vehicles dedicated to the installation process (in the amount of $1.5 million and $2.0 million in 1993 and 1992, respectively). The increase in the capitalization rate, while adding to current period profitability comparisons, defers recognition of expenses over the estimated useful life of the installed asset. The additional subscriber installation costs which are currently capitalized were expensed in prior years for subscribers in those years. Because capitalized subscriber installation costs for periods prior to January 1, 1992 were not adjusted for the change in accounting principle, installation costs for subscribers in those years will continue to be depreciated based on the lesser amounts capitalized in those periods. Consequently, depreciation of capitalized subscriber installation costs in the current year and until such capitalized costs prior to January 1, 1992 are fully depreciated will be less than if such prior periods' capitalized costs had been adjusted for the change in accounting. However, the Company believes the effect on net income in 1993 and in 1992 was immaterial. While the amounts of the costs incurred which are capitalized vary based on current market and operating conditions, the types of such costs which are currently included in BHS's capitalization rate will not change. The change in the capitalization rate has no additional effect on current or future cash flows or liquidity. COAL Coal operations had a $48.2 million operating loss in 1993 compared with an operating profit of $36.9 million in 1992. Operating results in 1993 included a $70.7 million charge for closing costs for mines which were closed at the end of 1993 and scheduled closures of mines in early 1994, including employee benefit costs and certain other noncash charges, together with the estimated liability in connection with previously reported litigation (the so-called "Evergreen Case") brought against the Company and a number of its coal subsidiaries by the trustees of certain pension and benefit trust funds established under collective bargaining agreements with the United Mine Workers of America ("UMWA"). Excluding this charge, coal operating results decreased $14.4 million in 1993 compared with 1992. Operating income in 1993 was negatively impacted by $10.0 million in expenses relating to retiree health benefits required by federal legislation enacted in October 1992 and a $1.8 million charge to settle litigation related to the moisture content of tonnage used to compute royalty payments to the UMWA pension and benefit funds during the period ended February 1, 1988. Coal operating profit also included other operating income of $9.8 million in 1993 compared with $9.0 million in the year-earlier period primarily for third party royalties and sales of properties and equipment. Average margin (realization less current production costs of coal sold) in 1993 of $3.30 per ton decreased 6% or $.20 per ton for the current year, as a 4% or $1.29 per ton decrease in average realization was only partially offset by a 4% or $1.09 per ton decrease in average current production costs of coal sold. The decrease in average realization in 1993 reflected lower export pricing and a downward price revision on a key domestic utility contract. The decrease in average current production costs of coal sold in 1993 was mainly due to a higher proportion of production sourced from company surface mine operations. Sales volume of 22.0 million tons in 1993 was 6% higher than sales volume in the year earlier. Production totalled 17.1 million tons in 1993, which was slightly lower than production in 1992. In 1993, 54% of total production was derived from deep mines and 46% was derived from surface mines compared with 65% and 35% of deep and surface mine production, respectively, in 1992. The strike by the UMWA against certain coal producers in the eastern United States, which lasted throughout a significant portion of 1993, has been settled. None of the operations of the Company's coal subsidiaries were involved in the strike. As a result of the strike, the supply of metallurgical coal was appreciably reduced. However, Australian producers increased production to absorb the shortfall. The strike had little impact on coal operating profits during 1993 since a large proportion of production is under contract. Coal operations benefitted from improved spot prices for domestic steam coal on relatively small amounts of uncommitted tonnage available for this market. Steam coal prices, which had strengthened during the strike, however, have weakened since the strike has been settled. Competition in the export metallurgical coal market is expected to be strong for the contract year beginning April 1994. While the Company has not yet reached agreements with its principal metallurgical export coal customers for such contract year, certain Australian, Canadian and U.S. producers of metallurgical coal have recently agreed to price reductions of as much as U.S. $4.00 per metric ton for the upcoming contract year, further exacerbating the deteriorating conditions in the metallurgical coal market which have been evident for over a decade. These recent price settlements may require the Company to further reduce production and sales to the metallurgical coal market. Given these recent developments, and in light of the Company's long-standing strategy to reduce its exposure in the metallurgical coal market, the Company is actively reviewing the carrying value of its production assets to determine whether they are economically viable and whether the Company should accelerate the continuing implementation of this strategy. During early 1994, coal production was sharply impacted by severe weather conditions which affected much of the United States. These weather conditions also restricted trucking of coal to plants and terminals and impaired shipments from river terminals due to frozen harbors. On January 14, 1994, Coal operations completed the acquisition of substantially all the coal mining operations and coal sales contracts of Addington Resources, Inc. This acquisition is expected to add approximately 8.5 million tons of low sulphur steam coal sales and production and provide substantial additional reserves of surface minable low sulphur coal. The contracts acquired, some of which contain terms in excess of five years, will provide a broader base of domestic utility customers and reduce exposure in the export metallurgical market, where contract prices are renegotiated annually. The Company's principal labor agreement with the UMWA expires on June 30, 1994. In 1992, operating profit for coal was $36.9 million compared with an operating loss of $84.1 million in 1991. Operating results in 1991 included $115.2 million of restructuring charges primarily related to costs associated with mine shutdowns. Production was augmented in 1992 with the addition of a new surface mine in eastern Kentucky, the on-time start-up of the $11 million new Moss 3 preparation plant in September and success of the highwall mining systems utilized at the Heartland surface mine in West Virginia. Excluding the 1991 restructuring charges, operating results for the Coal segment increased $5.8 million in 1992 compared with 1991. Operating results in 1991 included gains of $5.8 million from the disposal of excess coal reserves. There were no comparable disposals in 1992. Operating profit in 1992 benefitted from a 2.9 million (16%) increase in tonnage sold largely due to shipments to utilities under coal sales contracts acquired in March 1992 and under a contract being supplied by the Company's Heartland mine which began operations in the fourth quarter of 1991. Average margin per ton improved nearly 2% in 1992 compared with 1991, due to a 3% or $.85 per ton decrease in average current production costs of coal sold per ton only partially offset by lower per ton realization. The decrease in average current production costs of coal sold per ton reflects the increase in tonnage sold, increased productivity and a change in production mix. In 1992, 65% of total production was derived from deep mines, and 35% of production was derived from surface mines compared with 76% and 24% of deep and surface mine production, respectively, in 1991. Operating profit in 1992 also benefitted from a $2.4 million reduction in federal and state black lung expenses due to favorable claims experience. In October 1992, the Coal Industry Retiree Health Benefit Act of 1992 (the "Health Benefit Act") was enacted as part of the Energy Policy Act of 1992. The Health Benefit Act established new rules for the payment of future health care benefits for thousands of retired union mine workers and their dependents. Part of the burden for these payments has been shifted by the Health Benefit Act from certain coal producers, which had a contractual obligation to fund such payments, to producers such as the Company which have collective bargaining agreements with the UMWA that do not require such payments and to numerous other companies which are no longer in the coal business. The Health Benefit Act established a trust fund to which "signatory operators" and "related persons," including the Company and certain of its coal subsidiaries (the "Pittston Companies") would be obligated to pay annual premiums for assigned beneficiaries, together with a pro rata share for certain beneficiaries who never worked for such employers ("unassigned beneficiaries"), in amounts to be determined by the Secretary of Health and Human Services on the basis set forth in the Health Benefit Act. In October 1993, the Pittston Companies received notices from the Social Security Administration (the "SSA") with regard to their assigned beneficiaries for which they are responsible under the Health Benefit Act; the Pittston Companies also received a calculation of their liability for the first two years. For 1993 and 1994, this liability (on a pretax basis) is approximately $9.1 million and $11.0 million, respectively. The Company believes that the annual liability under the Health Benefit Act for the Pittston Companies' assigned beneficiaries will continue in the $10 to $11 million range for the next ten years and should begin to decline thereafter as the number of such assigned beneficiaries decreases. Based on the number of beneficiaries actually assigned by the SSA, the Company estimates the aggregate pretax liability relating to the Pittston Companies' assigned beneficiaries at approximately $265-$275 million, which when discounted at 8% provides a present value estimate of approximately $100-$110 million. The ultimate obligation that will be incurred by the Company could be significantly affected by, among other things, increased medical costs, decreased number of beneficiaries, governmental funding arrangements and such federal health benefit legislation of general application as may be enacted. In addition, the Health Benefit Act requires the Pittston Companies to fund, pro rata according to the total number of assigned beneficiaries, a portion of the health benefits for unassigned beneficiaries. At this time, the funding for such health benefits is being provided from another source and for this and other reasons the Pittston Companies' ultimate obligation for the unassigned beneficiaries cannot be determined. The Company accounts for its obligations under the Health Benefit Act as a participant in a multi-employer plan and recognizes the annual cost on a pay-as-you-go basis. In February 1990, the Pittston Coal Group companies and the UMWA entered into a successor collective bargaining agreement that resolved a labor dispute and related strike of Pittston Coal Group operations by UMWA-represented employees that began on April 5, 1989. As part of the agreement, the Pittston Coal Group companies agreed to make a $10 million lump sum payment to the 1950 Benefit Trust Fund and to renew participation in the 1974 Pension and Benefit Trust Funds at specified contribution rates. These aspects of the agreement were subject to formal approval by the trustees of the funds. The trustees did not accept the terms of the agreement and, therefore, payments are being made to escrow accounts for the benefit of union employees. In 1988, the trustees of certain pension and benefit trust funds established under collective bargaining agreements with the UMWA brought an action (the so-called "Evergreen Case") against the Company and a number of its coal subsidiaries in the United States District Court for the District of Columbia, claiming that the defendants are obligated to contribute to such trust funds in accordance with the provisions of the 1988 National Bituminous Coal Wage Agreement, to which neither the Company nor any of its subsidiaries is a signatory. In January 1992, the Court issued an order granting summary judgment in favor of the trustees on the issue of liability, which was thereafter affirmed by the Court of Appeals. In June 1993 the United States Supreme Court denied a petition for a writ of certiorari. The case has been remanded to District Court, and damage and other issues remain to be decided. In September 1993, the Company filed a motion seeking relief from the District Court's grant of summary judgment based on, among other things, the Company's allegation that plaintiffs improperly withheld evidence that directly refutes plaintiffs' representations to the District Court and the Court of Appeals in this case. In December 1993, that motion was denied. In furtherance of its ongoing effort to identify other available legal options for seeking relief from what it believes to be an erroneous finding of liability in the Evergreen Case, the Company has filed suit against the Bituminous Coal Operators Association and others to hold them responsible for any damages sustained by the Company as a result of the Evergreen Case. Although the Company is continuing that effort, the Company, following the District Court's ruling in December 1993, recognized the potential liability that may result from an adverse judgment in the Evergreen Case. In any event, any final judgment in the Evergreen Case will be subject to appeal. As a result of the Health Benefit Act, there is no continuing liability in this case in respect of health benefit funding after February 1, 1993. MINERAL VENTURES Mineral Ventures was formed in 1989 to develop opportunities in minerals other than coal. Mineral Ventures operations reported an operating loss of $8.3 million for 1993. This loss includes a $7.9 million charge related to the write-down of the company's investment in the Uley graphite mine in Australia. Although reserve drilling of the Uley property indicates substantial graphite deposits, processing difficulties, depressed graphite prices which have remained significantly below the level prevailing at the start of the project and an analysis of various technical and marketing conditions affecting the project resulted in the determination that the assets have been impaired and that loss recognition was appropriate. Excluding the $7.9 million charge, Mineral Ventures operations incurred a $.4 million operating loss. Operating results for 1993 reflected production from the Stawell gold mine. In December 1992, Mineral Ventures acquired its ownership in the Stawell property through its participation in a joint venture with Mining Project Investors Pty Ltd., (in which Mineral Ventures holds a 34% interest). The Stawell gold mine, which is in western Victoria, Australia, currently has proved reserves for approximately four years of production and a current annual output of approximately 70,000 ounces. The joint venture also has exploration rights in the highly prospective district around the mine. Mineral Ventures has a 67% net equity interest in the Stawell mine and its adjacent exploration acreage. In 1993, the Stawell mine produced 73,765 ounces of gold with Mineral Ventures' share of the operating profit amounting to $4.9 million. The contribution to operating profit from the Stawell mine was offset by administrative overhead in addition to exploration expenditures related chiefly to other potential gold mining projects. Operating losses, which primarily related to expenses for project review and exploration, totalled $3.4 million in 1992 and $3.5 million in 1991. FOREIGN OPERATIONS A portion of the Company's financial results is derived from activities in several foreign countries, each with a local currency other than the U.S. dollar. Because the financial results of the Company are reported in U.S. dollars, they are affected by the changes in the value of the various foreign currencies in relation to the U.S. dollar. The Company's international activity is not concentrated in any single currency, which limits the risks of foreign rate fluctuations. In addition, foreign currency rate fluctuations may adversely affect transactions which are denominated in currencies other than the functional currency. The Company routinely enters into such transactions in the normal course of its business. Although the diversity of its foreign operations limits the risks associated with such transactions, the Company uses foreign exchange forward contracts to hedge the risks associated with certain transactions denominated in currencies other than the functional currency. Realized and unrealized gains and losses on these contracts are deferred and recognized as part of the specific transaction hedged. At December 31, 1993, the Company held foreign exchange forward contracts of approximately $4.6 million. In addition, cumulative translation adjustments relating to operations in countries with highly inflationary economies are included in net income, along with all transaction gains or losses for the period. Brink's subsidiaries in Brazil and Israel operate in such highly inflationary economies. Additionally, the Company is subject to other risks customarily associated with doing business in foreign countries, including economic conditions, controls on repatriation of earnings and capital, nationalization, expropriation and other forms of restrictive action by local governments. The future effects, if any, of such risks on the Company cannot be predicted. OTHER OPERATING INCOME Other operating income increased $.9 million to $20.0 million in 1993 from $19.1 million in 1992 and decreased $11.1 million in 1992 from $30.2 million in 1991. Other operating income principally includes the Company's share of net income of unconsolidated foreign affiliates, which are substantially attributable to equity affiliates of Brink's, and royalty income from coal and natural gas properties. Equity earnings of foreign affiliates totalled $7.5 million, $8.0 million and $7.7 million in 1993, 1992 and 1991, respectively. In 1991, other operating income also included gains aggregating $5.8 million from the disposal of certain excess coal reserves. CORPORATE AND OTHER EXPENSES General corporate expenses were comparable for 1993, 1992 and 1991 and aggregated $16.7 million, $17.1 million and $16.1 million, respectively, in those years. Other income (expense), net was a net expense of $4.6 million in 1993, a net expense of $4.0 million in 1992 and net income of $9.8 million in 1991. The net amounts in 1992 and 1991 included gains of $2.3 million and $11.1 million, respectively, from the sales of investments in leveraged leases. INTEREST EXPENSE Interest expense totalled $10.2 million, $11.1 million and $15.9 million for 1993, 1992 and 1991, respectively. The $1.1 million decrease for 1993 compared with 1992 was largely a result of lower interest rates worldwide. The $4.8 million decrease in interest expense for 1992 compared with 1991 was principally due to lower average interest rates during 1992. TAXES AND EXTRAORDINARY CREDITS In 1993, the provision for income taxes is less than the statutory federal income tax rate of 35% due to the tax benefits of percentage depletion, favorable adjustments to the Company's deferred tax assets as a result of the increase in the statutory U.S. federal income tax rate and a reduction in the valuation allowance for deferred tax assets primarily in foreign jurisdictions. These benefits were partially offset by state income taxes and goodwill amortization. In 1992, the provision for income taxes exceeded the statutory federal income tax rate of 34% primarily due to provisions for state income taxes, goodwill amortization and the increase in the valuation allowance for deferred tax assets. In 1991, the credit for income taxes was less than the amount that would have been recognized using the statutory federal income tax rate of 34% since provisions for state income taxes, taxes on foreign earnings and goodwill amortization were in excess of the tax benefit from percentage depletion. Based on the Company's historical and expected taxable earnings, management believes it is more likely than not that the Company will realize the benefit of the existing deferred tax asset at December 31, 1993. FINANCIAL CONDITION CASH FLOW PROVIDED BY OPERATING ACTIVITIES Cash provided by operating activities for 1993 totalled $119.9 million compared with $124.8 million in 1992. Cash required to support the Company's investing and financing activities was less than cash generated from operations and, as a result, there were net repayments of debt in 1993 of $30.2 million and cash and cash equivalents increased $2.1 million during 1993. Net income, noncash charges and changes in operating assets and liabilities in 1993 were significantly affected by after-tax restructuring and other charges of $48.9 million which had no effect in 1993 on cash generated by operations. Of the total amount of the 1993 charges, $10.8 million was for noncash write-downs of assets and the remainder represents liabilities, of which $7.0 million are expected to be paid in 1994. The Company intends to fund any cash requirements during 1994 with anticipated cash flows from operations, with shortfalls, if any, financed through borrowings under revolving credit agreements or short-term borrowing arrangements. CAPITAL EXPENDITURES Cash capital expenditures totalled $97.8 million in 1993. An additional $64.0 million was financed through capital and operating leases. Approximately 40% of the gross capital expenditures in 1993 were incurred in the Coal segment. Of that amount, greater than 40% of the expenditures was for business expansion, and the remainder was for replacement and maintenance of current ongoing business operations. Expenditures made by Mineral Ventures approximated 2% of the Company's total capital expenditures and were primarily costs incurred for project development. Capital expenditures made by both Burlington and Brink's during 1993 were primarily for replacement and maintenance of current ongoing business operations and comprised approximately 21% and 19%, respectively, of the Company's total. Expenditures incurred by BHS during 1993 were 18% of total expenditures and were primarily for customer installations, representing the expansion in the subscriber base. OTHER INVESTING ACTIVITIES All other investing activities in 1993 provided cash of $11.8 million. In 1993, the Company sold assets of a coal subsidiary, from which cash, net of any expenses related to the transaction, totalled $9.7 million. Disposal of property, plant and equipment also provided $4.6 million in cash in 1993. In January 1994, the Company paid $157 million in cash for the acquisition of substantially all the coal mining operations and coal sales contracts of Addington Resources, Inc. (the "Addington Acquisition"). The purchase price of the acquisition was financed through the issuance of $80.5 million of a new series of convertible preferred stock, which is convertible into Minerals Stock, and additional debt under existing revolving credit facilities. FINANCING Gross capital expenditures in 1994 are not currently expected to increase significantly over 1993 levels. The Company intends to fund such expenditures through cash flow from operating activities or through operating leases if the latter are financially attractive. Any shortfalls will be financed through the Company's revolving credit agreements or short-term borrowing arrangements. As of December 31, 1993, revolving credit agreements provided for commitments of up to $250.0 million. At December 31, 1993, there was $2.1 million in borrowings outstanding under these agreements. In March 1994, the Company entered into a $350.0 million revolving credit agreement with a syndicate of banks (the "New Facility"), replacing the Company's previously existing $250.0 million of revolving credit agreements. The New Facility includes a $100.0 million five-year term loan, which matures in March 1999. The New Facility also permits additional borrowings, repayments and reborrowings of up to an aggregate of $250.0 million until March 1999. DEBT Net cash repayments of outstanding debt totalled $30.2 million in 1993 with total debt outstanding amounting to $75.8 million at year-end. The availability of funds for the repayment of debt in 1993 was largely due to $22.3 million of cash generated from operating activities in excess of the net requirement for investing activities and payment of cash dividends. Proceeds from exercise of stock options provided additional cash of $14.8 million in 1993. Subsequent to December 31, 1993, the Company financed the Addington Acquisition in part with debt under revolving credit facilities. In March 1994, the additional debt incurred for this acquisition was refinanced with a five-year term loan under the New Facility. CONTINGENT LIABILITIES In April 1990, the Company entered into a settlement agreement to resolve certain environmental claims against the Company arising from hydrocarbon contamination at a petroleum terminal facility ("Tankport") in Jersey City, New Jersey, which operations were sold in 1983. Under the settlement agreement, the Company is obligated to pay 80% of the remediation costs. Based on data available to the Company and its environmental consultants, the Company estimates its portion of the cleanup costs on an undiscounted basis using existing technologies to be between $4.5 million and $13.5 million over a period of three to five years. Management is unable to determine that any amount within that range is a better estimate due to a variety of uncertainties, which include the extent of the contamination at the site, the permitted technologies for remediation and the regulatory standards by which the cleanup will be measured by the New Jersey Department of Environmental Protection and Energy. The Company commenced insurance coverage litigation in 1990, in the United States District Court for the District of New Jersey, seeking a declaratory judgment that all amounts payable by the Company pursuant to the Tankport obligation were reimbursable under comprehensive general liability and pollution liability policies maintained by the Company. Although the underwriters have disputed this claim, management and its legal counsel believe that recovery is probable of realization in the full amount of the claim. This conclusion is based upon, among other things, the nature of the pollution policies which were broadly designed to cover such contingent liabilities, the favorable state of the law in the State of New Jersey (whose laws have been found to control the interpretation of the policies), and numerous other factual considerations which support the Company's analysis of the insurance contracts and rebut many of the underwriters' defenses. Accordingly, since management and its legal counsel believe that recovery is probable of realization in the full amount of the claim, there is no net liability in regard to the Tankport obligation. CAPITALIZATION On July 26, 1993, the Company's shareholders approved the Services Stock Proposal, as described in the Company's proxy statement dated June 24, 1993, which resulted in the reclassification of the Company's common stock. The outstanding shares of common stock of the Company were redesignated as Pittston Services Group Common Stock ("Services Stock") on a share-for-share basis and a second class of common stock, designated as Pittston Minerals Group Common Stock ("Minerals Stock"), was distributed on the basis of one- fifth of one share of Minerals Stock for each share of the Company's previous common stock held by shareholders of record on July 26, 1993. Minerals Stock and Services Stock are designed to provide shareholders with separate securities reflecting the performance of the Pittston Minerals Group (the "Minerals Group") and the Pittston Services Group (the "Services Group"), respectively, without diminishing the benefits of remaining a single corporation or precluding future transactions affecting either Group. The redesignation of the Company's common stock as Services Stock and the distribution of Minerals Stock as a result of the approval of the Services Stock Proposal did not result in any transfer of assets and liabilities of the Company or any of its subsidiaries. Holders of Services Stock and Minerals Stock are shareholders of the Company, which continues to be responsible for all its liabilities. Therefore, financial developments affecting the Minerals Group or the Services Group that affect the Company's financial condition could affect the results of operations and financial condition of both Groups. The change in the capital structure of the Company had no effect on the Company's total capital, except as to expenses incurred in the execution of the Services Stock Proposal. Since the approval of the Services Stock Proposal, capitalization of the Company has been affected by the share activity related to each of the classes of common stock. As of December 31, 1993, debt as a percent of total capitalization (total debt and shareholders' equity) was 18%, decreasing from 23% at December 31, 1992 largely due to decreased revolving credit debt at the end of 1993. In July 1993, the Company's Board of Directors (the "Board") authorized a new share repurchase program under which up to 1,250,000 shares of Services Stock and 250,000 shares of Minerals Stock may be repurchased. This program replaced the previous program under which 1,500,000 shares of common stock of the Company remained authorized for repurchase. During 1993 under the previous program 75,000 shares of the Company's common stock were repurchased at a total cost of $1.1 million. Under the new share repurchase program through December 31, 1993, 19,000 shares of Minerals Stock was repurchased at a total cost of $.4 million. There were no repurchases of Services Stock during 1993. In January 1994, the Company issued $80.5 million of a new series of convertible preferred stock, which is convertible into Minerals Stock, to finance a portion of the Addington Acquisition. DIVIDENDS The Board intends to declare and pay dividends on Services Stock and Minerals Stock based on the earnings, financial condition, cash flow and business requirements of the Services Group and the Minerals Group, respectively. Since the Company remains subject to Virginia law limitations on dividends and to dividend restrictions in its public debt and bank credit agreements, losses by one Group could affect the Company's ability to pay dividends in respect of stock relating to the other Group. Dividends on Minerals Stock are also limited by the Available Minerals Dividend Amount as defined in the Company's Articles of Incorporation. At December 31, 1993, the Available Minerals Dividend Amount was at least $10.1 million. After giving effect to the issuance of the convertible preferred stock, the pro forma Available Minerals Dividend Amount would have been at least $85.6 million. On an equivalent basis, in 1993 the Company paid dividends of 62.04 cents per share of Minerals Stock and 19.09 cents per share of Services Stock compared with 49.24 cents per share of Minerals Stock and 15.15 cents per share of Services Stock in 1992. In January 1994, 161,000 shares of convertible preferred stock (convertible into Minerals Stock) were issued to finance a portion of the Addington Acquisition. Commencing March 1, 1994, annual cumulative dividends of $31.25 per share of convertible preferred stock are payable quarterly, in cash, in arrears, out of all funds of the Company legally available therefor, when, as and if declared by the Company's Board of Directors. Such stock bears a liquidation preference of $500 per share, plus an amount equal to accrued and unpaid dividends thereon. PENDING ACCOUNTING CHANGES The Company is required to implement a new accounting standard for postemployment benefits - SFAS No. 112 - in 1994. SFAS No. 112 requires employers who provide benefits to former employees after employment but before retirement to accrue such costs as the benefits accumulate or vest. The Company has determined that the cumulative effect of adopting SFAS No. 112 is immaterial. The Company is required to implement a new accounting standard for investments in debt and equity securities - SFAS No. 115 - in 1994. SFAS No. 115 requires classification of debt and equity securities and recognition of changes in the fair value of the securities based on the purpose for which the securities are held. The Company has determined that the cumulative effect of adopting SFAS No. 115 is immaterial. PITTSTON SERVICES GROUP MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION The financial statements of the Pittston Services Group (the "Services Group") include the balance sheets, results of operations and cash flows of Burlington Air Express Inc. ("Burlington"), Brink's, Incorporated ("Brink's") and Brink's Home Security, Inc. ("BHS"), and a portion of The Pittston Company's (the "Company") corporate assets and liabilities and related transactions which are not separately identified with operations of a specific segment. The Services Group's financial statements are prepared using the amounts included in the Company's consolidated financial statements. Corporate allocations reflected in these financial statements are determined based upon methods which management believes to be an equitable allocation of such expenses and credits. The accounting policies applicable to the preparation of the Services Group's financial statements may be modified or rescinded at the sole discretion of the Company's Board of Directors (the "Board") without the approval of the shareholders, although there is no intention to do so. The Company will provide to holders of Pittston Services Group Common Stock ("Services Stock") separate financial statements, financial reviews, descriptions of business and other relevant information for the Services Group in addition to consolidated financial information of the Company. Notwithstanding the attribution of assets and liabilities (including contingent liabilities) between the Pittston Minerals Group (the "Minerals Group") and the Services Group for the purpose of preparing their financial statements, this attribution and the change in the capital structure of the Company as a result of the approval of the Services Stock Proposal, as described in the Company's proxy statement dated June 24, 1993, did not result in any transfer of assets and liabilities of the Company or any of its subsidiaries. Holders of Services Stock are shareholders of the Company, which continues to be responsible for all its liabilities. Therefore, financial developments affecting the Minerals Group or the Services Group that affect the Company's financial condition could affect the results of operations and financial condition of both Groups. Accordingly, the Company's consolidated financial statements must be read in connection with the Services Group's financial statements. The following discussion is a summary of the key factors management considers necessary in reviewing the Services Group's results of operations, liquidity and capital resources. This discussion should be read in conjunction with the financial statements and related notes of the Company. RESULTS OF OPERATIONS Net income for the Services Group for 1993 was $47.1 million compared with $27.3 million for 1992. Operating profit for 1993 was $89.9 million compared with $57.4 million in the prior year. Each of the segments in the Services Group contributed to the increase in operating profit for the current year compared with the prior year. Net income and operating profit in 1992 were positively impacted by a pension credit of $2.5 million and $4.0 million, respectively, relating to the amortization of the unrecognized initial net pension asset at the date of adoption of Statement of Financial Accounting Standards No. 87, "Employers' Accounting for Pensions", which was recognized over the estimated remaining average service life of employees since the date of adoption, which expired at the end of 1992. Revenues for 1993 increased $153.9 million compared with 1992, of which $97.7 million was from Burlington, $37.9 million was from Brink's and $18.3 million was from BHS. Operating expenses and selling, general and administrative expenses for 1993 increased $116.7 million, of which $75.7 million was from Burlington, $31.7 million was from Brink's, $8.3 million was from BHS and $1.0 million was due to an increase in the allocation of corporate expenses. In 1992, net income increased $6.1 million to $27.3 million from $21.2 million in 1991. Operating profit for 1992 was $57.4 million compared with operating profit of $54.7 million in 1991. The $2.7 million increase in operating profit is attributable to an increase in results for BHS partially offset by decreased results for Burlington. As of January 1, 1992, BHS elected to capitalize categories of costs not previously capitalized for home security installation to more accurately reflect subscriber installation costs. The effect of this change in accounting principle was to increase net income in 1992 by $2.6 million. Combined revenues for 1992 increased by $112.9 million, of which $69.4 million was attributable to Burlington, $28.7 million was attributable to Brink's and $14.8 million was attributable to BHS. Operating expenses and selling, general and administrative expenses for 1992 increased $109.6 million, of which $74.6 million was attributable to Burlington, $27.3 million was attributable to Brink's, $7.2 million was attributable to BHS and $.5 million was attributable to an increase in the allocation of corporate expenses. BURLINGTON Operating profit of Burlington increased $22.9 million to $38.0 million in 1993 from $15.1 million in 1992. Worldwide revenues increased $97.8 million or 11% to $998.1 million in 1993 from $900.3 million in 1992. The increase in revenues primarily reflects volume increases only partially offset by lower average yields (revenues per pound). Total weight shipped worldwide for 1993 increased 14% to 1,020.4 million pounds from 893.0 million pounds in 1992. Operating expenses increased $76.2 million in 1993, while selling, general and administrative expenses decreased $.5 million in 1993 compared with the prior year. Selling, general and administrative expenses in 1992 were adversely affected by charges for costs related to organizational downsizing in both domestic and foreign operations. Higher operating expenses resulting from the increased volume of business in 1993 were, however, favorably impacted by increased efficiency in private fleet operations achieved as a result of a fleet upgrade to DC8-71 aircraft replacing B707 aircraft, accomplished by lease transactions at year-end 1992 and in early 1993. Two additional DC8-71's were added to the fleet during the fourth quarter of 1993, replacing less fuel efficient DC8-63 freighters. These aircraft meet Stage III noise regulations and provide the company with a significant increase in its lift capacity. During the 1993 fourth quarter Burlington also completed a 30% expansion of its airfreight hub in Toledo, Ohio. This expansion assists in achieving continuing efficiency gains, including higher average weight shipped per container. The increase in operating profit for 1993 compared with 1992 is attributable to increased Americas' operating profit of $22.0 million and increased foreign operating profit of $.9 million. The increase in Americas' operating profit was largely due to increased domestic and export volume and lower transportation costs per pound, partially offset by decreased average yields. Intra-Americas' volume increases resulted from strong electronics industry shipments as well as increased shipments from the health care industry, retail businesses and local accounts. While average yields decreased in 1993 compared with 1992 reflecting a highly competitive pricing environment, market improvement was evident during the last quarter of the year as load factors reached record levels throughout the industry. Burlington's operating profit decreased $4.7 million to $15.1 million in 1992 from $19.8 million in 1991 even though worldwide revenues increased $69.4 million or 8%. The increase in revenues reflected significant company-wide volume increases occurring principally during the latter part of 1992, offset by weaker average yields. The 1992 volume gains reflected recovering economic conditions. Yield declines resulted from a change in customer mix, due to a loss of high-yielding business with volume gains in lower-yielding accounts, and a change in product mix to an increased proportion of second-day business. The decline in operating profit, resulting from increased operating expenses which exceeded increased revenues is principally attributable to decreased Americas' operating profit of $8.3 million, which was only partially offset by increased foreign operating profit of $3.6 million. Americas' operating profit was adversely affected by decreased yields in 1992, only partially offset by volume gains. Operating profit of foreign subsidiaries increased $3.6 million in the aggregate to $12.5 million from $8.9 million in 1991 as improved results in the Far East more than offset declines in Europe. Operating profit in the Far East benefitted from volume increases despite pressures on yields. Operating profit in Europe was adversely impacted by the weakening in foreign currencies in relation to the U.S. dollar. However, margins in local currencies were maintained due to strong volumes, despite lower yields. In 1991, although operating expenses were adversely affected by $2.8 million of costs related to the move of Burlington's freight sorting hub from Fort Wayne, Indiana to Toledo Express Airport in Ohio, station costs and corporate support group costs were positively impacted by productivity gains. BRINK'S Operating profit of Brink's totalled $35.0 million in 1993 compared with $30.4 million in 1992. Worldwide operating revenues increased 9% or $37.9 million to $481.9 million with increased operating expenses and selling, general and administrative expenses of $31.7 million. Revenues increased for North American operations largely as a result of new business, but were partially offset by weak securities volumes for U.S. air courier operations. Operating expenses increased largely as a result of new business expansion, while selling, general and administrative expenses increased only slightly compared with the prior year. Other operating income decreased $1.5 million in 1993 almost entirely due to a $1.2 million decrease in equity earnings of foreign affiliates. Improved operating results from North American ground operations, air courier operations and international subsidiaries in 1993 compared with 1992 were partially offset by decreased equity earnings of foreign affiliates. North American ground operations had a 25% or $3.6 million operating profit improvement in 1993 compared with 1992 with increases in ATM, armored car and coin wrapping results, partially offset by a decrease in currency processing results. Air courier results increased $.5 million in 1993 largely due to high volume of precious metals exports, foreign currency shipments and new money shipments, which more than offset lower diamond and jewelry margins and the continued decline in the domestic securities business. Operating results for international subsidiaries increased $1.2 million compared with 1992, while equity earnings of foreign affiliates, included in operating profit decreased $1.2 million to $6.9 million in 1993 from $8.1 million in 1992. The increased results for international subsidiaries were largely attributable to earnings reported for operations in Brazil, partially offset by decreased results from a U.K. subsidiary. Operations in Brazil reported a $1.4 million operating profit in 1993 compared with a $.3 million operating loss in 1992. Although results were positive during 1993, operational and inflationary problems caused by the Brazilian economy make it uncertain as to whether this favorable trend in earnings will continue. Results in the U.K. were affected by competitive price pressures and recessionary pressures and were impacted by the cost of a labor settlement which will reduce future labor rates. In 1993, equity earnings of foreign affiliates were negatively impacted by substantially lower earnings of a 20% owned affiliate in Mexico. Operations in Mexico have been affected by a recessionary economy, new competitive pressures, losses from new business ventures and severance costs incurred in streamlining the work force. In 1992, Brink's operating profit increased $.4 million to $30.4 million from $30.0 million in 1991. Worldwide operating revenues increased 7% or $28.7 million to $444.0 million with increased operating expenses and selling, general and administrative expenses of $27.3 million and decreased other operating income of $1.0 million. Revenues increased for domestic operations as a result of new business, expansion of service with existing customers and increased specials work as a result of Hurricane Andrew. U.S. revenue increases were partially offset by decreases from Canada as a result of competitive pricing pressures as well as recessionary pressures. Operating costs increased as a result of providing new and expanded service for domestic customers, rising foreign labor costs and costs incurred for expansion in foreign markets. These operating cost increases were partially offset by benefits gained from domestic operating efficiencies. Increased operating results from foreign and North American ground operations of $2.2 million and $.3 million, respectively, were offset by a $2.1 million reduction in air courier profits. Operating profit of North American ground operations in 1992 increased 2% to $14.3 million from $14.0 million in 1991. Canadian operations continued to be adversely impacted by the weak economy and significant competitive pressures. The slight increase in North American operating profits was attributable to increases in armored car and coin wrapping results, almost entirely offset by decreases in ATM and currency processing results. Operating profit of domestic and international air courier operations in the aggregate declined by 44% to $2.7 million in 1992 from $4.8 million in 1991, as increases in international diamond and jewelry business were more than offset by reduced Canadian profits. Foreign subsidiaries had operating profit of $7.2 million in 1992 compared with $3.7 million in the prior year as increased results in Brazil, Israel and Chile more than offset an earnings decline in the United Kingdom. Although the operating loss for Brazil decreased $3.3 million in 1992 compared with 1991, operations in Brazil, while nearly breaking even, continued to be adversely impacted by cost and pricing pressures caused by a hyperinflationary economy. Operations in Israel benefitted from a growing share of local diamond shipments. Operations in the United Kingdom were affected by competitive price pressures as well as recessionary pressures. Equity earnings of foreign affiliates included in operating profit increased by $.5 million in 1992 to $8.1 million primarily due to higher operating results reported by an affiliate in France. Results from Brink's Mexican affiliate were strong, although 1992 results fell short of prior year earnings. While results for both subsidiaries and equity affiliates increased over the prior year, overhead expenses increased $2.0 million principally for costs related to tighter management oversight and expansion in European markets. BHS Operating profit of BHS aggregated $26.4 million in 1993 compared with $16.5 million in 1992 and $8.9 million in 1991. The $9.9 million increase in operating profit in 1993 compared with 1992 reflects increased monitoring margin of $11.6 million, partially offset by increased installation expenses of $.9 million and increased overhead costs of $.8 million. The $7.6 million increase in operating profits in 1992 compared with 1991 reflects increased monitoring margin of $7.8 million and reduced installation expenses of $2.5 million, partially offset by increased overhead costs of $2.7 million. The increased monitoring margin in 1993 as in 1992 was largely attributable to an expanding subscriber base which resulted in improved economies of scale and other cost efficiencies achieved in servicing BHS's subscribers. Monitoring margin in 1993 also benefitted from higher per subscriber revenues. At year-end 1993, BHS had approximately 259,600 subscribers, 44% more than the year-end 1991 subscriber base. New subscribers totalled 59,700 in 1993 and 51,300 in 1992. As a result, BHS's average subscriber base increased by 20% in 1993 and in 1992 when compared with each year prior. The increased installation expenses in 1993 compared with 1992 largely resulted from the increase in new installations. The reduced installation expenses in 1992 reflect a change in the capitalization rate for home security installations. As of January 1, 1992, BHS elected to capitalize categories of costs not previously capitalized for home security installations to more accurately reflect subscriber installation costs included as capitalized installation costs, which added $4.1 million and $4.3 million to operating profit in 1993 and 1992, respectively. The additional costs not previously capitalized consisted of costs for installation labor and related benefits for supervisory, installation scheduling, equipment testing and other support personnel (in the amount of $2.6 million and $2.3 million in 1993 and 1992, respectively) and costs incurred in maintaining facilities and vehicles dedicated to the installation process (in the amount of $1.5 million and $2.0 million in 1993 and 1992, respectively). The increase in the capitalization rate, while adding to current period profitability comparisons, defers recognition of expenses over the estimated useful life of the installed asset. The additional subscriber installation costs which are currently capitalized were expensed in prior years for subscribers in those years. Because capitalized subscriber installation costs for periods prior to January 1, 1992 were not adjusted for the change in accounting principle, installation costs for subscribers in those years will continue to be depreciated based on the lesser amounts capitalized in those periods. Consequently, depreciation of capitalized subscriber installation costs in the current year and until such capitalized costs prior to January 1, 1992 are fully depreciated will be less than if such prior periods' capitalized costs had been adjusted for the change in accounting. However, the Company believes the effect on net income in 1993 and in 1992 was immaterial. While the amounts of the costs incurred which are capitalized vary based on current market and operating conditions, the types of such costs which are currently included in BHS's capitalization rate will not change. The change in the capitalization rate has no additional effect on current or future cash flows or liquidity. FOREIGN OPERATIONS A significant portion of the Services Group's financial results is derived from activities in several foreign countries, each with a local currency other than the U.S. dollar. Because the financial results of the Services Group are reported in U.S. dollars, they are affected by the changes in the value of the various foreign currencies in relation to the U.S. dollar. The Services Group's international activity is not concentrated in any single currency, which limits the risks of foreign rate fluctuation. In addition, foreign currency rate fluctuations may adversely affect transactions which are denominated in currencies other than the functional currency. The Services Group routinely enters into such transactions in the normal course of its business. Although the diversity of its foreign operations limits the risks associated with such transactions, the Company, on behalf of the Services Group, uses foreign exchange forward contracts to hedge the risk associated with certain transactions denominated in currencies other than the functional currency. Realized and unrealized gains and losses on these contracts are deferred and recognized as part of the specific transaction hedged. At December 31, 1993, the Company held, on behalf of the Services Group, foreign exchange forward contracts of approximately $4.6 million. In addition, cumulative translation adjustments relating to operations in countries with highly inflationary economies are included in net income, along with all transaction gains or losses for the period. Brink's subsidiaries in Brazil and Israel operate in such highly inflationary economies. Additionally, the Services Group is subject to other risks customarily associated with doing business in foreign countries, including economic conditions, controls on repatriation of earnings and capital, nationalization, expropriation and other forms of restrictive action by local governments. The future effects, if any, of such risks on the Services Group cannot be predicted. CORPORATE EXPENSES A portion of the Company's corporate general and administrative expenses and other shared services has been allocated to the Services Group based upon utilization and other methods and criteria which management believes to be equitable and a reasonable estimate of such expenses as if the Services Group operated on a stand alone basis. These allocations were $9.5 million, $8.6 million and $8.0 million in 1993, 1992 and 1991, respectively. OTHER OPERATING INCOME Other operating income decreased $.6 million to $9.7 million in 1993 from $10.3 million in 1992 and decreased $.5 million in 1992 from $10.8 million in 1991. Other operating income consists primarily of equity earnings of foreign affiliates. These earnings, which are primarily attributable to equity affiliates of Brink's, amounted to $7.0 million, $8.2 million and $7.7 million 1993, 1992 and 1991, respectively. OTHER INCOME (EXPENSE), NET Other income (expense), net improved by $1.9 million to a net expense of $4.1 million in 1993 from a net expense of $6.0 million in 1992. In 1992, other income (expense), net decreased by $4.6 million to a net expense of $6.0 million from a net expense of $1.4 million a year earlier. In 1992, other income (expense), net included losses on asset sales. Other changes for the comparable periods are largely due to fluctuations in foreign translation losses. INTEREST EXPENSE Interest expense for 1993 increased $1.2 million to $8.8 million from $7.6 million in 1992 and in 1992 interest expense decreased $6.4 million from $14.0 million a year earlier. The decrease in 1992 compared to 1991 was principally due to lower average interest rates during the year. TAXES AND EXTRAORDINARY CREDITS In 1993 and 1992, the provision for income taxes exceeded the statutory federal income tax rate of 35% in 1993 and 34% in 1992 primarily because of provisions for state income taxes and goodwill amortization. In 1991, the provision for income taxes exceeded the statutory federal income tax rate of 34% primarily because of provisions for state income taxes, taxes on foreign earnings and goodwill amortization. FINANCIAL CONDITION A portion of the Company's corporate assets and liabilities has been attributed to the Services Group based upon utilization of the shared services from which assets and liabilities are generated, which management believes to be equitable and a reasonable estimate of the assets and liabilities which would be generated if the Services Group operated on a stand alone basis. Corporate assets which were allocated to the Services Group consisted primarily of pension assets and deferred income taxes and amounted to $33.5 million and $36.0 million at December 31, 1993 and 1992, respectively. CASH FLOW PROVIDED BY OPERATING ACTIVITIES Cash provided by operations totalled $91.4 million in 1993, an $11.9 million increase compared with $79.4 million generated by operations in 1992. The net increase in 1993 compared with 1992 consisted of a $19.8 million increase in net income and a $10.5 million increase attributable to a change in noncash charges and credits, partially offset by $18.4 million in additional requirements to fund operating assets and liabilities. Cash generated from operations of the Services Group exceeded cash requirements for investing and financing activities and, as a result, cash and cash equivalents increased $1.9 million during 1993 to a year-end total of $30.3 million. CAPITAL EXPENDITURES Cash capital expenditures totalled $76.0 million in 1993. An additional $18.5 million was financed through capital and operating leases. A substantial portion of the Services Group's total cash capital expenditures was attributable to BHS customer installations representing the expansion in the subscriber base. Of the total cash capital expenditures, $26.4 million or 35% related to these costs. Capital expenditures made by both Burlington and Brink's during 1993 were primarily for replacement and maintenance of current ongoing business operations. Cash capital expenditures for 1993 were funded by cash flow from operating activities, with any shortfalls financed through the Company by borrowings under its revolving credit agreements or short-term borrowing arrangements, which were thereby attributed to the Services Group. FINANCING Gross capital expenditures in 1994 are not currently expected to increase significantly over 1993 levels. The Services Group intends to fund such expenditures through cash flow from operating activities or through operating leases if the latter are financially attractive. Any shortfalls will be financed through the Company's revolving credit agreements or short-term borrowing arrangements or borrowings from the Minerals Group. As of December 31, 1993, revolving credit agreements provided for commitments of up to $250.0 million. At December 31, 1993, there was $2.1 million in borrowings outstanding under these agreements which was attributed to the Services Group. In March 1994, the Company entered into a $350.0 million revolving credit agreement with a syndicate of banks (the "New Facility"), replacing the Company's previously existing $250.0 million of revolving credit agreements. The New Facility includes a $100.0 million five-year term loan, which matures in March 1999. The New Facility also permits additional borrowings, repayments and reborrowings of up to an aggregate of $250.0 million until March 1999. DEBT Total debt outstanding for the Services Group amounted to $88.8 million at year-end 1993, including $13.3 million payable to the Minerals Group. During 1993, cash generated from operations exceeded requirements for investing activities and as a result, net debt repayments totalled $17.0 million. CONTINGENT LIABILITIES Under the Coal Industry Retiree Health Benefit Act of 1992 (the "Health Benefit Act"), the Company and its majority-owned subsidiaries at July 20, 1992, including the Services Group are jointly and severally liable with the Minerals Group for the costs of health care coverage provided for by that Act. For a description of the Health Benefit Act and a calculation of certain of such costs, see Note 13 to the Company's consolidated financial statements. At this time, the Company expects the Minerals Group to generate sufficient cash flow to discharge its obligations under the Act. In April 1990, the Company entered into a settlement agreement to resolve certain environmental claims against the Company arising from hydrocarbon contamination at a petroleum terminal facility ("Tankport") in Jersey City, New Jersey, which operations were sold in 1983. Under the settlement agreement, the Company is obligated to pay 80% of the remediation costs. Based on data available to the Company and its environmental consultants, the Company estimates its portion of the cleanup costs on an undiscounted basis using existing technologies to be between $4.5 million and $13.5 million over a period of three to five years. Management is unable to determine that any amount within that range is a better estimate due to a variety of uncertainties, which include the extent of the contamination at the site, the permitted technologies for remediation and the regulatory standards by which the cleanup will be measured by the New Jersey Department of Environmental Protection and Energy. The Company commenced insurance coverage litigation in 1990, in the United States District Court for the District of New Jersey, seeking a declaratory judgment that all amounts payable by the Company pursuant to the Tankport obligation were reimbursable under comprehensive general liability and pollution liability policies maintained by the Company. Although the underwriters have disputed this claim, management and its legal counsel believe that recovery is probable of realization in the full amount of the claim. This conclusion is based upon, among other things, the nature of the pollution policies which were broadly designed to cover such contingent liabilities, the favorable state of the law in the State of New Jersey (whose laws have been found to control the interpretation of the policies), and numerous other factual considerations which support the Company's analysis of the insurance contracts and rebut many of the underwriters' defenses. Accordingly, since management and its legal counsel believe that recovery is probable of realization in the full amount of the claim, there is no net liability in regard to the Tankport obligation. CAPITALIZATION On July 26, 1993, the Company's shareholders approved the Services Stock Proposal, as described in the Company's proxy statement dated June 24, 1993, which resulted in the reclassification of the Company's common stock. The outstanding shares of common stock of the Company were redesignated as Services Stock on a share-for-share basis and a second class of common stock, designated as Pittston Mineral Group Common Stock ("Minerals Stock), was distributed on the basis of one-fifth of one share of Minerals Stock for each share of the Company's previous common stock held by shareholders of record on July 26, 1993. Minerals Stock and Services Stock are designed to provide shareholders with separate securities reflecting the performance of the Minerals Group and the Services Group, respectively, without diminishing the benefits of remaining a single corporation or precluding future transactions affecting either Group. The redesignation of the Company's common stock as Services Stock and the distribution of Minerals Stock as a result of the approval of the Services Stock Proposal did not result in any transfer of assets and liabilities of the Company or any of its subsidiaries. Holders of Services Stock and Minerals Stock are shareholders of the Company, which continues to be responsible for all its liabilities. Therefore, financial developments affecting the Minerals Group or the Services Group that affect the Company's financial condition could affect the results of operations and financial condition of both Groups. The change in the capital structure of the Company had no effect on the Company's total capital, except as to expenses incurred in the execution of the Services Stock Proposal. Since the approval of the Services Stock Proposal, capitalization of the Services Group has been affected by all share activity related to Services Stock. In July 1993, the Board authorized a new share repurchase program under which up to 1,250,000 shares of Services Stock and 250,000 shares of Minerals Stock may be repurchased. This program replaced the previous program under which 1,500,000 shares of common stock of the Company remained authorized for repurchase. During 1993 under the previous program 75,000 shares of the Company's common stock were repurchased at a total cost of $1.1 million. There were no repurchases of Services Stock during 1993 under the new share repurchase program. DIVIDENDS The Board intends to declare and pay dividends on Services Stock based on the earnings, financial condition, cash flow and business requirements of the Services Group. Since the Company remains subject to Virginia law limitations on dividends and to dividend restrictions in its public debt and bank credit agreements, losses by the Minerals Group could affect the Company's ability to pay dividends in respect of stock relating to the Services Group. On an equivalent basis, in 1993 the Company paid dividends of 19.09 cents per share of Services Stock compared with 15.15 cents per share of Services Stock in 1992. In January 1994, the Company issued 161,000 shares or $80.5 million of a new series of convertible preferred stock, which is convertible into Minerals Stock, to finance a portion of a coal acquisition. While the issuance of the preferred stock had no effect on the capitalization of the Services Group, commencing March 1, 1994, annual cumulative dividends of $31.25 per share of convertible preferred stock are payable quarterly, in cash, out of all funds of the Company legally available therefor, when, as and if declared by the Board. Such stock also bears a liquidation preference of $500 per share plus an amount equal to accrued and unpaid dividends thereon. PENDING ACCOUNTING CHANGES The Services Group is required to implement a new accounting standard for postemployment benefits - Statement of Financial Accounting Standards ("SFAS") No. 112 - in 1994. SFAS No. 112 requires employers who provide benefits to former employees after employment but before retirement to accrue such costs as the benefits accumulate or vest. The Services Group has determined that the cumulative effect of adopting SFAS No. 112 is immaterial. The Company is required to implement a new accounting standard for investments in debt and equity securities - SFAS No. 115 - in 1994. SFAS No. 115 requires classification of debt and equity securities and recognition of changes in the fair value of the securities based on the purpose for which the securities are held. The Services Group has determined that the cumulative effect of adopting SFAS No. 115 is immaterial. PITTSTON MINERALS GROUP MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION The financial statements of the Pittston Minerals Group (the "Minerals Group") include the balance sheets, results of operations and cash flows of the Coal and Mineral Ventures operations of The Pittston Company (the "Company"), and a portion of the Company's corporate assets and liabilities and related transactions which are not separately identified with operations of a specific segment. The Minerals Group's financial statements are prepared using the amounts included in the Company's consolidated financial statements. Corporate allocations reflected in these financial statements are determined based upon methods which management believes to be an equitable allocation of such expenses and credits. The accounting policies applicable to the preparation of the Minerals Group's financial statements may be modified or rescinded at the sole discretion of the Company's Board of Directors (the "Board") without the approval of the shareholders, although there is no intention to do so. The Company will provide to holders of the Pittston Minerals Group Common Stock ("Minerals Stock") separate financial statements, financial reviews, descriptions of business and other relevant information for the Minerals Group in addition to consolidated financial information of the Company. Notwithstanding the attribution of assets and liabilities (including contingent liabilities) between the Minerals Group and the Pittston Services Group (the "Services Group") for the purpose of preparing their financial statements, this attribution and the change in the capital structure of the Company as a result of the approval of the Services Stock Proposal, as described in the Company's proxy statement dated June 24, 1993, did not result in any transfer of assets and liabilities of the Company or any of its subsidiaries. Holders of Minerals Stock are shareholders of the Company, which continues to be responsible for all its liabilities. Therefore, financial developments affecting the Minerals Group or the Services Group that affect the Company's financial condition could affect the results of operations and financial condition of both Groups. Accordingly, the Company's consolidated financial statements must be read in connection with the Minerals Group's financial statements. The following discussion is a summary of the key factors management considers necessary in reviewing the Minerals Group's results of operations, liquidity and capital resources. This discussion should be read in conjunction with the financial statements and related notes of the Company. RESULTS OF OPERATIONS In 1993, the Minerals Group had a net loss of $33.0 million compared with net income of $21.8 million for 1992. In 1993, the Minerals Group had an operating loss of $63.8 million compared with an operating profit of $32.1 million for 1992. Net income and operating profit for 1993 included restructuring and other charges totalling $48.9 million and $78.6 million, respectively. The charges impacted both Coal and Mineral Ventures operations, and consequently, these operations each reported operating losses for 1993. Net income and operating profit for 1992 were positively impacted by a pension credit of $4.4 million and $7.0 million, respectively, relating to the amortization of the unrecognized initial net pension asset at the date of adoption of Statement of Financial Accounting Standards No. 87, "Employers' Accounting for Pensions", which was recognized over the estimated remaining average service life of the Company's employees since the date of adoption which expired at the end of 1992. Net income for 1992 was $21.8 million compared with a net loss of $173.0 million for 1991. Operating profit for 1992 was $32.1 million compared with an operating loss of $88.6 million in 1991. The operating loss in 1991 included restructuring charges for Coal operations of $115.2 million. Excluding the 1991 restructuring charges, operating profit increased $5.5 million in 1992 compared with 1991. The net loss for 1991 was due to the coal restructuring charges and to the net effect of two accounting changes adopted in 1991. The Minerals Group adopted the provisions of Statement of Financial Accounting Standards ("SFAS") No. 109, "Accounting for Income Taxes" and SFAS No. 106, "Employers Accounting for Postretirement Benefits Other Than Pensions". The cumulative effect of SFAS No. 109 increased net income by $6.4 million in 1991, while the cumulative effect of SFAS No. 106 decreased net income by $129.7 million in 1991. COAL Coal operations had a $48.2 million operating loss in 1993 compared with an operating profit of $36.9 million in 1992. Operating results in 1993 included a $70.7 million charge for closing costs for mines which were closed at the end of 1993 and scheduled closures of mines in early 1994, including employee benefit costs and certain other noncash charges, together with the estimated liability in connection with previously reported litigation (the so-called "Evergreen Case") brought against the Company and a number of its coal subsidiaries by the trustees of certain pension and benefit trust funds established under collective bargaining agreements with the United Mine Workers of America ("UMWA"). Excluding this charge, coal operating results decreased $14.4 million in 1993 compared with 1992. Operating income in 1993 was negatively impacted by $10.0 million in expenses relating to retiree health benefits required by federal legislation enacted in October 1992 and a $1.8 million charge to settle litigation related to the moisture content of tonnage used to compute royalty payments to the UMWA pension and benefit funds during the period ended February 1, 1988. Coal operating profit also included other operating income of $9.8 million in 1993 compared with $9.0 million in the year-earlier period primarily for third party royalties and sales of properties and equipment. Average margin (realization less current production costs of coal sold) in 1993 of $3.30 per ton decreased 6% or $.20 per ton for the current year, as a 4% or $1.29 per ton decrease in average realization was only partially offset by a 4% or $1.09 per ton decrease in average current production costs of coal sold. The decrease in average realization in 1993 reflected lower export pricing and a downward price revision on a key domestic utility contract. The decrease in average current production costs of coal sold in 1993 was mainly due to a higher proportion of production sourced from company surface mine operations. Sales volume of 22.0 million tons in 1993 was 6% higher than sales volume in the year earlier. Production totalled 17.1 million tons in 1993, which was slightly lower than production in 1992. In 1993, 54% of total production was derived from deep mines and 46% was derived from surface mines compared with 65% and 35% of deep and surface mine production, respectively, in 1992. The strike by the UMWA against certain coal producers in the eastern United States, which lasted throughout a significant portion of 1993, has been settled. None of the operations of the Company's coal subsidiaries were involved in the strike. As a result of the strike, the supply of metallurgical coal was appreciably reduced. However, Australian producers increased production to absorb the shortfall. The strike had little impact on coal operating profits during 1993 since a large proportion of production is under contract. Coal operations benefitted from improved spot prices for domestic steam coal on relatively small amounts of uncommitted tonnage available for this market. Steam coal prices, which had strengthened during the strike, however, have weakened since the strike has been settled. Competition in the export metallurgical coal market is expected to be strong for the contract year beginning April 1994. While the Minerals Group has not yet reached agreements with its principal metallurgical export coal customers for such contract year, certain Australian, Canadian and U.S. producers of metallurgical coal have recently agreed to price reductions of as much as U.S. $4.00 per metric ton for the upcoming contract year, further exacerbating the deteriorating conditions in the metallurgical coal market which have been evident for over a decade. These recent price settlements may require the Minerals Group to further reduce production and sales to the metallurgical coal market. Given these recent developments and in light of the Company's long-standing strategy to reduce its exposure in the metallurgical coal market, the Minerals Group is actively reviewing the carrying value of its production assets to determine whether they are economically viable and whether the Minerals Group should accelerate the continuing implementation of this strategy. During early 1994, coal production was sharply impacted by severe weather conditions which affected much of the United States. These weather conditions also restricted trucking of coal to plants and terminals and impaired shipments from river terminals due to frozen harbors. On January 14, 1994, Coal operations completed the acquisition of substantially all the coal mining operations and coal sales contracts of Addington Resources, Inc. This acquisition is expected to add approximately 8.5 million tons of low sulphur steam coal sales and production and provide substantial additional reserves of surface minable low sulphur coal. The contracts acquired, some of which contain terms in excess of five years, will provide a broader base of domestic utility customers and reduce exposure in the export metallurgical market, where contract prices are renegotiated annually. The Company's principal labor agreement with the UMWA expires on June 30, 1994. In 1992, operating profit for coal was $36.9 million compared with an operating loss of $84.1 million in 1991. Operating results in 1991 included $115.2 million of restructuring charges primarily related to costs associated with mine shutdowns. Production was augmented in 1992 with the addition of a new surface mine in eastern Kentucky, the on-time start-up of the $11 million new Moss 3 preparation plant in September and success of the highwall mining systems utilized at the Heartland surface mine in West Virginia. Excluding the 1991 restructuring charges, operating results for the Coal segment increased $5.8 million in 1992 compared with 1991. Operating results in 1991 included gains of $5.8 million from the disposal of excess coal reserves. There were no comparable disposals in 1992. Operating profit in 1992 benefitted from a 2.9 million (16%) increase in tonnage sold largely due to shipments to utilities under coal sales contracts acquired in March 1992 and under a contract being supplied by the Company's Heartland mine which began operations in the fourth quarter of 1991. Average margin per ton improved nearly 2% in 1992 compared with 1991, due to a 3% or $.85 per ton decrease in average current production costs of coal sold per ton only partially offset by lower per ton realization. The decrease in average current production costs of coal sold per ton reflects the increase in tonnage sold, increased productivity and a change in production mix. In 1992, 65% of total production was derived from deep mines, and 35% of production was derived from surface mines compared with 76% and 24% of deep and surface mine production respectively, in 1991. Operating profit in 1992 also benefitted from a $2.4 million reduction in federal and state black lung expenses due to favorable claims experience. In October 1992, the Coal Industry Retiree Health Benefit Act of 1992 (the "Health Benefit Act") was enacted as part of the Energy Policy Act of 1992. The Health Benefit Act established new rules for the payment of future health care benefits for thousands of retired union mine workers and their dependents. Part of the burden for these payments has been shifted by the Health Benefit Act from certain coal producers, which had a contractual obligation to fund such payments, to producers such as the Company which have collective bargaining agreements with the UMWA that do not require such payments and to numerous other companies which are no longer in the coal business. The Health Benefit Act established a trust fund to which "signatory operators" and "related persons," including the Company and certain of its coal subsidiaries (the "Pittston Companies") would be obligated to pay annual premiums for assigned beneficiaries, together with a pro rata share for certain beneficiaries who never worked for such employers ("unassigned beneficiaries"), in amounts to be determined by the Secretary of Health and Human Services on the basis set forth in the Health Benefit Act. In October 1993, the Pittston Companies received notices from the Social Security Administration (the "SSA") with regard to their assigned beneficiaries for which they are responsible under the Health Benefit Act; the Pittston Companies also received a calculation of their liability for the first two years. For 1993 and 1994, this liability (on a pretax basis) is approximately $9.1 million and $11.0 million, respectively. The Company believes that the annual liability under the Health Benefit Act for the Pittston Companies' assigned beneficiaries will continue in the $10 to $11 million range for the next ten years and should begin to decline thereafter as the number of such assigned beneficiaries decreases. Based on the number of beneficiaries actually assigned by the SSA, the Company estimates the aggregate pretax liability relating to the Pittston Companies' assigned beneficiaries at approximately $265-$275 million, which when discounted at 8% provides a present value estimate of approximately $100-$110 million. The ultimate obligation that will be incurred by the Company could be significantly affected by, among other things, increased medical costs, decreased number of beneficiaries, governmental funding arrangements and such federal health benefit legislation of general application as may be enacted. In addition, the Health Benefit Act requires the Pittston Companies to fund, pro rata according to the total number of assigned beneficiaries, a portion of the health benefits for unassigned beneficiaries. At this time, the funding for such health benefits is being provided from another source and for this and other reasons the Pittston Companies' ultimate obligation for the unassigned beneficiaries cannot be determined. The Company accounts for its obligations under the Health Benefit Act as a participant in a multi-employer plan and recognizes the annual cost on a pay-as-you-go basis. In February 1990, the Pittston Coal Group companies and the UMWA entered into a successor collective bargaining agreement that resolved a labor dispute and related strike of Pittston Coal Group operations by UMWA-represented employees that began on April 5, 1989. As part of the agreement, the Pittston Coal Group companies agreed to make a $10 million lump sum payment to the 1950 Benefit Trust Fund and to renew participation in the 1974 Pension and Benefit Trust Funds at specified contribution rates. These aspects of the agreement were subject to formal approval by the trustees of the funds. The trustees did not accept the terms of the agreement and, therefore, payments are being made to escrow accounts for the benefit of union employees. In 1988, the trustees of certain pension and benefit funds established under collective bargaining agreements with the UMWA brought an action (the so-called "Evergreen Case") against the Company and a number of its coal subsidiaries in the United States District Court for the District of Columbia, claiming that the defendants are obligated to contribute to such trust funds in accordance with the provisions of the 1988 National Bituminous Coal Wage Agreement, to which neither the Company nor any of its subsidiaries is a signatory. In January 1992, the Court issued an order granting summary judgment in favor of the trustees on the issue of liability, which was thereafter affirmed by the Court of Appeals. In June 1993 the United States Supreme Court denied a petition for a writ of certiorari. The case has been remanded to District Court, and damage and other issues remain to be decided. In September 1993, the Company filed a motion seeking relief from the District Court's grant of summary judgment based on, among other things, the Company's allegation that plaintiffs improperly withheld evidence that directly refutes plaintiffs' representations to the District Court and the Court of Appeals in this case. In December 1993, that motion was denied. In furtherance of its ongoing effort to identify other available legal options for seeking relief from what it believes to be an erroneous finding of liability in the Evergreen Case, the Company has filed suit against the Bituminous Coal Operators Association and others to hold them responsible for any damages sustained by the Company as a result of the Evergreen Case. Although the Company is continuing that effort, the Company, following the District Court's ruling in December 1993, recognized the potential liability that may result from an adverse judgment in the Evergreen Case. In any event, any final judgment in the Evergreen Case will be subject to appeal. As a result of the Health Benefit Act, there is no continuing liability in this case in respect of health benefit funding after February 1, 1993. MINERAL VENTURES Mineral Ventures was formed in 1989 to develop opportunities in minerals other than coal. Mineral Ventures operations reported an operating loss of $8.3 million for 1993. This loss includes a $7.9 million charge related to the write-down of the Minerals Group's investment in the Uley graphite mine in Australia. Although reserve drilling of the Uley property indicates substantial graphite deposits, processing difficulties, depressed graphite prices which have remained significantly below the level prevailing at the start of the project and an analysis of various technical and marketing conditions affecting the project resulted in the determination that the assets have been impaired and that loss recognition was appropriate. Excluding the $7.9 million charge, Mineral Ventures operations incurred a $.4 million operating loss. Operating results for 1993 reflected production from the Stawell gold mine. In December 1992, Mineral Ventures acquired its ownership in the Stawell property through its participation in a joint venture with Mining Project Investors Pty Ltd., (in which Mineral Ventures holds a 34% interest). The Stawell gold mine, which is in western Victoria, Australia, currently has proved reserves for approximately four years of production and a current annual output of approximately 70,000 ounces. The joint venture also has exploration rights in the highly prospective district around the mine. Mineral Ventures has a 67% net equity interest in the Stawell mine and its adjacent exploration acreage. In 1993, the Stawell mine produced 73,765 ounces of gold with Mineral Ventures' share of the operating profit amounting to $4.9 million. The contribution to operating profit from the Stawell mine was offset by administrative overhead in addition to exploration expenditures related chiefly to other potential gold mining projects. Operating losses, which primarily related to expenses for project review and exploration, totalled $3.4 million in 1992 and $3.5 million in 1991. CORPORATE EXPENSES A portion of the Company's corporate general and administrative expenses and other shared services has been allocated to the Minerals Group based upon utilization and other methods and criteria which management believes to be equitable and a reasonable estimate of such expenses as if the Minerals Group operated on a stand alone basis. These allocations were $7.2 million, $8.6 million and $8.1 million in 1993, 1992 and 1991, respectively. OTHER OPERATING INCOME Other operating income for the Minerals Group primarily consists of royalty income from coal and natural gas properties and gains and losses attributable to sales of property and equipment. Other operating income increased $1.5 million to $10.3 million in 1993 from $8.8 million in 1992 and decreased $10.6 million in 1992 from $19.4 million in 1991. In 1991, other operating income included gains aggregating $5.8 million from the disposal of certain excess coal reserves. There were no comparable disposals in 1993 or 1992. OTHER INCOME (LOSS), NET Other income (loss), net was a net loss of $.5 million in 1993 and net income in 1992 and 1991 of $1.9 million and $11.1 million, respectively. The net amounts in 1992 and 1991 included gains of $2.3 million and $11.1 million, respectively, from the sales of investments in leveraged leases. INTEREST EXPENSE Interest expense in 1993 decreased $2.2 million from $3.5 million in 1992 and increased $1.5 million in 1992 from $2.0 million in 1991. The decrease in 1993 was attributable to lower outstanding debt during the year, partially offset by interest assessed in 1993 on settlement of coal litigation related to the moisture content of tonnage used to compute royalty payments to UMWA pension and benefit funds. Interest expense in 1993, 1992 and 1991 included a portion of the Company's interest expense related to borrowings from the Company's revolving credit lines which was attributed to the Minerals Group. The amount of interest expense attributed to the Minerals Group for 1993, 1992 and 1991 was $.4 million, $2.8 million and $1.4 million, respectively. TAXES AND EXTRAORDINARY CREDITS In 1993, the credit for income taxes is higher than the amount that would have been recognized using the statutory federal income tax rate of 35% due to the tax benefits of percentage depletion, favorable adjustments to deferred tax assets as a result of the increase in the statutory U.S. federal income tax rate and a reduction in the valuation allowance for deferred tax assets primarily in foreign jurisdictions. In 1992, the provision for income taxes was less than the statutory federal income tax rate of 34% and in 1991 the credit for income taxes was higher than the amount that would have been recognized using the federal statutory income tax rate of 34% because of the tax benefit from percentage depletion. The Minerals Group's net deferred federal tax assets are based upon their expected utilization in the Company's consolidated federal income tax return and the benefit that would accrue to the Minerals Group under the Company's tax allocation policy. FINANCIAL CONDITION A portion of the Company's corporate assets and liabilities has been attributed to the Minerals Group based upon utilization of the shared services from which assets and liabilities are generated, which management believes to be equitable and a reasonable estimate of the assets and liabilities which would be generated if the Minerals Group operated on a stand alone basis. Corporate assets which were allocated to the Minerals Group consisted primarily of pension assets and deferred income taxes and amounted to $90.1 million and $54.3 million at December 31, 1993 and 1992, respectively. CASH FLOW PROVIDED BY OPERATING ACTIVITIES Cash provided by operations totalled $28.4 million in 1993, a $17.0 million decrease compared with $45.4 million generated by operations in 1992. The net decrease in 1993 compared with 1992 consisted of a $54.8 million decrease attributable to the change in net income and a $19.9 million decrease attributable to a change in net noncash charges and credits, partially offset by a $57.7 million decrease attributable to changes in operating assets and liabilities. Net income, noncash charges and changes in operating assets and liabilities in 1993 were significantly affected by after-tax restructuring and other charges for Minerals Group of $48.9 million which had no effect in 1993 on cash generated by operations. Of the total amount of the 1993 charges, $10.8 million was for noncash write-downs of assets and the remainder represents liabilities, of which $7.0 million are expected to be paid in 1994. The Minerals Group intends to fund any cash requirements during 1994 with anticipated cash flows from operations, with shortfalls, if any, financed through borrowings under the Company's revolving credit agreements or short-term borrowing arrangements or borrowings from the Services Group. Cash required to support the Minerals Group's investing activities was less than cash generated from operations and, as a result, after financing its stock activities, the Minerals Group made an additional cash loan to the Services Group of $13.3 million during 1993. CAPITAL EXPENDITURES Cash capital expenditures totalled $21.7 million for the 1993. An additional $45.5 million was financed in 1993 through operating leases which were predominately for surface mining equipment. Approximately 96% of the gross capital expenditures in 1993 were incurred in the Coal segment. Of that amount, greater than 40% of the expenditures was for business expansion, and the remainder was for replacement and maintenance of current ongoing business operations. Gross expenditures made by Mineral Ventures operations approximated 4% of the Minerals Group's total capital expenditures and were primarily costs incurred for project development. Cash capital expenditures for 1993 were funded by cash flow from operating activities, with any shortfalls financed through the Company by borrowings under its revolving credit agreements or short-term borrowing arrangements, which were thereby attributed to the Minerals Group. OTHER INVESTING ACTIVITIES All other investing activities in 1993 provided net cash of $12.0 million, which was largely attributable to proceeds from the sale of the assets of a coal subsidiary. Cash, net of any expenses related to the transaction, totaled $9.7 million. In January 1994, the Minerals Group paid $157 million in cash for the acquisition of substantially all the coal mining operations and coal sales contracts of Addington Resources, Inc. (the "Addington Acquisition"). The purchase price of the acquisition was financed through the issuance of $80.5 million of a new series of convertible preferred stock, which is convertible into Minerals Stock, and additional debt under existing revolving credit facilities. FINANCING Gross capital expenditures in 1994 are not currently expected to increase significantly over 1993 levels. The Minerals Group intends to fund such expenditures through cash flow from operating activities or through operating leases if the latter are financially attractive. Any shortfalls will be financed through the Company's revolving credit agreements or short-term borrowing arrangements. As of December 31, 1993, revolving credit agreements provided for commitments of up to $250.0 million. At December 31, 1993, no portion of the borrowings outstanding under those agreements, which amounted to $2.1 million, was attributed to the Minerals Group, as cash generated from operations was sufficient for Minerals' investing and financing activities. In March 1994, the Company entered into a $350.0 million revolving credit agreement with a syndicate of banks (the "New Facility"), replacing the Company's previously existing $250.0 million of revolving credit agreements. The New Facility includes a $100.0 million five-year term loan, which matures in March 1999. The New Facility also permits additional borrowings, repayments and reborrowings of up to an aggregate of $250.0 million until March 1999. DEBT Total debt outstanding for the Minerals Group amounted to $.3 million. At December 31, 1993, none of the Company's long-term debt was attributed to the Minerals Group. Subsequent to December 31, 1993, the Addington Acquisition was financed in part with debt under the Company's revolving credit facilities, which was attributed to the Minerals Group. In March 1994, the additional debt incurred for this acquisition was refinanced with a five-year term loan under the New Facility. CONTINGENT LIABILITIES In April 1990, the Company entered into a settlement agreement to resolve certain environmental claims against the Company arising from hydrocarbon contamination at a petroleum terminal facility ("Tankport") in Jersey City, New Jersey, which operations were sold in 1983. Under the settlement agreement, the Company is obligated to pay 80% of the remediation costs. Based on data available to the Company and its environmental consultants, the Company estimates its portion of the cleanup costs on an undiscounted basis using existing technologies to be between $4.5 million and $13.5 million over a period of three to five years. Management is unable to determine that any amount within that range is a better estimate due to a variety of uncertainties, which include the extent of the contamination at the site, the permitted technologies for remediation and the regulatory standards by which the cleanup will be measured by the New Jersey Department of Environmental Protection and Energy. The Company commenced insurance coverage litigation in 1990, in the United States District Court for the District of New Jersey, seeking a declaratory judgment that all amounts payable by the Company pursuant to the Tankport obligation were reimbursable under comprehensive general liability and pollution liability policies maintained by the Company. Although the underwriters have disputed this claim, management and its legal counsel believe that recovery is probable of realization in the full amount of the claim. This conclusion is based upon, among other things, the nature of the pollution policies which were broadly designed to cover such contingent liabilities, the favorable state of the law in the State of New Jersey (whose laws have been found to control the interpretation of the policies), and numerous other factual considerations which support the Company's analysis of the insurance contracts and rebut many of the underwriters' defenses. Accordingly, since management and its legal counsel believe that recovery is probable of realization in the full amount of the claim, there is no net liability in regard to the Tankport obligation. CAPITALIZATION On July 26, 1993, the Company's shareholders approved the Services Stock Proposal, as described in the Company's proxy statement dated June 24, 1993, which resulted in the reclassification of the Company's common stock. The outstanding shares of common stock of the Company were redesignated as Pittston Services Group Common Stock ("Services Stock") on a share-for-share basis and a second class of common stock, designated as Minerals Stock, was distributed on the basis of one-fifth of one share of Minerals Stock for each share of the Company's previous common stock held by shareholders of record on July 26, 1993. Minerals Stock and Services Stock are designed to provide shareholders with separate securities reflecting the performance of the Minerals Group and the Services Group, respectively, without diminishing the benefits of remaining a single corporation or precluding future transactions affecting either Group. The redesignation of the Company's common stock as Services Stock and the distribution of Minerals Stock as a result of the approval of the Services Stock Proposal did not result in any transfer of assets and liabilities of the Company or any of its subsidiaries. Holders of Services Stock and Minerals Stock are shareholders of the Company, which continues to be responsible for all its liabilities. Therefore, financial developments affecting the Minerals Group or the Services Group that affect the Company's financial condition could affect the results of operations and financial condition of both Groups. The change in the capital structure of the Company had no effect on the Company's total capital, except as to expenses incurred in the execution of the Services Stock Proposal. Since the creation of Minerals Stock upon approval of the Services Stock Proposal, capitalization of the Minerals Group has been affected by all share activity related to Minerals Stock. In July 1993, the Board authorized a new share repurchase program under which up to 1,250,000 shares of Services Stock and 250,000 shares of Minerals Stock may be repurchased. This program replaced the previous program under which 1,500,000 shares of common stock of the Company remained authorized for repurchase. During 1993 under the previous program 75,000 shares of the Company's common stock were repurchased at a total cost of $1.1 million. Under the new share repurchase program through December 31, 1993, 19,000 shares of Minerals Stock were repurchased at a total cost of $.4 million. In January 1994, the Company issued $80.5 million of a new series of convertible preferred stock, which is convertible into Minerals Stock, to finance a portion of the Addington Acquisition. DIVIDENDS The Board intends to declare and pay dividends on Minerals Stock based on the earnings, financial condition, cash flow and business requirements of the Minerals Group. Since the Company remains subject to Virginia law limitations on dividends and to dividend restrictions in its public debt and bank credit agreements, losses incurred by the Services Group could affect the Company's ability to pay dividends in respect of stock relating to the Minerals Group. Dividends on Minerals Stock are also limited by the Available Minerals Dividend Amount as defined in the Company's Articles of Incorporation. At December 31, 1993, the Available Minerals Dividend Amount was at least $10.1 million. After giving effect to the issuance of the convertible preferred stock, the pro forma Available Minerals Dividend Amount would have been at least $85.6 million. On an equivalent basis, in 1993 the Company paid dividends on 62.04 cents per share of Minerals Stock compared with 49.24 cents per share of Minerals Stock in 1992. In January 1994, 161,000 shares of convertible preferred stock (convertible into Minerals Stock) were issued to finance a portion of the Addington Acquisition. Commencing March 1, 1994, annual cumulative dividends of $31.25 per share of convertible preferred stock are payable quarterly, in cash, in arrears from the date of original issue out of all funds of the Company legally available therefor, when, as and if declared by the Board. Such stock bears a liquidation preference of $500 per share, plus an amount equal to accrued and unpaid dividends thereon. PENDING ACCOUNTING CHANGES The Minerals Group is required to implement a new accounting standard for postemployment benefits - SFAS No. 112 - in 1994. SFAS No. 112 requires employers who provide benefits to former employees after employment but before retirement to accrue such costs as the benefits accumulate or vest. The Minerals Group has determined the effect of adopting SFAS No. 112 is immaterial. The Minerals Group is required to implement a new accounting standard for investments in debt and equity securities - SFAS No. 115 - in 1994. SFAS No. 115 requires classification of debt and equity securities and recognition of changes in the fair value of the securities based on the purpose for which the securities are held. The Minerals Group does not have investments in debt or equity securities and therefore the provisions of SFAS No. 115 do not apply. Item 8:

Item 8: Financial Statements and Supplementary Data THE PITTSTON COMPANY AND SUBSIDIARIES STATEMENT OF MANAGEMENT RESPONSIBILITY The management of The Pittston Company (the "Company") is responsible for preparing the accompanying consolidated financial statements and for their integrity and objectivity. The statements were prepared in accordance with generally accepted accounting principles. Management has also prepared the other information in the annual report and is responsible for its accuracy. In meeting our responsibility for the integrity of the consolidated financial statements, we maintain a system of internal controls designed to provide reasonable assurance that assets are safeguarded, that transactions are executed in accordance with management's authorization and that the accounting records provide a reliable basis for the preparation of the financial statements. Qualified personnel throughout the organization maintain and monitor these internal controls on an ongoing basis. In addition, the Company maintains an internal audit department that systematically reviews and reports on the adequacy and effectiveness of the controls, with management follow-up as appropriate. Management has also established a formal Business Code of Ethics which is distributed throughout the Company. We acknowledge our responsibility to establish and preserve an environment in which all employees properly understand the fundamental importance of high ethical standards in the conduct of our business. The Company's consolidated financial statements have been audited by KPMG Peat Marwick, independent auditors. During the audit they review and make appropriate tests of accounting records and internal controls to the extent they consider necessary to express an opinion on the Company's consolidated financial statements. The Company's Board of Directors pursues its oversight role with respect to the Company's consolidated financial statements through the Audit and Ethics Committee, which is composed solely of outside directors. The Committee meets periodically with the independent auditors, internal auditors and management to review the Company's control system and to ensure compliance with applicable laws and the Company's Business Code of Ethics. We believe that the policies and procedures described above are appropriate and effective and do enable us to meet our responsibility for the integrity of the Company's consolidated financial statements. INDEPENDENT AUDITORS' REPORT THE BOARD OF DIRECTORS AND SHAREHOLDERS THE PITTSTON COMPANY We have audited the accompanying consolidated balance sheets of The Pittston Company and subsidiaries as of December 31, 1993 and 1992 and the related consolidated statements of operations, shareholders' equity and cash flows for each of the years in the three-year period ended December 31, 1993. These consolidated financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the consolidated financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the consolidated financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of The Pittston Company and subsidiaries as of December 31, 1993 and 1992, and the results of their operations and their cash flows for each of the years in the three-year period ended December 31, 1993, in conformity with generally accepted accounting principles. As discussed in Notes 4 and 16 to the consolidated financial statements, the Company changed its method of accounting for capitalizing subscriber installation costs in 1992. As discussed in Notes 6, 13 and 16 to the consolidated financial statements, the Company changed its methods of accounting for income taxes and accounting for postretirement benefits other than pensions in 1991. /s/ KPMG PEAT MARWICK KPMG Peat Marwick Stamford, Connecticut January 24, 1994 THE PITTSTON COMPANY AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS December 31, 1993 and 1992 See accompanying notes to consolidated financial statements. THE PITTSTON COMPANY AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF OPERATIONS Years Ended December 31, 1993, 1992 and 1991 (In thousands, except per share amounts) See accompanying notes to consolidated financial statements. THE PITTSTON COMPANY AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY Years Ended December 31, 1993, 1992 and 1991 (In thousands, except share amounts) See accompanying notes to consolidated financial statements. THE PITTSTON COMPANY AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS Years Ended December 31, 1993, 1992 and 1991 (In thousands) See accompanying notes to consolidated financial statements. THE PITTSTON COMPANY AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES BASIS OF PRESENTATION: On July 26, 1993, the shareholders of The Pittston Company (the "Company") approved the Services Stock Proposal, as described in Note 9, resulting in the reclassification of the Company's common stock into shares of Pittston Services Group Common Stock ("Services Stock") on a share-for-share basis. In addition, a second class of common stock, designated as Pittston Minerals Group Common Stock ("Minerals Stock") was distributed on a basis of one-fifth of one share of Minerals Stock for each share of the Company's previous common stock. The Pittston Services Group (the "Services Group") consists of the Burlington Air Express Inc. ("Burlington"), Brink's, Incorporated ("Brink's") and Brink's Home Security, Inc. ("BHS") operations of the Company. The Pittston Minerals Group (the "Minerals Group") consists of the Coal and Mineral Ventures operations of the Company. The approval of the Services Stock Proposal did not result in any transfer of assets and liabilities of the Company or any of its subsidiaries. The Company prepares separate financial statements for the Minerals and Services Groups in addition to consolidated financial information of the Company. Due to the reclassification of the Company's common stock, all stock and per share data in the accompanying financial statements for 1992 and 1991 have been restated from amounts previously reported. The primary impacts of this restatement are as follows: o Net income per common share has been restated in the Consolidated Statements of Operations to reflect the two classes of stock, Services Stock and Minerals Stock, as if they were outstanding for all periods presented. For the purposes of computing net income per common share of Services Stock and Minerals Stock, the number of shares of Services Stock are assumed to be the same as the total corresponding number of shares of the Company's common stock. The number of shares of Minerals Stock are assumed to be one-fifth of the shares of the Company's common stock. o All financial impacts of purchases and issuances of the Company's common stock prior to the effective date of the Services Stock Proposal have been attributed to each Group in relation of their respective common equity to the Company's common stock. Dividends paid by the Company were attributed to the Services and Minerals Groups in relation to the initial dividends paid on the Services Stock and the Minerals Stock. Accordingly, the Consolidated Statements of Shareholders' Equity have been restated to reflect these changes. For 1993, all stock activity (including dividends) prior to the Services Stock Proposal has been attributed to the Services Group and the Minerals Group based on the methods described above. PRINCIPLES OF CONSOLIDATION: The accompanying consolidated financial statements reflect the accounts of the Company and its majority-owned subsidiaries. The Company's interests in 20% to 50% owned companies are carried on the equity method. Undistributed earnings of such companies included in consolidated retained earnings approximated $39,104,000 at December 31, 1993. All material intercompany items and transactions have been eliminated in consolidation. Certain prior year amounts have been reclassified to conform to the current year's financial statement presentation. CASH AND CASH EQUIVALENTS: Cash and cash equivalents include cash on hand, demand deposits and investments with original maturities of three months or less. SHORT-TERM INVESTMENTS: Short-term investments primarily include funds set aside by management for certain obligations and are carried at cost which approximates market. INVENTORIES: Inventories are stated at cost (determined under the first-in, first-out or average cost method) or market, whichever is lower. PROPERTY, PLANT AND EQUIPMENT: Expenditures for maintenance and repairs are charged to expense and the costs of renewals and betterments are capitalized. Depreciation is provided principally on the straight-line method at varying rates depending upon estimated useful lives. Depletion of bituminous coal lands is provided on the basis of tonnage mined in relation to the estimated total of recoverable tonnage in the ground. Mine development costs, primarily included in bituminous coal lands, are capitalized and amortized over the estimated useful life of the mine. These costs include expenses incurred for site preparation and development as well as operating deficits incurred at the mines during the development stage. A mine is considered under development until all planned production units have been placed in operation. Subscriber installation costs for home security systems provided by BHS are capitalized and amortized over the estimated life of the assets and are included in machinery and equipment. The basic equipment that is installed, remains the property of BHS and is capitalized at cost. Other capitalized costs, which arise solely as a direct result of the installation process and bring the revenue producing asset to its intended use, include costs of setting up customers on the monitoring network, labor costs and costs incurred for installation scheduling and testing. When a customer is identified for disconnect, the remaining net book value of the basic equipment is fully depreciated. INTANGIBLES: The excess of cost over fair value of net assets of companies acquired is amortized on a straight-line basis over the estimated periods benefitted. INCOME TAXES: In 1991, the Company adopted Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes" ("SFAS 109"), which requires recognition of deferred tax liabilities and assets for the expected future tax consequences of events that have been included in the financial statements or tax returns. Under this method, deferred tax liabilities and assets are determined based on the difference between the financial statement and tax bases of assets and liabilities using enacted tax rates in effect for the year in which the differences are expected to reverse. PNEUMOCONIOSIS (BLACK LUNG) EXPENSE: The Company acts as self-insurer with respect to black lung benefits. Provision is made for estimated benefits in accordance with annual actuarial reports prepared by outside actuaries. The excess of the present value of expected future benefits over the accumulated book reserves is recognized over the amortization period as a level percentage of payroll. Cumulative actuarial gains or losses are calculated periodically and amortized on a straight-line basis. Assumptions used in the calculation of the actuarial present value of black lung benefits are based on actual retirement experience of the Company's coal employees, black lung claims incidence for active miners, actual dependent information, industry turnover rates, actual medical and legal cost experience and current inflation rates. As of December 31, 1993 and 1992, the accrued value of estimated future black lung benefits discounted at 6% was approximately $61,067,000 and $61,095,000, respectively, and are included in workers' compensation and other claims. Based on acruarial data, the Company charged to earnings $438,000 in 1993, $1,029,000 in 1992 and $3,113,000 in 1991. In addition, the Company accrued additional expenses for black lung benefits related to federal and state assessments, legal and administration expenses and other self insurance costs. These amounted to $2,887,000 in 1993, $2,073,000 in 1992 and $2,435,000 in 1991. POSTRETIREMENT BENEFITS OTHER THAN PENSIONS: In 1991, the Company adopted Statement of Financial Accounting Standards No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions" ("SFAS 106"), which requires employers to accrue the cost of such retirement benefits during the employees' service with the Company. FOREIGN CURRENCY TRANSLATION: Assets and liabilities of foreign subsidiaries have been translated at current exchange rates, and related revenues and expenses have been translated at average rates of exchange in effect during the year. Resulting cumulative translation adjustments have been recorded as a separate component of shareholders' equity. Translation adjustments relating to subsidiaries in countries with highly inflationary economies are included in net income, along with all transaction gains and losses for the period. A portion of the Company's financial results is derived from activities in several foreign countries, each with a local currency other than the U.S. dollar. Because the financial results of the Company are reported in U.S. dollars, they are affected by the changes in the value of the various foreign currencies in relation to the U.S. dollar. However, the Company's international activity is not concentrated in any single currency, which limits the risks of foreign currency rate fluctuations. FINANCIAL INSTRUMENTS: The Company uses foreign currency forward contracts to hedge risk of changes in foreign currency rates associated with certain transactions denominated in various currencies. Realized and unrealized gains and losses on these contracts, designated and effective as hedges, are deferred and recognized as part of the specific transaction hedged. The Company also utilizes other financial instruments to protect against adverse price movements in gold, which the Company produces, and crude oil and its derivative products, which the Company consumes. Gains and losses on these contracts, designated and effective as hedges, are deferred and recognized as part of the transaction hedged. The Company is required to adopt Statement of Financial Accounting Standards No. 115, "Accounting for Certain Investments in Debt and Equity Securities" ("SFAS 115"), in 1994. SFAS 115 requires classification of debt and equity securities and recognition of changes in the fair value of the securities based on the purpose for which the securities are held. The Company has determined that the cumulative effect of adopting SFAS 115 is immaterial. REVENUE RECOGNITION: Coal - Coal sales are generally recognized when coal is loaded onto transportation vehicles before shipment to customers. For domestic sales, this occurs when coal is loaded onto railcars at mine locations. For export sales, this occurs when coal is loaded onto marine vessels at terminal facilities. Mineral Ventures - Gold sales are recognized when products are shipped to a refinery. Settlement adjustments arising from final determination of weights and assays are reflected in sales when received. Burlington - Revenues related to transportation services are recognized, together with related transportation costs, on the date shipments physically depart from facilities en route to destination locations. Brink's - Revenues from contract carrier armored car, automatic teller machine, air courier, coin wrapping, and currency and deposit processing services are recognized when services are performed. BHS - Monitoring revenues are recognized when earned and amounts paid in advance are deferred and recognized as income over the applicable monitoring period, which is generally one year or less. Revenues from the sale of equipment, excluding equipment which is part of the standard package security system, are recognized, together with related costs, upon completion of the installation. Connection fee revenues are recognized to the extent of direct selling costs incurred and expensed. Connection fee revenues in excess of direct selling costs are deferred and recognized as income on a straight-line basis over ten years. NET INCOME PER COMMON SHARE: Net income per common share for Services Stock and Minerals Stock is computed by dividing the net income for each Group by the weighted average number of shares outstanding during the period. The potential dilution from the exercise of stock options is not material. The assumed conversion of the 9.20% convertible subordinated debentures is not included since its effect is antidilutive. The shares of Services Stock and Minerals Stock held in The Pittston Company Employee Benefits Trust (Note 9) are evaluated for inclusion in the calculation of net income per share under the treasury stock method and have no dilutive effect. 2. FINANCIAL INSTRUMENTS Financial instruments which potentially subject the Company to concentrations of credit risk consist principally of cash and cash equivalents and short-term investments and trade receivables. The Company places its cash and cash equivalents and short-term investments with high credit qualified financial institutions and, by policy, limits the amount of credit exposure to any one financial institution. Concentrations of credit risk with respect to trade receivables are limited due to the large number of customers comprising the Company's customer base, and their dispersion across many different industries and geographic areas. The following details the fair values of financial instruments for which it is practicable to estimate the value: CASH AND CASH EQUIVALENTS AND SHORT-TERM INVESTMENTS The carrying amounts approximate fair value because of the short maturity of these instruments. DEBT The aggregate fair value of the Company's long-term debt obligations, which is based upon quoted market prices and rates currently available to the Company for debt with similar terms and maturities, approximates the carrying amount. OFF-BALANCE SHEET INSTRUMENTS The Company enters into various off-balance sheet financial instruments, as discussed below, to hedge its foreign currency and other market exposures. Accordingly, the fair value of these instruments have been considered in determining the fair values of the assets and liabilities being hedged. The risk that counterparties to such instruments may be unable to perform is minimized by limiting the counterparties to major international banks. The Company does not expect any losses due to such counterparty default. Foreign currency forward contracts - The Company enters into foreign currency forward contracts with a duration of 30 to 45 days as a hedge against accounts payable denominated in various currencies. These contracts do not subject the Company to risk due to exchange rate movements because gains and losses on these contracts offset losses and gains on the payables being hedged. At December 31, 1993, the total contract value of foreign currency forward contracts outstanding was $4,600,000. As of such date, the carrying amounts of the foreign currency forward contracts approximate fair value. Forward sales contracts - In order to protect itself against downward movements in gold prices, the Company hedges a portion of its recoverable proved and probable reserves primarily through forward sales contracts. At December 31, 1993, 72,000 ounces of gold, representing approximately 50% of the Company's recoverable proved and probable reserves, were sold forward under forward sales contracts at an average price of $350 per ounce. Because only a portion of its future production is currently sold forward, the Company can take advantage of increases, if any, in the spot price of gold. At December 31, 1993, the aggregate carrying value of the Company's forward sales contracts exceeded their fair value by approximately $2,900,000. Other contracts - The Company has hedged a significant portion of its jet fuel requirements for the period January 1, 1994 through March 31, 1995, through swap contracts which were intended to fix the Company's per gallon fuel costs below 1993 levels. At December 31, 1993, the contract value of the jet fuel swaps, aggregating 50.1 million gallons, was $25,492,000. In addition, a call option was purchased for 12.6 million gallons of crude oil for the first half of 1994. Each of these transactions are settled monthly based upon the average of the high and low prices during each period. The fair value of these fuel hedge transactions may fluctuate over the course of the contract period due to changes in the supply and demand for oil and refined products. Thus, the economic gain or loss, if any, upon settlement of the contracts may differ from the fair value of the contracts at an interim date. At December 31, 1993, the aggregate carrying value of the swap contracts and the call option exceeded their fair value by approximately $1,700,000. 3. ACCOUNTS RECEIVABLE - TRADE In 1991, the Company entered into agreements with two financial institutions whereby it had the right to sell certain coal receivables, with recourse, to those institutions. One agreement expired on June 30, 1992. The other agreement, which expires September 27, 1994, limits the maximum amount of outstanding receivables that could be owned by the financial institution to $20,000,000. The Company sold total coal receivables of approximately $16,143,000 in 1993, $23,959,000 in 1992 and $2,776,000 in 1991 under these agreements. In 1985, the Company entered into an agreement whereby it had the right to sell certain coal receivables, with limited recourse, to a financial institution from time to time until December 31, 1991. During 1992, the Company continued to sell certain coal receivables to the financial institution under essentially the same terms and conditions as the expired agreement. The Company sold total coal receivables of approximately $41,272,000 in 1992 and $10,706,000 in 1991 under this agreement, which has since been terminated. As of December 31, 1993, there were no receivables sold which remained to be collected. As of December 31, 1992, receivables sold totalling $11,987,000 remained to be collected. 4. PROPERTY, PLANT AND EQUIPMENT Capitalized mine development costs totalled $2,181,000 in 1993, $18,487,000 in 1992 and $12,167,000 in 1991. During the three years ended December 31, 1993, changes in capitalized subscriber installation costs for home security systems were as follows: As of January 1, 1992, BHS elected to capitalize categories of costs not previously capitalized for home security system installations. This change in accounting principle is preferable because it more accurately reflects subscriber installation costs. The additional costs not previously capitalized consisted of costs for installation labor and related benefits for supervisory, installation scheduling, equipment testing and other support personnel (in the amount of $2,567,000 in 1993 and $2,327,000 in 1992) and costs incurred in maintaining facilities and vehicles dedicated to the installation process (in the amount of $1,484,000 in 1993 and $1,994,000 in 1992). The effect of this change in accounting principle was to increase operating profit of the consolidated group and the BHS segment in 1993 and 1992 by $4,051,000 and $4,321,000, respectively, and net income of the Services Group by $.07 per share in each year. Prior to January 1, 1992, the records needed to identify such costs were not available. Thus, it was impossible to accurately calculate the effect on retained earnings as of January 1, 1992 or the pro forma effects of retroactive application on the year ended December 31, 1991 for the change in accounting principle. However, the Company believes the effect on retained earnings as of January 1, 1992 was immaterial. Because capitalized subscriber installation costs for prior periods were not adjusted for the change in accounting principle, installation costs for subscribers in those years will continue to be depreciated based on the lesser amounts capitalized in prior periods. Consequently, depreciation of capitalized subscriber installation costs in the current year and until such capitalized costs prior to January 1, 1992 are fully depreciated will be less than if such prior periods' capitalized costs had been adjusted for the change in accounting. However, the Company believes the effect on net income in 1993 and 1992 was immaterial. New subscriber installations for which costs were capitalized totalled 56,700 in 1993, 48,600 in 1992 and 41,000 in 1991. Additional subscribers who purchased the installed equipment and for which no costs were capitalized totalled 1,600 in 1993 and 700 in each of 1992 and 1991. In 1993 and 1992, BHS also added 1,300 and 2,000 subscribers, respectively, as a result of converting previously installed competitors' systems to BHS monitoring. The acquisition of monitoring contracts added 6,400 subscribers in 1991. The estimated useful lives for property, plant and equipment are as follows: Depreciation of property, plant and equipment aggregated $63,953,000 in 1993, $57,291,000 in 1992 and $53,059,000 in 1991. 5. INTANGIBLES Intangibles consist entirely of the excess of cost over fair value of net assets of companies acquired and are net of accumulated amortization of $65,738,000 at December 31, 1993 and $58,739,000 at December 31, 1992. The estimated useful life of intangibles is generally forty years. Amortization of intangibles aggregated $7,126,000 in 1993, $7,184,000 in 1992 and $7,021,000 in 1991. 6. INCOME TAXES The provision (credit) for income taxes consists of the following: Effective January 1, 1991, the Company adopted SFAS 109, which requires recognition of deferred tax liabilities and assets for the expected future tax consequences of events that have been included in the financial statements or tax returns. Under this method, deferred tax liabilities and assets are determined based on the difference between the financial statement and tax bases of assets and liabilities using enacted tax rates in effect for the year in which the differences are expected to reverse. As of January 1, 1991, the Company recorded a tax credit of approximately $10,061,000, of which $3,665,000 or $.10 per share was attributed to the Services Group and $6,396,000 or $.86 per share was attributed to the Minerals Group, which amount represents the net decrease to the deferred tax liability as of that date. Such amount has been reflected in the consolidated statement of operations as the cumulative effect of an accounting change. For the years ended December 31, 1993, 1992 and 1991, cash payments for income taxes, net of refunds received, were $30,237,000, $6,129,000 and $15,285,000, respectively. The significant components of the deferred tax expense (benefit) were as follows: The tax benefit for compensation expense related to the exercise of certain employee stock options for tax purposes in excess of compensation expense for financial reporting purposes is recognized as an adjustment to shareholders' equity. The components of the net deferred tax asset as of December 31, 1993 and December 31, 1992 were as follows: The valuation allowance relates to deferred tax assets in certain foreign and state jurisdictions. Based on the Company's historical and expected taxable earnings, management believes it is more likely than not that the Company will realize the benefit of the existing deferred tax asset at December 31, 1993. The following table accounts for the difference between the actual tax provision and the amounts obtained by applying the statutory U.S. federal income tax rate of 35% in 1993 and 34% in 1992 and 1991 to the income (loss) before income taxes. It is the policy of the Company to accrue deferred income taxes on temporary differences related to the financial statement carrying amounts and tax bases of investments in foreign subsidiaries and affiliates which are expected to reverse in the foreseeable future. As of December 31, 1993 and December 31, 1992 the unrecognized deferred tax liability for temporary differences of approximately $43,640,000 and $36,200,000, respectively, related to investments in foreign subsidiaries and affiliates that are essentially permanent in nature and not expected to reverse in the foreseeable future was approximately $15,274,000 and $12,308,000, respectively. The Company and its domestic subsidiaries file a consolidated U.S. federal income tax return. Such returns have been audited and settled with the Internal Revenue Service through the year 1981. As of December 31, 1993, the Company had $30,774,000 of alternative minimum tax credits available to offset future U.S. federal income taxes and, under current tax law, the carryforward period for such credits is unlimited. The tax benefit of net operating loss carryforwards as at December 31, 1993 was $8,299,000 and relate to various state and foreign taxing jurisdictions. The expiration periods primarily range from 5-15 years. 7. LONG-TERM DEBT Consists of the following: For the four years through December 31, 1998, minimum repayments of long-term debt outstanding are as follows: At December 31, 1993, the Company had separate revolving credit agreements with several banks under which it is permitted to borrow, repay and reborrow up to an aggregate of $250,000,000. Interest is payable at rates based on prime, certificate of deposit, Eurodollar, money market or Federal Funds rates. The agreements, which have various expiration dates beginning in December 1994 and continuing through December 1997, include provisions under which borrowings are converted to term loans with various repayment dates. In March 1994, the Company entered into a $350,000,000 revolving credit agreement with a syndicate of banks (the "New Facility"), replacing the Company's previously existing $250,000,000 of revolving credit agreements. The New Facility includes a $100,000,000 five-year term loan, which matures in March 1999. The New Facility also permits additional borrowings, repayments and reborrowings of up to an aggregate of $250,000,000 until March 1999. Interest on borrowings under the New Facility is payable at rates based on prime, certificate of deposit, Eurodollar or money market rates. The Dutch guilder loan to Brink's, a wholly owned indirect subsidiary of the Company, bears interest based on a Euroguilder rate, or if converted to a U.S. dollar loan, bears interest based on prime, Eurodollar or money market rates. In January 1992, a portion of the guilder loan was converted into a U.S. dollar loan. In March 1993, a pound sterling loan to Brink's was converted into a U.S. dollar term loan due 1995 to 1997. Interest was previously based on the Eurosterling rate and is currently based on the Eurodollar rate. The Canadian dollar loan to a wholly owned indirect subsidiary of the Company was paid in June 1993. Under the terms of the loans, Brink's has agreed to various restrictions relating to net worth, disposition of assets and incurrence of additional debt. The 4% subordinated debentures due July 1, 1997 are exchangeable only for cash, at the rate of $157.80 per $1,000 debentures. The debentures are redeemable at the Company's option, in whole or in part, at any time prior to maturity, at redemption prices equal to 100% of principal amount. The 9.20% convertible subordinated debentures due July 1, 2004 are convertible into shares of Services Stock and Minerals Stock at the rate of two shares of Services Stock and two-fifths of a share of Minerals Stock for each $100 principal amount, subject to adjustment pursuant to antidilution provisions. The debentures are redeemable at the Company's option, in whole or in part, at any time prior to maturity, at redemption prices which decline from 102.76% of principal amount before July 1, 1994, to 100% of principal amount after June 30, 1999. Various international subsidiaries maintain lines of credit and overdraft facilities aggregating approximately $58,000,000 with a number of banks on either a secured or unsecured basis. Under the terms of some of its debt instruments, the Company has agreed to various restrictions relating to the payment of dividends, the repurchase of capital stock, maintenance of consolidated working capital and net worth, and the amount of additional funded debt which may be incurred. Allowable restricted payments for dividends and stock repurchases aggregated $107,365,000 at December 31, 1993. At December 31, 1993, the Company had outstanding unsecured letters of credit totalling $72,274,000, primarily supporting the Company's obligations under its various self-insurance programs. Cash payments made for interest for the years ended December 31, 1993, 1992 and 1991 were $10,207,000, $11,553,000 and $15,955,000, respectively. 8. STOCK OPTIONS The Company grants options under its 1988 Stock Option Plan (the "1988 Plan") to executives and key employees and under its Non-Employee Directors' Stock Option Plan (the "Non-Employee Plan") to outside directors to purchase common stock at a price not less than 100% of quoted market value at date of grant. The 1988 Plan provides for the grant of "incentive stock options", which terminate not later than ten years from the date of grant, and "nonqualified stock options", which terminate not later than ten years and two days from the date of grant. As part of the Services Stock Proposal (Note 9), the 1988 Plan was amended to permit option grants to be made to optionees with respect to either Services Stock or Minerals Stock, or both. The Non-Employee Plan authorizes initial and automatic grants of "nonqualified stock options" which terminate on the tenth anniversary of grant. Pursuant to the Non-Employee Plan, also amended for the Services Stock Proposal, each non-employee director of the Company elected after July 26, 1993, shall receive an initial grant of an option to purchase 10,000 shares of Services Stock and an option to purchase 2,000 shares of Minerals Stock. On July 1 of each subsequent year, each non-employee director will automatically be granted an option to purchase 1,000 shares of Services Stock and an option to purchase 200 shares of Minerals Stock. The first of such automatic grants was made on August 1, 1993. The Company's 1979 Stock Option Plan (the "1979 Plan") and 1985 Stock Option Plan (the "1985 Plan") terminated in 1985 and 1988, respectively, except as to options theretofore granted. At the Effective Date, as defined in Note 9, a total of 2,228,225 shares of common stock were subject to options outstanding under the 1988 Plan, the Non-Employee Plan, the 1979 Plan and the 1985 Plan. Pursuant to antidilution provisions in the option agreements covering such options, the Company has converted these options into options for shares of Services Stock or Minerals Stock, or both, depending primarily on the employment status and responsibilities of the particular optionee. In the case of optionees having Company-wide responsibilities, each outstanding option has been converted into an option for Services Stock and an option for Minerals Stock, in the same ratio as the distribution on the Effective Date of Minerals Stock to shareholders of the Company, viz., one share to one-fifth of a share, with any resultant fractional share of Minerals Stock rounded downward to the nearest whole number of shares. In the case of other optionees, each outstanding option has been converted into a new option for only Services Stock or Minerals Stock, as the case may be, following the Effective Date. As a result, 2,167,247 shares of Services Stock and 507,698 shares of Minerals Stock were subject to options outstanding as of the Effective Date. The table below summarizes the activity in all plans. At December 31, 1993, a total of 987,605 shares of Services Stock and 240,814 shares of Minerals Stock were exercisable. In addition, there were 2,578,770 shares of Services Stock and 640,298 shares of Minerals Stock reserved for issuance under the plans, including 199,966 shares of Services Stock and 16,800 shares of Minerals Stock reserved for future grant. 9. CAPITAL STOCK On July 26, 1993 (the "Effective Date"), the shareholders of the Company approved the Services Stock Proposal, as described in the Company's proxy statement dated June 24, 1993, resulting in the reclassification of the Company's common stock. The outstanding shares of Company common stock were redesignated as Services Stock on a share-for-share basis and a second class of common stock, designated as Minerals Stock, was distributed on the basis of one-fifth of one share of Minerals Stock for each share of the Company's previous common stock held by shareholders of record on July 26, 1993. Minerals Stock and Services Stock are designed to provide shareholders with separate securities reflecting the performance of the Minerals Group and the Services Group, respectively, without diminishing the benefits of remaining a single corporation or precluding future transactions affecting either Group. The Company, at any time, has the right to exchange each outstanding share of Minerals Stock for shares of Services Stock having a fair market value equal to 115% of the fair market value of one share of Minerals Stock. In addition, upon the sale, transfer, assignment or other disposition, whether by merger, consolidation, sale or contribution of assets or stock or otherwise of all or substantially all of the properties and assets of the Minerals Group to any person, entity or group (with certain exceptions), the Company is required to exchange each outstanding share of Minerals Stock for shares of Services Stock having a fair market value equal to 115% of the fair market value of one share of Minerals Stock. Shares of Services Stock are not subject to either optional or mandatory exchange. Holders of Services Stock have one vote per share. Holders of Minerals Stock have one vote per share, subject to adjustment on January 1, 1996, and on each January 1 every two years thereafter based upon the relative fair market value of one share of Minerals Stock and one share of Services Stock on each such date. Accordingly, beginning on January 1, 1996, each share of Minerals Stock may have more than, less than or continue to have exactly one vote. Holders of Services Stock and Minerals Stock vote together as a single voting group on all matters as to which all common shareholders are entitled to vote. In addition, as prescribed by Virginia law, certain amendments to the Company's Restated Articles of Incorporation affecting, among other things, the designation, rights, preferences or limitations of one class of common stock, or any merger or statutory share exchange, must be approved by the holders of such class of common stock, voting as a separate voting group, and, in certain circumstances, may also have to be approved by the holders of the other class of common stock, voting as a separate voting group. In the event of a dissolution, liquidation or winding up of the Company, the holders of Services Stock and Minerals Stock will receive the funds remaining for distribution, if any, to the common shareholders on a per share basis in proportion to the total number of shares of Services Stock and Minerals Stock, respectively, then outstanding to the total number of shares of both classes of common stock then outstanding. Prior to the approval of the Services Stock Proposal, the Company had a share repurchase program whereby the Company could acquire up to 8.2 million shares of its common stock from time to time in the open market or in private transactions, as conditions warrant. Through July 26, 1993, the Company had acquired 6,776,000 shares under the program at an aggregate cost of $88,616,000, of which 75,000 shares were acquired during 1993 at a total cost of $1,105,000. This program was replaced with a new share repurchase program authorized by the Board of Directors in July 1993, under which up to 1,250,000 shares of Services Stock and 250,000 shares of Minerals Stock may be repurchased. Through December 31, 1993, a total of 19,000 shares of Minerals Stock were repurchased under the new program at a total cost of $407,000; no shares of Services Stock were repurchased in 1993 under the new program. The program to acquire shares in the open market remains in effect in 1994. The Company has authority to issue up to 2,000,000 shares of preferred stock, par value $10 per share. In January 1994, the Company issued 161,000 shares of its $31.25 Series C Cumulative Convertible Preferred Stock, par value $10 per share (the "Convertible Preferred Stock") (Note 20). The Convertible Preferred Stock pays an annual cumulative dividend of $31.25 per share payable quarterly, in cash, in arrears, out of all funds of the Company legally available therefor, when, as and if declared by the Board of Directors of the Company, and bears a liquidation preference of $500 per share, plus an amount equal to accrued and unpaid dividends thereon. Each share of the Convertible Preferred Stock is convertible at the option of the holder at any time after March 11, 1994, unless previously redeemed or, under certain circumstances, called for redemption, into shares of Minerals Stock at a conversion price of $32.175 per share of Minerals Stock, subject to adjustment in certain circumstances. Except under certain circumstances, the Convertible Preferred Stock is not redeemable prior to February 1, 1997. On and after such date, the Company may at its option, redeem the Convertible Preferred Stock, in whole or in part, for cash initially at a price of $521.875 per share, and thereafter at prices declining ratably annually on each February 1 to an amount equal to $500.00 per share on and after February 1, 2004, plus in each case an amount equal to accrued and unpaid dividends on the date of redemption. Except under certain circumstances or as prescribed by Virginia law, shares of the Convertible Preferred Stock are nonvoting. Other than the Convertible Preferred Stock no shares of preferred stock are presently issued or outstanding. The Company's 9.20% convertible subordinated debentures (Note 7) are convertible into 556,216 shares of Services Stock and 111,243 shares of Minerals Stock. Under a Shareholder Rights Plan adopted by the Company's Board of Directors in 1987 and amended in December 1988, rights to purchase a new Series A Participating Cumulative Preferred Stock (the "Series A Preferred Stock") of the Company were distributed as a dividend at the rate of one right for each share of the Company's common stock. Pursuant to the Services Stock Proposal, the Shareholders Rights Plan was amended and restated to reflect the change in the capital structure of the Company. Each existing right was amended to become a Pittston Services Group right (a "Services Right"). Holders of Minerals Stock received one Pittston Minerals Group right (a "Minerals Right") for each outstanding share of Minerals Stock. Each Services Right, if and when it becomes exercisable, will entitle the holder to purchase one-thousandth of a share of Series A Preferred Stock at a purchase price of $40, subject to adjustment. Each Minerals Right, if and when it becomes exercisable, will entitle the holder to purchase one-thousandth of a share of Series B Participating Cumulative Preferred Stock (the "Series B Preferred Stock") at a purchase price of $40, subject to adjustment. Each fractional share of Series A Preferred Stock and Series B Preferred Stock will be entitled to participate in dividends and to vote on an equivalent basis with one whole share of Services Stock and Minerals Stock, respectively. Each right will not be exercisable until ten days after a third party acquires 20% or more of the total voting rights of all outstanding Services Stock and Minerals Stock or ten days after commencement of a tender offer or exchange offer by a third party for 30% or more of the total voting rights of all outstanding Services Stock and Minerals Stock. If after the rights become exercisable, the Company is acquired in a merger or other business combination, each right will entitle the holder to purchase, for the purchase price, common stock of the surviving or acquiring company having a market value of twice the purchase price. In the event a third party acquires 30% or more of all outstanding Services Stock and Minerals Stock or engages in one or more "self dealing" transactions with the Company, the rights will entitle each holder to purchase, at the purchase price, that number of fractional shares of Series A Preferred Stock and Series B Preferred Stock equivalent to the number of shares of common stock which at the time of the triggering event would have a market value of twice the purchase price. The rights may be redeemed by the Company at a price of $.01 per right and expire on September 25, 1997. The Company's Articles of Incorporation limits dividends on Minerals Stock to the lesser of (i) all funds of the Company legally available therefor (as prescribed by Virginia law) and (ii) the Available Minerals Dividend Amount (as defined in the Articles of Incorporation). At December 31, 1993, the Available Minerals Dividend Amount was at least $10,054,000. After giving effect to the issuance of the Convertible Preferred Stock, the pro forma Available Minerals Dividend Amount would have been at least $85,622,000. Dividends on Minerals Stock are also restricted by covenants in the Company's public indentures and bank credit agreements (Note 7). In December 1992, the Company formed The Pittston Company Employee Benefits Trust (the "Trust") to hold shares of its common stock to fund obligations under certain employee benefit programs. Upon formation of the Trust, the Company sold for a promissory note of the Trust, four million new shares of its common stock to the Trust at a price equal to the fair value of the stock on the date of sale. Upon approval of the Services Stock Proposal, 3,871,826 shares in the Trust were redesignated as Services Stock and 774,365 shares of Minerals Stock were distributed to the Trust. At December 31, 1993, 3,853,778 shares of Services Stock and 770,301 shares of Minerals Stock remained in the Trust, valued at market. These shares will be voted by the trustee in the same proportion as those voted by the Company's employees participating in the Company's Savings Investment Plan. The fair market value of the shares are included in common stocks and capital in excess of par and, in total, as a reduction to common shareholders' equity in the Company's consolidated balance sheet. 10. ACQUISITIONS During 1993, the Company acquired one small business and made installment and contingency payments related to other acquisitions made in prior years. The total consideration paid was $1,435,000. During 1992, the Company acquired several businesses for an aggregate purchase price of $47,800,000 including debt and installment payments to be made of $2,864,000. The fair value of assets acquired was $50,858,000 and liabilities assumed was $3,058,000. In addition, the Company made cash payments of $7,624,000 in the aggregate for an equity investment and contingency payments for acquisitions made in prior years. During 1991, the Company acquired one small business and made contingency payments related to other acquisitions made in prior years. The total consideration paid was $1,914,000. All acquisitions have been accounted for as purchases. In 1993, 1992 and 1991, the purchase price was essentially equal to the fair value of assets acquired. The results of operations of the acquired companies have been included in the Company's results of operations from their date of acquisition. 11. JOINT VENTURE The Company, through a wholly owned indirect subsidiary, entered into a partnership agreement in 1982 with four other coal companies to construct and operate coal port facilities in Newport News, Virginia, in the Port of Hampton Roads (the "Facilities"). The Facilities commenced operations in 1984, and now have an annual throughput capacity of 22 million tons, with a ground storage capacity of approximately 2 million tons. The Company initially had an indirect 25% interest in the partnership, DTA. Initial financing of the Facilities was accomplished through the issuance of $135,000,000 principal amount of revenue bonds by the Peninsula Ports Authority of Virginia (the "Authority"), which is a political subdivision of the Commonwealth of Virginia. In 1987, the original revenue bonds were refinanced by the issuance of $132,800,000 of coal terminal revenue refunding bonds of which two series of these bonds in the aggregate principal amount of $33,200,000 were attributable to the Company. In 1990, the Company acquired an additional indirect 7 1/2% interest in the DTA partnership, increasing its ownership to 32 1/2%. With the increase in ownership, $9,960,000 of the remaining four additional series of the revenue refunding bonds of $99,600,000 became attributable to the Company. In November 1992, all bonds attributable to the Company were refinanced with the issuance of a new series of coal terminal revenue refunding bonds in the aggregate principal amount of $43,160,000. The new series of bonds bear a fixed interest rate of 7 3/8%. The Authority owns the Facilities and leases them to DTA for the life of the bonds, which mature on June 1, 2020. DTA may purchase the Facilities for $1 at the end of the lease term. The obligations of the partners are several, and not joint. Under loan agreements with the Authority, DTA is obligated to make payments sufficient to provide for the timely payment of the principal of and interest on the bonds of the new series. Under a throughput and handling agreement, the Company has agreed to make payments to DTA that in the aggregate will provide DTA with sufficient funds to make the payments due under the loan agreements and to pay the Company's share of the operating costs of the Facilities. The Company has also unconditionally guaranteed the payment of the principal of and premium, if any, and the interest on the new series of bonds. Payments for operating costs aggregated $7,949,000 in 1993, $6,819,000 in 1992 and $6,885,000 in 1991. The Company has the right to use 32 1/2% of the throughput and storage capacity of the Facilities subject to user rights of third parties which pay the Company a fee. The Company pays throughput and storage charges based on actual usage at per ton rates determined by DTA. 12. LEASES The Company and its subsidiaries lease aircraft, facilities, vehicles, computers and coal mining and other equipment under long-term operating leases with varying terms, and most of the leases contain renewal and/or purchase options. As of December 31, 1993, aggregate future minimum lease payments under noncancellable operating leases were as follows: The above amounts are net of aggregate future minimum noncancellable sublease rentals of $6,451,000. Included in future minimum lease payments are rentals for aircraft and the Toledo, Ohio hub operated as part of a controlled airlift project by a wholly owned direct subsidiary of the Company. The Toledo, Ohio hub lease commenced in 1991, for a twenty-two year period. Certain costs of the project are being amortized over the terms of the respective leases. The unamortized expense as of December 31, 1993 and 1992 aggregated $1,525,000 and $2,825,000, respectively. A wholly-owned subsidiary of the Company entered into two transactions covering various leases which provide for the replacement of eight B707 aircraft with seven DC8-71 aircraft and completed an evaluation of other fleet related costs. One transaction, representing four aircraft, is reflected in the 1993 financial statements, while the other transaction, covering the remaining three aircraft, was reflected in the 1992 financial statements. The net effect of these transactions did not have a material impact on operating profit for either year. Rent expense amounted to $91,439,000 in 1993, $84,365,000 in 1992 and $78,758,000 in 1991 and is net of sublease rentals of $862,000, $1,488,000 and $2,218,000, respectively. The Company incurred capital lease obligations of $1,601,000 in 1993, $2,316,000 in 1992 and $5,530,000 in 1991. As of December 31, 1993, the Company's obligations under capital leases were not significant. 13. EMPLOYEE BENEFIT PLANS The Company and its subsidiaries maintain several noncontributory defined benefit pension plans covering substantially all nonunion employees who meet certain minimum requirements. Benefits of most of the plans are based on salary and years of service. The Company's policy is to fund the actuarially determined amounts necessary to provide assets sufficient to meet the benefits to be paid to plan participants in accordance with applicable regulations. The net pension credit for 1993, 1992 and 1991 for all plans is as follows: The funded status and prepaid pension expense at December 31, 1993 and 1992 are as follows: The assumptions used in determining the net pension credit for the Company's major pension plan for 1993, 1992 and 1991 were as follows: For the valuation of pension obligations and the calculation of the funded status, the discount rate was 7.5% in 1993 and 9.0% in 1992 and 1991. The expected long-term rate of return on assets was 10% in all years presented. The rate of increase in compensation levels used was 4% in 1993 and 5% in 1992 and 1991. The unrecognized initial net asset at January 1, 1986 (January 1, 1989 for certain foreign pension plans), the date of adoption of Statement of Financial Accounting Standards No. 87, has been amortized over the estimated remaining average service life of the employees. As of December 31, 1993, approximately 71% of plan assets were invested in equity securities and 29% in fixed income securities. Under the 1990 collective bargaining agreement with the United Mine Workers of America ("UMWA"), the Company has made payments, based on hours worked, into an escrow account established for the benefit of union employees (Note 18). The Company's coal operations recognized pension expense of $1,799,000 in 1993, $2,457,000 in 1992 and $2,273,000 in 1991 under the terms of the agreement. The total amount accrued at December 31, 1993 and 1992 under these escrow agreements was $21,064,000 and $20,184,000, respectively, and is included in miscellaneous accrued liabilities. The Company and its subsidiaries also provide certain postretirement health care and life insurance benefits for eligible active and retired employees in the United States and Canada. Effective January 1, 1991, the Company adopted SFAS 106, which requires the accrual method of accounting for postretirement health care and life insurance benefits based on actuarially determined costs to be recognized over the period from the date of hire to the full eligibility date of employees who are expected to qualify for such benefits. As of January 1, 1991, the Company recognized the full amount of its estimated accumulated postretirement benefit obligation on that date, which represents the present value of the estimated future benefits payable to current retirees and a pro rata portion of estimated benefits payable to active employees after retirement. The pretax charge to 1991 earnings was $201,810,000, with a net earnings effect of $133,078,000, of which $3,354,000 or $.09 per share was attributed to the Services Group and $129,724,000 or $17.40 per share was attributed to the Minerals Group. The latter amounts have been reflected in the statement of operations as the cumulative effect of an accounting change. For the years 1993, 1992 and 1991, the components of periodic expense for these postretirement benefits were as follows: Interest costs on the accumulated postretirement benefit obligation were based upon a rate of 9% for all years presented. At December 31, 1993 and 1992, the actuarial and recorded liabilities for these postretirement benefits, none of which have been funded, were as follows: The accumulated postretirement benefit obligation was determined using the unit credit method and an assumed discount rate of 7.5% in 1993 and 9.0% in 1992. The assumed health care cost trend rate used in 1993 was 10% for pre-65 retirees, grading down to 5% in the year 2000. For post-65 retirees, the assumed trend rate in 1993 was 8%, grading down to 5% in the year 2000. The assumed medicare cost trend rate used in 1993 was 7%, grading down to 5% in the year 2000. A one percent increase each year in the health care cost trend rate used would have resulted in a $3,309,000 increase in the aggregate service and interest components of expense for the year 1993, and a $35,528,000 increase in the accumulated postretirement benefit obligation at December 31, 1993. The Company also sponsors a Savings-Investment Plan to assist eligible employees in providing for retirement or other future financial needs. Employee contributions are matched at rates of 50% to 100% up to 5% of compensation (subject to certain limitations imposed by the Internal Revenue Code of 1986, as amended). Contribution expense under the plan aggregated $5,381,000 in 1993, $5,391,000 in 1992 and $4,742,000 in 1991. In 1992, 71,000 shares were issued to the plan valued at $902,000 to fund a portion of the matching contribution. The Company sponsors several other defined contribution benefit plans based on hours worked, tons produced or other measurable factors. Contributions under all of these plans aggregated $918,000 in 1993 and 1992 and $917,000 in 1991. In October 1992, the Coal Industry Retiree Health Benefit Act of 1992 (the "Health Benefit Act") was enacted as part of the Energy Policy Act of 1992. The Health Benefit Act established new rules for the payment of future health care benefits for thousands of retired union mine workers and their dependents. Part of the burden for these payments has been shifted by the Health Benefit Act from certain coal producers, which had a contractual obligation to fund such payments, to producers such as the Company which have collective bargaining agreements with the UMWA that do not require such payments and to numerous other companies which are no longer in the coal business. The Health Benefit Act established a trust fund to which "signatory operators" and "related persons," including the Company and certain of its coal subsidiaries (the "Pittston Companies") would be obligated to pay annual premiums for assigned beneficiaries, together with a pro rata share for certain beneficiaries who never worked for such employers ("unassigned beneficiaries"), in amounts to be determined by the Secretary of Health and Human Services on the basis set forth in the Health Benefit Act. In October 1993, the Pittston Companies received notices from the Social Security Administration (the "SSA") with regard to their assigned beneficiaries for which they are responsible under the Health Benefit Act; the Pittston Companies also received a calculation of their liability for the first two years. For 1993 and 1994, this liability (on a pretax basis) is approximately $9,100,000 and $11,000,000, respectively. The Company believes that the annual liability under the Health Benefit Act for the Pittston Companies' assigned beneficiaries will continue in the $10,000,000 to $11,000,000 range for the next ten years and should begin to decline thereafter as the number of such assigned beneficiaries decreases. Based on the number of beneficiaries actually assigned by the SSA, the Company estimates the aggregate pretax liability relating to the Pittston Companies' assigned beneficiaries at approximately $265-$275 million, which when discounted at 8% provides a present value estimate of approximately $100-$110 million. The ultimate obligation that will be incurred by the Company could be significantly affected by, among other things, increased medical costs, decreased number of beneficiaries, governmental funding arrangements and such federal health benefit legislation of general application as may be enacted. In addition, the Health Benefit Act requires the Pittston Companies to fund, pro rata according to the total number of assigned beneficiaries, a portion of the health benefits for unassigned beneficiaries. At this time, the funding for such health benefits is being provided from another source and for this and other reasons the Pittston Companies' ultimate obligation for the unassigned beneficiaries cannot be determined. The Company accounts for its obligations under the Health Benefit Act as a participant in a multi-employer plan and recognizes the annual cost on a pay-as-you-go basis. The Company is required to implement a new accounting standard for postemployment benefits, Statement of Financial Accounting Standards No. 112, "Employers' Accounting for Postemployment Benefits" ("SFAS 112") in 1994. This standard requires employers who provide benefits to former employees after employment but before retirement to accrue such costs as the benefits accumulate or vest. The Company has determined that the cumulative effect of adopting SFAS 112 is immaterial. 14. RESTRUCTURING AND OTHER CHARGES Operating results include restructuring and other charges of $78,633,000 in 1993 and $115,214,000 in 1991 which have been recognized in the statements of operations. The 1993 charges relate to mine closing costs including employee benefit costs and certain other noncash charges, together with the estimated liabilities in connection with previously reported litigation (the so-called "Evergreen Case") brought against the Company and a number of its coal subsidiaries by the trustees of certain pension and benefit trust funds established under collective bargaining agreements with the UMWA (Note 18). These charges impacted Coal and Mineral Ventures operating profit in the amount of $70,713,000 and $7,920,000, respectively. The charge in the Coal segment in 1993 consists of closing costs for mines which were closed at the end of 1993 and for scheduled closures of mines in early 1994, including employee severance and other benefit costs and estimated liabilities regarding the Evergreen Case. The charge in the Mineral Ventures segment in 1993 related to the write-down of the company's investment in the Uley graphite mine in Australia. Although reserve drilling of the Uley property indicates substantial graphite deposits, processing difficulties, depressed graphite prices which have remained significantly below the level prevailing at the start of the project and an analysis of various technical and marketing conditions affecting the project resulted in the determination that the assets have been impaired and that loss recognition was appropriate. Of the total amount of 1993 charges, $10,846,000 was for noncash write-downs of assets and the remainder represents liabilities, of which $7,015,000 are expected to be paid in 1994. The Company intends to fund any cash requirements during 1994 and thereafter with anticipated cash flows from operating activities with shortfalls, if any, financed through borrowings under revolving credit agreements or short-term borrowing arrangements. The 1991 charge impacted Coal segment operations and primarily related to costs associated with coal mine shutdowns. Of the total charge, $14,415,000 was for noncash asset write-downs. 15. OTHER INCOME AND EXPENSE Other operating income includes the Company's share of net income of unconsolidated affiliated companies which are carried on the equity method. The following table presents summarized financial information of the companies accounted for by the equity method. Amounts presented include the accounts of the following equity affiliates: The following table presents summarized financial information of these companies. Other operating income also includes gains aggregating $5,846,000 in 1991 from the disposal of certain excess coal reserves, which increased the Minerals Group's net income by $.51 per share. In addition, other operating income primarily includes royalty income generated from coal and natural gas properties owned by the Company. Other income (expense), net includes gains aggregating $2,341,000 in 1992 and $11,102,000 in 1991 from the sales of investments in leveraged leases, which increased the Minerals Group's net income by $.37 per share in 1992 and $1.11 per share in 1991. 16. ACCOUNTING CHANGES As of January 1, 1992, BHS elected to capitalize categories of costs not previously capitalized for home security installations to more accurately reflect subscriber installation costs. The effect of this change in accounting principle was to increase net income in 1993 by $2,435,000 and in 1992 by $2,596,000 (Note 4). During 1991, the Company adopted two changes in accounting principles in connection with the issuance of two accounting standards by the Financial Accounting Standards Board. The effect of these changes on the statement of operations as of January 1, 1991, the date of adoption, has been recognized as the cumulative effect of accounting changes as follows: 17. SEGMENT INFORMATION Net sales and operating revenues by geographic area are as follows: Segment operating profit (loss) by geographic area is as follows: Identifiable assets by geographic area are as follows: Segment operating profit (loss) includes restructuring and other charges aggregating $78,633,000 in 1993, of which $70,713,000 is included in United States and $7,920,000 is included in other foreign, and $115,214,000 in 1991, all of which is included in United States (Note 14). Industry segment information is as follows: * Includes equity in net income of unconsolidated foreign affiliates of $6,895,000 in 1993, $8,133,000 in 1992 and $7,629,000 in 1991. ** As of January 1, 1992, BHS elected to capitalize categories of costs not previously capitalized for home security installations to more accurately reflect subscriber installation costs. The effect of this change in accounting principle was to increase operating profit in 1993 by $4,051,000 and in 1992 by $4,321,000 (Note 4). *** Operating profit (loss) of the Coal segment includes restructuring and other charges of $70,713,000 in 1993 and $115,214,000 in 1991 (Note 14). Operating loss of the Mineral Ventures segment includes restructuring and other charges of $7,920,000 in 1993 (Note 14). 18. LITIGATION In 1988, the trustees of certain pension and benefit trust funds established under collective bargaining agreements with the UMWA brought an action (the so-called "Evergreen Case") against the Company and a number of its coal subsidiaries in the United States District Court for the District of Columbia, claiming that the defendants are obligated to contribute to such trust funds in accordance with the provisions of the 1988 National Bituminous Coal Wage Agreement, to which neither the Company nor any of its subsidiaries is a signatory. In January 1992, the Court issued an order granting summary judgment in favor of the trustees on the issue of liability, which was thereafter affirmed by the Court of Appeals. In June 1993 the United States Supreme Court denied a petition for a writ of certiorari. The case has been remanded to District Court, and damage and other issues remain to be decided. In September 1993, the Company filed a motion seeking relief from the District Court's grant of summary judgment based on, among other things, the Company's allegation that plaintiffs improperly withheld evidence that directly refutes plaintiffs' representations to the District Court and the Court of Appeals in this case. In December 1993, that motion was denied. In furtherance of its ongoing effort to identify other available legal options for seeking relief from what it believes to be an erroneous finding of liability in the Evergreen Case, the Company has filed suit against the Bituminous Coal Operators Association and others to hold them responsible for any damages sustained by the Company as a result of the Evergreen Case. Although the Company is continuing that effort, the Company, following the District Court's ruling in December 1993, recognized the potential liability that may result from an adverse judgment in the Evergreen Case (Note 14). In any event, any final judgment in the Evergreen Case will be subject to appeal. As a result of the Health Benefit Act (Note 13), there is no continuing liability in this case in respect of health benefit funding after February 1, 1993. In April 1990, the Company entered into a settlement agreement to resolve certain environmental claims against the Company arising from hydrocarbon contamination at a petroleum terminal facility ("Tankport") in Jersey City, New Jersey, which operations were sold in 1983. Under the settlement agreement, the Company is obligated to pay 80% of the remediation costs. Based on data available to the Company and its environmental consultants, the Company estimates its portion of the cleanup costs on an undiscounted basis using existing technologies to be between $4.5 million and $13.5 million over a period of three to five years. Management is unable to determine that any amount within that range is a better estimate due to a variety of uncertainties, which include the extent of the contamination at the site, the permitted technologies for remediation and the regulatory standards by which the cleanup will be measured by the New Jersey Department of Environmental Protection and Energy. The Company commenced insurance coverage litigation in 1990, in the United States District Court for the District of New Jersey, seeking a declaratory judgment that all amounts payable by the Company pursuant to the Tankport obligation were reimbursable under comprehensive general liability and pollution liability policies maintained by the Company. Although the underwriters have disputed this claim, management and its legal counsel believe that recovery is probable of realization in the full amount of the claim. This conclusion is based upon, among other things, the nature of the pollution policies which were broadly designed to cover such contingent liabilities, the favorable state of the law in the State of New Jersey (whose laws have been found to control the interpretation of the policies), and numerous other factual considerations which support the Company's analysis of the insurance contracts and rebut many of the underwriters' defenses. Accordingly, since management and its legal counsel believe that recovery is probable of realization in the full amount of the claim, there is no net liability in regard to the Tankport obligation. 19. COMMITMENTS At December 31, 1993, the Company had contractual commitments to purchase coal which is primarily used to blend with Company mined coal. Based on the contract provisions these commitments are currently estimated to aggregate approximately $195,790,000 and expire from 1994 through 1998 as follows: The 1994 amount includes a commitment of $23,250,000, relating to a purchase contract with Addington Resources, Inc. ("Addington"). This contract was part of the coal mining operations of Addington acquired in 1994 (Note 20). A new commitment totalling $127,920,000 over approximately four years was entered into with the operations of Addington which were not part of the acquisition. Purchases under the contracts were $81,069,000 in 1993, $74,331,000 in 1992 and $58,155,000 in 1991. 20. SUBSEQUENT EVENT In January 1994, a wholly owned indirect subsidiary of the Company completed the acquisition of substantially all of the coal mining operations and coal sales contracts of Addington for $157 million, subject to certain purchase price adjustments. The acquisition will be accounted for as a purchase; accordingly, the purchase price has been allocated to the underlying assets and liabilities based on their respective estimated fair values at the date of acquisition. Such allocation has been based on preliminary estimates which may be revised at a later date. The excess of the purchase price over the fair value of the assets acquired and liabilities assumed was approximately $77 million. The acquisition was financed by the issuance of $80.5 million of a new series of the Company's preferred stock convertible into Minerals Stock (Note 9), and additional debt under existing credit facilities. This financing has been attributed to the Minerals Group. In March 1994, the additional debt incurred for this acquisition was refinanced with a five-year term loan under the New Facility (Note 7). The following table presents, on a pro forma basis, a condensed consolidated balance sheet of the Company at December 31, 1993, giving effect to the acquisition as if it had occurred on that date. The acquisition will be included in the Company's consolidated statements of operations beginning in 1994. The following pro forma results, however, assume that the acquisition and related financing had occurred at the beginning of 1993. The unaudited pro forma data below are not necessarily indicative of results that would have occurred if the transaction were in effect for the year ended December 31, 1993, nor are they indicative of the future results of operations of the Company. 21. SELECTED QUARTERLY FINANCIAL DATA (UNAUDITED) Tabulated below are certain data for each quarter of 1993 and 1992. Net loss in the fourth quarter of 1993 includes restructuring and other charges of $78,633,000 (Note 14). Net income in the fourth quarter of 1992 includes gains of $2,341,000 from the sale of leveraged leases (Note 15). PITTSTON SERVICES GROUP STATEMENT OF MANAGEMENT RESPONSIBILITY The management of The Pittston Company (the "Company") is responsible for preparing the accompanying financial statements and for their integrity and objectivity. The statements were prepared in accordance with generally accepted accounting principles. Management has also prepared the other information in the annual report and is responsible for its accuracy. In meeting our responsibility for the integrity of the financial statements, we maintain a system of internal controls designed to provide reasonable assurance that assets are safeguarded, that transactions are executed in accordance with management's authorization and that the accounting records provide a reliable basis for the preparation of the financial statements. Qualified personnel throughout the organization maintain and monitor these internal controls on an ongoing basis. In addition, the Company maintains an internal audit department that systematically reviews and reports on the adequacy and effectiveness of the controls, with management follow-up as appropriate. Management has also established a formal Business Code of Ethics which is distributed throughout the Company. We acknowledge our responsibility to establish and preserve an environment in which all employees properly understand the fundamental importance of high ethical standards in the conduct of our business. The accompanying financial statements have been audited by KPMG Peat Marwick, independent auditors. During the audit they review and make appropriate tests of accounting records and internal controls to the extent they consider necessary to express an opinion on the Services Group's financial statements. The Company's Board of Directors pursues its oversight role with respect to the Services Group's financial statements through the Audit and Ethics Committee, which is composed solely of outside directors. The Committee meets periodically with the independent auditors, internal auditors and management to review the Company's control system and to ensure compliance with applicable laws and the Company's Business Code of Ethics. We believe that the policies and procedures described above are appropriate and effective and do enable us to meet our responsibility for the integrity of the Services Group's financial statements. INDEPENDENT AUDITORS' REPORT THE BOARD OF DIRECTORS AND SHAREHOLDERS THE PITTSTON COMPANY We have audited the accompanying balance sheets of Pittston Services Group (as described in Note 1) as of December 31, 1993 and 1992 and the related statements of operations and cash flows for each of the years in the three-year period ended December 31, 1993. These financial statements are the responsibility of The Pittston Company's management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements of Pittston Services Group present fairly, in all material respects, the financial position of Pittston Services Group as of December 31, 1993 and 1992, and the results of its operations and its cash flows for each of the years in the three-year period ended December 31, 1993, in conformity with generally accepted accounting principles. As more fully discussed in Note 1, the financial statements of Pittston Services Group should be read in connection with the audited consolidated financial statements of The Pittston Company and subsidiaries. As discussed in Notes 4 and 14 to the financial statements, Pittston Services Group changed its method of accounting for capitalizing subscriber installation costs in 1992. As discussed in Notes 7, 12 and 14 to the financial statements, Pittston Services Group changed its methods of accounting for income taxes and accounting for postretirement benefits other than pensions in 1991. /s/ KPMG Peat Marwick KPMG Peat Marwick Stamford, Connecticut January 24, 1994 PITTSTON SERVICES GROUP BALANCE SHEETS December 31, 1993 and 1992 See accompanying notes to financial statements. PITTSTON SERVICES GROUP STATEMENTS OF OPERATIONS Years Ended December 31, 1993, 1992 and 1991 (In thousands, except per share amounts) See accompanying notes to financial statements. PITTSTON SERVICES GROUP STATEMENTS OF CASH FLOWS Years Ended December 31, 1993, 1992 and 1991 (In thousands) See accompanying notes to financial statements. PITTSTON SERVICES GROUP NOTES TO FINANCIAL STATEMENTS 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES BASIS OF PRESENTATION: The approval on July 26, 1993 (the "Effective Date"), by the shareholders of The Pittston Company (the "Company") of the Services Stock Proposal, as described in the Company's proxy statement dated June 24, 1993, resulted in the reclassification of the Company's common stock. The outstanding shares of Company common stock were redesignated as Pittston Services Group Common Stock ("Services Stock") on a share-for-share basis and a second class of common stock, designated as Pittston Minerals Group Common Stock ("Minerals Stock"), was distributed on the basis of one-fifth of one share of Minerals Stock for each share of the Company's previous common stock held by shareholders of record on July 26, 1993. Minerals Stock and Services Stock provide shareholders with separate securities reflecting the performance of the Pittston Minerals Group (the "Minerals Group") and the Pittston Services Group (the "Services Group") respectively, without diminishing the benefits of remaining a single corporation or precluding future transactions affecting either Group. Accordingly, all stock and per share data prior to the reclassification have been restated to reflect the reclassification. The primary impacts of this restatement are as follows: o Net income per common share has been included in the Statements of Operations. For the purpose of computing net income per common share of Services Stock, the number of shares of Services Stock prior to the Effective Date are assumed to be the same as the total number of shares of the Company's common stock. o All financial impacts of purchases and issuances of the Company's common stock have been attributed to each Group in relation of their respective common equity to the Company's common stock. Dividends paid by the Company were attributed to the Services and Minerals Groups in relation to the initial dividends paid on the Services Stock and the Minerals Stock. The Company, at any time, has the right to exchange each outstanding share of Minerals Stock for shares of Services Stock having a fair market value equal to 115% of the fair market value of one share of Minerals Stock. In addition, upon the sale, transfer, assignment or other disposition, whether by merger, consolidation, sale or contribution of assets or stock or otherwise, of all or substantially all of the properties and assets of the Minerals Group to any person, entity or group (with certain exceptions), the Company is required to exchange each outstanding share of Minerals Stock for shares of Services Stock having a fair market value equal to 115% of the fair market value of one share of Minerals Stock. Shares of Services Stock are not subject to either optional or mandatory exchange. Holders of Services Stock have one vote per share. Holders of Minerals Stock have one vote per share subject to adjustment on January 1, 1996, and on each January 1 every two years thereafter based upon the relative fair market values of one share of Minerals Stock and one share of Services Stock on each such date. Accordingly, beginning on January 1, 1996, each share of Minerals Stock may have more than, less than or continue to have exactly one vote. Holders of Services Stock and Minerals Stock vote together as a single voting group on all matters as to which all common shareholders are entitled to vote. In addition, as prescribed by Virginia law, certain amendments to the Company's Restated Articles of Incorporation affecting, among other things, the designation, rights, preferences or limitations of one class of common stock, or any merger or statutory share exchange, must be approved by the holders of such class of common stock, voting as a separate voting group, and, in certain circumstances, may also have to be approved by the holders of the other class of common stock, voting as a separate voting group. In the event of a dissolution, liquidation or winding up of the Company, the holders of Services Stock and Minerals Stock will receive the funds remaining for distribution, if any, to the common shareholders on a per share basis in proportion to the total number of shares of Services Stock and Minerals Stock, respectively, then outstanding to the total number of shares of both classes of common stock then outstanding. In conjunction with the Services Stock Proposal, a new share repurchase program was approved whereby the Company could acquire up to 1,250,000 shares of Services Stock from time to time in the open market or in private transactions, as conditions warrant. No shares of Services Stock were repurchased in 1993 under the new program. The program to acquire shares remains in effect in 1994. The financial statements of the Services Group include the balance sheets, results of operations and cash flows of the Burlington Air Express Inc. ("Burlington"), Brink's, Incorporated ("Brink's") and Brink's Home Security, Inc. ("BHS") operations of the Company, and a portion of the Company's corporate assets and liabilities and related transactions which are not separately identified with operations of a specific segment (Note 2). The Services Group's financial statements are prepared using the amounts included in the Company's consolidated financial statements. Corporate allocations reflected in these financial statements are determined based upon methods which management believes to be an equitable allocation of such expenses and credits. The Company provides holders of Services Stock separate financial statements, financial reviews, descriptions of business and other relevant information for the Services Group in addition to consolidated financial information of the Company. Notwithstanding the attribution of assets and liabilities (including contingent liabilities) between the Minerals Group and the Services Group for the purpose of preparing their financial statements, this attribution and the change in the capital structure of the Company as a result of the approval of the Services Stock Proposal did not result in any transfer of assets and liabilities of the Company or any of its subsidiaries. Holders of Services Stock are shareholders of the Company, which continues to be responsible for all its liabilities. Therefore, financial developments affecting the Minerals Group or the Services Group that affect the Company's financial condition could affect the results of operations and financial condition of both Groups. Accordingly, the Company's consolidated financial statements must be read in connection with the Services Group's financial statements. PRINCIPLES OF COMBINATION: The accompanying financial statements reflect the combined accounts of the businesses comprising the Services Group and their majority-owned subsidiaries. The Services Group interests in 20% to 50% owned companies are carried on the equity method. Undistributed earnings of such companies approximated $38,857,000 at December 31, 1993. All material intercompany items and transactions have been eliminated in combination. Certain prior year amounts have been reclassified to conform to the current year's financial statement presentation. CASH AND CASH EQUIVALENTS: Cash and cash equivalents include cash on hand, demand deposits and investments with original maturities of three months or less. SHORT-TERM INVESTMENTS: Short-term investments are those with original maturities in excess of three months and are carried at cost which approximates market. INVENTORIES: Inventories are stated at cost (determined under the first-in, first-out or average cost method) or market, whichever is lower. PROPERTY, PLANT AND EQUIPMENT: Expenditures for maintenance and repairs are charged to expense, and the costs of renewals and betterments are capitalized. Depreciation is provided principally on the straight-line method at varying rates depending upon estimated useful lives. Subscriber installation costs for home security systems provided by BHS are capitalized and amortized over the estimated life of the assets and are included in machinery and equipment. The basic equipment that is installed, remains the property of BHS and is capitalized at cost. Other capitalized costs, which arise solely as a direct result of the installation process and bring the revenue producing asset to its intended use, include costs of setting up customers on the monitoring network, labor costs and costs incurred for installation scheduling and testing. When a customer is identified for disconnection, the remaining net book value of the basic equipment is fully depreciated. INTANGIBLES: The excess of cost over fair value of net assets of companies acquired is amortized on a straight-line basis over the estimated periods benefitted. INCOME TAXES: In 1991, the Services Group adopted Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes" ("SFAS 109"), which requires recognition of deferred tax liabilities and assets for the expected future tax consequences of events that have been included in the financial statements or tax returns. Under this method, deferred tax liabilities and assets are determined based on the difference between the financial statement and tax bases of assets and liabilities using enacted tax rates in effect for the year in which the differences are expected to reverse. See Note 2 for allocation of the Company's U.S. federal income taxes to the Services Group. POSTRETIREMENT BENEFITS OTHER THAN PENSIONS: In 1991, the Services Group adopted Statement of Financial Accounting Standards No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions" ("SFAS 106"), which requires employers to accrue the cost of such retirement benefits during the employees' service with the Services Group. FOREIGN CURRENCY TRANSLATION: Assets and liabilities of foreign operations have been translated at current exchange rates, and related revenues and expenses have been translated at average rates of exchange in effect during the year. Resulting cumulative translation adjustments have been included as a separate component of shareholder's equity. Translation adjustments relating to operations in countries with highly inflationary economies are included in net income, along with all transaction gains and losses for the period. A significant portion of the Services Group's financial results is derived from activities in several foreign countries, each with a local currency other than the U.S. dollar. Because the financial results of the Services Group are reported in U.S. dollars, they are affected by the changes in the value of the various foreign currencies in relation to the U.S. dollar. However, the Services Group's international activity is not concentrated in any single currency, which limits the risks of foreign currency rate fluctuations. FINANCIAL INSTRUMENTS: The Services Group uses foreign currency forward contracts to hedge risk of changes in foreign currency rates associated with certain transactions denominated in various currencies. Gains and losses on these contracts, designated and effective as hedges, are deferred and recognized as part of the specific transaction hedged. The Services Group also utilizes swap contracts and call options to protect against price increases in jet fuel and crude oil. Gains and losses on such financial instruments, designated and effective as hedges, are recognized as part of the specific transaction hedged. The Services Group is required to adopt Statement of Financial Accounting Standards No. 115, "Accounting for Certain Investments in Debt and Equity Securities" ("SFAS 115"), in 1994. SFAS 115 requires classification of debt and equity securities and recognition of changes in the fair value of the securities based on the purpose for which the securities are held. The Services Group has determined that the cumulative effect of adopting SFAS 115 is immaterial. REVENUE RECOGNITION: Burlington - Revenues related to transportation services are recognized, together with related transportation costs, on the date shipments physically depart from facilities en route to destination locations. Brink's - Revenues from contract carrier armored car, automatic teller machine, air courier, coin wrapping and currency and deposit processing services are recognized when services are performed. BHS - Monitoring revenues are recognized when earned and amounts paid in advance are deferred and recognized as income over the applicable monitoring period, which is generally one year or less. Revenues from the sale of equipment, excluding equipment which is part of the standard package security system, are recognized, together with related costs, upon completion of the installation. Connection fee revenues are recognized to the extent of direct selling costs incurred and expensed. Connection fee revenues in excess of direct selling costs are deferred and recognized as income on a straight-line basis over ten years. NET INCOME PER COMMON SHARE: Net income per Services Group common share is computed by dividing the net income by the weighted average number of Services Group common shares outstanding during the period. The potential dilution from the exercise of stock options is not material. The potential dilution from the assumed conversion of the 9.20% convertible subordinated debentures is not included since its effect is antidilutive. The shares of Services Stock held in The Pittston Company Employee Benefits Trust are evaluated for inclusion in the calculation of net income per share under the treasury stock method and have no dilutive effect. 2. RELATED PARTY TRANSACTIONS The following policies may be modified or rescinded by action of the Company's Board of Directors (the "Board"), or the Board may adopt additional policies, without approval of the shareholders of the Company, although the Board has no present intention to do so. The Company allocated certain corporate general and administrative expenses, net interest expense and related assets and liabilities in accordance with the policies described below. Corporate assets and liabilities are primarily cash, deferred pension assets, income taxes and accrued liabilities. FINANCIAL: As a matter of policy, the Company manages most financial activities of the Services Group and Minerals Group on a centralized, consolidated basis. Such financial activities include the investment of surplus cash; the issuance, repayment and repurchase of short-term and long-term debt; the issuance and repurchase of common stock and the payment of dividends. In preparing these financial statements for the three-year period ended December 31, 1993, transactions primarily related to invested cash, short-term and long-term debt (including convertible debt), related net interest and other financial costs have been attributed to the Services Group based upon its cash flows for the periods presented after giving consideration to the debt and equity structure of the Company. At December 31, 1993, the Company attributed all of its long-term debt to the Services Group based upon the specific purpose for which the debt was incurred and the cash flow requirements of the Services Group. See Note 8 for details and amounts of long-term debt. The portion of the Company's interest expense allocated to the Services Group for 1993, 1992 and 1991 was $5,206,000, $3,003,000 and $4,269,000, respectively. Management believes such method of allocation to be equitable and a reasonable estimate of such costs as if the Services Group operated on a stand alone basis. To the extent borrowings are deemed to occur between the Services Group and the Minerals Group, intercompany accounts have been established bearing interest at the rate in effect from time to time under the Company's unsecured credit lines or, if no such credit lines exist, at the prime rate charged by Chemical Bank from time to time. At December 31, 1993, the Services Group owed the Minerals Group $13,266,000 as the result of borrowings. SHARED SERVICES: A portion of the Company's corporate general and administrative expenses and other shared services has been allocated to the Services Group based upon utilization and other methods and criteria which management believes to be equitable and a reasonable estimate of such expenses as if the Services Group operated on a stand alone basis. These allocations were $9,514,000, $8,556,000 and $8,011,000 in 1993, 1992 and 1991, respectively. PENSION: The Services Group's pension cost related to its participation in the Company's noncontributory defined benefit pension plan is actuarially determined based on its respective employees and an allocable share of the pension plan assets and calculated in accordance with Statement of Financial Accounting Standards No. 87, "Employers' Accounting for Pensions" ("SFAS 87"). Pension plan assets have been allocated to the Services Group based on the percentage of its projected benefit obligation to the plan's total projected benefit obligation. Management believes such method of allocation to be equitable and a reasonable estimate of such costs as if the Services Group operated on a stand alone basis. INCOME TAXES: The Services Group is included in the consolidated U.S. federal income tax return filed by the Company. The Company's consolidated provision and actual cash payments for U.S. federal income taxes are allocated between the Services Group and Minerals Group in accordance with the Company's tax allocation policy and reflected in the financial statements for each Group. In general, the consolidated tax provision and related tax payments or refunds are allocated between the Groups, for financial statement purposes, based principally upon the financial income, taxable income, credits and other amounts directly related to the respective Group. Tax benefits that cannot be used by the Group generating such attributes, but can be utilized on a consolidated basis, are allocated to the Group that generated such benefits and an intercompany account is established for the benefit of the Group generating the attributes. At December 31, 1993 and 1992, the Services Group owed the Minerals Group $20,541,000 and $5,079,000, respectively, for such tax benefits, of which $14,709,000 and $2,918,000, respectively, was not expected to be paid within one year from such dates in accordance with the policy. As a result, the allocated Group amounts of taxes payable or refundable are not necessarily comparable to those that would have resulted if the Groups had filed separate tax returns. 3. SHAREHOLDER'S EQUITY The following analyzes shareholder's equity of the Services Group for the periods presented: Included in shareholder's equity is the cumulative foreign currency translation adjustment of $17,295,000, $13,191,000 and $8,886,000 at December 31, 1993, 1992 and 1991, respectively. 4. PROPERTY, PLANT AND EQUIPMENT During the three years ended December 31, 1993, changes in capitalized subscriber installation costs for home security systems were as follows: As of January 1, 1992, BHS elected to capitalize categories of costs not previously capitalized for home security system installations. This change in accounting principle is preferable because it more accurately reflects subscriber installation costs. The additional costs not previously capitalized consisted of costs for installation labor and related benefits for supervisory, installation scheduling, equipment testing and other support personnel (in the amount of $2,567,000 in 1993 and $2,327,000 in 1992) and costs incurred in maintaining facilities and vehicles dedicated to the installation process (in the amount of $1,484,000 in 1993 and $1,994,000 in 1992). The effect of this change in accounting principle was to increase operating profit of the Services Group and the BHS segment in 1993 and 1992 by $4,051,000 and $4,321,000, respectively, and net income of the Services Group by $.07 per share in each year. Prior to January 1, 1992, the records needed to identify such costs were not available. Thus, it was impossible to accurately calculate the effect on retained earnings as of January 1, 1992 or the pro forma effects of retroactive application on the year ended December 31, 1991 for the change in accounting principle. However, the Services Group believes the effect on retained earnings as of January 1, 1992 was immaterial. Because capitalized subscriber installation costs for prior periods were not adjusted for the change in accounting principle, installation costs for subscribers in those years will continue to be depreciated based on the lesser amounts capitalized in prior periods. Consequently, depreciation of capitalized subscriber installation costs in the current year and until such capitalized costs prior to January 1, 1992 are fully depreciated will be less than if such prior periods' capitalized costs had been adjusted for the change in accounting. However, the Services Group believes the effect on net income in 1993 and 1992 was immaterial. New subscriber installations for which costs were capitalized totalled 56,700 in 1993, 48,600 in 1992 and 41,000 in 1991. Additional subscribers who purchased the installed equipment and for which no costs were capitalized totalled 1,600 in 1993 and 700 in each of 1992 and 1991. In 1993 and 1992, BHS also added 1,300 and 2,000 subscribers, respectively, as a result of converting previously installed competitors' systems to BHS monitoring. The acquisition of monitoring contracts added 6,400 subscribers in 1991. The estimated useful lives for property, plant and equipment are as follows: Depreciation of property, plant and equipment aggregated $40,708,000 in 1993, $38,023,000 in 1992 and $37,060,000 in 1991. 5. INTANGIBLES Intangibles consist entirely of the excess of cost over fair value of net assets of companies acquired and are net of accumulated amortization of $65,574,000 at December 31, 1993 and $58,618,000 at December 31, 1992. The estimated useful life of intangibles is generally forty years. Amortization of intangibles aggregated $7,083,000 in 1993, $7,141,000 in 1992 and $6,978,000 in 1991. 6. FINANCIAL INSTRUMENTS Financial instruments which potentially subject the Services Group to concentrations of credit risk consist principally of cash and cash equivalents, short-term cash investments and trade receivables. The Services Group's cash and cash equivalents and short-term investments are placed with high credit qualified financial institutions. Also, by policy, the amount of credit exposure to any one financial institution is limited. Concentration of credit risk with respect to trade receivables are limited due to the large number of customers comprising the Services Group's customer base, and their dispersion across many different industries and geographic areas. The following details the fair values of financial instruments for which it is practicable to estimate the value: CASH AND CASH EQUIVALENTS AND SHORT-TERM INVESTMENTS The carrying amounts approximate fair value because of the short maturity of these instruments. DEBT The aggregate fair value of the Services Group's long-term debt obligations, which is based upon quoted market prices and rates currently available to the Services Group for debt with similar terms and maturities, approximates the carrying amount. OFF-BALANCE SHEET INSTRUMENTS The Services Group utilizes various off-balance sheet financial instruments, as discussed below, to hedge its foreign currency and other market exposures. Accordingly, the fair value of these instruments have been considered in determining the fair values of the assets and liabilities being hedged. The risk that counterparties to such instruments may be unable to perform is minimized by limiting the counterparties to major international banks. The Services Group does not expect any losses due to such counterparty default. Foreign currency forward contracts - The Company enters into foreign currency forward contracts with a duration of 30 to 45 days as a hedge against accounts payable denominated in various currencies. These contracts do not subject the Company to risk due to exchange rate movements because gains and losses on these contracts offset losses and gains on the payables being hedged. At December 31, 1993, the total contract value of foreign currency forward contracts outstanding was $4,600,000. As of such date, the carrying amounts of the foreign currency forward contracts approximate fair value. Other contracts - The Services Group has hedged a significant portion of its jet fuel requirements for the period January 1, 1994 through March 31, 1995, through swap contracts which were intended to fix the Company's per gallon fuel costs below 1993 levels. At December 31, 1993, the contract value of the jet fuel swaps, aggregating 50.1 million gallons, was $25,492,000. In addition, a call option was purchased for 12.6 million gallons of crude oil for the first half of 1994. Each of these transactions are settled monthly based upon the average of the high and low prices during each period. The fair value of these fuel hedge transactions may fluctuate over the course of the contract period due to changes in the supply and demand for oil and refined products. Thus, the economic gain or loss, if any, upon settlement of the contracts may differ from the fair value of the contracts at an interim date. At December 31, 1993, the aggregate carrying value of the swap contract and the call option exceeded their fair value by approximately $1,700,000. 7. INCOME TAXES The provision (credit) for income taxes consists of the following: Effective January 1, 1991, the Services Group adopted SFAS 109, which requires recognition of deferred tax liabilities and assets for the expected future tax consequences of events that have been included in the financial statements or tax returns. Under this method, deferred tax liabilities and assets are determined based on the difference between the financial statement and tax bases of assets and liabilities using enacted tax rates in effect for the year in which the differences are expected to reverse. As of January 1, 1991, the Services Group recorded a tax credit of approximately $3,665,000 or $.10 per share, which amount represents the net decrease to the deferred tax liability as of that date. Such amount has been reflected in the statement of operations as the cumulative effect of an accounting change. For the years ended December 31, 1993, 1992 and 1991, cash payments for income taxes, net of refunds received, were $27,776,000, $13,091,000 and $10,990,000, respectively. The significant components of the deferred tax expense (benefit) were as follows: The tax benefit for compensation expense related to the exercise of certain employee stock options for tax purposes in excess of compensation expense for financial reporting purposes is recognized as an adjustment to shareholder's equity. The components of the net deferred tax liability as of December 31, 1993 and December 31, 1992 were as follows: The valuation allowance relates to deferred tax assets in certain foreign jurisdictions. The following table accounts for the difference between the actual tax provision and the amounts obtained by applying the statutory U.S. federal income tax rate of 35% in 1993 and 34% in 1992 and 1991 to the income before income taxes. It is the policy of the Services Group to accrue deferred income taxes on temporary differences related to the financial statement carrying amounts and tax bases of investments in foreign subsidiaries and affiliates which are expected to reverse in the foreseeable future. As of December 31, 1993 and December 31, 1992 the unrecognized deferred tax liability for temporary differences of approximately $43,640,000 and $36,200,000, respectively, related to investments in foreign subsidiaries and affiliates that are essentially permanent in nature and not expected to reverse in the foreseeable future was approximately $15,274,000 and $12,308,000, respectively. The Services Group is included in the Company's consolidated U.S. federal income tax return. Such returns have been audited and settled with the Internal Revenue Services through the year 1981. As of December 31, 1993, the Services Group had $8,695,000 of alternative minimum tax credits allocated to it under the Company's tax allocation policy. Such credits are available to offset future U.S. federal income taxes and, under current tax law, the carryforward period for such credits is unlimited. The tax benefits of net operating loss carryforwards of the Services Group as at December 31, 1993 were $6,617,000 and relate to various state and foreign taxing jurisdictions. The expiration periods primarily range from 5 to 15 years. 8. LONG-TERM DEBT All outstanding debt under the Company's revolving credit agreements and the Company's subordinated obligations have been attributed to the Services Group. Total long-term debt of the Services Group consists of the following: For the four years through December 31, 1998, minimum repayments of long-term debt outstanding are as follows: The Dutch guilder loan bears interest based on Euroguilder rate, or if converted to a U.S. dollar loan, bears interest based on prime, Eurodollar or money market rates. In January 1992, a portion of the guilder loan was converted into a U.S. dollar loan. In March 1993, a pound sterling loan was converted into a U.S. dollar term loan due 1995 to 1997. Interest was previously based on the Eurosterling rate and is currently based on the Eurodollar rate. The Canadian dollar loan was paid in June 1993. Under the terms of the loans, Brink's has agreed to various restrictions relating to net worth, disposition of assets and incurrance of additional debt. At December 31, 1993, the Company had separate revolving credit agreements with several banks under which it is permitted to borrow, repay and reborrow up to an aggregate of $250,000,000. Interest is payable at rates based on prime, certificate of deposit, Eurodollar, money market or Federal Funds rates. The agreements, which have various expiration dates beginning in December 1994 and continuing through December 1997, include provisions under which borrowings are converted to term loans with various repayment dates. In March 1994, the Company entered into a $350,000,000 revolving credit agreement with a syndicate of banks (the "New Facility"), replacing the Company's previously existing $250,000,000 of revolving credit agreements. The New Facility includes a $100,000,000 five-year term loan, which matures in March 1999. The New Facility also permits additional borrowings, repayments and reborrowings of up to an aggregate of $250,000,000 until March 1999. Interest on borrowings under the New Facility is payable at rates based on prime, certificate of deposit, Eurodollar or money market rates. The 4% subordinated debentures due July 1, 1997, are exchangeable for cash, at the rate of $157.80 per $1,000 debentures. The debentures are redeemable at the Company's option, in whole or in part, at any time prior to maturity, at redemption prices equal to 100% of principal amount. The 9.20% convertible subordinated debentures due July 1, 2004 are convertible into shares of Services Stock and Minerals Stock at the rate of two shares of Services Stock and two-fifths of a share of Minerals Stock for each $100 principal amount of debenture, subject to adjustment pursuant to antidilution provisions. The debentures are redeemable at the Company's option, in whole or in part, at any time prior to maturity, at redemption prices which decline from 102.76% of principal amount before July 1, 1994, to 100% of principal amount after June 30, 1999. Various international operations maintain lines of credit and overdraft facilities aggregating approximately $58,000,000 with a number of banks on either a secured or unsecured basis. Under the terms of some of its debt instruments, the Company has agreed to various restrictions relating to the payment of dividends, the repurchase of capital stock, maintenance of consolidated working capital and net worth, and the amount of additional funded debt which may be incurred. See the Company's consolidated financial statements and related footnotes. At December 31, 1993, the Company's portion of outstanding unsecured letters of credit allocated to the Services Group was $31,163,000, primarily supporting the Services Group's obligations under aircraft leases and its various self-insurance programs. Cash payments made for interest for the years ended December 31, 1993, 1992 and 1991 were $8,081,000, $8,916,000 and $13,080,000, respectively. 9. STOCK OPTIONS The Company grants options under its 1988 Stock Option Plan (the "1988 Plan") to executives and key employees and under its Non-Employee Directors' Stock Option Plan (the "Non-Employee Plan") to outside directors to purchase common stock at a price not less than 100% of quoted market value at date of grant. The 1988 Plan provides for the grant of "incentive stock options", which terminate not later than ten years from the date of grant, and "nonqualified stock options", which terminate not later than ten years and two days from the date of grant. As part of the Services Stock Proposal (Note 1), the 1988 Plan was amended to permit option grants to be made to optionees with respect to either Services Stock or Minerals Stock, or both. The Non-Employee Plan authorizes initial and automatic grants of "nonqualified stock options" which terminate on the tenth anniversary of grant. Pursuant to the Non-Employee Plan, also amended for the Services Stock Proposal, each non-employee director of the Company elected after July 26, 1993, shall receive an initial grant of an option to purchase 10,000 shares of Services Stock and an option to purchase 2,000 shares of Minerals Stock. On July 1 of each subsequent year, each non-employee director will automatically be granted an option to purchase 1,000 shares of Services Stock and an option to purchase 200 shares of Minerals Stock. The first of such automatic grants was made on August 1, 1993. The Company's 1979 Stock Option Plan (the "1979 Plan") and 1985 Stock Option Plan (the "1985 Plan") terminated in 1985 and 1988, respectively, except as to options theretofore granted. At the Effective Date, as defined in Note 1, a total of 2,228,225 shares of common stock were subject to options outstanding under the 1988 Plan, the Non-Employee Plan, the 1979 Plan and the 1985 Plan. Pursuant to antidilution provisions in the option agreements covering such options, the Company has converted these options into options for shares of Services Stock or Minerals Stock, or both, depending primarily on the employment status and responsibilities of the particular optionee. In the case of optionees having Company-wide responsibilities, each outstanding option has been converted into an option for Services Stock and an option for Minerals Stock, in the same ratio as the distribution on the Effective Date of Minerals Stock to shareholders of the Company, viz., one share to one-fifth of a share, with any resultant fractional share of Minerals Stock rounded downward to the nearest whole number of shares. In the case of other optionees, each outstanding option has been converted into a new option for only Services Stock or Minerals Stock, as the case may be, following the Effective Date. As a result, 2,167,247 shares of Services Stock and 507,698 shares of Minerals Stock were subject to options outstanding as of the Effective Date. The table below summarizes the activity in all plans. At December 31, 1993, a total of 987,605 shares of Services Stock shares were exercisable. In addition, there were 2,578,770 shares of Services Stock reserved for issuance under the plans, including 199,966 shares of Services Stock reserved for future grant. 10. ACQUISITIONS During 1993, the Services Group acquired one small business and made a contingency payment related to an acquisition consummated in a prior year. The total consideration paid was $736,000. During 1992, the Services Group acquired a business for an aggregate purchase price of $2,658,000, including debt of $1,144,000. The fair value of assets acquired was $2,690,000 and liabilities assumed was $32,000. In addition, cash payments of $226,000 were made for contingency payments for acquisitions made in prior years. During 1991, the Services Group acquired one small business and made contingency payments related to other acquisitions consummated in prior years. The total consideration paid was $1,179,000. All acquisitions have been accounted for as purchases. In 1993, 1992 and 1991, the purchase price was essentially equal to the fair value of assets acquired. The results of operations of the acquired companies have been included in the Services Group's results of operations from their date of acquisition. 11. LEASES The Services Group's businesses lease aircraft, facilities, vehicles, computers and other equipment under long-term operating leases with varying terms, and most of the leases contain renewal and/or purchase options. As of December 31, 1993, aggregate future minimum lease payments under noncancellable operating leases were as follows: The above amounts are net of aggregate future minimum noncancellable sublease rentals of $6,364,000. Rent expense amounted to $66,585,000 in 1993, $58,795,000 in 1992 and $52,577,000 in 1991 and is net of sublease rentals of $793,000, $1,419,000 and $2,149,000, respectively. Included in future minimum lease payments are rentals for aircraft and the Toledo, Ohio hub operated as part of a controlled airlift project. The Toledo, Ohio hub lease commenced in 1991 for a twenty-two year period. Certain costs of the project are being amortized over the terms of the respective leases. The unamortized expense as of December 31, 1993 and 1992, aggregated $1,525,000 and $2,825,000, respectively. Burlington entered into two transactions covering various leases which provide for the replacement of eight B707 aircraft with seven DC8-71 aircraft and completed an evaluation of other fleet related costs. One transaction, representing four aircraft, is reflected in the 1993 financial statements, while the other transactions, covering three aircraft, is reflected in the 1992 financial statements. The net effect of these transactions did not have a material impact on operating profit for either year. The Services Group incurred capital lease obligations of $1,601,000 in 1993, $2,316,000 in 1992 and $5,530,000 in 1991. As of December 31, 1993, the Services Group's obligations under capital leases were not significant. 12. EMPLOYEE BENEFIT PLANS The Services Group's businesses participate in the Company's noncontributory defined benefit pension plan covering substantially all nonunion employees who meet certain minimum requirements in addition to sponsoring certain other defined benefit plans. Benefits of most of the plans are based on salary and years of service. The Services Group's pension cost relating to its participation in the Company's defined benefit pension plan is actuarially determined based on its respective employees and an allocable share of the pension plan assets. The Company's policy is to fund the actuarially determined amounts necessary to provide assets sufficient to meet the benefits to be paid to plan participants in accordance with applicable regulations. The net pension expense (credit) for 1993, 1992 and 1991 for all plans is as follows: The funded status and prepaid pension expense at December 31, 1993 and 1992, are as follows: The assumptions used in determining the net pension expense (credit) for the Company's major pension plan for 1993, 1992 and 1991 were as follows: For the valuation of pension obligations and the calculation of the funded status, the discount rate was 7.5% in 1993 and 9.0% in 1992 and 1991. The expected long-term rate of return on assets was 10% in all years presented. The rate of increase in compensation levels used was 4% in 1993 and 5% in 1992 and 1991. The unrecognized initial net asset at January 1, 1986 (January 1, 1989, for certain foreign pension plans), the date of adoption of SFAS 87, has been amortized over the estimated remaining average service life of the employees. As of December 31, 1993, approximately 69% of plan assets were invested in equity securities and 31% in fixed income securities. The Services Group also provide certain postretirement health care and life insurance benefits for eligible active and retired employees in the United States and Canada. Effective January 1, 1991, the Services Group adopted SFAS 106, which requires the accrual method of accounting for postretirement health care and life insurance benefits based on actuarially determined costs to be recognized over the period from the date of hire to the full eligibility date of employees who are expected to qualify for such benefits. As of January 1, 1991, the Services Group recognized the full amount of its estimated accumulated postretirement benefit obligation on that date, which represents the present value of the estimated future benefits payable to current retirees and a pro rata portion of estimated benefits payable to active employees after retirement. The pretax charge to 1991 earnings was $5,450,000, with a net income effect of $3,354,000 or $.09 per share. The latter amount has been reflected in the statement of operations as the cumulative effect of an accounting change. For the years 1993, 1992 and 1991, the components of periodic expense for these postretirement benefits were as follows: Interest costs on the accumulated postretirement benefit obligation were based on a rate of 9% for all years presented. At December 31, 1993 and 1992, the actuarial and recorded liabilities for these postretirement benefits, none of which have been funded, were as follows: The accumulated postretirement benefit obligation was determined using the unit credit method and an assumed discount rate of 7.5% in 1993 and 9.0% in 1992. The postretirement benefit obligation for U.S. salaried employees does not provide for changes in health care costs since the employer's contribution to the plan is a fixed monthly amount. The assumed health care cost trend rate used in 1993 for employees under a foreign plan was 10% grading down to 5% in the year 2000. A one percent increase each year in the health care cost trend rate used would have resulted in a $12,000 increase in the aggregate service and interest components of expense for the year 1993, and a $108,000 increase in the accumulated postretirement benefit obligation at December 31, 1993. The Services Group also participates in the Company's Savings-Investment Plan to assist eligible employees in providing for retirement or other future financial needs. Employee contributions are matched at rates of 50% to 100% up to 5% of compensation (subject to certain limitations imposed by the Internal Revenue Code of 1986, as amended). Contribution expense under the plan aggregated $3,360,000 in 1993, $3,332,000 in 1992 and $2,878,000 in 1991. The Services Group sponsors several other defined contribution benefit plans based on hours worked or other measurable factors. Contributions under all of these plans aggregated $443,000 in 1993, $498,000 in 1992 and $280,000 in 1991. The Services Group is required to implement a new accounting standard for postemployment benefits, Statement of Financial Accounting Standards No. 112, "Employers' Accounting for Postemployment Benefits" ("SFAS 112"), in 1994. This standard requires employers who provide benefits to former employees after employment but before retirement to accrue such costs as the benefits accumulate or vest. The Services Group has determined that the cumulative effect of adopting SFAS 112 is immaterial. 13. OTHER OPERATING INCOME Other operating income includes the Services Group's share of net income in unconsolidated affiliated companies which are carried on the equity method. Summarized financial information for these equity method companies is shown below. Amounts presented include the accounts of the following equity affiliates: The following table presents summarized financial information of these companies. 14. ACCOUNTING CHANGES As of January 1, 1992, BHS elected to capitalize categories of costs not previously capitalized for home security installations to more accurately reflect subscriber installation costs. The effect of this change in accounting principle was to increase net income in 1993 and 1992 by $2,435,000 and $2,596,000, respectively (Note 4). During 1991, the Services Group adopted two changes in accounting principles in connection with the issuance of two accounting standards by the Financial Accounting Standards Board. The effect of these changes on the statement of operations as of January 1, 1991, the date of adoption, has been recognized as the cumulative effect of accounting changes as follows: 15. SEGMENT INFORMATION Operating revenues by geographic area are as follows: The following is derived from the business segment information in the Company's consolidated financial statements as it relates to the Services Group. See Note 2, Related Party Transactions, for a description of the Company's policy for corporate allocations. The Services Group's portion of the Company's operating profit is as follows: The Services Group portion of the Company's assets at year end is as follows: Industry segment information is as follows: * Includes equity in net income of unconsolidated foreign affiliates of $6,895,000 in 1993, $8,133,000 in 1992 and $7,629,000 in 1991. ** As of January 1, 1992, BHS elected to capitalize categories of costs not previously capitalized for home security installations to more accurately reflect subscriber installation costs. The effect of this change in accounting principle was to increase operating profit in 1993 by $4,051,000 and in 1992 by $4,321,000 (Note 4). 16. CONTINGENT LIABILITIES Under the Coal Industry Retiree Health Benefit Act of 1992 (the "Act"), the Company and its majority-owned subsidiaries at July 20, 1992, including the Services Group included in these financial statements, are jointly and severally liable with the Minerals Group for the costs of health care coverage provided for by that Act. For a description of the Act and a calculation of certain of such costs, see Note 13 to the Company's consolidated financial statements. At this time, the Company expects the Minerals Group to generate sufficient cash flow to discharge its obligations under the Act. In April 1990, the Company entered into a settlement agreement to resolve certain environmental claims against the Company arising from hydrocarbon contamination at a petroleum terminal facility ("Tankport") in Jersey City, New Jersey, which operations were sold in 1983. Under the settlement agreement, the Company is obligated to pay 80% of the remediation costs. Based on data available to the Company and its environmental consultants, the Company estimates its portion of the cleanup costs on an undiscounted basis using existing technologies to be between $4.5 million and $13.5 million over a period of three to five years. Management is unable to determine that any amount within that range is a better estimate due to a variety of uncertainties, which include the extent of the contamination at the site, the permitted technologies for remediation and the regulatory standards by which the cleanup will be measured by the New Jersey Department of Environmental Protection and Energy. The Company commenced insurance coverage litigation in 1990, in the United States District Court for the District of New Jersey, seeking a declaratory judgment that all amounts payable by the Company pursuant to the Tankport obligation were reimbursable under comprehensive general liability and pollution liability policies maintained by the Company. Although the underwriters have disputed this claim, management and its legal counsel believe that recovery is probable of realization in the full amount of the claim. This conclusion is based upon, among other things, the nature of the pollution policies which were broadly designed to cover such contingent liabilities, the favorable state of the law in the State of New Jersey (whose laws have been found to control the interpretation of the policies), and numerous other factual considerations which support the Company's analysis of the insurance contracts and rebut many of the underwriters' defenses. Accordingly, since management and its legal counsel believe that recovery is probable of realization in the full amount of the claim, there is no net liability in regard to the Tankport obligation. 17. SELECTED QUARTERLY FINANCIAL DATA (UNAUDITED) Tabulated below are certain data for each quarter of 1993 and 1992. 18. SUBSEQUENT EVENTS In January 1994, 161,000 shares of convertible preferred stock (convertible into Minerals Stock) were issued to finance a portion of the acquisition of substantially all of the coal mining operations and coal sales contracts of Addington Resources, Inc. While the issuance of the preferred stock had no effect on the capitalization of the Services Group, commencing March 1, 1994, annual cumulative dividends of $31.25 per share of convertible preferred stock are payable quarterly, in cash, in arrears, from the date of original issue out of all funds of the Company legally available therefor, when, as and if declared by the Company's Board. A portion of the acquisition was also financed with additional debt under existing credit facilities. In March 1994, the additional debt incurred for this acquisition was refinanced with a five-year term loan under the New Facility (Note 8). The acquisition and related financing will be attributed to the Minerals Group. PITTSTON MINERALS GROUP STATEMENT OF MANAGEMENT RESPONSIBILITY The management of The Pittston Company (the "Company") is responsible for preparing the accompanying financial statements and for their integrity and objectivity. The statements were prepared in accordance with generally accepted accounting principles. Management has also prepared the other information in the annual report and is responsible for its accuracy. In meeting our responsibility for the integrity of the financial statements, we maintain a system of internal controls designed to provide reasonable assurance that assets are safeguarded, that transactions are executed in accordance with management's authorization and that the accounting records provide a reliable basis for the preparation of the financial statements. Qualified personnel throughout the organization maintain and monitor these internal controls on an ongoing basis. In addition, the Company maintains an internal audit department that systematically reviews and reports on the adequacy and effectiveness of the controls, with management follow-up as appropriate. Management has also established a formal Business Code of Ethics which is distributed throughout the Company. We acknowledge our responsibility to establish and preserve an environment in which all employees properly understand the fundamental importance of high ethical standards in the conduct of our business. The accompanying financial statements have been audited by KPMG Peat Marwick, independent auditors. During the audit they review and make appropriate tests of accounting records and internal controls to the extent they consider necessary to express an opinion on the Minerals Group's financial statements. The Company's Board of Directors pursues its oversight role with respect to the Minerals Group's financial statements through the Audit and Ethics Committee, which is composed solely of outside directors. The Committee meets periodically with the independent auditors, internal auditors and management to review the Company's control system and to ensure compliance with applicable laws and the Company's Business Code of Ethics. We believe that the policies and procedures described above are appropriate and effective and do enable us to meet our responsibility for the integrity of the Minerals Group's financial statements. INDEPENDENT AUDITORS' REPORT THE BOARD OF DIRECTORS AND SHAREHOLDERS THE PITTSTON COMPANY We have audited the accompanying balance sheets of Pittston Minerals Group (as described in Note 1) as of December 31, 1993 and 1992 and the related statements of operations and cash flows for each of the years in the three-year period ended December 31, 1993. These financial statements are the responsibility of The Pittston Company's management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements of Pittston Minerals Group present fairly, in all material respects, the financial position of Pittston Minerals Group as of December 31, 1993 and 1992, and the results of its operations and its cash flows for each of the years in the three-year period ended December 31, 1993, in conformity with generally accepted accounting principles. As more fully discussed in Note 1, the financial statements of Pittston Minerals Group should be read in connection with the audited consolidated financial statements of The Pittston Company and subsidiaries. As discussed in Notes 7, 13 and 16 to the financial statements, Pittston Minerals Group changed its methods of accounting for income taxes and accounting for postretirement benefits other than pensions in 1991. /s/ KPMG Peat Marwick KPMG Peat Marwick Stamford, Connecticut January 24, 1994 PITTSTON MINERALS GROUP BALANCE SHEETS December 31, 1993 and 1992 See accompanying notes to financial statements. PITTSTON MINERALS GROUP STATEMENTS OF OPERATIONS Years Ended December 31, 1993, 1992 and 1991 (In thousands, except per share amounts) See accompanying notes to financial statements. PITTSTON MINERALS GROUP STATEMENTS OF CASH FLOWS Years Ended December 31, 1993, 1992 and 1991 (In thousands) See accompanying notes to financial statements. PITTSTON MINERALS GROUP NOTES TO FINANCIAL STATEMENTS 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES BASIS OF PRESENTATION: The approval on July 26, 1993 (the "Effective Date"), by the shareholders of The Pittston Company (the "Company") of the Services Stock Proposal, as described in the Company's proxy statement dated June 24, 1993, resulted in the reclassification of the Company's common stock. The outstanding shares of Company common stock were redesignated as Pittston Services Group Common Stock ("Services Stock") on a share-for-share basis and a second class of common stock, designated as Pittston Minerals Group Common Stock ("Minerals Stock"), was distributed on the basis of one-fifth of one share of Minerals Stock for each share of the Company's previous common stock held by shareholders of record on July 26, 1993. Minerals Stock and Services Stock provide shareholders with separate securities reflecting the performance of the Pittston Minerals Group (the "Minerals Group") and the Pittston Services Group (the "Services Group") respectively, without diminishing the benefits of remaining a single corporation or precluding future transactions affecting either group. Accordingly, all stock and per share data prior to the reclassification have been restated to reflect the reclassification. The primary impacts of this restatement are as follows: o Net income per common share has been included in the Statements of Operations. For the purpose of computing net income per common share of Minerals Stock, the number of shares of Minerals Stock are assumed to be one-fifth of the total number of shares of the Company's common stock. o All financial impacts of purchases and issuances of the Company's common stock prior to the Effective Date have been attributed to each Group in relation of their respective common equity to the Company's common stock. Dividends paid by the Company were attributed to the Services and Minerals Groups in relation to the initial dividends paid on the Services Stock and the Minerals Stock. The Company, at any time, has the right to exchange each outstanding share of Minerals Stock for shares of Services Stock having a fair market value equal to 115% of the fair market value of one share of Minerals Stock. In addition, upon the sale, transfer, assignment or other disposition, whether by merger, consolidation, sale or contribution of assets or stock or otherwise, of all or substantially all of the properties and assets of the Minerals Group to any person, entity or group (with certain exceptions), the Company is required to exchange each outstanding share of Minerals Stock for shares of Services Stock having a fair market value equal to 115% of the fair market value of one share of Minerals Stock. Shares of Services Stock are not subject to either optional or mandatory exchange. Holders of Services Stock have one vote per share. Holders of Minerals Stock have one vote per share subject to adjustment on January 1, 1996, and on each January 1 every two years thereafter based upon the relative fair market values of one share of Minerals Stock and one share of Services Stock on each such date. Accordingly, beginning on January 1, 1996, each share of Minerals Stock may have more than, less than or continue to have exactly one vote. Holders of Services Stock and Minerals Stock vote together as a single voting group on all matters as to which all common shareholders are entitled to vote. In addition, as prescribed by Virginia law, certain amendments to the Company's Restated Articles of Incorporation affecting, among other things, the designation, rights, preferences or limitations of one class of common stock, or any merger or statutory share exchange, must be approved by the holders of such class of common stock, voting as a separate voting group, and, in certain circumstances, may also have to be approved by the holders of the other class of common stock, voting as a separate voting group. In the event of a dissolution, liquidation or winding up of the Company, the holders of Services Stock and Minerals Stock will receive the funds remaining for distribution, if any, to the common shareholders on a per share basis in proportion to the total number of shares of Services Stock and Minerals Stock, respectively, then outstanding to the total number of shares of both classes of common stock then outstanding. The Company's Articles of Incorporation limits dividends on Minerals Stock to the lesser of (i) all funds of the Company legally available therefore (as prescribed by Virginia law) and (ii) the Available Minerals Dividend Amount (as defined in the Articles of Incorporation). At December 31, 1993, the Available Minerals Dividend Amount was at least $10,054,000. After giving effect to the issuance of the Convertible Preferred Stock (Note 20), the pro forma Available Minerals Dividend Amount would have been at least $85,622,000. Dividends on Minerals Stock are also restricted by covenants in the Company's public indentures and bank credit agreements. In conjunction with the Services Stock Proposal, a new share repurchase program was approved whereby the Company could acquire up to 250,000 shares of Minerals Stock from time to time in the open market or in private transactions, as conditions warrant. Through December 31, 1993, 19,000 shares of Minerals Stock were repurchased under the new program at a total cost of $407,000. The program to acquire shares remains in effect in 1994. The financial statements of the Minerals Group include the balance sheets, results of operations and cash flows of the Coal and Mineral Ventures operations of the Company, and a portion of the Company's corporate assets and liabilities and related transactions which are not separately identified with operations of a specific segment (Note 2). The Minerals Group's financial statements are prepared using the amounts included in the Company's consolidated financial statements. Corporate allocations reflected in these financial statements are determined based upon methods which management believes to be an equitable allocation of such expenses and credits. The Company provides holders of Minerals Stock separate financial statements, financial reviews, descriptions of business and other relevant information for the Minerals Group in addition to consolidated financial information of the Company. Notwithstanding the attribution of assets and liabilities (including contingent liabilities) between the Minerals Group and the Services Group for the purpose of preparing their financial statements, this attribution and the change in the capital structure of the Company as a result of the approval of the Services Stock Proposal did not result in any transfer of assets and liabilities of the Company or any of its subsidiaries. Holders of Minerals Stock are shareholders of the Company, which continues to be responsible for all its liabilities. Therefore, financial developments affecting the Minerals Group or the Services Group that affect the Company's financial condition could affect the results of operations and financial condition of both Groups. Accordingly, the Company's consolidated financial statements must be read in connection with the Minerals Group's financial statements. PRINCIPLES OF COMBINATION: The accompanying financial statements reflect the accounts of the businesses comprising the Minerals Group. All material intercompany items and transactions have been eliminated in combination. Certain prior year amounts have been reclassified to conform to the current year's financial statement presentation. CASH AND CASH EQUIVALENTS: Cash and cash equivalents include cash on hand, demand deposits and investments with original maturities of three months or less. SHORT-TERM INVESTMENTS: Short-term investments primarily include funds set aside by management for certain obligations and are carried at cost which approximates market. INVENTORIES: Inventories are stated at cost (determined under the average cost method) or market, whichever is lower. PROPERTY, PLANT AND EQUIPMENT: Expenditures for maintenance and repairs are charged to expense, and the costs of renewals and betterments are capitalized. Depreciation is provided principally on the straight-line method at varying rates depending upon estimated useful lives. Depletion of bituminous coal lands is provided on the basis of tonnage mined in relation to the estimated total of recoverable tonnage in the ground. Mine development costs, primarily included in bituminous coal lands, are capitalized and amortized over the estimated useful life of the mine. These costs include expenses incurred for site preparation and development as well as operating deficits incurred at the mines during the development stage. A mine is considered under development until all planned production units have been placed in operation. INCOME TAXES: In 1991, the Minerals Group adopted Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes" ("SFAS 109"), which requires recognition of deferred tax liabilities and assets for the expected future tax consequences of events that have been included in the financial statements or tax returns. Under this method, deferred tax liabilities and assets are determined based on the difference between the financial statement and tax bases of assets and liabilities using enacted tax rates in effect for the year in which the differences are expected to reverse. See Note 2 for allocation of the Company's U.S. federal income taxes to the Minerals Group. PNEUMOCONIOSIS (BLACK LUNG) EXPENSE: The Minerals Group acts as self-insurer with respect to black lung benefits. Provision is made for estimated benefits in accordance with annual actuarial reports prepared by outside actuaries. The excess of the present value of expected future benefits over the accumulated book reserves is recognized over the amortization period as a level percentage of payroll. Cumulative actuarial gains or losses are calculated periodically and amortized on a straight-line basis. Assumptions used in the calculation of the actuarial present value of black lung benefits are based on actual retirement experience of the Company's coal employees, black lung claims incidence for active miners, actual dependent information, industry turnover rates, actual medical and legal cost experience and current inflation rates. As of December 31, 1993 and 1992, the accrued value of estimated future black lung benefits discounted at 6% was approximately $61,067,000 and $61,095,000, respectively and are included in workers' compensation and other claims. Based on actuarial data, the amount charged to earnings was $438,000 in 1993, $1,029,000 in 1992 and $3,113,000 in 1991. In addition, the Company accrued additional expenses for black lung benefits related to federal and state assessments, legal and administrative expenses and other self insurance. These amounted to $2,887,000 in 1993, $2,073,000 in 1992 and $2,435,000 in 1991. POSTRETIREMENT BENEFITS OTHER THAN PENSIONS: In 1991, the Minerals Group adopted Statement of Financial Accounting Standards No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions" ("SFAS 106"), which requires employers to accrue the cost of such retirement benefits during the employees' service with the Minerals Group. FOREIGN CURRENCY TRANSLATION: Assets and liabilities of foreign operations have been translated at current exchange rates, and related revenues and expenses have been translated at average rates of exchange in effect during the year. Resulting cumulative translation adjustments have been included as a separate component of shareholder's equity. FINANCIAL INSTRUMENTS: The Minerals Group hedges against downward movements in gold prices principally through the use of forward sales contracts. Gains and losses on these contracts, designated and effective as hedges, are deferred and recognized upon delivery of gold against these contracts. REVENUE RECOGNITION: Coal sales are generally recognized when coal is loaded onto transportation vehicles before shipment to customers. For domestic sales, this occurs when coal is loaded onto railcars at mine locations. For export sales, this occurs when coal is loaded onto marine vessels at terminal facilities. Gold sales are recognized when products are shipped to a refinery. Settlement adjustments arising from final determination of weights and assays are reflected in sales when received. NET INCOME PER COMMON SHARE: Net income per Pittston Minerals Group common share is computed by dividing the net income by the weighted average number of Pittston Minerals Group common shares outstanding during the period. The potential dilution from the exercise of stock options is not material. The shares of Minerals Stock held in The Pittston Company Employee Benefits Trust are evaluated for inclusion in the calculation of net income per Pittston Minerals Group common share under the treasury stock method and have no dilutive effect. 2. RELATED PARTY TRANSACTIONS The following policies may be modified or rescinded by action of the Company's Board of Directors (the "Board"), or the Board may adopt additional policies, without approval of the shareholders of the Company, although the Board has no present intention to do so. The Company allocated certain corporate general and administrative expenses, net interest expense and related assets and liabilities in accordance with the policies described below. Corporate assets and liabilities are primarily cash, deferred pension assets, income taxes and accrued liabilities. FINANCIAL: As a matter of policy, the Company manages most financial activities of the Minerals Group and the Services Group on a centralized, consolidated basis. Such financial activities include the investment of surplus cash; the issuance, repayment and repurchase of short-term and long-term debt; the issuance and repurchase of common stock and the payment of dividends. In preparing these financial statements for the three-year period ended December 31, 1993, transactions primarily related to invested cash, short-term and long-term debt (including convertible debt), related net interest and other financial costs have been attributed to the Minerals Group based upon its cash flows for the periods presented after giving consideration to the debt and equity structure of the Company. The portion of the Company's interest expense allocated to the Minerals Group for 1993, 1992 and 1991 was $359,000, $2,800,000 and $1,400,000, respectively. Management believes such method of allocation to be equitable and a reasonable estimate of such costs as if the Minerals Group operated on a stand alone basis. To the extent borrowings are deemed to occur between the Services Group and the Minerals Group, intercompany accounts have been established bearing interest at the rate in effect from time to time under the Company's unsecured credit lines or, if no such credit lines exist, at the prime rate charged by Chemical Bank from time to time. At December 31, 1993, the amount owed the Minerals Group by the Services Group as a result of borrowings totaled $13,266,000. SHARED SERVICES: A portion of the Company's corporate general and administrative expenses and other shared services has been allocated to the Minerals Group based upon utilization and other methods and criteria which management believes to be equitable and a reasonable estimate of such expenses as if the Minerals Group operated on a stand alone basis. These allocations were $7,218,000, $8,554,000 and $8,096,000 in 1993, 1992 and 1991, respectively. PENSION: The Minerals Group's pension cost related to its participation in the Company's noncontributory defined benefit pension plan is actuarially determined based on its respective employees and an allocable share of the pension plan assets and calculated in accordance with Statement of Financial Accounting Standards No. 87, "Employers' Accounting for Pensions" ("SFAS 87"). Pension plan assets have been allocated to the Minerals Group based on the percentage of its projected benefit obligation to the plan's total projected benefit obligation. Management believes such method of allocation to be equitable and a reasonable estimate of such costs as if the Minerals Group operated on a stand alone basis. INCOME TAXES: The Minerals Group is included in the consolidated U.S. federal income tax return filed by the Company. The Company's consolidated provision and actual cash payments for U.S. federal income taxes are allocated between the Minerals Group and Services Group in accordance with the Company's tax allocation policy and reflected in the financial statements for each Group. In general, the consolidated tax provision and related tax payments or refunds are allocated between the Groups, for financial statement purposes, based principally upon the financial income, taxable income, credits and other amounts directly related to the respective Group. Tax benefits that cannot be used by the Group generating such attributes, but can be utilized on a consolidated basis, are allocated to the Group that generated such benefits and an intercompany account is established for the benefit of the Group generating the attributes. At December 31, 1993 and 1992, the Minerals Group was owed $20,541,000 and $5,079,000, respectively, from the Services Group for such tax benefits, of which $14,709,000 and $2,918,000, respectively, was not expected to be received within one year from such dates in accordance with the policy. As a result, the allocated Group amounts of taxes payable or refundable are not necessarily comparable to those that would have resulted if the Groups had filed separate tax returns. 3. SHAREHOLDER'S EQUITY The following analyzes shareholder's equity of the Minerals Group for the periods presented: Included in shareholder's equity is the cumulative foreign currency translation adjustment of $1,086,000, $871,000 and $271,000 at December 31, 1993, 1992 and 1991, respectively. 4. PROPERTY, PLANT AND EQUIPMENT Mine development costs which were capitalized totalled $2,181,000 in 1993, $18,487,000 in 1992 and $12,167,000 in 1991. The estimated useful lives for property, plant and equipment are as follows: Depreciation of property, plant and equipment aggregated $23,245,000 in 1993, $19,268,000 in 1992 and $15,999,000 in 1991. 5. ACCOUNTS RECEIVABLE - TRADE In 1991, the Company, on behalf of the Minerals Group, entered into agreements with two financial institutions whereby it had the right to sell certain coal receivables, with recourse, to those institutions. One agreement expired on June 30, 1992. The other agreement, which expires September 27, 1994, limits the maximum amount of outstanding receivables that could be owned by the financial institution to $20,000,000. The Minerals Group sold total coal receivables of approximately $16,143,000 in 1993, $23,959,000 in 1992 and $2,776,000 in 1991 under these agreements. In 1985, the Company, on behalf of the Minerals Group, entered into an agreement whereby it had the right to sell certain coal receivables, with limited recourse, to a financial institution from time to time until December 31, 1991. During 1992, the Minerals Group continued to sell certain coal receivables to the financial institution under essentially the same terms and conditions as the expired agreement. The Minerals Group sold total coal receivables of approximately $41,272,000 in 1992 and $10,706,000 in 1991 under this agreement, which has since been terminated. As of December 31, 1993, there were no receivables sold which remained to be collected. As of December 31, 1992, receivables sold totalling $11,987,000 remained to be collected. 6. FINANCIAL INSTRUMENTS Financial instruments which potentially subject the Minerals Group to concentrations of credit risk consist principally of cash and cash equivalents, short-term investments and trade receivables. The Minerals Group's cash and cash equivalents and short-term investments are placed with high credit qualified financial institutions. Also, by policy, the amount of credit exposure to any one financial institution is limited. The Minerals Group makes substantial sales to relatively few large customers. Credit limits, ongoing credit evaluation and account monitoring procedures are utilized to minimize the risk of loss from nonperformance on trade receivables. The following details the fair values of financial instruments for which it is practicable to estimate the value: CASH AND CASH EQUIVALENTS AND SHORT-TERM INVESTMENTS The carrying amounts approximate fair value because of the short maturity of these instruments. DEBT The aggregate fair value of the Minerals Group's long term debt obligations, which is based upon quoted market prices and rates currently available to the Company for debt with similar terms and maturities, approximates the carrying amount. OFF-BALANCE SHEET INSTRUMENTS The Minerals Group utilizes off-balance sheet financial instruments, as discussed below, to hedge its foreign currency and other market exposures. Accordingly, the fair value of these instruments have been considered in determining the fair values of the assets and liabilities being hedged. The risk that counterparties to these contracts may be unable to perform is minimized by limiting the counterparties to major international banks. The Company does not expect any losses due to such counterparty default. In order to protect itself against downward movements in gold prices, the Minerals Group hedges a portion of its recoverable proved and probable reserves primarily through forward sales contracts. At December 31, 1993, 72,000 ounces of gold, representing approximately 50% of the Minerals Group's recoverable proved and probable reserves, were sold forward under forward sales contracts at an average price of $350 per ounce. Because only a portion of its future production is currently sold forward, the Minerals Group can take advantage of increases, if any, in the spot price of gold. At December 31, 1993, the aggregate carrying value of the Minerals Group's forward sales contracts exceeded their fair value by approximately $2,900,000. 7. INCOME TAXES The provision (credit) for income taxes consists of the following: Effective January 1, 1991, the Minerals Group adopted SFAS 109, which requires recognition of deferred tax liabilities and assets for the expected future tax consequences of events that have been included in the financial statements or tax returns. Under this method, deferred tax liabilities and assets are determined based on the difference between the financial statement and tax bases of assets and liabilities using enacted tax rates in effect for the year in which the differences are expected to reverse. As of January 1, 1991, the Minerals Group recorded a tax credit of approximately $6,396,000, or $.86 per share, which amount represents the net decrease to the deferred tax liability as of that date. Such amount has been reflected in the statement of operations as the cumulative effect of an accounting change. For the years ended December 31, 1993 and 1991, cash payments for income taxes, net of refunds received, were $2,461,000 and $4,295,000, respectively. For the year ended December 31, 1992, there was a net cash tax refund of $6,962,000. The significant components of the deferred tax expense (benefit) were as follows: The tax benefit for compensation expense related to the exercise of certain employee stock options for tax purposes in excess of compensation expense for financial reporting purposes is recognized as an adjustment to shareholder's equity. The components of the net deferred tax asset as of December 31, 1993, and December 31, 1992, were as follows: The recording of net deferred federal tax assets is based upon their expected utilization in the Company's consolidated federal income tax return and the benefit that would accrue to the Minerals Group under the Company's tax allocation policy. The valuation allowance relates to deferred tax assets in certain foreign and state jurisdictions. The following table accounts for the difference between the actual tax provision and the amounts obtained by applying the statutory U.S. federal income tax rate of 35% in 1993 and 34% in 1992 and 1991 to the income (loss) before income taxes. It is the policy of the Minerals Group to accrue deferred income taxes on temporary differences related to the financial statement carrying amounts and tax bases of investments in foreign subsidiaries and affiliates which are expected to reverse in the foreseeable future. As of December 31, 1993 and December 31, 1992, there was no unrecognized deferred tax liability for temporary differences related to investments in foreign subsidiaries and affiliates. The Minerals Group is included in the Company's consolidated U.S. federal income tax return. Such returns have been audited and settled with the Internal Revenue Service through the year 1981. As of December 31, 1993, the Minerals Group had $22,079,000 of alternative minimum tax credits allocated to it under the Company's tax allocation policy. Such credits are available to offset future U.S. federal income taxes and, under current tax law, the carryforward period for such credits is unlimited. The tax benefit of net operating loss carryforwards for the Minerals Group as at December 31, 1993 was $1,682,000 primarily related to foreign operations which have an unlimited carryforward period. 8. LONG-TERM DEBT At December 31, 1993, $309,000 of debt outstanding was directly incurred by the Minerals Group. At December 31, 1993 and 1992, none of the Company's long-term debt was attributed to the Minerals Group. Any borrowings by the Company for the benefit of the Minerals Group are directly attributed to it. See the Company's consolidated financial statements and related footnotes for additional discussions of the Company's long-term debt and various financial covenants related to debt agreements. At December 31, 1993, the Company had separate revolving credit agreements with several banks under which it is permitted to borrow, repay and reborrow up to an aggregate of $250,000,000. Interest is payable at rates based on prime, certificate of deposit, Eurodollar, money market or Federal Funds rates. The agreements, which have various expiration dates beginning in December 1994 and continuing through December 1997, include provisions under which borrowings are converted to term loans with various repayment dates. In March 1994, the Company entered into a $350,000,000 syndicated revolving credit agreement with a syndicate of banks (the "New Facility"), replacing the Company's previously existing $250,000,000 of revolving credit agreements. The New Facility includes a $100,000,000 five-year term loan, which matures in March 1999. The New Facility also permits additional borrowings, repayments and reborrowings of up to an aggregate of $250,000,000 until March 1999. Interest on borrowings under the New Facility is payable at rates based on prime, certificate of deposit, Eurodollar or money market rates. At December 31, 1993, the Company's portion of outstanding unsecured letters of credit allocated to the Minerals Group was $41,111,000, primarily supporting its obligations under its various self-insurance programs. Cash payments made for interest for the years ended December 31, 1993, 1992 and 1991 were $2,126,000, $2,637,000 and $2,875,000, respectively. 9. STOCK OPTIONS The Company grants options under its 1988 Stock Option Plan (the "1988 Plan") to executives and key employees and under its Non-Employee Directors' Stock Option Plan (the "Non-Employee Plan") to outside directors to purchase common stock at a price not less than 100% of quoted market value at date of grant. The 1988 Plan provides for the grant of "incentive stock options", which terminate not later than ten years from the date of grant, and "nonqualified stock options", which terminate not later than ten years and two days from the date of grant. As part of the Services Stock Proposal (Note 1), the 1988 Plan was amended to permit option grants to be made to optionees with respect to either Services Stock or Minerals Stock, or both. The Non-Employee Plan authorizes initial and automatic grants of "nonqualified stock options" which terminate on the tenth anniversary of grant. Pursuant to the Non-Employee Plan, also amended for the Services Stock Proposal, each non-employee director of the Company elected after July 26, 1993, shall receive an initial grant of an option to purchase 10,000 shares of Services Stock and an option to purchase 2,000 shares of Minerals Stock. On July 1 of each subsequent year, each non-employee director will automatically be granted an option to purchase 1,000 shares of Services Stock and an option to purchase 200 shares of Minerals Stock. The first of such automatic grants was made on August 1, 1993. The Company's 1979 Stock Option Plan (the "1979 Plan") and 1985 Stock Option Plan (the "1985 Plan") terminated in 1985 and 1988, respectively, except as to options theretofore granted. At the Effective Date, as defined in Note 1, a total of 2,228,225 shares of common stock were subject to options outstanding under the 1988 Plan, the Non-Employee Plan, the 1979 Plan and the 1985 Plan. Pursuant to antidilution provisions in the option agreements covering such options, the Company has converted these options into options for shares of Services Stock or Minerals Stock, or both, depending primarily on the employment status and responsibilities of the particular optionee. In the case of optionees having Company-wide responsibilities, each outstanding option has been converted into an option for Services Stock and an option for Minerals Stock, in the same ratio as the distribution on the Effective Date of Minerals Stock to shareholders of the Company, viz., one share to one-fifth of the share, with any resultant fractional share of Minerals Stock rounded downward to the nearest whole number of shares. In the case of other optionees, each outstanding option has been converted into a new option for only Services Stock or Minerals Stock, as the case may be, following the Effective Date. As a result, 2,167,247 shares of Services Stock and 507,698 shares of Minerals Stock were subject to options outstanding as of the Effective Date. The table below summarizes the activity in all plans. At December 31, 1993, total of 240,814 shares of Minerals Stock were exercisable. In addition, there were 640,298 shares of Minerals Stock reserved for issuance under the plans, including 16,800 shares of Minerals Stock reserved for future grant. 10. ACQUISITIONS During 1993, the Minerals Group made installment and contingency payments related to acquisitions consummated in prior years. Total consideration paid was $699,000. During 1992, the Minerals Group acquired two businesses for an aggregate purchase price of $45,142,000, including installment payments to be made of $1,720,000. Of the total purchase price, $42,734,000 was for the purchase of a company whose principal assets include two long-term coal supply contracts. The fair value of assets acquired was $48,168,000 and liabilities assumed was $3,026,000. The acquisitions have been accounted for as purchases and the purchase price was essentially equal to the fair value of net assets acquired. In addition, the Minerals Group made cash payments of $7,398,000 for an equity investment. During 1991, the Minerals Group made a contingency payment of $735,000 related to an acquisition consummated in a prior year. The results of operations of the acquired companies have been included in the Minerals Group's results of operations from their date of acquisition. 11. JOINT VENTURE The Minerals Group, through a wholly owned indirect subsidiary of the Company, entered into a partnership agreement in 1982 with four other coal companies to construct and operate coal port facilities in Newport News, Virginia, in the Port of Hampton Roads (the "Facilities"). The Facilities commenced operations in 1984, and now have an annual throughput capacity of 22 million tons, with a ground storage capacity of approximately 2 million tons. The Minerals Group initially had an indirect 25% interest in the partnership, Dominion Terminal Associates ("DTA"). Initial financing of the Facilities was accomplished through the issuance of $135,000,000 principal amount of revenue bonds by the Peninsula Ports Authority of Virginia (the "Authority"), which is a political subdivision of the Commonwealth of Virginia. In 1987, the original revenue bonds were refinanced by the issuance of $132,800,000 of coal terminal revenue refunding bonds of which two series of these bonds in the aggregate principal amount of $33,200,000 were attributable to the Minerals Group. In 1990, the Minerals Group acquired an additional indirect 7 1/2% interest in DTA for cash of $3,055,000 plus the assumption of bond indebtedness, increasing its ownership to 32 1/2%. With the increase in ownership, $9,960,000 of the remaining four additional series of the revenue refunding bonds of $99,600,000 became attributable to the Minerals Group. In November 1992, all bonds attributable to the Minerals Group were refinanced with the issuance of a new series of coal terminal revenue refunding bonds in the aggregate principal amount of $43,160,000. The new series of bonds bear a fixed interest rate of 7 3/8%. The Authority owns the Facilities and leases them to DTA for the life of the bonds, which mature on June 1, 2020. DTA may purchase the facilities for $1 at the end of the lease term. The obligations of the partners are several, and not joint. Under loan agreements with the Authority, DTA is obligated to make payments sufficient to provide for the timely payment of the principal of and interest on the bonds of the new series. Under a throughput and handling agreement, the Minerals Group has agreed to make payments to DTA that in the aggregate will provide DTA with sufficient funds to make the payments due under the loan agreements and to pay the Minerals Group's share of the operating costs of the Facilities. The Company has also unconditionally guaranteed the payment of the principal of and premium, if any, and the interest on the new series of bonds. Payments for operating costs aggregated $7,949,000 in 1993, $6,819,000 in 1992 and $6,885,000 in 1991. The Minerals Group has the right to use 32 1/2% of the throughput and storage capacity of the Facilities subject to user rights of third parties which pay the Minerals Group a fee. The Minerals Group pays throughput and storage charges based on actual usage at per ton rates determined by DTA. 12. LEASES The Minerals Group's businesses lease coal mining and other equipment under long-term operating leases with varying terms, and most of the leases contain renewal and/or purchase options. As of December 31, 1993, aggregate future minimum lease payments under noncancellable operating leases were as follows: The above amounts are net of aggregate future minimum noncancellable sublease rentals of $87,000. Almost all of the above amounts related to equipment are guaranteed by the Company. Rent expense amounted to $24,854,000 in 1993, $25,570,000 in 1992 and $26,181,000 in 1991 and is net of sublease rentals of $69,000 in each year. 13. EMPLOYEE BENEFIT PLANS The Minerals Group's businesses participate in the Company's noncontributory defined benefit pension plan covering substantially all nonunion employees who meet certain minimum requirements. Benefits under the plan are based on salary and years of service. The Minerals Group's pension cost is actuarially determined based on its employees and an allocable share of the pension plan assets. The Company's policy is to fund the actuarially determined amounts necessary to provide assets sufficient to meet the benefits to be paid to plan participants in accordance with applicable regulations. The net pension credit for 1993, 1992 and 1991 for the Minerals Group is as follows: The Minerals Group's allocated funded status and deferred pension assets at December 31, 1993 and 1992 are as follows: The assumptions used in determining the net pension credit for the Company's major pension plan for 1993, 1992 and 1991 were as follows: For the valuation of pension obligations and the calculation of the funded status, the discount rate was 7.5% in 1993 and 9.0% in 1992 and 1991. The expected long-term rate of return on assets was 10% in all years presented. The rate of increase in compensation levels used was 4% in 1993 and 5% in 1992 and 1991. The unrecognized initial net asset at January 1, 1986, the date of adoption of SFAS 87, has been amortized over the estimated remaining average service life of the employees, which period ended at December 31, 1992. As of December 31, 1993, approximately 73% of plan assets were invested in equity securities and 27% in fixed income securities. Under the 1990 collective bargaining agreement with the United Mine Workers of America ("UMWA"), the Minerals Group has made payments, based on hours worked, into escrow accounts established for the benefit of union employees (Note 18). The Minerals Group's coal operations recognized pension expense of $1,799,000 in 1993, $2,457,000 in 1992 and $2,273,000 in 1991 under the terms of the agreement. The total amount accrued at December 31, 1993 and 1992 under these escrow agreements was $21,064,000 and $20,184,000, respectively, and is included in miscellaneous accrued liabilities. The Minerals Group also provides certain postretirement health care and life insurance benefits for eligible active and retired employees in the United States. Effective January 1, 1991, the Minerals Group adopted SFAS 106, which requires the accrual method of accounting for postretirement health care and life insurance benefits based on actuarially determined costs to be recognized over the period from the date of hire to the full eligibility date of employees who are expected to qualify for such benefits. As of January 1, 1991, the Minerals Group recognized the full amount of its estimated accumulated postretirement benefit obligation on that date, which represents the present value of the estimated future benefits payable to current retirees and a pro rata portion of estimated benefits payable to active employees after retirement. The pretax charge to 1991 earnings was $196,360,000 with a net earnings effect of $129,724,000 or $17.40 per share. The latter amount has been reflected in the statement of operations as the cumulative effect of an accounting change. For the years 1993, 1992 and 1991, the components of periodic expense for these postretirement benefits were as follows: The interest costs on the accumulated postretirement benefit obligation was 9% for all years presented. At December 31, 1993 and 1992, the actuarial and recorded liabilities for these postretirement benefits, none of which have been funded, were as follows: The accumulated postretirement benefit obligation was determined using the unit credit method and an assumed discount rate of 7.5% in 1993 and 9.0% in 1992. The assumed health care cost trend rate used in 1993 was 10% for pre-65 retirees, grading down to 5% in the year 2000. For post-65 retirees, the assumed trend rate in 1993 was 8%, grading down to 5% in the year 2000. The assumed medicare cost trend rate used in 1993 was 7%, grading down to 5% in the year 2000. A one percent increase each year in the health care cost trend rate used would have resulted in a $3,297,000 increase in the aggregate service and interest components of expense for the year 1993, and a $35,421,000 increase in the accumulated postretirement benefit obligation at December 31, 1993. The Minerals Group also participates in the Company's Savings-Investment Plan to assist eligible employees in providing for retirement or other future financial needs. Employee contributions are matched up to 5% of compensation (subject to certain limitations imposed by the Internal Revenue Code of 1986, as amended). Contribution expense under the plan aggregated $2,021,000 in 1993, $2,059,000 in 1992 and $1,864,000 in 1991. The Minerals Group sponsors two other defined contribution plans and contributions under these plans aggregated $475,000 in 1993, $420,000 in 1992 and $637,000 in 1991. In October 1992, the Coal Industry Retiree Health Benefit Act of 1992 (the "Health Benefit Act") was enacted as part of the Energy Policy Act of 1992. The Health Benefit Act established new rules for the payment of future health care benefits for thousands of retired union mine workers and their dependents. Part of the burden for these payments has been shifted by the Health Benefit Act from certain coal producers, which had a contractual obligation to fund such payments, to producers such as the Company which have collective bargaining agreements with the UMWA that do not require such payments and to numerous other companies which are no longer in the coal business. The Health Benefit Act established a trust fund to which "signatory operators" and "related persons," including the Company and certain of its coal subsidiaries (the "Pittston Companies") would be obligated to pay annual premiums for assigned beneficiaries, together with a pro rata share for certain beneficiaries who never worked for such employers ("unassigned beneficiaries"), in amounts to be determined by the Secretary of Health and Human Services on the basis set forth in the Health Benefit Act. In October 1993, the Pittston Companies received notices from the Social Security Administration (the "SSA") with regard to their assigned beneficiaries for which they are responsible under the Health Benefit Act; the Pittston Companies also received a calculation of their liability for the first two years. For 1993 and 1994, this liability (on a pretax basis) is approximately $9,100,000 and $11,000,000, respectively. The Company believes that the annual liability under the Health Benefit Act for the Pittston Companies' assigned beneficiaries will continue in the $10,000,000 to $11,000,000 range for the next ten years and should begin to decline thereafter as the number of such assigned beneficiaries decreases. Based on the number of beneficiaries actually assigned by the SSA, the Company estimates the aggregate pretax liability relating to the Pittston Companies' assigned beneficiaries at approximately $265-$275 million, which when discounted at 8% provides a present value estimate of approximately $100-$110 million. The ultimate obligation that will be incurred by the Company could be significantly affected by, among other things, increased medical costs, decreased number of beneficiaries, governmental funding arrangements and such federal health benefit legislation of general application as may be enacted. In addition, the Health Benefit Act requires the Pittston Companies to fund, pro rata according to the total number of assigned beneficiaries, a portion of the health benefits for unassigned beneficiaries. At this time, the funding for such health benefits is being provided from another source and for this and other reasons the Pittston Companies' ultimate obligation for the unassigned beneficiaries cannot be determined. The Company accounts for its obligations under the Health Benefit Act as a participant in a multi-employer plan and recognizes the annual cost on a pay-as-you-go basis. The Minerals Group is required to implement a new accounting standard for postemployment benefits, Statement of Financial Accounting Standards No. 112, "Employers' Accounting for Postemployment Benefits" ("SFAS 112") in 1994. This standard requires employers who provide benefits to former employees after employment but before retirement to accrue such costs as the benefits accumulate or vest. The Minerals Group has determined that the cumulative effect of adopting SFAS 112 is immaterial. 14. RESTRUCTURING AND OTHER CHARGES Operating results include restructuring and other charges of $78,633,000 in 1993 and $115,214,000 in 1991 which have been recognized in the statements of operations. The 1993 charges relate to mine closing costs including employee benefit costs and certain other noncash charges, together with the estimated liabilities in connection with previously reported litigation (the so-called "Evergreen Case") brought against the Company and a number of its coal subsidiaries by the trustees of certain pension and benefit trust funds established under collective bargaining agreements with the UMWA (Note 18). These charges impacted Coal and Mineral Ventures operating profit in the amount of $70,713,000 and $7,920,000, respectively. The charge in the Coal segment in 1993 consists of closing costs for mines which were closed at the end of 1993 and for scheduled closures of mines in early 1994, including employee severance and other benefit costs and estimated liabilities regarding the Evergreen Case. The charge in the Mineral Ventures segment in 1993 related to the write-down of the Minerals Group's investment in the Uley graphite mine in Australia. Although reserve drilling of the Uley property indicates substantial graphite deposits, processing difficulties, depressed graphite prices which have remained significantly below the level prevailing at the start of the project and an analysis of various technical and marketing conditions affecting the project resulted in the determination that the assets have been impaired and that loss recognition was appropriate. Of the total amount of 1993 charges, $10,846,000 was for noncash write-downs of assets and the remainder represents liabilities, of which $7,015,000 are expected to be paid in 1994. The Minerals Group intends to fund any cash requirements during 1994 and thereafter with anticipated cash flows from operating activities with shortfalls, if any, financed through borrowings under revolving credit agreements or short-term borrowing arrangements. The 1991 charge impacted Coal segment operations and primarily related to costs associated with coal mine shutdowns. Of the total charge, $14,415,000 was for noncash asset write-downs. 15. OTHER INCOME AND EXPENSE Other operating income includes gains aggregating $5,846,000 in 1991 from the disposal of certain excess coal reserves which increased net income by $.51 per share. In addition, other operating income primarily includes coal royalty income generated from coal and natural gas properties owned by the Minerals Group. Other income includes gains aggregating $2,341,000 in 1992 and $11,102,000 in 1991 from the sale of investments in leveraged leases which increased net income by $.37 per share in 1992 and $1.11 per share in 1991. 16. ACCOUNTING CHANGES During 1991, the Minerals Group adopted two changes in accounting principles in connection with the issuance of two accounting standards by the Financial Accounting Standards Board. The effect of these changes on the statement of operations as of January 1, 1991, the date of adoption, has been recognized as the cumulative effect of accounting changes as follows: 17. SEGMENT INFORMATION Net sales by geographic area are as follows: The following is derived from the business segment information in the Company's consolidated financial statements as it relates to the Minerals Group. See Note 2, Related Party Transactions, for a description of the Company's policy for corporate allocations. The Minerals Group's portion of the Company's operating profit is as follows: * Operating profit (loss) includes restructuring and other charges aggregating $78,633,000 in 1993, of which $70,713,000 is included in the United States and $7,920,000 is included in Australia, and $115,214,000 in 1991, all of which is included in the United States (Note 14). The Minerals Group's portion of the Company's assets at year end is as follows: Industry segment information is as follows: * Operating profit (loss) of the Coal segment includes restructuring and other charges of $70,713,000 in 1993 and $115,214,000 in 1991 (Note 14). Operating loss of the Mineral Ventures segment includes restructuring and other charges of $7,920,000 in 1993 (Note 14). In 1993, 1992 and 1991, net sales to one customer of the Coal segment amounted to $106,253,000, $86,319,000 and $51,823,000, respectively. 18. LITIGATION In 1988, the trustees of certain pension and benefit trust funds established under collective bargaining agreements with the UMWA brought an action (the so-called "Evergreen Case") against the Company and a number of its coal subsidiaries in the United States District Court for the District of Columbia, claiming that the defendants are obligated to contribute to such trust funds in accordance with the provisions of the 1988 National Bituminous Coal Wage Agreement, to which neither the Company nor any of its subsidiaries is a signatory. In January 1992, the Court issued an order granting summary judgment in favor of the trustees on the issue of liability, which was thereafter affirmed by the Court of Appeals. In June 1993 the United States Supreme Court denied a petition for a writ of certiorari. The case has been remanded to District Court, and damage and other issues remain to be decided. In September 1993, the Company filed a motion seeking relief from the District Court's grant of summary judgment based on, among other things, the Company's allegations that plaintiffs improperly withheld evidence that directly refutes plaintiffs' representations to the District Court and the Court of Appeals in this case. In December 1993, that motion was denied. In furtherance of its ongoing effort to identify other available legal options for seeking relief from what it believes to be an erroneous finding of liability in the Evergreen Case, the Company has filed suit against the Bituminous Coal Operators Association and others to hold them responsible for any damages sustained by the Company as a result of the Evergreen Case. Although the Company is continuing that effort, the Company, following the District Court's ruling in December 1993, recognized the potential liability that may result from an adverse judgment in the Evergreen Case (Note 14). In any event, any final judgment in the Evergreen Case will be subject to appeal. As a result of the Health Benefit Act (Note 13), there is no continuing liability in this case in respect of health benefit funding after February 1, 1993. In April 1990 the Company entered into a settlement agreement to resolve certain environmental claims against the Company arising from hydrocarbon contamination at a petroleum terminal facility ("Tankport") in Jersey City, New Jersey, which operations were sold in 1983. Under the settlement agreement, the Company is obligated to pay 80% of the remediation costs. Based on data available to the Company and its environmental consultants, the Company estimates its portion of the cleanup costs on an undiscounted basis using existing technologies to be between $4.5 million and $13.5 million over a period of three to five years. Management is unable to determine that any amount within that range is a better estimate due to a variety of uncertainties, which include the extent of the contamination at the site, the permitted technologies for remediation and the regulatory standards by which the cleanup will be measured by the New Jersey Department of Environmental Protection and Energy. The Company commenced insurance coverage litigation in 1990, in the United States District Court for the District of New Jersey, seeking a declaratory judgment that all amounts payable by the Company pursuant to the Tankport obligation were reimbursable under comprehensive general liability and pollution liability policies maintained by the Company. Although the underwriters have disputed this claim, management and its legal counsel believe that recovery is probable of realization in the full amount of the claim. This conclusion is based upon, among other things, the nature of the pollution policies which were broadly designed to cover such contingent liabilities, the favorable state of the law in the State of New Jersey (whose laws have been found to control the interpretation of the policies), and numerous other factual considerations which support the Company's analysis of the insurance contracts and rebut many of the underwriters' defenses. Accordingly, since management and its legal counsel believe that recovery is probable of realization in the full amount of the claim, there is no net liability in regard to the Tankport obligation. 19. COMMITMENTS At December 31, 1993, the Minerals Group had contractual commitments to purchase coal which is primarily used to blend with company mined coal. Based on the contract provisions these commitments are currently estimated to aggregate approximately $195,790,000 and expire from 1994 through 1998 as follows: The 1994 amount includes a commitment of $23,250,000 relating to a purchase contract with Addington Resources, Inc. ("Addington"). This contract was part of the coal mining operations of Addington acquired in 1994 (Note 20). A new commitment totaling $127,920,000 over approximately four years was entered into with operations of Addington which were not part of the acquisition. Purchases under the contracts were $81,069,000 in 1993, $74,331,000 in 1992, $58,155,000 in 1991. 20. SUBSEQUENT EVENT In January 1994, a wholly owned indirect subsidiary of the Company completed the acquisition of substantially all of the coal mining operations and coal sales contracts of Addington for $157 million, subject to certain purchase price adjustments. The acquisition will be accounted for as a purchase; accordingly, the purchase price has been allocated to the underlying assets and liabilities based on their respective estimated fair values at the date of acquisition. Such allocation has been based on preliminary estimates which may be revised at a later date. The excess of the purchase price over the fair value of the assets acquired and liabilities assumed was approximately $77 million. The acquisition was financed by the issuance of $80.5 million of a new series of the Company's preferred stock convertible into Minerals Stock, described below, and additional debt under existing credit facilities. This financing will be attributed to the Minerals Group. In March 1994, the additional debt incurred for this acquisition was refinanced with a five-year term loan under the New Facility (Note 8). In January 1994, the Company issued 161,000 shares of its $31.25 Series C Cumulative Convertible Preferred Stock, par value $10 per share (the "Convertible Preferred Stock"). The Convertible Preferred Stock pays an annual cumulative dividend of $31.25 per share payable quarterly, in cash, in arrears, out of all funds of the Company legally available therefor, when, as and if declared by the Board and bears a liquidation preference of $500 per share, plus an amount equal to accrued and unpaid dividends thereon. Each share of the Convertible Preferred Stock is convertible at the option of the holder at any time after March 11, 1994, unless previously redeemed or, under certain circumstances, called for redemption, into shares of Minerals Stock at a conversion price of $32.175 per share of Minerals Stock, subject to adjustment in certain circumstances. Except under certain circumstances, the Convertible Preferred Stock is not redeemable prior to February 1, 1997. On and after such date, the Company may at its option, redeem the Convertible Preferred Stock, in whole or in part, for cash initially at a price of $521.875 per share, and thereafter at prices declining ratably annually on each February 1 to an amount equal to $500.00 per share on and after February 1, 2004, plus in each case an amount equal to accrued and unpaid dividends on a date of redemption. Except under certain circumstances or as prescribed by Virginia law, shares of the Convertible Preferred Stock are nonvoting. The following table presents, on a pro forma basis, a condensed consolidated balance sheet of the Minerals Group at December 31, 1993, giving effect to the acquisition as if it had occurred on that date. The acquisition will be included in the Minerals Group's statements of operations beginning in 1994. The following pro forma results, however, assume that the acquisition had occurred at the beginning of 1993. The unaudited pro forma data below are not necessarily indicative of results that would have occurred if the transaction were in effect for the year ended December 31, 1993, nor are they indicative of the future results of operations of the Minerals Group. 21. SELECTED QUARTERLY FINANCIAL DATA (UNAUDITED) Tabulated below are certain data for each quarter of 1993 and 1992. Net income (loss) includes fourth quarter 1993 restructuring and other charges of $78,633,000 (Note 14). Net income in the fourth quarter of 1992 includes gains of $2,341,000 from the sale of leveraged leases (Note 15). Item 9:

Item 9: Changes in and Disagreements with Accountants on Accounting and Financial Disclosure Not applicable. PART III Item 10:

Item 10: Directors and Executive Officers of the Registrant The information required by this Item regarding directors is incorporated by reference to Pittston's definitive proxy statement to be filed pursuant to Regulation 14A within 120 days after December 31, 1993. The information regarding executive officers is included in this report following Item 4, under the caption "Executive Officers of the Registrant." Item 11:

Item 11: Executive Compensation Item 12:

Item 12: Security Ownership of Certain Beneficial Owners and Management Item 13:

Item 13: Certain Relationships and Related Transactions The information required by Items 11 through 13 is incorporated by reference to Pittston's definitive proxy statement to be filed pursuant to Regulation 14A within 120 days after December 31, 1993. PART IV Item 14:

Item 14: Exhibits, Financial Statement Schedules and Reports on Form 8-K (a) 1. All financial statements - see index to financial statements and schedules 2. Financial statement schedules - see index to financial statements and schedules 3. Exhibits - see exhibit index (b) Reports on Form 8-K were filed as follows: 1. Report filed December 13, 1993, with respect to amendment of the Company's bylaws. 2. Report filed December 20, 1993, with respect to the Company's announcement of the acquisition of Addington Resources, Inc. 3. Report filed December 22, 1993, with respect to the Company's acquisition of Addington Resources, Inc. Undertaking For the purposes of complying with the amendments to the rules governing Form S-8 (effective July 13, 1990) under the Securities Act of 1933, the undersigned Registrant hereby undertakes as follows, which undertaking shall be incorporated by reference into Registrant's Registration Statements on Form S-8 Nos. 2-64258, 33-2039, 33-21393, 33-23333 and 33-69040: Insofar as indemnification for liabilities arising under the Securities Act of 1933 may be permitted to directors, officers and controlling persons of the Registrant pursuant to the foregoing provisions, or otherwise, the Registrant has been advised that in the opinion of the Securities and Exchange Commission such indemnification is against public policy as expressed in the Securities Act of 1933 and is, therefore, unenforceable. In the event that a claim for indemnification against such liabilities (other than the payment by the Registrant of expenses incurred or paid by a director, officer or controlling person of the Registrant in the successful defense of any action, suit or proceeding) is asserted by such director, officer or controlling person in connection with the securities being registered, the Registrant will, unless in the opinion of its counsel the matter has been settled by controlling precedent, submit to a court of appropriate jurisdiction the question whether such indemnification by it is against public policy as expressed in the Act and will be governed by the final adjudication of such issue. SIGNATURES Pursuant to the requirements of Section 13 or 15(d) 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, on March 30, 1994. The Pittston Company (Registrant) By J. C. Farrell (J. C. Farrell, Chairman of the Board, President and Chief Executive Officer) Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant and in the capacities indicated, on March 30, 1994. Signatures Title R. G. Ackerman* Director M. J. Anton* Director J. R. Barker* Director J. L. Broadhead* Director W. F. Craig* Director J. C. Farrell Director and Chairman of (J. C. Farrell) the Board, President and Chief Executive Officer (principal executive officer) C. F. Haywood* Director E. G. Jordan* Director D. L. Marshall* Director and Vice Chairman of the Board G. R. Rogliano Vice President -Controllership (G. R. Rogliano) and Taxes (principal accounting officer) R. H. Spilman* Director R. G. Stone, Jr.* Director A. H. Zimmerman* Director *By J. C. Farrell (J. C. Farrell, Attorney-in-Fact) The Registrant does not have any designated principal financial officer. Index to Financial Statements and Schedules THE PITTSTON COMPANY AND SUBSIDIARIES Statement of Management Responsibility Independent Auditors' Report Consolidated Balance Sheets Consolidated Statements of Operations Consolidated Statements of Shareholders' Equity Consolidated Statements of Cash Flows Notes to Consolidated Financial Statements PITTSTON SERVICES GROUP Statement of Management Responsibility Independent Auditors' Report Consolidated Balance Sheets Consolidated Statements of Operations Consolidated Statements of Cash Flows Notes to Consolidated Financial Statements PITTSTON MINERALS GROUP Statement of Management Responsibility Independent Auditors' Report Consolidated Balance Sheets Consolidated Statements of Operations Consolidated Statements of Cash Flows Notes to Consolidated Financial Statements Financial Statement Schedules: Independent Auditors' Report on Financial Statement Schedules THE PITTSTON COMPANY AND SUBSIDIARIES V - Property, Plant and Equipment VI - Accumulated Depreciation, Depletion and Amortization of Property, Plant and Equipment VIII - Valuation and Qualifying Accounts IX - Short-term Borrowings X - Supplementary Income Statement Information PITTSTON SERVICES GROUP VIII - Valuation and Qualifying Accounts IX - Short-term Borrowings X - Supplementary Income Statement Information PITTSTON MINERALS GROUP V - Property, Plant and Equipment VI - Accumulated Depreciation, Depletion and Amortization of Property, Plant and Equipment X - Supplementary Income Statement Information Schedules other than those listed above are omitted because they are not applicable or not required, or the information is included elsewhere in the financial statements. INDEPENDENT AUDITORS' REPORT THE BOARD OF DIRECTORS AND SHAREHOLDERS THE PITTSTON COMPANY Under date of January 24, 1994, we reported on the consolidated balance sheets of The Pittston Company and subsidiaries (the "Company") as of December 31, 1993 and 1992, and the related consolidated statements of operations, shareholders' equity and cash flows for each of the years in the three-year period ended December 31, 1993, the balance sheets of Pittston Services Group as of December 31, 1993 and 1992, and the related statements of operations and cash flows for each of the years in the three-year period ended December 31, 1993, and the balance sheets of Pittston Minerals Group as of December 31, 1993 and 1992, and the related statements of operations and cash flows for each of the years in the three-year period ended December 31, 1993, as contained in the 1993 Annual Report on Form 10-K of The Pittston Company. In connection with our audits of the aforementioned financial statements, we also audited the related financial statement schedules listed in the accompanying index. These financial statement schedules are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statement schedules based on our audits. In our opinion, the Company's financial statement schedules, when considered in relation to the basic consolidated financial statements of the Company taken as a whole, and the Groups' financial statement schedules, when considered in relation to the respective basic financial statements of Pittston Services Group and Pittston Minerals Group taken as a whole, present fairly, in all material respects, the information set forth therein. Our reports for Pittston Services Group and Pittston Minerals Group contain an explanatory paragraph that states that the financial statements of Pittston Services Group and Pittston Minerals Group should be read in connection with the audited consolidated financial statements of the Company. As discussed in Notes 4 and 16 to the consolidated financial statements of the Company, and Note 4 and 14 to the financial statements of Pittston Services Group, the Company and Pittston Services Group changed their methods of accounting for capitalizing subscriber installation costs in 1992. As discussed in Notes 6, 13 and 16 to the consolidated financial statements of the Company, Notes 7, 12 and 14 to the financial statements of Pittston Services Group, and Notes 7, 13 and 16 to the financial statements of Pittston Minerals Group, the Company, Pittston Services Group and Pittston Minerals Group changed their methods of accounting for income taxes and accounting for postretirement benefits other than pensions in 1991. /s/ KPMG Peat Marwick KPMG PEAT MARWICK Stamford, Connecticut January 24, 1994 THE PITTSTON COMPANY AND SUBSIDIARIES SCHEDULE V - PROPERTY, PLANT AND EQUIPMENT Years Ended December 31, 1993, 1992 and 1991 (In thousands of dollars) (a) Amount represents the reserves received as partial payment from the sale of assets of a coal subsidiary. THE PITTSTON COMPANY AND SUBSIDIARIES SCHEDULE VI - ACCUMULATED DEPRECIATION, DEPLETION AND AMORTIZATION OF PROPERTY, PLANT AND EQUIPMENT Years Ended December 31, 1993, 1992 and 1991 (In thousands of dollars) THE PITTSTON COMPANY AND SUBSIDIARIES SCHEDULE VIII - VALUATION AND QUALIFYING ACCOUNTS Years Ended December 31, 1993, 1992 and 1991 (In thousands of dollars) Notes: (A) Amounts recovered (B) Amounts reclassified from other accounts (C) Accounts written off THE PITTSTON COMPANY AND SUBSIDIARIES SCHEDULE IX - SHORT-TERM BORROWINGS Years Ended December 31, 1993, 1992 and 1991 (In thousands of dollars) (1) Represents weighted average interest rate at end of period. (2) Represents maximum amount outstanding at any month-end. (3) The average amount outstanding during the period was computed by dividing the total of the daily outstanding principal balances by 365. (4) The weighted average interest rate during the period was computed by dividing interest expense by avereage short-term debt outstanding. Borrowings and interest rates relate to foreign operations for all years. THE PITTSTON COMPANY AND SUBSIDIARIES SCHEDULE X - SUPPLEMENTARY INCOME STATEMENT INFORMATION YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 (IN THOUSANDS OF DOLLARS) ======== ======= ======= PITTSTON SERVICES GROUP SCHEDULE VIII - VALUATION AND QUALIFYING ACCOUNTS Years Ended December 31, 1993, 1992 and 1991 (In thousands of dollars) Notes: (A) Amounts recovered (B) Amounts reclassified from other accounts (C) Accounts written off PITTSTON SERVICES GROUP SCHEDULE IX - SHORT-TERM BORROWINGS YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 (In thousands of dollars) (1) Represents weighted average interest rate at end of period. (2) Represents maximum amount outstanding at any month-end. (3) The average amount outstanding during the period was computed by dividing the total of the daily outstanding principal balances by 365. (4) The weighted average interest rate during the period was computed by dividing interest expense by avereage short-term debt outstanding. Borrowings and interest rates relate to foreign operations for all years. PITTSTON SERVICES GROUP SCHEDULE X SUPPLEMENTARY INCOME STATEMENT INFORMATION YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 (In thousands of dollars) PITTSTON MINERALS GROUP SCHEDULE V - PROPERTY, PLANT AND EQUIPMENT Years Ended December 31, 1993, 1992 and 1991 (In thousands of dollars) (a) Amount represents the reserves received as partial payment from the sale of assets of a coal subsidiary. PITTSTON MINERALS GROUP SCHEDULE VI - ACCUMULATED DEPRECIATION, DEPLETION AND AMORTIZATION OF PROPERTY, PLANT AND EQUIPMENT Years Ended December 31, 1993, 1992 and 1991 (In thousands of dollars) PITTSTON MINERALS GROUP SCHEDULE X SUPPLEMENTARY INCOME STATEMENT INFORMATION Years Ended December 31, 1993, 1992 and 1991 (In thousands of dollars) Exhibit Index Exhibit Number Description Each Exhibit listed below that is followed by a reference to a previously filed document is hereby incorporated by reference to such document. 3(a) The Registrant's Restated Articles of Incorporation. Exhibit 3(a) to the Registrant's report on Form 8-K dated January 14, 1994. 3(b) The Registrant's Bylaws, as amended. Exhibit 3(b) to the Registrant's report on Form 8-K dated December 3, 1993. 4(a) (i) Rights Agreement (the "Rights Agreement") dated as of September 11, 1987, between the Registrant and Chemical Bank, as successor Rights Agent. Exhibit 1 to the Registrant's Registration Statement on Form 8-A filed September 15, 1987 (the "Form 8-A"). (ii) Amendment No. 1 dated as of December 12, 1988, to the Rights Agreement. Exhibit 4 to Amendment No. 2 on Form 8 to the Form 8-A filed February 15, 1989. (iii) Amendment No. 2 dated as of October 16, 1989, to the Rights Agreement. Exhibit 4(c)(iii) to the Registrant's Annual Report on Form 10-K for the year ended December 31, 1989 (the "1989 Form 10-K"). (iv) Form of Right Certificate. Exhibit 3 to the Form 8-A. Instruments defining the rights of holders of long-term debt of the Registrant and its consolidated subsidiaries have been omitted because the amount of debt under any such instrument does not exceed 10% of the total assets of the Registrant and its consolidated subsidiaries. The Registrant agrees to furnish a copy of any such instrument to the Commission upon request. 10(a)* The Registrant's 1979 Stock Option Plan, as amended. Exhibit 10(a) to the Registrant's Annual Report on Form 10-K for the year ended December 31, 1992 (the "1992 Form 10-K"). 10(b)* The Registrant's 1985 Stock Option Plan, as amended. Exhibit 10(b) to the 1992 Form 10-K. 10(c)* The Registrant's Key Employees Incentive Plan, as amended. Exhibit 10(c) to the Regi- strant's Annual Report on Form 10-K for the year ended December 31, 1991 (the "1991 Form 10-K"). 10(d)* The Registrant's Pension Equalization Plan, as amended. Exhibit 10(d) to the Registrant's Annual Report on Form 10-K for the year ended December 31, 1990 (the "1990 Form 10-K"). 10(e)* The Registrant's Executive Salary Continuation Plan. Exhibit 10(e) to the 1991 Form 10-K. 10(f)* The Registrant's 1988 Stock Option Plan, as amended. 10(g)* The Registrant's Non-Employee Directors' Stock Option Plan. 10(h)* (i) Employment Agreement dated as of May 1, 1993, between the Registrant and J. C. Farrell. Exhibit 10 to the Registrant's Quarterly Report on Form 10-Q for the quarter ended March 31, 1993. (ii) Amendment No. 1 to Employment Agreement dated as of May 1, 1993, between the Registrant and J. C. Farrell. 10(i)* (i) Employment agreement dated September 1, 1992, between the Registrant and D. L. Marshall. Exhibit 10(h) to the Registrant's Quarterly Report on Form 10-Q for the quarter ended September 30, 1992. (ii) Supplemental retirement benefit agreement dated July 12, 1991 between the Registrant and D. L. Marshall. Exhibit 10(i)(iii) to the 1991 Form 10-K. 10(j)* Supplemental retirement benefit agreement dated as of October 1, 1989, between the Registrant and R. D. Duke. Exhibit 10(b) to the Second Quarter 1990 Form 10-Q. 10(k)* (i) Form of change in control employment agreement between the Registrant and Messrs. Farrell and Marshall. Exhibit 10(j) to the 1987 Form 10-K. (ii) Form of change in control employment agreement between the Registrant and two of its officers. Exhibit 10(l)(ii) to the 1989 Form 10-K. (iii) Form of change in control employment agreement between the Registrant (or a subsidiary) and seven of the Registrant's officers. Exhibit 10(l)(iii) to the 1989 Form 10-K. (iv) Form of letter agreement amending change in control employment agreements between the Registrant (or a subsidiary) and seven of the Registrant's officers. 10(l)* Form of Indemnification Agreement entered into by the Registrant with its directors and officers. Exhibit 10(l) to the 1991 Form 10-K. 10(m)* Registrant's Retirement Plan for Non-Employee Directors. Exhibit 10(n) to the 1989 Form 10-K. 10(n)* Registrant's Amended and Restated Plan for Deferral of Directors' Fees. Exhibit 10(o) to the 1989 Form 10-K. 10(o) (i) Participation Agreement (the "Participation Agreement") dated as of December 19, 1985, among Burlington Air Express Inc. (formerly, Burlington Northern Air Freight Inc. and Burlington Air Express USA Inc.) ("Burlington"), the loan participants named therein (the "Loan Participants"), Manufacturers Hanover Leasing Corporation, as Owner Participant (the "Owner Participant"), The Connecticut National Bank, as Indenture Trustee (the "Indenture Trustee") and Meridian Trust Company, as Owner Trustee (the "Owner Trustee"). Exhibit 10(p)(i) to the Registrant's Annual Report on Form 10-K for the year ended December 31, 1988 (the "1988 Form 10-K"). (ii) Trust Agreement (the "Trust Agreement") dated as of December 19, 1985, between the Owner Participant and the Owner Trustee. Exhibit 10(p)(ii) to the 1988 Form 10-K. (iii) Trust Indenture and Mortgage (the "Trust Indenture and Mortgage") dated December 19, 1985, between the Owner Trustee, as Mortgagor, and the Indenture Trustee, as Mortgagee (the "Mortgagee"). Exhibit 10(p)(iii) to the 1988 Form 10-K. (iv) Lease Agreement (the "Lease Agreement") dated as of December 19, 1985, between the Owner Trustee, as Lessor, and Burlington, as Lessee. Exhibit 10(p)(iv) to the 1988 Form 10-K. (v) Tax Indemnity Agreement (the "Tax Indemnity Agreement") dated as of December 19, 1985, between the Owner Participant and Burlington, including Amendment No. 1 dated March 10, 1986. Exhibit 10(p)(v) to the 1988 Form 10-K. (vi) Guaranty (the "Guaranty") dated as of December 19, 1985, by the Registrant. Exhibit 10(p)(vi) to the 1988 Form 10-K. (vii) Trust Agreement and Mortgage Supplement Nos. 1 through 4, dated December 23 and 30, 1985 and March 10 and May 8, 1986, between the Owner Trustee, as Mortgagor, and the Indenture Trustee, as Mortgagee, including Amendment No. 1 dated as of October 1, 1986 to Trust Agreement and Mortgage Supplement Nos. 3 and 4. Exhibit 10(p)(vii) to the 1988 Form 10-K. (viii) Lease Supplements Nos. 1 through 4 dated December 23 and 30, 1985 and March 10 and May 8, 1986, between the Owner Trustee, as Lessor, and Burlington, as Lessee, including Amendment No. 1 dated as of October 1, 1986 to Lease Supplements Nos. 3 and 4. Exhibit 10(p)(viii) to the 1988 Form 10-K. (ix) Letter agreement dated March 10, 1986, among the Owner Participant, the Mortgagee, the Owner Trustee, the Loan Participants, Burlington and the Registrant, amending the Lease Agreement, the Trust Indenture and Mortgage and the Participation Agreement. Exhibit 10(p)(ix) to the 1988 Form 10-K. (x) Letter agreement dated as of May 8, 1986, among the Owner Participant, the Mortgagee, the Owner Trustee, the Loan Participants, Burlington and the Registrant, amending the Participation Agreement. Exhibit 10(p)(x) to the 1988 Form 10-K. (xi) Letter agreement dated as of May 25, 1988, between the Owner Trustee, as Lessor, and Burlington, as Lessee, amending the Lease Agreement. Exhibit 10(p)(xi) to the 1988 Form 10-K. (xii) Partial Termination of Lease, dated September 18, 1992, between the Owner Trustee, as Lessor, and Burlington, as Lessee, amending the Lease Agreement. Exhibit 10 (o) (xii) to the 1992 Form 10-K. (xiii) Partial Termination of Trust Indenture and Mortgage, dated September 18, 1992, between the Indenture Trustee, as Mortgagee, and the Owner Trustee, as Mortgagor, amending the Trust Indenture and Mortgage. Exhibit 10 (o) (xiii) to the 1992 Form 10-K. (xiv) Trust Agreement and Mortgage Supplement No. 5, dated September 18, 1992, between the Owner Trustee, as Mortgagor, and the Indenture Trustee, as Mortgagee. Exhibit 10 (o) (xiv) to the 1992 Form 10-K. (xv) Lease Supplement No. 5, dated September 18, 1992, between the Owner Trustee, as Lessor, and Burlington, as Lessee. Exhibit 10 (o) (xv) to the 1992 Form 10-K. (xvi) Lease Supplement No. 6, dated January 20, 1993, between the Owner Trustee, as Lessor, and Burlington, as Lessor, amend- ing the Lease Agreement. Exhibit 10 (o) (xvi) to the 1992 Form 10-K. 10(p) (i) Lease dated as of April 1, 1989 between Toledo-Lucas County Port Authority (the "Authority"), as Lessor, and Burlington, as Lessee. Exhibit 10(i) to the Registrant's quarterly report on Form 10-Q for the quarter ended June 30, 1989 (the "Second Quarter 1989 Form 10-Q"). (ii) Lease Guaranty Agreement dated as of April 1, 1989 between Burlington (formerly, Burlington Air Express Management Inc.), as Guarantor, and the Authority. Exhibit 10(ii) to the Second Quarter 1989 Form 10-Q. (iii) Trust Indenture dated as of April 1, 1989 between the Authority and Society Bank & Trust (formerly, Trustcorp Bank, Ohio) (the "Trustee"), as Trustee. Exhibit 10(iii) to the Second Quarter 1989 Form 10-Q. (iv) Assignment of Basic Rent and Rights Under a Lease and Lease Guaranty dated as of April 1, 1989 from the Authority to the Trustee. Exhibit 10(iv) to the Second Quarter 1989 Form 10-Q. (v) Open-End First Leasehold Mortgage and Security Agreement dated as of April 1, 1989 from the Authority to the Trustee. Exhibit 10(v) to the Second Quarter 1989 Form 10-Q. (vi) First Supplement to Lease dated as of January 1, 1990, between the Authority and Burlington, as Lessee. Exhibit 10 to the Registrant's quarterly report on Form 10-Q for the quarter ended March 31, 1990. (vii) Revised and Amended Second Supplement to Lease dated as of September 1, 1990, between the Authority and Burlington. Exhibit 10(i) to the Registrant's quarterly report on Form 10-Q for the quarter ended September 30, 1990 (the "Third Quarter 1990 Form 10-Q"). (viii) Amendment Agreement dated as of September 1, 1990, among City of Toledo, Ohio, the Authority, Burlington and the Trustee. Exhibit 10(ii) to the Third Quarter 1990 Form 10-K. (ix) Assumption and Non-Merger Agreement dated as of September 1, 1990, among Burlington, the Authority and the Trustee. Exhibit 10(iii) to the Third Quarter 1990 Form 10-Q. 10(q) Stock Purchase Agreement dated as of September 24 1993, between the Pittston Acquisition Company and Addington Holding Company, Inc. Exhibit 10 to the Registrant's Quarterly Report on Form 10-Q for the quarter ended September 30, 1993. 11 Computation of Earnings Per Common Share. 21 Subsidiaries of the Registrant. 23 Consent of independent auditors. 24 Powers of attorney. 99* Amendment to the Registrant's Pension- Retirement Plan relating to preservation of assets of the Pension-Retirement Plan upon a change in control. Exhibit 99 to the 1992 Form 10-K. _____________________ *Management contract or compensatory plan or arrangement.

72945_1993.txt

72945

1993

Item 1. Business Northrop Corporation was incorporated in Delaware in 1985. Northrop is an advanced technology company operating in the aerospace industry. The company designs, develops and manufactures aircraft, aircraft subassemblies and electronic systems for military and commercial use. Additional information required by this Item is contained in Part II Item 7 of this Annual Report on Form 10-K. Item 2.

Item 2. Properties The major locations, general status of the company's interest in the property and identity of the industry segments which use the property described, are indicated in the following table. Location Property Interest Anaheim, California(1)(5)(a)(b)(c)(e). . . . . . Owned and leased *Arlington, Virginia(5)(a) . . . . . . . . . . . . leased Auborn, Washington (1)(c) . . . . . . . . . . . . leased Carson, California(1)(c). . . . . . . . . . . . . leased Compton, California(1)(b)(c). . . . . . . . . . . leased Commerce, California(1)(c). . . . . . . . . . . . leased *Edwards Air Force Base, California(1) . . . . . . leased Elk Grove, Illinois(4)(a)(b)(c)(d). . . . . . . . leased El Segundo, California(1)(3)(a)(b)(c)(d). . . . . Owned and leased Fullerton, California(4)(a)(b)(c) . . . . . . . . leased Gardena, California(1)(4)(a)(b)(c). . . . . . . . Owned and leased *Hawthorne, California(1)(3)(4)(5)(a)(b)(c)(d) . . Owned and leased Hondo, Texas(2)(b)(c) . . . . . . . . . . . . . . leased Kent, Washington(1)(c). . . . . . . . . . . . . . leased Lawton, Oklahoma (2)(a) . . . . . . . . . . . . . Owned and leased Los Angeles,California(1)(5)(a)(b)(c)(d). . . . . leased Montebello, California(1)(c). . . . . . . . . . . leased Newbury Park, California(1)(a)(b)(c)(d) . . . . . Owned New Town, North Dakota(4)(a)(b)(c). . . . . . . . Owned and leased Norwood, Massachusetts(4)(a)(b)(c)(d) . . . . . . Owned and leased Palmdale, California(1)(a)(b)(c)(d)(e). . . . . . Owned and leased Perry, Georgia(1)(3)(a)(b)(c) . . . . . . . . . . Owned Pico Rivera, California(1)(5)(a)(b)(c)(d) . . . . Owned and leased Rolling Hills Estates, California(2)(a)(d). . . . Owned Rolling Meadows, Illinois(4)(a)(b)(c)(d). . . . . Owned and leased Torrance, California(1)(a)(b)(c). . . . . . . . . Owned and leased Warner Robins, Georgia(4)(a)(b) . . . . . . . . . Owned Warren, Michigan(1)(a)(b)(c)(d) . . . . . . . . . Leased __________ * Certain portions of the properties at each of these locations are leased or subleased to others. The company believes that in the aggregate the property covered by such leases or subleased to others is not material compared to the property actually utilized by the company in its business. Following each described property are numbers indicating the industry segments utilizing the property: (1) Aircraft (3) Missiles and Unmanned Vehicle Systems (2) Services (4) Electronics (5) General Corporate Asset Following each described property are letters indicating the types of facilities located at each location: (a) office (c) warehouse (b) manufacturing (d) research and testing (e) other Government-owned facilities used or administered by the company consist of 1,638,481 square feet at Air Force Plant 42, Palmdale, California and 430,511 square feet at Edwards Air Force Base, California. The company believes its properties are well-maintained and in good operating condition. Under present business conditions and the company's volume of business, productive capacity is currently in excess of requirements. Item 3.

Item 3. Legal Proceedings Environmental Proceedings Stringfellow Site On June 4, 1987, the United States District Court for the Central District of California entered an order against the company and other defendants declaring them jointly and severally liable under the Comprehensive Environmental Response, Compensation and Liability Act ("CERCLA") for clean-up and other costs at the Stringfellow site located near Riverside, California. The government contends it has spent in excess of $70 million to date in clean-up costs. The potentially responsible parties have expended approximately $6.9 million in clean-up costs of which the company has spent approximately $335,000. Present estimates of future clean-up costs are between $139 million and $200 million. A fourth interim action Record Of Decision ("ROD") was issued by the Environmental Protection Agency ("EPA") on September 30, 1990, mandating certain remedial actions. The company and 14 other potentially responsible parties signed a Consent Decree with the EPA to perform certain work under that ROD. A trial to determine the State of California's responsibility for clean-up costs was concluded on June 17, 1992. In December 1993, the Special Master issued a recommended order on apportionment finding that the State and certain other defendants are responsible for up to 65% of the clean-up costs associated with the site under CERCLA standards and up to 95% of such costs under State law claims. The Court found that the manufacturers as a group (including Northrop) are responsible for 25% of the clean-up costs under CERCLA and none of the costs under State law claims. The State has indicated that it will oppose the Special Master's recommended order. The United States Air Force and the United States Navy have stipulated to liability for certain of the clean-up costs arising out of their activities at the site. Northrop contributed less than 2% of the total volume of materials at the Stringfellow site. It is not known at this time whether a volumetric allocation for damages will be used in this matter. However, the clean-up costs attributable to Northrop are not expected to have a material adverse effect on the company's financial condition. Litigation False Claims Act Litigation On June 9, 1987, a complaint, entitled U.S. ex rel, David Peterson and Jeff Kroll v. Northrop Corporation, was filed in the U.S. District Court for the Central District of California alleging violations by the company of the False Claims Act in connection with the operation of petty cash funds, inspection, testing, and pricing for the MX Peacekeeper Missile program. On September 1, 1989, the government intervened and reduced the scope of the lawsuit by filing an amended complaint. The amended complaint does not completely specify the total amount being sought but, rather, seeks damages in excess of $1.2 million. On May 7, 1990, the Court ruled that the original plaintiffs may proceed with portions of the lawsuit that the government declined to include in the amended complaint. The trial in this matter is scheduled for August 1994. On August 31, 1992, the company was served with a complaint in an action entitled U.S. ex rel Rex Robinson v Northrop. The lawsuit is filed in the United States District Court for the Northern District of Illinois. The complaint alleges that the company violated the False Claims Act with respect to certain accounting practices at its Rolling Meadows facility. The U.S. Department of Justice has declined to intervene in the lawsuit which seeks unspecified damages. The company has been named a defendant in a lawsuit filed in the U.S. District Court for the Central District of California, entitled Janssen v Northrop, pursuant to the False Claims Act relating to the company's pricing of subassemblies for the F/A-18 Hornet Jet. On April 9, 1990, the U.S. Department of Justice intervened in the lawsuit and filed an amended complaint. The amended complaint, which seeks unspecified damages and penalties, alleges common law fraud, unjust enrichment, and mistake of fact in connection with purported false statements regarding labor hours, cost of materials and total dollar costs that were required for Northrop to manufacture F/A-18 Hornet Jet subassemblies. In May 1992, the U.S. Government filed an additional complaint containing allegations substantially identical to those contained in the April 9, 1990 amended complaint. This complaint seeks damages relating to foreign military sales of the F/A-18 Hornet Jet. In addition, the company is a party to a number of civil actions brought by private parties alleging violation of the False Claims Act in which the government has declined to intervene. These actions, which have been previously reported, relate to the MX Peacekeeper Missile, the Air Launched Cruise Missile and the Advanced Technology Bomber (B-2) programs. In a number of these actions, plaintiffs also allege employment related claims including claims of wrongful termination. Damages sought include claims for compensatory and punitive damages. A number of these civil actions were initially reported when it was unclear what position, if any, the government would take in the litigation. In light of the government's decision not to intervene or otherwise pursue the litigation, as well as the amounts involved, the cases will not be individually reported. Further, the company learns from time to time that it has been named as a defendant in lawsuits which are filed under seal pursuant to the False Claims Act. Since these matters remain under seal, the company does not possess sufficient information to accurately report on the particular allegations. General The company, as a government contractor, is from time to time subject to U.S. Government investigations relating to its operations. Government contractors that are found to have violated the False Claims Act, or are indicted or convicted for violations of other Federal laws, or are considered not to be responsible contractors may be suspended or debarred from government contracting for some period of time. Such convictions could also result in fines. Given the company's dependence on government contracting, suspension or debarment could have a material adverse effect on the company. With respect to the lawsuits and proceedings discussed above, based upon available information, the company does not expect that any fines, damages or penalties that may result will have a material adverse effect on its financial position. Executive Officers of the Registrant Item 4.

Item 4. Submission of Matters to a Vote of Security Holders No information is required in response to this Item. PART II Item 5.

Item 5. Market for Registrant's Common Equity and Related Stockholder Matters The information required by this Item is contained in Part II, Item 8 of this Annual Report on Form 10-K. Item 6.

Item 6. Selected Financial Data The information required by this Item is contained in Part II, Item 7

Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations Business Conditions Northrop's industry segments - aircraft, electronics, missiles and unmanned vehicle systems (MUVS) and services - are each a factor in the broadly defined aerospace industry. Much of the work in the missiles and unmanned vehicle systems segment is still classified, and contracts and program details cannot be disclosed. While Northrop is subject to the usual vagaries of the marketplace, it is also affected by the unique characteristics of the aerospace industry and by certain elements peculiar to its own business mix. Northrop is one of about a dozen major companies in the industry that compete for the relatively small number of large, long-term programs that characterize both the defense and commercial segments of the aerospace business. It is common in the aerospace industry for work on major programs to be shared between a number of companies. A company competing to be a prime contractor can turn out to be a subcontractor. It is not uncommon to compete with customers, and to simultaneously be both a supplier to and customer of a given competitor. Boeing, Lockheed and McDonnell Douglas are the largest companies in the aerospace industry at this time. Northrop also competes against many other companies for a relatively large number of smaller programs, notably in the electronics areas. Competition is intense, yet the nature of major aerospace programs, conducted under binding contracts, allows companies that perform well to benefit from a level of program continuity unknown in many industries. Thus, intense competition and long operating cycles are both characteristic of the industry's - and Northrop's - business. The B-2 bomber, for which the company is the prime contractor, is Northrop's largest program. Northrop's B-2 Division is responsible for assembly (in Palmdale, California) of the B-2's airframe, systems integration and parts of the B-2's navigation and electronic warfare/situational awareness system. Major subcontractors include Boeing, which makes the aft and outboard wing sections, landing gear and fuel system and Vought Aircraft, which makes fuselage sections. The Air Force plans to operate two B-2 bomber squadrons of eight aircraft each with the remaining four operational aircraft available to fill in for those in depot being serviced or upgraded. The company's Aircraft Division is the principal subcontractor on the McDonnell Douglas F/A-18 program. The F/A-18 is a fighter/ground-attack aircraft that can carry either one or two crew members. It is principally deployed by the U.S. Navy on aircraft carriers, but several nations have purchased the aircraft and use it as a land-based combat aircraft. The company builds approximately 40% of the aircraft including the center and aft fuselage sections and vertical tails. Of the several versions of the F/A-18 in service, the A is a single seat combat aircraft that was first delivered to the Navy in 1980 and the B is a two seat version principally used for training. A/B production ended in 1987 when a transition was made to the C and D versions of the aircraft that are now in production. The single seat C version differs from the A through better avionics, electronic warfare capability, the ability to carry more advanced missiles and a longer range. The F/A-18E/F program is an improved version of the F/A-18C/D under development for the U.S. Navy as its next generation multi- mission aircraft. Northrop's principal commercial program is the production of shipsets for the Boeing 747, which it has done since the program's inception in 1966. The company builds the 153 foot center fuselage section and related cargo and passenger doors, floor beams and other structural components. Northrop's Aircraft Division is responsible for developing the AGM-137 Tri-Service Stand-Off Attack Missile (TSSAM) which is a stealthy conventional cruise missile. The program is being managed by the Air Force, and was originally intended for all three U.S. military services, before the Army's recent withdrawal. The company currently intends to produce this missile at its Perry, Georgia, facility. Many aspects of the program remain classified. The company's Aircraft Division also produces aerial targets, principally the BQM-74/Chukar. The BQM-74 series has been in production since the 1960s. It is used by the Navy for air defense training, gunnery practice and weapon system evaluation. The company builds the airframe and the electronics that are used to guide the drone with the drone's engine being produced by Williams International. ECM denotes electronic countermeasures equipment manufactured by the company's Electronics Systems Division (ESD) - Rolling Meadows Site. The largest program in this business area is the AN/ALQ-135, which is an internally mounted radar jammer deployed on aircraft as part of that aircraft's Tactical Electronic Warfare System. The AN/ALQ-162 "Shadowbox" is a jammer built specifically to counter continuous wave (CW) radars. The AN/ALQ-162 has been installed on F/A-18C/D and AV-8B aircraft. It is also being deployed on U.S.Army helicopters and special mission aircraft and it has been sold to the Danish Air Force for installation on Draken and fighters. Northrop's ESD-Hawthorne Site, as the prime contractor to the U.S. Army, is developing a "brilliant" anti-armor submunition designated as BAT with production scheduled to commence in 1997. BAT is a three foot long, 44 pound, wide-area-attack submunition that would be used to disable and destroy armored vehicles and trucks. BATs are meant to be carried and dispensed by a larger missile. BATS will be ejected over an armored vehicle column or attacking formation. Each BAT has an infrared sensor that can home in on the heat generated by a vehicle's engine, and an acoustic sensor that can home in on the noise created by the tank or truck's engine. Tables of contract acquisitions, sales, and funded order backlog by major program follow and complement industry segment data. B-2, F/A-18 and 747 are currently the major programs of the aircraft industry segment. ECM, BAT and MX Peacekeeper are included in the electronics industry segment. The company's MUVS industry segment includes TSSAM. The "all other" category includes aerial targets and other work done by the MUVS industry segment, as well as the balance of the company's numerous other contracts, classified and unclassified. RESULTS OF OPERATIONS BY INDUSTRY SEGMENT AND MAJOR CUSTOMER Individual companies prosper in the competitive aerospace/defense environment according to their ability to develop and market innovative products. They must also have the ability to provide the people, facilities, equipment and financial capacity needed to deliver those products with maximum efficiency. It is necessary to maintain, as the company has, sources for raw materials, fabricated parts, electronic components and major subassemblies. In this manufacturing and systems integration environment, effective oversight of subcontractors and suppliers is as vital to success as managing internal operations. Northrop's operating policies are designed to enhance these capabilities. The company also believes that it maintains good relations with its employees, a small number of whom are covered by collective bargaining agreements. U.S. Government programs in which Northrop either participates, or strives to participate, must compete with other programs for consideration during our nation's budget formulation and appropriation processes. As a consequence of the end of the Cold War and pressure to reduce the federal budget deficit, the U.S. defense budget is expected to continue to decline for a number of years. Budget decisions made in this environment will have long-term consequences for the size and structure of Northrop and the entire defense industry. An important factor in determining Northrop's ability to successfully compete for future contracts will be its cost structure vis-a-vis other bidders. Given these conditions, it is difficult to predict the amount and rate of decline in defense outlays. Although the ultimate size of future defense budgets remains uncertain, the defense needs of the nation are expected to provide a substantial research and development (R&D) and procurement business base for the company to pursue in the future. Northrop has historically concentrated much of its efforts in such high technology areas as stealth and precision weapons. Even though a high priority has been assigned by the Department of Defense to our major programs, there remains the possibility that one or more of them may be reduced, stretched or terminated. In the commercial aircraft market, many airlines have deferred deliveries and purchases of new aircraft because of financial difficulties. This has caused The Boeing Company to announce substantial reductions in its scheduled production of various jetliners, including the 747. As a result, Northrop's subcontract workload for the 747 has been stretched out beginning in late 1993, with deliveries declining 40 percent through mid-1994 and another 33 percent through mid-1995. Although business conditions in the commercial aircraft industry currently remain tenuous, the company is optimistic about the longer-term prospects for its commercial aircraft structures business. In September 1992, Northrop purchased a minority interest in the parent company of Vought Aircraft Company (VAC), a manufacturer of major subsections for both commercial and military aircraft. Northrop has an option to purchase the remaining interest during a three-year period beginning in late 1995. The investment was made in line with our previously stated strategy to increase Northrop's participation in these markets over the longer term. The decision to exercise the option will be based in part on the business climate of the industry in the three-year period. VAC's cash flow has been large enough to enable it to repay all the debt undertaken to finance the acquisition, permit the early cancellation of Northrop's loan guaranties, and pay its first cash dividend to Northrop, nearly $2 million in 1993. Northrop's emphasis on debt reduction, primarily through better cash management, has resulted in lowering debt by over 86 percent during the last four years, from $1.12 billion to $160 million. This gives Northrop the ability to pursue new business opportunities when justified by acceptable financial returns and technological risks. Northrop examines opportunities to acquire or invest in new businesses and technologies to strengthen its traditional business areas. The company also is exploring new directions for marketing and capitalizing on its technologies and skills by entering into joint ventures, partnerships or associations with companies that are world class in nontraditional fields. Northrop, as well as many other companies in the defense industry, continues to suffer the effects of the Department of Defense's practice in the 1980s of structuring new, high-risk development contracts as fixed-price or capped cost-reimbursement type contracts. Although Northrop stopped accepting these types of contracts in 1988, it has experienced financial losses on several programs acquired under them in the past, including TSSAM. This is Northrop's last remaining development program being carried out under a fixed-price contract. While Northrop conducts most of its business with the U.S. Government, principally the Department of Defense, commercial sales still represent a significant portion of total revenue.Prime contracts with various agencies of the U.S. Government and subcontracts with other prime contractors are subject to a profusion of procurement regulations, with noncompliance found by any one agency possibly resulting in fines, penalties, debarment or suspension from receiving additional contracts with all agencies. Given the company's dependence on government business, suspension or debarment could have a material adverse affect on the company's future. Moreover, these contracts may be terminated at the Government's convenience. In the event of termination for convenience, however, contractors are normally protected by provisions covering reimbursement for costs incurred as well as the payment of any applicable fees or profits. Federal, state and local laws relating to the protection of the environment affect the company's manufacturing operations. The company has provided for the estimated cost to complete remediation where it is probable that the company will incur such costs in the future, including those for which it has been named a Potentially Responsible Party (PRP) by the Environmental Protection Agency or similarly designated by other environmental agencies. The company has been designated a PRP under federal Superfund laws at three hazardous waste sites (Chemtronics, Stringfellow and Operating Industries, Inc.) and under state law at four sites (Southland Oil; ESD - Precision Products Plants 2 and 7; and Lubrication Company of America). It is difficult to estimate the timing and ultimate amount of environmental cleanup costs to be incurred in the future due to the uncertainties regarding the extent of the required cleanup and the status of the law, regulations and their interpretations. Nonetheless, to assess the potential impact on the company's financial statements, management estimates the total reasonably possible remediation costs that could be incurred by the company. Such estimates take into consideration the professional judgment of the company's environmental engineers and, when necessary, consultation with outside environmental specialists. In most instances, only a range of reasonably possible costs can be estimated. The top end of the range is reflected as the total estimate of reasonably possible costs; however, in the determination of accruals the most probable amount is used when determinable and the low end of the range is used when no single amount is more probable. The company records accruals for environmental cleanup costs in the accounting period in which the company's responsibility is established and the costs can be reasonably estimated. Management estimates that at December 31, 1993, the reasonably possible range of future costs for environmental remediation, including Superfund sites, is $14 million to $26 million, of which $14 million has been accrued. The amount accrued has not been offset by potential recoveries from insurance carriers or other potentially responsible parties (PRPs). Should other PRPs not pay their allocable share of remediation costs the company may have to incur costs in addition to those already estimated and accrued. In 1993 the company was awarded a judgement of $6.7 million against its insurance carrier with respect to costs associated with the ESD-Precision Products Plant 2 remediation. This award is currently on appeal and is not reflected in the company's 1993 financial statements. The company is making the necessary investments to comply with environmental laws; however, the amounts, while not insignificant, are not considered material to the company's financial position or results of its operations. Measures of Volume Contract acquisitions tend to fluctuate widely and are determined by the size and timing of new and add-on orders. The effects of multiyear orders and/or funding can be seen in the highs and lows shown in the following table. B-2 acquisitions in 1993 include incremental funding for ongoing development work, long-lead funding for the last five remaining production aircraft, spares and other customer support for this 20 operational aircraft program. In January of 1994, $2.4 billion of funding was awarded to complete these five aircraft by modifying, effective October 29, 1993, the previous Low Rate Initial Production (LRIP) contract. The company still stands to gain future new post-production business, such as airframe depot maintenance, repair of components, operational software changes and product improvement modifications. The debate over the future of the B-2, which is built on the nation's only extant bomber producing facility, has yet to take place. Without future production orders the nations's multi- billion dollar investment in this capability will be disassembled and largely irretrievable. .......................................................................... Contract Acquisitions $ in millions 1993 1992 1991 1990 1989 B-2 $2,632 $2,235 $4,794 $3,749 $3,065 F/A-18C/D 89 576 564 529 632 F/A-18E/F 743 131 10 747 242 76 870 950 719 ECM 445 361 431 395 303 TSSAM 248 349 369 277 428 BAT 90 147 82 51 30 MX Peacekeeper 26 4 28 84 79 ATF 191 242 All other 292 285 404 374 485 $4,807 $4,164 $7,552 $6,600 $5,983 .......................................................................... In 1993, $743 million of funding was received toward the development of the next generation F/A-18, the E/F version. This development program has an estimated value of $1.4 billion to Northrop. No orders for new F/A- 18C/D shipsets were received in 1993 from the McDonnell Douglas Corporation. In 1992, orders for 88 F/A-18C/D shipsets were received. In 1991, 70 F/A-18C/D shipsets were ordered, compared with 84 in each of the years 1990 and 1989. The Boeing Company ordered one hundred 747 shipsets in each of the years 1989 through 1991. In 1993, additional contract value was received for, among other things, extending the delivery schedule of those shipsets into 1996. Year-to-year sales vary less than contract acquisitions and reflect performance under new and ongoing contracts. Sales for 1994 currently are expected to be about $4.4 billion. .......................................................................... Net Sales $ in millions 1993 1992 1991 1990 1989 B-2 $2,881 $3,212 $3,100 $2,744 $2,554 F/A-18C/D 362 492 562 597 629 F/A-18E/F 279 118 10 747 531 549 540 483 461 ECM 372 378 415 425 341 TSSAM 179 265 390 343 219 BAT 100 135 71 55 22 MX Peacekeeper 31 46 90 153 239 ATF 191 242 All other 328 355 516 499 541 $5,063 $5,550 $5,694 $5,490 $5,248 .......................................................................... The increasing trend of B-2 sales, begun in 1990 was reversed in 1993, one year earlier than forecasted a year ago. A decrease in revenues from engineering and manufacturing development (EMD) work exceeded the decrease in revenues for production work. The level of EMD effort, included in amounts reported as customer-sponsored R&D, constituted 28 percent of the total B-2 revenue, down from 34 percent in 1992. Current planning data indicate that the level of overall B-2 revenue will decline roughly 20 percent per year for the remainder of the decade. Sales under the F/A-18C/D program declined in 1993 with the delivery of 52 shipsets. In 1992, the company delivered 75 shipsets, compared with 80 in 1991, 94 in 1990, and 101 in 1989. In 1994 and 1995, the company plans to deliver 42 and 60 F/A-18C/D shipsets respectively. F/A-18E/F revenue is expected to exceed $400 million in 1994. Deliveries of 747 center fuselages were 54 in 1993, 60 in 1992, 62 in 1991, 56 in 1990, and 54 in 1989. Thirty-one fuselages are expected to be delivered in 1994 and 26 in 1995. Sales reversals were recorded on the TSSAM contract amounting to $128 million in 1993, $80 million in 1992 and $120 million in 1989. These reversals followed reductions in the estimate of the percentage of work completed to date on the contract. In addition, 1991 MUVS segment sales included the final revenue earned from the conclusion that year of the Tacit Rainbow missile program. Electronics segment revenues declined 13 percent in 1993 with half the decline coming from two programs -- lower BAT development revenue and lower MX Peacekeeper sales. The final seven Peacekeeper IMUs were delivered in 1991 versus 16 in 1990, and 28 in 1989. Ongoing system support work will generate a modest amount of future revenue. The second largest cause of reduced electronics segment revenues in 1993 stemmed from lower sales in the sensor product area while in both 1993 and 1992 fewer deliveries of missile components by the ESD-Precision Products operation were made versus the respective previous year. Overall Electronics sales are expected to decline only slightly for 1994. The year-end funded order backlog is the sum of the previous year-end backlog plus the year's contract acquisitions minus the year's sales. Backlog is converted into the following years' sales as deliveries are made under contract terms. It is expected that approximately 60 percent of the 1993 year-end backlog will be converted into sales in 1994. .......................................................................... Funded Order Backlog $ in millions 1993 1992 1991 1990 1989 B-2 $3,921 $4,170 $5,147 $3,453 $2,448 F/A-18C/D 443 716 632 630 698 F/A-18E/F 477 13 747 723 1,012 1,485 1,155 688 ECM 540 467 484 468 498 TSSAM 367 298 214 235 301 BAT 20 30 18 7 11 MX Peacekeeper 17 22 64 126 195 All other 411 447 517 629 754 $6,919 $7,175 $8,561 $6,703 $5,593 .......................................................................... Total U.S. Government orders, including those made on behalf of foreign governments (FMS), comprised 89 percent of the backlog at the end of 1993 compared with 85 percent at the end of 1992, 82 percent at the end of both 1991 and 1990, and 87 percent at the end of 1989. Total foreign customer orders, including FMS, accounted for 3 percent of the backlog at the end of 1993 compared with 2 percent in 1992, 3 percent in 1991, 4 percent in 1990, and 3 percent in 1989. Domestic commercial business remaining in backlog at the end of 1993 was 11 percent, 14 percent at the end of 1992, 17 percent for both 1991 and 1990, and 12 percent at the end of 1989. Measures of Performance Loss provisions made during 1993 on the TSSAM development contract aggregated $201 million, and followed similar provisions of $152 million made in the third quarter of 1992 and $150 million in the second quarter of 1989. The expected loss from the performance of this classified long-term fixed-price R&D contract caused major losses in the MUVS segment during four of the last six years. Most of these provisions resulted from additional costs necessary to comply with contractual requirements. Other recent factors included the U. S. Army's January 1994 stop work order preparatory to the deletion of its variant of TSSAM along with the Government's indication that it has further delayed a production decision on other variants until June 1994. Production delays cause increased amounts of sustaining labor to be absorbed by the development phase of the program. Anticipated total production quantities are approaching one-half of those originally contemplated. This could result in an increased production cost per unit. The company faces the challenge of successfully completing, by the end of 1997, the development phase of the program in which it has invested over $600 million. Given the pressure to shrink the defense budget, the Government may have to consider whether it should complete the current TSSAM program as planned, modify it, or terminate it for its convenience and reallocate available funds to other activities. The company plans to recover the $144 million investment in plant and equipment that it made for the production phase of the program through its successful execution. Should the Government decide not to produce the missile, the company will seek to recoup its investment from the government. Because of the nature of the TSSAM long-term fixed-price development contract, additional losses are possible. The ultimate loss on this contract will depend not only upon the accuracy of the company's cost projections, but also the eventual outcome of an equitable settlement of outstanding contractual issues with the U.S. Government, including a $154 million claim filed in November 1993. The company's traditional line of aerial targets was profitable in each of the last five years. The overall increase in MUVS operating profit in 1991 versus 1990 resulted from the completion of the Tacit Rainbow missile program at less cost than had previously been estimated. The company has improved the margin rate of each of its two largest and most mature industry segments -- Aircraft and Electronics. These improvements have been partially offset by the poor performance of the MUVS segment. Company-wide efforts to improve and streamline the management of the business continue. Tighter business controls, cost reduction, cash management and effective asset utilization are all aimed at contributing to two important long standing financial goals; achieving a 20 percent return on equity and repaying debt, if we so choose, by the mid-1990s. This financial report demonstrates the degree to which the accomplishment of these goals is being achieved. Operating profit in the aircraft industry segment increased to its highest level ever in 1993 as margin rates improved on all major aircraft programs - B-2, F/A-18 and 747. The F/A-18 and 747 improvements came despite reduced shipset deliveries in 1993. The primary cause of aircraft segment operating profit being higher in 1991 than 1992 was the one percentage point increase in the B-2 LRIP contract margin rate made during the fourth quarter of 1991 on sales recorded prior to that date ($40 million of margin). This 1991 margin rate adjustment followed definitization of the LRIP contract late in the year and took into account the company's production and assembly experience as of that date. Setting aside the $40 million adjustment, the B-2 program provided an increasing amount of operating margin in each of the last three years as the mix of sales continue its shift from relatively low-margin R&D work to production work. Following the recent award of the last increment of production funding for the B-2 the company will record future operating margin increases on all production aircraft as these units are delivered and accepted by the customer. At the time each unit is delivered an assessment will be made of the status of the production contract so as to estimate the amount of any probable additional margin available beyond that previously recognized. That unit's proportionate share of any such unrecognized remaining balance will then be recorded. In this fashion it is believed that margin improvements will be recognized on a more demonstrable basis, much like in the case of incentive or award fees. The current 15 production units are scheduled for their initial delivery over a five year period, which began in December 1993. All but two units (four equivalent units for this purpose) will be returned for scheduled retrofitting with final deliveries beginning in 1997 and ending in 2000. It is anticipated that the total of 30 equivalent units will be delivered at a rate of from three to five per year over the next seven years. Affecting the comparison of 1992 aircraft operating profit with that of 1991 were the slightly lower rates of margin earned on fewer F/A-18C/D and 747 shipset deliveries. In addition, a low rate of margin was recorded in 1992 on the F/A-18E/F as this program is in its early phase of development. Partially offsetting the B-2 margin improvement for 1991 was the lower rate of margin earned on the reduced number of F/A-18 shipsets delivered during 1991. A slightly lower rate of margin was earned on higher 747 shipset deliveries generating an overall increase in the amount of 747 margin. Affecting comparisons of 1991 aircraft segment operating profit with those of the previous two years are the amounts invested and written off on the ATF program - $66 million during 1990, compared with $73 million in 1989. With the completion of the DEM/VAL phase of ATF in 1990 the company discontinued making any material amount of expenditures for company-sponsored R&D. The 13 percent sales decline in the electronics segment for 1993 was accompanied by an 11 percent decline in operating profit. An increase in ECM operating margin and the benefit of a $5 million reduced loss at ESD's Precision Products operation offset lower margins in the sensor product area and on the BAT program. The amount and rate of operating profit earned by the electronics segment increased during 1992 despite the loss incurred by ESD Precision Products. ESD Precision Product's operating loss declined $7 million from that of 1991. In 1992 Precision Products suffered from the effects of a 24 percent sales decline coupled with a $6 million write-off of unrecoverable inventoried costs. Also influencing the trend in the electronics segment operating profit has been the replacement of high-margin Peacekeeper production revenue by low-margin BAT development revenue. While the rate of operating profit for 1991 improved slightly for the electronics segment, the amount of profit declined $2 million. The rate increase was largely achieved by the ECM area where improved margins accompanied higher sales of the successful AN/ALQ-135 system developed for the fighter aircraft. Offsetting this increase was the cost of settling various legal and product disputes, principally for ESD Precision Products. Of the aggregate of $31 million in provisions made during 1991 for these issues, $12 million is reported in Other Deductions in the Consolidated Statements of Operations. Operating margin in 1993 included $71 million of pension income compared with $83 million in 1992, and $23 million in 1991. Nearly offsetting the 1993 reduction in pension income was 1993's decline in the cost of providing retiree health care and life insurance benefits - $32 million in 1993 versus $41 million in 1992, and $47 million in 1991. For calculating the liability balances for these plans at December 31, 1993 the company reduced the discount rate used from 8 to 7 percent and changed its employee turnover assumptions. The net affect of this served to increase year-end liability balances for all plans by $402 million. Also, for 1994, these changes will cause a $27 million reduction in pension income and an $8 million increase in retiree health care and life insurance benefit costs from what they otherwise would be. The Financial Accounting Standards Board's (FASB) accounting standard No. 106 - Employers' Accounting for Postretirement Benefits Other than Pensions - was adopted by the company in 1991. The liability representing previously unrecognized costs of $145 million for all years prior to 1991 was recorded as of January 1, 1991, with an after-tax effect on earnings of $88 million or $1.86 per share. The company's adoption in 1992 of the new FASB accounting standard No. 112 - Employers' Accounting for Postemployment Benefits - had no material effect on the company's financial position or operating results. Interest expense declined in each of the last four years - $9 million in 1993, $33 million in 1992, $15 million in 1991, and $29 million in 1990, with nearly all of these reductions stemming from four years of debt reduction which totaled $960 million, or 86 percent. In 1991 the company adopted the FASB standard No. 109 - Accounting for Income Taxes - and recorded, as of January 1, 1991, a benefit of $21 million, or 43 cents per share. As described in the accounting policy footnote to the financial statements, any future change in the tax rate would result in the immediate recognition in current earnings of the cumulative effect from deferred tax assets and liabilities. The company's effective federal income tax rate was 43.5 percent in 1993, 32.8 percent in 1992, and 3.2 percent in 1991. The rate for 1993 would have been 31.8 percent but for the effects of the retroactive application of The Revenue Reconciliation Act of 1993. The one percentage point increase in the federal statutory income tax rate, now 35 percent, required the redetermination of December 31, 1992 deferred tax asset and liability balances. This redetermination added $18 million to 1993's tax provision thereby reducing earnings per share by 38 cents. During 1989 final regulations were issued concerning the research tax credit. The company took a conservative approach in calculating its tax provisions since 1981 pursuant to uncertain proposed regulations. An exhaustive study was undertaken throughout the company to redetermine qualifying expenditures in compliance with final regulations so as to recalculate prior years' tax credits and amend its tax returns as appropriate. The benefit resulting from the conclusion of that study was the $90 million in additional research credits recognized in the determination of the 1991 effective tax rate of 3.2 percent. Measures of Liquidity and Capital Resources The evolution of the company's financial condition and liquidity, which began in 1990, continued to improve in 1993. Over these last four years operating cash flows have averaged $385 million annually. While cash flow from operations increased $96 million in 1993 over that of 1992, it declined $325 million in 1992 from that of 1991. Much of the increase in 1991's cash flow from operations resulted from the company finalizing the B-2 LRIP contract, after it was about 50 percent complete, as well as follow-on contracts for 747 and F/A-18 work. To a great extent the pace of delivery of B-2 production aircraft and the satisfactory completion of program milestones will dictate the future level of any required capital resources. Provisions for contract losses are one of the important elements shown in illustrating the difference between Net Income(Loss) and cash flows from operating activities shown in the Reconciliation section of the Consolidated Statements of Cash Flows. Cash outflow resulting from accrued forward loss provisions on fixed-price R&D contracts follows in succeeding periods, when the costs that they represent are incurred. Most of the $664 million in loss provisions made in the MUVS segment over the last six years was necessitated by the TSSAM program. As of December 31, 1993 all but $140 million of those loss provisions represent costs already incurred. The trend and relationship of sales volume with accounts receivable and inventoried cost balances, before and after the benefit of progress payments, is a useful measure in assessing liquidity. In 1987 the company's net investment in these balances represented 25 percent of sales. It had subsequently grown to 32 percent at year-end 1989, when Northrop's debt peaked, before dropping to 27 percent at the end of 1993. The largest recent reduction in gross accounts receivable and inventoried cost balances occurred in 1991 as the result of the final billing and collection of ATF contract balances, along with the completion of a number of B-2 contract milestones during the year. A reduction in the rate used by the Government to make progress payments to its customers applies to new contracts entered into after legislation was enacted in 1993. Therefore, it is not expected to have a demonstrable effect on the company's level of working capital in the near term. The following table is a condensed summary of the detailed cash flow information contained in the Consolidated Statements of Cash Flows. .......................................................................... Year ended December 31 1993 1992 1991 1990 1989 Cash came from Customers 99% 98% 100% 85% 86% Lenders 1% 2% 11% 13% Buyers of assets 4% 1% 100% 100% 100% 100% 100% Cash went to Employees and suppliers of services and materials 89% 93% 88% 81% 83% Lenders 8% 3% 9% 16% 13% Suppliers of facilities 2% 2% 2% 2% 3% Sellers of assets 1% Shareholders 1% 1% 1% 1% 1% 100% 100% 100% 100% 100% .......................................................................... The above percentages of gross cash receipts and disbursements portray the extent to which lenders supplemented customer financing until 1990 when it became possible to repay that support through improved collections from customers. Some other important indicators of short-term liquidity are the trend in working capital, the current ratio and the ratio of long-term debt to shareholders' equity. This information is reported in the table captioned Selected Financial Data. Total debt peaked at $1.3 billion in mid-1989. In February of 1990 the company sold its headquarters complex in Los Angeles and applied the net proceeds of $218 million toward reducing its short-term debt. In October 1990 the company reduced its former $750 million credit agreement to $400 million and converted that amount of short-term debt into long-term debt that was repayable in 20 quarterly installments of $20 million. The company at its option elected to prepay larger amounts. Cash flow from operations during 1992 was sufficient to enable the company to pay the four required installments totaling $80 million in converted credit agreement debt as well as to prepay another $60 million of this debt. In February of 1993 the last two installments totaling $40 million were prepaid and in November $210 million of private placement debt was paid. During three months of 1993 it was necessary to supplement cash provided by operations with short-term borrowings. These borrowings peaked at $232 million and none was outstanding at 1993's year end. They were necessitated by intermittent spikes in working capital needs on the B-2 and TSSAM programs. Future near-term borrowing needs will be met through the use of short-term credit lines and the company's $400 million revolving credit agreement, which was renewed with comparable terms for four more years in January 1994. To provide for long-term liquidity the company believes it could obtain additional capital from such sources as: the public or private capital markets, the further sale of assets, sale and leaseback of operating assets and leasing rather than purchasing new assets. The company's final amount of indebtedness, $160 million of private placement debt, is due to be paid in November 1995. The cash improvement program underway throughout the company since early 1989 has produced favorable results, with the expectation that further efforts will result in minimizing, if not eliminating, the need to make short-term borrowings during 1994. Cash generated from operations is expected to be more than sufficient in 1994 to finance capital expansion projects and continue paying dividends to the shareholders. Noncontract R&D expenditures are expected to approximate $100 million in 1994 compared with $97 million in 1993. Capital expenditure commitments at December 31, 1993, were approximately $115 million including $9 million for environmental control and compliance purposes. The 1994 forecast of capital expenditures is $100 million. The company will continue to provide the productive capacity to perform its existing contracts, dispose of assets no longer needed to fulfill operational requirements, prepare for future contracts and conduct R&D in the pursuit of developing opportunities. While these expenditures tend to limit short-term liquidity and profitability, they are made with the intention of improving the long-term growth and profitability of the company. Based on recent cash flow improvements, anticipated future positive cash flows, and unused and available capital resources, management believes that it is in a strong position to pursue its strategic options - acquiring one or more other businesses, raising cash dividends, repurchasing outstanding common shares, or making other investments, to maximize the long-term return to our shareholders. Item 8.

Item 8. Financial Statements and Supplementary Data The accompanying notes are an integral part of these financial statements. The accompanying notes are an integral part of these financial statements. The accompanying notes are an integral part of these financial statements. The accompanying notes are an integral part of these financial statements. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Summary of Significant Accounting Policies Principles of Consolidation The consolidated financial statements include the accounts of the corporation and its subsidiaries. All material intercompany accounts, transactions and profits are eliminated in consolidation. The investment in the parent company of Vought Aircraft Company (VAC) is accounted for by the cost method because it is a nonvoting minority interest. As there is no trading in the shares of VAC, it is not practical to estimate its fair value. Management does believe that its fair value approximates its carrying amount of $45 million. Industry Segment and Major Customer Data Descriptions of the company's principal products and services can be found in the Management's Discussion and Analysis section of this report. Intersegment sales are transacted at actual cost incurred with no profit added. Operating profit is defined to include the Other Income earned by each industry segment, but exclude costs allocated to them for general corporate expenses and state and local income taxes. The amount of the difference between (1) the costs of retiree benefit plans (pension and nonpension) allocable to contracts as determined by government cost accounting standards, and (2) cost(income) as calculated in conformity with financial accounting standards is captioned Corporate Retiree Benefit Income(Cost) and is shown separately from general corporate expenses so as not to distort operating profit as reported by industry segment. General corporate assets include cash and cash equivalents, the company's centralized data processing assets, corporate office furnishings and equipment, other unallocable property, investments in affiliates, prepaid pension cost and intangible pension asset. Sales to the company's major customer, the U.S. Government (including foreign military sales), are reported within each industry segment and in total in Selected Financial Data. The company does not conduct a significant volume of activity through foreign operations or in foreign currencies. Sales Sales under cost-reimbursement, service, research and development, and construction-type contracts are recorded as costs are incurred and include estimated earned fees or profits calculated on the basis of the relationship between costs incurred and total estimated costs (cost-to-cost type of percentage-of-completion method of accounting). Construction-type contracts embrace those fixed-price contracts that provide for the delivery of a small number of units after a lengthy period of time over which a significant amount of costs have been incurred. Sales under other types of contracts are recorded as deliveries are made and are computed on the basis of the estimated final average unit cost plus profit (units-of-delivery type of percentage-of-completion method of accounting). Certain contracts contain provisions for price redetermination or for cost or performance incentives. Such redetermined amounts or incentives are included in sales when the amounts can reasonably be determined. In the case of the B-2 bomber production contract any future increases in operating margin will be recognized on a units-of-delivery basis and recorded as each equivalent production unit is delivered. Amounts representing contract change orders, claims or limitations in funding are included in sales only when they can be reliably estimated and realization is probable. In the period in which it is determined that a loss will result from the performance of a contract, the entire amount of the estimated ultimate loss is charged against income. Loss provisions are first offset against costs that are included in assets, with any remaining amount reflected in Other Current Liabilities. Other changes in estimates of sales, costs, and profits are recognized using the cumulative catch-up method of accounting. This method recognizes in the current period the cumulative effect of the changes on current and prior periods. Hence, the effect of the changes on future periods of contract performance is recognized as if the revised estimates had been the original estimates. Contract Research and Development Customer-sponsored research and development costs (direct and indirect costs incurred pursuant to contractual arrangements) are accounted for like other contract costs. Noncontract Research and Development This category includes independent research and development costs (indirect costs allocable to U.S. Government contracts) and company-sponsored research and development costs (direct and indirect costs not recoverable under contractual arrangements). Independent research and development (IR&D) costs are included in administrative and general expenses while company-sponsored research and development costs are charged against income as incurred. Environmental Costs Environmental liabilities are accrued when the company determines its responsibility for cleanup costs and such amounts are reasonably estimable. When only a range of amounts is established and no amount within the range is better than another the minimum amount in the range is recorded. The company does not anticipate and record insurance recoveries before collection is probable. Income Taxes Provisions(Benefits) for federal, state and local income taxes are calculated on reported financial statement pretax income(loss) based on current tax law and also include, in the current period, the cumulative effect of any changes in tax rates from those used previously in determining deferred tax assets and liabilities. Such provisions(benefits) differ from the amounts currently payable because certain items of income and expense are recognized in different time periods for financial reporting purposes than for income tax purposes. The company reports certain contracts using different methods of tax accounting for contracts in process and thus provides deferred taxes on the difference between the financial and taxable income reported during the performance of such contracts. State and local income and franchise tax provisions are included in administrative and general expenses. Earnings(Loss) per Share Earnings(Loss) per Share are based on the weighted average number of shares of common stock outstanding during each period, after giving recognition to stock splits and stock dividends. The dilutive effect of common stock equivalents, shares under stock options, was insignificant. Cash and Cash Equivalents Included are interest-earning liquid debt instruments that mature in three months or less from the date purchased. Amounts reported in the Consolidated Statements of Financial Position approximate their fair value. Accounts Receivable Included are amounts billed and currently due from customers under all types of contracts, amounts currently due but unbilled (primarily related to contracts accounted for under the cost-to-cost type of percentage-of-completion method of accounting), certain estimated contract changes, claims in negotiation and amounts retained pending contract completion. Inventoried Costs Inventoried costs primarily relate to work in process under fixed-price type contracts (excluding those included in unbilled accounts receivable as previously described). They represent accumulated contract costs less the portion of such costs allocated to delivered items. Accumulated contract costs include direct production costs, factory and engineering overhead, production tooling costs, and allowable administrative and general expenses (except for general corporate expenses and IR&D allocable to commercial contracts, which are charged against income as incurred). In accordance with industry practice, inventoried costs are classified as a current asset and include amounts related to contracts having production cycles longer than one year. Depreciable Properties Property, plant and equipment owned by the company are depreciated over the estimated useful lives of individual assets. Capital leases providing for the transfer of ownership upon their expiration or containing bargain purchase options are amortized over the estimated useful lives of individual assets. Most of these assets are depreciated using declining-balance methods, with the remainder using the straight-line method. Accounts Receivable Unbilled amounts represent sales for which billings have not been presented to customers at year-end, including differences between actual and estimated overhead and margin rates. These amounts are usually billed and collected within one year, progress payments are however received on a number of fixed-price contracts accounted for using the cost-to-cost type of percentage-of-completion method. Amounts due upon contract completion are retained by customers until work is completed and customer acceptance is obtained. Accounts receivable at December 31, 1993, are expected to be collected in 1994 except for approximately $3 million due in 1995 and $4 million due in 1996 and later. These amounts principally relate to long-term contracts with the U.S. Government. Allowances for doubtful amounts represent mainly estimates of overhead type costs which may not be successfully negotiated and collected. Contract loss provisions are reflected as an offset to accounts receivable to the extent related costs are contained therein. Inventoried costs relate to long-term contracts in process and include expenditures for raw materials and work in process beyond what is required for recorded orders. These expenditures are incurred to help maintain stable and efficient production schedules. However, no material amount representing claims, learning curve, unamortized tooling or other deferred costs is included in inventoried costs. The ratio of inventoried administrative and general expenses to total inventoried costs is assumed to be the same as the ratio of total administrative and general expenses to total contract costs. According to the provisions of U.S. Government contracts, the customer has title to, or a security interest in, substantially all inventories related to such contracts. Notes Payable to Banks The company has available short-term credit lines in the form of money market facilities with several banks. The amount of and conditions for borrowing under these credit lines depend on the availability and terms prevailing in the marketplace. No fees or compensating balances are required for these credit facilities. The average outstanding balance for days on which borrowings were made during 1993 was $80 million, at a weighted average interest rate of 3.4 percent. The maximum amount outstanding during the year occurred on December 24, 1993 - $232 million at a weighted average interest rate of 3.4 percent. At December 31, 1993, there were no outstanding money market loans. In addition, the company maintained a credit agreement with a group of domestic and foreign banks which made available $400 million on a revolving credit basis. This agreement was renewed on January 7, 1994, at the same dollar amount, for a period of four years. For 1993, the maximum amount outstanding was also the average outstanding balance for days on which borrowings were made -- $100 million at a weighted average interest rate of 3.7 percent. At December 31, 1993 there were no loans outstanding under the credit agreement. In 1993, the company paid quarterly a commitment fee of one-tenth percent per annum on the unused amounts and a facility fee of one-fifteenth percent per annum on the total amount of the revolving credit facility. Under both agreements, in the event of a "change in control," the banks are relieved of their commitments. Compensating balances are not required under these agreements. The company's credit agreements contain restrictions relating to the payment of dividends, acquisition of the company's stock, aggregate indebtedness for borrowed money and the maintenance of shareholders' equity. At December 31, 1993, $295 million of retained earnings were unrestricted as to the payment of dividends. Total indebtedness for all types of borrowed money is limited to 150 percent of shareholders' equity, as defined. At December 31, 1993, indebtedness was limited to $1,969 million. Income tax expense(benefit) differs from the amount computed by multiplying the statutory federal income tax rate times the income(loss) before income taxes(benefit) due to the following: The research and experimentation tax credit shown for 1991 was the outgrowth of an internal company study that determined the amount earned over the years 1981 through 1990 in excess of the amount previously recognized for those years pending final government regulations which were not issued until 1989. Deferred income taxes arise because of differences in the treatment of income and expense items for financial reporting and income tax purposes. The principal type of temporary difference stems from the recognition of income on contracts being reported under different methods for tax purposes than for financial reporting. Effective January 1, 1991, the company adopted FASB Statement No. 109. The tax effects of significant temporary differences and carryforwards that gave rise to year-end deferred tax balances since the adoption of FASB statement No. 109, as broadly categorized in the Consolidated Statements of Financial Position, were as follows: ........................................................................ $ in millions 1993 1992 1991 Net deferred tax assets Deductible temporary differences Income on contracts $ 21 $ 13 $ 8 Retiree benefit plan expense 21 21 16 Provision for estimated expenses 28 27 26 Other 2 2 3 72 63 53 Taxable temporary differences Retiree benefit plan income (19) (15) (7) Administrative and general expenses period-costed for tax purposes (3) (6) (19) (18) (13) $ 53 $ 45 $ 40 Net deferred tax liabilities Taxable temporary differences Income on contracts $ 811 $ 789 $ 772 Excess tax over book depreciation 70 89 93 Retiree benefit plan income 94 64 33 Administrative and general expenses period-costed for tax purposes 18 18 19 993 960 917 Deductible temporary differences Provision for estimated expenses (135) (120) (116) Retiree benefit plan expense (106) (93) (76) Other (9) (11) (17) (250) (224) (209) Tax carryforwards Operating losses (54) (117) (151) Tax credits (129) (140) (150) Alternative minimum tax credit (87) (40) (21) (270) (297) (322) $ 473 $ 439 $ 386 Overall net deferred tax liability Total deferred tax liabilities (taxable temporary differences above) $1,012 $ 978 $ 930 Less total deferred tax assets (deductible temporary differences and tax carryforwards above) 592 584 584 $ 420 $ 394 $ 346 ......................................................................... The tax carryforward benefits will be used in the periods that net deferred tax liabilities mature. The expiration dates for these tax carryforward benefits are: tax operating loss carryforwards - $54 million in 2004, and tax credit carryforwards in various amounts over the years 1994 through 2005. The alternative minimum tax credit can be carried forward indefinitely. The note purchase agreement with institutional investors contains restrictions as to mergers and limitations on liens and aggregate indebtedness - 150 percent of shareholders' equity. In the event of a "change in control" the noteholders could require the company to repurchase the outstanding notes at a premium. During 1993 the company prepaid the $40 million term loan outstanding at the end of 1992. The average outstanding balance during 1993, for the days on which notes remained outstanding, was $40 million at a weighted average interest rate of 3.7 percent. The company paid a facility fee of one-tenth percent per annum on the total amount outstanding. The principal amount of long-term debt outstanding at December 31, 1993, is due in 1995. Based on interest rates currently available for debt with terms and a due date similar to the company's $160 million in carrying value of long-term debt, an estimate of its fair value would be $175 million. Retirement Benefits The company sponsors several defined-benefit pension plans covering substantially all employees. Pension benefits for most employees are based on the employee's years of service and compensation during the last five years before retirement. It is the policy of the company to fund at least the minimum amount required for all qualified plans, using actuarial cost methods and assumptions acceptable under U.S. Government regulations, by making payments into a trust separate from the company. Two of the four qualified plans, including the main plan which covers over 80 percent of all employees, were in a legally defined full-funding limitation status. No contributions have been made to the main plan since 1986. To protect the surplus of assets in the master trust from a "change in control" the trust agreement and the main pension plan were appropriately amended during 1991. The company and a subsidiary also sponsor defined-contribution plans in which all employees are eligible to participate. Company contributions, up to 4 percent of compensation, are based on a formula resulting in the matching of employee contributions. In addition, the company and its subsidiaries provide certain health care and life insurance benefits for retired employees. Employees achieve eligibility to participate in these contributory plans upon retirement from active service and if they are age 55 with 10 or more years of service, or 65 with 5 years service. Election to participate must be made at the date of retirement. Qualifying dependents are also eligible for medical coverage. Approximately 75 percent of the company's current retirees participate in the medical plan. The cost and funded status for the medical and life benefits are combined in the tables that follow because (1) life benefits constitute an insignificant amount of the combined cost, and (2) the assets in trust for each plan can be used to pay benefits under either plan. Plan documents reserve the company's right to amend or terminate the plans at any time. Premiums charged retirees for medical coverage are based on years of service and are annually adjusted for the cost of the plan as determined by an independent actuary. In addition to this medical inflation cost-sharing feature, the plan also has provisions for deductibles, copayments, coinsurance percentages, out-of-pocket limits, schedule of reasonable fees, managed care providers, maintenance of benefits with other plans, Medicare carve-out and a maximum lifetime benefit of $250,000 per covered individual. It is the policy of the company to fund the maximum amount deductible for income taxes into the VEBA trust established for these benefits. Until 1991, the costs accrued for these plans were determined by the aggregate actuarial cost method with such amounts paid by the company, along with retiree contributions, into a separate trust. The company elected to implement the new accounting standard, FASB Statement No. 106, for 1991 by immediately recognizing the January 1, 1991, accumulated postretirement benefit obligation of $437 million. This amount was offset by $292 million, the fair value of plan assets held in trust outside the company, in recording a net obligation and pretax charge to operations of $145 million. Major assumptions as of each year-end used in the accounting for the defined-benefit plans are shown in the following table. Pension cost is determined using all three factors as of the beginning of each year, whereas the funded status of the plans, shown later, uses only the first two factors, as of the end of each year. These assumptions were also used in retiree health care and life insurance benefit calculations with one modification. Since, unlike the pension trust, the earnings of the VEBA trust are taxable, the above pretax 8.25 percent return on plan assets was reduced accordingly to 5.5 percent after taxes. A significant factor used in estimating future per capita cost, for the company and its retirees, of covered health care benefits is known as the health care cost trend rate assumption. The rate used was 10 percent for 1993 and is assumed to decrease gradually to 6 percent for 2006 and remain at that level thereafter. An additional one-percentage-point of increase each year in that rate would result in a $9 million annual increase in the aggregate of the service and interest cost components of net periodic postretirement benefit cost, and a $68 million increase in the accumulated postretirement benefit obligation at December 31, 1993. The following tables set forth the funded status and amounts recognized in the Consolidated Statements of Financial Position at each year-end for the company's defined-benefit pension and retiree health care and life insurance benefit plans. The summary showing pension plans whose accumulated benefits are in excess of assets at December 31, 1993, is comprised of one qualified plan along with four unfunded nonqualified plans for benefits provided to directors, officers and employees either beyond those provided by, or payable under, the company's main plan. Retiree health care and life insurance plan assets at December 31, 1993, were almost entirely comprised of equity type investments in listed companies. Contingencies The corporation and its subsidiaries have been named as defendants in various legal actions. Based upon available information, it is the company's expectation that those actions are either without merit or will have no material adverse effect on the company's results of operations or financial position. Stock Rights On September 21, 1988, the company adopted a Common Stock Purchase Rights plan. One right for each outstanding share of common stock was issued to shareholders of record on October 5, 1988. The rights will become exercisable on the tenth business day after a person or group has acquired 15 percent or more of the general voting power of the company, or announces an intention to make a tender offer for 30 percent or more of such voting power, without the prior consent of the Board of Directors. If the rights become exercisable, a holder will be entitled to purchase one share of common stock from the company at an initial exercise price of $105. If a person acquires more than 15 percent of the then outstanding voting power of the company or if the company is combined with an acquiror, each right will entitle its holder to receive, upon exercise, shares of the company's or the acquiror's (depending upon which is the surviving company) common stock having a value equal to two times the exercise price of the right. The company will be entitled to redeem the rights at $.02 per right at any time prior to the earlier of the expiration of the rights in October 1998 or within 10 days following the date that a person has acquired or obtained the right to acquire 15 percent of the general voting power of the company. The rights are not exercisable until after the date on which the company's prerogative to redeem the rights has expired. The rights do not have voting or dividend privilege and cannot be traded independently from the company's common stock until such time as they become exercisable. Long-Term Incentive Stock Plan The company's 1993 Long-Term Incentive Stock Plan provides for stock options, stock appreciation rights (SARs) and stock awards to key employees. This plan added 2,300,000 shares, of which up to one-half may be in the form of stock awards, to the pool available for future grants. The number of shares reserved for future grants shown in the following table reflects both stock options and stock awards. Stock awards, in the form of restricted performance stock rights, are granted to key employees without payment to the company. Recipients of the rights shall earn shares of stock based on a total shareholder return measure of performance over a five year period with interim distributions beginning three years after grant. If after the five year period no shares have been earned, based on performance, 70 percent of the original grant will be forfeited. Compensation expense will be estimated and accrued over the vesting period. Each grant of a stock option is made at the closing market price on the date of the grant. When stock options are exercised, the amount of the proceeds is added to paid-in capital. Under current accounting standards there are no additions to or deductions from income in connection with these options. Termination of employment can result in forfeiture of some or all of the benefits extended under the plans. Unaudited Selected Quarterly Data Quarterly financial results, as previously reported in unaudited quarterly reports to shareholders, are set forth in the following tables together with dividend and common stock price data: The sum of quarterly earnings per share for 1993 does not equal earnings per share for the year because the average number of common shares outstanding for the second half of 1993 was disproportionately higher than the full year average due to the high level of stock options exercised during the second half. Net income and earnings per share in the third quarter of 1993 were reduced for the cumulative effect of the retroactive application of The Revenue Reconciliation Act of 1993 signed into law August 10, 1993. The one percentage point increase in the federal statutory income tax rate required the redetermination of prior deferred tax asset and liability balances as well as an increase in the taxes provided on pretax earnings for the first three quarters of 1993. Third quarter 1993 net income and earnings per share were accordingly reduced by $18 million, 38 cents per share, and $2 million, 5 cents per share, respectively. The operating loss in the fourth quarter of 1993 resulted from a $164 million provision for an increase in the estimated cost to complete the TSSAM development contract. This provision followed similar ones amounting to $14 million, $5 million and $18 million in each of the three preceding quarters, respectively. The operating loss in the third quarter of 1992 resulted from a $152 million provision for the estimated financial impact of the company's proposal to the U.S. Air Force to extend the schedule to complete the TSSAM flight test program. The corporation's common stock is traded on the New York and Pacific Stock Exchanges (trading symbol NOC). The approximate number of holders of record of the corporation's common stock at January 31, 1994, was 11,550. INDEPENDENT AUDITORS' REPORT Board of Directors and Shareholders Northrop Corporation Los Angeles, California We have audited the accompanying consolidated statements of financial position of Northrop Corporation and Subsidiaries as of December 31 for each of the years 1989 through 1993, and the related consolidated statements of operations, changes in shareholders' equity and cash flows for the years then ended. Our audits also included the financial statement schedules listed in the Index at Item 14. These financial statements and financial statement schedules are the responsibility of the company's management. Our responsibility is to express an opinion on these financial statements and financial statement schedules based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, such consolidated financial statements present fairly, in all material respects, the financial position of Northrop Corporation and Subsidiaries at December 31 for each of the years 1989 through 1993, and the results of their operations and their cash flows for the years then ended in conformity with generally accepted accounting principles. Also, in our opinion, such financial statement schedules, when considered in relation to the basic consolidated financial statements taken as a whole, present fairly in all material respects the information set forth therein. As discussed in the footnotes to the consolidated financial statements, in 1991 the company changed its method of computing income taxes by adopting Financial Accounting Standards Board Statement No. 109 - Accounting for Income Taxes and its accounting for nonpension benefit plans by adopting Financial Accounting Standards Board Statement No. 106 - Employers' Accounting for Postretirement Benefits Other Than Pensions. Deloitte & Touche Los Angeles, California February 1, 1994 Item 9.

Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure No information is required in response to this Item. PART III Item 10.

Item 10. Directors and Executive Officers of the Registrant The information as to Directors will be incorporated herein by reference to the Proxy Statement for the 1994 Annual Meeting of Stockholders to be filed within 120 days after the end of the company's fiscal year. The information as to Executive Officers is contained in Part I of this report as permitted by General Instruction G(3). Item 11.

Item 11. Executive Compensation The information required by this Item will be incorporated herein by reference to the Proxy Statement for the 1994 Annual Meeting of Stockholders to be filed within 120 days after the end of the company's fiscal year. Item 12.

Item 12. Security Ownership of Certain Beneficial Owners and Management The information required by this Item will be incorporated herein by reference to the Proxy Statement for the 1994 Annual Meeting of Stockholders to be filed within 120 days after the end of the company's fiscal year. Item 13.

Item 13. Certain Relationships and Related Transactions The information required by this Item will be incorporated herein by reference to the Proxy Statement for the 1994 Annual Meeting of Stockholders to be filed within 120 days after the end of the company's fiscal year. PART IV Item 14.

Item 14. Exhibits, Financial Statement Schedules and Reports on Form 8-K (a) 1. Financial Statements Consolidated Statements of Financial Position Consolidated Statements of Operations Consolidated Statements of Changes in Shareholders' Equity Consolidated Statements of Cash Flows Notes to Consolidated Financial Statements Independent Auditors' Report 2. Financial Statement Schedules Schedule II - Amounts Receivable from Related Parties and Underwriters, Promoters and Employees other than Related Parties Schedule V - Property, Plant and Equipment Schedule VI - Accumulated Depreciation, Depletion and Amortization of Property, Plant and Equipment Schedule VII - Guarantees of Securities of Other Issuers Schedule VIII - Valuation and Qualifying Accounts All other schedules are omitted either because they are not applicable or not required or because the required information is included in the financial statements or notes thereto. Separate financial statements of the parent company are omitted since it is primarily an operating company and minority equity interests in and/or nonguaranteed long-term debt of subsidiaries held by others than the company are in amounts which together do not exceed 5 percent of the total consolidated assets at December 31, 1993. Exhibits: 3(a) Certificate of Incorporation, as amended (incorporated by reference to Form SE filed March 30, 1989). 3(b) Northrop Corporation Bylaws, as amended (incorporated by reference to Form SE filed March 30, 1993). 4(a) Common Stock Purchase Rights Plan (incorporated by reference to Form 8-A filed September 22, 1988 and amended on August 2, 1991). 4(b) Note Purchase Agreement dated October 15, 1988 among Northrop Corporation and various Institutional Investors (incorporated by reference to Form SE filed March 30, 1989). 10(a) Northrop Corporation Credit Agreement dated as of January 7, 1994. 10(b) Uncommitted Credit Facility dated June 14, 1990, between Northrop Corporation and Bank of New York (incorporated by reference to Form SE filed March 30, 1992), which is substantially identical to facilities between Northrop and certain banks some of which are parties to the Credit Agreement filed as Exhibit (10)(a) hereto. *10(c) 1973 Incentive Compensation Plan (incorporated by reference to Form 8-B filed June 21, 1985). *10(d) 1973 Performance Achievement Plan (incorporated by reference to Form 8-B filed June 21, 1985). *10(e) Northrop Supplemental Plan 2. *10(f) Northrop Corporation ERISA Supplemental Plan 1. *10(g) Retirement Plan for Independent Outside Directors (incorporated by reference to Form SE filed March 29, 1991). *10(h) 1987 Long-Term Incentive Plan, as amended (incorporated by reference to Form SE filed March 30, 1989). 10(i) Deferred Compensation Arrangement under Performance Achievement Plan (incorporated by reference to Form 8-B filed June 21, 1985). *10(j) Supplemental Life Insurance Policy (incorporated by reference to Form 8-B filed June 21, 1985). *10(k) Supplemental Accidental Death and Dismemberment Insurance Policy (incorporated by reference to Form 8-B filed June 21, 1985). *10(l) Supplemental Long-Term Disability Insurance Policy (incorporated by reference to Form 8-B filed June 21, 1985). *10(m) Supplemental Health Insurance Policy (incorporated by reference to Form 8-B filed June 21, 1985). *10(n) Supplemental Dental Insurance Policy (incorporated by reference to Form 8-B filed June 21, 1985). *10(o) Employment Agreement dated October 18, 1989 between Northrop Corporation and Oliver C. Boileau, Jr. (incorporated by reference to Form SE filed March 30, 1993). *10(p) Northrop Corporation 1993 Long-Term Incentive Stock Plan (incorporated by reference to Northrop Corporation 1993 Proxy Statement filed March 30, 1993). *10(q) Northrop Corporation 1993 Non-employee Directors Plan (incorporated by reference to Northrop Corporation 1993 Proxy Statement filed March 30, 1993). 10(r) Northrop Corporation Special Severance Pay Agreement 11 Statement Re Computation of Per Share Earnings 23 Independent Auditors' Consent 24 Power of Attorney ___________ * Listed as Exhibits pursuant to Item 601(b)(10) of Regulation S-K (b) No reports on Form 8-K were filed during the three months ended December 31, 1993. SIGNATURES Pursuant to the requirements of Section 13 or 15(d) 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, on the 28th day of February 1994. Northrop Corporation By: &&PINAZ2928 Nelson F. Gibbs Corporate Vice President and Controller (Principal Accounting Officer) Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed on behalf of the registrant this 28th day of February 1994, by the following persons and in the capacities indicated. Signature Title Kent Kresa* Chairman of the Board, President and Chief Executive Officer and Director (Principal Executive Officer) Oliver C. Boileau, Jr. * Director Jack R. Borsting* Director John T. Chain, Jr.* Director Jack Edwards* Director Barbara C. Jordan* Director Aulana L. Peters* Director Richard R. Rosenberg* Director William F. Schmied* Director John Brooks Slaughter* Director Wallace C. Solberg* Director Richard J. Stegemeier* Director Richard B. Waugh, Jr.* Corporate Vice President and Chief Financial Officer *By: &&PINAD1368 Sheila M. Gibbons, Attorney-in-Fact pursuant to a power of attorney ___________________ (1) Transfers between classifications and between operating elements and, in 1990, assets taken out of operation and held for sale transferred to prepaid expenses. Depreciation and amortization, including capital leases, is computed using the following lives: Years Land improvements . . . . . . . . . . . . . . . . . 4 to 25 Buildings . . . . . . . . . . . . . . . . . . . . . 4 to 45 Machinery and other equipment . . . .. . . . . . . 2 to 20 Leasehold improvements. . . . . . . .. . . . . . . Length of Lease __________ (1) Uncollectible amounts written off, net of recoveries. EXHIBIT 23 INDEPENDENT AUDITORS' CONSENT We consent to the incorporation by reference in Registration Statements Nos. 2-73293, 2-98614 and 33-15764 of Northrop Corporation on Form S-8 of our report dated February 1, 1994, appearing in this Annual Report on Form 10-K of Northrop Corporation for the year ended December 31, 1993. DELOITTE & TOUCHE Los Angeles, California February 28, 1994

31277_1993.txt

31277

1993

Item 1. Business Eaton Corporation (herein referred to as Eaton or Company) was incorporated in 1916. Eaton is a global manufacturer of vehicle powertrain components and a broad variety of controls serving transportation, industrial, commercial, aerospace, and military markets. The Company offers thousands of high-quality products worldwide. Principal products include truck transmissions and axles, engine components, electrical equipment and controls. The Company had 1993 net sales of $4.4 billion and 38,000 employees at 120 manufacturing facilities in 17 countries. In May 1993, the Company redeemed its share purchase rights at a redemption price of 3-1/3 cents for each right, for a total payment of $2 million. In June 1993, the Company distributed a two-for-one stock split effected in the form of a 100% stock dividend and increased its quarterly dividend on Common Shares to 30 cents per share from the post-split rate of 27-1/2 cents per share. Also, in June 1993, the Company reconsolidated the net assets and operating results of its remaining discontinued operations. The Company has concluded that, although it would still prefer to divest these operations, due to the ongoing contraction in the defense industry and uncertainty in the defense electronics market at the present time, it would be extremely difficult to implement its divestiture plans on an acceptable basis. Financial information for these operations is presented under Defense Systems in "Business Segment Information" on page 38 of this report. In December 1993, the Company recorded a $55 million acquisition integration charge before income tax credits ($34 million after income tax credits, or $.49 per Common Share) in conjunction with the January 31, 1994 acquisition of the Distribution and Control Business Unit (DCBU) of Westinghouse Electric Corporation. The acquisition, which will be accounted for as a purchase in 1994, was for a purchase price of $1.1 billion, plus the assumption of certain liabilities. The purchase price is subject to adjustment based upon changes in DCBU's adjusted net assets. DCBU will be combined with the Company's Industrial Control and Power Distribution Operations, which market Cutler-Hammer products, to form a Cutler-Hammer business unit with annual sales of $1.6 billion. DCBU had 1993 sales of $1.1 billion and Eaton's consolidated sales are expected to increase 25% as a result of the acquisition. Further information regarding the acquisition and its financing is presented under "Subsequent Event - Acquisition of DCBU and Integration Charge" on pages 20 through 22 of this report. Information regarding principal products, net sales, operating profit and identifiable assets by business segment and geographic region is found under "Business Segment and Geographic Region Information" on pages 35 to 39 of this report. Additional information regarding Eaton's business segments and its business in general is presented below. Vehicle Components Patents and Trademarks - Eaton owns, controls or is licensed under many patents related to this business segment. Although Eaton emphasizes its EATON trademark in the marketing of many of its products within this business segment, it also markets under a number of other trademarks, including CHAR-LYNN, DILL, FULLER, ROADRANGER and TOP SPEC. Seasonal Fluctuations - Sales of truck, passenger car and off-highway vehicle components are generally reduced in the third quarter of each year as a result of preparations by vehicle manufacturers for the following model year and their temporary shut-downs for taking physical inventories. Competition - The principal methods of competition in this business segment are price, service and product performance. Eaton occupies a strong competitive position in relation to its many competitors in this business segment and, with respect to many products, is considered among the market leaders. Major Customers - Approximately 18% of net sales in 1993 of the Vehicle Components segment were made to divisions and subsidiaries of Ford Motor Company. Also, approximately 39% of net sales in 1993 of the Vehicle Components segment were made to divisions and subsidiaries of five other large companies. Eaton has been doing business with each of these companies for many years. Sales to these companies include a number of different products and different models or types of the same product, the sales of which are not dependent upon one another. With respect to many of the products sold, the various divisions and subsidiaries of each of the companies are in the nature of separate customers, and sales to one division or subsidiary are not dependent upon sales to other divisions or subsidiaries. Electrical and Electronic Controls Patents and Trademarks - Eaton owns, controls or is licensed under many patents related to this business segment. The EATON, C-H CONTROL, CUTLER-HAMMER, DOLE, DURANT, DYNAMATIC, HEINEMANN, KENWAY, and PANELMATE trademarks are used in connection with the marketing of products included in this business segment. In addition, in conjunction with its January 1994 acquisition of DCBU, the Company has the right to use the CHALLENGER, COMMANDER and WESTINGHOUSE trademarks in the marketing of certain products. The use of the WESTINGHOUSE trademark is limited to a period of ten years. Competition - The principal methods of competition in this business segment are price, geographic coverage, service and product performance. The number of competitors varies with respect to the different products. Eaton occupies a strong competitive position in this business segment and, with respect to many products, is considered among the market leaders. Major Customers - Approximately 8% of net sales in 1993 of the Electrical and Electronic Controls segment were made to the United States Government. All contracts that the Company has with the United States Government are subject to termination at the election of the Government. Approximately 6% of net sales in 1993 of the Electrical and Electronic Controls segment were made to divisions and subsidiaries of Ford Motor Company, which is a major customer of the Company's Vehicle Components segment. Defense Systems Patents and Trademarks - Eaton owns, controls or is licensed under many patents related to this business segment. The AIL, INCHWORM and HYPERMANUAL trademarks are used in connection with the marketing of products included in this business segment. Competition - The principal methods of competition in this business segment are price, technological capability and product performance. The number of competitors is limited and varies with respect to the different technologies. Major Customers - Almost all net sales in 1993 of the Defense Systems segment were made to the United States Government. All contracts that the Company has with the United States Government are subject to the termination at the election the Government. Information Concerning Eaton's Business in General Raw Materials - The principal raw materials used by Eaton are iron, steel, copper, aluminum, brass, insulating materials, silver, rubber and plastic. These materials are purchased in various forms, such as pig iron, metal sheets and strips, forging billets, bar stock and plastic pellets. Eaton purchases its raw materials, as well as parts and other components, from many suppliers and under normal circumstances has no difficulty obtaining them. Order Backlog - Since a significant proportion of open orders placed with Eaton by original equipment manufacturers of trucks, passenger cars and off-highway vehicles are historically subject to month-to-month releases by the customers during each model year, such orders are not considered technically firm. In computing its backlog of orders, Eaton includes only the amount of such orders released by such customers as of dates listed. Using this criterion, Eaton's total backlog was approximately $1 billion and $900 million as of December 31, 1993 and 1992, respectively. The backlog should not be relied upon as being indicative of results of operations for future periods. Research and Development - Research and development expenses for new products and the improvement of existing products were $154 million in 1993, $151 million in 1992 and $138 million in 1991. Protection of the Environment - The operations of the Company involve the use, disposal and cleanup of certain substances regulated under environmental protection laws, as further discussed under "Protection of the Environment" on page 26 of this report. Subject to the difficulty in estimating future environmental costs, the Company expects that any sum it may have to pay in connection with environmental matters in excess of the amounts recorded or disclosed will not have a material adverse effect on its financial condition or results of operations. Eaton's estimated capital expenditures for environmental control facilities are not expected to be material for the remainder of 1994 and 1995. Employees - Eaton employed 38,000 individuals as of December 31, 1993. As a result of its January 1994 acquisition of DCBU, the Company added 12,500 employees. Item 2.

Item 2. Properties Eaton's world headquarters is located in Cleveland, Ohio. The Company maintains manufacturing facilities at 120 locations in 17 countries. In addition, as a result of its January 1994 acquisition of DCBU, the Company acquired 36 manufacturing facilities in various domestic and international locations, as well as 27 satellite operations and 12 distribution centers. The Company is a lessee under a number of operating leases for certain real properties and equipment. Information regarding the Company's commitments for operating leases is found under "Lease Commitments" on page 28 of this report. Eaton's principal research facilities are located in Southfield, Michigan, in Milwaukee, Wisconsin, and near Cleveland, Ohio. In addition, certain Eaton divisions conduct research in their own facilities. Management believes that the Company's manufacturing facilities are adequate for its operations, and such facilities are maintained in good condition. Item 3.

Item 3. Legal Proceedings None required to be reported. Item 4.

Item 4. Submission of Matters to a Vote of Security Holders None. Part II Item 5.

Item 5. Market for the Registrant's Common Equity and Related Stockholder Matters The Company's Common Shares are listed for trading on the New York, Chicago, Pacific and London stock exchanges. Information regarding cash dividends paid and the high and low market price per Common Share for each quarter in 1993 and 1992 is found under "Quarterly Data" on page 34 of this report. At December 31, 1993, there were 15,417 holders of record of the Company's Common Shares. Additionally, 15,508 employees were shareholders through participation in the Company's Share Purchase and Investment Plan. Item 6.

Item 6. Selected Financial Data Information regarding selected financial data of the Company is found in the "Five-Year Consolidated Financial Summary" on page 49 of this report. Item 7.

Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations "Management's Discussion and Analysis of Financial Condition and Results of Operations" is found on pages 41 to 48 of this report. Item 8.

Item 8. Financial Statements and Supplementary Data The consolidated financial statements and financial review of Eaton Corporation and the report of independent auditors are found on pages 13 through 39 of this report. Item 9.

Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure None. PART III Item 10.

Item 10. Directors and Executive Officers of the Registrant The information contained on pages 5 through 8 in the Company's definitive proxy statement dated March 18, 1994, with respect to directors of the Company, is incorporated herein by reference in response to this Item. The following is a list of Eaton's officers, their ages and their current positions and offices, as of February 1, 1994. Name Age Position (Date elected to position) - ---------------- --- ------------------------------------------- William E. Butler 62 Chairman and Chief Executive Officer (January 1, 1992); Director John S. Rodewig 60 President; Chief Operating Officer - Vehicle Components (September 22, 1993); Director Stephen R. Hardis 58 Vice Chairman and Chief Financial and Administrative Officer (April 23, 1986); Director Alexander M. Cutler 42 Executive Vice President; Chief Operating Officer - Controls (September 22, 1993); Director Gerald L. Gherlein 55 Executive Vice President and General Counsel (September 4, 1991) John M. Carmont 55 Vice President and Treasurer (December 1, 1981) Adrian T. Dillon 40 Vice President - Planning (March 1, 1991) Patrick X. Donovan 58 Vice President - International (April 27, 1988) John D. Evans 63 Vice President - Human Resources (January 1, 1982) Earl R. Franklin 50 Secretary and Associate General Counsel (September 1, 1991) John W. Hushen 58 Vice President - Corporate Affairs (August 1, 1991) Stanley V. Jaskolski 55 Vice President - Technical Management (October 1, 1990) Ronald L. Leach 59 Vice President - Accounting (December 1, 1981) William T. Muir 51 Vice President - Manufacturing Technologies (April 1, 1989) Derek R. Mumford 52 Vice President - Information Technologies (April 1, 1992) Billie K. Rawot 42 Vice President and Controller (March 1, 1991) All of the officers listed above have served in various capacities with Eaton over the past five years. There are no family relationships among the officers listed, and there are no arrangements or understandings pursuant to which any of them were elected as officers. All officers hold office for one year and until their successors are elected and qualified, unless otherwise specified by the Board of Directors; provided, however, that any officer is subject to removal with or without cause, at any time, by a vote of a majority of the Board of Directors. Item 11.

Item 11. Executive Compensation The information contained on pages 11 through 25 in Eaton's definitive proxy statement dated March 18, 1994, with respect to executive compensation, is incorporated herein by reference in response to this Item. Item 12.

Item 12. Security Ownership of Certain Beneficial Owners and Management The information contained on pages 28 and 29 of the Company's definitive proxy statement dated March 18, 1994, with respect to security ownership of certain beneficial owners and management, is incorporated herein by reference in response to this Item. Item 13.

Item 13. Certain Relationships and Related Transactions The information contained on page 10 of the Company's definitive proxy statement dated March 18, 1994, with respect to certain relationships and related transactions, is incorporated herein by reference in response to this Item. Part IV Item 14.

Item 14. Exhibits, Financial Statement Schedules, and Reports on Form 8-K (a) (1) The following consolidated financial statements and financial review of Eaton Corporation are filed as a separate section of this report: Consolidated Balance Sheets - December 31, 1993 and 1992 - Pages 14 and 15 Statements of Consolidated Income - Years ended December 31, 1993, 1992 and 1991 - Page 16 Statements of Consolidated Cash Flows - Years ended December 31, 1993, 1992 and 1991 - Page 17 Statements of Consolidated Shareholders' Equity - Years ended December 31, 1993, 1992 and 1991 - Page 18 Financial Review - Pages 19 to 39 (2) The summarized financial information for Eaton ETN Offshore Ltd. on page 40 and the following consolidated financial statement schedules for Eaton Corporation are filed as a separate section of this report: Schedule V - Property, Plant and Equipment - Page 50 Schedule VI - Accumulated Depreciation of Property, Plant and Equipment - Page 51 Schedule IX - Short-Term Borrowings - Page 52 Schedule X - Supplementary Income Statement Information - All other schedules for which provision is made in Regulation S-X of the Securities and Exchange Commission, are not required under the related instructions or are inapplicable and, therefore, have been omitted. (3) Exhibits 3 Amended Articles of Incorporation (as amended and restated as of January 24, 1989, filed on Form SE on March 13, 1989) and Amended Regulations (as amended and restated as of April 27, 1988, filed on Form SE on March 13, 1989) 4(a) Instruments defining rights of security holders, including indentures (Pursuant to Regulation S-K Item 601(b)(4), the Company agrees to furnish to the Commission, upon request, a copy of the instruments defining the rights of holders of long-term debt of the Company and its subsidiaries) 10 Material contracts (1) DCBU Purchase Agreement dated as of August 10, 1993 between Westinghouse Electric Corporation (Seller) and Eaton Corporation (Buyer) Regarding the Distribution and Control Business Unit of Westinghouse Electric Corporation (Agreement) - Incorporated by reference to the Company's Quarterly Report on Form 10-Q for the quarter ended September 30, 1993 Including the following Exhibits to the Agreement: (i) Form of Technology Agreement (Ex. 2.1) (ii) Terms of Lease for Shared Facilities (Ex.9.6(a) (1)) (iii) Terms of Sublease for Shared Facilities (Ex. 9.6(a) (2)) (iv) Terms of Lease for Vidalia, Georgia Shared Facility (Ex. 9.6(b) (1) (i)) (v) Terms of Lease by Buyer of Part of Horseheads Facility (Ex. 9.6(b) (1) (ii)) (vi) Terms for Jackson, Mississippi Sublease (Ex. 9.6(b) (2)) (vii) Form of Services Agreement (Ex. 9.8) (viii) Form of WESCO Distributor Agreement (Ex. 9.9) (ix) Form of Interim NEWCO Distributor Agreement (Ex. 7.15.2) (x) Form of NEWCO Distributor Agreement (xi) Form of Supplier and Vendor Agreement (Ex. 9.10) (2) The following are either a management contract or a compensatory plan or arrangement: (a) Deferred Incentive Compensation Plan (as amended and restated May 1, 1990; filed as a separate section of this report) (b) Executive Strategic Incentive Plan, effective as of January 1, 1991 - Incorporated by reference to the Company's Annual Report on Form 10-K for the year ended December 31, 1992 (c) Group Replacement Insurance Plan (GRIP), effective as of June 1, 1992 - Incorporated by reference to the Company's Annual Report on Form 10-K for the year ended December 31, 1992 (d) 1991 Stock Option Plan - Incorporated herein by reference to the Company's definitive proxy statement dated March 18, 1991 (e) The following are incorporated herein by reference to the Company's Quarterly Report on Form 10-Q for the quarter ended June 30, 1990: (i) Strategic Incentive and Option Plan (as amended and restated as of January 1, 1989) (ii) Limited Eaton Service Supplemental Retirement Income Plan (as amended and restated as of January 1, 1989) (iii) Amendments to the 1980 and 1986 Stock Option Plans (iv) Form of "Change in Control" Agreement entered into with all officers of Eaton Corporation (v) Eaton Corporation Supplemental Benefits Plan (as amended and restated as of January 1, 1989) (which provides supplemental retirement benefits) (vi) Eaton Corporation Excess Benefits Plan (as amended and restated as of January 1, 1989) (with respect to Section 415 limitations of the Internal Revenue Code) (f) The following are incorporated herein by reference to the Company's Annual Report on Form 10-K for the year ended December 31, 1990 (filed on Form SE dated March 28, 1991): (i) Executive Incentive Compensation Plan (ii) Plan for the Deferred Payment of Directors' Fees (as amended and restated as of January 1, 1989) (iii) Plan for the Deferred Payment of Directors' Fees (originally adopted in 1980 and amended and restated in 1989) (iv) Eaton Corporation Retirement Plan for Non-Employee Directors (as amended and restated as of January 1, 1989) 11 Statement regarding computations of net income per Common Share (filed as a separate section of this report) 21 Subsidiaries of Eaton Corporation (filed as a separate section of this report) 23 Consent of Independent Auditors (filed as a separate section of this report) 24 Power of Attorney (filed as a separate section of this report) (b) Reports on Form 8-K There were no reports on Form 8-K filed during the fourth quarter of 1993. (c) & (d) Exhibits and Financial Statement Schedules Certain exhibits and financial statement schedules required by this portion of Item 14 are filed as a separate section of this report. Signatures Pursuant to the requirements of Section 13 or 15(d) 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. Eaton Corporation -------------------- Registrant Date: March 28, 1994 /s/ Stephen R. Hardis --------------------- Stephen R. Hardis Vice Chairman and Chief Financial and Administrative Officer; Principal Financial Officer; Director Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the date indicated. DATE: March 28, 1994 Signature Title - -------------------- ------------------------------------- * - -------------------- William E. Butler Chairman and Chief Executive Officer; Principal Executive Officer; Director * - -------------------- John S. Rodewig President; Chief Operating Officer - Vehicle Components; Director * - -------------------- Alexander M. Cutler Executive Vice President; Chief Operating Officer - Controls; Director /s/ Ronald L. Leach - -------------------- Ronald L. Leach Vice President - Accounting; Principal Accounting Officer * - -------------------- Billie K. Rawot Vice President and Controller * - -------------------- Neil A. Armstrong Director * - -------------------- Phyllis B. Davis Director * - -------------------- Arthur Dole III Director * - -------------------- Charles E. Hugel Director * - -------------------- John R. Miller Director * - -------------------- Furman C. Moseley Director * - -------------------- Hooper G. Pattillo Director * - -------------------- A. William Reynolds Director * - -------------------- Gary L. Tooker Director *By /s/ Stephen R. Hardis -------------------------------------- Stephen R. Hardis, Attorney-in-Fact for the officers and directors signing in the capacities indicated Eaton Corporation 1993 Annual Report on Form 10-K Items 6, 7, 8 & Item 14 (c) and (d) Report of Independent Auditors Consolidated Financial Statements and Financial Review Summary Financial Information for Eaton ETN Offshore Ltd. Management's Discussion and Analysis of Financial Condition and Results of Operations Five-Year Consolidated Financial Summary Financial Statement Schedules Exhibits REPORT OF INDEPENDENT AUDITORS - ------------------------------ To the Shareholders Eaton Corporation We have audited the accompanying consolidated balance sheets of Eaton Corporation and the related consolidated statements of income, shareholders' equity, and cash flows for each of the three years in the period ended December 31, 1993. Our audits also included the summary financial information and financial statement schedules listed in Item 14(a). These financial statements, schedules and summary financial information are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements, schedules and summary financial information based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the consolidated financial position of Eaton Corporation at December 31, 1993 and 1992, and the consolidated results of its operations and cash flows for each of the three years in the period ended December 31, 1993, in conformity with generally accepted accounting principles. Also, in our opinion, the related summary financial information and financial statement schedules, when considered in relation to the basic financial statements taken as a whole, present fairly in all material respects the information set forth therein. As described under "Accounting Changes" on page 22 of this report, in 1992 the Company changed its methods of accounting for postretirement benefits other than pensions and for income taxes. Ernst & Young Cleveland, Ohio February 1, 1994 FINANCIAL REVIEW - ---------------- On June 28, 1993, the Company distributed a two-for-one stock split effected in the form of a 100% stock dividend. Accordingly, all per share amounts, average shares outstanding used in the calculation of per share amounts and stock option information have been adjusted retroactively to reflect the stock split. In June 1993, the Company reconsolidated the net assets and operating results of its remaining discontinued operations. Prior years have been restated to include these results. The Company has concluded that, although it would still prefer to divest these operations, due to the ongoing contraction in the defense industry and uncertainty in the defense electronics market at the present time, it would be extremely difficult to implement its divestiture plans on an acceptable basis. Financial information for these operations is presented under Defense Systems in "Business Segment Information" in the Financial Review. ACCOUNTING POLICIES - ------------------- Consolidation - ------------- The consolidated financial statements include accounts of the Company and all majority-owned subsidiaries. The equity method of accounting is used for investments where the Company has a 20% to 50% ownership interest. Foreign Currency Translation - ---------------------------- Financial statements for subsidiaries outside the United States, except those in highly inflationary economies, are translated into U.S. dollars at year-end exchange rates as to assets and liabilities and weighted average exchange rates as to revenues and expenses. The resulting translation adjustments are recorded in shareholders' equity. Financial statements for subsidiaries in highly inflationary economies are translated into U.S. dollars in the same manner except for inventories and property, plant and equipment-net, and related expenses, which are translated at historical exchange rates. The resulting translation adjustments are included in net income. Short-Term Investments - ---------------------- Short-term investments are carried at cost and are not considered to be cash equivalents for purposes of classification in the statements of consolidated cash flows. Inventories - ----------- Inventories are carried at lower of cost or market. Inventories in the United States, other than those associated with long-term contracts, are accounted for using the last-in, first-out (LIFO) method and all other inventories using the first-in, first-out (FIFO) method. Long-Term Contracts - ------------------- Income and costs on long-term contracts, which relate primarily to the Defense Systems business segment, are recognized on the percentage-of-completion method. Provision is made for anticipated losses on uncompleted contracts. Certain government contracts provide for incentive awards or penalties which are reflected in operations at the time amounts can be reasonably determined. Depreciation and Amortization - ----------------------------- Depreciation and amortization are computed by the straight-line method for financial statement purposes. Depreciation of plant and equipment is provided over the useful lives of the various classes of assets. Excess of cost over net assets of businesses acquired is amortized over fifteen to forty years (accumulated amortization was $78 million and $69 million at the end of 1993 and 1992, respectively). Other intangible assets, principally patents, are amortized over their respective lives. Income Taxes - ------------ In 1992, the Company adopted Statement of Financial Accounting Standards (SFAS) No. 109, "Accounting for Income Taxes", as discussed under "Accounting Changes" in the Financial Review. Deferred income taxes are not provided for undistributed earnings of consolidated subsidiaries outside the United States when such earnings are reinvested for an indefinite period of time by the subsidiaries. Financial Instruments - --------------------- Gains or losses on interest rate swap and cap agreements which hedge interest on debt are accrued in interest expense. Gains or losses on foreign currency forward exchange contracts and options which hedge specific transactions are recognized in net income, offsetting the underlying foreign currency transaction gains or losses. Gains or losses on foreign currency forward exchange contracts and options which hedge net investments in consolidated subsidiaries outside the United States are accrued in shareholders' equity. Premiums related to interest rate swap and cap agreements and foreign currency forward exchange contracts and options are amortized to net income over the life of the agreement. Net Income Per Common Share - --------------------------- Net income per Common Share is computed by dividing net income by the average month-end number of shares outstanding during each period. The dilutive effect of common stock equivalents is not material. SUBSEQUENT EVENT - ACQUISITION OF DCBU AND INTEGRATION CHARGE - ------------------------------------------------------------- On January 31, 1994, the Company acquired the Distribution and Control Business Unit (DCBU) of Westinghouse Electric Corporation for a purchase price of $1.1 billion, plus the assumption of certain liabilities. The purchase price is subject to adjustment based upon changes in DCBU's adjusted net assets. This acquisition will be accounted for as a purchase in 1994. DCBU had sales of $1.1 billion in 1993 and has estimated net assets of $600 million. DCBU is a leading North American manufacturer of electrical distribution equipment and industrial controls, headquartered in Pittsburgh, Pennsylvania. It has approximately 12,500 employees who are located at 36 plants and facilities in the United States, Puerto Rico, Central and South America, Canada and the United Kingdom, and at 27 satellite operations and 12 distribution centers. The purchase includes Challenger Electrical Equipment Corporation, which was acquired by Westinghouse in 1987. DCBU will be combined with Eaton's Industrial Control and Power Distribution Operations (ICPDO), which market Cutler-Hammer products, to form a Cutler-Hammer business unit with annual sales of $1.6 billion. Eaton's consolidated sales are expected to increase by 25% as a result of the acquisition. In order to finance the acquisition, the Company issued $930 million of short-term commercial paper. The Company plans to reduce these short-term financings by the middle of 1994 through equity and long-term debt financings. The timing and mix of these financings will depend on market conditions. Of these short-term financings, $555 million will be classified as long-term debt because the Company intends, and has the ability under a new five-year $555 million revolving credit agreement entered into in January 1994, to refinance this debt on a long-term basis. Also, in January 1994, the Company entered into a $555 million 364-day revolving credit agreement. In 1993, the Company entered into several interest rate hedge agreements related to the planned financing of the acquisition. In September 1993, the Company entered into four interest rate swaps commencing on January 18, 1994. Two thirty-year swaps will effectively convert $100 million of floating rate debt into fixed rate debt at an average rate of 6.685%, and two ten-year swaps will effectively convert $100 million of floating rate debt into fixed rate debt at an average rate of 5.788%. In October 1993, the Company purchased a one-year interest rate cap commencing on January 1, 1994 that effectively places a 5.5% ceiling on $400 million of floating rate debt, and a ten-month interest rate cap commencing January 1, 1995 that effectively places a 5.5% ceiling on $100 million of floating rate debt. In December 1993, in conjunction with the acquisition, the Company recorded a $55 million acquisition integration charge before income tax credits ($34 million after income tax credits, or $.49 per Common Share). Part of a comprehensive business plan, the charge addresses the costs of the integration of ICPDO product lines and operations with DCBU, related workforce reductions and an $8 million write-down of assets, largely in the United States. Expenditures are expected to occur over approximately the next four years and will be funded through cash flow from the combined operations. The Company anticipates that integration of the businesses will create permanent value by streamlining product lines, manufacturing capacity and organization structure and enable the businesses to attain maximum benefit from synergy of complementary product offerings, operations and technical expertise. Positive incremental benefits are anticipated following the first year of integration activities. EXTRAORDINARY ITEM AND RESTRUCTURING CHARGE - ------------------------------------------- In March 1993, the Company called for redemption, in April 1993, the $74 million outstanding balance of its 9% debentures, and in December 1993, the Company called for redemption, in January 1994, the $89 million outstanding balance of its 8.5% debentures. The extraordinary loss on these redemptions, including the write-off of debt issue costs, was $11 million before income tax credits ($7 million after income tax credits, or $.10 per Common Share). In 1991, as a result of the review of operating strategies and in order to improve competitiveness and future profitability, the Company recorded a restructuring charge of $39 million before income tax credits ($25 million after income tax credits, or $.38 per Common Share). The charge included provisions for restructuring, relocation and rationalization of product lines and operations and permanent workforce reductions involving a significant number of operations, primarily in the United States and Europe. ACCOUNTING CHANGES - ------------------ In 1992, the Company adopted SFAS No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions". SFAS No. 106 requires accrual of these benefits, primarily postretirement health care and life insurance for retirees in the United States, over the working lives of employees rather than recognition of expenses as claims are incurred. Included in net income for 1992 is the cumulative effect of this accounting change for prior years of $442 million before income tax credits ($274 million after income tax credits, or $3.97 per Common Share). As a result of this accounting change, 1992 postretirement health care and life insurance costs increased $25 million before income tax credits ($16 million after income tax credits, or $.23 per Common Share). Results for 1991 have not been restated for this accounting change. SFAS No. 106 has no effect on cash flows since claims will continue to be paid as incurred. In 1992, the Company also adopted SFAS No. 109, "Accounting for Income Taxes". The adoption of this standard changed the method of accounting for income taxes to the liability method from the deferred method. The liability method requires recognition of deferred income taxes based on temporary differences between the financial reporting and income tax bases of assets and liabilities, using currently- enacted income tax rates and regulations. Included in net income for 1992 is the cumulative effect of this accounting change for prior years of $6 million, or $.09 per Common Share. Results for 1991 have not been restated for this accounting change. SFAS No. 109 has no effect on cash flows. ACCOUNTS RECEIVABLE - ------------------- Included in accounts receivable at December 31, 1993 and 1992 were unbilled amounts of $23 million and $91 million, respectively, primarily related to long-term contracts of the Defense Systems business segment with the United States Government. These receivables will be billed in accordance with applicable contract terms and are expected to be collected within one year. Accounts receivable are net of an allowance for doubtful accounts of $10 million at the end of 1993 and 1992. INVENTORIES - ----------- December 31 --------------- (Millions of dollars) 1993 1992 ---- ---- Raw materials $141 $128 Work in process 238 264 Finished goods 139 146 ---- ---- Gross inventories at FIFO 518 538 Excess of current cost over LIFO cost (84) (83) ---- ---- Net inventories at LIFO $434 $455 ==== ==== Gross inventories accounted for using the LIFO method were $314 million and $294 million at the end of 1993 and 1992, respectively. DEBT AND OTHER FINANCIAL INSTRUMENTS - ------------------------------------ Information related to the 1994 financing of the acquisition of DCBU is contained under "Subsequent Event - Acquisition of DCBU and Integration Charge" in the Financial Review. The Company has lines of credit, primarily short-term, aggregating $119 million from various banks worldwide. Most of these arrangements do not have termination dates, but are reviewed periodically for renewal. At December 31, 1993, the Company had $24 million outstanding under lines of credit with banks. A summary of long-term debt, excluding the current portion, follows: December 31 --------------- (Millions of dollars) 1993 1992 ---- ---- 9% notes payable, due 2001 $100 $100 8% debentures, due 2006 (due 1996 at option of debenture holder) 86 86 8.9% debentures, due 2006 100 100 7% debentures, due 2011, net of unamor- tized discount of $95 million in 1993 and $96 million in 1992 (effective interest rate 14.6%) 105 104 8-7/8% debentures, due 2019 (due 2004 at option of debenture holder) 38 38 8.1% debentures, due 2022 100 100 Notes payable of Employee Stock Ownership Plan due through 1999 82 96 8.5% sinking fund debentures 89 9% sinking fund debentures 74 Other 38 46 ---- ---- $649 $833 ==== ==== During 1993, the Company called for redemption the $74 million outstanding balance of its 9% debentures and the $89 million outstanding balance of its 8.5% debentures, resulting in an extraordinary loss of $7 million. Notes payable of the Employee Stock Ownership Plan (ESOP), which are guaranteed by the Company, consist of $65 million at a floating interest rate (3.00% at December 31, 1993) based on LIBOR and $31 million at a fixed interest rate of 7.62%. The Company has entered into a series of interest rate swaps, which expire ratably through 1999, and which change the interest rate on the $31 million of fixed interest rate notes payable to fixed interest rates of 7.07% and 6.85% as to $9 million and $18 million, respectively, and to a floating interest rate (2.075% at December 31, 1993) based on LIBOR as to $4 million. In 1991, an unrelated party exercised its option under a 1990 agreement to enter into an interest rate swap expiring in 2000 with the Company. The agreement effectively converts $100 million of floating rate debt into fixed rate obligations. Payments are received at a floating interest rate (3.375% at December 31, 1993) based on LIBOR and are made at a fixed interest rate of 9%. Aggregate mandatory sinking fund requirements and annual maturities of long-term debt are as follows (in millions): 1994, $110; 1995, $21; 1996, $106; 1997, $21; and 1998, $22. The amount for 1994 includes $89 million of 8.5% debentures called for redemption in January 1994. The amount for 1996 includes $86 million of 8% debentures due in 1996 at the option of the debenture holder. Interest cost capitalized as part of acquisition or construction of major assets (in millions) was $12, $8, and $7 in 1993, 1992 and 1991, respectively. Interest paid (in millions) was $90, $94 and $81 in 1993, 1992 and 1991, respectively. At December 31, 1993, the Company held foreign currency forward exchange contracts and options, which primarily mature in 1994, for purchase or sale of largely European and Canadian currencies to hedge foreign currency transactions and net investment positions. Open purchase contracts totaled $63 million and open sales contracts totaled $290 million. Counterparties to various hedging instruments are a number of major international financial institutions. While the Company may be exposed to credit losses in the event of nonperformance by these counterparties, it does not anticipate losses due to its control over the limit of positions entered into with any one party and the strong credit ratings of these institutions. The following table summarizes the carrying amount and fair value of financial instruments: The fair value of equity investments, marketable securities, long-term debt and interest rate derivatives was principally based on quoted market prices. The fair value of foreign currency forward exchange contracts and options was estimated based on quoted market prices of comparable contracts, adjusted through interpolation where necessary for maturity differences. The carrying amount of financial instruments is not affected by the fair value measurement. PROTECTION OF THE ENVIRONMENT - ----------------------------- The Company has been named a potentially responsible party (PRP) under the Federal Superfund law at a number of waste disposal sites. Although this law technically imposes joint and several liability upon each PRP at each site, the extent of the Company's required financial contribution to the cleanup of these sites is expected to be limited based on the number and financial strength of the other named PRP's and the volumes of waste involved which might be attributable to the Company. The Company is also involved in remedial response and voluntary environmental cleanup expenditures at a number of other sites which are not the subject of any Superfund law proceeding, including certain of its currently-owned or formerly-owned plants. Although it is difficult to quantify the potential financial impact of compliance with environmental protection laws, management estimates that there is a reasonable possibility that the remediation and other costs associated with all of these sites may range between $10 million and $68 million, and that such costs would be incurred over a period of several years. The Company accrues for these costs when it is probable that a liability has been incurred and the amount of the loss can be reasonably estimated. At December 31, 1993, the Company's balance sheet included an accrual for the estimated remediation and other environmental costs of approximately $14 million. Actual costs to be incurred at identified sites in future periods may vary from the estimates, given inherent uncertainties in evaluating environmental exposures. Subject to the difficulty in estimating future environmental costs, the Company expects that any sum it may be required to pay in connection with environmental matters in excess of the amounts recorded or disclosed above will not have a material adverse effect on its financial condition or results of operations. With respect to the DCBU operations acquired at January 31, 1994, to date the Company has conducted only a due diligence, pre-acquisition review of the environmental loss contingencies and expenditures at these operations. Although additional investigation and review is in progress, the Company is not yet able to evaluate conclusively the scope of any environmental issues. The Company expects that these operations will have environmental exposure similar to that of other electrical equipment manufacturers. The Company's exposure is limited, however, by the agreement between the Company and Westinghouse Electric Corporation, pursuant to which the Company acquired DCBU. With respect to environmental conditions existing prior to the acquisition, Westinghouse has agreed to retain certain responsibilities, to share the cost of others and to indemnify the Company for its share of those costs to the extent that they exceed $3.5 million annually. For locations in the United States, this obligation to share and to indemnify extends for ten years, and for locations elsewhere it extends for fifteen years. The Company continues to modify, on an ongoing, regular basis, certain of its processes in order to reduce the impact on the environment. Efforts in this regard include the removal of many underground storage tanks and the reduction or elimination of certain chemicals and wastes in its operations. OPTIONS FOR COMMON SHARES - ------------------------- Options have been granted to certain employees, under various plans, to purchase the Company's Common Shares at prices equal to fair market value as of date of grant. These options expire ten years from date of grant. A summary of stock option activity follows: SHAREHOLDERS' EQUITY - -------------------- There are 150 million Common Shares authorized. There were 11 million and 12 million Common Shares held in treasury at the end of 1992 and 1991, respectively, which were reissued in conjunction with the June 1993 two-for-one stock split. At December 31, 1993, 5.8 million Common Shares were reserved principally for exercise and grant of stock options. At December 31, 1993, there were 15,417 holders of record of Common Shares. Additionally, 15,508 employees were shareholders through participation in the Share Purchase and Investment Plan. In private placements the Company sold 1.3 million Common Shares in 1993 for aggregate net proceeds of $62 million, and sold an additional 800,000 Common Shares in January 1994 for aggregate net proceeds of $38 million. In May 1993, the Company redeemed its share purchase rights at a redemption price of 3-1/3 cents for each right, for a total payment of $2 million. The Company's Employee Stock Ownership Plan (ESOP) was established to prefund a portion of the anticipated matching contributions through 1999 to its Share Purchase and Investment Plan (SPIP) for participating United States employees. That portion of SPIP expense related to the ESOP is calculated by first determining the ratio of shares allocated to employee ESOP accounts relative to shares released, and then applying that ratio to the amount contributed to the ESOP. That amount, along with dividends on unallocated Common Shares held by the ESOP, is used to repay the notes, including interest, in level installments. Unallocated ESOP shares are allocated to employee ESOP accounts in aggregate amounts based on loan principal payments made by the ESOP. LEASE COMMITMENTS - ----------------- Future minimum rental commitments as of December 31, 1993, under noncancelable operating leases, which expire at various dates and in most cases contain renewal options, are as follows (in millions): 1994, $28; 1995, $23; 1996, $17; 1997, $14; 1998, $12; and after 1998, $91. Rental expense in 1993, 1992 and 1991 (in millions) was $43, $45 and $49, respectively. PENSION PLANS - ------------- The Company has non-contributory defined benefit pension plans covering the majority of employees. Plans covering salaried and certain hourly employees provide benefits that are generally based on years of service and final average compensation. Benefits for other hourly employees are generally based on years of service. Company policy is to fund at least the minimum amount required by applicable regulations. In the event of a change in control of the Company, excess pension plan assets of North American operations may be dedicated to funding of health and welfare benefits for employees and retirees. The components of pension (expense) income are as follows: Year ended December 31 -------------------------- (Millions of dollars) 1993 1992 1991 ---- ---- ---- Service cost - benefits earned during year $(42) $(39) $(39) Interest cost on projected benefit obligation (97) (96) (92) Actual return on assets 155 203 216 Net amortization and deferral (17) (73) (90) ---- ---- ---- $ (1) $ (5) $ (5) ==== ==== ==== The following table sets forth, by funded status, the asset (liability) recognized in the consolidated balance sheets for pension plans: Measurement of the projected benefit obligation was based on a discount rate of 7.25% in 1993 and 8.25% in 1992 and 1991. The expected compensation growth rate was 4.95% in 1993 and 5.95% in 1992 and 1991. The expected long-term rate of return on assets was 10% in all three years; actual returns during each of these three years exceeded the expected 10% rate. Plan assets were invested in equity and fixed income securities and other instruments. Underfunded plans are associated principally with operations outside the United States. The change in the discount rate to 7.25% at the end of 1993 had the effect of increasing the accumulated pension benefit obligation by $103 million with an offsetting decrease in the unamortized net gain. This change will have an immaterial effect on future expense. POSTRETIREMENT BENEFIT PLANS OTHER THAN PENSIONS - ------------------------------------------------ Generally, employees become eligible for postretirement benefits other than pensions, primarily health care and life insurance for retirees in the United States, when they retire. These benefits are payable for life, although the Company retains the right to modify or terminate the plans providing these benefits. The plans are primarily contributory, with retiree contributions adjusted annually, and contain other cost-sharing features, including deductibles and co-payments. Effective January 1, 1993, certain plans were amended to limit the annual amount of the Company's future contributions towards employees' postretirement health care benefits. Company policy is to pay claims as they are incurred since, unlike pensions, there is no effective method to obtain a tax deduction for prefunding of these benefits under existing United States income tax regulations. Expense for postretirement benefits other than pensions, with amounts for 1993 and 1992 calculated under SFAS No. 106, is as follows: Year ended December 31 ---------------------- (Millions of dollars) 1993 1992 1991 ---- ---- ---- Service cost - benefits earned during year $ (7) $(12) Interest cost on projected benefit obligation (37) (44) Amortization of unrecognized prior service cost 9 Claims incurred and expensed $(27) ---- ---- ---- $(35) $(56) $(27) ==== ==== ==== The liability recognized in the consolidated balance sheets for postretirement benefit plans other than pensions is as follows: December 31 --------------- (Millions of dollars) 1993 1992 ---- ---- Accumulated postretirement benefit obligation Retirees $368 $345 Eligible plan participants 38 45 Noneligible plan participants 120 161 Unamortized amounts not yet recognized Prior service cost 91 Net loss (73) (5) ---- ---- $544 $546 ==== ==== Measurement of the accumulated postretirement benefit obligation at December 31, 1993, was based on a 12% annual rate of increase in per capita cost of covered health care benefits (13% for 1992). For 1993, the rate was assumed to decrease ratably to 5% through 2000 and remain at that level thereafter (6% for 1992). The discount rate was 7.25% in 1993 and 8.5% in 1992. An increase of 1% in assumed health care cost trend rates would increase the accumulated postretirement benefit obligation as of December 31, 1993 by $34 million and the net periodic cost for 1993 by $2 million. The changes in assumed rates had the effect of increasing the accumulated postretirement benefit obligation by $49 million with an offsetting increase in the unamortized net loss. This change will have an immaterial effect on future expense. INVESTMENT IN LIFE INSURANCE - ---------------------------- In 1993, the Company purchased company-owned life insurance policies insuring the lives of a portion of its active United States employees. These policies offer an attractive means of accumulating assets to meet future liabilities including the payment of employee benefits such as health care. At December 31, 1993, the investment in this life insurance, included in other assets, was $7 million, net of policy loans of $110 million. Net life insurance expense of $2 million, including interest expense of $4 million in 1993, was included in selling and administrative expense. INCOME TAXES - ------------ Year ended December 31 ---------------------- (Millions of dollars) 1993 1992 1991 ---- ---- ---- Income before income taxes United States $214 $147 $ 85 Outside the United States 48 34 16 ---- ---- ---- $262 $181 $101 ==== ==== ==== Income taxes, with amounts for 1993 and 1992 derived under SFAS No. 109, are summarized below: Year ended December 31 ---------------------- (Millions of dollars) 1993 1992 1991 ---- ---- ---- Current United States Federal $108 $ 42 $ 64 State and local 7 5 10 Outside the United States 30 20 10 ---- ---- ---- 145 67 84 Deferred United States Increase in statutory tax rate (5) Other Federal (50) (14) (47) State and local (2) (1) (8) Outside the United States Operating loss carryforwards (7) (11) Reduction of valuation allowance for deferred tax assets (5) Increase in statutory tax rate (1) Other 7 (2) ---- --- --- (63) (26) (57) ---- --- --- $ 82 $41 $27 ==== === === Significant components of net current and net long-term deferred income taxes derived under SFAS No. 109 are as follows: December 31, 1993 ------------------------------- Current Long-term Long-term (Millions of dollars) assets assets liabilities ------- --------- ----------- Accruals and other adjustments Employee benefits $ 44 $209 $ (4) Inventory 15 Long-term contracts 16 Restructuring 15 13 Depreciation and amortization (140) (15) Other 22 5 Operating loss carryforwards 50 2 Valuation allowance (15) Other items 15 (10) 7 ---- ---- ---- $127 $112 $(10) ==== ==== ==== December 31, 1992 ------------------------------- Current Long-term Long-term (Millions of dollars) assets assets liabilities ------- --------- ----------- Accruals and other adjustments Employee benefits $ 28 $209 $ (3) Inventory 26 Long-term contracts 17 (9) Restructuring 14 Depreciation and amortization (137) (19) Other 23 4 Operating loss carryforwards 42 4 Valuation allowance (20) Other items 12 (28) 4 ---- ---- ---- $120 $ 61 $(14) ==== ==== ==== The deferred income tax provision of $57 million for 1991 related primarily to long-term contracts. At December 31, 1993 certain subsidiaries outside the United States had tax loss carryforwards aggregating $115 million. Carryforwards of $68 million have no expiration dates and the balance expire at various dates from 1995 through 2005. The adoption of SFAS No. 109 reduced 1992 income tax expense by $11 million and the effective income tax rate by 6%, in comparison to the prior accounting method. The parent company has not provided income taxes on undistributed earnings of consolidated subsidiaries outside the United States of $332 million at December 31, 1993, since the earnings retained have been reinvested by the subsidiaries. If distributed, such remitted earnings would be subject to withholding taxes but substantially free of United States income taxes. Worldwide income tax payments, including Federal and state income taxes in the United States, in 1993, 1992 and 1991 (in millions) were $156, $71 and $97, respectively. QUARTERLY DATA - -------------- (Unaudited) Quarter ended (Millions of dollars except ----------------------------------- for per share data) Dec. 31 Sept. 30 June 30 Mar. 31 ------- -------- ------- ------- Net sales $1,115 $1,053 $1,147 $1,086 Gross margin 297 266 279 275 Percent of sales 27% 25% 24% 25% Income before extraordinary item 30 44 53 53 Extraordinary item (4) (3) Net income 26 44 53 50 Per Common Share Income before extraordinary item $ .41 $ .63 $ .77 $ .76 Extraordinary item (.05) (.05) Net income .36 .63 .77 .71 Cash dividends paid .30 .30 .275 .275 Market price High 55-3/8 51-3/4 47-1/8 43-3/4 Low 48 43 41-1/2 38-1/4 Net sales $1,030 $1,012 $1,064 $ 995 Gross margin 253 223 256 235 Percent of sales 24% 22% 24% 24% Income before cumulative effect of accounting changes 39 28 41 32 Cumulative effect of accounting changes Postretirement benefits other than pensions (274) Income taxes 6 Net income (loss) 39 28 41 (236) Per Common Share Income before cumulative effect of accounting changes $ .57 $ .40 $ .60 $ .46 Cumulative effect of accounting changes Postretirement benefits other than pensions (4.00) Income taxes .09 Net income (loss) .57 .40 .60 (3.45) Cash dividends paid .275 .275 .275 .275 Market price High 40-7/8 40-3/8 41-5/8 39-3/8 Low 35 35-7/8 35-1/2 30-7/8 The fourth quarter of 1993 includes an acquisition integration charge of $55 million before income tax credits ($34 million after income tax credits, or $.49 per Common Share). The redemption of debentures in 1993 resulted in extraordinary losses of $5 million and $6 million before income tax credits in the first and fourth quarters, respectively ($3 million and $4 million after income tax credits, or $.05 per Common Share in each quarter). The previously reported first quarter results were restated to segregate the extraordinary loss. Gross margin for the second quarter of 1993 was reduced by a charge of $9 million for the restructuring of certain vehicle components operations in Europe. The third quarter of 1992 includes an $11 million gain, before income taxes, on the sale of an interest in a limited partnership. The gain was partially offset by the accrual in the third quarter of 1992 of the contribution to the Company's charitable trust of marketable securities with a market value of $8 million. In 1992, the Company adopted the new accounting standards for postretirement benefits other than pensions and income taxes, retroactive to January 1, 1992. Net income in the first quarter of 1992 includes the cumulative effect of the accounting change for postretirement benefits other than pensions for prior years of $442 million before income tax credits ($274 million after income tax credits, or $4.00 per Common Share). Net income in the first quarter of 1992 also includes the cumulative effect of the accounting change for income taxes for prior years of $6 million, or $.09 per Common Share. BUSINESS SEGMENT AND GEOGRAPHIC REGION INFORMATION - -------------------------------------------------- Operations are classified among three business segments: Vehicle Components, Electrical and Electronic Controls and Defense Systems. The major classes of products included in each segment and other information follow. Vehicle Components - ------------------ Truck Components - Heavy and medium duty mechanical transmissions; power take-offs; drive, trailer and steering axles; brakes; locking differentials; engine valves; valve lifters; leaf springs; viscous fan drives; fans and fan shrouds; power steering pumps; tire pressure control systems; tire valves. Passenger Car Components - Engine valves; hydraulic valve lifters; viscous fan drives; fans and fan shrouds; locking differentials; spring fluid dampers; superchargers; tire valves. Off-Highway Vehicle Components - Mechanical and automatic transmissions; drive and steering axles; brakes; engine valves; hydraulic valve lifters; gear and piston pumps and motors; transaxles and steering systems; geroters; control valves and cylinders; forgings; tire valves. The principal market for these products is original equipment manufacturers of trucks, passenger cars and off-highway vehicles. Most sales of these products are made directly from the Company's plants to such manufacturers. Electrical and Electronic Controls - ---------------------------------- Industrial and Commercial Controls - Electromechanical and electronic controls: motor starters, contactors, overloads and electric drives; programmable controllers, counters, man/machine interface panels and pushbuttons; photoelectric, proximity, temperature and pressure sensors; circuit breakers; loadcenters; safety switches; panelboards; switchboards; dry type transformers; busway; meter centers; portable tool switches; commercial switches; relays; illuminated panels; annunciator panels; electrically actuated valves and actuators. Automotive and Appliance Controls - Electromechanical and electronic controls: convenience, stalk and concealed switches; knock sensors; climate control components; speed controls; timers; pressure switches; water valves; range controls; thermostats; gas valves; infinite switches; temperature and humidity sensors. Specialty Controls - Automated material handling systems; automated guided vehicles; stacker cranes; ion implanters; engineered fasteners; golf grips; industrial clutches and brakes. The principal markets for these products are industrial, commercial, automotive, appliance, aerospace and government customers. Sales are made directly by the Company or indirectly through distributors and manufacturers' representatives. Defense Systems - --------------- Strategic countermeasures; tactical jamming systems; electronic intelligence; electronic support measures. The principal market for these products is the United States Government. Other Information - ----------------- Operating profit represents net sales less operating expenses for each segment and geographic region and excludes interest expense and income, and general corporate expenses--net. Identifiable assets for each segment and geographic region represent those assets used in operations (including excess of cost over net assets of businesses acquired) and exclude general corporate assets (consisting principally of short-term investments, deferred income taxes, investments carried at equity, property and other assets). Net sales to divisions and subsidiaries of one customer, primarily from the Vehicle Components business segment, were $541 million in 1993, $491 million in 1992 and $394 million in 1991 (12% of sales in 1993, 12% in 1992 and 11% in 1991). Geographic Region Information Summary Financial Information for Eaton ETN Offshore Ltd. - --------------------------------------------------------- Eaton ETN Offshore Ltd. (Eaton Offshore) was incorporated by Eaton under the laws of Ontario, Canada, primarily for the purpose of raising funds through the offering of debt securities in the United States and making these funds available to Eaton and/or one or more of Eaton's direct or indirect subsidiaries. All of the issued and outstanding capital stock of Eaton Offshore is owned directly or indirectly by Eaton. In addition, Eaton Offshore owns all of the issued and outstanding capital stock of Eaton Yale ltd. (Eaton Yale) previously owned by Eaton. Eaton Yale is engaged principally in the manufacture of fasteners, leaf spring assemblies and electrical and electronic controls. In January 1992, Eaton Yale acquired Franz Kirsten KG. In January 1994, Eaton Yale acquired the Canadian operations of the Distribution and Control Business Unit of the Westinghouse Electric Corporation. Summary financial information for Eaton Offshore and its consolidated subsidiaries is as follows: Year ended December 31 ------------------------------------ (Millions of dollars) 1993 1992 1991 1990 1989 ---- ---- ---- ---- ---- Income statement data Net sales $281 $295 $165 $188 $207 Gross profit 38 42 26 29 29 Net income 13 17 13 12 7 Balance sheet data Current assets $144 $144 $124 $ 91 $ 49 Net intercompany receivables (payables) 22 24 33 17 (11) Noncurrent assets 81 86 42 48 45 Current liabilities 42 51 20 21 12 Noncurrent liabilities 109 115 104 73 12 MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS OVERVIEW - -------- The Company experienced an extraordinary year of achievement in 1993. Income after income taxes for the year increased to $214 million in 1993 before the recognition of a $34 million acquisition integration charge and a $7 million extraordinary loss on the redemption of debentures. This represents a 53% increase compared to income of $140 million in 1992 (before the cumulative effect of 1992 accounting changes). Earnings per Common Share, before the special charges, rose to $3.06 in 1993, a 51% increase over $2.03 (before the impact of accounting changes) in 1992. On January 31, 1994, the Company acquired Westinghouse Electric Corporation's Distribution and Control Business Unit (DCBU), and in December of 1993 recorded a $55 million charge ($34 million after income tax credits, or $.49 per Common Share) for the integration of the Company's Industrial Control and Power Distribution Operations (ICPDO) with DCBU to form the Cutler- Hammer business unit. This acquisition provides greater product depth with world class technology and substantially increases product offering and distribution opportunities. During March and December 1993, the Company called for redemption a total of $163 million of debentures. The loss on the redemptions was accounted for as an extraordinary item in each of those periods. In June, a two-for-one common stock split was distributed, effected in the form of a 100% stock dividend, and the quarterly dividend on Common Shares was increased by 2-1/2 cents (9%) to 30 cents per share, the third dividend increase in seven years. In June, the Company reconsolidated the net assets and operating results of its remaining discontinued operations. Prior years have been restated to include those results. 1993 COMPARED TO 1992 - --------------------- NET SALES - --------- Net sales in 1993 increased by 7% to $4.40 billion, over $4.10 billion in 1992. The increase occurred principally in the United States and was largely due to a strengthened North American market for heavy and light trucks, vans and sport utility vehicles, responding to a U.S. economic recovery. The improvement in North America more than offset the effects of the continued deep European recession. In North America, certain markets, which had been sluggish through most of 1993, showed sales improvements in the fourth quarter. The Vehicle Components segment net sales increased to $2.36 billion for 1993, rising 13% over 1992 sales of $2.09 billion. This improvement was largely due to significant growth in sales of truck components, following the best factory sales of heavy trucks in North America since 1979. The passenger car and light truck markets also showed improvement in 1993. Off-highway equipment markets, which had been down for several years, improved considerably. Strong sales growth in North America was partially offset by reduced sales in Europe where vehicle markets remain weak. The Electrical and Electronic Controls segment showed a net sales increase of 4% in 1993 to $1.85 billion compared to $1.78 billion in 1992. This increase was largely due to increased sales in the areas of industrial and commercial controls and specialty controls. Strong North American markets for automotive and appliance controls were largely offset, however, by the continued weakness in the corresponding European markets due to the economic recession and the negative impact of foreign currency exchange rate fluctuations. Rising demand for portable tools, factory equipment and residential housing drove the increase in sales of industrial and commercial controls. Sales of the Company's industrial and power distribution equipment, which tend to lag any North American economic recovery, rose sharply in the fourth quarter. The semiconductor equipment business, included in specialty controls, experienced strong results throughout the year, with a 19% improvement in sales for 1993 over 1992. OPERATING RESULTS - ----------------- Gross margin increased to $1.12 billion (25.4% of sales) in 1993, rising from $967 million (23.6% of sales) in 1992, due to significant sales growth as well as benefits achieved through ongoing cost containment and productivity improvements. This improvement in margin was achieved in spite of a $9 million charge, included in cost of products sold in 1993, for the restructuring of certain vehicle components operations in Europe. Selling and administrative expenses showed an increase of 2% in 1993 compared to 1992, with expense of $591 million in 1993 and $578 million in 1992. This level of increase is a clear indication of the results of cost control and restructuring efforts, which is further evidenced by their relationship to net sales, 13% in 1993 compared to 14% in 1992. Research and development expenses for 1993 were $154 million, rising from $151 million in 1992. This level of expenditure reflects the continued commitment to achieving expressed corporate targets in product innovation and enhancements and to maintaining leading-edge technology. The Vehicle Components segment operating profit rose to $247 million (10% of sales) for 1993, a substantial improvement over $170 million (8% of sales) for 1992 despite a $9 million restructuring charge recorded in 1993 for restructuring certain European operations. This improvement was largely a result of the improved market in North America for heavy and light trucks, vans and sport utility vehicles. Other factors contributing to increased profits were continuing stringent cost containment efforts and the economies achieved through restructuring certain businesses, which have better positioned operations to benefit from further growth in vehicle markets. The Electrical and Electronic Controls segment operating profit significantly improved, before the effect of the $55 million acquisition integration charge, rising 62% to $138 million in 1993 (7% of sales) from $85 million (5% of sales) in 1992. This improved segment profit picture is partially due to the sales growth experienced in certain controls markets, but is also a clear reflection of the continuing emphasis placed on containing and controlling costs and the realization of anticipated benefits of earlier restructuring efforts. The depressed European economy negatively impacted the controls businesses, particularly automotive and appliance controls. Profit for this segment was also reduced by a $55 million pretax charge recorded in December 1993 for the integration of ICPDO product lines and operations with DCBU to form the new Cutler-Hammer business unit. The DCBU acquisition will bring a more even balance in sales and earnings between the Electrical and Electronic Controls segment and the historically strong Vehicle Components segment. Interest expense declined to $75 million for 1993, the lowest level since 1986, from $89 million for 1992 largely due to the reduction of higher interest rate debt, lower debt levels during 1993 and increased capitalized interest. Other income--net was $12 million in 1993, down from $23 million in 1992, largely due to the $11 million pretax gain on the sale of the Company's interest in a limited partnership recorded in 1992. An analysis of changes in income taxes and the effective income tax rate is presented under "Income Taxes" in the Financial Review. In 1992, the Company adopted two new accounting standards for postretirement benefits other than pensions and for income taxes, which together reduced net income by $268 million due to the recognition of their cumulative effect for prior years. CHANGES IN FINANCIAL CONDITION - ------------------------------ The Company's financial condition remained strong during 1993. The current ratio was 1.9 at December 31, 1993 compared to 2.0 at December 31, 1992. The decline in working capital to $679 million at year-end 1993 from $751 million at year-end 1992 was primarily the result of an increase in the current portion of long-term debt due to the decision to redeem, in early 1994, the $89 million outstanding balance of 8.5% debentures. Cash and short-term investments increased by $84 million to $300 million at December 31, 1993 due to improved cash flow from operations and the sale of 1.3 million Common Shares in 1993 for net proceeds of $62 million. In spite of the increase in sales in 1993 to record levels, heightened emphasis on efficient asset management is reflected in the $21 million decline in inventories to $434 million at December 31, 1993. An increase in accounts receivable resulting from improved 1993 sales was more than offset by a reduction due to the collection of receivables at AIL as a consequence of the definitization of contract modifications as agreed to with the United States Air Force late in 1992; the net impact of the increase and offsetting decrease resulted in a $78 million decline in accounts receivable to $550 million at December 31, 1993. In addition, accounts receivable days sales outstanding at December 31, 1993 was 43, historically one of the lowest levels, in spite of the expanding economy and sales growth. Long-term debt declined to $649 million at year-end 1993 from $833 million at the end of 1992 primarily due to the call for redemption of $74 million of 9% debentures in March 1993 and $89 million of 8.5% debentures in December 1993. In private placements the Company sold 1.3 million Common Shares in 1993 for aggregate net proceeds of $62 million and, in January 1994, an additional 800,000 Common Shares for $38 million. Beginning in April 1995, the holder of these shares has the right to require the Company to register their public sales under the Federal securities law. Capital expenditures were $227 million, one of the Company's highest levels, in 1993 compared with $186 million in 1992, as the Company maintained its emphasis on enhancing manufacturing efficiencies and capabilities. Capital expenditures in 1994 are anticipated to be higher than 1993 for those businesses unrelated to the acquisition of DCBU. Further capital expenditures are planned relative to the combining of DCBU and ICPDO. During 1993, the Company invested $14 million in small businesses, primarily to establish a joint venture, which will round out product lines and open avenues for market expansion. Net cash provided by operating activities increased to $435 million for 1993 from $381 million for 1992. This increase resulted primarily from improved net income, reflecting higher sales and rigorous cost controls. Changes in operating assets and liabilities also contributed to the increase in net cash provided by operating activities in 1993. Operating cash flow and proceeds from the sale of Common Shares during 1993 were more than adequate to fund capital expenditures, cash dividends, the investment in certain small businesses and other corporate purposes. On May 25, 1993, the Company redeemed its share purchase rights at a redemption price of 3-1/3 cents for each right for a total payment of $2 million. At the end of 1993, as a result of the trend of declining long-term interest rates, the discount rate used to measure the projected benefit obligation for pensions was reduced to 7.25% from 8.25%. This change had the effect of increasing the accumulated pension benefit obligation by $103 million with an offsetting decrease in the unamortized net gain. In addition, the rates used to measure the projected benefit obligation for postretirement benefits other than pensions were changed. The changes in rates included a reduction in the discount rate to 7.25% from 8.5%, and in the annual rate of increase in per capita cost of covered health care benefits. These rate changes had the effect of increasing the accumulated postretirement benefit obligation by $49 million with an offsetting increase in the unamortized net loss. The effect on future expense for pensions and postretirement benefits other than pensions will be immaterial. At December 31, 1993 and 1992, the Company had net deferred income tax assets included in current and long-term assets. Management believes it is more likely than not that these tax benefits will be realized through the reduction of future taxable income. Significant factors considered by management in its determination of the probability of the realization of the deferred tax assets include the historical operating results of the Company, expectations of future earnings and the extended period of time over which the postretirement health care liability will be paid. On January 31, 1994, the Company acquired DCBU from Westinghouse Electric Corporation and issued $930 million of short-term commercial paper to finance the acquisition. The Company plans to reduce these short-term financings by the middle of 1994 through expanded use of equity and long-term debt financings. The timing and mix of these financings will depend on market conditions. Of these short-term financings, $555 million will be classified as long-term debt because the Company intends, and has the ability under a new five-year $555 million revolving credit agreement entered into in January 1994, to refinance this debt on a long-term basis. Also, in January 1994, the Company entered into a $555 million 364-day revolving credit agreement. Strong cash flow, reinforced by the projected results of the newly created Cutler-Hammer business unit, should permit the repayment of the financings within the next five years. The Company is maintaining the strength of its balance sheet, and two major debt-rating agencies, Standard and Poor's and Moody's, have confirmed the "A" rating on its long-term debt. The Company expects that the economic and market growth experienced in North America during 1993 will continue to expand to additional markets in 1994; however, that growth will likely be moderated by lingering weakness in Europe. Long-range plans continue to be focused on enhancements in quality, productivity and growth in all its major markets. The acquisition of DCBU and integration with ICPDO should create permanent value by streamlining product lines, manufacturing capacity and organization structure and will enable the businesses to realize the synergies resulting from complementary product offerings, operations and technical expertise. This acquisition will reinforce the goal of improving the balance in sales and earnings between the historically strong Vehicle Components segment and the Electrical and Electronic Controls segment. Investments in the form of research and development, marketing and manufacturing programs continue in all key product lines, and plans are to continue to make niche acquisitions which will promote the Company's position in worldwide markets. The Company believes capital resources available in the form of working capital on hand, lines of credit and funds provided by operations will more than adequately meet anticipated capital requirements for capital expenditures and business expansion through niche acquisitions. The acquisition of DCBU required the additional capital resources discussed above. The operations of the Company involve the use, disposal and cleanup of certain substances regulated under environmental protection laws, as further discussed under "Protection of the Environment" in the Financial Review. Subject to the difficulty in estimating future environmental costs, the Company expects that any sum it may have to pay in connection with environmental matters in excess of the amounts recorded or disclosed will not have a material adverse effect on its financial condition or results of operations. RESULTS OF OPERATIONS - --------------------- 1992 COMPARED TO 1991 - --------------------- Net Sales - --------- Net sales for 1992 were $4.10 billion, up 12% from $3.66 billion in 1991. Certain markets in North America experienced a modest recovery in 1992. However, economies in Europe, Japan and South America continued to weaken, affecting businesses in those areas, and offsetting some strength in North America. The Vehicle Components segment net sales increased to $2.09 billion for 1992, 16% higher than sales of $1.81 billion recorded for 1991. North American sales of heavy and light trucks, vans and sport utility vehicles were strong throughout the year. A marked increase in heavy truck production in North America during the second half of 1992 had a significant favorable impact on this segment's results. Heavy truck production increased 30% in 1992 over prior year levels. Strategic investments also contributed to sales growth through expansion of business into new products and territories. Sales of passenger car and off-highway vehicle equipment slowed in the last half of the year, after showing increases during the first half. Overseas vehicle markets, primarily in Europe, were depressed, and weakened further in the fourth quarter. The Electrical and Electronic Controls segment had net sales of $1.78 billion for 1992, rising 13% from sales of $1.58 billion in 1991. This increase reflects the acquisition of Kirsten, a European automotive controls manufacturer with 1992 sales of approximately $120 million, and other smaller acquisitions during 1992 and 1991. Existing automotive and appliance controls businesses experienced a strong rebound in their markets, adding to the improved results. Sales from industrial and commercial controls businesses were flat, with the recovery in residential markets offset by continued contraction in military and commercial aircraft industries. Sales from specialty controls businesses declined slightly, reflecting the continued weakening of the North American automated materials handling market, as well as significant softening of the semiconductor equipment markets in the United States and Japan. Operating Results - ----------------- Higher sales levels, benefits of recent restructurings and rigorous inventory controls produced an improved gross margin of $967 million in 1992 (24% of sales), up from $851 million in 1991 (23% of sales). Gross margin in 1992 was reduced by $17 million of increased expense related to the accounting change for postretirement benefits other than pensions. Selling and administrative expenses were held level relative to sales due to stringent cost controls, as well as the benefits of recent restructurings, with $578 million reported in 1992 compared to $520 million in 1991 (14% of sales in both years). The Company's continued commitment to improvement of established product lines, and to product innovation and development in markets offering the greatest potential for growth was reflected in the increase in research and development expenses to $151 million in 1992 from $138 million in 1991. The Vehicle Components segment operating profit showed a substantial increase to $170 million for 1992 over profit of $63 million in 1991. Profit for 1992 was reduced by $14 million due to recognition of additional expenses for postretirement benefits other than pensions. The improved profit was largely a result of increased demand for heavy and light trucks, vans and sport utility vehicles previously described and, additionally, benefitted from recent restructurings, for which a $22 million charge was recorded in 1991. Strict cost containment also contributed to growth in profit. Strategic investments in marketing, research and development, and manufacturing improvements should further promote sustainable growth and increases in profit as markets served by this segment strengthen. The Electrical and Electronic Controls segment operating profit was $85 million in 1992 compared to $88 million in 1991. Profit for this segment for 1992 was reduced by $11 million due to recognition of additional expenses related to the accounting change for postretirement benefits other than pensions. Profit for 1991 was reduced by a $17 million restructuring charge recorded in the first quarter. Start-up costs for integration of Kirsten and other acquisitions depressed 1992 profits, but these investments should provide opportunities for growth and profit improvement in the future. The acquisition of Kirsten, a European automotive controls manufacturer with operations in Germany, France and Spain, is a good example of the Company's investment in growth businesses through acquisitions. Restructuring costs due to downsizing of military-related operations reduced profits. In addition, profits for 1992 were affected by depressed sales in certain businesses, as discussed above, the costs of long-range programs in marketing, research and development, and manufacturing improvement, and cost/price pressures. Other income--net rose to $23 million for 1992 from $18 million for 1991, primarily due to an $11 million pretax gain on the sale of the Company's interest in a limited partnership recorded in 1992. An analysis of changes in income taxes and the effective income tax rate is presented under "Income Taxes" in the Financial Review. Eaton Corporation 1993 Annual Report on Form 10-K Item 14(c) Listing of Exhibits Filed 3 Amended Articles of Incorporation (as amended and restated as of January 24, 1989, filed on Form SE on March 13, 1989) and Amended Regulations (as amended and restated as of April 27, 1988, filed on Form SE on March 13, 1989) 4(a) Instruments defining rights of security holders, including indentures (Pursuant to Regulation S-K Item 601(b)(4), the Company agrees to furnish to the Commission, upon request, a copy of the instruments defining the rights of holders of long-term debt of the Company and its subsidiaries) 10 Material contracts (1) DCBU Purchase Agreement dated as of August 10, 1993 between Westinghouse Electric Corporation (Seller) and Eaton Corporation (Buyer) Regarding the Distribution and Control Business Unit of Westinghouse Electric Corporation (Agreement) - Incorporated by reference to the Company's Quarterly Report on Form 10-Q for the quarter ended September 30, 1993 Including the following Exhibits to the Agreement: (i) Form of Technology Agreement (Ex. 2.1) (ii) Terms of Lease for Shared Facilities (Ex.9.6(a) (1)) (iii) Terms of Sublease for Shared Facilities (Ex. 9.6(a) (2)) (iv) Terms of Lease for Vidalia, Georgia Shared Facility (Ex. 9.6(b) (1) (i)) (v) Terms of Lease by Buyer of Part of Horseheads Facility (Ex. 9.6(b) (1) (ii)) (vi) Terms for Jackson, Mississippi Sublease (Ex. 9.6(b) (2)) (vii) Form of Services Agreement (Ex. 9.8) (viii) Form of WESCO Distributor Agreement (Ex. 9.9) (ix) Form of Interim NEWCO Distributor Agreement (Ex. 7.15.2) (x) Form of NEWCO Distributor Agreement (xi) Form of Supplier and Vendor Agreement (Ex. 9.10) (2) The following are either a management contract or a compensatory plan or arrangement: (a) Deferred Incentive Compensation Plan (as amended and restated May 1, 1990; filed as a separate section of this report) (b) Executive Strategic Incentive Plan, effective as of January 1, 1991 - Incorporated by reference to the Company's Annual Report on Form 10-K for the year ended December 31, 1992 (c) Group Replacement Insurance Plan (GRIP), effective as of June 1, 1992 - Incorporated by reference to the Company's Annual Report on Form 10-K for the year ended December 31, 1992 (d) 1991 Stock Option Plan - Incorporated herein by reference to the Company's definitive proxy statement dated March 18, 1991 (e) The following are incorporated herein by reference to the Company's Quarterly Report on Form 10-Q for the quarter ended June 30, 1990: (i) Strategic Incentive and Option Plan (as amended and restated as of January 1, 1989) (ii) Limited Eaton Service Supplemental Retirement Income Plan (as amended and restated as of January 1, 1989) (iii) Amendments to the 1980 and 1986 Stock Option Plans (iv) Form of "Change in Control" Agreement entered into with all officers of Eaton Corporation (v) Eaton Corporation Supplemental Benefits Plan (as amended and restated as of January 1, 1989) (which provides supplemental retirement benefits) (vi) Eaton Corporation Excess Benefits Plan (as amended and restated as of January 1, 1989) (with respect to Section 415 limitations of the Internal Revenue Code) (f) The following are incorporated herein by reference to the Company's Annual Report on Form 10-K for the year ended December 31, 1990 (filed on Form SE dated March 28, 1991): (i) Executive Incentive Compensation Plan (ii) Plan for the Deferred Payment of Directors' Fees (as amended and restated as of January 1, 1989) (iii) Plan for the Deferred Payment of Directors' Fees (originally adopted in 1980 and amended and restated in 1989) (iv) Eaton Corporation Retirement Plan for Non-Employee Directors (as amended and restated as of January 1, 1989) 11 Statement regarding computations of net income per Common Share (filed as a separate section of this report) 21 Subsidiaries of Eaton Corporation (filed as a separate section of this report) 23 Consent of Independent Auditors (filed as a separate section of this report) 24 Power of Attorney (filed as a separate section of this report)

792863_1993.txt

792863

1993

ITEM 1. BUSINESS BACKGROUND Infinity Broadcasting Corporation (the "Company" or "Infinity") is the largest company in the United States whose business is exclusively devoted to radio broadcasting. It is one of only two companies able to offer advertisers a radio listening audience in each of the nation's top ten radio markets (the other being CBS, Inc.). Based on information contained in Duncan's Radio Market Guide (1994 ed.), and adjusting for the pro forma effect of the 1993 Acquisitions (as defined below), Infinity would have ranked first in total radio revenues in 1993 among all companies owning radio stations in the United States. The Company serves markets accounting for approximately $2.4 billion in radio advertising revenues, representing approximately 27% of the total radio advertising expenditures in the United States in 1993. Upon completion of the acquisitions of WPGC-AM/FM and WXYT-AM referred to below, Infinity would own and operate 26 radio stations serving 13 of the nation's largest radio markets. Since Infinity acquired its first radio station in May 1973, it has expanded by acquiring and developing underperforming stations in the nation's largest media markets, where the greatest proportion of radio advertising dollars is spent. The Company believes that its presence in large markets makes it attractive to advertisers and that the overall diversity of its stations reduces its dependence on any single station, local economy or advertiser. In each of its markets, the Company attracts a specific demographic group by targeting its program format and hiring popular on-air talent. The Company's stations serve diverse target demographics through a broad range of programming formats such as rock, oldies, adult contemporary, all-sports and country. The Company's overall programming strategy in part is to acquire significant on-air talent and broadcasting rights for sports franchises. The diversity of station and market characteristics, combined with the Company's successful acquisition and operating strategies, have enabled the Company to achieve consistent growth in revenues and operating cash flow (as used in this Form 10-K, the term "operating cash flow" means operating income plus depreciation and amortization). The Company was incorporated in 1972 in Delaware and first issued shares of its common stock to the public in June 1986. In August 1988, the Company became privately held as a result of a merger (the "Merger") with a company whose stockholders were the Company's principal stockholders and executive officers at the time. The Company was the surviving corporation in the Merger. On February 5, 1992, the Company and certain holders of warrants exercisable for shares of the Company's Class A Common Stock sold 13,788,826 shares of Class A Common Stock through an initial public offering (the "Common Stock IPO"). In addition, on May 13, 1993, the Company and certain holders of warrants exercisable for shares of the Company's Class A Common Stock sold 8,148,814 shares of Class A Common Stock through another public offering (the "Second Common Stock Offering"). RECENT DEVELOPMENTS On February 1, 1993, the Company completed the acquisition of radio stations WZGC-FM (Atlanta), WZLX-FM (Boston) and WUSN-FM (Chicago) for a total purchase price of approximately $100 million. On September 1, 1993, the Company completed the acquisition of WIP-AM, an all-sports radio station serving Philadelphia, for approximately $17.4 million (together with the acquisition of radio stations WZGC-FM, WZLX-FM and WUSN-FM described above, the "1993 Acquisitions"). In February 1994, the Company completed the acquisition of KRTH-FM, a radio station serving Los Angeles, for approximately $116 million. On October 4, 1993, the Company entered into an agreement to purchase WPGC- AM/FM in Washington, D.C. for approximately $60 million. On March 8, 1994, the Company entered into an agreement to acquire WXYT-AM, a news/talk radio station serving Detroit for approximately $23 million. In addition, on February 3, 1994 the Company, Unistar Communications Group, Inc. ("UCG") Unistar Radio Networks, Inc. ("Unistar") and Westwood One, Inc. ("Westwood One") consummated the Stock Purchase Agreement dated November 4, 1993 for the purchase by Westwood One of Unistar, an affiliate of the Company, for approximately $101.3 million. In connection with the Westwood One/Unistar transaction, an affiliate of the Company received 5 million newly issued shares of common stock of Westwood One for $3 per share (which represents approximately 16.45% of the issued and outstanding capital stock of Westwood One) and a warrant to purchase an additional 3 million shares of Westwood One's common stock at a purchase price of $3 per share, subject to certain vesting requirements. In connection with the transactions, the Company is managing the combined operations of Westwood One and Unistar pursuant to a management agreement, and the Company's Chief Executive Officer, Mel Karmazin, and Chief Financial Officer, Farid Suleman, serve as the Chief Executive Officer and Chief Financial Officer, respectively, of Westwood One. The agreement provides for a base management fee and additional warrants to acquire up to 1.5 million shares of Westwood One's Common Stock at a purchase price ranging from $3 to $5 per share in the event that Westwood One's Common Stock trades above certain target price levels. The Company continues to seek opportunities for expansion through the acquisition of additional radio stations, although its ability to make further acquisitions may be limited by certain regulatory requirements. See "Business--Federal Regulation of Radio Broadcasting", appearing elsewhere in this Report. COMPANY STRATEGY The Company's overall strategy is to own and operate radio stations in the nation's largest radio revenue markets. The Company believes that its presence in large markets makes it attractive to advertisers and that the overall diversity of its stations reduces its dependence on any single station, local economy, or advertiser. The Company also believes that by serving major markets, it is able to attract more highly skilled management, employees and on-air talent. In developing its stations, the Company takes a variety of actions to improve a station's operating cash flow, including instituting strict financial reporting requirements and cost controls, directing promotional activities, developing programming to improve the station's appeal to a targeted audience group and enhancing advertising sales efforts. In particular, the Company emphasizes increasing local advertising revenues in order to reduce dependence on national advertising revenues. During the year ended December 31, 1993, the Company generated approximately 74% of its total revenues from local and regional advertising. In operating its stations, the Company concentrates on the development of strong decentralized local management, which is responsible for the day-to-day operations of the station and is compensated based on the station's financial performance. Local management, in cooperation with corporate management, is responsible for developing programming. Corporate management is responsible for long-range planning, establishing policies and procedures, resource allocation and maintaining overall control of the stations. The overall mix of a station's programming is designed to fit each station's specific format and serve its local community. The Company's overall programming strategy includes acquiring significant on-air talent and sports franchises for its radio stations. The Company believes that this strategy, in addition to developing loyal audiences for its radio stations, enables the Company to obtain additional revenues from syndicating such programming franchises to other radio stations. In addition to its regular programming, all of the Company's stations provide non-entertainment programming, such as news and public affairs broadcasts. The Company expects to continue to acquire radio stations with strong growth potential in the Company's current markets, subject to the Communications Act of 1934, as amended (the "Communications Act"), and FCC rules, which impose certain limits on the maximum number of radio stations the Company can own nationwide and the number of stations the Company can own in the same geographic market. Because the Company has historically grown in part through the acquisition of broadcasting properties, limitations imposed by the FCC on the number of broadcasting properties the Company can acquire could limit the Company's ability to grow through acquisitions in the future. In 1992, the FCC adopted changes in its ownership rules that, among other things, increased the number of radio broadcasting properties the Company can own both nationwide and within a single geographic market. See "Business--Federal Regulation of Radio Broadcasting--Ownership Matters", appearing elsewhere in this Report. Other than as described in this Report, the Company has no present agreements or arrangements to acquire or sell any radio stations. The Company's affiliation with Westwood One and Unistar will enable the Company to expand its presence in the radio program distribution business while simultaneously enhancing the programming lineups of Westwood One and Unistar. ADVERTISING The Company believes that radio is one of the most efficient, cost-effective means for advertisers to reach specific demographic groups. Advertising rates charged by radio stations are based primarily on a station's ability to attract audiences in the demographic groups targeted by advertisers (as measured by rating service surveys quantifying the number of listeners tuned to the station at various times), on the number of stations in the market competing for the same demographic group and on the supply of and demand for radio advertising time. Rates are generally highest during morning and evening drive-time hours. Radio station revenues are derived substantially from local, regional and national advertising. Local and regional sales generally are made by a station's sales staff. National sales are made by "national rep" firms, which specialize in radio advertising sales on the national level. These firms are compensated on a commission-only basis. Most advertising contracts are short-term, generally running for only a few weeks. COMPETITION Radio broadcasting is a competitive business. The Company's radio stations compete for listeners and advertising revenues directly with other radio stations within their markets. Radio stations compete for listeners primarily on the basis of program content and by hiring on-air talent which appeals to a particular demographic group. By building a strong listenership base comprised of a specific demographic group in each of its markets, the Company is able to attract advertisers seeking to reach these listeners. Other media, including broadcast television, cable television, newspapers, magazines, direct mail, coupons and billboard advertising also compete with the Company's stations for advertising revenues. SEASONALITY The Company's revenues vary throughout the year. As is the case throughout the radio broadcast industry, the Company's first quarter generally reflects the lowest revenues for each year. EMPLOYEES As of December 31, 1993, the Company had approximately 675 full-time employees and approximately 180 part-time employees. Certain employees at the Company's stations in New York, Chicago, Philadelphia, and Boston, totalling approximately 125, are represented by unions. The Company believes that its relations with its employees and their unions are good. The Company employs several high-profile on-air personalities with large loyal audiences in their respective markets. The Company generally enters into employment agreements with its on-air talent and commissioned sales representatives to protect its interests in those relationships that it believes to be valuable. The Company has entered into employment agreements with three of its four executive officers (see "Executive Compensation--Employment Agreements" appearing in Part III of this Report, which is incorporated by reference) and with all of its high-profile on-air personalities. FEDERAL REGULATION OF RADIO BROADCASTING The ownership, operation and sale of radio stations, including those licensed to the Company, are subject to the jurisdiction of the FCC, which engages in extensive and changing regulation of the radio broadcasting industry under authority granted by the Communications Act. Among other things, the FCC assigns frequency bands for broadcasting; determines the particular frequencies, locations and operating power of stations; issues, renews, revokes and modifies station licenses; determines whether to approve changes in ownership or control of station licenses; regulates equipment used by stations; adopts and implements regulations and policies that directly or indirectly affect the ownership, operation and employment practices of stations; regulates program content (including indecent and obscene program material) and has the power to impose penalties for violations of its rules or the Communications Act. The following is a brief summary of certain provisions of the Communications Act and of specific FCC regulations and policies. Reference should be made to the Communications Act, FCC rules and the public notices and rulings of the FCC for further information concerning the nature and extent of federal regulation of broadcast stations. License Renewal. Radio broadcasting licenses are granted for maximum terms of seven years. They are subject to renewal upon application to the FCC. During certain periods when a renewal application is pending, (1) competing applicants are permitted to file for the radio frequency being used by the renewal applicant; (2) interested parties, including members of the public, are permitted to file petitions to deny license renewal applications; and (3) the transferability of the applicant's license is restricted. The FCC is required to hold evidentiary hearings on renewal applications if a competing application is filed against a renewal application, or if the FCC is unable to determine that renewal of a license would serve the public interest, convenience and necessity, or if a petition to deny raises a "substantial and material question of fact" as to whether the grant of the renewal application would be prima facie inconsistent with the public interest, convenience and necessity. The following table sets forth the date on which each of the Company's radio stations was acquired, the frequency on which each station operates, and the date on which each such station's FCC license expires: EXPIRATION DATE OF DATE OF FCC STATION MARKET(1) ACQUISITION FREQUENCY AUTHORIZATION - - ------- -------------------------- ----------- ----------- ------------- WXRK-FM New York, NY.............. 11/81 92.3 MHz 06/01/98 WZRC-AM New York, NY.............. 11/81 1480 KHz 06/01/98 WFAN-AM New York, NY.............. 04/92 660 KHz 06/01/98 KROQ-FM Los Angeles, CA........... 09/86 106.7 MHz 12/01/97 KRTH-FM(3) Los Angeles, CA........... 02/94 101.1 MHz 12/01/97 WJMK-FM Chicago, IL............... 07/84 104.3 MHz 12/01/96 WJJD-AM Chicago, IL............... 07/84 1160 KHz 12/01/96 WUSN-FM Chicago, IL............... 02/93 99.5 MHz 12/01/96 KOME-FM San Jose/ 05/73 98.5 MHz 12/01/97 San Francisco, CA... WYSP-FM(2) Philadelphia, PA.......... 11/81 94.1 MHz 08/01/91 WIP-AM Philadelphia, PA.......... 09/93 610 KHz 08/01/91 WOMC-FM Detroit, MI............... 04/88 104.3 MHz 10/01/96 WJFK-FM Washington, DC............ 12/86 106.7 MHz 10/01/95 KVIL-FM Dallas/Ft. Worth, TX...... 07/87 103.7 MHz 08/01/97 KVIL-AM Dallas/Ft. Worth, TX...... 07/87 1150 KHz 08/01/97 WBCN-FM Boston, MA................ 02/79 104.1 MHz 04/01/98 WZLX-FM Boston, MA................ 02/93 100.7 MHz 04/01/98 KXYZ-AM Houston, TX............... 06/83 1320 KHz 08/01/97 WLIF-FM Baltimore, MD............. 05/89 101.9 MHz 10/01/95 WJFK-AM Baltimore, MD............. 05/89 1300 KHz 10/01/95 WZGC-FM Atlanta, GA............... 02/93 92.9 MHz 04/01/96 WQYK-FM Tampa/St. Petersburg, FL.. 12/86 99.5 MHz 02/01/96 WQYK-AM Tampa/St. Petersburg, FL.. 11/87 1010 KHz 02/01/96 (1) Some stations are licensed to a different community located within the market which they serve. (2) An application for renewal of the WYSP-FM license was filed on April 1, 1991. Two Petitions to Deny were filed against such renewal application in July 1991. See "Business--Federal Regulation of Broadcasting--Programming and Operation," appearing elsewhere in this Report. One of these petitions has been dismissed by the FCC, and one remains pending. The station's operating authority remains effective during the pendency of the remaining petition. (3) The FCC granted its consent to assignment of the KRTH license to the Company on February 1, 1994. A Petition for Reconsideration of the FCC's grant was filed by Americans for Responsible Television on March 3, 1994. The station's operating authority and the FCC's grant of assignment remain effective during the pendency of this Petition. See "Business--Federal Regulation of Radio Broadcasting--Programming and Operation". Ownership Matters. The Communications Act prohibits the assignment of a license or the transfer of control of a broadcast licensee without the prior approval of the FCC. In determining whether to grant or renew a broadcast license, the FCC considers a number of factors pertaining to the licensee, including compliance with the Communications Act's limitations on alien ownership, compliance with various rules limiting common ownership of broadcast, cable and newspaper properties, and the "character" of the licensee and those persons holding "attributable" interests therein. Under the Communications Act, broadcast licenses may not be granted to any corporation having more than one-fifth of its issued and outstanding capital stock owned or voted by aliens (including non-U.S. corporations), foreign governments or their representatives (collectively, "Aliens") or having an Alien as an officer or director. The Communications Act also prohibits a corporation without FCC waiver, from holding a broadcast license if that corporation is controlled, directly or indirectly, by another corporation, any officer of which is an Alien, or more than one-fourth of the directors of which are Aliens, or more than one-fourth of the issued and outstanding capital stock of which is owned or voted by Aliens. The FCC has issued interpretations of existing law under which these restrictions in modified form apply to other forms of business organizations, including partnerships. As a result of these provisions, in the absence of a waiver (which the FCC has granted in very limited circumstances), the Company, which serves as a holding company for its various radio station subsidiaries, cannot have more than 25% of its stock owned or voted by Aliens, and cannot have an officer who is an Alien, or more than one-fourth of its Board of Directors consisting of Aliens. Certain merchant banking partnerships (the "Lehman Investors") affiliated with Shearson Lehman Brothers Holdings, Inc. ("SLBH") hold shares of the Company's capital stock and warrants exercisable for additional shares. See "Security Ownership of Certain Beneficial Owners and Management," appearing in Part III of this Report which is incorporated by reference. Certain of the Lehman Investors and certain limited partners in the Lehman Investors may be deemed to be Aliens or controlled by Aliens or their representatives under the Communications Act. Approximately 1.51% and .72% of the Company's issued and outstanding capital stock is owned and voted, respectively, by the Lehman Investors. Assuming the exercise of all warrants held by the Lehman Investors, approximately 20.36% and 9.37% of the Company's issued and outstanding capital stock would be owned and voted, respectively, by the Lehman Investors. The warrants held by the Lehman Investors can only be exercised by the Lehman Investors to the extent such exercise would not cause the Company to violate the Communications Act's limitations on Alien ownership or control. Current FCC rules limit the number of radio broadcast stations that can be commonly owned, operated or controlled. These rules prohibit the Company from owning, operating or controlling, directly or indirectly, more than 18 AM and 18 FM radio stations in the United States provided that an entity may have a noncontrolling interest in up to 3 additional FM and 3 additional AM stations that are controlled by members of minority groups or by certain small businesses. The 18 station limitation will increase to 20 in September 1994. The Company currently owns 15 FM radio stations and 8 AM radio stations, and has entered into agreements to acquire Washington, D.C. market radio stations WPGC(AM) and WPGC(FM) and Detroit, Michigan radio station WXYT(AM). The Communications Act and FCC rules also generally limit the common ownership, operation, or control of radio broadcast stations in the same service (AM or FM) serving the same geographic market, of a radio broadcast station and a television broadcast station serving the same geographic market and of a radio broadcast station and a daily newspaper serving the same geographic market. Under these rules, absent waivers, the Company would not be permitted to acquire any newspaper or television broadcast station (other than low-power television) in a geographic market in which it now owns any radio broadcast properties. The FCC's rules provide for the liberal grant of waivers of the rule prohibiting ownership of radio and television stations in the same geographic market in the top 25 television markets if certain other conditions are satisfied. Similar newly- enacted rules provide for liberal grant of waivers of the rule prohibiting common ownership of a radio station and a newspaper in the same market in the nation's 25 largest markets. Until August 1992, the multiple ownership rules permitted the Company to own both an AM and FM station in the same geographic market, but did not allow ownership of two AM or two FM stations in the same market. As a result of the 1992 rule changes, the Company is now permitted to own up to three stations, no more than two of which are FM stations, in markets with fewer than 15 commercial stations, so long as the owned stations represent less than 50% of the stations in the market; the Company may own up to two AM and two FM stations, so long as the combined audience share of those stations does not exceed 25%. The FCC is currently considering other possible changes to some of the FCC rules governing the ownership of broadcast properties. See "Federal Regulation of Radio Broadcasting--Proposed Changes". The Company owns three stations in each of the New York City and Chicago markets, and two FM stations in the Boston and Los Angeles markets, all of which ownership combinations are consistent with the new rules. Completion of the pending Washington, D.C. and Detroit acquisitions will also be consistent with these new rules. The FCC generally applies its ownership limits to "attributable" interests held by an individual, corporation, partnership or other association. In the case of corporations holding broadcast licenses, the interests of officers, directors and those who, directly or indirectly, have the right to vote 5% or more of the corporation's stock (or 10% or more of such stock in the case of insurance companies, mutual funds, bank trust departments and certain other passive investors that are holding stock for investment purposes only) are generally attributable, as are positions of an officer or director of a corporate parent of a broadcast licensee. Currently, none of the Company's officers, directors or stockholders has an attributable interest in any company licensed to operate broadcast stations other than the Company, except that one of the Company's directors has an attributable interest in an FM radio station located in the Denver, Colorado market. Certain stockholders and a director of the Company have a non-attributable interest in another broadcasting company, which is licensed to operate radio stations in some of the markets in which the Company's radio stations are located. Because such interests are non-attributable and have been disclosed repeatedly in ownership reports filed by the Company with the FCC, and in applications filed by the Company with the FCC which were granted, the Company believes that these cross-interests are consistent with FCC rules and policies. Local Marketing Agreements. Over the past several years, a number of radio stations have entered into what have commonly been referred to as "Local Marketing Agreements", or "LMAs". While these agreements may take varying forms, under a typical LMA, separately owned and licensed radio stations agree to enter into cooperative arrangements of varying sorts, subject to compliance with the requirements of the antitrust laws and the FCC's rules and policies, including the requirement that the licensee of each station maintain independent control over the programming and station operations of its own stations. One typical type of LMA is a programming agreement among two separately-owned radio stations serving a common service area, whereby the licensee of one station programs substantial portions of the broadcast day on the other licensee's station, subject to ultimate editorial and other controls being exercised by the latter licensee, and sells advertising time during such program segments. The FCC has held that such agreements are not contrary to the Communications Act, provided that the licensee of the station that is being substantially programmed by another entity maintains complete responsibility for, and control over, the operations of its broadcast station, and assures compliance with applicable FCC rules and policies. During the past year, the Company had such an arrangement with respect to its station WZRC(AM) in New York City. The FCC's rules provide that a station brokering more than 15% of the weekly broadcast time of another station serving of the same market will be considered to have an attributable ownership interest in the brokered station for purposes of the FCC's multiple ownership rules. As a result, under these rules, a broadcast station will not be permitted to enter into an LMA or time brokerage agreement giving it the right to program more than 15% of the broadcast time, on a weekly basis, of another local station that it could not own under the FCC's local ownership rules. The FCC's rules also prohibit a broadcast licensee from simulcasting more than 25% of its programming on another station in the same broadcast service (i.e., AM-AM or FM-FM), whether it owns that other station or has a time brokerage or LMA arrangement, with it where the brokered and brokering stations serve substantially the same geographic area. Programming and Operation. The Communications Act requires broadcasters to serve the "public interest". Since the late 1970s, the FCC gradually has relaxed or eliminated many of the more formalized procedures it developed to promote the broadcast of certain types of programming responsive to the needs of a station's community of license. However, licensees continue to be required to present programming that is responsive to community problems, needs and interests and to maintain certain records demonstrating such responsiveness. Complaints from listeners concerning a station's programming often will be considered by the FCC when it evaluates renewal applications of a licensee, although such complaints may be filed at any time. Stations also must follow various rules promulgated under the Communications Act that regulate, among other things, political advertising, the broadcast of obscene or indecent material, sponsorship identifications, the advertisement of contests and lotteries, and technical operations, including limits on radio frequency radiation. In addition, licensees must develop and implement affirmative action plans designed to promote equal employment opportunities, and must submit reports to the FCC with respect to these matters on an annual basis and in connection with renewal applications. Failure to observe these or other rules and policies can result in the imposition of various sanctions, including monetary forfeitures, the grant of "short" (less than the full seven-year) renewal terms or, for particularly egregious violations, the denial of a license renewal application or the revocation of a license. In a letter dated October 25, 1989, the FCC requested the Company to respond to a complaint that it had received alleging that WXRK-FM, the Company's New York City FM radio station, had broadcast certain programming that contained "indecent" material. On December 29, 1989, the Company submitted a letter to the FCC in which it contended that WXRK-FM had not broadcast "indecent" programming. On November 29, 1990, the FCC issued a Notice of Apparent Liability for Monetary Forfeiture advising WXRK-FM (New York), WYSP-FM (Philadelphia), and WJFK-FM (Washington, D.C.) of apparent liability for forfeitures in the amount of $2,000 each for the broadcast, which was part of the Howard Stern Show and had been originated by WXRK-FM and simulcast over the other two stations. On February 11, 1991, the Company responded to this Notice, opposing the imposition of any fine and again contending that "indecent" programming had not been broadcast. On October 23, 1992, the FCC's Staff issued a Memorandum Opinion and Order in which it determined that the three stations were liable for those forfeitures. Thereafter, the Company sought reconsideration of that Order which the FCC subsequently denied. On December 30, 1993, the Company advised the FCC that it did not intend to pay the forfeiture and that it wished to avail itself of de novo U.S. District Court procedures in the _______ event that the FCC wished to continue to pursue the matter by initiating a collection suit in such court as is required by statute. On December 18, 1992, the same date on which the FCC approved the Company's acquisition of the three Cook Inlet radio stations (see "Business--Recent Developments"), the FCC issued a Notice of Apparent Liability (the "1992 NAL") advising the Company that it may be liable for a $600,000 monetary forfeiture for broadcasts over WXRK-FM, WYSP-FM, and WJFK-FM, of certain material in the Howard Stern Show that the FCC believes may be "indecent". The 1992 NAL related to broadcasts aired after the FCC's October 1989 action. The NAL stated that additional enforcement action would result if additional violations of the FCC's indecency regulations have occurred or should occur, and that further action could include additional monetary forfeitures, renewal of licenses for short terms, or proceedings focusing upon the Company's qualifications to be an FCC licensee. The Company was afforded an opportunity to show why the proposed forfeiture should not be imposed or should be reduced. On February 23, 1993, the Company filed its response with the FCC, which asserted that the cited material is not indecent and set forth several other defenses. The FCC has taken no action on the Company's response and the matter is pending. On August 12,1993, the same date on which the FCC approved the Company's acquisition of Station WIP-AM in Philadelphia, the FCC issued a Notice of Apparent Liability for a Forfeiture (the "1993 NAL") in the amount of $500,000 which was directed to the Company's subsidiaries which operate Stations WJFK-AM/FM, WXRK-FM and WYSP-FM, and which relates to the broadcast of allegedly indecent material on certain dates in November and December 1992 and January 1993. The 1993 NAL stated that if additional violations of the FCC's indecency regulations should occur, further enforcement action could include proceedings focusing upon the Company's qualifications to be a licensee. The Company submitted a response to the 1993 NAL on October 15, 1993, which vigorously asserted its position that the material is not indecent, and advanced other defenses.The FCC has taken no action on the Company's response and the matter remains pending. On August 5, 1993, Americans for Responsible Television filed a Formal Petition to Deny against the Company's application to purchase Station KRTH-FM in Los Angeles, which contended that the Company's pending proceedings at the FCC involving indecency matters should cause the FCC to conclude that the Company is unqualified to purchase KRTH. In addition, an individual filed a late-filed Petition to Deny the KRTH assignment application, which made a similar argument. The Company opposed these Petitions, and on February 1, 1994, the FCC granted the KRTH application and the Company closed the KRTH transaction on February 15, 1994. On March 3, 1994, ART filed a Petition for Reconsideration of the FCC's grant. The Company intends to vigorously oppose ART's Petition, and the current due date for the Company's Opposition is April 13, 1994. On February 1, 1994, the same date on which the FCC granted the KRTH assignment application, the FCC released an NAL in the amount of $400,000 (the"1994 NAL") directed to Stations WXRK-FM, WYSP-FM and WJFK-AM/FM relating to the broadcast of allegedly indecent material within the Howard Stern Show on four dates in August, September and October, 1993. The Company intends to vigorously assert that the material in question is not indecent and will advance other defenses in a response that is currently due on April 4, 1994. On November 15, 1993, the African American Businesses Association (AABA) filed a Petition to Deny against the application for assignment of the WPGC(AM/FM) licenses to the Company. The Petition alleges that the Company, which carries the Howard Stern Show on its Station WJFK-FM in the Washington, DC market, is unqualified to be a licensee because such show contains allegedly racist comments; that the broadcast of such show creates a hostile, racist environment at WJFK-FM in violation of civil rights laws and the FCC's equal employment opportunity rules; and that the marketing environment created by the acquisition at WPGC(AM/FM) will be hostile to African American businesses because purchase of advertising time on WPGC(AM/FM) will purportedly subsidize the broadcast of the Howard Stern Show on WJFK-FM. AABA also requests the FCC to order that the renewal application for WJFK-FM be filed by the Company one year earlier than it would otherwise be due and that the renewal application be designated for hearing and denied. On November 22, 1993, a late-filed pleading styled "Petition to Deny" was filed by an individual which replicates the argument made by the AABA. The Company filed an Opposition to both Petitions on December 2, 1993, which vigorously contested the allegations set forth in the Petitions. The WPGC(AM/FM) assignment application is pending. The Company is involved in pending proceedings at the FCC (including complaints as to which the FCC has not taken any action that were filed after the 1994 NAL) which relate to the broadcast of allegedly indecent material by certain of the Company's stations. The Company is contesting, on an informal basis, the FCC's and complainants' contentions in these proceedings. Changes in FCC policy toward indecent broadcasts or the pending proceedings against the Company or other FCC licensees for allegedly indecent broadcasts could, among other things, result in the FCC calling into question the Company's continuing fitness as a licensee and delaying the grant of, or refusing to grant, its consent to the assignment of licenses to the Company. On July 1, 1991, the Philadelphia Lesbian and Gay Task Force, the National Organization for Women (Pennsylvania Chapter and Philadelphia Chapter), and Aspira, Philadelphia (collectively, the "Petitioners") filed a Petition to Deny the license renewal application of WYSP-FM, Philadelphia, Pennsylvania, and of three other radio stations owned by other companies in the Philadelphia market. The Petition alleges that WYSP-FM's employment of women and minorities during the previous license term was not in compliance with FCC rules. On August 30, 1991, a subsidiary of the Company, Infinity Broadcasting Corporation of Pennsylvania, licensee of WYSP-FM, filed an Opposition to the Petition contesting these allegations. On January 15, 1992, the Petitioners filed a Reply, which raised no new issues. The Company believes that the Petition to Deny would be granted by the FCC only if the Petition established a prima facie case of clearly inadequate equal employment opportunity efforts by WYSP-FM. The Company believes, and its Opposition demonstrates, that WYSP's equal employment opportunity efforts were fully adequate during the previous license term and that the allegations made in the Petition, even if accepted as true, would not warrant grant of the relief requested. Accordingly, while the Company cannot predict the outcome of this matter at this time, the Company believes that the Petition to Deny will not be granted. A second Petition filed by these entities and others against several radio stations in the Philadelphia market which focused upon programming efforts was denied by the FCC in August 1993. Proposed Changes. The Congress and the FCC have under consideration, and may in the future consider and adopt, new laws, regulations and policies regarding a wide variety of matters that could, directly or indirectly, affect the operation and ownership of the Company's radio broadcast properties. Such matters include, for example, the license renewal process; proposals to impose spectrum use or other governmentally imposed fees upon licensees; the FCC's equal employment opportunity rules and other matters relating to minority and female involvement in the broadcasting industry; proposals to change rules relating to political broadcasting; proposals to increase the thresholds or benchmarks for attributing ownership interests in broadcast media; proposals to permit lenders to take a security interest in FCC licenses; technical and frequency allocation matters, including those relative to the implementation of digital audio broadcasting on both a satellite and terrestrial basis; proposals to permit expanded use of FM translator stations; proposals to restrict or prohibit the advertising of beer, wine and other alcoholic beverages on radio; proposals to allow telephone companies to deliver audio and video programming to the home through existing phone lines; and changes to broadcast technical requirements and frequency allocation matters. The Company cannot predict whether any such proposed changes will be adopted nor can it judge in advance what impact, if any, any such proposed changes might have on its business. In addition, the Company cannot predict what other changes might be considered in the future, nor can it judge in advance what impact, if any, such other changes might have on its business. ITEM 2.

ITEM 2. PROPERTIES The Company's corporate headquarters are located in midtown Manhattan. The types of properties required to support each of the Company's radio stations include offices, studios, transmitter sites and antenna sites. A station's studios are generally housed with its offices in downtown or business districts. The transmitter sites and antenna sites are generally located so as to provide maximum market coverage. With the exception of the Company's Houston radio station, the studios and offices of the Company's stations, as well as its corporate headquarters in New York City, are located in leased facilities with lease terms that expire in one to ten years. The Company owns or leases its transmitter and antenna sites, with lease terms that expire in one to eleven years. The Company does not anticipate any difficulties in renewing those leases that expire within the next five years or in leasing other space, if required. No one property is material to the Company's overall operations. The Company believes that its properties are in good condition and suitable for its operations; however, the Company continually looks for opportunities to upgrade its properties. The Company owns substantially all of the equipment used in its radio broadcasting business. ITEM 3.

ITEM 3. LEGAL PROCEEDINGS The Company is a party to certain litigation in the ordinary course of business and also is a party to routine filings with the FCC and customary regulatory proceedings pending in connection with station acquisitions and license renewals, proceedings concerning the broadcast industry generally, and other legal and regulatory proceedings that management does not believe are material to the Company. For a description of certain matters pending before the FCC, see "Business--Federal Regulation of Radio Broadcasting--Programming and Operation", appearing elsewhere in this Report. ITEM 4.

ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS As reported in the Company's Quarterly Report on Form 10-Q for the quarter ended September 30, 1993, the Company's Board of Directors, pursuant to a Proxy Statement dated September 2, 1993, solicited the written consent of its stockholders to amend the Company's Restated Certificate of Incorporation. The amendment was approved by the stockholders of the Company and filed with the Secretary of State of the State of Delaware on October 22, 1993. The above information, together with additional information regarding such amendment, the number of votes cast for or withheld and the number of abstentions with respect to such amendment, is contained in the above-referenced Form 10-Q. PART II ITEM 5.

ITEM 5. MARKET FOR THE REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS Shares of the Company's Class A Common Stock, par value $.002 per share (the "Class A Shares"), have been quoted on the NASDAQ National Market System under the symbol INFTA since the consummation of the Common Stock IPO in February 1992. See "Business--Background" appearing elsewhere in this Report. The following table sets forth, for the calendar quarters indicated, the high and low sales prices of the Class A Shares on the NASDAQ National Market System, as reported in published financial sources. YEAR HIGH LOW - - ---- ------ ----- 1992: First Quarter (from February 5, 1992)........... 8.33 7.56 Second Quarter.................................. 9.44 7.00 Third Quarter................................... 9.33 8.44 Fourth Quarter.................................. 11.78 8.89 1993: First Quarter................................... 13.89 10.22 Second Quarter.................................. 18.67 13.56 Third Quarter................................... 32.17 20.33 Fourth Quarter.................................. 35.67 24.75 1994: First Quarter (through March 18, 1994).......... 33.75 27.00 The above table gives effect to the stock splits effected by the Company during 1993. See Note 2 of the Notes to Company's Consolidated Financial Statements, appearing elsewhere in this Report. There is no public trading market for the Company's Class B Common Stock, $.002 per share (the "Class B Shares"), or its Class C Common Stock, $.002 per share (the "Class C Shares"). As of March 18, 1994, there were 195 holders of record of the Class A Shares (which number does not include the number of stockholders whose shares are held of record by a broker or clearing agency but does include each such brokerage house or clearing agency as one record holder). As of March 18, 1994, there were six holders of record of the Class B Shares and four holders of record of the Class C Shares. The Company has never paid dividends on its shares of common stock, and the payment of dividends is restricted by the terms of the Credit Agreement and the Indenture. See Note 5 of the Notes to the Company's Consolidated Financial Statements, appearing elsewhere in this Report. It is not anticipated that any dividends will be paid on any shares of any class of the Company's common stock in the foreseeable future. ITEM 6.

ITEM 6. SELECTED FINANCIAL DATA The selected consolidated financial information for the Company presented below under the captions "Statement of Operations Data" and "Balance Sheet Data" for, and as of the end of, each of the years in the five-year period ended December 31, 1993, is derived from the Company's Consolidated Financial Statements. This selected consolidated financial information should be read in conjunction with the Company's Consolidated Financial Statements and the Notes thereto and with "Management's Discussion and Analysis of Financial Condition and Results of Operations", appearing elsewhere in this Report. - - --------------- (1) The historical consolidated financial results for the Company are not comparable from year to year because of the acquisition of various broadcasting properties by the Company during the periods covered. See "Business--Background" and "Management's Discussion and Analysis of Financial Condition and Results of Operations", appearing elsewhere in this Report. (2) See Notes 1(f) and 2 of the Notes to the Company's Consolidated Financial Statements, appearing elsewhere in this Report. ITEM 7.

ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS RESULTS OF OPERATIONS YEAR ENDED DECEMBER 31, 1993 COMPARED TO YEAR ENDED DECEMBER 31, 1992 Net revenues for the year ended December 31, 1993 were $204,522,000 as compared to $150,230,000 for the year ended December 31, 1992, an increase of approximately 36%. The increase was due principally to higher advertising revenues at most of the Company's stations and the 1993 Acquisitions and the acquisition of WFAN-AM effective April 16, 1992. On a pro forma basis, assuming the above acquisitions had occurred as of the beginning of 1992, net revenues for the year ended December 31, 1993 would have increased by approximately 14%. Station operating expenses (excluding depreciation and amortization) for the year ended December 31, 1993 were $109,601,000, as compared to $81,707,000, for the year ended December 31,1992 an increase of approximately 34%. The increase was due principally to the above acquisitions, expenses associated with higher revenues and higher programming expenses. On a pro forma basis, assuming the above acquisitions had occurred as of the beginning of 1992, station operating expenses in 1993 would have increased by approximately 12%. Depreciation and amortization expense for the year ended December 31, 1993 was $38,853,000, as compared to $28,926,000 for the year ended December 31, 1992, an increase of approximately $9,927,000 or 34%. The increase was due to the depreciation and amortization expense associated with the above acquisitions, partially offset by lower depreciation and amortization expense at the Company's other radio stations. Operating income for the year ended December 31, 1993 was $51,232,000, as compared to $35,415,000 for the year ended December 31, 1992, an increase of approximately 45%. The increase was due principally to improved results at the Company's radio stations. Net financing expense (defined as interest expense less interest income) for the year ended December 31, 1993 was $36,291,000 as compared to $38,238,000 for the year ended December 31, 1992, a decrease of approximately 5% The decrease was due principally to lower interest rates during 1993. Net earnings before extraordinary items for the year ended December 31, 1993 was $14,335,000 ($0.35 per share) as compared to a net loss of $9,432,000 ($0.30 per share) for the year ended December 31, 1992, an increase of approximately $23,767,000. As a result of the Common Stock IPO in February 1992, the Company recorded in 1992 a non-recurring charge of approximately $6,503,000, resulting from the issuance in 1990 of Common Stock to management. In 1992, the Company recorded extraordinary charges of approximately $12,318,000, including the write-off of deferred financing costs of approximately $7,416,000, as a result of (a) the redemption of all of the remaining, approximately $98,000,000 principal amount of the Company's 14.25% Subordinated Discount Debentures (the "14.25% Subordinated Debentures"), and (b) the refinancing of the Company's then existing bank credit agreement. YEAR ENDED DECEMBER 31, 1992 COMPARED TO YEAR ENDED DECEMBER 31, 1991 Net revenues for the year ended December 31, 1992 were $150,230,000, as compared to $117,959,000 for the year ended December 31, 1991, an increase of approximately $32,271,000, or 27%. The increase was due principally to the acquisition of New York radio station WFAN-AM, effective April 16, 1992, revenues associated with the various sports broadcasting rights, and higher local advertising revenues generally at the Company's stations in Los Angeles, New York, Detroit, Tampa/St. Petersburg, Philadelphia, Chicago, and Washington, D.C., partially offset by lower revenues at the Company's stations in Dallas/Fort Worth. On a pro forma basis, assuming the acquisition of WFAN-AM had occurred as of the beginning of 1991, net revenues in 1992, as compared to 1991, would have increased by approximately 8%. Station operating expenses (excluding depreciation and amortization) for the year ended December 31, 1992 were $81,707,000, as compared to $61,207,000 for the year ended December 31, 1991, an increase of approximately $20,500,000, or 33%. The increase was due principally to the acquisition of WFAN-AM and costs associated with various sports broadcasting rights. On a pro forma basis, assuming the acquisition of WFAN-AM had occurred as of the beginning of 1991, station operating expenses in 1992, as compared to 1991, would have increased by approximately 8%. Depreciation and amortization expense for the year ended December 31, 1992 was $28,926,000, as compared to $25,582,000 for the year ended December 31, 1991, an increase of approximately $3,344,000, or 13%. The increase was due to the acquisition of WFAN-AM. Operating income for the year ended December 31, 1992 was $35,415,000, as compared to $27,472,000 for the year ended December 31, 1991, an increase of approximately $7,943,000, or 29%. The increase was due principally to higher net revenues. Net financing expense (defined as interest expense less interest income) for the year ended December 31, 1992 was $38,238,000, as compared to $51,492,000 for the year ended December 31, 1991, a decrease of approximately 26%. The decrease was due principally to lower total borrowings, as well as lower interest rates during 1992. The Company's net financing expenses consist principally of interest on borrowings under its bank credit agreement and of interest on the 10 3/8% Senior Subordinated Notes Due 2002, which were sold to the public in March 1992. The Company redeemed all of its outstanding 14.25% Subordinated Debentures in 1992. Net loss before extraordinary items for the year ended December 31, 1992 was $9,432,000, as compared to a net loss of $24,026,000 for the year ended December 31, 1991, a decrease of approximately 61%. As a result of the Common Stock IPO in February 1992, the Company recorded a non-recurring, non-cash charge of approximately $6,503,000 during the first quarter of 1992, resulting from the issuance in 1990 of approximately 836,107 shares of the Company's common stock to management. Excluding the effect of this non-cash charge, net loss before extraordinary items for the year ended December 31, 1992 would have been $2,929,000, as compared to $24,026,000 for the year ended December 31, 1991, a decrease of approximately 88%. For the year ended December 31, 1992, the Company recorded extraordinary charges of approximately $12,318,000, including the write-off of non-cash deferred financing costs of approximately $7,416,000, as a result of (a) the redemption of all of the remaining, approximately $98,000,000 principal amount of the Company's 14.25% Subordinated Debentures, at a cost of approximately $102,900,000, and (b) the refinancing of the Company's bank credit agreement, in September 1992, in connection with the execution of a new bank credit agreement. See "Management's Discussion and Analysis of Financial Condition and Results of Operations--Liquidity and Capital Resources", appearing elsewhere in this Report. The Company recorded an extraordinary gain of approximately $18,020,000 during 1991, as a result of the purchase of approximately $87 million principal amount of its 14.25% Subordinated Debentures at a discount. LIQUIDITY AND CAPITAL RESOURCES The Company's primary needs for capital are to make acquisitions of radio stations and to cover debt service payments on its indebtedness. The Company's radio stations do not typically require substantial investments in capital expenditures. For the year ended December 31, 1993, net cash flow from operating activities was approximately $45,211,000, as compared to $18,310,000 for the year ended December 31, 1992, an increase of approximately $26,901,000 or 147%. The increase was principally due to improved earnings in 1993 partially offset by higher working capital requirements. In February 1993, the Company borrowed $103 million under the Credit Agreement to finance the acquisition and working capital of radio stations WZGC-FM, WZLX-FM and WUSN-FM. In September 1993, the Company borrowed approximately $18 million under the Credit Agreement to finance the acquisition and working capital of WIP-AM. On May 13, 1993, the Company completed the Second Common Stock Offering for net proceeds to the Company of approximately $100 million (including approximately $10.1 million paid to the Company upon exercise of certain warrants sold in the offering). The net proceeds from the offering were used to pay down borrowings under the acquisition facility under the Credit Agreement. The net cash flow from operating activities of approximately $45.2 million together with total cash from financing activities of approximately $78.1 million were used to finance acquisitions and capital expenditures of $123.3 million. The Credit Agreement contains various covenants and restrictions that impose certain limitations on the Company and its subsidiaries, including, among others, limitations on the incurrence of additional indebtedness by the Company or its subsidiaries, the payment of cash dividends or other distributions, the redemption or repurchase of the capital stock of the Company, the issuance of additional capital stock of the Company, the making of investments and acquisitions, and other similar limitations. Under the terms of a Security Agreement among the Company, its subsidiaries, and one of the banks acting as collateral agent, substantially all of the assets of the Company and its subsidiaries, as well as the stock of the Company's subsidiaries, are pledged to secure borrowings under the Credit Agreement. The Credit Agreement provides for the repayment of borrowings on a quarterly basis through September 2000. See Note 5 of the Notes to the Company's Consolidated Financial Statements. The Credit Agreement also permits voluntary prepayments in whole or in part at any time, and it requires mandatory prepayments under specified circumstances. In February 1994, the Company borrowed approximately $116 million under the Credit Agreement to finance the acquisition of Los Angeles radio station KRTH-FM. The Company is currently negotiating with its Agent Bank under the Credit Agreement to increase its acquisition facility by $150 million. The purchase price of the pending acquisitions of WPGC-AM/FM and WXYT-AM is expected to be financed by additional bank borrowings. ITEM 8.

ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA The information called for by this Item is included on Pages through of this Report on Form 10-K and is incorporated herein by reference. ITEM 9.

ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE The information called for by this Item is not applicable. PART III The information required in this Part is incorporated by reference from the registrant's definitive proxy statement (to be filed pursuant to Regulation 14A). PART IV ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K (a) 1. Financial Statements. 2. Financial Statement Schedules. The financial statements and schedules listed in the index to the Consolidated Financial Statements of the Company that appears on Page 31 of this Report on Form 10-K are filed as part of this Report. 3. Exhibits. Exhibit Number Description of Exhibit _______ ______________________ 2(a) Securities Purchase Agreement, dated as of September 30, 1991, by and among the Company, Michael A. Wiener, Gerald Carrus, Mel Karmazin, and Shearson Lehman Hutton Capital Partners II, L.P., Shearson Lehman Hutton Merchant Banking Portfolio Partnership L.P., Shearson Lehman Hutton Offshore Investment Partnership L.P., and Shearson Lehman Hutton Offshore Investment Partnership Japan L.P. (collectively, the "Lehman Investors"). (This exhibit can be found as Exhibit 2(a) to the Company's Quarterly Report on Form 10-Q for the quarter ended September 30, 1991 (File No. 0-14702) and is incorporated herein by reference.) 2(b) Stock Purchase Agreement, dated as of December 16, 1991, between Infinity Broadcasting Corporation of New York and KPWR, Inc. (This exhibit can be found as Exhibit 2(c) to the Company's Registration Statement on Forms S-1 and S-3 (Registration No. 33-44568) and is incorporated herein by reference.) 2(c) Assignment and Assumption Agreement, dated as of December 16, 1991, between Infinity Broadcasting Corporation of New York and the Company. (This exhibit can be found as Exhibit 2(d) to the Company's Registration Statement on Forms S-1 and S-3 (Registration No. 33-44568) and is incorporated herein by reference.) 2(d) Asset Purchase Agreement, dated as of August 15, 1992, between Cook Inlet Radio Partners, L.P., Cook Inlet Radio License Partnership, L.P., Infinity Broadcasting Corporation of Chicago, Infinity Broadcasting Corporation of Atlanta, Infinity Broadcasting Corporation of Boston and the Company. (This exhibit can be found as Exhibit 2(c) to the Company's Quarterly Report on Form 10-Q for the quarter Exhibit Number Description of Exhibit _______ ______________________ ended September 30, 1992 (File No. 0-14702) and is incorporated herein by reference.) 2(e) Asset Purchase Agreement, dated as of September 25, 1992, between Spectacor Broadcasting, L.P. and Infinity Broadcasting Corporation of Philadelphia. (This exhibit can be found as Exhibit 2(d) to the Company's Quarterly Report on Form 10-Q for the quarter ended September 30, 1992 (File No. 0-14702) and is incorporated herein by reference.) 2(f) Purchase Agreement, dated as of June 16, 1993, among Beasley FM Acquisition Corp., Infinity Broadcasting Corporation of California and the Company. (This exhibit can be found as Exhibit 2(e) to the Company's Quarterly Report on Form 10-Q for the quarter ended June 30, 1993 (File No. 0-14702) and is incorporated herein by reference.) 2(g) Asset Purchase Agreement, dated as of October 4, 1993, between Cook Inlet Radio Partners, L.P. and Cook Inlet Radio License Partnership, L.P. and Infinity Broadcasting Corporation of Maryland and the Company. (This exhibit can be found as Exhibit 2(f) to the Company's Quarterly Report on Form 10-Q for the quarter ended September 30, 1993 (File No. 0-14702) and is incorporated herein by reference.) 2(h) Asset Purchase Agreement, dated as of March 8, 1994, by and between Fritz Broadcasting, Inc., Infinity Broadcasting Corporation of Detroit and the Company, including a list of omitted schedules and an undertaking by the Company to furnish supplementally a copy of any such omitted schedule to the Securities and Exchange Commission upon request. 3(a) Restated Certificate of Incorporation of the Company, as amended October 22, 1993. (This exhibit can be found as Exhibit 3 to the Company's Quarterly Report on Form 10-Q for the quarter ended September 30, 1993 (File No. 0-14702) and is incorporated herein by reference.) Exhibit Number Description of Exhibit _______ ______________________ 3(b) Amended and Restated By-Laws of the Company. (This exhibit can be found as Exhibit 3(b) to the Company's Registration Statement on Forms S-1 and S-3 (Registration No. 33-46118) and is incorporated herein by reference.) 4(a) Indenture, dated as of March 24, 1992, between the Company and Bank of Montreal Trust Company, as Trustee. (This exhibit can be found as Exhibit 4(c) to the Company's Registration Statement on Form S-3 (Registration No. 33-61348) and is incor- porated herein by reference.) 4(b) Credit Agreement, dated as of September 22, 1992, by and among the Company, Hemisphere Broadcasting Corporation, Sagittarius Broadcasting Corporation, each of the sub- sidiaries of the Company identified under the caption "Subsidiary Guarantors" on the sig- nature page thereof, each of the banks that is a signatory thereto (collectively, the "Banks"), The Chase Manhattan Bank (National Association) as Administrative Agent for the Banks, Bank of Montreal, The Bank of New York, and Chemical Bank as co-agents for the Banks, and Chemical Bank as collateral agent for the Banks. (This exhibit can be found as Exhibit 4(j) to the Company's Quarterly Report on Form 10-Q for the quarter ended September 30, 1992 (File No. 0-14702) and is incorporated herein by reference.) 4(c) Amendment No. 1, dated as of December 1, 1992, to the Credit Agreement, dated as of September 22, 1992, among the Company, its subsidiaries and the banks that are signa- tories thereto. (This exhibit can be found as Exhibit 4(c) to the Company's Report on Form 8-K filed on February 12, 1993 (File No. 0-14702) and is incorporated herein by reference.) 4(d) Amendment No. 2, dated as of May 31, 1993, to the Credit Agreement, dated as of September 22, 1992, among the Company, its subsidiaries and the banks that are signatories thereto. (This exhibit can be found as Exhibit 4(a) to Exhibit Number Description of Exhibit _______ ______________________ the Company's Quarterly Report on Form 10-Q for the quarter ended June 30, 1993 (File No. 0-14702) and is incorporated herein by reference.) 4(e) Amendment No. 3, dated as of August 31, 1993, to the Credit Agreement, dated as of September 22, 1992, among the Company, its subsidiaries and the banks that are signa- tories thereto. (This exhibit can be found as Exhibit 4 to the Company's Quarterly Report on Form 10-Q for the quarter ended September 30, 1993 (file No. 0-14702) and is incorporated herein by reference.) 4(f) Security Agreement, dated as of September 22, 1992, by and among the Company, each of the subsidiaries of the Company identified under the caption "Subsidiaries" on the signature page thereof, and Chemical Bank, as col- lateral agent for the lenders or other finan- cial institutions or entities party, as lenders, to the Credit Agreement. (This exhibit can be found as Exhibit 4(k) to the Company's Quarterly Report on Form l0-Q for the quarter ended September 30, 1992 (File No. 0-14702) and is incorporated herein by reference.) 4(g) Amended and Restated Stockholders' Agreement, dated as of February 5, 1992, among the Com- pany, Michael A. Wiener, Gerald Carrus, Mel Karmazin and the Lehman Investors. (This exhibit can be found as Exhibit 4(j) to the Company's Registration Statement on Forms S-1 and S-3 (Registration No. 33-46118) and is incorporated herein by reference.) 4(h) Warrant Certificate, dated January 28, 1992, certifying that Shearson Lehman Hutton Capital Partners II L.P. is the owner of warrants to purchase 1,051,977 shares of Class C Common Stock, par value $.002 per share, of the Company. (This exhibit can be found as Exhibit 4(l) to the Company's Regis- tration Statement on Forms S-1 and S-3 (Registration No. 33-46118) and is incor- porated herein by reference.) Exhibit Number Description of Exhibit _______ ______________________ 4(i) Warrant Certificate, dated January 28, 1992, certifying that Lehman Brothers Merchant Banking Portfolio Partnership L.P. is the owner of warrants to purchase 1,547,373 shares of Class C Common Stock, par value $.002 per share, of the Company. (This exhibit can be found as Exhibit 4(m) to the Company's Registration Statement on Forms S-1 and S-3 (Registration No. 33-46118) and is incorporated herein by reference.) 4(j) Warrant Certificate, dated December 14, 1993, certifying that Shearson Lehman Hutton Offshore Investment Partnership L.P. is the owner of warrants to purchase 769,465 shares of Class C Common Stock, par value $.002 per share, of the Company. 4(k) Warrant Certificate, dated December 14, 1993, certifying that Shearson Lehman Hutton Offshore Investment Partnership Japan L.P. is the owner of warrants to purchase 2,317,522 shares of Class C Common Stock, par value $.002 per share, of the Company. 4(l) Securities Exchange Agreement, dated as of January 28, 1992, among the Company and the Lehman Investors. (This exhibit can be found as Exhibit 4(p) to the Company's Registration Statement on Forms S-1 and S-3 (Registration No. 33-46118) and is incorporated herein by reference.) 10(a)* Employment Agreement, dated as of December 30, 1985, between the Company and Michael A. Wiener. (This exhibit can be found as Exhibit 10(a) to the Company's Registration Statement on Form S-1 (Registration No. 33- 5190) and is incorporated herein by refer- ence.) ____________________ * Denotes management contract or compensatory plan or arrangement required to be filed as an exhibit pursuant to item 14(c) of Form 10-K. Exhibit Number Description of Exhibit _______ ______________________ 10(b)* Employment Agreement, dated as of December 30, 1985, between the Company and Gerald Carrus. (This exhibit can be found as Exhibit 10(b) to the Company's Registration Statement on Form S-1 (Registration No. 33- 5190) and is incorporated herein by refer- ence.) 10(c)* Employment Agreement, dated as of September 10, 1990, between the Company and Mel Karmazin. (This exhibit can be found as Exhibit 28(a) to the Company's Quarterly Report on Form 10-Q for the quarter ended September 30, 1990 (File No. 0-14702) and is incorporated herein by reference.) 10(d)* First Amendment, dated September 30, 1991, to the Employment Agreement, dated as of September 10, 1990, between the Company and Mel Karmazin. (This exhibit can be found as Exhibit 10(d) to the Company's Registration Statement on Forms S-1 and S-3 (Registration No. 33-44568) and is incorporated herein by reference.) 10(e)* Second Amendment, dated February 4, 1992, to the Employment Agreement, dated as of September 10, 1990, between the Company and Mel Karmazin. (This exhibit can be found as Exhibit 10(e) to the Company's Registration Statement on Forms S-1 and S-3 (Registration No. 33-46118) and is incorporated herein by reference.) 10(f)* Third Amendment, effective as of June 14, 1993, to the Employment Agreement, dated as of September 10, 1990, between the Company and Mel Karmazin. (This exhibit can be found as Exhibit 10(a) to the Company's Quarterly Report on Form 10-Q for the quarter ended June 30, 1993 (File No. 0-14702) and is in- corporated herein by reference.) ____________________ * Denotes management contract or compensatory plan or arrangement required to be filed as an exhibit pursuant to item 14(c) of Form 10-K. Exhibit Number Description of Exhibit _______ ______________________ 10(g)* Fourth Amendment, effective as of August 16, 1993, to the Employment Agreement, dated as of September 10, 1990, between the Company and Mel Karmazin. (This exhibit can be found as Exhibit 10(b) to the Company's Quarterly Report on Form 10-Q for the quarter ended June 30, 1993 (File No. 0-14702) and is in- corporated herein by reference.) 10(h)* Fifth Amendment, effective as of November 19, 1993, to the Employment Agreement, dated as of September 10, 1990, between the Company and Mel Karmazin. (This exhibit can be found as Exhibit 10(d) to the Company's Quarterly Report on Form 10-Q for the quarter ended September 30, 1993 (File No. 0-14702) and is incorporated herein by reference.) 10(i)* Sixth Amendment to the Employment Agreement, dated as of September 10, 1990, between the Company and Mel Karmazin, effective as of March 30, 1994 (subject in part to share- holder approval at the annual meeting of the shareholders to be held on June 13, 1994). 10(j)* The Company's Stock Option Plan, amended and restated as of August 16, 1993. 10(k)* Amendment, effective as of November 19, 1993, to the Company's Stock Option Plan, as amended and restated as of August 16, 1993. 10(l)* Amendment, adopted March 30, 1994 (subject to shareholder approval at the annual meeting of the Company's shareholders to be held June 13, 1994) to the Company's Stock Option Plan. 10(m)* The Company's Deferred Share Plan, amended and restated as of August 16, 1993. ____________________ * Denotes management contract or compensatory plan or arrangement required to be filed as an exhibit pursuant to item 14(c) of Form 10-K. Exhibit Number Description of Exhibit _______ ______________________ 10(n)* Amendment, effective as of November 19, 1993, to the Company's Deferred Share Plan, as amended and restated as of August 16, 1993. 10(o)* The Company's Cash Bonus Compensation Plan, adopted on March 30, 1994 (subject to share- holder approval at the annual meeting of the shareholders to be held on June 13, 1994). 10(p)* Indemnity Agreement, dated as of February 27, 1986, between the Company and Michael A. Wiener. (This exhibit can be found as Exhibit 10(f) to the Company's Registration Statement on Form S-1 (Registration No. 33- 5190) and is incorporated herein by refer- ence.) 10(q)* Indemnity Agreement, dated as of February 27, 1986, between the Company and Gerald Carrus. (This exhibit can be found as Exhibit 10(g) to the Company's Registration Statement on Form S-1 (Registration No. 33-5190) and is incorporated herein by reference.) 10(r)* Indemnity Agreement, dated as of February 7, 1986, between the Company and Mel Karmazin. (This exhibit can be found as Exhibit 10(h) to the Company's Registration Statement on Form S-1 (Registration No. 33-5190) and is incorporated herein by reference.) 10(s) Indemnity Agreement, dated as of June 22, 1987, between the Company and Farid Suleman. (This exhibit can be found as Exhibit 10(j) to the Company's Registration Statement on Form S-1 (Registration No. 33-15285) and is incorporated herein by reference.) 10(t) Indemnity Agreement, dated as of February 4, 1992, between the Company and Steven A. Lerman. (This exhibit can be found as Exhibit 10(l) to the Company's Registration Statement on Forms S-1 and S-3 (Registration ____________________ * Denotes management contract or compensatory plan or arrangement required to be filed as an exhibit pursuant to item 14(c) of Form 10-K. Exhibit Number Description of Exhibit _______ ______________________ No. 33-46118) and is incorporated herein by reference.) 10(u) Indemnity Agreement, dated as of November 9, 1992, between the Company and Alan R. Batkin. (This exhibit can be found as Exhibit 10(m) to the Company's Report on Form l0-K for the year ended December 31, 1992 (File No. 0-14702) and is incorporated herein by reference.) 10(v)* Indemnity Agreement, dated as of November 9, 1992, between the Company and O.J. Simpson. (This exhibit can be found as Exhibit 10(n) to the Company's Report on Form l0-K for the year ended December 31, 1992 (File No. 0-14702) and is incorporated herein by reference.) 10(w)* Stock Option Agreement, dated as of June 27, 1988, between the Company, as successor to WCK, and Mel Karmazin. (This exhibit can be found as Exhibit (c)(2) to the Statement on Schedule 13E-3 filed pursuant to Rule 13e-3 by WCK, the Management Investors (Michael A. Wiener, Gerald Carrus and Mel Karmazin) and the Company and is incorporated herein by reference.) 10(x)* Amendment Agreement, dated as of August 2, 1988, to Stock Option Agreement dated as of June 27, 1988, between the Company, as suc- cessor to WCK, and Mel Karmazin. (This exhibit can be found as Exhibit 9(c)(7) to Amendment No. 3 to Schedule 14D-1 filed by the Company as successor to WCK and is incor- porated herein by reference.) 10(y)* Amendment No. 1 to Stock Option Agreement, dated as of October 14, 1988, between the Company and Mel Karmazin. (This exhibit can be found as Exhibit 4(l) to the Company's Annual Report on Form 10-K for the year ended ____________________ * Denotes management contract or compensatory plan or arrangement required to be filed as an exhibit pursuant to item 14(c) of Form 10-K. Exhibit Number Description of Exhibit _______ ______________________ December 25, 1988 (File No. 0-14702) and is incorporated herein by reference.) 10(z)* Agreement, dated as of July 26, 1993, between the Company and Mel Karmazin, with respect to the exercise of certain options granted pur- suant to the Stock Option Agreement, dated as of June 27, 1988, as amended, between the Company, as successor to WCK, and Mel Karmazin. (This exhibit can be found as Exhibit 10(d) to the Company's Quarterly Report on Form 10-Q for the quarter ended June 30, 1993 (File No. 0-14702) and is in- corporated herein by reference.) 10(aa) Warrant Certificate, dated September 30, 1991, certifying that Mel Karmazin is the owner of warrants to purchase shares of Class A Common Stock, par value $.002 per share, of the Company. (This exhibit can be found as Exhibit 10(p) to the Company's Registration Statement on Forms S-1 and S-3 (Registration No. 33-46118) and is incorporated herein by reference.) 10(bb) Management Agreement, dated February 17, 1993, by and among the Company, Unistar Com- munications Group, Inc., Unistar Radio Networks, Inc., The Chase Manhattan Bank, N.A., National Westminster Bank, USA, and Novastar, Inc. (This exhibit can be found as Exhibit 10(s) to the Company's Annual Report on Form 10-K for the year ended December 31, 1992 (File No. 0-14702) and is incorporated herein by reference.) 10(cc) Amended and Restated Management Agreement, dated September 29, 1993, among the Company, Unistar Communications Group, Inc., Unistar Radio Networks, Inc., The Chase Manhattan Bank, N.A. and Novastar, Inc. (This exhibit can be found as Exhibit 10(a) to the Com- pany's Quarterly Report on Form 10-Q for the ____________________ * Denotes management contract or compensatory plan or arrangement required to be filed as an exhibit pursuant to item 14(c) of Form 10-K. Exhibit Number Description of Exhibit _______ ______________________ quarter ended September 30, 1993 (File No. 0- 14702) and is incorporated herein by refer- ence.) 10(dd) Amended and Restated Credit Agreement, Pur- chase and Release Agreement, dated as of February 3, 1994, among Unistar Radio Networks, Inc. (formerly known as Unistar Holdings, Inc.), UCGI, Inc. (formerly known as Unistar Communications Group, Inc.), TMRG, Inc. (formerly known as The Market Research Group, Inc.), The Chase Manhattan Bank (National Association), as lender and as agent, the Company and Novastar, Inc. 10(ee) Securities Purchase Agreement, dated as of November 4, 1993, between Westwood One, Inc. and Infinity Network Inc. (This exhibit can be found as Exhibit 10(b) to the Company's Quarterly Report on Form 10-Q for the quarter ended September 30, 1993 (File No. 0-14702) and is incorporated herein by reference.) 10(ff) Stock Purchase Agreement, dated as of November 4, 1993, among UCGI, Inc. (formerly known as Unistar Communications Group, Inc.), Unistar Radio Networks, Inc., the Company and Westwood One, Inc. and Infinity Network Inc. (This exhibit can be found as Exhibit 10(a) to the Company's Report on Form 8-K filed on November 17, 1993 (File No. 0-14702) and is incorporated herein by reference.) 10(gg) Management Agreement, dated as of February 3, 1994, between Westwood One, Inc. and the Company. 21 Subsidiaries of the Company. 23 Consent of KPMG Peat Marwick, Independent Certified Public Accountants. (b) Reports on Form 8-K. The Company filed a Report on Form 8-K, dated November 4, 1993, with the Securities and Exchange Commission and the National Association of Securities Dealers, Inc. on November 17, 1993, reporting in response to Item 5 of the Form 8-K. The Report on Form 8-K contained the consolidated financial statements at November 30, 1992 of Westwood One, Inc. SIGNATURES Pursuant to the requirements of Section 13 or 15(d) 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, on the 30th day of March, 1994. INFINITY BROADCASTING CORPORATION BY /S/ MICHAEL A. WIENER .................................. Michael Wiener Chairman of the Board of Directors and Secretary Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated. /s/ Michael A. Wiener March 30, 1994 ........................ ............... Michael A. Wiener Date Chairman of the Board of Directors and Secretary /s/ Gerald Carrus March 30, 1994 .................. .............. Gerald Carrus Date Co-Chairman of the Board of Directors and Treasurer /s/ Mel Karmazin March 30, 1994 ........................ ............... Mel A. Karmazin Date Director, President, and Chief Executive Officer /s/ Farid Suleman March 30, 1994 .................. .............. Farid Suleman Date Director, Vice President--Finance, and Chief Financial Officer * /s/ James A. Stern March 30, 1994 ........................ .............. James A. Stern Date Director /s/ James L. Singleton March 30, 1994 ....................... .............. James L. Singleton Date Director /s/ Steven A. Lerman March 30, 1994 ........................ .............. Steven A. Lerman Date Director /s/ Alan R. Batkin March 30, 1994 ........................ .............. Alan R. Batkin Date Director /s/ O.J. Simpson March 30, 1994 ........................ .............. O.J. Simpson Date Director - - --------------- * Mr. Suleman also performs the functions of Chief Accounting Officer INDEX TO CONSOLIDATED FINANCIAL STATEMENTS AND FINANCIAL STATEMENT SCHEDULES COVERED BY INDEPENDENT AUDITORS' REPORT (ITEM 14(A)1) Independent Auditors' Report............................................ Consolidated balance sheets as of December 31, 1992 and 1993............. Consolidated statements of operations for each of the years in the three-year period ended December 31, 1993............................ Consolidated statements of changes in stockholders' equity (deficiency) for each of the years in the three-year period ended December 31,1993.... Consolidated statements of cash flows for each of the years in the three-year period ended December 31, 1993............................ Notes to consolidated financial statements.............................. Financial statement schedules for each of the years in the three-year period ended December 31, 1993 VIII Valuation and qualifying accounts.................................. X Supplementary income statement information......................... All other schedules have been omitted because the required information either is not applicable or is shown in the consolidated financial statements or notes thereto. INDEPENDENT AUDITORS' REPORT ---------------------------- The Board of Directors and Stockholders Infinity Broadcasting Corporation: We have audited the consolidated financial statements of Infinity Broadcasting Corporation and subsidiaries as listed in the accompanying index. In connection with our audits of the consolidated financial statements, we also have audited the financial statement schedules as listed in the accompanying index. These consolidated financial statements and financial statement schedules are the responsibility of the Company's management. Our responsibility is to express an opinion on these consolidated financial statements and financial statement schedules based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Infinity Broadcasting Corporation and subsidiaries as of December 31, 1992 and 1993, and the results of their operations and their cash flows for each of the years in the three-year period ended December 31, 1993, in conformity with generally accepted accounting principles. Also in our opinion, the related financial statement schedules, when considered in relation to the basic consolidated financial statements taken as a whole, present fairly, in all material respects, the information set forth therein. KPMG PEAT MARWICK New York, New York February 1, 1994 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (a) Principles of Consolidation The consolidated financial statements include the accounts of the Company and its subsidiaries, which are wholly owned and are all involved in radio broadcasting. All significant intercompany balances and transactions have been eliminated in consolidation. (b) Revenue Recognition Revenues are recognized when advertisements are aired. (c) Property and Equipment Depreciation is provided on a straight line basis for financial statement purposes over the estimated useful lives of the related assets as follows: Buildings........................................ 18 years Machinery and equipment.......................... 3-10 years Leasehold improvements........................... Life of lease Furniture and fixtures........................... 10 years (d) Intangible Assets Intangible assets arising from acquisitions are amortized on a straight-line basis over their useful lives ranging generally from 3 to 40 years. (e) Income Taxes The Company and its subsidiaries file a consolidated Federal income tax return. Effective January 1, 1993, the Company implemented Statement of Financial Accounting Standards No. 109 (FAS 109), "Accounting for Income Taxes" which requires the use of the asset and liability method of financial accounting and reporting for income taxes. Under FAS 109, deferred income taxes reflect the impact of temporary differences between the amount of assets and liabilities recognized for financial reporting purposes and the amounts recognized for tax purposes. (f) Earnings Per Share Earnings (loss) per common share are based on the weighted average number of common shares and common equivalent shares (where inclusion of such equivalent shares would not be anti-dilutive) outstanding during the year. (g) Cash Equivalents Cash equivalents include certificates of deposit and commercial paper with maturities of one month or less. NOTE 2. PUBLIC STOCK OFFERINGS On February 5, 1992, the Company and certain holders of warrants exercisable for shares of the Company's Class A Common Stock, through an initial public offering (the "Common Stock IPO") sold 13,788,826 shares of Class A Common Stock, resulting in net proceeds to the Company of approximately $100.1 million before expenses of approximately $1.6 million. As a result of the Company's Common Stock IPO, the Company in the First Quarter of 1992 recorded a non-recurring non-cash charge of approximately $6,503,000, resulting from the issuance in 1990 of approximately 836,107 deferred shares of the Company's Common Stock to management. On May 13, 1993, the Company and certain holders of warrants exercisable for shares of the Company's Class A Common Stock sold through a public offering 8,148,814 shares of Class A Common Stock resulting in net proceeds to the Company of approximately $100 million. The net proceeds from this offering were used to pay down bank borrowings under the Company's bank credit agreement (the "Credit Agreement"). Effective August 9, 1993, the Company declared a three-for-two stock split in the form of a stock dividend payable on August 16, 1993 to shareholders of record at the close of business on August 9, 1993. Effective November 12, 1993, the company declared another three-for-two stock split in the form of a stock dividend payable on November 19, 1993 to shareholders of record at the close of business on November 12, 1993. During 1993, in connection with these stock splits, the Company increased the number of authorized shares of its Class A Common Stock to 75,000,000, Class B Common Stock to 17,500,000 and Class C Common Stock to 30,000,000. The accompanying consolidated financial statements reflect the effect of the stock dividends. On December 7, 1993, certain merchant banking partnerships affiliated with Lehman Brothers Inc. and certain officers of the Company sold in a secondary offering 5,550,000 shares of Class A Common Stock. NOTE 3. ACQUISITIONS On April 16, 1992, the Company acquired WFAN-AM, a radio station serving New York City, for approximately $70 million. On February 1, 1993, the Company acquired the assets of WZGC-FM (Atlanta), WZLX-FM (Boston) and WUSN-FM (Chicago) from Cook Inlet Radio Partners, L.P. and Cook Inlet Radio License Partnership, L.P. for a total purchase price of approximately $100 million. On September 1, 1993, the Company acquired WIP-AM, an all-sports radio station serving Philadelphia, from Spectacor Broadcasting, L.P. for approximately $17.4 million. The above acquisitions have been accounted for by the purchase method of accounting. The purchase price has been allocated to the assets acquired, principally intangible assets, including covenants not to compete, and the liabilities assumed based on their estimated fair values at the date of acquisition. The excess of purchase price over the estimated fair values of the net assets acquired has been recorded as goodwill. The operating results of these acquisitions are included in the Company's consolidated results of operations from the date of acquisition. The following unaudited pro forma summary presents the consolidated results of operations as if the acquisitions had occurred as of the beginning of 1992 and 1993, after giving effect to certain adjustments, including amortization of goodwill and interest expense on the acquisition debt. These pro forma results have been prepared for comparative purposes only and do not purport to be indicative of what would have occurred had the acquisitions been made as of those dates or of results which may occur in the future. Years Ended December 31, ------------------------ 1992 1993 ---------- ---------- (Unaudited) Net revenues.................................... $ 183,935 $ 210,317 Net earnings (loss) before extraordinary items.. (23,287) 13,524 Net earnings (loss)............................. (35,605) 13,524 Earnings (loss) per common share: Before extraordinary items...................... (.74) .33 Extraordinary items............................. (.39) -- ---------- ---------- Net earnings (loss) per common share............ (1.13) .33 ========== ========== On October 4, 1993, the Company entered into an agreement to acquire Washington, D.C. radio stations WPGC-AM/FM from Cook Inlet Radio Partners, L.P. and Cook Inlet Radio License Partnership, L.P. for approximately $60 million. On March 8, 1994, the Company entered into an agreement to acquire Detroit radio station WXYT-AM for approximately $23 million from Fritz Broadcasting Inc. The purchase price of the acquisitions of WPGC-AM/FM and WXYT-AM is expected to be financed by bank borrowings. In February 1994, the Company completed the acquisition of Los Angeles radio station KRTH-FM from Beasley FM Acquisitions Corp. for approximately $116 million. The purchase price of the acquisition was funded by borrowings under the Credit Agreement. On February 17, 1993, the Company entered into an agreement to manage the business and operations of Unistar Communications Group, Inc. ("UCG") and its subsidiaries. UCG is the parent of Unistar Radio Networks, Inc. ("Unistar"), the country's fourth-largest provider of radio network programming services. Under the terms of this agreement, as amended, the Company received at no cost approximately 20.23% of UCG's issued and outstanding capital stock, an option to acquire the remaining capital stock of UCG for a nominal price under certain conditions, and an annual management fee of approximately $2 million. On February 3, 1994, the Company, Unistar and Westwood One, Inc. ("Westwood One") completed the purchase by Westwood One of the radio network business of Unistar for approximately $101.3 million. Westwood One is the nation's largest producer and distributor of nationally sponsored radio programs. In connection with the transaction, an affiliate of the Company received 5 million newly issued shares of common stock of Westwood One for $3 per share (which represents approximately 16.45% of the issued and outstanding capital stock of Westwood One) and an option to purchase an additional 3 million shares of Westwood One's common stock at a purchase price of $3 per share, subject to certain vesting requirements. In connection with the transactions, the Company's Chief Executive Officer and Chief Financial Officer became the Chief Executive Officer and Chief Financial Officer, respectively, of Westwood One pursuant to a Management Agreement between the Company and Westwood One. Under the management agreement, the Company will receive a base management fee and additional warrants to acquire up to 1.5 million shares of Westwood One's Common Stock at a purchase price from $3 to $5 per share in the event that Westwood One's Common Stock trades above certain target price levels. NOTE 4. DEPRECIATION AND AMORTIZATION - - --------------- (a) At December 31, 1993, the Company's Credit Agreement provided for aggregate borrowings of up to approximately $295 million, including an acquisition facility of $115 million and a working capital facility of $30 million. The Credit Agreement provides for quarterly principal payments through September 30, 2000. Under the Credit Agreement, interest is payable quarterly, based on the (i) prime rate or (ii) London Interbank Offer Rate. In the normal course of business, the Company enters into a variety of interest rate protection agreements, options and swaps, in order to limit its exposure due to adverse fluctuations in interest rates. These instruments are executed with creditworthy financial institutions. As of December 31, 1993, the Company has entered into various interest rate protection agreements under which the Company's interest rate on $80 million of borrowings under the Credit Agreement is fixed at between 4.80% and 5.25% per annum, expiring in the first quarter of 1996. (b) On March 24, 1992, the Company sold $200 million principal amount of its 10 3/8% Senior Subordinated Notes due 2002, through a public offering for net proceeds to the Company of approximately $195 million. At December 31, 1993, the fair value of the Company's 10 3/8% Senior Subordinated Notes was estimated to be $215,000,000 based on the quoted market prices for the same issue. The scheduled maturities of long-term debt for the next five years and after are as follows: YEAR ENDING DECEMBER AMOUNT ------------------------------------------- -------------- (In Thousands) 1994....................................... $ 22,312 1995....................................... 15,170 1996....................................... 20,227 1997....................................... 20,227 1998....................................... 25,478 After 1998................................. 261,648 ------------- $ 365,062 ============= The debt agreements contain, among other things, restrictions on additional borrowings, capital expenditures, leases, sale of assets or common stock of subsidiaries, and payment of cash dividends. As of December 31, 1993, no earnings were available for payment of dividends. Substantially all of the assets of the Company and the common shares of its subsidiaries are pledged as collateral under the Credit Agreement. For years ended 1991, 1992 and 1993, the Company paid cash for interest of $32,066,000, $40,891,000 and $34,625,000, respectively. NOTE 6. EMPLOYEE AND OTHER POST RETIREMENT BENEFIT PLANS The Company has a qualified 401(k) profit sharing plan covering substantially all of its non-union full-time employees. For the years ended December 31, 1991, 1992 and 1993, no contributions to this plan were made by the Company. The Company does not provide any post retirement health care and life insurance benefits to its employees and accordingly, has no liabilities for such benefits. NOTE 7. INCOME TAXES The provision for income taxes for the years ended December 31, 1991, 1992 and 1993, consisting of current state and local taxes, was $6,000, $106,000 and $606,000, respectively. No federal income taxes were provided in 1991, 1992 and 1993 as a result of net losses incurred and available net loss carryforwards for each period. At December 31, 1993, the Company had net operating loss carryforwards for federal income tax purposes which expire from 2004 to 2008 of approximately $73 million. As discussed in note 1, the Company adopted FAS No. 109 as of January 1, 1993. There was no effect on the consolidated balance sheet as of December 31, 1993 of implementing FAS 109 as the value of the deferred tax asset resulting from the net operating loss carryforwards was offset by a valuation allowance of equal amount. For the years ended December 31, 1991, 1992 and 1993, the Company paid cash for income taxes of $33,000, $714,000 and $135,000, respectively. NOTE 8. EMPLOYEE STOCK PLANS Employee Stock Option Plan. The Company's 1988 Employee Stock Option Plan as amended provides for a grant of options to purchase 2,664,350 shares of the Company's Class A Common Stock and 187,500 shares of Class B Common Stock. The options are exercisable in equal amounts generally over five years from the date of grant. At December 31, 1992 and 1993, options for 686,700 and 905,981 shares, respectively, of Class A Common Stock were exercisable. Employee Deferred Share Plan. The Deferred Share Plan permits the grant of up to 240,641 Class A Deferred Shares and 782,969 Class B Deferred Shares to executives or other key employees of the Company. The following is a table summarizing the changes during the years ended December 31, 1992 and 1993 in options and deferred shares outstanding: CLASS A COMMON STOCK --------------------------- DEFERRED EXERCISE SHARES AND PRICE PER OPTIONS SHARE ------------ ------------ Outstanding as of December 31, 1991........... 1,203,196 $.001-.1333 Granted/Issued................................ 556,875 7.78 Canceled...................................... (50,076) .04-7.78 Exercised..................................... (58,495) .1333 ---------- Total outstanding as of December 31, 1992....... 1,651,500 Granted/Issued.................................. 963,750 8.78-26.00 Canceled........................................ -- -- Exercised................................ ..... (173,900) .1333-8.78 ----------- Total outstanding as of December 31, 1993....... 2,441,350 =========== NOTE 9. STOCKHOLDERS' EQUITY Each share of Class A Common Stock and each share of Class C Common Stock is entitled to one vote per share. Each share of Class B Common Stock is generally entitled to ten votes per share. Shares of Class B Common Stock and Class C Common Stock, at the option of the holder, may be converted at any time into an equal number of shares of Class A Common Stock. Each share of Class B Common Stock and Class C Common Stock automatically converts into one share of Class A Common Stock upon the sale, gift, or other transfer of such share to any person other than an associate of the Company (as defined) and upon certain other events. During 1988, the Company issued options with an exercise price of $.027 per share to an officer of the Company to purchase 2,107,998 shares of the Company's Class B Common Stock. During 1992 and 1993 options to purchase 33,750 and 134,942 shares were exercised. The Company has reserved 32,439 shares of Class A Common Stock, 2,051,807 shares of Class B Common Stock and 8,935,526 shares of Class C Common Stock for issuance upon the exercise of certain warrants and options outstanding as of December 31, 1993. NOTE 10. RELATED PARTY TRANSACTIONS The Company leases office space from an affiliate which is owned 70% by certain stockholders. The lease expires on December 31, 1998 and provides for an annual rent of $145,380 subject to certain annual adjustments. As of December 31, 1992 and 1993, the Company has loans receivable from certain stockholders amounting to $1,200,000 in the aggregate. Such loans, payable on June 1, 1994, are non-interest bearing and are included as other assets in the accompanying consolidated balance sheets. As of December 31, 1993, the Company had accounts receivable from Unistar amounting to approximately $204,000. NOTE 11. EXTRAORDINARY ITEMS In 1991, the Company purchased approximately $87 million principal amount of the 14.25% Subordinated Discount Debentures, resulting in an extraordinary gain of approximately $18 million. On March 24, 1992, the Company called for the redemption of all of the remaining approximately $98,000,000 of the 14.25% Subordinated Discount Debentures, resulting in an extraordinary loss of approximately $8,277,000. On September 22, 1992, the Company entered into a new credit agreement which replaced its prior bank credit agreement and which resulted in an extraordinary loss of $4,041,000. NOTE 12. COMMITMENTS AND CONTINGENCIES The Company and its subsidiaries occupy certain office space and transmitting facilities under lease agreements expiring at various dates through 2004. Management expects that in the normal course of business, leases that expire will be renewed or replaced by other leases. Most leases provide for escalation of rent based on increases in the Consumer Price Index and/or real estate taxes. The following is a summary of the future minimum rental commitments under existing leases: YEAR ENDING DECEMBER 31, AMOUNT ------------------------------------------ -------------- (In Thousands) 1994...................................... $ 3,766 1995...................................... 3,897 1996...................................... 3,740 1997...................................... 2,664 1998...................................... 2,556 After 1998................................ 7,343 -------------- $ 23,966 ============== Rent expense applicable to such leases amounted to approximately $2,049,000, $2,354,000 and $3,079,000 for the years ended December 31, 1991, 1992 and 1993, respectively. At December 31, 1993, the Company is committed to the purchase of broadcast rights for various sports events and other programming including on-air talent, aggregating approximately $62.5 million. The aggregate payments related to these commitments during the next five years are as follows: AMOUNT -------------- (In Thousands) 1994.................................... $ 26,475 1995.................................... 26,721 1996.................................... 6,203 1997.................................... 2,894 1998.................................... 179 -------------- $ 62,472 ============== NOTE 13. INTANGIBLE AND OTHER ASSETS Intangible assets at cost, as of December 31, 1992 and 1993 include: 1992 1993 -------- -------- (In Thousands) Franchise interests................ $214,458 $259,582 Favorable leasehold interest....... 30,708 30,542 Other, principally covenants....... not to complete.................. 45,068 60,000 -------- -------- $290,234 $350,124 ========= ========= Other assets include principally deferred financing costs and are amortized over the term of the financing.

ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K (a) 1. Financial Statements. 2. Financial Statement Schedules. The financial statements and schedules listed in the index to the Consolidated Financial Statements of the Company that appears on Page 31 of this Report on Form 10-K are filed as part of this Report. 3. Exhibits. Exhibit Number Description of Exhibit _______ ______________________ 2(a) Securities Purchase Agreement, dated as of September 30, 1991, by and among the Company, Michael A. Wiener, Gerald Carrus, Mel Karmazin, and Shearson Lehman Hutton Capital Partners II, L.P., Shearson Lehman Hutton Merchant Banking Portfolio Partnership L.P., Shearson Lehman Hutton Offshore Investment Partnership L.P., and Shearson Lehman Hutton Offshore Investment Partnership Japan L.P. (collectively, the "Lehman Investors"). (This exhibit can be found as Exhibit 2(a) to the Company's Quarterly Report on Form 10-Q for the quarter ended September 30, 1991 (File No. 0-14702) and is incorporated herein by reference.) 2(b) Stock Purchase Agreement, dated as of December 16, 1991, between Infinity Broadcasting Corporation of New York and KPWR, Inc. (This exhibit can be found as Exhibit 2(c) to the Company's Registration Statement on Forms S-1 and S-3 (Registration No. 33-44568) and is incorporated herein by reference.) 2(c) Assignment and Assumption Agreement, dated as of December 16, 1991, between Infinity Broadcasting Corporation of New York and the Company. (This exhibit can be found as Exhibit 2(d) to the Company's Registration Statement on Forms S-1 and S-3 (Registration No. 33-44568) and is incorporated herein by reference.) 2(d) Asset Purchase Agreement, dated as of August 15, 1992, between Cook Inlet Radio Partners, L.P., Cook Inlet Radio License Partnership, L.P., Infinity Broadcasting Corporation of Chicago, Infinity Broadcasting Corporation of Atlanta, Infinity Broadcasting Corporation of Boston and the Company. (This exhibit can be found as Exhibit 2(c) to the Company's Quarterly Report on Form 10-Q for the quarter Exhibit Number Description of Exhibit _______ ______________________ ended September 30, 1992 (File No. 0-14702) and is incorporated herein by reference.) 2(e) Asset Purchase Agreement, dated as of September 25, 1992, between Spectacor Broadcasting, L.P. and Infinity Broadcasting Corporation of Philadelphia. (This exhibit can be found as Exhibit 2(d) to the Company's Quarterly Report on Form 10-Q for the quarter ended September 30, 1992 (File No. 0-14702) and is incorporated herein by reference.) 2(f) Purchase Agreement, dated as of June 16, 1993, among Beasley FM Acquisition Corp., Infinity Broadcasting Corporation of California and the Company. (This exhibit can be found as Exhibit 2(e) to the Company's Quarterly Report on Form 10-Q for the quarter ended June 30, 1993 (File No. 0-14702) and is incorporated herein by reference.) 2(g) Asset Purchase Agreement, dated as of October 4, 1993, between Cook Inlet Radio Partners, L.P. and Cook Inlet Radio License Partnership, L.P. and Infinity Broadcasting Corporation of Maryland and the Company. (This exhibit can be found as Exhibit 2(f) to the Company's Quarterly Report on Form 10-Q for the quarter ended September 30, 1993 (File No. 0-14702) and is incorporated herein by reference.) 2(h) Asset Purchase Agreement, dated as of March 8, 1994, by and between Fritz Broadcasting, Inc., Infinity Broadcasting Corporation of Detroit and the Company, including a list of omitted schedules and an undertaking by the Company to furnish supplementally a copy of any such omitted schedule to the Securities and Exchange Commission upon request. 3(a) Restated Certificate of Incorporation of the Company, as amended October 22, 1993. (This exhibit can be found as Exhibit 3 to the Company's Quarterly Report on Form 10-Q for the quarter ended September 30, 1993 (File No. 0-14702) and is incorporated herein by reference.) Exhibit Number Description of Exhibit _______ ______________________ 3(b) Amended and Restated By-Laws of the Company. (This exhibit can be found as Exhibit 3(b) to the Company's Registration Statement on Forms S-1 and S-3 (Registration No. 33-46118) and is incorporated herein by reference.) 4(a) Indenture, dated as of March 24, 1992, between the Company and Bank of Montreal Trust Company, as Trustee. (This exhibit can be found as Exhibit 4(c) to the Company's Registration Statement on Form S-3 (Registration No. 33-61348) and is incor- porated herein by reference.) 4(b) Credit Agreement, dated as of September 22, 1992, by and among the Company, Hemisphere Broadcasting Corporation, Sagittarius Broadcasting Corporation, each of the sub- sidiaries of the Company identified under the caption "Subsidiary Guarantors" on the sig- nature page thereof, each of the banks that is a signatory thereto (collectively, the "Banks"), The Chase Manhattan Bank (National Association) as Administrative Agent for the Banks, Bank of Montreal, The Bank of New York, and Chemical Bank as co-agents for the Banks, and Chemical Bank as collateral agent for the Banks. (This exhibit can be found as Exhibit 4(j) to the Company's Quarterly Report on Form 10-Q for the quarter ended September 30, 1992 (File No. 0-14702) and is incorporated herein by reference.) 4(c) Amendment No. 1, dated as of December 1, 1992, to the Credit Agreement, dated as of September 22, 1992, among the Company, its subsidiaries and the banks that are signa- tories thereto. (This exhibit can be found as Exhibit 4(c) to the Company's Report on Form 8-K filed on February 12, 1993 (File No. 0-14702) and is incorporated herein by reference.) 4(d) Amendment No. 2, dated as of May 31, 1993, to the Credit Agreement, dated as of September 22, 1992, among the Company, its subsidiaries and the banks that are signatories thereto. (This exhibit can be found as Exhibit 4(a) to Exhibit Number Description of Exhibit _______ ______________________ the Company's Quarterly Report on Form 10-Q for the quarter ended June 30, 1993 (File No. 0-14702) and is incorporated herein by reference.) 4(e) Amendment No. 3, dated as of August 31, 1993, to the Credit Agreement, dated as of September 22, 1992, among the Company, its subsidiaries and the banks that are signa- tories thereto. (This exhibit can be found as Exhibit 4 to the Company's Quarterly Report on Form 10-Q for the quarter ended September 30, 1993 (file No. 0-14702) and is incorporated herein by reference.) 4(f) Security Agreement, dated as of September 22, 1992, by and among the Company, each of the subsidiaries of the Company identified under the caption "Subsidiaries" on the signature page thereof, and Chemical Bank, as col- lateral agent for the lenders or other finan- cial institutions or entities party, as lenders, to the Credit Agreement. (This exhibit can be found as Exhibit 4(k) to the Company's Quarterly Report on Form l0-Q for the quarter ended September 30, 1992 (File No. 0-14702) and is incorporated herein by reference.) 4(g) Amended and Restated Stockholders' Agreement, dated as of February 5, 1992, among the Com- pany, Michael A. Wiener, Gerald Carrus, Mel Karmazin and the Lehman Investors. (This exhibit can be found as Exhibit 4(j) to the Company's Registration Statement on Forms S-1 and S-3 (Registration No. 33-46118) and is incorporated herein by reference.) 4(h) Warrant Certificate, dated January 28, 1992, certifying that Shearson Lehman Hutton Capital Partners II L.P. is the owner of warrants to purchase 1,051,977 shares of Class C Common Stock, par value $.002 per share, of the Company. (This exhibit can be found as Exhibit 4(l) to the Company's Regis- tration Statement on Forms S-1 and S-3 (Registration No. 33-46118) and is incor- porated herein by reference.) Exhibit Number Description of Exhibit _______ ______________________ 4(i) Warrant Certificate, dated January 28, 1992, certifying that Lehman Brothers Merchant Banking Portfolio Partnership L.P. is the owner of warrants to purchase 1,547,373 shares of Class C Common Stock, par value $.002 per share, of the Company. (This exhibit can be found as Exhibit 4(m) to the Company's Registration Statement on Forms S-1 and S-3 (Registration No. 33-46118) and is incorporated herein by reference.) 4(j) Warrant Certificate, dated December 14, 1993, certifying that Shearson Lehman Hutton Offshore Investment Partnership L.P. is the owner of warrants to purchase 769,465 shares of Class C Common Stock, par value $.002 per share, of the Company. 4(k) Warrant Certificate, dated December 14, 1993, certifying that Shearson Lehman Hutton Offshore Investment Partnership Japan L.P. is the owner of warrants to purchase 2,317,522 shares of Class C Common Stock, par value $.002 per share, of the Company. 4(l) Securities Exchange Agreement, dated as of January 28, 1992, among the Company and the Lehman Investors. (This exhibit can be found as Exhibit 4(p) to the Company's Registration Statement on Forms S-1 and S-3 (Registration No. 33-46118) and is incorporated herein by reference.) 10(a)* Employment Agreement, dated as of December 30, 1985, between the Company and Michael A. Wiener. (This exhibit can be found as Exhibit 10(a) to the Company's Registration Statement on Form S-1 (Registration No. 33- 5190) and is incorporated herein by refer- ence.) ____________________ * Denotes management contract or compensatory plan or arrangement required to be filed as an exhibit pursuant to item 14(c) of Form 10-K. Exhibit Number Description of Exhibit _______ ______________________ 10(b)* Employment Agreement, dated as of December 30, 1985, between the Company and Gerald Carrus. (This exhibit can be found as Exhibit 10(b) to the Company's Registration Statement on Form S-1 (Registration No. 33- 5190) and is incorporated herein by refer- ence.) 10(c)* Employment Agreement, dated as of September 10, 1990, between the Company and Mel Karmazin. (This exhibit can be found as Exhibit 28(a) to the Company's Quarterly Report on Form 10-Q for the quarter ended September 30, 1990 (File No. 0-14702) and is incorporated herein by reference.) 10(d)* First Amendment, dated September 30, 1991, to the Employment Agreement, dated as of September 10, 1990, between the Company and Mel Karmazin. (This exhibit can be found as Exhibit 10(d) to the Company's Registration Statement on Forms S-1 and S-3 (Registration No. 33-44568) and is incorporated herein by reference.) 10(e)* Second Amendment, dated February 4, 1992, to the Employment Agreement, dated as of September 10, 1990, between the Company and Mel Karmazin. (This exhibit can be found as Exhibit 10(e) to the Company's Registration Statement on Forms S-1 and S-3 (Registration No. 33-46118) and is incorporated herein by reference.) 10(f)* Third Amendment, effective as of June 14, 1993, to the Employment Agreement, dated as of September 10, 1990, between the Company and Mel Karmazin. (This exhibit can be found as Exhibit 10(a) to the Company's Quarterly Report on Form 10-Q for the quarter ended June 30, 1993 (File No. 0-14702) and is in- corporated herein by reference.) ____________________ * Denotes management contract or compensatory plan or arrangement required to be filed as an exhibit pursuant to item 14(c) of Form 10-K. Exhibit Number Description of Exhibit _______ ______________________ 10(g)* Fourth Amendment, effective as of August 16, 1993, to the Employment Agreement, dated as of September 10, 1990, between the Company and Mel Karmazin. (This exhibit can be found as Exhibit 10(b) to the Company's Quarterly Report on Form 10-Q for the quarter ended June 30, 1993 (File No. 0-14702) and is in- corporated herein by reference.) 10(h)* Fifth Amendment, effective as of November 19, 1993, to the Employment Agreement, dated as of September 10, 1990, between the Company and Mel Karmazin. (This exhibit can be found as Exhibit 10(d) to the Company's Quarterly Report on Form 10-Q for the quarter ended September 30, 1993 (File No. 0-14702) and is incorporated herein by reference.) 10(i)* Sixth Amendment to the Employment Agreement, dated as of September 10, 1990, between the Company and Mel Karmazin, effective as of March 30, 1994 (subject in part to share- holder approval at the annual meeting of the shareholders to be held on June 13, 1994). 10(j)* The Company's Stock Option Plan, amended and restated as of August 16, 1993. 10(k)* Amendment, effective as of November 19, 1993, to the Company's Stock Option Plan, as amended and restated as of August 16, 1993. 10(l)* Amendment, adopted March 30, 1994 (subject to shareholder approval at the annual meeting of the Company's shareholders to be held June 13, 1994) to the Company's Stock Option Plan. 10(m)* The Company's Deferred Share Plan, amended and restated as of August 16, 1993. ____________________ * Denotes management contract or compensatory plan or arrangement required to be filed as an exhibit pursuant to item 14(c) of Form 10-K. Exhibit Number Description of Exhibit _______ ______________________ 10(n)* Amendment, effective as of November 19, 1993, to the Company's Deferred Share Plan, as amended and restated as of August 16, 1993. 10(o)* The Company's Cash Bonus Compensation Plan, adopted on March 30, 1994 (subject to share- holder approval at the annual meeting of the shareholders to be held on June 13, 1994). 10(p)* Indemnity Agreement, dated as of February 27, 1986, between the Company and Michael A. Wiener. (This exhibit can be found as Exhibit 10(f) to the Company's Registration Statement on Form S-1 (Registration No. 33- 5190) and is incorporated herein by refer- ence.) 10(q)* Indemnity Agreement, dated as of February 27, 1986, between the Company and Gerald Carrus. (This exhibit can be found as Exhibit 10(g) to the Company's Registration Statement on Form S-1 (Registration No. 33-5190) and is incorporated herein by reference.) 10(r)* Indemnity Agreement, dated as of February 7, 1986, between the Company and Mel Karmazin. (This exhibit can be found as Exhibit 10(h) to the Company's Registration Statement on Form S-1 (Registration No. 33-5190) and is incorporated herein by reference.) 10(s) Indemnity Agreement, dated as of June 22, 1987, between the Company and Farid Suleman. (This exhibit can be found as Exhibit 10(j) to the Company's Registration Statement on Form S-1 (Registration No. 33-15285) and is incorporated herein by reference.) 10(t) Indemnity Agreement, dated as of February 4, 1992, between the Company and Steven A. Lerman. (This exhibit can be found as Exhibit 10(l) to the Company's Registration Statement on Forms S-1 and S-3 (Registration ____________________ * Denotes management contract or compensatory plan or arrangement required to be filed as an exhibit pursuant to item 14(c) of Form 10-K. Exhibit Number Description of Exhibit _______ ______________________ No. 33-46118) and is incorporated herein by reference.) 10(u) Indemnity Agreement, dated as of November 9, 1992, between the Company and Alan R. Batkin. (This exhibit can be found as Exhibit 10(m) to the Company's Report on Form l0-K for the year ended December 31, 1992 (File No. 0-14702) and is incorporated herein by reference.) 10(v)* Indemnity Agreement, dated as of November 9, 1992, between the Company and O.J. Simpson. (This exhibit can be found as Exhibit 10(n) to the Company's Report on Form l0-K for the year ended December 31, 1992 (File No. 0-14702) and is incorporated herein by reference.) 10(w)* Stock Option Agreement, dated as of June 27, 1988, between the Company, as successor to WCK, and Mel Karmazin. (This exhibit can be found as Exhibit (c)(2) to the Statement on Schedule 13E-3 filed pursuant to Rule 13e-3 by WCK, the Management Investors (Michael A. Wiener, Gerald Carrus and Mel Karmazin) and the Company and is incorporated herein by reference.) 10(x)* Amendment Agreement, dated as of August 2, 1988, to Stock Option Agreement dated as of June 27, 1988, between the Company, as suc- cessor to WCK, and Mel Karmazin. (This exhibit can be found as Exhibit 9(c)(7) to Amendment No. 3 to Schedule 14D-1 filed by the Company as successor to WCK and is incor- porated herein by reference.) 10(y)* Amendment No. 1 to Stock Option Agreement, dated as of October 14, 1988, between the Company and Mel Karmazin. (This exhibit can be found as Exhibit 4(l) to the Company's Annual Report on Form 10-K for the year ended ____________________ * Denotes management contract or compensatory plan or arrangement required to be filed as an exhibit pursuant to item 14(c) of Form 10-K. Exhibit Number Description of Exhibit _______ ______________________ December 25, 1988 (File No. 0-14702) and is incorporated herein by reference.) 10(z)* Agreement, dated as of July 26, 1993, between the Company and Mel Karmazin, with respect to the exercise of certain options granted pur- suant to the Stock Option Agreement, dated as of June 27, 1988, as amended, between the Company, as successor to WCK, and Mel Karmazin. (This exhibit can be found as Exhibit 10(d) to the Company's Quarterly Report on Form 10-Q for the quarter ended June 30, 1993 (File No. 0-14702) and is in- corporated herein by reference.) 10(aa) Warrant Certificate, dated September 30, 1991, certifying that Mel Karmazin is the owner of warrants to purchase shares of Class A Common Stock, par value $.002 per share, of the Company. (This exhibit can be found as Exhibit 10(p) to the Company's Registration Statement on Forms S-1 and S-3 (Registration No. 33-46118) and is incorporated herein by reference.) 10(bb) Management Agreement, dated February 17, 1993, by and among the Company, Unistar Com- munications Group, Inc., Unistar Radio Networks, Inc., The Chase Manhattan Bank, N.A., National Westminster Bank, USA, and Novastar, Inc. (This exhibit can be found as Exhibit 10(s) to the Company's Annual Report on Form 10-K for the year ended December 31, 1992 (File No. 0-14702) and is incorporated herein by reference.) 10(cc) Amended and Restated Management Agreement, dated September 29, 1993, among the Company, Unistar Communications Group, Inc., Unistar Radio Networks, Inc., The Chase Manhattan Bank, N.A. and Novastar, Inc. (This exhibit can be found as Exhibit 10(a) to the Com- pany's Quarterly Report on Form 10-Q for the ____________________ * Denotes management contract or compensatory plan or arrangement required to be filed as an exhibit pursuant to item 14(c) of Form 10-K. Exhibit Number Description of Exhibit _______ ______________________ quarter ended September 30, 1993 (File No. 0- 14702) and is incorporated herein by refer- ence.) 10(dd) Amended and Restated Credit Agreement, Pur- chase and Release Agreement, dated as of February 3, 1994, among Unistar Radio Networks, Inc. (formerly known as Unistar Holdings, Inc.), UCGI, Inc. (formerly known as Unistar Communications Group, Inc.), TMRG, Inc. (formerly known as The Market Research Group, Inc.), The Chase Manhattan Bank (National Association), as lender and as agent, the Company and Novastar, Inc. 10(ee) Securities Purchase Agreement, dated as of November 4, 1993, between Westwood One, Inc. and Infinity Network Inc. (This exhibit can be found as Exhibit 10(b) to the Company's Quarterly Report on Form 10-Q for the quarter ended September 30, 1993 (File No. 0-14702) and is incorporated herein by reference.) 10(ff) Stock Purchase Agreement, dated as of November 4, 1993, among UCGI, Inc. (formerly known as Unistar Communications Group, Inc.), Unistar Radio Networks, Inc., the Company and Westwood One, Inc. and Infinity Network Inc. (This exhibit can be found as Exhibit 10(a) to the Company's Report on Form 8-K filed on November 17, 1993 (File No. 0-14702) and is incorporated herein by reference.) 10(gg) Management Agreement, dated as of February 3, 1994, between Westwood One, Inc. and the Company. 21 Subsidiaries of the Company. 23 Consent of KPMG Peat Marwick, Independent Certified Public Accountants. (b) Reports on Form 8-K. The Company filed a Report on Form 8-K, dated November 4, 1993, with the Securities and Exchange Commission and the National Association of Securities Dealers, Inc. on November 17, 1993, reporting in response to Item 5 of the Form 8-K. The Report on Form 8-K contained the consolidated financial statements at November 30, 1992 of Westwood One, Inc. SIGNATURES Pursuant to the requirements of Section 13 or 15(d) 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, on the 30th day of March, 1994. INFINITY BROADCASTING CORPORATION BY /S/ MICHAEL A. WIENER .................................. Michael Wiener Chairman of the Board of Directors and Secretary Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated. /s/ Michael A. Wiener March 30, 1994 ........................ ............... Michael A. Wiener Date Chairman of the Board of Directors and Secretary /s/ Gerald Carrus March 30, 1994 .................. .............. Gerald Carrus Date Co-Chairman of the Board of Directors and Treasurer /s/ Mel Karmazin March 30, 1994 ........................ ............... Mel A. Karmazin Date Director, President, and Chief Executive Officer /s/ Farid Suleman March 30, 1994 .................. .............. Farid Suleman Date Director, Vice President--Finance, and Chief Financial Officer * /s/ James A. Stern March 30, 1994 ........................ .............. James A. Stern Date Director /s/ James L. Singleton March 30, 1994 ....................... .............. James L. Singleton Date Director /s/ Steven A. Lerman March 30, 1994 ........................ .............. Steven A. Lerman Date Director /s/ Alan R. Batkin March 30, 1994 ........................ .............. Alan R. Batkin Date Director /s/ O.J. Simpson March 30, 1994 ........................ .............. O.J. Simpson Date Director - - --------------- * Mr. Suleman also performs the functions of Chief Accounting Officer INDEX TO CONSOLIDATED FINANCIAL STATEMENTS AND FINANCIAL STATEMENT SCHEDULES COVERED BY INDEPENDENT AUDITORS' REPORT (ITEM 14(A)1) Independent Auditors' Report............................................ Consolidated balance sheets as of December 31, 1992 and 1993............. Consolidated statements of operations for each of the years in the three-year period ended December 31, 1993............................ Consolidated statements of changes in stockholders' equity (deficiency) for each of the years in the three-year period ended December 31,1993.... Consolidated statements of cash flows for each of the years in the three-year period ended December 31, 1993............................ Notes to consolidated financial statements.............................. Financial statement schedules for each of the years in the three-year period ended December 31, 1993 VIII Valuation and qualifying accounts.................................. X Supplementary income statement information......................... All other schedules have been omitted because the required information either is not applicable or is shown in the consolidated financial statements or notes thereto. INDEPENDENT AUDITORS' REPORT ---------------------------- The Board of Directors and Stockholders Infinity Broadcasting Corporation: We have audited the consolidated financial statements of Infinity Broadcasting Corporation and subsidiaries as listed in the accompanying index. In connection with our audits of the consolidated financial statements, we also have audited the financial statement schedules as listed in the accompanying index. These consolidated financial statements and financial statement schedules are the responsibility of the Company's management. Our responsibility is to express an opinion on these consolidated financial statements and financial statement schedules based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Infinity Broadcasting Corporation and subsidiaries as of December 31, 1992 and 1993, and the results of their operations and their cash flows for each of the years in the three-year period ended December 31, 1993, in conformity with generally accepted accounting principles. Also in our opinion, the related financial statement schedules, when considered in relation to the basic consolidated financial statements taken as a whole, present fairly, in all material respects, the information set forth therein. KPMG PEAT MARWICK New York, New York February 1, 1994 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (a) Principles of Consolidation The consolidated financial statements include the accounts of the Company and its subsidiaries, which are wholly owned and are all involved in radio broadcasting. All significant intercompany balances and transactions have been eliminated in consolidation. (b) Revenue Recognition Revenues are recognized when advertisements are aired. (c) Property and Equipment Depreciation is provided on a straight line basis for financial statement purposes over the estimated useful lives of the related assets as follows: Buildings........................................ 18 years Machinery and equipment.......................... 3-10 years Leasehold improvements........................... Life of lease Furniture and fixtures........................... 10 years (d) Intangible Assets Intangible assets arising from acquisitions are amortized on a straight-line basis over their useful lives ranging generally from 3 to 40 years. (e) Income Taxes The Company and its subsidiaries file a consolidated Federal income tax return. Effective January 1, 1993, the Company implemented Statement of Financial Accounting Standards No. 109 (FAS 109), "Accounting for Income Taxes" which requires the use of the asset and liability method of financial accounting and reporting for income taxes. Under FAS 109, deferred income taxes reflect the impact of temporary differences between the amount of assets and liabilities recognized for financial reporting purposes and the amounts recognized for tax purposes. (f) Earnings Per Share Earnings (loss) per common share are based on the weighted average number of common shares and common equivalent shares (where inclusion of such equivalent shares would not be anti-dilutive) outstanding during the year. (g) Cash Equivalents Cash equivalents include certificates of deposit and commercial paper with maturities of one month or less. NOTE 2. PUBLIC STOCK OFFERINGS On February 5, 1992, the Company and certain holders of warrants exercisable for shares of the Company's Class A Common Stock, through an initial public offering (the "Common Stock IPO") sold 13,788,826 shares of Class A Common Stock, resulting in net proceeds to the Company of approximately $100.1 million before expenses of approximately $1.6 million. As a result of the Company's Common Stock IPO, the Company in the First Quarter of 1992 recorded a non-recurring non-cash charge of approximately $6,503,000, resulting from the issuance in 1990 of approximately 836,107 deferred shares of the Company's Common Stock to management. On May 13, 1993, the Company and certain holders of warrants exercisable for shares of the Company's Class A Common Stock sold through a public offering 8,148,814 shares of Class A Common Stock resulting in net proceeds to the Company of approximately $100 million. The net proceeds from this offering were used to pay down bank borrowings under the Company's bank credit agreement (the "Credit Agreement"). Effective August 9, 1993, the Company declared a three-for-two stock split in the form of a stock dividend payable on August 16, 1993 to shareholders of record at the close of business on August 9, 1993. Effective November 12, 1993, the company declared another three-for-two stock split in the form of a stock dividend payable on November 19, 1993 to shareholders of record at the close of business on November 12, 1993. During 1993, in connection with these stock splits, the Company increased the number of authorized shares of its Class A Common Stock to 75,000,000, Class B Common Stock to 17,500,000 and Class C Common Stock to 30,000,000. The accompanying consolidated financial statements reflect the effect of the stock dividends. On December 7, 1993, certain merchant banking partnerships affiliated with Lehman Brothers Inc. and certain officers of the Company sold in a secondary offering 5,550,000 shares of Class A Common Stock. NOTE 3. ACQUISITIONS On April 16, 1992, the Company acquired WFAN-AM, a radio station serving New York City, for approximately $70 million. On February 1, 1993, the Company acquired the assets of WZGC-FM (Atlanta), WZLX-FM (Boston) and WUSN-FM (Chicago) from Cook Inlet Radio Partners, L.P. and Cook Inlet Radio License Partnership, L.P. for a total purchase price of approximately $100 million. On September 1, 1993, the Company acquired WIP-AM, an all-sports radio station serving Philadelphia, from Spectacor Broadcasting, L.P. for approximately $17.4 million. The above acquisitions have been accounted for by the purchase method of accounting. The purchase price has been allocated to the assets acquired, principally intangible assets, including covenants not to compete, and the liabilities assumed based on their estimated fair values at the date of acquisition. The excess of purchase price over the estimated fair values of the net assets acquired has been recorded as goodwill. The operating results of these acquisitions are included in the Company's consolidated results of operations from the date of acquisition. The following unaudited pro forma summary presents the consolidated results of operations as if the acquisitions had occurred as of the beginning of 1992 and 1993, after giving effect to certain adjustments, including amortization of goodwill and interest expense on the acquisition debt. These pro forma results have been prepared for comparative purposes only and do not purport to be indicative of what would have occurred had the acquisitions been made as of those dates or of results which may occur in the future. Years Ended December 31, ------------------------ 1992 1993 ---------- ---------- (Unaudited) Net revenues.................................... $ 183,935 $ 210,317 Net earnings (loss) before extraordinary items.. (23,287) 13,524 Net earnings (loss)............................. (35,605) 13,524 Earnings (loss) per common share: Before extraordinary items...................... (.74) .33 Extraordinary items............................. (.39) -- ---------- ---------- Net earnings (loss) per common share............ (1.13) .33 ========== ========== On October 4, 1993, the Company entered into an agreement to acquire Washington, D.C. radio stations WPGC-AM/FM from Cook Inlet Radio Partners, L.P. and Cook Inlet Radio License Partnership, L.P. for approximately $60 million. On March 8, 1994, the Company entered into an agreement to acquire Detroit radio station WXYT-AM for approximately $23 million from Fritz Broadcasting Inc. The purchase price of the acquisitions of WPGC-AM/FM and WXYT-AM is expected to be financed by bank borrowings. In February 1994, the Company completed the acquisition of Los Angeles radio station KRTH-FM from Beasley FM Acquisitions Corp. for approximately $116 million. The purchase price of the acquisition was funded by borrowings under the Credit Agreement. On February 17, 1993, the Company entered into an agreement to manage the business and operations of Unistar Communications Group, Inc. ("UCG") and its subsidiaries. UCG is the parent of Unistar Radio Networks, Inc. ("Unistar"), the country's fourth-largest provider of radio network programming services. Under the terms of this agreement, as amended, the Company received at no cost approximately 20.23% of UCG's issued and outstanding capital stock, an option to acquire the remaining capital stock of UCG for a nominal price under certain conditions, and an annual management fee of approximately $2 million. On February 3, 1994, the Company, Unistar and Westwood One, Inc. ("Westwood One") completed the purchase by Westwood One of the radio network business of Unistar for approximately $101.3 million. Westwood One is the nation's largest producer and distributor of nationally sponsored radio programs. In connection with the transaction, an affiliate of the Company received 5 million newly issued shares of common stock of Westwood One for $3 per share (which represents approximately 16.45% of the issued and outstanding capital stock of Westwood One) and an option to purchase an additional 3 million shares of Westwood One's common stock at a purchase price of $3 per share, subject to certain vesting requirements. In connection with the transactions, the Company's Chief Executive Officer and Chief Financial Officer became the Chief Executive Officer and Chief Financial Officer, respectively, of Westwood One pursuant to a Management Agreement between the Company and Westwood One. Under the management agreement, the Company will receive a base management fee and additional warrants to acquire up to 1.5 million shares of Westwood One's Common Stock at a purchase price from $3 to $5 per share in the event that Westwood One's Common Stock trades above certain target price levels. NOTE 4. DEPRECIATION AND AMORTIZATION - - --------------- (a) At December 31, 1993, the Company's Credit Agreement provided for aggregate borrowings of up to approximately $295 million, including an acquisition facility of $115 million and a working capital facility of $30 million. The Credit Agreement provides for quarterly principal payments through September 30, 2000. Under the Credit Agreement, interest is payable quarterly, based on the (i) prime rate or (ii) London Interbank Offer Rate. In the normal course of business, the Company enters into a variety of interest rate protection agreements, options and swaps, in order to limit its exposure due to adverse fluctuations in interest rates. These instruments are executed with creditworthy financial institutions. As of December 31, 1993, the Company has entered into various interest rate protection agreements under which the Company's interest rate on $80 million of borrowings under the Credit Agreement is fixed at between 4.80% and 5.25% per annum, expiring in the first quarter of 1996. (b) On March 24, 1992, the Company sold $200 million principal amount of its 10 3/8% Senior Subordinated Notes due 2002, through a public offering for net proceeds to the Company of approximately $195 million. At December 31, 1993, the fair value of the Company's 10 3/8% Senior Subordinated Notes was estimated to be $215,000,000 based on the quoted market prices for the same issue. The scheduled maturities of long-term debt for the next five years and after are as follows: YEAR ENDING DECEMBER AMOUNT ------------------------------------------- -------------- (In Thousands) 1994....................................... $ 22,312 1995....................................... 15,170 1996....................................... 20,227 1997....................................... 20,227 1998....................................... 25,478 After 1998................................. 261,648 ------------- $ 365,062 ============= The debt agreements contain, among other things, restrictions on additional borrowings, capital expenditures, leases, sale of assets or common stock of subsidiaries, and payment of cash dividends. As of December 31, 1993, no earnings were available for payment of dividends. Substantially all of the assets of the Company and the common shares of its subsidiaries are pledged as collateral under the Credit Agreement. For years ended 1991, 1992 and 1993, the Company paid cash for interest of $32,066,000, $40,891,000 and $34,625,000, respectively. NOTE 6. EMPLOYEE AND OTHER POST RETIREMENT BENEFIT PLANS The Company has a qualified 401(k) profit sharing plan covering substantially all of its non-union full-time employees. For the years ended December 31, 1991, 1992 and 1993, no contributions to this plan were made by the Company. The Company does not provide any post retirement health care and life insurance benefits to its employees and accordingly, has no liabilities for such benefits. NOTE 7. INCOME TAXES The provision for income taxes for the years ended December 31, 1991, 1992 and 1993, consisting of current state and local taxes, was $6,000, $106,000 and $606,000, respectively. No federal income taxes were provided in 1991, 1992 and 1993 as a result of net losses incurred and available net loss carryforwards for each period. At December 31, 1993, the Company had net operating loss carryforwards for federal income tax purposes which expire from 2004 to 2008 of approximately $73 million. As discussed in note 1, the Company adopted FAS No. 109 as of January 1, 1993. There was no effect on the consolidated balance sheet as of December 31, 1993 of implementing FAS 109 as the value of the deferred tax asset resulting from the net operating loss carryforwards was offset by a valuation allowance of equal amount. For the years ended December 31, 1991, 1992 and 1993, the Company paid cash for income taxes of $33,000, $714,000 and $135,000, respectively. NOTE 8. EMPLOYEE STOCK PLANS Employee Stock Option Plan. The Company's 1988 Employee Stock Option Plan as amended provides for a grant of options to purchase 2,664,350 shares of the Company's Class A Common Stock and 187,500 shares of Class B Common Stock. The options are exercisable in equal amounts generally over five years from the date of grant. At December 31, 1992 and 1993, options for 686,700 and 905,981 shares, respectively, of Class A Common Stock were exercisable. Employee Deferred Share Plan. The Deferred Share Plan permits the grant of up to 240,641 Class A Deferred Shares and 782,969 Class B Deferred Shares to executives or other key employees of the Company. The following is a table summarizing the changes during the years ended December 31, 1992 and 1993 in options and deferred shares outstanding: CLASS A COMMON STOCK --------------------------- DEFERRED EXERCISE SHARES AND PRICE PER OPTIONS SHARE ------------ ------------ Outstanding as of December 31, 1991........... 1,203,196 $.001-.1333 Granted/Issued................................ 556,875 7.78 Canceled...................................... (50,076) .04-7.78 Exercised..................................... (58,495) .1333 ---------- Total outstanding as of December 31, 1992....... 1,651,500 Granted/Issued.................................. 963,750 8.78-26.00 Canceled........................................ -- -- Exercised................................ ..... (173,900) .1333-8.78 ----------- Total outstanding as of December 31, 1993....... 2,441,350 =========== NOTE 9. STOCKHOLDERS' EQUITY Each share of Class A Common Stock and each share of Class C Common Stock is entitled to one vote per share. Each share of Class B Common Stock is generally entitled to ten votes per share. Shares of Class B Common Stock and Class C Common Stock, at the option of the holder, may be converted at any time into an equal number of shares of Class A Common Stock. Each share of Class B Common Stock and Class C Common Stock automatically converts into one share of Class A Common Stock upon the sale, gift, or other transfer of such share to any person other than an associate of the Company (as defined) and upon certain other events. During 1988, the Company issued options with an exercise price of $.027 per share to an officer of the Company to purchase 2,107,998 shares of the Company's Class B Common Stock. During 1992 and 1993 options to purchase 33,750 and 134,942 shares were exercised. The Company has reserved 32,439 shares of Class A Common Stock, 2,051,807 shares of Class B Common Stock and 8,935,526 shares of Class C Common Stock for issuance upon the exercise of certain warrants and options outstanding as of December 31, 1993. NOTE 10. RELATED PARTY TRANSACTIONS The Company leases office space from an affiliate which is owned 70% by certain stockholders. The lease expires on December 31, 1998 and provides for an annual rent of $145,380 subject to certain annual adjustments. As of December 31, 1992 and 1993, the Company has loans receivable from certain stockholders amounting to $1,200,000 in the aggregate. Such loans, payable on June 1, 1994, are non-interest bearing and are included as other assets in the accompanying consolidated balance sheets. As of December 31, 1993, the Company had accounts receivable from Unistar amounting to approximately $204,000. NOTE 11. EXTRAORDINARY ITEMS In 1991, the Company purchased approximately $87 million principal amount of the 14.25% Subordinated Discount Debentures, resulting in an extraordinary gain of approximately $18 million. On March 24, 1992, the Company called for the redemption of all of the remaining approximately $98,000,000 of the 14.25% Subordinated Discount Debentures, resulting in an extraordinary loss of approximately $8,277,000. On September 22, 1992, the Company entered into a new credit agreement which replaced its prior bank credit agreement and which resulted in an extraordinary loss of $4,041,000. NOTE 12. COMMITMENTS AND CONTINGENCIES The Company and its subsidiaries occupy certain office space and transmitting facilities under lease agreements expiring at various dates through 2004. Management expects that in the normal course of business, leases that expire will be renewed or replaced by other leases. Most leases provide for escalation of rent based on increases in the Consumer Price Index and/or real estate taxes. The following is a summary of the future minimum rental commitments under existing leases: YEAR ENDING DECEMBER 31, AMOUNT ------------------------------------------ -------------- (In Thousands) 1994...................................... $ 3,766 1995...................................... 3,897 1996...................................... 3,740 1997...................................... 2,664 1998...................................... 2,556 After 1998................................ 7,343 -------------- $ 23,966 ============== Rent expense applicable to such leases amounted to approximately $2,049,000, $2,354,000 and $3,079,000 for the years ended December 31, 1991, 1992 and 1993, respectively. At December 31, 1993, the Company is committed to the purchase of broadcast rights for various sports events and other programming including on-air talent, aggregating approximately $62.5 million. The aggregate payments related to these commitments during the next five years are as follows: AMOUNT -------------- (In Thousands) 1994.................................... $ 26,475 1995.................................... 26,721 1996.................................... 6,203 1997.................................... 2,894 1998.................................... 179 -------------- $ 62,472 ============== NOTE 13. INTANGIBLE AND OTHER ASSETS Intangible assets at cost, as of December 31, 1992 and 1993 include: 1992 1993 -------- -------- (In Thousands) Franchise interests................ $214,458 $259,582 Favorable leasehold interest....... 30,708 30,542 Other, principally covenants....... not to complete.................. 45,068 60,000 -------- -------- $290,234 $350,124 ========= ========= Other assets include principally deferred financing costs and are amortized over the term of the financing.

861388_1993.txt

861388

1993

ITEM 1. Business. ORGANIZATION LG&E Energy Corp. (the Company), incorporated November 14, 1989, is a diversified energy-services holding company with two direct subsidiaries: Louisville Gas and Electric Company (LG&E) and LG&E Energy Systems Inc. (Energy Systems). In August 1990, the Company and LG&E implemented a corporate reorganization pursuant to a mandatory share exchange whereby each share of outstanding common stock of LG&E was exchanged on a share-for-share basis for the common stock of LG&E Energy Corp. The reorganization created a corporate structure that gives the Company the flexibility to take advantage of opportunities to expand into other businesses while insulating LG&E's utility customers and senior security holders from risks associated with such businesses. LG&E preferred stock and first mortgage bonds were not exchanged and remained securities of LG&E. The Company is not currently engaged in any business activity independent of LG&E and Energy Systems. LG&E is a regulated public utility that supplies natural gas to approximately 258,000 customers and electricity to approximately 336,000 customers in Louisville and adjacent areas in Kentucky. LG&E's service area covers approximately 700 square miles in 17 counties and has an estimated population of 800,000. Included in this area is the Fort Knox Military Reservation, to which LG&E provides both gas and electric service, but which maintains its own distribution systems. LG&E also provides gas service in limited additional areas. LG&E's coal fired generating plants, which are all equipped with systems to remove sulfur dioxide, produce most of LG&E's electricity; the remainder is generated by a hydroelectric power plant and combustion turbines. Underground gas storage fields help LG&E provide economical and reliable gas service to customers. During 1993, the Company's financial condition and results of operation depended to a large degree on the financial condition and results of operations of LG&E. In 1991, LG&E Energy Systems Inc. was formed to direct the Company's expansion into the non-utility marketplace and to separate the regulated utility from new business initiatives. This subsidiary explores business opportunities that fit the corporate strategy aimed at energy services opportunities, including cogeneration and independent power production; and fuel-related businesses, such as gathering, storing, transporting and marketing natural gas. Consistent with the Company's expansion strategy, Energy Systems purchased Hadson Power Systems, Incorporated, of Irvine, California, from Hadson Corporation in December 1991. Following the acquisition, Hadson Power Systems was renamed LG&E Power Systems Inc. and has been subsequently renamed LG&E Power Inc. (LPI). LPI develops, designs, builds, owns, operates, and maintains power generation facilities that sell energy to local industries and utilities. In 1992, Energy Systems acquired a 36.5% interest in Natural Gas Clearinghouse (NGC). Located in Houston, Texas, NGC is the largest independent natural gas marketer in the United States. In December 1993, the Company announced the sale of its equity interest in NGC to NOVA Corporation of Alberta, Canada. See Note 3 of Notes to Financial Statements under Item 8, for a further discussion of the sale of NGC. In February 1994, LPI announced it had reached a preliminary agreement with the DuPont Company (DuPont) to form a partnership that will own, improve, and operate energy production facilities at nine DuPont fiber manufacturing plants in the mid-Atlantic and southeastern regions of the United States. LPI will be the general partner in the arrangement and hold a 50% interest in the partnership. DuPont will be a limited partner and own the other half. Virginia Power and Electric Company (Virginia Power), one of the utilities in whose service territory the DuPont facilities reside, has made an administrative filing with the Virginia State Corporation Commission questioning certain aspects of the proposed transaction. See Item 3, Legal Proceedings - Other, for further discussion of this matter. In November 1993, the Company announced a major realignment and formation of new business units, effective January 1, 1994, to reflect its outlook for rapidly emerging competition in all segments of the energy services industry. The realignment does not affect the Company's legal structure, regulation of LG&E by the Kentucky Public Service Commission (the "Kentucky Commission" or "Commission") or the Company's status as an exempt holding company. Under the realignment, the Company has formed a national business unit, LG&E Energy Services, to develop and manage all of its utility and non-utility electric power generation and concentrate on the marketing and brokering of electric power on a regional and national basis. The realignment will allow the other business unit, LG&E, to increase its focus on customer service and to develop more customer options as the local utility industry becomes more competitive in the future. In addition to this realignment, the Company is currently in the process of re-evaluating its regulatory strategy to pursue full cost recovery of certain deferred expenses which the Company has recorded as regulatory assets. See Future Outlook, under Item 7, for a further disclosure of this issue. The Company began consideration of investment in international power projects in 1993. While it recognizes the increased risks associated with international projects, the Company believes significant opportunities exist as well. It has been working with strong international partners, successful financial institutions and industry leaders in the United States to review the risk/reward profiles of potential projects. The Company and its subsidiaries currently are exempt from all provisions, except Section 9(a)(2), of the Public Utility Holding Company Act of 1935 (the "Holding Company Act") on the basis that the Company and LG&E are incorporated in the same state and their business is predominately intrastate in character and carried on substantially in the state of incorporation. It is necessary for the Company to file an annual exemption statement with the Securities and Exchange Commission (SEC). The Company is not a public utility under the laws of the Commonwealth of Kentucky and is not subject to regulation as such by the Kentucky Commission. See Louisville Gas and Electric Company - Regulation and Rates below for a description of the regulation of LG&E by the Kentucky Commission, which includes the ability to regulate certain intra-company transactions between LG&E and the Company, including the Company's non-utility subsidiaries. LOUISVILLE GAS AND ELECTRIC COMPANY General LG&E's Trimble County Unit 1 (Trimble County or the Unit), a 495-megawatt, coal-fired electric generating unit, which LG&E began constructing in 1979, was placed in commercial operation on December 23, 1990. The Unit has been subject to numerous reviews by the Kentucky Commission. In July 1988, the Kentucky Commission issued an order stating that 25% of the total cost of the Unit would not be allowed for ratemaking purposes. For a more detailed discussion of the proceedings relating to Trimble County Unit 1, see Note 11 of the Notes to Financial Statements under Item 8. In February 1993, LG&E sold a 12.88% ownership interest in the Unit to Indiana Municipal Power Agency, completing LG&E's plan to sell the 25% not allowed for ratemaking. LG&E had previously sold a 12.12% ownership interest in the Unit to the Illinois Municipal Electric Agency in 1991. See Note 12 of the Notes to Financial Statements under Item 8 for a further discussion. Competition among energy suppliers is increasing. In particular, competition for off-system sales, which is based primarily on price and availability of energy, has become much more intense in recent years. The addition of electric generating capacity by other utilities in the Midwest has reduced the opportunities for LG&E to make interchange sales and has heightened price competition for such sales. However, such additional capacity has made lower cost power available for purchase by LG&E which, in certain instances, is at a cost lower than the variable cost of generating power from the generating stations owned by LG&E. In addition, the 1992 Energy Policy Act will provide utilities a wider choice of sources for their electrical supply than previously available. The Act also creates generating supply options that did not exist under previous legislation and is expected to increase competition for wholesale electric sales. (See Energy Policy Act of 1992 under Item 7 for a further discussion.) LG&E is responding to increased competition in a number of ways designed to lower its costs and increase sales. One such response has been the realignment by LG&E Energy Corp. into new business units as described on page 2 effective January 1, 1994. The realignment will allow LG&E to increase its focus on customer service and to develop more customer options as the utility industry becomes more competitive. The realignment does not affect the regulation of LG&E by the Commission. On May 24, 1993, the Federal Energy Regulatory Commission (FERC) gave final approval for a market-based rate tariff and two transmission service tariffs that were filed by LG&E. The market-based rate tariff enables LG&E to sell up to 75 Mw of firm generation capacity at market-based rates. It also enables LG&E to sell an unlimited amount of non-firm power at market-based rates, as long as the power is from LG&E's own generation resources. Under the two transmission service tariffs that were approved by FERC, utilities, independent power producers, and qualifying co-generation or small power production facilities may obtain firm or coordination transmission service from LG&E. These tariffs provide open access to LG&E's transmission system and enable parties requesting either type of transmission service to transmit wholesale power across LG&E's system. However, service under these tariffs is not available to ultimate consumers of electric utility service. In responding to competition in the gas distribution business, LG&E has upgraded gas storage facilities and invested in new equipment. By using the storage fields strategically, LG&E can buy gas when prices are low, store it, and retrieve the gas when demand is high. Accessing least cost gas was made easier in November 1993 when FERC's Order No. 636 went into effect. Previously, LG&E and other utilities purchased most of their gas services from pipeline companies. The order "unbundled" gas services, allowing utilities to purchase gas, transportation, and storage services separately from many different sources. Currently, LG&E buys competitively priced gas from several large producers under contracts of varying duration. By purchasing from multiple suppliers, and storing any excess gas, LG&E is able to secure favorably priced gas for its customers. Without storage capacity, LG&E would be forced to buy gas when customer demand increases, which is usually when the price is highest. (See FERC Order No. 636 under Item 7 for a further discussion.) LG&E is experiencing some of the issues common to electric and gas utility companies, namely, increased competition for customers, delays and uncertainties in the regulatory process and costs of compliance with environmental laws and regulations. The Clean Air Act Amendments of 1990 impose stringent limits on emissions of sulfur dioxide and nitrogen oxide by electric utility generating plants. While LG&E will incur some capital expenditures to comply with the Act's requirements, the overall impact of the Act on LG&E is expected to be minimal. See Environmental under Note 8 of Notes to Financial Statements under Item 8. For the year ended December 31, 1993, 74% of total utility revenues was derived from LG&E's electric operations and 26% from LG&E's gas operations. Electric and gas operating revenues and the percentages by classes of service on a combined basis for this period were as follows: See Note 13 of the Notes to Financial Statements under Item 8 for financial information concerning segments of business for the three years ended December 31, 1993. Electric Operations The sources of electric operating revenues and the volumes of sales for the three years ended December 31, 1993, were as follows: At December 31, 1993, LG&E had 336,124 electric customers. LG&E uses efficient coal-fired boilers that are fully equipped with sulfur dioxide removal systems to generate electricity. LG&E's system wide emission rate for sulfur dioxide in 1993 was approximately .78 lbs./MMBtu of heat input, which is significantly below the Phase II limit of 1.2 lbs./MMBtu established by the Clean Air Act Amendments for the year 2000. On Monday, August 30, 1993, LG&E set a record local peak load of 2,239 Mw, when the temperature at the time of peak reached 94 degrees F (average for the day was 84 degrees F). The record system peak of 3,223 Mw (which included purchases from and short-term sales to other electric utilities) occurred on Thursday, May 30, 1991. The reliability criterion for generation capacity planning is to provide a minimum reserve margin of 18%. At February 28, 1994, LG&E owned steam and combustion turbine generating facilities with a capacity of 2,613 Mw and an 80 Mw hydroelectric facility on the Ohio River. See Item 2, Properties. LG&E is a participating owner with 14 other electric utilities of Ohio Valley Electric Corporation (OVEC) whose primary customer is the Portsmouth Area uranium-enrichment complex of the U.S. Department of Energy at Piketon, Ohio. LG&E has electric transmission interconnections and/or interconnection/interchange agreements with PSI Energy, Kentucky Utilities Company, Southern Indiana Gas and Electric Company, The Cincinnati Gas & Electric Company, Indiana Michigan Power Company, OVEC, Big Rivers Electric Corporation, Tennessee Valley Authority, Wabash Valley Power Association, Indiana Municipal Power Agency, East Kentucky Power Cooperative (East Kentucky), Illinois Municipal Electric Agency, Jacksonville Electric Authority, and Ogelthorpe Power Corporation providing for various interchanges, emergency services, and other working arrangements. LG&E and East Kentucky have an agreement that allows East Kentucky to purchase power during its peak season, that period during which the utility's customers use the greatest amount of power, and LG&E to sell power during its off-peak season. The agreement entitles East Kentucky to buy from LG&E 30 to 145 megawatts from mid-December to mid-February through 1994-95. On February 28, 1991, LG&E sold a 12.12% ownership interest in Trimble County Unit 1 to the Illinois Municipal Electric Agency (IMEA), based in Springfield, Illinois, which is an agency of 30 municipalities that own and operate their own electric systems. On February 1, 1993, the Indiana Municipal Power Agency (IMPA), based in Carmel, Indiana, purchased a 12.88% interest in the Trimble County Unit. IMPA is composed of 31 municipalities that have joined together to meet their long-term electric power needs. Both IMEA and IMPA pay their proportionate share for operation and maintenance expenses of the Unit and for fuel and reactant used. They are also responsible for their proportionate share of incremental capital assets acquired. Electric and magnetic fields (sometimes referred to as EMF) surround electric wires or conductors of electricity such as electrical tools, household wiring and appliances, and high voltage electric transmission lines such as those owned by LG&E. Certain studies have suggested a possible association between electric and magnetic fields and adverse health effects. The Electric Power Research Institute, of which LG&E is a participating member, has expended approximately $65 million since 1987 in its investigation and research with regard to possible health effects posed by exposure to electric and magnetic fields. Gas Operations The sources of gas operating revenues and the volumes of sales for the three years ended December 31, 1993, were as follows: At December 31, 1993, LG&E had 258,185 gas customers. LG&E has extensive underground natural gas storage fields that help provide economical and reliable gas service to ultimate consumers. Reflecting the changing nature of the gas business, a number of industrial customers purchase their natural gas requirements directly from producers or brokers for delivery through LG&E's distribution system. Transportation of natural gas for LG&E's customers does not have an adverse effect on earnings because of the offsetting decrease in gas supply expenses. The transportation rates are designed to make LG&E economically indifferent as to whether gas is sold or merely transported. The all-time maximum day gas sendout of 545,000 Mcf occurred on Sunday, January 20, 1985, when the average temperature for the day was -11 F. During 1993, the maximum day gas sendout was 447,000 Mcf, occurring on February 18, when the average temperature for the day was 11 F. Supply on that day consisted of 171,000 Mcf from purchases, 238,000 Mcf delivered from underground storage and 38,000 Mcf transported for industrial customers. For further discussion, see Gas Supply. On November 1, 1993, LG&E began purchasing and transporting its natural gas supplies under the new requirements created by FERC Order No. 636 which was issued in 1992. While LG&E had previously been able to purchase natural gas and pipeline transportation services from Texas Gas Transmission Corporation (Texas Gas), LG&E now purchases only transportation services from Texas Gas pursuant to its FERC-approved tariff and acquires its supply of natural gas from several other sources. Throughout 1993, LG&E undertook a review to evaluate and select the pipeline services and gas supplies needed. As a result of this review, LG&E entered into several distinct transportation and purchase agreements. LG&E should benefit from Order No. 636 through enhanced access to competitively priced natural gas supplies as well as more flexible transportation services. LG&E has made the necessary modifications to its operations and to its gas supply clause to reflect these Order No. 636 changes. (For further discussion see Gas Supply.) Regulation and Rates The Kentucky Commission has regulatory jurisdiction over the rates and service of LG&E and over the issuance of certain of its securities. LG&E is a "public utility" as defined in the Federal Power Act, and is subject to the jurisdiction of the Department of Energy and the FERC with respect to the matters covered in such Act, including the sale of electric energy at wholesale in interstate commerce. In addition, the FERC has sole jurisdiction over the issuance by LG&E of short-term securities. For a discussion of the most recent rate order of the Kentucky Commission, see Rates and Regulation under Item 7 and Note 11 of the Notes to Financial Statements under Item 8. Increases and decreases in the cost of fuel for electric generation are reflected in the rates charged to all of LG&E's electric customers by means of LG&E's fuel adjustment clause. The Kentucky Commission requires public hearings at six-month intervals to examine past fuel adjustments, and at two-year intervals for the purpose of additional examination and transfer of the then current fuel adjustment charge or credit to the base charges. The Commission also requires that electric utilities, including LG&E, file certain documents relating to fuel procurement and the purchase of power and energy from other utilities. LG&E's gas rates contain a gas supply clause (GSC), whereby increases or decreases in the cost of gas supply are reflected in LG&E's rates, subject to approval of the Kentucky Commission. The GSC procedure prescribed by order of the Commission provides for quarterly rate adjustments to reflect the expected cost of gas supply in that quarter. In addition, the GSC contains a mechanism whereby any over- or under-recoveries of gas supply cost from prior quarters will be refunded to or recovered from customers through the adjustment factor determined for subsequent quarters. In November 1993, the Commission approved a comprehensive agreement on demand side management (DSM) programs. The agreement contains a rate mechanism that provides for the recovery of DSM program costs, allows LG&E to recover revenues due to lost sales associated with the DSM programs and provides LG&E an incentive for implementing DSM programs. See Rates and Regulation under Item 7 for a further discussion of DSM. As part of the corporate reorganization whereby the Company became the parent of LG&E, LG&E obtained the approval of the Kentucky Commission. The order of the Kentucky Commission authorizing LG&E to reorganize into a holding company structure contains certain provisions, which, among other things, ensure the Kentucky Commission access to books and records of the Company and its affiliates which relate to transactions with LG&E; require the Company and its subsidiaries to employ accounting and other procedures and controls and to protect against subsidization of non-utility activities by LG&E's customers; and preclude LG&E from guaranteeing any obligations of the Company without prior written consent from the Kentucky Commission. In addition, such order provides that LG&E's board of directors has the responsibility to use its dividend policy consistent with preserving the financial strength of the utility and that the Kentucky Commission, through its authority over LG&E's capital structure, can protect LG&E's ratepayers from the financial effects resulting from non-utility activities. Construction Program and Financing LG&E's construction program is designed to assure that there will be adequate capacity to meet the future electric and gas needs of its service area. These needs are continually being reassessed and appropriate revisions are made, when necessary, in construction schedules. The Company's estimates of its construction expenditures can vary substantially due to numerous items beyond the Company's control, such as changes in LG&E's rates, economic conditions, construction costs, and new environmental or other governmental laws and regulations. For a further discussion of construction expenditures and financing, see Construction Expenditures and Capitalization and Liquidity under Item 7. During the five years ended December 31, 1993, LG&E's gross property additions amounted to $580 million. Funds for about 97% of these gross additions were generated internally. The gross additions during this period amounted to approximately 24% of total utility plant at December 31, 1993, and consisted of $480 million for electric properties and $100 million for gas properties. Gross retirements during the same period were $40 million, consisting of $29 million for electric properties and $11 million for gas properties. Coal Supply Ninety percent of LG&E's present electric generating capacity is coal-fired, the remainder being made up of a hydroelectric plant and combustion turbine peaking units fueled by natural gas and oil. Coal will be the predominant fuel used by LG&E in the foreseeable future, with natural gas and oil being used for peaking capacity and flame stabilization in coal-fired boilers or in emergencies. LG&E has no nuclear generating units and has no plans to build any in the foreseeable future. In 1992, LG&E entered into coal supply agreements with various suppliers for coal deliveries for 1993 and beyond. LG&E normally augments its coal supply agreements with spot market purchases which, during 1993, were about 10% of total purchases. LG&E has a coal inventory policy, which is in compliance with the Kentucky Commission's directives and which LG&E believes provides adequate protection under most contingencies. LG&E had on hand at December 31, 1993, a coal inventory of approximately 433,000 tons, or a 28 day supply. LG&E expects, for the foreseeable future, to continue purchasing most of its coal from western Kentucky and southwest Indiana, which has a sulfur content in the 2%-3.5% range. The abundant supply of this relatively low priced coal, combined with present and future desulfurization technologies, is expected to enable LG&E to continue to provide adequate electric service in a manner acceptable under existing environmental laws and regulations. Coal for LG&E's Mill Creek plant is delivered by rail and barge, whereas deliveries to the Cane Run plant are primarily by rail and also by truck. Deliveries to the Trimble County plant are by barge only. The average delivered cost of coal purchased by LG&E, per ton and per million Btu, for the periods shown were as follows: Gas Supply During 1993, LG&E continued to purchase natural gas from and transport other natural gas supplies through Texas Gas at rates and terms regulated by the FERC. LG&E also continued purchasing a portion of its natural gas supplies on the spot-market and transporting those supplies under various transportation agreements with Texas Gas pursuant to applicable FERC-approved tariffs. LG&E received standby service from Texas Gas until its implementation of FERC Order No. 636. As a result of FERC Order No. 636 and effective November 1, 1993, LG&E entered into new transportation service agreements with Texas Gas. These agreements provide for 30,000 MMBtu (29,268 Mcf) per day in Firm Transportation (FT) throughout the year. This FT agreement expires October 31, 1997. During the winter months, LG&E also has 184,900 MMBtu (180,390 Mcf) per day in No-Notice Service (NNS); during the summer months that NNS level is 135,000 MMBtu (131,707 Mcf) per day. LG&E's NNS agreements with Texas Gas incorporate terms of 2, 5, and 8 years, and include unilateral roll-over provisions at LG&E's option. These transportation services are provided by Texas Gas pursuant to its FERC-approved tariff. Contemporaneously with the conclusion of its transportation arrangements with Texas Gas, LG&E also entered into a series of long-term firm supply arrangements with various suppliers in order to meet its firm sales obligation. The gas supply arrangements include pricing provisions which are market-responsive. These firm supplies, in tandem with pipeline transportation services, provide the reliable and flexible supply needed to replace the bundled sales service formerly supplied by the pipeline. During 1994, LG&E will be participating in several regulatory proceedings at FERC. Particularly, LG&E will be involved in reviewing Texas Gas' most recent rate filing, and Texas Gas' filing to recover certain transition costs associated with the FERC-mandated implementation of FERC Order No. 636. As a separate matter, the Kentucky Commission has indicated in an order issued in its Administrative Case No. 346 that transition costs, which are clearly identified as being related to the cost of the commodity itself, are appropriately recovered as a gas cost through LG&E's purchased gas adjustment. LG&E operates five underground gas storage fields with a current working gas capacity of 14.6 million Mcf. Gas is purchased and injected into storage during the summer season and is then withdrawn to supplement pipeline supplies to meet the gas-system load requirements during the winter heating season. The estimated maximum deliverability from storage during the early part of the 1992-1993 heating season was approximately 373,000 Mcf per day. Deliverability decreases during the latter portion of the heating season as the storage inventory is reduced by seasonal withdrawals. The average cost per Mcf of natural gas purchased by LG&E was $2.91 in 1993, $2.77 in 1992, and $2.39 in 1991. Although upcoming regulatory changes may alter the ways in which LG&E contracts for natural gas supplies, it is expected that LG&E will continue to have adequate access to natural gas supplies at market sensitive prices. Environmental Matters Protection of the environment is a major priority for LG&E. LG&E engages in a variety of activities within the jurisdiction of federal, state, and local regulatory agencies. Those agencies have issued LG&E permits for various activities subject to air quality, water quality, and waste management laws and regulations. For the five year period ending with 1993, expenditures for pollution control facilities represented $128 million or 22% of total construction expenditures. The cost of operating and maintaining these facilities amounted to $22 million in both 1993 and 1992. LG&E's anticipated capital expenditures for 1994 to comply with environmental laws are approximately $22 million. See Item 3 and Note 10 of the Notes to Financial Statements under Item 8 for a discussion of specific environmental proceedings affecting LG&E. LG&E ENERGY SYSTEMS INC. In 1991, the Company formed LG&E Energy Systems Inc. (Energy Systems) to direct the Company's expansion into the non-utility marketplace. In December 1991, Energy Systems purchased Hadson Power Systems, Incorporated, which was renamed at the time of purchase to LG&E Power Systems Inc. and subsequently renamed LG&E Power Inc. (together with its subsidiaries, "LPI"). In 1992, Energy Systems acquired a 36.5% interest in Natural Gas Clearinghouse (NGC). In December 1993, the Company announced the sale of its equity interest in NGC to NOVA Corporation of Alberta, Canada, which was completed in January 1994. See Note 3 of Notes to Financial Statements under Item 8 and Future Outlook under Item 7 for a further discussion of the NGC sale. LPI is involved in the development, design, construction, ownership, operation, and maintenance of power generation facilities in the United States. LPI, through its predecessor, has been in the independent power business since 1982 and has approximately 500 employees. It currently has in operation or under construction, projects capable of generating over 527 megawatts of electric power capacity in Maine, North Carolina, Virginia, and New York. For a description of LPI's projects and the ownership interests of LPI in such projects, see Item 3, Properties. Each of these projects currently is, or upon its completion will be, a qualifying cogeneration facility under the Public Utility Regulatory Policy Act of 1978 (PURPA). In addition, LPI has sought and obtained exempt wholesale generator (EWG) status for the entity which owns the Roanoke Valley I project in North Carolina. Such status will allow LPI to own and operate the 165 megawatt Roanoke Valley I facility without complying with PURPA's qualifying cogeneration facility operating standards. EWGs are not required to comply with such standards if the rates charged for a facility's electric generation have been accepted for filing by FERC. Such a filing was made and accepted for the Roanoke Valley I facility in December 1993. Generally, qualifying facility status exempts projects from the application of the Holding Company Act, many provisions of the Federal Power Act, and state laws and regulations respecting rates and financial or organization regulation of electric utilities. Exempt wholesale generators also are exempt from application of the Holding Company Act and many provisions of the Federal Power Act, but once such an entity files its electric generation rates with FERC, it becomes a jurisdictional public utility under the Federal Power Act. As such a "public utility," an EWG's rates and some of its corporate activity are subject to FERC regulation. Exempt wholesale generators also are subject to non-rate regulation under state laws governing electric utilities. While qualifying facility or exempt wholesale generator status entitles LPI's projects to certain regulatory exceptions and benefits under PURPA and the Holding Company Act, each project must still comply with other federal, state, and local laws, including those regarding siting, construction, operation, licensing, and pollution abatement. Through an affiliate, LPI also operates and maintains 12 projects in which it does not have an ownership interest that are located in California, Pennsylvania, and Montana. In order to permit it to operate EWGs, such affiliate also has been designated as an exempt wholesale generator under the Holding Company Act. LPI currently is involved in the construction of three cogeneration facilities, Roanoke Valley I, Roanoke Valley II, and Rensselaer. The Roanoke Valley I and II projects each are owned with Westmoreland Energy, Inc., a subsidiary of Westmoreland Coal Company (Westmoreland). The Roanoke Valley I project is a 165 megawatt coal-fired facility located near Weldon, North Carolina. The Roanoke Valley II project is a 44 megawatt coal-fired facility located adjacent to the Roanoke Valley I project. These facilities share certain common facilities. Both facilities will sell electricity to North Carolina Power and steam to Patch Rubber Company, a subsidiary of Myers Industries. TECO Coal Company is obligated to supply all of the plants' coal requirements although Westmoreland has entered into a subcontract arrangement with TECO whereby it is entitled to supply approximately 80% of such coal requirements. Subsidiaries of LPI will engineer, construct, and operate each project. The project owner has obtained a $393 million construction and term loan facility to finance its construction and operation of these projects. The Rensselaer project, a 79 megawatt gas-fired cogeneration plant, also is owned jointly with Westmoreland Energy, Inc. and is located in Rensselaer, New York. This facility will sell electricity to Niagara Mohawk Power Corp. and steam to BASF Corp. LPI is engaged in the construction of such facility and the project owner has arranged a $123 million construction and term loan facility to finance the construction and operation of this project. Completion of the Roanoke Valley I and Rensselaer projects are projected for mid-1994 and completion of the Roanoke Valley II project is expected for mid-1995. The financing and overall structure of the Roanoke Valley and Rensselaer projects are similar to that followed for previous LPI cogeneration projects. Subsidiaries of LPI, as builders of the projects, are contractually obligated to construct the project and to assure it meets certain performance standards. Financing for the construction of the project is provided to a partnership which is the owner of the project and in which LPI (or a wholly owned entity) is a partner. The partners are obligated to make equity contributions to the project at various stages prior to its completion. Each project has a long-term contract with the local utility to purchase electricity generated by the project and, for those projects which are qualifying cogeneration facilities, with an industrial company to purchase the steam from the project. Revenues from the sale of electricity and steam are designed to be sufficient to repay the debt incurred in financing the project. LPI's ownership interest in the project and the revenues from the sale of steam and electricity from the project are pledged as security to the lenders providing financing for the project. Although the financing of the project is non-recourse to the partnership owning the project, the various obligations of LPI under the contracts for construction of the project and LPI's equity commitments are guaranteed by Energy Systems. Through a support agreement with Energy Systems for the benefit of the project lenders, the Company has agreed in substance to provide Energy Systems with the necessary funds and financial support to meet these contingencies. See Project Obligations under Note 10 of the Notes to Financial Statements under Item 8. Westmoreland has similar guarantee obligations with respect to the equity commitments of Westmoreland Energy for the Roanoke Valley and Rensselaer projects. In April 1993, Westmoreland requested that Energy Systems provide financial assistance with respect to its guarantee obligations. Energy Systems agreed to provide such financial assistance by guaranteeing to the lenders for the Roanoke Valley and Rensselaer projects payment of those equity commitments of Westmoreland, up to a maximum aggregate amount of approximately $35.5 million ($26.9 million for the Roanoke Valley projects and $8.6 million for the Rensselaer project). LPI is entitled to receive fees for the provision of such financial assistance. The obligations of Westmoreland to repay any amounts actually paid by Energy Systems with respect to such guarantees and the other obligations which Westmoreland has to Energy Systems under this credit support arrangement are secured by pledges of Westmoreland Energy's ownership interests in the projects. In December 1993, Energy Systems and LPI entered into an arrangement with Nations Financial Capital Corporation (Nations), whereby Nations has agreed to fund on its behalf those amounts which Energy Systems is obligated to fund for Westmoreland with respect to the Roanoke Valley projects. While Energy Systems remains directly responsible to the Roanoke Valley lenders for the payment of Westmoreland's equity obligations for such projects, Nations has agreed that Westmoreland, and not Energy Systems, will be responsible for repayment of any amounts which Nations is obligated to fund. As security for the payment to Nations of any amounts so funded, the Company assigned to Nations those pledged interests in the Roanoke Valley projects and those related rights which were received from Westmoreland in April 1993. Energy Systems paid a fee to Nations in connection with the assumption by Nations of Westmoreland's Roanoke Valley funding obligations. Energy Systems is able to terminate such arrangement at any time. Both the lenders for the Roanoke Valley projects as well as Westmoreland have consented to Energy Systems' arrangements with Nations. LABOR RELATIONS LG&E's 1,652 operating, maintenance, and construction employees are members of the International Brotherhood of Electrical Workers (IBEW) Local 2100. On May 31, 1992, the IBEW voted to ratify a new three-year collective bargaining agreement. The new agreement became effective in November 1992 and will expire in November 1995. EMPLOYEES The Company and its subsidiaries had 3,293 full-time employees at December 31, 1993. During the last quarter of 1993 and early 1994, LG&E eliminated a number of full-time positions and made early retirement available to a number of other employees. See Note 5 of Notes to Financial Statements under Item 8 for a further discussion of this matter. ITEM 2.

ITEM 2. PROPERTIES. At February 28, 1994, LG&E owned and operated the following electric generating stations: LG&E's steam stations consist mainly of coal-fired units except for Cane Run Unit 3 which must use natural gas because of restrictions mandated by environmental regulations. LG&E also owns an 80 Mw hydroelectric generating station located in Louisville, operated under license issued by the Federal Energy Regulatory Commission. At December 31, 1993, LG&E's electric transmission system included 20 substations with a total capacity of approximately 10,518,897 Kva and approximately 645 structure miles of lines. The electric distribution system included 84 substations with a total capacity of approximately 2,948,768 Kva, 3,499 structure miles of overhead lines, 231 miles of underground conduit, and 5,170 miles of underground conductors. LG&E's gas transmission system includes 177 miles of transmission mains, and the gas distribution system includes 3,226 miles of distribution mains. LG&E operates underground gas storage facilities with a current working gas capacity of approximately 14.6 million Mcf. See Gas Supply under Item 1. In 1990, LG&E entered into an operating lease for its corporate office building located in downtown Louisville, Kentucky. The lease is for a period of 15 years and is scheduled to expire June 30, 2005. Other properties owned by LG&E include office buildings, service centers, warehouses, garages, and other structures and equipment, the use of which is common to both the electric and gas departments. The trust indenture securing LG&E's First Mortgage Bonds constitutes a direct first mortgage lien upon substantially all property owned by LG&E. At December 31, 1993, LPI owned the percentage indicated of the following qualifying cogeneration projects in operation or being constructed: LPI's ownership interests in these projects and the revenues from the sale of electricity and steam from the projects are pledged as security to the lenders who provided the financing for the project. ITEM 3.

ITEM 3. LEGAL PROCEEDINGS. Rate Case and Trimble County Station For a discussion of the most recent rate order of the Public Service Commission of Kentucky and a detailed discussion of the orders of the Kentucky Commission and rulings of the Franklin Circuit Court and the Kentucky Court of Appeals concerning Trimble County Unit 1, see Item 7 and Note 11 of the Notes to Financial Statements under Item 8. Statewide Power Planning As required by the regulations of the Kentucky Commission, on November 15, 1993, LG&E filed its 1993 biennial Integrated Resource Plan with the Kentucky Commission. The plan which updates LG&E's first Integrated Resource Plan filed in 1991, proposes to meet customers' future demand through 2007 by adding resources in small increments such as short-term power purchases (1996-1999), a customer-owned standby generation program (1997), two combustion turbines (1999-2000), an air conditioner load controls program (2001-2003), an upgrade to LG&E's existing hydroelectric plant (2003), and a compressed air energy storage plant (2004). The Kentucky Commission staff is in the process of reviewing LG&E's plan, and is not expected to issue its report and recommendations concerning the plan until late 1994 at the earliest. The Kentucky Commission's regulations do not require it to hold any hearings or issue any formal orders regarding the Plan. Environmental The Clean Air Act Amendments of 1990 impose stringent limits on emissions of sulfur dioxide and nitrogen oxides by electric utility generating plants. This legislation is extremely complex and its effect will substantially depend on regulations issued by the U.S. Environmental Protection Agency. While LG&E will incur some capital expenditures to comply with the Act's requirements, the overall impact of the Act on LG&E is expected to be minimal. LG&E is closely monitoring the continuing rule-making process, in order to assess the precise impact of the legislation on LG&E. For a complete discussion of the Company's environmental issues concerning its Mill Creek and Cane Run generating plants, manufacturing gas plant sites, and certain other environmental issues, see Note 10 of the Notes to Financial Statements under Item 8. Based upon prior precedents established by the Kentucky Commission and the Environmental Cost Recovery legislation, LG&E expects to have an opportunity to recover through future ratemaking proceedings, its costs associated with remedial measures required to comply with environmental laws and regulations. Like LG&E, LPI and its subsidiaries are subject to extensive federal, state, and local environmental laws and regulations governing the operations of the various power plants in which they participate as an owner or managing operator. Among other things, these laws and regulations govern the discharge of materials into waterways, the air, and the ground and, if violated, may require the owner or operator to take remedial action to maintain the affected facility's operating status. To the extent any such remedial environmental actions have been required of LPI or its subsidiaries in the past, related expenditures have not been material. Other As discussed in Item 1, LPI announced a preliminary agreement with the DuPont Company to form a power partnership. Virginia Power, one of the utilities in whose service territory the DuPont facilities reside, has made an administrative filing with the Virginia State Corporation Commission (SCC) questioning certain aspects of the proposed transaction. Virginia Power has requested that the SCC, among other things, enter a declaratory order determining that the proposed arrangement is unlawful and violates Virginia Power's rights under its certificate of public convenience and necessity. Due to the preliminary nature of this proceeding, it is not possible to predict with any certainty its outcome at this time. Nonetheless, LPI intends to vigorously pursue the proposed transaction. LG&E is a defendant in lawsuits seeking compensatory and, in certain instances, punitive damages for injuries purportedly incurred by individuals coming into contact with LG&E's electric or gas facilities and/or services. To the extent that damages are assessed in any of these lawsuits, LG&E believes that its insurance coverage is adequate and that the effect of any such damages will not be material. LPI and LPI's subsidiaries are defendants in lawsuits seeking compensatory damages primarily associated with various employment related matters. To the extent that damages are assessed in any of these lawsuits, LPI believes that the effect will not be material. ITEM 4.

ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS. None Executive Officers of the Company. Each of the following officers is an executive officer of a subsidiary of the Company and for purposes of the requirements of this report may also be considered an executive officer of the Company: The present term of office of each of the above executive officers extends to the meeting of the Board of Directors following the Annual Meeting of Stockholders, scheduled to be held May 24, 1994. There are no family relationships between executive officers of the Company or those executive officers of its subsidiaries. Mr. Hale was named to the position shown above concurrent with a corporate restructuring completed on August 17, 1990, pursuant to which LG&E became a subsidiary of the Company. Prior to January 1, 1994, Mr. Casey was Executive Vice President and Chief Financial Officer, and prior to January 1, 1993, President - LG&E Energy Systems (a subsidiary of the Company). Prior to January 1, 1994, Mr. Wood was Senior Vice President and Chief Administrative Officer - LG&E, and prior to December 1992, held the same position concurrently for the Company and LG&E. Prior to January 1, 1993, Mr. Markel was Senior Vice President and Chief Financial Officer, and prior to January 1992, Vice President-Finance and Treasurer. Messrs. Hale and Markel are also executive officers of the Company's subsidiary, LG&E. Mr. Fowler, Ms. Heck, Mr. Hermann, and Mr. Markel have been employed for more than five years in executive or management positions with the Company or its subsidiary, LG&E. Prior to election to the position shown in the table, the following executive officers held other positions with the Company or LG&E since January 1, 1989: Ms. Heck was Manager-Internal Audit prior to January 1990, Vice President-Internal Auditing prior to January 1, 1992, Vice President-Fuels and Operating Services prior to January 1, 1993, and Vice President-Fuels and Information Services thereafter; Mr. Hermann was Manager-Administration, Power Production prior to November 1989, General Manager-Power Production prior to January 1992 and General Manager-Wholesale Electric thereafter; Mr. Markel was Vice President and Treasurer prior to March 1, 1990, Vice President-Finance and Treasurer prior to January 1, 1992, and Senior Vice President and Chief Financial Officer thereafter. Effective January 1, 1993, Mr. Markel was named Corporate Vice President-Finance and Treasurer of the parent company, LG&E Energy Corp. Prior to election to his current position, Mr. Hale held the position of Chairman of the Board, President and Chief Executive Officer of LG&E, and prior to February 1, 1990, Mr. Hale was President and Chief Executive Officer of LG&E. Prior to June 1, 1989, Mr. Hale was employed by BellSouth Enterprises, Inc. and held the position of Executive Vice President. Prior to election to his current position, Mr. Staffieri was Senior Vice President-Public Policy, and General Counsel of the Company and LG&E, and prior to November 15, 1992, Senior Vice President, General Counsel and Corporate Secretary. Prior to March 15, 1992, Mr. Staffieri was employed by Long Island Lighting Company and held the position of General Counsel and Secretary from April 1989 to March 1992, and Deputy General Counsel prior to April 1989. Prior to election to his current position, Mr. Carey was Vice President and General Manager, Retail Electric Business of LG&E, prior to January 1, 1993, Vice President-Marketing and General Manager, Electric Service, prior to January 1, 1992, Vice President-Marketing and Planning, and prior to July 14, 1990, Vice President-Marketing and Sales. Prior to January 1990, Mr. Carey was employed by AT&T General Business Systems and held the position of Director-Strategic and Business Planning. Prior to election to his current position, Mr. Bennett was Vice President and General Manager, Gas Service Business of LG&E, and prior to January 1, 1992, General Manager, Gas Operations. Prior to May 1990, Mr. Bennett was employed by the Railroad Commission of Texas and held the position of Director of Transportation-Gas Utility Division. PART II ITEM 5.

ITEM 5. MARKET FOR THE REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS. The Company's Common Stock is listed on the New York and Chicago Stock Exchanges. The ticker symbol is "LGE". The newspaper stock exchange listings are "LGE Energy" or "LGE EN". The following table gives information with respect to price ranges, as reported in THE WALL STREET JOURNAL as New York Stock Exchange Composite Transactions, and dividends paid for the periods shown. Effective May 15, 1992, the outstanding shares of common stock were split on a three-for-two basis. The new shares were issued to shareholders of record on April 30, 1992. Prior period shares of common stock, dividends paid, prices, earnings per share of common stock, and dividends declared reported in this item and Item 6

ITEM 6. SELECTED FINANCIAL DATA. ITEM 7.

ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION. OVERVIEW LG&E Energy Corp.'s net income and earnings per share of common stock increased in 1993 as compared to 1992 because of strong performances by both the utility and the non-utility businesses. The contribution from Louisville Gas and Electric Company (LG&E) resulted primarily from a more normalized weather pattern in the utility's service area and the sale of a 12.88% interest in Trimble County Unit 1. Contributions to net income from the Company's non-utility businesses resulted primarily from earnings from projects under construction and in operation, project finance closings, and earnings from plants operated and maintained on behalf of third parties. In addition, earnings from the Company's 36.5% investment in Natural Gas Clearinghouse (NGC) increased in 1993 as compared to 1992. In December 1993, the Company agreed to sell its partnership interest in NGC to NOVA Corporation of Alberta, Canada. The sale was completed in January 1994, and the Company expects to post a pre-tax gain of approximately $87 million in the first quarter of 1994. Effective January 1, 1994, the Company announced a major realignment of its business units to reflect its outlook for rapidly emerging competition in all segments of the energy services industry. In addition to this organizational change, the Company is presently re-evaluating its regulatory strategy to pursue full cost recovery of certain deferred expenses which the Company has recorded as regulatory assets. See Future Outlook for a further discussion of this matter. The following discussion and analysis by management focuses on those factors that had a material effect on the Company's financial results of operations and financial condition during 1993 and 1992 and should be read in connection with the consolidated financial statements and notes thereto. The Company's financial results and conditions are dependent to a large degree on the financial results and conditions of Louisville Gas and Electric Company. RESULTS OF OPERATIONS Earnings per Share The Company's earnings per common share increased 36 cents for 1993 over 1992, including the 10 cents per common share gain recognized from the sale of a 12.88% portion of the Trimble County plant to the Indiana Municipal Power Agency (IMPA). LG&E's contribution to earnings came from increased electric sales as a result of the warmer summer weather experienced in 1993, higher sales to other utilities and reduced costs for debt and preferred stock attributable to favorable refinancing activities. Contributions to earnings from the non-utility businesses came from construction profits recognized by LG&E Power Inc. (LPI), earnings from operating power projects, a financial closing related to a power project and strong performance by NGC. After excluding the 13 cents per common share gain recognized in 1991 by LG&E on the sale of a 12.12% portion of the Trimble County plant to Illinois Municipal Electric Agency (IMEA), earnings for 1992 decreased 10 cents from 1991. This decrease was due primarily to lower electric sales to residential customers as a result of the cooler summer experienced in 1992 (40 cents), increased operating and depreciation expenses (15 cents), decreased interest earned on temporary cash investments of LG&E (3 cents), and various other factors (4 cents). These items were partially offset by the contribution to earnings from non-utility operations in 1992 (40 cents) and favorable financing activities of LG&E (12 cents). Rates and Regulation LG&E is subject to the jurisdiction of the Public Service Commission of Kentucky (Commission) in virtually all matters related to electric and gas utility regulation. LG&E last filed for a rate increase with the Commission in June 1990 based on the test-year ended April 30, 1990. The request was for a general rate increase of $34.9 million ($31.0 million electric and $3.9 million gas). A final order was issued in September 1991 that effectively granted LG&E an annual increase in rates of $6.8 million ($6.1 million electric and $.7 million gas). The Commission's order authorized a rate of return on common equity of 12.5%. On April 21, 1993, LG&E, the Kentucky Attorney General, the Jefferson County Attorney, and representatives of several customer-interest groups filed with the Commission a request for approval of a comprehensive agreement on demand side management (DSM) programs. Under the agreement, LG&E will commit up to $3.3 million over three years (from 1994 through 1996) for initial programs that include a residential energy conservation and education program and a commercial conservation audit program. Future programs will be developed through a formal collaborative process. The agreement contains a rate mechanism that will (1) provide LG&E concurrent recovery of DSM program costs, (2) provide LG&E an incentive for implementing DSM programs, and (3) allow LG&E to recover revenues due to lost sales associated with the DSM programs. On November 12, 1993, the Commission approved the agreement. Revenues from lost sales to residential customers are collected through a "decoupling mechanism". LG&E's residential decoupling mechanism breaks the link between the level of LG&E's residential kilowatt-hour and Mcf sales and its non- fuel revenues. Under traditional regulation, a utility's revenue varies with changes in its level of kilowatt-hour or Mcf sales. The residential decoupling mechanism will allow LG&E to recover a predetermined level of revenue per customer based on the rate set in LG&E's last rate case, which will not vary with the level of kilowatt-hour or Mcf sales. Residential revenues will be adjusted to reflect (1) changes in the number of residential customers and (2) a pre-established annual growth factor in residential revenue per customer. Decoupling, in effect, removes the impact on LG&E's non-fuel revenues from changes in kilowatt-hour or Mcf sales due to weather, fluctuations in the economy, and conservation efforts. Under this mechanism, if actual sales produce lower revenues than are produced by the predetermined per-customer amount, the difference is deferred for recovery from customers through an adjustment in rates over a period that will not exceed two years. Conversely, if actual sales produce more revenues than would be realized using the predetermined per-customer amount, the difference will be returned to customers through subsequent rate adjustments over a period not to exceed two years. Residential revenues reported in the financial statements for 1994 through 1996 will be determined in accordance with the predetermined amount per customer plus growth, and recovery of fuel and gas costs. The difference between the revenues shown in the financial statements and the amounts billed to customers will be recorded on the balance sheet and deferred for future recovery from or return to customers. As more fully discussed in Note 11 of Notes to Financial Statements under Item 8, the Commission has set a procedural schedule to determine the appropriate ratemaking treatment to exclude 25% of the Trimble County plant from customer rates. On May 24, 1993, the Federal Energy Regulatory Commission (FERC) gave final approval for a market-based rate tariff and two transmission service tariffs that were filed by LG&E. This tariff enables LG&E to sell up to 75 Mw of firm generation capacity at market-based rates. It also enables LG&E to sell an unlimited amount of non-firm power at market-based rates, as long as the power is from LG&E's own generation resources. Under the two transmission service tariffs that were approved by FERC, utilities, independent power producers, and qualifying co-generation or small power production facilities may obtain firm or coordination transmission service from LG&E. These tariffs provide open access to LG&E's transmission system and enable parties requesting either type of transmission service to transmit wholesale power across LG&E's system. However, service under these tariffs is not available to ultimate consumers of electric utility service. Revenues A comparison of LG&E's revenues for the years 1993 and 1992 with the immediately preceding years reflects both increases and decreases which have been segregated by the following principal causes (in thousands of $): Electric revenues increased in 1993 primarily because of the warmer summer weather. Sales of electricity to other utilities increased over 1992 levels due to LG&E's aggressive efforts in marketing off-system sales of energy. The increase in gas sales for 1993 is largely attributable to cooler winter weather in the region and customer growth. Non-utility revenues of $123.5 million are $6.5 million or 5% lower than last year due to lower project development fees and revenues. Construction revenues of $120 million were roughly equal to 1992, as progress continued on LPI's currently active projects at Roanoke Valley I and II in North Carolina, and Rensselaer in New York. LPI derives the majority of its revenues from the construction of power plants while its operating profit consists of plant development and construction profits in addition to earnings from operating power projects. LPI's ability to sustain this level of revenues is dependent, in part, upon its ability to continue to obtain major engineering and construction contracts. Expenses Fuel for electric generation and gas supply expenses account for a large segment of the Company's total operating costs. LG&E's electric and gas rates contain a fuel adjustment clause and a gas supply clause, respectively, whereby increases or decreases in the cost of fuel and gas supply may be reflected in LG&E's rates, subject to the approval of the Commission. Fuel expenses increased in 1993 primarily because of an increase in generation and the higher cost of coal purchased. The average delivered cost per ton of coal purchased for LG&E was $26.58 in 1993, $25.17 in 1992, and $24.51 in 1991. LG&E's increase in power purchased expense reflects an increase in the quantity of power purchased mainly because of wheeling arrangements with other utilities. Gas supply expenses increased in 1993 and 1992 largely because of an increase in both the cost and the volume of gas purchased. The average unit cost per Mcf of purchased gas for LG&E was $2.91 in 1993, $2.77 in 1992, and $2.39 in 1991. Utility operating and maintenance expenses increased approximately $5 million in 1993. This increase is primarily attributable to increased expenses for operation and maintenance of electric generating plants and higher administrative and general costs. The $2 million increase in 1992 over 1991 resulted primarily from costs associated with legal settlements relating to personal injury claims and storm damage expenses. General increases in labor and material costs are also reflected in operation and maintenance expenses. Non-utility expenses reflect the operating and business development expenses associated with the Company's non-utility operations. The majority of the expenses reflected herein pertain to LPI, including construction, project development, and general and administrative costs. LPI was acquired in December 1991. Other income and (deductions) decreased in 1993. Other income includes a $3.9 million before-tax gain on the sale of a 12.88% ownership interest in LG&E's Trimble County Unit 1 to IMPA. Other deductions reflect charges applicable to business restructurings and other non-recurring charge-offs. A decrease in 1992 from 1991 resulted primarily from a $7.9 million gain recorded in 1991 on the sale of a 12.12% ownership interest in Trimble County to IMEA and decreased interest income of $3 million from temporary cash investments. Interest charges decreased in 1993 and 1992 primarily because of an aggressive program to refinance at lower interest rates. LG&E refinanced approximately $205 million of its outstanding debt in 1993. The lower interest requirement at LG&E was partially offset by interest charges related to debt issued for the Company's expansion into non-utility businesses. Variations in income tax expenses are largely attributable to changes in pre-tax income and an increase in the corporate Federal income tax rate from 34% to 35% effective January 1, 1993. Preferred dividends reflect the lower dividend rates that resulted from LG&E's refunding of the $25 million, $8.90 Series with a $5.875 Series in May 1993. In February 1992, LG&E refunded the $8.72 and $9.54 Series with $50 million of Auction Rate Series. LG&E's weighted average preferred dividend rate at December 31, 1993, was 4.72%; at December 31, 1992, 5.36%. Income from discontinued operations reflect the net earnings realized from the Company's investment in NGC. In January 1994, the Company sold its interest in NGC. (See Note 3 of Notes to Financial Statements under Item 8.

ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA. LG&E ENERGY CORP. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF INCOME (Thousands of $ Except Per Share Data) CONSOLIDATED STATEMENTS OF RETAINED EARNINGS (Thousands of $) The accompanying notes are an integral part of these financial statements. LG&E ENERGY CORP. AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS (Thousands of $) The accompanying notes are an integral part of these financial statements. LG&E ENERGY CORP. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS (Thousands of $) The accompanying notes are an integral part of these financial statements. LG&E ENERGY CORP. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CAPITALIZATION (Thousands of $) The accompanying notes are an integral part of these financial statements. LG&E ENERGY CORP. AND SUBSIDIARIES NOTES TO FINANCIAL STATEMENTS NOTE 1 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES CONSOLIDATION. The consolidated financial statements include the accounts of LG&E Energy Corp. and its wholly-owned subsidiaries - Louisville Gas and Electric Company (LG&E) and LG&E Energy Systems Inc. (Energy Systems), collectively referred to herein as the "Company." In consolidation all intercompany transactions have been eliminated. The Company is exempt from regulation as a registered holding company under the Public Utility Holding Company Act of 1935. Accounting for the regulated utility business conforms with generally accepted accounting principles as applied to regulated public utilities and as prescribed by the Federal Energy Regulatory Commission (FERC) and the Public Service Commission of Kentucky (Commission). LG&E is subject to Statement of Financial Accounting Standards No. 71, ACCOUNTING FOR THE EFFECTS OF CERTAIN TYPES OF REGULATION. LG&E has recorded certain regulatory assets at December 31, 1993, totaling approximately $31 million. See Note 5, Post-Retirement Benefits and Early Retirement/Work Force Reduction, and Note 10, Environmental, for a discussion of these regulatory assets. See Future Outlook under Item 7, Management's Discussion and Analysis, for a discussion of the Company's re-evaluation of its current regulatory strategy in regards to these assets. During 1992, Energy Systems acquired a 36.5% partnership interest in Natural Gas Clearinghouse (NGC), a natural gas marketing company based in Houston, Texas. In December 1993, the Company announced the sale of its equity interest in NGC to NOVA Corporation with a closing date in January 1994. Accordingly, the Company's equity interest in NGC's earnings has been classified as Income from Discontinued Operations in the accompanying financial statements. See Note 3, Discontinued Operations. In December 1991, Energy Systems acquired Hadson Power Systems, Incorporated (HPS), in a transaction accounted for as a purchase. Subsequent to the acquisition, HPS was renamed LG&E Power Systems Inc. and has been subsequently renamed LG&E Power Inc. (LPI). LPI develops, designs, builds, owns, operates, and maintains power generation facilities that sell energy to local industries and utilities. LPI's revenues and expenses are classified as "non-utility" in the accompanying financial statements; approximately $97 million and $102 million of the expenses classified as "non-utility" primarily represented costs of construction revenues in 1993 and 1992, respectively. See Note 2, Acquisitions. UTILITY PLANT. LG&E's utility plant is stated at original cost, which includes payroll-related costs such as taxes, fringe benefits, and administrative and general costs. Construction work in progress has been included in the rate base, and, accordingly, LG&E has not recorded any allowance for funds used during construction. The cost of utility plant retired or disposed of in the normal course of business is deducted from utility plant accounts and such cost plus removal expense less salvage value is charged to the reserve for depreciation. When complete operating units are disposed of, appropriate adjustments are made to the reserve for depreciation and gains and losses, if any, are recognized. In December 1990, the 25% portion of the construction costs of the Trimble County Generating Station (Trimble County), which the Commission disallowed in setting customer rates, was reclassified from the Utility Plant section on the balance sheet to Other Property and Investments. In February 1991, LG&E sold a 12.12% undivided interest in Trimble County to the Illinois Municipal Electric Agency (IMEA). In February 1993, the remaining 12.88% of Trimble County not allowed in rates was sold to the Indiana Municipal Power Agency (IMPA). See Notes 11 and 12, Trimble County Generating Plant and Jointly Owned Electric Utility Plant, respectively, for a further discussion. DEPRECIATION. Depreciation is provided on the straight-line method over the estimated service lives of depreciable plant. The amounts provided for LG&E in 1993 and 1992 were 3.3% (3.2% electric, 3.2% gas, and 5% common); and for 1991, 3.3% (3.2% electric, 3% gas, and 6% common) of average depreciable plant. CASH AND TEMPORARY CASH INVESTMENTS. The Company considers all highly liquid debt instruments purchased with a maturity of three months or less to be cash equivalents. Temporary cash investments are carried at cost, which approximates fair value. DEFERRED INCOME TAXES. Deferred income taxes have been provided for all book-tax temporary differences. The Company adopted Statement of Financial Accounting Standards (SFAS) No. 109, ACCOUNTING FOR INCOME TAXES, effective January 1, 1993. SFAS No. 109 adopts the liability method of accounting for income taxes, requiring deferred income tax assets and liabilities to be computed using tax rates that will be in effect when the book and tax temporary differences reverse. For LG&E, the change in tax rates applied to accumulated deferred income taxes was not immediately recognized in operating results because of ratemaking treatment. At December 31, 1993, the deferred tax asset, which resulted primarily from unamortized investment tax credits, amounted to approximately $47 million. The deferred tax liability, which resulted primarily from book/tax utility property basis differences, totaled approximately $40 million. Regulatory assets and liabilities were established to recognize the future revenue requirement impact from these deferred taxes. The adoption of SFAS No. 109 did not have a material impact on the results of operations or financial position for either the regulated or non-regulated companies. The deferred tax balances and related regulatory assets and liabilities reflect the increase in the corporate income tax rate from 34% to 35%. INVESTMENT TAX CREDITS. Investment tax credits resulted from provisions of the tax law that permitted a reduction of the Company's tax liability based on credits for certain construction expenditures. Investment tax credits deferred and charged to income in prior years are being amortized to income over the estimated lives of the related property that gave rise to the credits. DEBT PREMIUM AND EXPENSE. Debt premium and expense are amortized over the lives of the related debt issues, consistent with regulatory practices. COMMON STOCK. Effective May 15, 1992, the outstanding shares of common stock were split on a three-for-two basis. The new shares were issued to shareholders of record on April 30, 1992. Prior period shares, dividends, and earnings per share of common stock have been restated to reflect the stock split. REVENUE RECOGNITION. Utility revenues are recorded based on service rendered to customers through month end. LG&E accrues an estimate for unbilled revenues from the date of each meter reading date to the end of the accounting period. See Management's Discussion and Analysis, Rates and Regulation under Item 7, for changes in recording residential revenues effective January 1, 1994. The Company's non-utility construction activities recognize revenues using the percentage of completion method of accounting. FUEL AND GAS COSTS. The cost of fuel for electric generation is charged to expense as used, and the cost of gas supply is charged to expense as delivered to the distribution system. REVENUES AND CUSTOMER RECEIVABLES. LG&E is an operating public utility that supplies natural gas to approximately 258,000 customers and electricity to approximately 336,000 customers in Louisville and adjacent areas in Kentucky. Customer receivables and gas and electric revenues arise from deliveries of natural gas and electric energy to a diversified base of residential, commercial and industrial customers and to public authorities and other utilities. For the year ended December 31, 1993, 74% of total utility revenue was derived from electric operations and 26% from gas operations. FAIR VALUE OF FINANCIAL INSTRUMENTS. Pursuant to the Financial Accounting Standards Board SFAS No. 107, DISCLOSURES ABOUT FAIR VALUE OF FINANCIAL INSTRUMENTS, the Company is required to disclose the fair value of financial instruments where practicable. The fair value for certain of the Company's investments and debt are estimated based on quoted market prices for those or similar instruments. Investments for which there are no quoted market prices are stated at cost because a reasonable estimate of fair value cannot be made without incurring excessive costs. The cost and estimated fair value of the Company's financial instruments as of December 31, 1993 and 1992, are as follows (in thousands of $): NOTE 2 - ACQUISITIONS In December 1991, Energy Systems acquired LPI (Hadson Power Systems, Incorporated), a developer, designer, builder, owner, and operator of non-regulated power generation facilities, headquartered in Irvine, California, for approximately $49.1 million, including acquisition related expenses. The Company accounted for the acquisition of LPI as a purchase, and accordingly, the net assets were recorded at their fair value on the acquisition date in the accompanying balance sheets. The excess of the purchase price over the fair value of the net assets acquired was recorded as goodwill, and is being amortized on a straight-line basis over 40 years. See Note 10, Commitments and Contingencies for information concerning equity funding commitments that LPI is required to provide. NOTE 3 - DISCONTINUED OPERATIONS In December 1993, the Company agreed to sell its 36.5% equity interest in NGC to NOVA Corporation for approximately $170 million. The sale of NGC, which was completed in January 1994, will result in a pre-tax gain of approximately $87 million. NGC was acquired in 1992 at a cost of approximately $70 million. At the disposal date, the Company's investment in NGC was approximately $83 million. This transaction was recorded as the disposal of a business segment and, accordingly, the investment balance and related equity in earnings of NGC have been classified as discontinued operations within the accompanying financial statements. NOTE 4 - INVESTMENTS IN AFFILIATES The Company's investments in affiliates reflect LPI's interest in partnerships that own and/or operate power producing plants. These investments are recorded using the equity method and were $63,241,000 and $59,273,000 at December 31, 1993 and 1992, respectively. The ownership percentages of LPI's joint ventures are summarized below: The Company's carrying amount exceeded the underlying equity in affiliates by $34,618,000 and $35,750,000 at December 31, 1993 and 1992, respectively. The difference represents adjustments to reflect the fair value of the underlying net assets acquired and goodwill. The fair value adjustments are being amortized over periods ranging from two to 25 years, and the goodwill is being amortized over 40 years. NOTE 5 - PENSION PLANS AND RETIREMENT BENEFITS PENSION PLANS. The Company has two non-contributory, defined-benefit pension plans, covering all eligible employees. Retirement benefits are based on the employee's years of service and compensation. The Company's policy is to fund annual actuarial costs, up to the maximum amount deductible for income tax purposes, as determined under the frozen entry age actuarial cost method. In addition, the Company has a supplemental executive retirement plan which covers officers of the Company. The plan provides retirement benefits based on average earnings during the final three or five years prior to retirement, reduced by social security benefits, any pension benefits received from plans of prior employers, and by amounts received under the pension plans mentioned in the preceding paragraph. Pension cost was $3,048,000 for 1993, $2,664,000 for 1992, and $2,245,000 for 1991, of which approximately $425,000, $241,000, and $306,000, respectively, were charged to construction. The components of periodic pension expense are shown below (in thousands of $): The assets of the plans consist primarily of common stocks, corporate bonds, United States government securities, and interests in a pooled real estate investment fund. The funded status of the pension plans at December 31 is shown below (in thousands of $): The projected benefit obligation was determined using an assumed discount rate of 7.5% for 1993 and 8.5% for 1992. An assumed annual rate of increase in future compensation levels ranged from 3.5% to 4.5% for 1993 and 3.5% to 6.5% for 1992. The assumed long-term rate of return on plan assets was 8.5% for both periods. Transition assets and prior service costs are being amortized over the average remaining service period of active participants. POST-RETIREMENT BENEFITS. The Company adopted Statement of Financial Accounting Standards No. 106, EMPLOYERS' ACCOUNTING FOR POST-RETIREMENT BENEFITS OTHER THAN PENSIONS (SFAS No. 106) January 1, 1993. SFAS No. 106 requires the accrual of the expected cost of retiree benefits other than pensions during the employee's years of service with the Company. The Company is amortizing the discounted present value of the post-retirement benefit obligation at the date of adoption over 20 years. The Company provides certain health care and life insurance benefits for eligible retired employees. Post-retirement health care benefits are subject to a maximum amount payable by the Company. Prior to January 1, 1993, the cost of retiree health care and life insurance benefits was generally recognized when paid. Beginning in 1993, the Company began to account for post-retirement benefits according to the provisions of SFAS No. 106. LG&E, based on an order from the Commission, has created a regulatory asset and is deferring the level of SFAS No. 106 expense in excess of the previous level of pay-as-you-go expense. The Commission's generic order stated that the proper level of expense for SFAS No. 106 would be determined in each utility's next general rate case. The components of the net periodic post-retirement benefit cost for 1993 as calculated under SFAS No. 106 are as follows (in thousands of $): The accumulated post-retirement benefit obligation as calculated under SFAS No. 106 at December 31, 1993, is shown below (in thousands of $): The annual service cost was calculated using an assumed discount rate of 8.5% at January 1, 1993, and 7.5% at December 31, 1993. A medical cost increase factor that ranged between 6% and 11% was also used. A 1% increase in the health care cost trend rate would increase the Accumulated Post-Retirement Benefit Obligation by approximately $1.8 million and the annual service and interest cost by approximately $200,000. No funding has been established by the Company for post-retirement benefits. POST-EMPLOYMENT BENEFITS. The Financial Accounting Standards Board issued SFAS No. 112, EMPLOYERS' ACCOUNTING FOR POST-EMPLOYMENT BENEFITS, which requires the accrual of the expected cost of benefits to former or inactive employees after employment but before retirement. The Company adopted the new standard effective January 1, 1994, as required. Adoption of SFAS No. 112 will not have a material adverse impact on the financial position or results of operation of the Company. EARLY RETIREMENT/WORK FORCE REDUCTION. During the last quarter of 1993 and early 1994, LG&E eliminated approximately 350 full-time positions. The cost of the employee reduction program, approximately $11.5 million, consists primarily of separation payments, enhanced early retirement benefits, and health care benefits. In 1992, an early retirement program was made available to all LG&E union employees who had reached age 55, or who had 35 years or more of continuous service regardless of age. The cost of the program was approximately $7 million and consisted primarily of enhanced early retirement and post-retirement health care benefits. THRIFT SAVINGS PLAN. The Company has Thrift Savings Plans under Section 401(k) of the Internal Revenue Code. Under these plans, eligible employees may defer and contribute to the plan a portion of current compensation in order to provide future retirement benefits. The Company makes contributions to the plans by matching a portion of employees' contributions according to a formula established by the plans. These costs were approximately $3,542,000 for 1993, $2,204,000 for 1992, and $598,000 for 1991. The increase in 1993 401(k) expenses is due to the expansion of the program to LG&E union employees; the increase in 1992 is due to the inclusion of LPI's Thrift Savings Plan. NOTE 6 - FEDERAL AND STATE INCOME TAXES Components of income tax expense from continuing operations are shown in the table below (in thousands of $): Variations in the 1993 income tax expense from 1992 and 1991 are largely attributable to changes in pre-tax income and an increase in the corporate Federal income tax rate from 34% to 35%, effective January 1, 1993. Provisions for deferred income taxes from continuing operations consist of the tax effects of the following temporary differences (in thousands of $): Depreciation and amortization fluctuations for 1993 are primarily attributable to the reversal of prior years' accumulated taxes as a result of the sale of a portion of Trimble County Unit 1 to IMPA. See Note 11, Trimble County Generating Plant, for a further discussion of the sale. The following are the tax effects of book-tax temporary differences resulting in deferred tax assets and liabilities as of December 31, 1993 (in thousands of $): The Company's effective income tax rate is computed by dividing the aggregate of current income taxes, deferred income taxes-net, and the investment tax credit-net, by income from continuing operations before income taxes. Reconciliation of the statutory Federal income tax rate to the effective income tax rate for continuing operations is shown in the table below: NOTE 7 - CAPITAL STOCK Changes in shares of common stock outstanding are shown in the table below (in thousands): The Company's Automatic Dividend Reinvestment and Stock Purchase Plan was modified on April 14, 1991, to provide that reinvested dividends and optional cash payments would be used to buy shares of common stock on the open market. Prior to this date, authorized but unissued shares of common stock were issued to plan participants. The plan was changed in 1993 to issue authorized but unissued common stock under the plan effective with the January 15, 1993, dividend. Effective January 15, 1994, the plan has been revised and reinvested dividends and optional cash payments will again be applied to purchase shares of the Company's stock on the open market. The Company has a long-term incentive plan whereby, in addition to other types of stock-based and related awards, incentive and nonqualified stock options can be granted to key personnel. A total of 299,250 shares of common stock have been reserved for issuance under the plan. Under the nonqualified stock option portion of the plan, the Company may grant stock options at an exercise price approximating market value. Each option entitles the holder to acquire one share of the Company's common stock no earlier than one year from the date granted. The options generally expire 10 years from the date granted. Common stock equivalents resulting from the options granted would not have a material dilutive effect on reported earnings per share. A summary of the status of the Company's nonqualified stock options follows: In 1990, the Company adopted a Shareholders Rights Plan designed to protect shareholders' interests in the event the Company is ever confronted with an unfair or inadequate acquisition proposal. Pursuant to the plan, the Company declared a dividend distribution of one "right" for each share of LG&E Energy Corp. common stock. As a result of the three-for-two stock dividend effective May 15, 1992, each share of common stock will have two-thirds of a "right" associated with it. Each right entitles the holder to purchase from the Company one one-hundredth of a share of new preferred stock of the Company under certain circumstances. The rights may be exercised if a person or group announces its intention to acquire, or does acquire, 20% or more of LG&E Energy Corp. common stock. Under certain circumstances, the holders of the rights will be entitled to purchase either shares of common stock of LG&E Energy Corp. or common stock of the acquirer at a reduced percentage of market value. The rights will expire in the year 2000 unless they are redeemed or exchanged. In May 1993, LG&E issued $25 million of $5.875 Cumulative Preferred Stock. The proceeds from the sale were used to redeem the outstanding $8.90 Cumulative Preferred Stock. NOTE 8 - FIRST MORTGAGE BONDS Annual requirements for the sinking funds of LG&E's First Mortgage Bonds (other than the First Mortgage Bonds issued in connection with the Pollution Control Bonds) are the amounts necessary to redeem 1% of the highest principal amount of each series of bonds at any time outstanding. Property additions (166 2/3% of principal amounts of bonds otherwise required to be so redeemed) have been applied in lieu of cash. It is the intent of LG&E to apply property additions to meet 1994 sinking fund requirements of the First Mortgage Bonds. The trust indenture securing the First Mortgage Bonds constitutes a direct first mortgage lien upon substantially all property owned by LG&E. The indenture, as supplemented, provides in substance that, under certain specified conditions, portions of retained earnings will not be available for the payment of dividends on common stock. No portion of retained earnings is presently restricted by this provision. Pollution Control Bonds (LG&E Projects) issued by Jefferson and Trimble Counties, Kentucky, are secured by the assignment of loan payments by LG&E to the Counties pursuant to loan agreements, and further secured by the delivery from time to time of an equal amount of LG&E's First Mortgage Bonds, Pollution Control Series. First Mortgage Bonds so delivered are summarized in the Statements of Capitalization. No principal or interest on these First Mortgage Bonds is payable unless default on the loan agreements occurs. The interest rate reflected in the Statements of Capitalization applies to the Pollution Control Bonds. In March 1993, due to the sale of 12.88% of Trimble County Unit 1, LG&E completed the defeasance of $25 million of its Pollution Control Bonds ($16.665 million of the 7.625% Series and $8.335 million of the 6.55% Series). LG&E issued several series of lower interest bearing First Mortgage and Pollution Control Bonds in 1993 to refinance bonds with higher interest rates. In August, LG&E issued two separate series of Pollution Control Bonds (a $35.2 million, Variable Rate Series, which had an interest rate of 2.586% at December 31, 1993, and a $102 million, 5.625% Series) and redeemed five series of Pollution Control Bonds totaling $137.2 million with interest rates ranging from 6.125% to 6.7%. In August, LG&E also issued $42.6 million of 6% First Mortgage Bonds and redeemed two series of First Mortgage Bonds ($19.7 million at 8.25% and $21.362 million at 8.5%). In November, LG&E issued $26 million of Pollution Control Bonds, 5.45% Series and redeemed the $26 million, 9.75% Series. LG&E also entered into an agreement in November 1993 with Goldman, Sachs & Co. to issue $40 million of tax-exempt Pollution Control Bonds in 1995 at a rate of 5.9%. The issuance of the bonds in 1995 is subject to certain conditions. If issued, the proceeds will be used to redeem, in 1995, the outstanding 9.25% Series of Pollution Control Bonds due July 1, 2015. LG&E has outstanding interest rate swap agreements totaling $30 million. Under the agreements, which were entered into in 1992, LG&E pays a fixed rate of 4.35% on $15 million for a five-year period and 4.74% on $15 million for a seven-year period. In return, LG&E receives a floating rate based on the weighted average JJ Kenny index. At December 31, 1993, the rate on the JJ Kenny index was 3.25%. LG&E's First Mortgage Bonds, 5.625% Series of $16 million is scheduled to mature in 1996 and the 6.75% Series of $20 million is scheduled to mature in 1998. There are no scheduled maturities of Pollution Control Bonds for the five years subsequent to December 31, 1993. NOTE 9 - NOTES PAYABLE At December 31, 1993, Energy Systems had notes payable outstanding of $20 million at an interest rate of 3.75%; at December 31, 1992, notes payable were $50 million at 3.82%. LG&E had no notes payable at December 31, 1993. At December 31, 1992, trust demand notes of LG&E amounted to $8 million, on which the composite interest rate was 3.45%. At December 31, 1993, lines of credit were in place totaling $320 million ($145 million for LG&E, $150 million for Energy Systems, and $25 million for LG&E Energy Corp.), for which the companies pay commitment or facility fees. These lines of credit were unused, except for the $20 million of Energy Systems' line mentioned above. The credit lines are scheduled to expire at various periods during 1994 and 1996. Management intends to renegotiate these lines when they expire. NOTE 10 - COMMITMENTS AND CONTINGENCIES CONSTRUCTION PROGRAM. The Company had commitments, primarily in connection with the construction program of LG&E, aggregating approximately $6 million at December 31, 1993. LG&E's construction expenditures for the calendar years 1994 and 1995 are estimated to total approximately $200 million. PROJECT OBLIGATIONS. In connection with the financing of various power projects, Energy Systems and LPI provide equity funding commitments and guarantee the construction and performance of the projects. Ascertainable equity funding commitments were $36 million and $38 million at December 31, 1993 and 1992, respectively. Contingent construction and project performance guarantees totaled approximately $198 million and $94 million at December 31, 1993 and 1992, respectively. Through a support agreement with Energy Systems for the benefit of certain Energy Systems' lenders, LG&E Energy Corp. has agreed to provide Energy Systems with the necessary funds and financial support to meet the foregoing contingencies. Westmoreland Energy Inc. (WEI) is a partner along with LPI in six cogeneration projects in operation or under construction. Under an agreement signed on April 15, 1993, LPI and Energy Systems have guaranteed (in exchange for fees and other consideration) the equity funding commitment of WEI in connection with the following three projects: Roanoke Valley I, Roanoke Valley II, and Rensselaer. The additional commitments resulting from this agreement total $35.5 million. During December 1993, the Company signed an agreement with Nations Financial Capital Corporation (Nations Financial) under which Nations Financial agreed, in exchange for fees, to assume $26.9 million of the Company's contingent equity funding commitment for Roanoke Valley I and II resulting from its April 15, 1993, agreement with WEI. FERC ORDER NO. 636. Order No. 636, which was issued by FERC in 1992, required LG&E and all other local distribution companies to revise their practices for purchasing and transporting gas. Whereas LG&E had previously purchased natural gas and pipeline transportation services from Texas Gas Transmission Corporation (Texas Gas), LG&E now purchases only transportation services from Texas Gas and purchases natural gas from other sources. Under Order No. 636 pipelines may recover costs associated with the transition to and implementation of this order from pipeline customers, including LG&E. Based on pipeline filings to date, LG&E estimates that its share of transition costs, which must be approved by FERC, will be approximately $2 million to $3 million a year for both 1994 and 1995. The Commission issued an order, based on proceedings that were held to investigate the impact of Order No. 636 on utilities and ratepayers in Kentucky, providing that transition costs assessed on utilities by the pipelines, which are clearly identifiable as being related to the cost of the commodity itself, are appropriate to be recovered from customers through the gas supply clause. OPERATING LEASES. LG&E Energy Corp. has an operating lease for its corporate office space with an expiration date of 1996. LG&E has an operating lease for its corporate office building that is scheduled to expire in June 2005. LPI has operating lease commitments related to two office facilities with expiration dates ranging from two to eight years. Total lease expense for 1993, 1992, and 1991 was $4,526,000, $5,454,000, and $2,736,000, respectively. The future minimum annual lease payments under these lease agreements for years subsequent to December 31, 1993, are as follows (in thousands of $): ENVIRONMENTAL. The Clean Air Act Amendments of 1990 impose stringent limits on emissions of sulfur dioxide and nitrogen oxides by electric utility generating plants. The legislation is extremely complex and its effect will substantially depend on regulations issued by the U.S. Environmental Protection Agency (USEPA). LG&E is closely monitoring the continuing rule-making process in order to assess the precise impact of the legislation on the Company. All of LG&E's coal-fired boilers are equipped with sulfur dioxide "scrubbers" and already achieve the final sulfur dioxide emission rates required by the year 2000 under the legislation. However, as part of its ongoing capital construction program, LG&E anticipates incurring capital expenditures during the next four years of approximately $40 million for remedial measures necessary to meet the Act's requirements for nitrogen oxides. The overall financial impact of the legislation on LG&E is expected to be minimal. LG&E is well-positioned in the market to be a "clean" power provider without the large capital expenditures that are expected to be incurred by many other utilities. In 1992, LG&E entered two agreed orders with the Air Pollution Control District (APCD) of Jefferson County in which LG&E committed to undertake remedial measures to address certain particulate emissions and excess sulfur dioxide emissions from its Mill Creek generating plant. LG&E is currently conducting work in compliance with the agreed-upon schedule for remedial measures and has incurred total capital expenditures of approximately $24 million through 1993. Based on current remedial designs, LG&E anticipates incurring additional capital costs of approximately $14 million for this project in 1994 as part of its ongoing capital construction program. In an effort to resolve property damage claims relating to particulate emissions from the Mill Creek plant, in July 1993, LG&E commenced extensive negotiations and property damage settlements with adjacent residents. LG&E currently estimates that property damage claims for the particulate emissions should be settled for an aggregate amount of approximately $12 million. Accordingly the Company has recorded an accrual of this amount. In August 1993, 34 persons filed a complaint in Jefferson Circuit Court against LG&E in which they are seeking certification of a class consisting of all persons within 2.5 miles of the Mill Creek plant. The court has not acted on the request for certification of a class. The plaintiffs seek compensation for alleged personal injury and property damage attributable to emissions from the Mill Creek plant, injunctive relief, a fund to finance future medical monitoring of area residents, and other relief. LG&E intends to vigorously defend itself in the pending litigation. In response to a notification from the APCD that LG&E's Cane Run plant may be the source of a potential exceedance of the National Ambient Air Quality Standards for sulfur dioxide, LG&E retained a contractor to conduct certain air dispersion modeling. In 1992, LG&E submitted a draft action plan and modeling schedule to the APCD and USEPA. The APCD and USEPA have approved the submittals and LG&E's contractor is currently conducting additional modeling activities. Although it is expected that corrective action will be accomplished through capital improvements, until the contractor completes its modeling activities, LG&E cannot determine the precise impact of this matter. LG&E owns or formerly owned three primary sites where manufactured gas plant operations were located. Such manufactured gas plant operations, conducted in the 1838 to 1960 time period, typically produced coal tar byproducts and other constituents that may necessitate cleanup measures. LG&E commenced site investigations at the two company owned sites to determine if significant levels of contaminants are present. LG&E has commenced discussions with the current owner of the third site regarding joint performance of a site investigation. LG&E anticipates spending a total of approximately $1.3 million on site investigations expected to be completed by 1995. Preliminary testing at all three sites has identified contaminants typical of manufactured gas plant operations. Until an investigation and associated regulatory review is completed for each site, LG&E will be unable to predict what, if any, cleanup activities may be necessary. In November 1993, LG&E was served with a third-party complaint filed in federal district court in Illinois by three third-party plaintiffs. The third-party plaintiffs allege that LG&E and 31 other parties are liable for contributions under the Comprehensive Environmental Response, Compensation, and Liability Act as amended (CERCLA) for $1.4 million in costs allegedly incurred by USEPA in conducting cleanup activities at the M.T. Richards site in Crossville, Illinois. A number of de minimis third-party defendants, including LG&E, have commenced preliminary discussions with the third-party plaintiffs. In LG&E's opinion, the resolution of the issue will not have a material adverse impact on its financial position or results of operations. In February 1993, LG&E was served with an amended complaint filed in federal district court in West Virginia by three potentially responsible parties (PRP) against LG&E and 39 other parties. The plaintiffs alleged that the parties were liable under CERCLA for in excess of $3 million in costs allegedly incurred by the plaintiffs in conducting cleanup activities at the Spencer Transformer Site located in Roane County, West Virginia. In November 1993, the federal court approved a consent decree that resolved the case as to LG&E and nine other de minimis parties. Under the terms of the consent decree, LG&E reimbursed the plaintiffs for $10,000 in cleanup costs. No further involvement of LG&E is anticipated. In June 1992, USEPA identified LG&E as a PRP allegedly liable under CERCLA for $1.6 million in costs allegedly incurred by USEPA in cleanup of the Sonora Site and Carlie Middleton Burn Site located in Hardin County, Kentucky. In November 1992, USEPA demanded immediate payment from the PRPs. To date, USEPA has identified nine PRPs for the site. LG&E and several other parties have commenced discussions with USEPA. In LG&E's opinion, the resolution of this issue will not have a material adverse impact on its financial position or results of operations. In 1987, USEPA identified LG&E as one of the numerous PRPs allegedly liable under CERCLA for the Smith's Farm site in Bullitt County, Kentucky. In March 1990, USEPA issued an administrative order requiring LG&E and 35 other PRPs to conduct certain cleanup activities. In February 1992, four PRPs filed a complaint in federal district court in Kentucky against LG&E and 52 other PRPs. Under the law, each PRP could be held jointly and severally liable for the cost of site cleanup, but would have the right to seek contribution from other PRPs. In July 1993, upon motion of the plaintiffs, the federal court dismissed LG&E and a number of others from the litigation in order to facilitate settlement negotiations among the parties. Cleanup costs for the site are currently estimated at approximately $70 million. LG&E and several other parties have shared certain cleanup costs in the interim until a voluntary allocation of liability can be reached among the parties. It is not possible at this time to predict the outcome or precise impact of this matter. However, management believes that this matter should not have a material adverse impact on the financial position or results of operations of LG&E as other financially viable PRPs appear to have primary liability for the site. Based upon prior precedents established by the Commission and the Environmental Cost Recovery legislation, LG&E expects to have an opportunity to recover, through future ratemaking proceedings, its costs associated with remedial measures required to comply with environmental laws and regulations. Like LG&E, LPI and its subsidiaries are subject to extensive federal, state, and local environmental laws and regulations governing the operation of the various power plants in which they participate as an owner or managing operator. Among other things, these laws and regulations govern the discharge of materials into waterways, the air and the ground and, if violated, may require the owner or operator to take remedial action to maintain the affected facility's operating status. To the extent any such remedial environmental actions have been required of LPI or its subsidiaries in the past, related expenditures have not been material. NOTE 11 - TRIMBLE COUNTY GENERATING PLANT. Trimble County Unit 1, a 495-megawatt, coal-fired electric generating unit, was placed in commercial operation on December 23, 1990. This Unit, which during its first three years of commercial operations has operated more reliably than projected, has been the subject of numerous regulatory and legal proceedings. The current regulatory process involving Trimble County is related to an order issued by the Commission on July 1, 1988, which stated that 25% of the total cost of the Unit would not be allowed for ratemaking purposes. In a rehearing order issued in April 1989, the Commission reaffirmed its decision that LG&E would not be allowed to include 25% of the cost of the Unit in customer rates; however, this order stated that "the disallowed portion of Trimble County remains with the Company and stockholders for their use." In 1989, the Commission initiated a proceeding to determine the appropriate ratemaking treatment to carry out the order that disallowed rate recovery for 25% of the Unit. Prior to the start of the hearings in this proceeding, LG&E filed a motion requesting the Commission to adopt a proposed plan to settle all of the issues surrounding Trimble County. Settlement discussions ensued between LG&E, intervenors, and the Commission staff. On October 2, 1989, the Commission approved the settlement agreement reached between LG&E and the Commission staff and, in accordance with the terms of the agreement, LG&E refunded $2.5 million to its customers in 1989 and reduced its electric rates by $8.5 million for the year beginning January 1, 1990. Certain intervenors, who participated in the proceedings but did not agree to the settlement, appealed the Commission's order approving the settlement to Franklin Circuit Court, claiming, among other things, that the Commission lacked the statutory authority to approve the agreement and that the intervenors who refused to sign the agreement were deprived of due process rights. In February 1991, the Franklin Circuit Court vacated the October 2, 1989 order of the Commission approving the settlement agreement. On September 27, 1991, the Court issued an opinion requiring a refund to ratepayers in excess of $100 million as a result of the Commission's order that disallowed 25% of the total cost of Trimble County from customer rates. The Court further ordered LG&E to post a bond if it appealed the Circuit Court's decision. LG&E posted a bond of $107 million and appealed all orders of the Circuit Court to the Kentucky Court of Appeals. On April 23, 1993, the Kentucky Court of Appeals overturned the Franklin Circuit Court ruling previously entered in the case. Although the decision upheld the Circuit Court's order vacating the 1989 settlement agreement approved by the Commission, the appeals court ruled that the Franklin Circuit Court order of September 27, 1991, improperly set utility rates in ordering refunds. The intervenor parties requested the Kentucky Supreme Court to review the case, and their request for review was denied on October 20, 1993. Under Kentucky procedural rules, this ruling makes final the Court of Appeals decision and returns the case to the Commission for further proceedings. The Commission has issued orders which set a portion of the procedural schedule for the case. Pursuant to the Commission's orders, LG&E filed direct testimony on January 7, 1994. Intervenor parties are scheduled to file testimony on March 28, 1994. No date has been set for a hearing. LG&E anticipates that the focus of Commission proceedings will be the determination of the appropriate ratemaking treatment to insulate ratepayers from 25% of Trimble County's costs and the amount of additional refunds, if any, that LG&E should return to ratepayers. In previous proceedings in 1988, the Commission had authorized rate increases, subject to refund, of $11.4 million on an annual basis, pending a determination of the appropriate ratemaking treatment for the disallowance. The order remained in effect from May 1988 through December 1990, resulting in an amount subject to refund of approximately $30 million. LG&E, through refunds and rate reductions, has already returned to its customers approximately $11 million of the total amount subject to refund. LG&E's position is that no additional refunds are needed to carry out the Commission's objective of reflecting the disallowance of 25% of Trimble County in customer rates and LG&E may be entitled to recover a portion, or all, of the amounts previously returned to customers. However, LG&E is unable to predict the outcome of the Commission proceedings, the amount of additional refunds or recoveries, if any, that may be ordered or whether the Commission will revise its earlier position. SALE OF PORTION OF TRIMBLE COUNTY. On February 28, 1991, LG&E sold a 12.12% ownership interest in the Trimble County Unit to the Illinois Municipal Electric Agency, based in Springfield, Illinois, which is an agency of 30 municipalities that own and operate their own electric systems. The sale price was $94.2 million and a book gain of $4.2 million, after-tax, was recognized in 1991 as a result of this sale. On February 1, 1993, the Indiana Municipal Power Agency (IMPA), based in Carmel, Indiana, purchased a 12.88% interest in the Trimble County plant. IMPA is composed of 31 municipalities that have joined together to meet their long-term electric power needs. The sale price was $91.1 million and an after-tax book gain of $3.2 million was recorded in 1993 as a result of this sale. LG&E has now completed the sale of the entire 25% of Trimble County that the Commission disallowed from customer rates. NOTE 12 - JOINTLY OWNED ELECTRIC UTILITY PLANT As of December 31, 1993, LG&E owned a 75% undivided interest in Trimble County Unit 1. Accounting for the 75% portion of the Unit, which the Commission has allowed to be reflected in customer rates, is similar to LG&E's accounting for other wholly owned utility plants. Of the remaining 25% of the Unit: * Illinois Municipal Electric Agency (IMEA) purchased a 12.12% undivided interest in the Unit on February 28, 1991. IMEA pays for 12.12% of the operation and maintenance expenses, their proportionate share of incremental assets acquired and for fuel used. * Indiana Municipal Power Agency (IMPA) purchased a 12.88% undivided interest in the Unit on February 1, 1993. IMPA is responsible for 12.88% of the operation and maintenance expenses, their proportionate share of incremental assets acquired and for fuel used. The following data represent shares of the jointly owned property: NOTE 13 - SEGMENTS OF BUSINESS LG&E Energy Corp. has business operations in both the regulated and non-regulated energy markets. The regulated business is conducted through LG&E, a public utility engaged in the generation, transmission, distribution, and sale of electricity and the transmission, distribution and sale of natural gas. The non-regulated energy business is conducted through Energy Systems, which manages the Company's non-utility operations. Energy Systems directly owns LPI. LPI and its subsidiaries develop, design, build, own, operate, and maintain power generation facilities that sell energy to local industries and utilities. In January 1994, Energy Systems sold its 36.5% partnership interest in NGC. See Note 3 of Notes to Financial Statements for further discussion. REPORT OF MANAGEMENT The management of LG&E Energy Corp. and subsidiaries is responsible for the preparation and integrity of the consolidated financial statements and related information included in this Annual Report. These statements have been prepared in accordance with generally accepted accounting principles applied on a consistent basis and, necessarily, include amounts that reflect the best estimates and judgment of management. The Company's financial statements have been audited by Arthur Andersen & Co., independent public accountants whose report follows the Notes to Financial Statements. Management has made available to Arthur Andersen & Co. all the Company's financial records and related data as well as the minutes of shareholders' and directors' meetings. Management has established and maintains a system of internal controls that provides reasonable assurance that transactions are completed in accordance with management's authorization, that assets are safeguarded and that financial statements are prepared in conformity with generally accepted accounting principles. Management believes that an adequate system of internal controls is maintained through the selection and training of personnel, appropriate division of responsibility, establishment and communication of policies and procedures and by regular reviews of internal accounting controls by the Company's internal auditors. Management reviews and modifies its system of internal control in light of changes in conditions and operations, as well as in response to recommendations from the internal auditors and the independent public accountants. These recommendations for the year ended December 31, 1993 did not identify any significant deficiencies in the design and operation of the Company's internal control structure. The Audit Committee of the Board of Directors is composed entirely of outside directors. In carrying out its oversight role for the financial reporting and internal controls of the Company, the Audit Committee meets regularly with the Company's independent public accountants, internal auditors and management. The Audit Committee reviews the results of the independent accountants' audit of the consolidated financial statements and their audit procedures, and discusses the adequacy of internal accounting controls. The Audit Committee also approves the annual internal auditing program, and reviews the activities and results of the internal auditing function. Both the independent public accountants and the internal auditors have access to the Audit Committee at any time. LG&E Energy Corp. and subsidiaries maintain and internally communicate a written code of business conduct that addresses, among other items, potential conflicts of interest, compliance with laws, including those relating to financial disclosure, and the confidentiality of proprietary information. REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS TO LG&E ENERGY CORP.: We have audited the accompanying consolidated balance sheets and statements of capitalization of LG&E Energy Corp. (a Kentucky corporation) and subsidiaries as of December 31, 1993 and 1992, and the related consolidated statements of income, retained earnings and cash flows for each of the three years in the period ended December 31, 1993. These financial statements and the schedules referred to below are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements and schedules based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of LG&E Energy Corp. and subsidiaries as of December 31, 1993 and 1992, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 1993, in conformity with generally accepted accounting principles. As further discussed in Note 11, the potential amount of future rate refunds that may be required, if any, once the outcome of the legal and regulatory process is known, is uncertain at this time. As discussed in Notes 1 and 5 to the consolidated financial statements, effective January 1, 1993, the Company changed its methods of accounting for income taxes and post-retirement benefits other than pensions. Our audits were made for the purpose of forming an opinion on the basic financial statements taken as a whole. The schedules listed under Item 14(a)2 are presented for purposes of complying with the Securities and Exchange Commission's rules and are not part of the basic financial statements. These schedules have been subjected to the auditing procedures applied in our audits of the basic financial statements and, in our opinion, fairly state in all material respects the financial data required to be set forth therein in relation to the basic financial statements taken as a whole. Louisville, Kentucky, Arthur Andersen & Co. January 28, 1994 ---------------------------------- SELECTED QUARTERLY FINANCIAL DATA (Unaudited) Selected financial data for the four quarters of 1993 and 1992 are shown below. Because of seasonal fluctuations in temperature and other factors, results for quarters may fluctuate throughout the year. ITEM 9.

ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE. None. PART III ITEMS 10, 11, 12 AND 13 are omitted pursuant to General Instruction G, inasmuch as the Company filed copies of a definitive proxy statement with the Commission on March 28, 1994, pursuant to Regulation 14A under the Securities Exchange Act of 1934. Such proxy statement is incorporated herein by this reference. In accordance with General Instruction G of Form 10-K, the information required by Item 10

ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K. (a) 1. Financial Statements (included in Item 8): Statements of Income for the three years ended December 31, 1993 (page 30). Statements of Retained Earnings for the three years ended December 31, 1993 (page 30). Balance Sheets - December 31, 1993, and 1992 (page 31). Statements of Cash Flows for the three years ended December 31, 1993 (page 32). Statements of Capitalization - December 31, 1993, and 1992 (page 33). Notes to Financial Statements (pages 34-52). Report of Management (page 53). Report of Independent Public Accountants (page 54). Selected Quarterly Financial Data for 1993, and 1992 (page 55). 2. Financial Statement Schedules (included in Part IV): Schedule V - Property, Plant and Equipment for the three years ended December 31, 1993 (pages 71-73). Schedule VI - Accumulated Depreciation, Depletion, and Amortization of Property, Plant and Equipment for the three years ended December 31, 1993 (pages 74-76). Schedule VIII - Valuation and Qualifying Accounts for the three years ended December 31, 1993 (page 77). Schedule IX - Short-Term Borrowings for the three years ended December 31, 1993 (page 78). Schedule X - Supplementary Income Statement Information for the three years ended December 31, 1993 (page 79). All other schedules have been omitted as not applicable or not required or because the information required to be shown is included in the Financial Statements or the accompanying Notes to Financial Statements. 3. Exhibits: Exhibit No. Description -------- ----------- 3.01 Copy of Articles of Incorporation. [Filed as Exhibit 4.01 to Registration Statement 33-33687 and incorporated by reference herein] 3.02 Amendment to Articles of Incorporation dated December 5, 1990. [Filed as Exhibit 3.02 to the Company's Annual Report on Form 10- K for the year ended December 31, 1990, and incorporated by reference herein] 3.03 Copy of Bylaws as amended through December 4, 1991. [Filed as Exhibit 3.03 to the Company's Annual Report on Form 10-K for the year ended December 31, 1991, and incorporated by reference herein] 4.01 Copy of Trust Indenture dated November 1, 1949, from LG&E to Harris Trust and Savings Bank, Trustee. [Filed as Exhibit 7.01 to LG&E's Registration Statement 2-8283 and incorporated by reference herein] 4.02 Copy of Supplemental Indenture dated February 1, 1952, which is a supplemental instrument to Exhibit 4.01 hereto. [Filed as Exhibit 4.05 to LG&E's Registration Statement 2-9371 and incorporated by reference herein] 4.03 Copy of Supplemental Indenture dated February 1, 1954, which is a supplemental instrument to Exhibit 4.01 hereto. [Filed as Exhibit 4.03 to LG&E's Registration Statement 2-11923 and incorporated by reference herein] 4.04 Copy of Supplemental Indenture dated September 1, 1957, which is a supplemental instrument to Exhibit 4.01 hereto. [Filed as Exhibit 2.04 to LG&E's Registration Statement 2-17047 and incorporated by reference herein] 4.05 Copy of Supplemental Indenture dated October 1, 1960, which is a supplemental instrument to Exhibit 4.01 hereto. [Filed as Exhibit 2.05 to LG&E's Registration Statement 2-24920 and incorporated by reference herein] 4.06 Copy of Supplemental Indenture dated June 1, 1966, which is a supplemental instrument to Exhibit 4.01 hereto. [Filed as Exhibit 2.06 to LG&E's Registration Statement 2-28865 and incorporated by reference herein] 4.07 Copy of Supplemental Indenture dated June 1, 1968, which is a supplemental instrument to Exhibit 4.01 hereto. [Filed as Exhibit 2.07 to LG&E's Registration Statement 2-37368 and incorporated by reference herein] 4.08 Copy of Supplemental Indenture dated June 1, 1970, which is a supplemental instrument to Exhibit 4.01 hereto. [Filed as Exhibit 2.08 to LG&E's Registration Statement 2-37368 and incorporated by reference herein] 4.09 Copy of Supplemental Indenture dated August 1, 1971, which is a supplemental instrument to Exhibit 4.01 hereto. [Filed as Exhibit 2.09 to LG&E's Registration Statement 2-44295 and incorporated by reference herein] 4.10 Copy of Supplemental Indenture dated June 1, 1972, which is a supplemental instrument to Exhibit 4.01 hereto. [Filed as Exhibit 2.10 to LG&E's Registration Statement 2-52643 and incorporated by reference herein] 4.11 Copy of Supplemental Indenture dated February 1, 1975, which is a supplemental instrument to Exhibit 4.01 hereto. [Filed as Exhibit 2.11 to LG&E's Registration Statement 2-57252 and incorporated by reference herein] 4.12 Copy of Supplemental Indenture dated September 1, 1975, which is a supplemental instrument to Exhibit 4.01 hereto. [Filed as Exhibit 2.12 to LG&E's Registration Statement 2-57252 and incorporated by reference herein] 4.13 Copy of Supplemental Indenture dated September 1, 1976, which is a supplemental instrument to Exhibit 4.01 hereto. [Filed as Exhibit 2.13 to LG&E's Registration Statement 2-57252 and incorporated by reference herein] 4.14 Copy of Supplemental Indenture dated October 1, 1976, which is a supplemental instrument to Exhibit 4.01 hereto. [Filed as Exhibit 2.14 to LG&E's Registration Statement 2-65271 and incorporated by reference herein] 4.15 Copy of Supplemental Indenture dated June 1, 1978, which is a supplemental instrument to Exhibit 4.01 hereto. [Filed as Exhibit 2.15 to LG&E's Registration Statement 2-65271 and incorporated by reference herein] 4.16 Copy of Supplemental Indenture dated February 15, 1979, which is a supplemental instrument to Exhibit 4.01 hereto. [Filed as Exhibit 2.16 to LG&E's Registration Statement 2-65271 and incorporated by reference herein] 4.17 Copy of Supplemental Indenture dated September 1, 1979, which is a supplemental instrument to Exhibit 4.01 hereto. [Filed as Exhibit 4.17 to LG&E's Annual Report on Form 10-K for the year ended December 31, 1980, and incorporated by reference herein] 4.18 Copy of Supplemental Indenture dated September 15, 1979, which is a supplemental instrument to Exhibit 4.01 hereto. [Filed as Exhibit 4.18 to LG&E's Annual Report on Form 10-K for the year ended December 31, 1980, and incorporated by reference herein] 4.19 Copy of Supplemental Indenture dated September 15, 1981, which is a supplemental instrument to Exhibit 4.01 hereto. [Filed as Exhibit 4.19 to LG&E's Annual Report on Form 10-K for the year ended December 31, 1981, and incorporated by reference herein] 4.20 Copy of Supplemental Indenture dated March 1, 1982, which is a supplemental instrument to Exhibit 4.01 hereto. [Filed as Exhibit 4.20 to LG&E's Annual Report on Form 10-K for the year ended December 31, 1982, and incorporated by reference herein] 4.21 Copy of Supplemental Indenture dated March 15, 1982, which is a supplemental instrument to Exhibit 4.01 hereto. [Filed as Exhibit 4.21 to LG&E's Annual Report on Form 10-K for the year ended December 31, 1982, and incorporated by reference herein] 4.22 Copy of Supplemental Indenture dated September 15, 1982, which is a supplemental instrument to Exhibit 4.01 hereto. [Filed as Exhibit 4.22 to LG&E's Annual Report on Form 10-K for the year ended December 31, 1982, and incorporated by reference herein] 4.23 Copy of Supplemental Indenture dated February 15, 1984, which is a supplemental instrument to Exhibit 4.01 hereto. [Filed as Exhibit 4.23 to LG&E's Annual Report on Form 10-K for the year ended December 31, 1984, and incorporated by reference herein] 4.24 Copy of Supplemental Indenture dated July 1, 1985, which is a supplemental instrument to Exhibit 4.01 hereto. [Filed as Exhibit 4.24 to LG&E's Annual Report on Form 10-K for the year ended December 31, 1985, and incorporated by reference herein] 4.25 Copy of Supplemental Indenture dated November 15, 1986, which is a supplemental instrument to Exhibit 4.01 hereto. [Filed as Exhibit 4.25 to LG&E's Annual Report on Form 10-K for the year ended December 31, 1986, and incorporated by reference herein] 4.26 Copy of Supplemental Indenture dated November 16, 1986, which is a supplemental instrument to Exhibit 4.01 hereto. [Filed as Exhibit 4.26 to LG&E's Annual Report on Form 10-K for the year ended December 31, 1986, and incorporated by reference herein] 4.27 Copy of Supplemental Indenture dated August 1, 1987, which is a supplemental instrument to Exhibit 4.01 hereto. [Filed as Exhibit 4.27 to LG&E's Annual Report on Form 10-K for the year ended December 31, 1987, and incorporated by reference herein] 4.28 Copy of Supplemental Indenture dated February 1, 1989, which is a supplemental instrument to Exhibit 4.01 hereto. [Filed as Exhibit 4.28 to LG&E's Annual Report on Form 10-K for the year ended December 31, 1988, and incorporated by reference herein] 4.29 Copy of Supplemental Indenture dated February 2, 1989, which is a supplemental instrument to Exhibit 4.01 hereto. [Filed as Exhibit 4.29 to LG&E's Annual Report on Form 10-K for the year ended December 31, 1988, and incorporated by reference herein] 4.30 Copy of Supplemental Indenture dated June 15, 1990, which is a supplemental instrument to Exhibit 4.01 hereto. [Filed as Exhibit 4.30 to LG&E's Annual Report on Form 10-K for the year ended December 31, 1990, and incorporated by reference herein] 4.31 Copy of Supplemental Indenture dated November 1, 1990, which is a supplemental instrument to Exhibit 4.01 hereto. [Filed as Exhibit 4.31 to LG&E's Annual Report on Form 10-K for the year ended December 31, 1990, and incorporated by reference herein] 4.32 Copy of Supplemental Indenture dated September 1, 1992, which is a supplemental instrument to Exhibit 4.01 hereto. [Filed as Exhibit 4.32 to LG&E's Annual Report on Form 10-K for the year ended December 31, 1992, and incorporated by reference herein] 4.33 Copy of Supplemental Indenture dated September 2, 1992, which is a supplemental instrument to Exhibit 4.01 hereto. [Filed as Exhibit 4.33 to LG&E's Annual Report on Form 10-K for the year ended December 31, 1992, and incorporated by reference herein] 4.34 Copy of Supplemental Indenture dated August 15, 1993, which is a supplemental instrument to Exhibit 4.01 hereto. [Filed as Exhibit 4.34 to LG&E's Annual Report on Form 10-K for the year ended December 31, 1993, and incorporated by reference herein] 4.35 Copy of Supplemental Indenture dated August 16, 1993, which is a supplemental instrument to Exhibit 4.01 hereto. [Filed as Exhibit 4.35 to LG&E's Annual Report on Form 10-K for the year ended December 31, 1993, and incorporated by reference herein] 4.36 Copy of Supplemental Indenture dated October 15, 1993, which is a supplemental instrument to Exhibit 4.01 hereto. [Filed as Exhibit 4.36 to LG&E's Annual Report on Form 10-K for the year ended December 31, 1993, and incorporated by reference herein] 10.01 Copy of Agreement dated September 1, 1970, between Texas Gas Transmission Corporation and LG&E covering the purchase of natural gas. [Filed as Exhibit 4.01 to LG&E's Registration Statement 2-40985 and incorporated by reference herein] 10.02 Copies of Agreement between Sponsoring Companies re: Project D of Atomic Energy Commission, dated May 12, 1952, Memorandums of Understanding between Sponsoring Companies re: Project D of Atomic Energy Commission, dated September 19, 1952 and October 28, 1952, and Power Agreement between Ohio Valley Electric Corporation and Atomic Energy Commission, dated October 15, 1952. [Filed as Exhibit 13(y) to LG&E's Registration Statement 2-9975 and incorporated by reference herein] 10.03 Copy of Modification No. 1 dated July 23, 1953, to the Power Agreement between Ohio Valley Electric Corporation and Atomic Energy Commission. [Filed as Exhibit 4.03(b) to LG&E's Registration Statement 2-24920 and incorporated by reference herein] 10.04 Copy of Modification No. 2 dated March 15, 1964, to the Power Agreement between Ohio Valley Electric Corporation and Atomic Energy Commission. [Filed as Exhibit 5.02c to LG&E's Registration Statement 2-61607 and incorporated by reference herein] 10.05 Copy of Modification No. 3 and No. 4 dated May 12, 1966 and January 7, 1967, respectively, to the Power Agreement between Ohio Valley Electric Corporation and Atomic Energy Commission. [Filed as Exhibits 4(a)(13) and 4(a)(14) to LG&E's Registration Statement 2-26063 and incorporated by reference herein] 10.06 Copy of Modification No. 5 dated August 15, 1967, to the Power Agreement between Ohio Valley Electric Corporation and Atomic Energy Commission. [Filed as Exhibit 13(c) to LG&E's Registration Statement 2-27316 and incorporated by reference herein] 10.07 Copies of (i) Inter-Company Power Agreement, dated July 10, 1953, between Ohio Valley Electric Corporation and Sponsoring Companies (which Agreement includes as Exhibit A the Power Agreement, dated July 10, 1953, between Ohio Valley Electric Corporation and Indiana-Kentucky Electric Corporation); (ii) First Supplementary Transmission Agreement, dated July 10, 1953, between Ohio Valley Electric Corporation and Sponsoring Companies; (iii) Inter-Company Bond Agreement, dated July 10, 1953, between Ohio Valley Electric Corporation and Sponsoring Companies; (iv) Inter-Company Bank Credit Agreement, dated July 10, 1953, between Ohio Valley Electric Corporation and Sponsoring Companies. [Filed as Exhibit 5.02f to LG&E's Registration Statement 2-61607 and incorporated by reference herein] 10.08 Copy of Modification No. 1 and No. 2 dated June 3, 1966 and January 7, 1967, respectively, to Inter-Company Power Agreement dated July 10, 1953. [Filed as Exhibits 4(a)(8) and 4(a)(10) to LG&E's Registration Statement 2-26063 and incorporated by reference herein] 10.09 Copies of Amendments to Agreements (iii) and (iv) referred to under 10.07 above as follows: (i) Amendment to Inter-Company Bond Agreement and (ii) Amendment to Inter-Company Bank Credit Agreement. [Filed as Exhibit 5.02h to LG&E's Registration Statement 2-61607 and incorporated by reference herein] 10.10 Copy of Modification No. 1, dated August 20, 1958, to First Supplementary Transmission Agreement, dated July 10, 1953, among Ohio Valley Electric Corporation and the Sponsoring Companies. [Filed as Exhibit 5.02i to LG&E's Registration Statement 2-61607 and incorporated by reference herein] 10.11 Copy of Modification No. 2, dated April 1, 1965, to the First Supplementary Transmission Agreement, dated July 10, 1953, among Ohio Valley Electric Corporation and the Sponsoring Companies. [Filed as Exhibit 5.02j to LG&E's Registration Statement 2-6l607 and incorporated by reference herein] 10.12 Copy of Modification No. 3, dated January 20, 1967, to First Supplementary Transmission Agreement, dated July 10, 1953, among Ohio Valley Electric Corporation and the Sponsoring Companies. [Filed as Exhibit 4(a)(7) to LG&E's Registration Statement 2-26063 and incorporated by reference herein] 10.13 Copy of Modification No. 6 dated November 15, 1967, to the Power Agreement between Ohio Valley Electric Corporation and Atomic Energy Commission. [Filed as Exhibit 4(g) to LG&E's Registration Statement 2-28524 and incorporated by reference herein] 10.14 Copy of Modification No. 3 dated November 15, 1967, to the Inter-Company Power Agreement dated July 10, 1953. [Filed as Exhibit 4.02m to LG&E's Registration Statement 2-37368 and incorporated by reference herein] 10.15 Copy of Modification No. 7 dated November 5, 1975, to the Power Agreement between Ohio Valley Electric Corporation and Atomic Energy Commission. [Filed as Exhibit 5.02n to LG&E's Registration Statement 2-56357 and incorporated by reference herein] 10.16 Copy of Modification No. 4 dated November 5, 1975, to the Inter-Company Power Agreement dated July 10, 1953. [Filed as Exhibit 5.02o to LG&E's Registration Statement 2-56357 and incorporated by reference herein] 10.17 Copy of Modification No. 4 dated April 30, 1976, to First Supplementary Transmission Agreement, dated July 10, 1953, among Ohio Valley Electric Corporation and the Sponsoring Companies. [Filed as Exhibit 5.02p to LG&E's Registration Statement 2-6l607 and incorporated by reference herein] 10.18 Copy of Modification No. 8 dated June 23, 1977, to the Power Agreement between Ohio Valley Electric Corporation and Atomic Energy Commission. [Filed as Exhibit 5.02q to LG&E's Registration Statement 2-61607 and incorporated by reference herein] 10.19 Copy of Modification No. 9 dated July 1, 1978, to the Power Agreement between Ohio Valley Electric Corporation and Atomic Energy Commission. [Filed as Exhibit 5.02r to LG&E's Registration Statement 2-63149 and incorporated by reference herein] 10.20 Copy of Modification No. 10 dated August 1, 1979, to the Power Agreement between Ohio Valley Electric Corporation and Atomic Energy Commission. [Filed as Exhibit 2 to LG&E's Annual Report on Form 10-K for the year ended December 31, 1979, and incorporated by reference herein] 10.21 Copy of Modification No. 11 dated September 1, 1979, to the Power Agreement between Ohio Valley Electric Corporation and Atomic Energy Commission. [Filed as Exhibit 3 to LG&E's Annual Report on Form 10-K for the year ended December 31, 1979, and incorporated by reference herein] 10.22 Copy of Modification No. 5 dated September 1, 1979, to Inter-Company Power Agreement dated July 5, 1953, among Ohio Valley Electric Corporation and Sponsoring Companies. [Filed as Exhibit 4 to LG&E's Annual Report on Form 10-K for the year ended December 31, 1979, and incorporated by reference herein] 10.23 Copy of Agreement dated December 16, 1966, between Peabody Coal Company and LG&E covering the purchase of coal. [Filed as Exhibit 10.23 to LG&E's Annual Report on Form 10-K for the year ended December 31, 1980, and incorporated by reference herein] 10.24 Copy of Amendments to Coal Supply Agreement referred to in 10.23 above as follows: (i) Amendment effective July 1, 1970, (ii) effective January 1, 1975, and (iii) effective December 1, 1976. [Filed as Exhibit 10.24 to LG&E's Annual Report on Form 10-K for the year ended December 31, 1980, and incorporated by reference herein] 10.25 Copy of Modification No. 12 dated August 1, 1981, to the Power Agreement between Ohio Valley Electric Corporation and Atomic Energy Commission. [Filed as Exhibit 10.25 to LG&E's Annual Report on Form 10-K for the year ended December 31, 1981, and incorporated by reference herein] 10.26 Copy of Modification No. 6 dated August 1, 1981, to Inter-Company Power Agreement dated July 5, 1953, among Ohio Valley Electric Corporation and Sponsoring Companies. [Filed as Exhibit 10.26 to LG&E's Annual Report on Form 10-K for the year ended December 31, 1981, and incorporated by reference herein] 10.27 Copy of Agreement dated December 20, 1985, between Shawnee Coal Company and LG&E covering the purchase of coal. [Filed as Exhibit 10.27 to LG&E's Annual Report on Form 10-K for the year ended December 31, 1985, and incorporated by reference herein] 10.28 Copy of Diversity Power Agreement dated September 9, 1987, between East Kentucky Power Cooperative and LG&E covering the purchase and sale of power between the two companies from 1988 through 1995. [Filed as Exhibit 10.28 to LG&E's Annual Report on Form 10-K for the year ended December 31, 1987, and incorporated by reference herein] 10.29 Copy of Supplemental Executive Retirement Plan as amended through January 3, 1990, covering all officers of LG&E. [Filed as Exhibit 10.29 to LG&E's Annual Report on Form 10-K for the year ended December 31, 1989, and incorporated by reference herein] 10.30 Copy of Termination Agreement and Release dated February 1, 1989, between Peabody Coal Company and LG&E canceling the Coal Supply Agreement dated December 16, 1966 referred to in Exhibit Nos. 10.23 and 10.24. [Filed as Exhibit 10.30 to LG&E's Annual Report on Form 10-K for the year ended December 31, 1988, and incorporated by reference herein] 10.31 Copy of Agreements dated February 1 and February 15, 1989, between Peabody Development Company and LG&E covering the purchase of coal. [Filed as Exhibit 10.31 to LG&E's Annual Report on Form 10-K for the year ended December 31, 1988, and incorporated by reference herein] 10.32 Copy of Omnibus Long-Term Incentive Plan effective January 1, 1990, covering officers and key employees of LG&E. [Filed as Exhibit 4.01 to LG&E's Registration Statement 33-38557 and incorporated by reference herein] 10.33 Copy of Key Employee Incentive Plan effective January 1, 1990, covering officers and key employees of LG&E. [Filed as Exhibit 10.33 to LG&E's Annual Report on Form 10-K for the year ended December 31, 1989, and incorporated by reference herein] 10.34 Copy of LG&E Energy Corp. Deferred Stock Compensation Plan effective January 1, 1992, covering non-employee directors of the Company and its subsidiaries. [Filed as Exhibit 10.34 to the Company's Annual Report on Form 10-K for the year ended December 31, 1991, and incorporated by reference herein] 10.35 Copy of Agreement dated August 1, 1991, between Texas Gas Transmission Corporation and LG&E covering the purchase of natural gas. [Filed as Exhibit 10.35 to LG&E's Annual Report on Form 10-K for the year ended December 31, 1991, and incorporated by reference herein] 10.36 Copy of Credit Agreement dated as of March 11, 1992, among LG&E Energy Systems Inc. as Borrower, the Banks named therein, and Citibank, N.A. as Agent. [Filed as Exhibit 10.36 to the Company's Annual Report on Form 10-K for the year ended December 31, 1992, and incorporated by reference herein] 10.37 Copy of Support Agreement dated as of December 9, 1991, between LG&E Energy Corp. and LG&E Energy Systems Inc. [Filed as Exhibit 10.37 to the Company's Annual Report on Form 10-K for the year ended December 31, 1992, and incorporated by reference herein] 10.38 Copy of Sales Service Agreement between Texas Gas Transmission Corporation and Louisville Gas and Electric Company effective February 1, 1992. [Filed as Exhibit 10.36 to LG&E's Annual Report on Form 10-K for the year ended December 31, 1992, and incorporated by reference herein] 10.39 Copy of Sales Service Agreement between Texas Gas Transmission Corporation and Louisville Gas and Electric Company effective November 1, 1992. [Filed as Exhibit 10.37 to LG&E's Annual Report on Form 10-K for the year ended December 31, 1992, and incorporated by reference herein] 10.40 Copy of form of change in control agreement for officers of LG&E Energy Corp. [Filed as Exhibit 10.40 to the Company's Annual Report on Form 10-K for the year ended December 31, 1992, and incorporated by reference herein] 10.41 Copy of Employment Agreement between Roger W. Hale and Louisville Gas and Electric Company, effective June 1, 1989, as amended. [Filed as Exhibit 10.41 to the Company's Annual Report on Form 10-K for the year ended December 31, 1992, and incorporated by reference herein] 10.42 Copy of Supplemental Executive Retirement Plan for R. W. Hale, effective June 1, 1989. [Filed as Exhibit 10.42 to the Company's Annual Report on Form 10-K for the year ended December 31, 1992, and incorporated by reference herein] 10.43 Copy of Nonqualified Savings Plan covering officers of the Company, effective January 1, 1992. [Filed as Exhibit 10.43 to the Company's Annual Report on Form 10-K for the year ended December 31, 1992, and incorporated by reference herein] 10.44 Copy of Modification No. 13 dated September 1, 1989, to the Power Agreement between Ohio Valley Electric Corporation and Atomic Energy Commission. [Filed as Exhibit 10.42 to LG&E's Annual Report on Form 10-K for the year ended December 31, 1993, and incorporated by reference herein] 10.45 Copy of Modification No. 7 dated January 15, 1992, to Inter- Company Power Agreement dated July 10, 1953, among Ohio Valley Electric Corporation and Sponsoring Companies. [Filed as Exhibit 10.44 to LG&E's Annual Report on Form 10-K for the year ended December 31, 1993, and incorporated by reference herein] 10.46 Copy of Modification No. 14 dated January 15, 1992, to the Power Agreement between Ohio Valley Electric Corporation and Atomic Energy Commission. [Filed as Exhibit 10.43 to LG&E's Annual Report on Form 10-K for the year ended December 31, 1993, and incorporated by reference herein] 10.47 Copy of Modification No. 15 dated February 15, 1993, to the Power Agreement between Ohio Valley Electric Corporation and Atomic Energy Commission. [Filed as Exhibit 10.45 to LG&E's Annual Report on Form 10-K for the year ended December 31, 1993, and incorporated by reference herein] 10.48 Firm Transportation Agreement, dated November 1, 1993, between Texas Gas Transmission Corporation and LG&E covering the transmission of natural gas. [Filed as Exhibit 10.46 to LG&E's Annual Report on Form 10-K for the year ended December 31, 1993, and incorporated by reference herein] 10.49 Firm No Notice Transportation Agreement effective November 1, 1993, between Texas Gas Transmission Corporation and LG&E (8-year term) covering the transmission of natural gas. Firm No Notice Transportation Agreement effective November 1, 1993, between Texas Gas Transmission Corporation and LG&E (2-year term) covering the transmission of natural gas. Firm No Notice Transportation Agreement effective November 1, 1993, between Texas Gas Transmission Corporation and LG&E (5-year term) covering the transmission of natural gas. [Filed as Exhibit 10.47 to LG&E's Annual Report on Form 10-K for the year ended December 31, 1993, and incorporated by reference herein] 10.50 Employment Contract between the Company and Roger W. Hale effective November 3, 1993. 10.51 Copy of LG&E Energy Corp. Stock Option Plan for Non-Employee Directors. 21 Subsidiaries of the Registrant 23 Consent of Independent Public Accountants 24 Power of Attorney (b) Executive Compensation Plans and Arrangements: Supplemental Executive Retirement Plan as amended through January 3, 1990, covering all officers of LG&E. [Filed as Exhibit 10.29 to LG&E's Annual Report on Form 10-K for the year ended December 31, 1989, and incorporated by reference herein] Omnibus Long-Term Incentive Plan effective January 1, 1990, covering officers and key employees of LG&E. [Filed as Exhibit 4.01 to LG&E's Registration Statement 33-38557 and incorporated by reference herein] Key Employee Incentive Plan effective January 1, 1990, covering officers and key employees of LG&E. [Filed as Exhibit 10.33 to LG&E's Annual Report on Form 10-K for the year ended December 31, 1989, and incorporated by reference herein] LG&E Energy Corp. Deferred Stock Compensation Plan effective January 1, 1992, covering non-employee directors of the Company and its subsidiaries. [Filed as Exhibit 10.34 to the Company's Annual Report on Form 10-K for the year ended December 31, 1991, and incorporated by reference herein] Form of change in control agreement for officers of LG&E Energy Corp. [Filed as Exhibit 10.40 to the Company's Annual Report on Form 10-K for the year ended December 31, 1992, and incorporated by reference herein] Employment Agreement between Roger W. Hale and Louisville Gas and Electric Company, effective June 1, 1989, as amended. [Filed as Exhibit 10.41 to the Company's Annual Report on Form 10-K for the year ended December 31, 1992, and incorporated by reference herein] Supplemental Executive Retirement Plan for R. W. Hale, effective June 1, 1989. [Filed as Exhibit 10.42 to the Company's Annual Report on Form 10-K for the year ended December 31, 1992, and incorporated by reference herein] Nonqualified Savings Plan covering officers of the Company effective January 1, 1992. [Filed as Exhibit 10.43 to the Company's Annual Report on Form 10-K for the year ended December 31, 1992, and incorporated by reference herein] Employment Contract between the Company and Roger W. Hale effective November 3, 1993. [Filed as Exhibit 10.50 to the Company's Annual Report on Form 10-K for the year ended December 31, 1993] LG&E Energy Corp. Stock Option Plan for Non-Employee Directors. [Filed as Exhibit 10.51 to the Company's Annual Report on Form 10-K for the year ended December 31, 1993] (c) Reports on Form 8-K: The following 8-K reports were filed during the fourth quarter of 1993: (i) On October 27, 1993, a report on Form 8-K was filed announcing the following: Trimble County Generating Plant. On October 20, 1993, the Kentucky Supreme Court declined to review a Kentucky Court of Appeals order overturning a lower court's order that had improperly directed LG&E to refund approximately $150 million to its customers in a case involving LG&E's Trimble County electric generating station. Management Change. Walter M. Higgins, III, President and Chief Operating Officer of LG&E resigned to accept the position of President and Chief Operating Officer of Sierra Pacific Resources. Sierra Pacific Resources indicated plans for Mr. Higgins to become Chief Executive Officer early in 1994. (ii) On November 23, 1993, a report on Form 8-K was filed announcing that the Company would undergo a major realignment and formation of new business units effective January 1, 1994, to reflect its outlook for rapidly emerging competition in all segments of the energy services industry. (iii) On December 22, 1993, a report on Form 8-K was filed announcing that the Company had agreed to sell its 36.5% interest in Natural Gas Clearinghouse of Houston, Texas, to NOVA Corporation of Alberta, a Canadian natural gas and chemical company, for $170 million in cash. SCHEDULE V (Page 1 of 3) LG&E ENERGY CORP. AND SUBSIDIARIES SCHEDULE V - PROPERTY, PLANT AND EQUIPMENT (INCLUDING INTANGIBLES) FOR THE YEAR ENDED DECEMBER 31, 1993 (Thousands of $) SCHEDULE V (Page 2 of 3) LG&E ENERGY CORP. AND SUBSIDIARIES SCHEDULE V - PROPERTY, PLANT AND EQUIPMENT (INCLUDING INTANGIBLES) FOR THE YEAR ENDED DECEMBER 31, 1992 (Thousands of $) SCHEDULE V (Page 3 of 3) LG&E ENERGY CORP. AND SUBSIDIARIES SCHEDULE V - PROPERTY, PLANT AND EQUIPMENT (INCLUDING INTANGIBLES) FOR THE YEAR ENDED DECEMBER 31, 1991 (Thousands of $) SCHEDULE VI (Page 1 of 3) LG&E ENERGY CORP. AND SUBSIDIARIES SCHEDULE VI - ACCUMULATED DEPRECIATION, DEPLETION, AND AMORTIZATION OF PROPERTY, PLANT AND EQUIPMENT FOR THE YEAR ENDED DECEMBER 31, 1993 (Thousands of $) SCHEDULE VI (Page 2 of 3) LG&E ENERGY CORP. AND SUBSIDIARIES SCHEDULE VI - ACCUMULATED DEPRECIATION, DEPLETION, AND AMORTIZATION OF PROPERTY, PLANT AND EQUIPMENT FOR THE YEAR ENDED DECEMBER 31, 1992 (Thousands of $) SCHEDULE VI (Page 3 of 3) LG&E ENERGY CORP. AND SUBSIDIARIES SCHEDULE VI - ACCUMULATED DEPRECIATION, DEPLETION, AND AMORTIZATION OF PROPERTY, PLANT AND EQUIPMENT FOR THE YEAR ENDED DECEMBER 31, 1991 (Thousands of $) SCHEDULE VIII LG&E ENERGY CORP. AND SUBSIDIARIES SCHEDULE VIII - VALUATION AND QUALIFYING ACCOUNTS FOR THE THREE YEARS ENDED DECEMBER 31, 1993 (Thousands of $) SCHEDULE IX LG&E ENERGY CORP. AND SUBSIDIARIES SCHEDULE IX - SHORT-TERM BORROWINGS FOR THE THREE YEARS ENDED DECEMBER 31, 1993 (Thousands of $) SCHEDULE X LG&E ENERGY CORP. AND SUBSIDIARIES SCHEDULE X - SUPPLEMENTARY INCOME STATEMENT INFORMATION FOR THE THREE YEARS ENDED DECEMBER 31, 1993 (Thousands of $) The amounts of royalties and advertising costs charged to operating expenses were each less than one percent of total operating revenues. SIGNATURES Pursuant to the requirements of Section 13 or 15(d) 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. LG&E ENERGY CORP. Registrant March 28, 1994 By /s/ Charles A. Markel III ----------------------------------------------------- (Date) Charles A. Markel III Corporate Vice President, Finance and Treasurer Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the date indicated. Signature Title Date ROGER W. HALE Chairman of the Board, President and Chief Executive Officer (Principal Executive Officer); CHARLES A. MARKEL III Corporate Vice President, Finance and Treasurer (Principal Financial and Accounting Officer); WILLIAM C. BALLARD, JR. Director; OWSLEY BROWN II Director; S. GORDON DABNEY Director; GENE P. GARDNER Director; DAVID B. LEWIS Director; ANNE H. MCNAMARA Director; T. BALLARD MORTON, JR. Director; and DR. DONALD C. SWAIN Director. By /s/ Charles A. Markel III March 28, 1994 ------------------------------------------ CHARLES A. MARKEL III (Attorney-In-Fact)

912025_1993.txt

912025

1993

ITEM 1. BUSINESS. General Development of Business EQK Green Acres Trust (the 'Trust' or the 'Company'), a Delaware business trust, was formed pursuant to a Certificate of Trust dated September 8, 1993. The Trust has an indefinite life and intends to elect real estate investment trust ('REIT') status under the Internal Revenue Code of 1986, as amended. Under the Internal Revenue Code, a real estate investment trust that meets applicable requirements is not subject to Federal income tax on that portion of its taxable income that is distributed to its shareholders. The principal executive offices of the Trust are located at Suite 800, One Tower Bridge, W. Conshohocken, Pennsylvania 19428, and the telephone number is (215) 941-2933. On February 28, 1994, EQK Green Acres, L.P. (the 'Partnership') merged with and into Green Acres Mall Corp., a wholly-owned subsidiary of the Trust (the 'Merger'). Prior to February 28, 1994, the Trust did not have significant operations. The Partnership was a Delaware limited partnership formed pursuant to a certificate of limited partnership dated June 30, 1986. Equitable Realty Portfolio Management, Inc. ('ERPM', successor in interest to EQK Partners), which is wholly owned by Equitable Real Estate Investment Management, Inc. ('Equitable Real Estate'), itself an indirect wholly owned subsidiary of The Equitable Life Assurance Society of the United States ('Equitable'), acted as the advisor (the 'Advisor') to the Partnership. The Partnership had been formed to acquire and operate Green Acres Mall (the 'Mall'), a regional shopping mall located in Nassau County, Long Island, New York. In 1991, the Partnership completed the conversion of a leased industrial building, located adjacent to the Property, into a convenience shopping center known as the Plaza at Green Acres (the 'Plaza'). The Mall and the Plaza are referred to collectively as the 'Property' and are described below and under Item 2.

ITEM 2. PROPERTIES General. Green Acres Mall is a one-level and two-level T-shaped enclosed regional shopping mall, which together with 14 free-standing outparcel buildings and a convenience center known as the Plaza at Green Acres, is located on a site of approximately 100 acres. Adjacent to the Mall parking area are parcels owned by unaffiliated parties consisting of soon-to-be opened Home Depot and Caldor stores which are not part of the Property and in which the Company has not acquired any interest. The total building area of the Property is allocated as shown in the table below. - ------------------ (a) The improvements constituting the Sears department and auto accessory stores (aggregating 144,537 gross leasable square feet) are owned by Sears pursuant to ground leases of the land underlying such improvements. The Company has acquired title to such land, but will not acquire title to such improvements until such ground leases have terminated. Gross leasable area information contained herein includes the gross leasable area of such improvements. (b) Anchor tenant square footage includes approximately 51,421 square feet of separately leased storage space. (c) Includes stores leased to Kids 'R' Us, The Wiz, Red Lobster and Home Federal Savings Bank, among others. Does not include five outparcel buildings which are owned by the respective tenants subject to ground leases from the Company of the land underlying such stores. The Company is a lessee in a long-term lease for a ten-acre site adjacent to the Property on which there is situated a 170,000 square foot retail facility. The lease provides for an initial term of 30 years with three six-year option terms for a total term of up to 48 years. This building was converted in 1991 into the Plaza, a convenience center which initially contained a supermarket (Waldbaum, Inc., a division of The Great Atlantic and Pacific Tea Company, Inc.), a home improvement center (Pergament Home Improvement Center) and several small retail shops. In January 1993, the Company terminated its lease with Pergament and entered into a new lease agreement covering Pergament's space and all but one of the Plaza's small store spaces with Kmart Corporation. The convenience center began operations in September 1991. In April 1993, the Company completed the acquisition of an adjacent industrial tract (the 'Bulova Parcel') through a subsidiary partnership and entered into a lease/purchase agreement for this real estate with Home Depot. Pursuant to the lease/purchase agreement, Home Depot paid $9,500,000 to the Company, a portion of which was used to complete the purchase of the Bulova Parcel. As a result of the completion in 1993 of specified environmental work, the lease/purchase agreement obligated Home Depot to take title to the Bulova Parcel. In connection with this lease/purchase agreement, the Company recognized a gain on sale of real estate of $440,000 during 1993. During the first quarter of 1994, the Company completed the sale to Home Depot of an approximate two acre parking lot tract adjacent to the Bulova Parcel. The proceeds from the sale were $1,500,000, resulting in a 1994 gain on sale of real estate of approximately $800,000. Development History. The Property opened in 1958 as a single-level, open-air mall. The Mall was enclosed and climate-controlled in 1970. An extensive renovation, expansion and remerchandising program carried out in 1982-1983 included the following: (i) the addition of the Sears store and Auto Service Center, and a new two-level mall connecting the Sears store with the existing one-level mall; (ii) construction of a new three-level parking structure adjacent to the Sears store; and (iii) renovation of the existing one-level mall area and the J.C. Penney store. The outparcel buildings were not renovated in connection with this program. A renovation program for the interior of the Mall was completed during 1991-1992. The program included new tile flooring throughout the common areas, intensified lighting, new seating areas, and decorative columns and other features in a new color scheme. The food court was also renovated. Management has not yet determined whether to proceed with a previously planned expansion of the Mall that was suspended in 1992 for the lack of financing. The expansion will be accomplished only if its net effect on operations is expected to be positive and, in any event, actual construction would not be expected to commence prior to 1997. Remerchandising Program. In anticipation of the 1993-1996 lease expirations, the Company has under way a remerchandising campaign, the primary goal of which is to alter the tenant mix to appeal to a broader cross-section of the market while achieving increased revenues. Management estimates that approximately 95% of tenants whose leases expire between 1993 and 1996 are paying below market rents. The Company is negotiating with a group of prominent national retailers that Management believes will further enhance the overall financial stability of the Mall while maintaining the Mall's distinctive character associated with successful local and regional tenants. Over 50% of the Mall (excluding department stores) is leased to national retailers, including such major chains as The Limited (The Limited, Express, Victoria's Secret, and Bath & Body Works), The Gap, Footlocker, Mothercare, Edison Brothers (5-7-9, Coda, The Wild Pair), Melville (Kay-Bee Toy & Hobby, Fan Club), Waldenbooks and Radio Shack. Several national retailers have expressed interest in both expanding their current divisional presence as well as bringing new divisions into the Mall. By developing a leasing plan that takes advantage of upcoming lease rollovers, the Company expects to accommodate the requests of the larger national retailers, while at the same time meeting the space needs of smaller regional and local tenants. Management believes the remerchandising program will address consumers' needs for a diversified retail mix, thus strengthening the Mall's overall competitive position. Management estimates that the program will be completed by early 1995 and that the cost of tenant allowances required for the program will be approximately $3.5 million, approximately $1.8 million of which has already been expended. ITEM 3.

ITEM 3. LEGAL PROCEEDINGS. None. ITEM 4.

ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS. On December 23, 1993, the Trust and the Partnership issued a written Consent Solicitation Statement/Prospectus to the Partnership's Unitholders of record as of December 6, 1993. The Prospectus solicited the consent of Unitholders to a conversion of the Partnership with and into the Trust, a real estate investment trust, pursuant to a merger of the Partnership into a wholly-owned subsidiary of the Trust ('Proposal 1') and an amendment to the Amended and Restated Agreement of Limited Partnership of EQK Green Acres, L.P. (the 'Partnership Agreement') so as to permit the acquisition of additional real estate investments ('Proposal 2') . On February 28, 1994, the conversion of the Partnership with and into the Trust and the amendment to the Partnership Agreement were approved by a majority of the Partnership's Unitholders. The final tabulation of votes cast was as follows: - ------------------ (1) Represents the percentage of votes cast. The total votes cast, 6,860,879, represents 67.4% of total Units outstanding. For a detailed description of this matter, reference is made to the Registration Statement of the Partnership and the Trust on Form S-4 (Registration No. 33-68664), declared effective by the Securities and Exchange Commission on December 17, 1993. PART II ITEM 5.

ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS. The Company's Common Shares of Beneficial Interest are traded on the New York Stock Exchange (symbol EGA). The Company is listed in the stock tables as 'EQK Green.' As of March 1, 1994, the record number of Common Shareholders was 1,663. Although the Company does not know the exact number of beneficial holders the Company's Common Shares of Beneficial Interest, it believes the number exceeds 5,900. The Company's Common Shares of Beneficial Interest began trading on the New York Stock Exchange on March 1, 1994. The following table presents cash distributions and the high and low prices of the predecessor Partnership's Units based on The New York Stock Exchange daily composite transactions. - ------------------ (a) On January 25, 1994, a distribution of $.2750 per Common Share was declared with a record date of March 31, 1994 and a payment date of May 15, 1994. ITEM 6.

ITEM 6. SELECTED FINANCIAL DATA. - ------------------ (a) The distribution for the first quarter of 1990 of $.3225 was declared on December 8, 1989. Such amount was accrued as a distribution in the 1989 financial statements but is reflected as a 1990 distribution in the table above. ITEM 7.

ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS. This discussion should be read in conjunction with the Consolidated Financial Statements and accompanying Notes to Consolidated Financial Statements. FINANCIAL CONDITION MERGER TRANSACTION On February 28, 1994, EQK Green Acres, L.P. (the 'Partnership') merged with and into Green Acres Mall Corp., a wholly-owned subsidiary of EQK Green Acres Trust (the 'Trust'). The Trust and the Partnership are collectively referred to herein as the 'Company.' See Item 1 and Note 1 to the consolidated financial statements for a discussion of the Company's common shares (the 'Common Shares') issued in connection with this merger (the 'Merger'). The issuance of 10,277,469 Common Shares to the Unitholders and the General Partners on account of their respective percentage interests in the Partnership represents a reorganization of entities under common control and, accordingly, was accounted for in a manner similar to a pooling of interests. The financial statements of the Partnership and the Trust have been combined at historical cost retroactive to January 1, 1991. The issuance of these Common Shares has been reflected as of this date at the amount of the Unitholders' and General Partners' original contributions to the Partnership. The issuance of Common Shares to the Special General Partner on account of its residual interest in the Partnership and to Equitable Realty Portfolio Management, Inc. (the 'Advisor') will be reflected in the Company's consolidated financial statements as of February 28, 1994 and March 30, 1994, respectively. The issuance of Common Shares to the Special General Partner will increase the Company's carrying value of land and buildings and improvements by $3,024,000 and $13,347,000, respectively, representing the value of the Special General Partner's residual interest in accordance with the allocation methodology utilized by the Partnership in connection with the Merger. Annual depreciation expense will increase by approximately $342,000 as a result of the increase in the basis of the Mall. The issuance of Common Shares to the Advisor will be reflected as a charge to earnings during the first quarter of 1994 in the approximate amount of $3,843,000. In connection with the Merger, the Company recognized as an expense nonrecurring legal, accounting, and printing costs aggregating approximately $1,250,000. CASH FLOWS FROM OPERATING, INVESTING, AND FINANCING ACTIVITIES Cash flows from operating activities for 1993 and 1992 were $6,649,000 and $13,719,000, respectively. The 1993 results, and the related decline from 1992, are principally attributable to payments in 1993 of $1,951,000 and $2,684,000 for 1992 real estate taxes and deferred advisory and property management fees, respectively, and the payments of $1,123,000 for interest on the collateralized floating rate notes (the 'Floating Rate Notes'), $686,000 for deferred leasing costs, and $382,000 for Merger costs. During 1992, the Company's net cash provided by operating activities decreased by $1,131,000 compared to 1991. The primary cause of this decrease was the payment of $2,203,000 in 1992 for certain advisory and property management fees attributable to 1991. In 1991, the payment of these fees had been deferred, resulting in a nonrecurring cash flow benefit in that year. Offsetting this benefit in 1991 was the nonrecurrence of certain real estate taxes collected in 1990 attributable to the one-time acceleration of the billing of such taxes to tenants, and higher interest costs. Cash flows from investing activities increased by $6,713,000 in 1993 over the prior year, primarily due to the receipt of proceeds from the April 1993 transfer of an adjacent industrial tract (the 'Bulova Parcel') to Home Depot. Pursuant to a lease/purchase agreement, Home Depot paid $9,500,000 to the Company, a portion of which was used to complete the purchase of the Bulova Parcel. In connection with this lease/purchase agreement, the Company recognized a gain on sale of real estate of $440,000 during 1993. Subsequent to December 31, 1993, the Company's restricted cash balance of $500,000 was released from escrow. During 1992, net cash used in investing activities by the Company increased $193,000 compared to 1991. The Company's capital expenditures for 1992 included payments of $1,884,000 related to the acquisition of the Bulova Parcel, predevelopment costs of $1,110,000 related to the deferred mall expansion project and tenant allowance and other capital items. In 1991, the Company completed a $2,700,000 interior renovation, and spent an additional $2,100,000 in developing the Plaza. Cash flows used in financing activities for 1993 and 1992 were $8,753,000 and $8,220,000, respectively. The increase in cash used in financing activities is primarily attributable to the refinancing activities in August 1993 in which the net proceeds from the issuance of the Floating Rate Notes were used to purchase a zero coupon mortgage note (the 'Zero Note') and to repay $16,500,000 in second mortgage financing. During 1992, the Company's net cash used in financing activities increased $300,000 compared to 1991. The increase was due to a decline in net additional borrowings substantially offset by lower distributions paid to Common Shareholders. The Company believes that Funds from Operations represents an indicator of its ability to make cash distributions. Funds from Operations is defined as net income before depreciation, amortization of financing and other deferred expenses, and gains or losses on sales of assets. Management believes that Funds from Operations is the most significant factor in determining the amount of cash distributions, although Funds from Operations does not represent net income or cash flows from operating activities as defined by generally accepted accounting principles and is not necessarily indicative of cash available to fund all cash flow needs. Furthermore, Funds from Operations should not be considered as an alternative to net income as an indicator of the Company's operating performance or to cash flows from operating activities as a measure of liquidity. As indicated in the Consolidated Statements of Cash Flows, the Company experienced an unfavorable trend in cash provided by operating activities over the periods presented. However, the trend in Funds from Operations, which is not affected by temporary changes in working capital, has not been as unfavorable. The following table sets forth Funds from Operations and cash provided by operating activities of the Company for the periods indicated: The decrease of $1,152,000 in Funds from Operations for 1993 compared to 1992 is attributable to the 1993 incurrence of currently payable interest expense on the Floating Rate Notes and payments of Merger expenses of $1,824,000 and $1,250,000, respectively, offset by the nonrecurrence of a $1,439,000 write-off of capitalized predevelopment costs in 1992. The decline of $1,479,000 in Funds from Operations for 1992 compared to 1991 is also attributable to this 1992 write-off. DEBT REFINANCING On August 19, 1993, the Company, through a wholly-owned subsidiary, issued the Floating Rate Notes in an aggregate principal amount of $118,000,000. The Floating Rate Notes are secured by a first mortgage on substantially all of the real property comprising Green Acres Mall and a first leasehold mortgage on the Plaza. The early extinguishment of the Zero Note, as described above, resulted in an extraordinary charge of $6,373,000. The remainder of the proceeds from the Floating Rate Notes was used to purchase an interest rate cap and to pay mortgage recording taxes and other costs incurred in connection with the refinancing. The entire principal amount of the Floating Rate Notes is due on their maturity date, August 19, 1998. The Floating Rate Notes have a floating interest rate equal to 78 basis points in excess of the three-month LIBOR. The interest rate on this debt, which is subject to quarterly reset, was 4.28% at December 31, 1993. Payments of interest expense will be funded from cash flows from operations supplemented, as necessary, by borrowings under the revolving credit facility described below. Amortization of the deferred financing costs, approximating $1,161,000 per annum, will result in an additional charge (non-cash) to interest expense. As a result of an interest rate cap agreement also entered into on August 19, 1993, the effective interest rate of the Floating Rate Notes will not exceed 9% per annum. The mortgage and indenture relating to the Floating Rate Notes limit additional indebtedness that may be incurred by Green Acres Mall Corp., but not by the Trust. Those agreements also contain certain other covenants which, among other matters, effectively subordinate distributions from Green Acres Mall Corp. to the debt service requirements of the Floating Rate Notes. On August 19, 1993, the Partnership also obtained an 18 month unsecured revolving credit facility in the amount of $3,400,000 which bears interest at 1% over the lender's prime rate (effective interest rate of 7.00% at December 31, 1993). At December 31, 1993, $1,800,000 was outstanding. The Floating Rate Notes' mortgage agreement places certain limitations on the Company's ability to borrow under the line of credit agreement. At December 31, 1993, limitations related to future capital expenditures reduced the Company's available borrowing capacity to approximately $1,150,000. In February 1994, the Company borrowed an additional $900,000 under this credit facility. The Company anticipates that it will refinance the revolving credit facility prior to the expiration of such facility. The Company also anticipates that it will refinance the Floating Rate Notes at maturity in August 1998. Given the substantial equity the Partnership has in the Property (the principal amount of the Floating Rate Notes represents less than 50% of the Property's estimated fair value at December 31, 1993), Management anticipates that it will have considerable flexibility in obtaining such refinancing. However, at this time, Management has not identified any specific sources of such refinancing. In connection with the issuance of the Floating Rate Notes, interest expense is expected to decline significantly after 1993. Although the refinancing program will result in substantial interest savings, interest will be payable currently rather than accrued and, as a result, cash flow available for distributions will be reflective of such expenditures. DIVIDENDS The Company's current quarterly dividend rate of $.275 per Common Share represents an annual dividend rate of $1.10 per Common Share. The issuance of Common Shares to the Special General Partner and the Advisor will reduce the cash available per Common Share for distribution to the former Unitholders of the Partnership. However, the Special General Partner and the Advisor have agreed that all distributions received by them prior to May 1995 on account of the Common Shares issued in respect of the Special General Partner's residual interest in the Partnership and the termination of the agreement with the Advisor will be reinvested through a distribution reinvestment plan in newly issued Common Shares. As a result, the issuance of such Common Shares to the Special General Partner and Advisor will not affect cash flow available for distribution to the former Unitholders of the Partnership until after May 1995. Management anticipates that annual distributions on account of 1994 operations will be $1.10 per Common Share. The Company expects that an increase in Funds from Operations (before interest) will offset the effect of paying interest on the Floating Rate Notes on a current basis in 1994 and through maturity. The anticipated growth in Funds from Operations in 1994 reflects cost reductions resulting from the termination of the Advisory Agreement, net of costs associated with the Company's planned acquisitions program, and an increase in rental revenues. The Company also received, during the first quarter of 1994, $1,500,000 from the sale of two acres of property to Home Depot, which supplements Funds from Operations available for distribution. During 1994, the Company anticipates that its capital expenditures will be approximately $2,900,000 which it intends to fund from borrowings. The Company is currently pursuing an extension of its existing line of credit, although there can be no assurance that it will receive such an extension. Should it be unable to fund capital expenditures from borrowings, or should there be a shortfall in budgeted revenue growth or an unanticipated increase in interest expense, the Company's ability to maintain distributions at $1.10 per Common Share could be adversely affected. Commencing in May 1995, the Special General Partner and the Advisor will be entitled to receive cash distributions on their Common Shares. Consequently, in addition to the aforementioned growth in Funds from Operations required in 1994, Funds from Operations in 1995 must increase an additional $1,950,000 to maintain the current distribution rate of $1.10 per Common Share for 1995 and future years. Based on the information presently available, Management believes that stipulated rent increases from existing tenants, additional income from new tenants, renewal of expiring leases at higher market rents and increases in percentage rents will increase Funds from Operations by an amount sufficient to sustain the current dividend level in 1995, although there is no assurance as to this. Further, it is anticipated that capital expenditure requirements will decline significantly in 1995 due to the completion of the remerchandising program and the resulting reduction in future tenant allowances. The Company intends to acquire additional real estate investments. Financing for any such investments would be sought through any combination of public or private debt and/or equity financing (including possibly financing provided in whole or in part by sellers) determined by the Company to be advisable at the time. It is premature to seek such financing and there can be no assurance that any such financing could be obtained on favorable terms or at all. RESULTS OF OPERATIONS COMPARISON OF 1993, 1992, AND 1991 The Company reported a net loss of $5,223,000 ($.51 per Common Share) in 1993, compared with a net loss of $163,000 ($.02 per Common Share) in 1992 and net income of $2,511,000 ($.24 per Common Share) in 1991. The 1993 results were impacted by the recognition of an extraordinary loss of $6,373,000 ($.62 per Common Share) from the early retirement of the Zero Note. The extraordinary loss was comprised principally of prepayment penalties and the write-off of deferred financing costs. Earnings in 1993 also declined as a result of the recognition of $1,250,000 of Merger costs. The earnings decline in 1993 was partially offset by the $440,000 gain on sale of real estate and a decrease in interest expense from 1992. The 1992 results were impacted by the writeoff of predevelopment costs. In June 1992, the Company announced its decision to defer a planned expansion of the Mall due to its inability to secure financing for this project. It is uncertain when, or if, the expansion program will be resumed. Accordingly, capitalized costs related to the predevelopment phase of the expansion, totaling $1,439,000, were written off. The earnings decline in 1992 over 1991 was also affected by higher interest expense in 1992, partially offset by an increase in revenues from rental operations. The trend in earnings is more fully described in the discussion of revenues and expenses that follows. Revenues from rental operations in 1993 decreased modestly from the prior year. The decline in 1993 revenues of $106,000 was attributable to a $334,000 decline in Plaza revenues, primarily related to the buildout of the new Kmart discount store, partially offset by higher Mall revenues attributable to specialty leasing of space to temporary tenants. In January 1993, the Company replaced Pergament Home Improvement Center, Inc. ('Pergament'), one of the Plaza's anchor tenants, and all but one of the Plaza's small store spaces, with a new Kmart discount store. In connection with the lease termination, the Partnership paid $450,000 to Pergament on July 1, 1993. The Company also paid a $150,000 fee to the Advisor in connection with the securing of Kmart as a new anchor tenant. This change in Plaza tenants is expected to generate an additional $350,000 of income from rental operations on an annualized basis compared to the income generated from the Plaza in 1992. Revenues from rental operations in 1992 increased from 1991 by $3,061,000 or 18%. Approximately one-half of the revenue increase was attributable to the operation of the Plaza, which was open for its first full year of business in 1992. In addition, the 1992 minimum rent from mall tenants increased due to improved occupancy, percentage rents increased due to higher tenant sales levels and other income increased due to an expanded temporary leasing program. Net operating expenses increased in 1993 to $2,059,000 from $1,779,000 in 1992 and $195,000 in 1991. This $280,000 increase in 1993 is primarily attributable to increases in net real estate taxes and food court costs of $147,000 and $119,000, respectively. The increase in net operating expenses in 1992 over 1991 is due to an increase in the expenses of the Plaza, which was in its first full year of operations, and increases in net operating expenses associated with common area maintenance and real estate taxes of $485,000 and $522,000, respectively. Included in net operating expenses are property management fees of $786,000, $785,000, and $697,000 for 1993, 1992, and 1991, respectively, attributable to the related agreement with Compass Retail, Inc. ("Compass"). In connection with the Merger, the agreement with Compass was amended and restated to extend its termination date by two years to August 31, 1998, and to limit Compass' scope of responsibilities primarily to accounting and financial services currently provided in connection with the operations of the Property. Compass' compensation will be reduced from 4% to 2% of net rental and service income collected from tenants. Operating expense increases attributable to inflation generally do not have a significant effect on the Company's income from rental operations as substantially all operating expenses are reimbursed by tenants in accordance with the terms of their leases. Advisory fees have declined to $1,625,000 in 1993 from $1,709,000 in 1992 and $1,931,000 in 1991. The advisory fee was comprised of an annual base fee of $250,000 and an annual subordinated incentive advisory fee of $1,250,000 which increased in proportion to the amount by which aggregate distributions of operating cash flow to Unitholders exceed a ten percent return on the Unitholder's Adjusted Capital Contributions (as defined in the Partnership Agreement). Decreases in operating cash flows over the three year period account for the reductions in the advisory fees. The advisory agreement will terminate on March 30, 1994, upon the expiration of a 30-day transition period agreement. The provision for doubtful accounts was $424,000 in 1993, $809,000 in 1992 and $505,000 in 1991. The 1992 provision was attributable to anticipated losses associated with certain delinquent tenants whose leases were subsequently terminated. Such tenants were symptomatic of credit risk found in the retail industry, particularly among smaller local and regional tenants. Due to the absence of significant credit losses and due to certain recoveries of receivables previously written off, the Company experienced an improvement in its provision for doubtful accounts in 1993. Interest expense was $9,834,000, $10,787,000, and $8,401,000 for 1993, 1992, and 1991, respectively. The decrease in interest expense in 1993 over 1992 is due to the August 19, 1993 debt refinancing. The Zero Note, with an effective interest rate of 10.4% per annum, and the $16,500,000 in second mortgage financing, bearing interest at rates between 6% and 7% per annum, were replaced with Floating Rates Notes that had an initial interest rate of 4.03% that was reset to 4.28% on November 12, 1993. Interest expense increased in 1992 over 1991 due to the amortization of the discount on the Zero Note. In addition, 1992 interest expense increased due to a full year of interest recognized on the capitalized portion of the Plaza lease, higher interest cost on the line of credit and interest payable on the deferred advisory and property management fees. Other expenses consist primarily of the administrative costs of running the Company. There were no significant fluctuations in these costs during the three-year period ended December 31, 1993. Distributions to security holders were $11,305,000 ($1.10 per Common Share) in 1993, $11,999,000 ($1.168 per Common Share) in 1992, and $13,823,000 ($1.345 per Common Share) in 1991. The Company has paid out substantially all of its net cash flow since inception. Taking into account the anticipated impact on net cash flow of the previously discussed refinancing, distributions were reduced to an annual rate of $1.10 in June 1992. ITEM 8.

ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA. The Registrant's consolidated financial statements and supplementary data listed in Item 14(a) appear immediately following the signature pages. ITEM 9.

ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE. None. PART III ITEM 10.

ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT. The Company is managed by members of a Board of Trustees (the 'Managing Trustees') initially comprised of the directors of the Partnership's former managing general partner. It is anticipated that the Board of Trustees will be expanded in 1994 to include additional independent trustees. The Managing Trustees are divided into three classes as nearly equal in number as possible, with the term of office of one class expiring in each year. After expiration of the initial terms as set forth in the following table, trustees will serve for three-year terms. The Managing Trustees will be responsible for electing the Company's executive officers, who will serve at the discretion of the Board of Trustees. Myles H. Tanenbaum will serve as the Company's President and as Chairman of the Company's Board of Trustees. In addition to Mr. Tanenbaum, the Company's executive officers will include Randall C. Stein, who will serve as Senior Vice President; Kimli Cross Smith, who will serve as Vice President-Leasing; Richard P. Ferrell, who will serve as Vice President-Management; and Dennis Harkins, who will serve as Treasurer and Controller. By mid-1994, the Company intends to retain an Assistant Vice President-Construction. Brief summaries of Mr. Tanenbaum's and the other Managing Trustees' and executive officers' business experience and certain other information are set forth following the table. - ------------------ (1) Member of the nominating committee. (2) Member of the audit committee. (3) Member of the compensation committee. Myles H. Tanenbaum, age 63, is a Managing Trustee and President of the Company and Chairman of Arbor Enterprises, an investment and holding company, and formerly a consultant to Equitable Real Estate, of which the former Advisor to the Partnership is a wholly-owned subsidiary. He was formerly the President of EQK Partners (formerly the Partnership's advisor) from its inception in September 1983 until October 1987 and was Chairman until December 1989. Prior to that time, from 1970 he served as Executive Vice President and the Chairman of the Executive Committee of Kravco, Inc. Mr. Tanenbaum is also managing partner of the Partnership's former special general partner, a general partnership which is the sole shareholder of the Partnership's former managing general partner. Prior to joining Kravco, Inc. in 1970, Mr. Tanenbaum had been a partner in the law firm of Wolf, Block, Schorr and Solis-Cohen, Philadelphia, Pennsylvania. He is also a certified public accountant. Mr. Tanenbaum is currently a director of Universal Health Realty Trust, a New York Stock Exchange ('NYSE')-listed real estate investment trust which owns hospitals, and of The Pep Boys--Manny, Moe & Jack, Inc., an NYSE-listed company engaged in the retail sale of automotive parts and accessories, and the provision of automotive services. Sylvan M. Cohen, age 79, has been President and Trustee of Pennsylvania Real Estate Investment Trust, an American Stock Exchange-listed real estate investment trust since its inception in 1960. Mr. Cohen is also a partner in the Philadelphia law firm of Cohen, Shapiro, Polisher, Shiekman and Cohen. Mr. Cohen is a former director of Fidelity Bank, Philadelphia, Pennsylvania, and is a director of FPA Corporation, an American Stock Exchange-listed real estate development company, and a trustee of EQK Realty Investors I, a NYSE-listed real estate investment trust. He formerly served as President of the National Association of Real Estate Investment Trusts and the International Council of Shopping Centers. Alton G. Marshall, age 72, is President of Alton G. Marshall Associates, Inc., a New York City real estate investment firm since 1971. He has been Senior Fellow of the Nelson A. Rockefeller Institute of Government in Albany, New York since January 1, 1991. He was Chairman of the Board and Chief Executive Officer of The Lincoln Savings Bank, FSB, from March 1984 through December 1990, and remains a Director and Chairman of the Bank's Executive Committee. From 1971 to 1981, he was President of the Rockefeller Center, Inc., a real estate, manufacturing and entertainment company. Mr. Marshall is currently a director of the Hudson River Trust, and New York State Electric & Gas Corp., and a trustee of EQK Realty Investors I. He is an independent partner of Alliance Capital and Alliance Capital Retirement Fund. George R. Peacock, age 70, retired in August 1988 after serving as Chairman and Chief Executive Officer of Equitable Real Estate, parent of the Partnership's former Advisor which is a wholly-owned subsidiary of Equitable. Mr. Peacock is a past member of Equitable's Investment Policy Committee. Prior to his retirement he was also a Senior Vice President of parent Equitable for approximately twelve years. Mr. Peacock is a former director of Equitable Real Estate and remains a trustee of EQK Realty Investors I. Phillip E. Stephens, age 46, has been President of Compass Retail, the Partnership's former property manager and a subsidiary of Equitable Real Estate, since January 1992 and was Executive Vice President of the Compass Retail division of Equitable Real Estate from January 1990 to December 1991. He has also served as President of ERPM, the Partnership's former Advisor and a wholly-owned subsidiary of Equitable Real Estate, since December 1989. From October 1987 to December 1989, he was President of EQK Partners (formerly the Partnership's Advisor), the predecessor in interest to ERPM. From its inception in September 1983 to October 1987, he was Senior Vice President of EQK Partners. He is also President and a trustee of EQK Realty Investors I. Randall C. Stein, age 35, has been Senior Vice President of the Trust since March 1994. From February 1992 to January 1994, Mr. Stein was Senior Vice President of Dusco Inc., New York, New York, a company engaged in the fund management of a portfolio of regional malls for institutional investors. Prior to that, from January 1984 to February 1992, Mr. Stein was Director of Development and Acquisitions for Strouse, Greenberg & Co., Philadelphia, Pennsylvania, a company engaged in real estate investment, management, leasing and development. Prior to that, from June 1981, Mr. Stein was Senior Tax Advisor at Laventhol & Horwath, Philadelphia, Pennsylvania. Kimli Cross Smith, age 31, has been a leasing representative for Compass Retail, the Partnership's former property manager and a subsidiary of Equitable Real Estate since November 1990. From March 1988 until she joined Compass Retail, Ms. Smith was a leasing representative for Strouse, Greenberg & Co., Inc., Philadelphia, Pennsylvania. Richard P. Ferrell, age 36, has been Vice President -- Management of the Trust since March 1994. Prior to that, from December 1992, Mr. Ferrell was Vice President of the Partnership's former managing general partner and the Manager of Green Acres Mall. From December 1991 to December 1992 Mr. Ferrell worked for the Rouse Company as Vice President and General Manager of the Citadel, an enclosed mall located in Colorado Springs, Colorado. Prior to that, from February 1989 to December 1991, Mr. Ferrell was employed by the Rouse Company as Manager of Retail Operations for the Cherry Hill Mall in Cherry Hill, New Jersey. Dennis Harkins, age 31, has been the Controller of Green Acres Mall since June 1993. Prior to that, from August 1990 Mr. Harkins was Controller for Hayim and Co., Hempstead, New York, a company engaged in the importation and distribution of rugs. Prior to that, from January 1990 Mr. Harkins was Assistant Controller of the Yarmouth Group, New York, New York, a real estate investment company. From June 1987 until January 1990, Mr. Harkins was an accounting manager for Angeles Corp., Los Angeles, California, a real estate investment company. Pursuant to the Delaware Business Trust Act, the Company is required to have as a trustee a person or entity that is a resident of or has its principal place of business in the State of Delaware. The Delaware resident trustee is Wilmington Trust Company (the 'Resident Trustee'). The Declaration of Trust provides that the management of the Company is vested exclusively in the Managing Trustees who make up the Board of Trustees of the Company and that the Resident Trustee will not participate in the management of the Company except as directed by the Board of Trustees and consented to by the Resident Trustee. The principal offices of the Resident Trustee are located at 1100 N. Market Street, Rodney Square North, Wilmington, Delaware 19890-0001. Section 16(a) of the Securities Exchange Act of 1934 requires the Company's officers and trustees and persons who own more than ten percent of a registered class of the Company's equity securities, along with the predecessor Partnership's officers and directors and persons who owned more than ten percent of a registered class of the Partnership's equity securities (collectively, the 'Reporting Persons') to file reports of ownership and changes in ownership with the Securities and Exchange Commission and to furnish the Company with copies of these reports. Based on the Company's review of the copies of these reports received by it, and written representations received from Reporting Persons, the Company believes that all filings required to be made by the Reporting Persons during 1993 were made on a timely basis. ITEM 11.

ITEM 11. EXECUTIVE COMPENSATION. EXECUTIVE COMPENSATION Until the conversion to a REIT on February 28, 1994, the Company was not internally managed, and therefore was not responsible for executive compensation. During 1993, the Partnership reimbursed its managing general partner for the $10,000 annual fees and the $1,000 per meeting fees payable to each of the managing general partner's independent directors, Messrs. Cohen and Marshall. Messrs. Cohen and Marshall also received $25,000 each for services rendered as members of a special committee in connection with their determination of desirability of the proposed conversion of the Partnership into a real estate investment trust and their recommendations with respect to the related terms and conditions. Except for such fees, the directors, officers and employees of the former managing general partner did not receive any salaries or other compensation from the Partnership. The former Advisor received an annual fee of $250,000 and a subordinated incentive advisory fee of $1,375,000 with respect to the year ended December 31, 1993 With respect to the Company, except for those trustees who are also employees of the Company (initially Mr. Tanenbaum), trustees will receive annual fees of $15,000 in connection with their services as trustees of the Company, plus $1,000 for each board meeting and committee meeting they participate in. The Resident Trustee will receive annual fees of $2,500. In connection with Mr. Tanenbaum's service as President and Chief Executive Officer of the Company, Mr. Tanenbaum is expected to receive base salary at the annual rate of $175,000, subject to increases at the discretion of the Company's Board of Trustees. In addition to his base salary, Mr. Tanenbaum is expected to be eligible to receive an annual incentive bonus based upon individual and Company performance. In addition to his cash compensation, Mr. Tanenbaum was granted options in January 1994 to purchase up to 750,000 Common Shares at an exercise price of $10 per Common Share, equal to the market price of the shares on the date of grant. Such options vest at the rate of 20% per year commencing one year after the grant date, or January 25, 1995. The Company estimates that aggregate cash compensation for 1994 payable to the current executive officers listed in Item 10 (other than Mr. Tanenbaum) will be approximately $500,000. Additionally, it is anticipated that an Assistant Vice President-Construction will be retained and will receive aggregate cash compensation of less than $100,000. On January 25, 1994, the Board of Trustees adopted an Incentive Share Plan (the 'Plan'), which provides for the issuance of up to 1,500,000 Common Shares to outside Trustees and officers and key executives of the Company through options to purchase Common Shares, share appreciation rights, and restricted share grants. Common Share options may be options that are intended to qualify as incentive share options under the Internal Revenue Code of 1986, as amended, or options which are not intended to so qualify. Options will be granted at an exercise price that approximates the fair value of Common Shares on the grant date. Concurrent with the adoption of this Plan, the Company granted options to purchase 7,500 Common Shares to each of its four eligible trustees and options to purchase an aggregate of 875,000 Common Shares to certain officers (including options to purchase 750,000 Common Shares granted to Mr. Tanenbaum as described above). Certain officers also received an aggregate of 5,950 restricted Common Shares. All such options have an exercise price of $10 per Common Share and vest ratably commencing one year from the grant date, or January 25, 1995, in equal annual increments over three and five years for the Trustee and Officer options, respectively. The restricted shares become unrestricted in equal annual increments over three years commencing one year from the grant date, or January 25, 1995. ITEM 12.

ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT. The following table shows the beneficial holdings of Common Shares as of March 1, 1994 of all persons known by the Company, based upon filings with the Securities and Exchange Commission, to be beneficial owners of more than 5% of its outstanding Common Shares, of all Trustees of EQK Green Acres Trust individually, and of all Trustees and Officers of EQK Green Acres Trust as a group. - ------------------ (1) The 308,933 Common Shares issuable to the Advisor on March 30, 1993 pursuant to the termination of the advisory agreement are considered outstanding for the purposes of this computation. (2) Includes the estimated allocation of Common Shares issued to the former general partners of EQK Green Acres, L.P., although a final allocation has not yet been completed. Until the Common Shares are distributed, voting of the shares will be controlled by Mr. Tanenbaum. (3) Includes 1,000 Common Shares owned by Mr. Peacock's wife, of which Mr. Peacock disclaims beneficial ownership. (4) The number of Common Shares represents less than 1% of the outstanding Common Shares. (5) Includes 12,700 Common Shares owned by Mr. Tanenbaum's wife and 10,000 Common Shares owned by a trust of which he is a trustee. Excludes 107,609 Common Shares owned by Mr. Tanenbaum's adult children, of which Mr. Tanenbaum disclaims beneficial ownership. Also excludes 750,000 Common Shares issuable upon exercise of options which were issued to Mr. Tanenbaum and which vest at the rate of 20% per year commencing one year after the January 25, 1994 grant date. (6) Includes Mr. Tanenbaum's share of Common Shares issued to the General Partners pursuant to the Merger. (7) Includes 5,950 restricted Common Shares that will become unrestricted in equal annual increments over three years commencing one year from the grant date, or January 25, 1995. Excludes executive officer options to purchase 875,000 Common Shares (inclusive of Mr. Tanenbaum's options to purchase 750,000 Common Shares) that vest at the annual rate of 20% commencing one year from the grant date, or January 25, 1995, and Trustee options for 30,000 Common Shares that vest in equal annual increments over three years commencing one year from the grant date, or January 25, 1995. ITEM 13.

ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS. The Property was acquired by the Partnership on August 27, 1986 at a purchase price of $135,859,782 from Green Acres Associates, a general partnership among Equitable, Sunrise Associates and the General Partners of the Partnership. Sunrise Associates, a limited partnership, is an affiliate of the General Partners of the Partnership. On December 1, 1989, a wholly owned subsidiary of Equitable Real Estate acquired the 50% interest in EQK Partners (former advisor to the Partnership) owned by Kravco Partners, Ltd., bringing to 100% Equitable Real Estate's ownership interest in EQK Partners. Mr. Tanenbaum and Mr. Stephens owned, directly or indirectly, 25.2% and 14.4%, respectively, of Kravco Partners, Ltd. Subsequently, ERMP, a wholly owned subsidiary of Equitable Real Estate, became Advisor to the Partnership as the successor in interest to EQK Partners. As Advisor, ERPM received an annual base advisory fee of $250,000 for the years ended December 31, 1993, 1992, and 1991. ERPM also earned a subordinated incentive advisory fee of $1,375,000, $1,459,000, and $1,681,000, respectively, for the years ended December 31, 1993, 1992, and 1991. In addition, ERMP has earned fees of $40,000 in each of 1993, 1992 and 1991 for tax reporting services. Compass will receive a fee of $40,000 for tax reporting services in 1994. In December 1992, the Partnership entered into an agreement with ERPM pursuant to which ERPM provided development services in conjunction with the termination of its lease with Pergament, a former anchor tenant at the Plaza, and the procurement of a new lease with Kmart. The fee for these services was $150,000. Upon sale of all or any portion of any real estate investment of the Partnership, the Advisor was entitled to receive a disposition fee equal to 2% of the gross sale price (including outstanding indebtedness taken subject to or assumed by the buyer and any purchase money indebtedness taken back by the Partnership). The disposition fee was to be reduced by the amount of any brokerage commissions and legal expenses incurred by the Partnership in connection with such sales. Pursuant to this agreement with the Advisor, the Company paid a $290,000 fee to the Advisor during 1993 relating to services rendered in connection with the acquisition and development of the Bulova Parcel and its ultimate transfer to Home Depot (see Items 1,7 and 8). Pursuant to the Merger discussed in Item 4, upon the expiration of a 30 day transition period agreement commencing March 1, 1994, the agreement with the Advisor will be terminated. The Partnership had entered into a property management agreement with Compass, a subsidiary of Equitable Real Estate, effective January 1, 1991. Pursuant to this agreement, property management fees were based on 4% of net rental and service income collected from tenants. In connection with the Merger discussed in Items 1 and 4, the agreement with Compass was amended and restated to extend its termination date by two years to August 31, 1998, and to limit Compass' scope of responsibilities primarily to accounting and financial services currently provided in connection with the operations of the Property. Compass' compensation will be reduced from 4% to 2% of net rental and service income collected from tenants. For the years ended December 31, 1993, 1992 and 1991, management fees earned by Compass were $786,000, $785,000, and $697,000, respectively. In 1992, the Partnership agreed to pay interest to both the Advisor and Compass as consideration for their willingness to defer the payment of fees which were otherwise due and payable. The Advisor and Compass deferred such fees as an accommodation to the Company in connection with its refinancing efforts as described in Items 7 and 8. For the years ended December 31, 1993 and 1992, the Partnership recorded interest expense on deferred fees of $249,000 and $223,000, respectively, representing an interest rate of 7.31% through April 1, 1993 and 8.5% thereafter applied to the cumulative unpaid fee balance. Such fees and the interest thereon were paid in full from the proceeds from the August 19, 1993 issuance of collateralized floating rate notes (see Items 7 and 8). Pursuant to an agreement with the Advisor to provide services in connection with such debt refinancing, the Advisor received a fee of $300,000 in 1993. The Company's executive offices will be located at One Tower Bridge, W. Conshohocken, PA 19428. These offices, including furniture, telephones, and certain ofice services and equipment, will be furnished for a period of between four and seven months at a monthly rate of approximately $11,500 from a partnership owned by Mr. Tanenbaum and his sons. Such terms have been approved by the Board of Trustees, with the abstention of Mr. Tanenbaum, based upon a conclusion that the terms of the lease are as favorable to the Company as those generally available from unaffiliated third parties. For a description of Common Shares issued to the Advisor pursuant to the Merger in connection with the termination of the advisory agreement and of Common Shares issued to the General Partners, see Items 1, 7 and 8. PART IV ITEM 14.

ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K - ------------------ (1) Incorporated herein by reference to exhibit filed with Registrant's Registration Statement on Form S-11, File No. 33-6992. (2) Incorporated herein by reference to exhibit filed with Registrant's Form 10-K for the fiscal year ended December 31, 1988. (3) Incorporated herein by reference to exhibit filed with Registrant's Form 10-K for the fiscal year ended December 31, 1989. (4) Incorporated herein by reference to exhibit filed with Registrant's Form 10-K for the fiscal year ended December 31, 1990. (5) Incorporated herein by reference to exhibit filed with Registrant's Form 10-K for the fiscal year ended December 31, 1991. (6) Incorporated herein by reference to exhibit filed with Registrant's Form 10-K for the fiscal year ended December 31, 1992. (7) Incorporated herein by reference to exhibit filed with Registrant's Registration Statement on Form S-4, File No. 38-68664. SIGNATURES Pursuant to the requirements of Section 13 or 15(d) 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, on the 29th day of March, 1994. EQK Green Acres Trust By:/s/ Myles H. Tanenbaum Myles H. Tanenbaum, Chairman of the Board of Trustees, President Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed on March 29, 1994 by the following persons on behalf of the Registrant and in the capacities indicated. EQK GREEN ACRES TRUST INDEPENDENT AUDITORS' REPORT To the Board of Trustees and Shareholders of EQK Green Acres Trust: We have audited the accompanying consolidated balance sheets of EQK Green Acres Trust (a Delaware business trust) as of December 31, 1993 and 1992, and the related consolidated statements of operations, shareholders' equity, and cash flows for each of the three years in the period ended December 31, 1993. These consolidated financial statements and the consolidated financial statement schedules discussed below are the responsibility of the Trust's management. Our responsibility is to express an opinion on these financial statements and financial statement schedules based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, such consolidated financial statements present fairly, in all material respects, the financial position of EQK Green Acres Trust as of December 31, 1993 and 1992, and the results of its operations and its cash flows for each of the three years in the period ended December 31, 1993 in conformity with generally accepted accounting principles. Our audits also comprehended the consolidated financial statement schedules of EQK Green Acres Trust as of December 31, 1993 and 1992, and for each of the three years in the period ended December 31, 1993. In our opinion, such consolidated financial statement schedules, when considered in relation to the basic consolidated financial statements, present fairly in all material respects the information shown therein. Deloitte & Touche Atlanta, Georgia March 10, 1994 EQK GREEN ACRES TRUST CONSOLIDATED BALANCE SHEETS (IN THOUSANDS, EXCEPT COMMON SHARE DATA) See accompanying Notes to Consolidated Financial Statements EQK GREEN ACRES TRUST CONSOLIDATED STATEMENTS OF OPERATIONS (IN THOUSANDS, EXCEPT COMMON SHARE DATA) See accompanying Notes to Consolidated Financial Statements EQK GREEN ACRES TRUST CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY (IN THOUSANDS) See accompanying Notes to Consolidated Financial Statements EQK GREEN ACRES TRUST CONSOLIDATED STATEMENTS OF CASH FLOWS (IN THOUSANDS) See accompanying Notes to Consolidated Financial Statements EQK GREEN ACRES TRUST NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE 1: MERGER TRANSACTION AND BASIS OF PRESENTATION EQK Green Acres Trust (the 'Trust'), formed on September 8, 1993 as a Delaware business trust, has an indefinite life and intends to elect real estate investment trust ('REIT') status under the Internal Revenue Code of 1986, as amended. On February 28, 1994, EQK Green Acres, L.P. (the 'Partnership') merged with and into Green Acres Mall Corp., a wholly-owned subsidiary of the Trust. Prior to February 28, 1994, the Trust did not have significant operations. The Trust and the Partnership are collectively referred to herein as the 'Company'. The Partnership had been formed pursuant to an Agreement of Limited Partnership dated as of June 30, 1986 (and amended and restated as of August 27, 1986) to acquire and operate Green Acres Mall (the 'Property' or the 'Mall'), a regional shopping mall located in Nassau County, Long Island, New York. In 1991, the Partnership completed the conversion of a leased industrial building, located adjacent to the Property, into a convenience shopping center known as the Plaza at Green Acres (the 'Plaza'). Pursuant to the merger, Unitholders of the Partnership received 10,172,639 common shares of the Trust (the 'Common Shares') on account of their 98.98% percentage interest in the Partnership; the General Partners of the Partnership received 104,830 Common Shares on account of their 1.02% percentage interest in the Partnership; and the Special General Partner of the Partnership received 1,316,251 Common Shares in satisfaction of its residual interest in the Partnership. Pursuant to the termination of the Partnership's advisory agreement (see Note 5), the Advisor is entitled to receive 308,933 Common Shares on March 30, 1994. The issuance of 10,277,469 Common Shares to the Unitholders and the General Partners on account of their respective interests in the Partnership represents a reorganization of entities under common control and, accordingly, was accounted for in a manner similar to a pooling of interests. The financial statements of the Trust and the Partnership have been combined at historical cost retroactive to January 1, 1991. The issuance of these Common Shares has been reflected as of January 1, 1991 at an amount that equals the Unitholders' and General Partners' original contribution to the Partnership. The issuances of Common Shares to the Special General Partner and the Advisor will be reflected in the Company's financial statements as of February 28, 1994 and March 30, 1994, respectively. The issuance of such Common Shares to the Special General Partner will increase the Trust's carrying value of land and buildings and improvements by $3,024,000 and $13,347,000, respectively, representing the agreed-upon value of the Special General Partner's residual interest in accordance with the allocation methodology utilized by the Partnership in connection with the Merger. Had this Common Share issuance been recorded on January 1, 1991, depreciation expenses would have increased by approximately $342,000 in each of the three years ended December 31, 1993 ($.03 per Common Share outstanding). The issuance of Common Shares to the Advisor will be reflected as a charge to earnings during the first quarter of 1994 in the approximate amount of $3,843,000. In connection with the merger, the Company recorded as expense in 1993 nonrecurring legal, accounting, and printing costs aggregating approximately $1,250,000 ($.12 per Common Share). NOTE 2: SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES REVENUE RECOGNITION Minimum rents are recognized on a straight-line basis over the terms of the related leases. Percentage rents are recognized on an accrual basis. CAPITALIZATION, DEPRECIATION AND AMORTIZATION Investments in the Property are recorded at cost. Costs directly associated with major renovations and improvements to mall property and to leased property are capitalized until the related project is substantially complete and ready for its intended use. In 1991, capitalized improvements and additions included $867,000 of interest on funds borrowed to finance construction. No interest was capitalized in 1993 and 1992. Capitalized leases are recorded at the lower of fair market value or the present value of future lease payments. Depreciation of the Property is provided on a straight-line basis over the estimated useful lives of the related assets, ranging generally from 10 to 40 years. Capitalized lease assets are amortized over the lease term. Intangible assets are amortized on a straight-line basis over their estimated useful lives. DEFERRED LEASING COSTS Costs incurred in connection with the execution of a new lease, including leasing commissions, costs associated with the acquisition or buyout of existing leases and legal fees, are deferred and amortized over the term of the new lease. NET INCOME (LOSS) AND DISTRIBUTIONS PER COMMON SHARE Net income (loss) and distributions per Common Share for the years ended December 31, 1993, 1992, and 1991 have been computed based on the 10,277,469 Common Shares outstanding during the periods. INCOME TAXES No provision has been made in the accompanying consolidated financial statements for income tax liabilities since the Unitholders and General Partners of the Partnership were required to include their respective share of profits and losses in their individual tax returns. The ongoing operations of the Company generally will not be subject to Federal income taxes as long as the Company qualifies as a REIT. In order to qualify as a REIT, the Company will be required to distribute at least 95% of its taxable income to the shareholders and to meet certain asset and income tests, as well as certain other requirements. CONSOLIDATED STATEMENTS OF CASH FLOWS Cash equivalents include short-term investments with an original maturity of three months or less. Included in the consolidated statements of cash flows are cash payments for interest (net of amount capitalized) of $3,334,000, $1,986,000 and $789,000 for the years ended December 31, 1993, 1992, and 1991, respectively. At December 31, 1993, accrued refinancing costs amounted to $131,000. In 1992, the Company capitalized $8,084,000 representing the purchase price, plus related expenditures for interest, taxes, insurance and predevelopment costs of the adjacent industrial tract which it had committed to purchase (see Note 6). The corresponding obligation for the unpaid balance of the purchase contract at December 31, 1992, amounting to $4,850,000, was reflected in other liabilities. Such amount was paid in 1993. In 1991, cash used in investing activities included $771,000 of expenditures accrued at December 31, 1990. FINANCIAL INSTRUMENTS Management has reviewed the various assets and liabilities of the Company at December 31, 1993 and 1992 in accordance with Statement of Financial Accounting Standards No. 107, 'Disclosure about Fair Value of Financial Instruments' (which is not applicable to real estate assets). Management has concluded that all of the Company's financial instruments, except for the zero coupon mortgage note outstanding at December 31, 1992, have terms such that their book value approximates fair value. At December 31, 1992 and continuing into 1993, there was no readily available source of zero coupon mortgage financing and, therefore, management determined that the estimation of a fair value of the zero coupon mortgage note was not practicable. On August 19, 1993, the Company retired the zero coupon mortgage note with the proceeds from the issuance of its collateralized floating rate notes (see Note 4). RECLASSIFICATIONS Certain reclassifications have been made to the prior years' consolidated financial statements in order to conform their presentation to that used in the current year. NOTE 3: LEASING ARRANGEMENTS THE COMPANY AS LESSOR The Company leases shopping center space to approximately 200 tenants, generally under non-cancelable operating leases. The leases generally provide for minimum rentals, plus percentage rentals based upon the retail stores' sales volume. Percentage rentals amounted to $2,563,000, $2,621,000 and $2,306,000 for the years ended December 31, 1993, 1992, and 1991, respectively. In addition, the tenants pay certain utility charges to the Company and, in most leases, reimburse their proportionate share of real estate taxes and common area expenses. The Company leases space to national, regional, and local tenants. Diversity in the tenant mix minimizes exposure to credit risk from geographic concentration. However, regional and local tenants may represent a higher level of credit risk. In certain instances, the Company obtains security deposits to mitigate risk from less creditworthy tenants. Future minimum rentals under existing leases at December 31, 1993 are as follows: THE COMPANY AS LESSEE In 1990, the Company entered into a 30-year lease, with three, six-year renewal options, on the Plaza, an adjacent 9-acre site on which there is situated an industrial building that has been renovated and converted into retail shopping space. The Plaza opened for business in September 1991. In addition to specified rents, the Plaza lease requires the Company to pay property taxes, insurance, operating expenses and additional rentals based on a percentage of revenues generated by the operations of the Plaza. No such additional rentals were paid in 1993, 1992 or 1991. In accordance with applicable accounting standards, the portion of the lease related to the building is accounted for as a capital lease while the portion related to the land is accounted for as an operating lease. The following is a schedule of future minimum lease payments under the lease as of December 31, 1993: For the years ended December 31, 1993, 1992, and 1991, total rental expense under the operating lease portion of this lease was $734,000, $709,000 and $329,000, respectively, all of which represented minimum lease payments. As of December 31, 1993, the Company has signed sublease agreements with certain tenants of the Plaza, which agreements generally provide for rentals based on a percentage of tenant sales in addition to base rental. Sublease income of $42,953,000 will be received over the remaining terms of the respective leases. Such income is included in the future minimum rentals table presented above. Sublease income totalled $2,189,000, $2,523,000, and $765,000 for the years ended December 31, 1993, 1992, and 1991, respectively. In January 1993, the Partnership terminated its lease with Pergament Home Improvement Center ('Pergament'), one of the anchor tenants at the Plaza, and entered into a new lease agreement covering Pergament's space and all but one of the Plaza's small store spaces with Kmart Corporation. In connection with the lease termination, the Company paid Pergament $450,000. NOTE 4: DEBT FINANCING On August 19, 1993, the Company completed a comprehensive refinancing by issuing collateralized floating rate notes ('floating rate notes') in the aggregate principal amount of $118,000,000. The proceeds from the sale of the floating rate notes were used, in part, to pay the approximate $95,399,000 purchase price for the zero coupon first mortgage note previously outstanding and retire a $16,500,000 term loan note at face value. The proceeds from the issuance of the floating rate notes were also used to purchase an interest rate cap for $1,023,000 and to pay mortgage recording taxes and other costs incurred in connection with this refinancing. The floating rate notes were recorded net of a $118,000 discount. In connection with the early extinguishment of the zero coupon first mortgage note, the Company recognized an extraordinary charge to earnings of $6,373,000. The floating rate notes are due August 19, 1998 and are collateralized by a first mortgage on substantially all of the real property comprising Green Acres Mall and a first leasehold mortgage on the Plaza. The floating rate notes bear interest at a rate equal to 78 basis points in excess of the three-month LIBOR, which is payable on a quarterly basis commencing November 12, 1993. The interest rate is subject to reset on such interest payment dates. The initial interest rate, 4.03%, was effective for the period August 19, 1993 to November 11, 1993. On November 12, 1993, the interest rate was reset to 4.28%. The interest rate cap provides that the effective interest rate applicable to the $118,000,000 face value of the notes will not exceed 9% per annum through their maturity date. Should such debt's interest rate rise above 9%, the Company would record amounts receivable from the counter-party as a reduction to interest expense. The Company is exposed to certain losses in the event of non-performance by the counter-party to this agreement. The mortgage and indenture agreement relating to the floating rate notes limit additional indebtedness that may be incurred by Green Acres Mall Corp.. Those agreements also contain certain other covenants which, among other matters, effectively subordinate distributions from Green Acres Mall Corp. to debt service requirements of the floating rate notes. As part of its comprehensive debt restructuring, the Company also obtained a $3,400,000 unsecured line of credit facility from a bank. The line of credit agreement bears interest at 1% above the bank's prime rate and will mature in February 1995, unless extended. The line of credit agreement also contains certain covenants which, among other matters, limit the amount of the Company's annual dividend to an amount that does not exceed operating cash flow (as defined), and require the Company to maintain a quarterly debt service coverage ratio (as defined). At December 31, 1993, the Company had borrowed $1,800,000 under this credit facility. The floating rate notes' mortgage agreement places certain limitations on Green Acres Mall Corp.'s ability to borrow under the line of credit agreement. At December 31, 1993, limitations related to future capital expenditures reduced the Company's available borrowing capacity to approximately $1,150,000. Subsequent to year end, the Company borrowed an additional $900,000 under this credit facility. The Partnership had issued the previously outstanding zero coupon mortgage note on August 27, 1986 in connection with its financing of the acquisition of the Property. The zero coupon mortgage note, which was secured by substantially all of the real property comprising Green Acres Mall, had an effective annual interest rate of 10.4% compounded semi-annually. The $16,500,000 term loan note retired on August 19, 1993 originated on June 30, 1993 upon the conversion of a matured line of credit. This line of credit, along with predecessor facilities, bore interest at rates ranging from the bank's prime rate to such prime rate plus 1%. In connection with a renewal and the conversion of the line of credit facility to a term loan in 1993, the Company paid fees to the bank of approximately $125,000. Borrowings under these facilities were secured by a second mortgage on substantially all of the real property comprising Green Acres Mall and a first leasehold mortgage on the Plaza. NOTE 5: ADVISORY AND MANAGEMENT AGREEMENTS Prior to the termination of its advisory agreement as discussed below, Equitable Realty Portfolio Management, Inc., a wholly owned subsidiary of Equitable Real Estate Investment Management, Inc. ('Equitable Real Estate'), acted as 'Advisor' to the Partnership. The Advisor made recommendations to the Managing General Partner concerning investments, administration and day-to-day operations. For performing these services, the Advisor received an annual base advisory fee of $250,000. The Advisor also received an annual subordinated incentive advisory fee of $1,250,000 which increased in proportion to the amount by which aggregate distributions of operating cash flow to Unitholders exceeded a 10% return on the Unitholders' Adjusted Capital Contributions (as defined in the Partnership Agreement). Payment of this fee was subordinated to a minimum annual distribution equal to a 10% return to Unitholders. Portions of the fee not paid in any year because of such subordination were to be deferred and paid from future operating cash flow on a subordinated basis. For the years ended December 31, 1993, 1992, and 1991, the subordinated incentive advisory fee was $1,375,000, $1,459,000, and $1,681,000, respectively. As of December 31, 1992 and 1991, $1,459,000 and $1,264,000, respectively, were reflected as obligations on the Company's consolidated balance sheets. Upon sale of all or any portion of any real estate investment of the Partnership, the Advisor was entitled to receive a disposition fee equal to 2% of the gross sale price (including outstanding indebtedness taken subject to or assumed by the buyer and any purchase money indebtedness taken back by the Partnership). The disposition fee was to be reduced by the amount of any brokerage commissions and legal expenses incurred by the Partnership in connection with such sales. Pursuant to this agreement with the Advisor, the Company paid a $290,000 fee to the Advisor during 1993 relating to services rendered in connection with the acquisition and development of the Bulova Parcel and its ultimate transfer to Home Depot (see Note 6). Such fees paid to the Advisor reduced the amount of the gain recognized from this transaction. Pursuant to an agreement with the Advisor to provide services in connection with the refinancing of the Company's debt as described in Note 4, the Advisor was paid a $300,000 fee in 1993. In December 1992, the Partnership entered into an agreement with the Advisor pursuant to which the Advisor provided development services in conjunction with the termination of its lease with Pergament and the procurement of a new lease with Kmart Corporation (see Note 3). The fee for these services was $150,000, which was paid in 1993. Pursuant to the merger discussed in Note 1, upon the expiration of a 30 day transition period agreement commencing March 1, 1994, the agreement with the Advisor will be terminated. The Partnership had entered into a property management agreement with Compass Retail, Inc. ('Compass'), a subsidiary of Equitable Real Estate, effective January 1, 1991. Pursuant to this agreement, property management fees were based on 4% of net rental and service income collected from tenants. In connection with the merger discussed in Note 1, the agreement with Compass was amended and restated to extend its termination date by two years to August 31, 1998, and to limit Compass' scope of responsibilities primarily to accounting and financial services currently provided in connection with the operations of the Property. Compass' compensation will be reduced from 4% to 2% of net rental and service income collected from tenants. For the years ended December 31, 1993, 1992 and 1991, management fees earned by Compass were $786,000, $785,000, and $697,000, respectively. In 1992, the Partnership agreed to pay interest to both the Advisor and Compass as consideration for their willingness to defer the payment of fees which were otherwise due and payable. The Advisor and Compass deferred such fees as an accommodation to the Partnership in connection with its refinancing effort (see Note 4). For the years ended December 31, 1993 and 1992, the Company recorded interest expense on deferred fees of $249,000 and $223,000 respectively, representing interest rates of 7.31% through April 1, 1993 and 8.5% thereafter applied to the cumulative unpaid fee balances. NOTE 6: DEVELOPMENT ACTIVITIES In January 1992, the Company announced plans for a major expansion of the Mall. The Company filed the required zoning and other related applications necessary for the commencement of such expansion. In June 1992, the Company announced its decision to defer the planned expansion of the Mall due to its inability to secure financing for this project. It is uncertain when, or if, the expansion program will be resumed. Accordingly, capitalized costs related to the predevelopment phase of the expansion were written-off. In April 1993, the Company completed the acquisition of an adjacent industrial tract (the 'Bulova Parcel') through a subsidiary partnership and entered into a lease/purchase agreement for this real estate with Home Depot. Pursuant to the lease/purchase agreement, Home Depot paid $9,500,000 to the Company, a portion of which was used to complete the purchase of the Bulova Parcel. As a result of the completion in 1993 of specified environmental work, the lease/purchase agreement obligated Home Depot to take title to the Bulova Parcel. In connection with this lease/purchase agreement, the Company recognized a gain on sale of real estate of $440,000 during 1993. Subsequent to December 31, 1993, the Company's restricted cash balance of $500,000 was released from escrow. During the first quarter of 1994, the Company completed the sale to Home Depot of an approximate two acre parking lot tract adjacent to the Bulova Parcel. The proceeds for the sale were $1,500,000, resulting in a 1994 gain on sale of real estate of approximately $800,000. NOTE 7: COMMITMENTS AND CONTINGENCIES Pursuant to the terms of the Plaza lease, the Company was required to provide, or cause a third party lender to provide, mortgage financing of $4,800,000 to the lessor. In January 1992, the Company arranged such financing from a third party lender for a term of five years at an interest rate of 10.25%. The Company has an option to extend the financing for an additional five years at a variable rate of interest. This financing replaced an existing mortgage, and is secured by the Plaza property, but is non-recourse to the lessor. The Company is required to make all debt service payments on behalf of the lessor and will receive an annual offset to its minimum rent equal to 12% of the total financing provided to the lessor. NOTE 8: SELECTED QUARTERLY FINANCIAL DATA (UNAUDITED) The following is a summary of selected quarterly financial data for the years ended December 31, 1993 and 1992. Such data include certain reclassifications to accounts presented in quarterly reports on Form 10-Q in order to conform their presentation to that used in the consolidated statements of operations presented herein. In connection with the merger discussed in Note 1, the Company recorded as expense in the fourth quarter of 1993 nonrecurring legal, accounting, and printing costs aggregating $1,250,000 ($.12 per Common Share). As discussed in Note 6, during the second quarter of 1992, the Company wrote-off $1,439,000 of capitalized costs related to the predevelopment phase of a mall expansion project that was deferred ($.14 per Common Share). NOTE 9: SUBSEQUENT EVENTS On January 25, 1994, the Board of Trustees adopted an Incentive Share Plan (the 'Plan'), which provides for the issuance of up to 1,500,000 Common Shares to outside Trustees, officers and key executives of the Company through options to purchase Common Shares, share appreciation rights, and restricted share grants. Common Share options may be options that are intended to qualify as incentive options under the Internal Revenue Code of 1986, as amended, or options which are not intended to so qualify. Options will be granted with an exercise price that approximates the fair value of the Common Shares on the grant date. Concurrent with the adoption of this Plan, the Company granted options to purchase 7,500 Common Shares to each of its four eligible trustees and options to purchase an aggregate of 875,000 Common Shares to certain officers. Certain officers also received in aggregate 5,950 restricted Common Shares. All such options have an exercise price of $10 per Common Share and vest ratably commencing one year from the grant date in equal annual increments over three and five years for the Trustee and officer options, respectively. The restricted shares become unrestricted in equal annual increments over three years commencing one year from the grant date. - -------------------------------------------------------------------------------- FINANCIAL STATEMENT SCHEDULES DECEMBER 31, 1993 (IN THOUSANDS) - -------------------------------------------------------------------------------- SCHEDULE VIII -- VALUATION AND QUALIFYING ACCOUNTS - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- (1) Write-offs of accounts receivable - -------------------------------------------------------------------------------- SCHEDULE IX -- SHORT-TERM BORROWINGS - -------------------------------------------------------------------------------- (1) Average of month-end balances outstanding during the period. (2) Year-to-date interest expense divided by average of month-end balances outstanding during the period. - -------------------------------------------------------------------------------- SCHEDULE X -- SUPPLEMENTARY INCOME STATEMENT INFORMATION - -------------------------------------------------------------------------------- (1) Substantially all such costs are recovered from tenants based on the provisions of the tenants' leases. (2) Principally represents amortization of deferred financing costs, which is classified as interest expense. - -------------------------------------------------------------------------------- SCHEDULE XI -- REAL ESTATE AND ACCUMULATED DEPRECIATION - -------------------------------------------------------------------------------- (1) Encumbrance is a floating rate note constituting a first lien on the real estate. (2) The Plaza at Green Acres is a leased asset. Encumbrances constitute a first leasehold mortgage collateralizing the floating rate notes ($117,891) and the obligation under the capitalized lease ($6,971). (3) Includes $10,175 representing the deemed value of units issued to affiliates of the former owners of Green Acres Mall and the General Partnership interest ($2,075 in Land, $8,100 in Buildings and Improvements). (4) Original construction was completed in 1955; mall was expanded/renovated in 1982-83 and renovated again in 1990-91. (5) The aggregate tax basis of the Partnership's property is $143,829 as of December 31, 1993.

39677_1993.txt

39677

1993

Item 1. Business Avatar Holdings Inc. (a Delaware corporation incorporated in 1970) and its subsidiaries (collectively, "Avatar" or the "Company") are engaged in two principal business activities: real estate and water and wastewater utilities operations. Avatar's real estate operations, which are located in the states of Florida, Arizona and California, include the development and sale of homesites; the development and sale of improved and unimproved homesites and commercial/industrial land tracts; the construction and sale of single family and multifamily housing; operations of amenities and resorts; development, sale and management of vacation ownership units in Avatar's Poinciana community; cable television operations and property management services. Avatar provides financing for a large portion of its homesite sales, mainly under a deed and mortgage arrangement. Avatar's utility operations consist of water and wastewater treatment plants which serve communities in Florida and Arizona. During 1993, approximately 56% and 44% of the total revenues were generated through real estate and utility operations, respectively, net of the gain on the sale of the midwest water utilities discussed below. On August 31, 1993, the Company sold its water and wastewater utilities located in Indiana, Missouri, Ohio, and Michigan (the "Midwest Water Utilities") for an aggregate selling price of $62,000,000, resulting in a pre-tax gain of $21,822,000. In the current year the Company has invested approximately $51,000,000 cash in an investment trading portfolio. (See Liquidity section) Avatar's revised business strategy includes a shift away from homesite sales and toward housing, retail and industrial real estate development, sales of vacation ownership intervals and resort operations. Certain of Avatar's properties are being developed and such developments are at different stages of completion. In addition, Avatar is examining each of its remaining principal properties in an effort to determine the best long-term use or development. Information regarding revenues, results of operations and assets of the two business segments noted above are included in Item 8 under the caption "Notes to Consolidated Financial Statements". Real Estate Avatar's assets include real estate inventory in the states of Florida, Arizona and California. In its Florida communities of Poinciana, Barefoot Bay, Cape Coral, Golden Gate and Leisure Lakes, as well as in its Arizona community of Rio Rico, Avatar's activities include homesite and industrial/commercial land sales, the construction and sale of single family and multifamily housing, and the construction, sale and management of vacation ownership units, with the types of activities varying from community to community. Avatar owns other sites including Harbor Islands in Hollywood, Florida; Banyan Bay in Martin County, Florida; Ocala Springs in Marion County, Florida; and Woodland Hills in Los Angeles County, California. Poinciana, located in central Florida approximately 21 miles south of Orlando and 10 miles from Walt Disney World, encompasses 47,000 acres of land, approximately 15,500 of which are owned by Avatar. This planned community development includes subdivisions for single family, multifamily and manufactured housing, and commercial/industrial areas. Since 1971, 21,860 homesites have been sold and approximately 4,219 housing units, primarily single family houses and townhouses, have been Item 1. Business -- Continued constructed by Avatar and other non-affiliated builders. As of December 31, 1993, approximately 12,965 developed and undeveloped homesites remained in inventory at Poinciana. Additionally, approximately 4,456 acres of land zoned for industrial/commercial and multifamily use also remained in inventory. At December 31, 1993, Avatar had firm contracts at Poinciana to construct 49 single family units with a total sales volume of $3,726,488. Avatar's real estate activities at Poinciana also include the construction, sale and management of vacation ownership units. As of December 31, 1993, 1,606 unit weeks had been sold and 1,306 unit weeks remained in inventory at Poinciana. Avatar also owns and operates a 31,100 square foot shopping center at Poinciana that was 100% occupied at December 31, 1993. Recreational facilities owned and operated by Avatar at the Poinciana development include an 18-hole Devlin Von-Hagge championship golf course, tennis courts, a golf and racquet club with a swimming pool, a community center and a series of nature walks and trails. Barefoot Bay is located on Florida's east coast, midway between Vero Beach and Melbourne. Avatar's operations at Barefoot Bay include the sale of manufactured homes and homesites. Since operations commenced in 1970, approximately 94% of the 5,020 available homesites have been sold. At December 31, 1993, Avatar had firm contracts to construct 8 housing units at a total selling price of $683,000. Recreational facilities owned and operated at Barefoot Bay by Avatar include an 18-hole executive golf course, a community center, swimming pools, tennis courts, a private beach and a fishing pier. Avatar also owns and operates a 13,420 square foot shopping center in Barefoot Bay that was 100% occupied at December 31, 1993. Avatar also owns 268 acres adjacent to Barefoot Bay. Platting, design and engineering for this proposed golf course community of 630 conventional single-family and zero-lot line homesites commenced in 1989 and is continuing through 1994. Cape Coral is a 60,700-acre community, of which approximately 3,727 acres are owned by Avatar, located on Florida's west coast seven miles west of Fort Myers. Its population has increased from 11,470 in 1970 to approximately 84,000 in 1993. To accommodate this increase, Avatar constructed, during 1991, the Camelot Isles Shopping Center, a 70,000 square foot retail center that opened in February 1992. At December 31, 1993, the shopping center was 89% occupied. Remaining inventory at December 31, 1993, included approximately 3,734 single family homesites and 2,700 acres of land zoned for commercial, industrial and multifamily use. Avatar's Tarpon Point Marina, which is located in Cape Coral, accommodates 175 vessels and features dockmaster facilities, a ship's store and fueling facilities. The Camelot Marina, for which the initial phase of construction was completed in 1991, will accommodate 76 vessels and feature 3,500 feet of boardwalk upon completion. Other amenities available to the residents of Cape Coral include Avatar's Cape Coral Golf and Tennis Resort that features an 18-hole championship golf course, a 9-hole executive golf course, eight tennis courts and a 100- room motel. Golden Gate City, located east of Naples in southwest Florida, had remaining inventory as of December 31, 1993 which included 32 single family and duplex homesites, 43 acres of land zoned for multifamily use and 10 acres zoned for commercial use. Golden Gate Estates comprises 2,497 acres of land subdivided into 5,800 homesites. Remaining inventory as of December 31, 1993, includes approximately 130 homesites of varying size, the majority of which are approximately 1 and 1-1/4 acre homesites, and 7,400 acres of land held for future use. Item 1. Business -- Continued Avatar's land holdings in Leisure Lakes, located near the city of Lake Placid in South Central Florida, consist of 3,244 homesites remaining in inventory at December 31, 1993. Amenities at Leisure Lakes include a 9-hole executive golf course, a small lakefront motel, tennis courts, shuffleboard courts, a swimming pool, a club house with pro shop, a coffee shop, a private beach, a boat ramp, a card room and various lakes available for water sports. Rio Rico, a 55,000-acre community development in southern Arizona, is located 57 miles south of Tucson. This community, with a population of approximately 4,700 residents, consists of single family homes and townhouses and includes several areas zoned for commercial and industrial development. Avatar owns and operates a 175-room hotel complex, an 18-hole Robert Trent Jones designed championship golf course and a 36,800 square foot shopping center, which was 98% occupied as of December 31, 1993. Remaining inventory at Rio Rico at December 31, 1993 included approximately 3,575 single family homesites, 2,536 acres of land zoned for commercial, industrial and multifamily use, 4,762 acres of land held for future development, sale or other use, and 2,838 acres of undeveloped mountain range reserved for open space. The Harbor Islands Project encompasses 191 acres, including 30 acres conveyed to the city of Hollywood for future parks, adjoining the Intra-coastal Waterway in Hollywood, Florida. An approved plan for this water-oriented community provides for 2,700 high-rise condominium units, 447 townhouses and triplex dwelling units, 28 single family homesites, 65,000 square feet of commercial space and a 150-room hotel. Additionally, permits have been obtained and preliminary construction completed on a 196-boat slip marina. Banyan Bay, located in Martin County, Florida, comprises 251 acres of land. Future plans contemplate a medium-density residential development of two and four story condominiums. Ocala Springs, located five miles northeast of Ocala in Marion County, Florida, comprises 4,600 acres of land. The concept plan for this project provides for 700 single family ranchettes on 1-1/4 to 1- 1/2 acre lots, 4,800 single family homesites on 1/4 to 1/2 acre lots, 400 homesites for manufactured housing and 1,000 multifamily condominium units. Also planned are an 18-hole golf course and more than 130 acres for commercial, industrial and service facilities. These plans have been reviewed by all appropriate state, regional and local governmental agencies and the plat for Phase I has been filed with and accepted by Marion County. Woodland Hills, located in northwest Los Angeles County, California, consists of the Natoma tract that encompasses approximately 430 acres of land. Conceptual planning for this tract has been completed for 108 luxury homesites. An environmental impact report has been filed and is being reviewed by the City of Los Angeles. In addition to the real estate holdings described above, Avatar owns approximately 2,500 acres of land in Florida that is being held for future development or bulk sales. Utilities Avatar's water and wastewater treatment facilities include 12 water treatment facilities and 10 wastewater treatment facilities serving 6 communities in Florida (including Poinciana, Barefoot Bay and Golden Gate). These facilities provide for the treatment, distribution and sale of water for public and Item 1. Business -- Continued private use, and the treatment and disposal of wastewater. At December 31, 1993, Avatar's utility operations had approximately 35,000 water customers and 29,000 wastewater customers. On January 30, 1993, the Company entered into stock purchase agreements for the sale of its Midwest Water Utilities. The closing of the sale of the Midwest Water Utilities took place on August 31, 1993, for an aggregate selling price of $62,000,000, resulting in a pre-tax gain of $21,822,000. An Avatar subsidiary provides consulting, data processing and other services to non-affiliated utility companies as well as to various Avatar subsidiaries. This subsidiary is beginning to operate water and wastewater systems under contracts with unaffiliated companies. Employees As of December 31, 1993, Avatar employed approximately 950 individuals on a full-time or part-time basis. In addition, Avatar utilizes on a daily basis such additional personnel as may be required to perform various land development activities. Avatar's relations with its employees are satisfactory and there have been no work stoppages. Regulation Avatar's real estate operations are regulated by various local, regional, state and federal agencies, including the Federal Trade Commission (FTC). The extent and nature of these regulations include matters such as planning, zoning, design, construction of improvements, environmental considerations and sales activities. For its community developments in Florida and Arizona, state laws and regulations may require the filing of registration statements, copies of promotional materials and numerous supporting documents, and the delivery of an approved disclosure report to purchasers, prior to the execution of a land sales contract. In addition to Florida and Arizona, certain states impose requirements relating to the inspection of properties, approval of sales literature, disclosures to purchasers of specified information, assurances of future improvements, approval of terms of sale and delivery to purchasers of a report describing the property. Federal regulations adopted pursuant to the Interstate Land Sales Full Disclosure Act provide for the filing or certification of a registration statement with the Office of Interstate Land Sales Regulation of the Department of Housing and Urban Development. Avatar's homesite installment sales activities are required to comply with the Federal Consumer Credit Protection ("Truth-in-Lending") Act. Avatar's utility operations and rate structures are regulated by various federal, state and county agencies and must comply with federal and state treatment standards. All sources of water and wastewater effluent are required to be tested on a regular basis and purified in order to comply with governmental standards. The Company believes it is in compliance with applicable laws and regulations in all material respects. Competition Avatar's real estate operations, particularly in the state of Florida, are highly competitive. In its sales of homesites and housing units, Avatar competes, as to price and product, with several land Item 1. Business -- Continued development companies for the discretionary income of individuals who desire eventually to relocate or establish a second home in Florida or Arizona. In recent years, there have been extensive land development projects in the geographical areas in which Avatar operates. The vacation ownership sales business is also highly competitive with companies throughout the United States and abroad selling vacation ownership unit weeks on terms similar to those offered by Avatar. Item 2.

Item 2. Properties Avatar's real estate operations are described in Item 1 above. Land in the process of being developed, or held for investment and/or future development, has an aggregate cost of approximately $113,623,000 as of December 31, 1993. Avatar's utility operations include water and wastewater plants and equipment located in Florida. Such properties have a net book value of $150,812,206 at December 31, 1993. Avatar's corporate headquarters are located at 255 Alhambra Circle, Coral Gables, Florida, in approximately 26,595 square feet of leased office space. For additional information concerning properties leased by Avatar, see Item 8, "Notes to Consolidated Financial Statements." Item 3.

Item 3. Legal Proceedings Avatar is involved in various pending litigation matters primarily arising in the normal course of its business. Although the outcome of these and the following matters can not be determined, it is the opinion of management that the resolution of such matters will not have a material effect on Avatar's business or financial position. On October 1, 1993, the United States, on behalf of the U.S. Environmental Protection Agency, filed a civil action against a utility subsidiary of Avatar in the U.S. District Court for the Middle District of Florida. (United States vs. Florida Cities Water Company, Civil Action No. 93-281-C1) The complaint alleges that the subsidiary's wastewater treatment plant in North Fort Myers, Florida, committed various violations of the Clean Water Act, 33 U.S.C. S1251 et seq., including (1) discharge of pollutants without an operating permit from October 1, 1988 to October 31, 1989; (2) discharging from an unpermitted discharge location from November 1, 1989 until July 14, 1992; and (3) discharging pollutants in excess of permit limitations at various times from July 1991 to June of 1992. The government is seeking the statutory maximum civil penalties of $25,000 per day, per violation based upon the allegations. The Subsidiary strongly believes that there are mitigating facts as well as valid legal defenses that could reduce or eliminate the imposition of monetary sanctions. On March 1, 1994, the Wisconsin Department of Natural Resources (the "Department") sent Avatar notice that the Department had recently issued a second Record of Decision ("ROD") in connection with the Edgerton Sand & Gravel Landfill site (the "Site"). The ROD calls for the City of Edgerton's public water supply system to be extended to the owners of private wells in the vicinity of the Site. The ROD also states that other work related to soil and groundwater remedial action would be required at the Site. The Department demanded that all potentially responsible parties ("PRPs") associated with the Site organize into a PRP group to undertake the implementation of the ROD. Avatar was previously identified as a PRP by the Department. Avatar believes that it is not liable for any claims by any governmental or private party in connection with the Site. Item 3. Legal Proceedings -- Continued On February 25, 1994, Mr. Wilkov commenced a lawsuit against Avatar, Mr. Jacobson and Odyssey Partners, L.P. ("Odyssey"), in the Circuit Court of Eleventh Judicial Circuit in and for Dade County Florida, claiming damages arising out of Mr. Wilkov's termination of his employment purportedly for "Good Reason" (as defined in his employment agreement). Mr. Wilkov also seeks to recover damages from Avatar for libel and slander and from Odyssey and Mr. Jacobson based on their alleged malicious interference with his employment agreement. Avatar denies that Mr. Wilkov had Good Reason to terminate his employment agreement. Avatar, Odyssey and Mr. Jacobson do not believe there is any valid basis for Mr. Wilkov's claims, and various affirmative defenses have been asserted. Avatar also has asserted counterclaims against Mr. Wilkov for breach of contract, promissory estoppel and improper inducement in connection with amendments to Mr. Wilkov's employment agreement. Item 4.

Item 4. Submission of Matters to a Vote Security Holders None Executive Officers of the Registrant Pursuant to General Instruction G (3) to Form 10-K, the following list is included as an unnumbered item in Part I of this report in lieu of being included in the Proxy Statement for the Annual Meeting of Stockholders to be held on May 26, 1994. The following is a list of names and ages of all of the executive officers of Avatar, indicating all positions and offices with Avatar held by each such person and each such person's principal occupation(s) or employment during the past five years unless otherwise indicated. All such persons have been elected to serve until the next annual election of officers (which is expected to occur on May 26, 1994) when they are reappointed or their successors are elected, or until their earlier resignation or removal. Name Age Office and Business Experience Leon Levy 68 Chairman of the Board since January 1981; General Partner, Odyssey Partners, L.P., a private partnership engaged in investment, trading and related activities; Chairman of the Board of Oppenheimer Funds; former Chairman of the Board (1974-1985) of Oppenheimer Management Corp.; Director of: Electra Investment Trust PLC, Mercury Assets Management, Ltd., and S.G. Warburg & Co., Ltd. (Jersey Funds). Edwin Jacobson 64 President and Chief Executive Officer since February 1994; Chairman of the Executive Committee since June 1992; President and Chief Executive Officer of Chicago Milwaukee Corporation since June 1985; President and Chief Executive Officer of CMC Heartland Partners since September 1990, and President and Chief Executive Officer, since June 1985, of Milwaukee Land Company, a non- diversified, closed-end management investment company, publicly traded since July 1993. Dennis J. Getman 49 Executive Vice President since March 1984. Senior Vice President from September 1981 to March 1984 and General Counsel since September 1981. Charles L. McNairy 47 Executive Vice President since September 1993 and Treasurer and Chief Financial Officer since September 1992. Senior Vice President from September 1992 to September 1993. Vice President - Finance from January 1985 to September 1992, except from April 1987 to September 1988. Juanita I. Kerrigan 47 Vice President and Secretary since September 1980. Executive Officers of the Registrant -- continued G. Patrick Settles 45 Vice President since November 1986 and Assistant General Counsel since September 1983. John J. Yanopoulos 37 Vice President -- Finance and Controller since September 1992. Assistant Vice President from May 1990 to September 1992 and Corporate Controller since May 1989. Formerly Senior Audit Manager, Kenneth Leventhal and Company from 1986 to 1989. The above executive officers have held their present positions with Avatar for more than five years, except as otherwise noted. No director or executive officer of Avatar has any family relationship with any other director or executive officer of Avatar. PART II Item 5.

Item 5. Market for Registrant's Common Stock and Related Stockholder Matters The Common Stock of Avatar Holdings Inc. is traded through the National Market System of the National Association of Securities Dealers Automated Quotation System ("NASDAQ") under the symbol AVTR. The approximate number of record holders of Common Stock at February 28, 1994, was 9,100. High and low quotations, as reported, for the last two years were: Avatar has not declared any cash dividends on Common Stock since its issuance and has no present intention to pay cash dividends. Avatar is subject to certain restrictions on the payment of dividends as set forth in Item 8, "Notes to Consolidated Financial Statements". Item 6.

Item 6. Selected Financial Data FIVE YEAR COMPARISON OF SELECTED FINANCIAL DATA Dollars in thousands (except per-share data) (1) The Company adopted the installment method for homesite sales effective January 1, 1989. Prior to 1989, Avatar used the full accrual method of profit recognition for homesite sales. During 1993, the sale of the Midwest Water Utilities was completed. (See Results of Operations.) Item 7.

Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations (dollars in thousands) RESULTS OF OPERATIONS The following is management's discussion and analysis of certain significant factors that have affected Avatar during the periods included in the accompanying consolidated statements of operations. A summary of the period to period changes in the items included in the consolidated statements of income is shown below. Operations for the years ended December 31, 1993, 1992 and 1991 resulted in a pre-tax gain (loss) before the changes in accounting methods and extraordinary item of $18,236, ($4,342) and ($12,307), respectively. The improvement in pre-tax income during 1993 compared to 1992 is primarily attributable to the sale of the Midwest Water Utilities for $62,000 which resulted in a pre-tax gain of $21,822 and an adjustment to the estimated development liability for sold land as a result of the purchase of Rio Rico Utilities of $4,532. The improvement in pre-tax results of operations in 1992 compared to 1991 was primarily attributable to higher profit contributions from the Company's utility operations and lower real estate selling expenses. Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations (dollars in thousands) -- continued RESULTS OF OPERATIONS -- continued Avatar uses the installment method of profit recognition for homesite sales. Under the installment method the gross profit on recorded homesite sales is deferred and recognized in income of future periods, as principal payments on contracts are received. Fluctuations in deferred gross profit result from deferred gross profit on current homesite sales less recognized deferred gross profit on prior years' homesite sales. In accordance with the Company's business plan, the Company continued its gradual transition from selling predominantly Avatar- owned homesites to providing a diversified mix of products and services including introducing additional housing products, developing amenities and support facilities, expanding vacation ownership operations, expanding property management services and converting land holdings into income producing operations. Avatar's business plan also established objectives of modifying the Company's historic homesite sales program with the goal of maintaining or slightly increasing homesite sales volume. A slight improvement in consumer confidence and the economy combined to enable the Company to achieve budgeted levels for homesite sales volume in 1993. The 1993 average selling prices of housing and homesites were comparable to 1992 levels. Gross real estate revenues increased 15% during 1993 when compared to 1992 and decreased 7.9% during 1992 when compared to 1991. The increase in real estate revenues for 1993 when compared to 1992 is primarily a result of increased housing and homesite sales volume. Real estate expenses increased $2,594 or 5.8% in 1993 when compared to 1992 and decreased $7,831 or 14.9% in 1992 when compared to 1991. The increase in real estate expenses for 1993 when compared to 1992 is primarily a result of an increase in cost of products sold due to the increase in real estate sales. Margins have improved based on a reduction in related costs as a percentage of real estate sales and a more profitable sales mix of increased homesite and housing sales for 1993 when compared to 1992. The decline in real estate revenues and expenses for 1992 when compared to 1991 resulted primarily from decreased homesite and housing sales during 1992. Utility revenues decreased $7,252 or 13.6% during 1993 when compared to 1992 and increased $4,078 or 8.3% during 1992 when compared to 1991. Utility expenses decreased $1,991 or 5.4% during 1993 when compared to 1992 and increased $1,173 or 3.3% during 1992 when compared to 1991. Utility revenues decreased in 1993 as a result of the sale of the Midwest Water Utilities which closed on August 31, 1993. Utility expenses did not decline correspondingly primarily due to increased expenses relating to postretirement benefit costs. The increases for 1992 when compared to 1991 are due to increases in Avatar's customer base and rate increases. In comparing the remaining utility subsidiaries, revenues increased $1,565 or 6.4% in 1993 when compared to 1992 and expenses increased $4,699 or 38.9% in 1993 when compared to 1992. The increase in expenses is primarily a result of postretirement benefit costs, the amortization of rate case costs, and the accrual of professional fees. Interest income decreased $2,411 or 14.7% during 1993 when compared to 1992 and $2,686 or 14.1% during 1992 when compared to 1991. The declines in interest income are attributable to lower average aggregate balances of the Company's contract and mortgage notes receivable portfolio. The Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations (dollars in thousands) -- continued RESULTS OF OPERATIONS -- continued average balance of Avatar's receivable portfolio was $127,909, $153,053 and $181,550 for 1993, 1992 and 1991, respectively. This decrease in interest income was partially offset by earnings from Avatar's investment securities of $903, $479 and $927 for 1993, 1992 and 1991, respectively. Pre-tax gain on sale of subsidiaries of $21,822 in 1993 is a result of the sale of the Midwest Water Utilities which generated net proceeds of approximately $59,371. Other revenues for 1993 includes a reduction of the estimated development liability for sold land of $4,532 as a result of the purchase of Rio Rico Utilities. General and administrative expenses increased $811 or 10.4% in 1993 compared to 1992 and $196 or 2.6% during 1992 when compared to 1991. The increases in 1993 and 1992 are primarily a result of incentive compensation recorded for senior officers and an increase in professional fees. Additionally, an increase in real estate revenue contributed to the increase for 1993. Interest expense decreased $2,822 or 15.3% in 1993 when compared to 1992 and $738 or 3.8% during 1992 when compared to 1991. These decreases are attributable to an overall decrease in notes, mortgage notes and other debt outstanding during 1993 and lower interest rates during 1992 than in 1991. LIQUIDITY AND CAPITAL RESOURCES Avatar's primary business activities, which include homesite sales, land development and utility services, are capital intensive in nature. Avatar expects to fund its operations and capital requirements through a combination of cash and investment securities on hand, operating cash flows and external borrowings. In 1993, net cash provided by operating activities amounted to $9,925 and resulted primarily from operations including principal payments on contracts receivable of $21,249. Net cash provided by investing activities of $14,823 in 1993 resulted from the proceeds from the sale of subsidiaries of $59,371 and proceeds from the sale of securities of $17,444 reduced by investments in property, plant and equipment of $11,567 and investments in securities of $50,425. Net cash used in financing activities of $20,214 resulted primarily from the principal payment on revolving lines of credit and long-term borrowings of $48,538 and the purchase of treasury stock of $27,000 less net proceeds from revolving lines of credit and long-term borrowings of $26,121 and proceeds from the issuance of common stock in conjunction with the redemption/conversion of the 5-1/4% Debentures (as defined below) of $30,340. Avatar renegotiated certain of its existing bank credit lines and established a new credit line, thereby increasing its secured lines of credit from $36,200 at December 31, 1992, to $45,534 at December 31, 1993. Avatar's unsecured credit lines were decreased from $44,500 at December 31, 1992, to $15,000 at December 31, 1993. The unused portions of these credit lines were $17,000 and $10,325 for the secured and unsecured lines, respectively, at December 31, 1993. Included in these lines of credit is a new line of credit entered into during 1993, secured by investments, which had Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations (dollars in thousands) -- continued LIQUIDITY AND CAPITAL RESOURCES -- continued an outstanding balance at December 31, 1993 of $13,000 and will mature during the fourth quarter of 1994. Also included is an amended and restated line of credit with a balance outstanding at December 31, 1993 of $15,534 collateralized by certain contracts receivables and due May 31, 1995. Avatar has planned utility construction for 1994 totaling approximately $22,000. Additionally, the Company has planned land development expenditures of $9,700 during 1994, which will result in additional homesite inventory and preservation of development permits. It is anticipated that land development and utility construction expenditures for 1994 will be funded by operating cash flow and borrowings from external sources. On June 4, 1993 the Company called for the redemption of all its outstanding 5-1/4% convertible-purchase subordinated debentures due May 1, 2007 (the ``5-1/4% Debentures ) at a redemption price of 100% of the principal amount plus accrued and unpaid interest from January 15, 1993 through the redemption date of July 4, 1993. The principal purpose of the redemption was to reduce the Company's annual interest expense, improve its liquidity and increase its stockholders' equity. Holders were entitled to convert their 5-1/4% Debentures into shares of the Company's common stock at a conversion price of $23.00 per share provided they paid in cash an amount equal to the principal amount of the 5-1/4% Debentures being converted, for which they received additional shares of common stock equal to the number issued on conversion. A total of $30,917 principal amount of the 5-1/4% Debentures were converted and 2,688,276 shares of common stock were issued. The remaining $57 principal amount of 5-1/4% Debentures were redeemed as of July 4, 1993. The net result of this transaction, after expenses, was an increase in cash of $30,340, a decrease in debt of $30,973 and an increase in stockholders' equity of $60,835. The closing of the sale of the Midwest Water Utilities took place on August 31, 1993, with an aggregate selling price of $62,000, resulting in a pre-tax gain of $21,822. The Company has invested approximately $51,000 in investment securities which are classified as trading. The Company intends to continue to actively trade such securities in an effort to generate profits and will reinvest such profits until such time as the Company 's cash requirements necessitate the use or partial use of the portfolio proceeds. Avatar's investment portfolio at December 31, 1993 includes $20,045 invested in corporate bonds rated B- or above by Moody's and/or Standard and Poor's and $12,775 invested in non-rated bonds of companies which are in bankruptcy and have defaulted as to payments of principal and interest on such bonds. These bonds are thinly traded and may require sixty to ninety days to liquidate. The portfolio also includes an unsecured claim on a company in bankruptcy of $5,689 which is not readily marketable, $7,020 of equity securities, $1,661 of money market accounts and $3,994 of U.S. Goverment and Agency securities. As of December 31, 1993, $39,932 of the investments serves as collateral for a secured line of credit with an outstanding balance of $13,000. On September 30, 1993 the Company purchased 1,000,000 shares of the Company's common stock from the estate of Peter J. Sharp for $27.00 per share resulting in a decrease in cash of $27,000 and a corresponding decrease in stockholders' equity. These shares are being held in the Company's treasury for future corporate purposes. Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations (dollars in thousands) -- continued LIQUIDITY AND CAPITAL RESOURCES -- continued Avatar's Board of Directors has authorized expenditures for the purchase of Avatar's 8% and 9% senior debentures. During 1993, Avatar expended $31 for the purchase of its 8% senior debentures and $1,106 for the purchase of its 9% debentures. As of December 31, 1993, the remaining authorization for such expenditures was $4,301. As a result of the proceeds received from the sale of the Midwest Water Utilities and the redemption/conversion of the 5-1/4% Debentures, net of the funds expended for the stock repurchase, the Company believes it has sufficient capital resources to satisfy anticipated liquidity requirements. Management does not anticipate a significant change in interest rates for 1994, and accordingly, does not expect Avatar's primary business activities to be adversely affected by interest rates. Avatar's homesite sales are not dependent upon the customer obtaining third party financing. A high interest rate environment would be likely to adversely affect Avatar's real estate results of operations and liquidity because certain of Avatar's debt obligations are tied to prevailing interest rates. Increases in interest rates affecting the Company's utility operations generally are passed on to the consumer through the regulatory process. EFFECTS OF INFLATION AND ECONOMIC CONDITIONS Inflation has had a minimal impact on Avatar's operations over the past several years, and management believes its effect has been neither significant nor greater than its effect to the industry as a whole. It is anticipated that the impact of inflation on Avatar's operations for 1994 will not be significant. IMPACT OF TAX INSTALLMENT METHOD In 1992, 1991, 1989 and 1988, the Company elected the installment method for recording a substantial amount of its homesite sales in its federal income tax return, which deferred taxable income into future fiscal periods. As a result of this election, the Company may be required to pay compound interest on certain federal income taxes in future fiscal periods attributable to the taxable income deferred under the installment method. The Company believes that the potential interest amount, if any, will not be material to its financial position and results of operations of the affected future periods. RETIREMENT PLANS AND POSTRETIREMENT BENEFITS OTHER THAN PENSIONS In December 1990, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions". The Company adopted this statement in 1993, as required. This statement requires the accrual of postretirement benefits (such as health care benefits) during the years an employee provides services. These benefits for retirees are currently provided only to the employees of the Company's utility subsidiaries. The costs of these benefits were previously expensed on a pay-as-you-go basis. The accrual for postretirement benefit costs at December 31, 1993 amounted to $712. Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations (dollars in thousands) -- continued RETIREMENT PLANS AND POSTRETIREMENT BENEFITS OTHER THAN PENSIONS--continued As discussed in Notes J and K to the consolidated financial statements, the weighted average discount rate used in determining both the projected benefit obligation for the Company's defined benefit pension plan and the accumulated postretirement benefit obligation for its postretirement benefit plan is 8%. If the Company were to lower the discount rate by 1/2% in 1994, it would result in an increase in the obligation. To illustrate, a decrease in the discount rate from 8% to 7-1/2% in determining the projected benefit obligation for the Company's defined benefit pension plan, would increase the obligation by approximately $275 and pension expense by approximately $44. The same change in discount rate in estimating the accumulated postretirement benefit obligation for the Company's defined benefit postretirement plan, would increase the obligation by approximately $200. Because the Company has elected to record the transition obligation for postretirement benefits over 20 years, as allowed by Statement No. 106, the effect of reducing the discount rate from 8% to 7-1/2% in 1994 would be less than $30. Item 8.

Item 8. Financial Statements and Supplementary Data Report of Independent Certified Public Accountants.......... 20 Consolidated Balance Sheets -- December 31, 1993 and 1992... 21 Consolidated Statements of Operations -- For the years ended December 31, 1993, 1992, 1991.............................. 22 Consolidated Statements of Stockholders' Equity -- For the years ended December 31, 1993, 1992, 1991................. 23 Consolidated Statements of Cash Flows -- For the years ended December 31, 1993, 1992, 1991............................... 24 Notes to Consolidated Financial Statements.................. 26 REPORT OF INDEPENDENT CERTIFIED PUBLIC ACCOUNTANTS Stockholders and Board of Directors Avatar Holdings Inc. We have audited the accompanying consolidated balance sheets of Avatar Holdings Inc. and subsidiaries as of December 31, 1993, and 1992, and the related consolidated statements of operations, stockholders' equity, and cash flows for each of the three years in the period ended December 31, 1993. Our audits also included the financial statement schedules listed in the Index at Item 14. These financial statements and schedules are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements and schedules based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements and related schedules are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the consolidated financial position of Avatar Holdings Inc. and subsidiaries at December 31, 1993 and 1992, and the consolidated results of their operations and their cash flows for each of the three years in the period ended December 31, 1993, in conformity with generally accepted accounting principles. Also, in our opinion, the related financial statement schedules, when considered in relation to the basic financial statements taken as a whole, present fairly in all material respects the information set forth therein. As discussed in Note A to the consolidated financial statements, in 1993 the Company changed its methods of accounting for income taxes, investments and postretirement benefits other than pensions. /s/ ERNST & YOUNG Miami, Florida February 23, 1994, except for the third paragraph of Note R, as to which the date is March 1, 1994 AVATAR HOLDINGS INC. AND SUBSIDIARIES Consolidated Balance Sheets (Dollars in thousands) See notes to consolidated financial statements. AVATAR HOLDINGS INC. AND SUBSIDIARIES Consolidated Statements of Operations (Dollars in thousands except per share data) See notes to consolidated financial statements. AVATAR HOLDINGS INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY (Dollars in thousands except per-share data) (a) $1 par value per share; 15,500,000 shares authorized and 12,715,448, 10,026,956, and 10,020,827, shares issued at December 31, 1993, 1992 and 1991, respectively, including treasury stock. (b) Retained earnings is subsequent to the October 1, 1980 Plan of Reorganization. (c) Treasury stock included 3,620,346 shares at December 31, 1993 and 2,620,346 shares at December 31, 1992 and 1991. There are 5,000,000 authorized shares of preferred stock, none of which are issued. See notes to consolidated financial statements. AVATAR HOLDINGS INC. AND SUBSIDIARIES Consolidated Statements of Cash Flows (Dollars in Thousands) AVATAR HOLDINGS INC. AND SUBSIDIARIES Consolidated Statements of Cash Flows -- continued (Dollars in Thousands) SUPPLEMENTAL SCHEDULE OF NON-CASH TRANSACTIONS SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION SUPPLEMENTAL SCHEDULE OF NON-CASH FINANCING ACTIVITIES See notes to consolidated financial statements. AVATAR HOLDINGS INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS December 31, 1993 (Dollars in thousands except per-share data) NOTE A - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES Principles of Consolidation: The consolidated financial statements include Avatar Holdings Inc. and its subsidiaries ("Avatar"). All significant intercompany accounts and transactions have been eliminated in consolidation. General: Avatar is principally engaged in the business of developing and selling improved and unimproved real estate, single and multifamily residential housing and providing water and wastewater utility services. Restricted Cash: Restricted cash represents collections of monthly payments on pledged mortgage notes receivable. These collections will be applied to reduce the related mortgage trust notes (See Note H). Land Inventories: Land inventories are stated at the lower of cost or estimated net realizable value. Cost includes expenditures for acquisition, construction, development and carrying charges. Interest costs incurred during the period of land development, when applicable, are capitalized as part of the cost of such projects. Land acquisition costs are allocated to individual land parcels based upon the relationship that the estimated sales prices of specific parcels bear to the total sales price of the entire community. Construction and development costs are added to the value of the specific parcels for which the costs are incurred. Revenues: The Company uses the installment method of profit recognition for sales of homesites and vacation ownership units. Under the installment method, the gross profit on recorded sales is deferred and recognized in income of future periods as principal payments on related contracts are received. Under the installment method, deferred profit is included in the balance sheet, as a reduction of contracts receivable, until recognized. Sales of housing units are recognized in full upon the transfer of title to a purchaser. Revenues from commercial land and bulk land sales are recognized in full at closing, provided the purchaser's initial investment is adequate, all financing is considered collectible, and Avatar is not obligated to perform significant future activities. Utility revenues are recorded as the service is provided. NOTE A - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES -- continued Property, Plant and Equipment: Property, plant and equipment are stated at cost and depreciation is computed principally by the straight line method over the estimated useful lives of the assets. Depreciation, maintenance and operating expenses of equipment utilized in the development of land are capitalized as land inventory cost. Property Held for Sale: Property held for sale consists principally of utility property, plant and equipment related to certain water and wastewater utilities which were held for sale at December 31, 1992, and which were sold during 1993. Such assets are reflected at historical cost. Income Taxes: Effective January 1, 1993, the Company adopted Financial Accounting Standards Board ("FASB") Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes." Under Statement No. 109, the liability method is used in accounting for income taxes. Under this method, deferred income tax assets and liabilities are determined based on differences between financial reporting and tax basis of assets and liabilities and are measured using the enacted tax rates and laws that are expected to be in effect when the differences reverse. Prior to the adoption of Statement No. 109, income tax expense was based on items of income and expense that were reported in different years in the financial statements and tax returns and were measured at the tax rates in effect in the year the difference originated (deferred method). As permitted by Statement No. 109, the Company has elected not to restate the financial statements of any prior years. The cumulative effect of adopting Statement No. 109 resulted in a charge to net income during the first quarter of 1993 of $964. The cumulative effect of adopting Statement No. 109 for Avatar's utility subsidiaries was not credited or charged to net income, but was recorded as a regulatory liability or regulatory asset in accordance with accounting procedures applicable to regulated enterprises. The regulatory liabilities and regulatory assets will generally be amortized to income or expense over the useful life of the utility system and reflect probable future revenue reductions or increases from ratepayers. The effect of the change on income from continuing operations for the year ended December 31, 1993 was not material. Deferred Customer Betterment Fees: Amounts collected from customers for utility improvements are classified as "Deferred Customer Betterment Fees". These fees will be reclassified to "Contributions in Aid of Construction" when service to the customer begins. Contributions in Aid of Construction: Advances from real estate developers and other direct contributions to utility subsidiaries for plant construction are recorded as "Contributions in Aid of Construction". To the extent required by regulatory agencies, the account balance is amortized over the depreciable life of the utility plant as an offset to depreciation expense. NOTE A - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES -- continued Investments: In May 1993, the FASB issued Statement of Financial Accounting Standards No. 115, "Accounting for Certain Investments in Debt and Equity Securities" which, among other things, requires companies to classify certain debt and equity securities as "held to maturity", "available for sale" or "trading." The Company elected to adopt Statement No. 115 as of December 31, 1993, and has classified all of its investment portfolio as trading. This category is defined as including debt and marketable equity securities held for resale in anticipation of earning profits from short-term movements in market prices. Trading account securities are carried at fair value which was $51,184 at December 31, 1993. Subsequent to the initial adoption of Statement No. 115, both realized and unrealized gains and losses will be included in net trading account profit. The cumulative effect as of December 31, 1993 of adopting Statement No. 115 was an increase in net income of $388 (net of income taxes of $238) or $.04 per share. Postretirement Benefits: In 1993, the Company adopted Statement of Financial Accounting Standards No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions". This statement requires the accrual of postretirement benefits (such as health care benefits) during the years an employee provides services. These benefits for retirees currently are provided only to the employees of the Company's utility subsidiaries. The costs of these benefits were previously expensed on a pay-as-you-go basis. Net Income Per Common Share: Net income per common share is computed on the basis of the weighted average number of shares outstanding plus common stock equivalents, if any, that would result from the dilutive effect of the assumed conversion (and associated purchase) of the 5-1/4% convertible-purchase subordinated Debentures. In 1993, $30,917 of the Company's 5-1/4% convertible-purchase subordinated Debentures were converted into 2,688,276 shares of common stock. The result of this redemption and conversion was dilutive for the year ended December 31, 1993. The primary and fully diluted computations assume the actual conversion occurred at the beginning of the year. Reclassifications: Certain 1992 and 1991 financial statement items have been reclassified to conform with 1993 presentation. NOTE B - REAL ESTATE SALES The components of real estate sales are as follows: NOTE C - INVESTMENTS Avatar's investment portfolio at December 31, 1993 includes $20,045 invested in corporate bonds rated B- or above by Moody's and/or Standard and Poor's and $12,775 invested in non-rated bonds of companies which are in bankruptcy and have defaulted as to payments of principal and interest on such bonds. These bonds are thinly traded and may require sixty to ninety days to liquidate. The portfolio also includes an unsecured claim on a company in bankruptcy of $5,689 which is not readily marketable, $7,020 of equity securities, $1,661 of money market accounts and $3,994 of U.S. Government and Agency securities. Fair values for actively traded debt securities and equity securities are based on quoted market prices on national markets. Fair values for thinly traded investment securities are generally based on prices quoted by investment brokerage companies. At December 31, 1992 investments securities consisted of U.S. Treasury Notes and Bills. Investments securities at December 31, 1992 are carried at cost which approximates market value. NOTE D - CONTRACTS, MORTGAGE NOTES AND OTHER RECEIVABLES Contracts, mortgage notes and other receivables are summarized as as follows: Contracts and mortgage notes receivable are generated through the sale of homesites at various sales offices located throughout the northeast, midwest and west coast of the United States. A significant portion of the contracts and mortgage notes receivable at December 31, 1993, resulted from sales made to customers in the northeast. Contracts receivable are collectible primarily over a ten year period and bear interest at rates primarily ranging from 7 1/2% to 12% per annum (weighted average rate 9.9%). A contract receivable is considered delinquent if the scheduled installment payment remains unpaid 30 days after its due date. Delinquent principal amounts of contracts and mortgage notes receivable at December 31, 1993, and 1992 were $13,442 or 11.5% and $18,365 or 13.3%, respectively. Scheduled maturities for the five years subsequent to 1993 are: 1994 - $16,072; 1995 - $19,289; 1996 - $20,209; 1997 - $19,546 and 1998 - $16,285. NOTE E - LAND AND OTHER INVENTORIES Inventories consist of the following: NOTE F - ESTIMATED DEVELOPMENT LIABILITY FOR SOLD LAND The estimated cost to complete required land and utility improvements in all areas designated for homesite sales is summarized as follows: These estimates are based on engineering studies of quantities of work to be performed based on current estimated costs. These estimates are reevaluated annually and adjusted accordingly. A major portion of the estimated development liability for sold land relates to utility extensions for homesites at Avatar's Arizona community (Rio Rico) which were sold prior to 1980. At Rio Rico, Avatar entered into various service and construction agreements with Citizens Utilities Company (Citizens), a non-related company, generally providing for Avatar to construct certain utility facilities and deed them to Citizens. Avatar's expenditures, related to the construction of some of these facilities, are expected to be reimbursed from Citizens' present and future customers. Some of these reimbursable amounts are determined by specific formulas. The recovery of these expenditures is dependent upon the community attaining an occupancy and/or usage level sufficient to allow reimbursement prior to the expiration of the agreements. During 1993, Avatar purchased Citizens Utilities' water and wastewater treatment division thereby eliminating the portion of the existing agreement relating to water and wastewater extensions, leaving only the electrical portion. Avatar may be obligated to advance to its utility subsidiary approximately $9,200 (current costs) to complete water and wastewater utility facilities at its Poinciana subdivision. These possible future obligations are based on internal engineering studies and are not included in the estimated development liability discussed above. As such, past and future expenditures are expected to be recovered from customers' fees and future revenues. Expenditures, net of recoveries, for homesite improvement costs totaling $29,933 are estimated as follows: 1994-$8,967, 1995-$8,381 and $12,585 thereafter. Because the timing of the expenditures after 1995 is dependent upon certain future occurrences beyond Avatar's control, projection by year after 1995 is not presently practicable. NOTE G - PROPERTY, PLANT AND EQUIPMENT Property, plant and equipment and accumulated depreciation consist of the following: Depreciation charged to operations during 1993, 1992 and 1991 was $6,524, $7,607 and $6,373, respectively, net of amortization of contributions in aid of construction of $2,917, $2,632 and $2,532, during 1993, 1992 and 1991, respectively. NOTE H - NOTES, MORTGAGE NOTES AND OTHER DEBT Notes, mortgage notes and other debt are summarized as follows: NOTE H - NOTES, MORTGAGE NOTES AND OTHER DEBT - continued At December 31, 1993, Avatar had unsecured bank credit lines of $15,000 and secured bank credit lines of $45,534. The unused portions of the unsecured and secured lines were $10,325 and $17,000, respectively. Interest rates for borrowings under these lines range from 4 1/2% to 6% on the unsecured bank credit lines and from 4 3/4% to 6 1/4% on the secured bank credit lines at December 31, 1993. Additionally, certain credit lines provide for fixed rate borrowing pursuant to Eurodollar interest rates. Under the terms of these agreements Avatar is restricted from paying dividends with certain exceptions and is required to maintain a minimum net worth as defined. The secured lines are collateralized by certain contracts and mortgage notes receivable of $20,712 and investment securities of $39,932 at December 31, 1993. In July 1992, Avatar issued $51,160 of 7% Mortgage Trust Notes, pursuant to the securitization of a portion of its homesite receivables. The notes mature on December 15, 2002, however, the Company expects the notes to be repaid in approximately 36 months through the collection of principal payments, including principal prepayments and late collections and all interest payments, net of servicing fee and other adjustments on the mortgage loans. Additionally, all liquidation proceeds with respect to the mortgage loans, proceeds from the sale of property acquired through foreclosure or deed-in-lieu of foreclosure proceedings and proceeds from the purchase of mortgage loans by the issuer are required to be applied to these notes. The balance of these notes at December 31, 1993 was $32,439. Maturities of notes, mortgage notes and other debt at December 31, 1993, are as follows: Maturities for 1994 include approximately $15,633 related to the Company's bank credit lines. There is no assurance that Avatar will be able to obtain satisfactory extensions or refinancing of these or other credit lines. Interest capitalized during 1993, 1992 and 1991 amounted to $381, $772, and $746, respectively. Property, plant and equipment and inventory pledged as collateral for notes, mortgage notes and other indebtedness had a net book value of approximately $151,000 at December 31, 1993. NOTE I - MINORITY INTEREST IN CONSOLIDATED SUBSIDIARIES As of December 31, 1993 and 1992, preferred stock outstanding is as follows: Avatar's utility subsidiary's 9% cumulative preferred stock issue provides for redemption to occur no earlier than March 1, 1997, in whole or in part; however, a minimum of $1,800 of the preferred stock must be redeemed per annum beginning in 1997. A redemption of all outstanding shares shall occur no later than March 1, 2001. Maturities of preferred stock are as follows: 1997-$1,800, 1998 - $1,800 and $5,458 thereafter. Charges to operations recorded as "Other Expenses" relating to preferred stock dividends of subsidiaries amounted to $1,261 in 1993, $1,544 in 1992, and $1,231 in 1991. NOTE J - RETIREMENT PLANS Avatar has two defined contribution savings plans that cover substantially all employees. Under one of the savings plans, Avatar contributes to the plan based upon specified percentages of employees' voluntary contributions. The other savings plan does not provide for contributions by Avatar. Avatar's non-contributory defined benefit pension plan covers substantially all employees of its subsidiary, Avatar Utilities Inc. The benefits are based on years of service and the employees' compensation during the highest 5 out of the last 10 years of employment. Avatar's funding policy is to contribute amounts to the plan sufficient to meet the minimum funding requirements set forth in the Employee Retirement Income Security Act of 1974. NOTE J - RETIREMENT PLANS - continued The following table sets forth the defined benefit plan's funded status as of December 31, 1993, 1992 and 1991 and the retirement expense recognized in the consolidated statements of income for the years then ended. The weighted-average discount rate and rate of increase in future compensation levels used in determining the actuarial present value of the projected benefit obligation were 8% and 6%, respectively, at December 31, 1993, 1992 and 1991. The expected long-term rate of return on plan assets for 1993, 1992 and 1991 was 8%. At December 31, 1993, and 1992, the plan assets are invested in a group annuity contract with a major insurance company. Approximately 70% and 80%, respectively, of the plan assets at December 31, 1993 and 1992, are invested in a general asset fund of the insurance company that is comprised primarily of fixed income securities. The remaining assets are invested in equity securities, public bonds and cash equivalents in the insurance company's separate accounts. NOTE K - POSTRETIREMENT BENEFITS OTHER THAN PENSIONS Avatar's utility subsidiary sponsors a defined benefit postretirement plan that provides medical and life insurance benefits to both salaried and nonsalaried employees after retirement. The postretirement medical and life insurance plan is non-contributory. Avatar's utility subsidiary's funding policy for its postretirement plan is to fund on a pay-as-you-go basis. Prior to 1993, the expense was also measured on this basis. In 1993, the Company adopted FASB Statement No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions", which requires accounting for postretirement benefits on an accrual basis. The effect of adopting Statement No. 106 increased net periodic postretirement benefit expense by $712 for 1993. Postretirement expense for 1992 and 1991 has not been restated. The following table sets forth the plan's status as of December 31, 1993: For measurement purposes, a 13% annual rate of increase in the per capita cost of covered health care benefits was assumed for 1993; the rate of increase was assumed to decrease gradually to 6% for the year 2000 and remain at that level thereafter. The health care cost trend rate assumption has a significant effect on the amounts reported. To illustrate, increasing the assumed health care cost trend rates by 1 percentage point each year would increase the accumulated postretirement benefit obligation as of December 31, 1993 by $626 and the aggregate of the service and interest cost components of net periodic postretirement benefit for the year then ended by $122. The weighted average discount rate used in determining the accumulated postretirement benefit obligation is 8%. NOTE L - LEASE COMMITMENTS Avatar leases the majority of its administration and sales offices under operating leases that expire at varying times through 1999. Rental expenses for the years 1993, 1992 and 1991 were $1,186, $1,513, and $2,037, respectively. Minimum rental commitments under noncancelable operating leases as of December 31, 1993 were as follows: 1994 - $954; 1995 - $929; 1996 - $923; 1997-$746; 1998 - $618; and thereafter - $1,512. NOTE M - ACCRUED AND OTHER LIABILITIES Accrued and other liabilities are summarized as follows: As of December 31, 1993, the Company had agreements with four executive officers providing as incentive compensation a cash payment to each officer (to the extent vested), within ten days following the respective fifth anniversary date of the respective agreement (or the termination date, if earlier), in an amount equal to the excess of a formula amount based upon the closing prices of Avatar common stock during a specified period prior to the respective fifth anniversary date (or termination date, if earlier) over the closing price of Avatar common stock on the date of the respective agreement. Each of these executive officers will vest in the rights to this incentive compensation with respect to one-fifth thereof on each of the first through fifth anniversaries, subject to certain terms and conditions of the contracts should their employment status change prior to the fifth anniversary. For the year ended December 31, 1993, the Company recorded incentive compensation of $469 associated with these agreements. The liability for incentive compensation included in other liabilities at December 31, 1993 and 1992 is $754 and $285, respectively. (See Note R - Contingencies) NOTE N - INCOME TAXES Avatar Holdings Inc. is the successor in interest to GAC Corporation. GAC, together with certain of its subsidiaries, was reorganized pursuant to Chapter X of the Federal Bankruptcy Act of 1898. The Bankruptcy Court confirmed the Trustees' Plan of Reorganization and issued a final decree on October 16, 1981, discharging the Trustees from their duties. Under the installment method of tax reporting for homesite sales, Avatar anticipates that its 1993 consolidated federal income tax return will reflect a net operating loss carryforward of approximately $18,000, which expires in years 2003 through 2004. The net operating loss carryforward was generated after the reorganization as a result of electing the installment method of reporting homesite sales for tax purposes. In addition, investment tax credits and alternative minimum tax credit carryforwards of approximately $5,000 are available, a portion of which expires in years 1994 to 2001. These NOTE N - INCOME TAXES - continued carryforwards have not been examined by the Internal Revenue Service. The Company has recorded a valuation allowance of $33,000 with respect to the deferred income tax assets which remain after offset by the deferred income tax liabilities. Included in the valuation allowance for deferred income tax assets is approximately $9,000 which, if utilized, will be credited to additional paid-in capital. Deferred income taxes reflect the net tax effect of temporary differences between the carrying amounts of assets and liabilities for financial reporting purposes and the amounts used for income tax purposes. Significant components of the Company's deferred income tax assets and liabilities as of December 31, 1993 are as follows: The provision for income taxes consists of the following: Deferred income tax credits result from timing differences in the recognition of certain expenses for tax and financial reporting purposes. For the years ended December 31, 1992 and 1991, the principal components of deferred income tax credits are the theoretical income tax related to the interest discount NOTE N - INCOME TAXES - continued on debentures issued as part of the reorganization and the deferred income tax attributable to the difference between book and income tax depreciation on certain utility assets with long useful lives. A reconciliation of income tax expense (credit) to the expected income tax expense (credit) at the federal statutory rate of 35% for the twelve months ended December 31 is as follows: In 1992, 1991, 1989 and 1988, the Company elected the installment method for recording a substantial amount of its homesite sales in its federal income tax return, which deferred taxable income into future fiscal periods. As a result of such election, the Company may be required to pay compound interest on certain federal income taxes in future fiscal periods attributable to the taxable income deferred under the installment method. The Company believes that the potential interest amount, if any, will not be material to its financial position and results of operations of the affected future periods. NOTE O - SALE OF SUBSIDIARIES On January 30, 1993, the Company entered into stock purchase agreements for the sale of its Midwest Water Utilities located in Indiana, Missouri, Ohio, and Michigan. The closing of the sale of the midwest water utilities took place on August 31, 1993, with an aggregate selling price of $62,000, resulting in a pre-tax gain of $21,822, subject to post-closing adjustments. NOTE P - REDEMPTION/CONVERSION OF 5-1/4% CONVERTIBLE-PURCHASE SUBORDINATED DEBENTURES On June 4, 1993 the Company called for the redemption of all its outstanding 5-1/4% convertible-purchase subordinated Debentures due May 1, 2007 at a redemption price of 100% of the principal amount plus accrued and unpaid interest from January 15, 1993 through the redemption date, July 4, 1993. Holders were entitled to convert their 5-1/4% Debentures into shares of the Company's common stock at a conversion price of $23.00 per share provided they paid in cash an amount equal to the principal amount of the 5-1/4% Debentures being converted, for which they received additional shares of common stock equal to the number issued on conversion. A total of $30,917 principal amount of the 5-1/4% Debentures were converted and 2,688,276 shares of common stock were NOTE P - REDEMPTION/CONVERSION OF 5-1/4% CONVERTIBLE-PURCHASE SUBORDINATED DEBENTURES - continued issued. The remaining $57 principal amount of 5-1/4% Debentures were redeemed as of July 4, 1993. The net result of this transaction, after expenses, was an increase in cash of $30,340, a decrease in debt of $30,973 and an increase in stockholders' equity of $60,835. NOTE Q - TREASURY STOCK PURCHASE On September 30, 1993 the Company purchased 1,000,000 shares of the Company's common stock from the estate of Peter J. Sharp at a purchase price of $27.00 per share. These shares are being held in the Company's treasury for future corporate purposes. NOTE R - CONTINGENCIES Avatar is involved in various pending litigation matters primarily arising in the normal course of its business. Although the outcome of these and the following matters can not be determined, it is the opinion of management that the resolution of these matters will not have a material effect on Avatar's business or financial position. On October 1, 1993, the United States, on behalf of the U.S. Environmental Protection Agency, filed a civil action against a utility subsidiary of Avatar in the U.S. District Court for the Middle District of Florida. (United States vs. Florida Cities Water Company, Civil Action No. 93-281-C1) The complaint alleges that the subsidiary's wastewater treatment plant in North Fort Myers, Florida, committed various violations of the Clean Water Act, 33 U.S.C. S1251 et seq., including (1) discharge of pollutants without an operating permit from October 1, 1988 to October 31, 1989; (2) discharging from an unpermitted discharge location from November 1, 1989 until July 14, 1992; and (3) discharging pollutants in excess of permit limitations at various times from July 1991 to June of 1992. The government is seeking the statutory maximum civil penalties of $25,000 per day, per violation based upon the allegations. The Subsidiary strongly believes that there are mitigating factors as well as valid legal defenses that could reduce or eliminate the imposition of monetary sanctions. On March 1, 1994, the Wisconsin Department of Natural Resources (the "Department") sent Avatar notice that the Department had recently issued a second Record of Decision ("ROD") in connection with the Edgerton Sand & Gravel Landfill site (the "Site"). The ROD calls for the City of Edgerton's public water supply system to be extended to the owners of private wells in the vicinity of the Site. The ROD also states that other work related to soil and groundwater remedial action would be required at the Site. The Department demanded that all potentially responsible parties ("PRP's") associated with the Site organize into a PRP group to undertake the implementation of the ROD. Avatar was previously identified as a PRP by the Department. Avatar believes that it is not liable for any claims by any governmental or private party in connection with the Site. On February 25, 1994, the Company's former President and Chief Executive Officer commenced a lawsuit against Avatar and others claiming damages arising out of his termination of his employment purportedly for "Good Reason" (as defined in his employment agreement.) He also seeks to recover damages from Avatar for libel and slander and from the other defendants based on their alleged malicious interference with his employment agreement. Avatar denies that he had Good Reason to terminate his employment agreement. Avatar does not believe there is any valid basis for his claims, and various affirmative defenses have been asserted. Avatar also has asserted counterclaims against him for breach of contract, promissory estoppel and improper inducement in connection with amendments to his employment agreement. NOTE S - FINANCIAL INFORMATION RELATING TO INDUSTRY SEGMENTS NOTE S - FINANCIAL INFORMATION RELATING TO INDUSTRY SEGMENTS -- continued (a) Avatar's businesses are primarily conducted in the United States. (b) In computing operating profit, interest has been reflected separately. (c) Intersegment revenues contain primarily intercompany interest and management fees charged to affiliates. (d) Identifiable assets by segment are those assets that are used in the operations of each segment. General corporate assets are principally cash, receivables and investments. (e) No significant part of the business is dependent upon a single customer or group of customers. (f) Cable TV, mortgage and hotel and recreational operations which primarily serve Avatar communities do not qualify individually as separate reportable segments and are included in the real estate segment. (g) General corporate expenses are included in the real estate segment. NOTE T- FAIR VALUE OF FINANCIAL INSTRUMENTS The carrying amounts and fair values of the Company's financial instruments at December 31, 1993, are as follows: The following methods and assumptions were used by the Company in estimating the fair value of financial instruments: Cash and restricted cash: The carrying amount reported in the balance sheet for cash approximates its fair value. Investments: The carrying amount in the balance sheet for investments is at fair market value which is generally determined by quoted market prices. Contracts, mortgage notes and other receivables: The fair value amount of the Company's contracts, mortgage notes, and other receivables are estimated based on a discounted cash flow analysis. Notes, mortgage notes and other debt: The carrying amounts of the Company's borrowings under its short-term bank credit lines approximate their fair value. The fair values of the Company's mortgage obligations, mortgage bonds, and promissory notes are estimated using discounted cash flow analysis, based on the Company's current incremental borrowing rates for similar types of borrowing arrangements. NOTE T- FAIR VALUE OF FINANCIAL INSTRUMENTS - continued Senior debentures: The fair values of the Company's Senior and Subordinated debentures are estimated based on quoted market prices. Mortgage trust notes: The carrying amount in the balance sheet for mortgage trust notes approximates its fair value. The current market rate for similar types of borrowing arrangements approximates the rate of the mortgage trust notes. NOTE U - QUARTERLY FINANCIAL DATA (UNAUDITED) Summarized quarterly financial data for 1993 and 1992 is as follows: (1) Net revenues include homesite sales which are recorded on the installment method of profit recognition. Item 9.

Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosures. Not applicable. PART III Item 10.

Item 10. Directors and Executive Officers of the Registrant A. Identification of Directors The information called for in this item is incorporated by reference to Avatar's 1994 definitive proxy statement (under "Election of Directors") to be filed with the Securities and Exchange Commission on or before April 30, 1994. B. Identification of Executive Officers For information with respect to the executive officers of Avatar, see "Executive Officers of the Registrant" at the end of Part I of this report. Item 11.

Item 11. Executive Compensation The information called for by this item is incorporated by reference to Avatar's 1994 definitive proxy statement (under the caption "Executive Compensation and Other Information") to be filed with the Securities and Exchange Commission on or before April 30, 1994. Item 12.

Item 12. Security Ownership of Certain Beneficial Owners and Management The information called for by this item is incorporated by reference to Avatar's 1994 definitive proxy statement (under the captions "Principal Stockholders" and "Security Ownership of Management") to be filed with the Securities and Exchange Commission on or before April 30, 1994. Item 13.

Item 13. Certain Relationships and Related Transactions None PART IV Item 14.

Item 14. Exhibits, Financial Statement Schedules, and Reports on Form 8-K Financial Statements and Schedules: See Item 8 "Financial Statements and Supplementary Data" on Page 17 of this report. Schedules: I - Marketable Securities and Other Investments V - Property, Plant and Equipment VI - Accumulated Depreciation, Depletion and Amortization of Property, Plant and Equipment VIII - Valuation and Qualifying Accounts IX - Short-Term Borrowings X - Supplementary Income Statement Information Schedules other than those listed above are omitted, since the information required is not applicable or is included in the financial statements or notes thereto. Exhibits: 3(a) * Certificate of Incorporation, as amended (previously filed as an exhibit to the Form 10-K for the year ended December 31, 1986). 3(b) By-laws, as amended through March 24, 1994 (filed herewith). 4(a) * Instruments defining the rights of security holders, including indenture for 8% senior debentures (previously filed as an exhibit to the Form 8-K dated as of September 12, 1980). 4(b) * Supplemental Indenture for 8% senior debentures dated as of December 19, 1992 (previously filed as an exhibit to Form 10-K for the year ended December 31, 1992). 4(c) * Indenture for 9% senior debentures dated as of December 19, 1992 (previously filed as an exhibit to Form 10-K for the year ended December 31, 1992). 4(d) * Indenture for 5-1/4% convertible-purchase subordinated debentures dated May 1, 1987 (previously filed as an exhibit to Form 10-Q for the period ended March 31, 1987). Item 14. Exhibits, Financial Statement Schedules, and Reports on Form 8-K -- continued 10(a) * Consulting Agreement, dated as of December 31, 1990, by and between Avatar Properties Inc. and John Sladkus (previously filed as an exhibit to Form 10-K for the year ended December 31, 1990). Consulting Agreement, dated as of December 31, 1990, by and between Avatar Utilities Inc. and John Sladkus (previously filed as an exhibit to Form 10-K for the year ended December 31, 1990). 10(b) * 1 Employment Agreement, dated as of June 15, 1992, by and between Avatar Holdings Inc. and Lawrence Wilkov (previously filed as an exhibit to Form 10-K for the year ended December 31, 1992). 10(c) * 1 Employment Agreement, dated as of June 15, 1992, by and between Avatar Holdings Inc. and Edwin Jacobson (previously filed as an exhibit to Form 10-K for the year ended December 31, 1992). 10(d) 1 Amendment to Employment Agreement, dated as of March 1, 1994, by and between Avatar Holdings Inc. and Edwin Jacobson (filed herewith). 10(e) * Four separate Stock Purchase Agreements dated January 30, 1993, with respect to the sale of the Registrant's utilities located in Indiana, Missouri, Ohio and Michigan, respectively (previously filed as an exhibit to Form 8-K dated as of February 3, 1993). 10(f) * Agreement dated January 30, 1993, with respect to the transactions contemplated by the Stock Purchase Agreements (previously filed as an exhibit to Form 8-K dated as of February 3, 1993). 10(g) * Guarantee by the Registrant (previously filed as an exhibit to Form 8-K dated as of February 3, 1993). 10(h) * Guarantee by American Water Works Company, Inc. (previously filed as an exhibit to Form 8-K dated as of February 3, 1993). 10(i) 1 Incentive Compensation Agreement, dated as of January 18, 1993 by and between Avatar Holdings Inc. and Dennis Getman (filed herewith). 10(j) 1 Incentive Compensation Agreement, dated as of September 9, 1993 by and between Avatar Holdings Inc. and Charles McNairy (filed herewith). 10(k) Revolving Credit Agreement between Avatar Properties Inc. and BHF Bank dated November 30, 1993 (filed herewith). 11 Statement Re: Computation of per share earnings (filed herewith). Item 14. Exhibits, Financial Statement Schedules, and Reports on Form 8-K -- continued 22 Subsidiaries of the Registrant (filed herewith). Reports on Form 8-K: No reports on Form 8-K were filed during the quarter ended December 31, 1993. * These exhibits are incorporated by reference and are on file with the Securities and Exchange Commission. 1 Employment and compensation agreements. SCHEDULE I - MARKETABLE SECURITIES AND OTHER INVESTMENTS AVATAR HOLDINGS INC. AND SUBSIDIARIES (Dollars in thousands, except number of shares) (1) Corporation in Bankruptcy/Principal and Interest in Default SCHEDULE V - PROPERTY, PLANT AND EQUIPMENT AVATAR HOLDINGS INC. AND SUBSIDIARIES (Dollars in thousands) SCHEDULE VI - ACCUMULATED DEPRECIATION, DEPLETION AND AMORTIZATION OF PROPERTY, PLANT AND EQUIPEMNT AVATAR HOLDINGS INC. AND SUBSIDIARIES (Dollars in thousands) (1) The annual provisions for depreciation have been computed principally in accordance with the following ranges of rates: Utility, plant and equipment 1.5% to 10% Other property, plant and equipment 5% to 20% (a) Charged principally to estimated cost of development of land sold and amortization of contributions in aid of construction. SCHEDULE VIII - VALUATION AND QUALIFYING ACCOUNTS AVATAR HOLDINGS INC. AND SUBSIDIARIES (Dollars in thousands) (1) Charged to operations as a reduction of revenues. (2) Uncollectible accounts written off (3) Credited principally to interest income or allowance for doubtful accounts upon write-off of uncollectible accounts. (4) Valuation allowance for deferred tax assets recorded in conjunction with the adoption of FASB Statement No. 109. SCHEDULE IX - SHORT-TERM BORROWINGS AVATAR HOLDINGS INC. AND SUBSIDIARIES (Dollars in thousands) SCHEDULE X - SUPPLEMENTARY INCOME STATEMENT INFORMATION AVATAR HOLDINGS INC. AND SUBSIDIARIES (Dollars in thousands) Amounts for royalties not presented as such amounts are less than one percent of total revenue. SIGNATURES ---------- Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, as amended, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. AVATAR HOLDINGS INC. Dated: March 24, 1994 By: /s/Charles L. McNairy Charles L. McNairy, Executive Vice President, Treasurer and Chief Financial Officer Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant in the capacities and on the dates indicated. Dated: March 24, 1994 By: /s/Geoffrey C. Hazard, Jr. Geoffrey C. Hazard, Jr., Director and Audit Committee Member Dated: March 24, 1994 By: /s/J. Edward Houston J. Edward Houston, Director, Chairman of the Audit Committee and Executive Committee Member Dated: March 24, 1994 By: /s/Edwin Jacobson Edwin Jacobson, Director, Chairman of the Executive Committee, President and Chief Executive Officer Dated: March 24, 1994 By: /s/Leon T. Kendall Leon T. Kendall, Director and Audit Committee Member Dated: March 24, 1994 By: /s/Leon Levy Leon Levy, Chairman of the Board of Directors and Executive Committee Member Dated: March 24, 1994 By: /s/Martin Meyerson Martin Meyerson, Director and Audit Committee Member Dated: March 24, 1994 By: /s/William Porter William Porter, Director and Audit Committee Member Dated: March 24, 1994 By: /s/Fred Stanton Smith Fred Stanton Smith, Director and Executive Committee Member Dated: March 24, 1994 By: /s/Henry King Stanford Henry King Stanford, Director Dated: March 24, 1994: By: Lawrence Wilkov, Director Dated: March 24, 1994 By: /s/John J. Yanopoulos John J. Yanopoulos, Vice-President - Finance and Controller Exhibit Index 3(a) * Certificate of Incorporation, as amended (previously filed as an exhibit to the Form 10-K for the year ended December 31, 1986). 3(b) By-laws, as amended through March 24, 1994 (filed herewith)........................................60 4(a) * Instruments defining the rights of security holders, including indenture for 8% senior debentures (previously filed as an exhibit to the Form 8-K dated as of September 12, 1980). 4(b) * Supplemental Indenture for 8% senior debentures dated as of December 19, 1992 (previously filed as an exhibit to Form 10-K for the year ended December 31, 1992). 4(c) * Indenture for 9% senior debentures dated as of December 19, 1992 (previously filed as an exhibit to Form 10-K for the year ended December 31, 1992). 4(d) * Indenture for 5-1/4% convertible-purchase subordinated debentures dated May 1, 1987 (previously filed as an exhibit to Form 10-Q for the period ended March 31, 1987). 10(a) * Consulting Agreement, dated as of December 31, 1990, by and between Avatar Properties Inc. and John Sladkus (previously filed as an exhibit to Form 10-K for the year ended December 31, 1990). Consulting Agreement, dated as of December 31, 1990, by and between Avatar Utilities Inc. and John Sladkus (previously filed as an exhibit to Form 10-K for the year ended December 31, 1990). 10(b) * Employment Agreement, dated as of June 15, 1992, by 1 and between Avatar Holdings Inc. and Lawrence Wilkov (previously filed as an exhibit to Form 10-K for the year ended December 31, 1992). 10(c) * Employment Agreement, dated June 15, 1992, by 1 and between Avatar Holdings Inc. and Edwin Jacobson (previously filed as an exhibit to Form 10-K for the year ended December 31, 1992). 10(d) Amendment to Employment Agreement, dated as of March 1, 1994, by and between Avatar Holdings Inc. and Edwin Jacobson (filed herewith).................80 10(e) * Four separate Stock Purchase Agreements dated January 30, 1993, with respect to the sale of the Registrant's utilities located in Indiana, Missouri, Ohio and Michigan, respectively (previously filed as an exhibit to Form 8-K dated as of February 3, 1993). 10(f) * Agreement dated January 30, 1993, with respect to the transactions contemplated by the Stock Purchase Agreements (previously filed as an exhibit to Form 8- K dated as of February 3, 1993). Exhibit Index -- continued 10(g) * Guarantee by the Registrant (previously filed as an exhibit to Form 8-K dated as of February 3, 1993). 10(h) * Guarantee by American Water Works Company, Inc. (previously filed as an exhibit to Form 8-K dated as of February 3, 1993). 10(i) 1 Incentive Compensation Agreement, dated as of January 18, 1993 by and between Avatar Holdings Inc. and Dennis Getman (filed herewith)......................82 10(j) 1 Incentive Compensation Agreement, dated as of September 9, 1993 by and between Avatar Holdings Inc. and Charles McNairy (filed herewith)............... 93 10(k) Revolving Credit Agreement between Avatar Properties Inc. and BHF Bank dated November 30, 1993 (filed herewith)..........................................102 11 Statement Re: Computation of per share earnings (filed herewith)...................................138 22 Subsidiaries of the Registrant (filed herewith)..........................................139 * These exhibits are incorporated by reference and are on file with the Securities and Exchange Commission. 1 Employment and Compensation agreements.

312667_1993.txt

312667

1993

ITEM 1. BUSINESS INTRODUCTION Spelling Entertainment Group Inc. (the "Company") is a fully- integrated producer and distributor of filmed entertainment and has an extensive library of television series, mini-series, movies-for-television, pilots and feature films (collectively referred to hereinafter as "film product"), which are licensed for viewing both in the United States and international markets. The Company also licenses music and merchandising rights associated with its film product. The Company's current entertainment operations are conducted through subsidiaries of Spelling Entertainment Inc. ("SEI"). The Company acquired 82% of SEI in the first half of 1991 and the remainder in July 1992 (see Note 2 to the Company's Consolidated Financial Statements; references to Notes hereinafter refer to the notes to such financial statements). The Company's production operations are conducted by Spelling Television and Laurel Entertainment ("Laurel"); distribution activities are conducted primarily through Worldvision Enterprises, Inc. ("Worldvision") and Spelling Films International ("SFI"); licensing and merchandising activities are conducted by Hamilton Projects. Unless the context indicates otherwise, "Spelling" or the "Company" refers to Spelling Entertainment Group Inc. and its subsidiaries. The Company's former petroleum operations have been sold and are classified as discontinued operations in the accompanying financial statements (see "Discontinued Operations" and Note 11). Approximately 48% of the Company's Common Stock was owned by American Financial Corporation and its subsidiaries ("AFC") until March 31, 1993, when AFC sold the Common Stock it owned to Blockbuster Entertainment Corporation and its subsidiaries ("BEC"). BEC acquired additional Common Stock during 1993, both from third parties and from the Company (see Note 7). As of March 25, 1994 BEC owned approximately 70.5% of the Company's outstanding stock. In September 1993, the Company and Republic Pictures Corporation ("Republic") entered into an agreement in principle pursuant to which the Company agreed to acquire by merger all of the outstanding shares of common stock of Republic for $13 per share in cash (the "Republic Merger"), including the approximate 35% interest in Republic held by BEC. Additionally, options and warrants to acquire Republic common stock will be converted into the right to receive, upon payment of the exercise price, 1.6508 shares of the Company's Common Stock for each share of Republic common stock into which such option or warrant was exercisable. Republic common stock will be converted into options to acquire the Company's Common Stock. In December 1993, the Company and Republic entered into a definitive agreement covering the Republic Merger, which is expected to be consummated in the second quarter of 1994. In January 1994, BEC entered into a merger agreement pursuant to which BEC has agreed to merge with and into Viacom Inc. ("Viacom"), with Viacom being the surviving corporation. Upon the closing of the merger, which closing is subject to customary conditions, including approval of the merger by BEC's shareholders, Viacom would own a majority of the Company's Common Stock. Spelling Entertainment Group Inc. (formerly the Charter Company) was incorporated in Florida in 1959 and has its principal executive offices at 5700 Wilshire Boulevard, Los Angeles, California 90036, telephone (213) 965-5700. PRODUCTION Originally established in 1965 as Aaron Spelling Productions, Spelling Television has a history of successful network television production, including nearly 3,000 hours of television series, movies-for-television, mini-series and pilots, as well as feature films. In association with a variety of partnerships, Aaron Spelling has been one of the industry's most creative and profitable producers of network programming, producing such successful series as "Beverly Hills, 90210," "Melrose Place," "Love Boat," "Dynasty," "Hotel," "Vegas," "Matt Houston," "Fantasy Island," "Charlie's Angels," "Starsky and Hutch," "Family" and "Hart to Hart." Laurel, which was acquired by SEI in 1989, had been engaged primarily in the development and production of first-run syndicated series (see below) and feature films. In recent years however, it has diversified its activities to include the development and production of network mini-series and movies-for-television. Laurel has pursued a strategy of lower cost productions outside of the traditional Hollywood system and showcasing new or emerging talent. Laurel has produced or is producing several projects based on books or materials by author Stephen King. Worldvision finances third party production through the payment of guaranteed advances in exchange for certain distribution rights. See "Distribution - Acquiring Distribution Rights." SFI also finances third party production through the payment of guaranteed advances payable to producers in exchange for international distribution rights. See "Distribution." DEVELOPMENT The Company (primarily through Spelling Television and Laurel) is continually developing concepts and acquiring properties on which it can base pilots (and ultimately series), movies-for-television, mini-series and feature films. The Company may conduct such development internally, or in conjunction with a television network or motion picture studio/distributor. The development costs include property acquisition costs and the costs associated with writing a screenplay or teleplay. The Company has projects in development with a number of successful writers, producers, and/or individuals including Eric Roth, Joel Schumacher, Charles Rosen and Kareem Abdul-Jabbar. NETWORK PROGRAMMING Scripts for television programming are submitted to the network for review. If the network accepts the script, it will typically order production of a pilot or a prototype episode, for which it will pay the Company a negotiated fixed license fee. The Company's cost of producing such a pilot or prototype usually exceeds the network license fee. As of March 25, 1994, the Company had received orders for two new series projects. One is an eight episode order of a one-hour series for the Fox Broadcasting Company ("Fox") network tentatively titled "Models, Inc." Another is a six episode order of a one-hour series, for the Fox network, tentatively entitled "Shock Rock". The Company has other projects under consideration at the networks including an half-hour comedy tentatively titled "Madmen of the People." If the network decides to order a series, the license agreement generally provides for a minimum number of episodes to be delivered, with the network having certain rights to order additional episodes. The license agreement normally grants the network the right to exhibit the series in the United States during the license period and all other distribution rights are retained by the Company, subject to certain network-related holdback periods. The episodic license fee is normally less than the Company's costs of producing each series episode. In recent years, the size of the series deficits incurred by the Company has generally increased; however, in many cases the Company has been successful in obtaining international sales through Worldvision to substantially offset such production deficits. The Company is currently producing the television series "Beverly Hills, 90210" and "Melrose Place," both of which are being aired on the Fox television network. "Beverly Hills, 90210" is in its fourth season and has been renewed for the 1994-95 television season. "Melrose Place," which debuted during the summer of 1992 as a spin-off of "Beverly Hills, 90210," is in its second season, and has also been renewed for the 1994-95 television season. The Company is also producing the television series "Winnetka Road" and "Burke's Law," both mid-season replacements. The Company has received an order for an additional 13 episodes of "Burke's Law" from CBS for the 1994-95 television season. In 1993, Laurel produced "The Stand," an eight-hour mini-series based on one of Stephen King's best selling books, which was delivered to the ABC network in December 1993 and is scheduled to air in May 1994. The Company has recently received orders for two four hour mini-series from the ABC network, one based on James Michener's novel, "Texas" and the other based on Stephen King's novel, "The Langoliers." Laurel also produced a movie-for-television, "Precious Victims," which aired on the CBS network in September 1993. As with television series, the network license fees received for mini-series and movies-for-television are normally less than the costs of production, and the deficit must be covered by revenue from other markets, primarily through the exploitation of international rights. The Company had revenue from the Fox network in 1993, 1992 and 1991 representing 22%, 22% and 13% of revenue, respectively. FIRST-RUN SYNDICATED PROGRAMMING First-run syndicated television series are produced and sold directly to television stations in the United States without any prior network broadcast. These programs are licensed to individual or groups of television stations, on a market by market basis, in contrast to network distribution, which provides centralized access to a national audience. In first-run snydication, the Company licenses its film product in exchange for cash payments, advertising time (barter) or a combination of both. In cash licensing, a broadcaster normally agrees to pay a fixed licensing fee in one or more installments in exchange for the right to broadcast the product a specified number of times over an agreed upon set period of time. Where product is licensed in exchange for advertising time, through what are known as "barter agreements," a broadcaster agrees to give the Company a specified amount of advertising time, which the Company subsequently sells. Particularly in the initial years of such programming revenue can be less than the Company's costs of producing the programming. Worldvision is currently marketing for first-run barter syndication 22 episodes each of two series, currently titled "Robin's Hoods" and "Heaven Help Us," to be produced by Spelling Television. Worldvision has also begun to market these programs to international television markets for cash license fees. In first-run syndication, the Company retains greater control over creative and production decisions than is the case with network programming; however, there is a greater financial risk associated with such programming. Fixed license fees paid by the networks usually cover approximately 75% of the Company's production costs. Barter revenue is not fixed but is dependent on achieving specific ratings in targeted demographic areas. If a show's ratings are high, the advertising revenue received by the Company through its barter arrangements could be substantial. Laurel has produced for first-run syndication a movie-for-television, "The Vernon Johns Story," starring James Earl Jones, and two television series, "Tales From The Darkside" and "Monsters," both of which are anthology format one-half hour programs. The libraries of 90 and 72 episodes of "Tales From The Darkside" and "Monsters," respectively, represent a sufficient number of episodes to permit repeat syndication. "Tales From The Darkside" is currently licensed in the basic cable market by Worldvision. FEATURE FILMS The Company or certain of its employees act as producer or executive producer for feature films. Because of the significant amounts of capital required to finance the production and distribution of feature films, the Company generally has not sought to finance feature films entirely on its own, but rather has arranged for both financing and distribution from a major studio or other third party. This strategy limits the financial risks and rewards associated with any single film. The Company's potential to realize profits from a successful motion picture is also limited since as a producer it receives a fixed fee and only a contingent profit participation after the film is released. The Company's aggregate receipts from profit participations in the feature films it has produced have not been substantial to date. See "Distribution" for the acquisition of international distribution rights by SFI. OTHER MARKETS As noted above, network licensing fees and first-run syndication revenue are normally less than the associated costs of production. As a result, successful exploitation of the Company's television programming in other media and markets is a key to the profitability of the Company's production activities. Programming produced by the Company prior to its March 1989 acquisition of Worldvision is distributed under various distribution arrangements with third parties such as Warner Brothers or Twentieth Century-Fox. Distribution of product produced subsequent to the acquisition has been handled primarily through Worldvision. See "Distribution." As of December 31, 1993, the Company had contractual agreements with licensees covering film product which provide for approximately $145,000,000 in future gross license fees (revenue), approximately half of which are expected to be recognized after 1994. DISTRIBUTION Worldvision has been engaged in the distribution of filmed entertainment for over thirty-five years, originally serving as the distribution arm of the ABC network. Today, Worldvision is a leading worldwide distributor for the Company and other independent producers, with rights to more than 4,000 hours of television programming available for domestic distribution and more than 12,000 hours of television programming for international distribution. Worldvision currently distributes such programming in 110 countries through offices in New York, Chicago, Atlanta, Los Angeles, London, Paris, Rome, Toronto, Sydney, Tokyo and Rio de Janeiro. SFI was formed in 1990 to engage in the international distribution of feature films. SFI typically acquires all international distribution rights to such films by agreeing to pay a guaranteed advance to the producer against the producer's share of distribution receipts. Such advances are normally payable by SFI upon completion and delivery of the films by the producers. SFI then sells or licenses the films to various international subdistributors in each territory in exchange for a guaranteed advance plus, in most cases, a share of future profits. In certain international territories Worldvision handles television and home video distribution of SFI's films. SFI has, on a limited basis, developed feature film projects internally. SFI's revenue during 1993 was primarily generated by its distribution of "Short Cuts," directed by Robert Altman, and "Shadowlands," starring Anthony Hopkins and Debra Winger. ACQUIRING DISTRIBUTION RIGHTS A substantial portion of Worldvision's revenue is derived from fees earned from the distribution and licensing of television programming produced by the Company. See "Production." In addition, since 1989, Worldvision has invested approximately $150 million in the acquisition of distribution rights to film product from third parties. Worldvision acquires the exhibition rights to film product through contracts with the producers or other owners of such product. These contracts generally give Worldvision the exclusive distribution rights to license an unlimited number of exhibitions of the film product over a period of time, typically in excess of twenty years. Worldvision also acquires distribution rights from third party producers through advances to such producers which are recovered by Worldvision from revenue earned from distribution. Usually Worldvision recovers its distribution fees, expenses and advances before the producers or owners receive any additional proceeds. As an example, Worldvision contributed certain funding to "Twin Peaks," a first-run network series aired by ABC during the 1989-90 and 1990-91 television seasons. Worldvision also advanced funds for thirteen episodes of "Land of the Lost," aired by ABC during the 1992-93 season, and 52 half-hour episodes of the animated first-run syndicated series "Camp Candy," featuring the cartoon image of John Candy. Worldvision has also funded the production of various home video projects, including "Golf My Way" and "Golf My Way (II)," starring Jack Nicklaus. Over 350,000 units of these two programs have been distributed in the home video market. Recently, Worldvision began acquiring domestic distribution rights to made-for-video feature-length films. Films acquired for release in 1994 were "Breaking Point," a suspense-thriller starring Gary Busey and Kim Cattrall; "Crackerjack," featuring Thomas Ian Griffin, Nastassja Kinski and Christopher Plummer; and "Bulletproof Heart" with Mimi Rogers and Anthony LaPaglia. In September 1992, Worldvision purchased from Carolco Television Inc. ("Carolco") the domestic television rights to a library of more than 150 feature films, together with certain related receivables. The library includes box-office hits such as "Terminator 2," "Basic Instinct," "the Rambo trilogy," "L.A. Story," "Red Heat," "Total Recall," "Platoon," "The Last Emperor" and "Universal Soldier." Due to pre-existing licensing agreements covering these films, Worldvision will not recognize significant revenue from the exploitation of these rights until after 1996. MARKETS The Company generates revenue in addition to the revenue generated from the initial network or first-run syndicated market by licensing its film product in the following markets: (i) international television distribution, (ii) domestic off-network distribution (repeat airings on domestic broadcast television stations), (iii) worldwide cable and pay television, (iv) worldwide home video and (v) worldwide licensing and merchandising. INTERNATIONAL TELEVISION DISTRIBUTION. Demand for American-made film product in international markets has increased in recent years due to the increase in the number of television stations in those markets and, in some territories, the privatization of the local television industry. The Company typically begins to earn international television revenue from television programming during the same season such programming is originally broadcast on domestic television, or soon thereafter. Substantially all of the Company's television programming is presently being distributed in international television markets, including "Beverly Hills, 90210" and "Melrose Place," which are currently licensed in over seventy countries around the world. Television revenue from the distribution of feature films is normally delayed until after the films have been exploited in the theatrical and home video markets in each territory. See "Governmental Regulation" for restrictions placed on exhibition of the Company's film product in certain markets. DOMESTIC OFF-NETWORK DISTRIBUTION. The profitability of the Company's network television programming continues to depend substantially on its ability to distribute such programming in the domestic syndication television market after the initial network airing. However, in recent years the license fees obtainable from this market have declined and are expected to continue to decline, due in part to the increase in original programming available to independent stations from the emergence of the Fox network and the increased production of programming produced specifically for first-run syndication. Expected revenue per episode in this market normally increases for longer running series. In the Company's experience, a minimum of 65 episodes (normally three seasons) is generally required to successfully market repeat showings of a network series in the syndication market. Therefore, it is important to produce series which are aired over at least several broadcast seasons. Episodes from a network series normally become available for off-network syndication distribution four or five years after the series' initial network telecast. In 1992, Worldvision began to market "Beverly Hills, 90210" for off-network syndication telecast on a combined cash-and-barter basis for delivery in the third quarter of 1994. The series "Vegas" and "Little House on the Prairie" and several Worldvision feature film packages were aired in domestic repeat syndication during 1993. See also "Production - First-Run Syndicated Programming." BASIC CABLE TELEVISION. Domestic basic cable television represents an increasingly significant market for the Company's film product. The series "Tales From The Darkside," "The Love Boat," "Hotel" and "HeartBeat," among others, have been licensed to cable television systems. In the past, licensing a program to a cable exhibitor generally only reduced the amount of license fees that could be obtained from domestic off-network syndication distribution; in recent years, cable exhibition has effectively developed as an alternate market to domestic syndication. Cable exhibitors in some instances have purchased rights to short-running television series which do not include sufficient episodes to allow for traditional off-network syndication distribution. Cable television operations outside the U.S., while still in the early stages of development in many countries, have also been growing rapidly. See "Distribution - Spelling Satellite Networks" regarding the international cable and satellite television operations conducted by the Company. HOME VIDEO. Worldvision also distributes the Company's film product in the worldwide home video market, generally in the lower-priced sell-through market. "Monsters," "Tales From The Darkside" and the two-hour pilot and an episode of "Beverly Hills, 90210" have been successfully distributed in the home video market. Additionally, the Company distributes third party film product in this market. "Happily Ever After," an animated feature film, began distribution in late 1993. Also, by paying a guaranteed advance, the Company has acquired distribution rights for three films, "Breaking Point," "Crackerjack," and "Bulletproof Heart," which are intended for initial domestic distribution in the home video market. Generally, the budget for these pictures is under $2,000,000, and the Company puts up less than one-half of the budget in exchange for all domestic rights. LICENSING AND MERCHANDISING. Hamilton Projects merchandises products and licenses music associated with the Company's television properties, including "Beverly Hills, 90210," and "Melrose Place." Hamilton Projects is a full- service licensing and merchandising company, providing strategic planning, concept development and program execution to third parties, including those outside the entertainment industry. SPELLING SATELLITE NETWORKS (SSN) SSN was formed in January 1993 to capitalize on the increased global demand for American film product and the rapidly expanding technologies and exhibition outlets in the cable and satellite arena. SSN launched its first cable channel, TeleUNO, in March 1993. TeleUNO currently reaches more than two million homes in Latin America, including Mexico, Argentina and Brazil. TeleUNO generates revenue from both subscription fees and advertising through multi-year contracts with cable operators throughout Latin America. TeleUNO conducts its operations in association with Multivision, Mexico's largest multi-point, multi-channel distribution systems (MMDS). The Company is responsible for providing the film product which will air on the channel and for all sales and marketing activities. Multivision is responsible for all technical operations, including supplying the satellite transponder. The Company and Multivision will share revenue generated through licensing of the channel or sale of advertising on the channel. SSN is also currently exploring the possibility of launching additional channels in partnership with programmers or others in other markets around the world. PROGRAMMING LIBRARY The following tables provide a sampling of significant titles in the programming library which contains more than 400 titles and over 12,000 hours of programming to which the Company has certain distribution rights. TELEVISION SERIES: FEATURE FILMS: (a) These ten productions in the aggregate accounted for approximately 53% of the Company's 1993 revenue. (b) Represents programming owned by the Company. (c) Acquired in the 1992 purchase of the Carolco film library. (d) Distribution rights are for varying terms. COMPETITION The motion picture and television industry is highly competitive with respect to access to the available literary properties, creative personnel, talent, production personnel, television acceptance, distribution commitments and financing which are essential to produce and sell film product. Certain of the Company's competitors have greater financial resources and more people engaged in the acquisition, development, production and distribution of both television programming and feature films. The Company's arrangements with the networks provide it with pilot, series and movies-for-television commitments; however, the networks are under no obligation to actually broadcast the Company's product. The Company's successful domestic repeat syndication of a network series generally depends upon the ratings achieved through network exhibition of such a series over a number of years sufficient to generate a minimum of 65 episodes. In turn, the Company's overall success in achieving multiple years of network exhibition of a series is dependent upon factors such as the viewing public's taste (as reflected in the ratings) and critical reviews. In addition, see the discussion in "Government Regulation" regarding the relaxation of certain government regulations which may permit the television networks to acquire financial interests in, and syndication rights to, television programs. The Company must continue to acquire distribution rights to television programming and feature films to maintain its competitive position. In order to acquire rights to distribute new third party film product, the Company may be required to increase its advances to producers or to reduce its distribution fees. Licensing television programming to broadcasters and cable networks has also become increasingly competitive as new products continually enter the syndication market and certain producers attempt to develop an additional network to distribute their product. Likewise, SFI is competing with numerous well-financed, experienced companies engaged in feature film production and international feature film distribution. The Company's relative lack of experience and financial strength in distributing feature films in the international market may hinder its ability to compete effectively with companies which are more experienced and have greater financial capabilities. TRADEMARKS AND SERVICE MARKS The Company or its subsidiaries own various United States federal trademark or service mark registrations including SPELLING(R), BEVERLY HILLS, 90210(R), MELROSE PLACE(R), and has applied for registration for numerous other marks relating to its film product in the United States and foreign countries. The Company or its subsidiaries own various foreign trademark or service mark registrations or have applied for trademark or service mark registrations include TELE UNO(R). Certain of the Company's trademark and service marks may offer significant merchandising opportunities. See "Licensing and Merchandising." GOVERNMENT REGULATION The production and distribution of television programming by independent producers is not directly regulated by the federal or state governments, but the marketplace for television programming is substantially affected by regulations of the Federal Communications Commission ("FCC") applicable to television stations, television networks and cable television systems. The FCC's syndicated program exclusivity rules affect the sale of programming to commercial television stations, regional superstations, and cable networks. Pursuant to these rules, commercial television stations can bargain for the right to exclusive showing of programming within a 35-mile radius and to require cable television systems with 1,000 or more subscribers to black out showings of the same programming on certain television stations they carry in order to preserve contracted exclusivity. The FCC also allows regional superstations (such as WTBS in Atlanta and WGN in Chicago) and group owners to purchase rights to programming on a nationwide basis. In addition, distributors of syndicated programming may exercise such rights for a period of one year after first licensing a particular syndicated program or package in areas where that programming has not yet been licensed. The Cable Television Consumer Protection and Competition Act of 1992 ("Cable Act") prohibits certain unfair or discriminatory practices in the distribution of satellite superstations or in the sale of satellite cable programming by entities affiliated with cable operators. The Cable Act also strictly limits entities affiliated with cable operators in offering exclusive contracts for satellite cable programming or superstations. Furthermore, the Cable Act prohibits certain coercive and discriminatory acts by cable operators and other multichannel video program distributors against program vendors. In addition, the Cable Act provides all commercial television stations with the right to bargain for and withhold consent to the retransmission of their signals by cable television systems, and certain local stations have the option to demand carriage on cable systems. These provisions are subject to interpretation by the FCC, and various entities have petitioned the Commission to reconsider certain aspects of the rules it has adopted to enforce these requirements. Moreover, judicial appeals relating to various aspects of these rules are pending. Accordingly, the Company cannot predict the specific impact of the Cable Act on its business. In 1989, the twelve-member European Community ("EC") adopted a "directive" that its member states ensure that more than 50% of the programming shown on their television stations be European-produced "where practicable." These guidelines could restrict the amount of American television programming and feature films that are shown on European television. In the recently-concluded General Agreement on Trade & Tariffs, the EC refused to make any commitment to modify these guidelines or to refrain from adopting additional barriers. Because of significant questions regarding the interpretation and enforcement of the guidelines, the Company cannot predict what effect they may have on its business. In addition, certain European countries have adopted individual national restrictions on broadcasting of programming based on origin. Other countries in which the Company distributes its programming may adopt similar restrictions, which may have an adverse effect on its ability to distribute its programs or create stronger incentives for the Company to establish ventures with international firms. The effect of the foregoing regulations on the Company's operations cannot be accurately assessed at this time. In 1993, the FCC further relaxed its rules governing financial interests in and syndication of programming by the broadcast television networks (known as the "fin syn" rules). The relaxed rules still prohibit the three largest broadcast networks from holding or acquiring financial interests and syndication rights in any first-run non-network program or series they have not solely produced; from domestically syndicating any prime time network first-run non-network program; and from withholding a prime time network program from syndication for more than a specified period. However, these remaining restrictions on program syndication by the networks are set to expire in November of 1995, and are currently the subject of judicial review. In 1993, a Federal district court vacated certain provisions of consent decrees which prohibited television networks from acquiring financial interests and syndication rights in television programming produced by non-network suppliers such as the Company. The effect of the relaxed fin syn rules and the court's action on the operations of the Company is as yet unclear; however, these regulatory changes could have a material adverse effect on the operations of the Company. EMPLOYEES At December 31, 1993, Spelling employed or had service agreements with approximately 223 employees who are employed in administrative or other positions which are relatively independent of the Company's current level of production activities. In addition, the Company employs individuals for particular production projects. As a result, the number of employees and production project employees providing services to the Company can vary substantially during the course of a year depending upon the number and scheduling of its productions. The Company's union representation, wage scales and fringe benefits follow prevailing industry standards. Certain subsidiaries of the Company are signatories to collective bargaining agreements relating to the various types of employees and independent contractors required to produce television programming and feature films. These employees include writers, directors, actors, musicians and studio craftsmen. The following table sets forth the union contracts to which certain Spelling subsidiaries are parties and the relevant expiration dates: (*) Cancelable by either party subject to one year's notice. Although the Company considers all employee relations to be satisfactory at present, the renewal of union contracts does not depend on its activities or decisions alone. If the relevant union and the motion picture and television industry were unable to come to a new agreement prior to these expiration dates, any resulting work stoppage could adversely affect the Company's production activities. DISCONTINUED OPERATIONS The Company, formerly known as The Charter Company, was engaged in petroleum marketing operations, but in 1991 and 1992 sold substantially all of such operations. Additional information relating to discontinued operations including information regarding environmental contingencies is provided in the accompanying financial statements (see Note 11). PETROLEUM MARKETING. Revenue from the Company's petroleum marketing operations had been derived primarily from sales of commercial grade fuel oils such as residual fuel oil and other petroleum products. These operations were conducted by its wholly-owned subsidiaries, New England Petroleum Corporation ("NEPCO") and Penndel Energy Corporation ("Penndel"). The major portion of petroleum marketing sales was made under term and spot contracts for the sale of residual fuel oil to electric utilities and other commercial customers. During July and August 1992, the Company sold the "Penndel Group," consisting of two subsidiaries and a terminal facility, for approximately $17.7 million in cash. In December 1992 and January 1993, NEPCO's major utility supply contracts were sold. These utility supply contacts comprised the remainder of the Company's oil operations. OIL PRODUCING CONCESSION. In April 1991, the Company completed the sale of its 24.5% interest in an oil producing concession located in the Persian Gulf (the "Concession") to two Concession partners. The Company received approximately $23.9 million in cash, including the repayment of $6.1 million in advances made to the Concession in 1991. MARKETING GROUP AND INVESTMENT IN CIRCLE K. In 1988, the Company sold its Marketing Group of convenience stores to The Circle K Corporation ("Circle K"), a former affiliate of the Company's former principal shareholder, for $130 million in cash plus preferred stock originally valued at $50 million. In May 1990, Circle K and its principal subsidiaries filed for protection under Chapter 11 of the United States Bankruptcy Code ("Chapter 11") and suspended dividends on its preferred stock held by the Company. ITEM 2.

ITEM 2. PROPERTIES The Company leases office space of approximately 51,000 square feet in Los Angeles and 63,000 square feet in New York. In addition, the Company leases offices in other cities in the United States and in various other countries throughout the world in connection with its international distribution activities. The Company also rents facilities on a short-term basis for the production of its film product, including a facility in Vancouver, British Columbia. Management believes comparable space is readily available should any lease expire without renewal. ITEM 3.

ITEM 3. LEGAL PROCEEDINGS The Company has become subject to various lawsuits, claims and other legal matters in the course of conducting its business. The Company believes such lawsuits, claims and other legal matters should not have a material adverse effect on the Company's consolidated results of operations or financial condition. In September 1993, five purported class action lawsuits were filed in the Delaware Chancery Court against the Company, Republic, BEC and the members of the Board of Directors of Republic. The complaints seek preliminary and permanent injunctive relief against BEC's offer for acquisition and damages caused to Republic's public stockholders. On March 24, 1994, all parties to the litigation entered into a Memorandum of Understanding that contemplates the negotiation of a definitive settlement agreement and a hearing pursuant to the Delaware Chancery Court Rules to consider the fairness of the settlement. At such hearing, attorneys for the plaintiff class will apply for fees and expenses in an amount not to exceed $225,000, and defendants will not oppose such application. The Company is also involved in a number of legal actions including threatened claims, pending lawsuits and contract disputes, environmental clean-up assessments, damages from alleged dioxin contamination and other matters. While the outcome of these suits and claims cannot be predicted with certainty, the Company believes based upon its knowledge of the facts and circumstances and applicable law that the ultimate resolution of such suits and claims will not have a material adverse effect on the Company's results of operations or financial condition. This belief is also based upon allowances that have been established for estimated losses on disposal of former operations and remaining Chapter 11 disputed claims, and an insurance-type indemnity agreement which covers up to $35,000,000 of certain such liabilities in excess of a threshold amount of $25,000,000, subject to certain adjustments. Substantial portions of such allowances are intended to cover environmental costs associated with the Company's former operations. See Note 11 for information regarding the environmental and remaining Chapter 11 contingencies relating to the Company's discontinued operations. ITEM 4.

ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS No matters were submitted to a vote of security holders. ______________________________________________ PART II ITEM 5.

ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS The Company's Common Stock is traded on the New York and Pacific Stock Exchanges under the symbol SP. The table below sets forth the high and low sales prices for the Common Stock as reported on the Composite Tape. The number of holders of record of the Company's Common Stock as of March 25, 1994, was approximately 64,605,268. In the fourth quarter of 1991, the Company declared and paid an annual cash dividend of $.05 per common share. In the first quarter of 1992, the Company began paying quarterly cash dividends of $.02 per common share. There are no restrictions that materially limit the Company's ability to pay dividends. ITEM 6.

ITEM 6. SELECTED FINANCIAL DATA The following table sets forth certain data for the years ended December 31 (in thousands, except per share data): (a) Due to the acquisition of SEI in the second quarter of 1991, amounts are not comparable to prior years. (b) Per share amounts are calculated after preferred dividends of $810,000, except for 1993 which is $724,000. ITEM 7.

ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The following discussion should be read in conjunction with the Consolidated Financial Statements of the Company and the related Notes. BUSINESS COMBINATIONS AND ACQUISITIONS The Company makes its decisions to acquire or invest in businesses based on financial and strategic considerations. The Company may from time to time invest in or acquire businesses or assets in addition to those described below. In May 1991, the Company acquired ownership of approximately 82% of the common stock of SEI for approximately $166,800,000 in cash and $22,745,000 principal amount of ten-year notes. This acquisition was accounted for using the purchase method of accounting and, accordingly, the operations of SEI have been included in the Company's financial statements from the date of acquisition. In July 1992, the Company acquired the remaining minority interest (see Note 2). In December 1991, the Company acquired Hamilton Projects and ownership of certain television programming, and received $24,000,000 in cash, in exchange for its distribution rights to Hanna-Barbera's animated programming (see Note 2). In September 1992, the Company purchased from Carolco domestic television distribution rights for more than 150 feature films, together with certain related receivables. The purchase price for these assets included $50,000,000 in cash and the assumption of approximately $14,000,000 in related liabilities. The cash portion of the purchase price was funded through SEI's bank facility (see Notes 3 and 4). In September 1993, the Company and Republic entered into an agreement in principle pursuant to which the Company agreed to acquire by merger all of the outstanding shares of common stock of Republic for $13 per share in cash, including the approximate 35% interest in Republic held by BEC. Additionally, certain options to acquire Republic common stock will be converted into options to acquire the Company's Common Stock. In December 1993, the Company and Republic entered into a definitive agreement covering the Republic Merger, which is expected to be consummated in the second quarter of 1994. The aggregate cash payments to the shareholders of Republic will be approximately $100,000,000, which will be funded through borrowings under the Company's credit arrangements with BEC (see Note 4 and "Financial Condition" below). RESULTS OF CONTINUING OPERATIONS The results of operations for any period are significantly affected by the quantity and performance of the Company's film product which is licensed to, and available for exhibition by, licensees in various media and territories. Consequently, results of operations may vary significantly between periods, and the results of operations in any one period may not be indicative of results of operations in future periods. The success of the Company's business depends, in part, upon the network exhibition of its television series over several years to allow for more profitable licensing and syndication arrangements. During the initial years of a television series, network and international license fees normally approximate the production costs of the series, and accordingly the Company recognizes only minimal profit or loss during this period. If a sufficient number of episodes of a series are produced, the Company is reasonably assured that it will also be able to sell the series in the domestic off-network market, and the Company would then expect to be able to realize a more substantial profit with respect to the series. The Company's business in general may also be affected by the public taste, which is unpredictable and subject to change, and by conditions within the filmed entertainment industry, including, but not limited to, the quality and availability of creative talent and the negotiation and renewal of union contracts relating to writers, directors, actors, musicians and studio craftsmen as well as any changes in the law and governmental regulation. In 1993, a Federal district court vacated certain provisions of consent decrees which prohibited television networks from acquiring financial interests and syndication rights in television programming produced by non-network suppliers such as the Company. Accordingly, subject to certain restrictions imposed by the Federal Communications Commission, the networks will be able to negotiate with program suppliers to acquire financial interests and syndication rights in television programs that air on the networks and therefore could become competitors of the Company. The following paragraphs discuss significant items in the Consolidated Statements of Operations for the three years ended December 31, 1993. REVENUE The following table sets forth the components of revenue from the Company's major markets for the years ended December 31 (in thousands): * Includes only the eight months following the acquisition of SEI. Network revenue remained at approximately the same level in 1993 as in 1992, as opposed to the significant increase in such revenue in 1992. In 1993, the Company delivered fewer hours of programming than in 1992, but the effect of this decrease was offset by an increase in the average license fee per hour or episode of programming. The increase in 1992 was attributable to (i) the fact that the results of operations include SEI's operations for only eight months in 1991 as compared to 12 months in 1992; and (ii) the delivery of additional programming in 1992. Network revenue in all three periods included license fees attributable to "Beverly Hills, 90210." The license fees from "Melrose Place" began in the fall of 1992. Both of these series have been ordered by the Fox network for the 1994/1995 season, and "Beverly Hills, 90210" is also expected to be released in the domestic off-network marketplace in the fall of 1994. The Company has received orders for two new series, "Burke's Law" (13 episodes) and "Winnetka Road" (six episodes), for the current season, as well as an order for two four hour mini-series, one based on James Michener's novel "Texas" and the other based on Stephen King's novel "The Langoliers." The CBS network has also ordered an additional 13 episodes of "Burke's Law" for the 1994/1995 season. Home video revenue increased $14,161,000 or 103%, in 1993 as compared to 1992. This increase was primarily due to the distribution of "Happily Ever After," an animated feature film, and the international licensing of "The Stand." The increase in such revenue in 1992 was $8,097,000, or 142%, as compared to 1991, primarily due to (i) the significant efforts by the Company to increase its presence in the home video distribution market, and (ii) the fact that SEI's operations were only included for eight months in 1991. International film distribution revenue decreased $5,024,000, or 24%, in 1993 as compared to 1992. During 1993, the Company delivered two feature films, "Short Cuts" and "Shadowlands," as compared to four during 1992, including "The Player." There were no comparable distribution activities in 1991. Licensing and merchandising revenue remained relatively constant in 1993, but increased $13,535,000 or 530%, in 1992 as compared to 1991. The increase from 1991 to 1992 was primarily due to the successful licensing of "Beverly Hills, 90210," and the acquisition of Hamilton Projects in December 1991. Other distribution revenue includes revenue from the licensing of the Company's extensive library of feature films and television programming in worldwide free and pay television markets other than domestic network television. The revenue from these markets remained relatively stable between 1993 and 1992. The increase between 1992 and 1991 was primarily due to the inclusion of SEI's operations for only eight months in 1991. Generally, the future growth in these markets is expected to occur in the international area rather than the domestic market; see Item 1. "Business - Distribution." FILM AND TELEVISION COSTS Film and television costs consist primarily of the amortization of capitalized product costs and the accrual of third party participations and residuals. Such costs in 1993 increased $4,457,000, or 2%, as compared to 1992, primarily as a result of the overall increase in revenue in 1993, although the percentage relationship between such costs and the related revenue decreased to 73% in 1993 from 76% in 1992. Such costs increased $106,924,000, or 119%, in 1992 as compared to 1991; this increase also resulted primarily from the increases in the Company's revenue. Additionally, the percentage relationship between these costs and the related revenue increased from 73% in 1991 to 76% in 1992. This percentage relationship is a function of (i) the mix of film product generating revenue in each period and (ii) changes in the projected profitability of individual film product based on the Company's estimates of such product's ultimate revenue and costs. SELLING, GENERAL AND ADMINISTRATIVE Selling, general and administrative costs in 1993 decreased $1,516,000, or 4%, as compared to 1992. This decrease primarily resulted from a decrease in management fees charged to the Company by the Company's former principal shareholder in 1993 following BEC's acquisition of a majority interest in the Company. Selling, general and administrative costs in 1992 increased $11,392,000, or 48%, as compared to 1991, primarily due to the inclusion of SEI's costs for only the last eight months of 1991 as compared to a full twelve months for 1992. In addition, a subsidiary recorded a nonrecurring gain from the relocation of its offices in 1991. INTEREST INCOME Interest income increased $1,347,000 in 1993 as compared to 1992, following an increase of $890,000 in 1992 as compared to 1991. These increases were principally due to the amortization of discount on receivables acquired from Carolco for the full year 1993 and from the date of acquisition in 1992. INTEREST EXPENSE Interest expense in 1993 decreased $2,019,000, or 20%, despite the Company's increased level of borrowings during the first three quarters of 1993. This decrease was primarily due to (i) the lower effective interest rates during the year and (ii) the repayment or redemption of a substantial amount of the Company's debt during the fourth quarter of 1993 (see Note 4 and "Financial Condition" below). Interest expense increased $2,890,000, or 41%, in 1992 due to the Company's increased level of borrowings during the year. The Company's borrowings will increase in 1994 as a result of the amounts borrowed to fund the aquisition of Republic (see Note 15). MINORITY INTEREST During 1992 the Company had minority interest expense of $1,327,000 related to the earnings of SEI for the period up to the date of the Company's acquisition of the minority interest. In 1991 the similar charge was $932,000. There was no such charge in 1993. PROVISION FOR INCOME TAXES During 1993, the Company's provision for income taxes increased $3,871,000, or 42%, over the provision in 1992. This increase was primarily due to the increase in pre-tax income in 1993, as described in the foregoing paragraphs. The effective tax rate decreased significantly in 1993, largely as a result of the effect of a reduction in the valuation allowance against the realizability of certain tax loss and credit ("tax attribute") carryforwards. Tax benefits from the utilization of certain tax attribute carryforwards in 1992 and 1991 were recorded as extraordinary items under then applicable accounting rules. (See Note 10). The Company adopted Statement of Financial Accounting Standards No. 109 ("SFAS 109") effective January 1, 1993. The cumulative effect of adopting SFAS 109 was not material. During 1992, the provision for income taxes increased by $6,350,000, or 224%, as compared to 1991. This increase is primarily due to the increase in pre-tax income, partially offset by a decrease in the overall effective tax rate for the year, as a result of the reduced effect of non-deductible intangible expenses. DISCONTINUED OPERATIONS The Company, formerly known as The Charter Company, was engaged in petroleum marketing operations, but in 1991 and 1992 sold substantially all of the remaining such operations. (See Note 11.) In April 1991, the Company completed the sale of its interest in an oil producing concession to two of its partners in the concession. The Company recognized a net gain of $8,848,000 after a provision for income taxes of $4,556,000. During July and August 1992, the Company sold two subsidiaries and a terminal facility. In December 1992 and January 1993, the Company sold its remaining utility supply contracts. No material gain or loss resulted from the overall disposition of these operations. The Company continues to sell the few remaining assets of the discontinued operations whenever possible and to settle remaining obligations associated with the discontinued operations. The financial position of discontinued operations is presented in the Balance Sheets under the caption "Net liabilities related to discontinued operations." Included in such amounts are certain allowances for estimated losses on disposal of the remaining oil operations and disputed claims relating to the reorganization in 1986 under Chapter 11 of the Bankruptcy Code. These allowances totaled approximately $29,621,000 and $30,587,000 at December 31, 1993 and 1992, respectively. See Note 11 regarding the insurance-type indemnity agreement the Company entered into in early 1993 which covers up to $35,000,000 in such claims over a threshold of $25,000,000. The Company is involved in a number of legal actions including threatened claims, pending lawsuits and contract disputes, environmental clean-up assessments, damages from alleged dioxin contamination and other matters. Some of the parties involved in such actions seek significant amounts of damages. While the outcome of these suits and claims cannot be predicted with certainty, the Company believes based upon its knowledge of the facts and circumstances and applicable law that the ultimate resolution of such suits and claims will not have a material adverse effect on the Company's results of operations or financial condition. This belief is also based upon allowances that have been established for estimated losses on disposal of former operations and remaining Chapter 11 disputed claims and an insurance-type indemnity agreement which covers up to $35,000,000 of certain such liabilities in excess of a threshold amount of $25,000,000, subject to certain adjustments. Substantial portions of such allowances are intended to cover environmental costs associated with the Company's former operations. Although there are significant uncertainties inherent in estimating environmental liabilities, based upon the Company's experience it is considered unlikely that the amount of possible environmental liabilities and Chapter 11 disputed claims would exceed the amount of the allowances by more than $50 million. In 1993, the Company had a net loss from discontinued operations of $3,971,000 after an income tax benefit of $2,529,000. This loss resulted primarily from the premium paid for the insurance-type indemnity described above. EXTRAORDINARY ITEMS In connection with the early extinguishment of certain indebtedness, the Company in 1993 recorded an extraordinary loss of $2,022,000 (net of a tax benefit of $1,287,000) from the write-off of unamortized discount and debt issuance costs relating to such debt. During 1992 and 1991, the Company had extraordinary income of $3,948,000 and $4,572,000, respectively, from tax benefits relating to utilization of certain tax attribute carryforwards; a similar benefit in 1993 was included in the Company's provision for income taxes in accordance with the provisions of SFAS 109. FINANCIAL CONDITION The Company's operations require the production of film product and the acquisition of rights to distribute film product produced by others. The Company's expenditures in this regard totalled $150,648,000 and $154,607,000 in 1993 and 1992, respectively. The cost of producing network television programming is largely funded through the receipt of the related network license fees. The cost of other production and acquisition activities is funded through the Company's operating cash flow and borrowings under its various credit arrangements. In connection with the Republic Merger, the Company in October 1993 issued 13,362,215 shares of the Company's Common Stock to BEC in exchange for 3,652,542 shares of BEC common stock. The BEC shares were subsequently resold, with the Company realizing approximately $100,445,000 in proceeds. The Company subsequently used these proceeds to prepay or redeem (i) all of the outstanding principal amount of its 10% Senior Subordinated Notes and 12% Subordinated Debentures, (ii) approximately $39,500,000 of SEI's bank debt and (iii) all of its outstanding Preferred Stock. (See Notes 4 and 6). As a result, the Company will borrow under its credit facilities to fund the completion of the Republic Merger in the second quarter of 1994. In January 1994, the Company terminated its existing bank credit agreement and entered into a three-year credit agreement with BEC (the "BEC Facility") (see Note 4). The BEC Facility provides for a three-year term loan facility of $100,000,000 to fund the Company's acquisition of Republic and a revolving credit facility of $75,000,000 to fund the Company's working capital and other requirements. The entire amount outstanding under the BEC Facility may be accelerated if BEC's indebtedness is accelerated by its banks. The events which might result in such an acceleration include the consummation of BEC's merger with Viacom (see Note 15) without the receipt of a waiver from BEC's banks. The Company has not been informed as to whether such waiver will be granted by BEC's lenders. However, the Company is currently exploring and believes it can obtain credit arrangements with third parties under terms and conditions which are not materially different from those contained in the BEC Facility. The Company believes that its financial condition remains strong and that it has the financial resources necessary to meet its anticipated capital requirements. In addition to cash provided by operating activities, and the issuance of Common Stock, the Company has sufficient resources available under its credit facility to meet its ongoing plans for the production and acquisition of film product and to take advantage of internal and external development and acquisition opportunities. INFLATION The Company anticipates that its business will be affected by general economic trends. During a period of high inflation, the Company believes that if costs increase, it should be able to pass such increases on to its customers. RECENTLY ISSUED ACCOUNTING STANDARDS Effective January 1994, the Company adopted SFAS No. 112, "Employers' Accounting for Postemployment Benefits," and SFAS No. 115, "Accounting for Certain Investments in Debt and Equity Securities." SFAS No. 112 will not have an effect on the Company's results of operations or financial condition because the Company does not provide such benefits. However, the adoption of SFAS No. 115 will require the Company to adjust the carrying value of a common stock investment to fair market value with a corresponding adjustment to its Shareholders' Equity (see Note 1). ITEM 8:

ITEM 8: FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA INDEX REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS TO SPELLING ENTERTAINMENT GROUP INC. We have audited the accompanying consolidated balance sheet of Spelling Entertainment Group Inc. (a Florida Corporation) and subsidiaries as of December 31, 1993, and the related consolidated statements of operations, shareholders' equity, and cash flows for the year then ended. These financial statements and the schedules for the year ended December 31, 1993 listed in the index at Item 14(a) are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements and the schedules based on our audit. We conducted our audit in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audit provides a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of Spelling Entertainment Group Inc. and subsidiaries as of December 31, 1993, and the results of their operations and their cash flows for the year then ended in conformity with generally accepted accounting principles. Our audit was made for the purpose of forming an opinion on the basic financial statements taken as a whole. The schedules for the year ended December 31, 1993 listed in the index at Item 14(a) are presented for purposes of complying with the Securities and Exchange Commission's rules and are not part of the basic financial statements. These schedules have been subjected to the auditing procedures applied in the audit of the basic financial statements and, in our opinion, fairly state in all material respects the financial data required to be set forth therein in relation to the basic financial statements taken as a whole. ARTHUR ANDERSEN & CO. Los Angeles, California February 1, 1994 REPORT OF INDEPENDENT AUDITORS BOARD OF DIRECTORS SPELLING ENTERTAINMENT GROUP INC. We have audited the accompanying consolidated balance sheet of Spelling Entertainment Group Inc. and subsidiaries (formerly The Charter Company) as of December 31, 1992 and the related consolidated statements of operations, changes in shareholders' equity, and cash flows for each of the two years in the period ended December 31, 1992. Our audits also included the financial statement schedules listed in the Index at Item 14(a). These financial statements and schedules are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements and schedules based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the consolidated financial position of Spelling Entertainment Group Inc. and subsidiaries at December 31, 1992, and the consolidated results of their operations and their cash flows for each of the two years in the period ended December 31, 1992, in conformity with generally accepted accounting principles. Also, in our opinion, the related financial statement schedules, when considered in relation to the basic financial statements taken as a whole, present fairly in all material respects the information set forth therein. ERNST & YOUNG Cincinnati, Ohio March 19, 1993 SPELLING ENTERTAINMENT GROUP INC. AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS (IN THOUSANDS, EXCEPT SHARE DATA) The accompanying Notes to Consolidated Financial Statements are an integral part of these statements. SPELLING ENTERTAINMENT GROUP INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF OPERATIONS (IN THOUSANDS, EXCEPT PER SHARE DATA) The accompanying Notes to Consolidated Financial Statements are an integral part of these statements. SPELLING ENTERTAINMENT GROUP INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS' EQUITY (IN THOUSANDS, EXCEPT NUMBER OF SHARES) The accompanying Notes to Consolidated Financial Statements are an integral part of these statements. SPELLING ENTERTAINMENT GROUP INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS (IN THOUSANDS) The accompanying Notes to Consolidated Financial Statements are an integral part of these statements. SPELLING ENTERTAINMENT GROUP INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES BASIS OF PRESENTATION. The consolidated financial statements present the consolidated financial position and results of operations of Spelling Entertainment Group Inc. and subsidiaries (the "Company" or "Spelling"). All material intercompany accounts and transactions have been eliminated. Certain reclassifications have been made to prior periods to conform to the current year's presentation. In May 1991, the Company acquired ownership of approximately 82% of the common stock of Spelling Entertainment Inc. ("SEI"). The acquisition of SEI has been accounted for as a purchase, and, accordingly, the results of SEI's operations since its acquisition are included in the accompanying consolidated financial statements (see Note 2). In July 1992 the Company acquired the remaining minority interest. Until March 31, 1993 American Financial Corporation and subsidiaries ("AFC") owned 24,594,215 shares (48%) of the Company's common stock, $.10 par value ("Common Stock"), and 9,000 shares (100%) of the preferred stock, $.10 par value ("Preferred Stock"); at that date, AFC sold the shares of Common Stock to Blockbuster Entertainment Corporation ("BEC"). Subsequently, BEC increased its ownership to 45,658,640 shares (approximately 70.5%) of the Company's Common Stock during 1993. (See Note 7). CASH AND CASH EQUIVALENTS. Cash equivalents consist of interest-bearing securities with original maturities of less than ninety days. ACCOUNTS RECEIVABLES, NET. Accounts receivable are net of allowance of $4,983,000 and $3,974,000 at December 31, 1993 and 1992, respectively. ACCOUNTING FOR FILM AND TELEVISION COSTS. Film and television costs include production or acquisition costs (including advance payments to producers), capitalized overhead and interest, prints and advertising expected to benefit future periods. These costs are amortized, and third party participations and residuals are accrued, on an individual product basis in the ratio that current year gross revenue bears to estimated future gross revenue. Film and television costs are stated at the lower of cost less amortization or estimated net realizable value on an individual film product basis. Estimates of total gross revenue, costs and participations are reviewed quarterly and revised as necessary. When estimates of total revenue and costs indicate that a television program or feature film will result in an ultimate loss, additional amortization is provided to fully recognize such loss in that period. PROPERTY, PLANT AND EQUIPMENT, NET. The carrying values of property, plant and equipment are based on cost, and provision for depreciation is made principally on the straight-line method over estimated useful lives. Property, plant and equipment are net of accumulated depreciation of $5,003,000 and $4,828,000 at December 31, 1993 and 1992, respectively. OTHER ASSETS. Included in other assets is a common stock investment at a carrying value (at cost) of $1,963,000 at December 31, 1993. The fair value of such investment, based on the closing over-the-counter market price on December 31, 1993, was $20,797,000. It is not clear that the Company could realize such a value if the investment were to be sold due to the relatively low trading volume of such shares relative to the number of shares owned by the Company. The Financial Accounting Standards Board ("FASB") issued Statement of Financial Accounting Standards ("SFAS") No. 115, "Accounting for Certain Investments in Debt and Equity Securities," which will be effective in 1994. This statement will require the Company to adjust the carrying value of this asset, which will be classified as "available for sale" under the applicable provisions of SFAS No. 115, to fair market value with a corresponding adjustment to Shareholders' Equity. INTANGIBLE ASSETS, NET. Intangible assets represent the acquisition cost of SEI in excess of the market value of its identified net assets. This cost is being amortized on a straight-line basis over 40 years. Amortization expense relating to such intangible assets was $3,825,000, $4,086,000 and $2,626,000 for the years ended December 31, 1993 and 1992, and the eight months ended December 31, 1991, respectively. Intangible assets are net of accumulated amortization of $10,527,000 and $6,713,000 at December 31, 1993 and 1992, respectively. SPELLING ENTERTAINMENT GROUP INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) DEFERRED REVENUE. A substantial portion of the network license fees related to television programming are received prior to the time the programming is completed or delivered to the network. Such fees, and other fees received prior to the time that the related television programming or feature film (collectively, "film product") is available to the licensee, are recorded on the balance sheet as deferred revenue. Such amounts are normally repayable by the Company only if it fails to deliver the related film product to the licensee. REVENUE RECOGNITION. Revenue from licensing agreements covering film product owned by the Company is recognized when the film product is available to the licensee for telecast, exhibition or distribution, and other conditions of the licensing agreements have been met. Long-term noninterest-bearing receivables arising from such agreements are discounted to present value. Revenue from television distribution of film product which is not owned by the Company is recognized when billed. Revenue from direct home video distribution is recognized, net of an allowance for estimated returns, together with related costs, in the period in which the product is available for rental or sale by the Company's customers. ACCOUNTING FOR ENVIRONMENTAL MATTERS. The allowances for estimated losses on disposal and disputed claims reported in Note 11 include accruals for environmental liabilities, including anticipated remediation costs of properties held for sale. Such accruals are determined independently of the estimated net realizable value of any related asset, and are recorded without discount or offset for either (i) time value of money prior to the anticipated date of payment, or (ii) expected recoveries from insurance or contribution claims against unaffiliated entities. The allowances are reviewed quarterly and revised as necessary. DEBT DISCOUNT. Debt discount is amortized over the lives of the respective borrowings, generally on the interest method. There was no unamortized debt discount at December 31, 1993. NET INCOME PER COMMON SHARE. Net income per common share amounts are based on the weighted average common shares outstanding during the respective period. Primary and fully-diluted net income per common share are not presented as they result in a dilution of less than 3% from basic net income per common share. SPELLING ENTERTAINMENT GROUP INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) 2. BUSINESS COMBINATIONS AND ACQUISITIONS In May 1991, the Company acquired approximately 27,200,000 shares (82%) of the common stock and all of the preferred stock ($25,000,000 liquidation value) of SEI for approximately $166,800,000 in cash and $22,745,000 principal amount of ten-year, 10% notes (see Note 4 ). The preferred stock and 14,000,000 of the common shares were purchased from Great American Communications Company ("GACC", an AFC affiliate) for approximately $107,500,000 in cash. In July 1992, the Company issued approximately $43,820,000 (5,843,000 shares) of Common Stock in exchange for the remaining publicly held SEI common shares. If the Company had owned 100% of SEI effective at the beginning of 1992, the unaudited pro forma results of operations of the Company for 1992 would have been as follows (in thousands, except per share amount): The pro forma results are not necessarily indicative of the results that would have been realized had the acquisition actually taken place on that date or of the results which may occur in the future. In December 1991, the Company acquired Hamilton Projects (a licensing and merchandising company) and ownership of certain television programming, and received $24,000,000 in cash, from GACC in exchange for its distribution rights to Hanna-Barbera's animated programming. No gain or loss was recognized from this transaction. See Note 4 regarding the acquisition of film distribution rights from Carolco Television, Inc. ("Carolco"), Note 11 regarding the disposition of assets related to the Company's discontinued operations and Note 15 regarding the Company's agreement to acquire Republic Pictures Corporation ("Republic"). SPELLING ENTERTAINMENT GROUP INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) 3. FILM AND TELEVISION COSTS Film and television costs are comprised of the following at December 31 (in thousands): Film and television rights include the Company's acquisition from Carolco in September 1992 of the domestic television rights to more than 150 of Carolco's feature films. The purchase price for these rights, plus certain related receivables, was $50,000,000 in cash plus the assumption of approximately $14,000,000 of related liabilities. Film and television rights also include advances to producers for distribution rights and other film product not produced by the Company. Based on the Company's estimates of future gross revenue as of December 31, 1993, approximately 60% of unamortized released television costs and film and television rights will be amortized during the three years ending December 31, 1996. 4. DEBT Debt consisted of the following at December 31 (in thousands): SPELLING ENTERTAINMENT GROUP INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) In July 1992, SEI entered into a five-year bank credit agreement (the "Bank Agreement") which replaced a prior banking arrangement. The Bank Agreement provided for a term loan facility and a revolving credit facility, with a maximum aggregate availability of $90,000,000. The Bank Agreement contained certain restrictions on the ability of SEI to pay dividends to the parent company. The Bank Agreement was repaid and terminated in January 1994. In January 1994, the Company entered into a three-year credit agreement with BEC (the "BEC Facility"). The BEC Facility provides for (i) a three-year term loan facility of $100,000,000 to fund the Company's acquisition of Republic (see Note 15) and (ii) a revolving credit facility of $75,000,000 to fund the Company's working capital and other requirements. Under the BEC Facility, the Company pays an annual fee of 0.175 % of the unused portion of the revolving credit facility and certain facility and administration fees; interest on the revolving facility is payable at LIBOR plus 1.0%; and interest on the term loan will be at 6.625%. Borrowings under the BEC Facility are secured by all of the assets of the Company. In addition, the Company has agreed to guarantee the obligations of BEC under BEC's credit facility to the extent of the Company's borrowings from BEC under the BEC Facility. The fees and interest rate applicable to the revolving credit portion of the BEC Facility are subject to renegotiation should BEC's facility be terminated, repaid or restructured, and the entire amount outstanding under the BEC Facility may be accelerated if BEC's facility is accelerated by its lenders. The events which might result in an acceleration of BEC's facility include the consummation of BEC's merger with Viacom (see Note 15) without the receipt of a waiver from BEC's lenders. The Company has not been informed as to whether such waiver will be granted by BEC's lenders. However, the Company is currently exploring and believes it can obtain arrangements with third parties under terms and conditions which are not materially different from those contained in the BEC Facility. In February 1993, the Company redeemed its 12-1/4% Subordinated Notes. The Company prepaid all of the outstanding principal amount of its 10% Senior Subordinated Notes and paid or prepaid a substantial portion of its bank debt in October 1993, and redeemed all of the outstanding principal amount of its 12% Subordinated Debentures in November 1993. The Company made cash interest payments of $7,800,000 in 1993, $8,800,000 in 1992 and $7,000,000 in 1991. At December 31, 1993, the carrying value of all of the Company's term loans approximated fair value. SPELLING ENTERTAINMENT GROUP INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) 5. EXTRAORDINARY ITEMS Details of the extraordinary items for the three years ended December 31 were as follows (in thousands): In connection with the early extinguishment of certain indebtedness in 1993 (see Note 4), the Company recorded an extraordinary loss from the write-off of unamortized discount and debt issuance costs relating to such debt. See Note 10 regarding the change in 1993 in the Company's method of accounting for income taxes. 6. PREFERRED STOCK At December 31, 1993, there were 20,000,000 shares of Preferred Stock authorized. 9,000 shares of Series A Preferred Stock had been issued by the Company with a dividend yield of 9% and a liquidation value of $1,000 per share. The Company redeemed all of the Series A Preferred Stock in November 1993. 7. COMMON STOCK The Company declared and paid cash dividends on its Common Stock of $.08, $.08 and $.05 for the years ended December 31, 1993, 1992 and 1991, respectively. SALE OF COMMON STOCK. In October 1993, in connection with the negotiation of the Republic merger (see Note 15), the Company sold 13,362,215 shares of its Common Stock to BEC in exchange for 3,652,542 shares of BEC's common stock. The BEC shares were subsequently sold, with the Company realizing approximately $100,445,000 in cash. STOCK OPTION PLAN. The Company has a stock option plan under which both incentive and nonqualified stock options may be granted to certain key employees and directors to purchase up to five million shares of Common Stock. Options may be granted at a price not less than the fair value of the underlying Common Stock on the date of grant, in the case of incentive stock options, or 50% thereof, in the case of nonqualified options. Each SPELLING ENTERTAINMENT GROUP INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) option may be granted subject to various terms and conditions established on the date of grant, including exercise and expiration dates; provided, however, that all options will expire no later than ten years from their date of grant. The options typically become exercisable at the rate of 20% to 25% annually, beginning one year after date of grant. In October 1992, the Company's shareholders approved amendments that provided for the issuance of options to purchase approximately one million shares of Common Stock to replace options to purchase an identical number of SEI common shares. Stock option data follows: 8. BENEFIT PLANS The Company maintained two defined contribution employee retirement plans which covered substantially all non-union employees of SEI. Contributions by SEI were discretionary or set by formula. Effective January 1, 1993, SEI adopted a new 401(k) Contribution Plan that replaced the two prior plans. Expenses under the various employee retirement plans were $463,000, $586,000 and $355,000 for the years ended December 31, 1993 and 1992 and eight months ended December 31, 1991, respectively. A significant number of the Company's production employees are covered by union sponsored, collectively bargained, multi-employer pension plans. The Company contributed approximately $4,259,000, $3,714,000, $1,383,000 for the years ended December 31, 1993 and 1992 and the eight months ended December 31, 1991, respectively. The FASB issued SFAS No. 106, "Employers' Accounting for Postretirement Benefits other than Pensions" (effective in 1993) and SFAS No. 112 "Employers' Accounting for Postemployment Benefits" (effective in 1994). The Company does not have any postretirement or postemployment benefits. SPELLING ENTERTAINMENT GROUP INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) 9. RELATED PARTY TRANSACTIONS See Note 4 regarding the Company's credit facility with BEC and Note 7 regarding the Company's sale of Common Stock to BEC. From their issuance in May 1991 until their prepayment in October 1993 (see Note 4), a director of the Company held $18,287,500 principal amount of the Company's 10% Senior Subordinated Notes. The Company paid $1,791,000, $1,828,000, and $914,000 in interest (at 10%) on these obligations during 1993, 1992 and 1991, respectively. During 1993, the Company recorded revenue of approximately $3,100,000 from the sale of home videocassettes to BEC. During 1993 the Company paid AFC a premium of $5,000,000 for an insurance-type indemnity against up to $35,000,000 of certain costs it may have to pay (in excess of $25,000,000) in resolving environmental and bankruptcy related claims over a twelve year period. (See Note 11). BEC and AFC provided the Company with management services for which the Company was charged by AFC $1,283,000, $1,493,000 and $928,000 for the years ended December 31, 1993, 1992 and 1991, respectively. The amount charged by BEC in 1993 was $380,000. As of December 31, 1993 the Company had a net receivable from BEC of $1,930,000. 10. INCOME TAXES The provision for income taxes for continuing operations, discontinued operations and extraordinary items for each of the three years ending December 31 include (in thousands): SPELLING ENTERTAINMENT GROUP INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) Effective January 1, 1993, the Company adopted SFAS No. 109, "Accounting for Income Taxes" ("SFAS 109"). SFAS 109 requires an asset and liability approach in accounting for income taxes. Under this method, deferred income taxes are recognized, at enacted rates, to reflect the future effects of tax loss and credit ("tax attribute") carryforwards and temporary differences arising between the tax bases of assets and liabilities and their financial reporting amounts at each year-end. Deferred tax assets and liabilities are adjusted for tax rate changes when they occur. This statement also eliminated the concept of recognizing the benefits of subsequent period utilization of tax attribute carryforwards as extraordinary items, by requiring the immediate recognition of attributes in the year incurred, subject to realization. The cumulative effect of adopting SFAS 109 was not material. The temporary differences and tax attribute carryforwards which gave rise to deferred tax assets and liabilities at December 31, 1993 were as follows (in thousands): The components of income from continuing operations before the provision for income taxes in 1993 were as follows (in thousands): SPELLING ENTERTAINMENT GROUP INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) The primary reasons for the effective tax rates on the income from continuing operations differing from the statutory federal tax rates for each of the three years ended December 31 are summarized as follows: SPELLING ENTERTAINMENT GROUP INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) In connection with adopting SFAS 109, the Company established a valuation allowance against certain of its tax attribute carryforwards. During the year, the Company reassessed (under the criteria of SFAS 109) the realizability of the tax attribute carryforwards in light of factors arising from, or related to, the acquisition of a majority of the Company's Common Stock by BEC. Based on this reassessment, the Company reduced the valuation reserve by approximately $4,200,000 and reflected a corresponding benefit in its provision for income taxes for the third quarter of 1993. Under the "deferred" method previously used by the Company, income tax expense was determined giving effect to differences between income and expense for financial reporting and tax return purposes. The provision for income taxes in 1992 and 1991 included provisions for deferred taxes (primarily related to timing differences in the recognition of film revenue and costs) that would be required in the absence of tax attribute carryforwards. The tax benefit from utilization of such carryforwards was reflected as an extraordinary item in such years. Total cash income tax payments were $6,300,000, $4,100,000 and $5,200,000, respectively for 1993, 1992 and 1991. As of December 31, 1993, the Company had available net operating loss carryforwards of approximately $54,500,000, capital loss carryforwards of $9,500,000, foreign tax credit carryforwards of $3,401,000, investment tax credit carryforwards of $1,773,000 and AMT credit carryforwards of $2,147,000. The use of these attributes, which except for the AMT credit will expire in 1994 through 2007, is subject to certain limitations as a result of BEC's acquisition of a majority interest in the Company during 1993. SPELLING ENTERTAINMENT GROUP INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) 11. DISCONTINUED OPERATIONS All of the Company's former business segments are reported as discontinued. A summary of financial data for discontinued operations for each of the three years ended December 31 follows (in thousands, except per share data): (a) Interest expense incurred prior to the acquisition of SEI which is attributable to discontinued operations. SPELLING ENTERTAINMENT GROUP INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) Net assets (liabilities) of discontinued operations which are held for disposition consisted of the following at December 31 (in thousands): In April 1991, the Company completed the sale of its 24.5% interest in an oil producing concession located in the Persian Gulf (the "Concession") to two Concession partners. The Company recognized a pretax gain of $13.4 million on the sale and received approximately $23.9 million in cash, which included the repayment of $6.1 million in advances made to the Concession in 1991. In December 1991, the Company's Board of Directors authorized management to sell the remaining oil operations. During July and August 1992, the Company sold the "Penndel Group", consisting of two oil group subsidiaries and its Philadelphia terminal facility, for approximately $17.7 million in cash. During December 1992 and January 1993, the Company's major utility supply contracts were sold. No material gain or loss resulted from the overall disposition of these operations. The Company received $50 million in preferred stock of the Circle K Corporation as partial consideration for the sale of its Marketing Group to Circle K in 1988. In May 1990, Circle K and its principal subsidiaries filed for protection under Chapter 11 of the United States Bankruptcy Code. The Company recorded a provision for impairment of $25 million in 1989 and an additional provision of $20 million in 1990. In December 1991, the Company sold the stock and recorded a $4.9 million pretax loss. CONTINGENCIES. The Company continues to be involved in a number of legal and other actions, including threatened claims and pending litigation from matters such as contract disputes, remaining disputed claims under the joint plan of reorganization of the Company and certain of its subsidiaries (the "Joint Plan"), environmental clean-up assessments, damages from alleged dioxin contamination and others. Some of these parties seek damages from the Company in very large amounts. The allowances for estimated losses on disposal and disputed claims set forth above include accruals with respect to these actions. While the results of such actions cannot be predicted with certainty, based upon its knowledge of the facts and circumstances and applicable laws, the Company believes the ultimate resolution of these matters should not have a material adverse effect on its financial condition and its results of operations. This belief is also based upon (i) allowances that have been established for SPELLING ENTERTAINMENT GROUP INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) estimated losses on disposal of former operations and remaining Chapter 11 disputed claims (see table above), and (ii) an insurance-type indemnity agreement with AFC. Substantial portions of such allowances are intended to cover environmental liabilities associated with the Company's former operations. Although there are significant uncertainties inherent in estimating environmental-related liabilities, based upon the Company's experience it is considered unlikely that the amount of possible environmental liabilities and Joint Plan disputed claims would exceed the amount of allowances by more than $50 million. The AFC indemnity, which was agreed to in exchange for a one-time payment of $5 million expensed by the Company as part of discontinued operations in the first quarter of 1993, provides for the reimbursement to the Company of certain costs it may have to pay in resolving environmental and bankruptcy related claims over a twelve year period. The indemnity covers up to $35 million of such liabilities in excess of a threshold amount of $25 million, subject to certain adjustments. (A) In December 1986, the Bankruptcy Court for the Middle District of Florida, Jacksonville Division, confirmed a Joint Plan of Reorganization under Chapter 11 of the Bankruptcy Code for the Company and four of its subsidiaries. There were $13.2 million of remaining Chapter 11 claims pending at December 31, 1993 (reduced from $111 million at December 31, 1986). To the extent such claims are allowed by the Bankruptcy Court, additional payments will be required under the Joint Plan. (B) A subsidiary of the Company, Independent Petrochemical Corporation ("IPC"), has been named as a defendant in a number of personal injury and property damage actions arising from the alleged improper disposal in 1971 of waste material, which was later determined to contain dioxin, at a number of sites in Missouri. These actions were brought by approximately 2,450 individual plaintiffs, the United States (U.S. v. Bliss, et al., U.S. District Court for the Eastern District of Missouri, filed January 20, 1984), the State of Missouri and certain codefendants. Substantially all of the claims by individuals against IPC have been settled by its insurers for an aggregate of approximately $33 million. Although IPC settled with United States and Missouri in 1993, agreeing to liability of $106 million plus future costs, the settlements provide that such amounts are collectible only from insurance potentially available to IPC. The Company has written off its investment in IPC. The Company and two other subsidiaries, Charter Oil Company ("Charter Oil") and Charter International Oil Company were joined as defendants in many of these actions and have settled the claims of (i) substantially all the individuals for $9.5 million, (ii) the United States for $5 million, and (iii) the State of Missouri for $1 million, principally to assure the feasibility of the Joint Plan of Reorganization at the time of its confirmation by the Bankruptcy Court in 1986. The Company, Charter Oil and IPC brought an action against their insurers to secure coverage for the dioxin claims (IPC v. Aetna, et al., U.S. District Court for the District of Columbia, SPELLING ENTERTAINMENT GROUP INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) filed November 9, 1983). On January 10, 1994, the court granted the insurers' motion for summary judgment based upon pollution exclusion language in their policies. Unless this decision is reversed on reconsideration or appeal, there will be no further insurance coverage for the dioxin claims. The only counterclaims that were filed in the coverage case, by two insurers seeking recovery of certain defense costs and $12 million of the settlement amounts they paid to individuals, have been dismissed voluntarily with prejudice. (C) The Company has had contact with various governmental agencies regarding possible contamination of soil and groundwater at eight properties that are or have been owned or leased by Company's subsidiaries. Private actions also have been brought or threatened with respect to such possible contamination at an additional five locations. The Company may be assessed for cleanup costs under relevant local, state or federal environmental laws, and future claims could be asserted with respect to other formerly owned or leased properties. Notification of possible responsibility has also been received regarding twelve other sites where waste materials allegedly were delivered. The Company's liability insurers have been placed on notice of many of these claims and have taken the position that there is no coverage under their policies. While the Company does not agree that coverage is not available under its past policies, there is no assurance that pending or future claims will be covered by such insurance. Although comprehensive evaluations of liability and of the extent of contamination have not been performed in all cases, the following claims are believed by the Company at this time to be the most significant. A subsidiary has begun the cleanup of a petroleum terminal property owned by the subsidiary in Tiverton, Rhode Island. The estimated remaining cost is $8 million, which has been fully accrued. The subsidiary is investigating whether former owners or insurers may be liable for a portion of the cost. In 1990, a subsidiary declined to join a settlement agreement among the United States, a state government and 15 companies regarding the Sullivan's Ledge superfund site in New Bedford, Massachusetts, based upon certain legal defenses and the belief that any liability the subsidiary may have should be less than a pro rata allocation among the settling parties. Under the proposed agreement, the subsidiary would have been obligated to pay between $2 million and $3 million in cleanup costs. The subsidiary subsequently has agreed with the United States to settle its potential liability for $215,000, subject to court approval. The settlement, which is being objected to by members of the prior settling group, will be asserted by the subsidiary as a defense to any private cost recovery action filed by the group. A subsidiary has been informed that it is one of thirteen identified potentially responsible parties at the Sikes superfund site in Crosby, Texas, and that a cleanup plan estimated to cost approximately $89 million has been selected and is being implemented by the EPA. Although joint and several liability is possible with respect to such sites, and there is little relevant information presently available, management believes that there are meritorious defenses against any material liability. SPELLING ENTERTAINMENT GROUP INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) An unaffiliated company has suggested that a subsidiary of the Company is one of 18 potentially responsible parties at the Petro-chemical Systems superfund site in Liberty County, Texas, at which the EPA has selected a cleanup plan estimated to cost approximately $26 million. Bankruptcy defenses will be relevant to possible cost recovery actions by the EPA or other parties concerning this site. PENSION PLAN. The Company has a noncontributory, defined benefit pension plan which covers employees of the discontinued operations, a significant number of which have vested benefits. Contributions are made on an actuarial basis in amounts primarily based on employees' years of service and average salary when employed. At December 31, 1992 and 1991, the plan assets exceeded the projected benefit obligation by $2.5 million and $2.3 million, respectively. In 1993, the Company recorded an additional minimum pension liability of $5,217,000 (net of a tax benefit of $3,321,000), with an offsetting charge to Shareholders' Equity, to reflect the adjustment to pension liability resulting from the reduction in the discount rate from 8.5% in 1992 to 7% in 1993. The following table sets forth the plan's funded status and amounts recognized as of December 31, 1993 (in thousands): Net pension cost for 1993 which was charged against net liabilities related to discontinued operations in the balance sheet (in thousands): The weighted-average discount rate and the rate of increase in future compensation levels used in determining the actuarial present value of the projected benefit obligation were 7% and 6.25%, respectively. The expected long-term rate of return on assets was 9%. The plan assets are invested primarily in fixed income securities. Included in the plan assets at December 31, 1993 and 1992, was $5.5 million principal amount of AFC 12.25% debentures due 2003. SPELLING ENTERTAINMENT GROUP INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) 12. COMMITMENTS AND CONTINGENCIES The Company continues to be involved in a number of legal and other actions including threatened claims and pending litigation. While the results of such actions cannot be predicted with certainty, based upon its knowledge of the facts and circumstances and applicable laws, the Company believes that the ultimate resolution of all disputed claims, pending litigation and threatened claims will not have a material adverse effect on its financial condition or its results of operations. See Note 11 for contingencies relating to discontinued operations. As of December 31, 1993, SEI had operating leases for offices and equipment. The rental expense for the years ended December 31, 1993 and 1992, and eight months ended December 31, 1991, was $4.5 million, $4.0 million and $1.8 million, respectively. The future minimum annual rental commitments under non-cancelable operating leases, excluding renewal options, for the subsequent five years and thereafter for continuing operations are as follow (in thousands): SPELLING ENTERTAINMENT GROUP INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) 13. QUARTERLY OPERATING RESULTS (UNAUDITED) The following table presents quarterly results of operations for the years ended December 31, 1993 and 1992 (in thousands, except per share data). (a) Certain reclassifications have been made in the financial statements to the prior presentations of revenue; selling, general and administrative expense; interest income; and other expense. In this table, only revenue is affected by these reclassifications. SPELLING ENTERTAINMENT GROUP INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) 14. BUSINESS SEGMENTS The Company's continuing business activities consist of one business segment. The Company had revenue from one customer in 1993, 1992 and 1991 representing 22%, 22% and 13% of revenue, respectively. Net assets, capital expenditures and depreciation outside the United States were not material in relation to consolidated amounts. International revenue is earned primarily from television and theatrical distribution and home video sales; substantially all of such revenue is earned under license agreements denominated in U.S. dollars. International export revenue by major geographic area follows for the years ended December 31 (as a percentage of total revenue): (*) Specific sources not available 15. SUBSEQUENT EVENTS On September 12, 1993, the Company and Republic entered into an agreement in principle pursuant to which the Company agreed to acquire by merger all of Republic's outstanding common stock for $13 per share in cash. Additionally, options and warrants to acquire Republic common stock outstanding prior to the merger will be converted into the right to receive, upon payment of the exercise price, 1.6508 shares of the Company's Common Stock for each share of Republic common stock into which such option or warrant was exercisable. The definitive merger agreement was signed by the Company and Republic on December 7, 1993. The actual merger is expected to be consummated in the second quarter of 1994, with the shareholders of Republic receiving a total consideration of approximately $100,000,000 in cash. In January 1994, BEC entered into a merger agreement pursuant to which BEC has agreed to merge with and into Viacom, Inc. ("Viacom") with Viacom being the surviving corporation. Under the terms of the agreement each share of BEC's common stock shall be converted into the right to receive .08 shares of Viacom Class A common stock, .60615 shares of Viacom Class B common stock and under certain circumstances, up to an additional .13829 shares of Viacom Class B common stock. Upon the closing of the merger, which closing is subject to customary conditions including approval of the merger by the BEC's shareholders, Viacom would own a majority of the Company's Common Stock. The Company entered into a credit facility with BEC in January 1994; see Note 4. SPELLING ENTERTAINMENT GROUP INC. SCHEDULE II -- AMOUNTS RECEIVABLE FROM RELATED PARTIES AND UNDERWRITERS, PROMOTERS AND EMPLOYEES OTHER THAN RELATED PARTIES THREE YEARS ENDED DECEMBER 31, 1993 (IN THOUSANDS) (a) Individual ceased being an employee during the year. (b) Represents secured receivables of SEI acquired in 1991. Represents loans made for the purchase of personal residences in connection with relocations. The notes bear interest at 8% and each was secured by trust deeds on the property. SPELLING ENTERTAINMENT GROUP INC. SCHEDULE VIII--VALUATION AND QUALIFYING ACCOUNTS YEAR ENDED DECEMBER 31, (IN THOUSANDS) (a) During 1993, all reserves for disputed claims and other items were reclassed into losses on disposal and disputed claims. ITEM 9.

ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE On June 1, 1993, the Company replaced Ernst & Young with Arthur Andersen & Co. as its independent accountants. The decision to replace Ernst & Young was approved by the Board of Directors of the Company. The report of Ernst & Young dated March 19, 1993 relating to the Consolidated Financial Statements of the Company for the two years ended December 31, 1992 contained no adverse opinion or disclaimer of opinion and was not qualified or modified as to uncertainty, audit scope or accounting principle. In connection with its audit of the Company for the year ended December 31, 1992 and through May 31, 1993, there have been no disagreements with Ernst & Young on any matter of accounting principles or practices, financial statement disclosure or auditing scope or procedure, which disagreement if not resolved to the satisfaction of Ernst & Young would have caused them to make reference thereto in their financial report on the financial statements for such years. _____________________________________________ PART III The information required by the following items will be included in the Company's definitive Proxy Statement, which will be filed with the Securities and Exchange Commission in connection with the 1994 Annual Meeting of Shareholders, and is incorporated herein by reference: ITEM 10.

ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT ITEM 11.

ITEM 11. EXECUTIVE COMPENSATION ITEM 12.

ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT ITEM 13.

ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS _____________________________________________ PART IV ITEM 14.

ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K (a) Documents filed as part of this Report: 1. Financial Statements are included in Part II, Item 8. 2. Financial Statement Schedules: A. Selected Quarterly Financial Data is included in Note 13 to the Company's Consolidated Financial Statements B. Schedules filed herewith for 1993, 1992 and 1991: All other schedules for which provisions are made in the applicable regulation of the Securities and Exchange Commission have been omitted as they are not applicable, not required, or the information required thereby is set forth in the Consolidated Financial Statements or the notes thereto. 3. Exhibits - see Exhibit Index on page 61. (b) Reports on Form 8-K: (1) Form 8-K dated October 5, 1993 related to the consummation of the sale of 13,362,215 shares of the Company's Common Stock to a subsidiary of Blockbuster Entertainment Corporation. (2) Form 8-K dated December 8, 1993 related to the Definitive Agreement and Plan of Merger with Republic Pictures Corporation. (3) Form 8-K dated January 31, 1994 related to the Credit Agreement with Blockbuster Entertainment Corporation. SIGNATURES Pursuant to the requirements of Section 13 or 15 (d) 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. SPELLING ENTERTAINMENT GROUP INC. Date: By: /s/ H. STEVEN R. BERRARD ------------------------------- Steven R. Berrard President and Chief Executive Officer Pursuant to the requirements of the Securities Exchange Act of 1934, this Report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated. Date: By: /s/ H. WAYNE HUIZENGA ------------------------------- H. Wayne Huizenga Chairman of the Board By: /s/ AARON SPELLING ------------------------------- Aaron Spelling Vice Chairman of the Board By: /s/ STEVEN R. BERRARD ------------------------------- Steven R. Berrard President and Chief Executive Officer (Principal Executive Officer) By: /s/ THOMAS P. CARSON ------------------------------- Thomas P. Carson Senior Vice President, Treasurer and Chief Financial Officer (Principal Financial Officer) By: /s/ KATHLEEN COUGHLAN -------------------------------- Kathleen Coughlan Vice President and Corporate Controller (Principal Accounting Officer) By: /s/ JOHN T. LAWRENCE -------------------------------- John T. Lawrence Director By: /s/ S. CRAIG LINDNER -------------------------------- S. Craig Lindner Director By: /s/ ALFRED W. MARTINELLI -------------------------------- Alfred W. Martinelli Director By: /s/ JOHN L. MEUTHING -------------------------------- John L. Meuthing Director SPELLING ENTERTAINMENT GROUP INC. INDEX TO EXHIBITS

29917_1993.txt

29917

1993

ITEM 1. BUSINESS - ----------------- Dow Corning Corporation (Dow Corning or the Company) was incorporated in 1943 by Corning Glass Works (now Corning Incorporated) and The Dow Chemical Company (Dow Chemical) to develop, produce and market silicones. Corning Incorporated provided the basic silicone technology and Dow Chemical supplied the chemical processing and manufacturing know-how. Both companies provided initial key employees. Dow Corning built a new business based on silicone chemistry. The starting point is quartz rock, a form of silica. The silicon-oxygen-silicon polymer chain, the backbone of all silicones, is derived from a series of chemical processes. Various organic groups attached to this polymer chain can modify properties and alter physical form. Regardless of form, most silicones share a combination of properties, including electrical resistance, ability to maintain performance across a broad range of temperatures, resistance to aging, water repellency, lubricating characteristics and relative chemical and physiological inertness. The versatility of silicones has led to a wide variety of applications across a broad spectrum of industries in all major countries. Dow Corning has supplemented its product line with selected silicone modified organic and non-silicone products, including reactive chemicals based upon silicon. In addition to silicone lubricants, Dow Corning makes and sells specialty lubricants based on molybdenum disulfide, principally under the trademark MOLYKOTE(R). Hemlock Semiconductor Corporation, a subsidiary in which Dow Corning has a 63.25% interest, produces polycrystalline silicon which is the basic material for most semiconductor devices. Polycrystalline silicon is also used to manufacture solar cells. Today, Dow Corning manufactures and sells more than 4,500 products to over 45,000 customers throughout the world. No one customer accounts for more than 3% of net sales. Raw Materials - ------------- The principal raw material used in the production of Dow Corning products is elemental silicon, which is produced and sold by a number of U.S. and non-U.S. firms. Dow Corning currently purchases silicon from various domestic and foreign producers. Dow Corning is a party to a number of silicon supply contracts which cover the majority of anticipated annual requirements. Worldwide production capacity is judged to be adequate to meet expected demand and shortages appear unlikely. Therefore, Dow Corning believes that it has adequate sources of supply of silicon. Dow Corning also purchases substantial quantities, and believes it has adequate sources of supply, of methyl alcohol, methyl chloride, and other raw materials required for its manufacturing operations. Although from time to time temporary shortages of particular raw materials may exist, Dow Corning believes that it has adequate sources of raw materials required to maintain its operations. Foreign Operations - ------------------ The foreign operations of Dow Corning, principally in Europe and Asia, are conducted primarily through wholly-owned subsidiaries and involve sales of substantially all Dow Corning products. These products are manufactured either domestically or by one of the Company's foreign subsidiaries. See Note 16 of Notes to Consolidated Financial Statements included in this report for financial information relating to foreign operations. Foreign business is subject to special considerations, including exchange controls, fluctuations in currency values, dividend and payment restrictions, political instability and international credit or financial problems. While these conditions associated with foreign business involve risks different from those associated with domestic business activities, Dow Corning does not regard the overall risks of its foreign operations, on the whole, to be materially greater than those of its operations in the United States. Competition - ----------- Dow Corning is a leader among the various companies which produce silicone products throughout the world. Substantial competition for Dow Corning products both in the United States and abroad comes from other manufacturers of silicone products. In addition, virtually all silicone products compete with non- silicone products in specific applications. The risk of product substitution is common to all Dow Corning products. The principal competitive elements in the sale of Dow Corning products are: product quality and performance, responsive customer service, new product development, cost effectiveness, and application expertise. Research and Development - ------------------------ Since its inception, Dow Corning has been engaged in a continuous program of basic and applied research on silicon-based materials to develop new products and processes, to improve and refine existing products and processes, and to develop new applications for existing products. The Company also provides a wide variety of technical services to its customers. Research and development expenditures totalled (in millions of dollars) $163.9 in 1993, $161.2 in 1992, and $148.7 in 1991. Patents and Licenses - -------------------- Dow Corning consistently applies for United States and foreign patents and owns, directly or indirectly, a substantial number of such patents. The Company is a licensor under a number of patent licenses and technology agreements. While Dow Corning considers its patents and licenses a valuable asset, it does not regard its business as being materially dependent on any single patent or license or any group of related patents or licenses. Protection of the Environment - ----------------------------- Dow Corning has set a goal to reduce within the United States its toxic releases by 80% in 1995 compared to 1987. This goal is consistent with voluntary commitments made by the Company under two programs with the U.S. Environmental Protection Agency - - the 33/50 Voluntary Reduction Program under which the Company has committed to reductions of all of its toxic chemical releases, and the Clean Air Act Early Reduction Credit Program under which the Company has committed to major reductions in methyl chloride releases at its largest U.S. manufacturing facilities. As a member of the Chemical Manufacturers Association, the Company is also committed to and is implementing the codes of management practices specified in Responsible Care(R). Dow Corning expends funds consistent with its commitments to limit the discharge of materials into the environment. It is expected that Dow Corning's pollution control related expenditures will be partially offset through the recovery of raw materials in the pollution control process. These expenditures should not materially affect Dow Corning's earnings or competitive position. The Company records a charge to earnings for environmental matters when it is probable that a liability has been incurred and the Company's costs can be reasonably estimated. For information concerning environmental liabilities, see Note 2 of Notes to Consolidated Financial Statements. Employees - --------- Dow Corning's average employment for 1993 was 8,600 persons. Average employment for 1992, determined on a comparable basis, was 9,000 persons. ITEM 2.

ITEM 2. PROPERTIES - ------------------- Dow Corning owns or leases extensive property for use in its business and believes that its properties are in good operating condition and are generally suited for the purposes for which they are presently being used. Principal United States production plants are located in Kentucky, Michigan and North Carolina. Principal foreign manufacturing plants are located in Australia, Belgium, Germany, Japan, South Korea and the United Kingdom. Dow Corning owns substantially all of its manufacturing facilities. Approximately 62% of Dow Corning's aggregate investment in plant and equipment is represented by its United States facilities. Dow Corning owns its executive and corporate offices, which are located near Midland, Michigan, and certain foreign offices. The Company also owns research and development facilities in the United States, Europe and Asia. Domestic and foreign sales offices are primarily in leased facilities. Dow Corning leases most of its computers and communications equipment. For information concerning lease commitments, see Note 15 of Notes to Consolidated Financial Statements. ITEM 3.

ITEM 3. LEGAL PROCEEDINGS - -------------------------- ENVIRONMENTAL MATTERS The Company has agreed to participate in the Toxic Substances Control Act (TSCA) Section 8(e) compliance audit program. The Company expects to pay a civil penalty which will exceed $100,000. While the exact amount of the civil penalty is not yet known, the United States Environmental Protection Agency (EPA) has put a limit of $1 million on any civil penalty to be paid. On September 26, 1991, the EPA filed an administrative complaint against the Company under TSCA alleging that, from 1988 to 1990, the Company had imported a chemical substance that did not appear on the TSCA Inventory of Existing Chemical Substances. EPA proposed a civil penalty of $230,000 for the violations alleged in the complaint, but reduced the amount to $172,500 because the Company had voluntarily disclosed the situation to the EPA immediately upon discovering it. On July 13, 1993, the Company finalized a consent agreement with the EPA. Under this agreement, the Company agreed to pay a civil penalty of $46,000 and complete a supplemental enforcement project at its Carrollton, Kentucky Facility. BREAST IMPLANT LITIGATION Breast Implant Products Liability Purported Class Action Lawsuits - ----------------------------------------------------------------- As of January 20, 1994, the Company had been named, generally as one of several defendants, in 41 purported breast implant products liability class action lawsuits filed on behalf of individuals who claim to have or have had silicone gel breast implants. Of these lawsuits, 30 have been brought in various Federal District Courts, 9 have been brought in various state courts, and 2 have been brought in courts in Canada. Among the Federal District Court class action lawsuits, 20 were filed in the first quarter of 1992, 4 were filed in the second quarter of 1992, 1 was filed in the third quarter of 1992, 2 were filed in the fourth quarter of 1992, 1 was filed in the first quarter of 1993, 1 was filed in the second quarter of 1993, and 1 was filed in the third quarter of 1993. These cases have been filed in the Federal District Courts for the District of Arizona, the Northern District of California (3 cases), the Central District of California, the Southern District of California, the District of Hawaii, the Northern District of Illinois, the Eastern District of Kentucky, the Northern District of Louisiana, the Eastern District of Michigan, the District of Minnesota (2 cases), the Eastern District of New York (2 cases), the Northern District of Ohio (3 cases), the Southern District of Ohio (7 cases), the Eastern District of Pennsylvania, the Western District of Pennsylvania (2 cases), the District of Utah and the Eastern District of Virginia. In the purported class action case filed in the Federal District Court for the Eastern District of Virginia, all proceedings have been stayed and class certification has been denied. All of these federal purported breast implant products liability class action lawsuits have been transferred to the Federal District Court for the Northern District of Alabama for discovery purposes (see "Consolidation of Breast Implant Products Liability Lawsuits" below). In one of the federal class actions filed in the Southern District of Ohio (later transferred to the Northern District of Alabama), a class action was conditionally certified on behalf of all breast implant recipients in the United States (and their spouses). The Federal District Court in Alabama has announced that this certification order will be reconsidered and could be confirmed, modified, or vacated. In the class action filed in the District of Utah, a class certification motion has been denied. In the class action filed in the Eastern District of Michigan, the Court was asked to certify a class action on behalf of breast implant recipients residing outside the United States; this motion was denied, but class certification may be sought again in the future. Among the 9 purported class action lawsuits brought in various state courts, 6 were filed in the first quarter of 1992, 1 was filed in the second quarter of 1992, 1 was filed in the third quarter of 1992, and 1 was filed in the fourth quarter of 1992. These cases have been filed in the following state courts: The Dade County, Florida Eleventh Judicial Circuit Court; the District Court for the Third Judicial District of Utah; the Philadelphia County, Pennsylvania Court of Common Pleas; the Dauphin County, Pennsylvania Court of Common Pleas; the Cook County, Illinois Circuit Court (2 cases); the Marion County, Indiana Superior Court; the Civil District Court for the Parish of Orleans, Louisiana; and the District Court for Douglas County, Nebraska. In 5 of these cases (the 2 cases in the Cook County, Illinois Circuit Court, the case in the District Court for the Third Judicial District of Utah, the case in the Philadelphia County, Pennsylvania Court of Common Pleas and the case in the Dauphin County, Pennsylvania Court of Common Pleas), either the purported class action claims have been dismissed or class certification has been denied. The case filed in Douglas County, Nebraska was removed from state to federal court and was then transferred to the Federal District Court for the Northern District of Alabama; the purported class action claims in this case have been withdrawn. In the case filed in the Civil District Court for the Parish of Orleans, Louisiana, the Court certified a class of women with silicone breast implants who either reside in or received their implants in the State of Louisiana; this order certifying a class action has been upheld on appeal. Three of these state purported class action cases remain active. A purported class action was filed in Ontario, Canada, during the first quarter of 1993 against Dow Corning Canada, Inc., a wholly-owned subsidiary of the Company. The Judge has entered an order certifying a class of breast implant recipients in the Province of Ontario, Canada; the Ontario Court of Appeals has declined to hear an appeal from this class certification order. In the third quarter of 1993, a petition was filed in Montreal, Canada, seeking authorization to institute a class action on behalf of a purported class of breast implant recipients in the Province of Quebec, Canada, against Dow Corning Corporation and Dow Corning Canada, Inc. The court has not yet decided whether to authorize such a class action. The typical alleged factual bases for these lawsuits include allegations that the plaintiffs' breast implants caused specified ailments, including, among other things, autoimmune disease, scleroderma, systemic disorders, joint swelling and chronic fatigue. The Company is sometimes named as the manufacturer of silicone gel breast implants, and other times the Company is named as the supplier of silicone materials to other breast implant manufacturers. Plaintiffs in these cases typically seek relief in the form of monetary damages, often in unspecified amounts, and have also asked for certain types of equitable relief such as requiring the Company to fund the removal of the breast implants of the class members, to fund medical research into any ailments caused by silicone gel breast implants and to fund periodic medical checkups for the class members. The purported federal class action in the Federal District Court for the Eastern District of Pennsylvania claims monetary damages of more than $75,000 for each plaintiff. One of the purported federal class actions in the Federal District Court for the Southern District of Ohio claims monetary damages of more than $50,000 for each plaintiff. One of the purported federal class actions in the Federal District Court for the District of Minnesota claims an unspecified amount of monetary damages, but claims less than $50,000 for each plaintiff on fraud claims. The purported federal class action in the Federal District Court for the Southern District of California claims more than $50,000 for each plaintiff. One of the purported federal class actions in the Federal District Court for the Western District of Pennsylvania claims damages of $50,000 compensatory and $50,000 punitive damages for each plaintiff. Each other purported federal class action specifies monetary damages in an unspecified amount except that they claim the minimal jurisdictional amount. The purported state class action in the Dade County, Florida Eleventh Judicial Circuit Court claims $500,000,000 in punitive damages and unspecified compensatory damages for the class. Each other purported state class action specifies monetary damages in an unspecified amount except that they claim the minimal jurisdictional amounts. The purported class action in Ontario, Canada, claims $80,000 in monetary damages for each named plaintiff and unspecified monetary damages for other members of the purported class. Monetary damages claimed in these cases in the aggregate may be substantial; however, the Company does not consider the monetary damages claimed to be a realistic measure of the Company's ultimate resolution costs. Individual Breast Implant Products Liability Lawsuits - ----------------------------------------------------- As of January 20, 1994, the Company has been named, often along with other defendants, in approximately 11,800 individual breast implant products liability lawsuits filed in federal courts and state courts in many different jurisdictions; many of these cases involve multiple plaintiffs. The typical alleged factual bases for these lawsuits include allegations that the plaintiffs' breast implants caused specified ailments, including, among others, autoimmune disease, scleroderma, systemic disorders, joint swelling and chronic fatigue. The Company is sometimes named as the manufacturer of silicone gel breast implants, and other times the Company is named as the supplier of silicone raw materials to other breast implant manufacturers. Plaintiffs in these cases typically seek relief in the form of monetary damages, often in unspecified amounts. In those individual breast implant cases where management is aware that monetary damages are specified, the amount of monetary damages alleged ranges from approximately $100,000 to approximately $140,000,000. Also, many of these cases only specify as monetary damages an amount in excess of the jurisdictional minimum for the courts in which such cases are filed. Monetary damages claimed in these cases in the aggregate may be substantial; however, the Company does not consider the monetary damages claimed to be a realistic measure of the Company's ultimate resolution costs. Consolidation of Breast Implant Products Liability Lawsuits - ----------------------------------------------------------- Many of these breast implant products liability cases have been or are in the process of being consolidated for purposes of case management in federal and state courts. As previously reported, on June 25, 1992, the Judicial Panel on Multidistrict Litigation in "In Re Silicone Gel Breast Implants Products Liability Litigation" consolidated all federal breast implant cases for discovery purposes in the Federal District Court for the Northern District of Alabama under the multidistrict litigation rules "in order to avoid duplication of discovery, prevent inconsistent pretrial rulings, and preserve the resources of the parties, their counsel and the judiciary." Substantially all federal breast implant cases have been consolidated or are in the process of transfer, or are likely to be transferred, to the Federal District Court for the Northern District of Alabama. A substantial number of breast implant cases originally filed in state courts have been removed to federal court and either have been or are likely to be similarly transferred and consolidated. The Company anticipates that any federal breast implant products liability cases filed after June 25, 1992, as well as some state breast implant cases removed to federal courts, will be transferred to the Federal District Court for the Northern District of Alabama for discovery purposes under the multidistrict litigation rules. In addition, the consolidation of many state breast implant products liability cases has proceeded in many jurisdictions where a substantial number of state breast implant lawsuits have been filed; however, this consolidation of state cases has not occurred in all jurisdictions. As of December 31, 1993, substantially more than half of all breast implant cases were consolidated for pretrial purposes at the federal and state levels. The Company views these case consolidation measures as positive steps toward the management of these various lawsuits and anticipates that current and future breast implant lawsuit consolidations will result in a reduction of litigation defense costs per case. For more information on these matters, see Note 2 of Notes to Consolidated Financial Statements. Settlement Proposed to Resolve Breast Implant Claims - ---------------------------------------------------- On September 9, 1993, the Company announced that representatives of plaintiffs and defendants involved with silicone breast implant litigation have developed a "Statement of Principles for Global Resolution of Breast Implant Claims" (the "Statement of Principles"). The Statement of Principles summarizes a proposed claims based structured resolution of claims arising out of breast implants which have been or could be asserted against various implant manufacturers, suppliers, physicians and hospitals (the "Proposed Settlement"). Under the Proposed Settlement, if implemented, industry participants (the "Funding Participants") would contribute up to $4.75 billion over a period of thirty years to establish several special purpose funds. The Proposed Settlement would define the circumstances under which payments from the funds would be made. The Proposed Settlement includes provisions for (a) class membership and the ability of plaintiffs to opt out of the class, (b) the establishment of defined funds for medical diagnostic/evaluation procedures, explantation, ruptures, compensation for specific diseases and administration, (c) payment terms and timing and (d) claims administration. The Proposed Settlement defines periods during which breast implant plaintiffs may elect not to settle their claims by way of the Proposed Settlement and continue their individual breast implant litigation against manufacturers and other defendants (the "Opt Out Plaintiffs"). In certain circumstances, if any defendant who is a Funding Participant considers the number of Opt Out Plaintiffs maintaining lawsuits against such defendant to be excessive, such defendant may decide to exercise the option to withdraw from participation in the Proposed Settlement. For more information on these matters, see Note 2 of Notes to Consolidated Financial Statements. SECURITIES LAWS AND SHAREHOLDER DERIVATIVE LAWSUITS Securities Laws Purported Class Action Lawsuits - ----------------------------------------------- As of January 20, 1994, the Company and certain of its directors and officers were named, as defendants with others, in two purported securities laws class action lawsuits filed by purchasers of stock of Corning Incorporated (Corning) and The Dow Chemical Company (Dow Chemical). These cases were originally filed as several separate cases in the Federal District Court for the Southern District of New York in the first quarter of 1992; these cases were consolidated in the second quarter of 1992 so that there is one case involving claims on behalf of purchasers of stock of Corning and one case involving claims on behalf of purchasers of stock of Dow Chemical. The plaintiffs in these cases allege, among other things, misrepresentations and omissions of material facts and breach of duty with respect to purchasers of stock of Corning and Dow Chemical relative to the breast implant issue. The relief sought in these cases is monetary damages in unspecified amounts. Motions to dismiss both cases have been filed by all defendants. Shareholder Derivative Lawsuits - ------------------------------- As of January 20, 1994, the Company and/or certain of its directors and officers were named in three shareholder derivative lawsuits filed by shareholders of Corning and Dow Chemical. The plaintiffs in these cases allege various breaches of fiduciary duties claimed to be owed by the defendants relative to the breast implant issue. The relief sought by the shareholders filing these suits on behalf of Dow Chemical and Corning is monetary damages in unspecified amounts. Motions to dismiss these cases have been filed by all defendants. GRAND JURY INVESTIGATION On February 8, 1993, the Company received two federal grand jury subpoenas initiated by the Assistant U.S. Attorney in Baltimore, Maryland, seeking documents and information related to silicone breast implants. The Company has provided information in response to the subpoenas and continues to cooperate with the Assistant U.S. Attorney's requests. LAWSUIT AGAINST INSURANCE CARRIERS On June 30, 1993, the Company filed a complaint, which was subsequently amended, in the Superior Court of California against 99 insurance companies which issued occurrence based products liability insurance policies to the Company from 1962 through 1985 ("Insurers"). The complaint also names as defendants three state insurance guaranty funds. This action (the "California Action") resulted from an inability of some of the Insurers to reach an agreement with the Company on a formula for the allocation among the Insurers of payments of defense and indemnity expenses submitted by the Company related to breast implant products liability lawsuits and claims ("Insurance Allocation Agreement"). The California Action was filed to seek, among other things, a judicial enforcement of the obligations of the Insurers under the relevant insurance policies. On September 10, 1993, several of the Company's insurers filed a complaint against the Company and other insurers for declaratory relief in Wayne County Michigan Circuit Court (the "Michigan Action"). This complaint named additional insurers, particularly the insurers that provided coverage on a claims-made basis subsequent to 1985, and raised issues similar to those described above for determination by the courts. On September 13, 1993, plaintiff insurers in the Michigan Action brought a motion in the California Action for the California Action to be stayed or dismissed in favor of the Michigan Action on the grounds of inconvenient forum. On October 1, 1993, the California Court dismissed the California Action on the grounds of inconvenient forum. In light of this ruling, the Company has elected to litigate the coverage issues on breast implant product liability lawsuits and claims in the Michigan Action. Notwithstanding this litigation, the Company is continuing its negotiations with the Insurers to obtain an Insurance Allocation Agreement as described above. SECURITIES AND EXCHANGE COMMISSION INFORMAL INVESTIGATION The Company received a request, dated July 9, 1993, from the Boston Regional Office of the Securities and Exchange Commission for certain documents and information related to silicone breast implants. The request states that an informal investigation of the Company and its equity owners is being conducted by the Boston Regional Office. On July 30, 1993, the Company responded to this request enclosing the documents and information requested along with related information. The Company will continue to cooperate with the Boston Regional Office. ITEM 4.

ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS - ------------------------------------------------------------ Item omitted in accordance with provisions of General Instruction J of Form 10-K. PART II ITEM 5.

ITEM 5. MARKET FOR REGISTRANT'S COMMON STOCK AND RELATED STOCKHOLDER MATTERS - --------------------------------------------------------- The Company's common stock is owned in equal portions by Corning Incorporated and Dow Holdings Inc., a wholly-owned subsidiary of The Dow Chemical Company. None of the Company's common stock has been sold or traded since the Company's inception in 1943. The Company did not pay dividends in 1993. In the first quarter of 1992, the Company paid a dividend of $8.20 per common share. The Company paid a dividend of $6.00 per common share in each of the remaining quarters of 1992. Under the provisions of the Revolving Credit Agreement (which is described in Note 8 of Notes to Consolidated Financial Statements) the Company is subject to certain restrictions as to the payment of dividends. The amount of the restriction is based on a formula which considers, among other things, the income before income taxes for the most recent fiscal year. Based on the computation completed for the year ended December 31, 1993, the Company is restricted from issuing dividends in 1994. ITEM 6.

ITEM 6. SELECTED FINANCIAL DATA - -------------------------------- ITEM 7.

ITEM 7. MANAGEMENT'S NARRATIVE ANALYSIS - ---------------------------------------- (all amounts in millions of dollars) Results of Operations - --------------------- 1993 Compared to 1992 --------------------- 1993 net sales increased $88.0 or 4.5% over levels reported for 1992. The increase for 1993 was principally attributable to higher sales volumes, particularly in Asia, offset slightly by lower selling prices, and unfavorable currency effects in Europe. Manufacturing cost of sales, as a percent of net sales, was relatively unchanged for 1993 as compared to 1992. Marketing and administrative expenses, as a percent of net sales, were 19.8% in 1993 compared to 21.0% in 1992. This decrease is attributable to lower freight costs, commissions and allowances. Implant costs of $640.0 in 1993 and $69.0 in 1992 represent provisions for costs associated with breast implant litigation, claims and related matters, as further described in Note 2 of Notes to Consolidated Financial Statements. These costs were reported separately to better identify the Company's profitability from ongoing operations and the financial impact resulting from breast implant litigation. Special items of $40.0 in 1992 relate to provisions for restructuring activities, consisting largely of costs associated with the cessation of manufacturing activities at a subsidiary in Brazil and costs involved in global expense reduction, including elimination of low-priority activities, redeployment of people and reduction in the value of affected facilities. The Company incurred an operating loss in 1993 of $404.1, compared to operating income of $93.1 in 1992. Operating results in both years have been negatively impacted by breast implant related charges of $640.0 in 1993 and $69.0 in 1992. Operating results were also negatively impacted in 1992 due to special items of $40.0 described above. Other income was $15.4 in 1993 compared to other expense of $20.6 in 1992. As a result of the turmoil in European financial markets in September 1992, the Company incurred losses in 1992 related to positions taken in several financial instruments. These losses were generated as the market values of these instruments were sensitive to movements in cross-currency exchange rates and interest rates in certain foreign markets. During September 1992, the Company offset these positions and reduced its exposure to the effects of further instability in the European markets. Implant costs of $640.0 described above were offset by a related tax benefit of $225.0. Excluding the impact of this charge and the related tax benefit, the effective tax rate was 34.0% in 1993 compared to 20.2% in 1992. The higher effective rate in 1993 is due to lower foreign tax credits. During 1992, the Company adopted Statements of Financial Accounting Standards No. 106, Employers' Accounting for Postretirement Benefits Other Than Pensions, and No. 109, Accounting for Income Taxes. The impact of these changes, as further explained in Notes 11 and 13 of Notes to Consolidated Financial Statements, reduced 1992 net income by $111.9, $100.4 of which represented the cumulative effect of these changes for years prior to 1992. 1992 Compared to 1991 --------------------- 1992 net sales increased $110.3 or 6.0% over levels reported for 1991. The increase for 1992 was principally attributable to higher sales volumes. The effects of currencies strengthening in Europe and Asia have also contributed to this increase. Weak economic conditions in most industrialized countries were the major reasons for low volume growth in 1992. Economic conditions and competitive pressures limited opportunities for price improvements and selling prices were lower in 1992 than in 1991. Manufacturing cost of sales, as a percent of net sales, was 68.7% in 1992 compared to 64.8% for 1991. These increases, in large part, reflect the effects of lower selling prices on products sold and growth in employee costs, the latter partially attributable to effects related to the adoption of Statement of Financial Accounting Standards No. 106 and to increases in staffing levels associated with the operation of new facilities. For 1992, manufacturing costs were also unfavorably affected by higher purchased material costs, faster sales growth in lower margin products and higher depreciation charges. Marketing and administrative expenses, as a percent of net sales, were relatively unchanged for 1992 as compared to 1991. Implant costs of $69.0 in 1992 and $25.0 in 1991 represent provisions for costs associated with discontinued breast implant products, as further described in Note 2 of Notes to Consolidated Financial Statements. These costs were reported separately to better identify the financial impact of the breast implant controversy and the Company's profitability from ongoing operations. Special items of $40.0 in 1992 relate to provisions for restructuring activities, consisting largely of costs associated with the cessation of manufacturing activities at a subsidiary in Brazil and costs involved in global expense reduction, including elimination of low-priority activities, redeployment of people and reduction in the value of affected facilities. Special items of $29.0 in 1991 represent provisions for costs of certain legal contract disputes and recognition of partial impairment in the value of certain foreign assets. Operating income for 1992 was down $105.5 or 53.1% from prior year levels. Results have been negatively impacted by charges relating to the breast implant controversy and restructuring activities, weak economic conditions, competitive pricing pressure and expense growth. Other expense for 1992 increased significantly from levels for 1991. As a result of the turmoil in European financial markets in September 1992, the Company incurred losses related to positions taken in several financial instruments. These losses were generated as the market values of these instruments were sensitive to movements in cross-currency exchange rates and interest rates in certain foreign markets. During September 1992, the Company offset these positions and reduced its exposure to the effects of further instability in the European markets. The Company's use of interest and currency rate derivatives is described in Note 10 of Notes to Consolidated Financial Statements. Interest income was also down slightly from 1991 reflecting lower average invested cash balances and lower interest rates. The effective tax rate in 1992 was 20.2%, compared to 27.9% for 1991. The lower effective rate in 1992 was due to higher levels of foreign tax credit utilization. During 1992, the Company elected to adopt Statements of Financial Accounting Standards No. 106, Employers' Accounting for Postretirement Benefits Other Than Pensions, and No. 109, Accounting for Income Taxes. The impact of these changes, as further explained in Notes 11 and 13 of Notes to Consolidated Financial Statements, reduced 1992 net income by $111.9, $100.4 of which represented the cumulative effect of these changes for years prior to 1992. Credit Availability - ------------------- During 1993, the Company terminated a revolving credit agreement which was in place at December 31, 1992, and replaced it with a revolving credit agreement with 16 domestic and foreign banks which provides for borrowings on a revolving credit basis until November, 1997 of up to $400.0. At December 31, 1993, there was $150.0 outstanding under this facility. Availability of credit under this facility may be affected by certain debt restrictions and provisions as described in Note 8 of Notes to Consolidated Financial Statements. Additionally, the Company has agreements in place whereby it may sell on an ongoing basis fractional ownership interests in a designated pool of U.S. trade receivables, with limited recourse, in amounts up to $65.0. As of December 31, 1993, the Company had no amounts outstanding under these agreements. Under other agreements, $63.2 of foreign trade receivables had been sold and remained uncollected at December 31, 1993. The Company also has agreements with several banks whereby it may borrow up to $269.5 under short-term lines of credit. The Company pays a fixed service fee for certain of these facilities in lieu of any compensating cash balances. Included in short-term borrowings are amounts outstanding under these facilities at December 31, 1993, of $83.7. The Company has registered with the Securities and Exchange Commission $400.0 of debt securities. As of December 31, 1993, $275.0 of these registered securities had been designated to medium-term note programs with $100.0 issued, and $125.0 had been issued in debentures. During 1993, the Company obtained long-term financing totalling $58.8 ($28.6 of which is denominated in foreign currencies) bearing interest at rates ranging from 4.1% to 11.5% at December 31, 1993 and with maturities ranging from two to five years. Management believes that, in light of the Company's positive operating cash flow, the credit facilities currently in place are adequate to meet the short-term financing needs of the Company. Management also believes that the Company will generate the financial liquidity required to meet ongoing operational needs and to participate in the breast implant litigation settlement currently being negotiated (as described in Note 2 of Notes to Consolidated Financial Statements). This belief is based on, among other things, management's estimate of future operational cash flows, its assessment that recovery of substantial amounts of settlement obligations from its insurance carriers is probable, and its evaluation of current financing arrangements. Inflation - --------- The impact of inflation on the Company's financial position and results of operations has been minimal. The Company expects that future impacts of inflation will be offset by increased prices and productivity gains. Contingencies - ------------- For information regarding contingencies, including a discussion of breast implant litigation and the Company's environmental liabilities, see Note 2 of Notes to Consolidated Financial Statements. Management Changes - ------------------ On June 25, 1993, the Company's Board of Directors elected Richard A. Hazleton, President of the Company, to the additional position of Chief Executive Officer. Keith R. McKennon, formerly Chief Executive Officer, continues as the Chairman of the Board of Directors. On December 10, 1993, the Company's Board of Directors elected John W. Churchfield, formerly the Assistant Chief Financial Officer, to the position of Vice President for Planning and Finance and Chief Financial Officer. Edward Steinhoff, formerly Vice President for Finance and Chief Financial Officer, announced in early 1993 his intention to retire and retired December 31, 1993. ITEM 8.

ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA - ---------------------------------------------------- See the "Index to Financial Statements" which is located in the section entitled "Financial Statements for the Year Ended December 31, 1993" included in this report, as well as the "Report of Independent Accountants." ITEM 9.

ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE - --------------------------------------------------------- None. PART III ITEM 10.

ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT - ------------------------------------------------------------ Item omitted in accordance with provisions of General Instruction J of Form 10-K. ITEM 11.

ITEM 11. EXECUTIVE COMPENSATION - -------------------------------- Item omitted in accordance with provisions of General Instruction J of Form 10-K. ITEM 12.

ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT - ------------------------------------------------------------- Item omitted in accordance with provisions of General Instruction J of Form 10-K. ITEM 13.

ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS - -------------------------------------------------------- Item omitted in accordance with provisions of General Instruction J of Form 10-K. PART IV ITEM 14.

ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K - ----------------------------------------------------------------- Documents filed as part of Form 10-K for the year ended December 31, 1993 are as follows: (a) Financial Statements and Financial Statement Schedules: See the "Index to Financial Statements" which is located in the section entitled "Financial Statements for the Year Ended December 31, 1993" included in this report, as well as the "Report of Independent Accountants." (b) Reports on Form 8-K: A report on Form 8-K dated January 14, 1994, was filed in connection with a special charge to reflect the Company's best estimate of the costs of resolving breast implant litigation and related matters. (c) Exhibits: See the "Exhibit Index" which is located on page 52. SIGNATURES Pursuant to the requirements of Section 13 or 15(d) 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. DOW CORNING CORPORATION Date January 28, 1994 By R. A. Hazleton ---------------- ------------------------ R. A. Hazleton President and Chief Executive Officer Date January 28, 1994 By J. W. Churchfield ---------------- ------------------------ J. W. Churchfield Vice President for Planning and Finance and Chief Financial Officer Date January 28, 1994 By G. P. Callaghan ---------------- ------------------------ G. P. Callaghan Corporate Controller Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons (a majority of the Board of Directors) on behalf of the registrant and in the capacities and on the dates indicated. Date January 28, 1994 By G. E. Anderson ---------------- ------------------------ G. E. Anderson Director, Dow Corning Corporation Date January 28, 1994 By V. C. Campbell ---------------- ------------------------ V. C. Campbell Director, Dow Corning Corporation Date January 28, 1994 By D. A. Duke ---------------- ------------------------ D. A. Duke Director, Dow Corning Corporation Date January 28, 1994 By E. C. Falla ---------------- ------------------------ E. C. Falla Director, Dow Corning Corporation Date January 28, 1994 By R. A. Hazleton ---------------- ------------------------ R. A. Hazleton Director, Dow Corning Corporation Date January 28, 1994 By K. R. McKennon ---------------- ------------------------ K. R. McKennon Director, Dow Corning Corporation Date January 28, 1994 By L. A. Reed ---------------- ------------------------ L. A. Reed Director, Dow Corning Corporation Date January 28, 1994 By D. R. Weyenberg ---------------- ------------------------ D. R. Weyenberg Director, Dow Corning Corporation UNITED STATES SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 FORM 10-K FOR CORPORATIONS FINANCIAL STATEMENTS FOR THE YEAR ENDED DECEMBER 31, 1993 DOW CORNING CORPORATION MIDLAND, MICHIGAN 48686-0994 STATEMENT OF MANAGEMENT RESPONSIBILITY FOR ------------------------------------------ FINANCIAL STATEMENTS -------------------- The management of Dow Corning Corporation is responsible for the preparation, presentation and integrity of the consolidated financial statements and other information included in this annual report on Form 10-K. The financial statements have been prepared in conformity with generally accepted accounting principles appropriate in the circumstances and necessarily include amounts based on management's best estimates and judgments. In meeting its responsibility for the reliability of these financial statements, Dow Corning maintains comprehensive systems of internal accounting control. These systems are designed to provide reasonable assurance at reasonable cost that corporate assets are protected against loss or unauthorized use and that transactions and events are properly recorded. Such systems are reinforced by written policies, selection and training of competent financial personnel, appropriate division of responsibilities and a program of internal audits. The financial statements have been audited by our independent accountants, Price Waterhouse. Their responsibility is to express an independent professional opinion with respect to the consolidated financial statements on the basis of an audit conducted in accordance with generally accepted auditing standards. In addition to the audit performed by the independent accountants, Dow Corning maintains a professional staff of internal auditors whose audit coverage is coordinated with that of the independent accountants. The Board of Directors, through its Audit Committee, is responsible for reviewing and monitoring Dow Corning's financial reporting and accounting practices and recommending annually the appointment of the independent accountants. The Committee, composed of nonmanagement directors, meets periodically with management, the internal auditors and the independent accountants to review and assess the activities of each. Both the independent accountants and the internal auditors meet with the Committee, without management present, to review the results of their audits and their assessment of the adequacy of the system of internal accounting controls and the quality of financial reporting. January 20, 1994 R. A. Hazleton J. W. Churchfield - ------------------------- --------------------------- R. A. Hazleton J. W. Churchfield President and Vice President for Chief Executive Officer Planning and Finance and Chief Financial Officer Suite 3900 Telephone 313 259 0500 200 Renaissance Center Detroit, MI 48243 Price Waterhouse Report of Independent Accountants January 20, 1994 To the Stockholders and Board of Directors of Dow Corning Corporation In our opinion, the consolidated financial statements listed in the accompanying index present fairly, in all material respects, the financial position of Dow Corning Corporation and its subsidiaries at December 31, 1993 and 1992, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 1993, in conformity with generally accepted accounting principles. These financial statements are the responsibility of the Company's management; our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits of these statements in accordance with generally accepted auditing standards which require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for the opinion expressed above. As discussed in Note 2 to the financial statements, the Company is involved in product liability litigation and claims related to breast implants for which it is seeking payment from insurance carriers. The Company has recorded an estimated liability and insurance receivable for these matters based upon all currently available information. As additional facts and circumstances develop in the future, it may be necessary for the Company to revise these estimates. As discussed in Note 6 to the financial statements, the Company changed its method of applying fixed costs to inventory in 1991. In 1992, the Company changed its method of accounting for postretirement benefits other than pensions to conform with Statement of Financial Accounting Standards No. 106 as discussed in Note 11 and its method of accounting for income taxes to conform with Statement of Financial Accounting Standards No. 109 as discussed in Note 13. Price Waterhouse (THIS PAGE INTENTIONALLY BLANK) DOW CORNING CORPORATION ----------------------- ----------------------------- Page ---- Consolidated balance sheets at December 31, 1993 and 1992 23 Consolidated statements of operations and retained earnings for the years ended December 31, 1993, 1992 and 1991 25 Consolidated statements of cash flow for the years ended December 31, 1993, 1992 and 1991 26 Notes to consolidated financial statements 28 Supplementary Data - for the years ended December 31, 1993 and 1992: Quarterly financial information 46 Financial Statement Schedules for the years ended December 31, 1993, 1992 and 1991: V - Property, plant and equipment 47 VI - Accumulated depreciation and amortization of property, plant and equipment 48 VIII - Valuation and qualifying accounts and reserves 49 IX - Short-term borrowings 50 X - Supplementary income statement information 51 All other supplementary data and financial statement schedules are omitted because they are not applicable or the required information is shown in the consolidated financial statements or the accompanying notes. DOW CORNING CORPORATION ----------------------- CONSOLIDATED BALANCE SHEETS --------------------------- (in millions of dollars) ASSETS ------ December 31, -------------------- 1993 1992 -------- -------- CURRENT ASSETS: Cash and cash equivalents $ 263.0 $ 8.4 -------- -------- Short-term investments 0.9 - -------- -------- Accounts and notes receivable - Trade (less allowance for doubtful accounts of $8.4 in 1993 and 1992) 318.5 285.9 Other receivables 54.5 53.0 -------- -------- 373.0 338.9 -------- -------- Inventories 285.6 356.1 -------- -------- Other current assets - Deferred income taxes 118.4 90.5 Other 28.3 33.8 -------- -------- 146.7 124.3 -------- -------- Total current assets 1,069.2 827.7 -------- -------- PROPERTY, PLANT AND EQUIPMENT: Land and land improvements 130.9 119.3 Buildings 436.0 413.1 Machinery and equipment 2,011.3 1,906.5 Construction-in-progress 132.5 148.9 -------- -------- 2,710.7 2,587.8 Less - Accumulated depreciation (1,544.6) (1,396.5) -------- -------- 1,166.1 1,191.3 -------- -------- OTHER ASSETS: Implant insurance receivable 663.7 - Deferred income taxes 229.6 31.8 Other 133.7 139.9 -------- -------- 1,027.0 171.7 -------- -------- $3,262.3 $2,190.7 ======== ======== The Notes to Consolidated Financial Statements are an integral part of these financial statements. DOW CORNING CORPORATION ----------------------- CONSOLIDATED BALANCE SHEETS --------------------------- (in millions of dollars except share data) LIABILITIES AND STOCKHOLDERS' EQUITY ------------------------------------ December 31, -------------------- 1993 1992 -------- -------- CURRENT LIABILITIES: Notes payable $ 233.7 $ 160.0 Current portion of long-term debt 33.5 37.7 Trade accounts payable 147.1 124.7 Income taxes payable 18.6 41.1 Accrued payrolls and employee benefits 60.4 54.6 Accrued taxes, other than income taxes 19.6 17.2 Implant reserve 158.7 46.2 Other current liabilities 99.0 87.4 -------- -------- Total current liabilities 770.6 568.9 -------- -------- LONG-TERM DEBT 314.7 298.0 -------- -------- OTHER LONG-TERM LIABILITIES: Implant reserve 1,100.0 - Deferred income taxes 14.6 0.2 Other 311.2 306.3 -------- -------- 1,425.8 306.5 -------- -------- CONTINGENT LIABILITIES (NOTE 2) MINORITY INTEREST IN CONSOLIDATED SUBSIDIARIES 102.8 85.2 -------- -------- STOCKHOLDERS' EQUITY: Common stock, $5 par value - 2,500,000 shares authorized and outstanding 12.5 12.5 Retained earnings 604.3 891.3 Cumulative translation adjustment 31.6 28.3 -------- -------- Stockholders' equity 648.4 932.1 -------- -------- $3,262.3 $2,190.7 ======== ======== The Notes to Consolidated Financial Statements are an integral part of these financial statements. (THIS PAGE INTENTIONALLY BLANK) DOW CORNING CORPORATION ----------------------- NOTES TO CONSOLIDATED FINANCIAL STATEMENTS ------------------------------------------ (in millions of dollars except where noted) NOTE 1 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES - --------------------------------------------------- Principles of Consolidation - --------------------------- The accompanying consolidated financial statements include the accounts of Dow Corning Corporation and all of its wholly-owned and majority-owned domestic and foreign subsidiaries (the Company). The Company's interests in 20% to 50% owned affiliates are carried on the equity basis and are included in other assets. Intercompany transactions and balances have been eliminated in consolidation. Cash Equivalents and Short-Term Investments - ------------------------------------------- Cash equivalents include all highly liquid investments purchased with an original maturity of ninety days or less. All other temporary investments are classified as short-term investments. The carrying amounts for cash equivalents and short-term investments approximate their fair values. The Company enters into agreements to purchase and resell securities. As of December 31, 1993, there was approximately $243.1 outstanding under these agreements. Of this amount, $208.1 had been purchased from Merrill Lynch Mortgage Capital, Inc. with a weighted average maturity of twelve days, and $35.0 had been purchased from Lehman Commercial Paper, Inc. with a weighted average maturity of eight days. Securities purchased under agreements to resell are included in cash and cash equivalents in the accompanying balance sheet. Inventories - ----------- Inventories are stated at the lower of cost or market. The cost of the majority of inventories is determined using the last-in, first-out (LIFO) method and the remainder is valued using the first-in, first-out (FIFO) method. Property and Depreciation - ------------------------- Property, plant and equipment are carried at cost and are depreciated principally using accelerated methods over estimated useful lives ranging from 10 to 20 years for land improvements, 10 to 45 years for buildings and 3 to 20 years for machinery and equipment. Upon retirement or other disposal, the asset cost and related accumulated depreciation are removed from the accounts and the net amount, less any proceeds, is charged or credited to income. Expenditures for maintenance and repairs are charged against income as incurred. Expenditures which significantly increase asset value or extend useful asset lives are capitalized. The Company follows the policy of capitalizing interest as a component of the cost of capital assets constructed for its own use. Interest capitalized was $12.0 in 1993, $11.8 in 1992, and $11.8 in 1991. NOTE 1 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued) - --------------------------------------------------- Intangibles - ----------- Other assets include $27.0 and $32.7 of intangible assets at December 31, 1993 and 1992, respectively, representing the excess of cost over net assets of businesses acquired. These intangible assets are being amortized on a straight-line basis over 10 years. Other identifiable intangible assets are amortized on a straight-line basis over their estimated useful lives. Deferred Investment Grants - -------------------------- Included in other long-term liabilities are deferred investment incentives (grants) which the Company has received related to certain capital expansion projects in Belgium, Canada and the United Kingdom. Such grants are deferred and recognized in income over the service lives of the related assets. At December 31, 1993 and 1992, gross deferred investment incentives were $84.6 and $90.7 with related accumulated amortization of $62.8 and $60.8, respectively. Income Taxes - ------------ The Company adopted the provisions of Statement of Financial Accounting Standards No. 109 (SFAS 109), Accounting for Income Taxes, effective on January 1, 1992. SFAS 109 requires a company to recognize deferred tax assets and liabilities for the expected future tax consequences of events that have been recognized in a company's financial statements or tax returns. Under this method, deferred tax assets and liabilities are determined based on the difference between the financial statement carrying amounts and tax bases of assets and liabilities using enacted tax rates in effect in the years in which the differences are expected to reverse. Research and Development Costs - ------------------------------ Research and development costs are charged to operations when incurred and are included in manufacturing cost of sales. These costs totalled $163.9 in 1993, $161.2 in 1992, and $148.7 in 1991. Currency Translation - -------------------- Assets and liabilities of certain foreign subsidiaries are translated into U.S. dollars at end-of-period exchange rates; translation gains and losses, hedging activity and related tax effects from these subsidiaries are reported as a separate component of stockholders' equity. Assets and liabilities of other foreign subsidiaries are remeasured into U.S. dollars using end-of-period and historical exchange rates; remeasurement gains and losses, hedging activity and related tax effects for these subsidiaries are recognized in the statement of operations. Revenues and expenses for all foreign subsidiaries are translated at average exchange rates during the period. Foreign currency transaction gains and losses are included in current earnings. NOTE 1 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued) - --------------------------------------------------- Interest and Currency Rate Derivatives - -------------------------------------- The Company enters into a variety of interest rate and currency swaps, interest rate caps and floors, options and forward exchange contracts in its management of interest rate and foreign currency exposures. The differential to be paid or received on interest rate swaps, including interest rate elements in combined currency and interest rate swaps, interest rate caps and floors is recognized over the life of the agreements as an adjustment to interest expense. Gains and losses on terminated interest rate instruments that were entered into for the purpose of changing the nature of underlying debt obligations are deferred and amortized to income as an adjustment to interest expense. Currency option premiums are amortized over the option period. Gains and losses on purchased currency options that are designated and effective as hedges are deferred and recognized in income in the same period as the hedged transaction. Realized and unrealized gains and losses on currency swaps, including currency elements in combined currency and interest rate swaps, and forward exchange contracts are recognized currently in other income and expense, or, if such contracts are effective as net investment hedges, in stockholders' equity. New Accounting Standards - ------------------------ In November 1992, Statement of Financial Accounting Standards No. 112 "Employers' Accounting for Post-employment Benefits" was issued. The Company will be required to adopt this new method of accounting for benefits paid to former or inactive employees after employment but before retirement no later than 1994. This new standard requires, among other things, that the expected costs of these benefits be recognized when they are earned or become payable when certain conditions are met rather than the current method which recognizes these costs when they are paid. The Company does not expect this standard to materially impact its financial condition or results of operations when it is adopted in 1994. Reclassifications - ----------------- Certain reclassifications of prior year amounts have been made to conform to the presentation adopted in 1993. NOTE 2 - CONTINGENCIES - ---------------------- Breast Implant Business - ----------------------- Prior to January 6, 1992, the Company, directly and through its wholly-owned subsidiary, Dow Corning Wright Corporation, was engaged in the manufacture and sale of silicone gel breast implants. As part of a review process initiated in 1991 by the United States Food and Drug Administration (FDA) of Premarket Approval Applications (PMAA) for silicone gel breast implants, on January 6, 1992, the FDA asked breast implant producers and medical practitioners to voluntarily halt the sale and use of silicone gel breast implants pending further review of the safety and effectiveness of such devices, and the Company complied with the FDA's request and suspended shipments of implants. Subsequently, the Company announced that it would not resume the production or sale of silicone gel breast implants and that it would withdraw its PMAA for silicone gel breast implants from consideration by the FDA. The Company also commenced a program to provide up to $1,200 (in whole dollars) per patient to support medical costs of removing the Company's silicone gel breast implants from women who have a documented medical need to have their implants removed and who cannot afford the procedure. As of January 20, 1994, approximately 2,800 women have made use of this program. NOTE 2 - CONTINGENCIES (Continued) - ---------------------- Since late 1991, there has been considerable publicity associated with the breast implant controversy, and the Company experienced a substantial increase in the number of lawsuits against the Company relating to breast implants. As of January 20, 1994, the Company has been named, often together with other defendants, in approximately 11,800 pending breast implant products liability lawsuits filed by or on behalf of individuals who claim to have or have had silicone gel breast implants. Many of these cases involve multiple plaintiffs. In addition, there were 41 purported breast implant products liability class action lawsuits which had been filed against the Company as of January 20, 1994. It is anticipated that the Company will be named as a defendant in additional breast implant lawsuits in the future. The typical alleged factual bases for these lawsuits include allegations that the plaintiffs' breast implants caused specified ailments, including, among other things, autoimmune disease, scleroderma, systemic disorders, joint swelling and chronic fatigue. The Company is sometimes named as the manufacturer of silicone gel breast implants, and other times the Company is named as the supplier of silicone raw materials to other breast implant manufacturers. Although there are similarities among the cases, there are also differences which can significantly affect the cost of defending and disposing of each case, and many cases are at such a preliminary stage that the Company has not yet been able to obtain information relevant to the evaluation of each case. For these reasons, the amounts involved in prior dispositions of breast implant cases are not necessarily indicative of the amounts that may be required to dispose of such cases in the future. The Company is vigorously defending this litigation asserting, among other defenses, that there is no causal connection between silicone breast implants and the ailments alleged by the plaintiffs in these cases. During 1992 and 1993, consolidation of a substantial number of breast implant lawsuits for pretrial purposes occurred in federal court (U.S. District Court for the Northern District of Alabama) and various state courts where a substantial number of breast implant lawsuits have been filed. As of December 31, 1993, substantially more than half of all breast implant cases have been consolidated for pretrial purposes at the federal and state levels. Discovery is proceeding under the supervision of the courts. The Company anticipates that current and future breast implant lawsuit consolidations will result in a reduction of per case litigation defense costs. On September 9, 1993, the Company announced that representatives of plaintiffs and defendants involved with silicone breast implant litigation have developed a "Statement of Principles for Global Resolution of Breast Implant Claims" (the "Statement of Principles"). The Statement of Principles summarizes a proposed claims based structured resolution of claims arising out of breast implants which have been or could be asserted against various implant manufacturers, suppliers, physicians and hospitals (the "Proposed Settlement"). The Statement of Principles does not constitute an agreement and a number of issues remain to be resolved before a tentative settlement agreement can be reached. A number of specifics of settlement concepts contained in the Statement of Principles continue to be undefined and many uncertainties remain. Various steps must be completed before a settlement can be implemented, including review and support of the Proposed Settlement by the boards of directors, managements and insurance carriers of Funding Participants (as defined below) and review and acceptance of the Proposed Settlement by breast implant plaintiffs and their counsel. In addition, a court supervised fairness review process of the Proposed Settlement must be completed before a final agreement can be implemented. The timetable for the completion of this process is currently undetermined. Once a final agreement is approved by the court, claims can then be validated and administered. NOTE 2 - CONTINGENCIES (Continued) - ---------------------- Under the Proposed Settlement, if implemented, industry participants (the "Funding Participants") would contribute up to $4.75 billion over a period of thirty years to establish several special purpose funds. The specific participants and their respective contributions to this fund are currently under negotiation. The Proposed Settlement, if implemented, would be a claims based structured resolution of claims arising out of silicone breast implants, and would define the circumstances under which payments from the funds would be made. The Proposed Settlement includes provisions for (a) class membership and the ability of plaintiffs to opt out of the class, (b) the establishment of defined funds for medical diagnostic/evaluation procedures, explantation, ruptures, compensation for specific diseases and administration, (c) payment terms and timing and (d) claims administration. The Proposed Settlement defines periods during which breast implant plaintiffs may elect not to settle their claims by way of the Proposed Settlement and continue their individual breast implant litigation against manufacturers and other defendants (the "Opt Out Plaintiffs"). In certain circumstances, if any defendant who is a Funding Participant considers the number of Opt Out Plaintiffs maintaining lawsuits against such defendant to be excessive, such defendant may decide to exercise the option to withdraw from participation in the Proposed Settlement. Management believes that a settlement incorporating concepts underlying the Statement of Principles would be a responsible and cost efficient approach to resolving breast implant litigation against the Company. Management continues to evaluate the Proposed Settlement in that light and believes that it would be viable if, among other things, (a) an acceptable agreement as to allocation of liability under the Proposed Settlement among Funding Participants can be reached, (b) adequate insurance support is provided to Funding Participants by their insurance carriers and (c) substantially all plaintiffs participate in the settlement. The Company continues to negotiate with other potential parties to the Proposed Settlement to reach a tentative settlement agreement similar in concept to the Statement of Principles. Since the announcement of the Statement of Principles, the Company has participated in negotiations with other key Funding Participants to reach an agreement regarding, among other things, the respective contribution of each of these Funding Participants to the settlement fund. These negotiations are currently ongoing and have progressed to a point where the Company believes it has sufficient information to estimate its potential liability for breast implant litigation. Notwithstanding the limited information available regarding most of the claims asserted against the Company and the uncertainties related to the eventual resolution of these claims, the Company has made efforts in the past to reflect anticipated financial consequences to the Company of the breast implant situation. In December 1991, the Company recorded a $25.0 pretax charge associated with the breast implant business to cover implant inventories, dedicated equipment and costs associated with confirming the safety of the product. In the first quarter of 1992, the Company recorded $24.0 of pretax costs related to silicone gel breast implant litigation, claims and related matters. In the second quarter of 1992, the Company recorded a $45.0 pretax charge associated with its discontinued breast implant products. This charge represented management's best estimate at the time of future costs for ongoing research associated with breast implants; continued communication with patients, the medical community and other interested parties; the retrieval of breast implant inventories from the Company's medical customers; and various legal defense matters. NOTE 2 - CONTINGENCIES (Continued) - ---------------------- Based on information developed in settlement negotiations, on January 14, 1994, the Company announced a pretax charge of $640.0 for the fourth quarter of 1993. This charge included the Company's best current estimate of its potential liability for breast implant litigation based on current settlement negotiations, and also included provisions for legal, administrative, and research costs related to breast implants, for a total of $1.24 billion, less expected insurance recoveries of $600.0. The amounts recorded by the Company for the estimated cost of settling breast implant litigation and claims and anticipated insurance reimbursements were determined on a present-value basis using a discount rate of 7.0% over a period of more than 30 years. The estimated liability of $1.24 billion as described above is approximately $2.3 billion on an undiscounted basis. The expected insurance recovery of $600.0 as described above is approximately $1.2 billion on an undiscounted basis. The estimated liability of $1.24 billion described above has been combined with reserves of $18.7 remaining from breast implant related charges recorded prior to 1993. This total liability amount is shown opposite the captions "Implant Reserves" in the accompanying balance sheet. The receivable of $600.0 described above has been combined with a receivable of $63.7 which represents breast implant related payments made prior to December 31, 1993, for which recovery through insurance is anticipated. This receivable is shown opposite the caption "Implant Insurance Receivable" in the accompanying balance sheet. The Company believes that a substantial portion of the indemnity, settlement and defense costs related to breast implant lawsuits and claims will be covered by the Company's products liability insurance subject to deductibles, exclusions, retentions and policy limits. The Company's insurers have reserved and may reserve the right to deny coverage, in whole or in part, due to differing theories regarding, among other things, the applicability of coverage and when coverage may attach. Also, a number of the breast implant lawsuits pending against the Company request punitive damages and compensatory damages arising out of alleged intentional torts. Depending on policy language, applicable law and agreements with carriers, any damages which may be awarded pursuant to such lawsuits may or may not be covered, in whole or in part, by insurance. As of December 31, 1993, the Company had a substantial amount of unexhausted claims-made insurance coverage with respect to lawsuits and claims commencing 1986 and thereafter. For lawsuits and claims involving implant dates prior to 1986, the Company believes substantial coverage exists under a number of primary and excess occurrence policies having various limits. Because the defense and disposition of particular breast implant lawsuits and claims may be covered, in whole or in part, both by the claims-made coverage issued from and after 1986, and one or more of the occurrence policies issued prior to 1986, determination of aggregate insurance coverage depends on, among other things, how defense and indemnity costs are allocated among the various policy periods. Discussions among the Company and its primary insurance carriers have occurred and are continuing with a view toward reaching an agreement as to the allocation of costs of breast implant litigation among the various insurance carriers issuing products liability insurance policies to the Company relative to breast implants and other products. The Company became dissatisfied with the progress being made toward reaching such an agreement. Consequently, the Company commenced a lawsuit against certain of these insurance carriers seeking, among other things, a judicial enforcement of the obligations of the insurance carriers under certain of these insurance policies (for additional information regarding this lawsuit, see Legal Proceedings, Part I, Item 3). Management continues to believe that it is probable that the Company NOTE 2 - CONTINGENCIES (Continued) - ---------------------- will recover from its insurance carriers a substantial amount of breast implant related payments which have been or may be made by the Company. In reaching this belief, the Company has analyzed its insurance policies, considered its history of coverage and insurance reimbursement for these types of claims, and consulted with knowledgeable third parties with significant experience in insurance coverage matters. The amount recorded by the Company as an insurance receivable is substantially less than the amount for which the Company would seek reimbursement if a settlement proceeds. Management believes that the Company will generate the financial liquidity required to meet ongoing operational needs and to participate in the settlement currently being negotiated. This belief is based on, among other things, management's estimate of future operational cash flows, its assessment that recovery of substantial amounts of settlement obligations from its insurance carriers is probable, and its evaluation of current financing arrangements. The Implant Reserves less the Implant Insurance Receivable reflects management's best current estimate of the cost of ultimate resolution of breast implant litigation. As breast implant litigation settlement negotiations continue, additional circumstances may develop which could affect the reliability and precision of the current estimate. Those circumstances include, among other things, development of additional information regarding the allocation of settlement payments among the Funding Participants, any revisions to the timing of those payments, the number and extent of claims not covered by a settlement, the amount and timing of insurance recoveries and the allocation of insurance payments among the Company's insurance carriers, and the possibility of resolution of the litigation through alternatives to a settlement of the type currently proposed. As additional facts and circumstances develop, the estimate may be revised, or provisions may be necessary to reflect any additional costs of resolving breast implant litigation and claims not covered by a settlement. Future charges resulting from any revisions or provisions, if required, could have a material adverse effect on Dow Corning's financial position or results of operations in the period or periods in which such charges are recorded. Environmental Matters - --------------------- The Company has been advised by the United States Environmental Protection Agency (EPA) that the Company, together with others, is a Potentially Responsible Party (PRP) with respect to a portion of the cleanup costs and other related matters involving a number of abandoned hazardous waste disposal facilities. Management believes that there are 12 sites at which the Company may have some liability, although management currently expects to settle the Company's liability for a majority of these sites for de minimis amounts. Based upon preliminary estimates by the EPA or the PRP groups formed with respect to these sites, the aggregate liabilities for all PRPs at these sites at which management currently believes the Company may have more than the de minimis liability is $33.0. Management cannot currently estimate the aggregate liability for all PRPs at those sites at which management expects the Company has a de minimis liability. NOTE 2 - CONTINGENCIES (Continued) - ---------------------- The Company records a charge to earnings for sites when it is probable that a liability has been incurred and the Company's costs can be reasonably estimated. The Company has accrued for its estimated liabilities with respect to these sites; such accrual is substantially less than the estimated aggregate liability for all PRPs at these sites as it reflects the Company's estimated share of total remaining cleanup costs. While there are a number of uncertainties with respect to the Company's estimate of its ultimate liability for cleanup costs at these sites, it is the opinion of the Company that these matters will not materially adversely affect the Company's consolidated financial position or results of operations. This opinion is based upon the number of identified PRPs at each site, the number of such PRPs that are believed by management to be solvent, and the portion of waste sent to the sites for which management believes the Company might be held responsible based on available records. Receivables Sold - ---------------- The Company has sold certain receivables subject to recourse provisions. The Company has agreements in place whereby it may sell on an ongoing basis fractional ownership interests in a designated pool of U.S. trade receivables, with limited recourse, in amounts up to $65.0. As of December 31, 1993, the Company had no amounts outstanding under these agreements. The amount of receivables sold under these agreements which remained uncollected at December 31, 1992 was $49.0. In addition, another $63.2 and $25.1 of receivables had been sold at December 31, 1993 and 1992, respectively, under other agreements. During 1993 and 1992, net proceeds of approximately $74.7 and $73.5, respectively, were received upon the sale of receivables. DOW CORNING FIRE STOP(R) - ------------------------ In May, 1993, the Company began communicating additional information and test results to the owners of buildings which contain DOW CORNING FIRE STOP(R) Intumescent Wrap Strip 2002, recommending that the owners conduct a review with a qualified Fire Protection Engineer to determine whether remedial action is warranted, including possible replacement of the product due to uncertainty about its ability to perform consistently and predictably over time. DOW CORNING FIRE STOP(R) Intumescent Wrap Strip 2002 is a non-silicone, resin-based fire stop product which was installed in buildings as a passive fire protection product. The Company ceased the sale of this product in 1992. The potential liability associated with replacement of this product cannot be estimated at this time. However, management believes that the ultimate resolution of this issue will not have a material adverse effect on the Company's consolidated financial position or results of operations. NOTE 3 - SPECIAL ITEMS - ---------------------- Charges of $40.0 in 1992 relate to provisions for restructuring activities, consisting largely of costs associated with the cessation of manufacturing activities at a subsidiary in Brazil and costs involved in global expense reduction, including elimination of low-priority activities, redeployment of people and reduction in the value of affected facilities. Charges of $29.0 in 1991 represent provisions for costs of certain legal contract disputes and recognition of partial impairment in the value of certain foreign assets. NOTE 4 - SALE OF ASSETS AND ACQUISITIONS - ---------------------------------------- In June 1992, the Company announced its intent to offer for sale its medical device business, which principally included metal orthopedic implant devices and other specialty devices. Subsequent to that decision, management decided to retain most of the specialty device product lines and offer for sale principally the metal orthopedic device business. On July 1, 1993, the Company sold the metal orthopedic device assets for approximately $66.3 in cash. The Company's investment in assets was approximately $70.0, most of which represented current assets. The sale of the metal orthopedic device business did not have a material effect on the Company's consolidated net sales, financial position or results of operations. On July 14, 1992, the Company acquired ARA - Werk Kraemer GmbH (ARA), a German supplier of sealants, polyurethane foam products and related application tools. The purchase price included $18.9 of cash and $19.2 in notes to be paid within one year of the acquisition date. The acquisition was accounted for by the purchase method of accounting, and, accordingly, the purchase price has been allocated to the assets acquired and the liabilities assumed based on their estimated fair values at date of acquisition. The excess of purchase price over estimated fair values of the net assets acquired was $25.6 and has been recorded as goodwill, which will be amortized over 10 years. The operating results of ARA are included in the Company's consolidated results from the acquisition date. Consolidated net sales, net income and related per share amounts for the years ended December 31, 1992 and 1991, respectively, would not have been materially different had this acquisition taken place at the beginning of 1991. On November 2, 1992, the Company acquired for $12.8 an additional 40% interest in Lucky-DC Silicone Co., Ltd. (Lucky-DC), a company in which Dow Corning previously had held a 50.0% interest. In addition, under the terms of the agreement with the partner, Lucky Ltd., the Company will acquire for $3.2 the remaining 10% interest by November 1995, subject to the approval by the Government of South Korea. Consolidated net sales, net income and related per share amounts for the years ended December 31, 1992 and 1991, respectively, would not have been materially different had this acquisition taken place at the beginning of 1991. NOTE 5 - FOREIGN CURRENCY - ------------------------- Following is an analysis of the changes in the cumulative translation adjustment: 1993 1992 1991 ----- ----- ----- Balance, beginning of year $28.3 $66.2 $32.5 Translation adjustments and gains (losses) from certain hedges and intercompany balances (0.2) (37.5) 30.5 Income tax effect of current year activity 3.5 (0.4) 3.2 ----- ----- ----- Balance, end of year $31.6 $28.3 $66.2 ===== ===== ===== Net foreign currency gains (losses) currently recognized in income amounted to $(8.1) in 1993, $(35.2) in 1992, and $11.1 in 1991. In 1991, the Company changed functional currencies of certain subsidiary companies in Europe. This change did not materially impact the Company's consolidated financial position or results of operations. NOTE 6 - INVENTORIES - -------------------- Following is a summary of inventories by costing method at December 31: 1993 1992 ------ ------ Raw material, work-in-process and finished goods: Valued at LIFO $197.0 $224.9 Valued at FIFO 88.6 131.2 ------ ------ $285.6 $356.1 ====== ====== Under the dollar value LIFO method used by the Company, it is impracticable to separate inventory values by classifications. Inventories valued using LIFO at December 31, 1993 and 1992 are stated at approximately $70.9 and $96.1, respectively, less than they would have been if valued at replacement cost. Reduction in LIFO reserves in 1993 did not have a material impact on results of operations. In 1991, the Company changed its method of applying fixed costs to inventory by using actual production volumes as a basis for allocating these costs to inventory rather than practical capacity volumes. Management believes this change will result in a better matching of product costs with related sales in reported operating results. The $16.3 cumulative effect of the change on prior years, net of income taxes of $8.4, is included in net income for 1991. The change also increased inventories, net of an adjustment for LIFO valuation, by $24.7. Except for the cumulative effect, the change did not have a material effect on operating results for the periods presented. NOTE 7 - INVESTMENTS AND LOANS - ------------------------------ At December 31, 1993 and 1992, the carrying amounts for investments of $24.6 and $20.4, respectively, which excludes those investments accounted for on the equity basis, and loans of $10.0 and $15.0, respectively, approximate their fair value. Fair values are determined based on quoted market prices or, if quoted market prices are not available, on market prices of comparable instruments. Investments and loans are included in short-term investments and other assets in the accompanying consolidated balance sheets. NOTE 8 - NOTES PAYABLE AND CREDIT FACILITIES - -------------------------------------------- Notes payable at December 31 consisted of: 1993 1992 ------ ------ Revolving Credit Agreement $150.0 $100.0 Other bank borrowings 83.7 60.0 ------ ------ $233.7 $160.0 ====== ====== NOTE 8 - NOTES PAYABLE AND CREDIT FACILITIES (Continued) - -------------------------------------------- During 1993, the Company terminated a revolving credit agreement which was in place at December 31, 1992, and replaced it with a Revolving Credit Agreement with 16 domestic and foreign banks which provides for borrowings on a revolving credit basis until November, 1997, of up to $400.0. The Company also has agreements with several other banks whereby it may borrow up to $269.5 under short-term lines of credit. The Company pays a fixed service fee for certain of these facilities in lieu of any compensating cash balances. Included in other bank borrowings are amounts outstanding under these other facilities at December 31, 1993 and 1992 of $83.7 and $34.4, respectively. The carrying amounts of the Company's short-term borrowings approximate their fair value. Various debt agreements, the Revolving Credit Agreement included, contain various debt restrictions and provisions relating to property liens, sale and leaseback transactions, debt to tangible capital ratio, and funds flow. In addition, the Revolving Credit Agreement provides creditors the right, subject to a majority vote, to demand payment in the event that uninsured breast implant litigation expenditures and judgments exceed certain limits. A settlement agreement of the type currently being negotiated (as described in Note 2 of Notes to Consolidated Financial Statements) would likely exceed these limits. At December 31, 1993, the Company was in compliance with all debt restrictions and provisions. Under the provisions of the Revolving Credit Agreement, the Company is subject to certain restrictions as to the payment of dividends. The amount of the restriction is based on a formula which considers, among other things, the income before income taxes for the most recent fiscal year. Based on the computation completed for the year ended December 31, 1993, the Company is restricted from issuing dividends in 1994. NOTE 9 - LONG-TERM DEBT - ----------------------- Long-term debt at December 31 consisted of: 1993 1992 ------ ------ 9.625% Sinking Fund Debentures due 2005 $ 4.8 $ 4.8 9.375% Debentures due 2008 75.0 75.0 8.15% Debentures due 2029 50.0 50.0 7.61%-9.50% Medium-term Notes due 1994-2001, 8.68% average rate at December 31, 1993 54.5 80.0 5.76% Term Loans, maturing serially 1994-1999 32.1 37.2 Variable-rate Notes due 1994-1998, 5.39% at December 31, 1993 55.2 35.0 Variable-rate Note, maturing serially 1997-1999, 4.1% at December 31, 1993 20.0 - 3.58%-6.50% Japanese yen Notes due 1994-1998 33.4 33.2 Other obligations due 1994-2001 23.2 20.5 ------ ------ 348.2 335.7 Less - Payments due within one year 33.5 37.7 ------ ------ $314.7 $298.0 ====== ====== NOTE 9 - LONG-TERM DEBT (Continued) - ----------------------- The fair value of the Company's long-term debt was approximately $45.0 higher than book value at December 31, 1993 and $38.0 higher than book value at December 31, 1992. The fair value was based largely on interest rates offered on U.S. Treasury obligations with comparable maturities using discounted cash flow analysis. These rates were not adjusted to reflect the premium that the Company might pay over U.S. Treasury rates. A one percentage point increase in these rates would decrease the fair value by approximately $15.0. The Company has $400.0 of debt securities registered with the Securities and Exchange Commission at December 31, 1993, of which $275.0 had been designated to medium-term note programs and another $125.0 had been issued in debentures. At December 31, 1993, $100.0 had been issued under the medium-term note programs, of which $54.5 was still outstanding. The 9.625% debentures, which mature in 2005, require the Company to make annual sinking fund payments of not less than $2.5 nor more than $5.0 through 2004. The Company held $21.9 of these debentures for redemption requirements as of December 31, 1993. The 9.375% and 8.15% debentures are not redeemable by the Company prior to their maturity; however, the holders of the 8.15% debentures may elect to have all or a portion of their debentures repaid on October 15, 1996, at 100% of the principal amount. Aggregate annual maturities of long-term debt are: $33.5 in 1994, $47.9 in 1995, $24.2 in 1996, $23.4 in 1997, $60.7 in 1998 and $108.5 thereafter. Excluded from such maturities are $50.0 of 8.15% debentures, due in 2029, which are subject to early redemptions at the holders' option in 1996. Cash paid during the year for interest, net of amounts capitalized, was $31.8 in 1993, $20.8 in 1992, and $21.1 in 1991. NOTE 10 - INTEREST AND CURRENCY RATE DERIVATIVES - ------------------------------------------------ The Company utilizes a variety of financial instruments, several with off-balance sheet risks, in its management of current and future interest rate and foreign currency exposures. These financial instruments include interest rate and currency swaps, interest rate caps and floors, options and forward exchange contracts. These instruments involve, to varying degrees, elements of credit and interest rate risk in excess of the amount recognized in the consolidated balance sheet. The contract or notional amounts of these instruments are used to measure the volume of these agreements and do not represent exposure to credit loss. The notional amounts, book values and fair values of these instruments were: NOTE 10 - INTEREST AND CURRENCY RATE DERIVATIVES (Continued) - ------------------------------------------------ The Company enters into interest rate swaps to exchange fixed and variable rate interest payment obligations without the exchange of the underlying principal amounts in order to manage interest rate exposures. The Company also enters into interest rate caps, floors, and swaptions in order to transfer, modify, or reduce interest rate risk. These instruments are used to hedge the Company's debt portfolio and hedge accounting is used to recognize the differential to be paid or received as an adjustment to interest expense over the life of the agreements. At December 31, 1993, these instruments had a weighted average remaining life of 4.1 years. The Company enters into currency swaps and options and forward exchange contracts to hedge some of its foreign currency exposures. Gains and losses on these contracts are recognized concurrent with the transaction gains and losses from the associated exposures. At December 31, 1993, currency swaps and options had a weighted average remaining life of 2.4 years, and forward exchange contracts had a weighted average remaining life of less than one year. The fair values are estimated based on quoted market prices of comparable instruments adjusted through interpolation where necessary for maturity differences. The book values of these instruments approximate their fair values, except for interest rate instruments which were entered into for the purpose of changing the nature of underlying debt obligations. The risks involved with these instruments have been significantly mitigated by the Company entering into offsetting positions. In the event of default by a counterparty, the risk in these transactions is limited to the cost of replacing the instrument at current market rates. All transactions are with major banks and other substantial financial institutions. Although the Company may be exposed to losses in the event of nonperformance by counterparties and interest and currency rate movements, it does not anticipate significant losses due to these financial arrangements. NOTE 11 - POST EMPLOYMENT BENEFITS - ---------------------------------- The Company maintains defined benefit employee retirement plans covering most domestic and certain foreign employees. The Company also has various defined contribution and savings plans covering certain employees. Plan benefits for defined benefit employee retirement plans are based primarily on years of service and compensation. The Company's funding policy is consistent with national laws and regulations. Plan assets include marketable equity securities, insurance contracts, corporate and government debt securities, real estate and cash. The components of pension expense for the Company's domestic and foreign plans are set forth below. NOTE 11 - POST EMPLOYMENT BENEFITS (Continued) - ---------------------------------- The following table presents reconciliations of defined benefit plans' funded status with amounts recognized in the Company's consolidated balance sheets as part of other assets and other long-term liabilities. Plans with assets exceeding the accumulated benefit obligation (ABO) are segregated by column from plans with ABO exceeding assets. Assets exceed ABO for all domestic plans. The weighted average discount rate used in determining the actuarial present value of the projected benefit obligation for defined benefit plans was 7.3% in 1993 and 8.2% in 1992. The weighted average rate of increase in future compensation levels was determined using an age specific salary scale and was 5.6% in 1993 and 5.7% in 1992. The weighted average expected long-term rate of return on plan assets was 8.6% in 1993 and 8.5% in 1992. In addition to providing pension benefits, the Company, primarily in the United States, provides certain health care and life insurance benefits for most retired employees. In 1992, the Company adopted Statement of Financial Accounting Standards No. 106, Employers' Accounting for Postretirement Benefits Other Than Pensions. The Company elected to immediately recognize the cumulative effect of the change in accounting for postretirement benefits of $176.9 ($116.8 net of income tax benefit) which represents the accumulated postretirement benefit obligation existing at January 1, 1992. In addition, the effect of adopting the new rules increased 1992 net periodic postretirement benefit cost by $17.4 ($11.5 net of income tax benefit). Prior to 1992, the cost of retiree health care and life insurance benefits was recognized as an expense as benefits were incurred. The cost of providing these benefits in the United States was $3.4 in 1991. The cost of providing these benefits to retirees outside the United States was not significant. Net periodic postretirement benefit cost includes the following components: NOTE 11 - POST EMPLOYMENT BENEFITS (Continued) - ---------------------------------- 1993 1992 ----- ----- Service cost $ 6.0 $ 6.6 Interest cost 10.3 15.6 Amortization of negative prior service cost (14.3) - ----- ----- $ 2.0 $22.2 ===== ===== The following table presents the plan's funded status reconciled with amounts recognized in the Company's consolidated balance sheets as part of other long-term liabilities: December 31, December 31, 1993 1992 ------------ ------------ Accumulated postretirement benefit obligation: Retirees $ 55.5 $ 49.1 Fully eligible, active plan participants 52.6 41.3 Other active plan participants 37.7 30.8 ----- ------ 145.8 121.2 Unrecognized negative prior service cost 61.5 76.2 Unrecognized net loss (16.8) (3.1) ----- ------ Accrued postretirement benefit cost $190.5 $194.3 ====== ====== In December 1992, the Company amended its retiree health care benefit plan to require that, beginning in 1994, employees have a certain number of years of service to be eligible for any retiree health care benefit. The retiree health care plan anticipates certain cost-sharing changes that will go into effect in 1995 which limit the annual increase in the Company's share of retiree health care costs. The Company continues to fund benefit costs on a pay-as-you-go basis with the retiree paying a portion of the costs. The health care cost trend rate used in measuring the accumulated postretirement benefit obligation was 11.1% in 1993 and was assumed to decrease gradually to 5.75% in 2005 and remain at that level thereafter. For retirees under age 65, plan features limit the health care cost trend rate assumption to a maximum of 8% for years 1994 and later. The health care cost trend rate assumption has a significant effect on the amounts reported. Increasing the assumed health care cost trend rates by one percentage point in each year would increase the accumulated postretirement benefit obligation by 13% and the aggregate of the service and interest cost components of net periodic postretirement benefit cost for 1993 by 11%. The discount rate used in determining the accumulated postretirement benefit obligation was 7.25% at December 31, 1993 and 8.25% at December 31, 1992. NOTE 12 - RELATED PARTY TRANSACTIONS - ------------------------------------ The Company purchased raw materials and services totalling $39.4 in 1993, $43.5 in 1992, and $44.4 in 1991 from The Dow Chemical Company and its affiliates. The Company believes that the costs of such purchases were competitive with alternative sources of supply. Other transactions between the Company and related parties were not material. NOTE 13 - INCOME TAXES - ---------------------- The components of income (loss) before income taxes are as follows: 1993 1992 1991 -------- ------- ------ U.S. companies $(516.7) $(20.8) $115.4 Non-U.S. companies 94.7 70.8 93.6 ------- ------ ------ $(422.0) $ 50.0 $209.0 ======= ====== ====== The components of the income tax provision (benefit) are as follows: 1993 1992 1991 -------- ------- ------ Current U.S. federal $ 11.7 $ 2.2 $25.7 U.S. state 2.6 2.5 6.3 Non-U.S. 37.9 59.9 56.6 ------- ----- ----- 52.2 64.6 88.6 ------- ----- ----- Deferred U.S. federal (205.4) (26.7) (16.1) Non-U.S. 2.3 (27.8) (14.2) ------- ----- ----- (203.1) (54.5) (30.3) ------- ----- ----- $(150.9) $10.1 $58.3 ======= ===== ===== The tax effects of the principal temporary differences giving rise to deferred tax assets and liabilities were as follows: December 31, December 31, 1993 1992 ------------ ------------ Implant costs $225.0 $ 15.7 Accrued expenses 62.8 45.8 Postretirement health care and life insurance 63.0 66.0 Basis in inventories 24.8 25.3 Tax credit and net operating loss carry forwards 5.6 22.7 Other 20.9 17.5 ------ ----- 402.1 193.0 Valuation allowance (3.5) (3.5) ------ ----- 398.6 189.5 ------ ----- Property, plant and equipment (60.1) (64.3) Other (5.8) (4.2) ------ ----- (65.9) (68.5) ------ ----- Net deferred tax asset $332.7 $121.0 ====== ====== NOTE 13 - INCOME TAXES (Continued) - ---------------------- At December 31, 1993, income and remittance taxes have not been recorded on $198.7 of undistributed earnings of foreign subsidiaries, either because any taxes on dividends would be offset substantially by foreign tax credits or because the Company intends to indefinitely reinvest those earnings. Cash paid during the year for income taxes, net of refunds received, was $72.5 in 1993, $68.2 in 1992, and $90.9 in 1991. The effective rates of (35.8)% for 1993, 20.2% for 1992, and 27.9% for 1991 differ from the U.S. federal statutory income tax rate in effect during those years for the following reasons: Year ended December 31, 1993 1992 1991 ------ ------ ------ Statutory rate (35.0)% 34.0% 34.0% Foreign taxes, net 0.1 (16.4) (8.0) Foreign sales corporation (0.5) (1.9) (1.7) State income taxes 0.4 3.2 2.0 Other, net (0.8) 1.3 1.6 ----- ----- ---- Effective rate (35.8)% 20.2% 27.9% ===== ==== ==== In the first quarter of 1992, the Company adopted Statement of Financial Accounting Standards No. 109 (SFAS 109), Accounting for Income Taxes, which requires an asset and liability approach in the measurement of deferred taxes. Financial statements prior to 1992 have not been restated for this change in accounting principle. The cumulative effect of adopting SFAS 109 as of January 1, 1992, increased 1992 net income by $16.4. Except for the cumulative effect, the change did not have a material effect on operating results for the periods presented. On August 11, 1993, the Revenue Reconciliation Act of 1993 was signed into law. The Act increased the U.S. corporate statutory tax rate from 34% to 35% for years beginning after December 31, 1992, changed the deductibility of certain expenses and extended certain tax credits. The effect of this retroactive increase in the statutory tax rate on 1993 earnings was offset by a gain from the revaluation of net deferred tax assets, and the net impact of these changes did not have a material impact on the Company's effective tax rate for 1993. NOTE 14 - COMMON STOCK - ---------------------- The outstanding shares of the Company's common stock are held in equal portions by Corning Incorporated and Dow Holdings Inc., a wholly-owned subsidiary of The Dow Chemical Company. There were no changes in outstanding shares during 1993, 1992 or 1991. NOTE 15 - COMMITMENTS AND GUARANTEES - ------------------------------------ The Company leases certain real and personal property under agreements which generally require the Company to pay for maintenance, insurance and taxes. Rental expense was $46.2 in 1993, $48.4 in 1992, and $46.9 in 1991. The minimum future rental payments required under noncancellable operating leases at December 31, 1993, in the aggregate are $129.2, including the following amounts due in each of the next five years: 1994 - $33.8, 1995 - $24.4, 1996 - $17.1, 1997 - $15.0, and 1998 - $12.8. At December 31, 1993, the Company had issued financial guarantees with off-balance sheet risk, which total approximately $11.1. These guarantees are issued primarily to support employee housing programs. The Company believes it will not have to perform under these agreements as the likelihood of default by the primary parties is remote. NOTE 16 - INDUSTRY SEGMENT AND FOREIGN OPERATIONS - ------------------------------------------------- The Company's operations are classified as a single industry segment. Financial data by geographic area are presented below: 1993 1992 1991 -------- -------- -------- Net sales to customers: United States $ 830.6 $ 822.6 $ 797.8 Europe 490.9 528.7 476.8 Asia 619.9 500.8 467.4 Other 102.3 103.6 103.4 -------- -------- -------- Net sales $2,043.7 $1,955.7 $1,845.4 ======== ======== ======== Interarea sales: United States $ 219.6 $ 228.3 $ 224.7 Europe 54.7 45.1 42.7 Asia 34.7 25.2 23.6 Other 0.3 1.9 0.6 -------- -------- -------- Total interarea sales $ 309.3 $ 300.5 $ 291.6 ======== ======== ======== Operating profit: United States $ 187.5 $ 143.7 $ 185.6 Europe 57.8 38.1 56.5 Asia 73.3 74.0 70.8 Other and eliminations 7.4 (2.4) 12.5 -------- -------- -------- 326.0 253.4 325.4 General corporate expenses (722.1) (163.4) (116.6) Unallocated income (expense), net (25.9) (40.0) 0.2 -------- -------- -------- Income before income taxes $ (422.0) $ 50.0 $ 209.0 ======== ======== ======== Identifiable assets: United States $1,525.8 $1,297.8 $1,271.4 Europe 460.3 488.9 510.6 Asia 586.2 507.7 466.9 Other and eliminations (253.4) (199.7) (204.2) -------- -------- -------- 2,318.9 2,094.7 2,044.7 Corporate assets 943.4 96.0 75.2 -------- -------- -------- Total assets $3,262.3 $2,190.7 $2,119.9 ======== ======== ======== Interarea sales are made on the basis of arm's length pricing. Operating profit is total sales less certain operating expenses. Special items have been identified principally with the United States and Europe in computing operating profit for each area. General corporate expenses, equity in earnings of associated companies, interest income and expense, certain currency gains (losses), minority interests' share in income, and income taxes have not been reflected in computing operating profit. General corporate expenses include certain research and development costs, corporate administrative personnel and facilities costs not specifically identified with a geographic area, and implant costs. Identifiable assets are those operating assets identified with the operations in each geographic area. Corporate assets are principally cash and cash equivalents, short-term investments, intangible assets, investments accounted for on the equity basis, corporate facilities and implant insurance receivable. DOW CORNING CORPORATION ----------------------- SCHEDULE X - SUPPLEMENTARY INCOME STATEMENT INFORMATION ------------------------------------------------------- YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 -------------------------------------------- (in millions of dollars) Charged to operating costs and expenses for year ended December 31, ------------------------------------ 1993 1992 1991 ---- ---- ---- Depreciation and amortization $197.1 $190.6 $171.5 Maintenance and repairs 88.6 91.3 82.9 Advertising costs 11.7 14.0 15.6 DOW CORNING CORPORATION ----------------------- EXHIBIT INDEX ------------- These exhibits are numbered in accordance with Exhibit Table I of Item 601 of Regulation S-K Exhibit # Description Page Number --------- ----------- ----------- 3.1 Restated Articles of Incorporation 53 of Dow Corning Corporation dated March 25, 1988 3.2 By-Laws of Dow Corning Corporation dated June 25, 1993 66 4 Dow Corning Corporation agrees to furnish the Securities and Exchange Commission upon its request a copy of any instrument which defines the rights of holders of long-term debt of the registrant and all of its subsidiaries for which consolidated or unconsolidated financial statements are required to be filed. 12 Computation of ratio of earnings to fixed charges 102 21 Subsidiaries of the Registrant -- has been omitted in accordance with provisions of General Instruction J of Form 10-K. 23 Consent of Price Waterhouse 103

84613_1993.txt

84613

1993

ITEM 1. Business General Development of Business: Rockland Electric Company (the "Company") is a New Jersey corporation which was incorporated in 1899 under an Act of the Legislature of New Jersey and is engaged in the transmission, distribution and sale of electricity. Its principal New Jersey office is located at 82 East Allendale Road, Saddle River, New Jersey 07458. The Company has a wholly owned non-utility subsidiary, Saddle River Holdings Corp. ("SRH"), a Delaware corporation. SRH has two wholly owned non-utility subsidiaries, O&R Energy, Inc. and Atlantic Morris Broadcasting, Inc., both Delaware corporations. O&R Energy, Inc. has a wholly owned non-utility subsidiary, Millbrook Holdings, Inc., also a Delaware corporation. All of the Company's outstanding common stock is owned by Orange and Rockland Utilities, Inc. (the "Parent"). The Parent is a New York corporation, with its principal office at One Blue Hill Plaza, Pearl River, New York 10965. The Parent has two wholly owned utility subsidiaries, the Company and Pike County Light & Power Company ("Pike"), a Pennsylvania corporation, as well as three non-utility subsidiaries. Financial Information about Industry Segments: Consolidated financial information regarding the Company's principal business segments, Electric Utility Operations and Diversified Activities, is contained in Note 11 of the Notes to Consolidated Financial Statements - "Segments of Business" in Part II, Item 8 of this Form 10-K Annual Report. Narrative Description of Business: Principal Business The Company serves a territory with a population of approximately 155,000, located in parts of northern Bergen and Passaic Counties in the northeastern corner of New Jersey (adjacent to the southeastern portion of the territory served by its Parent in New York) and a small area in Sussex County in the northwestern corner of New Jersey along the Delaware River. At December 31, 1993, the Company served approximately 64,000 customers in 26 communities. There have been no significant changes in either the population of the Company's service territory or in the number of customers served since December 31, 1992. At that time, service was provided to approximately 63,000 customers in 26 communities with an estimated population of 155,000. While the territory served is predominantly residential, the Company also serves a number of commercial and industrial customers in diversified lines of business activities, from which significant electric revenues are received. No customer accounts for more than 10% of sales. The business of the Company is seasonal to the extent that sales of electricity are higher during the summer, mainly due to air conditioning requirements. Events Affecting the Company On August 16, 1993, the Rockland County, New York District Attorney charged a then Vice President of the Parent and the Company with grand larceny, commercial bribery and making illegal political contributions and commenced a related investigation of the Parent. Two other former employees of the Parent, who had reported to the Vice President were also charged with grand larceny. On August 20, 1993, the Parent's Board of Directors created a Special Committee (the "Special Committee") of the Board, consisting entirely of outside Directors, to conduct an independent investigation of the issues raised by the Rockland County District Attorney and any other matters discovered in the course of the investigation as the Special Committee deems necessary or desirable. The Special Committee was granted full and complete power and authority to take whatever steps it deems necessary or desirable, including retention of counsel and other advisors, presenting to the Parent's Board of Directors periodic reports regarding its activities and at the appropriate time its full findings, and making recommendations to the Parent's Board of Directors with respect to any remedial measures it deems appropriate to prevent a recurrence of any improprieties or irregularities discovered by the investigation. The Special Committee has retained the law firm of Stier, Anderson & Malone as investigative counsel, and Price Waterhouse & Co. as accounting experts, to assist it in conducting its independent investigation. The Special Committee will present preliminary conclusions of its investigation at the Parent's Annual Meeting of Shareholders on May 11, 1994. The Special Committee intends to complete its investigation as promptly as practicable after the Annual Meeting and will report its final conclusions and recommendations to the Parent's Board of Directors at that time. In addition, during the fourth quarter, James F. Smith was terminated for cause as Chief Executive Officer of the Parent and the Company and removed as Chairman of the Parent's and the Company's Board of Directors. President and Chief Operating Officer of the Parent and the Company, Victor J. Blanchet, Jr. was appointed to serve as acting Chief Executive Officer of the Parent and the Company. Details concerning these events, including the cost incurred for legal counsel, accounting services, and other professional and consultative services related to the ongoing investigations and their effect of the Company's Results of Operations are contained in the "Management's Discussion and Analysis of Financial Condition and Results of Operations" under the caption "Events Affecting the Company" and in Note 10 of the Notes to Consolidated Financial Statements under the caption "Legal Proceedings" in this Form 10-K Annual Report. Reference is also made to Item 3, "Legal Proceedings", of this Form 10-K Annual Report. Electric Operations The Company's electricity supply requirements, together with all operating and service personnel, are furnished by its Parent pursuant to contracts. The contract for the supply of electricity has been approved by the Federal Energy Regulatory Commission (the "FERC") and the contract for provision of operating and service personnel has been approved by the New Jersey Board of Regulatory Commissioners (the "NJBRC"). Such contracts provide, in general, for the reimbursement to the Parent, by the Company, of costs allocable to electricity and services furnished to the Company, and require additional payments to the Parent of an amount sufficient to yield specified returns on its investment in plant and other assets allocable to the Company under certain formulae. During 1992, the Parent was a party to a proceeding initiated by the FERC to determine the rate of return authorized for use in establishing wholesale rates between the Parent, the Company and Pike. Pursuant to an agreement which was approved by the FERC on February 19, 1993, the Parent has been authorized to earn an 11.7% return on equity effective as of January 1, 1993, which is a decrease from the previously authorized 12.25% return on equity. Generating Capacity and Purchased Power. As described more fully in Item 2, "Properties", of this Form 10-K Annual Report, the capacity of the Parent's plants provides the Parent and its utility subsidiaries with a net generating capability of 1,032 megawatts ("Mw") in the winter and 1,020 Mw in the summer. The maximum historical one-hour demand for the Parent and its utility subsidiaries of 1,037 Mw occurred on July 8, 1993. During 1993, the Parent's purchased power accounted for approximately 42% of the total energy supply of the Company and its utility subsidiaries. Purchased power is available to the Parent primarily through its membership in the New York Power Pool (the "NYPP"), through which member companies are able to coordinate inter- utility transfers of bulk power in order to achieve economy and efficiency. Through the NYPP control center, the Parent is able to purchase power in order to optimize its generation/purchase mix, using the lowest cost energy available to its interconnected system at any time. During 1993, the Parent purchased 464,334 megawatt hours ("Mwh") from or through the NYPP, which represents approximately 23% of the total purchased power. By agreement with the NYPP, the Parent must maintain capacity reserves including firm capacity purchases of not less than 18% of its peak load. In addition, the Parent has agreements with the New York Power Authority (the "NYPA") and certain other utilities for the purchase of firm power. During 1993, an agreement with the NYPA provided for firm purchases of 25 Mw of year-round capacity from the Blenheim-Gilboa pumped-storage generating facility ("Gilboa Facility") and firm power purchase agreements with Central Hudson Gas & Electric Corporation ("Central Hudson") and Pennsylvania Power & Light Company ("PP&L"), provided for an additional 225 Mw of capacity. Other agreements were in effect from time to time throughout 1993 with several other utilities, including an agreement with Philadelphia Electric Company pursuant to which significant economy purchases were made during 1993, which provided for short-term, firm purchases on an as-available, as-needed basis. The NYPA agreement for firm purchases from the Gilboa Facility, which provides for 25 Mw of year-round capacity, will be in effect through April 2015. The firm purchase agreement with Central Hudson will provide 50 Mw of capacity through April 1994, and the agreement with PP&L will provide capacity ranging between 10 Mw and 125 Mw through October 1995. In addition, a firm purchase power agreement with Public Service Electric & Gas Company ("PSE&G") will provide between 75 Mw and 300 Mw of capacity during the base contract term which extends from May 1994 through April 1998, with an additional 100 MW available throughout the base contract term at the option of the Parent. The contract also provides that at the option of the Parent 100 Mw of additional capacity would be available to the Parent between May 1992 and April 1994 and 400 Mw of additional capacity will be available from May 1998 through October 2000. During 1994, the Company expects to purchase 50 Mw of capacity above the base contract amount under these options. Other agreements will continue to be in effect which will enable the Company to take advantage of economic power purchases on an as available, as- needed basis. Additional information regarding the Parent's future power supply, particularly capacity purchase contracts with Independent Power Producers and Qualifying Facilities, is contained under the caption "Future Energy Supply and Demand" in this Item I. The Parent also maintains interconnections with Central Hudson, PSE&G and Consolidated Edison Company of New York, Inc. ("Con Ed"). Through these interconnections, and as a member of the NYPP, the Parent can exchange power directly with the above utilities and, through the facilities of other members of the NYPP, the Parent can exchange power with all members of the NYPP and with utilities in pools in neighboring states. Fuel Supply. The Parent's 1,032 Mw winter generating capacity is available from various fuel sources including gas, coal, oil and hydro power. Electricity available for sale is a mix of Company generation by various fuel types, supplemented by purchased power when such power is available at a price lower than the price of generation or is needed to meet load requirements. Details for the years 1989 through 1993 are as follows: 1989 1990 1991 1992 1993 Gas 25% 27% 22% 21% 16% Coal 29 32 36 33 33 Oil 28 19 14 10 5 Hydro 3 4 3 3 4 Purchased Power 15 18 25 33 42 Total 100% 100% 100% 100% 100% Gas - During 1993, the Parent was able to use significant volumes of natural gas for boiler fuel at both its Lovett Plant and the Bowline Point Plant. It also expects to be able to use natural gas in the Lovett Plant and Bowline Point Plant during 1994, whenever such gas is more economical than alternative fuels. In 1993, the Parent used 2.1 billion cubic feet ("Bcf") and 6.0 Bcf of gas, respectively, at the Lovett Plant and the Bowline Point Plant. The annual average cost per thousand cubic feet ("Mcf") of natural gas burned in the Parent's generating plants during the years ended December 31, 1989 through 1993 was $2.79, $2.78, $2.64, $2.82 and $3.01, respectively. This is equivalent to $2.71, $2.69, $2.56, $2.74 and $2.92, respectively, per million British Thermal Unit ("MMBTU"). Coal - The low sulfur coal (1.0 lbs. SO2 per MMBTU) used in the Parent's Lovett Plant Units 4 and 5 is supplied to the Parent primarily through long term contracts with Massey Coal Sales, Inc. ("Massey") and the Pittston Coal Sales Co., ("Pittston") as well as through spot market purchases, which accounted for approximately 22% of the Parent's 1993 coal requirements. The Parent has the right, under the coal purchase contracts, to suspend the purchase of coal if alternative fuel sources become less expensive. The coal is fully washed and, as such, is low in ash (typically 7%) and high in BTU content (26 MMBTU's per ton). The annual average cost per ton of coal consumed at the Lovett Plant during each of the years ended December 31, 1989 through 1993 was $58.53, $58.40, $56.57, $55.95 and $55.25, respectively. This is equivalent to $2.26, $2.25, $2.18, $2.16 and $2.14, respectively, per MMBTU. During 1993 coal was the predominant fuel burned at the Lovett Plant, and the Parent expects it to be the predominant fuel burned during 1994. In February 1994, the contract with Pittston was terminated by the Parent because of Pittston's failure to meet the coal quality specification of its contract. Alternative supplies have been obtained and arrangements for longer term replacement coal are under review. Oil - The Parent does not anticipate purchasing any significant quantity of fuel oil for its Lovett Plant. Con Ed has undertaken the supply of #6 fuel oil (0.37% maximum sulfur content by weight) to the Bowline Point Plant, which is supplied under a contract between Con Ed and the Parent. Pursuant to that contract, Con Ed has also undertaken to provide a backup oil supply for the Company's Lovett Plant under certain conditions. The Parent believes that it will be able to secure sufficient oil supplies to meet the total requirements of #6 fuel oil for the calendar year 1994. The annual average cost per barrel of oil burned in the Parent's generating plants during the years ended December 31, 1989 through 1993 was $19.21, $23.73, $21.23, $20.43 and $21.27, respectively. This is equivalent to $3.09, $3.81, $3.40, $3.26 and $3.39, respectively, per MMBTU. Hydro - Water for the operation of the Parent's Mongaup River Hydro Plants is controlled by the Parent through the ownership of the necessary land in fee or through easements. In the case of the Parent's Grahamsville Plant, water is obtained under contract with the City of New York Board of Water Supply. This contract, which expires in 2005, entitles the Parent to 8.1 Bcf of free water each year. Water in excess of the 8.1 Bcf, which amounted to 9.0 Bcf during 1993, is billed at varying rates based on an average cost of all fuels used in power generation. Purchased Power - the Parent's practice regarding purchased power is to supplement the Parent's electric generation by purchasing both capacity and energy when needed to meet load and reserve requirements and also when such power is available at a price lower than the cost of production. Details regarding purchased power are contained under the captions "Generating Capacity and Purchased Power" and "Future Energy Supply and Demand" in this Item 1. In addition, information regarding the cost of electric energy is contained under the caption "Energy Costs" in the "Management's Discussion and Analysis of Financial Condition and Results of Operations" in this Form 10-K Annual Report. Future Energy Supply and Demand. The Parent and the Company continue to be committed to meeting customer energy needs by providing reliable energy service at the lowest prudent cost and in an environmentally sound manner. Through the Integrated Resource Plan the Parent and the Company have responded to the changes that have occurred in the utility industry and have incorporated a significant number of conservation and demand reduction alternatives as well as purchased power from both utility and non-utility generators, into their energy strategy. The Demand-Side Management ("DSM") program involves efforts to control electric peak demand and energy usage, and addresses the need to improve plant utilization by making customer demand more complementary over time to the available capacity. DSM programs are available to all market segments. Through December 31, 1993, DSM efforts have reduced the annual need for increased generating capacity and energy by 97.9 Mw and 173,104 Mwh, respectively, both through programs administered by the Parent and the Company as well as through contracts with outside consultants pursuant to the competitive bidding program. The New York State Public Service Commission ("NYPSC") has consistently authorized the recovery of DSM costs, and in New Jersey, the Company's DSM costs are recoverable on a current basis. The Parent's Supply-Side Management program involves the acquisition of future increments of capacity and energy from both investor-owned utilities and from non-utility generators. The Parent has entered into several agreements in this regard. In 1990, the Parent entered into a power supply agreement ("Wallkill Agreement") with Wallkill Generating, L.P. ("Wallkill Generating"). The Wallkill Agreement was approved by the NJBRC in October 1991, and in July 1991 the FERC approved the rates contained in the Wallkill Agreement. Pursuant to the agreement, Wallkill Generating, a limited partnership formed by PG&E/Bechtel Generating Company (now U.S. Generating Company), has contracted to construct and operate a gas- fired combined cycle generating facility in the Town of Wallkill, N.Y. and sell 95 Mw of capacity and associated energy to the Parent. The original target date for commercial operation of this project as set forth in the Wallkill Agreement was April, 1994. Wallkill Generating has reported that construction of the project will begin in the spring of 1994 and it will be available for commercial operation in late 1995. In 1990, the Parent entered into a long-term power supply agreement ("State Line Agreement") with State Line Power Associates Limited Partnership ("State Line"). Under the terms of the State Line Agreement, State Line contracted to construct and operate a gas-fired combined cycle generating facility in the Borough of Ringwood, New Jersey and sell 100 Mw of capacity and associated energy to the Parent. In July 1992, the State Line Agreement was terminated by the Parent for, among other things, State Line's failure to make a required milestone payment pursuant to specified contract terms. On August 3, 1992, State Line filed suit against the Parent in the United States District Court for the Southern District of New York claiming that the Parent had wrongfully terminated the State Line Agreement. On January 7, 1994, State Line and the Parent settled all litigation relating to the State Line Agreement. In addition to the Wallkill Agreement, future increments of purchased capacity and energy have been contracted from investor owned utilities and the NYPA as previously described under the caption "Generating Capacity and Purchased Power" in this Item 1. In addition, the Parent has contracted to purchase approximately 90 Mw of capacity and associated energy from various Public Utility Regulatory Policies Act ("PURPA") Qualifying Facilities. These contracts include a contract between the Parent and Harriman Energy Partners, Ltd., ("Harriman Energy") a limited partnership, the general partner of which is Destec Holding, Inc. (formerly PSE, Inc.). This contract provides for the construction of a project that upon commercial operation, which Harriman Energy has reported to be in late 1996, would provide the Parent with approximately 57 Mw of capacity and associated energy for a period of 25 years. This contract has been approved by the NYPSC and the New Jersey Board of Regulatory Commissioners ("NJBRC"). Construction has not been commenced on either the Wallkill Generating or Harriman Energy projects and the Parent cannot predict whether either of these projects will be constructed. If either or both of these projects are not constructed, other economic sources of capacity and energy should be available to the Parent and the Company. Diversified Activities The Company's wholly owned non-utility subsidiary, Saddle River Holdings Corp. ("SRH"), was established for the purpose of investing in non-utility business ventures and, through subsidiaries, is currently engaged in natural gas marketing and radio broadcasting. Capital contributions to SRH are borne by the Company's shareholder. Any losses or profits from investments in SRH accrue to the shareholder and are not included in the cost of service for ratemaking purposes. Gas marketing activities are conducted through a subsidiary, O&R Energy, Inc., which provides natural gas to industrial, commercial and institutional end users, gas distribution companies and electric generating facilities in 38 states. A subsidiary of O&R Energy, Inc., Millbrook Holdings, Inc., holds approximately twelve acres of non-utility real estate in Morris County, New Jersey. Broadcasting activities are conducted through Atlantic Morris Broadcasting, Inc., a subsidiary of SRH, which owns radio stations WKTU (FM) in Ocean City, New Jersey, WABT (FM) in Dundee, Illinois, WALL (AM) and WKOJ (FM) in Middletown, New York and WCSO (FM) and WLPZ (AM) in Portland, Maine. The Company's Consolidated Financial Statements include the results of operations of all diversified activities. The diversified activities, which consist primarily of gas marketing activities, are considered to be a reportable business segment. However, the net earnings realized from diversified activities are less than 10% of total net earnings and the identifiable assets of the diversified activities consist primarily of gas marketing receivables which generally have corresponding gas marketing payables. Based on these factors, the disclosure related to the Company's diversified activities, as prescribed by Regulation S-K, has, with few exceptions, been omitted from other sections of this Form 10-K Annual Report. Construction Program and Financing Construction Program. The construction expenditures, excluding allowance for funds used during construction ("AFDC"), of the Company for the period 1994 through 1998 are presently estimated at approximately $37 million, as set forth in the table below. The Company's construction program is under continuous review and the estimated construction expenditures are, therefore, subject to periodic revision to reflect, among other things, changes in energy demands, economic conditions, environmental regulations, construction delays, the level of internally generated funds and other modifications to the construction program. Forecasted Construction Expenditures (000's) 1994 1995 1996 1997 1998 Transmission & Substations $ 805 $1,270 $1,520 $3,565 $3,255 Electric Distribution 4,480 4,960 5,450 5,300 5,315 Electric General 115 25 25 25 530 Total Construction $5,400 $6,255 $6,995 $8,890 $9,100 The Company's forecasted construction expenditures for the five year period 1994 through 1998 consists primarily of routine transmission and distribution projects for capital replacements or system betterments. Information regarding the Company's construction program is contained under the caption "Liquidity and Capital Resources" in the "Management's Discussion and Analysis of Financial Condition and Results of Operations" in Part II, Item 7 of this Form 10-K Annual Report, as well as in Note 10 of the Notes to Consolidated Financial Statements - "Construction Program" in Part IV, Item 14 of this Form 10-K Annual Report. Financing. During the three year period 1991-1993, the Company's total construction expenditures were financed with internally generated funds. It is expected that the construction expenditures for the years 1994-1998 will also be financed with internally generated funds. Additional information regarding the Company's financing activities is contained under the caption "Liquidity and Capital Resources" in the "Management's Discussion and Analysis of Financial Condition and Results of Operations" in Part I, Item 7 as well as in Note 7 of the Notes to Consolidated Financial Statements - "Cash and Short-Term Debt" of this Form 10-K Annual Report. Regulatory Matters Regulation. The Company is subject to the jurisdiction of the NJBRC with respect to, among other things, rates, services, the issuance of securities, and accounting and depreciation procedures. In addition, approval by the NYPSC is required for the purchase of any securities of the Company by the Parent or for any capital contribution made to the Company by the Parent. The Company is also subject to the jurisdiction of the FERC with respect to the interstate transmission of electricity and certain other matters, including accounting, recordkeeping and reporting. The Company is also subject to regulation by various other Federal, state, county and local agencies under numerous regulations dealing with, among other things, environmental matters, energy conservation, long-range planning, fuel use, plant siting and gas pricing. Current Rate Activities. Information regarding the Company's rate activities is contained under the caption "Rate Activities" in the "Management's Discussion and Analysis of Financial Condition and Results of Operations" in Part II, Item 7, as well as in "Legal Proceedings" in Part I, Item 3 of this Form 10-K Annual Report. Rate Relief. The amounts of rate relief approved by the NJBRC during the last five years are set forth in the following table: Historical Rate Relief 1989 - 1993 Annual Amount Overall Rate Return on ($000's) of Return Equity Effective Date Requested Granted Granted (%) Granted (%) 1989-1991 - - - - 1/24/92 12,863 5,100 10.17 12.00 1/01/93 (A) 1,685 (A) (A) (A) Rate increase as ordered by the NJBRC to reflect the effect of revised legislation regarding gross receipts and franchise taxes. Rate recovery with interest is permitted over a ten year period. Information regarding possible rate impacts of certain events described under the caption "Events Affecting the Company" in this Item 1 is contained in Item 3 "Legal Proceedings", of this Form 10-K Annual Report. Utility Industry Risk Factors The electric utility industry is exposed to risks relating to increases in fuel costs, numerous regulatory and environmental restrictions, delays in obtaining adequate rate relief, increases in the costs of construction and construction delays, the effects of energy conservation, the effect of weather-related sales and revenue fluctuations and meeting the growth of energy sales. The Company is, to some extent, experiencing all of these challenges. However, the impact on the Company has been less than for the utility industry in general, principally due to the Company's relatively low construction expenditures and low external financing requirements. The problems associated with nuclear energy have not affected the Company, as its Parent has no operating nuclear plants, nor any under construction, and has no plans for future participation in nuclear projects. Additional information on the recovery by the Company of its investment in the Parent's cancelled Sterling Nuclear Project, is contained in Note 3 of the Notes to Consolidated Financial Statements - "Sterling Nuclear Project" in Part IV, Item 14 of this Form 10-K Annual Report. Competition There are competitive factors present in the industry which affect utility companies in varying degrees. Among these are the use by interruptible or dual-fuel customers of lower priced alternative fuels; the establishment of municipal distribution agencies; the presence of cogenerating systems, small power producers and independent power producers; and the increasing interest in, and research on, the development of energy sources other than those now in use. In recent years, changing laws and governmental regulation, combined with growing interest in self-generation and an increase in nonregulated energy suppliers has served to intensify the level of competition experienced by regulated utilities. The National Energy Policy Act of 1992 ("Energy Policy Act") is expected to bring major changes to the electric utility industry, including increased competition from a new category of wholesale electric generators which are exempt from the Public Utility Holding Company Act of 1935. The Energy Policy Act also empowers the FERC to require utilities, under certain circumstances, to provide open access to electric wholesalers for use of the utility's transmission systems. The Parent and the Company recognize the changes in the regulated utility environment and are committed to remain competitive in the core business. The Parent's and the Company's five year strategic plan has put forth as a corporate objective the achievement of a competitive edge by providing the most economical and effective energy service to customers. Such competitive factors are not expected to have a material effect on either the Parent or the Company for the foreseeable future. Marketing The primary focus of the Company's marketing efforts is the efficient use of energy by the Company's residential, commercial and industrial customers. Existing programs being marketed include all state approved DSM programs as well as other energy conservation programs. The Company is also marketing the Job Development Rates authorized by the NJBRC. These rates offer discounts to firms locating to vacant buildings or expanding their operations. Environmental Matters The Parent and the Company are subject to regulation by Federal, state, county and, to some extent, local authorities with respect to the environmental effects of its operations, including regulations relating to air and water quality, aesthetics, levels of noise, hazardous wastes, toxic substances, protection of vegetation and wildlife and limitations on land use. In connection with such regulation, various permits are required with respect to the Parent's and the Company's facilities. Generally, the principal environmental areas and requirements to which the Parent is subject are as follows: Water Quality. The Parent is required to comply with Federal and state water quality statutes and regulations including the Federal Clean Water Act ("Clean Water Act"). The Clean Water Act requires that the Parent's generating stations be in compliance with state issued State Pollutant Discharge Elimination System Permits ("SPDES Permits"), which prescribe applicable conditions to protect water quality. On May 18, 1992, the Parent applied to the State of New York Department of Environmental Conservation (the "NYDEC") for the renewal of its SPDES Permit for the Lovett Coal Ash Management Facility. The existing permit expired on December 1, 1992, but remains in effect until issuance of a new permit. The Parent also has an SPDES Permit, effective October 1, 1991 for its Lovett generating station. The Parent's Bowline Point generating station currently operates under a SPDES permit which expired on October 1, 1992. This permit remains in effect since a permit renewal application was filed on April 3, 1992, which was within the statutory deadline for renewal application. The Parent is now proceeding with the State Environmental Quality Review Act process as part of the permit renewal procedure. The Parent entered into a settlement with the United States Environmental Protection Agency (the "EPA") and others that relieved the Parent for at least 10 years from a regulatory agency requirement that, in effect, would have required that cooling towers be installed at the Bowline Point generating station. In return, the Parent agreed to certain plant modifications, operating restrictions and other measures. The settlement expired in May, 1991. On May 15, 1991, the Parent and others entered into an Interim Agreement with the NYDEC to continue specific operating conditions and other measures for a period from May 15, 1991 to September 30, 1992. Several interveners to the original settlement filed a civil action challenging the Interim Agreement's legality. On March 23, 1992, the parties to the Interim Agreement and interveners signed a Consent Order terminating litigation and agreeing to certain operating limitations and biological monitoring requirements. The Consent Order was due to expire on September 1, 1993. On August 5, 1993, the parties executed the First Amended Consent Order which extends the agreement through September 1, 1994. Air Quality. Under the Federal Clean Air Act, the EPA has promulgated national primary and secondary air quality standards for certain pollutants, including sulfur oxides, particulate matter and nitrogen oxides. The NYDEC has adopted, and the EPA has approved, the New York State Implementation Plan ("SIP") for the attainment, maintenance and enforcement of these standards. In order to comply with the SIP, the Parent burns #6 fuel oil at its Lovett and Bowline Point generating stations with a 0.37% maximum sulfur content by weight. Pursuant to the SIP, the Parent is governed by the following limitations when it is burning coal at Lovett Units 4 and 5: if one unit is burning, the Parent may emit sulfur dioxide at a rate not to exceed 1.5 lb/MMBTU, and if two units are burning, the Parent may emit sulfur dioxide at a rate not to exceed 1.0 lb/MMBTU per unit. The Clean Air Act Amendments of 1990, which became law on November 15, 1990, could restrict the Parent's ability to meet increased electric energy demand after the year 2000 or could substantially increase the cost to meet such demand. Regulations pertaining to nitrogen oxide reduction and continuous emissions monitoring systems will require increased capital expenditures by the Parent totaling $26.2 million during 1994 through 1996 as follows: $8.2 million in 1994, $12.0 million in 1995 and $6.0 million in 1996. The Parent will continue to assess the impact of the Clean Air Act Amendments of 1990 on its power generating operations as additional regulations implementing these Amendments are promulgated. The NYDEC has proposed to revise the SIP to meet ozone attainment standards and to provide a mechanism for Title V emissions fee billing. Under the proposed fee revision, beginning in 1994, Title V sources which include the Parent's Lovett Plant and Bowline Point Plant will be required to pay an emission fee based upon actual air emissions reported to NYDEC at a rate of approximately $25 per ton of air emissions. The effect of the proposed revision, based on 1992 emissions would have been approximately $450,000. Toxic Substances and Hazardous Wastes. The Federal Comprehensive Environmental Response, Compensation and Liability Act of 1980, as amended by the Superfund Amendments and Reauthorization Act of 1986 ("Superfund"), provides that both the owners and operators of facilities where releases of hazardous substances into the environment have occurred or are imminent, and the generators and transporters of hazardous substances disposed of at the facilities, are, regardless of fault, jointly and severally liable for all response, removal and remedial action costs and also for damages to natural resources. As part of its operations, the Parent generates materials which are deemed to be hazardous substances under Superfund. These materials include asbestos and dielectric fluids containing polychlorinated biphenyls ("PCB's"), both of which are disposed of at licensed, off-site locations not owned by the Parent. Other hazardous substances may be generated in the course of the Parent's operations or may be present at Parent-owned locations. The Parent has from time to time, received process or notice of claims under Superfund or similar state statutes relating to sites at which it is alleged that hazardous substances generated by the Parent (and, in most instances, by a large number of other potentially responsible parties) were disposed of. Similar claims may be asserted from time to time hereafter, involving additional sites. Typically, many months, and sometimes years, are required to determine fully the probable magnitude of the cleanup costs for a site, the extent, if any, of the Parent's responsibility, the number and responsibility of other parties involved, the financial ability of the other parties to pay their proportionate share of any costs, and the probable ultimate liability exposure, if any, of the Parent. This process is still under way at most of the sites of which the Parent has notice, and the costs at some of these sites may be substantial. However, based on the information and relevant circumstances known to the Parent at this time, the Parent's share of these costs is not expected to be material. Environmental Expenditures. The Parent estimates that its expenditures attributable, in whole or in substantial part, to environmental considerations totaled $13.7 million in 1993. Compliance with Federal, state and local laws and regulations which have been enacted or adopted regulating the discharge of materials into the environment or otherwise relating to the protection of the environment is not anticipated to have a material financial impact on the Parent or the Company. Projected environmental expenditures are under continuous review and are revised periodically to reflect changes in environmental regulations, inflation, technology and other factors which are beyond the control of the Parent. Although the Parent and the Company are unable to predict the ultimate impact of environmental regulations on existing or proposed facilities or on the operations of the Parent or the Company, the Company believes that its expenditures for compliance with environmental regulations will be given appropriate rate treatment. Research and Development The Company and its Parent support research and development agencies involved in utility research, provide funds for joint utility research projects and the Parent conducts its own internal program. Electric research and development expenditures of the Parent, a portion of which were borne by the Company based on the Company's use of the consolidated electric system capacity, amounted to approximately $4.0 million in 1993, $3.1 million in 1992, and $2.7 million in 1991. The Parent and the Company provide support to national agencies such as the Electric Power Research Institute. At the state level, the Parent and the Company support the Empire State Electric Energy Research Corporation and the New York State Energy Research and Development Authority. Generally, the Parent's internal research and development program concentrates on projects which uphold the corporate goal of providing safe and reliable electric and gas service to customers at a minimum price and in an environmentally acceptable manner. The program includes projects which seek improvement of generation and distribution systems, mitigation of environmental impacts of electric power generation, and advancement in customer utilization and conservation. Current projects include a demonstration of magnetic bearings on a power plant fan and motor, the development of a new technique for locating faults in underground cables, and the development of a methodology for measuring the impact of commercial and industrial demand-side management programs. Franchises The Company has municipal consents or franchises covering substantially all the territory in which it operates, which consents or franchises have been approved by the NJBRC in every case in which such approval is required. In certain areas served by the Company, the original franchises were granted for limited periods, and have since expired. The Company, however, has operated in these areas for many years with the acquiescence of the municipal authorities and, in the opinion of outside counsel, its continued operation in these areas is lawful. None of the municipal consents or franchises held by the Company are exclusive. Under the present provisions of the public utility law of the State of New Jersey, no other private corporation can commence public utility operations in any part of the territory now served by the Company without obtaining a certificate of public convenience and necessity from the NJBRC. Such certificate would not be required with respect to a municipality furnishing electric service under the provisions of the statutes pertaining to municipalities. Municipal corporations, upon compliance with the provisions of the municipal law, are authorized to acquire the public utility service of any public utility company by purchase or by condemnation. Employee Relations The Company does not have any employees other than officers. Personnel for Company operations are furnished by the Parent on a reimbursement basis. The Parent's current contract with Local 503 of the International Brotherhood of Electrical Workers ("IBEW"), representing 977 production, maintenance, commercial and service employees of the Parent became effective June 1, 1991 and expires June 1, 1994. This contract does not include supervisory employees. At December 31, 1993, the Company's non-utility subsidiary had 198 employees of which 51 were part-time employees, none of whom were covered by the Parent's contract with the IBEW or any other collective bargaining agreement. ITEM 2.

ITEM 2. Properties The Company's property consists primarily of electric transmission and distribution facilities. These properties are required for the continued operation of the Company's major business segment. In addition, the Company maintains certain miscellaneous utility and non- utility property. The Company's facilities are in satisfactory condition, are suitable for the particular purpose for which they were acquired, and are adequate for the Company's present operations. Electric Generating Facilities. The Parent's generating plants, all of which are located in New York State, are as follows: Maximum Percent Summer of Net Mwh Net MW Total Generated Plant Name Units Energy Source Capability Capability In 1993 Swinging Bridge, 8 Mongaup & Rio Hydroelectric 25.8 2.5% 60,437 Grahamsville 1 Hydroelectric 18.0 1.8 103,941 Hillburn 1 Jet Fuel/Gas 37.0 3.6 2,509 Shoemaker 1 Jet Fuel/Gas 37.0 3.6 5,048 Lovett 5 Coal/Oil/Gas 501.7 49.2 1,869,967 Bowline Point 2 Oil/Gas 400.6 (1) 39.3 850,930 1,020.1 100.0% 2,892,832 (1) Parent's share of maximum summer net megawatt capability. Electric Transmission and Distribution Facilities. The Company owns and operates 93 miles of transmission lines, 16 substations, 17,910 in-service line transformers and 1,160 miles of distribution lines. The electric transmission and distribution facilities of the Company are located within the Company's New Jersey service territory, which is described under the caption "Principal Business" in Item 1 of this Form 10-K. Miscellaneous Properties. The Company owns structures at different locations within the Company's service territory which are used as offices, service buildings, store houses and garages. The Company leases its principal office in Saddle River, New Jersey, as well as office space at other locations. Character of Ownership. The Company's major electric substations are located on land owned by the Company in fee. Electric transmission facilities of the Company (including substations) are, with minor exceptions, located on land owned in fee or occupied pursuant to perpetual easements. Electric distribution lines are located in, on or under public highways or private lands pursuant to lease, easement, permit, municipal consent, agreement or license, express or implied through use by the Company without objection by the owners. In the case of distribution lines, the Company owns approximately 60% of the poles upon which its wires are installed and has a joint right of use in the remaining poles on which its wires are installed, which poles are owned, in most cases, by telephone companies. The Parent's electric and gas plants are owned by the Parent except for the gas turbines at Hillburn and Shoemaker which are leased and the Bowline Point Plant which is jointly owned with Consolidated Edison Company of New York, Inc. and operated by the Parent. Substantially all of the utility plant and other physical property owned by the Company are subject to the lien of the indenture securing the first mortgage bonds of the Company. ITEM 3.

ITEM 3. Legal Proceedings Investigations and Related Litigation: On August 16, 1993, Linda Winikow, then a Vice President of the Parent and the Company, was arrested by the Rockland County (New York) District Attorney and charged with grand larceny, commercial bribery and making campaign contributions under a false name. In essence, the District Attorney alleged that Ms. Winikow (1) had been coercing or inducing certain vendors of goods or services to the Parent to make contributions to political candidates or causes, while arranging for some of those contributions to be, in effect, reimbursed by means of false or inflated invoices paid by the Parent, and (2) had used advertising contracts to try to influence news reports about the Parent. Two other former employees of the Parent who reported to Ms. Winikow were charged with grand larceny. Ms. Winikow was immediately placed on leave of absence by the Parent and the Company. The District Attorney also announced that he would commence an investigation of the Parent and the Parent announced that it would undertake its own investigation into the matters cited by the District Attorney. The Company's Board of Directors terminated Ms. Winikow's employment as of August 26, 1993. On the same day, the Parent's Board of Directors terminated Ms. Winikow's employment with the Parent. On October 5, 1993, the independent Directors of the Parent determined to terminate for cause the employment of James F. Smith as Chief Executive Officer of the Parent and to remove him as Chairman of the Board. On October 7, 1993, notice of such termination was delivered to Mr. Smith and he was suspended from all duties effective immediately. On the same day, the Board of Directors of the Parent appointed Victor J. Blanchet, Jr. to serve as Acting Chief Executive Officer of the Parent. Mr. Smith had certain rights under his employment agreement with the Parent to take corrective action with respect to his termination for cause which lapsed, without such action being taken, on December 6, 1993. Mr. Smith also has the right to contest his termination for cause in an arbitration proceeding. Also effective as of October 7, 1993, the Parent, acting as sole shareholder of the Company, removed Mr. Smith as a Director of the Company and the Company's Board of Directors removed Mr. Smith from the offices of Chairman of the Board of Directors and Chief Executive Officer of the Company and appointed Mr. Blanchet to serve as Acting Chief Executive Officer of the Company. On October 6, 1993, Ms. Winikow pleaded guilty in the Supreme Court of the State of New York, County of Rockland, to grand larceny (a class D felony), commercial bribery (a class A misdemeanor) and making a campaign contribution under a false name (an unclassified misdemeanor) and, on November 10, 1993, the two former employees pleaded guilty to grand larceny (a class D felony). In pleading guilty to the felony count, Ms. Winikow stated she had been acting on behalf of the Parent. The presiding judge informed Ms. Winikow that her sentence would be based on her assistance to the prosecution in its investigation. Ms. Winikow's sentencing on these pleas is currently scheduled for April 7, 1994. On March 22 1994, a Rockland County Grand Jury indictment was returned charging Mr. Smith with eight felony counts of grand larceny and two misdemeanor counts of petit larceny. According to the press release issued by the Rockland County District Attorney on March 22, 1994, the ten count indictment charges Mr. Smith with stealing from the Parent by charging personal expenses to the Parent, including (i) approximately $7,300 to rent four vans and a panel truck that were used by Mr. Smith's son's film production company, including approximately $780 worth of parking summonses issued to the rental van and a car owned by the Parent that was being used by Mr. Smith's son' (ii) approximately $3,037 in moving costs to have Mr. Smith's daughter's belongings moved to Westchester County on two separate occasions and to have other belongings moved to Mr. Smith's summer home in Kennebunkport, Maine; (iii) approximately $4,600 for assorted graphic printing, consisting of engagement invitations for both of his children, a hand-colored wedding program for his daughter, as well as printed directions to his Kennebunkport, Maine summer home; (iv) approximately $7,000 for holiday baskets for Mr. Smith's family members, friends and his Maine Realtor; (v) approximately $1,100 for assorted holiday plants delivered to Mr. Smith's home; (vi) approximately $1,760 to have Mr. Smith's home cleaned following a boiler replacement; (vii) approximately $1,098 for printed materials associated with Mr. Smith's wife's election campaign for village trustee (which Mr. Smith subsequently repaid to the Parent after Ms. Winikow's arrest); (viii) approximately $2,000 for a surprise 50th birthday party for Mr. Smith's wife at the Parent's conference center facilities; (ix) approximately $300 worth of auto repairs made to Mr. Smith's son-in-law's automobile; and (x) approximately $600 worth of watches given by Mr. Smith to his children and their spouses. Mr. Smith was arraigned in Rockland County Supreme Court on March 22, 1994, and entered a plea of not guilty. On November 3, 1993, the Parent and the District Attorney executed a Joint Cooperation Agreement (the "Agreement"). As part of the Agreement, the District Attorney confirmed that, in light of the Parent's cooperation, as reflected by its undertakings in the Agreement, and in light of the clear demonstration by the Parent's Board of Directors of its determination to uncover all past improper activities of the types being investigated by the District Attorney and the New York State Public Service Commission ("NYPSC"), no criminal charge of any kind will be filed against the Parent or any of its affiliates or subsidiaries in connection with the District Attorney's investigation. The Agreement is annexed as Exhibit 99.1 to the Parent's Form 10-Q Quarterly Report for the quarter ended September 30, 1993. On November 3, 1993, the New Jersey Board of Regulatory Commissioners ("NJBRC") commenced its periodic management audit of the Company. As a result of the events and investigations described above, the NJBRC audit includes, in addition to a standard review of operating procedures, policies and practices, a review of the posture of Company management regarding business ethics and a determination regarding the effect of such events on Company ratepayers. Under an agreement with the NJBRC to return to customers funds misappropriated by employees in connection with the events described above, the Company refunded to New Jersey ratepayers $94,100 through reductions in the applicable fuel adjustment charges in February and March 1994. The Parent has also pledged to return any other funds that are discovered to have been misappropriated. On August 18, 1993, Feiner v. Orange and Rockland Utilities, Inc., a purported ratepayer class action complaint against the Parent, the Company, Ms. Winikow and others was filed in the United States District Court, Southern District of New York. The complaint names a number of "John Does" who are described as officers and directors of the Parent but does not identify any current or former officer or director by name except Ms. Winikow. The Feiner complaint alleges that the defendants violated RICO and New York common law by using false and misleading testimony to obtain rate increases from the NYPSC and used funds obtained from ratepayers in furtherance of an alleged scheme to make illegal campaign contributions and other illegal payments. Plaintiffs seek damages in the amount of $900 million (which they seek to treble pursuant to the RICO statute). The Parent and the Company intend to vigorously contest these claims and the Parent filed a motion to dismiss them on February 19, 1994. On August 31, 1993, Patents Management Corporation v. Orange and Rockland Utilities, Inc., et al. ("Patents Management"), a purported shareholder derivative complaint, was filed in the Supreme Court of the State of New York, County of New York, against the Parent, all but one of the Directors and several other named defendants by an alleged shareholder of the Parent. Plaintiff claims that the named Directors breached their fiduciary duties by condoning the wrongful acts of Ms. Winikow or failing to exercise appropriate supervisory control over Ms. Winikow. Plaintiff requests that the Court require each Director to indemnify the Parent against all losses sustained by the Parent as a result of these alleged wrongful acts of Ms. Winikow. The defendants intend to vigorously contest these claims. On November 23, 1993, Gross v. Orange and Rockland Utilities, Inc. ("Gross"), a purported shareholder class action complaint, was filed in the United States District Court, Southern District of New York. Plaintiff alleges that various Securities and Exchange Commission filings of the Parent during the period March 2, and November 4, 1993, contained false and misleading information, and thereby violated Sections 11 and 12(2) of the Securities Act of 1933, by failing to disclose what the plaintiff alleges was a "scheme" by the Parent to make illegal political payments and campaign contributions to various public officials and politicians. As a result, plaintiff claims, during such period persons who purchased the Parent's stock through the Company's Dividend Reinvestment and Stock Purchase Plan did so at artificially inflated prices. The complaint seeks unspecified money damages. The Parent intends to vigorously contest these claims. On July 31, 1992, State Line Power Associates, Limited Partnership v. Orange and Rockland Utilities, Inc., a complaint brought by a New Jersey partnership, was filed against the Parent in the United States District Court, Southern District of New York. The plaintiff had, pursuant to an Agreement dated October 11, 1990 (the Agreement), agreed to build a gas-fired combined cycle generating facility in Ringwood, New Jersey and sell 100 Mw of capacity and associated energy to the Parent. The complaint, which alleged that the Parent had improperly terminated the Agreement, sought compensatory damages in excess of $50 million and a declaratory judgment to the effect that the Parent remained obligated to purchase 100 Mw of capacity and associated energy from the plaintiff pursuant to the terms of the Agreement. In its answer to the complaint, the Parent denied the plaintiff's allegations. On January 7, 1994, the parties entered into a settlement agreement pursuant to which the Parent, without any admission of liability, paid to the plaintiff an amount that is not material to the financial condition of the Parent, and the plaintiff delivered to the Parent a release of all outstanding claims against the Parent. The Company will be responsible for payment of a portion of the settlement and related costs pursuant to the Power Supply Agreement. Environmental The Federal Comprehensive Environmental Response, Compensation and Liability Act of 1980 and certain similar state statutes authorize various governmental authorities to issue orders compelling responsible parties to take cleanup action at sites determined to present an imminent and substantial danger to the public and to the environment because of an actual or threatened release of hazardous substances. The Parent is a party to a number of administrative proceedings involving potential impact on the environment. Such proceedings arise out of, without limitation, the operation and maintenance of facilities for the generation, transmission and distribution of electricity and natural gas. Such proceedings are not, in the aggregate, material to the business or financial condition of the Parent or the Company. Pursuant to the Clean Air Act Amendments of 1990, which became law on November 15, 1990, a permanent nationwide reduction of 10 million tons in sulfur dioxide emissions from 1980 levels, as well as a permanent reduction of 2 million tons of nitrogen oxide emissions from 1980 levels must be achieved by January 1, 2000. In addition, continuous emission monitoring systems will be required at all affected facilities. The Parent has two base load generating stations that burn fossil fuels that will be impacted by the legislation in the year 2000. These generating facilities already burn low sulfur fuels, so additional capital costs are not anticipated for compliance with the sulfur dioxide emission requirements. However, installation of low nitogren oxide burners at Lovett Plant and operational modifications at Bowline Plant are expected to be required. Additional emission monitoring systems will be installed at both facilities. The Parent's construction expenditures for this work is estimated to be approximately $28.2 million from 1993 to 1996. Beginning with calendar year 1994, Title V sources (Bowline Point and Lovett) will be required to pay an emission fee. Each facility's fee will be based upon actual air emissions reported to NYSDEC at a rate of approximately $25 per ton of air emissions. (If this fee was in effect in 1992, the Parent's obligation would have been approximately $.5 million). The Company will continue to assess the impact of the Clean Air Act Amendments of 1990 on its power generating operations as the regulations implementing these Amendments are promulgated. The Company will be responsible for a portion of the costs to comply with such regulations. Regulatory Matters: On December 30, 1992, in connection with the Company's 1991 electric rate case (Docket No. ER910303565), the NJBRC issued a Decision and Order dealing with the appropriateness of additional tax liability placed on New Jersey utilities pursuant to New Jersey's June 1, 1991 tax legislation. Pursuant to this legislation the Company will be required to pay an additional combined approximate $16 million of gross receipts and franchise taxes in 1993 and 1994. In its Decision and Order, the NJBRC allowed the Company to recover this amount over a ten year period with interest on the unamortized balance at an annual rate of 7.5%. On February 26, 1993, Rate Counsel filed a Notice of Appeal from the NJBRC Decision and Order with the Superior Court of New Jersey, Appellate Division, stating as grounds for the appeal that the Decision is arbitrary and capricious and would result in unjust and unreasonable rates. On August 9, 1993, Rate Counsel filed its initial brief with regard to its appeal. Thereafter, on October 12, 1993, the Company filed its initial brief and on October 27, 1993 Rate Counsel filed its reply brief in this matter. Oral argument was held on March 7, 1994, on March 21, 1994 the Superior Court affirmed the NJBRC's December 20, 1992 Decision and Order. ITEM 4.

ITEM 4. Submission of Matters to a Vote of Security Holders None PART II ITEM 5.

ITEM 5. Market for the Registrant's Common Equity and Related Stockholder Matters As more fully described in Part III, Item 12, "Security Ownership of Certain Beneficial Owners and Management" of this Form 10-K Annual Report, all of the outstanding common stock of the Company is owned by the Parent. There is no trading in any market for such common stock. As described in Note 4 of the Notes to Consolidated Financial Statements - "Retained Earnings" in Part IV, Item 14 of this Form 10-K Annual Report, the Company has various restrictions on the use of retained earnings for cash dividends, which are contained in or result from covenants in the Company's Mortgage Trust Indenture dated as of July 1, 1954, as supplemented. As of December 31, 1993 and 1992, approximately $7,501,600 was so restricted. It has not been the practice of the Company to pay quarterly common stock dividends to the Parent since 1984 although the Company has had sufficient unrestricted retained earnings and cash available for the payment of such dividends. ITEM 6.

ITEM 6. Selected Consolidated Financial Data ITEM 7.

ITEM 7. Management's Discussion and Analysis of Financial Condition and Results of Operations Financial Condition Financial Performance. In 1993, the Company's consolidated net income was $4.7 million, an increase of $.3 million from the $4.4 million earned in 1992. Earnings in 1992 decreased by $2.0 million, from the $6.4 million earned in 1991. Earnings per average common share outstanding in 1993 were $42.12, an increase of $2.46 from the $39.66 earned in 1992. Earnings per average common share for 1992 were $17.36 lower than 1991 earnings per share of $57.02. A discussion of the items causing the change in earnings is contained in the "Results of Operations." The Company's interest coverage, as computed under the terms of its mortgage indenture, was 3.3 times for the current year as compared to 2.9 times in 1992 and 3.6 times in 1991. The after tax interest and preferred dividend coverage was 2.42 times in 1993 as compared to 2.29 times in 1992 and 2.82 times in 1991. Events Affecting the Company. During the third quarter of 1993, the Rockland County (NY) District Attorney charged a then Vice President of the Parent and the Company with grand larceny, commercial bribery and making illegal political contributions and commenced a related investigation of the Parent. Two other former employees of the Parent reporting to the Vice President were charged with grand larceny. The Board of Directors of the Parent promptly formed a Special Committee of outside directors (Special Committee), with authority to take any steps deemed necessary or desirable, to conduct an independent investigation into such matters, in order to determine to what extent there were any other improprieties and to make recommendations as to any necessary remedial measures. The Special Committee has retained investigative counsel and an accounting firm to assist its inquiry. The New Jersey Board of Regulatory Commission (NJBRC) also began an investigation to determine the impact of these events on the Company's ratepayers. The Company is cooperating fully in the inquiries and has pledged to return to customers any funds that are discovered to have been misappropriated. Under an agreement reached with the NJBRC, the Company agreed to refund $94,100 to New Jersey ratepayers in February and March 1994 through reductions in the applicable fuel adjustment charges. On November 4, 1993 the Parent signed a Joint Cooperation Agreement with the Rockland County District Attorney's office which creates an Inspector General's office within the Parent to monitor its efforts to implement and maintain programs to ensure the highest ethical standards of business conduct. The agreement also specified a number of other steps the Parent will undertake to aid in the on-going investigation and prevent any recurrence. As a result of the agreement and the Parent's continued cooperation with the inquiry, the District Attorney has agreed not to file any criminal charges against the Parent or any of its subsidiaries in connection with the current investigation. The former officer of the Parent and the Company and two former employees of the Parent charged by the District Attorney subsequently pleaded guilty to all counts. The District Attorney's Office has identified $374,124 as representing the amount of consolidated funds misappropriated by these individuals. As part of their plea, the two former employees of the Parent agreed to a partial restitution agreement pursuant to which they will reimburse to the Parent and its subsidiaries a sum of $199,709 prior to their sentencing, scheduled for May 4, 1994. The investigations being conducted by the Special Committee of the Board of Directors of the Parent and the District Attorney, along with those of the NJBRC, are still under way. The Parent and the Company intend to take all appropriate actions to protect the interests of its customers and shareholders. It is not possible to predict at this time the extent of additional refunds that may be required by the NJBRC, if any. During 1993 the Company incurred expenses of $1.3 million for legal counsel, accountants, and other consultants in connection with the investigation and related matters. These activities are currently anticipated to continue through the first half of 1994. It is currently estimated that the Company will incur from $.7 to $1.3 million of expenses in 1994 to conclude the investigation. These expenditures are not recoverable from ratepayers. The Company will attempt to offset these costs to the extent possible by achieving savings in the cost of operations during the year. During the fourth quarter, James F. Smith was terminated for cause as Chief Executive Officer of the Parent and the Company and removed as Chairman of the Board of Directors of the Parent, and Victor J. Blanchet, Jr. was appointed to serve as Acting Chief Executive Officer of the Parent and the Company. In order to fully protect its interests the Parent, has initiated lawsuits in federal and state courts to recover misappropriated funds. In related activities, two lawsuits have been brought by shareholders and another by ratepayers seeking damages resulting from these events. For more information on these legal proceedings, refer to Note 10 of the Notes to Consolidated Financial Statements. Rate Activities. In January 1992, an increase in electric rates of $5.1 million was granted by the NJBRC in response to the Company's March 18, 1991 petition requesting a $12.9 million increase in base rates. This increase includes a 12% rate of return on equity. In addition, the NJBRC initiated a Phase II proceeding in this case to address the effect of tax legislation adopted June 1, 1991. That legislation changed the procedure under which certain taxes are collected from the State's utilities. Previously, the Company had been subject to an effective gross receipts and franchise tax of 12.5%, which the utilities paid in lieu of property taxes. The new tax is based upon the number of units of energy (kwh or therms) delivered by a utility rather than revenues. The legislation also requires that utilities accelerate payment to the State of New Jersey of the taxes collected. As a result, the Company is required to make additional tax payments of approximately $16 million during the period 1993-1994. On November 12, 1992, the NJBRC approved the recovery of the additional tax over a ten-year period. A carrying charge of 7.5% on the unamortized balance was also approved. The amount of unamortized accelerated payments is included in Deferred Revenue Taxes in the accompanying financial statements. On February 26, 1993 the New Jersey Department of Public Advocate, Division of Rate Counsel ("Rate Counsel") filed a Notice of Appeal from the NJBRC Decision and Order with the Superior Court of New Jersey Appellate Division, stating as grounds for the appeal that the Decision is arbitrary and capricious and would result in unjust and unreasonable rates. On August 9, 1993, Rate Counsel filed its initial brief with regard to its appeal. Thereafter, on October 12, 1993, the Company filed its initial brief and on October 27, 1993, Rate Counsel filed its reply brief with regard to this matter. Oral argument was held on March 7, 1994, and on March 21, 1994 the Superior Court affirmed the NJBRC's December 30, 1992 Decision and Order. Results of Operations The discussion which follows identifies the principal causes of significant changes in the amount of revenues and expenses affecting net income, by comparing 1993 to 1992 and 1992 to 1991. The discussion should be read in conjunction with the Notes to Consolidated Financial Statements which immediately follow the financial statements contained in this Form 10-K Annual Report. Changes in net income during the periods presented in the accompanying Consolidated Statements of Income and Retained Earnings are highlighted as follows: Increase (Decrease) From Prior Year 1993 1992 (Thousands of Dollars) Utility Operations: Operating revenues $ 6,926 $ (385) Energy Costs (522) (2,720) Net revenues from utility operations 7,448 2,335 Other utility operating expenses 5,751 4,008 Diversified activities-net (661) (198) Income from Operations 1,036 (1,871) Other income and deductions (845) (49) Interest charges net of AFDC (84) 25 Net Income $ 275 $(1,945) Utility Revenues. Revenues increased by 5.5% or $6.9 million, in 1993, after decreasing 0.3% or $0.4 million in 1992. These changes were attributable to the following factors: Increase (Decrease) From Prior Year 1993 1992 (Thousands of Dollars) Retail Sales: Base rates $ 4,847 $ 4,259 Fuel recoveries (1,311) (3,071) Sales volume 3,492 (1,566) Other operating revenues (102) (7) Total $ 6,926 $ (385) Fuel recovery revenues represent amounts collected pursuant to the levelized fuel adjustment clause included in the Company's tariff schedule, as authorized by the NJBRC. During 1993, the fuel recovery rate fell to approximately 2.74 cents per kilowatt hour from the 2.94 cents per kilowatt hour recovered during 1992 and 3.23 cents per kilowatt hour during 1991. Revenue increases due to higher sales volumes reflect an increase in kilowatt hour sales during 1993 of 3.6%. Total sales in 1993 amounted to 1,239.6 million kilowatt hours. During 1992 sales volumes totaled 1,196.2 million kilowatt hours or a 1.7% decrease over the 1991 level of 1,219.6 million kilowatt hours. The increase in 1993 was the result of the warmer weather during the summer months of 1993 compared to the same period of 1992, coupled with an increase in the average number of customers. The decrease in 1992 was primarily attributable to cooler summer weather, partially offset by the increase in number of customers compared to 1991. Energy Costs. All of the energy requirements of the Company are furnished by its Parent pursuant to a contract approved by the FERC. Energy costs are adjusted to match revenues recovered through the operation of the levelized electric energy adjustment clause. The cost of power purchased from the Parent decreased by .8% and 3.9% for the years 1993 and 1992, respectively. The components of the changes in electric energy costs are as follows: Increase (Decrease) From Prior Year 1993 1992 (Thousands of Dollars) Prices paid for purchased power $ (548) $ 2,259 Changes in kilowatt hours purchased 1,791 (1,462) Deferred fuel charges (1,765) (3,517) Total $ (522) $(2,720) The average price paid per kilowatt hour purchased during 1993 amounted to 5.12 cents compared to 5.16 cents during 1992 and 4.99 cents during 1991. Any fluctuations in the price paid per kilowatt hour are reflective of the Parent's costs to generate or purchase electricity, particularly the cost of fuel used in electric production. Other Utility Operating Expenses. The increases (decreases) in other operating expenses are presented in the following table: Increase (Decrease) From Prior Year 1993 1992 (Thousands of Dollars) Other operation & maintenance $ 2,994 $ 5,055 Depreciation 151 321 Taxes 2,606 (1,368) Total $ 5,751 $ 4,008 Other Operation and Maintenance. The cost of conservation programs increased other operation and maintenance expenses in 1993 by $2.9 million and 1992 by $3.1 million. These costs are recoverable in revenues on a current basis. The remaining increase in 1993 was the result of higher operation expenses associated with inflation. The increase in 1992 is primarily the result of an increase in the Company's circuit maintenance programs along with inflationary increases. Depreciation. Depreciation expenses increased $0.2 million and $0.3 million in 1993 and 1992, respectively. These increases are the result of plant additions in both years. Taxes. The Company's tax expense increased by $2.6 million in 1993 after decreasing by $1.4 million in 1992. Taxes other than income taxes increased $1.4 million in 1993 after a decrease of $0.4 million in 1992. The 1993 increase is the result of increases in gross receipts and franchise tax. Federal income tax expense increased by $1.2 million in 1993 following a $1.0 million decrease the year before. Changes in Federal income taxes are detailed in Note 2 of the Notes to Consolidated Financial Statements under the caption "Federal Income Taxes" in Part IV, Item 14 of this Form 10-K Annual Report. Diversified Activities. The Company's diversified activities, which are conducted through it's wholly owned non-utility subsidiaries, consist of natural gas marketing and radio broadcasting activities. Revenues from diversified activities increased $87.6 million and $88.4 million in 1993 and 1992, respectively. The increased revenues in both years is primarily the result of increased sales volumes from gas marketing activities. However, an extremely competitive market for non- utility gas sales in 1993 resulted in significantly lower gross profit margins on these sales when compared to 1992. This resulted in a decrease in operating income of $0.7 million in 1993 after a decrease of $0.2 million in 1992. The increase in gas marketing payables and receivables are directly related to the favorable increase in customers and higher sales volumes. Gas marketing payables increase proportionately to gas marketing receivables. A description of the non-utility subsidiaries of the Company is included in Part I, Item 1 of this Form 10-K Annual Report under the caption "Diversified Activities." The Company will continue to look to its gas marketing activities to increase operating results in the future while the Company's radio broadcasting activities have been, and will continue to be, affected by the economy. Other Income, Deductions and Interest Charges. Other nonoperating income, net of deductions and interest charges, decreased by $0.9 million during 1993 after decreasing by $0.3 million during 1992. The most significant reason for the decrease was the cost of the investigation and related matters described under the caption "Events Affecting the Company" in this Item 7, which amounted to $1.3 million. The fluctuation in net nonoperating income is also a result of fluctuations in interest expense items as well as the change in allowance for funds used during construction from the previous year. Liquidity and Capital Resources Utility construction expenditures, net of AFDC, amounted to $6.5 million, $7.6 million and $8.5 million during 1993, 1992 and 1991, respectively. The expenditures represent fixed asset replacements and are predominantly associated with the Company's transmission and distribution systems. During that three year period, the total construction expenditures, including those from diversified activities, were financed with internally generated funds. The Company estimates that its 1994-1998 capital requirements, which include construction expenditures and funds required for debt maturities, will be as follows: 1994 - $6,291,000; 1995 - $9,220,000; 1996 - $8,007,000; 1997 - $8,890,000; and 1998 -$9,100,000. It is expected that these capital requirements will be financed with internally generated funds. Information regarding the Company's construction program is contained in Part 1, Item 1 of this Form 10-K Annual Report under the caption Construction Program and in Note 10 of the Notes to Consolidated Financial Statements - under the caption "Construction Program" in Part IV, Item 14 of this Form 10-K Annual Report. At December 31, 1993, the Company had available bank lines of credit of $10.0 million, against which no short-term borrowings were outstanding. For additional information regarding the Company's short- term borrowings, see Note 7 of the Notes to Consolidated Financial Statements under the caption "Cash and Short Term Debt" in Part IV, Item 14 of this Form 10-K Annual Report. The Company's capital structure at the end of 1993 was 67% common equity and 33% long-term debt. The Company was required under the terms of its Sixth Supplemental Indenture to make an annual sinking fund payment on June 14 of each year of $240,000 with respect to its Series "F" Bonds and, pursuant to its Seventh Supplemental Indenture, to make sinking fund payments of $333,000 on January 31 of each year with respect to its Series "G" Bonds. During 1992 and 1991 cash payments were made to satisfy both requirements and during 1993 both issues were redeemed. On February 25, 1993 the Company sold $20 million of First Mortgage 6% Bonds, Series I due 2000 (Series I Bonds). The Series I Bonds were sold at a discount to yield 6.11% to the public. The net proceeds to the Company from the sale of the Series I bonds were used to pay the principal and redemption premium on an aggregate of $16,017,000 of the Company's outstanding First Mortgage Bonds and for other corporate purposes. The principal amount and series of First Mortgage Bonds refunded on March 27, 1993 were: $5,000,000 of 9 1/8% bonds, Series D due 2000; $6,000,000 of 7 7/8% Bonds, Series E due 2001; $3,680,000 of 8.95% Bonds, Series F due 2004; and $1,337,000 of 10% Bonds, Series G due 1997. Cash payments totaling $333,000 were made to satisfy the Series G sinking fund requirement of the Company in 1993. SRH and its subsidiaries also maintain certain lines of credit and undertake long and short-term borrowings or make investments from time to time. At December 31, 1993 SRH and its' subsidiaries had outstanding loans aggregating $2.9 million, the proceeds of which were used to make investments in broadcasting properties. In addition, O&R Energy, Inc., a subsidiary of SRH had an available line of credit and standby letters of credit which together amounted to $15.0 million and under which $1.2 million was outstanding at December 31, 1993. Non-utility temporary cash investments amounted to $685,000 at year end. Credit Ratings The credit ratings of the Company's First Mortgage Bonds are as follows: Company First Mortgage Agency Bonds Moody's Investors Service, Inc. A2 Standard & Poor's Corporation A+ The Company's First Mortgage Bonds are not rated on a stand-alone basis. They are reviewed annually in conjunction with the debt, preferred stock and commercial paper ratings of the Parent. The ratings assigned to the Company's securities by the rating agencies are not a recommendation to buy, sell or hold the Company's securities, but rather are assessments of the credit-worthiness of the Company's securities by the rating agencies. Other Developments SFAS No. 112. In November 1992 the Financial Accounting Standards Board (FASB) issued Statement of Financial Accounting Standards No. 112 "Employers Accounting for Postemployment Benefits", (SFAS No. 112), which requires the recognition of postemployment benefits, such as salary continuation, severance pay, and disability benefits, provided to former or inactive employees on an accrual basis. The Company currently recognizes the cost of such benefits as they are paid. Adoption of SFAS No. 112 is mandatory for fiscal years beginning after December 15, 1993. The Company anticipates adopting this accounting standard in 1994; however, it does not expect adoption to have a material adverse effect on the Company's results of operations. Inflation The Company's utility revenues are based on rate regulation, which provides for recovery of operating costs and a return on rate base. Inflation affects the Company's construction costs, operating expenses and interest charges and can impact the Company's financial performance if rate relief is not granted on a timely basis. Financial statements, which are prepared in accordance with generally accepted accounting principles, report operating results in terms of historic costs and do not recognize the impact of inflation. ITEM 8.

ITEM 8. Financial Statements and Supplementary Data The financial statements and schedules required by this Item are contained on pages 41 through 65 of this Form 10-K Annual Report. Such information is listed in Item 14(a)(1) "Financial Statements" on page 37 of this Form 10-K Annual Report. ITEM 9.

ITEM 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure On February 10, 1994, the Executive Committee of the Board of Directors of the Parent appointed the accounting firm of Arthur Andersen & Co. to audit the books, records and accounts of the Parent and the Company for the 1994 fiscal year. The appointment of Arthur Andersen & Co. is subject to the approval of the Parent's shareholders at the Annual Meeting to be held on May 11, 1994. The accounting firm of Grant Thornton audited the Company's consolidated financial statements for 1993 and prior years. Upon recommendation of the Audit Committee, the Board of Directors of the Parent decided to solicit bids for the performance of auditing services for the Parent and the Company for 1994. Bids were received from six public accounting firms, including Grant Thornton. Based on a review of the competing bids, the Audit Committee believed that the selection of Arthur Andersen & Co. would be in the best interests of the Parent and the Company and recommended such selection to the Parents Board of Directors. The reports of Grant Thornton on the Company's consolidated financial statements for the past two fiscal years did not contain an adverse opinion or a disclaimer of opinion and the reports were not qualified or modified as to uncertainty, audit scope or accounting principals, except that the report for 1993 was modified by inclusion of an explanatory paragraph regarding the uncertainty of the pending investigations of the Parent and related litigation described in the Company's Quarterly Report on Form 10-Q for the quarter ended September 30, 1993. Since January 1, 1992, there have been no disagreements with Grant Thornton on any matter of accounting principles or practices, financial statement disclosure or auditing scope or procedure, which if not resolved to the satisfaction of Grant Thornton, would have caused Grant Thornton to make reference to the subject matter of such disagreements in connection with its report. PART III ITEM 10.

ITEM 10. Directors and Executive Officers of the Registrant Directors The persons listed below are the Directors of the Company; Messrs. Blanchet and Chambers were elected to the Board in April 1993, and Mr. Vanderhoef was elected to the Board in March 1994, by the Parent, as sole holder of the Company's common stock, to hold office for one year or until their successors are elected and qualified. Principal Occupation; Business Experience Name Age Past Five Years Since (2) Victor J. Blanchet 52 President, Chief Operating 1991 Officer and Director of the Company, the Parent and Pike. Acting Chief Executive Officer (1) Patrick J. Chambers, Jr. 59 Senior Vice President, 1980 Chief Financial Officer and Director of the Company, the Parent and Pike (1) H. Kent Vanderhoef 71 Acting Chairman of the Parent's 1994 Board of Directors; Director of the Company and Pike; Director and former Chairman of the Board of Directors and Chief Executive Officer, Kay-Fries, Inc., Rockleigh, New Jersey, a chemical manufacturer. Mr. Vanderhoef was president of Kay-Fries until 1981 and, from 1983 until 1990, was a consultant to that company. Director, Rockland Country Club Foundation. Chairman, Executive Committee of the Parent's Board of Directors and Member, Audit Committee of the Parent's Board of Directors. (1) The business experience of this director is contained under the heading "Identification of Executive Officers and Business Experience" in this Item 10. (2) Denotes date of election to the Board of Directors. Identification of Executive Officers and Business Experience The executive officers of the Company are also officers of the Parent and Pike. All of the executive officers of the Company are appointed on an annual basis at the first Board of Directors' meeting following the annual meeting. Officer, Age and Title Business Experience Past Five Years of Victor J. Blanchet, Jr., 52 Acting Chief Executive Officer since Acting Chief Executive Officer, October 7, 1993. President and Chief Operating President and Chief Operating Officer Officer since January 1991. Executive Vice President from April 1990 until January 1991. Vice President from 1977 to April 1990. Patrick J. Chambers, Jr., 59 Senior Vice President since 1978 and Senior Vice President and Chief Financial Officer since 1979. Chief Financial Officer Robert J. Biederman, Jr., 41 Vice President since April 1990. Vice President, Transmission Director of Operations from 1986 and Distribution until April 1990. Terry L. Dittrich, 48 Acting Controller since Acting Controller March 18, 1994. Director of Accounting since April 1990. Manager of Accounting from 1985 to April 1990. Frank E. Fischer, 60 Vice President since 1978. Vice President, Engineering and Production Gerard A. Maher, 59 Assistant Secretary since April 1989. Assistant Secretary and Assistant Treasurer since April 1990. Assistant Treasurer Assistant General Counsel from April 1989 to August 1991. Partner, Nixon, Hargrave, Devans & Doyle from November 1986 to March 1989. Robert J. McBennett, 51 Treasurer since April 1984. Treasurer Victor A. Roque, 47 General Counsel since April 1989. Vice President, General Counsel Vice President and Secretary since and Secretary January 1987. Senior Attorney from 1981 to January 1987. ITEM 11.

ITEM 11. EXECUTIVE COMPENSATION The table below shows all compensation awarded to, earned by or paid to persons serving as Chief Executive Officer in 1993 for services rendered in all capacities to the Company and its subsidiary during the fiscal years ended December 31, 1993, December 31, 1992 and December 31, 1991. There were no other executive officers during 1993 whose total annual salary and bonus exceeded $100,000: (1) Pursuant to the Incentive Plan (described in the following section), the amount of annual awards depends upon the level of achievement of one-year goals. If performance is below a minimum level, no award is earned. Actual amounts of annual awards earned under the Plan are shown. All decisions with regard to payments for the achievement of 1993 goals have been deferred until after the investigation has been concluded. Mr. Smith will not receive a payment. (2) Interest in excess of 120% of the long-term federal rate, with compounding, prescribed under section 1274(d) of the Internal Revenue Code, paid or payable on compensation deferred at the officer's election. (3) At the end of the last fiscal year, the Company had no program or plan that awards restricted stock, stock options or stock appreciation rights. (4) Pursuant to the Incentive Plan, the amount of long-term awards depends upon the achievement of long-term goals. If performance is below a minimal level, no award is earned. Installments of long- term incentive awards earned for the period 1986-1988 which were paid or payable in 1991, and awards earned for the period 1989-1991 which were paid or payable in 1992 are shown. (5) The long-term incentive award earned for the period 1989-1991 is payable in three annual installments beginning in 1992. The first installment was paid in February 1992. The second installment, which ordinarily would have been made in February 1993, was approved by the Parent's Board of Directors for payout in December 1992. Consequently, no payment of the long-term incentive award was made in 1993. (6) Interest earned on long-term incentive awards which were deferred under the terms of the Incentive Plan and not at the election of the officer. In 1993, the amounts were: Mr. Smith, $9,570; and Mr. Blanchet $3,842. In addition, Mr. Smith's compensation reflects the average annual premium of $1,334 for a supplemental long-term disability insurance policy purchased for him in 1991. (7) Upon notice of his termination for cause, Mr. Smith was suspended from all duties with pay during the period in which he was entitled to take corrective action with respect to his termination for cause, which lapsed on December 6, 1993. However, the Company ceased paying Mr Smith's salary effective November 30, 1993 after Mr. Smith filed an election to commence receiving his pension plan benefits as of such date. Incentive Plan. The Parent has an Incentive Compensation Plan ("Incentive Plan") for officers and certain other key executives, as specified on an annual basis. The Incentive Plan established a system of awards for the achievement of one-year goals and three-year goals. Payment of the three-year award is made over a three-year period beginning the year following the end of the cycle. The current three- year award cycle is for the period 1992 through 1994. The Compensation Committee of the Parent's Board of Directors approves the setting of goals and objectives upon which incentive compensation awards are based and submits these goals and objectives to the Parent's Board of Directors for approval. The three-year goals for the three-year period 1992 through 1994 include the attainment of a target return on equity, retail price comparisons for electric and gas operations and the achievement of demand-side management objectives. At the end of each Incentive Plan year an amount is accrued towards the payment of incentive compensation based upon the three-year goals. The incentive compensation based upon the three-year goals may be more or less than the portion so set aside, depending upon the level of achievement actually attained. A portion of the three-year award may be deferred at the discretion of the Parent's Board of Directors until the participant's retirement, death, disability or severe hardship. The following table sets forth the dollar value of the range of the estimated payouts under the Incentive Plan. The amounts reported in columns (d), (e) and (f) of the following table represent amounts estimated for fiscal year 1993 assuming, respectively, (i) the achievement of a minimally acceptable level of performance under the Incentive Plan (if performance is below this minimal level, no award will be paid); (ii) the achievement of certain goals which are formulated in each case to be attainable during the calendar year, absent major changes in external factors over which the Company may have little control; or (iii) the achievement of certain goals at a level which theoretically can be attained during the calendar year, but cannot be attained if any external factors adversely affect the achievement of the goals. Subsidiary Performance Plan. In 1992, a Performance Unit Incentive Plan (the "Performance Unit Incentive Plan") was adopted by the Parent and certain of its wholly-owned non-utility subsidiaries. The Performance Unit Incentive Plan, administered by the Compensation Committee, was designed to provide incentive awards to certain qualifying individuals in the Company and its subsidiaries, including O&R Energy, Inc. and Atlantic Morris Broadcasting, Inc. (together, the "Participating Companies"). Pursuant to the Performance Unit Incentive Plan, in 1992 certain key employees of the Participating Companies, including Messrs. Smith and Chambers ("Participants"), were granted awards entitling each of them to certain rights, measured as Performance Units. Each Performance Unit gives each Participant the opportunity to receive up to 1% of the combined net gain in value of the Participating Companies over a starting net value measured as the combined initial investment in each of the Participating Companies ("Starting Value"). If the percentage of net gain over the Starting Value does not exceed the average corporate bond rate, Participants will not be entitled to any payout under the Performance Unit Incentive Plan. Under the terms of the Performance Unit Incentive Plan, the award held by Mr. Smith has been cancelled as a result of his termination for cause. With respect to the Performance Unit Plan, the following table sets forth in column (b) the number of Performance Units awarded, while the amounts reported in columns (d) and (e) represent amounts, including those attributable to the Company estimated, respectively, (i) assuming no gain in net value over the Starting Value and (ii) based on an average 1992 quarterly corporate bond rate of 8.13%. _____________ (1) Estimated long-term awards under the Parent's Incentive Plan. (2) Rights under the Performance Unit Incentive Plan and the Incentive Compensation Plan were canceled as a result of Mr. Smith's termination for cause. ITEM 12.

ITEM 12. Security Ownership of Certain Beneficial Owners and Management Amount and Nature of Name of Beneficial Percent Title of Class Beneficial Owner Ownership of Class Common Stock - Orange and Rockland $100 Par Value Utilities, Inc. 112,000 100% (Parent) ITEM 13.

ITEM 13. Certain Relationships and Related Transactions None. PART IV ITEM 14.

ITEM 14. Exhibits, Financial Statement Schedules and Reports on Form 8-K (a)(1) Financial Statements: The following consolidated financial statements of the Company are included in Part II, Item 8. Page Report of Independent Certified Public Accountants. 42 Consolidated Balance Sheets as of December 31, 1993 and 1992. 44 Consolidated Statements of Income and Retained Earnings 46 for the Years Ended December 31, 1993, 1992 and 1991. Consolidated Cash Flow Statements for the Years Ended December 31, 1993, 1992 and 1991. 47 Notes to Consolidated Financial Statements. 48 (a)(2) Financial Statement Schedules: Page Property, Plant and Equipment and Non-utility Property for the Years Ended December 31, 1993, 1992 and 1991. (Schedule V). 66 Accumulated Depreciation, Depletion and Amortization of Property, Plant and Equipment and Non-utility Property for the Years Ended December 31, 1993, 1992 and 1991 (Schedule VI). 69 Valuation and Qualifying Accounts and Reserves for the Years Ended December 31, 1993, 1992 and 1991 (Schedule VIII). 72 Supplementary Income Statement Information for the Years Ended December 31, 1993, 1992 and 1991 (Schedule X). 73 All other schedules are omitted because they are either not applicable or the required information is shown in the financial statements or notes thereto. (a) (3) Exhibits *3.1 Certificate of Incorporation, as amended through November 5, 1987. (Exhibit 3.1 to Form 10-K for the fiscal year ended December 31, 1992, File No. 2-36005). 3.5 By-Laws, as amended through October 7, 1993. *4.1 Mortgage Trust Indenture of Rockland Electric Company, dated as of July 1, 1954. (Exhibit 2.16 to Registration Statement No. 2-14159). *4.4 Third Supplemental Indenture of Rockland Electric Company, dated as of August 15, 1965. (Exhibit 4.23 to Registration Statement No. 2-24682). *4.10 Ninth Supplemental Indenture of Rockland Electric Company, dated as of March 1, 1993. (Exhibit 4.10 to Form 10-K for the fiscal year ended December 31, 1992, File No. 2-36005). *10.0 Joint Operating Agreement, dated as of February 5, 1976 between Orange and Rockland Utilities, Inc. and the Company. (Exhibit 10.0 to Form 10-K for Fiscal year ended December 31, 1989, File No. 2-36005). 10.1 Power Supply Agreement, dated as of January 1, 1993 between Orange and Rockland Utilities, Inc. and the Company, as filed with the Federal Energy Regulatory Commission. *+10.3 Performance Unit Incentive Plan effective December 3, 1992. (Exhibit 10.3 to Form 10-K for the fiscal year ended December 31, 1992, File No. 2-36005). *+10.4 Award Agreement under the Performance Unit Incentive Plan applicable to P. J. Chambers, Jr. dated December 3, 1992. (Exhibit 10.4 to Form 10-K for the fiscal year ended December 31, 1992, File No. 2-36005). *+10.5 Award Agreement under the Performance Unit Incentive Plan applicable to J. F. Smith dated December 3, 1992. (Exhibit 10.5 to Form 10-K for the fiscal year ended December 31, 1992, File No. 2-36005). *22 Subsidiaries of the Company. (Exhibit 22 to Form 10-K for the fiscal year ended December 31, 1992, File No. 2-36005). *Incorporated by reference to the indicated filings. +Denotes Executive Compensation Plans and Arrangements (b) Reports on Form 8-K On February 17, 1994, the Company filed a Current Report on Form 8-K, dated February 10, 1994, reporting, under Item 4. "Changes in Registrant's Certifying Accountant", the appointment by the Executive Committee of the Parent's Board of Directors of the accounting firm of Arthur Andersen & Co. to audit the books, records and accounts of the Company and its subsidiaries for the 1994 fiscal year. On February 22, 1994, the Company filed a Form 8-K/A dated February 22, 1994, amending the February 10, 1994 Form 8-K to include as Exhibit 16, a letter from the accounting firm of Grant Thornton, which firm audited the Company's consolidated financial statements for the 1993 fiscal year and prior years. SIGNATURES Pursuant to the requirements of Section 13 or 15(d) 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. ROCKLAND ELECTRIC COMPANY (Registrant) By VICTOR J. BLANCHET JR. (Victor J. Blanchet, Jr. Acting Chief Executive Officer, President, Chief Operating Officer and Director) Date: March 25, 1994 Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated. Signature and Title Capacity in Which Signing VICTOR J. BLANCHET, JR. Chief Operating (Victor J. Blanchet, Jr., Officer; Director Acting Chief Executive Officer, President and Chief Operating Officer) PATRICK J. CHAMBERS, JR. Principal Financial (Patrick J. Chambers, Jr., Officer; Director Senior Vice President and Chief Financial Officer) TERRY L. DITTRICH Principal Accounting (Terry L. Dittrich, Officer - Acting Acting Controller) Date: March 25, 1994 ROCKLAND ELECTRIC COMPANY (A WHOLLY OWNED SUBSIDIARY OF ORANGE AND ROCKLAND UTILITIES, INC.) CONSOLIDATED FINANCIAL STATEMENTS AND SUPPLEMENTAL SCHEDULES WITH REPORT OF INDEPENDENT CERTIFIED PUBLIC ACCOUNTANTS Prepared for filing as part of Annual Report (Form 10-K) to the Securities and Exchange Commission REPORT OF INDEPENDENT CERTIFIED PUBLIC ACCOUNTANTS Board of Directors of Rockland Electric Company and Subsidiary We have audited the accompanying consolidated balance sheets of Rockland Electric Company (a wholly owned subsidiary of Orange and Rockland Utilities, Inc.) and Subsidiary as of December 31, 1993 and 1992, and the related consolidated statements of income and retained earnings and cash flows for each of the three years in the period ended December 31, 1993. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of Rockland Electric Company and Subsidiary as of December 31, 1993 and 1992, and the consolidated results of their operations and their consolidated cash flows for each of the three years in the period ended December 31, 1993, in conformity with generally accepted accounting principles. As more fully discussed in Note 10 (Legal Proceedings) to the Consolidated Financial Statements, the Company, Orange and Rockland Utilities, Inc. and various state regulatory authorities are currently investigating misappropriations of funds by certain former employees of Orange and Rockland Utilities, Inc. and the impact on ratepayers. As a result of these improprieties, several class action and derivative complaints have been filed against the Company, Orange and Rockland Utilities, Inc. and others. Although Orange and Rockland Utilities, Inc. and the Company have agreed to refund certain amounts to ratepayers as of December 31, 1993, the ultimate outcome of the investigations and litigation cannot presently be determined. Accordingly, no provision for any additional liability that may result from these matters has been made in the accompanying financial statements. As discussed in Notes 2 and 9 of the Consolidated Financial Statements, the Company changed its method of accounting for income taxes and postretirement benefits in 1993. We have also audited the schedules listed in the Index at Item 14(a)(2). In our opinion, these schedules present fairly, in all material respects, the information required to be set forth therein. GRANT THORNTON New York, New York February 16, 1994 ROCKLAND ELECTRIC COMPANY AND SUBSIDIARY ROCKLAND ELECTRIC COMPANY AND SUBSIDIARY (A Wholly Owned Subsidiary of Orange and Rockland Utilities, Inc.) Notes to Consolidated Financial Statements NOTE 1 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES. General: Rockland Electric Company (the "Company"), a New Jersey corporation, is a wholly owned subsidiary of Orange and Rockland Utilities, Inc. (the "Parent"), a New York corporation. The Company is subject to regulation by the Federal Energy Regulatory Commission (the "FERC") and the State of New Jersey Board of Regulatory Commissioners (the "NJBRC") with respect to its rates and accounting. The Company's accounting policies conform to generally accepted accounting principles, as applied in the case of regulated public utilities, and are in accordance with the accounting requirements and rate-making practices of the regulatory authority having jurisdiction. A description of the Company's significant accounting policies follows. Principles of Consolidation: The consolidated financial statements include the accounts of the Company and its wholly owned non-utility subsidiary. All intercompany balances and transactions have been eliminated. The Company's non-utility subsidiary is engaged in gas marketing and radio broadcasting activities. Utility Revenues: Utility Revenues are recorded on the basis of cycle billings rendered to certain customers monthly and others bimonthly. Unbilled revenues are accrued at the end of each month for estimated energy usage since the last meter reading. Electric Fuel Costs: The tariff schedules of the Company contain adjustment clauses which utilize estimated prospective energy costs based on a twelve-month period beginning on the first of January each year. The recovery of such estimated costs is made through monthly charges per kilowatt hour over the year of projection. Any over or under recoveries are deferred and refunded or charged to customers during the subsequent twelve-month period. Utility Plant: Utility plant is stated at original cost. The cost of additions to and replacements of utility plant includes contracted work, direct labor and material, allocable overheads, allowance for funds used during construction ("AFDC") and indirect charges for engineering and supervision. Replacement of minor items of property and the cost of repairs is charged to maintenance expense. At the time depreciable plant is retired or otherwise disposed of, the original cost together with removal cost, less salvage, are charged to accumulated provision for depreciation. Depreciation: For financial reporting purposes depreciation is computed on the straight-line method based on estimated useful lives of the various classes of property. Provisions for depreciation were equivalent to the composite rates based on the average depreciable property balances at the beginning and end of the year; 2.84% in 1993, 1992 and 1991. Federal Income Taxes: The Parent and its subsidiaries file a consolidated Federal income tax return and income taxes are allocated, for financial reporting purposes, to the Parent and its subsidiaries, based on the taxable income or loss of each. Investment tax credits, which were available prior to the Tax Reform Act of 1986, have been fully normalized and are being amortized over the remaining useful life of the related property for financial statement reporting purposes. The Company adopted Statement of Financial Accounting Standards No. 109 (SFAS No. 109) "Accounting for Income Taxes" on January 1, 1993, which requires a change from the deferred method to the asset and liability method of accounting for income taxes. SFAS No. 109 retains the requirement to record deferred income taxes for temporary differences that are reported in different years for financial reporting and tax purposes. The statement also requires that deferred tax liabilities or assets be adjusted for the future effects of any changes in tax laws or rates and that regulated enterprises recognize an offsetting regulatory asset representing the probable future rate recoveries for additional deferred tax liabilities. The probable future rate recoveries (revenues) to be recorded take into consideration the additional future taxes which will be generated by that revenue. Deferred taxes are also provided on temporary differences of the Company's non-regulated subsidiaries, which are charged to expense rather than offset by regulatory assets. Deferred Revenue Taxes: Deferred revenue taxes represent the unamortized balance of an accelerated payment of New Jersey Gross Receipts and Franchise Tax required by legislation enacted effective June 1, 1991. In accordance with an order by the New Jersey Board of Regulatory Commissioners (NJBRC) the expenditure has been deferred and is being recovered in rates, with a carrying charge of 7.5% on the unamortized balance, over a ten-year period. Allowance for Funds Used During Construction: AFDC is a non-cash income item and is defined in the approved Uniform System of Accounts as the net cost, during the period of construction, of borrowed funds used for construction purposes and a reasonable rate upon other funds when so used. AFDC is considered a cost of utility plant. In accordance with the order issued by the FERC, AFDC is segregated, in the accompanying financial statements, into two components related to the source of funds from which the credits are derived. The annual rates used by the Company to record AFDC are as follows: Year Ended Borrowed Other December 31, Funds Funds 1993 4.23% 5.55% 1992 4.42% 5.54% 1991 8.06% 3.17% AFDC amounted to 1.6%, 3.6% and 4.5% of net income applicable to common stock for the years 1993, 1992 and 1991, respectively. Reserves for Claims and Damages: Costs arising from worker's compensation claims, property damages and general liability are partially self-funded. Provisions for the reserves are based on experience, risk of loss and the rate-making practices of the regulatory authority. Intercompany Transactions: A comparative summary of the significant intercompany transactions (other than those relating to Federal income taxes - Notes 1 and 2) between the Company and its Parent is as follows: Year Ended December 31, 1993 1992 1991 (Thousands of Dollars) Purchase of electricity $67,266 $65,903 $63,567 Rents paid $ 1,977 $ 1,882 $ 1,680 Investigation costs $ 1,300 - - Interest paid $ 47 $ 10 $ 2 The Company purchases 100 percent of its electric energy requirements from its Parent under a FERC approved purchased power agreement. This agreement is cancelable by either party on six (6) months written notice with no penalties or minimum payments required under termination of the agreement. Reclassifications: Certain amounts from prior years have been reclassified to conform with the current year presentation. These reclassifications had no effect on previously recorded net income. NOTE 2 - FEDERAL INCOME TAXES. The Internal Revenue Service (IRS) concluded its audit of the Parent's Consolidated Federal Income tax returns through 1987. Presently, the IRS is examining tax returns for 1988 and 1989. Notification of their findings for these years has not yet been received. The components of Federal income taxes are as follows: Year Ended December 31, 1993 1992 1991 (Thousands of Dollars) Charged to Operations: Current $1,237 $2,578 $5,252 Deferred - net 1,734 (469) (2,076) Deferred investment tax credit (121) (137) (132) 2,850 1,972 3,044 Charged to Other Income: Current (506) (131) (97) Deferred - net 89 168 144 (417) 37 47 Total $2,433 $2,009 $3,091 Effective January 1, 1993, the Company adopted the provisions of SFAS No. 109, which required the recording of an additional deferred tax liability of approximately $6.4 million. The adoption of SFAS No. 109 did not have a significant impact on the results of current operations because of the recording of offsetting regulatory assets for utility operations and the relatively minor impact from diversified operations. The resultant cumulative effect of a change in accounting principle of $(.1) million is included in current operations. The fiscal years 1992 and 1991 were not restated to apply the provisions of SFAS No. 109. The tax effect of temporary differences which gave rise to deferred tax assets and liabilities as of December 31, 1993 are as follows: (Thousands of Dollars) Liabilities: Accelerated depreciation $19,930 Other 4,650 Total liabilities 24,580 Assets: Employee benefits (3,113) Deferred fuel costs (478) Other (4,388) Total assets (7,979) Total $16,601 Reconciliation of the difference between Federal income tax expenses and the amount computed by applying the prevailing statutory income tax rate to income before income taxes for the years ended December 31, 1993, 1992 and 1991 is as follows: % of Pre-Tax Income 1993 1992 1991 Statutory tax rate 35% 34% 34% Increase (decrease) in computed taxes resulting from: Amortization of investment tax credits (2) (2) (1) Amortization of Sterling Reserve (2) (2) (1) Additional depreciation deducted for book purposes 2 3 2 Other 1 (2) (1) Effective Tax Rate 34% 31% 33% On August 10, 1993 the Budget Reconciliation Act of 1993 was signed into law. Among other things, the Act increased the corporate federal income tax rate to 35% from 34% retroactive to January 1, 1993. Pursuant to the provisions of SFAS No. 109, the Company adjusted its deferred tax and regulatory asset balances during 1993 to reflect the higher rate. The impact of this rate change was to increase the deferred tax liability by $.7 million, however, because of the recording of offsetting regulatory assets the increase in income tax expense was less than $.1 million. NOTE 3 - STERLING NUCLEAR PROJECT. Costs associated with the Sterling Nuclear Project, which was abandoned in 1980, and in which the Company's Parent was a 33% participant, are recorded in Deferred Debits - Extraordinary Property Loss. The Company's allocated costs amount to 29% of the Parent's costs. The NJBRC has approved a twenty-year amortization, which commenced June 23, 1982, for costs (excluding a return on the unamortized balance) attributable to the Company. At December 31, 1993 and 1992, the unamortized Sterling Nuclear Project costs, which have been approved for amortization and recovery, before reduction for deferred taxes, amounted to $5,585,000 and $5,942,000, respectively. Such costs are not subject to an earned return on the unamortized balance. NOTE 4 - RETAINED EARNINGS. The Company has various restrictions on the availability of retained earnings for cash dividends, which are contained in or result from covenants in the indentures supplemental to the Mortgage Trust Indenture. Approximately $7,501,600 at December 31, 1993 and 1992 was so restricted. NOTE 5 - COMMON STOCK. All of the Company's common stock, $100 par value, outstanding is owned by the Parent and has been pledged as collateral for the first mortgage bonds of the Parent. NOTE 6 - LONG-TERM DEBT. Details of long-term debt are shown below: Year Ended December 31, 1993 1992 (Thousands of Dollars) First Mortgage Bonds: Series C, 4 5/8% due August 15, 1995 $ 2,000 $ 2,000 Series D, 9 1/8% due February 15, 2000 - 5,000 Series E, 7 7/8% due April 15, 2001 - 6,000 Series F, 8.95% due June 15, 2004 - 3,680 Series G, 10% due February 1, 1997 - 1,670 Series H, 9.59% due July 1, 2020 20,000 20,000 Series I, 6% due July 1, 2000 20,000 - Diversified Activities: Secured Notes, 6-7% due through August 31, 1996 2,868 3,511 Total 44,868 41,861 Less: Amount due within one year 891 1,255 43,977 40,606 Unamortized discount on long-term debt (111) - Total Long-Term Debt $43,866 $40,606 The Company was required under the terms of the Sixth Supplemental Indenture to its Mortgage Trust Indenture dated as of July 1, 1954, as supplemented, to make an annual sinking fund payment of $240,000 with respect to the Series F bonds on June 14 of each year. Similarly, pursuant to the Seventh Supplemental Indenture to such Mortgage Trust Indenture, the Company was required to make annual sinking fund payments of $333,000 with respect to the Series G bonds on January 31 of each year. In March 1993, both Series F and G bonds were redeemed. During 1993, a cash payment of $333,000 was made to satisfy the Series G requirement. The aggregate amount of maturities and sinking fund requirements for each of the five years following 1993 is as follows: 1994 - $891,000; 1995 - $2,965,000; and 1996 - $1,012,000. There are no sinking fund requirements for 1997 and 1998. Substantially all of the utility plant and non-utility property of the Company is subject to the lien of the indenture securing the first mortgage bonds of the Company. On March 10, 1993 the Company sold $20 million of First Mortgage 6% Bonds, Series I due 2000 ("Series I Bonds"). The Series I Bonds were sold at a discount to yield 6.11% to the public. The net proceeds to the Company from the sale of the Series I Bonds were used to pay the principal of and redemption premium on an aggregate of $16,017,000 of the Company's First Mortgage Bonds outstanding and for other corporate purposes. The principal amount and series of First Mortgage Bonds refunded are: $5,000,000 of 9 1/8% Bonds, Series D due 2000; $6,000,000 of 7 7/8% Bonds, Series E due 2001; $3,680,000 of 8.95% Bonds, Series F due 2004; and $1,337,000 of 10%, Bonds Series G due 1997. NOTE 7 - CASH AND SHORT-TERM DEBT. The Company considers all cash and highly liquid debt instruments purchased with a maturity date of three months or less to be cash and cash equivalents for the purpose of the Consolidated Statements of Cash Flows. At December 31, 1993 and 1992, the Company held $3,000,000 and $2,000,000 of commercial paper issued by the Parent. At December 31, 1993, the Company had unsecured lines of credit with two commercial banks aggregating $10 million. Annual fees equal to one-eighth of one percent are paid to the Banks for such lines of credit. The Company may borrow under the lines of credit through the issuance of promissory notes to the banks at their prevailing interest rate for prime commercial borrowers. The aggregate amount of promissory notes outstanding at any time cannot exceed the total combined lines of credit. In addition, O&R Energy, Inc., a non-utility wholly owned subsidiary of Saddle River Holdings Corporation (which is a wholly owned subsidiary of the Company) has an outstanding line of credit and standby letters of credit which together amount to $15.0 million. Amounts advanced under the line of credit bear interest equal to one-half of one percent above the bank's prime rate. As of December 31, 1993, $1.2 million was outstanding and in 1992 there were no such borrowings outstanding. Additional information regarding the Company's short-term borrowings is as follows: Year Ended December 31, 1993 1992 1991 Weighted average interest rate at year-end 6.5% -% -% Amount outstanding at year-end $1,200,000 - - Average amount outstanding for year $1,077,973 $310,274 $20,274 Daily weighted interest rate during year 6.47% 4.75% 9.13% Maximum amount outstanding at any month end $1,200,000 - - NOTE 8 - FAIR VALUE OF FINANCIAL INSTRUMENTS. Financial Accounting Standards No. 107 ("SFAS No. 107"), "Fair Value of Financial Instruments", required disclosure of the estimated fair value of an entity's financial instrument assets and liabilities. For the Company, financial instruments consist principally of cash and cash equivalents, temporary cash investments, long-term debt and notes payable. The following methods and assumptions were used to estimate the fair value of each class of financial instruments for which it is practicable to estimate that value: Cash and cash equivalents and Temporary cash investments -- The carrying amount reasonably approximates fair value because of the short maturity of those instruments. Long-term debt--The fair value of the Company's long-term debt is estimated based on the quoted market prices for the same or similar issues. Notes Payable -- reasonably approximates fair value of the short maturity of those instruments. 1993 1992 Carrying Fair Carrying Fair Amount Amount Amount Amount (Thousands of Dollars) Cash and cash equivalents $13,813 $13,813 $14,827 $14,827 Temporary cash investments 685 685 128 128 Long-term debt 44,868 47,006 41,861 43,986 Notes payable 1,200 1,200 - - In addition, off balance sheet financial instruments, which consist of non-utility natural gas futures contracts used to hedge firm and anticipated gas sales commitments, had a fair value of $3,856,000 at December 31, 1993 compared to an acquisition cost of $3,944,000. NOTE 9 - PENSION AND POSTRETIREMENT BENEFITS. Pension Benefits The Parent maintains a non-contributory defined benefit retirement plan, covering substantially all employees. The plan calls for benefits to be paid to eligible employees at retirement, based primarily on years of service and average career compensation. Pension costs are accounted for in accordance with the requirements of Statement of Financial Accounting Standards No. 87 - "Employers Accounting for Pensions" (SFAS No. 87). SFAS No. 87 results in a difference in the method of determining pension costs for financial reporting and funding purposes. Plan valuation for funding and income tax purposes is prepared on the unit credit method, which makes no assumptions as to future years of service or compensation levels. In contrast, the projected unit of credit cost method required for accounting purposes by SFAS No. 87 reflects assumptions as to future years of employee service and compensation levels. The Parent's policy is to fund the pension costs determined by the unit credit method subject to the IRS funding limitation rules. For rate-making purposes, pension expense determined under SFAS No. 87 is reconciled with the amount provided in rates for pensions. The Parent's net periodic pension cost in 1993, 1992 and 1991 includes the following components: December 31, 1993 1992 1991 (Thousands of Dollars) Service cost-benefits earned during year $ 5,690 $ 5,896 $ 5,114 Interest cost on projected benefit obligation 12,915 10,301 9,396 Actual return on plan assets (19,383) (15,135) (32,839) Net amortization and deferral 5,014 4,397 22,635 Net Pension Expense $ 4,236 $ 5,459 $ 4,306 The following table sets forth the funded status of the Parent's Plan and amounts recognized in the Parent's Consolidated Balance Sheets at December 31, 1993 and 1992. Plan assets are stated at fair market value and are comprised primarily of common stock and investment grade debt securities. December 31, 1993 1992 (Thousands of Dollars) Actuarial present value of benefit obligations: Vested $(153,730) $(128,611) Non-vested (9,758) ( 16,281) Accumulated benefit obligation $(163,488) $(144,892) Projected benefit obligation $(180,176) $(162,371) Plan assets at fair market value 182,810 169,842 Excess of plan assets over projected benefit obligation 2,634 7,471 Unamortized net transition asset at adoption of SFAS No. 87 being amortized over 15 years (8,909) (10,022) Unrecognized prior service cost 28,528 8,514 Unrecognized net gain (47,960) (27,434) Accrued Pension Cost $ (25,707) $ (21,471) The expected long term rate of return on plan assets, the weighted average discount rate and the annual rate of increase in future compensation assumed in determining the projected benefit obligation were 8%, 7.75% and 4%, respectively for 1993. For the year 1992 the expected long term rate of return on plan assets, the discount rate and the annual rate of increase in future compensation assumed in determining the projected benefit obligation were 7.5%, 7% and 5%, respectively. Postretirement Benefits In addition to providing pension benefits, the Parent provides certain health care and life insurance benefits for retired employees. Employees retiring from the Company on or after having attained age 55 who have rendered at least 5 years of service are entitled to postretirement health care coverage. Prior to January 1, 1993 the Parent recognized the cost of providing these benefits by expending the annual insurance premiums, which amounted to $2.4 million and $1.9 million for retiree benefits during 1992 and 1991 respectively. Effective January 1, 1993 the Company adopted the provisions of Statement of Financial Accounting Standards No. 106 (SFAS No. 106), "Employers Accounting for Postretirement Benefits Other than Pensions", which established revised accounting and financial reporting standards for postretirement benefits other than pensions. SFAS No. 106 requires the Company to accrue the estimated future cost of postretirement health and non-pension benefits during the years that the employee renders the necessary service, rather than recognizing the cost of such benefits after the employee has retired and when the benefits are actually paid. Deferred accounting for any difference between the expense charge required under SFAS No. 106 and the current rate allowance has been authorized by the NJBRC. Rate recovery of SFAS No. 106 costs applicable to the Company's operations will be addressed in the next rate filing. The Emerging Issues Task Force (EITF) Committee of the FASB addressed implementation issues of SFAS No. 106 for regulated industries in EITF Issue No. 92-12. A consensus was reached that deferral of the difference between SFAS No. 106 costs and amounts allowed in rates was proper so long as the subsequent recovery period was within approximately 20 years. Accordingly, this change in accounting did not have a material impact on the Company's results of operations in that the Company was able to record a regulatory asset relating to the difference between SFAS No. 106 costs and amounts allowed in rates in its service jurisdiction. In order to provide funding for active employees' postretirement benefits as well as benefits paid to current retirees, the Company has established Voluntary Employees' Beneficiary Association (VEBA) trusts for collectively bargained employees and management employees. Contributions to the VEBA trusts are tax deductible, subject to limitations contained in the Internal Revenue Code. No contributions to the trusts have been made as of December 31, 1993. The Company's policy is to fund the SFAS 106 postretirement health and life insurance costs to the extent of rate recoveries realized for these costs. As permitted by SFAS No. 106, the Parent has elected to amortize the postretirement benefit obligation at the date of adoption of the accounting standards, January 1, 1993, over a 20 year period. This transition obligation totaled $57.2 million. The following table sets forth the plan's funded status, reconciled with amounts recognized in the Parent's financial statements at December 31, 1993: Accumulated postretirement benefit obligation: Fully eligible active employees $(18,386) Other active employees (27,073) Retirees (20,337) Total benefit obligation (65,796) Plan assets at fair value - Accumulated postretirement obligation in excess of plan asset (65,796) Unrecognized experience net (gain) loss 4,694 Unrecognized transition obligation 54,383 Accrued postretirement benefit cost $( 6,719) The components of net periodic postretirement benefit cost for the year ended December 31, 1993 are as follows: Service cost $ 1,535 Interest cost 4,598 Return on plan assets - Amortization of transition obligation 2,861 Deferred and capitalized (6,719) Net Expense $ 2,275 Of the plan totals, $1,454 of the accrued postretirement benefit cost and $492 of the net expense have been allocated to the Company. The calculation of the actuarial present value of benefit obligations at December 31, 1993 assumes a discount rate of 7.75% and health care cost trend rates of 9.0% for medical costs and 14% for prescription drugs in 1994 decreasing through 2003 to a rate of 5.0%. If the health care trend rate assumptions were increased by 1 percent, the Parent's accumulated postretirement benefit obligation would be increased by approximately $7.2 million. The effect of this change on the sum of the service cost and interest cost would be an increase of $.8 million. Other In addition to the plans described above, the Parent sponsors a 401(k) savings plan (Savings Plan) for its employees. Eligible employees may contribute up to a combined 20% of their compensation, subject to IRS restrictions, on a before-tax and after-tax basis. The Parent makes no contributions to the Savings Plan. The Parent also has an unfunded non-contributory supplemental retirement plan covering certain management employees. As of December 31, 1993, the Parent's obligation under this plan is fully provided for. The Parent has established a Subsidiary Equity Incentive Plan in which plan participants are entitled to certain rights measured as Performance Units. Each Performance Unit gives the plan participant the opportunity to receive an incentive award of up to 1% of the net gain, subject to certain restrictions, in the value of the Parent's investment in the participating subsidiaries over its initial investment. As of December 31, 1993 no incentive awards have been granted under the plan. In November 1992, the FASB issued Statement of Financial Accounting Standards No. 112 "Employers Accounting for Postemployment Benefits," (SFAS No. 112), which requires the recognition of postemployment benefits, including health and welfare benefits, provided to former or inactive employees on an accrual basis. The Company currently recognizes the cost of such benefits as they are paid. As of December 31, 1993, the effect of adopting SFAS 112 will require the recognition of a liability of approximately $.8 million. SFAS No. 112 will not have a material adverse impact on the Company's results of operations because the Parent expects to record an offsetting regulatory asset. The Parent adopted SFAS No. 112 on January 1, 1994. NOTE 10 - COMMITMENTS AND CONTINGENCIES. CONSTRUCTION PROGRAM Under the Company's construction program, it is estimated that expenditures (excluding AFDC) of approximately $36,640,000 will be incurred during the years 1994 through 1998. The estimated amounts by year are: $5,400,000, $6,255,000, $6,995,000, $8,890,000 and $9,100,000, respectively. CONCENTRATION OF CREDIT RISK Financial instruments which potentially subject the Company to concentrations of credit risk, as defined by Statement of Financial Accounting Standards No. 105 "Financial Instruments with Concentrations of Credit Risk", consist principally of temporary cash investments, accounts receivable and gas marketing accounts receivable. The Company places its temporary cash investments with high quality financial institutions. Concentrations of credit risk with respect to accounts receivable are limited due to the Company's large, diverse customer base within its service territory. With respect to gas marketing operations, the customer base consists of a large, diverse group of users of natural gas across the United States, with the Company's credit risk being dependent on overall economic conditions. As of December 31, 1993, the Company had no significant concentrations of credit risk. GAS FUTURES CONTRACTS O&R Energy, Inc., a non-utility subsidiary of the Company, has entered into futures contracts that have been designated as hedges against firm fixed-price, fixed-quantity and anticipated sales commitments. The gain and losses on future contracts are included in the cost of gas sold when the physical delivery of gas occurs. The aggregate amount of these commitments is approximately $4.7 million. LONG-TERM PERFORMANCE AWARDS The Company and its non-utility subsidiary have granted awards to certain key officers, whereby they will be entitled to receive a specified percentage of the incremental net value of the gas marketing and broadcasting subsidiaries over the initial investment in such subsidiaries, as defined. The awards expire December 31, 1997 or with the occurrence of certain events. POWER SUPPLY AGREEMENT On January 1, 1993, Orange and Rockland Utilities, Inc. (the Parent) and the Company entered into an agreement to sell and deliver the Company's entire requirements of electricity in quantities sufficient for the Company's own use and for resale in the Company's franchise territory located in New Jersey. The rate for all electricity delivered shall reimburse the Parent for the cost of rendering service, including return on investment. The Parent renders bills monthly and payment is due on or before the last day of the month following the month in which service is rendered. Simple interest shall accrue from the due date until the date of payment. This agreement shall remain in effect unless cancelled by either party by written notice given not less than six months prior to the proposed date of cancellation. LEGAL PROCEEDINGS During the third quarter of 1993, the Rockland County (NY) District Attorney charged a then Vice President of the Company with grand larceny, commercial bribery and making illegal political contributions and commenced a related investigation of the Company. Two other former employees reporting to the Vice President were charged with grand larceny. The Board of Directors promptly formed a Special Committee of outside directors (the Special Committee), with authority to take any steps deemed necessary or desirable, to conduct an independent investigation into such matters, in order to determine to what extent there were any other improprieties and to make recommendations as to any necessary remedial measures. The Special Committee has retained investigative counsel and an accounting firm to assist its inquiry. The New Jersey Board of Regulatory Commission (NJBRC) also began an investigation to determine the impact of these events on the Company's ratepayers. The Company is cooperating fully in the inquiries and has pledged to return to customers any funds that are discovered to have been misappropriated. The Company agreed to refund $94,100 in February and March 1994 through reductions in the applicable fuel adjustment charges. On November 4, 1993 the Parent signed a Joint Cooperation Agreement with the Rockland County District Attorney's office which creates an Inspector General's office within the Company to monitor its efforts to implement and maintain programs to ensure the highest ethical standards of business conduct. The agreement also specified a number of other steps the Company will undertake to aid in the on-going investigation and prevent any recurrence. As a result of the agreement and the Company's continued cooperation with the inquiry, the District Attorney has agreed not to file any criminal charges against the Company or any of its subsidiaries in connection with the current investigation. The former Company officer and two former employees charged by the District Attorney subsequently pleaded guilty to all counts. The District Attorney's Office has identified $374,124 as representing the amount of consolidated funds misappropriated by these individuals. As part of their plea, the two former employees agreed to a partial restitution agreement pursuant to which they will reimburse to the Parent and its subsidiaries a sum of $199,709 prior to their sentencing, scheduled for May 4, 1994. The investigations being conducted by the Special Committee of the Board of Directors and the District Attorney, along with the NJBRC, are still under way. The Company intends to take all appropriate actions to protect the interests of its customers and shareholders. It is not possible to predict at this time the extent of additional refunds that may be required by the NJBRC, if any. During the fourth quarter, James F. Smith was terminated for cause as Chief Executive Officer and removed as Chairman of the Board of Directors, and Victor J. Blanchet, Jr. was appointed to serve as Acting Chief Executive Officer. On March 22 1994, a Rockland County Grand Jury indictment was returned charging Mr. Smith with eight felony counts of grand larceny and two misdemeanor counts of petit larceny. According to the press release issued by the Rockland County District Attorney on March 22, 1994, the ten count indictment charges Mr. Smith with stealing from the Parent by charging personal expenses to the Parent, including (i) approximately $7,300 to rent four vans and a panel truck that were used by Mr. Smith's son's film production company, including approximately $780 worth of parking summonses issued to the rental van and a car owned by the Parent that was being used by Mr. Smith's son (ii) approximately $3,037 in moving costs to have Mr. Smith's daughter's belongings moved to Westchester County on two separate occasions and to have other belongings moved to Mr. Smith's summer home in Kennebunkport, Maine; (iii) approximately $4,600 for assorted graphic printing, consisting of engagement invitations for both of his children, a hand-colored wedding program for his daughter, as well as printed directions to his Kennebunkport Maine summer home; (iv) approximately $7,000 for holiday baskets for Mr. Smith's family members, friends and his Maine Realtor; (v) approximately $1,100 for assorted holiday plants delivered to Mr. Smith's home; (vi) approximately $1,760 to have Mr. Smith's home cleaned following a boiler replacement; (vii) approximately $1,098 for printed materials associated with Mr. Smith's wife's election campaign for village trustee (which Mr. Smith subsequently repaid to the Parent after Ms. Winikow's arrest); (viii) approximately $2,000 for a surprise 50th birthday party for Mr. Smith's wife at the Parent's conference center facilities; (ix) approximately $300 worth of auto repairs made to Mr. Smith's son-in-law's automobile; and (x) approximately $600 worth of watches given by Mr. Smith to his children and their spouses. Mr. Smith was arraigned in Rockland County Supreme Court on March 22, 1994, and entered a plea of not guilty. In order to fully protect its interests, the Company, has initiated lawsuits in federal and state courts to recover misappropriated funds. In related activities, two lawsuits have been brought by shareholders and another by ratepayers seeking damages resulting from these events. On August 18, 1993, Feiner v. Orange and Rockland Utilities, Inc., a purported ratepayer class action complaint against the Parent, the Company, former Vice President of the Parent and the Company Linda Winikow and others, was filed in the United States District Court, Southern District of New York. Plaintiffs allege that the defendants violated the Federal Racketeer Influenced and Corrupt Organizations Act (RICO) and New York common law by using false and misleading testimony to obtain rate increases from the NYPSC and used funds obtained from ratepayers in furtherance of an alleged scheme to make illegal campaign contributions and other illegal payments. Plaintiffs seek damages in the amount of $900 million (which they seek to treble pursuant to the RICO statute). The Parent and the Company intend to vigorously contest these claims. On August 31, 1993, Patents Management Corp. v. Orange and Rockland Utilities, Inc., a purported shareholder derivative complaint, was filed in the Supreme Court of the State of New York, County of New York, against the Parent, all but one of the Parent's Directors and several other named defendants by an alleged shareholder of the Parent. Plaintiff claims that the Parent's Directors breached their fiduciary duties by condoning the alleged wrongful acts of Mrs. Winikow or failing to exercise appropriate supervisory control over Mrs. Winikow. Plaintiff requests that the Court require each Director to indemnify the Parent against all losses sustained by the Parent as a result of these alleged wrongful acts of Mrs. Winikow. The Parent intends to vigorously contest these claims. On November 23, 1993, Gross v. Orange and Rockland Utilities, Inc., a purported shareholder class action complaint, was filed in the United States District Court, Southern District of New York. Plaintiff alleges that various Securities and Exchange Commission filings of the Parent during the period between March 2, 1993 and November 4, 1993, contained false and misleading information, and thereby violated Sections 11 and 12(2) of the Securities Act of 1933, by failing to disclose what the plaintiff alleges was a "scheme" by the Parent to make illegal political payments and campaign contributions to various public officials and politicians. As a result, plaintiff claims, during such period persons who purchased the Company's stock through the Parent's Dividend Reinvestment Plan did so at artificially inflated prices. The complaint seeks unspecified money damages. The Parent intends to vigorously contest these claims. The costs of outside professional and consultant firms associated with the investigation of the misuse of Company funds by former employees of the Parent amounted to $1.3 million for the year ending December 31, 1993. These investigations are currently anticipated to continue through the first half of 1994. The Company currently estimates it will incur from $.7 to $1.3 million of expenses in 1994 to conclude the investigation. These expenditures are not recoverable from ratepayers. The Company will attempt to offset these costs to the extent possible by achieving savings in the cost of operations during the year. On July 31, 1992, State Line Power Associates, Limited Partnership v. Orange and Rockland Utilities, Inc., a complaint brought by a New Jersey partnership, was filed against the Parent in the United States District Court, Southern District of New York. The plaintiff had, pursuant to an Agreement dated October 11, 1990 (the Agreement), agreed to build a gas- fired combined cycle generating facility in Ringwood, New Jersey and sell 100 Mw of capacity and associated energy to the Parent. The complaint, which alleged that the Parent had improperly terminated the Agreement, sought compensatory damages in excess of $50 million and a declaratory judgment to the effect that the Parent remained obligated to purchase 100 Mw of capacity and associated energy from the plaintiff pursuant to the terms of the Agreement. In its answer to the complaint, the Parent denied the plaintiff's allegations. On January 7, 1994, the parties entered into a settlement agreement pursuant to which the Parent, without any admission of liability, paid to the plaintiff an amount that is not material to the financial condition of the Parent, and the plaintiff delivered to the Parent a release of all outstanding claims against the Parent. The Company will be responsible for payment of a portion of the settlement and related costs pursuant to the Power Supply Agreement. Environmental The Federal Comprehensive Environmental Response, Compensation and Liability Act of 1980 and certain similar state statutes authorize various governmental authorities to issue orders compelling responsible parties to take cleanup action at sites determined to present an imminent and substantial danger to the public and to the environment because of an actual or threatened release of hazardous substances. The Parent is a party to a number of administrative proceedings involving potential impact on the environment. Such proceedings arise out of, without limitation, the operation and maintenance of facilities for the generation, transmission and distribution of electricity and natural gas. Such proceedings are not, in the aggregate, material to the business or financial condition of the Parent or the Company. Pursuant to the Clean Air Act Amendments of 1990, which became law on November 15, 1990, a permanent nationwide reduction of 10 million tons in sulfur dioxide emissions from 1980 levels, as well as a permanent reduction of 2 million tons of nitrogen oxide emissions from 1980 levels must be achieved by January 1, 2000. In addition, continuous emission monitoring systems will be required at all affected facilities. The Parent has two base load generating stations that burn fossil fuels that will be impacted by the legislation in the year 2000. These generating facilities already burn low sulfur fuels, so additional capital costs are not anticipated for compliance with the sulfur dioxide emission requirements. However, installation of low nitogren oxide burners at Lovett Plant and operational modifications at Bowline Plant are expected to be required. Additional emission monitoring systems will be installed at both facilities. The Parent's construction expenditures for this work is estimated to be approximately $28.2 million from 1993 to 1996. Beginning with calendar year 1994, Title V sources (Bowline Point and Lovett) will be required to pay an emission fee. Each facility's fee will be based upon actual air emissions reported to NYSDEC at a rate of approximately $25 per ton of air emissions. (If this fee was in effect in 1992, the Parent's obligation would have been approximately $.5 million). The Company will continue to assess the impact of the Clean Air Act Amendments of 1990 on its power generating operations as the regulations implementing these Amendments are promulgated. The Company will be responsible for a portion of the costs to comply with such regulations. NOTE 11 - SEGMENTS OF BUSINESS The Company defines its principal business segment as electric utility operations and diversified activities. The diversified activities include gas marketing and radio broadcasting. Total electric operating revenues as reported in the Consolidated Statements of Income include sales to unaffiliated customers, which are billed at a tariff rate. Income from operations is total operating revenues less total operating expenses. Identifiable assets by segment are those assets that are used in the distribution and sales operations in each segment. Corporate assets are principally property, cash, sundry receivables and unamortized debt expense. Schedule V ROCKLAND ELECTRIC COMPANY Property, Plant and Equipment and Nonutility Property For the Year Ended December 31, 1993 (Thousands of Dollars) Column A Column F Total Utility Nonutility Balance at Classification Plant Property End of Period Transmission Plant $ 32,163 $ - $ 32,163 Distribution Plant 104,259 - 104,259 General Plant 3,149 25 3,174 Plant Held for Future Use 1,007 - 1,007 Other 6 7,372 7,378 140,584 7,397 147,981 Construction Work In Progress 2,815 - 2,815 Total $143,399 $7,397 $150,796 Neither the total additions nor the total deductions during the year ended December 31, 1993 amounted to more than 10% of the closing balance of total utility plant and other physical property, and the information required by Columns B, C, D and E is, therefore, omitted. A summary of Columns C, D and E for the year ended December 31, 1993 is as follows: Column C - Additions at cost $ 6,590 Column D - Retirements 705 Column E - Other changes 320* Net Change $ 6,205 * Other changes represent transfers of property between the respondent and the Parent amounting to $320. For information concerning depreciation procedures, see Note 1 of Notes to Consolidated Financial Statements. Schedule V ROCKLAND ELECTRIC COMPANY Property, Plant and Equipment and Nonutility Property For the Year Ended December 31, 1992 (Thousands of Dollars) Column A Column F Total Utility Nonutility Balance at Classification Plant Property End of Period Transmission Plant $ 31,711 $ - $ 31,711 Distribution Plant 98,626 - 98,626 General Plant 3,015 25 3,040 Plant Held for Future Use 1,007 - 1,007 Other 6 6,585 6,591 134,365 6,610 140,975 Construction Work In Progress 3,616 - 3,616 Total $137,981 $6,610 $144,591 Neither the total additions nor the total deductions during the year ended December 31, 1992 amounted to more than 10% of the closing balance of total utility plant and other physical property, and the information required by Columns B, C, D and E is, therefore, omitted. A summary of Columns C, D and E for the year ended December 31, 1992 is as follows: Column C - Additions at cost $ 7,728 Column D - Retirements 1,399 Column E - Other changes 429* Net Change $ 6,758 * Other changes represent transfers of property between the respondent and the Parent amounting to $429. For information concerning depreciation procedures, see Note 1 of Notes to Consolidated Financial Statements. Schedule V ROCKLAND ELECTRIC COMPANY Property, Plant and Equipment and Nonutility Property For the Year Ended December 31, 1991 (Thousands of Dollars) Column A Column F Total Utility Nonutility Balance at Classification Plant Property End of Period Transmission Plant $ 31,487 $ - $ 31,487 Distribution Plant 93,772 - 93,772 General Plant 2,871 25 2,896 Plant Held for Future Use 1,007 - 1,007 Other 6 6,072 6,078 129,143 6,097 135,240 Construction Work In Progress 2,593 - 2,593 Total $131,736 $6,097 $137,833 Neither the total additions nor the total deductions during the year ended December 31, 1991 amounted to more than 10% of the closing balance of total utility plant and other physical property, and the information required by Columns B, C, D and E is, therefore, omitted. A summary of Columns C, D and E for the year ended December 31, 1991 is as follows: Column C - Additions at cost $10,348 Column D - Retirements 690 Column E - Other changes 81* Net Change $ 9,739 * Other changes represent transfers of property between the respondent and the Parent amounting to $81. For information concerning depreciation procedures, see Note 1 of Notes to Consolidated Financial Statements. Schedule VI ROCKLAND ELECTRIC COMPANY Accumulated Depreciation and Amortization of Property, Plant and Equipment and Nonutility Property For the Year Ended December 31, 1993 (Thousands of Dollars) Column A Column B Column C Column D Column E Column F Additions Balance at charged to Other Balance at beginning costs and changes-add end of Description of period expenses Retirements (deduct) period Accumulated deprecia- tion of utility plant $34,530 $3,757 $ 786 $ (148)(A) $37,353 Accumulated deprecia- tion of nonutility property $ 1,692 $ 510 $ - $ - $ 2,202 (A) Other changes include the following: additions of $135 materials salvaged, $12 charged to other accounts, and net miscellaneous additions of $109 less deductions of $404 for removal costs. Schedule VI ROCKLAND ELECTRIC COMPANY Accumulated Depreciation and Amortization of Property, Plant and Equipment and Nonutility Property For the Year Ended December 31, 1992 (Thousands of Dollars) Column A Column B Column C Column D Column E Column F Additions Balance at charged to Other Balance at beginning costs and changes-add end of Description of period expenses Retirements (deduct) period Accumulated deprecia- tion of utility plant $32,796 $3,606 $1,627 $ (245)(A) $34,530 Accumulated deprecia- tion of nonutility property $ 1,312 $ 380 $ - $ - $ 1,692 (A) Other changes include the following: additions of $146 materials salvaged, $12 charged to other accounts, and net miscellaneous additions of $92 less deductions of $495 for removal costs. Schedule VI ROCKLAND ELECTRIC COMPANY Accumulated Depreciation and Amortization of Property, Plant and Equipment and Nonutility Property For the Year Ended December 31, 1991 (Thousands of Dollars) Column A Column B Column C Column D Column E Column F Additions Balance at charged to Other Balance at beginning costs and changes-add end of Description of period expenses Retirements (deduct) period Accumulated depre- ciation of utility plant $26,554 $3,285 $ 811 $3,768(A) $32,796 Accumulated depre- ciation of non- utility property $ 982 $ 330 $ - $ - $ 1,312 (A) Other changes include the following: additions of $4,073 materials salvaged, $13 charged to other accounts, and net miscellaneous additions of $21 less deductions of $339 for removal costs. Schedule VIII ROCKLAND ELECTRIC COMPANY Valuation and Qualifying Accounts and Reserves Years Ended December 31, 1993, 1992 and 1991 (Thousands of Dollars) Column A Column B Column C Column D Column E Additions (1) (2) Balance at Charged to Charged Balance at beginning costs and to other end of Description of period expenses accounts Deductions period December 31, 1993 Allowance for Uncollectible Accounts: Customer accounts $190 $220 $39 $239 $210 Other accounts 35 91 - 73 52 Gas marketing accounts 75 548 - 153 471 $300 $859 $39(A) $465(B) $733 Reserve for Claims and Damages $223 $122 $ - $ 77(C) $268 December 31, 1992 Allowance for Uncollectible Accounts: Customer accounts $196 $251 $29 $286 $190 Other accounts 59 77 - 102 35 Gas marketing accounts 40 43 - 8 75 $295 $371 $29(A) $396(B) $300 Reserve for Claims and Damages $387 $ 9 $93 $266(C) $223 December 31, 1991 Allowance for Uncollectible Accounts: Customer accounts $205 $470 $23 $502 $196 Other accounts 50 130 6 127 59 Gas marketing accounts 0 41 - 1 40 $255 $641 $29(A) $630(B) $295 Reserve for Claims and Damages $475 $ 124 $ - $212(C) $387 (A) Collection of accounts previously written off. (B) Accounts considered uncollectible and written off. (C) Payment of damage claims. Schedule X ROCKLAND ELECTRIC COMPANY Supplementary Income Statement Information (Thousands of Dollars) Column B Column A Charged to Costs and Expenses Year Ended December 31, Item 1993 1992 1991 1. Maintenance $ 5,430 $ 5,396 $ 4,816 2. Taxes other than income taxes: Miscellaneous Federal taxes $ 1,230 $ 1,297 $ 1,259 Municipal property taxes 236 215 203 State gross earnings (franchise) 6,161 5,775 5,699 State unemployment 71 44 17 State utility gross receipts 11,412 10,380 10,672 State sales, use and capital stock 166 284 260 19,276 17,995 18,110 Less: charged to construction work in progress accounts 399 402 414 Total $18,877 $17,593 $17,696 Other items not shown are less than one percent of revenues. UNITED STATES SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 FORM 10-K EXHIBITS ROCKLAND ELECTRIC COMPANY (Exact name of Registrant as Specified in its Charter) Fiscal Year Ended December 31, 1993 Commission File Number 2-36005 ROCKLAND ELECTRIC COMPANY EXHIBIT LIST 1993 Form 10-K Exhibit * 3.1 Certificate of Incorporation, as amended through November 5, 1987. (Exhibit 3.1 to Form 10-K for the fiscal year ended December 31, 1992, File No. 2-36005). 3.5 By-Laws, as amended through October 7, 1993. * 4.1 Mortgage Trust Indenture of Rockland Electric Company, dated as of July 1, 1954. (Exhibit 2.16 to Registration Statement No. 2-14159). * 4.4 Third Supplemental Indenture of Rockland Electric Company, dated as of August 15, 1965. (Exhibit 4.23 to Registration Statement No. 2-24682). *4.10 Ninth Supplemental Indenture of Rockland Electric Company, dated March 1, 1993. (Exhibit 4.10 to Form 10-K for the fiscal year ended December 31, 1992, File No. 2-36005). *10.0 Joint Operating Agreement, dated as of February 5, 1976 between Orange and Rockland Utilities, Inc. and the Company. (Exhibit 10.0 to Form 10-K for fiscal year ended December 31, 1989). 10.1 Power Supply Agreement, dated as of January 1, 1993 between Orange and Rockland Utilities, Inc. and the Company, as filed with the Federal Energy Regulatory Commission. * +10.3 Performance Unit Incentive Plan effective December 3, 1992. (Exhibit 10.3 to Form 10-K for the fiscal year ended December 31, 1992, File No. 2-36005). ROCKLAND ELECTRIC COMPANY EXHIBIT LIST 1993 Form 10-K Exhibit * +10.4 Award Agreement under the Performance Unit Incentive Plan applicable to P. J. Chambers, Jr. dated December 3, 1992. (Exhibit 10.4 to Form 10-K for the fiscal year ended December 31, 1992, File No. 2-36005). * 22 Subsidiaries of the Company. (Exhibit 22 to Form 10-K for the fiscal year ended December 31, 1992, File No. 2-36005). *Incorporated by reference to the indicated filings. +Denotes Executive Compensation Plans and Arrangements.

42872_1993.txt

42872

1993

Item 1. Business. INTRODUCTION W. R. Grace & Co., through its subsidiaries, is primarily engaged in the specialty chemical business on a worldwide basis and in specialized health care activities. In its chemical operations, Grace develops, manufactures and markets specialty chemicals and materials and related systems. In health care, Grace is primarily engaged in supplying kidney dialysis and home infusion and respiratory therapy services and products. As used in this Report, the term "Company" refers to W. R. Grace & Co., a New York corporation, and the term "Grace" refers to the Company and/or one or more of its subsidiaries. Grace's principal executive offices are located at One Town Center Road, Boca Raton, Florida 33486-1010, and its telephone number is 407/362-2000. At year-end 1993, Grace had approximately 34,000 full-time employees worldwide in its continuing operations (approximately 7,000 in discontinued operations). Grace's Consolidated Financial Statements for the three years in the period ended December 31, 1993 ("Consolidated Financial Statements") and certain other financial information included in the Company's 1993 Annual Report to Shareholders are set forth in the Financial Supplement to this Report and incorporated by reference herein. STRATEGIC RESTRUCTURING In 1991, Grace announced a new corporate strategy with the principal objective of enhancing shareholder value. The major components of the strategy are (a) focusing on core businesses to accelerate growth; (b) upgrading financial performance, principally by selling or monetizing non-core businesses, lowering the ratio of debt to total capital and reducing overhead; and (c) integrating corporate and operating unit functions through global product line management. The core businesses referred to above are packaging, health care, catalysts and other silica-based products, construction products, water treatment and process chemicals, and container products. As part of its new corporate strategy, Grace has reorganized the management of these core businesses on the basis of global product lines. Grace has also organized task forces that are developing and implementing "best practices" relating to financial planning, information systems, human resources, logistics and other management functions; has implemented a process to better allocate capital among its businesses; and has retired or refinanced most of its higher-cost debt. DIVESTMENTS AND OTHER DISPOSITIONS. Pursuant to its new strategy, Grace has divested or monetized a number of non-core businesses and has announced plans to divest others. In 1991, Grace sold its specialty textiles business; its automotive chemicals and sound deadening components businesses; investments in two pharmaceutical businesses; its Trinidadian fertilizer operations; its animal feed businesses; its polyurethane foam sealant manufacturing business; and its Japanese microwave products business. In 1992, Grace sold its book, video and software distribution businesses and its organic chemicals business and related assets. In December 1992, Grace also completed a transaction to monetize a portion of its cocoa and chocolate business by selling a 21% limited partnership interest in Grace Cocoa Associates, L.P. ("Grace Cocoa"), which owns this business and other assets, resulting in Grace's receipt of approximately $300 million in cash. During the first half of 1993, Grace sold substantially all of its oil and gas and energy services businesses for net cash proceeds of $386 million, and it is in the process of liquidating the remaining miscellaneous assets and liabilities of those businesses. Grace also sold a number of other non-core businesses and corporate investments in 1993, including a 50% interest in a Japanese chemical business (for approximately $31.4 million), a food hygiene services business (for approximately $11.2 million) and minority investments in Grace-Sierra Horticultural Products Company and Canonie Environmental Services Corp. (for proceeds totaling $41.3 million). In January 1994, Grace received $42.8 million in exchange for the securities of The Restaurant Enterprises Group, Inc. held by Grace. In the fourth quarter of 1992, Grace classified Colowyo Coal Company, a coal mining subsidiary, as a discontinued operation. In the second quarter of 1993, after evaluating the expected contribution of its remaining non-core businesses to its future performance and growth, Grace reclassified as discontinued operations its cocoa and battery separators businesses; certain engineered materials businesses (principally printing products, electromagnetic radiation control and material technology businesses); and substantially all of its other non-core businesses. Grace is actively pursuing the sale of these businesses. STRATEGIC ACQUISITIONS. As part of its strategy to focus on core business growth, Grace has made, and expects to continue to make, strategic acquisitions directly related to its core businesses. In 1992, Grace acquired the North American food service packaging business of Du Pont Canada for approximately $20 million. In 1993, Grace acquired (a) the water treatment and related operations of Aquatec Quimica S.A. of Brazil, which has significant operations throughout South America, as well as operations in Portugal and the - 2 - United States; and (b) the Katalistics fluid cracking catalyst additive business previously owned by a joint venture between Union Carbide Corporation and Allied-Signal Inc. In the 1991-92 period, Grace acquired the Renacare unit of Lloyds Chemists plc, the leading United Kingdom producer of dialysis concentrate and a distributor of associated products, as well as additional dialysis centers located primarily in the United States, for approximately $54 million in the aggregate. In 1993, Grace acquired Home Intensive Care, Inc., a national provider of alternate site infusion therapy and dialysis health care services, for approximately $129 million in cash (inclusive of expenses); Virginia-based American Homecare Equipment, Inc., a provider of home infusion and respiratory therapy services, for approximately 116,000 shares of the Company's common stock and other consideration; and Riggers Medizintechnik GmbH, a German manufacturer and distributor of dialysis products. Additionally, during 1993, Grace acquired regional providers of home infusion therapy services and home support nursing services, as well as 26 additional dialysis centers located primarily in the United States, for a total of approximately $92 million. In March 1994, Grace announced that it had agreed to acquire Home Nutritional Services, Inc., a national provider of home infusion therapy services, for approximately $120 million in cash (inclusive of expenses and debt to be assumed); completion of the transaction is anticipated during the second quarter of 1994. Grace is considering additional acquisitions in the health care industry, with a view to continued development of its international health care business. See Notes 3, 6, 9 and 11 to the Consolidated Financial Statements and "Management's Discussion and Analysis of Financial Condition and Results of Operations" in the Financial Supplement for additional information. INDUSTRY SEGMENTS Information concerning the sales and revenues, pretax operating profit and identifiable assets of Grace's continuing operations by industry segment and geographic area for 1993, 1992 and 1991 is contained in Note 17 to Grace's Consolidated Financial Statements in the Financial Supplement. SPECIALTY CHEMICALS Grace's specialty chemical operations consist of the development, manufacture and sale of products and systems in five core market groups (see "Strategic Restructuring" above). These products and systems typically serve highly specialized markets and represent an important component (but a relatively small portion of the cost) of the end products in which they are used. Accordingly, competition is generally based primarily on technological capability, customer service and product quality. Grace's specialty - 3- chemical products and systems are marketed primarily through direct sales organizations. The following is a description of the products and services provided by each of Grace's core specialty chemical businesses. PACKAGING. Grace's packaging business ("Grace Packaging") provides high-performance total packaging systems on a worldwide basis, competing principally by providing superior quality products and services for specialized customer needs. The principal products and services provided by Grace Packaging are (a) flexible packaging systems (including material, equipment and services) for a broad range of perishable foods such as fresh meat, prepared foods, baked goods, poultry, produce, cheese, and smoked and processed meat products; (b) shrink films for packaging a variety of consumer and industrial products; (c) foam trays for supermarkets and poultry and other food processors; and (d) rigid plastic containers for dairy and other food and non-food products. Grace Packaging competes through three product groups: flexible packaging (marketed extensively under the Cryovac-R- registered trademark), foam trays, and rigid plastic containers. Cryovac-R- flexible packaging products include shrink bags, shrink films, laminated films, medical films, and equipment. The Cryovac packaging products group developed and introduced flexible plastic vacuum shrink packaging in the late 1940s, contributing to expanded food distribution and marketing by providing better protection against decay-inducing bacteria and moisture loss. The market for Cryovac products has subsequently shifted from industrial food applications toward the retail food market, and Cryovac packaging technology has also been introduced in non-food applications such as flexible packaging for display items and electronic and medical products. The flexible packaging products group emphasizes five core competencies to differentiate itself from competitors: (1) proprietary film processing technology; (2) resin technology, permitting the production of materials suited to specific customer needs; (3) packaging and food science expertise, providing better understanding of the interaction between packaging materials and packaged products; (4) complete systems support capability, to provide a single source of supply for customer needs; and (5) strategically located production, warehousing and distribution networks. Foam trays are produced by the Formpac business group of Grace Packaging, primarily for sale to supermarkets and poultry and other food processors in the eastern United States. Formpac's proprietary technology has also been successfully utilized in certain packaging applications outside the United States, and Formpac is exploring opportunities to expand its business outside North America. - 4 - Grace Packaging's Omicron business group produces rigid plastic packaging applications, primarily for dairy products in Australia. These products utilize proprietary thermoforming technology, involving the controlled thinning and shaping of hot plastic sheets to increase strength and rigidity while minimizing weight. Grace Packaging's sales and revenues were $1.3 billion in 1993 and $1.2 billion in each of 1991 and 1992. Approximately 50% of Grace Packaging's 1993 sales and revenues were generated in North America, 30% in Europe, 10% in Asia Pacific, and the remainder in Latin America. At year-end 1993, Grace Packaging employed approximately 9,000 people in 23 production facilities (9 in North America, 6 in Europe, 5 in Latin America and 3 in Asia Pacific) and 77 sales offices, serving more than 18,000 customers. A majority of the raw materials used by Grace Packaging are resins that are generally available at stable prices. In most cases, multiple sources of raw materials exist, with at least one source being located in each regional market. The primary external influence affecting the packaging business is the general economy; seasonality is not significant to Grace Packaging's business. CATALYST AND OTHER SILICA-BASED PRODUCTS. This core business ("Grace Davison") is composed of three principal product groups: fluid cracking catalysts, polyolefin catalysts, and silica and zeolite adsorbents. These products involve silica, alumina and zeolite technology and the design and manufacture of products to meet customer specifications; they are sold to major oil refiners, plastics and chemical manufacturers, and consumer products companies. Fluid cracking catalysts are used by refiners to upgrade oil to more valuable transportation fuels such as gasoline and jet and diesel fuel. Oil refining is a highly specialized discipline, demanding that products be tailored to meet local variations in raw materials and operational needs. Competition is based on technology, product performance, customer service and price. Polyolefin catalysts and catalyst supports are essential components used in manufacturing nearly half of all high density and linear low density produced polyethylene resins, which are used in products such as packaging film and plastic pipe. The catalyst business is technology-intensive and focused on providing products specifically formulated to meet end-user applications. Manufacturers generally compete on a worldwide basis, and competition has intensified recently due to excess capacity in the catalyst industry, with resultant price sensitivity. Silica and zeolite adsorbents are used in plastics, dentifrices, paints, insulated glass and other products, and in the refining of edible oils. Silicas are used in coatings as flatting agents, in plastics to improve handling, in toothpastes as thickeners and - 5 - cleaners, in food to carry flavors and prevent caking, and in the purification of edible oils. Grace Davison's sales and revenues were $572 million in 1993, $519 million in 1992, and $470 million in 1991; approximately 59% of Grace Davison's 1993 sales and revenues were generated in North America, 34% in Europe, 6% in Asia Pacific and 1% in Latin America. At year-end 1993, Grace Davison employed approximately 2,600 persons worldwide in nine facilities (six in the United States and one each in Canada, Germany and Brazil). Most raw materials used in the manufacture of Grace Davison products are available from multiple sources and, in some instances, are produced or supplied by Grace. Because of the diverse applications of products utilizing Grace Davison technology and the geographic areas in which such products are used, seasonality does not have a significant effect on Grace Davison's businesses. CONSTRUCTION PRODUCTS. Grace Construction Products ("GCP") is a leading supplier of specialty materials and systems to the world-wide construction industry. GCP products and systems strengthen concrete, control corrosion, prevent water damage and protect structural steel against collapse due to fire. These products include concrete admixtures, cement processing additives, and fireproofing and waterproofing materials. In North America, GCP also manufactures and distributes reinforced fiberglass building components, masonry block additives and products, and vermiculite products used in construction and other industrial applications. GCP's products are sold to a broad customer base, including cement manufacturers, ready mixed and precast concrete producers, specialty subcontractors and applicators, masonry block manufacturers, building materials distributors and other industrial manufacturers. GCP is a principal supplier of the products it manufactures, competing with several large global suppliers and smaller regional competitors. Competition is based largely on pricing, product performance, proprietary technology and technical support and service. GCP's 1993 sales and revenues totaled $333 million (70% in North America, 17% in Europe, 13% in Asia Pacific and less than 1% in Latin America). Sales and revenues for 1992 and 1991 were $333 million and $345 million, respectively. At year-end 1993, GCP employed approximately 2,000 persons at approximately 59 production facilities (33 in North America, 9 in Southeast Asia, 7 in Australia, 5 in Europe, 4 in Latin America and 1 in Japan) and 73 sales offices worldwide. Supplies and raw materials used for manufacturing GCP products are primarily commodities obtained from multiple sources, including commodity chemical producers, petroleum companies, other construction industry suppliers and paper manufacturers. In most instanc- - 6 - ES, there are at least two alternative suppliers for the raw materials utilized by GCP. The construction business is seasonal, based on weather conditions, and cyclical, in response to economic conditions and construction demand. To increase profitability and minimize the impact of cyclical downturns in regional economies, GCP strives to introduce new and improved products, has implemented a lower cost structure in North America and Europe and is emphasizing expansion in European and Southeast Asian markets. WATER TREATMENT. Grace's water treatment and process chemicals business ("Grace Dearborn") consists of the water treatment and paper industry services business lines, which market the following products and services: (a) chemical treatments and systems to prevent corrosion, scale and microbiological growth in industrial process waters, heating and cooling applications, and industrial wastewater applications for clarification, sludge de-watering, odor control and water recycling; (b) paper industry process chemicals, support equipment and related specialist and consulting services; (c) hydrocarbon processing chemicals, related support equipment and services to protect and optimize processing system performance; (d) chemical treatments, support equipment and services for sugar processing, including processing sugar into alcohol as a gasoline substitute; (e) chemical treatments to protect industrial canned food cooking and sterilizing equipment; and (f) paint detackification products and services to remove paint sludge from water wash paint spray systems. Grace Dearborn sales and revenues for 1993 totaled $330 million (42% in North America, 40% in Europe, 16% in Latin America and 2% in Asia Pacific). Sales and revenues for 1992 and 1991 were $302 million and $292 million, respectively. At year-end 1993, Grace Dearborn employed approximately 2,800 persons at 21 plants (7 in Latin America, 6 in North America and 4 in each of Europe and Asia Pacific) and 107 sales offices. Raw materials used in the Grace Dearborn business lines are readily available from multiple sources, generally at stable prices. The paper industry services business is affected by the cyclicality of the global paper market. The water treatment services business responds to (but is not adversely affected by) seasonal fluctuations, concentrating on boiler treatment in winter and cooling system treatment in summer. The effects of seasonality are further diminished by the geographic diversity of the markets in which Grace Dearborn competes. CONTAINER PRODUCTS. Grace's container business ("Grace Container") consists of three product lines: container sealants, closures and coatings. The principal products marketed by these product lines include sealing compounds and related application equipment for food and beverage cans and other rigid containers; gasketing materials to the metal crown, aluminum roll-on and plastic closure segments of the glass/closure packaging markets; adhe- - 7 - sive lacquers and associated protective and decorative coatings for plastic and metal closures; protective and decorative coatings and lacquers for rigid food and beverage containers; and lubricants used primarily in two-piece can manufacturing. Grace Container sales and revenues (excluding those of Grace Specialty Polymers, discussed below) were $238 million, $253 million and $248 million in 1993, 1992 and 1991, respectively. Its products are marketed internationally, with 37% of sales and revenues in Europe, 27% in North America, 25% in Asia Pacific and 11% in Latin America. At year-end 1993, Grace Container employed approximately 1,830 persons at 25 plants and 39 sales offices worldwide. Competition is based on providing high-quality customer service, as well as on price and product quality and reliability. Raw materials are generally available from multiple sources at stable prices. Although demand for container packaging and sealant products tends to increase during the warmest months of the year, the impact of such seasonality on Grace Container is offset almost entirely by the geographic diversity of the markets in which it competes. Recently integrated with Grace Container is Grace Specialty Polymers, which develops formulated engineered polymers for printed circuit board and component assembly in the electronics, electrical, automotive and defense industries. These include surface mount and conductive adhesives, capacitor coatings, light emitting diode encapsulants and conformal coatings. The integration of these product lines reflects the reliance of both businesses on polymer technology as an integral feature of the products they manufacture. HEALTH CARE Grace's health care business ("Grace Health Care") is primarily engaged in supplying kidney dialysis and home infusion and respiratory therapy services, and in the manufacture and sale of products used to provide dialysis and other medical services. Grace Health Care provides kidney dialysis and related services for outpatients with chronic renal failure. At December 31, 1993, Grace Health Care operated 501 centers providing dialysis and related services (471 in the United States and Puerto Rico, 23 in Portugal, 4 in Spain, 2 in the Czech Republic and 1 in Argentina); these centers, substantially all of which are leased, average ap- proximately 5,600 square feet in size. Grace Health Care also provides inpatient acute dialysis services under contracts with hospitals in the United States (385 at December 31, 1993) and furnishes dialysis equipment and supplies to patients who elect home treatment. At December 31, 1993, Grace Health Care was treating approximately 37,000 patients in the U.S. and 3,000 patients in other - 8 - countries. Revenues from kidney dialysis services were $1,012 million in 1993, $860 million in 1992 and $720 million in 1991. Additionally, Grace Health Care manufactures disposable bloodlines, dialysis solutions and artificial kidneys (dialyzers), for use in its dialysis centers and for sale to unaffiliated dialysis facilities and home patients; distributes dialysis supplies and equipment and other medical products and supplies manufactured by others; and provides laboratory services (including hepatitis testing) to dialysis patients. More than two-thirds of the sales of dialysis and other medical products supplies and equipment reflect sales to patients not directly treated, or facilities not operated, by Grace Health Care. Grace Health Care also provides infusion and respiratory therapy services and other medical equipment and supplies to patients for home use through a network of 97 locations (96 leased and 1 owned). Infusion therapy includes intravenous delivery of an expanding range of medications and nutritional preparations, such as chemotherapy, total parenteral nutrition, antibiotic therapy and drugs for pain management. Respiratory therapy includes delivery of oxygen and aerosolized drugs and the use of ventilators. In addition, Grace Health Care provides home nursing support services through nine branch locations. Grace Health Care's business is dependent on the continuation of Medicare and other third-party insurance coverage for dialysis and home care services and products. At such time as Medicare becomes a patient's primary payor for dialysis (generally, 3 months following commencement of treatment or, in the case of patients covered by employer-sponsored health insurance, 21 months after commencement of treatment) and/or homecare products and services, Medicare currently reimburses suppliers of such services and products for approximately 80% of established fees or reasonable charges; the remaining 20% is paid by the patient and/or his non-Medicare insurance carrier. Because in most cases the prices of dialysis services and products in the U.S. are directly or indirectly regulated by Medicare, competition in the industry is based primarily on quality and accessibility of service. In addition, some states limit competition under laws that restrict the number of dialysis facilities within a geographic area based on need, as determined by state agencies. Competition in the home care business is also based on quality of service as well as price, and, where state laws do not impose limits on competition, there are no significant barriers to entering this business. Cost efficiency, therefore, is also a key element of competition in this market. Based upon Grace's knowledge and understanding of the health care industry in general and of other providers of kidney dialysis and infusion therapy, as well as information obtained from publicly available sources, Grace Health Care believes that it is among the most cost-efficient of - 9 - the companies in its field and that it is the leading United States supplier of dialysis services and products and a leading United States provider of infusion therapy. Except as noted in the following paragraph, Grace Health Care believes there are adequate sources of supply for the raw materials and products utilized in its health care services and medical products businesses. At year-end 1993, Grace Health Care employed a total of approximately 13,600 persons full-time at its facilities worldwide. Grace Health Care's businesses generally are not seasonal or cyclical in nature. It is unclear at this time whether and to what extent any of the currently proposed reforms in U.S. health care law will affect Grace Health Care's operations. National Medical Care, Inc. ("NMC") is Grace's principal health care subsidiary. In 1993, the United States Food and Drug Administration ("FDA") issued import alerts with respect to (a) hemodialysis bloodlines manufactured at NMC's plant located in Reynosa, Mexico and (b) hemodialyzers manufactured in NMC's Dublin, Ireland facility. Products subject to FDA import alerts may not enter the United States until the FDA approves the quality assurance systems of the facility at which such products are manufactured. In January 1994, NMC entered into a consent decree providing for the resumption of importation of bloodlines and hemodialyzers following certification by NMC that the relevant facility complies with FDA regulations and successful completion of an FDA inspection to verify such compliance. In accordance with the consent decree, NMC certified compliance to the FDA with respect to the Reynosa, Mexico facility in January 1994 and the FDA lifted the bloodline import alert in March 1994, following a thorough reinspection by the FDA and a commitment by NMC to finish certain studies by May 1994 and, in the interim, to perform additional product testing. Certification of compliance at the Dublin, Ireland facility is anticipated in the second quarter of 1994. The consent decree also requires NMC to certify and maintain compliance with applicable FDA device manufacturing laws and regulations at all of its United States manufacturing facilities. NMC has conducted a full review of such facilities and upgraded its quality assurance systems as necessary, and all certifications required with respect to such facilities have been filed. No fines or penalties were imposed on NMC as a result of any of the FDA's actions relating to the import alerts or in connection with the consent decree. Neither the import alerts nor previously reported recalls of certain NMC products have had, nor are they expected to have, a material effect on Grace's results of operations or financial position. HEALTH CARE INVESTMENT. Grace has a 47% common equity interest in a company that serves hospitals and other health care institutions by recruiting nurses and other trained health care personnel and placing them on temporary assignments throughout the United States. Grace also owns preferred stock of the company and op- - 10 - tions, exercisable commencing in 1994, to acquire the balance of such company's common equity. See "Strategic Restructuring" above for information concerning 1993 and early 1994 transactions involving Grace's health care business. OTHER OPERATIONS THERMAL AND EMISSION CONTROL SYSTEMS. In 1993, Grace combined its web processing equipment business and its air emission control catalysts and systems business to form a new product line in thermal and emission control systems, named "Grace TEC Systems". The principal products currently marketed by this product line are (a) air flotation dryers and auxiliary web processing equipment for the printing, coating and converting industries, and (b) air emission control catalysts and systems to control volatile organic compounds, carbon monoxide and nitrogen oxides emissions from power generation, industrial and automotive sources. DISCONTINUED OPERATIONS. In the fourth quarter of 1992, Grace classified Colowyo Coal Company ("Colowyo") as a discontinued operation. Colowyo, a partnership wholly owned by Grace, operates the largest surface coal mine in Colorado under federal and state leases covering proven and/or probable surface reserves of approximately 195 million tons of low-sulfur coal. In the second quarter of 1993, Grace classified as discontinued operations its remaining non-core businesses, including Grace Cocoa, an international producer and supplier of high-quality intermediate cocoa and chocolate products to the bakery, confectionery, dairy and beverage industries; Grace's battery separators business; and certain engineered materials businesses, principally printing products, electromagnetic radiation control and material technology businesses. Grace is actively pursuing the divestment of these discontinued operations and those referred to under "Strategic Restructuring" above. See Notes 3 and 6 to Grace's Consolidated Financial Statements in the Financial Supplement and "Strategic Restructuring" for additional information. RESEARCH ACTIVITIES Grace engages in active research and development programs directed toward the development of new products and processes and the improvement of, and development of new uses for, existing products and processes. Research is carried out by divisional laboratories in the United States, Europe and Japan and by the Corporate Research Division, which has facilities in Columbia, - 11 - Maryland; Lexington, Massachusetts and Atsugi, Japan. The Research Division's activities focus on Grace's core product lines and include specialty polymers; biomedical devices; catalysis; construction materials; photopolymers; specialty packaging; and process engineering, principally involving the development of technologies to manufacture chemical specialties and biomedical products. As part of Grace's commitment to focus resources on core businesses, corporate research programs for the core product lines are being increased, while funding in support of non-core businesses and discontinued operations is being eliminated. In addition, product line and corporate research programs are being integrated and concentrated on key projects. Research and development expenses relating to continuing operations amounted to $135 million in 1993, $130 million in 1992 and $128.1 million in 1991 (including expenses incurred in funding external research projects). The amount of research and development expenses relating to government- and customer-sponsored projects (as opposed to projects sponsored by Grace) is not material. ENVIRONMENTAL, HEALTH AND SAFETY MATTERS In constructing and operating its facilities, Grace incurs capital and operating expenditures relating to the protection of the environment, as well as costs to remediate previously contaminated properties. Costs incurred to operate and maintain environmental facilities and dispose of hazardous and non-hazardous wastes with respect to continuing operations were $45 million in 1993, $56 million in 1992 and $38 million in 1991, and are estimated to be $50 million and $54 million in 1994 and 1995, respectively. Grace's capital expenditures for environmental control facilities relating to continuing operations were approximately $20 million, $18 million and $17 million in 1993, 1992 and 1991, respectively, and are estimated to be $19 million and $23 million during 1994 and 1995, respectively. Costs incurred to remediate previously contaminated sites were $44 million, $35 million and $18 million in 1993, 1992 and 1991, respectively, and are estimated to be $44 million and $35 million in 1994 and 1995, respectively. Such expenditures have not had, and are not expected to have, a material effect on Grace's other capital expenditures or on its earnings or competitive position. See Note 11 to Grace's Consolidated Financial Statements and "Management's Discussion and Analysis of Results of Operations and Financial Condition" in the Financial Supplement. Grace has established an Environmental, Health and Safety ("EHS") policy and related programs that include specialized safety training for employees, monitoring of the workplace environment, and training and guidance for employees with respect to EHS regulatory compliance. These programs are supported by a central EHS department organized in 1993. This department also audits oper- - 12 - ating facilities and manages Grace's environmental remediation activities. The Responsible Care program of the Chemical Manufacturers Association, in which Grace's United States chemical operations have participated, has been extended to Grace operations worldwide under the name "Commitment to Care". The goal of this program is to promote best management practices in the areas of product stewardship, employee health and safety, community awareness and emergency response, process safety, distribution practices and pollution prevention. Grace's EHS auditing program has also been expanded to include all facilities worldwide; this program involves the onsite inspection of facilities for compliance with applicable laws, as well as Grace's policies, standards and guidelines. See Item 3, "Legal Proceedings", in this Report, and "Management's Discussion and Analysis of Results of Operations and Financial Condition" in the Financial Supplement, for information concerning environmental proceedings to which Grace is a party. MATERIALS AND ENERGY The availability and prices of the raw materials and fuels used by Grace are subject to worldwide market conditions and governmental policies. On the basis of existing arrangements, Grace does not anticipate any major disruptions of its business in 1994 as a result of shortages of raw materials or energy. Should shortages occur, their effect on Grace's operations would depend upon their nature, duration and severity and consequently cannot be determined at this time. However, arrangements have been made, and will continue to be made, for long-term commitments for many of Grace's raw materials and fuel requirements from primary sources of supply. ITEM 2.

ITEM 2. PROPERTIES. Grace operates chemical, manufacturing and other types of plants and facilities (including office and other service facilities) throughout the world. Grace considers its major operating properties to be in good operating condition and suitable for their current use. Although Grace believes that the productive capacity of most of its plants and other facilities is adequate for current operations and foreseeable growth, it conducts ongoing, long-range forecasting of its capital requirements to assure that additional capacity will be available when and as needed (see information regarding Grace's capital expenditures on page of the Financial Supplement). Accordingly, Grace does not anticipate that its operations or income will be materially affected by the absence of available capacity. - 13 - Additional information regarding Grace's properties is set forth in Item 1 above, in Schedules V and VI on pages and of the Financial Supplement and in Notes 1, 8 and 11 to Grace's Consolidated Financial Statements in the Financial Supplement. ITEM 3.

ITEM 3. LEGAL PROCEEDINGS. ASBESTOS LITIGATION. Grace is a defendant in lawsuits relating to previously sold asbestos-containing products and anticipates that it will be named as a defendant in additional asbestos-related lawsuits in the future. At year-end 1993, Grace was a defendant in approximately 38,100 asbestos-related lawsuits representing approximately 56,700 claims (as compared to approximately 30,900 lawsuits and 53,000 claims at year-end 1992). 92 of the lawsuits pending at year-end 1993 involved claims for property damage allegedly caused by the use of asbestos-containing materials in the construction of buildings. The plaintiffs in these lawsuits generally seek, among other things, to have the defendants absorb the cost of removing, containing or repairing the asbestos-containing materials in the affected buildings. The remaining asbestos-related lawsuits involve claims for personal injury. In most of Grace's asbestos-related lawsuits, it is one of many defendants. Through year-end 1993, 120 asbestos property damage cases had been dismissed with respect to Grace without payment of any damages or settlement amounts; judgments were entered in favor of Grace in twelve cases; in six cases (four of which are on appeal), Grace was held liable for a total of $68.3 million; and 131 property damage suits and claims had been settled by Grace for a total of $300.0 million. Grace has recorded a receivable for the insurance pro- ceeds it expects to receive in connection with these adverse verdicts and settlements, as well as defense costs initially paid by Grace (see "Insurance Litigation" below and Note 2 to Grace's Consolidated Financial Statements in the Financial Supplement). Included in the asbestos property damage lawsuits pending against Grace and others at year-end 1993 are the following class actions: (1) a Pennsylvania state court action (PRINCE GEORGE CENTER, INC. V. U.S. GYPSUM COMPANY, ET AL., Court of Common Pleas of Philadelphia County) covering all commercial buildings in the United States leased in whole or in part to the United States government on or after May 30, 1986; (2) an action, conditionally certified by the United States Court of Appeals for the Fourth Circuit in September 1993 and pending in the United States District Court for the District of South Carolina, covering all public and private colleges and universities in the United States whose buildings contain asbestos materials (CENTRAL WESLEYAN COLLEGE, ET AL. V. W. R. GRACE, ET AL.); (3) an action (IN RE: ASBESTOS SCHOOL LITIGATION), brought in 1983 in the United States District Court for the Eastern District of Pennsylvania, on behalf of all public and private elementary and secondary schools in the United States - 14 - that contain asbestos materials, which action has been scheduled for trial in late 1994 on a limited number of issues; and (4) a purported class action (ANDERSON MEMORIAL HOSPITAL, ET AL. V. W. R. GRACE & CO., ET AL.), filed in 1992 in the Court of Common Pleas for Hampton County, South Carolina, on behalf of all entities that own, in whole or in part, any building containing asbestos materials manufactured by Grace or one of the other named defendants, other than buildings subject to the class action lawsuits described above and any building owned by the federal or any state government. The remaining asbestos lawsuits pending at year-end 1993 involved claims for personal injury. Through year-end 1993, approximately 7,000 personal injury lawsuits involving 17,900 claims had been dismissed with respect to Grace without payment of any damages or settlement amounts (primarily on the basis that Grace products were not involved), and approximately 11,300 such suits involving 13,400 claims had been settled for a total of $52.2 million (see "Insurance Litigation" below). In January 1993, in EDWARD M. CARLOUGH, ET AL. V. AMCHEM PRODUCTS, INC., ET AL., the United States District Court for the Eastern District of Pennsylvania conditionally certified a class of all future asbestos personal injury claimants, including individuals who have been occupationally exposed to asbestos-containing materials but who do not presently allege asbestos-related injury. Although Grace is not among the defendants named in the class action complaint, dissemination of the required class notice may generate additional litigation against Grace. In 1991, the Judicial Panel on Multi-District Litigation consolidated in the United States District Court for the Eastern District of Pennsylvania, for pre-trial purposes, all asbestos personal injury cases pending in the federal courts (including approximately 7,000 cases against Grace). To date, no action has been taken by the court handling the consolidated cases that would indicate whether the consolidation will affect Grace's cost of disposing of these cases or its defense costs. Grace's ultimate exposure in respect of its asbestos-related lawsuits and claims will depend on the extent to which its insurance will cover damages for which it may be held liable, amounts paid in settlement and litigation costs. While (a) Grace's insurance carriers have not acknowledged or have denied the applicability of their insurance coverage to Grace's asbestos property damage lawsuits and claims (except as discussed below under "Insurance Litigation"), (b) Grace is currently in litigation with certain carriers concerning the applicability and extent of its insurance coverage and (c) the resolution of certain issues, primarily relating to the availability of coverage for specific years, will require further judicial proceedings, Grace believes that its insurance will cover a substantial portion of any damages, settlement amounts and litigation costs related to its asbestos litigation and - 15 - claims. Consequently, Grace believes that the resolution of its asbestos litigation will not have a material adverse effect on its consolidated financial position or results of operations. See "Insurance Litigation" below and Note 2 to Grace's Consolidated Financial Statements in the Financial Supplement for additional information. ENVIRONMENTAL AND OTHER PROCEEDINGS. Grace (together with other companies) has been designated a "potentially responsible party" ("PRP") by the United States Environmental Protection Agency ("EPA") with respect to absorbing the costs of investigating and remediating pollution at various sites. Grace has not incurred any material liability with respect to sites as to which such proceedings have been concluded by agreement with the EPA. At year-end 1993, proceedings were pending with respect to approximately 35 sites as to which Grace has been designated a PRP. Although federal law provides that all PRPs may be held jointly and severally liable for the costs of investigation and remediation of a site, after consideration of the liabilities of other PRPs with respect to these sites and their respective levels of financial responsibility, Grace believes that the amount recorded in its Consolidated Financial Statements for environmental remediation is adequate to cover its exposure with respect to these sites (see Note 11 to the Consolidated Financial Statements in the Financial Supplement for further information). In addition, Grace is presently involved in litigation with its insurance carriers seeking to hold them responsible for certain amounts for which Grace may be held liable with respect to these sites. The outcome of such litigation, as well as the amount of any recovery that Grace may receive in connection therewith, is presently uncertain. Grace is also involved in other litigation, including certain environmental proceedings brought by federal, state and/or local government agencies and private parties. No such litigation is expected to result in significant monetary or other sanctions or in other material liabilities. However, as a voluntary participant in the EPA Toxic Substances Control Act Compliance Audit Program, Grace agreed to undertake a corporate-wide audit of compliance with Section 8 of such Act and to pay a stipulated civil penalty for each study or report that should have been, but was not, submitted to the EPA as required under such Section. Although final review of the audit is not complete, Grace believes it will be required to pay the EPA penalties aggregating from $250,000 to $400,000 for information discovered in the course of the audit. In addition, Grace has voluntarily reported to the EPA violations of certain notification and related requirements under such Act, and it is anticipated that penalties will be assessed against Grace in connection therewith; the amount of such penalties cannot be determined at this time. For additional information, see Note 2 to Grace's Consolidated Financial Statements in the Financial Supplement. - 16 - In addition, in April 1993, the United States Department of Justice filed suit against Grace in the United States District Court for the District of Montana, Great Falls Division, alleging certain violations of the Clean Air Act in connection with the demolition of a mill in Libby, Montana during late 1991 and early 1992. The complaint seeks damages of up to $25,000 per day for each of seven alleged violations and injunctive relief against future violations, and the Department of Justice previously informed Grace that it might seek penalties of up to $3.3 million in connection therewith. However, subject to certain conditions, Grace and the Department of Justice have agreed in principle to settle this matter upon the payment by Grace of penalties substantially lower than the amount initially contemplated by the Department of Justice. Further, Hatco Corporation ("Hatco"), which purchased the assets of a Grace chemical business in 1978, previously instituted a lawsuit against Grace in the United States District Court for the District of New Jersey seeking recovery of cleanup costs for waste allegedly generated at a New Jersey facility during the period of Grace's ownership. Grace has also filed a lawsuit against its insurance carriers seeking indemnity against any damages assessed against Grace in the underlying lawsuit, as well as defense costs. In decisions rendered during 1993, the Court ruled that Grace is responsible for a substantial portion of Hatco's costs. In an earlier decision, the Court had resolved, in a manner favorable to Grace, certain legal issues regarding Grace's right to insurance coverage; however, the ultimate liability of Grace's insurance carriers will be determined at trial. Remedial costs, and Grace's share of such costs, will be determined once ongoing site investigations are completed and a remediation plan is approved by the State of New Jersey, which is not expected to occur before the latter part of 1994. As a result of the above factors, neither the amount that Grace may be required to pay Hatco, nor the amount that Hatco may have to absorb, nor the amount of Grace's recoveries from its insurance carriers can be reliably estimated at this time. However, based on its investigation to date, Grace believes that the ultimate resolution of this matter will not have a material effect on its financial condition. INSURANCE LITIGATION. Grace is involved in litigation with certain insurance carriers with respect to asbestos-related claims and environmental liabilities. Its asbestos-related insurance actions consist of two cases styled MARYLAND CASUALTY CO. V. W. R. GRACE & CO., both pending in the United States District Court for the Southern District of New York; STATE OF MISSISSIPPI V. THE FLINTKOTE CO., ET AL., pending in the Circuit Court of Jackson County, Mississippi; DAYTON INDEPENDENT SCHOOL DISTRICT V. UNITED STATES MINERAL PRODUCTS COMPANY, ET AL., pending in the United States District Court for the Eastern District of Texas; INDEPENDENT SCHOOL DISTRICT NO. 197, ET AL. V. W. R. GRACE & CO. AND ACCIDENT & CASUALTY INSURANCE CO., ET AL., pending in the First - 17 - Judicial District in Minnesota; THE COUNTY OF HENNEPIN V. CENTRAL NATIONAL INSURANCE COMPANY, ET AL., pending in the Fourth Judicial District in Minnesota; ECOLAB, INC. V. CENTRAL NATIONAL INSURANCE CO., pending in the District Court for Ramsey County, Minnesota; AMERICAN EMPLOYERS' INSURANCE CO., AMERICAN REINSURANCE CO., AND COMMERCIAL UNION INSURANCE CO., AND UNIGARD SECURITY INSURANCE CO. V. W. R. GRACE & CO., CONTINENTAL CASUALTY CO., AND MARYLAND CASUALTY CO., which is pending in the New York state courts; and W. R. GRACE & CO.-CONN. V. ADMIRAL INSURANCE CO., ET AL., pending in the Superior Court of California for the County of Los Angeles. Grace's insurance actions relating to environmental liabilities consist of MARYLAND CASUALTY CO. V. W. R. GRACE & CO., pending in the United States District Court for the Southern District of New York; and HATCO CORP. V. W. R. GRACE & CO.-CONN., pending in the United States District Court for the District of New Jersey. The relief sought by Grace in these actions would provide insurance sufficient to cover Grace's estimated exposure with respect to the actions' subject matter, including damages for amounts previously expended by Grace to defend claims and satisfy judgments and settlements (see Note 2 to Grace's Consolidated Financial Statements in the Financial Supplement). The factual bases underlying these actions are the nature of the underlying asbestos-related and environmental claims, the language of the insurance policies sold by the carriers to Grace and the drafting history of those policies. In March 1991 (in one of the above asbestos-related cases involving Maryland Casualty Co.), the United States District Court for the Southern District of New York held that Grace's primary insurance carriers are obligated to defend and indemnify Grace for damages (other than certain punitive damages), settlement amounts and litigation costs with respect to asbestos-related property damage and personal injury claims; in so holding, the Court determined that coverage for property damage is triggered by the "discovery of damage" during the period covered by the relevant policy. On September 1, 1993, the United States Court of Appeals for the Second Circuit reversed the District Court's ruling as to a "discovery of damage" trigger for such claims and, instead, adopted a trigger based on the date of installation of asbestos-containing materials. In January 1994, the United States Court of Appeals for the Second Circuit granted Grace's petition for a rehearing concerning the September 1, 1993 decision. The Second Circuit has requested that the parties rebrief the issue of the trigger of coverage, which rebriefing is scheduled to be concluded in April 1994. It is not known whether oral argument concerning this issue will be scheduled in connection with the rehearing of this case. In December 1991, the Mississippi Court referred to above also held that Grace's primary and excess insurance carriers are obligated to defend and indemnify Grace, determining that, for purposes of insurance coverage, damage to buildings from asbestos-containing products occurs at the time such products are put in place and that the damage continues as long as the building contains the products - 18 - (referred to as a "continuous trigger"). In November 1992, the Minnesota court referred to above reached a similar decision in interpreting a Grace insurance policy. In 1993, Grace received $74.6 million under settlements with insurance carriers, in reimbursement for amounts previously expended by Grace in connection with asbestos-related litigation. These settlements also provide for future reimbursements of $114.0 million. In early 1994, Grace settled with two additional insurance carriers and received approximately $88.8 million under such settlements. Prior to 1993, Grace received payments totalling $97.7 million from insurance carriers ($30.9 million prior to 1991; $35.3 million in 1991 and $31.5 million in 1992), the majority of which represented the aggregate remaining obligations owed to Grace by those carriers for primary-level insurance coverage written for the period June 30, 1962 through June 30, 1987. As a result of the payments received in 1990 and 1991, insurance litigations were dismissed as to the primary-level product liability insurance coverage previously sold by the relevant insurers to Grace; however, litigations continue as to certain other primary- and excess-level carriers. Grace continues to be involved in litigation with certain of its insurance carriers, including an affiliated group of carriers, that had agreed to a settlement and had made a series of payments thereunder during 1993. The group of carriers subsequently notified Grace that it would not honor the agreement (which had not been executed) due to the September 1, 1993 decision of the United States Court of Appeals for the Second Circuit referred to above. Grace believes that the settlement agreement is binding and initiated action to enforce the settlement agreement. In January 1994, the United States District Court for the Eastern District of Texas held that the agreement is enforceable. The affiliated group of carriers is expected to appeal this ruling to the United States Court of Appeals for the Fifth Circuit. See Note 2 to Grace's Consolidated Financial Statements, appearing in the Financial Supplement for additional information. FUMED SILICA PLANT LITIGATION. In January 1993, Grace initiated legal action in the Belgian courts against the Flemish government to recover losses resulting from the closing of Grace's fumed silica plant in Puurs, Belgium. (See Note 8 to Grace's Consolidated Financial Statements in the Financial Supplement for additional information). Grace is seeking damages in excess of four billion Belgian francs (approximately $120 million at current exchange rates), plus interest and loss of profits. There are also pending two separate arbitrations, one involving the engineering company that was responsible for the design and construction of the fumed silica plant, and the other involving a claim by the company from which the plant had agreed to purchase hydrogen under a long-term - 19 - contract. The outcomes of these proceedings may affect the action filed against the Flemish government. ITEM 4.

ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS. This Item is inapplicable, as no matters were submitted to a vote of the Company's security holders during the fourth quarter of 1993. EXECUTIVE OFFICERS The Company's current executive officers are listed below. Executive officers are elected to serve until the following annual meeting of the Company's Board of Directors; the next such meeting is scheduled to be held on May 10, 1994. NAME AND AGE OFFICE FIRST ELECTED ------------ ------ ------------- J. P. Bolduc (54) President and 08/02/90 Chief Executive Officer 01/01/93 R. H. Beber (60) Executive Vice President 05/10/93 and General Counsel F. Peter Boer (53) Executive Vice President 01/05/89 Hugh L. Carey (74) Executive Vice President 12/03/87 Jean-Louis Greze (62) Executive Vice President 05/10/93 Constantine L. Hampers (61) Executive Vice President 06/06/91 Donald H. Kohnken (59) Executive Vice President 12/07/89 James P. Neeves (56) Executive Vice President 09/06/90 Brian J. Smith (49) Executive Vice President 07/06/89 and Chief Financial Officer All the above executive officers have been actively engaged in Grace's business for the past five years. Mr. Carey was a partner of Finley, Kumble, Wagner, Heine, Underberg, Manley, Meyerson & Casey (a law firm) from 1983 to 1987; that firm is currently involved in bankruptcy proceedings commenced subsequent to Mr. Carey's departure. Mr. Carey is cooperating with the trustee in bankruptcy to secure a plan of reorganization that would result in some limited liability for Mr. Carey. - 20 - PART II ITEM 5.

ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS. Except as provided below, the information called for by this Item appears in the Financial Supplement under the heading "Financial Summary" opposite the caption "Other Statistics - Common shareholders of record" (page); under the heading "Quarterly Summary" opposite the captions "Dividends declared per common share" and "Market price of common stock" (page); and in Note 13 to Grace's Consolidated Financial Statements (page). Each share of the Company's Common Stock has an attendant Common Stock Purchase Right ("Right"). The Rights are not and will not become exercisable unless and until certain events occur (as described below). Until such events occur, the Rights will automatically trade with the Common Stock and separate certificates for the Rights will not be distributed. The Rights will become exercisable on the tenth business day (or such later business day as may be fixed by the Company's Board of Directors) after a person or group (a) becomes an "interested shareholder", as defined in Section 912 of the New York Business Corporation Law (generally, a beneficial owner of 20% or more of the outstanding voting stock), or (b) commences a tender offer or exchange offer that would result in such person or group becoming an interested shareholder. The Rights will not have any voting power at any time. When the Rights become exercisable, each Right will initially entitle the holder to buy from the Company one share of Common Stock for $87.50, subject to adjustment in certain cases ("purchase price"). If, at any time after the Rights become exercisable, (a) the Company is involved in a merger or other business combination in which (i) the Company is not the surviving corporation or (ii) any of the Common Stock is changed or converted into or exchanged for stock or other securities of any other person or cash or other property, or (b) 50% of the Company's assets, cash flow or earning power is sold, each Right will entitle the holder to buy a number of shares of common stock of the acquiring company having a market value equal to twice the purchase price. Alternatively, each right not owned by a person who becomes an interested shareholder would become exercisable for Common Stock (or other consideration) having a market value equal to twice the purchase price. The Rights may be redeemed by the Company at $.025 per Right (payable in cash, Common Stock or any other form of consideration deemed appropriate by the Board) at any time through the tenth business day (or such later business day as may be fixed by the Board) after a public announcement that a person or group has become an interested shareholder; this right of redemption may be reinstated if all interested shareholders reduce their holdings to - 21 - 10% or less of the outstanding Common Stock. The Rights will expire in January 1997. The Rights may be amended either before or after they become exercisable. However, the basic economic terms of the Rights (such as the purchase and redemption prices and the expiration date) cannot be changed. ITEM 6.

ITEM 6. SELECTED FINANCIAL DATA. The information called for by this Item appears under the heading "Financial Summary" (page of the Financial Supplement) and in Notes 5, 6, 9 and 16 to Grace's Consolidated Financial Statements (pages,, and of the Financial Supplement). In addition, Exhibit 12 to this Report (page of the Financial Supplement) contains the ratio of earnings to fixed charges and combined fixed charges and preferred stock dividends for Grace for the years 1989-1993. ITEM 7.

ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS. The information called for by this Item appears on pages to of the Financial Supplement. ITEM 8.

ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA. See the Index to Consolidated Financial Statements and Financial Statement Schedules and Exhibits on page of the Financial Supplement. ITEM 9.

ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE. This item is inapplicable, as no such changes or disagreements have occurred. PART III ITEM 10.

ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT. Except for information regarding the Company's executive officers (see page 20), the information called for by this Item is incorporated in this Report by reference to the definitive Proxy Statement for the Company's 1994 Annual Meeting of Shareholders, except for information not deemed to be "soliciting material" or - 22 - "filed" with the Securities and Exchange Commission ("SEC"), information subject to Regulations 14A or 14C under the Securities Exchange Act of 1934 ("Exchange Act") or information subject to the liabilities of Section 18 of the Exchange Act. ITEM 11.

ITEM 11. EXECUTIVE COMPENSATION. ITEM 12.

ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT. ITEM 13.

ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS. The information called for by Items 11, 12 and 13 is incorporated in this Report by reference to the definitive Proxy Statement for the Company's 1994 Annual Meeting of Shareholders, except for information not deemed to be "soliciting material" or "filed" with the SEC, information subject to Regulations 14A or 14C under the Exchange Act or information subject to the liabilities of Section 18 of the Exchange Act. PART IV ITEM 14.

ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K. FINANCIAL STATEMENTS AND SCHEDULES. See the Index to Consolidated Financial Statements and Financial Statement Schedules and Exhibits on page of the Financial Supplement. REPORTS ON FORM 8-K. The Company filed no Reports on Form 8-K during the fourth quarter of 1993. EXHIBITS. The exhibits to this Report are listed below. Other than exhibits that are filed herewith, all exhibits listed below are incorporated herein by reference. Exhibits indicated by an asterisk (*) are the management contracts and compensatory plans, contracts or arrangements required to be filed as exhibits to this Report. EXHIBIT WHERE LOCATED ------- ------------- Certificate of Incorporation of Exhibit 3 to Form 8-K W. R. Grace & Co., as amended (filed 6/9/88) By-laws of W. R. Grace & Co., as Exhibit 3.2 to Form 10-K amended (filed 3/26/93) - 23 - Indenture dated as of Septem- Exhibit 4.2 to Form 10-K ber 29, 1992 among W. R. Grace (filed 3/26/93) & Co.-Conn., W. R. Grace & Co. and Bankers Trust Company Indenture dated as of January Exhibit 4.4 to Form 10-K 28, 1993 among W. R. Grace (filed 3/26/93) & Co.-Conn., W. R. Grace & Co. and NationsBank of Georgia, N.A. Credit Agreement dated as of Exhibit 4.2 to Form 8-K September 1, 1992 among W. R. (filed 9/26/92) Grace & Co., W. R. Grace & Co.- Conn. and the Several Banks Parties thereto and Chemical Bank, as Agent Amended and Restated Rights Exhibit to Amendment on Agreement dated as of June 7, Form 8 to Application for 1990 between W. R. Grace & Co. Registration on Form 8-B and Manufacturers Hanover Trust (filed 6/19/90) Company W. R. Grace & Co. Executive Exhibit 19(f) to Form Salary Protection Plan, as 8-K (filed 6/9/88)* amended W. R. Grace & Co. 1981 Stock Exhibit 28(a) to Form Incentive Plan, as amended 10-Q (filed 8/13/91)* W. R. Grace & Co. 1986 Stock Exhibit 28(b) to Form Incentive Plan, as amended 10-Q (filed 8/13/91)* W. R. Grace & Co. 1989 Stock Exhibit 28(c) to Form Incentive Plan, as amended 10-Q (filed 8/13/91)* Forms of Stock Option Agreements Exhibit 10(h) to Form 10-K (filed 3/28/92)* Forms of Restricted Share Award Exhibit 10(i) to Form Agreements 10-K (filed 3/28/92)* Information Concerning W. R. Pages 10 and 11 of Proxy Grace & Co. Incentive Compen- Statement (filed 4/10/93)* sation Program and Deferred Compensation Program W. R. Grace & Co. Long-Term Exhibit 10(l) to Form Incentive Plan 10-K (filed 3/29/91)* W. R. Grace & Co. Retirement Exhibit 10(o) to Form Plan for Outside Directors, as 10-K (filed 3/28/92)* amended - 24 - Employment Agreement dated August Exhibit 10(r) to Form 7, 1989 between W. R. Grace & Co. 10-K (filed 3/29/91)* and Joseph R. Wright, Jr. Employment Agreement dated Exhibit 10(x) to Form as of April 1, 1991 between 10-K (filed 3/28/92)* W. R. Grace & Co.-Conn. and Constantine L. Hampers, as amended Housing Loan Agreement dated Exhibit 10(q) to Form as of August 1, 1987 between 10-K (filed 3/29/88); W. R. Grace & Co. and J. P. Exhibit 19(i) to Form Bolduc, related Amendment and 8-K (filed 6/9/88)* Assignment dated May 10, 1988 Employment Agreement dated Filed herewith* August 1, 1993 between J. P. Bolduc and W. R. Grace & Co. Stock Option Agreement dated Filed herewith* June 30, 1993 between David L. Yunich and W. R. Grace & Co. Stock Option Agreement dated Filed herewith* June 30, 1993 between David L. Yunich and W. R. Grace & Co. National Medical Care, Inc. and Exhibit 10 (aa) to Form Subsidiaries Executive Bonus 10-K (filed 3/28/92)* Plans Retirement Agreement between Exhibit 10.23 to Form 10-K W. R. Grace & Co. and J. Peter (filed 3/26/93)* Grace dated December 21, 1992 Executive Severance Agreement Exhibit 10.24 to Form 10-K dated as of September 1, 1992 (filed 3/26/93)* between W. R. Grace & Co. and J. P. Bolduc Executive Severance Agreement Exhibit 10.26 to Form 10-K dated September 1, 1992 (filed 3/26/93)* between W. R. Grace & Co. and Constantine L. Hampers Form of Executive Severance Exhibit 10.28 to Form 10-K Agreement between W. R. Grace (filed 3/26/93)* & Co. and others - 25 - Consulting Agreement Exhibit 10.29 to Form 10-K dated June 1, 1992 between (filed 3/26/93)* W. R. Grace & Co. and Kamsky Associates, Inc. Incentive Compensation Agreement Exhibit 10.30 to Form 10-K dated June 1, 1992 between (filed 3/26/93)* National Medical Care, Inc. and Kamsky Associates, Inc. Consulting Agreement dated as of Filed herewith* June 16, 1993 by and between National Medical Care, Inc., The Humphrey Group, Inc. and Gordon J. Humphrey Employment Termination Agreement Filed herewith* dated June 30, 1993 between J. R. Wright, Jr. and W. R. Grace & Co. W. R. Grace & Co. Supplemental Filed herewith* Executive Retirement Plan, as amended Weighted Average Number of Filed herewith Shares and Earnings Used in (in Financial Supplement Per Share Computations to 10-K) Computation of Ratio of Earnings Filed herewith to Fixed Charges and Combined (in Financial Supplement Fixed Charges and Preferred to 10-K) Stock Dividends Selected Portions of the 1993 Filed herewith Annual Report to Shareholders (in Financial Supplement of W. R. Grace & Co. to 10-K) List of Subsidiaries of Filed herewith W. R. Grace & Co. Consent of Independent Accoun- Filed herewith tants (in Financial Supplement to 10-K) Powers of Attorney Filed herewith - 26 - SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this Report to be signed on its behalf by the undersigned, thereun- to duly authorized. W. R. GRACE & CO. By /s/ B. J. Smith _______________________ B. J. Smith (Executive Vice President) Date: March 28, 1994 Pursuant to the requirements of the Securities Exchange Act of 1934, this Report has been signed below by the following persons on behalf of the registrant and in the capacities indicated on March 28, 1994. SIGNATURE TITLE --------- ----- J. P. Bolduc* President and Director (Principal Executive Officer) G. C. Dacey* R. C. Macauley* ] E. W. Duffy* R. Milliken* ] H. A. Eckmann* J. E. Phipps* ] C. H. Erhart, Jr.* J. A. Puelicher* ] J. P. Grace* E. W. Pyne* ] Directors R. H. Grierson* D. W. Robbins, Jr.* ] C. L. Hampers* G. S. Vance* ] T. A. Holmes* D. L. Yunich* ] G. J. Humphrey* G. P. Jenkins* /s/ B. J. Smith Executive Vice President - ----------------------- (Principal Financial Officer) (B. J. Smith) /s/ R. N. Sukenik Vice President and Controller - ----------------------- (Principal Accounting Officer) (R. N. Sukenik) ____________ * By signing his name hereto, Robert B. Lamm is signing this docu- ment on behalf of each of the persons indicated above pursuant to powers of attorney duly executed by such persons and filed with the Securities and Exchange Commission. By /s/ Robert B. Lamm ------------------------ Robert B. Lamm (Attorney-in-Fact) - 27 - FINANCIAL SUPPLEMENT to Annual Report on Form 10-K for the Year Ended December 31, 1993 W. R. GRACE & CO. AND SUBSIDIARIES Index to Consolidated Financial Statements and Financial Statement Schedules and Exhibits ---------------------------------------------- PAGE ---- Report of Independent Accountants on Financial Statement Schedules. . Consent of Independent Accountants. . . . . . . . . . . . . . . . . . Report of Independent Accountants . . . . . . . . . . . . . . . . . . Consolidated Statement of Operations for the three years in the period ended December 31, 1993 . . . . . . . . . . . . . . . Consolidated Statement of Cash Flows for the three years in the period ended December 31, 1993 . . . . . . . . . . . . . . . Consolidated Balance Sheet as at December 31, 1993 and 1992 . . . . . Consolidated Statement of Shareholders' Equity for the three years in the period ended December 31, 1993 . . . . . . . . Notes to Consolidated Financial Statements. . . . . . . . . . . . . . -F-24 Quarterly Summary - Unaudited . . . . . . . . . . . . . . . . . . . . Quarterly Statistics. . . . . . . . . . . . . . . . . . . . . . . . . Worldwide Operations. . . . . . . . . . . . . . . . . . . . . . . . . Capital Expenditures, Net Fixed Assets and Depreciation and Lease Amortization . . . . . . . . . . . . . . . . . . . . . Financial Summary . . . . . . . . . . . . . . . . . . . . . . . . . . Management's Discussion and Analysis of Results of Operations and Financial Condition. . . . . . . . . . . . . . . . . . . Financial Statement Schedules Schedule II - Amounts receivable from officers and employees exceeding $100,000 . . . . Schedule V - Property, plant and equipment . . . . . . . Schedule VI - Accumulated depreciation, depletion and amortization of property, plant and equipment . . . . . . . . . . . . . . . Schedule VIII - Valuation and qualifying account and reserves . . . . . . . . . . . . . . . Schedule IX - Short-term borrowings . . . . . . . . . . . Schedule X - Supplementary income statement information Exhibit 11: Weighted Average Number of Shares and Earnings Used in Per Share Computations . . . . . . . . . . . . . . . . . . . Exhibit 12: Computation of Ratio of Earnings to Fixed Charges and Combined Fixed Charges and Preferred Stock Dividends . . . . The financial data listed above appearing in this Financial Supplement are incorporated by reference herein. The Financial Statement Schedules should be read in conjunction with the Consolidated Financial Statements and Notes thereto. Financial statements of 50%- or less-owned persons and other persons accounted for by the equity method have been omitted as provided in Rule 3-09 of Securities and Exchange Commission Regulation S-X. Financial Statement Schedules not included have been omitted because they are not applicable or the required information is shown in the Consolidated Financial Statements or Notes thereto. REPORT OF INDEPENDENT ACCOUNTANTS ON FINANCIAL STATEMENT SCHEDULES To the Shareholders and Board of Directors of W. R. Grace & Co. Our audits of the consolidated financial statements referred to in our report dated February 8, 1994 appearing on page 25 of the 1993 Annual Report to Shareholders of W. R. Grace & Co. (which report and consolidated financial statements are included in this Annual Report on Form 10-K) also included an audit of the Financial Statement Schedules listed on page in the Index to Consolidated Financial Statements and Financial Statement Schedules and Exhibits of this Form 10-K. In our opinion, these Financial Statement Schedules present fairly, in all material respects, the information set forth therein when read in conjunction with the related consolidated financial statements. PRICE WATERHOUSE New York, New York February 8, 1994 CONSENT OF INDEPENDENT ACCOUNTANTS We hereby consent to the incorporation by reference in the Pros- pectuses constituting parts of the Registration Statements on Form S-3 (Nos. 33-51041, 33-50983 and 33-25962) and Form S-8 (Nos. 33-7504, 33-15182 and 33-27960) of W. R. Grace & Co. of our report dated February 8, 1994 appearing on page 25 of the 1993 Annual Report to Shareholders, which report is included at page of this Report on Form 10-K. We also consent to the inclusion in this Report of our report on the Financial Statement Schedules, which appears above. PRICE WATERHOUSE New York, New York March 28, 1994 MANAGEMENT'S RESPONSIBILITY FOR FINANCIAL REPORTING Management is responsible for the preparation, as well as the integrity and objectivity, of the consolidated financial statements and other financial information included in this report. Such financial information has been prepared in conformity with generally accepted accounting principles and accordingly includes certain amounts that represent management's best estimates and judgments. For many years, management has maintained internal control systems to assist it in fulfilling its responsibility for financial reporting, including careful selection of personnel, segregation of duties, formal business, accounting and reporting policies and procedures and an extensive internal audit function. While no system can ensure elimination of all errors and irregularities, Grace's systems, which are reviewed and modified in response to changing conditions, have been designed to provide reasonable assurance that assets are safeguarded, policies and procedures are followed and transactions are properly executed and reported. The concept of reasonable assurance is based on the recognition that there are limitations in all systems and that the cost of such systems should not exceed the benefits to be derived. The Audit Committee of the Board of Directors, which is comprised of directors who are neither officers nor employees of nor consultants to Grace, meets regularly with Grace's senior financial personnel, internal auditors and independent accountants to review audit plans and results as well as the actions taken by management in discharging its responsibilities for accounting, financial reporting and internal control systems. The Audit Committee reports its findings and also recommends the selection of independent accountants to the Board of Directors. Grace's management, internal auditors and independent accountants have direct and confidential access to the Audit Committee at all times. The independent accountants are engaged to conduct audits of and render a report on the consolidated financial statements in accordance with generally accepted auditing standards. These standards include a review of the systems of internal controls and tests of transactions to the extent considered necessary by the independent accountants for purposes of supporting their opinion as set forth in their report. B. J. Smith Executive Vice President and Chief Financial Officer REPORT OF INDEPENDENT ACCOUNTANTS PRICE WATERHOUSE February 8, 1994 1177 Avenue of the Americas New York, NY 10036 TO THE SHAREHOLDERS AND BOARD OF DIRECTORS OF W. R. GRACE & CO. In our opinion, the consolidated financial statements appearing on pages through of this report present fairly, in all material respects, the financial position of W. R. Grace & Co. and subsidiaries at December 31, 1993 and 1992, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 1993, in conformity with generally accepted accounting principles. These financial statements are the responsibility of the Company's management; our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits of these statements in accordance with generally accepted auditing standards which require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for the opinion expressed above. As discussed in Notes 5 and 16, the Company adopted new accounting standards for income taxes and postretirement benefits in 1992. CONSOLIDATED FINANCIAL STATEMENTS - ------------------------------------------------------------------------------- W. R. GRACE & CO. AND SUBSIDIARIES CONSOLIDATED STATEMENT OF OPERATIONS - ------------------------------------------------------------------------------- CONSOLIDATED STATEMENT OF CASH FLOWS - ------------------------------------------------------------------------------- CONSOLIDATED BALANCE SHEET - ------------------------------------------------------------------------------- - ------------------------------------------------------------------------------- THE NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, PAGES TO, ARE INTEGRAL PARTS OF THESE STATEMENTS. CONSOLIDATED STATEMENT OF SHAREHOLDERS' EQUITY - ------------------------------------------------------------------------------- - ------------------------------------------------------------------------------- THE NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, PAGES TO, ARE INTEGRAL PARTS OF THESE STATEMENTS. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - ------------------------------------------------------------------------------- - ------------------------------------------------------------------------------- DOLLARS IN MILLIONS, EXCEPT PER SHARE AMOUNTS - ------------------------------------------------------------------------------- 1. SUMMARY OF SIGNIFICANT ACCOUNTING AND FINANCIAL REPORTING POLICIES - ------------------------------------------------------------------------------- PRINCIPLES OF CONSOLIDATION The consolidated financial statements include the accounts of W. R. Grace & Co. and all majority-owned companies (collectively Grace). Intercompany transactions and balances are eliminated in consolidation. Investments in affiliated companies (20% - 50% owned) are accounted for under the equity method. RECLASSIFICATIONS Certain amounts in the prior years' consolidated financial statements have been reclassified to conform to the current year's presentation and as required with respect to discontinued operations. CASH EQUIVALENTS Cash equivalents consist of highly liquid instruments with maturities of three months or less when purchased. The recorded amount approximates fair value because of the short maturities of these investments. INVENTORIES Inventories are stated at the lower of cost or market. Due to the diversified nature of Grace's operations, several methods of determining cost are used, including first-in/first-out, average and, for substantially all U.S. chemical inventories, last-in/first-out. Market value for raw and packaging materials is based on current cost and, for other inventory classifications, on net realizable value. PROPERTIES AND EQUIPMENT Properties and equipment are stated at the lower of cost or net realizable value. Depreciation of properties and equipment is generally computed using the straight-line method over the estimated useful lives of the assets. Interest is capitalized in connection with major project expenditures and amortized, generally on a straight-line basis, over the estimated useful lives of the assets. Fully depreciated assets are retained in properties and equipment and related accumulated depreciation accounts until they are removed from service. In the case of disposals, assets and related depreciation are removed from the accounts and the net amount, less any proceeds from disposal, is charged or credited to income. GOODWILL AND OTHER AMORTIZATION Goodwill arises from certain purchase transactions and is amortized using the straight-line method over appropriate periods not exceeding 40 years. Patient relationships (see Note 7) are amortized using the straight-line method over 17 years. INCOME TAXES Effective January 1, 1992, Grace adopted Statement of Financial Accounting Standards (SFAS) No. 109, "Accounting for Income Taxes." The Statement requires the use of an asset and liability approach for the accounting and financial reporting of income taxes. FOREIGN CURRENCY TRANSLATION Foreign currency transactions and financial statements (except for those relating to countries with highly inflationary economies) are translated into U.S. dollars at current exchange rates, except that revenues, costs and expenses are translated at average exchange rates during each reporting period. The financial statements of subsidiaries located in countries with highly inflationary economies must be remeasured as if the functional currency were the U.S. dollar. The remeasurement creates translation adjustments that are reflected in net income. The allocation for income taxes included in the translation adjustments account in shareholders' equity was not significant. EARNINGS PER SHARE Primary earnings per share are computed on the basis of the weighted average number of common shares outstanding. Fully diluted earnings per share assume the conversion of convertible debentures (with an increase in net income for the after-tax interest savings) and the issuance of common stock equivalents related to stock options. FINANCIAL INSTRUMENTS Grace enters into interest rate swaps, options and caps, and foreign currency contracts to manage exposure to fluctuations in interest and foreign currency exchange rates. The differentials paid or received on interest rate agreements are accrued and recognized as adjustments to interest expense; gains and losses realized upon settlement of these agreements are deferred and amortized to interest expense over a period relevant to the agreement if the underlying hedged instrument remains outstanding, or immediately if the underlying hedged instrument is settled. Premiums paid on caps are amortized to interest expense over the term of the cap. Gains and losses on foreign currency contracts offset gains and losses resulting from the underlying transactions. Gains and losses on contracts that hedge specific foreign currency commitments are deferred and recognized in net income in the period in which the transaction is consummated. Gains and losses on contracts that hedge net investments in foreign subsidiaries are recognized in the cumulative translation adjustments account in shareholders' equity. - ------------------------------------------------------------------------------- 2. ASBESTOS AND RELATED INSURANCE LITIGATION - ------------------------------------------------------------------------------- Grace is a defendant in lawsuits relating to previously sold asbestos-containing products and anticipates that it will be named as a defendant in additional asbestos- related lawsuits in the future. At December 31, 1993, Grace was a defendant in approximately 38,100 asbestos- related lawsuits representing approximately 56,700 claims (versus approximately 30,900 lawsuits and 53,000 claims at December 31, 1992). Of the lawsuits pending at December 31, 1993, 92 (105 at December 31, 1992) involved claims for property damage allegedly caused by the use of asbestos-containing materials in the construction of buildings. The plaintiffs in these lawsuits generally seek, among other things, to have the defendants absorb the cost of removing, containing or repairing the asbestos- containing materials in the affected buildings. The remaining asbestos-related lawsuits involved claims for personal injury. In most of these lawsuits, Grace is one of many defendants. PROPERTY DAMAGE LITIGATION Through December 31, 1993, 120 asbestos property damage cases had been dismissed with respect to Grace without payment of any damages or settlement amounts; judgments were entered in favor of Grace in twelve cases; in six cases (four of which are on appeal), Grace was held liable for a total of $68.3; and 131 property damage suits and claims had been settled by Grace for a total of $300.0. Grace has recorded a receivable for the insurance proceeds it expects to receive in connection with these adverse verdicts and settlements, as well as for defense costs initially paid by Grace. (See "Insurance Litigation" below.) On September 1, 1993, the U.S. Court of Appeals for the Second Circuit issued a decision regarding the availability of insurance coverage with respect to Grace's asbestos property damage litigation and claims. In January 1994, the Court granted Grace's petition for a re- hearing concerning such decision. Included in the asbestos property damage lawsuits pending against Grace and others at year-end 1993 are the following purported class actions: (1) a Pennsylvania state court action, certified in 1992, covering all commercial buildings in the U.S. leased in whole or in part to the U. S. government on or after May 30, 1986; (2) an action, certified by the U.S. Court of Appeals for the Fourth Circuit in September 1993 and pending in a U.S. District Court in South Carolina, covering all public and private colleges and universities in the U. S. whose buildings contain asbestos materials; (3) an action, brought in 1983 in a U.S. District Court in Pennsylvania, on behalf of all public and private elementary and secondary schools in the U.S. that contain asbestos materials, which has been scheduled for trial in late 1994 on a limited number of issues; and (4) an action filed in a South Carolina state court in 1992 on behalf of all entities that own, in whole or in part, any building containing asbestos materials manufactured by Grace or one of the other named defendants, other than buildings subject to the class action lawsuits described above, as well as any building owned by the federal or any state government. PERSONAL INJURY LITIGATION Through December 31, 1993, approximately 7,000 asbestos personal injury lawsuits involving 17,900 claims had been dismissed with respect to Grace without payment of any damages or settlement amounts (primarily on the basis that Grace products were not involved), and approximately 11,300 such suits involving 13,400 claims had been settled for a total of $52.2. In January 1993, the U.S. District Court for the Eastern District of Pennsylvania conditionally certified a class of all future asbestos personal injury claimants, including individuals who have been occupationally exposed to asbestos-containing materials but who do not presently allege asbestos-related injury. Although Grace is not among the defendants named in the class action complaint, dissemination of the required class notice may generate additional litigation against Grace. RANGE OF POTENTIAL EXPOSURE Although personal injury cases are generally similar to each other (differing only in the type of asbestos-related illness allegedly suffered by the plaintiff), each property damage case is unique in that building type, size and utilization and difficulty of abatement, if necessary, vary from structure to structure; thus, the amounts involved in prior dispositions of property damage cases are not necessarily indicative of the amounts that may be required to dispose of such cases in the future. In addition, in property damage cases, information regarding product identification on a building-by-building basis (I.E., whether or not Grace products were actually used in the construction of the building), the age, type, size and use of the building, the jurisdictional history of prior cases and the court in which the case is pending provide the only meaningful guidance as to potential future costs. However, much of this information is not yet available in a majority of the property damage cases currently pending against Grace. Accordingly, estimates of future costs to dispose of these cases are, in most instances, based on incomplete information, as well as assumptions that may not be accurate. Further, the filing of the class actions and uncertainty with respect to the class certification in the national elementary and secondary schools class action (see "Property Damage Litigation" above) make it more difficult to reliably predict the costs Grace will incur in disposing of asbestos-related litigation. Subject to the preceding qualifications (which Grace believes to be significant), Grace has attempted to determine its future costs to dispose of this litigation and has concluded that it is probable that the personal injury and property damage cases pending at December 31, 1993 can be disposed of for a total amount estimated at $813.7 (inclusive of legal fees and expenses), of which Grace has recorded $713.7 as a noncurrent liability and $100.0 as a current liability. This compares to the estimated liability (current and noncurrent) of $848.0 at September 30, 1993, reflecting payments made in the fourth quarter of 1993. In addition, Grace has recorded a receivable of $962.3 for the insurance proceeds it expects to receive in reimbursement for prior payments and estimated future payments to dispose of asbestos- related litigation. This compares to the receivable of $644.0 at September 30, 1993, which reflected a $300.0 after-tax provision recorded in the third quarter of 1993 related to the Second Circuit Court of Appeals decision, while the fourth quarter 1993 activity included the partial reversal of such provision, as well as insurance proceeds received during the quarter. (See "Insurance Litigation" below.) Grace has also settled coverage disputes with certain insurance carriers. These settlements provide for future payments of $114.0 and have been recorded as notes receivable. Further, Grace continues to seek to recover the balance of the payments it has made with respect to asbestos-related litigation from its excess insurers and from insurance companies that sold insurance policies to predecessor companies of Grace, as discussed below. INSURANCE LITIGATION Grace's ultimate exposure in respect of its asbestos- related lawsuits and claims will depend on the extent to which its insurance will cover damages for which it may be held liable, amounts paid in settlement and litigation costs. In March 1991, the U. S. District Court for the Southern District of New York held that Grace's primary insurance carriers are obligated to defend and indemnify Grace with respect to damages (other than certain punitive damages), settlement amounts and litigation costs in connection with both personal injury and property damage asbestos claims. The court held that coverage for asbestos property damage is triggered by the "discovery of damage" during the policy period. On September 1, 1993, the U.S. Court of Appeals for the Second Circuit issued a decision regarding the availability of insurance coverage with respect to Grace's asbestos litigation and claims. The Court of Appeals reversed the District Court's ruling as to a "discovery of damage" trigger for asbestos property damage claims and instead adopted a trigger based on the date of installation of asbestos-containing materials. As a result of this decision, Grace recorded an after-tax provision of $300.0 during the third quarter of 1993 to reflect the reduction in insurance coverage for its asbestos property damage lawsuits and claims. In January 1994, the U.S. Court of Appeals for the Second Circuit granted Grace's petition for a re-hearing concerning the September 1, 1993 decision. In view of the Court's action, during the fourth quarter of 1993, Grace reversed $200.0 of the after-tax provision recorded in the third quarter. In December 1991, the Circuit Court for Jackson County, Mississippi held that Grace's primary and excess insurance carriers are obligated to defend and indemnify Grace, holding that for the purposes of insurance coverage, damage to buildings from asbestos-containing products occurs at the time such products are put in place and that the damage continues as long as the building contains the products (a "continuous trigger"). A similar decision was rendered by a Minnesota state court in November 1992. In 1993, Grace received $74.6 under settlements with insurance carriers, in reimbursement for monies previously expended by Grace in connection with asbestos-related litigation ; as mentioned above, these settlements also provide for future reimbursements of $114.0. In early 1994, Grace settled with two additional insurance carriers and received approximately $88.8 under such settlements. Prior to 1993, Grace received payments totalling $97.7 from insurance carriers, the majority of which represented the aggregate remaining obligation owed to Grace by those carriers for primary level insurance coverage written by them for the period June 30, 1962 through June 30, 1987. Grace continues to be involved in litigation with certain of its insurance carriers, including an affiliated group of carriers that had agreed to a settlement and had made a series of payments under that agreement in 1993. The group of carriers subsequently notified Grace that it would no longer honor the agreement (which had not been executed) due to the September 1, 1993 U.S. Court of Appeals decision discussed above. Grace believes that the settlement agreement (which involves approximately $200.0 of the asbestos-related receivable of $962.3 at December 31, 1993) is binding and initiated action to enforce the settlement agreement. In January 1994, the U.S. District Court for the Eastern District of Texas held the agreement to be enforceable. The affiliated group of carriers is expected to appeal this ruling to the U.S. Court of Appeals for the Fifth Circuit. For the period October 20, 1962 through June 30, 1985--the most relevant period for asbestos-related litigation--Grace purchased, on an annual basis, as much as eight levels of excess insurance coverage. In general, excess policies provide that when claims paid exhaust coverage at one level, the insured may seek payment from the carriers at the next higher level. For that 23-year period, the first six levels of excess insurance available from insurance companies that Grace believes to be solvent (based primarily upon reports from a leading independent insurance rating service) provide coverage in excess of $1.4 billion. If, however, the amount available in the first six levels should prove to be insufficient, Grace has substantial additional coverage available in its two remaining levels of excess coverage. In Grace's opinion, it is probable that recoveries from its excess insurance coverage will be available to satisfy Grace's asbestos- related exposure after giving effect to the provision recorded in 1993. Consequently, Grace believes that the resolution of its asbestos-related litigation will not have a material effect on its consolidated financial position or results of operations. - ------------------------------------------------------------------------------- 3. ACQUISITIONS, DIVESTMENTS AND STRATEGIC RESTRUCTURING - ------------------------------------------------------------------------------- ACQUISITIONS Businesses acquired in 1993 consisted primarily of health care and water treatment businesses. Grace acquired Home Intensive Care, Inc. in the second quarter of 1993 for approximately $129.0 in cash (inclusive of related costs) and acquired other health care businesses during 1993 for an aggregate of approximately $115.0 in cash and $3.8 in common stock. Grace also acquired Latin America's largest water treatment business in the first quarter of 1993 for approximately $57.6 in cash. In July 1992, Grace completed the purchase of the common stock of Grace Energy Corporation (Grace Energy) not owned by Grace for $77.3 in cash. See Note 6 for a discussion of 1993 divestment activity with respect to Grace Energy's businesses. During 1992, Grace continued to expand its health care operations through the acquisition of several businesses and facilities for consideration totalling $44.2 in cash. In 1991, Grace purchased the 25% minority interest in Grace Cocoa for $74.6 in cash and purchased an initial 47% common equity interest in a health care service company. In addition, Grace Energy purchased its former partner's 50% interest in Colowyo Coal Company (Colowyo) for $34.2 in cash plus related debt repayments. All of the above transactions were accounted for as purchases, and the results of operations of the acquired businesses are included in the consolidated financial statements from the respective dates of acquisition. DIVESTMENTS In 1993, Grace completed the sale of substantially all of the oil and gas operations of Grace Energy, along with certain corporate investments; see Note 6 for further information. Other non-core businesses divested during 1993 included a 50% interest in a Japanese chemical business and a food industry hygiene services business for approximately $31.4 and $11.2, respectively. In December 1992, Grace sold its organic chemicals business and related net assets for approximately $100.0 in cash plus non-voting preferred stock of the buyer. In March 1992, Grace sold its book, video and software distribution business (Grace Distribution), which was classified as a discontinued operation in the fourth quarter of 1991; see Note 6 for further information. STRATEGIC RESTRUCTURING The 1991 net gain on strategic restructuring of $6.1 (see Note 4) includes gains of $108.8, inclusive of cumulative translation gains of $37.9, on the disposition of certain non-core businesses and investments. Offsetting these gains were expenses related to the relocation of Grace's corporate headquarters from New York to Florida, provisions for litigation and certain environmental and plant closure expenses and a reserve for the costs of restructuring activities. - ------------------------------------------------------------------------------- 4. OTHER INCOME - ------------------------------------------------------------------------------- Other, net in 1993 represents principally the gain on the sale of a 50% interest in a Japanese chemical business (see Note 3), offset by provisions for environmental and plant closure expenses. Interest income in 1993 includes $21.9 relating to the settlement of prior years' Federal income tax returns. - ------------------------------------------------------------------------------- 5. INCOME TAXES - ------------------------------------------------------------------------------- Effective January 1, 1992, Grace adopted SFAS No. 109, "Accounting for Income Taxes," which applies an asset and liability approach requiring the recognition of deferred tax assets and liabilities with respect to the expected future tax consequences of events that have been recorded in the consolidated financial statements and tax returns. If it is more likely than not that all or a portion of a deferred tax asset will not be realized, a valuation allowance must be recognized. As permitted under SFAS No. 109, Grace elected not to restate prior periods' consolidated financial statements to give effect to SFAS No. 109. Excluding the deferred tax benefit recognized upon the adoption of SFAS No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions," the effect of the adoption of SFAS No. 109 on Grace's 1992 financial statements was not material. In the third quarter of 1993, Grace recorded the effects of the Omnibus Budget Reconciliation Act of 1993 (OBRA), which was enacted in August 1993. Among other things, OBRA increased the highest U.S. Federal corporate tax rate to 35%, effective January 1, 1993. However, neither this increase in the U.S. Federal corporate tax rate (from 34%), nor the other provisions of OBRA, had a material effect on Grace's results of operations. The components of income/(loss) from continuing operations before income taxes are as follows: The provision/(benefit) for income taxes allocated to continuing operations consisted of: - ------------------------------------------------------------------------------- At December 31, 1993 and 1992, the deferred tax assets and liabilities consisted of the following items: In connection with the adoption of SFAS No. 109 effective January 1, 1992, Grace recognized a valuation allowance of $88.4, which was adjusted in 1992 and 1993. The valuation allowance relates to the uncertainty as to the realization of certain deferred tax assets, including U.S. tax credit carryforwards, state and local net operating loss carryforwards and net deferred tax assets, and net operating loss carryforwards in certain foreign jurisdictions. Based upon anticipated future results, Grace has concluded, after consideration of the valuation allowance, that it is more likely than not that the net deferred tax asset balance will be realized. The items giving rise to deferred tax assets and liabilities at December 31, 1991 included depreciation, research and development costs that have been capitalized for tax purposes, and other items the tax treatment of which does not conform to their treatment for financial statement purposes. At December 31, 1993, there are $59.9 of tax credit carryforwards with expiration periods through 1998 and $25.0 of tax credit carryforwards with no expiration period. Additionally, there are state and local and foreign net operating loss carryforwards with a tax effect of $47.1 and various expiration periods. The U.S. Federal corporate tax rate reconciles to the effective tax rate for continuing operations as follows: U.S. and foreign taxes have not been provided on approximately $444.0 of undistributed earnings of certain foreign subsidiaries, as such earnings are being retained indefinitely by such subsidiaries for reinvestment. The distribution of these earnings would result in additional foreign withholding taxes of approximately $26.3 and additional U.S. Federal income taxes to the extent they are not offset by foreign tax credits, but it is not practicable to estimate the total tax liability that would be incurred upon such a distribution. - ------------------------------------------------------------------------------- 6. DISCONTINUED OPERATIONS - ------------------------------------------------------------------------------- COCOA, BATTERY SEPARATORS AND ENGINEERED MATERIALS AND SYSTEMS In the second quarter of 1993, Grace classified as discontinued operations its cocoa and battery separators businesses; certain engineered materials businesses, principally its printing products, electromagnetic radiation control and material technology businesses (collectively EMS); and other non-core businesses pending their divestment. A provision of $105.0 (net of an applicable tax benefit of $22.3) was recorded in the second quarter of 1993, which includes the loss expected on the divestment of these businesses, their anticipated net operating results and a $15.7 provision for interest expense allocated to the discontinued operations through their expected dates of divestment. GRACE ENERGY During the first and second quarters of 1993, Grace sold substantially all the oil and gas operations of Grace Energy, which was classified as a discontinued operation in 1992, for net cash proceeds of $386.0, which was consistent with prior estimates. The loss from discontinued operations in 1992 included a provision of $155.0 (net of an applicable tax benefit of $81.8) relating to the losses expected on the divestment of Grace Energy's operations. Grace is pursuing the divestment of Colowyo, a partnership wholly owned by Grace Energy, and expects to conclude such a transaction in 1994. Grace is in the process of liquidating the remaining miscellaneous assets and liabilities of Grace Energy's oil and gas operations. GRACE DISTRIBUTION AND OTHER As mentioned above, in the second quarter of 1993, Grace classified as discontinued operations certain non-core businesses, which include its animal genetics and Caribbean fertilizer operations, the operating results and net assets of which are included under "Other" in the following tables. In 1992, Grace classified as discontinued operations certain corporate investments, including Grace's minority interests in Canonie Environmental Services Corp. and Grace-Sierra Horticultural Products Company. In December 1993, Grace completed the sale of these minority interests for total proceeds of $41.3. Grace is pursuing the sale of the remaining non-core businesses and corporate investments and expects to conclude such transactions in 1994. The loss from discontinued operations in 1992 included an after-tax provision of $12.1 relating to the loss associated with the sale of Grace's remaining Mexican- style restaurant operation. In March 1992, Grace completed the sale of Grace Distribution for $97.8 in cash and notes. Operating results of Grace's discontinued operations subsequent to their classification as such have been consistent with amounts originally estimated and are recorded against established reserves. Operating results prior to classification as discontinued operations and sales and revenues for the three years ended December 31, 1993, 1992 and 1991 were as follows: For financial reporting purposes, the assets, liabilities, results of operations and cash flows of Grace Cocoa Associates, L.P. (LP) are included in Grace's consolidated financial statements as a component of discontinued operations, and the outside investors' interest in LP is reflected as a minority interest in the Consolidated Balance Sheet. See Note 12 for a further discussion of LP. Net assets of Grace's discontinued operations (excluding intercompany assets) at December 31, 1993 were as follows: - ------------------------------------------------------------------------------- 7. OTHER BALANCE SHEET ITEMS During 1993 and 1992, Grace entered into agreements to sell up to $270.0 and $345.0, respectively, of interests in designated pools of trade receivables. At December 31, 1993 and 1992, $263.8 and $307.9, respectively, had been received pursuant to such sales, which amounts are reflected as reductions to trade accounts receivable. Included in the trade receivables sold at December 31, 1992 are $50.0 of trade receivables the sale of which has been reflected as a reduction in net assets of discontinued operations. Under the terms of these agreements, new interests in trade receivables are sold as collections reduce previously sold trade receivables. There is no recourse to Grace, nor is Grace required to repurchase any of the trade receivables in the pools; if certain trade receivables in the pools prove to be uncollectible, other trade receivables are substituted (to the extent available). Costs related to these sales are expensed as incurred. There were no gains or losses on these transactions. Inventories valued at LIFO cost comprised 29.0% and 22.9% of inventories at December 31, 1993 and 1992, respectively. Liquidation of prior years' LIFO inventory layers in 1993, 1992 and 1991 did not materially affect cost of goods sold in any of these years. - ------------------------------------------------------------------------------- 8. PROPERTIES AND EQUIPMENT - ------------------------------------------------------------------------------- Interest costs have been incurred in connection with the financing of certain assets prior to placing them in service. Interest costs capitalized in 1993, 1992 and 1991 were $7.4, $20.4 and $21.4, respectively. Depreciation and amortization expense relating to properties and equipment amounted to $189.2, $194.9 and $203.4 in 1993, 1992 and 1991, respectively. Grace's rental expense for operating leases amounted to $63.8, $80.0 and $67.7 in 1993, 1992 and 1991, respectively. See Note 11 for information regarding contingent rentals. At December 31, 1993, minimum future payments for operating leases were: - ------------------------------------------------------------------------------- The above minimum lease payments include sublease income of $12.1 per year for 1994 through 1998 and a total of $53.6 in later years. In 1992, a critical raw material supplier to Grace's fumed silica plant in Belgium was effectively denied a previously promised permit for by-product disposal, resulting in the shutdown of the supplier's plant. As a result, the continued operation of Grace's plant would have required Grace to obtain other suppliers and/or take other actions requiring significant additional investment. Consequently, Grace closed its plant and in the third quarter of 1992 recorded a one-time provision of $140.0, reflecting the entire net book value of the facility and certain additional expenses. This provision could be offset in part by recoveries from litigation, the renegotiation of certain contracts relating to the plant and/or the sale of the plant. As of December 31, 1993, Grace substantially completed the shutdown of this facility and believes the amounts recorded are adequate to cover remaining contingencies. - ------------------------------------------------------------------------------- 9. DEBT Payment of substantially all of Grace's borrowings may be accelerated, and its principal borrowing agreements terminated, upon the occurrence of a default under certain other Grace borrowings. Scheduled maturities of debt outstanding at December 31, 1993 are: 1994--$9.1; 1995--$166.3; 1996--$13.9; 1997--$6.1, and 1998--$4.4. Interest expense for 1993, 1992 and 1991 amounted to $81.5, $90.0 and $115.4, respectively. Interest payments made in 1993, 1992 and 1991 amounted to $102.5, $166.8 and $263.9, respectively. By managing its interest rate exposure through interest rate derivative agreements, Grace reduced interest expense for the years ended December 31, 1993 and 1992 by $20.3 and $4.7, respectively. See Note 10 for a further discussion of interest rate hedge agreements. During the fourth quarter of 1993, Grace filed a registration statement with the Securities and Exchange Commission covering $750.0 of debt and/or equity securities that may be sold from time to time; the registration statement became effective in January 1994. - ------------------------------------------------------------------------------- 10. FINANCIAL INSTRUMENTS - ------------------------------------------------------------------------------- INTEREST RATE SWAPS Grace enters into interest rate hedge agreements to manage interest costs and risks associated with changing interest rates; most of these agreements effectively convert underlying fixed-rate debt into variable-rate debt based on LIBOR. At December 31, 1993 and 1992, the notional principal amount of these agreements totalled $1,250.0 and $1,035.0, respectively. At December 31, 1993, Grace would have been required to pay $25.8 to settle these agreements, representing the excess of carrying value over fair value, based on estimates received from financial institutions. The fair value at December 31, 1992 was not material. Due to previously settled agreements, Grace has unamortized gains of $56.3 and $4.9 as of December 31, 1993 and 1992, respectively, which are reflected as adjustments to interest expense over appropriate periods relevant to the respective financial instruments. FOREIGN CURRENCY CONTRACTS Grace enters into a variety of short-term currency swaps, foreign exchange contracts and options to manage its exposure to fluctuations in foreign currency exchange rates. These contracts generally involve the exchange of one currency for another at a future date. At December 31, 1993, Grace had a notional principal amount of approximately $34.9 in contracts to buy or sell foreign currency in the future. The carrying value at December 31, 1993 and 1992, which approximated fair value based on exchange rates at December 31, 1993 and 1992, was not significant. OTHER FINANCIAL INSTRUMENTS At December 31, 1993 and 1992, the carrying value of financial instruments such as cash, short-term investments, trade receivables and payables and short- term debt approximated their fair values, based on the short-term maturities of these instruments. Additionally, the carrying value of both long-term investments and receivables approximated fair values. Fair value is determined based on expected future cash flows, discounted at market interest rates, and other appropriate valuation methodologies. At December 31, 1993 and 1992, the fair value of long-term debt was $1,216.4 and $1,400.9, respectively. Both periods include approximately $510.0 of borrowings supported by the revolver agreement, for which the carrying value approximated fair value. The fair value of debt is determined by obtaining quotes from financial institutions. Exposure to market risk on interest rate and foreign currency contracts results from fluctuations in floating rate indices and currency rates, respectively, during the periods in which the contracts are outstanding. The counterparties to Grace's interest rate hedge agreements and currency exchange contracts consist of a diversified group of major financial institutions. Grace is exposed to credit risk to the extent of nonperformance by these counterparties; however, management believes the risk of incurring losses due to credit risk is remote. The notional amount of the instruments discussed above reflected the extent of involvement in the instruments, but did not represent its exposure to market risk. Considerable judgment is required to develop the estimates of fair value; thus, the estimates provided above are not necessarily indicative of the amounts that could be realized in a current market exchange. - ------------------------------------------------------------------------------- 11. COMMITMENTS AND CONTINGENT LIABILITIES - ------------------------------------------------------------------------------- Grace is the named tenant or guarantor with respect to certain lease obligations of previously divested businesses. The leases, some of which extend to 2015, have future minimum lease payments aggregating $68.4. Grace is also the named tenant or guarantor with respect to lease obligations having future minimum lease payments of $43.7, as to which Channel Home Centers, Inc., a previously divested business, has been released in bankruptcy; offsetting this is $39.7 of future minimum rental income from subtenants. Grace continues to attempt to sublease the remaining properties and believes its ultimate exposure is not material. Grace is the named tenant with respect to lease obligations with future minimum lease payments of $19.5 that have been assigned to Hermans, a previously divested business currently operating under Chapter 11 of the Federal Bankruptcy Code. Hermans has advised Grace that it intends to continue to occupy premises under leases with future minimum payments of $17.9 and is negotiating termination agreements as to the remainder. Grace believes its ultimate exposure under these leases is not material, as Hermans is performing on its current lease obligations and expects to emerge from bankruptcy as a viable company. Additionally, Grace is fully indemnified by other parties for any losses it may incur under these leases. In 1992 and 1993, Grace provided The Restaurant Enterprises Group, Inc. (REG) with various forms of financial support, including a letter of credit support facility to assist REG in meeting certain liquidity and other financial requirements. During 1993, REG was reorganized, and in January 1994 the letter of credit was canceled and Grace received $42.8 in exchange for all of the REG securities held by Grace. The reorganized REG (now named Family Restaurants, Inc.) has agreed to indemnify Grace with respect to leases entered into by REG's subsidiaries under which Grace remains contingently liable. At December 31, 1993, these leases have future minimum lease payments of $72.4. Grace believes any risk of loss from these contingent liabilities is remote. Grace is subject to loss contingencies resulting from environmental laws and regulations, which include obligations to remove or mitigate the effects on the environment of the disposal or release of certain wastes and other substances at various sites. Grace accrues for anticipated costs associated with investigatory and remediation efforts where an assessment has indicated that a loss is probable and can be reasonably estimated. At December 31, 1993, Grace's accrued liability for environmental remediation totalled approximately $160.0. The measurement of the liability is evaluated quarterly based on currently available information, including the progress of remedial investigation at each site, the current status of discussions with regulatory authorities regarding the method and extent of remediation at each site, and the extent of apportionment of costs among other potentially responsible parties. As some of these matters are decided (the outcome of which is subject to various uncertainties) and/or new sites are assessed and costs can be reasonably estimated, Grace will review and analyze the need for additional accruals. - ------------------------------------------------------------------------------- 12. Minority Interests - ------------------------------------------------------------------------------- In December 1992, LP, formerly a general partnership named Grace Cocoa that was wholly owned by two Grace entities, admitted two additional Grace entities as general partners and also admitted one new limited partner. As a result of the admission of these new partners, the total capital of LP increased to $1,430.5, which included a $300.0 cash contribution made by the new limited partner, $297.0 of which was funded by outside investors. LP's assets consist of Grace Cocoa's worldwide cocoa and chocolate business, long-term notes and demand loans due from various Grace entities, which are guaranteed by W. R. Grace & Co. and its principal operating subsidiary, and cash. The cash contribution from the new limited partner was initially lent by LP to the principal operating subsidiary of W. R. Grace & Co. and was used to retire certain domestic borrowings and for general corporate purposes. Four Grace entities serve as general partners of LP and own general partnership interests totalling 79.03% in LP; the new limited partner owns a 20.97% limited partner interest in LP. LP is a separate and distinct legal entity from each of the Grace entities and has separate assets, liabilities, business functions and operations. For financial reporting purposes, the assets, liabilities, results of operations and cash flows of LP are included in Grace's consolidated financial statements as a component of discontinued operations and the outside investors' interest in LP is reflected as a minority interest. - ------------------------------------------------------------------------------- 13. Shareholders' Equity - ------------------------------------------------------------------------------- The weighted average number of shares of common stock outstanding during 1993 was 91,461,000 (1992 -- 89,543,000; 1991 -- 87,236,000). W. R. Grace & Co. is authorized to issue 300,000,000 shares of common stock. Of the common stock unissued at December 31, 1993, approximately 8,767,000 shares may be issued or delivered upon the exercise of stock options or grant of share awards in connection with stock incentives such as stock options. In addition, at December 31, 1993, 102,232,000 shares were reserved in connection with Common Stock Purchase Rights (Rights). A Right is issued for each outstanding share of common stock; the Rights are not and will not become exercisable unless and until certain events occur, and at no time will the Rights have any voting power. Preferred stocks authorized, issued and outstanding are: Dividends paid on the preferred stocks amounted to $.5 in each of 1993, 1992 and 1991. The Certificate of Incorporation also authorizes 5,000,000 shares of Class C Preferred Stock, $1 par value, none of which has been issued. - ------------------------------------------------------------------------------- 14. Stock Incentive Plans - ------------------------------------------------------------------------------- - ------------------------------------------------------------------------------- At December 31, 1993, options covering 5,056,256 shares (1992 -- 4,025,840, 1991 -- 3,690,088) were exercisable and 1,804,122 shares (1992 -- 3,087,994, 1991 -- 4,637,368) were available for additional grants. In 1991, certain executive officers surrendered all or a portion of their outstanding stock options in exchange for shares of common stock equal in value to the excess of (1) the market value of the option shares at the date of surrender over (2) the purchase price of the option shares. The shares received upon surrender were subject to restrictions on transfer. The officers surrendering options generally were granted new options covering an equal number of shares with a purchase price equal to 110% of the fair market value of the common stock on the date of grant. Subject to certain exceptions, such options may not be exercised until 1996, at which time they become exercisable in five annual installments. - ------------------------------------------------------------------------------- 15. PENSION PLANS - ------------------------------------------------------------------------------- Grace maintains defined benefit pension plans covering employees of certain units who meet age and service requirements. Benefits are generally based on final average salary and years of service. Grace funds its U.S. pension plans in accordance with federal laws and regulations. Non-U.S. pension plans are funded under a variety of methods because of differing local laws and customs and therefore cannot be summarized. Approximately 55% of U.S. and non-U.S. plan assets at December 31, 1993 were common stocks, with the remainder primarily fixed income securities. Pension (benefit)/cost is comprised of the following components: - ------------------------------------------------------------------------------- - ------------------------------------------------------------------------------- The funded status of these plans was as follows: - ------------------------------------------------------------------------------- The following significant assumptions were used in 1993, 1992 and 1991: - ------------------------------------------------------------------------------- As a result of classifying certain operations as discontinued and divesting other operations, Grace recognized an increase in the net prepaid pension benefit of $6.2 and $10.9 in 1992 and 1991, respectively. In addition, Grace settled certain pension obligations of one of its non-U.S. plans, resulting in gains of $.6, $.7 and $11.8 in 1993, 1992 and 1991, respectively. Grace's Retirement Plan for Salaried Employees (Plan) contains provisions under which the Plan would automatically terminate in the event of a change in control of W. R. Grace & Co. and Plan benefits would be secured through the purchase of annuity contracts. Upon such termination, a portion of the Plan's excess assets would be placed in an irrevocable trust to fund various employee benefit plans and arrangements of Grace, and any balance would be returned to Grace. - ------------------------------------------------------------------------------- - ------------------------------------------------------------------------------- 16. Other Postretirement Benefit Plans - ------------------------------------------------------------------------------- Grace provides certain other postretirement health care and life insurance benefits for retired employees of specified U.S. units. These retiree medical and life insurance plans provide various levels of benefits to employees (depending on their date of hire) who retire from Grace after age 55 with at least 10 years of service. The plans are currently unfunded. Effective January 1, 1992, Grace adopted SFAS No. 106, which requires the accrual method of accounting for the future costs of postretirement health care and life insurance benefits over the employees' years of service. The "pay as you go" method of accounting, used prior to 1992, recognized these costs on a cash basis. The adoption of SFAS No. 106 on the immediate recognition basis, concurrent with the adoption of SFAS No. 109, resulted in a charge to 1992 earnings of $190.0, net of $98.0 of deferred income taxes. In addition, the application of SFAS No. 106 resulted in a decrease of $5.1 in 1992 after-tax earnings from continuing operations. Grace's cash flow, however, is unaffected by implementation of SFAS No. 106, as Grace continues to pay the costs of postretirement benefits as they are incurred. Included in noncurrent liabilities as of December 31, 1993 and 1992 are the following: Net periodic postretirement benefit cost for the years ended December 31, 1993 and 1992 is comprised of the following components: The cost of these benefits (cash basis) to Grace's continuing operations was approximately $5.6 for 1991. As a result of classifying certain operations as discontinued, Grace recognized reductions in the accrued postretirement benefit obligation of approximately $16.6 and $23.5 in 1993 and 1992, respectively, which are reflected in the reserve for discontinued operations. During 1992, Grace's retiree medical plans were amended to increase cost sharing by employees retiring after January 1, 1993. This amendment decreased the accumulated postretirement benefit obligation by $52.9 at December 31, 1993 and will be amortized over an average remaining future service life of approximately 13 years. Medical care cost trend rates were projected at 11.7% in 1993, declining to 5.0% through 2003 and remaining level thereafter. The effect of a one percentage point increase in each year's assumed medical care cost trend rate, holding all other assumptions constant, would be to increase the annual net periodic postretirement benefit cost by $1.6 and the accumulated postretirement benefit obligation by $16.5. The discount rates at December 31, 1993 and 1992 were 7.5% and 8.0%, respectively. In November 1992, the Financial Accounting Standards Board issued SFAS No. 112, "Employers' Accounting for Postemployment Benefits," which requires accrual accounting for non-accumulating postemployment benefits. Grace's primary postemployment obligation is for disabled workers' medical benefits. These are currently included in accrued postretirement costs under SFAS No. 106. The adoption of SFAS No. 112 is not expected to have a material effect on Grace's results of operations or financial position. - -------------------------------------------------------------------------------- 17. Industry and Geographic Segments - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- QUARTERLY SUMMARY UNAUDITED--DOLLARS IN MILLIONS, EXCEPT PER SHARE - -------------------------------------------------------------------------------- MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION REVIEW OF OPERATIONS OVERVIEW Sales and revenues increased 8% in 1993 over 1992, excluding businesses divested in 1992; including the divested businesses, 1993 sales and revenues increased by 2% as compared to 1992. Sales and revenues increased 9% in 1992 over 1991, excluding businesses sold in both years. In the third quarter of 1993, Grace recorded a special noncash after-tax charge of $300 million ($475 million pretax) to reflect a September 1, 1993 decision of the U.S. Court of Appeals for the Second Circuit, which had the effect of reducing Grace's insurance coverage for asbestos property damage lawsuits and claims. In the fourth quarter of 1993, Grace reversed $200 million of the after-tax provision ($316 million pretax) following the Court's decision to grant Grace's petition for a re-hearing concerning the September 1, 1993 decision; the remaining after-tax provision of $100 million ($159 million pretax) reflects anticipated additional legal expenses and other uncertainties related to Grace's asbestos lawsuits and claims. In the third quarter of 1992, Grace closed its Belgian fumed silica plant and recorded a one-time provision of $140 million, representing the entire net book value of the facility and certain additional expenses. Excluding the 1993 asbestos and 1992 fumed silica charges, income from continuing operations for 1993 increased 19%, to $234.4 million, over 1992 (including businesses divested in 1992). Income from continuing operations decreased by 2% in 1992 as compared to 1991 (excluding the provision relating to the fumed silica plant, but including businesses divested in both years). For all periods presented, the statement of operations has been restated to reflect the classification of certain businesses as discontinued operations, as discussed in Note 6 to the Consolidated Financial Statements. SPECIALTY CHEMICALS Including the results of chemical businesses divested in 1992, sales and revenues decreased by 5% in 1993 as compared to 1992, and operating income after taxes (operating income) decreased by 6% for 1993 versus 1992 (excluding the 1992 provision related to the fumed silica plant). The following discussion excludes sales and revenues and operating income of divested businesses and the fumed silica provision referred to above. Sales and revenues increased 3% in 1993 as compared to 1992, reflecting favorable volume and price/product mix variances estimated at 6% and 2%, respectively, offset by an unfavorable currency exchange variance estimated at 5%. Volume increases occurred in 1993 in packaging (due to improved sales of films and laminates), water treatment (reflecting the acquisition of Latin America's largest water treatment business in the first quarter of 1993), fluid cracking catalysts and silica products (reflecting improvements in market share and pricing) and construction products (reflecting the introduction of new concrete admixtures and stronger sales in waterproofing systems). Operating income was flat in 1993 compared to 1992. North American results significantly improved in 1993, as strong growth occurred in packaging, fluid cracking catalysts and silica products and construction products, due mainly to the volume increases noted above. European results for most product lines were adversely affected by continuing recessionary conditions, leading to reduced profitability; however, results for European fluid cracking catalysts and silica products improved, primarily due to increased volumes achieved following the withdrawal of certain competitors from this market in 1992. In Asia Pacific, favorable results were achieved, primarily in packaging and fluid cracking catalysts and silica products. In Latin America, results were down, primarily due to the costs of integrating the operations of the new water treatment business, partially offset by favorable results in packaging. Sales increased by 5% in 1992 compared to 1991, excluding from both periods the sales of chemical businesses divested in both years; sales were essentially flat including those businesses. The increase was primarily due to favorable volume, price/product mix and foreign currency exchange variances estimated at 3%, 1% and 1%, respectively. Volume increases occurred in most product lines, particularly packaging and fluid cracking catalysts and silica products. Operating income for 1992 decreased 5% over 1991, excluding the divested chemical businesses; operating income increased 3% including those businesses. North American results for most product lines improved in 1992, as strong growth was exhibited in packaging and fluid cracking catalysts and silica products, mainly due to strong volume increases. European results were adversely affected by recessionary conditions, leading to reduced profitability. However, favorable results were achieved in both Asia Pacific and Latin America for most product lines. HEALTH CARE Sales and revenues for 1993 increased by 19% over 1992, due to increases of 18%, 36% and 11%, respectively, in kidney dialysis services, home health care and medical products operations (including laboratory services). 1993 results for dialysis services and home health care include the results of Home Intensive Care, Inc., acquired in June 1993, as well as a number of smaller acquisitions during the year. The number of centers providing dialysis and related services increased 20%, from 419 at year-end 1992 to 501 at year-end 1993 (471 in the U.S. and Puerto Rico, 23 in Portugal, 4 in Spain, 2 in the Czech Republic and 1 in Argentina). Operating income in 1993 increased by 35% over 1992. The 1993 results for all health care businesses benefited from improvements in cost controls, operating efficiencies and/or capacity utilization, partially offset by the costs of improving and expanding quality assurance systems for medical products manufacturing (see below for further discussion). In addition, results for 1992 included costs related to previously reported long-term incentive arrangements with certain health care executives. It is unclear at this time whether and to what extent any of the currently proposed reforms in U.S. health care will affect Grace's health care operations. However, based on its knowledge and understanding of the health care industry in general and of other providers of kidney dialysis and infusion therapy, as well as on publicly available information, Grace believes that its health care operations are among the most cost-efficient in the industry. Sales and revenues of health care operations increased by 20%, to $1.3 billion, in 1992 as compared to 1991, reflecting improvements of 19%, 16% and 26%, respectively, in kidney dialysis services, home health care and medical products operations. Operating income for 1992 increased by 27% over 1991, reflecting the continued growth of all health care businesses, as well as improvements in operating efficiencies and capacity utilization. In 1993, the U.S. Food and Drug Administration (FDA) issued import alerts with respect to (1) hemodialysis bloodlines manufactured at the plant of National Medical Care, Inc. (NMC), Grace's principal health care subsidiary, located in Reynosa, Mexico and (2) hemodialyzers manufactured in NMC's Dublin, Ireland facility. Products subject to FDA import alerts may not enter the U.S. until the FDA approves the quality assurance systems of the facility at which such products are manufactured. In January 1994, NMC entered into a consent decree providing for the resumption of importation of bloodlines and hemodialyzers following certification by NMC that the relevant facility complies with FDA regulations and successful completion of an FDA inspection to verify such compliance. In accordance with the consent decree, NMC certified compliance to the FDA with respect to the Reynosa, Mexico facility in January 1994, and the FDA lifted the bloodline import alert in March 1994 following a thorough reinspection by the FDA and a commitment by NMC to finish certain studies by May 1994 and, in the interim, to perform additional product testing. Certification of compliance at the Dublin, Ireland facility is anticipated in the second quarter of 1994. The consent decree also requires NMC to certify and maintain compliance with applicable FDA device manufacturing laws and regulations at all of its U.S. manufacturing facilities. NMC has conducted a full review of its facilities and upgraded, as necessary, all of its quality assurance systems. No fines or penalties were imposed on NMC as a result of any of the FDA's actions relating to the import alerts or in connection with the consent decree. Neither the import alerts nor previously reported recalls of certain NMC products are expected to have a material effect on Grace's results of operations or financial position. STATEMENT OF OPERATIONS OTHER INCOME See Note 4 to the Consolidated Financial Statements for information relating to other income. INTEREST EXPENSE Interest expense decreased by 9% in 1993 versus 1992, primarily due to lower debt levels and lower interest rates, the use of financial instruments (see Note 10 to the Consolidated Financial Statements) and the replacement of certain fixed-rate debt with lower-cost floating-rate borrowings, partially offset by a reduction in interest allocated to discontinued operations and interest capitalized. See "Financial Condition: Liquidity and Capital Resources" below for information on borrowings. RESEARCH AND DEVELOPMENT EXPENSES Research and development (R&D) spending increased by 4% in 1993 versus 1992. R&D spending is now primarily directed toward Grace's core specialty chemicals and health care businesses. INCOME TAXES The effective tax rate was 39.2% in 1993 versus 43.1% in 1992, before giving effect to the 1992 provision of $51.9 million for a valuation allowance for deferred tax assets. The lower effective tax rate in 1993 resulted primarily from reductions in certain foreign tax rates and higher utilization of research and development and foreign tax credits, partially offset by tax costs associated with repatriating to the U.S. earnings of foreign subsidiaries. The valuation allowance for 1993 and 1992 relates to the uncertainty as to the realization of certain deferred tax assets, including U.S. tax credit carryforwards, state and local net operating loss carryforwards and net deferred tax assets, and net operating loss carryforwards in certain foreign jurisdictions. Based upon anticipated future results, the Company has concluded, after consideration of the valuation allowance, that it is more likely than not that the net deferred tax asset balance will be realized. In the third quarter of 1993, Grace recorded the effects of the Omnibus Budget Reconciliation Act of 1993 (OBRA), which was enacted in August 1993. Among other things, OBRA increased the highest U.S. Federal corporate tax rate to 35%, effective January 1, 1993. However, neither this increase in the U.S. Federal corporate tax rate (from 34%), nor the other provisions of OBRA, had a material effect on Grace's results of operations. The 1992 effective tax rate increased to 43.1% (before the above provision for the valuation allowance) as compared with 39.6% in 1991, largely due to the additional costs of repatriating to the U.S. a higher level of earnings of foreign subsidiaries and an increase in state income taxes. See Note 5 to the Consolidated Financial Statements for further information on income taxes. LOSS FROM DISCONTINUED OPERATIONS In 1993, Grace restated its financial statements to reflect the classification of certain businesses as discontinued operations. See Note 6 to the Consolidated Financial Statements for further information. FINANCIAL CONDITION LIQUIDITY AND CAPITAL RESOURCES During 1993, the net pretax cash flow provided by Grace's continuing operating activities was $301.6 million versus $358.9 million in 1992, primarily due to the use of $44.1 million of net cash to repurchase accounts receivable in 1993, as compared to the receipt of $96.8 million of net proceeds from the sale of accounts receivable in 1992, and a net cash outflow of $103.1 million relating to asbestos in 1993 (see below for further discussion), compared with a net cash outflow of $70.3 million in 1992. Also, in 1993 cash flow provided by operating activities includes $67.9 million in proceeds from the settlement of interest rate hedge agreements. After giving effect to discontinued operations and payments of income taxes, the net cash provided by operating activities was $243.1 million in 1993. Investing activities used $151.9 million of cash in 1993, largely reflecting capital expenditures and business acquisitions and investments, primarily in the health care and water treatment businesses. During 1993, Grace acquired 100% of the outstanding stock of Home Intensive Care, Inc. for approximately $129 million (inclusive of related costs). These investing activities were offset by net proceeds of $464.8 million from divestments (mainly those of Grace Energy's oil and gas operations). Management anticipates that the level of capital expenditures in 1994 will increase to approximately $350 million as compared to the $309.6 million of capital spending in 1993. Capital spending is expected to be concentrated on Grace's core businesses. Net cash used for financing activities in 1993 was $105.9 million, primarily reflecting the payment of $128.4 million of dividends. Total debt was approximately $1.7 billion at year-end 1993, a decrease of $113.1 million from year-end 1992. Grace's total debt as a percentage of total capital (debt ratio) decreased from 54.1% at year-end 1992 to 52.9% at year-end 1993, primarily as a result of the reduction in total debt. In January 1993, Grace sold $300 million principal amount of 7.4% Notes Due 2000. The net proceeds from the sale of these Notes were used to repay commercial paper and bank borrowings. In the third quarter of 1993, Grace completed the redemption in full of its outstanding Liquid Yield Option Notes due 2006 (LYONs) and 6 1/4% Convertible Subordinate Debentures Due 2002. Of the $1,012.5 million principal amount at maturity of LYONs outstanding, approximately 31% ($309.6 million) was converted into 2.8 million shares of common stock; the remaining LYONs ($702.9 million) were redeemed for approximately $258 million in cash. Substantially all of the $150 million principal amount of the 6 1/4% Convertible Debentures due 2002 outstanding immediately prior to redemption was redeemed for cash (equal to the principal amount outstanding). Grace expects to satisfy its 1994 cash requirements from the following sources: (1) funds generated by operations, (2) proceeds from the sales of businesses and (3) financings. Such financings could include new borrowings, the availability and cost of which will depend upon general economic and market conditions. ASBESTOS-RELATED MATTERS As reported in Note 2 to the Consolidated Financial Statements, Grace is a defendant in lawsuits relating to previously sold asbestos-containing products. In 1993, Grace paid $103.1 million in connection with the defense and disposition of property damage and personal injury litigation related to asbestos, net of amounts received in 1993 from settlements with certain of Grace's insurance carriers. As more fully discussed above in "Review of Operations: Overview," Grace recorded a net noncash charge of $159 million (pretax) in 1993 to reflect anticipated additional legal expenses and other uncertainties related to Grace's asbestos lawsuits and claims. The balance sheet at year-end 1993 includes a receivable due from insurance carriers, subject to litigation, of $962.3 million. Grace has also recorded a receivable of approximately $114 million for amounts to be received pursuant to settlement agreements previously entered into with certain insurance carriers. While Grace cannot precisely estimate the amounts to be paid in 1994 in respect of asbestos-related lawsuits and claims, Grace expects that it will be required to expend approximately $50 million in 1994 to defend and dispose of such lawsuits and claims (after giving effect to payments to be received from certain insurance carriers, as discussed above and in Note 2 to the Consolidated Financial Statements). As indicated therein, the amounts reflected in the Consolidated Financial Statements with respect to the probable cost of disposing of pending asbestos lawsuits and claims and probable recoveries from insurance carriers represent estimates; neither the outcomes of such lawsuits and claims nor the outcomes of Grace's continuing litigations with certain of its insurance carriers can be predicted with certainty. ENVIRONMENTAL MATTERS Grace incurs costs related to environmental protection due to laws and regulations, Grace's commitment to industry initiatives such as Responsible Care -R- (the Chemical Manufacturers Association program) and its own internal standards. Worldwide expenses of continuing operations related to the operation and maintenance of environmental facilities and disposal of hazardous and nonhazardous wastes totalled $45 million, $56 million and $38 million in 1993, 1992 and 1991, respectively.In addition, worldwide capital expenditures for continuing operations relating to environmental protection in 1993 totalled $20 million, compared with $18 million and $17 million in 1992 and 1991, respectively. Grace has also incurred costs to remediate previously contaminated sites. These costs were $44 million, $35 million and $18 million in 1993, 1992 and 1991, respectively. These amounts were charged against previously established reserves for estimated expenses for environmental spending, which were identified and charged to income in prior years. Grace accrues for anticipated costs associated with investigatory and remediation efforts in accordance with Statement of Financial Accounting Standards No. 5, "Accounting for Contingencies," which governs probability and the ability to reasonably estimate future costs. During 1993, 1992 and 1991, there were periodic provisions recorded for environmental and plant closure expenses, which include the costs of future investigatory and remediation activities. At year-end 1993, Grace's accruals for environmental remediation totalled approximately $160 million. These reserves do not take into account any discounting for future expenditures or possible future insurance recoveries. The liabilities are reassessed whenever environmental circumstances become better defined and/or remediation efforts and their costs can be better estimated. Annual environmental-related cash outlays are expected to total $44 million in 1994 and $35 million in 1995. Expenditures have been funded from internal sources of cash and are not expected to have a significant effect on liquidity. SCHEDULE II W. R. GRACE & CO. AND SUBSIDIARIES AMOUNTS RECEIVABLE FROM OFFICERS AND EMPLOYEES EXCEEDING $100,000* (dollar amounts in thousands) SCHEDULE V W. R. GRACE & CO. AND SUBSIDIARIES PROPERTY, PLANT AND EQUIPMENT (in millions) For the Year 1993 Depreciation and Lease Amortization Rates - ----------------------------------------- In view of the variety of properties and depreciation and lease amortization rates, it is not practicable to set forth detailed rates. The average depreciation and lease amortization rates on a consolidated basis for 1993, 1992 and 1991 were as follows: SCHEDULE VI W. R. GRACE & CO. AND SUBSIDIARIES ACCUMULATED DEPRECIATION, DEPLETION AND AMORTIZATION OF PROPERTY, PLANT AND EQUIPMENT (in millions) For the Year 1993 SCHEDULE VIII W. R. GRACE & CO. AND SUBSIDIARIES VALUATION AND QUALIFYING ACCOUNTS AND RESERVES (in millions) For the Year 1993 For the Year 1992 For the Year 1991 SCHEDULE IX W. R. GRACE & CO. AND SUBSIDIARIES SHORT-TERM BORROWINGS (dollar amounts in millions) SCHEDULE X W. R. GRACE & CO. AND SUBSIDIARIES SUPPLEMENTARY INCOME STATEMENT INFORMATION (in millions) Exhibit 11 W. R. GRACE & CO. AND SUBSIDIARIES WEIGHTED AVERAGE NUMBER OF SHARES AND EARNINGS USED IN PER SHARE COMPUTATIONS The weighted average number of shares of Common Stock outstanding were as follows: Exhibit 12 W. R. GRACE & CO. AND SUBSIDIARIES COMPUTATION OF RATIO OF EARNINGS TO FIXED CHARGES AND COMBINED FIXED CHARGES AND PREFERRED STOCK DIVIDENDS (in millions except ratios) (Unaudited) Exhibit Index W. R. GRACE & CO. Annual Report on Form 10-K for the Fiscal Year Ended December 31, 1993 ------------------------------------------- EXHIBIT INDEX EXHIBIT NO. EXHIBIT WHERE LOCATED - ------- ------- ------------- 3.01 Certificate of Incorporation of Exhibit 3 to Form 8-K W. R. Grace & Co., as amended (filed 6/9/88) 3.02 By-laws of W. R. Grace & Co., as Exhibit 3.2 to Form 10-K amended (filed 3/26/93) 4.01 Indenture dated as of September Exhibit 4.2 to Form 10-K 29, 1992 among W. R. Grace (filed 3/26/93) & Co.-Conn., W. R. Grace & Co. and Bankers Trust Company 4.02 Indenture dated as of January Exhibit 4.4 to Form 10-K 28, 1993 among W. R. Grace (filed 3/26/93) & Co.-Conn., W. R. Grace & Co. and NationsBank of Georgia, N.A. 4.03 Credit Agreement dated as of Exhibit 4.2 to Form 8-K September 1, 1992 among W. R. (filed 9/26/92) Grace & Co., W. R. Grace & Co.- Conn. and the Several Banks Parties thereto and Chemical Bank, as Agent 4.04 Amended and Restated Rights Exhibit to Amendment on Agreement dated as of June 7, Form 8 to Application for 1990 between W. R. Grace & Co. Registration on Form 8-B and Manufacturers Hanover Trust (filed 6/19/90) Company ____________________________ Other than exhibits that are filed herewith, all exhibits listed in this Exhibit Index are incorporated herein by reference. Exhibits indicated by an asterisk (*) are the management contracts and compensatory plans, contracts or arrangements required to be filed as exhibits to this Report. In accordance with paragraph (b) (4) (iii) of Item 601 of Regulation S-K, certain instruments relating to long-term debt are not being filed; W. R. Grace & Co. agrees to furnish a copy of any such instrument to the Securities and Exchange Commission upon request. EXHIBIT NO. EXHIBIT WHERE LOCATED - ------- ------- ------------- 10.01 W. R. Grace & Co. Executive Exhibit 19(f) to Form Salary Protection Plan, as 8-K (filed 6/9/88)* amended 10.02 W. R. Grace & Co. 1981 Stock Exhibit 28(a) to Form Incentive Plan, as amended 10-Q (filed 8/13/91)* 10.03 W. R. Grace & Co. 1986 Stock Exhibit 28(b) to Form Incentive Plan, as amended 10-Q (filed 8/13/91)* 10.04 W. R. Grace & Co. 1989 Stock Exhibit 28(c) to Form Incentive Plan, as amended 10-Q (filed 8/13/91)* 10.05 Forms of Stock Option Agreements Exhibit 10(h) to Form 10-K (filed 3/28/92)* 10.06 Forms of Restricted Share Award Exhibit 10(i) to Form Agreements 10-K (filed 3/28/92)* 10.07 Information Concerning W. R. Grace Pages 10 and 11 of & Co. Incentive Compensation Proxy Statement Program and Deferred Compensation (filed 4/10/93)* Program 10.08 W. R. Grace & Co. Long-Term Exhibit 10(l) to Form Incentive Plan 10-K (filed 3/29/91)* 10.09 W. R. Grace & Co. Retirement Exhibit 10(o) to Form Plan for Outside Directors, as 10-K (filed 3/28/92)* amended 10.10 Employment Agreement dated August Exhibit 10(r) to Form 7, 1989 between W. R. Grace & Co. 10-K (filed 3/29/91)* and Joseph R. Wright, Jr. 10.11 Employment Agreement dated Exhibit 10(x) to Form as of April 1, 1991 between 10-K (filed 3/28/92)* W. R. Grace & Co.-Conn. and Constantine L. Hampers, as amended - 2 - EXHIBIT NO. EXHIBIT WHERE LOCATED - ------- ------- ------------- 10.12 Housing Loan Agreement dated Exhibit 10(q) to Form as of August 1, 1987 between 10-K (filed 3/29/88); W. R. Grace & Co. and J. P. Exhibit 19(i) to Form Bolduc, related Amendment and 8-K (filed 6/9/88)* Assignment dated May 10, 1988 10.13 Employment Agreement dated Filed herewith* August 1, 1993 between J. P. Bolduc and W. R. Grace & Co. 10.14 Stock Option Agreement dated Filed herewith* June 30, 1993 between David L. Yunich and W. R. Grace & Co. 10.15 Stock Option Agreement dated Filed herewith* June 30, 1993 between David L. Yunich and W. R. Grace & Co. 10.16 National Medical Care, Inc. and Exhibit 10 (aa) to Form Subsidiaries Executive Bonus 10-K (filed 3/28/92)* Plans 10.17 Retirement Agreement between Exhibit 10.23 to Form W. R. Grace & Co. and J. Peter 10-K (filed 3/26/93)* Grace dated December 21, 1992 10.18 Executive Severance Agreement Exhibit 10.24 to Form dated as of September 1, 1992 10-K (filed 3/26/93)* between W. R. Grace & Co. and J. P. Bolduc 10.19 Executive Severance Agreement Exhibit 10.26 to Form dated September 1, 1992 10-K (filed 3/26/93)* between W. R. Grace & Co. and Constantine L. Hampers 10.20 Form of Executive Severance Exhibit 10.28 to Form Agreement between W. R. Grace 10-K (filed 3/26/93)* & Co. and others - 3 - EXHIBIT NO. EXHIBIT WHERE LOCATED - ------- ------- ------------- 10.21 Consulting Agreement Exhibit 10.29 to Form dated June 1, 1992 between 10-K (filed 3/26/93)* W. R. Grace & Co. and Kamsky Associates, Inc. 10.22 Incentive Compensation Agreement Exhibit 10.30 to Form dated June 1, 1992 between 10-K (filed 3/26/93)* National Medical Care, Inc. and Kamsky Associates, Inc. 10.23 Consulting Agreement dated as of Filed herewith* June 16, 1993 by and between National Medical Care, Inc., The Humphrey Group, Inc. and Gordon J. Humphrey 10.24 Employment Termination Agreement Filed herewith* dated June 30, 1993 between J. R. Wright, Jr. and W. R. Grace & Co. 10.25 W. R. Grace & Co. Supplemental Filed herewith* Executive Retirement Plan, as amended 11 Weighted Average Number of Filed herewith Shares and Earnings Used in (in Financial Per Share Computations Supplement to 10-K) 12 Computation of Ratio of Earnings Filed herewith to Fixed Charges and Combined (in Financial Fixed Charges and Preferred Supplement to 10-K) Stock Dividends 13 Selected Portions of the 1993 Filed herewith Annual Report to Shareholders (in Financial of W. R. Grace & Co. Supplement to 10-K) 22 List of Subsidiaries of Filed herewith W. R. Grace & Co. - 4 - EXHIBIT NO. EXHIBIT WHERE LOCATED - ------- ------- ------------- 24 Consent of Independent Accoun- Filed herewith tants (in Financial Supplement to 10-K) 25 Powers of Attorney Filed herewith - 5 -

2648_1993.txt

2648

1993

Item 1. Business. A. Organization of Business Aetna Life and Casualty Company was organized in 1967 as a Connecticut insurance corporation. Aetna Life and Casualty Company and its subsidiaries (collectively, "Aetna" or the "company") constitute one of the nation's largest insurance/financial services organizations in the United States based on its assets at December 31, 1992. Based on 1992 premium rankings, the company also is one of the nation's largest stock insurers of property-casualty lines and one of the largest writers of group health and managed care products, and group life, annuity and pension products. Although the company offers insurance and financial services products in foreign countries, 90% of its total revenue in 1993 was derived from domestic sources. The company's reportable segments and principal products included in such segments are: Health and Life Insurance and Services: Group life Group health and disability Managed health care Individual life Financial Services: Group pensions and related financial services Individual and group annuities Investment products Commercial Property-Casualty Insurance and Services: Automobile Fidelity and surety Fire and allied lines General liability Marine Multiple peril Professional liability Workers' compensation Personal Property-Casualty: Automobile Homeowners International: Group life, health and disability, and pensions Individual life, health, accident and disability, and annuities Property-casualty Investment products B. Financial Information about Industry Segments Revenue, income (loss) from continuing operations before income taxes, extraordinary item and cumulative effect adjustments, net income (loss), and assets by industry segment are set forth in Note 14 to the Financial Statements which is incorporated by reference from the Annual Report. Revenue and income (loss) from continuing operations before extraordinary item and cumulative effect adjustments attributable to each industry segment are incorporated herein by reference from the Selected Financial Data in the Annual Report. Certain reclassifications have been made to 1992 and 1991 financial information to conform to 1993 presentation. C. Description of Business Segments 1. Health and Life Insurance and Services Principal Products __________________ Group health and life insurance products and services, including managed health care products and services, are marketed through units of the Health and Life Insurance and Services segment ("Health and Life") primarily to employers and employer-sponsored groups. These products and services are provided to employees or other individuals covered under benefit plans sponsored by those organizations. Individual life insurance products also are included in Health and Life. Group life insurance consists chiefly of renewable term coverage, the amounts of which frequently are linked to individual employee wage levels. The company also offers group universal life and sponsored universal and whole life products. Group health and disability insurance includes coverage for medical and dental care expenses and for disabled employees' income replacement benefits. Health coverage is provided under both traditional indemnity and prepaid arrangements, whereby Aetna assumes the full insurance risk, and under alternative risk- sharing plans, whereby employers assume all or a significant portion of the insurance risk. Health and Life also provides administrative and claim services and, in many cases, partial insurance protection, for an appropriate fee or premium charge. Continuing concern over the rising costs of health care and the need for quality assurance have resulted in a continuation of a market shift away from traditional forms of health benefit coverage to a variety of "managed care" products. Managed care products, which may be sold on a stand-alone basis or in combination with traditional indemnity products, vary from traditional indemnity products primarily through the use of health care networks (physicians and hospitals) and the implementation of medical management procedures designed to enhance the quality and reduce the cost of medical services provided. Such procedures, including contracted physician reimbursement rates and required pre-authorization for certain medical procedures, are designed to enable managed care companies and their customers to control medical costs more effectively. The company offers a broad spectrum of traditional indemnity and managed care group products. The latter include preferred provider organizations ("PPOs"), which offer enhanced coverage benefits for services received from participating providers; point-of-service ("POS") plans, which typically combine PPO-style benefit designs with stronger utilization management; and health maintenance organizations ("HMOs"), which arrange for non-emergency services exclusively through the HMO's network of providers. The company's HMOs are primarily Individual Practice Associations in which the HMO generally shares some financial risk with the physicians based on medical utilization results. At year-end 1993, Aetna operated various types of managed care networks in approximately 211 Standard Metropolitan Statistical Areas with enrollment of approximately 5 million. The number of members covered under all arrangements, including traditional health plans, was 15 million at December 31, 1993. Health and Life units continue to develop a wide range of products and services tailored to help employers manage their employee benefit plan costs effectively. Through its individual life unit, the company markets a variety of universal life, interest-sensitive whole life and term products. Aetna's universal life product accounted for approximately 86% of individual life sales in 1993. Life insurance agents are typically paid a renewal commission or service fee to encourage them to retain business. The company's universal and interest-sensitive whole life insurance contracts typically impose a surrender penalty on policyholder balances withdrawn in the first 10 to 15 years of the contract life. The period of time and level of the penalty vary by product. In addition, more favorable credited rates and policy loan terms may be offered after policies have been in force more than 10 years. Certain of the company's life insurance and annuity products allow for customers to borrow against their policies. At December 31, 1993, approximately 17% of outstanding policy loans were on individual annuity policies and had fixed interest rates ranging from 1% to 3%. Approximately 79% of outstanding policy loans at December 31, 1993 were on individual life policies and had fixed interest rates ranging from 5% to 8%. The remaining 4% of outstanding policy loans had variable interest rates averaging 8% at December 31, 1993. Investment income on outstanding policy loans was $24 million for the year ended December 31, 1993. The company ceased selling individual health insurance products in mid-1990 and transferred this business to another company in 1991. The following table summarizes group life, group health and disability, and individual life and health premiums for the years indicated: Competition ___________ The markets for Health and Life products are highly competitive. In addition to competition among insurance companies, competition in the health field arises from organizations such as Blue Cross and Blue Shield, from various specialty service providers, from local and regional HMOs and other types of medical and dental provider organizations, from integrated health care delivery organizations and, in certain coverages, from the federal and state governments. Additionally, in recent years, many large employers have moved to totally self-insured and self-administered benefit plans. Competition largely is based upon product features and prices and, in the case of managed health care products, upon the quality of services provided, the geographic scope of the provider networks and the medical specialties available in such networks. Based on 1992 written premiums, Aetna is one of the largest insurance company providers of group health and life benefits in the United States. Method of Distribution ______________________ Group products are sold principally through salaried field representatives and home office marketing personnel who often work with independent consultants and brokers who assist in the production and servicing of business. Individual life insurance products are marketed primarily by independent agents and brokers who also may sell insurance products for other companies. Certain life insurance products are sold by agents and brokers who are registered representatives of selected broker-dealers. Reserves ________ For group life products, policy reserve liabilities are established as premiums are received to reflect the present value of expected future obligations net of the present value of expected future premiums. Reserves for most of these products reflect retrospective experience rating except for the smaller group insurance cases which currently are not retrospectively experience rated. Policy reserves for group paid-up life insurance generally reflect long-term fixed obligations and are computed on the basis of assumed or guaranteed yield and benefit payments. Assumptions are based on Aetna's experience, which is periodically reviewed against published industry data. For group health products, reserves reflect estimates of the ultimate cost of claims including (i) claims that have been reported but not settled, and (ii) claims that have been incurred but have not yet been reported. Group health and life claim reserves are based on factors derived from past experience. Reserves for universal life products are equal to cumulative premiums less charges plus credited interest thereon. Reserves for all other fixed individual life and health contracts are computed on the basis of assumed investment yield, mortality, morbidity and expenses (including a margin for adverse deviation), which generally vary by plan, year of issue and policy duration. Reserve interest rates as of December 31, 1993 ranged from 2.25% to 11.25%. Investment yield is based on the company's experience. Mortality, morbidity and withdrawal rate assumptions also are based on the experience of the company, and in addition, are periodically reviewed against both industry standards and experience. Reinsurance ___________ Aetna utilizes a variety of reinsurance agreements with non- affiliated insurers to share insurance risks on group health and life business as directed by the insured and to control its exposure to large losses. Generally, these agreements are established on a case-by-case basis to reflect the circumstances of specific group insurance risks. The company retains no more than $10.0 million of risk per individual life policy. Amounts in excess of the retention limit are reinsured with unaffiliated companies. For additional information on reinsurance, see Note 15 of Notes to Financial Statements in the Annual Report. Group Life Insurance In Force and Other Statistical Data ________________________________________________________ The following table summarizes changes in group life insurance in force before deductions for reinsurance ceded to other companies for the years indicated: Individual Life Insurance In Force and Other Statistical Data _____________________________________________________________ The following table summarizes changes in individual life insurance in force before deductions for reinsurance ceded to other companies for the years indicated(1): 2. Financial Services Principal Products __________________ Business units in the Financial Services segment ("Financial Services") market a variety of retirement and other savings and investment products (including pension and annuity products) and services to businesses, government units, associations, collectively bargained welfare trusts, hospitals, educational institutions and individuals. Financial Services units offer pension, annuity and other investment products to employers and individuals for retirement and savings plan funding and disbursement. Some of these products provide a variety of investment guarantees, funding and benefit payment distribution options and other services. (For additional information regarding the products offered by Financial Services, see Management's Discussion and Analysis of Financial Condition and Results of Operations ("MD&A") - Financial Services in the Annual Report). In January 1994, the company announced its decision to discontinue the sale of its fully guaranteed large case pension products and recorded an $825 million after-tax charge in 1993 for the anticipated future losses on such products. The company will honor all obligations under existing fully guaranteed, large case pension contracts. Such obligations are expected to run off over approximately 30 years. (For additional information, see MD&A - Financial Services in the Annual Report.) Individual annuity contracts typically impose a surrender penalty on policyholder balances withdrawn in the first 10 years of the contract life. The period of time and level of the penalty vary by product. Existing tax penalties on annuity distributions prior to age 59-1/2 provide an additional disincentive to premature surrenders of annuity balances. The majority of those products which utilize Separate Accounts provide contractholders with a vehicle for investments under which the contractholders assume the investment risks as well as the benefit of favorable performance. Separate Accounts offered include accounts that invest in real estate, mortgages, international investments, mutual funds, and a variety of other equity and fixed income investments. Aetna earns a management fee on these Separate Accounts or on the mutual funds in which certain of the Separate Accounts invest. Various investment advisory services also are offered through a number of wholly owned subsidiaries that are registered investment advisors. At December 31, assets under management, including Separate Accounts, were $67.1 billion in 1993, $61.8 billion in 1992, $60.7 billion in 1991, $57.7 billion in 1990, and $53.7 billion in 1989. The following table summarizes pension and annuity premiums for the years indicated: Deposits, which are not included in premiums or revenue under Financial Accounting Standard No. 97 ("FAS 97"), are shown in the following table for the years indicated: Competition ___________ In the pension and annuity markets, competition arises from other insurance companies, banks, bank trust departments, mutual funds and other investment managers. Principal competitive factors are cost, service, level of investment performance and the perceived financial strength of the investment manager. (For additional information, see MD&A - Liquidity and Capital Resources in the 1993 Annual Report.) Measured by assets under management at December 31, 1992, Aetna is the 19th largest manager of pension assets in the United States. Method of Distribution ______________________ Group pension products are sold principally through salaried field representatives and home office marketing personnel, who often work with independent consultants and brokers who assist in the production and servicing of business. Annuity products are distributed primarily through dedicated annuity agents selling only Aetna annuity products. Reserves ________ The loss on discontinuance of fully guaranteed large case pension products ($825 million as of the December 31, 1993 measurement date) represents the present value of anticipated net cash flow shortfalls as the liabilities are run off. Such net cash flow shortfalls include anticipated losses from negative interest margins (i.e., the amount by which interest credited to holders of such contracts exceeds interest earned on investment assets supporting the contracts), future capital losses, and operating expenses and other costs expected to be incurred as the liabilities are run off. In addition to the reserve described above, the company maintains reserves for guaranteed investment contracts equal to the amount on deposit for such contracts plus credited interest thereon. Reserves for annuity contracts reflect the present value of benefits based on actuarial assumptions established at the time of contract purchase. Such assumptions are based on Aetna's experience, which is periodically reviewed against published industry data. Reserves for experience rated contracts reflect cumulative deposits, less withdrawals and charges, plus credited interest thereon, less net realized capital gains/losses (which the company seeks to recover through credited rates). 3. Commercial Property-Casualty Insurance and Services Principal Products __________________ The business units in the Commercial Property-Casualty Insurance and Services segment ("Commercial Property-Casualty") provide most types of property-casualty insurance, bonds, and insurance-related services for businesses, government units and associations. Commercial coverages accounted for 67% of Aetna's 1993 property- casualty net written premiums. These coverages are sold for risks of all sizes and include fire and allied lines, multiple peril, marine, workers' compensation, general liability (including product liability), commercial automobile, certain professional liability, and fidelity and surety bonds. In addition, Aetna offers various services to businesses that choose to self-insure certain exposures. Aetna also reinsures various property and liability risks, primarily through agreements with non-affiliated insurers, on both a treaty and facultative basis. Approximately 82% of Aetna's 1993 commercial business was voluntary. The remainder was written by various assigned risk plans, facilities and pools of which Aetna is a member. These organizations are formed to meet statutory requirements relating to the writing of certain types of commercial risk or to spread particularly large loss exposures among insurers pursuant to a prearranged allocation formula. Participation is mandatory, and underwriting decisions are made by such facilities independent of their membership. For a significant portion of the commercial property-casualty business, Aetna uses advisory or compulsory rate structures and, in some instances, forms that were developed by agencies and bureaus in which insurance companies are authorized to participate through state regulation. However, in recent years, Aetna has emphasized the development of independent coverages designed for sale to specific market segments. The following table sets forth the premium revenue, underwriting results and net investment income, fees and other income and net realized capital gains of Commercial Property-Casualty for the years indicated: Property-casualty underwriting profitability generally is expressed in terms of combined ratios. When the combined ratio is under 100%, underwriting results are considered profitable; when the ratio is over 100%, underwriting results are considered unprofitable. The combined ratio is the sum of (i) the percentage of earned premiums that is paid or reserved for losses and related loss adjustment expenses (the "loss ratio"), (ii) the percentage of earned premiums that is paid or reserved for dividends to policyholders, and (iii) the percentage of written premiums that is paid or reserved for sales commissions, premium taxes, administrative and other underwriting expenses (the "expense ratio"). The combined ratio does not reflect net investment income, fees and other income, net realized capital gains/losses or federal income taxes. The statutory combined ratio does not reflect adjustments to underwriting results in accordance with GAAP. Adjusted underwriting income/loss reflects GAAP adjustments (primarily deferred policy acquisition costs and pre-1992 salvage and subrogation) to underwriting results. The following table sets forth for major domestic Commercial Property-Casualty coverages for the years indicated (a) the percentage of Commercial Property-Casualty statutory net written premiums (NWP) and (b) statutory combined ratios before policyholders' dividends: PERCENTAGE DISTRIBUTION OF STATUTORY NET WRITTEN PREMIUMS AND COMBINED RATIOS The following table summarizes Commercial Property-Casualty statutory net written premiums for the years indicated: The following table sets forth Aetna's percentage distributions of Commercial Property-Casualty direct written premiums in various jurisdictions for the years indicated: GEOGRAPHIC DISTRIBUTION OF DIRECT WRITTEN PREMIUMS Competition ___________ Commercial property-casualty insurance is highly competitive in the areas of price, service and agent relationships. There are approximately 3,900 property-casualty insurance companies in the United States. Approximately 900 of these operate in all or most states and write the vast majority of the business. In addition, an increasing amount of commercial risks are covered by purchaser self-insurance, risk-purchasing groups, risk-retention groups and captive companies. Based on 1992 written premiums, Aetna is one of the largest underwriters of commercial property-casualty coverages in the United States. Method of Distribution ______________________ Aetna's commercial property-casualty coverages are sold through approximately 4,400 independent agents and brokers supervised and serviced by 41 field offices. Reserves ________ See Reserves Related to Property-Casualty Operations on pages 18 through 21. Reinsurance ___________ Approximately one-half of the property-casualty reinsurance ceded by Aetna arises in connection with its servicing relationships with various pools (frequently involuntary pools). Aetna services or writes a portion of the pool's individual policies, handling all premium and loss transactions. These "service" premiums and losses are then 100% ceded (net of an expense reimbursement) to the pools, whose members are jointly liable to Aetna as a servicer. In addition to the above, Aetna utilizes a variety of reinsurance agreements, primarily with non-affiliated insurers, to control its exposure to large property-casualty losses. These agreements, most of which are renegotiated annually as to coverage, limits and price, are structured either on a treaty basis (where all risks meeting prescribed criteria are automatically covered) or on a facultative basis (where the circumstances of specific individual insurance risks are reflected). The amount of risk retained by Aetna depends on the underwriter's evaluation of the specific account, subject to maximum limits based on risk characteristics and the type of coverage. The principal catastrophe reinsurance agreement currently in force covers approximately 81% of specified property losses between $150 million and $325 million. For additional information on reinsurance, see MD&A - Property- Casualty Reserves and Note 15 of Notes to Financial Statements in the Annual Report. Aetna has internal property-casualty reinsurance arrangements under which the risks and premiums of virtually all coverages written by the company's property-casualty subsidiaries are redistributed among those subsidiaries on a percentage basis. The percentages are adjusted from time to time to reflect the relative underwriting capacities and other capital needs of participants in the reinsurance agreement. 4. Personal Property-Casualty Principal Products __________________ The business units in the Personal Property-Casualty segment ("Personal Property-Casualty") provide primarily personal automobile insurance and homeowners insurance. Personal coverages accounted for 33% of Aetna's 1993 property-casualty net written premiums. The following table sets forth the premium revenue, underwriting results and net investment income, other income and net realized capital gains/losses of the personal property-casualty operations for the years indicated: Approximately 86% of Aetna's 1993 personal property-casualty business was voluntary. The remainder was written by various assigned risk plans, facilities and pools of which Aetna is a member. These organizations are formed to meet statutory requirements relating to certain types of property-casualty risk or to spread particularly large loss exposures among insurers pursuant to prearranged allocation formulas. Participation is mandatory, and underwriting decisions are made by such facilities independent of their membership. The following table sets forth for major personal property- casualty coverages for the years indicated (a) the percentage of total personal property-casualty statutory net written premiums (NWP) and (b) the statutory combined ratios: The following table summarizes personal property-casualty statutory net written premiums for the years indicated: The following table sets forth Aetna's percentage distributions of Personal Property-Casualty direct written premiums in various jurisdictions for the years indicated: Reserves ________ See Reserves Related to Property-Casualty Operations on pages 18 through 21. Competition ___________ Personal property-casualty insurance is highly competitive in the areas of price, service, agent relationships and method of distribution (i.e., use of independent agents, captive agents and/or employees). Currently, there are over 2,400 property- casualty companies in the United States that offer one or more individual products similar to those marketed by Aetna. Measured by 1992 premium volume, Aetna is the 11th largest underwriter of personal property-casualty products in the United States. State Farm and Allstate have significant market share in the personal property-casualty market. Method of Distribution ______________________ Aetna's personal property-casualty products are marketed by independent agents and brokers who may sell insurance products for other companies. Reinsurance ___________ See Reinsurance on page 15. 5. Reserves Related to Property-Casualty Operations Aetna establishes reserve liabilities designed to reflect estimates of the ultimate cost of claims (including claim adjustment expenses). Such liabilities for workers' compensation life table indemnity claims are discounted. Estimating the ultimate cost of claims is a complex and uncertain process that relies on actuarial and statistical methods of analysis. The company's reserves include: (i) claims that have been reported but not settled ("case" reserves), and (ii) claim costs that have been incurred but have not yet been reported ("IBNR" reserves). The establishment of case reserves is dependent upon, among other things, the extent to which coverage was provided, the extent of injury or damage, and, in the case of a contested claim, an estimate of the likely outcome of the adjudication process (to the extent such outcome is estimable). IBNR reserves, established to reflect events and occurrences that are not known to the company but, based on actuarial and historical data (adjusted for the effects of current social, economic and legal developments, trends and factors), are likely to result in claims, also include provision for development on case reserves. As claims are reported and valued by the company, IBNR reserves are reduced by the amount of the reported claim cost. IBNR reserves also are adjusted as the estimates of losses for a given accident year develop. The length of time for which the cost of claims must be estimated varies depending on the coverage and type of claim involved. Estimates become more difficult to make (and are therefore more subject to change) as the length of time increases. Actual claim costs are dependent upon a number of complex factors including social and economic trends and changes in doctrines of legal liability and damage awards. Reserves for property-casualty coverage are recomputed periodically using a variety of actuarial and statistical techniques for producing current estimates of actual claim costs, claim frequency, and other economic and social factors. A provision for inflation in the calculation of estimated future claim costs is implicit since reliance is placed on both actual historical data that reflect past inflation and on other factors which are judged to be appropriate modifiers of past experience. Adjustments to reserves are reflected in the net income of the period in which such adjustments are made. Aetna also establishes unearned premium reserves that are calculated on a pro rata basis and reserves for additional premiums or refunds on retrospectively rated policies based on experience. This means that when a loss which will produce an additional premium payment is incurred on a retrospectively rated policy, the premium is recorded at the same time. Likewise when loss experience is favorable, reserves for premium refunds are established. During the fourth quarter of 1993, the company added $574 million (pretax, before discount) to prior accident year loss reserves for workers' compensation claims. This increase resulted from a recently completed study of the company's workers' compensation reserves which indicated that workers' compensation claims have a longer duration than previously estimated. Concurrent with the addition to workers' compensation reserves, the company implemented a change in accounting to discount reserves for workers' compensation life table indemnity claims consistent with industry practice. This discounting resulted in a reduction of $634 million (pretax) to loss reserves for workers' compensation claims in 1993. For additional information on property-casualty reserves, including reserves for asbestos and environmental-related claims, see MD&A-Property Casualty Reserves in the Annual Report. The following represents changes in aggregate reserves, net of reinsurance, for the combined property-casualty experience (1,2): The following table reconciles, as of year end, reserves determined in accordance with accounting principles and practices prescribed or permitted by insurance regulatory authorities ("statutory basis reserves") to reserves determined in accordance with generally accepted accounting principles ("GAAP basis reserves"), net of reinsurance for the combined property-casualty unpaid claims and claim adjustment expense experience (1): The following reserve runoff table represents Aetna's combined property-casualty loss and loss expense experience. Each column shows, for the year indicated: the reserve held at year end; cumulative data for payments made in each subsequent year for that reserve year; liability reestimates made in each subsequent year for that reserve year; the redundancy (deficiency) represented by the difference between the original reserve held at the end of that year and the reestimated liability as of the end of 1993; and the change in redundancy (deficiency) from the end of each reserve year shown to the end of each subsequent reserve year. The majority of increases to prior accident year reserves were for losses and related expenses for asbestos and other product liability risks attributable to policies written prior to 1978 and for workers' compensation claims. The table represents historical data; it would not be appropriate to use such data to project the company's future reserving activity or its future performance generally. 6. International The International segment ("International"), through subsidiaries and joint venture operations, sells primarily life insurance and financial services products in non-U.S. markets including Canada, Malaysia, Taiwan, Chile, Mexico, the United Kingdom, Hong Kong, Korea and New Zealand. International operations are subject to regulation in the various jurisdictions in which they do business. In most of the geographic areas and markets in which International has operations, the competition is extensive. Methods of distribution vary by country and by product, and include direct sales, sales through agents and brokers, and sales through joint ventures. On June 30, 1993, the company completed the sale of its U.K. life and investment management operations. The company realized an after-tax capital loss of $12 million on the sale as well as $37 million of tax benefits from cumulative operating losses of the subsidiary not previously available for tax benefits. The company completed the sale of its 43% interest in La Estrella S.A. de Seguros, a Spanish insurance company, to Banco Hispano Americano in May 1991. The company realized a net capital gain of $33 million (after-tax) on the sale. Operations outside the U.S. have added risks such as nationalization, expropriation, and the potential for restrictive capital regulations. Given the particular countries in which International has operations, and the current size and nature of those operations, management does not believe such risks are material to the company. The following table sets forth International's premium revenue, net investment income, other income and net realized capital gains/losses and life insurance in force, before deductions for reinsurance ceded to other companies: Premium growth in 1992 included $128 million from the second quarter consolidation of a previously unconsolidated subsidiary as a result of an increase in the company's ownership percentage. 7. Investments The investment income and realized capital gains and losses from the investment portfolios of the company's insurance subsidiaries contribute to the results of the insurance operations described above. Investment strategies and portfolios are designed to reflect the liability profiles, competitive requirements and tax characteristics of the company's different products. The distribution of maturities is monitored, and security purchases and sales are executed with the objective of having adequate funds available to satisfy the company's maturing liabilities. The company also utilizes futures and forward contracts and swap agreements in order to manage investment returns and to align maturities, interest rates, currency rates and funds availability with its obligations. See MD&A - Investments in the Annual Report for a further discussion of investments. a. Investments Related to Life, Health, Annuity and Pension Operations Consistent with the nature of the contract obligations involved in the company's group and individual life, health and disability, annuity and pension operations, the majority of the general account assets attributable to such operations have been invested in intermediate and long-term, fixed income obligations such as treasury obligations, mortgage-backed securities, corporate debt securities and mortgage loans. For information concerning the valuation of investments, see Notes 1, 5, and 6 of Notes to Financial Statements in the Annual Report. The following table sets forth the distribution of invested assets, cash and cash equivalents and accrued investment income as of the end of the years indicated (1): Mortgage-backed securities at December 31, 1993, 1992 and 1991 included the following categories of collateralized mortgage obligations (1): The following table summarizes investment results of the company's life, health, annuity and pension operations (1): b. Investments Related to Property-Casualty Operations The investment strategies for assets related to personal and commercial property-casualty operations are designed to maximize yield with appropriate liquidity and preservation of principal, and to permit periodic adjustment of the portfolio mix, in order to reflect changes in underwriting results and thus maximize after-tax income. Common stocks are held with the primary objective of achieving portfolio appreciation through capital gains and income. The size of common stock holdings is controlled in relation to surplus levels. For information concerning the valuation of investments, see Notes 1, 5, and 6 of Notes to Financial Statements in the Annual Report. The following table sets forth the distribution of invested assets, cash and cash equivalents and accrued investment income as of the end of the years indicated (1): Mortgage-backed securities at December 31, 1993, 1992 and 1991 included the following categories of collateralized mortgage obligations (1): The following table summarizes investment results of the company's property-casualty insurance operations (1): 8. Other Matters a. Regulation General Aetna's insurance businesses are subject to comprehensive, detailed regulation throughout the United States and the foreign jurisdictions in which they do business. The laws of the various jurisdictions establish supervisory agencies with broad authority to regulate, among other things, the granting of licenses to transact business, premium rates for certain coverages, trade practices, agent licensing, policy forms, underwriting and claims practices, reserve adequacy, insurer solvency, the maximum interest rates that can be charged on life insurance policy loans, and the minimum rates that must be provided for accumulation of surrender value. Many also regulate investment activities on the basis of quality, distribution and other quantitative criteria. Further, many jurisdictions compel participation in, and regulate composition of, various residual market mechanisms. Aetna's operations and accounts are subject to examination at regular intervals by domestic and other insurance regulators. Although the federal government does not directly regulate the business of insurance, many federal laws do affect that business. Existing or recently proposed federal laws that may significantly affect or would affect, if passed, the insurance business cover such matters as employee benefits (including regulation of federally qualified HMOs), controls on medical care costs, medical entitlement programs (e.g., Medicare), environmental regulation and liability, product liability, civil justice procedural reform, earthquake insurance, removal of barriers preventing banks from engaging in the insurance and mutual fund businesses, repeal of some portions of the McCarran-Ferguson exemption of the business of insurance from federal antitrust laws, the taxation of insurance companies (see Notes 1 and 10 of Notes to Financial Statements in the Annual Report), and the tax treatment of insurance products. Health Care In addition to regulations applicable to insurance companies generally (described above), Aetna's managed health care products are subject to varying levels of state insurance, health maintenance organization ("HMO") and/or health department regulation. Among other things, these regulations address health care network composition, new product offerings, product and benefit contracts and the extent to which insurance companies may provide incentives to insureds to use services from "preferred" health care service providers or pay contractual and non- contractual health care providers unequally for equivalent services. Some jurisdictions also regulate the extent to which managed health care plans may offer their enrollees the option of receiving health care services from non-contracting providers. Additionally, these plans are subject to state, and in some cases federal, regulation concerning solvency and other operational requirements. Both the Clinton Administration and a number of states have proposed significant health care reform legislation. (For additional discussion, see MD&A - Health and Life Insurance and Services in the Annual Report.) Insurance and Insurance Holding Company Laws Several states, including Connecticut, regulate affiliated groups of insurers such as Aetna under insurance holding company statutes. Under such laws, intercorporate asset transfers and dividend payments from insurance subsidiaries may require prior notice to or approval of the insurance regulators, depending on the size of such transfers and payments relative to the financial position of the affiliate making the transfer. These laws also regulate changes in control, as do Connecticut corporate laws (which also apply to insurance corporations). See Note 8 of Notes to Financial Statements in the Annual Report. As a licensed Connecticut-domiciled insurer, the company is subject to Connecticut insurance laws. These laws, among other things, enable insurers to redeem their stock from any shareholder who fails, in the good faith determination of the insurer's board of directors, to (i) meet the qualifications prescribed under Connecticut law for licensure or (ii) to secure the regulatory approvals required under Connecticut law for ownership of such stock. Securities Laws The Securities and Exchange Commission ("SEC") and, to a lesser extent, the states regulate the sales and investment management activities of broker-dealer and investment advisory subsidiaries of the company. The SEC also regulates some of its pension, annuity, life insurance and other investment and retirement products. Additionally, certain Separate Accounts and mutual funds of Aetna Life Insurance and Annuity Company are subject to SEC regulation under the Investment Company Act of 1940. As a stock company, Aetna also is subject to extensive reporting obligations under the Securities Exchange Act of 1934. Property-Casualty Over the past several years, the company's insurance businesses, particularly personal automobile and workers' compensation, have been the target of various regulatory and legislative initiatives that management believes have limited the basis upon which the company conducts its activities. Such initiatives have, among other things, sought to (1) freeze or reduce rates that may be charged for certain insurance products, (2) force the company to issue and renew insurance in markets where the company cannot achieve an acceptable rate of return, and (3) restructure residual or involuntary markets. Residual or involuntary markets are established to provide coverage to insureds unable to obtain policies in the private marketplace. As state-mandated rates are frequently inadequate, these markets are in effect often subsidized by the insurance industry. More recently, attempts have been made to apply these initiatives to the property insurance lines as a means of addressing the availability of property insurance in certain urban and shorefront locations. Insurance Company Guaranty Fund Assessments Under insurance guaranty fund laws existing in all states, insurers doing business in those states can be assessed (up to prescribed limits) for certain obligations of insolvent insurance companies to policyholders and claimants. The after-tax charges to earnings for guaranty fund obligations for the years ended December 31, 1993, 1992 and 1991 were $17 million, $49 million, and $23 million, respectively. The increase in the 1992 provision is principally related to insolvencies of certain large insurance companies. The amounts ultimately assessed may differ from the amounts charged to earnings because such assessments may not be made for several years and will depend upon the final outcome of regulatory proceedings. While the company has historically recovered more than half of guaranty fund assessments through statutorily permitted premium tax offsets and policy surcharges, significant increases in assessments could jeopardize future efforts to recover such assessments. The company has actively supported improved insurer solvency regulation, including measures that would facilitate earlier identification of troubled insurers, and amendments to guaranty fund laws that would reduce the costs of such insolvencies to solvent insurers such as Aetna. Proposition 103 In March 1992, the California Insurance Commissioner ("Commissioner") issued a notice of hearing to the company requiring that it show cause why it should not be ordered to pay refunds with interest pursuant to Proposition 103. Proposition 103 is a voter initiative adopted in November 1988 which requires, among other things, certain premium rollbacks or refunds by insurance companies. The Commissioner alleged that the company's refund obligation was $110 million, plus 10% interest from May 1989 (or $51 million as of December 31, 1993). On January 13, 1994, the company entered into a stipulation with the California Department of Insurance ("Department") under which the company agreed to make refunds of $31 million, including interest, with respect to certain California policies issued or renewed between November 8, 1988 and November 7, 1989. The Department has agreed that this refund constitutes the company's complete and entire rollback and refund obligation. Given applicable reserves, the agreement with the Department will not materially affect the company's earned premium revenue or net income. See MD&A - Regulatory Environment in the Annual Report for additional discussion of regulatory matters. b. NAIC IRIS Ratios The NAIC "IRIS" ratios cover 12 categories of financial data with defined acceptable ranges for each category. The ratios are intended to provide insurance regulators "early warnings" as to when a given company might warrant special attention. An insurance company may fall out of the acceptable range for one or more ratios and such variances may result from specific transactions that are in themselves immaterial or eliminated at the consolidated level. In 1992, two of Aetna Life and Casualty Company's significant subsidiaries had more than two IRIS ratios that were outside of NAIC acceptable ranges, as discussed below. Aetna Life Insurance Company ("ALIC") fell outside acceptable ranges in 1992 for: (i) the Net Change in Capital and Surplus Ratio which is calculated by dividing the change in capital and surplus between the prior and the current year (net of any capital and surplus paid in) by the prior year capital and surplus; (ii) the Adequacy of Investment Income Ratio which compares investment income to credited interest; (iii) the Change in Product Mix Ratio which measures changes in the percentage of total premiums by product line; and (iv) the Change in Reserving Ratio which is designed for an open growing block of business. During 1992, significant capital was contributed by Aetna Life and Casualty Company to ALIC. The regulators were satisfied, after analysis, that ALIC did not warrant special attention. In 1992, The Aetna Casualty and Surety Company ("AC&S") fell outside of acceptable ranges for: (i) the Two-year Overall Operating Ratio, which is a combination of a two-year combined ratio minus a two-year investment income ratio; (ii) the Change in Surplus which measures the improvement or deterioration in a company's financial condition during the year; and (iii) the Ratio of Liabilities to Liquid Assets which measures the liquidity of a company. During 1992, AC&S sold its wholly owned subsidiary, American Re-Insurance Company. Proceeds from this sale were dividended to Aetna Life and Casualty Company. This one-time event caused certain of the ratios described above to fall outside of acceptable ranges. The regulators were satisfied, after analysis, that AC&S did not warrant special attention. Management expects that certain of the company's significant subsidiaries will have more than two IRIS ratios outside of NAIC acceptable ranges for 1993. c. Ratios of Earnings to Fixed Charges and Earnings to Combined Fixed Charges and Preferred Stock Dividends The following table sets forth Aetna's ratio of earnings to fixed charges and ratio of earnings to combined fixed charges and preferred stock dividends for the years ended December 31: For purposes of computing both the ratio of earnings to fixed charges and the ratio of earnings to combined fixed charges and preferred stock dividends, "earnings" represent consolidated earnings from continuing operations before income taxes, cumulative effect adjustments and extraordinary items plus fixed charges and minority interest. "Fixed charges" consist of interest (and the portion of rental expense deemed representative of the interest factor). Preferred stock dividends, which are not deductible for income tax purposes, have been increased to a taxable equivalent basis. This adjustment has been calculated by using the effective tax rate of the applicable year. All shares of Aetna's preferred stock were redeemed in 1989 and, as a result, for the years ended December 31, 1993, 1992, 1991 and 1990 the ratios of earnings to combined fixed charges and preferred stock dividends were the same as the ratios of earnings to fixed charges. d. Miscellaneous Aetna had approximately 42,600 domestic employees at December 31, 1993. Management believes that the company's computer facilities, systems and related procedures are adequate to meet its business needs. The company's data processing systems and backup and security policies, practices and procedures are regularly evaluated by the company's management and its internal auditors and are modified as considered necessary. Portions of Aetna's insurance business are seasonal in nature. Reported claims under group health and certain property-casualty products are generally higher in the first quarter. Sales, particularly of individual life products, are generally lowest in the first quarter and highest in the fourth quarter. No customer accounted for 10% or more of Aetna's consolidated revenues in 1993. In addition, no segment of Aetna's business is dependent upon a single customer or a few customers, the loss of which would have a significant effect on the segment. See Note 14 of Notes to Financial Statements regarding segment information in the Annual Report. The loss of business from any one, or a few, independent brokers or agents would not have a material adverse effect on the company or any of its segments. In general, the company is not contractually obligated or committed to accept a fixed portion of business submitted by any of its property-casualty agents or brokers. The company generally reviews all of its policy applications, both new and renewal, for approval and acceptance. There are cases where the company has delegated limited underwriting authority to select agents generally for smaller business for specific classes of risks. The risks accepted by the company under these conditions are reviewed by company underwriters. This authority generally can be rescinded at any time at the discretion of the company and without prior notice to the agents. Item 2.

Item 2. Properties. The home office of Aetna, owned by Aetna Life Insurance Company, is a building complex located at 151 Farmington Avenue, Hartford, Connecticut, with approximately 1.6 million square feet. The company also owns or leases other space in the greater Hartford area as well as various field locations throughout the country. The company expects to vacate certain of these facilities in 1994 (please see MD&A - Overview in the Annual Report). The foregoing does not include numerous investment properties held by Aetna in its general and separate accounts. Item 3.

Item 3. Legal Proceedings. In Re: Stepak v. Aetna Life and Casualty Company et al. On October 22, 1990, a shareholder filed a lawsuit in United States District Court for the District of Connecticut ("District Court"). The suit, which was filed on behalf of a class of company shareholders, named as defendants Aetna Life and Casualty Company ("Aetna") and certain present and former Aetna officers and directors. The suit alleges that the defendants fraudulently and in violation of federal securities laws failed, among other things, to adequately disclose alleged deterioration in the value of mortgage loan and real estate investment portfolios and that the plaintiff, acting in reliance upon such allegedly misleading public statements, purchased Aetna common stock at artificially inflated prices. The suit seeks certification of the class and unspecified compensatory and punitive damages. In November 1990, the plaintiff filed an amended complaint. The defendants moved to have the amended complaint dismissed. The plaintiff subsequently filed a second amended complaint, and in August 1991 the District Court denied the defendants' motion to dismiss this complaint. In the interim, the plaintiff dropped all but two of the original individual defendants. Subsequently, a class was conditionally certified composed of purchasers of Aetna common stock during the period from February 16, 1989 through November 13, 1990, with some exceptions. Aetna has answered the complaint, denying all substantive averments, and discovery is substantially complete. Aetna believes that the suit is neither supported as a matter of fact nor as a matter of law and, with the other defendants, will continue to contest vigorously the litigation. In Re: Standard Financial Indemnity Corporation et al. v. The Aetna Casualty and Surety Company et al. In 1989, the Standard Financial Indemnity Corporation ("SFIC") filed an antitrust suit in Texas state court against The Aetna Casualty and Surety Company ("Aetna Casualty") and all other insurers acting as servicing carriers for the Texas workers' compensation assigned risk pool (collectively, "defendants"). The complaint alleged that the plaintiff's application to become a servicing carrier had been wrongfully denied pursuant to a conspiracy among the servicing carriers. In February 1990, Preferred Employers' Insurance Company ("Preferred") joined the suit as a plaintiff and made an additional claim alleging that the servicing carriers had intentionally overpaid claims in order to raise prices and to drive workers' compensation customers into the assigned risk pool. The defendants' motion to dismiss the original suit brought by SFIC, which Preferred had later joined as a plaintiff, was granted in March 1990. SFIC appealed this ruling and on May 19, 1993, the Court of Appeal, Third District of Texas ("Court of Appeal") reversed and remanded the matter to the trial court. Preferred did not appeal the initial dismissal of the original suit and, therefore, is no longer a party to the litigation. On March 12, 1992, the Texas Commissioner of Insurance placed SFIC into receivership. On August 25, 1993, the Court of Appeal denied defendant's motion for rehearing. On September 24, 1993, defendants filed an application for writ of error with the Supreme Court of Texas. A settlement for an amount not material to the company has been reached with SFIC's receiver and has become final. In Re: Attorneys General Antitrust Litigation The description of this litigation is contained in Note 16 of Notes to Financial Statements in the Annual Report and is incorporated herein by reference. Other Litigation Aetna is continuously involved in numerous other lawsuits arising, for the most part, in the ordinary course of its business operations either as a liability insurer defending third-party claims brought against its insureds or as an insurer defending coverage claims brought against itself, including lawsuits related to issues of policy coverage and judicial interpretation. One such area of coverage litigation involves legal liability for asbestos and environmental-related claims. These lawsuits and other factors make reserving for asbestos and environmental-related claims subject to significant uncertainties. See MD&A - Property-Casualty Reserves in the Annual Report. While the ultimate outcome of the litigation described herein cannot be determined at this time, management does not believe it likely that such litigation, net of reserves established therefor and giving effect to reinsurance, will result in judgments for amounts material to the financial condition of the company, although it may affect results of operations in future periods. Litigation related to asbestos and environmental claims is subject to significant uncertainties; therefore management is unable to determine whether the effects on operations in future periods will be material. Item 4.

Item 4. Submission of Matters to a Vote of Security Holders. None. EXECUTIVE OFFICERS OF AETNA LIFE AND CASUALTY COMPANY* The Chairman of Aetna Life and Casualty Company is elected and all other executive officers listed below are appointed by the Board of Directors of the company at its Annual Meeting each year to hold office until the next Annual Meeting of the Board or until their successors are elected or appointed. None of these officers have family relationships with any other executive officer or Director. (1) Mr. Compton has served as Chairman since March 1, 1992. He is also President, a position he has held since July 1988. (2) Ms. Baird has served in her current position since April 1992. From July 1990 to April 1992 she served as Vice President and General Counsel. From 1986 to July 1990 she was with General Electric Company, Fairfield, Connecticut, most recently as Counselor and Staff Executive. (3) Mr. Benanav has served in his current position since December 1993. From April 1992 to December 1993 he served as Group Executive responsible for International, individual life insurance, annuities, mutual funds, and small case pensions. From April 1990 through April 1992, he served as Senior Vice President, International Insurance. From August 1989 until April 1990, he served as Vice President, International Insurance Division. From June 1986 to August 1989 he served as Vice President - Finance and Treasurer. (4) Ms. Champlin has served in her current position since November 1992. From February 1991 through November 1992 she served as Vice President, Aetna Human Resources. From June 1989 through January 1991 she served as Assistant Vice President, Corporate Management, Office of the Chairman. From August 1988 to May 1989 she served as Director, Corporate Management, Office of the Chairman. (5) Mr. Kearney has served in his current position since December 1993. From February 1991 to December 1993 he served as Group Executive responsible for investments and large case pensions. From 1990 to February 1991 he served as the principal of Daniel P. Kearney, Inc. From 1989 to 1990 he served as President and Chief Executive Officer of the Oversight Board of the Resolution Trust Corporation. From 1988 to 1989 he served as a principal of Aldrich, Eastman and Waltch, Inc. (a pension fund advisor). (6) Mr. Kenny has served in his current position since March 1992. From January 1988 through February 1992, he served as Senior Vice President, Finance. (7) Ms. Krupnick has served in her current position since November 1992. From October 1989 through November 1992, she served as Vice President, Corporate Affairs. From January 1988 to October 1989 she served as Assistant Vice President, Corporate Affairs. (8) Mr. McLane has served in his current position since December 1993. From April 1992 to December 1993, he served as Group Executive responsible for group health and life insurance including managed care operations. From February 1991 through April 1992 he served as Chief Executive Officer, Aetna Health Plans; from 1985 through 1991 he served as Senior Vice President, Global Insurance Division, Citicorp. (9) Mr. McMurtry has served in his current position since November 1992. From February 1989 through November 1992 he served as Staff Director and Chief Counsel, Committee on Finance, United States Senate. From January 1986 through February 1989 he served as Legislative Director for Lloyd M. Bentsen Jr., United States Senate. (10) Mr. Broatch has served in his current position since December 1993. From May 1988 to December 1993, he served as Vice President and Corporate Controller. (11) Mr. Loewenberg has served in his current position since March 1989. From September 1987 to March 1989 he served as Senior Vice President and Chief Administrative Officer, Agency Group, Capital Holding Corporation. (12) Mr. Scott has served in his current position since November 1991. From April 1991 until November 1991, he served as Vice President, Standard Commercial Accounts. From October 1988 through April 1991, he served as Senior Vice President, Standard Markets Department, Commercial Insurance Division. PART II Item 5.

Item 5. Market for Registrant's Common Equity and Related Stockholder Matters. Aetna Life and Casualty Company's common stock is listed on the New York and Pacific Stock Exchanges, with unlisted trading privileges on other regional exchanges. Its symbol is AET. The common stock also is listed on the Swiss Stock Exchanges at Basel, Geneva and Zurich. Call and put options on the common stock are traded on the American Stock Exchange. As of February 25, 1994, there were 27,452 record holders of the common stock. The dividends declared and the high and low sales prices with respect to Aetna Life and Casualty Company's common stock for each quarterly period for the past two years are incorporated herein by reference from "Quarterly Data" in the Annual Report. Information regarding restrictions on the company's present and future ability to pay dividends is incorporated herein by reference from Note 8 of Notes to Financial Statements in the Annual Report. Item 6.

Item 6. Selected Financial Data. The information contained in "Selected Financial Data" in the Annual Report is incorporated herein by reference. Item 7.

Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations. The information contained in "Management's Discussion and Analysis of Financial Condition and Results of Operations" in the Annual Report is incorporated herein by reference. Item 8.

Item 8. Financial Statements and Supplementary Data. The 1993 Consolidated Financial Statements and the report of the registrant's independent auditors and the unaudited information set forth under the caption "Quarterly Data" is incorporated herein by reference to the Annual Report. Item 9.

Item 9. Changes in and Disagreements With Accountants on Accounting and Financial Disclosure. None. PART III Item 10.

Item 10. Directors and Executive Officers of the Registrant. Information concerning Executive Officers is included in Part I pursuant to General Instruction G to Form 10-K. Information concerning Directors and concerning compliance with Section 16 (a) of the Securities Exchange Act of 1934 is incorporated herein by reference to the Proxy Statement. Item 11.

Item 11. Executive Compensation. The information under the caption "Executive Compensation" is incorporated herein by reference to the Proxy Statement. Item 12.

Item 12. Security Ownership of Certain Beneficial Owners and Management. The information under the caption "Security Ownership of Certain Beneficial Owners, Directors, Nominees and Executive Officers" is incorporated herein by reference to the Proxy Statement. Item 13.

Item 13. Certain Relationships and Related Transactions. The information under the caption "Certain Transactions and Relationships" is incorporated herein by reference to the Proxy Statement. PART IV Item 14.

Item 14. Exhibits, Financial Statement Schedules and Reports on Form 8-K. (a) The following documents are filed as part of this report: 1. Financial statements: The Consolidated Financial Statements and the report of the registrant's independent auditors are incorporated herein by reference to the Annual Report. 2. Financial statement schedules: The supporting schedules of the consolidated entity are included in this Item 14. See Index to Financial Statement Schedules on page 41. 3. Exhibits: * (3) Articles of Incorporation and By-Laws. Certificate of Incorporation of Aetna Life and Casualty Company, incorporated herein by reference to the registrant's 1992 Form 10-K, filed on March 17, 1993. By-Laws of Aetna Life and Casualty Company. (4) Instruments defining the rights of security holders, including indentures. Conformed copy of Indenture, dated as of October 15, 1977 between Aetna Life and Casualty Company and Morgan Guaranty Trust Company of New York, Trustee, incorporated herein by reference to the registrant's 1992 Form 10-K, filed on March 17, 1993 (the "1992 Form 10-K"). Conformed copy of Indenture, dated as of October 15, 1986 between Aetna Life and Casualty Company and The First National Bank of Boston, Trustee, incorporated herein by reference to the 1992 Form 10-K. Conformed copy of Indenture, dated as of August 1, 1993, between Aetna Life and Casualty Company and State Street Bank and Trust Company of Connecticut, National Association, as Trustee, incorporated herein by reference to the registrant's Registration Statement on Form S-3 (File No. 33-50427). Rights Agreement dated as of October 27, 1989, between Aetna Life and Casualty Company and First Chicago Trust Company of New York incorporated herein by reference to the 1992 Form 10-K. Summary of Rights to Purchase Preferred Stock, incorporated herein by reference to the 1992 Form 10-K. (10) Material contracts. The 1984 and 1979 Stock Option Plans of Aetna Life and Casualty Company and amendments thereto, incorporated herein by reference to the 1992 Form 10-K. Aetna Life and Casualty Company's Supplemental Incentive Savings Plan, incorporated herein by reference to the 1992 Form 10-K. Aetna Life and Casualty Company's Supplemental Pension Benefit Plan, incorporated herein by reference to the 1992 Form 10-K. Aetna Life and Casualty Company's Performance Unit Plan, incorporated herein by reference to the 1992 Form 10-K. Aetna Life and Casualty Company's 1986 Management Incentive Plan, as amended effective February 25, 1994. The Aetna Life and Casualty Directors' Deferred Compensation Plan, incorporated herein by reference to the 1992 Form 10-K. Letter Agreement, dated December 18, 1993, between Aetna Life and Casualty Company and David A. Kocher. Aetna Life and Casualty Company Non-Employee Director Deferred Stock Plan, incorporated herein by reference to the 1992 Form 10-K. Description of certain arrangements not embodied in formal documents, as described with respect to Directors' fees and benefits, and under the caption "Executive Compensation," are incorporated herein by reference to the Proxy Statement. (11) Statement re computation of per share earnings. Incorporated herein by reference to Note 1 of Notes to Financial Statements in the company's 1993 Annual Report. (12) Statement re computation of ratios. Statement re: computation of ratio of earnings to fixed charges. Statement re: computation of ratio of earnings to combined fixed charges and preferred stock dividends. (13) Annual Report to security holders. Selected Financial Data, Management's Discussion and Analysis of Financial Condition and Results of Operations, Consolidated Financial Statements and the report of the registrant's independent auditors, and unaudited Quarterly Data from the Annual Report. (18) Letter re change in accounting principles Letter from Independent Auditors regarding the preferability of the change in accounting principle for reporting reserves for workers' compensation life table indemnity claims to a discounted basis. (21) Subsidiaries of the registrant. A listing of subsidiaries of Aetna Life and Casualty Company. (23) Consents of experts and counsel. Consent of Independent Auditors to Incorporation by Reference in the Registration Statements on Form S-3 and Form S-8. (28) Information from Reports Furnished to State Insurance Regulatory Authorities. 1993 Consolidated Schedule P of Annual Statements provided to state regulatory authorities. ** (b) Reports on Form 8-K None. * Exhibits other than those listed are omitted because they are not required or are not applicable. Copies of exhibits are available without charge by writing to the Office of the Corporate Secretary, Aetna Life and Casualty Company, 151 Farmington Avenue, Hartford, Connecticut 06156. ** Filed under cover of Form SE. INDEX TO FINANCIAL STATEMENT SCHEDULES AETNA LIFE AND CASUALTY COMPANY AND SUBSIDIARIES Page ____ Independent Auditors' Report........................ 42 I Summary of Investments - Other than Investments in Affiliates as of December 31, 1993.......................... 43 III Condensed Financial Information of the Registrant as of December 31, 1993 and 1992 and for the years ended December 31, 1993, 1992 and 1991........................... 44 V Supplementary Insurance Information as of and for the years ended December 31, 1993, 1992 and 1991................................. 50 VIII Valuation and Qualifying Accounts and Reserves for the years ended December 31, 1993, 1992 and 1991...................................... 53 IX Short-term Borrowings for the years ended December 31, 1993, 1992 and 1991.............. 54 X Supplemental Information Concerning Property-Casualty Operations for the years ended December 31, 1993, 1992 and 1991........ 55 Schedules other than those listed above are omitted because they are not required or are not applicable, or the required information is shown in the Financial Statements or Notes thereto in the company's 1993 Annual Report. Columns omitted from schedules filed have been omitted because the information is not applicable. Certain reclassifications have been made to 1992 and 1991 financial information to conform to 1993 presentation. INDEPENDENT AUDITORS' REPORT The Shareholders and Board of Directors Aetna Life and Casualty Company: Under date of February 8, 1994, we reported on the consolidated balance sheets of Aetna Life and Casualty Company and Subsidiaries as of December 31, 1993 and 1992, and the related consolidated statements of income, shareholders' equity, and cash flows for each of the years in the three-year period ended December 31, 1993, as contained in the 1993 annual report to shareholders. These consolidated financial statements and our report thereon are incorporated by reference in the annual report on Form 10-K for the year 1993. In connection with our audits of the aforementioned consolidated financial statements, we also have audited the related financial statement schedules as listed in the accompanying index. These financial statement schedules are the responsibility of the company's management. Our responsibility is to express an opinion on these financial statement schedules based on our audits. In our opinion, such financial statement schedules, when considered in relation to the basic consolidated financial statements taken as a whole, present fairly, in all material respects, the information set forth therein. As discussed in Note 1 to the consolidated financial statements, in 1993 the company changed its methods of accounting for certain investments in debt and equity securities, reinsurance of short-duration and long-duration contracts, postemployment benefits, workers' compensation life table indemnity reserves and retrospectively rated reinsurance contracts. In 1992, the company changed its methods of accounting for income taxes and postretirement benefits other than pensions. By KPMG PEAT MARWICK _____________________ (Signature) KPMG PEAT MARWICK Hartford, Connecticut February 8, 1994 AETNA LIFE AND CASUALTY COMPANY AND SUBSIDIARIES SCHEDULE I Summary of Investments - Other than Investments in Affiliates As of December 31, 1993 AETNA LIFE AND CASUALTY COMPANY AND SUBSIDIARIES SCHEDULE III Condensed Financial Information AETNA LIFE AND CASUALTY COMPANY Statements of Income AETNA LIFE AND CASUALTY COMPANY AND SUBSIDIARIES SCHEDULE III Condensed Financial Information AETNA LIFE AND CASUALTY COMPANY Balance Sheets AETNA LIFE AND CASUALTY COMPANY AND SUBSIDIARIES SCHEDULE III Condensed Financial Information AETNA LIFE AND CASUALTY COMPANY Statements of Shareholders' Equity AETNA LIFE AND CASUALTY COMPANY AND SUBSIDIARIES SCHEDULE III Condensed Financial Information AETNA LIFE AND CASUALTY COMPANY Statements of Cash Flows AETNA LIFE AND CASUALTY COMPANY AND SUBSIDIARIES SCHEDULE III Condensed Financial Information AETNA LIFE AND CASUALTY COMPANY Notes to Condensed Financial Statements The accompanying condensed financial statements should be read in conjunction with the Consolidated Financial Statements and Notes thereto in the company's 1993 Annual Report. Certain reclassifications have been made to 1992 and 1991 financial information to conform to 1993 presentation. 1. Long-Term Debt See Note 9 to the Consolidated Financial Statements in the Annual Report for a description of the long-term debt and aggregate maturities for 1994 to 1998 and thereafter. 2. Dividends The amounts of cash dividends paid to Aetna Life and Casualty Company by insurance affiliates for the years ended December 31, 1993, 1992 and 1991 were as follows: See Note 8 to the Consolidated Financial Statements in the Annual Report for a description of dividend restrictions from the consolidated insurance subsidiaries to the company. AETNA LIFE AND CASUALTY COMPANY AND SUBSIDIARIES SCHEDULE III Condensed Financial Information AETNA LIFE AND CASUALTY COMPANY Notes to Condensed Financial Statements (Continued) 3. Accounting Changes See Note 1 to the Consolidated Financial Statements in the Annual Report for a description of accounting changes. 4. Discontinued Products See Note 2 to the Consolidated Financial Statements in the Annual Report for a description of discontinued products. 5. Sales of Subsidiaries See Note 3 to the Consolidated Financial Statements in the Annual Report for a description of the sales of subsidiaries. 6. Severance and Facilities Charge See Note 4 to the Consolidated Financial Statements in the Annual Report for a description of the severance and facilities charges. 7. Federal and Foreign Income Taxes See Note 10 to the Consolidated Financial Statements in the Annual Report for a description of federal and foreign income taxes. 8. Litigation See Note 16 to the Consolidated Financial Statements in the Annual Report for a description of the Attorneys General Antitrust litigation. AETNA LIFE AND CASUALTY COMPANY AND SUBSIDIARIES SCHEDULE V Supplementary Insurance Information As of and for the year ended December 31, 1993 AETNA LIFE AND CASUALTY COMPANY AND SUBSIDIARIES SCHEDULE V Supplementary Insurance Information As of and for the year ended December 31, 1992 AETNA LIFE AND CASUALTY COMPANY AND SUBSIDIARIES SCHEDULE V Supplementary Insurance Information As of and for the year ended December 31, 1991 AETNA LIFE AND CASUALTY COMPANY AND SUBSIDIARIES SCHEDULE VIII Valuation and Qualifying Accounts and Reserves AETNA LIFE AND CASUALTY COMPANY AND SUBSIDIARIES SCHEDULE IX Short-Term Borrowings AETNA LIFE AND CASUALTY COMPANY AND SUBSIDIARIES SCHEDULE X Supplemental Information Concerning Property-Casualty Operations SIGNATURES Pursuant to the requirements of Section 13 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: March 18, 1994 AETNA LIFE AND CASUALTY COMPANY (Registrant) By ROBERT E. BROATCH ______________________________ (Signature) Robert E. Broatch Senior Vice President, Finance and Corporate Controller Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities indicated on March 18, 1994. Signature Title RONALD E. COMPTON ________________________ Ronald E. Compton Chairman, President and Director (Principal Executive Officer) WALLACE BARNES ________________________ Wallace Barnes Director JOHN F. DONAHUE ________________________ John F. Donahue Director WILLIAM H. DONALDSON ________________________ William H. Donaldson Director BARBARA HACKMAN FRANKLIN ________________________ Barbara Hackman Franklin Director EARL G. GRAVES ________________________ Earl G. Graves Director GERALD GREENWALD ________________________ Gerald Greenwald Director MICHAEL H. JORDAN ________________________ Michael H. Jordan Director JACK D. KUEHLER ________________________ Jack D. Kuehler Director FRANK R. O'KEEFE JR. ________________________ Frank R. O'Keefe Jr. Director DAVID M. RODERICK ________________________ David M. Roderick Director PATRICK W. KENNY ________________________ Patrick W. Kenny Group Executive, Finance and Administration (Principal Financial Officer)

36029_1993.txt

36029

1993

789538_1993.txt

789538

1993

Item 1. Business. Formation ML Venture Partners II, L.P. (the "Partnership" or the "Registrant") is a Delaware limited partnership organized on February 4, 1986. The General Partners of the Partnership consist of four individuals (the "Individual General Partners") and MLVPII Co., L.P. (the "Managing General Partner"), a New York limited partnership in which Merrill Lynch Venture Capital Inc. (the "Management Company") is the general partner. The Management Company is an indirect subsidiary of Merrill Lynch & Co., Inc. and an affiliate of Merrill Lynch, Pierce, Fenner & Smith Incorporated ("MLPF&S"). DLJ Capital Management Corporation (the "Sub-Manager"), an affiliate of Donaldson, Lufkin and Jenrette, Inc., is the sub-manager pursuant to a sub-management agreement, dated May 23, 1991, among the Partnership, the Managing General Partner, the Management Company and the Sub-Manager. The Partnership operates as a business development company under the Investment Company Act of 1940. The Partnership's investment objective is to seek long-term capital appreciation by making venture capital investments in new and developing companies and other special investment situations. The Partnership considers this activity to constitute the single industry segment of venture capital investing. Through MLPF&S, the Partnership publicly offered 120,000 Units at $1,000 per Unit. The Units were registered under the Securities Act of 1933 pursuant to a Registration Statement on Form N-2 (File No. 33-3220) which was declared effective on February 10, 1987. The Partnership held its initial and final closings on March 31, 1987 and June 10, 1987, respectively. A total of 120,000 Units were accepted at such closings and the additional limited partners (the "Limited Partners") were admitted to the Partnership. The information set forth under the captions "Risk and Other Important Factors" (pages 8 through 11), "Investment Objective and Policies" (pages 14 through 16), "Venture Capital Operations" (pages 17 through 20) and "Portfolio Valuation" (pages 27 and 28) in the prospectus of the Partnership dated February 10, 1987, filed with the Securities and Exchange Commission pursuant to Rule 424(b) under the Securities Act of 1933, as supplemented by a supplement thereto dated April 21, 1987 and filed pursuant to Rule 424(c) under the Securities Act of 1933 (the "Prospectus"), is incorporated herein by reference. The Venture Capital Investments During the year ended December 31, 1993, the Partnership invested $8 million in its portfolio of investments: $3.6 million in two new portfolio companies and $4.4 million in six existing portfolio companies. At December 31, 1993, the Partnership had invested $110.7 million in 58 portfolio investments. In addition, subsequent to year-end, the Partnership had an outstanding investment commitment totaling $1.1 million (see Note 6 of Notes to Financial Statements). At December 31, 1993, the Partnership's investment portfolio consisted of 32 active investments with a cost of $55.1 million and a fair value of $107 million. From its inception through December 31, 1993, the Partnership has fully or partially liquidated investments with an aggregate cost basis of $55.6 million for a total return of $46.6 million. The Partnership's cumulative net realized loss from the liquidation of these investments is $9 million at December 31, 1993. Additionally, from December 31, 1993 to February 18, 1994, the Partnership sold, or partially sold, investments for $13.9 million, realizing a gain of $12.8 million. Venture capital investments made in 1993 are as follows: The descriptions of the Partnership's follow-on investments in Corporate Express, Inc., Diatech, Inc. and HCTC Investment, L.P. set forth in Item 5 of Part II of the Partnership's quarterly report on Form 10-Q for the quarter ended March 31, 1993 are incorporated herein by reference. The descriptions of the Partnership's investments in Inference Corporation and OccuSystems, Inc. and the Partnership's follow-on investments Corporate Express, Inc., HCTC Investment, L.P. and Diatech, Inc. set forth in Item 5 of Part II of the Partnership's quarterly report on Form 10-Q for the quarter ended June 30, 1993 are incorporated herein by reference. The descriptions of the Partnership's follow-on investments in Trancel Corporation, Neocrin Corporation (formerly Trancel) and HCTC Investment, L.P. set forth in Item 5 of Part II of the Partnership's quarterly report on Form 10-Q for the quarter ended September 30, 1993 are incorporated herein by reference. On August 12, 1993, the Partnership converted promissory notes from Diatech, Inc. with an aggregate face value of $494,000 and accrued interest totaling $26,015 into 208,006 preferred shares of the company at $2.50 per share. On October 6, 1993, the Partnership paid $6,957 to MLMS Cancer Research, Inc. in connection with a call on a non-interest bearing promissory note payable on demand to the company. The payment increased the cost basis of the Partnership's common stock investment in the company from $40,000 to $46,957 and reduced the outstanding obligation under the promissory note from $400,000 to $393,043. Competition The Partnership encounters competition from other entities having similar investment objectives, including other entities affiliated with Merrill Lynch & Co., Inc. Primary competition for venture capital investments has been from venture capital partnerships, venture capital affiliates of large industrial and financial companies, small business investment companies and wealthy individuals. Competition has also been from foreign investors and from large industrial and financial companies investing directly rather than through venture capital affiliates. The Partnership has frequently been a co-investor with other professional venture capital groups and these relationships generally have expanded the Partnership's access to investment opportunities. Employees The Partnership has no employees. The Partnership Agreement provides that the Managing General Partner, subject to the supervision of the Individual General Partners, manages and controls the Partnership's venture capital investments. The Management Company performs, or arranges for others to perform, the management and administrative services necessary for the operation of the Partnership and is responsible for managing the Partnership's short-term investments. The Sub-Manager, subject to the supervision of the Management Company and Individual General Partners, provides management services in connection with the Partnership's venture capital investments and investments of the Partnership in unaffiliated venture capital funds. Item 2.

Item 2. Properties. The Partnership does not own or lease physical properties. Item 3.

Item 3. Legal Proceedings. The Partnership has been named as a defendant in an action relating to its ownership of securities of In-Store Advertising, Inc. ("In-Store Advertising"). On or about July 16, 1993, a Second Amended Consolidated Class Action Complaint (the "Amended Complaint") was filed in the United States District Court for the Southern District of New York in the In Re In- Store Advertising Securities Litigation. The action is a purported class action suit wherein the plaintiffs (the "Plaintiffs") are persons who allegedly purchased shares of In-Store Advertising common stock in the July 19, 1990 initial public offering (the "Offering") and through November 8, 1990. The defendants named in the Amended Complaint include present and former individual officers and directors of In-Store Advertising, the underwriters involved in the Offering, KPMG Peat Marwick (In-Store Advertising's auditors) and certain other defendants, including the Partnership, who owned In-Store Advertising securities prior to the Offering (the "Venture Capital Defendants"). Prior to the filing of the Amended Complaint, In-Store Advertising filed a "prepackaged" plan in U.S. Bankruptcy Court pursuant to Chapter XI of the U.S. Bankruptcy Code. The Amended Complaint alleges violations under Sections 11, 12(2) and 15 of the Securities Act of 1933, as amended (the "1933 Act"), Section 10(b) and 20 of the Securities Exchange Act of 1934, as amended (the "1934 Act") and Rule 10b-5 promulgated thereunder, and common law claims of negligent misrepresentation, fraud and deceit in connection with the sale of securities. The Plaintiffs seek rescission of the purchases of In-Store Advertising's common stock to the extent the members of the alleged classes still hold their shares, together with damages and certain costs and expenses. The Amended Complaint alleges that the Venture Capital Defendants are liable under Section 10(b) of the 1934 Act and Rule 10b-5, and are also liable as controlling persons of In-Store Advertising within the meaning of Section 15 of the 1933 Act and Section 20(a) of the 1934 Act. The Venture Capital Defendants are also being sued as alleged knowing and substantial aiders and abettors of the other defendants' wrongful conduct and under common law fraud and negligence theories. An individual director of In- Store Advertising, named as a defendant in the action, was a Vice President of Merrill Lynch Venture Capital Inc., the General Partner of the Managing General Partner of the Partnership. The Partnership believes that it has meritorious defenses to the allegations in the Amended Complaint (see Note 8 of Notes to Financial Statements). Item 4.

Item 4. Submission of Matters to a Vote of Security Holders. No matter was submitted during the fourth quarter of the fiscal year covered by this report to a vote of security holders. The 1994 Annual Meeting of the limited partners of the Partnership is scheduled to be held on May 3, 1994. PART II Item 5.

Item 5. Market for Registrant's Common Equity and Related Stockholder Matters. The information with respect to the market for the Units set forth under the subcaption "Substituted Limited Partners" on pages 30 and 31 of the Prospectus is incorporated herein by reference. There is no established public trading market for the Units as of March 18, 1994. The approximate number of holders of Units as of March 18, 1994 is 13,700. The Managing General Partner and the Individual General Partners of the Partnership also hold interests in the Partnership. Effective November 9, 1992, the Registrant was advised that Merrill Lynch, Pierce, Fenner & Smith Incorporated ("Merrill Lynch" or "MLPF&S") introduced a new limited partnership secondary service through Merrill Lynch's Limited Partnership Secondary Transaction Department ("LPSTD"). This service will assist Merrill Lynch clients wishing to buy or sell Registrant Units. The LPSTD has replaced the Merrill Lynch Investor Service, a service which was designed to match interested buyers and sellers of partnership interests, but which had been suspended since September 1991 for transactions involving the Registrant's Units. On May 26, 1993, the Partnership made a cash distribution to Limited Partners of record on March 31, 1993 totaling $15.6 million, or $130 per Unit. On April 30, 1992, the Partnership made a cash distribution to Limited Partners of record on March 31, 1992 totaling $9 million, or $75 per Unit. On April 26, 1991, the Partnership made a cash distribution to Limited Partners of record on March 31, 1991 totaling $6 million, or $50 per Unit. These distributions primarily resulted from proceeds received by the Partnership from the sale of certain portfolio investments. Cumulative cash distributions paid to Limited Partners from inception through December 31, 1993 total $42.6 million, or $355 per $1,000 Unit. On March 2, 1994, the General Partners approved a cash distribution to Limited Partners totaling $16.2 million, or $135 per Unit. The distribution will be paid in May 1994 to Limited Partners of record on March 31, 1994 and will bring cumulative cash distributions paid to Limited Partners to $58.8 million, or $490 per $1,000 Unit. Item 6.

Item 6. Selected Financial Data. ($ In Thousands, Except Per Unit Information) Fiscal Years Ended December 31, 1993 1992 1991 1990 1989 Net Realized Gain (Loss) on Investments $ 10,605 $ (5,677) $ 1,968$ (15,142) $ 2,931 Net Change in Unrealized Appreciation of Investments 9,430 11,657 14,361 4,525 1,137 Net Increase (Decrease) in Net Assets Resulting from Operations 18,581 4,809 15,954 (9,976) 5,375 Cash Distributions to Limited Partners 15,600 9,000 6,000 - 12,000 Cumulative Cash Distributions to Limited Partners 42,600 27,000 18,000 12,000 12,000 Net Assets 112,671 109,690 113,881 103,927 113,903 Net Unrealized Appreciation of Investments 51,908 42,478 30,821 16,460 11,936 Purchase of Portfolio Investments8,050 13,781 9,845 7,790 21,088 Cumulative Cost of Portfolio Investments 110,682 102,633 88,852 79,006 71,217 PER UNIT OF LIMITED PARTNERSHIP INTEREST: Net Realized Gain (Loss) on Investments $ 87 $ (47) $ 16 $ (125) $ 25 Net Increase (Decrease) in Net Assets Resulting from Operations 120 29 104 (65) 37 Cash Distributions 130 75 50 - 100 Cumulative Cash Distributions 355 225 150 100 100 Net Unrealized Appreciation of Investments 355 310 225 133 79 Net Asset Value, Including Net Unrealized Appreciation of Investments 852 862 908 854 919 Item 7.

Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations. Liquidity and Capital Resources During the year ended December 31, 1993, the Partnership invested $8 million in portfolio investments; $3.6 million in two new portfolio companies and $4.4 million in five existing portfolio companies. From its inception through December 31, 1993, the Partnership had invested $110.7 million in 58 portfolio investments. Additionally, subsequent to December 31, 1993, the Partnership had a commitment to make a follow-on investment of $1.1 million in Corporate Express, Inc. As of December 31, 1993, 26 of the Partnership's 58 portfolio investments had been fully liquidated. Portfolio investments sold and written-off through December 31, 1993 had a cost of $55.6 million and returned $46.6 million, resulting in a cumulative net realized loss of $9 million. At December 31, 1993, the Partnership held $5.4 million in cash and short- term investments; $4 million in short-term securities with maturities of less than one year and $1.4 million in an interest-bearing cash account. It is anticipated that funds needed to cover future operating expenses will be obtained from the Partnership's existing cash reserves and from proceeds received from the future sale of portfolio investments. Subsequent to the end of fiscal 1993, the Partnership sold or partially sold investments in three portfolio companies for $13.9 million. As a result, on March 2, 1994, the General Partners approved a cash distribution to Limited Partners of $16.2 million, or $135 per Unit. This distribution will be paid in May 1994 to Limited Partners of record on March 31, 1994 and will bring cumulative cash distributions paid to Limited Partners to $58.8 million, or $490 per $1,000 Unit. Results of Operations Net realized gain or loss from operations is comprised of 1) net realized gains or losses from portfolio investments sold and written-off and 2) net investment income or loss. For the year ended December 31, 1993, the Partnership had a net realized gain from operations of $9.2 million. In 1992, the Partnership had a net realized loss from operations of $6.8 million and in 1991, the Partnership had a net realized gain from operations of $1.6 million. Realized Gains and Losses from Portfolio Investments - For the year ended December 31, 1993, the Partnership had a $10.6 million net realized gain from portfolio investments sold and written-off. During the year, the Partnership sold 525,000 common shares of Regeneron Pharmaceuticals, Inc. in the public market for $8.2 million, realizing a gain of $7.6 million. In January 1993, the Partnership sold its investment in Pyxis Corporation in a private transaction for $7.8 million, realizing a gain of $7.2 million. In February 1993, the Partnership sold 187,912 common shares of Ringer Corporation for $567,000, realizing a gain of $4,000. During the year, In-Store Advertising, Inc. ("ISA") filed for protection under Chapter 11 of the federal Bankruptcy Code resulting in the write-off of the Partnership's remaining $1.1 million investment in the company. The Partnership also received a final liquidation payment from InteLock Corporation resulting in the write-off of the Partnership's remaining $123,000 investment in the company. Additionally, the Partnership wrote-off its $2 million investment in Ogle Resources, Inc. ("Ogle") and the remaining $900,000 of its investment in Communications International, Inc. ("CII"). Several smaller portfolio transactions completed in 1993 resulted in an additional $46,000 net realized loss for the period. For the year ended December 31, 1992, the Partnership had a $5.7 million net realized loss from portfolio investments sold and written-off. In February and March 1992, the Partnership sold its remaining 157,500 common shares of Everex Systems, Inc. in the public market for $1 million, realizing a gain of $371,000. The Partnership also sold 45,000 common shares of Regeneron Pharmaceuticals, Inc. in the public market for $627,000, realizing a gain of $575,000. In September 1992, the Partnership received 50,111 shares of Bolt Beranek and Newman Inc. common stock in connection with the termination of BBN Integrated Switch Partners, L.P. The shares were sold in the public market in October and November 1992 for $200,000 which resulted in a realized gain of $13,000. In May 1992, Allez, Inc. filed for protection under Chapter 11 of the federal Bankruptcy Code. As a result, the Partnership realized a loss from its $1.8 million investment in the company. The Partnership also realized losses of $1.1 million of its $1.3 million investment in InteLock due to the company's financial restructuring and continued operating difficulties. In October 1992, the Partnership sold its investment in R-Byte to Exabyte Corporation for $1.3 million, which resulted in a realized loss of $444,000. Also during 1992, the Partnership realized a loss of $1.1 million on its $2.3 million investment in ISA due to the continued depressed public market price of the company's common stock. The Partnership also realized losses of $919,000 on its $1.8 million investment in CII, $1.1 million on its $1.5 million investment in Target Vision, Inc. and $102,000 on its remaining investment in TCOM Systems, Inc. due to continued operational and financial difficulties at the companies. For the year ended December 31, 1991, the Partnership had a $2 million net realized gain from investments sold and written-off. In November 1991, the Partnership sold 500,000 common shares of Regeneron in the public market for $9.2 million, realizing a gain of $9.0 million. In April 1991, the Partnership sold 30,000 common shares of Everex in the public market for $196,000, realizing a gain of $76,000. In January 1991, Ringer completed its acquisition of Safer, Inc. The Partnership sold its holdings of Safer for 275,317 common shares of Ringer. The transaction resulted in the Partnership realizing a loss of $2.2 million of its $3 million original investment in Safer. The Partnership realized additional losses during 1991 totaling $4.9 million from the full or partial write-off of four portfolio investments. S&J Industries, Inc. completed a restructuring that negatively affected the Partnership's investment in the company, resulting in the write-off of its $1.6 million investment. SF2 Corporation incurred substantial operating difficulties which led to a financial restructuring of the company. Consequently, the Partnership wrote-off its $1.9 million equity investment in SF2. The Partnership also wrote-off its $1.1 million investment in Touch Communications Incorporated which ceased operations in 1991. Additionally, the Partnership wrote-off its remaining $300,000 investment in The Computer-Aided Design Group, Inc. due to a financial restructuring of the company which negatively impacted the value of the Partnership's investment. Investment Income and Expenses - Net investment loss (investment income less operating expenses) for the years ended December 31, 1993, 1992 and 1991 was $1.5 million, $1.2 million and $374,000, respectively. The increase in net investment loss for 1993 compared to 1992 primarily is attributable to a decrease in investment income, specifically, interest income earned from the Partnership's short-term investments and the write- off of $406,000 of accrued interest receivable related to the Partnership's promissory note due from Ogle in the 1993 period. The reduction in investment income in 1993 was partially offset by a decrease in the 1993 management fee, as discussed below. The increase in net investment loss for 1992 compared to 1991 primarily is attributable to a decrease in interest income earned in 1992 from the Partnership's short-term investments partially offset by a decrease in the 1992 management fee, as discussed below. Interest earned from short-term investments for the years ended December 31, 1993, 1992 and 1991 was $360,000, $805,000 and $1.9 million, respectively. The decrease for each consecutive year primarily is due to a reduction in funds invested in short-term investments and declining interest rates. At December 31, 1993, 1992 and 1991, funds invested in short-term securities totaled $5.4 million, $12 million and $32.8 million, respectively. Funds available for investment in short-term securities declined as idle funds were used to purchase venture capital investments. The Management Company performs, or arranges for others to perform, the management and administrative services necessary for the operation of the Partnership. The Management Company receives an annual fee of 2.5% of the gross capital contributions to the Partnership, reduced by selling commissions, organizational and offering expenses paid by the Partnership, return of capital and realized capital losses, with a minimum fee of $200,000. Such fee is determined and payable quarterly. The management fee for the years ended December 31, 1993, 1992 and 1991 was $1.4 million, $1.7 million and $1.9 million, respectively. The management fee is expected to continue to decline in future periods as portfolio investments mature and capital is returned to Partners. The management fee and other operating expenses are paid with funds provided from operations. Funds provided from operations for the period were obtained from interest received from short-term investments, dividend and interest income from portfolio investments and proceeds from the sale of certain portfolio investments. Unrealized Gains and Losses from Portfolio Investments - For the year ended December 31, 1993, the Partnership had a $20.8 million unrealized gain from the net upward revaluation of certain portfolio investments. This unrealized gain primarily is a result of the net upward revaluation of the Partnership's investments in Regeneron, CellPro, Incorporated and Corporate Express, Inc. during 1993. Additionally, during the year, the Partnership transferred $13.6 million from unrealized gain to realized gain primarily relating to the sale of its investments in Pyxis and Regeneron and transferred $2.2 million from unrealized loss to realized loss relating to the write-offs of its investments in CII, Ogle, InteLock and ISA, as discussed above. The $20.8 million unrealized gain offset by the $11.4 million net transfer from unrealized gain to realized gain, resulted in a $9.4 million increase in the Partnership's net unrealized appreciation of investments for 1993. For the year ended December 31, 1992, the Partnership had a $6.8 million unrealized gain from the net upward revaluation of certain portfolio investments. This unrealized gain primarily resulted from the upward revaluation of the Partnership's investments in Pyxis and CellPro. Additionally, during the year, the Partnership transferred $4.9 million from unrealized loss to realized loss relating to the sale of Everex and the full or partial write-off of several other investments, as discussed above. The $6.8 million unrealized gain combined with the $4.9 million transfer from unrealized loss to realized loss resulted in an $11.7 million increase in the Partnership's net unrealized appreciation of investments for 1992. For the year ended December 31, 1991, the Partnership had a $14.3 million unrealized gain from the net upward revaluation of certain portfolio investments. This unrealized gain primarily resulted from the upward revaluation of the Partnership's investment in Regeneron. Additionally, during the year, the Partnership transferred a net $56,000 from unrealized loss to realized loss relating to the sale and write-off of several investments, as discussed above. The $14.3 million unrealized gain combined with the $56,000 net transfer from unrealized loss to realized loss resulted in a $14.4 million increase in the Partnership's net unrealized appreciation of investments for 1991. Net Assets - Changes in net assets resulting from operations is comprised of 1) net realized gains and losses from operations and 2) changes to net unrealized appreciation or depreciation of portfolio investments. For the year ended December 31, 1993, 1992 and 1991, the Partnership had a net increase in net assets resulting from operations of $18.6 million, $4.8 million and $16 million, respectively. At December 31, 1993, the Partnership's net assets were $112.7 million, an increase of $3 million from $109.7 million at December 31, 1992. This increase resulted from the $18.6 million net increase in net assets resulting from operations for 1993 offset by the $15.6 million cash distribution to Limited Partners paid in May 1993. At December 31, 1992, the Partnership's net assets were $109.7 million, a decrease of $4.2 million from $113.9 million at December 31, 1991. This decrease resulted from the $9 million cash distribution to Limited Partners paid in April 1992 exceeding the $4.8 million net increase in net assets resulting from operations for 1992. At December 31, 1991, the Partnership's net assets were $113.9 million, an increase of $10 million from $103.9 million at December 31, 1990. This increase resulted from the $16 million net increase in net assets resulting from operations for 1991 offset by the $6 million cash distribution to Limited Partners paid in April 1991. Gains and losses from investments are allocated to Partners' capital accounts when realized, in accordance with the Partnership Agreement (see Note 3 of Notes to Financial Statements). However, for purposes of calculating the net asset value per unit of limited partnership interest, net unrealized appreciation of investments has been included as if the net appreciation had been realized and allocated to the Limited Partners in accordance with the Partnership Agreement. Pursuant to such calculation, the net asset value per $1,000 Unit at December 31, 1993, 1992 and 1991 was $852, $862 and $908, respectively. Item 8.

Item 8. Financial Statements and Supplementary Data. ML VENTURE PARTNERS II, L.P. INDEX Independent Auditors' Report Balance Sheets as of December 31, 1993 and 1992 Schedule of Portfolio Investments as of December 31, 1993 Schedule of Portfolio Investments as of December 31, 1992 Statements of Operations for the years ended December 31, 1993, 1992 and Statements of Cash Flows for the years ended December 31, 1993, 1992 and Statements of Changes in Partners' Capital for the years ended December 31, 1991, 1992 and 1993 Notes to Financial Statements Schedule I - Money Market Investments as of December 31, 1993 and 1992 NOTE - All schedules, other than Schedule I, are omitted because of the absence of conditions under which they are required or because the required information is included in the financial statements or the notes thereto. DELOITTE & TOUCHE 1633 Broadway New York, NY 10019-6754 INDEPENDENT AUDITORS' REPORT ML Venture Partners II, L.P.: We have audited the accompanying balance sheets of ML Venture Partners II, L.P., including the schedules of portfolio investments, as of December 31, 1993 and 1992, and the related statements of operations, cash flows, and changes in partners' capital for each of the three years in the period ended December 31, 1993. Our audits also included the financial statement schedules listed in the Index at Item 8 of Form 10-K. These financial statements and financial statement schedules are the responsibility of the Partnership's management. Our responsibility is to express an opinion on these financial statements and financial statement schedules based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. Our procedures included confirmation of securities owned at December 31, 1993 and 1992 by correspondence with the custodian; where confirmation was not possible, we performed other audit procedures. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, such financial statements present fairly, in all material respects, the financial position of ML Venture Partners II, L.P. at December 31, 1993 and 1992, and the results of its operations and its cash flows for each of the three years in the period ended December 31, 1993 in conformity with generally accepted accounting principles. Also, in our opinion, such financial statement schedules, when considered in relation to the basic financial statements taken as a whole, present fairly in all material respects the information set forth therein. As explained in Note 2, the financial statements include securities valued at $107,038,636 and $97,529,004 at December 31, 1993 and 1992, respectively, representing 95% and 89% of net assets, respectively, whose values have been estimated by the Managing General Partner in the absence of readily ascertainable market values. We have reviewed the procedures used by the Managing General Partner in arriving at its estimate of value of such securities and have inspected underlying documentation, and, in the circumstances, we believe the procedures are reasonable and the documentation appropriate. However, because of the inherent uncertainty of valuation, those estimated values may differ significantly from the values that would have been used had a ready market for the securities existed, and the differences could be material. As discussed in Note 8 to the financial statements, the Partnership is a defendant in litigation relating to the Partnership's ownership of securities of In-Store Advertising, Inc. The ultimate outcome of the litigation cannot presently be determined. Accordingly, no provision for any loss that may result upon resolution of this matter has been made in the accompanying financial statements. Deloitte & Touche February 21, 1994, except for Note 7, as to which the date is March 2, 1994 ML VENTURE PARTNERS II, L.P. BALANCE SHEETS December 31, December 31, 1993 1992 ASSETS Investments - Note 2 Portfolio investments, at fair value (cost $55,130,444 at December 31, 1993 and $55,051,259 at December 31, 1992) $ 107,038,636 $ 97,529,004 Money market investments, at amortized cost 3,991,697 9,660,277 Cash and cash equivalents 1,412,882 2,306,339 Accrued interest receivable 220,067 53,879 Notes receivable 102,579 454,931 Receivable from securities sold 321,300 144,373 TOTAL ASSETS $ 113,087,161 $ 110,148,803 LIABILITIES AND PARTNERS' CAPITAL Liabilities: Accounts payable $ 41,535 $ 36,416 Due to Management Company - Note 4 353,242 402,047 Due to Independent General Partners - Note 5 21,450 19,950 Total liabilities 416,227 458,413 Partners' Capital: Managing General Partner 1,033,457 941,956 Individual General Partners 3,410 3,108 Limited Partners (120,000 Units) 59,725,875 66,267,581 Unallocated net unrealized appreciation of investments - Note 2 51,908,192 42,477,745 Total partners' capital 112,670,934 109,690,390 TOTAL LIABILITIES AND PARTNERS' CAPITAL $ 113,087,161 $ 110,148,803 See notes to financial statements. ML VENTURE PARTNERS II, L.P. SCHEDULE OF PORTFOLIO INVESTMENTS DECEMBER 31, 1993 ACTIVE PORTFOLIO INVESTMENTS: Initial Investment Fair Company / Position Date Cost Value Biocircuits Corporation*+ 515,269 shares of Common Stock May 1991 $1,422,501 $1,356,446 Borg-Warner Automotive, Inc.*+(A) 500,000 shares of Common Stock Sept. 1988 2,500,000 9,485,000 Borg-Warner Security Corporation*+(A) 500,000 shares of Common Stock Sept. 1988 2,500,000 7,584,375 CellPro, Incorporated*+(B) 783,333 shares of Common Stock Mar. 1989 1,455,944 19,417,868 Children's Discovery Centers of America, Inc.*+ 115,267 shares of Common Stock July 1988 2,000,259 920,695 Clarus Medical Systems, Inc.* 507,458 shares of Preferred Stock Jan. 1991 2,037,290 807,350 Warrants to purchase 20,238 shares of Common Stock at $3.75 per share, expiring on 7/31/97 0 0 Corporate Express, Inc.* 442,136 shares of Common Stock May 1992 99,478 2,431,748 914,250 shares of Preferred Stock 1,830,435 5,028,375 Diatech, Inc.*(C) 1,258,006 shares of Preferred Stock Dec. 1991 2,620,015 3,145,015 Eckerd Corporation*+(D) 92,843 shares of Common Stock July 1992 857,004 1,156,824 Elantec, Inc. 2,889,947 shares of Preferred Stock Aug. 1988 1,069,569 1,069,569 852,273 shares of Common Stock 340,909 340,909 Home Express, Inc.* 486,067 shares of Preferred Stock Jan. 1992 1,822,751 1,822,751 Horizon Cellular Telephone Company, L.P.: HCTC Investment, L.P. 10% Promissory Note May 1992 2,587,500 2,587,500 SPTHOR Corporation 10% Promissory Note May 1992 646,875 646,875 34.5 shares of Common Stock 215,625 215,625 I.D.E. Corporation* 493,391 shares of Preferred Stock Mar. 1988 1,110,909 555,455 ML VENTURE PARTNERS II, L.P. SCHEDULE OF PORTFOLIO INVESTMENTS DECEMBER 31, 1993 ACTIVE PORTFOLIO INVESTMENTS (CONTINUED): Initial Investment Fair Company / Position Date Cost Value IDEC Pharmaceuticals Corporation+: ML/MS Associates, L.P.* 34.4% Limited Partnership interest June 1989 $3,960,000 $3,960,000 Warrants to purchase 380,000 shares of Common Stock of IDEC Pharmaceuticals Corporation at $7.25 per share, expiring on 2/17/95 217,391 0 MLMS Cancer Research, Inc. 400,000 shares of Common Stock July 1989 46,957 46,957 Inference Corporation 702,427 shares of Preferred Stock Apr. 1993 785,032 785,032 Warrants to purchase 193,682 shares of Preferred Stock at $1 per share, expiring on 4/19/99 22,777 22,777 Warrants to purchase 24,233 shares of Preferred Stock at $1.05 per share, expiring on 12/16/97 6,531 6,531 Warrants to purchase 295,827 shares of Common Stock at $1 per share, expiring on 6/10/98 79,725 79,725 Komag, Incorporated+ 234,486 shares of Common Stock Aug. 1988 2,160,987 3,724,810 Ligand Pharmaceuticals Inc.*+ 115,440 shares of Class A Common Stock Apr. 1989 304,116 872,293 346,323 shares of Class B Common Stock 912,350 1,477,346 Warrants to purchase 5,158 shares of Common Stock at $4.80 per share, expiring between 1/18/96 and 7/31/97 0 3,556 Micro Linear Corporation(E) 800,214 shares of Common Stock Aug. 1988 1,120,300 960,257 Neocrin Corporation(F) 1,586,831 shares of Preferred Stock June 1991 3,369,046 2,102,381 OccuSystems, Inc. 531,400 shares of Preferred Stock June 1993 2,657,000 2,657,000 Photon Dynamics, Inc.* 990,530 shares of Preferred Stock Sept. 1988 2,034,090 990,530 Raytel Medical Corporation* 1,000,000 shares of Preferred Stock Feb. 1990 1,000,000 1,000,000 Regeneron Pharmaceuticals, Inc.*+(G) 1,517,895 shares of Common Stock Jan. 1988 1,778,052 19,577,845 Research Applications, Inc.* 4,000 shares of Common Stock Apr. 1988 100,000 0 ML VENTURE PARTNERS II, L.P. SCHEDULE OF PORTFOLIO INVESTMENTS DECEMBER 31, 1993 ACTIVE PORTFOLIO INVESTMENTS (CONTINUED): Initial Investment Fair Company / Position Date Cost Value Ringer Corporation+(H) 78,271 shares Common Stock Apr. 1987 $234,813 $254,381 Sanderling Biomedical, L.P.*(I) 80% Limited Partnership interest May 1988 2,000,000 2,833,665 Shared Resource Exchange, Inc. 2,777 shares of Common Stock Apr. 1987 250,000 0 SDL, Inc.*(J) 8% Subordinated Note July 1992 2,019,721 2,019,721 97,011 shares of Common Stock 169,769 169,769 26,270 shares of Preferred Stock 849,834 849,834 Target Vision, Inc.* 395,000 shares of Preferred Stock Apr. 1987 395,000 0 The Business Depot Ltd.*(K) 94,435 shares of Preferred Stock May 1992 1,214,184 1,214,184 United States Paging Corporation*+ 450,053 shares of Common Stock Apr. 1987 1,479,405 1,446,290 Warrants to purchase 16,887 shares of Common Stock at $3.33 per share, expiring between 2/27/95 and 4/28/95 0 0 Warrants to purchase 5,537 shares of Common Stock at $4.22 per share, expiring on 6/23/94 0 0 Warrants to purchase 25,330 shares of Common Stock at $.89 per share, expiring between 12/15/95 and 3/8/96 0 40,072 Viasoft, Inc. 806,647 shares of Preferred Stock Dec. 1987 846,300 1,371,300 TOTALS FROM ACTIVE PORTFOLIO INVESTMENTS $55,130,444$107,038,636 ML VENTURE PARTNERS II, L.P. SCHEDULE OF PORTFOLIO INVESTMENTS - CONTINUED DECEMBER 31, 1993 SUPPLEMENTAL INFORMATION: LIQUIDATED PORTFOLIO INVESTMENTS(L) PORTFOLIO INVESTMENTS SOLD AT A LOSS OR WRITTEN-OFF: Liquidation Realized Company Date Cost Loss Return Allez, Inc. 1992 $1,781,320 $(1,781,320) $0 The Aqua Group, Inc. 1990 2,000,000 (1,999,999) 1 BBN Advanced Computer Partners, L.P. 1990 868,428 (864,028) 4,400 BBN Integrated Switch Partners, L.P. 1990/1992 5,022,380 (4,822,797) 199,583 Communications International, Inc. 1992/199 1,819,332 (1,819,332) 0 Computer-Aided Design Group 1990/1991 1,131,070 (1,131,069) 1 Dastek International 1991 204,250 0 204,250 Data Recording Systems, Inc. 1988 1,615,129 (1,499,999) 115,130 Elantec, Inc. 1993 1,640 (1,640) 0 Hoffman & Company, L.P. 1993 40,000 (40,000) 0 In-Store Advertising, Inc. 1992 2,259,741 (2,259,741) 0 InteLock Corporation 1992 1,254,125 (1,251,274) 2,851 Ligand Pharmaceuticals Inc. 1992 187,250 0 187,250 Magnesys 1989 1,440,997 (1,412,049) 28,948 Meteor Message Corporation 1990 1,501,048 (1,501,047) 1 Ogle Resources, Inc. 1993 1,974,286 (1,974,186) 100 Pandora Industries, Inc. 1990 2,060,139 (2,060,138) 1 R-Byte Inc. 1992 1,991,098 (497,601) 1,493,497 Ringer Corporation 1991 2,794,839 (2,227,580) 567,259 S & J Industries 1991/1992 1,600,150 (1,555,149) 45,001 Saxpy Computer Corporation 1988 2,000,000 (2,000,000) 0 SDL, Inc. 1993 1,717,941 0 1,717,941 SF2 Corporation 1991 2,193,293 (1,864,223) 329,070 Shared Resource Exchange, Inc. 1990 749,999 (749,999) 0 Special Situations, Inc. 1988 215,000 (187,175) 27,825 Target Vision, Inc. 1992 1,105,000 (1,105,000) 0 TCOM Systems, Inc. 1990/1992 4,715,384 (4,711,536) 3,848 Touch Communications Incorporated 1991 1,119,693(1,119,693) TOTALS FROM PORTFOLIO INVESTMENTS SOLD AT A LOSS OR WRITTEN-OFF $45,363,532 $(40,436,575) $4,926,957 ML VENTURE PARTNERS II, L.P. SCHEDULE OF PORTFOLIO INVESTMENTS - CONTINUED DECEMBER 31, 1993 SUPPLEMENTAL INFORMATION: LIQUIDATED PORTFOLIO INVESTMENTS(L) PORTFOLIO INVESTMENTS SOLD AT A GAIN: Fiscal Realized Company Year Sold Cost Gain Return Amdahl Corporation 1989 $729,742 $1,837,787 $2,567,529 Everex Systems, Inc. 1991/1992 750,000 447,606 1,197,606 Regeneron Pharmaceuticals, Inc. 1991-1993 900,083 17,152,467 18,052,550 Pyxis Corporation 1993 634,598 7,169,424 7,804,022 Storage Technology Corporation 1990 2,174,000 1,466,802 3,640,802 Telecom USA, Inc. 1989 5,000,000 3,361,778 8,361,778 TOTALS FROM PORTFOLIO INVESTMENTS SOLD AT A GAIN $10,188,423 $31,435,864 $41,624,287 Cost Realized Loss Return TOTALS FROM LIQUIDATED PORTFOLIO INVESTMENTS $55,551,955 $(9,000,711) $46,551,244 Combined Net Combined Unrealized and Fair Value Cost Realized Gain and Return TOTALS FROM ACTIVE & LIQUIDATED PORTFOLIO INVESTMENTS $110,682,399 $42,907,481 $153,589,880 (A) As part of a financial restructuring completed in January 1993, the automotive division of Borg-Warner Corporation, now Borg-Warner Automotive, Inc. ("BWA"), was spun out to existing shareholders in a tax free transaction. As a result of this restructuring, the Partnership received 500,000 common shares of BWA. Additionally, in connection with the restructuring, Borg-Warner Corporation changed its name to Borg-Warner Security Corporation ("BWS") and on January 20, 1993, BWS completed its initial public offering. The Partnership exchanged its 500,000 common shares of Borg-Warner Corporation for 500,000 common shares of BWS. On August 12, 1993, Borg-Warner Automotive, Inc. completed its initial public offering. (B) Subsequent to the end of 1993, the Partnership sold 370,000 common shares of CellPro, Incorporated for $11.3 million, realizing a gain of $10.6 million. (C) In November 1993, the Partnership exchanged its promissory notes due from Diatech, Inc. totaling $494,000 and accrued interest of $26,015 for 208,006 preferred shares of the company. (D) On August 5, 1993, Eckerd Corporation completed its initial public offering. In connection with the offering, the Partnership exchanged its 71,417 common shares of EDS Holdings Inc. for 92,843 common shares of Eckerd Corporation. ML VENTURE PARTNERS II, L.P. SCHEDULE OF PORTFOLIO INVESTMENTS - CONTINUED DECEMBER 31, 1993 (E) In August 1993, the Partnership converted 11,203 preferred shares of Micro Linear Corporation into 800,214 common shares of the company. (F) As a result of a restructuring of Trancel Corporation and a subsequent merger with Neocrin Corporation, formerly a joint venture between Trancel and a wholly-owned subsidiary of Baxter Healthcare Corporation, the Partnership exchanged its 2,393,685 preferred shares and 18,197 common shares of Trancel for 1,123,423 preferred shares of Neocrin. Additionally, during the year, the Partnership purchased 463,408 preferred shares of Neocrin for $463,408. (G) During the fiscal year, the Partnership sold 525,000 common shares of Regeneron Pharmaceuticals, Inc. for $8.2 million, realizing a gain of $7.6 million. Additionally, subsequent to the end of 1993, the Partnership sold 140,000 shares of Regeneron for $2.3 million, realizing a gain of $2.2 million. (H) In February 1993, the Partnership sold 187,912 common shares of Ringer Corporation for $567,000, realizing a gain of $4,000. Subsequent to the end of fiscal 1993, the Partnership sold its remaining 78,271 common shares of Ringer for $254,000, realizing a gain of $20,000. (I) Indirectly, the Partnership has an additional investment in Regeneron Pharmaceuticals, Inc. through its 80% limited partnership interest in Sanderling Biomedical, L.P. (J) During the year, Spectra Diode Laboratories, Inc. changed its name to SDL, Inc. Additionally, in July 1993, the Partnership received a $1.7 million principal payment on its $3.5 million subordinated note due from SDL. In connection with this payment, $246,000 of accrued interest was capitalized to the note. (K) In February 1994, the Partnership sold an option to purchase all of its 94,435 preferred shares of The Business Depot Ltd. for $208,000. The option is exercisable by the holder at 33 Canadian dollars per share (approximately $26.40 per share) before August 1994 or 38 Canadian dollars per share (approximately $30.40 per share) before February 1995. (L) Amounts provided for "Supplemental Information: Liquidated Portfolio Investments" are cumulative from inception through December 31, 1993. + Publicly-held company * Company may be deemed an affiliated person of the Partnership as such term is defined in the Investment Company Act of 1940. See notes to financial statements. ML VENTURE PARTNERS II, L.P. SCHEDULE OF PORTFOLIO INVESTMENTS DECEMBER 31, 1992 ACTIVE PORTFOLIO INVESTMENTS: Initial Investment Fair Company / Position Date Cost Value Biocircuits Corporation 515,269 shares of Common Stock May 1991 $1,422,501 $1,819,956 Borg-Warner Corporation 500,000 shares of Common Stock Sept. 1988 5,000,000 15,262,500 CellPro, Incorporated 783,333 shares of Common Stock Mar. 1989 1,455,944 10,488,829 Children's Discovery Centers of America, Inc. 115,267 shares of Common Stock July 1988 2,000,259 305,313 Clarus Medical Systems, Inc. 507,458 shares of Preferred Stock Jan. 1991 2,037,290 2,537,290 Warrants to purchase 20,238 shares of Common Stock at $3.75 per share, expiring on 7/31/97 0 12,649 Communications International, Inc. 900 shares of Preferred Stock Apr. 1987 900,000 0 Corporate Express, Inc. 442,136 shares of Common Stock May 1992 99,478 99,478 507,200 shares of Preferred Stock 862,240 1,115,840 Diatech, Inc. 1,050,000 shares of Preferred Stock Dec. 1991 2,100,000 2,100,000 EDS Holdings Inc. 71,417 shares of Common Stock July 1992 857,004 2,142,510 Elantec, Inc. 2,889,947 shares of Preferred Stock Aug. 1988 1,069,569 1,069,569 852,273 shares of Common Stock 340,909 340,909 Warrants to purchase 164,030 shares of Common Stock at $.55 per share, expiring on 8/12/93 1,640 1,640 Hoffman & Company, L.P. 33% Limited Partnership Interest Jan. 1991 40,000 40,000 Home Express, Inc. 486,067 shares of Preferred Stock June 1992 1,822,751 1,822,751 Horizon Cellular Telephone Company, L.P.: HCTC Investment, L.P. 10% Promissory Note May 1992 900,000 900,000 SPTHOR Corporation 10% Promissory Note May 1992 225,000 225,000 12 shares of Common Stock 75,000 75,000 ML VENTURE PARTNERS II, L.P. SCHEDULE OF PORTFOLIO INVESTMENTS DECEMBER 31, 1992 ACTIVE PORTFOLIO INVESTMENTS - CONTINUED: Initial Investment Fair Company / Position Date Cost Value I.D.E. Corporation 493,391 shares of Preferred Stock Mar. 1988 $1,110,909 $1,110,909 IDEC Pharmaceuticals Corporation: ML/MS Associates, L.P. 34.4% Limited Partnership Interest June 1989 3,960,000 3,960,000 Warrants to purchase 380,000 shares of Common Stock of IDEC Pharmaceuticals Corporation at $7.25 per share, expiring on 2/17/95 217,391 0 MLMS Cancer Research, Inc. 400,000 shares of Common Stock July 1989 40,000 40,000 In-Store Advertising, Inc. 728,859 shares of Common Stock May 1988 1,130,000 313,701 InteLock Corporation 357,143 shares of Preferred Stock Dec. 1989 125,412 0 Komag, Incorporated 234,486 shares of Common Stock Aug. 1988 2,160,987 3,682,603 Ligand Pharmaceuticals Inc. 115,440 shares of Class A Common Stock Apr. 1989 304,116 591,632 346,323 shares of Class B Common Stock 912,350 1,232,562 Warrants to purchase 5,158 shares of Common Stock at $4.80 per share, expiring between 1/18/96 and 7/31/97 0 418 Micro Linear Corporation 11,203 shares of Preferred Stock Aug. 1988 1,120,300 960,257 MTI Technology Corporation 3,496 shares of Common Stock Feb. 1991 0 0 404 shares of Common Stock (in escrow) 0 0 8% Demand Note due 9/3/93 277,780 138,890 Ogle Resources Inc. 216 shares of Common Stock Mar. 1988 120,000 0 280 shares of Junior Preferred Stock 140,000 0 9% Promissory Note due 1/28/98 1,714,286 1,714,286 Photon Dynamics, Inc. 990,530 shares of Preferred Stock Sept. 1988 2,034,090 2,034,090 Pyxis Corporation 195,262 shares of Common Stock May 1992 634,598 7,804,022 Raytel Medical Corporation 1,000,000 shares of Preferred Stock Feb. 1990 1,000,000 1,000,000 ML VENTURE PARTNERS II, L.P. SCHEDULE OF PORTFOLIO INVESTMENTS DECEMBER 31, 1992 ACTIVE PORTFOLIO INVESTMENTS (CONTINUED): Initial Investment Fair Company / Position Date Cost Value Regeneron Pharmaceuticals, Inc. 2,042,895 shares of Common Stock Jan. 1988 $2,382,975 $20,010,714 Research Applications, Inc. 4,000 shares of Common Stock Apr. 1988 100,000 0 Ringer Corporation 266,183 shares of Common Stock Apr. 1987 798,549 609,273 Sanderling Biomedical, L.P. 80% Limited Partnership Interest May 1988 2,000,000 2,000,000 Shared Resource Exchange, Inc. 2,777 shares of Common Stock Apr. 1987 250,000 0 Spectra Diode Laboratories, Inc. 8% Subordinated Note July 1992 3,491,200 3,491,200 97,011 shares of Common Stock 169,769 169,769 26,270 shares of Preferred Stock 849,834 849,834 Target Vision, Inc. 395,000 shares of Preferred Stock Apr. 1987 395,000 0 The Business Depot Ltd. 94,435 shares of Preferred Stock May 1992 1,214,184 1,214,184 Trancel Corporation 2,027,093 shares of Preferred Stock June 1991 2,860,259 1,593,594 15,840 shares of Common Stock 1,980 1,980 United States Paging Corporation 450,053 shares of Common Stock Apr. 1987 1,479,405 1,243,270 Warrants to purchase 16,887 shares of Common Stock at $3.33 per share, expiring between 2/27/95 and 4/28/95 0 0 Warrants to purchase 5,537 shares of Common Stock at $4.22 per share, expiring on 6/23/94 0 0 Warrants to purchase 25,330 shares of Common Stock at $.89 per share, expiring between 12/15/95 and 3/8/96 0 31,282 Viasoft, Inc. 806,647 shares of Preferred Stock Dec. 1987 846,300 1,371,300 TOTALS FROM ACTIVE PORTFOLIO INVESTMENTS $55,051,259 $97,529,004 ML VENTURE PARTNERS II, L.P. SUPPLEMENTAL INFORMATION: LIQUIDATED PORTFOLIO INVESTMENTS (A) DECEMBER 31, 1992 Cost Realized Loss Return TOTALS FROM LIQUIDATED PORTFOLIO INVESTMENTS $47,581,639 $(19,605,730) $27,975,909 Combined Combined Cost of Net Unrealized Fair Value Investments and Realized Gain and Return TOTALS FROM ACTIVE & LIQUIDATED PORTFOLIO INVESTMENTS $102,632,898 $22,872,015 $125,504,913 (A) Amounts provided for "Supplemental Information: Liquidated Portfolio Investments" are cumulative from inception through December 31, 1992. See notes to financial statements. ML VENTURE PARTNERS II, L.P. STATEMENTS OF OPERATIONS FOR THE YEARS ENDED DECEMBER 31, 1993 1992 1991 INVESTMENT INCOME Interest from money market investments $ 360,441 $ 805,138 $ 1,860,148 Interest and other income from portfolio investments 134,921 385,311 192,120 Total investment income 495,362 1,190,449 2,052,268 Expenses: Management fee - Note 4 1,444,988 1,680,176 1,854,537 Mailing and printing 210,561 145,708 211,904 Professional fees 184,665 233,288 237,601 Independent General Partners' fees - Note 5 93,841 102,901 92,651 Custodial fees 14,979 13,833 15,966 Consulting fees - 2,357 3,733 Miscellaneous 1,250 450 3,697 Amortization of deferred organizational costs - Note 2 - 1,509 6,096 Interest expense - Note 4 - 180,521 - Total expenses 1,950,284 2,360,743 2,426,185 NET INVESTMENT LOSS (1,454,922) (1,170,294) (373,917) NET REALIZED GAIN (LOSS) FROM INVESTMENTS SOLD AND WRITTEN-OFF 10,605,019 (5,677,493) 1,967,746 NET REALIZED GAIN (LOSS) FROM OPERATIONS (allocable to Partners) - Note 3 9,150,097 (6,847,787) 1,593,829 NET CHANGE IN UNREALIZED APPRECIATION 9,430,447 11,656,947 14,360,547 NET INCREASE IN NET ASSETS RESULTING FROM OPERATIONS $ 18,580,544 $ 4,809,160 $ 15,954,376 See notes to financial statements. ML VENTURE PARTNERS II, L.P. STATEMENTS OF CASH FLOWS FOR THE YEARS ENDED DECEMBER 31, 1993 1992 1991 CASH FLOWS PROVIDED FROM OPERATING ACTIVITIES Net investment loss $ (1,454,922)$ (1,170,294) $ (373,917) Adjustments to reconcile net investment loss to cash provided from operating activities: (Increase) decrease in receivables and other assets 186,164 (201,294) (52,826) Decrease in accrued interest on money market investments 14,803 259,633 77,213 Decrease in payables (42,186) (96,487) (43,708) Amortization of deferred organizational costs - 1,509 6,096 Total (1,296,141) (1,206,933) (387,142) Net return (purchase) of money market investments 5,653,777 20,793,496 1,062,210 Purchase of portfolio investments (8,049,501)(13,781,370) (9,845,164) Net proceeds from the sale of portfolio investments 16,334,397 3,011,360 9,433,929 Repayment of investments in notes 2,064,011 431,737 204,250 Cash provided from operating activities 14,706,543 9,248,290 468,083 CASH FLOWS FOR FINANCING ACTIVITIES Cash distributions to Limited Partners (15,600,000) (9,000,000) (6,000,000) Increase (decrease) in cash and cash equivalents (893,457) 248,290 (5,531,917) Cash and cash equivalents at beginning of period 2,306,339 2,058,049 7,589,966 CASH AND CASH EQUIVALENTS AT END OF PERIOD $ 1,412,882$ 2,306,339 $ 2,058,049 See notes to financial statements. ML VENTURE PARTNERS II, L.P. STATEMENTS OF CHANGES IN PARTNERS' CAPITAL FOR THE YEARS ENDED DECEMBER 31, 1991, 1992 AND 1993 Unallocated Managing Individual Net Unrealized General General Limited Appreciation of Partner Partners Partners Investments Total Balance at December 31, 1990 $994,496 $3,281 $86,468,826 $16,460,251 $103,926,854 Cash distribution paid April 26, 1991 - - Note 7 - - (6,000,000) - (6,000,000) Allocation of net investment loss - - Note 3 (3,739) (12) (370,166) - (373,917) Allocation of net realized gain on investments - - Note 3 19,677 65 1,948,004 - 1,967,746 Net change in unrealized appreciation of investments - - - 14,360,547 14,360,547 Balance at December 31, 19911,010,434 3,334 82,046,664(A) 30,820,798 113,881,230 Cash distribution paid April 30, 1992 - - Note 7 - - (9,000,000) - (9,000,000) Allocation of net investment loss - - Note 3 (11,703) (39) (1,158,552) - (1,170,294) Allocation of net realized loss on investments - - Note 3 (56,775) (187) (5,620,531) - (5,677,493) Net change in unrealized appreciation of investments - - - 11,656,947 11,656,947 Balance at December 31, 1992 941,956 3,108 66,267,581(A) 42,477,745 109,690,390 Cash distribution paid May 26, 1993 - Note 7 - - (15,600,000) - (15,600,000) Allocation of net investment loss - - Note 3 (14,549) (48) (1,440,325) - (1,454,922) Allocation of net realized gain on investments - - Note 3 106,050 350 10,498,619 - 10,605,019 Net change in unrealized appreciation of investments - - - 9,430,447 9,430,447 Balance at December 31, 1993$1,033,457 $3,410 $59,725,875(A) $51,908,192 $112,670,934 (A) The net asset value per unit of limited partnership interest, including an assumed allocation of net unrealized appreciation of investments, was $908, $862 and $852 at December 31, 1991, 1992 and 1993, respectively. Cumulative cash distributions paid to Limited Partners from inception to December 31, 1993 totaled $355 per Unit. See notes to financial statements. ML VENTURE PARTNERS II, L.P. NOTES TO FINANCIAL STATEMENTS 1. Organization and Purpose ML Venture Partners II, L.P. (the "Partnership") is a Delaware limited partnership formed on February 4, 1986. MLVPII Co., L.P., the managing general partner of the Partnership (the "Managing General Partner") and four individuals (the "Individual General Partners") are the general partners of the Partnership. The general partner of MLVPII Co., L.P. is Merrill Lynch Venture Capital Inc. (the "Management Company"), an indirect subsidiary of Merrill Lynch & Co., Inc. The Partnership's objective is to achieve long-term capital appreciation from its portfolio of venture capital investments, originally made in new and developing companies and other special investment situations. The Partnership does not engage in any other business or activity. The Partnership is scheduled to terminate on December 31, 1997. The Individual General Partners can extend the termination date for up to two additional two-year periods if they determine that such extensions would be in the best interest of the Partnership. 2. Significant Accounting Policies Valuation of Investments - Money market investments are carried at amortized cost which approximates market. Portfolio investments are carried at fair value as determined quarterly by the Managing General Partner under the supervision of the Individual General Partners. The fair value of publicly-held portfolio securities is adjusted to the average closing public market price for the last five trading days of each quarter discounted by a factor of 0% to 50% for sales restrictions. Factors considered in the determination of an appropriate discount include, underwriter lock-up or Rule 144 trading restrictions, insider status where the Partnership either has a representative serving on the Board of Directors or is greater than a 10% shareholder, and other liquidity factors such as the size of the Partnership's position in a given company compared to the trading history of the public security. Privately-held portfolio securities are carried at cost until significant developments affecting the portfolio company provide a basis for change in valuation. The fair value of private securities is adjusted 1) to reflect meaningful third-party transactions in the private market or 2) to reflect significant progress or slippage in the development of the company's business such that cost is clearly no longer reflective of fair value. As a venture capital investment fund, the Partnership's portfolio investments involve a high degree of business and financial risk that can result in substantial losses. The Managing General Partner considers such risks in determining the fair value of the Partnership's portfolio investments. Investment Transactions - Investment transactions are recorded on the accrual method. Portfolio investments are recorded on the trade date, the date the Partnership obtains an enforceable right to demand the securities or payment therefor. Realized gains and losses on investments sold are computed on a specific identification basis. Income Taxes - No provision for income taxes has been made since all income and losses are allocable to the Partners for inclusion in their respective tax returns. The Partnership's net assets for financial reporting purposes differ from its net assets for tax purposes. Net unrealized appreciation of $51.9 million at December 31, 1993, which was recorded for financial statement purposes, was not recognized for tax purposes. Additionally, from inception to December 31, 1993, other timing differences relating to realized losses totaling $5.5 million have been recorded on the Partnership's financial statements but have not yet been reflected as realized losses for tax purposes. Statements of Cash Flows - The Partnership considers its interest-bearing cash account to be cash equivalents. Organizational Costs - Organizational costs of $30,465 were amortized over a sixty-month period beginning April 1, 1987. 3. Allocation of Partnership Profits and Losses The Partnership Agreement provides that the Managing General Partner will be allocated, on a cumulative basis over the life of the Partnership, 20% of the Partnership's aggregate investment income and net realized gains and losses from venture capital investments, provided that such amount is positive. All other gains and losses of the Partnership are allocated among all the Partners (including the Managing General Partner) in proportion to their respective capital contributions to the Partnership. From its inception to December 31, 1993, the Partnership had a $7.4 million net realized loss from its venture capital investments. ML VENTURE PARTNERS II, L.P. NOTES TO FINANCIAL STATEMENTS - CONTINUED 4. Related Party Transactions The Management Company performs, or arranges for others to perform, the management and administrative services necessary for the operation of the Partnership and receives a management fee at the annual rate of 2.5% of the gross capital contributions to the Partnership, reduced by selling commissions, organizational and offering expenses paid by the Partnership, capital distributed and realized capital losses with a minimum annual fee of $200,000. Such fee is determined and payable quarterly. On May 11, 1992, the Securities and Exchange Commission (the "SEC") issued an exemptive order permitting the Partnership, subject to certain conditions including review and approval by the Independent General Partners, to make venture capital investments with affiliates of DLJ Capital Management Corporation, the Partnership's sub-manager (the "Sub- Manager"). On May 20, 1992, the Partnership purchased four venture capital investments from the Management Company for $2,441,060 representing reimbursement of the original cost of such investments totaling $2,367,061 plus $73,999 of interest expense. Since an affiliate of the Sub-Manager is an investor in each of these companies, the Management Company had purchased these investments on the Partnership's behalf while the Partnership awaited SEC exemptive relief to co-invest with affiliates of the Sub-Manager. The four investments purchased by the Partnership on May 20, 1992 were: 47,218 shares of series A preferred stock of The Business Depot Ltd., acquired by the Management Company on June 19, 1991, for $651,233 representing original cost of $620,745 plus interest expense of $30,488, 195,262 shares of series G preferred stock of Pyxis Corporation, acquired by the Management Company on August 21, 1991, for $658,686 representing original cost of $634,598 plus interest expense of $24,088, 507,200 shares of series A convertible preferred stock and 442,136 shares of common stock of Corporate Express, Inc., acquired by the Management Company on November 27, 1991, for $980,186 representing original cost of $961,718 plus interest expense of $18,468 and a $112,500 promissory note from HCTC Investment, L.P., a $28,125 promissory note from SPTHOR Corporation and 1.5 shares of common stock of SPTHOR Corporation, acquired by the Management Company on March 27, 1992, for $150,955 representing original cost of $150,000 plus interest expense of $955. Additionally, on May 29, 1992, the SEC issued an exemptive order permitting the Partnership to acquire 71,417 shares of class A common stock of EDS Holdings Inc. from an affiliate of the Management Company subject to certain conditions and approval by the Independent General Partners. On July 20, 1992, the Partnership purchased these shares for $963,526, representing original cost of $857,004 plus interest expense of $106,522. 5. Independent General Partners' Fees As compensation for services rendered to the Partnership, each of the three Independent General Partners ("IGP's") receives $19,000 annually in quarterly installments, $1,200 for each meeting of the General Partners attended or for each other meeting, conference or engagement in connection with Partnership activities at which attendance by an IGP is required and $1,200 for each committee meeting attended ($500 if a committee meeting is held on the same day as a meeting of the General Partners). 6. Commitments Subsequent to the end of the fiscal year, the Partnership approved a commitment to make a follow-on investment of $1.1 million in Corporate Express, Inc. On January 26, 1994, the Management Company purchased this investment on behalf of the Partnership and will hold the investment until the Partnership obtains an exemptive order from the Securities and Exchange Commission allowing the Partnership to acquire this investment from the Management Company. The purchase price to the Partnership will be the lesser of the fair value of the investment or the Management Company's cost, plus interest, as of the date of acquisition by the Partnership. Additionally, the Partnership has guaranteed $1.8 million of bank debt of SDL, Inc. which is payable by the company on or before June 30, 1995. The Partnership also has a $393,043 non-interest bearing obligation payable on demand to MLMS Cancer Research, Inc. ML VENTURE PARTNERS II, L.P. NOTES TO FINANCIAL STATEMENTS - CONTINUED 7. Cash Distributions On May 26 1993, the Partnership made a cash distribution to Limited Partners of record on March 31, 1993 totaling $15.6 million, or $130 per $1,000 Unit. On April 30, 1992, the Partnership made a cash distribution to Limited Partners of record on March 31, 1992 totaling $9 million, or $75 per $1,000 Unit. On April 26, 1991, the Partnership made a cash distribution to Limited Partners of record on March 31, 1991, totaling $6 million, or $50 per Unit. These distributions primarily represented proceeds received by the Partnership from the sale of certain portfolio investments. Cumulative cash distributions paid to Limited Partners from inception through December 31, 1993 total $42.6 million, or $355 per $1,000 Unit. Additionally, on March 2, 1994, the General Partners approved a cash distribution to Limited Partners of $16.2 million, or $135 per Unit. This distribution will be paid in May 1994 to Limited Partners of record on March 31, 1994 and will bring cumulative cash distributions paid to Limited Partners to $58.8 million, or $490 per $1,000 Unit. 8. Pending Litigation The Partnership has been named as a defendant, along with other entities and individuals, in an action relating to its ownership interest in In- Store Advertising, Inc. ("ISA"). The action is a purported class action suit wherein the plaintiffs, who purchased shares of ISA in its July 19, 1990 initial public offering through November 8, 1990, allege violations under certain sections of the Securities Act of 1933, the Securities Exchange Act of 1934 and common law. The plaintiffs seek rescission of their purchases of ISA common stock together with damages and certain costs and expenses. The Partnership believes it has meritorious defenses to the allegations and that the cost of resolution of the litigation will not have a material impact on the financial condition and results of operations of the Partnership (see Part I, Item 3, Legal Proceedings, for additional information). ML VENTURE PARTNERS II, L.P. MONEY MARKET INVESTMENTS SCHEDULE I DECEMBER 31, 1993 AND 1992 Principal Amortized Amount Cost Cost COMMERCIAL PAPER Golden Managers Acceptance Corporation $ 2,000,000 $ 1,988,275 $ 1,996,464 Golden Managers Acceptance Corporation 2,000,000 1,991,933 1,995,233 Total at December 31, 1993 $ 4,000,000 $ 3,980,208 $ 3,991,697 BANKER'S ACCEPTANCE Tokai Bank $ 3,000,000 $ 2,969,521 $ 2,982,675 CERTIFICATE OF DEPOSIT Chemical Bank 202,378 202,378 202,378 COMMERCIAL PAPER Golden Managers Acceptance Corporation 3,000,000 2,985,627 2,993,467 Golden Managers Acceptance Corporation 2,000,000 1,990,146 1,993,163 Dunlop Tire Corporation 1,500,000 1,486,313 1,488,594 Total at December 31, 1992 $ 9,702,378 $ 9,633,985 $ 9,660,277 Item 9.

Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosures. None PART III Item 10.

Item 10. Directors and Executive Officers of the Registrant. The Partnership The information set forth under the caption "Election of General Partners" in the Partnership's proxy statement in connection with the 1994 Annual Meeting of Limited Partners to be filed with the Securities and Exchange Commission pursuant to Regulation 14A under the Securities Exchange Act of 1934 (the "Proxy Statement") is incorporated herein by reference. The Management Company The Management Company performs, or arranges for others to perform, the management and administrative services necessary for the operation of the Partnership pursuant to a Management Agreement, dated as of May 23, 1991, between the Partnership and the Management Company. At March 18, 1994, the directors of the Management Company and the officers of the Management Company involved in the administrative support of the Partnership are: Served in Present Name and Age Position Held Capacity Since Kevin K. Albert (41) Director April 2, 1990 President July 5, 1991 Robert F. Aufenanger (40) Director April 2, 1990 Executive Vice President February 2, 1993 Robert W. Seitz (47) Director February 1, 1993 Vice President February 2, 1993 Joseph W. Sullivan (36) Treasurer February 2, 1993 The directors of the Management Company will serve as directors until the next annual meeting of stockholders and until their successors are elected and qualify. The officers of the Management Company will hold office until the next annual meeting of the Board of Directors of the Management Company and until their successors are elected and qualify. Information with respect to Messrs. Aufenanger, Seitz and Sullivan is set forth under Item 13 "Certain Relationships and Related Transactions". The information with respect to Mr. Albert set forth under the subcaption "Individual General Partners" in the Proxy Statement is incorporated herein by reference. There are no family relationships among any of the Individual General Partners of the Partnership and the officers and directors of the Management Company. Item 11.

Item 11. Executive Compensation. The information with respect to the compensation of the Individual General Partners set forth under the subcaption "Individual General Partners - Compensation" in the Proxy Statement is incorporated herein by reference. The information with respect to the allocation and distribution of the Partnership's profits and losses to the Managing General Partner set forth under the subcaption "Managing General Partner - Allocations and Distributions" in the Proxy Statement is incorporated herein by reference. The information with respect to the management fee payable to the Management Company set forth under the subcaption "Terms of the Management Agreement - Management Fee" in the Proxy Statement is incorporated herein by reference. The information with respect to the sub-management fee payable to the Sub- Manager set forth under the subcaption "Terms of Contracts - Sub-Management Agreement" in the Proxy Statement is incorporated herein by reference. The Management Company has arranged for Palmeri Fund Administrators, Inc., an independent administrative services company, to provide administrative services to the Partnership. Fees for such services are paid directly by the Management Company. Item 12.

Item 12. Security Ownership of Certain Beneficial Owners and Management. The information concerning the security ownership of the Individual General Partners set forth under the subcaption "Individual General Partners" in the Partnership's Proxy Statement is incorporated herein by reference. As of March 18, 1994, no person or group is known by the Partnership to be the beneficial owner of more than 5 percent of the Units. Mark Clein, a limited partner of the Managing General Partner, owns 34 Units of the Partnership. The Individual General Partners and the directors and officers of the Management Company do not own any Units. The Partnership is not aware of any arrangement which may, at a subsequent date, result in a change of control of the Partnership. Item 13.

Item 13. Certain Relationships and Related Transactions. Kevin K. Albert, a Director and President of the Management Company and a Managing Director of Merrill Lynch Investment Banking Group ("ML Investment Banking"), joined Merrill Lynch in 1981. Robert F. Aufenanger, a Director and Executive Vice President of the Management Company, a Vice President of Merrill Lynch & Co. Corporate Strategy, Credit and Research and a Director of the Partnership Management Department, joined Merrill Lynch in 1980. Robert W. Seitz, a Director and Vice President of the Management Company, a First Vice President of Merrill Lynch & Co. Corporate Strategy, Credit and Research and a Managing Director within the Corporate Credit Division of Merrill Lynch, joined Merrill Lynch in 1981. Joseph W. Sullivan, a Treasurer of the Management Company and a Controller in the Partnership Analysis and Management Department, joined Merrill Lynch in 1990. From 1988 to 1990, Mr. Sullivan was an Assistant Vice President with Standard & Poor's Debt Rating Group. PART IV Item 14.

Item 14. Exhibits, Financial Statement Schedules and Reports on Form 8-K. (a) 1. Financial Statements Balance Sheets as of December 31, 1993 and December 31, 1992 Schedule of Portfolio Investments as of December 31, 1993 Schedule of Portfolio Investments as of December 31, 1992 Statements of Operations for the years ended December 31, 1993, 1992 and 1991 Statements of Cash Flows for the years ended December 31, 1993, 1992 and 1991 Statements of Changes in Partners' Capital for the years ended December 31, 1993, 1992 and 1991 Notes to Financial Statements 2. Schedule I - Money Market Investments as of December 31, 1993 and 1992 3. Exhibits (3) (a) Amended and Restated Certificate of Limited Partnership of the Partnership, dated as of January 12, 1987. (1) (3) (b) Amended and Restated Certificate of Limited Partnership of the Partnership, dated July 27, 1990. (2) (3) (c) Amended and Restated Certificate of Limited Partnership of the Partnership, dated March 25, 1991. (3) (3) (d) Amended and Restated Agreement of Limited Partnership of the Partnership, dated as of May 4, 1987. (4) (3) (e) Amendment No. 1 dated February 14, 1989 to Amended and Restated Agreement of Limited Partnership of the Partnership. (5) (3) (f) Amendment No. 2 dated July 27, 1990 to Amended and Restated Agreement of Limited Partnership of the Partnership. (2) (3) (g) Amendment No. 3 dated March 25, 1991 to Amended and Restated Agreement of Limited Partnership of the Partnership. (3) (3) (h) Amendment No. 4 dated May 23, 1991 to Amended and Restated Agreement of Limited Partnership of the Partnership. (6) (10) (a) Management Agreement dated as of May 23, 1991 among the Partnership, Management Company and the Managing General Partner. (6) (10) (b) Form of Sub-Management Agreement among the Partnership, Management Company, the Managing General Partner and the Sub-Manager. (8) (13) (a) Page 20 of the Quarterly Report on Form 10-Q for the quarter ended March 31, 1993. (13) (b) Page 19 of the Quarterly Report on Form 10-Q for the quarter ended June 30, 1993. (13) (c) Page 17 of the Quarterly Report on Form 10-Q for the quarter ended September 30, 1993. (28) Prospectus of the Partnership dated February 10, 1987 filed with the Securities and Exchange Commission pursuant to Rule 424(b) under the Securities Act of 1933, as supplemented by a supplement thereto dated April 21, 1987 filed pursuant to Rule 424(c) under the Securities Act of 1933. (7) (b) No reports on Form 8-K have been filed since the beginning of the last quarter of the period for which this report is filed. (1) Incorporated by reference to the Partnership's Annual Report on Form 10-K for the year ended December 31, 1988 filed with the Securities and Exchange Commission on March 27, 1989. (2) Incorporated by reference to the Partnership's Quarterly Report on Form 10-Q for the quarter ended December 31, 1990 filed with the Securities and Exchange Commission on November 14, 1990. (3) Incorporated by reference to the Partnership's Annual Report on Form 10-K for the year ended December 31, 1990 filed with the Securities and Exchange Commission on March 28, 1991. (4) Incorporated by reference to the Partnership's Quarterly Report on Form 10-Q for the quarter ended June 30, 1987 filed with the Securities and Exchange Commission on August 14, 1987. (5) Incorporated by reference to the Partnership's Quarterly Report on Form 10-Q for the quarter ended March 31, 1989 filed with the Securities and Exchange Commission on May 15, 1989. (6) Incorporated by reference to the Partnership's Quarterly Report on Form 10-Q for the quarter ended June 30, 1991 filed with the Securities and Exchange Commission on August 14, 1991. (7) Incorporated by reference to the Partnership's Quarterly Report on Form 10-Q for the quarter ended March 31, 1987 filed with the Securities and Exchange Commission on May 15, 1987. (8) Incorporated by reference to the Partnership's Annual Report on Form 10-K for the year ended December 31, 1992 filed with the Securities and Exchange Commission on March 26, 1993. SIGNATURES Pursuant to the requirements of Section 13 or 15(d) 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 on the 25th day of March 1994. ML VENTURE PARTNERS II, L.P. /s/ Kevin K. Albert By: Kevin K. Albert General Partner Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant and in the capacities indicated on the 25th day of March 1994. By: MLVPII Co., L.P. its Managing General Partner By: Merrill Lynch Venture Capital Inc. its General Partner By: /s/ Kevin K. Albert Kevin K. Albert President (Principal Executive Officer) By: /s/ Joseph W. Sullivan Joseph W. Sullivan Treasurer (Principal Financial and Accounting Officer) By: /s/ Steward S. Flaschen Steward S. Flaschen General Partner ML Venture Partners II, L.P. By: /s/ Jerome Jacobson Jerome Jacobson General Partner ML Venture Partners II, L.P. By: /s/ William M. Kelly William M. Kelly General Partner ML Venture Partners II, L.P. Exhibit Index Exhibits Page (3) (a) Amended and Restated Certificate of Limited Partnership of the Partnership, dated January 12, 1987. (1) (3) (b) Amended and Restated Certificate of Limited Partnership of the Partnership, dated July 27, 1990. (2) (3) (c) Amended and Restated Certificate of Limited Partnership of the Partnership, dated March 25, 1991. (3) (3) (d) Amended and Restated Agreement of Limited Partnership of the Partnership, dated as of May 4, 1987. (4) (3) (e) Amendment No. 1 dated February 14, 1989 to Amended and Restated Agreement of Limited Partnership of the Partnership. (5) (3) (f) Amendment No. 2 dated July 27, 1990 to Amended and Restated Agreement of Limited Partnership of the Partnership. (2) (3) (g) Amendment No. 3 dated March 25, 1991 to Amended and Restated Agreement of Limited Partnership of the Partnership. (3) (3) (h) Amendment No. 4 dated May 23, 1991 to Amended and Restated Agreement of Limited Partnership of the Partnership. (6) (10) (a) Management Agreement dated as of May 23, 1991 among the Partnership, Management Company and the Managing General Partner. (6) (10) (b) Form of Sub-Management Agreement among the Partnership, Management Company, the Managing General Partner and the Sub-Manager. (8) (13) (a) Page 20 of the Quarterly Report on Form 10-Q for the quarter ended March 31, 1993. (13) (b) Page 19 of the Quarterly Report on Form 10-Q for the quarter ended June 30, 1993. (13) (c) Page 17 of the Quarterly Report on Form 10-Q for the quarter ended September 30, 1993. (28) Prospectus of the Partnership dated February 10, 1987 filed with the Securities and Exchange Commission pursuant to Rule 424(b) under the Securities Act of 1933, as supplemented by a supplement thereto dated April 21, 1987 filed pursuant to Rule 424(c) under the Securities Act of 1933. (7) ______________________________ (1) Incorporated by reference to the Partnership's Annual Report on Form 10-K for the year ended December 31, 1988 filed with the Securities and Exchange Commission on March 27, 1989. (2) Incorporated by reference to the Partnership's Quarterly Report on Form 10-Q for the quarter ended December 31, 1990 filed with the Securities and Exchange Commission on November 14, 1990. (3) Incorporated by reference to the Partnership's Annual Report on Form 10-K for the year ended December 31, 1990 filed with the Securities and Exchange Commission on March 28, 1991. (4) Incorporated by reference to the Partnership's Quarterly Report on Form 10-Q for the quarter ended June 30, 1987 filed with the Securities and Exchange Commission on August 14, 1987. (5) Incorporated by reference to the Partnership's Quarterly Report on Form 10-Q for the quarter ended March 31, 1989 filed with the Securities and Exchange Commission on May 15, 1989. (6) Incorporated by reference to the Partnership's Quarterly Report on Form 10-Q for the quarter ended June 30, 1991 filed with the Securities and Exchange Commission on August 14, 1991. (7) Incorporated by reference to the Partnership's Quarterly Report on Form 10-Q for the quarter ended March 31, 1987 filed with the Securities and Exchange Commission on May 15, 1987. (8) Incorporated by reference to the Partnership's Annual Report on Form 10-K for the year ended December 31, 1992 filed with the Securities and Exchange Commission on March 26, 1993.

225300_1993.txt

225300

1993

ITEM 1. Business Overview Equitable of Iowa Companies ("company"), a Des Moines, Iowa based insurance holding company organized in 1977, is a provider of individual annuity and life insurance products, targeting middle-income individuals and small businesses throughout the United States. Through its insurance subsidiaries, Equitable Life Insurance Company of Iowa ("Equitable Life") and USG Annuity & Life Company ("USG"), the company offers its products in 49 states and the District of Columbia. Equitable Life was founded in 1867 and is the oldest life insurance company west of the Mississippi. The company began actively marketing annuity products in 1988, principally through USG, which was acquired by the company in 1988 as a shell organization. Both Equitable Life and USG are rated "A+" (Superior) by A.M. Best. A.M. Best's ratings are directed toward the protection of policyholders, not investors. The company has had a rapid rate of growth in assets over the past few years, primarily as a result of increased demand for its annuity products. The company's total assets grew 27%, 16% and 26% in 1993, 1992 and 1991, respectively. Industry-wide asset growth averaged 7% in 1992 and 10% in 1991, based on information compiled by the American Council of Life Insurance. The company's total assets at December 31, 1993 were $6.4 billion, compared to $5.1 billion at December 31, 1992. The company achieved its growth in assets while generating spreads and an overall level of profitability that met or exceeded its objectives. In 1993, the company increased the number of authorized shares of common stock from 35,000,000 to 70,000,000 shares and declared a 2-for-1 stock split to holders of record on May 12, 1993. On October 21, 1993 a public offering of 2,300,000 shares of common stock was completed netting a per share price of $33.16 to the company after underwriting discount and expenses. Strategy The company's continuing strategy to achieve its growth and profit goals is to: - offer a diversified portfolio of annuity and life insurance products designed to appeal to a broad range of customers in the fast-growing retirement savings market segment; - expand its existing base of over 33,000 agents; - provide superior, cost-effective service to its policyholders and agents, brokers and other producers; - maintain high quality ratings; - issue competitive products with protection from early policy termination; and - maintain high quality investments having maturities consistent with the characteristics of the company's policy liabilities. The company believes that, because of its diversified portfolio of annuity and life insurance products, it is well-positioned to take advantage of certain demographic and economic trends that are expected to increase demand for these types of products. These trends include: an aging "baby boomer" segment of the population that is increasingly concerned about retirement and estate planning; an increase in the number of families that are concerned about maintaining their standard of living at retirement; lower public confidence that government and employer-provided benefits at retirement will be sufficient; and the recent increase in individual federal income tax rates. The company believes that ratings also are important in attracting customers, and give it a competitive advantage over other companies in the annuity marketplace. The company intends to manage its business to preserve its current ratings. The company structures its products to contractually protect itself from early policy termination. The majority of the company's life insurance products currently sold incorporate a charge for early withdrawal of the cash value of the policy. In addition, all deferred annuity policies sold by the company include surrender charges, which generally decline over time and apply only during a stated period. In recent years, the company has increased the average surrender charges and lengthened the average period during which charges are assessed. The company's investment strategy emphasizes current income and low credit risk. The persistency of the company's products enables the company to lengthen the duration of its investments. Longer maturities typically provide higher yields than shorter maturities. These higher yields, together with the overall quality of the investment portfolio, allow the company to maintain competitive crediting rates on its interest-sensitive products. Products The company offers, through its insurance subsidiaries, a portfolio of life insurance and annuity products designed to meet the needs of its customers for supplemental retirement income, estate planning and protection from unexpected death. For all products, the target market is middle-income individuals, families and small businesses throughout the United States. The company requires that each of its products be priced to earn an adequate margin between the return to the policyholder and the return earned by the company on its investments. Annuities. Annuities are long-term savings vehicles that are particularly attractive to customers over the age of 50 who are planning for retirement and seeking secure, tax-deferred savings products. The individual annuity business is a growing segment of the savings and retirement market, and among the fastest growing segments of the life insurance industry. Annuity products currently enjoy an advantage over certain other retirement savings products, because the payment of federal income taxes on interest credited on annuity policies is deferred during the investment accumulation period. The company offers a variety of annuity products. Single premium deferred annuities ("SPDAs"), in general, are savings vehicles in which the policyholder, or annuitant, makes a single premium payment to an insurance company. The insurance company credits the account of the annuitant with earnings at an interest rate (the "crediting rate"), which is declared by the insurance company from time to time and may exceed but may not be lower than any contractually guaranteed minimum crediting rate. All of the company's annuities have a minimum guaranteed crediting rate. The company also offers flexible premium deferred annuities ("FPDAs"). FPDAs are deferred annuities in which the policyholder may elect to make more than one premium payment. The company does not currently underwrite variable annuity products, although the company is developing plans to market these products in 1994. The company had 160,000 in force deferred annuity policies at December 31, 1993, with an average account balance of $26,000. At least once each month the company establishes an interest crediting rate for its new annuity policies. In determining the company's interest crediting rate on new policies, management considers the competitive position of the company, prevailing market rates and the profitability of the annuity product. The company maintains the initial crediting rate for a minimum period of one year. Thereafter, the company may adjust the crediting rate not more frequently than once a year. In establishing renewal crediting rates, the company primarily considers the anticipated yield on its investment portfolio. Interest rates credited on the company's in force annuity policies ranged from 4.5% to 10.0% at December 31, 1993. All of the company's annuity products have minimum guaranteed crediting rates ranging from 3.0% to 4.5% for the life of the policy. At December 31, 1993, less than 6% of the company's in force annuity policies had rates credited for a multi-year period. Certain of the company's annuity policies have a bonus crediting rate for the first year of the policy, which typically exceeds the annual crediting rate by 0.5% to 2.5%. The bonus and the base crediting rates are fully disclosed in the annuity contract. The expected renewal crediting rate on such policies is lower than the expected rate on the company's comparable products that do not have a bonus feature. The company incorporates a number of features in its annuity products designed to reduce the early withdrawal or surrender of the policies and to partially compensate the company for lost investment opportunities and costs if policies are withdrawn early. Under the terms of the company's policies, the policyholder is permitted to withdraw all or part of the premium paid plus the amount credited to his or her account, less a surrender charge for withdrawals. Certain of the company's deferred annuity contracts provide for penalty-free partial withdrawals, typically up to 10% of the accumulation value annually. Surrender charge periods on annuity policies currently range from five years to the term of the policy, with the majority of such policies being issued with a surrender charge period of more than seven years. The average length of the surrender period on the company's deferred annuity policies issued during 1993 was 10.6 years. The initial surrender charge on annuity policies generally ranges from 5% to 20% of the premium and decreases over the surrender charge period. At December 31, 1993, 75% of the company's annuity liabilities were subject to a surrender charge of 5% or more, and only 4% carried no surrender penalty. In 1992, the company introduced a number of annuity products with a Market Value Adjustment feature, in which a "market value adjustment" is applied to adjust the applicable surrender charge (either up or down but not below the amount of the initial premium plus credited interest at a stated rate) during the surrender charge period. MVA policies accounted for 53% of the company's total annuity sales during 1993 and 18% of total annuity liabilities at December 31, 1993. The company also markets tax-qualified retirement annuities that meet the requirements of Section 403(b) of the Internal Revenue Code of 1986 ("TSAs") to employees of public schools and certain other tax-exempt organizations. Teachers and other school employees purchase TSAs through automatic payroll deductions. TSA products tend to be purchased by customers who are younger than purchasers of the company's other annuity products. Therefore, the company's specialty TSA products tend to incorporate features that are attractive to customers in this younger age bracket (early 40s to early 50s) who have a longer period to retirement, such as combining a higher crediting interest rate with a longer surrender charge period. The company believes that the market for TSAs is attractive because TSAs broaden its customer base and provide an on-going source of premium renewals. During 1993, the company derived 6% of its annuity premiums from TSAs and expects this percentage to continue to grow over time. In addition to TSAs, the company also sells other tax-qualified retirement annuities such as individual retirement annuities and simplified employee pension plans. Total tax-qualified retirement annuity premiums totalled $390 million, or 35% of total annuities sold during 1993. Life Insurance Products. The company offers a variety of traditional, universal and term life insurance products. Traditional life insurance policies incorporate a fixed premium schedule and combine guaranteed insurance protection with a savings feature. Traditional life policies cost more than comparable term life insurance coverage when the policyholder is younger but less as the policyholder grows older. The policyholder may borrow against the accumulated cash value, with policy loans typically available at a rate of interest lower than that available from other lending sources. The policyholder may also choose to surrender the policy at any time and receive the accumulated cash value, less any applicable withdrawal charge, rather than continuing the insurance protection. The company currently offers fixed premium current interest and other traditional life insurance products, and its insurance in force also includes participating policies. Universal life insurance products provide whole life insurance and adjustable rates of return related to current interest rates. Policyholders may vary the frequency and size of their premium payments, although policy benefits may also fluctuate according to such payments. Term life insurance policies provide insurance protection for unexpected death during the period in which the policy is in force, generally one, five, ten or twenty years. These products are designed to meet customers' shorter-term needs because the policies do not have an investment feature and no cash value is built up. Term life premiums are accordingly lower than certain of the company's other products. The company's current term life products include annually renewable term and five-year, ten-year and fifteen-year renewable and convertible term. In order to discourage early policy withdrawals and to partially compensate the company for lost investment opportunities and costs if policies are terminated, all of the company's universal life and interest-sensitive policies issued since 1986 have incorporated withdrawal charges or similar provisions. At December 31, 1993, 16% of the company's life insurance liabilities were subject to such charges. Reserves. In accordance with applicable insurance regulations, the company records as liabilities in its statutory financial statements, actuarially determined reserves that are calculated to meet future obligations under outstanding insurance policies. The reserves are based on statutorily recognized methods using prescribed morbidity and mortality tables, as applicable, and interest rates. Reserves include premium deposits, claims that have been reported but are not yet paid, claims that have been incurred but have not been reported, and claims in the process of settlement. The company's reserves satisfy statutory requirements. The reserves reflected in the company's Consolidated Financial Statements are calculated based on generally accepted accounting principles ("GAAP"). These reserves are based upon the company's best estimates of mortality, persistency, expenses and investment income, with appropriate provisions for adverse statistical deviation, and the use of the net level premium method for all non interest-sensitive products and at full account value with no reduction for surrender penalties, for interest-sensitive products. GAAP reserves differ from statutory reserves due to the use of different assumptions regarding mortality and interest rates and the introduction of lapse assumptions into the GAAP reserve calculation. The following table sets forth certain consolidated information regarding the development of the company's annuity and insurance business and its reserves calculated based on GAAP for each of the five years in the period ended December 31, 1993. Premiums represent premiums and deposits received (as adjusted for due and deferred premiums), and include premiums on universal life and investment contracts as well as premiums on traditional products. (Table following) 1 Before reduction for ceded reinsurance of: 1993 - $1,326,020; 1992 - $1,242,003; 1991 - $1,066,555; 1990 - $996,939 and 1989 - $861,853. Sales are not concentrated in any geographical area, nor are assets and profitability separately attributed to geographical areas. The states from which the most life and annuity premiums were received are: 1993 - California 15.9%; 1992 - California 11.6%; 1991 - Texas 13.6%; 1990 - Texas 14.5% and 1989 - California 11.0%. Marketing and Distribution The company maintains a diverse distribution network that seeks to provide high quality service to its customers, including the company's policyholders, agents, brokers and other producers, while controlling costs. USG has a variable cost distribution system and markets its products through over 32,000 insurance brokerage agents and 70 financial institutions, such as banks and thrifts. Equitable Life distributes its products through a sales force of approximately 290 career agents, 420 insurance brokerage agents and 210 other personal producers. During 1993, sales through insurance brokerage agents and financial institutions represented 95% of the company's annuity sales, and 18% of life insurance sales. Since 1992, the company has offered certain life insurance products through USG's distribution network and certain of USG's annuity products through Equitable Life's agents and producers. The company intends to continue to take advantage of opportunities to expand the range of products offered through both distribution networks. USG relies primarily on national and regional wholesale marketing organizations to market its products and to recruit agents and other producers. The organizations typically recruit agents for USG by advertising USG's products and its commission structure, through direct mail advertising, or through seminars for insurance agents and brokers. These organizations bear most of the costs incurred in marketing USG and its products. USG compensates the marketing organization by paying it a percentage of the commissions earned on new annuity and insurance policies generated by the agents recruited by the organizations. USG generally does not enter into exclusive arrangements with these marketing organizations. Certain of the marketing organizations with which USG has a relationship are specialty organizations that have a marketing expertise or a distribution system relating to a particular product, such as TSA policies. USG believes that use of wholesale marketing organizations is a cost-effective means of recruiting capable agents and brokers, and advertising its products. The company employs marketing personnel and customer service representatives who respond by telephone to questions from agents, brokers and other producers regarding USG and its products. The company believes that the high level of service it provides to the agents, brokers and other producers who market and sell its products helps establish a relationship between the company and its sales force, and that such interaction also provides marketing opportunities. Equitable Life utilizes a career insurance agent system to sell its individual life insurance and annuity policies. Located nationwide, these career agents primarily distribute Equitable Life products. Equitable Life provides the agents with a professional support program that includes a competitive benefits package, ongoing training, assistance in professional certification, and advertising and advanced sales support. In addition, Equitable Life provides conferences and seminars designed to motivate and train its career agents. Equitable Life also distributes its products through an increasing number of insurance brokerage agents and other personal producers, who are provided with a comparable professional support program, but not the benefits package offered to career agents. Ratings A. M. Best, an independent insurance industry rating organization, assigns fifteen letter ratings to insurance companies. A. M. Best's ratings currently range from "A++" to "F" and some insurance companies are not rated. A. M. Best performs a quantitative and qualitative evaluation for each company it rates. The quantitative evaluation compares a company's performance to industry standards established by A. M. Best in three areas: profitability, leverage, and liquidity. The qualitative evaluation examines eight factors for each company: spread of risk, quality and appropriateness of the reinsurance program, quality and diversification of assets, adequacy of policy or loss reserves, adequacy of surplus, capital structure, management's experience and objectives, and policyholders' confidence. A. M. Best also may review other qualitative factors. Publications of A. M. Best indicate that "A+" and "A++" ratings are assigned to those companies which, in A. M. Best's opinion, have achieved superior overall performance when compared to the standards established by A. M. Best and generally have demonstrated a strong ability to meet their policyholder obligations over a long period of time. A. M. Best's ratings are directed toward the protection of policyholders, not investors. Equitable Life has received A. M. Best's quality rating of "A+" (Superior) (or comparable rating) since the ratings were established in 1905. USG has also received A. M. Best's rating of "A+" (Superior), which was based on the consolidated financial condition and operating performance of USG and its parent, Equitable Life. Underwriting Substantially all of the life insurance policies written by the company's insurance subsidiaries are individually underwritten, although standardized underwriting procedures have been adopted for certain coverages. The company uses information from a prospective policyholder's application, and in some cases, inspection reports, doctors' statements or medical examinations, to determine whether a policy should be issued as applied for, issued at a higher premium because of unfavorable factors, or rejected. In addition, the company may request medical examinations from any applicant, regardless of age and amount of insurance, if information obtained from the application or other sources indicates an examination is advisable before determining to underwrite the risk. The company requires medical examinations for applicants for insurance in excess of prescribed amounts. Underwriting with respect to annuities is minimal. The increasing incidence of Acquired Immune Deficiency Syndrome ("AIDS") is expected to adversely affect mortality rates for the life insurance industry. The company regularly requires applicants for insurance in excess of $100,000 to submit to blood screening for AIDS, drug and alcohol abuse and other factors. Investments The company's investment philosophy emphasizes the careful underwriting of credit risk, identifying relative values within a range of investment choices, providing liquidity to meet operating needs and maximizing current income. As part of its objective of effective asset-liability management, the company conducts computer simulations which model its assets and liabilities under commonly used stress-test interest rate scenarios. Based on the results of these computer simulations, the company's investment portfolio has been structured with a view to maintaining a desired investment spread between the yield on portfolio assets and the rate credited on its reserves. Competition The insurance and annuity business is highly competitive with numerous companies offering similar products through comparable marketing and distribution systems. Companies typically compete for policyholders on the basis of benefit rates, financial strength and customer service and compete for agents and brokers on the basis of commissions, financial strength and customer service. The company maintains competitive policy benefit rates. However, the company believes that it competes primarily on the basis of its high-level of customer service and its financial strength. Regulation The company's life insurance operations are conducted in a highly regulated environment. Each aspect of the company's insurance operations may be affected by regulatory authorities to some degree. Each of the company's insurance subsidiaries is subject to the insurance laws of the state in which it is organized and of the other jurisdictions in which it transacts business. Such laws and regulations and the level of supervisory authority that may be exercised by the state insurance agencies vary from jurisdiction to jurisdiction. The primary regulators of the Company's insurance operations are the Commissioner of Insurance for the State of Iowa for Equitable Life and the Commissioner of Insurance for the State of Oklahoma for USG. State insurance laws generally provide regulators with broad administrative and supervisory powers related to the grant and revocation of licenses to transact business, the establishment of guaranty fund associations, the licensing of agents, the approval of policy forms, the establishment of reserve requirements, the prescription of the form and content of required financial statements and reports, the determination of the reasonableness and adequacy of statutory capital and surplus, and the regulation of the type and amount of investments permitted. Although the federal government does not directly regulate the insurance industry, federal initiatives often have an impact on the insurance business. Federal legislation has been proposed from time to time relating in general to the solvency of insurers and other subjects. Recently, the insurance regulatory framework has been placed under increased scrutiny by various states and the National Association of Insurance Commissioners ("NAIC"). Various states have considered or enacted legislation that changes, and in many cases increases, the state's authority to regulate insurance companies. The NAIC, in conjunction with state regulators, also has been reviewing existing insurance laws and regulations. The NAIC recently approved and recommended to the states for adoption and implementation several regulatory initiatives designed to reduce the risk of insurance company insolvencies. These initiatives include new investment reserve requirements, risk-based capital standards, and restrictions on an insurance company's ability to pay dividends to its stockholders. Other Operations Locust Street Securities, Inc. ("LSSI"), a wholly-owned subsidiary of the company, markets mutual funds, variable annuities, tax-exempt bond funds and investment-oriented products of other companies primarily through Equitable Life career agents. Founded in 1968, LSSI also contracts with agents of other companies to be a wholesaler of broker/dealer products. LSSI has a distribution network of approximately 550 representatives in 44 states. Employees At December 31, 1993, the company had 379 full-time and 8 part-time employees. The company provides its employees with a comprehensive range of employee benefit programs. The company believes that its employee relations are excellent. ITEM 2.

ITEM 2. Properties Substantially all of the company's business is carried on in leased facilities located at 604 Locust Street, 699 Walnut Street, and 700 Locust Street in Des Moines, Iowa. All owned properties consist of real estate held for investment purposes or acquired through foreclosure. Property and equipment primarily represent leasehold improvements at the company's headquarters and at various agency offices and office furniture and equipment, and are not considered to be significant to the company's overall operations. Property and equipment are reported at cost less allowances for depreciation. The company believes that its present facilities are adequate for its anticipated needs. ITEM 3.

ITEM 3. Legal Proceedings From time to time, in the ordinary course of business, the company is involved in litigation. Management believes it is unlikely that the outcome of any pending litigation will have a material adverse effect on the company's financial condition. ITEM 4.

ITEM 4. Submission of Matters to a Vote of Security Holders None. PART II ITEM 5.

ITEM 5. Market for Registrant's Common Equity and Related Stockholder Matters. Stock Symbols Prior to September 13, 1993, the company's common stock was quoted on the NASDAQ National Market System with a stock symbol of EQIC. On and after September 13, 1993, the company's common stock was quoted on the New York Stock Exchange with a stock symbol of EIC. Quarterly Stock Quotations The following table shows the range of high and low closing sales prices per share of Common Stock of the company for the periods indicated as reported on the NASDAQ National Market System prior to September 13, 1993. Over-the-counter market quotations may reflect inter-dealer prices, without retail mark-up, mark-down, or commissions and may not necessarily represent actual transactions. Prices on or after September 13, 1993 are as reported on the New York Stock Exchange. Prices prior to June 2, 1992 have been adjusted to give effect to the two-for-one stock split payable to stockholders of record as of May 14, 1992, and prices prior to June 1, 1993 have been adjusted to give effect to a second two-for-one stock split payable to stockholders of record as of May 12, 1993. Prices prior to the consolidation of the company's Class A and Class B common stock into a single class of Common Stock on a one-for-one basis on May 1, 1992 reflect prices of the company's Class B common stock. Number of Holders of Record The number of holders of record of common stock was 946 at February 24, 1994, the dividend record date. Dividends Cash dividends are paid quarterly, at an amount determined by the Board of Directors. The corporation's bank credit arrangements restrict the amount of dividends paid annually on its common stock. Also, insurance regulations restrict the amount of dividends that can be paid to the company by Equitable Life. See Note 1 to the consolidated financial statements and Item 7, Management's Discussion and Analysis - Liquidity and Capital Resources. Dividends paid per share of common stock, after giving effect to the 2-for-1 stock splits as of May 12, 1993 and May 14, 1992, were $0.405 in 1993 and $0.35 in 1992. Transfer Agent and Registrar Boatmen's Trust Company, 510 Locust, P.O. Box 14768, St. Louis, Missouri 63178. ITEM 6.

ITEM 6. Selected Financial Data The following table sets forth a consolidated summary of selected financial data for the company and its subsidiaries (all significant intercompany accounts have been eliminated) for each of the last ten years. In this table the years ended December 31, 1984 through 1987 have been restated to reflect the implementation of SFAS No. 97 in 1988. In addition, the years ended December 31, 1984 through 1991 have been restated to reflect the sale of Younkers, Inc. in 1992 and treatment of that entity as a discontinued operation. This summary should be read in conjunction with the related consolidated financial statements and notes thereto. (Table following) 1 Operating income equals income from continuing operations before cumulative effect of change in accounting principles, excluding realized gains or losses (net of related income taxes) and excluding amortization of deferred policy acquisition costs related to realized gains and losses (net of related income taxes). Operating income in 1991 excludes the after-tax income effect ($10,259,000) ($(0.36) per share) of accrual for insurance guaranty fund assessments. 2 Excludes the cumulative effect of changes in the method of accounting for postretirement benefits (1992) and deferred income taxes (1991). 3 Includes the cumulative effect of changes in the method of accounting for postretirement benefits of $(4,678,000) ($(0.16) per share) in 1992 and deferred income taxes of $9,444,000 ($0.34 per share) in 1991. 4 Share and per share amounts have been restated to reflect the 2-for-1 stock splits as of May 12, 1993 and May 14, 1992 and the reversion of Class A and Class B stock to one class of common stock as of May 1, 1992. 1 Operating income equals income from continuing operations before cumulative effect of change in accounting principles, excluding realized gains or losses (net of related income taxes). 2 Excludes the cumulative effect of the change in the method of accounting for the participating line of business in 1988. 3 Includes the cumulative effect of change in the method of accounting for the participating line of business of $11,555,000 ($0.35 per share) in 1988. 4 Share and per share data amounts have been restated to reflect the 2-for-1 stock splits as of May 12, 1993 and May 14, 1992 and the reversion of Class A and Class B stock to one class of common stock as of May 1, 1992. Additionally, 1985 and prior years have also been restated to reflect the 50% stock dividend in December 1986. ITEM 7.

ITEM 7. Management's Discussion and Analysis of Financial Condition and Results of Operations The purpose of this section is to discuss and analyze the company's consolidated financial condition, liquidity and capital resources and results of operations. This analysis should be read in conjunction with the consolidated financial statements and related notes which appear elsewhere in this report. The company reports financial results on a consolidated basis. The consolidated financial statements include the accounts of the company and its subsidiaries, all of which are wholly-owned at December 31, 1993. The company's retail subsidiary, Younkers, Inc. was sold through a public stock offering on April 29, 1992 and has been classified as a discontinued operation. The company's primary subsidiaries are Equitable Life Insurance Company of Iowa ("Equitable Life") and USG Annuity & Life Company ("USG"). FINANCIAL CONDITION Investments The company's total investments grew 27.5% in 1993 compared to 25.6% in 1992. This growth in the company's investment portfolio resulted from record sales of the company's insurance and annuity products. The company carefully monitors the growth of its insurance operations in order to maintain adequate capital ratios. The sale of 2,300,000 shares of the company's common stock in October 1993 generated net proceeds totalling $76,264,000, $70,000,000 of which has been contributed to the company's insurance subsidiaries to fund growth in these operations over the next several years. With the availability of this capital, the company has established a goal of growing assets at least 20% annually. To support the company's annuities and life insurance products, cash flow was invested primarily in fixed income investments. At December 31, 1993, 99.7% of the company's investments, excluding policy loans, were in cash or fixed income investments. Fixed income investments consist of government and agency mortgage-backed securities (6.5%); investment grade corporate and conventional mortgage-backed securities, as determined by either Standard & Poor's Corporation ("Standard & Poor's") or Moody's Investors Service ("Moody's") (79.1%); below investment grade corporate securities (6.6%) and mortgage loans on real estate (6.3%). The company reports its fixed maturity securities at amortized cost. The company purchases such investments with the intention to hold them to maturity. Several factors demonstrate the company's ability to hold investments until maturity. The company's insurance and annuity liabilities are long term by nature. The company has generally experienced low lapse rates on its insurance policies, and all whole life and annuity policies currently being sold have features that tend to discourage lapse or surrender of policies. In addition, one of the company's investment objectives is to manage its portfolio so that the duration of its assets is consistent with the duration of its liabilities. In May 1993, the Financial Accounting Standards Board ("FASB") issued Statement of Financial Accounting Standards ("SFAS") No. 115, "Accounting for Certain Investments in Debt and Equity Securities", which changes the accounting treatment afforded the company's fixed maturity securities. This SFAS is discussed below under the caption "Emerging Accounting and Regulatory Issues." At December 31, 1993, the ratings assigned by Standard & Poor's and Moody's to the individual securities in the company's fixed maturities portfolio are summarized as follows: Note: Estimated market values of publicly traded securities are as reported by an independent pricing service. Market values of conventional mortgage-backed securities not actively traded in a liquid market are estimated using a third party pricing system, which uses a matrix calculation assuming a spread over U.S. Treasury bonds based upon the expected average lives of the securities. Market values of private placement bonds are estimated using a matrix that assumes a spread (based on interest rates and a risk assessment of the bonds) over U.S. Treasury bonds. Estimated market values of redeemable preferred stocks are as reported by the National Association of Insurance Commissioners ("NAIC"). Net unrealized appreciation of fixed maturity investments of $329,132,000 was comprised of gross appreciation of $354,088,000 and gross depreciation of $24,956,000 on the individual securities. At December 31, 1993, below investment grade securities, using the higher rating by Moody's or Standard & Poor's, totalled $361,869,000, or 6.6% of the company's investment portfolio. Included in this total were $105,374,000 of securities, rated investment grade when purchased and later downgraded. The company estimates that the market value of its below investment grade portfolio was $371,370,000, or 102.6% of carrying value, at December 31, 1993. Below investment grade securities have different characteristics than investments in investment grade corporate debt securities. Risk of loss upon default by the borrower is significantly greater with respect to below investment grade securities than with other corporate debt securities because below investment grade securities are generally unsecured and are often subordinated to other creditors of the issuer. Also, issuers of below investment grade securities usually have high levels of debt and are more sensitive to adverse economic conditions, such as recession or increasing interest rates, than are investment grade issuers. The company attempts to reduce the overall risk in its below investment grade portfolio, as in all of its investments, through careful credit analysis, investment policy limitations, and diversification by company and by industry. During 1993, the company purchased 31 below investment grade securities at a total cost of $187,162,000. At December 31, 1993 these securities were rated 2 or 3 by the NAIC and had an estimated market value of $185,047,000. The company intends to purchase additional below investment grade securities but it does not expect the percentage of its portfolio invested in below investment grade securities to increase significantly. During 1993, the company sold two below investment grade securities with a combined carrying value of $5,481,000. These sales resulted from a deterioration in the credit quality of one of the security's issuers and due to expectations that the other security would be called. Gains of $284,000 were realized as a result of these sales. Also during 1993, portions of 10 other issues with a combined carrying value of $51,318,000 were called or repaid. Gains of $3,539,000 were recognized on these disposals. At December 31, 1993, the company's total investment in below investment grade securities consists of investments in 81 issuers totalling $361,869,000, or 6.6% of the company's investment portfolio compared to 60 issuers totalling $236,080,000, or 5.5% of the portfolio at December 31, 1992. The company analyzes its investment portfolio at least quarterly in order to determine if its ability to realize its carrying value on any investment has been impaired. If impairment in value is determined to be other than temporary (i.e. the company has doubt about an issuer's ability to comply on a timely basis with the payment provisions of the instrument), the company prepares an estimate of net realizable value by estimating expected future cash flows from the investment and, in turn, recognizes the impairment as a charge to realized gains and losses if the estimated nondiscounted cash flows from the investment are less than the carrying value of the investment. One below investment grade security with a carrying value of $699,000 and an estimated market value of $160,000 was in default at December 31, 1993. During the second quarter of 1993, the company determined that the decline in value of this security was other than temporary. As a result of that determination, the company recognized a pre-tax loss of $6,443,000 to write the security down to its estimated net realizable value of $699,000. The company's estimates of future cash flows from this security indicate that the company will recover its remaining carrying value, and, consequently, no additional writedown of carrying value is deemed necessary. The carrying value of the fixed maturity investment considered to have an other than temporary impairment represented 0.1% of total stockholders' equity at December 31, 1993. The use of nondiscounted cash flows to evaluate net realizable value may result in lower realized losses in the current period than if the company had elected to use discounting in its evaluation process. Additionally, the rate of return actually realized by the company on investments whose value suffers an impairment that is other than temporary is less than the yield to maturity at the date of original purchase. This lower rate of return results from a downward adjustment in expected cash flows from the investment. The yield recognized in future periods on these investments may also be less than yields recognized on other investments or those yields expected when the securities were originally purchased. The company will be required to use fair value or discounted cash flows in evaluating net realizable value when it adopts SFAS No. 115, "Accounting for Certain Investments in Debt and Equity Securities" on January 1, 1994. See Emerging Accounting and Regulatory Issues. Below investment grade investments, as well as other investments, are monitored on an ongoing basis and future events may occur, or additional or updated information may be received, which may necessitate further write-downs of securities in the company's portfolio. Significant write-downs in the carrying value of investments could materially adversely affect the company's net income in future periods. At December 31, 1993, the company's below investment grade portfolio had a yield to maturity of 9.7% compared to 8.4% for the company's corporate investment grade portfolio. A reduction in the amount of the company's investments in below investment grade securities could have a negative impact on the company's operating results. The size of such impact would depend on many factors, including the magnitude of the reduction, the yield of alternative investments, and the interest rate credited to policyholder account balances. During 1993, investment grade corporate and conventional mortgage-backed securities with a combined carrying value of $891,511,000 were called or prepaid by their issuers. Aggregate pre-tax gains of $47,385,000 were realized due to these disposals. These gains are treated as realized gains on investments in the company's financial statements, and are not a part of investment income. Aggregate pre-tax gains from sales, calls, tender offers, prepayments and write-downs of fixed maturity investments totaled $41,754,000 in 1993 compared to $7,001,000 in 1992. At December 31, 1993, the company's fixed maturity investment portfolio had a combined yield of 8.5% compared to 9.3% at December 31, 1992. Since new investment rates are lower than the company's current portfolio yield, the overall yield on the company's investment portfolio is declining as cash flows from insurance and annuity sales are invested at relatively lower rates. This decline in yield is compounded as investments in higher yielding securities are called or repaid by their issuers and proceeds from these early payments are invested at current rates. The impact of these declining portfolio yields on the company's operating results will depend upon the magnitude of the decline and the level of interest rates credited to policyholder account balances. At December 31, 1993, the average annual interest rate in effect for interest-sensitive products, including annuities, universal life, and participating life policies, was 6.2% compared to 7.1% at December 31, 1992. Mortgage loans make up approximately 6.3% of the company's investment portfolio, as compared to an industry average of 14.8%, as reported in the 1993 ACLI Fact Book. During 1992, the company resumed active mortgage lending to broaden its investment alternatives and, as a result of this increase in lending activity, mortgages outstanding increased to $346,829,000 from $249,585,000 during 1993. The company expects this asset category to continue to grow over the next several years. The company's mortgage loan portfolio includes 244 loans with an average size of $1,421,000 and average seasoning of 11 years if weighted by the number of loans, and 5.7 years if weighted by mortgage loan carrying values. The company's mortgage loans are typically secured by occupied buildings in major metropolitan locations and not speculative developments, and are diversified by type of property and geographic location. At December 31, 1993, the yield on the company's mortgage loan portfolio was 9.0%. Distribution of these loans by type of collateral and geographic location is as follows: During 1993, the company determined that the carrying value of one of its mortgage loans exceeded its estimated net realizable value. As a result of that determination, the company recognized a pre-tax loss of $363,000 to reduce the carrying value of the loan to its estimated net realizable value of $1,300,000. At December 31, 1993, 0.5% of the commercial mortgage portfolio, or $1,904,000, was delinquent by 90 days or more. In addition, the company holds $15,718,000 in foreclosed real estate. The company does not expect to incur material losses from these investments since delinquent loans represent a small percentage of the portfolio. The company has been able to recover 87% of the principal amount of problem mortgages that have been resolved in the last three years. In total, the company has experienced a relatively small number of problems with its total investment portfolio, with less than 1/20th of 1% of the company's investments in default at December 31, 1993. The company estimates its total investment portfolio, excluding policy loans, had a market value equal to 106.5% of carrying value for accounting purposes at December 31, 1993. Other assets Accrued investment income increased $14,376,000 during 1993 due to an increase in new fixed income investments and in the overall size of the portfolio. Notes and other receivables increased $12,230,000 primarily as a result of the "gross-up" of receivables for reserve credits on ceded reinsurance totalling $9,931,000 as required by SFAS No. 113, "Accounting and Reporting for Reinsurance of Short-Duration and Long-Duration Contracts." Deferred policy acquisition costs increased $95,075,000 over year-end 1992 levels as the deferral of current period costs (primarily commissions) incurred to generate insurance and annuity sales and premiums continued to exceed the amortization of costs deferred in previous periods. At December 31, 1993, the company had total assets of $6,431,435,000, an increase of 26.9% over total assets at December 31, 1992. Liabilities In conjunction with the volume of insurance and annuity sales and premiums, and the resulting increase in business in force, the company's liability for policy liabilities and accruals increased $1,178,579,000, or 26.7%, during 1993. Total consolidated debt decreased $5,294,000 with the December 1993 maturity of bonds totalling $10,500,000, partially offset by a $5,226,000 increase in commercial paper notes payable. Total consolidated debt amounted to $84,214,000 at December 31, 1993. Other liabilities increased $23,438,000 from year-end 1992 levels primarily as the result of an increase in liabilities for outstanding checks and draft accounts payable related to the company's asset retention program. The company's insurance subsidiaries are assessed contributions by life and health guaranty associations in almost all states to indemnify policyholders of failed companies. In some states, such assessments are offset by reductions in future premium taxes. The company cannot predict whether and to what extent legislative initiatives may affect the right to offset. The amount of these assessments prior to 1991 was not material. Failures of substantially larger companies since 1990, could result in future assessments in material amounts. During 1991, the company established a reserve of $21,049,000 to cover such assessments, which was partially offset by $5,678,000 of expected related future premium tax credits. The company regularly reviews information regarding known failures and revises its estimate of future guaranty fund assessments accordingly. During 1993, this review caused the company to accrue and charge to expense an additional $2,109,000 to cover amounts not previously reserved. At December 31, 1993, the company has reserved $15,211,000 to cover estimated future assessments (net of related anticipated premium tax credits) and has established an asset totalling $8,309,000 for amounts expected to be recoverable through future premium tax offsets. The company believes this reserve is sufficient to cover expected future insurance guaranty fund assessments. At December 31, 1993, the company had total liabilities of $5,903,473,000 compared to $4,693,073,000 at December 31, 1992, a 25.8% increase. Equity At December 31, 1993, stockholders' equity was $527,962,000, or $16.76 per share, compared to $373,801,000, or $12.89 per share, on a restated basis at year-end 1992. The ratio of consolidated debt to total capital was 13.8% at December 31, 1993, down from 19.3% at year-end 1992 as stockholders' equity increased and consolidated debt decreased. At December 31, 1993, there were 31,504,586 common shares outstanding compared to a restated 28,994,640 shares at December 31, 1992. This increase is primarily the result of the completion of an offering of 2,300,000 shares of common stock by the company on October 21, 1993. December 31, 1992 share and per share amounts have been restated to reflect the impact of a 2-for-1 stock split on June 1, 1993. The effects of inflation and changing prices on the company are not material since insurance assets and liabilities are primarily monetary. One effect of inflation, which has been low in recent years, is a decline in purchasing power when monetary assets exceed monetary liabilities. LIQUIDITY AND CAPITAL RESOURCES The liquidity requirements of the company's subsidiaries are met by cash flow from insurance and annuity premiums, investment income, and maturities of fixed maturity investments and mortgage loans. The company primarily uses funds for the payment of insurance and annuity benefits, operating expenses and commissions, and the purchase of new investments. No material capital expenditures are planned. The company issues short-term debt, including commercial paper notes, for working capital needs and to provide short term liquidity. At December 31, 1993 the company had $34,000,000 in commercial paper notes outstanding, an increase of $5,226,000 from December 31, 1992 as additional commercial paper was issued to fund short-term advances to the company's insurance subsidiaries to smooth timing differences between cash receipts and disbursements. On July 16, 1993, Duff & Phelps Credit Rating Co. announced that it had assigned a commercial paper rating of Duff 1 to the company's commercial paper. The company's commercial paper continues to be rated A1 by Standard and Poor's and P2 by Moody's. To enhance short term liquidity and back up its outstanding commercial paper notes, the company maintains a $100,000,000 credit agreement with five banks that terminates in May 1996. To reduce the risk of rising short-term interest rates, the company had entered into interest rate swap agreements with three banks wherein the company agreed to pay a fixed rate of interest and received a floating short-term rate of interest tied to prime commercial paper or LIBOR rates. The total notional amount of these swap agreements was $50,000,000. The company terminated these swaps at a cost of $3,011,000 in the third quarter of 1993. Since Equitable of Iowa Companies is a holding company, funds required to meet its debt service requirements, dividend payments and other expenses are primarily provided by its subsidiaries. The ability of the company's insurance subsidiaries to pay dividends and other distributions to the company is regulated by state law. Iowa law provides that an insurance company may pay dividends, without prior regulatory approval if, together with all dividends or distributions made during the preceding twelve month period, the dividends would not exceed the greater of (a) 10% of the insurer's statutory surplus as of the next preceding year-end; or (b) the statutory net gain from operations for the twelve month period ending as of the next preceding year-end. In addition, Iowa law provides that the insurer may only make dividend payments to its shareholders from its earned surplus (i.e., its surplus as regards policyholders less paid-in and contributed surplus). Equitable Life could pay dividends to the company without prior regulatory approval of approximately $39,335,000 during 1994. The NAIC's risk-based capital requirements were adopted in December 1992 and require insurance companies to calculate and report information under a risk-based capital formula. These requirements are intended to allow insurance regulators to identify inadequately capitalized insurance companies based upon the type and mixture of risks inherent in the company's operations. The formula includes components for asset risk, liability risk, interest rate exposure and other factors. The company's insurance subsidiaries provided the required disclosures in their December 31, 1993 statutory financial statements. Amounts reported in these statutory financial statements indicate that the company's insurance subsidiaries have total adjusted capital (as defined in the requirements) which is well above all required capital levels. The terms of the $100,000,000 line of credit agreement require the company to maintain certain consolidated tangible net worth levels. "Consolidated tangible net worth" is defined as consolidated stockholders' equity, less consolidated intangible assets. The most restrictive of these covenants requires the company to maintain consolidated tangible net worth equal to or in excess of the sum of (i) $280,000,000, plus (ii) 50% of consolidated net income from January 1, 1993 to the end of the most recent quarter, plus (iii) net proceeds from the issuance of stock from January 1, 1993 to the end of the most recent quarter. At December 31, 1993, $123,913,000 of retained earnings were free of restrictions and could be distributed to the company's public stockholders. Developing and writing increased volumes of insurance and annuity business require increased amounts of capital and surplus for the company's insurance operations including amounts in excess of those which may be realized from operating results. The company may also expand its insurance operations through acquisition of blocks of business from other insurance companies, or through the acquisition of an insurance company, although no such acquisitions are currently planned. In recent periods the company has funded the growth of its insurance operations with the proceeds from the April 1992 sale of the company's former retail subsidiary. On April 29, 1992, the company sold its former retail subsidiary, Younkers, through a public stock offering and received net proceeds of approximately $50,000,000 after taxes. The company contributed $10,000,000 of these proceeds to its insurance subsidiaries in the fourth quarter of 1992 and $20,000,000 in the third quarter of 1993 to fund the growth in these operations. On October 21, 1993, the company completed a stock offering of 3,273,200 shares to the public at a price of $35 per share. Included in this amount were 2,300,000 shares offered by the company and 973,200 offered by certain stockholders of the company. The company received net proceeds totaling $76,264,000 from the sale of its 2,300,000 shares after deduction of the underwriter's discount and expenses. The company did not receive any of the proceeds from the sale of shares by the selling stockholders. The company has contributed $70,000,000 of these proceeds to its insurance subsidiaries during 1993. Over time, further growth in the company's insurance operations may require additional capital although the company believes it now has sufficient capital resources to support growth in these operations for the next several years. The company's primary sources of capital are issuance of additional common stock or issuance of additional debt. To improve the liquidity of the company's common stock, on April 29, 1993, the company's Board of Directors approved a 2-for-1 stock split of the company's common stock, payable on June 1, 1993 to holders of record as of May 12, 1993. The company's stockholder's also approved an increase in the number of authorized shares of its common stock from 35,000,000 to 70,000,000 and the Board adjusted the exercise price under the company's Rights Agreement to $100 per share (post split). The company's insurance subsidiaries operate under the regulatory scrutiny of each of the state insurance departments supervising business activities in the states where each company is licensed. The company is not aware of any current recommendations by these regulatory authorities which, if they were to be implemented, would have a material effect on the company's liquidity, capital resources or operations. RESULTS OF OPERATIONS - 1993 COMPARED TO 1992 Sales Total life insurance and annuity sales, as measured by first year and single premiums, increased $236,777,000, or 26.7%, to $1,122,797,000 in the year ended December 31, 1993. Annuity sales increased $232,912,000, or 26.7%, to $1,104,222,000 in 1993. The company believes that its commitment to customer service, the quality of its investment portfolio and its overall financial strength attract consumers to its annuity products as consumers continue to seek a secure return on their retirement savings. First year and single life insurance premiums increased $3,865,000, or 26.3%, to $18,575,000 in the year ended December 31, 1993. Life insurance sales (at face amounts) during 1993 increased $18,549,000, or 1.3%, to $1,416,576,000 compared to 1992, as increased sales of the company's universal life products more than offset declines in sales of term life insurance products. Revenues Total revenues increased $114,594,000, or 25.0%, to $572,968,000, in 1993, compared to 1992. Universal life insurance and annuity product charges increased $3,869,000, or 12.7%, to $34,281,000, compared to the year ended December 31, 1992, as the company's marketing efforts continued to focus on the sale of deferred annuities and interest-sensitive life insurance products. Premiums from traditional life insurance products also improved during 1993, increasing by $3,848,000, or 8.9%, to $46,870,000, compared to 1992, as these products were made available to the company's insurance brokerage distribution system. Net investment income increased $71,636,000, or 19.8%, to $434,069,000 in 1993, as the increase in invested assets more than offset the decline in portfolio yield. The average annualized yield on invested assets supporting policy accounts for interest-sensitive products, including annuities, universal life-type policies and participating life policies was 9.1% during 1993, compared to 9.7% during 1992. The company's total investment portfolio, excluding policy loans, had a yield to maturity of 8.5% at December 31, 1993, compared to 9.2% at December 31, 1992, reflecting a general decline in interest rates, and substantial principal repayments of investments. The effect of the decline in the portfolio yield on the company's future net income will depend on many factors, including the level of interest rates credited to policyholder account balances. During 1993, the company realized gains on the sale of investments of $41,985,000, compared to $8,164,000 in 1992, primarily resulting from calls and prepayments of fixed maturity investments. Included in these totals were write-downs of $6,806,000 in 1993 and $5,328,000 in 1992, to reduce the carrying value of various investments to estimated net realizable value. Expenses Total insurance benefits and expenses increased $66,054,000, or 18.6%, to $420,435,000 in 1993. Interest credited to universal life and annuity account balances increased $37,168,000, or 16.0%, to $268,992,000, in 1993, as a result of higher account balances associated with those products. The average annualized interest rate credited to policy accounts for interest- sensitive products, including annuities and universal life-type policies and participating life policies, was 6.6% for 1993 compared to 7.5% in 1992. The average annual interest rate in effect for those policies at December 31, 1993 was 6.2%, compared to 7.1% at December 31, 1992. The company's practice is to reduce rates credited to policy accounts as investment yields decline. Most of the company's interest-sensitive policies allow for interest rate adjustments at least annually. Death benefits on traditional life products and benefit claims incurred in excess of account balances on universal life products increased $2,897,000, or 11.8%, to $27,536,000, while other benefits declined $8,129,000, or 20.1%, to $32,344,000 in 1993, due to lower lapses of the company's insurance policies. These changes were offset by a corresponding change in the reserve for future policy benefits and, therefore, had no material impact on net income. The withdrawal ratio for the company's annuity products, as calculated by dividing average aggregate surrenders and withdrawals by average aggregate account balances, was 4.6% in 1993 compared to 6.3% in 1992. The 1992 annuity withdrawal rate included withdrawals resulting from the exercise of a "bailout" feature by policyholders which allowed them to withdraw their account balance without penalty as credited rates fell below predetermined levels. This "bailout" feature can only be exercised for a limited period, and less than 1% of remaining annuity liabilities are subject to a "bailout" feature. Excluding these "bailout" withdrawals, the 1992 withdrawal rate was 4.2%. Most of the company's annuity products have penalties or other features designed to discourage early withdrawals, and to allow the company to recover a portion of the expenses incurred to generate annuity sales in the event of early withdrawal. The company anticipates an increase in annuity withdrawals as this block of business matures. The company's lapse ratio for life insurance, measured in terms of face amount and using A. M. Best's formula, was 7.2% in 1993 compared to 8.4% in 1992. Commissions increased $29,083,000, or 34.5%, to $113,450,000 in 1993, primarily because of increased sales of annuity products. This increase was offset by an increase in the deferral of such policy acquisition costs and thus had little impact on total insurance expenses. General insurance expenses increased $5,260,000, or 16.3%, to $37,554,000 related to increases in sales, assets and policies in force. The amortization of deferred policy acquisition costs increased by $21,902,000, or 108.6%, to $42,078,000 in 1993. During 1993, the estimate and timing of gross profits from certain universal life and annuity product lines changed, which, in accordance with SFAS No. 97, necessitated that the company recompute or "unlock" the amortization of deferred policy acquisition costs. This "unlocking" primarily resulted from realized investment gains leading to higher gross profits than originally expected. As a result, 1993 amortization was increased by $13,916,000, and amortization in future periods will be decreased. Income Operating income (income from continuing operations before cumulative effect of change in accounting principles, excluding realized gains and losses, net of related income taxes, and excluding amortization of deferred policy acquisition costs related to realized gains and losses, net of related income taxes) increased $19,602,000, or 39.8%, to $68,911,000 in 1993, or $2.33 per share, compared to $49,309,000, or $1.72 per share, in 1992. The company recognized realized gains on the sale of investments and deferred policy acquisition costs related to realized gains (net of related income taxes) as follows: Income from continuing operations before the cumulative effect of change in accounting principle for postretirement benefits improved to $87,156,000, or $2.95 per share, in 1993, compared to $57,260,000, or $1.99 per share, in 1992. The company's discontinued retail operations contributed income of $1,924,000, or $0.07 per share, during 1992. During the fourth quarter of 1992, the company implemented a new accounting standard for postretirement benefits other than pensions and incurred a charge to earnings of $4,678,000, or $0.16 per share, which was treated as a cumulative effect of change in accounting principle. Net income was $87,156,000, or $2.95 per share, in 1993, compared to $54,506,000, or $1.90 per share, in 1992. 1992 per share amounts reported above have been restated to reflect the 2-for-1 stock split on June 1, 1993. RESULTS OF OPERATIONS - 1992 COMPARED TO 1991 Sales Total life insurance and annuity sales, as measured by first year and single premiums, increased $395,090,000, or 80.5%, to $886,020,000 in the year ended December 31, 1992. Annuity sales increased $409,505,000, or 88.7%, to $871,310,000 in 1992, compared to 1991. Annuity sales were positively impacted by the company's financial strength, low short-term interest rates which made annuity products more attractive than certain other savings options and availability of capital from the sale of the company's former retail department store subsidiary. First year and single life insurance premiums declined $14,415,000, or 49.5%, to $14,710,000 in the year ended December 31, 1992. Life insurance sales (at face amounts) during 1992 increased $259,779,000, or 22.8%, to $1,398,027,000, compared to 1991, as a result of increased sales of the company's term life insurance products. Revenues Total revenues increased $58,085,000, or 14.5%, to $458,374,000, in 1992, compared to 1991. Universal life insurance and investment product charges increased $1,387,000, or 4.8%, to $30,412,000, compared to the year ended December 31, 1991. Premiums from traditional life insurance products decreased $8,012,000, or 15.7%, to $43,022,000, compared to 1991, as the company's marketing efforts continued to focus on the sale of deferred annuities and interest-sensitive life insurance products. Over half of the decline in traditional insurance premiums resulted from the termination of all reinsurance obligations with the company's former subsidiary, Massachusetts Casualty Insurance Company, as the company refunded premiums of $4,759,000. This refund was offset by a release of related reserves and, therefore, had no effect on income. Net investment income increased $50,616,000, or 16.2%, to $362,433,000 in 1992, as the increase in invested assets more than offset the decline in portfolio yield. The company's investment portfolio, excluding policy loans, had a yield to maturity of 9.2% at December 31, 1992, compared to 9.7% at December 31, 1991, reflecting a general decline in interest rates and a reduction in the percentage of the portfolio invested in below investment grade securities. During 1992, the company realized gains on the sale of investments of $8,164,000, compared to losses of $5,220,000 in 1991. Included in these totals were writedowns of $5,328,000 in 1992 and $3,763,000 in 1991, to reduce the carrying value of various investments to estimated net realizable value. The gains realized in 1992 primarily resulted from calls and prepayments of fixed maturity investments. Expenses Total insurance benefits and expenses increased $14,843,000, or 4.4%, to $354,381,000 in 1992. Interest credited to universal life and investment product account balances increased $40,414,000, or 21.1%, to $231,842,000, in 1992, as a result of higher account balances associated with those products. Death benefits on traditional life products and benefit claims incurred in excess of account balances on universal life products declined $4,819,000, or 16.4%, to $24,639,000, in 1992 as a result of favorable mortality experience. This favorable mortality experience increased after-tax earnings by approximately $1,600,000, or $0.11 per share, compared to 1991. Most of the company's new policies are treated as universal life or investment products for accounting purposes and changes in reserves for these products do not affect net income. The withdrawal ratio for the company's annuity products was 6.3% in 1992 compared to 4.9% in 1991. The decline in general interest rates and the company's portfolio yield caused the company to reduce the rate of interest credited to its annuity account balances below "bailout" levels during 1992. As a result, $57,049,000, or 21% of annuity policies with a "bailout" feature, were surrendered during 1992, and were responsible for a significant portion of the increase in the overall withdrawal ratio for the company's annuity products. Excluding the surrenders on products with this bailout feature, the company's annuity withdrawal rate would have been 4.2%. The increase in annuity withdrawals did not have a material impact on earnings, since interest rates credited to new products sales were lower than on the "bailout" policies surrendered. As a result of the company's rate actions, less than 1% of annuity reserves are now subject to a "bailout" provision. The company's lapse ratio for life insurance, measured in terms of face amount and using A. M. Best's formula, was 8.4% in 1992 and 1991. Commissions increased $40,583,000, or 92.7%, to $84,367,000 in 1992, primarily because of increased sales of annuity products. This increase was offset by an increase in the deferral of such policy acquisition costs and thus had little impact on total insurance expenses. General expenses declined $10,263,000, or 24.1%, to $32,294,000 in 1992. Expenses in 1991 included a $15,371,000 pre-tax expense incurred to establish a reserve for expected future insurance guaranty fund assessments. The amortization of deferred policy acquisition costs increased by $1,069,000, or 5.6%, to $20,176,000 in 1992. During the third quarter of 1992, the company recomputed or "unlocked" the amortization of deferred policy acquisition costs. This "unlocking" primarily resulted from higher interest margins in the current and future periods resulting in higher gross profits than originally expected and from a decline in the rate used to discount future gross profits. As a result, amortization of these costs was adjusted retrospectively and 1992 amortization was reduced by $1,570,000. Income Operating income (income from continuing operations before cumulative effect of change in accounting principles, excluding realized gains and losses, net of related income taxes and, in 1991, excluding the after-tax effect ($10,259,000) of accrual for insurance guaranty fund assessments) increased $9,188,000, or 22.9%, to $49,309,000 in 1992, or $1.72 per share, compared to $40,121,000, or $1.42 per share, in 1991. The company recognized realized gains on the sale of investments (net of related income taxes) of $7,951,000, or $0.27 per share, in 1992, compared to realized losses of $5,122,000, or $(0.19) per share, in 1991. As a result, income from continuing operations before cumulative effect of change in accounting principles improved to $57,260,000, or $1.99 per share, in 1992, compared to $24,740,000, or $0.87 per share, in 1991. Income from discontinued operations during 1992 amounted to $1,924,000, or $0.07 per share, which was comprised of a $3,182,000 operating loss (to the measurement date) and a $5,106,000 after-tax gain on disposal. The company reported income from discontinued operations during 1991 of $6,346,000, or $0.22 per share. Net income was $54,506,000, or $1.90 per share, in 1992, compared to $40,530,000, or $1.43 per share, in 1991. During the fourth quarter of 1992, the company implemented SFAS No. 106, which changed the accounting treatment for postretirement benefits other than pensions. The company elected to recognize the cumulative effect (to December 31, 1991) of this change in accounting principle as a one-time charge to earnings. As a result, 1992 net income includes a loss of $4,678,000, or $(0.16) per share, for the after-tax effect of implementing this change in accounting principle. During the fourth quarter of 1991, the company implemented SFAS No. 109, which changed the accounting treatment for income taxes. The effect of implementing this change in accounting principle was to increase 1991 net income by $9,444,000, or $0.34 per share. EMERGING ACCOUNTING AND REGULATORY ISSUES SFAS No. 115. In May 1993, the FASB issued SFAS No. 115, "Accounting for Certain Investments in Debt and Equity Securities". SFAS No. 115 changes the accounting treatment afforded the company's fixed maturity investments by segregating fixed maturity securities into three accounts: held to maturity, available for sale and trading. Securities may be designated as held to maturity only if a company has the positive intent and ability to hold these securities to maturity. An enterprise may not classify a security as held to maturity if the enterprise has the intent to hold the security only for an indefinite period. Accounting for securities held to maturity would be unchanged and these securities would continue to be carried at amortized cost. Trading account and available for sale securities are to be carried at fair value (i.e. market value). Unrealized gains and losses on trading account securities are to be charged/credited to the income statement while unrealized gains and losses on available for sale securities (net of deferred policy acquisition costs and applicable deferred taxes) are to be charged/credited directly to stockholders' equity, much the same as the current accounting for equity securities. Transfers between categories are severely restricted. In addition, the Securities and Exchange Commission requires certain assets and liabilities, such as minority interests and deferred policy acquisition costs, to be adjusted at the same time unrealized gains and losses from available for sale securities are recognized in stockholders' equity. Such adjustments are to be made if those assets and liabilities would have been adjusted had the unrealized holding gains and losses actually been realized. SFAS No. 115 is effective for fiscal years beginning after December 15, 1993, although the company had the option of adopting this standard on December 31, 1993. Retroactive application of this SFAS is not permitted. The company will adopt this SFAS on January 1, 1994. The company currently is studying the new standard and planning for its implementation. Because of the severe restrictions imposed by SFAS No. 115 in defining held to maturity securities, the company may determine that it is appropriate to designate a portion of its investment securities as available for sale. The company currently estimates that 5%-15% of its fixed maturity securities may be so designated, although the final determination will depend upon estimates of factors such as interest rate levels, cash receipts and disbursements and tax law changes. The effect of the implementation of SFAS No. 115 on the company's financial statements cannot be determined at this time. Specific securities must be designated for each classification and such classifications cannot be determined until the company completes its analysis. The company does not expect to designate any securities as trading account securities. If all of the company's securities were classified as available for sale at December 31, 1993, stockholders' equity would have increased by approximately $148,217,000, or $4.70 per share, reflecting the unrealized appreciation in the value of the company's securities portfolio, net of adjustments to deferred policy acquisition costs and deferred taxes. SFAS No. 114. In May 1993, the FASB also issued SFAS No. 114, "Accounting by Creditors for Impairment of a Loan". SFAS No. 114 applies to all loans except large groups of smaller-balance homogeneous loans that are collectively evaluated for impairment, loans measured at fair value or at lower of cost or fair value, leases and debt securities as defined in SFAS No. 115. SFAS No. 114 requires that impaired loans be valued at the present value of expected future cash flows discounted at the loan's effective interest rate or, as a practical expedient, at the loan's observable market price or the fair value of the collateral if the loan is collateral dependent. This SFAS is effective for fiscal years beginning after December 15, 1994, with earlier adoption encouraged. SFAS No. 114 applies primarily to the company's mortgage loan portfolio. The company actively monitors this portfolio and evaluates the net realizable value of any loan which is deemed to be impaired. Net realizable value is assessed based upon current appraised value of the underlying collateral. If carrying value exceeds this estimated realizable value, carrying value is reduced to the estimated realizable value by a charge to earnings. As such, SFAS No. 114 does not represent a material change from the company's current accounting practices and the company does not expect SFAS No. 114 to have any material effect on the company's reported financial results. Exposure Draft. On June 30, 1993, the FASB issued an Exposure Draft entitled "Accounting for Stock-based Compensation". If adopted as a SFAS in its present form, this exposure draft would require that compensation expense be recognized for all stock options in an amount equal to "fair value" on the date of grant. Fair value is to be calculated using an option pricing model or similar valuation technique that takes into effect: the option's exercise price, the expected term of the option, the current price of the underlying stock, expected dividends from the stock, the expected volatility of the stock and the expected risk-free rate of return during the term of the option. Recognition of compensation expense using this methodology is expected to be required for options granted after December 31, 1996 with pro-forma disclosure for options granted after December 31, 1993. During the last three years the company has granted options for approximately 219,000 shares of common stock each year to key employees at option prices ranging from $4.97 to $36.75 per share. These options generally vest over a three to five year period. Option prices are equal to market value on the date of grant and the terms of the options are fixed. As a result, the company does not currently recognize compensation expense on these options. Calculation of the effect of the proposed SFAS has not been completed since the final form of such a SFAS and the company's response to such a requirement has not been determined. Insurance Regulation. Currently, the company's insurance subsidiaries are subject to regulation and supervision by the states in which they are admitted to transact business. State insurance laws generally establish supervisory agencies with broad administrative and supervisory powers related to granting and revoking licenses to transact business, establishing guaranty fund associations, licensing agents, approving policy forms, regulating premium rates for some lines of business, establishing reserve requirements, prescribing the form and content of required financial statements and reports, determining the reasonableness and adequacy of statutory capital and surplus and regulating the type and amount of investments permitted. Recently, the insurance regulatory framework has been placed under increased scrutiny by various states, the federal government and the NAIC. Various states have considered or enacted legislation which changes, and in many cases increases, the states' authority to regulate insurance companies. Legislation is under consideration in Congress which could result in the federal government assuming some role in the regulation of insurance companies. The NAIC, in conjunction with state regulators, has been reviewing existing insurance laws and regulations. The NAIC recently approved and recommended to the states for adoption and implementation several regulatory initiatives designed to reduce the risk of insurance company insolvencies. These initiatives include new investment reserve requirements, risk-based capital standards and restrictions on an insurance company's ability to pay dividends to its stockholders. A committee of the NAIC is developing proposals to govern insurance company investments scheduled for adoption as a model law by the end of 1994. While the specific provisions of such a model law are not known at this time, and current proposals are still being debated, the company is monitoring developments in this area and the effects any change would have on the company. Federal Income Tax Legislation. In early August, the Omnibus Budget Reconciliation Act of 1993 was enacted. This law increases the marginal tax rate for all corporations from 34% to 35% retroactive to January 1, 1993. As a result of this legislation, the company's marginal tax rate has increased from 34% to 35%. This increase has been reflected in the company's financial statements for the year ended December 31, 1993 and was not material. Other than the increase in the marginal tax rate, the company does not believe that this law will have a material adverse effect on its business or financial condition. Currently, under the Internal Revenue Code, income tax payable by policyholders on investment earnings is deferred during the accumulation period of certain life insurance and annuity products. This favorable federal income tax treatment may enhance the competitiveness of certain of the company's products as compared with other retirement savings products that do not offer such benefits. If the Code were to be revised to eliminate or reduce the tax deferred status of life insurance and annuity products, including the products offered by the company, market demand for some or all of the company's products could be adversely affected. The Omnibus Budget Reconciliation Act of 1993 did not affect the federal income tax treatment of life insurance and annuity products. ITEM 8.

ITEM 8. Financial Statements and Supplementary Data Note: Amounts set forth in the above statement for the year ended December 31, 1991 have not been restated to reflect the 2-for-1 stock split payable June 2, 1992 to holders of record on May 14, 1992. Also, amounts set forth in the above statement for the years ended December 31, 1992 and 1991 have not been restated to reflect the 2-for-1 stock split payable June 1, 1993 to holders of record on May 12, 1993. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS December 31, 1993 1. SIGNIFICANT ACCOUNTING POLICIES Consolidation: The consolidated financial statements include the company and its subsidiaries. The principal subsidiaries are Equitable Life Insurance Company of Iowa ("Equitable Life") and USG Annuity & Life Company ("USG"). Equitable Life and USG operate predominantly in the individual life and annuity area of the life insurance business. At December 31, 1993 and 1992, all subsidiaries are wholly-owned. See Note 9 to consolidated financial statements which discusses the sale of the company's retail subsidiary, Younkers, Inc. in 1992. All significant intercompany accounts and transactions have been eliminated. Investments: Fixed maturity investments (bonds and redeemable preferred stocks) are reported at cost adjusted for amortization of premiums and accrual of discounts. Premiums and discounts are amortized/accrued utilizing the scientific interest method which results in a constant yield over the securities' expected life. Amortization/accrual of premiums and discounts on mortgage-backed securities incorporates a prepayment assumption to estimate the securities' expected life. The company has the ability and intent to hold fixed maturity investment securities to maturity and, therefore, reports such investments at amortized cost. Changes in the market value of fixed maturity investments, except for declines which are other than temporary, are not reflected in the company's financial statements. The company's liabilities are long-term in nature, so the company does not expect to be required to sell such securities. Accordingly, there are no fixed maturity securities which are currently segregated in "assets held for sale" accounts. Equity securities (common and non-redeemable preferred stocks) are reported at market if readily marketable, or at cost if not readily marketable. The change in unrealized appreciation and depreciation of marketable equity securities (net of related deferred income taxes, if any) is included directly in stockholders' equity. The carrying value of the company's fixed maturity and equity securities are reviewed on an ongoing basis. If this review indicates a decline in value which is other than temporary for any security, the company's carrying value in the security is reduced to its estimated realizable value. Such reductions in carrying value are recognized as realized losses in the determination of net income. The company attempts to identify declines in value that are other than temporary through a formal quarterly review of reports prepared by the company's investment research analysts. This review process includes an analysis of debt service coverages, cash flow and earnings projections, debt to equity ratios, the overall business and industry environment, the company's forecast of the issuer's business opportunities and challenges, the relative position of the company's investment within the issuer's capital structure and, if appropriate and available, an analysis of the assets of the issuer. Based upon these reviews, the company makes a judgment as to whether the combination of these and other factors indicate that it is likely that the company will be unable to realize its carrying value, because future nondiscounted cash payments received will not be equal to or in excess of carrying value in the case of fixed maturities, or because of depressed market values that are not expected to recover in the case of equity securities. These judgments serve as the primary criteria for the determination as to whether declines in value are other than temporary. For each fixed maturity investment where the decline in value is judged to be other than temporary, the company estimates the expected cash flows from the investment under the scenario for the issuer's future performance judged most likely, based upon the facts and circumstances known to the company at the time. The scenario may involve anticipated restructuring of the issuer's debt to adjust interest, principal and other terms, complete liquidation of the issuer to satisfy creditors, or other possible means of satisfying the issuer's obligations. If the estimated nondiscounted cash flows are less than the carrying value of the company's investment in the issuer, the company recognizes a loss and reduces the carrying value of the investment to the net realizable value based upon estimated nondiscounted cash flows. Further, for each fixed maturity investment where a decline in value is judged to be other than temporary, the company reverses any accrued interest income, and records future interest income only when cash is received (at the rate implicit in the calculation of net realizable value). Because the company has elected to utilize nondiscounted cash flows in its net realizable value calculations, the yield recognized in future periods on such investments may be less than yields recognized on other investments or those yields expected when the security was originally purchased. The accounting treatment for debt and equity securities will change on January 1, 1994, when the company adopts Statement of Financial Accounting Standards ("SFAS") No. 115, "Accounting for Certain Investments in Debt and Equity Securities". See the Emerging Accounting and Regulatory Issues section of Management's Discussion and Analysis for a discussion of SFAS No. 115. Mortgage loans on real estate are reported at cost adjusted for amortization of premiums and accrual of discounts. If the value of any mortgage loan is determined to be uncollectible, the carrying value of the mortgage loan is reduced to the amount estimated as collectible by a charge to realized gains and losses. This accounting treatment will be modified on January 1, 1994 when the company adopts SFAS No. 114, "Accounting by Creditors for Impairment of a Loan". See the Emerging Accounting and Regulatory Issues section of Management's Discussion and Analysis for a discussion of SFAS No. 114. Real estate, which includes real estate acquired through foreclosure, is reported at cost less allowances for depreciation. Real estate acquired through foreclosure, or in-substance foreclosure, is recorded at the lower of cost (which includes the balance of the mortgage loan, any accrued interest and any costs incurred to obtain title to the property) or fair value at the foreclosure date. The carrying value of these assets is subject to regular review. If the fair value of real estate acquired through foreclosure decreases to an amount lower than its carrying value, a valuation allowance is established for the difference. This valuation allowance can be restored should the fair value of the property increase. To date, the company's analysis has shown that significant valuation allowances are not needed. Policy loans are reported at unpaid principal. Short-term investments are reported at cost adjusted for amortization of premiums and accrual of discounts. Investments accounted for by the equity method include investments in, and advances to, various joint ventures and partnerships. Market values, as reported herein, of publicly traded fixed maturity securities are as reported by an independent pricing service. Market values of conventional mortgage-backed securities not actively traded in a liquid market are estimated using a third party pricing system, which uses a matrix calculation assuming a spread over U.S. Treasury bonds based upon the expected average lives of the securities. Market values of private placement bonds are estimated using a matrix that assumes a spread (based on interest rates and a risk assessment of the bonds) over U.S. Treasury bonds. Market values of redeemable preferred stocks are as reported by the National Association of Insurance Commissioners ("NAIC"). Market values of equity securities are based on the latest quoted market prices, or where not readily marketable, at values which are representative of the market values of issues of comparable yield and quality. Realized gains and losses are determined on the basis of specific identification of investments. Cash and Cash Equivalents: For purposes of the consolidated statement of cash flows, the company considers all demand deposits and interest-bearing accounts not related to the investment function to be cash equivalents. All interest-bearing accounts classified as cash equivalents have original maturities of three months or less. Deferred Policy Acquisition Costs: Certain costs of acquiring new insurance business, principally commissions and other expenses related to the production of new business, have been deferred. For universal life and annuity products, such costs are being amortized generally in proportion to the present value (using the assumed crediting rate) of expected gross profits. This amortization is adjusted retrospectively, or "unlocked", when the company revises its estimate of current or future gross profits to be realized from a group of products. For traditional life insurance products, such costs are being amortized over the premium-paying period of the related policies in proportion to premium revenues recognized, using principally the same assumptions for interest, mortality and withdrawals that are used for computing liabilities for future policy benefits subject to traditional "lock-in" concepts. Property and Equipment: Property and equipment primarily represent leasehold improvements at the company's headquarters and at various agency offices and office furniture and equipment and are not considered to be significant to the company's overall operations. Property and equipment are reported at cost less allowances for depreciation. Depreciation expense is computed primarily on the basis of the straight-line method over the estimated useful lives of the assets. Intangible Assets: Intangible assets include the value of various licenses acquired in conjunction with the purchase of USG and capitalized costs related to the company's debt issues. Intangible assets related to insurance licenses are being amortized over forty years using the straight-line method. Capitalized debt issuance costs are being amortized over the life of the underlying debt issues using the straight-line method. Future Policy Benefits: The liability for future policy benefits for traditional life insurance products has been calculated on a net-level premium basis. Interest assumptions range from 2.75% for 1956 and prior issues to a 9.00% level, graded to 6.00% after twenty years for current issues. Mortality, morbidity and withdrawal assumptions generally are based on actual experience. These assumptions have been modified to provide for possible unfavorable deviation from the assumptions. Future dividends for participating business (which accounted for 2.6% of premiums in 1993) are provided for in the liability for future policy benefits. With respect to universal life and annuity products, the company utilizes the retrospective deposit accounting method. Policy reserves represent the premiums received plus accumulated interest, less mortality and administration charges. Interest credited to these policies ranged from 4.50% to 10.00% during 1993, 4.50% to 9.00% during 1992 and 6.35% to 9.20% during 1991. The unearned revenue reserve reflects the unamortized balance of the excess of first year administration charges over renewal period administration charges (policy initiation fees) on universal life and annuity products. These excess charges have been deferred and are being recognized in income over the period benefitted using the same assumptions and factors used to amortize deferred policy acquisition costs. Recognition of Premium Revenues and Costs: Traditional life insurance premiums are recognized as revenues over the premium-paying period. Future policy benefits and policy acquisition costs are associated with the premiums as earned by means of the provision for future policy benefits and amortization of deferred policy acquisition costs. Revenues for universal life and annuity products consist of policy charges for the cost of insurance, renewal period administration charges, amortization of policy initiation fees and surrender charges assessed against policyholder account balances during the period. Expenses related to these products include interest credited to policyholder account balances and benefit claims incurred in excess of policyholder account balances. Deferred Income Taxes: As discussed in Note 6, effective January 1, 1991, the company adopted SFAS No. 109, "Accounting for Income Taxes". Under SFAS No. 109, deferred tax assets or liabilities are computed based on the difference between the financial statement and income tax bases of assets and liabilities using the enacted marginal tax rate. Deferred income tax expenses or credits are based on the changes in the asset or liability from period to period. Interest Rate Swaps: The company had interest rate swap agreements outstanding during 1993, whereby any interest rate differential to be received/paid was recognized as an adjustment to interest expense. All of these swap agreements expired or were terminated in August 1993. Separate Accounts: The transactions in the separate accounts (which are charged or credited directly to the accounts) are excluded from the consolidated statements of income. Capital Stock: On April 30, 1992, the company's shareholders approved a plan to consolidate the company's Class A and Class B common stock into a single class of common stock on a one-to-one basis. The plan was effective as of May 1, 1992. On April 30, 1992 the company's Board of Directors approved a 2-for-1 stock split payable June 2, 1992, to holders of record on May 14, 1992. On April 29, 1993 the company's Board of Directors approved an additional 2-for-1 stock split payable June 1, 1993, to holders of record on May 12, 1993. With respect to the balance sheet and statement of changes in stockholders' equity, share and per share amounts prior to January 1, 1992, have not been restated to reflect the 1992 and 1993 stock splits and share and per share amounts prior to January 1, 1993, have not been restated to reflect the 1993 stock split. All other share and per share data presented in the consolidated financial statements and notes thereto have been restated to reflect the stock splits. Net Income per Share of Common Stock: Net income per share is based on the weighted average number of shares of common stock outstanding during each year (1993 - 29,540,274; 1992 - 28,688,660 and 1991 - 28,392,860). Installment notes convertible into shares of common stock and employee stock options have not been included in the net income per share computations because their effect is not material. Dividends per Share of Common Stock: For the years ended December 31, 1993, 1992 and 1991, the company paid dividends per share of $0.405, $0.35 and $0.32, respectively, after giving effect for the 2-for-1 stock splits as of May 14, 1992 and May 12, 1993. Dividend Restrictions: The company's ability to pay dividends to its stockholders is restricted by certain debt covenants. The most restrictive covenant requires the company to maintain tangible net worth equal to the sum of $280,000,000 plus proceeds from any issuance of common stock plus one-half of net income recognized subsequent to January 1, 1993. At December 31, 1993, retained earnings available for dividends aggregated $123,913,000. The ability of Equitable Life to pay dividends to the parent company is restricted because prior approval of insurance regulatory authorities is required for payment of dividends to the stockholder which exceed an annual limitation. During 1994, Equitable Life could pay dividends to the parent company of approximately $39,335,000 without prior approval of statutory authorities. Also, the amount ($206,901,000 at December 31, 1993) by which the stockholder's equity stated in conformity with generally accepted accounting principles exceeds statutory capital and surplus as reported is restricted and cannot be distributed. Emerging Accounting Issues: The Financial Accounting Standards Board ("FASB") issued SFAS No. 114, "Accounting by Creditors for Impairment of a Loan", SFAS No. 115, "Accounting for Certain Investments in Debt and Equity Securities" and an Exposure Draft entitled "Accounting for Stock-based Compensation". See the Emerging Accounting and Regulatory Issues section of Management's Discussion and Analysis for discussions of these and other items. 2. BASIS OF FINANCIAL REPORTING - LIFE INSURANCE OPERATIONS The financial statements of the life insurance subsidiaries differ from related statutory financial statements principally as follows: (1) acquisition costs of acquiring new business are deferred and amortized over the life of the policies rather than charged to operations as incurred, (2) future policy benefit reserves on traditional life insurance products are based on reasonable assumptions of expected mortality, interest and withdrawals which include a provision for possible unfavorable deviation from such assumptions, which may differ from reserves based upon statutory mortality rates and interest, (3) future policy benefit reserves for universal life and annuity products are based on full account values, rather than the greater of cash surrender value or amounts derived from discounting methodologies utilizing statutory interest rates, (4) reserves are reported before reduction for reserve credits related to reinsurance ceded and a receivable is established, net of an allowance for uncollectible amounts, for these credits rather than presented net of these credits, (5) deferred income taxes are provided for the difference between the financial statement and income tax bases of assets and liabilities, (6) net realized gains or losses subsequent to January 1, 1992 attributed to changes in the level of interest rates in the market are recognized when the sale is completed rather than deferred and amortized over the remaining life of the fixed maturity security or mortgage loan, (7) declines in the estimated realizable value of investments are recognized through reductions in the carrying values of the related investment, and recognition of realized losses in the statements of income, when such declines are judged to be other than temporary, rather than through the establishment of a formula-determined statutory investment reserve (carried as a liability), changes in which are charged directly to surplus, (8) gains arising from sale lease-back transactions are deferred and amortized over the life of the lease rather than recognized in the period of sale, (9) a liability is established for anticipated guaranty fund assessments, net of estimated premium tax credits, rather than capitalized when assessed and amortized in accordance with procedures permitted by insurance regulatory authorities, (10) agents' balances and certain other assets designated as "non-admitted assets" for statutory purposes are reported as assets rather than being charged to surplus, (11) revenues for universal life and annuity products consist of policy charges for the cost of insurance, policy administration charges, amortization of policy initiation fees and surrender charges assessed rather than premiums received, (12) pension income or expense is recognized in accordance with SFAS No. 87, "Employers' Accounting for Pensions" rather than by the rules and regulations permitted by the Employee Retirement Income Security Act of 1974, (13) expenses for postretirement benefits other than pensions are recognized for all qualified employees rather than for only vested and fully-eligible employees, and the accumulated postretirement benefit obligation for years prior to adoption of SFAS No. 106, "Employers' Accounting for Postretirement Benefits Other than Pensions" was recognized as a cumulative effect of change in accounting method rather than deferred and amortized over twenty years, and (14) assets and liabilities are restated to fair values when a change in ownership occurs, with provisions for goodwill and other intangible assets, rather than continuing to be presented at historical cost. Net income for Equitable Life, USG and Equitable American Insurance Company (formed in 1993) as determined in accordance with statutory accounting practices was $42,182,000 in 1993, $36,281,000 in 1992 and $51,659,000 in 1991. Total statutory capital and surplus was $393,351,000 at December 31, 1993 and $275,978,000 at December 31, 1992. 3. INVESTMENT OPERATIONS Realized gains (losses) and unrealized appreciation (depreciation) on investments are summarized below: *See Note 6 for the income tax effects attributable to realized gains and losses on investments. Major categories of net investment income are summarized below: Short-term investments, all with maturities of 30 days or less, have been excluded from the above schedules. Amortized cost approximates market value for these securities. The carrying value and estimated market value of debt securities at December 31, 1993, by contractual maturity, are shown below. Expected maturities will differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties. The carrying value and market value of mortgage-backed securities, which comprise 34.7% of the company's investment in fixed maturity securities at December 31, 1993, by type, are as follows: The company has limited its investments in mortgage-backed securities (including CMO's and REMIC's) to securities where principal payments are securitized as senior positions within the mortgage loan pool. The company holds no derivative-type mortgage-backed securities. Further, the company has not purchased obligations at significant premiums, thereby limiting exposure to loss during periods of accelerated prepayments. At December 31, 1993, unamortized premiums on mortgage-backed securities totalled $6,161,000 and unaccrued discounts on mortgage-backed securities totalled $48,863,000. An analysis of sales, maturities and principal repayments of the company's fixed maturities portfolio for the years ended December 31, 1993, 1992 and 1991 is as follows: At December 31, 1993, unrealized depreciation of equity securities of $167,000 is comprised solely of gross unrealized depreciation on the individual security. The carrying value of investments which have been non-income producing for the twelve months preceding December 31, 1993, includes: mortgage loans on real estate - $250,000 and real estate - $239,000. The company analyzes its investment portfolio at least quarterly in order to determine if its ability to realize its carrying value has been impaired. If an impairment in value appears to be other than temporary, the company recognizes the impairment as a charge to realized gains and losses. During the year ended December 31, 1993, the company recognized pre-tax losses on one fixed maturity investment of $6,443,000 and one mortgage loan investment of $363,000. The company also established a valuation allowance of $86,000 on one of its foreclosed real estate properties. Of these amounts, losses of $449,000 were recorded in the fourth quarter of 1993. During the year ended December 31, 1992, the company recognized pre-tax losses on one fixed maturity investment of $3,563,000, two real estate investments of $418,000 and two equity method investments of $1,347,000, prior to the investments' actual disposal. Of these amounts, losses of $1,347,000 were recorded in the fourth quarter of 1992. During the year ended December 31, 1991, the company recognized pre-tax losses on one fixed maturity investment of $1,452,000, one equity security investment of $954,000, two mortgage loans of $1,197,000 and three real estate investments of $160,000, prior to the investments' actual disposal. At December 31, 1993, affidavits of deposits covering bonds with a par value of $1,388,913,000 (1992 - $1,304,573,000), mortgage loans with an unpaid principal balance of $188,464,000 (1992 - $189,916,000) and policy loans with an unpaid balance of $173,097,000 (1992 - $174,787,000) were on deposit with state agencies to meet regulatory requirements. In addition, at December 31, 1993, pursuant to a reinsurance agreement, the company had investments with a carrying value of $93,472,000 (market value of $94,964,000) deposited in a trust for the benefit of the ceding company. The company's investment policies related to its investment portfolio require diversification by asset type, company and industry and set limits on the amount which can be invested in an individual issuer. Such policies are at least as restrictive as those set forth by regulatory authorities. Fixed maturity investments included investments in various non-governmental mortgage-backed securities (28% in 1993, 23% in 1992), public utilities (24% in 1993, 27% in 1992), basic industrials (20% in 1993, 23% in 1992) and consumer products (14% in 1993, 13% in 1992). Mortgage loans on real estate have been analyzed by geographical locations. Concentrations of mortgage loans are in California (10% in 1993, 16% in 1992) and Illinois (10% in 1993, 18% in 1992). There are no significant concentrations of mortgage loans in any other state or region. Mortgage loans on real estate have also been analyzed by collateral type with significant concentrations identified in retail facilities (33% in 1993, 23% in 1992), industrial buildings (28% in 1993, 36% in 1992), multi-family residential buildings (19% in 1993, 17% in 1992) and office buildings (15% in 1993, 20% in 1992). Equity securities, real estate and investments accounted for by the equity method are not significant to the company's overall investment portfolio. No investment in any person or its affiliates (other than bonds issued by agencies of the United States government) exceeded ten percent of stockholders' equity at December 31, 1993. 4. FAIR VALUES OF FINANCIAL INSTRUMENTS SFAS No. 107, "Disclosures about Fair Value of Financial Instruments" requires disclosure of estimated fair value of all financial instruments, including both assets and liabilities recognized and not recognized in a company's balance sheet, unless specifically exempted. Most of the company's investments, insurance liabilities and debt, as well as off-balance-sheet items such as interest rate swaps and loan guarantees, fall within the standard's definition of a financial instrument. Although the company's life insurance liabilities, are specifically exempted from this disclosure requirement, estimated fair value disclosure of these liabilities is also provided in order to make the disclosures more meaningful. The accounting, actuarial and regulatory bodies are continuing to study the methodologies to be used in developing fair value information, particularly as it relates to such things as liabilities for insurance contracts. Accordingly, care should be exercised in deriving conclusions about the company's business or financial condition based on the information presented herein. The company closely monitors the level of its insurance liabilities, the level of interest rates credited to its interest-sensitive products and the assumed interest margin provided for within the pricing structure of its other products. These amounts are taken into consideration in the company's overall management of interest rate risk, which attempts to minimize exposure to changing interest rates through the matching of investment maturities with amounts expected to be due under insurance contracts. As such, the company believes that it has reduced the volatility inherent in its "fair value" adjusted stockholders' equity, although such volatility will not be reduced completely. As discussed below, the company has used discount rates in its determination of fair values for its liabilities which are consistent with market yields for related assets. The use of the asset market yield is consistent with management's opinion that the risks inherent in its asset and liability portfolios are similar. This assumption, however, might not result in values that are consistent with those obtained through an actuarial appraisal of the company's business or values that might arise in a negotiated transaction. The following compares carrying values as shown for financial reporting purposes with estimated fair values. The following methods and assumptions were used by the company in estimating fair values. Fixed maturities: Estimated market values of publicly traded securities are based on the latest quoted market prices as reported by an independent pricing service. Market values of conventional mortgage-backed securities not actively traded in a liquid market are estimated using a third party matrix calculation assuming a spread over U.S. Treasury bonds based upon the expected average lives of the securities. Market values of private placement bonds are estimated using a matrix that assumes a spread (based on interest rates and a risk assessment of the bonds) over U.S. Treasury bonds. Estimated market values of redeemable preferred stocks are as reported by the NAIC. Equity securities: Estimated fair values are based upon the latest quoted market prices, where available. For equity securites not actively traded, estimated fair values are based upon values of issues of comparable yield and quality. Mortgage loans on real estate: Fair values are estimated by discounting expected cash flows, using interest rates currently being offered for similar loans. Short-term investments, cash and cash equivalents, notes and other receivables, commercial paper notes: Carrying values reported in the company's historical cost basis balance sheet approximate estimated fair value for these instruments, due to their short-term nature. Separate account assets and liabilities: Separate account assets and liabilities are reported at estimated fair value in the company's historical cost basis balance sheet. Future policy benefits: Estimated fair values of the company's liabilities for future policy benefits for universal life and current interest products, annuity products, participating life insurance and dividend accumulations and non-par traditional life insurance products are based upon discounted cash flow calculations. Cash flows of future policy benefits are discounted using the market yield rate of the assets supporting these liabilities. Estimated fair values are presented net of the estimated fair value of corresponding policy loans due to the interdependent nature of the cash flows associated with these items. Deferred policy acquisition costs and intangible assets: For historical cost purposes, the recovery of policy acquisition costs is based on the realization, among other things, of future interest spreads and gross premiums on in-force business. Because these cash flows are considered in the computation of the future policy benefit cash flows, the deferred policy acquisition cost balance does not appear on the estimated fair value balance sheet. Intangible assets do not appear in the estimated fair value balance sheet because there are no cash flows related to these assets. Long-term debt: Estimated fair value of the company's publicly-traded debt issue is based upon quoted market prices. Estimated fair value of the company's non-public industrial revenue bonds in 1992 was based upon the value which would have been required to defease the issue. Estimated fair value of the company's subordinated convertible installment notes is assumed to be equal to carrying value at December 31, 1993 since these notes were repaid on January 3, 1994, and was based upon conversion value at December 31, 1992. Off-balance-sheet instruments: Estimated fair values of the company's unrecognized pension assets are based upon amounts not recognized in the financial statement pension accruals. Estimated fair values of interest rate swaps in 1992 were based upon settlement values reported to the company by the instruments' counterparties. The company also has made guarantees on behalf of certain borrowers in the event the borrower is not able to make its principal or interest payments. The company has not provided a fair value liability for these obligations as management believes the value of the collateral underlying the commitments is sufficient. Deferred income taxes on fair value adjustments: Deferred income taxes have been reported at the statutory rate for the differences (except for those attributed to permanent differences) between the carrying value and estimated fair value of assets and liabilities set forth herein. Non-financial assets and liabilities: Values are presented at historical cost. SFAS No. 107, "Disclosures about Fair Value of Financial Instruments", requires disclosure of estimated fair value information about financial instruments, whether or not recognized in the consolidated balance sheet, for which it is practicable to estimate that value. In cases where quoted market prices are not available, estimated fair values are based on estimates using present value or other valuation techniques. Those techniques are significantly affected by the assumptions used, including the discount rate and estimates of future cash flows. In that regard, the derived fair value estimates cannot be substantiated by comparison to independent markets and, in many cases, could not be realized in immediate settlement of the instrument. The above presentation should not be viewed as an appraisal as there are several factors, such as the fair value associated with customer or agent relationships and other intangible items, which have not been considered. In addition, interest rates and other assumptions might be modified if an actual appraisal were to be performed. ACCORDINGLY, THE AGGREGATE ESTIMATED FAIR VALUE AMOUNTS PRESENTED HEREIN ARE LIMITED BY EACH OF THESE FACTORS AND DO NOT PURPORT TO REPRESENT THE UNDERLYING VALUE OF THE COMPANY. 5. CREDIT ARRANGEMENTS Long-term debt: At December 31, 1993, the company's long-term debt consisted of: notes payable bearing interest at 9.3% totalling $49,996,000 ($50,000,000 at December 31, 1992) maturing June 1, 1998 and subordinated installment notes bearing interest at 9% totalling $218,000 ($234,000 at December 31, 1992) which were repaid on January 3, 1994. The subordinated installment notes were convertible, at the option of the lender, into the company's common stock at the rate of 7.44 shares of common stock for each $44 principal amount of installment notes, subject to adjustment in certain circumstances. The installment notes were subordinated to senior indebtedness. During the years ended December 31, 1993 and 1992, respectively, 2,642 and 5,380 shares of common stock were issued pursuant to this conversion feature. The Industrial Development Revenue Refunding Bonds Series 1983 bearing interest at 9.16% totalling $10,500,000 at December 31, 1992, were repaid on December 1, 1993. Guarantees of Indebtedness of Others: At December 31, 1993 and 1992, the company had unconditionally guaranteed $26,310,000 and $26,663,000, respectively, in remaining principal amount of notes payable issued by the Walnut Mall Limited Partnership ("WMLP"). The company receives an annual fee of $148,000 for its guarantee. The final payment on this note is due in 1996, although earlier redemption is allowed. The proceeds of the notes were used to partially finance the construction of an office/retail facility in Des Moines, Iowa. The company received a first mortgage on the property, together with guarantees from the partners, to secure its guarantee. In the event of a default on the notes payable by WMLP, the company would be required to make payments to note holders and seek recourse from the partners and/or through exercise of its rights as a mortgagee. The company had also unconditionally guaranteed Industrial Development Revenue Bonds Series 1984 of Lerac Limited Partnership, a joint venture partially owned by a subsidiary of Equitable Life. The final payment on these bonds is due in 1999. The proceeds were used to finance the construction of a retail facility including a store leased by Younkers. The outstanding balance at December 31, 1993 and 1992, was $3,090,000 and $3,160,000, respectively. Commercial Paper Notes: The company issues commercial paper notes to provide for working capital needs and to provide short term liquidity. This commercial paper program is supported by the company's line of credit discussed below. Commercial paper notes are issued for periods not exceeding 270 days. At December 31, 1993 and 1992, commercial paper notes of $34,000,000 and $28,774,000, respectively, were outstanding under this arrangement at a weighted average interest rate of 3.4% and 4.3%, respectively. At December 31, 1993, the company's commercial paper was rated A1 by Standard and Poor's Corporation, P2 by Moody's Investors Service and Duff 1 by Duff & Phelps Credit Rating Company. Line of Credit: The company maintains a line of credit arrangement with five banks to support its commercial paper notes payable and to provide short-term liquidity. The maximum borrowing allowed under this facility is $100,000,000 (no amounts outstanding at December 31, 1993). This credit arrangement has an annual commitment fee of 1/4% on the unused portion of the line and terminates on May 4, 1996. The terms of the credit arrangement set limits on debt of the company and its insurance subsidiaries, require maintenance of a minimum level of consolidated tangible net worth and insurance subsidiary statutory capital and surplus and risk-based capital and restrict certain investments. Interest Rate Swaps: The company had entered into interest rate swap agreements with several banks with a combined notional principal amount of $50,000,000. During August 1993, swap agreements with a combined notional principal amount of $20,000,000 expired and the remaining swap agreements ($30,000,000) were terminated by the company at a cost of $3,011,000. 6. INCOME TAXES During 1991, the company adopted SFAS No. 109, "Accounting for Income Taxes", which requires the use of the liability method in accounting for income taxes. The cumulative effect of adopting this change as of January 1, 1991 has been reflected in the statements of income included herein. This change is net of non-tax expenses of $239,000 directly related to the increase in net income of discontinued operations caused by the change. The company and all of its subsidiaries file a consolidated federal income tax return. The parent company and its subsidiaries each report current income tax expense as allocated under a consolidated tax allocation agreement. Generally, this allocation results in profitable companies recognizing a tax provision as if the individual company filed a separate return and loss companies recognizing benefits to the extent their losses contribute to reduce consolidated taxes. Deferred income taxes have been established by each member of the consolidated group based upon the temporary differences, the reversal of which will result in taxable or deductible amounts in future years when the related asset or liability is recovered or settled, within each entity. Income tax expenses (credits) are included in the consolidated financial statements as follows: Income tax expense (credits) attributed to realized gains and losses on investments amounted to $14,695,000, $213,000 and $(98,000) for the years ended December 31, 1993, 1992 and 1991, respectively. The effective tax rate on income from continuing operations before income taxes, equity income (loss) and cumulative effect of change in accounting principles is different from the prevailing federal income tax rate as follows: The Internal Revenue Service ("IRS") is currently examining the company's consolidated income tax returns for 1990 and 1991. The 1992 consolidated income tax return remains open to examination. During the years ended December 31, 1993, 1992 and 1991, the company provided $200,000, $1,200,000 and $2,800,000 (including $400,000 allocated to discontinued operations), respectively, for issues raised by the IRS. Management believes these amounts are adequate to settle any adjustments raised by the IRS. The Deficit Reduction Act of 1984 required life insurance companies to recompute future policy benefits for tax purposes as of January 1, 1984. Prior to adoption of SFAS No. 109, the portion of the fresh-start adjustment not recognized in 1984 was treated as a permanent difference in the tax computation over the life of the applicable business in force or upon utilization of net operating losses. At January 1, 1991, the company had $734,000 of the original fresh-start adjustment which had yet to be recognized for financial reporting purposes. This amount was included in the cumulative effect adjustment recorded as a result of the adoption of SFAS No. 109. The tax effect of temporary differences giving rise to the company's deferred income tax assets at December 31, 1993 and 1992, are as follows: At December 31, 1993, the company has net operating loss carryforwards of approximately $11.4 million which expire in 2007. These losses relate to the operations of the non-life consolidated group and are only available initially to offset future income generated by the non-life group. The company is subject to limitations with respect to the availability of any remaining amounts that can be utilized to offset income generated by the life insurance subsidiaries. A deferred tax asset has been established for the tax effect of these losses. Management has not established a valuation allowance for this asset or other net deferred tax assets reported by the members of the non-life consolidated group (aggregating in total $1,173,000) as the company anticipates future taxable income which will exceed this amount. The life insurance subsidiaries have also established a deferred tax asset which aggregates $10,410,000 at December 31, 1993. The life insurance subsidiaries have paid income taxes during the last three preceding years (the carryback period) which greatly exceed this amount. Prior to 1984, a portion of Equitable Life's current income was not subject to current income taxation, but was accumulated, for tax purposes, in a memorandum account designated as "policyholders' surplus account". The aggregate accumulation in this account at December 31, 1993, was $14,388,000. Should the policyholders' surplus account of Equitable Life exceed the limitation prescribed by federal income tax law, or should distributions be made by Equitable Life to the parent company in excess of $244,434,000 such excess would be subject to federal income taxes at rates then effective. Deferred income taxes of $5,036,000 have not been provided on amounts included in this memorandum account since the company contemplates no action and can foresee no events that would create such a tax. Deferred income taxes (credits) were also reported on equity income and on the loss from discontinued operations during these periods. These taxes arise from the recognition of income and losses differently for purposes of filing federal income tax returns than for financial reporting purposes. 7. EMPLOYEE STOCK AND INCENTIVE COMPENSATION PLANS On April 30, 1992, the company's stockholders approved the 1992 Stock Incentive Plan as a successor to the 1982 Stock Incentive Plan. These plans provide for the award of stock options or shares of the company's common stock to key employees through three means: qualified incentive stock options (as defined in the Internal Revenue Code), non-qualified stock options and restricted shares. Shares of common stock may be awarded under the 1982 plan for outstanding stock options granted prior to adoption of the 1992 plan. Under the 1992 plan an initial base of 2,240,000 shares of common stock may be awarded with automatic increases of 7.5% for shares issued after April 30, 1992. At December 31, 1993, the company has reserved 3,292,125 shares (3,348,148 shares at January 1, 1993) of its common stock for future issuances under these plans. After giving effect for the 2-for-1 stock splits as of May 12, 1993 and May 14, 1992, stock option transactions under these plans are summarized as follows: The non-qualified stock options are compensatory, and require the accrual of compensation expense over the period of service from the date the options are granted until they become fully exercisable if market values exceed the option price on the measurement date. During the years ended December 31, 1993, 1992 and 1991, compensation expense of $89,000, $188,000 and $239,000, respectively, was recognized related to these options. During 1993 and 1992, respectively, the company awarded 35,770 and 16,000 shares of restricted common stock to certain key employees and directors. These shares are subject to forfeiture to the company should the individuals terminate their relationship with the company for reasons other than death, permanent disability or change in company control prior to full vesting. Shares granted to key employees generally vest on the fifth anniversary of grant. Shares granted to directors vest equally on the first, second and third anniversaries of grant. Directors and officers who retired or resigned forfeited 5,628 and 5,412 shares of unvested restricted common stock during 1993 and 1992, respectively. The company amortizes as compensation expense the market value on date of grant ($997,000 in 1993 and $190,000 in 1992) of the restricted stock using the straight-line method over the vesting periods. Compensation expense recognized during the years ended December 31, 1993, 1992 and 1991 aggregated $607,000, $495,000 and $602,000, respectively. The company has a discretionary stock award plan under which employees are awarded shares of stock for superior performance. During the years ended December 31, 1993, 1992 and 1991, awards of 750, 1,020 and 2,560 shares of the company's common stock resulted in charges to income of $19,000, $11,000 and $13,000, respectively. Equitable Life sponsors a long-term incentive compensation plan which allows certain agents to earn units equal to shares of the company's common stock based on personal production and the maintenance of specific levels of assets under management. This program resulted in charges to income of $926,000, $855,000 and $308,000 in the years ended December 31, 1993, 1992 and 1991, respectively. 8. RETIREMENT PLANS Substantially all full-time employees of the company are covered by a non-contributory self-insured defined benefit pension plan. The benefits are based on years of service and the employee's compensation during the last five years of employment. Further, the company sponsors a supplemental defined benefit plan to provide benefits in excess of amounts allowed pursuant to Internal Revenue Code Section 401(a) (17) and those allowed due to integration rules. The company's funding policy with respect to these plans is consistent with the funding requirements of federal law and regulations. The following table sets forth the plans' funded status and amounts recognized in the company's consolidated balance sheet: Net periodic pension benefit included the following components: The weighted-average discount rate and rate of increase in future compensation levels used in determining the actuarial present value of the projected benefit obligation were 7.0% and 5.0%, respectively, at December 31, 1993, and 6.8% and 4.0%, respectively, at December 31, 1992. The average expected long term rate of return on plan assets was 8.5% in 1993, 8.5% in 1992 and 9.5% in 1991. In addition to the company's defined benefit pension plan, the company sponsors plans that provide postretirement medical and group term life insurance benefits to full-time employees and agents who have worked five years and attained age 55 while in service with the company. The medical plans are contributory, with retiree contributions adjusted annually, and contain other cost-sharing features such as deductibles and coinsurance. The accounting for these plans anticipates that the company's contributions will increase annually by the lesser of the health care inflation rate or 3%, with increases in excess of these amounts borne by the employee or agent. All costs for group term life insurance benefits are funded on a pay-as-you-go (cash) basis by the company. In 1992, the company adopted SFAS No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions". The company elected to recognize the accumulated postretirement benefit obligation as of January 1, 1992, as a one-time charge to earnings which has been treated as a cumulative effect of change in accounting principle. The cumulative effect adjustment aggregated $4,678,000, or $(0.16) per share, after a deferred tax benefit of $2,454,000 and is reflected in the 1992 consolidated statement of income. Postretirement benefit costs for 1991 have not been restated. The company has chosen not to fund any amounts in excess of current benefits. The following table sets forth the amounts recognized in the company's consolidated balance sheet: Net periodic postretirement benefit costs include the following components: The weighted-average annual assumed rate of increase in the per capita cost of health care benefits (i.e. health care cost trend rate) used in determining the actuarial present value of the accummulated postretirement benefit obligation was 14.5% at December 31, 1993 and 12.0% at December 31, 1992 for employees under 65 and 9.5% for employees over 65 in both years, with the rates for both groups to be graded down to 5.5% for 2005 and thereafter. The health care cost trend rate assumption has a significant effect on the amounts reported. For example, increasing the assumed health care trend rates by one percent would increase the accumulated postretirement benefit obligation as of December 31, 1993 by $800,000 and net periodic postretirement benefit costs for the year ended December 31, 1993 by $102,000. The weighted-average discount rate used in determining the accumulated postretirement benefit obligation was 7.0% at December 31, 1993 and 6.8% at December 31, 1992. As previously noted, the costs associated with these plans for the year ended December 31, 1991 were reported on the pay-as-you-go (cash basis) method. For the year ended December 31, 1991, costs recognized by the company related to these benefits were $238,000. Had the company continued using the pay-as-you-go method, the cost of these plans would have aggregated $347,000 and $340,000 for the years ended December 31, 1993 and 1992, respectively. The company also sponsors an unfunded deferred compensation plan providing benefits to certain former employees. The company recognized benefits of $44,000, $24,000 and $30,000 during the years ended December 31, 1993, 1992 and 1991, respectively, in connection with this plan. The company sponsors pension plans for its employees which are qualified under Internal Revenue Code Section 401(k). Employees may contribute a portion of their annual salary, subject to limitation, to the plans. The company contributes an additional amount, subject to limitation, based on the voluntary contribution of the employee. Company contributions charged to expense with respect to these plans during the years ended December 31, 1993, 1992 and 1991 were $287,000, $234,000 and $217,000, respectively. Equitable Life has non-contributory self-insured defined contribution pension plans for its agents. Contributions charged to expense under these plans during the years ended December 31, 1993, 1992 and 1991 amounted to $566,000, $596,000 and $525,000, respectively. Certain assets related to these plans are on deposit with Equitable Life and amounts relating to these plans are included in these consolidated financial statements. 9. DISCONTINUED OPERATIONS On April 29, 1992, the company and its former retail subsidiary, Younkers, Inc. completed a public offering by selling 6,170,000 shares of Younkers' common stock. Prior to the offering, the company owned 4,703,555 shares of Younkers' common stock, all of which were sold in the public offering. The consolidated financial statements of the company have been restated to report the operating results of retail operations as discontinued operations. Income from discontinued operations for 1992 includes retail sales to the measurement date of $83,815,000 and $330,013,000 in 1991. The loss from discontinued operations in 1992 prior to the measurement date is due to the seasonal nature of the retail business. The sale of the company's retail operations resulted in a pre-tax gain of $8,897,000 ($5,106,000, or $0.18 per share, after tax). Proceeds to the company from the sale, net of commissions and expenses, were $54,938,000. 10. COMMITMENTS AND CONTINGENCIES In the normal course of business, the company seeks to limit its exposure to loss on any single insured and to recover a portion of benefits paid by ceding reinsurance to other insurance enterprises or reinsurers. Reinsurance coverages for life insurance vary according to the age and risk classification of the insured with retention limits ranging up to $500,000 of coverage per individual life. The company does not use financial or surplus relief reinsurance. At December 31, 1993, life insurance in force ceded on a consolidated basis amounted to $1,326,020,000, or approximately 13.8% of total life insurance in force. Reinsurance contracts do not relieve the company of its obligations to its policyholders. To the extent that reinsuring companies are later unable to meet obligations under reinsurance agreements, the company's life insurance subsidiaries would be liable for these obligations, and payment of these obligations could result in losses to the company. To limit the possibility of such losses the company evaluates the financial condition of its reinsurers, monitors concentrations of credit risk arising from factors such as similar geographic regions and limits its exposure to any one reinsurer. At December 31, 1993, the company had reinsurance treaties with 18 reinsurers, all of which are deemed to be long-duration, retroactive contracts, and has established a receivable totalling $11,239,000 for reserve credits, reinsurance claims and other receivables from these reinsurers. No allowance for uncollectible amounts has been established since none of the receivables are deemed to be uncollectible, and because such receivables, either individually or in the aggregate, are not material to the company's operations. The company's liability for future policy benefits and notes and other receivables have been increased by $9,931,000 at December 31, 1993 for reserve credits on reinsured policies. Prior period liabilities for future policy benefits have not been restated because such reserve credits were not material. This "gross-up" of assets and liabilities for reserve credits on reinsurance had no impact on the company's net income. Insurance premiums and product charges have been reduced by $5,653,000, $5,845,000 and $4,599,000 and insurance benefits have been reduced by $3,498,000, $3,554,000 and $1,280,000 in 1993, 1992 and 1991, respectively, as a result of the cession agreements. The amount of reinsurance assumed is not significant. Assessments are, from time to time, levied on the company's life insurance subsidiaries by life and health guaranty associations in most states in which these subsidiaries are licensed to cover losses of policyholders of insolvent or rehabilitated insurers. In some states, these assessments can be partially recovered through a reduction in future premium taxes. Based upon information currently available, the company believes that it is probable that these failures will result in future assessments which will be material to the company's financial statements. During 1991, the company accrued and charged to expense $15,544,000 to cover estimated future assessments (net of related anticipated premium tax credits) resulting from these failures. Consolidated net income for 1991 was reduced by $10,259,000, or $0.36 per share, for the after-tax impact of insurance guaranty fund assessment accruals. Based upon information received during 1993, the company determined that expected future assessments (net of related anticipated premium tax credits) were greater than amounts previously reserved. As a result, the company accrued and charged to expense an additional $2,109,000 during 1993. At December 31, 1993, the company has reserved $15,211,000 to cover estimated future assessments (net of related anticipated premium tax credits) and has established an asset totalling $8,309,000 for items expected to be recoverable through future premium tax offsets. The company cannot predict whether and to what extent legislative initiatives may affect the right to offset. The company leases its home office space and certain other equipment under operating leases which expire through 1999. During the years ended December 31, 1993, 1992 and 1991, rent expense totalled $1,831,000, $2,294,000 and $2,220,000, respectively. At December 31, 1993, minimum rental payments due under all non-cancelable operating leases with initial terms of one year or more are: 1994 - $2,145,000; 1995 - $2,170,000; 1996 - - $1,907,000; 1997 - $1,431,000; 1998 - $1,405,000 and thereafter - $234,000. At December 31, 1993, outstanding commitments to fund mortgage loans on real estate totalled $37,111,000. 11. SUMMARY OF QUARTERLY RESULTS OF OPERATIONS (UNAUDITED) AND DIVIDENDS PAID Per share amounts have been restated to reflect the 2-for-1 stock splits as of May 12, 1993 and May 14, 1992. Insurance revenues and profitability are typically not seasonal in nature. However, the recognition of realized gains and losses on investments may vary from quarter to quarter. During 1993, the company recognized pre-tax realized gains of: first quarter - $7,642,000; second quarter - $8,835,000; third quarter - $8,229,000 and fourth quarter - $17,279,000. During 1992, the company recognized pre-tax realized gains of: first quarter - $763,000; second quarter - $4,573,000; third quarter - $2,575,000 and fourth quarter - $253,000. REPORT OF INDEPENDENT AUDITORS The Board of Directors and Stockholders Equitable of Iowa Companies We have audited the accompanying consolidated balance sheets of Equitable of Iowa Companies and subsidiaries as of December 31, 1993 and 1992, and the related consolidated statements of income, changes in stockholders' equity, and cash flows for each of the three years in the period ended December 31, 1993. Our audits also included the financial statement schedules listed in the Index at Item 14(a). These financial statements and schedules are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements and schedules based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the consolidated financial position of Equitable of Iowa Companies and subsidiaries at December 31, 1993 and 1992, and the consolidated results of their operations and their cash flows for each of the three years in the period ended December 31, 1993, in conformity with generally accepted accounting principles. Also, in our opinion, the related financial statement schedules, when considered in relation to the basic financial statements taken as a whole, present fairly in all material respects the information set forth therein. As discussed in Notes 6 and 8 to the consolidated financial statements, in 1992 the Company changed its method of accounting for postretirement benefits other than pensions and, in 1991 the Company changed its method of accounting for income taxes. \s\ Ernst & Young Des Moines, Iowa February 10, 1994 MANAGEMENT REPORT ON RESPONSIBILITY FOR FINANCIAL REPORTING The accompanying financial statements of Equitable of Iowa Companies have been prepared by management, which is responsible for their integrity and objectivity. The statements have been prepared in conformity with generally accepted accounting principles appropriate in the circumstances and are not misstated due to material error or fraud. These statements include some amounts that are based upon management's best estimates and judgements. Financial information contained elsewhere in this annual report is consistent with that contained in the financial statements. In meeting its responsibility for the integrity of the financial statements, management relies on the company's system of internal control. This system is designed to provide reasonable assurance that assets are safeguarded and that transactions are properly recorded and executed in accordance with management's authorization. The company maintains a strong internal auditing program that independently assesses the effectiveness of the internal controls and recommends possible improvements thereto. The company's financial statements have been audited by Ernst & Young, independent auditors. In connection with this audit, Ernst & Young performed examinations in accordance with generally accepted auditing standards, which include a review of the system of internal control and assurance that the financial statements are fairly presented. Management has made pertinent records available to Ernst & Young and, furthermore, believes that all representations made to Ernst & Young during its audit were valid and appropriate. \s\ Fred S. Hubbell FRED S. HUBBELL Chief Executive Officer \s\ Paul E. Larson PAUL E. LARSON Chief Financial Officer \s\ David A. Terwilliger DAVID A. TERWILLIGER Chief Accounting Officer ITEM 9.

ITEM 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure None PART III ITEM 10.

ITEM 10. Directors and Executive Officers of the Registrant Information regarding directors and executive officers on pages 3 through 7 and on page 17 of the Proxy Statement for the annual meeting of shareholders to be held April 28, 1994 ("Proxy Statement") is incorporated herein by reference. ITEM 11.

ITEM 11. Executive Compensation Executive compensation information on pages 8 through 17 of the Proxy Statement is incorporated herein by reference. ITEM 12.

ITEM 12. Security Ownership of Certain Beneficial Owners and Management Security ownership information on pages 2, 6 and 7 of the Proxy Statement is incorporated herein by reference. ITEM 13.

ITEM 13. Certain Relationships and Related Transactions Information regarding certain relationships and related transactions on page 17 of the Proxy Statement is incorporated herein by reference. PART IV ITEM 14.

ITEM 14. Exhibits, Financial Statement Schedules, and Reports on Form 8-K (a)(1) and (a)(2) Financial statements and schedules The following consolidated financial statements of Equitable of Iowa Companies and subsidiaries are included in Item 8: Consolidated balance sheets - December 31, 1993 and 1992 Consolidated statements of income - Years ended December 31, 1993, 1992 and 1991 Consolidated statements of changes in stockholders' equity - Years ended December 31, 1993, 1992 and 1991 Consolidated statements of cash flows - Years ended December 31, 1993, 1992 and 1991 Notes to consolidated financial statements The following consolidated financial statement schedules of Equitable of Iowa Companies and Subsidiaries are included in Item 14 (d): Schedule I - Summary of investments - other than investments in related parties Schedule III - Condensed financial information of registrant Schedule V - Supplementary insurance information Schedule VI - Reinsurance Schedule IX - Short-term borrowings All other schedules to the consolidated financial statements pursuant to Article 7 of Regulation S-X are not required under the related instructions or are inapplicable and therefore have been omitted. Financial statements and summarized financial information of unconsolidated subsidiaries or 50% or less owned persons accounted for by the equity method have been omitted because they do not, considered individually or in the aggregate, constitute a significant subsidiary. (a)(3), and (c) Exhibits Exhibits filed are listed in the attached exhibit index. (b) No reports on Form 8-K were filed for the quarter ended December 31, 1993. ITEM 14(d). Schedules Note 1: Except as stated in Note 2 below, cost is defined as original cost for stocks and other invested assets, amortized cost for bonds and unpaid principal for policy loans and mortgage loans on real estate, adjusted for amortization of premiums, accrual of discounts and cost less allowances for depreciation for real estate. Note 2: Original cost and amortized cost of investments have been adjusted to reflect other than temporary declines in value by charges to income as follows. Corporate bonds: 1993 - $6,443,000. Mortgage loans on real estate: 1993 - $363,000. Real estate: 1993 - $86,000; 1992 - $258,000; 1991 - $123,000 and 1990 - $992,000. SCHEDULE III CONDENSED FINANCIAL INFORMATION OF REGISTRANT EQUITABLE OF IOWA COMPANIES (PARENT COMPANY) (Dollars in thousands, except per share data) NOTES TO CONDENSED FINANCIAL STATEMENTS The accompanying condensed financial statements should be read in conjunction with the consolidated financial statements and notes thereto of Equitable of Iowa Companies and subsidiaries. The company has guaranteed certain indebtedness of subsidiaries. Additionally, the company has issued commercial paper and also maintains a line of credit with various banks. See Note 5 to notes to consolidated financial statements. *Eliminated in consolidation. *Eliminated in consolidation. 1 The average amount outstanding during the period was computed on a daily average basis. 2 The weighted average interest rate during the period was computed by dividing the actual interest expense by average short-term debt outstanding. SIGNATURES Pursuant to the requirements of Section 13 or 15(d) 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. EQUITABLE OF IOWA COMPANIES (Registrant) Dated March 4, 1994 By \s\Frederick S. Hubbell __________________________ Frederick S. Hubbell President Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated. Signatures Title ________________________ ___________________ \s\Frederick S. Hubbell Chairman of the Board, ________________________ President, Chief Frederick S. Hubbell Executive Officer (principal executive officer) and Director \s\Paul E. Larson Executive Vice President ________________________ and Chief Financial Paul E. Larson Officer (principal financial officer) \s\David A. Terwilliger Vice President and ________________________ Controller David A. Terwilliger (principal accounting officer) \s\Richard B. Covey Director ________________________ Richard B. Covey \s\Doris M. Drury Director ________________________ Doris M. Drury Signatures Title ________________________ ___________________ \s\James L. Heskett Director ________________________ James L. Heskett \s\Richard S. Ingham Director ________________________ Richard S. Ingham \s\Robert E. Lee Director ________________________ Robert E. Lee \s\James E. Luhrs Director ________________________ James E. Luhrs \s\Jack D. Rehm Director ________________________ Jack D. Rehm \s\Thomas N. Urban Director ________________________ Thomas N. Urban \s\Hans F.E. Wachtmeister Director ________________________ Hans F.E. Wachtmeister \s\Richard S. White Director ________________________ Richard S. White Signature date: March 4, 1994 INDEX Exhibits to Annual Report on Form 10-K Year ended December 31, 1993 EQUITABLE OF IOWA COMPANIES 3 Articles of Incorporation and By-Laws (a) Restated Articles of Incorporation as amended through April 29, 1993, filed as Exhibit 3(a) to Form 10-Q for the period ended June 30, 1993, is incorporated by reference (b) Amended and restated By-Laws filed as Exhibit 2 to Form 8-K dated November 11, 1991, is incorporated by reference 4 Instruments Defining the Rights of Security Holders, Including Indentures (a) Letter Agreement to furnish Commission upon request copies of other long-term debt instruments (b)(i) Rights Agreement filed as Exhibit 1 to Form 8-K dated April 30, 1992, is incorporated by reference (ii) First amendment to Rights Agreement changing Rights Agent filed as Exhibit 4(b)(ii) to Form 10-Q for the period ended September 30, 1992, is incorporated by reference (iii) Second amendment to Rights Agreement dated April 29, 1993, adjusting Purchase Price filed as Exhibit 2.2 to Form 8-A/A dated May 13, 1993, is incorporated by reference 10 Material Contracts (a) Executive compensation plans and arrangements * (i) Restated Executive Severance Pay Plan filed as Exhibit 10(a) to Form 10-K for the year ended December 31, 1992, is incorporated by reference (ii) Directors' Deferred Compensation Plan filed as Exhibit 10(b) to Form 10-K for the year ended December 31, 1989, is incorporated by reference (iii) 1982 Stock Incentive Plan filed as Exhibit 10(c) to Form 10-K for the year ended December 31, 1989, is incorporated by reference (iv) Excess Benefit Plan filed as Exhibit 10(d) to Form 10-K for the year ended December 31, 1989, is incorporated by reference (v) Supplemental Employee Retirement Plan filed as Exhibit 10(e) to Form 10-K for the year ended December 31, 1989, is incorporated by reference (vi) Executive Flexible Perquisite Program filed as Exhibit 10(f) to Form 10-K for the year ended December 31, 1992, is incorporated by reference (vii) Key Employee Incentive Plan filed as Exhibit 10(g) to Form 10-K for the year ended December 31, 1992, is incorporated by reference INDEX Exhibits to Annual Report on Form 10-K Year ended December 31, 1993 EQUITABLE OF IOWA COMPANIES (viii) 1992 Stock Incentive Plan, as amended, Registration Statement No. 33-57492 filed as Exhibit 10(i) to Form 10-Q for the period ended March 31, 1993, is incorporated by reference (ix) James E. Luhrs Consulting Agreement filed as Exhibit 10(j) to Form 10-Q for the period ended June 30, 1992, is incorporated by reference * Management contracts or compensation plans required to be filed as an Exhibit pursuant to Item 14(c) of Form 10(K). 11 Statement re: Computation of Per Share Earnings 21 Subsidiaries List 23 Consent of Experts and Counsel (a) Consent of independent auditors (b) Consent of counsel (not required) 27 Financial Data Schedule (not required) 99 Additional Exhibits Independence Policy filed as an Exhibit to Form 8-K dated November 11, 1991, is incorporated by reference

69952_1993.txt

69952

1993

Item 1 - Business CoreStates Financial Corp ("CoreStates") is a bank holding company registered under the Federal Bank Holding Company Act of 1956, as amended (the "Act") and incorporated under the laws of Pennsylvania with executive offices at Philadelphia National Bank Building, Broad & Chestnut Streets, Philadelphia, Pennsylvania 19107 (telephone number 215-973-3827). At December 31, 1993, CoreStates had total consolidated assets of approximately $23.7 billion and shareholders' equity of approximately $1.96 billion and, based on December 31, 1993 rankings of bank holding companies, was believed to be the 32nd largest bank holding company in the United States at such date. Banking Subsidiaries The lead banking subsidiary of CoreStates is CoreStates Bank, N.A. ("CoreStates Bank"), a national banking association with executive offices located in Philadelphia, Pennsylvania. Divisions of CoreStates Bank are marketed as Philadelphia National Bank Division, the wholesale banking unit, CoreStates First Pennsylvania Bank Division, the retail banking unit, and since its merger into CoreStates Bank in August 1993, CoreStates Hamilton Bank, the unit serving central Pennsylvania. Other principal banking subsidiaries of CoreStates are New Jersey National Bank ("NJNB"), a national banking association with its executive offices located in Pennington, New Jersey and CoreStates Bank of Delaware N.A. ("CBD"), a national banking association with its sole office located in New Castle County, Delaware. CoreStates Bank, NJNB and CBD are sometimes referred to herein as the "Banking Subsidiaries". Through CoreStates Bank, NJNB and CBD, CoreStates has been engaging in the business of providing wholesale banking services, consumer financial services which includes retail banking, trust & investment management services and electronic payment services which are provided through CoreStates' Electronic Payment Services, Inc. affiliate. Other Direct and Indirect Subsidiaries and Affiliates Congress Financial Corporation, ("Congress") a majority-owned subsidiary of ------------------------------ CoreStates, and its subsidiaries are engaged in commercial financing and factoring with headquarters in New York City and offices in Atlanta, Boston, Chicago, Columbia, Dallas, Los Angeles, Miami, Milwaukee, Portland and San Juan. As of December 31, 1993, factored receivables of Congress and its subsidiaries totalled $555.2 million while outstanding commercial finance obligations and other receivables totalled $1,426.4 million. CoreStates Capital Corp ("Capital") is CoreStates' designated financing ----------------------- entity to obtain both short-term and long-term financing for CoreStates and its other subsidiaries. At December 31, 1993, Capital had outstanding commercial paper in the aggregate principal amount of $468.8 million and debt securities in the aggregate outstanding principal amount of $1,433 million, with maturities ranging from 1 month to 11 years. Electronic Payment Services, Inc. ("EPS") is a joint venture formed in late --------------------------------- 1992 that combined the separate consumer electronic transaction processing business of CoreStates, Banc One Corporation, PNC Financial Corp. and Society Corporation into the nation's leading provider of automated teller machine and point of sale processing services to individuals, financial institutions and retail stores. CoreStates former electronic payment services business is now conducted by EPS. EPS has announced the signing of a definitive agreement providing for two additional banking companies to enter the joint venture. The transactions are expected to be completed in 1994. CoreStates also has several other direct and indirect subsidiaries including companies engaged in discount brokerage services, investment advisory services, lease financing activities, holding real property facilities used by CoreStates' Banking Subsidiaries and companies created solely to facilitate the business of other subsidiaries. For analytical purposes, management has focused CoreStates into four core businesses: Wholesale Banking, Consumer Financial Services, Trust & Investment Management and Electronic Payment Services conducted by EPS. Further information regarding CoreStates' four core businesses is presented in Management's Discussion and Analysis of Financial Condition and Results of Operations at pages 21 through 23 of the CoreStates Annual Report to Shareholders for the fiscal year ended December 31, 1993 (Exhibit 13 pages 7 through 10) which pages of the Annual Report are incorporated herein by reference. A brief discussion of the four core businesses is presented below. There is considerable inter-relationship among these businesses. Wholesale Banking Wholesale banking services are provided through the ----------------- Banking Subsidiaries and Congress by the following groups: corporate and institutional banking; investment banking; cash management; international banking; corporate middle market; and specialized finance. Domestic financing services include commercial, industrial and real estate loans, the financing of receivables, inventory, equipment and other requirements of business customers and the provision of financial services for correspondent banks. Foreign and international finance services include the making of loans and acceptances, the issuance and confirmation of letters of credit and related financial services. Also provided are transaction processing services, including cash management, lock box, funds transfer and collection and disbursement management on both a domestic and international basis. International activities are conducted directly by CoreStates Bank through its head office in Philadelphia and 23 foreign offices. In addition, banking and financing activities are conducted through two wholly-owned Edge Act subsidiaries. Advisory services are also provided which relate to loan syndications, private placements, mergers and acquisitions, company valuations and other similar matters. This business also deals in and underwrites obligations of the United States Government, federal agencies and general obligations of States and municipal sub-divisions and assists individual corporate customers as well as other institutions with the purchase and sale of all types of marketable securities. Consumer Financial Services This core business is provided by the Banking --------------------------- Subsidiaries and includes community banking and specialty products. Specialty products includes credit card, student lending and residential mortgage. Community banking services are offered through the branch network of the Banking Subsidiaries in Pennsylvania and New Jersey. This branch banking network provides a full range of products including deposit, loan and related financial products, primarily on a full relationship basis. The specialty products and consumer finance line of business is provided primarily by CBD which is the issuer of credit cards and also engages in a direct consumer loan business. Trust & Investment Management This core business provides products through ----------------------------- four business lines: institutional trust, personal trust, private banking and investment management. These products are offered through the Banking Subsidiaries and include fiduciary administration and transaction processing services, corporate trust services and through CoreStates Investment Advisors, Inc., investment management services. Electronic Payment Services This core business includes the MAC automated --------------------------- teller machine network ("MAC") and point of sale processing ("POS"). Customers for these businesses include individuals, financial institutions and retail stores. The MAC and POS business lines were contributed to EPS on December 4, 1992. Strategic Actions A discussion of strategic actions taken by CoreStates in 1993 is presented in Management's Discussion and Analysis of Financial Condition and Results of Operations at pages 19 through 21 of the CoreStates Annual Report to Shareholders for the fiscal year ended December 31, 1993 (Exhibit 13 pages 4 through 7) which pages of the Annual Report are incorporated herein by reference. Government Supervision and Regulation CoreStates is a registered bank holding company subject to the supervision of, and to regular inspection by, the Board of Governors of the Federal Reserve System ("Federal Reserve"). All three Banking Subsidiaries are organized as national banking associations, which are subject to regulation by the Comptroller of the Currency ("OCC"). The Banking Subsidiaries are also subject to regulation by other federal bank regulatory bodies. In addition to banking laws, regulations and regulatory agencies, CoreStates and its subsidiaries and affiliates are subject to various other laws, regulations and regulatory agencies, all of which directly or indirectly affect CoreStates' operations, management and ability to make distributions. The following discussion summarizes certain aspects of those laws and regulations that affect CoreStates. Proposals to change the laws and regulations governing the banking industry are frequently raised in Congress, in the state legislatures and before the various bank regulatory agencies. The likelihood and timing of any changes and the impact such changes might have on CoreStates and its Banking Subsidiaries are difficult to determine. An important function of the Federal Reserve System is to regulate the national supply of bank credit. Among the instruments of monetary policy used by the Federal Reserve System to implement its objectives are: open market operations in U.S. Government securities; changes in the discount rate on bank borrowings; and changes in reserve requirements on bank deposits. Under the Act, CoreStates' activities, and those of companies which it controls or in which it holds more than 5% of the voting stock, are limited to banking or managing or controlling banks or furnishing services to or performing services for its subsidiaries, or any other activity which the Federal Reserve determines to be so closely related to banking or managing or controlling banks as to be a proper incident thereto. In making such determinations, the Federal Reserve is required to consider whether the performance of such activities by a bank holding company or its subsidiaries can reasonably be expected to produce benefits to the public such as greater convenience, increased competition or gains in efficiency that outweigh possible adverse effects, such as undue concentration of resources, decreased or unfair competition, conflicts of interest or unsound banking practices. Bank holding companies, such as CoreStates, are required to obtain prior approval of the Federal Reserve to engage in any new activity or to acquire more than 5% of any class of voting stock of any company. The Act also requires bank holding companies to obtain the prior approval of the Federal Reserve before acquiring more than 5% of any class of voting shares of any bank which is not already majority-owned. Provisions of federal banking laws restrict the amount of distributions that can be paid to CoreStates by the Banking Subsidiaries. Under applicable federal laws, no dividends may be paid in an amount greater than net profits then on hand, reduced by certain loan losses (as defined in the applicable statutes). In addition, for each of CoreStates' Banking Subsidiaries, prior approval of federal banking authorities is required if dividends declared by a Banking Subsidiary in any calendar year will exceed its net profits (as defined) for that year, combined with its retained net profits for the preceding two calendar years. Based on these regulations, CoreStates' Banking Subsidiaries, without regulatory approval, could declare dividends at December 31, 1993 of $171 million. The OCC, in the cases of the Banking Subsidiaries, also has authority to prohibit payment of a dividend if such payment constitutes what, in the OCC's opinion, is an unsafe or unsound practice. In addition, the ability of CoreStates and its national Banking Subsidiaries to pay dividends may be affected by the various minimum capital requirements and the capital and non- capital standards to be established under the Federal Deposit Insurance Corporation Improvement Act of 1991 ("FDICIA"), as described below. The rights of CoreStates, its shareholders and its creditors to participate in any distribution of the assets or earnings of its Banking Subsidiaries is further subject to the prior claims of creditors of the respective Banking Subsidiaries. According to Federal Reserve policy, CoreStates is expected to act as a source of financial strength to each Banking Subsidiary and to commit resources to support each Banking Subsidiary in circumstances in which it might not do so absent such policy. In addition, any capital loans by Corestates to any Banking Subsidiary would be subordinated in right of payment to deposits and certain other indebtedness of each Banking Subsidiary. In addition, CoreStates' Banking Subsidiaries are subject to certain restrictions imposed by Federal law on any extension of credit to, and certain other transactions with CoreStates, Capital and certain other non-bank subsidiaries, on investments in stock or other securities thereof and on the taking of such securities as collateral for loans. Among other things, the aggregate of such loans made by each Banking Subsidiary to CoreStates or to any single non-bank subsidiary generally may not exceed 10% of the sum of such Banking Subsidiaries' capital and surplus, as defined, and all loans by each Banking Subsidiary to CoreStates and its non-bank subsidiaries are limited to 20% of such Banking Subsidiaries' capital and surplus. Such loans must be secured by collateral with a value between 100% and 130% of the loan amount, depending on the type of collateral. The Banking Subsidiaries may extend credit to CoreStates and its non-bank subsidiaries without regard to these restrictions to the extent such extensions of credit are secured by specific kinds of collateral such as obligations of or guaranteed by the U.S. Government or its agencies and certain bank deposits. FDICIA modifies certain provisions of the Federal Deposit Insurance Act and makes revisions to several other banking statutes. In general, FDICIA subjects banks to significantly increased regulation and supervision, and requires the federal banking agencies to take "prompt corrective action" with respect to banks which do not meet minimum capital requirements. Among other things, FDICIA requires a bank which does not meet any one of its capital requirements set by its regulators to submit a capital restoration plan for improving its capital. A holding company of a bank must guarantee that the bank will meet its capital plan, subject to certain limitations. If such a guarantee were deemed to be a commitment to maintain capital under the U.S. federal Bankruptcy Code, a claim under such guarantee in a bankruptcy proceeding involving the holding company would be entitled to a priority over third party creditors of the holding company. In addition, FDICIA prohibits a bank from making a capital distribution to its holding company or otherwise if it fails to meet any capital requirements. Furthermore, under certain circumstances, a holding company of a bank which fails to meet certain of its capital requirements may be prohibited from making any capital distributions to its shareholders or otherwise. Critically undercapitalized banks (which are defined to include banks which still have a positive net worth) are generally subject to the mandatory appointment of a receiver. All of CoreStates' Banking Subsidiaries meet current regulatory capital requirements and are "well capitalized" as defined by regulatory authorities. Pursuant to FDICIA, in 1993 the FDIC issued a regulation entitled "Annual Independent Audits and Reporting Requirements" for banks which requires, among other things, a management assessment on the effectiveness of the internal controls over financial reporting as of the end of fiscal year 1993. CoreStates and the Banking Subsidiaries have complied with this regulation for 1993. The Financial Institution Reform, Recovery, and Enforcement Act ("FIRREA") enacted in August 1989 provides among other things for cross-guarantees of the liabilities of insured depository institutions pursuant to which any bank or savings association subsidiary of a holding company may be required to reimburse the FDIC for any loss or anticipated loss to the FDIC that arises from a default of any of such holding company's other subsidiary banks or savings associations or assistance provided to such an institution in danger of default. The Banking Subsidiaries of CoreStates are subject to such cross-guarantee. The deposits of each of the Banking Subsidiaries are insured up to applicable limits by the FDIC. Accordingly, the Banking Subsidiaries are subject to deposit insurance assessments to maintain the Bank Insurance Fund (the "BIF") of the FDIC. Pursuant to FDICIA, the FDIC has established a risk- based insurance assessment system. This approach is designed to ensure that a banking institution's insurance assessment is based on three factors: the probability that the applicable insurance fund will incur a loss from the institution; the likely amount of the loss; and the revenue needs of the insurance fund. Effective January 1, 1993, the FDIC established a risk related premium assessment system, with assessment rates ranging from .23% of domestic deposits (the same rate as under the previous flat-rate assessment system) for those banks deemed to pose the least risk to the insurance fund, to .31% for those banks deemed to pose the greatest risk (with intermediate rates of .26%, .29% and .30%). All Corestates' Banking Subsidiaries have been notified by the FDIC that, for the semiannual assessment period beginning January 1, 1993, each will be subject to an assessment rate of .23%. CAPITAL GUIDELINES A discussion of capital guidelines and capital strengths is included in Management's Discussion and Analysis of Financial Condition and Results of Operations on pages 23 and 24 of the CoreStates Annual Report to Shareholders for the fiscal year ended December 31, 1993 (Exhibit 13 pages 11 and 12) which pages of the Annual Report are incorporated herein by reference. COMPETITION The activities in which CoreStates and the Banking Subsidiaries engage are highly competitive. Generally, the lines of activity and markets served involve competition with other banks and non-bank financial institutions, as well as other entities which offer financial services, located both within and without the United States. The methods of competition center around various factors, such as customer services, interest rates on loans and deposits, lending limits and location of offices. The four core business segments in the markets served by the Banking Subsidiaries and EPS are highly competitive and the Banking Subsidiaries and EPS compete with other commercial banks, savings and loan associations and other businesses which provide services similar to those offered by the Banking Subsidiaries and EPS. The Banking Subsidiaries actively compete in wholesale banking with local, regional and international banks and non-bank financial organizations, some of which are significantly larger than certain of the Banking Subsidiaries. In providing consumer financial services, the Banking Subsidiaries' competitors include other banks, savings and loan associations, credit unions, regulated small loan companies and other non-bank organizations offering financial services. In providing trust and investment management services, the Banking Subsidiaries compete with other banks, investment counselors and insurance companies in national markets for institutional funds and corporate pension and profit sharing accounts. The Banking Subsidiaries also compete with other banks, insurance agents, financial counselors and other fiduciaries for personal trust business. The Banking Subsidiaries also actively compete for funding. A primary source of funds is deposits, and competition for deposits includes other deposit taking organizations, such as commercial banks, savings and loan associations and credit unions, and so- called "money market" mutual funds. The Banking Subsidiaries also actively compete for funds with U.S. Government securities and in the open money market. Employees As of February 28, 1994, CoreStates and its subsidiaries employed 11,180 persons on a full time basis and 2,855 persons on a part-time basis. CoreStates provides a variety of employment benefits and considers its relations with its employees to be satisfactory. Selected Statistical Information Tables and selected statistical information concerning CoreStates and its subsidiaries as described below and set forth on pages of the CoreStates 1993 Annual Report to Shareholders (and Exhibit 13 page numbers) set forth below are incorporated herein by reference: Information illustrating the interest sensitivity of CoreStates interest earning assets and interest bearing liabilities is contained on page 74 of the Annual Report to Shareholders (Exhibit 13 page 84) and on page 11 of this Form 10-K. Corestates Financial Corp And Subsidiaries Interest Sensitivity Analysis at December 31, 1993 (In Millions) Notes to interest sensitivity analysis: (a) Non-performing loans are included in 1-90 days. (b) Deposit volume exclude time deposits not at interest. (c) Represents the portion of total interest earning assets which are funded by non-interest bearing funding sources including demand deposits and shareholders' equity. EXECUTIVE OFFICERS OF THE REGISTRANT The following table shows the name and age of the current executive officers of CoreStates Financial Corp ("Corporation") and their present and previous positions held by them for at least the past five years. Item 2

Item 2 - Properties The principal offices of CoreStates and CoreStates Bank are located in a 25-story building known as the Philadelphia National Bank Building ("PNB Building"), located at Broad and Chestnut Streets, Philadelphia, Pennsylvania, owned by Clymer Realty Corporation, a real estate subsidiary of CoreStates Bank, and in leased space located at Centre Square West, 16th and Market Streets, Philadelphia, Pennsylvania. CoreStates and its subsidiaries and affiliates occupy approximately 260,000 square feet of the PNB Building's approximately 400,000 square feet of office space and 547,600 square feet of the office space in the Centre Square complex. Approximately 194,100 square feet of office space in the Widener Building adjacent to the PNB Building is leased for use by CoreStates Bank. In addition, office space is leased for use by CoreStates and CoreStates Bank in the following Philadelphia locations: approximately 393,000 square feet in the Penn Mutual Buildings, 510, 520 and 530 Walnut Street, approximately 111,600 square feet in the Curtis Center, 6th and Walnut Streets, and approximately 62,100 square feet in the Graham Building, One Penn Square West. Fifth and Market Corporation, a real estate subsidiary of CoreStates Bank, owns the 11 story building located at Fifth and Market Streets, Philadelphia, Pennsylvania. The building, containing approximately 587,000 square feet, is comprised of almost 493,000 square feet of office space, a branch banking office and an underground garage, in addition to the public access and service areas. CoreStates Bank's operations center and its loss prevention and security, human resources and loan accounting units presently occupy all of the office space in this building. CoreStates Bank also owns a service and warehouse building at 1306 Spring Garden Street in Philadelphia and a six story building at 3020 Market Street in Philadelphia which is used for storage. An administrative center at 1097 Commercial Avenue, Lancaster, Pennsylvania and the executive offices of its CoreStates Hamilton Bank division at 100 North Queen Street, Lancaster, Pennsylvania are also owned by CoreStates Bank. Of 183 CoreStates Bank domestic banking offices at December 31, 1993, 70 were in CoreStates Bank owned premises and 113 were in leased premises. The lease provisions for rented properties generally provide for initial terms of at least 10 to 15 years with varying options for renewal. On May 13, 1977, CoreStates (then National Central Financial Corporation) borrowed $25 million from two institutional lenders at an interest rate of 8 5/8% per annum. The loan is payable over 25 years, with level monthly installments which are set to fully amortize the loan by maturity. The loan is secured by a first lien mortgage on 30 CoreStates Bank owned properties previously owned by Hamilton Bank and occupied by the CoreStates Hamilton Bank division of CoreStates Bank. As of December 31, 1993, NJNB maintained 103 bank and bank-related properties. Of the total, 55 were owned in fee and 48 were leased, of which 13 were owned partially in fee and partially under lease. Of the leased properties most of the leases range from five to 27 years. All real estate and buildings owned by NJNB are free from mortgages. Of the buildings owned by NJNB, four include space leased to others, and of the buildings leased by NJNB, one includes space leased to others. CBD leases space in three office buildings located at 1523 Concord Pike, New Castle County, Delaware. The buildings contain 131,593 square feet of rental space, all of which is occupied by CBD. The leases expire in 1995 and contain three five-year renewal options in favor of CBD. The offices of CoreStates' other direct and indirect subsidiaries and the foreign branch and representative offices of CoreStates Bank are in leased premises. Rental expense, reduced by sublease income, for CoreStates and its subsidiaries in 1993 was $56.6 million. Item 3

Item 3 - Legal Proceedings In the normal course of business, CoreStates and its subsidiaries are subject to numerous pending and threatened legal actions and proceedings, some for which the relief or damages sought are substantial. Management does not believe the outcome of these actions and proceedings will have a materially adverse effect on the consolidated financial position of CoreStates. Item 4

Item 4 - Submission of Matters to a Vote of Security Holders Not applicable. PART II Item 5

Item 5 - Market for the Registrant's Common Stock and Related Stockholder Matters CoreStates Common Shares are traded on the New York Stock Exchange under the symbol "CFL". Until December 29, 1993, CoreStates Common Shares were traded in the over-the-counter market and the price quotations were reported on the NASDAQ National Market System. The table below sets forth, for the periods indicated, the high and low prices for CoreStates Common shares as reported on the New York Stock Exchange or as quoted on the NASDAQ National Market System, as applicable, and cash dividends declared per share. Over-the-counter market quotations reflect inter-dealer prices, without retail mark-up, mark-down or commission and may not necessarily represent actual transactions. The information set forth in the table has been adjusted retroactively for a stock dividend in the form of a two-for-one stock split declared on August 17, 1993 and distributed on October 15, 1993 to shareholders of record on September 15, 1993. On March 4, 1994, there were approximately 32,848 registered holders of Common Stock of CoreStates. CoreStates currently expects to continue its policy of paying regular cash dividends, although there can be no assurance as to further dividends because they are dependent upon further operating results, capital requirements and financial condition. The approval of the Comptroller of the Currency is required for national banks to pay dividends if the total of all dividends declared in any calendar year exceeds the bank's net profits for that year combined with its retained net profits for the preceding two calendar years. Under this formula CoreStates Bank, NJNB and CBD can declare dividends to CoreStates of approximately $151 million, $19 million and $1 million, respectively, plus an additional amount equal to CoreStates Bank's, NJNB's and CBD's retained net profits for 1994 up to the date of dividend declaration. Item 6

Item 6 - Selected Financial Data Pursuant to General Instructions G(2), information required by this Item is incorporated by reference from pages 66, 67 and 68 of the CoreStates Annual Report to Shareholders for the fiscal year ended December 31, 1993 (Exhibit 13 pages 75 through 77). Item 7

Item 7 - Management's Discussion and Analysis of Financial Condition and Results of Operations Pursuant to General Instructions G(2), information required by this Item is incorporated by reference from pages 18 through 40 of the CoreStates Annual Report to Shareholders for the fiscal year ended December 31, 1993 (Exhibit 13 pages 1 through 37). Item 8

Item 8 - Financial Statements and Supplementary Data Pursuant to General Instructions G(2), information required by this Item is incorporated by reference from pages 40 through 77 of the CoreStates Annual Report to Shareholders for the fiscal year ended December 31, 1993 (Exhibit 13 pages 38 through 90). Item 9

Item 9 - Changes in and Disagreements with Accountants on Accounting and Financial Disclosure Not applicable. PART III Item 10

Item 10 - Directors and Executive Officers of the Registrant Pursuant to General Instruction G(3), information required by this Item is incorporated by reference from pages 1 through 7 of the CoreStates Proxy Statement dated March 17, 1994 and from Part I of this report on Form 10-K. Item 11

Item 11 - Executive Compensation Pursuant to General Instruction G(3), information required by this Item is incorporated by reference from pages 10 through 18 of the CoreStates Proxy Statement dated March 17, 1994. Such incorporation by reference shall not be deemed to specifically incorporate by reference the information referred to in Item 402(a)(8) of Regulation S-K. Item 12

Item 12 - Security Ownership of Certain Beneficial Owners and Management Pursuant to General Instruction G(3), information required by this Item is incorporated by reference from pages 2-7, 15-16, and 18 of the CoreStates Proxy Statement dated March 17, 1994. On March 25, 1994 CoreStates received a corrected Schedule 13G from Mellon Bank Corporation which indicates that Mellon Bank Corporation and its subsidiaries and affiliates own 3.06% of the outstanding Shares of Common Stock of CoreStates rather than the 5.34% as reported on the original Schedule 13G dated February 9, 1994 and reflected on page 7 of the CoreStates Proxy Statement dated March 17, 1994. Item 13

Item 13 - Certain Relationships and Related Transactions Pursuant to General Instruction G(3), information required by this Item is incorporated by reference from page 10 of the CoreStates Proxy Statement dated March 17, 1994. PART IV Item 14

Item 14 - Exhibits, Financial Statement Schedules and Reports on Form 8-K (a) 1. Financial Statements: The following consolidated statements of CoreStates Financial Corp included in the Annual Report of the Registrant to its Shareholders for the year ended December 31, 1993, are incorporated by reference in Item 8: (a) 2. Financial Statement Schedules All other schedules for which provision is made in the applicable accounting regulation of the Securities and Exchange Commission are not required under the related instructions or are inapplicable, and therefore have been omitted. (a) 3. Exhibits -------- * Management contract or compensatory plan or arrangement required to be filed as an exhibit pursuant to Item 14(c) of Form 10-K. (b) Reports on Form 8-K for the quarter ended December 31, 1993: A report on Form 8-K was filed on October 12, 1993 reporting that CoreStates Financial Corp and Constellation Bancorp had entered into a definitive agreement providing for CoreStates to acquire Constellation pursuant to an exchange of stock. In addition, the following financial statements were filed: (1) Interim condensed consolidated statements of Constellation Bancorp as of June 30, 1993 and for the six months ended June 30, 1993 and 1992. (2) Year-End consolidated financial statements of Constellation Bancorp as of and for the year ended December 31, 1992. (3) Pro Forma Financial Information for CoreStates Financial Corp and Constellation Bancorp as follows: (i) Pro Forma Condensed Combined Balance Sheet as of June 30, 1993 (ii) Pro Forma Condensed Combined Statements of Income for: Six months ended June 30, 1993 and 1992 Year ended December 31, 1992, 1991 and 1990 A Report on Form 8-K was filed on October 21, 1993 reporting earnings information contained in the news release of CoreStates Financial Corp dated October 20, 1993. A Report on Form 8-K was filed on November 19, 1993 reporting that CoreStates Financial Corp and Independence Bancorp had entered into a definitive agreement for CoreStates to acquire Independence in an exchange of stock. A Report on Form 8-K was filed on December 13, 1993 reporting that CoreStates Financial Corp and Independence Bancorp had entered into a definitive agreement for CoreStates to acquire Independence in an exchange of stock. In addition, the following financial statements of Independence Bancorp were filed: (1) Interim condensed consolidated statements of Independence Bancorp, Inc. as of September 30, 1993 and for the Nine months ended September 30, 1993 and 1992. (2) Year-end consolidated financial statements of Independence Bancorp, Inc. as of and for the year ended December 31, 1992. NOTE: CoreStates Financial Corp will furnish, at cost, any exhibit not accompanying this document upon request. Cost for each document is determined by the number of pages in the document. REPORT OF INDEPENDENT AUDITORS The Board of Directors and Shareholders CoreStates Financial Corp We have audited the accompanying consolidated balance sheets of CoreStates Financial Corp as of December 31, 1993 and 1992, and the related consolidated statements of income, changes in shareholder' equity, and cash flows for each of the three years in the period ended December 31, 1993. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of CoreStates Financial Corp at December 31, 1993 and 1992, and the consolidated results of its operations and its cash flows for each of the three years in the period ended December 31, 1993, in conformity with generally accepted accounting principles. As discussed in Note 1 to the financial statements, in 1993 the Company changed its methods of accounting for certain investments in debt and equity securities and for postemployment benefits, and in 1992 the Company changed its method of accounting for income taxes and for postretirement benefits other than pensions. /s/Ernst & Young Philadelphia, Pennsylvania February 1, 1994 SIGNATURES Pursuant to the requirements of Section 13 or 15 (d) 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. (Registrant) CORESTATES FINANCIAL CORP Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated.

41091_1993.txt

41091

1993

ITEM 1. BUSINESS SOUTHERN was incorporated under the laws of Delaware on November 9, 1945. SOUTHERN is domesticated under the laws of Georgia and is qualified to do business as a foreign corporation under the laws of Alabama. SOUTHERN owns all the outstanding common stock of ALABAMA, GEORGIA, GULF, MISSISSIPPI and SAVANNAH, each of which is an operating public utility company. ALABAMA and GEORGIA each own 50% of the outstanding common stock of SEGCO. The operating affiliates supply electric service in the states of Alabama, Georgia, Florida, Mississippi and Georgia, respectively, and SEGCO owns generating units at a large electric generating station which supplies power to ALABAMA and GEORGIA. More particular information relating to each of the operating affiliates is as follows: ALABAMA is a corporation organized under the laws of the State of Alabama on November 10, 1927, by the consolidation of a predecessor Alabama Power Company, Gulf Electric Company and Houston Power Company. The predecessor Alabama Power Company had had a continuous existence since its incorporation in 1906. GEORGIA was incorporated under the laws of the State of Georgia on June 26, 1930, and admitted to do business in Alabama on September 15, 1948. GULF is a corporation which was organized under the laws of the State of Maine on November 2, 1925, and admitted to do business in Florida on January 15, 1926, in Mississippi on October 25, 1976 and in Georgia on November 20, 1984. MISSISSIPPI was incorporated under the laws of the State of Mississippi on July 12, 1972, was admitted to do business in Alabama on November 28, 1972, and effective December 21, 1972, by the merger into it of the predecessor Mississippi Power Company, succeeded to the business and properties of the latter company. The predecessor Mississippi Power Company was incorporated under the laws of the State of Maine on November 24, 1924, and was admitted to do business in Mississippi on December 23, 1924, and in Alabama on December 7, 1962. SAVANNAH is a corporation existing under the laws of Georgia; its charter was granted by the Secretary of State on August 5, 1921. SOUTHERN also owns all the outstanding common stock of SEI, Southern Nuclear, SCS (the system service company), and various other subsidiaries related to foreign operations and domestic non-utility operations (see Exhibit 21 herein). At this time, the operations of the other subsidiaries are not material. SEI designs, builds, owns and operates power production facilities and provides a broad range of technical services to industrial companies and utilities in the United States and a number of international markets. A further description of SEI's business and organization follows later in this section. Southern Nuclear provides services to the Southern electric system's nuclear plants. SEGCO owns electric generating units with an aggregate capacity of 1,019,680 kilowatts at Plant Gaston on the Coosa River near Wilsonville, Alabama, and ALABAMA and GEORGIA are each entitled to one-half of SEGCO's capacity and energy. ALABAMA acts as SEGCO's agent in the operation of SEGCO's units and furnishes coal to SEGCO as fuel for its units. SEGCO also owns three 230,000 volt transmission lines extending from Plant Gaston to the Georgia state line at which point connection is made with the GEORGIA transmission line system. THE SOUTHERN SYSTEM The transmission facilities of each of the operating affiliates and SEGCO are connected to the respective company's own generating plants and other sources of power and are interconnected with the transmission facilities of the other operating affiliates and SEGCO by means of heavy-duty high voltage lines. (In the case of GEORGIA's integrated transmission system, see Item 1 - BUSINESS - "Territory Served" herein.) Operating contracts covering arrangements in effect with principal neighboring utility systems provide for capacity exchanges, capacity purchases and sales, transfers of economy energy and other similar transactions. Additionally, the operating affiliates have entered into voluntary reliability agreements with the subsidiaries of Entergy Corporation, Florida Electric Power Coordinating Group and TVA and with Carolina Power & Light Company, Duke Power Company, South Carolina Electric & Gas Company and Virginia Electric I-1 and Power Company, each of which provides for the establishment and periodic review of principles and procedures for planning and operation of generation and transmission facilities, maintenance schedules, load retention programs, emergency operations, and other matters affecting the reliability of bulk power supply. The operating affiliates have joined with other utilities in the Southeast (including those referred to above) to form the SERC to augment further the reliability and adequacy of bulk power supply. Through the SERC, the operating affiliates are represented on the National Electric Reliability Council. An intra-system interchange agreement provides for coordinating operations of the power producing facilities of the operating affiliates and SEGCO and the capacities available to such companies from non-affiliated sources and for the pooling of surplus energy available for interchange. Coordinated operation of the entire interconnected system is conducted through a central power supply coordination office maintained by SCS. The available sources of energy are allocated to the operating affiliates to provide the most economical sources of power consistent with good operation. The resulting benefits and savings are apportioned among the operating affiliates. SCS has contracted with each operating affiliate, SEI, various of the other subsidiaries, Southern Nuclear and SEGCO to furnish, at cost and upon request, the following services: general executive and advisory services, power pool operations, general engineering, design engineering, purchasing, accounting and statistical, finance and treasury, taxes, insurance and pensions, corporate, rates, budgeting, public relations, employee relations, systems and procedures and other services with respect to business and operations. SOUTHERN also has a contract with SCS for certain of these specialized services. Southern Nuclear has contracted with ALABAMA to operate its Farley Nuclear Plant, as authorized by amendments to the plant operating licenses. Southern Nuclear also has a contract to provide GEORGIA with technical and other services to support GEORGIA's operation of plants Hatch and Vogtle. Applications are now pending before the NRC for amendments to the Hatch and Vogtle operating licenses which would authorize Southern Nuclear to become the operator. See Item 1 - BUSINESS - "Regulation - Atomic Energy Act of 1954" herein. NEW BUSINESS DEVELOPMENT SOUTHERN continues to consider new business opportunities, particularly those which allow use of the expertise and resources developed through its regulated utility experience. These endeavors began in 1981 and are conducted through SEI and other existing subsidiaries. SEI's primary business focus is international and domestic cogeneration, the independent power market, and the privatization of generation facilities in the international market. SEI currently operates two domestic independent power production projects totaling 225 megawatts and is one-third owner of one of these (which produces 180 megawatts). It has a contract to sell electric energy to Virginia Electric and Power Company from a facility SEI is developing (through subsidiaries) in King George, Virginia. Upon completion, currently planned for 1996, SEI will operate the 220 megawatt coal-fired plant and own 50% of the project. In April 1993, SOUTHERN completed the purchase of a 50% interest in Freeport, an electric utility on the Island of Grand Bahama, for a purchase price of $35.5 million. Freeport has generating capacity of about 112 megawatts. In August 1993, SOUTHERN completed the purchase of a 55% interest in Alicura, an entity that owns the right to use the generation from a 1,000 megawatt hydroelectric generating facility in Argentina, for a net purchase price of approximately $188 million. In December 1993, SOUTHERN completed the purchase of a 35% interest in Edelnor for the purchase price of $73 million. Edelnor is a utility located in Northern Chile that owns and operates a transmission grid and a 96 megawatt generating facility and is building an additional 150 megawatt facility. SEI has continued to render consulting services and market SOUTHERN system expertise in the United States and throughout the world. It contracts with other public utilities, commercial concerns and government agencies for the rendition of services and the licensing of intellectual property. In addition, SEI engages in energy management-related services and activities. These continuing efforts to invest in and develop new business opportunities offer the potential of earning returns which may exceed those of rate-regulated operations. However, because of the absence of any assured return or rate of return, they also involve a higher I-2 degree of risk. SOUTHERN expects to make substantial investments over the period 1994-1996 in these and other new businesses. CERTAIN FACTORS AFFECTING THE INDUSTRY The electric utility industry is expected to become increasingly competitive in the future as a result of the enactment of the Energy Act (see each registrant's "Management's Discussion and Analysis - Future Earnings Potential" in Item 7 herein), deregulation, competing technologies and other factors. In recent years the electric utility industry in general has experienced problems in a number of areas including the uncertain cost of capital needed for construction programs, difficulty in obtaining sufficient return on invested capital and in securing adequate rate increases when required, high costs and other issues associated with compliance with environmental and nuclear regulations, changes in regulatory climate, prudence audits and the effects of inflation and other factors on the costs of operations and construction expenditures. The SOUTHERN system has been experiencing certain of these problems in varying degrees and management is unable to predict the future effect of these or other factors upon its operations and financial condition. CONSTRUCTION PROGRAMS The subsidiary companies of SOUTHERN are engaged in continuous construction programs to accommodate existing and estimated future loads on their respective systems. Construction additions or acquisitions of property during 1994 through 1996 by the operating affiliates, SEGCO, SCS and Southern Nuclear are estimated as follows: (in millions) *Does not add due to changes made in subsidiaries' construction budget subsequent to approval of SOUTHERN system construction budget. Reference is made to Note 4 to the financial statements of each registrant in Item 8 herein for the amounts of AFUDC included in the above estimates. The construction estimates for the period 1994 through 1996 do not include amounts which may be spent by SEI (or the subsidiary(s) created to effect such project(s)) on future power production projects or the projects discussed earlier under "New Business Development." (See also Item 1 - BUSINESS - "Financing Programs" herein.) I-3 Estimated construction costs in 1994 are expected to be apportioned approximately as follows: (in millions) *SCS and Southern Nuclear plan capital additions to general plant in 1994 of $26 million and $1 million, respectively, while SEGCO plans capital additions of $14 million to generating facilities. Does not add due to changes made in subsidiaries' construction budget subsequent to approval of SOUTHERN system construction budget. The construction programs are subject to periodic review and revision, and actual construction costs may vary from the above estimates because of numerous factors. These factors include changes in business conditions; revised load growth estimates; changes in environmental regulations; changes in existing nuclear plants to meet new regulatory requirements; increasing cost of labor, equipment and materials; cost of capital and SEI securing a contract(s) to buy or build additional generating facilities. The operating affiliates do not have any baseload generating plants under construction and current energy demand forecasts do not require any additional baseload generating facilities before 2011. However, within the service area, the construction of combustion turbine peaking units with an aggregate capacity of approximately 1,700 megawatts is planned to be completed by 1996. In addition, significant construction of transmission and distribution facilities and upgrading of generating plants will be continuing. During 1991, the Georgia legislature passed legislation which requires GEORGIA and SAVANNAH each to file an Integrated Resource Plan for approval by the Georgia PSC. Under the plan rules, the Georgia PSC must pre-certify the construction of new power plants. (See Item 1 - BUSINESS - "Rate Matters - Integrated Resource Planning" herein.) See Item 1 - BUSINESS - "Regulation - Environmental Regulation" herein for information with respect to certain existing and proposed environmental requirements and Item 2

ITEM 2. PROPERTIES ELECTRIC PROPERTIES The operating affiliates and SEGCO, at December 31, 1993, operated 33 hydroelectric generating stations, 31 fossil fuel generating stations and three nuclear generating stations. The amounts of capacity owned by each company are shown in the table below. I-18 Notes: (1) Owned by ALABAMA and MISSISSIPPI as tenants in common in the proportions of 60% and 40%, respectively. (2) Excludes the capacity owned by AEC. (See Item 2 - PROPERTIES - "Jointly-Owned Facilities" herein.) (3) Capacity shown is GEORGIA's or GULF's (Unit 3 only) current portion: 8.4% of Units 1 and 2, 75% (25% for GULF) for Unit 3 and 33.1% for Unit 4 of total plant capacity. See Item 2 - PROPERTIES - "Proposed Sales of Property" and "Jointly-Owned Facilities" herein. (4) Capacity shown is GEORGIA's portion (53.5%) of total plant capacity. (5) Represents 50% of the plant which is owned as tenants in common by GULF and MISSISSIPPI. (6) SEGCO is jointly-owned by ALABAMA and GEORGIA. (See Item 1 - BUSINESS herein.) (7) Capacity shown is GEORGIA's portion (50.1%) of total plant capacity. (8) Capacity shown is GEORGIA's portion (45.7%) of total plant capacity. (9) Generation is dedicated to a single industrial customer. Except as discussed below under "Titles to Property", the principal plants and other important units of the SOUTHERN system are owned in fee by the operating affiliates and SEGCO. It is the opinion of management of each such company that its operating properties are adequately maintained and are substantially in good operating condition. MISSISSIPPI owns a 79-mile length of 500-kilovolt transmission line which is leased to Gulf States. The line, completed in 1984, extends from Plant Daniel to the Louisiana state line. Gulf States is paying a use fee over a forty-year period covering all expenses and the amortization of the original $57 million cost of the line. The all-time maximum demand on the SOUTHERN system was 25,936,900 kilowatts and occurred in July 1993. This amount excludes demand served by generation retained by OPC, MEAG and Dalton and excludes demand associated with power purchased from SEPA by its preference customers. At that time, 27,342,700 kilowatts were supplied by SOUTHERN system generation and 1,405,800 kilowatts (net) were sold to other parties through net purchased and interchanged power. The reserve margin for the Southern electric system at that time was 13.2%. For information on the other registrants' peak demands reference is made to Item 6 - SELECTED FINANCIAL DATA herein. ALABAMA and GEORGIA will incur significant costs in decommissioning their nuclear units at the end of their useful lives. (See Item 1 - BUSINESS - I-19 "Regulation - Atomic Energy Act of 1954" and Note 1 to SOUTHERN's, ALABAMA's and GEORGIA's financial statements in Item 8 herein.) OTHER ELECTRIC GENERATION FACILITIES Through special purpose subsidiaries, SOUTHERN owns a 50% interest in Freeport, a 35% interest in Edelnor, a 55.3% interest Alicura and a 33.3% interest in a co-generation facility in Hawaii. For further discussion of other SEI projects, see Item 1 - BUSINESS - "New Business Development" herein. The generating capacity of these utilities (or facilities) at December 31, 1993, was as follows: * Represents a concession contract that provides SEI with the rights to use the generation. I-20 JOINTLY-OWNED FACILITIES ALABAMA has sold an undivided interest in two units of Plant Miller to AEC. GEORGIA has sold undivided interests in certain generating plants and other related facilities to OPC, MEAG, Dalton, FP&L and JEA. The percentages of ownership resulting from these sales are as follows: ALABAMA and GEORGIA have contracted to operate and maintain the respective units in which each has an interest (other than Rocky Mountain, as described below) as agent for the joint owners. See "Proposed Sales of Property" below for a description of the proposed sale of GEORGIA's remaining unsold ownership interest in Plant Scherer Unit 4. In connection with the joint ownership arrangements for Plant Vogtle, GEORGIA has remaining commitments to purchase declining fractions of OPC's and MEAG's capacity and energy until 1994 for Unit 1 and 1996 for Unit 2 and, with regard to a portion of a 5% interest in Plant Vogtle owned by MEAG, until the latter of the retirement of the plant or the latest stated maturity date of MEAG's bonds issued to finance such ownership interest. The payments for capacity are required whether any capacity is available. The energy cost is a function of each unit's variable operating costs. Except for the portion of the capacity payments related to the 1987 and 1990 write-offs of Plant Vogtle costs, the cost of such capacity and energy is included in purchased power in the Statements of Income in Item 8 herein. In December 1988, GEORGIA and OPC completed a joint ownership agreement for the Rocky Mountain project under which GEORGIA will retain its present investment in the project and OPC will finance, complete and operate the facility. Upon completion (scheduled for 1995), GEORGIA will own an undivided interest in the project equal to the proportion its investment bears to the total investment in the project (excluding each party's cost of funds and ad valorem taxes). For purposes of the ownership formula, GEORGIA's investment will be expressed in nominal dollars and OPC's investment will be expressed in constant 1987 dollars. Based on current cost estimates, GEORGIA's final ownership is estimated at approximately 25% of the project at completion. GEORGIA has held preliminary discussions regarding the potential disposition of its remaining interest in the project. PROPOSED SALES OF PROPERTY In 1991 and 1993, GEORGIA completed the first two in a series of four separate transactions to sell Unit 4 of Plant Scherer to FP&L and JEA for a total price of approximately $806 million, including any gains on these transactions. FP&L would eventually own approximately 76.4% of this unit, with JEA owning the remainder. The capacity from this unit was previously dedicated to off-system sales contracts with Gulf States that were suspended in 1988. GEORGIA will continue to operate the unit. I-21 The 1991 and 1993 sales and the remaining transactions are scheduled as follows: Plant Scherer, a jointly owned coal-fired generating plant, has four units with a total capacity of 3,272 megawatts. Unit 4 was completed in 1989. TITLES TO PROPERTY The operating affiliates' and SEGCO's interests in the principal plants (other than certain pollution control facilities, one small hydroelectric generating station leased by GEORGIA and the land on which four combustion turbine generators of MISSISSIPPI are located, which is held by easement) and other important units of the respective companies are owned in fee by such companies, subject only to the liens of applicable mortgage indentures (except for SEGCO) and to excepted encumbrances as defined therein. The operating affiliates own the fee interests in certain of their principal plants as tenants in common. (See Item 2 - PROPERTIES - "Jointly-Owned Facilities" herein.) Properties such as electric transmission and distribution lines and steam heating mains are constructed principally on rights-of-way which are maintained under franchise or are held by easement only. A substantial portion of lands submerged by reservoirs is held under flood right easements. In substantially all of its coal reserve lands, SEGCO owns or will own the coal only, with adequate rights for the mining and removal thereof. PROPERTY ADDITIONS AND RETIREMENTS During the period from January 1, 1989, to December 31, 1993, the operating affiliates, SEGCO, and other (i.e. SCS, Southern Nuclear and, beginning in 1993, various of the special purpose subsidiaries) gross property additions and retirements were as follows: (1) Includes approximately $62 million attributable to property sold to AEC in 1992. (2) Includes approximately $480 million attributable to property sold to OPC, FP&L and JEA, but excludes $231 million from the write-off of certain Plant Vogtle costs in 1990. (3) Net of intercompany eliminations. ITEM 3.

ITEM 3. LEGAL PROCEEDINGS (1) STEPAK V. CERTAIN SOUTHERN OFFICIALS (U.S. District Court for the Southern District of Georgia) In April 1991, two SOUTHERN stockholders filed a derivative action suit against certain current and former directors and officers of SOUTHERN. The suit alleges violations of RICO by officers and breaches of fiduciary duty and gross negligence by all defendants resulting from alleged fraudulent accounting for spare parts, illegal political campaign contributions, violations of federal securities laws involving misrepresentations and omissions in SEC filings, and concealment of the foregoing acts. The complaint seeks damages, including treble damages pursuant to RICO, in an unspecified amount, which if awarded, would be payable to SOUTHERN. The plaintiffs' amended complaint was dismissed by the court in March 1992. The court ruled the plaintiffs had failed to present adequately their allegation that the I-22 SOUTHERN board of directors' refusal of an earlier demand by the plaintiffs was wrongful. The plaintiffs appealed the dismissal to the U.S. Court of Appeals for the Eleventh Circuit. (2) JOHNSON V. ALABAMA (Circuit Court of Shelby County, Alabama) In September 1990, two customers of ALABAMA filed a civil complaint in the Circuit Court of Shelby County, Alabama, against ALABAMA seeking to represent all persons who, prior to June 23, 1989, entered into agreements with ALABAMA for the financing of heat pumps and other merchandise purchased from vendors other than ALABAMA. The plaintiffs contended that ALABAMA was required to obtain a license under the Alabama Consumer Finance Act to engage in the business of making consumer loans. The plaintiffs were seeking an order declaring these agreements null and void and requiring ALABAMA to refund all payments, principal and interest, made under these agreements. The aggregate amount under these agreements, together with interest paid, currently is estimated to be $40 million. In June 1993, the court ordered ALABAMA to refund or forfeit interest of approximately $10 million because of ALABAMA's failure to obtain such license. However, the court's order did not require any refund or forfeiture with respect to any principal payments under the agreements at issue. ALABAMA has appealed the court's order to the Supreme Court of Alabama. The final outcome of this matter cannot be determined; however, in management's opinion, the final outcome will not have a material adverse effect on SOUTHERN's or ALABAMA's financial statements. (3) OHIO RIVER COMPANY, ET AL.VS. GULF, ET AL. (U.S. District Court for Southern District of Ohio, Western Division) In 1993, a complaint against GULF and SCS was filed in federal district court in Ohio by two companies with which GULF had contracted for the transportation by barge for certain GULF coal supplies. The complaint alleges breach of the contract by GULF and seeks damages estimated by the plaintiffs to be in excess of $85 million. The final outcome of this matter cannot now be determined; however, in management's opinion the final outcome will not have a material adverse effect on SOUTHERN's or GULF's financial statements. See Item 1 - BUSINESS - "Construction Programs," "Fuel Supply," "Regulation - - Federal Power Act" and "Rate Matters", for a description of certain other administrative and legal proceedings discussed therein. Additionally, each of the operating affiliates and SEI are, in the normal course of business, engaged in litigation or administrative proceedings that include, but are not limited to, acquisition of property, injuries and damages claims, and complaints by present and former employees. In management's opinion these various actions will not have a material adverse effect on any of the registrants' financial statements. ITEM 4.

ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS None. I-23 EXECUTIVE OFFICERS OF SOUTHERN (Inserted in Part I in accordance with Regulation S-K, Item 401(b), Instruction 3) EDWARD L. ADDISON Chairman and CEO Age 63 Elected in 1983; responsible primarily for the formation of overall corporate policy. He was elected Chairman of SOUTHERN effective January 1994. A. W. DAHLBERG President and Director Age 53 Elected in 1985; President and Chief Executive Officer of GEORGIA from 1988 through 1993. He was elected Executive Vice President of SOUTHERN in 1991. He was elected President of SOUTHERN effective January 1994. PAUL J. DENICOLA Executive Vice President and Director Age 45 Elected in 1989; Executive Vice President of SOUTHERN since 1991. Elected President and Chief Executive Officer of SCS effective January 1994. He previously served as Executive Vice President of SCS from 1991 to 1993 and President and Chief Executive Officer of MISSISSIPPI from 1989 to 1991. H. ALLEN FRANKLIN Executive Vice President and Director Age 49 Elected in 1988; President and Chief Executive Officer of SCS from 1988 through 1993 and, beginning 1991, Executive Vice President of SOUTHERN. He was elected President and CEO of GEORGIA effective January 1994. ELMER B. HARRIS Executive Vice President and Director Age 54 Elected in 1989; President and Chief Executive Officer of ALABAMA since 1989 and, beginning 1991, Executive Vice President of SOUTHERN. He previously served as Senior Executive Vice President of GEORGIA from 1986 to 1989. W. L. WESTBROOK Financial Vice President Age 54 Elected in 1986; responsible primarily for all aspects of financing for SOUTHERN. He has served as Executive Vice President of SCS since 1986. BILL M. GUTHRIE Vice President Age 60 Elected in 1991; serves as Chief Production Officer for the SOUTHERN system. Senior Executive Vice President of SCS effective January 1994. He has also served as Executive Vice President of ALABAMA since 1988. Each of the above is currently an officer of SOUTHERN, serving a term running from the last annual meeting of the directors (May 26, 1993) for one year until the next annual meeting or until his successor is elected and qualified. I-24 PART II ITEM 5.

ITEM 5. MARKET FOR REGISTRANTS' COMMON EQUITY AND RELATED STOCKHOLDER MATTERS (a) The common stock of SOUTHERN is listed and traded on the New York Stock Exchange. The stock is also traded on regional exchanges across the United States. High and low stock prices, per the New York Stock Exchange Composite Tape and as adjusted to reflect a two-for-one stock split in the form of a stock distribution for each share held as of February 7, 1994, during each quarter for the past two years were as follows: There is no market for the other registrants' common stock, all of which is owned by SOUTHERN. On February 28, 1994, the closing price of SOUTHERN's common stock was $20-5/8. (b) Number of SOUTHERN's common stockholders at December 31, 1993: 237,105 Each of the other registrants have one common stockholder, SOUTHERN. (c) Common dividends are payable at the discretion of each registrant's board of directors. The common dividends paid by SOUTHERN and the operating affiliates to their stockholder(s) for the past two years were as follows: (in thousands) In January 1994, SOUTHERN's board of directors authorized a two-for-one common stock split in the form of a stock distribution for each share held as of February 7, 1994. For all reported common stock data, the number of common shares outstanding and per share amounts for earnings, dividends, and market price have been adjusted to reflect the stock distribution. II-1 The dividend paid per share by SOUTHERN was 27.5c. for each quarter of 1992 and 28.5c. for each quarter of 1993. SOUTHERN's common dividend for the first quarter of 1994 was raised to 29.5c. per share. The amount of common dividends that may be paid by the subsidiary registrants is restricted in accordance with their respective first mortgage bond indenture and charter. The amounts of earnings retained in the business and the amounts restricted against the payment of cash dividends on common stock at December 31, 1993, were as follows: ITEM 6.

ITEM 6. SELECTED FINANCIAL DATA SOUTHERN. Reference is made to information under the heading "Selected Consolidated Financial and Operating Data," contained herein at pages II-38 through II-49. ALABAMA. Reference is made to information under the heading "Selected Financial and Operating Data," contained herein at pages II-78 through II-91. GEORGIA. Reference is made to information under the heading "Selected Financial and Operating Data," contained herein at pages II-123 through II-137. GULF. Reference is made to information under the heading "Selected Financial and Operating Data," contained herein at pages II- 166 through II-179. MISSISSIPPI. Reference is made to information under the heading "Selected Financial and Operating Data," contained herein at pages II-207 through II-220. SAVANNAH. Reference is made to information under the heading "Selected Financial and Operating Data," contained herein at pages II-245 through II-258. ITEM 7.

ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION SOUTHERN. Reference is made to information under the heading "Management's Discussion and Analysis of Results of Operations and Financial Condition," contained herein at pages II-8 through II-15. ALABAMA. Reference is made to information under the heading "Management's Discussion and Analysis of Results of Operations and Financial Condition," contained herein at pages II-53 through II-58. GEORGIA. Reference is made to information under the heading "Management's Discussion and Analysis of Results of Operations and Financial Condition," contained herein at pages II-95 through II-101. GULF. Reference is made to information under the heading "Management's Discussion and Analysis of Results of Operations and Financial Condition," contained herein at pages II-141 through II-147. MISSISSIPPI. Reference is made to information under the heading "Management's Discussion and Analysis of Results of Operations and Financial Condition," contained herein at pages II-183 through II-189. SAVANNAH. Reference is made to information under the heading "Management's Discussion and Analysis of Results of Operations and Financial Condition," contained herein at pages II-224 through II-230. II-2 ITEM 8.

ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA INDEX TO 1993 FINANCIAL STATEMENTS II-3 ITEM 9.

ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE None. II-4 THE SOUTHERN COMPANY AND SUBSIDIARY COMPANIES FINANCIAL SECTION II-5 MANAGEMENT'S REPORT The Southern Company and Subsidiary Companies 1993 Annual Report The management of The Southern Company has prepared -- and is responsible for - -- the consolidated financial statements and related information included in this report. These statements were prepared in accordance with generally accepted accounting principles appropriate in the circumstances and necessarily include amounts that are based on the best estimates and judgments of management. Financial information throughout this annual report is consistent with the financial statements. The company maintains a system of internal accounting controls to provide reasonable assurance that assets are safeguarded and that books and records reflect only authorized transactions of the company. Limitations exist in any system of internal controls, however, based on a recognition that the cost of the system should not exceed its benefits. The company believes its system of internal accounting controls maintains an appropriate cost/benefit relationship. The company's system of internal accounting controls is evaluated on an ongoing basis by the company's internal audit staff. The company's independent public accountants also consider certain elements of the internal control system in order to determine their auditing procedures for the purpose of expressing an opinion on the financial statements. The audit committee of the board of directors, composed of three directors who are not employees, provides a broad overview of management's financial reporting and control functions. Periodically, this committee meets with management, the internal auditors, and the independent public accountants to ensure that these groups are fulfilling their obligations and to discuss auditing, internal controls, and financial reporting matters. The internal auditors and independent public accountants have access to the members of the audit committee at any time. Management believes that its policies and procedures provide reasonable assurance that the company's operations are conducted according to a high standard of business ethics. In management's opinion, the consolidated financial statements present fairly, in all material respects, the financial position, results of operations, and cash flows of The Southern Company and its subsidiaries in conformity with generally accepted accounting principles. As discussed in Note 4 to the financial statements, an uncertainty exists with respect to the actions of regulators regarding recoverability of the investment in the Rocky Mountain pumped storage hydroelectric project. The outcome of this uncertainty cannot be determined until regulatory proceedings are concluded. Accordingly, no provision for any write-down of the costs associated with the Rocky Mountain project resulting from the potential actions of the Georgia Public Service Commission has been made in the accompanying financial statements. /s/ E. L. Addison /s/ W. L. Westbrook - ------------------------------------ ---------------------------- Edward L. Addison W. L. Westbrook Chairman and Chief Executive Officer Financial Vice President II-6 REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS TO THE BOARD OF DIRECTORS AND TO THE STOCKHOLDERS OF THE SOUTHERN COMPANY: We have audited the accompanying consolidated balance sheets and consolidated statements of capitalization of The Southern Company (a Delaware corporation) and its subsidiaries as of December 31, 1993 and 1992, and the related consolidated statements of income, retained earnings, paid-in capital, and cash flows for each of the three years in the period ended December 31, 1993. These financial statements are the responsibility of the company's management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements (pages II-16 through II-37) referred to above present fairly, in all material respects, the financial position of The Southern Company and its subsidiaries as of December 31, 1993 and 1992, and the results of their operations and their cash flows for the periods stated, in conformity with generally accepted accounting principles. As explained in Notes 2 and 9 to the financial statements, effective January 1, 1993, The Southern Company changed its methods of accounting for postretirement benefits other than pensions and for income taxes. As more fully discussed in Note 4 to the financial statements, an uncertainty exists with respect to the actions of the regulators regarding recoverability of the investment in the Rocky Mountain pumped storage hydroelectric project. The outcome of this uncertainty cannot be determined until regulatory proceedings are concluded. Accordingly, no provision for any write-down of the costs associated with the Rocky Mountain project resulting from the potential actions of the Georgia Public Service Commission has been made in the accompanying financial statements. /s/ Arthur Andersen & Co. Atlanta, Georgia February 16, 1994 II-7 MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION The Southern Company and Subsidiary Companies 1993 Annual Report RESULTS OF OPERATIONS EARNINGS AND DIVIDENDS The Southern Company's 1993 financial performance exceeded the strong results recorded for 1992, and set several new records. The company's financial strength continued to gain momentum for the third consecutive year. In January 1994, The Southern Company board of directors increased the quarterly dividend rate by 3.5 percent, and approved a two-for-one common stock split in the form of a stock distribution. For all reported common stock data, the number of common shares outstanding and per share amounts for earnings, dividends, and market price have been adjusted to reflect the stock distribution. For 1993, The Southern Company's net income of $1.0 billion established a new record high and the company's common stock reached an all-time high closing price during the year of 23 3/8 -- surpassing the record of 19 1/2 set in 1992. Also, return on average common equity reached the highest level since 1986. Earnings reported for 1993 totaled $1,002 million or $1.57 per share, an increase of $49 million or 6 cents per share from the previous year. Both 1993 and 1992 earnings were affected by special non-operating or non-recurring items. After excluding these special items in both years, earnings from operations of the ongoing business of selling electricity were $1,016 million or $1.59 per share, an increase of $77 million or 10 cents per share compared with 1992. The special items that affected 1993 and 1992 earnings were as follows: In 1993, several items -- both positive and negative -- had an impact on earnings, which resulted in a net reduction of $14 million. These items were: (1) The conclusion of a settlement agreement -- discussed later -- with Gulf States Utilities (Gulf States) increased earnings. (2) The second in a series of four separate transactions to sell Plant Scherer Unit 4 to two Florida utilities increased earnings. (3) Environmental clean-up costs incurred at sites located in Alabama and Georgia decreased earnings. (4) Costs associated with a transportation fleet reduction program decreased earnings. The improvements in 1993 earnings resulted primarily from increased retail energy sales and continued emphasis on effective cost controls. The special items that increased 1992 earnings were primarily related to additional settlement provisions from Gulf States, and to gains on the sale of Gulf States common stock received in 1991. Returns on average common equity were 13.43 percent in 1993, 13.42 percent in 1992, and 12.74 percent in 1991. Dividends paid on common stock during 1993 were $1.14 per share or 28 1/2 cents per quarter. During 1992 and 1991, dividends paid per share were $1.10 and $1.07, respectively. In January 1994, The Southern Company board of directors raised the quarterly dividend to 29 1/2 cents per share or an annual rate of $1.18 per share. REVENUES Operating revenues increased in 1993 and 1992 and decreased in 1991 as a result of the following factors: II-8 MANAGEMENT'S DISCUSSION AND ANALYSIS (continued) The Southern Company and Subsidiary Companies 1993 Annual Report Retail revenues of $7.3 billion in 1993 increased 7.4 percent from last year, compared with an increase of 1.6 percent in 1992. Under fuel cost recovery provisions, fuel revenues generally equal fuel expense -- including the fuel component of purchased energy -- and do not affect net income. Sales for resale revenues within the service area were $447 million in 1993, up 9.2 percent from the prior year. This increase resulted primarily from the prolonged hot summer weather, which increased the demand for electricity. Revenues from sales for resale within the service area were $409 million in 1992, down 1.9 percent from the prior year. The decrease resulted from certain municipalities and cooperatives in the service area retaining more of their own generation at facilities jointly owned with Georgia Power. Revenues from sales to utilities outside the service area under long-term contracts consist of capacity and energy components. Capacity revenues reflect the recovery of fixed costs and a return on investment under the contracts. Energy is generally sold at variable cost. The capacity and energy components were as follows: Capacity revenues decreased in 1993 and 1992 because the amount of capacity under contract declined by some 500 megawatts and 300 megawatts, respectively. In 1994, the contracted capacity will decline another 400 megawatts. Changes in revenues are influenced heavily by the amount of energy sold each year. Kilowatt-hour sales for 1993 and the percent change by year were as follows: The rate of growth in 1993 retail energy sales was the highest since 1986. Residential energy sales registered the highest annual increase in two decades as a result of hotter-than-normal summer weather and the addition of 46,000 new customers. Commercial sales were also affected by the warm summer. Industrial energy sales in 1993 and 1992 showed moderate growth, reflecting a recovery in the business and economic conditions in The Southern Company's service area. Energy sales to retail customers are projected to grow at an average annual rate of 1.7 percent during the period 1994 through 2004. Energy sales for resale outside the service area are predominantly unit power sales under long-term contracts to Florida utilities. Economy sales and amounts sold under short-term contracts are also sold for resale outside the service area. Sales to customers outside the service area have decreased for the third consecutive year primarily as a result of the scheduled decline in megawatts of capacity under contract. In addition, the decline in 1992 and 1991 sales was also influenced by fluctuations in prices for oil and natural gas, the primary fuel sources for utilities with which the company has long-term contracts. When oil and gas prices fall below a certain level, these customers can generate electricity to meet their requirements more economically. However, the fluctuation in these energy sales, excluding the impact of contractual declines, had minimal effect on earnings because The Southern Company is paid for dedicating specific amounts of its generating capacity to these utilities. EXPENSES Total operating expenses of $6.7 billion for 1993 were up 6.5 percent compared with the prior year. The increase was attributable to higher production expenses of $75 million to meet increased energy demands and an additional $50 million in depreciation expenses and property taxes resulting from additional utility plant being placed into service. The transportation fleet reduction program and environmental clean-up costs discussed earlier increased expenses by some $62 million. Also, a $67 million change in deferred Plant Vogtle expenses compared with the amount in 1992 contributed to the rise in total operating expenses. In 1992, total operating expenses of $6.3 billion were at the same level reported for 1991. The costs to produce and deliver electricity in 1992 declined by $165 million primarily as a result of less energy being sold and continued effective cost controls. However, expenses in 1991 were reduced by proceeds from a settlement II-9 MANAGEMENT'S DISCUSSION AND ANALYSIS (continued) The Southern Company and Subsidiary Companies 1993 Annual Report agreement with Gulf States that more than offset the decline in 1992 expenses when compared with 1991. Deferred expenses related to Plant Vogtle in 1992 increased by $47 million when compared with the prior year. Fuel costs constitute the single largest expense for The Southern Company. The mix of fuel sources for generation of electricity is determined primarily by system load, the unit cost of fuel consumed, and the availability of hydro and nuclear generating units. The amount and sources of generation and the average cost of fuel per net kilowatt-hour generated were as follows: Fuel and purchased power expenses of $2.6 billion in 1993 increased 1.3 percent compared with the prior year because of increased energy demands and slightly higher average cost of fuel per net kilowatt-hour generated. Fuel and purchased power costs in 1992 decreased $137 million or 5.0 percent compared with 1991 primarily because 1.1 billion fewer kilowatt-hours were needed to meet customer requirements. Also, the decrease in these costs was attributable to a lower average cost of fuel per net kilowatt-hour generated. Income taxes for 1993 increased $69 million compared with the prior year. The increase is attributable to a number of factors, including a 1 percent increase in the corporate federal income tax rate effective January 1993, the second sale of additional ownership interest in Plant Scherer Unit 4, and the increase in taxable income from operations. For 1992, income taxes rose $11 million or 1.7 percent above the amount reported for 1991. For the fifth consecutive year, total gross interest charges and preferred stock dividends declined from amounts reported in the previous year. The declines are attributable to lower interest rates and significant refinancing activities during the past two years. In 1993, these costs were $831 million - -- down $21 million or 2.3 percent. These costs for 1992 decreased $71 million. As a result of favorable market conditions during 1993, some $3.0 billion of senior securities was issued for the primary purpose of retiring higher-cost debt and preferred stock. EFFECTS OF INFLATION The Southern Company is subject to rate regulation and income tax laws that are based on the recovery of historical costs. Therefore, inflation creates an economic loss because the company is recovering its costs of investments in dollars that have less purchasing power. While the inflation rate has been relatively low in recent years, it continues to have an adverse effect on The Southern Company because of the large investment in long-lived utility plant. Conventional accounting for historical cost does not recognize this economic loss nor the partially offsetting gain that arises through financing facilities with fixed-money obligations such as long-term debt and preferred stock. Any recognition of inflation by regulatory authorities is reflected in the rate of return allowed. FUTURE EARNINGS POTENTIAL The results of operations for the past three years are not necessarily indicative of future earnings potential. The level of future earnings depends on numerous factors ranging from growth in energy sales to regulatory matters. Georgia Power has completed two of four separate transactions to sell Unit 4 of Plant Scherer to two Florida utilities. The remaining transactions are scheduled to take place in 1994 and 1995. If the sales take place as planned, Georgia Power could realize an after-tax gain currently estimated to total approximately $20 million. See Note 7 to the financial statements for additional information. In early 1994, Georgia Power and the system service company announced work force reduction programs that are estimated to reduce 1994 earnings by some $55 million. These actions will assist in efforts to control the growth in operating expenses. II-10 MANAGEMENT'S DISCUSSION AND ANALYSIS (continued) The Southern Company and Subsidiary Companies 1993 Annual Report See Note 4 to the financial statements for information on an uncertainty regarding full recovery of an investment in the Rocky Mountain pumped storage hydroelectric project. Future earnings in the near term will depend upon growth in energy sales, which are subject to a number of factors. Traditionally, these factors have included changes in contracts with neighboring utilities, energy conservation practiced by customers, the elasticity of demand, weather, competition, and the rate of economic growth in the company's service area. However, the Energy Policy Act of 1992 (Energy Act) will have a profound effect on the future of the electric utility industry. The Energy Act promotes energy efficiency, alternative fuel use, and increased competition for electric utilities. The law also includes provisions to streamline the licensing process for new nuclear plants. The Southern Company is preparing to meet the challenge of this major change in the traditional business practices of selling electricity. The Energy Act allows independent power producers (IPPs) to access a utility's transmission network in order to sell electricity to other utilities, and this may enhance the incentive for IPPs to build cogeneration plants for a utility's large industrial and commercial customers and sell excess energy generation to other utilities. Although the Energy Act does not require transmission access to retail customers, pressure for legislation to allow retail wheeling will continue. If The Southern Company does not remain a low-cost producer and provide quality service, the company's retail energy sales growth, as well as new long-term contracts for energy sales outside the service area, could be limited, and this could significantly erode earnings. An important part of the Energy Act was to amend the Public Utility Holding Company Act of 1935 (PUHCA) and allow holding companies to form exempt wholesale generators and foreign utility companies to sell power largely free of regulation under PUHCA. These new entities are able to sell power to affiliates -- under certain restrictions -- and to own and operate power generating facilities in other domestic and international markets. To take advantage of these opportunities, Southern Electric International (Southern Electric) -- founded in 1981 -- is focusing on international and domestic cogeneration, the independent power market, and the privatization of generating facilities in the international market. During 1993, investments of some $315 million were made in entities that own and operate generating facilities in various international markets. In the near term, Southern Electric is expected to have minimal effect on earnings, but the possibility exists that it could be a prime contributor to future earnings growth. Demand-side options -- programs that enable customers to lower or alter their peak energy requirements -- have been implemented by some of the system operating companies and are a significant part of integrated resource planning. See Note 3 to the financial statements under "Georgia Power's Demand-Side Conservation Programs" for information concerning the recovery of certain costs. Customers can receive cash incentives for participating in these programs as well as reduce their energy requirements. Expansion and increased utilization of these programs will be contingent upon sharing of cost savings between the customers and the utility. Besides promoting energy efficiency, another benefit of these programs could be the ability to defer the need to construct baseload generating facilities further into the future. The ability to defer major construction projects in conjunction with precertification approval processes of such projects by the respective state public service commissions in Alabama, Georgia, and Mississippi will diminish the possible exposure to prudency disallowances and the resulting impact on earnings. In addition, Georgia Power has conducted a competitive bidding process for additional peaking capacity needed in 1996 and 1997. To meet expected requirements for 1996, Georgia Power has filed a plan with the state public service commission for certification of a four-year purchase power contract and for an ownership interest in a combustion turbine peaking unit. Rates to retail customers served by the system operating companies are regulated by the respective state public service commissions in Alabama, Florida, Georgia, and Mississippi. Rates for Alabama Power and Mississippi Power are adjusted periodically within certain limitations based on earned retail rate of return compared with an allowed return. See Note 3 to the financial statements for information about other regulatory matters. The Federal Energy Regulatory Commission (FERC) regulates wholesale rate schedules and power sales contracts that The Southern Company has with its sales for resale customers. The FERC currently is reviewing the rate of return on common equity included in some of these schedules and contracts and may require such returns to be lowered, possibly retroactively. See Note 3 to the financial statements under "FERC Reviews Equity Returns" for additional information. Compliance costs related to the Clean Air Act Amendments of 1990 (Clean Air Act) could reduce earnings if such costs are not fully recovered. The Clean Air Act is discussed later under "Environmental Matters." II-11 MANAGEMENT'S DISCUSSION AND ANALYSIS (continued) The Southern Company and Subsidiary Companies 1993 Annual Report NEW ACCOUNTING STANDARDS The Financial Accounting Standards Board (FASB) issued Statement No. 112, Employers' Accounting for Postemployment Benefits, which must be effective by 1994. The new standard requires that all types of benefits provided to former or inactive employees and their families prior to retirement be accounted for on an accrual basis. These benefits include salary continuation, severance pay, supplemental unemployment benefits, disability-related benefits, job training, and health and life insurance coverage. In 1993, The Southern Company adopted Statement No. 112, with no material effect on the financial statements. The FASB has issued Statement No. 115, Accounting for Certain Investments in Debt and Equity Securities, which is effective in 1994. Statement No. 115 supersedes FASB Statement No. 12, Accounting for Certain Marketable Securities. The Southern Company adopted the new rules January 1, 1994, with no material effect on the financial statements. FINANCIAL CONDITION OVERVIEW The Southern Company's financial condition is now the strongest since the mid-1980s. Record levels of performance were set in 1993 related to earnings, market price of common stock, and energy sold to retail customers. In January 1994, The Southern Company board of directors increased the common stock dividend for the third consecutive year, and approved a two-for-one common stock split in the form of a stock distribution. Another major change in The Southern Company's financial condition was gross property additions of $1.4 billion to utility plant. The majority of funds needed for gross property additions since 1990 have been provided from operating activities, principally from earnings and non-cash charges to income such as depreciation and deferred income taxes. The Consolidated Statements of Cash Flows provide additional details. On January 1, 1993, The Southern Company changed its methods of accounting for postretirement benefits other than pensions and for income taxes. See notes 2 and 9 to the financial statements, regarding the impact of these changes. CAPITAL STRUCTURE The company achieved a ratio of common equity to total capitalization -- including short-term debt -- of 43.5 percent in 1993, compared with 42.8 percent in 1992 and 41.5 percent in 1991. The company's goal is to maintain the common equity ratio generally within a range of 40 percent to 45 percent. During 1993, the operating companies sold $2.2 billion of first mortgage bonds and, through public authorities, $385 million of pollution control revenue bonds, at a combined weighted interest rate of 6.5 percent. Preferred stock of $426 million was issued at a weighted dividend rate of 5.7 percent. The operating companies continued to reduce financing costs by retiring higher-cost bonds and preferred stock. Retirements, including maturities, of bonds totaled $2.5 billion during 1993, $2.8 billion during 1992, and $1.0 billion during 1991. Retirements of preferred stock totaled $516 million during 1993, $326 million during 1992, and $125 million during 1991. As a result, the composite interest rate on long-term debt decreased from 9.2 percent at December 31, 1990, to 7.6 percent at December 31, 1993. During this same period, the composite dividend rate on preferred stock declined from 8.5 percent to 6.4 percent. In 1993, The Southern Company raised $205 million from the issuance of new common stock under the Dividend Reinvestment and Stock Purchase Plan (DRIP) and the Employee Savings Plan. At the close of 1993, the company's common stock had a market value of $22.00 per share, compared with a book value of $11.96 per share. The market-to-book value ratio was 184 percent at the end of 1993, compared with 168 percent at year-end 1992 and 156 percent at year-end 1991. CAPITAL REQUIREMENTS FOR CONSTRUCTION The construction program of the operating companies is budgeted at $1.5 billion for 1994, $1.3 billion for 1995, and $1.5 billion for 1996. The total is $4.3 billion for the three years. Actual construction costs may vary from this estimate because of factors such as changes in environmental regulations; changes in existing nuclear plants to meet new regulations; revised load projections; the cost and efficiency of construction labor, equipment, and materials; and the cost of capital. The operating companies do not have any baseload generating plants under construction, and current energy demand forecasts do not require any additional baseload facilities until well into the future. However, within the II-12 MANAGEMENT'S DISCUSSION AND ANALYSIS (continued) The Southern Company and Subsidiary Companies 1993 Annual Report service area, the construction of combustion turbine peaking units of approximately 1,700 megawatts of capacity is planned to be completed by 1996 to meet increased peak-hour demands. In addition, significant construction of transmission and distribution facilities and upgrading of generating plants will be continuing. OTHER CAPITAL REQUIREMENTS In addition to the funds needed for the construction program, approximately $789 million will be required by the end of 1996 for present sinking fund requirements, redemptions announced, and maturities of long-term debt. Also, the operating subsidiaries plan to continue a program to retire higher-cost debt and preferred stock and replace these obligations with lower-cost capital. ENVIRONMENTAL MATTERS In November 1990, the Clean Air Act was signed into law. Title IV of the Clean Air Act -- the acid rain compliance provision of the law -- will have a significant impact on The Southern Company. Specific reductions in sulfur dioxide and nitrogen oxide emissions from fossil-fired generating plants will be required in two phases. Phase I compliance must be implemented in 1995 and affects eight generating plants -- some 10,000 megawatts of capacity or 35 percent of total capacity -- in the Southern electric system. Phase II compliance is required in 2000, and all fossil-fired generating plants in the Southern electric system will be affected. Beginning in 1995, the Environmental Protection Agency (EPA) will allocate annual sulfur dioxide emission allowances through the newly established allowance trading program. An emission allowance is the authority to emit one ton of sulfur dioxide during a calendar year. The method for allocating allowances is based on the fossil fuel consumed from 1985 through 1987 for each affected generating unit. Emission allowances are transferable and can be bought, sold, or banked and used in the future. The sulfur dioxide emission allowance program is expected to minimize the cost of compliance. The market for emission allowances is developing slower than expected. However, The Southern Company's sulfur dioxide compliance strategy is designed to take advantage of allowances as the market develops. The Southern Company expects to achieve Phase I sulfur dioxide compliance at the eight affected plants by switching to low-sulfur coal, and this has required some equipment upgrades. This compliance strategy is expected to result in unused emission allowances being banked for later use. Additional construction expenditures are required to install equipment for the control of nitrogen oxide emissions at these eight plants. Also, continuous emissions monitoring equipment would be installed on all fossil-fired units. Under this Phase I compliance approach, additional construction expenditures are estimated to total approximately $275 million through 1995. Phase II compliance costs are expected to be higher because requirements are stricter and all fossil-fired generating plants are affected. For sulfur dioxide compliance, The Southern Company could use emission allowances banked during Phase I, increase fuel switching, install flue gas desulfurization equipment at selected plants, and/or purchase more allowances depending on the price and availability of allowances. Also, in Phase II, equipment to control nitrogen oxide emissions will be installed on additional system fossil-fired plants as required to meet anticipated Phase II limits. Therefore, during the period 1996 to 2000, compliance could require total construction expenditures ranging from approximately $450 million to $800 million. However, the full impact of Phase II compliance cannot now be determined with certainty, pending the development of a market for emission allowances, the completion of EPA regulations, and the possibility of new emission reduction technologies. An average increase of up to 3 percent in revenue requirements from customers could be necessary to fully recover the cost of compliance for both Phase I and Phase II of the Clean Air Act. Compliance costs include construction expenditures, increased costs for switching to low-sulfur coal, and costs related to emission allowances. There can be no assurance that all Clean Air Act costs will be recovered. Metropolitan Atlanta is classified as a non-attainment area with regard to the ozone ambient air quality standards. Title I of the Clean Air Act requires the state of Georgia to conduct specific studies and establish new control rules by November 1994 -- affecting sources of nitrogen oxides and volatile organic compounds -- to achieve attainment by 1999. As the required first step, the state has issued rules for the application of reasonably available control technology to reduce nitrogen oxide emissions by May 31, 1995. The results of these new rules require nitrogen oxide controls, above Title IV II-13 MANAGEMENT'S DISCUSSION AND ANALYSIS (continued) The Southern Company and Subsidiary Companies 1993 Annual Report requirements, on some Georgia Power plants. Final attainment rules, based on modeling studies, could require installation of additional controls for nitrogen oxide emissions as early as 1997. Compliance with any new rules could result in significant additional costs. The impact of new rules will depend on the development and implementation of such rules. Title III of the Clean Air Act requires a multi-year EPA study of power plant emissions of hazardous air pollutants. The study will serve as the basis for a decision on whether additional regulatory control of these substances is warranted. Compliance with any new control standards could result in significant additional costs. The impact of new standards -- if any -- will depend on the development and implementation of applicable regulations. The EPA continues to evaluate the need for a new short-term ambient air quality standard for sulfur dioxide. Preliminary results from an EPA study on the impact of a new standard indicate that a number of plants could be required to install sulfur dioxide controls. These controls would be in addition to the controls already required to meet the acid rain provision of the Clean Air Act. The EPA is expected to take some action on this issue in 1994. The impact of any new standard will depend on the level chosen for the standard and cannot be determined at this time. In addition, the EPA is evaluating the need to revise the ambient air quality standards for particulate matter, nitrogen oxides, and ozone. The impact of any new standard will depend on the level chosen for the standard and cannot be determined at this time. In 1994 or 1995, the EPA is expected to issue revised rules on air quality control regulations related to stack height requirements of the Clean Air Act. The full impact of the final rules cannot be determined at this time, pending their development and implementation. In 1993, the EPA issued a ruling confirming the non-hazardous status of coal ash. However, the EPA has until 1998 to classify co-managed utility wastes -- coal ash and other utility wastes -- as either non-hazardous or hazardous. If the EPA classifies the co-managed wastes as hazardous, then substantial additional costs for the management of such wastes may be required. The full impact of any change in the regulatory status will depend on the subsequent development of co-managed waste requirements. The Southern Company must comply with other environmental laws and regulations that cover the handling and disposal of hazardous waste. Under these various laws and regulations, the company could incur costs to clean up properties currently or previously owned. The company conducts studies to determine the extent of any required clean-up costs and has recognized in the financial statements costs to clean up known sites. Several major pieces of environmental legislation are in the process of being reauthorized or amended by Congress. These include: the Clean Water Act; the Comprehensive Environmental Response, Compensation, and Liability Act; and the Resource Conservation and Recovery Act. Changes to these laws could affect many areas of The Southern Company's operations. The full impact of these requirements cannot be determined at this time, pending the development and implementation of applicable regulations. Compliance with possible new legislation related to global climate change, electromagnetic fields, and other environmental and health concerns could significantly affect The Southern Company. The impact of new legislation -- if any -- will depend on the subsequent development and implementation of applicable regulations. In addition, the potential for lawsuits alleging damages caused by electromagnetic fields exists. SOURCES OF CAPITAL In early 1994, The Southern Company sold -- through a public offering -- common stock with proceeds totaling $120 million. The company may require additional equity capital during the remainder of 1994. The amount and timing of additional equity capital to be raised in 1994 -- as well as in subsequent years -- will be contingent on The Southern Company's investment opportunities. Equity capital can be provided from any combination of public offerings, private placements, or the company's stock plans. Any portion of the common stock required during 1994 for the DRIP and the employee stock plans that is not provided from the issuance of new stock will be acquired on the open market in accordance with the terms of such plans. The operating subsidiaries plan to obtain the funds required for construction and other purposes from sources similar to those used in the past. However, the type and timing of any financings -- if needed -- will depend on market conditions and regulatory approval. II-14 MANAGEMENT'S DISCUSSION AND ANALYSIS (continued) The Southern Company and Subsidiary Companies 1993 Annual Report Completing the sale of Unit 4 of Plant Scherer will provide some $260 million of cash during the years 1994 and 1995. As required by the Nuclear Regulatory Commission, Alabama Power and Georgia Power established external sinking funds for nuclear decommissioning costs. For 1994 through 2000, the combined amount to be funded for both Alabama Power and Georgia Power totals $36 million annually. The cumulative effect of funding over this period will diminish internally funded capital and may require capital from other sources. For additional information concerning nuclear decommissioning costs, see Note 1 to the financial statements under "Depreciation and Nuclear Decommissioning." To meet short-term cash needs and contingencies, the system companies had approximately $178 million of cash and cash equivalents and $1.1 billion of unused credit arrangements with banks at the beginning of 1994. To issue additional first mortgage bonds and preferred stock, the operating companies must comply with certain earnings coverage requirements designated in their mortgage indentures and corporate charters. The ability to issue securities in the future will depend on coverages at that time. The coverage ratios were, at the end of the respective years, as follows: *Savannah Electric's requirement is 2.50. II-15 CONSOLIDATED STATEMENTS OF INCOME For the Years Ended December 31, 1993, 1992, and 1991 The Southern Company and Subsidiary Companies 1993 Annual Report CONSOLIDATED STATEMENTS OF RETAINED EARNINGS For the Years Ended December 31, 1993, 1992, and 1991 The accompanying notes are an integral part of these statements. II-16 CONSOLIDATED STATEMENTS OF CASH FLOWS For the Years Ended December 31, 1993, 1992, and 1991 The Southern Company and Subsidiary Companies 1993 Annual Report The accompanying notes are an integral part of these statements. II-17 CONSOLIDATED STATEMENTS OF BALANCE SHEETS At December 31, 1993, and 1992 The Southern Company and Subsidiary Companies 1993 Annual Report The accompanying notes are an integral part of these balance sheets. II-18 CONSOLIDATED BALANCE SHEETS (continued) At December 31, 1993 and 1992 The Southern Company and Subsidiary Companies 1993 Annual Report The accompanying notes are an integral part of these balance sheets. II-19 CONSOLIDATED STATEMENTS OF CAPITALIZATION At December 31, 1993 and 1992 The Southern Company and Subsidiary Companies 1993 Annual Report II-20 CONSOLIDATED STATEMENTS OF CAPITALIZATION (continued) At December 31, 1993 and 1992 The Southern Company and Subsidiary Companies 1993 Annual Report The accompanying notes are an integral part of these statements. II-21 NOTES TO FINANCIAL STATEMENTS The Southern Company and Subsidiary Companies 1993 Annual Report 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES GENERAL The Southern Company is the parent company of five operating companies, a system service company, Southern Electric International (Southern Electric), Southern Nuclear Operating Company (Southern Nuclear), and various other subsidiaries related to foreign utility operations and domestic non-utility operations. At this time, the operations of the other subsidiaries are not material. The operating companies provide electric service in four Southeastern states. Contracts among the companies -- dealing with jointly owned generating facilities, interconnecting transmission lines, and the exchange of electric power -- are regulated by the Federal Energy Regulatory Commission (FERC) or the Securities and Exchange Commission (SEC). The system service company provides, at cost, specialized services to The Southern Company and to the subsidiary companies. Southern Electric designs, builds, owns, and operates power production facilities and provides a broad range of technical services to industrial companies and utilities in the United States and a number of international markets. Southern Nuclear provides services to The Southern Company's nuclear power plants. The Southern Company is registered as a holding company under the Public Utility Holding Company Act of 1935 (PUHCA). Both the company and its subsidiaries are subject to the regulatory provisions of the PUHCA. The operating companies also are subject to regulation by the FERC and their respective state regulatory commissions. The companies follow generally accepted accounting principles and comply with the accounting policies and practices prescribed by their respective commissions. All material intercompany items have been eliminated in consolidation. Consolidated retained earnings at December 31, 1993, include $2.6 billion of undistributed retained earnings of subsidiaries. Certain prior years' data presented in the consolidated financial statements have been reclassified to conform with current year presentation. REVENUES AND FUEL COSTS The operating companies accrue revenues for service rendered but unbilled at the end of each fiscal period. Fuel costs are expensed as the fuel is used. The operating companies' electric rates include provisions to adjust billings for fluctuations in fuel and the energy component of purchased power costs. Revenues are adjusted for differences between recoverable fuel costs and amounts actually recovered in current rates. Fuel expense includes the amortization of the cost of nuclear fuel and a charge, based on nuclear generation, for the permanent disposal of spent nuclear fuel. Total charges for nuclear fuel included in fuel expense amounted to $137 million in 1993, $132 million in 1992, and $162 million in 1991. Alabama Power and Georgia Power have contracts with the U.S. Department of Energy (DOE) that provide for the permanent disposal of spent nuclear fuel, which was scheduled to begin in 1998. However, the actual year this service will begin is uncertain. Sufficient storage capacity currently is available to permit operation into 2003 at Plant Hatch, into 2009 at Plant Vogtle, and into 2012 and 2014 at Plant Farley units 1 and 2, respectively. Also, the Energy Policy Act of 1992 required the establishment in 1993 of a Uranium Enrichment Decontamination and Decommissioning Fund, which is to be funded in part by a special assessment on utilities with nuclear plants. This assessment will be paid over a 15-year period, which began in 1993. This fund will be used by the DOE for the decontamination and decommissioning of its nuclear fuel enrichment facilities. The law provides that utilities will recover these payments in the same manner as any other fuel expense. Georgia Power -- based on its ownership interests -- and Alabama Power currently estimate their liability under this law to be approximately $39 million and $46 million, respectively. These obligations are recorded in the Consolidated Balance Sheets. DEPRECIATION AND NUCLEAR DECOMMISSIONING Depreciation of the original cost of depreciable utility plant in service is provided primarily by using composite straight-line rates, which approximated 3.3 percent in 1993, 1992, and 1991. When property subject to depreciation is retired or otherwise disposed of in the normal course of business, its cost -- together with the cost of removal, less salvage -- is charged to the accumulated provision for depreciation. Minor items of property included in the original cost of the plant are retired when the related property unit is retired. Depreciation expense includes an amount for the expected costs of decommissioning nuclear facilities. II-22 NOTES (continued) The Southern Company and Subsidiary Companies 1993 Annual Report In 1988, the Nuclear Regulatory Commission (NRC) adopted regulations requiring all licensees operating commercial power reactors to establish a plan for providing, with reasonable assurance, funds for decommissioning. Reasonable assurance may be in the form of an external sinking fund, a surety method, or prepayment. Alabama Power and Georgia Power have established external sinking funds to comply with the NRC's regulations. Prior to the enactment of these regulations, Alabama Power and Georgia Power had reserved nuclear decommissioning costs. The NRC's minimum external funding requirements are based on a generic estimate of the cost to decommission the radioactive portions of a nuclear unit based on the size and type of reactor. Alabama Power and Georgia Power have filed plans with the NRC to ensure that -- over time -- the deposits and earnings of the external trust funds will provide the minimum funding amounts prescribed by the NRC. The estimated cost of decommissioning and the amounts being recovered through rates at December 31, 1993, for Alabama Power's Plant Farley and Georgia Power's plants Hatch and Vogtle -- based on its ownership interests -- were as follows: The amounts in the internal reserve are being transferred into the external trust fund over a set period of time as approved by the respective state public service commissions. The decommissioning cost estimates are based on prompt dismantlement and removal of the plant from service. The actual decommissioning costs may vary from the above estimates because of regulatory requirements, changes in technology, and changes in costs of labor, materials, and equipment. PLANT VOGTLE PHASE-IN PLANS In 1987 and 1989, the Georgia Public Service Commission (GPSC) ordered that the allowed costs of Plant Vogtle, a two-unit nuclear facility of which Georgia Power owns 45.7 percent, be phased into rates under plans that meet the requirements of Financial Accounting Standards Board (FASB) Statement No. 92, Accounting for Phase-In Plans. Under these plans, Georgia Power deferred financing costs and depreciation expense until the allowed investment was fully reflected in rates as of October 1991. In 1991, the GPSC modified the Plant Vogtle phase-in plan to begin earlier amortization of the costs deferred under the plan. Also, the GPSC levelized capacity buyback expense from co-owners of Plant Vogtle. See Note 3 for additional information regarding Georgia Power's 1991 rate order. Previously, pursuant to two separate interim accounting orders by the GPSC, Georgia Power deferred substantially all operating expenses and financing costs related to Plant Vogtle. Units 1 and 2 began commercial operation in May 1987 and May 1989, respectively. The accounting orders were for the periods from the date of each unit's commercial operation until October 1987 and 1989, respectively. Under phase-in plans and accounting orders from the GPSC, Georgia Power deferred and began amortizing the costs -- recovered through rates -- related to Plant Vogtle as follows: The unrecovered balance above includes approximately $160 million related to the adoption in 1993 of FASB Statement No. 109, Accounting for Income Taxes. See Note 9 for information about Statement No. 109. II-23 NOTES (continued) The Southern Company and Subsidiary Companies 1993 Annual Report Each GPSC order calls for recovery of deferred costs within 10 years. Also, the orders authorized Georgia Power to impute a return similar to allowance for funds used during construction (AFUDC) on its investment in Plant Vogtle units 1 and 2 after the units began commercial operation. These deferred returns are included in the above amounts, except for the equity component in the case of the Unit 2 accounting order. INCOME TAXES The companies provide deferred income taxes for all significant income tax temporary differences. Investment tax credits utilized are deferred and amortized to income over the average lives of the related property. In years prior to 1993, income taxes were accounted for and reported under Accounting Principles Board Opinion No. 11. Effective January 1, 1993, The Southern Company adopted FASB Statement No. 109, Accounting for Income Taxes. Statement No. 109 required, among other things, conversion to the liability method of accounting for accumulated deferred income taxes. See Note 9 for additional information about Statement No. 109. AFUDC AND DEFERRED RETURN AFUDC represents the estimated debt and equity costs of capital funds that are necessary to finance the construction of new facilities. While cash is not realized currently from such allowance, it increases the revenue requirement over the service life of the plant through a higher rate base and higher depreciation expense. The composite rates used by the companies to calculate AFUDC during the years 1991 through 1993 ranged from a before-income-tax rate of 4.9 percent to 11.4 percent. Deferred income taxes related to capitalized debt cost were $5 million, $4 million, and $7 million in 1993, 1992, and 1991, respectively. After Plant Vogtle units 1 and 2 began commercial operation in 1987 and 1989, respectively, Georgia Power imputed a deferred return similar to AFUDC on its investment in the units under the short-term cost deferrals and phase-in plans, as discussed earlier. AFUDC and the deferred return, net of income tax, as a percent of consolidated net income were 1.7 percent in 1993, 1.8 percent in 1992, and 6.0 percent in 1991. The deferred return was discontinued in October 1991 after the allowed investment in Plant Vogtle was fully reflected in rates. UTILITY PLANT Utility plant is stated at original cost less regulatory disallowances. Original cost includes: materials; labor; minor items of property; appropriate administrative and general costs; payroll-related costs such as taxes, pensions, and other benefits; and the estimated cost of funds used during construction. The cost of maintenance, repairs, and replacement of minor items of property is charged to maintenance expense. The cost of replacements of property (exclusive of minor items of property) is charged to utility plant. CASH AND CASH EQUIVALENTS For purposes of the Consolidated Statements of Cash Flows, temporary cash investments are considered cash equivalents. Temporary cash investments are securities with original maturities of 90 days or less. FINANCIAL INSTRUMENTS In accordance with FASB Statement No. 107, Disclosure About Fair Value of Financial Instruments, all financial instruments of The Southern Company -- for which the carrying amount does not approximate fair value -- are shown in the table below at December 31: The fair values of nuclear decommissioning trusts and investment securities were based on listed closing market prices. The fair values for long-term debt and preferred II-24 NOTES (continued) The Southern Company and Subsidiary Companies 1993 Annual Report stock subject to mandatory redemption were based on either closing market prices or closing prices of comparable instruments. MATERIALS AND SUPPLIES Generally, materials and supplies include the cost of transmission, distribution, and generating plant materials. Materials are charged to inventory when purchased and then expensed or capitalized to plant, as appropriate, when installed. In 1992, Georgia Power converted to the inventory method of accounting for certain emergency spare parts. This conversion resulted in a regulatory liability that will be amortized as a credit to income over approximately four years. This conversion will not have a material effect on net income. VACATION PAY The operating companies' employees earn their vacation in one year and take it in the subsequent year. However, for ratemaking purposes, vacation pay is recognized as an allowable expense only when paid. Consistent with this ratemaking treatment, the companies accrue a current liability for earned vacation pay and record a current asset representing the future recoverability of this cost. The amount was $73 million and $70 million at December 31, 1993 and 1992, respectively. In 1994, an estimated 71 percent of the 1993 deferred vacation cost will be expensed, and the balance will be charged to construction and other accounts. 2. RETIREMENT BENEFITS PENSION PLAN The system companies have defined benefit, trusteed, non-contributory pension plans that cover substantially all regular employees. Benefits are based on the greater of amounts resulting from two different formulas: years of service and final average pay or years of service and a flat-dollar benefit. Primarily, the companies use the "entry age normal method with a frozen initial liability" actuarial method for funding purposes, subject to limitations under federal income tax regulations. Amounts funded to the pension fund are primarily invested in equity and fixed-income securities. FASB Statement No. 87, Employers' Accounting for Pensions, requires use of the "projected unit credit" actuarial method for financial reporting purposes. POSTRETIREMENT BENEFITS The system companies also provide certain medical care and life insurance benefits for retired employees. Substantially all employees may become eligible for these benefits when they retire. A qualified trust for medical benefits has been established for funding amounts to the extent deductible under federal income tax regulations. Amounts funded are primarily invested in debt and equity securities. Accrued costs of life insurance benefits, other than current cash payments for retirees, currently are not being funded. Effective January 1, 1993, the system companies adopted FASB Statement No. 106, Employers' Accounting for Postretirement Benefits Other Than Pensions, on a prospective basis. Statement No. 106 requires that medical care and life insurance benefits for retired employees be accounted for on an accrual basis using a specified actuarial method, "benefit/years-of-service." In October 1993, the GPSC ordered Georgia Power to phase in the adoption of Statement No. 106 to cost of service over a five-year period, whereby one-fifth of the additional costs would be expensed in 1993 and the remaining costs would be deferred. An additional one-fifth of the costs would be expensed each succeeding year until the costs are fully reflected in cost of service in 1997. The costs deferred during the five-year period will be amortized to expense over a 15-year period beginning in 1998. As a result of regulatory treatment allowed by the operating companies' respective public service commissions, the adoption of Statement No. 106 did not have a material impact on consolidated net income. Prior to 1993, the system companies, except for Georgia Power and Savannah Electric, recognized these benefit costs on an accrual basis using the "aggregate cost" actuarial method, which spreads the expected cost of such benefits over the remaining periods of employees' service as a level percentage of payroll costs. Consistent with regulatory treatment in these years, Georgia Power and Savannah Electric recognized these costs on a cash basis as payments were made. The total costs of such benefits recognized by system companies in 1992 and 1991 were $42 million and $36 million, respectively. STATUS AND COST OF BENEFITS Shown in the following tables are actuarial results and assumptions for pension and postretirement medical and life insurance benefits as computed under the requirements of FASB Statement Nos. 87 and 106, respectively. Retiree medical and life insurance information is shown only for 1993 because Statement II-25 NOTES (continued) The Southern Company and Subsidiary Companies 1993 Annual Report No. 106 was adopted as of January 1, 1993, on a prospective basis. The funded status of the plans at December 31 was as follows: The weighted average rates assumed in the above actuarial calculations were: An additional assumption used in measuring the accumulated postretirement medical benefit obligation was a weighted average medical care cost trend rate of 11.3 percent for 1993, decreasing gradually to 6.0 percent through the year 2000 and remaining at that level thereafter. An annual increase in the assumed medical care cost trend rate by 1 percent would increase the accumulated medical benefit obligation at December 31, 1993, by $129 million and the aggregate of the service and interest cost components of the net retiree medical cost by $14 million. Components of the plans' net cost are shown below: Of the above net pension amounts, pension income of $9 million in 1993 and pension expense of $2 million in 1992 and $11 million in 1991 were recorded in operating expenses, and the remainder was recorded in construction and other accounts. Of the above net postretirement medical and life insurance costs recorded in 1993, $64 million was charged to operating expenses, $21 million was deferred, and the remainder was charged to construction and other accounts. II-26 NOTES (continued) The Southern Company and Subsidiary Companies 1993 Annual Report WORK FORCE REDUCTION PROGRAMS The system companies have incurred additional costs for work force reduction programs. The costs related to these programs were $35 million, $37 million, and $72 million for the years 1993, 1992, and 1991, respectively. A portion of the cost of these programs was deferred and is being amortized in accordance with regulatory treatment. The unamortized balance of these costs was $19 million at December 31, 1993. 3. LITIGATION AND REGULATORY MATTERS RETAIL RATEPAYERS' SUIT CONCLUDED In March 1993, several retail ratepayers of Georgia Power filed a civil complaint in the Superior Court of Fulton County, Georgia, against Georgia Power, The Southern Company, the system service company, and Arthur Andersen & Co. The complaint alleged that Georgia Power obtained excessive rate increases by improper accounting for spare parts and sought actual damages estimated by the plaintiffs to be in excess of $60 million -- plus treble and punitive damages -- for alleged violations of the Georgia Racketeer Influenced and Corrupt Organizations Act and other state statutes, statutory and common law fraud, and negligence. These state law allegations were substantially the same as those included in a 1989 suit brought in federal district court in Georgia. That suit and similar ones filed in Alabama, Florida, and Mississippi federal courts were subsequently dismissed. The defendants' motions to dismiss the current complaint were granted by the Superior Court of Fulton County, Georgia, in July 1993. In January 1994, the plaintiffs' appeal of the dismissal to the Supreme Court of Georgia was rejected, and this matter is concluded. STOCKHOLDER SUIT In April 1991, two Southern Company stockholders filed a derivative action suit in the U.S. District Court for the Southern District of Georgia against certain current and former directors and officers of The Southern Company. The suit alleges violations of the Federal Racketeer Influenced and Corrupt Organizations Act (RICO) by officers and breaches of fiduciary duty and gross negligence by all defendants resulting from alleged fraudulent accounting for spare parts, illegal political campaign contributions, violations of federal securities laws involving misrepresentations and omissions in SEC filings, and concealment of the foregoing acts. The complaint seeks damages -- including treble damages pursuant to RICO -- in an unspecified amount, which if awarded, would be payable to The Southern Company. The plaintiffs' amended complaint was dismissed by the court in March 1992. The court ruled the plaintiffs had failed to present adequately their allegation that The Southern Company board of directors' refusal of an earlier demand by the plaintiffs was wrongful. The plaintiffs have appealed the dismissal to the U.S. Court of Appeals for the 11th Circuit. ALABAMA POWER HEAT PUMP FINANCING SUIT In September 1990, two customers of Alabama Power filed a civil complaint in the Circuit Court of Shelby County, Alabama, against Alabama Power seeking to represent all persons who, prior to June 23, 1989, entered into agreements with Alabama Power for the financing of heat pumps and other merchandise purchased from vendors other than Alabama Power. The plaintiffs contended that Alabama Power was required to obtain a license under the Alabama Consumer Finance Act to engage in the business of making consumer loans. The plaintiffs were seeking an order declaring these agreements null and void and requiring Alabama Power to refund all payments -- principal and interest -- made under these agreements. The aggregate amount under these agreements, together with interest paid, currently is estimated to be $40 million. In June 1993, the court ordered Alabama Power to refund or forfeit interest of approximately $10 million because of Alabama Power's failure to obtain such license. However, the court's order did not require any refund or forfeiture with respect to any principal payments under the agreements at issue. Alabama Power has appealed the court's order to the Supreme Court of Alabama. The final outcome of this matter cannot now be determined; however, in management's opinion, the final outcome will not have a material adverse effect on the company's financial statements. GULF POWER COAL BARGE TRANSPORTATION SUIT In 1993, a complaint against Gulf Power and the system service company was filed in federal district court in Ohio by two companies with which Gulf Power had contracted for the transportation by barge for certain Gulf Power coal supplies. The complaint alleges breach of the contract by Gulf Power and seeks damages estimated by the plaintiffs to be in excess of $85 million. II-27 NOTES (continued) The Southern Company and Subsidiary Companies 1993 Annual Report The final outcome of this matter cannot now be determined; however, in management's opinion, the final outcome will not have a material adverse effect on the company's financial statements. ALABAMA POWER RATE ADJUSTMENT PROCEDURES In November 1982, the Alabama Public Service Commission (APSC) adopted rates that provide for periodic adjustments based upon Alabama Power's earned return on end-of-period retail common equity. The rates also provide for adjustments to recognize the placing of new generating facilities in retail service. Both increases and decreases have been placed into effect since the adoption of these rates. The rate adjustment procedures allow a return on common equity range of 13.0 percent to 14.5 percent and limit increases or decreases in rates to 4 percent in any calendar year. The APSC issued an order in December 1991 that reduced a scheduled 2.03 percent annual increase in rates to 1.03 percent, effective January 1992. The 1 percent reduction will remain in effect through 1994. The rate reduction was designed to refund to retail ratepayers a portion of the benefits from a settled contract dispute with Gulf States Utilities Company (Gulf States). The present value of this portion of the settlement -- amounting to some $60 million -- is being amortized to income to offset the rate reduction in accordance with the APSC's rate order. See Note 8 for additional information concerning the Gulf States settlement. Also in the December 1991 rate order, the APSC reaffirmed its satisfaction with the ratemaking mechanism and stated that it did not foresee any further review or changes in the procedures until after 1994. The ratemaking procedures will remain in effect after 1994 unless the APSC votes to modify or discontinue them. GEORGIA POWER'S DEMAND-SIDE CONSERVATION PROGRAMS In October 1993, a Superior Court of Fulton County, Georgia, judge ruled that rate riders previously approved by the GPSC for recovery of Georgia Power's costs incurred in connection with demand-side conservation programs were unlawful. The judge held that the GPSC lacked statutory authority to approve such rate riders except through general rate case proceedings and that those procedures had not been followed. Georgia Power suspended collection of the demand-side conservation costs and appealed the court's decision to the Georgia Court of Appeals. In December 1993, the GPSC approved Georgia Power's request for an accounting order allowing Georgia Power to defer all current unrecovered and future costs related to these programs until the superior court's decision is reversed or until the next general rate case proceedings. An association of industrial customers has filed a petition for review of the accounting order in superior court. Georgia Power's costs related to these conservation programs through 1993 were $60 million, of which $15 million has been collected and the remainder deferred. The estimated costs, assuming no change in the programs certified by the GPSC, are $38 million in 1994 and $40 million in 1995. The final outcome of this matter cannot now be determined; however, in management's opinion, the final outcome will not have a material adverse effect on the company's financial statements. GEORGIA POWER 1991 RATE ORDER; PHASE-IN PLAN MODIFICATIONS Georgia Power received a rate order in 1991 from the GPSC that modified the Plant Vogtle phase-in plans to begin earlier amortization of the costs deferred under the plans. The amortization period began October 1991 -- rather than October 1994 as originally scheduled -- and extends through September 1999. In addition, the GPSC ordered the levelization of capacity buyback expense from the co-owners of Plant Vogtle over a six-year period beginning October 1991. This results in net cost deferrals during the first three years and subsequent amortization of the deferred amounts in the last three years. MISSISSIPPI POWER RETAIL RATE ADJUSTMENT PLAN Mississippi Power's retail base rates have been set under a Performance Evaluation Plan (PEP) since 1986 with various modifications in 1991 and the latest in 1994. In 1993, the Mississippi Public Service Commission (MPSC) ordered Mississippi Power to review and propose changes that would enhance the plan. Mississippi Power filed a revised plan, and the MPSC approved PEP-2 on January 4, 1994. Under PEP-2, Mississippi Power's rate of return will be measured on retail net investment rather than on common equity, as previously calculated. Also, the number of indicators used to evaluate Mississippi Power's performance was reduced to three with emphasis on price and service to the customer. In addition, PEP-2 provides for the sharing of rate adjustments based on low rates and on the performance rating. The evaluation periods for PEP-2 are semiannual. Any change in rates is limited to 2 percent of retail revenues per period before a public hearing is required. PEP-2 will remain in effect until the MPSC modifies or terminates the plan. II-28 NOTES (continued) The Southern Company and Subsidiary Companies 1993 Annual Report FERC REVIEWS EQUITY RETURNS In May 1991, the FERC ordered that hearings be conducted concerning the reasonableness of the Southern electric system's wholesale rate schedules and contracts that have a return on common equity of 13.75 percent or greater. The contracts that could be affected by the hearings include substantially all of the transmission, unit power, long-term power, and other similar contracts. Any changes in the rate of return on common equity that may occur as a result of this proceeding would be effective 60 days after a proper notice of the proceeding is published. A notice was published on May 10, 1991. In August 1992, a FERC administrative law judge issued an opinion that changes in rate schedules and contracts were not necessary and that the FERC staff failed to show how any changes were in the public interest. The FERC staff has filed exceptions to the administrative law judge's opinion, and the matter remains pending before the FERC. The final outcome of this matter cannot now be determined; however, in management's opinion, the final outcome will not have a material adverse effect on the company's financial statements. 4. CONSTRUCTION PROGRAM GENERAL The operating companies are engaged in continuous construction programs, currently estimated to total some $1.5 billion in 1994, $1.3 billion in 1995, and $1.5 billion in 1996. These estimates include AFUDC of $34 million in 1994, $41 million in 1995, and $35 million in 1996. The construction programs are subject to periodic review and revision, and actual construction costs may vary from the above estimates because of numerous factors. These factors include changes in business conditions; revised load growth estimates; changes in environmental regulations; changes in existing nuclear plants to meet new regulatory requirements; increasing costs of labor, equipment, and materials; and cost of capital. At December 31, 1993, significant purchase commitments were outstanding in connection with the construction program. The operating companies do not have any new baseload generating plants under construction. However, within the service area, the construction of combustion turbine peaking units of approximately 1,700 megawatts is planned to be completed by 1996. In addition, significant construction will continue related to transmission and distribution facilities and the upgrading and extension of the useful lives of generating plants. See Management's Discussion and Analysis under "Environmental Matters" for information on the impact of the Clean Air Act Amendments of 1990 and other environmental matters. ROCKY MOUNTAIN PROJECT STATUS In its 1985 financing order, the GPSC concluded that completion of the Rocky Mountain pumped storage hydroelectric project in 1991 was not economically justifiable and reasonable and withheld authorization for Georgia Power to spend funds from approved securities issuances on that project. In 1988, Georgia Power and Oglethorpe Power Corporation (OPC) entered into a joint ownership agreement for OPC to assume responsibility for the construction and operation of the project, as discussed in Note 6. However, full recovery of Georgia Power's costs depends on the GPSC's treatment of the project's cost and disposition of the project's capacity output. In the event Georgia Power cannot demonstrate to the GPSC the project's economic viability based on current ownership, construction schedule, and costs, then part or all of such costs may have to be written off. At December 31, 1993, Georgia Power's investment in the project amounted to approximately $197 million. AFUDC accrued on the Rocky Mountain project has not been credited to income or included in the project cost since December 1985. If accrual of AFUDC is not resumed, Georgia Power's portion of the estimated total plant additions at completion would be approximately $199 million. The plant is currently scheduled to begin commercial operation in 1995. Georgia Power has held preliminary discussions with other parties regarding the potential disposition of its remaining interest in the project. The ultimate outcome of this matter cannot now be determined. 5. FINANCING, INVESTMENT, AND COMMITMENTS GENERAL In early 1994, The Southern Company sold -- through a public offering -- 5.6 million shares of common stock with proceeds totaling $120 million. The company may require additional equity capital during the remainder of 1994. The amount and timing of additional equity capital to be raised in 1994 -- as well as in subsequent years -- will be contingent on The Southern Company's investment opportunities. Equity capital can be provided from any combination of public offerings, private placements, or the company's stock plans. II-29 NOTES (continued) The Southern Company and Subsidiary Companies 1993 Annual Report To the extent possible, the operating companies' construction programs are expected to be financed primarily from internal sources. Short-term debt will be utilized when necessary; the amounts available are discussed below. The subsidiary companies may issue additional long-term debt and preferred stock primarily for the purposes of debt maturities and for redeeming higher-cost securities. FOREIGN UTILITY OPERATIONS During 1993, The Southern Company made investments of approximately $315 million in utilities that own and operate generating facilities in various foreign markets. The consolidated financial statements reflect these investments in majority-owned subsidiaries on a consolidated basis and other investments on an equity basis. BANK CREDIT ARRANGEMENTS At the beginning of 1994, unused credit arrangements with banks totaled $1.1 billion, of which approximately $500 million expires at various times during 1994 and 1995; $130 million expires at May 1, 1996; $400 million expires at June 30, 1996; and $70 million expires at December 1, 1996. Georgia Power's revolving credit agreements of $150 million, of which $130 million remained unused as of December 31, 1993, expire May 1, 1996. During the term of these agreements, Georgia Power may convert short-term borrowings into term loans, payable in 12 equal quarterly installments, with the first installment due at the end of the first calendar quarter after the applicable termination date or at an earlier date at Georgia Power's option. In connection with these credit arrangements, Georgia Power agrees to pay commitment fees based on the unused portions of the commitments or to maintain compensating balances with the banks. The $400 million expiring June 30, 1996, is under revolving credit arrangements with several banks providing The Southern Company, Alabama Power, and Georgia Power up to the total credit amount of $400 million. To provide liquidity support to commercial paper programs, $135 million and $165 million of the $400 million available credit are currently dedicated to the exclusive use of Alabama Power and Georgia Power, respectively. During the term of these agreements, short-term borrowings may be converted into term loans, payable in 12 equal quarterly installments, with the first installment due at the end of the first calendar quarter after the applicable termination date or at an earlier date at the companies' option. In addition, these agreements require payment of commitment fees based on the unused portions of the commitments or the maintenance of compensating balances with the banks. Mississippi Power has $70 million of revolving credit agreements expiring December 1, 1996. These agreements allow short-term borrowings to be converted into term loans, payable in 12 equal quarterly installments, with the first installment due at the end of the first calendar quarter after the applicable termination date or at an earlier date at Mississippi Power's option. In connection with these credit arrangements, Mississippi Power agrees to pay commitment fees based on the unused portions of the commitments or to maintain compensating balances with the banks. Savannah Electric has $20 million of revolving credit arrangements expiring December 31, 1995. These agreements allow short-term borrowings to be converted into term loans, payable in 12 equal quarterly installments, with the first installment due at the end of the first calendar quarter after the applicable termination date or at an earlier date at Savannah Electric's option. In connection with these credit arrangements, Savannah Electric agrees to pay commitment fees based on the unused portions of the commitments. In connection with all other lines of credit, the companies have the option of paying fees or maintaining compensating balances, which are substantially all the cash of the companies except for daily working funds and similar items. These balances are not legally restricted from withdrawal. In addition, the companies from time to time borrow under uncommitted lines of credit with banks, and in the case of Alabama Power and Georgia Power, through commercial paper programs that have the liquidity support of committed bank credit arrangements. ASSETS SUBJECT TO LIEN The operating companies' mortgages, which secure the first mortgage bonds issued by the companies, constitute a direct first lien on substantially all of the companies' respective fixed property and franchises. FUEL COMMITMENTS To supply a portion of the fuel requirements of the system's generating plants, the subsidiary companies have II-30 NOTES (continued) The Southern Company and Subsidiary Companies 1993 Annual Report entered into various long-term commitments for the procurement of fossil and nuclear fuel. In most cases, these contracts contain provisions for price escalations, minimum purchase levels, and other financial commitments. Total estimated long-term obligations were approximately $15 billion at December 31, 1993. Additional commitments for coal and nuclear fuel will be required in the future to supply the operating companies' fuel needs. To take advantage of lower-cost coal supplies, agreements were reached in 1986 for the payment of $121 million to terminate two contracts for the supply of coal to Plant Daniel, which is jointly owned by Gulf Power and Mississippi Power. Also, in March 1988, Gulf Power made an advance payment of $60 million to a coal supplier under an agreement to lower the cost of future coal purchased under an existing contract. These amounts are being amortized to expense. The remaining unamortized amount included in deferred charges at December 31, 1993, was $70 million. OPERATING LEASES The operating companies have entered into coal rail car rental agreements with various terms and expiration dates. Rental expense totaled $11 million, $9 million, and $7 million for 1993, 1992, and 1991, respectively. At December 31, 1993, estimated minimum rental commitments for noncancelable operating leases were as follows: 6. FACILITY SALES AND JOINT OWNERSHIP AGREEMENTS In 1992, Alabama Power sold an undivided interest in units 1 and 2 of Plant Miller and related facilities to Alabama Electric Cooperative, Inc. Since 1975, Georgia Power has sold undivided interests in plants Vogtle, Hatch, Scherer, and Wansley in varying amounts, together with transmission facilities, to OPC, the Municipal Electric Authority of Georgia (MEAG), and the city of Dalton, Georgia. Georgia Power has completed two of four separate transactions to sell Unit 4 of Plant Scherer to two Florida utilities. See Note 7 for additional information concerning these sales. In addition, Georgia Power has entered into a joint ownership agreement with OPC with respect to the Rocky Mountain project, as discussed later. At December 31, 1993, Alabama Power's and Georgia Power's ownership and investment (exclusive of nuclear fuel) in jointly owned facilities with the above entities were as follows: *Estimated ownership at date of completion. Georgia Power and OPC have entered into a joint ownership agreement regarding the 848-megawatt Rocky Mountain pumped storage hydroelectric project. Under the agreement, Georgia Power will retain its present investment in the project and OPC will finance, complete, and operate the facility. Upon completion, Georgia Power will own an undivided interest in the project equal to the proportion its investment bears to the total investment in the project (excluding each party's cost of funds and ad valorem taxes). Based on current cost estimates, Georgia Power's final ownership is estimated at approximately 25 percent of the project at completion. Georgia Power has held preliminary discussions with other parties regarding the potential disposition of its remaining interest in the project. II-31 NOTES (continued) THE SOUTHERN COMPANY AND SUBSIDIARY COMPANIES 1993 ANNUAL REPORT Alabama Power and Georgia Power have contracted to operate and maintain the jointly owned facilities -- except for the Rocky Mountain project -- as agents for their respective co-owners. The companies' proportionate share of their plant operating expenses is included in the corresponding operating expenses in the Consolidated Statements of Income. In connection with a joint ownership arrangement at Plant Vogtle, Georgia Power has remaining commitments to purchase declining fractions of OPC's and MEAG's capacity and energy from this plant for periods of up to 10 years following commercial operation (and, with regard to a portion of the 5 percent additional interest in Plant Vogtle owned by MEAG, until the latter of the retirement of the plant or the latest stated maturity date of MEAG's bonds issued to finance such ownership interest). The payments for such capacity are required whether any capacity is available. The energy cost of these purchases is a function of each unit's variable operating costs. Except as noted below, the cost of such capacity and energy is included in purchased power in the Consolidated Statements of Income. Capacity payments totaled $183 million, $289 million, and $320 million, for 1993, 1992, and 1991, respectively. Projected capacity payments for the next five years are as follows: $132 million in 1994; $77 million in 1995; $70 million in 1996; $59 million in 1997; and $59 million in 1998. Also, a portion of the above capacity payments relates to Plant Vogtle costs that were written off after being disallowed for retail ratemaking purposes. In 1991, the GPSC ordered that the Plant Vogtle capacity buyback expense be levelized over a six-year period. The amounts deferred and not expensed in the year paid totaled $38 million in 1993, $100 million in 1992, and $30 million in 1991. The projected net amount to be deferred in 1994 is $1 million. The projected net amortization of the deferred expense is $49 million in 1995, $62 million in 1996, and $57 million in 1997. 7. PLANNED SALES OF INTEREST IN PLANT SCHERER Georgia Power has completed two of four separate transactions to sell Unit 4 of Plant Scherer to Florida Power & Light Company (FP&L) and Jacksonville Electric Authority (JEA) for a total price of approximately $806 million, including any gains on these transactions. FP&L would eventually own approximately 76.4 percent of the unit, with JEA owning the remainder. The capacity from this unit was previously dedicated to long-term power sales contracts with Gulf States that were suspended in 1988. Georgia Power will continue to operate the unit. The completed and scheduled remaining transactions are as follows: Plant Scherer -- a jointly owned coal-fired generating plant -- has four units with a total capacity of 3,272 megawatts. Unit 4 was completed in 1989. See Note 6 for information regarding current plant ownership. 8. LONG-TERM POWER SALES AGREEMENTS GENERAL The operating subsidiaries of The Southern Company have entered into long-term contractual agreements for the sale of capacity and energy to certain non-affiliated utilities located outside the system's service area. Certain of these agreements are non-firm and are based on capacity of the system in general. Other agreements are firm and pertain to capacity related to specific generating units. Because the energy is generally sold at cost under these agreements, revenues from capacity sales primarily affect profitability. The capacity revenues have been as follows: Long-term non-firm power of 400 megawatts was sold in 1993 to Florida Power Corporation (FPC). In January 1994, this amount decreased to 200 megawatts, and the contract will expire at year-end. Unit power from specific generating plants is currently being sold to FP&L, FPC, JEA, and the city of Tallahassee, Florida. Under these agreements, an average II-32 NOTES (continued) The Southern Company and Subsidiary Companies 1993 Annual Report of 1,700 megawatts of capacity is scheduled to be sold during 1994 and 1995. Thereafter, these sales will decline to some 1,600 megawatts and remain at that approximate level -- unless reduced by FP&L, FPC, and JEA for the periods after 1999 -- until the expiration of the contracts in 2010. GULF STATES SETTLEMENT COMPLETED On November 7, 1991, subsidiaries of The Southern Company entered into a settlement agreement with Gulf States that resolved litigation between the companies that had been pending since 1986 and arose out of a dispute over certain unit power and other long-term power sales contracts. In 1993, all remaining terms and obligations of the settlement agreement were satisfied. Based on the value of the settlement proceeds received -- less the amounts to be refunded to customers and the amounts previously included in income -- The Southern Company recorded an increase in consolidated net income of $114 million, or 18 cents per share, in November 1991. With respect to Alabama Power's portion of proceeds received in 1991, see Note 3 concerning the regulatory treatment of amounts being refunded to retail customers over a three-year period. 9. INCOME TAXES Effective January 1, 1993, The Southern Company adopted FASB Statement No. 109, Accounting for Income Taxes. The adoption of Statement No. 109 resulted in cumulative adjustments that had no material effect on consolidated net income. The adoption also resulted in the recording of additional deferred income taxes and related assets and liabilities. The related assets of $1.5 billion are revenues to be received from customers. These assets are attributable to tax benefits flowed through to customers in prior years and to taxes applicable to capitalized AFUDC. The related liabilities of $1.1 billion are revenues to be refunded to customers. These liabilities are attributable to deferred taxes previously recognized at rates higher than current enacted tax law and to unamortized investment tax credits. Additionally, deferred income taxes related to accelerated tax depreciation previously shown as a reduction to utility plant were reclassified. Details of the federal and state income tax provisions are as follows: The tax effects of temporary differences between the carrying amounts of assets and liabilities in the financial statements and their respective tax bases, which give rise to deferred tax assets and liabilities, are as follows: II-33 NOTES (continued) The Southern Company and Subsidiary Companies 1993 Annual Report Deferred investment tax credits are amortized over the life of the related property with such amortization normally applied as a credit to reduce depreciation in the Consolidated Statements of Income. Credits amortized in this manner amounted to $29 million in 1993, $41 million in 1992, and $48 million in 1991. At December 31, 1993, all investment tax credits available to reduce federal income taxes payable had been utilized. A reconciliation of the federal statutory income tax rate to the effective income tax rate is as follows: The Southern Company and its subsidiaries file a consolidated federal income tax return. Under a joint consolidated income tax agreement, each company's current and deferred tax expense is computed on a stand-alone basis, and consolidated tax savings are allocated to each company based on its ratio of taxable income to total consolidated taxable income. 10. COMMON STOCK STOCK DISTRIBUTION In January 1994, The Southern Company board of directors authorized a two-for-one common stock split in the form of a stock distribution for each share held as of February 7, 1994. For all reported common stock data, the number of common shares outstanding and per share amounts for earnings, dividends, and market price have been adjusted to reflect the stock distribution. SHARES RESERVED At December 31, 1993, a total of 24 million shares was reserved for issuance pursuant to the Dividend Reinvestment and Stock Purchase Plan, the Employee Savings Plan, and the Executive Stock Option Plan. EXECUTIVE STOCK OPTION PLAN The Southern Company's Executive Stock Option Plan authorizes the granting of non-qualified stock options to key employees of The Southern Company, including officers. Currently, 34 employees are eligible to participate in the plan. As of December 31, 1993, 38 current and former employees participated in the plan. The maximum number of shares of common stock that may be issued under the Executive Stock Option Plan may not exceed 6 million. The price of options granted to date has been at the fair market value of the shares on the date of grant. Options granted to date become exercisable pro rata over a maximum period of four years from date of grant, such that all options generally are exercisable by 1997. Options outstanding will expire upon termination of the plan, which will occur on December 7, 1997, unless terminated earlier by the board of directors. Stock option activity in 1992 and 1993 is summarized below: II-34 NOTES (continued) The Southern Company and Subsidiary Companies 1993 Annual Report 11. OTHER LONG-TERM DEBT Details of other long-term debt are as follows: With respect to the collateralized pollution control revenue bonds, the operating companies have authenticated and delivered to trustees a like principal amount of first mortgage bonds as security for obligations under installment sale or loan agreements. The principal and interest on the first mortgage bonds will be payable only in the event of default under the agreements. Assets acquired under capital leases are recorded as utility plant in service, and the related obligation is classified as other long-term debt. The net book value of capitalized leases was $217 million and $236 million at December 31, 1993 and 1992, respectively. At December 31, 1993, the composite interest rates for nuclear fuel, buildings, and other were 3.6 percent, 9.7 percent, and 12.0 percent, respectively. Sinking fund requirements and/or serial maturities through 1998 applicable to other long-term debt are as follows: $89 million in 1994; $154 million in 1995; $58 million in 1996; $26 million in 1997; and $7 million in 1998. 12. LONG-TERM DEBT DUE WITHIN ONE YEAR A summary of the improvement fund requirements and scheduled maturities and redemptions of long-term debt due within one year is as follows: The first mortgage bond improvement (sinking) fund requirements amount to 1 percent of each outstanding series of bonds authenticated under the indentures prior to January 1 of each year, other than those issued to collateralize pollution control and other obligations. The requirements may be satisfied by depositing cash or reacquiring bonds, or by pledging additional property equal to 166 2/3 percent of such requirements. II-35 NOTES (continued) The Southern Company and Subsidiary Companies 1993 Annual Report 13. NUCLEAR INSURANCE Under the Price-Anderson Amendments Act of 1988, Alabama Power and Georgia Power maintain agreements of indemnity with the NRC that, together with private insurance, cover third-party liability arising from any nuclear incident occurring at the companies' nuclear power plants. The act limits to $9.4 billion public liability claims that could arise from a single nuclear incident. Each nuclear plant is insured against this liability to a maximum of $200 million by private insurance, with the remaining coverage provided by a mandatory program of deferred premiums that could be assessed, after a nuclear incident, against all owners of nuclear reactors. A company could be assessed up to $79 million per incident for each licensed reactor it operates but not more than an aggregate of $10 million per incident to be paid in a calendar year for each reactor. Such maximum assessment, excluding any applicable state premium taxes, for Alabama Power and Georgia Power -- based on its ownership and buyback interests -- is $159 million and $171 million, respectively, per incident but not more than an aggregate of $20 million and $22 million, respectively, to be paid for each incident in any one year. Alabama Power and Georgia Power are members of Nuclear Mutual Limited (NML), a mutual insurer established to provide property damage insurance in an amount up to $500 million for members' nuclear generating facilities. The members are subject to a retrospective premium adjustment in the event that losses exceed accumulated reserve funds. Alabama Power's and Georgia Power's maximum annual assessments are limited to $14 million and $18 million, respectively, under current policies. Additionally, both companies have policies that currently provide decontamination, excess property insurance, and premature decommissioning coverage up to $2.25 billion for losses in excess of the $500 million NML coverage. This excess insurance is provided by Nuclear Electric Insurance Limited (NEIL), a mutual insurance company, and American Nuclear Insurers/Mutual Atomic Energy Liability Underwriters. NEIL also covers the additional costs that would be incurred in obtaining replacement power during a prolonged accidental outage at a member's nuclear plant. Members can be insured against increased costs of replacement power in an amount up to $3.5 million per week -- starting 21 weeks after the outage -- for one year and up to $2.3 million per week for the second and third years. Under each of the NEIL policies, members are subject to assessments if losses each year exceed the accumulated funds available to the insurer under that policy. The maximum annual assessments under current policies for Alabama Power and Georgia Power for excess property damage would be $16 million and $15 million, respectively. The replacement power assessments are $9 million for Alabama Power and $13 million for Georgia Power. For all on-site property damage insurance policies for commercial nuclear power plants, the NRC requires that the proceeds of such policies issued or renewed on or after April 2, 1991, shall be dedicated first for the sole purpose of placing the reactor in a safe and stable condition after an accident. Any remaining proceeds are to be applied next toward the costs of decontamination and debris removal operations ordered by the NRC, and any further remaining proceeds are to be paid either to the company or to its bond trustees as may be appropriate under the policies and applicable trust indentures. Alabama Power and Georgia Power participate in an insurance program for nuclear workers that provides coverage for worker tort claims filed for bodily injury caused at commercial nuclear power plants. In the event that claims for this insurance exceed the accumulated reserve funds, Alabama Power and Georgia Power could be subject to a maximum total assessment of $6 million and $7 million, respectively. II-36 NOTES (continued) The Southern Company and Subsidiary Companies 1993 Annual Report 14. COMMON STOCK DIVIDEND RESTRICTIONS The income of The Southern Company is derived primarily from equity in earnings of its operating subsidiaries. At December 31, 1993, $1.6 billion of consolidated retained earnings was restricted against the payment by the operating companies of cash dividends on common stock under terms of bond indentures or charters. 15. QUARTERLY FINANCIAL INFORMATION (UNAUDITED) Summarized quarterly financial data for 1993 and 1992 are as follows: *Common stock data have been adjusted to reflect a two-for-one stock split in the form of a stock distribution for each share held as of February 7, 1994. The company's business is influenced by seasonal weather conditions and the timing of rate changes. II-37 SELECTED CONSOLIDATED FINANCIAL AND OPERATING DATA The Southern Company and Subsidiary Companies 1993 Annual Report (See Note Below) Note: Common stock data have been adjusted to reflect a two-for-one stock split in the form of a stock distribution for each share held as of February 7, 1994. II-38 SELECTED CONSOLIDATED FINANCIAL AND OPERATING DATA The Southern Company and Subsidiary Companies 1993 Annual Report (See Note Below) II-39 SELECTED CONSOLIDATED FINANCIAL AND OPERATING DATA (continued) The Southern Company and Subsidiary Companies 1993 Annual Report II-40 SELECTED CONSOLIDATED FINANCIAL AND OPERATING DATA (continued) The Southern Company and Subsidiary Companies 1993 Annual Report II-41 CONSOLIDATED STATEMENTS OF INCOME The Southern Company and Subsidiary Companies II-42 CONSOLIDATED STATEMENTS OF INCOME The Southern Company and Subsidiary Companies II-43 CONSOLIDATED STATEMENTS OF CASH FLOWS The Southern Company and Subsidiary Companies II-44 CONSOLIDATED STATEMENTS OF CASH FLOWS The Southern Company and Subsidiary Companies II-45 CONSOLIDATED BALANCE SHEETS The Southern Company and Subsidiary Companies II-46 CONSOLIDATED BALANCE SHEETS The Southern Company and Subsidiary Companies II-47 CONSOLIDATED BALANCE SHEETS The Southern Company and Subsidiary Companies II-48 CONSOLIDATED BALANCE SHEETS The Southern Company and Subsidiary Companies II-49 ALABAMA POWER COMPANY FINANCIAL SECTION II-50 MANAGEMENT'S REPORT Alabama Power Company 1993 Annual Report The management of Alabama Power Company has prepared -- and is responsible for - -- the financial statements and related information included in this report. These statements were prepared in accordance with generally accepted accounting principles appropriate in the circumstances and necessarily include amounts that are based on the best estimates and judgments of management. Financial information throughout this annual report is consistent with the financial statements. The company maintains a system of internal accounting controls to provide reasonable assurance that assets are safeguarded and that the books and records reflect only authorized transactions of the company. Limitations exist in any system of internal controls based on a recognition that the cost of the system should not exceed its benefits. The company believes its system of internal accounting controls maintains an appropriate cost/benefit relationship. The company's system of internal accounting controls is evaluated on an ongoing basis by the company's internal audit staff. The company's independent public accountants also consider certain elements of the internal control system in order to determine their auditing procedures for the purpose of expressing an opinion on the financial statements. The audit committee of the board of directors, composed of directors who are not employees, provides a broad overview of management's financial reporting and control functions. Periodically, this committee meets with management, the internal auditors and the independent public accountants to ensure that these groups are fulfilling their obligations and to discuss auditing, internal controls, and financial reporting matters. The internal auditors and independent public accountants have access to the members of the audit committee at any time. Management believes that its policies and procedures provide reasonable assurance that the company's operations are conducted according to a high standard of business ethics. In management's opinion, the financial statements present fairly, in all material respects, the financial position, results of operations and cash flows of Alabama Power Company in conformity with generally accepted accounting principles. /s/ Elmer B. Harris /s/ William B. Hutchins, III - -------------------------- ------------------------------ Elmer B. Harris William B. Hutchins III President Senior Vice President and Chief Executive Officer and Chief Financial Officer II-51 REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS TO THE BOARD OF DIRECTORS OF ALABAMA POWER COMPANY: We have audited the accompanying balance sheets and statements of capitalization of Alabama Power Company (an Alabama corporation and wholly owned subsidiary of The Southern Company) as of December 31, 1993 and 1992, and the related statements of income, retained earnings, and cash flows for each of the three years in the period ended December 31, 1993. These financial statements are the responsibility of the company's management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements (pages II-59 through II-77) referred to above present fairly, in all material respects, the financial position of Alabama Power Company as of December 31, 1993 and 1992, and the results of its operations and its cash flows for the periods stated, in conformity with generally accepted accounting principles. As explained in Notes 2 and 8 to the financial statements, effective January 1, 1993, the company changed its methods of accounting for postretirement benefits other than pensions, and for income taxes. /s/ Arthur Andersen & Co. Birmingham, Alabama February 16, 1994 II-52 MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION Alabama Power Company 1993 Annual Report RESULTS OF OPERATIONS EARNINGS The company's 1993 net income after dividends on preferred stock was $346 million, representing a 2.3 percent increase over the prior year. This improvement can be attributed to higher retail energy sales and lower financing costs. Retail energy sales increased 5.1 percent from 1992 levels. This was primarily due to the extreme weather during 1993, especially when compared to the unusually mild weather of 1992. Long-term debt interest expense and preferred stock dividends decreased in 1993 reflecting the continued redemption and refinancing of higher cost debt and preferred stock. These positive factors were partially offset by higher operating costs and a scheduled reduction in capacity sales to non-affiliated utilities. When comparing 1992 earnings with the prior year, it should be noted that 1991 earnings included an unusual item -- the settlement of litigation with Gulf States Utilities Company (Gulf States) that resulted in an after-tax gain of $9 million. A comparison of 1992 to 1991, excluding this unusual item, would reflect a 1992 increase in earnings of $8 million. The return on average common equity for 1993 was 13.9 percent compared to 14.0 percent in 1992, and 14.6 percent in 1991. REVENUES The following table summarizes the principal factors that affected operating revenues for the past three years: Retail revenues of $2.4 billion in 1993 increased $180 million (8.0 percent) over the prior year, compared with no increase in 1992. The extreme weather during 1993 and sales growth contributed to the increase in retail revenues over 1992. Fuel revenues increased substantially during 1993. However, changes in fuel revenues are offset with corresponding changes in recoverable fuel expenses and have no effect on net income. Gains in 1992 retail revenues, due to higher rates and sales growth, were partially offset by lower fuel cost recovery revenues. Revenues from sales to non-affiliated utilities under long-term contracts consist of capacity and energy components. Capacity revenues reflect the recovery of fixed costs and a return on investment under the contracts. Energy is generally sold at variable cost. The capacity and energy components were: II-53 MANAGEMENT'S DISCUSSION AND ANALYSIS (continued) Alabama Power Company 1993 Annual Report Capacity revenues decreased in 1993 due to a scheduled reduction in capacity dedicated to unit power sales customers for the first five months of the year. The major factor contributing to the increase in capacity revenues in 1992 and 1991 was a new generating unit, Plant Miller Unit 4, that was placed in commercial service in March 1991 and dedicated to unit power sales. This unit's fixed costs are higher than those of the unit it replaced, which previously provided energy to unit power sales customers. Sales to affiliated companies within the Southern electric system will vary from year to year depending on demand and the availability and cost of generating resources at each company. These sales have no material impact on earnings. Kilowatt-hour (KWH) sales for 1993 and the percent change by year were as follows: EXPENSES Total operating expenses of $2.4 billion for 1993 were up 7.0 percent compared with the prior year. The increase was mainly attributable to higher production expenses of $95 million to meet increased energy demands. Total operating expenses for 1992 increased moderately over those recorded in 1991. However, absent the Gulf States settlement, which reduced 1991 operating expenses, total operating expenses would have decreased $6 million. Fuel costs are the single largest expense for the company. The mix of fuel sources for generation of electricity is determined primarily by system load, the unit cost of fuel consumed, and the availability of hydro and nuclear generating units. Fuel expense increases in 1993 represent $83 million of the production expense increase mentioned above. Fuel expense decreased in 1992 as a result of the reduction in the cost of both coal and nuclear fuel, offset somewhat by a small increase in generation. Fuel cost per kilowatt-hour generated was 1.73 cents in 1993, 1.64 cents in 1992 and 1.69 cents in 1991. Purchased power expenses decreased in 1992 primarily due to less purchased energy and a decrease in the price of such energy. Other operation expenses increased 6.0 percent in 1993 following a minimal increase in 1992. The increase in 1993 is primarily the result of environmental cleanup costs, net expenses of a March snowstorm, and the one-time cost of a transportation fleet reduction program, which together totaled $16.1 million. Depreciation and amortization expense increased 3.4 percent in 1993 and 3.5 percent in 1992. This is principally due to continued growth in depreciable plant in service. Taxes other than income taxes increased 4.0 percent in 1993 and 1.4 percent in 1992. These increases were the result of the addition of new facilities and higher revenue-related taxes. The increase in income tax expense of 2.6 percent for 1993 is primarily attributable to a one percent increase in the corporate federal income tax rate effective January 1, 1993. Interest expense and dividends on preferred stock decreased $7.5 million (2.8 percent) and $7.2 million (2.6 percent) in 1993 and 1992, respectively. These reductions are due to significant refinancing of long-term debt and preferred stock. II - 54 MANAGEMENT'S DISCUSSION AND ANALYSIS (continued) Alabama Power Company 1993 Annual Report EFFECTS OF INFLATION The company is subject to rate regulation that is based on the recovery of historical costs and, therefore is subject to economic losses caused by inflation. While the inflation rate has been relatively low in recent years, it continues to have an adverse effect on the company because of the large investment in long-lived utility plant. Conventional accounting for historical cost does not recognize this economic loss nor the partially offsetting gain that arises through financing facilities with fixed-money obligations, such as long-term debt and preferred stock. Any recognition of inflation by regulatory authorities is reflected in the rate of return allowed. FUTURE EARNINGS POTENTIAL The results of operations for the past three years are not necessarily indicative of future earnings potential. The level of future earnings depends on numerous factors ranging from growth in energy sales to regulatory matters. Future earnings in the near term will also depend upon growth in electric sales, which are subject to a number of factors. Traditionally, these factors have included changes in contracts with neighboring utilities, energy conservation practiced by customers, the elasticity of demand, weather, competition, and the rate of economic growth in the company's service area. In addition, the Energy Policy Act of 1992 (Energy Act) will have a profound effect on the future of the electric utility industry. The Energy Act promotes energy efficiency, alternative fuel use, and increased competition for electric utilities. The law also includes provisions to streamline the licensing process for new nuclear plants. The company is preparing to meet the challenge of this major change in the traditional business practices of selling electricity. The Energy Act allows independent power producers (IPPs) to access a utility's transmission network in order to sell electricity to other utilities, and this may enhance the incentive for IPPs to build cogeneration plants for a utility's large industrial and commercial customers and sell excess energy generation to other utilities. Although the Energy Act does not require transmission access to retail customers, pressure for legislation to allow retail wheeling will continue. If the company does not remain a low-cost producer and provide quality service, the company's retail energy sales growth, as well as any new long-term contracts for energy sales outside the service area, could be limited, and this could significantly erode earnings. Rates to retail customers served by the company are regulated by the Alabama Public Service Commission (APSC). Rates for the company can be adjusted periodically within certain limitations based on earned retail rate of return compared with an allowed return. See Note 3 to the financial statements for information about other regulatory matters. The Federal Energy Regulatory Commission (FERC) regulates wholesale rate schedules and power sales contracts that the company has with its sales for resale customers. The FERC currently is reviewing the rate of return on common equity included in these schedules and contracts and may require such returns to be lowered, possibly retroactively. See Note 3 to the financial statements under "FERC Reviews Equity Returns" for additional information. Compliance costs related to the Clean Air Act Amendments of 1990 (Clean Air Act) could reduce earnings if such costs are not fully recovered. The Clean Air Act is discussed later under "Environmental Matters." NEW ACCOUNTING STANDARDS The Financial Accounting Standards Board (FASB) issued Statement No. 112, Employers' Accounting for Postemployment Benefits, which must be effective by 1994. The new standard requires that all types of benefits provided to former or inactive employees and their families prior to retirement be accounted for on an accrual basis. These benefits include salary continuation, severance pay, supplemental unemployment benefits, disability-related benefits, job training, and health and life insurance coverage. In 1993, the company adopted Statement No. 112, with no material effect on the financial statements. The FASB has issued Statement No. 115, Accounting for Certain Investments in Debt and Equity Securities, which is effective in 1994. Statement No. 115 supersedes FASB Statement No. 12, Accounting for Certain Marketable Securities. The company adopted the new rules January 1, 1994, with no material effect on the financial statements. II-55 MANAGEMENT'S DISCUSSION AND ANALYSIS (continued) Alabama Power Company 1993 Annual Report FINANCIAL CONDITION OVERVIEW The company's financial condition remained stable in 1993. Growth in energy sales combined with a significant lowering of the cost of capital, achieved through the refinancing and/or redemption of higher-cost long-term debt and preferred stock contributed to this stability. The company had gross property additions of $436 million in 1993. The majority of funds needed for gross property additions since 1990 have been provided from operating activities, principally from earnings and non-cash charges to income such as depreciation and deferred income taxes. The Statements of Cash Flows provide additional details. On January 1, 1993, the company changed its methods of accounting for postretirement benefits other than pensions, and for income taxes. See Notes 2 and 8 to the financial statements, regarding the impact of these changes. CAPITAL STRUCTURE The company's ratio of common equity to total capitalization was 47.4 percent in 1993, compared with 47.6 percent in 1992, and 45.4 percent in 1991. In 1993, the company issued $860 million of first mortgage bonds, $158 million of preferred stock and, through public authorities, $144 million of pollution control revenue bonds. The company continued to reduce financing costs by retiring higher-cost bonds and preferred stock. Retirements, including maturities, of bonds totaled $835 million, and preferred stock retirements totaled $207 million. Composite financing rates as of year-end for 1991 through 1993 were as follows: The company's current securities ratings are as follows: CAPITAL REQUIREMENTS Capital expenditures are estimated to be $588 million for 1994, $572 million for 1995, and $531 million for 1996. The total is $1.7 billion for the three years. Actual capital costs may vary from this estimate because of factors such as changes in environmental regulations; changes in the existing nuclear plant to meet new regulations; revised load projections; increasing costs of labor, equipment, and materials; and the cost of capital. The company does not have any baseload generating plants under construction, and current energy demand forecasts do not require any additional baseload generating units until well into the future. However, the construction of combustion turbine peaking units of approximately 720 megawatts of capacity is planned by 1996 to meet increased peak-hour demands. In addition, significant construction of transmission and distribution facilities and upgrading of generating plants will continue. In addition to the funds needed for the capital budget, approximately $80 million will be required by the end of 1996 for present sinking fund requirements, redemptions announced, and maturities of first mortgage bonds. Also, the company plans to continue a program to retire higher-cost debt and preferred stock and replace these obligations with lower-cost capital. ENVIRONMENTAL MATTERS In November 1990, the Clean Air Act was signed into law. Title IV of the Clean Air Act -- the acid rain compliance provision of the law -- will have a significant impact on the Southern electric system. Specific reductions in sulfur dioxide and nitrogen oxide emissions from fossil-fired generating plants will be required in two phases. Phase I compliance must be implemented in 1995 and affects eight generating plants -- some 10,000 II-56 MANAGEMENT'S DISCUSSION AND ANALYSIS (continued) Alabama Power Company 1993 Annual Report megawatts of capacity or 35 percent of total capacity -- in the Southern electric system. Phase II compliance is required in 2000, and all fossil-fired generating plants in the Southern electric system will be affected. Beginning in 1995, the Environmental Protection Agency (EPA) will allocate annual sulfur dioxide emission allowances through the newly established allowance trading program. An emission allowance is the authority to emit one ton of sulfur dioxide during a calendar year. The method for allocating allowances is based on the fossil fuel consumed from 1985 through 1987 for each affected generating unit. Emission allowances are transferable and can be bought, sold, or banked and used in the future. The sulfur dioxide emission allowance program is expected to minimize the cost of compliance. The market for emission allowances is developing slower than expected. However, The Southern Company's sulfur dioxide compliance strategy is designed to take advantage of allowances as the market develops. The Southern Company expects to achieve Phase I sulfur dioxide compliance at the eight affected plants by switching to low-sulfur coal, and this has required some equipment upgrades. This compliance strategy is expected to result in unused emission allowances being banked for later use. Additional construction expenditures are required to install equipment for the control of nitrogen oxide emissions at these eight plants. Also, continuous emissions monitoring equipment would be installed on all fossil-fired units. Under this Phase I compliance approach, additional construction expenditures are estimated to total approximately $275 million through 1995 for The Southern Company, of which the company's portion is approximately $30 million. Phase II compliance costs are expected to be higher because requirements are stricter and all fossil-fired generating plants are affected. For sulfur dioxide compliance, The Southern Company could use emission allowances banked during Phase I, increase fuel switching, install flue gas desulfurization equipment at selected plants, and/or purchase more allowances depending on the price and availability of allowances. Also, in Phase II, equipment to control nitrogen oxide emissions will be installed on additional system fossil-fired plants as required to meet anticipated Phase II limits. Therefore, during the period 1996 to 2000, compliance could require total construction expenditures ranging from approximately $450 million to $800 million for The Southern Company, of which the company's portion is approximately $225 million to $350 million. However, the full impact of Phase II compliance cannot now be determined with certainty, pending the development of a market for emission allowances, the completion of EPA regulations, and the possibility of new emission reduction technologies. An increase of up to 2 percent in annual revenue requirements from customers could be necessary to fully recover the company's cost of compliance for both Phase I and Phase II of the Clean Air Act. Compliance costs include construction expenditures, increased costs for switching to low-sulfur coal, and costs related to emission allowances. There can be no assurance that all Clean Air Act costs will be recovered. Title III of the Clean Air Act requires a multi-year EPA study of power plant emissions of hazardous air pollutants. The study will serve as the basis for a decision on whether additional regulatory control of these substances is warranted. Compliance with any new control standards could result in significant additional costs. The impact of new standards -- if any -- will depend on the development and implementation of applicable regulations. The EPA continues to evaluate the need for a new short-term ambient air quality standard for sulfur dioxide. Preliminary results from an EPA study on the impact of a new standard indicate that a number of plants could be required to install sulfur dioxide controls. These controls would be in addition to the controls already required to meet the acid rain provision of the Clean Air Act. The EPA is expected to take some action on this issue in 1994. The impact of any new standard will depend on the level chosen for the standard and cannot be determined at this time. In addition, the EPA is evaluating the need to revise the ambient air quality standards for particulate matter, nitrogen oxides, and ozone. The impact of any new standard will depend on the level chosen for the standard II-57 MANAGEMENT'S DISCUSSION AND ANALYSIS (continued) Alabama Power Company 1993 Annual Report and cannot be determined at this time. In 1994 or 1995, the EPA is expected to issue revised rules on air quality control regulations related to stack height requirements of the Clean Air Act. The full impact of the final rules cannot be determined at this time, pending their development and implementation. In 1993, the EPA issued a ruling confirming the non-hazardous status of coal ash. However, the EPA has until 1998 to classify co-managed utility wastes -- coal ash and other utility wastes -- as either non-hazardous or hazardous. If the EPA classifies the co-managed wastes as hazardous, then substantial additional costs for the management of such wastes may be required. The full impact of any change in the regulatory status will depend on the subsequent development of co-managed waste requirements. The company must comply with other environmental laws and regulations that cover the handling and disposal of hazardous waste. Under these various laws and regulations, the company could incur costs to clean up properties currently or previously owned. The company conducts studies to determine the extent of any required clean-up costs and has recognized in the financial statements costs to clean up known sites. Several major pieces of environmental legislation are in the process of being reauthorized or amended by Congress. These include: the Clean Water Act; the Comprehensive Environmental Response, Compensation, and Liability Act; and the Resource Conservation and Recovery Act. Changes to these laws could affect many areas of The Southern Company's operations. The full impact of these requirements cannot be determined at this time, pending the development and implementation of applicable regulations. Compliance with possible new legislation related to global climate change, electromagnetic fields, and other environmental and health concerns could significantly affect the Southern electric system. The impact of new legislation -- if any -- will depend on the subsequent development and implementation of applicable regulations. In addition, the potential for lawsuits alleging damages caused by electromagnetic fields exists. SOURCES OF CAPITAL It is anticipated that the funds required will be derived from sources in form and quantity similar to those used in the past. To issue additional first mortgage bonds and preferred stock, the company must comply with certain earnings coverage requirements designated in its mortgage indenture and corporate charter. The company's coverages are at a level that would permit any necessary amount of security sales at current interest and dividend rates. As required by the Nuclear Regulatory Commission and as ordered by the APSC, the company has established external trust funds for nuclear decommissioning costs. Also, during 1993, the APSC issued a policy statement which will require external funding of postretirement benefits. The cumulative effect of funding these items over a long period will diminish internally funded capital and may require capital from other sources. For additional information concerning nuclear decommissioning costs, see Note 1 to the financial statements under "Depreciation and Nuclear Decommissioning." II-58 STATEMENTS OF INCOME For the Years Ended December 31, 1993, 1992, and 1991 Alabama Power Company The accompanying notes are an integral part of these statements. II-59 STATEMENTS OF CASH FLOWS For the Years Ended December 31, 1993, 1992, and 1991 Alabama Power Company ( ) Denotes use of cash. The accompanying notes are an integral part of these statements. II-60 BALANCE SHEETS At December 31, 1993 and 1992 Alabama Power Company The accompanying notes are an integral part of these statements. II-61 BALANCE SHEETS At December 31, 1993 and 1992 Alabama Power Company The accompanying notes are an integral part of these statements. II-62 STATEMENTS OF CAPITALIZATION At December 31, 1993 and 1992 Alabama Power Company The accompanying notes are an integral part of these statements. II-63 STATEMENTS OF RETAINED EARNINGS For the Years Ended December 31, 1993, 1992, and 1991 Alabama Power Company The accompanying notes are an integral part of these statements. II-64 NOTES TO FINANCIAL STATEMENTS Alabama Power Company 1993 Annual Report 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES GENERAL The company is a wholly owned subsidiary of The Southern Company which is the parent company of five operating companies, a system service company, Southern Electric International (Southern Electric), Southern Nuclear Operating Company (Southern Nuclear), and various other subsidiaries related to foreign utility operations and domestic non-utility operations. At this time, the operations of the other subsidiaries are not material. The operating companies (Alabama Power Company, Georgia Power Company, Gulf Power Company, Mississippi Power Company, and Savannah Electric and Power Company) provide electric service in four Southeastern states. Contracts among the companies -- dealing with jointly-owned generating facilities, interconnecting transmission lines, and the exchange of electric power -- are regulated by the Federal Energy Regulatory Commission (FERC) or the Securities and Exchange Commission (SEC). The system service company provides, at cost, specialized services upon request to The Southern Company and to the subsidiary companies. Southern Electric designs, builds, owns and operates power production facilities and provides a broad range of technical services to industrial companies and utilities in the United States and a number of international markets. Southern Nuclear provides services to The Southern Company's nuclear power plants. The Southern Company is registered as a holding company under the Public Utility Holding Company Act of 1935 (PUHCA). Both The Southern Company and its subsidiaries are subject to the regulatory provisions of the PUHCA. The company is also regulated by the FERC and the Alabama Public Service Commission (APSC). The company follows generally accepted accounting principles and complies with the accounting policies and practices prescribed by the respective commissions. Certain prior years' data presented in the financial statements have been reclassified to conform with current year presentation. REVENUES AND FUEL COSTS The company accrues revenues for services rendered but unbilled at the end of each fiscal period. Fuel costs are expensed as the fuel is used. The company's electric rates include provisions to adjust billings for fluctuations in fuel and the energy component of purchased power costs. Revenues are adjusted for differences between recoverable fuel costs and amounts actually recovered in current rates. Fuel expense includes the amortization of the cost of nuclear fuel and a charge, based on nuclear generation, for the permanent disposal of spent nuclear fuel. Total charges for nuclear fuel included in fuel expense amounted to $62 million in 1993, $48 million in 1992, and $69 million in 1991. The company has a contract with the U.S. Department of Energy (DOE) that provides for the permanent disposal of spent nuclear fuel, which was scheduled to begin in 1998. However, the actual year this service will begin is uncertain. Sufficient storage capacity currently is available to permit operation into 2012 and 2014 at Plant Farley units 1 and 2, respectively. Also, the Energy Policy Act of 1992 required the establishment in 1993 of a Uranium Enrichment Decontamination and Decommissioning Fund, which is to be funded in part by a special assessment on utilities with nuclear plants. This assessment will be paid over a 15-year period, which began in 1993. This fund will be used by the DOE for the decontamination and decommissioning of its nuclear fuel enrichment facilities. The law provides that utilities will recover these payments in the same manner as any other fuel expense. The company currently estimates its liability under this law to be approximately $46 million. This obligation is recognized in the accompanying Balance Sheets. DEPRECIATION AND NUCLEAR DECOMMISSIONING Depreciation of the original cost of depreciable utility plant in service is provided primarily by using composite straight-line rates which approximated 3.3 percent in 1993, 1992, and 1991. When property subject to depreciation is retired or otherwise disposed of in the normal course of business, its cost -- together with the cost of removal, less salvage -- is charged to the accumulated provision for depreciation. Minor items of property included in the original cost of the plant are retired when the related property unit is retired. Depreciation expense includes an amount for the expected cost of decommissioning nuclear facilities. II-65 NOTES (continued) Alabama Power Company 1993 Annual Report In 1988, the Nuclear Regulatory Commission (NRC) adopted regulations requiring all licensees operating commercial power reactors to establish a plan for providing, with reasonable assurance, funds for decommissioning. Reasonable assurance may be in the form of an external trust fund, a surety method, or prepayment. The company has established external trust funds to comply with the NRC's regulations. Prior to the enactment of these regulations, the company had reserved nuclear decommissioning costs. The NRC's minimum external funding requirements are based on a generic estimate of the cost to decommission the radioactive portions of a nuclear unit based on the size and type of reactor. The company has filed plans with the NRC to ensure that -- over time -- the deposits and earnings of the external trust funds will provide the minimum funding amount prescribed by the NRC. The estimated cost of decommissioning and the amounts being recovered through rates at December 31, 1993, for Plant Farley were as follows: The amount in the internal reserve is being transferred into the external trust funds over the remaining life of the license for Plant Farley as approved by the APSC. The decommissioning cost estimates are based on prompt dismantlement and removal of the plant from service. The actual decommissioning costs may vary from the above estimates because of regulatory requirements, changes in technology, and changes in costs of labor, materials, and equipment. INCOME TAXES The company provides deferred income taxes for all significant income tax temporary differences. Investment tax credits utilized are deferred and amortized to income over the average lives of the related property. In years prior to 1993, income taxes were accounted for and reported under Accounting Principles Board Opinion No. 11. Effective January 1, 1993, the company adopted Financial Accounting Standards Board (FASB) Statement No. 109, Accounting for Income Taxes. Statement No. 109 required, among other things, conversion to the liability method of accounting for accumulated deferred income taxes. See Note 8 for additional information about Statement No. 109. ALLOWANCE FOR FUNDS USED DURING CONSTRUCTION (AFUDC) AFUDC represents the estimated debt and equity costs of capital funds that are necessary to finance the construction of new facilities. While cash is not realized currently from such allowance, it increases the revenue requirement over the service life of the plant through a higher rate base and higher depreciation expense. The composite rate used to determine the amount of allowance, net of deferred income tax, was 6.2 percent in 1991. Such method of computing AFUDC ceased upon the commercial operation of Plant Miller Unit 4 in March 1991. For construction projects begun after 1986, deferral of taxes related to capitalized interest is no longer permitted. For those projects, the composite rate used to determine the amount of allowance was 7.8 percent in 1993, 7.9 percent in 1992, and 8.3 percent in 1991. AFUDC, net of income tax, as a percent of net income after dividends on preferred stock was 1.5 percent in 1993, 1.1 percent in 1992, and 2.0 percent in 1991. UTILITY PLANT Utility plant is stated at original cost. Original cost includes: materials; labor; minor items of property; appropriate administrative and general costs; payroll-related costs such as taxes, pensions, and other benefits; and the estimated cost of funds used during construction. The cost of maintenance, repairs and replacements of minor items of property is charged to maintenance expense. The cost of replacements of property (exclusive II-66 NOTES (continued) Alabama Power Company 1993 Annual Report of minor items of property) is charged to utility plant. FINANCIAL INSTRUMENTS In accordance with FASB Statement No. 107, Disclosure About Fair Value of Financial Instruments, all financial instruments of the company -- for which the carrying amount does not approximate fair value -- are shown in the table below as of December 31: The fair values of nuclear decommissioning trusts and investment securities were based on listed closing market prices. The fair values for long-term debt were based on either closing market prices or closing prices of comparable instruments. MATERIALS AND SUPPLIES Generally, materials and supplies include the cost of transmission, distribution, and generating plant materials. Materials are charged to inventory when purchased and then expensed or capitalized to plant, as appropriate, when installed. VACATION PAY The company's employees earn their vacation in one year and take it in the subsequent year. However, for ratemaking purposes, vacation pay is recognized as an allowable expense only when paid. Consistent with this ratemaking treatment, the company accrues a current liability for earned vacation pay and records a current asset representing future recoverability of this cost. The amount was $23 million and $22 million at December 31, 1993 and 1992, respectively. In 1994, an estimated 65 percent of the 1993 deferred vacation cost will be expensed and the balance will be charged to construction and other accounts. 2. RETIREMENT BENEFITS PENSION PLAN The company has a defined benefit, trusteed, non-contributory pension plan that covers substantially all regular employees. Benefits are based on the greater of amounts resulting from two different formulas: years of service and final average pay or years of service and a flat-dollar benefit. The company uses the "entry age normal method with a frozen initial liability" actuarial method for funding purposes, subject to limitations under federal income tax regulations. Amounts funded to the pension fund are primarily invested in equity and fixed-income securities. FASB Statement No. 87, Employers' Accounting for Pensions, requires use of the "projected unit credit" actuarial method for financial reporting purposes. POSTRETIREMENT BENEFITS The company also provides certain medical care and life insurance benefits for retired employees. Substantially all employees may become eligible for these benefits when they retire. A qualified trust for medical benefits has been established for funding amounts to the extent deductible under federal income tax regulations. Amounts funded are primarily invested in debt and equity securities. Accrued costs of life insurance benefits, other than current cash payments for retirees, currently are not being funded. However, in December 1993, the APSC issued an accounting policy statement which requires the company to externally fund all postretirement benefits. It is expected that an external funding program will begin in 1994. Effective January 1, 1993, the company adopted FASB Statement No. 106, Employers' Accounting for Postretirement Benefits Other Than Pensions, on a prospective basis. Statement No. 106 requires that medical care and life insurance benefits for retired employees be accounted for on an accrual basis using a specified actuarial method, "benefit/years-of-service." II-67 NOTES (continued) Alabama Power Company 1993 Annual Report Because the adoption of Statement No. 106 was reflected in rates, it did not have a material impact on net income. Prior to 1993, the company recognized these benefit costs on an accrual basis using the "aggregate cost" actuarial method, which spreads the expected cost of such benefits over the remaining periods of employees' service as a level percentage of payroll costs. The total costs of such benefits recognized by the company in 1992 and 1991 were $15.2 million and $15.4 million, respectively. Status and Cost of Benefits Shown in the following tables are actuarial results and assumptions for pension and postretirement medical and life insurance benefits as computed under the requirements of Statement Nos. 87 and 106, respectively. Retiree medical and life insurance information is shown only for 1993 because Statement No. 106 was adopted as of January 1, 1993, on a prospective basis. The funded status of the plans at December 31 was as follows: The weighted average rates assumed in the actuarial calculations were: An additional assumption used in measuring the accumulated postretirement medical benefit obligation was a weighted average medical care cost trend rate of 11.3 percent for 1993, decreasing gradually to 6.0 percent through the year 2000 and remaining at that level thereafter. An annual increase in the assumed medical care cost trend rate by 1.0 percent would increase the accumulated medical benefit obligation as of December 31, 1993, by $32.8 million and the aggregate of the service and interest cost components of the net retiree medical cost by $3.4 million. II-68 NOTES(continued) Alabama Power Company 1993 Annual Report Components of the plans' net cost are shown below: Of the above net pension amounts, $(8.9) million in 1993, $(5.1) million in 1992, and $0.7 million in 1991 were recorded in operating expenses, and the remainder was recorded in construction and other accounts. Of the above net postretirement medical and life insurance costs recorded in 1993, $22 million was charged to operating expenses and the remainder was charged to construction and other accounts. WORK FORCE REDUCTION PROGRAM The company has incurred additional costs for work force reduction programs. The costs related to these programs were $16.1 million, $13.4 million and $6.7 million for the years 1993, 1992 and 1991, respectively. A portion of the cost of these programs was deferred and is being amortized in accordance with regulatory treatment. The unamortized balance of these costs was $15.3 million at December 31, 1993. 3. LITIGATION AND REGULATORY MATTERS RETAIL RATE ADJUSTMENT PROCEDURES In November 1982, the APSC adopted rates that provide for periodic adjustments based upon the company's earned return on end-of-period retail common equity. The rates also provide for adjustments to recognize the placing of new generating facilities in retail service. Both increases and decreases have been placed into effect since the adoption of these rates. The rate adjustment procedures allow a return on common equity range of 13.0 percent to 14.5 percent and limit increases or decreases in rates to 4 percent in any calendar year. The APSC issued an order in December 1991 that reduced a scheduled 2.03 percent annual increase in rates to 1.03 percent, effective January 1992. The 1 percent reduction will remain in effect through 1994. The rate reduction was designed to refund to retail ratepayers a portion of the benefits from a settled contract dispute with Gulf States Utilities Company (Gulf States). The present value of this portion of the settlement amounting to approximately $60 million is being amortized to revenues to offset the rate reduction in accordance with the APSC's rate order. See Note 7 for additional information concerning the Gulf States settlement. Also in the December 1991 rate order, the APSC reaffirmed its satisfaction with the ratemaking mechanism and stated that it did not foresee any further review or changes in the procedures until after 1994. The ratemaking procedures will remain in effect after 1994 unless the APSC votes to modify or discontinue them. In February 1993, the APSC ordered - at the company's request - a moratorium on rate increases for the first two quarters of 1993, which facilitated the transition of an accounting change. This accounting change permitted the accrual of estimated operation and maintenance expenses related to nuclear refueling outages during the period between outages rather than at the time the expenses are incurred. HEAT PUMP FINANCING SUIT In September 1990, two customers of the company filed a civil complaint in the Circuit Court of Shelby County, Alabama, against the company seeking to represent all II-69 NOTES(continued) Alabama Power Company 1993 Annual Report persons who, prior to June 23, 1989, entered into agreements with the company for the financing of heat pumps and other merchandise purchased from vendors other than the company. The plaintiffs contended that the company was required to obtain a license under the Alabama Consumer Finance Act to engage in the business of making consumer loans. The plaintiffs were seeking an order declaring these agreements null and void and requiring the company to refund all payments -- principal and interest -- made under these agreements. The aggregate amount under these agreements, together with interest paid, currently is estimated to be $40 million. In June, 1993, the court ordered the company to refund or forfeit interest of approximately $10 million because of the company's failure to obtain such license. However, the court's order did not require any refund or forfeiture with respect to any principal payments under the agreements at issue. The company has appealed the court's order to the Supreme Court of Alabama. The final outcome of this matter cannot now be determined; however, in management's opinion, the final outcome will not have a material effect on the company's financial statements. FERC REVIEWS EQUITY RETURNS In May 1991, the FERC ordered that hearings be conducted concerning the reasonableness of the Southern electric system's wholesale rate schedules and contracts that have a return on common equity of 13.75 percent or greater. The contracts that could be affected by the hearings include substantially all of the transmission, unit power, long-term power and other similar contracts. Any changes in the rate of return on common equity that may occur as a result of this proceeding would be effective 60 days after a proper notice of the proceeding is published. A notice was published on May 10, 1991. In August 1992, a FERC administrative law judge issued an opinion that changes in rate schedules and contracts were not necessary and that the FERC staff failed to show how any changes were in the public interest. The FERC staff has filed exceptions to the administrative law judge's opinion, and the matter remains pending before the FERC. The final outcome of this matter cannot now be determined; however, in management's opinion, the final outcome will not have a material effect on the company's financial statements. 4. CAPITAL BUDGET The company's capital expenditures are currently estimated to total $588 million in 1994, $572 million in 1995 and $531 million in 1996. The estimates include AFUDC of $10 million in 1994, $11 million in 1995 and $12 million in 1996. The estimates for property additions for the three-year period includes $36.5 million committed to meeting the requirements of the Clean Air Act. The capital budget is subject to periodic review and revision, and actual capital cost incurred may vary from the above estimates because of numerous factors. These factors include changes in business conditions; revised load growth projections; changes in environmental regulations; changes in the existing nuclear plant to meet new regulatory requirements; increasing costs of labor, equipment, and materials; and cost of capital. At December 31, 1993, significant purchase commitments were outstanding in connection with the construction program. The company does not have any new baseload generating plants under construction. However, the construction of combustion turbine peaking units of approximately 720 megawatts is planned to be completed by 1996. In addition, significant construction will continue related to transmission and distribution facilities and the upgrading and extension of the useful lives of generating plants. 5. FINANCING, INVESTMENT, AND COMMITMENTS GENERAL To the extent possible, the company's construction program is expected to be financed primarily from internal sources. Short-term debt will be utilized when necessary; the amounts available are discussed below. The company may issue additional long-term debt and preferred stock primarily for the purposes of debt maturities and for redeeming higher-cost securities. FINANCING The ability of the company to finance its capital budget depends on the amount of funds generated internally and the funds it can raise by external financing. The II-70 NOTES(continued) Alabama Power Company 1993 Annual Report company's primary sources of external financing are sales of first mortgage bonds and preferred stock to the public, receipt of additional paid-in capital from The Southern Company, and leasing of nuclear material. In order to issue additional first mortgage bonds and preferred stock, the company must comply with certain earnings coverage requirements contained in its mortgage indenture and corporate charter. The most restrictive of these provisions requires, for the issuance of additional first mortgage bonds, that before-income-tax earnings, as defined, cover pro forma annual interest charges on outstanding first mortgage bonds at least twice; and for the issuance of additional preferred stock, that gross income available for interest cover pro forma annual interest charges and preferred stock dividends at least one and one-half times. These coverages, for first mortgage bonds and for preferred stock for the year ended December 31, 1993, were 5.70 and 2.71, respectively. BANK CREDIT ARRANGEMENTS The company, along with The Southern Company and Georgia Power Company, has entered into agreements with several banks outside the service area to provide $400 million of revolving credit to the companies through June 30, 1996. To provide liquidity support for commercial paper programs, the company and Georgia Power Company have exclusive right to $135 million and $165 million, respectively, of the available credit. The companies have the option of converting the short-term borrowings into term loans, payable in 12 equal quarterly installments, with the first installment due at the end of the first calendar quarter after the applicable termination date or at an earlier date at the companies' option. In addition, these agreements provide for payment of commitment fees based on the unused portions of the commitments or the maintenance of compensating balances with the banks. Additionally, the company maintains committed lines of credit in the amount of $350 million which expire at various times during 1994 and, in certain cases, provide for average annual compensating balances. Because the arrangements are based on an average balance, the company does not consider any of its cash balances to be restricted as of any specific date. Moreover, the company borrows from time to time pursuant to arrangements with banks for uncommitted lines of credit. In connection with all other lines of credit, the company has the option of paying fees or maintaining compensating balances, which are substantially all the cash of the company except for daily working funds and similar items. These balances are not legally restricted from withdrawal. At December 31, 1993, the company had regulatory approval to have outstanding up to $450 million of short-term borrowings. ASSETS SUBJECT TO LIEN The company's mortgage, as amended and supplemented, securing the first mortgage bonds issued by the company, constitutes a direct lien on substantially all of the company's fixed property and franchises. FUEL COMMITMENTS To supply a portion of the fuel requirements of its generating plants, the company has entered into various long-term commitments for the procurement of fossil and nuclear fuel. In most cases, these contracts contain provisions for price escalations, minimum purchase levels and other financial commitments. Total estimated long-term obligations through the year 2013 were approximately $8 billion at December 31, 1993. In addition, a contract with a certain coal contractor requires reimbursement or purchase, at net book value, of the investment in the mine or equipment upon termination of the contract. At December 31, 1993, such net book value was approximately $13 million. Additional commitments for coal and for nuclear fuel will be required in the future to supply the company's fuel needs. 6. FACILITY SALES AND JOINT OWNERSHIP AGREEMENTS The company and Georgia Power Company own equally all of the outstanding capital stock of Southern Electric Generating Company (SEGCO), which owns electric generating units with a total rated capacity of 1,019,680 kilowatts, together with associated transmission facilities. The capacity of these units is sold equally to the company and Georgia Power Company under a contract expiring in 1994 which, in substance, requires payments sufficient to provide for the operating expenses, taxes, interest expense II-71 NOTES(continued) Alabama Power Company 1993 Annual Report and a return on equity, whether or not SEGCO has any capacity and energy available. The company's share of expenses totaled $86 million in 1993, $73 million in 1992 and $82 million in 1991, and is included in "Purchased power from affiliates" in the Statements of Income. An amended contract has been filed with the FERC with substantially the same provisions, but the term thereof would be extended automatically for two year periods, subject to any party's right to cancel upon two years' notice. In addition, the company has guaranteed unconditionally the obligation of SEGCO under an installment sale agreement for the purchase of certain pollution control facilities at SEGCO's generating units, pursuant to which $24.5 million principal amount of pollution control revenue bonds are outstanding. Georgia Power Company has agreed to reimburse the company for the pro rata portion of such obligation corresponding to its then proportionate ownership of stock of SEGCO if the company is called upon to make such payment under its guaranty. At December 31, 1993, the capitalization of SEGCO consisted of $58 million of equity and $84 million of long-term debt on which the annual interest requirement is $3.8 million. SEGCO paid dividends totaling $11.3 million in 1993, $12.0 million in 1992, and $4.5 million in 1991, of which one-half of each was paid to the company. SEGCO's net income was $8.3 million, $9.3 million and $9.2 million for 1993, 1992 and 1991, respectively. In June 1992 the company completed the sale of a portion of Plant Miller Units 1 and 2 to Alabama Electric Cooperative, Inc. (AEC). The company's percentage ownership and investment in jointly-owned generating plants at December 31, 1993, follows: (1) Jointly owned with an affiliate, Mississippi Power Company. (2) Jointly owned with AEC. 7. LONG-TERM POWER SALES AGREEMENTS GENERAL The operating subsidiaries of The Southern Company, including the company, have entered into long-term and short-term contractual agreements for the sale of capacity and energy to certain non-affiliated utilities located outside the system's service area. Certain of these agreements are non-firm and are based on capacity of the system in general. Other agreements are firm and pertain to capacity related to specific generating units. Because the energy is generally sold at cost under these agreements, revenues from capacity sales primarily affect profitability. The company's portion of off-system capacity revenues has been as follows: Long-term non-firm power of 400 megawatts was sold by the Southern electric system in 1993 to Florida Power Corporation (FPC). In January 1994, this amount decreased to 200 megawatts, and the contract will expire at year-end. Unit power from Plant Miller is being sold to FPC, Florida Power & Light Company (FP&L), Jacksonville Electric Authority (JEA) and the City of Tallahassee, Florida (Tallahassee). Under these agreements, an average of 1,100 megawatts of capacity is scheduled to be II-72 NOTES(continued) Alabama Power Company 1993 Annual Report sold during 1994. Thereafter, these sales will increase to some 1,200 megawatts and remain at that approximate level -- unless reduced by FP&L, FPC, and JEA for the periods after 1999 -- until the expiration of the contracts in 2010. GULF STATES SETTLEMENT COMPLETED On November 7, 1991, subsidiaries of The Southern Company entered into a settlement agreement with Gulf States that resolved litigation between the companies that had been pending since 1986 and arose out of a dispute over certain unit power and other long-term power sales contracts. In 1993, all remaining terms and obligations of the settlement agreement were satisfied. With respect to the company's portion of proceeds received in 1991, see Note 3 concerning the regulatory treatment of amounts being refunded to retail customers over a three-year period. ALABAMA MUNICIPAL ELECTRIC AUTHORITY (AMEA) CAPACITY CONTRACTS In August 1986, the company entered into a firm power purchase contract with AMEA entitling AMEA to scheduled amounts of capacity (to a maximum 100 megawatts) for a period of 15 years commencing September 1, 1986 (1986 Contract). In October 1991, the company entered into a second firm power purchase contract with AMEA entitling AMEA to scheduled amounts of additional capacity (to a maximum 80 megawatts) for a period of 15 years commencing October 1, 1991 (1991 Contract). In both contracts the power will be sold to AMEA for its member municipalities that previously were served directly by the company as wholesale customers. Under the terms of the contracts, the company received payments from AMEA representing the net present value of the revenues associated with the respective capacity entitlements, discounted at effective annual rates of 9.96 percent and 11.19 percent for the 1986 and 1991 Contracts, respectively. These payments are being recognized as operating revenues and the discounts are being amortized to other interest expense as scheduled capacity is made available over the terms of the contracts. In order to secure AMEA's advance payments and the company's performance obligation under the contracts, the company issued and delivered to an escrow agent first mortgage bonds representing the maximum amount of liquidated damages payable by the company in the event of a default under the contracts. No principal or interest is payable on such bonds unless and until a default by the company occurs. As the liquidated damages decline under the contracts, a portion of the bonds equal to the decreases are returned to the company. At December 31, 1993, $153 million of such bonds were held by the escrow agent under the contracts. 8. INCOME TAXES Effective January 1, 1993, the company adopted FASB Statement No. 109, Accounting for Income Taxes. The adoption of Statement No. 109 resulted in cumulative adjustments that had no material effect on net income. The adoption also resulted in the recording of additional deferred income taxes and related assets and liabilities. The related assets of $469 million are revenues to be received from customers. These assets are attributable to tax benefits flowed through to customers in prior years and to taxes applicable to capitalized AFUDC. The related liabilities of $441 million are revenues to be refunded to customers. These liabilities are attributable to deferred taxes previously recognized at rates higher than current enacted tax law and to unamortized investment tax credits. Additionally, deferred income taxes related to accelerated tax depreciation previously shown as a reduction to utility plant were reclassified. II-73 NOTES (continued) Alabama Power Company 1993 Annual Report Details of the federal and state income tax provisions are as follows: The tax effects of temporary differences between the carrying amounts of assets and liabilities in the financial statements and their respective tax bases, which give rise to deferred tax assets and liabilities are as follows: Deferred investment tax credits are amortized over the life of the related property with such amortization normally applied as a credit to reduce depreciation in the Statements of Income. Credits amortized in this manner amounted to $13 million in 1993, $18 million in 1992, and $16 million in 1991. At December 31, 1993, all investment tax credits available to reduce federal income taxes payable had been utilized. A reconciliation of the federal statutory income tax rate to the effective income tax rate is as follows: The Southern Company and its subsidiaries file a consolidated federal income tax return. Under a joint consolidated income tax agreement, each company's current and deferred tax expense is computed on a stand-alone basis, and consolidated tax savings are allocated to each company based on its ratio of taxable income to total consolidated taxable income. II-74 NOTES (continued) Alabama Power Company 1993 Annual Report 9. OTHER LONG-TERM DEBT Details of other long-term debt are as follows: Pollution control obligations represent installment purchases of pollution control facilities financed by funds derived from sales by public authorities of revenue bonds. The company is required to make payments sufficient for the authorities to meet principal and interest requirements of such bonds. With respect to $154.5 million of such pollution control obligations, the company has authenticated and delivered to the trustees a like principal amount of first mortgage bonds as security for its obligations under the installment purchase agreements. No principal or interest on these first mortgage bonds is payable unless and until a default occurs on the installment purchase agreements. The company has capitalized leased nuclear material and recorded the related lease obligations. The arrangement provides for the payment of interest at varying rates and times dependent on options selected by the company from types of loans available under the arrangement. At the end of 1993 the effective rate of this lease arrangement, including applicable fees, was 3.58 percent. Principal payments are required under the arrangement based on the cost of fuel burned. The company has also capitalized certain office building leases and a street light lease. Monthly principal payments plus interest are required, and at December 31, 1993, the interest rate was 9.5 percent for office buildings and 13.0 percent for street lights. The net book value of capitalized leases included in utility plant in service was $94.7 million and $103.0 million at December 31, 1993 and 1992, respectively. The estimated aggregate annual maturities of other long-term debt through 1998 are as follows: $38.9 million in 1994, $33.3 million in 1995, $18.7 million in 1996, $6.4 million in 1997 and $3.0 million in 1998. 10. LONG-TERM DEBT DUE WITHIN ONE YEAR A summary of the improvement fund requirements and scheduled maturities and redemptions of long-term debt due within one year is as follows: The annual first mortgage bond improvement fund requirement is one percent of the aggregate principal amount of bonds of each series authenticated, so long as a portion of that series is outstanding, and may be satisfied by the deposit of cash and/or reacquired bonds, the certification of unfunded property additions or a combination thereof. The 1994 requirement of $20.1 million was satisfied by the deposit of cash in 1994, which was used for the partial redemption of various series of outstanding bonds. In addition, maturing in 1994 are other long-term debt of $38.9 million consisting primarily of capitalized nuclear fuel obligations. II-75 NOTES (continued) Alabama Power Company 1993 Annual Report 11. NUCLEAR INSURANCE Under the Price-Anderson Amendments Act of 1988 (Act), the company maintains agreements of indemnity with the NRC that, together with private insurance, cover third-party liability arising from any nuclear incident occurring at Plant Farley. The Act limits to $9.4 billion, public liability claims that could arise from a single nuclear incident. Plant Farley is insured against this liability to a maximum of $200 million by private insurance, with the remaining coverage provided by a mandatory program of deferred premiums which could be assessed, after a nuclear incident, against all owners of nuclear reactors. A company could be assessed up to $79 million per incident for each licensed reactor it operates but not more than an aggregate of $10 million per incident to be paid in a calendar year for each reactor. Such maximum assessment, excluding any applicable state premium taxes, for the company is $159 million per incident but not more than an aggregate of $20 million to be paid for each incident in any one year. The company is a member of Nuclear Mutual Limited (NML), a mutual insurer established to provide property damage insurance in an amount up to $500 million for members' nuclear generating facilities. The members are subject to a retrospective premium adjustment in the event that losses exceed accumulated reserve funds. The company's maximum annual assessment per incident is limited to $14 million under the current policy. Additionally, the company has policies that currently provide decontamination, excess property insurance, and premature decommissioning coverage up to $2.25 billion for losses in excess of the $500 million NML coverage. This excess insurance is provided by Nuclear Electric Insurance Limited (NEIL), a mutual insurance company, and American Nuclear Insurers/Mutual Atomic Energy Liability Underwriters. NEIL also covers the additional cost that would be incurred in obtaining replacement power during a prolonged accidental outage at a member's nuclear plant. Members can be insured against increased cost of replacement power in an amount up to $3.5 million per week (starting 21 weeks after the outage) for one year and up to $2.3 million per week for the second and third years. Under each of the NEIL policies, members are subject to assessments if losses each year exceed the accumulated funds available to the insurer under that policy. The maximum annual assessments per incident under current policies for the company would be $16 million for excess property damage and $9 million for replacement power. For all on-site property damage insurance policies for commercial nuclear power plants, the NRC requires that the proceeds of such policies issued or renewed on or after April 2, 1991, shall be dedicated first for the sole purpose of placing the reactor in a safe and stable condition after an accident. Any remaining proceeds are to be applied next toward the costs of decontamination and debris removal operations ordered by the NRC, and then, any further remaining proceeds are to be paid either to the company or to its bond trustees as may be appropriate under applicable trust indentures. The company participates in an insurance program for nuclear workers that provides coverage for worker tort claims filed for bodily injury caused at commercial nuclear power plants. In the event that claims for this insurance exceed the accumulated reserve funds, the company could be subject to a maximum total assessment of $6.4 million. II-76 NOTES (continued) Alabama Power Company 1993 Annual Report 12. COMMON STOCK DIVIDEND RESTRICTIONS The company's first mortgage bond indenture contains various common stock dividend restrictions that remain in effect as long as the bonds are outstanding. At December 31, 1993, $653 million of retained earnings was restricted against the payment of cash dividends on common stock under terms of the mortgage indenture. Supplemental indentures in connection with future first mortgage bond issues may contain more stringent common stock dividend restrictions than those currently in effect. 13. QUARTERLY FINANCIAL INFORMATION (UNAUDITED) Summarized quarterly financial data for 1993 and 1992 are as follows: The company's business is influenced by seasonal weather conditions and the timing of rate adjustments. II-77 SELECTED FINANCIAL AND OPERATING DATA Alabama Power Company II-78 SELECTED FINANCIAL AND OPERATING DATA Alabama Power Company II-79 SELECTED FINANCIAL AND OPERATING DATA (continued) Alabama Power Company Notes: (1) Generating capacity and fuel data includes Alabama Power Company's 50% portion of SEGCO. (2) Includes Southeastern Power Administration allotment. * Less than one-tenth of one percent. II-80 SELECTED FINANCIAL AND OPERATING DATA (continued) Alabama Power Company II-81 STATEMENTS OF INCOME Alabama Power Company * Includes the effect of recognizing, beginning in 1987, retail service rendered but not yet billed to customers. II-82 STATEMENTS OF INCOME Alabama Power Company II-83 STATEMENTS OF CASH FLOWS Alabama Power Company ( ) Denotes use of cash. II-84 STATEMENTS OF CASH FLOWS Alabama Power Company II-85 BALANCE SHEETS Alabama Power Company *Includes the effect of recognizing, beginning in 1987, retail service rendered but not yet billed to customers. II-86 BALANCE SHEETS Alabama Power Company II-87 BALANCE SHEETS Alabama Power Company *Includes the effect of recognizing, beginning in 1987, retail service rendered but not yet billed to customers. II-88 BALANCE SHEETS Alabama Power Company II-89 ALABAMA POWER COMPANY OUTSTANDING SECURITIES AT DECEMBER 31, 1993 FIRST MORTGAGE BONDS II-90 ALABAMA POWER COMPANY SECURITIES RETIRED DURING 1993 FIRST MORTGAGE BONDS II-91 GEORGIA POWER COMPANY FINANCIAL SECTION II-92 MANAGEMENT'S REPORT Georgia Power Company 1993 Annual Report The management of Georgia Power Company has prepared this annual report and is responsible for the financial statements and related information. These statements were prepared in accordance with generally accepted accounting principles appropriate in the circumstances, and necessarily include amounts that are based on the best estimates and judgments of management. Financial information throughout this annual report is consistent with the financial statements. The Company maintains a system of internal accounting controls to provide reasonable assurance that assets are safeguarded and that the books and records reflect only authorized transactions of the Company. Limitations exist in any system of internal controls based upon the recognition that the cost of the system should not exceed its benefits. The Company believes that its system of internal accounting controls maintains an appropriate cost/benefit relationship. The Company's system of internal accounting controls is evaluated on an ongoing basis by the Company's internal audit staff. The Company's independent public accountants also consider certain elements of the internal control system in order to determine their auditing procedures for the purpose of expressing an opinion on the financial statements. The audit committee of the board of directors, which is composed of five directors who are not employees, provides a broad overview of management's financial reporting and control functions. At least three times a year this committee meets with management, the internal auditors, and the independent public accountants to ensure that these groups are fulfilling their obligations and to discuss auditing, internal control and financial reporting matters. The internal auditors and the independent public accountants have access to the members of the audit committee at any time. Management believes that its policies and procedures provide reasonable assurance that the Company's operations are conducted with a high standard of business ethics. In management's opinion, the financial statements present fairly the financial position, results of operations and cash flows of Georgia Power Company in conformity with generally accepted accounting principles. As discussed in Note 4 to the financial statements, an uncertainty exists with respect to the actions of regulators regarding recoverability of the Company's investment in the Rocky Mountain pumped storage hydroelectric project. The outcome of this uncertainty cannot be determined until regulatory proceedings are concluded. Accordingly, no provision for any write-down of the costs associated with the Rocky Mountain project resulting from the potential actions of the Georgia Public Service Commission has been made in the accompanying financial statements. /s/ H. Allen Franklin /s/ Warren Y. Jobe - --------------------- -------------------------- H. Allen Franklin Warren Y. Jobe President and Chief Executive Vice President, Executive Officer Treasurer and Chief Financial Officer II-93 REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS TO THE BOARD OF DIRECTORS OF GEORGIA POWER COMPANY: We have audited the accompanying balance sheets and statements of capitalization of Georgia Power Company (a Georgia corporation) as of December 31, 1993 and 1992, and the related statements of income, retained earnings, paid-in capital, and cash flows for each of the three years in the period ended December 31, 1993. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements (pages II-102 through II-122) referred to above present fairly, in all material respects, the financial position of Georgia Power Company as of December 31, 1993 and 1992, and the results of its operations and its cash flows for the periods stated, in conformity with generally accepted accounting principles. As explained in Notes 2 and 7 to the financial statements, effective January 1, 1993, the Company changed its methods of accounting for postretirement benefits other than pensions and for income taxes. As more fully discussed in Note 4 to the financial statements, an uncertainty exists with respect to the actions of the regulators regarding the recoverability of the Company's investment in the Rocky Mountain pumped storage hydroelectric project. The outcome of this uncertainty cannot be determined until regulatory proceedings are concluded. Accordingly, no provision for any write-down of the costs associated with the Rocky Mountain project resulting from the potential actions of the Georgia Public Service Commission has been made in the accompanying financial statements. /s/ Arthur Andersen & Co. Atlanta, Georgia February 16, 1994 II-94 MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION Georgia Power Company 1993 Annual Report RESULTS OF OPERATIONS EARNINGS Georgia Power Company's 1993 earnings totaled $570 million, representing a $49 million (9.5 percent) increase over the prior year. This improvement is primarily a result of higher retail revenues and lower financing costs. Also, during the period, the Company had an $18 million after-tax gain on the sale of a portion of Plant Scherer Unit 4. Higher retail revenues reflect growth in energy sales of 6.1 percent from 1992 levels primarily due to exceptionally hot summer weather during 1993. Interest expense and preferred stock dividends decreased in 1993 due to the redemption and refinancing of higher-cost debt and preferred stock. These positive events were partially offset by higher operating expenses. In comparing 1992 earnings to the prior year, it should be noted that 1991 earnings included two unusual items that significantly affect this comparison. Earnings in 1991 were $89 million higher due to the completion of a settlement agreement with Gulf States Utilities Company (Gulf States) related to power sales contracts. This increase was partially offset by an after-tax charge of $33 million in 1991 for a work force reduction program. A comparison of 1992 to 1991 -- excluding these unusual items -- would reflect a 1992 increase in earnings of $102 million. REVENUES The following table summarizes the factors impacting operating revenues for the 1991-1993 period: Retail revenues of $3.8 billion in 1993 increased $262 million (7.4 percent) over the prior year, compared with an increase of $87 million (2.5 percent) in 1992. The exceptionally hot weather during the summer of 1993 was the primary factor affecting the increase in retail revenues over 1992. The increase in retail revenues for 1992 was a result of higher retail rates and sales growth, partially offset by mild weather and lower fuel revenues. Fuel revenues generally represent the direct recovery of fuel expense, including the fuel component of purchased energy, and do not affect net income. Revenues from demand-side options programs generally represent the direct recovery of program costs. See Note 3 to the financial statements for further information on these programs. Revenues from sales to non-affiliated utilities decreased in both 1993 and 1992. Contractual unit power sales to Florida utilities for 1993 and 1992 are down compared with prior years, primarily due to scheduled reductions that corresponded with the sales to these utilities of portions of Plant Scherer Unit 4 in July 1991 and June II-95 MANAGEMENT'S DISCUSSION AND ANALYSIS (continued) Georgia Power Company 1993 Annual Report 1993. Sales to municipalities and cooperatives increased slightly in 1993 due to the hot summer weather. Generally, these sales have been decreasing as these customers retain more of their own generation at facilities jointly owned with the Company. Revenues from sales to non-affiliated utilities outside the service area under long-term contracts consist of capacity and energy components. Capacity revenues reflect the recovery of fixed costs and a return on investment under the contracts. Energy is generally sold at variable cost. The capacity and energy components were as follows: Revenues from sales to affiliated companies within the Southern electric system will vary from year to year depending on demand and the availability and cost of generating resources at each company. Sales to affiliated companies do not have a significant impact on earnings. Changes in revenues are a function of the amount of energy sold each year. Kilowatt-hour (KWH) sales for 1993 and the percent change by year were as follows: The hot summer weather during 1993 contributed primarily to the sales growth in the residential and commercial classes. Continued improvement in economic conditions positively impacted sales growth in the commercial and industrial classes. Residential energy sales growth in 1992 reflected mild weather. Commercial and industrial sales growth in 1992 is attributable to improved economic conditions. The decrease in energy sales to non-affiliated utilities reflects scheduled reductions in contractual power sales. EXPENSES Fuel expense increased 2.3 percent in 1993 due to higher generation, which was partially offset by lower nuclear fuel costs. In 1992, fuel expense decreased 6.9 percent due to lower generation and lower fuel costs. Purchased power expense has decreased significantly since 1991, reflecting declining contractual capacity purchases from the co-owners of plants Vogtle and Scherer. Purchased power expense decreased $88 million in 1993 and $43 million in 1992. The declines in Plant Vogtle contractual capacity purchases did not have a significant impact on earnings in 1993 or 1992 as these costs are being levelized over six years under the terms of the 1991 Georgia Public Service Commission (GPSC) retail rate order. The levelization is reflected in the amortization of deferred Plant Vogtle expenses in the income statements. See Note 3 to the financial statements for additional information. Other Operation and Maintenance (O & M) expenses increased 9.0 percent in 1993 after remaining relatively flat in 1992. The increase in 1993 is primarily the result of environmental remediation costs at various current and former operating sites, the one- time costs of an automotive fleet reduction program and the recognition of higher employee benefit costs under new accounting rules adopted in 1993. See Note 2 to the financial statements for additional information concerning these new rules. Also, during 1993, O & M expenses reflect costs associated with new demand-side option programs. These costs were offset by increases in retail revenues. See Note 3 to the financial statements for additional information on the recovery of demand-side option program costs. Depreciation and amortization expense increased slightly due to additional plant investment. The 1992 decrease is due to the effects of lower depreciation rates effective in October 1991. Taxes other than income taxes increased 7.4 percent in 1993 and 3.8 percent in 1992. II-96 MANAGEMENT'S DISCUSSION AND ANALYSIS (continued) Georgia Power Company 1993 Annual Report These increases reflect higher ad valorem taxes. The 1993 increase also includes higher taxes paid to municipalities as a result of increased sales. Income tax expense increased $62 million in 1993 due primarily to higher earnings and the effect of a one percent increase in the federal tax rate effective January, 1993. Also, the Company incurred $27 million of tax expense in connection with the second in a series of four separate transactions to sell Plant Scherer Unit 4. The sale resulted in an after-tax gain of $18 million. Interest expense and dividends on preferred stock decreased $19 million (4.0 percent) and $49 million (9.3 percent) in 1993 and 1992, respectively. These reductions are due to significant refinancing of long-term debt and preferred stock. The Company refinanced $1.7 billion of securities in both 1993 and 1992. In addition, the Company has retired $544 million of long-term debt with the proceeds from the 1991 and 1993 Plant Scherer Unit 4 sales. Other interest charges in 1993 include interest related to the settlement of an Internal Revenue Service audit. The settlement, in total, did not have an effect on 1993 net income. The Company has deferred certain expenses and recorded a deferred return related to Plant Vogtle under phase-in plans. See Note 3 to the financial statements under "Plant Vogtle Phase-In-Plans" for information regarding the deferral and subsequent amortization of costs related to Plant Vogtle. EFFECTS OF INFLATION The Company is subject to rate regulation and income tax laws that are based on the recovery of historical costs. Therefore, inflation creates an economic loss because the Company is recovering its costs of investments in dollars that have less purchasing power. While the inflation rate has been relatively low in recent years, it continues to have an adverse effect on the Company because of the large investment in long-lived utility plant. Conventional accounting for historical cost does not recognize either this economic loss or the partially offsetting gain that arises through financing facilities with fixed-money obligations such as long-term debt and preferred stock. Any recognition of inflation by regulatory authorities is reflected in the rate of return allowed. FUTURE EARNINGS POTENTIAL The results of operations for the past three years are not necessarily indicative of future earnings. The level of future earnings depends on numerous factors ranging from growth in energy sales to regulatory matters. Growth in energy sales is subject to a number of factors which traditionally have included changes in contracts with neighboring utilities, energy conservation practiced by customers, the elasticity of demand, weather, competition, and the rate of economic growth in the Company's service area. Assuming normal weather, retail sales growth is projected to be approximately 2 percent annually on average during 1994 through 1996. The scheduled addition of four combustion turbine generating units in 1994, four units in 1995 and one unit in 1996, as well as the Rocky Mountain pumped storage hydroelectric project in 1995, will increase related O & M and depreciation expenses. See Note 4 to the financial statements for information on regulatory uncertainties related to the Rocky Mountain project. The GPSC has certified the construction of the 1994 and 1995 combustion turbine generating units for meeting peak generating needs. In addition, the Company has completed a demonstration competitive bidding process for its supply-side requirements expected for 1996. The Company has filed with the GPSC for certification of a four-year purchase power agreement beginning in 1996, and for construction of a jointly owned combustion turbine to be completed in 1996 to meet these needs. As part of efforts to curtail growth in operating expenses, the Company is reducing its work force through an early-retirement program announced in January 1994. The program resulted in a first quarter 1994 after-tax charge to earnings of $39 million. The program has an expected payback period of approximately two years. Pursuant to an Integrated Resource Plan approved by the GPSC in 1992, the Company has implemented various demand-side option programs and has been authorized by the GPSC to recover associated program costs through rate riders. On October 15, 1993, a superior court judge ruled that recovery of these costs through rate riders is unlawful. The Company has ceased collection of the rate riders and is deferring program costs as ordered by the II-97 MANAGEMENT'S DISCUSSION AND ANALYSIS (continued) Georgia Power Company 1993 Annual Report GPSC pending the final outcome of this matter. See Note 3 to the financial statements for additional information. The Company has completed two in a series of four separate transactions to sell Unit 4 of Plant Scherer to two Florida utilities. The remaining transactions are scheduled to take place in 1994 and 1995. If the sales take place as planned, the Company would realize an additional after-tax gain estimated to total approximately $20 million. See Note 5 to the financial statements for additional information. Compliance costs related to the Clean Air Act Amendments of 1990 (Clean Air Act) could reduce earnings if such costs cannot be billed to customers. The Clean Air Act is discussed later under "Environmental Issues." The Energy Policy Act of 1992 (Energy Act) will have a profound effect on the future of the electric utility industry. The Energy Act promotes energy efficiency, alternative fuel use, and increased competition among electric utilities. The law also includes provisions to streamline the licensing process for new nuclear generating plants. The Energy Act marks the beginning of a major change in the traditional business practices of selling electricity. The Energy Act allows Independent Power Producers (IPPs) and other electric suppliers access to a utility's transmission lines to sell their electricity to other utilities. This may enhance the incentives for IPPs to build cogeneration plants for the Company's large industrial and commercial customers. If the Company does not remain a low cost producer and provide quality service, the Company's sales growth could be limited and this could significantly erode earnings. The Company continues to compete with other electric suppliers within the state. In Georgia, most new retail customers with more than 900 kilowatts of connected load may choose their electricity supplier. In addition, the bulk power market has become very competitive as utilities, IPPs and cogenerators seek to supply future capacity needs. Competition can create new business opportunities, but it increases risk and has the potential to adversely affect earnings. The Federal Energy Regulatory Commission (FERC) regulates wholesale rate schedules and power sales contracts that the Company has with its sales for resale customers. The FERC currently is reviewing the rate of return on common equity included in these schedules and contracts and may require such returns to be lowered, possibly retroactively. See Note 3 to the financial statements under "FERC Review of Equity Returns" for additional information. NEW ACCOUNTING STANDARDS The Financial Accounting Standards Board (FASB) issued Statement No. 112, Employers' Accounting for Postemployment Benefits, which must be adopted by 1994. The new standard requires that all types of benefits provided to former or inactive employees and their families prior to retirement be accounted for on an accrual basis. These benefits include salary continuation, severance pay, supplemental unemployment benefits, disability-related benefits, job training, and health and life insurance coverage. In 1993, the Company adopted Statement No. 112, with no material effect on the financial statements. The FASB has issued Statement No. 115, Accounting for Certain Investments in Debt and Equity Securities, which will be effective in 1994. Statement No. 115 supersedes FASB Statement No. 12, Accounting for Certain Marketable Securities. The Company adopted the new rules in January, 1994, with no material effect on the financial statements. FINANCIAL CONDITION OVERVIEW The principal changes in the Company's financial condition in 1993 were gross utility plant additions of $674 million and the lowering of the cost of capital achieved through the refinancing or retirement of $1.7 billion of long-term debt and preferred stock. On January 1, 1993, the Company changed its methods of accounting for postretirement benefits other than pensions and for income taxes. See Notes 2 and 7 to the financial statements regarding the impact of these changes. The funds needed for gross property additions are currently provided from operations. The Statements of Cash Flows provide additional details. II-98 MANAGEMENT'S DISCUSSION AND ANALYSIS (continued) Georgia Power Company 1993 Annual Report FINANCING ACTIVITIES In 1993, the Company continued to lower its financing costs by issuing new securities and other debt, and retiring or repaying high-cost issues. New issues during 1991 through 1993 totaled $3.0 billion and retirement or repayment of securities totaled $4.2 billion. The retirements included the redemption of $253 million and $291 million in 1993 and 1991, respectively, of first mortgage bonds with the proceeds from the Plant Scherer Unit 4 sales. Composite financing rates for the years 1991 through 1993, as of year-end, were as follows: The Company's current securities ratings are as follows: * Not rated by Duff & Phelps LIQUIDITY AND CAPITAL REQUIREMENTS Cash provided from operations increased by $236 million in 1993, primarily due to higher retail sales, lower interest costs, decreasing capacity purchases from the co-owners of plants Vogtle and Scherer and the receipt of cash payments from Gulf States that completed the settlement of litigation. The Company estimates that construction expenditures for the years 1994 through 1996 will total $688 million, $555 million and $629 million, respectively. The Company will continue to invest in transmission and distribution facilities and enhance existing generating plants. These expenditures also include amounts for nine combustion turbine generating units and equipment that will be required to comply with the provisions of the Clean Air Act. The Company's contractual capacity purchases will decline by $113 million over the next three years. Cash requirements for sinking fund requirements, redemptions announced, and maturities of long-term debt are expected to total $377 million during 1994 through 1996. As a result of requirements by the Nuclear Regulatory Commission, the Company has established external sinking funds for the purpose of funding nuclear decommissioning costs. For 1994 through 1996, the amount to be funded for the Company totals $16 million annually. For additional information concerning nuclear decommissioning costs, see Note 1 to the financial statements under "Nuclear Decommissioning." SOURCES OF CAPITAL The Company expects to meet future capital requirements primarily using funds generated from operations and, if needed, by the issuance of new debt and equity securities, term loans, and short-term borrowings. To meet short-term cash needs and contingencies, the Company had approximately $540 million of unused credit arrangements with banks at the beginning of 1994. See Note 8 to the financial statements for additional information. Completing the remaining two transactions for the sale of Plant Scherer Unit 4 will generate approximately $130 million in both 1994 and in 1995. The Company is required to meet certain coverage requirements specified in its mortgage indenture and corporate charter to issue new first mortgage bonds and preferred stock. The Company's ability to satisfy all coverage requirements is such that it could issue new first mortgage bonds and preferred stock to provide sufficient funds for all anticipated requirements. ENVIRONMENTAL ISSUES In November 1990, the Clean Air Act was signed into law. Title IV of the Clean Air Act -- the acid rain compliance provision of the law -- will have a significant impact on The Southern Company. Specific reductions in sulfur dioxide and nitrogen oxide emissions from fossil-fired generating plants will be required in two phases. Phase I compliance must be implemented in 1995 and affects eight generating plants -- some 10,000 megawatts II-99 MANAGEMENT'S DISCUSSION AND ANALYSIS (continued) Georgia Power Company 1993 Annual Report of capacity or 35 percent of total capacity -- in the Southern electric system. Phase II compliance is required in 2000, and all fossil-fired generating plants in the Southern electric system will be affected. Beginning in 1995, the Environmental Protection Agency (EPA) will allocate annual sulfur dioxide emission allowances through the newly established allowance trading program. An emission allowance is the authority to emit one ton of sulfur dioxide during a calendar year. The method for allocating allowances is based on the fossil fuel consumed from 1985 through 1987 for each affected generating unit. Emission allowances are transferable and can be bought, sold, or banked and used in the future. The sulfur dioxide emission allowance program is expected to minimize the cost of compliance. The market for emission allowances is developing slower than expected. However, The Southern Company's sulfur dioxide compliance strategy is designed to take advantage of allowances as the market develops. The Southern Company expects to achieve Phase I sulfur dioxide compliance at the eight affected plants by switching to low-sulfur coal, and this has required some equipment upgrades. This compliance strategy is expected to result in unused emission allowances being banked for later use. Additional construction expenditures are required to install equipment for the control of nitrogen oxide emissions at these eight plants. Also, continuous emissions monitoring equipment would be installed on all fossil-fired units. Under this Phase I compliance approach, Georgia Power's construction expenditures are estimated to total approximately $150 million through 1995. Phase II compliance costs are expected to be higher because requirements are stricter and all fossil-fired generating plants are affected. For sulfur dioxide compliance, The Southern Company could use emission allowances banked during Phase I, increase fuel switching, install flue gas desulfurization equipment at selected plants, and/or purchase more allowances depending on the price and availability of allowances. Also, in Phase II, equipment to control nitrogen oxide emissions will be installed on additional system fossil-fired plants as required to meet anticipated Phase II limits. Therefore, during the period 1996 to 2000, compliance could require total Georgia Power construction expenditures ranging from approximately $150 million to $325 million. However, the full impact of Phase II compliance cannot now be determined with certainty, pending the development of a market for emission allowances, the completion of EPA regulations, and the possibility of new emission reduction technologies. An increase of up to 2 percent in Georgia Power's annual revenue requirements from customers could be necessary to fully recover the cost of compliance for both Phase I and Phase II of the Clean Air Act. Compliance costs include construction expenditures, increased costs for switching to low-sulfur coal, and costs related to emission allowances. There can be no assurance that all Clean Air Act costs will be recovered. Metropolitan Atlanta is classified as a non-attainment area with regard to the ozone ambient air quality standards. Title I of the Clean Air Act requires the state of Georgia to conduct specific studies and establish new control rules by November 1994 -- affecting sources of nitrogen oxides and volatile organic compounds -- to achieve attainment by 1999. As the required first step, the state has issued rules for the application of reasonably available control technology to reduce nitrogen oxide emissions by May 31, 1995. The results of these new rules require nitrogen oxide controls, above Title IV requirements, on some Company plants. Final attainment rules, based on modeling studies, could require installation of additional controls for nitrogen oxide emissions as early as 1997. Compliance with any new rules could result in significant additional costs. The impact of new rules will depend on the development and implementation of such rules. Title III of the Clean Air Act requires a multi-year EPA study of power plant emissions of hazardous air pollutants. The study will serve as the basis for a decision on whether additional regulatory control of these substances is warranted. Compliance with any new control standards could result in significant additional costs. The impact of new standards -- if any -- will depend on the development and implementation of applicable regulations. The EPA continues to evaluate the need for a new short-term ambient air quality standard for sulfur dioxide. Preliminary results from an EPA study on the impact of a II-100 MANAGEMENT'S DISCUSSION AND ANALYSIS (continued) Georgia Power Company 1993 Annual Report new standard indicate that a number of plants could be required to install sulfur dioxide controls. These controls would be in addition to the controls already required to meet the acid rain provision of the Clean Air Act. The EPA is expected to take some action on this issue in 1994. In addition, the EPA is evaluating the need to revise the ambient air quality standards for particulate matter, nitrogen oxides, and ozone. The impact of any new standards will depend on the level chosen for the standards and cannot be determined at this time. In 1994 or 1995, the EPA is expected to issue revised rules on air quality control regulations related to stack height requirements of the Clean Air Act. The full impact of the final rules cannot be determined at this time, pending their development and implementation. In 1993, the EPA issued a ruling confirming the nonhazardous status of coal ash. However, the EPA has until 1998 to classify co-managed utility wastes -- coal ash and other utility wastes -- as either nonhazardous or hazardous. If the EPA classifies the co-managed wastes as hazardous, then substantial additional costs for the management of such wastes may be required. The full impact of any change in the regulatory status will depend on the subsequent development of co-managed waste requirements. The Company must comply with other environmental laws and regulations that cover the handling and disposal of hazardous waste. These laws include the Comprehensive Environmental Response Compensation and Liability Act of 1980 (CERCLA or Superfund). Under these various laws and regulations, the Company could incur costs to clean up properties currently or previously owned. The Company conducts studies to determine the extent of any required clean-up costs and has recognized costs to clean-up known sites in the financial statements. Several major pieces of environmental legislation are in the process of being reauthorized or amended by Congress. These include: the Clean Water Act; the Comprehensive Environmental Response, Compensation, and Liability Act; and the Resource Conservation and Recovery Act. Changes to these laws could affect many areas of the Company's operations. The full impact of these requirements cannot be determined at this time, pending the development and implementation of applicable regulations. Compliance with possible new legislation related to global climate change, electromagnetic fields and other environmental and health concerns could significantly affect the Company. The impact of new legislation -- if any -- will depend on the subsequent development and implementation of applicable regulations. In addition, the potential for lawsuits alleging damages caused by electromagnetic fields exists. II-101 STATEMENTS OF INCOME For the Years Ended December 31, 1993, 1992, and 1991 Georgia Power Company 1993 Annual Report The accompanying notes are an integral part of these statements. II-102 BALANCE SHEETS At December 31, 1993 and 1992 Georgia Power Company 1993 Annual Report The accompanying notes are an integral part of these statements. II-103 BALANCE SHEETS At December 31, 1993 and 1992 Georgia Power Company 1993 Annual Report The accompanying notes are an integral part of these statements. II-104 STATEMENTS OF CAPITALIZATION AT December 31, 1993 and 1992 Georgia Power Company 1993 Annual Report II-105 STATEMENTS OF CAPITALIZATION At December 31, 1993 and 1992 Georgia Power Company 1993 Annual Report The accompanying notes are an integral part of these statements. II-106 STATEMENTS OF RETAINED EARNINGS For the Years Ended December 31, 1993, 1992, and 1991 Georgia Power Company 1993 Annual Report The accompanying notes are an integral part of these statements. II-107 STATEMENTS OF CASH FLOWS For the Years Ended December 31, 1993, 1992, and 1991 Georgia Power Company 1993 Annual Report The accompanying notes are an integral part of these statements. II-108 NOTES TO FINANCIAL STATEMENTS Georgia Power Company 1993 Annual Report 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES GENERAL The Company is a wholly owned subsidiary of The Southern Company, which is the parent company of five operating companies, Southern Company Services (SCS), Southern Electric International (Southern Electric), and Southern Nuclear Operating Company (Southern Nuclear), and various other subsidiaries related to foreign utility operations and domestic non-utility operations. The operating companies (Alabama Power Company, Georgia Power Company, Gulf Power Company, Mississippi Power Company, and Savannah Electric and Power Company) provide electric service in four southeastern states. Intracompany contracts dealing with jointly owned generating facilities, transmission lines and exchange of electric power are regulated by the Federal Energy Regulatory Commission (FERC) or the Securities and Exchange Commission. SCS provides, at cost, specialized services to The Southern Company and each of the subsidiary companies. Southern Electric designs, builds, owns, and operates power production facilities and provides a broad range of technical services to industrial companies and utilities in the United States and a number of international markets. Southern Nuclear provides support services for nuclear power plants in the Southern electric system. The Southern Company is registered as a holding company under the Public Utility Holding Company Act of 1935. Both The Southern Company and its subsidiaries are subject to the regulatory provisions of this act. The Company is also subject to regulation by the FERC and the Georgia Public Service Commission (GPSC). The Company follows generally accepted accounting principles and complies with the accounting policies and practices prescribed by the respective regulatory commissions. Certain prior years' data presented in the financial statements have been reclassified to conform with current year presentation. REVENUES AND FUEL COSTS The Company accrues revenues for services rendered but unbilled at the end of each fiscal period. Fuel costs are expensed as fuel is used. The Company is authorized by state law and FERC regulations to recover fuel costs and the fuel component of purchased energy costs through fuel cost recovery provisions, which are periodically adjusted to reflect increases or decreases in such costs. Revenues are adjusted for differences between recoverable fuel costs and amounts actually recovered in current rates. Fuel costs were under recovered by $79 million and $4 million at December 31, 1993, and 1992, respectively. These amounts are included in customer accounts receivable on the balance sheets. The fuel cost recovery rate was increased effective December 6, 1993. The cost of nuclear fuel is amortized to fuel expense based on estimated thermal units used to generate electric energy and includes a provision for the disposal of spent fuel. Total charges for nuclear fuel amortized to expense were $75 million in 1993, $84 million in 1992, and $93 million in 1991. The Company has contracted with the U.S. Department of Energy (DOE) for permanent disposal of spent fuel beginning in 1998; however, the actual year this service will begin is uncertain. Pending permanent disposition of the spent fuel, sufficient storage capacity is available at Plant Hatch into 2003 and at Plant Vogtle into 2009. Also, the Energy Policy Act of 1992 required the establishment in 1993 of a Uranium Enrichment Decontamination and Decommissioning Fund which is to be funded, in part, by a special assessment on utilities with nuclear plants. This fund will be used by the DOE for the decontamination and decommissioning of its nuclear fuel enrichment facilities. The law provides that utilities will recover these payments in the same manner as any other fuel expense. The Company -- based on its ownership interest -- estimates its total assessment under this law to be approximately $42 million to be paid over a 15-year period beginning in 1993. This obligation is recognized in the accompanying Balance Sheets and is being recovered through the fuel cost recovery provisions. The remaining liability at December 31, 1993, is $39 million. II-109 NOTES (continued) Georgia Power Company 1993 Annual Report NUCLEAR REFUELING OUTAGE COSTS Prior to 1992, the Company expensed nuclear refueling outage costs as incurred during the outage period. Pursuant to the 1991 GPSC retail rate order, the Company began accounting for these costs on a normalized basis in 1992. Under this method of accounting, refueling outage costs are deferred and subsequently amortized to expense over the operating cycle of each unit, which is normally 18 months. Deferred nuclear outage costs were $17 million and $6 million at December 31, 1993 and 1992, respectively. DEPRECIATION Depreciation is provided on the cost of depreciable utility plant in service and is calculated primarily on the straight-line basis over the estimated composite service life of the property. The composite rate of depreciation was 3.1 percent in 1993 and 1992, and 3.2 percent in 1991. Effective October 1991, the Company adopted lower depreciation rates consistent with the 1991 GPSC retail rate order. When a property unit is retired or otherwise disposed of in the normal course of business, its costs and the costs of removal, less salvage, are charged to the accumulated provision for depreciation. Minor items of property included in the cost of the plant are retired when the related property unit is retired. NUCLEAR DECOMMISSIONING In 1988, the Nuclear Regulatory Commission (NRC) adopted regulations requiring all licensees operating commercial nuclear power reactors to establish a plan for providing, with reasonable assurance, funds for decommissioning. Reasonable assurance may be in the form of an external sinking fund, a surety method, or prepayment. The Company has established external trust funds to comply with the NRC's regulations. Prior to the enactment of these regulations, the Company had internally reserved nuclear decommissioning costs. The NRC's minimum external funding requirements are based on a generic estimate of the cost to decommission the radioactive portions of a nuclear unit based on the size and type of reactor. The estimated cost of decommissioning and the amounts being recovered through rates at December 31, 1993, for the Company's ownership interest in plants Hatch and Vogtle were as follows: The amounts in the internal reserve are being transferred into the external trust fund over a period of approximately nine years as approved by the GPSC in its 1991 retail rate order. The estimates approved by the GPSC for ratemaking exclude costs of non-radiated structures and site contingency costs. The actual decommissioning cost may vary from the above estimates because of regulatory requirements, changes in technology, and increased costs of labor, materials, and equipment. The decommissioning cost estimates are based on prompt dismantlement and removal of the plant from service. The Company expects the GPSC to periodically review and adjust, if necessary, the amounts collected in rates for the anticipated cost of decommissioning. PLANT VOGTLE PHASE-IN PLANS In 1987 and 1989, the GPSC ordered that the costs of Plant Vogtle Units 1 and 2 be phased into rates under plans that meet the requirements of Financial Accounting Standards Board (FASB) Statement No. 92, Accounting for Phase-In Plans. In 1991, the GPSC modified the phase-in plans. In addition, the Company deferred certain Plant Vogtle operating expenses and financing costs under accounting orders issued by the GPSC. See Note 3 for further information. II-110 NOTES (continued) Georgia Power Company 1993 Annual Report INCOME TAXES The Company provides deferred income taxes for all significant income tax temporary differences. Investment tax credits utilized are deferred and amortized to income over the average lives of the related property. In years prior to 1993, income taxes were accounted for and reported under Accounting Principles Board Opinion No. 11. Effective January 1, 1993, the Company adopted FASB Statement No. 109, Accounting for Income Taxes. See Note 7 to the financial statements for further information. ALLOWANCE FOR FUNDS USED DURING CONSTRUCTION (AFUDC) AND DEFERRED RETURN AFUDC represents the estimated debt and equity costs of capital funds that are necessary to finance the construction of new facilities. While cash is not realized currently from such allowance, it increases the revenue requirement over the service life of the plant through a higher rate base and higher depreciation expense. For the years 1993, 1992 and 1991, the average AFUDC rates were 4.87 percent, 7.16 percent and 9.90 percent, respectively. The reduction in the average AFUDC rate since 1991 reflects the Company's greater use of lower cost short-term debt. The Company also imputed a return on its investment in Plant Vogtle Units 1 and 2 after they began commercial operation, under short-term cost deferrals and phase-in plans as described in Note 3. AFUDC and the Vogtle deferred returns, net of taxes, as a percentage of net income after dividends on preferred stock, amounted to 1.4 percent, 2.1 percent and 9.2 percent for 1993, 1992 and 1991, respectively. UTILITY PLANT Utility plant is stated at original cost with the exception of Plant Vogtle, which is stated at cost less regulatory disallowances. Original cost includes materials; labor; appropriate administrative and general costs; payroll-related costs such as taxes, pensions, and other benefits; and the estimated cost of funds used during construction. CASH AND CASH EQUIVALENTS For purposes of the Statements of Cash Flows, temporary cash investments are considered cash equivalents. Temporary cash investments are securities with original maturities of 90 days or less. FINANCIAL INSTRUMENTS All financial instruments of the Company -- for which the carrying amount does not approximate fair value -- are shown in the table below at December 31: The fair values of nuclear decommissioning trusts and investment securities were based on listed closing market prices. The fair values for long-term debt and preferred stock subject to mandatory redemption were based on either closing market prices or closing prices of comparable instruments. MATERIALS AND SUPPLIES Generally, materials and supplies include the cost of transmission, distribution and generating plant materials. Materials are charged to inventory when purchased and then expensed or capitalized to plant, as appropriate, when installed. In December 1992, the Company converted to the inventory method of accounting for certain emergency spare parts. This conversion resulted in a regulatory liability that is being amortized as credits to income over II-111 NOTES (continued) Georgia Power Company 1993 Annual Report approximately four years. This conversion will not have a material effect on income in any year. VACATION PAY Company employees earn vacation in one year and take it in the subsequent year. However, for ratemaking purposes, vacation pay is recognized as an allowable expense only when paid. Consistent with this ratemaking treatment, the Company accrues a current liability for earned vacation pay and records a current asset representing the future recoverability of this cost. This amount was $42 million at December 31, 1993, and $40 million at December 31, 1992. In 1994, approximately 72 percent of the 1993 deferred vacation costs will be expensed, and the balance will be charged to construction and other accounts. 2. RETIREMENT BENEFITS PENSION PLAN The Company has a defined benefit, trusteed, non-contributory pension plan covering substantially all regular employees. Benefits are based on the greater of amounts resulting from two different formulas: years of service and final average pay or years of service and a flat dollar benefit. The Company uses the "entry age normal method with a frozen initial liability" actuarial method for funding purposes, subject to limitations under federal income tax regulations. Amounts funded to the pension fund are primarily invested in equity and fixed-income securities. FASB Statement No. 87, Employers' Accounting for Pensions, requires use of the projected unit credit actuarial method for financial reporting purposes. POSTRETIREMENT BENEFITS The Company also provides certain medical care and life insurance benefits for retired employees. Substantially all employees may become eligible for these benefits when they retire. For medical care benefits, a qualified trust has been established for funding amounts to the extent deductible under federal income tax regulations. Amounts funded are primarily invested in debt and equity securities. Accrued costs of life insurance benefits, other than current cash payments for retirees, currently are not being funded. Effective January 1, 1993, the Company adopted FASB Statement No. 106, Employers' Accounting for Postretirement Benefits Other Than Pensions, on a prospective basis. Statement No. 106 requires that medical care and life insurance benefits for retired employees be accounted for on an accrual basis using a specified actuarial method, "benefit/years-of-service." In October 1993, the GPSC ordered the Company to phase in the adoption of Statement No. 106 to cost of service over a five-year period, whereby one-fifth of the additional expense was recognized -- approximately $6 million -- in 1993 and the remaining additional expense was deferred. An additional one-fifth of the costs will be expensed each succeeding year until the costs are fully reflected in cost of service in 1997. The cost deferred during the five-year period will be amortized to expense over a 15-year period beginning in 1998. As a result of the regulatory treatment allowed by the GPSC, the adoption of Statement No. 106 did not have a material impact on net income. Prior to 1993, the Company recognized these cost on a cash basis as payments were made. The total costs of such benefits recognized by the Company in 1993, 1992, and 1991 were $56 million, $13 million, and $9 million, respectively. STATUS AND COST OF BENEFITS Shown in the following tables are actuarial results and assumptions for pension and postretirement medical and life insurance benefits as computed under the requirements of Statement Nos. 87 and 106, respectively. Retiree medical and life insurance information is shown only for 1993 because Statement No. 106 was adopted as II-112 NOTES (continued) Georgia Power Company 1993 Annual Report of January 1, 1993, on a prospective basis. The funded status of the plans at December 31 was as follows: Weighted average rates used in actuarial calculations: An additional assumption used in measuring the accumulated postretirement medical benefit obligation was a weighted average medical care cost trend rate of 11.3 percent for 1993, decreasing gradually to 6.0 percent through the year 2000 and remaining at that level thereafter. An annual increase in the assumed medical care cost trend rate by 1.0 percent would increase the accumulated medical benefit obligation as of December 31, 1993, by $68 million and the aggregate of the service and interest cost components of the net retiree medical cost by $7 million. The components of the plans' net costs are shown below: Of net pension costs (income) recorded, $(6) million in 1993 and $5 million in 1991, were recorded to operating expense, with the balance being recorded to construction and other accounts. II-113 NOTES (continued) Georgia Power Company 1993 Annual Report Of the above net postretirement medical and life insurance costs recorded in 1993, $21 million was charged to operating expenses, $21 million was deferred, and the remainder was charged to construction and other accounts. 3. LITIGATION AND REGULATORY MATTERS DEMAND-SIDE CONSERVATION PROGRAMS In October 1993, a Superior Court of Fulton County, Georgia, judge ruled that rate riders previously approved by the GPSC for recovery of the Company's costs incurred in connection with demand-side conservation programs were unlawful. The judge held that the GPSC lacked statutory authority to approve such rate riders except through general rate case proceedings and that those procedures had not been followed. The Company has suspended collection of the demand-side conservation costs and appealed the court's decision to the Georgia Court of Appeals. In December 1993, the GPSC approved the Company's request for an accounting order allowing the Company to defer all current unrecovered and future costs related to these programs until the court's decision is reversed or until the next general rate case proceeding. An association of industrial customers has filed a petition for review of such accounting order in the Superior Court of Fulton County, Georgia. The Company's costs related to these conservation programs through 1993 were $60 million of which $15 million has been collected and the remainder deferred. The estimated costs, assuming no change in the programs certified by the GPSC, are $38 million in 1994 and $40 million in 1995. The final outcome of this matter cannot now be determined; however, in management's opinion, the final outcome will not have a material adverse effect on these financial statements. RETAIL RATEPAYERS' SUIT CONCLUDED In March 1993, several retail ratepayers of Georgia Power filed a civil complaint in the Superior Court of Fulton County, Georgia, against Georgia Power, The Southern Company, the system service company, and Arthur Andersen & Co. The complaint alleged that Georgia Power obtained excessive rate increases by improper accounting for spare parts and sought actual damages estimated by the plaintiffs to be in excess of $60 million -- plus treble and punitive damages -- for alleged violations of the Georgia Racketeer Influenced and Corrupt Organizations Act and other state statutes, statutory and common law fraud, and negligence. These state law allegations were substantially the same as those included in a 1989 suit brought in federal district court in Georgia. That suit and similar ones filed in Alabama, Florida, and Mississippi federal courts were subsequently dismissed. The defendants' motions to dismiss the current complaint were granted by the Superior Court of Fulton County, Georgia, in July 1993. In January 1994, the plaintiffs' appeal of the dismissal to the Supreme Court of Georgia was rejected. This matter is now concluded. GULF STATES SETTLEMENT On November 7, 1991, subsidiaries of The Southern Company entered into a settlement agreement with Gulf States that resolved litigation between the companies that had been pending since 1986 and arose out of a dispute over certain unit power and long-term power sales contracts. In 1993, all remaining terms and obligations of the settlement agreement were satisfied. Based on the value of the settlement proceeds received, the Company recorded increases of $3 million in 1992 and $89 million in 1991 net income. FERC REVIEW OF EQUITY RETURNS In May 1991, the FERC ordered that hearings be conducted concerning the reasonableness of the Southern electric system's wholesale rate schedules and contracts that have a return on common equity of 13.75 percent or greater. The contracts that could be affected by the hearings include substantially all of the transmission, unit power, long-term power, and other similar contracts. Any changes in the rate of return on common equity that may occur as a result of this proceeding would be effective 60 days after a proper notice of the proceeding is published. A notice was published on May 10, 1991. In August 1992, a FERC administrative law judge issued an opinion that changes in rate schedules and contracts were not necessary and that the FERC staff failed to show how any changes were in the public interest. The FERC staff has filed exceptions to the administrative law judge's opinion, and the matter remains pending before the FERC. II-114 NOTES (continued) Georgia Power Company 1993 Annual Report The final outcome of this matter cannot now be determined; however, in management's opinion, the final outcome will not have a material adverse effect on the Company's financial statements. PLANT VOGTLE PHASE-IN PLANS Pursuant to orders from the GPSC, the Company recorded a deferred return under phase-in plans for Plant Vogtle Units 1 and 2 until October 1991 when the allowed investment was fully reflected in rates. In addition, the GPSC issued two separate accounting orders that required the Company to defer substantially all operating and financing costs related to both units until rate orders addressed these costs. These GPSC orders provide for the recovery of deferred costs within 10 years. The GPSC modified the phase-in plans in 1991 to accelerate the recognition of costs previously deferred under the Plant Vogtle Unit 2 phase-in plan and to levelize the remaining Plant Vogtle declining capacity buyback expenses. Under these orders, the Company has deferred and begun amortizing these costs (as recovered through rates) as follows: NUCLEAR PERFORMANCE STANDARDS In October 1989, the GPSC adopted a nuclear performance standard for the Company's nuclear generating units under which the performance of plants Hatch and Vogtle will be evaluated every three years. The performance standard is based on each unit's capacity factor as compared to the average of all U.S. nuclear units operating at a capacity factor of 50% or higher during the three-year period of evaluation. Depending on the performance of the units, the Company could receive a monetary reward or penalty under the performance standards criteria. The first evaluation was conducted in 1993 for performance during the 1990-92 period. During this three-year period, the Company's units performed at an average capacity factor of 81 percent compared to an industry average of approximately 73 percent. Based on these results, the GPSC approved a performance reward of approximately $8.5 million for the Company. This reward is being collected through the retail fuel cost recovery provision and recognized in income over a 36- month period beginning November, 1993. 4. COMMITMENTS AND CONTINGENCIES CONSTRUCTION PROGRAM The Company is engaged in a continuous construction program and currently estimates property additions to be approximately $688 million in 1994, $555 million in 1995 and $629 million in 1996. These estimated additions include AFUDC of $19 million in 1994, $27 million in 1995, and $18 million in 1996. The estimates for property additions for the three-year period include $88 million committed to meeting the requirements of the Clean Air Act. While the Company has no new baseload generating plants under construction, the construction of nine combustion turbine peaking units is planned to be completed by 1996. In addition, significant construction of transmission and distribution facilities, and upgrading and extending the useful life of generating plants will continue. The construction program is subject to periodic review and revision, and actual construction costs may vary from estimates because of numerous factors, including, but not limited to, changes in business conditions, load growth estimates, environmental regulations, and regulatory requirements. II-115 NOTES (continued) Georgia Power Company 1993 Annual Report FUEL COMMITMENTS To supply a portion of the fuel requirements of its generating plants, the Company has entered into various long-term commitments for the procurement of fossil and nuclear fuel. In most cases, these contracts contain provisions for price escalations, minimum purchase levels and other financial commitments. Total estimated long-term obligations were approximately $4.8 billion at December 31, 1993. Additional commitments for coal and for nuclear fuel will be required in the future to supply the Company's fuel needs. OPERATING LEASES The Company has entered into coal rail car rental agreements with various terms and expiration dates. Rental expense totaled $8 million, $7 million, and $5 million for 1993, 1992, and 1991, respectively. Minimum annual rental commitments for noncancellable rail car leases are $9 million annually for years 1994 through 1998, and total approximately $191 million thereafter. ROCKY MOUNTAIN PROJECT STATUS In its 1985 financing order, the GPSC concluded that completion of the Rocky Mountain pumped storage hydroelectric project in 1991 as then planned was not economically justifiable and reasonable and withheld authorization for the Company to spend funds from approved securities issuances on that project. In 1988, the Company and Oglethorpe Power Corporation (OPC) entered into a joint ownership agreement for OPC to assume responsibility for the construction and operation of the project, as discussed in Note 5. The joint ownership agreement significantly reduces the risk of the project being canceled. However, full recovery of the Company's costs depends on the GPSC's treatment of the project's cost and disposition of the project's capacity output. In the event the Company cannot demonstrate to the GPSC the project's economic viability based on current ownership, construction schedule, and costs, then part or all of such costs may have to be written off in accordance with FASB Statement No. 90, Accounting for Abandonments and Disallowed Plant Costs. At December 31, 1993, the Company's investment in the project amounted to approximately $197 million. AFUDC accrued on the Rocky Mountain project has not been credited to income or included in the project cost since December 1985. If accrual of AFUDC is not resumed, the Company's portion of the estimated total plant additions at completion would be approximately $199 million. The plant is currently scheduled to begin commercial operation in 1995. The Company has held preliminary discussions with other parties regarding the potential disposition of its remaining interest in the project. The ultimate outcome of this matter cannot now be determined. NUCLEAR INSURANCE Under the Price-Anderson Amendments Act of 1988, the Company maintains agreements of indemnity with the NRC that, together with private insurance, cover third-party liability arising from any nuclear incident occurring at the Company's nuclear power plants. The act limits to $9.4 billion public liability claims that could arise from a single nuclear incident. Each nuclear plant is insured against this liability to a maximum of $200 million by private insurance, with the remaining coverage provided by a mandatory program of deferred premiums that could be assessed, after a nuclear incident, against all owners of nuclear reactors. A company could be assessed up to $79 million per incident for each licensed reactor it operates but not more than an aggregate of $10 million per incident to be paid in a calendar year for each reactor. Such maximum assessment for the Company -- based on its ownership and buyback interests -- is $171 million per incident but not more than an aggregate of $22 million to be paid for each incident in any one year. The Company is a member of Nuclear Mutual Limited (NML), a mutual insurer established to provide property damage insurance in an amount up to $500 million for members' nuclear generating facilities. The members are subject to a retrospective premium adjustment in the event that losses exceed accumulated reserve funds. The Company's maximum assessment per incident is limited to $18 million under current policies. Additionally, the Company has policies that currently provide decontamination, excess property insurance, and premature decommissioning coverage up to $2.25 billion for losses in excess of the $500 million NML coverage. This excess insurance is provided by Nuclear Electric II-116 NOTES (continued) Georgia Power Company 1993 Annual Report Insurance Limited (NEIL), a mutual insurance company, and American Nuclear Insurers/Mutual Atomic Energy Liability Underwriters. NEIL also covers the additional costs that would be incurred in obtaining replacement power during a prolonged accidental outage at a member's nuclear plant. Members can be insured against increased costs of replacement power in an amount up to $3.5 million per week -- starting 21 weeks after the outage -- for one year and up to $2.3 million per week for the second and third years. Under each of the NEIL policies, members are subject to assessments if losses each year exceed the accumulated funds available to the insurer under that policy. The maximum assessments per incident under the current policies for the Company would be $15 million for excess property damage and $13 million for replacement power. For all on-site property damage insurance policies for commercial nuclear power plants, the NRC requires that the proceeds of such policies issued or renewed on or after April 2, 1991, shall be dedicated first for the sole purpose of placing the reactor in a safe and stable condition after an accident. Any remaining proceeds are to be applied next toward the costs of decontamination and debris removal operations ordered by the NRC, and any further remaining proceeds are to be paid either to the Company or to its bond trustees as may be appropriate under the policies and applicable trust indentures. The Company participates in an insurance program for nuclear workers that provides coverage for worker tort claims filed for bodily injury caused at commercial nuclear power plants. In the event that claims for this insurance exceed the accumulated reserve funds, the Company could be subject to a maximum total assessment of $7 million. 5. FACILITY SALES AND JOINT OWNERSHIP AGREEMENTS Since 1975, the Company has sold undivided interests in plants Hatch, Wansley, Vogtle, and Scherer Units 1 and 2, together with transmission facilities, to OPC, an electric membership generation and transmission corporation; the Municipal Electric Authority of Georgia (MEAG), a public corporation and an instrumentality of the state of Georgia; and the City of Dalton, Georgia. The Company has sold an interest in Plant Scherer Unit 3 to Gulf Power, an affiliate. Additionally, the Company has completed two of four separate transactions to sell Unit 4 of Plant Scherer to Florida Power & Light Company (FPL) and Jacksonville Electric Authority (JEA) for a total price of approximately $806 million, including any gains on these transactions. FPL will eventually own approximately 76.4 percent of the unit, with JEA owning the remainder. Georgia Power will continue to operate the unit. The completed and scheduled remaining transactions are as follows: Except as otherwise noted, the Company has contracted to operate and maintain all jointly owned facilities. The Company includes its proportionate share of plant operating expenses in the corresponding operating expenses in the Statements of Income. As discussed in Note 4, the Company and OPC have a joint ownership arrangement for the Rocky Mountain pumped storage hydroelectric project under which the Company will retain its present investment in the project and OPC will finance and complete the remainder of the project and operate the completed facility. Based on current cost estimates the Company's ownership will be approximately 25% of the project (194 megawatts of capacity) at completion. The Company will own six of eight 80 megawatt combustion turbine generating units and 75% of the related common facilities being jointly constructed with Savannah Electric, an affiliate. The Company's investment in the project at December 31, 1993, was $100 million and is expected to total approximately $182 million when the project is completed. All units are II-117 NOTES (continued) Georgia Power Company 1993 Annual Report expected to be completed by June, 1995. Savannah Electric will operate these units. In connection with the joint ownership arrangements for plants Vogtle and Scherer, the Company has made commitments to purchase declining fractions of OPC's and MEAG's capacity and energy from these units. These commitments are in effect during periods of up to 10 years following commercial operation (and with regard to a portion of a 5 percent interest in Plant Vogtle owned by MEAG, until the latter of the retirement of the plant or the latest stated maturity date of MEAG's bonds issued to finance such ownership interest). The payments for capacity are required whether or not any capacity is available. The energy cost is a function of each unit's variable operating costs. Except as noted below, the cost of such capacity and energy is included in purchased power from non-affiliates in the Company's Statements of Income. Capacity payments totaled $183 million, $289 million and $320 million in 1993, 1992 and 1991, respectively. The Plant Scherer buyback agreements ended in 1993. The current projected Plant Vogtle capacity payments for the next five years are as follows: $132 million in 1994, $77 million in 1995, $70 million in 1996, $59 million in 1997 and $59 million in 1998. Portions of the payments noted above relate to costs in excess of Plant Vogtle's allowed investment for ratemaking purposes. The present value of these portions was written off in 1987 and 1990. Additionally, the Plant Vogtle declining capacity buyback expense is being levelized over a six-year period. See Note 3 for further information. At December 31, 1993, the Company's percentage ownership and investment (exclusive of nuclear fuel) in jointly owned facilities in commercial operation, were as follows: (1) Investment net of write-offs. The Company and an affiliate, Alabama Power, own equally all of the outstanding capital stock of Southern Electric Generating Company (SEGCO), which owns electric generating units with a total rated capacity of 1,020 megawatts, as well as associated transmission facilities. The capacity of the units has been sold equally to the Company and Alabama Power under a contract expiring in 1994, which, in substance, requires payments sufficient to provide for the operating expenses, taxes, debt service and return on investment, whether or not SEGCO has any capacity and energy available. An amended contract has been filed with the FERC with substantially the same provisions, but the term thereof would be extended automatically for two year periods, subject to any party's right to cancel upon two year's notice. The Company's share of expenses included in purchased power from affiliates in the Statements of II-118 NOTES (continued) Georgia Power Company 1993 Annual Report Income, is as follows: At December 31, 1993, the capitalization of SEGCO consisted of $58 million of equity and $84 million of long-term debt on which the annual interest requirement is $3.8 million. 6. LONG-TERM POWER SALES AGREEMENTS The Company and the operating affiliates of The Southern Company have entered into long-term contractual agreements for the sale of capacity and energy to certain non-affiliated utilities located outside the system's service territory. Certain of these agreements are non-firm and are based on the capacity of the Southern system. Other agreements are firm and pertain to capacity related to specific generating units. Because energy is generally sold at cost under these agreements, it is primarily the capacity revenues that affect the Company's profitability. The capacity revenues have been as follows: Long-term non-firm power of 400 megawatts was sold by the Southern electric system in 1993 to Florida Power Corporation (FPC). This amount decreases to 200 megawatts in 1994 and the contract expires at year-end. Sales under these long-term non-firm power sales agreements are made from available power pool energy, and the revenues from the sales are shared by the operating affiliates. Unit power from specific generating plants is being sold to FPL, JEA, and the City of Tallahassee, Florida and beginning in 1994 to FPC. Under these agreements, the Company sold approximately 830 megawatts of capacity in 1993 and is scheduled to sell approximately 403 megawatts of capacity in 1994. Thereafter, these sales will decline to an estimated 157 megawatts by the end of 1996 and will remain at that approximate level through 1999. After 2000, capacity sales will decline to approximately 101 megawatts -- unless reduced by FPL and JEA -- until the expiration of the contracts in 2010. 7. INCOME TAXES Effective January 1, 1993, the Company adopted FASB Statement No. 109, Accounting for Income Taxes. The adoption of Statement No. 109 resulted in cumulative adjustments that had no material effect on net income. The adoption also resulted in the recording of additional deferred income taxes and related assets and liabilities. The related assets of $993 million are revenues to be received from customers. These assets are attributable to tax benefits flowed-through to customers in prior years, and taxes applicable to capitalized AFUDC. The related liabilities of $453 million are revenues to be refunded to customers. These liabilities are attributable to deferred taxes previously recognized at rates higher than current enacted tax law and to unamortized investment tax credits. Additionally, deferred income taxes related to accelerated tax depreciation previously shown as a reduction to utility plant were reclassified. Details of the federal and state income tax provisions are as follows: II-119 NOTES (continued) Georgia Power Company 1993 Annual Report The tax effects of temporary differences between the carrying amounts of assets and liabilities in the financial statements and their respective tax basis, which give rise to deferred tax assets and liabilities are as follows: Deferred investment tax credits are amortized over the life of the related property with such amortization normally applied as a credit to reduce depreciation in the Statements of Income. Credits amortized in this manner amounted to $19 million in 1993, $19 million in 1992, and $27 million in 1991. At December 31, 1993, all investment tax credits available to reduce federal income taxes payable had been utilized. A reconciliation of the federal statutory tax rate to effective income tax rate is as follows: The Southern Company and its subsidiaries file a consolidated federal income tax return. Under a joint consolidated income tax agreement, each company's current and deferred tax expense is computed on a stand-alone basis, and consolidated tax savings are allocated to each company based on its ratio of taxable income to total consolidated taxable income. 8. CAPITALIZATION COMMON STOCK DIVIDEND RESTRICTIONS The Company's first mortgage bond indenture contains various common stock dividend restrictions that remain in effect as long as the bonds are outstanding. At December 31, 1993, $742 million of retained earnings were restricted against the payment of cash dividends on common stock under terms of the mortgage indenture. Supplemental indentures in connection with future first mortgage bond issues may contain more stringent common stock dividend restrictions than those currently in effect. The Company's charter limits cash dividends on common stock to the lesser of the retained earnings balance or 75 percent of net income available for such stock during a prior period of 12 months if the ratio of common stock equity to total capitalization, including retained earnings, adjusted to reflect the payment of the proposed dividend, is below 25 percent, and to 50 percent of such net income if such ratio is less than 20 percent. At December 31, 1993, the ratio as defined was 46.1 percent. II-120 NOTES (continued) Georgia Power Company 1993 Annual Report REMARKETED BONDS In 1992, the Company issued two series of variable rate first mortgage bonds each with principal amounts of $100 million due 2032. The current composite interest rate on the bonds is 6.20 percent and is fixed for the first three years of the issues. POLLUTION CONTROL BONDS The Company has incurred obligations in connection with the sale by public authorities of tax-exempt pollution control and industrial development revenue bonds. The Company has authenticated and delivered to trustees an aggregate of $407.7 million of its first mortgage bonds, which are pledged as security for its obligations under pollution control and industrial development contracts. No interest on these first mortgage bonds is payable unless and until a default occurs on the installment purchase or loan agreements. An aggregate of approximately $1.3 billion of the pollution control and industrial development bonds is secured by a subordinated interest in specific property of the Company. Details of pollution control bonds are as follows: BANK CREDIT ARRANGEMENTS At the beginning of 1994, the Company had unused credit arrangements with banks totaling $540 million, of which $10 million expires June 30, 1994, $130 million expires at May 1, 1996, and $400 million expires at June 30, 1996. The $400 million expiring June 30, 1996, is under revolving credit arrangements with several banks providing the Company, Alabama Power, and The Southern Company up to a total credit amount of $400 million. To provide liquidity support for commercial paper programs and for other short-term cash needs, $165 million and $135 million of the $400 million available credit are currently dedicated for the Company and Alabama Power, respectively. However, the allocations can be changed among the borrowers by notifying the respective banks. During the term of the agreements expiring in 1996, short-term borrowings may be converted into term loans, payable in 12 equal quarterly installments, with the first installment due at the end of the first calendar quarter after the applicable termination date or at an earlier date at the companies' option. In addition, these agreements require payment of commitment fees based on the unused portions of the commitments or the maintenance of compensating balances with the banks. The $10 million credit arrangement expiring in 1994 allows borrowings for up to 90 days. Commitment fees are based on the unused portion of the commitment. In addition, the Company borrows under uncommitted lines of credit with banks and through a $150 million commercial paper program that has the liquidity support of committed bank credit arrangements. Average compensating balances held under these committed facilities were not material in 1993. OTHER LONG-TERM DEBT Assets acquired under capital leases are recorded in the Balance Sheets as utility plant in service, and the related obligations are classified as long-term debt. At December 31, 1993, the Company had a capitalized lease obligation for its corporate headquarters building of $88 million with an interest rate of 8.1 percent. Other capitalized lease obligations were $137 thousand with a composite interest rate of 6.8 percent. The maturities of capital lease obligations through 1998 are approximately as follows: $423 thousand in 1994, $309 thousand in 1995, $335 thousand in 1996, $362 thousand in 1997, and $392 thousand in 1998. The lease agreement for the corporate headquarters building provides for payments that are minimal in early years and escalate through the first 21 years of the lease. For ratemaking purposes, the GPSC has treated the lease as an operating lease and has allowed only the lease II-121 NOTES (continued) Georgia Power Company 1993 Annual Report payments in cost of service. The difference between the accrued expense and the lease payments allowed for ratemaking purposes is being deferred as a cost to be recovered in the future as ordered by the GPSC. At December 31, 1993, and 1992, the interest and lease amortization deferred on the Balance Sheets are $47 million and $48 million, respectively. In December 1993, the Company borrowed $37 million through a long-term note due in 1995. ASSETS SUBJECT TO LIEN The Company's mortgage dated as of March 1, 1941, as amended and supplemented, securing the first mortgage bonds issued by the Company, constitutes a direct lien on substantially all of the Company's fixed property and franchises. LONG-TERM DEBT DUE WITHIN ONE YEAR The current portion of the Company's long-term debt is as follows: *Less than .1 million The indenture's first mortgage bond improvement fund requirement amounts to 1 percent of each outstanding series of bonds authenticated under the indenture prior to January 1 of each year, other than those issued to collateralize pollution control obligations. The requirement may be satisfied by depositing cash or reacquired bonds, or by pledging additional property equal to 1 2/3 times the requirement. The 1993 and 1992 requirements were met in the first quarter of each year by depositing cash subsequently used to redeem bonds. The 1994 requirement was funded in December 1993. REDEMPTION OF HIGH-COST SECURITIES The Company plans to continue a program of redeeming or replacing high-cost debt and preferred stock in cases where opportunities exist to reduce financing costs. High-cost issues may be repurchased in the open market or called at premiums as specified under terms of the issue. They may also be redeemed at face value to meet improvement fund and sinking fund requirements, to meet replacement provisions of the mortgage, or by use of proceeds from the sale of property pledged under the mortgage. In general, for the first five years a series is outstanding the Company is prohibited from redeeming for improvement fund purposes more than 1 percent annually of the original issue amount. 9. QUARTERLY FINANCIAL DATA (UNAUDITED): Summarized quarterly financial information for 1993 and 1992 is as follows: The Company's business is influenced by seasonal weather conditions and the timing of rate increases. II-122 SELECTED FINANCIAL AND OPERATING DATA Georgia Power Company 1993 Annual Report II-123 SELECTED FINANCIAL AND OPERATING DATA Georgia Power Company 1993 Annual Report II-124 SELECTED FINANCIAL AND OPERATING DATA (continued) Georgia Power Company 1993 Annual Report Note: As of 9/1/91, Georgia Power Company's sales to Oglethorpe Power Company are not included in Peak-Hour Demand * Less than one-tenth of one percent. II-125 SELECTED FINANCIAL AND OPERATING DATA (continued) Georgia Power Company 1993 Annual Report II-126 STATEMENTS OF INCOME Georgia Power Company Note: Reflects major sales of facilities to Jacksonville Electric Authority, Florida Power & Light Company, OPC, MEAG, and Dalton. Increases in net income, after total taxes, from these sales were $18,391,000 in 1993, $14,542,000 in 1991, $6,336,000 in 1990, $3,851,000 in 1987, and $21,250,000 in 1984. II-127 STATEMENTS OF INCOME Georgia Power Company II-128 STATEMENTS OF CASH FLOWS Georgia Power Company ( ) Denotes use of cash. II-129 STATEMENTS OF CASH FLOWS Georgia Power Company II-130 BALANCE SHEETS Georgia Power Company II-131 BALANCE SHEETS Georgia Power Company II-132 BALANCE SHEETS Georgia Power Company II-133 BALANCE SHEETS Georgia Power Company II-134 GEORGIA POWER COMPANY OUTSTANDING SECURITIES AT DECEMBER 31, 1993 FIRST MORTGAGE BONDS II-135 GEORGIA POWER COMPANY OUTSTANDING SECURITIES (Continued) AT DECEMBER 31, 1993 (1) Issued in exchange for $5.00 preferred outstanding at the time of company formation. II-136 GEORGIA POWER COMPANY SECURITIES RETIRED DURING 1993 FIRST MORTGAGE BONDS (1) Issued in exchange for $5.00 preferred outstanding at the time of company formation. * Less than $500. II-137 GULF POWER COMPANY FINANCIAL SECTION II-138 MANAGEMENT'S REPORT Gulf Power Company 1993 Annual Report The management of Gulf Power Company has prepared and is responsible for the financial statements and related information included in this report. These statements were prepared in accordance with generally accepted accounting principles appropriate in the circumstances and necessarily include amounts that are based on the best estimates and judgments of management. Financial information throughout this annual report is consistent with the financial statements. The Company maintains a system of internal accounting controls to provide reasonable assurance that assets are safeguarded and that books and records reflect only authorized transactions of the Company. Limitations exist in any system of internal controls, however, based on a recognition that the cost of the system should not exceed its benefits. The Company believes its system of internal accounting controls maintains an appropriate cost/benefit relationship. The Company's system of internal accounting controls is evaluated on an ongoing basis by the Company's internal audit staff. The Company's independent public accountants also consider certain elements of the internal control system in order to determine their auditing procedures for the purpose of expressing an opinion on the financial statements. The audit committee of the board of directors, composed of the directors who are not employees, provides a broad overview of management's financial reporting and control functions. Periodically, this committee meets with management, the internal auditors, and the independent public accountants to ensure that these groups are fulfilling their obligations and to discuss auditing, internal controls, and financial reporting matters. The internal auditors and independent public accountants have access to the members of the audit committee at any time. Management believes that its policies and procedures provide reasonable assurance that the Company's operations are conducted according to a high standard of business ethics. In management's opinion, the financial statements present fairly, in all material respects, the financial position, results of operations, and cash flows of Gulf Power Company in conformity with generally accepted accounting principles. /s/ D. L. McCrary /s/ A. E. Scarbrough - -------------------------- ------------------------ Douglas L. McCrary Arlan E. Scarbrough Chairman of the Board Vice President - Finance and Chief Executive Officer II-139 REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS TO THE BOARD OF DIRECTORS OF GULF POWER COMPANY: We have audited the accompanying balance sheets and statements of capitalization of Gulf Power Company (a Maine corporation and a wholly owned subsidiary of The Southern Company) as of December 31, 1993 and 1992, and the related statements of income, retained earnings, paid-in capital, and cash flows for each of the three years in the period ended December 31, 1993. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements (pages II-148 through II-165) referred to above present fairly, in all material respects, the financial position of Gulf Power Company as of December 31, 1993 and 1992, and the results of its operations and its cash flows for the periods stated, in conformity with generally accepted accounting principles. As explained in Notes 2 and 8 to the financial statements, effective January 1, 1993, Gulf Power Company changed its methods of accounting for postretirement benefits other than pensions and for income taxes. /s/ Arthur Andersen & Co. Atlanta, Georgia February 16, 1994 II-140 MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION Gulf Power Company 1993 Annual Report RESULTS OF OPERATIONS EARNINGS Gulf Power Company's net income after preferred stock dividends was $54.3 million for 1993, a $0.2 million increase over 1992 net income. Earnings reflect a $2.3 million gain on the sale of Gulf States Utilities Company (Gulf States) stock and the reversal of a $1.7 million wholesale rate refund as the result of a court order which is further discussed in Note 3 to the financial statements under "Recovery of Contract Buyout Costs". The company also experienced growth in residential and commercial sales and a decrease in interest expense on long-term debt as a result of security refinancings, offset by higher operation and maintenance expense, and decreased industrial sales reflecting the loss of the Company's largest industrial customer, Monsanto, which began cogeneration in August of 1993. The Company's 1992 net income after dividends on preferred stock decreased $3.7 million compared to the prior year. The 1991 earnings included an after-tax gain of $12.7 million representing the settlement of litigation with Gulf States. See Note 7 to the financial statements under "Gulf States Settlement Completed" for further details. Excluding this settlement from 1991, earnings for 1992 increased $8.4 million -- or approximately -- 18.7 percent over 1991. This improvement was due to increased energy sales; lower interest expense and preferred dividends as a result of security refinancings; and continued emphasis on cost controls. The Company's return on average common equity was 13.29 percent for 1993, a slight decrease from the 13.62 percent return earned in 1992, which was up from the 12.03 percent earned in 1991 (excluding the Gulf States settlement). REVENUES Changes in operating revenues over the last three years are the result of the following factors: * Includes the non-interest portion of the wholesale rate refund reversal discussed in "Earnings." Retail revenues of $471.7 million in 1993 increased $10.2 million or 2.2 percent from last year, compared with an increase of 1.2 percent in 1992 and 4.9 percent in 1991. Revenues increased in the residential and commercial classes primarily due to customer growth, and favorable weather and economic conditions. Revenues in the industrial class declined due to the loss of the Company's largest industrial customer, Monsanto, which began operating its cogeneration facility in August 1993. See "Future Earnings Potential" for further details. The change in base rates for 1993 and 1992 reflects the expiration of a retail rate penalty in September 1992. Sales for resale were $95.4 million in 1993, increasing $1.2 million or 1.3 percent over 1992. Sales to affiliated companies vary from year to year depending on demand and the availability and cost of generating resources at each company. The majority of non-affiliated energy sales arise from long-term contractual agreements. Non-affiliated long-term contracts include capacity and energy components. Capacity revenues reflect the recovery of II-141 MANAGEMENT'S DISCUSSION AND ANALYSIS (continued) Gulf Power Company 1993 Annual Report fixed costs and return on investment. Energy is sold at its variable cost. The capacity and energy components under these long-term contracts were as follows: Beginning in June 1992, all the capacity from the Company's ownership portion of Plant Scherer Unit No. 3 was sold through unit power sales, resulting in increased capacity revenues. In 1993, changes in other operating revenues are primarily due to the recognition of $2.6 million under the Environmental Cost Recovery (ECR) clause which is fully discussed in Note 3 to the financial statements under "Environmental Cost Recovery", which is offset by true-ups of other regulatory cost recovery clauses. The increase in other operating revenues in 1992 was primarily due to true-ups of regulatory cost recovery clauses and the changes in franchise fee collections and Florida gross receipts taxes (discussed under "Expenses") which had no effect on earnings. Energy sales for 1993 and percent changes in sales since 1991 are reported below. Overall retail sales remained relatively flat in 1993. Increases in residential and commercial sales -- reflecting customer growth, favorable weather and an improving economy -- were offset by the decreased sales in the industrial class reflecting the loss of Monsanto. Retail sales increased 3.8 percent in 1992 primarily due to an increase in the number of customers served and a moderately improving economy. Energy sales for resale to non-affiliates increased 2.0 percent and are predominantly unit power sales under long-term contracts to Florida utilities which are discussed above. Energy sales to affiliated companies vary from year to year as mentioned above. EXPENSES Total operating expenses for 1993 increased $16.6 million or 3.5 percent over 1992 primarily due to increased operation and maintenance expenses and higher taxes. Other operation expenses increased $10.9 million or 11.1 percent from the 1992 level. The increase is attributable to additional costs of $7.4 million related to increases in the buyout of coal supply contracts and $1.4 million of environmental clean-up costs. Also, higher employee benefit costs and the costs of an automotive fleet reduction program increased expenses by $2.1 million. Operating expenses for 1992 increased by approximately $16 million over 1991. Excluding the Gulf States settlement, an after-tax reduction of $0.6 million in 1992 and $12.7 million in 1991, 1992 total operating expenses increased $4.3 million or 0.9 percent over 1991. Fuel and purchased power expenses decreased $3.8 million or 1.8 percent from 1992 reflecting the lower cost of fuel. Total 1992 fuel and purchased power increased $1.4 million or 0.7 percent from 1991. Maintenance expense increased $4.1 million or 9.7 percent over 1992 due to scheduled maintenance of production facilities. The 1992 maintenance expense was down $3.5 million or 7.7 percent from 1991 due to a decrease in scheduled maintenance. Federal income taxes increased $0.7 million primarily due to a corporate federal income tax rate increase from 34 percent to 35 percent effective January 1993. Taxes other than income taxes increased $2.3 million in 1993, an increase of 6.1 percent over the 1992 expense II-142 MANAGEMENT'S DISCUSSION AND ANALYSIS (continued) Gulf Power Company 1993 Annual Report primarily due to increases in property taxes and gross receipt taxes. Taxes other than income taxes decreased $4.5 million, or 10.5 percent in 1992 compared to 1991 due primarily to the Company discontinuing the collection of franchise fees for two Florida counties which was partially offset by an increase in gross receipt taxes. Changes in franchise fee collections and gross receipt taxes had no impact on earnings. Interest expense decreased $3.2 million or 8.1 percent from the 1992 level and 1992 interest expense decreased $5.6 million or 12.5 percent from 1991. The decrease in both years is primarily attributable to refinancing some of the Company's higher cost securities. EFFECTS OF INFLATION The Company is subject to rate regulation and income tax laws that are based on the recovery of historical costs. Therefore, inflation creates an economic loss because the Company is recovering its cost of investments in dollars that have less purchasing power. While the inflation rate has been relatively low in recent years, it continues to have an adverse effect on the Company because of the large investment in long-lived utility plant. Conventional accounting for historical cost does not recognize this economic loss nor the partially offsetting gain that arises through financing facilities with fixed-money obligations, such as long-term debt and preferred stock. Any recognition of inflation by regulatory authorities is reflected in the rate of return allowed. FUTURE EARNINGS POTENTIAL The results of operations for the past three years are not necessarily indicative of future earnings potential. The level of future earnings depends on a number of factors. It is expected that higher operating costs and carrying charges on increased investment in plant, if not offset by proportionate increases in operating revenues (either by periodic rate increases or increases in sales), will adversely affect future earnings. Growth in energy sales will be subject to a number of factors, including the volume of sales to neighboring utilities, energy conservation practiced by customers, the elasticity of demand, customer growth, weather, competition, and the rate of economic growth in the service area. In addition to the traditional factors discussed above, the Energy Policy Act of 1992 (Energy Act) will have a profound effect on the future of the electric utility industry. The Energy Act promotes energy efficiency, alternative fuel use, and increased competition for electric utilities. The Company is preparing to meet the challenges of a major change in the traditional business practices of selling electricity. The Energy Act allows independent power producers (IPPs) to access the Company's transmission network in order to sell electricity to other utilities, and this may enhance the incentive for IPPs to build cogeneration plants for the Company's large industrial and commercial customers and sell excess energy generation to the Company or other utilities. Although the Energy Act does not require transmission access to retail customers, pressure for legislation to allow retail wheeling will continue. If the Company does not remain a low-cost producer and provide quality service, the Company's retail energy sales growth, its ability to retain large industrial and commercial customers, and obtain new long-term contracts for energy sales outside the Company's service area, could be limited, and this could significantly erode earnings. The future effect of cogeneration and small-power production facilities cannot be fully determined at this time, but may be adverse. One effect of cogeneration which the Company has experienced is the loss of its largest industrial customer, Monsanto, in August of 1993. The loss of the Monsanto load reduced revenues, and will result in a reduction in net income of approximately $3 million in the first twelve months. The Federal Energy Regulatory Commission (FERC) regulates wholesale rate schedules and power sales contracts that the Company has with its sales for resale customers. The FERC is currently reviewing the rate of return on common equity included in these schedules and contracts that have a return on common equity of 13.75 percent or greater, and may require such returns to be lowered, possibly retroactively. See Note 3 to the financial statements under "FERC Reviews Equity Returns" for additional information. Compliance costs related to the Clean Air Act Amendments of 1990 (Clean Air Act) could reduce earnings if such costs are not fully recovered. The Clean Air Act is discussed later under "Environmental Matters". II-143 MANAGEMENT'S DISCUSSION AND ANALYSIS (continued) Gulf Power Company 1993 Annual Report Also, recently enacted legislation that provides for recovery of prudent environmental compliance costs is discussed in Note 3 to the financial statements under "Environmental Cost Recovery." The Company filed a notice with the Florida Public Service Commission (FPSC) of its intent to obtain rate relief in February 1993. On May 4, 1993, the FPSC approved a stipulation between the Company, the Office of Public Counsel, and the Florida Industrial Power Users Group to cancel the filing of the rate case. The stipulation also allowed the Company to retain, for the next four years, its existing method for calculating accruals for future power plant dismantlement costs. The existing method provides a more even allocation of expenses over the life of the plants and results in an avoided increase in expenses of about $6 million annually over the next four years when compared to the FPSC method. The stipulation also provided for the reduction of the Company's allowed return on equity midpoint from 12.55 percent to 12.0 percent. After the February 1993 filing date, interest rates continued to remain low, resulting in lower cost of capital. Also, the Florida legislature adopted legislation which allows utilities to petition the FPSC for recovery of environmental costs through an adjustment clause if these costs are not being recovered in base rates. See Note 3 to the financial statements under "Environmental Cost Recovery" for further details. The combination of the circumstances discussed above, placed the Company in a better position to manage its finances without an increase in base rates while still providing a fair return for the Company's investors. Consequently, the Company agreed, as a part of this stipulation, to cancel the filing of the rate case. NEW ACCOUNTING STANDARDS The Financial Accounting Standards Board (FASB) issued Statement No. 112, Employers' Accounting for Postemployment Benefits, which must be effective by 1994. The new standard requires that all types of benefits provided to former or inactive employees and their families prior to retirement be accounted for on an accrual basis. These benefits include salary continuation, severance pay, supplemental benefits, disability-related benefits, job training, and health and life insurance coverage. In 1993, the Company adopted Statement No. 112, which resulted in a decrease in earnings of $0.3 million. The FASB has issued Statement No. 115, Accounting for Certain Investments in Debt and Equity Securities, which is effective in 1994. Statement No. 115 supersedes FASB Statement No. 12, Accounting for Certain Marketable Securities. The Company does not have any investments that qualify for FASB Statement No. 115 treatment. FINANCIAL CONDITION OVERVIEW The principal changes in the Company's financial condition during 1993 were gross property additions of $79 million. Funds for these additions were provided by internal sources. The Company continued to refinance higher cost securities to lower the Company's cost of capital. See "Financing Activities" below and the Statements of Cash Flows for further details. On January 1, 1993, the Company changed its method of calculating the accruals for postretirement benefits other than pensions and its method of accounting for income taxes. See Notes 2 and 8 to the financial statements, regarding the impact of these changes. FINANCING ACTIVITIES As mentioned above, the Company continued to lower its financing costs by issuing new securities and other debt, and retiring higher-cost issues in 1993. The Company sold $75 million of first mortgage bonds and, through public authorities, $53.4 million of pollution control revenue bonds, issued $35 million of preferred stock, and obtained $25 million with a long-term bank note. Retirements, including maturities during 1993, totaled $88.8 million of first mortgage bonds, $40.7 million of pollution control revenue bonds, and $21.1 million of preferred stock. (See the Statements of Cash Flows for further details.) II-144 MANAGEMENT'S DISCUSSION AND ANALYSIS (continued) Gulf Power Company 1993 Annual Report Composite financing rates for the years 1991 through 1993 as of year end were as follows: CAPITAL REQUIREMENTS FOR CONSTRUCTION The Company's gross property additions, including those amounts related to environmental compliance, are budgeted at $200 million for the three years beginning 1994 ($77 million in 1994, $55 million in 1995, and $68 million in 1996). The estimates of property additions for the three-year period include $25 million committed to meeting the requirements of the Clean Air Act, the cost of which is expected to be recovered through the ECR clause which is discussed in Note 3 to the financial statements under "Environmental Cost Recovery". Actual construction costs may vary from this estimate because of factors such as the granting of timely and adequate rate increases; changes in environmental regulations; revised load projections; the cost and efficiency of construction labor, equipment, and materials; and the cost of capital. The Company does not have any baseload generating plants under construction. However, the Company plans to construct two 80 megawatt combustion turbine peaking units. The first is scheduled to be completed in 1998, and the second in 1999. Significant construction of transmission and distribution facilities and upgrading of generating plants will be continuing. OTHER CAPITAL REQUIREMENTS In addition to the funds needed for the construction program, approximately $86 million will be required by the end of 1996 in connection with maturities of long-term debt and preferred stock subject to mandatory redemption. Also, the Company plans to continue a program to retire higher-cost debt and preferred stock and replace these obligations with lower-cost capital. ENVIRONMENTAL MATTERS In November 1990, the Clean Air Act was signed into law. Title IV of the Clean Air Act -- the acid rain compliance provision of the law -- will have a significant impact on the Company. Specific reductions in sulfur dioxide and nitrogen oxide emissions from fossil-fired generating plants will be required in two phases. Phase I compliance must be implemented in 1995 and affects eight generating plants -- some 10,000 megawatts of capacity or 35 percent of total capacity -- in the Southern electric system. Phase II compliance is required in 2000, and all fossil-fired generating plants in the Southern electric system will be affected. Beginning in 1995, the Environmental Protection Agency (EPA) will allocate annual sulfur dioxide emission allowances through the newly established allowance trading program. An emission allowance is the authority to emit one ton of sulfur dioxide during a calendar year. The method for allocating allowances is based on the fossil fuel consumed from 1985 through 1987 for each affected generating unit. Emission allowances are transferable and can be bought, sold, or banked and used in the future. The sulfur dioxide emission allowance program is expected to minimize the cost of compliance. The market for emission allowances is developing slower than expected. However, The Southern Company's sulfur dioxide compliance strategy is designed to take advantage of allowances as the market develops. The Southern Company expects to achieve Phase I sulfur dioxide compliance at the eight affected plants by switching to low-sulfur coal, and this has required some equipment upgrades. This compliance strategy is expected to result in unused emission allowances being banked for later use. Additional construction expenditures are required to install equipment for the control of nitrogen oxide emissions at these eight plants. Also, continuous emissions monitoring equipment would be installed on all fossil-fired units. Under this Phase I compliance approach, additional construction expenditures are estimated to total approximately $275 million for The Southern Company including $34 million for Gulf Power Company through 1995. II-145 MANAGEMENT'S DISCUSSION AND ANALYSIS (continued) Gulf Power Company 1993 Annual Report Phase II compliance costs are expected to be higher because requirements are stricter and all fossil-fired generating plants are affected. For sulfur dioxide compliance, The Southern Company could use emission allowances banked during Phase I, increase fuel switching, install flue gas desulfurization equipment at selected plants, and/or purchase more allowances depending on the price and availability of allowances. Also, in Phase II, equipment to control nitrogen oxide emissions will be installed on additional system fossil-fired plants as required to meet anticipated Phase II limits. Therefore, during the period 1996 to 2000, compliance could require total construction expenditures ranging from approximately $450 million to $800 million for The Southern Company including approximately $30 million to $40 million for Gulf Power Company. However, the full impact of Phase II compliance cannot now be determined with certainty, pending the development of a market for emission allowances, the completion of EPA regulations, and the possibility of new emission reduction technologies. Following adoption of legislation in April of 1992, allowing electric utilities in Florida to seek FPSC approval of their Clean Air Act Compliance Plans, the Company filed its petition for approval. The Commission approved the Company's plan for Phase I compliance, deferring until a later date approval of its Phase II Plan. An average increase of up to 4 percent in annual revenue requirements from Gulf Power Company customers could be necessary to fully recover the cost of compliance for both Phase I and Phase II of the Clean Air Act. Compliance costs include construction expenditures, increased costs for switching to low-sulfur coal, and costs related to emission allowances. The Florida Legislature recently adopted legislation that allows a utility to petition the FPSC for recovery of prudent environmental compliance costs through an ECR clause without lengthy regulatory full revenue requirements rate proceedings. The legislation is discussed in Note 3 to the financial statements under "Environmental Cost Recovery". Title III of the Clean Air Act requires a multi-year EPA study of power plant emissions of hazardous air pollutants. The study will serve as the basis for a decision on whether additional regulatory control of these substances is warranted. Compliance with any new control standards could result in significant additional costs. The impact of new standards -- if any -- will depend on the development and implementation of applicable regulations. The EPA continues to evaluate the need for a new short-term ambient air quality standard for sulfur dioxide. Preliminary results from an EPA study on the impact of a new standard indicate that a number of plants could be required to install sulfur dioxide controls. These controls would be in addition to the controls already required to meet the acid rain provision of the Clean Air Act. The EPA is expected to take some action on this issue in 1994. The impact of any new standard will depend on the level chosen for the standard and cannot be determined at this time. In addition, the EPA is evaluating the need to revise the ambient air quality standards for particulate matter, nitrogen oxides, and ozone. The impact of any new standard will depend on the level chosen for the standard and cannot be determined at this time. In 1994 or 1995, the EPA is expected to issue revised rules on air quality control regulations related to stack height requirements of the Clean Air Act. The full impact of the final rules cannot be determined at this time, pending their development and implementation. In 1993, the EPA issued a ruling confirming the non-hazardous status of coal ash. However, the EPA has until 1998 to classify co-managed utility wastes -- coal ash and other utility wastes -- as either non-hazardous or hazardous. If the EPA classifies the co-managed wastes as hazardous, then substantial additional costs for the management of such wastes may be required. The full impact of any change in the regulatory status will depend on the subsequent development of co-managed waste requirements. Gulf Power Company must comply with other environmental laws and regulations that cover the handling and disposal of hazardous waste. Under these various laws and regulations, the Company could incur costs to clean up properties currently or previously owned. The Company conducts studies to determine the extent of any required clean-up costs and has recognized in the financial statements costs to clean up known sites. II-146 MANAGEMENT'S DISCUSSION AND ANALYSIS (continued) Gulf Power Company 1993 Annual Report Several major pieces of environmental legislation are in the process of being reauthorized or amended by Congress. These include: the Clean Water Act; the Comprehensive Environmental Response, Compensation, and Liability Act; and the Resource Conservation and Recovery Act. Changes to these laws could affect many areas of Gulf Power Company's operations. The full impact of these requirements cannot be determined at this time, pending the development and implementation of applicable regulations. Compliance with possible new legislation related to global climate change, electromagnetic fields, and other environmental and health concerns could significantly affect Gulf Power Company. The impact of new legislation - -- if any -- will depend on the subsequent development and implementation of applicable regulations. In addition, the potential for lawsuits alleging damages caused by electromagnetic fields exists. COAL STOCKPILE DECREASES To reduce the working capital invested in the coal stockpile inventory, the Company implemented a coal stockpile reduction program in 1992. The Company's actual year end inventory at December 31, 1993 was $20.7 million which is considerably lower than the desired level of $31.4 million. This situation exists because a limited supply of coal was available at competitive prices primarily due to the United Mine Workers strike from July to December 1993. In addition, barge transportation was stranded due to floods in the Midwest. As a result of these circumstances, management chose to allow the existing coal inventory to decline until coal prices stabilized. Current market conditions indicate that substantial coal supplies at competitive prices are now available. Therefore, the Company plans to increase purchases and return the coal stockpile inventory to the desired level by the end of the third quarter, 1994. SOURCES OF CAPITAL At December 31, 1993, the Company had $5.6 million of cash and cash equivalents to meet its short-term cash needs. It is anticipated that the funds required for construction and other purposes, including compliance with environmental regulations, will be derived from operations; the sale of additional first mortgage bonds, pollution control bonds, and preferred stock; and capital contributions from The Southern Company. The Company is required to meet certain coverage requirements specified in its mortgage indenture and corporate charter to issue new first mortgage bonds and preferred stock. The Company's coverage ratios are sufficient to permit, at present interest and preferred dividend levels, any foreseeable security sales. The amount of securities which the Company will be permitted to issue in the future will depend upon market conditions and other factors prevailing at that time. II-147 STATEMENTS OF INCOME For the Years Ended December 31, 1993, 1992, and 1991 Gulf Power Company 1993 Annual Report The accompanying notes are an integral part of these statements. II-148 STATEMENTS OF CASH FLOWS For the Years Ended December 31, 1993, 1992, and 1991 Gulf Power Company 1993 Annual Report ( ) Denotes use of cash. The accompanying notes are an integral part of these statements. II-149 BALANCE SHEETS At December 31, 1993 and 1992 Gulf Power Company 1993 Annual Report The accompanying notes are an integral part of these statements. II-150 BALANCE SHEETS (continued) At December 31, 1993 and 1992 Gulf Power Company 1993 Annual Report The accompanying notes are an integral part of these statements. II-151 STATEMENTS OF CAPITALIZATION At December 31, 1993 and 1992 Gulf Power Company 1993 Annual Report II-152 STATEMENTS OF CAPITALIZATION (CONTINUED) At December 31, 1993 and 1992 Gulf Power Company 1993 Annual Report The accompanying notes are an integral part of these statements. II-153 STATEMENTS OF RETAINED EARNINGS For the Years Ended December 31, 1993, 1992, and 1991 Gulf Power Company 1993 Annual Report STATEMENTS OF PAID-IN CAPITAL For the Years Ended December 31, 1993, 1992, and 1991 Gulf Power Company 1993 Annual Report The accompanying notes are an integral part of these statements. II-154 NOTES TO FINANCIAL STATEMENTS At December 31, 1993, 1992 and 1991 Gulf Power Company 1993 Annual Report 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES: GENERAL Gulf Power Company is a wholly owned subsidiary of The Southern Company, which is the parent company of five operating companies, Southern Company Services, Inc. (SCS), Southern Electric International (Southern Electric), Southern Nuclear Operating Company (Southern Nuclear) and various other subsidiaries related to foreign utility operations and domestic non-utility operations. At this time, the operations of the other subsidiaries are not material. The operating companies (Alabama Power Company, Georgia Power Company, Gulf Power Company, Mississippi Power Company, and Savannah Electric and Power Company) provide electric service in four Southeastern states. Contracts among the companies -- dealing with jointly owned generating facilities, interconnecting transmission lines, and the exchange of electric power -- are regulated by the Federal Energy Regulatory Commission (FERC) or the Securities and Exchange Commission. SCS provides, at cost, specialized services to The Southern Company and to the subsidiary companies. Southern Electric designs, builds, owns and operates power production facilities and provides a broad range of technical services to industrial companies and utilities in the United States and a number of international markets. Southern Nuclear provides services to The Southern Company's nuclear power plants. The Southern Company is registered as a holding company under the Public Utility Holding Company Act of 1935 (PUHCA). Both The Southern Company and its subsidiaries are subject to the regulatory provisions of the PUHCA. The Company is also subject to regulation by the FERC and the Florida Public Service Commission (FPSC). The Company follows generally accepted accounting principles and complies with the accounting policies and practices prescribed by these commissions. Certain prior years' data presented in the financial statements have been reclassified to conform with current year presentation. REVENUES AND FUEL COSTS The Company accrues revenues for service rendered but unbilled at the end of each fiscal period. Fuel costs are expensed as fuel is used. The Company's electric rates include provisions to periodically adjust billings for fluctuations in fuel and the energy component of purchased power costs. Revenues are adjusted for differences between recoverable fuel costs and amounts actually recovered in current rates. The FPSC has also approved the recovery of purchased power capacity costs, energy conservation costs, and environmental compliance costs in cost recovery clauses that are similar to the method used to recover fuel costs. DEPRECIATION AND AMORTIZATION Depreciation of the original cost of depreciable utility plant in service is provided primarily using composite straight-line rates which approximated 3.8 percent in 1993, 1992, and 1991. When property subject to depreciation is retired or otherwise disposed of in the normal course of business, its cost -- together with the cost of removal, less salvage -- is charged to the accumulated provision for depreciation. Minor items of property included in the original cost of the plant are retired when the related property unit is retired. INCOME TAXES The Company provides deferred income taxes for all significant income tax temporary differences. Investment tax credits utilized are deferred and amortized to income over the average lives of the related property. In years prior to 1993, income taxes were accounted for and reported under Accounting Principles Board Opinion No. 11. Effective January 1, 1993, the Company adopted FASB Statement No. 109, Accounting for Income Taxes. Statement No. 109 required, among other things, conversion to the liability method of accounting for accumulated deferred income taxes. See Note 8 for additional information about Statement No. 109. The Company is included in the consolidated federal income tax return of The Southern Company. II-155 NOTES (CONTINUED) Gulf Power Company 1993 Annual Report ALLOWANCE FOR FUNDS USED DURING CONSTRUCTION (AFUDC) AFUDC represents the estimated debt and equity costs of capital funds that are necessary to finance the construction of certain new facilities. While cash is not realized currently from such allowance, it increases the revenue requirement over the service life of plant through a higher rate base and higher depreciation expense. The FPSC-approved composite rate used to calculate AFUDC was 7.27 percent effective on July 1, 1993 and 8.03 percent for the first half of 1993, and for 1992, and 1991. AFUDC amounts for 1993, 1992, and 1991 were $966 thousand, $60 thousand, and $149 thousand, respectively. The increase in 1993 is due to an increase in construction projects at Plant Daniel. UTILITY PLANT Utility plant is stated at original cost. Original cost includes: materials; labor; minor items of property; appropriate administrative and general costs; payroll-related costs such as taxes, pensions, and other benefits; and the estimated cost of funds used during construction. The cost of maintenance, repairs, and replacement of minor items of property is charged to maintenance expense. The cost of replacements of property (exclusive of minor items of property) is charged to utility plant. CASH AND CASH EQUIVALENTS For purposes of the Statements of Cash Flows, temporary cash investments are considered cash equivalents. Temporary cash investments are securities with original maturities of 90 days or less. FINANCIAL INSTRUMENTS In accordance with FASB Statement No. 107, Disclosure About Fair Value of Financial Instruments, all financial instruments of the Company -- for which the carrying amount does not approximate fair value -- are shown in the table below as of December 31: The fair values of investment securities were based on listed closing market prices. The fair values for long-term debt and preferred stock subject to mandatory redemption were based on either closing market prices or closing prices of comparable instruments. MATERIALS AND SUPPLIES Generally, materials and supplies include the cost of transmission, distribution, and generating plant materials. Materials are charged to inventory when purchased and then expensed or capitalized to plant, as appropriate, when installed. VACATION PAY The Company's employees earn their vacation in one year and take it in the subsequent year. However, for ratemaking purposes, vacation pay is recognized as an allowable expense only when paid. Consistent with this ratemaking treatment, the Company accrues a current liability for earned vacation pay and records a current asset representing the future recoverability of this cost. The amount was $4.0 million and $3.8 million at December 31, 1993 and 1992, respectively. In 1994, an estimated 84 percent of the 1993 deferred vacation cost II-156 NOTES (CONTINUED) Gulf Power Company 1993 Annual Report will be expensed and the balance will be charged to construction. PROVISION FOR INJURIES AND DAMAGES The Company is subject to claims and suits arising in the ordinary course of business. As permitted by regulatory authorities, the Company is providing for the uninsured costs of injuries and damages by charges to income amounting to $1.2 million annually. The expense of settling claims is charged to the provision to the extent available. The accumulated provision of $2.2 million and $2.5 million at December 31, 1993 and 1992, respectively, is included in miscellaneous current liabilities in the accompanying Balance Sheets. PROVISION FOR PROPERTY DAMAGE Due to a significant increase in the cost of traditional insurance, effective in 1993, the Company became self-insured for the full cost of storm and other damage to its transmission and distribution property. As permitted by regulatory authorities, the Company provides for the estimated cost of uninsured property damage by charges to income amounting to $1.2 million annually. At December 31, 1993 and 1992, the accumulated provision for property damage amounted to $10.5 million and $9.7 million, respectively. The expense of repairing such damage as occurs from time to time is charged to the provision to the extent it is available. 2. RETIREMENT BENEFITS: PENSION PLAN The Company has a defined benefit, trusteed, non-contributory pension plan that covers substantially all regular employees. Benefits are based on the greater of amounts resulting from two different formulas: years of service and final average pay or years of service and a flat-dollar benefit. The Company uses the "entry age normal method with a frozen initial liability" actuarial method for funding purposes, subject to limitations under federal income tax regulations. Amounts funded to the pension trust fund are primarily invested in equity and fixed-income securities. FASB Statement No. 87, Employers' Accounting for Pensions, requires use of the "projected unit credit" actuarial method for financial reporting purposes. POSTRETIREMENT BENEFITS The Company also provides certain medical care and life insurance benefits for retired employees. Substantially all employees may become eligible for these benefits when they retire. A qualified trust for medical benefits has been established for funding amounts to the extent deductible under federal income tax regulations. Amounts funded are primarily invested in debt and equity securities. Accrued costs of life insurance benefits, other than current cash payments for retirees, currently are not being funded. Effective January 1, 1993, the Company adopted FASB Statement No. 106, Employers' Accounting for Postretirement Benefits Other Than Pensions, on a prospective basis. Statement No. 106 requires that medical care and life insurance benefits for retired employees be accounted for on an accrual basis using a specified actuarial method, "benefit/years-of-service." Prior to the adoption of Statement No. 106, Gulf Power Company recognized these benefit costs on an accrual basis using the "aggregate cost" actuarial method, which spreads the expected cost of such benefits over the remaining periods of employees' service as a level percentage of payroll costs. The costs of such benefits recognized by the Company in 1993, 1992, and 1991 were $3.9 million, $3.1 million, and $2.7 million, respectively. STATUS AND COST OF BENEFITS Shown in the following tables are actuarial results and assumptions for pension and postretirement medical and life insurance benefits as computed under the requirements of Statement Nos. 87 and 106, respectively. Retiree medical and life insurance information is shown only for 1993 because Statement No. 106 was adopted as of January 1, 1993, on a prospective basis. II-157 NOTES (CONTINUED) Gulf Power Company 1993 Annual Report The funded status of the plans at December 31 was as follows: The weighted average rates assumed in the actuarial calculations were: An additional assumption used in measuring the accumulated postretirement medical benefit obligation was a weighted average medical care cost trend rate of 11.3 percent for 1993, decreasing to 6.0 percent through the year 2000 and remaining at that level thereafter. An annual increase in the assumed medical care cost trend rate by 1.0 percent would increase the accumulated medical benefit obligation as of December 31, 1993, by $4.8 million and the aggregate of the service and interest cost components of the net retiree medical cost by $543 thousand. Components of the plans' net cost are shown below: Of the above net pension amounts, $(601) thousand in 1993, $3 thousand in 1992, and $518 thousand in 1991, were recorded in operating expenses, and the remainder was recorded in construction and other accounts. Of the above net postretirement medical and life insurance amounts recorded in 1993, $3.0 million was recorded in operating expenses, and the remainder was recorded in construction and other accounts. II-158 NOTES (CONTINUED) Gulf Power Company 1993 Annual Report 3. LITIGATION AND REGULATORY MATTERS: COAL BARGE TRANSPORTATION SUIT On August 19, 1993, a complaint against the Company and Southern Company Services, an affiliate, was filed in federal district court in Ohio by two companies with which the Company had contracted for the transportation by barge for certain of the Company's coal supplies. The complaint alleges breach of the contract by the Company and seeks damages estimated by the plaintiffs to be in excess of $85 million. The final outcome of this matter cannot now be determined; however, in management's opinion the final outcome will not have a material adverse effect on the Company's financial statements. FPSC APPROVES STIPULATION In February 1993, the Company filed a notice with the FPSC of its intent to obtain rate relief. On May 4, 1993, the FPSC approved a stipulation between the Company, the Office of Public Counsel, and the Florida Industrial Power Users Group to cancel the filing of the rate case and to allow the Company to retain for the next four years its existing method for calculating accruals for future power plant dismantlement costs. The stipulation also required the reduction of the Company's allowed return on equity midpoint from 12.55 percent to 12.0 percent. See Management's Discussion and Analysis under "Future Earnings Potential" for further details of circumstances that contributed to the company canceling the rate case. FERC REVIEWS EQUITY RETURNS In May 1991, the FERC ordered that hearings be conducted concerning the reasonableness of the Southern electric system's wholesale rate schedules and contracts that have a return on common equity of 13.75 percent or greater. The contracts that could be affected by the hearings include substantially all of the transmission, unit power, long-term power and other similar contracts. Any changes in the rate of return on common equity that may occur as a result of this proceeding would be effective 60 days after a proper notice of the proceeding is published. A notice was published on May 10, 1991. In August 1992, a FERC administrative law judge issued an opinion that changes in rate schedules and contracts were not necessary and that the FERC staff failed to show how any changes were in the public interest. The FERC staff has filed exceptions to the administrative law judge's opinion, and the matter remains pending before the FERC. The final outcome of this matter cannot now be determined; however, in management's opinion, the final outcome will not have a material adverse effect on the Company's financial statements. RECOVERY OF CONTRACT BUYOUT COSTS In July 1990, the Company filed a request for waiver of FERC's fuel adjustment charge regulation to permit recovery of coal contract buyout costs from wholesale customers. On April 4, 1991, the FERC issued an order granting recovery of the buyout costs from wholesale customers from July 19, 1990, forward, but denying retroactive recovery of the buyout costs from January 1, 1987 through July 18, 1990. The Company's request for rehearing was denied by the FERC. The Company refunded $2.7 million (including interest) in June 1991 to its wholesale customers. On July 31, 1991, the Company filed a petition for review of the FERC's decision to the U.S. Court of Appeals for the District of Columbia Circuit. On January 22, 1993, the Court vacated the Commission's order, finding FERC's denial of the Company's request for a retroactive waiver to be arbitrary and capricious. The Court remanded the matter to FERC for consideration consistent with its opinion. Management expects that the commission will ultimately allow the Company to recover the amount refunded plus interest. Accordingly, the Company recorded the reversal of the $2.7 million refund to income in 1993. ENVIRONMENTAL COST RECOVERY In April 1993, the Florida Legislature adopted legislation for an Environmental Cost Recovery (ECR) clause, which allows a utility to petition the FPSC for recovery of all prudent environmental compliance costs that are not being recovered through base rates or any other rate-adjustment clause. Such environmental costs include operation and maintenance expense, depreciation, and a return on invested capital. II-159 NOTES (CONTINUED) Gulf Power Company 1993 Annual Report On January 12, 1994, the FPSC approved the Company's petition under the ECR clause for recovery of environmental costs that were projected to be incurred from July 1993 through September 1994. The order allows the recovery from customers of such costs amounting to $7.8 million during the period, February through September 1994. Thereafter, recovery under ECR will be determined semi-annually and will include a true-up of the prior period and a projection of the ensuing six-month period. In December 1993, the Company recorded $2.6 million as additional revenue for the portion of costs incurred during 1993. 4. CONSTRUCTION PROGRAM: The Company is engaged in a continuous construction program, the cost of which is currently estimated to total $77 million in 1994, $55 million in 1995, and $68 million in 1996. These estimates include AFUDC of approximately $0.7 million, $0.3 million, and $0.2 million, in 1994, 1995, and 1996, respectively. The construction program is subject to periodic review and revision, and actual construction costs may vary from the above estimates because of numerous factors. These factors include changes in business conditions; revised load growth estimates; changes in environmental regulations; increasing costs of labor, equipment and materials; and cost of capital. The Company does not have any new baseload generating plants under construction. However, the Company plans to construct two 80 megawatt combustion turbine peaking units. The first is scheduled to be completed in 1998, and the second in 1999. In addition, significant construction will continue related to transmission and distribution facilities and the upgrading and extension of the useful lives of generating plants. See Management's Discussion and Analysis under "Environmental Matters" for information on the impact of the Clean Air Act Amendments of 1990 and other environmental matters. 5. FINANCING AND COMMITMENTS: GENERAL Current projections indicate that funds required for construction and other purposes, including compliance with environmental regulations will be derived primarily from internal sources. Requirements not met from internal sources will be financed from the sale of additional first mortgage bonds, preferred stock, and capital contributions from The Southern Company. In addition, the Company may issue additional long-term debt and preferred stock primarily for the purposes of debt maturities and redemptions of higher-cost securities. Because of the attractiveness of current short term interest rates, the Company may maintain a higher level of short term indebtedness than has historically been true. At December 31, 1993, the Company had $49 million of lines of credit with banks of which $6.1 million was committed to cover checks presented for payment. These credit arrangements are subject to renewal June 1 of each year. In connection with these committed lines of credit, the Company has agreed to pay certain fees and/or maintain compensating balances with the banks. The compensating balances, which represent substantially all the cash of the Company except for daily working funds and like items, are not legally restricted from withdrawal. In addition, the Company has bid-loan facilities with eight major money center banks that total $180 million, of which, none was committed at December 31, 1993. ASSETS SUBJECT TO LIEN The Company's mortgage, which secures the first mortgage bonds issued by the Company, constitutes a direct first lien on substantially all of the Company's fixed property and franchises. FUEL COMMITMENTS To supply a portion of the fuel requirements of its generating plants, the Company has entered into long-term commitments for the procurement of fuel. In most cases, these contracts contain provisions for price escalations, minimum purchase levels and other financial commitments. Total estimated long-term obligations were approximately $1.4 billion at December 31, 1993. Additional commitments will be required in the future to supply the Company's fuel needs. To take advantage of lower-cost coal supplies, agreements were reached in 1986 to terminate two long-term contracts for the supply of coal to Plant Daniel, which is jointly owned by the Company and Mississippi Power, an operating affiliate. The Company's portion of II-160 NOTES (CONTINUED) Gulf Power Company 1993 Annual Report this payment was some $60 million. This amount is being amortized to expense on a per ton basis over a nine-year period. The remaining unamortized amount included in deferred charges, including the current portion, was $18 million at December 31, 1993. In 1988, the Company made an advance payment of $60 million to another coal supplier under an arrangement to lower the cost of future coal purchased under an existing contract. This amount is being amortized to expense on a per ton basis over a ten-year period. The remaining unamortized amount included in deferred charges, including the current portion, was $36 million at December 31, 1993. Also, in 1993 the Company made a payment of $16.4 million to a coal supplier under an arrangement to suspend the purchase of coal under an existing contract for one year. This amount is being amortized to expense on a per ton basis over a one year period. The remaining unamortized amount, which is included in current assets, was $11 million at December 31, 1993. The amortization of these payments is being recovered through the fuel cost recovery clause discussed under "Revenues and Fuel Costs" in Note 1. LEASE AGREEMENT In 1989, the Company entered into a twenty-two year operating lease agreement for the use of 495 aluminum railcars to transport coal to Plant Daniel. Mississippi Power, as joint owner of Plant Daniel, is responsible for one half of the lease costs. The Company's share of the lease is charged to fuel inventory and allocated to fuel expense as the fuel is used. The lease costs charged to inventory were $1.2 million in 1993, $1.2 million in 1992 and $1.3 million in 1991. For the year 1994, the Company's annual lease payment will be $1.2 million. The Company's annual lease payment for 1995 will be $2.4 million and for 1996, 1997, and 1998 the payment will be $1.2 million. Lease payments after 1998 total approximately $17.4 million. The Company has the option, after three years from the date of the original contract, to purchase the railcars at the greater of termination value or fair market value. Additionally, at the end of the lease term, the Company has the option to renew the lease. 6. JOINT OWNERSHIP AGREEMENTS: The Company and Mississippi Power jointly own Plant Daniel, a steam-electric generating plant, located in Jackson County, Mississippi. In accordance with an operating agreement, Mississippi Power acts as the Company's agent with respect to the construction, operation, and maintenance of the plant. The Company and Georgia Power jointly own Plant Scherer Unit No. 3, a steam-electric generating plant, located near Forsyth, Georgia. In accordance with an operating agreement, Georgia Power acts as the Company's agent with respect to the construction, operation, and maintenance of the unit. The Company's pro rata share of expenses related to both plants is included in the corresponding operating expense accounts in the Statements of Income. At December 31, 1993, the Company's percentage ownership and its amount of investment in these jointly owned facilities were as follows: (1) Includes net plant acquisition adjustment. (2) Total megawatt nameplate capacity: Plant Scherer Unit No. 3: 818 Plant Daniel: 1,000 II-161 NOTES (CONTINUED) Gulf Power Company 1993 Annual Report 7. LONG-TERM POWER SALES AGREEMENTS: GENERAL The Company and the other operating affiliates of The Southern Company have contractual agreements for the sale of capacity and energy to certain non-affiliated utilities located outside of the system's service area. Certain of these agreements are non-firm and are based on the capacity of the system in general. Other agreements are firm and pertain to capacity related to specific generating units. Because the energy is generally sold at cost under these agreements, the capacity revenues from these sales primarily affect profitability. The Company's capacity revenues have been as follows: Long-term non-firm power of 400 megawatts was sold in 1993 to Florida Power Corporation (FPC) by the Southern electric system. In 1994, this amount decreased to 200 megawatts, and the contract will expire at year-end 1994. Capacity and energy sales under these long-term non-firm power sales agreements are made from available power pool capacity, and the revenues from the sales are shared by the operating affiliates. Unit power from specific generating plants is currently being sold to FPC, Florida Power & Light Company (FP&L), Jacksonville Electric Authority (JEA), and the City of Tallahassee, Florida. Under these agreements, 209 megawatts of net dependable capacity were sold by the Company during 1993, and sales will remain at that approximate level until the expiration of the contracts in 2010, unless reduced by FPC, FP&L and JEA after 1999. Capacity and energy sales to FP&L, the Company's largest single customer, provided revenues of $39.5 million in 1993, $46.2 million in 1992, and $42.1 million in 1991, or 6.8 percent, 8.1 percent, and 7.5 percent of operating revenues, respectively. GULF STATES SETTLEMENT COMPLETED On November 7, 1991, the subsidiaries of The Southern Company entered into a settlement agreement with Gulf States Utilities Company (Gulf States) that resolved litigation between the companies that had been pending since 1986 and arose out of a dispute over certain unit power and other long-term power sales contracts. In 1993, all remaining terms and obligations of the settlement agreement were satisfied. Based on the value of the settlement proceeds received - less the amounts previously included in income - the Company recorded increases in net income of approximately $0.6 million in 1992 and $12.7 million in 1991. In 1993, the Company sold all of its remaining Gulf States common stock received in the settlement, resulting in a gain of $2.3 million after tax. 8. INCOME TAXES: Effective January 1, 1993, Gulf Power Company adopted FASB Statement No. 109, Accounting for Income Taxes. The adoption of Statement No. 109 resulted in cumulative adjustments that had no effect on net income. The adoption also resulted in the recording of additional deferred income taxes and related assets and liabilities. The related assets of $31.3 million are revenues to be received from customers. These assets are attributable to tax benefits flowed through to customers in prior years and to taxes applicable to capitalized AFUDC. The related liabilities of $76.9 million are revenues to be refunded to customers. These liabilities are attributable to deferred taxes previously recognized at rates higher than current enacted tax law and to unamortized investment tax credits. Additionally, deferred income taxes related to accelerated tax depreciation previously shown as a reduction to utility plant were reclassified. II-162 NOTES (CONTINUED) Gulf Power Company 1993 Annual Report Details of the federal and state income tax provisions are as follows: The tax effects of temporary differences between the carrying amounts of assets and liabilities in the financial statements and their respective tax bases, which give rise to deferred tax assets and liabilities are as follows: Deferred investment tax credits are amortized over the life of the related property with such amortization normally applied as a credit to reduce depreciation in the Statements of Income. Credits amortized in this manner amounted to $2.3 million in 1993, 1992 and 1991. At December 31, 1993, all investment tax credits available to reduce federal income taxes payable had been utilized. A reconciliation of the federal statutory income tax rate to the effective income tax rate is as follows: Gulf Power Company and the other subsidiaries of The Southern Company file a consolidated federal tax return. Under a joint consolidated income tax agreement, each company's current and deferred tax expense is computed on a stand-alone basis, and consolidated tax savings are allocated to each company based on its ratio of taxable income to total consolidated taxable income. II-163 NOTES (CONTINUED) Gulf Power Company 1993 Annual Report 9. LONG-TERM DEBT: POLLUTION CONTROL OBLIGATIONS Obligations incurred in connection with the sale by public authorities of tax-exempt pollution control revenue bonds are as follows: * Sinking fund requirement applicable to the 6 percent pollution control bonds is $100 thousand for 1994 with increasing increments thereafter through 2005, with the remaining balance due in 2006. With respect to the collateralized pollution control revenue bonds, the Company has authenticated and delivered to trustees a like principal amount of first mortgage bonds as security for obligations under collateralized installment agreements. The principal and interest on the first mortgage bonds will be payable only in the event of default under the agreements. OTHER LONG-TERM DEBT Long-term debt also includes $17.5 million for the Company's portion of notes payable issued in connection with the termination of Plant Daniel coal contracts (see Note 5 for information on fuel commitments). The notes bear interest at 8.25 percent with the principal being amortized through 1995. Also included in long-term debt is a 30-month note payable for $25 million which was obtained to refinance higher cost securities. The principal is due in June 1996 and bears interest at 4.69 percent which is payable quarterly beginning March 1994. The estimated annual maturities of the notes payable through 1996 are as follows: $8.4 million in 1994, $9.1 million in 1995, and $25 million in 1996. 10. LONG-TERM DEBT DUE WITHIN ONE YEAR: A summary of the improvement fund requirement and scheduled maturities and redemptions of long-term debt due within one year is as follows: The first mortgage bond improvement (sinking) fund requirement amounts to 1 percent of each outstanding series of bonds authenticated under the indenture prior to January 1 of each year, other than those issued to collateralize pollution control obligations. The requirement may be satisfied by depositing cash, reacquiring bonds, or by pledging additional property equal to 1 and 2/3 times the requirement. In 1994, $12 million of 4 5/8 percent First Mortgage Bonds due October 1, 1994 and $15 million of 6 percent First Mortgage Bonds due June 1, 1996 are scheduled to be redeemed. II-164 NOTES (CONTINUED) Gulf Power Company 1993 Annual Report 11. COMMON STOCK DIVIDEND RESTRICTIONS: The Company's first mortgage bond indenture contains various common stock dividend restrictions which remain in effect as long as the bonds are outstanding. At December 31, 1993, $101 million of retained earnings was restricted against the payment of cash dividends on common stock under the terms of the mortgage indenture. The Company's charter limits cash dividends on common stock to 50 percent of net income available for such stock during a prior period if the capitalization ratio is below 20 percent and to 75 percent of such net income if such ratio is 20 percent or more but less than 25 percent. The capitalization ratio is defined as the ratio of common stock equity to total capitalization, including retained earnings, adjusted to reflect the payment of the proposed dividend. At December 31, 1993, the ratio was 44.4 percent. 12. QUARTERLY FINANCIAL DATA (UNAUDITED): Summarized quarterly financial data for 1993 and 1992 are as follows: The Company's business is influenced by seasonal weather conditions and the timing of rate changes, among other factors. II-165 SELECTED FINANCIAL AND OPERATING DATA Gulf Power Company 1993 Annual Report II-166 SELECTED FINANCIAL AND OPERATING DATA (CONTINUED) Gulf Power Company 1993 Annual Report II-167 SELECTED FINANCIAL AND OPERATING DATA (CONTINUED) Gulf Power Company 1993 Annual Report II-168 SELECTED FINANCIAL AND OPERATING DATA (CONTINUED) Gulf Power Company 1993 Annual Report II-169 STATEMENTS OF INCOME Gulf Power Company II-170 STATEMENTS OF INCOME Gulf Power Company II-171 STATEMENTS OF CASH FLOWS Gulf Power Company II-172 STATEMENTS OF CASH FLOWS Gulf Power Company II-173 BALANCE SHEETS Gulf Power Company II-174 BALANCE SHEETS Gulf Power Company II-175 BALANCE SHEETS Gulf Power Company II-176 BALANCE SHEETS Gulf Power Company II-177 GULF POWER COMPANY OUTSTANDING SECURITIES AT DECEMBER 31, 1993 FIRST MORTGAGE BONDS POLLUTION CONTROL BONDS PREFERRED STOCK (1) Subject to mandatory redemption of 5% annually on or before February 1. II-178 GULF POWER COMPANY SECURITIES RETIRED DURING 1993 FIRST MORTGAGE BONDS POLLUTION CONTROL BONDS PREFERRED STOCK II-179 MISSISSIPPI POWER COMPANY FINANCIAL SECTION II-180 MANAGEMENT'S REPORT Mississippi Power Company 1993 Annual Report The management of Mississippi Power Company has prepared--and is responsible for--the financial statements and related information included in this report. These statements were prepared in accordance with generally accepted accounting principles appropriate in the circumstances and necessarily include amounts that are based on best estimates and judgments of management. Financial information throughout this annual report is consistent with the financial statements. The Company maintains a system of internal accounting controls to provide reasonable assurance that assets are safeguarded and that books and records reflect only authorized transactions of the Company. Limitations exist, however, in any system of internal control, based upon a recognition that the cost of the system should not exceed its benefits. The Company believes its system of internal accounting control maintains an appropriate cost/benefit relationship. The Company's system of internal accounting controls is evaluated on an ongoing basis by the internal audit staff. The Company's independent public accountants also consider certain elements of the internal control system in order to determine their auditing procedures for the purpose of expressing an opinion on the financial statements. The audit committee of the board of directors, composed of four directors who are not employees, provides a broad overview of management's financial reporting and control functions. Periodically, this committee meets with management, the internal auditors, and the independent public accountants to ensure that these groups are fulfilling their obligations and to discuss auditing, internal controls, and financial reporting matters. The internal auditors and independent public accountants have access to the members of the audit committee at any time. Management believes that its policies and procedures provide reasonable assurance that the Company's operations are conducted according to a high standard of business ethics. In management's opinion, the financial statements present fairly, in all material respects, the financial position, results of operations, and cash flows of Mississippi Power Company in conformity with generally accepted accounting principles. /s/ David M. Ratcliffe -------------------------------------------------- David M. Ratcliffe President and Chief Executive Officer /s/ Thomas A. Fanning -------------------------------------------------- Thomas A. Fanning Vice President and Chief Financial Officer II-181 REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS TO THE BOARD OF DIRECTORS OF MISSISSIPPI POWER COMPANY: We have audited the accompanying balance sheets and statements of capitalization of Mississippi Power Company (a Mississippi corporation and a wholly owned subsidiary of The Southern Company) as of December 31, 1993 and 1992, and the related statements of income, retained earnings, paid-in capital, and cash flows for each of the three years in the period ended December 31, 1993. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements (pages II-190 through II-206) referred to above present fairly, in all material respects, the financial position of Mississippi Power Company as of December 31, 1993 and 1992, and the results of its operations and its cash flows for the periods stated, in conformity with generally accepted accounting principles. As explained in Notes 2 and 9 to the financial statements, effective January 1, 1993, Mississippi Power Company changed its methods of accounting for postretirement benefits other than pensions and for income taxes. /s/ Arthur Andersen & Co. Atlanta, Georgia February 16 , 1994 II-182 MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION Mississippi Power Company 1993 Annual Report RESULTS OF OPERATIONS EARNINGS Mississippi Power Company's net income after dividends on preferred stock for 1993 totaled $42.4 million, an increase of $5.6 million over the prior year. This improvement is attributable primarily to increased energy sales and retail rate increases. A retail rate increase under the Company's Performance Evaluation Plan (PEP-1A) of $6.4 million annually became effective in July 1993. Under the Environmental Compliance Overview Plan (ECO Plan) retail rates increased by $2.6 million annually effective April 1993. A comparison of 1992 to 1991 - excluding the events occurring in 1991 discussed below - would reflect a 1992 increase in earnings of $4.9 million or 15.5 percent. The Company's financial performance in 1991 reflected the after-tax operating and disposal losses of $11.9 million recorded by the Company's former merchandise subsidiary. These losses were partially offset by a $2.6 million positive impact on earnings from the settlement of the contract dispute with Gulf States Utilities Company (Gulf States). REVENUES The following table summarizes the factors impacting operating revenues for the past three years: *Includes the effect of the retail rate increase approved under the ECO Plan. Retail revenues of $368 million in 1993 increased 9.0 percent over the prior year, compared with an increase of 2.2 percent for 1992 and a decrease of 1.5 percent in 1991. The increase in retail revenues for 1993 was a result of growth in energy sales and customers, the favorable impact of weather, and retail rate increases. Changes in base rates reflect rate changes made under the PEP plans and the ECO Plan as approved by the Mississippi Public Service Commission (MPSC). The increase in revenues for the recovery of fuel costs for 1993 reversed two years of decline. Under the fuel cost recovery provision, recorded fuel revenues are equal to recorded fuel expenses, including the fuel component and the operation and maintenance component of purchased energy. Therefore, changes in recoverable fuel expenses are offset with corresponding changes in fuel revenues and have no effect on net income. II-183 MANAGEMENT'S DISCUSSION AND ANALYSIS (continued) Mississippi Power Company 1993 Annual Report Included in sales for resale to non-affiliates are revenues from rural electric cooperative associations and municipalities located in southeastern Mississippi. Energy sales to these customers in 1993 increased 9.0 percent over the prior year with the related revenues rising 14.1 percent. The customer demand experienced by these utilities is determined by factors very similar to Mississippi Power's. Sales for resale to non-affiliated non-territorial utilities are primarily under long-term contracts consisting of capacity and energy components. Capacity revenues reflect the recovery of fixed costs and a return on investment under the contracts. Energy is generally sold at variable cost. The capacity and energy components were: Capacity revenues for Mississippi Power increased in 1993 and 1992 due to a change in the allocation of transmission capacity revenues throughout the Southern electric system. Most of the Company's capacity revenues are derived from transmission charges. Sales to affiliated companies within the Southern electric system will vary from year to year depending on demand and the availability and cost of generating resources at each company. These sales have no material impact on earnings. The increase in other operating revenues for 1993 was due to increased rents collected from microwave equipment use and the transmission of non-associated companies' electricity. Below is a breakdown of kilowatt-hour sales for 1993 and the percent change for the last three years: Total retail energy sales in 1993 increased compared to the previous year, due primarily to weather influences and the improvement in the economy. The increase in commercial energy sales also reflects the impact of recently established casinos within the Company's service area. Industrial sales increased in 1992 as a result of new contracts with two large industrial customers. The decrease in energy sales for resale to non-affiliates is predominantly due to reductions in unit power sales under long-term contracts to Florida utilities. Economy sales and amounts sold under short-term contracts are also sold for resale to non-affiliates. Sales for resale to non-affiliates are influenced by those utilities' own customer demand, plant availability, and the cost of their predominant fuels -- oil and natural gas. EXPENSES Total operating expenses for 1993 were higher than the previous year because of higher production expenses, which reflects increased demand, an increase in the federal income tax rate, and higher employee-related costs. (See Note 2 to the financial statements for information regarding employee and retiree benefits.) Additionally, included in other operation expenses are increased costs associated with environmental remediation of a Southern electric system research facility. Expenses in 1992 were lower than 1991, excluding the Gulf States settlement, primarily because of lower production expenses stemming from decreased demand. II-184 MANAGEMENT'S DISCUSSION AND ANALYSIS (continued) Mississippi Power Company 1993 Annual Report Fuel costs constitute the single largest expense for Mississippi Power. These costs increased in 1993 due to an 11.0 percent increase in generation, which reflects higher demand. Fuel expenses in 1992, compared to 1991, were lower because of less generation and the negotiation of new coal contracts. Generation decreased primarily because of the availability of lower cost generation elsewhere within the Southern electric system. Purchased power consists primarily of energy purchases from the affiliates of the Southern electric system. Purchased power transactions (both sales and purchases) among Mississippi Power and its affiliates will vary from period to period depending on demand and the availability and variable production cost at each generating unit in the Southern electric system. Taxes other than income taxes increased in 1993 because of higher ad valorem taxes, which are property based, and municipal franchise taxes, which are revenue based. The decline in 1992 was attributable to lower franchise taxes. Income tax expense in 1993 increased because of the enactment of a higher corporate income tax rate retroactive to January 1, 1993, coupled with higher earnings. The change in income taxes for 1992 and 1991 reflected the change in operating income. EFFECTS OF INFLATION Mississippi Power is subject to rate regulation and income tax laws that are based on the recovery of historical costs. Therefore, inflation creates an economic loss because the Company is recovering its costs of investments in dollars that have less purchasing power. While the inflation rate has been relatively low in recent years, it continues to have an adverse effect on the Company because of the large investment in long-lived utility plant. Conventional accounting for historical costs does not recognize this economic loss nor the partially offsetting gain that arises through financing facilities with fixed-money obligations, such as long-term debt and preferred stock. Any recognition of inflation by regulatory authorities is reflected in the rate of return allowed. FUTURE EARNINGS POTENTIAL The results of operations for the past three years are not necessarily indicative of future earnings potential. The level of future earnings depends on numerous factors ranging from regulatory matters to growth in energy sales. Expenses are subject to constant review and cost control programs. Among the efforts to control costs are utilizing employees more effectively through a functionalization program for the Southern electric system, redesigning compensation and benefit packages, and re- engineering work processes. Mississippi Power is also maximizing the utility of invested capital and minimizing the need for capital by refinancing, decreasing the average fuel stockpile, raising generating plant availability and efficiency, and curbing the construction budget. Operating revenues will be affected by any changes in rates under the PEP-2, the Company's revised performance based ratemaking plan. The PEP plans have proved to be a stabilizing force on electric rates, with only moderate changes in rates taking place. The ECO Plan, approved by the MPSC in 1992, provides for recovery of costs associated with environmental projects approved by the MPSC, most of which are required to comply with Clean Air Act Amendments of 1990 regulations. The ECO Plan is operated independently of PEP-2. The FERC regulates wholesale rate schedules and power sales contracts that Mississippi Power has with its sales for resale customers. The FERC is currently reviewing the rate of return on common equity included in these schedules and contracts and may require such returns to be lowered, possibly retroactively. Also, pending before the FERC is the Company's request for a $3.6 million wholesale rate increase. Further discussion of the PEP plans, the ECO Plan, and proceedings before the FERC is made in Note 3 to the financial statements herein. Future earnings in the near term will depend upon growth in energy sales, which are subject to a number of factors. Traditionally, these factors have included changes in contracts with neighboring utilities, energy conservation practiced by customers, the elasticity of demand, weather, competition, and the rate of economic growth in Mississippi Power's service area. However, the Energy II-185 MANAGEMENT'S DISCUSSION AND ANALYSIS (continued) Mississippi Power Company 1993 Annual Report Policy Act of 1992 (Energy Act) will have a profound effect on the future of the electric utility industry. The Energy Act promotes energy efficiency, alternative fuel use, and increased competition for electric utilities. The Energy Act allows Independent Power Producers (IPPs) to access a utility's transmission network in order to sell electricity to other utilities, and this may enhance the incentive of IPPs to build cogeneration plants for a utility's large industrial and commercial customers. Although the Energy Act does not require transmission access to retail customers, pressure for legislation to allow retail wheeling will continue. Mississippi Power is preparing to meet the challenge of this major change in the traditional business practices of selling electricity. If Mississippi Power does not remain a low-cost producer and provider of quality service, the Company's retail energy sales growth, as well as new long-term contracts for energy sales outside the service area, could be limited, which could significantly reduce earnings. NEW ACCOUNTING STANDARDS The Financial Accounting Standards Board (FASB) issued Statement No. 112, Employers' Accounting for Postemployment Benefits, which must be effective by 1994. The new standard requires that all types of benefits provided to former or inactive employees and their families prior to retirement be accounted for on an accrual basis. These benefits include salary continuation, severance pay, supplemental unemployment benefits, disability-related benefits, job training, and health and life insurance coverage. In 1993, Mississippi Power adopted Statement No. 112, with no material effect on the financial statements. The FASB has issued Statement No. 115, Accounting for Certain Investments in Debt and Equity Securities, which is effective in 1994. Statement No. 115 supersedes FASB Statement No. 12, Accounting for Certain Marketable Securities. In January 1994, Mississippi Power adopted the new rules, with no material effect on the financial statements. On January 1, 1993, Mississippi Power changed its methods of accounting for postretirement benefits other than pensions and income taxes. See Notes 2 and 9 to the financial statements regarding the impact of these changes. FINANCIAL CONDITION OVERVIEW The principal changes in Mississippi Power's financial condition during 1993 were gross property additions of $140 million to utility plant, a significant lowering of cost of capital through refinancings, and the resolution of PEP and ratepayer litigation. Funding for gross property additions came primarily from capital contributions from The Southern Company, earnings and other operating cash flows. The Statements of Cash Flows provide additional details. FINANCING ACTIVITY Mississippi Power continued to lower its financing costs in 1993 by issuing new debt and equity securities and retiring high- cost issues. The Company sold $132 million of first mortgage bonds, preferred stock and, through public authorities, pollution control revenue bonds. Retirements, including maturities during 1993, totaled some $101 million of such securities. (See the Statements of Cash Flows for further details.) Composite financing rates for the years 1991 through 1993 as of year-end were as follows: II-186 MANAGEMENT'S DISCUSSION AND ANALYSIS (continued) Mississippi Power Company 1993 Annual Report CAPITAL STRUCTURE At year-end 1993, the Company's ratio of common equity to total capitalization was 49.8 percent, compared to 47.3 percent in 1992 and 44.4 percent in 1991. The increase in the ratio in 1993 can be attributed primarily to the receipt of $30 million of capital contributions from The Southern Company. CAPITAL REQUIREMENTS FOR CONSTRUCTION The Company's projected construction expenditures for the next three years total $256 million ($96 million in 1994, $62 million in 1995, and $98 million in 1996). The major emphasis within the construction program will be on complying with Clean Air Act regulations, completion of a 78-megawatt combustion turbine, and upgrading existing facilities. The estimates for property additions for the three-year period include $39 million committed to meeting the requirements of Clean Air Act regulations. Revisions may be necessary because of factors such as revised load projections, the availability and cost of capital, and changes in environmental regulations. OTHER CAPITAL REQUIREMENTS In addition to the funds required for the Company's construction program, approximately $51 million will be required by the end of 1996 for present sinking fund requirements and maturities of long-term debt. Mississippi Power plans to continue, when economically feasible, to retire high-cost debt and preferred stock and replace these obligations with lower-cost capital. ENVIRONMENTAL MATTERS In November 1990, the Clean Air Act Amendments of 1990 (Clean Air Act) were signed into law. Title IV of the Clean Air Act -- the acid rain compliance provision of the law -- will have a significant impact on Mississippi Power and the other operating companies of The Southern Company. Specific reductions in sulfur dioxide and nitrogen oxide emissions from fossil-fired generating plants will be required in two phases. Phase I compliance must be implemented in 1995, and affects eight generating plants -- some 10 thousand megawatts of capacity or 35 percent of total capacity -- in the Southern electric system. Phase II compliance is required in 2000, and all fossil-fired generating plants in the Southern electric system will be affected. Beginning in 1995, the Environmental Protection Agency (EPA) will allocate annual sulfur dioxide emission allowances through the newly established allowance trading program. An emission allowance is the authority to emit one ton of sulfur dioxide during a calendar year. The method for allocating allowances is based on the fossil fuel consumed from 1985 through 1987 for each affected generating unit. Emission allowances are transferable and can be bought, sold, or banked and used in the future. The sulfur dioxide emission allowance program is expected to minimize the cost of compliance. The market for emission allowances is developing more slowly than expected. However, The Southern Company's sulfur dioxide compliance strategy is designed to take advantage of allowances as the market develops. The Southern Company expects to achieve Phase I sulfur dioxide compliance at the eight affected plants by switching to low-sulfur coal, and this has required some equipment upgrades. This compliance strategy is expected to result in unused emission allowances being banked for later use. Additional construction expenditures are required to install equipment for the control of nitrogen oxide emissions at these eight plants. Also, continuous emissions monitoring equipment would be installed on all fossil-fired units. Under this Phase I compliance approach, additional construction expenditures are estimated to total approximately $275 million through 1995 for The Southern Company, of which Mississippi Power's portion is approximately $60 million. Phase II compliance costs are expected to be higher because requirements are stricter and all fossil-fired generating plants are affected. For sulfur dioxide compliance, The Southern Company could use emission allowances banked during Phase I, increase fuel switching, install flue gas desulfurization equipment at selected plants, and/or purchase more allowances depending on the price and availability of allowances. Also, in Phase II, equipment to control nitrogen oxide emissions will be installed on additional system fossil-fired plants as required to meet anticipated Phase II limits. Therefore, during the period 1996 to 2000, compliance for The Southern Company could require total construction expenditures ranging from approximately $450 million to $800 million, II-187 MANAGEMENT'S DISCUSSION AND ANALYSIS (continued) Mississippi Power Company 1993 Annual Report of which Mississippi Power's portion is approximately $25 million. However, the full impact of Phase II compliance cannot now be determined with certainty, pending the development of a market for emission allowances, the completion of EPA regulations, and the possibility of new emission reduction technologies. An average increase of up to 3 percent in revenue requirements from customers could be necessary to fully recover The Southern Company's costs of compliance for both Phase I and II of the Clean Air Act. Compliance costs include construction expenditures, increased costs for switching to low-sulfur coal, and costs related to emission allowances. Mississippi Power's ECO Plan is designed to allow recovery of costs of compliance with the Clean Air Act, as well as other environmental statutes and regulations. The MPSC reviews environmental projects and the Company's environmental policy through the ECO Plan. Under the ECO Plan, any increase in the annual revenue requirement is limited to 2 percent of retail revenues. However, the plan also provides for carryover of any amount over the 2 percent limit into the next year's revenue requirement. Mississippi Power's management believes that the ECO Plan will provide for recovery of the Clean Air Act costs. Title III of the Clean Air Act requires a multi-year EPA study of power plant emissions of hazardous air pollutants. The study will serve as the basis for a decision on whether additional regulatory control of these substances is warranted. Compliance with any new control standard could result in significant additional costs. The impact of new standards -- if any -- will depend on the development and implementation of applicable regulations. The EPA continues to evaluate the need for a new short-term ambient air quality standard for sulfur dioxide. Preliminary results from an EPA study on the impact of a new standard indicate that a number of plants could be required to install sulfur dioxide controls. These controls would be in addition to the controls already required to meet the acid rain provisions of the Clean Air Act. The EPA is expected to take some action on this issue in 1994. The impact of any new standard will depend on the level chosen for the standard and cannot be determined at this time. In addition, the EPA is evaluating the need to revise the ambient air quality standards for particulate matter, nitrogen oxides, and ozone. The impact of any new standard will depend on the level chosen for the standard and cannot be determined at this time. In 1994 or 1995, the EPA is expected to issue revised rules on air quality control regulations related to stack height requirements of the Clean Air Act. The full impact of the final rules cannot be determined at this time, pending their development and implementation. In 1993, the EPA issued a ruling confirming the non-hazardous status of coal ash. However, the EPA has until 1998 to classify co-managed utility wastes -- coal ash and other utility wastes -- as either non-hazardous or hazardous. If the EPA classifies the co-managed wastes as hazardous, then substantial additional costs for the management of such wastes may be required. The full impact of any change in the regulatory status will depend on the subsequent development of co-managed waste requirements. The Company must comply with other environmental laws and regulations that cover the handling and disposal of hazardous waste. Under these various laws and regulations, the Company could incur costs to clean up properties currently or previously owned. The Company conducts studies to determine the extent of any required clean-up costs and has recognized in the financial statements costs to clean up known sites. Several major pieces of environmental legislation are in the process of being reauthorized or amended by Congress. These include: the Clean Water Act; the Resource Conservation and Recovery Act; and the Comprehensive Environmental Response, Compensation, and Liability Act. Changes to these laws could affect many areas of the Company's operations. The full impact of these requirements cannot be determined at this time, pending the development and implementation of applicable regulations. Compliance with possible new legislation related to global climate change, electromagnetic fields, and other environmental and health concerns could significantly affect the Company. The impact of new legislation -- if any -- will depend on the subsequent development and implementation of applicable regulations. In addition, the II-188 MANAGEMENT'S DISCUSSION AND ANALYSIS (continued) Mississippi Power Company 1993 Annual Report potential for lawsuits alleging damages caused by electromagnetic fields exists. SOURCES OF CAPITAL At December 31, 1993, the Company had $70 million of committed credit in revolving credit agreements and also had $21 million of committed short-term credit lines. The $40 million of notes payable outstanding at year end 1993 were apart from the committed credit facilities. It is anticipated that the funds required for construction and other purposes, including compliance with environmental regulations will be derived from operations, the sale of additional first mortgage bonds, pollution control obligations, and preferred stock, and the receipt of additional capital contributions from The Southern Company. Mississippi Power is required to meet certain coverage requirements specified in its mortgage indenture and corporate charter to issue new first mortgage bonds and preferred stock. The Company's coverage ratios are sufficiently high enough to permit, at present interest rate levels, any foreseeable security sales. The amount of securities which the Company will be permitted to issue in the future will depend upon market conditions and other factors prevailing at that time. II-189 STATEMENTS OF INCOME For the Years Ended December 31, 1993, 1992, and 1991 Mississippi Power Company 1993 Annual Report The accompanying notes are an integral part of these statements. II-190 STATEMENTS OF CASH FLOWS For the Years ended December 31, 1993, 1992, and 1991 Mississippi Power Company 1993 Annual Report ( ) Denotes use of cash. The accompanying notes are an integral part of these statements. II-191 BALANCE SHEETS At December 31, 1993 and 1992 Mississippi Power Company 1993 Annual Report The accompanying notes are an integral part of these statements. II-192 BALANCE SHEETS At December 31, 1993 and 1992 Mississippi Power Company 1993 Annual Report II-193 STATEMENTS OF CAPITALIZATION At December 31, 1993 and 1992 Mississippi Power Company 1993 Annual Report The accompanying notes are an integral part of these statements. II-194 STATEMENTS OF RETAINED EARNINGS For the Years Ended December 31, 1993, 1992, and 1991 Mississippi Power Company 1993 Annual Report STATEMENTS OF PAID-IN CAPITAL For the Years Ended December 31, 1993, 1992, and 1991 The accompanying notes are an integral part of these statements. II-195 NOTES TO FINANCIAL STATEMENTS Mississippi Power Company 1993 Annual Report 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES GENERAL Mississippi Power Company is a wholly owned subsidiary of The Southern Company, which is the parent company of five operating companies, Southern Company Services (SCS), Southern Electric International (Southern Electric), Southern Nuclear Operating Company (Southern Nuclear), and various other subsidiaries related to foreign utility operations and domestic non-utility operations. The operating companies (Alabama Power Company, Georgia Power Company, Gulf Power Company, Mississippi Power Company, and Savannah Electric and Power Company) provide electric service in four southeastern states. Contracts among the companies--dealing with jointly owned generating facilities, interconnecting transmission lines, and the exchange of electric power--are regulated by the Federal Energy Regulatory Commission (FERC) or the Securities and Exchange Commission. SCS provides, at cost, specialized services to The Southern Company and to the subsidiary companies. Southern Electric designs, builds, owns, and operates power production facilities and provides a broad range of technical services to industrial companies and utilities in the United States and a number of international markets. Southern Nuclear provides services to The Southern Company's nuclear power plants. The Southern Company is registered as a holding company under the Public Utility Holding Company Act of 1935 (PUHCA). Both The Southern Company and its subsidiaries are subject to the regulatory provisions of the PUHCA. Mississippi Power is also subject to regulation by the FERC and the Mississippi Public Service Commission (MPSC). The Company follows generally accepted accounting principles and complies with the accounting policies and practices prescribed by the respective commissions. The 1991 financial statements of the Company included the accounts of Electric City Merchandise Company, Inc. (Electric City), which discontinued operations in 1991. All significant intercompany transactions were eliminated in consolidation. Certain prior years' data presented in the financial statements have been reclassified to conform with current year presentation. REVENUES Mississippi Power accrues revenues for service rendered but unbilled at the end of each fiscal period. The Company's retail and wholesale rates include provisions to adjust billings for fluctuations in fuel and the energy component of purchased power. Retail rates also include provisions to adjust billings for fluctuations in costs for ad valorem taxes. Revenues are adjusted for differences between the recoverable fuel and ad valorem expenses and the amounts actually recovered in current rates. DEPRECIATION Depreciation of the original cost of depreciable utility plant in service is provided by using composite straight-line rates which approximated 3.1 percent in 1993 and 3.3 percent in 1992 and 1991. When property subject to depreciation is retired or otherwise disposed of in the normal course of business, its cost -- together with the cost of removal, less salvage -- is charged to the accumulated provision for depreciation. Minor items of property included in the original cost of the plant are retired when the related property unit is retired. INCOME TAXES Mississippi Power provides deferred income taxes for all significant income tax temporary differences. Investment tax credits utilized are deferred and amortized to income over the average lives of the related property. In years prior to 1993, income taxes were accounted for and reported under Accounting Principles Board Opinion No. 11. Effective January 1, 1993, Mississippi Power adopted FASB Statement No. 109, Accounting for Income Taxes. Statement No. 109 required, among other things, conversion to the liability method of accounting for accumulated deferred income taxes. See Note 9 to the financial statements for additional information about Statement No. 109. II-196 NOTES (continued) Mississippi Power Company 1993 Annual Report ALLOWANCE FOR FUNDS USED DURING CONSTRUCTION (AFUDC) AFUDC represents the estimated debt and equity costs of capital funds that are necessary to finance the construction of new facilities. While cash is not realized currently from such allowance, it increases the revenue requirement over the service life of the plant through a higher rate base and higher depreciation expense. The composite rates used to capitalize the cost of funds devoted to construction were 6.8 percent in 1993, 8.2 percent in 1992, and 9.8 percent in 1991. AFUDC (net of income taxes), as a percent of net income after dividends on preferred stock, was 3.5 percent in 1993, 2.7 percent in 1992, and 4.8 percent in 1991. UTILITY PLANT Utility plant is stated at original cost. This cost includes: materials; labor; minor items of property; appropriate administrative and general costs; payroll-related costs such as taxes, pensions, and other benefits; and the estimated cost of funds used during construction. The cost of maintenance, repair, and replacement of minor items of property is charged to maintenance expense except for the maintenance of coal cars and a portion of the railway track maintenance, which are charged to fuel stock. The cost of replacements of property (exclusive of minor items of property) is charged to utility plant. CASH AND CASH EQUIVALENTS For purposes of the Statements of Cash Flows, temporary cash investments are considered cash equivalents. Temporary cash investments are securities with original maturities of 90 days or less. FINANCIAL INSTRUMENTS In accordance with FASB Statement No. 107, Disclosure About Fair Value of Financial Instruments, all financial instruments of the Company -- for which the carrying amount does not approximate fair value -- are shown in the table below as of December 31: The fair value of investment securities was based on listed closing market prices. The fair value for long-term debt was based on either closing market prices or closing prices of comparable instruments. MATERIALS AND SUPPLIES Generally, materials and supplies include the cost of transmission, distribution and generating plant materials. Materials are charged to inventory when purchased and then expensed or capitalized to plant, as appropriate, when used or installed. VACATION PAY Mississippi Power's employees earn their vacation in one year and take it in the subsequent year. However, for ratemaking purposes, vacation pay is recognized as an allowable expense only when paid. Consistent with this ratemaking treatment, the Company accrues a current liability for earned vacation pay and records a current asset representing the future recoverability of this cost. Such amounts were $4.8 million and $4.7 million at December 31, 1993 and 1992, respectively. In 1994, an estimated 80 percent of the 1993 deferred vacation cost will be expensed, and the balance will be charged to construction and other accounts. II-197 NOTES (continued) Mississippi Power Company 1993 Annual Report PROVISION FOR PROPERTY DAMAGE Due to the significant increase in the cost of traditional insurance, effective in 1993, Mississippi Power became self-insured for the full cost of storm and other damage to its transmission and distribution property. As permitted by regulatory authorities, the Company provided for the cost of storm, fire and other uninsured casualty damage by charges to income of $1.5 million in 1993, 1992, and 1991. The cost of repairing damage resulting from such events that individually exceed $50 thousand is charged to the accumulated provision to the extent it is available. As of December 31, 1993, the accumulated provision amounted to $10.5 million. Regulatory treatment by the MPSC allows a maximum accumulated provision of $10.9 million. DISCONTINUED OPERATIONS Electric City began operating as a subsidiary of Mississippi Power in October 1987 and was formally dissolved as of December 31, 1991. Under an agreement reached in October 1991, a portion of Electric City's assets, including inventory and fixed assets, was sold to a concern independent of Mississippi Power. The remaining assets and liabilities, which were not material, were transferred to the Company. The impact of Electric City on Mississippi Power's consolidated earnings in 1991 consisted of (a) a pretax operating loss of $10.2 million ($6.4 million after income taxes) and (b) the pretax loss of $8.7 million ($5.5 million after income taxes) resulting from the disposal of Electric City. 2. RETIREMENT BENEFITS: PENSION PLAN Mississippi Power has a defined benefit, trusteed, non-contributory pension plan that covers substantially all regular employees. Benefits are based on the greater of amounts resulting from two different formulas: years of service and final average pay or years of service and a flat-dollar benefit. The Company uses the "entry age normal method with a frozen initial liability" actuarial method for funding purposes, subject to limitations under federal income tax regulations. Amounts funded to the pension fund are primarily invested in equity and fixed-income securities. FASB Statement No. 87, Employers' Accounting for Pensions, requires use of the "projected unit credit" actuarial method for financial reporting purposes. POSTRETIREMENT BENEFITS Mississippi Power also provides certain medical care and life insurance benefits for retired employees. Substantially all employees may become eligible for these benefits when they retire. A qualified trust for medical benefits has been established for funding amounts to the extent deductible under federal income tax regulations. Amounts funded are primarily invested in debt and equity securities. Accrued costs of life insurance benefits, other than current cash payments for retirees, currently are not being funded. Effective January 1, 1993, Mississippi Power adopted FASB Statement No. 106, Employers' Accounting for Postretirement Benefits Other Than Pensions, on a prospective basis. Statement No. 106 requires that medical care and life insurance benefits for retired employees be accounted for on an accrual basis using a specified actuarial method, "benefit/years-of-service." Because the adoption of Statement No. 106 was reflected in rates, it did not have a material impact on net income. Prior to 1993, Mississippi Power recognized these benefit costs on an accrual basis using the "aggregate cost" actuarial method, which spreads the expected cost of such benefits over the remaining periods of employees' service as a level percentage of payroll costs. The total costs of such benefits recognized by the Company in 1992 and 1991 were $3.6 million and $3.0 million, respectively. II-198 NOTES (continued) Mississippi Power Company 1993 Annual Report STATUS AND COST OF BENEFITS Shown in the following tables are actuarial results and assumptions for pension and postretirement medical and life insurance benefits as computed under the requirements of FASB Statement Nos. 87 and 106, respectively. Retiree medical and life insurance information is shown only for 1993 because Statement No. 106 was adopted as of January 1, 1993, on a prospective basis. The funded status of the plans at December 31 was as follows: The weighted average rates assumed in the above actuarial calculations were: An additional assumption used in measuring the accumulated postretirement medical benefit obligation was a weighted average medical care cost trend rate of 11.3 percent for 1993, decreasing gradually to 6.0 percent through the year 2000 and remaining at that level thereafter. An annual increase in the assumed medical care cost trend rate by 1.0 percent would increase the accumulated medical benefit obligation as of December 31, 1993, by $6.4 million and the aggregate of the service and interest cost components of the net retiree medical cost by $722 thousand. Components of the plans' net cost are shown below: II-199 NOTES (continued) Mississippi Power Company 1993 Annual Report Of the above net pension amounts recorded, ($170 thousand) in 1993, $269 thousand in 1992, and $576 thousand in 1991 were recorded in operating expenses, and the remainder was recorded in construction and other accounts. Of the above net postretirement medical and life insurance costs recorded in 1993, $3.9 million was charged to operating expense and the remainder was charged to construction and other accounts. 3. LITIGATION AND REGULATORY MATTERS: RETAIL RATE ADJUSTMENT PLANS Mississippi Power's retail base rates have been set under a Performance Evaluation Plan (PEP) since 1986. During 1993, all matters related to the original PEP case were finally resolved when the Supreme Court of Mississippi granted a joint motion to dismiss pending appeals. Also in 1993, the MPSC ordered Mississippi Power to review and propose changes to the plan that would reduce the impact of rate changes on the customer and provide incentives for Mississippi Power to keep customer prices low. In response, Mississippi Power filed a revised plan and, on January 4, 1994, the MPSC approved PEP-2. The revised plan includes a mechanism for sharing rate adjustments based on the Company's ability to maintain low rates for customers and on the Company's performance as measured by three performance indicators that emphasize those factors which most directly impact the customers. PEP-2 provides for semiannual evaluations of Mississippi's performance-based return on investment, rather than on common equity as previously calculated. As in previous plans, any change in rates is limited to 2 percent of retail revenues per evaluation period before a public hearing is required. PEP-2 will remain in effect until the MPSC modifies or terminates the plan. ENVIRONMENTAL COMPLIANCE OVERVIEW PLAN The MPSC approved Mississippi Power's ECO Plan in 1992. The plan establishes procedures to facilitate the MPSC's overview of the Company's environmental strategy and provides for recovery of costs associated with environmental projects approved by the MPSC. Under the ECO Plan any increase in the annual revenue requirement is limited to 2 percent of retail revenues. However, the plan also provides for carryover of any amount over the 2 percent limit into the next year's revenue requirement. The ECO Plan resulted in an annual retail rate increase of $2.6 million effective April 1993. FERC REVIEWS EQUITY RETURNS AND OTHER REGULATORY MATTERS In May 1991, the FERC ordered that hearings be conducted concerning the reasonableness of the Southern electric system's wholesale rate schedules and contracts that have a return on equity of 13.75 percent or greater. The contracts that could be affected by the hearings include substantially all of the transmission, unit power, long-term power and other similar contracts, including the Company's Transmission Facilities Agreement (TFA) discussed in Note 8 under "Lease Agreements." Any changes in rate of return on common equity that may occur as a result of this proceeding would be effective 60 days after a proper notice of the proceeding is published. A notice was published on May 10, 1991. In August 1992, an administrative law judge issued an opinion that changes in rate schedules and contracts were not necessary and that the FERC staff failed to show how any changes were in the public interest. The FERC staff has filed exceptions to the administrative law judge's opinion, and the matter remains pending before the FERC. The final outcome of this matter cannot now be determined; however, in management's opinion, the final outcome will not have a material adverse effect on Mississippi Power's financial statements. In 1988, the Company and its operating affiliates filed with the FERC a contract governing the pricing and other aspects of power transactions among the companies. In 1989, the FERC ordered hearings on the contract and made revenues collected under the contract subject to refund. In 1992, the II-200 NOTES (continued) Mississippi Power Company 1993 Annual Report FERC ruled that certain production costs under the contract had not been properly classified and ordered that the contract be revised and that refunds be made. Under reconsideration, the FERC determined that refunds were not necessary and ordered that its mandated changes in computing certain expenses under the system interchange contract become effective in August 1993. The changes mandated by the FERC will not materially affect the Company's net income. WHOLESALE RATE FILING On September 1, 1993, Mississippi Power filed a $3.6 million wholesale rate increase request with the FERC. Prior to this filing, the Company conferred and negotiated a settlement with all of its wholesale all requirements customers, who have executed a Settlement Agreement and Certificates of Concurrence to be included in this filing with the FERC. The Company is awaiting a response from the FERC. RETAIL RATEPAYERS' SUITS CONCLUDED In 1989, three retail ratepayers of the Company filed a civil complaint in the U.S. District Court for the Southern District of Mississippi against Mississippi Power and other parties. The complaint alleged that Mississippi Power obtained excessive rate increases by improper accounting for spare parts and sought actual damages estimated to be at least $10 million, plus treble and punitive damages, on behalf of all retail ratepayers of the Company for alleged violations of the federal Racketeer Influenced and Corrupt Organizations Act, federal and state antitrust laws, other federal and state statutes, and common law fraud. Mississippi Power also was named as a defendant, together with other parties in a similar civil action filed in the U.S. District Court for the Northern District of Florida. The defendants' motions for dismissal were granted by the courts, resolving these suits. 4. CONSTRUCTION PROGRAM: Mississippi Power is engaged in continuous construction programs, the costs of which are currently estimated to total some $96 million in 1994, $62 million in 1995, and $98 million in 1996. These estimates include AFUDC of $1.6 million in 1994, $1.6 million in 1995, and $2.7 million in 1996. The construction program is subject to periodic review and revision, and actual construction costs may vary from the above estimates because of numerous factors. These factors include changes in business conditions; revised load growth estimates; changes in environmental regulations; increasing costs of labor, equipment and materials; and cost of capital. The Company does not have any new baseload generating plants under construction. However, the construction of a combustion turbine generation unit of 78 megawatts was completed in February 1994. In addition, significant construction will continue related to transmission and distribution facilities and the upgrading and extension of the useful lives of generating plants. See Management's Discussion and Analysis under "Environmental Matters" for information on the impact of the Clean Air Act and other environmental matters. 5. FINANCING AND COMMITMENTS: FINANCING Mississippi Power's construction program is expected to be financed from internal and other sources, such as the issuance of additional long-term debt and preferred stock and the receipt of capital contributions from The Southern Company. The amounts of first mortgage bonds and preferred stock which can be issued in the future will be contingent upon market conditions, adequate earnings levels, regulatory authorizations and other factors. See Management's Discussion and Analysis under "Sources of Capital" for information regarding the Company's coverage requirements. At December 31, 1993, Mississippi Power had committed credit agreements (360 day committed lines) with banks for $21 million. Additionally, Mississippi Power had $70 million of unused committed credit agreements in the form of revolving credit agreements expiring December 1, 1996. These agreements allow short-term borrowings to be converted into term loans, payable in 12 equal quarterly installments, with the first installment due at the end of the first calendar quarter after the applicable termination date or at an earlier date at the Company's option. In connection with these credit arrangements, the Company agrees to pay commitment fees based on the unused portions of the commitments or to maintain compensating balances with the banks. As of December 31, 1993, Mississippi Power had $40 million in short-term bank borrowings all of which were made apart from committed credit arrangements. II-201 NOTES (continued) Mississippi Power Company 1993 Annual Report ASSETS SUBJECT TO LIEN Mississippi Power's mortgage indenture dated as of September 1, 1941, as amended and supplemented, which secures the first mortgage bonds issued by the Company, constitutes a direct first lien on substantially all the Company's fixed property and franchises. FUEL COMMITMENTS To supply a portion of the fuel requirements of its generating plants, Mississippi Power has entered into various long-term commitments for the procurement of fuel. In most cases, these contracts contain provisions for price escalations, minimum production levels, and other financial commitments. Total estimated obligations were approximately $243 million at December 31, 1993. Additional commitments for fuel will be required in the future to supply the Company's fuel needs. In order to take advantage of lower cost coal supplies, agreements were reached in December 1986 to terminate two contracts for the supply of coal to Plant Daniel, which is jointly owned by Mississippi Power and Gulf Power, an operating affiliate. The Company's portion of this payment was about $60 million. In accordance with the ratemaking treatment, the cost to terminate the contracts is being amortized through 1995 to match costs with savings achieved. The remaining unamortized amount of Mississippi Power's share of principal payments to the suppliers including the current portion totaled $18 million at December 31, 1993. 6. JOINT OWNERSHIP AGREEMENTS: Mississippi Power and Alabama Power own as tenants in common Greene County Electric Generating Plant (coal) located in Alabama; and Mississippi Power and Gulf Power own as tenants in common Daniel Electric Generating Plant (coal) located in Mississippi. At December 31, 1993, Mississippi Power's percentage ownership and investment in these jointly owned facilities were as follows: Mississippi Power's share of plant operating expenses is included in the corresponding operating expenses in the Statements of Income. 7. LONG-TERM POWER SALES AGREEMENTS: GENERAL Mississippi Power and the other operating affiliates of The Southern Company have entered into long-term contractual agreements for the sale of capacity and energy to certain non-affiliated utilities located outside of the system's service area. Some of these agreements (unit power sales) are firm commitments and pertain to capacity related to specific generating units. Mississippi Power's participation in firm production capacity unit power sales ended in January 1989. However, the Company continues to participate in transmission and energy sales under the unit power sales agreements. The other agreements (other long-term sales) are non-firm commitments and are based on capacity of the system in general. Because the energy is generally sold at variable costs under these agreements, only revenues from capacity sales affect profitability. Off-system capacity revenues for the Company have been as follows: Long-term non-firm power of 400 megawatts was sold in 1993 by the Southern electric system to Florida Power Corporation. In January 1994, this amount decreased to 200 megawatts, and the contract will expire at year-end. II-202 NOTES (continued) Mississippi Power Company 1993 Annual Report GULF STATES SETTLEMENT COMPLETED On November 7, 1991, subsidiaries of The Southern Company entered into a settlement agreement with Gulf States that resolved litigation between the companies that had been pending since 1986 and arose out of a dispute over certain unit power and other long-term power sales contracts. In 1993, all remaining terms and obligations of the settlement agreement were satisfied. Based on the value of the settlement proceeds received -- less the amounts previously included in income -- Mississippi Power recorded an increase in net income of approximately $2.6 million in 1991. 8. LEASE AGREEMENTS: In 1984, Mississippi Power and Gulf States entered into a forty-year transmission facilities agreement whereby Gulf States began paying a use fee to the Company covering all expenses relative to ownership and operation and maintenance of a 500 kV line, including amortization of its original $57 million cost. In 1993, 1992, and 1991 the use fees collected under the agreement, net of related expenses, amounted to $3.9 million, $3.9 million and $4.0 million, respectively, and are included with other income, net, in the Statements of Income. For other information see Note 3 under "FERC Reviews Equity Returns and Other Regulatory Matters." In 1989, Mississippi Power entered into a twenty-two year operating lease agreement for the use of 495 aluminum railcars to transport coal to Plant Daniel. Gulf Power, as joint owner of Plant Daniel, is responsible for one half of the lease costs. The Company's share of the lease is charged to fuel inventory and allocated to fuel expense as the fuel is used. The lease costs charged to inventory were $1.2 million in 1993, $1.2 million for 1992 and $1.3 million for 1991. For the year 1994, the Company's annual lease payment will be $1.2 million. The Company's annual lease payment for 1995 will be $2.4 million and for 1996, 1997, and in 1998 the payment will be $1.2 million. Lease payments after 1998 total approximately $17.4 million. The Company has the option after three years to purchase the railcars at the greater of termination value or fair market value. Additionally, at the end of the lease term, Mississippi Power has the option to renew the lease. 9. INCOME TAXES: Effective January 1, 1993, Mississippi Power adopted FASB Statement No. 109, Accounting for Income Taxes. The adoption of Statement No. 109 resulted in cumulative adjustments that had no effect on net income. The adoption also resulted in the recording of additional deferred income taxes and related assets and liabilities. The related assets of $25 million are revenues to be received from customers. These assets are attributable to tax benefits flowed through to customers in prior years and to taxes applicable to capitalized AFUDC. The related liabilities of $48 million are revenues to be refunded to customers. These liabilities are attributable to deferred taxes previously recognized at rates higher than current enacted tax law and unamortized investment tax credits. Additionally, deferred income taxes related to accelerated tax depreciation previously shown as a reduction to utility plant were reclassified. II-203 NOTES (continued) Mississippi Power Company 1993 Annual Report Details of the federal and state income tax provisions are shown below: The tax effects of temporary differences between the carrying amounts of assets and liabilities in the financial statements and their respective tax bases, which give rise to deferred tax assets and liabilities are as follows: In 1989, under order of the MPSC, Mississippi Power began amortizing deferred income taxes not covered by the Internal Revenue Service normalization requirements, that had been recorded at rates higher than those specified by the current statutory income tax rules. This amortization occurred over a 60-month period, the effect of which was a reduction of income tax expense of approximately $2.7 million per year. At December 31, 1993, this tax rate differential was fully amortized. Deferred investment tax credits are amortized over the life of the related property with such amortization normally applied as a credit to reduce depreciation in the Statements of Income. Credits amortized in this manner amounted to $1.5 million in 1993, $1.4 million in 1992 and $1.5 million in 1991. At December 31, 1993, all investment tax credits available to reduce federal income taxes payable had been utilized. II-204 NOTES (continued) Mississippi Power Company 1993 Annual Report The total provision for income taxes as a percentage of pre-tax income and the differences between those effective rates and the statutory federal tax rates were as follows: Mississippi Power and its affiliates file a consolidated federal income tax return. Under a joint consolidated income tax agreement, each company's current and deferred tax expense is computed on a stand-alone basis, and consolidated tax savings are allocated to each company based on its ratio of taxable income to total consolidated taxable income. 10. OTHER LONG-TERM DEBT: Details of other long-term debt are as follows: Pollution control obligations represent installment or lease purchases of pollution control facilities financed by application of funds derived from sales by public authorities of tax-exempt revenue bonds. Mississippi Power has authenticated and delivered to the Trustee a like principal amount of first mortgage bonds as security for obligations under collateralized installment agreements. The principal and interest on the first mortgage bonds will be payable only in the event of default under these agreements. The 5.8% Series of pollution control obligations has a cash sinking fund requirement of $10 thousand annually through 1997 and $20 thousand in 1998. At December 31, 1993, under "Other Property and Investments" approximately $6 million related to the 6.20% Series of Pollution Control Obligations remains available for completion of certain solid waste disposal facilities. The 8.25 percent notes payable relate to the termination of two coal contracts. See Note 5 under "Fuel Commitments" for information on these coal contracts. The annual estimated maturities of total notes payable are $8.8 million in 1994 and $10.8 million in 1995. II-205 NOTES (continued) Mississippi Power Company 1993 Annual Report 11. LONG-TERM DEBT DUE WITHIN ONE YEAR: A summary of the improvement fund requirements and scheduled maturities and redemptions of long-term debt due within one year is as follows: The first mortgage bond improvement fund requirement is one percent of each outstanding series authenticated under the indenture of Mississippi Power prior to January 1 of each year, other than first mortgage bonds issued as collateral security for certain pollution control obligations. The requirement must be satisfied by June 1 of each year by depositing cash or reacquiring bonds, or by pledging additional property equal to 166-2/3 percent of such requirement. 12. COMMON STOCK DIVIDEND RESTRICTIONS: Mississippi Power's first mortgage bond indenture and the Articles of Incorporation contain various common stock dividend restrictions. At December 31, 1993, $86 million of retained earnings was restricted against the payment of cash dividends on common stock under the most restrictive terms of the mortgage indenture or Articles of Incorporation. 13. QUARTERLY FINANCIAL DATA (UNAUDITED): Summarized quarterly financial data for 1993 and 1992 are as follows: Mississippi Power's business is influenced by seasonal weather conditions and the timing of rate changes. II-206 SELECTED FINANCIAL AND OPERATING DATA Mississippi Power Company 1993 Annual Report II-207 II-208 II-209 II-210 STATEMENTS OF INCOME Mississippi Power Company II-211 STATEMENTS OF INCOME Mississippi Power Company II-212 STATEMENTS OF CASH FLOWS Mississippi Power Company II-213 STATEMENTS OF CASH FLOWS Mississippi Power Company II-214 BALANCE SHEETS Mississippi Power Company II-215 BALANCE SHEETS Mississippi Power Company II-216 BALANCE SHEETS Mississippi Power Company II-217 BALANCE SHEETS Mississippi Power Company II-218 MISSISSIPPI POWER COMPANY OUTSTANDING SECURITIES AT DECEMBER 31, 1993 FIRST MORTGAGE BONDS POLLUTION CONTROL BONDS PREFERRED STOCK II-219 MISSISSIPPI POWER COMPANY SECURITIES RETIRED DURING 1993 FIRST MORTGAGE BONDS POLLUTION CONTROL BONDS PREFERRED STOCK II-220 SAVANNAH ELECTRIC AND POWER COMPANY FINANCIAL SECTION II-221 MANAGEMENT'S REPORT Savannah Electric and Power Company 1993 Annual Report The management of Savannah Electric and Power Company has prepared -- and is responsible for -- the financial statements and related information included in this report. These statements were prepared in accordance with generally accepted accounting principles appropriate in the circumstances and necessarily include amounts that are based on the best estimates and judgments of management. Financial information throughout this annual report is consistent with the financial statements. The Company maintains a system of internal accounting controls to provide reasonable assurance that assets are safeguarded and that books and records reflect only authorized transactions of the Company. Limitations exist in any system of internal controls, however, based on a recognition that the cost of the system should not exceed its benefits. The Company believes its system of internal accounting controls maintains an appropriate cost/benefit relationship. The Company's system of internal accounting controls is evaluated on an ongoing basis by the Company's internal audit staff. The Company's independent public accountants also consider certain elements of the internal control system in order to determine their auditing procedures for the purpose of expressing an opinion on the financial statements. The audit committee of the board of directors, composed of four directors who are not employees, provides a broad overview of management's financial reporting and control functions. Periodically, this committee meets with management, the internal auditors and the independent public accountants to ensure that these groups are fulfilling their obligations and to discuss auditing, internal controls and financial reporting matters. The internal auditors and the independent public accountants have access to the members of the audit committee at any time. Management believes that its policies and procedures provide reasonable assurance that the Company's operations are conducted according to a high standard of business ethics. In management's opinion, the financial statements present fairly, in all material respects, the financial position, results of operations and cash flows of Savannah Electric and Power Company in conformity with generally accepted accounting principles. /s/ Arthur M. Gignilliat, Jr. /s/ K. R. Willis - -------------------------------- ------------------------------------- Arthur M. Gignilliat, Jr. K. R. Willis President Vice-President and Chief Executive Officer Treasurer and Chief Financial Officer II-222 REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS TO THE BOARD OF DIRECTORS OF SAVANNAH ELECTRIC AND POWER COMPANY: We have audited the accompanying balance sheets and statements of capitalization of Savannah Electric and Power Company (a Georgia corporation) as of December 31, 1993 and 1992, and the related statements of income, retained earnings, paid-in capital, and cash flows for each of the three years in the period ended December 31, 1993. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements (pages II-231 through II-244) referred to above present fairly, in all material respects, the financial position of Savannah Electric and Power Company as of December 31, 1993 and 1992, and the results of its operations and its cash flows for the periods stated, in conformity with generally accepted accounting principles. As explained in Notes 2 and 7 to the financial statements, effective January 1, 1993, the Company changed its methods of accounting for postretirement benefits other than pensions and for income taxes. /s/ Arthur Andersen & Co. Atlanta, Georgia, February 16, 1994 II-223 MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION Savannah Electric and Power Company 1993 Annual Report RESULTS OF OPERATIONS Earnings Savannah Electric and Power Company's net income after dividends on preferred stock for 1993 totaled $21.5 million, representing a $1.0 million (4.6 percent) increase from the prior year. The revenue impact of an increase in retail energy sales due to exceptionally hot summer weather was partially offset by the implementation of a work force reduction program which resulted in a one-time charge to operating expenses of approximately $4.5 million. In 1992, earnings were $20.5 million, representing a $3.5 million (14.6 percent) decrease from the prior year. This decrease resulted primarily from increases in maintenance and administrative and general expenses, partially offset by a 4.6 percent increase in retail operating revenues. Operating revenues increased despite the negative impact of a $2.8 million annual reduction in retail base rates effective in June 1992, and mild weather. REVENUES Total revenues for 1993 were $218.4 million, reflecting a 10.5 percent increase over 1992, primarily due to an increase in retail energy sales. The following table summarizes the factors impacting operating revenues compared to the prior year for the 1991-1993 period: Total retail revenues increased 11.5 percent in 1993, compared to a 4.6 percent increase in 1992. The increase in 1993 retail revenues attributable to growth in both retail customers and average use per customer was enhanced by exceptionally hot weather during the summer. The substantial increase in fuel cost recovery and other revenues reflects increases in net generation and the unit cost of purchased power. The increase in 1992 retail revenues resulted from growth in both retail customers and average use per customer, but was substantially offset by mild weather and the June 1992 base rate reduction. II-224 MANAGEMENT'S DISCUSSION AND ANALYSIS (continued) Savannah Electric and Power Company 1993 Annual Report Under the Company's fuel cost recovery provisions, fuel revenues equal fuel expense, including the fuel and capacity components of purchased energy, and have no effect on earnings. Revenues from sales to non-affiliated utilities under long-term contracts consist of capacity and energy components. Capacity revenues reflect the recovery of fixed costs and a return on investment under the contracts. Energy is generally sold at variable cost. The capacity and energy components were: Sales to affiliated companies within the Southern electric system vary from year to year depending on demand and the availability and cost of generating resources at each company. These sales have little impact on earnings. Kilowatt-hour sales for 1993 and the percent change by year were as follows: The increases in energy sales in 1993 and 1992 continue to reflect a growing customer base, an increase in average energy sales per customer, and improved economic conditions in the Company's service area. Sales were enhanced in 1993 by temperature extremes in the summer months and in December. EXPENSES Total operating expenses for 1993 increased $20.3 million (12.4 percent) over the prior year. This increase includes a $10.8 million increase in fuel expense, and an $8.7 million increase in other operation expenses. Fuel expenses increased primarily because of higher generation due to extremely hot weather and higher cost fuel sources. In 1992 an increase in purchased power reflected a 15.4 percent decrease in generation compared to 1991. Despite the decrease in generation, total 1992 fuel expenses were substantially unchanged from the prior year reflecting generation from higher cost fuel sources. The increase in other operation expenses reflects a $4.5 million cost associated with a one-time charge related to a work force reduction program. The Company also recognized higher employee benefits costs under new accounting rules adopted in 1993. See Note 2 to the financial statements for additional information on these new rules. In 1992, the increase in other operation expenses was primarily a result of increases in outside services and administrative and general expenses, which reflected higher employee training and benefits expenses. Total interest expense on long-term debt was reduced by 5.4 percent in 1992, as the Company refinanced higher-cost debt. II-225 MANAGEMENT'S DISCUSSION AND ANALYSIS (continued) Savannah Electric and Power Company 1993 Annual Report The mix of energy supply is determined primarily by system load, the unit cost of fuel consumed and the availability of units. The amount and sources of energy supply and the average cost of fuel per net kilowatt-hour generated and purchased power were as follows: EFFECTS OF INFLATION The Company is subject to rate regulation and income tax laws that are based on the recovery of historical costs. Therefore, inflation creates an economic loss because the Company is recovering its costs of investments in dollars that have less purchasing power. While the inflation rate has been relatively low in recent years, it continues to have an adverse effect on the Company because of the large investment in long-lived utility plant. Conventional accounting for historical cost does not recognize this economic loss nor the partially offsetting gain that arises through financing facilities with fixed-money obligations such as long-term debt and preferred stock. Any recognition of inflation by regulatory authorities is reflected in the rate of return allowed. FUTURE EARNINGS POTENTIAL The results of operations for the past three years are not necessarily indicative of future earnings potential. The level of future earnings depends on numerous factors ranging from growth in energy sales to regulatory matters. Future earnings in the near term will depend upon growth in energy sales, which is subject to a number of factors. Traditionally, these factors included changes in contracts with neighboring utilities, energy conservation practiced by customers, the elasticity of demand, weather, competition, and the rate of economic growth in the Company's service area. However, the Energy Policy Act of 1992 (Energy Act) will have a profound effect on the future of the electric utility industry. The Energy Act promotes energy efficiency, alternative fuel use, and increased competition for electric utilities. The Energy Act allows Independent Power Producers (IPPs) to access a utility's transmission network to sell electricity to other utilities. This may enhance the incentives for IPPs to build cogeneration plants for the Company's large industrial and commercial customers. Although the Energy Act does not require transmission access to retail customers, pressure for legislation to allow retail wheeling will continue. The Company is preparing now to meet the challenge of these major changes in the traditional business practices of selling electricity. If the Company does not remain a low-cost producer and provide quality service, the Company's retail energy sales growth, as well as new long-term contracts for energy sales outside the service area, could be limited, and this could significantly erode earnings. Demand-side options -- programs that enable customers to lower or alter their peak energy requirements -- have been initiated by the Company and are a significant part of integrated resource planning. Customers can receive cash incentives for participating in these programs in addition to reducing their energy requirements. Expansion and increased utilization of these programs will be contingent upon sharing of cost savings between the customers and the Company. Besides promoting energy efficiency, another benefit of these programs could be the ability to defer the need to construct baseload generating facilities further into the future. The ability to defer major construction projects, in conjunction with the precertification approval process for such projects by the Georgia Public Service Commission (GPSC), will II-226 MANAGEMENT'S DISCUSSION AND ANALYSIS (continued) Savannah Electric and Power Company 1993 Annual Report diminish the possible exposure to prudency disallowances and the resulting impact on earnings. Compliance costs related to the Clean Air Act Amendments of 1990 (Clean Air Act) could reduce earnings if such costs are not fully recovered. The Clean Air Act is discussed later under "Environmental Matters." Rates to retail customers served by the Company are regulated by the GPSC. In May 1992, the Company requested, and subsequently received, approval by the GPSC to reduce annual base revenues by $2.8 million, effective June 1992. The reduction includes a base rate reduction of approximately $2.5 million spread among all classes of retail customers. An additional $0.3 million reduction resulted from the implementation of an experimental, time-of-use rate for certain commercial customers. As part of this rate settlement, it was informally agreed that the Company's earned rate of return on common equity should be 12.95 percent. NEW ACCOUNTING STANDARDS The Financial Accounting Standards Board (FASB) issued Statement No. 112, Employers' Accounting for Postemployment Benefits, which must be implemented by 1994. The new standard requires that all types of benefits provided to former or inactive employees and their families prior to retirement be accounted for on an accrual basis. These benefits include salary continuation, severance pay, supplemental unemployment benefits, disability-related benefits, job training, and health and life insurance coverage. The FASB has issued Statement No. 115, Accounting for Certain Investments in Debt and Equity Securities, which is effective in 1994. Statement No. 115, supersedes FASB Statement No. 12, Accounting for Certain Marketable Securities. The Company adopted the new rules January 1, 1994, with no material effect on the financial statements. On January 1, 1993, the Company changed its methods of accounting for postretirement benefits other than pensions and for income taxes. See notes 2 and 7 to the financial statements regarding the impact of these changes. FINANCIAL CONDITION OVERVIEW The principal change in the Company's financial condition in 1993 was additions of $73 million to utility plant. The majority of funds needed for gross property additions since 1990 have been provided from operating activities, principally from earnings and non-cash charges to income such as depreciation and deferred income taxes. See Statements of Cash Flows for additional information. CAPITAL STRUCTURE As of December 31, 1993, the Company's capital structure consisted of 45.3 percent common equity, 10.3 percent preferred stock and 44.4 percent long-term debt, excluding amounts due within one year. The Company's long-term financial objective for capitalization ratios is to maintain a capital structure of common equity at 45 percent, preferred stock at 10 percent and debt at 45 percent. Maturities and retirements of long-term debt were $4 million in 1993, $53 million in 1992 and $23 million in 1991. In November 1993, the Company issued 1,400,000 shares of 6.64 percent series preferred stock. In December 1993, the Company redeemed all 800,000 shares outstanding of its 9.5 percent series preferred stock at the prescribed redemption price of $26.57 plus accrued dividends. The composite interest rates for the years 1991 through 1993 as of year-end were as follows: II-227 MANAGEMENT'S DISCUSSION AND ANALYSIS (continued) Savannah Electric and Power Company 1993 Annual Report The Company's current securities ratings are as follows: CAPITAL REQUIREMENTS FOR CONSTRUCTION The Company's projected construction expenditures for the next three years total $98 million ($33 million in 1994, $32 million in 1995, and $33 million in 1996). Actual construction costs may vary from this estimate because of such factors as changes in environmental regulations; revised load projections; the cost and efficiency of construction labor, equipment and materials; and the cost of capital. The largest project during this period is the addition of two 80 megawatt combustion turbine units, to be placed into service in 1994. The estimated cost of this project is $61 million. The Company is also constructing six combustion turbine units for Georgia Power Company. OTHER CAPITAL REQUIREMENTS In addition to the funds needed for the construction program, approximately $5.9 million will be needed by the end of 1996 for present sinking fund requirements and maturities. ENVIRONMENTAL MATTERS In November 1990, the Clean Air Act was signed into law. Title IV of the Clean Air Act -- the acid rain compliance provision of the new law -- will have a significant impact on the Company and other subsidiaries of the Southern electric system. Specific reductions in sulfur dioxide and nitrogen oxide emissions from fossil-fired generating plants will be required in two phases. Phase I compliance must be implemented in 1995, and affects eight generating plants -- some 10,000 megawatts of capacity or 35 percent of total capacity -- in the Southern electric system. Phase II compliance is required in 2000, and all fossil-fired generating plants in the Southern electric system will be affected. Beginning in 1995, the Environmental Protection Agency (EPA) will allocate annual sulfur dioxide emission allowances through the newly established allowance trading program. An emission allowance is the authority to emit one ton of sulfur dioxide during a calendar year. The method for allocating allowances is based on the fossil fuel consumed from 1985 through 1987 for each affected generating unit. Emission allowances are transferable and can be bought, sold, or banked and used in the future. The sulfur dioxide emission allowance program is expected to minimize the cost of compliance. The market for emission allowances is developing slower than expected. However, The Southern Company's sulfur dioxide compliance strategy is designed to take advantage of allowances as the market develops. The Southern Company expects to achieve Phase I sulfur dioxide compliance at the eight affected plants by switching to low-sulfur coal, and this would require some equipment upgrades. This compliance strategy is expected to result in unused emission allowances being banked for later use. Additional construction expenditures are required to install equipment for the control of nitrogen oxide emissions at these eight plants. Also, continuous emissions monitoring equipment would be installed on all fossil-fired units. Under this Phase I compliance approach, additional construction expenditures are estimated to total approximately $275 million through 1995 for The Southern Company, of which the Company's portion is approximately $2 million. Phase II compliance costs are expected to be higher because requirements are stricter and all fossil-fired generating plants are affected. For sulfur dioxide compliance, The Southern Company could use emission allowances banked during Phase I and increase fuel switching, install flue gas desulfurization equipment at selected plants, and/or purchase more allowances depending on the price and availability of allowances. Also, in Phase II, equipment to control nitrogen oxide emissions will be installed on additional system fossil-fired plants as required to meet anticipated Phase II limits. Therefore, during the period 1996 through 2000, compliance could require total construction expenditures ranging from approximately $450 million to $800 million of which the Company's portion is expected to be approximately $25 million. However, the full impact of II-228 MANAGEMENT'S DISCUSSION AND ANALYSIS (continued) Savannah Electric and Power Company 1993 Annual Report Phase II compliance cannot now be determined with certainty, pending the development of a market for emission allowances, the completion of EPA regulations, and the possibility of new emission reduction technologies. An increase of up to 5 percent in annual revenue requirements from customers could be necessary to fully recover the Company's costs of compliance for both Phase I and II of the Clean Air Act. Compliance costs include construction expenditures, increased costs for switching to low-sulfur coal, and costs related to emission allowances. There can be no assurance that all Clean Air Act costs will be recovered. Title III of the Clean Air Act requires a multi-year EPA study of power plant emissions of hazardous air pollutants. The study will serve as the basis for a decision on whether additional regulatory control of these substances is warranted. Compliance with any new control standards could result in significant additional costs. The impact of new standards -- if any - -- will depend on the development and implementation of applicable regulations. The EPA continues to evaluate the need for a new short-term ambient air quality standard for sulfur dioxide. Preliminary results from an EPA study on the impact of a new standard indicate that a number of plants could be required to install sulfur dioxide controls. These controls would be in addition to the controls already required to meet the acid rain provision of the Clean Air Act. The EPA is expected to take some action on this issue in 1994. The impact of any new standard will depend on the level chosen for the standard and cannot be determined at this time. In addition, the EPA is evaluating the need to revise the ambient air quality standards for particulate matters, nitrogen oxides, and ozone. The impact of any new standard will depend on the level chosen for the standard and cannot be determined at this time. In 1994 or 1995, the EPA is expected to issue revised rules on air quality control regulations related to stack height requirements of the Clean Air Act. The full impact of the final rules cannot be determined at this time, pending their development and implementation. In 1993, the EPA issued a ruling confirming the non-hazardous status of coal ash. However, the EPA has until 1998 to classify co-managed utility wastes--coal ash and other utility wastes--as either non-hazardous or hazardous. If the EPA classifies the co-managed wastes as hazardous, then substantial additional costs for the management of such wastes may be required. The full impact of any change in the regulatory status will depend on the subsequent development of co-managed waste requirements. Savannah Electric and Power Company must comply with other environmental laws and regulations that cover the handling and disposal of hazardous waste. Under these various laws and regulations, the Company could incur costs to clean up properties currently or previously owned. The Company conducts studies to determine the extent of any required clean-up costs and will recognize in the financial statements any costs to clean up known sites. Several major pieces of environmental legislation are in the process of being reauthorized or amended by Congress. These include: the Clean Water Act, the Comprehensive Environmental Response, Compensation, and Liability Act, and the Resource Conservation and Recovery Act. Changes to these laws could affect many areas of the Company's operations. The full impact of these requirements cannot be determined at this time, pending the development and implementation of applicable regulations. Compliance with possible new legislation related to global climate change, electromagnetic fields, and other environmental and health concerns could significantly affect The Southern Company. The impact of new legislation - -- if any -- will depend on the subsequent development and implementation of applicable regulations. In addition, the potential for lawsuits alleging damages caused by electromagnetic fields exists. SOURCES OF CAPITAL At December 31, 1993, the Company had $3.9 million of cash and $14.5 million of unused credit arrangements with banks to meet its short-term cash needs. The Company had $3 million of short-term bank borrowings at December 31, 1993. In January 1994, the Company renegotiated a two-year revolving credit arrangement with four of its II-229 MANAGEMENT'S DISCUSSION AND ANALYSIS (continued) Savannah Electric and Power Company 1993 Annual Report existing banks for a total credit line of $20 million. The primary purpose of this additional credit is to provide interim funding for the Company's combustion turbine construction program. It is anticipated that the funds required for construction and other purposes, including compliance with environmental regulations, will be derived from operations and the sale of additional first mortgage bonds and preferred stock and capital contributions from The Southern Company. The Company is required to meet certain coverage requirements specified in its mortgage indenture and corporate charter to issue new first mortgage bonds and preferred stock. The Company's coverage ratios are sufficiently high enough to permit, at present interest levels, any foreseeable security sales. The amount of securities which the Company will be permitted to issue in the future will depend upon market conditions and other factors prevailing at that time. II-230 STATEMENTS OF INCOME For the Years Ended December 31, 1993, 1992, and 1991 Savannah Electric and Power Company 1993 Annual Report The accompanying notes are an integral part of these statements. II-231 STATEMENTS OF CASH FLOWS For the Years Ended December 31, 1993, 1992, and 1991 Savannah Electric and Power Company 1993 Annual Report ( ) Denotes use of cash. The accompanying notes are an integral part of these statements. II-232 BALANCE SHEETS At December 31, 1993 and 1992 Savannah Electric and Power Company 1993 Annual Report The accompanying notes are an integral part of these statements. II-233 BALANCE SHEETS At December 31, 1993 and 1992 Savannah Electric and Power Company 1993 Annual Report The accompanying notes are an integral part of these statements. II-234 STATEMENTS OF CAPITALIZATION At December 31, 1993 and 1992 Savannah Electric and Power Company 1993 Annual Report The accompanying notes are an integral part of these statements. II-235 STATEMENTS OF RETAINED EARNINGS For the Years Ended December 31, 1993, 1992, and 1991 Savannah Electric and Power Company 1993 Annual Report The accompanying notes are an integral part of these statements. II-236 NOTES TO FINANCIAL STATEMENTS Savannah Electric and Power Company 1993 Annual Report 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES GENERAL Savannah Electric and Power Company is a wholly owned subsidiary of The Southern Company, which is the parent company of five operating companies, a system service company, Southern Electric International (Southern Electric), Southern Nuclear Operating Company (Southern Nuclear), and various other subsidiaries related to foreign utility operations and domestic non-utility operations. At this time, the operations of the other subsidiaries are not material. The operating companies (Alabama Power Company, Georgia Power Company, Gulf Power Company, Mississippi Power Company, and Savannah Electric and Power Company) provide electric service in four Southeastern states. Contracts among the companies -- dealing with jointly owned generating facilities, interconnecting transmission lines and the exchange of electric power -- are regulated by the Federal Energy Regulatory Commission (FERC) or the Securities and Exchange Commission (SEC). The system service company provides, at cost, specialized services to The Southern Company and to the subsidiary companies. Southern Electric designs, builds, owns and operates power production facilities and provides a broad range of technical services to industrial companies and utilities in the United States and a number of international markets. Southern Nuclear provides services to The Southern Company's nuclear power plants. The Southern Company is registered as a holding company under the Public Utility Holding Company Act of 1935 (PUHCA). Both The Southern Company and its subsidiaries are subject to the regulatory provisions of the PUHCA. The Company also is subject to regulation by the FERC and the Georgia Public Service Commission (GPSC). The Company follows generally accepted accounting principles and complies with the accounting policies and practices prescribed by the GPSC. Certain prior years' data presented in the financial statements have been reclassified to conform with current year presentation. REVENUES AND FUEL COSTS The Company accrues revenues for services rendered but unbilled at the end of each fiscal period. Fuel costs are expensed as the fuel is used. The Company's electric rates include provisions to adjust billings for fluctuations in capacity and the energy components of purchased power costs. Revenues include the actual cost of fuel and purchased power incurred. DEPRECIATION AND AMORTIZATION Depreciation of the original cost of depreciable utility plant in service is provided primarily by using composite straight-line rates, which approximated 2.9 percent in 1993 and 3.2 percent in 1992, and 1991. The decrease in 1993 reflects the Company's implementation of new depreciation rates approved by the GPSC. These new rates provide for a timely recovery of the investments in the Company's depreciable properties. When property subject to depreciation is retired or otherwise disposed of in the normal course of business, its cost -- together with the cost of removal, less salvage -- is charged to the accumulated provision for depreciation. Minor items of property included in the original cost of the plant are retired when the related property unit is retired. INCOME TAXES The Company, which is included in the consolidated federal income tax return filed by The Southern Company, provides deferred income taxes for all significant income tax temporary differences. Investment tax credits utilized are deferred and amortized to income over the average lives of the related property. In years prior to 1993, income taxes were accounted for and reported under Accounting Principles Board Opinion No. 11. Effective January 1, 1993, the Company adopted FASB Statement No. 109, Accounting for Income Taxes. Statement No. 109 required, among other things, conversion to the liability method of accounting for accumulated deferred income taxes. See Note 7 for additional information about Statement No. 109. II-237 NOTES (continued) Savannah Electric and Power Company 1993 Annual Report ALLOWANCE FOR FUNDS USED DURING CONSTRUCTION (AFUDC) AFUDC represents the estimated debt and equity costs of capital funds that are necessary to finance the construction of new facilities. While cash is not realized currently from such allowance, it increases the revenue requirement over the service life of the plant through a higher rate base and higher depreciation expense. The composite rates used by the Company to calculate AFUDC were 8.77 percent in 1993, 11.27 percent in 1992, and 11.38 percent in 1991. UTILITY PLANT Utility plant is stated at original cost, which includes materials, labor, minor items of property, appropriate administrative and general costs, payroll-related costs such as taxes, pensions and other benefits and the estimated cost of funds used during construction. The cost of maintenance, repairs, and replacement of minor items of property is charged to maintenance expense. The cost of replacements of property (exclusive of minor items of property) is charged to utility plant. CASH AND CASH EQUIVALENTS For purposes of the Statements of Cash Flows, temporary cash investments are considered cash equivalents. Temporary cash investments are securities with original maturities of 90 days or less. FINANCIAL INSTRUMENTS In accordance with FASB Statement No. 107, Disclosure About Fair Value of Financial Instruments, items for which the carrying amount does not approximate fair value must be disclosed. At December 31, 1993, the fair value of long-term debt was $164 million and the carrying amount was $154 million. The fair value of long-term debt was $117 million and the carrying amount was $109 million at December 31, 1992. The fair value for long-term debt was based on either closing market prices or closing prices of comparable instruments. MATERIALS AND SUPPLIES Generally, materials and supplies include the cost of transmission, distribution, and generating plant materials. Materials are charged to inventory when purchased and then expensed or capitalized to plant, as appropriate, when installed. 2. RETIREMENT BENEFITS PENSION PLANS The Company has a defined benefit, trusteed, non-contributory pension plan that covers substantially all regular employees. Benefits under this plan reflect the employee's years of service, age at retirement and average compensation for the three years immediately preceding retirement. The Company uses the projected unit credit actuarial method for funding purposes, subject to limitations under federal income tax regulations. Amounts funded to the pension fund are primarily invested in equity and debt securities. FASB Statement No. 87, Employers' Accounting for Pensions, requires use of the "projected unit credit" actuarial method for financial reporting purposes. POSTRETIREMENT BENEFITS The Company also provides certain medical care and life insurance benefits for retired employees. Substantially all employees may become eligible for these benefits when they retire. A qualified trust for medical benefits has been established for funding amounts to the extent deductible under federal income tax regulations. Accrued costs of life insurance benefits, other than current cash payments for retirees, currently are not being funded. Effective January 1, 1993, the Company adopted FASB Statement No. 106, Employers' Accounting for Postretirement Benefits Other Than Pensions, on a prospective basis. Statement No. 106 requires that medical care and life insurance benefits for retired employees be accounted for on an accrual basis using a specified actuarial method, "benefit/years-of-service." II-238 NOTES (continued) Savannah Electric and Power Company 1993 Annual Report Consistent with regulatory treatment, the Company recognized these costs on a cash basis as payments were made in 1992 and 1991. The total costs of such benefits recognized by the Company amounted to $375 thousand in 1992 and $487 thousand in 1991. STATUS AND COST OF BENEFITS Shown in the following tables are actuarial results and assumptions for pension and postretirement medical and life insurance benefits as computed under the requirements of FASB Statements Nos. 87 and 106, respectively. Retiree medical and life insurance information is shown for 1993 only because Statement No. 106 was adopted as of January 1, 1993, on a prospective basis. The funded status of the plans at December 31 was as follows: The weighted average rates assumed in the actuarial calculations were: In accordance with Statement No. 87, an additional liability related to under-funded accumulated benefit obligations was recognized at December 31, 1993. A corresponding net-of-tax charge of $2.1 million was recognized as a separate component of Common Stock Equity in the Statements of Capitalization. The assumption used in measuring the accumulated postretirement medical benefit obligation was a weighted average medical care cost trend rate of 11.3 percent for 1993, decreasing gradually to 6.0 percent through the year 2000 and remaining at that level thereafter. An annual increase in the assumed medical care cost trend rate by 1.0 percent would increase the accumulated medical benefit obligation as of December 31, 1993, by $1.7 million and the aggregate of the service and interest cost components of the net retiree medical cost by $0.2 million. II-239 NOTES (continued) Savannah Electric and Power Company 1993 Annual Report Components of the plans' net costs are shown below: Of the above net pension amounts, $2.0 million in 1993, $1.7 million in 1992 and $1.5 million in 1991 were recorded in operating expenses, and the remainder was recorded in construction and other accounts. Net postretirement medical and life insurance costs of $1.8 million in 1993 were charged to operating expenses. The Company has a supplemental retirement plan for certain executive employees. The plan is unfunded and payable from the general funds of the Company. The Company has purchased life insurance on participating executives, and plans to use these policies to satisfy this obligation. Benefit costs associated with this plan for 1993, 1992 and 1991 were $980 thousand, $316 thousand and $338 thousand, respectively. The 1993 benefit costs reflect a one-time expense related to employees who were part of the work force reduction program. WORK FORCE REDUCTION PROGRAM The Company has incurred additional costs for a one-time charge related to the implementation of a work force reduction program. In 1993, $4.5 million was charged to operating expenses and $0.6 million was charged to other income (expense). 3. REGULATORY MATTERS RATE MATTERS In May 1992, the Company filed for, and subsequently received, GPSC approval to implement new base rates designed to decrease base operating revenues by $2.8 million annually. The reduction included a base rate reduction of approximately $2.5 million spread among all classes of customers, effective June 1992. An additional $0.3 million reduction resulted from the implementation of an experimental, time-of-use rate for certain commercial customers in August 1992. 4. CONSTRUCTION PROGRAM The Company is engaged in a continuous construction program, currently estimated to total $33 million in 1994, $32 million in 1995 and $33 million in 1996. The estimates include AFUDC of $1.6 million in 1994, $0.6 million in 1995 and $0.7 million in 1996. The construction program is subject to periodic review and revision, and actual construction costs may vary from the above estimates because of numerous factors. These factors include: changes in business conditions; revised load growth estimates; changes in environmental regulations; increasing cost of labor, equipment and materials; and cost of capital. The construction of two combustion turbine peaking units totaling 160 megawatts is planned to be completed in mid 1994. The Company is also constructing six combustion turbine peaking units owned by Georgia Power Company. The construction is to be completed in 1996. See Management's Discussion and Analysis under "Environmental Matters" for information on the impact of the Clean Air Act Amendments of 1990 and other environmental matters. II-240 NOTES (continued) Savannah Electric and Power Company 1993 Annual Report 5. FINANCING AND COMMITMENTS GENERAL To the extent possible, the Company's construction program is expected to be financed from internal sources and from the issuance of additional long-term debt and preferred stock and capital contributions from The Southern Company. Should the Company be unable to obtain funds from these sources, the Company would have to use short-term indebtedness or other alternative, and possibly costlier, means of financing. The amounts of long-term debt and preferred stock that can be issued in the future will be contingent on market conditions, the maintenance of adequate earnings levels, regulatory authorizations and other factors. See Management's Discussion and Analysis for information regarding the Company's earnings coverage requirements. BANK CREDIT ARRANGEMENTS At the beginning of 1994, unused credit arrangements with four banks totaled $14.5 million, and expire at various times during 1994. The Company has $20 million of revolving credit arrangements expiring December 31, 1995. These agreements allow short-term borrowings to be converted into term loans, payable in 12 equal quarterly installments, with the first installment due at the end of the first calendar quarter after the applicable termination date or at an earlier date at the Company's option. In connection with these credit arrangements, the Company agrees to pay commitments fees based on the unused portions of the commitments. In connection with all other lines of credit, the Company has the option of paying fees or maintaining compensating balances, which are substantially all the cash of the Company except for daily working funds and similar items. These balances are not legally restricted from withdrawal. ASSETS SUBJECT TO LIEN As amended and supplemented, the Company's Indenture of Mortgage, which secures the first mortgage bonds issued by the Company, constitutes a direct first lien on substantially all of the Company's fixed property and franchises. OPERATING LEASES The Company has rental agreements with various terms and expiration dates. Rental expenses totaled $1.5 million, $1.5 million, and $1.4 million for 1993, 1992, and 1991, respectively. At December 31, 1993, estimated future minimum lease payments for non-cancelable operating leases were as follows: 6. LONG-TERM POWER SALES AGREEMENTS The operating subsidiaries of The Southern Company, including the Company, have entered into long-term contractual agreements for the sale of capacity and energy to certain non-affiliated utilities located outside the system's service area. Certain of these agreements are non-firm and are based on capacity of the system in general. Other agreements are firm and pertain to the capacity related to specific generating units. Because the energy is generally sold at cost under these agreements, revenues from capacity sales primarily affect profitability. The Company's portion of capacity revenues has been as follows: Long-term non-firm power of 400 megawatts was sold by the Southern electric system in 1993 to Florida Power Corporation (FPC). In January 1994, this amount decreased to 200 megawatts, and the contract will expire at year-end. II-241 NOTES (continued) Savannah Electric and Power Company 1993 Annual Report 7. INCOME TAXES Effective January 1, 1993, the Company adopted FASB Statement No. 109, Accounting for Income Taxes. The adoption of Statement No. 109 resulted in cumulative adjustments that had no material effect on net income. The adoption also resulted in the recording of additional deferred income taxes and related assets and liabilities. The related assets of $25 million are revenues to be received from customers. These assets are attributable to tax benefits flowed through to customers in prior years and to taxes applicable to capitalized AFUDC. The related liabilities of $26 million are revenues to be refunded to customers. These liabilities are attributable to deferred taxes previously recognized at rates higher than current enacted tax law and unamortized investment tax credits. Additionally, deferred income taxes related to accelerated tax depreciation previously shown as a reduction to utility plant were reclassified. Details of the federal and state income tax provisions are as follows: The tax effects of temporary differences between the carrying amounts of assets and liabilities in the financial statements and their respective tax bases, which give rise to deferred tax assets and liabilities are as follows: Deferred investment tax credits are amortized over the life of the related property with such amortization normally applied as a credit to reduce depreciation in the Statements of Income. Credits amortized in this manner amounted to $0.7 million in 1993, 1992 and 1991. At December 31, 1993, all investment tax credits available to reduce federal income taxes payable had been utilized. A reconciliation of the effective income tax rate to the statutory tax rate is as follows: The Southern Company and its subsidiaries file a consolidated federal income tax return. Under a joint consolidated income tax agreement, each company's current and deferred tax expense is computed on a stand-alone basis, and consolidated tax savings are allocated to each company based on its ratio of taxable income to total consolidated taxable income. II-242 NOTES (continued) Savannah Electric and Power Company 1993 Annual Report 8. CUMULATIVE PREFERRED STOCK In November 1993, the Company issued 1,400,000 shares of 6.64 percent Series Preferred stock which has redemption provisions of $26.66 per share plus accrued dividends if on or prior to November 1, 1998, and at $25 per share plus accrued dividends thereafter. In December 1993, the Company redeemed all 800,000 shares outstanding of its 9.5 percent Series Preferred stock at the prescribed redemption price of $26.57 plus accrued dividends. Cumulative preferred stock dividends are preferential to the payment of dividends on common stock. 9. LONG-TERM DEBT The Company's Indenture related to its First Mortgage Bonds is unlimited as to the authorized amount of bonds which may be issued, provided that required property additions, earnings and other provisions of such Indenture are met. On February 19, 1993, the Company refunded its $4.1 million, 6.25 percent Series Pollution Control Bonds, due 1998 with $4.1 million of variable rate Series Pollution Control Bonds due 2016. In 1994, there is a first mortgage bond maturity of $3.7 million. The sinking fund requirements of first mortgage bonds are being satisfied by certification of property additions. See Note 10 "Long-Term Debt Due Within One Year" for details. Details of other long-term debt are as follows: Sinking fund requirements and /or maturities through 1998 applicable to long-term debt are as follows: $4.5 million in 1994; $0.7 million in 1995; $0.7 million in 1996; $0.1 million in 1997 and no requirement is needed for 1998. Assets acquired under capital leases are recorded as utility plant in service and the related obligation is classified as other long-term debt. Leases are capitalized at the net present value of the future lease payments. However, for ratemaking purposes, these obligations are treated as operating leases, and as such, lease payments are charged to expense as incurred. The Company leases combustion turbine generating equipment under a non-cancelable lease expiring in 1995, with renewal options extending until 2010. The Company also leases a portion of its transportation fleet. Under the terms of these leases, the Company is responsible for taxes, insurance and other expenses. II-243 NOTES (continued) Savannah Electric and Power Company 1993 Annual Report 10. LONG-TERM DEBT DUE WITHIN ONE YEAR A summary of the improvement fund/sinking fund requirements and scheduled maturities and redemptions of long-term debt due within one year is as follows: The first mortgage bond improvement (sinking) fund requirements amount to 1 percent of each outstanding series of bonds authenticated under the indentures prior to January 1 of each year, other than those issued to collateralize pollution control and other obligations. The requirements may be satisfied by depositing cash or reacquiring bonds, or by pledging additional property equal to 1 2/3 times the requirements. 11. COMMON STOCK DIVIDEND RESTRICTIONS The Company's Charter and Indentures contain certain limitations on the payment of cash dividends on the preferred and common stocks. At December 31, 1993, approximately $55 million of retained earnings was restricted against the payment of cash dividends on common stock under the terms of the Mortgage Indenture. 12. QUARTERLY FINANCIAL INFORMATION (UNAUDITED) Summarized quarterly financial data for 1993 and 1992 are as follows (in thousands): The Company's business is influenced by seasonal weather conditions, a seasonal rate structure and the timing of rate changes, among other factors. II-244 SELECTED FINANCIAL AND OPERATING DATA Savannah Electric and Power Company 1993 Annual Report Note: NR = Not Rated II-245 SELECTED FINANCIAL AND OPERATING DATA Savannah Electric and Power Company 1993 Annual Report II-246 SELECTED FINANCIAL AND OPERATING DATA (continued) Savannah Electric and Power Company 1993 Annual Report II-247 SELECTED FINANCIAL AND OPERATING DATA (continued) Savannah Electric and Power Company 1993 Annual Report II-248 STATEMENTS OF INCOME Savannah Electric and Power Company * Tax-free common stock/bond exchange II-249 STATEMENTS OF INCOME Savannah Electric and Power Company II-250 STATEMENTS OF CASH FLOWS Savannah Electric and Power Company II-251 STATEMENTS OF CASH FLOWS Savannah Electric and Power Company II-252 BALANCE SHEETS Savannah Electric and Power Company II-253 BALANCE SHEETS Savannah Electric and Power Company II-254 BALANCE SHEETS Savannah Electric and Power Company II-255 BALANCE SHEETS Savannah Electric and Power Company II-256 SAVANNAH ELECTRIC AND POWER COMPANY OUTSTANDING SECURITIES AT DECEMBER 31, 1993 FIRST MORTGAGE BONDS II-257 SAVANNAH ELECTRIC AND POWER COMPANY SECURITIES RETIRED DURING 1993 POLLUTION CONTROL BONDS II-258 PART III Items 10, 11, 12 and 13 for SOUTHERN are incorporated by reference to ELECTION OF DIRECTORS in SOUTHERN's definitive Proxy Statement relating to the 1994 annual meeting of stockholders. Item 10.

Item 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANTS ALABAMA (a) (1) Identification of directors of ALABAMA. ELMER B. HARRIS (1) President and Chief Executive Officer of ALABAMA Age 54 Served as Director since 3-1-89. BILL M. GUTHRIE Executive Vice President of ALABAMA Age 60 Served as Director since 12-16-88 EDWARD L. ADDISON (2) Age 63 Served as Director since 11-1-83 WHIT ARMSTRONG (2) Age 46 Served as Director since 9-24-82 PHILIP E. AUSTIN (2) Age 52 Served as Director since 1-25-91 MARGARET A. CARPENTER (2) Age 69 Served as Director since 2-26-93 PETER V. GREGERSON, SR. (2) Age 65 Served as Director since 10-22-93 CRAWFORD T. JOHNSON, III (2) Age 68 Served as Director since 4-18-69 CARL E. JONES, JR. (2) Age 53 Served as Director since 4-22-88 WALLACE D. MALONE, JR. (2) Age 57 Served as Director since 6-22-90 WILLIAM V. MUSE (2) Age 54 Served as Director since 2-26-93 JOHN T. PORTER (2) Age 62 Served as Director since 10-22-93 GERALD H. POWELL (2) Age 67 Served as Director since 2-28-86 ROBERT D. POWERS (2) Age 43 Served as Director since 1-24-92 JOHN W. ROUSE (2) Age 56 Served as Director since 4-22-88 WILLIAM J. RUSHTON, III (2) Age 64 Served as Director Since 9-18-70 JAMES H. SANFORD (2) Age 49 Served as Director since 8-1-83 JOHN C. WEBB, IV (2) Age 51 Served as Director since 4-22-77 LOUIS J. WILLIE (2) Age 70 Served as Director since 3-23-84 JOHN W. WOODS (2) Age 62 Served as Director since 4-20-73 (1) Previously served as Director of ALABAMA from 1980 to 1985. (2) No position other than Director. Each of the above is currently a director of ALABAMA, serving a term running from the last annual meeting of ALABAMA's stockholder (April 23, 1993) for III-1 meeting of ALABAMA's stockholder (April 23, 1993) for one year until the next annual meeting or until a successor is elected and qualified, except for the individuals elected in October 1993. There are no arrangements or understandings between any of the individuals listed above and any other person pursuant to which he was or is to be selected as a director or nominee, other than any arrangements or understandings with directors or officers of ALABAMA acting solely in their capacities as such. (b)(1) Identification of executive officers of ALABAMA. ELMER B. HARRIS (1) President, Chief Executive Officer and Director Age 54 Served as Executive Officer since 3-1-89 BANKS H. FARRIS Senior Vice President Age 59 Served as Executive Officer since 12-3-91 WILLIAM B. HUTCHINS, III Senior Vice President and Chief Financial Officer Age 50 Served as Executive Officer since 12-3-91 T. HAROLD JONES Senior Vice President Age 63 Served as Executive Officer since 12-1-91 CHARLES D. MCCRARY Senior Vice President Age 42 Served as Executive Officer since 1-1-91 (1) Previously served as executive officer of ALABAMA from 1979 to 1985. Each of the above is currently an executive officer of ALABAMA, serving a term running from the last annual meeting of the directors (April 23, 1993) for one year until the next annual meeting or until his successor is elected and qualified. There are no arrangements or understandings between any of the individuals listed above and any other person pursuant to which he was or is to be selected as an officer, other than any arrangements or understandings with officers of ALABAMA acting solely in their capacities as such. (c)(1) Identification of certain significant employees. None. (d)(1) Family relationships. None. (e)(1) Business experience. ELMER B. HARRIS - Elected in 1989; Chief Executive Officer. He previously served as Senior Executive Vice President of GEORGIA from 1986 to 1989. Director of SOUTHERN and AmSouth Bancorporation. BILL M. GUTHRIE - Elected in 1988; also served since 1991 as Chief Production Officer of SOUTHERN system and Executive Vice President and Chief Production Officer of SCS; Vice President of SOUTHERN, GULF, MISSISSIPPI and SAVANNAH and Executive Vice President of GEORGIA. Responsible primarily for providing overall management of materials management, fuel services, operating and planning services, fossil, hydro and bulk power operations of the Southern electric system. EDWARD L. ADDISON - Elected in 1983; President of SOUTHERN from 1983 until elected Chairman of the Board in 1994. Director of SOUTHERN, GEORGIA, Phelps Dodge Corporation, Protective Life Corporation, Wachovia Bank of Georgia, N.A., Wachovia Corporation of Georgia and CSX Corporation. WHIT ARMSTRONG - President, Chairman and Chief Executive Officer of The Citizens Bank, Enterprise, Alabama. Also, President and Chairman of the Board of Enterprise Capital Corporation, Inc. PHILIP E. AUSTIN - Chancellor, The University of Alabama System. Previously President and Chancellor of Colorado State University. MARGARET A. CARPENTER - President, Compos-it, Inc. (typographics), Montgomery, Alabama. PETER V. GREGERSON, SR. - Chairman Emeritus of Gregerson's Foods, Inc. (retail groceries), Gadsden, Alabama. Director of AmSouth Bank of Gadsden, Alabama. III-2 CRAWFORD T. JOHNSON, III - Chairman of Coca-Cola Bottling Company United, Inc., Birmingham, Alabama. Director of Protective Life Corporation, AmSouth Bancorporation and Russell Corporation. CARL E. JONES, JR. - Chairman and Chief Executive Officer of First Alabama Bank, Mobile, Alabama. WALLACE D. MALONE, JR. - Chairman and Chief Executive Officer of SouthTrust Corporation, bank holding company, Birmingham, Alabama. WILLIAM V. MUSE - President and Chief Executive Officer of Auburn University. He previously served as President of the University of Akron from 1984 to 1992. JOHN T. PORTER - Pastor of Sixth Avenue Baptist Church, Birmingham, Alabama. Director of Citizen Federal Bank. GERALD H. POWELL - President, Dixie Clay Company of Alabama, Inc. (refractory clay producer), Jacksonville, Alabama. ROBERT D. POWERS - President, The Eufaula Agency, Inc. (real estate and insurance), Eufaula, Alabama. JOHN W. ROUSE - President and Chief Executive Officer of Southern Research Institute (non-profit research institute), Birmingham, Alabama. Director of Protective Life Corporation. WILLIAM J. RUSHTON, III - Chairman of the Board, Protective Life Corporation (insurance holding company), Birmingham, Alabama. Director of SOUTHERN and AmSouth Bancorporation. JAMES H. SANFORD - President, HOME Place Farms Inc. (diversified farmers and ginners), Prattville, Alabama. JOHN C. WEBB, IV - President, Webb Lumber Company, Inc. (wholesale lumber), Demopolis, Alabama. LOUIS J. WILLIE - Chairman of the Board and President of Booker T. Washington Insurance Co. Director of SOUTHERN. JOHN W. WOODS - Chairman and Chief Executive Officer, AmSouth Bancorporation (multi-bank holding company), Birmingham, Alabama. Director of Protective Life Corporation. BANKS H. FARRIS - Elected in 1991; responsible primarily for providing the overall management of the Human Resources, Information Resources, Power Delivery and Marketing Departments and the six geographic divisions. He previously served as Vice President - Human Resources from 1989 to 1991 and Division Vice President from 1985 to 1989. WILLIAM B. HUTCHINS, III - Elected in 1991; Chief Financial Officer, responsible primarily for providing the overall management of accounting and financial planning activities. He previously served as Vice President and Treasurer from 1983 to 1991. T. HAROLD JONES - Elected in 1991; responsible primarily for providing the overall management of the Fossil Generation, Hydro Generation, Power Generation Services and Fuels Departments. He previously served as Vice President - Fossil Generation from 1986 to 1991. CHARLES D. MCCRARY - Elected in 1991; responsible for the External Relations Department, Operating Services and Corporate Services. Also, assumes responsibility for financial matters while Mr. Hutchins is on medical leave. He previously served as Vice President of Administrative Services - Nuclear of SCS from 1988 to 1991. (f)(1) Involvement in certain legal proceedings. None. III-3 GEORGIA (a)(2) Identification of directors of GEORGIA. H. ALLEN FRANKLIN President and Chief Executive Officer. Age 49 Served as Director since 1-1-94. WARREN Y. JOBE Executive Vice President, Treasurer and Chief Financial Officer. Age 53 Served as Director since 8-1-82 EDWARD L. ADDISON (1) Age 63 Served as Director since 11-1-83 BENNETT A. BROWN (1) Age 64 Served as Director since 5-15-80 WILLIAM P. COPENHAVER (1) Age 69 Served as Director since 6-18-86 A. W. DAHLBERG (1) Age 53 Served as Director since 6-1-88 WILLIAM A. FICKLING, JR. (1) Age 61 Served as Director since 4-18-73 L. G. HARDMAN, III (1) Age 54 Served as Director since 6-25-79 JAMES R. LIENTZ, JR. (1) Age 50 Served as Director since 7-1-93 WILLIAM A. PARKER, JR. (1) Age 66 Served as Director since 5-19-65 G. JOSEPH PRENDERGAST (1) Age 48 Served as Director since 1-20-93 HERMAN J. RUSSELL (1) AGE 63 Served as Director since 5-18-88 GLORIA M. SHATTO (1) Age 62 Served as Director since 2-20-80 ROBERT STRICKLAND (1) Age 66 Served as Director since 11-21-79 WILLIAM JERRY VEREEN (1) Age 53 Served as Director since 5-18-88 THOMAS R. WILLIAMS (1) Age 65 Served as Director since 3-17-82 (1) No position other than Director. Each of the above is currently a director of GEORGIA, serving a term running from the last annual meeting of GEORGIA's stockholder (May 19, 1993) for one year until the next annual meeting or until a successor is elected and qualified, except Messrs. Franklin and Lientz. There are no arrangements or understandings between any of the individuals listed above and any other person pursuant to which he/she was or is to be selected as a director or nominee, other than any arrangements or understandings with directors or officers of GEORGIA acting solely in their capacities as such. (b)(2) Identification of executive officers of GEORGIA. H. ALLEN FRANKLIN President, Chief Executive Officer and Director Age 49 Served as Executive Officer since 1-1-94 WARREN Y. JOBE Executive Vice President, Treasurer, Chief Financial Officer and Director Age 53 Served as Executive Officer since 5-19-82 III-4 DWIGHT H. EVANS Executive Vice President - External Affairs Age 45 Served as Executive Officer since 4-19-89 GENE R. HODGES Executive Vice President - Customer Operations Age 55 Served as Executive Officer since 11-19-86 KERRY E. ADAMS Senior Vice President - Fossil and Hydro Power Age 49 Served as Executive Officer since 5-1-89 WAYNE T. DAHLKE Senior Vice President - Power Delivery Age 53 Served as Executive Officer since 4-19-89 JAMES K. DAVIS Senior Vice President - Corporate Relations Age 53 Served as Executive Officer since 10-1-93 ROBERT H. HAUBEIN Senior Vice President - Administrative Services Age 54 Served as Executive Officer since 2-19-92 GALE E. KLAPPA Senior Vice President - Marketing Age 43 Served as Executive Officer since 2-19-92 FRED D. WILLIAMS Senior Vice President - Bulk Power Markets Age 49 Served as Executive Officer since 11-18-92 Each of the above is currently an executive officer of GEORGIA, serving a term running from the last annual meeting of the directors (May 19,1993) for one year until the next annual meeting or until his successor is elected and qualified, except Messrs. Franklin and Davis. There are no arrangements or understandings between any of the individuals listed above and any other person pursuant to which he was or is to be selected as an officer, other than any arrangements or understandings with officers of GEORGIA acting solely in their capacities as such. (c)(2) Identification of certain significant employees. None. (d)(2) Family relationships. None. (e)(2) Business experience. H. ALLEN FRANKLIN - President and Chief Executive Officer since January 1994. He previously served as President and Chief Executive Officer of SCS from 1988 through 1993. Director of SOUTHERN and SouthTrust Bank. WARREN Y. JOBE - Executive Vice President and Chief Financial Officer since 1982 and Treasurer since 1992. Responsible for financial and accounting operations and planning, internal auditing, procurement, corporate secretary and treasury operations. EDWARD L. ADDISON - President of SOUTHERN from 1983 until his election as Chairman of Board in 1994. Director of SOUTHERN, ALABAMA, Wachovia Bank of Georgia, N.A., Wachovia Corporation of Georgia, Phelps Dodge Corporation, Protective Life Corporation and CSX Corporation. BENNETT A. BROWN - Retired from serving as Chairman of the Board of NationsBank on December 31, 1992. Previously Chairman of the Board and Chief Executive Officer of C&S/Sovran Corporation. Director of Confederation Life Insurance Company. WILLIAM P. COPENHAVER - Director, Arcadian Fertilizer, L.P. (agricultural and industrial chemicals). Director of SOUTHERN and Georgia Bank & Trust Company. A. W. DAHLBERG - President of SOUTHERN effective in 1994. He previously served as President and Chief Executive Officer of GEORGIA from 1988 through 1993. Director of SOUTHERN, Trust Company Bank, Trust Company of Georgia, Protective Life Corporation and Equifax, Inc. WILLIAM A. FICKLING, JR. - Chairman of the Board, Mulberry Street Investment Company, Macon, Georgia, and Co-chairman of Beech Street Corporation (insurance). III-5 L. G. HARDMAN, III - Chairman of the Board of First National Bank of Commerce, Georgia and Chairman of the Board and Chief Executive Officer of First Commerce Bancorp. Chairman of the Board, President and Treasurer of Harmony Grove Mills, Inc. (real estate investments). Director of SOUTHERN. JAMES R. LIENTZ, JR. - President of NationsBank of Georgia since 1993. He previously served as President and Chief Executive Officer of former Citizens & Southern Bank of South Carolina (now NationsBank) from 1990 to 1993, and from 1987 to 1990, he was head of Corporate Bank Group of NationsBank of Georgia, N.A. WILLIAM A. PARKER, JR. - Chairman of the Board, Cherokee Investment Company, Inc. (private investments), Atlanta, Georgia. Director of SOUTHERN, Genuine Parts Company, Life Insurance Company of Georgia, First Union Real Estate Investment Trust, Atlantic Realty Company, ING North America Insurance Company, Post Properties, Inc. and Haverty Furniture Companies, Inc. G. JOSEPH PRENDERGAST - President and Chief Executive Officer, Wachovia Corporation of Georgia and Wachovia Bank of Georgia, N.A. since 1993. From 1988 to 1993, he served as Executive Vice President of Wachovia Corporation and President of Wachovia Corporate Services, Inc. HERMAN J. RUSSELL - Chairman of the Board and Chief Executive Officer, H. J. Russell & Company (construction), Atlanta, Georgia. Chairman of the Board, Citizens Trust Bank, and Citizens Bancshares Corporation Atlanta, Georgia. Director of Wachovia Corporation. GLORIA M. SHATTO - President, Berry College, Mount Berry, Georgia. Director of SOUTHERN, Becton Dickinson & Company, Kmart Corporation and Texas Instruments, Inc. ROBERT STRICKLAND - Retired Chairman of the Board and Chief Executive Officer of SunTrust Banks, Inc. Director of Georgia US Corporation, Equifax, Inc., Life Insurance Company of Georgia, Oxford Industries, Inc. and The Investment Centre. WILLIAM JERRY VEREEN - President and Chief Executive Officer of Riverside Manufacturing Company (manufacture and sale of uniforms), Moultrie, Georgia. Director of Gerber Garment Technology, Inc. and Textile Clothing Technology Corp. THOMAS R. WILLIAMS - President of The Wales Group, Inc. (investments) Atlanta, Georgia. Director of ConAgra, Inc., BellSouth Corporation, National Life Insurance Company of Vermont, AppleSouth, Inc., and American Software, Inc. DWIGHT H. EVANS - Executive Vice President - External Affairs since 1989. Senior Vice President - Public Affairs from 1988 to 1989. GENE R. HODGES - Executive Vice President - Customer Operations since 1992. Senior Vice President - Region/Land Operations from 1990 to 1992. Senior Vice President - Division Operations from 1986 to 1990. KERRY E. ADAMS - Senior Vice President - Fossil and Hydro Power since 1989. WAYNE T. DAHLKE - Senior Vice President - Power Delivery since February 1992. Senior Vice President - Marketing from 1989 to 1992. JAMES K. DAVIS - Senior Vice President - Corporate Relations since October 1993. Vice President of Corporate Relations from 1988 to 1993. ROBERT H. HAUBEIN - Senior Vice President - Administrative Services since 1992. Vice President - Northern Region from 1990 to 1992. Division Vice President of ALABAMA from 1985 to 1990. GALE E. KLAPPA - Senior Vice President - Marketing since 1992. Vice President - - Public Relations of SCS from 1981 to 1992. FRED D. WILLIAMS - Senior Vice President - Bulk Markets since 1992. Vice President - Bulk Power Markets from 1984 to 1992. (f)(2) Involvement in certain legal proceedings. None. III-6 GULF (a)(3) Identification of directors of GULF. D. L. MCCRARY (1) Chairman of the Board and Chief Executive Officer Age 64 Served as Director since 4-28-83 TRAVIS J. BOWDEN President Age 55 Served as Director since 2-1-94 PAUL J. DENICOLA (2) Age 45 Served as Director since 4-19-91 REED BELL, SR., M.D. (2) Age 67 Served as Director since 1-17-86 FRED C. DONOVAN, SR. (2) Age 53 Served as Director since 1-18-91 W. D. HULL, JR. (2) Age 61 Served as Director since 10-14-83 C. W. RUCKEL (2) Age 66 Served as Director since 4-20-62 J. K. TANNEHILL (2) Age 60 Served as Director since 7-19-85 (1) Retires May 1, 1994. (2) No position other than Director. Each of the above is currently a director of GULF, serving a term running from the last annual meeting of GULF's stockholder (June 29, 1993) for one year until the next annual meeting or until a successor is elected and qualified, except for Mr. Bowden. There are no arrangements or understandings between any of the individuals listed above and any other person pursuant to which he was or is to be selected as a director or nominee, other than any arrangements or understandings with directors or officers of GULF acting solely in their capacities as such. (b)(3) Identification of executive officers of GULF. D. L. MCCRARY Chairman of the Board and Chief Executive Officer Age 64 Served as Executive Officer since 5-1-83 TRAVIS J. BOWDEN President Age 55 Served as Executive Officer since 2-1-94 F. M. FISHER, JR. Vice President - Employee and External Relations Age 45 Served as Executive Officer since 5-19-89 JOHN E. HODGES, JR. Vice President - Customer Operations Age 50 Served as Executive Officer since 5-19-89 G. EDISON HOLLAND, JR. Vice President and Corporate Counsel Age 41 Served as Executive Officer since 4-25-92 EARL B. PARSONS, JR. Vice President - Power Generation and Transmission Age 55 Served as Executive Officer since 4-14-78 A. E. SCARBROUGH Vice President - Finance Age 57 Served as Executive Officer since 9-21-77 Each of the above is currently an executive officer of GULF, serving a term running from the last annual meeting of the directors (July 23, 1993) for one year until the next annual meeting or until his successor is elected and qualified, except for Mr. Bowden. III-7 There are no arrangements or understandings between any of the individuals listed above and any other person pursuant to which he was or is to be selected as an officer, other than any arrangements or understandings with officers of GULF acting solely in their capacities as such. (c)(3) Identification of certain significant employees. None. (d)(3) Family relationships. None. (e)(3) Business experience. D. L. MCCRARY - Elected Chairman of the Board effective February 1994. He previously served as President and Chief Executive Officer from 1983 to 1994; responsible primarily for formation of overall corporate policy. TRAVIS J. BOWDEN - Elected President effective February 1994 and, upon Mr. McCrary's retirement May 1994, Chief Executive Officer. He previously served as Executive Vice President of ALABAMA from 1985 to 1994. PAUL J. DENICOLA - President and Chief Executive Officer of SCS effective January 1994. He previously served as Executive Vice President of SCS from 1991 through 1993 and President and Chief Executive Officer of MISSISSIPPI from 1989 to 1991. Director of SOUTHERN, MISSISSIPPI and SAVANNAH. REED BELL, SR., M.D. - Medical Doctor and since 1989, employee of the State of Florida. He serves as Medical Director of Children's Medical Services, District 1. He previously served as Medical Director of the Escambia County Public Health Unit until July 1992. He also previously maintained a private medical practice and served as Medical Director of Children's Medical Services from 1988 to 1989. FRED C. DONOVAN, SR. - President of Baskerville - Donovan, Inc., Pensacola, Florida, an architectural and engineering firm. Director of Baptist Health Care, Inc. W. D. HULL, JR. - Vice Chairman of the Sun Bank/West Florida, Panama City, Florida. He previously served as President and Chief Executive Officer and Director of the Sun Commercial Bank, Panama City, Florida from 1987 to 1992. C. W. RUCKEL - Chairman of the Board of The Vanguard Bank and Trust Company, Valparaiso, Florida. President and owner of Ruckel Properties, Inc., Valparaiso, Florida. J. K. TANNEHILL - President and Chief Executive Officer of Tannehill International Industries, Lynn Haven, Florida. He previously served as President and Chief Executive Officer of Stock Equipment Company, Chagrin Falls, Ohio, until 1991. Director of Sun Bank/West Florida, Panama City, Florida. F. M. FISHER, JR. - Elected Vice President - Employee and External Relations in 1989. He previously served as General Manager of Central Division from 1988 to 1989. JOHN E. HODGES, JR. - Elected Vice President - Customer Operations in 1989. He previously served as General Manager of Western Division from 1986 to 1989. G. EDISON HOLLAND, JR. - Elected Vice President and Corporate Counsel in 1992; responsible for all legal matters associated with GULF and serves as compliance officer. Also served, since 1982, as a partner in the law firm, Beggs & Lane. EARL B. PARSONS, JR. - Elected Vice President - Power Generation and Transmission in 1989; responsible for generation and transmission of electrical energy. He previously served as Vice President - Electric Operations from 1978 to 1989. A. E. SCARBROUGH - Elected Vice President - Finance in 1980; responsible for all accounting and financial services of GULF. (f)(3) Involvement in certain legal proceedings. None. III-8 MISSISSIPPI (a)(4) Identification of directors of MISSISSIPPI. DAVID M. RATCLIFFE President and Chief Executive Officer Age 45 Served as Director since 4-24-91 PAUL J. DENICOLA (1) Age 45 Served as Director since 5-1-89 EDWIN E. DOWNER (1) Age 62 Served as Director since 4-24-84 ROBERT S. GADDIS (1) Age 62 Served as Director since 1-21-86 WALTER H. HURT, III (1) Age 58 Served as Director since 4-6-82 AUBREY K. LUCAS (1) Age 59 Served as Director since 4-24-84 EARL D. MCLEAN, JR. (1) Age 68 Served as Director since 10-21-78 GERALD J. ST. Pe (1) Age 54 Served as Director since 1-21-86 LEO W. SEAL, JR. (1) Age 69 Served as Director since 4-4-67 N. EUGENE WARR (1) Age 58 Served as Director since 1-21-86 (1) No position other than Director. Each of the above is currently a director of MISSISSIPPI, serving a term running from the last annual meeting of MISSISSIPPI's stockholder (April 6, 1993) for one year until the next annual meeting or until a successor is elected and qualified. There are no arrangements or understandings between any of the individuals listed above and any other person pursuant to which he or she was or is to be selected as a director or nominee, other than any arrangements or understandings with directors or officers of MISSISSIPPI acting solely in their capacities as such. (b)(4) Identification of executive officers of MISSISSIPPI. DAVID M. RATCLIFFE President, Chief Executive Officer and Director Age 45 Served as Executive Officer since 4-24-91 H. E. BLAKESLEE Vice President - Customer Services and Marketing Age 53 Served as Executive Officer since 1-25-84 THOMAS A. FANNING Vice President and Chief Financial Officer Age 37 Served as Executive Officer since 4-1-92 DON E. MASON Vice President - External Affairs and Corporate Services Age 52 Served as Executive Officer since 7-27-83 Each of the above is currently an executive officer of MISSISSIPPI, serving a term running from the last annual meeting of the directors (April 28, 1993) for one year until the next annual meeting or until his successor is elected and qualified. There are no arrangements or understandings between any of the individuals listed above and any other person pursuant to which he was or is to be selected as an officer, other than any arrangements or understandings with officers of MISSISSIPPI acting solely in their capacities as such. (c)(4) Identification of certain significant employees. None. (d)(4) Family relationships. None. (e)(4) Business experience. III-9 DAVID M. RATCLIFFE - President and Chief Executive Officer since 1991. He previously served as Executive Vice President of SCS from 1989 to 1991 and Vice President of SCS from 1985 to 1989. PAUL J. DENICOLA - President and Chief Executive Officer of SCS effective 1994. Executive Vice President of SCS from 1991 through 1993. He previously served as President and Chief Executive Officer of MISSISSIPPI from 1989 to 1991. Director of SOUTHERN, SAVANNAH and GULF. EDWIN E. DOWNER - Business consultant specializing in economic analysis, management controls and procedural studies since 1990. President and Chief Executive Officer, Unifirst Bank for Savings, F.A., Midland Division, Meridian, Mississippi from 1985 to 1990. ROBERT S. GADDIS - President of the Trustmark National Bank - Laurel, Mississippi. WALTER H. HURT, III - President and Director of NPC Inc. (Investments). Vicar, All Saints Church, Inverness, Mississippi, and St. Thomas Church, Belzoni, Mississippi. Retired newspaper editor and publisher. AUBREY K. LUCAS - President of the University of Southern Mississippi, Hattiesburg, Mississippi. EARL D. MCLEAN, JR. - Co-owner of the T. C. Griffith Insurance Agency, Inc. (insurance and real estate), Columbia, Mississippi. Director of SOUTHERN. GERALD J. ST. Pe - President of Ingalls Shipbuilding and Corporate Vice President of Litton Industries, Inc. since 1985. Director of Merchants and Marine Bank, Pascagoula, Mississippi. LEO W. SEAL, JR. - Chairman of the Board and Chief Executive Officer of Hancock Bank, Gulfport, Mississippi, and Chairman of the Board of Harrison Life Insurance Company. Director of Hancock Bank and Bank of Wiggins. N. EUGENE WARR - Retailer (Biloxi and Gulfport, Mississippi.) Chairman of the Board of First Jefferson Corporation and the Jefferson Bank of Biloxi, Mississippi. H. E. BLAKESLEE - Elected Vice President in 1984. Primarily responsible for rate design, economic analysis and revenue forecasting, economic development, marketing and district operations. THOMAS A. FANNING - Elected Vice President in 1992; responsible primarily for accounting, treasury, finance, information resources and risk management. He previously served as Treasurer of SEI from 1986 to 1992 and Director of Corporate Finance of SCS from 1988 to 1992. DON E. MASON - Elected Vice President in 1983. Primarily responsible for the external affairs functions, including governmental and regulatory affairs, corporate communications, security, materials and general services, as well as the human resources function. (f)(4) Involvement in certain legal proceedings. None. SAVANNAH (a)(5) Identification of directors of SAVANNAH. ARTHUR M. GIGNILLIAT, JR. President and Chief Executive Officer Age 61 Served as Director since 8-31-82 HELEN QUATTLEBAUM ARTLEY (1) Age 66 Served as Director since 5-17-77 PAUL J. DENICOLA (1) Age 45 Served as Director since 3-14-91 BRIAN R. FOSTER (1) Age 44 Served as Director since 5-16-89 WALTER D. GNANN (1) Age 58 Served as Director since 5-17-83 JOHN M. MCINTOSH (1) Age 69 Served as Director since 2-27-68 III-10 ROBERT B. MILLER, III (1) Age 48 Served as Director since 5-17-83 JAMES M. PIETTE (1) Age 69 Served as Director since 6-12-73 ARNOLD M. TENEBAUM (1) Age 57 Served as Director since 5-17-77 FREDERICK F. WILLIAMS, JR. (1) Age 66 Served as Director since 7-2-75 (1) No Position other than Director. Each of the above is currently a director of SAVANNAH, serving a term running from the last annual meeting of SAVANNAH's stockholder (May 18, 1993) for one year until the next annual meeting or until a successor is elected and qualified. There are no arrangements or understandings between any of the individuals listed above and any other person pursuant to which he/she was or is to be selected as a director or nominee, other than any arrangements or understandings with directors or officers of SAVANNAH acting solely in their capacities as such. (b)(5) Identification of executive officers of SAVANNAH. ARTHUR M. GIGNILLIAT, JR. President, Chief Executive Officer and Director Age 61 Served as Executive Officer since 2-15-72 W. MILES GREER Vice President - Marketing and Customer Services Age 50 Served as Executive Officer since 11-20-85 LARRY M. PORTER Vice President - Operations Age 49 Served as Executive Officer since 7-1-91 KIRBY R. WILLIS Vice President, Treasurer and Chief Financial Officer Age 42 Served as Executive Officer since 1-1-94 Each of the above is currently an executive officer of SAVANNAH, serving a term running from the last annual meeting of the directors (May 18, 1993) for one year until the next annual meeting or until his successor is elected and qualified, except Mr. Willis. There are no arrangements or understandings between any of the individuals listed above and any other person pursuant to which he was or is to be selected as an officer, other than any arrangements or understandings with officers of SAVANNAH acting solely in their capacities as such. (c)(5) Identification of certain significant employees. None. (d)(5) Family relationships. None. (e)(5) Business experience. ARTHUR M. GIGNILLIAT, JR. - Elected President and Chief Executive Officer in 1985. Director of Savannah Foods and Industries, Inc. HELEN QUATTLEBAUM ARTLEY - Homemaker and Civic Worker. PAUL J. DENICOLA - President and Chief Executive Officer of SCS effective January 1994. Executive Vice President of SCS from 1991 through 1993. He previously served as President and Chief Executive Officer of MISSISSIPPI from 1989 to 1991. Director of SOUTHERN, GULF and MISSISSIPPI. BRIAN R. FOSTER - President of NationsBank of Georgia, N.A., in Savannah since 1988. WALTER D. GNANN - President of Walt's TV, Appliance and Furniture Co., Inc., Springfield, Georgia. Past Chairman of the Development Authority of Effingham County, Georgia. III-11 JOHN M. MCINTOSH - Chairman of the Executive Committee, SAVANNAH; retired Chairman of the Board of Directors and Chief Executive Officer, SAVANNAH from 1974 to 1984. Director of SOUTHERN. ROBERT B. MILLER, III - President of American Builders of Savannah. JAMES M. PIETTE - Vice President - Special Projects, Union Camp Corporation, since 1989. Retired Vice Chairman, Board of Directors, Union Camp Corporation from 1987 to 1989. ARNOLD M. TENENBAUM - President of Chatham Steel Corporation. Director of First Union National Bank of Georgia and Savannah Foods and Industries, Inc. FREDERICK F. WILLIAMS, JR. - Retired Partner and Consultant, Hilb, Rogal and Hamilton Employee Benefits, Incorporated (Insurance Brokers), formerly Jones, Hill & Mercer. W. MILES GREER - Vice President - Marketing and Customer Services effective January 1994. Formerly served as Vice President - Economic Development and Corporate Services from 1989 through 1993 and Vice President - Economic Development and Governmental Affairs from 1985 to 1989. LARRY M. PORTER - Vice President - Operations since 1991. Responsible for managing the areas of fuel procurement, power production, transmission and distribution, engineering and system operation. Previously he served as Assistant Plant Manager of GEORGIA's Plant Scherer from 1984 to 1991. KIRBY R. WILLIS - Vice President, Treasurer and Chief Financial Officer effective January 1994. Responsible for all financial activities, Information Resources, Human Resources, Corporate Services, and Environmental Affairs and Safety. He previously served as Treasurer, Controller and Assistant Secretary from 1991 to 1993 and Treasurer and Secretary from 1987 to 1991. (f)(5) Involvement in certain legal proceedings. None. III-12 ITEM 11.

ITEM 11. EXECUTIVE COMPENSATION (A) SUMMARY COMPENSATION TABLES. The following tables set forth information concerning the Chief Executive Officer and the four most highly compensated executive officers for each of the operating affiliates (ALABAMA, GEORGIA, GULF, MISSISSIPPI and SAVANNAH), serving as of December 31, 1993 whose total annual salary and bonus exceeded $100,000. No information is provided for any person for any year in which such person did not serve as an executive officer of the operating affiliate. The number of SOUTHERN common shares do not reflect the stock distribution resulting from the two-for-one common stock split approved by SOUTHERN's board of directors in January, 1994. KEY TERMS used in this Item will have the following meanings:- AME........... ABOVE-MARKET EARNINGS ON DEFERRED COMPENSATION ESP........... EMPLOYEE SAVINGS PLAN ESOP.......... EMPLOYEE STOCK OWNERSHIP PLAN SBP........... SUPPLEMENTAL BENEFIT PLAN VBP........... VEHICLE BUYOUT PROGRAM ALABAMA SUMMARY COMPENSATION TABLE III-13 ALABAMA SUMMARY COMPENSATION TABLE (CONTINUED) (1) Tax reimbursement by ALABAMA and certain personal benefits, including membership fee of $28,402 for Mr. Jones in 1992. In accordance with the transition rules of the SEC, information for 1991 is omitted. (2) Payouts made in 1992, 1993 and 1994 for the four-year performance periods ending December 31, 1991, 1992 and 1993, respectively. (3) ALABAMA contributions to the ESP, ESOP, non-pension related accruals under the SBP (ERISA excess plan under which accruals are made to offset Internal Revenue Code imposed limitations under the Employee Savings and Stock Ownership Plans), and payments under a VBP for the following:- Name ESP ESOP SBP VBP - ---- --- ---- --- --- E. B. Harris $6,746 $1,709 $12,933 $18,000 T. J. Bowden 8,369 1,709 3,193 18,000 B. H. Farris 7,193 1,499 726 18,000 T. H. Jones 6,908 1,331 754 5,100 W. B. Hutchins, III 6,746 1,400 671 18,000 In accordance with the transition rules of the SEC, information for 1991 is omitted. (4) Effective January 31, 1994, Mr. Bowden resigned to become president of GULF. III-14 GEORGIA SUMMARY COMPENSATION TABLE (1) Due to the pay schedules at GEORGIA, 1992 salary reflects one additional pay period compared with 1991. (2) Tax reimbursement by GEORGIA on certain personal benefits. In accordance with the transition rules of the SEC, information for 1991 is omitted. (3) Payouts made in 1992, 1993 and 1994 for the four-year performance periods ending December 31, 1991, 1992 and 1993, respectively. (4) GEORGIA contributions to the ESP, ESOP, non-pension related accruals under the SBP (ERISA excess plan under which accruals are made to offset Internal Revenue Code imposed limitations under the Employee Savings and Stock Ownership Plans) and payments under a VBP for the following:- Name ESP ESOP SBP VBP - ---- --- ---- --- --- A. W. Dahlberg $6,746 $1,709 $18,092 $18,000 D. H. Evans 8,592 1,709 1,218 18,000 W. Y. Jobe 7,667 1,709 1,882 18,000 G. R. Hodges 7,349 1,620 3,660 18,000 K. E. Adams 7,204 1,634 1,462 18,000 In accordance with the transition rules of the SEC, information for 1991 is omitted. (5) Effective December 31, 1993, Mr. Dahlberg resigned to become president of SOUTHERN. III-15 GULF SUMMARY COMPENSATION TABLE (1) Tax reimbursement by GULF on certain personal benefits. In accordance with the transition rules of the SEC, information for 1991 is omitted. (2) Payouts made in 1992, 1993 and 1994 for the four-year performance periods ending December 31, 1991, 1992 and 1993, respectively. (3) GULF contributions to the ESP, ESOP, non-pension related accruals under the SBP (ERISA excess plan under which accruals are made to offset Internal Revenue Code imposed limitations under the Employee Savings and Stock Ownership Plans) and payments under a VBP for the following:- Name ESP ESOP SBP VBP - ---- --- ---- --- --- D. L. McCrary $9,300 $1,709 $6,057 $ 2,788 G. E. Holland, Jr. 4,652 - - 16,363 E. B. Parsons, Jr 6,948 1,709 410 16,363 A. E. Scarbrough 6,746 1,338 282 16,363 J. E. Hodges, Jr. 6,651 1,313 - 16,363 In accordance with the transition rules of the SEC, information for 1991 is omitted. (4) Employee and executive officer of GULF since April 25, 1992. Not eligible to participate in the Long-Term Incentive Plan until January 1, 1993. (5) "All Other Compensation" previously reported as $4,149 for Mr. Holland in the Form 10-K for the year ended December 31, 1992, should have been $0 since Mr. Holland was not yet eligible to participate in ESP and ESOP. III-16 MISSISSIPPI SUMMARY COMPENSATION TABLE (1) Tax reimbursement by MISSISSIPPI on certain personal benefits. In accordance with the transition rules of the SEC, information for 1991 is omitted. (2) Payouts made in 1992, 1993 and 1994 for the four-year performance periods ending December 31, 1991, 1992 and 1993, respectively. (3) MISSISSIPPI contributions to the ESP, ESOP, non-pension related accruals under the SBP (ERISA excess plan under which accruals are made to offset Internal Revenue Code imposed limitations under the Employee Savings and Stock Ownership Plans) and payments under a VBP for the following:- Name ESP ESOP SBP VBP - ---- --- ---- --- --- David M. Ratcliffe $7,895 $1,709 $2,774 $5,509 R. G. Dawson 6,746 1,252 - 7,045 H. E. Blakeslee 6,843 1,355 - 7,452 D. E. Mason 6,671 1,286 - 7,452 T. A. Fanning 5,520 1,019 - 8,116 In accordance with the transition rules of the SEC, information for 1991 is omitted. (4) Effective March 1, 1994, Mr. Dawson resigned to become a vice president of SEI. (5) Benefits under MISSISSIPPI's VBP for 1992 in the amounts of $13,169 and $12,425 to Messrs. Dawson and Fanning, respectively, previously reported in the Form 10-K for the year ended December 31, 1992, under the "Other Annual Compensation" column have been moved to the "All Other Compensation" column. III-17 SAVANNAH SUMMARY COMPENSATION TABLE (1) Tax reimbursement by SAVANNAH on certain personal benefits. In accordance with the transition rules of the SEC, information for 1991 is omitted. (2) Payouts made in 1992, 1993 and 1994 for the four-year performance periods ending December 31, 1991, 1992 and 1993, respectively. (3) SAVANNAH contributions to the ESP, under Section 401(k) of the Internal Revenue Code, ESOP, AME and payments under a VBP for the following:- Name ESP ESOP AME VBP - ---- --- ---- --- --- A. M. Gignilliat $6,746 $3,092 $7,479 $14,195 E. O. Veale 6,163 2,359 5,702 - L. M. Porter 4,943 1,774 658 14,195 W. M. Greer 5,045 1,764 877 14,195 J. L. Rayburn 2,284 1,650 1,911 14,195 In accordance with the transition rules of the SEC, information for 1991 is omitted. (4) Retired effective December 31, 1993. (5) Not eligible for Long-term Incentive Payout until January 1, 1994. (6) Resigned effective December 31, 1993. III-18 STOCK OPTION GRANTS IN 1993 (B) STOCK OPTION GRANTS. The following table sets forth all stock option grants to the named executive officers of each operating subsidiary during the year ending December 31, 1993. The number of SOUTHERN common shares shown and the per share exercise price and market price do not reflect the stock distribution resulting from the two-for-one common stock split approved by SOUTHERN's board of directors in January, 1994. See next page for footnotes. III-19 STOCK OPTION GRANTS IN 1993 (1) Grants were made on July 19, 1993, and vest 25% per year on the anniversary date of the grant. Grants fully vest upon termination incident to death, disability, or retirement. The exercise price is the average of the high and low fair market value of SOUTHERN's common stock on the date granted. In accordance with the terms of the Executive Stock Plan, Mr. Jones' unexercised options expire on April 1, 1998, three years after his normal retirement date; Mr. McCrary's unexercised options expire on May 1, 1997, three years after his normal retirement date; and Mr. Gignilliat's unexercised options expire on September 3, 2000, three years after his normal retirement date. (2) A total of 179,746 stock options were granted in 1993 to key executives participating in SOUTHERN's Executive Stock Plan. (3) Based on the Black-Scholes option valuation model. The actual value, if any, an executive officer may realize ultimately depends on the market value of SOUTHERN's common stock at a future date. This valuation is provided pursuant to SEC disclosure rules and there is no assurance that the value realized will be at or near the value estimated by the Black-Scholes model. Assumptions used to calculate this value: price volatility - 12.45%; risk-free rate of return - 5.81%; dividend yield - 5.37%; and time to exercise - ten years. III-20 AGGREGATED STOCK OPTION EXERCISES IN 1993 AND YEAR-END OPTION VALUES (C) AGGREGATED STOCK OPTION EXERCISES. The following table sets forth information concerning options exercised during the year ending December 31, 1993, by the named executive officers and the value of unexercised options held by them as of December 31, 1993. The number of SOUTHERN common shares shown and the per share exercise price and market price do not reflect the stock distribution resulting from the two-for-one common stock split approved by SOUTHERN's board of directors in January, 1994. See next page for footnotes. III-21 AGGREGATED STOCK OPTION EXERCISES IN 1993 AND YEAR-END OPTION VALUES (1) This represents the excess of the fair market value of SOUTHERN's common stock of $44.125 per share, as of December 31, 1993, above the exercise price of the options. One column reports the "value" of options that are vested and therefore could be exercised; the other "value" of options that are not vested and therefore could not be exercised as of December 31, 1993. (2) The "Value Realized" is ordinary income, before taxes, and represents the amount equal to the excess of the fair market value of the shares at the time of exercise over the exercise price. III-22 LONG-TERM INCENTIVE PLANS - AWARDS IN 1993 (D) LONG-TERM INCENTIVE PLANS. The following table sets forth the long-term incentive plan awards made to the named executive officers for the performance period January 1, 1993 through December 31, 1996. See next page for footnotes. III-23 LONG-TERM INCENTIVE PLANS - AWARDS IN 1993 III-24 PENSION PLAN TABLE (e)(1) The following table sets forth the estimated combined annual pension benefits under the pension and supplemental defined benefit plans in effect during 1993 for ALABAMA, GEORGIA, GULF and MISSISSIPPI. Employee compensation covered by the pension and supplemental benefit plans for pension purposes is limited to the average of the highest three of the final 10 years' base salary and wages (reported under column titled "Salary" in the Summary Compensation Tables on pages III-13 through III-18). The amounts shown in the table were calculated according to the final average pay formula and are based on a single life annuity without reduction for joint and survivor annuities (although married employees are required to have their pension benefits paid in one of various joint and survivor annuity forms, unless the employee elects otherwise with the spouse's consent) or computation of the Social Security offset which would apply in most cases. This offset amounts to one-half of the estimated Social Security benefit (primary insurance amount) in excess of $3,000 per year times the number of years of accredited service, divided by the total possible years of accredited service to normal retirement age. As of December 31, 1993, the applicable compensation levels and years of accredited service are presented in the following tables: III-25 SAVANNAH has in effect a qualified, trusteed, noncontributory, defined benefit pension plan which provides pension benefits to employees upon retirement at the normal retirement age after designated periods of accredited service and at a specified compensation level. The plan provides pension benefits under a formula which includes each participant's years of service with the Southern system and average annual earnings of the highest three of the final ten years of service with the Southern system preceding retirement. Plan benefits are reduced by a portion of the benefits participants are entitled to receive under Social Security. The plan provides for reduced early retirement benefits at age 55 and a pension for the surviving spouse equal to one-half of the deceased retiree's pension. The following table sets forth the estimated annual pension benefits under the pension plan in effect during 1993 which are payable by SAVANNAH to employees upon retirement at the normal retirement age after designated periods of accredited service and at a specified compensation level. (1)The number of accredited years of service includes ten years credited to Mr. Holland pursuant to a supplemental pension agreement. III-26 As of December 31, 1993, the applicable compensation levels and years of accredited service is presented in the following table: (e)(2) DEFERRED COMPENSATION PLAN; SUPPLEMENTAL EXECUTIVE RETIREMENT PLAN. SAVANNAH has in effect a voluntary deferred compensation plan for certain executive employees pursuant to which such employees may defer a portion of their respective annual salaries. In addition, SAVANNAH has a supplemental executive retirement plan for certain of its executive employees which became effective January 1, 1984. The deferred compensation plan is designed to provide supplemental retirement or survivor benefit payments. The supplemental executive retirement plan is also designed to provide retiring executives of SAVANNAH with a supplemental retirement benefit, which, in conjunction with social security and benefits under SAVANNAH's qualified pension plan, will equal 70 percent of the highest three of the final ten years average annual compensation (including deferrals under the deferred compensation plan). Both of these plans are unfunded and the liability is payable from general funds of SAVANNAH. The deferred compensation plan became effective December 1, 1983, and all of SAVANNAH's executive officers are participating in the plan. In addition, all executives are participating in the supplemental executive retirement plan. In order to provide for its liabilities under the deferred compensation plan and the supplemental executive retirement plan, SAVANNAH has purchased life insurance on participating executive employees in actuarially determined amounts which, based upon assumptions as to mortality experience, policy dividends, tax effects, and other factors which, if realized, along with compensation deferred by employees and the death benefits payable to (1) The plan benefits are subject to the maximum benefit limitations set forth in Section 415 of the Internal Revenue Code. III-27 SAVANNAH, are expected to cover all such insurance premium payments, and all benefit payments to participants, plus a factor for the cost of funds of SAVANNAH. (f) COMPENSATION OF DIRECTORS. (1) Standard Arrangements. The following table presents compensation paid to the directors, during 1993 for service as a member of the board of directors and any board committee(s), except that employee directors received no fees or compensation for service as a member of the board of directors or any board committee. All or a portion of these fees may be deferred until membership on the board is terminated. ALABAMA, GEORGIA, GULF, MISSISSIPPI and SAVANNAH also provide retirement benefits to non-employee directors who are credited with a minimum of 60 months of service on the board of directors of one or more system companies, under the Outside Directors Pension Plan. Eligible directors are entitled to benefits under the Plan upon retirement from the board on the retirement date designated in the respective companies by-laws. The annual benefit payable ranges from 75 to 100 percent of the annual retainer fee in effect on the date of retirement, based upon length of service. Payments continue for the greater of the lifetime of the participant or 10 years. (2) Other Arrangements. No director received other compensation for services as a director during the year ending December 31, 1993 in addition to or in lieu of that specified by the standard arrangements specified above. (1) Committee Chairmen receive an additional $500 per year fee. (2) Established for period September 15, 1993 through May 31, 1994. (3) Chairman of Executive Committee receives an additional $3,000 per month fee. III-28 (g) EMPLOYMENT CONTRACTS AND TERMINATION OF EMPLOYMENT AND CHANGE IN CONTROL ARRANGEMENTS. None. (h) REPORT ON REPRICING OF OPTIONS. None. (i) ADDITIONAL INFORMATION WITH RESPECT TO COMPENSATION COMMITTEE INTERLOCKS AND INSIDER PARTICIPATION IN COMPENSATION DECISION. ALABAMA Elmer B. Harris serves on the Compensation Committee of AmSouth Bancorporation. John W. Woods, a director of ALABAMA is an executive officer of AmSouth Bancorporation. GULF Messrs. Paul J. DeNicola and Douglas L. McCrary are ex officio members of its Compensation Committee. III-29 ITEM 12.

ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT (A) SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS. SOUTHERN is the beneficial owner of 100% of the outstanding common stock of registrants ALABAMA, GEORGIA, GULF, MISSISSIPPI and SAVANNAH. (B) SECURITY OWNERSHIP OF MANAGEMENT. The following table shows the number of shares of SOUTHERN common stock and operating subsidiary preferred stock owned by the directors, nominees and executive officers as of December 31, 1993. It is based on information furnished by the directors, nominees and executive officers. The shares owned by all directors, nominees and executive officers as a group constitute less than one percent of the total number of shares of the respective classes outstanding on December 31, 1993. The number of SOUTHERN common shares shown do not reflect the stock distribution resulting from the two-for-one common stock split approved by SOUTHERN'S board of directors in January, 1994. III-30 III-31 III-32 III-33 (1) As used in this table, "beneficial ownership" means the sole or shared power to vote, or to direct the voting of, a security and/or investment power with respect to a security (i.e., the power to dispose of, or to direct the disposition of, a security). (2) The shares shown include shares of common stock of which certain directors and executive officers have the right to acquire beneficial ownership within 60 days pursuant to the Executive Stock Plan, as follows: Mr. Addison, 86,357 shares; Mr. Blakeslee, 660 shares; Mr. Bowden, 5,763 shares; Mr. Dahlberg, 4,278 shares; Mr. Farris, 863 shares; Mr. Gignilliat, 8,556 shares; Mr. Guthrie 15,720 shares; Mr. Harris, 14,215 shares; Mr. Haubein, 835 shares; Mr. Hodges, 5,429 shares; Mr. Holland, 698 shares; Mr. Hutchins, 706 shares; Mr. Jones, 848 shares; Mr. Klappa, 671 shares, Mr. C. D. McCrary, 691 shares; Mr. D. L. McCrary, 9,668 shares; and Mr. Ratcliffe, 5,643 shares. Also included are shares of SOUTHERN common stock held by the spouses of the following directors: Mr. Addison, 670 shares; Mr. Copenhaver, 350 shares; Mr. Harris, 155 shares; Mr. Parker, 22 shares; and Dr. Shatto, 5,067 shares. III-34 (C) CHANGES IN CONTROL. The operating affiliates know of no arrangements which may at a subsequent date result in any change in control. GEORGIA'S Mr. Russell failed to file on a timely basis a single report disclosing one transaction on Form 4 as required by Section 16 of the Securities Exchange Act of 1934. MISSISSIPPI'S Messrs. McLean, Jr., Hurt and Seal, Jr. each failed to file on a timely basis a single report disclosing one transaction on Form 4 as required by Section 16 of the Securities Exchange Act of 1934. SAVANNAH'S Mr. Gnann failed to file on a timely basis a single report disclosing one transaction on Form 4 as required by Section 16 of the Securities Exchange Act of 1934. MR. DENICOLA, a director of GULF, MISSISSIPPI and SAVANNAH, failed to file on a timely basis a single report, disclosing one transaction on Form 4 as required by Section 16 of the Securities Exchange Act of 1934. III-35 ITEM 13.

ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS ALABAMA (a) Transactions with management and others. During 1993, ALABAMA, in the ordinary course of business, paid premiums amounting to approximately $400,000 for various types of insurance policies purchased from Protective Life Insurance Company, a subsidiary of Protective Life Corporation, a company in which Mr. William J. Rushton, III, a director of ALABAMA, owns an interest and of which he serves as Chairman. The firm of Inzer, Stivender, Haney & Johnson, P.A., performed certain legal services for ALABAMA during 1993. Mr. James C. Inzer, Jr., partner in this firm, is also a director of ALABAMA. ALABAMA purchased automobiles and parts in the amount of approximately $200,000 from companies in which Mr. Blount, a director of ALABAMA, owns 85% interests. ALABAMA purchased electrical supplies in the amount of approximately $200,000 from L & K Electric Supply Company, Ltd. during 1993. Mr. Willie, director of ALABAMA and SOUTHERN, owns an interest in and serves as president of this firm. ALABAMA believes that these transactions have been on terms representing competitive market prices that are no less favorable than those available from others. (b) Certain business relationships. None. (c) Indebtedness of management. None. (d) Transactions with promoters. None. GEORGIA (a) Transactions with management and others. In 1993, GEORGIA was indebted in a maximum amount of $105 million to Wachovia Bank and its affiliates, of which G. Joseph Prendergast serves as President and Chief Executive Officer of Wachovia Corporation of Georgia and Wachovia Bank of Georgia, N.A. In 1993, GEORGIA was indebted in a maximum amount of $285 million to NationsBank and its affiliates of which Mr. James R. Lientz, Jr. serves as President of NationsBank of Georgia. (b) Certain business relationships. None. (c) Indebtedness of management. None. (d) Transactions with promoters. None. GULF (a) Transactions with management and others. The firm of Beggs & Lane, P.A. serves as local counsel for GULF and received from GULF approximately $800,000 for services rendered. Mr. G. Edison Holland, Jr. is a partner in the firm and also serves as Vice President and Corporate Counsel of GULF. (b) Certain business relationships. None. (c) Indebtedness of management. None. (d) Transactions with promoters. None. MISSISSIPPI (a) Certain business relationships. During 1993, MISSISSIPPI was indebted in a maximum amount of $12.4 million to Hancock Bank, of which Leo W. Seal, Jr. serves as Chairman of the Board and Chief Executive Officer. (b) Certain business relationships. None. (c) Indebtedness of management. None. III-36 (d) Transactions with promoters. None. SAVANNAH (a) Transactions with management and others. Mr. Tenenbaum is a Director of First Union national Bank of Georgia, and Mr. Foster is President of NationsBank of Georgia, N.A., in Savannah. During 1993, these banks furnished a number of regular banking services in the ordinary course of business to SAVANNAH. SAVANNAH intends to maintain normal banking relations with all of the aforesaid banks in the future. (b) Certain business relationships. (c) Indebtedness of management. None. (d) Transactions with promoters. None. III-37 PART IV ITEM 14.

ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K (a) The following documents are filed as a part of this report on this Form 10-K: (1) Financial Statements: Reports of Independent Public Accountants on the financial statements for SOUTHERN and Subsidiary Companies, ALABAMA, GEORGIA, GULF, MISSISSIPPI and SAVANNAH are listed under Item 8 herein. The financial statements filed as a part of this report for SOUTHERN and Subsidiary Companies, ALABAMA, GEORGIA, GULF, MISSISSIPPI and SAVANNAH are listed under Item 8 herein. (2) Financial Statement Schedules: Reports of Independent Public Accountants as to Schedules for SOUTHERN and Subsidiary Companies, ALABAMA, GEORGIA, GULF, MISSISSIPPI and SAVANNAH are included herein on pages IV-12 through IV-17. Financial Statement Schedules for SOUTHERN and Subsidiary Companies, ALABAMA, GEORGIA, GULF, MISSISSIPPI and SAVANNAH are listed in the Index to the Financial Statement Schedules at page S-1. (3) Exhibits: Exhibits for SOUTHERN, ALABAMA, GEORGIA, GULF, MISSISSIPPI and SAVANNAH are listed in the Exhibit Index at page E-1. (b) Reports on Form 8-K: During the fourth quarter of 1993 the registrants filed Current Reports on Form 8-K as follows: ALABAMA filed Forms 8-K dated October 27, 1993, and November 16, 1993, to facilitate security sales. GEORGIA filed a Form 8-K dated October 20, 1993, to facilitate a security sale. GULF filed a Form 8-K dated November 3, 1993, to facilitate a security sale. SAVANNAH filed a Form 8-K dated November 9, 1993, to facilitate a security sale. IV-1 Pursuant to the requirements of Section 13 or 15(d) 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. The signature of the undersigned company shall be deemed to relate only to matters having reference to such company and any subsidiaries thereof. THE SOUTHERN COMPANY By Edward L. Addison, Chairman By Wayne Boston (Wayne Boston, Attorney-in-fact) Date: March 25, 1994 Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated. The signature of each of the undersigned shall be deemed to relate only to matters having reference to the above-named company and any subsidiaries thereof. Edward L. Addison Chairman of the Board (Principal Executive Officer) W. L. Westbrook Financial Vice President (Principal Financial and Accounting Officer) Directors: W. P. Copenhaver John M. McIntosh. A. W. Dahlberg Earl D. McLean, Jr. Paul J. DeNicola William A. Parker Jack Edwards William J. Rushton, III H. Allen Franklin Gloria M. Shatto L. G. Hardman, III Herbert Stockham Elmer B. Harris Louis J. Willie By Wayne Boston (Wayne Boston, Attorney-in-fact) Date: March 25, 1994 Pursuant to the requirements of Section 13 or 15(d) 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. The signature of the undersigned company shall be deemed to relate only to matters having reference to such company and any subsidiaries thereof. ALABAMA POWER COMPANY By Elmer B. Harris, President By Wayne Boston (Wayne Boston, Attorney-in-fact) Date: March 25, 1994 Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated. The signature of each of the undersigned shall be deemed to relate only to matters having reference to the above-named company and any subsidiaries thereof. Elmer B. Harris President, Chief Executive Officer and Director (Principal Executive Officer) Charles D. McCrary Senior Vice President (Principal Financial Officer) David L. Whitson Vice President and Comptroller (Principal Accounting Officer) Directors: Edward L. Addison William V. Muse Whit Armstrong John T. Porter Philip E. Austin Gerald H. Powell Margaret A. Carpenter Robert D. Powers Peter V. Gregerson, Sr. John W. Rouse Bill M. Guthrie James H. Sanford Crawford T. Johnson, III John Cox Webb, IV Carl E. Jones, Jr. Louis J. Willie Wallace D. Malone, Jr. John W. Woods By Wayne Boston (Wayne Boston, Attorney-in-fact) Date: March 25, 1994 IV-2 Pursuant to the requirements of Section 13 or 15(d) 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. The signature of the undersigned company shall be deemed to relate only to matters having reference to such company and any subsidiaries thereof. GEORGIA POWER COMPANY By H. Allen Franklin, President By Wayne Boston (Wayne Boston, Attorney-in-fact) Date: March 25, 1994 Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated. The signature of each of the undersigned shall be deemed to relate only to matters having reference to the above-named company and any subsidiaries thereof. H. Allen Franklin President, Chief Executive Officer and Director (Principal Executive Officer) Warren Y. Jobe Executive Vice President, Treasurer, Chief Financial Officer and Director (Principal Financial Officer) C. B. Harreld Vice President and Comptroller (Principal Accounting Officer) Directors: Edward L. Addison G. Joseph Prendergast Bennett A. Brown Herman J. Russell William P. Copenhaver Gloria M. Shatto A. W. Dahlberg Robert Strickland William A. Fickling, Jr. William Jerry Vereen L. G. Hardman, III Thomas R. Williams James R. Lientz, Jr. By Wayne Boston (Wayne Boston, Attorney-in-fact) Date: March 25, 1994 Pursuant to the requirements of Section 13 or 15(d) 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. The signature of the undersigned company shall be deemed to relate only to matters having reference to such company and any subsidiaries thereof. GULF POWER COMPANY By D. L. McCrary, Chairman of the Board By Wayne Boston (Wayne Boston, Attorney-in-fact) Date: March 25, 1994 Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated. The signature of each of the undersigned shall be deemed to relate only to matters having reference to the above-named company and any subsidiaries thereof. D. L. McCrary Chairman of the Board and Chief Executive Officer (Principal Executive Officer) A. E. Scarbrough Vice President - Finance (Principal Financial and Accounting Officer) Directors: Reed Bell Travis J. Bowden Paul J. DeNicola Fred C. Donovan W. D. Hull, Jr. C. W. Ruckel J. K. Tannehill By Wayne Boston (Wayne Boston, Attorney-in-fact) Date: March 25,1994 IV-3 Pursuant to the requirements of Section 13 or 15(d) 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. The signature of the undersigned company shall be deemed to relate only to matters having reference to such company and any subsidiaries thereof. MISSISSIPPI POWER COMPANY By David M. Ratcliffe, President By Wayne Boston (Wayne Boston, Attorney-in-fact) Date: March 25, 1994 Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated. The signature of each of the undersigned shall be deemed to relate only to matters having reference to the above-named company and any subsidiaries thereof. David M. Ratcliffe President, Chief Executive Officer and Director (Principal Executive Officer) Thomas A. Fanning Vice President and Chief Financial Officer (Principal Financial and Accounting Officer) Directors: Paul J. DeNicola Edwin E. Downer Robert S. Gaddis Walter H. Hurt, III Aubrey K. Lucas Earl D. McLean, Jr. Gerald J. St. Pe' Leo W. Seal, Jr. N. Eugene Warr By Wayne Boston (Wayne Boston, Attorney-in-fact) Date: March 25, 1994 Pursuant to the requirements of Section 13 or 15(d) 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. The signature of the undersigned company shall be deemed to relate only to matters having reference to such company and any subsidiaries thereof. SAVANNAH ELECTRIC AND POWER COMPANY By Arthur M. Gignilliat, Jr., President By Wayne Boston (Wayne Boston, Attorney-in-fact) Date: March 25, 1994 Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated. The signature of each of the undersigned shall be deemed to relate only to matters having reference to the above-named company and any subsidiaries thereof. Arthur M. Gignilliat, Jr. President, Chief Executive Officer and Director (Principal Executive Officer) Kirby R. Willis Vice President, Treasurer and Chief Financial Officer (Principal Financial and Accounting Officer) Directors: Helen Q. Artley Paul J. DeNicola Brian R. Foster Walter D. Gnann John M. McIntosh Robert B. Miller, III James M. Piette Arnold M. Tenenbaum Frederick F. Williams, Jr. By Wayne Boston (Wayne Boston, Attorney-in-fact) Date: March 25, 1994 IV-4 EXHIBIT 21. SUBSIDIARIES OF THE REGISTRANTS. (1) Owned by Alabama Power Company. (2) Owned by Georgia Power Company. (3) Owned by SEI Holdings, Inc. (4) 94% owned jointly by Asociados de Electricidad, S. A. (14%) and SEI Holdings, Inc. (80%) (5) 59% owned by SEI y Asociados de Argentina, S. A. (6) Owned by SEI Holdings III, Inc. (7) 36% owned by SEI Chile, S. A. (8) Owned by SEI Holdings IV, Inc. (9) Owned jointly by Inversores de Electricidad, S. A. (15%) and SEI Bahamas Argentina I, Inc. (85%) (10) Owned by Southern Electric Bahamas Holdings, Ltd. (11) 50% owned by Southern Electric Bahamas, Ltd. (12) Owned equally by Alabama Power Company and Georgia Power Company. (13) Owned by Southern Electric International, Inc. (14) Owned by Southern Electric Wholesale Generators, Inc. IV-5 ARTHUR ANDERSEN & CO. Exhibit 23(a) CONSENT OF INDEPENDENT PUBLIC ACCOUNTANTS As independent public accountants, we hereby consent to the incorporation of our reports dated February 16, 1994 on the financial statements of The Southern Company and its subsidiaries and the related financial statement schedules, included in this Form 10-K, into The Southern Company's previously filed Registration Statement File Nos. 2-78617, 33-3546, 33-23152, 33-30171, 33-23153 and 33-51433. /s/ Arthur Andersen & Co. Atlanta, Georgia March 25, 1994 IV-6 ARTHUR ANDERSEN & CO. Exhibit 23(b) CONSENT OF INDEPENDENT PUBLIC ACCOUNTANTS As independent public accountants, we hereby consent to the incorporation of our reports dated February 16, 1994 on the financial statements of Alabama Power Company and the related financial statement schedules, included in this Form 10-K, into Alabama Power Company's previously filed Registration Statement File No. 33-49653. /s/ Arthur Andersen & Co. Birmingham, Alabama March 25, 1994 IV-7 ARTHUR ANDERSEN & CO. Exhibit 23(c) CONSENT OF INDEPENDENT PUBLIC ACCOUNTANTS As independent public accountants, we hereby consent to the incorporation of our reports dated February 16, 1994 on the financial statements of Georgia Power Company and the related financial statement schedules, included in this Form 10-K, into Georgia Power Company's previously filed Registration Statement File No. 33-49661. /s/ Arthur Andersen & Co. Atlanta, Georgia March 25, 1994 IV-8 ARTHUR ANDERSEN & CO. Exhibit 23(d) CONSENT OF INDEPENDENT PUBLIC ACCOUNTANTS As independent public accountants, we hereby consent to the incorporation of our reports dated February 16, 1994 on the financial statements of Gulf Power Company and the related financial statement schedules, included in this Form 10-K, into Gulf Power Company's previously filed Registration Statement File No. 33-50165. /s/ Arthur Andersen & Co. Atlanta, Georgia March 25, 1994 IV-9 ARTHUR ANDERSEN & CO. Exhibit 23(e) CONSENT OF INDEPENDENT PUBLIC ACCOUNTANTS As independent public accountants, we hereby consent to the incorporation of our reports dated February 16, 1994 on the financial statements of Mississippi Power Company and the related financial statement schedules, included in this Form 10-K, into Mississippi Power Company's previously filed Registration Statement File Nos. 33-49320 and 33-49649. /s/ Arthur Andersen & Co. Atlanta, Georgia March 25, 1994 IV-10 ARTHUR ANDERSEN & CO. Exhibit 23(f) CONSENT OF INDEPENDENT PUBLIC ACCOUNTANTS As independent public accountants, we hereby consent to the incorporation of our reports dated February 16, 1994 on the financial statements of Savannah Electric and Power Company and the related financial statement schedules, included in this Form 10-K, into Savannah Electric and Power Company's previously filed Registration Statement File Nos. 33-45757 and 33-52509. /s/ Arthur Andersen & Co. Atlanta, Georgia March 25, 1994 IV-11 ARTHUR ANDERSEN & CO. REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS AS TO SCHEDULES To The Southern Company: We have audited in accordance with generally accepted auditing standards, the consolidated financial statements of The Southern Company and its subsidiaries included in this Form 10-K, and have issued our report thereon dated February 16, 1994. Our report on the consolidated financial statements includes an explanatory paragraph which states that an uncertainty exists with respect to the actions of the regulators regarding recoverability of the investment in the Rocky Mountain pumped storage hydroelectric project, as discussed in Note 4 to The Southern Company's consolidated financial statements. Our audits were made for the purpose of forming an opinion on those statements taken as a whole. The schedules listed under Item 14(a)(2) herein as it relates to The Southern Company and its subsidiaries (pages S-2 and S-3, S-11 through S-14, S-35 through S-37, S-53, and S-59) are the responsibility of The Southern Company's management and are presented for purposes of complying with the Securities and Exchange Commission's rules and are not part of the basic consolidated financial statements. These schedules have been subjected to the auditing procedures applied in the audits of the basic consolidated financial statements and, in our opinion, fairly state in all material respects the financial data required to be set forth therein in relation to the basic consolidated financial statements taken as a whole. /s/ Arthur Andersen & Co. Atlanta, Georgia February 16, 1994 IV-12 ARTHUR ANDERSEN & CO. REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS AS TO SCHEDULES To Alabama Power Company: We have audited in accordance with generally accepted auditing standards, the financial statements of Alabama Power Company included in this Form 10-K, and have issued our report thereon dated February 16, 1994. Our audits were made for the purpose of forming an opinion on those statements taken as a whole. The schedules listed under Item 14(a)(2) herein as it relates to Alabama Power Company (pages S-4, S-15 through S-18, S-38 through S-40, S-54, and S-60) are the responsibility of Alabama Power Company's management and are presented for purposes of complying with the Securities and Exchange Commission's rules and are not part of the basic financial statements. These schedules have been subjected to the auditing procedures applied in the audits of the basic financial statements and, in our opinion, fairly state in all material respects the financial data required to be set forth therein in relation to the basic financial statements taken as a whole. /s/ Arthur Andersen & Co. Birmingham, Alabama February 16, 1994 IV-13 ARTHUR ANDERSEN & CO. REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS AS TO SCHEDULES To Georgia Power Company: We have audited in accordance with generally accepted auditing standards, the financial statements of Georgia Power Company included in this Form 10-K, and have issued our report thereon dated February 16, 1994. Our report on the financial statements includes an explanatory paragraph which states that an uncertainty exists with respect to the actions of the regulators regarding the recoverability of Georgia Power Company's investment in the Rocky Mountain pumped storage hydroelectric project, as discussed in Note 4 to Georgia Power Company's financial statements. Our audits were made for the purpose of forming an opinion on those statements taken as a whole. The schedules listed under Item 14(a)(2) herein as it relates to Georgia Power Company (pages S-5, S-19 through S-22, S-41 through S-43, S-55, and S-61) are the responsibility of Georgia Power Company's management and are presented for purposes of complying with the Securities and Exchange Commission's rules and are not part of the basic financial statements. These schedules have been subjected to the auditing procedures applied in the audits of the basic financial statements and, in our opinion, fairly state in all material respects the financial data required to be set forth therein in relation to the basic financial statements taken as a whole. /s/ Arthur Andersen & Co. Atlanta, Georgia February 16, 1994 IV-14 ARTHUR ANDERSEN & CO. REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS AS TO SCHEDULES To Gulf Power Company: We have audited in accordance with generally accepted auditing standards, the financial statements of Gulf Power Company included in this Form 10-K, and have issued our report thereon dated February 16, 1994. Our audits were made for the purpose of forming an opinion on those statements taken as a whole. The schedules listed under Item 14(a)(2) herein as it relates to Gulf Power Company (pages S-6, S-23 through S-26, S-44 through S-46, S-56, and S-62) are the responsibility of Gulf Power Company's management and are presented for purposes of complying with the Securities and Exchange Commission's rules and are not part of the basic financial statements. These schedules have been subjected to the auditing procedures applied in the audits of the basic financial statements and, in our opinion, fairly state in all material respects the financial data required to be set forth therein in relation to the basic financial statements taken as a whole. /s/ Arthur Andersen & Co. Atlanta, Georgia February 16, 1994 IV-15 ARTHUR ANDERSEN & CO. REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS AS TO SCHEDULES To Mississippi Power Company: We have audited in accordance with generally accepted auditing standards, the financial statements of Mississippi Power Company included in this Form 10-K, and have issued our report thereon dated February 16, 1994. Our audits were made for the purpose of forming an opinion on those statements taken as a whole. The schedules listed under Item 14(a)(2) herein as it relates to Mississippi Power Company (pages S-7 and S-8, S-27 through S-30, S-47 through S-49, S-57, and S-63) are the responsibility of Mississippi Power Company's management and are presented for purposes of complying with the Securities and Exchange Commission's rules and are not part of the basic financial statements. These schedules have been subjected to the auditing procedures applied in the audits of the basic financial statements and, in our opinion, fairly state in all material respects the financial data required to be set forth therein in relation to the basic financial statements taken as a whole. /s/ Arthur Andersen & Co. Atlanta, Georgia February 16, 1994 IV-16 ARTHUR ANDERSEN & CO. REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS AS TO SCHEDULES To Savannah Electric and Power Company: We have audited in accordance with generally accepted auditing standards, the financial statements of Savannah Electric and Power Company included in this Form 10-K, and have issued our report thereon dated February 16, 1994. Our audits were made for the purpose of forming an opinion on those statements taken as a whole. The schedules listed under Item 14(a)(2) herein as it relates to Savannah Electric and Power Company (pages S-9 and S-10, S-31 through S-34, S-50 through S-52, S-58, and S-64) are the responsibility of Savannah Electric and Power Company's management and are presented for purposes of complying with the Securities and Exchange Commission's rules and are not part of the basic financial statements. These schedules have been subjected to the auditing procedures applied in the audits of the basic financial statements and, in our opinion, fairly state in all material respects the financial data required to be set forth therein in relation to the basic financial statements taken as a whole. /s/ Arthur Andersen & Co. Atlanta, Georgia February 16, 1994 IV-17 INDEX TO FINANCIAL STATEMENT SCHEDULES Schedules I through XIV not listed above are omitted as not applicable or not required. Columns omitted from schedules filed have been omitted because the information is not applicable or not required. S-1 THE SOUTHERN COMPANY AND SUBSIDIARY COMPANIES SCHEDULE V - UTILITY PLANT, INCLUDING INTANGIBLES (STATED IN THOUSANDS OF DOLLARS) See Summary of Transactions and Notes on Page S-3 S-2 THE SOUTHERN COMPANY AND SUBSIDIARY COMPANIES SCHEDULE V - UTILITY PLANT, INCLUDING INTANGIBLES (STATED IN THOUSANDS OF DOLLARS) Total additions and total retirements for 1991, 1992 and 1993, as summarized below, were each less than 10% of the total balances as of the respective year-ends. Retirements include non-depreciable plant retirements and unamortized portions of retirements to acquisition adjustments. There were no additions to individual accounts in excess of two percent of total assets other than transfers from Construction Work in Progress. (NOTE 1) OTHER CHANGES INCLUDE THE FOLLOWING (STATED IN THOUSANDS OF DOLLARS) S-3 ALABAMA POWER COMPANY SCHEDULE V -- UTILITY PLANT, INCLUDING INTANGIBLES (STATED IN THOUSANDS OF DOLLARS) Total additions and total retirements for 1991, 1992 and 1993, as summarized below, were each less than 10% of the total balances as of the respective year-ends. Retirements below include non-depreciable plant retirements. There were no additions to individual accounts in excess of two percent of total assets other than transfers from Construction Work in Progress. Other changes include a reduction to utility plant of $61,960,000 for the partial sale of Miller Steam Plant in 1992. S-4 GEORGIA POWER COMPANY SCHEDULE V - UTILITY PLANT, INCLUDING INTANGIBLES (STATED IN THOUSANDS OF DOLLARS) Total additions and total retirements for 1991, 1992 and 1993, as summarized below, were each less than 10% of the total balances as of the respective year-ends. Retirements include non-depreciable plant retirements and unamortized portions of Plant Scherer acquisition adjustment retired for sales in 1991 and 1993. There were no additions to individual accounts in excess of two percent of total assets other than transfers from Construction Work in Progress. Other changes for 1993, include an increase to plant of $46,473,000 for the taxes applicable to capitalized AFUDC debt. S-5 GULF POWER COMPANY SCHEDULE V - UTILITY PLANT, INCLUDING INTANGIBLES (STATED IN THOUSANDS OF DOLLARS) Total additions and total retirements for 1991, 1992 and 1993, as summarized below, were each less than 10% of the total balances as of the respective year-ends. There were no additions to individual accounts in excess of two percent of total assets other than transfers from Construction Work in Progress. S-6 MISSISSIPPI POWER COMPANY SCHEDULE V - UTILITY PLANT, INCLUDING INTANGIBLES (STATED IN THOUSANDS OF DOLLARS) Total additions and total retirements for 1991 and 1992, as summarized below, were each less than 10% of the total balances as of the respective year-ends. Additions for 1993 were greater than 10% of the year-end balance and, consequently, 1993 is reported in full detail on page S-8. There were no additions to individual accounts in excess of two percent of total assets other than transfers from Construction Work in Progress. S-7 MISSISSIPPI POWER COMPANY SCHEDULE V - UTILITY PLANT, INCLUDING INTANGIBLES FOR THE YEAR ENDED DECEMBER 31,1993 (STATED IN THOUSANDS OF DOLLARS) S-8 SAVANNAH ELECTRIC AND POWER COMPANY SCHEDULE V - UTILITY PLANT, INCLUDING INTANGIBLES (STATED IN THOUSANDS OF DOLLARS) Total additions and total retirements for 1991 and 1992, as summarized below, were each less than 10% of the total balances as of the respective year-ends. Additions for 1993 were greater than 10% of the year-end balance and, consequently, 1993 is reported in full detail on page S-10. There were no additions to individual accounts in excess of two percent of total assets other than transfers from Construction Work in Progress. S-9 SAVANNAH ELECTRIC AND POWER COMPANY SCHEDULE V - UTILITY PLANT, INCLUDING INTANGIBLES FOR THE YEAR ENDED DECEMBER 31, 1993 (STATED IN THOUSANDS OF DOLLARS) S-10 THE SOUTHERN COMPANY AND SUBSIDIARY COMPANIES SCHEDULE VI -- ACCUMULATED PROVISION FOR DEPRECIATION OF UTILITY PLANT FOR THE YEAR ENDED DECEMBER 31, 1993 (STATED IN THOUSANDS OF DOLLARS) See Notes on Page S-14 S-11 THE SOUTHERN COMPANY AND SUBSIDIARY COMPANIES SCHEDULE VI -- ACCUMULATED PROVISION FOR DEPRECIATION OF UTILITY PLANT FOR THE YEAR ENDED DECEMBER 31, 1992 (STATED IN THOUSANDS OF DOLLARS) See Notes on Page S-14 S-12 THE SOUTHERN COMPANY AND SUBSIDIARY COMPANIES SCHEDULE VI -- ACCUMULATED PROVISION FOR DEPRECIATION OF UTILITY PLANT FOR THE YEAR ENDED DECEMBER 31, 1991 (STATED IN THOUSANDS OF DOLLARS) See Notes on Page S-14 S-13 THE SOUTHERN COMPANY AND SUBSIDIARY COMPANIES NOTES TO SCHEDULE VI -ACCUMULATED PROVISION FOR DEPRECIATION OF UTILITY PLANT FOR THE YEARS ENDING DECEMBER 31, 1993, 1992 AND 1991 (STATED IN THOUSANDS OF DOLLARS) S-14 ALABAMA POWER COMPANY SCHEDULE VI -- ACCUMULATED PROVISION FOR DEPRECIATION OF UTILITY PLANT FOR THE YEAR ENDED DECEMBER 31, 1993 (STATED IN THOUSANDS OF DOLLARS) See Notes on Page S-18 S-15 ALABAMA POWER COMPANY SCHEDULE VI -- ACCUMULATED PROVISION FOR DEPRECIATION OF UTILITY PLANT FOR THE YEAR ENDED DECEMBER 31, 1992 (STATED IN THOUSANDS OF DOLLARS) See Notes on Page S-18 S-16 ALABAMA POWER COMPANY SCHEDULE VI --ACCUMULATED PROVISION FOR DEPRECIATION OF UTILITY PLANT FOR THE YEAR ENDED DECEMBER 31, 1991 (STATED IN THOUSANDS OF DOLLARS) See Notes on Page S-18 S-17 ALABAMA POWER COMPANY NOTES TO SCHEDULE VI -- ACCUMULATED PROVISION FOR DEPRECIATION OF UTILITY PLANT FOR THE YEARS ENDING DECEMBER 31, 1993, 1992 AND 1991 (STATED IN THOUSANDS OF DOLLARS) S-18 GEORGIA POWER COMPANY SCHEDULE VI -- ACCUMULATED PROVISION FOR DEPRECIATION OF UTILITY PLANT FOR THE YEAR ENDED DECEMBER 31, 1993 (STATED IN THOUSANDS OF DOLLARS) See Notes on Page S-22 S-19 GEORGIA POWER COMPANY SCHEDULE VI -- ACCUMULATED PROVISION FOR DEPRECIATION OF UTILITY PLANT FOR THE YEAR ENDED DECEMBER 31, 1992 (STATED IN THOUSANDS OF DOLLARS) See Notes on Page S-22 S-20 GEORGIA POWER COMPANY SCHEDULE VI -- ACCUMULATED PROVISION FOR DEPRECIATION OF UTILITY PLANT FOR THE YEAR ENDED DECEMBER 31, 1991 (STATED IN THOUSANDS OF DOLLARS) See Notes on Page S-22 S-21 GEORGIA POWER COMPANY NOTES TO SCHEDULE VI -- ACCUMULATED PROVISION FOR DEPRECIATION OF UTILITY PLANT FOR THE YEARS ENDING DECEMBER 31, 1993, 1992 AND 1991 (STATED IN THOUSANDS OF DOLLARS) S-22 GULF POWER COMPANY SCHEDULE VI -- ACCUMULATED PROVISION FOR DEPRECIATION OF UTILITY PLANT FOR THE YEAR ENDED DECEMBER 31, 1993 (STATED IN THOUSANDS OF DOLLARS) See Notes on Page S-26 S-23 GULF POWER COMPANY SCHEDULE VI -- ACCUMULATED PROVISION FOR DEPRECIATION OF UTILITY PLANT FOR THE YEAR ENDED DECEMBER 31, 1992 (STATED IN THOUSANDS OF DOLLARS) See Notes on Page S-26 S-24 GULF POWER COMPANY SCHEDULE VI -- ACCUMULATED PROVISION FOR DEPRECIATION OF UTILITY PLANT FOR THE YEAR ENDED DECEMBER 31, 1991 (STATED IN THOUSANDS OF DOLLARS) See Notes on Page S-26 S-25 GULF POWER COMPANY NOTES TO SCHEDULE VI -ACCUMULATED PROVISION FOR DEPRECIATION OF UTILITY PLANT FOR THE YEARS ENDING DECEMBER 31, 1993, 1992 AND 1991 (STATED IN THOUSANDS OF DOLLARS) S-26 MISSISSIPPI POWER COMPANY SCHEDULE VI --ACCUMULATED PROVISION FOR DEPRECIATION OF UTILITY PLANT FOR THE YEAR ENDED DECEMBER 31, 1993 (STATED IN THOUSANDS OF DOLLARS) See Notes on Page S-30 S-27 MISSISSIPPI POWER COMPANY SCHEDULE VI --ACCUMULATED PROVISION FOR DEPRECIATION OF UTILITY PLANT FOR THE YEAR ENDED DECEMBER 31, 1992 (STATED IN THOUSANDS OF DOLLARS) See Notes on Page S-30 S-28 MISSISSIPPI POWER COMPANY SCHEDULE VI --ACCUMULATED PROVISION FOR DEPRECIATION OF UTILITY PLANT FOR THE YEAR ENDED DECEMBER 31, 1991 (STATED IN THOUSANDS OF DOLLARS) See Notes on Page S-30 S-29 MISSISSIPPI POWER COMPANY NOTES TO SCHEDULE VI -ACCUMULATED PROVISION FOR DEPRECIATION OF UTILITY PL FOR THE YEARS ENDING DECEMBER 31, 1993, 1992 AND 1991 (STATED IN THOUSANDS OF DOLLARS) S-30 SAVANNAH ELECTRIC AND POWER COMPANY SCHEDULE VI --ACCUMULATED PROVISION FOR DEPRECIATION OF UTILITY PLANT FOR THE YEAR ENDED DECEMBER 31, 1993 (STATED IN THOUSANDS OF DOLLARS) See Notes on Page S-34 S-31 SAVANNAH ELECTRIC AND POWER COMPANY SCHEDULE VI -- ACCUMULATED PROVISION FOR DEPRECIATION OF UTILITY PLANT FOR THE YEAR ENDED DECEMBER 31, 1992 (STATED IN THOUSANDS OF DOLLARS) See Notes on Page S-34 S-32 SAVANNAH ELECTRIC AND POWER COMPANY SCHEDULE VI -- ACCUMULATED PROVISION FOR DEPRECIATION OF UTILITY PLANT FOR THE YEAR ENDED DECEMBER 31, 1991 (STATED IN THOUSANDS OF DOLLARS) See Notes on Page S-34 S-33 SAVANNAH ELECTRIC AND POWER COMPANY NOTES TO SCHEDULE VI -- ACCUMULATED PROVISION FOR DEPRECIATION OF UTILITY PLANT FOR THE YEARS ENDING DECEMBER 31, 1993, 1992 AND 1991 (STATED IN THOUSANDS OF DOLLARS) S-34 THE SOUTHERN COMPANY AND SUBSIDIARY COMPANIES SCHEDULE VIII - VALUATION AND QUALIFYING ACCOUNTS AND RESERVES FOR THE YEAR ENDED DECEMBER 31, 1993 (Stated in Thousands of Dollars) - ------------------------- Notes: (1) Represents write-off of accounts considered to be uncollectible, less recoveries of amounts previously written off. (2) Insurance recoveries net of charges to reserve for purposes for which reserve was created. (3) See Note 1 to SOUTHERN's financial statements under "Nuclear Decommissioning" in Item 8 herein for further information. (4) Represents additional funding to reserve. (5) See Note 1 to SOUTHERN's financial statements under "Revenues and Fuel Costs" in Item 8 herein for further information. S-35 THE SOUTHERN COMPANY AND SUBSIDIARY COMPANIES SCHEDULE VIII - VALUATION AND QUALIFYING ACCOUNTS AND RESERVES FOR THE YEAR ENDED DECEMBER 31, 1992 (Stated in Thousands of Dollars) - ----------------------------- Notes: (1) Represents write-off of accounts considered to be uncollectible, less recoveries of amounts previously written off. (2) See Note 1 to SOUTHERN's financial statements under "Depreciation and Nuclear Decommissioning" in Item 8 herein for further information. (3) See Note 1 to SOUTHERN's financial statements under "Revenues and Fuel Costs" in Item 8 herein for further information. (4) Capitalized. S-36 THE SOUTHERN COMPANY AND SUBSIDIARY COMPANIES SCHEDULE VIII--VALUATION AND QUALIFYING ACCOUNTS AND RESERVES FOR THE YEAR ENDED DECEMBER 31, 1991 (Stated in Thousands of Dollars) - ------------------ Notes: (1) See Note 8 to SOUTHERN's financial statements in Item 8 herein for a description of the Gulf States settlement. (2) Represents write-off of accounts considered to be uncollectible, less recoveries of amounts previously written off. (3) Insurance recoveries net of charges to reserve for purposes for which reserve was created. (4) See Note 1 to SOUTHERN's financial statements under "Depreciation and Nuclear Decommissioning" in Item 8 herein for further information. S-37 ALABAMA POWER COMPANY SCHEDULE VIII - VALUATION AND QUALIFYING ACCOUNTS AND RESERVES FOR THE YEAR ENDED DECEMBER 31, 1993 (Stated in Thousands of Dollars) - ------------------ Notes: (1) Represents write-off of accounts considered to be uncollectible, less recoveries of amounts previously written off. (2) See Note 1 to ALABAMA's financial statements under "Depreciation and Nuclear Decommissioning" in Item 8 herein for further information. (3) Represents additional funding to reserve. (4) See Note 1 to ALABAMA's financial statements under "Revenues and Fuel Costs" in Item 8 herein for further information. S-38 ALABAMA POWER COMPANY SCHEDULE VIII - VALUATION AND QUALIFYING ACCOUNTS AND RESERVES FOR THE YEAR ENDED DECEMBER 31, 1992 (Stated in Thousands of Dollars) - ----------------------------- Notes: (1) Represents write-off of accounts considered to be uncollectible, less recoveries of amounts previously written off. (2) See Note 1 to ALABAMA's financial statements under "Depreciation and Nuclear Decommissioning" in Item 8 herein for further information. (3) See Note 1 to ALABAMA's financial statements under "Revenues and Fuel Costs" in Item 8 herein for further Information. S-39 ALABAMA POWER COMPANY SCHEDULE VIII - VALUATION AND QUALIFYING ACCOUNTS AND RESERVES FOR THE YEAR ENDED DECEMBER 31, 1991 (Stated in Thousands of Dollars) - ----------------------- Notes: (1) See Note 7 to the financial statements in Item 8 herein for a description of the Gulf States settlement. The provision for uncollectible was reversed. (2) Represents write-off of accounts considered to be uncollectible, less recoveries of amounts previously written off. (3) See Note 1 to ALABAMA's financial statements under "Depreciation and Nuclear Decommissioning" in Item 8 herein for further information. S-40 GEORGIA POWER COMPANY SCHEDULE VIII - VALUATION AND QUALIFYING ACCOUNTS AND RESERVES FOR THE YEAR ENDED DECEMBER 31, 1993 (Stated in Thousands of Dollars) - -------------------- Notes: (1) Represents write-off of accounts considered to be uncollectible, less recoveries of amounts previously written off. (2) See Note 1 to GEORGIA's financial statements under "Nuclear Decommissioning" in Item 8 herein for further information. (3) Represents additional funding to reserve. (4) See Note 1 to GEORGIA's financial statements under "Revenues and Fuel Costs" in Item 8 herein for further information. S-41 GEORGIA POWER COMPANY SCHEDULE VIII - VALUATION AND QUALIFYING ACCOUNTS AND RESERVES FOR THE YEAR ENDED DECEMBER 31, 1992 (Stated in Thousands of Dollars) - ----------------------- Notes: (1) Represents write-off of accounts considered to be uncollectible, less recoveries of amounts previously written off. (2) See Note 1 to GEORGIA's financial statements under "Nuclear Decommissioning" in Item 8 herein for further information. (3) See Note 1 to GEORGIA's financial statements under "Revenues and Fuel Costs" in Item 8 herein for further information. S-42 GEORGIA POWER COMPANY SCHEDULE VIII - VALUATION AND QUALIFYING ACCOUNTS AND RESERVES FOR THE YEAR ENDED DECEMBER 31, 1991 (Stated in Thousands of Dollars) - ------------------ Note: (1) See Note 3 to GEORGIA's financial statements in Item 8 herein for a description of the Gulf States settlement. The provision for uncollectible accounts was reversed. (2) Represents write-off of accounts considered to be uncollectible, less recoveries of amounts previously written off. (3) See Note 1 to GEORGIA's financial statements under "Nuclear Decommissioning" in Item 8 herein for further information. S-43 GULF POWER COMPANY SCHEDULE VIII - VALUATION AND QUALIFYING ACCOUNTS AND RESERVES FOR THE YEAR ENDED DECEMBER 31, 1993 (Stated in Thousands of Dollars) - --------------- Note: Represents write-off of accounts considered to be uncollectible, less recoveries of amounts previously written off. S-44 GULF POWER COMPANY SCHEDULE VIII - VALUATION AND QUALIFYING ACCOUNTS AND RESERVES FOR THE YEAR ENDED DECEMBER 31, 1992 (Stated in Thousands of Dollars) - -------------------- Note: Represents write-off of accounts considered to be uncollectible, less recoveries of amounts previously written off. S-45 GULF POWER COMPANY SCHEDULE VIII - VALUATION AND QUALIFYING ACCOUNTS AND RESERVES FOR THE YEAR ENDED DECEMBER 31, 1991 (Stated in Thousands of Dollars) - ------------------ Notes: (1) See Note 7 to GULF's financial statements in Item 8 herein for a description of the Gulf States settlement. The provision for uncollectible was reversed. (2) Represents write-off of accounts considered to be uncollectible, less recoveries of amounts previously written off. S-46 MISSISSIPPI POWER COMPANY SCHEDULE VIII - VALUATION AND QUALIFYING ACCOUNTS AND RESERVES FOR THE YEAR ENDED DECEMBER 31, 1993 (Stated in Thousands of Dollars) - --------------- Note: Represents write-off of accounts considered to be uncollectible, less recoveries of amounts previously written off. S-47 MISSISSIPPI POWER COMPANY SCHEDULE VIII - VALUATION AND QUALIFYING ACCOUNTS AND RESERVES FOR THE YEAR ENDED DECEMBER 31, 1992 (Stated in Thousands of Dollars) - ------------------ Note: Represents write-off of accounts considered to be uncollectible, less recoveries of amounts previously written off. S-48 MISSISSIPPI POWER COMPANY SCHEDULE VIII - VALUATION AND QUALIFYING ACCOUNTS AND RESERVES FOR THE YEAR ENDED DECEMBER 31, 1991 (Stated in thousands of Dollars) - ----------------- Notes: (1) See Note 7 to MISSISSIPPI's financial statements in Item 8 herein for a description of the Gulf States settlement. The provision for uncollectible was reversed. (2) Represents write-off of accounts considered to be uncollectible, less recoveries of amounts previously written off. S-49 SAVANNAH ELECTRIC AND POWER COMPANY SCHEDULE VIII - VALUATION AND QUALIFYING ACCOUNTS AND RESERVES FOR THE YEAR ENDED DECEMBER 31, 1993 (Stated in Thousands of Dollars) - -------------------------- Note: Represents write-off of accounts receivable considered to be uncollectible, less recoveries of amounts previously written off. S-50 SAVANNAH ELECTRIC AND POWER COMPANY SCHEDULE VIII - VALUATION AND QUALIFYING ACCOUNTS AND RESERVES FOR THE YEAR ENDED DECEMBER 31, 1992 (Stated in Thousands of Dollars) - ---------------------- Note: Represents write-off of accounts receivable considered to be uncollectible, less recoveries of amounts previously written off. S-51 SAVANNAH ELECTRIC AND POWER COMPANY SCHEDULE VIII - VALUATION AND QUALIFYING ACCOUNTS AND RESERVES FOR THE YEAR ENDED DECEMBER 31, 1991 (Stated in Thousands of Dollars) Note: Represents write-off of accounts receivable considered to be uncollectible, less recoveries of amounts previously written off. S-52 THE SOUTHERN COMPANY AND SUBSIDIARY COMPANIES SCHEDULE IX - SHORT-TERM BORROWINGS DECEMBER 31, 1993, 1992 AND 1991 (Stated in Thousands of Dollars) - ---------------------- Notes: (1) At month-end. (2) Average based on daily borrowings during period (averages and rates quoted on an actual day year basis). (3) This note payable is an obligation of SEI and does not include borrowings from SOUTHERN. (4) See Note 5 to SOUTHERN's financial statements in Item 8 herein for details regarding SOUTHERN's and its subsidiaries lines of credit and general terms of commitment agreements. S-53 ALABAMA POWER COMPANY SCHEDULE IX - SHORT -TERM BORROWINGS DECEMBER 31, 1993, 1992, 1991 (Stated in Thousands of Dollars) - ----------------- Notes: (1) At month-end. (2) Average based on daily borrowings during the period (averages and rates quoted on an actual day year basis). (3) ALABAMA also issued commercial paper during 1993, although none was outstanding at year-end. The data shown reflects the issuance of commercial paper. (4) See Note 5 to ALABAMA's financial statements in Item 8 herein for details regarding ALABAMA's lines of credit. S-54 GEORGIA POWER COMPANY SCHEDULE IX - SHORT -TERM BORROWINGS DECEMBER 31, 1993, 1992 AND 1991 (Stated in Thousands of Dollars) - -------------------- Notes: (1) At month-end (2) Average based on daily borrowings during period (averages and rates quoted on an actual day year basis). (3) See Note 8 to GEORGIA's financial statements in Item 8 herein for details regarding GEORGIA's lines of credit and general terms of its commitment agreements. S-55 GULF POWER COMPANY SCHEDULE IX - SHORT -TERM BORROWINGS DECEMBER 31, 1993, 1992 AND 1991 (Stated in Thousands of Dollars) - ---------------------- Notes: (1) At month-end (2) Average based on daily borrowings during period (averages and rates quoted on an actual day year basis). (3) See Note 5 to GULF's financial statements in Item 8 herein for a description of this short-term indebtedness. (4) See Note 5 to GULF's financial statements in Item 8 herein for details regarding GULF's lines of credit and general terms of its commitment agreements. S-56 MISSISSIPPI POWER COMPANY SCHEDULE IX - SHORT -TERM BORROWINGS DECEMBER 31, 1993, 1992 AND 1991 (Stated in Thousands of Dollars) - ---------------------- Notes: (1) At month-end (2) Average based on daily borrowings during period (averages and rates quoted on an actual day year basis). (3) See Note 5 to MISSISSIPPI's financial statements in Item 8 herein for details regarding MISSISSIPPI's lines of credit and general terms of its commitment agreements. S-57 SAVANNAH ELECTRIC AND POWER COMPANY SCHEDULE IX - SHORT -TERM BORROWINGS DECEMBER 31, 1993, 1992 AND 1991 (Stated in Thousands of Dollars) Notes: (1) At month-end (2) Average based on daily borrowings during period (averages and rates quoted on an actual day year basis). (3) See Note 5 to SAVANNAH's financial statements in Item 8 herein for details regarding SAVANNAH's lines of credit and general terms of its commitment agreements. S-58 THE SOUTHERN COMPANY AND SUBSIDIARY COMPANIES SCHEDULE X - SUPPLEMENTARY INCOME STATEMENT INFORMATION DECEMBER 31, 1993, 1992 AND 1991 (Thousands of Dollars) S-59 ALABAMA POWER COMPANY SCHEDULE X - SUPPLEMENTARY INCOME STATEMENT INFORMATION DECEMBER 31, 1993, 1992 AND 1991 (Thousands of Dollars) S-60 GEORGIA POWER COMPANY SCHEDULE X - SUPPLEMENTARY INCOME STATEMENT INFORMATION DECEMBER 31, 1993, 1992 AND 1991 (Thousands of Dollars) S-61 GULF POWER COMPANY SCHEDULE X - SUPPLEMENTARY INCOME STATEMENT INFORMATION DECEMBER 31, 1993, 1992 AND 1991 (Thousands of Dollars) S-62 MISSISSIPPI POWER COMPANY SCHEDULE X - SUPPLEMENTARY INCOME STATEMENT INFORMATION DECEMBER 31, 1993, 1992 AND 1991 (Thousands of Dollars) S-63 SAVANNAH ELECTRIC AND POWER COMPANY SCHEDULE X - SUPPLEMENTARY INCOME STATEMENT INFORMATION DECEMBER 31, 1993, 1992 AND 1991 (Thousands of Dollars) S-64 EXHIBIT INDEX The following exhibits indicated by an asterisk preceding the exhibit number are filed herewith. The balance of the exhibits have heretofore been filed with the SEC, respectively, as the exhibits and in the file numbers indicated and are incorporated herein by reference. Reference is made to a duplicate list of exhibits being filed as a part of this Form 10-K, which list, prepared in accordance with Item 601 of Regulation S-K of the SEC, immediately precedes the exhibits being physically filed with this Form 10-K. (3) ARTICLES OF INCORPORATION AND BY-LAWS SOUTHERN (a) 1 - Composite Certificate of Incorporation of SOUTHERN, reflecting all amendments to date. (Designated in Registration No. 33-3546 as Exhibit 4(a), in Certificate of Notification, File No. 70-7341, as Exhibit A and in Certificate of Notification, File No. 70-8181, as Exhibit A.) (a) 2 - By-laws of SOUTHERN as amended effective October 21, 1991, and as presently in effect. (Designated in Form U-1, File No. 70-8181 as Exhibit A-2.) ALABAMA (b) 1 - Charter of ALABAMA and amendments thereto through November 19, 1993. (Designated in Registration Nos. 2-59634 as Exhibit 2(b), 2-60209 as Exhibit 2(c), 2-60484 as Exhibit 2(b), 2-70838 as Exhibit 4(a)-2, 2-85987 as Exhibit 4(a)-2, 33-25539 as Exhibit 4(a)-2, 33-43917 as Exhibit 4(a)-2, in Form 8-K dated February 5, 1992, File No. 1-3164, as Exhibit 4(b)-3, in Form 8-K dated July 8, 1992, File No. 1-3164, as Exhibit 4(b)-3, in Form 8-K dated October 27, 1993, File No. 1-3164, as Exhibits 4(a) and 4(b) and in Form 8-K dated November 16, 1993, File No. 1-3164, as Exhibit 4(a).) (b) 2 - By-laws of ALABAMA as amended effective April 24, 1992, and as presently in effect. (Designated in Registration No. 33-48885 as Exhibit 4(c).) GEORGIA (c) 1 - Charter of GEORGIA and amendments thereto through October 25, 1993. (Designated in Registration Nos. 2-63392 as Exhibit 2(a)-2, 2-78913 as Exhibits 4(a)-(2) and 4(a)-(3), 2-93039 as Exhibit 4(a)-(2), 2-96810 as Exhibit 4(a)-2, 33-141 as Exhibit 4(a)-(2), 33-1359 as Exhibit 4(a)(2), 33-5405 as Exhibit 4(b)(2), 33-14367 as Exhibits 4(b)-(2) and 4(b)-(3), 33-22504 as Exhibits 4(b)-(2), 4(b)-(3) and 4(b)-(4), in GEORGIA's Form 10-K for the year ended December 31, 1991, File No. 1-6468, as Exhibits 4(a)(2) and 4(a)(3), in Registration No. 33-48895 as Exhibits 4(b)-(2) and 4(b)-(3), in Form 8-K dated December 10, 1992, File No. 1-6468 as Exhibit 4(b), in Form 8-K dated June 17, 1993, File No. 1-6468, as Exhibit 4(b) and in Form 8-K dated October 20, 1993, File No. 1-6468, as Exhibit 4(b).) E-1 (c) 2 - By-laws of GEORGIA as amended effective July 18, 1990, and as presently in effect. (Designated in GEORGIA's Form 10-K for the year ended December 31, 1990, File No.1-6468, as Exhibit 3.) GULF (d) 1 - Restated Articles of Incorporation of GULF and amendments thereto through November 8, 1993. (Designated in Registration No. 33-43739 as Exhibit 4(b)-1, in Form 8-K dated January 15, 1992, File No. 0-2429, as Exhibit 1(b), in Form 8-K dated August 18, 1992, File No. 0-2429, as Exhibit 4(b)-2, in Form 8-K dated September 22, 1993, File No. 0-2429, as Exhibit 4 and in Form 8-K dated November 3, 1993, File No. 0-2429, as Exhibit 4.) *(d) 2 - By-laws of GULF as amended effective February 25, 1994, and as presently in effect. MISSISSIPPI (e) 1 - Articles of incorporation of MISSISSIPPI, articles of merger of Mississippi Power Company (a Maine corporation) into MISSISSIPPI and articles of amendment to the articles of incorporation of MISSISSIPPI through August 19, 1993. (Designated in Registration No. 2-71540 as Exhibit 4(a)-1, in Form U5S for 1987, File No. 30-222-2, as Exhibit B-10, in Registration No. 33-49320 as Exhibit 4(b)-(1), in Form 8-K dated August 5, 1992, File No. 0-6849, as Exhibits 4(b)-2 and 4(b)-3, in Form 8-K dated August 4, 1993, File No. 0-6849, as Exhibit 4(b)-3 and in Form 8-K dated August 18, 1993, File No. 0-6849, as Exhibit 4(b)-3.) (e) 2 - By-laws of MISSISSIPPI as amended effective August 22, 1989, and as presently in effect. (Designated in MISSISSIPPI's Form 10-K for the year ended December 31, 1989, as Exhibit 3(b).) SAVANNAH (f) 1 - Charter of SAVANNAH and amendments thereto through November 10, 1993. (Designated in Registration Nos. 33-25183 as Exhibit 4(b)-(1), 33-45757 as Exhibit 4(b)-(2) and in Form 8-K dated November 9, 1993, File No. 1-5072, as Exhibit 4(b).) *(f) 2 - By-laws of SAVANNAH as amended effective February 16, 1994, and as presently in effect. (4) INSTRUMENTS DESCRIBING RIGHTS OF SECURITY HOLDERS, INCLUDING INDENTURES ALABAMA (b) - Indenture dated as of January 1, 1942, between ALABAMA and Chemical Bank, as Trustee, and indentures supplemental thereto through that dated as of January 1, 1994. (Designated in Registration Nos. 2-59843 as Exhibit 2(a)-2, 2-60484 as Exhibits 2(a)-3 and 2(a)-4, 2-60716 as Exhibit 2(c), 2-67574 as E-2 Exhibit 2(c), 2-68687 as Exhibit 2(c), 2-69599 as Exhibit 4(a)-2, 2-71364 as Exhibit 4(a)-2, 2- 73727 as Exhibit 4(a)-2, 33-5079 as Exhibit 4(a)-2, 33-17083 as Exhibit 4(a)-2, 33-22090 as Exhibit 4(a)-2, in ALABAMA's Form 10-K for the year ended December 31, 1990, File No. 1-3164, as Exhibit 4(c), in Registration Nos. 33-43917 as Exhibit 4(a)-2, 33-45492 as Exhibit 4(a)-2, 33- 48885 as Exhibit 4(a)-2, 33-48917 as Exhibit 4(a)-2, in Form 8-K dated January 20, 1993, File No. 1-3436, as Exhibit 4(a)-3, in Form 8-K dated February 17, 1993, File No.1-3436, as Exhibit 4(a)-3, in Form 8-K dated March 10, 1993, File No. 1-3436, as Exhibit 4(a)-3, in Certificate of Notification, File No. 70-8069, as Exhibits A and B, in Form 8-K dated June 24, 1993, File No. 1- 3436, as Exhibit 4, in Certificate of Notification, File No. 70-8069, as Exhibit A, in Form 8-K dated November 16, 1993, File No. 1-3436, as Exhibit 4(b) and in Certificate of Notification, File No. 70-8069, as Exhibits A and B.) GEORGIA (d) - Indenture dated as of March 1, 1941, between GEORGIA and Chemical Bank, as Trustee, and indentures supplemental thereto dated as of March 1, 1941, March 3, 1941 (3 indentures), March 6, 1941 (139 indentures), March 1, 1946 (88 indentures) and December 1, 1947, through January 1, 1994. (Designated in Registration Nos. 2-4663 as Exhibits B-3 and B-3(a), 2-7299 as Exhibit 7(a)-2, 2- 61116 as Exhibit 2(a)-3 and 2(a)-4, 2-62488 as Exhibit 2(a)-3, 2-63393 as Exhibit 2(a)-4, 2-63705 as Exhibit 2(a)-3, 2-68973 as Exhibit 2(a)-3, 2-70679 as Exhibit 4(a)-(2), 2-72324 as Exhibit 4(a)-2, 2-73987 as Exhibit 4(a)-(2), 2-77941 as Exhibits 4(a)-(2) and 4(a)-(3), 2-79336 as Exhibit 4(a)-(2), 2-81303 as Exhibit 4(a)-(2), 2-90105 as Exhibit 4(a)-(2), 33-5405 as Exhibit 4(a)-(2), 33-14367 as Exhibits 4(a)-(2) and 4(a)-(3), 33-22504 as Exhibits 4(a)-(2), 4(a)-(3) and 4(a)-(4), 33-32420 as Exhibit 4(a)-(2), 33-35683 as Exhibit 4(a)-(2), in GEORGIA's Form 10-K for the year ended December 31, 1990, File No. 1-6468, as Exhibit 4(a)(3), in Form 10-K for the year ended December 31, 1991, File No. 1-6468, as Exhibit 4(a)(5), in Registration No. 33-48895 as Exhibit 4(a)-(2), in Form 8-K dated August 26, 1992, File No. 1-6468, as Exhibit 4(a)-(3), in Form 8-K dated September 9, 1992, File No. 1-6468, as Exhibits 4(a)-(3) and 4(a)-(4), in Form 8-K dated September 23, 1992, File No. 1-6468, as Exhibit 4(a)-(3), in Form 8-A dated October 12, 1992, as Exhibit 2(b), in Form 8-K dated January 27, 1993, File No. 1-6468, as Exhibit 4(a)-(3), in Registration No. 33-49661 as Exhibit 4(a)-(2), in Form 8-K dated July 26, 1993, File No. 1-6468, as Exhibit 4, in Certificate of Notification, File No. 70-7832, as Exhibit M and in Certificate of Notification, File No. 70-7832, as Exhibit C.) GULF (e) - Indenture dated as of September 1, 1941, between GULF and The Chase Manhattan Bank (National Association) and The Citizens & Peoples National Bank of Pensacola, as Trustees, and indentures supplemental thereto through E-3 November 1, 1993. (Designated in Registration Nos. 2-4833 as Exhibit B-3, 2-62319 as Exhibit 2(a)-3, 2-63765 as Exhibit 2(a)-3, 2-66260 as Exhibit 2(a)-3, 33-2809 as Exhibit 4(a)-2, 33-43739 as Exhibit 4(a)-2, in GULF's Form 10-K for the year ended December 31, 1991, File No. 0-2429, as Exhibit 4(b), in Form 8-K dated August 18, 1992, File No. 0-2429, as Exhibit 4(a)-3, in Registration No. 33-50165 as Exhibit 4(a)-2, in Form 8-K dated July 12, 1993, File No. 0-2429, as Exhibit 4 and in Certificate of Notification, File No. 70-8229, as Exhibit A.) MISSISSIPPI (f) - Indenture dated as of September 1, 1941, between MISSISSIPPI and Morgan Guaranty Trust Company of New York, as Trustee, and indentures supplemental thereto through November 1, 1993. (Designated in Registration Nos. 2-4834 as Exhibit B-3, 2-62965 as Exhibit 2(b)-2, 2-66845 as Exhibit 2(b)-2, 2-71537 as Exhibit 4(a)-(2), 33-5414 as Exhibit 4(a)-(2), 33-39833 as Exhibit 4(a)-2, in MISSISSIPPI's Form 10-K for the year ended December 31, 1991, File No. 0-6849, as Exhibit 4(b), in Form 8-K dated August 5, 1992, File No. 0-6849, as Exhibit 4(a)-2, in Second Certificate of Notification, File No. 70-7941, as Exhibit I, in MISSISSIPPI's Form 8-K dated February 26, 1993, File No. 0-6849, as Exhibit 4(a)-2, in Certificate of Notification, File No. 70-8127, as Exhibit A, in Form 8-K dated June 22, 1993, File No. 0-6849, as Exhibit 1 and in Certificate of Notification, File No. 70-8127, as Exhibit A.) SAVANNAH (g) - Indenture dated as of March 1, 1945, between SAVANNAH and NationsBank of Georgia, National Association, as Trustee, and indentures supplemental thereto through July 1, 1993. (Designated in Registration Nos. 33-25183 as Exhibit 4(a)-(1), 33-41496 as Exhibit 4(a)-(2), 33-45757 as Exhibit 4(a)-(2), in SAVANNAH's Form 10-K for the year ended December 31, 1991, File No. 1-5072, as Exhibit 4(b), in Form 8-K dated July 8, 1992, File No. 1-5072, as Exhibit 4(a)-3, in Registration No. 33-50587 as Exhibit 4(a)-(2) and in Form 8-K dated July 22, 1993, File No. 1-5072, as Exhibit 4.) (10) MATERIAL CONTRACTS SOUTHERN (a) 1 - Service contracts dated as of January 1, 1984 and Amendment No. 1 dated as of September 6, 1985, between SCS and ALABAMA, GEORGIA, GULF, MISSISSIPPI, SEGCO and SOUTHERN. (Designated in SOUTHERN's Form 10-K for the year ended December 31, 1984, File No. 1-3526, as Exhibit 10(a) and in SOUTHERN's Form 10-K for the year ended December 31, 1985, File No. 1-3526, as Exhibit 10(a)(3).) (a) 2 - Service contract dated as of July 17, 1981, between SCS and SEI. (Designated in SOUTHERN's Form 10-K for the year ended December 31, 1985, File No. 1-3526, as Exhibit 10(a)(2).) E-4 (a) 3 - Service contract dated as of March 3, 1988, between SCS and SAVANNAH. (Designated in SAVANNAH's Form 10-K for the year ended December 31, 1987, File No. 1-5072, as Exhibit 10-p.) (a) 4 - Service contract dated as of January 15, 1991, between SCS and Southern Nuclear. (Designated in SOUTHERN's Form 10-K for the year ended December 31, 1991, File No. 1-3526, as Exhibit 10(a)(4).) (a) 5 - Interchange contract dated October 28, 1988, effective January 1, 1989, between ALABAMA, GEORGIA, GULF, MISSISSIPPI, SAVANNAH and SCS. (Designated in SAVANNAH's Form 10-K for the year ended December 31, 1988, File No. 1-5072, as Exhibit 10(b).) (a) 6 - Agreement dated as of January 27, 1959 and Amendment No. 1 dated as of October 27, 1982, among SEGCO, ALABAMA and GEORGIA. (Designated in Registration No. 2-59634 as Exhibit 5(c) and in GEORGIA's Form 10-K for the year ended December 31, 1982, File No. 1-6468, as Exhibit 10(d)(2).) (a) 7 - Joint Committee Agreement dated as of August 27, 1976, among GEORGIA, OPC, MEAG and Dalton. (Designated in Registration No. 2-61116 as Exhibit 5(d).) (a) 8 - Edwin I. Hatch Nuclear Plant Purchase and Ownership Participation Agreement dated as of January 6, 1975, between GEORGIA and OPC. (Designated in Form 8-K for January, 1975, File No. 1-6468, as Exhibit (b)(1).) (a) 9 - Edwin I. Hatch Nuclear Plant Operating Agreement dated as of January 6, 1975, between GEORGIA and OPC. (Designated in Form 8-K for January, 1975, File No. 1-6468, as Exhibit (b)(3).) (a) 10 - Revised and Restated Integrated Transmission System Agreement dated as of November 12, 1990, between GEORGIA and OPC. (Designated in GEORGIA's Form 10-K for the year ended December 31, 1990, File No. 1-6468, as Exhibit 10(g).) (a) 11 - Plant Hal Wansley Purchase and Ownership Participation Agreement dated as of March 26, 1976, between GEORGIA and OPC. (Designated in Certificate of Notification, File No. 70-5592, as Exhibit A.) (a) 12 - Plant Hal Wansley Operating Agreement dated as of March 26, 1976, between GEORGIA and OPC. (Designated in Certificate of Notification, File No. 70-5592, as Exhibit B.) (a) 13 - Edwin I. Hatch Nuclear Plant Purchase and Ownership Participation Agreement dated as of August 27, 1976, between GEORGIA, MEAG and Dalton. (Designated in Form 8-K dated as of June 13, 1977, File No. 1-6468, as Exhibit (b)(1).) E-5 (a) 14 - Edwin I. Hatch Nuclear Plant Operating Agreement dated as of August 27, 1976, between GEORGIA, MEAG and Dalton. (Designated in Form 8-K for February, 1977, File No. 1-6468, as Exhibit (b)(2).) (a) 15 - Alvin W. Vogtle Nuclear Units Number One and Two Purchase and Ownership Participation Agreement dated as of August 27, 1976 and Amendment No. 1 dated as of January 18, 1977, among GEORGIA, OPC, MEAG and Dalton. (Designated in Form U-1, File No. 70-5792, as Exhibit B-1 and in Form 8-K for January 1977, File No. 1-6468, as Exhibit (B)(3).) (a) 16 - Alvin W. Vogtle Nuclear Units Number One and Two Operating Agreement dated as of August 27, 1976, among GEORGIA, OPC, MEAG and Dalton. (Designated in Form U-1, File No. 70-5792, as Exhibit B-2.) (a) 17 - Alvin W. Vogtle Nuclear Units Number One and Two Purchase, Amendment, Assignment and Assumption Agreement dated as of November 16, 1983, between GEORGIA and MEAG. (Designated in GEORGIA's Form 10-K for the year ended December 31, 1983, File No. 1-6468, as Exhibit 10(k)(4).) (a) 18 - Plant Hal Wansley Purchase and Ownership Participation Agreement dated as of August 27, 1976, between GEORGIA and MEAG. (Designated in Form 8-K dated as of July 5, 1977, File No. 1-6468, as Exhibit (b)(2).) (a) 19 - Plant Hal Wansley Operating Agreement dated as of August 27, 1976, between GEORGIA and MEAG. (Designated in Form 8-K dated as of July 5, 1977, File No. 1-6468, as Exhibit (b)(4).) (a) 20 - Integrated Transmission System Agreement dated as of August 27, 1976, between GEORGIA and Dalton. (Designated in Form 8-K dated as of July 5, 1977, File No. 1-6468, as Exhibit (b)(8).) (a) 21 - Integrated Transmission System Agreement dated as of August 27, 1976, between GEORGIA and MEAG. (Designated in Form 8-K for February, 1977, File No. 1-6468, as Exhibit (b)(4).) (a) 22 - Plant Hal Wansley Purchase and Ownership Participation Agreement dated as of April 19, 1977, between GEORGIA and Dalton. (Designated in Form 8-K dated as of June 13, 1977, File No. 1-6468, as Exhibit (b)(3).) (a) 23 - Plant Hal Wansley Operating Agreement dated as of April 19, 1977, between GEORGIA and Dalton. (Designated in Form 8-K dated as of June 13, 1977, File No. 1-6468, as Exhibit (b)(7).) (a) 24 - Plant Robert W. Scherer Units Number One and Two Purchase and Ownership Participation Agreement dated as of May 15, 1980, Amendment No. 1 dated as of December 30, 1985, Amendment No. 2 dated as of July 1, 1986 and Amendment No. 3 dated as of August 1, 1988, among GEORGIA, OPC, MEAG and Dalton. (Designated in Form U-1, File No. 70-6481, as Exhibit B-3, in SOUTHERN's Form 10-K for the year ended December 31, 1987, File E-6 No. 1-3526, as Exhibit 10(o)(2) and in SOUTHERN's Form 10-K for the year ended December 31, 1989, File No. 1-3526, as Exhibit 10(n)(2).) (a) 25 - Plant Robert W. Scherer Units Number One and Two Operating Agreement dated as of May 15, 1980 and Amendment No. 1 dated as of December 3, 1985, among GEORGIA, OPC, MEAG and Dalton. (Designated in Form U-1, File No. 70-6481, as Exhibit B-4 and in SOUTHERN's Form 10-K for the year ended December 31, 1987, File No. 1-3526, as Exhibit 10(o)(4).) (a) 26 - Plant Robert W. Scherer Purchase, Sale and Option Agreement dated as of May 15, 1980, between GEORGIA and MEAG. (Designated in Form U-1, File No. 70-6481, as Exhibit B-1.) (a) 27 - Plant Robert W. Scherer Purchase and Sale Agreement dated as of May 16, 1980, between GEORGIA and Dalton. (Designated in Form U-1, File No. 70-6481, as Exhibit B-2.) (a) 28 - Plant Robert W. Scherer Unit Number Three Purchase and Ownership Participation Agreement dated as of March 1, 1984, Amendment No. 1 dated as of July 1, 1986 and Amendment No. 2 dated as of August 1, 1988, between GEORGIA and GULF. (Designated in Form U-1, File No. 70-6573, as Exhibit B-4, in SOUTHERN's Form 10-K for the year ended December 31, 1987, as Exhibit 10(o)(2) and in SOUTHERN's Form 10-K for the year ended December 31, 1989, as Exhibit 10(n)(2).) (a) 29 - Plant Robert W. Scherer Unit Number Three Operating Agreement dated as of March 1, 1984, between GEORGIA and GULF. (Designated in Form U-1, File No. 70-6573, as Exhibit B-5.) (a) 30 - Plant Robert W. Scherer Unit No. Four Amended and Restated Purchase and Ownership Participation Agreement by and among GEORGIA, FP&L and JEA, dated as of December 31, 1990. (Designated in Form U-1, File No. 70-7843, as Exhibit B-1.) (a) 31 - Plant Robert W. Scherer Unit No. Four Operating Agreement by and among GEORGIA, FP&L and JEA, dated as of December 31, 1990. (Designated in Form U-1, File No. 70-7843, as Exhibit B-2.) (a) 32 - Amended and Restated Unit Power Sales Agreement dated February 18, 1982 and Amendment No. 1 dated May 18, 1982, between FP&L and ALABAMA, GEORGIA, GULF, MISSISSIPPI and SCS. (Designated in MISSISSIPPI's Form 10-K for the year ended December 31, 1981, File No. 0-6849, as Exhibit 10(c)(2) and in GEORGIA's Form 10-K for the year ended December 31, 1982, File No. 1-6468, as Exhibit 10(r)(3).) (a) 33 - Amended and Restated Unit Power Sales Agreement dated May 19, 1982, Amendment No. 1 dated August 30, 1984 and Amendment No. 2 dated October 30, 1987, between JEA and ALABAMA, GEORGIA, GULF, MISSISSIPPI and SCS. (Designated in GEORGIA's Form 10-K for the year E-7 ended December 31, 1982, File No. 1-6468, as Exhibit 10(s)(2), in SOUTHERN's Form 10-K for the year ended December 31, 1984, File No. 1-3526, as Exhibit 10(r)(2) and in GEORGIA's Form 10-K for the year ended December 31, 1990, File No. 1-6468 as Exhibit 10(s)(2).) (a) 34 - Unit Power Sales Agreement dated July 19, 1988, between FPC and ALABAMA, GEORGIA, GULF, MISSISSIPPI, SAVANNAH and SCS. (Designated in SAVANNAH's Form 10-K for the year ended December 31, 1988, File No. 1-5072, as Exhibit 10(d).) (a) 35 - Amended Unit Power Sales Agreement dated July 20, 1988, between FP&L and ALABAMA, GEORGIA, GULF, MISSISSIPPI, SAVANNAH and SCS. (Designated in SAVANNAH's Form 10-K for the year ended December 31, 1988, File No. 1-5072, as Exhibit 10(e).) (a) 36 - Amended Unit Power Sales Agreement dated August 17, 1988, between JEA and ALABAMA, GEORGIA, GULF, MISSISSIPPI, SAVANNAH and SCS. (Designated in SAVANNAH's Form 10-K for the year ended December 31, 1988, File No. 1-5072, as Exhibit 10(f).) (a) 37 - Unit Power Sales Agreement dated December 8, 1990, between Tallahassee and ALABAMA, GEORGIA, GULF, MISSISSIPPI, SAVANNAH and SCS. (Designated in GEORGIA's Form 10-K for the year ended December 31, 1990, File No. 1-6468, as Exhibit 10(x).) (a) 38 - The Southern Company Executive Stock Plan For the Southern Electric System and the First Amendment thereto. (Designated in Registration No. 33-30171 as Exhibit 4(c).) (a) 39 - Transition Energy Agreement dated December 31, 1990, between JEA and ALABAMA, GEORGIA, GULF, MISSISSIPPI, SAVANNAH and SCS. (Designated in GULF's Form 10-K for the year ended December 31, 1991, File No. 0-2429, as Exhibit 10(1).) (a) 40 - Transition Energy Agreement dated December 31, 1990, between FP&L and ALABAMA, GEORGIA, GULF, MISSISSIPPI, SAVANNAH and SCS. (Designated in GULF's Form 10-K for the year ended December 31, 1991, File No. 0-2429, as Exhibit 10(m).) (a) 41 - Rocky Mountain Pumped Storage Hydroelectric Project Ownership Participation Agreement dated November 18, 1988, between OPC and GEORGIA. (Designated in GEORGIA's Form 10-K for the year ended December 31, 1988, File No. 1-6468, as Exhibit 10(x).) (a) 42 - Rocky Mountain Pumped Storage Hydroelectric Project Operating Agreement dated November 18, 1988, between OPC and GEORGIA. (Designated in GEORGIA's Form 10-K for the year ended December 31, 1988, File No. 1-6468, as Exhibit 10(y).) E-8 (a) 43 - Purchase and Ownership Agreement for Joint Ownership Interest in the James H. Miller, Jr. Steam Electric Generating Plant Units One and Two dated November 18, 1988, between ALABAMA and AEC. (Designated in Form U-1, File No. 70-7609, as Exhibit B-1.) (a) 44 - Operating Agreement for Joint Ownership Interest in the James H. Miller, Jr. Steam Electric Generating Plant Units One and Two dated November 18, 1988, between ALABAMA and AEC. (Designated in Form U-1, File No. 70-7609, as Exhibit B-2.) (a) 45 - Transmission Facilities Agreement dated February 25, 1982, Amendment No. 1 dated May 12, 1982 and Amendment No. 2 dated December 6, 1983, between Gulf States and MISSISSIPPI. (Designated in MISSISSIPPI's Form 10-K for the year ended December 31, 1981, File No. 0-6849, as Exhibit 10(f), in MISSISSIPPI's Form 10-K for the year ended December 31, 1982, File No. 0-6849, as Exhibit 10(f)(2) and in MISSISSIPPI's Form 10-K for the year ended December 31, 1983, File No. 0-6849, as Exhibit 10(f)(3).) (a) 46 - Form of commitment agreement, Amendment No. 1 and Amendment No. 2 with respect to SOUTHERN, ALABAMA, GEORGIA and MISSISSIPPI revolving credits. (Designated in Form U-1, File No. 70-7738, as Exhibit A-5 and in Form U-1, File No. 70-7937, as A-5(b).) (a) 47 - Block Power Sale Agreement between GEORGIA and OPC dated as of November 12, 1990. (Designated in GEORGIA's Form 10-K for the year ended December 31, 1990, File No. 1-6468, as Exhibit 10(cc).) (a) 48 - Coordination Services Agreement between GEORGIA and OPC dated as of November 12, 1990. (Designated in GEORGIA's Form 10-K for the year ended December 31, 1990, File No. 1-6468, as Exhibit 10(dd).) *(a) 49 - Amended and Restated Nuclear Managing Board Agreement for Plant Hatch and Plant Vogtle among GEORGIA, OPC, MEAG and Dalton dated as of July 1, 1993. (a) 50 - Integrated Transmission System Agreement, Power Sale and Coordination Umbrella Agreement between GEORGIA and OPC dated as of November 12, 1990. (Designated in GEORGIA's Form 10-K for the year ended December 31, 1990, File No. 1-6468, as Exhibit 10(ff).) (a) 51 - Revised and Restated Integrated Transmission System Agreement between GEORGIA and Dalton dated as of December 7, 1990. (Designated in GEORGIA's Form 10-K for the year ended December 31, 1990, File No. 1-6468, as Exhibit 10(gg).) (a) 52 - Revised and Restated Integrated Transmission System Agreement between GEORGIA and MEAG dated as of December 7, 1990. (Designated in GEORGIA's Form 10-K for the year ended December 31, 1990, File No. 1-6468, as Exhibit 10(hh).) E-9 (a) 53 - Long Term Transmission Service Agreement between Entergy Power, Inc. and ALABAMA, MISSISSIPPI and SCS. (Designated in SOUTHERN's Form 10-K for the year ended December 31, 1992, File No. 1-3526, as Exhibit 10(a)53.) *(a) 54 - Amendment No. 4 to the Plant Robert W. Scherer Units Number One and Two Purchase and Ownership Participation Agreement dated as of December 31, 1990. *(a) 55 - Amendment No. 2 to the Plant Robert W. Scherer Units Number One and Two Operating Agreement dated as of December 31, 1990. *(a) 56 - Plant Scherer Managing Board Agreement dated as of December 31, 1990 among GEORGIA, OPC, MEAG, Dalton, GULF, FP&L and JEA. *(a) 57 - Plant McIntosh Combustion Turbine Purchase and Ownership Participation Agreement between GEORGIA and SAVANNAH dated as of December 15, 1992. *(a) 58 - Plant McIntosh Combustion Turbine Operating Agreement between GEORGIA and SAVANNAH dated as of December 15, 1992. *(a) 59 - Power Purchase Agreement dated as of December 3, 1993 between GEORGIA and FPC. ALABAMA (b) 1 - Indenture dated as of June 1, 1959, between SEGCO and Citibank, N.A., as Trustee, and indentures supplemental thereto through December 1, 1962. (Designated in Registration No. 2-59843 as Exhibit 2(a)-8.) (b) 2 - Service contracts dated as of January 1, 1984 and Amendment No. 1 dated as of September 6, 1985, between SCS and ALABAMA, GEORGIA, GULF, MISSISSIPPI, SEGCO and SOUTHERN. See Exhibit 10(a)1 herein. (b) 3 - Interchange contract dated October 28, 1988, effective January 1, 1989, between ALABAMA, GEORGIA, GULF, MISSISSIPPI, SAVANNAH and SCS. See Exhibit 10(a)5 herein. (b) 4 - Agreement dated as of January 27, 1959 and Amendment No. 1 dated as of October 27, 1982, among SEGCO, ALABAMA and GEORGIA. See Exhibit 10(a)6 herein. (b) 5 - Amended and Restated Unit Power Sales Agreement dated February 18, 1982 and Amendment No. 1 dated May 18, 1982, between FP&L and ALABAMA, GEORGIA, GULF, MISSISSIPPI and SCS. See Exhibit 10(a)32 herein. E-10 (b) 6 - Amended and Restated Unit Power Sales Agreement dated May 19, 1982, Amendment No. 1, dated August 30, 1984 and Amendment No. 2, dated October 30, 1987, between JEA and ALABAMA, GEORGIA, GULF, MISSISSIPPI and SCS. See Exhibit 10(a)33 herein. (b) 7 - Unit Power Sales Agreement dated July 19, 1988, between FPC and ALABAMA, GEORGIA, GULF, MISSISSIPPI, SAVANNAH and SCS. See Exhibit 10(a)34 herein. (b) 8 - Amended Unit Power Sales Agreement dated July 20, 1988, between FP&L and ALABAMA, GEORGIA, GULF, MISSISSIPPI, SAVANNAH and SCS. See Exhibit 10(a)35 herein. (b) 9 - Amended Unit Power Sales Agreement dated August 17, 1988, between JEA and ALABAMA, GEORGIA, GULF, MISSISSIPPI, SAVANNAH and SCS. See Exhibit 10(a)36 herein. (b) 10 - Unit Power Sales Agreement dated December 8, 1990, between Tallahassee and ALABAMA, GEORGIA, GULF, MISSISSIPPI, SAVANNAH and SCS. See Exhibit 10(a)37 herein. (b) 11 - Transition Energy Agreement dated December 31, 1990, between JEA and ALABAMA, GEORGIA, GULF, MISSISSIPPI, SAVANNAH and SCS. See Exhibit 10(a)39 herein. (b) 12 - Transition Energy Agreement dated December 31, 1990, between FP&L and ALABAMA, GEORGIA, GULF, MISSISSIPPI, SAVANNAH and SCS. See Exhibit 10(a)40 herein. (b) 13 - Firm Power Purchase Contract between ALABAMA and AMEA. (Designated in Certificate of Notification, File No. 70-7212, as Exhibit B.) (b) 14 - 1991 Firm Power Purchase Contract between ALABAMA and AMEA. (Designated in Form U-1, File No. 70- 7873, as Exhibit B-1.) (b) 15 - Purchase and Ownership Agreement for Joint Ownership Interest in the James H. Miller, Jr. Steam Electric Generating Plant Units One and Two dated November 18, 1988, between ALABAMA and AEC. See Exhibit 10(a)43 herein. (b) 16 - Operating Agreement for Joint Ownership Interest in the James H. Miller, Jr. Steam Electric Generating Plant Units One and Two dated November 18, 1988, between ALABAMA and AEC. See Exhibit 10(a)44 herein. (b) 17 - Form of commitment agreement, Amendment No. 1 and Amendment No. 2 with respect to SOUTHERN, ALABAMA, GEORGIA and MISSISSIPPI revolving credits. See Exhibit 10(a)46 herein. E-11 (b) 18 - Long Term Transmission Service Agreement between Entergy Power, Inc. and ALABAMA, MISSISSIPPI and SCS. See Exhibit 10(a)53 herein. GEORGIA (c) 1 - Indenture dated as of June 1, 1959, between SEGCO and Citibank, N.A., as Trustee, and indentures supplemental thereto through December 1, 1962. See Exhibit 10(b)1 herein. (c) 2 - Service contracts dated as of January 1, 1984 and Amendment No. 1 dated as of September 6, 1985, between SCS and ALABAMA, GEORGIA, GULF, MISSISSIP PI, SEGCO and SOUTHERN. See Exhibit 10(a)1 herein. (c) 3 - Interchange contract dated October 28, 1988, effective January 1, 1989, between ALABAMA, GEORGIA, GULF, MISSISSIPPI, SAVANNAH and SCS. See Exhibit 10(a)5 herein. (c) 4 - Agreement dated as of January 27, 1959 and Amendment No. 1 dated as of October 27, 1982, among SEGCO, ALABAMA and GEORGIA. See Exhibit 10(a)6 herein. (c) 5 - Joint Committee Agreement dated as of August 27, 1976, among GEORGIA, OPC, MEAG and Dalton. See Exhibit 10(a)7 herein. (c) 6 - Edwin I. Hatch Nuclear Plant Purchase and Ownership Participation Agreement dated as of January 6, 1975, between GEORGIA and OPC. See Exhibit 10(a)8 herein. (c) 7 - Edwin I. Hatch Nuclear Plant Operating Agreement dated as of January 6, 1975, between GEORGIA and OPC. See Exhibit 10(a)9 herein. (c) 8 - Revised and Restated Integrated Transmission System Agreement dated as of November 12, 1990, between GEORGIA and OPC. See Exhibit 10(a)10 herein. (c) 9 - Plant Hal Wansley Purchase and Ownership Participation Agreement dated as of March 26, 1976, between GEORGIA and OPC. See Exhibit 10(a) 11 herein. (c) 10 - Plant Hal Wansley Operating Agreement dated as of March 26, 1976, between GEORGIA and OPC. See Exhibit 10(a)12 herein. (c) 11 - Edwin I. Hatch Nuclear Plant Purchase and Ownership Participation Agreement dated as of August 27, 1976, between GEORGIA, MEAG and Dalton. See Exhibit 10(a)13 herein. (c) 12 - Edwin I. Hatch Nuclear Plant Operating Agreement dated as of August 27, 1976, between GEORGIA, MEAG and Dalton. See Exhibit 10(a)14 herein. E-12 (c) 13 - Alvin W. Vogtle Nuclear Units Number One and Two Purchase and Ownership Participation Agreement dated as of August 27, 1976 and Amendment No. 1 dated as of January 18, 1977, among GEORGIA, OPC, MEAG and Dalton. See Exhibit 10(a)15 herein. (c) 14 - Alvin W. Vogtle Nuclear Units Number One and Two Operating Agreement dated as of August 27, 1976, among GEORGIA, OPC, MEAG and Dalton. See Exhibit 10(a)16 herein. (c) 15 - Alvin W. Vogtle Nuclear Units Number One and Two Purchase, Amendment, Assignment and Assumption Agreement dated as of November 16, 1983, between GEORGIA and MEAG. See Exhibit 10(a)17 herein. (c) 16 - Plant Hal Wansley Purchase and Ownership Participation Agreement dated as of August 27, 1976, between GEORGIA and MEAG. See Exhibit 10(a)18 herein. (c) 17 - Plant Hal Wansley Operating Agreement dated as of August 27, 1976, between GEORGIA and MEAG. See Exhibit 10(a)19 herein. (c) 18 - Integrated Transmission System Agreement dated as of August 27, 1976, between GEORGIA and Dalton. See Exhibit 10(a)20 herein. (c) 19 - Integrated Transmission System Agreement dated as of August 27, 1976, between GEORGIA and MEAG. See Exhibit 10(a)21 herein. (c) 20 - Plant Hal Wansley Purchase and Ownership Participation Agreement dated as of April 19, 1977, between GEORGIA and Dalton. See Exhibit 10(a)22 herein. (c) 21 - Plant Hal Wansley Operating Agreement dated as of April 19, 1977, between GEORGIA and Dalton. See Exhibit 10(a)23 herein. (c) 22 - Plant Robert W. Scherer Units Number One and Two Purchase and Ownership Participation Agreement dated as of May 15, 1980, Amendment No. 1 dated as of December 30, 1985, Amendment No. 2 dated as of July 1, 1986 and Amendment No. 3 dated as of August 1, 1988, among GEORGIA, OPC, MEAG and Dalton. See Exhibit 10(a)24 herein. (c) 23 - Plant Robert W. Scherer Units Number One and Two Operating Agreement dated as of May 15, 1980 and Amendment No. 1 dated as of December 3, 1985, among GEORGIA, OPC, MEAG and Dalton. See Exhibit 10(a)25 herein. (c) 24 - Plant Robert W. Scherer Purchase, Sale and Option Agreement dated as of May 15, 1980, between GEORGIA and MEAG. See Exhibit 10(a)26 herein. (c) 25 - Plant Robert W. Scherer Purchase and Sale Agreement dated as of May 16, 1980, between GEORGIA and Dalton. See Exhibit 10(a)27 herein. E-13 (c) 26 - Plant Robert W. Scherer Unit Number Three Purchase and Ownership Participation Agreement dated as of March 1, 1984, Amendment No. 1 dated as of July 1, 1986 and Amendment No. 2 dated as of August 1, 1988, between GEORGIA and GULF. See Exhibit 10(a)28 herein. (c) 27 - Plant Robert W. Scherer Unit Number Three Operating Agreement dated as of March 1, 1984, between GEORGIA and GULF. See Exhibit 10(a)29 herein. (c) 28 - Plant Robert W. Scherer Unit No. Four Amended and Restated Purchase and Ownership Participation Agreement by and among GEORGIA, FP&L and JEA dated as of December 31, 1990. See Exhibit 10(a) 30 herein. (c) 29 - Plant Robert W. Scherer Unit No. Four Operating Agreement by and among GEORGIA, FP&L and JEA dated as of December 31, 1990. See Exhibit 10(a)31 herein. (c) 30 - Amended and Restated Unit Power Sales Agreement dated February 18, 1982 and Amendment No. 1 dated May 18, 1982, between FP&L and ALABAMA, GEORGIA, GULF, MISSISSIPPI and SCS. See Exhibit 10(a)32 herein. (c) 31 - Amended and Restated Unit Power Sales Agreement dated May 19, 1982, Amendment No. 1, dated August 30, 1984 and Amendment No. 2 dated October 30, 1987, between JEA and ALABAMA, GEORGIA, GULF, MISSISSIPPI and SCS. See Exhibit 10(a)33 herein. (c) 32 - Unit Power Sales Agreement dated July 19, 1988, between FPC and ALABAMA, GEORGIA, GULF, MISSISSIPPI, SAVANNAH and SCS. See Exhibit 10(a) 34 herein. (c) 33 - Amended Unit Power Sales Agreement dated July 20, 1988, between FP&L and ALABAMA, GEORGIA, GULF, MISSISSIPPI, SAVANNAH and SCS. See Exhibit 10(a) 35 herein. (c) 34 - Amended Unit Power Sales Agreement dated August 17, 1988, between JEA and ALABAMA, GEORGIA, GULF, MISSISSIPPI, SAVANNAH and SCS. See Exhibit 10(a) 36 herein. (c) 35 - Unit Power Sales Agreement dated December 8, 1990, between Tallahassee and ALABAMA, GEORGIA, GULF, MISSISSIPPI, SAVANNAH and SCS. See Exhibit 10(a)37 herein. *(c) 36 - Power Purchase Agreement dated as of December 3, 1993 between GEORGIA and FPC. See Exhibit 10(a) 59 herein. (c) 37 - Transition Energy Agreement dated December 31, 1990, between JEA and ALABAMA, GEORGIA, GULF, MISSISSIPPI, SAVANNAH and SCS. See Exhibit 10(a) 39 herein. E-14 (c) 38 - Transition Energy Agreement dated December 31, 1990, between FP&L and ALABAMA, GEORGIA, GULF, MISSISSIPPI, SAVANNAH and SCS. See Exhibit 10(a) 40 herein. (c) 39 - Rocky Mountain Pumped Storage Hydroelectric Project Ownership Participation Agreement dated November 18, 1988, between OPC and GEORGIA. See Exhibit 10(a)41 herein. (c) 40 - Rocky Mountain Pumped Storage Hydroelectric Project Operating Agreement dated November 18, 1988, between OPC and GEORGIA. See Exhibit 10(a)42 herein. (c) 41 - Form of commitment agreement, Amendment No. 1 and Amendment No. 2 with respect to SOUTHERN, ALABAMA, GEORGIA and MISSISSIPPI revolving credits. See Exhibit 10(a)46 herein. (c) 42 - Block Power Sale Agreement between GEORGIA and OPC dated as of November 12, 1990. See Exhibit 10(a)47 herein. (c) 43 - Coordination Services Agreement between GEORGIA and OPC dated as of November 12, 1990. See Exhibit 10(a)48 herein. *(c) 44 - Amended and Restated Nuclear Managing Board Agreement for Plant Hatch and Plant Vogtle among GEORGIA, OPC, MEAG and Dalton dated as of July 1, 1993. See Exhibit 10(a)49 herein. (c) 45 - Integrated Transmission System Agreement, Power Sale and Coordination Umbrella Agreement between GEORGIA and OPC dated as of November 12, 1990. See Exhibit 10(a)50 herein. (c) 46 - Revised and Restated Integrated Transmission System Agreement between GEORGIA and Dalton dated as of December 7, 1990. See Exhibit 10(a)51 herein. (c) 47 - Revised and Restated Integrated Transmission System Agreement between GEORGIA and MEAG dated as of December 7, 1990. See Exhibit 10(a)52 herein. *(c) 48 - Amendment No. 4 to the Plant Robert W. Scherer Units Number One and Two Purchase and Ownership Participation Agreement dated as of December 31, 1990. See Exhibit 10(a)54 herein. *(a) 49 - Amendment No. 2 to the Plant Robert W. Scherer Units Number One and Two Operating Agreement dated as of December 31, 1990. See Exhibit 10(a)55 herein. *(c) 50 - Plant Scherer Managing Board Agreement dated as of December 31, 1990 among GEORGIA, OPC, MEAG, Dalton, GULF, FP&L and JEA. See Exhibit 10(a)56 herein. E-15 *(c) 51 - Plant McIntosh Combustion Turbine Purchase and Ownership Participation Agreement between GEORGIA and SAVANNAH dated as of December 15, 1992. See Exhibit 10(a)57 herein. *(c) 52 - Plant McIntosh Combustion Turbine Operating Agreement between GEORGIA and SAVANNAH dated as of December 15, 1992. See Exhibit 10(a)58 herein. GULF (d) 1 - Service contracts dated as of January 1, 1984 and Amendment No. 1 dated as of September 6, 1985, between SCS and ALABAMA, GEORGIA, GULF, MISSISSIPPI, SEGCO and SOUTHERN. See Exhibit 10(a)1 herein. (d) 2 - Interchange contract dated October 28, 1988, effective January 1, 1989, between ALABAMA, GEORGIA, GULF, MISSISSIPPI, SAVANNAH and SCS. See Exhibit 10(a)5 herein. (d) 3 - Plant Robert W. Scherer Unit Number Three Purchase and Ownership Participation Agreement dated as of March 1, 1984, Amendment No. 1 dated as of July 1, 1986 and Amendment No. 2 dated as of August 1, 1988, between GEORGIA and GULF. See Exhibit 10(a)28 herein. (d) 4 - Plant Robert W. Scherer Unit Number Three Operating Agreement dated as of March 1, 1984, between GEORGIA and GULF. See Exhibit 10(a)29 herein. (d) 5 - Amended and Restated Unit Power Sales Agreement dated February 18, 1982 and Amendment No. 1 dated May 18, 1982, between FP&L and ALABAMA, GEORGIA, GULF, MISSISSIPPI and SCS. See Exhibit 10(a)32 herein. (d) 6 - Amended and Restated Unit Power Sales Agreement dated May 19, 1982, Amendment No. 1 dated August 30, 1984 and Amendment No. 2 dated October 30, 1987, between JEA and ALABAMA, GEORGIA, GULF, MISSISSIPPI and SCS. See Exhibit 10(a)33 herein. (d) 7 - Unit Power Sales Agreement dated July 19, 1988, between FPC and ALABAMA, GEORGIA, GULF, MISSISSIPPI, SAVANNAH and SCS. See Exhibit 10(a) 34 herein. (d) 8 - Amended Unit Power Sales Agreement dated July 20, 1988, between FP&L and ALABAMA, GEORGIA, GULF, MISSISSIPPI, SAVANNAH and SCS. See Exhibit 10(a) 35 herein. (d) 9 - Amended Unit Power Sales Agreement dated August 17, 1988, between JEA and ALABAMA, GEORGIA, GULF, MISSISSIPPI, SAVANNAH and SCS. See Exhibit 10(a) 36 herein. E-16 (d) 10 - Agreement between GULF and AEC, effective August 1, 1985. (Designated in GULF's Form 10-K for the year ended December 31, 1985, File No. 0-2429, as Exhibit 10(g).) (d) 11 - Unit Power Sales Agreement dated December 8, 1990, between Tallahassee and ALABAMA, GEORGIA, GULF, MISSISSIPPI, SAVANNAH and SCS. See Exhibit 10(a)37 herein. (d) 12 - Transition Energy Agreement dated December 31, 1990, between JEA and ALABAMA, GEORGIA, GULF, MISSISSIPPI, SAVANNAH and SCS. See Exhibit 10(a) 39 herein. (d) 13 - Transition Energy Agreement dated December 31, 1990, between FP&L and ALABAMA, GEORGIA, GULF, MISSISSIPPI, SAVANNAH and SCS. See Exhibit 10(a) 40 herein. MISSISSIPPI (e) 1 - Service contracts dated as of January 1, 1984 and Amendment No. 1 dated September 6, 1985, between SCS and ALABAMA, GEORGIA, GULF, MISSISSIPPI, SEGCO and SOUTHERN. See Exhibit 10(a)1 herein. (e) 2 - Interchange contract dated October 28, 1988, effective January 1, 1989, between ALABAMA, GEORGIA, GULF, MISSISSIPPI, SAVANNAH and SCS. See Exhibit 10(a)5 herein. (e) 3 - Amended and Restated Unit Power Sales Agreement dated February 18, 1982 and Amendment No. 1 dated May 18, 1982, between FP&L and ALABAMA, GEORGIA, GULF, MISSISSIPPI and SCS. See Exhibit 10(a)32 herein. (e) 4 - Amended and Restated Unit Power Sales Agreement dated May 19, 1982, Amendment No. 1 dated August 30, 1984, and Amendment No. 2 dated October 30, 1987, between JEA and ALABAMA, GEORGIA, GULF, MISSISSIPPI and SCS. See Exhibit 10(a)33 herein. (e) 5 - Unit Power Sales Agreement dated July 19, 1988, between FPC and ALABAMA, GEORGIA, GULF, MISSISSIPPI, SAVANNAH and SCS. See Exhibit 10(a) 34 herein. (e) 6 - Amended Unit Power Sales Agreement dated July 20, 1988, between FP&L and ALABAMA, GEORGIA, GULF, MISSISSIPPI, SAVANNAH and SCS. See Exhibit 10(a) 35 herein. (e) 7 - Amended Unit Power Sales Agreement dated August 17, 1988, between JEA and ALABAMA, GEORGIA, GULF, MISSISSIPPI, SAVANNAH and SCS. See Exhibit 10(a) 36 herein. E-17 (e) 8 - Unit Power Sales Agreement dated December 8, 1990, between Tallahassee and ALABAMA, GEORGIA, GULF, MISSISSIPPI, SAVANNAH and SCS. See Exhibit 10(a)37 herein. (e) 9 - Transition Energy Agreement dated December 31, 1990, between JEA and ALABAMA, GEORGIA, GULF, MISSISSIPPI, SAVANNAH and SCS. See Exhibit 10(a) 39 herein. (e) 10 - Transition Energy Agreement dated December 31, 1990, between FP&L and ALABAMA, GEORGIA, GULF, MISSISSIPPI, SAVANNAH and SCS. See Exhibit 10(a) 40 herein. (e) 11 - Transmission Facilities Agreement dated February 25, 1982, Amendment No. 1 dated May 12, 1982 and Amendment No. 2 dated December 6, 1983, between Gulf States and MISSISSIPPI. See Exhibit 10(a)45 herein. (e) 12 - Form of commitment agreement, Amendment No. 1 and Amendment No. 2 with respect to SOUTHERN, ALABAMA, GEORGIA and MISSISSIPPI revolving credits. See Exhibit 10(a)46 herein. (e) 13 - Long Term Transmission Service Agreement between Entergy Power, Inc. and ALABAMA MISSISSIPPI and SCS. See Exhibit 10(a)53 herein. SAVANNAH (f) 1 - Service contract dated as of March 3, 1988, between SCS and SAVANNAH. See Exhibit 10(a)3 herein. (f) 2 - Interchange contract dated October 28, 1988, effective January 1, 1989, between ALABAMA, GEORGIA, GULF, MISSISSIPPI, SAVANNAH and SCS. See Exhibit 10(a)5 herein. (f) 3 - Unit Power Sales Agreement dated July 19, 1988, between FPC and ALABAMA, GEORGIA, GULF, MISSISSIPPI, SAVANNAH and SCS. See Exhibit 10(a) 34 herein. (f) 4 - Amended Unit Power Sales Agreement dated July 20, 1988, between FP&L and ALABAMA, GEORGIA, GULF, MISSISSIPPI, SAVANNAH and SCS. See Exhibit 10(a) 35 herein. (f) 5 - Amended Unit Power Sales Agreement dated August 17, 1988, between JEA and ALABAMA, GEORGIA, GULF, MISSISSIPPI, SAVANNAH and SCS. See Exhibit 10(a) 36 herein. (f) 6 - Unit Power Sales Agreement dated December 8, 1990, between Tallahassee and ALABAMA, GEORGIA, GULF, MISSISSIPPI, SAVANNAH and SCS. See Exhibit 10(a)37 herein. E-18 (f) 7 - Transition Energy Agreement dated December 31, 1990, between JEA and ALABAMA, GEORGIA, GULF, MISSISSIPPI, SAVANNAH and SCS. See Exhibit 10(a) 39 herein. (f) 8 - Transition Energy Agreement dated December 31, 1990, between FP&L and ALABAMA, GEORGIA, GULF, MISSISSIPPI, SAVANNAH and SCS. See Exhibit 10(a) 40 herein. *(f) 9 - Plant McIntosh Combustion Turbine Purchase and Ownership Participation Agreement between GEORGIA and SAVANNAH dated as of December 15, 1992. See Exhibit 10(a) 57 herein. *(f) 10 - Plant McIntosh Combustion Turbine Operating Agreement between GEORGIA and SAVANNAH dated December 15, 1992. See Exhibit 10(a)58 herein. (21) *SUBSIDIARIES OF REGISTRANTS - Contained herein at page IV-5. (23) CONSENTS OF EXPERTS AND COUNSEL SOUTHERN *(a) - The consent of Arthur Andersen & Co. is contained herein at page IV-6. ALABAMA *(b) - The consent of Arthur Andersen & Co. is contained herein at page IV-7. GEORGIA *(c) - The consent of Arthur Andersen & Co. is contained herein at page IV-8. GULF *(d) - The consent of Arthur Andersen & Co. is contained herein at page IV-9. MISSISSIPPI *(e) - The consent of Arthur Andersen & Co. is contained herein at page IV-10. SAVANNAH *(f) - The consent of Arthur Andersen & Co. is contained herein at page IV-11. E-19 (24) POWERS OF ATTORNEY AND RESOLUTIONS SOUTHERN *(a) - Power of Attorney and resolution. ALABAMA *(b) - Power of Attorney and resolution. GEORGIA *(c) - Power of Attorney and resolution. GULF *(d) - Power of Attorney and resolution. MISSISSIPPI *(e) - Power of Attorney and resolution. SAVANNAH *(f) - Power of Attorney and resolution. E-20

351936_1993.txt

351936

1993

ITEM 1. Business Xerox Credit Corporation, a Delaware corporation (together with its subsidiaries herein called "the Company" unless the context otherwise requires), was organized on June 23, 1980. All of the Company's outstanding capital stock is owned by Xerox Financial Services, Inc. (XFSI), a holding company, which is wholly-owned by Xerox Corporation (Xerox Corporation together with its subsidiaries are herein called "Xerox" unless the context otherwise requires). The Company is engaged in financing long-term accounts receivable arising out of equipment sales by Xerox to its Document Processing customers throughout the United States. Contract terms on these accounts receivable range primarily from two to five years. The Company discontinued its real-estate development and related real- estate financing businesses in the first quarter of 1990. In the fourth quarter of 1990, the Company discontinued its third-party financing and leasing businesses. See Note 2 to the Consolidated Financial Statements for further information regarding the Company's discontinued operations. Xerox is a global company serving the worldwide Document Processing markets. Xerox' Document Processing activities encompass developing, manufacturing, marketing, servicing and financing a complete range of document processing products and services designed to make offices around the world more productive. These products and systems are marketed in over 130 countries by a direct sales force and a network of agents, dealers and distributors. The financing of Xerox equipment is generally carried out by the Company in the United States and internationally by several foreign financing subsidiaries. In December 1993, Xerox announced a worldwide restructuring program aimed at improving its productivity and significantly lowering its cost base. The ongoing operations of the Company are unaffected by this decision. (2) ITEM 2.

ITEM 2. Properties The Company does not directly own any facilities in order to carry on its principal business. Its principal executive offices in Stamford, Connecticut comprise approximately 25,000 square feet of office space. In addition, the Company leases approximately 1,200 square feet of office space at various domestic and international locations, the majority of which are used by the Company's discontinued operations. These facilities are deemed adequate by management. ITEM 3.

ITEM 3. Legal Proceedings None. ITEM 4.

ITEM 4. Submission of Matters to a Vote of Security Holders Not Required. PART II ITEM 5.

ITEM 5. Market for the Registrant's Common Equity and Related Stockholder Matters This item is inapplicable to Registrant, which is a wholly-owned subsidiary of Xerox. ITEM 6.

ITEM 6. Selected Financial Data Not Required. (3) ITEM 7.

ITEM 7. Management's Discussion and Analysis of Financial Condition and Results of Operations Results of Operations Continuing Operations Contracts receivable income represents income earned under an agreement with Xerox by which the Company purchases long-term accounts receivable associated with Xerox' sold equipment. These receivables arose from Xerox equipment being sold under installment sales and sales-type leases. In 1993, the Company purchased receivables from Xerox totaling $1,848 million compared to $1,964 million in 1992. Earned income from contracts receivable decreased in 1993 to $376 million from $389 million in 1992. The decreases in earned income is the result of lower purchases of contracts receivable in 1993 compared to 1992 due to weak United States sales early in 1993 because of reorganization of the Xerox United States Customer Operations sales force, as well as lower interest income earned on Xerox contracts receivable resulting from declining interest rates. Earned income from contracts receivable increased in 1992 to $389 million from $380 million in 1991. The increase reflected the growth of Xerox equipment sales financed through the Company in 1992 compared to 1991. In connection with the contracts receivable purchased from Xerox, the Company retains an allowance for losses at the time of purchase, which is intended to protect against future losses. Should any additional allowances be required, Xerox is required to provide such funding. The resultant effect is to relieve the Company of any exposure with regard to write-offs associated with the contracts receivable purchased from Xerox. Interest expense was $209 million in 1993 compared to $212 million in 1992, a decrease of $3 million. The 1993 decrease resulted from lower interest rates partially offset with increased borrowings required to fund the Companys additional investment in contracts receivable. The $212 million of interest expense in 1992 was an increase of $12 million from the 1991 interest expense of $200 million. The 1992 increase in interest expense reflected increased borrowings required to fund the additional investment in contracts receivable. The Company intends to continue to match its contracts receivable and indebtedness to maintain the relationship between interest income and interest expense. Operating and administrative expenses were $13 million for 1993, a decrease of $6 million from 1992. The decrease was due primarily to operating efficiencies associated with the administration of contracts receivable purchased from Xerox. Operating and administrative expenses increased to $19 million in 1992 compared to $16 million in 1991. This increase was due primarily to additional administrative costs associated with the increase in the volume of Xerox contracts receivable financed in 1992 compared to 1991. The effective income tax rate for 1993 was 40.9 percent as compared with 39.9 percent and 40.2 percent for 1992 and 1991, respectively. The increase in the effective tax rates in 1993 compared to 1992 and 1991 is due primarily to the 1993 increase in the corporate federal income tax rates from 34 percent to 35 percent retroactive to January 1, 1993. (4) Discontinued Operations Since their discontinuance in 1990, the Company has made substantial progress in disengaging from the real-estate and third-party financing businesses. During the three years ended December 31, 1993, the Company received net cash proceeds of $2,089 million from the sale of discontinued business units and assets, from several asset securitizations and from run-off collection activities. The amounts received were consistent with the Company's estimates in the disposal plan and were primarily used to reduce the Company's short-term indebtedness. At December 31, 1993, the Company remains contingently liable for approximately $126 million under recourse provisions associated with the securitization transactions. Since a portion of the remaining assets ($120 million) represents passive lease receivables, many with long-duration contractual maturities and unique tax attributes, the Company expects that the wind-down of the portfolio will be significantly slower in 1994 and future years, compared with 1993 and prior years. The Company believes that the liquidation of the remaining assets will not result in a net loss. Additional information regarding discontinued operations is included in Note 2 to the Consolidated Financial Statements. (5) Capital Resources and Liquidity The Company's principal sources of funds are cash from the collection of Xerox contracts receivable and borrowings. At December 31, 1993 the Company and Xerox have joint access to three revolving credit agreements totaling $3 billion with various banks, which expire from 1994 to 1998. The interest on amounts borrowed under these facilities is at rates based, at the borrower's option, on spreads above certain reference rates such as LIBOR and Federal funds rates. Net cash used in operating activities was $48 million in 1993 compared with $23 million of cash used in 1992. The 1993 increase in cash used by operating activities is mainly attributable to the reduction in accounts payable and accrued liabilities due to timing of payments. Net cash used in operating activities was $23 million in 1992 compared with $161 million of cash provided by operating activities in 1991. The 1992 decrease in cash provided by operating activities is mainly attributable to the reduction in deferred income taxes payable which declined as a result of the Company's adoption of Statement of Financial Accounting Standards (SFAS) No. 109- "Accounting for Income Taxes" and sales of certain discontinued operation's assets. Net cash provided by investing activities was $21 million in 1993 compared to $58 million of cash used in investing activities in 1992. The increase in cash provided by investing activities was the result of higher net collections from the Company's investment in contracts receivable in 1993, which was partially offset by lower net collections from discontinued operations. Net cash provided by investing activities during 1992 decreased $815 million from $757 million of cash provided by investing activities during 1991. The decrease resulted from lower net collections from the sale and run off activity of discontinued assets. Net cash provided by financing activities was $26 million in 1993 compared to $79 million in 1992. The decrease in cash provided was the result of increased principal payments on the Company's long- term debt. Net cash provided by financing activities was $79 million during 1992, compared with $926 million of cash used in financing activities during 1991. The proceeds from the 1991 sales and asset securitizations of the third-party financing and leasing assets enabled the Company to reduce the short-term indebtedness of the Company more in 1991 than in 1992, and pay higher dividends in 1991 than in 1992. (6) The Company believes that cash provided by continuing operations, cash available under its commercial paper program supported by its credit facilities, and its readily available access to the capital markets are more than sufficient for its funding needs. During 1994, new borrowing associated with the financing of customer purchases of Xerox equipment will continue. The timing, principal amount and form of new short- and long-term financing will be determined based upon the Company's need for financing and prevailing debt market conditions. The Company intends to continue to match its contracts receivable and indebtedness to maintain the relationship between investment income and interest expense. To assist in managing its interest rate exposure, the Company has entered into a number of interest rate swap agreements. In general, the Company's objective is to hedge its variable-rate debt by paying fixed rates under the swap agreements while receiving variable-rate based payments in return. The Company has also entered into swap agreements that convert both fixed-and non-commercial paper based variable-rate interest payments into payments that are indexed to commercial paper rates. During 1993, the Company entered into third-party interest rate swap agreements, which effectively converted $750 million of variable-rate debt into fixed-rate debt. These agreements mature at various dates through 1997 and resulted in a weighted average fixed-rate of 4.52 percent at December 31,1993. The Company also entered into third-party interest rate swap agreements, during 1993 which effectively converted $425 million of variable-rate debt into variable-rate debt that is indexed to the commercial paper rates. These agreements mature at various dates through 1997. As of December 31, 1993 the Company's overall debt-to-equity ratio was 6.5 to 1. The Company declared aggregate dividends of $59 million, $85 million and $230 million during 1993, 1992 and 1991, respectively. The Company intends to maintain a debt-to-equity ratio of approximately 6.5 to 1 over time. Pursuant to a Support Agreement between the Company and Xerox, Xerox has also agreed to retain ownership of 100 percent of the voting capital stock of the Company and to make periodic payments to the extent necessary to ensure that the Company's annual pre-tax earnings available for fixed charges equal at least 1.25 times the Company's fixed charges. (7) ITEM 8.

ITEM 8. Financial Statements and Supplementary Data The financial statements of the Company and its consolidated subsidiaries and the notes thereto, the financial statement schedules, and the report thereon of KPMG Peat Marwick, independent auditors, are set forth on pages 10 through 30 hereof. The other financial statements and schedules required herein are filed as "Financial Statement Schedules" pursuant to Item 14 of this report on Form 10-K. ITEM 9.

ITEM 9. Disagreements on Accounting and Financial Disclosure Not Applicable. ITEM 10.

ITEM 10. Directors and Executive Officers of the Registrant Not Required. ITEM 11.

ITEM 11. Executive Compensation Not Required. ITEM 12.

ITEM 12. Security Ownership of Certain Beneficial Owners and Management Not Required. ITEM 13.

ITEM 13. Certain Relationships and Related Transactions Not Required. PART IV ITEM 14.

ITEM 14. Exhibits, Financial Statement Schedules, and Reports on Form 8-K (a) (1) and (2) The financial statements and the financial statement schedules and the report of independent auditors thereon filed herewith are listed or otherwise included in the attachment hereto. (3) The exhibits filed herewith are set forth on the Exhibit Index included herein. (b) A Current Report on Form 8-K dated December 8, 1993 reporting Item 5 "Other Events" was filed during the last quarter of the period covered by this Report. (8) SIGNATURE Pursuant to the requirements of Section 13 or 15 (d) 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. (REGISTRANT) XEROX CREDIT CORPORATION BY (NAME AND TITLE) Sandeep B. Thakore, Vice President and Treasurer (DATE) March 18, 1994 Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the date indicated. (NAME AND TITLE) David Roe, President and Chief Executive Officer and Director (Principal Executive Officer) (NAME AND TITLE) Sandeep B. Thakore, Vice President and Treasurer (Principal Financial Officer) (NAME AND TITLE) Paul G. Ryan, Controller (Principal Accounting Officer) (NAME AND TITLE) Donald R. Altieri*, Director (NAME AND TITLE) David R. McLellan*, Director (NAME AND TITLE) Stuart B. Ross*, Director *By Power of Attorney (NAME AND TITLE) Sandeep B. Thakore, Vice President and Treasurer Attorney-in-Fact (DATE) March 18, 1994 (9) SIGNATURE Report of Independent Auditors The Board of Directors Xerox Credit Corporation: We have audited the consolidated financial statements of Xerox Credit Corporation and subsidiaries as listed in the accompanying index. In connection with our audits of the consolidated financial statements, we also have audited the financial statement schedules as listed in the accompanying index. These consolidated financial statements and financial statement schedules are the responsibility of the Company's management. Our responsibility is to express an opinion on these consolidated financial statements and financial statement schedules based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the consolidated financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the consolidated financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Xerox Credit Corporation and subsidiaries at December 31, 1993 and 1992, and the results of their operations and their cash flows for each of the years in the three-year period ended December 31, 1993, in conformity with generally accepted accounting principles. Also in our opinion, the related financial statement schedules, when considered in relation to the basic consolidated financial statements taken as a whole, present fairly, in all material respects, the information set forth therein. As discussed in Notes 1 and 6 to the consolidated financial statements, the Company changed its method of accounting for income taxes and its method of accounting for postretirement benefits other than pensions in 1992. KPMG PEAT MARWICK Stamford, Connecticut January 31, 1994 (10) XEROX CREDIT CORPORATION INDEX TO FINANCIAL STATEMENTS AND SCHEDULES Financial Statements: Consolidated statements of income for each of the years in the three-year period ended December 31, 1993 Consolidated balance sheets at December 31, 1993 and 1992 Consolidated statements of shareholder's equity for each of the years in the three-year period ended December 31, 1993 Consolidated statements of cash flows for each of the years in the three-year period ended December 31, 1993 Notes to consolidated financial statements Schedules: II Amounts receivable from related parties and underwriters, promoters and employees other than related parties VIII Valuation and qualifying accounts IX Short-term borrowings All other schedules are omitted as they are not applicable or the information required is included in the consolidated financial statements or notes thereto. (11) XEROX CREDIT CORPORATION CONSOLIDATED STATEMENTS OF INCOME Years Ended December 31, 1993, 1992 and 1991 (In Millions) 1993 1992 1991 Earned Income: Contracts receivable $ 376 $ 389 $ 380 Expenses: Interest 209 212 200 Operating and administrative 13 19 16 Total expenses 222 231 216 Income before income taxes 154 158 164 Provision for income taxes 63 63 66 Net income $ 91 $ 95 $ 98 See notes to consolidated financial statements. (12) XEROX CREDIT CORPORATION CONSOLIDATED BALANCE SHEETS December 31, 1993 and 1992 (In Millions) ASSETS 1993 1992 Cash and cash equivalents $ 1 $ 2 Investments: Contracts receivable 4,148 4,006 Notes receivable - Xerox and affiliates 58 57 Investments in Xerox affiliates, at equity 74 - Unearned income (437) (520) Allowance for losses (153) (139) Total investments 3,690 3,404 Net assets of discontinued operations 357 650 Other assets 2 3 Total assets $4,050 $4,059 LIABILITIES, DEFERRED INCOME TAXES AND SHAREHOLDER'S EQUITY Liabilities: Notes payable within one year: Commercial paper $1,653 $1,257 Xerox Corporation - 78 Current portion of notes payable after one year 554 709 Notes payable after one year 1,079 1,145 Notes payable after one year-Xerox and affiliates 75 - Due to Xerox Corporation, net 54 39 Accounts payable and accrued liabilities 74 105 Liabilities of business transferred 17 78 Total liabilities 3,506 3,411 Deferred income taxes 38 174 Shareholder's Equity: Common stock, no par value, 2,000 shares authorized, issued, and outstanding 23 23 Additional paid-in capital 145 145 Retained earnings 337 305 Cumulative translation adjustment 1 1 Total shareholder's equity 506 474 Total liabilities, deferred income taxes and shareholder's equity $4,050 $4,059 See notes to consolidated financial statements. (13) XEROX CREDIT CORPORATION CONSOLIDATED STATEMENTS OF SHAREHOLDER'S EQUITY Years Ended December 31, 1993, 1992 and 1991 (In Millions) Additional Cumulative Common Paid-In Retained Translation Stock Capital Earnings Adjustment Total Balance at December 31, 1990 $ 23 $ 138 $ 427 $ 2 $ 590 Net Income 98 98 Dividends (230) (230) XFSI Capital Contribution 7 7 Translation adjustment (1) (1) Balance at December 31, 1991 23 145 295 1 464 Net Income 95 95 Dividends* (85) (85) Balance at December 31, 1992 23 145 305 1 474 Net Income 91 91 Dividends (59) (59) Balance at December 31, 1993 $ 23 $ 145 $ 337 $ 1 $ 506 * Includes a non-cash dividend of $25 million. See notes to consolidated financial statements. (14) XEROX CREDIT CORPORATION CONSOLIDATED STATEMENTS OF CASH FLOWS Years Ended December 31, 1993, 1992 and 1991 (In Millions) 1993 1992 1991 Cash Flows from Operating Activities Net income $ 91 $ 95 $ 98 Adjustments to reconcile net income to net cash (used in) provided by operating activities: Amortization of discount on long-term debt - 2 32 (Decrease) increase in deferred income taxes (136) (149) 21 Other, net (3) 29 10 Net cash (used in) provided by operating activities (48) (23) 161 Cash Flows from Investing Activities Purchases of investments (1,848) (1,964) (1,784) Proceeds from investments 1,637 1,426 1,164 Net collections from discontinued operations 232 480 1,377 Net cash provided by (used in) investing activities 21 (58) 757 Cash Flows from Financing Activities Increase in short-term debt, net 305 382 269 Proceeds from long-term debt 475 406 216 Principal payments of long-term debt (695) (649) (1,188) Dividends (59) (60) (230) Capital contribution - - 7 Net cash provided by (used in) financing activities 26 79 (926) Decrease in cash and cash equivalents (1) (2) (8) Cash and cash equivalents, beginning of year 2 4 12 Cash and cash equivalents, end of year $ 1 $ 2 $ 4 See notes to consolidated financial statements. (15) XEROX CREDIT CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (1) Summary of Significant Accounting Policies Basis of Presentation The consolidated financial statements include the accounts of Xerox Credit Corporation (the Company) and its subsidiaries. The Company is a wholly-owned subsidiary of Xerox Financial Services, Inc. (XFSI), which is in turn wholly-owned by Xerox Corporation (Xerox). All significant transactions between the Company and its subsidiaries have been eliminated. Recognition of Earned Income The Company utilizes the finance method for the recognition of earned income associated with contracts receivable. Under this method, the difference between the amount of gross contract receivable and the cost of the contract is recorded as unearned income. The unearned income is amortized to income over the term of the transaction under an effective yield method. Cash and Cash Equivalents All highly liquid investments of the Company, with a maturity of three months or less at date of purchase, are considered to be cash equivalents. Allowance for Losses In connection with the contracts receivable purchased from Xerox, the Company retains an allowance for losses at the time of purchase which is intended to protect against future losses. Should any additional allowances be required, Xerox is required to provide such funding. The resultant effect is to relieve the Company of any exposure with regard to write-offs associated with the contracts receivable purchased from Xerox. (16) XEROX CREDIT CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) Charge Off of Delinquent Receivables The Company's policy with respect to the charge-off of delinquent receivables to the reserve is that such receivables are to be charged off as soon as it becomes apparent that the collection of the receivables through normal means is unlikely. The policy contemplates that delinquent receivables will be charged off before the aging of such delinquent receivables reaches 180 days. New Accounting Pronouncements Effective January 1, 1992, the Company adopted Statement of Financial Accounting Standard (SFAS) No. 109- "Accounting for Income Taxes." The effect of adopting SFAS No. 109 has no impact on income and shareholder's equity for continuing operations in 1992. A tax benefit of $87 million was recorded to discontinued operations and represents the cumulative tax benefits associated with the discontinued real-estate operations that were not previously recorded. Also, effective January 1, 1992, the Company adopted SFAS No. 106- "Employees' Accounting for Postretirement Benefits other than Pensions," which changes the method of recording other postretirement benefit costs from a cash basis to the accrual basis. The cumulative effect of adopting SFAS No. 106 on the Company was immaterial. In November 1992, the Financial Accounting Standards Board issued SFAS No. 112- "Employers' Accounting for Postemployment Benefits." SFAS No. 112 requires accrual accounting for employee benefits that are paid after the termination of active employment but prior to retirement. The Company is required to adopt SFAS No. 112 beginning in 1994. the adoption of SFAS No. 112 is not expected to have a significant impact on the Company since the applicable benefits are either routinely accrued or are types of benefits not currently offered by the Company. (17) XEROX CREDIT CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) (2) Discontinued Operations The Company has made substantial progress in disengaging from the real-estate and third-party financing businesses that were discontinued in 1990. During the three years ended December 31, 1993, the Company received aggregate net cash proceeds of $2,089 million ($232 million in 1993, $480 million in 1992 and $1,377 million in 1991) from the sale of individual assets or of business units, from several asset securitizations and from run-off collection activities. The amounts received were consistent with the Company's estimates in the disposal plan and were used primarily to repay short-term indebtedness. At December 31, 1993, the Company remains contingently liable for $126 million under recourse provisions associated with the securitization transactions. In addition, the Company has issued certain guarantees with respect to obligations and debt of one operation sold, Highline Financial Services, Inc. As a result of the guarantees, liabilities in the amount of $17 million are included in the Company's balance sheet at December 31, 1993, under the caption "Liabilities of business transferred." Because the Company has full recourse to the underlying assets associated with the guarantees, $17 million of assets remain on the Company's December 31, 1993 balance sheet, under the caption "Net assets of discontinued operations." These liabilities and assets will decrease proportionately with the collection of the underlying receivables, which have a remaining life of approximately 12 months. During 1991 and 1992, incremental tax benefits of $22 million and $122 million, respectively, were realized by the Company related to the writeoff of its real estate businesses in 1990. Rather than recording these tax benefits in net income, the Company increased before-tax reserves related to the discontinued businesses. Management believed this prudent in view of weak market conditions and continuing uncertainties in the domestic real-estate and credit markets. Approximately $120 million (34 percent) of the remaining assets represent passive lease receivables, many with long-duration contractual maturities and unique tax attributes. Accordingly, the Company expects that the wind-down of the portfolio will be slower during 1994 and in future years, compared with prior years. The Company believes that the liquidation of the remaining assets will not result in a net loss. Short-and long-term debt represents debt included in the Company's consolidated balance sheets that has been assigned to the discontinued businesses in accordance with historical methodologies. Proceeds from disposition of these businesses, along with their results of operations during the phase-out period, are expected to be used to repay such consolidated indebtedness. (18) XEROX CREDIT CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) Summarized information of discontinued operations for the three years ended December 31, 1993 follows: 1993 1992 1991 (In Millions) Summary of Operations Loss before income taxes $ - $ (122) $ (22) Income tax benefit - 122 * 22 Net income (loss) from $ - $ - $ - discontinued operations Balance Sheet Data Gross finance receivables $ 202 $ 515 $ 1,014 Unearned income (53) (87) (134) Other assets 208 222 359 Investment in discontinued operations, net $ 357 $ 650 $ 1,239 Allocated short- and long-term debt $ 244 $ 400 $ 709 * Includes $87 million resulting from the cumulative effect of adopting statement of Financial Accounting Standards No. 109- "Accounting for Income Taxes," effective January 1, 1992. Contractual maturities of the gross finance receivables at December 31, 1993 follow (in millions): 1994-$60; 1995-$17; 1996-$20; 1997-$25; 1998; $13; 1999 and thereafter-$67. (19) XEROX CREDIT CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) (3) Investments Contracts receivable represent purchases of long-term trade accounts receivable from Xerox. These receivables arose from Xerox equipment being sold under installment sales and sales-type leases. Contract terms on these receivables range primarily from two to five years and are generally collateralized by a security interest in the underlying assets. The Company purchased receivables from Xerox totaling $1,848 million in 1993, $1,964 million in 1992, and $1,784 million in 1991. The Company was charged $11 million in 1993, $10 million in 1992, and $9 million in 1991 by Xerox for administrative costs associated with the contracts receivable purchased from Xerox. Under SFAS No. 107- "Disclosures about Fair Values of Financial Instruments," the Company is not required to determine the fair value of these receivables. Management believes that any revaluation of the contracts receivable would result in a fair value significantly in excess of the carrying value of these receivables. During 1990, the Company sold, with limited recourse, $750 million of Xerox contracts receivable in two asset securitizations. At December 31, 1993, $40 million of these receivables remain outstanding. For the securitization transactions, the Company or one of its subsidiaries acts as collection agent for the accounts and remits the principal collected plus a floating rate of interest to the purchasers on a monthly basis. The scheduled maturities of contracts receivable at December 31, 1993 are as follows (in millions): 1994-$1,663; 1995-$1,205; 1996-$781; 1997-$365; 1998-$127; 1999 and thereafter- $7. Experience has shown that a portion of these contracts receivable will be prepaid prior to maturity. Accordingly, the preceding schedule of contractual maturities should not be considered a forecast of future cash collections. Included in notes receivable from Xerox and affiliates are receivables from related parties payable on demand at various interest rates. For additional information relating to these amounts, see Schedule II- Amounts Receivable from Related Parties and Underwriters, Promoters and Employees Other than Related Parties. In September 1993, the Company acquired 873,550 shares of common stock of Xerox Financial Services Life Insurance Company ("XFSLIC"), a subsidiary of XFSI, representing approximately 26 percent of total common stock outstanding, from a Xerox affiliate. In connection with the purchase of the XFSLIC common stock, the Company issued a $75 million adjustable rate promissory note due 1998, with an initial interest rate of 6 percent. The XFSLIC investment is accounted for on the equity method and is recorded at Xerox' historical cost because all parties involved are part of the Xerox group. Xerox intends to dispose of its investment in XFSLIC and the Company is expected to receive book value upon ultimate disposition of this investment. (20) XEROX CREDIT CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) (4) Lines of Credit, Interest Rate Swaps and Notes Payable- Xerox Corporation At December 31, 1993 the Company and Xerox had joint access to three revolving credit agreements totaling $3.0 billion with groups of banks, which expire from 1994 to 1998. These agreements are unused and are available to back the issuance of commercial paper. At December 31, 1993, Xerox' domestic operations had borrowed approximately $2.4 billion of commercial paper backed by these agreements of which approximately $1.7 billion is related to the Company. The Company routinely enters into interest rate swap agreements in the management of interest rate exposure. An interest rate swap is an agreement to exchange interest rate payment streams based on a notional principal amount. In general, the Company's objective is to hedge its variable-rate debt by paying fixed rates under the swap agreements and receiving variable-rate payments in return. These swap agreements effectively convert an amount (equal to the notional amount) of underlying variable-rate debt into fixed-rate debt. The net interest rate differentials that will be paid or received are recorded currently as adjustments to interest expense. The counterparties to these swap agreements are typically major commercial banks. At December 31, 1993 and 1992, there were outstanding swap agreements which effectively converted $2,200 million and $1,850 million, respectively, of short- and long-term variable-rate debt into fixed-rate debt. These swap agreements mature at various dates through 1999 and result in weighted- average fixed rates of 5.39 percent and 6.17 percent at December 31, 1993 and 1992, respectively. During 1993, the Company also entered into interest rate swap agreements which effectively converted $425 million of short- and long- term variable-rate debt into variable-rate debt that is indexed to the commercial paper rates. These agreements mature at various dates through 1997. In addition, at December 31, 1993 and 1992, the Company had an agreement which effectively converted $100 million of fixed-rate debt, with a weighted average fixed-rate of 8.97 percent, into variable-rate debt that is indexed to the commercial paper rates. At December 31, 1993, the Company's swap agreements had an aggregate net fair value of $35 million, based on quotes from banks, which represents the estimated net amount the Company would be required to pay to terminate all the agreements as of December 31, 1993. The Company has no present plans to terminate any of these agreements prior to their scheduled maturities. Because the $35 million represents a theoretical liability of the Company, there was no significant credit risk in the event of a counterparty default. Notes payable- Xerox Corporation is an intercompany payable with Xerox relating to the purchase of long-term trade accounts receivables. These amounts are settled periodically throughout the year. (21) XEROX CREDIT CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) (5) Notes Payable After One Year A summary of notes payable at December 31, 1993 and 1992 follows: 1993 1992 (In Millions) 8.75% Notes due 1993 $ - $ 200 8.20% Notes due 1993 - 20 10.00% Notes due 1993 - 125 9.25% Notes due 1993 - 200 9.125% Notes due 1993 - 100 9.58% Notes due 1993 - 14 9.50% Notes due 1994 100 100 9.76% Notes due 1994 14 14 4.119% Notes due 1994 50 50 Floating Rate Notes due 1994 (a) 275 - 5.375% Notes due 1995 150 150 3.75 % Notes due 1995 50 - Floating Rate Notes due 1995 (a) 50 - 8.75% Notes due 1995 150 150 6.25% Notes due 1996 200 200 Floating rate Notes due 1996 (a) 50 - 4.80% Notes due 1997 50 - 8.00% Notes due 1999 (b) 100 100 10.00% Notes due 1999 150 150 10.125% Notes due 1999 (c) 150 150 Floating Rate Notes due 2048 (d) 61 62 Other Notes due 1993 - 50 Other Notes due 1994 - 1997 34 21 Subtotal $ 1,634 $ 1,856 Less unamortized discount (1) (2) Less current portion of notes payable after one year (554) (709) Total Notes Payable After one Year $ 1,079 $ 1,145 (a) The notes carry interest rates which are based primarily on spreads above certain reference rates such as U.S. Treasury Bill, LIBOR and Federal funds rates. (b) The notes are redeemable on or after March 1, 1994, at the option of the Company, in whole or in part, at a premium plus accrued interest. (c) The notes are redeemable on or after April 15, 1996, at the option of the Company, in whole or in part, at their principal amount plus accrued interest. (22) XEROX CREDIT CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) (d) The notes mature August 15, 2048 and are repayable at the option of the noteholders beginning August 15, 1991 and annually thereafter. On August 15, 1993 and 1991, $1 million and $2 million of these notes were repaid, respectively. The outstanding notes are classified as notes payable after one year, since the Company has the ability to refinance them on a long-term basis, if required. The interest rate is indexed to rates on commercial paper placed for issuers whose commercial paper rating is "AA" or the equivalent as reported in Federal Reserve Statistical Release H.15 (519), which at year-end was 3.34 percent. Principal payments on notes payable for the next five years are: $554 million in 1994; $400 million in 1995; $415 million in 1996; $54 million in 1997; $0 million in 1998; and $211 million thereafter. Certain of the Company's debt agreements allow it to redeem outstanding debt, usually at par, prior to scheduled maturity. Outstanding debt issues with these call features are classified on the balance sheet and in the preceding five-year maturity table in accordance with management's current expectations. The actual decision as to early redemption will be made at the time the early redemption option becomes exercisable and will be based on economic and business conditions then in existence. Interest payments on notes payable for 1993, 1992 and 1991 were $148 million, $166 million, and $237 million, respectively. Interest payments on commercial paper for 1993, 1992 and 1991 were $48 million, $40 million and $55 million, respectively. The weighted-average commercial paper interest rates for 1993, 1992 and 1991 were 3.3 percent, 3.9 percent and 6.1 percent, respectively. At December 31, 1993, $1,634 million of notes payable remains out- standing, substantially all of which are subject to the requirements of SFAS No. 107- "Disclosures about Fair Values of Financial Instruments." The fair value of the Company's notes payable at December 31, 1993 was $1,698 million, which was estimated based on quoted market prices for these or similar issues or on the current rates offered to the Company for debt of the same remaining maturities. The difference between the fair value and the carrying value represents the theoretical net premium the Company would have to pay to retire all notes payable at December 31, 1993. The Company has no plans to retire its notes payable after one year prior to their call or final maturity dates. The original issue discount and other expenses associated with the debt offerings are amortized over the term of the related issue. (23) XEROX CREDIT CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) (6) Income Taxes "SFAS No. 109 requires a change from the deferred method of accounting for income taxes of APB Opinion 11 (APB No. 11) to the asset and liability method of accounting for income taxes. Under the asset and liability method of SFAS No. 109, deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases. Deferred tax assets and liabilities are measured using enacted tax rates that apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. Under SFAS No. 109 the effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date. Effective January 1, 1992, the Company prospectively adopted SFAS No. 109. The cumulative effect of that change was immaterial and had no impact on income from continuing operations. A tax benefit of $87 million was recorded in 1992 to discontinued operations, which represented the cumulative tax benefits associated with the discontinued real-estate operations that were not previously recorded. Pursuant to the deferred method under APB No. 11, which was applied in 1991 and prior years, deferred income taxes were recognized for income and expense items that were reported in different years for financial reporting purposes and income tax purposes using the tax rate applicable to the year of the calculation. Under APB No. 11, deferred taxes were not adjusted for subsequent changes in tax rates. Income taxes are provided at statutory rates based on income before income taxes exclusive of the amortization of investment tax credits and earnings not subject to Federal taxation. Substantially all of the Company's operations are included in Xerox' consolidated income tax returns. In connection with these consolidated returns, the Company paid Xerox $136 million, $15 million, and $41 million in 1993, 1992 and 1991, respectively. The Company paid $1 million in 1993, 1992 and 1991, to taxing authorities for Company operations not included in Xerox' consolidated tax returns. (24) XEROX CREDIT CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) The components of income from continuing operations before taxes and the provision for income taxes are as follows: 1993 1992 1991 (In Millions) Income from continuing operations before income taxes: $ 154 $ 158 $ 164 Federal income taxes Current $ 50 $ 52 $ 57 Deferred (1) (3) (7) State income taxes Current 14 15 18 Deferred - (1) (2) Total provision for income taxes $ 63 $ 63 $ 66 Deferred income taxes for 1993, 1992, and 1991 result from differences between financial and tax reporting in the timing of the recognition of income on securitized assets. In addition, deferred income taxes for 1991 included differences due to the timing of interest expense recognized on the Company's $250 million Zero Coupon Notes which were redeemed during 1992. A reconciliation of the effective tax rate from the U.S. Federal statutory tax rate follows: 1993 1992 1991 U.S. Federal statutory rate 35.0% 34.0% 34.0% Tax exempt interest income - - (0.4) State income taxes, net of Federal income tax benefit 5.9 5.9 6.6 Effective tax rate 40.9% 39.9% 40.2% (25) XEROX CREDIT CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) The tax effects of temporary differences that give rise to significant portions of deferred taxes at December 31, 1993 follows: 1993 1992 Tax effect of future tax deductions: Discontinued real-estate tax benefit $ 42 $ 47 Tax effect on future taxable income: Discontinued leverage leases and other (77) (219) Continuing operations- asset securitizations (3) (2) Total deferred taxes, net $ (38) $(174) Total net deferred tax liabilities included in the Company's balance sheets at December 31, 1991 was $323 million. The 1993 reduction in deferred income taxes payable is the result of sales of certain discontinued operations assets. The Company believes that it is more likely than not that the deferred tax assets will be realized in the ordinary course of operations based on scheduling of deferred tax liabilities and income from operating activities. (7) Xerox Corporation Support Agreement The terms of a Support Agreement with Xerox provide that the Company will receive income maintenance payments, to the extent necessary, so that the Company's earnings shall not be less than 1.25 times its fixed charges. For purposes of this calculation, both earnings and fixed charges are as defined in Section 1404 (formerly Section 81(2)) of the New York Insurance Law. In addition, the agreement requires that Xerox retain 100 percent ownership of the Company's voting capital stock. (26) XEROX CREDIT CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) (8) Quarterly Results of Operations (Unaudited) A summary of interim financial information follows: First Second Third Fourth Quarter Quarter Quarter Quarter Total (In Millions) Earned income $ 102 $ 93 $ 87 $ 94 $ 376 Interest expense 56 53 52 48 209 Operating and administrative expenses 4 2 4 3 13 Income taxes 17 15 13 18 63 77 70 69 69 285 Net income $ 25 $ 23 $ 18 $ 25 $ 91 Earned income $ 99 $ 98 $ 96 $ 96 $ 389 Interest expense 54 52 53 53 212 Operating and administrative expenses 5 4 5 5 19 Income taxes 16 17 15 15 63 75 73 73 73 294 Net income from continuing operations 24 25 23 23 95 Income (loss) from discontinued operations* 122 - - (122) - Net income (loss) $ 146 $ 25 $ 23 $ (99) $ 95 * 1992 first quarter includes $87 million benefit resulting from the cumulative effect of adopting SFAS No. 109. (27) SCHEDULE II XEROX CREDIT CORPORATION Amounts Receivable from Related Parties and Underwriters, Promoters and Employees Other than Related Parties Years Ended December 31, 1993, 1992 and 1991 (In Millions) Balance at Balance End of Period Beginning Amounts of Period Additions Collected Current Not Current Name of Debtor Xerox Financial Services, Inc. (A) $ 50 $ 3 $ 3 $ 50 $ - Xerox Financial Services, Inc. - 6 - 6 - CBC Funding Corporation 7 - 5 2 - $ 57 $ 9 $ 8 $ 58 $ - Van Kampen Merritt, Inc. (A) $ 50 $ 3 $ 3 $ 50 $ - CBC Funding Corporation 26 - 19 7 - $ 76 $ 3 $ 22 $ 57 $ - Van Kampen Merritt, Inc. (A) $ 51 $ 3 $ 4 $ 50 $ - CBC Funding Corporation - 33 7 - 26 Crum and Forster, Inc. 6 6 12 - - Xerox Finance N.V. 9 - 9 - - $ 66 $ 42 $ 32 $ 50 $ 26 (A) During February 1993, this note was assumed by XFSI. The note bears interest at the commercial paper rate plus 1.0 percent annually. (28) SCHEDULE VIII XEROX CREDIT CORPORATION Valuation and Qualifying Accounts Years Ended December 31, 1993, 1992 and 1991 (In Millions) Additions Balance Charged Retained Balance at to at at Beginning Costs Time End of and of of Period Expenses Purchase Deductions Period (A) (B) Allowance for losses- continuing operations $ 139 $ - $ 63 $ 49 $ 153 Allowance for losses- continuing operations $ 108 $ - $ 75 $ 44 $ 139 Allowance for losses- continuing operations $ 127 $ - $ 36 $ 55 $ 108 (A) In connection with the contracts receivable purchased from Xerox, the Company retains an allowance for losses at the time of purchase which is intended to protect against future losses. Should any additional allowances be required, Xerox is required under the Operating Agreement to provide such funding. For the period covered by this Schedule, no additional funding was required or provided. (B) Amounts written off, net of recoveries. (29) SCHEDULE IX XEROX CREDIT CORPORATION Short-Term Borrowings Years Ended December 31, 1993, 1992 and 1991 (In Millions) Maximum Weighted Amount Weighted Balance Average Outstanding Average At End Interest At Any Average Interest Of Period Rate Month-End Balance Rate (A) (B) Commercial Paper $ 1,653 3.3% $ 1,653 $ 1,478 3.3% Commercial Paper $ 1,257 3.8% $ 1,283 $ 1,026 3.9% Commercial Paper $ 906 4.9% $ 1,246 $ 898 6.1% (A) Average Commercial Paper outstanding during the period is computed by dividing the daily outstanding balances by the number of days commercial paper was outstanding. (B) The weighted average interest rate during the period is computed by dividing the interest charged for the period by the weighted average amount outstanding during the period. (30) XEROX CREDIT CORPORATION Form 10-K For the Year Ended December 31, 1993 Index of Exhibits Document (3) (a) Certificate of Incorporation of Registrant filed with the Secretary of State of Delaware on June 23, 1980. Incorporated by reference to Exhibit 3(a) to Registration Statement No. 2-71503. (b) By-Laws of Registrant, as amended through July 15, 1991. Incorporated by reference to Exhibit 3(b) to Registrants Quarterly Report on Form 10-Q for the quarter ended June 30, 1991. (4) (a) Indenture dated as of February 1, 1987 between Registrant and Continental Illinois National Bank and Trust Company of Chicago relating to unlimited amounts of debt securities which may be issued from time to time by Registrant when and as authorized by Registrant's Board of Directors or the Executive Committee of the Board of Directors. Incorporated by reference to Exhibit 4(a) to Registration Statement No. 33-12160. (b) Indenture dated as of October 1, 1987 between Registrant and The Bank of New York relating to unlimited amounts of debt securities which may be issued from time to time by Registrant when and as authorized by Registrant's Board of Directors or the Executive Committee of the Board of Directors. Incorporated by reference to Exhibit 4(a) to Registration Statement No. 33-18258. (c) Indenture dated as of March 1, 1988 between Registrant and The First National Bank of Chicago relating to unlimited amounts of debt securities which may be issued from time to time by Registrant when and as authorized by Registrant's Board of Directors or the Executive Committee of the Board of Directors, as supplemented by the First Supplemental Indenture dated as of July 1, 1988. Incorporated by reference to Exhibit 4(a) to Registration Statement No. 33-20640 and to Exhibit 4(a)(2) to Registrant's Current Report on Form 8-K dated July 13, 1988. (31) XEROX CREDIT CORPORATION Form 10-K For the Year Ended December 31, 1993 Index of Exhibits Document (d) Indenture dated as of March 1, 1989 between Registrant and Citibank, N.A. relating to unlimited amounts of debt securities which may be issued from time to time by Registrant when and as authorized by Registrant's Board of Directors or the Executive Committee of the Board of Directors, as supplemented by the First Supplemental Indenture dated as of October 1, 1989. Incorporated by reference to Exhibit 4(a) to Registration Statement No. 33-27525 and to Exhibit 4(a)(2) to Registration Statement No. 33-31367. (e) Indenture dated as of October 1, 1989 between Registrant and Chemical Bank (as successor by merger to Manufacturers Hanover Trust Company) relating to unlimited amounts of debt securities which may be issued from time to time by Registrant when and as authorized by Registrant's Board of Directors or the Executive Committee of the Board of Directors. Incorporated by reference to Exhibit 4(a) to Registration Statement No. 33-31366. (f) Indenture dated as of August 1, 1991, as supplemented by the First Supplemental Indenture dated as of December 31, 1991, between the Registrant and Bank of Montreal Trust Company relating to unlimited amounts of debt securities which may be issued from time to time by Registrant when and as authorized by the Registrant's Board of Directors or the Executive Committee of the Board of Directors. Incorporated by reference to Exhibit 4(a) to Registration Statement No. 33-39838. (g) Indenture dated as of October 1, 1991 between Registrant and Citibank, N.A. relating to unlimited amounts of debt securities which may be issued from time to time by Registrant when and as authorized by the Registrant's Board of Directors or the Executive Committee of the Board of Directors, as supplemented by the First Supplemental Indenture dated as of May 1, 1992. Incorporated by reference to Exhibit 4(a)(1) and 4(a)(2) to Registration Statement No. 33-43470. (32) XEROX CREDIT CORPORATION Form 10-K For the Year Ended December 31, 1993 Index of Exhibits Document (h) Instruments with respect to long-term debt where the total amount of securities authorized thereunder does not exceed ten percent of the total assets of Registrant and its subsidiaries on a consolidated basis have not been filed. Registrant agrees to furnish the Commission a copy of each such instrument upon request. (10) (a) Amended and Restated Operating Agreement originally made and entered into as of November 1, 1980, amended and restated as of December 31, 1992 between Registrant and Xerox Corporation ("Xerox"). Incorporated by reference to Exhibit 10(a) of Registrant's Annual Report on Form 10-K for the year ended December 31, 1992. (b) Support Agreement dated as of November 1, 1980 between Registrant and Xerox. Incorporated by reference to Exhibit 10(b) to Registration Statement No. 2-71503. (c) Tax Allocation Agreement dated as of January 1, 1981 between Registrant and Xerox. Incorporated by reference to Exhibit 10(c) to Registration Statement No. 2-71503. (12) (a) Computation of Registrant's Ratio of Earnings to Fixed Charges. See Page 34 of this Report on Form 10-K. (b) Computation of Xerox' Ratio of Earnings to Fixed Charges. See Page 35 of this Report on Form 10-K. (23) Consent of KPMG Peat Marwick. See Page 37 of this Report on Form 10-K. (24) Power of Attorney. See Page 38 of this Report on Form 10-K. (33)

77098_1993.txt

77098

1993

ITEM 1. BUSINESS INTRODUCTION American Premier Underwriters, Inc. (the "Company"), the Registrant, was incorporated in the Commonwealth of Pennsylvania in 1846. Effective March 25, 1994, the Company changed its corporate name from The Penn Central Corporation to American Premier Underwriters, Inc. in order to better reflect its new identity as a property and casualty insurance specialist. Formerly a diversified company, the Company has reoriented its corporate focus on specialty property and casualty insurance through a number of strategic acquisitions and divestitures. Its principal operations are conducted by a group of non-standard private passenger automobile insurance companies (the "NSA Group") that were purchased in 1990 and by Republic Indemnity Company of America ("Republic Indemnity"), a California workers' compensation insurance company that the Company purchased in 1989. See "Description of Businesses--Insurance". In furtherance of its acquisition strategy, on February 10, 1994, the Company announced that it is considering a proposal from American Financial Corporation ("AFC") for the purchase by the Company of the personal lines insurance businesses owned by Great American Insurance Company ("GAI"), a wholly owned subsid- iary of AFC, for a proposed purchase price of approximately $380 million in cash. GAI's personal lines businesses reported net earned premiums of $342 million in 1993 and $322 million in 1992. Approximately 70% of these premiums came from standard private passenger automobile insurance, 25% from multiperil homeowners' insurance and 5% from other lines. GAI has advised the Company that separate income statements for the personal lines businesses are not available because these lines have been included with GAI's other insurance lines for financial reporting purposes. However, GAI estimates that on a stand-alone basis the personal lines businesses had pro forma accident year statutory combined ratios of 99.0% in 1993 and 99.1% in 1992. AFC's proposal for the sale of the personal lines businesses to the Company would include the transfer by GAI of an investment portfolio of securities with a market value of approximately $450 million, consisting principally of investment grade bonds. GAI estimates that the generally accepted accounting principles ("GAAP") net book value of the businesses that would be trans- ferred at closing would be approximately $200 million. The Company's Board of Directors (the "Board") has at this stage concluded that the proposed acquisition merits serious consideration, in part because it could further the Company's strategy of achieving higher returns by investing its substantial cash resources in profitable property and casualty insurance businesses. The Board also concluded that the proposed acquisi- tion is potentially attractive in that it could provide the Company with the opportunity to become a full-service provider of private passenger automobile insurance on a nationwide basis that can take advantage of the Company's existing auto insurance management and underwriting skills. The Board has appointed a special committee of its outside directors to review the proposal. The special committee is empowered to negotiate all aspects of the proposed transaction, including the purchase price proposed by AFC. Completion of a transaction would be subject to certain conditions, including approval by the special committee, receipt by the Company of an appropriate fairness opinion from an investment banking firm and any required regulatory approvals. AFC owns 40.5% of the Com- pany's Common Stock and AFC's principal shareholder, Carl H. Lindner, is Chairman of the Board and Chief Executive Officer of the Company. On May 20, 1993, the Company purchased Leader National Insurance Company ("Leader National") from The Dyson-Kissner- Moran Corporation for $38 million in cash. Leader National writes non-standard private passenger automobile insurance and, to a lesser extent, non-standard commercial automobile insur- ance. The Company continues to seek acquisitions and investment opportunities, primarily in the property and casualty insurance area. At December 31, 1993, the Company had $611.2 million of cash, temporary investments and marketable securities (other than those held by its insurance operations) that could be available for such purposes. It is not possible to predict the nature or impact on the Company of any other acquisition or investment that might be made. In furtherance of its strategy to sell all of its wholly owned non-insurance operating subsidiaries, the Company sold in August 1993 the defense services operations conducted by Vitro Corporation for approximately $94 million and also sold in 1993 and the first quarter of 1994 units that install satellite commu- nications networks, provide engineering services to the nuclear energy industry and provide rail testing services, respectively, for an aggregate of approximately $17.8 million. During 1993, the Company, in underwritten public offerings, sold its 19.3% position in the common shares of Tejas Gas Corpo- ration for net proceeds of $106.6 million (resulting in a pre-tax gain to the Company of $80.0 million) and sold its 20% position in the limited partnership units of Buckeye Partners, L.P. for net proceeds of $71.6 million (resulting in a pre-tax gain of $18.5 million). In December 1993, the Company signed an agreement in princi- ple with the Metropolitan Transportation Authority of the State of New York (the "MTA") that provides for an extension of the end of the Company's lease to the MTA of Grand Central Terminal ("GCT") and the Harlem and Hudson commuter rail lines from the year 2032 to 2274. It also provides for the grant of an option to the MTA to purchase the leased property in 25 years. In return, the Company would receive consideration having an esti- mated present value of $55 million, principally in the form of increased future lease rental payments. See "Description of Businesses--Non-Insurance Operations--Other--GCT and Related Development Rights". The Company has reported, as of the beginning of its 1993 tax year, an aggregate consolidated net operating loss carry- forward for Federal income tax purposes of $825 million and an aggregate capital loss carryforward of $384 million. The 1993 consolidated Federal income tax return will report a remaining net operating loss carryforward currently estimated at $610 million, which will expire at the end of 1996 unless previously utilized, and a remaining capital loss carryforward estimated at $262 million, which will expire at the end of 1997 unless previ- ously utilized. See Note 7 of the Notes to Financial Statements of the Company and its subsidiaries ("Notes to Financial State- ments") that are incorporated herein by reference to the Com- pany's 1993 Annual Report to Shareholders. DESCRIPTION OF BUSINESSES Set forth below is a narrative description of the business operations of the Company's Insurance segment, which is the only reportable industry segment for which financial information is presented in the financial statements referred to in Item 8 of this Report. In addition, information is presented with respect to the Company's "Non-Insurance Operations". INSURANCE Introduction ------------ The Company's principal operations are conducted through specialty property and casualty insurance subsidiaries that underwrite and market non-standard automobile and workers' compensation insurance. The Company's primary objective in its insurance operations is to achieve underwriting profitability, in addition to earning income from investment of premiums. The Company has met this objective in each of the four full years that it has owned its insurance operations. In 1993, these operations had an overall GAAP combined ratio of 96.2% (representing a 3.8% underwriting profit). On a statutory basis, the combined ratio was 94.0%, as compared with a property and casualty statutory insurance average of 109.2% (as estimated by A.M. Best). The Company experienced net earned premium growth of 27.5% in 1993 while maintaining underwriting profitability. Management's philosophy is to refrain from writing business that is not expected to produce an underwriting profit even if it is necessary to limit premium growth to do so. The overall profitability of the Company's insurance busi- ness is a function of both its underwriting profitability and the performance of its investment portfolio. See "Liquidity and Capital Resources--Investing and Financing Activity" and "Analy- sis of Continuing Operations--Insurance" in "Management's Discus- sion and Analysis of Financial Condition and Results of Operations" ("Management's Discussion and Analysis") that is incorporated herein by reference to the Company's 1993 Annual Report to Shareholders and Note 3 of the Notes to Financial Statements for information regarding investments and investment income of the Company's Insurance segment. In October 1993, the Clinton Administration introduced in Congress proposed legislation called the Health Security Act (the "HSA"), which would guarantee all Americans access to comprehen- sive health care services provided through health plans. If the HSA were enacted, health plans would provide medical treatment for injuries sustained in the workplace or in an automobile accident. Workers' compensation and automobile insurers would continue to be responsible for the costs of treatment covered by their policies and would reimburse health plans for services provided. The HSA also would create a Commission on Integration of Health Benefits, which would study the feasibility and appro- priateness of transferring to health plans financial responsi- bility for all medical benefits covered under workers' compensa- tion and automobile insurance and would submit a report to the President by July 1, 1995 that would provide a detailed plan for integration if integration is recommended. The Company is unable to predict whether or in what form the HSA will be enacted or, if enacted, what effect it would have on the Company's insurance operations. However, depending on its actual terms, the HSA, and any subsequent legislation mandating such integration, could potentially have a material adverse effect on the Company's future insurance operations. Non-Standard Automobile Insurance --------------------------------- General. The NSA Group is engaged in the writing of insur- ance coverage on private passenger automobile physical damage and liability policies for "non-standard risks". The NSA Group has four principal operating units comprised of Atlanta Casualty Company, Windsor Insurance Company, Infinity Insurance Company and Leader National Insurance Company and their respective subsidiaries ("Atlanta Casualty", "Windsor", "Infinity" and "Leader National", respectively) and includes a total of ten insurance companies. Atlanta Casualty, Windsor, Infinity and Leader National are rated A+ (Superior), A+ (Superior), A (Excellent) and A- (Excellent), respectively, by A.M. Best, which rates insurance companies based upon factors of concern to policyholders. Non-standard risks are those individuals who are unable to obtain insurance through standard market carriers due to factors such as age, record of prior accidents, driving violations, particular occupation or type of vehicle. Premium rates for non-standard risks are generally higher than for standard risks. Total private passenger automobile insurance premiums written by insurance carriers in the United States in 1993 have been esti- mated by A.M. Best to be approximately $93 billion. Since it can be viewed as a residual market, the size of the non-standard private passenger automobile insurance market changes with the insurance environment and grows when standard coverage becomes more restrictive. Although this factor, as well as industry differences in the criteria which distinguish standard from non- standard insurance, make it difficult to make estimates of non-standard market size, NSA Group management believes that the voluntary non-standard market has accounted for approximately 10% to 15% of total private passenger automobile insurance premiums written in recent years. State "assigned risk" plans also service this market as an alternative to voluntary private insurance. The NSA Group's net written premiums increased from $660 million in 1992 to $902 million in 1993. The NSA Group attrib- utes its premium growth in recent years primarily to entry into new states, increased market penetration in its existing states, overall growth in the non-standard market and the inclusion of $46.2 million of net written premiums following the May 1993 purchase of Leader National. Management of the Company believes the non-standard market has experienced significant growth in recent years as standard insurers have become more restrictive in the types of risks they will write. The NSA Group writes busi- ness in 38 states and holds licenses to write policies in 45 states and the District of Columbia. The geographic distribution of the NSA Group gross written premiums in 1993, including Leader National's gross written premiums from its May 20, 1993 date of acquisition by the Compa- ny, compared to 1992 was as follows: In early 1993, the Company acquired 51% of the stock of a start- up insurance company in the United Kingdom which specializes in non-standard automobile insurance. During 1993, this company had gross written premiums of $23.7 million, of which $9.8 million was reinsured by one of the Company's wholly owned insurance subsidiaries. Underwriting results of insurance companies are frequently measured by their combined ratios. Underwriting results are generally considered profitable when the combined ratio is under 100%. The following table sets forth information with respect to the combined ratios for the NSA Group and the total private passenger automobile insurance industry for the periods shown: (1) Industry information was derived from Best's Insurance Management Reports Property/Casualty Supplement (January 3, 1994 edition). The comparison shown is to the private passenger automobile insurance industry. Although the Com- pany believes that there is no reliable regularly published combined ratio data for the non-standard automobile insurance industry, the Company believes that such a com- bined ratio would present a less favorable comparison in that it would be lower than the private passenger automobile industry average shown above. The increase in the combined ratio for 1993 was primarily caused by rate adjustments which more favorably affected 1992 underwrit- ing results and an increase in losses in the 1993 first quarter resulting from a more severe winter than in 1992. A decrease in the underwriting expense ratio due to growth in earned premiums which outpaced associated expenses partially offset such factors. The NSA Group management believes that it has achieved underwriting profits over the past several years as a result of refinement of various risk profiles, thereby dividing the consum- er market into more defined segments which can either be excluded from coverage or surcharged adequately. Effective cost control measures, both in the underwriting and claims handling areas, have further contributed to the underwriting profitability of the NSA Group. In addition, the NSA Group generally writes policies of short duration, allowing more frequent evaluation of the rates on individual risks. Marketing. Each of the four principal units in the NSA Group is responsible for its own marketing, sales, underwriting and claims processing. Sales efforts are primarily directed toward independent agents to convince them to select an NSA Group insurance company for their customers. These units each write policies through approximately 5,000 to 20,000 independent agents. Of the approximately 920,000 NSA Group policies in force at December 31, 1993, fewer than 6% had policy limits in excess of $50,000 per occurrence. Most NSA Group policies are written for policy periods of six months or less, and some are as short as one month. Reinsurance. Due in part to the limited exposure on indi- vidual policies, none of the insurance carriers in the NSA Group is involved to a material degree in reinsuring risks with third party insurance companies. Risks written by NSA Group companies in excess of certain limits are in some cases reinsured with a major reinsurance company. In general, the risk retained by the NSA Group companies ranges from $100,000 to $500,000 of ultimate net loss for each occurrence and certain portions of ultimate net losses in excess of such limits. Reinsurance premiums paid by the NSA Group in 1993 amounted to less than 1% of net written premi- ums of the NSA Group for the period. See Notes 3 and 17 of the Notes to Financial Statements for further information regarding reinsurance. Competition. A large number of national, regional and local insurers write non-standard private passenger automobile insur- ance coverage. Insurers in this market generally compete on the basis of price (including differentiation on liability limits, variety of coverages offered and deductibles), geographic avail- ability and ease of enrollment and, to a lesser extent, reputa- tion for claims handling, financial stability and customer service. NSA Group management believes that sophisticated data analysis for refinement of risk profiles has helped the NSA Group to compete successfully on the basis of price without negatively affecting underwriting profitability. The NSA Group attempts to provide selected pricing for a wider spectrum of risks and with a greater variety of payment options, deductibles and limits of liability than are offered by many of its competitors. The NSA Group does not issue any participating policies and does not pay dividends to policyholders, except for Leader National, which paid policyholders $107,000 in dividends in 1993 pursuant to certain commercial vehicle programs. Regulation. Like all insurance companies, including Republic Indemnity discussed below under "Workers' Compensation Insurance", the NSA Group insurance companies are subject to regulation in the jurisdictions in which they do business. In general, the insurance laws of the various states establish regulatory agencies with broad administrative powers governing, among other things, premium rates, solvency standards, licensing of insurers, agents and brokers, trade practices, forms of poli- cies, maintenance of specified reserves and capital for the protection of policyholders, deposits of securities for the benefit of policyholders, investment activities and relationships between insurance subsidiaries and their parents and affiliates. Material transactions between insurance subsidiaries and their parents andaffiliates generally must be disclosed and prior approval of the applicableinsurance regulatory authorities generally is required for any such transaction which may be deemed to be extraordinary. In addition, while regulations differ from state to state, they typically restrict the maximum amount of dividends that may be paid by an insurer to its share- holders in any twelve-month period without advance regulatory approval. Such limitations are generally based on earnings or statutory surplus. Under applicable restrictions, the maximum amount of dividends that may be paid by the NSA Group to the Company during 1994 without seeking regulatory clearance is $32.8 million. Most states have created insurance guarantee associations to provide for the payment of claims for which insolvent insurers are liable but which cannot be paid out of such insolvent in- surers' assets. In applicable states, insurance companies, including the NSA Group companies, are subject to assessment by such associations, generally to the extent of such companies' pro rata share of such claims based on premiums written in the particular line of business in the year preceding the assessment, and subject to certain ceilings on the amount of such assessments in any year. In 1993, the NSA Group companies paid assessments to such associations aggregating approximately $1.2 million. In addition, many states have created "assigned risk" plans, jointunderwriting associations and other similar arrangements to provide state mandated minimum levels of automobile liability coverage to drivers whose driving records or other relevant characteristics make it difficult for them to obtain insurance in the voluntary market. Automobile liability insurers in those states are required to sell such coverage to a proportionate number (generally based on the insurer's share of the automobile liability insurance market in such state) of those drivers applying for placement as assigned risks. Assigned risks account- ed for less than 1% of net written premiums of the NSA Group companies in 1993. Premium rates for assigned risk business are established by the regulators of the particular state plan and are frequently inadequate in relation to the risks insured, resulting in underwriting losses. In 1993, the NSA Group received approximately $54.0 million in net written premiums from California. Prior to 1989, automo- bile insurance rates in California, other than assigned risk rates discussed above, were not subject to approval by any governmental agency and generally were determined by competitive market forces. In November 1988, Proposition 103 was approved by the California voters. It mandated important changes in the California insurance market, including the requirement that insurance companies roll back automobile insurance rates to 80% of the November 1987 levels, maintain those rates for one year and obtain prior approval of rates beginning in 1989. The Company's acquisition of the NSA Group in 1990 was structured to protect the Company against the consequences of any rate rollback applied to the acquired operations. As for the prior approval requirements, the company through which the NSA Group obtains its net written premiums in California increased its rates in August 1989; disposition of its applications for additional rate increases had, as with other companies, been suspended pending adoption of regulations implementing Proposition 103. However, recent legislation in California generally provides that applica- tions for rate increases made on or after July 1, 1993 will be deemed approved after 180 days unless disapproved by the Depart- ment of Insurance. The Company is unable to predict whether or at what level future rate increases, when applied for, may be approved. Over time, the failure to receive appropriate rate increases could result in reduced underwriting profitability in California for the NSA Group. In addition, the Company could experience loss of premium volume in California as a result of actions it would take to maintain such profitability. The operations of the NSA Group are dependent on the laws and regulations of the states in which its insurance companies are domiciled or licensed or otherwise conduct business, and changes in those laws and regulations have the potential to materially affect the revenues and expenses of the NSA Group. The Company is unable to predict whether or when Proposition 103-type initiatives or similar laws or regulations may be adopted or enacted in other states or what the impact of such developments would be on the future operations and revenues of its insurance businesses in such states. Workers' Compensation Insurance ------------------------------- General. Republic Indemnity is engaged in the sale of workers' compensation insurance in California. In 1993, it also began writing in Arizona. Republic Indemnity is currently rated A+ (Superior) by A.M. Best. Workers' compensation insurance policies provide coverage for workers' compensation and employer's liability. The workers' compensation portion of the coverage provides for statutorily prescribed benefits that employers are required to pay to employ- ees who are injured in the course of employment including, among other things, temporary or permanent disability benefits, death benefits, medical and hospital expenses and expenses of vocation- al rehabilitation. The benefits payable and the duration of such benefits are set by statute, and vary with the nature and severi- ty of the injury or disease and the wages, occupation and age of the employee. The employer's liability portion of the coverage provides protection to an employer for its liability for losses suffered by its employees which are not included within the statutorily prescribed workers' compensation coverage. Republic Indemnity generally ssues policies for one-year periods. Workers' compensation insurance operations are affected by employment trends in their markets, the incidence of litigation activities, legal and medical costs, the use of vocational reha- bilitation programs and the filing of traditionally non-occupa- tional injuries, such as stress and trauma claims. While higher claims costs are ultimately reflected in premium rates, there historically has been a time lag of varying periods between the incurrence of higher claims costs and premium rate adjustments, which may unfavorably affect underwriting results. In California, minimum premium rates for workers' compensa- tion insurance are determined by the California Insurance Commis- sioner (the "Insurance Commissioner") based in part upon recom- mendations of the Workers' Compensation Insurance Rating Bureau of California (the "Bureau"). Such rates are set for over 400 categories of employment and generally are applied to the policy- holder's payroll. The Bureau proposed a 12.6% rate increase for new and renewal policies entered into on and after January 1, 1993, but the Insurance Commissioner did not grant any increase. Moreover, as discussed under "--Regulation" below, on July 16, 1993, the California legislature enacted legislation reducing workers' compensation insurance minimum premium rates by 7% with immediate effect and, on July 28, 1993, enacted legislation repealing the minimum rate law effective January 1, 1995. In addition, on December 1, 1993, the Insurance Commissioner ordered a 12.7% minimum premium rate decrease effective January 1, 1994 for new and renewal policies entered into on and after January 1, 1994. The following table sets forth information with respect to the combined ratios for Republic Indemnity and the total workers' compensation industry for the periods shown: (1) Industry information was derived from Best's Insurance Management Reports Property/Casualty Supplement (January 3, 1994 edition). The decrease in the combined ratio for 1993 was primarily caused by a decrease in the frequency of losses, in part due to a reduction in fraudulent claims, and a lower underwriting expense ratio as compared with 1992. Management believes that the sum of Republic Indemnity's loss and LAE and underwriting expense ratios (together, its "loss and expense ratio") has been relatively low compared to that of other companies writing workers' compensation in California. As a result of its lower loss and expense ratio, Republic Indemnity has been able to pay policyholder dividends which are higher than those paid by most of its competitors. Management believes that Republic Indemnity's favorable loss and expense ratio record has been attributable to strict under- writing standards, loss control services, a disciplined claims philosophy and expense containment. Management believes that these factors, as well as Republic Indemnity's favorable reputa- tion with insureds for paying policyholder dividends, have contributed to a high policy renewal rate. From 1991 through 1993, the percentage of Republic Indemnity's policies renewed increased from 72.8% to 83.9% and the percentage of premiums represented by policy renewals increased from 77.2% to 89.2% of the premiums eligible for renewal. In recent years, the California market has been adversely affected by recessionary economic conditions, resulting in lower payrolls of California employers that form the basis of premium assessments. Nevertheless, Republic Indemnity experienced a 17.3% growth in net written premiums in 1993 over 1992. A con- tributing factor to Republic Indemnity's 1993 premium growth was the withdrawal from the Southern California market by several large workers' compensation carriers due to continuing underwrit- ing losses. Marketing. Republic Indemnity writes insurance through approximately 550 independent property and casualty insurance brokers. In 1993, none of these produced more than 4.6% of total premiums. The largest three of these produced approximately 10% of total premiums. Republic Indemnity has in excess of 11,300 policies in force, the largest of which represents less than 1% of net premiums written. Reinsurance. In its normal course of business and in accordance with industry practice, Republic Indemnity reinsures a portion of its exposure with other insurance companies so as to limit its maximum loss arising out of any one occurrence. Rein- surance does not legally discharge the original insurer from primary liability. Republic Indemnity retains the first $1.5 million of each loss, the next $1.5 million of each loss is reinsured with a major reinsurance company, the next $2 million of each loss is shared equally by Republic Indemnity and the reinsurance company and the remaining $120 million of each loss is covered by reinsurance provided by a group of more than 50 reinsurance companies. Premiums for reinsurance ceded by Republic Indemnity in 1993 were 1.0% of net written premiums for the period. Republic Indemnity does not assume reinsurance, except as an accommodation to policyholders who have a small percentage of their employees outside the state of California. See Notes 3 and 17 of the Notes to Financial Statements for further information on reinsurance. Competition. Republic Indemnity competes with both the California State Compensation Insurance Fund (the "State Fund") and over 300 other companies writing workers' compensation insurance in California. In 1992, the State Fund wrote approxi- mately $1.8 billion in direct written premiums, which was approx- imately 20.6% of the insured workers' compensation market in California. In addition, many employers are self-insured. According to published sources, no other company wrote in excess of $470 million in direct written premiums in 1992. Republic Indemnity wrote $401 million in statutory direct written premiums in 1992. With a market share of approximately 4.7% in 1992, not including risks self-insured by employers, Republic Indemnity believes that it is currently the third largest writer of workers' compensation insurance in California, including the State Fund. Approximately 95% of net premiums written by Republic Indemnity in 1993 were from the sale of policies that provide for the discretionary payment of dividends to policyholders as a refund of premiums paid when Republic Indemnity's experience with such policyholders has been more favorable than certain specified levels and Republic Indemnity has had favorable financial results. Because companies may not set workers' compensation premiums at rates lower than those approved by the Insurance Commissioner, competition is based primarily on an insurer's reputation for paying dividends to policyholders. Management believes that Republic Indemnity's record and reputation for paying relatively high policyholder dividends have enhanced its competitive posi- tion. Moreover, the Company believes that its position was favorably impacted by the State Fund's reduction of its policy- holder dividends during 1992 which made the State Fund program less attractive to the market. Other competitive factors include loss control services, claims service, service to brokers and commission schedules. While many companies, including certain of the largest writers, specialize in the writing of California workers' compensation insurance, Republic Indemnity believes it has a competitive advantage over certain other companies offering all lines of insurance in that its specialization in the workers' compensation field enables it to concentrate on that business with a favorable effect upon operations. Republic Indemnity may be at a competitive disadvantage when businesses that purchase general property and casualty insurance are encouraged by other insurers to place their workers' compensation insurance as part of an overall insurance package. Although Republic Indemnity is one of the largest writers of workers' compensation insurance in California, certain of its competitors are larger and/or have greater resources than Republic Indemnity. Regulation. Republic Indemnity's insurance activities are regulated by the California Department of Insurance for the benefit of policyholders. The Department of Insurance has broad regulatory, supervisory and administrative powers along the lines of those promulgated by most states relating to the activities of their domestically incorporated insurers and the conduct of all insurance business within their respective jurisdictions, as described more fully under "Non-Standard Automobile Insurance" above. As indicated above, minimum premium rates for workers' compensation insurance are determined by the Insurance Commis- sioner based in part upon recommendations of the Bureau. On July 16, 1993, California enacted legislation effecting an overall 7% reduction in workers' compensation insurance premium rates with immediate effect, increasing statutory wor- kers' compensation benefits for temporary and permanent disabili- ty commencing initially July 1, 1994 and increasing again in 1995 and 1996, expanding the rights of employers under workers' compensation insurance policies to obtain access to insurance company files and introducing several reforms intended to reduce workers' compensation costs. The reforms include a tightening of the standards for job-related stress and post-termination claims, introducing measures designed to curb medical costs, limiting the frequency of medical-legal evaluations, capping the amount of compensable vocational rehabilitation expenses and strengthening penalties for fraudulent claims. The legislation authorizes the Insurance Commissioner to approve further reductions in premium rates so long as the further reduced rates are "adequate". It also prohibits the Insurance Commissioner, prior to January 1, 1995, from approving any premium rate that is greater than the reduced rates effected by the legislation. On July 28, 1993, California enacted further legislation that will replace the workers' compensation insurance minimum rate law, effective January 1, 1995, with a procedure permitting insurers to use any rate within 30 days after filing it with the Insurance Commissioner unless the rate is disapproved by the Insurance Commissioner. On December 1, 1993, the Insurance Commissioner ordered an additional 12.7% minimum premium rate decrease effec- tive January 1, 1994 for new and renewal policies entered into on and after January 1, 1994. The legislation also provides for the licensing of "managed" health care organizations to provide care for injuries covered by workers' compensation and generally permits employers to require employees to obtain medical services for their work-related injuries for a certain period of time from a health care organization selected by the employer, unless the employee chooses to be treated by a physician designated by the employee prior to the injury. If the workers' compensation cost savings resulting from the new legislation are inadequate to offset the impact of premium rate reductions, increased benefits and expanded employers' rights, the profitability of Republic Indemnity's workers' compensation insurance operations could be adversely affected. Management believes that this effect may be mitigated by Republic Indemnity's ability to reduce its relatively high policyholder dividends, although a reduction in dividends could affect premium volume. Greater price competition is expected to result when the repeal of the minimum premium rates that now govern all workers' compensation insurers becomes effective, and Republic Indemnity's operations could be affected adversely. The Company believes that the legislation's provisions relating to "managed" health care organizations will probably result in certain workers' compensation insurers seeking affiliation, contractual or other- wise, with one or more health care organizations. The Company continues to evaluate the implications of these provisions but is unable to predict whether their ultimate impact on its workers' compensation insurance operations will be positive or adverse. While Republic Indemnity has continued to operate on a profitable basis, no assurance can be given that it could continue to do so in the face of adverse regulatory developments. Shareholder dividends paid within any twelve-month period from a California property and casualty insurance company to its parent without regulatory approval cannot exceed the greater of 10% of the insurer's statutory policyholders' surplus as of the preceding December 31, or 100% of its net income for the preced- ing calendar year, a limitation during 1994 of $61.6 million in the aggregate for Republic Indemnity. Due to the existence of the State Fund, California does not require licensed insurers to participate in any involuntary pools or assigned risk plans for workers' compensation insurance. California has guarantee regulations to protect policyholders of insolvent insurance companies. In California, an insurer cannot be assessed an amount greater than 1% of its premiums written in the preceding year, and the full amount is required to be recov- ered through a mandated surcharge to policyholders. Premiums written under workers' compensation policies are subject to assessment only with respect to covered losses incurred by the insolvent insurer under workers' compensation policies. There were no such assessments for policy year 1993. Proposition 103, which is described more fully under "Non- Standard Automobile Insurance" above, does not affect workers' compensation insurance as directly as other lines of business principally because its rate rollback feature does not apply to workers' compensation insurance. Reinsurance Subsidiary ---------------------- Penn Central Reinsurance Company, a subsidiary of the Company, commenced the writing of reinsurance in 1990. Earned premiums in 1993 and 1992 were approximately $10.7 million and $9.8 million, respectively. Liability for Property-Casualty Losses and Loss Adjustment Expenses ------------------------------------------------------------------- The consolidated financial statements of the Company and its subsidiaries that are incorporated herein by reference include the estimated liability for unpaid losses and LAE of the Com- pany's insurance subsidiaries. The liabilities for losses and LAE are determined using actuarial and statistical procedures and represent undiscounted estimates of the ultimate net cost of all unpaid losses and LAE incurred through December 31 of each year. These estimates do not represent an exact calculation of liabili- ties but rather involve actuarial projections at a given time of what the Company expects the ultimate settlement and administra- tion of claims will cost based on facts and circumstances then known, estimates of incurred but not reported losses, predictions of future events, estimates of future trends in claims' severity and judicial theories of liability as well as other factors such as inflation and are subject to the effect of future trends on claim settlement. These estimates are continually reviewed and adjusted as experience develops and new information becomes known. In light of present facts and current legal interpreta- tions, management believes that adequate provision has been made for loss and LAE reserves. However, establishment of appropriate reserves is an inherently uncertain process, and there can be no certainty that currently established reserves will prove adequate in light of subsequent actual experience. Future loss develop- ment could require reserves for prior periods to be increased, which would adversely impact earnings in future periods. Increases in claim payments are caused by a number of factors that vary with the individual types of policies written. Future costs of claims are projected based on historical trends adjusted for changes in underwriting standards, policy provi- sions, the anticipated effect of inflation and general economic trends. These anticipated trends are monitored based on actual development and are reflected in estimates of ultimate claim costs. The following table provides an analysis of changes in the estimated liability for losses and LAE over the past three years, net of all reinsurance activity, in accordance with GAAP: (1) New accounting rules effective in 1993 require that insurance liabilities be reported without deducting reinsurance amounts. See Note 1 of Notes to Financial Statements. The decreases in the provision for claims occurring in prior years results from reductions in the estimated ultimate losses and LAE related to such claims. The difference between the liability for losses and LAE reported in the annual statements filed with the state insurance departments in accordance with statutory accounting principles and that reported in the consolidated financial statements that are incorporated herein by reference in accordance with GAAP is $45.1 million at December 31, 1993, which is equal to the reinsurance receivable on unpaid losses and LAE at December 31, 1993. The following table presents the development of the liabil- ity for losses and LAE net of reinsurance for 1989 (the year the Company acquired its first insurance subsidiary) through 1993. The top line of the table shows the estimated liability for unpaid losses and LAE recorded at the end of the indicated years. The remainder of the table presents development as percentages of the estimated liability. The development results from additional information and experience in subsequent years. The middle line shows a cumulative redundancy which represents the aggregate percentage decrease in the liability initially estimated. The lower portion of the table indicates the cumulative amounts paid as of successive periods as a percentage of the original liability. The preceding table does not present accident or policy year development data. As indicated in the preceding table, the Company has developed redundancies for all periods presented. These redundancies were offset, in part, by deficiencies related to workers' compensation in the 1990 and 1991 accident years. Furthermore, in evaluating the re-estimated liability and cumula- tive redundancy, it should be noted that each percentage includes the effects of changes in amounts for prior periods. For exam- ple, a redundancy related to losses settled in 1993, but incurred in 1989, would be included in the re-estimated liability and cumulative redundancy percentage for each of the years 1989 through 1992. Conditions and trends that have affected develop- ment of the liability in the past may not necessarily exist in the future. Accordingly, it is not appropriate to extrapolate future redundancies based on this table. NON-INSURANCE OPERATIONS Businesses Divested and to be Divested -------------------------------------- On December 10, 1992, the Company announced its intention to pursue the divestiture of all of its wholly owned non-insurance subsidiaries, consisting of its defense services operations and five smaller diversified industrial businesses. On August 25, 1993, the Company sold its defense services operations, which provide diverse technology and engineering support to government agencies worldwide and manufacture various technical products, to Tracor, Inc. for approximately $94 million in cash, subject to post-closing working capital adjustments. On July 13, 1993, the Company sold its Engineering and Technical Services unit, which principally designs, engineers and installs satellite and microwave communications networks, for cash and notes approximating its $7 million book value. On September 22, 1993, the Company sold its NES unit, which provides consulting, engineering, systems design and other services to the nuclear energy and hazardous waste industries, for cash and notes appro- ximating its $1 million book value. On March 11, 1994, the Company sold its Sperry Rail unit, which provides track testing services for the railroad industry, for approximately $9.8 million in cash. The Company also is pursuing the sale of the following two businesses: The Company's Apparatus unit manufactures aerial lift trucks and utility bodies (mobile tools) under the Telsta and Holan product names for the telecommunications, electric utility and cable television industries which are used for installing and maintaining aerial cable. This unit also manufactures telecommunications cable pressurization and safety equipment under the Puregas and Mopeco product names for the telecommunications and power utility industries. The Company's Marathon Power Technologies Company unit manufactures vented-cell nickel-cadmium batteries which are used primarily for private, commercial and military aircraft and other heavy-duty starting applications and also as a standby power source. This unit also manufactures sealed- cell nickel-cadmium batteries, as well as static inverters for aircraft electrical systems. The Company has reached agreements in principle for the sale of these two businesses for an aggregate of approximately $36 million. See Note 2 of Notes to Financial Statements for information with respect to the revenues, operating income and carrying value of the businesses sold and to be sold. Other ----- Contract Drilling. The Company owns approximately 53.9% of the common stock of DI Industries, Inc. ("DI"), which is engaged primarily in the business of providing onshore contract drilling and well workover services to firms in the oil and gas industry. DI owns or operates 97 drilling and workover rigs located in 12 states, four rigs in Argentina and one rig in Guatemala. Drill- ing operations are conducted primarily in Texas, Louisiana, Oklahoma, Arkansas, Ohio, western Pennsylvania, New York, Michi- gan, Argentina and Guatemala. Well workover services are provid- ed in Montana, Utah, North Dakota and Colorado. Customers include large and small independent producers and major oil companies. DI also engages in commercial drilling activities, generally consisting of drilling shafts for underground tunneling projects and caissons for highway and bridge projects, and heavy equipment sales and repair. DI also engages in oil and gas exploration, production and development, primarily in Oklahoma, Texas and Louisiana. Oil and Gas Properties. The Company owns certain oil and gas properties, located primarily in Oklahoma and Texas. Coal Properties. The Company and a subsidiary own fee interests in coal properties in Illinois, Ohio and Pennsylvania. Most of these properties are leased at various royalty rates to coal mining companies under long-term arrangements, including fixed-term leases with renewal options and exhaustion leases. The Company does not produce, prepare or sell coal or conduct mining operations. Eight mines operated by lessees of the leased coal proper- ties, and carried at approximately $3.4 million, supply steam coal for electrical utilities or industrial customers. The future level of royalties above certain minimum and advance royalties from the reserves presently under lease will depend upon the rate of mining, the change in certain price indices and, in some instances, the sales price of the coal. During 1993, the leased coal properties produced royalties of $6.7 million. GCT and Related Development Rights. Subsidiaries of the Company own GCT in New York City and rights (the "Development Rights") to develop or transfer approximately 1.7 million square feet of floor space in the GCT area. The Development Rights are derived from such subsidiaries' ownership of the land upon which GCT is constructed. Utilization or transfer of such rights requires the approval of certain New York City agencies. If required governmental approvals are obtained, the floor space may be developed on the GCT site, contiguous sites or certain parcels of land in the vicinity, in each case subject to the requirements of applicable law. In 1972, the Company leased GCT (but not the Development Rights) and its related Harlem and Hudson rail lines to the MTA for an initial term expiring in 2032, which is subject to renewal options. In December 1993, the Company reached an agreement in principle with the MTA that provides for an extension of the end of the Company's lease to the MTA of GCT and the Harlem and Hudson commuter rail lines from the year 2032 to 2274. It also provides for the grant of an option to the MTA to purchase the leased property in 25 years. In return, the Company would receive consideration having an estimated present value of $55 million, consisting principally of a $5 million cash payment and an increase in future lease rental payments to the Company of approximately $2 million per year. The agreement in principle also calls for the Company to relinquish its right to construct an office building over GCT. However, the Company will retain its rights to transfer the Development Rights from GCT to other sites in the surrounding area. In November 1983, the Company and two of its subsidiaries entered into an agreement (the "Agreement") with a partnership controlled by The First Boston Corporation (the "Partnership") for the sale by the two subsidiaries to the Partnership of 1.5 million square feet of Development Rights for use on one or more sites neighboring GCT. If a closing were to occur under the Agreement, the purchase price to be received by the two subsid- iaries and the consideration to be received by the Company for release of its leasehold interest in the Development Rights could, under the applicable contractual formula, exceed $95 million. Consummation of the transaction is conditioned on receipt by the Partnership of a special permit from the New York City Planning Commission (the "CPC") to transfer at least a majority of the Development Rights under contract to a site owned by the Partnership in the vicinity of GCT. In August 1989, the CPC denied the Partnership's application for such a permit, whereupon the Partnership brought a lawsuit in New York State Supreme Court challenging the denial. In August 1991, the Court dismissed the lawsuit on a summary judgment motion. In May 1993, the Appellate Division of the New York State Supreme Court af- firmed the dismissal. The New York State Court of Appeals refused to grant leave for further appeal. In February 1994, the Partnership petitioned the U.S. Supreme Court for a writ of certiorari to review the case. It is not possible at this time to predict whether the Partnership's lawsuit will be successful. The Agreement terminates by its terms one year after final resolution of the lawsuit if a special permit for the transfer of Development Rights to the Partnership's site has not theretofore been issued by the CPC. Real Estate Operations. Subsidiaries of the Company own certain land and rights associated with the potential development of areas adjacent to, and above, certain rail lines in the New York City and Westchester County, New York areas. Scarsdale, New York has designated a subsidiary of the Company as preferred developer for the construction of a residential and retail use project adjacent to the Scarsdale commuter railroad station. The agreement in principle with the MTA discussed above under "GCT and Related Development Rights" would transfer all such develop- ment rights to the MTA, except those related to the proposed Scarsdale project. The Company also has a program for the sale of real estate assets that relate to its former rail operations and other surplus land and manufacturing facilities. Management Company. Buckeye Management Company, a subsid- iary of the Company, manages as the sole general partner of, and owns a 1% interest in, Buckeye Partners, L.P., which owns and operates refined petroleum products and crude oil pipelines in the northeast and midwestern United States. GENERAL Compliance with federal, state and local environmental protection laws during 1993 had no material effect upon the Company's capital expenditures, earnings or competitive position, and management anticipates no such material effects resulting from compliance during 1994. However, certain claims are pending against the Company and certain of its subsidiaries relating to the generation, disposal or release into the environment of allegedly hazardous substances, as described below under Item 3 - -"Legal Proceedings". EMPLOYEES As of December 31, 1993, the approximate number of employees of the Company and its consolidated subsidiaries was: Insurance ....................................... 3,000 Non-Insurance Operations ........................ 2,300 Corporate........................................ 100 ----- Total ........................................... 5,400 ----- ----- Approximately 550 of these employees, all in the Non-Insur- ance Operations, are covered by collective bargaining agreements. ITEM 2.

ITEM 2. PROPERTIES The Company's operations are conducted principally within the United States, and the Company believes that its principal facilities, all of which are owned unless otherwise noted, are maintained in good operating condition and are adequate for the present needs of its operations. The principal facilities by reportable industry segment and other operations are as follows: INSURANCE Non-Standard Automobile ----------------------- The NSA Group's principal offices are leased facilities located in Birmingham, Alabama (57,000 square feet), Atlanta (78,000 square feet) and Norcross (58,000 square feet), Georgia and Independence, Ohio (29,000 square feet). These leases expire in January 1995, May 1998, August 2000 and March 1998, respec- tively. Workers' Compensation --------------------- Republic Indemnity leases office space in Encino (72,000 square feet), San Francisco (43,000 square feet), San Diego (11,000 square feet) and Sacramento (9,000 square feet), Califor- nia, and Phoenix, Arizona (2,000 square feet) under agreements expiring in May 1996, March 2001, December 1998, July 1996 and September 1994, respectively. NON-INSURANCE OPERATIONS Businesses to be Divested ------------------------- The Company's Apparatus unit operates four plants in four states, which have an aggregate floor space of approximately 301,000 square feet. Two of these four plants (aggregating 41,000 square feet) are leased under leases expiring in July 1996 and January 1997, respectively, and both have renewal options. Power Tech owns 50 acres in Waco, Texas on which it has a 200,000 square-foot battery manufacturing facility and a 15,000 square-foot office facility. Contract Drilling ----------------- At March 15, 1994, DI's contract oil and gas well drilling fleet consisted of 60 rigs (21 active) based in Texas, Louisiana, Oklahoma, Arkansas, Ohio, western Pennsylvania, New York, Michi- gan, Argentina and Guatemala. At March 15, 1994, the well workover service rig fleet totaled 24 rigs (18 active) based in Montana, Utah, North Dakota and Colorado. In addition, at March 15, 1994, DI owned 3 and operated 13 commercial drilling rigs under a cash flow sharing agreement, 6 of which were active. Also, at March 15, 1994, 2 rigs were held for resale. Oil and Gas Properties ---------------------- All of the Company's oil and gas properties are located in the United States. As of December 31, 1993, the Company had interests in 73 gross (36 net) producing oil wells and 4 gross (1 net) producing gas wells and 6,160 gross (2,965 net) developed and 23,246 gross (5,601 net) undeveloped acres. As of March 31, 1993, DI had interests in 238 gross (9 net) producing oil wells and 574 gross (14.7 net) producing gas wells and 179,539 gross (5,648 net) developed and 335 net undeveloped acres. Coal Properties --------------- The Company and a subsidiary own fee interests in approxi- mately 161,000 acres of coal properties in Illinois, Ohio and Pennsylvania. Approximately 105,000 acres of these properties remain leased at various royalty rates to coal mining companies under long-term arrangements, including fixed-term leases with renewal options and exhaustion leases. GCT and Related Development Rights ---------------------------------- Subsidiaries of the Company own GCT and rights to develop floor space in the Grand Central Terminal area of New York City, as discussed under Item 1 - -"Description of Businesses--Non- Insurance Operations--GCT and Related Development Rights". Real Estate Operations ---------------------- The Company's real estate inventory at December 31,1993 included approximately 20,000 acres of real estate (including approximately 80 acres with surplus manufacturing facilities) spread throughout 13 states. ITEM 3.

ITEM 3. LEGAL PROCEEDINGS The U.S. Government and other parties have asserted claims against the Company as a potentially responsible party for clean-up costs ("Clean-up Costs") under the Comprehensive Environmental Response, Compensation and Liability Act ("CERCLA") at a Superfund site at the Paoli, Pennsylvania railyard ("Paoli Yard"), formerly owned and operated by the Company's prede- cessor, Penn Central Transportation Company ("PCTC"). A Record of Decision was issued by the U.S. Environmental Protection Agency on July 21, 1992 presenting a final selected remedial action for the Paoli Yard in accordance with CERCLA having an estimated cost of approximately $28.3 million. This figure is an estimate of the cost to remediate the entire yard and off-site property to a level acceptable to the U.S. EPA. In March 1992, the Company filed a lawsuit in the Special Court created by the Regional Rail Reorganization Act (the "Rail Act") seeking to enjoin the U.S. Government, Consolidated Rail Corporation ("Con- rail") and other parties from prosecuting claims against the Company for the Clean-up Costs on the grounds that the Paoli Yard environmental claims are barred by: (1) the terms by which the Paoli Yard was transferred by PCTC to Conrail "as is" in 1976 pursuant to the Rail Act; (2) the 1980 settlement of the Valua- tion Case proceedings to determine compensation to be paid by the U.S. Government for the railroad properties transferred by PCTC pursuant to the Rail Act; and (3) the U.S. Constitution. On February 9, 1993, the Special Court denied the U.S. Government's motion to dismiss the Company's complaint for lack of subject matter jurisdiction, holding that it had exclusive jurisdiction to decide these issues. On April 30, 1993, the U.S. Government's separate action in U.S. District Court to recover Clean-up Costs from the Company was stayed pending final judgment by the Special Court in the lawsuit filed by the Company. The parties have filed cross motions for summary judgment, which were argued to the Special Court on February 23, 1994 and are now under submis- sion. In addition to the Special Court litigation, the Company believes that it has other substantial defenses to claims for Clean-up Costs at the Paoli Yard, including its position that other parties are responsible for substantial percentages of such Clean-up Costs by virtue of their operation of electrified rail- road cars at the Paoli Yard that discharged PCB's at higher levels than discharged by cars operated by PCTC. The Company also intends to make claims against certain insurance carriers for reimbursement of any Clean-up Costs that the Company may incur. The Company has not established any accrual for potential liability for Clean-up Costs at the Paoli Yard. There are certain other claims involving the Company and certain of its subsidiaries, including claims relating to the generation, disposal or release into the environment of allegedly hazardous substances and pre-reorganization personal injury claims, that allege or involve amounts that are potentially substantial in the aggregate. The Paoli Yard litigation and the preponderance of the other claims arose out of railroad operations disposed of by PCTC prior to its 1978 reorganization and, accordingly, any ultimate liabil- ity resulting therefrom in excess of previously established loss accruals would be attributable to such pre-reorganization events and circumstances. In accordance with the Company's reorganiza- tion accounting policy, any such ultimate liability will reduce the Company's capital surplus and shareholders' equity, but will not be charged to income. The Company believes that its maximum aggregate potential exposure at December 31, 1993 with respect to the foregoing environmental claims (other than Paoli Yard), net of related loss accruals, was approximately $15 million for claims arising out of pre-reorganization operations and in the range of $1 million to $4 million for claims arising out of post-reorganization opera- tions (which range depends upon the method of remediation, if any, required). The Company believes that it has meritorious defenses in such matters, including its position that other parties are responsible for substantial percentages of such amounts claimed and, in the case of the post-reorganization matter referred to above, its belief that the relevant regulatory authority will permit remediation to be deferred until there is a change in the use of the facility which the Company believes is unlikely. In management's opinion, the outcome of the foregoing claims will not, individually or in the aggregate, have a material adverse effect on the financial condition or results of opera- tions of the Company. In making this assessment, management has taken into account previously established loss accruals in its financial statements and probable recoveries from insurance carriers and other third parties. ITEM 4.

ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS Not applicable. EXECUTIVE OFFICERS OF THE REGISTRANT The persons named below are executive officers of the Company who have been elected to serve in the capacities indicat- ed at the pleasure of the Company's Board of Directors. NAME, AGE AND PRINCIPAL BUSINESS AFFILIATIONS POSITIONS WITH THE COMPANY DURING PAST FIVE YEARS - -------------------------- ------------------------------- Carl H. Lindner, 74 Mr. Lindner has been Chairman Chairman of the Board and of the Board and Chief Execu- Chief Executive Officer tive Officer of the Company for more than five years. During the past five years, Mr. Lindner has been Chairman of the Board and Chief Executive Officer of American Financial Corporation, a diversified financial ser- vices company. He is also a director of American Annuity Group, Inc., American Financial Enterprises, Inc., Chiquita Brands International, Inc., General Cable Corporation and Great American Communications Company. Mr. Lindner is Carl H. Lindner III's father. NAME, AGE AND PRINCIPAL BUSINESS AFFILIATIONS POSITIONS WITH THE COMPANY DURING PAST FIVE YEARS - -------------------------- ------------------------------- Carl H. Lindner III, 40 Mr. Lindner was elected Presi- President and Chief Operating dent and Chief Operating Officer and a Director Officer of the Company in February 1992. Prior thereto, he had served as Vice Chairman of the Board of the Company since October 1991. During the past five years, Mr. Lindner has been President of Great American Insurance Company, a property and casualty insurance company owned by American Financial Corporation. Richard M. Haverland, 53 Mr. Haverland was elected Executive Vice President-- Executive Vice President-- Insurance Group and a Insurance Group of the Company Director in February 1991. Prior thereto, Mr. Haverland was Executive Vice President of Great American Holding Corpora- tion, a holding company subsid- iary of American Financial Corporation, a diversified financial services company (April 1984 to February 1991). Neil M. Hahl, 45 Mr. Hahl has been Senior Vice Senior Vice President President of the Company for and a Director more than five years. Mr. Hahl is a director of Buckeye Management Company. Robert W. Olson, 48 Mr. Olson has been Senior Vice Senior Vice President, President, General Counsel and General Counsel and Secretary of the Company for Secretary and a Director more than five years. Mr. Olson is a director of DI Industries, Inc. Robert F. Amory, 48 Mr. Amory was elected Vice Vice President and Controller President of the Company in December 1989 and Controller in September 1986. R. Bruce Brumbaugh, 41 Mr. Brumbaugh was elected Vice Vice President -- Risk President -- Risk Management of Management the Company in February 1990. Prior thereto, Mr. Brumbaugh was Staff Vice President--Risk Management (June 1987 to February 1990). Richard A. Carlson, 42 Mr. Carlson was elected Vice Vice President and President in February 1994 and, Assistant General Counsel prior thereto, had been Staff Vice President since January 1990 and Assistant General Counsel since April 1988. Michael L. Cioffi, 41 Mr. Cioffi was elected Vice Vice President and President in February 1993 and, Assistant General Counsel prior thereto, had been Staff Vice President since January 1990 and Assistant General Counsel since February 1988. Robert E. Gill, 47 Mr. Gill was elected Vice Vice President--Taxes President--Taxes of the Company in February 1990. Prior thereto, Mr. Gill was Staff Vice President--Taxes (July 1986 to February 1990). Philip A. Hagel, 49 Mr. Hagel was elected Vice Vice President and Treasurer President of the Company in February 1990 and Treasurer in January 1988. Mr. Hagel is a director of DI Industries, Inc. Michael D. Mauer, 41 Mr. Mauer was elected Vice Vice President President of the Company in February 1990. Prior thereto, he was Staff Vice President-- General Auditor and Adminis- trative Services (January 1987 to February 1990). PART II ITEM 5.

ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS "Dividend Policy and Stock Market Prices" on page 47 of the Company's 1993 Annual Report to Shareholders is incorporated herein by reference. ITEM 6.

ITEM 6. SELECTED FINANCIAL DATA "Selected Consolidated Financial Data" on page 25 of the Company's 1993 Annual Report to Shareholders is incorporated herein by reference. ITEM 7.

ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS "Management's Discussion and Analysis of Financial Condition and Results of Operations" on pages 15 through 24 of the Company's 1993 Annual Report to Shareholders is incorporated herein by reference. ITEM 8.

ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA The consolidated financial statements of the Company and its subsidiaries, included on pages 26 through 44 of the Company's 1993 Annual Report to Shareholders, and "Quarterly Financial Data", included on page 46 of such Annual Report, are incorporated herein by refer- ence. ITEM 9.

ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE Not applicable. PART III ITEM 10.

ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT Except to the extent included in Part I under the caption "Executive Officers of the Registrant", the information called for by Item 10 is incorporated by reference to the definitive proxy statement involving the election of directors which the Company intends to file with the Commission pursuant to Regulation 14A under the Securities Exchange Act of 1934 not later than 120 days after December 31, 1993. ITEM 11.

ITEM 11. EXECUTIVE COMPENSATION The information called for by Item 11 is incorporated by reference to the definitive proxy statement involv- ing the election of directors which the Company intends to file with the Commission pursuant to Regulation 14A under the Securities Exchange Act of 1934 not later than 120 days after December 31, 1993. ITEM 12.

ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT The information called for by Item 12 is incorporated by reference to the definitive proxy statement involv- ing the election of directors which the Company intends to file with the Commission pursuant to Regulation 14A under the Securities Exchange Act of 1934 not later than 120 days after December 31, 1993. American Financial Corporation ("AFC") beneficially owns approximately 41% of the outstanding Common Stock of the Company and has substantial influence over the management and operations of the Company. Carl H. Lindner, Chairman of the Board and Chief Executive Officer of the Company, is Chairman of the Board and Chief Executive Officer of AFC. All of AFC's out- standing Common Stock is owned by Mr. Lindner, members of his family and trusts for their benefit. AFC and Mr. Lindner may be deemed to be controlling persons of the Company. See "Executive Officers of the Regis- trant" in Part I. ITEM 13.

ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS The information called for by Item 13 is incorporated by reference to the definitive proxy statement involv- ing the election of directors which the Company intends to file with the Commission pursuant to Regulation 14A under the Securities Exchange Act of 1934 not later than 120 days after December 31, 1993. PART IV ITEM 14.

ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K (a) The following documents are filed as a part of this report: (1) and (2) Financial Statements and Financial State- ment Schedules--see Index to Financial Statements and Financial Statement Schedules appearing on Page . (3) Exhibits: EXHIBIT NUMBER (REFERENCED TO ITEM 601 OF REGULATION S-K) --------------- (3) (i) ---Amended and Restated Articles of Incor- poration of the Company, as amended effec- tive March 25, 1994. (ii) ---By-Laws of the Company, as amended * July 30, 1992, incorporated by reference to Exhibit (3)(iii) to the Company's Annual Report on Form 10-K for 1992. (4)(i) ---Order No. 3708 of the United States * District Court for the Eastern District of Pennsylvania in In the Matter of Penn Central Transportation Company, Debtor, Bankruptcy No. 70-347 dated August 17, 1978 directing the consummation of the Plan of Reorganization for Penn Central Transportation Company, incorporated by reference to Exhibit 4 to Form 8-K Current Report of Penn Central Transportation Company for August 1978. (4)(ii) (a) ---Certain instruments with respect to long-term debt of subsidiaries of the Company which do not relate to debt exceeding 10% of the total assets of the Company and its consolidated sub- sidiaries are omitted pursuant to Item 601(b)(4)(iii)(A) of Regulation S-K, 17 C.F.R. Section 229.601. The Company hereby agrees to furnish supplementally to the Securities and Exchange Commission a copy of each such instrument upon request. (b) ---(i) Indenture dated as of August 1, * 1989 between the Company and Morgan Guaranty Trust Company of New York, as Trustee, regarding the Company's Sub- ordinated Debt Securities (the "Indenture"), incorporated by reference to Exhibit 4.1 to the Company's Form 8-K Current Report dated August 10, 1989. ---(ii) Instrument of Resignation of Trustee * and Appointment and Acceptance of Successor Trustee and Appointment of Agent dated as of November 15, 1991 among the Company, Morgan Guaranty Trust Company of New York as Resigning Trustee and Star Bank, N.A. as Successor Trustee, incorporated by reference to Exhibit (4)(ii)(d)(ii) to the Company's Annual Report on Form 10-K for 1991. ---(iii) Officer's Certificate Pursuant to * Sections 102 and 301 of the Indenture relating to authentication and designation of the Company's 9-3/4% Subordinated Notes due August 1, 1999, to which is attached the Form of Note, incorporated by reference to Exhibit 4.2 to the Company's Form 8-K Current Report dated August 10, 1989. - --------------- * Asterisk indicates an exhibit previously filed with the Securities and Exchange Commission incorporated herein by reference. EXHIBIT NUMBER (REFERENCED TO ITEM 601 OF REGULATION S-K) --------------- ---(iv) Officer's Certificate Pursuant to * Sections 102 and 301 of the Indenture relating to authentication and designation of the Company's 10-5/8% Subordinated Notes due April 15, 2000, to which is attached the Form of Note, incorporated by reference to Exhibit 4.1 to the Company's Form 8-K Current Report dated April 19, 1990. ---(v) Officer's Certificate Pursuant to * Sections 102 and 301 of the Indenture relating to authentication and designation of the Company's 10-7/8% Subordinated Notes due May 1, 2011, to which is attached the Form of Note, incorporated by reference to Exhibit 4.1 to the Company's Form 8 amendment dated May 8, 1991 to the Com- pany's Form 8-K Current Report dated May 7, 1991. (10)(i) (a) ---(i) Intercompany Agreement, dated June 9, * 1992, by and between the Company and General Cable Corporation, incorporated by reference to Exhibit 10.1 to the Company's Current Report on Form 8-K dated June 9, 1992. ---(ii) Subordinated Promissory Note of * General Cable Corporation due 2007 in the principal amount of $255,000,000 payable to the Company, incorporated by reference to Exhibit 10.1 to the Company's Current Report on Form 8-K dated June 30, 1992. (b) ---Stock Purchase Agreement, dated as of * June 10, 1993, among the Company, PCC Technical Industries, Inc. and Tracor, Inc., incorporated by reference to Exhibit (99) to the Company's Current Report on Form 8-K dated May 26, 1993. The following Exhibits (10)(iii)(a) through (10)(iii)(g) are compensatory plans and arrangements in which directors or execu- tive officers participate: (iii) (a) ---(i) The Company's Stock Option Plan, as * amended March 25, 1992, incorporated by reference to Exhibit (10)(iii)(a)(i) to the Company's Annual Report on Form 10-K for 1992. ---(ii) Amendment to the Company's Stock * Option Plan adopted by the Company's Board of Directors on March 24, 1993, incorporated by reference to Exhibit (10)(iii)(a)(ii) to the Company's Annual Report on Form 10-K for 1992. ---(iii) Forms of stock option agreements * used to evidence options granted under the Company's Stock Option Plan to officers and directors of the Company, incorporated by reference to Exhibit (10)(iii)(a)(iii) to the Company's Annual Report on Form 10-K for 1992. ---(iv) The Company's Stock Option Loan * Program, as amended February 8, 1991, incorporated by reference to Exhibit (10)(iii)(a)(v) to the Company's Annual Report on Form 10-K for 1990. ---(v) The Company's 1992 Spin-Off Stock * Option Plan adopted by the Company's Board of Directors on March 25, 1992, incorporated by reference to Exhibit (10)(iii)(a)(vi) to the Company's Annual Report on Form 10-K for 1991. - --------------- * Asterisk indicates an exhibit previously filed with the Securities and Exchange Commission and incorporated herein by reference. EXHIBIT NUMBER (REFERENCED TO ITEM 601 OF REGULATION S-K) --------------- (b) ---The Company's Annual Incentive Compen- * sation Plan, as amended February 12, 1992, incorporated by reference to Exhibit (10)(iii)(b) to the Company's Annual Report on Form 10-K for 1991. (c) ---Description of the Company's retirement * program for outside directors, as adopted by the Company's Board of Directors on March 23, 1983, incorporated by reference to Exhibit (10)(iii)(i) to the Company's Annual Report on Form 10-K for 1982. (d) ---The Company's Employee Stock Redemption * Program, as adopted by the Company's Board of Directors on March 28, 1985, incorporated by reference to Exhibit (10)(iii)(j) to the Company's Annual Report on Form 10-K for 1984. (e) ---(i) Severance Agreement dated March 29, * 1987 between the Company and Alfred W. Martinelli, a director of the Company, incorporated by reference to Exhibit (10)(iii)(a)(i) to the Company's Form 10-Q Quarterly Report for the Quarter Ended March 31, 1987. ---(ii) Consulting Agreement dated as of * March 29, 1987 between the Company and Alfred W. Martinelli, incorporated by reference to Exhibit (10)(iii)(a)(ii) to the Company's Form 10-Q Quarterly Report for the Quarter Ended March 31, 1987. ---(iii) Letter agreement amending the fore- * going Consulting and Severance Agreements dated December 9, 1991 between the Company and Alfred W. Martinelli, incorporated by reference to Exhibit (10)(iii)(e)(iii) to the Company's Annual Report on Form 10-K for 1991. (f) ---Letters dated April 9, 1987 from the * Company to each of Neil M. Hahl and Robert W. Olson, officers of the Company, with respect to severance arrangements, as supplemented by letters dated June 26, 1987 to each such officer, incorporated by reference to Exhibit (10)(iii)(a) to the Company's Form 10-Q Quarterly Report for the Quarter Ended June 30, 1987. (g) ---(i) Excess of Loss Agreement, effective * March 31, 1988, between Republic Indemnity Company of America and Great American Insurance Company, incorporated by refer- ence to Exhibit (g)(1) to Amendment No. 1 to Schedule 13E-3, dated January 17, 1989, relating to Republic American Corporation filed by Republic American Corporation, the Company, RAWC Acquisition Corp., American Financial Corporation and Carl H. Lindner (the "Schedule 13E-3 Amendment"). ---(ii) First Amendment to Excess of Loss * Agreement, effective March 31, 1988, between Republic Indemnity Company of America and Great American Insurance Company, incorporated by reference to Exhibit (g)(2) to the Schedule 13E-3 Amendment. (h) ---(i) Business Assumption Agreement, * effective as of December 31, 1990, between Stonewall Insurance Company and Dixie Insurance Company, incorporated by reference to Exhibit (10)(iii)(o)(i) to the Company's Annual Report on Form 10-K for 1990. - --------------- * Asterisk indicates an exhibit previously filed with the Securities and Exchange Commission and incorporated herein by reference. EXHIBIT NUMBER (REFERENCED TO ITEM 601 OF REGULATION S-K) --------------- ---(ii) Quota Share Agreements, effective * December 31, 1990, between Stonewall Insurance Company and Dixie Insurance Company, incorporated by reference to Exhibit (10)(iii)(o)(ii) to the Company's Annual Report on Form 10-K for 1990. ---(iii) Management Agreement, effective as * of January 1, 1991, by and between Dixie Insurance Company and Stonewall Insurance Company, incorporated by reference to Exhibit (10)(iii)(o)(iii) to the Company's Annual Report on Form 10-K for 1990. (i) ---Excess of Loss Agreements, effective * December 31, 1990, between Great American Insurance Company and each of Atlanta Casualty Company, Dixie Insurance Company and Windsor Insurance Company, incorporated by reference to Exhibit (10)(iii)(p) to the Company's Annual Report on Form 10-K for 1990. (j) ---Premium Payment Agreement, effective as * of January 1, 1991, by and between Great American Insurance Company and the Company, incorporated by reference to Exhibit (10)(iii)(q) to the Company's Annual Report on Form 10-K for 1990. (11) ---Supplemental information regarding computa- tions of net income per share amounts. (12) ---Calculation of ratio of earnings to fixed charges. (13) ---Portions of the Company's 1993 Annual Report to Shareholders. (21) ---List of subsidiaries of the Company. (23) ---Consent of Deloitte & Touche. (28) ---Information from reports provided to state regulatory authorities. (b) Reports on Form 8-K filed during the quarter ended December 31, 1993: None - --------------- * Asterisk indicates an exhibit previously filed with the Securities and Exchange Commission and incorporated herein by reference. For the purposes of complying with the amendments to the rules governing Form S-8 (effective July 13, 1990) under the Securities Act of 1933, the undersigned registrant hereby under- takes as follows, which undertaking shall be incorporated by reference into registrant's Registration Statement on Form S-8 No. 2-81422 (filed January 20, 1983), registrant's Post- Effective Amendment No. 1 to Registration Statement on Form S-8 No. 2-72453 (filed December 23, 1983), registrant's Registration Statement on Form S-8 No. 33-34871 (filed May 11, 1990) and registrant's Registration Statement on Form S-8 No. 33-48700 (filed June 17, 1992): Insofar as indemnification for liabilities arising under the Securities Act of 1933 may be permitted to direc- tors, officers and controlling persons of the registrant pursuant to the foregoing provisions, or otherwise, the registrant has been advised that in the opinion of the Securities and Exchange Commission such indemnification is against public policy as expressed in the Securities Act of 1933 and is, therefore, unenforceable. In the event that a claim for indemnification against such liabilities (other than the payment by the registrant of expenses incurred or paid by a director, officer or controlling person of the registrant in the successful defense of any action, suit or proceeding) is asserted by such director, officer or contro- lling person in connection with the securities being regis- tered, the registrant will, unless in the opinion of its counsel the matter has been settled by controlling prece- dent, submit to a court of appropriate jurisdiction the question whether such indemnification by it is against public policy as expressed in the Act and will be governed by the final adjudication of such issue. SIGNATURES PURSUANT TO THE REQUIREMENTS OF SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT OF 1934, THE REGISTRANT HAS DULY CAUSED THIS REPORT TO BE SIGNED ON ITS BEHALF BY THE UNDERSIGNED, THERE- UNTO DULY AUTHORIZED. AMERICAN PREMIER UNDERWRITERS, INC. (Registrant) By Carl H. Lindner --------------------------------- Carl H. Lindner Chairman of the Board and Chief Executive Officer Date: March 29, 1994 PURSUANT TO THE REQUIREMENTS OF THE SECURITIES EXCHANGE ACT OF 1934, THIS REPORT HAS BEEN SIGNED BELOW BY THE FOLLOWING PERSONS ON BEHALF OF THE REGISTRANT AND IN THE CAPACITIES AND ON THE DATES INDICATED. Date: March 29, 1994 By Hugh F. Culverhouse -------------------------------- Hugh F. Culverhouse Director Date: March 29, 1994 By Theodore H. Emmerich ------------------------------ Theodore H. Emmerich Director Date: March 29, 1994 By James E. Evans -------------------------------- James E. Evans Director Date: March 29, 1994 By Neil M. Hahl -------------------------------- Neil M. Hahl Senior Vice President and a Director (Principal Financial Officer) Date: March 29, 1994 By Richard M. Haverland -------------------------------- Richard M. Haverland Director Date: March 29, 1994 By Thomas M. Hunt -------------------------------- Thomas M. Hunt Director PAGE Date: March 29, 1994 By Carl H. Lindner -------------------------------- Carl H. Lindner Chairman of the Board and Chief Executive Officer and a Director Date: March 29, 1994 By Carl H. Lindner III -------------------------------- Carl H. Lindner III Director Date: March 29, 1994 By S. Craig Lindner -------------------------------- S. Craig Lindner Director Date: March 29, 1994 By Alfred W. Martinelli -------------------------------- Alfred W. Martinelli Director Date: March 29, 1994 By Robert W. Olson -------------------------------- Robert W. Olson Director Date: March 29, 1994 By Robert F. Amory -------------------------------- Robert F. Amory Vice President and Controller (Principal Accounting Officer) AMERICAN PREMIER UNDERWRITERS, INC. INDEX TO FINANCIAL STATEMENTS AND FINANCIAL STATEMENT SCHEDULES PAGE NUMBER ----------- Independent Auditors' Report............................... American Premier Underwriters, Inc. and Consolidated Subsidiaries: Statement of Income--For the years ended December 31, 1993, 1992 and 1991............................ * Balance Sheet--December 31, 1993 and 1992............ * Statement of Cash Flows--For the years ended December 31, 1993, 1992 and 1991................... * Notes to Financial Statements........................ * Schedule II--Amounts Receivable from Related Parties and Underwriters, Promoters and Employees Other than Related Parties......................... S-1 Schedule III--Condensed Financial Information of Registrant......................................... S-3 Schedule VII--Guarantees of Securities and Other Obligations of Other Issuers....................... S-5 Schedule VIII--Valuation and Qualifying Accounts........................................... S-5 Schedule X--Supplemental Information Concerning Property-Casualty Insurance Operations............. S-6 Schedules other than those listed above are omitted because they are either not applicable or not required or the information required is included in the consolidated financial statements or notes thereto. - ------------------- * Incorporated by reference to the Company's 1993 Annual Report to Shareholders. INDEPENDENT AUDITORS' REPORT American Premier Underwriters, Inc.: We have audited the financial statements and the financial statement schedules of American Premier Underwriters, Inc. and Consolidated Subsidiaries listed in the accompanying Index to Financial Statements and Financial Statement Schedules. These financial statements and financial statement schedules are the responsibility of the Company's management. Our responsibility is to express an opinion on the financial statements and finan- cial statement schedules based on our audits. We conducted our audits in accordance with generally accept- ed auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, such financial statements present fairly, in all material respects, the financial position of American Premier Underwriters, Inc. and Consolidated Subsidiaries at December 31, 1993 and 1992 and the results of its operations and its cash flows for each of the three years in the period ended December 31, 1993 in conformity with generally accepted accounting princi- ples. Also, in our opinion, such financial statement schedules, when considered in relation to the basic financial statements taken as a whole, present fairly in all material respects the information shown therein. As discussed in Note 1 to the financial statements, in 1992 the Company changed its method of accounting for income taxes to conform with Statement of Financial Accounting Standards No. 109. Deloitte & Touche Cincinnati, Ohio February 16, 1994 (March 25, 1994 with respect to the change of the Company's name as discussed in Note 1 to the financial statements) SCHEDULE II AMERICAN PREMIER UNDERWRITERS, INC. AND CONSOLIDATED SUBSIDIARIES Amounts Receivable from Related Parties and Underwriters, Promoters and Employees Other than Related Parties For the Years Ended December 31, 1993, 1992 and 1991 (Dollars in Thousands) __________ (a) Non-interest bearing amounts due to the Company, representing payments made by the Company on behalf of the successor of a previously spun-off subsidiary of the Company. (b) Subordinated note of previously spun-off company, bearing interest at 9.98 percent per annum, due September 30, 2007 (see Note 2 of Notes to Financial Statements). (c) Short-term note of previously spun-off company. (d) Interest notes received in lieu of cash interest payments on the subordinated note referred to in (b) above, paid in full on February 14, 1994. (e) Promissory notes of participants in the Company's Stock Option Loan Program delivered in payment of up to 95 percent of the purchase price for the Company's Common Stock purchased upon the exercise of stock options, secured by the stock purchased, bearing interest at rates ranging from 3.65 to 7.06 percent per annum. (f) Individual ceased to be an employee or a related party during the year. (g) Includes recourse promissory notes of participants in the Company's Career Share Purchase Plan delivered in payment of up to 95 percent of the purchase price for Career Shares (see Note 9 of Notes to Financial Statements), secured by the Career Shares purchased, bearing interest at 9 percent per annum and payable not later than ten years after the purchase date. (h) Mortgage notes receivable, incidental to employees' relocations, secured by homesites. Principal and interest are payable monthly based on amortization schedules which range from 15 to 30 years and carry annual interest rates ranging from 9 1/2 to 9 3/4 percent. (i) Non-interest bearing temporary home loans, incidental to employees' relocations, payable within one year of the date of the loans. (j) Note receivable, incidental to employee relocation, bearing interest at 6.49 percent per annum. Principal and interest are payable on or before June 30, 2000. (k) Promissory notes referred to in (e) above were collected during 1992. (l) Mortgage note referred to in (h) above was sold during 1991 in the secondary market. S-2 SCHEDULE III AMERICAN PREMIER UNDERWRITERS, INC. Condensed Financial Information of Registrant (Note 1) (In Millions) COMBINED CONDENSED INCOME STATEMENT COMBINED CONDENSED BALANCE SHEET S-3 SCHEDULE III (continued) AMERICAN PREMIER UNDERWRITERS, INC. Condensed Financial Information of Registrant (Note 1) (In Millions) COMBINED CONDENSED STATEMENT OF CASH FLOWS Note 1: For purposes of preparing the combined condensed financial statements included in this Schedule III, the accounts of the Company ("Registrant") have been combined with the accounts of Pennsylvania Company ("Pennco"). Pennco is a wholly owned direct subsidiary of the Registrant, and is itself a holding company. At December 31, 1993, approximately 61% of Investments and substantially all Investments in Subsidiaries as reported on the Combined Condensed Balance Sheet were owned by Pennco. Pennco has no debt obligations and there are no restrictions affecting transfers of funds between Pennco and the Registrant. Accordingly, management believes that the financial resources held at Pennco as well as Pennco's cash flow are available, if necessary, to service the obligations of the Registrant. S-4 SCHEDULE VIII AMERICAN PREMIER UNDERWRITERS, INC. AND CONSOLIDATED SUBSIDIARIES Valuation and Qualifying Accounts For the Years Ended December 31, 1993, 1992 and 1991 (Dollars In Millions) (a) Includes additions for businesses acquired. (b) Includes reductions for divested businesses. (c) Includes reductions of valuation accounts for actual charges incurred. (d) Includes a reduction in reserves for uncollectibility of notes which resulted from the prior sale of certain offshore drilling rigs, to reflect the receipt of significant principal and interest payments. (e) Includes changes in unrealized gains and/or losses on securities. (f) Includes transfers to/from other reserve accounts. S-5 SCHEDULE X AMERICAN PREMIER UNDERWRITERS, INC. AND CONSOLIDATED SUBSIDIARIES Supplemental Information Concerning Property - Casualty Insurance Operations For The Years Ended December 31, 1993, 1992 and 1991 (Dollars in Millions) SCHEDULE X (continued) AMERICAN PREMIER UNDERWRITERS, INC. AND CONSOLIDATED SUBSIDIARIES Supplemental Information Concerning Property - Casualty Insurance Operations For The Years Ended December 31, 1993, 1992 and 1991 (Dollars in Millions) (1) Gross of ceded reinsurance receivable of $45.1 million. S-6

51143_1993.txt

51143

1993

ITEM 1. BUSINESS: IBM develops, manufactures and sells advanced information processing products, including computers and microelectronic technology, software, networking systems and information technology-related services. IBM offers value worldwide through its United States, Canada, Europe/Middle East/Africa, Latin America, and Asia/Pacific business units, by providing comprehensive and competitive product choices. The value of unfilled orders is not a meaningful indicator of future revenues due to the significant proportion of revenue from services, the volume of products delivered from shelf inventories, and the shortening of product delivery schedules. Therefore, the Company believes that backlog information is not material to an understanding of its business. IBM owns or is licensed under a number of patents relating to its products. Licenses under patents owned by IBM have been and are being granted to others. IBM believes its business as a whole is not materially dependent upon any particular patent or license, or any particular group of patents or licenses. The following information is included in IBM's 1993 Annual Report to Stockholders and is incorporated herein by reference: 1. Segment information and revenue by classes of similar products or services--Pages 59 and 60 2. Financial information by geographic areas--Pages 61 and 62 3. Amount spent during each of the last three years on research and development activities--Page 45 4. The number of persons employed by the registrant--Page 31 5. Management discussion overview --Pages 20 and 21 ITEM 2.

ITEM 2. PROPERTIES: At December 31, 1993, IBM's manufacturing and development facilities in the United States had aggregate floor space of 57.4 million square feet, of which 46.6 million was owned and 10.8 million was leased. Of these amounts, 4.3 million square feet was vacant and .7 million square feet was being leased to non-IBM businesses. Similar facilities in 15 other countries totaled 21.8 million square feet, of which 18.3 million was owned and 3.5 million was leased. Of these amounts, .6 million square feet was vacant and .3 million square feet was being leased to non-IBM businesses. Although improved production techniques, productivity gains, and restructuring actions have resulted in reduced manufacturing floor space, continuous upgrading of facilities is essential to maintain technological leadership, improve productivity, and meet customer demand. For additional information on expenditures for plant and other property, refer to page 27 (Investments) of IBM's 1993 Annual Report to Stockholders which is incorporated herein by reference. ITEM 3.

ITEM 3. LEGAL PROCEEDINGS: No material pending legal proceedings. ITEM 4.

ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS: Not applicable. PART I (CONTINUED) EXECUTIVE OFFICERS OF THE REGISTRANT (AT MARCH 28, 1994): - ------------ (1) Member of the Board of Directors. All officers are elected by the Board of Directors and serve until the next election of officers in conjunction with the annual meeting of the stockholders as provided in the By-laws. Each officer named above, with the exception of Gerald M. Czarnecki, Louis V. Gerstner, Jr., Paul J. Rizzo, G. Richard Thoman, Jerome B. York, and Frederick W. Zuckerman has been an officer or an executive of IBM or its subsidiaries during the past five years. Mr. Czarnecki was the chairman of the board and chief executive officer, of Bank of America-Hawaii from 1992 until joining IBM in 1993. From 1987 to 1992, he was chairman of the board and chief executive officer of HonFed Bank in Honolulu, Hawaii. Mr. Gerstner was the chairman of the board and chief executive officer of RJR Nabisco Holdings Corporation from 1989 until joining IBM in 1993. From 1985 to 1989, he was chairman and chief executive officer of American Express Travel Related Services Co., Inc. Mr. Rizzo was the Dean of the Kenan-Flagler Business School at the University of North Carolina-Chapel Hill from 1987 to 1992. He then became a partner in Franklin Street Partners, a Chapel Hill investment firm. He rejoined IBM in 1993, having previously retired in 1988. Mr. Thoman was the president of Nabisco International from 1992 until joining IBM in 1993. From 1985 to 1989, he was president of American Express Travel Related Services International, and co-CEO of American Express Travel Related Services Co., and CEO of American Express International from 1989 to 1992. Mr. York was the executive vice president-finance and chief financial officer of Chrysler Corporation from 1990 until joining IBM in 1993. From 1979 to 1990, he had also served as vice president and controller at Chrysler, vice president in charge of the company's Dodge car and truck division, and managing director of its operations in Mexico. Mr. Zuckerman was the senior vice president and treasurer of RJR Nabisco from 1991 until joining IBM in 1993. From 1981 to 1991, he was the corporate vice president and treasurer of Chrysler Corporation. PART II ITEM 5.

ITEM 5. MARKET FOR THE REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS: Refer to page 63 and the inside back cover of IBM's 1993 Annual Report to Stockholders which are incorporated herein by reference solely as they relate to this item. There were 738,948 common stockholders of record at February 10, 1994. ITEM 6.

ITEM 6. SELECTED FINANCIAL DATA: Refer to page 63 of IBM's 1993 Annual Report to Stockholders which is incorporated herein by reference. ITEM 7.

ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS: Refer to pages 20 through 31 of IBM's 1993 Annual Report to Stockholders which are incorporated herein by reference. On March 1, 1994, Loral Corporation completed its acquisition of the Federal Systems Company for $1.503 billion in cash. The amount of any gain resulting from this sale may be dependent on future performance of the Advanced Automation System contract for the Federal Aviation Authority and certain other open matters. ITEM 8.

ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA: Refer to pages 18 and 19 and 32 through 62 of IBM's 1993 Annual Report to Stockholders which are incorporated herein by reference. Also refer to the Financial Statement Schedules on pages S-1 to S-5 of this Form. ITEM 9.

ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE: Not applicable. PART III ITEM 10.

ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT: Refer to pages 2 through 4 and 7 of IBM's definitive Proxy Statement dated March 14, 1994 which are incorporated herein by reference solely as they relate to this item. Also refer to the Item entitled "Executive Officers of the Registrant" in Part I of this Form. ITEM 11.

ITEM 11. EXECUTIVE COMPENSATION: Refer to pages 9 through 16 of IBM's definitive Proxy Statement dated March 14, 1994, which are incorporated herein by reference. ITEM 12.

ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT: (A) SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS: Not applicable. (B) SECURITY OWNERSHIP OF MANAGEMENT: Refer to the section entitled "Stock Ownership" appearing on pages 7 and 8 of IBM's definitive Proxy Statement dated March 14, 1994, which is incorporated herein by reference. ITEM 13.

ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS: Refer to page 7 (Other Relationships) of IBM's definitive Proxy Statement dated March 14, 1994, which is incorporated herein by reference. PART IV ITEM 14.

ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K: (A) THE FOLLOWING DOCUMENTS ARE FILED AS PART OF THIS REPORT: 1. FINANCIAL STATEMENTS FROM IBM'S 1993 ANNUAL REPORT TO STOCKHOLDERS WHICH ARE INCORPORATED HEREIN BY REFERENCE: Report of Independent Accountants (page 19). Consolidated Statement of Operations for the years ended December 31, 1993, 1992 and 1991 (page 32). Consolidated Statement of Financial Position at December 31, 1993 and 1992 (page 33). Consolidated Statement of Cash Flows for the years ended December 31, 1993, 1992 and 1991 (page 34). Consolidated Statement of Stockholders' Equity at December 31, 1993, 1992 and 1991 (page 35). Notes to Consolidated Financial Statements (pages 36 through 62). 2. FINANCIAL STATEMENT SCHEDULES REQUIRED TO BE FILED BY ITEM 8 OF THIS FORM: All other schedules are omitted as the required matter is not present, the amounts are not significant or the information is shown in the financial statements or the notes thereto. 3. EXHIBITS: INCLUDED IN THIS FORM 10-K: PART IV (CONTINUED) NOT INCLUDED IN THIS FORM 10-K: -- A copy of the IBM 1989 Long-Term Performance Plan, a management compensatory plan, is contained in Registration Statement No. 33-29022 on Form S-8, filed on May 31, 1989, and is hereby incorporated by reference. -- Board of Directors compensatory plans, as described under Directors' Compensation on page 7 of IBM's definitive Proxy Statement dated March 14, 1994, which is incorporated herein by reference. -- The instruments defining the rights of the holders of the 6 3/8% Notes due 1997 and the 7 1/4% Notes due 2002 are Exhibits 4(a) through 4(1) to Registration Statement No. 33-33590 on Form S-3, filed on February 22, 1990, and are hereby incorporated by reference. -- The instruments defining the rights of the holders of the 9% Notes due 1998 are Exhibit 4 to the Company's Quarterly Report on Form 10-Q for the quarter ended June 30, 1985, and Exhibit 4(b) to Registration Statement No. 33-6889 on Form S-3, filed on July 1, 1986, and are hereby incorporated by reference. -- The instruments defining the rights of the holders of the 6 3/8% Notes due 2000 and the 7 1/2% Debentures due 2013 are Exhibits 4(a) through 4(1) to Registration Statement No. 33-49475(1) on Form S-3, filed May 24, 1993, and are hereby incorporated by reference. -- The instruments defining the rights of holders of the 8 3/8% Debentures due 2019 are Exhibits 4(a)(b)(c) and (d) to Registration Statement 33-31732 on Form S-3, filed on October 24, 1989, and are hereby incorporated by reference. -- IBM's definitive Proxy Statement dated March 14, 1994, certain sections of which have been incorporated herein by reference. (B) REPORTS ON FORM 8-K: -- No reports on Form 8-K were filed during the last quarter of 1993. SIGNATURES PURSUANT TO THE REQUIREMENTS OF SECTION 13 OR 15(D) 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. INTERNATIONAL BUSINESS MACHINES CORPORATION (Registrant) By: LOUIS V. GERSTNER, JR. .................................. (LOUIS V. GERSTNER, JR. CHAIRMAN OF THE BOARD OF DIRECTORS AND CHIEF EXECUTIVE OFFICER) Date: March 28, 1994 PURSUANT TO THE REQUIREMENTS OF THE SECURITIES EXCHANGE ACT OF 1934, THIS REPORT HAS BEEN SIGNED BELOW BY THE FOLLOWING PERSONS ON BEHALF OF THE REGISTRANT AND IN THE CAPACITIES AND ON THE DATES INDICATED. REPORT OF INDEPENDENT ACCOUNTANTS ON FINANCIAL STATEMENT SCHEDULES To the Board of Directors of INTERNATIONAL BUSINESS MACHINES CORPORATION Our audits of the consolidated financial statements referred to in our report dated February 16, 1994 (which refers to the changes in the methods of accounting for postemployment benefits in 1993, income taxes in 1992, and nonpension postretirement benefits in 1991) appearing on page 19 of the 1993 Annual Report to Stockholders of International Business Machines Corporation (which report and consolidated financial statements are incorporated by reference in this Annual Report on Form 10-K) also included an audit of the Financial Statement Schedules listed in Item 14(a)2 of this Form 10-K. In our opinion, these Financial Statement Schedules present fairly, in all material respects, the information set forth therein when read in conjunction with the related consolidated financial statements. PRICE WATERHOUSE 1177 Avenue of the Americas New York, N.Y. 10036 February 16, 1994 SCHEDULE V INTERNATIONAL BUSINESS MACHINES CORPORATION AND SUBSIDIARY COMPANIES PLANT, RENTAL MACHINES AND OTHER PROPERTY FOR THE YEAR ENDED DECEMBER 31: (DOLLARS IN MILLIONS) DEPRECIATION: Plant, rental machines and other property are carried at cost and depreciated over their estimated useful lives using the straight-line method. With minor exceptions, the estimated useful lives of depreciable properties are as follows: Land improvements....................................... 20 years Buildings and building equipment........................ 5 to 50 years Plant, laboratory and office equipment.................. 2 to 16 years Rental machines......................................... 1 to 7 years S-1 SCHEDULE VI INTERNATIONAL BUSINESS MACHINES CORPORATION AND SUBSIDIARY COMPANIES ACCUMULATED DEPRECIATION OF PLANT, RENTAL MACHINES AND OTHER PROPERTY FOR THE YEAR ENDED DECEMBER 31: (DOLLARS IN MILLIONS) - ------------ (A) Includes charge for accelerated depreciation due to restructuring actions taken in 1993 of $1,068 million. (B) Includes charge for accelerated depreciation due to restructuring actions taken in 1992 of $4,185 million. (C) Includes charge for accelerated depreciation due to restructuring action taken in 1991 of $378 million. S-2 SCHEDULE VIII INTERNATIONAL BUSINESS MACHINES CORPORATION AND SUBSIDIARY COMPANIES VALUATION AND QUALIFYING ACCOUNTS FOR THE YEAR ENDED DECEMBER 31: (DOLLARS IN MILLIONS) - ------------ (A) Includes additions charged to costs and expenses less accounts written off and translation adjustments. Note-- The receivables upon which the above allowances are based are highly diversified by geography, industry, and individual customer. The allowances for receivable losses for the year ended 1993, approximate less than three and one-half percent of the company's current receivables and less than two percent of the company's non-current receivables. The allowances for the year ended 1992, approproximate less than three percent of the company's current receivables and less than two percent of the company's non-current receivables. The allowances for the year ended 1991, approximate less than two percent in both categories of receivables. S-3 SCHEDULE IX INTERNATIONAL BUSINESS MACHINES CORPORATION AND SUBSIDIARY COMPANIES SHORT-TERM BORROWINGS FOR THE YEAR ENDED DECEMBER 31: (DOLLARS IN MILLIONS) - ------------ Note-- The balance at end of period excludes the current portion of long-term debt of $4,006 million, $3,256 million, and $4,363 million for the years 1993, 1992, and 1991, respectively. Effective 1993, short-term loan amounts in subsidiaries where the economic environment is highly inflationary, were primarily denominated in U.S. dollars. In prior years, these loans were denominated in local currencies, and the high interest rates in those operations were largely offset by the effects of inflation on funds borrowed. If the inflationary effects of these loans were excluded, the weighted average interest rate at year-end would have been 7.5% and 8.7% for the years 1992 and 1991, respectively, and the weighted average interest rate during the year would have been 7.8% and 9.0% for 1992 and 1991, respectively. The average amount outstanding during the year and the weighted average interest rate during the year were calculated by averaging the quarterly balances and rates. S-4 SCHEDULE X INTERNATIONAL BUSINESS MACHINES CORPORATION AND SUBSIDIARY COMPANIES SUPPLEMENTARY INCOME STATEMENT INFORMATION FOR THE YEAR ENDED DECEMBER 31: (DOLLARS IN MILLIONS) - ------------ (A) Includes amounts charged to all accounts, including inventories and fixed assets. S-5 EXHIBIT INDEX

17206_1993.txt

17206

1993

Item 1. BUSINESS ORGANIZATION AND SEGMENTS Capital Holding Corporation (the "Company"), an insurance and diversified financial services holding company based in Louisville, Kentucky, was incorporated in Delaware in 1969 by Commonwealth Life Insurance Company ("Commonwealth Life"). The objective was to achieve earnings growth through acquisitions of other insurance companies and, thus, effect economies of scale and the sharing of commonly needed resources, while preserving the strengths of acquired companies' marketing operations. Through affiliates of its Agency Group, Direct Response Group and Accumulation and Investment Group, the Company offers accumulation, life and annuity, accident and health and property and casualty insurance products. The Company's Banking Group affiliates provide consumer loans, deposits and other banking services. Agency Group By 1976, the Company had acquired Peoples Life Insurance Company ("Peoples Life") in Washington, D.C.; National Standard Life Insurance Company ("National Standard") in Orlando, Florida; Georgia International Life Insurance Company ("Georgia International") in Atlanta, Georgia; Home Security Life Insurance Company ("Home Security") in Durham, North Carolina; and several other companies that were subsequently merged into these affiliates. On October 1, 1985, Peoples Life and Home Security were merged to form Peoples Security Life Insurance Company ("Peoples Security") with headquarters in Durham. On March 31, 1987, the Company sold Georgia International to Southmark Corporation. On April 1, 1988, National Standard was merged into Commonwealth Life. On September 8, 1989, the Company acquired Southlife Holding Company and its primary operating companies, Public Savings Life Insurance Company ("Public Savings Insurance") and Security Trust Life Insurance Company ("Security Trust"). In December 1991 the Company created Capital Security Life Insurance Company ("Capital Security") with headquarters in Durham, as the successor to Public Savings Insurance. On November 14, 1991, the Company acquired Durham Corporation ("Durham") and its primary operating company, Durham Life Insurance Company ("Durham Life"), with headquarters in Raleigh, North Carolina. Agency Group's business is conducted primarily through four affiliates: Commonwealth Life, Peoples Security, Capital Security and Durham Life. Direct Response Group National Liberty Corporation ("National Liberty") in Valley Forge, Pennsylvania, was acquired on January 14, 1981, and added a nationwide direct marketing operation to what previously had been a regional, agent based marketing system. In addition, National Home Life Assurance Company ("National Home"), domiciled in Missouri, was also acquired as National Liberty's primary operating company, together with its principal subsidiaries, Veterans Life Insurance Company ("Veterans Life") and National Home Life Insurance Company of New York ("National Home NY"). - 2 - Item 1. (continued) In 1979, Commonwealth Life's property and casualty operation was recapitalized, made a direct subsidiary of the Company and later renamed Capital Enterprise Insurance Company ("Capital Enterprise"). On December 31, 1986, the Company acquired Worldwide Underwriters Insurance Company ("Worldwide Insurance"), located in St. Louis, Missouri, and the personal lines property and casualty insurance business of the Wausau Insurance Companies. Concurrently, it made Capital Enterprise a direct subsidiary of Worldwide Insurance. These two affiliates, together with Capital Landmark Insurance Company, a subsidiary of Capital Enterprise, and Worldwide Underwriters Insurance Company of North Carolina, a subsidiary of Worldwide Underwriters Insurance, form the property and casualty line of business of the Company's Direct Response Group. On January 15, 1993, Worldwide Insurance acquired Academy Insurance Group ("Academy") and its subsidiaries, Academy Life Insurance Company and Pension Life Insurance Company. Academy principally markets life insurance to active duty military service personnel. Accumulation And Investment Group In 1987, the institutional accumulation product business, previously managed in Agency Group, and the retail accumulation product business, previously managed by National Liberty, were moved to the Accumulation and Investment Group. Affiliates of Agency Group and Direct Response Group offer these institutional and retail accumulation products. In addition to the marketing and management of accumulation (investment-type) products, Accumulation and Investment Group manages the Company's insurance-related investment portfolios. Banking Group In April 1984, the Company acquired a controlling interest in First Deposit Corporation ("First Deposit"), located in San Francisco, California, which owns a consumer bank (First Deposit National Bank) and a credit card bank (First Deposit National Credit Card Bank). Ownership in First Deposit was increased each year until 1989 when the remaining shares were purchased. These affiliates form the Banking Group. Financial information about business segments is included in Item 7, Management's Discussion and Analysis of Financial Condition and Results of Operations. PRODUCTS Insurance Commonwealth Life, Peoples Security, Capital Security, Durham Life, National Home, Veterans Life, National Home NY and Academy write a variety of individual, nonparticipating life insurance products. These include universal life contracts, traditional and interest-sensitive whole life insurance, term life insurance, endowments, accidental death and dismemberment coverage and premium waiver disability insurance. - 3 - Item 1. (continued) The following table progresses total life insurance in force for the year ended December 31, 1993: Total Life Insurance (dollars in thousands) In force at December 31, 1992 $58,262,410 Sales and additions 18,483,161 76,745,571 Terminations: Surrender and Conversion 2,380,274 Lapse 6,664,218 Reinsurance - Other 1,714,575 Subtotal 10,759,067 In force at December 31, 1993 $65,986,504 (1) Number of policies in force before reinsurance ceded at December 31, 1993 1,850,455 (1) (1) Reinsurance assumed has been included. Reinsurance ceded has not been deducted. Commonwealth Life, Peoples Security, Capital Security, Durham Life, National Home, Veterans Life, National Home NY and Academy also issue an assortment of individual accident and health insurance products. These include coverages for regular income during periods of hospitalization, scheduled reimbursement for specific hospital/surgical expenses and cancer treatments, hospice care, deductible and co-payment amounts not covered by other health insurance, lump sum payments for accidental death or dismemberment and benefits for death and injury resulting from an accident. Additionally, National Home and Academy offer a Medicare supplement product. Worldwide Insurance, Capital Enterprise and their subsidiaries underwrite personal lines automobile, homeowners and umbrella liability coverages, mainly for standard and preferred risks. Accumulation The institutional line of accumulation products, offered through Commonwealth Life, Peoples Security and National Home, consists of fixed rate guaranteed investment contracts ("GICs") and floating rate GICs which can receive interest based on rates indexed to either short-, intermediate- or long-term rates. In addition, the institutional line includes Trust GICs where the plan sponsor owns and retains assets related to these contracts and Commonwealth Life and Peoples Security provide benefit responsiveness in the event that benefit requests and other contractual commitments exceed current cash flows. Further, Commonwealth Life and Peoples Security offer to institutional customers Total Return Account Contracts ("TRACs"), which guarantee the total return of selected indices without the additional transaction costs, including - 4 - Item 1. (continued) the S & P 500 Index, the Shearson Lehman Aggregate Index and the Government Corporate Index. Through National Home, Commonwealth Life and Peoples Security, the Company offers retail products including immediate life annuities (primarily structured settlements), variable annuities, single premium and flexible premium deferred annuities and individual retirement annuities. Single premium deferred annuities and flexible premium deferred annuities are offered at a fixed interest rate on either a fixed or indexed basis. In addition, flexible premium deferred annuities are offered on a variable contract basis. Banking Banking Group affiliates offer both secured and unsecured loan accounts, as well as a broad range of deposit products. The receivables portfolio consists primarily of unsecured consumer loans which use a VISAR or MasterCardR credit card as the credit extension vehicle, a revolving cash loan product without a credit card, a secured line of credit using a VISAR or MasterCardR credit card, a home equity secured loan product called Select EquityR and insurance premium finance installment loans. Banking Group affiliates also offer fee-based products designed to suspend certain customer payment obligations in situations such as loss of income due to unemployment or disability. Deposit products include retail and institutional certificates of deposit and money market deposit accounts. MARKETING Agency Group markets individual insurance products primarily through home service agents, who call on customers in their homes to sell policies and provide related services. Home office and field associates, including individuals who provide direct customer sales and those who deliver service and support, are organized as Customer Service Units ("CSUs"), each of which operates under a single management structure, as opposed to the prior organization where marketing and administration were managed separately. There are 11 CSUs providing full service to customers in particular geographic and/or market segments. Substantially all of the home service representatives are employees of Agency Group affiliates and do not represent other insurers. Such representatives receive compensation from sales commissions and from renewal and service commissions. The compensation arrangement is designed to reward representatives who not only sell new policies, but who also effectively maintain and service in-force business to meet Company sales and persistency objectives. In addition to its home service sales organization, marketing partnerships have also been formed whereby products are distributed through the insurance and marketing organizations of third parties. Direct Response Group primarily uses television and print media solicitation, direct mail, telephone and third-party programs to market its insurance products. Additional mail correspondence and telephone communications are used to follow up and close sales. Sponsored marketing programs are conducted through major banks, oil companies, department stores, associations and other businesses with large customer bases. Products are also marketed to active duty military personnel on military bases through Agents/Counselors. Property and casualty products are also marketed through some of the home service agents of Agency Group. - 5 - Item 1. (continued) Institutional accumulation products of the Accumulation and Investment Group are marketed through a small sales staff, bank trustees, municipal GIC brokers, GIC fund managers, brokers and direct marketing. Retail products are marketed through financial planners, stock brokerage firms, pension consultants, savings and loan associations, banks and other financial institutions. Banking Group's consumer loan and deposit products are primarily marketed using direct mail and telemarketing channels and other direct response methods. Installment loans are primarily marketed through agents. In 1993, the Banking Group also entered into joint marketing arrangements with unaffiliated third parties whereby the Banking Group's consumer credit products would be endorsed by, or offered in connection with the products or services of, such third parties. The Company's Agency Group affiliates concentrate their marketing efforts in the Southeast and Mid-Atlantic states, while the Direct Response, Accumulation and Investment and Banking Groups market their products nationwide. RISK Risk is integral to insurance but, as is customary in the insurance business, risk exposure is kept within acceptable limits. The Company's subsidiaries retain no more than $1,000,000 of life insurance and $250,000 of accidental death benefits for any single life. Excess coverages are reinsured externally. At December 31, 1993, approximately $4.6 billion, or approximately 6.9 percent of total life insurance in force, was reinsured with nonaffiliated insurance companies. The Company would become liable for the reinsured risks if the reinsurers could not meet their obligations. The Company's life insurance affiliates in many cases require evidence of insurability before issuing individual life policies including, in some cases, a medical examination or a statement by an attending physician. Home office underwriters review that evidence and approve the issuance of the policy in accordance with the application if the risk is acceptable. Some applicants who are substandard risks are rejected, but many are offered policies with higher premiums or restricted coverages. As of December 31, 1993, approximately 1.9 percent of life insurance in force was represented by risks which were substandard at the time the policy was issued. The majority of individual health insurance is Direct Response Group business and written without evidence of insurability, relying on safeguards such as product design, limits on the amount of coverage, and premiums which recognize the resultant higher level of claims. Banking Group's unsecured consumer loans are principally generated through direct mail solicitations sent to a prescreened list of prospective account holders, followed by credit verification. Four principles guide development of specific underwriting criteria for each mailing: (i) sufficient credit history; (ii) no unacceptable derogatory credit remarks; (iii) necessary income qualification; and (iv) no rapid increase in outstanding debt or credit availability. - 6 - Item 1. (continued) As a diversified financial services company, many of the Company's assets and liabilities are monetary in nature and thus are sensitive to changes in the interest rate environment. Detailed discussions about the Company's investments are included in Note C to the Consolidated Financial Statements on pages 44 through 46 of the Company's 1993 Annual Report and Item 7, Management's Discussion and Analysis of Financial Condition and Results of Operations. REGULATION Insurance The business of the Company's insurance subsidiaries is subject to regulation and supervision by the insurance regulatory authority of each state in which the subsidiaries are licensed to do business. Such regulators grant licenses to transact business; regulate trade practices; approve policy forms; license agents; approve certain premium rates; establish minimum reserve and loss ratio requirements; review form and content of required financial statements; prescribe type and amount of investments permitted; and assure that capital, surplus and solvency requirements are met. Insurance companies can also be required under the solvency or guaranty laws of most states in which they do business to pay assessments up to prescribed limits to fund policyholder losses or liabilities of insolvent insurance companies. They are also required to file detailed annual reports with supervisory agencies, and records of their business are subject to examination at any time. Under the rules of the National Association of Insurance Commissioners (the "NAIC"), a self-regulatory organization of state insurance commissioners, insurance companies are examined periodically by one or more of the regulatory authorities. The NAIC adopted, in December of 1992, a "Risk Based Capital for Life and/or Health Insurers Model Act" (the "Model Act") which was designed to identify inadequately capitalized life and health insurers. The Model Act defines two key measures: (i) Adjusted Capital, which equals an insurer's statutory capital and surplus plus its Asset Valuation Reserve, plus half its liability for policyholder dividends, and (ii) Risk Based Capital. Risk Based Capital is determined by a complex formula which is intended to take into account the various risks assumed by an insurer. Should an insurer's Adjusted Capital fall below certain prescribed levels (defined in terms of its Risk Based Capital), the Model Act provides for four different levels of regulatory attention: "Plan Level": Triggered if an insurer's Adjusted Capital is less than 100% but greater than or equal to 75% of its Risk Based Capital; requires the insurer to submit a plan to the appropriate regulatory authority that discusses proposed corrective action. "Action Level": Triggered if an insurer's Adjusted Capital is less than 75% but greater than or equal to 50% of its Risk Based Capital; authorizes the regulatory authority to perform a special examination of the insurer and to issue an order specifying corrective actions. - 7 - Item 1. (continued) "Authorized Control Level": Triggered if an insurer's Adjusted Capital is less than 50% but greater than or equal to 35% of its Risk Based Capital; authorizes the regulatory authority to take whatever action it deems necessary. "Mandatory Control Level": Triggered if an insurer's Adjusted Capital falls below 35% of its Risk Based Capital; requires the regulatory authority to place the insurer under its control. Since the Adjusted Capital levels of the Company's insurance subsidiaries currently exceed all of the regulatory action levels as defined by the NAIC's Model Act, the Model Act currently has no impact on the Company's operations or financial condition. The federal government does not directly regulate insurance business, except with respect to Medicare supplement plans; however, legislation and administration policies concerning premiums, age and gender discrimination, financial services and taxation, among other areas, can significantly affect the insurance business. Banking First Deposit's consumer banking subsidiaries are subject to federal and state regulation with respect to lending and investment practices, capital requirements, and financial reporting. The primary regulator for these consumer banking subsidiaries is the Office of the Comptroller of the Currency. Holding Company States have enacted legislation requiring registration and periodic reporting by insurance companies domiciled within their respective jurisdictions that control or are controlled by other corporations so as to constitute a holding company system. The Company and its subsidiaries have registered as a holding company system pursuant to such legislation in Kentucky, Missouri, North Carolina, New York, Illinois, Pennsylvania and New Jersey. Insurance holding company system statutes and rules impose various limitations on investments in subsidiaries and may require prior regulatory approval for the payment of dividends and other distributions in excess of statutory net gain from operations on an annual noncumulative basis by the registered insurance company to the holding company or its affiliates. Separate Accounts Separate accounts of the Company's subsidiaries which offer retail variable annuities are registered with the Securities and Exchange Commission under the Investment Company Act of 1940 and are governed by the provisions of the Internal Revenue Code of 1986, as amended, pertaining to the tax treatment of annuities. - 8 - Item 1. (continued) COMPETITION The insurance industry is highly competitive with over 2,000 life insurance companies competing in the United States, some of which have substantially greater financial resources, broader product lines and larger staffs than the Company's insurance subsidiaries. Additionally, life insurance companies face increasing competition from banks, mutual funds and other financial entities for attracting investment funds. The Company's insurance subsidiaries differentiate themselves through progressive marketing techniques, product features, price, customer service, stability and reputation, as well as competitive credit ratings. The insurance subsidiaries maintain their competitive position by their focus on low risk/high return markets and an efficient cost structure. Other competitive strengths include integrated asset/liability management, risk management and innovative product engineering. The credit card and consumer revolving loan industry business in which First Deposit's subsidiaries are engaged is also highly competitive. The industry has recently experienced consolidation, lower growth and rising charge-offs. Competitors are increasing their use of advertising, target marketing, pricing competition and incentive programs and have also announced changes in the terms of certain credit cards, including lowering the fixed annual percentage rate charged on balances or converting the annual percentage rate charged on balances from a fixed per annum rate to a variable rate. In addition, other credit card issuers have announced "tiered" or "risk-adjusted" rates under which the annual percentage rate for the issuer's most creditworthy customers is lowered. In response to the competitive environment, First Deposit's subsidiaries have implemented a variety of new programs to attract and retain customers, including reducing interest rates on selected accounts. First Deposit's subsidiaries have generally retained the right to alter various charges, fees and other terms with respect to consumer credit accounts. In addition, the Banking Group has experienced steady growth in its secured loan products and is increasing its efforts to offer its products to underserved markets. EMPLOYEES The total number of persons employed by the Company and its subsidiaries was approximately 9,360 as of December 31, 1993, including an agency sales force of 3,609. The Company has approximately 350 employees. FOREIGN OPERATIONS Substantially all of the Company's operations are conducted in the United States. - 9 - Item 2.

Item 2. PROPERTIES Principal properties of the Company and its affiliates include home offices located in Louisville, Kentucky (Commonwealth Life) and Valley Forge, Pennsylvania (National Liberty and Worldwide Insurance), which are owned; and Louisville, Kentucky (Capital Holding Corporation), Durham, North Carolina (Peoples Security, Capital Security and Durham Life) and San Francisco and Pleasanton, California (First Deposit), which are leased. Item 3.

Item 3. LEGAL PROCEEDINGS The last subsection, titled "Legal Proceedings", of Note J - Commitments and Contingencies on page 53 of the Annual Report for the year ended December 31, 1993, is incorporated by reference. Item 4.

Item 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS None EXECUTIVE OFFICERS OF THE REGISTRANT Name and Age Principal Occupation and Business Experience Irving W. Bailey II Chairman of the Board of Directors, Capital Holding Age: 52 Corporation, since November 1988, and President and Chief Executive Officer, Capital Holding Corporation, since April 1988. President and Chief Operating Officer, Capital Holding Corporation, September 1987 to April 1988. Executive Vice President and Chief Investment Officer, Capital Holding Corporation, from February 1981 to September 1987. He was with Phoenix Mutual Life Insurance Company for 9 1/2 years, serving as Senior Vice President, Investments from 1979 to 1981 and Vice President, Investments from 1976 to 1979. Robert L. Walker Senior Vice President - Finance and Chief Financial Age 43 Officer, Capital Holding Corporation, since August 1993. He served as Vice President and General Counsel, Capital Holding Corporation, from December 1991 to August 1993, and Vice President, Corporate Tax, Capital Holding Corporation, from March 1988 to December 1991. Prior to joining Capital Holding Corporation, he was with The Mead Corporation from 1975 to 1988, serving most recently as Tax Counsel. Steven T. Downey Vice President and Controller, Capital Holding Age: 36 Corporation, since November 1993. He served as Director, Finance and Accounting - Accumulation and Investment Group, Capital Holding Corporation, from January 1993 to November 1993, and Second Vice President and Assistant Controller from August 1991 to January 1993. Prior to joining Capital Holding Corporation, he was with Ernst & Young, Certified Public Accountants, from 1978 to 1991. - 10 - EXECUTIVE OFFICERS OF THE REGISTRANT (continued) Name and Age Principal Occupation and Business Experience Shailesh J. Mehta Executive Vice President, Capital Holding Age: 44 Corporation and President and CEO - Direct Response Group, Capital Holding Corporation, since August 1993. Also, President and CEO - Banking Group, Capital Holding Corporation, and Chairman of the Board, President and Chief Executive Officer of First Deposit Corporation (FDC) and subsidiaries since April 1988. He served as Executive Vice President and Chief Operating Officer of FDC from March 1986 until his selection as CEO. Prior to joining FDC, he served as Vice President, 1977 to 1982; Senior Vice President of Bank Operations, 1982 to 1985; and finally Executive Vice President, 1985 to 1986, of AmeriTrust Bank, Cleveland, Ohio. During his thirteen year tenure at AmeriTrust, he also served on the boards of AmeriTrust Venture Capital Corporation, AmeriTrust Development Bank, NationNet National ATM Network, and InstaNet National ATM Network. He is one of the founders of the Cirrus debit card network. Lee Adrean President and CEO - Agency Group, Capital Holding Age: 42 Corporation, since August 1993. He served as Senior Vice President, Planning and Finance and Chief Financial Officer, Capital Holding Corporation, from December 1991 to August 1993, and Senior Vice President, Strategic Planning and Corporate Development, Capital Holding Corporation, from September 1990 to August 1993. Prior to joining Capital Holding Corporation, he was with Bain & Company, Inc. from 1979 to 1990, serving as Vice President, 1985 to 1990; Manager, 1982 to 1985; and Consultant, 1979 to 1982. Joseph M. Tumbler President and CEO - Accumulation and Investment Age: 45 Group, Capital Holding Corporation, since November 1989. He served as Senior Vice President - Strategic Planning and Corporate Development, Capital Holding Corporation, from January 1988 to November 1989. Previously with National Liberty Corporation as Executive Vice President - Financial Marketing from September 1986 to January 1988. He was with CIGNA Corporation from 1978 to 1986, serving as Senior Vice President, International Life and Group, 1983 to 1986; Vice President, Planning, CIGNA Worldwide, Inc., 1981 to 1983; Director - Corporate Strategy, INA Corporation, 1978 to 1981. - 11 - EXECUTIVE OFFICERS OF THE REGISTRANT (continued) Name and Age Principal Occupation and Business Experience Lawrence Pitterman Senior Vice President of Administration, Capital Age: 46 Holding Corporation, since January 1991. Previously with First Deposit Corporation as Vice President, Human Resources, from July 1990 to December 1990; Vice President, Corporate Communications, from 1989 to 1990; and Vice President, First Deposit Savings Bank, from 1987 to 1989. Prior to joining FDC, he served as Director, Human Resources, for Data General Corporation from 1983 to 1987. Elaine J. Robinson Vice President and Treasurer, Capital Holding Age 45 Corporation, since December 1991, Second Vice President and Assistant Treasurer, Capital Holding Corporation, from November 1987 to December 1991, and Second Vice President, Corporate Finance, Capital Holding Corporation, from August 1987 to November 1987. Prior to joining Capital Holding Corporation, she was with Brown-Forman Corporation from 1971 to 1987, serving most recently as Assistant Vice President, Corporate Finance and Treasury. Bruce E. Ogle Vice President and Corporate Auditor, Capital Holding Age 38 Corporation, since 1989. He served as Director, Marketing Support-Agency Group, Capital Holding Corporation, from 1987 to 1988, and as Manager, Computer Audit Function-Agency Group, Capital Holding Corporation, from 1984 to 1987. Frederick C. Kessell Vice President and Chief Investment Officer - Age 45 Accumulation and Investment Group, Capital Holding Corporation, since 1988, and Vice President, Fixed Income Securities - Accumulation and Investment Group, Capital Holding Corporation from May, 1985 to 1988. Prior to joining Capital Holding Corporation, he was with Schroder Capital Management from 1979 to 1985, serving as Vice President. PART II Item 5.

Item 5. MARKET FOR THE REGISTRANT'S COMMON STOCK AND RELATED STOCKHOLDER MATTERS Common Stock Dividend and Market Data, and Quarterly Price Ranges of Common Stock and Dividends Per Common Share on pages 32 and 34 of the Annual Report for the year ended December 31, 1993 are incorporated by reference. Item 6.

Item 6. SELECTED FINANCIAL DATA Selected Financial Data on pages 18 and 19 of the Annual Report for the year ended December 31, 1993, is incorporated by reference. - 12 - PART II (continued) Item 7.

Item 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Consolidated Results and Analysis on pages 18 and 19, Results by Business Segment on pages 20 through 31, Business Segment Data on pages 22 and 23, Supplemental Earnings Data on page 35 and Liquidity and Capital Resources and Inflation on pages 31 and 32 of the Annual Report for the year ended December 31, 1993, are incorporated by reference. Item 8.

Item 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA The Consolidated Financial Statements of Capital Holding Corporation and Subsidiaries included on pages 37 through 53 and Quarterly Financial Data on page 34 of the Annual Report for the year ended December 31, 1993, are incorporated by reference. Item 9.

Item 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE None. PART III Item 10.

Item 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT Election of Directors on pages 3 through 5 of the Proxy Statement for the Annual Meeting of Stockholders to be held May 11, 1994, is incorporated by reference. Item 11.

Item 11. EXECUTIVE COMPENSATION Compensation of Directors and Executive Officers on pages 5 through 14 of the Proxy Statement for the Annual Meeting of Stockholders to be held May 11, 1994, is incorporated by reference. Item l2. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT Security Ownership of Certain Beneficial Owners and Management on pages 1 and 2 and Compliance with Section 16(a) of the Securities Exchange Act of 1934 on page 18 of the Proxy Statement for the Annual Meeting of Stockholders to be held May 11, 1994, are incorporated by reference. Item 13.

Item 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS None. - 13 - PART IV Item 14.

Item 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K (a) (1) and (2)--The response to these portions of Item 14 is submitted as a separate section of this report. (a) (3)--The response to this portion of Item 14 is submitted as a separate section of this report. (b) No reports on Form 8-K were filed for the three month period ended December 31, 1993. (c) Exhibits are submitted as a separate section of this report. (d) Financial statement schedules are submitted as a separate section of this report. - 14 - SIGNATURES Pursuant to the requirements of Section 13 or 15(d) 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, in the City of Louisville, and the Commonwealth of Kentucky, on the 16th day of February 1994: CAPITAL HOLDING CORPORATION Irving W. Bailey II Irving W. Bailey II Chairman, President and Chief Executive Officer Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant in the capacities indicated on the 16th day of February 1994: SIGNATURE TITLE Irving W. Bailey II Chairman, President, Chief Executive Irving W. Bailey II Officer and Director Robert L. Walker Senior Vice President and Robert L. Walker Chief Financial Officer Steven T. Downey Vice President and Controller Steven T. Downey (Principal Accounting Officer) John L. Clendenin Director John L. Clendenin Director John M. Cranor III Joseph F. Decosimo Director Joseph F. Decosimo - 15 - SIGNATURE TITLE Lyle Everingham Director Lyle Everingham Raymond V. Gilmartin Director Raymond V. Gilmartin J. David Grissom Director J. David Grissom Watts Hill, Jr. Director Watts Hill, Jr. F. Warren McFarlan Director F. Warren McFarlan Martha R. Seger Director Martha R. Seger Director Florence R. Skelly Larry D. Thompson Director Larry D. Thompson Director John L. Weinberg - 16 - ANNUAL REPORT ON FORM 10-K ITEM l4(a)(1), (2) and (3), (c) and (d) LIST OF FINANCIAL STATEMENTS AND FINANCIAL STATEMENT SCHEDULES FINANCIAL STATEMENT SCHEDULES LIST AND INDEX OF EXHIBITS YEAR ENDED DECEMBER 31, 1993 CAPITAL HOLDING CORPORATION LOUISVILLE, KENTUCKY - 17 - FORM 10-K--ITEM 14(a)(1) and (2) CAPITAL HOLDING CORPORATION AND SUBSIDIARIES INDEX OF FINANCIAL STATEMENTS AND FINANCIAL STATEMENT SCHEDULES The following Consolidated Financial Statements of Capital Holding Corporation and Subsidiaries, included on pages 37 through 53 of the Annual Report for the year ended December 31, 1993, are incorporated by reference in Item 8: Page Consolidated Statements of Income - Years Ended December 31, 1993, 1992 and 1991 37 Consolidated Statements of Financial Condition - December 31, 1993 and 1992 38-39 Consolidated Statements of Cash Flows - Years Ended December 31, 1993, 1992 and 1991 40 Consolidated Statements of Shareholders' Equity - Years Ended December 31, 1993, 1992 and 1991 41 Notes to Consolidated Financial Statements 42-53 The following financial statement schedules and the related Report of Independent Auditors are included in Item 14(d): Schedule I - Summary of Investments - Other Than Investments in Related Parties Schedule III - Condensed Financial Information of Registrant Schedule V - Supplementary Insurance Information Schedule VI - Reinsurance Schedule IX - Short-term Borrowings Information required in Schedule VIII, "Valuation and Qualifying Accounts," is included in Note C to the consolidated financial statements of Capital Holding Corporation and subsidiaries, incorporated herein by reference. All other schedules for which provision is made in the applicable accounting regulation of the Securities and Exchange Commission are not required under the related instructions or are inapplicable and, therefore, have been omitted. - 18 - REPORT OF INDEPENDENT AUDITORS Board of Directors and Shareholders Capital Holding Corporation We have audited the consolidated financial statements of Capital Holding Corporation and subsidiaries listed in the accompanying Index to financial statements (Item 14(a)). Our audits also included the financial statement schedules listed in the Index at Item 14(a). These financial statements and schedules are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements and schedules based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the consolidated financial position of Capital Holding Corporation and subsidiaries at December 31, 1993 and 1992, and the consolidated results of their operations and their cash flows for each of the three years in the period ended December 31, 1993, in conformity with generally accepted accounting principles. Also, in our opinion, the financial statement schedules, when considered in relation to the basic financial statements taken as a whole, present fairly, in all material respects, the information set forth therein. ERNST & YOUNG Louisville, Kentucky February 9, 1994 - 19 - - 23 - SCHEDULE III--CONDENSED FINANCIAL INFORMATION OF REGISTRANT - CONTINUED CAPITAL HOLDING CORPORATION (PARENT COMPANY) NOTES TO CONDENSED FINANCIAL STATEMENTS In the parent company only condensed financial statements, the Company's investment in subsidiaries is stated at cost plus equity in undistributed income of subsidiaries since date of acquisition. The condensed financial statements of the parent company should be read in conjunction with the Consolidated Financial Statements and Notes of Capital Holding Corporation and Subsidiaries. Note A Federal Income Tax The Company files a consolidated federal income tax return with certain of its subsidiaries. The federal income tax benefit in the accompanying condensed financial statements reflects the Company's allocable share of the consolidated provision. See Note G to the Consolidated Financial Statements of Capital Holding Corporation and Subsidiaries for a description of the components of the consolidated federal income tax provision. Note B Long-Term Debt Long-term debt of the Company at December 31, 1993 and 1992 consisted of Debentures and Notes in the amount of $587,750,000. See Note H to the Consolidated Financial Statements of Capital Holding Corporation and Subsidiaries for a description of the terms and aggregate maturities of the Company's long-term debt. Note C Common Stock On February 17, 1993, the Board of Directors declared a two-for-one stock split of the Company's common stock effected in the form of a stock dividend. The stock dividend was payable on April 30, 1993, to holders of record on April 15, 1993. Note D Preferred Stock The Company has 6,000,000 shares of preferred stock, par value $5, authorized for issuance in series. Redeemable Cumulative Preferred Stock Held By Subsidiary The Company has designated 827,400 shares of preferred stock as redeemable cumulative preferred stock to be issued in different series with varying annual dividend rates. The shares outstanding at December 31, 1993 and 1992 were 707,400 and 768,600, respectively. The subsidiary has the right, on an annual basis, to waive receipt of dividends and has waived any dividends payable through 1993. The characteristics of the redeemable preferred stock are as follows: SCHEDULE III--CONDENSED FINANCIAL INFORMATION OF REGISTRANT - CONTINUED CAPITAL HOLDING CORPORATION (PARENT COMPANY) NOTES TO CONDENSED FINANCIAL STATEMENTS - NOTE D - CONTINUED Shares outstanding Dividend Shares Year at December 31 Period of Series rate authorized issued 1993 1992 redemption B 12.25% 57,400 1980 57,400 65,600 1991-2000 C 14.00% 120,000 1981 120,000 135,000 1992-2001 D 15.00% 90,000 1982 90,000 100,000 1993-2002 E 14.25% 135,000 1982 135,000 150,000 1993-2002 G 12.00% 237,000 1983 117,000 130,000 1993-2002 H 11.50% 100,000 1984 100,000 100,000 1994-2003 I 12.00% 88,000 1984 88,000 88,000 1994-2003 827,400 707,400 768,600 Mandatory pro-rata sinking fund payments are required to redeem 10% of each series of redeemable preferred stock annually, beginning approximately ten years after issuance at $100 per share. As the shares are redeemed, they are retired thereby reducing the total authorized shares. The Company redeemed the following shares of cumulative preferred stock in 1993: 8,200 of the Series B; 15,000 of the Series C; 10,000 of the Series D; 15,000 of the Series E; and 13,000 of the Series G. The aggregate amount of mandatory pro-rata sinking fund payments required for redemption of the redeemable preferred stock in each of the following years are: 1994-$8,000,000; 1995-$8,000,000; 1996-$8,000,000, 1997-$8,000,000 and 1998-$8,000,000. The Company shall have the annual non-cumulative option to double any sinking fund payment subject to an aggregate limitation of 25% of the total issue. The redeemable preferred stock is non-callable for approximately ten years and callable thereafter at $105 per share plus accrued dividends. However, in the event the Company is required to obtain approval of a specified percentage of the holders of the issue to effect a merger, consolidation, or sale of assets and such approval is denied, then the Company may redeem the preferred stock in its entirety at $100 per share plus accrued dividends. Noncumulative Convertible Junior Preferred Stock On November 14, 1991, the Company issued 1,918,200 shares of Noncumulative Convertible Junior Preferred Stock, Series J, par value $5, in connection with the acquisition of Durham Corporation. Effective June 16, 1993, each outstanding share of Series J preferred stock was exchanged for 5.55 shares of the Company's common stock and all rights of the holders of Series J preferred stock, including the rights to receive dividends, were terminated. Adjustable Rate Cumulative Preferred Stock In 1982, the Company issued 1,000,000 shares of Adjustable Rate Cumulative Preferred Stock, Series F, par value $5, at face value of $100 per share. See Note I to the Consolidated Financial Statements of Capital Holding Corporation and Subsidiaries for a description of the terms and dividend rate of the Series F Preferred Stock. On March 2, 1994, the Company redeemed the preferred stock for cash at face value. Note E Management and Service Fees The Company provides its subsidiaries with general management support, including services in the data processing, human resources, legal and financial areas. The related charges are billed to the subsidiaries being serviced as management fees, and are computed using various allocation methods which are, in the opinion of management, reasonable in relation to services rendered. - 25 - - 30 - FORM 10-K--ITEM 14(a)(3) AND (c) CAPITAL HOLDING CORPORATION AND SUBSIDIARIES LIST AND INDEX OF EXHIBITS Reference Number Per Exhibit Exhibit Table Description of Exhibit Number Page (3) Certificate of Incorporation as amended 3.1 - on October 17, 1991. (Incorporated by reference as Exhibit 3.1 of the Company's Annual Report on Form 10-K for the year ended December 31, 1991.) (3) By-Laws of Capital Holding Corporation as 3.2 - amended on February 17, 1988. (Incorporated by reference as Exhibit 3.3 of the Company's Annual Report on Form 10-K for the year ended December 31, 1989.) (4) Indenture dated April 1, 1983 between 4.1 - the Company and Connecticut National Bank (as successor to National Westminster Bank USA) for Debt Securities (which now are 8 3/4% Sinking Fund Debentures due January 15, 2017 and Medium Term Notes due 1995 to 2022). (Incorporated by reference as Exhibit 4.2 to Registration Statement on Form S-3, Registration No. 2-82957 filed with the Commission on April 8, 1983.) (4) Supplemental Indenture, dated 4.2 - September 1, 1989, between the Company and Connecticut National Bank (as successor to National Westminster Bank USA), Supplements the Indenture dated April 1, 1983, between the Company and Connecticut National Bank (as successor to National Westminster Bank USA). (Incorporated by reference as Exhibit 4.1 of Form 8-K dated September 18, 1989.) (4) Capital Holding Corporation 1987 4.3 - Shareholder Rights Agreement as amended on November 4, 1992. (Incorporated by reference as Exhibit 4.5 of the Company's Annual Report on Form 10-K for the year ended December 31, 1992.) (4) Indenture between the Company and 4.4 - Morgan Guaranty Trust Company of New York, as Trustee, dated as of January 1, 1994. (Provided as part of electronic submission). - 31 - FORM 10-K--ITEM 14(a)(3) AND (c) CAPITAL HOLDING CORPORATION AND SUBSIDIARIES LIST AND INDEX OF EXHIBITS (CONTINUED) Reference Number Per Exhibit Exhibit Table Description of Exhibit Number Page (10) Capital Holding Corporation 1981 10.1 - Stock Option Incentive Plan, through August 7,1991 (Incorporated by reference as Exhibit 10.1 of the Company's Annual Report on Form 10-K for the year ended December 31, 1990.) (10) 1991 amendments to 1981 Stock Option 10.2 - Incentive Plan and 1989 Stock Option Plan. (Incorporated by reference as Exhibit 10.2 of the Company's Annual Report on Form 10-K for the year ended December 31, 1991.) (10) Capital Holding Corporation 1981 Tax- 10.3 - Qualified Stock Option Plan, as amended. (Incorporated by reference as Exhibit 10.2 of the Company's annual Report on Form 10-K for the year ended December 31, 1990.) (10) Employment Agreement between Capital 10.4 - Holding Corporation and Irving W. Bailey II. (Incorporated by reference as Exhibit 10.6 of the Company's Annual Report on Form 10-K for the year ended December 31, 1987.) (10) Descriptions of Company's Management 10.5 - Incentive Plan, First Deposit Corporation's Annual Incentive Plan and Company's Long-Term Incentive Plan. (Incorporated by reference to the descriptions of the Incentive Compensation Plans as described on Pages 6 and 7 of the Proxy Statement for the Annual Meeting of Stockholders held May 1, 1992.) (10) Capital Holding Corporation 1989 Stock 10.6 - Option Plan, through August 7, 1991. (Incorporated by reference as Exhibit 10.6 of the Company's Annual Report on Form 10-K for the year ended December 31, 1990.) - 32 - FORM 10-K--ITEM 14(a)(3) AND (c) CAPITAL HOLDING CORPORATION AND SUBSIDIARIES LIST AND INDEX OF EXHIBITS (CONTINUED) Reference Number Per Exhibit Exhibit Table Description of Exhibit Number Page (10) Amendment to Employment Agreement 10.7 - between Capital Holding Corporation and Irving W. Bailey II. (Incorporated by reference as Exhibit 10.7 of the Company's Annual Report on Form 10-K for the year ended December 31, 1989.) (10) Employment Agreements between 10.8 - Capital Holding Corporation and Joseph M. Tumbler. (Incorporated by reference as Exhibit 10.8 of the Company's Annual Report on Form 10-K for the year ended December 31, 1989.) (10) Employment Agreements between Capital 10.9 - Holding Corporation and Lee Adrean, Shailesh J. Mehta and Lawrence Pitterman. (Incorporated by reference as Exhibit 10.9 of the Company's Annual Report on Form 10-K for the year ended December 31, 1990.) (10) Employment Agreements between Capital 10.10 - Holding Corporation and Frederick C. Kessell and Robert L. Walker. (Incorporated by reference as Exhibit 10.11 of the Company's Annual Report on Form 10-K for the year ended December 31, 1991.) (10) First Deposit Corporation Equity Unit 10.11 - Plan. (Incorporated by reference as Exhibit 10.12 of the Company's Annual Report on Form 10-K for the year ended December 31, 1991.) (10) Capital Holding Corporation Deferred 10.12 - Compensation Plan for Deferral of Payments under the Capital Holding Corporation Management Incentive Plan. (Incorporated by reference as Exhibit 10.13 of the Company's Annual Report on Form 10-K for the year ended December 31, 1991.) - 33 - FORM 10-K--ITEM 14(a)(3) AND (c) CAPITAL HOLDING CORPORATION AND SUBSIDIARIES LIST AND INDEX OF EXHIBITS (CONTINUED) Reference Number Per Exhibit Exhibit Table Description of Exhibit Number Page (10) Capital Holding Corporation Deferred 10.13 - Compensation Plan under the Capital Holding Corporation Long-Term Incentive Plan. (Incorporated by reference as Exhibit 10.14 of the Company's Annual Report on Form 10-K for the year ended December 31, 1991.) (10) First Deposit Corporation Deferred 10.14 - Compensation Plan under the First Deposit Corporation Annual Incentive Plan. (Incorporated by reference as Exhibit 10.15 of the Company's Annual Report on Form 10-K for the year ended December 31, 1991.) (10) Descriptions of Capital Holding 10.15 - Corporation Supplemental Non-qualified Thrift Savings Plan and Non-qualified Pension Agreements. (Incorporated by reference to the descriptions of the Retirement Plans and Thrift Savings Plan as described on pages 7 through 9 of the Proxy Statement for the Annual meeting of Stockholders held May 1, 1992.) (10) Capital Holding Corporation Stock 10.16 - Ownership Plan (Incorporated by reference as Exhibit 10.17 of the Company's Annual Report on Form 10-K for the year ended December 31, 1992.) (12) Computation of ratio of earnings to fixed 12.1 35 charges (Provided as part of electronic transmission.) (13) Portions of the Annual Report for the year 13.1 - ended December 31, 1993. (Provided as part of electronic transmission.) (21) List of subsidiaries. (Provided as part 21.1 37 of electronic transmission.) (23) Consent of independent auditors. (Provided 23.1 39 as part of electronic transmission.) - 34 -

13372_1993.txt

13372

1993

Item 1. Business - ----------------- (a) General Development of Business - ----------------------------------- Boston Edison Company (the Company) is an investor-owned regulated public utility incorporated in 1886 under Massachusetts law. The Company operates in the energy and energy services business, which includes the generation, purchase, transmission, distribution and sale of electric energy and the development and implementation of demand side management (DSM) programs. In 1993 the Company established an unregulated subsidiary known as the Boston Energy Technology Group (BETG) following approval from the Massachusetts Department of Public Utilities (DPU). The Company was granted authority to invest up to $45 million in this wholly-owned subsidiary over the next three years. BETG will engage in demand side management, electric transportation and electric generation and distribution activities through its wholly-owned subsidiaries Ener-G-Vision, Inc. and TravElectric Services Corporation. In January 1994 BETG acquired a substantial majority interest in the assets of REZ-TEK International, Inc. The new entity, REZ-TEK International Corporation, will continue the business of manufacturing ozone water treatment systems. The Company does not currently have a substantial investment in BETG and does not expect the subsidiary to significantly impact the results of operations in the next several years. (b) Financial Information about Industry Segments - ------------------------------------------------- The Company operates primarily as a regulated electric public utility, therefore industry segment information is not applicable. (c) Narrative Description of Business - ------------------------------------- Principal Products and Services The Company supplies electricity at retail to an area of approximately 590 square miles encompassing the City of Boston and 39 surrounding cities and towns. The population of the area served with electricity at retail is approximately 1.5 million. In 1993 the Company served an average of approximately 651,000 customers. The Company also supplies electricity at wholesale for resale to other utilities and municipal electric departments. Revenues by class for the last three years are as follows: Sources and Availability of Fuel The majority of the Company's residual oil purchases consists of imported oil acquired primarily from international suppliers. The Company has contracts with major oil companies that can supply most of its estimated requirements, assuming no major disruptions in oil producing regions. Within contract provisions, the Company has the ability to purchase significant amounts of oil in the spot market when it is economical to do so. Most of the Company's natural gas is supplied on an interruptible basis whereby a contract permits interruptions in deliveries by the supplier when natural gas pipeline capacity is unavailable. Deliveries of natural gas to the Company's generating units from suppliers may also be dependent on the availability of pipeline capacity to the New England region and competitive forces prevailing in the pipeline industry. Beginning in April 1995 the Company will be required to operate New Boston Station using exclusively natural gas as fuel, except in certain emergency circumstances, as part of a 1991 consent order from the Massachusetts Department of Environmental Protection (DEP). The Company has arrangements for a nine month supply of natural gas to the station until April 1995 and is currently in the process of negotiating with suppliers and transporters concerning the economics and availability of natural gas to the station on a year-round basis after that time. Year-round gas supplies are currently not available to the station and, as a result, the outcome of the Company's negotiations with natural gas suppliers and transporters and the impact on the operation of New Boston Station are uncertain. In order to obtain nuclear fuel for use at Pilgrim Station the Company must obtain supplies of uranium concentrates and secure contracts for these concentrates to go through the processes of conversion, enrichment and fabrication of nuclear fuel assemblies. The Company currently has contracts for supplies of uranium concentrates and the processes of conversion, enrichment and fabrication that will individually allow operation of Pilgrim Station through 1998, 2000, 2001 and 2012, respectively. Franchises Through its charter, which is unlimited in time, the Company has the right to engage in the business of producing and selling electricity, steam and other forms of energy, has powers incidental thereto and is entitled to all the rights and privileges of and subject to the duties imposed upon electric companies under Massachusetts laws. The locations in public ways for the Company's electric transmission and distribution lines are obtained from municipal and other state authorities, which in granting these locations act as agents for the state. In some cases the action of these authorities is subject to appeal to the DPU. The locations are unlimited in time, but their rights are not vested and are subject to the action of these authorities and the legislature. Seasonal Nature of Business The Company's kWh sales and revenues have historically been less in the spring and fall than during winter and summer as sales tend to vary with weather conditions. In addition, the Company bills higher base rates to commercial and industrial customers during the billing months of June through September as mandated by the DPU. Accordingly, a significant portion of annual earnings occurs in the Company's third quarter. See Selected Consolidated Quarterly Financial Data (Unaudited) in Item 8. Working Capital Practices The Company has no special practices with respect to working capital that would be considered unusual for the electric utility industry or significant for the understanding of the Company's business. Customer Dependence No material portion of the Company's business is dependent upon one or a few customers. Government Contracts No material portion of the Company's business is subject to renegotiation or termination of government contracts or subcontracts. Competitive Conditions The Company is experiencing a substantial increase in competition from other electric utilities and non-utility generators to sell electricity for resale. In response to the current environment the Company has secured long-term power supply agreements with its four current wholesale customers which set rates principally through the year 2002. The Company also obtained a new wholesale customer for which it will provide up to 30 megawatts (MW) of contract demand power for ten years beginning November 1994. The DPU has created an integrated resource management (IRM) process in which electric utilities forecast their future energy needs and propose how they will meet those needs by balancing conservation programs with all other supplies of energy. The Company submitted a draft IRM filing in March 1994 that covers the period 1994 through 2004. In this filing the Company concluded that adequate resources exist to meet customer needs for continued reliable, low cost power through the period without procurement of any new generation resources. The IRM process requires a settlement period in which intervenors and other interested parties have the opportunity to review, comment and request information on the draft filing. Any settlements reached will be reflected in the Company's final IRM filing to be submitted in July 1994. Any remaining issues will be litigated at the DPU through formal proceedings. Direct competition with other electric utilities for retail electricity sales is still subject to substantial limitations, but these limitations may be reduced in the future. The Company and other Massachusetts electric utilities are protected in several ways by the DPU and municipal statutes against other utilities offering service to retail customers in their service areas. Another electric utility may not extend its service area to include municipalities other than those named in its agreement of association or charter without DPU authorization granted after notice and public hearing. Also, another company may not obtain an initial location for its lines in a municipality served by the Company without the approval of municipal authorities, subject to the right of appeal to the DPU. Additionally, a municipality may not engage in the electric utility business without complying with statutes requiring specific city or town approval and the purchase of Company property within municipality limits. However, the Company is currently experiencing some forms of competition in the retail electric market. Current legislation allows industrial and large commercial customers to own and operate their own electric generating units. Retail customers may also substitute natural gas or oil for electricity as fuel for heating and cooling purposes. The Company is responding to the current and anticipated competitive pressures with a commitment to cost control and increased operating efficiencies without sacrificing quality of service or profitability. Research Activities The Company actively participates in several industry-sponsored research activities. These expenditures, included in other operations and maintenance expense on the consolidated income statements in Item 8, were not material in 1993. Environmental Matters The Company is subject to numerous federal, state and local standards with respect to air and water quality, waste disposal and other environmental considerations. These standards can require modification of existing facilities or curtailment or termination of operations at facilities, delay construction of new facilities or increase capital and operating costs by substantial amounts. Noncompliance with certain standards can, in some cases, also result in the imposition of monetary civil penalties. The Company believes that its operating facilities are in substantial compliance with currently applicable statutory and regulatory environmental requirements. The Company's capital expenditures for environmental purposes during the five years 1989 through 1993 were approximately $125 million. Environmental-related capital expenditures for the years 1994 through 1998 are currently expected to approximate $43 million, including $17 million in 1994 and $9 million in 1995. These amounts exclude costs associated with asbestos removal which were approximately $11 million during the five years 1989 through 1993 and are currently expected to be approximately $10 million for the years 1994 through 1998. The 1994 expected capital expenditures for environmental purposes include costs to complete modifications at New Boston Station in order to improve air quality and reduce emissions of nitrogen oxides, as discussed in the Environmental section of Other Matters in Item 7, and to install air monitoring systems at other Company generating units. Substantial additional expenditures could be required as changes in environmental requirements occur. The Company is subject to regulation by the United States Environmental Protection Agency (EPA) and the Massachusetts Department of Environmental Protection (DEP) with respect to discharges of effluent from the Company's generating stations into receiving waters. The Federal Clean Water Act and the Massachusetts Clean Waters Act require the Company to receive permits that limit discharges in accordance with applicable water quality standards and are subject to renewal every five years. The Company has received discharge permits as required by the EPA and the DEP for each of its electric generating stations. The Company is also subject to EPA and DEP regulation relative to emissions from its fossil-fired generating units pursuant to Federal and Massachusetts clean air laws, including the 1990 Clean Air Act Amendments. These regulations require the installation of various emissions controls and the use of low sulfur content fuels in certain cases. The Company's current status regarding compliance with DEP regulations and the 1990 Clean Air Act Amendments is discussed in the Environmental section in Item 7. The Company is subject to various federal, state and local laws and regulations pertaining to the generation, treatment, transportation, storage and disposal of certain hazardous substances and to the cleanup of locations where such substances have either been disposed of or spilled. One of the requirements of these laws and regulations is that certain facilities which treat, store or dispose of hazardous wastes must be licensed. The only facility owned by the Company which requires such a license is Pilgrim Station. Currently Pilgrim Station has received interim status approval for the treatment and storage of certain wastes that are both hazardous and radioactive. The Company has exposure to potential joint and several liability for the cleanup of sites where hazardous wastes may have been spilled or disposed of in the past. The Company has been notified of such potential liability for approximately twelve sites, most of which involve numerous parties. Complex litigation or negotiations among the parties and with regulatory authorities is in process concerning the scope and cost of cleanup and the sharing of costs among the potentially responsible parties for several of these sites. The Company also faces additional exposure for the cleanup of Company-owned or operated sites due to state regulations revised in 1993. The potential hazardous waste liabilities are further described in the Environmental section of Item 7. The Company currently disposes of low-level radioactive waste (LLW) generated at Pilgrim Station through arrangements with licensed disposal facilities located in Barnwell, South Carolina. As a result of developments which have occurred pursuant to the Low-Level Radioactive Waste Policy Amendments Act of 1985, the Company's continued access to such disposal facilities has become severely limited and significantly increased in cost. See Note D to the consolidated financial statements in Item 8 for further discussion regarding LLW disposal. The Company's existing fuel storage facility at Pilgrim Station includes sufficient room for spent nuclear fuel generated through early 1995. A request for a license amendment to allow modification of the storage facility to provide sufficient room for spent nuclear fuel generated through the end of Pilgrim's operating license in 2012 is pending before the Nuclear Regulatory Commission (NRC). The Company expects approval of the request in 1994. At that time the Company will initially modify the facility to provide spent fuel storage capacity through approximately 2003. In addition, the United States Department of Energy (DOE), which is ultimately responsible for the disposal of spent nuclear fuel as required by the Nuclear Waste Policy Act of 1982, is currently conducting scientific studies evaluating a potential spent nuclear fuel repository site at Yucca Mountain, Nevada. The potential site, however, has encountered substantial public and political opposition and litigation and the DOE has publicly stated that it may be unable to construct such a repository in a timely manner. The Company is unable to predict whether and on what schedule the DOE will eventually construct a repository and what the effect will be on the Company. Published reports have discussed the possibility that adverse health effects may be caused by electromagnetic fields associated with electric transmission and distribution facilities and appliances and wiring in buildings and homes. This topic is discussed more fully in the Environmental section of Item 7. Number of Employees The Company had 4,404 full-time and 14 part-time employees as of the end of 1993, 2,775 of which are represented by two locals of the Utility Workers Union of America, AFL-CIO. The current four-year labor contract in effect with the locals is scheduled to expire in May 1994. Labor contract negotiations began in early February 1994 and the Company anticipates favorable resolution of these negotiations. (d) Financial Information about Foreign and Domestic Operations - --------------------------------------------------------------- and Export Sales - ---------------- See Principal Products and Services for information regarding the geographical area served by the Company and revenues by class for the last three years. (e) Additional Information - -------------------------- Regulation The Company and its wholly-owned subsidiary, Harbor Electric Energy Company (HEEC), operate primarily under the authority of the DPU, whose jurisdiction includes supervision over retail rates for electricity, financing, investing and accounting. In addition, the Federal Energy Regulatory Commission (FERC) has jurisdiction over various phases of the Company's business including rates for power sold at wholesale for resale, facilities used for the transmission or sale of such power, certain issuances of short-term debt and regulation of the system of accounts. The Company's subsidiary BETG and its subsidiaries are not subject to such regulation. Recent requirements imposed on the Company by the DPU are discussed under Competitive Conditions of this item and Non-Utility Generator Purchase Contracts in Item 2.

Item 2. Properties and Power Supply - ------------------------------------ Company-Owned Facilities The Company's total installed electric generation capacity as of December 31, 1993 is as follows: All of the Company's steam fossil fuel-fired electric generating units are located at tide water and have access to fuel oil storage and/or natural gas or oil pipelines from nearby suppliers. The Company is also a 5.888% joint owner in W.F. Wyman Unit 4. The 619 MW oil-fired unit located in Yarmouth, Maine began operations in 1978 and is operated by Central Maine Power Company. Additional electric generation capacity is available to the Company through its contractual arrangements with other utilities and non-utilities and its participation in the New England Power Pool as further described in this item. As of December 31, 1993 the Company's transmission system was comprised of approximately 362 miles of overhead circuits operating at 115,000, 230,000 and 345,000 volts and approximately 155 miles of underground circuits operating at 115,000 and 345,000 volts. The substations supported by these lines consist of 42 transmission or combined transmission and distribution substations with transformer capacity of 10,025 megavolt amperes (MVA), 71 distribution substations with transformer capacity of 1,238 MVA and 18 primary network units with 88 MVA capacity. In addition, high tension service was delivered to 231 customers' substations. The overhead distribution system covers approximately 4,652 miles of streets and the underground distribution system extends through approximately 892 miles of streets. HEEC, the Company's regulated subsidiary, has a distribution system that consists principally of a 4.09 mile 115Kv submarine distribution line and a temporary substation which is located on Deer Island in Boston, Massachusetts. The Company's significant items of property consist of electric generating stations, substations and certain service centers and are generally located on Company-owned land, with certain exceptions as set forth in the Company's First Mortgage Bond Indenture and its supplements. The Company's high-tension transmission lines are generally located on land either owned by the Company or subject to easements in its favor. The Company's low-tension distribution lines and fossil fuel pipelines are located principally on public property under permission granted by local or state authorities. The Massachusetts Energy Facilities Siting Board (EFSB) must approve Company plans for the construction of certain new generation or transmission facilities based upon findings that such facilities are consistent with state public health, environmental protection and resource use and development policies. The Company currently has no proceedings before the EFSB. Long-Term Power Contracts Refer to Note K to the consolidated financial statements in Item 8 for further information regarding the following contracts. The Company also has short-term agreements with several other utilities for varying periods for purchases of system and unit power, for sales of Company system and unit power and for transmission services. Utility Purchase Contracts: - --------------------------- The Company has a contract with a subsidiary of Commonwealth Energy System and two other utilities in which the participants are sharing in equal amounts the output of an oil-fired electric generation plant. The Company is obligated to pay 25% of the unit's fixed and operating costs plus an annual return over a period of approximately 33 years for its proportionate share of generation. The Company has two long-term purchased power contracts with the Massachusetts Bay Transit Authority (MBTA) for the availability of two of the MBTA's jet turbines. The MBTA retains the right to utilize the jets for its own emergency use and for testing purposes but the Company retains New England Power Pool credit for their capacity and output. The Company owns 9.5% of the common stock of Connecticut Yankee Atomic Power Company, which operates a nuclear generating unit. The Company is entitled to receive 9.5% of the unit's output and is obligated to pay Connecticut Yankee 9.5% of its fixed and operating costs plus an annual return on investment. Non-Utility Generator Purchase Contracts: - ----------------------------------------- The Company currently purchases approximately 500 MW of capacity and associated energy from non-utility generators. A majority of these purchases are from Ocean State Power and Northeast Energy Associates. In 1993 the L'Energia facility located in Lowell, Massachusetts was declared commercial and the Company began purchasing electricity from this unit under a twenty-year agreement. In addition, the Company is purchasing power from two small hydro facilities, and began purchasing capacity and energy from the MassPower facility located in Springfield, Massachusetts in January 1994. In June 1993 the DPU ordered the Company to purchase 132 MW of power from Altresco Lynn, LP, an independent power producer, starting as early as 1995. The Company opposes this order since it does not believe it needs any new power for several years. In July 1993 the Company asked the Massachusetts Supreme Judicial Court to reverse the order. The Court has not yet ruled on the Company's request. The Company has supported an appeal filed by other interested parties of the Energy Facilities Siting Board's conditional approval of Altresco Lynn's project. In February 1994 Altresco Lynn alleged that the Company's actions in opposing the project were improper and that it may seek to hold the Company responsible for any resulting damages. Sales Contracts: - ---------------- The Company has agreements with Montaup Electric Company, a subsidiary of Eastern Utilities Associates, and with Commonwealth Electric Company, a subsidiary of Commonwealth Energy System, under which Montaup and Commonwealth each purchase 11% of the capacity and corresponding energy of Pilgrim Station and pay 11% of the unit's fixed and operating costs plus an annual return. Montaup and Commonwealth have also agreed to indemnify the Company to the extent of 11% each of all loss, liability or damage not covered by insurance resulting from the operation, condemnation, shutdown or retirement of the unit. In addition, the Company has similar agreements with multiple municipal electric companies for a total of 3.7% of the capacity and corresponding energy of Pilgrim Station. New England Power Pool The Company is a member of the New England Power Pool (NEPOOL), a voluntary association of electric utilities in New England responsible for the coordination, monitoring and directing of the operations of the major generating and transmission facilities in the region. To assume maximum benefits of power pooling, the electric facilities of all member companies are operated by NEPOOL as if they were a single power system. This is accomplished through the use of a central dispatching system that uses the lowest cost generating and transmission equipment available at any given time. This operation is the responsibility of NEPOOL's central dispatch center, the New England Power Exchange (NEPEX). As a result of its participation in NEPOOL, the Company's operating revenues and costs are affected to some extent by the operations of the other members. The Company's net capacity was 3,663 MW at its summer peak and 3,533 MW at is winter peak. Its corresponding NEPOOL capacity obligations were estimated to be 3,190 MW and 3,289 MW, respectively. In 1983 the NEPOOL participants signed an agreement, known as Phase I, with Hydro-Quebec of Canada to provide up to three million MWH of hydro-electric power annually to NEPOOL from 1986-1997. In 1985 a second agreement, known as Phase II, was made between NEPOOL and Hydro-Quebec to provide an additional seven million MWH of hydro-electric power annually for ten years. This agreement required expansion of the existing 690 MW Phase I interconnection. The Company and other New England electric utilities entered into an agreement to expand the interconnection with the Hydro-Quebec system of Canada to 2,000 MW. The Phase II facilities began full commercial operation up to the 2,000 MW level in July 1991. The price of this energy is based on the average cost of fossil fuel in New England for the previous year. The contract price for the first five years is 80% of that average, and for the second five years will be 95% of that average. The Company receives capacity credit through NEPOOL for approximately 11% of the generation equivalent of the total Hydro-Quebec interconnection. The Company has an approximately 11% equity ownership interest in the two companies which constructed the Phase II facilities. All equity participants are required to guarantee, in addition to their own share, the total obligations of those participants not meeting certain credit criteria. Amounts so guaranteed by the Company were approximately $22 million at December 31, 1993. As a result of the continuing additions to New England generating capacity and minimally increasing energy requirements, the dispatching of Company-owned generating facilities by NEPEX may be affected. Item 3.

Item 3. Legal Proceedings - -------------------------- In March 1991 the Company was named in a lawsuit brought in the United States District Court for the District of Massachusetts alleging discriminatory employment practices under the Age Discrimination in Employment Act of 1967 concerning 46 employees affected by the Company's 1988 reduction in force. Legal counsel is vigorously defending this case. Based on the information presently available, the Company does not expect that this litigation will have a material impact on the Company's financial condition. However, an unfavorable decision ordered against the Company could have a material impact on quarterly earnings. See also Item 1, Environmental Matters and Note H to the consolidated financial statements in Item 8 for a discussion of legal issues involving hazardous waste sites. Item 4.

Item 4. Submission of Matters to a Vote of Security Holders - ------------------------------------------------------------ There were no matters submitted to a vote of security holders during the fourth quarter of 1993. Executive Officers of the Registrant - ------------------------------------ The names, ages, positions and business experience during the last five years of all the executive officers of Boston Edison Company and its subsidiaries as of March 1, 1994 are listed below. There are no family relationships between any of the officers of the Company, nor any arrangement or understanding between any Company officer and another person pursuant to which the officer was elected. Officers of the Company hold office until the first meeting of the directors following the next annual meeting of the stockholders and until their respective successors are chosen and qualified. Part II Item 5.

Item 5. Market for the Registrant's Common Stock and Related - ------------------------------------------------------------- Stockholder Matters - ------------------- (a) Market Information - ---------------------- The Company's common stock is listed on the New York and Boston Stock Exchanges. (b) Holders - ----------- As of December 31, 1993, the Company had 42,392 holders of record of its common stock (actual count of record holders). (c) Dividends - ------------- Item 6.

Item 6. Selected Financial Data - -------------------------------- Item 7.

Item 7. Management's Discussion and Analysis - --------------------------------------------- REGULATORY PROCEEDINGS Retail settlement agreements Effective November 1992 our state regulators, the Massachusetts Department of Public Utilities, approved a three-year settlement agreement. This agreement provides us with retail rate increases, allows for the recovery of demand side management (DSM) conservation program expenditures, specifies certain accounting adjustments and clarifies the timing and recognition of certain expenses. The agreement also sets a limit on our rate of return on common equity of 11.75% for 1993 through 1995, excluding any penalties or rewards from performance incentives. The retail rate increases consist of a new annual performance adjustment charge effective November 1992 and two additional rate increases of $29 million effective November 1993 and November 1994. The performance adjustment charge varies annually based upon the performance of our Pilgrim Nuclear Power Station. This charge is further described in our discussion of financial condition. Our 1993 results of operations were affected by the recovery of DSM program expenditures, accounting adjustments and timing and recognition of certain expenses as further described in the following Results of Operations section. Our state regulators approved a previous three-year settlement agreement effective November 1989. That agreement also provided us with retail rate increases and specified certain accounting adjustments. The 1989 agreement primarily affected our results of operations through 1992. RESULTS OF OPERATIONS 1993 VERSUS 1992 Earnings per common share were $2.28 in 1993 and $2.10 in 1992. The increase in earnings is primarily the result of an annual rate increase effective November 1992, lower purchased power expense due to a long-term contract expiration, no amortization of deferred cancelled nuclear unit costs and lower interest expense. These positive changes were partially offset by higher operations and maintenance expense and higher income tax and property tax expenses. Operating revenues Retail electric revenues increased $70.8 million. The November 1992 and 1993 rate increases resulted in $40.6 million of additional revenues in 1993. Fuel and purchased power revenues increased $29.5 million over 1992, partly due to lower revenues received from short-term power sales as discussed below. We began recovery of certain demand side management program costs, lost base revenues and incentives in August 1992. Our 1993 revenues provided $45.9 million related to 1991, 1992 and 1993 DSM programs. Our 1992 revenues of $12.3 million related primarily to 1991 programs. The decrease in wholesale and other revenues reflects an estimated provision for refunds to customers of approximately $8 million as a result of orders from our state regulators on our generating unit performance program. Lower short-term power sales revenues were a result of changes in our generation availability and the needs of short-term power purchasers. All revenues from short-term sales serve to reduce fuel and purchased power billings to retail customers and have no effect on earnings. Operating expenses Fuel expense decreased $19.5 million primarily due to a 21.5% decrease in generation, resulting from planned overhauls of our fossil plants. Interchange purchases increased due to the lower generation, resulting in a $7.5 million net increase in purchased power expense. The net increase also reflects savings of approximately $10 million from a long-term purchased power contract that expired in October 1993. Both our fuel and purchased power expenses are substantially fully recoverable through fuel and purchased power revenues. Other operations and maintenance expense increased 7.1% primarily due to increases in employee benefits and nuclear production expenses. Postretirement benefits expense increased by $7 million primarily as a result of the adoption of a new accounting standard and pension expense increased by $5 million; both are provided for in our 1992 settlement agreement and further explained in Note I to the consolidated financial statements. A refueling outage at Pilgrim Station in 1993 resulted in higher nuclear production expenses. Depreciation and amortization expense increased in 1993 primarily due to a higher annual decommissioning charge for Pilgrim Station effective November 1992 provided by the 1992 settlement agreement. The new charge is based on a 1991 estimate of decommissioning costs as further discussed in Note D to the consolidated financial statements. In addition, the effect of lower depreciation rates implemented in accordance with the settlement agreement was offset by the effect of a higher depreciable plant balance. In accordance with our 1992 settlement agreement we did not expense any of the $19 million of remaining deferred costs associated with the cancelled Pilgrim 2 nuclear unit in 1993. We will expense the remaining costs in 1994 and/or 1995. Amortization of deferred nuclear outage costs includes amounts related to the 1993 and 1991 refueling outages at Pilgrim Station. In 1993 we deferred approximately $14 million of refueling outage costs. We began to amortize these costs in June 1993 over five years are approved in the 1992 settlement agreement. The increase in demand side management programs expense is consistent with the increase in DSM revenues. DSM expense includes some costs recovered over a twelve month period and other costs recovered over six years. We began to recover previously deferred DSM expenses in August 1992. In 1993 we expensed and collected from customers approximately $30 million of deferred 1991, 1992 and 1993 program costs. Over six years we are expensing and collecting from our customers $11 million of costs capitalized in 1992 and $37 million of costs capitalized in 1993. The 1993 expense related to these capitalized costs was $7 million. Municipal property and other taxes increased in 1993 due to the absence of tax abatements. In 1992 property taxes were reduced by $10.4 million of tax abatements in accordance with our 1989 settlement agreement. Our effective annual income tax rate for 1993 was 23.4% vs. 8.7% for 1992. Both rates were significantly reduced by adjustments to deferred income taxes of $20 million in 1993 and $23 million in 1992 made in accordance with the 1992 and 1989 settlement agreements. The 1992 rate was also reduced due to tax benefits of approximately $7 million resulting from mandated payments made in accordance with the 1989 agreement. Our adoption of a new accounting standard for income taxes in 1993 did not significantly affect earnings. We expect our effective tax rate to be close to the statutory rate in 1994. Interest charges and preferred and preference dividends Total interest charges decreased $3.8 million in 1993. Interest on long-term debt decreased primarily due to the refinancing of substantially all our first mortgage bonds in 1993 at lower interest rates, partially offset by higher amortization of redemption premiums. Other interest charges decreased due to a lower short-term debt level and lower short-term interest rates. Allowance for funds used during construction (AFUDC), which represents the financing costs of construction, decreased as a result of a lower AFUDC rate related to lower short-term interest rates. Preferred and preference dividends decreased 5% due to the replacement of a preferred and a preference stock issue with less costly issues of preferred stock. 1992 VERSUS 1991 Earnings per common share were $2.10 in 1992 and $1.96 in 1991. The increase in earnings is primarily the result of a rate increase effective November 1991, incentive revenues earned from the performance of Pilgrim Station and lower income tax and interest expenses. These increases were partially offset by higher operations and maintenance and property tax expenses. We also had a one-time charge in 1992 for costs incurred for a deferred generating plant project. Operating revenues Retail electric revenues increased $27.7 million. We received a $25 million rate increase effective November 1991 as part of the 1989 settlement agreement. We also earned $8.2 million in incentive revenues in 1992 as a result of Pilgrim Station's capacity factor exceeding its target set in the agreement. Fuel and purchased power revenues decreased approximately $5 million due to higher purchased power costs more than offset by higher revenues received from short-term power sales as discussed below. In 1992 we began to receive revenues for the recovery of certain DSM program costs, lost base revenues and incentives. The 1992 revenues relate primarily to 1991 DSM programs. Our short-term power sales increased in 1992 as a result of our high generating unit availability and the greater power needs of other New England utilities. All revenues from short-term sales served to reduce fuel and purchased power billings to retail customers and had no effect on earnings. Operating expenses Purchased power expense increased $18 million in 1992 due to new long-term purchased power contracts. Both our fuel and purchased power expenses are substantially fully recoverable through fuel and purchased power revenues. Other operations and maintenance expense increased 2.3% due primarily to increases in employee benefit expenses and bad debts. Amortization of deferred nuclear outage costs in 1992 and 1991 includes amounts primarily related to the 1991 refueling outage at Pilgrim Station. In 1991 we deferred approximately $23 million of refueling outage costs. We began to expense these costs over five years in September 1991 as approved by our state regulators. Municipal property and other taxes increased 21% primarily due to a reduction in residential and commercial real estate values caused by the depressed economy. This resulted in higher tax rates applied to our personal property values. In accordance with our 1989 settlement agreement, municipal property tax expenses were reduced by tax abatements of $10.4 million in 1992 and $13.6 million in 1991. Our effective annual income tax rate for 1992 was 8.7% vs. 16.5% for 1991. Both rates were significantly reduced by adjustments to deferred income taxes of $23 million in 1992 and $13 million in 1991 made in accordance with the 1989 settlement agreement. We also received tax benefits in both years as a result of payments mandated by the agreement. Other income and expense In 1992 we expensed $8 million of costs previously invested in the proposed Edgar Energy Park generation project. This project was deferred indefinitely as additional generating capacity is not expected to be needed for several years. Interest charges and preferred and preference dividends Total interest charges decreased 4.6% primarily due to lower interest rates on our average short-term borrowings. AFUDC decreased 12.7% due to a lower AFUDC rate related to lower short-term interest rates. Preferred and preference dividends decreased approximately $1 million primarily due to the replacement of two preference stock series with less costly issues of preferred stock. Earnings per share Net income increased 13%. However, earnings per common share for 1992 increased only 7%, reflecting an increase in the weighted average number of common shares outstanding primarily a result of our 1991 and 1992 common stock issuances. FINANCIAL CONDITION Our 1992 settlement agreement provides us with increased revenues from retail customers over the three-year period ending October 1995. Additionally, a long-term purchased power contract with annual charges of approximately $60 million expired in October 1993 with no related change in revenues. We are limited to an annual rate of return on equity during the three-year period of 11.75%, excluding any penalties or rewards from performance incentives. Our continued ability to achieve or exceed the 11.75% rate of return on equity will be primarily dependent upon our ability to control costs and to earn performance incentives from generation performance mechanisms specified in both the 1989 and 1992 settlement agreements. The most significant impact that incentives can have on our financial results is based on Pilgrim Station's annual capacity factor. Effective November 1993 an annual capacity factor between 60% and 68% will provide us with approximately $45 million of revenues through the performance adjustment charge. For each percentage point increase in capacity factor above 68%, annual revenues will increase by $670,000. For each percentage point decrease in capacity factor below 60% (to a minimum of 35%) annual revenues will decrease by $770,000. Pilgrim's capacity factor for the performance year ending October 1994 is expected to be approximately 81% (assuming normal operating conditions), an increase over the 66% capacity factor achieved in the performance year ended October 1993, as no refueling outage is scheduled for 1994. We earned approximately $40 million in performance charge revenues in the performance year ended October 1993. Our fossil generation unit performance can provide an increase or decrease of up to $4 million in revenues in each performance year, however, we do not expect any revenue adjustments from this mechanism. LIQUIDITY We meet our plant expenditure cash requirements primarily with internally generated funds. These funds (excluding payments made related to settlement agreements) provided for 74%, 90% and 89% of our plant expenditures in 1993, 1992 and 1991, respectively. Our current estimate of plant expenditures for 1994 is $233 million, including $20 million of nuclear fuel additions. These expenditures will be used primarily to maintain and improve existing transmission, distribution and generation facilities. We also estimate capitalizable DSM expenditures to be $38 million in 1994, which will be collected from customers over six years. We do not expect plant expenditures, excluding nuclear fuel and DSM, to vary significantly from the 1994 amount in the four years thereafter. We have long-term debt and preferred stock payment requirements of $2 million in 1994, $102.6 million in 1995, and $103.6 million per year in 1996 through 1998. External financings continue to be necessary to supplement our internally generated funds, primarily the issuance of short-term commercial paper and bank borrowings. We currently have authority from our federal regulators to issue up to $350 million of short-term debt. We have a $200 million revolving credit agreement and arrangements with several banks to provide additional short-term credit on a committed as well as on an uncommitted and as available basis. At December 31, 1993 we had $204.1 million of short-term debt outstanding, none of which was incurred under the revolving credit agreement. In 1993 our state regulators approved a financing plan allowing us to issue up to $1.1 billion in securities through 1994 and to use the proceeds to refinance long-term securities and short-term debt. At December 31, 1993 we had $245 million remaining authorized to be issued under the plan which can be used to issue common stock, preferred stock and long-term debt. As a result of our refinancing activities in 1993 we expect to realize annualized savings of approximately $11.5 million. Refer to Note F to the consolidated financial statements for specific information relating to our recent financing activities. OUTLOOK FOR THE FUTURE Electricity sales A significant portion of our electricity sales are made to commercial customers rather than industrial customers. As a result our sales have been only moderately impacted by the decline in the local Massachusetts economy. Our retail sales increased 1.2% in 1993 and we anticipate only slight growth in retail sales in the near term. Implementation of DSM programs, which are designed to assist customers in reducing electricity use, will result in lower growth in electricity sales. The 1992 settlement agreement established annual DSM spending levels over $50 million through 1994. The agreement provides for collection from customers of certain costs primarily in the year incurred and others over a six-year period. We are also provided with incentives and recovery of lost revenues based on the actual reduction in customer electricity usage from these programs and a return on the costs that we recover over six years. Competition As we are operating in a time of increasing competition from other electric utilities and non-utility generators to sell electricity for resale, we have secured long-term power supply agreements with our four wholesale customers. Through these agreements our rates are set principally through the year 2002. We also obtained a new wholesale customer in 1993 for which we will provide up to 30 megawatts of contract demand power for ten years beginning November 1994. Our state regulators require utilities to purchase power from qualifying non-utility generators at prices set through a bidding process. In June 1993 our state regulators ordered us to purchase 132 megawatts of power from an independent power producer, starting as early as 1995. We oppose this order since we do not believe we need any new power for several years. In July 1993 we asked the Massachusetts Supreme Judicial Court to reverse the order. We are currently awaiting a decision from the court. In addition, our state regulators have created an integrated resource management (IRM) process in which electric utilities forecast their future energy needs and propose how they will meet those needs by balancing conservation programs with all other supplies of energy. We will submit an IRM filing in March 1994. Direct competition with other electric utilities for retail electricity sales is still subject to substantial limitations, but these limitations may be reduced in the future. In 1993 we announced our goal of not seeking additional rate increases, other than those provided in the 1992 settlement agreement, for our residential, commercial and industrial customers until at least the year 2000. We plan to accomplish this by controlling costs and increasing operating efficiencies without sacrificing quality of service or profitability. The announcement reflects our strong commitment to be a competitively priced reliable provider of energy. Non-utility business In 1993 we created an unregulated subsidiary known as the Boston Energy Technology Group (BETG) following approval from our state regulators. We have authority to invest up to $45 million in this wholly-owned subsidiary over the next three years. BETG will engage in demand side management activities through its wholly-owned subsidiary Ener-G-Vision, Inc. and businesses involving electric transportation and the related infrastructure through its wholly-owned subsidiary TravElectric Services Corporation. We do not currently have a substantial investment in BETG and do not anticipate it significantly impacting our results of operations in the next several years. In January 1994 BETG acquired a substantial majority interest in the assets of REZ-TEK International, Inc., a manufacturer of ozone water treatment systems. The new entity, which will be known as REZ-TEK International Corp., will continue the business of producing a system that treats cooling water used in commercial and industrial air conditioning systems in an energy efficient and environmentally sound manner. OTHER MATTERS Environmental We are subject to numerous federal, state and local standards with respect to air and water quality, waste disposal and other environmental considerations. These standards can require that we modify our existing facilities or incur increased operating costs. In 1991 we entered into a consent order with the Massachusetts Department of Environmental Protection (DEP) and other interested parties to undertake certain improvements in the emission control systems at New Boston Station. These improvements included the replacement of four existing chimney stacks with two taller stacks in order to improve the air quality in the vicinity of the station, and the installation of low nitrogen oxides burners. The capital cost of these modifications along with other associated improvements has been approximately $78 million through 1993 with an additional $3 million expected to complete these projects in 1994. New Boston Station has the ability to burn natural gas, oil or both. As part of the DEP consent order we also agreed to operate the station using natural gas as fuel for a minimum of nine months per year beginning in April 1992. Beginning in April 1995 we will be required to operate the station fueled exclusively by natural gas, except in certain emergency circumstances. We have made arrangements for a nine month supply of natural gas to the station until April 1995 and are currently in the process of negotiating with natural gas suppliers and transporters concerning the economics and availability of natural gas to New Boston on a year-round basis after that time. Year- round gas supplies are currently not available to the station and, as a result, the outcome of our negotiations with natural gas suppliers and transporters and the impact on the operation of New Boston Station are uncertain. The 1990 Clean Air Act Amendments will require a significant reduction in nationwide emissions of sulfur dioxide from fossil fuel- fired generating units. The reduction will be accomplished by restricting sulfur dioxide emissions through a market-based system of allowances. We believe that we will have allowances issued to us that are in excess of our needs and which may be marketable. Any gain from the sale of these may be subject to future regulatory treatment. Other provisions of the 1990 Clean Air Act Amendments involve limitations on emissions of nitrogen oxides from existing generating units. Combustion system modifications made to New Boston and Mystic Stations, including the installation of the low nitrogen oxides burners at New Boston, will allow the units to meet the provisions of the 1995 standards. Depending upon the outcome of certain air quality modeling studies, additional emission reductions may also be required by 1999. The extent of any additional reductions and the cost of any further modifications is uncertain at this time. State regulations revised in 1993 require that properties where releases of hazardous materials occurred in the past be further cleaned up according to a timetable developed by the DEP. We are currently evaluating the potential costs associated with the cleanup of sites where we have been identified as the owner or operator. There are uncertainties associated with these potential costs due to the complexities of cleanup technology, regulatory requirements and the particular characteristics of the different sites. We also continue to face possible liability as a potentially responsible party in the cleanup of certain other multi-party hazardous waste sites in Massachusetts and other states. At the majority of these other sites we are one of many potentially responsible parties and our alleged share of the responsibility is a small percentage. We do not expect any of our potential cleanup liabilities to have a material impact on financial condition, although provisions for cleanup costs could have a material impact on quarterly earnings. We presently dispose of low-level radioactive waste (LLW) generated at Pilgrim Station at licensed disposal facilities in Barnwell, South Carolina. As a result of developments which have occurred pursuant to the Low-Level Radioactive Waste Policy Amendments Act of 1985, our continued access to such disposal facilities has become severely limited and significantly increased in cost. Refer to Note D to the consolidated financial statements for further discussion regarding LLW disposal. In recent years a number of published reports have discussed the possibility that adverse health effects may be caused by electromagnetic fields (EMF) associated with electric transmission and distribution facilities and appliances and wiring in buildings and homes. Some scientific reviews conducted to date by several state and federal agencies have suggested associations between EMF and such health effects, while other studies have not substantiated such associations. We support further research into the subject and are participating in the funding of industry sponsored studies. We are aware that public concern regarding EMF in some cases has resulted in litigation, in opposition to existing or proposed facilities before regulators, or in requests for legislation or regulatory standards concerning EMF levels. We have not been significantly affected to date by these developments and cannot predict their potential impact on us, however, we continue to closely monitor all aspects of the EMF issue. Litigation In March 1991 we were named in a lawsuit alleging discriminatory employment practices under the Age Discrimination in Employment Act of 1967 concerning 46 employees affected by our 1988 reduction in force. Legal counsel is vigorously defending this case. Based on the information presently available we do not expect that this litigation or certain other legal matters in which we are currently involved will have a material impact on our financial condition. However, an unfavorable decision ordered against us could have a material impact on quarterly earnings. Labor negotiations We began negotiations involving our labor contracts in early February 1994. These contracts expire on May 15, 1994. We anticipate favorable resolution of these negotiations prior to that date. New accounting pronouncements We will adopt Statement of Financial Accounting Standards (SFAS) No. 112, Employers' Accounting for Postemployment Benefits, and SFAS No. 115, Accounting for Certain Investments in Debt and Equity Securities, in the first quarter of 1994. Refer to Notes I and J to the consolidated financial statements for further discussion of these pronouncements. The accompanying notes are an integral part of the consolidated financial statements. The accompanying notes are an integral part of the consolidated financial statements. The accompanying notes are an integral part of the consolidated financial statements. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE A. SIGNIFICANT ACCOUNTING POLICIES 1. Basis of Consolidation and Accounting The consolidated financial statements include the activities of our wholly-owned subsidiaries, Harbor Electric Energy Company and Boston Energy Technology Group. All significant intercompany transactions have been eliminated. We follow accounting policies prescribed by our federal and state regulators. We are also subject to the accounting and reporting requirements of the Securities and Exchange Commission. The financial statements comply with generally accepted accounting principles. Certain prior period amounts on the financial statements were reclassified to conform with current presentation. 2. Revenue Recognition We record revenues for electricity used by our customers, but not yet billed, in order to more closely match revenues with expenses. 3. Forecasted Fuel and Purchased Power Rates The rate charged to retail customers for fuel and purchased power allows for all fuel costs, the capacity portion of some purchased power costs and some transmission costs to be billed to customers monthly using a forecasted rate. The difference between actual and estimated costs is included in accounts receivable on our consolidated balance sheets until subsequent rates are adjusted. State regulators have the right to reduce our subsequent fuel rates if they find that we have been unreasonable or imprudent in the operation of our generating units or in purchasing fuel. 4. Depreciation and Nuclear Fuel Amortization Our physical property was depreciated on a straight-line basis in 1993, 1992 and 1991 at composite rates of approximately 3.09%, 3.36% and 3.41% per year, respectively, based on estimated useful lives of the various classes of property. The cost of decommissioning Pilgrim Station, our nuclear unit, is excluded from the depreciation rates. When property units are retired, their cost, net of salvage value, is charged to accumulated depreciation. The cost of nuclear fuel is amortized based on the amount of energy Pilgrim Station produces. Nuclear fuel expense also includes an amount for the estimated costs of ultimately disposing of the spent nuclear fuel and for the decontamination and decommissioning of the United States enrichment facilities used in the production of nuclear fuel. These costs are recovered from our customers through fuel charges. 5. Allowance for Funds Used During Construction (AFUDC) AFUDC represents the estimated costs to finance plant expenditures. In accordance with regulatory accounting, AFUDC is included as a cost of utility plant. AFUDC is not an item of current cash income, but payment is received for these costs from customers over the service life of the plant in the form of increased revenues collected as a result of higher depreciation expense. Our AFUDC rates in 1993, 1992 and 1991 were 3.62%, 4.48%, and 6.85%, respectively, and represented only the cost of debt. 6. Cash and Cash Equivalents Cash and cash equivalents are comprised of highly liquid securities with maturities of three months or less. 7. Allowance for Doubtful Accounts Our accounts receivable are substantially all recoverable. This recovery occurs both from customer payments and from the portion of customer charges that provides for the recovery of bad debt expense. Accordingly, we do not maintain a significant allowance for doubtful accounts balance. 8. Deferred Debits Deferred debits consist primarily of costs incurred which will be collected from customers through future charges in accordance with agreements with our state regulators. These costs will be expensed when the corresponding revenues are received in order to appropriately match revenues and expenses. A portion of these costs is currently being charged to and collected from customers. 9. Amortization of Discounts, Premiums and Redemption Premiums on Securities We expense discounts, premiums, redemption premiums and related expenses associated with issuances of securities or refinancing of existing securities in equal annual installments over the life of the replacement securities subject to regulatory approval. NOTE B. RETAIL SETTLEMENT AGREEMENTS In 1992 and 1989 our state regulators, the Massachusetts Department of Public Utilities, approved three-year settlement agreements relating to our rate case proceedings. These agreements provided for retail rate increases, accounting adjustments and demand side management program expenditures; clarified the timing and recognition of certain expenses and set limits on our rate of return on common equity. Refer to Management's Discussion and Analysis for further information related to these settlement agreements. The settlement agreements did not affect our contract or wholesale power rates charged to other utilities, which are regulated by our federal regulators, the Federal Energy Regulatory Commission. NOTE C. INCOME TAXES In the first quarter of 1993 we prospectively adopted Statement of Financial Accounting Standards No. 109, Accounting for Income Taxes (SFAS 109). This required us to change our methodology of accounting for income taxes from the deferred method to an asset and liability approach. The deferred method of accounting was based on the tax effects of timing differences between income for financial reporting purposes and taxable income. The asset and liability approach requires the recognition of deferred tax liabilities and assets for the future tax effects of temporary differences between the carrying amounts and the tax basis of assets and liabilities. In accordance with SFAS 109 we recorded a net regulatory asset of $26.9 million and a corresponding net increase in accumulated deferred income taxes as of December 31, 1993. The regulatory asset represents the additional future revenues to be collected from customers for deferred income taxes. Accumulated deferred income taxes on our consolidated balance sheet at December 31, 1993 includes $587.8 million of gross deferred income tax liabilities net of $103.0 million of gross deferred income tax assets. We have approximately $19 million of alternative minimum tax carryforwards available at December 31, 1993. The major components of accumulated deferred income taxes are a result of differences between book and tax expenses relating to property, plant and equipment. Deferred income tax expense reflected in our consolidated income statements is incurred when certain income and expenses are reported on the tax return in different years than reported in the financial statements. Investment tax credits are included in income over the estimated useful lives of the related property. NOTE D. ESTIMATED FUTURE COSTS OF DISPOSING OF SPENT NUCLEAR FUEL AND RETIRING NUCLEAR GENERATING PLANTS The existing fuel storage facility at Pilgrim Station includes sufficient room for spent nuclear fuel generated through early 1995. We have a request for a license amendment pending before the Nuclear Regulatory Commission (NRC) to allow modification of the storage facility to provide sufficient room for spent nuclear fuel generated through the end of Pilgrim's operating license in 2012. The NRC is reviewing our request and we expect approval in 1994. At that time we will initially modify the facility to provide spent fuel storage capacity through approximately 2003. It is the ultimate responsibility of the United States Department of Energy (DOE) to permanently dispose of spent nuclear fuel as required by the Nuclear Waste Policy Act of 1982. We currently pay a fee of $1.00 per net megawatthour sold from Pilgrim Station generation under a nuclear fuel disposal contract with the DOE. The fee is collected from customers through fuel charges. When Pilgrim Station's operating license expires in 2012 we will be required to decommission the plant. During rate proceedings we provided our regulators a 1991 study documenting a cost of $328 million to decommission the plant. The study is based on the "green field" method of decommissioning, which provides for the plant site to be completely restored to its original state. We are expensing these estimated decommissioning costs over Pilgrim's expected service life. The 1993 expense of approximately $13 million is included in depreciation expense on the consolidated income statements. We receive recovery of this expense from charges to our retail customers and from other utility companies and municipalities who purchase a contracted amount of Pilgrim's electric generation. The funds we collect from decommissioning charges are deposited in an external trust and are restricted so that they may only be used for decommissioning and related expenses. The net earnings on the trust funds, which are also restricted, increase the nuclear decommissioning fund balance and nuclear decommissioning reserve, thus reducing the amount to be collected from customers. The 1991 decommissioning study has been partially updated for internal planning purposes to evaluate the potential financial impact of long-term spent fuel storage options resulting from delays in DOE spent fuel removal on the estimated decommissioning cost. The partial update indicates an estimated decommissioning cost of approximately $400 million in 1991 dollars based upon a revised spent fuel removal schedule and utilization of dry spent fuel storage technology. We will continue to monitor DOE spent fuel removal schedules and developments in spent fuel storage technology along with their impact on the decommissioning estimate. We are also an investor in two other domestic nuclear units. Both of these units receive through the rates charged to their customers an amount to cover the estimated cost to dispose of their spent nuclear fuel and to retire the units at the end of their useful lives. We presently dispose of low-level radioactive waste (LLW) generated at Pilgrim Station at licensed disposal facilities in Barnwell, South Carolina. As a result of developments which have occurred pursuant to the Low-Level Radioactive Waste Policy Amendments Act of 1985, our continued access to such disposal facilities has become severely limited and significantly increased in cost. We have access to the South Carolina site through July 1994, but do not presently believe that disposal site access will be provided after that date. Although legislation has been enacted in Massachusetts establishing a regulatory method for managing the state's LLW including the possible siting, licensing and construction of a LLW disposal facility within the state, it appears unlikely that such a facility will be constructed in a timely manner. Pending the construction of a disposal facility within the state or the adoption by the state of some other LLW management method, we continue to monitor the situation and are investigating other available options, including the possibility of on-site storage. NOTE E. CANCELLED NUCLEAR UNIT In May 1982 we began to expense the cost of our cancelled Pilgrim 2 nuclear unit over approximately eleven and one-half years in accordance with an order received from state regulators. We did not expense any of these costs in 1993. Instead, the remaining balance of approximately $19 million at December 31, 1993 and 1992 will be expensed in 1994 and/or 1995 as approved by our state regulators in our 1992 settlement agreement. NOTE F. CAPITAL STOCK AND INDEBTEDNESS (a) In November 1991 our Articles of Organization were amended to increase authorized common stock from 50 million to 100 million shares and reduce the par value from $5 to $1 per common share. (b) We used the net proceeds of the 1991 common stock issuance to retire $55 million of Series X, 11% first mortgage bonds. (c) We used the net proceeds of the 1992 common stock issuance to reduce short-term debt. (d) At December 31, 1993, the remaining authorized common shares reserved for future issuance under the Dividend Reinvestment and Common Stock Purchase Plan were 815,170 shares. 2. Cumulative Non-Mandatory Redeemable Preferred and Preference Stock In June 1992 we issued 400,000 shares of 8.25% cumulative non-mandatory redeemable preferred stock at par. The stock is redeemable at $100 per share plus accrued dividends beginning in June 1997. These shares were sold in the form of 1.6 million depositary shares, each representing a one-fourth interest in a share of the preferred stock. We used the proceeds of this issue to fully retire the $1.46 series cumulative non-mandatory redeemable preference stock. In May 1993 we issued 400,000 shares of 7.75% cumulative non-mandatory redeemable preferred stock at par. The stock is redeemable at $100 per share plus accrued dividends beginning in May 1998. These shares were sold in the form of 1.6 million depositary shares, each representing a one-fourth interest in a share of the preferred stock. We used the proceeds of this issue to fully retire the 8.88% series cumulative non-mandatory redeemable preferred stock. 3. Cumulative Mandatory Redeemable Preferred Stock The 480,000 shares of our 7.27% sinking fund series cumulative preferred stock are currently redeemable at our option at $104.36. The redemption price declines annually each May to par value in May 2002. In May 1993 the stock became subject to sinking fund requirements to retire 20,000 shares at $100 per share plus accrued dividends each year through May 2002. In 1992 we purchased 20,000 shares at a discount on the open market which satisfied the mandatory sinking fund requirement for May 1993. Beginning in 1993, we have the non-cumulative option each May to redeem additional shares, not to exceed 20,000, for the sinking fund at $100 per share plus accrued dividends. We are not able to redeem any part of our 500,000 shares of $100 par value 8% series cumulative preferred stock prior to December 2001. The entire series is subject to mandatory redemption in December 2001 at $100 per share, plus accrued dividends. 4. Long-Term Debt Substantially all our property, plant, equipment, materials and supplies are subject to lien under the terms of our Indenture of Trust and First Mortgage dated December 1, 1940, and its supplements. Currently only the outstanding Series S and U first mortgage bonds are subject to the terms of the indenture. The aggregate principal amounts of our first mortgage bonds, debentures, and sewage facility revenue bonds (including sinking fund requirements) due in 1994 and 1995 are $0 and $100.6 million, respectively, and $101.6 million per year in 1996 through 1998. Our first mortgage bonds, Series S, adjustable rate due 2002, paid interest at 9.2% per year for the period January 15, 1993 through January 14, 1994. The rate is adjusted annually and is based upon the ten-year constant maturity Treasury rate as published by the Federal Reserve Board. The interest rate for the period January 15, 1994 through January 14, 1995 is 8.2%. In September 1992 we issued $60 million of 8.25% debentures which mature in September 2022. The debentures are redeemable at prices decreasing from 103.78% of par beginning in September 2002, to 100% of par beginning in September 2012. We used the net proceeds from the sale to reduce short-term debt. In October 1992 we redeemed the remaining balance of $45 million Series X first mortgage bonds. In February 1993 we issued $65 million of 6.8% debentures due in 2000. We used the proceeds of this issue to reduce short-term debt. These debentures are not redeemable prior to maturity. In March 1993 we issued $650 million of debentures and used the proceeds to retire ten of twelve outstanding series of first mortgage bonds and reduce short-term debt. The debentures were issued in five separate series with interest rates ranging from 5.125% to 7.8% and maturing between 1996 and 2023. The 5 1/8% debentures due 1996, 5.70% due 1997, 5.95% due 1998 and 6.80% due 2003 are not redeemable prior to maturity. The 7.80% debentures due 2023 are first redeemable in March 2003 at a redemption price of 103.73%. The redemption price decreases annually each March to par value in March 2013. There is no sinking fund requirement for any series of the debentures. In August 1993 we issued $100 million of 6.05% debentures due in 2000. We used the proceeds from this sale to reduce short-term debt. These debentures are not redeemable prior to maturity and have no sinking fund requirements. We redeemed $50 million of 9.65% medium-term notes in September 1992 and $50 million of 9.75% medium-term notes in September 1993. 5. Sewage Facility Revenue Bonds In December 1991, Harbor Electric Energy Company (HEEC), a wholly-owned subsidiary, issued $36.3 million of long-term sewage facility revenue bonds. The bonds are tax-exempt, subject to annual mandatory sinking fund redemption requirements and mature in the years 1995-2015. The weighted average interest rate of the bonds is 7.3%. A portion of the proceeds from the bonds was used to retire $21 million of short-term sewage facility revenue bonds at maturity. The remainder of the proceeds, which is on deposit with the trustee, is being used to finance the construction of HEEC's permanent substation located on Deer Island (in Boston Harbor) and to fund an amount which must remain in reserve with the trustee. If HEEC should have insufficient funds to pay certain costs on a timely basis or be unable to meet certain net worth requirements, we would be required to make additional capital contributions or loans to the subsidiary up to a maximum of $7 million. 6. Short-Term Debt We have arrangements with certain banks to provide short-term credit on both a committed and an uncommitted and as available basis. We currently have authority to issue up to $350 million of short-term debt. We have a $200 million revolving credit agreement with a group of banks. This agreement is intended to provide a standby source of short-term borrowings. Under the terms of this agreement we are required to maintain a common equity ratio of not less than 30% at all times. Commitment fees must be paid on the unused portion of the total agreement amount. NOTE G. FAIR VALUE OF SECURITIES The following methods and assumptions were used to estimate the fair value of each class of securities for which it is practicable to estimate the value: Nuclear decommissioning fund The fair value of $70.1 million is based on quoted market prices of securities held. Cash and cash equivalents The carrying amount of $8.8 million approximates fair value due to the short-term nature of these securities. Mandatory redeemable cumulative preferred stock, first mortgage bonds, sewage facility revenue bonds and debentures NOTE H. COMMITMENTS AND CONTINGENCIES 1. Capital Commitments At December 31, 1993, we had estimated contractual obligations for plant and equipment of approximately $71 million. 2. Lease Commitments We will capitalize a portion of these lease rentals as part of plant expenditures in the future. Our total expense for both lease rentals and transmission agreements for 1993, 1992 and 1991 was $30 million, $30 million and $33.5 million, respectively, net of capitalized expenses of $5 million, $5 million, and $4.8 million, respectively. 3. Hydro-Quebec We have an approximately 11% equity ownership interest in two companies which own and operate transmission facilities to import electricity from the Hydro-Quebec system in Canada, which is included in our consolidated financial statements. As an equity participant we are required to guarantee, in addition to our own share, the total obligations of those participants who do not meet certain credit criteria and are compensated accordingly. At December 31, 1993, our portion of these guarantees was approximately $22 million. 4. Yankee Atomic Electric Company In February 1992 the Board of Directors of Yankee Atomic Electric Company (Yankee Atomic) decided to permanently discontinue power operation of the Yankee Atomic nuclear generating station and, in time, decommission that facility. We relied on Yankee Atomic for less than one percent of our system capacity. We have a 9.5% stock investment of approximately $2 million in Yankee Atomic. In 1993 Yankee Atomic received approval from federal regulators to continue to collect its investment and decommissioning costs through July 2000, the period of the plant's operating license. The estimate of our share of Yankee Atomic's investment and costs of decommissioning is approximately $33 million as of December 31, 1993. This estimate is recorded on our consolidated balance sheet as a power contract liability in deferred credits. An offsetting power contract regulatory asset is included in deferred debits as we continue to collect these costs from our customers in accordance with our 1992 settlement agreement. 5. Nuclear Insurance The federal Price-Anderson Act currently provides $9.4 billion of financial protection for public liability claims and legal costs arising from a single nuclear-related accident. The first $200 million of nuclear liability is covered by commercial insurance. Additional nuclear liability insurance up to approximately $8.8 billion is provided by a retrospective assessment of up to $75.5 million per incident levied on each of the 116 units licensed to operate in the United States, with a maximum assessment of $10 million per reactor per accident in any year. The additional nuclear liability insurance amount may change as new commercial nuclear units are licensed and existing units give up their licenses. In addition to the nuclear liability retrospective assessments, if the sum of all public liability claims and legal costs arising from any nuclear accident exceeds the maximum amount of financial protection, each licensee can be assessed an additional five percent of the maximum retrospective assessment. We have purchased insurance from Nuclear Electric Insurance Limited (NEIL) to cover some of the costs to purchase replacement power during a prolonged accidental outage at Pilgrim Station and the cost of repair, replacement, decontamination or decommissioning of our utility property resulting from covered incidents at Pilgrim Station. Our maximum potential total assessment for losses which occur during current policy years is approximately $14.6 million under both the replacement power and excess property damage, decontamination and decommissioning policies. All companies insured with NEIL are subject to retroactive assessments if losses are in excess of the total funds available to NEIL. While assessments may also be made for losses in certain prior policy years, we are not aware of any losses in those years which we believe are likely to result in an assessment. 6. Litigation In March 1991 we were named in a lawsuit alleging discriminatory employment practices under the Age Discrimination in Employment Act of 1967 concerning 46 employees affected by our 1988 reduction in force. Legal counsel is vigorously defending this case. Based on the information presently available we do not expect that this litigation or certain other legal matters in which we are currently involved will have a material impact on our financial condition. However, an unfavorable decision ordered against us could have a material impact on quarterly earnings. 7. Hazardous Waste State regulations revised in 1993 require that properties where releases of hazardous materials occurred in the past be further cleaned up according to a timetable developed by the Massachusetts Department of Environmental Protection. We are currently evaluating the potential costs associated with the cleanup of sites where we have been identified as the owner or operator. There are uncertainties associated with these potential costs due to the complexities of cleanup technology, regulatory requirements and the particular characteristics of the different sites. We also continue to face possible liability as a potentially responsible party in the cleanup of certain other multi-party hazardous waste sites in Massachusetts and other states. At the majority of these other sites we are one of many potentially responsible parties and our alleged share of the responsibility is a small percentage. We do not expect any of our potential cleanup liabilities to have a material impact on financial condition, although provisions for cleanup costs could have a material impact on quarterly earnings. NOTE I. PENSIONS, OTHER POSTRETIREMENT AND POSTEMPLOYMENT BENEFITS 1. Pensions We have a noncontributory funded retirement plan, with certain features that allow voluntary contributions. Benefits are based upon an employee's years of service and compensation during the last years of employment. Our funding policy is to contribute each year an amount that is not less than the minimum required contribution under federal law or greater than the maximum tax deductible amount. Plan assets are primarily equities, bonds, insurance contracts and real estate. We changed our discount rate assumption to 7.0% for calculating pension cost effective January 1994. 2. Other Postretirement Benefits In addition to pension benefits, we also currently provide health care and other benefits to our retired employees who meet certain age and years of service eligibility requirements. Effective January 1993 we adopted Statement of Financial Accounting Standards No. 106, Employer's Accounting for Postretirement Benefits Other Than Pensions (SFAS 106). This requires us to record a liability during the working years of employees for the expected costs of providing their postretirement benefits other than pensions (PBOPs). Prior to 1993 our policy was to record the cost of PBOPs when paid. Our transition obligation on January 1, 1993 was approximately $183 million, which we elected to recognize over 20 years as permitted by SFAS 106. Our total cost of PBOPs under SFAS 106 in 1993 was approximately $28 million, an increase of approximately $18 million over costs incurred under our prior method of accounting for PBOPs. Our 1992 settlement agreement provides us with a phase-in of a portion of the increased costs and allows us to defer the additional costs in excess of the phase-in amounts to the extent that we fund an external trust. In December 1993 we deposited $18 million on a tax deductible basis into external trusts for the payment of PBOPs. Accordingly, in 1993 we recorded an expense of approximately $16 million, reflecting the amount of cost recovery from customers, and deferred approximately $12 million for future recovery. We capitalized approximately 19% of these costs. We used an 8.0% weighted average discount rate and 4.5% rate of compensation increase assumption for calculating the transition obligation and the 1993 postretirement benefits cost. Our expected long-term rate of return on assets is 9.0%. We also assumed a 12.5% health care cost trend rate. Effective January 1, 1994 we changed the discount and health care cost trend rates to 7.0% and 9.0%, respectively, in order to more accurately estimate our future benefit payments. The health care cost trend rate is assumed to decrease by one percent each year to 5% in 1998 and years thereafter. Changes in the health care cost trend rate will affect our cost and obligation amounts. For example, a one percent increase in the rate would increase the total service and interest costs in 1993 by approximately 16% and would increase the accumulated obligation at December 31, 1993 by approximately 13%. The trust assets consist of money market funds at December 31, 1993. 3. Postemployment Benefits Statement of Financial Accounting Standards No. 112, Employers' Accounting for Postemployment Benefits, will be effective for the first quarter of 1994. This statement will require us to record a liability computed on an actuarial basis for the estimated cost of providing postemployment benefits. Postemployment benefits provided to former or inactive employees, their beneficiaries and covered dependents include salary continuation, severance benefits, disability-related benefits (including workers' compensation), job training and counseling and continuation of health care and life insurance coverage. We currently recognize the cost of these benefits primarily as claims are paid. We do not anticipate a material effect on net income from adopting this statement. NOTE J. NEW ACCOUNTING PRONOUNCEMENT We will adopt Statement of Financial Accounting Standards No. 115, Accounting for Certain Investments in Debt and Equity Securities, in the first quarter of 1994. This statement may require us to classify the investments in our nuclear decommissioning fund on our consolidated balance sheet based on how long we intend to hold the individual securities. These investments may be classified as "available for sale" and we may also be required to report any unrealized gains and losses on the investments as a separate component of shareholders' equity. We do not expect the adoption of this statement to have a material effect on shareholders' equity. NOTE K. LONG-TERM POWER CONTRACTS 1. Long-Term Contracts for the Purchase of Electricity We purchase electric power under several long-term contracts for which we pay a share of the generating unit's capital and fixed operating costs through the contract expiration date. The total cost of these contracts is included in purchased power expense in our consolidated income statements. Information relating to these contracts as of December 31, 1993 is as follows: Our total fixed and variable costs for these contracts in 1993, 1992 and 1991 were approximately $225 million, $217 million and $154 million, respectively. Our minimum fixed payments under these contracts for the years after 1993 are as follows: 2. Long-Term Power Sales Under these contracts, the utilities pay their proportional share of the costs of operating Pilgrim Station and associated transmission facilities. These costs include operation and maintenance expenses, insurance, local taxes, depreciation, decommissioning and a return on capital. Electricity sales and revenues are seasonal in nature, with both being lower in the spring and fall seasons. Quarterly earnings for 1993 reflect a change in the months for which certain customers were billed at higher rates as mandated by the DPU. These customers were billed at these higher rates in July through October in 1992 and in June through September in 1993. The change in billing increased second quarter earnings and reduced fourth quarter earnings by approximately $0.23 per share in 1993. Item 9. Changes in and Disagreements with Accountants on Accounting and - ------- --------------------------------------------------------------- Financial Disclosure -------------------- None. Part III -------- Item 10. Directors and Executive Officers of the Registrant - ------------------------------------------------------------ (a) Identification of Directors - -------------------------------- See "Election of Directors - Information about Nominees and Incumbent Directors" on pages 1 through 4 of the definitive Proxy Statement dated March 17, 1994 incorporated herein by reference. (b) Identification of Executive Officers - ----------------------------------------- The information required by this item is included at the end of Part I of this Form 10-K under the caption Executive Officers of the Registrant. (c) Identification of Certain Significant Employees - ---------------------------------------------------- Not applicable. (d) Family Relationships - ------------------------- Not applicable. (e) Business Experience - ------------------------ For information relating to the business experience during the past five years and other directorships (of companies subject to certain SEC requirements) held by each person nominated to be a director, see "Election of Directors - Information about Nominees and Incumbent Directors" on pages 1 through 4 of the definitive Proxy Statement dated March 17, 1994, incorporated herein by reference. For information relating to the business experience during the past five years of each person who is an executive officer, see Executive Officers of the Registrant in this Form 10-K. (f) Involvement in Certain Legal Proceedings - --------------------------------------------- Not applicable. (g) Promoters and Control Persons - ---------------------------------- Not applicable. Item 11. Executive Compensation - -------------------------------- See "Director and Executive Compensation" on pages 5 through 11 of the definitive Proxy Statement dated March 17, 1994, incorporated herein by reference. Item 12. Security Ownership of Certain Beneficial Owners and Management - ------------------------------------------------------------------------ (a) Security Ownership of Certain Beneficial Owners - ---------------------------------------------------- To the knowledge of management, no person owns beneficially more than five percent of the outstanding voting securities of the Company. (b) Security Ownership of Management - ------------------------------------- See "Stock Ownership by Directors and Executive Officers" on pages 4 through 5 of the definitive Proxy Statement dated March 17, 1994, incorporated herein by reference. (c) Changes in Control - ----------------------- Not applicable. Item 13. Certain Relationships and Related Transactions - -------------------------------------------------------- Not applicable. Part IV ------- Item 14. Exhibits, Financial Statement Schedules and Reports on Form 8-K - ------------------------------------------------------------------------- All other schedules are omitted since they are not required, not applicable, or contain only information which is otherwise provided in the financial statements or notes in Item 8.

857571_1993.txt

857571

1993

Item 1.BUSINESS - -------------------------------------------------------------------------------- GENERAL AEP was incorporated under the laws of the State of New York in 1906 and reorganized in 1925. It is a public utility holding company which owns, directly or indirectly, all of the outstanding common stock of its operating electric utility subsidiaries. Substantially all of the operating revenues of AEP and its subsidiaries are derived from the furnishing of electric service. The service area of AEP's electric utility subsidiaries covers portions of the states of Indiana, Kentucky, Michigan, Ohio, Tennessee, Virginia and West Virginia. The generating and transmission facilities of AEP's subsidiaries are physically interconnected, and their operations are coordinated, as a single integrated electric utility system. Transmission networks are interconnected with extensive distribution facilities in the territories served. At December 31, 1993, the subsidiaries of AEP had a total of 20,007 employees. AEP, as such, has no employees. The principal operating subsidiaries of AEP are: APCo (organized in Virginia in 1926), which is engaged in the generation, purchase, transmission and distribution of electric power to approximately 838,000 customers in the southwestern portion of Virginia and southern West Virginia, and in supplying electric power at wholesale to other electric utility companies and municipalities in those states and in Tennessee. At December 31, 1993, APCo and its wholly owned subsidiaries had 4,587 employees. A generating subsidiary of APCo, Kanawha Valley Power Company, which owns and operates under Federal license three hydroelectric generating stations located on Government lands adjacent to Government- owned navigation dams on the Kanawha River in West Virginia, sells its net output to APCo. Among the principal industries served by APCo are coal mining, primary metals, chemicals, textiles, paper, stone, clay, glass and concrete products and furniture. In addition to its AEP System interconnection, APCo also is interconnected with the following unaffiliated utility companies: Carolina Power & Light Company, Duke Power Company and VEPCo. A comparatively small part of the properties and business of APCo is located in the northeastern end of the Tennessee Valley. APCo has several points of interconnection with TVA and has entered into agreements with TVA under which APCo and TVA interchange and transfer electric power over portions of their respective systems. CSPCo (organized in Ohio in 1937, the earliest direct predecessor company having been organized in 1883), which is engaged in the generation, purchase, transmission and distribution of electric power to approximately 578,000 customers in Ohio, and in supplying electric power at wholesale to other electric utilities and to municipally owned distribution systems within its service area. At December 31, 1993, CSPCo had 2,143 employees. CSPCo's service area is comprised of two areas in Ohio, which include portions of twenty-five counties. One area includes the City of Columbus and the other is a predominantly rural area in south central Ohio. Approximately 80% of CSPCo's retail revenues are derived from the Columbus area. Among the principal industries served are food processing, chemicals, primary metals, electronic machinery and paper products. In addition to its AEP System interconnection, CSPCo also is interconnected with the following unaffiliated utility companies: CG&E, DP&L and Ohio Edison Company. I&M (organized in Indiana in 1925), which is engaged in the generation, purchase, transmission and distribution of electric power to approximately 525,000 customers in northern and eastern Indiana and southwestern Michigan, and in supplying electric power at wholesale to other electric utility companies, rural electric cooperatives and municipalities. At December 31, 1993, I&M had 3,944 employees. Among the principal industries served are transportation equipment, primary metals, fabricated metal products, electrical and electronic machinery, rubber and miscellaneous plastic products and chemicals and allied products. Since 1975, I&M has leased and operated the assets of the municipal system of the City of Fort Wayne, Indiana. In addition to its AEP System interconnection, I&M also is interconnected with the following unaffiliated utility companies: Central Illinois Public Service Company, CG&E, Commonwealth Edison Company, Consumers Power Company, Illinois Power Company, Indianapolis Power & Light Company, Louisville Gas and Electric Company, Northern Indiana Public Service Company, PSI Energy Inc. and Richmond Power & Light Company. KEPCo (organized in Kentucky in 1919), which is engaged in the generation, purchase, transmission and distribution of electric power to approximately 161,000 customers in an area in eastern Kentucky, and in supplying electric power at wholesale to other utilities and municipalities in Kentucky. At December 31, 1993, KEPCo had 842 employees. In addition to its AEP System interconnection, KEPCo also is interconnected with the following unaffiliated utility companies: Kentucky Utilities Company and East Kentucky Power Cooperative Inc. KEPCo is also interconnected with TVA. Kingsport Power Company (organized in Virginia in 1917), which provides electric service to approximately 41,000 customers in Kingsport and eight neighboring communities in northeastern Tennessee. Kingsport Power Company has no generating facilities of its own. It purchases electric power distributed to its customers from APCo. At December 31, 1993, Kingsport Power Company had 102 employees. OPCo (organized in Ohio in 1907 and reincorporated in 1924), which is engaged in the generation, purchase, transmission and distribution of electric power to approximately 657,000 customers in the northwestern, east central, eastern and southern sections of Ohio, and in supplying electric power at wholesale to other electric utility companies and municipalities. At December 31, 1993, OPCo and its wholly owned subsidiaries had 5,749 employees. Among the principal industries served by OPCo are primary metals, stone, clay, glass and concrete products, rubber and plastic products, petroleum refining, chemicals and metal and wire products. In addition to its AEP System interconnection, OPCo also is interconnected with the following unaffiliated utility companies: CG&E, The Cleveland Electric Illuminating Company, DP&L, Duquesne Light Company, Kentucky Utilities Company, Monongahela Power Company, Ohio Edison Company, The Toledo Edison Company and West Penn Power Company. Wheeling Power Company (organized in West Virginia in 1883 and reincorporated in 1911), which provides electric service to approximately 41,000 customers in northern West Virginia. Wheeling Power Company has no generating facilities of its own. It purchases electric power distributed to its customers from OPCo. At December 31, 1993, Wheeling Power Company had 143 employees. Another principal electric utility subsidiary of AEP is AEGCo, which was organized in Ohio in 1982 as an electric generating company. AEGCo sells power at wholesale to I&M, KEPCo and VEPCo. AEGCo has no employees. See Item 2

Item 2.PROPERTIES - -------------------------------------------------------------------------------- At December 31, 1993, subsidiaries of AEP owned (or leased where indicated) generating plants with the net power capabilities (winter rating) shown in the following table: - -------- (a) Unit 1 of the Rockport Plant is owned one-half by AEGCo and one-half by I&M. Unit 2 of the Rockport Plant is leased one-half by AEGCo and one-half by I&M. The leases terminate in 2022 unless extended. (b) Unit 3 of the John E. Amos Plant is owned one-third by APCo and two-thirds by OPCo. (c) Represents CSPCo's ownership interest in generating units owned in common with CG&E and DP&L. (d) I&M plans to close the Breed Plant on March 31, 1994. (e) Leased from the City of Fort Wayne. Indiana. Since 1975, I&M has leased and operated the assets of the municipal system of the City of Fort Wayne, Indiana under a 35-year lease with a provision for an additional 15-year extension at the election of I&M. See Item 1 under Fuel Supply, for information concerning coal reserves owned or controlled by subsidiaries of AEP. The following table sets forth the total circuit miles of transmission and distribution lines of the AEP System, APCo, CSPCo, I&M, KEPCo and OPCo and that portion of the total representing 765,000-volt lines: - -------- (a)Includes jointly owned lines. (b)Includes lines of other AEP System companies not shown. TITLES The AEP System's electric generating stations are generally located on lands owned in fee simple. The greater portion of the transmission and distribution lines of the System has been constructed over lands of private owners pursuant to easements or along public highways and streets pursuant to appropriate statutory authority. The rights of the System in the realty on which its facilities are located are considered by it to be adequate for its use in the conduct of its business. Minor defects and irregularities customarily found in title to properties of like size and character may exist, but such defects and irregularities do not materially impair the use of the properties affected thereby. System companies generally have the right of eminent domain whereby they may, if necessary, acquire, perfect or secure titles to or easements on privately-held lands used or to be used in their utility operations. Substantially all the physical properties of APCo, CSPCo, I&M, KEPCo and OPCo are subject to the lien of the mortgage and deed of trust securing the first mortgage bonds of each such company. SYSTEM TRANSMISSION LINES AND FACILITY SITING Legislation in the states of Indiana, Kentucky, Michigan, Ohio, Virginia, and West Virginia requires prior approval of sites of generating facilities and/or routes of high-voltage transmission lines. Delays and additional costs in constructing facilities have been experienced as a result of proceedings conducted pursuant to such statutes, as well as in proceedings in which operating companies have sought to acquire rights-of-way through condemnation, and such proceedings may result in additional delays and costs in future years. PEAK DEMAND The AEP System is interconnected through 119 high-voltage transmission interconnections with 29 neighboring electric utility systems. The all-time and 1993 one-hour peak demands were 25,174,000 and 22,142,000 kilowatts, respectively, (including 6,459,000 and 4,043,000 kilowatts, respectively, of scheduled deliveries to unaffiliated systems which the System might, on appropriate notice, have elected not to schedule for delivery) and occurred on January 18, 1994 and July 26, 1993, respectively. The net dependable capacity to serve the System load on such dates, including power available under contractual obligations, was 24,202,000 and 23,896,000 kilowatts, respectively. The all-time and 1993 one-hour internal peak demands were 19,236,000 and 18,085,000 kilowatts, respectively, and occurred on January 19, 1994 and July 28, 1993, respectively. The net dependable capacity to serve the System load on such dates, including power available under contractual arrangements, was 24,202,000 and 23,896,000 kilowatts, respectively. The all-time one-hour integrated and internal net system peak demands and 1993 peak demands for AEP's generating subsidiaries are shown in the following tabulation: HYDROELECTRIC PLANTS Licenses for hydroelectric plants, issued under the Federal Power Act, reserve to the United States the right to take over the project at the expiration of the license term, to issue a new license to another entity, or to relicense the project to the existing licensee. In the event that a project is taken over by the United States or licensed to a new licensee, the Federal Power Act provides for payment to the existing licensee of its "net investment" plus severance damages. Licenses for six System hydroelectric plants expired in 1993 and applications for new licenses for these plants were filed in 1991. The existing licenses for these plants were extended on an annual basis and will be renewed automatically until new licenses are issued. No competing license applications were filed. One new license was issued in March 1994. COOK NUCLEAR PLANT Unit 1 of the Cook Plant, which was placed in commercial operation in 1975, has a nominal net electric rating of 1,020,000 kilowatts. Unit 1's availability factor was 100% during 1993 and 64.8% during 1992. Unit 2, of slightly different design, has a nominal net electrical rating of 1,090,000 kilowatts and was placed in commercial operation in 1978. Unit 2's availability factor was 96.6% during 1993 and 19.5% during 1992. The availability of Units 1 and 2 was affected in 1992 by outages to refuel and Unit 2 main turbine/generator vibrational problems. Units 1 and 2 are licensed by the NRC to operate at 100% of rated thermal power to October 25, 2014 and December 23, 2017, respectively. NUCLEAR INSURANCE The Price-Anderson Act limits public liability for a nuclear incident at any nuclear plant in the United States to $9.4 billion. I&M has insurance coverage for liability from a nuclear incident at its Cook Plant. Such coverage is provided through a combination of private liability insurance, with the maximum amount available of $200,000,000, and mandatory participation for the remainder of the $9.4 billion liability, in an industry retrospective deferred premium plan which would, in case of a nuclear incident, assess all licensees of nuclear plants in the U.S. Under the deferred premium plan, I&M could be assessed up to $158,600,000 payable in annual installments of $20,000,000 in the event of a nuclear incident at Cook or any other nuclear plant in the U.S. There is no limit on the number of incidents for which I&M could be assessed these sums. I&M also has property damage, decontamination and decommissioning insurance for loss resulting from damage to the Cook Plant facilities in the amount of $2.75 billion. Nuclear insurance pools provide $1.265 billion of coverage and Nuclear Electric Insurance Limited (NEIL) and Energy Insurance Bermuda (EIB) provide the remainder. If NEIL's and EIB's losses exceed their available resources, I&M would be subject to a total retrospective premium assessment of up to $15,327,023. NRC regulations require that, in the event of an accident, whenever the estimated costs of reactor stabilization and site decontamination exceed $100,000,000, the insurance proceeds must be used, first, to return the reactor to, and maintain it in, a safe and stable condition and, second, to decontaminate the reactor and reactor station site in accordance with a plan approved by the NRC. The insurers then would indemnify I&M for property damage up to $2.5 billion less any amounts used for stabilization and decontamination. The remaining $250,000,000, as provided by NEIL (reduced by any stabilization and decontamination expenditures over $2.5 billion), would cover decommissioning costs in excess of funds already collected for decommissioning. See Fuel Supply--Nuclear Waste. NEIL's extra-expense program provides insurance to cover extra costs resulting from a prolonged accidental outage of a nuclear unit. I&M's policy insures against such increased costs up to approximately $3,500,000 per week (starting 21 weeks after the outage) for one year, $2,350,000 per week for the second and third years, or 80% of those amounts per unit if both units are down for the same reason. If NEIL's losses exceed its available resources, I&M would be subject to a total retrospective premium assessment of up to $8,929,456. POTENTIAL UNINSURED LOSSES Some potential losses or liabilities may not be insurable or the amount of insurance carried may not be sufficient to meet potential losses and liabilities, including liabilities relating to damage to the Cook Plant and costs of replacement power in the event of a nuclear incident at the Cook Plant. Future losses or liabilities which are not completely insured, unless allowed to be recovered through rates, could have a material adverse effect on results of operation and the financial condition of AEP, I&M and other AEP System companies. Item 3.

Item 3.LEGAL PROCEEDINGS - -------------------------------------------------------------------------------- In February 1990 the Supreme Court of Indiana overturned an order of the IURC, affirmed by the Indiana Court of Appeals, which had awarded I&M the right to serve a General Motors Corporation light truck manufacturing facility located in Fort Wayne. In August 1990 the IURC issued an order transferring the right to serve the GM facility to an unaffiliated local distribution utility. In October 1990 the local distribution utility sued I&M in Indiana under a provision of Indiana law that allows the local distribution utility to seek damages equal to the gross revenues received by a utility that renders retail service in the designated service territory of another utility. On November 30, 1992, the DeKalb Circuit Court granted I&M's motion for summary judgment to dismiss the local distribution utility's complaint. The local distribution utility has begun an appeal to the Indiana Court of Appeals. I&M received revenues of approximately $29,000,000 from serving the GM facility. It is not clear whether the plaintiffs claim will be upheld on appeal because the service was rendered in accordance with an IURC order I&M believed in good faith to be valid. On April 4, 1991, then Secretary of Labor Lynn Martin announced that the U.S. Department of Labor ("DOL") had issued a total of 4,710 citations to operators of 847 coal mines who allegedly submitted respirable dust sampling cassettes that had been altered so as to remove a portion of the dust. The cassettes were submitted in compliance with DOL regulations which require systematic sampling of airborne dust in coal mines and submission of the entire cassettes (which include filters for collecting dust particulates) to the Mine Safety and Health Administration ("MSHA") for analysis. The amount of dust contained on the cassette's filter determines an operator's compliance with respirable dust standards under the law. OPCo's Meigs No. 2, Meigs No. 31, Martinka, and Windsor Coal mines received 16, 3, 15 and 2 citations, respectively. MSHA has assessed civil penalties totalling $56,900 for all these citations. OPCo's samples in question involve about 1 percent of the 2,500 air samples that OPCo submitted over a 20-month period from 1989 through 1991 to the DOL. OPCo is contesting the citations before the Federal Mine Safety and Health Review Commission. An administrative hearing was held before an administrative law judge with respect to all affected coal operators. On July 20, 1993, the administrative law judge rendered a decision in this case holding that the Secretary of Labor failed to establish that the presence of a "white center" on the dust sampling filter indicated intentional alteration. The administrative law judge has set for trial the case of an unaffiliated mine to determine if there was an intentional alteration of the dust sampling filter. All remaining cases, including the citations involving OPCo's mines, have been stayed. On September 21, 1993, CSPCo was served with a complaint issued by Region V, Federal EPA which alleged violations by Conesville Plant of the Toxic Substances Control Act and proposed a penalty of $41,000. On October 4, 1993, I&M was served with a complaint issued by Region V, Federal EPA which alleged violations by Breed Plant of the Clean Water Act and proposed a penalty of $70,000. On October 4, 1993, OPCo was served with a complaint issued by Region V, Federal EPA which alleged violations by OPCo's General Service Center (Canton, Ohio) of the Toxic Substances Control Act and proposed a penalty of $24,000. Settlement discussions have been held in each of these cases and it is expected that these matters will be resolved shortly. On June 18, 1993, OPCo was served with a complaint issued by Region V, Federal EPA which alleged violations by Muskingum River Plant of the Toxic Substances Control Act and proposed a penalty of $87,000. In February 1994, OPCo paid a penalty of $12,185 and agreed to undertake supplemental environmental projects in 1994 valued at $61,547. On February 28, 1994, Ormet Corporation filed a complaint in the U.S. District Court, Northern District of West Virginia, against AEP, OPCo, the Service Corporation and two of its employees, Federal EPA and the Administrator of Federal EPA. Ormet is the operator of a major aluminum reduction plant in Ohio and is a customer of OPCo. See Certain Industrial Contracts. Pursuant to the Clean Air Act Amendments of 1990, OPCo received sulfur dioxide emission allowances for its Kammer Plant. See Environmental and Other Matters. Ormet's complaint seeks a declaration that it is the owner of approximately 89% of the Phase I and Phase II allowances issued for use by the Kammer Plant. OPCo believes that since it is the owner and operator of Kammer Plant and Ormet is a contract power customer, Ormet is not entitled to any of the allowances attributable to the Kammer Plant. See Item 1 for a discussion of certain environmental and rate matters. Meigs Mine--On July 11, 1993, water from an adjoining sealed and abandoned mine owned by Southern Ohio Coal Company ("SOCCo"), a mining subsidiary of OPCo, entered Meigs 31 mine, one of two mines currently being operated by SOCCo. Ohio EPA approved a plan to pump water from the mine to certain Ohio River tributaries under stringent conditions for biological and water quality monitoring and restoring the streams after pumping. On July 30, pumping commenced in accordance with the Ohio EPA approved plan. Since September 16, 1993, SOCCo has processed all water removed from the mine through its expanded treatment system and is in compliance with the effluent limitations in its water discharge permit. Pumping has removed most of the water that entered the mine on July 11 and the mine was returned to service in February 1994. On July 26, 1993, the Ohio Department of Natural Resources Division of Reclamation issued an administrative order directing SOCCo to cease pumping due to that agency's concern over possible environmental harm. On July 26, 1993, following SOCCo's appeal of the cessation order, the chairman of the Reclamation Board of Review issued a temporary stay pending a hearing by the full Reclamation Board. On January 14, 1994, the administrative proceeding was settled on the basis of agreements by the Division of Reclamation to dismiss the administrative order and by SOCCo to treat all water removed from the mine in accordance with its discharge permit and to pay certain expenses of the Division of Reclamation. On August 19, 1993, the U.S. District Court for the Southern District of Ohio granted SOCCo's motion for a preliminary injunction against the Federal Office of Surface Mining Reclamation and Enforcement ("OSM") and Federal EPA preventing them from exercising jurisdiction to issue orders to cease pumping. On August 30, 1993, the U.S. Court of Appeals for the Sixth Circuit denied OSM's motion for a stay of the District Court's preliminary injunction but granted Federal EPA's motion for a stay in part which allowed Federal EPA to investigate and make findings with respect to alleged violations of the Clean Water Act and thereafter to exercise its enforcement authority under the Clean Water Act if a violation was identified. On September 2, 1993, Federal EPA issued an administrative order requiring a partial cessation of pumping, the effect of which was delayed by Federal EPA until September 8, 1993. On September 8, 1993, the District Court granted SOCCo's motion requesting that enforcement of the Federal EPA order be stayed. On September 23, 1993, the Court of Appeals ruled that the District Court could not review the Federal EPA order in the absence of a civil enforcement action and lifted the stay. A further decision of the Court of Appeals with respect to the appeal of the preliminary injunction is pending. On January 3, 1994, the District Court held that the complaint filed by SOCCo should not be dismissed and concluded that sufficient legal and factual grounds existed for the court to consider SOCCo's claim that Federal EPA could not override Ohio EPA's authorization for SOCCo to bypass its water treatment system on an emergency basis during pumping activities. In a separate opinion, the District Court denied Federal EPA's request that the District Court defer consideration of SOCCo's motion involving a request for a Declaration of Rights with respect to the mine water releases into area streams. The West Virginia Division of Environmental Protection ("West Virginia DEP") has proposed fining SOCCo $1,800,000 for violations of West Virginia Water Quality Standards and permitting requirements alleged to have resulted from the release of mine water into the Ohio River. SOCCo is meeting with the West Virginia DEP in an attempt to resolve this matter. Although management is unable to predict what enforcement action Federal EPA or OSM may take, the resolution of the aforementioned litigation, environmental mitigation costs and mine restoration costs are not expected to have a material adverse impact on results of operations or financial condition. Item 4.

Item 4.SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS - -------------------------------------------------------------------------------- AEP, APCO, I&M AND OPCO. None. AEGCO, CSPCO AND KEPCO. Omitted pursuant to Instruction J(2)(c). ---------------- EXECUTIVE OFFICERS OF THE REGISTRANTS AEP The following persons are, or may be deemed, executive officers of AEP. Their ages are given as of March 15, 1994. - -------- (a) All of the executive officers listed above have been employed by the Service Corporation or System companies in various capacities (AEP, as such, has no employees) during the past five years, except E. Linn Draper, Jr. who was Chairman of the Board, President and Chief Executive Officer of Gulf States Utilities Company from 1987 until 1992 when he joined AEP and the Service Corporation. All of the above officers are appointed annually for a one-year term by the board of directors of AEP, the board of directors of the Service Corporation, or both, as the case may be. APCO The names of the executive officers of APCo, the positions they hold with APCo, their ages as of March 15, 1994, and a brief account of their business experience during the past five years appears below. The directors and executive officers of APCo are elected annually to serve a one-year term. - -------- (a)Positions are with APCo unless otherwise indicated. OPCO The names of the executive officers of OPCo, the positions they hold with OPCo, their ages as of March 15, 1994, and a brief account of their business experience during the past five years appear below. The directors and executive officers of OPCo are elected annually to serve a one-year term. - -------- (a)Positions are with OPCo unless otherwise indicated. PART II --------------------------------------------------------------------- Item 5.

Item 5.MARKET FOR REGISTRANTS' COMMON EQUITY AND RELATED STOCKHOLDER MATTERS - -------------------------------------------------------------------------------- AEP. AEP Common Stock is traded principally on the New York Stock Exchange. The following table sets forth for the calendar periods indicated the high and low sales prices for the Common Stock as reported on the New York Stock Exchange Composite Tape and the amount of cash dividends paid per share of Common Stock. - -------- (1) See Note 5 of the Notes to the Consolidated Financial Statements of AEP for information regarding restrictions on payment of dividends. At December 31, 1993, AEP had approximately 194,000 shareholders of record. AEGCO, APCO, CSPCO, I&M, KEPCO AND OPCO. The information required by this item is not applicable as the common stock of all these companies is held solely by AEP. Item 6.

Item 6.SELECTED FINANCIAL DATA - -------------------------------------------------------------------------------- AEGCO. Omitted pursuant to Instruction J(2)(a). AEP. The information required by this item is incorporated herein by reference to the material under Selected Consolidated Financial Data in the AEP 1993 Annual Report (for the fiscal year ended December 31, 1993). APCO. The information required by this item is incorporated herein by reference to the material under Selected Consolidated Financial Data in the APCo 1993 Annual Report (for the fiscal year ended December 31, 1993). CSPCO. Omitted pursuant to Instruction J(2)(a). I&M. The information required by this item is incorporated herein by reference to the material under Selected Consolidated Financial Data in the I&M 1993 Annual Report (for the fiscal year ended December 31, 1993). KEPCO. Omitted pursuant to Instruction J(2)(a). OPCO. The information required by this item is incorporated herein by reference to the material under Selected Consolidated Financial Data in the OPCo 1993 Annual Report (for the fiscal year ended December 31, 1993). Item 7.

Item 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION - -------------------------------------------------------------------------------- AEGCO. Omitted pursuant to Instruction J(2)(a). Management's narrative analysis of the results of operations and other information required by Instruction J(2)(a) is incorporated herein by reference to the material under Management's Narrative Analysis of Results of Operations in the AEGCo 1993 Annual Report (for the fiscal year ended December 31, 1993). AEP. The information required by this item is incorporated herein by reference to the material under Management's Discussion and Analysis of Results of Operations and Financial Condition in the AEP 1993 Annual Report (for the fiscal year ended December 31, 1993). APCO. The information required by this item is incorporated herein by reference to the material under Management's Discussion and Analysis of Results of Operations and Financial Condition in the APCo 1993 Annual Report (for the fiscal year ended December 31, 1993). CSPCO. Omitted pursuant to Instruction J(2)(a). Management's narrative analysis of the results of operations and other information required by Instruction J(2)(a) is incorporated herein by reference to the material under Management's Narrative Analysis of Results of Operations in the CSPCo 1993 Annual Report (for the fiscal year ended December 31, 1993). I&M. The information required by this item is incorporated herein by reference to the material under Management's Discussion and Analysis of Results of Operations and Financial Condition in the I&M 1993 Annual Report (for the fiscal year ended December 31, 1993). KEPCO. Omitted pursuant to Instruction J(2)(a). Management's narrative analysis of the results of operations and other information required by Instruction J(2)(a) is incorporated herein by reference to the material under Management's Narrative Analysis of Results of Operations in the KEPCo 1993 Annual Report (for the fiscal year ended December 31, 1993). OPCO. The information required by this item is incorporated herein by reference to the material under Management's Discussion and Analysis of Results of Operations and Financial Condition in the OPCo 1993 Annual Report (for the fiscal year ended December 31, 1993). Item 8.

Item 8.FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA - -------------------------------------------------------------------------------- AEGCO. The information required by this item is incorporated herein by reference to the financial statements and supplementary data described under Item 14 herein. AEP. The information required by this item is incorporated herein by reference to the financial statements and supplementary data described under Item 14 herein. APCO. The information required by this item is incorporated herein by reference to the financial statements and supplementary data described under Item 14 herein. CSPCO. The information required by this item is incorporated herein by reference to the financial statements and supplementary data described under Item 14 herein. I&M. The information required by this item is incorporated herein by reference to the financial statements and supplementary data described under Item 14 herein. KEPCO. The information required by this item is incorporated herein by reference to the financial statements and supplementary data described under Item 14 herein. OPCO. The information required by this item is incorporated herein by reference to the financial statements and supplementary data described under Item 14 herein. Item 9.

Item 9.CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE - -------------------------------------------------------------------------------- AEGCO, AEP, APCO, CSPCO, I&M, KEPCO AND OPCO. None. PART III -------------------------------------------------------------------- Item 10.

Item 10.DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANTS - -------------------------------------------------------------------------------- AEGCO. Omitted pursuant to Instruction J(2)(c). AEP. The information required by this item is incorporated herein by reference to the material under Nominees for Director and Share Ownership of Directors and Executive Officers of the definitive proxy statement of AEP, dated March 10, 1994, for the 1994 annual meeting of shareholders. Reference also is made to the information under the caption Executive Officers of the Registrants in Part I of this report. APCO. The information required by this item is incorporated herein by reference to the material under Election of Directors of the definitive information statement of APCo for the 1994 annual meeting of stockholders, to be filed within 120 days after December 31, 1993. Reference also is made to the information under the caption Executive Officers of the Registrants in Part I of this report. CSPCO. Omitted pursuant to Instruction J(2)(c). I&M. The names of the directors and executive officers of I&M, the positions they hold with I&M, their ages as of March 15, 1994, and a brief account of their business experience during the past five years appear below. The directors and executive officers of I&M are elected annually to serve a one- year term. - -------- (a)Positions are with I&M unless otherwise indicated. (b)Dr. Draper is a director of Pacific Nuclear Systems, Inc. and Mr. Lhota is a director of Huntington Bancshares Incorporated. (c)Messrs. DeMaria, Dowd, Draper, Lhota and Maloney are directors of AEGCo, APCo, CSPCo, KEPCo and OPCo. Messrs. DeMaria, Dowd, Draper and Maloney are also directors of AEP. KEPCO. Omitted pursuant to Instruction J(2)(c). OPCO. The information required by this item is incorporated herein by reference to the material under the heading Election of Directors of the definitive information statement of OPCo for the 1994 annual meeting of shareholders, to be filed within 120 days after December 31, 1993. Reference also is made to the information under the caption Executive Officers of the Registrants in Part I of this report. Item 11.

Item 11.EXECUTIVE COMPENSATION - ------------------------------------------------------------------------------- AEGCO. Omitted pursuant to Instruction J(2)(c). AEP. The information required by this item is incorporated herein by reference to the material under Compensation of Directors, Executive Compensation and the performance graph of the definitive proxy statement of AEP, dated March 10, 1994, for the 1994 annual meeting of shareholders. APCO. The information required by this item is incorporated herein by reference to the material under Executive Compensation of the definitive information statement of APCo for the 1994 annual meeting of stockholders, to be filed within 120 days after December 31, 1993. CSPCO. Omitted pursuant to Instruction J(2)(c). KEPCO. Omitted pursuant to Instruction J(2)(c). OPCO. The information required by this item is incorporated herein by reference to the material under Executive Compensation of the definitive information statement of OPCo for the 1994 annual meeting of shareholders, to be filed within 120 days after December 31, 1993. I&M Certain executive officers of I&M are employees of the Service Corporation. The salaries of these executive officers are paid by the Service Corporation and a portion of their salaries has been allocated and charged to I&M. The following table shows for 1993, 1992 and 1991 the compensation earned from all AEP System companies by (i) the chief executive officer and four other most highly compensated executive officers (as defined by regulations of the SEC) of I&M at December 31, 1993 and (ii) a chief executive officer and executive officer, both of whom retired in 1993. Summary Compensation Table - -------- (1) Reflects payments under the AEP Management Incentive Compensation Plan ("MICP") in which individuals in key management positions with AEP System companies participate. Amounts for 1993 are estimates but should not change significantly. For 1991 and 1993, these amounts included both cash paid and a portion deferred in the form of restricted stock units. These units are paid out in cash after three years based on the price of AEP Common Stock at that time. Dividend equivalents are paid during the three- year period. At December 31, 1993, Dr. Draper and Messrs. DeMaria, Maloney, Dowd and Lhota held 813, 746, 715, 593 and 639 units having a value of $30,177, $27,701, $26,526, $22,020 and $23,730, respectively, based upon a $37 1/8 per share closing price of AEP's Common Stock as reported on the New York Stock Exchange. For 1992, MICP payments were made entirely in cash. (2) Includes amounts contributed by AEP System companies under the American Electric Power System Employees Savings Plan on behalf of their employee participants. For 1993 this amount was $7,075 for Dr. Draper and Messrs. Katlic, Maloney, Dowd and Lhota and $6,000 for Mr. Disbrow and $7,006 for Mr. DeMaria. The AEP System Savings Plan is available to all employees of AEP System companies (except for employees covered by certain collective bargaining agreements) who have met minimum service requirements. Includes director's fees for AEP System companies. For 1993 these fees were: Dr. Draper, $11,105; Mr. Disbrow, $3,580; Mr. DeMaria, $10,805; Mr. Katlic, $2,300; Mr. Maloney, $10,925; Mr. Dowd, $8,685; and Mr. Lhota, $10,085. Includes payments of $93,173 and $36,077 for unused accrued vacation which Messrs. Disbrow and Katlic, respectively, received upon their retirement. (3) Dr. Draper was elected chairman of the board and chief executive officer of I&M and other AEP System companies and chairman of the board, president and chief executive officer of AEP and the Service Corporation, succeeding Mr. Disbrow, who retired, effective April 28, 1993. Retirement Benefits The American Electric Power System Retirement Plan provides pensions for all employees of AEP System companies (except for employees covered by certain collective bargaining agreements), including the executive officers of I&M. The Retirement Plan is a noncontributory defined benefit plan. The following table shows the approximate annual annuities under the Retirement Plan that would be payable to employees in certain higher salary classifications, assuming retirement at age 65 after various periods of service. The amounts shown in the table are the straight life annuities payable under the Plan without reduction for the joint and survivor annuity. Retirement benefits listed in the table are not subject to any deduction for Social Security or other offset amounts. The retirement annuity is reduced 3% per year in the case of retirement between ages 60 and 62 and further reduced 6% per year in the case of retirement between ages 55 and 60. If an employee retires after age 62, there is no reduction in the retirement annuity. PENSION PLAN TABLE Compensation upon which retirement benefits are based consists of the average of the 36 consecutive months of the employee's highest salary, as listed in the Summary Compensation Table, out of the employee's most recent 10 years of service. With respect to Messrs. Disbrow and Katlic, since they retired in 1993, the amounts of $600,000 and $316,944, respectively, are the actual salaries upon which their retirement benefits are based. Mr. Disbrow's retirement benefit was enhanced by computing his benefit based on his 1992 base salary. As of December 31, 1993, the number of full years of service credited under the Retirement Plan to each of the executive officers of I&M named in the Summary Compensation Table were as follows: Dr. Draper, 1 year; Mr. Disbrow, 39 years; Mr. DeMaria, 34 years; Mr. Katlic, 10 years; Mr. Maloney, 38 years; Mr. Dowd, 31 years; and Mr. Lhota, 29 years. Dr. Draper's employment agreement described below provides him with a supplemental retirement annuity that credits him with 24 years of service in addition to his years of service credited under the Retirement Plan less his actual pension entitlement under the Retirement Plan and any pension entitlements from prior employers. Mr. Katlic has a contract with the Service Corporation under which the Service Corporation agrees to provide him with a supplemental retirement annuity equal to the annual pension that Mr. Katlic would have received with service of 30 years under the AEP System Retirement Plan as then in effect, less his actual annual pension entitlement under the Retirement Plan. Mr. Katlic commenced receiving his supplemental annuity upon his retirement effective October 31, 1993. AEP has determined to pay supplemental retirement benefits to 23 AEP System employees (including Messrs. Disbrow, DeMaria, Maloney and Lhota) whose pensions may be adversely affected by amendments to the Retirement Plan made as a result of the Tax Reform Act of 1986. Such payments, if any, will be equal to any reduction occurring because of such amendments. Upon his retirement on April 28, 1993, Mr. Disbrow began receiving an annual supplemental benefit of $2,642. Assuming retirement of the remaining eligible employees in 1994, none would be eligible to receive supplemental benefits. AEP made available a voluntary deferred-compensation program in 1982 and 1986, which permitted certain executive employees of AEP System companies to defer receipt of a portion of their salaries. Under this program, an executive was able to defer up to 10% or 15% annually (depending on the terms of the program offered), over a four-year period, of his or her salary, and receive supplemental retirement or survivor benefit payments over a 15-year period. The amount of supplemental retirement payments received is dependent upon the amount deferred, age at the time the deferral election was made, and number of years until the executive retires. The following table sets forth, for the executive officers named in the Summary Compensation Table, the amounts of annual deferrals and, assuming retirement at age 65, annual supplemental retirement payments under the 1982 and 1986 programs. Employment Agreement Dr. Draper has a contract with AEP and the Service Corporation which provides for his employment for an initial term from no later than March 15, 1992 until March 15, 1997. Dr. Draper commenced his employment with AEP and the Service Corporation on March 1, 1992. AEP or the Service Corporation may terminate the contract at any time and, if this is done for reasons other than cause and other than as a result of Dr. Draper's death or permanent disability, the Service Corporation must pay Dr. Draper's then base salary through March 15, 1997, less any amounts received by Dr. Draper from other employment. -------------- Directors of I&M receive a fee of $100 for each meeting of the Board of Directors attended in addition to their salaries. -------------- The AEP System is an integrated electric utility system and, as a result, the member companies of the AEP System have contractual, financial and other business relationships with the other member companies, such as participation in the AEP System savings and retirement plans and tax returns, sales of electricity, transportation and handling of fuel, sales or rentals of property and interest or dividend payments on the securities held by the companies' respective parents. Item 12.

Item 12.SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT - ------------------------------------------------------------------------------- AEGCO. Omitted pursuant to Instruction J(2)(c). AEP. The information required by this item is incorporated herein by reference to the material under Share Ownership of Directors and Executive Officers of the definitive proxy statement of AEP, dated March 10, 1994, for the 1994 annual meeting of shareholders. APCO. The information required by this item is incorporated herein by reference to the material under Share Ownership of Directors and Executive Officers in the definitive information statement of APCo for the 1994 annual meeting of stockholders, to be filed within 120 days after December 31, 1993. CSPCO. Omitted pursuant to Instruction J(2)(c). I&M. All 1,400,000 outstanding shares of Common Stock, no par value, of I&M are directly and beneficially held by AEP. Holders of the Cumulative Preferred Stock of I&M generally have no voting rights, except with respect to certain corporate actions and in the event of certain defaults in the payment of dividends on such shares. The table below shows the number of shares of AEP Common Stock that were beneficially owned, directly or indirectly, as of December 31, 1993, by each director and nominee of I&M and each of the executive officers of I&M named in the summary compensation table, and by all directors and executive officers of I&M as a group. It is based on information provided to I&M by such persons. No such person owns any shares of any series of the Cumulative Preferred Stock of I&M. Unless otherwise noted, each person has sole voting power and investment power over the number of shares of AEP Common Stock set forth opposite his name. Fractions of shares have been rounded to the nearest whole share. - -------- (a) The amounts include shares held by the trustee of the AEP Employees Savings Plan, over which directors, nominees and executive officers have voting power, but the investment/disposition power is subject to the terms of such Plan, as follows: Mr. Bailey, 550 shares; Mr. DeMaria, 2,081 shares; Mr. Disbrow, 4,027 shares; Mr. D'Onofrio, 2,889 shares; Mr. Katlic, 2,230 shares; Mr. Lhota, 5,245 shares; Mr. Maloney, 2,142 shares; Mr. Menge, 2,566 shares; Mr. Prater, 1,561 shares; Mr. Synowiec, 1,754 shares; Mr. Walters, 3,685 shares; and all directors and executive officers as a group, 33,806 shares. Messrs. Disbrow's, Dowd's and Maloney's holdings include 85 shares each; Messrs. Bailey's, DeMaria's, D'Onofrio's, Katlic's, Lhota's, Menge's, Prater's, Synowiec's, and Walter's holdings include 44, 83, 59, 60, 60, 62, 48, 53 and 45 shares, respectively; and the holdings of all directors and executive officers as a group include 738 shares, each held by the trustee of the AEP Employee Stock Ownership Plan, over which shares such persons have sole voting power, but the investment/disposition power is subject to the terms of such Plan. (b) Includes shares with respect to which such directors, nominees and executive officers share voting and investment power as follows: Mr. DeMaria, 3,624 shares; Mr. Disbrow, 283 shares; Mr. Draper, 115 shares; Mr. Lhota, 1,368 shares; Mr. Maloney, 2,000 shares; Mr. Menge, 24 shares; and all directors and executive officers as a group, 7,883 shares. Mr. DeMaria disclaims beneficial ownership of 807 shares. (c) 85,231 shares in the American Electric Power System Educational Trust Fund, over which Messrs. DeMaria, Lhota and Maloney share voting and investment power as trustees (they disclaim beneficial ownership of such shares), are not included in their individual totals, but are included in the group total. (d) Represents less than 1 percent of the total number of shares outstanding on December 31, 1993. KEPCO. Omitted pursuant to Instruction J(2)(c). OPCO. The information required by this item is incorporated herein by reference to the material under Share Ownership of Directors and Executive Officers in the definitive information statement of OPCo for the 1994 annual meeting of shareholders, to be filed within 120 days after December 31, 1993. Item 13.

Item 13.CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS - ------------------------------------------------------------------------------- AEP. The information required by this item is incorporated herein by reference to the material under Transactions With Management of the definitive proxy statement of AEP, dated March 10, 1994, for the 1994 annual meeting of shareholders. APCO, I&M AND OPCO. None. AEGCO, CSPCO, AND KEPCO. Omitted pursuant to Instruction J(2)(c). PART IV ------------------------------------------------------------------- Item 14.

Item 14.EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K - -------------------------------------------------------------------------------- (a) The following documents are filed as a part of this report: (b) No Reports on Form 8-K were filed during the quarter ended December 31, 1993. SIGNATURES PURSUANT TO THE REQUIREMENTS OF SECTION 13 OR 15(D) 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. THE SIGNATURE OF THE UNDERSIGNED COMPANY SHALL BE DEEMED TO RELATE ONLY TO MATTERS HAVING REFERENCE TO SUCH COMPANY AND ANY SUBSIDIARIES THEREOF. AEP Generating Company By: /s/ G. P. Maloney --------------------------------- (G. P. MALONEY, VICE PRESIDENT) Date: March 23, 1994 PURSUANT TO THE REQUIREMENTS OF THE SECURITIES EXCHANGE ACT OF 1934, THIS REPORT HAS BEEN SIGNED BELOW BY THE FOLLOWING PERSONS ON BEHALF OF THE REGISTRANT AND IN THE CAPACITIES AND ON THE DATES INDICATED. THE SIGNATURE OF EACH OF THE UNDERSIGNED SHALL BE DEEMED TO RELATE ONLY TO MATTERS HAVING REFERENCE TO THE ABOVE-NAMED COMPANY AND ANY SUBSIDIARIES THEREOF. SIGNATURE TITLE DATE --------- ----- ---- (I) PRINCIPAL EXECUTIVE OFFICER: *E. Linn Draper, Jr. President, Chief Executive Officer and Director (II) PRINCIPAL FINANCIAL OFFICER: /s/ G. P. Maloney Vice President and March 23, 1994 - ------------------------------------- Director (G. P. MALONEY) (III) PRINCIPAL ACCOUNTING OFFICER: /s/ P. J. DeMaria Vice President, March 23, 1994 - ------------------------------------- Treasurer and (P. J. DEMARIA) Director (IV) A MAJORITY OF THE DIRECTORS: *A. Joseph Dowd *Henry Fayne *John R. Jones, III *Wm. J. Lhota *James J. Markowsky /s/ G. P. Maloney *By: ---------------------------------- March 23, 1994 (G. P. MALONEY, ATTORNEY-IN-FACT) SIGNATURES PURSUANT TO THE REQUIREMENTS OF SECTION 13 OR 15(D) 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. American Electric Power Company, Inc. By: /s/ G. P. Maloney --------------------------------- (G. P. MALONEY, VICE PRESIDENT) Date: March 23, 1994 PURSUANT TO THE REQUIREMENTS OF THE SECURITIES EXCHANGE ACT OF 1934, THIS REPORT HAS BEEN SIGNED BELOW BY THE FOLLOWING PERSONS ON BEHALF OF THE REGISTRANT AND IN THE CAPACITIES AND ON THE DATES INDICATED. SIGNATURE TITLE DATE --------- ----- ---- (I) PRINCIPAL EXECUTIVE OFFICER: *E. Linn Draper, Jr. Chairman of the Board, President, Chief Executive Officer and Director (II) PRINCIPAL FINANCIAL OFFICER: /s/ G. P. Maloney Vice President and March 23, 1994 - ------------------------------------- Director (G. P. MALONEY) (III) PRINCIPAL ACCOUNTING OFFICER: /s/ P. J. DeMaria Treasurer and March 23, 1994 - ------------------------------------- Director (P. J. DEMARIA) (IV) A MAJORITY OF THE DIRECTORS: *A. Joseph Dowd *Robert M. Duncan *Arthur G. Hansen *Lester A. Hudson, Jr. *Angus E. Peyton *Toy F. Reid *W. Ann Reynolds *Linda Gillespie Stuntz *Morris Tanenbaum *Ann Haymond Zwinger *By: /s/ G. P. Maloney ---------------------------------- March 23, 1994 (G. P. MALONEY, ATTORNEY-IN-FACT) SIGNATURES PURSUANT TO THE REQUIREMENTS OF SECTION 13 OR 15(D) 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. THE SIGNATURE OF THE UNDERSIGNED COMPANY SHALL BE DEEMED TO RELATE ONLY TO MATTERS HAVING REFERENCE TO SUCH COMPANY AND ANY SUBSIDIARIES THEREOF. Appalachian Power Company By: /s/ G. P. Maloney --------------------------------- (G. P. MALONEY, VICE PRESIDENT) Date: March 23, 1994 PURSUANT TO THE REQUIREMENTS OF THE SECURITIES EXCHANGE ACT OF 1934, THIS REPORT HAS BEEN SIGNED BELOW BY THE FOLLOWING PERSONS ON BEHALF OF THE REGISTRANT AND IN THE CAPACITIES AND ON THE DATES INDICATED. THE SIGNATURE OF EACH OF THE UNDERSIGNED SHALL BE DEEMED TO RELATE ONLY TO MATTERS HAVING REFERENCE TO THE ABOVE-NAMED COMPANY AND ANY SUBSIDIARIES THEREOF. SIGNATURE TITLE DATE --------- ----- ---- (I) PRINCIPAL EXECUTIVE OFFICER: *E. Linn Draper, Jr. Chairman of the Board, Chief Executive Officer and Director (II) PRINCIPAL FINANCIAL OFFICER: /s/ G. P. Maloney Vice President and March 23, 1994 - ------------------------------------- Director (G. P. MALONEY) (III) PRINCIPAL ACCOUNTING OFFICER: /s/ P. J. DeMaria Vice President, March 23, 1994 - ------------------------------------- Treasurer and (P. J. DEMARIA) Director (IV) A MAJORITY OF THE DIRECTORS: *A. Joseph Dowd *Luke M. Feck *Wm. J. Lhota *James J. Markowsky *J. H. Vipperman *By: /s/ G. P. Maloney ---------------------------------- March 23, 1994 (G. P. MALONEY, ATTORNEY-IN-FACT) SIGNATURES PURSUANT TO THE REQUIREMENTS OF SECTION 13 OR 15(D) 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. THE SIGNATURE OF THE UNDERSIGNED COMPANY SHALL BE DEEMED TO RELATE ONLY TO MATTERS HAVING REFERENCE TO SUCH COMPANY AND ANY SUBSIDIARIES THEREOF. Columbus Southern Power Company By: /s/ G. P. Maloney --------------------------------- (G. P. MALONEY, VICE PRESIDENT) Date: March 23, 1994 PURSUANT TO THE REQUIREMENTS OF THE SECURITIES EXCHANGE ACT OF 1934, THIS REPORT HAS BEEN SIGNED BELOW BY THE FOLLOWING PERSONS ON BEHALF OF THE REGISTRANT AND IN THE CAPACITIES AND ON THE DATES INDICATED. THE SIGNATURE OF EACH OF THE UNDERSIGNED SHALL BE DEEMED TO RELATE ONLY TO MATTERS HAVING REFERENCE TO THE ABOVE-NAMED COMPANY AND ANY SUBSIDIARIES THEREOF. SIGNATURE TITLE DATE --------- ----- ---- (I) PRINCIPAL EXECUTIVE OFFICER: *E. Linn Draper, Jr. Chairman of the Board, Chief Executive Officer and Director (II) PRINCIPAL FINANCIAL OFFICER: /s/ G. P. Maloney Vice President and March 23, 1994 - ------------------------------------- Director (G. P. MALONEY) (III) PRINCIPAL ACCOUNTING OFFICER: Vice President, March 23, 1994 /s/ P. J. DeMaria Treasurer and - ------------------------------------- Director (P. J. DEMARIA) (IV) A MAJORITY OF THE DIRECTORS: *A. Joseph Dowd *C. A. Erikson *Henry Fayne *Wm. J. Lhota *James J. Markowsky *By: /s/ G. P. Maloney ---------------------------------- March 23, 1994 (G. P. MALONEY, ATTORNEY-IN-FACT) SIGNATURES PURSUANT TO THE REQUIREMENTS OF SECTION 13 OR 15(D) 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. THE SIGNATURE OF THE UNDERSIGNED COMPANY SHALL BE DEEMED TO RELATE ONLY TO MATTERS HAVING REFERENCE TO SUCH COMPANY AND ANY SUBSIDIARIES THEREOF. Indiana Michigan Power Company By: /s/ G. P. Maloney --------------------------------- (G. P. MALONEY, VICE PRESIDENT) Date: March 23, 1994 PURSUANT TO THE REQUIREMENTS OF THE SECURITIES EXCHANGE ACT OF 1934, THIS REPORT HAS BEEN SIGNED BELOW BY THE FOLLOWING PERSONS ON BEHALF OF THE REGISTRANT AND IN THE CAPACITIES AND ON THE DATES INDICATED. THE SIGNATURE OF EACH OF THE UNDERSIGNED SHALL BE DEEMED TO RELATE ONLY TO MATTERS HAVING REFERENCE TO THE ABOVE-NAMED COMPANY AND ANY SUBSIDIARIES THEREOF. SIGNATURE TITLE DATE --------- ----- ---- (I) PRINCIPAL EXECUTIVE OFFICER: *E. Linn Draper, Jr. Chairman of the Board, Chief Executive Officer and Director (II) PRINCIPAL FINANCIAL OFFICER: /s/ G. P. Maloney Vice President and March 23, 1994 - ------------------------------------- Director (G. P. MALONEY) (III) PRINCIPAL ACCOUNTING OFFICER: /s/ P. J. DeMaria Vice President, March 23, 1994 - ------------------------------------- Treasurer and (P. J. DEMARIA) Director (IV) A MAJORITY OF THE DIRECTORS: *Mark A. Bailey *W. N. D'Onofrio *A. Joseph Dowd *Wm. J. Lhota *Richard C. Menge *R. E. Prater *D. B. Synowiec *W. E. Walters *By: /s/ G. P. Maloney March 23, 1994 ---------------------------------- (G. P. MALONEY, ATTORNEY-IN-FACT) SIGNATURES PURSUANT TO THE REQUIREMENTS OF SECTION 13 OR 15(D) 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. THE SIGNATURE OF THE UNDERSIGNED COMPANY SHALL BE DEEMED TO RELATE ONLY TO MATTERS HAVING REFERENCE TO SUCH COMPANY AND ANY SUBSIDIARIES THEREOF. Kentucky Power Company By: /s/ G. P. Maloney --------------------------------- (G. P. MALONEY, VICE PRESIDENT) Date: March 23, 1994 PURSUANT TO THE REQUIREMENTS OF THE SECURITIES EXCHANGE ACT OF 1934, THIS REPORT HAS BEEN SIGNED BELOW BY THE FOLLOWING PERSONS ON BEHALF OF THE REGISTRANT AND IN THE CAPACITIES AND ON THE DATES INDICATED. THE SIGNATURE OF EACH OF THE UNDERSIGNED SHALL BE DEEMED TO RELATE ONLY TO MATTERS HAVING REFERENCE TO THE ABOVE-NAMED COMPANY AND ANY SUBSIDIARIES THEREOF. SIGNATURE TITLE DATE --------- ----- ---- (I) PRINCIPAL EXECUTIVE OFFICER: *E. Linn Draper, Jr. Chairman of the Board, Chief Executive Officer and Director (II) PRINCIPAL FINANCIAL OFFICER: /s/ G. P. Maloney Vice President and March 23, 1994 - ------------------------------------- Director (G. P. MALONEY) (III) PRINCIPAL ACCOUNTING OFFICER: /s/ P. J. DeMaria Vice President, March 23, 1994 - ------------------------------------- Treasurer and (P. J. DEMARIA) Director (IV) A MAJORITY OF THE DIRECTORS: *C. R. Boyle, III *A. Joseph Dowd *Wm. J. Lhota *Ronald A. Petti *By: /s/ G. P. Maloney --------------------------------- March 23, 1994 (G. P. MALONEY, ATTORNEY-IN-FACT) SIGNATURES PURSUANT TO THE REQUIREMENTS OF SECTION 13 OR 15(D) 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. THE SIGNATURE OF THE UNDERSIGNED COMPANY SHALL BE DEEMED TO RELATE ONLY TO MATTERS HAVING REFERENCE TO SUCH COMPANY AND ANY SUBSIDIARIES THEREOF. Ohio Power Company By: /s/ G. P. Maloney --------------------------------- (G. P. MALONEY, VICE PRESIDENT) Date: March 23, 1994 PURSUANT TO THE REQUIREMENTS OF THE SECURITIES EXCHANGE ACT OF 1934, THIS REPORT HAS BEEN SIGNED BELOW BY THE FOLLOWING PERSONS ON BEHALF OF THE REGISTRANT AND IN THE CAPACITIES AND ON THE DATES INDICATED. THE SIGNATURE OF EACH OF THE UNDERSIGNED SHALL BE DEEMED TO RELATE ONLY TO MATTERS HAVING REFERENCE TO THE ABOVE-NAMED COMPANY AND ANY SUBSIDIARIES THEREOF. SIGNATURES TITLE DATE ---------- ----- ---- (I) PRINCIPAL EXECUTIVE OFFICER: *E. Linn Draper, Jr. Chairman of the Board, Chief Executive Officer and Director (II) PRINCIPAL FINANCIAL OFFICER: /s/ G. P. Maloney Vice President and March 23, 1994 - ------------------------------------- Director (G. P. MALONEY) (III) PRINCIPAL ACCOUNTING OFFICER: /s/ P. J. DeMaria Vice President, March 23, 1994 - ------------------------------------- Treasurer and (P. J. DEMARIA) Director (IV) A MAJORITY OF THE DIRECTORS: *A. Joseph Dowd *C. A. Erikson *Henry Fayne *Wm. J. Lhota *James J. Markowsky *By: /s/ G. P. Maloney March 23, 1994 ---------------------------------- (G. P. MALONEY, ATTORNEY-IN-FACT) INDEX TO FINANCIAL STATEMENT SCHEDULES S-1 INDEPENDENT AUDITORS' REPORT American Electric Power Company, Inc. and Subsidiaries: We have audited the consolidated financial statements of American Electric Power Company, Inc. and its subsidiaries and the financial statements of certain of its subsidiaries, listed in Item 14 herein, as of December 31, 1993 and 1992, and for each of the three years in the period ended December 31, 1993, and have issued our reports thereon dated February 22, 1994; such financial statements and reports are included in your respective 1993 Annual Report to Shareowners and are incorporated herein by reference. Our audits also included the financial statement schedules of American Electric Power Company, Inc. and its subsidiaries and of certain of its subsidiaries, listed in Item 14. These financial statement schedules are the responsibility of the respective Company's management. Our responsibility is to express an opinion based on our audits. In our opinion, such financial statement schedules, when considered in relation to the corresponding basic financial statements taken as a whole, present fairly in all material respects the information set forth therein. Deloitte & Touche Columbus, Ohio February 22, 1994 S-2 AMERICAN ELECTRIC POWER COMPANY, INC. AND SUBSIDIARY COMPANIES SCHEDULE V -- PROPERTY, PLANT AND EQUIPMENT - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- Total additions of $676,404,000 in 1993, $718,154,000 in 1992 and $733,909,000 in 1991 were less than 10% of the total as of the respective year- ends. Retirements or sales of $278,435,000 in 1993, $297,460,000 in 1992 and $198,352,000 in 1991 were less than 10% of the total as of the respective year- ends. There were no additions to individual accounts in excess of two percent of total assets other than transfers from Construction Work in Progress. Amortization of nuclear fuel of $41,325,000 in 1993, $19,343,000 in 1992 and $50,124,000 in 1991 was credited directly to the property account and charged to fuel expense. In 1993 other charges include a reduction of $157,535,000 to reflect the PUCO disallowance of a portion of the Zimmer Plant investment as discussed in Note 3 of the Notes to Consolidated Financial Statements. The methods used to compute the annual provisions for depreciation are described in Note 1 of the Notes to Consolidated Financial Statements. The current provisions were determined using the following composite rates for functional classes of property: S-3 AMERICAN ELECTRIC POWER COMPANY, INC. AND SUBSIDIARY COMPANIES SCHEDULE VI -- ACCUMULATED DEPRECIATION AND AMORTIZATION OF PROPERTY, PLANT AND EQUIPMENT - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- S-4 AMERICAN ELECTRIC POWER COMPANY, INC. AND SUBSIDIARY COMPANIES SCHEDULE VIII -- VALUATION AND QUALIFYING ACCOUNTS AND RESERVES - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- - -------- (a)Recoveries on accounts previously written off. (b)Uncollectible accounts written off. (c)Billings to others. (d)Payments and accrual adjustments. (e)Includes interest on trust funds. (f)Adjust royalty provision. S-5 AMERICAN ELECTRIC POWER COMPANY, INC. AND SUBSIDIARY COMPANIES SCHEDULE IX -- SHORT-TERM BORROWINGS - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- - -------- (a)Sum of month-end short-term borrowings divided by number of months outstanding. (b)Interest for the period divided by average amount outstanding. S-6 AEP GENERATING COMPANY SCHEDULE V -- PROPERTY, PLANT AND EQUIPMENT - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- Total additions of $4,089,000 in 1993, $4,512,000 in 1992 and $3,796,000 in 1991 were less than 10% of the total as of the respective year-ends. Retirements or sales of $1,038,000 in 1993, $1,830,000 in 1992 and $1,450,000 in 1991 were less than 10% of the total as of the respective year-ends. There were no additions to individual accounts in excess of two percent of total assets. The methods used to compute the annual provisions for depreciation are described in Note 1 of the Notes to Financial Statements. The current provisions were determined using the following composite rates for functional classes of property: S-7 AEP GENERATING COMPANY SCHEDULE VI -- ACCUMULATED DEPRECIATION OF PROPERTY, PLANT AND EQUIPMENT - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- S-8 AEP GENERATING COMPANY SCHEDULE IX -- SHORT-TERM BORROWINGS - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- - -------- (a)Sum of month-end short-term borrowings divided by number of months outstanding. (b)Interest for the period divided by average amount outstanding. S-9 APPALACHIAN POWER COMPANY AND SUBSIDIARIES SCHEDULE V -- PROPERTY, PLANT AND EQUIPMENT - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- Total additions of $201,169,000 in 1993, $198,116,000 in 1992 and $196,937,000 in 1991 were less than 10% of the total as of the respective year- ends. Retirements or sales of $47,254,000 in 1993, $42,926,000 in 1992 and $32,428,000 in 1991 were less than 10% of the total as of the respective year- ends. There were no additions to individual accounts in excess of two percent of total assets other than transfers from Construction Work in Progress. The methods used to compute the annual provisions for depreciation are described in Note 1 of the Notes to Consolidated Financial Statements. The current provisions were determined using the following composite rates for functional classes of property: S-10 APPALACHIAN POWER COMPANY AND SUBSIDIARIES SCHEDULE VI -- ACCUMULATED DEPRECIATION AND AMORTIZATION OF PROPERTY, PLANT AND EQUIPMENT - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- S-11 APPALACHIAN POWER COMPANY AND SUBSIDIARIES SCHEDULE VIII -- VALUATION AND QUALIFYING ACCOUNTS AND RESERVES - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- - -------- (a) Recoveries on accounts previously written off. (b) Uncollectible accounts written off. (c) Payments and transfers. S-12 APPALACHIAN POWER COMPANY AND SUBSIDIARIES SCHEDULE IX -- SHORT-TERM BORROWINGS - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- - -------- (a) Sum of month-end short-term borrowings divided by number of months outstanding. (b) Interest for the period divided by average amount outstanding. S-13 COLUMBUS SOUTHERN POWER COMPANY AND SUBSIDIARIES SCHEDULE V -- PROPERTY, PLANT AND EQUIPMENT - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- Total additions of $97,455,000 in 1993, $80,279,000 in 1992 and $111,856,000 in 1991 were less than 10% of the total as of the respective year-ends. Retirements or sales of $18,161,000 in 1993, $21,999,000 in 1992 and $19,773,000 in 1991 were less than 10% of the total as of the respective year- ends. There were no additions to individual accounts in excess of two percent of total assets other than transfers from Construction Work in Progress. In 1993 other charges include a reduction of $157,535,000 to reflect the PUCO disallowance of a portion of the Zimmer Plant investment as discussed in Note 2 of the Notes to Consolidated Financial Statements. The methods used to compute the annual provisions for depreciation are described in Note 1 of the Notes to Consolidated Financial Statements. The current provisions were determined using the following composite rates for functional classes of property: S-14 COLUMBUS SOUTHERN POWER COMPANY AND SUBSIDIARIES SCHEDULE VI -- ACCUMULATED DEPRECIATION OF PROPERTY, PLANT AND EQUIPMENT - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- - -------- (a) Reflects the write-off of accumulated depreciation related to a portion of the Zimmer Plant investment that was disallowed by the PUCO as discussed in Note 2 of the Notes to Consolidated Financial Statements. S-15 COLUMBUS SOUTHERN POWER COMPANY AND SUBSIDIARIES SCHEDULE VIII -- VALUATION AND QUALIFYING ACCOUNTS AND RESERVES - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- - -------- (a) Recoveries on accounts previously written off. (b) Uncollectible accounts written off. (c) Payments. S-16 COLUMBUS SOUTHERN POWER COMPANY AND SUBSIDIARIES SCHEDULE IX -- SHORT-TERM BORROWINGS - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- - -------- (a) Sum of month-end short-term borrowings divided by number of months outstanding. (b) Interest for the period divided by average amount outstanding. S-17 INDIANA MICHIGAN POWER COMPANY AND SUBSIDIARIES SCHEDULE V -- PROPERTY, PLANT AND EQUIPMENT - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- Total additions of $125,247,000 in 1993, $175,728,000 in 1992 and $149,187,000 in 1991 were less than 10% of the total as of the respective year- ends. Retirements or sales of $61,586,000 in 1993, $25,301,000 in 1992 and $40,396,000 in 1991 were less than 10% of the total as of the respective year- ends. There were no additions to individual accounts in excess of two percent of total assets other than transfers from Construction Work in Progress. Amortization of nuclear fuel of $41,325,000 in 1993, $19,343,000 in 1992 and $50,124,000 in 1991 was credited directly to the property account and charged to fuel expense. The methods used to compute the annual provisions for depreciation are described in Note 1 of the Notes to Consolidated Financial Statements. The current provisions were determined using the following composite rates for functional classes of property: S-18 INDIANA MICHIGAN POWER COMPANY AND SUBSIDIARIES SCHEDULE VI -- ACCUMULATED DEPRECIATION AND AMORTIZATION OF PROPERTY, PLANT AND EQUIPMENT - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- S-19 INDIANA MICHIGAN POWER COMPANY AND SUBSIDIARIES SCHEDULE VIII -- VALUATION AND QUALIFYING ACCOUNTS AND RESERVES - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- - -------- (a) Recoveries on accounts previously written off. (b) Uncollectible accounts written off. (c) Billings to others. (d) Payments and accrual adjustments. (e) Includes interest on trust funds. (f) Adjust Royalty Provision. S-20 INDIANA MICHIGAN POWER COMPANY AND SUBSIDIARIES SCHEDULE IX -- SHORT-TERM BORROWINGS - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- - -------- (a) Sum of month-end short-term borrowings divided by number of months outstanding. (b) Interest for the period divided by average amount outstanding. S-21 KENTUCKY POWER COMPANY SCHEDULE V -- PROPERTY, PLANT AND EQUIPMENT - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- Total additions of $37,808,000 in 1993, $35,203,000 in 1992 and $31,369,000 in 1991 were less than 10% of the total as of the respective year-ends. Retirements or sales of $12,000,000 in 1993, $11,352,000 in 1992 and $8,092,000 in 1991 were less than 10% of the total as of the respective year-ends. There were no additions to individual accounts in excess of two percent of total assets other than transfers from Construction Work in Progress. The methods used to compute the annual provisions for depreciation are described in Note 1 of the Notes to Financial Statements. The current provisions were determined using the following composite rates for functional classes of property: S-22 KENTUCKY POWER COMPANY SCHEDULE VI -- ACCUMULATED DEPRECIATION AND AMORTIZATION OF PROPERTY, PLANT AND EQUIPMENT - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- S-23 KENTUCKY POWER COMPANY SCHEDULE VIII -- VALUATION AND QUALIFYING ACCOUNTS AND RESERVES - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- - -------- (a) Recoveries on accounts previously written off. (b) Uncollectible accounts written off. (c) Payments. S-24 KENTUCKY POWER COMPANY SCHEDULE IX -- SHORT-TERM BORROWINGS - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- - -------- (a) Sum of month-end short-term borrowings divided by number of months outstanding. (b) Interest for the period divided by average amount outstanding. S-25 OHIO POWER COMPANY AND SUBSIDIARIES SCHEDULE V -- PROPERTY, PLANT AND EQUIPMENT - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- Total additions of $197,089,000 in 1993, $201,737,000 in 1992 and $228,500,000 in 1991 were less than 10% of the total as of the respective year- ends. Retirements or sales of $128,775,000 in 1993, $191,662,000 in 1992 and $90,472,000 in 1991 were less than 10% of the total as of the respective year- ends. There were no additions to individual accounts in excess of two percent of total assets other than transfers from Construction Work in Progress. The methods used to compute the annual provisions for depreciation are described in Note 1 of the Notes to Consolidated Financial Statements. The current provisions for other than mining assets were determined using the following composite rates for functional classes of property: The current provisions for mining assets were calculated by use of the following methods: S-26 OHIO POWER COMPANY AND SUBSIDIARIES SCHEDULE VI -- ACCUMULATED DEPRECIATION AND AMORTIZATION OF PROPERTY, PLANT AND EQUIPMENT - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- S-27 OHIO POWER COMPANY AND SUBSIDIARIES SCHEDULE VIII -- VALUATION AND QUALIFYING ACCOUNTS AND RESERVES - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- - -------- (a) Recoveries on accounts previously written off. (b) Uncollectible accounts written off. (c) Billings to others. (d) Payments. S-28 OHIO POWER COMPANY AND SUBSIDIARIES SCHEDULE IX -- SHORT-TERM BORROWINGS - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- - -------- (a) Sum of month-end short-term borrowings divided by number of months outstanding. (b) Interest for the period divided by average amount outstanding. S-29 EXHIBIT INDEX Certain of the following exhibits, designated with an asterisk(*), are filed herewith. The exhibits not so designated have heretofore been filed with the Commission and, pursuant to 17 C.F.R. (S)201.24 and (S)240.12b-32, are incorporated herein by reference to the documents indicated in brackets following the descriptions of such exhibits. Exhibits, designated with a dagger (+), are management contracts or compensatory plans or arrangements required to be filed as an exhibit to this form pursuant to Item 14(c) of this report. AEGCO E-1 AEGCO (continued) E-2 AEP++ (continued) E-3 AEP++ (continued) E-4 APCO++ (continued) E-5 APCO++ (continued) E-6 CSPCO++ (continued) E-7 I&M++ (continued) E-8 I&M++ (continued) E-9 KEPCO (continued) E-10 OPCO++ (continued) E-11 OPCO++ (continued) -------------- ++Certain instruments defining the rights of holders of long-term debt of the registrants included in the financial statements of registrants filed herewith have been omitted because the total amount of securities authorized thereunder does not exceed 10% of the total assets of registrants. The registrants hereby agree to furnish a copy of any such omitted instrument to the SEC upon request. E-12

30099_1993.txt

30099

1993

Item 1. Business of Dresser. - ------ ------------------- Dresser Industries, Inc., together with its subsidiaries (hereinafter "Dresser" or "Registrant" or the "Company") is a global supplier serving the total hydrocarbon energy stream, both upstream and downstream. Registrant's highly engineered and integrated products and technical services are primarily utilized in oil and gas drilling, production and transmission; gas distribution and power generation; gas processing; petroleum refining and marketing; and petrochemical production. Dresser was incorporated under the laws of Delaware in 1956 as a successor to a Pennsylvania corporation organized in 1938 by the consolidation of S. R. Dresser Manufacturing Company and Clark Bros. Company. Both were carrying on businesses founded in 1880. Dresser's executive offices are located at 2001 Ross Avenue, Dallas, Texas 75201 (telephone number 214/740- 6000). For the fiscal year ended October 31, 1993, consolidated sales and service revenues of Registrant amounted to $4,216 million. A majority of such revenues was derived from the sale of products and services to energy-oriented industries, including oil and gas exploration, drilling and production, gas transmission and distribution; petroleum and chemical processing; production of electricity; and marketing of petroleum products. Registrant's operations are divided into three industry segments: Oilfield Services; Hydrocarbon Processing Industry; and Engineering Services. Effective February 1, 1993, Registrant acquired the stock of Bredero Price Holding B.V. and its subsidiary companies ("Bredero Price"), a Netherlands based company that provides pipe coating for both onshore and offshore markets. These operations are included in the Oilfield Services segment. Effective April 1, 1993, Registrant acquired TK Valve & Manufacturing, Inc. ("TK Valve"), a Texas corporation that supplies ball valves for the oil and gas production and transmission industry. These operations are also included in the Oilfield Services segment. On December 8, 1993, Registrant announced an agreement to sell its 29.5% interest in Western Atlas International, Inc. to a wholly owned subsidiary of Litton Industries, Inc. The sale closed on January 28,1994. On January 19, 1994 shareholders of Registrant voted to approve the merger (the "Merger") of BCD Acquisition Corporation ("BCD"), a wholly owned subsidiary of Registrant, into Baroid Corporation ("Baroid"). The Merger was effective January 21, 1994 (the "Effective Date"), pursuant to an Agreement and Plan of Merger (the "Merger Agreement") dated September 7, 1993, among Registrant, BCD and Baroid. Shareholders of Baroid on the Effective Date will receive 37,286,662 million shares of Registrant's Common Stock in exchange for all of the issued and outstanding shares of Baroid. In addition, approximately 3.6 million shares of Registrant's Common Stock are reserved for issuance upon exercise of outstanding warrants to purchase Baroid common stock and for issuance pursuant to certain benefit plans assumed by Registrant. For financial reporting purposes, the Merger will be treated as a pooling of interests combination. Baroid operations include drilling fluids, drilling services and products and offshore services businesses. Further information concerning Baroid is included under the caption "Baroid" and Note R to the Consolidated Financial Statements. In connection with the Merger, Registrant and Baroid announced December 23, 1993, that they reached an agreement with the Antitrust Division of the Department of Justice (the "Antitrust Division") pursuant to which Registrant must dispose of either its 64% interest in M-I Drilling Fluids Company or Baroid Drilling Fluids Inc., a wholly-owned subsidiary of Baroid. In addition, Registrant must also dispose of the United States diamond drill bit business of DB Stratabit, Inc. ("DBS") and grant to the purchaser a non-exclusive license to manufacture steel-bodied diamond drill bits worldwide. Divestiture of the drilling fluids business must occur by June 1, 1994 and the diamond drill bit transaction must occur by July 1, 1994. On January 27, 1994, Registrant announced that it has agreed in principle to sell its interest in M-I Drilling Fluids Company to Smith International, Inc. The completion of the transaction is subject to the negotiation and execution of a definitive agreement, approval from both the Smith and Dresser Boards of Directors, the consent of minority partner Halliburton Company and certain regulatory approvals. Baroid operations are conducted principally through subsidiaries as follows: Drilling Fluids - --------------- Baroid Drilling Fluids Inc. provides specially formulated fluids used in the drilling process to lubricate and cool the drill bit, seal porous well formations, remove rock cuttings and control downhole pressure. Baroid Drilling Fluids Inc. is a worldwide integrated producer and distributor of drilling fluids. Drilling Services and Products - ------------------------------ Sperry-Sun Drilling Services Inc. ("Sperry-Sun") rents specialized steering and measurement-while-drilling ("MWD") tools and provides directional drilling services for oil and gas wells throughout the world. DBS provides diamond drill bits and coring products and services to the oil and gas industry worldwide. Offshore Services - ----------------- Sub Sea International Inc. ("Sub Sea") provides diving and underwater engineering services to the oil and gas industry to inspect, construct, maintain and repair offshore drilling rigs and platforms, underwater pipelines and other offshore oil and gas facilities. Unmanned, remotely operated vehicles ("ROVs") are often used to perform these services. Sub Sea designs, manufactures and deploys ROVs. Sub Sea also owns and operates marine equipment which performs pipeline installation, burial and inspection and maintenance and repair work on platforms in offshore oil and gas fields. The Information by Industry Segment is included in Note P to Consolidated Financial Statements on pages 50-52 and in Management's Discussion and Analysis on pages 12-20. This information includes sales and service revenues, operating profit or loss and identifiable assets attributable to each of Registrant's business segments for each of the past three fiscal years. This information should be read in conjunction with the consolidated financial statements, notes and accountant's report appearing in Item 8 of this report. OILFIELD SERVICES Registrant's oilfield services segment supplies products and services essential to oil and gas exploration, drilling and production. These products and services include drilling fluid systems, rock bits, production tools, pipe coating and resource exploration services. Drilling Fluid Systems and Related Services. M-I Drilling Fluids Company, a Texas general partnership in which Registrant has a 64% interest, provides a variety of drilling fluid systems and markets such fluids and related services for use in connection with drilling oil and gas wells. M-I markets drilling fluid systems and related services through its sales force to major domestic and international oil companies, independent drilling operators and contractors and foreign government-owned companies. Through its Swaco Geolograph operations, M-I designs, builds and markets a broad line of detection and control equipment used during drilling, often in conjunction with the above described fluid systems, and shakers, desilters, degassers and centrifuges used to remove solids and gas prior to re- use of the fluids. Total net revenues for M-I were $398.6 million in 1993, $384.1 million in 1992 and $443.5 million in 1991. Pipe Coating. Bredero Price, acquired in February 1993, provides pipe coating services for use both in on-shore and offshore pipelines, primarily in Europe and Asia. Rock Bits. Registrant produces a full line of oilfield and mining rock bits which are marketed under the Security trademark and are used in drilling oil and gas wells and in the mining industry. Production Tools. Registrant's Guiberson AVA Division produces and markets a broad line of tools which are sold to the completion, production and workover segments of the oil production industry. Drilling and well servicing contractors provide the primary market for bits and tools. Resource Exploration Services. Western Atlas International, Inc. ("Western Atlas"), an unconsolidated affiliate in which Registrant owns 29.5% of the outstanding shares, performs seismic services; integrated reservoir description services; data reduction and interpretation; core and fluids analysis; wireline logging; and provides specialized oilfield services equipment. Primary customers are the energy industry and governments worldwide. On December 8, 1993, Registrant announced it will sell its interest in Western Atlas to an affiliate of Litton Industries, Inc. for $558 million. HYDROCARBON PROCESSING INDUSTRY This segment designs, manufactures and markets highly engineered products and systems for energy producers, transporters, processors, distributors and users throughout the world. Products and systems of this segment include compressors, turbines, electrical generator systems, pumps, power systems, measurement and control devices, and gasoline dispensing systems. Compressors. Dresser-Rand Company, a New York general partnership in which Registrant has a 51% interest, manufactures industrial and aircraft derivative gas turbines, centrifugal compressors, axial compressors, reciprocating compressors, axial expanders, single and multi-stage steam turbines, and electric motors and generators. Gas turbines, motors, and steam turbines are used to drive compressors, generators and pumps with applications in many markets including: cogeneration, power generation, natural gas gathering, processing, transmission and distribution, natural gas injection, petrochemical plants, and refineries. An extensive line of centrifugal compressors is used in a multitude of services including: gas injection, gas lift, gas processing, transmission and distribution, urea and ammonia production, ethylene and liquified natural gas (LNG) production, coal gasification, refinery services and other petrochemical processes. Axial compressors are used in coal gasification, blast furnace, nitric acid and refinery services. Axial expanders are used in power recovery applications, nitric acid plants and refinery processes. Dresser-Rand also manufactures and supplies water cooled reciprocating compressors. Separate compressor lines are manufactured and marketed for the process, enhanced oil recovery, natural gas, and industrial air commercial markets and special shipboard air compressors for the Navy. Dresser-Rand's single and multi-stage mechanical drive steam turbines are used to power pumps, fans, blowers, reciprocating compressors and centrifugal compressors; steam turbine generator sets provide electric power for co- generation and alternate fuel markets; electric motors (synchronous and induction type); and electric generators are used with reciprocating engine, hydroturbine, steam turbine and gas turbine drivers. Dresser-Rand also manufactures and markets cryogenic expanders, combined with single stage compressors or generators, to recover energy from production of low temperature process gases used in air separation hydrocarbon facilities. The primary markets for such products are petroleum, petrochemical, chemical, paper and sugar industries, and engineering firms which design plants for such industries. The Consolidated statement of earnings for 1993 includes the $1,118.1 million of Dresser-Rand's sales revenues. Sales revenues for Dresser-Rand were not included in the consolidated statements of earnings for 1992 and 1991 while it was only 50% owned by Registrant. Pumps. Effective October 1, 1992, Registrant's Pump operations (excepting Mono Pump and Peabody) were combined with the Pump operations of Ingersoll-Rand Company into Ingersoll-Dresser Pump Company, a Delaware general partnership in which Registrant has a 49% interest. Ingersoll-Rand Company holds a 51% interest in Ingersoll-Dresser Pump Company. Ingersoll-Dresser Pump Company designs, develops, manufactures and markets centrifugal pumps which are used for critical applications in energy processing and petrochemical markets as well as in utility and municipal water and waste water markets. Ingersoll-Dresser Pump also manufactures heavy duty process pumps, submersible pumps, vertical turbine pumps, standard end-suction pumps, horizontal split-case and multistage pumps designed for general industrial, pipeline and high pressure services. Such pumps have a wide variety of applications in oil and gas production and refining, chemical and petrochemical processing, marine, sugar, agricultural, mining and mineral processing, utilities and general industry. Registrant's consolidated statements of earnings include net revenues for the Pump businesses transferred to Ingersoll-Dresser Pump Company of $517.5 million for eleven months for 1992 and $553.1 million for 1991. Registrant's Mono Pump operations produce progressing cavity pumps for handling viscous fluids. Power Systems. Registrant's Waukesha Engine Division produces heavy-duty reciprocating gas and diesel engines and packaged engine driven generator sets. Roots, the developer of the rotary lobe blower, offers a full line of low to medium pressure air and gas handling blowers along with vacuum pumps. These include rotary lobe and screw-type positive displacement products and several turbomachinery (centrifugal) lines. The primary markets served by Roots are waste water treatment, pneumatic conveying, paper, chemical and general industrial. Control Products. Control products encompass an assortment of sensing, indicating, transducing, transmitting and controlling devices. Instruments, valves and meters sold under registered trademarks - ASHCROFT, CONSOLIDATED, DEWRANCE, DURAGAUGE, DURATEMP, DURATRAN, EBRO, HANCOCK, HEISE, MASONEILAN and WILLY - measure and control pressure, temperature, level and flow of liquids and gases. These products are sold primarily to the process, power and gas distribution industries. Specialty products include gas meters, pipe fittings, couplings and repair devices for sale to the gas and water utilities and other industrial markets under the registered DRESSER trademark. Marketing Systems. Registrant manufactures and sells a variety of gasoline and diesel fuel dispensing systems and automated control systems under the Wayne trade name. ENGINEERING SERVICES Registrant's wholly owned subsidiary, The M. W. Kellogg Company, provides engineering, construction and related services, primarily to the hydrocarbon process industries. Sales and service revenues for The M.W. Kellogg Company were $1,209.3 million, $1,558.8 million, and $1,594.2 million for 1993, 1992 and 1991 respectively. BACKLOG The backlog of unfilled orders at October 31, 1993, 1992 and 1991 is included in Management's Discussion and Analysis on page 18. SALES AND DISTRIBUTION Registrant's products and services are marketed through various channels. In the United States, sales are generally made through a group or division sales organization or through independent distributors. Sales in Canada are usually effected through a division of a Canadian subsidiary. Sales in other countries are made directly by a United States division or subsidiary, through foreign subsidiaries or affiliates, and through distributor arrangements or with the assistance of independent sales agents. COMPETITION AND ECONOMIC CONDITIONS Dresser's products are sold in highly competitive markets, and its sales and earnings can be affected by changes in competitive prices, fluctuations in the level of activity in major markets, or general economic conditions. FOREIGN OPERATIONS Registrant maintains manufacturing, marketing or service facilities serving more than 75 foreign countries. Global distribution of products and services is accomplished through more than 290 subsidiary and affiliated companies engaged in various production, manufacturing, service, and marketing functions, and through foreign representatives serving the principal market areas of the world. The Information by Geographic Area is included in Note P to Consolidated Financial Statements on pages 50-52. Registrant's foreign operations are subject to the usual risks which may affect such operations. Such risks include unsettled political conditions in certain areas, exposure to possible expropriation or other governmental actions, operating in highly inflationary environments, and exchange control and currency problems. RESEARCH, DEVELOPMENT AND PATENTS Registrant's divisions, subsidiaries and affiliates conduct research and development activities in laboratories and test facilities within their particular fields for the purposes of improving existing products and developing new ones to meet the needs of their customers. In addition, research and development programs are directed toward development of new products and services for diversification or expansion. For the fiscal years ended October 31, 1993, 1992 and 1991, Registrant spent $81.5 million, $11 million and $9.4 million, respectively, for research and development activities. At December 1, 1993, Registrant and its subsidiaries and affiliates owned 1,536 patents and had pending 503 patent applications, covering various products and processes. They also were licensed under patents owned by others. Registrant does not consider that any patent or group of patents relating to a particular product or process is of material importance when judged from the standpoint of Registrant's total business. EMPLOYEES As of October 31, 1993, Registrant had approximately 15,700 employees in the United States (a decrease of approximately 12% from October 31, 1992), of whom approximately 5,500 were members of 10 unions represented by 21 bargaining units. As of the same date, Registrant had approximately 10,200 employees at foreign locations of whom approximately 4,500 were members of unions. During fiscal 1993, Registrant experienced one strike which lasted for 44 days. Relations between Registrant and its employees are generally considered to be satisfactory. EXECUTIVE OFFICERS OF REGISTRANT The names and ages of all executive officers of Registrant, all positions and offices with Registrant presently held by each person named and their business experience during the last five years are stated below: Principal Occupation During --------------------------- Name, Age and Position Past Five Years ---------------------- --------------- OFFICER EMPLOYED BY JOINT VENTURE COMPANY All officers are elected annually by the Board of Directors at a meeting following the Annual Meeting of Shareholders. The officers serve at the pleasure of the Board of Directors and can be removed at any time by the Board. Item 2.

Item 2. Properties - ------ ---------- Registrant, together with its subsidiaries and affiliates, has more than 65 manufacturing plants, ranging in size from approximately 3,000 square feet to in excess of 980,000 square feet and totaling more than 10.8 million square feet, located in the United States, Canada, and various other foreign countries. The majority of the manufacturing sites are owned in fee. In addition, sales offices, warehouses, service centers and stock points are maintained, almost all in leased space, in the United States, Canada and certain other foreign countries. The properties are believed to be generally well maintained, adequate for the purposes for which they are used, and capable of supporting a higher level of market demand. During fiscal 1993 M-I Drilling Fluids Company also had 24 grinding and/or other facilities for beneficiating mineral ores, containing approximately 287 acres in plant site property. The following are the locations of the principal facilities of Registrant and its majority owned joint ventures for each industry segment as of October 31, 1993. - ---------------- (1) all or a portion of these facilities are leased. M-I Drilling Fluids Company, a partnership in which Registrant has a 64% interest, has mineral rights to proven and prospective reserves of barite, bentonite and lignite. Such rights included leaseholds and mining claims and property owned in fee. The principal deposit of barite is located in Nevada, with deposits also located in Ireland and Scotland. Reserves of bentonite are located in Wyoming and Greece. Based on the number of tons of each of the above minerals mined in fiscal 1993, M-I Drilling Fluids Company estimates its reserves, which it considers to be proven, to be sufficient for operation for a period of 15 years or more. Registrant has an undivided one-half interest in lead deposits located in Missouri. The lead ore is mined and concentrated under contract with Cominco American Incorporated, a U. S. subsidiary of Cominco Ltd., a Canadian company, as Operator. Based on recent assessment by the Operator, measured and indicative reserves total approximately 2.75 million tons grading 8.32% lead, 1.21% zinc and 0.27% copper. A reduced production, remnant mining phase began in 1993. Reduced grade of ore produced in recent months and the depressed price of lead and zinc have combined to limit projected mine life to the second half of 1994. Item 3.

Item 3. Legal Proceedings. - ------ ----------------- The Company is involved in various legal proceedings. Information called for by this Item is included in Note L to the Consolidated Financial Statements on pages 41-44. Item 4.

Item 4. Submission of Matters to a Vote of Security Holders. - ------ --------------------------------------------------- No matters were submitted to a vote of the Company's security holders during the quarter ended October 31, 1993. PART II Item 5.

Item 5. Market for the Registrant's Common Equity and Related Stockholder - ------ ----------------------------------------------------------------- Matters. ------- Registrant is listed on the New York and Pacific Stock Exchanges. The stock symbol is DI. The quarterly market prices for Registrant's Common Stock, traded principally on the New York Stock Exchange, were as follows for the two most recent fiscal years: Dividends on Registrant's Common Stock are declared by the Board of Directors and normally paid to shareholders as of the record date during the third week of March, June, September and December. The cash dividends paid per share of common stock for the first quarter of fiscal 1993 and for the 1993 and 1992 fiscal years were: As of January 25, 1994, there were approximately 25,700 shareholders of the Registrant's Common Stock. Item 6.

Item 6. Selected Consolidated Financial Data - ------- ------------------------------------ The following selected consolidated financial data should be read in conjunction with the consolidated financial statements and notes thereto included in this report. Item 7.

Item 7. Management's Discussion and Analysis of Financial - ------- ------------------------------------------------- Condition and Results of Operations ----------------------------------- Results of Operations 1993 Compared to 1992 - ------------------------------------------- Earnings from continuing operations in 1993 increased $57 million to $127 million. The increase is attributable to the acquisition of Bredero Price, improved earnings in Oilfield Services and Engineering Services operations and changes implemented to reduce costs associated with retiree medical benefit plans. Revenues increased from $3.8 billion to $4.2 billion. The consolidation of Dresser-Rand's financial statements in 1993 was the primary reason for the increase. In 1992, Dresser-Rand was accounted for using the equity method. Earnings from operations were $219 million in 1993 compared to $126 million in 1992. Both 1993 ($74.1 million) and 1992 ($70.0 million) included Special Charges. The 1993 charge was primarily due to the settlement of the Parker & Parsley litigation ($65 million) while in 1992 the charges were mainly attributable to restructuring, particularly the Ingersoll-Dresser Pump joint venture. Excluding the Special Charges, Earnings from Operations were $293 million in 1993 and $196 million in 1992. In 1993, Earnings from Operations included 100% of Dresser-Rand's results, which added $46 million compared to 1992. In addition, the Company and its joint ventures amended retiree medical benefit plans, thereby reducing the related 1993 expense by some $26 million compared to 1992. Also during 1993, Ingersoll-Dresser Pump Company Results of Operations 1993 Compared to 1992 (Continued) - ------------------------------------------------------- sold the inventory the Company contributed to the joint venture, allowing the release of the associated LIFO inventory reserves of $21 million. This gain is reflected as a component of the earnings from the joint venture. See the Industry Segment Analysis beginning on page 15 for a discussion of the results for each segment. Other income increased from $18 million in 1992 to $32 million in 1993 because of a $13 million gain resulting from a plan change in retiree medical benefits for younger employees. Reduced interest expense resulting from the redemption of sinking fund debentures in 1992 was offset by interest on debt incurred to finance acquisitions. The effective tax rate declined to 33% in 1993 from 45% in 1992 as a result of reduced losses in foreign countries with no tax benefit, increased utilization of foreign tax credits and a $9 million benefit associated with a change in the tax rate from 34% to 35%. The consolidation of Dresser-Rand in 1993 resulted in an increase in minority interest representing our partner's 49% share of Dresser-Rand's earnings. Results of Operations 1992 Compared to 1991 - ------------------------------------------- Earnings from continuing operations were $70 million in 1992, down from $132 million in 1991. The decrease reflected the after-tax special charge of $50 million for restructuring and the increased expense for retiree medical benefits of $21 million net of tax. Revenues declined to $3.8 billion from $4.0 billion in 1991, with slightly lower revenues in each segment accounting for the reduction. Earnings from operations before Special Charges in 1992 of $196 million were $51 million lower than the $247 million recorded in 1991. The change in accounting for retiree medical benefits in 1992 accounted for $32 million of the reduction. See the Industry Segment Analysis beginning on page 15 for a discussion of the results for each segment. Other income amounted to $18 million in 1992 versus net expense of $2.3 million in 1991. The redemption of high rate sinking fund debentures reduced interest expense by $8 million. Also in 1992, the Company sold a partial interest in M. W. Kellogg's United Kingdom subsidiary resulting in a $15.5 million gain. The effective tax rate increased to 45% in 1992 from 38% in 1991. A reduction in utilization of foreign tax credits and increased foreign losses with no corresponding tax benefit caused the increase. Results of Operations 1992 Compared to 1991 (Continued) - ------------------------------------------------------- In 1992, the Company spun-off its industrial products operations (INDRESCO) and made the decision to dispose of its Environmental Products business. The results of these operations are reflected as Discontinued Operations in the 1992 and 1991 financial statements. In 1992, the Company adopted two new accounting standards relating to retiree medical benefits and income taxes. The combined net effect of these changes was a one time non-cash charge of $394 million or $2.91 per share, which is reflected as the Cumulative Effect of Accounting Changes in the 1992 Statement of Earnings. Legal and Environmental Matters - ------------------------------- During 1993, the Company settled litigation involving Parker & Parsley for a cash payment of $58 million. See Note L - Commitments and Contingencies for further discussion of this settlement and other pending legal matters. Note L also includes disclosure of environmental clean-up situations in which the Company is involved. Cash Flow and Financial Position - -------------------------------- Dresser's overall financial position remains strong at October 31, 1993. During 1993, the Company redeemed the last of its 11-3/4% debentures and issued $300 million of 6.25% Notes due 2000. The ratio of debt to total capitalization was 36%, which is consistent with the Company's objective of 35% debt and 65% equity. Available cash and short-term credit lines, combined with cash provided by operations, should be adequate to finance known requirements. Cash provided by operations before payments associated with the Parker & Parsley settlement of $58 million was adequate to cover capital expenditures of $140 million and dividends of $82 million. The proceeds from the $300 million of 6.25% Notes issued during the year, together with $200 million of commercial paper borrowings, was used to finance the acquisition of Bredero Price and TK Valve ($267 million), repay long-term debt ($80 million) and pay the settlement of the Parker & Parsley litigation ($58 million). Capital expenditures increased in 1993 by $51 million to $140 million. Most of the increase was due to the consolidation of Dresser-Rand in 1993. Dresser- Rand's capital expenditures amounted to $58 million in 1993 compared to the Pump Operations capital expenditures of $13 million in 1992. Capital expenditures planned for 1994 approximate $140 million. Industry Segment Analysis - ------------------------- See details of financial information by Industry Segment on pages 18 to 20. Oilfield Services Segment - ------------------------- Consolidated revenues in 1993 included $209 million from the operations of Bredero Price and TK Valve, which were acquired in early 1993. Excluding revenues of the acquired operations, segment revenues in 1993 were essentially unchanged from 1992. The favorable impact of higher North American drilling activity on the sales volume of M-I Drilling Fluids (owned 64% by Dresser), Guiberson AVA Division and Security Division was substantially offset by the impact of lower international drilling activity. Excluding the operating profit of Bredero Price and TK Valve, 1993 operating profit of consolidated operations increased $16 million or 93% over 1992. Higher M-I Drilling Fluids profit reflected higher domestic sales volume and the benefit of operating cost reductions for a full year. Operating profit improved in both the Security and Guiberson AVA divisions. Oilfield Services results in 1992 were significantly affected by lower U.S. drilling activity compared to 1991. Consolidated revenues were down 13% from 1991, resulting in operating profit $45 million under 1991. Operating expense reductions made during 1992 only partly offset the impact of lower sales volume in M-I Drilling Fluids, Security Division and Guiberson AVA Division. In 1992, special charges of $17 million were recorded for restructuring to reduce consolidated oilfield services operations to a size appropriate to the lower level of domestic exploration, drilling and production activity. Western Atlas International, owned 29.5% by Dresser, benefited from better North American activity and continuing expanded international markets in 1993. On 10% lower revenues, the Company's share of operating profit increased to $39 million or 11% from 1992, which showed a similar increase over 1991. The Company has agreed to sell its interest in Western Atlas International to the majority partner in early 1994 for $558 million. The merger of Dresser with Baroid, a worldwide supplier of oilfield services and equipment with sales of $850 million, will significantly expand the Company's range of products and services to Oilfield customers. See Note R to Consolidated Financial Statements for information which gives effect to the merger. Industry Segment Analysis (Continued) - ------------------------------------- Hydrocarbon Processing Industry Segment - --------------------------------------- Changes in ownership and the formation of a major joint venture have significantly affected the comparison of revenues and operating profit in the Hydrocarbon Processing Segment. Dresser increased its ownership in Dresser-Rand Company from 50% to 51% as of October 1, 1992. As a result, Dresser-Rand is included as a consolidated subsidiary in 1993 and as a major joint venture in 1992 and 1991. Ingersoll-Dresser Pump Company was formed as of October 1, 1992 with Dresser owning 49%. Ingersoll-Dresser Pump is included as a major joint venture in 1993. Dresser's Pump business, which was transferred to Ingersoll- Dresser Pump, is included as consolidated Pump Operations in 1992 and 1991. Revenues for 1993 of consolidated operations other than Dresser-Rand and Pump Operations decreased 4% from 1992. A 12% decrease in sales in the Valve and Controls Division was primarily due to depressed market conditions in key international markets and to the strength of the dollar compared to other currencies. Operating profit of the consolidated operations other than Dresser-Rand and Pump Operations of $128 million was 2% under 1992. A strong performance in 1993 by the Wayne Division with earnings up $15 million from 1992 offset a 23% decline for Valve and Controls. Earnings in international markets, principally Europe, were down in 1993 compared to the prior year. Also, inventory reductions in 1992, which resulted in a favorable LIFO impact of $9 million, did not recur in 1993. In 1992, consolidated sales excluding Dresser-Rand and Pump Operations were down slightly from 1991 with no significant changes in any one division. Earnings in 1992 increased $13 million compared to 1991. Strong earnings for the Wayne Division, improvements in the Instrument and Valve and Controls divisions and the LIFO benefit referred to above were the primary reasons for the increase. Dresser-Rand, reported as a consolidated operation in 1993, had sales of $1.1 billion, which were 13% lower than in 1992. In 1992, sales which were not included in Dresser's consolidated revenues increased from $1.2 billion in 1991 to $1.3 billion. Operating profit for each of the last three years was $90 million in 1993, $86 million in 1992 and $94 million in 1991. Expenses associated with the change in accounting for retiree medical costs reduced earnings by $14 million and $20 million in 1993 and 1992, respectively, compared to 1991. Industry Segment Analysis (Continued) - ------------------------------------- Hydrocarbon Processing Industry Segment (Continued) - --------------------------------------------------- Ingersoll-Dresser Pump Company operated at break-even in 1993, as the joint venture with Ingersoll-Rand rationalized the operations of the two former separate businesses. Also a significant portion of the joint venture's market is the European Community, which was in the midst of a recession in 1993. Operating profit for 1993 consists primarily of a $21 million release of LIFO inventory reserves related to inventory contributed to the joint venture by the Company, which was sold to third parties during the year. The Company's separate Pump Operations contributed earnings of $32 million and $36 million in 1992 and 1991, respectively. Special charges of $7 million were recorded in 1993 related to plant closing and other restructuring in the Wayne and Valve and Control operations, primarily in Europe, and similar actions at Dresser-Rand. In 1992, special charges related to the restructuring of Pump Operations ($35 million) and restructuring and special warranty claims in other Hydrocarbon Processing operations ($14 million). Engineering Services Segment - ---------------------------- Revenues in 1993 of $1.2 billion decreased 22% from 1992. In 1992, revenues were 2% under 1991. The decline in revenues reflected reduced hydrocarbon processing activity in certain international areas and slow growth and project delays in the U.S. In 1991, revenues included a $22 million payment received by The M. W. Kellogg Company for its retained interest in a foreign project. Engineering Services operating profit in 1993 increased $8 million from 1992; in 1992 operating profit was $15 million over 1991. In 1992, M. W. Kellogg realized a $15 million gain from the sale of a partial interest in its U.K. subsidiary. Operating profit in 1991 included the $22 million in revenue for the retained interest in a foreign project. Increased operating profit on lower revenues is due to enhanced gross margins on large international projects involving technologies in which M. W. Kellogg possesses expertise. Backlog of Unfilled Orders - -------------------------- INDUSTRY SEGMENT FINANCIAL INFORMATION - COVERED BY REPORT OF INDEPENDENT ACCOUNTANTS The following financial information by Industry Segment for the years ended October 31, 1993, 1992 and 1991 is an integral part of Note P to Consolidated Financial Statements. The Company increased its ownership in Dresser-Rand Company from 50% to 51% as of October 1, 1992. As a result, Dresser-Rand is included as a consolidated subsidiary in 1993 and as a major joint venture operation in 1992 and 1991. Ingersoll-Dresser Pump Company was formed as of October 1, 1992 with the Company owning 49%. Ingersoll-Dresser is included as a major joint venture investment in 1993. The Company's Pump business that was transferred to Ingersoll-Dresser is included as Pump Operations in 1992 and 1991. INDUSTRY SEGMENT FINANCIAL INFORMATION - COVERED BY REPORT OF INDEPENDENT ACCOUNTANTS (CONTINUED) INDUSTRY SEGMENT FINANCIAL INFORMATION - COVERED BY REPORT OF INDEPENDENT ACCOUNTANTS (CONTINUED) Item 8.

Item 8. Financial Statements and Supplementary Data - ------- ------------------------------------------- Report of Management The consolidated financial statements of Dresser Industries, Inc. have been prepared by management and have been audited by independent accountants. The management of the Company is responsible for the financial information and representations contained in the financial statements and other sections of this Annual Report on Form 10-K. Management believes that the financial statements have been prepared in conformity with generally accepted accounting principles appropriate under the circumstances to reflect, in all material respects, the substance of events and transactions that should be included. In preparing the financial statements, it is necessary that management make informed estimates and judgments based on currently available information of the effects of certain events and transactions. In meeting its responsibility for the reliability of the financial statements, management depends on the Company's internal control structure. This internal control structure is designed to provide reasonable assurance that assets are safeguarded and transactions are executed in accordance with management's authorization and are properly recorded. In designing control procedures, management recognizes that errors or irregularities may occur. Also, estimates and judgments are required to assess and balance the relative cost and expected benefits of the controls. Management believes that the Company's internal control structure provides reasonable assurance that errors or irregularities that could be material to the financial statements are prevented or would be detected within a timely period by employees in the normal course of performing their assigned functions. The Board of Directors pursues its oversight role for the accompanying financial statements through its Audit and Finance Committee, which is composed solely of directors who are not officers or employees of the Company. The Committee meets with management and the internal auditors to review the work of each and to monitor the discharge by each of its responsibilities. The Committee also meets with the independent accountants and internal auditors, without management present, to discuss internal control structure, auditing and financial reporting matters. REPORT OF INDEPENDENT ACCOUNTANTS To the Board of Directors and Shareholders of Dresser Industries, Inc. In our opinion, the consolidated financial statements listed in the index appearing under Item 14(A)(1) and (2) and 14(D) on page present fairly, in all material respects, the financial position of Dresser Industries, Inc. and its subsidiaries at October 31, 1993 and 1992, and the results of their operations and their cash flows for each of the three years in the period ended October 31, 1993, in conformity with generally accepted accounting principles. These financial statements are the responsibility of the Company's management; our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits of these statements in accordance with generally accepted auditing standards which require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for the opinion expressed above. As discussed in Notes A, G and M to the consolidated financial statements, the Company adopted Statement of Financial Accounting Standards No. 106, Employers' Accounting for Postretirement Benefits Other than Pensions, and Statement of Financial Accounting Standards No. 109, Accounting for Income Taxes, both effective as of November 1, 1991. /s/ Price Waterhouse PRICE WATERHOUSE Dallas, Texas December 9, 1993 CONSOLIDATED STATEMENTS OF EARNINGS (LOSS) See Accompanying Notes to Consolidated Financial Statements. CONSOLIDATED BALANCE SHEETS See Accompanying Notes to Consolidated Financial Statements. CONSOLIDATED BALANCE SHEETS See Accompanying Notes to Consolidated Financial Statements. CONSOLIDATED STATEMENTS OF SHAREHOLDERS' INVESTMENT See Accompanying Notes to Consolidated Financial Statements. CONSOLIDATED STATEMENTS OF CASH FLOWS See Accompanying Notes to Consolidated Financial Statements. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Note A - Summary of Significant Accounting Policies - ------------------------------------------------------------------------------- Consolidation - ------------- All majority-owned subsidiaries are consolidated and all material intercompany accounts and transactions are eliminated. Investments in 20% to 50% owned partnerships and affiliates are reported at cost adjusted for the Company's equity in undistributed earnings. Revenue Recognition - ------------------- Revenues and earnings from long-term construction contracts are recognized on the percentage-of-completion method, measured generally on a cost incurred basis. Estimated contract costs include allowances for completion risks, process and schedule guarantees and warranties that generally are not finally determinable until the latter stages of a contract. Estimated contract earnings are reviewed and revised periodically as the work progresses. The cumulative effect of any estimated loss is charged against earnings in the period in which such losses are identified. Revenues from sale of products other than from long-term construction contracts are recorded when the products are shipped. Inventories - ----------- Inventories are valued at the lower of cost or market. The cost of most U.S. inventories produced by divisions of the Parent Company and wholly-owned subsidiaries is determined using the last-in, first-out (LIFO) method. The valuation of inventories not on LIFO, principally foreign inventories and inventories of consolidated joint venture companies, is determined using either the first-in, first-out (FIFO) or average cost method. Property, Plant and Equipment - ----------------------------- Fixed assets are depreciated over the estimated service life. Most assets are depreciated on a straight-line basis. Certain assets with service lives of more than 10 years are depreciated on accelerated methods. Accelerated depreciation methods are also used for tax purposes, wherever permitted. Due to the large number of asset classes, it is not practicable to state the rates used in computing the provisions for depreciation. Maintenance and repairs are expensed as incurred. Betterments are capitalized. Intangibles - ----------- The difference between purchase price and fair values at date of acquisition of net assets of businesses acquired is amortized on a straight-line basis over the estimated periods benefited, not exceeding 40 years. Note A - Summary of Significant Accounting Policies (Continued) - --------------------------------------------------- --------------------------- Postretirement Benefits - ----------------------- Effective November 1, 1991, postretirement benefits other than pensions are accounted for in accordance with Statement of Financial Accounting Standards No. 106, Employers' Accounting for Postretirement Benefits Other than Pensions (SFAS 106). Under SFAS 106, the Company accrues the estimated cost of these benefits during the employees' active service period. The Company previously expensed the cost of these benefits as claims and premiums were paid. See Note M for additional information. Income Taxes - ------------ Effective November 1, 1991, income taxes are accounted for in accordance with Statement of Financial Accounting Standards No. 109, Accounting for Income Taxes (SFAS 109). Under SFAS 109, the Company accounts for income taxes by the asset and liability method. Previously the Company deferred the tax effects of timing differences between financial reporting and taxable income. The asset and liability method requires the recognition of deferred tax assets and liabilities for the future tax consequences of temporary differences between the financial statement basis and the tax basis of assets and liabilities. Taxes on the minority interest's share of domestic partnership earnings of consolidated entities are provided at the Company's effective domestic tax rate. See Note G for additional information. Translation of Foreign Currencies - --------------------------------- For subsidiaries in countries which do not have highly inflationary economies, asset and liability accounts are translated at rates in effect at the balance sheet date, and revenue and expense accounts are translated at rates approximating the actual rates on the dates of the transactions. Translation adjustments are included as a separate component of shareholders' investment. For subsidiaries in countries with highly inflationary economies, inventories, cost of sales, property, plant and equipment and related depreciation are translated at historical rates. Other asset and liability accounts are translated at rates in effect at the balance sheet date, and revenues and expenses excluding cost of sales and depreciation are translated at rates approximating the actual rates on the dates of the transactions. Translation adjustments are reflected in the statement of earnings. Financial Instruments - Fair Value and Off-Balance-Sheet Risk - ------------------------------------------------------------- The carrying amounts of cash and cash equivalents, short-term investments and accounts and notes payable approximate fair value because of the short maturity of those instruments. The carrying amount of long-term debt is approximately equal to fair value based on market information. Note A - Summary of Significant Accounting Policies (Continued) - --------------------------------------------------- --------------------------- Financial Instruments - Fair Value and Off-Balance-Sheet Risk (Continued) - ------------------------------------------------------------------------- The Company has cash and cash equivalents held in currencies other than local currencies, and receivables and payables to be settled in currencies other than local currencies. These financial assets and liabilities create exposure to potential foreign exchange gains and losses arising on future changes in currency exchange rates. The Company protects against such risks by entering into forward exchange contracts. The Company does not engage in speculation, nor does the Company typically hedge nontransaction-related balance sheet exposure. At October 31, 1993, the Company had $237 million of forward exchange contracts outstanding, 98% of which were in European currencies. The fair value of foreign exchange contracts is based on year-end quoted rates for contracts with similar terms and maturity dates. However, such fair values are offset by gains and losses on the assets and liabilities hedged by such contracts, so that there is no significant difference between the recorded value and fair value of the Company's net foreign exchange position. Reclassification of Prior Years - ------------------------------- Prior years' financial statements have been reclassified to conform to 1993 presentations. Note B - Cash Flow Statement - ------------------------------------------------------------------------------- Cash and cash equivalents include cash on hand and investments with maturities of three months or less at time of original purchase. Supplemental information about cash payments and significant noncash investing and financing activities is as follows (in millions): Note C - Major Unconsolidated Joint Ventures - ------------------------------------------------------------------------------- Ingersoll-Dresser Pump Company Effective October 1, 1992, the Company and Ingersoll-Rand Company formed a joint venture comprised of the pump businesses of the two companies including all standard and engineered pump operations except the Company's Mono Pump subsidiaries. The new company, Ingersoll-Dresser Pump Company, is a general partnership owned 49% by the Company and 51% by Ingersoll-Rand Company. The Company contributed approximately $151 million of net assets, including reserves for restructuring and retiree benefits other than pensions, in exchange for its ownership interest. The operating results of the contributed Dresser Pump business prior to October 1, 1992 are fully consolidated in the Company's statement of earnings. The Company's share of operating results for the month of October, 1992 and all of 1993 are included in earnings from major joint ventures. Summarized financial information is as follows (in millions): The Company's share of pre-tax earnings includes $21.3 million from the release of LIFO inventory valuation reserves related to inventory contributed to the joint venture by the Company and sold by Ingersoll-Dresser Pump Company to third parties. Note C - Major Unconsolidated Joint Ventures (Continued) - ------------------------------------------------------------------------------- In connection with the Ingersoll-Dresser Pump Company joint venture agreement, the Company granted to Ingersoll-Rand Company an option to purchase 51% of the stock of Mono Group Limited for a price equal to 51% of its book value, including the unamortized goodwill, at the exercise date. The option period begins October 1, 1994, and expires April 30, 1995. If the option to purchase is exercised by Ingersoll-Rand Company, both Ingersoll-Rand and the Company have agreed to contribute their respective Mono Group Limited shares to the Ingersoll-Dresser Pump Company as a contribution of capital to the partnership. Western Atlas International, Inc. - --------------------------------- Western Atlas International, Inc. is a joint venture that was formed May 1, 1987 when the Company and Litton Industries combined their respective Atlas Wireline division and Western Geophysical division. On December 8, 1993, the Company announced an agreement to sell its 29.5% interest in Western Atlas International, Inc. to a wholly-owned subsidiary of Litton Industries. See Note R for additional information. Summarized financial information is as follows (in millions): Note C - Major Unconsolidated Joint Ventures (Continued) - ------------------------------------------------------------------------------- Dresser-Rand Company - -------------------- The Company owned 50% of Dresser-Rand from its inception on January 1, 1987 through September 30, 1992. Effective October 1, 1992, the Company acquired an additional 1% ownership interest. Since the Company now owns 51% of Dresser- Rand, it is included as a fully consolidated subsidiary with a 49% minority interest for 1993. Summarized financial information for the periods when equity accounting was applied is as follows (in millions): Note D - Business Combinations - ------------------------------------------------------------------------------- Effective February 1, 1993 the Company acquired all the outstanding stock of Bredero Price Holding B.V., a Netherlands corporation, from Koninklijke Begemann Groep N.V. for approximately $161.5 million in cash. Bredero Price is a multinational company that provides pipe coating for both onshore and offshore markets. Effective April 1, 1993, the Company acquired TK Valve & Manufacturing, Inc. from Sooner Pipe & Supply Corporation, Tulsa, Oklahoma for approximately $143.5 million in cash. TK Valve supplies ball valves for the oil and gas production and transmission industry. The purchase price exceeded the fair value of the net assets acquired by approximately $122 million for Bredero Price and approximately $92 million for TK Valve. Both acquisitions were accounted for as purchases. The resulting goodwill is being amortized on a straight-line basis over 40 years. The Consolidated Statement of Earnings includes the results of operations of Bredero Price from February 1, 1993 and TK Valve from April 1, 1993. Note D - Business Combinations (Continued) - ------------------------------------------------------------------------------- The following unaudited pro forma summary presents information as if the acquisitions had occurred at the beginning of each fiscal year. The pro forma information is provided for information purposes only. It is based on historical information and does not necessarily reflect the actual results that would have occurred nor is it necessarily indicative of future results of operations of the combined enterprises (in millions except per share amounts): In 1992, the Company acquired all of the shares of AVA International Corp. (AVA) in exchange for 1.9 million shares of the Company's common stock with a value of $43.3 million and $1.9 million cash. AVA produces well completion products that are sold primarily in foreign markets. The transaction, which was accounted for as a purchase, resulted in goodwill of $39.3 million which is being amortized on a straight-line basis over 40 years. The pro forma effect of the AVA acquisition was not significant. Note E - Long-Term Contracts - ------------------------------------------------------------------------------- Consistent with industry practice, service revenues and cost of services include the value of materials, equipment and labor contracts furnished by customers and for which the Company is responsible for the ultimate acceptability of performance of the project based on such material, equipment or labor. The value of such items was $112.4 million, $114.0 million and $471.7 million for the years ended October 31, 1993, 1992 and 1991, respectively. Amounts billed in excess of revenues recognized to date are included in current liabilities under advances from customers on contracts. Note F - Inventories - ------------------------------------------------------------------------- Inventories on the LIFO method were $77.9 million and $73.9 million at October 31, 1993 and 1992, respectively. Under the average cost method, inventories would have increased by $92.2 million and $98.8 million at October 31, 1993 and 1992, respectively. Note F - Inventories (Continued) - --------------------------------------------------------------------- During 1992, the Company experienced significant quantity reductions in LIFO inventories which were carried at lower costs that prevailed in prior years. Quantity reductions reduced the cost of sales by $14.6 million and increased earnings, net of tax, by $9.5 million or $.06 per share in 1992. Inventories are stated net of progress payments received on contracts of $175.7 million and $118.9 million at October 31, 1993 and 1992, respectively. Note G - Income Taxes - ------------------------------------------------------------------------------- The Company adopted Statement of Financial Accounting Standards No. 109 (SFAS 109), Accounting for Income Taxes, as of November 1, 1991. The 1992 Statement of Earnings includes a charge of $40.8 million for the cumulative effect of the change. Prior year financial statements were not restated when SFAS 109 was adopted. The domestic and foreign components of earnings before income taxes of continuing operations consist of the following (in millions): The components of the provision for income taxes of continuing operations are as follows (in millions): Under the provisions of SFAS 109, the tax benefits of loss and credit carryforwards can be recognized in the period they arise if certain realization criteria are met. As a result of these provisions, the tax benefits attributable to approximately $40 million domestic carryforwards and $28 million of foreign carryforwards were reflected as a reduction in the 1992 cumulative effect charge referred to above. Note G - Income Taxes (Continued) - --------------------------------------------------------------------- The 1991 current taxes of $103.2 contain a charge of $5.6 million equivalent to income taxes which would have been incurred had net operating loss carryforwards not been available. The income tax benefits resulting from utilizing the operating loss carryforwards are presented as an extraordinary item in 1991. Since the Company plans to continue to finance foreign operations and expansion through reinvestment of undistributed earnings of its foreign subsidiaries (approximately $537 million at October 31, 1993), no provisions are generally made for U.S. or additional foreign taxes on such earnings. When the Company identifies exceptions to the general reinvestment policy, additional taxes are provided. The following is a reconciliation of income taxes at the U.S. Federal income tax rate (34.8% for 1993 and 34% for 1992 and 1991) to the provision for income taxes for continuing operations reflected in the Consolidated Statements of Earnings (in millions): Note G - Income Taxes (Continued) - ------------------------------------------------------------------- Deferred income tax benefits result from the recognition of temporary differences. Temporary differences are differences between the tax bases of assets and liabilities and their reported amounts in the financial statements that will result in differences between income for tax purposes and income for financial statement purposes in future years. The deferred income tax provisions (credits) related to the following (in millions): The components of the net deferred tax asset as of October 31, 1993, were as follows (in millions): At October 31, 1993, the Company had foreign operating loss carryforwards of approximately $54 million that had not been benefited. The tax benefit of these losses is recorded as a deferred tax asset and offset with a corresponding valuation allowance. These losses are available to reduce the future tax liabilities of their respective foreign entity. Approximately $42 million of these losses will carryforward indefinitely while the remaining amounts expire at various dates from 1994 to 2002. The net change of $4.2 million in the valuation allowance for deferred tax assets related all to changes in foreign loss carryforwards. Note H - Short-Term Debt - ------------------------------------------------------------------ Short-term debt at October 31, 1993 consisted of $216 million of domestic commercial paper maturing on December 31, 1993 and $13.5 million of primarily foreign bank loans. The Company has short-term committed bank lines of credit totalling $250 million of which $216.0 million support commercial paper. Such lines provide for borrowings at the prevailing interest rates. The lines of credit may be used by the Company and certain foreign subsidiaries, and include Eurodollars and foreign currencies. The lines of credit may be terminated at the option of the banks or the Company. Loan arrangements have been established with banks outside the United States, under which the Company's foreign subsidiaries may borrow on an overdraft and short-term note basis. At October 31, 1993, the amount available and unused under these arrangements aggregated $114.2 million. Note I - Long-Term Debt - ------------------------------------------------------------------ Long-term debt is summarized as follows (in millions): In June 1993, the Company made a public offering of debt securities in the form of $300.0 million of 6.25% Notes due 2000 from which the Company received $298.2 million in proceeds. The proceeds were used to retire short-term debt that was issued to acquire Bredero Price Holding B.V. and TK Valve & Manufacturing, Inc. (See Note D). The interest is payable semi-annually on May 15 and November 15. During 1992 the Company redeemed $133.1 million of Sinking Fund Debentures at redemption prices ranging from 100% to 106% of principal amount. On November 2, 1992, the Company redeemed the remaining $62.5 million in principal amounts of its 11 3/4% Sinking Fund Debentures due 2007 at a redemption price of 105.68%. The resulting loss was accrued as of October 31, 1992. The $9.8 million total losses on the debenture redemptions above are reported net of taxes of $3.5 million as an extraordinary loss in the 1992 Statement of Earnings. Note J - Employee Incentive Plans - ------------------------------------------------------------------------------- Stock Compensation Plan - ----------------------- The Company's shareholders have approved the 1992 Stock Compensation Plan which includes a Stock Option Program, a Restricted Incentive Stock Program and a Performance Stock Unit Program. The Stock Option Program provides for the granting of options to officers and key employees for purchase of the Company's common shares. The Plan is administered by the Executive Compensation Committee of the Board of Directors, whose members are not eligible for grants under the Plan. No option can be for a term of more than ten years from date of grant. The option price is recommended by the committee, but cannot be less than 100% of the average of the high and low prices of the shares on the New York Stock Exchange on the day the options are granted. The exercise price for options granted during 1993 increases on the annual anniversary dates of grant. Changes in outstanding options during the three years ended October 31, 1993 and options exercisable at October 31, 1993 are as follows: Shares reserved for granting of future options under the 1992 plan were 8,814,762 shares at October 31, 1993. Deferred Compensation Plan - -------------------------- Under the Deferred Compensation Plan, a portion of the incentive compensation for officers and key employees can be deferred in the form of common stock units or in cash for payment after retirement or termination of employment. Payments are made either in common shares of the Company or in cash at the equivalent market value of the common stock units at the option of the employee. Deferred compensation was $38.9 million at October 31, 1993 and $39.8 million at October 31, 1992. Note K - Capital Shares - ------------------------------------------------------------------------------- Changes in issued common shares during the three years ended October 31, 1993 are as follows: Changes in common shares held in treasury during the three years ended October 31, 1993 are as follows: Preferred Stock Purchase Rights - ------------------------------- In 1990, the Company issued one new Preferred Stock Purchase Right for each outstanding share of the Company's Common Stock. The Rights will expire in 2000 unless they are redeemed earlier. The Rights will generally not be exercisable until after 10 days (or such later time as the Board of Directors may determine) from the earlier of a public announcement that a person or group has, without Board approval, acquired beneficial ownership of 15% or more of the Company's Common Stock or the commencement of, or public announcement of an intent to commence, a tender or exchange offer which, if successful, would result in the offeror acquiring 30% or more of the Company's Common Stock. Once exercisable, each Right would entitle its holder to purchase 1/100 of a share of the Company's Series A Junior Preferred Stock at an exercise price of $90, subject to adjustment in certain circumstances. If the Company is acquired in a merger or other business combination not previously approved by the Company's Continuing Directors, each Right then exercisable would entitle its holder to purchase at the exercise price that number of shares of the surviving company's common stock which has a market value equal to twice the Right's exercise price. In addition, if any person or group (with certain exceptions) were to acquire beneficial ownership of 15% or more of the Company's Common Stock (unless pursuant to a transaction approved by the Company's Continuing Directors), each Right would entitle all rightholders, other than the 15% stockholder or group, to purchase that number of Series A Junior Preferred Stock having a market value equal to twice the Right's price. Note K - Capital Shares (Continued) - ------------------------------------------------------------------------------- Preferred Stock Purchase Rights (Continued) - ------------------------------------------- The Rights may be redeemed by the Company for $.01 per Right until the tenth day after a person or group has obtained beneficial ownership of 15% or more of the Company's Common Stock (or such later date as the Continuing Directors may determine). The Rights are not considered to be common stock equivalents because there is no indication that any event will occur which would cause them to become exercisable. Note L - Commitments and Contingencies - ------------------------------------------------------------------------------- Parker & Parsley Litigation - --------------------------- The Company was involved in litigation brought by Parker & Parsley Petroleum Company and related plaintiffs in 1989. On April 19, 1993, the Company entered into an agreement in principle to settle with the plaintiffs in the Parker & Parsley litigation, whereby the Company, without admitting any wrong doing, agreed to pay $57.5 million to settle all current and future claims brought forth by the plaintiffs. The settlement was paid on May 26, 1993. Legal actions arising from the same facts filed by Glyn Snell, et. al., and working interest owners who did not participate in the Parker & Parsley case (Texas Ten vs. Dresser et. al.) remain outstanding. The Company recorded a Special Charge of $65.0 million in 1993 to cover the Parker & Parsley settlement, legal fees and other expenses related to the Parker & Parsley litigation, the Glyn Snell, et. al. litigation, and the working interest owners litigation. The Company believes that it has insurance coverage for the amounts that it has paid or will pay pursuant to the above-described settlement of the litigation, and in fact $13.5 million has been received from certain insurance carriers. However, other insurance carriers have denied coverage, and the Company is engaged in litigation with these carriers seeking recovery of the costs and expenses incurred by the Company in the defense and settlement of the litigation. The Company's claim includes the $57.5 million settlement, as well as all unreimbursed costs and expenses incurred by the Company in defending the action. The insurance carriers had previously sued seeking a declaration that the claims asserted by the Company are not covered by the relevant insurance policies. The carrier's action has been abated in favor of the action brought by the Company. Discovery in the action is proceeding. Trial is currently scheduled for April, 1994. The Company also believes it has insurance coverage with respect to claims made in the suits brought by royalty owners and working interest owners. The amount and timing of any recoveries from the insurance carriers cannot be determined with certainty. Any recoveries will be recognized when amounts can be determined with certainty. Note L - Commitments and Contingencies (Continued) - ------------------------------------------------------------------------------- Asbestosis Litigation - --------------------- The Company has approximately 42,800 pending claims (approximately 12,000 filed in 1993) in which it is alleged that third parties sustained injuries and damages resulting from inhalation of asbestos fibers used in products manufactured by the Company and its predecessor companies. The Company has never been a miner or processor of asbestos but did produce a few refractory products that contained some asbestos. Approximately 50% of the pending claims allege injury as a result of exposure to such products, while the other 50% of the claimants allege injury as a result of exposure to asbestos gaskets and packings used in other products manufactured by the Company. Since 1976, the Company has tried, settled or summarily disposed of approximately 13,000 such claims for a total cost of $29 million including legal fees. The Company has entered into agreements with insurance carriers with respect to such claims. Management has no reason to believe the carriers will not be able to meet their obligations pursuant to the agreements. Under the agreements, insurance covers 60%-67% of legal fees and any settlements or awards. The net cost to the Company after recoveries from the carriers has been approximately $10 million. Of the 13,000 claims settled, approximately 80% relate to cases involving refractory products. Any future refractory product claims filed are the responsibility of INDRESCO Inc. pursuant to an agreement entered into at the time of the spin-off. The Company has provided for the estimated exposure, based on past experience, for the remaining open cases involving refractory products. The Company has also provided for estimated exposure relating to non-refractory product claims. However, the Company has less experience in settling such claims. Generally when settlements have been made, the amounts involved are substantially lower than the claims involving refractory products. In 1993, the Company did sustain an adverse judgment in cases filed by employees of Ingalls Shipyard in Pascagoula, Mississippi. The Company's share of damages awarded in six cases amounted to $3.8 million plus 10% add on for punitive damages. The judgment does not conform to the Company's past experience and was not in accord with the evidence. The court has entered judgment in the case and the Company has filed the appropriate post trial motions. The court has not ruled on the motions. If relief is denied, the Company will appeal the decision. Any ultimate loss would be covered by the agreement with the insurance carriers and would not result in a net loss exceeding approximately $1 million. Management recognizes the uncertainties of litigation and the possibility that a series of adverse rulings could materially impact operating results. However, based upon the Company's historical experience with similar claims, the time elapsed since the Company discontinued sale of products containing asbestos, and management's understanding of the facts and circumstances which gave rise to such claims, management believes that the pending asbestos claims will be resolved without material effect on the Company's financial position or results of operations. Note L - Commitments and Contingencies (Continued) - ------------------------------------------------------------------------------- Quantum Chemical Litigation - --------------------------- In October 1992, Quantum Chemical Corporation ("Quantum") brought suit against the Company's wholly owned subsidiary, The M. W. Kellogg Company ("Kellogg"), alleging that Kellogg negligently failed to provide an adequate design for an ethylene facility which Kellogg designed and constructed for Quantum and fraudulently misrepresented the state of development of its Millisecond Furnace technology to be used in the facility. Quantum is seeking $200 million in actual damages and punitive damages equal to twice the actual damages claimed. Kellogg has answered denying the claim and has filed a counterclaim against Quantum alleging libel, slander, breach of contract and fraud. Discovery in the action is proceeding, and trial is set for April 11, 1994. Management believes the Quantum lawsuit is totally without merit and will be resolved without material adverse effect on the Company's financial position or results of operations. Other Litigation - ---------------- The Company and its subsidiaries are involved in certain other legal actions and claims arising in the ordinary course of business. Management recognizes the uncertainties of litigation and the possibility that one or more adverse rulings could materially impact operating results. However, based upon the nature of and management's understanding of the facts and circumstances which gave rise to such actions and claims, management believes that such litigation and claims will be resolved without material effect on the Company's financial position or results of operations. Environmental Matters - --------------------- The Company is identified as a potentially responsible party in 67 Superfund sites. Primary responsibility for eight of these sites was assumed by INDRESCO Inc. at the time of the INDRESCO spin-off in 1992 (See Note O). At three of the 67 sites, Fisher-Calo, Bio-Ecology, and Operating Industries, the Company may be responsible for remediation costs ranging between $200,000 and $1 million. The Company previously has entered into de minimis settlements in respect of several other Superfund sites. Based upon the Company's historical experience with similar claims and management's understanding of the facts and circumstances relating to the sites other than Fisher-Calo, Bio-Ecology, and Operating Industries, management believes that the other situations will be resolved at nominal cost to the Company. Other - ----- The Company and certain subsidiaries are contingently liable as guarantors of obligations aggregating approximately $200 million at October 31, 1993, of which $170.0 million were guarantees of loans to Komatsu Dresser Company, a partnership in which INDRESCO Inc. (See Note O) has an ownership interest. Obligations to guarantee loans to Komatsu Dresser Company expired November 1, 1993. The Company has no further obligations regarding Komatsu Dresser Company. Note L - Commitments and Contingencies (Continued) - ------------------------------------------------------------------------------- Other (Continued) - ----------------- Total rental and lease expense charged to earnings was $74.7 million in 1993, $66.4 million in 1992 and $73.7 million in 1991. At October 31, 1993, the aggregate minimum annual obligations under noncancelable leases were: $36.4 million for 1994; $28.4 million for 1995; $20.7 million for 1996; $11.6 million for 1997; $9.1 million for 1998; and $49.8 million for all subsequent years. The lease obligations related primarily to general and sales office space and warehouses. Note M - Postretirement and Postemployment Benefits - ------------------------------------------------------------------------------- Benefits Other than Pensions - ---------------------------- The Company sponsors a number of plans providing health and life insurance benefits for retired U.S. bargaining and non-bargaining employees meeting eligibility requirements. Although certain plans are contributory, the Company has generally absorbed the majority of the costs. The Company funds the benefit plans as claims and premiums are paid. The Company adopted Statement of Financial Accounting Standards No. 106, Employers' Accounting for Postretirement Benefit Plans Other than Pensions (SFAS 106), for its U.S. benefit plans as of November 1, 1991. The Company elected to recognize this change in accounting on the immediate recognition basis. The cumulative effect as of November 1, 1991, reflected in the Statement of Earnings for the year ended October 31, 1992 as cumulative effect of an accounting change, was as follows (in millions, except per share amount): The effects of postretirement benefits for non-U.S. employees, which supplement foreign government plans, are not significant under SFAS 106. During fiscal 1993, the Company, Dresser-Rand and Ingersoll-Dresser Pump Company adopted amendments to certain postretirement medical benefit plans, primarily the non-union plans. The major amendments included the elimination of benefits for younger employees and the introduction of limits on the amount of future cost increases which will be absorbed by the companies. These amendments resulted in a curtailment gain of $12.8 million which was recognized in 1993 and unrecognized gains of $208.3 million which will be recognized as a reduction in benefit expense on a straight line basis over the periods ranging from 12 years to 18 years. Note M - Postretirement and Postemployment Benefits (Continued) - ------------------------------------------------------------------------------- Benefits Other than Pensions (Continued) - ---------------------------------------- The liability of the U.S. plans at October 31, 1993 and 1992 was as follows (in millions): Accrued compensation and benefits on the Balance Sheet include the current portion of the benefit liability. The net periodic postretirement benefit expense for the years ended October 31, 1993 and 1992 included the following components (in millions): *Includes $14.3 million in 1993 and $20 million in 1992 for Dresser-Rand Company which was not consolidated in 1992. Assumptions used to calculate the Accumulated Postretirement Benefit Obligation were as follows: Health care trend rate (weighted based on participant count) - October 31, 1993 - 13% for 1993 declining to 5.5% in 2003 and level thereafter. October 31, 1992 - 15% for 1992 declining to 6.0% in 2006 and level thereafter. The above changes in assumptions and changes in circumstances and experience resulted in an unrecognized net loss of $(28.2) million. Note M - Postretirement and Postemployment Benefits (Continued) - ------------------------------------------------------------------------------- Benefits Other than Pensions (Continued) - ---------------------------------------- A one percentage-point increase in the assumed health care cost trend rate for each year would increase the accumulated postretirement benefit obligation as of October 31, 1993 by approximately $44 million and would increase the net postretirement benefit cost for 1993 by approximately $5 million. Defined Benefit Pension Plans - ----------------------------- The Company has numerous defined benefit pension plans covering substantially all employees in the United States. The benefits for the U.S. plans covering the salaried employees are based primarily on years of service and employees' qualifying compensation during the final years of employment. The benefits for the U.S. plans covering the hourly employees are based primarily on years of service. The U.S. plans are funded in accordance with the requirements of applicable laws and regulations. The U.S. plan assets are invested in cash, short-term investments, equities, fixed-income instruments and real estate at October 31, 1993. The Company has additional defined benefit pension plans for employees outside the United States. The benefits under these plans are based primarily on years of service and compensation levels. The Company funds these plans in amounts sufficient to meet the minimum funding requirements under governmental regulations, plus such additional amounts as the Company may deem appropriate. The Company recognized a minimum pension liability for underfunded plans. The minimum liability is equal to the excess of the accumulated benefit obligation over plan assets. A corresponding amount is recognized as either an intangible asset or a reduction of shareholders' investment. The Company had recorded additional liabilities of $39.9 million and $19.5 million, intangible assets of $15.9 million and $12.6 million, and adjustments to shareholders' investment, net of income taxes, of $13.8 million and $4.0 million, as of October 31, 1993 and 1992, respectively. Pension expense includes the following (in millions): Cash contributions to the plans in 1993 were $38.7 million. Note M - Postretirement and Postemployment Benefits (Continued) - ------------------------------------------------------------------------------- Defined Benefit Pension Plans (Continued) - ----------------------------------------- The funded status of the plans on the August 1 measurement dates was as follows (in millions): On the Balance Sheet, other assets include prepaid pension costs and accrued compensation and benefits include the current portion of the pension liabilities. Note M - Postretirement and Postemployment Benefits (Continued) - ------------------------------------------------------------------------------- Defined Benefit Pension Plans (Continued) - ----------------------------------------- Contributions made in August and October 1993 to the trust for the pension plans decreased the liability for plans with accumulated benefits exceeding assets by $7.2 million. The actuarial assumptions used in determining funded status of the plans were as follows: The changes in assumptions in 1993 increased the projected benefit obligation by approximately $40 million. Defined Contribution Plans - -------------------------- The Company has defined contribution plans for most of its U.S. salaried employees. Under these plans, eligible employees may contribute amounts through payroll deductions supplemented by employer contributions for investment in various funds established by the plans. The cost of these plans was $12.5 million, $8.8 million and $7.1 million in 1993, 1992 and 1991, respectively. Postemployment Benefits - ----------------------- In November 1992, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 112, Employers' Accounting for Postemployment Benefits (SFAS 112), which requires that accrual accounting be used for the cost of benefits provided to former or inactive employees who have not yet retired. Such benefits include salary continuation, disability, severance and health care. Under SFAS 112, the cost of benefits must be accrued either over the employee's service period or at the date of an event that gives rise to the benefits. SFAS 112 must be adopted by the Company no later than fiscal year 1995. The Company currently accrues the cost of some benefits covered by SFAS 112 but not all. SFAS 112 requires a cumulative catch-up charge to earnings upon adoption. The Company has not determined the amount of the cumulative adjustment. The Company expects to adopt SFAS 112 in the first quarter of fiscal 1995. Note N - Supplementary Earnings Statement Information and Special Charges - ------------------------------------------------------------------------------- Earnings per common share are based on the average number of common shares outstanding during each period. The average common shares outstanding were 137.3 million in 1993, 135.5 million in 1992 and 134.2 million in 1991. Common stock equivalents do not have a material effect on earnings per share. Depreciation of property, plant and equipment charged to earnings amounted to $141.5 million in 1993, $87.5 million in 1992 and $78.9 million in 1991. The increase in 1993 is primarily due to the consolidation of Dresser-Rand. Amortization of intangibles was $17.2 million in 1993, $11.1 million in 1992 and $10.6 million in 1991 and is included in selling, engineering, administrative and general expenses. Engineering, research and development costs were $152.9 million in 1993, and $94.0 million in 1992 and 1991. Research and development costs, as defined by Statement of Financial Accounting Standards No. 2, charged to earnings were $81.5 million in 1993, $11.0 million in 1992 and $9.4 million in 1991. The increases in 1993 costs are primarily due to the consolidation of Dresser-Rand. The components of other income (deductions), net on the Consolidated Statements of Earnings are as follows (in millions): Special Charges - --------------- The Company recorded special charges totalling $74.1 million in 1993. The charges included $65.0 million to cover settlement, legal fees and expenses of the Parker & Parsley and related litigation (See Note L) and $13.2 million for restructuring and termination costs partially offset by a $4.1 million gain from curtailment of retiree medical benefits. The curtailments resulted from employee terminations associated with plant closings. The special charges reduced segment operating profit by $6.9 million and the remaining $67.2 million was reflected as nonsegment expenses. In 1992, the Company recorded special charges totalling $70.0 million. The charges provided $35.0 million for the restructuring of the pump joint venture, $25.0 million for restructuring and termination costs in other operations, and $10.0 million primarily for the settlement of special warranty claims. The special charges reduced segment earnings of Oilfield Services by $17.1 million and Hydrocarbon Processing Industry by $49.3 million. The remaining $3.6 million was reflected as nonsegment expenses. Note O - Discontinued Operations - ------------------------------------------------------------------------------- In 1992, the Company decided to dispose of its Environmental Products business and recorded a $12.0 million charge for the estimated costs of disposal and future operating losses. Effective August 1, 1992, the Company divested its industrial products and equipment businesses including its 50% interest in Komatsu Dresser Company. The divestiture/spin-off was accomplished by a distribution of one INDRESCO share for every five shares of the Company's common stock. The results of operations net of income taxes for Environmental Products (including the $12 million charge in 1992) and for the INDRESCO businesses are reported as discontinued operations. Summarized information on the Discontinued Operations is as follows (in millions): Note P - Information by Industry Segment and Geographic Area - ------------------------------------------------------------------------------- The Company's industry segments are outlined below. See Notes C and O for information about changes in joint venture operations and discontinued operations. Oilfield Services ----------------- The Segment provides products and technical services utilized in the worldwide search for and development of crude oil and natural gas through exploration, drilling and production activities. Principal products and services of consolidated operations include drilling fluid systems, rock bits, downhole production tools, pipe coating and ball valves. The Western Atlas unconsolidated joint venture, which the Company has agreed to sell as discussed in Note R, provides integrated reservoir description services, seismic services, core analysis and wireline logging services. The Bredero Price and TK Valve & Manufacturing acquired operations are included in this segment (See Note D). Note P - Information by Industry Segment and Geographic Area (Continued) - ------------------------------------------------------------------------------- Hydrocarbon Processing Industry ------------------------------- The Segment provides highly engineered products, which are essential to the transportation and processing of various hydrocarbon raw materials, the conversion of the hydrocarbon raw materials into higher value-added energy forms and the marketing of refined products. Principal products, services and systems of consolidated operations include compressors, turbines, diesel engines, measurement and control devices, gas meters, piping specialties and gasoline dispensing systems along with related repair services. The Ingersoll-Dresser Pump unconsolidated joint venture provides pumps along with related repair services. Engineering Services -------------------- The Segment, which consists of the M. W. Kellogg Company, is involved in the design, engineering and construction of energy-related complexes throughout the world. Total revenues include sales and services to unaffiliated customers and either intersegment sales and services or intergeographic area sales and services. The intersegment and intergeographic area sales and services are accounted for at prices which approximate arm's length market prices. Operating profit consists of total revenues less total operating expenses and includes equity earnings or losses from unconsolidated affiliates. General corporate expenses, foreign exchange gains or losses, interest income and expense, and other income and expenses (including administrative and general expenses applicable to divested operations) not identifiable with a segment have been excluded in determining operating profit. Identifiable assets are those assets that are identified with particular segments. Corporate assets are principally cash and cash equivalents and deferred income tax benefits. Industry Segment Financial Information - -------------------------------------- The financial information by industry segment for the years ended October 31, 1993, 1992 and 1991 is included in Item 7., Management's Discussion and Analysis on pages 18 to 20 of this report, and is an integral part of this Note to Consolidated Financial Statements. Note P - Information by Industry Segment and Geographic Area (Continued) - ------------------------------------------------------------------------------- Geographic Area Financial Information - ------------------------------------- The financial information by Geographic Area for the years ended October 31, 1993, 1992 and 1991 is as follows (in millions): Note Q - Quarterly Financial Data (Unaudited) - ------------------------------------------------------------------------------- * Includes after-tax special charges for restructuring costs, termination costs and special warranty claims of $36.0 million. ** Includes $12.0 million for the estimated costs of disposal and future operating losses. Note R - Subsequent Events (Unaudited) - ------------------------------------------------------------------------------- Merger with Baroid Corporation - ------------------------------ On September 7, 1993, the Company and Baroid Corporation (Baroid) announced an agreement to merge the two companies. The agreement provides that, upon consummation of the merger, stockholders of Baroid will receive 0.40 shares of Dresser common stock for each share of issued and outstanding Baroid common stock and Baroid will become a wholly-owned subsidiary of Dresser. The merger will be accounted for as a pooling of interests. Supplemental unaudited earnings statement information assuming the merger had occurred on November 1, 1990, is as follows (in millions except earnings per share): Expenses associated with the merger of approximately $30.0 million less a tax benefit of $2.9 million, for a net special charge of $27.1 million or $0.16 per share, have been reflected in the combined results of operations for the year ended October 31, 1993 shown above. The above supplemental unaudited earnings statement information includes Baroid information for the twelve months ended October 31, 1993, December 31, 1992 and December 31, 1991. Following the merger, the Company is required by the United States Department of Justice to dispose of either its 64% general partnership interest in M-I Drilling Fluids Company or its 100% interest in Baroid Drilling Fluids Inc. prior to June 1, 1994. Dresser has not yet determined which drilling fluids company will be divested but is at present negotiating with interested parties. M-I Drilling Fluids Company revenues were $398 million and earnings before taxes were $25 million for the year ended October 31, 1993 and Baroid Drilling Fluids Inc. revenues were $372 million and earnings before taxes were $39 million for the same period. Note R - Subsequent Events (Unaudited) (Continued) - ------------------------------------------------------------------------------- Sale of Interest in Western Atlas International, Inc. - ----------------------------------------------------- On December 8, 1993, Dresser and Litton Industries, Inc. announced an agreement for the sale of Dresser's 29.5% interest in Western Atlas International, Inc. to a wholly-owned subsidiary of Litton for $358 million in cash and $200 million in 7 1/2% notes due over seven years. The sale is expected to close in January, 1994 and will result in an after-tax gain of approximately $150 million that Dresser will recognize in the first quarter of fiscal year 1994. Item 9.

Item 9. Changes in and Disagreements with Accountants on Accounting and - ------ --------------------------------------------------------------- Financial Disclosure. -------------------- None. PART III Item 10.

Item 10. Directors and Executive Officers of Registrant. - ------- ---------------------------------------------- Certain information required by this Item is incorporated by reference to Dresser's definitive proxy statement to be filed with the Securities and Exchange Commission pursuant to Regulation 14A within 120 days after the end of the fiscal year covered by this report (the "Dresser Proxy Statement"). Item 11.

Item 11. Executive Compensation. - ------- ---------------------- The information required by this Item is incorporated by reference to the Dresser Proxy Statement. Item 12.

Item 12. Security Ownership of Certain Beneficial Owners and Management. - ------- -------------------------------------------------------------- The information required by this Item is incorporated by reference to the Dresser Proxy Statement. Item 13.

Item 13. Certain Relationships and Related Transactions. - ------- ---------------------------------------------- The information required by this Item is incorporated by reference to the Dresser Proxy Statement. PART IV Item 14.

Item 14. Exhibits, Financial Statement Schedules and Reports on Form 8-K. - ------- --------------------------------------------------------------- (a) List of Financial Statements, Financial Statement Schedules and Exhibits. (1) and (2) - Response to this portion of Item 14 is submitted as a separate section of this report. (3) Response to this portion of Item 14 is submitted as a separate section of this report. (b) Reports on Form 8-K. None. (c) Exhibits - Response to this portion of Item 14 is submitted as a separate section to this report. Management contracts or compensatory plans or arrangements in which Directors or executive officers participate are included in Exhibits 10.1 - 10.27. (d) Financial Statement Schedules - The response to this portion of Item 14 is submitted as a separate section of this report. Separate financial statements for the formerly unconsolidated Dresser-Rand Company are filed because under the Rules of the Securities and Exchange Commission it constituted a significant subsidiary as of October 31, 1991. The financial statements of Dresser-Rand Company, together with the report of Price Waterhouse dated November 12, 1992, appearing on pages 3 through 17 of the accompanying Consolidated Financial Statements of Dresser-Rand Company are incorporated by reference in this report. With the exception of the aforementioned information, the Consolidated Financial Statements of Dresser-Rand Company is not to be deemed filed as a part of this Form 10-K Annual Report. UNDERTAKINGS For the purpose of complying with the rules governing registration statements on Form S-8 under the Securities Act of 1933 (as amended effective July 31, 1990), the undersigned Registrant hereby undertakes as follows, which undertaking shall be incorporated by reference into Registrant's registration statements on Form S-8 Nos. 2-76847 (filed April 5, 1982), 2-81536 (filed January 28, 1983), 33-26099 (filed December 21, 1988), 33-30821 (filed August 28, 1989), and 33-48165 (filed May 27, 1992): Insofar as indemnification for liabilities arising under the Securities Act of 1933 may be permitted to directors, officers and controlling persons of Registrant pursuant to the provisions of the Company's Restated Certificate of Incorporation, as amended, or otherwise, Registrant has been advised that in the opinion of the Securities and Exchange Commission such indemnification is against public policy as expressed in the Securities Act of 1933 and is, therefore, unenforceable. In the event that a claim for indemnification against such liabilities (other than the payment by Registrant of expenses incurred or paid by a director, officer or controlling person of Registrant in the successful defense of any action, suit or proceeding) is asserted by such director, officer or controlling person in connection with the securities being registered, Registrant will, unless in the opinion of its counsel the matter has been settled by controlling precedent, submit to a court of appropriate jurisdiction the question whether such indemnification by it is against public policy as expressed in the Act and will be governed by the final adjudication of such issue. SIGNATURES Pursuant to the requirements of Section 13 or 15(d) 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 on, January 28, 1994. DRESSER INDUSTRIES, INC. By: /s/ George H. Juetten --------------------- George H. Juetten, Vice President - Controller Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant and in the capacities indicated on January 28, 1994. FORM 10-K ITEM 14(A)(1) AND (2) AND ITEM 14(D) FINANCIAL STATEMENTS AND FINANCIAL STATEMENT SCHEDULES YEAR ENDED OCTOBER 31, 1993 DRESSER INDUSTRIES, INC. DALLAS, TEXAS LIST OF FINANCIAL STATEMENTS AND FINANCIAL STATEMENT SCHEDULES The following consolidated financial statements and report of independent accountants are included in Item 8: The following consolidated financial statement schedules of Dresser Industries, Inc. and report of independent accountants are included herein: Schedule II-- Amounts Receivable from Related Parties and Underwriters, Promoters, and Employees Other than Related Parties Schedule VIII-- Valuation and Qualifying Accounts Schedule IX-- Short-Term Borrowings Schedule X-- Supplementary Income Statement Information All other schedules for which provision is made in the applicable accounting regulation of the Securities and Exchange Commission are not required under the related instructions or are inapplicable, and therefore have been omitted. LIST OF FINANCIAL STATEMENTS AND FINANCIAL STATEMENT SCHEDULES (CONTINUED) Separate financial statements for the formerly unconsolidated Dresser-Rand Company are filed because it constituted a significant subsidiary as of October 31, 1991. Effective October 1, 1992, Dresser-Rand Company became a majority- owned consolidated subsidiary. The following consolidated financial statements of Dresser-Rand Company and report of independent accountants are included herein: Financial Highlights Operations Review Report of Independent Accountants Consolidated Statements of Operations-- Years ended September 30, 1992, 1991 and 1990 Consolidated Balance Sheets-- September 30, 1992 and 1991 Consolidated Statements of Partners' Equity-- Years ended September 30, 1992, 1991 and 1990 Consolidated Statements of Cash Flows-- Years ended September 30, 1992, 1991 and 1990 Notes to Consolidated Financial Statements Dresser-Rand Company Form 10-K Financial Schedules are included herein as follows: Report of Independent Accountants on Financial Statement Schedules Schedule V-- Property, Plant and Equipment Schedule VI-- Accumulated Depreciation, Depletion, and Amortization of Property, Plant and Equipment Schedule VIII-- Valuation and Qualifying Accounts Schedule IX-- Short-Term Borrowings Schedule X-- Supplementary Income Statement Information All other Dresser-Rand Company schedules for which provision is made in the applicable accounting regulation of the Securities and Exchange Commission are not required under the related instructions or are inapplicable, and therefore have been omitted. LIST OF FINANCIAL STATEMENTS AND FINANCIAL STATEMENT SCHEDULES (CONTINUED) Separate financial statements are not presented for any of the other unconsolidated affiliates because none constitutes a significant subsidiary. Summarized financial statement information for Ingersoll-Dresser Pump Company (49% owned) and Western Atlas International, Inc. (29.5% owned) is presented in Note C to Consolidated Financial Statements included in Item 8. Other 20% to 50% owned unconsolidated affiliates are not material. Schedule II - Amounts Receivable from Related Parties and Underwriters, Promoters, and Employees Other Than Related Parties Dresser Industries, Inc. and Subsidiaries (Millions of Dollars) Note: Amounts receivable for purchases subject to the usual trade terms and other such items arising in the ordinary course of business are excluded. SCHEDULE VIII - VALUATION AND QUALIFYING ACCOUNTS DRESSER INDUSTRIES, INC. AND SUBSIDIARIES (MILLIONS OF DOLLARS) Notes: (A) Primarily reclassification from other accrued liabilities, and addition of accounts due to acquisition. (B) Primarily addition of accounts due to acquisition of additional interest, partially offset by removal of companies accounts contributed to Ingersoll-Dresser Pump Company. (C) Primarily reclassification from other noncurrent liabilities, and reclassification to reserve for accounts receivable from unconsolidated affiliate. (D) Receivable write-offs and reclassifications, net of recoveries. SCHEDULE IX - SHORT-TERM BORROWINGS DRESSER INDUSTRIES, INC. AND SUBSIDIARIES (MILLIONS OF DOLLARS) Notes: (A) The rates do not include the hyperinflationary countries as those rates include factors to offset monetary devaluations which cannot be separated from the true interest rate. (B) The average borrowings are based on the amounts outstanding at each quarter-end. (C) The rates were computed by dividing actual interest expense for the year by the average debt outstanding during the year. Hyperinflationary country debt and interest rates were excluded as in (A). (D) Includes $300 million that was classified as long-term debt in April, 1993, since it was being refinanced. SCHEDULE X - SUPPLEMENTARY INCOME STATEMENT INFORMATION DRESSER INDUSTRIES, INC. AND SUBSIDIARIES (MILLIONS OF DOLLARS) *Amounts are not presented because such amounts are less than 1% of total net sales and service revenues. DRESSER-RAND COMPANY (A PARTNERSHIP) CONSOLIDATED FINANCIAL STATEMENTS * * * * * SEPTEMBER 30, 1992 AND 1991 DRESSER-RAND COMPANY DRESSER-RAND COMPANY FINANCIAL HIGHLIGHTS - ------------------------------------------------------------ Dollars in millions DRESSER-RAND ------------ OPERATIONS REVIEW Dresser-Rand reported revenues of $1.3 billion in 1992, up slightly from 1991. The 1992 earnings before taxes and extraordinary item of $93.5 million were essentially flat to the prior year. Earnings before tax reflect a 7.2% return on sales. Bookings in 1992 of $1.3 billion were the same as last year. The larger projects were received in Europe and the Middle East. Dresser-Rand also booked a large compression services contract in Venezuela with Maraven to be performed over 1993-94. Backlog at year-end was $1.1 billion. Turbo products bookings activity, while down from the record year in 1991, included orders for gas processing and transmission applications in Abu Dhabi, the North Sea and Czechoslovakia. Other applications involved the upgrading of refineries for reformulated gasoline requirements. Turbo was also successful on several oil production projects in the Americas. Turbo Division has enhanced its competitive position with Memorandums of Understanding with European Gas Turbines Ltd. for the joint marketing of gas turbine driven compressor packages, and with MAN/GHH for the manufacturing and marketing of axial flow compressors. The Engine Process Compressor Division benefitted from an overall increase in the worldwide market for motor driven process reciprocating compressors. The European markets were particularly strong, while the North American market softened in the last half of the year. Domestic gas price recovery has shown improvement in the compression services segments. In 1993, we see increased natural gas production as an opportunity for the reciprocating product and continued impact of environmentally driven projects in the North American refining market. Steam Turbine, Motor and Generator Division capitalized on the expansion of the power generation market in the pulp and paper industry through several major orders for turbine generators. The Electric Machinery operation also benefitted from higher demand by utilities, municipal projects, and offshore turbine activity. The petrochemical and refining markets were the major source of Steam Turbine business in the European markets. The worldwide petrochemical/refining markets require steam turbines to drive pumps and compressors, and provide a solid booking base in the future. We continue to register our worldwide manufacturing facilities under the ISO 9000 series, including those in the U.S. We received ISO registration at our Wellsville, New York, Steam Turbine facility in late 1992. All of our major units should achieve registration in 1993. Selective partnering and the practical application of employee quality training remain key parts of Dresser-Rand's focus of providing total customer satisfaction by being the best in product design, manufacture, and customer service. ------------------------------------- Ben R. Stuart President and Chief Executive Officer November, 1992 REPORT OF INDEPENDENT ACCOUNTANTS To the Partners and Management Committee of Dresser-Rand Company In our opinion, the accompanying consolidated balance sheets and the related consolidated statements of operations, partners' equity and cash flows present fairly, in all material respects, the financial position of Dresser-Rand Company (a Dresser Industries, Inc. and Ingersoll-Rand Company partnership) and its subsidiaries at September 30, 1992 and 1991, and the results of their operations and their cash flows for each of the three years in the period ended September 30, 1992, in conformity with generally accepted accounting principles. These financial statements are the responsibility of the Company's management; our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits of these statements in accordance with generally accepted auditing standards which require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for the opinion expressed above. /s/ Price Waterhouse PRICE WATERHOUSE Hackensack, New Jersey November 12, 1992 DRESSER-RAND COMPANY CONSOLIDATED STATEMENTS OF OPERATIONS See accompanying notes to consolidated financial statements. DRESSER-RAND COMPANY CONSOLIDATED BALANCE SHEETS See accompanying notes to consolidated financial statements. DRESSER-RAND COMPANY CONSOLIDATED STATEMENTS OF PARTNERS' EQUITY See accompanying notes to consolidated financial statements. DRESSER-RAND COMPANY CONSOLIDATED STATEMENTS OF CASH FLOWS Noncash financing activity: During 1991, amounts due from partners of $40,000,000 were reclassified as a return of Partners' capital. See accompanying notes to consolidated financial statements. DRESSER-RAND COMPANY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE 1 - FORMATION, OWNERSHIP AND OPERATIONS On December 31, 1986, Dresser Industries, Inc. and Ingersoll-Rand Company (the Partners) entered into a partnership agreement for the formation of Dresser-Rand Company (the Company), a New York general partnership (the partnership) owned equally by Dresser Industries, Inc. (Dresser) and Ingersoll-Rand Company (Ingersoll-Rand). The Partners contributed substantially all of the operating assets (excluding domestic cash and accounts receivable) and certain related liabilities which comprised their worldwide reciprocating compressor, steam turbine, and turbo-machinery businesses in exchange for an equal ownership interest. The net assets contributed by the Partners were recorded by the Company at amounts approximating their historical values. The Company commenced operations on January 1, 1987, and principally serves the petroleum, gas, petrochemical, chemical, and electric power industries on a worldwide basis. Effective October 1, 1992, Dresser contributed $8,035,000 to the Company and ownership interests became 51 percent Dresser and 49 percent Ingersoll-Rand. At the same time, the Company's fiscal year was changed to end on October 31. NOTE 2 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES Significant accounting policies used in the preparation of the accompanying consolidated financial statements are set forth below. Basis of Presentation The consolidated financial statements include the accounts of all wholly-owned and majority-owned subsidiaries. Investments in affiliates owned 50% or less are accounted for on the equity method. The Company's equity in the net earnings of these affiliates was not material. All material intercompany items have been eliminated in consolidation. Cash Equivalents Cash equivalents are stated at cost which approximates market. For purposes of the Consolidated Statements of Cash Flows, the Company considers all highly liquid debt instruments purchased with a maturity of three months or less to be cash equivalents. Inventories Inventories are stated at cost, which is not in excess of net realizable value, and are valued principally using the first-in, first-out (FIFO) method. Property and Depreciation Property, plant and equipment is recorded at cost, and is depreciated over the estimated useful lives of the various classes NOTE 2 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED) of assets. Depreciation is computed principally using accelerated methods, except for U.S. fixed assets with a service life of ten years or less, which are depreciated on a straight-line basis. Intangible Assets Costs in excess of values assigned to the underlying net assets of businesses acquired by the Partners which were contributed to the Company are being amortized on a straight-line basis over periods not exceeding 40 years. Such amortization amounted to $1,744,000 in 1992, 1991 and 1990. Income Taxes The Company is a partnership and generally does not provide for U.S. income taxes since all partnership income and losses are allocated to the Partners for inclusion in their respective income tax returns. Income taxes are provided on the taxable earnings of U.S. and foreign subsidiaries, including deferred taxes arising from timing differences between financial and tax reporting of income and expense items. Statement of Financial Accounting Standards No. 109 "Accounting for Income Taxes" was issued in February 1992. The statement requires the Company to make changes in accounting for income taxes no later than fiscal year 1994. Based on a preliminary review of the provisions of this statement, the Company does not believe its implementation will have a material effect on income or retained earnings. Revenue Recognition and Warranties Revenue from the sale of products and estimated provisions for warranty costs are recorded for financial reporting purposes generally when the products are shipped. Service and equipment rental revenues are accrued as earned. Research, Engineering and Development Costs Expenses for research and development activities, including engineering costs, are expensed as incurred and amounted to $67,074,000 in 1992, $63,768,000 in 1991, and $55,583,000 in 1990. Foreign Currency Assets and liabilities of foreign entities operating in other than highly inflationary economies are translated at current exchange rates, and income and expenses are translated using average-for-the-year exchange rates. Adjustments resulting from translation are recorded in Partners' equity and will be included in net earnings only upon sale or liquidation of the underlying foreign investment. For foreign subsidiaries operating in highly inflationary economies, inventory and property balances and related income statement accounts are translated using historical exchange rates and resulting gains and losses are credited or charged to earnings. NOTE 2 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED) The Company enters into forward foreign exchange contracts as a hedge against movements on the Company's assets and liabilities exposed to foreign exchange rate fluctuations. Gains and losses are recognized currently in income, and the resulting credit or debit offsets foreign exchange gains or losses on those assets and liabilities. Foreign currency translation and exchange gains (losses) recorded in other income (expense) in the accompanying Consolidated Statements of Operations amounted to $995,000 in 1992, $2,321,000 in 1991, and $(783,000) in 1990. NOTE 3 - INVENTORIES The components of inventory are as follows (in thousands): Finished products and work in process inventories are stated after deducting customer progress payments of $117,022,000 in 1992 and $162,910,000 in 1991. NOTE 4 - PROPERTY, PLANT AND EQUIPMENT Property, plant and equipment is summarized as follows (in thousands): Depreciation expense was $33,886,000 in 1992, $36,607,000 in 1991, and $35,233,000 in 1990. NOTE 5 - SHORT-TERM BORROWINGS Short-term borrowings consist primarily of foreign bank loans. At September 30, 1992, the Company had no U.S. bank loans or lines of credit for short-term borrowing facilities. Credit facilities have been arranged with banks outside the United States under which the Company's foreign operating units may borrow in the local currency or other currencies on an overdraft and short-term note basis. The amount of available lines of credit under these arrangements aggregated $55,355,000, of which $55,109,000 were unused at September 30, 1992. At September 30, 1992, the weighted average interest rate on outstanding borrowings was 11.75%. NOTE 5 - SHORT-TERM BORROWINGS (CONTINUED) Under the terms of the partnership agreement, the Company must obtain the consent of the Partners for any borrowing if, after giving effect to such borrowing, aggregate indebtedness equals or exceeds 33-1/3% of the sum of the Company's indebtedness and the Partners' capital accounts. NOTE 6 - TRANSACTIONS WITH AFFILIATES In the normal course of business, the Company engages in sales and purchases of manufactured products with the Partners and their affiliates. There are also various licensing, subcontracting, and servicing arrangements among the parties pursuant to the partnership and other agreements. Some of the agreements had planned expiration dates while others continue at the option of the Company or the Partners. Costs and charges under these arrangements are generally at normal and competitive market rates. In addition, certain administrative services of nominal value are provided at no cost to the Company. A summary of transactions with the Partners and their affiliates is as follows (in thousands): Amounts due from Partners consist of trade accounts and advances. The trade accounts represent the net balance arising from the sale or purchase of equipment and services to and from the Partners and do not accrue interest. Advances, which primarily represent cash in excess of the immediate working capital needs of the partnership, do not bear interest and have no repayment terms. Amounts due from (to) Partners are as follows (in thousands): One partner continues to operate a foreign manufacturing company on behalf of the Company. Net gains(losses) of $644,000 in 1992, $(383,000) in 1991, and $701,000 in 1990 relating to this operation are included in the accompanying Consolidated Statements of Operations. NOTE 7 - PENSION PLANS AND OTHER EMPLOYEE BENEFITS Pension Plans The Company has noncontributory pension plans covering substantially all U.S. and Canadian employees. In addition, pension or retirement indemnity coverage is provided for the majority of employees in other countries. The Company's U.S. salaried employees generally receive benefits based on years of service and qualifying compensation on a final average earnings formula. Benefit plans covering hourly employees generally have flat benefit formulas based primarily on years of service. These plans, with some modifications, have been adopted by the Company as a continuation of prior coverage under defined benefit and contribution plans sponsored by the Partners. The Company also maintained a defined contribution plan covering employees at one of its domestic facilities which was terminated in July 1990. Foreign plans provide benefits based on earnings and years of service. The Company's policy is to fund sufficient amounts to maintain the plans on a sound actuarial basis. Such amounts could be in excess of pension costs expensed, subject to the limitations imposed by current tax regulations. The components of pension costs are as follows (in thousands): A merit salary scale with a 5% inflation factor was used to project future compensation levels as a basis for 1992, 1991 and 1990 U.S. pension cost. For the foreign plans, rates of 6.2%, 6.4% and 6.6% were used to project future compensation levels for 1992, 1991 and 1990, respectively. NOTE 7 - PENSION PLANS AND OTHER EMPLOYEE BENEFITS (CONTINUED) The Company credited $1,556,000 in 1990 to operations for plan curtailments and termination benefits associated with the termination of employees at plant facilities closed. Plan assets are invested primarily in fixed income and equity securities. Plans where assets exceed accumulated benefits are immaterial. The funded status of employee pension benefit plans is as follows (in thousands): In addition to the above accrued pension cost, the Company has accrued $3,676,000 and $3,997,000 ($3,160,000 and $3,481,000 included in noncurrent liabilities) at September 30, 1992 and 1991, respectively, for pension costs relating to a plan maintained by a former employing partner. Pension expense for foreign operations, computed under Statement of Financial Accounting Standards No. 87 (SFAS 87), amounted to $1,920,000 in 1992, $2,380,000 in 1991 and $1,219,000 in 1990. In addition, the Company incurred a cost of $362,000 in 1992, $147,000 in 1991 and $145,000 in 1990 related to foreign defined contribution plans. The provisions of SFAS 87 require the recognition of a liability in the amount of the Company's unfunded accumulated benefit obligation with an equal amount recognized as an intangible asset or as a separate component (reduction) of equity; such amounts are adjusted each year based on actuarial valuations. As of September 30, 1992, the Company has recognized a noncurrent liability of $7,709,000, an intangible asset of $4,665,000 (included in other assets) and a charge to equity of $3,044,000. These amounts are $875,000, $5,000 and $870,000, respectively, lower than those reported as of September 30, 1991. Retiree Benefits In addition to providing pension benefits, the Company provides certain health care and life insurance benefits for retired employees. Most employees who retire are eligible for these benefits. The cost of retiree health care is recognized as an NOTE 7 - PENSION PLANS AND OTHER EMPLOYEE BENEFITS (CONTINUED) expense as claims are paid, and the cost of retiree life insurance is recognized by expensing the annual insurance premiums. These costs were $2,901,000 in 1992, $2,836,000 in 1991 and $1,840,000 in 1990. In December 1990 the Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 106 "Employers Accounting for Postretirement Benefits Other Than Pensions" (SFAS 106). Effective for fiscal years beginning after December 15, 1992, this new statement requires accrual of postretirement benefits (such as health care and life insurance) during the years an employee provides services. The Company expects to adopt SFAS 106 in the first quarter of 1993 and estimates the accumulated liability for postretirement benefits to be $160,000,000 on a pre-tax basis. Upon adoption, the Company will record this amount as a one time charge against earnings. The annual pre-tax postretirement benefit expense for fiscal 1993 is estimated to be $17,000,000. Savings and Investment Plans The Company also sponsors certain savings and investment plans. The cost for these plans amounted to $2,410,000 in 1992, $2,255,000 in 1991, and $2,039,000 in 1990. NOTE 8 - INCOME TAXES The components of income before income taxes and extraordinary item are as follows (in thousands): NOTE 8 - INCOME TAXES (CONTINUED) An analysis of the difference between the U.S. statutory rate and the effective rate is as follows: Current taxes of $17,910,000 in 1992, $10,972,000 in 1991, and $8,420,000 in 1990 do not include charges of $3,094,000, $8,907,000, and $4,197,000, respectively, equivalent to income taxes which would have been incurred had operating loss carryforwards not been available. The income tax benefit resulting from realization of the operating loss carryforwards is presented as an extraordinary item in the accompanying Consolidated Statements of Operations. For tax purposes the Company has net operating loss carryforwards of $22,014,000, of which $4,741,000 carryforward indefinitely, and the remaining amounts expire at various dates through 1998. NOTE 9 - INFORMATION BY GEOGRAPHIC AREA The Company operates in one industry segment consisting of the design, manufacture, and marketing of energy processing and conversion equipment. There are no significant concentrations of credit risk in trade receivables at September 30, 1992. Customers are not concentrated in any specific geographic region and no single customer accounted for 10 percent or more of net sales. Identifiable assets are those assets that are identified with particular geographic areas and operations. General corporate assets consist principally of property, plant and equipment. NOTE 9 - INFORMATION BY GEOGRAPHIC AREA (CONTINUED) The financial information by geographic area is as follows (in thousands): Foreign sales of U.S. manufactured products were $475,074,000 in 1992, $351,635,000 in 1991, and $231,621,000 in 1990. These sales represent the customer value of the transfers between geographic areas, primarily to Europe, and domestic exports sold directly to foreign customers of $299,824,000 in 1992, $170,677,000 in 1991, and $102,202,000 in 1990. NOTE 10 - COMMITMENTS AND CONTINGENCIES - --------------------------------------- All principal manufacturing facilities are owned by the Company. Certain office, warehouse and light manufacturing facilities, transportation vehicles, and data processing equipment are leased. Future minimum lease payments required under noncancellable operating leases with initial terms in excess of one year are as follows (in thousands): NOTE 10 - COMMITMENTS AND CONTINGENCIES (CONTINUED) - --------------------------------------------------- Total rental expense amounted to $16,312,000 in 1992, $13,305,000 in 1991, and $13,934,000 in 1990. Capital lease commitments of the Company are not significant. In the normal course of business, the Company issues direct and indirect guarantees, primarily contract performance bonds and letters of credit. Management believes these guarantees will not adversely affect the consolidated financial statements. The Company is involved in various litigation and claims arising in the normal course of business. Based on advice of counsel, management believes that recovery or liability with respect to these matters will not have a material effect on the consolidated financial position or results of operations of the Company. NOTE 11 - SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION - ----------------------------------------------------------- Cash paid during the year for interest and income taxes was as follows (in thousands): DRESSER-RAND COMPANY EXECUTIVE OFFICES 1 BARON STEUBEN PLACE CORNING, NY 14830 (607)937-6400 OFFICERS - ----------------------------------------------- BEN R. STUART President and Chief Executive Officer JOHN A. HELDMAN Vice President and Chief Financial Officer PAUL M. BRYANT Vice President, Human Resources EUGENE H. MOORE Vice President, General Counsel MANAGEMENT COMMITTEE - ----------------------------------------------- THEODORE H. BLACK Chairman of the Board and Chief Executive Officer Ingersoll-Rand Company WILLIAM E. BRADFORD President and Chief Operating Officer Dresser Industries, Inc. JOHN J. MURPHY Chairman of the Board and Chief Executive Officer Dresser Industries, Inc. JAMES E. PERRELLA President Ingersoll-Rand Company BEN R. STUART President and Chief Executive Officer of the Company AUDIT COMMITTEE - ----------------------------------------------- Consists of three (3) Directors each from Dresser Industries, Inc. and Ingersoll-Rand Company, for a total of six (6) Audit Committee members. REPORT OF INDEPENDENT ACCOUNTANTS ON FINANCIAL STATEMENT SCHEDULES To The Partners of Dresser-Rand Company Our audits of the consolidated financial statements referred to in our report dated November 12, 1992, appearing on page 3 of the 1992 consolidated financial statements of Dresser-Rand Company, also included an audit of the financial statement schedules listed in item 14 (d) of this Form 10-K. In our opinion, these financial statement schedules present fairly, in all material respects, the information set forth therein when read in conjunction with the related consolidated financial statements. /s/ Price Waterhouse PRICE WATERHOUSE Hackensack, NJ November 12, 1992 DRESSER-RAND COMPANY SCHEDULE V - PROPERTY, PLANT AND EQUIPMENT FOR THE YEARS ENDED SEPTEMBER 30, 1992, 1991 AND 1990 (AMOUNTS IN THOUSANDS) (*) Other primarily represents reclassifications among categories and the effects of foreign currency translation. SCHEDULE IX - SHORT-TERM BORROWINGS FOR THE YEARS ENDED SEPTEMBER 30, 1992, 1991 AND 1990 (AMOUNTS IN THOUSANDS) The average amounts outstanding were determined based on the sum of the month- end amounts outstanding divided by the number of months in the period. The weighted average interest rates were based on the sum of the quarter-end rates divided by the number of quarters in the period. DRESSER-RAND COMPANY SCHEDULE X - SUPPLEMENTARY INCOME STATEMENT INFORMATION FOR THE YEARS ENDED SEPTEMBER 30, 1992, 1991 AND 1990 (AMOUNTS IN THOUSANDS) CHARGED TO COSTS AND EXPENSES 1992 1991 1990 ------------------------------- Maintenance and repairs....... $22,473 $22,691 $21,481 ======= ======= ======= Amounts for preoperating costs and similar deferrals, royalties, advertising costs, and taxes other than payroll and income taxes are not presented because such amounts are less than one percent of total net sales. INDEX TO EXHIBITS - ---------- * Filed Herewith INDEX TO EXHIBITS (CONT.) - ---------- * Filed Herewith INDEX TO EXHIBITS (CONT.) - ---------- * Filed Herewith

745448_1993.txt

745448

1993

ITEM 1. BUSINESS. MascoTech, Inc. (formerly Masco Industries, Inc.) is a diversified manufacturer of original equipment and aftermarket parts for the transportation industry; commercial, institutional and residential building products for the construction industry; and other diversified products principally for the defense industry. Sophisticated technology plays a significant role in the Company's businesses and in the design, engineering and manufacturing of many of its products. Transportation-Related Products are manufactured utilizing a variety of metalworking and other process technologies. Although published industry statistics are not available, the Company believes that it is a leading independent producer of many of the industrial component parts that it produces using cold, warm or hot forming processes. In addition to its manufacturing activities, the Company provides design and engineering services primarily for the automotive, heavy truck and aerospace industries. MascoTech was incorporated under the laws of Delaware in 1984 as a wholly-owned subsidiary of Masco Corporation, which in May, 1984 transferred to MascoTech its industrial businesses. The Company became a separate public company in July, 1984 when Masco Corporation distributed shares of Company Common Stock as a special dividend to its stockholders. Masco Corporation currently owns approximately 42 percent of the Company's outstanding Common Stock. See "Management's Discussion and Analysis of Financial Condition and Results of Operations -- Corporate Development," included in Item 7 of this Report. Except as the context otherwise indicates, the terms "MascoTech" and the "Company" refer to MascoTech, Inc. and its consolidated subsidiaries. RECENT DEVELOPMENTS The Company has undertaken the planned disposition of its energy-related business segment, which consisted of seven business units, as part of its long-term strategic plan to de-leverage its balance sheet and increase the focus on its core operating capabilities. As a result, the Company's financial statements have been reclassified to present such businesses as discontinued operations. These businesses manufactured specialized tools, equipment and other products for energy-related industries. Two of the businesses were sold in late 1993, including one business to the Company's affiliate, TriMas Corporation, and the Company expects to divest the remaining businesses in 1994. See "Management's Discussion and Analysis of Financial Condition and Results of Operations -- Discontinued Operations," included in Item 7 of this Report. Except as the context otherwise indicates, all information contained herein has been reclassified for these discontinued operations. In July, 1993, the Company issued $216 million (liquidation value) of Dividend Enhanced Convertible StockSM. In late 1993, the Company redeemed for cash its outstanding $100 million of 10% Exchangeable Preferred Stock and, following a call for redemption, the outstanding $187 million of the Company's 6% Convertible Subordinated Debentures due 2011 were converted into 10.4 million shares of Company Common Stock (including approximately 7 million shares issued to Masco Corporation). In early 1994, the Company issued, in a public offering, $345 million of 4 1/2% Convertible Subordinated Debentures due 2003 which are convertible into Company Common Stock at $31.00 per share. The net proceeds from this offering were used to redeem, on February 1, 1994, the outstanding $250 million of the Company's 10 1/4% Senior Subordinated Notes due 1997 and reduce outstanding bank debt. INDUSTRY SEGMENTS The following table sets forth for the three years ended December 31, 1993, the contribution of the Company's continuing industry segments to net sales and operating profit: - ------------------------- (1) Results in 1992 and 1991 have been reclassified to conform with the presentation adopted in 1993 (including amounts for discontinued operations -- see the Note to the Company's Consolidated Financial Statements captioned "Discontinued Operations" included in Item 8 of this Report). (2) Amounts are before general corporate expense. Additional financial information concerning the Company's operations by industry segments as of and for the three years ended December 31, 1993, is set forth in Item 8 of this Report in the Note to the Company's Consolidated Financial Statements captioned "Segment Information." TRANSPORTATION-RELATED PRODUCTS The Company manufactures a broad range of semi-finished components, subassemblies and assemblies for the transportation industry. Transportation-Related Products represented 76 percent of 1993 sales from continuing operations and primarily consist of original equipment products for the automotive and truck industries. The Company's products include a number of high-performance products for which reliability, quality and certainty of supply are major factors in customers' selection of suppliers. Over half of the products are used for engine and drivetrain applications (such as semi-finished transmission shafts, drive gears, engine connecting rods, wheel spindles and front wheel drive and exhaust system components) and for chassis and suspension functions (including electromechanical solenoids and relays and suspension components). Products manufactured for exterior body trim applications include automotive trim, luggage racks and accessories, and metal stampings. Aftermarket products include fuel and emission systems components, windshield wiper blades, constant-velocity joints, brake hardware repair kits, and luggage racks and accessories. In addition to its manufacturing activities, the Company provides engineering services primarily for the automotive and heavy-duty truck industries, and is engaged in specialty vehicle development and conversion programs. Products are manufactured using various metalworking technologies, including cold, warm and hot forming, powdered metal forming and stamping. Approximately one-quarter of the Company's sales of Transportation-Related Products resulted from using cold, warm or hot metal forming technologies. The Company believes that its metalworking technologies provide cost-competitive, high-performance, quality components that are required in order to meet the increasing demands of the automotive and truck markets it serves. Approximately 85 percent of the Company's Transportation-Related Products sales in 1993 were original equipment automotive products and services. Sales to original equipment manufacturers are made through factory sales personnel and independent sales representatives. During 1993, sales to various divisions and subsidiaries of Ford Motor Company, General Motors Corporation and Chrysler Corporation accounted for approximately 20 percent, 14 percent and 12 percent, respectively, of the Company's net sales. Sales to the automotive aftermarket are made primarily to distributors utilizing factory sales and service personnel. SPECIALTY PRODUCTS Architectural Products The Company manufactures a variety of Architectural Products for commercial, institutional and residential markets. Products include steel doors and frames; stainable and low maintenance steel doors; wood windows and aluminum-clad wood windows; leaded, etched and beveled glass for decorative windows and entryways; residential entry systems; garage doors; sectional and rolling doors; security grilles; and modular metal partitions. The Company's commercial and institutional markets include office buildings, factories, hotels, schools, hospitals, retail stores and malls, warehouses and mini-warehouses. Residential markets include single family new construction as well as repair and remodeling. Architectural Products are sold principally to wholesale distributors who sell the products to builders, developers, dealers, retailers (such as do-it-yourself home centers) and residential, commercial, industrial and institutional end users. Security grilles are sold directly to builders, developers and end users. Other Specialty Products The Company's Other Specialty Products consist primarily of Defense Products, including large diameter cold formed cartridge cases, projectiles and casings for rocket motors and missiles for the United States government and its suppliers. Changes in government procurement practices and requirements have adversely affected orders, sales and profits of such products in recent years and are expected to continue to do so in the future. As a result, the Company is pursuing other commercial applications for the resources related to the manufacturing of Defense Products, including its metal forging capability and waste-water treatment capability. Since obtaining the necessary permits in 1990, the Company has marketed waste-water treatment services to other industrial companies principally in southern California. The Company's government contracts contain standard clauses providing for termination at the convenience of the government which, in such cases, would provide the Company with compensation for work performed and costs of termination. Defense Products are sold both directly to the federal government and to other prime contractors to the federal government. GENERAL INFORMATION CONCERNING INDUSTRY SEGMENTS No material portion of the Company's business is seasonal or has special working capital requirements. The Company does not consider backlog orders to be a material factor in its industry segments, and, except as noted above, no material portion of its business in its other industry segments is dependent upon any one customer or subject to renegotiation of profits or termination of contracts at the election of the federal government. Compliance with federal, state and local regulations relating to the discharge of materials into the environment, or otherwise relating to the protection of the environment, is not expected to result in material capital expenditures by the Company or to have a material effect on the Company's earnings or competitive position. See, however, "Legal Proceedings," included as Item 3 of this Report, for a discussion of certain pending proceedings concerning environmental matters. In general, raw materials required by the Company are obtainable from various sources and in the quantities desired. INTERNATIONAL OPERATIONS The Company, through its subsidiaries, has businesses located in Canada, Germany, Italy and the United Kingdom. Products manufactured by the Company outside of the United States include forged automotive component parts, constant-velocity joints and extruded urethane lineals. In addition, the Company provides engineering services outside of the United States, primarily serving automotive manufacturers in the United Kingdom and Germany. For 1991 through 1993, the Company's annual net export sales from the United States to other countries, as a percentage of annual consolidated net sales from continuing operations, approximated five percent. The Company's foreign operations are subject to political, monetary, economic and other risks attendant generally to international businesses. These risks generally vary from country to country. EQUITY INVESTMENTS TriMas Corporation The Company owns approximately 43 percent of the outstanding common stock of TriMas Corporation ("TriMas"). The Company's common equity interest in TriMas increased from 28 percent as a result of the late 1993 conversion of TriMas convertible preferred stock held by the Company into 7.8 million shares of TriMas common stock. TriMas manufactures a number of industrial products, including a variety of steel, stainless steel, aluminum and other non-ferrous fasteners for the building construction, farm implement, medium and heavy-duty truck, appliance, aerospace, electronics and other industries. TriMas also provides metal treating services for manufacturers of fasteners and comparable products. TriMas manufactures towing systems products, including vehicle hitches, jacks, winches, couplers and related accessories for the passenger car, light truck, recreational vehicle, marine, agricultural and industrial markets. TriMas also manufactures specialty container products, including industrial container closures, sealing caps and dispensing spigots primarily for the chemical, agricultural, food, petroleum and health care industries, as well as high-pressure seamless compressed gas cylinders used for shipping, storing and dispensing oxygen, nitrogen, argon and helium, specialty industrial gaskets for refining, petrochemical and other industrial applications, and a complete line of low-pressure welded cylinders used to contain and dispense acetylene gas for the welding and cutting industries. In addition, TriMas manufactures flame-retardant facings and jacketings used in conjunction with fiberglass insulation, principally for commercial and industrial construction applications, pressure-sensitive specialty tape products and a variety of specialty precision tools such as center drills, cutters, end mills, reamers, master gears, gages and punches. Emco Limited The Company owns approximately 43 percent of the outstanding common stock and convertible debentures of Emco Limited ("Emco"), as a result of the transactions described under "Management's Discussion and Analysis of Financial Condition and Results of Operations -- Corporate Development," included in Item 7 of this Report. Emco is a major, publicly traded, Canadian-based manufacturer and distributor of building and home improvement products, including roofing materials, wood fiber products, vinyl siding, stainless steel sinks and vinyl windows, and a distributor of plumbing and related products. In addition, Emco manufactures and distributes worldwide fluid handling equipment for the petroleum and petrochemical and other industries, and produces custom components, brass and aluminum forgings, plastic components, tools, dies and molds. Emco also provides other services on a contract basis for original equipment manufacturers and others. Titan Wheel International, Inc. The Company owns approximately 21 percent of the outstanding common stock of Titan Wheel International, Inc. ("Titan"), as a result of the transactions described in the Note to the Company's Consolidated Financial Statements captioned "Equity and Other Investments in Affiliates," included in Item 8 of this Report. Titan is a manufacturer of wheels and other products for agricultural, construction and other off-highway equipment. Other Equity Investments The Company has equity investments in several other companies which are engaged in activities related to the Company's businesses, including the manufacture of plastic component parts utilizing the reaction injection molding process, primarily for the automotive and truck industries, and the manufacture of electrical and electronic components, primarily for the automotive and truck industries. PATENTS AND TRADEMARKS The Company holds a number of patents, patent applications, licenses, trademarks and trade names. The Company considers its patents, patent applications, licenses, trademarks and trade names to be valuable, but does not believe that there is any reasonable likelihood of a loss of such rights which would have a material adverse effect on the Company's industry segments or its present business as a whole. COMPETITION The major domestic and foreign markets for the Company's products in its industry segments are highly competitive. Competition is based primarily on price, performance, quality and service, with the relative importance of such factors varying among products. Government procurement practices are an additional factor in the case of Defense Products. In the case of Transportation-Related Products, the Company's competitors include a large number of other well-established independent manufacturers as well as certain customers who have their own metalworking and engineering capabilities. Although a number of companies of varying size compete with the Company in its industry segments, no single competitor is in substantial competition with the Company with respect to more than a few of its product lines and services. EMPLOYEES At December 31, 1993, the Company employed approximately 12,200 people. Satisfactory relations have generally prevailed between the Company and its employees. ITEM 2.

ITEM 2. PROPERTIES. The following list includes the Company's principal manufacturing facilities by location and the industry segments utilizing such facilities: Arizona..............Chandler (2) California...........Santa Fe Springs (4), Vernon (3) and Yuba City (1) Florida..............Auburndale (2), Deerfield Beach (1) and Orlando (2) Georgia..............Adel (1), Lawrenceville (1) and Valdosta (1) Indiana..............Kendallville (1) Iowa.................Dubuque (2) Kentucky.............Nicholasville (1) Michigan.............Auburn Hills (1)(1), Brighton (1), Burton (1), Coopersville (1), Detroit (1)(1)(1), Farmington Hills (1), Fraser (1), Green Oak Township (1 and 3), Hamburg (1 and 3), Holland (1), Livonia (1), Mesick (1), Mt. Clemens (1), Oxford (1) (1) (1), Port Huron (1), Redford (1), Roseville (1), Royal Oak (1), Shelby Township (1), St. Clair (1), St. Clair Shores (1), Sterling Heights (1), Traverse City (1) (1) (1) (1) (1), Troy (1)(1), Warren (1) (1), West Branch (2) and Ypsilanti (1) Mississippi..........Nesbit (2) New York.............Brooklyn (2) and Maspeth (2) Ohio.................Blue Ash (2), Bluffton (1), Canal Fulton (1), Columbus (2), Lima (1), Minerva (1), Perrysburg (2), Port Clinton (1) and Upper Sandusky (1) Oklahoma.............Tulsa (4) Pennsylvania.........Ridgway (1) Texas................Bryan (4), Dallas (4), Greenville (4) and Houston (4) (4) (4) Virginia.............Duffield (1) Germany..............Riedstadt (2) and Zell am Harmersbach (1 and 3) Italy................Poggio Rusco (1) United Kingdom.......Wednesfield, England (1) Note: Multiple footnotes within the same parenthesis indicate the facility is engaged in significant activities relating to more than one segment. Multiple footnotes to the same municipality denote separate facilities in that location. Industry segments in the preceding table are identified as follows: (1) Transportation-Related Products; (2) Specialty Products -- Architectural; (3) Specialty Products -- Other; and (4) Discontinued Operations. The Company's largest manufacturing facility is located in Vernon, California and is a multi-plant facility of approximately 920,000 square feet. The Company owns the largest plant, comprising approximately 540,000 square feet and operates the remaining portions of this facility under leases, the earliest of which expires at the end of 1994. Except for the foregoing facility and an additional manufacturing facility covering approximately 605,000 square feet, the Company's manufacturing facilities range in size from approximately 25,000 square feet to 325,000 square feet, are owned by the Company or leased, and are not subject to significant encumbrances. The Company's executive offices are located in Taylor, Michigan, and are provided by Masco Corporation to the Company under a corporate services agreement. The Company's buildings, machinery and equipment have been generally well maintained, are in good operating condition, and are adequate for current production requirements. The following list identifies the manufacturing facilities of TriMas by location and the industry segments utilizing such facilities: California.................... Commerce(a) Illinois...................... Wood Dale(a) Indiana....................... Auburn(c), Elkhart(b), Frankfort(a) and Mongo(b) Louisiana..................... Baton Rouge(c) Massachusetts................. Plymouth(d) Michigan...................... Canton(b), Detroit(a) and Warren(d)(d)(d)(d) New Jersey.................... Edison(d), Netcong(d) and North Bergen(d) Ohio.......................... Lakewood(a) Texas......................... Houston(c) and Longview(c) Wisconsin..................... Mosinee(b) Australia..................... Dandenong South, Victoria(b) Canada........................ Brampton, Ontario(c), Fort Erie, Ontario(c) and Oakville, Ontario(b) Mexico........................ Mexico City(c) Note: Multiple footnotes to the same municipality denote separate facilities in that location. Industry segments in the preceding table are identified as follows: (a) Specialty Fasteners; (b) Towing Systems; (c) Specialty Container Products; and (d) Corporate Companies. TriMas' buildings, machinery and equipment have been generally well maintained, are in good operating condition, and are adequate for current production requirements. ITEM 3.

ITEM 3. LEGAL PROCEEDINGS. A civil suit was filed in the United States District Court for the Central District of California in April, 1983 by the United States of America and the State of California against 30 defendants, including the Company's NI Industries, Inc. subsidiary ("NI"), for alleged release into the environment of hazardous waste disposed of at the Stringfellow Disposal Site in California. The plaintiffs have requested, among other things, that the defendants clean up the contamination at that site. A consent decree has been entered into by the plaintiffs and the defendants, including NI, providing that the consenting parties perform partial remediation at the site. Another civil suit was filed in the United States District Court for the Central District of California in December, 1988 by the United States of America and the State of California against more than 180 defendants, including NI, for alleged release into the environment of hazardous waste disposed of at the Operating Industries, Inc. site in California. This site served for many years as a depository for municipal and industrial waste. The plaintiffs have requested, among other things, that the defendants clean up the contamination at that site. Two partial consent decrees have been entered into by the plaintiffs and a group of the defendants, including NI, providing that the consenting parties perform certain interim remedial work at the site and reimburse the plaintiffs for certain past costs incurred by the plaintiffs at the site. Based upon its present knowledge, and subject to future legal and factual developments, the Company does not believe that any of this litigation will have a material adverse effect on its consolidated financial position. In November, 1993 the California Environmental Protection Agency issued a proposed enforcement order and a tentative civil penalty in the amount of $180,000 against the Company's subsidiary, NI Industries, Inc., principally on account of alleged past violations of certain California environmental laws and regulations relating to the subsidiary's handling of waste material and relating to its permit allowing it to treat industrial waste. The proposed enforcement order is under negotiation and is not yet final. During the fourth quarter of 1991, a division of the Company was assessed a civil penalty in excess of $100,000 by a municipal sewer authority for alleged past violations of limitations of waste-water discharges into the authority's sanitary sewer system. This assessment was appealed by the division, and the appeal is pending. The division is now in compliance with all applicable waste-water discharge requirements and the Company believes that the costs of penalties, if paid, would be immaterial to the Company. The Company is subject to other claims and litigation in the ordinary course of its business, but does not believe that any such claim or litigation will have a material adverse effect on its consolidated financial position. ITEM 4.

ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS. Not applicable. SUPPLEMENTARY ITEM. EXECUTIVE OFFICERS OF REGISTRANT (PURSUANT TO INSTRUCTION 3 TO ITEM 401(B) OF REGULATION S-K). Each of the executive officers is elected to a term of one year or less and serves at the discretion of the Board of Directors. Mr. Manoogian is and has been for over five years a Director, Chairman of the Board and the Chief Executive Officer of Masco Corporation, an affiliate of the Company that is a manufacturer of building and home improvement and home furnishings products for the home and family. Mr. Manoogian also is a Director and Chairman of the Board of TriMas Corporation. Mr. Gardner was appointed President and Chief Operating Officer of the Company in October, 1992. Prior to his appointment, Mr. Gardner was President -- Automotive. He joined the Company in 1987, and in 1990 assumed responsibility for all of the Company's businesses serving the transportation industry. PART II ITEM 5.

ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS. The Company's Common Stock commenced trading on the New York Stock Exchange ("NYSE") on June 23, 1993 under the symbol "MSX." The Company's Common Stock was previously traded over-the-counter and quoted on the National Association of Securities Dealers Automated Quotation System -- National Market System ("NASDAQ-NMS") under the symbol "MASX." The following table sets forth for the periods indicated the high and low sales prices of the Company's Common Stock as reported on the NASDAQ-NMS for the periods prior to June 23, 1993 and as reported on the NYSE Composite Tape commencing June 23, 1993: On March 15, 1994 there were approximately 5,600 holders of record of the Company's Common Stock. The Company commenced paying cash dividends on its Common Stock in August, 1993 and to date has declared four and paid three quarterly dividends, each in the amount of $.02 per share. Future declarations of dividends on the Common Stock are discretionary with the Board of Directors and will depend upon the Company's earnings, capital requirements, financial condition and other factors. Dividends may not be paid on Company Common Stock if there are any dividend arrearages on the Company's outstanding Preferred Stock. In addition, certain of the Company's long-term debt instruments contain provisions that restrict the dividends that it may pay on its capital stock. See the Note to the Company's Consolidated Financial Statements captioned "Long-Term Debt," included in Item 8 of this Report. ITEM 6.

ITEM 6. SELECTED FINANCIAL DATA. The following table sets forth summary consolidated financial information of the Company, for the years and dates indicated (information related to the statements of income and, in 1993, the balance sheet, have been reclassified for discontinued operations): Results for 1993 and 1992 include pre-tax income of approximately $9 million and $25 million, respectively, as a result of gains associated with the sale of common stock through public offerings by equity affiliates and, in 1992, a prepayment premium related to the redemption of debentures held by the Company. This income was largely offset by costs and expenses related to cost-reduction initiatives, the restructuring of certain operations and product lines, adjustments to the carrying value of certain long-term assets, and other costs and expenses. Results for 1993 were reduced by a charge of approximately $.03 per common share reflecting the increased 1993 federal corporate income tax rate related to adjusting deferred tax balances as of December 31, 1992 for the higher income tax rate. Results for 1993 are before the effect of a $5.8 million pre-tax extraordinary charge ($3.7 million after-tax or $.06 per common share) related to the early extinguishment of subordinated debt (see the Note to the Company's Consolidated Financial Statements captioned "Long-Term Debt," included in Item 8 of this Report). 1993 results are also before an after-tax charge of approximately $22 million ($.39 per common share) related to the disposition of a segment of the Company's business (see the Note to the Company's Consolidated Financial Statements captioned "Discontinued Operations," included in Item 8 of this Report). Net income for 1993 before preferred stock dividends was $47.6 million or $.57 per common share. Income from continuing operations per common share in 1993 is presented on a fully diluted basis. Primary earnings from continuing operations per common share were $.97 in 1993. For years 1989 through 1992, the assumed conversion of dilutive securities is anti-dilutive. Income from continuing operations before extraordinary loss attributable to common stock was $56.0 million and $29.7 million after preferred stock dividends in 1993 and 1992, respectively. Results for 1991 include the effect of charges for restructurings and other costs, aggregating approximately $41 million pre-tax, which reduced operating profit by $27 million, income from continuing operations before extraordinary income by $27 million and earnings per common share by $.45. Loss from continuing operations attributable to common stock in 1991 was $20.0 million after preferred stock dividends. Results for 1990 include the effect of charges for restructurings and other costs, aggregating approximately $40 million pre-tax, which reduced operating profit by $38 million, income from continuing operations before extraordinary income by $26 million and earnings per common share by $.35. Net loss in 1990 was $18.6 million or $.25 per common share after inclusion of extraordinary income of $8.2 million or $.11 per common share related to the early extinguishment of debt. Results for 1989 include the effect of charges for restructurings and other costs, aggregating approximately $54 million pre-tax, which reduced operating profit by $39 million, income from continuing operations before extraordinary income by $36 million and earnings per common share by $.45. ITEM 7.

ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS. MASCOTECH Masco Corporation undertook a major corporate restructuring during 1984, transferring its Products for Industry businesses to the Company at their historical net book value. MascoTech became a separate public company in mid-1984, when Masco Corporation distributed common shares of MascoTech as a special dividend to its shareholders. At December 31, 1993, Masco Corporation owned approximately 42 percent of MascoTech Common Stock. In 1993 the Company changed its name to MascoTech, Inc. from Masco Industries, Inc. to reflect the significance of technology in the design, engineering and manufacturing of many of the Company's products. CORPORATE DEVELOPMENT Since mid-1984, the Company has acquired a number of businesses for approximately $650 million in cash and Company Common Stock. These acquisitions have contributed significantly to the more than tripling of the sales volume of the Company during this time. The Company has invested more than $1.2 billion in capital expenditures and acquisitions combined to build up the Company's technological positions in its industrial markets. Since late 1988 the Company has divested several operations as part of its long-term strategic plan to de-leverage its balance sheet and focus on its core operating capabilities. The Company's divestiture activity included several businesses transferred to its equity affiliate, TriMas Corporation ("TriMas"), and in late 1993 the announcement of the Company's plan to dispose of its energy-related business segment. In addition to its continuing common equity ownership interest in TriMas (43 percent at December 31, 1993), the Company has realized cash proceeds of approximately $400 million through December 31, 1993 from its divestiture activity which has been applied to reduce the Company's indebtedness. In early 1993, the Company acquired from Masco Corporation 10 million shares of Company Common Stock, $77.5 million of the Company's 12% Exchangeable Preferred Stock held by Masco Corporation, and Masco Corporation's holdings of Emco Limited ("Emco") common stock and convertible debentures. In exchange, Masco Corporation received from the Company $87.5 million in cash, $100 million of the Company's 10% Exchangeable Preferred Stock (subsequently redeemed in 1993) and seven-year warrants to purchase 10 million shares of Company Common Stock at $13 per share. As part of this transaction, as modified in late 1993, Masco Corporation agreed to purchase from the Company, at the Company's option through March, 1997, up to $200 million of subordinated debentures. As a result of these transactions, the Company owns approximately 43 percent of the outstanding common stock and convertible debentures of Emco, a major, publicly traded, Canadian-based manufacturer and distributor principally of building and other industrial products with annual sales of approximately $800 million in 1993. DISCONTINUED OPERATIONS In late November, 1993, the Company adopted a formal plan to divest its energy-related business segment which consisted of seven business units. Accordingly, the applicable financial statements and related notes have been reclassified to present such energy-related segment as discontinued operations and include a 1993 fourth quarter charge of approximately $22 million after-tax to reflect the estimated loss from the disposition of this segment. During 1993, two energy-related business units were sold for approximately $93 million, including the sale of one business unit to the Company's equity affiliate, TriMas, for $60 million. The remaining five energy-related business units had net assets at December 31, 1993 of approximately $68 million (adjusted to reflect the anticipated loss upon disposition, net of tax benefit) and are expected to be disposed of during 1994. Net sales attributable to the discontinued operations during 1993 (through the decision to discontinue), 1992 and 1991 were $192 million, $202 million and $201 million, respectively. The discontinued operations had operating profit of approximately $6 million, $3 million and $1 million in 1993, 1992 and 1991, respectively. PROFIT MARGINS -- CONTINUING OPERATIONS Operating profit margin from continuing operations was nine percent in 1993, eight percent in 1992 and three percent in 1991. The increase in the operating profit margin from continuing operations in 1993 compared with the previous two years is primarily attributable to increased sales volumes in the Transportation-Related Products segment, and from the benefits of internal cost reductions and restructuring initiatives undertaken in recent years. Margins in 1993 related to the Company's Specialty Products segment continue to be hampered by the depressed industry conditions affecting the construction and defense markets that the Company serves. Operating profit from continuing operations was reduced by significant charges aggregating approximately $27 million in 1991. These charges reflect expenses related to the discontinuance of product lines, costs related to the restructuring of several businesses and other expenses. Of these charges, approximately $15 million in 1991 relate to the Company's automotive vehicle conversion business, which has been restructured and returned to profitability. In addition, margins from continuing operations were negatively impacted in 1991 as a result of reduced sales volumes in certain of the Company's Transportation-Related Products operations, due to production cutbacks by automotive customers, and in virtually all of the Company's other product groups due to recessionary market conditions. CASH FLOWS AND CAPITAL EXPENDITURES Net cash flow from operating activities, including discontinued operations, increased to $100 million in 1993 from $58 million in 1992 principally as a result of improved operating performance. In 1993, the Company received approximately $210 million from the issuance of equity (6% Dividend Enhanced Convertible StockSM -- the "DECS") and $93 million from the sale of two energy-related businesses. These proceeds were applied to reduce the Company's indebtedness. The Company redeemed $100 million of non-convertible preferred stock for cash and, in early 1993, the Company invested $87.5 million as described in Corporate Development. During 1991 and 1992, the Company received approximately $260 million in cash from the disposition of its investment in Masco Capital (during 1991 the Company had advanced Masco Capital approximately $44 million to fund debt repayment obligations and working capital requirements) and from the early redemption by TriMas, including a prepayment premium, of TriMas' subordinated debentures held by the Company. These proceeds were applied to reduce the Company's indebtedness in late 1991 and 1992. From January 1, 1991 to December 31, 1993, the Company repaid or repurchased over $380 million, net, of its outstanding debt, and an additional $187 million of convertible debt was converted to Company Common Stock. The Company has substantial new business opportunities over the next few years in its Transportation-Related Products segment which are anticipated to require an increase from the recent level of capital expenditures and increased working capital needs. INVENTORIES The Company's investment in inventories decreased to $140 million at December 31, 1993. This decrease was the result of the sale during 1993 of a portion of the Company's energy-related segment and the reclassification of the remaining inventories in the energy-related segment at December 31, 1993 into net assets of discontinued operations. The Company's continued emphasis on inventory management, utilizing Just-In-Time (JIT) and other inventory management techniques has contributed to higher inventory turnover rates in recent years. FINANCIAL POSITION AND LIQUIDITY During 1993, the Company's financial position was substantially improved as the Company's equity increased by approximately $314 million while its total indebtedness decreased by approximately $339 million. This improvement in financial position resulted from the Company's positive operating performance, the issuance of the DECS, the conversion of the Company's previously outstanding convertible debt into Company Common Stock and from the collection of $93 million of proceeds related to the sale of two of the Company's energy-related businesses. The Company also redeemed its $100 million of 10% Exchangeable Preferred Stock with significantly lower cost bank borrowings, and invested $87.5 million as part of the transactions whereby it acquired the Emco holdings. The Company's financial flexibility and liquidity were also substantially improved during 1993. In September, 1993, the Company entered into a new $675 million revolving credit agreement, replacing a prior bank agreement which required principal payments commencing September 30, 1993. Amounts outstanding under this new agreement are due in January, 1997; however, under certain circumstances the due date may be extended until July, 1998. In addition, the Company in early 1994 sold $345 million of 4 1/2% Convertible Subordinated Debentures due 2003. The proceeds from this offering were used to redeem $250 million of 10 1/4% Subordinated Notes (called in late 1993 for redemption on February 1, 1994) and to retire other indebtedness. The Company at December 31, 1993 had cash and cash investments of $83 million. As a result of the above mentioned transactions, the Company's debt as a percent of debt plus equity was reduced to 54 percent at December 31, 1993 from 76 percent at December 31, 1992. In addition, the Company's annual financing costs have been reduced by approximately $20 million after-tax. As of December 31, 1993, adjusted on a pro forma basis for the issuance in early 1994 of the 4 1/2% Convertible Debentures, the Company had floating rate debt of approximately $213 million (at a current interest rate of approximately 4%) and $578 million of fixed rate debt (at a weighted average interest rate of under 7%). At December 31, 1993 current assets, which aggregated approximately $556 million, were approximately three times current liabilities. In addition, the Company has significant financial assets, including 20 percent or more ownership positions in the securities of three publicly traded companies with an aggregate carrying value of approximately $137 million. This compares with an aggregate quoted market value at December 31, 1993 (which may differ from the amounts that would have been realized upon disposition) of approximately $524 million. The Company's cash, additional borrowings available under the Company's new revolving credit agreement and anticipated internal cash flow are expected to provide sufficient liquidity to fund its near-term working capital and other investment needs. The Company believes that its longer-term working capital and other general corporate requirements, including the retirement of Senior Subordinated Notes maturing in 1995, will be satisfied through its internal cash flow, proceeds from the early 1994 issuance of the 4 1/2% Convertible Debentures, divestiture of the remaining businesses in the energy-related segment, other nonstrategic operating assets and certain additional financial assets and, to the extent necessary, future financings in the financial markets. GENERAL FINANCIAL ANALYSIS 1993 versus 1992 -- Continuing Operations In 1993, net sales from continuing operations increased nine percent to $1.58 billion from $1.46 billion in 1992. Income from continuing operations in 1993, after preferred stock dividends, was $56.0 million or $.91 per common share, assuming full dilution, compared with income from continuing operations, after preferred stock dividends, of $29.7 million or $.49 per common share in 1992. Including the results of discontinued operations and the loss upon disposition of those businesses, and an extraordinary loss ($3.7 million after-tax) related to the early extinguishment of debt, earnings for 1993 after preferred stock dividends were $.57 per common share, compared with earnings, after preferred stock dividends, of $.48 per common share in 1992. Sales of Transportation-Related Products increased 13 percent, principally due to increased levels of automotive production. Sales also benefitted from new product introductions which were partially offset by the phase-out of existing programs, including the mid-1993 completion of the Company's conversion program for the Ford Mustang convertible. Operating profit in 1993 for Transportation- Related Products increased to $160 million from $124 million in 1992. Operating margins, in 1993, continued to be favorably impacted by higher sales volumes for most of the Company's Transportation-Related Products. Margins in both 1993 and 1992 have benefitted from the internal cost reductions and restructuring initiatives that the Company has undertaken in recent years. Sales of Specialty Products in 1993 decreased approximately two percent from 1992 levels reflecting the continued unfavorable market conditions for the Company's Architectural and Defense Products. Operating profit declined to $1 million in 1993 from $5 million in 1992 as the result of the $4 million operating loss for Architectural Products in 1993. This loss was principally the result of costs and expenses related to the consolidation of certain operating activities, start-up costs associated with a new manufacturing process and the unfavorable conditions existing in the markets served by these products. Other expense, net decreased to $25 million in 1993 from $44 million in 1992. Other expense, net in 1993 benefitted from reduced interest expense resulting from a reduction in debt and lower interest rates; and from increased equity and interest income from affiliates related primarily to the Company's Emco holdings. Additionally, 1993 and 1992 results benefitted from gains from sales of marketable securities of approximately $11.5 million and $4.0 million, respectively. Other expense, net for 1993 and 1992 include gains aggregating approximately $13 million and $25 million pre-tax, respectively. These gains resulted from the sale of stock through public offerings by equity affiliates (including in 1993, affiliate shares held by the Company) and, in 1992, a prepayment premium related to the redemption of debentures held by the Company. The Company's equity affiliates may, from time to time, issue additional common equity depending upon their financing requirements. This income was largely offset by costs and expenses related to cost reduction initiatives, the restructuring of certain operations and product lines, adjustments to the carrying values of certain long-term assets and other costs and expenses. Earnings in 1993 were reduced by an extraordinary charge of $3.7 million after-tax related to the early extinguishment of debt. Although the federal statutory corporate tax rate increased in 1993, the Company's effective tax rate on income from continuing operations declined slightly in 1993 as compared with 1992. This decrease was the result of the relationship of substantially higher pre-tax income in 1993 to certain book expenses that are not deductible for tax purposes and to the Company's foreign and state tax expenses. In addition, the application of the increased tax rate to deferred tax balances at December 31, 1992 resulted in a 1993 third quarter one-time charge of approximately $.03 per common share. 1992 versus 1991 -- Continuing Operations In 1992, net sales from continuing operations increased 15 percent to $1.46 billion from $1.27 billion in 1991. Income from continuing operations in 1992, after preferred stock dividends, was $29.7 million or $.49 per common share, compared with a loss from continuing operations, after preferred stock dividends, of $20.0 million or $.33 per common share in 1991. Sales of Transportation-Related Products increased 21 percent due to a modest improvement in levels of automotive production, increased market penetration and the inclusion of a full year of Creative Industries Group sales. Excluding the acquisition of Creative Industries Group, 1992 Transportation-Related Products sales would have increased 16 percent. Operating profit in 1992 for Transportation-Related Products increased 68 percent to $124 million from $74 million in 1991. Operating margins, in 1992, were favorably impacted by higher sales volumes for most of the Company's Transportation-Related Products. In addition, 1992 margins have benefitted from the internal cost reductions and restructuring initiatives that the Company has undertaken in recent years. Sales of Specialty Products were generally unchanged from 1991, as a seven percent increase in sales of Architectural Products was substantially offset by reduced sales of Other Specialty Products. Operating profit for Specialty Products in 1992 was $5 million compared with an operating loss of $15 million in 1991. This improvement resulted principally from improved operating performance of the Architectural Products group which had operating profit of $2 million in 1992 compared with a loss of $16 million in 1991. The 1991 Architectural Products group results were impacted by $8 million of charges related to discontinuance of product lines, restructuring costs and other expenses. Other expense, net decreased to $44 million in 1992 from $56 million in 1991. Other expense, net in 1992 benefitted from reduced interest expense resulting from a reduction in debt and lower interest rates. This was partially offset by reduced interest income as a result of the redemptions of TriMas subordinated debentures previously held by the Company and lower income from sales of marketable securities. Other expense, net for 1992 benefitted from the inclusion of income aggregating approximately $25 million pre-tax in the second quarter resulting from a prepayment premium related to the redemption by TriMas of the subordinated debentures held by the Company, and from the change in the Company's common equity ownership interest in TriMas. This income was substantially offset by costs and expenses aggregating approximately $21 million pre-tax in the second quarter (of which $15 million is included in other expense) related to the restructuring of certain operations, and for adjustments to the carrying values of certain long-term assets. Other expense, net in 1991 benefitted from the inclusion of an approximate $22 million gain related to the disposition of certain operations and reduced interest expense, principally as a result of lower interest rates. Additionally, net gains from sales of marketable securities, including the effect of valuation allowances, aggregated approximately $12 million in 1991. The Company's effective tax rate exceeds the statutory rate primarily as a result of the impact of state taxes and nondeductible amortization. ITEM 8.

ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA. REPORT OF INDEPENDENT ACCOUNTANTS To the Board of Directors and Shareholders of MascoTech, Inc.: We have audited the accompanying consolidated balance sheet of MascoTech, Inc. and subsidiaries (formerly Masco Industries, Inc.) as of December 31, 1993 and 1992, and the related consolidated statements of income and cash flows for each of the three years in the period ended December 31, 1993, and the financial statement schedules as listed in Item 14(a)(2)(i) of this Form 10-K. These financial statements and financial statement schedules are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements and financial statement schedules based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of MascoTech, Inc. and subsidiaries as of December 31, 1993 and 1992, and the consolidated results of their operations and their cash flows for each of the three years in the period ended December 31, 1993, in conformity with generally accepted accounting principles. In addition, in our opinion, the financial statement schedules referred to above, when considered in relation to the basic financial statements taken as a whole, present fairly, in all material respects, the information required to be included therein. COOPERS & LYBRAND Detroit, Michigan February 24, 1994 MASCOTECH, INC. CONSOLIDATED BALANCE SHEET DECEMBER 31, 1993 AND 1992 The accompanying notes are an integral part of the consolidated financial statements. MASCOTECH, INC. CONSOLIDATED STATEMENT OF INCOME FOR THE YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 - ------------------------- * Anti-dilutive The accompanying notes are an integral part of the consolidated financial statements. MASCOTECH, INC. CONSOLIDATED STATEMENT OF CASH FLOWS FOR THE YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 The accompanying notes are an integral part of the consolidated financial statements. MASCOTECH, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS ACCOUNTING POLICIES: Principles of Consolidation. The consolidated financial statements include the accounts of the Company and all majority-owned subsidiaries. All significant intercompany transactions have been eliminated. Corporations that are 20 to 50 percent owned are accounted for by the equity method of accounting. Capital transactions by equity affiliates at amounts differing from the Company's carrying amount are reflected in other income or expense and the investment in affiliates account. Certain amounts for the years ended December 31, 1992 and 1991 have been reclassified to conform to the presentation adopted in 1993. The statements of income and cash flows for 1993, 1992 and 1991 and related notes have been reclassified to present the Energy-related segment as discontinued operations. In addition, the balance sheet as of December 31, 1993 reflects the Energy-related segment as discontinued operations (see "Discontinued Operations" note). The balance sheet as of December 31, 1992 has not been reclassified for discontinued operations. Effective June 23, 1993 the Company changed its name to MascoTech, Inc. from Masco Industries, Inc. The Company has a corporate services agreement with Masco Corporation, which at December 31, 1993 owned approximately 42 percent of the Company's Common Stock. Under the terms of the agreement, the Company pays fees to Masco Corporation for various corporate staff support and administrative services, research and development and facilities. Such fees, which are determined principally as a percentage of net sales, including net sales related to discontinued operations, aggregated approximately $11 million in each of 1993, 1992 and 1991. Cash and Cash Investments. The Company considers all highly liquid debt instruments with an initial maturity of three months or less to be cash and cash investments. The carrying amount reported in the balance sheet for cash and cash investments approximates fair value. At December 31, 1993, the Company has $33 million on deposit with a German bank that is subject to currency exchange rate fluctuations. Receivables. Receivables are presented net of allowances for doubtful accounts of $5.1 million and $7.2 million at December 31, 1993 and 1992, respectively. Inventories. Inventories are stated at the lower of cost or net realizable value, with cost determined principally by use of the first-in, first-out method. Property and Equipment, Net. Property and equipment additions, including significant betterments, are recorded at cost. Upon retirement or disposal of property and equipment, the cost and accumulated depreciation are removed from the accounts, and any gain or loss is included in income. Repair and maintenance costs are charged to expense as incurred. Depreciation and Amortization. Depreciation is computed principally using the straight-line method over the estimated useful lives of the assets. Annual depreciation rates are as follows: buildings and land improvements, 2 1/2 to 10 percent, and machinery and equipment, 6 2/3 to 33 1/3 percent. Deferred financing costs are amortized over the lives of the related debt securities. The excess of cost over net assets of acquired companies is amortized using the straight-line method over the period estimated to be benefitted, not exceeding 40 years. At each balance sheet date management assesses whether there has been a permanent impairment of the excess of cost over net assets of acquired companies by comparing anticipated undiscounted future cash flows from operating activities with the carrying amount of the excess of cost over net assets of acquired companies. The factors considered by management in performing this assessment include current operating results, business prospects, market trends, potential product obsolescence, competitive activities and other economic factors. Based on this assessment there was no permanent impairment related to excess of cost over net assets of acquired companies at December 31, 1993. MASCOTECH, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) At December 31, 1993 and 1992, accumulated amortization of the excess of cost over net assets of acquired companies and patents was $98.4 million and $105.1 million, respectively. Amortization expense was $22.2 million, $22.8 million and $21.2 million in 1993, 1992 and 1991, respectively, including amortization expense of approximately $1.6 million in each year related to discontinued operations. Income Taxes. In January, 1993, the Company adopted Statement of Financial Accounting Standards No. 109 ("SFAS No. 109"), "Accounting for Income Taxes." SFAS No. 109 is an asset and liability approach that requires the recognition of deferred tax assets and liabilities for the expected future tax consequences of events that have been recognized in the Company's financial statements or tax returns. In estimating future tax consequences, SFAS No. 109 generally allows consideration of all expected future events other than enactments of changes in the tax law or tax rates. Previously, the Company used the SFAS No. 96 asset and liability approach that gave no recognition to future events other than the recovery of assets and settlement of liabilities at their carrying amounts. There was no income statement impact from the adoption of SFAS No. 109 and the required balance sheet reclassification was immaterial. Provision is made for U.S. income taxes on the undistributed earnings of foreign subsidiaries unless such earnings are considered permanently reinvested. Earnings (Loss) Per Common Share. Primary earnings (loss) per common share are based on the weighted average number of shares of common stock and common stock equivalents outstanding (including the dilutive effect of options and warrants, utilizing the treasury stock method) of 57.4 million, 60.9 million and 59.7 million in 1993, 1992 and 1991, respectively, and earnings (loss) after deducting preferred stock dividends of $14.9 million, $9.3 million and $9.6 million in 1993, 1992 and 1991, respectively. Fully diluted earnings (loss) per common share are only presented when the assumed conversion of convertible debentures is dilutive. Fully diluted earnings per share in 1993 were calculated based on 68.8 million weighted average common shares outstanding. Convertible securities did not have a dilutive effect on earnings (loss) in 1992 or 1991. The shares of Dividend Enhanced Convertible Stock DECSSM (the "DECS") issued in 1993 (see "Shareholders' Equity" note) are common stock equivalents, but are not included in the calculation of primary or fully diluted shares outstanding as such inclusion would be anti-dilutive. In late 1993, approximately 10.4 million shares were issued as a result of the conversion of the 6% Convertible Subordinated Debentures (see "Shareholders' Equity" note). If such conversion had taken place at the beginning of 1993, the primary earnings per common and common equivalent share amounts would have approximated the amounts presented for earnings per common and common equivalent share, assuming full dilution, for the year ended December 31, 1993. Adoption of Statements of Financial Accounting Standards. The Company expects that the adoption of Statements of Financial Accounting Standards ("SFAS") No. 112 "Employers' Accounting for Postemployment Benefits", SFAS No. 114 "Accounting by Creditors for Impairment of a Loan" and SFAS No. 115 "Accounting for Certain Investments in Debt and Equity Securities" will not have a material impact on the financial position or the results of operations of the Company when adopted in 1994 and 1995. SUPPLEMENTARY CASH FLOWS INFORMATION: Significant transactions not affecting cash were: in 1993: in addition to the payment by the Company of $87.5 million, the non-cash portion of the issuance of Company Preferred Stock and warrants in exchange for Company Common Stock, Company Preferred Stock and Masco Corporation's holdings of Emco Limited common stock and convertible debentures (see "Shareholders' Equity" note); conversion of $187 million of convertible debentures into Company Common Stock MASCOTECH, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) (see "Shareholders' Equity" note); and conversion of the Company's TriMas Corporation ("TriMas") convertible preferred stock holdings into TriMas common stock (see "Equity and Other Investments in Affiliates" note); and in 1991: an exchange of certain operating assets (see "Dispositions of Other Operations" note); and the assumption of liabilities of $18 million in partial exchange for the acquisition of Creative Industries Group (see "Equity and Other Investments in Affiliates" note). Income taxes paid were $32 million in 1993 and $23 million in 1992. Income tax refunds of $8 million were received in 1991. Interest paid was $82 million, $91 million and $115 million in 1993, 1992 and 1991, respectively. DISCONTINUED OPERATIONS: In late November, 1993, the Company adopted a formal plan to divest its Energy-related business segment, which consisted of seven business units. Accordingly, the consolidated statements of income and cash flows and related notes have been reclassified to present such Energy-related segment as discontinued operations. During 1993, two such business units were sold for approximately $93 million, including the sale of one business unit to the Company's equity affiliate, TriMas for $60 million cash. The expected loss from the planned disposition of the Company's Energy-related segment resulted in a fourth quarter 1993 pre-tax charge of approximately $41 million (approximately $22 million after-tax), including a provision for the businesses not yet sold and the deferral of a portion of the gain (approximately $6 million after-tax) related to the sale of the business to TriMas. The Company expects to sell the remaining business units in privately negotiated transactions in 1994. Selected financial information for discontinued operations is as follows as at December 31, 1993 and for the period up to the decision to discontinue in 1993 and for the years ended December 31, 1992 and 1991: The unusual relationship of income taxes to pre-tax income in 1992 results principally from foreign losses for which no tax benefit was recorded. Operating and pre-tax income include charges of $6 million in 1991, principally related to the discontinuance of product lines and the cost of restructuring several businesses. MASCOTECH, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) DISPOSITIONS OF OTHER OPERATIONS: In separate transactions from late 1989 to early 1991, the Company divested itself of three subsidiaries and received consideration of approximately $160 million, of which $108 million was received in 1990. The remaining $52 million was received in 1991. In addition, in 1991 the Company disposed of certain equity affiliates, and exchanged operating assets aggregating approximately $27 million. These transactions, including the disposition of Masco Capital Corporation (see "Equity and Other Investments in Affiliates" note), resulted in an approximate $22 million pre-tax gain in 1991. INVENTORIES: EQUITY AND OTHER INVESTMENTS IN AFFILIATES: Equity and other investments in affiliates consist primarily of the following common stock interests in publicly traded affiliates: MASCOTECH, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) The carrying amount of investments in affiliates at December 31, 1993 and 1992 and quoted market values at December 31, 1993 for publicly traded affiliates (which may differ from the amounts that could have been realized upon disposition) are as follows: In 1988, the Company transferred several businesses to TriMas, a publicly traded, diversified manufacturer of commercial, industrial and consumer products. In exchange, the Company received $128 million principal amount of 14% Subordinated Debentures (which were subsequently redeemed resulting in prepayment premium income to the Company of $9 million in 1992 and $4 million in 1991), $70 million (liquidation value) of 10% Convertible Participating Preferred Stock and 9.3 million shares of TriMas common stock. During the second quarter of 1992, TriMas sold 9.2 million shares of newly issued common stock at $9.75 per share in a public offering, which reduced the Company's common equity ownership interest in TriMas to 28 percent from 41 percent. As a result, the Company recognized a pre-tax gain of $16.7 million from the change in the Company's common equity ownership interest in TriMas. In late 1993, the TriMas 10% Convertible Participating Preferred Stock held by the Company was converted at a conversion price of $9 per share into 7.8 million shares of TriMas common stock, increasing the Company's common equity ownership interest in TriMas to 43 percent. In 1993, the Company sold a business unit to TriMas for $60 million cash (see "Discontinued Operations" note). Included in notes receivable are approximately $10.7 million of notes which resulted from the sale by the Company of one million shares of its TriMas common stock holdings to members of the Company's executive management group in mid-1989. The notes have an effective interest rate of nine percent, payable at maturity in mid-1994. Ownership and resale of certain of such shares is restricted and subject to the continuing employment of these executives. TriMas' Board of Directors declared a 100 percent stock distribution (one additional share for every share held) to its shareholders effective July 19, 1993. TriMas share amounts and per share prices have been restated to reflect this distribution. The Company's holdings in Emco Limited ("Emco") were acquired from Masco Corporation in 1993 (see "Shareholders' Equity" note). Emco is a major, publicly traded, Canadian-based MASCOTECH, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) manufacturer and distributor of building and other industrial products with annual sales of approximately $800 million. At December 31, 1992, the Company had an approximate 47 percent common equity ownership interest in Titan Wheel International, Inc. ("Titan"), a manufacturer of wheels and other products for agricultural, construction and other off-highway equipment markets. In May, 1993, Titan completed an initial public offering of three million shares of common stock at $15 per share (including 292,000 shares held by the Company), reducing the Company's common equity ownership interest in Titan to 24 percent. The Company's ownership interest was further reduced in late 1993 to 21 percent as a result of the issuance of additional common shares by Titan in connection with an acquisition by Titan. These transactions resulted in 1993 gains aggregating approximately $12.8 million pre-tax (principally in the second quarter) as a result of the sale of shares held by the Company and from the change in the Company's common equity ownership interest in Titan. During the second quarter of 1991, the Company acquired the remaining 50 percent equity ownership interest of Creative Industries Group, which had sales in 1990 of approximately $150 million. In 1991, Masco Capital Corporation ("Masco Capital") sold its principal asset and used the proceeds to repay its outstanding bank borrowings and to make loan repayments and distributions to its shareholders, whereby the Company received approximately $65 million (including repayment of $44 million advanced during 1991). In addition, the Company subsequently sold its 50 percent equity ownership interest in Masco Capital to the other shareholder, Masco Corporation, for approximately $50 million (which resulted in a pre-tax gain of approximately $5 million) and contingent amounts based on the future value of certain assets held by Masco Capital. In addition to its equity and other investments in publicly traded affiliates, the Company retains interests in privately held manufacturers of automotive components, including the Company's 50 percent common equity ownership interests in Autostyle, Inc., a manufacturer of reaction injection molded automotive components, and Elbi-Hi Ram, Inc., a manufacturer of electrical and electronic automotive components. Approximate combined condensed financial data of the Company's equity affiliates (including Emco after date of investment, Creative Industries Group through date of acquisition (second quarter 1991) and Masco Capital through date of disposition) are as follows: MASCOTECH, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) Equity and interest income from affiliates consists of the following: PROPERTY AND EQUIPMENT, NET: Depreciation expense totalled $48 million, $46 million and $47 million in 1993, 1992 and 1991, respectively. These amounts include depreciation expense of approximately $8 million in each year related to discontinued operations. ACCRUED LIABILITIES: MASCOTECH, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) LONG-TERM DEBT: In 1993, the Company entered into a new $675 million revolving credit agreement with a group of banks, replacing its prior bank credit agreement (which had consisted of a revolving credit facility and a bank term loan at December 31, 1992). Amounts outstanding under the revolving credit agreement are due in January, 1997; however, under certain circumstances, the due date may be extended to July, 1998. The interest rates applicable to the revolving credit agreement are principally at alternative floating rates provided for in the agreement (approximately four percent at December 31, 1993). The revolving credit agreement requires the maintenance of a specified level of shareholders' equity, with limitations on the ratio of senior debt to earnings, long-term debt (at December 31, 1993 additional borrowing capacity of approximately $380 million was available under this agreement), intangible assets and the acquisition of Company Capital Stock. Under the most restrictive of these provisions, $120 million of retained earnings was available at December 31, 1993 for the payment of cash dividends and the acquisition of Company Capital Stock. The 6% Convertible Subordinated Debentures were converted into Company Common Stock in late 1993 (see "Shareholders' Equity" note). The senior subordinated notes contain limitations on the payment of cash dividends and the acquisition of Company Capital Stock. In late 1993, the Company called for redemption, on February 1, 1994, the $250 million of 10 1/4% Senior Subordinated Notes. During 1992, the Company repurchased, in open-market transactions, approximately $67 million of its 10% Senior Subordinated Notes at prices approximating face value. In early 1994, the Company issued, in a public offering, $345 million of 4 1/2% Convertible Subordinated Debentures due December 15, 2003. These debentures are convertible into Company Common Stock at $31 per share. The net proceeds were used to redeem the $250 million of 10 1/4% Subordinated Notes (called in late 1993 for redemption on February 1, 1994) and to reduce other indebtedness. In the fourth quarter of 1993, the Company recognized a $5.8 million pre-tax extraordinary charge ($3.7 million after-tax) related to the call premium (1.25%) and unamortized prepaid debenture expense associated with the call for early extinguishment of the $250 million of 10 1/4% Subordinated Notes. The 10 1/4% Subordinated Notes are classified as non-current as the Company had the intent and the ability to maintain these borrowings on a long-term basis (due to the issuance of the 4 1/2% Convertible Subordinated Debentures). The maturities of long-term debt during the next five years are as follows (in millions): 1994 -- $3; 1995 -- $234; 1996 -- $1; 1997 -- $303; and 1998 -- $0. MASCOTECH, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) SHAREHOLDERS' EQUITY: On March 31, 1993, the Company acquired from Masco Corporation 10 million shares of Company Common Stock, recorded at $100 million, $77.5 million of the Company's previously outstanding 12% Exchangeable Preferred Stock, and Masco Corporation's holdings of Emco Limited common stock and convertible debentures, recorded at $80.8 million. In exchange, Masco Corporation received $100 million (liquidation value) of the Company's 10% Exchangeable Preferred Stock, seven-year warrants to purchase 10 million shares of Company Common Stock at $13 per share, recorded at $70.8 million, and $87.5 million in cash. The transferable warrants are not exercisable by Masco Corporation if an exercise would increase Masco Corporation's common equity ownership interest in the Company above 35 percent. The cash portion of this transaction is included in the accompanying statement of cash flows as cash used for investing activities of $87.5 million. As part of this transaction, as modified in late 1993, Masco Corporation agreed to purchase from the Company, at the Company's option through March, 1997, up to $200 million of subordinated debentures. In late 1993, the Company redeemed the 10% Exchangeable Preferred Stock for its $100 million liquidation value. In July, 1993, the Company issued 10.8 million shares of 6% Dividend Enhanced Convertible Stock (DECS) at $20 per share ($216 million aggregate liquidation amount) in a public offering (classified as MASCOTECH, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) Convertible Preferred Stock). The net proceeds from this issuance were used to reduce the Company's indebtedness. On July 1, 1997, each of the then outstanding shares of the DECS will convert into one share of Company Common Stock, if not previously redeemed by the Company or converted at the option of the holder, in both cases for Company Common Stock. Each share of the DECS is convertible at the option of the holder anytime prior to July 1, 1997 into .806 of a share of Company Common Stock, equivalent to a conversion price of $24.81 per share of Company Common Stock. Dividends are cumulative and each share of the DECS has 4/5 of a vote, voting together as one class with holders of Company Common Stock. Beginning July 1, 1996, the Company, at its option, may redeem the DECS at a call price payable in shares of Company Common Stock principally determined by a formula based on the then current market price of Company Common Stock. Redemption by the Company, as a practical matter, will generally not result in a call price that exceeds one share of Company Common Stock or is less than .806 of a share of Company Common Stock (resulting from the holder's conversion option). The Company's 6% Convertible Subordinated Debentures were called for redemption in late 1993. Substantially all holders, including Masco Corporation, exercised their right to convert these debentures into Company Common Stock (at a conversion price of $18 per share), resulting in the issuance of approximately 10.4 million shares of Company Common Stock. The Company's consideration for a 1987 acquisition included two million shares of Company Common Stock which were subject to a stock value guarantee agreement. During the second quarter of 1993, the Company's stock value guarantee obligation was settled, resulting in no material financial impact to the Company. The Company commenced paying cash dividends on its Common Stock in August, 1993 and declared three and paid two quarterly dividends in 1993, each in the amount of $.02 per common share. STOCK OPTIONS AND AWARDS: For the three years ended December 31, 1993, stock option data pertaining to stock option plans for key employees of the Company and affiliated companies are as follows: As of December 31, 1993, options have been granted and are outstanding with exercise prices ranging from $4 1/2 to $26 per share, the fair market value at the dates of grant. Pursuant to restricted stock incentive plans, the Company granted long-term incentive awards, net, for 202,000, 251,000 and 675,000 shares of Company Common Stock during 1993, 1992 and 1991, respectively, to key employees of the Company and affiliated companies. The unamortized costs of MASCOTECH, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) incentive awards, aggregating approximately $20 million at December 31, 1993, are being amortized over the ten-year vesting periods. At December 31, 1993 and 1992, a combined total of 5,631,000 and 5,759,000 shares, respectively, of Company Common Stock were available for the granting of options and incentive awards under the above plans. EMPLOYEE BENEFIT PLANS: Pension and Profit-Sharing Benefits. The Company sponsors defined-benefit pension plans for most of its employees. In addition, substantially all salaried employees participate in noncontributory profit-sharing plans, to which payments are approved annually by the Directors. Aggregate charges to income under these plans were $10.9 million in 1993, $10.3 million in 1992 and $8.3 million in 1991, including approximately $.9 million in each year related to discontinued operations. Net periodic pension cost for the Company's defined-benefit pension plans includes the following components for the three years ended December 31, 1993: Major assumptions used in accounting for the Company's defined-benefit pension plans are as follows: MASCOTECH, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) The funded status of the Company's defined-benefit pension plans at December 31, 1993 and 1992 is as follows: Postretirement Benefits. The Company provides postretirement medical and life insurance benefits for certain of its active and retired employees. Effective January 1, 1993, the Company adopted Statement of Financial Accounting Standards No. 106 "Employers' Accounting for Postretirement Benefits Other Than Pensions" ("SFAS 106") for its postretirement benefit plans. This statement requires the accrual method of accounting for postretirement health care and life insurance based on actuarially determined costs to be recognized over the period from the date of hire to the full eligibility date of employees who are expected to qualify for such benefits. In conjunction with the adoption of SFAS 106, the Company elected to recognize the transition obligation on a prospective basis and accordingly, the net transition obligation is being amortized over 20 years. Net periodic postretirement benefit cost includes the following components for the year ended December 31, 1993: The incremental cost in 1993 of accounting for postretirement health care and life insurance benefits under SFAS 106 amounted to approximately $1.7 million. MASCOTECH, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) Postretirement benefit obligations, none of which are funded, are summarized as follows for the year ended December 31, 1993: The discount rate used in determining the accumulated postretirement benefit obligation was seven percent. The assumed health care cost trend rate in 1993 was 12 percent, decreasing to an ultimate rate in the year 2000 of seven percent. If the assumed medical cost trend rates were increased by one percent, the accumulated postretirement benefit obligation would increase by $2.6 million and the aggregate of the service and interest cost components of net periodic postretirement benefit cost would increase by $.2 million. SEGMENT INFORMATION: The Company's business segments involve the production and sale of the following: Transportation-Related Products: Precision products, generally produced using advanced metalworking technologies with significant proprietary content, and aftermarket products for the transportation industry. Specialty Products: Architectural -- Doors, windows, security grilles and office panels and partitions for commercial and residential markets. Other -- Products manufactured principally for the defense industry. Amounts related to the Company's Energy-related segment have been presented as discontinued operations. Corporate assets consist primarily of cash and cash investments, equity and other investments in affiliates and notes receivable. MASCOTECH, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) - --------------- (A) Included within this segment are sales to one customer of $324 million, $268 million and $217 million in 1993, 1992 and 1991, respectively; sales to another customer of $222 million, $216 million and $201 million in 1993, 1992 and 1991, respectively; and sales to a third customer of $186 million, $184 million and $126 million in 1993, 1992 and 1991, respectively. (B) Included in 1991 operating profit (principally Transportation-Related Products and Architectural Products) are charges of $27 million to reflect the expenses related to the discontinuance of product lines, and the costs of restructuring several businesses. Other expense, net in 1992 and 1991, includes approximately $15 million and $14 million, respectively, to reflect disposition costs related to idle facilities and other long-term assets. MASCOTECH, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) OTHER INCOME (EXPENSE), NET: Gains realized from sales of marketable securities are determined on a specific identification basis at the time of sale. INCOME TAXES: MASCOTECH, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) The components of the net deferred taxes as at December 31, 1993 were as follows: The following is a reconciliation of tax computed at the U.S. federal statutory rate to the provision for income taxes (credit) allocated to income (loss) from continuing operations before income taxes (credit) and extraordinary loss: Provisions for deferred income taxes by temporary difference components for the years ended December 31, 1992 and 1991 were as follows: MASCOTECH, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) FAIR VALUE OF FINANCIAL INSTRUMENTS: In accordance with Statement of Financial Accounting Standards No. 107, "Disclosures about Fair Value of Financial Instruments," the following methods were used to estimate the fair value of each class of financial instruments: Notes Receivable and Other Assets. Fair values of financial instruments included in notes receivable and other assets were estimated using various methods including quoted market prices and discounted future cash flows based on the incremental borrowing rates for similar types of investments. In addition, for variable-rate notes receivable that fluctuate with the prime rate, the carrying amounts approximate fair value. Long-Term Debt. The carrying amount of bank debt and certain other long-term debt instruments approximate fair value as the floating rates inherent in this debt reflect changes in overall market interest rates. The fair values of the Company's subordinated debt instruments are based on quoted market prices. The fair values of certain other debt instruments are estimated by discounting future cash flows based on the Company's incremental borrowing rate for similar types of debt instruments. The carrying amounts and fair values of the Company's financial instruments as at December 31, 1993 and 1992 are as follows: MASCOTECH, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) INTERIM AND OTHER SUPPLEMENTAL FINANCIAL DATA (UNAUDITED): MASCOTECH, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) Certain amounts presented above have been reclassified to present a segment of the Company's business as discontinued operations (see "Discontinued Operations" note). Results for the second quarters of 1993 and 1992 include pre-tax income of approximately $9 million and $25 million, respectively, as a result of gains associated with the sale of common stock through public offerings by equity affiliates and, in 1992, a prepayment premium related to the redemption of debentures held by the Company. This income was largely offset by costs and expenses related to cost reduction initiatives, the restructuring of certain operations and product lines, adjustments to the carrying value of certain long-term assets, and other costs and expenses. Results for the third quarter of 1993 were reduced by a charge of approximately $.04 per common share reflecting the recently increased 1993 federal corporate income tax rate. The fourth quarter of 1993 net loss includes the effect of a $5.8 million pre-tax extraordinary charge ($3.7 million after-tax or $.06 per common share) related to the early extinguishment of subordinated debt (see "Long-Term Debt" note). The fourth quarter of 1993 net loss also includes an after-tax charge of approximately $22 million ($.38 per common share) related to the disposition of a segment of the Company's business (see "Discontinued Operations" note). The 1993 results include the benefit of approximately $11.5 million pre-tax income ($6.7 million after-tax or $.12 per common share), primarily in the third and fourth quarters, resulting from net gains from sales of marketable securities. The 1992 results include the benefit of approximately $4 million pre-tax income ($2 million after-tax or $.04 per common share), primarily in the fourth quarter, resulting from net gains from sales of marketable securities. The 1993 income (loss) per common share amounts for the quarters do not total to the full year amounts due to the changes in the number of common shares outstanding during the year and the dilutive effect of first, second and third quarter 1993 results. The calculation of earnings per common and common equivalent share for the fourth quarter of 1993 results in dilution for income from continuing operations, assuming full dilution. Therefore, the fully diluted earnings per share computation is used for all computations, even though the result is anti-dilutive for one of the per share amounts. MASCOTECH, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONCLUDED) The following supplemental unaudited financial data combine the Company with Masco Capital Corporation (through date of disposition) and TriMas and have been presented for analytical purposes. The Company had a common equity ownership interest in TriMas of approximately 43 percent at December 31, 1993 and 28 percent at December 31, 1992. The interests of the other common shareholders are reflected below as "Equity of other shareholders of TriMas." All significant intercompany transactions have been eliminated. ITEM 9.

ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE. Not applicable. PART III ITEM 10.

ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT. Information regarding executive officers required by this Item is set forth as a Supplementary Item at the end of Part I hereof (pursuant to Instruction 3 to Item 401(b) of Regulation S-K). Other information required by this Item will be contained in the Company's definitive Proxy Statement for its 1994 Annual Meeting of Stockholders, to be filed on or before April 30, 1994, and such information is incorporated herein by reference. ITEM 11.

ITEM 11. EXECUTIVE COMPENSATION. Information required by this Item will be contained in the Company's definitive Proxy Statement for its 1994 Annual Meeting of Stockholders, to be filed on or before April 30, 1994, and such information is incorporated herein by reference. ITEM 12.

ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT. Information required by this Item will be contained in the Company's definitive Proxy Statement for its 1994 Annual Meeting of Stockholders, to be filed on or before April 30, 1994, and such information is incorporated herein by reference. ITEM 13.

ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS. Information required by this Item will be contained in the Company's definitive Proxy Statement for its 1994 Annual Meeting of Stockholders, to be filed on or before April 30, 1994, and such information is incorporated herein by reference. PART IV ITEM 14.

ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K. (A) LISTING OF DOCUMENTS. (1) Financial Statements. The Company's Consolidated Financial Statements included in Item 8 hereof, as required at December 31, 1993 and 1992, and for the years ended December 31, 1993, 1992 and 1991, consist of the following: Consolidated Balance Sheet Consolidated Statement of Income Consolidated Statement of Cash Flows Notes to Consolidated Financial Statements (2) Financial Statement Schedules. (i) Financial Statement Schedules of the Company appended hereto, as required for the years ended December 31, 1993, 1992 and 1991, consist of the following: II. Amounts Receivable from Related Parties and Underwriters, Promoters, and Employees Other than Related Parties V. Property, Plant and Equipment VI. Accumulated Depreciation, Depletion and Amortization of Property, Plant and Equipment VIII. Valuation and Qualifying Accounts X. Supplementary Income Statement Information (ii) (A) TriMas Corporation and Subsidiaries Consolidated Financial Statements appended hereto, as required at December 31, 1993 and 1992, and for the years ended December 31, 1993, 1992 and 1991, consist of the following: Consolidated Statements of Income Consolidated Balance Sheets Consolidated Statements of Cash Flows Notes to Consolidated Financial Statements (ii) (B) TriMas Corporation and Subsidiaries Financial Statement Schedules appended hereto, as required for the years ended December 31, 1993, 1992 and 1991, consist of the following: V. Property, Plant and Equipment VI. Accumulated Depreciation, Depletion and Amortization of Property, Plant and Equipment VIII. Valuation and Qualifying Accounts X. Supplementary Income Statement Information (3) Exhibits. 3.i Restated Certificate of Incorporation of MascoTech, Inc. and amendments thereto. 3.ii Bylaws of MascoTech, Inc., as amended.(3) 4.a Indenture dated as of November 1, 1986 between Masco Industries, Inc. (now known as MascoTech, Inc.) and Morgan Guaranty Trust Company of New York, as Trustee, and Directors' resolutions establishing the Company's 4 1/2% Convertible Subordinated Debentures Due 2003. - ------------------------- (1) Incorporated by reference to the Exhibits filed with MascoTech, Inc.'s Current Report on Form 8-K dated November 22, 1993. (2) Incorporated by reference to the Exhibits filed with MascoTech, Inc.'s Quarterly Report on Form 10-Q for the quarter ended September 30, 1993. (3) Incorporated by reference to the Exhibits filed with MascoTech, Inc.'s Current Report on Form 8-K dated June 22, 1993. (4) Incorporated by reference to the Exhibits filed with MascoTech, Inc.'s Registration Statement on Form S-3 dated March 9, 1993. (5) Incorporated by reference to the Exhibits filed with MascoTech, Inc.'s Current Report on Form 8-K dated February 1, 1993. (6) Incorporated by reference to the Exhibits filed with MascoTech, Inc.'s Annual Report on Form 10-K for the year ended December 31, 1992. (7) Incorporated by reference to the Exhibits filed with MascoTech, Inc.'s Annual Report on Form 10-K for the year ended December 31, 1991. (8) Incorporated by reference to the Exhibits filed with MascoTech, Inc.'s Annual Report on Form 10-K for the year ended December 31, 1990. (9) Incorporated by reference to the Exhibits filed with MascoTech, Inc.'s Annual Report on Form 10-K for the year ended December 31, 1989. (B) REPORTS ON FORM 8-K. The following Current Reports on Form 8-K were filed by MascoTech, Inc. in the calendar quarters ended December 31, 1993 and March 31, 1994: 1. Report on Form 8-K dated November 22, 1993 reporting under Item 2 "Acquisition or Disposition of Assets" the Company's plan to dispose of its energy-related businesses and to treat such businesses as discontinued operations for financial reporting purposes. The following financial statements and financial information were filed with such report: (i) MascoTech, Inc. and Subsidiaries unaudited pro forma consolidated condensed balance sheet as of September 30, 1993, and unaudited pro forma consolidated condensed statements of income for the year ended December 31, 1992 and the nine-month period ended September 30, 1993. 2. Report on Form 8-K dated January 11, 1994 reporting under Item 5 "Other Events" the reclassification of certain of the Company's financial statements and financial information to reflect the treatment of the Company's energy-related businesses as discontinued operations in connection with the Company's previously reported plan to dispose of such businesses. The following financial statements and financial information were filed with such report: (i) Selected Financial Data; (ii) MascoTech, Inc. and Subsidiaries Audited Consolidated Financial Statements as of December 31, 1992 and 1991 and for the three years in the period ended December 31, 1992 and notes thereto; and (iii) MascoTech, Inc. and Subsidiaries Unaudited Consolidated Condensed Financial Statements as of September 30, 1993 and December 31, 1992 and for the three month and nine month periods ended September 30, 1993 and 1992 and notes thereto. 3. Report on Form 8-K dated March 2, 1994 reporting under Item 5 "Other Events" certain financial information related to 1993. The following financial statements were filed with such report: (i) MascoTech, Inc. and Subsidiaries Audited Consolidated Financial Statements as of December 31, 1993 and 1992 and for the three years in the period ended December 31, 1993 and notes thereto. SIGNATURES Pursuant to the requirements of Section 13 or 15(d) 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. MASCOTECH, INC. By /s/ TIMOTHY WADHAMS -------------------------------------- TIMOTHY WADHAMS Vice President -- Controller and Treasurer March 22, 1994 Pursuant to the requirements of the Securities Exchange Act of 1934, this Report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the date indicated. MASCOTECH, INC. FINANCIAL STATEMENT SCHEDULES PURSUANT TO ITEM 14(A)(2) OF FORM 10-K ANNUAL REPORT TO THE SECURITIES AND EXCHANGE COMMISSION FOR THE YEAR ENDED DECEMBER 31, 1993 MASCOTECH, INC. FINANCIAL STATEMENT SCHEDULES Schedules, as required for the years ended December 31, 1993, 1992 and 1991: MASCOTECH, INC. SCHEDULE II. AMOUNTS RECEIVABLE FROM RELATED PARTIES AND UNDERWRITERS, PROMOTERS, AND EMPLOYEES OTHER THAN RELATED PARTIES FOR THE YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 All amounts receivable are related to an incentive program of the Company that has been disclosed in previous proxy statements of the Company and that will be described in the Company's definitive Proxy Statement for its 1994 Annual Meeting of Stockholders to be filed on or before April 30, 1994. NOTES: (A) Represents accrual of interest. (B) Amounts receivable (including interest of $3,400,000) from employees are due June 30, 1994. The stated rate of interest is 7%. (C) Represents the discount pertaining to the difference between the stated rate of interest of 7% and the effective rate of interest of approximately 9%. Activity in 1992 includes discount amortization of $550,000, interest of $710,000 and the cancellation of the receivable balance of $1,350,000 for an ex-employee. Activity in 1991 includes discount amortization of $340,000 and interest of $1,040,000. MASCOTECH, INC. SCHEDULE V. PROPERTY, PLANT AND EQUIPMENT FOR THE YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 NOTES: (A) Includes property, plant and equipment additions of $20 million in 1991 obtained through the acquisition of companies. (B) Includes property, plant and equipment from the disposition of certain operations in 1991. (C) Adjustments and reclassifications to present the Energy-related segment as discontinued operations in 1993, and the effect of foreign currency translation. MASCOTECH, INC. SCHEDULE VI. ACCUMULATED DEPRECIATION, DEPLETION AND AMORTIZATION OF PROPERTY, PLANT AND EQUIPMENT FOR THE YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 Notes: (A) Includes accumulated depreciation of property, plant and equipment from the disposition of operations in 1991. (B) Adjustments and reclassifications to present the Energy-related segment as discontinued operations in 1993, and the effect of foreign currency translation. MASCOTECH, INC. SCHEDULE VIII. VALUATION AND QUALIFYING ACCOUNTS FOR THE YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 Notes: (A) Allowance of companies reclassified for discontinuance of Energy-related segment in 1993, and other adjustments, net in 1991. (B) Deductions, representing uncollectible accounts written off, less recoveries of accounts written off in prior years. MASCOTECH, INC. SCHEDULE X. SUPPLEMENTARY INCOME STATEMENT INFORMATION FOR THE YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 Notes: Other captions provided for under this schedule are excluded, as the amounts related to such captions are not material. Amounts reflect the reclassification of the Company's Energy-related segment as discontinued operations. REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS To the Board of Directors and Shareholders of TriMas Corporation: We have audited the consolidated financial statements and the financial statement schedules of TriMas Corporation and subsidiaries listed in Item 14(a)(2)(ii) of this Form 10-K. These financial statements and financial statement schedules are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements and financial statement schedules based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of TriMas Corporation and subsidiaries as of December 31, 1993 and 1992, and the consolidated results of their operations and their cash flows for each of the three years in the period ended December 31, 1993 in conformity with generally accepted accounting principles. In addition, in our opinion, the financial statement schedules referred to above, when considered in relation to the basic financial statements taken as a whole, present fairly, in all material respects, the information required to be included therein. COOPERS & LYBRAND Detroit, Michigan February 8, 1994 TRIMAS CORPORATION AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF INCOME The accompanying notes are an integral part of the consolidated financial statements. TRIMAS CORPORATION AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS The accompanying notes are an integral part of the consolidated financial statements. TRIMAS CORPORATION AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS The accompanying notes are an integral part of the consolidated financial statements. TRIMAS CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE 1. ACCOUNTING POLICIES PRINCIPLES OF CONSOLIDATION The consolidated financial statements include the accounts of TriMas Corporation and its majority owned subsidiaries (the "Company"). All significant intercompany transactions have been eliminated. AFFILIATES As of December 31, 1993 MascoTech, Inc.'s common stock ownership in the Company approximated 43 percent, and Masco Corporation's common stock ownership approximated 5 percent. The Company has a corporate services agreement with Masco Corporation. Under the terms of the agreement, the Company pays a fee to Masco Corporation for various corporate support staff, administrative services, and research and development services. Such fee equals .8 percent of the Company's net sales, subject to certain adjustments. CASH AND CASH EQUIVALENTS The Company considers all highly liquid debt instruments purchased with a maturity of three months or less to be cash equivalents. INVENTORIES Inventories are stated at the lower of cost or net realizable value, with cost determined principally by use of the first-in, first-out method. PROPERTY AND EQUIPMENT Property and equipment additions, including significant betterments, are recorded at cost. Upon retirement or disposal of property and equipment, the cost and accumulated depreciation are removed from the accounts and any gain or loss is included in income. Maintenance and repair costs are charged to expense as incurred. DEPRECIATION AND AMORTIZATION Depreciation is computed principally using the straight-line method over the estimated useful lives of the assets. Annual depreciation rates are as follows: buildings and land improvements, 2 1/2 to 5 percent, and machinery and equipment, 6 2/3 to 33 1/3 percent. The excess of cost over net assets of acquired companies is being amortized using the straight-line method over the periods estimated to be benefitted, not exceeding 40 years. At December 31, 1993 and 1992 accumulated amortization of the excess of cost over net assets of acquired companies and other intangible assets was $21.5 million and $17.0 million, respectively. Amortization expense was $4.5 million, $4.2 million, and $3.4 million in 1993, 1992 and 1991, respectively. As of each balance sheet date management assesses whether there has been an impairment in the value of excess of cost over net assets of acquired companies by comparing anticipated undiscounted future cash flows from the related operating activities with the carrying value. The factors considered by management in performing this assessment include current operating results, trends and prospects, as well as the effects of obsolescence, demand, competition and other economic factors. Based on this assessment there was no impairment at December 31, 1993. TRIMAS CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) NOTE 1. ACCOUNTING POLICIES (CONTINUED) INCOME TAXES The Company uses the liability method of accounting for income taxes. Deferred income taxes result from temporary differences between the tax basis of assets and liabilities and the basis as reported in the consolidated financial statements. The Company has not provided for taxes on $9.4 million of undistributed earnings of foreign subsidiaries at December 31, 1993, because such earnings are considered permanently reinvested. FOREIGN CURRENCY TRANSLATION Net assets of the Company's operations outside of the United States are translated into U.S. dollars using current exchange rates with the effects of translation adjustments deferred and included as a separate component of shareholders' equity. Revenues and expenses are translated at the average rates of exchange during the period. EARNINGS PER COMMON SHARE On June 7, 1993 the Company's Board of Directors adopted a resolution for a stock split, effected in the form of a 100 percent stock distribution, with issuance to shareholders on July 6, 1993. Accordingly, information in the consolidated financial statements and related notes, including the number of common shares and per common share amounts, has been adjusted to reflect this distribution. Primary earnings per common share in 1993, 1992 and 1991 were calculated on the basis of 31.1 million, 26.0 million and 19.8 million weighted average common and common equivalent shares outstanding. Fully diluted earnings per common share in 1993, 1992 and 1991 were calculated on the basis of 39.1 million, 33.9 million and 27.6 million weighted average common and common equivalent shares outstanding. On December 15, 1993 MascoTech, Inc. converted all of the $100 Convertible Participating Preferred Stock into 7.8 million shares of Company common stock. On a pro forma basis, as if the conversion had occurred on January 1, 1993, primary and fully diluted earnings per common share for 1993 would have been $1.03 and $1.01, respectively. NOTE 2. ACQUISITIONS In 1993 the Company acquired all of the capital stock of Lamons Metal Gasket Co. ("Lamons") from MascoTech, Inc. for $60.3 million cash and the assumption of certain liabilities. The acquisition was accounted for as a purchase. The excess of cost over net assets acquired of approximately $45.4 million is being amortized on a straight-line basis over 40 years. The results of operations of Lamons have been included in the consolidated financial statements from the effective date of the transaction. Additional purchase price amounts, contingent upon the achievement of specified levels of future profitability by Lamons, may be payable to MascoTech, Inc. beginning in 1997. These payments, if required, will be recorded as additional excess of cost over net assets of acquired businesses. Lamons is engaged in the manufacture of specialty metallic and non-metallic gaskets used in the refinery, chemical and petrochemical industries. The acquisition was financed through partial use of the Company's bank credit facility. TRIMAS CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) NOTE 2. ACQUISITIONS (CONTINUED) On a pro forma, unaudited basis, as if the Lamons acquisition had occurred as of January 1, 1992, net sales, net income, earnings available for common stock, primary earnings per common share and fully diluted earnings per common share for 1993 would have been $475.6 million, $40.6 million, $35.4 million, $1.14 and $1.08, respectively, and net sales, income before extraordinary charge, net income, earnings available for common stock, primary earnings per common share before extraordinary charge, fully diluted earnings per common share before extraordinary charge, primary earnings per common share and fully diluted earnings per common share for 1992 would have been $437.8 million, $33.7 million, $27.9 million, $20.9 million, $1.02, $.99, $.80 and $.80, respectively. During 1991 the Company acquired all of the capital stock of Monogram Aerospace Fasteners, Inc. for $50.2 million cash and the assumption of certain operating liabilities. The acquisition was accounted for as a purchase. The excess of cost over net assets acquired of $13.4 million is being amortized on a straight-line basis over 40 years. The results of operations of Monogram Aerospace Fasteners, Inc. have been included in the consolidated financial statements from the date of acquisition. NOTE 3. SUPPLEMENTAL CASH FLOWS INFORMATION NOTE 4. RECEIVABLES Accounts receivable are presented net of an allowance for doubtful accounts of $1.8 million and $1.4 million at December 31, 1993 and 1992, respectively. Accounts receivable at December 31, 1993 include approximately $3.2 million due from MascoTech, Inc. relating to the acquisition of Lamons Metal Gasket Co. TRIMAS CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) NOTE 5. INVENTORIES NOTE 6. PROPERTY AND EQUIPMENT Depreciation expense was $13.9 million, $12.7 million and $10.6 million in 1993, 1992 and 1991, respectively. NOTE 7. NOTES RECEIVABLE Notes receivable are net of an allowance for doubtful accounts of $.7 million at both December 31, 1993 and 1992, and consist principally of the long-term portion of notes receivable arising from the sale of certain products in the normal course of business. These notes bear various fixed interest rates and mature through 2000. At December 31, 1993 the carrying value of these notes receivable approximated their estimated fair value as calculated using the interest rates in effect on that date. NOTE 8. ACCRUED LIABILITIES TRIMAS CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) NOTE 9. LONG-TERM DEBT In August, 1993 the Company issued $115.0 million of 5% Convertible Subordinated Debentures Due 2003. The Debentures are convertible into Company common stock at $22 5/8 per share, subject to adjustment in certain events. The Debentures are redeemable, at a premium, at the Company's option after August 1, 1996. The Company has a $350.0 million revolving credit facility maturing in 1998 with a group of domestic and international banks. The facility permits the Company to borrow under several different interest rate options. The facility contains certain restrictive covenants, the most restrictive of which, at December 31, 1993, requires $186.4 million of shareholders' equity. Borrowings from banks at December 31, 1993 and 1992 include $122.0 million and $147.0 million, respectively, owing under the Company's revolving credit facilities. At December 31, 1993 the blended interest rate on borrowings equalled 3.5 percent. The Company had available credit of $228.0 million under the credit facility at December 31, 1993. At December 31, 1992 the Company had borrowed $30.0 million from several banks under short term, uncommitted credit facilities. As the Company had the ability and the intent to maintain these borrowings on a long-term basis, borrowings under these short term facilities were classified as long-term debt. NOTE 10. SUBORDINATED DEBT HELD BY AFFILIATE On December 31, 1991 the Company utilized available cash to retire $40.0 million of the $128.0 million 14 percent Subordinated Debentures due 2008, held by MascoTech, Inc., and recognized a $3.9 million pre-tax extraordinary charge ($2.5 million after tax, or $.13 per common share) relative to the payment of the redemption premium associated with the early extinguishment. Effective January 1, 1992 the Company exchanged the remaining $88.0 million of 14 percent Subordinated Debentures for a new issue of $88.0 million 12 percent Subordinated Debentures due 1999. In April, 1992 the Company retired the $88.0 million 12 percent Subordinated Debentures and recognized a $9.0 million pre-tax extraordinary charge ($5.7 million after tax, or $.22 per common share) relative to the payment of the redemption premium associated with the early extinguishment. At December 31, 1993 there were no outstanding Subordinated Debentures held by MascoTech, Inc. TRIMAS CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) NOTE 11. SHAREHOLDERS' EQUITY During 1993, dividends on the $100 Convertible Participating Preferred Stock, held by MascoTech, Inc., converted from an annual to a quarterly payment schedule. Therefore, the Company paid $12.3 million in preferred stock dividends in 1993 representing dividends accrued through the first three quarters of 1993 and the full year 1992. On December 15, 1993 MascoTech, Inc. converted all of the preferred stock into 7.8 million shares of Company common stock. On the basis of amounts paid (declared), cash dividends per common share were $.11 ($.11 1/2) in 1993 and $.02 1/2 ($.05) in 1992. NOTE 12. STOCK OPTIONS AND AWARDS The Company has a Stock Option Plan and a Restricted Stock Incentive Plan which permit the grant of up to a combined total of 2,000,000 shares of Company common stock for stock options or awards to key employees of the Company and its affiliates. Shares available for grant through these two plans were 419,944 and 549,156 at December 31, 1993 and December 31, 1992, respectively. TRIMAS CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) NOTE 12. STOCK OPTIONS AND AWARDS (CONTINUED) Stock option data are as follows (option prices are the fair market value at the dates of grant): Restricted long-term incentive stock awards of a net total of 974,056 shares have been granted as of December 31, 1993, with the related costs being expensed over the ten year vesting period. At December 31, 1993 non-vested incentive stock awards had an aggregate carrying value of $7.8 million. NOTE 13. RETIREMENT PLANS The Company has noncontributory retirement benefit plans, both defined benefit plans and profit-sharing and other defined contribution plans, for most of its employees. At December 31, 1993 the combined assets of the Company's defined benefit plans exceeded the combined accumulated benefit obligation by $5.7 million. The annual expense for all plans was: Contributions to profit-sharing and other defined contribution plans are generally determined as a percentage of the covered employee's annual salary. Defined benefit plans provide retirement benefits for salaried employees based primarily on years of service and average earnings for the five highest consecutive years of compensation. Defined benefit plans covering hourly employees generally provide benefits of stated amounts for each year of service. These plans are funded based on an actuarial evaluation and review of the assets, liabilities and requirements of each plan. Plan assets are held by a trustee and invested principally in cash equivalents and marketable equity and fixed income instruments. TRIMAS CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) NOTE 13. RETIREMENT PLANS (CONTINUED) Net periodic pension cost of defined benefit plans includes the following components: Net amortization and deferral consists of amortization of the net asset or overfunded position at the date of adoption and deferral and amortization of subsequent net gains and losses caused by the actual plan and investment experience differing from that assumed. Weighted average rate assumptions used were as follows: The following table sets forth the funded status of the defined benefit plans: Several of the Company's subsidiaries and divisions provide certain postretirement health care and life insurance benefits for eligible retired employees under unfunded plans. Some of the plans have cost-sharing provisions. Prior to 1993, the expense recognized for postretirement health care and life insurance benefits was based on actual expenditures. Effective January 1, 1993 the estimated costs TRIMAS CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) NOTE 13. RETIREMENT PLANS (CONTINUED) of these postretirement benefits are being accrued in accordance with the Financial Accounting Standards Board's Statement of Financial Accounting Standards No. 106, Employers' Accounting for Postretirement Benefits Other Than Pensions. The new accounting method has no effect on the Company's cash flows related to these retiree benefits. The Company has decided to amortize the unrecognized accumulated postretirement benefit obligation existing at January 1, 1993 over 20 years as permitted by the new Standard. Net periodic postretirement benefit cost for 1993 includes the following components: Rate assumptions used were as follows: The following sets forth the plans' status reconciled with the amount recognized in the Company's balance sheet as of December 31, 1993: Accumulated postretirement benefit obligation: A one percentage point increase each year in the assumed rate of increase in health care costs would have increased the aggregate of the service and interest cost components of net periodic postretirement benefit cost by approximately $.1 million during 1993, and would have increased the accumulated postretirement benefit obligation at December 31, 1993 by approximately $.8 million. NOTE 14. OTHER INCOME (EXPENSE), NET TRIMAS CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) NOTE 15. BUSINESS SEGMENT INFORMATION The Company's operations in its business segments consist principally of the manufacture and sale of the following: Specialty Fasteners: Cold formed fasteners and related metallurgical processing. Towing Systems: Vehicle hitches, jacks, winches, couplers and related towing accessories. Specialty Container Products: Industrial container closures, pressurized gas cylinders and metallic and non-metallic gaskets. Corporate Companies: Specialty drills, cutters and specialized metal finishing services, and flame-retardant facings and jacketings and pressure-sensitive tapes. Corporate assets consist primarily of cash and cash equivalents and notes receivable. Operations are located principally in the United States. (A) Includes $8.2 million from business acquired. (B) Includes $19.0 million from business acquired. TRIMAS CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) NOTE 16. INCOME TAXES The following is a reconciliation of the U.S. federal statutory tax rate to the effective tax rate applicable to income before income taxes and extraordinary charge: TRIMAS CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) NOTE 16. INCOME TAXES (CONTINUED) Items that gave rise to deferred taxes: At December 31, 1993 capital loss carryforwards, for tax purposes only, equalled $3.2 million and expire in 1995. NOTE 17. INTERIM FINANCIAL INFORMATION (UNAUDITED) TRIMAS CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONCLUDED) NOTE 17. INTERIM FINANCIAL INFORMATION (UNAUDITED) (CONTINUED) Quarterly earnings per common share amounts for 1993 do not total to the full year amount due to the change in the number of common shares outstanding occurring during the year. Earnings per common share in the fourth quarter of 1993 and 1992 were improved by $.04 and $.03, net, respectively, resulting from various year-end adjustments to accrual estimates recorded earlier in each year. QUARTERLY COMMON STOCK PRICE AND DIVIDEND INFORMATION: TRIMAS CORPORATION AND SUBSIDIARIES SCHEDULE V. PROPERTY, PLANT AND EQUIPMENT FOR THE YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 Notes: (A) Including fixed asset additions of $8,210,000 in 1993 and $18,990,000 in 1991 obtained through the acquisition of companies. (B) Adjustments and reclassifications between accounts. TRIMAS CORPORATION AND SUBSIDIARIES SCHEDULE VI. ACCUMULATED DEPRECIATION, DEPLETION AND AMORTIZATION OF PROPERTY, PLANT AND EQUIPMENT FOR THE YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 Note: (A) Adjustments and reclassifications between accounts. TRIMAS CORPORATION AND SUBSIDIARIES SCHEDULE VIII. VALUATION AND QUALIFYING ACCOUNTS FOR THE YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 Notes: (A) Allowance of companies acquired, and other adjustments, net. (B) Doubtful accounts charged off, less recoveries. TRIMAS CORPORATION AND SUBSIDIARIES SCHEDULE X. SUPPLEMENTARY INCOME STATEMENT INFORMATION FOR THE YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 Other captions provided under this schedule are excluded as the amounts related to such captions are not material, or they are disclosed in the notes to the financial statements. EXHIBIT INDEX - ------------------------- (1) Incorporated by reference to the Exhibits filed with MascoTech, Inc.'s Current Report on Form 8-K dated November 22, 1993. (2) Incorporated by reference to the Exhibits filed with MascoTech, Inc.'s Quarterly Report on Form 10-Q for the quarter ended September 30, 1993. (3) Incorporated by reference to the Exhibits filed with MascoTech, Inc.'s Current Report on Form 8-K dated June 22, 1993. (4) Incorporated by reference to the Exhibits filed with MascoTech, Inc.'s Registration Statement on Form S-3 dated March 9, 1993. (5) Incorporated by reference to the Exhibits filed with MascoTech, Inc.'s Current Report on Form 8-K dated February 1, 1993. (6) Incorporated by reference to the Exhibits filed with MascoTech, Inc.'s Annual Report on Form 10-K for the year ended December 31, 1992. (7) Incorporated by reference to the Exhibits filed with MascoTech, Inc.'s Annual Report on Form 10-K for the year ended December 31, 1991. (8) Incorporated by reference to the Exhibits filed with MascoTech, Inc.'s Annual Report on Form 10-K for the year ended December 31, 1990. (9) Incorporated by reference to the Exhibits filed with MascoTech, Inc.'s Annual Report on Form 10-K for the year ended December 31, 1989.

315641_1993.txt

315641

1993

ITEM 1. BUSINESS (a) GENERAL DEVELOPMENT OF BUSINESS UNR Industries, Inc., a Delaware Corporation ("Registrant" or "UNR") was organized in 1979 as a holding company with businesses engaged principally in metal fabrication. On July 29, 1982, Registrant and ten of its subsidiaries, filed separate voluntary petitions for reorganization under Chapter 11 of the United States Bankruptcy Code in the United States Bankruptcy Court for the Northern District of Illinois, Eastern Division ("Bankruptcy Court"). The Registrant was designated as debtor-in-possession and its operations continued in the ordinary course of business. On March 15, 1989, Registrant and the seven subsidiaries not having been previously discharged, filed a Disclosure Statement and a Consolidated Plan of Reorganization ("Plan") with the Bankruptcy Court. Effective June 2, 1989, the Registrant's Plan was confirmed by the Bankruptcy Court following acceptance of the Plan by the Registrant's creditors and stockholders. Pursuant to the Plan, 42,404,847 shares of common stock of the reorganized Registrant were issued to the unsecured creditors and to the existing and future asbestos claimants in full discharge of all claims. The Plan also provided that all proceeds from certain litigation against the insurance companies would become unencumbered assets of the Registrant. Existing shareholders retained 3,687,378 shares of common stock and received six-year warrants to purchase an additional 3,687,378 shares of common stock at $5.15 per share. On December 31, 1992, Unarco Industries, Inc. and UNR, Inc. merged into UNR. All remaining subsidiaries became subsidiaries of UNR except Holco Corporation which remains a subsidiary of Leavitt Structural Tubing Company, a subsidiary of UNR. On April 27, 1993, Registrant acquired Real Time Solutions, Inc., a producer of automated inventory management products for $4.2 million of cash and 616,102 shares of stock valued at approximately $4.2 million. On May 3, 1993 the business and principal assets of the Midwest CATV Division of Midwest Corporation, a wholly owned subsidiary of Registrant ("Midwest"), were sold to Anixter Bros, Inc., and on May 4, 1993 the business and principal assets of the Midwest Steel Division of Midwest Corporation were sold to L.B. Foster Company. Operating results of these divisions were reclassified to discontinued operations in 1992. On June 11, 1993, UNR received a letter from the UNR Asbestos-Disease Claims Trust (the "Trust"), holder at that time of 62% of the common stock of Registrant, proposing that UNR's Board of Directors consider retaining a financial adviser to solicit third-party proposals for acquisition of UNR through a merger or other business combination in which UNR's shareholders would receive cash for their shares and to advise whether any such proposed transactions would be fair from a financial point of view to UNR's shareholders. On June 22, 1993, UNR's Board of Directors established a Special Committee of independent directors to consider and to implement appropriate action in response to the Trust's proposal, including the solicitation and evaluation of offers for acquisition of UNR and to make a report and recommendation to the Board of Directors. On August 4, 1993, the Special Committee engaged J. P. Morgan Securities Inc. as its financial adviser. On February 9, 1994, UNR announced that the proposals received were subject to conditions and that none of the proposals indicated a per share value greater than $6.50. On February 22, 1994, UNR announced that the proposals received were either inadequate or too conditional to warrant recommendations by the Special Committee to the Board of Directors, that all discussions with potential buyers had been terminated and all efforts to seek further offers have ceased. (b) FINANCIAL INFORMATION ABOUT INDUSTRY SEGMENTS Information required under this section appears as Note 11 to the 1993 Consolidated Financial Statements of the Registrant included as Exhibit 13 to this Form 10-K and incorporated herein by reference. (c) NARRATIVE DESCRIPTION OF BUSINESS Registrant's divisions are engaged in the manufacture and sale of steel products, primarily welded steel tubing, material handling equipment, including storage racks, shopping carts and supermarket storage and display equipment, stainless steel sinks and steel communication and lighting towers. The Registrant employs approximately 2,200 persons, of whom 1,600 are factory personnel. The Registrant's sales are made through manufacturers' representatives, as well as through its own employees. The principal raw material used by Registrant's divisions is steel. These divisions purchase steel from both foreign and domestic suppliers. In the opinion of the Registrant's management, no purchase commitments presently outstanding are at prices which will result in a loss. INDUSTRIAL PRODUCTS One of Registrant's industrial products divisions manufactures and sells mechanical and structural electric resistance welded steel tubing in a variety of sizes and shapes. Such tubing is a fabricated steel product, the use of which has increased in a variety of industries in recent years. Registrant's division currently has sixteen tube-making machines operating in two locations in the Chicago area, in Hammond, Indiana and in Gluckstadt, Mississippi, which can produce in excess of 500,000 tons of tubing annually. The size range of tubing manufactured by the Registrant is 3/8" to 12 3/4" outer diameter. Substantially all of the Registrant's steel tubing products are sold to steel service centers and industrial users, with no single customer accounting for more than 10% of total sales. Sales are made throughout the continental United States. The tubing ultimately is used by makers of farm equipment, automotive equipment, vehicle trailers, bicycles and playground equipment, sign and lamp posts, grocery carts, furniture, storage racks, truck trailer frames and axles and in industrial and commercial buildings. The other industrial products division fabricates steel storage rack components, which are installed primarily by independent contractors. Most sales are made through a nation-wide network of material handling distributors who sell and, in some cases, stock storage racks and parts. The Registrant maintains a regional warehouse, in Somerset, N.J., from which distributors can fill orders for merchandise they do not have in stock. The main plant is in Springfield, Tennessee. In addition, this division provides automated inventory management products to the warehouse and distribution industry, from facilities located in Berkeley and Napa, California. The primary product is a light directed display based inventory picking, sorting, packing and shipping system using the trademark "EASYpick." COMMERCIAL PRODUCTS One of the Registrant's commercial products divisions manufactures and sells wire and plastic shopping carts, self-service luggage carts, office and other carts, wire baskets and continuous shelving systems. These products are manufactured primarily from steel tubing, wire and plastic in a plant in Wagoner, Oklahoma. Sales are made through direct solicitation of customers by sales agents. In addition, this division manufactures and sells supermarket equipment for the handling, preparation and display of meats and produce. Sales are made principally through stocking distributors. From plants in Peoria, Illinois and Frankfort, Indiana, a second division manufactures and markets towers, with related accessories, used principally to support communications equipment for microwave and cellular transmission, broadcasting, home television and amateur broadcasting. Other towers are produced to support high level illumination for highways, parking lots, stadiums and other commercial areas. The division's facility in Bessemer, Alabama produces equipment shelters from laminated fiberglass and concrete which are primarily used to house broadcast electronics. These products are marketed nationally and for export markets. The third commercial products division manufactures, in a plant in Ruston, Louisiana, stainless steel sinks which are sold to retail outlets under the "Federal" and "American" labels and to plumbing wholesalers under the "Republic" label. In addition, this division manufactures and markets a line of composite sinks under the trade name "Asterite." PATENTS Registrant owns or licenses a number of domestic and foreign patents on products and processes. Certain domestic and foreign patent applications on additional products and processes are pending, but there is no assurance that any of such applications will be granted. Although certain patents were of considerable value in the growth of the business and will continue to be important in the future, the Registrant's success or growth are not dependent upon any one patent or group of related patents. RESEARCH & DEVELOPMENT The Registrant spent approximately $797,000 in 1993, $300,000 in 1992 and $300,000 in 1991 for research on new and improved products. Approximately 29 employees are currently engaged full time in this activity. COMPETITION All business segments of the Registrant are highly competitive. Although no authoritative statistics are available, based on its knowledge of its markets and information received from customers and salesmen, the Registrant believes that its sales of grocery shopping carts are greater than those of any competitor. Although the Registrant believes it is currently one of the nation's leading producers of mechanical and structural steel tubing in the size range it produces ( 3/8" to 12 3/4" outer diameter), there is considerable competition in all sizes and shapes of steel tubing. The Registrant believes that it is impossible to state its rank in overall sales of all sizes of steel tubing (including sizes not manufactured by the Registrant). It is known, however, that several companies have substantially greater sales of particular sizes of steel tubing within the size range manufactured by the Registrant and substantially greater overall sales of all sizes of steel tubing. The Registrant also believes that because of the wide range of towers produced by it, there are only a few other companies which manufacture and sell similar product lines comparable in completeness. Other products sold by the Registrant compete with products of other companies, some of which are much larger than the Registrant and enjoy substantially larger shares of their respective markets. BACKLOG AND FOREIGN SALES The backlog of unfilled orders at the end of any period is not a significant factor and is not material to an understanding of the business of the Registrant. Foreign sales in 1993, 1992 and 1991 were approximately $10.4 million, $6.9 million and $7.2 million, respectively. ITEM 2.

ITEM 2. PROPERTIES The following table sets forth information concerning location, size, use and nature of the principal manufacturing facilities owned or leased by the Registrant. The Registrant believes its plants are suitable for their purposes, are well maintained and are adequately insured. Not included in the table are warehouses, owned and leased, aggregating 455,000 square feet and the Registrant's executive and sales offices, all of which are leased. The Registrant uses a wide variety of standard and specialized machine tools, many varying types of equipment and many different manufacturing processes in producing its products. The Registrant considers, that in general, its plants are equipped with modern and well-maintained equipment. The Registrant's operations make virtually full use of all existing facilities except as noted above. ITEM 3.

ITEM 3. LEGAL PROCEEDINGS (a) On July 29, 1982, Registrant and certain of its subsidiaries, filed separate voluntary petitions for reorganization under Chapter 11 of the United States Bankruptcy Code in the United States Bankruptcy Court for the Northern District of Illinois ("Bankruptcy Court"), Eastern Division. On March 15, 1989, Registrant and its subsidiaries filed a Disclosure Statement and a Consolidated Plan of Reorganization (the "Reorganization Plan") with the Bankruptcy Court. An order confirming the Plan was entered by the Bankruptcy Court effective June 2, 1989 ("Confirmation Order"). The Bankruptcy Court also entered orders establishing the UNR Asbestos-Disease Claims Trust ("Trust Order") and permanently enjoining any actions against the Registrant by asbestos-disease claimants ("Injunction"). On June 9, 1989, certain former employees of the Registrant's Bloomington, Illinois plant ("Bloomington Workers") filed an appeal from the Confirmation Order, the Injunction and the Trust Order. On December 6, 1990, the United States District Court for the Northern District of Illinois, Eastern Division ("District Court"), issued an order dismissing the appeal from the Confirmation Order as moot, affirming the Injunction, and remanding to the Bankruptcy Court for a determination of whether the Appellants' claims fell into Class 2 (Workmen's Compensation Claims) or Class 5 (Asbestos-Disease Claims) under the Plan. On April 13, 1993, the District Court dismissed the appeal of the Trust Order. The Bloomington Workers filed appeals with the United States Court of Appeals for the Seventh Circuit from the dismissal of their appeals from the Confirmation Order, the Injunction and the Trust Order. Oral argument occurred in the Court of Appeals on December 8, 1993. Registrant and its counsel believe that the Bloomington Workers' appeals are not well founded and that the decisions of the District Court should be affirmed. On July 28, 1992, the Bankruptcy Court entered an order holding that the claims of certain Bloomington Workers to recover compensation under the Illinois Workers' Occupational Diseases Act should be classified as both Workers' Compensation Claims and as Asbestos-Disease Claims under the Plan ("Classification Order"). Registrant and its counsel believe that the Bankruptcy Court ruling was erroneous and filed an appeal to the District Court. On January 18, 1994, the District Court entered an order denying UNR's appeal on the ground that the Court lacked jurisdiction of the appeal of the Classification Order because of the appeals pending in the Court of Appeals. UNR believes this order is in error and has filed a motion for reconsideration. Following the Bankruptcy Court's July 28, 1992 ruling, certain former employees of the Registrant's Paterson, New Jersey plant filed Petitions with the New Jersey Department of Labor, Division of Workers' Compensation, seeking to pursue claims under New Jersey Workers' Compensation laws. This matter is now pending in the Bankruptcy Court. It is the opinion of UNR and its counsel that UNR has meritorious defenses to all of these claims, and even if these claims are allowed to be pursued, they would not have a material adverse effect on the Registrant's operations or its financial condition. (b) Under the terms of the Warrant Agreement dated June 2, 1989, upon exercise of a warrant and the payment of the exercise price of $5.15 (subject to adjustment upon the occurrence of certain events), a warrantholder is entitled to receive, in addition to the one share of common stock (subject to adjustment upon the occurrence of certain events), the amount of all "extraordinary" dividends (as such term is defined in the Warrant Agreement) which would have been paid on the common stock since the issuance of the warrants. On January 15, 1991, the Registrant paid a dividend of $.20 per share of common stock to stockholders of record on December 20, 1990. On January 15, 1992, the Registrant paid a regular cash dividend of $.20 per share and an extraordinary cash dividend of $1.00 per share of common stock to stockholders of record on December 31, 1991. In December 1991, the Registrant was advised by one of its warrantholders that it is the warrantholder's position that the $.20 per share dividend paid in 1991 and the $.20 regular dividend per share paid in 1992, constituted extraordinary dividends for purposes of the Warrant Agreement. The Registrant believes this warrantholder's position is without merit. (c) In addition to the above, the Registrant is involved in certain other pending litigation and disputes. The Registrant believes that it has adequate insurance coverage or meritorious defenses, or both, in substantially all such litigation. It is the opinion of the Registrant, after consultation with its counsel, that the outcome of all other litigation will not have a material adverse effect on the Registrant's operations or its financial condition. ITEM 4.

ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS None. PART II ITEM 5.

ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS The Registrant's Common Stock and Warrants are publicly traded in the over-the-counter market on the NASDAQ National Market System and are listed on the Chicago Stock Exchange. The Registrant's Common Stock and Warrants bear the symbols UNRI and UNRIW, respectively. The high and low bids are as reported in the Wall Street Journal Quotations from the NASDAQ National Market System. As of March 21, 1994, the Registrant had 3,309 record holders of its Common Stock. On January 15, 1992, the Registrant paid a $.20 regular and $1.00 extraordinary cash dividend to Stockholders of record on December 31, 1991. On February 1, 1993, the Registrant paid a $.20 regular and $2.00 extraordinary cash dividend to Stockholders of record on January 15, 1993. On December 1, 1993, the Registrant paid a $1.20 extraordinary cash dividend to Stockholders of record on November 16, 1993. On March 3, 1994, the Registrant declared a $.20 regular cash dividend to be paid on April 1, 1994 to Stockholders of record on March 18, 1994. As of March 21, 1994, the Registrant had 1,508 record holders of its warrants. ITEM 6.

ITEM 6. SELECTED FINANCIAL DATA The financial information for the five years ended December 31, 1993, appearing on page 1 of UNR Industries, Inc. 1993 Annual Report to Stockholders is incorporated herein by reference. ITEM 7.

ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS. Management's Discussion and Analysis of Results appearing on pages 29 through 31 of UNR Industries, Inc. 1993 Annual Report to Stockholders is incorporated herein by reference. ITEM 8.

ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA The information required by this item is incorporated by reference from the Statements of Income, Statements of Cash Flows, Balance Sheets, Statements of Changes in Stockholders' Equity and Notes to Financial Statements included in the UNR Industries, Inc. 1993 Annual Report to Stockholders. ITEM 9.

ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE. None. PART III ITEM 10.

ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT (a) Information required by this item with respect to the directors of Registrant is hereby incorporated by reference to Registrant's definitive proxy statement to be filed pursuant to Regulation 14A promulgated by the Securities and Exchange Commission under the Securities Exchange Act of 1934, which proxy statement is anticipated to be filed within 120 days after the end of Registrant's fiscal year ended December 31, 1993. (b) Executive Officers of the Registrant The description of tenure included below refers to continuous tenure with the Registrant. All of the executive officers are elected by the Board of Directors at the annual meeting for one-year terms and serve until such time as their respective successors are duly elected and qualified. ITEM 11.

ITEM 11. EXECUTIVE COMPENSATION Information required by this item with respect to executive compensation is hereby incorporated by reference to Registrant's definitive proxy statement to be filed pursuant to Regulation 14A promulgated by the Securities and Exchange Commission under the Securities Exchange Act of 1934, which proxy statement is anticipated to be filed within 120 days after the end of Registrant's fiscal year ended December 31, 1993. ITEM 12.

ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT Information required by this item is hereby incorporated by reference to Registrant's definitive proxy statement to be filed pursuant to Regulation 14A promulgated by the Securities and Exchange Commission under the Securities Exchange Act of 1934, which proxy statement is anticipated to be filed within 120 days after the end of the Registrant's fiscal year ended December 31, 1993. ITEM 13.

ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS Information required by this item is hereby incorporated by reference to Registrant's definitive proxy statement to be filed pursuant to Regulation 14A promulgated by the Securities and Exchange Commission under the Securities Exchange Act of 1934, which proxy statement is anticipated to be filed within 120 days after the end of the Registrant's fiscal year ended December 31, 1993. PART IV ITEM 14.

ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K (a) 1. Financial Statements: The information required by this item is incorporated by reference in Item 8 of this report. 2. The following financial schedules for the years 1993, 1992 and 1991 are submitted herewith: Changes in Plant and Equipment and Related Reserves for Depreciation Allowance for Doubtful Accounts Supplementary Profit and Loss Information 3. Exhibits: The following list sets forth the exhibits to this Form 10-K as required by Item 601 of Regulation S-K. Certain exhibits are filed herewith, while the balances are hereby incorporated by reference to documents previously filed with the Securities and Exchange Commission. Exhibits hereto incorporated by reference to such other filed documents are indicated by an asterisk. EXHIBIT NO. (3) *Amended and Restated Certificate of Incorporation dated March 13, 1980, filed as an exhibit to the 1990 Form 10-K. *Certificate of Amendment dated June 2, 1989 to amended and restated Certificate of Incorporation filed as an exhibit to the 1990 Form 10-K. *Certificate of Amendment dated July 12, 1990 to amended and restated Certificate of Incorporation filed as an exhibit to the 1990 Form 10-K. *Amended and Restated By-laws dated July 12, 1990, filed as an exhibit to the 1990 Form 10-K. *Amended and Restated By-laws dated July 30, 1992, filed as an exhibit to the 1992 Form 10-K. Eighth Amended and Restated By-laws effective as of May 6, 1993. Ninth Amended and Restated By-laws effective as of May 5, 1994. (4) *Warrant Agreement (including form of warrant) issued pursuant to the provisions of Article III of the Registrant's Consolidated Plan of Reorganization confirmed on June 2, 1989, filed as an exhibit to the 1989 Form 10-K. (9) None (10) Material Contracts *UNR Industries, Inc. Key Executives' Stock Option Plan, as amended May 30, 1990, filed as an exhibit to the 1990 Form 10K. *UNR Industries, Inc. 1992 Restricted Stock Plan, filed as an exhibit to the 1992 Form 10-K. *Employment Agreement entered into between UNR Industries, Inc. and Thomas A. Gildehaus, President and Chief Executive Officer, filed as an exhibit to the 1992 Form 10-K. *Form of Change of Control Agreements entered into between UNR Industries, Inc., and Henry Grey, Vice President-- Finance & Treasurer and Victor E. Grimm, Vice President, Corporate Secretary and General Counsel, filed as an exhibit to the 1992 Form 10-K. UNR Industries, Inc. Supplemental Executive Retirement Plan effective as of January 1, 1993. Agreement with J.P. Morgan Securities Inc. dated August 3, 1993. The SEC File Number for Unarco Industries, Inc., Registrant's predecessor was 1-3296; for Registrant the SEC File Number is 1-8009. (11) The computation can be determined from report. (12) Not Applicable (13) Registrant's 1993 Annual Report to Shareholders. (16) Not Applicable (18) None (19) None (21) List of Subsidiaries of Registrant. (22) Not Applicable (23) Consent of Independent Public Accountants. (24) None (28) None (29) None (b) No Form 8-K was filed for the quarter ended December 31, 1993. (c) Exhibits--See 3, 10, 13, 21 and 23 above. REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS ON SUPPLEMENTAL SCHEDULES To the Stockholders and Board of Directors of UNR Industries, Inc.: We have audited in accordance with generally accepted auditing standards, the consolidated financial statements included in UNR Industries, Inc.'s 1993 Annual Report to Stockholders incorporated by reference in this Form 10-K, and have issued our report thereon dated March 3, 1994. Our audit was made for the purpose of forming an opinion on the basic consolidated financial statements taken as a whole. The schedules included in Part IV, Item 14(d) (Changes in Plant and Equipment and Related Reserves for Depreciation, Allowance for Doubtful Accounts and Supplementary Profit and Loss Information) are the responsibility of the Company's management and are presented for purposes of complying with the Securities and Exchange Commission's rules and are not part of the basic consolidated financial statements. These schedules have been subjected to the auditing procedures applied in the audit of the basic consolidated financial statements and, in our opinion, fairly state in all material respects the financial data required to be set forth therein in relation to the basic consolidated financial statements taken as a whole. ARTHUR ANDERSEN & CO. Chicago, Illinois, March 3, 1994. (d) Financial statement schedules required by Regulation S-X which are excluded from the Consolidated Financial Statements included under Item 8 of this report. (1) CHANGES IN PLANT AND EQUIPMENT AND RELATED RESERVES FOR DEPRECIATION (IN THOUSANDS) PLANT AND EQUIPMENT YEAR 1991 YEAR 1992 YEAR 1993 RESERVES FOR DEPRECIATION YEAR 1991 YEAR 1992 YEAR 1993 (2) ALLOWANCE FOR DOUBTFUL ACCOUNTS (IN THOUSANDS) Changes in the allowance for doubtful accounts for the three years ended December 31, are as follows: (3) SUPPLEMENTARY PROFIT AND LOSS INFORMATION (IN THOUSANDS) Costs relating to amortization of intangibles, advertising, royalties and research and development were not listed in the above table because each, separately, was less than 1% of the net sales. SIGNATURES Pursuant to the requirements of Section 13 or 15(d) 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. UNR INDUSTRIES, INC. /s/ THOMAS A. GILDEHAUS --------------------------------------- Thomas A. Gildehaus CHIEF EXECUTIVE OFFICER, PRESIDENT & DIRECTOR March 21, 1994 Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated.

41499_1993.txt

41499

1993

ITEM 1. DESCRIPTION OF BUSINESS GENERAL The Gillette Company was incorporated under the laws of the State of Delaware in 1917 as the successor of a Massachusetts corporation incorporated in 1912 which corporation was the successor of a Maine corporation organized in 1901 by King C. Gillette, inventor of the safety razor. A description of the Company and its businesses appears in the 1993 Annual Report on the inside of the front cover and at pages 3 through 5 under the caption "Letter to Stockholders" and at page 42 under the caption "Principal Divisions and Subsidiaries," the texts of which are incorporated by reference. See also Item 7, Management's Discussion. BUSINESS SEGMENTS The approximate percentages of consolidated net sales and segment profit from operations during the last five years for each of the Company's business segments appear in the 1993 Annual Report at page 39 under the caption, "Business Segments," and are incorporated by reference. "Financial Information by Business Segment," and "Segment and Area Commentary" containing information on net sales, profit from operations, identifiable assets, capital expenditures and depreciation for each of the last three years, appear in the 1993 Annual Report at page 37 and are incorporated by reference. The Company's businesses range across several industry segments, including blades and razors, toiletries and cosmetics, stationery products, electric shavers, small household appliances, hair care appliances, oral care appliances and oral care products. Descriptions of those businesses appear in the 1993 Annual Report at pages 6 through 15, the text of which is incorporated by reference. DISTRIBUTION In the Company's major markets, traditional Gillette product lines are sold to wholesalers, chain stores and large retailers and are resold to consumers primarily through food, drug, discount, stationery, tobacco and department stores. Jafra skin care products are sold directly to consumers by independent consultants, primarily at classes in the home. Waterman and Parker products are sold to wholesalers and retailers and are resold to consumers through fine jewelry, fine stationery and department stores, pen specialists and other retail outlets. Braun products are sold to wholesalers and retailers and are resold to consumers mainly through department, discount, catalogue and specialty stores. In many small Gillette International and Braun markets, products are distributed through local distributors and sales agents. Oral-B products are marketed directly to dental professionals for distribution to patients and also are sold to wholesalers, chain stores and large retailers for resale to consumers through food, drug and discount stores. PATENTS Certain of the Company's patents and licenses in the blade and razor segment are of substantial value and importance when considered in the aggregate. Additionally, the Company holds significant patents in the toiletries and cosmetics, writing instruments and Braun business segments. No patent or license held by the Company is considered to be of material importance when judged from the standpoint of the Company's total business. Gillette has licensed many of its blade and razor patents to other manufacturers. In all these categories, Gillette competitors also have significant patent positions. The patents and licenses held by the Company are of varying remaining durations. TRADEMARKS In general, the Company's principal trademarks have been registered in the United States and throughout the world where the Company's products are sold. Gillette products are marketed outside the United States under various trademarks, many of which are the same as those used in the United States. The trademark Gillette is of principal importance to the Company. In addition, a number of other trademarks owned by the Company and its subsidiaries have significant importance within their business segments. The Company's rights in these trademarks endure for as long as they are used or registered. COMPETITION The blades and razors segment is marked by competition in product performance, innovation and price, as well as by competition in marketing, advertising and promotion to retail outlets and to consumers. The Company's major competitors worldwide are Warner-Lambert Company, with its Schick and Wilkinson Sword (in North America and Europe) product lines, and Societe Bic S.A., a French company. Additional competition in the United States is provided by the American Safety Razor Company, Inc. under its own brands and a number of private label brands. The toiletries and cosmetic segment is highly competitive in terms of price, product innovation and market positioning, with frequent introduction of new brands and marketing concepts, especially for products sold through retail outlets, and with product life cycles typically shorter than in the other business segments of the Company. Competition in the stationery products segment, particularly in the writing instruments market, is marked by a high degree of competition from domestic and foreign suppliers and low entry barriers, and is focused on a wide variety of factors including product performance, design and price, with price an especially important factor in the commercial sector. Competition in the electric shaver, small household, hair care and oral care appliances segments is based primarily on product performance, innovation and price, with numerous competitors in the small household and hair care appliances segments. Competition in the oral care product segment is focused on product performance, price and dental profession endorsement. EMPLOYEES At year-end, Gillette employed 33,400 persons, three-quarters of them outside the United States. RESEARCH AND DEVELOPMENT In 1993, research and development expenditures were $133.1 million, compared with $123.8 million in 1992 and $108.9 million in 1991. RAW MATERIALS The raw materials used by Gillette in the manufacture of products are purchased from a number of outside suppliers, and substantially all such materials are readily available. OPERATIONS BY GEOGRAPHIC AREA The following table indicates the geographic sources of consolidated net sales and profit from operations of the Company for the last three years: "Financial Information by Geographic Area" and "Segment and Area Commentary" containing information on net sales, profit from operations and identifiable assets for each of the last three years appear in the 1993 Annual Report under the same captions at page 37 and are incorporated by reference. ITEM 2.

ITEM 2. DESCRIPTION OF PROPERTY The Company owns and leases manufacturing facilities and other important properties in the United States and abroad consisting of approximately 14,041,000 square feet of floor space, of which 76%, or about 10,690,000 square feet, is devoted to the Company's principal manufacturing operations. Additional premises, such as sales and administrative offices, research laboratories, and warehouse, distribution and other manufacturing facilities account for about 24% of Gillette's principal property holdings, or about 3,370,000 square feet. Gillette's executive offices are located in the Prudential Center, Boston, Massachusetts, where the Company holds a long-term lease covering approximately 300,000 square feet. Approximately 84% of these U.S. manufacturing facilities and the land they occupy are owned by Gillette. The Santa Monica property is leased in its entirety and 308,000 square feet of the St. Paul facility is located on leased land. Foreign manufacturing subsidiaries of Gillette, excluding Braun and Oral-B, operate plants with an aggregate of approximately 4.7 million square feet of floor space, about 87% of which is on land owned by Gillette. Many of the international facilities are engaged in the manufacture of products from two or more of the Company's major business segments. Approximately 85% of these facilities and 94% of the land they occupy are owned by Braun. Oral-B's executive offices are in leased space in Redwood City, California. In addition to its Iowa City plant, it owns or leases approximately 200,000 square feet of manufacturing facilities in four countries outside the United States. Miscellaneous manufacturing operations in North Chicago, Illinois and other locations account for approximately 80,000 square feet. The above facilities are in good repair, adequately meet the Company's needs and operate at reasonable levels of production capacity. ITEM 3.

ITEM 3. LEGAL PROCEEDINGS The Company is subject to legal proceedings and claims arising out of its business, which cover a wide range of matters, including antitrust and trade regulation, product liability, contracts, environmental issues, patent and trademark matters and taxes. Management, after review and consultation with counsel considers that any liability from all of these legal proceedings and claims would not materially affect the consolidated financial position or results of operations of the Company. The previously reported class action titled In re Gillette Securities Litigation filed in the Federal District Court in Boston has been settled subject to the final approval of the court. The previously reported derivative action titled Albert B. Evans v. Colman M. Mockler, Jr., et al. filed in the same court has been dismissed with prejudice. The previously reported environmental suits filed in the Federal District Court in Boston titled United States v. Charles George Trucking Company, Inc., et al. and Commonwealth of Massachusetts v. Charles George Trucking Company, Inc., et al. have been settled and consent decrees have been entered. Certain parties have appealed the settlements. ITEM 4.

ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS Not applicable. ------------------------ The Executive Officers hold office until the first meeting of the Board of Directors following the annual meeting of the stockholders and until their successors are respectively elected or appointed and qualified, unless a shorter period shall have been specified by the terms of their election or appointment, or until their earlier resignation, removal or death. PART II ITEM 5.

ITEM 5. MARKET FOR THE REGISTRANT'S COMMON STOCK AND RELATED SECURITY HOLDER MATTERS The information required by this item appears in the 1993 Annual Report on the inside back cover and at page 39 under the caption, "Quarterly Financial Information," and is incorporated by reference. As of March 1, 1994, the record date for the 1994 Annual Meeting, there were 29,067 Gillette stockholders of record. ITEM 6.

ITEM 6. SELECTED FINANCIAL DATA The information required by this item appears in the 1993 Annual Report at pages 40 and 41 under the caption, "Historical Financial Summary," and is incorporated by reference. ITEM 7.

ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The information required by this item appears in the 1993 Annual Report at pages 23 through 25 under the caption, "Management's Discussion," and is incorporated by reference. ITEM 8.

ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA ITEM 9.

ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE Not applicable. PART III ITEM 10.

ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS The information required by this item with respect to the Directors of the Company appears in the 1994 Proxy Statement at pages 1 through 4, at page 7 under the caption "Certain Transactions with Directors and Officers" and at page 24 under the caption "Compliance with Section 16(a) of the Exchange Act," the texts of which are incorporated by reference. The information required for Executive Officers of the Company appears at the end of Part I of this report at page 5. ITEM 11.

ITEM 11. EXECUTIVE COMPENSATION The information required by this item appears in the 1994 Proxy Statement at page 8 under the caption "Compensation of Directors" and at pages 11 through 17 under the captions "Compensation of Chief Executive Officer" and "Executive Compensation" and is incorporated by reference. ITEM 12.

ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT The information required by this item concerning the security ownership of certain beneficial owners and management appears in the 1994 Proxy Statement at pages 6 through 7 under the caption, "Stock Ownership of Certain Beneficial Owners and Management," and is incorporated by reference. ITEM 13.

ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS The information required by this item appears in the 1994 Proxy Statement at page 7 under the caption "Certain Transactions with Directors and Officers" and at page 8 under the caption "Compensation of Directors" and is incorporated by reference. PART IV ITEM 14.

ITEM 14. EXHIBITS, FINANCIAL STATEMENTS, SCHEDULES, AND REPORTS ON FORM 8-K A. FINANCIAL STATEMENTS, SCHEDULES AND EXHIBITS Schedules other than those listed above are omitted because they are either not required or not applicable. B. REPORTS ON FORM 8-K There were no reports on Form 8-K filed by the Company during the last quarter of the period covered by this report. OTHER MATTERS For the purposes of complying with the amendments to the rules governing Form S-8 (effective July 13, 1990) under the Securities Act of 1933, the undersigned registrant hereby undertakes as follows, which undertaking shall be incorporated by reference into the following Registration Statements of the registrant on Form S-8 (1) No. 33-27916, filed April 10, 1989, and amended thereafter, which incorporates by reference therein Registration Statements on Form S-8 Nos. 2-90276, 2-63951 and 1-50710, and all amendments thereto, all relating to shares issuable and deliverable under The Gillette Company 1971 Stock Option Plan and 1974 Stock Purchase Plan and on Form S-7 No. 2-41016 relating to shares issuable and deliverable under The Gillette Company 1971 Stock Option Plan; (2) No. 33-9495, filed October 20, 1986, and all amendments thereto, relating to shares and plan interests in The Gillette Company Employees' Savings Plan; (3) No. 2-93230, filed September 12, 1984, and all amendments thereto, relating to shares and plan interests in the Oral-B Laboratories Savings Plan; (4) No. 33-56218, filed December 23, 1992, relating to shares and plan interests in The Gillette Company Employees' Savings Plan; and (5) No. 33-52465, filed March 1, 1994, and all amendments thereto, relating to shares issuable and deliverable under The Gillette Company Global Employee Stock Ownership Plan. Insofar as indemnification for liabilities arising under the Securities Act of 1933 may be permitted to directors, officers and controlling persons of the registrant, the registrant has been advised that in the opinion of the Securities and Exchange Commission such indemnification is against public policy as expressed in the Securities Act of 1933 and is, therefore, unenforceable. In the event a claim for indemnification against such liabilities (other than the payments by the registrant of expenses incurred or paid by a director, officer or controlling person of the registrant in the successful defense of any action, suit or proceeding) is asserted by such director, officer, or controlling person in connection with the securities being registered, the registrant will, unless in the opinion of its counsel the matter has been settled by controlling precedent, submit to a court of appropriate jurisdiction the question whether such indemnification by it is against public policy as expressed in the Act and will be governed by the final adjudication of such issue. INDEPENDENT AUDITORS' REPORT The Stockholders and Board of Directors of The Gillette Company: Under date of January 27, 1994, we reported on the consolidated balance sheet of The Gillette Company and subsidiary companies as of December 31, 1993 and 1992, and the related consolidated statements of income and earnings reinvested in the business and cash flows for each of the years in the three-year period ended December 31, 1993, as contained in the 1993 Annual Report to Stockholders. These consolidated financial statements and our report thereon are incorporated by reference in the annual report on Form 10-K for the year 1993. In connection with our audits of the aforementioned consolidated financial statements, we also have audited the related financial statement schedules listed on page 7 of this report. These financial statement schedules are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statement schedules based on our audits. In our opinion, such financial statement schedules, when considered in relation to the basic consolidated financial statements taken as a whole, present fairly, in all material respects, the information set forth therein. KPMG PEAT MARWICK Boston, Massachusetts January 27, 1994 THE GILLETTE COMPANY AND SUBSIDIARY COMPANIES - --------------- (A) -- Transfers between accounts. (B) -- Foreign currency exchange fluctuations from beginning of year to end of year. (C) -- Acquisitions. THE GILLETTE COMPANY AND SUBSIDIARY COMPANIES - --------------------- Note -- Depreciation is computed primarily on a straight-line basis over the estimated useful lives of assets which are as follows: THE GILLETTE COMPANY AND SUBSIDIARY COMPANIES * Acquisition balances THE GILLETTE COMPANY AND SUBSIDIARY COMPANIES - --------------- NOTE: Short-term borrowings, excluding commercial paper, represent primarily foreign currency debt. The maximum and average amounts outstanding during the year are based on quarter-end total outstanding balances and are representative of the year. Average interest rates on short-term borrowings in all three years have been materially impacted by high interest rates in the hyperinflationary economies. Borrowings in these economies have been significantly reduced compared with 1991. THE GILLETTE COMPANY AND SUBSIDIARY COMPANIES - --------------- * Restated to reflect reported years on a comparable basis. SIGNATURES Pursuant to the requirements of Section 13 or 15(d) 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. THE GILLETTE COMPANY (Registrant) By THOMAS F. SKELLY ------------------------------- Thomas F. Skelly Senior Vice President and Chief Financial Officer Date: March 22, 1994 By THOMAS F. SKELLY -------------------------- Thomas F. Skelly as Attorney-In-Fact

855433_1993.txt

855433

1993

ITEM 1. BUSINESS. General BHC Communications, Inc. ("BHC"), the majority owned (71.8% at February 28, 1994) television broadcasting subsidiary of Chris- Craft Industries, Inc. ("Chris-Craft"), was organized in Delaware in 1977 under the name "BHC, Inc." and changed its name to BHC Communications, Inc. on August 4, 1989. BHC's principal business is television broadcasting, conducted through its wholly owned subsidiaries, Chris-Craft Television, Inc. ("CCTV") and Pinelands, Inc. ("Pinelands"), and its majority owned (54.3% at February 28, 1994) subsidiary, United Television, Inc. ("UTV"). At February 28, 1994, BHC, solely through subsidiaries, had 979 full-time employees and 97 part-time employees. Television Broadcasting BHC operates six very high frequency ("VHF") television stations and two ultra high frequency ("UHF") television stations, together constituting Chris-Craft's Television Division. Commercial television broadcasting in the United States is con- ducted on 68 channels numbered 2 through 69. Channels 2 through 13 are in the VHF band, and channels 14 through 69 are in the UHF band. In general, UHF stations are at a disadvantage relative to VHF stations, because UHF frequencies are more difficult for households to receive. This disadvantage is eliminated when a viewer receives the UHF station through a cable system. Commercial broadcast television stations may be either affiliated with one of the three national networks (ABC, NBC and CBS) or may be independent. In addition, Fox Broadcasting Company ("Fox") has established itself as a national network by entering into affiliation agreements with independent stations in many television markets. Chris-Craft, through BHC, is organizing, in partnership with Paramount Communications, Inc., an additional network, The Paramount Network, which currently plans to commence broadcasting in January 1995. There can be no assurance that the network will be viable. Moreover, BHC knows of one other effort to establish a network, and it is considered unlikely that two additional networks will be viable. The following table sets forth certain information with respect to BHC's stations and their respective markets: Television stations derive their revenues primarily from selling advertising time. The television advertising sales market consists primarily of national network advertising, national spot advertising and local spot advertising. An advertiser wishing to reach a nationwide audience usually purchases advertising time directly from the national networks, from "superstations" (i.e., broadcast stations carried by cable operators in areas outside their broadcast coverage area) or from "unwired" networks (groups of otherwise unrelated stations whose advertising time is combined for national sale). A national advertiser wishing to reach a particular regional or local audience usually buys advertising time from local stations through national advertising sales representative firms having contractual arrangements with local stations to solicit such advertising. Local businesses generally purchase advertising from the stations' local sales staffs. Television stations compete for television advertising revenue primarily with other television stations serving the same DMA. There are 211 DMAs in the United States. DMAs are ranked annually by the estimated number of households owning a television set within the DMA. Advertising rates that a television station can command vary in part with the size, in terms of television households, of the DMA served by the station. Within a DMA, the relative advertising rates charged by competing stations depend primarily on three factors: the stations' program ratings (number of television households or persons within those households tuned to a program as a percentage of total television households or persons within those households in the viewing area); the time of day the advertising will run; and the demographic qualities of a program's viewers (primarily age and sex). Ratings data for television markets are measured by A.C. Nielsen Co. ("Nielsen"). This rating service uses two terms to quantify a station's audience: rating points and share points. A rating point represents one percent of all television households in the entire DMA, and a share point represents one percent of all television households within the DMA actually using at least one television set at the time of measurement. Because the major networks regularly provide first-run programming during prime time viewing hours (in general, 8:00 P.M. to 11:00 P.M. Eastern time), their affiliates generally (but do not always) achieve higher audience shares during those hours than independent stations. However, independent stations generally have substantially more advertising time ("inventory") for sale than network affiliates, because the networks use almost all of their affiliates' inventory during network shows. Independent stations' smaller audiences and greater inventory during prime time hours generally result in lower advertising rates charged and more advertising time sold during those hours, whereas affiliates' larger audiences and limited inventory generally allow affiliates to charge higher advertising rates for prime time programming. By selling more advertising time, an independent station typically achieves a share of advertising revenues in its market greater than its audience ratings. On the other hand, because a nonaffiliated station broadcasts more syndicated programming than a network- affiliated station, total programming costs for an independent station are generally higher than those of a network affiliate in the same market. Programming BHC's independent stations depend heavily on independent third parties for programming, as do BHC's network affiliates for their non-network broadcasts. Recognizing the need to have a more direct influence on the quality of programming available to its stations, and desiring to participate in potential profits through national syndication of programming, BHC has begun to invest directly in the development of original programming. The aggregate amount invested through December 31, 1993 was not significant to BHC's financial position. BHC's independent stations currently expect to broadcast, as affiliates of The Paramount Network, four hours of original prime time programming over two nights per week, beginning in January 1995. BHC's television stations also produce programming directed to meet the needs and interests of the area served, such as local news and events, public affairs programming, children's programming and sports. Programs obtained from independent sources consist principally of syndicated television shows, many of which have been shown previously on a network, and syndicated feature films, which were either made for network television or have been exhibited previously in motion picture theatres (most of which films have been shown previously on network and cable television). Syndicated programs are sold to individual stations to be broadcast one or more times. Independent television stations generally have large numbers of syndication contracts; each contract is a license for a particular series or program that usually prohibits licensing the same programming to other television stations in the same market. A single syndication source may provide a number of different ser- ies or programs. Licenses for syndicated programs are often offered for cash sale (i.e., without any barter element) to stations; however, some are offered on a barter or cash plus barter basis. In the case of a cash sale, the station purchases the right to broadcast the program, or a series of programs, and sells advertising time during the broadcast. The cash price of such programming varies, de- pending on the perceived desirability of the program and whether it comes with commercials that must be broadcast (i.e., on a cash plus barter basis). Bartered programming is offered to stations without charge, but comes with a greater number of commercials that must be broadcast, and therefore with less time available for sale by the station. Recently, the amount of bartered and cash plus barter programming broadcast both industry-wide and by BHC's stations has increased substantially. BHC television stations are frequently required to make substantial financial commitments to obtain syndicated programming while such programming is still being broadcast by a network and before it is available for broadcast by BHC stations or before it has been produced. Generally, syndication contracts require the station to acquire an entire program series, before the number of episodes of original showings that will be produced has been determined. While analyses of network audiences are used in estimating the value and potential profitability of such pro- gramming, there is no assurance that a successful network program will continue to be successful or profitable when broadcast after network airing. For many years, the FCC has restricted the ability of television networks to acquire financial interests in the production of television shows by independent sources, or to participate in the syndication of television programs, either on a first-run or an off-network basis. These rules were based in part on concern that networks engaged in syndication would have economic incentives to discriminate against independent stations (such as those owned by BHC) in making programs available in the syndication market, either by warehousing them or favoring the network's owned or affiliated stations. Late in 1992, the United States Court of Appeals for the Seventh Circuit remanded the rules to the FCC with instructions to revisit the need for them. In 1993, the FCC adopted new rules which allow networks to acquire financial interests and passive syndication rights in off-network programs, but bar them from actively syndicating such programs in the United States or delaying the entry into syndication of any long-running prime time network-owned series beyond the fourth year after its network debut. The new rules also bar networks from acquiring domestic financial interests or syndication rights in first-run programs unless the network is the sole producer of the program and prohibit networks from active domestic syndication of all first-run programs. However, these rules are scheduled to expire in November 1995, unless the FCC issues an order to the contrary. A number of petitions for review of these new regulations have been filed, which have been consolidated and transferred to the Seventh Advertising is generally placed with BHC stations through advertising agencies, which are allowed a commission generally equal to 15% of the price of advertising placed. National advertising time is usually sold through an independent national sales representative, which also receives a commission, while local advertising time is sold by each station's sales staff. Practices with respect to sale of advertising time do not differ markedly between BHC's network and non-network stations, although the net- work-affiliated stations have less inventory to sell. Government Regulation Television broadcasting operations are subject to the jurisdiction of the FCC under the Communications Act of 1934, as amended (the "Communications Act"). The Communications Act empowers the FCC, among other things, to issue, revoke or modify broadcast licenses, to assign frequencies, to determine the loca- tions of stations, to regulate the broadcasting equipment used by stations, to establish areas to be served, to adopt such regulations as may be necessary to carry out the provisions of the Communications Act and to impose certain penalties for violation of its regulations. BHC television stations are subject to a wide range of technical, reporting and operational requirements imposed by the Communications Act or by FCC rules and policies. The Communications Act provides that a license may be granted to any applicant if the public interest, convenience and necessity will be served thereby, subject to certain limitations, including the requirement that the FCC allocate licenses, frequencies, hours of operation and power in a manner that will provide a fair, efficient and equitable distribution of service throughout the United States. Television licenses generally are issued for five- year terms. Upon application, and in the absence of a conflicting application that would require the FCC to hold a hearing, or adverse questions as to the licensee's qualifications, television licenses have usually been renewed for additional terms without a hearing by the FCC. An existing license automatically continues in effect once a timely renewal application has been filed until a final FCC decision is issued. KMSP's license renewal was granted on April 15, 1993, and is due to expire on April 1, 1998. KTVX's license renewal was granted on September 29, 1993, and is due to expire on October 1, 1998. KMOL's license renewal application is currently pending, subject to two petitions challenging the station's compliance with FCC requirements concerning equal employment opportunity; UTV has vigorously opposed the petitions, and believes that they are without merit. KUTP, KCOP, KBHK, and KPTV have each filed timely renewal applications, which are pending. No petitions to deny any of those applications have been filed, no competing applications have been filed, and the deadlines for filing such petitions and competing applications have all expired. Pursuant to FCC requirements, each station's application has reported instances in which the station has exceeded the commercial limits applicable to children's programs. In the case of KBHK, these instances have been substantial, and the FCC has recently granted renewals, in such cases, subject to forfeitures of as much as $80,000. WWOR's license renewal was granted on January 22, 1992 and expires on June 1, 1994. A renewal application was timely filed on January 31, 1994. The deadline for filing petitions to deny or competing applications against that application has not yet expired. Under existing FCC regulations governing multiple ownership of broadcast stations, a license to operate a television station generally will not be granted to any party (or parties under common control) if such party directly or indirectly owns, operates, controls or has an attributable interest in another television or radio station serving the same market or area. The FCC, however, is favorably disposed to grant waivers of this rule for radio station-television station combinations in the top 25 television markets, in which there will be at least 30 separately owned, operated and controlled broadcast licenses, and in certain other circumstances. FCC regulations further provide that a broadcast license will not be granted if that grant would result in a concentration of control of radio and television broadcasting in a manner inconsis- tent with the public interest, convenience or necessity. FCC rules generally deem such concentration of control to exist if any party, or any of its officers, directors or stockholders, directly or in- directly, owns, operates, controls or has an attributable interest in more than 12 television stations, or in television stations capable of reaching, in the aggregate, a maximum of 25% of the national audience. This percentage is determined by the DMA market rankings of the percentage of the nation's television households considered within each market. Because of certain limitations of the UHF signal, however, the FCC will attribute only 50% of a market's DMA reach to owners of UHF stations for the purpose of calculating the audience reach limits. Applying the 50% reach attribution rule to UHF stations KBHK and KUTP, the eight BHC stations are deemed to reach approximately 18% of the nation's television households. To facilitate minority group participation in radio and television broadcasting, the FCC will allow entities with attributable ownership interests in stations controlled by minority group members to exceed the ownership limits. The FCC's multiple ownership rules require the attribution of the licenses held by a broadcasting company to its officers, directors and certain of its stockholders, so there would ordinarily be a violation of FCC regulations where an officer, director or such a stockholder and a television broadcasting company together hold interests in more than the permitted number of stations or more than one station that serves the same area. In the case of a corporation controlling or operating television stations, such as BHC, there is attribution only to stockholders who own 5% or more of the voting stock, except for institutional investors, including mutual funds, insurance companies and banks acting in a fiduciary capacity, which may own up to 10% of the vot- ing stock without being subject to such attribution, provided that such entities exercise no control over the management or policies of the broadcasting company. The Communications Act and FCC regulations prohibit the holder of an attributable interest in a television station from having an attributable interest in a cable television system located within the predicted coverage area of that station. FCC regulations also prohibit the holder of an attributable interest in a television station from having an attributable interest in a daily newspaper located within the predicted coverage area of that station. The Communications Act limits the amount of capital stock that aliens may own in a television station licensee or any corporation directly or indirectly controlling such licensee. No more than 20% of a licensee's capital stock and, if the FCC so determines, no more than 25% of the capital stock of a company controlling a licensee, may be owned or voted by aliens or their representatives. Should alien ownership exceed this limit, the FCC may revoke or refuse to grant or renew a television station license or approve the assignment or transfer of such license. BHC believes the ownership of its stock by aliens to be below the applicable limit. The Communications Act prohibits the assignment of a broadcast license or the transfer of control of a licensee without the prior approval of the FCC. Legislation was introduced in the past that would impose a transfer fee on sales of broadcast properties. Although that legislation was not adopted, similar proposals, or a general spectrum licensing fee, may be advanced and adopted in the future. Recent legislation has imposed annual regulatory fees applicable to BHC's stations, currently ranging as high as $18,000 per station. The foregoing does not purport to be a complete summary of all the provisions of the Communications Act or regulations and policies of the FCC thereunder. Reference is made to the Communications Act, such regulations and the public notices promulgated by the FCC for further information. Other Federal agencies, including principally the Federal Trade Commission, also impose a variety of requirements that affect the business and operations of broadcast stations. Proposals for additional or revised requirements are considered by the FCC, other Federal agencies or Congress from time to time. BHC cannot predict what new or revised Federal requirements may result from such consideration or what impact, if any, such requirements might have upon the operation of BHC television stations. Competition BHC television stations compete for advertising revenue in their respective markets, primarily with other broadcast television stations and cable television channels, and compete with other advertising media, as well. Such competition is intense. In addition to programming, management ability and experience, technical factors and television network affiliations are important in determining competitive position. Competitive success of a television station depends primarily on public response to the pro- grams broadcast by the station in relation to competing entertainment, and the results of this competition affect the advertising revenues earned by the station from the sale of advertising time. Audience ratings provided by Nielsen have a direct bearing on the competitive position of television stations. In general, network programs achieve higher ratings than independent station programs. There are at least five other commercial television stations in each market served by a BHC station. BHC believes that the three VHF network-affiliated stations and the two other independent VHF stations in New York City generally attract a larger viewing audience than does WWOR, and that WWOR generally attracts a viewing audience larger than the audience attracted by the UHF stations in the New York City market. In Los Angeles, the three VHF network- affiliated stations and two independent VHF stations generally attract a larger viewing audience than does KCOP, and KCOP generally attracts a viewing audience approximately the same size as the audiences attracted by the other independent VHF station but larger than the ten UHF stations in Los Angeles. In Portland, the three VHF network-affiliated stations generally attract a larger audience than does KPTV, which generally attracts a larger audience than the other independent stations, both of which are UHF sta- tions. BHC believes that, in Minneapolis/St. Paul, KMSP generally attracts a smaller viewing audience than the three VHF network- affiliated stations, but a larger viewing audience than the other independent stations, all of which are UHF stations. In Salt Lake City, KTVX generally ranks first of the six television stations in terms of audience share. In San Antonio, KMOL ranks third of the six stations in terms of audience share. KBHK generally ranks fifth in terms of audience share, behind the one independent and three network-affiliated VHF television stations, of the 14 commer- cial television stations in San Francisco. KUTP ranks sixth in terms of audience share, of the eight commercial stations in the Phoenix market. BHC stations may face increased competition in the future from additional television stations that may enter their respective markets. See note (c) to the table under Television Broadcasting. Cable television has become a major competitor of television broadcasting stations. Because cable television systems operate in each market served by a BHC station, the stations are affected by rules governing cable operations. If a station is not widely accessible by cable in those markets having strong cable pene- tration, it may lose effective access to a significant portion of the local audience. Even if a television station is carried on a local cable system, an unfavorable channel position on the cable system may adversely affect the station's audience ratings and, in some circumstances, a television set's ability to receive the station being carried on an unfavorable channel position. Some cable system operators may be inclined to place broadcast stations in unfavorable channel locations. FCC regulations requiring cable television stations to carry or reserve channels for retransmission of local broadcast signals have twice been invalidated in Federal court. In October 1992, Congress enacted legislation designed to provide television broadcast stations the right to be carried on cable television stations (and to be carried on specific cable channel positions), or (at the broadcaster's election) to prohibit cable carriage of the television broadcast station without its consent. This legislation is currently being challenged in the United States Supreme Court, and BHC cannot predict the outcome. While Federal law now generally prohibits local telephone companies from providing video programming to subscribers in their service areas, this restriction has been invalidated by one federal district court and is currently being challenged in other federal courts; legislation eliminating or relaxing the law has been proposed. "Syndicated exclusivity" rules allow television stations to prevent local cable operators from importing distant television programming that duplicates syndicated programming in which local stations have acquired exclusive rights. In conjunction with these rules, network nonduplication rules protect the exclusivity of network broadcast programming within the local video marketplace. The FCC is also reviewing its "territorial exclusivity" rule, which limits the area in which a broadcaster can obtain exclusive rights to video programming. BHC believes that the competitive position of BHC stations would likely be enhanced by an expansion of broadcasters' permitted zones of exclusivity. Alternative technologies could increase competition in the areas served by BHC stations and, consequently, could adversely affect their profitability. Direct broadcast satellite ("DBS") systems and subscription television ("STV"), recognized as potential competitors a few years ago, have thus far failed to materialize as such. However, at least two DBS operators are scheduled to begin service in 1994. An additional challenge is now posed by multichannel multipoint distribution services ("MMDS"). Two four-channel MMDS licenses have been granted in most television markets. MMDS operation can provide commercial programming on a paid basis. A similar service can also be offered using the instructional television fixed service ("ITFS"). The FCC now allows the educational entities that hold ITFS licenses to lease their "excess" capacity for commercial purposes. The multichannel capacity of ITFS could be combined with either an existing single channel MDS or a new MMDS to increase the number of available channels offered by an individual operator. The emergence of home satellite dish antennas has also made it possible for individuals to receive a host of video programming options via satellite trans- mission. Technological developments in television transmission have created the possibility that one or more of the broadcast and nonbroadcast television media will provide enhanced or "high definition" pictures and sound to the public of a quality that is technically superior to that of the pictures and sound currently available. It is not yet clear when and to what extent technology of this kind will be available to the various television media; whether and how television broadcast stations will be able to avail themselves of these improvements; whether all television broadcast stations will be afforded sufficient spectrum to do so; what channels will be assigned to each of them to permit them to do so; whether viewing audiences will make choices among services upon the basis of such differences; or, if they would, whether significant additional expense would be required for television stations to provide such services. Many segments of the television industry are intensively studying enhanced and "high definition" television technology, and both Congress and the FCC have initiated proceedings and studies on its potential and its application to television service in the United States. The broadcasting industry is continuously faced with technological changes, competing entertainment and communications media and governmental restrictions or actions of Federal regulatory bodies, including the FCC. These technological changes may include the introduction of digital compression by cable systems that would significantly increase the number and availability of cable program services with which BHC stations compete for audience and revenue, the establishment of interactive video services, and the offering of multimedia services that include data networks and other computer technologies. Such fac- tors have affected, and will continue to affect, the revenue growth and profitability of BHC. ITEM 2.

ITEM 2. PROPERTIES. KCOP owns its studios and offices in two buildings in Los Angeles containing a total of approximately 54,000 square feet located on adjacent sites having a total area of approximately 1.93 acres. KCOP's transmitter is located atop Mt. Wilson on property utilized pursuant to a permit issued by the United States Forest Service. KPTV owns its studios and offices in a building in Portland, Oregon, containing approximately 33,520 square feet located on a site of approximately 1.09 acres. Its transmitter is located on its own property at a separate site containing approximately 16.18 acres. WWOR owns office and studio facilities in Secaucus, New Jersey, containing approximately 110,000 square feet on approximately 3.5 acres and leases additional office space in New York City. Along with almost all of the television stations licensed to the New York market, WWOR's transmitter is located on top of the World Trade Center in New York City pursuant to a lease agreement which expires in 2004, unless terminated by WWOR in 1994 or 1999. Physical facilities consisting of offices and studio facilities are owned by UTV in Minneapolis, San Antonio and Phoenix and are leased in Salt Lake City and San Francisco. The Salt Lake City lease agreement expires in 1999 and is renewable, at an increased rental, for two five-year periods. The San Francisco lease expires in 2007. The Minneapolis facility includes approximately 49,700 square feet of space on a 5.63-acre site. The Salt Lake City facility is approximately 30,400 square feet on a 2.53-acre site. The San Antonio facility is approximately 41,000 square feet on a .92-acre site. The San Francisco facility is approximately 27,700 square feet in downtown San Francisco. The Phoenix facility is approximately 26,400 square feet on a 3.03-acre site. Smaller buildings containing transmission equipment are owned by UTV at sites separate from the studio facilities. UTV owns a 55-acre tract in Shoreview, Minnesota, of which 40 acres are used by KMSP for transmitter facilities and tower. KTVX's transmitter facilities and tower are located at a site on Mt. Nelson, close to Salt Lake City, under a lease that expires in 2004. KTVX also maintains back-up transmitter facilities and tower at a site on nearby Mt. Vision under a lease that expires in 2002 and is renewable, at no increase in rental, for a 50-year period. KMOL's transmitter facilities are located at a site near San Antonio on land and on a tower owned by Texas Tall Tower Corporation, a corporation owned in equal shares by UTV and another television station that also transmits from the same tower. KBHK's transmitter is located on Mt. Sutro, as part of the Sutro Tower complex, which also houses equipment for other San Francisco television stations and many of its FM radio stations. The lease for the Mt. Sutro facilities expires in February 1995. KUTP's transmitter facilities and tower are located on a site within South Mountain Park, a communications park owned by the City of Phoenix, which also contains transmitter facilities and towers for the other television stations in Phoenix as well as facilities for several FM radio stations. The license for this space expires in 2012. BHC believes its properties are adequate for their present uses. ITEM 3.

ITEM 3. LEGAL PROCEEDINGS. Not applicable. ITEM 4.

ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS. Not applicable. EXECUTIVE OFFICERS OF THE REGISTRANT The executive officers of BHC, as of February 28, 1994, are as follows: Chris-Craft, through its majority ownership of BHC, is principally engaged in television broadcasting. The principal occupation of each of the individuals for the past five years is stated in the foregoing table, except that prior to being elected General Counsel and Secretary of BHC on December 14, 1992, Brian C. Kelly served as President of Finevest Foods, Inc. ("Finevest") from July 1992 through December 13, 1992, served as Executive Vice President, General Counsel and Secretary of Finevest from March 1992 until July 1992 and served as Vice President, General Counsel and Secretary of Finevest from January 1989 through February 1992. Finevest filed a Chapter 11 bankruptcy petition on February 11, 1991, and emerged from bankruptcy on July 9, 1992 pursuant to a confirmed reorganization plan. All officers hold office until the meeting of the Board following the next annual meeting of stockholders or until removed by the Board. Evan C Thompson, age 51, is Executive Vice President of Chris- Craft. Although not an officer of BHC, as President of UTV and Chris-Craft's Television Division for more than the past five years, Mr. Thompson may be considered an executive officer of BHC, within the Securities and Exchange Commission definition of the term. PART II ITEM 5.

ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS. The information appearing in the Annual Report under the caption STOCK PRICE, DIVIDEND AND RELATED INFORMATION is incorporated herein by this reference. ITEM 6.

ITEM 6. SELECTED FINANCIAL DATA. The information appearing in the Annual Report under the caption SELECTED FINANCIAL DATA is incorporated herein by this reference. ITEM 7.

ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS. The information appearing in the Annual Report under the caption MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS is incorporated herein by this reference. ITEM 8.

ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA. The consolidated financial statements, notes thereto, report of independent public accountants thereon and quarterly financial information (unaudited) appearing in the Annual Report are incor- porated herein by this reference. Except as specifically set forth herein and elsewhere in this Form 10-K, no information appearing in the Annual Report is incorporated by reference into this report nor is the Annual Report deemed to be filed, as part of this report or otherwise, pursuant to the Securities Exchange Act of 1934. ITEM 9.

ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE. Not applicable. PART III ITEM 10.

ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT. The information appearing in the Proxy Statement under the caption ELECTION OF DIRECTORS -- Nominees of the Board of Directors is incorporated herein by this reference. Information relating to BHC's executive officers is set forth in Part I under the caption EXECUTIVE OFFICERS OF THE REGISTRANT. ITEM 11.

ITEM 11. EXECUTIVE COMPENSATION. The information appearing in the Proxy Statement under the caption ELECTION OF DIRECTORS -- Executive Compensation is incorporated herein by this reference. ITEM 12.

ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT. The information appearing in the Proxy Statement under the caption ELECTION OF DIRECTORS -- Voting Securities of Certain Beneficial Owners and Management is incorporated herein by this reference. ITEM 13.

ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS. The information appearing in the Proxy Statement under the caption ELECTION OF DIRECTORS -- Certain Relationships and Related Transactions is incorporated herein by this reference. PART IV ITEM 14.

ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K. (a) The following documents are filed as part of this report: 1. The financial statements and quarterly financial information incorporated by reference from the Annual Report pursuant to Item 8. 2. The report of predecessor independent public accountants and the schedules and report of independent accountants thereon, listed in the Index to Consolidated Financial Statements and Schedules. 3. Exhibits listed in the Exhibit Index, including the following compensatory plans listed below: Chris-Craft's Benefit Equalization Plan Employment Agreement dated as of January 1, 1994 between and Evan C Thompson and Chris-Craft (b) No reports on Form 8-K were filed by the registrant during the last quarter of the period covered by this report. SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, there- unto duly authorized. Date: March 29, 1994 BHC COMMUNICATIONS, INC. (Registrant) By: WILLIAM D. SIEGEL William D. Siegel Senior Vice President Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated. Signature and Title Date HERBERT J. SIEGEL March 29, 1994 Herbert J. Siegel Chairman, President and Director (principal exe- cutive officer) WILLIAM D. SIEGEL March 29, 1994 William D. Siegel Director (principal financial officer) JOELEN K. MERKEL March 29, 1994 Joelen K. Merkel Vice President, Controller and Director (principal accounting officer) JOHN L. EASTMAN March 29, 1994 John L. Eastman Director BARRY S. GREENE March 29, 1994 Barry S. Greene Director LAURENCE M. KASHDIN March 29, 1994 Laurence M. Kashdin Director MORGAN L. MILLER March 29, 1994 Morgan L. Miller Director JOHN C. SIEGEL March 29, 1994 John C. Siegel Director VIN WEBER March 29, 1994 Vin Weber Director BHC COMMUNICATIONS, INC. AND SUBSIDIARIES INDEX TO CONSOLIDATED FINANCIAL STATEMENTS AND SCHEDULES CONSOLIDATED FINANCIAL STATEMENTS: Report of Independent Accountants Consolidated Balance Sheets -- December 31, 1993 and 1992 Consolidated Statements of Income -- For the Years Ended December 31, 1993, 1992 and 1991 Consolidated Statements of Cash Flows -- For the Years Ended December 31, 1993, 1992 and 1991 Consolidated Statements of Shareholders' Investment -- For the Years Ended December 31, 1993, 1992 and 1991 Notes to Consolidated Financial Statements SCHEDULES: Report of Predecessor Independent Public Accountants Report of Independent Accountants on Financial Statement Schedules I. Marketable Securities - Other Investments II. Amounts Receivable from Related Parties, Underwriters, Promoters and Employees other than Related Parties X. Supplementary Income Statement Information Schedules other than those listed above have been omitted since the information is not applicable, not required or is included in the respective financial statements or notes thereto. REPORT OF PREDECESSOR INDEPENDENT PUBLIC ACCOUNTANTS To the Shareholders and Board of Directors of BHC Communications, Inc.: We have audited the consolidated statements of income, shareholders' investment and cash flows of BHC Communications, Inc. (a Delaware corporation and majority owned subsidiary of Chris- Craft Industries, Inc.) and subsidiaries for the year ended December 31, 1991. These financial statements and the schedules referred to below are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements and schedules based on our audit. We conducted our audit in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audit provides a reasonable basis for our opinion. In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the results of operations and cash flows of BHC Communications, Inc. and subsidiaries for the year ended December 31, 1991, in conformity with generally accepted accounting principles. Our audit was made for the purpose of forming an opinion on the basic financial statements taken as a whole. The schedules listed in the index to consolidated financial statements and schedules for the year ended December 31, 1991 are presented for purposes of complying with the Securities and Exchange Commission's rules and are not part of the basic financial statements. These schedules have been subjected to the auditing procedures applied in the audit of the basic financial statements and, in our opinion, fairly state in all material respects the financial data required to be set forth therein in relation to the basic financial statements taken as a whole. ARTHUR ANDERSEN & CO. New York, New York, February 10, 1992. REPORT OF INDEPENDENT ACCOUNTANTS ON FINANCIAL STATEMENT SCHEDULES To the Board of Directors of BHC Communications, Inc. Our audits of the consolidated financial statements referred to in our report dated February 8, 1994 appearing on page 11 of the 1993 Annual Report to Shareholders of BHC Communications, Inc. (which report and consolidated financial statements are incorporated by reference in this Annual Report on Form 10-K) also included audits of the Financial Statement Schedules as of December 31, 1993 and 1992, and the years then ended, listed in Item 14(a) of this Form 10-K. In our opinion, these Financial Statement Schedules present fairly, in all material respects, the information set forth therein when read in conjunction with the related consolidated financial statements. PRICE WATERHOUSE New York, New York February 8, 1994 Schedule I BHC COMMUNICATIONS, INC. AND SUBSIDIARIES MARKETABLE SECURITIES - OTHER INVESTMENTS DECEMBER 31, 1993 (Columns C, D, and E in Thousands) Schedule X BHC COMMUNICATIONS, INC. AND SUBSIDIARIES SUPPLEMENTARY INCOME STATEMENT INFORMATION (In Thousands) EXHIBIT INDEX

811664_1993.txt

811664

1993

ITEM 1. BUSINESS - ----------------- WorldCorp, Inc., a Delaware corporation ("WorldCorp" or the "Company"), was organized in March 1987 to serve as the holding company for World Airways, Inc., a Delaware corporation ("World Airways"), which was organized in March 1948 and is the predecessor to the Company. Currently, WorldCorp operates in two business areas: air transportation services and transaction processing. WorldCorp's air transportation subsidiary, World Airways, was a wholly-owned subsidiary in 1993. In February 1994, the Company sold 24.9% of its ownership to MHS Berhad, a Malaysian aviation company. World Airways is a leading worldwide provider of air transportation for commercial and government customers. In March 1987, WorldCorp acquired Key Airlines, Incorporated, a Delaware corporation ("KeyAir"), which was subsequently sold on October 23, 1992. WorldCorp's transaction processing business consists of its ownership interest in US Order, Inc. ("US Order") and WorldGames. US Order, a developmental stage company, has developed a patented order and payment system ("ScanFone(R)") which facilitates the purchase of goods and services from the home. In December 1993, US Order completed a $12.0 million private equity placement. As a result of this transaction, WorldCorp currently owns 46% of the voting stock of US Order. WorldCorp has an option through December 15, 1994 to purchase additional shares of the capital stock of US Order for consideration equal to $5.0 million which, if exercised, would increase its voting ownership percentage to 79%. WorldGames, a wholly-owned subsidiary, is the sole licensee of ScanFone(R) technology for applications in the gaming industry. The principal executive offices of WorldCorp are located at Washington Dulles International Airport in The Hallmark Building, 13873 Park Center Road, Herndon, Virginia 22071. WorldCorp's telephone number is (703) 834-9200. Airline Operations - ------------------ World Airways is a certificated air carrier, operations of which are limited to the air transportation industry ("Airline Operations"). Airline Operations accounted for 100% of the Company's operating revenue and operating income in 1986 through 1991. In 1992 and 1993, revenue from other business areas represented less than 1% of the Company's total operating revenues. World Airways provides supplemental air transportation to major international airlines, freight forwarders, small package shippers, international vacation tour operators and the U.S. government. World Airways' customers purchase the use of the entire aircraft and then sell either passenger seats or cargo space directly to their customers. World Airways' customers assume the risk of filling the aircraft with passengers or cargo. World Airways uses quick-change passenger/cargo convertible aircraft to target different seasonal peaks throughout the year and to respond rapidly to demands for supplemental airlift which arise on short notice, such as Operation Desert Storm. World Airways' fleet of DC10-30 and MD-11 aircraft appeal to customers who desire long-range, non-stop, international service. Some of World Airways' competitors fly shorter-range aircraft which must make inconvenient and time-consuming refueling and technical stops. World Airways uses specialized operating techniques in pursuit of its strategic objective to maintain consistently high levels of on-time reliability. For example, World Airways implements programs that are designed to maintain World Airways' aircraft to exacting standards, is converting its fleet to new, state-of-the-art MD-11 aircraft, and extensively trains all flight and technical personnel and carries maintenance representatives and extensive spare parts kits on board its aircraft. On October 30, 1993, WorldCorp, World Airways, and MHS Berhad ("MHS") entered into a stock purchase agreement (the "Stock Purchase Agreement") pursuant to which MHS, subject to satisfactory completion of its due diligence investigations, agreed to purchase 24.9% of World Airways' common stock. At the time of the signing of the Stock Purchase Agreement, World Airways was a wholly owned subsidiary of WorldCorp. On February 28, 1994, WorldCorp, World Airways, and MHS concluded the transaction according to the terms described above. MHS recently announced that it will acquire 32% of Malaysian Airline System Berhad ("MAS"), the flag carrier of Malaysia. MAS is one of World Airways' largest commercial customers. Transaction Processing - ---------------------- US Order is a provider of interactive transaction services to the home and the only company with a screen-based telephone that is fully operational with a broad menu of available services. Transaction services are currently offered via screen-based telephones, although the Company expects to offer its bill pay services via personal computers and touch tone telephones using audio response units in 1994. Longer term, the Company plans to develop the capability to support services offered via interactive cable, video games control units, and personal digital assistants. Services currently offered by US Order include bank account inquiry, funds transfer, bill payment, catalog shopping, home delivery of groceries and restaurant meals, and enhanced telephone services. The Company generates revenues through the monthly fees charged to customers for its screen-based telephone ("ScanFone(R)") and transaction services used, as well as the fees paid to the Company by service providers. US Order's Regional Bell Operating Company (RBOC) strategy has evolved from a joint marketing relationship to a value-added reseller relationship for the RBOC's enhanced caller services such as Caller ID. This evolution has taken place as a result of the RBOC's increased focus on video and cable television interactivity. In particular the video focus by Bell Atlantic led to the termination of the Bell Atlantic joint marketing agreement with US Order in March 1994 as Bell Atlantic consolidated its efforts in the video arena. Because screen-based telephones greatly improve the ease of use of enhanced telephone services such as Caller ID, strategic relationships with RBOCs are developing along this track. US Order's product offering to financial institutions have expanded in 1994. In addition to pursuing joint marketing alliances, US Order will also provide bill payment services to financial institutions through existing Audio Response Units, commonly known as touch tone or telephone banking services. The company is currently negotiating agreements with several major banks to offer these services in 1994. US Order is also expanding its direct sales of screen-based telephones and interactive services to consumers. In October 1993, US Order announced its next generation screen-based telephone, PhonePlus /TM/, which it expects to have available to consumers in the third quarter of 1994. As in the cellular telephone industry, the price of the telephone will be related to the length and type of service contract the consumer chooses. On February 3, 1992, the US Patent and Trademark Office ("PTO") issued an order granting a request to reexamine US Order's patent based on a previously issued patent to a third party. On April 3, 1993, the PTO completed its reexamination and approved the amended claims of US Order's patent. Other claims of patent infringement have also been asserted or threatened against US Order. Although US Order and its counsel believe that US Order has substantial defenses to any claim of infringement, there can be no assurances that US Order would prevail in any such proceedings. In addition, upon the occurrence of certain events such as the bankruptcy of US Order, an investor of the company receives a fully paid, non exclusive worldwide license to certain of US Order's licensed technology. In December 1993, US Order underwent a private equity placement with financial and strategic partners. As a result of this transaction, WorldCorp owns 46% of the capital stock of US Order. WorldCorp has an option to purchase all of the remaining shares of common stock of US Order, which, if exercised, would increase its ownership percentage to 79%. Aviation Fuel - ------------- The Company's source of aviation fuel is primarily from major oil companies, under annual delivery contracts, at often frequented commercial locations, and from United States military organizations at military bases. More than one supplier is under contract at several locations. Although the crisis in the Persian Gulf resulted in substantially higher fuel prices during the third and fourth quarters of 1990 and the first quarter of 1991, the Company has experienced no difficulty purchasing fuel during the past three years and does not expect availability to be a problem in the foreseeable future. The availability and price of aviation fuels remains subject to the various unpredictable economic and market factors that affect the supply of all petroleum products. Most of the air transportation contracts held by World Airways provide for either customer supplied fuel or a pass-through of fuel price changes. Although rapidly escalating fuel costs may cause a decrease in the overall level of activity in the industry, the Company does not anticipate that any future industry-wide energy problems would have a substantial adverse effect upon the profitability of Airline Operations. Seasonality - ----------- The contract air carrier transportation business is significantly affected by seasonal factors. Typically, Airline Operations experience lower levels of utilization during the first quarter as demand for passenger and cargo services are lower relative to other times of the year. During the first quarter of 1991, the Company experienced unusually high demand due to operations in support of Operation Desert Storm for the United States Air Mobility Command ("AMC"). Airline Operations generally experience higher levels of utilization in the second and third quarters due to demand for commercial passenger service including the annual Hadj pilgrimage. Fourth quarter utilization generally depends upon the overall world economic climate, global trade patterns and the resulting demand for air cargo services. Airline Operations experienced soft demand and weak yields in worldwide cargo and passenger markets in the fourth quarters of 1993, 1992, and 1991. The quarterly financial data is contained in Note 19 "Unaudited Quarterly Results" of the Company's Notes to Consolidated Financial Statements in Item 8. Customers - --------- Significant customers of WorldCorp's Airline Operations are AMC, MAS, and P.T. Garuda Indonesia ("Garuda"). The loss of any of these customers or a substantial reduction in business from any of these sources, if not replaced, would have a material adverse effect on the Company. AMC has awarded contracts to World Airways since 1956. World Airways' current annual contract with AMC will expire in September 1994. The minimum contract amount for 1994 of $20.4 million is a 68% increase over 1993, and will be augmented by further expansion business. Expansion business totalled 161% of the minimum contract amount for 1993 and 53% for 1992. World Airways cannot determine how any future cuts in military spending may affect future operations with AMC. World Airways has provided service to MAS since 1981, transporting passengers for the annual Hadj pilgrimage as well as providing aircraft for integration into MAS' scheduled passenger and cargo operations. The current MAS contract, which was entered into in 1992, expires in 1996. In 1992, the government of Malaysia instructed the Malaysian Hadj Board (which in turn instructed MAS) to competitively rebid the contract for the 1993 Hadj. MAS rebid the contract for the 1993 Hadj and World Airways was again selected to provide 1993 Hadj service to MAS. World Airways' management believes that its contract with MAS through 1996 is a legally binding obligation. MHS Berhad, which recently acquired 24.9% of World Airways, is in the process of acquiring 32% of MAS from the Malaysian government. World Airways has provided service to Garuda since 1988 under an annual contract. World Airways will provide six aircraft for the 1994 Garuda Hadj operations. In addition, World Airways has provided aircraft for Garuda's cargo operations. The information regarding major customers and foreign revenue is contained in Note 15 "Segment Information" of the Company's Notes to Consolidated Financial Statements in Item 8. Information concerning classification of products within the air transportation industry comprising 10% or more of the Company's consolidated operating revenues is presented in the following table (in millions): Competition - ----------- The Company's Airline Operations compete to varying degrees for commercial contract revenue with other air carriers and, indirectly, suppliers of surface transportation. The Company believes that the basis for competition is price, availability of scheduled passenger air transportation to a destination, speed of delivery for cargo, and performance characteristics of aircraft. In addition, other competitors could choose to enter contract flight services at any time, thereby significantly increasing competition. The allocation of military air transportation contracts by AMC is based upon the number and type of aircraft a carrier, alone and/or through joint venture, makes available to the Civil Reserve Air Fleet ("CRAF"). An increase by other air carriers in their commitment of aircraft to the CRAF, a reduction in the number of aircraft controlled by the Company, a reduction of AMC's air transportation requirements or federal appropriations for such purpose, the failure to renew joint venture arrangements, or a change in AMC's policy concerning the method of awarding AMC contracts, among other things, could adversely affect the amount of AMC contracts, if any, which are awarded in future years. US Order has developed a patented, automated ordering system with residential and commercial applications. Residential services include banking, grocery shopping, telephone services, mail-order catalog shopping, and take-out food and flower ordering, among others. US Order's Scanfone(R) system is a screen-based telephone which is currently the lowest cost means of providing home shopping and bill paying. US Order believes that the basis for competition is price, ease of use of equipment, state-of-the-art equipment, availability of services, and customer acceptance and satisfaction. US Order is one of the first companies to enter this market and believes that this provides a distinct competitive advantage. However, other companies are attempting to enter the home transaction services market using similar types of systems, principally AT&T, Northern Telecom and Philips. As demonstrated by the number of potential competitors, US Order expects competition for this service to increase in the future. Regulatory Matters - ------------------ All certificated air carriers, including the Company's Airline Operations, are subject to regulation by the Federal Aviation Administration (the "FAA") under the Federal Aviation Act of 1958, as amended (collectively the "Federal Aviation Act"). Generally, the FAA has regulatory jurisdiction over flight operations, including equipment, personnel, maintenance, and other safety matters. To assure compliance with its operational standards, the FAA requires air carriers to obtain operating, airworthiness and other certificates, which may be suspended or revoked for cause. The FAA also conducts safety audits and has the power to impose fines and other sanctions for violations of airline safety regulations. Under the Act, the Department of Transportation has jurisdiction over certain aviation matters such as antitrust concerns (mergers, acquisitions and unfair competitive practices), accounts and records, and international routes and fares. Additionally, foreign governments assert jurisdiction over air routes and fares to and from the United States, airport operation rights and facilities access. Airline Operations must comply with FAA noise standard regulations promulgated under the Federal Aviation Act, as amended by the Noise Control Act of 1972 and the Quiet Communities Act of 1978, and with Environmental Protection Agency engine emissions regulations promulgated under the Clean Air Act of 1970, as amended. In addition, certain of the operations of World Airways are subject to laws and regulations relating to the disposal of hazardous wastes. Certain airport operations have adopted local regulations which, among other things, impose curfews and noise abatement regulations. By virtue of the extensive use of radio and other communications facilities in its Airline Operations, the Company is also subject to the Federal Communications Act of 1934, as amended. Labor Relations in the air transport industry are generally regulated under the Federal Railway Labor Act, as amended, which vests certain regulatory powers in the National Mediation Board with respect to disputes between airlines and labor unions arising under collective bargaining agreements. Airlines certificated prior to October 24, 1978, including the Company's Airline Operations, are also subject to regulations issued by the Department of Labor which implements the statutory preferential hiring rights granted by the Airline Deregulation Act of 1978 to certain airline employees who have been furloughed or terminated. The Company's Airline Operations are also subject to regulations of the Department of Defense whenever flights are conducted for the military, as well as other regulations which all U.S. corporations experience as a result of doing business pursuant to state and federal legal requirements. Employees - --------- At March 24, 1994, the Company and its subsidiaries employed approximately 675 persons. Airline Operations provide various employee benefits customary in the air transportation industry. Approximately 368, or 54.5%, of the employees are covered by collective bargaining agreements with various labor unions. The following table presents additional information concerning Airline Operations' labor agreements. (1) As of March 24, 1994 the contract has not been amended. On June 17, 1987, World Airways and the International Brotherhood of Teamsters ("Teamsters") executed a five-year agreement on behalf of the World Airways' cockpit crewmembers, which was ratified on July 30, 1987. On July 16, 1987, World Airways and the Teamsters executed a five-year agreement on behalf of the World Airways' flight attendants, which was ratified on August 5, 1987. Both contracts expired in July 1992 and since that time the cockpit crewmembers and flight attendants have been employed under the terms of their prior contract pursuant to the provisions of the Railway Labor Act. The Company is currently in active negotiations with the Teamsters concerning renewal of the contracts for the cockpit crewmembers and flight attendants. On December 11, 1992, World Airways and the Teamsters jointly requested the assistance of a federal mediator to facilitate negotiations between World Airways and its cockpit crewmembers. The outcome of the negotiations cannot be determined at this time. The agreements between World Airways and the Teamsters, on behalf of both groups, incorporate letters of agreement which require World Airways to give notice to the Teamsters of any acquisition or merger and would require World Airways and any successor of World Airways, among other things, to provide severance pay for employees furloughed within eighteen months of such acquisition or merger when such furlough results from the merger. The agreements also make provision for integration of seniority lists if World Airways' operations are merged with another air carrier. On February 21, 1990, World Airways and the Transport Workers Union executed a three and one-half year contract on behalf of the World Airways' Dispatchers, which was ratified on February 27, 1990. As of March 24, 1994 this contract has not been amended. ITEM 2.

ITEM 2. PROPERTIES - ------------------- Flight Equipment At December 31, 1993, Airline Operations' aggregate operating fleet consisted of nine leased aircraft as follows: Notes ----- (a) Based on standard operating configurations. Other configurations are occasionally used. (b) The terms of the leases expire between 1994 and 2004. (c) This aircraft is currently operated under an hourly utilization lease. Ground Facilities WorldCorp, World Airways, and US Order lease office space located near Washington Dulles International Airport which houses its corporate headquarters and substantially all of the administrative employees of the airline and transaction processing operations. Airline Operations lease additional office and warehouse space for their principal ground facilities in Wilmington, Delaware; Philadelphia, Pennsylvania; Kuala Lumpur, Malaysia; Yakota, Japan; and Frankfurt, Germany. Additional small office and maintenance material storage space are leased at often frequented airports to provide administrative and maintenance support for commercial and military contracts. ITEM 3.

ITEM 3. LEGAL PROCEEDINGS - -------------------------- For a description of the Company's current legal proceedings, see Note 17, "Commitments and Contingencies" of the Company's Notes to Consolidated Financial Statements in Item 8. ITEM 4.

ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS - ------------------------------------------------------------ No matters were submitted to a vote of security holders during the fourth quarter of 1993. PART II ITEM 5.

ITEM 5. MARKET FOR REGISTRANT'S COMMON STOCK & RELATED SECURITY HOLDER - ----------------------------------------------------------------------- MATTERS ------- The Company's common stock is traded on the New York Stock Exchange. The high and low closing sales prices of the Company's common stock, as reported on the New York Stock Exchange for each quarter in the last two fiscal years, are as follows: In March 1992, the Company filed with the Securities and Exchange Commission ("SEC") a registration statement on Form S-3 registering $60.0 to $90.0 million of Convertible Subordinated Debentures due 2004 (the "Debentures"). On May 26, 1992, $65.0 million of the Debentures were issued. The Debentures are convertible into WorldCorp common stock at $11.06 per share and bear an annual interest rate of 7%. Semi-annual interest payments are due on May 15 and November 15. The Company did not declare any cash dividends in 1993 or 1992 and does not plan to do so in the foreseeable future. The Indenture governing the Company's Debentures and 13 7/8% Subordinated Notes due 1997 in certain circumstances may restrict the Company from paying dividends or making other distributions on its common stock. The approximate number of shareholders of record at March 24, 1994 is 2,869. ITEM 6.

ITEM 6. SELECTED FINANCIAL DATA - -------------------------------- WORLDCORP, INC. AND SUBSIDIARIES Selected Financial Data (in thousands except per share data) ITEM 7.

ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS - -------------------------------------------------------------------------------- OF OPERATIONS ------------- Management's Discussion and Analysis of Financial Condition and Results of Operations presented below relates to the operations of WorldCorp, Inc. ("the Company") as reflected in its consolidated financial statements. These statements primarily include the accounts of the contract flight operations of World Airways, Inc. ("World Airways") and Key Airlines, Incorporated ("KeyAir") until October 23, 1992 when WorldCorp sold 100% of KeyAir. WorldCorp also has an ownership interest in US Order, Inc. ("US Order"), a developmental stage company, which has developed a patented order and payment system ("ScanFone(R)") which facilitates the purchase of goods and services from the home. On July 1, 1992, the Company increased its ownership to 51%. In December 1993, US Order completed a $12.0 million private equity placement. As a result of this transaction, WorldCorp currently owns 46% of the voting stock of US Order. WorldCorp has an option through December 15, 1994, to purchase additional shares of the capital stock of US Order for consideration equal to $5.0 million, which if exercised, would increase its voting ownership percentage to 79%. US Order's results of operations are consolidated in the accompanying financial statements for the period subsequent to July 1, 1992. GENERAL In 1993, WorldCorp operated in two business areas: air transportation services and transaction processing. WorldCorp's air transportation subsidiary, World Airways, is a leading worldwide provider of air transportation for commercial and government customers. WorldCorp's transaction processing business consists of its 46% ownership of the voting stock of US Order and 100% ownership of WorldGames. US Order develops and sells patented, automated ordering systems with residential and commercial applications. WorldGames is the sole licensee of ScanFone(R) technology for applications in the gaming industry. World Airways was a wholly-owned subsidiary of the Company in 1993. In February 1994, the Company sold 24.9% of its ownership to MHS Berhad, a Malaysian aviation company (see "Liquidity and Capital Resources"). AIR TRANSPORTATION SERVICES - --------------------------- World Airways is a contract air carrier that charges customers based on a block hour basis rather than a per seat or per pound basis as do scheduled passenger carriers or overnight express carriers. A "block hour" is defined as the elapsed time computed from the moment the aircraft moves at its point of origin to the time it comes to rest at its destination. Fluctuations in flight revenues are not necessarily indicative of true growth because of shifts in the mix between full service contracts and basic contracts. Under the terms of full service contracts, World Airways is responsible for all costs associated with operating these contracts and receives a higher rate per hour. Under the terms of basic contracts, World Airways provides only certain services associated with the contract including aircraft, crews, insurance, and maintenance. World Airways typically charges a lower rate per hour for basic contracts since the customer is responsible for other operating costs. For this reason, it is important to measure pure growth through block hours flown rather than actual revenues earned. Typically, U.S. military contracts are full service contracts where the rate paid is set annually and consists of all flying costs, including fuel and ground handling of the aircraft and cargo. World Airways, as a matter of policy, includes fuel cost adjustment mechanisms in full service contracts, thus minimizing the risk of fuel price volatility to World Airways. Customers - --------- World Airways' business relies heavily on its U.S. Air Mobility Command ("AMC"), Malaysian Airline System Berhad ("MAS") and P.T. Garuda Indonesia ("Garuda") contracts, which provided 24%, 17% and 21%, respectively, of consolidated revenues in 1993, and 19%, 16%, and 16%, respectively, of total block hours. During 1992, AMC, MAS, and Garuda contracts provided 41%, 24%, and 13%, respectively, of consolidated revenues, and 31%, 29%, and 11%, respectively, of total block hours. The loss of any of these contracts or a substantial reduction in business from any of these contracts, if not replaced, would have a material adverse effect on the Company's revenues and financial condition. AMC has awarded contracts to World Airways since 1956. World Airways' current annual contract with AMC will expire in September 1994. The minimum contract amount for 1994 of $20.4 million is a 68% increase over 1993, and will be augmented by further expansion business. Expansion business totalled 161% of the minimum contract amount for 1993 and 53% for 1992. World Airways cannot determine how any future cuts in military spending may affect future operations with AMC. World Airways has provided service to MAS since 1981, transporting passengers for the annual Hadj pilgrimage as well as providing aircraft for integration into MAS' scheduled passenger and cargo operations. The current MAS contract, which was entered into in 1992, expires in 1996. In 1992, the government of Malaysia instructed the Malaysian Hadj Board (which in turn instructed MAS) to competitively rebid the contract for the 1993 Hadj. MAS rebid the contract for the 1993 Hadj and World Airways was again selected to provide 1993 Hadj service to MAS. World Airways' management believes that its contract with MAS through 1996 is a legally binding obligation. MHS Berhad, which recently acquired 24.9% of World Airways, is in the process of acquiring 32% of MAS from the Malaysian government. World Airways has provided service to Garuda since 1988 under an annual contract. World Airways will provide six aircraft for the 1994 Garuda Hadj operations. In addition, World Airways has provided aircraft for Garuda's cargo operations. TRANSACTION PROCESSING SERVICES - ------------------------------- US Order is a leading provider of interactive transaction services to the home and the only company with a screen-based telephone that is fully operational with a broad menu of available services. Transaction services are currently offered via screen-based telephones, although the Company expects to offer its bill pay services via personal computers and touch tone telephones using audio response units in 1994. Longer term, the Company plans to develop the capability to support services offered via interactive cable, video games control units, and personal digital assistants. Services currently offered by US Order include bank account inquiry, funds transfer, bill payment, catalog shopping, home delivery of groceries and restaurant meals, and enhanced telephone services. Future services are expected to encompass a greatly expanded set of applications. The Company generates revenues through the monthly fees charged to customers for its screen-based telephone ("ScanFone(R)") and transaction services used, as well as the fees paid to the Company by service providers. RESULTS OF OPERATIONS 1993 COMPARED WITH 1992 - ----------------------- Operating Revenue - ----------------- In 1993, operating revenues increased $2.3 million (1%) to $202.7 million primarily due to an increase in block hours flown. Block hours increased five percent to 23,462 in 1993 from 22,263 in 1992. Due to peak airlift requirements of World Airways' customers for the 1992 Hadj pilgrimage, certain flights were subcontracted to other carriers which resulted in $11.5 million of revenue in 1992 with no corresponding block hours flown. This was not necessary in 1993. This increase was partially offset by a five percent decrease in revenue per block hour to $8,589 in 1993 from $8,996 in 1992. Block hours under full service contracts were 85% of total block hours in 1993 and 84% in 1992. Aircraft capacity, the number of days that the Company's aircraft are available for service (including days in maintenance), increased to 8.8 available aircraft per day in 1993 from 7.2 in 1992. This increase was offset by a 13% decrease in daily aircraft utilization to 7.3 hours from 8.4 hours. Aircraft utilization is measured by the total block hours that the Company's aircraft were in use divided by the number of days that the aircraft were available for service (including days in maintenance). Included in other revenues in 1992 is $4.1 million related to settlements of contract claims from AMC. Operating Expenses - ------------------ Flight costs increased $10.6 million (20%) due to costs associated with the integration of MD-11 aircraft (see "Capital Plans"). The Company maintained the maximum number of crews available during the first six months of 1993 in order to support intensive crewmember training for the MD-11 aircraft while maintaining the previous year's level of flight operations. This resulted in higher crew costs than normal given the low level of utilization during the first quarter of 1993. Maintenance costs decreased by $5.8 million (17%) due to lower maintenance costs for new MD-11 aircraft and lower engine overhaul repair expense for the DC10-30 fleet. Maintenance cost per block hour was $1,222 in 1993 compared with $1,548 in 1992. The reduced maintenance costs are due, in part, to guarantees and warranties received from the engine and aircraft manufacturers of the MD-11 aircraft. Because the MD-11 is a relatively new aircraft, cost experience on the maintenance of the aircraft is unavailable. Therefore, the Company is, in part, relying on manufacturers' guidelines to estimate future maintenance costs on the MD-11 aircraft. Aircraft costs increased by $17.1 million (49%) in 1993. This increase was primarily due to a $20.5 million increase in rent cost associated with the delivery of four MD-11 aircraft during March and April 1993. In July 1993, two DC10-30 aircraft were returned to their lessors, resulting in a $1.5 million early termination payment of which $1.1 million was expensed in 1993. Partially offsetting these increases was a reduction of $5.4 million in rent costs associated with the return of the two DC10 aircraft and short-term aircraft leases not required in 1993. Fuel costs increased by $2.9 million (8%) due to the increase in block hours flown and a small increase in fuel prices paid per gallon. Flight operations subcontracted to other carriers decreased by $10.3 million (89%). In 1992, World Airways subcontracted a portion of its AMC contract award in order to redeploy one of its aircraft for commercial passenger flying. This was not necessary in 1993. Depreciation and amortization increased $0.4 million (7%) due to the purchase of spare parts for MD-11 aircraft integrated into the fleet in 1993. Selling and administrative costs increased $2.2 million (12%) primarily as a result of a $0.9 million settlement associated with the return of a DC10-30 aircraft, increased legal fees, and the formation of World Flight Crew Services, a new subsidiary of WorldCorp. Loss on Sale of Key Airlines - ---------------------------- On October 23, 1992, WorldCorp sold 100% of the outstanding common stock of KeyAir. Loss on sale of KeyAir in 1993 primarily consists of the write-off of a $0.3 million uncollateralized line of credit and $0.3 million drawdown of a letter of credit. Transaction Processing-US Order - ------------------------------- On July 1, 1992, the Company purchased an incremental 6% of the preferred stock of US Order for $1.0 million which increased the Company's ownership in US Order to 51%. Accordingly, US Order's results of operations are consolidated in the accompanying financial statements beginning on July 1, 1992. In December 1993, US Order completed a $12.0 million private equity placement. Following this transaction, WorldCorp owns 46% of the voting stock of US Order. WorldCorp has an option through December 15, 1994 to purchase additional shares of the voting stock of US Order for consideration equal to $5.0 million, which would increase its ownership of the voting stock to 79%. The accompanying statements of operations include 59% of the results of operations of US Order beginning December 1993. This 59% is based on liquidation preferences. In 1993, the Company recorded $9.2 million of losses (net of minority interest) relating to US Order, compared to $2.4 million of losses in 1992. This $6.8 million increase resulted primarily from an increase in overhead costs associated with expanded research and development and the writedown of an older generation of terminal components. Non-Operating Items - ------------------- Interest income decreased as a result of lower investment balances and lower interest rates in 1993. Interest expense decreased $0.1 million in 1993 as a result of partially replacing the 13 7/8% Subordinated Notes ("the Notes") with the 7% convertible debentures (the "Debentures") and lower debt balances. Offsetting these decreases was interest associated with MD-11 rotables financing, aircraft rent deferrals, and a bank line of credit. 1992 COMPARED WITH 1991 - ----------------------- Operating Revenue - ----------------- On October 23, 1992, WorldCorp sold 100% of the outstanding common shares of its wholly-owned subsidiary, KeyAir, to Savannah Aviation Group ("SAG"). Accordingly, KeyAir's net loss for the period January 1, 1992 through October 23, 1992 is reflected in the accompanying financial statements under the caption "Loss from operation of Key Airlines". The Consolidated Statement of Operations for 1991 has not been reclassified to conform with the 1992 presentation. The following consolidated financial information presents 1991 results of operations of KeyAir in a manner consistent with the 1992 presentation. This financial information is presented to facilitate a comparative analysis of the ongoing operations of the Company and is used as the basis for Management's Discussion and Analysis of Financial Condition and Results of Operations presented below. In 1992, revenue decreased $26.3 million (12%) to $200.4 million. Block hours decreased 13% from 25,570 in 1991 to 22,263 in 1992. Due to peak airlift requirements of World Airways' customers for the 1992 Hadj pilgrimage, certain flights were subcontracted to other carriers which resulted in $11.5 million of revenue in 1992 with no corresponding block hours flown. Excluding this revenue, operating revenue decreased $36.5 million. This decrease is due to a shift from military flying in support of Operation Desert Storm in 1991 to commercial passenger flying at lower revenue rates in 1992. Revenue also decreased as a result of a shift to more basic contracts in 1992. Full service block hours represented 84% of total DC10 block hours in 1992 compared with 92% of DC10 block hours in 1991. In addition, revenue decreased as a result of lower block hour rates received for full service contracts in 1992. Included in other revenues in 1992 is $4.1 million related to settlements of contract claims from the AMC. World Airways' block hour decrease is primarily due to a decrease in aircraft utilization. Aircraft utilization is measured by the total block hours that the Company's aircraft were in use divided by the number of days that the aircraft were available for service including days in maintenance. World Airways' aircraft utilization decreased 13% from 9.6 hours per day in 1991 to 8.4 hours per day in 1992. World Airways' DC10 aircraft capacity remained essentially the same in 1992 as compared with 1991. Aircraft capacity is defined as the number of days that the Company's aircraft are available for service including days in maintenance. In 1991, World Airways operated four DC10-10 aircraft under various lease terms and one DC10-30 aircraft under a short-term lease. The four DC10-10 aircraft were returned to their lessors at various times in 1991 and 1992. These aircraft were replaced with two DC10-30 passenger aircraft integrated into World Airways' fleet in April 1992. Also, two DC10-30 passenger aircraft were operated under short-term leases beginning in May 1992 to meet peak airlift requirements of World Airways' customers for the 1992 Hadj pilgrimage. These factors combined to create a 1% decrease in DC10 aircraft capacity in 1992. Operating Expenses - ------------------ Flight costs decreased $3.0 million. This decrease is due to lower variable costs associated with the 13% decrease in DC10 block hours flown and a shift to more basic contracts in 1992. Maintenance costs decreased $11.0 million. This decrease is primarily due to ongoing cost control efforts (specifically, material, component repair costs and parts rental charges), and the return to their lessors of four DC10-10 aircraft which, historically, have been more costly to maintain. World Airways maintenance costs also decreased as a result of the 13% decrease in DC10 block hours flown. Total World Airways maintenance expense was $1,548 per block hour in 1992 compared to $1,779 per block hour in 1991. Aircraft costs increased $0.4 million. DC10 aircraft rent decreased $0.3 million primarily due to the replacement of four DC10-10 and one DC10-30 aircraft with four DC10-30 aircraft. Aircraft hull insurance increased $0.7 million as a result of increases in insured values due to replacing DC10-10 aircraft with DC10-30 aircraft and increases in insurance rates charged. Depreciation expense increased $0.9 million primarily as a result of adding leasehold improvements and rotables relating to two DC10-30 aircraft integrated into World Airways' fleet in April 1992. Fuel costs decreased $13.9 million as a result of the 13% decrease in DC10 block hours flown and the decrease in fuel costs since the end of the Persian Gulf War. Due to peak airlift requirements of World Airways' customers for the 1992 Hadj pilgrimage, certain other flights were subcontracted to other carriers which resulted in expenses of $11.6 million. Selling and administrative costs decreased $1.4 million primarily due to the World Airways' Profit Sharing Bonus Plan (the "Plan") expense being included in flight costs in 1992 and included in selling and administrative costs in 1991. Through 1991, payments under the Plan were first made to individuals who were entitled to repayment of wage concessions from December 1, 1982 through January 31, 1985. With the payment of the 1991 Plan expense amount, all wage concession amounts have been repaid. Beginning in 1992, amounts expensed pursuant to the Plan are for profit sharing and are paid to current employees, primarily crewmembers. Loss (Income) From Operation of Key Airlines - -------------------------------------------- Operating results of Key Airlines decreased to a loss of $6.0 million in 1992 from income of $0.2 million in 1991. This is partially due to ten months of activity in 1992 compared with twelve months of activity in 1991. This $6.2 million decrease is primarily attributable to a 10% decrease in block hours flown combined with a 20% decrease in revenue yield per block hour. KeyAir's revenue decreased $15.0 million in 1992. In 1991, KeyAir's customers consisted of tour operators and the U.S. military which typically guaranteed payment for blocks of seats or for the full aircraft on a point-to-point basis. In 1992, KeyAir operated its Caribbean Connection service based on a hub and spoke system and sold tickets to individual passengers directly, through travel agencies, or through tour operators. As a result, in 1992, KeyAir experienced an overall increase in expenses directly attributable to this new type of flying. For example, expenses associated with KeyAir's headquarters in Savannah, Georgia increased, and advertising expense, credit card and bank fees, travel agent commissions, and reservations systems costs all increased in 1992 or were not incurred in 1991. Loss on Sale of Key Airlines - ---------------------------- Loss on sale of Key Airlines consists principally of the non-cash write- down of the B727 aircraft and related rotables to estimated net realizable values and the write-off of the remaining goodwill associated with the purchase of KeyAir in 1987. Transaction Processing - US Order - --------------------------------- On July 1, 1992, the Company purchased an incremental 6% of the preferred stock of US Order, a transaction processing company, for $1.0 million which increased the Company's ownership in US Order to 51%. Accordingly, US Order's results of operations are consolidated in the accompanying financial statements for the period subsequent to July 1, 1992. For the six months ended December 31, 1992, US Order incurred operating costs of $4.0 million. To date, US Order has generated limited revenue through the rental of ScanFones(R) and transaction processing fees. Non-Operating Items - ------------------- Interest expense decreased primarily as a result of the redemption of $48.8 million of 13 7/8% Subordinated Notes (the "Notes") partially offset by the issuance of $65.0 million of 7% Convertible Debentures (the "Debentures") in May 1992. Interest expense also decreased as a result of the settlement, in January 1992, of World Airways' litigation with the State of California Franchise Tax Board, decreases in variable interest rates, the payoff of World Airways' short- term line of credit for most of the year, and the paydown of B727-100 aircraft debt. Interest income decreased as a result of lower investment balances held in 1992 and lower interest rates. In 1992, the gain on investments consists primarily of a $1.1 million gain on sales of bonds and the termination of an interest rate swap agreement, reduced by a $0.9 million loss from WorldCorp's equity investment in US Order. During the first six months of 1992, WorldCorp's investment in US Order was recorded using the equity method of accounting. Accordingly, WorldCorp's share of US Order's losses were recorded as a loss on investments. In 1991, loss on investments primarily result from the sale of high-yield securities held in the Company's investment portfolio. In 1992, $48.8 million of the face value of the Notes were repurchased at a loss of $3.3 million. In 1991, $10.3 million of the Notes were repurchased at an average of 60% of face value resulting in a gain of $3.5 million. During the fourth quarter of 1991, World Airways settled litigation with the State of California Franchise Tax Board (the "Board") concerning assessments of deficiencies in state franchise taxes for the years 1973-75 and 1978. The Board had asserted a total tax deficiency of approximately $2.4 million and accrued interest of approximately $5.9 million. World Airways settled this case with the Board and reversed a previously recorded liability which resulted in a non-operating gain of $5.5 million, net of legal expenses. LIQUIDITY AND CAPITAL RESOURCES The Company's air transportation subsidiary operates in a very challenging business environment. The combination of a generally weak economy, reduced military spending, and the depressed state of the airline industry and the economy has adversely affected the Company's operating performance. The Company is highly leveraged primarily due to losses sustained by World Airways' scheduled operations between 1979 and 1986, debt restructurings in 1984 and 1987, and losses the Company incurred in 1990, 1992, and 1993. The Company has historically financed its working capital and capital expenditure requirements out of cash flow from operating activities, secured borrowings, and other financings from banks and other lenders. Cash Flows from Operating Activities - ------------------------------------ During 1993, operating activities used $8.6 million compared to $17.5 million in the prior year. Excluding the non-cash loss on the sale of KeyAir in 1992, losses in 1993 were $14.2 million higher than 1992. The increased losses were offset by the deferral of certain aircraft rental payments, an increase in accounts payable and a decrease in accounts receivable. Accounts receivable decreased due to lower levels of military flying in the fourth quarter of 1993. Cash Flows from Investing Activities - ------------------------------------ Cash flows from investing activities used $14.6 million in 1993 as compared to $4.4 million in 1992 resulting primarily from the purchase of spare parts for the MD-11 aircraft in 1993, partially offset by proceeds received from the disposal of DC10 and B727 rotable spare parts. Cash Flows from Financing Activities - ------------------------------------ In 1993, financing activities provided $26.4 million compared to providing $12.9 million in the prior year. In 1992, the Company received $62.9 million from the sale of the Debentures and used $47.1 million of these proceeds to repurchase the 13 7/8% Notes. In 1993, the Company financed $19.1 million of spare parts related to the integration of the MD-11 aircraft, and entered into a $20.0 million credit facility. The Company made debt payments of approximately $28.7 million in 1993 compared to $10.3 million in 1992. This $18.4 million increase primarily relates to the repayment of the Company's two bank lines of credit. The US Order private placement (see "Financing Developments") and the exercise of options and warrants of the Company provided $8.4 million in 1993. Capital Plans - ------------- World Airways plans to exit higher cost DC10 aircraft and ultimately standardize its fleet around the MD-11 aircraft. In October 1992 and January 1993, World Airways signed a series of agreements to lease seven new MD-11 aircraft for initial lease terms of two to five years. As of March 25, 1994, World Airways has taken delivery of four passenger MD-11 aircraft and is scheduled to take delivery of one freighter MD-11 in April 1994, and two convertible MD-11s in 1995. Two of the passenger MD-11 aircraft replaced the two passenger DC10-30 aircraft which were integrated into World Airways' fleet in April 1992 and returned to McDonnell Douglas in July 1993. The delivery of the convertible MD-11s is expected to occur approximately six months after the end of the lease in 1994 of three DC10-30 convertibles. World Airways made $20.7 million of capital expenditures and cash deposits for MD-11 integration in 1993, of which $19.1 was financed. World Airways estimates that its required capital expenditures for MD-11 integration will be approximately $7.3 million in 1994 and $9.8 million in 1995. As of December 31, 1993, the Company holds approximately $14.7 million of aircraft spare parts and transaction processing terminals currently available for sale. The Company anticipates proceeds from the sale of these assets to be approximately $7.5 million in 1994. US Order's working capital and capital expenditure requirements for 1994 are expected to be approximately $8.0 million. As of December 31, 1993, WorldCorp had invested $18.1 million of funds in US Order. US Order is currently seeking a private equity placement for up to $8.0 million with financial and strategic partners. However, there can be no assurance that such financing will be obtained. WorldCorp does not plan to provide additional financing to US Order in 1994. On December 7, 1993, World Airways entered into a $20.0 million revolving line of credit borrowing arrangement. This credit facility is collateralized by aircraft spare parts and certain receivables. $4.4 million of these proceeds were used to repay the outstanding balance on the $5.0 million revolving line of credit borrowing arrangement which expired in 1993. Financing Developments - ---------------------- In its most recent Form 10-Q filing, the Company stated management would take several steps to add to its cash reserves. As of this date, the Company has closed certain transactions and executed agreements covering other transactions which, in aggregate, have significantly increased the cash reserves of WorldCorp, World Airways, and US Order. First, on October 30, 1993, WorldCorp, Inc., World Airways, Inc., and MHS Berhad entered into a Stock Purchase Agreement (the "Stock Purchase Agreement") pursuant to which MHS, subject to satisfactory completion of its due diligence investigations, agreed to purchase 24.9% of World Airways' common stock for $27.4 million in cash. Under this Agreement, World Airways would receive upon closing (the "Closing") $12.4 million to fund its working capital requirements. The remaining $15.0 million (less a $2.7 million deposit received in December 1993) would be paid to WorldCorp to add to its cash reserves. At the time of the signing of the Stock Purchase Agreement, World Airways was a wholly-owned subsidiary of WorldCorp. On February 28, 1994, WorldCorp, World Airways, and MHS concluded the transaction according to the terms described above. As a result of this transaction, WorldCorp will recognize a gain of approximately $27.0 million in the first quarter of 1994. Second, World Airways finalized an agreement with a financial institution for a $20.0 million credit facility collateralized by certain receivables and spare parts. This agreement contains certain covenants related to World Airways' financial condition and operating results. Approximately $10.8 million of the proceeds from this transaction were used to retire existing obligations. The balance was added to cash reserves. As of March 24, 1994, $0.8 million of the $8.0 million portion of the credit facility collateralized by receivables was utilized. Third, on November 8, 1993, World Airways completed negotiations for $14.7 million of lease payment deferrals and related financings for eight of its nine aircraft in 1993. The ninth aircraft was returned to the lessor in October 1993. Additionally, World Airways received a permanent reduction in the lease rate for one DC10 aircraft, the only DC10 that will remain on long-term lease after September 1994. In 1993, $6.6 million of the deferrals were repaid. The remaining deferrals are scheduled to be repaid beginning in the second quarter of 1994, and bear interest at rates ranging from 7% to 12%. Fourth, in December 1993, US Order completed a private equity placement with financial and strategic partners for $12.0 million, of which WorldCorp invested $1.7 million. As a result of this transaction, WorldCorp owns 46% of the voting stock of US Order. WorldCorp has an option through December 15, 1994, to purchase additional shares of capital stock of US Order for consideration equal to $5.0 million, which if exercised, would increase its ownership percentage of the voting stock to 79%. US Order is currently seeking a private equity placement for up to $8.0 million with other financial and strategic partners. Fifth, in October and November 1993, the Company received $2.6 million of new equity investment through a series of warrant exercises by Ganz Capital Management. Finally, WorldCorp is seeking to place privately two securities of US Order that it currently holds: a $3.5 million increasing rate note with warrants in US Order, and $7.5 million of non-convertible preferred stock with warrants in US Order. No assurances can be made that the Company will be successful in placing these securities. The Company believes that the combination of the financings consummated to date and the operating and additional financing plans described above will be sufficient to allow the Company to meet its operating and capital requirements during 1994. BUSINESS TRENDS The Company is highly leveraged primarily due to losses sustained by World Airways' scheduled operations between 1979 and 1986, debt restructurings in 1984 and 1987 and losses the Company incurred in 1990, 1992, and 1993. In addition, the Company incurred substantial debt and operating lease commitments during 1993 in connection with acquiring MD-11 aircraft and related spare parts. As a result, in the second half of 1993, the Company took several steps to improve its liquidity, including: negotiating rent deferrals on eight aircraft and the early return to the lessor of another aircraft, arranging a $20.0 million accounts receivable and aircraft parts financing, and consummating the sale of 24.9% of World Airways. The Company's air transportation business is highly seasonal. Typically, World Airways experiences reduced demand during the first quarter for passenger and cargo services relative to other times of the year. World Airways generally experiences stronger results in the second and third quarters due to demand for commercial passenger services including the annual Hadj pilgrimage. Fourth quarter results depend upon the overall world economic climate and global trade patterns. Since the end of the Persian Gulf War, soft demand and weakening yields have adversely effected worldwide cargo and passenger markets. In management's view, block hours flown are a critical indicator of the airline's profitability. In order for World Airways to achieve positive operating results and meet its requirements under certain financing agreements, it will be necessary to increase block hours flown from 1993 levels. In response, World Airways has significantly increased its worldwide sales and marketing presence by 1) selling 24.9% of its equity to MHS Berhad solidifying a marketing alliance with a leading aviation company in Malaysia, 2) recruiting three active outside board members with experience in worldwide aviation and travel services, and 3) increasing its internal sales and marketing staff from two to seven executives. These actions were taken with the objective of increasing World Airways' flying levels. The fourth quarter of 1993 was the first recent quarter where flying level trends turned positive, increasing by 40% over the prior year's fourth quarter. Also, in the first quarter of 1994, management expects flying levels to be up more than 20% compared to 1993 levels. Management believes that positive trends will continue for the second and third quarters. Fourth quarter 1994 flying levels will largely depend upon global trade demand for cargo and the placement of at least two MD-11 passenger aircraft under longer-term contracts. On February 28, 1994, WorldCorp, World Airways, and MHS concluded the 24.9% sale of World Airways' common stock for $27.4 million in cash. WorldCorp will recognize a gain of approximately $27.0 million from this transaction in the first quarter of 1994. The Company has an objective to replicate a similar investment with strategic partners in Latin America. US Order is a provider of interactive transaction processing services to the home and the only company with a screen-based telephone that is fully operational with a broad menu of available services. US Order, however, is a development stage company and expects to continue to incur losses in 1994 and has significant working capital and capital expenditure requirements for 1994 (see "Liquidity and Capital Resources" and "Capital Plans"). US Order's Regional Bell Operating Company (RBOC) strategy has evolved from a joint marketing relationship to a value-added reseller relationship for the RBOC's enhanced caller services such as Caller ID. This evolution has taken place as a result of the RBOC's increased focus on video and cable television interactivity. In particular the video focus by Bell Atlantic led to the termination of the Bell Atlantic joint marketing agreement with US Order in March 1994 as Bell Atlantic consolidated its efforts in the video arena. Because screen-based telephones greatly improve the ease of use of enhanced telephone services such as Caller ID, strategic relationships with RBOCs are developing along this track. US Order's product offering to financial institutions have expanded in 1994. In addition to pursuing joint marketing alliances, US Order will also provide bill payment services to financial institutions through existing Audio Response Units, commonly known as touch tone or telephone banking services. The company is currently negotiating agreements with several major banks to offer these services in 1994. Later in 1994, US Order expects to offer similar "back end" bill payment support via personal computers. US Order is also significantly expanding its direct sales of screen-based telephones and interactive services to consumers. In October 1993, US Order announced its next generation screen-based telephone, PhonePlus /TM/, which it expects to have available to consumers in the third quarter of 1994. As in the cellular telephone industry, the price of the telephone will be related to the length and type of service contract the consumer chooses. OTHER MATTERS On August 11, 1992, WorldCorp, World Airways, and certain other commercial paper customers of Washington Bancorporation ("WBC") were served with a complaint by WBC as debtor-in-possession by and through the Committee of Unsecured Creditors of WBC (the "Committee"). The complaint arises from investment proceeds totaling $6.8 million received by WorldCorp and World Airways from WBC in May 1990 in connection with the maturity of WBC commercial paper. The Committee seeks to recover this amount on the grounds that these payments constituted voidable preferences and/or fraudulent conveyances under the Federal Bankruptcy Code and under applicable state law. On June 9, 1993, the Company filed a motion to dismiss this litigation and intends to vigorously contest the claim. No assurances can be given of the eventual outcome of this litigation. World Airways' cockpit and flight attendant crewmembers are covered by collective bargaining agreements which expired in July 1992. World Airways is currently in negotiations with the International Brotherhood of Teamsters ("Teamsters") to develop new agreements for cockpit and flight attendant crewmembers. World Airways and the Teamsters jointly requested the assistance of a federal mediator to facilitate negotiations between World Airways and its cockpit crewmembers. The outcome of the negotiations cannot be determined at this time. WorldCorp has never paid any cash dividends and does not plan to do so in the foreseeable future. Both the 13 7/8% Subordinated Notes Indenture and the indenture pursuant to which the Debentures were issued (the "Indentures") restrict the Company's ability to pay dividends or make other distributions on its common stock. In addition, the Indentures originally restricted the ability of World Airways to pay dividends other than to the Company. In 1994, however, the Company received approval from the holders of the Indentures to allow World Airways to pay dividends to parties other than the Company. The $20 million credit facility also contains restrictions on World Airways' ability to pay dividends. Under this agreement, World Airways cannot declare, pay, or make any dividend or distribution in excess of the lesser of $4.5 million or 50% of net income for the previous six months. In addition, World Airways must have a cash balance of at least $7.5 million immediately after giving effect to such dividend. All of the funds from operations are generated by the Company's subsidiaries. The ability of the Company and its subsidiaries to pay principal and interest on their respective short and long-term obligations is substantially dependent upon the payment to the Company of dividends, interest or other charges by its subsidiaries and upon funds generated by the operations of the subsidiaries. As of December 31, 1993, the Company had net operating loss carryforwards, investment tax credit carryforwards, and alternative minimum tax credit carryforwards of $137.2 million, $9.6 million, and $2.2 million, respectively (the "Carryforwards"). The availability of net operating loss and tax credit carryforwards to reduce the Company's future federal income tax liability is subject to limitations under the Internal Revenue Code of 1986, as amended (the "Code"). Generally, these limitations restrict availability of net operating loss and tax credit carryforwards upon an ownership change. In August 1991, the Company experienced an ownership change, and the use of $72.6 million of net operating loss carryforwards available to the Company from losses generated prior to the ownership change, plus the tax credit carryforwards described above, are limited to approximately $6.3 million annually (the "Limitation"). As a result of the transaction with MHS in February 1994, however, the Carryforwards will be split into two components: those generated solely by World Airways, and those generated by the remaining entities of the controlled group. As a result, approximately $84.8 million of the consolidated net operating loss carryforward will no longer be available to offset federal taxable income reflected on future consolidated tax returns. Instead, the $84.8 million will be available to World Airways on a separate company basis (subject to the Limitation). World Airways will also retain sole use of the $9.6 million investment tax credit carryforward and the $2.2 million alternative minimum tax credit carryforward to reduce its future federal income tax liability, subject to limitations under the Code. ITEM 8.

ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA - ---------------------------------------------------- WORLDCORP, INC. AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS ASSETS (in thousands) (Continued) WORLDCORP, INC. AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS LIABILITIES AND COMMON STOCKHOLDERS' DEFICIT (in thousands except share data) (Continued) See accompanying Notes to Consolidated Financial Statements WORLDCORP, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF OPERATIONS (in thousands except share data) WORLDCORP, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF OPERATIONS (Continued) * Fully diluted earnings per share are anti-dilutive. See accompanying Notes to Consolidated Financial Statements WORLDCORP, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CHANGES IN COMMON STOCKHOLDERS' DEFICIT Years ended December 31, 1993, 1992 and 1991 (in thousands except share data) See accompanying Notes to Consolidated Financial Statements WORLDCORP, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS (in thousands) See accompanying Notes to Consolidated Financial Statements WORLDCORP, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 1. SUMMARY OF SIGNIFICANT ACCOUNTING PRINCIPLES A. Principles of Consolidation The accompanying consolidated financial statements include the accounts of WorldCorp, Inc. ("WorldCorp" or the "Company"), its wholly-owned subsidiaries: World Airways, Inc., ("World Airways") (see Note 18); Key Airlines, Incorporated ("KeyAir") (see Note 3); WorldCorp Leasing, Inc.; WorldCorp Leasing II, Inc.; WorldCorp Services, Inc.; World Airways Cargo, Inc.; WorldCorp Investments, Inc.; World Flight Crew Services, Inc.; and a 46% ownership interest in the voting stock in US Order, Inc. ("US Order"). All significant intercompany balances have been eliminated. B. Financial Statement Reclassifications Certain items in prior year financial statements included herein have been reclassified to conform to 1993 financial statement presentation. C. Cash Equivalents For purposes of the Statements of Cash Flows, the Company considers all highly liquid investments purchased with an original maturity of ninety days or less to be cash equivalents. D. Revenue Recognition Contract flight operations and transaction processing revenues are recognized as the services are provided. E. Net Earnings (Loss) Per Common Share Primary earnings (loss) per common share have been computed by dividing earnings (loss) by the weighted average number of common and common equivalent shares outstanding. Common equivalent shares include warrants and options. Fully diluted earnings per common and common equivalent shares including convertible debt, have not been presented where the results are anti-dilutive. F. Investments Short-term investments are carried at the lower of aggregate cost or market value. Interest to be paid or received on notional principal amounts associated with interest rate swap agreements are measured as interest rates change and are recorded ratably over the life of the agreement. G. Equipment and Property Equipment and property are stated at cost or if acquired under capital leases, at the present value of the minimum lease payments. Engine overhauls and major airframe maintenance and repairs are charged to operating expense on an accrual basis. Modifications performed in response to Airworthiness Directives issued by the Federal Aviation Administration are capitalized at cost. Provisions for depreciation and amortization of equipment and property are computed over estimated useful lives by the straight-line method, with estimated residual values of 0 - 15%. Estimated useful lives of equipment and property are as follows: DC10 and MD11 flight equipment 15-16 years Other equipment and property 3-10 years H. Assets Held for Sale Assets held for sale are recorded at the lower of cost or estimated net realizable value. I. Intangible Assets The excess cost of the Company's investment in US Order over the fair value of the Company's share of US Order's net assets at the date of acquisition is being amortized over 17 years using the straight-line method. J. Income Taxes In February 1992, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes," ("FAS #109"). Under the asset and liability method of FAS #109, deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. Under FAS #109, the effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date. Effective January 1, 1992, the Company adopted FAS #109 which did not result in any cumulative adjustment to the accompanying consolidated financial statements. K. Postretirement Benefits Other Than Pensions World Airways' cockpit crewmembers and eligible dependents are covered under postretirement health care benefits to age 65. Effective January 1, 1992, World Airways adopted Statement of Financial Accounting Standards No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions" ("FAS #106"). The Company elected to immediately recognize the cumulative effect of the change in accounting for postretirement benefits of $2.0 million. The Company funds the benefit costs on a pay-as-you-go (cash) basis. L. Transactions in Subsidiaries' Stock Gains or losses realized in connection with the sale of stock by a subsidiary are recognized in income by the Company. 2. OPERATING ENVIRONMENT The Company is highly leveraged primarily due to losses sustained by World Airways' scheduled operations between 1979 and 1986, debt restructurings in 1984 and 1987 and losses the Company incurred in 1990, 1992, and 1993. In addition, the Company incurred substantial debt and operating lease commitments during 1993 in connection with acquiring MD-11 aircraft and related spare parts. As a result, in the second half of 1993, the Company took several steps to improve its liquidity, including: negotiating rent deferrals on eight aircraft and the early return to the lessor of another aircraft, arranging a $20.0 million accounts receivable and aircraft parts financing, and consummating the sale of 24.9% of World Airways. The Company's air transportation business is highly seasonal. Typically, World Airways experiences reduced demand during the first quarter for passenger and cargo services relative to other times of the year. World Airways generally experiences stronger results in the second and third quarters due to demand for commercial passenger services including the annual Hadj pilgrimage. Fourth quarter results depend upon the overall world economic climate and global trade patterns. Since the end of the Persian Gulf War, soft demand and weakening yields have adversely effected worldwide cargo and passenger markets. In management's view, block hours flown are a critical indicator of the airline's profitability. In order for World Airways to achieve positive operating results and meet its requirements under certain financing agreements, it will be necessary to increase block hours flown from 1993 levels. In response, World Airways has significantly increased its worldwide sales and marketing presence by 1) selling 24.9% of its equity to MHS Berhad solidifying a marketing alliance with a leading aviation company in Malaysia, 2) recruiting three active outside board members with experience in worldwide aviation and travel services, and 3) increasing its internal sales and marketing staff from two to seven executives. These actions were taken with the objective of increasing World Airways' flying levels. The fourth quarter of 1993 was the first recent quarter where flying level trends turned positive, increasing by 40% over the prior year's fourth quarter. Also, in the first quarter of 1994, management expects flying levels to be up more than 20% compared to 1993 levels. Management believes that positive trends will continue for the second and third quarters. Fourth quarter 1994 flying levels will largely depend upon global trade demand for cargo and the placement of at least two MD-11 passenger aircraft under longer-term contracts. The Company's investment in its US Order subsidiary has also required substantial support by WorldCorp in recent years. The Company's share of US Order losses in 1993 approximated $9.2 million. US Order, a development stage company, expects to continue to incur losses in 1994. In December 1993, US Order completed a private equity financing (see Note 16 for additional information) and is currently seeking additional equity financing. However, there can be no assurance that such financing will be obtained. WorldCorp does not plan to provide additional financing to US Order in 1994. The Company believes that the combination of the financings consummated to date and the operating and additional financing plans described above will be sufficient to allow the Company to meet its operating and capital requirements during 1994. 3. SALE OF KEY AIRLINES In September 1992, WorldCorp decided to dispose of its wholly-owned subsidiary, KeyAir and on October 6, 1992, WorldCorp entered into a letter of intent to sell the stock of KeyAir to Savannah Aviation Group ("SAG"). The sale of KeyAir was completed on October 23, 1992. Accordingly, KeyAir's net loss for 1992 is reflected in the accompanying financial statements, under the caption "Loss from operation of Key Airlines". Included in "Loss from operation of Key Airlines" in 1992 is $40.7 million of KeyAir operating revenues and $46.7 million of KeyAir operating expenses. The 1991 financial statements were not reclassified to conform with the 1992 presentation. Under the terms of the stock purchase agreement, WorldCorp sold all of the outstanding common shares of KeyAir for $6.5 million. As consideration for the shares, WorldCorp accepted a $3.5 million Senior Secured Note (the "Note") and a $3.0 million Convertible Subordinated Debenture (the "Debenture") from SAG, which were not recorded by the Company due to uncertainty regarding realization of these amounts. WorldCorp recorded an estimated loss on the sale of KeyAir of $31.4 million in the accompanying financial statements as of December 31, 1992. Loss on sale of KeyAir in 1992 consisted primarily of a writedown of the B727 aircraft and related rotables to estimated net realizable values and a write-off of the remaining goodwill associated with the purchase of KeyAir in 1987. As a result of the sale of KeyAir and the Company's inability to deploy the aircraft in other long-term opportunities beyond 1992, the Company discontinued operating the B727-100 aircraft after December 31, 1992. The Company entered into a consignment agreement with a third party to dismantle and sell certain of the B727-100 aircraft and the related rotables beginning in November 1992. As a result, in 1992, the Company reduced the carrying values of the B727 aircraft to estimated net realizable values and classified these amounts as assets held for sale in the accompanying balance sheet (see Note 7). On February 8, 1993, KeyAir filed a voluntary petition for bankruptcy protection under Chapter 11 and certain disputes arose between the Company and the purchasers of KeyAir. During 1993, in connection with the settlement of these disputes, the Company relinquished all rights to collection of the Notes and the Debentures. The Company recorded a loss of approximately $0.8 million in 1993 related to amounts outstanding under a line of credit and certain letters of credit related to KeyAir which will not be recovered by the Company. 4. SUPPLEMENTAL INFORMATION -- STATEMENTS OF CASH FLOWS Additional information pertaining to certain cash payments and noncash investing and financing activities is as follows (in thousands): During 1993, US Order completed a $12.0 million private equity placement in which WorldCorp invested $1.7 million (see Note 16). Included in the remaining $10.3 million investment was $2.5 million received in the form of an advertising credit and $4.3 million received in the form of forgiveness of various liabilities of US Order. Additionally, during 1993, US Order entered into $1.7 million of capital leases and other long-term obligations in connection with the purchase of transaction processing equipment. During 1993, the Company sold $9.5 million of MD-11 aircraft spare parts and leased the parts back under a 79 month capital lease. The following is a summary of the transaction (in thousands): During 1991 and 1992, the Company purchased $59.1 million of its 13 7/8% Subordinated Notes (the "Notes"). The following is a summary of these transactions (in thousands): During 1991, the Company sold a DC10-30 aircraft and leased the aircraft back under a 12-year operating lease. The following is a summary of the transaction (in thousands): During 1991, the Company sold a DC10-30 engine generating net proceeds of $1.3 million and leased the engine back under a 60 month operating lease. The following is a summary of the transaction (in thousands): 5. SHORT-TERM INVESTMENTS At December 31, 1993 and 1992, short-term investments consist of cash pledged as collateral for letters of credit with expiration dates in excess of ninety days. In December 1992, the Company sold its $3.0 million partnership investment for $4.7 million. The $4.7 million is included in other receivables at December 31, 1992 and was received in 1993. Interest income in 1992 includes $1.7 million related to this partnership investment. 6. OTHER ASSETS AND DEFERRED CHARGES Other assets and deferred charges consist of the following (in thousands): Debt issuance costs consist of the costs of issuing the 13 7/8% Subordinated Notes due 1997, the Convertible Subordinated Debentures due 2004, and revolving lines of credit agreements. These costs are being amortized over the term of the respective debt instruments using the effective interest method (see Note 9 and 10). 7. ASSETS HELD FOR SALE Assets held for sale consist primarily of DC10 and B727 rotables with a net book value of $8.9 million and two DC10 engines with a net book value of $4.5 million. The Company has consigned these parts with a third party to sell these parts over a reasonable period of time with the objective of maximizing the proceeds from sale. During 1993, US Order recorded a $1.8 million writedown associated with its older generation of terminal components, a portion of which are available for sale. 8. EQUIPMENT AND PROPERTY World Airways was awarded an insurance settlement which resulted in a $1.1 million reduction in maintenance expenses in 1991 for repairs associated with an aircraft that was damaged in a volcanic eruption. On May 1, 1991, World Airways sold a DC10-30 engine for $3.2 million and leased the engine back under a 60 month operating lease. On December 29, 1989, World Airways purchased a McDonnell Douglas DC10-30CF series aircraft (the "Aircraft") from Potomac Capital Investment Corporation, for approximately $42.0 million. The Aircraft had been involved in a sale leaseback transaction with Burnham Leasing Incorporated in 1987, and was in the World Airways fleet under an operating lease which was terminated at the time of the purchase. Upon purchase of the Aircraft, World Airways reduced the carrying value of the Aircraft and, correspondingly, the deferred gain from the 1987 sale by $5.0 million. On January 15, 1991, World Airways sold the Aircraft for $47.5 million, retired $38.1 million in related debt, and leased the Aircraft back under a twelve year operating lease. The resulting gain on sale of $12.1 million is being amortized over the lease period. 9. NOTE PAYABLE TO BANK In 1993, World Airways entered into an $8.0 million revolving line of credit borrowing arrangement which is collateralized by certain receivables which were sold to the bank with recourse. Borrowing availability under the line is based on the amount of eligible receivables. Borrowings under the line of credit were $7.1 million at December 31, 1993 and bear interest at the greater of the federal funds rate plus 2.5% or the prime rate plus 2%. At December 31, 1993, the interest rate was 8%. World Airways is required to pay any outstanding amounts under the line of credit by January 7, 1996, with the option to extend for one year. This agreement contains certain covenents related to World Airways' financial condition and operating results, including minimum quarterly net income tests. In addition, there is an unused facility fee of 0.5% per year (see Note 10). The Company had a $10.0 million revolving line of credit borrowing arrangement, collateralized by certain receivables, available during 1992. Approximately $9.8 million was available under this credit facility at December 31, 1992 based upon the amount of outstanding receivables. Borrowings under the line of credit were $9.3 million at December 31, 1992 and bear interest at the lesser of the LIBOR rate plus 2.75% per annum or the lender's prime rate plus 0.5% per annum. At December 31, 1992 the interest rate was 6.5%. The line of credit was paid in full on December 7, 1993 and expired at the end of the year. 10. LONG-TERM OBLIGATIONS Long-Term Debt The Company's long-term obligations at December 31 are as follows (in thousands): The Indenture pursuant to which the 13 7/8% Subordinated Notes (the "Indenture") were issued may restrict the Company's ability to pay dividends on its common stock. Under the Indenture, the Notes are redeemable beginning August 15, 1992, at which time they are redeemable at 104% of par value and at rates declining thereafter. In May 1992, the Company issued $65.0 million of Convertible Subordinated Debentures due 2004 (the "Debentures"). The Debentures are convertible into WorldCorp common stock at $11.06 per share, subject to adjustment in certain events, and bear an annual interest rate of 7%. Semi-annual interest payments are due on May 15 and November 15. During the second and third quarters of 1992, the Company used $47.1 million of the proceeds from this borrowing to retire a portion of its 13 7/8% Subordinated Notes due 1997 (the "Notes"). WorldCorp has never paid any cash dividends and does not plan to do so in the foreseeable future. Both the 13 7/8% Subordinated Notes Indenture and the indenture pursuant to which the Debentures were issued (the "Indentures") restrict the Company's ability to pay dividends or make other distributions on its common stock. In addition, the Indentures originally restricted the ability of World Airways to pay dividends other than to the Company. In 1994, however, the Company received approval from the holders of the Indentures to allow World Airways to pay dividends to parties other than the Company. The aircraft parts security agreement is subject to the terms of the $8.0 million revolving line of credit borrowing (see Note 9). Under this agreement the borrowing must be reduced by the amount of proceeds received from the sale of excess DC10 and B727 spare parts, but at a minimum of $0.5 million each month. The borrowing facility also restricts World Airways' ability to pay dividends. Under this agreement, World Airways cannot declare, pay, or make any dividend or distribution in excess of the lesser of $4.5 million or 50% of net income for the previous six months. In addition, World Airways must have a cash balance of at least $7.5 million immediately after giving effect to such dividend. The following table shows the aggregate amount of scheduled principal maturities (in thousands) of debt outstanding at December 31, 1993: Deferred Aircraft Rent During 1993, the Company negotiated with several of its lessors to defer approximately $14.7 million of lease payments on eight aircraft. Of this amount, $6.6 million was repaid during 1993. The remaining deferrals are scheduled to be repaid beginning the second quarter of 1994 and bear interest at rates ranging from 7% to 12%. Principal payments in 1994 amount to $6.3 million, with the remaining amounts due as follows (in thousands): Capital Leases The present values of the obligations under capital leases at December 31, 1993 are calculated using rates ranging from 6.14% to 11.7%. The following are scheduled minimum capital lease payments (in thousands) due in the succeeding five years and thereafter, together with the present value of such obligations: Property under capital leases consists of equipment leases and are amortized on a straight-line basis over the lease terms or expected useful life of the assets. Accumulated amortization under capital leases was $3.2 million and $2.5 million at December 31, 1993, and 1992, respectively. Amortization expense of property under capital lease totaled $658,000, $522,000, and $456,000 for the years ended December 31, 1993, 1992, and 1991, respectively. Operating Leases In October 1992 and January 1993, World Airways signed a series of agreements with International Lease Finance Corporation ("ILFC"), McDonnell Douglas Corporation, GATX Capital Corporation, and Pratt and Whitney to lease seven new McDonnell Douglas MD-11 aircraft under initial lease terms of two to five years. Six of the seven aircraft leases contain annual renewal options in years three through fifteen of the lease term. Under the terms of the lease agreements, World Airways may be required to pay additional rent in excess of the fixed monthly amounts depending on block hours flown. World Airways took delivery of four passenger MD-11s in 1993, and is scheduled to take delivery of one freighter MD-11 in 1994 and two convertible MD-11s in 1995. The delivery of the convertible MD-11s is expected to occur approximately six months after the end of the lease in 1994 of three DC10-30 convertibles. The leases contain options to purchase the aircraft at various times throughout the lease terms. Long-term deposits consist primarily of deposits on the MD-11 leases. As part of the lease agreements, World Airways was assigned purchase options for four additional MD-11 aircraft. At December 31, 1992, World Airways made non- refundable deposits toward three of the option aircraft. During 1993, the options' exercise dates were extended to July 30, 1994 with scheduled aircraft delivery dates from August 1995 to September 1996. If the options are exercised, World Airways intends to obtain financing for the purchases. In February 1992, World Airways signed twelve year operating leases for two McDonnell Douglas DC10-30 passenger aircraft. In July 1993, World Airways returned these aircraft to their lessor which resulted in a $1.5 million early termination payment of which $1.1 million was expensed in 1993. In October 1993, the Company returned an aircraft to its lessor and recorded an expense of $1.2 million related to the early termination of the lease. Rental expense, primarily relating to aircraft leases, totaled approximately $52.1 million, $39.6 million, and $43.0 million for the years ended December 31, 1993, 1992, and 1991, respectively. The following is a schedule of future annual minimum rental payments (in thousands), principally aircraft rentals (excluding variable portions), required under operating leases that have initial or remaining noncancellable lease terms in excess of one year as of December 31, 1993: 11. COMMON STOCK PURCHASE WARRANTS Drexel Warrants On June 30, 1988, the Company issued to Drexel Burnham Lambert, Incorporated ("Drexel") warrants expiring May 24, 1994 to purchase 1,000,000 shares of the Company's common stock at a price of $8.00 per share, subject to certain antidilution adjustments (the "Drexel Warrants"). On July 31, 1989, the Company purchased 500,000 of these warrants from Drexel for $1.3 million. In 1992, 37,500 of these warrants were exercised. At December 31, 1993, there were 462,500 Drexel Warrants fully vested and outstanding. BNYFC Warrants On December 7, 1993, in connection with a revolving line of credit facility and an aircraft parts security agreement (see Notes 9 and 10), the Company granted to Bank of New York Financial Corporation ("BNYFC") warrants expiring December 7, 1996 to purchase 250,000 shares of the Company's common stock, at a price of $6.15 per share. These warrants include certain registration rights. At December 31, 1993, these warrants were fully vested and outstanding. 1986 Executive Warrants During 1986, the Company entered into agreements with certain officers of the Company to issue 3,600,000 warrants, expiring May 24, 1994, each to purchase one share of the Company's common stock at a price of $5.00 per share, subject to certain antidilution adjustments (the "1986 Executive Warrants"). During 1993, 1992, and 1991, 779,875, 0, and 237,789, respectively, of these warrants were exercised. At December 31, 1993, a total of 2,362,336 of the 1986 Executive Warrants are fully vested and outstanding. 1989 Executive Warrants During 1989, the Company entered into warrant agreements with certain officers of the Company providing for the issuance of warrants ("1989 Executive Warrants") to purchase a total of 745,000 shares of Company common stock at an exercise price of $5.50; such warrants to vest, at differing rates, over 60 months. The 1989 Executive Warrants expire on August 31, 1997. On November 1, 1990, Mr. T. Coleman Andrews cancelled his right to receive 250,000 warrants granted to him under his 1989 Executive Warrant agreement, and the agreement was terminated. Mr. Andrews agreed to cancel his right to receive the 250,000 warrants so that equity compensation under the 1988 Stock Option Plan could be granted in 1990 to officers of the Company and its subsidiaries. During 1991, 163,417 of the warrants were cancelled. During 1992, 40,000 of these warrants were cancelled. At December 31, 1993, there were 291,583 1989 Executive Warrants outstanding of which 276,416 are fully vested. 12. STOCK OPTIONS On July 19, 1988, the Board of Directors approved The WorldCorp, Inc. 1988 Stock Option Plan (the "1988 Plan"). The 1988 Plan was amended and restated on May 13, 1992. The 1988 Plan calls for one share of WorldCorp common stock to be issued upon exercise of one stock option. Shares issuable under the 1988 Plan, as amended, shall not exceed 2,800,000 in the aggregate. Options may be granted to employees and directors at the discretion of the Administrative Committee of the 1988 Plan. In 1990, the 1988 Plan was amended to change the vesting percentage to 20% per year beginning on the grant date provided that the grantee was still an employee of the Company or a subsidiary. During 1991, the Company made cash payments totaling $35,054 in exchange for the cancellation of 9,670 options. A summary of option transactions under the 1988 Plan for the years ended December 31, 1991, 1992, and 1993 is presented below: A total of 961,692 options have vested and are exercisable by the participants under the 1988 Plan as of December 31, 1993. 13. EMPLOYEE BENEFIT PLANS During 1989, the Company adopted an Employee Stock Ownership Plan (the "ESOP") for the benefit of employees not covered by collective bargaining agreements. The ESOP is designed as a stock bonus plan which qualifies for favorable tax treatment under Section 401(a) of the Internal Revenue Code of 1986, as amended (the "Code"), and as an employee stock ownership plan under Section 4975(e)(7) of the Code. In addition, the ESOP includes a "cash or deferred arrangement" under Section 401(k) of the Code. During 1989, the ESOP acquired 450,000 shares of common stock from Violet June Daly and 450,000 shares of common stock from the Estate of Edward J. Daly. The purchase price in each transaction was $4.00 per share or a total of $3.6 million. The ESOP obtained bank financing of $3.6 million (the "ESOP Loan") that matures seven years from funding and requires quarterly principal payments of $90,000 and a final principal payment of $1,080,000. Interest at 85% of the bank's prime rate is payable monthly. At December 31, 1993, the ESOP had pledged 478,501 shares as collateral for the loan and the loan is guaranteed by WorldCorp. Under the guarantee, the Company is also required to meet certain restrictive covenants. The Company is required to make minimum annual discretionary contributions to the ESOP in an amount necessary to pay principal and interest due on the ESOP Loan to the extent that other contributions to the ESOP are insufficient to make such payments. In 1992, contributions from employees combined with employer matching contributions were sufficient to make required principal and interest payments. The Company expensed $0.2 million and $0.1 million of principal and interest for the ESOP Loan in 1993 and 1991, respectively. In 1990, the ESOP was replaced by the Employee Savings and Stock Ownership Plan ("ESSOP"). Participation in the ESSOP is limited to employees not covered under a collective bargaining agreement. Employees may elect to invest Salary Deferral Contributions in either the WorldCorp Stock Fund or in Other Investment Funds. The ESSOP provides employer matching contributions in the WorldCorp Stock Fund at a rate determined by the Board of Directors, but at least 50% of the Salary Deferral Contribution. The employer matching contribution rate in the WorldCorp Stock Fund for 1993, 1992 and 1991 was 100%. The employer matching contribution in Other Investment Funds is at the rate of 33 1/3% of the Salary Deferral Contribution. The Company charged approximately $416,000, $394,000, and $273,000 to expense for its contributions to the ESSOP in 1993, 1992 and 1991, respectively. The World Airways' Crewmembers Target Benefit Plan is a defined contribution plan covering flight engineers and pilots with contributions based upon defined wages. This is a tax-qualified retirement plan under Section 401(a) of the Code. The World Airways' Flight Attendants Target Benefit Plan is a defined contribution plan covering flight attendants with contributions based upon defined wages. This is a tax-qualified retirement plan under Section 401(a) of the Code. Pension expense for both plans totaled $1,524,000, $1,288,000, and $1,165,000 for the years ended December 31, 1993, 1992 and 1991, respectively. Effective January 1, 1987, World Airways adopted the World Airways, Inc. Profit Sharing Bonus Plan (the "1987 Profit Sharing Plan"). Contributions to the 1987 Profit Sharing Plan are equal to 20% of World Airways' defined operating income, subject to an annual limitation of 10% of the total annual aggregate compensation of World Airways' employees participating in the 1987 Profit Sharing Plan in that year. This is not a tax-qualified retirement plan under Section 401(a) of the Code. Prior to 1993, contributions to the 1987 Profit Sharing Plan were allocated first to payments to all persons or their beneficiaries whose wages were reduced during the time from December 1, 1982 to January 31, 1985. The total wage reduction for this period was approximately $5.8 million. World Airways has repaid the entire $5.8 million as of December 31, 1992. Approximately $0.8 million was distributed in 1993 pertaining to 1992 financial results. The Company does not anticipate any distributions in 1994 pertaining to 1993 financial results. World Airways' cockpit crewmembers and eligible dependents are covered under postretirement health care benefits to age 65. Effective January 1, 1992, World Airways adopted Statement of Financial Accounting Standards No. 106, Employers' ---------- Accounting for Postretirement Benefits Other Than Pensions ("FAS #106"). FAS - ---------------------------------------------------------- #106 requires accrual accounting for all postretirement benefits other than pensions. Prior to the adoption of FAS #106, the cost of health benefits for cockpit retirees was recognized by charging claims to expense as they were incurred. The Company elected to immediately recognize the cumulative effect of the change in accounting for postretirement benefits of $2.0 million in 1992. 1991's financial results have not been restated. World Airways funds the benefit costs on a pay-as-you-go (cash) basis. A summary of the net periodic postretirement benefit cost for the year ended December 31, 1993 is as follows: The assumed discount rate used to measure the accumulated postretirement benefit obligation for 1993 was 6.25%. The medical cost trend rate in 1993 was 11.75% trending down to an ultimate rate in 2011 of 4.25%. A one percentage point increase in the assumed health care cost trend rates for each future year would have increased the aggregate of the service and interest cost components of 1993 net periodic postretirement benefit cost by $30,000 and would have increased the accumulated postretirement benefit obligation as of December 31, 1993 by $175,000. 14. FEDERAL AND STATE INCOME TAXES Effective January 1, 1992 the Company adopted FAS #109. There was no adjustment necessary for the cumulative effect of this change in accounting for income taxes as of January 1, 1992. The 1991 financial statements have not been restated to apply the provisions of FAS #109. The consolidated provision for income taxes consists entirely of current income taxes and excludes any amounts related to US Order since US Order is not part of WorldCorp and subsidiaries consolidated income tax return. Total income tax expense was allocated as follows (in thousands): Income tax expense attributable to income from continuing operations consists of (in thousands): There is no deferred tax expense or benefit for the years ended December 31, 1993, 1992 and 1991. Income tax expense attributable to income (loss) from continuing operations for the years ended December 31, 1993, 1992, and 1991 differed from the amounts computed by applying the U.S. Federal income tax rate of 34 percent as a result of the following (in thousands): The effect of the alternative minimum tax as set forth in the above table is caused by the limitation on the utilization of net operating loss carryforwards for alternative minimum tax purposes. The tax effects of temporary differences that give rise to significant portions of deferred tax assets and liabilities at December 31, 1993 are as follows (in thousands): The valuation allowance for deferred tax assets as of January 1, 1993 was $64.4 million. The net change in the total valuation allowance for the year ended December 31, 1993 was an increase of $8.6 million. The availability of net operating loss, investment tax credit, and alternative minimum tax credit carryforwards to reduce the Company's future Federal income tax liability is subject to limitations under the Internal Revenue Code of 1986, as amended (the "Code"). Generally, these limitations restrict the availability of net operating loss and investment tax credit carryforwards upon certain changes in stock ownership by five percent shareholders which, in aggregate, exceed 50 percentage points in value in the three-year testing period ("Ownership Change"). In August 1991, 5.7 million shares of common stock were sold by a group of existing shareholders. This transaction constituted an Ownership Change, which reduced the annual utilization of net operating loss, alternative minimum tax credit, and investment tax credit carryforwards ("Carryforwards") available to the Company in 1991 and future years. As of December 31, 1993, the Company had net operating loss carryforwards for federal income tax purposes of $72.6 million [subject to a $6.3 million annual limitation based on the value of the outstanding Common Stock immediately prior to the Ownership Change and the statutorily provided long-term tax exempt rate (the "Limitation")] and $64.6 million (generated after the Ownership Change) which are available to offset future federal taxable income. These carryforwards expire between 1995 and 2008. On February 28, 1994, the Company sold 24.9% of World Airways' common stock to MHS Berhad ("MHS"), decreasing WorldCorp's ownership in World Airways to 75.1% (see Note 18). The Code permits a controlled group to file a consolidated tax return that includes all subsidiaries which are at least 80% owned by the parent company. As a result, for the period beginning March 1, 1994, World Airways will be required to file a separate company tax return and will no longer be included in the WorldCorp and subsidiaries consolidated U.S. income tax return. As a result, approximately $84.4 million of the consolidated net operating loss carryforwards for federal income tax purposes (subject to the Limitation) will be allocated to World Airways, and will no longer be available to offset federal taxable income reflected on future consolidated tax returns. World Airways settled its litigation with the State of California Franchise Tax Board (the "Board") concerning assessments of deficiencies in state franchise taxes for the years 1973-1975 and 1978. The Board had asserted a total tax deficiency of $2.4 million and unpaid interest of $5.9 million. This final settlement resulted in the reversal of a previously recorded liability and the recognition of a 1991 non-operating gain of $5.5 million, net of related legal expenses. 15. SEGMENT INFORMATION The Company operates in two business segments: air transportation and transaction processing. The air transportation segment consists of the operations of World Airways, a worldwide provider of air transportation for commercial and government customers. The Company's transaction processing business consists of its 46% ownership of the voting stock of US Order, a company that has developed a patented, automated ordering system with residential and commercial applications. Summarized financial information by business segment is as follows (in thousands): There were no significant intersegment sales or transfers during 1993 and 1992. Information concerning customers for years in which their revenues comprised 10% or more of the Company's consolidated operating revenues is presented in the following table (in thousands): The Company's contract with the United States Air Mobility Command ("AMC") expires in September 1994. The Company anticipates that future renewals of the AMC contract will be on an annual basis. World Airways has provided service to MAS since 1981, transporting passengers for the annual Hadj pilgrimage as well as providing aircraft for integration into MAS' scheduled passenger and cargo operations. The current MAS contract, which was entered into in 1992, expires in 1996. However, in 1992 the government of Malaysia instructed the Malaysian Hadj Board (which in turn instructed MAS) to competitively rebid the contract for the 1993 Hadj. MAS rebid the contract for the 1993 Hadj and World Airways was again selected to provide 1993 Hadj service to MAS. World's management believes that its contract with MAS through 1996 is a legally binding obligation. MHS has agreed to acquire 32% of MAS in 1994 (see Note 18). World Airways has provided service to Garuda since 1988 under an annual contract. World Airways supplied six of Garuda's sixteen aircraft necessary for its 1993 Hadj operations and will provide six aircraft for the 1994 Garuda Hadj operations. World Airways provided service to Burlington Air Express in 1993. At this time, World Airways has no contract for services in 1994. All export contracts are denominated in U.S. dollars as are substantially all of the related expenses. The classification between domestic and export revenues is based on entity definitions prescribed in the economic regulations of the Department of Transportation. Information concerning the Company's export revenues is presented in the following table (in thousands): 16. RELATED PARTY TRANSACTIONS Effective November 10, 1988, T. Coleman Andrews', III employment agreement to serve as Chief Executive Officer and President of WorldCorp, which was originally entered into in August 1986, was extended an additional five years to August 1, 1994. The contract will automatically be extended annually at the end of the term of the agreement unless either party provides a twelve month advance, written notice of their intent to terminate the agreement. The Company and Mr. Andrews did not provide written notice of their intent to terminate the Agreement, and therefore, Mr. Andrews' employment agreement has been automatically extended through August 1995. In connection with the employment agreement, Mr. Andrews also entered into a Supplemental Incentive agreement with WorldCorp that provides for a bonus in the amount of $1,300,000 plus interest earned at 8.91% to be paid to Mr. Andrews on August 1, 1994 provided he is still an employee of WorldCorp at that time. This amount is included in accrued wages in the accompanying 1993 consolidated balance sheet. In connection with this employment arrangement, the Company loaned Mr. Andrews $1,300,000 on January 10, 1989. Mr. Andrews executed and delivered to the Company a full recourse promissory note dated January 10, 1989. The principal amount of the note is due and payable on December 31, 1994 and interest accrues quarterly and is payable at maturity at a fixed rate of 8.91% per annum. This amount is included in prepaid expenses and other current assets in the accompanying 1993 consolidated balance sheet. On September 10, 1990, the Board of Directors of WorldCorp unanimously authorized WorldCorp to enter into and consummate a Stock Purchase Agreement dated as of September 14, 1990 (the "Stock Purchase Agreement"), under which WorldCorp agreed to purchase Series A Preferred Stock ("Preferred Stock") issued by US Order. The Board of Directors of the Company authorized the purchase of US Order, a development stage company with limited revenue to date, as part of the Company's continuing efforts to diversify its interests. Mr. Gorog is Chairman of the Board of US Order and is Chairman of the Board of Directors of WorldCorp. Mr. Gorog, together with certain members of his immediate family (the "Founders"), were majority owners of US Order. On July 1, 1992, the Company purchased an incremental 6% of the preferred stock of US Order for $1.0 million which increased the Company's ownership in US Order to 51%. Accordingly, US Order's financial position, results of operations, and statement of cash flows have been consolidated in the accompanying financial statements for the period subsequent to July 1, 1992. All significant intercompany balances have been eliminated. Prior to July 1, 1992, WorldCorp's investment was accounted for using the equity method. As of December 31, 1993, WorldCorp had purchased for $5.3 million a total of 5,204,082 shares of US Order preferred stock, which are convertible into common stock. In December 1992, WorldCorp agreed to convert $7.6 million in principal amount of loans from WorldCorp to US Order into 7,550 shares of redeemable preferred stock of US Order. The preferred stock pays quarterly dividends at a rate of 7.5%. As part of this transaction, WorldCorp's option to purchase additional shares of the capital stock of US Order was extended from September 15, 1993 to December 15, 1994, and WorldCorp received an exclusive license to apply US Order's transaction processing technology to lottery and gaming applications. In December 1993, US Order completed a private equity placement for $12.0 million with financial and strategic partners. WorldCorp invested $1.7 million in this equity offering. Following this transaction, WorldCorp owns 46% of the voting stock of US Order. US Order is still in the developmental stage and, therefore, the gain resulting from this transaction of $0.8 million was recorded as additional paid-in-capital in the accompanying consolidated financial statements. Additionally, the intangible asset previously recorded by the Company was eliminated. WorldCorp and the financial and strategic partners of US Order own stock which carry liquidation preferences pursuant to which WorldCorp is currently entitled to 59% of any distributions. The results of operations of US Order are allocated based on liquidation preferences. WorldCorp provided consulting services to assist US Order's management during 1993, 1992 and 1991. US Order paid consulting fees to WorldCorp equal to the cost of the salary and benefits of WorldCorp personnel who performed these services. W. Jerrold Scoutt, Jr., a member of the Board of Directors of WorldCorp, is a member of the law firm of Zuckert, Scoutt & Rasenberger, Washington, D.C. Zuckert, Scoutt & Rasenberger rendered legal services to the Company during 1993, 1992 and 1991. 17. COMMITMENTS AND CONTINGENCIES Litigation and Claims On August 11, 1992, WorldCorp, World Airways, and certain other commercial paper customers of Washington Bancorporation ("WBC") were served with a complaint by WBC as debtor-in-possession by and through the Committee of Unsecured Creditors of WBC (the "Committee"). The complaint arises from investment proceeds totaling $6.8 million received by WorldCorp and World Airways from WBC in May 1990 in connection with the maturity of WBC commercial paper. The Committee seeks to recover $2.0 million from WorldCorp and $4.8 million from World Airways on the grounds that these payments constituted voidable preferences and/or fraudulent conveyances under the Federal Bankruptcy Code and under applicable state law. The Company has filed a motion to dismiss this complaint and intends to defend vigorously against these claims. No assurances can be given of the eventual outcome of this litigation. On February 3, 1992, the US Patent and Trademark Office ("PTO") issued an order granting a request to reexamine US Order's patent based on a previously issued patent to a third party. On April 3, 1993, the PTO completed its reexamination and approved the amended claims of US Order's patent. Other claims of patent infringement have also been asserted or threatened against US Order. Although US Order and its counsel believe that US Order has substantial defenses to any claim of infringement, there can be no assurances that US Order would prevail in any such proceedings. In addition, upon the occurrence of certain events such as the bankruptcy of US Order, an investor of the company receives a fully paid, non exclusive worldwide license to certain of US Order's licensed technology. The Company is involved in various other claims and legal actions arising in the ordinary course of business. In the opinion of management, the ultimate disposition of these matters will not have a material adverse effect on the Company's consolidated financial position. Letters of Credit At December 31, 1993 and 1992, restricted cash and short-term investments included customer deposits held in escrow and cash pledged as collateral for various letters of credit facilities issued by a bank on the Company's behalf totaling $1.0 million and $2.9 million, respectively, with expiration dates principally occurring in 1994. Options on MD-11 Aircraft The Company has options to purchase four MD-11 aircraft, which, if exercised, would require a downpayment equal to five percent of the purchase price in July 1994. 18. SUBSEQUENT EVENTS On October 30, 1993, WorldCorp, Inc., World Airways, Inc., and MHS Berhad ("MHS") entered into a Stock Purchase Agreement (the "Stock Purchase Agreement") pursuant to which MHS, subject to satisfactory completion of its due diligence investigations, agreed to purchase 24.9% of World Airways' common stock for $27.4 million in cash. Under this Agreement, World Airways would receive upon closing $12.4 million to fund its working capital requirements. The remaining $15.0 million would be paid to WorldCorp to add to its cash reserves. The Company received $2.7 million prior to December 31, 1993 as an advance on the sales price. At the time of the signing of the Stock Purchase Agreement, World Airways was a wholly-owned subsidiary of WorldCorp. On February 28, 1994, WorldCorp, World Airways, and MHS concluded the transaction according to the terms described above. As a result of this transaction, WorldCorp will recognize a gain of approximately $27.0 million in the first quarter of 1994. Under this agreement, if at any time after October 30, 1996 World Airways registers its common stock under the Securities Act of 1993, MHS has the right to demand the registration of its shares. Also, if without the prior written consent of MHS: (1) World Airways sells all or substantially all of its business; or (2) World Airways fundamentally changes its line of business, then MHS has the option (a) to sell or transfer all or a portion of its shares to a third party notwithstanding the aforementioned three-year holding period; and/or (b) to require WorldCorp to purchase all or part of MHS's shares at fair market value. Fair market value may not be less than the aggregate of the costs borne by MHS in acquiring and holding its World Airways shares. Management has indicated that it does not intend to take any such actions without the prior consent of MHS. MHS recently announced that it will acquire 32% of Malaysian Airline System Berhad ("MAS"), the flag carrier of Malaysia. MAS is one of World Airways' largest commercial customers. 19. UNAUDITED QUARTERLY RESULTS The results of the Company's quarterly operations for 1993 and 1992 are as follows (in thousands except per share amounts): (a) Includes the effects of the aircraft lease termination expenses of approximately $2.7 million and a write-down of $1.5 million for older generation transaction processing equipment. (b) Included in total revenue in 1992 is $4.1 million relating to settlements from AMC of two contract claims ($2.4 million in the second quarter and $1.7 million in the fourth quarter). (c) As the result of the sale of KeyAir on October 23, 1992, the results of KeyAir's operations for the year ended December 31, 1992 have been presented on a separate line within operating expenses. (d) Adjustment is the result of adopting Statement of Financial Accounting Standards No. 106, Employer's Accounting for Postretirement Benefits Other Than Pensions effective January 1, 1992. The adoption of FAS# 109 as of January 1, 1992 had no impact on previously reported results. INDEPENDENT AUDITORS' REPORT The Board of Directors and Stockholders WorldCorp, Inc. : We have audited the accompanying consolidated balance sheets of WorldCorp, Inc. and subsidiaries (WorldCorp) as of December 31, 1993 and 1992, and the related consolidated statements of operations, changes in common stockholders' deficit and cash flows for each of the years in the three-year period ended December 31, 1993. In connection with our audits of the consolidated financial statements, we also have audited the related financial statement schedules as listed in Item 14(a)2 herein. These consolidated financial statements and financial statement schedules are the responsibility of WorldCorp's management. Our responsibility is to express an opinion on these consolidated financial statements and financial statement schedules based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of WorldCorp, Inc. and subsidiaries as of December 31, 1993 and 1992, and the results of their operations and their cash flows for each of the years in the three-year period ended December 31, 1993, in conformity with generally accepted accounting principles. Also in our opinion, the related financial statement schedules, when considered in relation to the basic consolidated financial statements taken as a whole, present fairly, in all material respects, the information set forth therein. As discussed in Notes 13 and 14 to the consolidated financial statements, effective January 1, 1992, WorldCorp adopted the provisions of the Financial Accounting Standards Board's Statements of Financial Accounting Standards No. 106,"Employers' Accounting for Postretirement Benefits Other Than Pensions", and No. 109,"Accounting for Income Taxes". KPMG PEAT MARWICK Washington, D.C. March 14, 1994 ITEM 9.

ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND - ------------------------------------------------------------------------- FINANCIAL DISCLOSURE -------------------- None. PART III ITEM 10.

ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT - ------------------------------------------------------------ Directors The Company incorporates herein by reference the information concerning directors contained in its Notice of Annual Stockholder's Meeting and Proxy Statement to be filed within 120 days after the end of the Company's fiscal year (the "1994 Proxy Statement"). Executive Officers The following table sets forth the names and ages of all executive officers of the Company and all positions and offices within the Company presently held by such executive officers: Mr. T. Coleman Andrews, III was elected Chief Executive Officer, President and a director of World Airways in August 1986 and of WorldCorp in June 1987. From 1983 through 1986, he was Chairman of Key Holding Corporation and its principal operating subsidiary, KeyAir. From 1978 through 1986, he was affiliated with Bain & Company, an international management consulting firm. At Bain, he was elected partner in 1982 and was a founding general partner of Bain Capital Fund, a private venture capital partnership, in 1984. Prior to his experience with Bain & Company, Mr. T. Coleman Andrews, III served in several appointed positions in the Ford Administration. He is the brother of A. Scott Andrews. Mr. William F. Gorog has served as Chief Executive Officer of US Order since May 1, 1990. He was elected a director of WorldCorp in April 1989 and was elected Vice-Chairman of the WorldCorp Board of Directors in October 1992. From October 1987 until founding US Order, he has served as Chairman of the Board of Arbor International, an investment management firm. From 1982 to 1987, he served as President and Chief Executive Officer of Magazine Publishers of America, a trade association representing the principal consumer publications in the United States. During the Ford Administration, Mr. Gorog served as Deputy Assistant to the President for Economic Affairs and Executive Director of the White House Council on International Economic Policy. Prior to that time, he founded and served as Chief Executive Officer of Data Corporation, which developed the LEXIS and NEXIS information systems for legal and media research. He currently serves as a director of NationsBank (Maryland), a bank holding company, Verifone, Inc., a manufacturer of point of sale terminals, and Fiskars, Inc., a Finnish manufacturing company. Mr. John H. DeWitt was elected President of World Flight Crew Service in November of 1992. From June 1989 until October 1992 he was Vice President, Flight Operations of World Airways, Inc. Mr. DeWitt served as Vice President, Operations Planning, of World Airways, Inc. from September 1988 until May 1989. Since joining World Airways, Inc. in 1967 he has served in several flight operations management positions including that of System Chief Pilot. Mr. Charles W. Pollard was elected President of World Airways in May 1992. He was elected General Counsel and Secretary of WorldCorp in October 1987, and Vice President, Administration and Legal Affairs in October 1990. From August 1983 to October 1987, he practiced law in the corporate department of Skadden, Arps, Slate, Meagher & Flom, Washington, D.C. Mr. Pollard is a member of the District of Columbia Bar. Mr. A. Scott Andrews joined WorldCorp as Treasurer in August 1987 and was elected Vice President of the Company in April 1988 and Chief Financial Officer in May, 1992. From August 1985 to February 1987, he was Vice President, Finance of Presidential Airlines. From September 1980 to August 1985, he was associated with J.P. Morgan & Co., most recently as Assistant Vice President. He is the brother of T. Coleman Andrews, III. Mr. Andrew M. Paalborg joined World Airways as General Counsel in October 1989 and was elected Vice President, Legal and General Counsel of WorldCorp in May 1992. From 1984 to 1989 Mr. Paalborg was an associate with Hogan & Hartson, McLean, Virginia. From 1982 to 1984 he was an associate with Morgan, Lewis & Bockius, New York, New York. Mr. Paalborg received his law degree cum laude from Georgetown University in 1982 and is a member of the New York, Virginia and District of Columbia Bars. Beneficial Ownership Reporting The Company incorporates herein by reference the information required by Item 405 of Regulation S-K contained in its 1994 Proxy Statement. ITEM 11.

ITEM 11. EXECUTIVE COMPENSATION - --------------------------------- The Company incorporates herein by reference the information concerning executive compensation contained in the 1994 Proxy Statement. ITEM 12.

ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT - ------------------------------------------------------------------------------- The Company incorporates herein by reference the information concerning security ownership of certain beneficial owners and management contained in the 1994 Proxy Statement. ITEM 13.

ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS - ------------------------------------------------------------ The Company incorporates herein by reference the information concerning certain relationships and related transactions contained in the 1994 Proxy Statement. PART IV ITEM 14.

ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K - -------------------------------------------------------------------------- (a) The following documents are filed as part of this report: (1) Financial Statements The following consolidated financial statements of WorldCorp, Inc. and subsidiaries are filed herewith: Consolidated Balance Sheets, December 31, 1993 and 1992 Consolidated Statements of Operations, Years Ended December 31, 1993, 1992, and 1991 Consolidated Statements of Changes in Common Stockholders' Deficit, Years Ended December 31, 1993, 1992 and 1991 Consolidated Statements of Cash Flows, Years Ended December 31, 1993, 1992 and 1991 Notes to Consolidated Financial Statements Independent Auditors' Report (2) Financial Statement Schedules Schedule Number -------- II. Amounts Receivable from Related Parties and Underwriters, Promoters, and Employees other than Related Parties V. Property, Plant and Equipment VI. Accumulated Depreciation and Amortization of Property, Plant and Equipment VIII. Valuation and Qualifying Accounts IX. Short-Term Borrowings NOTE: All other schedules are omitted because the requisite information is either presented in the financial statements or notes thereto or is not present in amounts sufficient to require submission of the schedules. (b) Reports on Form 8-K None filed. * * * * * * * * * * * * * * * Status of Prior Documents WorldCorp's Annual Report on Form 10-K for the year ended December 31, 1993, at the time of filing with the Securities and Exchange Commission, shall modify and supersede all prior documents filed pursuant to Sections 13, 14, and 15(d) of the Securities Exchange Act of 1934 for purposes of any offers or sales of any securities after the date of such filing pursuant to any Registration Statement or Prospectus filed pursuant to the Securities Act of 1933, as amended, which incorporates by reference such Annual Report on Form 10-K. (3) Index to Exhibits SCHEDULE II WORLDCORP, INC. AND CONSOLIDATED SUBSIDIARIES AMOUNTS RECEIVABLE FROM RELATED PARTIES AND UNDERWRITERS, PROMOTERS AND EMPLOYEES OTHER THAN RELATED PARTIES For the years ended December 31, 1993, 1992 and 1991 (in thousands) (a) Mr. T. Coleman Andrews, III entered into a five-year employment agreement with the Company in November 1988. In connection with this employment arrangement, the Company loaned him $1,300,000 on January 10, 1989. Mr. Andrews executed and delivered to the Company a full recourse promissory note dated January 10, 1989. The principal amount of the note is due and payable on December 31, 1994 and interest accrues quarterly and is payable at maturity at a fixed rate of 8.91% per annum. SCHEDULE V WORLDCORP, INC. AND CONSOLIDATED SUBSIDIARIES PROPERTY, PLANT AND EQUIPMENT For the years ended December 31, 1993, 1992 and 1991 (in thousands) (Continued) SCHEDULE V (Continued) WORLDCORP, INC. AND CONSOLIDATED SUBSIDIARIES PROPERTY, PLANT AND EQUIPMENT For the years ended December 31, 1993, 1992 and 1991 (1) During 1993, $18.3 million MD-11 rotables were purchased. $9.2 million of these rotables were sold and leased back. (2) In 1993, an engine with a cost basis of $3.3 million and rotables with a cost basis of $12.7 million were reclassified to assets held for sale. In addition, three DC10-30 aircraft were returned in 1993 along with the $7.4 million in leasehold improvements which related to these aircraft. (3) Other equipment increased by $3.2 million during 1993 due to the purchase of ScanFone(R) terminal equipment by US Order. (4) During 1992, $3.6 million was invested in DC10-30 leasehold improvements. Also, $2.2 million additional DC10-30 rotables were purchased. (5) Other equipment increased $1.5 million during 1992 due to the purchase of ScanFone(R) terminals by US Order since WorldCorp acquired a majority ownership interest on July 1, 1992. (6) During 1992, eight owned B727-100 aircraft with a cost basis of $31.9 million at the beginning of 1992 were reclassified to assets held for sale. In addition, rotables with a cost basis of $7.7 million were reclassified to assets held for sale. (7) Other equipment increased $2.0 million during 1992 due to the acquisition of a majority interest in US Order. This increase was offset by a decrease of $0.7 million due to the sale of KeyAir. (8) Other property under capital lease increased due to the acquisition of a majority interest in US Order. (9) In January 1991, the Company sold and leased back a DC10-30 aircraft under a twelve year operating lease. The cost basis of the aircraft was $37.0 million at the time of the sale-leaseback. (10) During 1991, the cost basis of one B727-100 aircraft was reduced $392,000. (11) In March 1991, KeyAir sold selected assets at its Las Vegas facility in conjunction with the early termination of a domestic military contract. The cost basis of the assets was $603,000 at the time of the sale. SCHEDULE VI WORLDCORP, INC, AND CONSOLIDATED SUBSIDIARIES ACCUMULATED DEPRECIATION AND AMORTIZATION OF PROPERTY, PLANT AND EQUIPMENT For the years ended December 31, 1993, 1992 and 1991 (in thousands) (Continued) SCHEDULE VI (Continued) WORLDCORP, INC. AND CONSOLIDATED SUBSIDIARIES ACCUMULATED DEPRECIATION AND AMORTIZATION OF PROPERTY, PLANT AND EQUIPMENT For the years ended December 31, 1993, 1992 and 1991 (1) Depreciation expense does not agree to the statement of operations as a result of the classification of depreciation on certain transaction processing equipment. (2) Includes $5.2 million related to DC10-30 rotables and a DC10-10 engine which were reclassified to assets held for sale in 1993. (3) Includes depreciation of $1.7 million for eight B727-100 series aircraft and $1.2 million for rotables in 1992. (4) Accumulated depreciation related to the eight B727-100 aircraft and excess rotables was reclassified to assets held for sale in 1992. (5) Includes depreciation of $87,000 for one DC10-30CF aircraft, $2.3 million for eight B727-100 series aircraft and $1.2 million for rotables in 1991. (6) In January 1991, the Company sold and leased back a DC10-30CF aircraft under a twelve year operating lease. Accumulated depreciation on the aircraft was $2.2 million at the time of the sale-leaseback. (7) In March 1991, KeyAir sold selected assets at its Las Vegas facility in conjunction with the early termination of a domestic military contract. The accumulated depreciation of the assets was $0.5 million at the time of the sale. SCHEDULE VIII WORLDCORP, INC. AND CONSOLIDATED SUBSIDIARIES VALUATION AND QUALIFYING ACCOUNTS For the years ended December 31, 1993, 1992 and 1991 (in thousands) SCHEDULE IX WORLDCORP, INC. AND CONSOLIDATED SUBSIDIARIES SHORT-TERM BORROWINGS For the years ended December 31, 1993, 1992 and 1991 (in thousands) (a) The period used to calculate averages is from the beginning of the month of inception to the last applicable month during each year that each individual borrowing was outstanding. (b) A revolving line of credit, collateralized by certain receivables, for a maximum of $8.0 million, which bears interest at the higher of the lender's prime rate plus 2% or the federal funds rate plus 2.5%. (c) A revolving line of credit, collateralized by certain receivables, for a maximum of $10.0 million, which bears interest at the lessor of the LIBOR rate plus 2.75% or the lender's prime rate plus 0.5%. (d) A short-term loan, collateralized by $15.9 million face value of the Company's repurchased 13 7/8% Subordinated Notes, which bears interest at variable rates ranging from 3/4% to 1 1/4% above the broker's call money rate. (e) A revolving line of credit, collateralized by certain receivables, for a maximum of $10.0 million, which bears interest at the lender's prime rate of interest plus 3/4%. SIGNATURES Pursuant to the requirements of Section 13 or 15(d) 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. WORLDCORP, INC. By -------------------------------------- T. Coleman Andrews, III Chief Executive Officer and President Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated. SIGNATURES Pursuant to the requirements of Section 13 or 15(d) 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. WORLDCORP, INC. By -------------------------------------- T. Coleman Andrews, III Chief Executive Officer and President Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated.

18808_1993.txt

18808

1993

Item 1. Business. Overview. Central Vermont Public Service Corporation (the "Company"), incorporated under the laws of Vermont on August 20, 1929, is engaged in the purchase, production, transmission, distribution and sale of electricity. The Company has various wholly and partially owned subsidiaries. These subsidiaries are described below. The Company is the largest electric utility in Vermont and serves 133,658 customers in 175 of the 245 towns in Vermont. This represents about 50% of the Vermont population. In addition, the Company supplies electricity at wholesale to one rural cooperative, and one private utility. The Company's sales are derived from a diversified customer mix. The Company's sales to residential, commercial and industrial customers accounted for 59% of total MWH sales for the year 1993. Sales to the five largest retail customers receiving electric service from the Company during the same period constituted about 4.5% of the Company's total electric revenues for the year. The Company's requirements resale sales accounted for approximately 6%, entitlement sales accounted for 27% and other resale sales which include contract sales, opportunity sales and sales to NEPOOL accounted for approximately 8% of total MWH sales for the year 1993. Connecticut Valley Electric Company Inc. ("Connecticut Valley"), a wholly owned subsidiary of the Company, incorporated under the laws of New Hampshire on December 9, 1948, distributes and sells electricity in parts of New Hampshire bordering the Connecticut River. It serves 10,202 customers in 13 communities in New Hampshire. About 2% of the New Hampshire population resides in its service area. Connecticut Valley's sales are also derived from a diversified customer mix. Connecticut Valley's sales to residential, commercial and industrial customers accounted for 99.5% of total MWH sales for the year 1993. Sales to its five largest retail customers during the same period equaled about 17% of Connecticut Valley's total electric revenues for the year. The Company also owns 56.8% of the common stock and 46.6% of the preferred stock of Vermont Electric Power Company, Inc. ("VELCO"). VELCO owns the high voltage transmission system in Vermont. VELCO created a wholly owned subsidiary, Vermont Electric Transmission Company, Inc. ("VETCO"), to finance, construct and operate the Vermont portion of the 450 KV DC transmission line connecting Quebec with Vermont and New England. In addition, the Company owns 31.3% of the common stock of Vermont Yankee Nuclear Power Corporation ("Vermont Yankee"), a nuclear generating company. The Company also owns 2% of the outstanding common stock of Maine Yankee Atomic Power Company, 2% of the outstanding common stock of Connecticut Yankee Atomic Power Company and 3.5% of the outstanding common stock of Yankee Atomic Electric Company. The Company has two wholly owned subsidiaries that were created for the purpose of financing and constructing two hydroelectric facilities in Vermont: Central Vermont Public Service Corporation - Bradford Hydroelectric, Inc. ("Bradford"), which became operational December 20, 1982, and Central Vermont Public Service Corporation - East Barnet Hydroelectric, Inc. ("East Barnet"), which became operational September 1, 1984. These hydro electric facilities have been leased and operated by the Company since their respective in-service dates. The Company also has the following wholly owned non-utility subsidiaries: C.V. Realty Inc., a real estate company, Catamount Energy Corporation whose purpose is to invest in energy-related projects, CV Energy Services, Inc. (a), whose purpose was to provide energy-related services and SmartEnergy Services, Inc., whose purpose is to cost effectively provide reliable energy efficient products and services, including the rental of electric water heaters. Catamount Energy Corporation has established four wholly owned subsidiaries: (See "DIVERSIFICATION"); Catamount Rumford Corp., Equinox Vermont Corporation, Appomattox Vermont Corp. and Catamount Williams Lake L.P. See Exhibit EX-13 for additional information of the Company's diversification activities. REGULATION AND COMPETITION State Commissions. The Company is subject to the regulatory authority of the Vermont Public Service Board ("PSB") with respect to rates, and the Company and VELCO are subject to PSB jurisdiction respecting securities issues, construction of major generation and transmission facilities and various other matters. The Company is subject to the regulatory authority of the New Hampshire Public Utilities Commission as to matters pertaining to construction and transfers of utility property in New Hampshire. Additionally, the Public Utilities Commission of Maine and the Connecticut Department of Public Utility Control exercise limited jurisdiction over the Company based on its ownership as a tenant-in-common of Wyman #4 and Millstone #3, respectively. Connecticut Valley is subject to the regulatory authority of the New Hampshire Public Utilities Commission ("NHPUC") with respect to rates, securities issues and various other matters. Federal Power Act. Certain phases of the businesses of the Company and VELCO, including certain rates, are subject to the jurisdiction of the Federal Energy Regulatory Commission ("FERC"): the Company as a licensee of hydroelectric developments under Part I, and the Company and VELCO as interstate public utilities under Parts II and III, of the Federal Power Act, as amended and supplemented by the National Energy Act. The Company has licenses expiring at various times under Part I of the Federal Power Act for twelve of its hydroelectric plants. The Company has obtained an exemption from licensing for the Bradford and East Barnet projects. Public Utility Holding Company Act of 1935. Although the Company, by reason of its ownership of utility subsidiaries, is a holding company, as defined in the Public Utility Holding Company Act of 1935, it is presently exempt, pursuant to Rule 2, promulgated by the Commission under said Act, from all the provisions of said Act except Section 9(a)(2) thereof relating to the acquisition of securities of public utility affiliates. (a) CV Energy Services, Inc. was dissolved effective March 16, 1993. Environmental Matters. In recent years, public concern for the physical environment has resulted in increased governmental regulation of environmental matters. The Company is subject to these regulations in the licensing and operation of the generation, transmission, and distribution facilities in which it has interest, as well as the licensing and operations of the facilities in which it is a co-licensee. These environmental regulations are administered by local, state and Federal regulatory authorities and concern the impact of the Company's generation, transmission, distribution, transportation and waste handling facilities on air, water, land and aesthetic qualities. The Company cannot presently forecast the costs or other effects which environmental regulation may ultimately have upon its existing and proposed facilities and operations, because the extent of the applicability is not known at this time. The Company believes that any such costs related to its utility operations would be recoverable through the rate-making process. Refer to Exhibit EX-13 incorporated herein by reference for disclosures relating to environmental contingencies, hazardous substance releases and the control measures related thereto. Nuclear Matters. The nuclear generating facilities of Vermont Yankee and the other nuclear facilities in which the Company has an interest are subject to extensive regulations by the Nuclear Regulatory Commission ("NRC"). The NRC is empowered to regulate the siting, construction and operation of nuclear reactors with respect to public health, safety, environmental and antitrust matters. Under its continuing jurisdiction, the NRC may, after appropriate proceedings, require modification of units for which operating licenses have already been issued, or impose new conditions on such licenses, and may require that the operation of a unit cease or that the level of operation of a unit be temporarily or permanently reduced. Refer to Exhibit EX-13 incorporated herein by reference for disclosures relating to the shut down of the Yankee Atomic Nuclear Power plant. Competition. The Company's retail electric businesses in both Vermont and New Hampshire are generally free from competition by other electric utilities, municipalities or other public agencies. Pursuant to Vermont statutes (30 V.S.A. Section 249), the PSB has established as the service area for Central Vermont the area it now serves. Under 30 V.S.A. Section 251(b) no other company is legally entitled to serve any retail customers in the Company's established service area. However, an amendment to 30 V.S.A. Section 212(a) enacted May 28, 1987 authorizes the Vermont Department of Public Service ("Department") to purchase and distribute power at retail to all customers of electricity in Vermont, subject to certain preconditions specified in new sections 212(b) and 212(c). Section 212(b) provides that a review board consisting of the Governor and certain other designated legislative officers review and approve any retail proposal by the Department if they are satisfied that the benefits outweigh any potential risk to the State. However, the Department may proceed to file the retail proposal with the PSB either upon approval by the review board or the failure of the board to act within sixty (60) days of the submission. Section 212(c) provides that the Department shall not enter into any retail sales arrangement before the PSB determines and approves certain findings. Those findings are (1) the need for the sale, (2) the rates are just and reasonable, (3) the sale will result in economic benefit, (4) the sale will not adversely affect system stability and reliability and (5) the sale will be in the best interest of ratepayers. Section 212(d) provides that upon PSB approval of the Department retail sales proposal, Vermont utilities shall make arrangements for distributing such electricity on terms and conditions that are negotiated. Failing such negotiation, the PSB is directed to determine such terms as will compensate the utility for all costs reasonably and necessarily incurred to provide such arrangements. See Rate Developments below for additional details involving retail sales by the Department. In addition, Chapter 79 of Title 30 authorizes municipalities to acquire the electric distribution facilities located within their boundaries. The exercise of such authority is conditioned upon an affirmative three-fifths vote of the legal voters in an election and upon the payment of just compensation including severance damages. Once the price is determined, whether by agreement of the parties or by the PSB, a second affirmative three-fifths vote of the legal voters is required. There has been only one instance where Chapter 79 of Title 30 has been invoked; the Town of Springfield acted to acquire the Company's distribution facilities in that community pursuant to a vote in 1977. This action was subsequently discontinued by agreement between Springfield and the Company in 1985. No other municipality served by the Company, so far as is known to the Company, is taking steps in an attempt to establish a municipal electric distribution system. For a discussion relating to the Company's wholesale electric business see "Wholesale Rates" below. RATE DEVELOPMENTS Vermont Retail Rates. From July 1, 1985 through July 31, 1993, a block of energy obtained by the Department of Public Service (DPS) from the New York Power Authority (NYPA) and from Ontario Hydro was sold by the DPS directly to the Company's retail customers. When the DPS's sources were not sufficient, on a short-term basis, the Company provided back-up energy and capacity to meet the DPS's block requirements. Under this arrangement, which became effective July 1, 1989, the Company was reimbursed for all back-up energy and capacity. During most of 1989 the DPS's block equaled the first 200 KWH sold to certain retail customers, but the block was reduced to 120 KWH beginning with bills rendered on December 1, 1989, to 85 KWH beginning with bills rendered on January 1, 1990, and to 75 KWH beginning with bills rendered on February 3, 1992. Effective February 1, 1993, the DPS block was reduced to a maximum of 25 KWH from 75 KWH due to the termination of the Ontario Hydro power contract with the DPS on October 31, 1992. Since the Company sells to customers all KWH over the DPS's block, the Company's rates were reduced to provide the same net revenues under the 120, 85, 75, and 25 KWH blocks as they would have under the 200 KWH block. Effective February 1, 1992, the PSB allowed the Company to increase its billing and service fees charged to the DPS from 2.3 cents per KWH to 3.6 cents per KWH. The PSB subsequently delayed the effective date to December 1, 1992 but allowed the Company to collect the lost revenues plus interest after November 1, 1992 through a 3.0% surcharge on April and May 1993 bills. On November 18, 1992, the Company filed with the PSB a tariff in response to expected and proposed changes to the provision of power by the DPS. The Company proposed to supply an initial non-seasonally differentiated block of 150 KWH/month to residential customers in the Company's service territory. On December 22, 1992, the DPS filed with the PSB to supply an initial block of 25 KWH/month to the Company's residential customers, reflecting the expiration, on October 31, 1992, of the Ontario Hydro power contract. On December 29, 1992, the PSB approved, on an interim basis pending investigation, a joint DPS-Company block of 150 KWH/month at a non-seasonal uniform rate of 8.4 cents per KWH. Initially, the DPS would sell the first 25 KWH and the Company would sell the remaining 125 KWH. The PSB's interim order resulted in a non-seasonal 25 KWH block at 5.2 cents per KWH for the DPS and a non-seasonal 125 KWH block at 9.0 cents per KWH for the Company. Accordingly, effective February 1, 1993, the DPS block was reduced to a maximum of 25 KWH from 75 KWH. The remaining NYPA power allotment, which was the sole remaining power source of the DPS other than the Company, was reduced substantially effective July 1, 1993. Effective August 1, 1993, the DPS ceased altogether selling to the Company's retail customers. That NYPA power allotment is now sold directly to the Company and the retail sales formerly made by the DPS are now made by the Company. In addition, the Company's rates now provide for an initial non-seasonal 250 KWH block of sales to certain retail customers. In response to a March 1993 PSB inquiry into the appropriateness of a general review of the Company's retail rates, in April 1993 the DPS and the Company entered into a Stipulation that was approved by the PSB in September 1993. In the Stipulation the Company agreed to a decrease in its allowed rate of return on common equity from 12.5% to 12.0% for 1993, to accelerate the recovery of $1.5 million of Conservation and Load Management ("C&LM") costs deferred in 1993, to not seek recovery of further C&LM costs deferred in 1993 equal to amounts in excess of the 12.0% rate of return on common equity for 1993, and to not file a general rate increase that would become effective before August 1, 1994. The PSB in its September 1993 order also announced the opening of an investigation on November 16, 1993, the earliest date the Company could file for a rate increase under the Stipulation, into the Company's cost of service and resulting rates. In response to that investigation, on January 18, 1994 the Company filed a revenue requirement supporting a $16.1 million or 8.0% increase in retail rates for the year beginning November 1, 1993. The Company noted in its filing that current rate levels are justified and that the Company does not want any rate increase to be effective for that period. The Company also noted in its filing that rate relief would be needed in late 1994. Thus on February 15, 1994, the Company filed for a rate increase of $17.9 million or 8.9% to become effective November 1, 1994. The Company anticipates filing for rate increases periodically, primarily to recover increasing purchased power and other operating costs. New Hampshire Retail Rates. Connecticut Valley's retail rate tariffs, approved by the NHPUC, contain a fuel adjustment clause (FAC) and a purchased power cost adjustment clause (PPCA). Under these clauses, Connecticut Valley recovers its estimated annual costs for purchased energy and capacity, respectively, which are reconciled when actual data is available. Although the tariffs provide for annual changes of the FAC and PPCA effective January 1, the Company requested and the NHPUC approved a delay of the effective date to March 1, 1994. The NHPUC also ordered an interim increase in the PPCA effective December 1, 1993. On the basis of estimates of costs for 1994 and reconciliations from 1993, the combined PPCA and FAC will result in a decrease in revenues of approximately $16,000 or 0.1% for 1994. Connecticut Valley filed in 1991 to redesign the revenue recovery from each rate component within each rate class, as well as from each rate class, to more accurately reflect the cost of service for each rate component and rate class. Negotiations with the NHPUC Staff resulted in a settlement rate design which was approved by the NHPUC effective in two steps: January 1, 1992 and March 1, 1992. The redesigned rates feature higher rates during the winter when Connecticut Valley is likely to experience a peak use of electricity. The settlement also provided for subsequent phases of rate redesign. Phase 2 resulted in an increase of the peak to off-peak season price ratio from 1.45 to 1.0 to a ratio of 1.6 to 1.0. This phase of rate redesign caused no change in the overall revenue requirement or the allocation of the revenue requirement among rate classes. The NHPUC approved this phase of rate redesign effective January 1, 1993. The NHPUC approved a delay of the effectiveness of Phase 3 to 1995. Connecticut Valley's retail rate tariffs, approved by the NHPUC, also provide for Conservation and Load Management Percentage Adjustments (C&LMPA) for residential and commercial/industrial customers in order to collect deferred and forecast C&LM costs. The forecast costs are updated effective January 1 of each year and are reconciled when actual data are available. In addition, Connecticut Valley's earnings are made whole through recovery of lost revenues related to fixed costs which Connecticut Valley loses as a result of C&LM activities. However, the Company is not made whole because the fixed costs of the wholesale transaction between the Company and Connecticut Valley are not recovered when C&LM activities occur in Connecticut Valley. The C&LMPA further provides for the future recovery of shareholder incentives related to past C&LM activities. The filing in September 1993 of the annual update of the 1994 C&LMPA rates resulted in a delay of the effective date to March 1, 1994 and a settlement on all issues except for one relating to the basis for determination of lost revenues. The NHPUC approved 1994 C&LMPA rates which result in a revenue decrease of $26,000 or 0.2%. Effective July 1, 1993, the NHPUC allowed a revenue increase of $127,000 or 0.8% related to Connecticut Valley's adoption of the Statement of Financial Accounting Standards No. 106 for Postretirement Benefits Other Than Pensions and the re-enactment of the New Hampshire Franchise Tax. Connecticut Valley also purchases power from several independent power producers who own qualifying facilities under the Public Utility Regulatory Practices Act of 1978. Connecticut Valley filed a complaint with the Federal Energy Regulatory Commission (FERC) informing them of its concern that a solid waste facility owned and operated by Wheelabrator Claremont Company, L.P. has not been such a qualifying facility since the plant began operation. The outcome of this filing is unknown at this time. Potential outcomes of this filing could result in a refund, with interest, of past purchased power costs as well as lower future costs. Any refunds and future lower costs are likely to be reflected in the FAC when known. Connecticut Valley has petitioned the NHPUC for current recovery of costs related to pursuing this filing. Connecticut Valley has also petitioned for a deferral of such costs if a current recovery of these costs is not allowed by the NHPUC. Wholesale Rates. The Company sells firm power to Connecticut Valley under a wholesale rate schedule based on forecast data for each calendar year which is reconciled to actual data annually. The Company filed with the FERC for a revenue increase of $294,300 or 3.2% for 1994 power costs. The rate schedule provides for an automatic update of annual rates, as well as the subsequent reconciliation to actual data. The Company sold firm system capacity to four Vermont village municipal electric departments ("Municipal Departments") under a wholesale tariff based on forecast data for each calendar year which is reconciled to actual data annually. As allowed in the tariff, the Company gave the Municipal Departments notice of extension of termination date of the tariff to October 21, 2008 from October 31, 1993. FERC approved the extension of the termination date. Due to current market conditions, the Municipal Departments did not opt to purchase power under this tariff during the period of the extension. Sales under the tariffs terminated October 31, 1993. One of the Company's requirements wholesale customers, Woodsville Fire District Water and Light Department, with a peak of 3.6 MW began receiving power from the Company under a 15-year contract. The effective date was May 1, 1993 and the effect was to increase revenues from the customer. Another of the Company's requirements wholesale customers, New Hampshire Electric Cooperative, Inc., with an average monthly peak of 2.8 MW has given the Company notice of termination of service under FERC Electric Tariff, First Revised Volume No. 1, effective in March 1995. The Company will continue to provide the transmission service and will enter into negotiations to supply power under another contract. POWER RESOURCES Overview. The Company's and Connecticut Valley's energy production, which includes generated and purchased power, required to serve their retail and firm wholesale customers was 2,414,970 MWH for the year ended December 31, 1993. The maximum one-hour integrated demand during that period was 418.2 MW, which occurred on December 27, 1993. The Company's and Connecticut Valley's total production in 1993, including production related to all resale customers, was 3,651,319 MWH. Wholly Owned Plants. The Company owns and operates 18 hydroelectric generating facilities in Vermont which have an aggregate nameplate capability of 37.5 MW. It also leases and operates hydroelectric facilities at Bradford and East Barnet, Vermont. These two plants have a nameplate capability of 1.5 MW and 2.2 MW, respectively. In addition, the Company owns and operates diesel and gas turbine generating facilities on a peaking or standby basis having a combined nameplate capability of 28.9 MW.  The Company has a 1.73% joint-ownership interest in Millstone #3, an 1149 MW nuclear generating facility located in Waterford, Connecticut, which commenced commercial operation in April 1986. Under the Millstone Sharing Agreement, the Company is entitled to receive its share of the output and capacity of the facility and is responsible for its share of the operating expenses, including decommissioning. The Company also has a 1.78% joint-ownership interest in Wyman #4, a 619 MW oil-fired generating facility located in Yarmouth, Maine and a 20% joint-ownership interest in McNeil, a 53 MW wood, gas and oil-fired generating facility located in Burlington, Vermont. The Company receives its share of the output and capacity from these generating plants and is responsible for its share of the operating expenses of each. Finally the Company has a 46.08% joint-ownership interest in the Highgate Convertor, a 200 MW facility located in Highgate Springs, Vermont. This facility is directly connected to the Hydro-Quebec System to the north of the Convertor and to the VELCO System for delivery of power to Vermont Utilities. This facility can deliver power either direction, but normally delivers power from Hydro-Quebec to Vermont. Equity Ownership in Plants. In 1966 the Company purchased 35% of the Vermont Yankee common stock and was entitled to receive a like percentage of the output of the unit. In late 1969 and early 1970, the Company sold at cost a combined total of 3.7% of its original equity investment and currently resells at cost 4.7% of its entitlement. The Company's current equity ownership and net entitlement percentages are 31.3 and 30.5, respectively. The Atomic Energy Commission, now the NRC, granted a full-term (40-year), full power operating license for the Vermont Yankee plant, which was to expire in December 2007. On December 17, 1990 the NRC issued an amendment of the operating license extending its term to March 2012.  Vermont Yankee's net capability is 514 MW of which 156.7 MW (F1) is the Company's net entitlement. Vermont Yankee's plant performance for the past five years is shown below: Availability Capacity Factor Factor (F2) (F3) 1989......................... 84.2 80.1 1990......................... 84.4 80.3 1991......................... 93.6 91.2 1992......................... 87.5 82.7 1993......................... 78.3 74.9 As was described in the overview section above, the Company is a stockholder, together with other New England electric utilities, in the following three nuclear generating companies: Maine Yankee Atomic Power Company, Connecticut Yankee Atomic Power Company and Yankee Atomic Electric Company. Net Company's Company Capability Entitlement Maine Yankee(F4).............. 847 MW 2.0% - 16.9 MW Connecticut Yankee............ 582 MW 2.0% - 11.6 MW Yankee Atomic................. (F5) (F5) The Company is obligated to pay its entitlement percentage of the operating expenses of Vermont Yankee and the other Yankee companies, including depreciation and a return on invested capital, whether or not the plant is operating. The Company is obligated to contribute its entitlement percentage of the capital requirements of Vermont Yankee and Maine Yankee and has a similar, but more limited obligation to Connecticut Yankee. The Company's ownership percentages are identical to the entitlement percentages. For additional information regarding Equity Ownership in Plants, refer to Exhibit EX-13 incorporated herein by reference. _______________ (FN) (F1) Currently, the Company resells at cost, through VELCO, 23.2 MW of its original entitlement to other Vermont utilities. (F2) "Availability Factor" means the hours that the plant is capable of producing electricity divided by the total hours in the period. (F3) "Capacity Factor" means the total net electrical generation divided by the product of the maximum dependable electrical capacity multiplied by the total hours in the period. (F4) Currently, the Company resells at cost 1.8 MW of its entitlement to certain municipal utilities in Massachusetts. (F5) Yankee Atomic permanently ceased power operations of the Yankee Nuclear Power Station. See Decommissioning Expense discussion below. Decommissioning Expense. Each of the Yankee Companies has developed its own estimate of the cost of decommissioning its nuclear generating unit. These estimates vary depending upon the method of decommissioning, economic assumptions, site and unit specific variables, and other factors. Each of the Yankee Companies includes charges for decommissioning costs in the cost of capacity, as approved by the FERC. On February 26, 1992, the Board of Directors of Yankee Atomic decided to permanently discontinue operation of their plant, and, in time, decommission the facility. The decision to prematurely retire the plant was based on continuing regulatory uncertainty and economics. The Company relied on Yankee Atomic for less than 1.5% of its system capacity. Presently, purchased power costs billed to the Company by Yankee Atomic, which include a provision for ultimate decommissioning of the unit, are being collected from the Company's customers via existing retail and wholesale rate tariffs. On March 18, 1993, the FERC approved the settlement agreement regarding the decommissioning plan, recovery of plant investment and all issues with respect to prudency of the decision to discontinue operation. Yankee Atomic has estimated that as of December 31, 1993, its costs of discontinuing operations are approximately $345 million, which includes $200 million of decommissioning costs in 1992 dollars. The Company's total current share of its cost with respect to Yankee Atomic's decision to discontinue operation is approximately $12 million. This amount is subject to ongoing review and revision and is reflected in the accompanying balance sheet both as a regulatory asset and deferred power contract obligation (current and non-current). The Company believes that its proportionate share of Yankee Atomic costs will be recovered through the regulatory process and, therefore, the ultimate resolution of the premature retirement of the plant will not have a material adverse effect on the Company's earnings or financial condition. Although the estimated costs of decommissioning are subject to change due to changing technologies and regulations, the Company expects that the nuclear generating companies' liability for decommissioning, including any future changes in the liability, will be recovered in their rates over their operating lives. In 1982 the State of Maine enacted legislation that requires the development of a decommissioning trust fund for the Maine Yankee nuclear plant. This statute also provides that, if the trust has insufficient funds to decommission the plant, the licensee, Maine Yankee, is responsible for the deficiency and, if the licensee is unable to provide the entire amount, the owners of the licensee are jointly and severally responsible for the remainder. The definition of owner under the statute includes the Company. It is expected that any payments required by the Company under these provisions would be recovered through rates. Nuclear Fuel. Vermont Yankee has approximately $165 million of "requirements based" purchase contracts for nuclear fuel needs to meet substantially all of its power production requirements through 2002. Under these contracts, any disruption of operating activity would allow Vermont Yankee to cancel or postpone deliveries until actually needed. Vermont Yankee has contracted for uranium enrichment services through 2002. Vermont Yankee also has an enrichment contract with the DOE which expires in 2001. However, Vermont Yankee has exercised its right to partially terminate the DOE contract for the period 1990 to 1996. Vermont Yankee has a contract with the United States Department of Energy ("DOE") for the permanent disposal of spent nuclear fuel. Under the terms of this contract, in exchange for the one-time fee discussed below and a quarterly fee of $.001 per KWH of electricity generated and sold, the DOE agrees to provide disposal services when a facility for spent nuclear fuel and other high-level radioactive waste is available, which is required by current statute to be prior to January 31, 1998. The DOE contract obligates Vermont Yankee to pay a one-time fee of $39.3 million for disposal costs for all spent fuel discharged through April 7, 1983. Although such amount has been collected in rates from the Sponsors, Vermont Yankee has elected to defer payment of the fee to the DOE as permitted by the DOE contract. The fee must be paid no later than the first delivery of spent nuclear fuel to the DOE. Interest accrues on the unpaid obligation based on the thirteen-week Treasury Bill rate and is compounded quarterly. Through 1993 Vermont Yankee deposited approximately $37.5 million, including $8.2 million in 1993, in an irrevocable trust to be used exclusively for defeasing this obligation at some future date provided the DOE complies with the terms of the aforementioned contract. In 1991 and 1992, Vermont Yankee deposited an additional amount of approximately $8.2 and $5.2 million, respectively, into this trust. On December 31, 1991 the DOE issued a final rule amending the Standard Contract for Disposal of Spent Nuclear Fuel and/or High-Level Radioactive Waste. The amended final rule conforms with a March 17, 1989 ruling of the U.S. Court of Appeals for the District of Columbia that the $.001 per KWH fee in the Standard Contract should be based on net electricity generated and sold. The impact of the amendment on Vermont Yankee was to reduce the basis for the fee by 6% on an ongoing basis and to establish a receivable from the DOE at December 31, 1991 of $2.2 million for previous overbillings and accrued interest. Vermont Yankee has recognized in its rates the full impact of the amended final rule to the Standard Contract. The DOE is refunding the overpayments (including interest) to utilities over the next four year period ending in 1995 via credits against quarterly payments. Interest is based on the 90-day Treasury Bill Auction Bond Equivalent and will continue to accrue on amounts remaining to be credited. At December 31, 1993 and 1992 approximately $.9 and $1.6 million in principal and interest is reflected in other accounts receivable in the Vermont Yankee's Balance Sheet. The average cost to the Company of energy generated at the Vermont Yankee plant was 4.04, 4.60, 3.69, 4.71 and 5.34 mills per KWH for the years 1989 through 1993, respectively. The Company has been advised by the companies operating other nuclear generating stations in which the Company has an interest that they have contracted for certain segments of the nuclear fuel production cycle through various dates. Contracts for the remainder of the fuel cycle will be required but their availability, prices and terms cannot be predicted. Nuclear Liability and Insurance. For a complete disclosure regarding nuclear liability and insurance see Exhibit EX-13 incorporated herein by reference. Major long-term purchases. Canadian Purchases - Under various contracts, the Company purchases from Hydro-Quebec capacity and associated energy. Under the terms of these contracts, the Company is required to pay certain fixed capacity costs whether or not energy purchases above a minimum level described in the contracts are made. Such minimum energy purchases must be made whether or not other less expensive energy sources might be available. The state of Vermont contract, between the Company and the Vermont Department of Public Service, terminates on September 22, 1995. The Company receives 69 MW of firm capacity and associated energy delivered at the Highgate interconnection. The Company's portion of the 1987 Hydro-Quebec contract consists of: Schedule A, 25 MW of firm capacity and associated energy to be delivered at the Highgate interconnection through September 22, 1995. All of this power is being sold back to Hydro-Quebec for the duration of the contract. This sell-back of 25 MW continues as Schedule C-1 power at the termination of the Schedule A contract. This sell-back contract is not cancelable. Schedule C-1, 31 MW and Schedule C-2, 21 MW of firm capacity and associated energy are to be delivered at the NEPOOL/Hydro-Quebec (Phase I and Phase II) interconnection through October 2012. Under a cancelable contract, the Company is selling back to Hydro-Quebec 30 MW and 20 MW of its C-1 and C-2 entitlements, respectively, for the period ending October 31, 1996. Under the terms of this agreement, the Company can exercise an option, on an annual basis, to cancel all or any portion of this sell-back and resume deliveries of this power under the appropriate C-1 and C-2 schedules. Further agreements allow for the interruption of the sell-back, and the provision of 50 MW of capacity and delivery of associated energy for the period March through October of a given year. The Company must return this energy by the month of March of the following year or pay Hydro-Quebec 150% of the Schedule C-1 and Schedule C-2 energy price. Hydro-Quebec has the option under this sell-back agreement to buy back 50 MW for the period November 1, 1996 through October 31, 2000. This option must be exercised no later than October 31, 1994. These sell-back agreements provide the Company with the necessary flexibility to minimize near-term costs while retaining the long-term benefits of the purchase contracts. Schedule B, 92 MW of firm capacity and associated energy is expected to be delivered at the Highgate interconnection for 20-years beginning September 23, 1995. The Company will sell back 25 MW of Schedule B entitlement for the period September 23 through October 31, 1995. Schedule C-4a, 24 MW of firm capacity and associated energy is expected to be delivered over the NEPOOL/Hydro-Quebec (Phase I and Phase II) interconnection beginning November 1, 1996 through October 31, 2012. Merrimack #2 - Merrimack #2 is a 320 MW capacity coal-fired steam unit located in Bow, New Hampshire, and is owned and operated by Public Service Company of New Hampshire ("PSNH"). In 1968 VELCO contracted with PSNH to purchase a block of 100 MW of the plant's output for 30 years and to pay a proportionate share of the plant's actual capacity and operating costs. Under an agreement dated February 10, 1968, between the Company and VELCO, the Company buys from VELCO at VELCO's cost 47.0 MW of that block for a 30-year period commencing May 1, 1968. Northeast Utilities (N.U.) has acquired all of PSNH's assets including the Merrimack #2 plant, pursuant to a merger agreement in 1991. The Merrimack 2 unit is subject to limits on sulfur dioxide ("SO2") and Nitrogen Oxides ("NOx") starting in 1995, mandated by the Clean Air Act Amendments ("CAAA"). The CAAA establishes SO2 allowances to reduce SO2 emissions. PSNH expects to have sufficient SO2 allowances to meet CAAA SO2 requirements. If any gains are realized from the sale of excess allowances, the Company will receive its proportionate share from VELCO. Likewise, the Company will pay its share of any allowances purchased. The CAAA NOx limits will be specified in Administrative Rules to be established by the state of New Hampshire. The New Hampshire Air Resources Division ("NHARD") has a proposed rule which includes Merrimack 2 NOx limits, that replaces a previous proposed rule submitted to the U.S. Environmental Protection Agency ("EPA") in 1993. The current proposed rule must be approved by the NHARD and the EPA, and implement the NOx reductions by May 31, 1995. PSNH expects to comply with the current proposed Merrimack 2 NOx limits by installing Selective Noncatalytic Reduction equipment ("SNCR") and reducing load at Merrimack 2. Installation of the SNCR will increase capital and operating costs. PSNH will implement load reductions based on actual unit operating characteristics and dispatch, to comply with the NOx rule at the lowest cost. PSNH expects that an average load reduction of 22 per cent will be required for compliance. The Company will share on a pro-rata basis the SNCR and load reduction costs, based on its share of the VELCO contract. Other Purchases. Cogeneration/Small Power Qualifying - The Company continues to work with customers exploring the opportunities for either cogeneration by customers or the purchase by the Company of the output of small power qualifying. Cogeneration is the production of electricity and usable thermal energy from the same fuel. A number of small producers using hydroelectric, biomass, and refuse-burning generation are currently producing energy that the Company is purchasing. For the year ended December 31, 1993, the Company received 186,899 MWH from these sources for which it paid $18,213,351. New York Power Authority - Prior to July 1, 1985, under agreements between the State and NYPA, the Department purchased St. Lawrence and Niagara Project power. The Company in turn contracted with the Department to purchase the St. Lawrence and Niagara Project power at cost, and credited the lower cost thereof to certain of the Company's retail customers. From July 1, 1985 through July 31, 1993, the St. Lawrence and/or Niagara Project power was purchased by the DPS and sold directly to residential customers in the Company's service territory. This power is expected to be reduced to a minimum level in July 1994 and continue at that level through October 2003. For additional information regarding the DPS's sales to the Company's residential customers see "Vermont Retail Rates". The St. Lawrence Project power continues to be available to the Department but will be reduced each July 1 over a ten-year period until 1994, at which time the State will receive one MW of this power through 2002. New England Power Pool - The Company, through VELCO, is a participant in the New England Power Pool ("NEPOOL"), which is open to all investor-owned, municipal and cooperative utilities in New England under an agreement in effect since 1971. The NEPOOL Agreement provides for joint planning and operation of generating and transmission facilities and also incorporates generating capacity reserve obligations and provisions regarding the use of major transmission lines and payment for such use. Because of its participation in NEPOOL, the Company's operating revenues and costs are affected to some extent by the operations of other participants in that agreement. The primary purposes of NEPOOL are to provide energy reliability for the region, centralized economic dispatch and coordination of generation planning and construction by the individual participants. The Company's peak demand for 1993 occurred on December 27, 1993 and equaled 418.2 MW. At the time of this peak, the Company had a reserve margin of 21%. NEPOOL's peak for the year occurred on July 8, 1993 and totaled 19,570 MW. NEPOOL had a 26% reserve margin at the time of its 1993 peak. Power Resources - Future. The Company purchases about 90% of the power it needs, including the power it receives as part owner of the various Yankee nuclear plants. In 1993, about 35% of the Company's purchased power came from renewable sources, primarily water and wood. The Company's core business has no plans at this time to build any new generating facilities to supply power, instead it intends to satisfy customers' energy needs through a combination of power purchases and energy-efficiency services. Therefore, the Company uses a process called "integrated resource planning," or IRP, to help determine the resources necessary to meet future power needs. IRP is an evolving, on-going process. An interdisciplinary team representing various functional planning area works together continuously to coordinate and integrate planning. A Corporate Review Committee provides policy guidance and reviews resource investment recommendations from the IRP team. The primary objective of IRP is to provide reliable, least-cost energy resources consistent with the Company's policy to protect the environment. The choice of least-cost resources explicitly seeks a balance between traditional supply resources and energy efficiency investments with the Company's customers. Flexibility and diversity are investment guidelines designed to provide least-cost resources over a broad range of possible futures. The Company does not currently plan to build generation resources. The resource plan calls for investments in energy efficiency through the 1990's with additional investments in energy-efficiency programs or power purchases beginning in the late 1990's. The energy efficiency and power purchase commitments made in the late 1980's served the Company and its shareholders well during the recent recessionary downturn. The resources from developers of cogeneration projects were deferred due to decreased need. Power purchases from Hydro-Quebec were deferred until the mid-1990's with the ability to recall on one-year notice. Energy efficiency investments associated with new customers and new end-uses naturally declined during the period of reduced load growth. Thus the resource investment strategy with inherent flexibility and diversity provided near-term benefits with unpredictable changing economic conditions. Based upon current load forecasts, the Company expects to be able to satisfy its load requirements into the mid-1990's through its ownership in various generating facilities and purchases from various other New England, New York, Canadian utilities, Independent Power Qualifying, and Conservation and Load Management. Current load and capacity forecasts for NEPOOL indicate adequate reserves and availability of power for the region as a whole into the late-1990's. TRANSMISSION Vermont Electric Power Company, Inc. Since 1958 VELCO has been engaged in the operation of a high-voltage transmission system which interconnects the electric utilities in the State including the areas served by the Company. VELCO is also engaged in the business of purchasing bulk power for resale, at cost, to the Company and the other electric utilities (cooperative, municipal and investor-owned) in Vermont (the "Vermont utilities") and transmitting such power for the Vermont utilities. Refer to the notes to financial statements for a discussion of the 1985 Four Party Agreement between the Company, VELCO and two other major distribution companies in Vermont. VELCO provides transmission services for the State of Vermont, acting by and through the Department, and for all of the electric distribution utilities in the State of Vermont. VELCO is reimbursed for its costs (as defined in the agreements relating thereto) for the transmission of power for such entities. The Company, as the largest electric distribution utility in Vermont, is the major user of VELCO's transmission system. The Company owns 34,083 shares (56.8%) of the Class B common stock of VELCO, the balance being owned by other Vermont utilities. Each share of Class B common stock has one vote. The Company also owns 46,624 shares (46.6%) of the Class C preferred stock of VELCO, the balance being owned by other Vermont utilities. Shares of Class C preferred stock have no voting rights except the limited right to vote VELCO's shares of common stock in Vermont Electric Transmission Company, Inc. if certain dividend requirements are not met. NEPOOL Arrangements. VELCO participates for itself and as agent for the Company and twenty-one other Vermont utilities in NEPOOL (see "Business-New England Power Pool" for additional details). Capitalization. VELCO has authorized 92,000 shares of Class B common stock, $100 par value, of which 60,000 shares were outstanding on December 31, 1993 and 125,000 shares of Class C preferred stock, of which 100,000 shares were outstanding at December 31, 1993. On that date there were authorized and outstanding three issues of First Mortgage Bonds, aggregating $41,263,000, issued under an Indenture of Mortgage dated as of September 1, 1957, as amended, between VELCO and Bankers Trust Company, as Trustee (the "VELCO Indenture"). The issuance of bonds under the VELCO Indenture is unlimited in amount but is subject to certain restrictions. New transmission and associated facilities will be required by VELCO in 1994 to transmit power to Vermont utilities. The costs of such facilities are presently estimated at $1,833,000 including allowance for funds used during construction calculated at a rate of approximately 4.5%. For a description of VELCO's properties, see "VELCO" under Item 2.

Item 2. Properties. The Company. The Company's properties are operated as a single system which is interconnected by transmission lines of VELCO, New England Power Company and PSNH. The Company owns and operates 21 small generating stations with a total current nameplate capability of 66,370 KW, has a 1.78% joint-ownership interest in an oil generating plant in Maine, has a 20% joint-ownership interest in a wood, gas and oil-fired generating plant in Vermont, has a 1.73% joint-ownership interest in a nuclear generating plant in Connecticut, has a 46.08% joint-ownership interest in a transmission interconnection with Hydro-Quebec in Vermont and leases and operates two hydro generating stations from wholly owned subsidiaries, Bradford and East Barnet, 1,500 KW and 2,200 KW, respectively. The electric transmission and distribution systems of the Company include about 613 miles of overhead transmission lines, about 7,136 miles of overhead distribution lines and about 192 miles of underground distribution lines which are located in Vermont except for about 23 miles of transmission lines which are located in New Hampshire and about two miles of transmission lines which are located in New York. Connecticut Valley. Connecticut Valley's electric properties consist of two principal systems in New Hampshire which are not interconnected with each other but each of which is connected directly with facilities of the Company. The electric systems of Connecticut Valley include about two miles of transmission lines and about 422 miles of overhead distribution lines and about nine miles of underground distribution lines. All the principal plants and important units of the Company and its subsidiaries are held in fee. Transmission and distribution facilities which are not located in or over public highways are, with minor exceptions, located either on land owned in fee or pursuant to easements substantially all of which are perpetual. Transmission and distribution lines located in or over public highways are so located pursuant to authority conferred on public utilities by statute, subject to regulation of state or municipal authorities. VELCO. VELCO's properties consist of about 483 miles of high voltage overhead transmission lines and associated substations. The lines connect on the west at the Vermont-New York state line with the lines of Niagara Mohawk Power Corporation near Whitehall, New York, and Bennington, Vermont and with the submarine cable of NYPA near Plattsburg, New York; on the south and east with lines of New England Power Company and PSNH; and on the south with the facilities of Vermont Yankee. VETCO. VETCO has approximately 52 miles of high voltage DC transmission line connecting at the Quebec-Vermont border in the Town of Norton, Vermont with the transmission line of Hydro-Quebec and connecting at the Vermont-New Hampshire border near New England Power Company's Moore hydro-electric generating station with the transmission line of New England Electric Transmission Corporation, a subsidiary of New England Electric System. Item 3.

Item 3. Legal Proceedings. On December 5, 1991, Bonneville Pacific Corporation (Bonneville) filed for protection under Chapter 11 of the Bankruptcy Laws. On August 30, 1993, Bonneville's trustee in bankruptcy filed suit in the United States Bankruptcy Court in Utah, claiming damages in excess of two million dollars in connection with two contracts between Bonneville and the Company concerning the development of a 52 MW co-generation plant in Vermont and the sale of power from the plant to the Company. The Company and Bonneville have settled the case and Bonneville's claim has been dismissed with prejudice. On March 20, 1992, Sunnyside Cogeneration Associates filed suit in the United States District Court for the District of Vermont against the Company, CV Energy Resources, Inc. (CVER) and a subsidiary of CVER alleging damages in excess of five million dollars resulting from the parties inability to come to agreement on the terms of CVER's proposed investment in the plaintiff's waste coal cogeneration facility under construction in Sunnyside, Utah. The Company has filed an answer denying the allegations and does not expect the resolution of the case to have a material affect on the business or financial condition of the Company. There are no other material pending legal proceedings, other than ordinary routine litigation incidental to the business, to which the Company or any of its subsidiaries is a party or to which any of their property is subject. Item 4.

Item 4. Submission of Matters to a Vote of Security Holders. There were no matters submitted to security holders during the fourth quarter of 1993. PART II Item 5.

Item 5. Market for Registrant's Common Equity and Related Stockholder Matters. (a) The Company's common stock is traded on the New York Stock Exchange ("NYSE") under the trading symbol CV. The table below shows the high and low sales price of the Company's common stock, as reported on the NYSE composite tape by The Wall Street Journal, for each quarterly period during the last two years as follows: Market Price High Low First quarter.............. $ 25 5/8 $ 24 1/8 Second quarter............. 25 1/8 22 Third quarter.............. 24 3/4 23 1/4 Fourth quarter............. 23 3/4 20 1/8 1992(F1) First quarter.............. $ 22 7/8 $ 19 5/8 Second quarter............. 21 1/4 19 1/2 Third quarter.............. 22 1/2 20 7/8 Fourth quarter............. 25 21 1/8 (FN) (F1)Retroactively adjusted to reflect the three-for-two stock split on February 11, 1993. (b) As of December 31, 1993, there were 16,620 holders of the Company's common stock, $6 par value. (c) Common stock dividends have been declared quarterly. Cash dividends of $.355 per share were paid for all quarters of 1993 and post-split cash dividends of $.3475 per share were paid for all quarters of 1992. So long as any Senior Preferred Stock or Second Preferred Stock is outstanding, except as otherwise authorized by vote of two-thirds of each such class, if the Common Stock Equity (as defined) is, or by the declaration of any dividend will be, less than 20% of Total Capitalization (as defined), dividends on Common Stock (including all distributions thereon and acquisitions thereof), other than dividends payable in Common Stock, during the year ending on the date of such dividend declaration, shall be limited to 50% of the Net Income Available for Dividends on Common Stock (as defined) for that year; and if the Common Stock Equity is, or by the declaration of any dividend will be, from 20% to 25% of Total Capitalization, such dividends on Common Stock during the year ending on the date of such dividend declaration shall be limited to 75% of the Net Income Available for Dividends on Common Stock for that year. The defined terms identified above are used herein in the sense as defined in subdivision 8A of the Company's Articles of Association; such definitions are based upon the unconsolidated financial statements of the Company. As of December 31, 1993, the Common Stock Equity of the Company was 52.7% of total capitalization. For additional information regarding dividend restrictions see Exhibit EX-13 incorporated herein by reference. Item 6.

Item 6. Selected Financial Data. Information required to be furnished in response to this Item is submitted as Exhibit EX-13 incorporated herein by reference. Item 7.

Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations. Information required to be furnished in response to this Item is submitted as Exhibit EX-13 incorporated herein by reference. Item 8.

Item 8. Financial Statements and Supplementary Data. Information required to be furnished in response to this Item is submitted as Exhibit EX-13 incorporated herein by reference. Item 9.

Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure. None. PART III Item 10.

Item 10. Directors and Executive Officers of the Registrant. The Company's Articles of Incorporation and By-Laws provide for the division of the Board of Directors into three classes having staggered terms of office. In accordance with the Company's By-Laws, the Board of Directors has fixed at ten (10) the number of Directors for the ensuing year. The Directors whose terms will expire at the 1994 Annual Meeting of Stockholders are Frederic H. Bertrand, Mary Alice McKenzie and Robert D. Stout. Each of these Directors will stand for re-election to a three-year term expiring in 1997. Proxies will be voted (unless otherwise instructed) in favor of the election of the three nominees as indicated in the table below. The following table sets forth certain information regarding the three nominees for Director, as well as all Directors presently serving on the Board whose terms will expire after the 1994 Annual Meeting. Each of the individuals listed in the table has been employed by the firm or has had the occupation set forth under his or her name for the past five years. In general, the business experience of each of these persons during this time was typical of a person engaged in the principal occupation listed for each. Names and Principal Occupation Served as of Nominees and Directors Age Director Since Nominees whose terms will expire in 1997: FREDERIC H. BERTRAND 57 1984 Chairman of the Board and Chief Executive Officer, National Life Insurance Co. Montpelier, Vermont MARY ALICE MCKENZIE 36 1992 President, John McKenzie Packing Co., Inc. Burlington, Vermont (Manufacturer of Meat Products) ROBERT D. STOUT 67 1985 Retired President and Chief Executive Officer, Putnam Memorial Health Corporation Bennington, Vermont Directors whose terms will expire in 1996: ROBERT P. BLISS, JR. 70 1973 President, Bob Bliss, Ltd. St. Albans, Vermont (Insurance Industry Consultants) ELIZABETH COLEMAN 56 1990 President, Bennington College Bennington, Vermont PRESTON LEETE SMITH 63 1977 President and Chief Executive Officer, S-K-I Ltd. c/o Killington Ltd. Killington, Vermont (Ski Business) THOMAS C. WEBB 59 1986 President and Chief Executive Officer, Central Vermont Public Service Corporation Rutland, Vermont Directors whose terms will expire in 1995: LUTHER F. HACKETT 60 1979 President, Hackett, Valine & MacDonald, Inc. Burlington, Vermont (Insurance Agents) F. RAY KEYSER, JR. 66 1980 Chairman of the Board, Central Vermont Public Service Corporation, Of Counsel, Keyser, Crowley, Meub, Layden, Kulig & Sullivan, P.C. Rutland, Vermont (Lawyers) GORDON P. MILLS 57 1980 Chairman, EHV-Weidmann Industries, Inc. St. Johnsbury, Vermont (Manufacturer of Electric Transformer Insulation) The following table sets forth the names and ages of all executive officers of the Company, all positions and offices held within the Company, as well as work experience and positions held during the past five years. None of the executive officers of the Company has any family relationship with any other executive officer of the Company. Executive Officers of the Registrant: Name and Age Office Officer Since Thomas C. Webb, 59 President and Chief Executive Officer 1985 Robert H. Young, 46 Executive Vice President and Chief Operating Officer 1987 Steven J. Allenby, 39(F1) Senior Vice President- Marketing and Customer Services 1985 Robert de R. Stein, 44 Senior Vice President- Engineering and Energy Resources 1988 Jacquel-Anne Chouinard, 54 Vice President-Human Resources 1986 Thomas J. Hurcomb, 56 Vice President-Marketing and Public Affairs 1975 Robert G. Kirn, 42 Vice President-Division Operations 1991 Donald L. Rushford, 63 Vice President and General Counsel 1972 Patricia A. Wakefield, 51(F1) Vice President-Marketing and Customer Services 1988 William J. Deehan, 41 Assistant Vice President-Rates and Economic Analysis 1991 Jonathan W. Booraem, 55 Treasurer 1984 James M. Pennington, 38 Controller 1993 Joseph M. Kraus, 39 Secretary and General Counsel 1987 Mr. Webb joined the Company in 1985 as Executive Vice President - Finance and Administration and in 1986 was also designated Chief Operating Officer. He was elected Director, President and Chief Executive Officer on July 1, 1986. From 1977 to 1985, Mr. Webb was employed by Central Maine Power Company as Senior Vice President - Finance and Administration and in other executive positions. Mr. Young joined the Company in 1987 as Vice President - Finance and Administration. Mr. Young was named Senior Vice President - Finance and Administration in 1988, and in 1993 was elected Executive Vice President and Chief Operating Officer. During 1985-1986, he served as Senior Management Consultant for A. D. Little Co. Mr. Stein joined the Company on June 1, 1988 as Assistant Vice President - Energy Planning. Mr. Stein was elected Vice President - Energy Supply Planning and Engineering effective January 1, 1990, and Senior Vice President - Engineering and Energy Resources in 1993. During the period 1984-1988, he served United Illuminating Company as Manager of Revenue Requirements and Manager of Generation Planning and Power Contracts. Ms. Chouinard joined the Company in 1985 as Director - Human Resources. She was elected Assistant Vice President - Human Resources in 1986 and assumed her present position in 1988. Mr. Hurcomb joined the Company in 1967 in the Marketing and customer Service area. He was elected Vice President - External Affairs in 1975, and Vice President - Marketing and Public Affairs in 1993. Mr. Kirn joined the Company in 1991 as Vice President - Division Operations. From 1979 to 1991, he was employed by New York State Electric & Gas Corporation. He served as Operations Manager of the Lancaster Division Electric from 1988 until 1991 and as Operating Superintendent of the Berkshire District from 1985 to 1988. Mr. Rushford joined the Company in 1972 and has served as Vice President and General Counsel since that time. Mr. Rushford retired effective January 1, 1994. Mr. Deehan joined the Company in 1985. Prior to being elected to his present position, he served as Director of Rate Administration and Forecasting since 1987 and as Energy Forecaster from 1985-1987. Mr. Booraem has been with the Company since 1969. Prior to being elected Treasurer in 1984, he was Director of Finance & Planning. Mr. Kraus joined the Company in 1981 as Assistant Corporate Counsel. He was named Associate Corporate Counsel in 1983 and Senior Corporate Counsel in 1987. He was also elected Corporate Secretary and Senior Corporate Counsel in 1987 and Corporate Secretary and General Counsel effective January 1, 1994. Mr. Pennington joined the Company in 1989 as Director of Taxes. He was named Director of Taxes and Plant Accounting in 1990. Mr. Pennington was designated Acting Controller effective July 19, 1992, and was elected Controller and named Principal Accounting Officer in 1993. From 1984 to 1989, he served as Senior Tax Accountant for Northern Indiana Public Service Company. (FN) (F1) Steven J. Allenby and Patricia A. Wakefield resigned from the Company effective October 31, 1993. The term of each officer is for one year or until a successor is elected. Item 11.

Item 11. Executive Compensation. The following table sets forth all cash compensation paid or to be paid by the Company and its subsidiaries, as well as the number of stock option awards earned during the last three fiscal years by the Company's Chief Executive Officer and the Company's four other most highly compensated policy making executive officers ("officer(s)") whose direct cash compensation for services rendered to the Company and its subsidiaries in all capacities exceeded $100,000. STOCK OPTIONS The following table sets forth options granted to the Company's chief executive officer and the Company's four other most highly compensated executive officers during 1993 under the Company's 1988 Stock Option Plan. Under SEC regulations, companies are required to project an estimate of appreciation of the underlying shares of stock during the option term. The Company has chosen the Black-Scholes model formula approved by the SEC. However, the ultimate value will depend on the market value of the Company's stock at a future date, which may or may not correspond to the projections below.  The following table sets forth stock options exercised by the Company's Chief Executive Officer and the Company's four other most highly compensated executive officers during 1993, and the number and value of all unexercised options at year-end. The value of "in-the-money" options refers to options having an exercise price which is less than the market price of the Company's stock on December 31, 1993.  DEFERRED COMPENSATION PLAN Employees of the Company who are officers are eligible to defer receipt of a portion of their compensation pursuant to the Company's Deferred Compensation Plan for Officers. Also, certain of the Directors of the Company have elected to defer receipt of all or a portion of their fees under a similar plan for Directors. Under the Plan approved effective January 1, 1990 Directors and Officers of the Company may elect to defer over a 5-year period receipt of a specified amount of compensation or fees otherwise currently payable to them until retirement at age 65 (age 70 for Directors), or until their death, disability, or resignation. Officers may receive a reduced benefit beginning at age 60 with 10 years of service. Amounts deferred are not currently taxable for state and Federal income taxes. The benefit is equal to the compensation deferred plus interest credited by the Company. This plan is a defined contribution program under which the Company recovers any costs, including the cost of capital, through the proceeds of the supporting life insurance policies. In addition, if death of a Director occurs before age 70, an additional survivor benefit equal to the annual amount deferred will be paid to the beneficiary each year for fifteen years. This benefit is also financed by life insurance proceeds. PENSION PLAN The Pension Plan of Central Vermont Public Service Corporation and Its Subsidiaries (the "Plan") covers employees, among others, who are officers. The Company pays the full cost of the Plan.  The table below shows the annual amounts payable under the present provisions of the Plan as amended through December 31, 1993, based on Final Average Earnings for various years of service, assuming the employee would retire at age 65 in 1994. Final Average Earnings is the highest five-year average of consecutive years' Base Salary (item (c) from the Summary Compensation Table) over an employee's career with the Corporation. The amounts above are payable for the life of the retiree only, and would be reduced on an actuarial basis if survivor options were chosen. In addition, no Social Security offset applies to amounts above. The credited years of service at December 31, 1993 under the Plan for those individuals named in the Summary Compensation Table were as follows: Mr. Webb, 9 years; Mr. Young, 6 years, 6 months; Mr. Stein, 5 years, 7 months; Mr. Rushford, 21 years, 6 months; and Mr. Hurcomb, 26 years. OFFICERS' INSURANCE AND SUPPLEMENTAL RETIREMENT PLAN The Officers' Insurance and Supplemental Retirement Plan (the "Plan") is designed to supplement the retirement benefits available to the Company's officers. The Plan is a part of the Company's overall strategy for attracting and maintaining top managerial talent in the utility industry. The Company pays the entire cost of the Plan. Under the Plan, each officer is entitled to receive, upon his or her retirement at age 65, fifteen annual payments in amounts equal to a specified percentage of his or her final year's Base Salary (item (c) from the Summary Compensation Table). A reduced benefit is available at age 60 with ten years of service. The applicable percentages for the individuals named in Summary Compensation Table are as follows: Mr. Webb, 44.5%; Mr. Young, 33%; Mr. Stein, 33%; Mr. Rushford, 33%; and Mr. Hurcomb, 33%. Shown below is the estimated Company provided benefit payable at age 65 for those individuals named in the Summary Compensation Table who receive a benefit under the Officers' Insurance and Supplemental Retirement Plan: Assumed Final Annual Base Pay $ 33% 44.5% 80,000 26,400 35,600 100,000 33,000 44,500 120,000 39,600 53,400 140,000 46,200 62,300 160,000 52,800 71,200 180,000 59,400 80,100 220,000 72,600 97,900 260,000 85,800 115,700 300,000 99,000 133,500 340,000 112,200 151,300 PREDECESSOR DEFERRED COMPENSATION PLAN Between 1986 and 1990, the Company allowed officers to defer receipt of compensation in return for fifteen annual payments of a defined benefit amount upon retirement. The Company will pay the difference, if any, between the defined benefit cost and the accumulated value of deferred compensation. Shown below is the estimated Company-provided benefit, payable at age 65, for those individuals named in the Summary Compensation Table who elected to participate. Since these benefits do not apply to all of the named individuals, they have not been reflected in the foregoing pension table. Annual Company- Provided Benefit Name Payable at Age 65 Mr. Webb $29,800 Mr. Rushford 19,700 Mr. Hurcomb 13,900 Item 12.

Item 12. Security Ownership of Certain Beneficial Owners and Management. Section 16(a) of the Securities and Exchange Act of 1934 requires the Company's Officers and Directors to file reports of ownership and changes in ownership of Company securities with the Securities and Exchange Commission and to furnish the Company with copies of all such reports. In 1993, Director Mary Alice McKenzie inadvertently failed to file with the Securities and Exchange Commission on a timely basis one required report involving one transaction in Common Stock of the Company which she beneficially owns. Except for the foregoing, the Company believes that during 1993 all filing requirements applicable to its Officers and Directors have been met. In making this statement, the Company has relied on copies of reports that have been filed with the Commission. Section 16(a) of the Securities Exchange Act of 1934 also requires executive officers and directors and persons who beneficially own more than ten percent (10%) of the Company's stock to file initial reports of ownership and subsequent reports of changes in ownership with the SEC and the NYSE. Based solely on a review of the copies of such forms prepared and filed during 1993 on behalf of our executive officers and directors, and on written representations that no other reports were required the Company believes its directors and executive officers have complied with all Section 16(a) filing requirements. The Company does not have a ten percent holder. The following is a tabulation of equity securities of the Company beneficially owned by all present Directors and Executive Officers of the Company as a group (19 persons) as of January 31, 1994. No Director, nominee for Director or Executive Officer owns any shares of the various classes of the Company's outstanding non-voting preferred stock. Title of Class Amount Beneficially Owned Percent of Class Common Stock, $6 Par Value 187,908 shares (F1) 1.6% (FN) (F1) Includes 124,625 shares that the directors and executive officers have a right to acquire pursuant to options granted under Stock Option plans. The Company knows of no person, entity or group (within the meaning of Section 13(d)(3) of the Securities Exchange Act of 1934) which owns beneficially more than 5% of any class of the Company's outstanding equity securities. Item 13.

Item 13. Certain Relationships and Related Transactions. None. Filed Herewith at Page PART IV Item 14.

Item 14. Exhibits, Financial Statement Schedules, and Reports on Form 8-K. (a) The following documents are filed as part of this report: 1. Management's Discussion: 1.1 Central Vermont Public Service Corporation and its wholly owned subsidiaries: (See Item 7) Management's Discussion and Analysis of Financial Condition and Results of Operations  2. Financial Statements: 2.1 Central Vermont Public Service Corporation and its wholly owned subsidiaries: (See Item 8) Consolidated Statement of Income, years ended December 31, 1993, 1992, and 1991. Consolidated Statement of Cash Flows, years ended December 31, 1993, 1992 and 1991. Consolidated Balance Sheet, December 31, 1993 and 1992. Consolidated Statement of Capitalization, December 31, 1993 and 1992. Consolidated Statement of Changes in Common Stock Equity, years ended December 31, 1993, 1992 and 1991. Notes to Consolidated Financial Statements. 3. Financial Statement Schedules: 3.1 Central Vermont Public Service Corporation and its wholly owned subsidiaries: Schedule V - Utility Plant, years ended December 31, 1993, 1992 and 1991. Schedule VI - Accumulated Depreciation of Utility Plant, years ended December 31, 1993, 1992 and 1991. Filed Herewith at Page PART IV Item 14. Exhibits, Financial Statement Schedules, and Reports on Form 8-K Continued. Schedule VIII - Reserves, years ended December 31, 1993, 1992 and 1991. Schedule IX - Short-term borrowings, years ended December 31, 1993, 1992 and 1991. 3.2 Financial Statements and Schedules for Vermont Yankee Nuclear Power Corporation - per index attached. Schedules not included have been omitted because they are not applicable or the required information is shown in the financial statements or notes thereto. Separate financial statements of the Registrant (which is primarily  an operating company) have been omitted since they are consolidated only with those of totally held subsidiaries. Separate financial statements of subsidiary companies not consolidated have been omitted since, if considered in the aggregate, they would not constitute a significant subsidiary. Other than Vermont Yankee Nuclear Power Corporation, separate financial statements of 50% or less owned persons for which the investment is accounted for by the equity method by the Registrant have been omitted since, if considered in the aggregate, they would not constitute a significant investment. (b) Reports on Form 8-K: There were no reports on Form 8-K for the quarter ended December 31, 1993. (c) See exhibits index. REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS To the Board of Directors of Central Vermont Public Service Corporation: We have audited in accordance with generally accepted auditing standards, the consolidated financial statements included in Central Vermont Public Service Corporation's annual report to shareholders incorporated by reference in this Form 10-K, and have issued our report thereon dated February 7, 1994. Our audit was made for the purpose of forming an opinion on those statements taken as a whole. The schedules listed in the index above are the responsibility of the Company's management and are presented for purposes of complying with the Securities and Exchange Commission's rules and are not part of the basic financial statements. These schedules have been subjected to the auditing procedures applied in the audit of the basic consolidated financial statements and, in our opinion, fairly state, in all material respects, the consolidated financial data required to be set forth therein in relation to the basic consolidated financial statements taken as a whole. ARTHUR ANDERSEN & CO. Boston, Massachusetts, February 7, 1994  Schedule V CENTRAL VERMONT PUBLIC SERVICE CORPORATION AND ITS WHOLLY OWNED SUBSIDIARIES  Schedule VI CENTRAL VERMONT PUBLIC SERVICE CORPORATION AND ITS WHOLLY OWNED SUBSIDIARIES Accumulated Depreciation Of Electric Plant And Amortization Of Nuclear Fuel Years ended December 31, 1993, 1992 and 1991  Schedule VIII CENTRAL VERMONT PUBLIC SERVICE CORPORATION AND ITS WHOLLY OWNED SUBSIDIARIES Reserves Year ended December 31, 1993  Schedule VIII CENTRAL VERMONT PUBLIC SERVICE CORPORATION AND ITS WHOLLY OWNED SUBSIDIARIES Reserves Year ended December 31, 1992  Schedule VIII CENTRAL VERMONT PUBLIC SERVICE CORPORATION AND ITS WHOLLY OWNED SUBSIDIARIES Reserves Year ended December 31, 1991  Schedule IX CENTRAL VERMONT PUBLIC SERVICE CORPORATION AND ITS WHOLLY OWNED SUBSIDIARIES Short-Term Borrowings Years Ended December 31, 1993, 1992, 1991 Independent Auditor's Report The Stockholders and Board of Directors Vermont Yankee Nuclear Power Corporation: We have audited the accompanying balance sheet of Vermont Yankee Nuclear Power Corporation as of December 31, 1993, and the related statements of income and retained earnings and cash flows for the year then ended. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audit. The financial statements of Vermont Yankee Nuclear Power Corporation as of December 31, 1992 and 1991, were audited by other auditors whose report, dated February 5, 1993, expressed an unqualified opinion on those statements and included an additional paragraph discussing the Company's 1992 change in accounting for postretirement benefits other than pensions. We conducted our audit in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audit provides a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of Vermont Yankee Nuclear Power Corporation as of December 31, 1993, and the results of its operations and cash flows for the year then ended, in conformity with generally accepted accounting principles. As discussed in note 10 of the accompanying financial statements, effective January 1, 1993 the Company adopted the provisions of Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes". Our audit was made for the purpose of forming an opinion on the basic financial statements taken as whole. The supplementary schedules are presented for purposes of additional analysis and are not a required part of the basic financial statements. This information has been subjected to the auditing procedures applied in our audit of the basic financial statements and, in our opinion, is fairly stated, in all material respects, in relation to the basic financial statements taken as a whole. Arthur Andersen & Co. Boston, Massachusetts January 27, 1994 VERMONT YANKEE NUCLEAR POWER CORPORATION Index to Financial Statements and Financial Statement Schedules Financial Statements: Balance Sheets, December 31, 1993 and 1992 Statements of Income and Retained Earnings, years ended December 31, 1993, 1992 and 1991 Statements of Cash Flows, years ended December 31 ,1993, 1992 and 1991 Notes to Financial Statements Financial Statement Schedules: Schedule I - Marketable Securities and Other Investments at December 31, 1993 Schedule V - Property, Plant and Equipment, years ended December 31, 1993, 1992 and 1991 Schedule VI - Accumulated Depreciation, Depletion and Amortization of Property, Plant and Equipment, years ended December 31, 1993, 1992 and 1991 All other schedules are omitted as the required information is inapplicable or the required information is included in the financial statements or related notes. Balance Sheets Assets December 31, 1993 1992 (Dollars in thousands) Utility plant: Electric plant, at cost (note 6) $ 374,736 $ 362,278 Less accumulated depreciation 198,389 185,263 176,347 177,015 Construction work in progress 597 6,408 Net electric plant 176,944 183,423 Nuclear fuel, at cost (note 6): Assemblies in reactor 69,063 74,025 Fuel in process - 5,236 Spent fuel 287,700 259,199 356,763 338,460 Less accumulated amortization of burned nuclear fuel 317,039 302,362 39,724 36,098 Less accumulated amortization of final core nuclear fuel 7,220 6,487 Net nuclear fuel 32,504 29,611 Net utility plant 209,448 213,034 Current assets: Cash and temporary investments 2,349 1,922 Accounts receivable from sponsors 12,235 15,407 Other accounts receivable 4,522 2,715 Materials and supplies 17,081 16,862 Prepaid expenses 3,949 4,381 Total current assets 40,136 41,287 Deferred charges: Deferred decommissioning costs (note 2) 34,379 34,389 Accumulated deferred income taxes (note 10) 18,231 10,378 Deferred DOE enrichment site decontamination and decommissioning fee (note 4) 18,627 18,143 Net unamortized loss on reacquired debt 2,942 - Other deferred charges (note 4) 3,643 4,994 Total deferred charges 77,822 67,904 Long-term funds at amortized cost: Decommissioning fund (notes 2, 5, and 7) 98,880 82,091 Disposal fee defeasance fund (notes 5, 7, and 8) 43,484 33,892 Total long-term funds 142,364 115,983 $469,770 $438,208 See accompanying notes to financial statements. Balance Sheets Capitalization and Liabilities December 31, 1993 1992 (Dollars in thousands) Capitalization: Common stock equity: Common stock, $100 par value; authorized 400,100 shares; issued 400,014 shares of which 7,533 are held in Treasury $ 40,001 $ 40,001 Additional paid-in capital 14,227 14,227 Treasury stock (7,533 shares at cost) (1,131) (1,131) Retained earnings 1,067 1,178 Total common stock equity 54,164 54,275 Long-term obligations, net (notes 6 and 7) 79,636 74,193 Total capitalization 133,800 128,468 Commitments and contingencies (notes 2, 14 and 15) Disposal fee and accrued interest for spent nuclear fuel (notes 7 and 8) 80,688 78,239 Current liabilities: Accrued liabilities 28,063 22,743 Accounts payable 2,117 2,591 Accrued interest 635 974 Accrued taxes 1,206 1,472 Total current liabilities 32,021 27,780 Deferred credits: Accrued decommissioning costs (note 2) 134,614 117,601 Accumulated deferred income taxes 56,478 58,963 Net regulatory tax liability (note 10) 8,351 - Accumulated deferred investment tax credits 7,013 7,590 Net unamortized gain on reacquired debt - 1,732 Accrued DOE enrichment site decontamination and decommissioning fee (note 4) 15,966 17,220 Other deferred credits 839 615 Total deferred credits 223,261 203,721 $469,770 $438,208 See accompanying notes to financial statements. Statements of Income and Retained Earnings Years ended December 31, 1993 1992 1991 (Dollars in thousands except per share amounts) Operating revenues $180,145 $175,919 $151,722 Operating expenses: Nuclear fuel expense 19,526 21,240 24,864 Other operating expense 74,013 72,967 59,666 Maintenance 31,405 27,878 13,664 Depreciation 13,707 13,253 11,800 Decommissioning expense (note 2) 11,315 10,649 8,065 Taxes on income (note 10) 3,777 3,401 3,485 Property and other taxes 9,961 10,227 10,294 Total operating expenses 163,704 159,615 131,838 Operating income 16,441 16,304 19,884 Other income and (deductions): Net earnings on decommissioning fund (notes 2 and 5) 5,653 5,395 4,423 Decommissioning expense (note 2) (5,653) (5,395) (4,423) Allowance for equity funds used during construction 92 89 124 Interest 1,550 2,046 1,377 Taxes on other income (note 10) (623) (756) (447) Other, net (232) (199) (917) 787 1,180 137 Income before interest expense 17,228 17,484 20,021 Interest expense: Interest on long-term debt 7,281 7,101 7,684 Interest on disposal costs of spent nuclear fuel (note 8) 2,450 2,801 4,312 Allowance for borrowed funds used during construction (297) (339) (465) Total interest expense 9,434 9,563 11,531 Net income 7,794 7,921 8,490 Retained earnings at beginning of year 1,178 1,166 1,982 8,972 9,087 10,472 Dividends declared 7,905 7,909 9,306 Retained earnings at end of year $ 1,067 $ 1,178 $ 1,166 Average number of shares outstanding in thousands 392 392 394 Net income per average share of common stock outstanding $ 19.86 $ 20.18 $ 21.56 Dividends per average share of common stock outstanding $ 20.14 $ 20.15 $ 23.71 See accompanying notes to financial statements. Statements of Cash Flows Years ended December 31, 1993 1992 1991 (Dollars in thousands) Cash flows from operating activities: Net income $7,794 $ 7,921 $ 8,490 Adjustments to reconcile net income to net cash provided by operating activities: Amortization of nuclear fuel 15,410 18,143 21,002 Depreciation 13,707 13,253 11,800 Decommissioning expense 11,315 10,649 8,065 Deferred tax expense (979) (2,169) (801) Amortization of deferred investment tax credits (577) (641) (740) Nuclear fuel disposal fee interest accrual 2,450 2,802 4,312 Interest and dividends on disposal fee defeasance fund (1,402) (1,385) (1,495) (Increase) decrease in accounts receivable 1,365 688 (129) (Increase) decrease in prepaid expenses 432 (1,159) 163 (Increase) in materials and supplies inventory (219) (454) (1,531) Increase (decrease) in accounts payable and accrued liabilities 4,846 (7,453) 5,495 Increase (decrease) in interest and taxes payable (605) 306 (760) Other (1,228) (1,410) (1,665) Total adjustments 44,515 31,170 43,716 Net cash provided by operating activities 52,309 39,091 52,206 Cash flows from investing activities: Electric plant additions (7,229) (10,750) (6,596) Nuclear fuel additions (18,303) (4,707) (18,444) Payments to decommissioning fund (11,250) (10,612) (8,323) Payments to disposal fee defeasance fund (8,190) (5,190) (8,216) Net cash used in investing activities (44,972) (31,259) (41,579) Cash flows from financing activities: Dividend payments (7,905) (7,909) (9,306) Purchase of treasury stock - - (1,131) Issuance of Series H first mortgage bonds, net - - 10,374 Issuance of Series I first  mortgage bonds, net 75,125 - - Retirement of first mortgage bonds including redemption costs (74,629) (6,521) (13,178) Payments of long-term obligations (137,911) (107,763) (53,419) Borrowings under long-term agreements 138,410 111,215 53,798 Net cash used in financing activities (6,910) (10,978) (12,862) Net increase (decrease) in cash and temporary investments 427 (3,146) (2,235) Cash and temporary investments at beginning of year 1,922 5,068 7,303 Cash and temporary investments at end of year $ 2,349 $ 1,922 $ 5,068 See accompanying notes to financial statements. Notes to Financial Statements NOTE 1. Summary of Significant Accounting Policies (a) Regulations and Operations Vermont Yankee Nuclear Power Corporation ("the Company") is subject to regulations prescribed by the Federal Energy Regulatory Commission ("FERC"), and the Public Service Board of the State of Vermont with respect to accounting and other matters. The Company is also subject to regulation by the Nuclear Regulatory Commission ("NRC") for nuclear plant licensing and safety, and by federal and state agencies for environmental matters such as air quality, water quality and land use. Prior to November, 1993, the Company was subject to regulation by the Securities and Exchange Commission. As a result of the debt refinancing discussed in note 6, the Company is no longer subject to such regulation. The Company recognizes revenue pursuant to the terms of the Power Contracts and Additional Power Contracts. The Sponsors, a group of nine New England utilities, are severally obligated to pay the Company each month their entitlement percentage of amounts equal to the Company's total fuel costs and operating expenses of its Plant, plus an allowed return on equity (since December 1, 1989, 12.25%). Such contracts also obligate the Sponsors to make decommissioning payments through the end of the Plant's service life and the completion of the decommissioning of the Plant. All Sponsors are committed to such payments regardless of the Plant's operating level or whether the Plant is out of service during the period. Under the terms of the Capital Funds Agreements, the Sponsors are committed, subject to obtaining necessary regulatory authorizations, to make funds available to obtain or maintain licenses necessary to keep the Plant in operation. (b) Depreciation and Maintenance Electric plant is being depreciated on the straight-line method at rates designed to fully depreciate all depreciable properties over the lesser of estimated useful lives or the Plant's remaining NRC license life, which extends to March, 2012. Depreciation expense was equivalent to overall effective rates of 3.74%, 3.56% and 3.23% for the years 1993, 1992 and 1991, respectively. Renewals and betterments constituting retirement units are charged to electric plant. Minor renewals and betterments are charged to maintenance expense. When properties are retired, the original cost, plus cost of removal, less salvage, is charged to the accumulated provision for depreciation. (c) Amortization of Nuclear Fuel The cost of nuclear fuel is amortized to expense based on the rate of burn-up of the individual assemblies comprising the total core. The Company also provides for the costs of disposing of spent nuclear fuel at rates specified by the United States Department of Energy ("DOE") under a contract for disposal between the Company and the DOE. The Company amortizes to expense on a straight-line basis the estimated costs of the final unspent nuclear fuel core, which is expected to be in place at the expiration of the Plant's NRC operating license in conformity with rates authorized by the FERC. (d) Amortization of Materials and Supplies The Company amortizes to expense a formula amount designed to fully amortize the cost of the material and supplies inventory that is expected to be on hand at the expiration of the Plant's NRC operating license. (e) Long-term Funds The Company accounts for its investments in long-term funds at amortized cost since it has both the intent and ability to hold these investments for the foreseeable future. Amortized cost represents the cost to purchase the investment, net of any unamortized premiums or discounts. Notes to Financial Statements NOTE 1. Summary of Significant Accounting Policies (Continued) (f) Amortization of Gain and Loss on Reacquired Debt The difference between the amount paid upon reacquisition of any debt security and the face value thereof, plus any unamortized premium, less any related unamortized debt expense and reacquisition costs, or less any unamortized discount, related unamortized debt expense and reacquisition costs applicable to the debt redeemed, retired and canceled, is deferred by the Company and amortized to expense on a straight-line basis over the remaining life of the applicable security issues. (g) Allowance for Funds Used During Construction Allowance for funds used during construction ("AFUDC") is the estimated cost of funds used to finance the Company's construction work in progress and nuclear fuel in process which is not recovered from the Sponsors through current revenues. The allowance is not realized in cash currently, but under the Power Contracts, the allowance will be recovered in cash over the Plant's service life through higher revenues associated with higher depreciation and amortization expense. AFUDC was capitalized at overall effective rates of 5.92%, 6.82% and 6.98% for 1993, 1992 and 1991, respectively, using the gross rate method. (h) Decommissioning The Company is accruing the estimated costs of decommissioning its Plant over the Plant's remaining NRC license life. Any amendments to these estimated costs are accounted for prospectively. (i) Taxes on Income Effective January 1, 1993, the Company began accounting for taxes on income under the liability method required by Statement of Financial Accounting Standard 109. See Note 10 for a further discussion of this change in accounting. Investment tax credits have been deferred and are being amortized to income over the lives of the related assets. (j) Cash Equivalents For purposes of the Statements of Cash Flows, the Company considers all highly liquid short-term investments with an original maturity of three months or less to be cash equivalents. (k) Reclassifications Certain information in the 1992 and 1991 financial statements has been reclassified to conform with the 1993 presentation. (l) Earnings per Common Share Earnings per common share have been computed by dividing earnings available to common stock by the weighted average number of shares outstanding during the year. Notes to Financial Statements NOTE 2. Decommissioning The Company accrues estimated decommissioning costs for its nuclear plant over its remaining NRC licensed life based on studies by an independent engineering firm that assumes that decommissioning will be accomplished by the prompt removal and dismantling method. This method requires that radioactive materials be removed from the plant site and that all buildings and facilities be dismantled immediately after shutdown. Studies estimate that approximately six years would be required to dismantle the Plant at shutdown, remove wastes and restore the site. The Company has implemented rates based on a settlement agreement with the FERC which allowed $190 million, in 1988 dollars, as the estimated decommissioning cost. This allowed amount is used to compute the Company's liability and billings to the Sponsors. Based on an assumed inflation rate of 6% per annum and an expiration of the Plant's NRC operating license in 2012, the estimated current cost of decommissioning is $253 million and, at the end of 2012, is approximately $769 million. The present value of the pro rata portion of decommissioning costs recorded to date is $134.6 million. On December 31, 1993, the balance in the Decommissioning Trust was $98.9 million. Billings to Sponsors for estimated decommissioning costs commenced during 1983, at which time the Company recorded a deferred charge for the present value of decommissioning costs applicable to operations of the Plant for prior periods. Current period decommissioning costs not funded through billings to Sponsors or earnings on decommissioning fund assets are also deferred. These deferred costs will be amortized to expense as they are funded over the remaining life of the NRC operating license. In 1994, the Company must file a revised estimate of decommissioning costs and a revised schedule of future annual decommissioning fund collections reflecting the historical differences between assumed and actual rates of inflation and the historical differences between assumed and actual rates of earnings on decommissioning fund assets. Filings are required to be made within four years of the most recent FERC approval of decommissioning cost estimates and rates. Cash received from Sponsors for plant decommissioning costs is deposited into the Vermont Yankee Decommissioning Trust in either the Qualified Fund (i.e., amounts currently deductible pursuant to the IRS regulations) or the Nonqualified Fund (i.e., excess collections pursuant to FERC authorization which are not currently deductible). Funds held by the Trust are invested in high-grade U.S. government securities and municipal obligations. Interest earned by the Decommissioning Trust assets is recorded in other income and deductions, with an equal and offsetting amount representing the current period decommissioning cost funded by such earnings reflected as decommissioning expense. Decommissioning expense for 1991 included an adjustment of approximately $2.1 million resulting from the Company's rate reduction filing approved by the FERC on February 28, 1991 as discussed in Note 3. NOTE 3. FERC Rate Case Matters On April 27, 1989, Vermont Yankee filed an application with the NRC to extend the term of the operating license from 2007 to 2012 so that the Plant may operate for 40 years after it entered commercial service in 1972. On December 17, 1990, the NRC issued an amendment to the operating license extending its term to March 21, 2012. The Company submitted a rate reduction filing with the FERC to reflect in rates the adjustments to decommissioning, depreciation and amortization resulting from the license extension. The Company proposed to make this reduction effective as of March 1, 1991 and, since the extension was issued in 1990, to reflect the necessary adjustment for the period January 1, 1990 through February 28, 1991. On February 28, 1991, the FERC approved the Company's rate reduction filing. The effects of this ruling were accounted for prospectively in fiscal 1991, producing a net revenue reduction of approximately $7.4 million in 1991, which reflected the retroactive treatment to January 1, 1990. This ruling resulted in reduced revenue requirements of approximately $3.5 million for both 1992 and 1993, and similar reductions are expected in future years. Notes to Financial Statements NOTE 3. FERC Rate Case Matters (Continued) On March 26, 1993, the FERC initiated a review of the return on common equity component of the formula rates included in the Company's Power Contracts. On October 22, 1993, the FERC approved a settlement whereby the Company retained its 12.25% authorized rate of return on common equity and agreed to credit monthly power billings by approximately $139,000 beginning in June, 1993. In 1994, the Company will submit a rate filing to the FERC which will include, among other things, a revised estimate of decommissioning costs and a revised schedule of future annual decommissioning fund collections. NOTE 4. Other Deferred Charges and Credits In October, 1992, Congress passed the Energy Policy Act of 1992 which requires, among other things, that certain utilities help pay for the cleanup of the DOE's enrichment facilities over a 15-year period. The Company's annual fee is estimated based on the historical share of enrichment service provided by the DOE and is indexed to inflation. These fees will not be adjusted for future business as the DOE's future cost of sales will include a decontamination and decommissioning component. The Act stipulates that the annual fee shall be fully recoverable in rates in the same manner as other fuel costs. In 1993, the DOE billed and the Company paid the first of the 15 annual fees. As of December 31, 1993, the Company has recognized a current accrued liability of $2.6 million for the two fee payments expected to be made in 1994, a deferred credit of $16.0 million for the 12 annual fee payments that are due subsequent to 1994 and a corresponding regulatory asset of $18.6 million which represents the total amount includable in future billings to the purchasers under the Power Contracts. While these amounts are reflected in these financial statements, the Company is reviewing the DOE's calculation of the annual fee and believes that the annual fee will ultimately be reduced. Approximately $2.1 and $3.3 million of the $3.6 and $5.0 million in other deferred charges at December 31, 1993 and 1992, respectively, relate to payments made to the Vermont Low Level Radioactive Waste Authority ("VLLRWA"), an agency of the State of Vermont for the siting and construction of a low-level waste disposal facility. NOTE 5. Long-term Funds The book value and estimated market value of long-term fund investment securities at December 31, is as follows: 1993 1992 Book Market Book Market value value value value (Dollars in thousands) Decommissioning fund: U.S. Treasury obligations $17,262 18,666 $22,000 $23,067 Municipal obligations 79,755 84,576 57,141 59,009 Accrued interest and money market funds 1,863 1,863 2,950 2,950 98,880 105,105 82,091 85,026  Disposal fee defeasance fund: Short-term investments 39,870 39,870 26,457 26,457 Corporate bonds and notes 3,195 3,083 6,110 5,940 Accrued interest and money market funds 419 419 1,325 1,325 43,484 43,372 33,892 33,722 Total long-term fund investments $142,364 $148,477 $115,983 $118,748 Notes to Financial Statements NOTE 5. Long-term Funds (Continued) At December 31, 1993 and 1992, gross unrealized gains and losses pertaining to the long-term investment securities were as follows: 1993 1992 (Dollars in thousands) Unrealized gains on U.S. Treasury obligations $ 1,431 $ 1,071 Unrealized losses on U.S. Treasury obligations $ (27) $ (4) Unrealized gains on Municipal obligations $ 4,843 $ 1,895 Unrealized losses on Municipal obligations $ (22) $ (27) Unrealized losses on corporate bonds and notes $ (112) $ (170) Maturities of short-term obligations, bonds and notes (face amount) at December 31, 1993 are as follows (dollars in thousands): Within one year $42,200 Two to five years 16,977 Five to seven years 19,670 Over seven years 57,860 $136,707 NOTE 6. Long-term Obligations A summary of long-term obligations at December 31, 1993 and 1992 is as follows: 1993 1992 (Dollars in thousands) First mortgage bonds: Series B - 8.50% due 1998 $ - $1,307 Series C - 7.70% due 1998 - 1,612 Series D - 10.125% due 2007 - 23,147 Series E - 9.875% due 2007 - 5,703 Series F - 9.375% due 2007 - 5,704 Series G - 8.94% due 1995 - 25,000 Series H - 8.25% due 1996 - 8,388 Series I - 6.48% due 2009 75,845 - Total first mortgage bonds 75,845 70,861 Eurodollar Agreement Commercial Paper 3,791 3,292 Unamortized premium on debt - 40 Total long-term obligations $ 79,636 $ 74,193 The first mortgage bonds are issued under, have the terms and provisions set forth in, and are secured by an Indenture of Mortgage dated as of October 1, 1970 between the Company and the Trustee, as modified and supplemented by 13 supplemental indentures. All bonds are secured by a first lien on utility plant, exclusive of nuclear fuel, and a pledge of the Power Contracts and the Additional Power Contracts (except for fuel payments) and the Capital Funds Agreements with Sponsors. On July 1, 1993, the Company retired the outstanding Series B and Series C first mortgage bonds. In November, 1993, the Company issued $75.8 million of Series I, first mortgage bonds stated to mature on November 1, 2009. The Company applied the proceeds of the bond issuance principally to retire the remaining Series D, Series E, Series F, Series G and Series H first mortgage bonds including call premiums totalling $3.7 million based on the early redemption of the bonds. Cash sinking fund requirements for the Series I first mortgage bonds are $5.4 million annually beginning in November, 1999. The Company has a $75.0 million Eurodollar Credit Agreement that expires on December 31, 1995 subject to three optional one-year extensions. The Company issued commercial paper under this agreement with weighted average interest rates of 3.22% for 1993 and 3.95% for 1992. Payment of the commercial paper is supported by the Eurodollar Credit Agreement, which is secured by a second mortgage on the Company's generating facility. Notes to Financial Statements NOTE 7. Disclosures About the Fair Value of Financial Instruments The carrying amounts for cash and temporary investments, trade receivables, accounts receivable from sponsors, accounts payable and accrued liabilities approximate their fair values because of the short maturity of these instruments. The fair values of long-term funds are estimated based on quoted market prices for these or similar investments. The fair values of each of the Company's long-term debt instruments are estimated based on the quoted market prices for the same or similar issues, or on the current rates offered to the Company for debt of the same remaining maturities. The estimated fair value of the Company's financial instruments as of December 31 are summarized as follows (dollars in thousands): 1993 1992 Carrying Estimated Carrying Estimated Amount Fair Value Amount Fair Value Decommissioning fund $98,880 $105,105 $82,091 $85,026 Disposal fee defeasance fund 43,484 43,372 33,892 33,722 Long-term debt 79,636 77,361 74,193 78,235 Disposal fee and accrued interest 80,688 80,688 78,239 78,239 Fair value estimates are made at a specific point in time, based on relevant market information and information about the financial instrument. These estimates are subjective in nature and involve uncertainties and matters of significant judgment and therefore cannot be determined with precision. Changes in assumptions could significantly affect the estimates. NOTE 8. Disposal Fee for Spent Nuclear Fuel The Company has a contract with the United States Department of Energy ("DOE") for the permanent disposal of spent nuclear fuel. Under the terms of this contract, in exchange for the one-time fee discussed below and a quarterly fee of 1 mil per kwh of electricity generated and sold, the DOE agrees to provide disposal services when a facility for spent nuclear fuel and other high-level radioactive waste is available, which is required by current statute to be prior to January 31, 1998. The DOE contract obligates the Company to pay a one-time fee of approximately $39.3 million for disposal costs for all spent fuel discharged through April 7, 1983. Although such amount has been collected in rates from the Sponsors, the Company has elected to defer payment of the fee to the DOE as permitted by the DOE contract. The fee must be paid no later than the first delivery of spent nuclear fuel to the DOE. Interest accrues on the unpaid obligation based on the thirteen-week Treasury Bill rate and is compounded quarterly. Through 1993, the Company deposited approximately $37.5 in an irrevocable trust to be used exclusively for defeasing this obligation at some future date, provided the DOE complies with the terms of the aforementioned contract. On December 31, 1991, the DOE issued an amended final rule modifying the Standard Contract for Disposal of Spent Nuclear Fuel and/or High-level Radioactive Waste. The amended final rule conforms with a March 17, 1989 ruling of the U.S. Court of Appeals for the District of Columbia that the 1 mil per kilowatt hour fee in the Standard Contract should be based on net electricity generated and sold. The impact of the amendment on the Company was to reduce the basis for the fee by 6% on an ongoing basis and to establish a receivable from the DOE for previous overbillings and accrued interest. The Company has recognized in its rates the full impact of the amended final rule to the Standard Contract. The DOE is refunding the overpayments, including interest, to utilities over a four-year period ending in 1995 via credits against quarterly payments. Interest is based on the 90-day Treasury Bill Auction Bond Equivalent and will continue to accrue on amounts remaining to be credited. At December 31, 1993 and 1992, respectively, approximately $0.9 and $1.6 million in principal and interest is reflected in other accounts receivable. Notes to Financial Statements NOTE 9. Short-term Borrowings The Company had lines of credit from various banks totalling $6.3 million at December 31, 1993 and 1992. The maximum amount of short-term borrowings outstanding at any month-end during 1993, 1992 and 1991 was approximately $0.2 million, $0.6 million and $0.4 million, respectively. The average daily amount of short-term borrowings outstanding was approximately $0.3 million for 1993, and $0.1 million for 1992 and 1991 with weighted average interest rates of 5.75% in 1993, 6.12 % in 1992 and 8.19% in 1991. There were no amounts outstanding under these lines of credit as of December 31, 1993 and 1992. NOTE 10. Taxes on Income In February, 1992, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes", which required the Company to change from the deferred method to the liability method of accounting for income taxes on January 1, 1993. The liability method accounts for deferred income taxes by applying enacted statutory rates in effect at the balance sheet date to differences between the book basis and the tax basis of assets and liabilities ("temporary differences"). This new statement requires recognition of deferred tax liabilities for (a) income tax benefits associated with timing differences previously passed on to customers and (b) the equity component of allowance for funds used during construction, and of a deferred tax asset for the tax effect of the accumulated deferred investment tax credits. It also requires the adjustment of deferred tax liabilities or assets for an enacted change in tax laws or rates, among other things. Although adoption of this new statement has not and is not expected to have a material impact on the Company's cash flow, results of operations or financial position because of the effect of rate regulation, the Company was required to recognize an adjustment to accumulated deferred income taxes and a corresponding regulatory asset or liability to customers (in amounts equal to the required deferred income tax adjustment) to reflect the future revenues or reduction in revenues that will be required when the temporary differences turn around and are recovered or settled in rates. In addition, this new statement required a reclassification of certain deferred income tax liabilities to liabilities to customers in order to reflect the Company's obligation to flow back deferred income taxes provided at rates higher than the current 35% federal tax rate. The Company has applied the provisions of this new statement without restating prior year financial statements. The components of income tax expense for the years ended December 31, 1993, 1992 and 1991 are as follows: 1993 1992 1991 (Dollars in thousands) Taxes on operating income: Current federal income tax $ 4,236 $ 4,926 $ 4,003 Deferred federal income tax (1,059) (1,840) (1,285) Current state income tax 1,097 1,285 1,024 Deferred state income tax 80 (329) 483 Investment tax credit adjustment (577) (641) (740) 3,777 3,401 3,485 Taxes on other income: Current federal income tax 496 598 353 Current state income tax 127 158 94 623 756 447 Total income taxes $ 4,400 $ 4,157 $ 3,932 Notes to Financial Statements NOTE 10. Taxes on Income (Continued) A reconciliation of the Company's effective income tax rates with the federal statutory rate is as follows: 1993 1992 1991 Federal statutory rate 35.0% 34.0% 34.0% State income taxes, net of federal income tax benefit 6.9 6.1 6.1 Investment credit (4.7) (5.3) (6.0) Book depreciation in excess of tax basis 2.0 1.9 1.7 AFUDC equity 0.6 0.9 0.9 Flowback of excess deferred taxes (3.6) (3.1) (6.7) Other (0.1) (0.1) 1.7 36.1% 34.4% 31.7% The items comprising deferred income tax expense are as follows: 1993 1992 1991 (Dollars in thousands) Decommissioning expense not currently deductible $ (351) $ (104) $ 14 Tax depreciation over (under) financial statement depreciation (978) (679) 955 Tax fuel amortization over (under) financial statement amortization (255) (637) (1,389) Tax loss on reacquisition of debt over (under) financial statement expense 1,887 187 178 Pension expense not currently deductible (167) (192) (562) Postemployment benefits deduction over (under) financial statement expense 67 (141) - Amortization of materials and supplies not currently deductible (335) (343) (239) Low-level waste deduction over (under) financial statement expense (596) 139 825 Flowback of excess deferred taxes (442) (376) (828) Other 191 (23) 245 $ (979) $ (2,169) $ (801) Notes to Financial Statements NOTE 10. Taxes on Income (Continued) The tax effects of temporary differences that give rise to significant portions of the deferred tax assets and deferred tax liabilities at December 31, 1993 and January 1, 1993 are presented below: December 31, January 1, 1993 1993 (Dollars in thousands) Deferred tax assets: Accumulated amortization of final nuclear core $ 2,914 $ 2,559 Nuclear decommissioning liability 2,810 2,291 Regulatory liabilities 5,856 6,793 Accumulated deferred investment credit 2,830 2,984 Accumulated amortization of materials and supplies 2,281 1,851 Other 2,771 4,591 Total gross deferred tax assets 19,462 21,069 Less valuation allowance 1,231 1,142 Net deferred tax assets 18,231 19,927 Deferred tax liabilities: Plant and equipment (51,258) (51,399) Other (5,220) (5,574) Total gross deferred tax liabilities (56,478) (56,973) Net deferred tax liability (38,247) (37,046) The valuation allowance is the result of a provision in Vermont tax law which limits refunds resulting from carrybacks of net operating losses. NOTE 11. Supplemental Cash Flow Information The following information supplements the cash flow information provided in the Statements of Cash Flows: 1993 1992 1991 (Dollars in thousands) Cash paid during the year for: Interest (net of amount capitalized) $ 7,632 $ 7,062 $ 7,990 Income taxes $ 7,070 $ 6,192 $ 4,793 NOTE 12. Pension Plans The Company has two noncontributory pension plans covering substantially all of its regular employees. The Company's funding policy is to fund the net periodic pension expense accrued each year. Benefits are based on age, years of service and the level of compensation during the final years of employment. The aggregate funded status of the Company's pension plans as of December 31, 1993 and 1992 is as follows: December 31, 1993 1992 (Dollars in thousands) Vested benefits $ 8,882 $ 6,548 Nonvested benefits 1,338 918 Accumulated benefit obligation 10,220 7,466  Additional benefits related to future compensation levels 8,540 7,728 Projected benefit obligation 18,760 15,194 Fair value of plan assets, invested primarily in equities and bonds 16,343 13,791 Projected benefit obligation in excess of plan assets $ 2,417 $ 1,403 Notes to Financial Statements NOTE 12. Pension Plans (Continued) The increase in the projected benefit obligation from $15.2 million in 1992 to $18.8 million in 1993 is the result of additional service accruals, interest costs and changed plan assumptions. Certain changes in the items shown above are not recognized as they occur, but are amortized systematically over subsequent periods. Unrecognized amounts still to be amortized and the amount that is included in the balance sheet appear below. December 31, 1993 1992 (Dollars in thousands) Unrecognized net transition obligation $ 996 $1,057 Unrecognized net gain (4,086) (4,939) Pension liability included in balance sheet 4,866 4,610 Unrecognized prior service costs 641 675 Projected benefit obligation in excess of plan assets $ 2,417 $ 1,403 The following are pension plan assumptions as of December 31, 1993 and 1992: December 31, 1993 1992 Discount rate 7.0% 8.0% Compensation scale 5.5% 6.5% Expected return on assets 8.5% 8.5% Net pension expense for the three years ending December 31, 1993 included the following components: 1993 1992 1991 (Dollars in thousands) Service cost - benefits earned $ 1,141 $ 1,275 $ 1,147 Interest cost on projected benefit obligation 1,288 1,305 1,104 Actual (return) loss on plan assets (1,792) (867) (2,124) Net amortization and deferral 631 78 1,452 Net pension expense $ 1,268 $ 1,791 $ 1,579 NOTE 13. Postretirement Benefits Other Than Pensions The Company adopted Statement of Financial Accounting Standards No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions" (SFAS 106), on January 1, 1992. This statement requires companies to use accrual accounting for postretirement benefits other than pensions. Prior to 1992, the Company accrued and collected a portion of postretirement benefits costs through decommissioning billings while the remaining cost was expensed when benefits were paid. The incremental cost, above the amount collected through decommissioning billings, approximately $2.4 million, is now accrued and since January, 1992, has been included in the Company's monthly power billings to Sponsors. The Company is funding this liability by placing monies in separate trusts. In order to maximize the deductible contributions permitted under IRS regulations, the Company has amended its pension plans and established separate VEBA trusts for management and union employees. Notes to Financial Statements NOTE 13. Postretirement Benefits Other Than Pensions (Continued) In December, 1992, the FERC issued its policy statement setting forth how utilities can recover in rates the increased costs associated with the implementation of SFAS 106. The policy statement specifies three conditions that must be met before FERC will consider companies' election of the accrual method: (a) the Company must agree to make cash deposits to an irrevocable external trust fund, at least quarterly, in amounts that are proportional and, on an annual basis, equal to the annual test period allowance for postretirement benefits other than pensions; (b) the Company must agree to maximize the use of income tax deductions for contributions to funds of this nature; and (c) in order to recover the transition obligation, the Company must file a general rate change within three years of adoption of SFAS 106. The following table presents the plan's funded status reconciled with amounts recognized in the Company's balance sheets as of December 31, 1993 and December 31, 1992 (dollars in thousands): Accumulated postretirement benefit obligation: 1993 1992 Retirees $ 1,078 $ 1,277 Fully eligible active plan participants 921 1,332 Other active participants 8,071 9,935 Total accumulated postretirement benefit obligation 10,070 12,544 Fair value of plan assets, invested primarily in short-term investments 2,457 1,595 Accumulated postretirement benefit obligation in excess of plan assets $ 7,613 $10,949 Unrecognized net transition obligation $ 7,933 $10,314 Unrecognized net gain (1,980) (126) Accrued postretirement benefit cost  collected through decommissioning billings and included in accrued liabilities 1,660 761 Accumulated postretirement benefit obligation in excess of plan assets $ 7,613 $ 10,949 The net periodic postretirement benefit cost for 1993 and 1992 includes the following components (dollars in thousands): 1993 1992 Service cost $ 735 $ 958 Interest cost 652 941 Net amortization and deferral 350 543 Net periodic postretirement benefit cost $ 1,737 $2,442 For measurement purposes, a 15% annual rate of increase in the per capita cost of covered benefits (i.e., health care cost trend rate) was assumed for 1993; the rate was assumed to decrease gradually to 6% by the year 2001 and remain at that level thereafter. The health care cost trend rate assumption has a significant effect on the amounts reported. For example, increasing the assumed health care cost trend rates by one percentage point in each year would increase the accumulated postretirement benefit obligation as of December 31, 1993 by $2.2 million and the aggregate of the service and interest cost components of net periodic postretirement benefit cost for the year ended December 31, 1993 by $0.3 million. The weighted-average discount rate used in determining the accumulated postretirement benefit obligation was 7% at December 31, 1993. The change in the accumulated postretirement benefit obligation from $12.5 million in 1992 to $10.0 million in 1993 is the result of adjustments made to reflect a lower actual medical cost increase during 1993 than projected. The reduction in the unrecognized net transition obligation from $10.3 million in 1992 to $7.9 million in 1993 is primarily the result of elimination of Medicare Part B coverage. Notes to Financial Statements NOTE 14. Lease Commitments The Company leases equipment and systems under noncancelable operating leases. Charges against income for rentals under these leases were approximately $3.7 million, $2.6 million and $3.7 million in 1993, 1992 and 1991, respectively. Minimum future rentals as of December 31, 1993 are as follows: Annual Fiscal years ended rentals (Dollars in thousands) 1994 $ 3,283 1995 3,060 1996 2,878 1997 2,798 1998 and after 5,053 The Company has entered into an agreement with General Electric Capital Corporation to lease certain equipment being constructed by General Electric Corporation valued at approximately $29 million including installation costs. Under the lease agreement, the Company will make 120 monthly payments of $342,358 per month commencing on the later of (1) April 15, 1995 or (2) the commissioning date of the equipment. The lease will also include the sale and leaseback of a $2 million turbine rotor forging previously owned by the Company. The lease will be classified as an operating lease for accounting purposes. The construction contract requires progress payments to be paid by Vermont Yankee prior to installation of the equipment. Just prior to delivery of the equipment, the lessor will reimburse Vermont Yankee for these payments and will continue to make the remaining payments until the commencement date of the lease. During the time period subsequent to equipment delivery before the equipment is commissioned, the Company will pay interim rent to the lessor based on the amount of outstanding progress payments. The final documentation of the lease is currently being negotiated, and if a final agreement cannot be reached, the Company would be responsible for substantial termination payments. Low-level Waste In February, 1993, the Vermont Public Service Board issued an order which requires the Company to pay its share of expenses incurred by the Vermont Low Level Radioactive Waste Authority for the period April, 1993 through June, 1994, currently capped at $4.5 million. In addition, in accordance with Vermont Act 296, the order established a fund for the long-term care of any eventual Vermont low-level waste disposal facility. Based on this order, the Company must make annual payments of approximately $0.8 million into the long-term care fund. Payments made to the VLLRWA, not pertaining directly to the siting and construction of a low-level waste disposal facility, are being expensed currently. In parallel with siting a low-level radioactive waste facility in Vermont, there has been a three-state effort between Vermont, Maine, and Texas to form a compact to site such a facility in Texas. The Texas Legislature has approved, and Governor Ann Richards of Texas has signed into law, a bill that would form such a compact. On November 2, 1993, Maine voters ratified the compact. Early during its 1994 session, the Vermont Legislature is scheduled to vote to approve entry into the compact. Following approval by the Vermont Legislature, the compact will require approval of the U.S. Congress. Notes to Financial Statements NOTE 15. Commitments and Contingencies (Continued) If the compact is successful and proceeds on schedule, Vermont Yankee would begin sending its waste to a Texas facility during 1997. Under the proposed compact, Vermont would pay the State of Texas $25 million ($12.5 million when the U.S. Congress ratifies the compact and $12.5 million when the facility opens). In addition, Vermont must pay $2.5 million ($1.25 million when Congress ratifies the compact and $1.25 million when the facility is licensed) for community assistance projects in Hudspeth County, Texas, where the facility is to be located. Vermont would also pay one-third of the Texas Low-Level Radioactive Waste Disposal Compact Commission's expenses until the facility opens. The Disposal fees for generators in Vermont and Maine would then be set at a level that is the same for generators in Texas. The Company anticipates recovering the costs of the compact from sponsors. Nuclear Fuel The Company has approximately $165 million of "requirements based" purchase contracts for nuclear fuel needs to meet substantially all of its power production requirements through 2002. Under these contracts, any disruption of operating activity would allow the Company to cancel or postpone deliveries until actually needed. Insurance The Price-Anderson Act, as amended, currently limits public liability from a single incident at a nuclear power plant to $9.4 billion. Any damages beyond $9.4 billion are indemnified under an agreement with the NRC, but subject to Congressional approval. The first $200 million of liability coverage is the maximum provided by private insurance. The Secondary Financial Protection program is a retrospective insurance plan providing additional coverage up to $9.2 billion per incident by assessing retrospective premiums of $79.3 million against each of the 116 reactor units that are currently subject to the Program in the United States, limited to a maximum assessment of $10 million per incident per nuclear unit in any one year. The maximum assessment is to be adjusted at least every five years to reflect inflationary changes. The above insurance covers all workers employed at nuclear facilities prior to January 1, 1988, for bodily injury claims. The Company has purchased a Master Worker insurance policy with limits of $200 million with one automatic reinstatement of policy limits to cover workers employed on or after January 1, 1988. Vermont Yankee's estimated contingent liability for a retrospective premium on the Master Workers policy as of December, 1993 is $3.1 million. The Secondary Financial Protection program referenced above provides coverage in excess of the Master Worker policy. Insurance has been purchased from Nuclear Electric Insurance Limited (NEIL II) to cover the costs of property damage, decontamination or premature decommissioning resulting from a nuclear incident. All companies insured with NEIL II are subject to retroactive assessments if losses exceed the accumulated funds available to NEIL II. The maximum potential assessment against the Company with respect to losses arising during the current policy year is $5.8 million at the time of a first loss and $12.3 million at the time of a subsequent loss. The Company's liability for the retrospective premium adjustment for any policy year ceases six years after the end of that policy year unless prior demand has been made. Notes to Financial Statements VERMONT YANKEE NUCLEAR POWER CORPORATION Schedule I Marketable Securities - Other Investments (Dollars in Thousands) __________________________________________________________________________ Name of Issuer and Number Cost of Market Amount Title of Each Issue of Shares Each Value of at Which or Units Issue Each Each Principal * Issue Portfolio Amounts of at of Equity Bonds and 12/31/93 Security Notes Issues and Each Other Security Issue Is Carried on the Balance Sheet __________________________________________________________________________ Decommissioning fund: U.S. Treasury obligations $ 16,252 $ 17,262 $ 18,666 $ 17,262 Municipal obligations 78,055 79,755 84,576 79,755 Money market funds and Accrued Interest 1,863 1,863 1,863 1,863 $ 96,170 $ 98,880 $105,105 $ 98,880 Disposal fee defeasance fund: Short-term investments $ 40,200 $ 39,870 $ 39,870 $ 39,870 Corporate bonds and notes 3,200 3,195 3,083 3,195 Money market funds and Accrued Interest 419 419 419 419 $ 43,819 $ 43,484 $ 43,372 $ 43,484 * Cost includes accrued interest and amortization of premiums and discounts. VERMONT YANKEE NUCLEAR POWER CORPORATION Schedule V - Property, Plant and Equipment Years Ended December 31, 1993, 1992, and 1991 ($000) 1993 1992 1991 Electric Plant: Land and land rights $ 1,397 $ 1,127 $ 984 Structures and improvements 61,887 61,868 61,515 Reactor, turbogenerator and accessory equipment 304,388 292,561 285,808 Transmission equipment 5,948 5,606 6,141 Other 1,116 1,116 1,116 Construction work in progress 597 6,408 4,188 375,333 368,686 359,752 Nuclear Fuel: Assemblies in reactor 69,063 74,025 83,213 Fuel in process - 5,236 637 Fuel in stock - - 22,863 Spent fuel 287,700 259,199 227,040 356,763 338,460 333,753 Total $732,096 $707,146 $693,505 Neither total additions of $25,361,000, $15,167,000 or $25,002,000 nor total retirements of $411,000, $1,526,000, or $0 for the years ended December 31, 1993, 1992 and 1991, respectively, exceeded 10% of the utility plant balance at the end of the year. VERMONT YANKEE NUCLEAR POWER CORPORATION Schedule VI - Accumulated Depreciation, Depletion and Amortization of Property, Plant and Equipment Years Ended December 31, 1993, 1992 and 1991 (Dollars in Thousands) Additions Other Balance Charged to Charges Balance Beginning Costs and and At End of Year Expenses Retirements (Deduct) of Year Accumulated depreciation of electric plant: (F1) 1993 185,263 13,707 (411) (170) (B) 198,389 1992 173,827 13,253 (1,526) (291) (B) 185,263 1991 162,065 11,800 - ( 38) (B) 173,827 Accumulated amortization of nuclear fuel: 1993 308,848 19,526 - (4,115) (C) 324,259 1992 291,013 21,240 - (3,405) (C) 308,848 1991 270,011 24,864 - (3,862) (C) 291,013 Total accumulated depreciation and amortization 1993 494,111 33,234 (411) (4,286) 522,648 1992 464,840 34,493 (1,526) (3,696) 494,111 1991 432,076 36,664 - (3,900) 464,840 (FN) (F1) Electric plant is being depreciated on the straight-line method at rates designed to fully depreciate all depreciable properties by 2012. (See Note 1 to the financial statements). (B) Represents net salvage and removal costs. (C) Represents disposal costs of spent nuclear fuel. CONSENT OF INDEPENDENT PUBLIC ACCOUNTANTS As independent public accountants, we hereby consent to the incorporation of our report dated February 7, 1994 included or incorporated by reference in this Form 10-K, into Central Vermont Public Service Corporation's previously filed Registration Statements on Form S-8, File No. 33-22741, Form S-8, File No. 33-22742, Form S-8, File No. 33-58102, Form S-8, File No. 33-6200 and Form S-3, File No. 33-37095. ARTHUR ANDERSEN & CO. Boston, Massachusetts March 25, 1994 CONSENT OF INDEPENDENT AUDITORS The Board of Directors Central Vermont Public Service Corporation: We consent to the incorporation by reference in the Registration Statement on Form S-8, File No. 33-22741, Form S-8, File No. 33-22742, Form S-8, File No. 33-58102, Form S-8, File No. 33-6200, and Form S-3, File No. 33-37095, of our report dated February 5, 1993 relating to the balance sheet of Vermont Yankee Nuclear Power Corporation as of December 31, 1992 and the related statements of income and retained earnings and cash flows for each of the years in the two-year period ended December 31, 1992, which report is included in the December 31, 1993 Annual Report on Form 10-K of Central Vermont Public Service Corporation. KPMG PEAT MARWICK Boston, Massachusetts March 24, 1994 EXHIBIT INDEX Each document described below is incorporated by reference to the files of the Securities and Exchange Commission, unless the reference to the document is marked as follows: * - Document has heretofore been filed with the Commission as is incorporated by reference and made a part hereof. Exhibit Number Description 3. Articles of Incorporation and By-Laws 3-1 By-Laws, as amended December 3, 1990. (Exhibit No. 3-1, 1990 10-K) 3-2 Articles of Association, as amended August 11, 1992. (Exhibit No. 3-2, 1992 10-K) 4. Instruments defining the rights of security holders including Indentures Incorporated herein by reference: B-1 Mortgage dated October 1, 1929, between the Company and Old Colony Trust Company, Trustee, securing the Company's First Mortgage Bonds. (Exhibit B-3, File No. 2-2364) B-2 Supplemental Indenture dated as of August 1, 1936, supplemental to B-1. (Exhibit B-4 File No. 2364) B-3 Copy of Supplemental Indenture dated as of November 15, 1943, supplemental to B-1. (Exhibit B-3, File No. 2-5250 B-4 Copy of Supplemental Indenture dated as of December 1, 1943, supplemental to B-1. (Exhibit No. B-4, File No. 2-5250) B-5 Copy of directors' resolutions adopted December 14, 1943, establishing the Series C Bonds and dealing with other related matters, supplemental to B-1. (Exhibit B-5, File No. 2-5250) B-6 Copy of Supplemental Indenture dated as of April 1, 1944 supplemental to B-1. (Exhibit No. B-6, File No. 2-5466) B-7 Copy of Supplemental Indenture dated as of February 1, 1945, supplemental to B-1. (Exhibit 7.6, File No. 2-5615 (22-385) B-8 Directors' resolutions adopted April 9, 1945, establishing the Series D Bonds and dealing with other matters, supplemental to B-1. (Exhibit 7.8, File No. 2-5615 (22-385) B-9 Copy of Supplemental Indenture dated as of September 2, 1947,  supplemental to B-1. (Exhibit 7.9, File No. 2-7489) B-10 Copy of Supplemental Indenture dated as of July 15, 1948, and directors' resolutions establishing the Series E Bonds and dealing with other matters, supplemental to B-1. (Exhibit 7.10, File No. 2-8388) B-11 Copy of Supplemental Indenture dated as of May 1, 1950, and directors' resolutions establishing the Series F Bonds and dealing with other matters, supplemental to B-1. (Exhibit 7.11, File No. 2-8388) B-12 Copy of Supplemental Indenture dated August 1, 1951, and and directors'resolutions, establishing the Series G Bonds and dealing with other matters, supplemental to B-1. (Exhibit 7.12, File No. 2-9073) B-13 Copy of Supplemental Indenture dated May 1, 1952, and directors' resolutions, establishing the Series H Bonds and dealing with other matters, supplemental to B-1. (Exhibit 4.3.13, File No. 2-9613) B-14 Copy of Supplemental Indenture dated as of July 10, 1953, supplemental to B-1. (July, 1953 Form 8-K) B-15 Copy of Supplemental Indenture dated as of June 1, 1954, and directors' resolutions establishing the Series K Bonds and dealing with other matters, supplemental to B-1. (Exhibit 4.2.16, File No. 2-10959) B-16 Copy of Supplemental Indenture dated as of February 1, 1957 and directors' resolutions establishing the Series L Bonds and dealing with other matters, supplemental to B-1. (Exhibit 4.2.16, File No. 2-13321) B-17 Copy of Supplemental Indenture dated as of March 15, 1960, supplemental to B-1. (March, 1960 Form 8-K) B-18 Copy of Supplemental Indenture dated as of March 1, 1962, supplemental to B-1. (March, 1962 Form 8-K) B-19 Copy of Supplemental Indenture dated as of March 2, 1964, supplemental to B-1. (March, 1964 Form 8-K) B-20 Copy of Supplemental Indenture dated as of March 1, 1965, and directors' resolutions establishing the Series M Bonds and dealing with other matters, supplemental to B-1. (April, 1965 Form 8-K) B-21 Copy of Supplemental Indenture dated as of December 1, 1966, and directors' resolutions establishing the Series N Bonds and dealing with other matters, supplemental to B-1. (January, 1967 Form 8-K) B-22 Copy of Supplemental Indenture dated as of December 1, 1967, and directors' resolutions establishing the Series O Bonds and dealing with other matters, supplemental to B-1. (December, 1967 Form 8-K)  B-23 Copy of Supplemental Indenture dated as of July 1, 1969, and directors' resolutions establishing the Series P Bonds and dealing with other matters, supplemental to B-1. (July, 1969 Form 8-K) B-24 Copy of Supplemental Indenture dated as of December 1, 1969, and directors' resolutions establishing the Series Q Bonds January, and dealing with other matters, supplemental to B-1. (January, 1970 Form 8-K) B-25 Copy of Supplemental Indenture dated as of May 15, 1971, and directors' resolutions establishing the Series R Bonds and dealing with other matters, supplemental to B-1. (May, 1971 Form 8-K) B-26 Copy of Supplemental Indenture dated as of April 15, 1973, and directors' resolutions establishing the Series S Bonds and dealing with other matters, supplemental to B-1. (May, 1973 Form 8-K) B-27 Copy of Supplemental Indenture dated as of April 1, 1975, and directors' resolutions establishing the Series T Bonds and dealing with other matters, supplemental to B-1. (April, 1975 Form 8-K) B-28 Copy of Supplemental Indenture dated as of April 1, 1977, modifying B-1. (Exhibit 2.42, File No. 2-58621) B-29 Copy of Supplemental Indenture dated as of July 29, 1977, and directors' resolutions establishing the Series U, V, W, and X Bonds and dealing with other matters, supplemental to B-1. (Exhibit 2.43, File No. 2-58621) B-30 Copy of Thirtieth Supplemental Indenture dated as of September 15, 1978, and directors' resolutions establishing the Series Y Bonds and dealing with other matters, supplemental to B-1. (Exhibit B-30, 1980 Form 10-K) B-31 Copy of Thirty-first Supplemental Indenture dated as of September 1, 1979, and directors' resolutions establishing the Series Z Bonds and dealing with other matters, supplemental to B-1. (Exhibit B-31, 1980 Form 10-K) B-32 Copy of Thirty-second Supplemental Indenture dated as of June 1, 1981, and directors' resolutions establishing the Series AA Bonds and dealing with other matters, supplemental to B-1. (Exhibit B-32, 1981 Form 10-K) B-33 Copy of Trust Indenture dated as of May 1, 1962, between the Company and Mellon National Bank and Trust Company, Trustee, relating to the Company's 4 7/8% Debentures due May 1, 1987. (Exhibit 4.2.24, File No. 2-26485) B-34 Copy of Trust Indenture dated as of May 1, 1968, between the Company and The First National Bank of Boston, Trustee, relating to the Company's 7% Debentures due May 1, 1993. (May, 1986 Form 8-K)  B-35 Copy of Trust Indenture dated as of April 1, 1970, between the Company and The First National Bank of Boston, Trustee, relating to the Company's 10 5/8% Debentures due April 1, 1995. (April, 1970 Form 8-K) B-36 Copy of Indenture of Mortgage, dated as of September 1, 1957, between Vermont Electric Power Company, Inc. ("Velco") and Bankers Trust Company, securing Velco's First Mortgage Bonds. (Exhibit (b)(1), 1957 Form 10-K) B-37 Copy of Supplemental Indenture dated as of December 1, 1958, modifying B-36. (Exhibit (b)(1), 1958 Form 10-K) B-38 Copy of Supplemental Indenture dated as of December 1, 1969, modifying B-36. (Exhibit 2.35, File 2-57458) B-39 Copy of Supplemental Indenture dated as of November 1, 1970, modifying B-36. (Exhibit 2.36, File No. 2-57458) B-40 Copy of Supplemental Indenture dated as of December 1, 1971, modifying B-36. (Exhibit 2.37, File No. 2-57458) B-41 Copy of Supplemental Indenture dated as of December 1, 1972, modifying B-36. (Exhibit 2.38, File No. 2-57458) B-42 Copy of Supplemental Indenture dated as of July 1, l974, modifying B-36. (Exhibit 2.39, File No. 2-57458) B-43 Copy of Supplemental Indenture dated as of January 1, 1975, modifying B-36. (Exhibit 2.40, File No. 2-57458) B-44 Copy of Supplemental Indenture dated as of January 1, 1979, modifying B-36. (Exhibit B-44, 1981 Form 10-K) B-45 Copy of Thirty-third Supplemental Indenture dated as of August 15, 1983, and directors' resolutions establishing the Series BB Bonds and dealing with other matters, supplemental to B-1. (Exhibit B-45, 1983 Form 10-K) B-46 Copy of Bond Purchase Agreement between Merrill, Lynch, Pierce, Fenner & Smith, Inc., Underwriters and The Industrial Development Authority of the State of New Hampshire, issuer and Central Vermont Public Service Corporation. (Exhibit B-46, 1984 Form 10-K) B-47 Copy of Thirty-Fourth Supplemental Indenture dated as of January 15, 1985, and directors' resolutions establishing the Series CC Bonds and Series DD Bonds and matters connected therewith, supplemental to B-1. (B-47, 1985 Form 10-K) B-48 Copy of Bond Purchase Agreement among Connecticut Development Authority and Central Vermont Public Service Corporation with E. F. Hutton & Company Inc. dated December 11, 1985. (Exhibit B-48, 1985 Form 10-K) B-49 Stock-Purchase Agreement between Vermont Electric Power Company, Inc. and the Company dated August 11, 1986 relative to purchase of Class C Preferred Stock. (Exhibit B-49, 1986  Form 10-K) 4-50 Copy of Thirty-Fifth Supplemental Indenture dated as of December 15, 1989 and directors' resolutions establishing the Series EE, Series FF and Series GG Bonds and matters connected therewith, supplemental to B-1. (Exhibit 4-50, 1989 Form 10-K) 4-51 Copy of Thirty-Sixth Supplemental Indenture dated as of December 10, 1990 and directors' resolutions establishing the Series HH Bonds and matters connected therewith, supplemental to B-1. (Exhibit 4-51, 1990 Form 10-K) 4-52 Copy of Thirty-Seventh Supplemental Indenture dated December 10, 1991 and directors' resolutions establishing the Series JJ Bonds and matters connected therewith, supplemental to B-1. (Exhibit 4-52, 1991 Form 10-K) * 4-53 Copy of Thirty-Eight Supplemental Indenture dated December 10, 1993 establishing Series KK, LL, MM, NN, OO supplemental to B-1 (Exhibit 4-53, 1993 Form 10-K) 10. Material Contracts (*Denotes filed herewith) Incorporated herein by reference: 10.l Copy of firm power Contract dated August 29, 1958, and supplements thereto dated September 19, 1958, October 7, 1958, and October 1, 1960, between the Company and the State of Vermont (the "State"). (Exhibit C-1, File No. 2-17184) 10.1.1 Agreement setting out Supplemental NEPOOL Understandings dated as of April 2, 1973. (Exhibit C-22, File No. 5-50198) 10.2 Copy of Transmission Contract dated June 13, 1957, between Velco and the State, relating to transmission of power. (Exhibit C-2, 1957 Form 10-K) 10.2.1 Copy of letter agreement dated August 4, 1961, between Velco and the State. (Exhibit C-3, File No. 2-26485) 10.2.2 Amendment dated September 23, 1969. (Exhibit C-4, File No. 2-38161) 10.2.3 Amendment dated March 12, 1980. (Exhibit C-92, 1982 Form 10-K) 10.2.4 Amendment dated September 24, 1980. (Exhibit C-93, 1982 Form 10-K) 10.3 Copy of subtransmission contract dated August 29, 1958, between Velco and the Company (there are seven similar contracts between Velco and other utilities). (Exhibit C-5, 1957 Form 10-K) 10.3.1 Copies of Amendments dated September 7, 196l, November 2, 1967, March 22, 1968, and October 29, 1968. (Exhibit C-6, File No. 2-32917)  10.3.2 Amendment dated December 1, 1972. (Exhibit C-91, 1982 Form 10-K) 10.4 Copy of Three-Party Agreement dated September 25, 1957, between the Company, Green Mountain and Velco. (Exhibit C-7, File No. 2-17184) 10.4.1 Superseding Three Party Power Agreement dated January 1, 1990. (Exhibit 10-201, 1990 Form 10-K) 10.4.2 Agreement Amending Superseding Three Party Power Agreement dated May 1, 1991. (Exhibit 10.4.2, 1991 Form 10-K) 10.5 Copy of firm power Contract dated December 29, 1961, between the Company and the State, relating to purchase of Niagara Project power. (Exhibit C-8, File No. 2-26485) 10.5.1 Amendment effective as of January 1, 1980. (Exhibit C-51, 1980 Form 10-K) 10.6 Copy of agreement dated July 16, 1966, and letter supplement dated July 16, 1966, between Velco and Public Service Company of New Hampshire relating to purchase of single unit power from Merrimack II. (Exhibit C-9, File No. 2-26485) 10.6.1 Copy of Letter Agreement dated July 10, 1968, modifying Exhibit A. Exhibit C-10, File No. 2-32917) 10.7 Copy of Capital Funds Agreement between the Company and Vermont Yankee dated as of February 1, 1968. (Exhibit C-11, File No. 70-4611) 10.7.1 Copy of Amendment dated March 12, 1968. (Exhibit C-12, File No. 70-4611) 10.8 Copy of Power Contract between the Company and Vermont Yankee dated as of February 1, 1968. (Exhibit C-13, File No. 70-4591) 10.8.1 Amendment dated April 15, 1983. (C-106, 1983 Form 10-K) 10.8.2 Copy of Additional Power Contract dated February 1, 1984. (Exhibit C-123, 1984 Form 10-K ) 10.8.3 Amendment No. 3 to Vermont Yankee Power Contract, dated April 24, 1985. (Exhibit 10-144, 1986 Form 10-K) 10.8.4 Amendment No. 4 to Vermont Yankee Power Contract, dated June 1, 1985. (Exhibit 10-145, 1986 Form 10-K) 10.8.5 Amendment No. 5 dated May 6, 1988. (Exhibit 10-179, 1988 Form 10-K) 10.8.6 Amendment No. 6 dated May 6, 1988. (Exhibit 10-180, 1988 Form 10-K) 10.8.7 Amendment No. 7 dated June 15, 1989. (Exhibit 10-195,  1989 Form 10-K) 10.9 Copy of Capital Funds Agreement between the Company and Maine Yankee dated as of May 20, 1968. (Exhibit C-14, File No. 70-4658) 10.9.1 Amendment No. 1 dated August 1, 1985. (Exhibit C-125, 1984 Form 10-K ) 10.10 Copy of Power Contract between the Company and Maine Yankee dated as of May 20, 1968. (Exhibit C-15, File No. 70-4658) 10.10.1 Amendment No. 1 dated March 1, 1984. (Exhibit C-112, 1984 Form 10-K) 10.10.2 Amendment No. 2 effective January 1, 1984. (Exhibit C-113, 1984 Form 10-K) 10.10.3 Amendment No. 3 dated October 1, 1984. (Exhibit C-114, 1984 Form 10-K) 10.10.4 Additional Power Contract dated February 1, 1984. (Exhibit C-126, 1985 Form 10-K) 10.11 Copy of Agreement dated January 17, 1968, between Velco and Public Service Company of New Hampshire relating to purchase of additional unit power from Merrimack II. (Exhibit C-16, File No. 2-32917) 10.12 Copy of Agreement dated February 10, 1968 between the Company and Velco relating to purchase by Company of Merrimack II unit power. (There are 25 similar agreements between Velco and other utilities.) (Exhibit C-17, File No. 2-32917) 10.13 Copy of Three-Party Power Agreement dated as of November 21, 1969, among the Company, Velco, and Green Mountain relating to purchase and sale of power from Vermont Yankee Nuclear Power Corporation. (Exhibit C-18, File No. 2-38161) 10.13.1 Amendment dated June 1, 1981. (Exhibit C-59, 1981 Form 10-K) 10.14 Copy of Three-Party Transmission Agreement dated as of November 21, 1969, among the Company, Velco, and Green Mountain providing for transmission of power from Vermont Yankee Nuclear Power Corporation. (Exhibit C-19, File No. 2-38161) 10.14.1 Amendment dated June 1, 1981. (Exhibit C-60, 1981 Form 10-K) 10.15 Copy of Stockholders Agreement dated March 29, 1957, between the Company, Velco, Green Mountain and Citizens Utilities Company. (Exhibit No. C-20, File No. 70-3558) 10.16 New England Power Pool Agreement dated as of September 1, 1971, as amended to November 1, 1975. (Exhibit C-21, File No. 2-55385)  10.16.1 Amendment dated December 31, 1976. (Exhibit C-52, 1980 Form 10-K) 10.16.2 Amendment dated January 23, 1977. (Exhibit C-53 1980 Form 10-K) 10.16.3 Amendment dated July 1, 1977. (Exhibit C-54, 1980 Form 10-K) 10.16.4 Amendment dated August 1, 1977. (Exhibit C-55, 1980 Form 10-K) 10.16.5 Amendment dated August 15, 1978. (Exhibit C-56, 1980 Form 10-K) 10.16.6 Amendment dated January 31, 1979. (Exhibit C-57 1980 Form 10-K) 10.16.7 Amendment dated Feburary 1, 1980. (Exhibit C-58, 1980 Form 10-K) 10.16.8 Amendment dated December 31, 1976. (Exhibit C-72, 1981 Form 10-K) 10.16.9 Amendment dated January 31, 1977. (Exhibit C-73, 1981 Form 10-K) 10.16.10 Amendment dated July 1, 1977. (Exhibit C-74, 1981 Form 10-K) 10.16.11 Amendment dated August 1, 1977. (Exhibit C-75, 1981 Form 10-K) 10.16.12 Amendment dated August 15, 1978. (Exhibit C-76, 1981 Form 10-K) 10.16.13 Amendment dated January 31, 1980. (Exhibit C-77, 1981 Form 10-K) 10.16.14 Amendment dated February 1, 1980. (Exhibit C-78, 1981 Form 10-K) 10.16.15 Amendment dated September 1, 1981. (Exhibit C-79 1981 Form 10-K) 10.16.16 Amendment dated December 1, 1981. (Exhibit C-80 1981 Form 10-K) 10.16.17 Amendment dated June 15, 1983. (Exhibit C-105, 1983 Form 10-K) 10.16.18 Amendment dated September 1, 1985. (Exhibit 10-160, 1986 Form 10-K) 10.16.19 Amendment dated April 30, 1987. (Exhibit 10-172, 1987 Form 10-K) 10.16.20 Amendment dated March 1, 1988. (Exhibit 10-178, 1988  Form 10-K) 10.16.21 Amendment dated March 15, 1989. (Exhibit 10-194, 1989 Form 10-K) 10.16.22 Amendment dated October 1, 1990. (Exhibit 10-203, 1990 Form 10-K) 10.16.23 Amendment dated September 15, 1992. (Exhibit 10.16.23, 1992 Form 10-K) 10.16.24 Amendment dated May 1, 1993 10.16.25 Amendment dated June 1, 1993 10.17 Agreement dated October 13, 1972, for Joint Ownership, Construction and Operation of Pilgrim Unit No. 2 among Boston Edison Company and other utilities, including the Company. (Exhibit C-23, File No. 2-45990) 10.17.1 Amendments dated September 20, 1973, and September 15, 1974. (Exhibit C-24, File No. 2-51999) 10.17.2 Amendment dated December 1, 1974. (Exhibit C-25, File No. 2-54449) 10.17.3 Amendent dated February 15, 1975., (Exhibit C-26, File No. 2-53819) 10.17.4 Amendment dated April 30, 1975. (Exhibit C-27, File No. 2-53819) 10.17.5 Amendment dated as of June 30, 1975. (Exhibit C-28, File No. 2-54449) 10.17.6 Instrument of Transfer dated as of October 1, 1974, assigning partial interest from the Company to Green Mountain Power Corporation. (Exhibit C-29, File No. 2-52177) 10.17.7 Instrument of Transfer dated as of January 17, 1975, assigning a partial interest from the Company to the Burlington Electric Department. (Exhibit C-30, File No. 2-55458) 10.17.8 Addendum dated as of October 1, 1974 by which Green Mountain Power Corporation became a party thereto. (Exhibit C-31, File No. 2-52177) 10.17.9 Addendum dated as of January 17, 1975 by which the Burlington Electric Department became a party thereto. (Ehibit C-32, File No. 2-55450) 10.17.10 Amendment 23 dated as of 1975. (Exhibit C-50, 1975 Form 10-K) 10.18 Agreement for Sharing Costs Associated with Pilgrim Unit No.2 Transmission dated October 13, 1972, among Boston Edison Company and other utilities including the Company. (Exhibit C-33, File No. 2-45990) 10.18.1 Addendum dated as of October 1, 1974, by which Green  Mountain Power Corporation became a party thereto. (Exhibit C-34, File No. 2-52177) 10.18.2 Addendum dated as of January 17, 1975, by which Burlington Electric Department became a party thereto. (Exhibit C-35, File No. 2-55458) 10.19 Agreement dated as of May 1, 1973, for Joint Ownership, Construction and Operation of New Hampshire Nuclear Units among Public Service Company of New Hampshire and other utilities, including Velco. (Exhibit C-36, File No. 2-48966) 10.19.1 Amendments dated May 24, 1974, June 21, 1974, September 25, 1974, October 25, l974, and January 31, 1975. (Exhibit C-37, File No. 2-53674) 10.19.2 Instrument of Transfer dated September 27, 1974, assigning partial interest from Velco to the Company. (Exhibit C-38, File No. 2-52177) 10.19.3 Amendments dated May 24, 1974, June 21, 1974, and September 25, 1974. (Exhibit C-81, File No. 2-51999) 10.19.4 Amendments dated October 25, 1974 and January 31, 1975. (Exhibit C-82, File No. 2-54646) 10.19.5 Sixth Amendment dated as of April 18, 1979. (Exhibit C-83, File No. 2-64294) 10.19.6 Seventh Amendment dated as of April 18, 1979. (Exhibit C-84, File No. 2-64294) 10.19.7 Eighth Amendment dated as of April 25, 1979. (Exhibit C-85, File No. 2-64815) 10.19.8 Ninth Amendment dated as of June 8, 1979. (Exhibit C-86, File No. 2-64815) 10.19.9 Tenth Amendment dated as of October 10, 1979. (Exhibit C-87, File No. 2-66334 ) 10.19.10 Eleventh Amendment dated as of December 15, 1979. (Exhibit C-88, File No.2-66492) 10.19.11 Twelfth Amendment dated as of June 16, 1980. (C-89, File No. 2-68168) 10.19.12 Thirteenth Amendment dated as of December 31, 1980. (Exhibit C-90, File No. 2-70579) 10.19.13 Fourteenth Amendment dated as of June 1, 1982.(Exhibit C-104, 1982 Form 10-K) 10.19.14 Fifteenth Amendment dated April 27, 1984. (Exhibit 10-134, 1986 Form 10-K) 10.19.15 Sixteenth Amendment dated June 15, 1984. (Exhibit 10-135, 1986 Form 10-K)  10.19.16 Seventeenth Amendment dated March 8, 1985. (Exhibit 10-136, 1986 Form 10-K) 10.19.17 Eighteenth Amendment dated March 14, 1986. (Exhibit 10-137, 1986 Form 10-K) 10.19.18 Nineteenth Amendment dated May 1, 1986. (Exhibit 10-138, 1986 Form 10-K) 10.19.19 Twentieth Amendment dated September 19, 1986. (Exhibit 10-139, 1986 Form 10-K) 10.19.20 Amendment No. 22 dated January 13, 1989. (Exhibit 10-193, 1989 Form 10-K) 10.20 Transmission Support Agreement dated as of May 1, 1973, among Public Service Company of New Hampshire and other utilities, including Velco, with respect to New Hampshire Nuclear Units. (Exhibit C-39, File No. 248966) 10.21 Sharing Agreement - 1979 Connecticut Nuclear Unit dated September 1, 1973, to which the Company is a party. (Exhibit C-40, File No. 2-50142) 10.21.1 Amendment dated as of August 1, 1974. (Exhibit C-41, File No. 2-51999) 10.21.2 Instrument of Transfer dated as of February 28, 1974, transferring partial interest from the Company to Green Mountain. (Exhibit C-42, File No. 2-52177) 10.21.3 Instrument of Transfer dated January 17, 1975, transferring a partial interest from the Company to Burlington Electric Department. (Exhibit C-43, File No. 2-55458) 10.21.4 Amendment dated May 11, 1984. (Exhibit C-110, 1984 Form 10-K) 10.22 Preliminary Agreement dated as of July 5, 1974, with respect to 1981 Montague Nuclear Generating Units. (Exhibit C-44, File No. 2-51733) 10.22.1 Amendment dated June 30, 1975. (Exhibit C-45, File No. 2-54449) 10.23 Agreement for Joint Ownership, Construction and Operation of William F. Wyman Unit No. 4 dated November 1, 1974, among Central Maine Power Company and other utilities including the Company. (Exhibit C-46, File No. 2-52900) 10.23.1 Amendment dated as of June 30, 1975. (Exhibit C-47, File No. 2-55458) 10.23.2 Instrument of Transfer dated July 30, 1975, assigning a partial interest from Velco to the Company. (Exhibit C-48, File No. 2-55458)  10.24 Transmission Agreement dated November 1, 1974, among Central Maine Power Company and other utilities including the Company with respect to William F. Wyman Unit No. 4. (Exhibit C-49, File No. 2-54449) 10.25 Copy of Power Contract between the Company and Yankee Atomic dated as of June 30, 1959. (Exhibit C-61, 1981 Form 10-K) 10.25.1 Revision dated April 1, 1975. (Exhibit C-61, 1981 Form 10-K) 10.25.2 Amendment dated May 6, 1988. (Exhibit 10-181, 1988 Form 10-K) 10.25.3 Amendment dated June 26, 1989. (Exhibit 10-196, 1989 Form 10-K) 10.25.4 Amendment dated July 1, 1989. (Exhibit 10-197, 1989 Form 10-K) 10.25.5 Amendment dated February 1, 1992 (Exhibit 10.25.5, 1992 Form 10-K) 10.26 Copy of Transmission Contract between the Company and Yankee Atomic dated as of June 30, 1959. (Exhibit C-63, 1981 Form 10-K) 10.27 Copy of Power Contract between the Company and Connecticut Yankee dated as of June 1, 1964. (Exhibit C-64, 1981 Form 10-K) 10.27.1 Supplementary Power Contract dated March 1, 1978. (Exhibit C-94, 1982 Form 10-K) 10.27.2 Amendment dated August 22, 1980. (Exhibit C-95 1982 Form 10-K) 10.27.3 Amendment dated October 15, 1982. (Exhibit C-96, 1982 Form 10-K) 10.27.4 Second Supplementary Power Contract dated April 30, 1984. (Exhibit C-115, 1984 Form 10-K) 10.27.5 Additional Power Contract dated April 30, 1984. (Exhibit C-116, 1984 Form 10-K) 10.28 Copy of Transmission Contract between the Company and Connecticut Yankee dated as of July 1, 1964. (Exhibit C-65 1981 Form 10-K) 10.29 Copy of Capital Funds Agreement between the Company and Connecticut Yankee dated as of July 1, 1964. (Exhibit C-66, 1981 Form 10-K) 10.29.1 Copy of Capital Funds Agreement between the Company and Connecticut Yankee dated as of September 1, 1964. (Exhibit C-67, 1981 Form 10-K)  10.30 Copy of Five-Year Capital Contribution Agreement between the Company and Connecticut Yankee dated as of November 1, 1980. (Exhibit C-68, 1981 Form 10-K) 10.31 Form of Guarantee Agreement dated as of November 7, 1981, among certain banks, Connecticut Yankee and the Company, relating to revolving credit notes of Connecticut Yankee. (Exhibit C-69, 1981 Form 10-K) 10.32 Form of Guarantee Agreement dated as of November 13, 1981, between The Connecticut Bank and Trust Company, as Trustee, and the Company, relating to debentures of Connecticut Yankee. (Exhibit C-70, 1981 Form 10-K) 10.33 Form of Guarantee Agreement dated as of November 5, 1981, between Bankers Trust Company, as Trustee of the Vernon Energy Trust, and the Company, relating to Vermont Yankee Nuclear Fuel Sale Agreement. (Exhibit C-71, 1981 Form 10-K) 10.34 Preliminary Vermont Support Agreement re Quebec Interconnection between Velco and among seventeen Vermont Utilities dated May 1, 1981. (Exhibit C-97, 1982 Form 10-K) 10.34.1 Amendment dated June 1, 1982. (Exhibit C-98, 1982 Form 10-K) 10.35 Vermont Participation Agreement for Quebec Interconnection between Velco and among seventeen Vermont Utilities dated July 15, 1982. (Exhibit C-99, 1982 Form 10-K) 10.35.1 Amendment No. 1 dated January 1, 1986. (Exhibit C-132, 1986 Form 10-K) 10.36 Vermont Electric Transmission Company Capital Funds Support Agreement between Velco and among sixteen Vermont Utilities dated July 15, 1982. (Exhibit C-100, 1982 Form 10-K) 10.37 Vermont Transmission Line Support Agreement, Vermont Electric Transmission Company and twenty New England Utilities dated December 1, 1981, as amended by Amendment No. 1 dated June 1, 1982, and by Amendment No. 2 dated November 1, 1982. (Exhibit C-101, 1982 Form 10-K) 10.37.1 Amendment No. 3 dated January 1, 1986. (Exhibit 10-149, 1986 Form 10-K) 10.38 Phase 1 Terminal Facility Support Agreement between New England Electric Transmission Corporation and twenty New England Utilities dated December 1, 1981, as amended by Amendment No. 1 dated as of June 1, 1982 and by Amendment No. 2 dated as of November 1, 1982. (Exhibit C-102, 1982 Form 10-K) 10.39 Power Purchase Agreement between Velco and CVPS dated June 1, 1981. (Exhibit C-103, 1982 Form 10-K) 10.40 Agreement for Joint Ownership, Construction and Operation of the Joseph C. McNeil Generating Station by and between City of Burlington Electric Department, Central Vermont Realty, Inc.  and Vermont Public Power Supply Authority dated May 14, 1982. (Exhibit C-107, 1983 Form 10-K 10.40.1 Amendment No. 1 dated October 5, 1982. (Exhibit C-108, 1983 Form 10-K) 10.40.2 Amendment No. 2 dated December 30, 1983. (Exhibit C-109, 1983 Form 10-K) 10.40.3 Amendment No. 3 dated January 10, 1984. (Exhibit 10-143, 1986 Form 10-K) 10.41 Transmission Service Contract between Central Vermont Public Service Corporation and The Vermont Electric Generation & Transmission Cooperative, Inc. dated May 14, 1984. (Exhibit C-111, 1984 Form 10-K) 10.42 Copy of Highgate Transmission Interconnection Preliminary Support Agreement dated April 9, 1984. (Exhibit C-117, 1984 Form 10-K) 10.43 Copy of Allocation Contract for Hydro-Quebec Firm Power dated July 25, 1984. (Exhibit C-118, 1984 Form 10-K) 10.43.1 Tertiary Energy for Testing of the Highgate HVDC Station Agreement, dated September 20, 1985. (Exhibit C-129, 1985 Form 10-K) 10.44 Copy of Highgate Operating and Management Agreement dated August 1, 1984. (Exhibit C-119, 1986 Form 10-K) 10.44.1 Amendment No. 1 dated April 1, 1985. (Exhibit 10-152, 1986 Form 10-K) 10.44.2 Amendment No. 2 dated November 13, 1986. (Exhibit 10-167, 1987 Form 10-K) 10.44.3 Amendment No. 3 dated January 1, 1987. (Exhibit 10-168, 1987 Form 10-K) 10.45 Copy of Highgate Construction Agreement dated August 1, 1984. (Exhibit C-120, 1984 Form 10-K) 10.45.1 Amendment No. 1 dated April 1, 1985. (Exhibit 10-151, 1986 Form 10-K) 10.46 Copy of Agreement for Joint Ownership, Construction and Operation of the Highgate Transmission Interconnection. (Exhibit C-121, 1984 Form 10-K) 10.46.1 Amendment No. 1 dated April 1, 1985. (Exhibit 10-153, 1986 Form 10-K) 10.46.2 Amendment No. 2 dated April 18, 1985. (Exhibit 10-154, 1986 Form 10-K) 10.46.3 Amendment No. 3 dated February 12, 1986. (Exhibit 10-155, 1986 Form 10-K)  10.46.4 Amendment No. 4 dated November 13, 1986. (Exhibit 10-169, 1987 Form 10-K) 10.46.5 Amendment No. 5 and Restatement of Agreement dated January 1, 1987. (Exhibit 10-170, 1987 Form 10-K) 10.47 Copy of the Highgate Transmission Agreement dated August 1, 1984. (Exhibit C-122, 1984 Form 10-K) 10.48 Copy of Preliminary Vermont Support Agreement Re: Quebec Interconnection - Phase II dated September 1, 1984. (Exhibit C-124, 1984 Form 10-K) 10.48.1 First Amendment dated March 1, 1985. (Exhibit C-127, 1985 Form 10-K) 10.49 Vermont Transmission and Interconnection Agreement between New England Power Company and Central Vermont Public Service Corporation and Green Mountain Power Corporation with the consent of Vermont Electric Power Company, Inc., dated May 1, 1985. (Exhibit C-128, 1985 Form 10-K) 10.50 Service Contract Agreement between the Company and the State of Vermont for distribution and sale of energy from St. Lawrence power projects ("NYPA Power") dated as of June 25, 1985. (Exhibit C-130, 1985 Form 10-K) 10.50.1 Lease and Operating Agreement between the Company and the State of Vermont dated as of June 25, 1985. (Exhibit C-131, 1985 Form 10-K) 10.51 System Sales & Exchange Agreement Between Niagara Mohawk Power Corporation and Central Vermont Public Service Corporation dated October 1, 1986. (Exhibit C-133, 1986 Form 10-K) 10.52 Agreement of Purchase & Sale of 1.59096% Seabrook Ownership between Central Vermont Public Service Corporation and Eastern Utilities Associates dated February 19, 1986. (Exhibit 10-140, 1986 Form 10-K) 10.52.1 Addendum dated June 27, 1986. (Exhibit 10-141, 1986 Form 10-K) 10.53 Agreement between Bangor Hydro-Electric Company, Central Maine Power Company, Central Vermont Public Service Corporation, Fitchburg Gas and Electric Light Company, Maine Public Service Company and EUA Power Corporation dated October 20, 1986 conveying interests in transmission project facilities related to Seabrook. (Exhibit 10-142, 1986 Form 10-K) 10.54 Transmission Agreement between Vermont Electric Power Company, Inc. and Central Vermont Public Service Corporation dated January 1, 1986. (Exhibit 10-146, 1986 Form 10-K) 10.55 1985 Four Party Agreement between Vermont Electric Power Company, Central Vermont Public Service Corporation, Green Mountain Power Corporation and Citizens Utilities dated July 1, 1985. (Exhibit 10-146, 1986 Form 10-K)  10.55.1 Amendment dated February 1, 1987. (Exhibit 10-171, 1987 Form 10-K) 10.56 1985 Option Agreement between Vermont Electric Power Company, Central Vermont Public Service Corporation, Green Mountain Power Corporation and Citizens Utilities dated December 27, 1985. (Exhibit 10-148, 1986 Form 10-K) 10.56.1 Amendment No. 1 dated September 28, 1988. (Exhibit 10-182, 1988 Form 10-K) 10.56.2 Amendment No. 2 dated October 1, 1991. (Exhibit 10.56.2, 1991 Form 10-K) 10.57 Highgate Transmission Agreement dated August 1, 1984 by and between the owners of the project and the Vermont electric distribution companies. (Exhibit 10-156, 1986 Form 10-K) 10.57.1 Amendment No. 1 dated September 22, 1985. (Exhibit 10-157, 1986 Form 10-K) 10.58 Vermont Support Agency Agreement re: Quebec Interconnection - Phase II between Vermont Electric Power Company, Inc. and participating Vermont electric utilities dated June 1, 1985. (Exhibit 10-158, 1986 Form 10K) 10.58.1 Amendment No. 1 dated June 20, 1986. (Exhibit 10-159, 1986 Form 10-K) 10.59 Indemnity Agreement B-39 dated May 9, 1969 with amendments 1-16 dated April 17, 1970 thru April 16, 1985 between licensees of Millstone Unit No. 3 and the Nuclear Regulatory Commission. (Exhibit 10-161, 1986 Form 10-K) 10.59.1 Amendment No. 17 dated November 25, 1985. (Exhibit 10-162, 1986 Form 10-K) 10.60 Memorandum of Understanding by and between The Champlain Pipeline Company and Northern New England Gas Corporation, Noverco Corporation and Central Vermont Equity Corporation dated February 2, 1987. (Exhibit 10-163, 1987 Form 10-K) 10.60.1 Amendment No. 1 dated April 10, 1987. (Exhibit 10-164, 1987 Form 10-K) 10.60.2 Assignment Agreement by and between CV Energy Resources, Inc. and CV Champlain Investments, Inc. dated December 31, 1987. (Exhibit 10-165, 1987) 10.61 General Partnership Agreement re: Champlain Pipeline Partnership dated January 1, 1988 by and between Noverco, Northern New England Gas Corporation, CV Energy Resources, Inc. and Providence Energy Corporation. (Exhibit 10-166, 1987 Form 10-K) 10.62 Contract for the Sale of 50MW of firm power between Hydro-Quebec and Vermont Joint Owners of Highgate Facilities dated February 23, 1987. (Exhibit 10-173, 1987 Form 10-K)  10.63 Interconnection Agreement between Hydro-Quebec and Vermont Joint Owners of Highgate facilities dated February 23, 1987. (Exhibit 10-174, 1987 Form 10-K) * 10.63.1 Amendment dated September 1, 1993 (Exhibit 10.63.1, 1993 Form 10-K) 10.64 Firm Power and Energy Contract by and between Hydro-Quebec and Vermont Joint Owners of Highgate for 500MW dated December 4, 1987. (Exhibit 10-175, 1987 Form 10-K) 10.64.1 Amendment No. 1 dated August 31, 1988. (Exhibit 10-191, 1988 Form 10-K) 10.64.2 Amendment No. 2 dated September 19, 1990. (Exhibit 10-202, 1990 Form 10-K) 10.64.3 Firm Power & Energy Contract dated January 21, 1993 by and between Hydro-Quebec and Central Vermont Public Service Corporation for the sale back of 25 MW of power. (Exhibit 10.64.3, 1992 Form 10-K) 10.64.4 Firm Power & Energy Contract dated January 21, 1993 by and between Hydro-Quebec and Central Vermont Public Service Corporation for the sale back of 50 MW of power. (Exhibit 10.64.4, 1992 Form 10-K) 10.65 Settlement Agreement between EUA Power Corporation, Bangor Hydro-Electric Company, Central Maine Power Company, Central Vermont Public Service Corporation and Maine Public Service Company dated January 31, 1988 re: Seabrook real estate. (Exhibit 10-176, 1988 Form 10-K) 10.66 Hydro-Quebec Participation Agreement dated April 1, 1988 for 600 MW between Hydro-Quebec and Vermont Joint Owners of Highgate. (Exhibit 10-177, 1988 Form 10-K) 10.67 Sale of firm power and energy (54MW) between Hydro-Quebec and Vermont Utilities dated December 29, 1988. (Exhibit 10-183, 1988 Form 10-K) EXECUTIVE COMPENSATION PLANS AND ARRANGEMENTS 10.68 Stock Option Plan for Non-Employee Directors dated July 18, 1988. (Exhibit 10-184, 1988 Form 10-K) 10.69 Stock Option Plan for Key Employees dated July 18, 1988. (Exhibit 10-185, 1988 Form 10-K) 10.70 Officers Supplemental Insurance Plan authorized July 9, 1984. (Exhibit 10-186, 1988 Form 10-K) 10.71 Officers Supplemental Deferred Compensation Plan dated November 4, 1985. (Exhibit 10-187, 1988 Form 10-K) 10.72 Directors' Supplemental Deferred Compensation Plan dated November 4, 1985. (Exhibit 10-188, 1988 Form 10-K)  10.73 Management Incentive Compensation Plan as adopted September 9, 1985. (Exhibit 10-189, 1988 Form 10-K) 10.73.1 Revised Management Incentive Plan as adopted February 5, 1990. (Exhibit 10-200. 1989 Form 10-K) 10.74 Officers' Change of Control Agreements as approved October 3, 1988. (Exhibit 10-190, 1988 Form 10-K) * 10.78 Stock Option Plan for Non-Employee Directors dated April 30, 1993 (Exhibit 10.78, 1993 Form 10-K) * 10.79 Officers Insurance Plan dated November 15, 1993 (Exhibit 10.79, 1993 Form 10-K) * 10.80 Directors'Supplemental Deferred Compensation Plan dated (Exhibit 10.80, 1993 Form 10-K) * 10.81 Officers' Supplemental Deferred Compensation Plan dated (Exhibit 10.81, 1993 Form 10-K) -------------------------------------------- 10.75 Receivables Purchase Agreement between Central Vermont Public Service Corporation, Central Vermont Public Service Corporation as Service Agent and The First National Bank of Boston dated November 29, 1988. (Exhibit 10-192, 1988 Form 10-K) * 10.75.1 Agreement Amendment No. 1 dated December 21, 1988 (Exhibit 10.75.1, 1993 Form 10-K) * 10.75.2 Letter Agreement dated December 4, 1989 (Exhibit 10.75.2, 1993 Form 10-K) * 10.75.3 Agreement Amendment No. 2 dated November 29, 1990 (Exhibit 10.75.3, 1993 Form 10-K) * 10.75.4 Agreement Amendment No. 3 dated November 29, 1991 (Exhibit 10.75.4, 1993 Form 10-K) * 10.75.5 Agreement Amendment No. 4 dated November 29, 1992 (Exhibit 10.75.5, 1993 Form 10-K) 10.76 Power Purchase Agreement with Bonneville Pacific Corporation, Unit I, dated November 15, 1989. (Exhibit 10-198, 1989 Form 10-K) 10.77 Power Purchase Agreement with Bonneville Pacific Corporation, Unit II, dated November 15, 1989. (Exhibit 10-199, 1989 Form 10-K) * 10.82 Transmission Service Agreement between this Company and Green Mountain Power Corporation dated September 1, 1993 (Exhibit 10.82, 1993 Form 10-K) 11. Not applicable. 12. Not applicable. 13. 1992 Annual Report to Stockholders * 13.1 Portions of the Annual Report to Stockholders of Central Vermont Public Service Corporation that have been incorporated by reference under Items 6, 7 and 8 16. Change in certifying accountant (July 1, 1985 Form 8-K) 18. Letter re change in accounting principles (1980 3rd Quarter Form 10-Q) 21. Subsidiaries of the Registrant * 21.1 List of subsidiaries of registrant SIGNATURES Pursuant to the requirements of Section 13 or 15(d) 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. CENTRAL VERMONT PUBLIC SERVICE CORPORATION By /s/ Thomas C. Webb Thomas C. Webb, President and Chief Executive Officer By /s/ Robert H. Young Robert H. Young, Executive Vice President - Chief Operating Officer and Principal Financial Officer By /s/ James M. Pennington James M. Pennington, Controller and Principal Accounting Officer March 14, 1994 Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated. March 14, 1994 /s/ Frederic H. Bertrand Frederic H. Bertrand Director March 14, 1994 /s/ Robert P. Bliss, Jr. Robert P. Bliss, Jr. Director March 14, 1994 /s/ Elizabeth Coleman Elizabeth Coleman Director March 14, 1994 /s/ Luther F. Hackett Luther F. Hackett Director March 14, 1994 /s/ F. Ray Keyser, Jr. F. Ray Keyser, Jr. Director March 14, 1994 /s/ Mary Alice McKenzie Mary Alice McKenzie Director March 14, 1994 /s/ Gordon P. Mills Gordon P. Mills Director March 14, 1994 /s/ Preston Leete Smith Preston Leete Smith Director March 14, 1994 /s/ Robert D. Stout Robert D. Stout Director March 14, 1994 /s/ Thomas C. Webb Thomas C. Webb Director SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 FORM 10-K Annual Report Pursuant to Section 13 of 15(d) of the Securities Exchange Act of 1934 For the fiscal year ended Commission File No. 1-8222 December 31, 1993 CENTRAL VERMONT PUBLIC SERVICE CORPORATION EXHIBITS TO 1993 FORM 10-K INDEX List of Exhibits 1993 Form 10-K 4-53 Copy of Thirty-Eight Supplemental Indenture dated December 10, 1993 establishing Series KK, LL, MM, NN, OO supplemental to B-1 10.16.24 Amendment dated May 1, 1993. 10.16.25 Amendment dated June 1, 1993 10.63.1 Amendment dated September 1, 1993 10.75.1 Agreement Amendment No. 1 dated December 21, 1988 10.75.2 Letter Agreement dated December 4, 1989 10.75.3 Agreement Amendment No. 2 dated November 29, 1990 10.75.4 Agreement Amendment No. 3 dated November 29, 1991 10.75.5 Agreement Amendment No. 4 dated November 29, 1992 10.78 Stock Option Plan for Non-Employee Directors dated April 30, 10.79 Officers Insurance Plan dated November 15, 1993 10.80 Directors'Supplemental Deferred Compensation Plan dated January 1, 1990 10.81 Officers' Supplemental Deferred Compensation Plan dated January 1, 1990 10.82 Transmission Service Agreement between this Company and Green Mountain Power Corporation dated September 1, 1993 13 Annual Report to Security holders 13.1 Portions of the Annual Report to Stockholders of Central Vermont Public Service Corporation that have been incorporated by reference under Items 6, 7 and 8 18. Letter re change in accounting principles (1980 3rd Quarter Form 10-Q) 21. Subsidiaries of the Registrant * 21.1 List of subsidiaries of registrant

95304_1993.txt

95304

1993

ITEM 3. LEGAL PROCEEDINGS In April 1993, Sun Company, Inc. (R&M) ("Sun (R&M)"), a wholly owned subsidiary of the Company, was advised by the Department of Justice, Environmental Enforcement Division ("DOJ") and the United States Environmental Protection Agency ("EPA") that they contemplated the filing of a lawsuit against Sun, seeking civil penalties and certain remedial action regarding certain alleged violations of federal and state air emissions regulations at its Philadelphia refinery. Sun (R&M) has participated in discussions with the DOJ and EPA in an effort to review and settle these allegations. A settlement in principle has been reached, and it is anticipated that any negotiated settlement will involve the payment of a civil fine in excess of $100,000 and an additional obligation to undertake certain remedial activities at the facility. Sun and several other energy companies have been negotiating with the New York Department of Environmental Compliance ("NY DEC") regarding the terms of certain environmental remediation which the NY DEC is requiring to be conducted at certain facilities owned by Sun and other energy companies in Syracuse, NY. The companies and the NY DEC are discussing the provisions of the draft consent agreement. However, should these negotiations prove unsuccessful, the NY DEC has indicated that it will issue administrative action against Sun and the other energy companies to seek to compel environmental remediation at the facilities, and to seek civil penalties in excess of $100,000. On March 17, 1992, Region III of the EPA issued a Compliance Order to Sun (R&M) as a result of Sun (R&M)'s inability to meet the deadline for implementing required marine vapor controls pertaining to the loading of benzene at its refinery in Marcus Hook, Pennsylvania. The deadline was missed primarily because of the need to resolve several related matters with the U.S. Coast Guard. Although a civil settlement in principle was reached with EPA whereby Sun (R&M) expects to make a payment in excess of $100,000, the negotiated consent decree has not yet been signed by the government, pending the resolution of certain issues involving the testing and monitoring procedures related to Sun's vapor recovery system. On July 7, 1992, the EPA issued a Complaint and Compliance Order to Cordero Mining Co. ("Cordero"), then a wholly owned subsidiary of the Company, alleging violations of the Resource Conservation and Recovery Act with regard to the handling and disposal of spent solvents. The EPA had sought a civil penalty in excess of $100,000 from Cordero. On June 4, 1993, the Company completed the divestment of all of the common stock of Cordero. Many other legal and administrative proceedings are pending against Sun. Although the ultimate outcome of these proceedings cannot be ascertained at this time, it is reasonably possible that some of them could be resolved unfavorably to Sun. Management of Sun believes that any liabilities which may arise from such proceedings, including those discussed above, would not be material in relation to the consolidated financial position of Sun at December 31, 1993. ITEM 4.

ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS None. EXECUTIVE OFFICERS OF SUN COMPANY, INC. NAME, AGE AND PRESENT POSITION WITH SUN COMPANY, INC. ---------------------- BUSINESS EXPERIENCE DURING PAST FIVE YEARS -------------------------- Robert M. Aiken, Jr., 51 Senior Vice President and Chief Financial Officer Mr. Aiken was named to his present position in May 1992. From September 1990 until May 1992, he held the position of Senior Vice President, Finance, and from April 1979 to September 1990, he was Comptroller. Robert H. Campbell, 56 Chairman of the Board, Chief Executive Officer and President Mr. Campbell was elected Chairman of the Board in May 1992, Chief Executive Officer in September 1991 and President and Chief Operating Officer in February 1991. From November 1988 to February 1991, he was Executive Vice President. He has been a Director since November 1988. Richard L. Cartlidge, 39 Comptroller Mr. Cartlidge has been in his present position since October 1991. From July 1989 to October 1991, he was Controller of Sun's domestic refining and marketing subsidiary, and from 1988 to July 1989, Manager, Corporate Financial Analysis. Jack L. Foltz, 58 Vice President and General Counsel Mr. Foltz has been in his present position since October 1992, and from December 1991 to October 1992, he was Assistant General Counsel, Refining and Marketing. From December 1989 to December 1991, he was Vice President and General Counsel, Sun Refining and Marketing Company. From 1985 to December 1989, he was Assistant General Counsel, Sun Company, Inc. NAME, AGE AND PRESENT POSITION WITH SUN COMPANY, INC. ---------------------- BUSINESS EXPERIENCE DURING PAST FIVE YEARS -------------------------- David E. Knoll, 50 Senior Vice President Marketing and Logistics Mr. Knoll has been in his present position since October 1992 and from October 1991 to October 1992, he was Group Vice President, Refining and Marketing. From November 1988 to October 1991, he was President, Sun Refining and Marketing Company. Harwood S. Roe, Jr., 49 Senior Vice President Operations Mr. Roe has been in his present position since October 1992. From 1991 to October 1992, he was Vice President, Operations and from 1988 to 1991, he was Vice President, Refining of Sun's domestic refining and marketing subsidiary. Malcolm I. Ruddock, 51 Treasurer Mr. Ruddock has been in his present position since July 1989. He was Director, Finance from November 1988 to July 1989. Sheldon L. Thompson, 55 Senior Vice President and Chief Administrative Officer Mr. Thompson has been in his present position since October 1992. Prior to assuming this position, he served in various capacities within Sun's domestic refining and marketing subsidiary: from 1991 to October 1992, he was its Vice President for Chemicals, Lubricants and Technology; from 1989 to 1991, Vice President for Chemicals and Technology; and from 1988 to 1989, Vice President for Chemicals. Robert H. Writz, Jr., 51 Senior Vice President Other Businesses Mr. Writz has been in his present position since October 1992. From October 1991 to October 1992, he was Group Vice President, Additional Businesses. From February 1991 to October 1991, he was Vice President, Business Development. From 1987 to February 1991, he was Executive Vice President, Resources Group, of Suncor Inc., a subsidiary. PART II ITEM 5.

ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS Market for Sun Company, Inc. Stock and Related Security Holder Matters on page 77 of the Company's 1993 Annual Report to Shareholders is incorporated herein by reference. The market exchanges on which the Company's stock is traded are listed on the cover page of this Annual Report on Form 10-K. ITEM 6.

ITEM 6. SELECTED FINANCIAL DATA The information required by this Item is incorporated herein by reference to the Selected Financial Data on page 25 of the Company's 1993 Annual Report to Shareholders. ITEM 7.

ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The information required by this Item is incorporated herein by reference to pages 26-40 in the Company's 1993 Annual Report to Shareholders. ITEM 8.

ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA The following information in the Company's 1993 Annual Report to Shareholders is incorporated herein by reference: the Consolidated Financial Statements on pages 41-44; the Notes to Consolidated Financial Statements on pages 45-61; the Report of Independent Accountants on page 62; and Supplemental Financial and Operating Information on pages 67-73 (excluding the sections on Exploration Expenses, Revenues Per Unit of Oil and Gas Production and Average Net Oil and Gas Production) and 75-76. ITEM 9.

ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE None. PART III ITEM 10.

ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT The information on directors required by this Item is incorporated herein by reference to the Company's definitive Proxy Statement which will be filed with the Securities and Exchange Commission ("SEC") within 120 days after December 31, 1993. Information concerning the Company's executive officers appears in Part I of this Annual Report on Form 10-K. ITEM 11.

ITEM 11. EXECUTIVE COMPENSATION The information required by this Item is incorporated herein by reference to the Company's definitive Proxy Statement which will be filed with the SEC within 120 days after December 31, 1993. ITEM 12.

ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT The information required by this Item is incorporated herein by reference to the Company's definitive Proxy Statement which will be filed with the SEC within 120 days after December 31, 1993. ITEM 13.

ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS The information required by this Item is incorporated herein by reference to the Company's definitive Proxy Statement which will be filed with the SEC within 120 days after December 31, 1993. PART IV ITEM 14.

ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K (a) The following documents are filed as a part of this report: 1. Consolidated Financial Statements: The information appearing in the Company's 1993 Annual Report to Shareholders as described in Item 8 is incorporated herein by reference. 2. Financial Statement Schedules: Page ---- Report of Independent Accountants.................. 33 Schedule V - Properties, Plants and Equipment..... 34 Schedule VI - Accumulated Depreciation, Depletion and Amortization of Properties, Plants and Equipment................. 35 Schedule VIII - Valuation Accounts................. 37 Schedule IX - Short-Term Borrowings................ 38 Schedule X - Supplementary Income Statement Information.......................... 39 Other schedules are omitted because the required information is shown elsewhere in this report, is not required or is not applicable. 3. Exhibits: 3.(i) - Articles of Incorporation of Sun Company, Inc., as restated and amended. 3.(ii) - Sun Company, Inc. Bylaws, as amended July 5, 1990 (incorporated by reference to Exhibit 3(b) of the Form SE filed March 15, 1991). 4 - Instruments defining the rights of security holders of long-term debt of the Company and its subsidiaries are not being filed since the total amount of securities authorized under each such instrument does not exceed 10 percent of the total assets of the Company and its subsidiaries on a consolidated basis. The Company will provide the SEC a copy of any instruments defining the rights of holders of long- term debt of the Company and its subsidiaries upon request. 10.1* - Long-Term Incentive Plan, as amended (incorporated by reference to Exhibit 10(c) of the Form SE filed March 15, 1989). 10.2* - Executive Retirement Plan, as amended September 6, 1991 (incorporated by reference to Exhibit 10(d) of the Form SE filed March 13, 1992). 10.3* - Directors' Deferred Compensation Plan as amended and restated, effective September 5, 1991 (incorporated by reference to Exhibit 10.5 of the Form SE filed March 11, 1993). 10.4* - Deferred Compensation Plan (incorporated by reference to Exhibit 10(e) of the Form SE filed March 20, 1986, File No. 1-6841). 10.5* - Pension Restoration Plan as amended and restated effective January 1, 1991 and amended September 6, 1991 (incorporated by reference to Exhibit 10(g) of the Form SE filed March 13, 1992). 10.6* - Special Executive Severance Plan (incorporated by reference to Exhibit 10(g) of the Form SE filed March 20, 1986, File No. 1-6841). 10.7* - Executive Incentive Plan, as amended and restated, effective January 1, 1992 and revised November 5, 1992 (incorporated by reference to Exhibit 10.9 of the Form SE filed March 11, 1993). 10.8* - Sun Company, Inc. Savings Restoration Plan (incorporated by reference to Exhibit 10(j) of the Company's Annual Report on Form 10-K, as amended, for the fiscal year ended December 31, 1987, File No. 1-6841). 10.9* - Sun Company, Inc. Savings Restoration Plan II, effective April 6, 1989 (incorporated by reference to Exhibit 10(k) of the Company's Annual Report on Form 10-K, as amended, for the fiscal year ended December 31, 1989). 10.10* - Sun Company, Inc. Non-Employee Directors Retirement Plan (incorporated by reference to Exhibit 10(k) of the Company's Annual Report on Form 10-K, as amended, for the fiscal year ended December 31, 1988, File No. 1-6841). 10.11* - Sun Company, Inc. Deferred Compensation and Benefits Trust (incorporated by reference to Exhibit 10(l) of the Form SE filed March 15, 1989). 10.12* - Sun Company, Inc. Retainer Stock Plan for Outside Directors, as amended and restated effective April 1, 1992 (incorporated by reference to Exhibit 10.14 of the Form SE filed March 11, 1993). 10.13* - Sun Company, Inc. Executive Long-Term Stock Investment Plan, as amended November 1, 1993. 10.14* - Memorandum of Agreement between Alexander B. Trowbridge and Sun Company, Inc. (incorporated by reference to Exhibit 10.16 of the Form SE filed March 11, 1993). 11 - Statements re Sun Company, Inc. and Subsidiaries Computation of Per Share Earnings for the Years Ended December 31, 1993, 1992 and 1991. 12 - Statement re Sun Company, Inc. and Subsidiaries Computation of Ratio of Earnings to Fixed Charges for the Year Ended December 31, 1993. 13 - Sun Company, Inc. 1993 Annual Report to Shareholders Financial Section. 21 - Subsidiaries of Sun Company, Inc. 23 - Consent of Independent Accountants. 24.1 - Power of Attorney executed by certain officers and directors of Sun Company, Inc. 24.2 - Certified copy of the resolution authorizing certain officers to sign on behalf of Sun Company, Inc. - ----------- *These exhibits constitute the Executive Compensation Plans and Arrangements of the Company. (b) Reports on Form 8-K: The Company did not file any reports on Form 8-K during the quarter ended December 1993. A report on Form 8-K dated February 24, 1994 was filed to disclose under Item 5, "Other Events," that Sun has signed a letter of intent with Chevron U.S.A. Products Co. to purchase Chevron's 177,000- barrel-a-day Philadelphia refinery plus Chevron's one-third interest in a petroleum pipeline connecting the refinery to the New York Harbor, for approximately $170 million, including inventory. Note: Copies of each Exhibit to this Form 10-K are available upon request, at $2 per copy. SIGNATURES PURSUANT TO THE REQUIREMENTS OF SECTION 13 OR 15(D) 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. SUN COMPANY, INC. By s/ROBERT M. AIKEN, JR. Robert M. Aiken, Jr. Senior Vice President and Chief Financial Officer Date March 3, 1994 PURSUANT TO THE REQUIREMENTS OF THE SECURITIES EXCHANGE ACT OF 1934, THIS REPORT HAS BEEN SIGNED BELOW BY OR ON BEHALF OF THE FOLLOWING PERSONS ON BEHALF OF THE REGISTRANT AND IN THE CAPACITIES INDICATED ON MARCH 3, 1994: Signatures Titles ---------- ------ ROBERT M. AIKEN, JR.* Senior Vice President and Chief --------------------- Financial Officer Robert M. Aiken, Jr. (Principal Financial Officer) ROBERT H. CAMPBELL* Chairman of the Board, Chief Executive ------------------- Officer, President and Director Robert H. Campbell (Principal Executive Officer) RAYMOND E. CARTLEDGE* Director --------------------- Raymond E. Cartledge RICHARD L. CARTLIDGE* Comptroller --------------------- (Principal Accounting Officer) Richard L. Cartlidge ROBERT E. CAWTHORN* Director ------------------- Robert E. Cawthorn MARY J. EVANS* Director -------------- Mary J. Evans THOMAS P. GERRITY* Director ------------------ Thomas P. Gerrity JAMES G. KAISER* Director ---------------- James G. Kaiser THOMAS W. LANGFITT* Director ------------------- Thomas W. Langfitt R. ANDERSON PEW* Director ---------------- R. Anderson Pew ALBERT E. PISCOPO* Director ------------------ Albert E. Piscopo WILLIAM F. POUNDS* Director ------------------ William F. Pounds B. RAY THOMPSON, JR.* Director --------------------- B. Ray Thompson, Jr. ALEXANDER B. TROWBRIDGE* Director ------------------------ Alexander B. Trowbridge *By s/ROBERT M. AIKEN, JR. Individually and as Attorney-in-Fact ---------------------- Robert M. Aiken, Jr. REPORT OF INDEPENDENT ACCOUNTANTS To the Shareholders and Board of Directors, Sun Company, Inc.: Our report on the consolidated financial statements of Sun Company, Inc. and its subsidiaries has been incorporated by reference in this Form 10-K from page 62 of the Sun Company, Inc. 1993 Annual Report to Shareholders. In connection with our audits of such financial statements, we have also audited the related financial statement schedules listed in the index on page 27 of this Form 10-K. In our opinion, the financial statement schedules referred to above, when considered in relation to the basic financial statements taken as a whole, present fairly, in all material respects, the information required to be included therein. Coopers & Lybrand 2400 Eleven Penn Center Philadelphia, PA 19103 February 15, 1994 SUN COMPANY, INC. AND SUBSIDIARIES SCHEDULE VI--ACCUMULATED DEPRECIATION, DEPLETION AND AMORTIZATION OF PROPERTIES, PLANTS AND EQUIPMENT FOR THE YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991--(CONTINUED) (MILLIONS OF DOLLARS) Notes: YEARS ENDED DECEMBER 31 ----------------------- 1993 1992 1991 ---- ---- ---- (A) Depreciation, depletion and amortization.....$354 $385 $433 Leasehold impairment......................... 5 4 5 ---- ---- ---- Total additions............................ 359 389 438 Dry hole costs............................... 9 30 48 ---- ---- ---- Amounts shown in the consolidated statements of cash flows as depreciation, depletion and amortization and dry hole costs and leasehold impairment...........$368 $419 $486 ==== ==== ==== (B) A summary of the principal annual rates utilized in computing the annual provision for depreciation, depletion and amortization is not considered practicable because of the varying types of property and the rates applied thereto. (C) Includes foreign currency translation adjustments and intersegment transfers. In 1992, also includes $59 million in refining and marketing, $350 million in exploration and production and $67 million in oil sands mining attributable to a provision for write-down of assets and other matters. (See Note 2 to the Consolidated Financial Statements in the Company's 1993 Annual Report to Shareholders.) SUN COMPANY, INC. AND SUBSIDIARIES SCHEDULE VIII--VALUATION ACCOUNTS FOR THE YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 (MILLIONS OF DOLLARS) ADDITIONS BALANCE AT CHARGED TO BALANCE BEGINNING COSTS AND DEDUC- AT END OF PERIOD EXPENSES TIONS OF PERIOD ---------- ---------- ------ --------- For the year ended December 31, 1993: Deducted from asset in balance sheet--allowance for doubtful accounts and notes receivable.......... $11 $ 2 $ 2 $11 === === === === For the year ended December 31, 1992: Deducted from asset in balance sheet--allowance for doubtful accounts and notes receivable.......... $12 $ 7 $ 8 $11 === === === === For the year ended December 31, 1991: Deducted from asset in balance sheet--allowance for doubtful accounts and notes receivable.......... $11 $14 $13 $12 === === === === SUN COMPANY, INC. AND SUBSIDIARIES SCHEDULE IX--SHORT-TERM BORROWINGS FOR THE YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 (DOLLARS IN MILLIONS) MAXIMUM AVERAGE WEIGHTED AMOUNT AMOUNT AVERAGE WEIGHTED OUT- OUT- INTEREST BALANCE AVERAGE STANDING STANDING RATE AT END INTEREST DURING DURING DURING OF PERIOD RATE PERIOD PERIOD(A) PERIOD(B) --------- -------- ------- --------- --------- For the year ended December 31, 1993: Commercial paper.... $ 50 3.6% $308 $127 3.5% Amounts due to banks and others.. 60 3.5% $ 65 15 3.4% ---- ---- $110 3.5% $142 3.5% ==== ==== For the year ended December 31, 1992: Commercial paper.... $215 3.7% $307 $173 4.1% ==== ==== For the year ended December 31, 1991: Commercial paper.... $143 5.2% $340 $211 6.2% Amounts due to banks and others.. -- N/A $ 17 1 12.4% ---- ---- $143 5.2% $212 6.3% ==== ==== Notes: (A) Determined from daily balances. (B) Represents the ratio of actual interest to average amounts outstanding. SUN COMPANY, INC. AND SUBSIDIARIES SCHEDULE X--SUPPLEMENTARY INCOME STATEMENT INFORMATION FOR THE YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 (MILLIONS OF DOLLARS) 1993 1992 1991 ---- ---- ---- Maintenance and repairs........................ $223 $295 $335 ==== ==== ==== APPENDIX The Company's Management's Discussion and Analysis of Financial Condition and Results of Operations included in its 1993 Annual Report to Shareholders contains three bar charts concerning Sun's: (1) improvement in income before special items (page 26); (2) capitalization (page 37); and (3) capital expenditures (page 37). Descriptions of these bar charts have been provided within Exhibit 13.

65622_1993.txt

65622

1993

Item 1. Business General Michigan Bell Telephone Company (the "Company") is incorporated under the laws of the State of Michigan and has its principal office at 444 Michigan Avenue, Detroit, Michigan 48226 (telephone number 313-223-9900). The Company is a wholly owned subsidiary of Ameritech Corporation ("Ameritech"), a Delaware corporation. Ameritech is the parent of the Company, Illinois Bell Telephone Company, Indiana Bell Telephone Company, Incorporated, The Ohio Bell Telephone Company and Wisconsin Bell, Inc. (the "landline telephone companies"), as well as several other communications businesses, and has its principal executive offices at 30 South Wacker Drive, Chicago, Illinois 60606 (telephone number 312-750-5000). The Company is managed by its sole shareholder rather than a Board of Directors, as permitted by Michigan law. In 1993, Ameritech restructured its landline telephone companies and two other related businesses into a structure of customer-specific business units supported by a single, regionally coordinated network unit. The five Bell companies continue to function as legal entities, owning Bell company assets in each state and continue to be regulated by the individual state public utility commissions. Products and services are now marketed under a single common brand identity, "Ameritech", rather than using the "Bell" name. While the Ameritech logo is now used to identify all the Ameritech companies, the Company is sometimes regionally identified as Ameritech Michigan. The Company is engaged in the business of furnishing a wide variety of advanced telecommunications services in Michigan, including local exchange and toll service and network access services. In accordance with the Consent Decree and resulting Plan of Reorganization ("Plan") described below, the Company provides two basic types of telecommunications services within specified geographical areas termed Local Access and Transport Areas ("LATAs"), which are generally centered on a city or other identifiable community of interest. The first of these services is the transporting of telecommunications traffic between telephones and other equipment on customers' premises located within the same LATA ("intraLATA service"), which can include toll service as well as local service. The second service is providing exchange access service, which links a customer's telephone or other equipment to the network of transmission facilities of interexchange carriers which provide telecommunications service between LATAs ("interLATA service"). About 82% of the population and 42% of the area of Michigan is served by the Company. The remainder of the State is served by other telecommunications companies. The Company does not furnish local service in the areas and localities served by such companies. Muskegon is the only city of over 50,000 population in the State in which local service is furnished by a non-affiliated telephone company. The Company estimates that on December 31, 1993, non-affiliated telephone companies had approximately 794,000 customer lines in service. Other communications services offered by the Company include data transmission, transmission of radio and television programs and private line voice and data services. The following table sets forth for the Company the number of customer lines in service at the end of each year. Thousands 1993 1992 1991 1990 1989 Customer Lines in Service 4,563 4,431 4,314 4,242 4,150 XXX BEGIN PAGE 5 HERE XXX The Company has certain agreements with Ameritech Publishing, Inc. ("Ameritech Publishing"), an Ameritech business unit doing business as "Ameritech Advertising Services", under which Ameritech Publishing publishes and distributes classified directories under a license from the Company and provides services to the Company relating to both classified and alphabetical directories. Ameritech Publishing pays license fees to the Company under the agreements. See the discussion in Part II, Item 7., on page 20 for further information on the status of the agreements. Ameritech Services, Inc. ("ASI") is a company jointly owned by the Company and the other Ameritech landline telephone companies. ASI provides to those companies human resources, technical, marketing, regulatory planning and real estate asset management services, purchasing and material management support, as well as labor contract bargaining oversight and coordination. ASI acts as a shared resource for the Ameritech subsidiaries providing operational support for the landline telephone companies and integrated communications and information systems for all the business units. Ameritech Information Systems, Inc., a subsidiary of Ameritech, sells, installs and maintains business customer premises equipment and sells network and central office-based services provided by the Company and the other four landline telephone companies. It also provides expanded marketing, product support and technical design resources to large business customers in the Ameritech region. In 1993, about 90% of the total operating revenues of the Company were from telecommunications services and the remainder principally from billing and collection services, rents, directory advertising and other miscellaneous nonregulated operations. About 77% of the revenues from telecommunication services were attributable to intrastate operations. Capital Expenditures Capital expenditures represent the single largest use of Company funds. The Company has been making and expects to continue to make large capital expenditures to meet the demand for telecommunications services and to further improve such services. The total investment in telecommunications plant increased from about $6,789,500,000 at December 31, 1988, to about $7,559,000,000 at December 31, 1993, after giving effect to retirements but before deducting accumulated depreciation at either date. Capital expenditures of the Company since January 1, 1989 were approximately as follows: 1989. . . . . . . $502,000,000 1992. . . . . . . $523,000,000 1990. . . . . . . $530,000,000 1993. . . . . . . $452,000,000 1991. . . . . . . $542,000,000 Expanding on the aggressive deployment plan it began it 1992, in January 1994, Ameritech unveiled a multi-billion dollar plan for a digital network to deliver video services. Ameritech is launching a digital video network upgrade that by the end of the decade will enable six million customers in its region to access interactive information and entertainment services, as well as traditional cable TV services, from their homes, schools, offices, libraries and hospitals. The Company, for its part in the network upgrade has made an initial filing with the FCC seeking approval of the program. The filing reflects capital expenditures of approximately $55 million over the next three years. The video network concept, along with other competitive concerns, is discussed on page 20. The Company may also, depending on market demand, make additional capital expenditures under the digital video network upgrade program. In addition to the video network upgrade expenditures, other capital expenditures are expected to be about $348 million in 1994. These are part of a $2 billion, four-year program that Ameritech began in 1992 to incur construction-related costs to expand and improve Michigan's telecommunications infrastructure with technologies such as fiber optics and digital switching. Through December 31, 1993, Ameritech has spent over $1 billion in Michigan toward that program. XXX BEGIN PAGE 5 HERE XXX Consent Decree and Line of Business Restrictions On August 24, 1982, the United States District Court for the District of Columbia ("Court") approved and entered a consent decree entitled "Modification of Final Judgment" ("Consent Decree"), which arose out of antitrust litigation brought by the Department of Justice ("DOJ"), and which required American Telephone and Telegraph Company ("AT&T") to divest itself of ownership of those portions of its wholly owned Bell operating communications company subsidiaries ("Bell Companies") that related to exchange telecommunications, exchange access and printed directory advertising, as well as AT&T's cellular mobile communications business. On August 5, 1983, the Court approved a Plan of Reorganization ("Plan") outlining the method by which AT&T would comply with the Consent Decree. Pursuant to the Consent Decree and the Plan, effective January 1, 1984, AT&T divested itself of, by transferring to Ameritech, one of the seven regional holding companies ("RHCs") resulting from divestiture, its ownership of the exchange telecommunications, exchange access and printed directory advertising portions of the Ameritech landline telephone companies, as well as its regional cellular mobile communications business. The Consent Decree, as originally approved by the Court in 1982, provided that the Company (as well as the other Bell Companies) could not, directly or through an affiliated enterprise, provide interLATA telecommunications services or information services, manufacture or provide telecommunications products or provide any product or service, except exchange telecommunications and exchange access service, that is not a natural monopoly service actually regulated by tariff. The Consent Decree allowed the Company and the other Bell Companies to provide printed directory advertising and to provide, but not manufacture, customer premise equipment. The Consent Decree provided that the Court could grant a waiver to a Bell Company or its affiliates upon a showing to the Court that there is no substantial possibility that the Bell Company could use its monopoly power to impede competition in the market it seeks to enter. The Court has, from time to time, granted waivers to the Company and other Bell Companies to engage in various activities. The Court's order approving the Consent Decree provided for periodic reviews of the restrictions imposed by it. Following the first triennial review, in decisions handed down in September 1987 and March 1988, the Court continued the prohibitions against Bell Company manufacturing of telecommunications products and provision of interLATA services. The rulings allowed limited provision of information services by transmission of information and provision of information gateways, but excluded generation or manipulation of information content. In addition, the rulings eliminated the need for a waiver for entry into non-telephone related businesses. In April 1990, a Federal appeals court decision affirmed the Court's decision continuing the restriction on Bell Company entry into interLATA services and the manufacture of telecommunications equipment, but directed the Court to review its ruling that restricted RHC involvement in the information services business and to determine whether removal of the information services restriction would be in the public interest. In July 1991, the Court lifted the information services ban but stayed the effect of the decision pending outcome of the appeals process. Soon after, the stay was lifted on appeal and in July 1993, the U.S. Court of Appeals unanimously upheld the Court's order allowing the Bell Companies to produce and package information for sale across business and home phone lines. In November 1993, the U.S. Supreme Court declined to review the lower court ruling. Members of Congress and the White House are intensifying efforts to enact legislative reform of telecommunications policy in order to stimulate the development of a modern national information infrastructure to bring the benefits of advanced communications and information services to the American people. XXX BEGIN PAGE 7 HERE XXX Intrastate Rates and Regulation Prior to January 1, 1992, most of the intrastate communications services provided by the Company were subject to regulation by the Michigan Public Service Commission ("MPSC") with respect to intrastate rates and services. The MPSC prescribed a uniform system of accounts that largely parallels the one promulgated by the Federal Communications Commission and prescribed depreciation rates for the intrastate portion of the Company's assets. Effective January 1, 1992, the authority of the MPSC over many of the Company's services and asset depreciation parameters has been removed or narrowed by the new Michigan Telecommunications Act of 1991 ("MTA"), Public Act 179. Under MTA, the MPSC retains administrative responsibility for the Act and has duties such as establishing quality of service standards and investigating complaints. Effective January 1, 1992, for a four-year period, MTA replaced the 1913 Michigan Telephone Act and 1986 Public Act 305 which were scheduled to sunset December 31, 1991. A major goal of MTA was to encourage the development of a modern, high-quality telecommunications infrastructure that would allow the state to be competitive in a national and international information economy. MTA encourages the Company to commit significant investment in advanced technology by allowing new flexibility in developing and pricing telecommunications services. New services may be introduced without MPSC approval; however, the MPSC has the authority to regulate such services in the future if they are found to be adverse to the public interest. Prices of certain services such as intraLATA toll may be reduced without prior MPSC approval. MTA also allows the Company to seek a waiver from federal restrictions to provide two-way interactive video across LATA boundaries for educational services and also allows the Company to offer cable television services if permitted by federal law. The Act established a 400-call allowance for residential flat- rate local service. Calls above the 400 allowance are billed on a per- call basis, which was later approved at 6.2 cents per call. Unlimited residence flat-rate local calling is provided to persons age 60 and older, handicapped individuals and persons volunteering services to certain charitable and veterans organizations. MTA froze residential monthly basic local exchange rates for two years at rates in effect at the end of 1991. It also caps intraLATA long-distance rates for the four-year life of the Act at those in effect at the end of 1991, unless carrier access charges are increased during that period. However, the Act institutes a streamlined system for changes to basic rates, depending on the size of the change. Rate changes which do not exceed 1% less than the change in the consumer price index ("CPI") may be put in place after 90 days' notice unless the MPSC takes further action, but proposed rate changes greater than 1% less than the CPI change require MPSC approval. As a direct response to the new pricing flexibility afforded by MTA, the Company immediately reduced intraLATA message toll rates by $20 million effective January 1, 1992, with an additional reduction of over $20 million implemented on December 15, 1992. In addition, the Company made progress in reducing pricing anomalies that had resulted from the fully regulated pricing structure which had evolved over the decades before competition was introduced. Where prices did increase, primarily in discretionary services such as operator handled call surcharges and certain nonregulated services, they were to recognize increased costs and to price these services more in line with the marketplace. In the more flexible regulatory environment created by MTA, the Company introduced new products and services made possible by new technologies. Caller ID, ScanFone, and Voice Mail were three information services that became available during 1992. Caller ID helps customers identify a calling party before they answer by displaying the telephone number from which the call is made. ScanFone services uses specialized telephone equipment to pay bills and shop electronically, and Voice Mail provides electronic answering service. XXX BEGIN PAGE 8 HERE XXX Two new calling plans were introduced effective February 1, 1992. Circle Calling 20 allows seven hours of calling within a 20- mile radius of a residential customer for a charge of $20 a month. Circle Calling 30 provides a 30 percent discount on long-distance charges within a 30-mile radius and includes 30 minutes of toll calling for a fee of $3 per month. Overall, the reductions and discount plans will amount to a cut of more than 12 percent in prices residence and business customers pay for long-distance calls within LATAs. In addition, the Company introduced other new services such as Information Call Completion in which the Company will complete the call to a number supplied by an information operator for a nominal fee. Halfway through the four year life of MTA, the Company believes the record shows that the Act has been an unqualified success. MTA has been nationally recognized as progressive, forward looking legislation that has served as a model for change in other jurisdictions. MTA is scheduled to sunset on December 31, 1995. On February 16, 1993, the Company filed an application with the MPSC for approval to increase the local message charge for calls from public and semi-public coin telephones from 20 cents to 25 cents per call. The 20-cent rate has been in effect since 1976. The Company estimated the annual revenue impact of the proposal to be an increase of approximately $5.6 million after a 90-day period required to convert all coin phones to the new rate. Also on February 16, 1993, the Company filed a separate application to change the way it charges for directory assistance service. The Company proposed that changes would be implemented in three phases over a twelve-month period. In the first phase, the monthly allowance of free calls would be reduced from twenty to eight and the charge for calls over the allowance will increase from 22 cents to 35 cents per call. In the second phase, six months after MPSC approval, the calling allowance would be reduced to five calls per month, and in the final phase, six months later, the calling allowance would be reduced to three. On May 11, 1993, the MPSC issued orders on both of the applications discussed above. In the 25 cent coin telephone filing, the MPSC declined approval of the Company's proposal, finding that there was unsatisfactory resolution of the issues concerning the size of the local calling area for customer-owned customer operated coin phones and the charges for directory assistance calls made from those phones. The MPSC directed the Company to initiate a contested case proceeding under Section 203 of MTA. On August 6, 1993, the Company complied by resubmitting its February 16, 1993 application. Currently, the contested case is approximately halfway through the scheduled proceedings, with a proposal for decision by the administrative law judge anticipated in April 1994, and an MPSC order expected in June 1994. In the May 11, 1993 MPSC order related to directory assistance service, the MPSC approved portions of the Company's proposal but only under the condition that the effects of the changes be revenue neutral. Specifically, the MPSC approved the first phase of the Company's proposal which called for an increase of the per call charge from 22 cents to 35 cents and a reduction in the free call allowance from twenty to eight. The Company implemented this phase on July 1, 1993, after receiving approval of its revenue neutral plan which reduced rates in other areas, primarily access charges. The MPSC also approved a second phase of a directory assistance increase to begin six months after the first phase which increases the per call charge to 45 cents and reduces the free call allowance from eight to five per month. The Company is still in the process of developing its revenue neutral proposal related to this phase, but it is anticipated that rate reductions will again be made primarily in access charges to be effective in July 1994. The May 11, 1993 MPSC order rejected the Company's proposal for a third phase on directory assistance service which would have reduced the free call allowance from five to three per month. XXX BEGIN PAGE 9 HERE XXX FCC Regulatory Jurisdiction The Company is also subject to the jurisdiction of the Federal Communications Commission ("FCC") with respect to intraLATA interstate services, interstate access services and other matters. The FCC prescribes for communications companies a uniform system of accounts apportioning costs between regulated and non-regulated services, depreciation rates (for interstate services) and the principles and standard procedures ("separations procedures") used to separate property costs, revenues, expenses, taxes and reserves between those applicable to interstate services under the jurisdiction of the FCC and those applicable to services under the jurisdiction of the respective state regulatory authorities. For certain companies, including the Company, interstate services regulated by the FCC are covered by a price cap plan. The plan creates incentives to improve productivity over benchmark levels in order to retain higher earnings. Price cap regulation sets maximum limits on the prices that may be charged for telecommunications services but also provides for a sharing of productivity gains. Earnings in excess of 12.25% will result in prospective reduction to the price ceilings on interstate services. In January 1994, the FCC began a scheduled fourth-year comprehensive review of price cap regulation for local exchange companies. Access Charge Arrangements Interstate Access Charges. The Ameritech landline telephone companies provide access services for the origination and termination of interstate telecommunications. The access charges are of three types: common line, switched access and trunking. The common line portion of interstate revenue requirements are recovered through monthly subscriber line charges and per minute carrier common line charges. The carrier common line rates include recovery of transitional and long-term support payments for distribution to other local exchange carriers. Transitional support payments were made over a four-year period which ended on April 1, 1993. Long-term support payments will continue indefinitely. Effective January 1, 1994, rates for local transport services were restructured and a new "trunking" service category created. Trunking services consist of two types: those associated with the local transport element of switched access and those associated with special access. Trunking services associated with switched access handle the transmission of traffic between a local exchange carrier's serving wire center and a Company end office where local switching occurs. Trunking services associated with special access handle the transmission of telecommunications services between any two customer-designated premises or between a customer-designated premise and a Company end office where multiplexing occurs. High volume customers generally use the flat-rated dedicated facilities associated with special access, while usage sensitive rates apply for lower-volume customers that utilize a common switching center. Local transport rate elements for switched services assess a flat monthly rate and a mileage sensitive rate for the physical facility between the customer's point of termination and the end office, a usage sensitive and mileage sensitive rate assessed for the facilities between the end office through the access tandem to the customer's serving wire center, and a minute of use charge assessed to all local transport. The flat rate transport rates and structure generally mirror special access rate elements. Customers can order direct transport between the serving wire center or end office and the access tandem and tandem switched transport between the access tandem and the end office. Special access charges are monthly charges assessed to customers for access to interstate private line service. Charges are paid for local distribution channels, interoffice mileage and optional features and functions. XXX BEGIN PAGE 10 HERE XXX State Access Charges. Compensation arrangements required in connection with origination and termination of intrastate communications by interexchange carriers are subject to the jurisdiction of the MPSC. The Company currently provides intrastate access services to interexchange carriers pursuant to MPSC tariffs which generally parallel the terms of the interstate access tariffs. The MPSC granted authority to certain interexchange carriers to provide intrastate interLATA service and, effective January 1, 1988, intrastate intraLATA communications services in Michigan. The Company provides intraLATA access service under the same tariffs as are applicable to intrastate interLATA services. On February 24, 1994, the MPSC issued an order on intrastate intraLATA communications service. See discussion under "IntraLATA Long Distance Service Order" in Part II, Item 7., on page 19. Separate arrangements have historically governed compensation between the Company and independent telephone companies for jointly provided communications within the Company's local serving areas and associated independent telephone company exchanges. The FCC ordered, effective January 1, 1988, that Meet Point Billing be implemented. Meet Point Billing requires the local exchange carriers ("LEC's") involved to divide ordering, rating and billing services on a proportional basis, so that each carrier bills under its respective tariff. On December 21, 1989, the MPSC issued an order on access charge arrangements. The MPSC ordered that, effective January 1, 1990, all intrastate toll carriers, including the Company, purchase any necessary access services from other local exchange carriers at their access tariff rates. Competition Regulatory, legislative and judicial decisions and technological advances, as well as heightened customer interest in advanced telecommunications services, have expanded the types of available communications services and products and the number of companies offering such services. Market convergence, already a reality, is expected to intensify. The FCC has taken a series of steps that are expanding opportunities for companies to compete with local exchange carriers in providing services that fall under the FCC's jurisdiction. In September 1992, the FCC mandated that local exchange carriers provide network access for special transmission paths to competitive access providers, interexchange carriers and end users. In February 1993, Ameritech filed a tariff with the FCC, which was effective in May, making possible this type of interconnection. In August 1993, the FCC issued an order that permits competitors to interconnect to local telephone company switches. Under the new rules, certain telephone companies must allow all interested parties to terminate their switched access transmission facilities at phone company central offices, wire centers, tandem switches and certain remote nodes. Ameritech filed a tariff in November 1993 to effect that change in February 1994. Ameritech is seeking opportunities to compete on an equal footing. Although the Company is barred from providing interLATA and nation-wide cable services, its competitors are not. Cellular telephone and other wireless technologies are poised to bypass Ameritech's local access network. Cable providers, who currently serve more than eighty percent of American homes, could provide telephone service and have expressed their desire to do so. Certain interexchange carriers and competitive access providers have demonstrated interest in providing local exchange service. Ameritech's plan is to facilitate competition in the local exchange business in order to compete in the total communications marketplace. Customers First: Ameritech's Advanced Universal Access Plan In 1993, Ameritech embarked on a long-range restructuring with the intent of dramatically changing the way it serves its customers, and in the process altered its corporate framework, expanding the nature and scope of its services and supporting the development of a fully competitive marketplace. In March, Ameritech filed a plan with the FCC to change the way local telecommunications services are provided and regulated and to furnish a policy framework for advanced universal access to modern telecommunications services - voice, data and video information. XXX BEGIN PAGE 11 HERE XXX Ameritech proposes to facilitate competition in the local exchange business by allowing other service providers to purchase components of its network and to repackage them with their own services for resale, in exchange for the freedom to compete in both its existing and currently prohibited businesses. Ameritech has requested regulatory reforms to match the competitive environment as well as support of its efforts to remove restraints, such as the interLATA service restriction, which currently restrict its participation in the full telecommunications marketplace. In addition, Ameritech asks for more flexibility in pricing new and competitive services and replacement of caps on earnings with price regulation. Under the plan, customers would be able to choose from competitive providers for local service as they now can choose a provider for interexchange service. To demonstrate conclusively the substantial customer and economic benefits of full competition, in December 1993, Ameritech proposed a trial of its plan beginning in 1995. Ameritech has petitioned the DOJ to recommend Federal District Court approval of a waiver of the long-distance restriction of the Consent Decree so that Ameritech can offer interexchange service. At the same time, Ameritech would facilitate the development of local communications markets by unbundling the local network and integrating competitors' switches. The trial would begin in Illinois in the first quarter of 1995 and would last indefinitely. Other states could be added over time. If the trial is approved by the DOJ, the request must be acted on by the Court which retains jurisdiction over administering the terms of the Consent Decree. In February 1994, Ameritech filed tariffs with the Illinois Commerce Commission that propose specific rates and procedures to open the local network in that state. Approval could take up to 11 months. Ameritech has received broad support for the plan from Midwest elected officials, national and Midwest business leaders, and education, health industry, economic development and consumer leaders. The national and local offices of the Communications Workers of America ("CWA") and the International Brotherhood of Electrical Workers ("IBEW") also support the plan. Ameritech has alternative regulatory proposals pending with other state regulatory commissions in its region to support implementation of the plan. Ameritech's Video Network Concept In January 1994, Ameritech filed plans with the FCC to construct a digital video network upgrade that will enable it to reach 6 million customers by the end of the decade. Ameritech expects to spend $4.4 billion to upgrade its network to provide video services, part of a total of approximately $29 billion Ameritech estimates it will spend on network improvements over the next fifteen years. Ameritech is pursuing alliances and partnerships that will position it as a key participant in the emerging era of interactive video experiences. Pending FCC approval of Ameritech's plan and clearing of other regulatory hurdles, the construction of the first phase of the network could begin as soon as the fourth quarter of 1994. The new network, which will be separate from Ameritech's core local communications network, will be expanded by approximately 1 million additional Midwest customers in each of the next five years. Ameritech will be only one of many users of the broadband network. A multitude of competing video information providers, businesses, institutions, interexchange carriers and video telephony customers will also have access to the technology. With the new system, customers will have access to a virtually unlimited variety of programming sources. These will include basic broadcast services, similar to today's cable service, and advanced interactive services such as video on demand, home healthcare, interactive educational software, distance learning, interactive games and shopping, and a variety of other entertainment and information services that can be accessed from homes, offices, schools, hospitals, libraries and other public and private institutions. XXX BEGIN PAGE 12 HERE XXX Cable/Telco Cross-ownership Ban In November 1993, Ameritech filed lawsuits in two federal courts seeking freedom from the ban on providing video services in its own service area. Ameritech asked U.S. District Courts in Illinois and Michigan to declare unconstitutional the provisions of the Cable Act of 1984 that bar the RHCs from providing cable TV service in areas where they hold monopolies on local phone service. In August 1993, a U.S. District Court granted a request by Bell Atlantic Corporation for such an order, but that court denied similar requests by Ameritech and the other RHCs. Legislation has been introduced in Congress that would repeal the cross-ownership ban. Employee Relations As of December 31, 1993, the Company employed 14,561 persons, a decrease from 15,142 at December 31, 1992. During 1993, approximately 217 management employees left the payroll as a result of voluntary and involuntary workforce reduction programs, and 214 nonmanagement employees took advantage of a Supplemental Protection Program ("SIPP") established under labor agreements to voluntarily exit the workforce. Additional restructuring was done by normal attrition. On March 25, 1994, Ameritech announced that it will reduce its nonmanagement workforce by 6,000 employees by the end of 1995, including approximately 1,560 at the Company. Under terms of agreements between Ameritech, the CWA and the IBEW, Ameritech is implementing an enhancement to the Ameritech pension plan by adding three years to the age and net credited service of eligible nonmanagement employees who leave the business during a designated period that ends in mid-1995. In addition, Ameritech's network business unit is offering financial incentives under the terms of its current contracts with the CWA and IBEW to selected nonmanagement employees who leave the business before the end of 1995. The reduction of workforce results from technological improvements, consolidations and initiatives identified by management to balance its cost structure with emerging competition. Approximately 12,021 employees are represented by the CWA which is affiliated with the AFL-CIO. In July and August 1993, the Ameritech landline telephone companies and Ameritech Services reached agreement with the CWA and the IBEW on a workforce transition plan for assigning union- represented employees to the newly established business units. The separate agreements with the two unions extend existing union contracts with the landline telephone companies and Ameritech Services to the new units. The pacts address a number of force assignment, employment security and union representation issues. In 1995, when union contracts are due to expire, the parties will negotiate regional contracts. Item 2.

Item 2. Properties The properties of the Company do not lend themselves to description by character and location of principal units. At December 31, 1993, central office equipment represented 40% of the Company's investment in telecommunications plant in service; land and buildings (occupied principally by central offices) represented 9%; and connecting lines which constitute outside plant, the majority of which are on or under public roads, highways or streets and the remainder of which are on or under private property, represented 46%. Substantially all of the installations of central office equipment and administrative offices are located in buildings owned by the Company situated on land which it owns in fee. Many garages, business offices and some administrative offices are in leased premises. XXX BEGIN PAGE 13 HERE XXX Item 3.

Item 3. Legal Proceedings Pre-divestiture Contingent Liabilities Agreement The Plan provides for the recognition and payment of liabilities that are attributable to pre-divestiture events (including transactions to implement the divestiture) but that do not become certain until after divestiture. These contingent liabilities relate principally to litigation and other claims with respect to the former Bell System's rates, taxes, contracts, equal employment matters, environmental matters and torts (including business torts, such as alleged violations of the antitrust laws). With respect to such liabilities, AT&T and the Bell Companies, including the Company, will share the costs of any judgment or other determination of liability entered by a court or administrative agency, the costs of defending the claim (including attorneys' fees and court costs) and the cost of interest or penalties with respect to any such judgment or determination. Except to the extent that affected parties may otherwise agree, the general rule is that responsibility for such contingent liabilities will be divided among AT&T and the Bell Companies on the basis of their relative net investment (defined as total assets less reserves for depreciation) as of the effective date of divestiture. Different allocation rules apply to liabilities which relate exclusively to pre-divestiture interstate or intrastate operations. Although complete assurance cannot be given as to the outcome of any litigation, in the opinion of the Company's management any monetary liability or financial impact to which the Company would be subject after final adjudication or settlement of all such liabilities would not be material in amount to the financial position of the Company. XXX BEGIN PAGE 14 HERE XXX PART II Item 6.

Item 6. Selected Financial and Operating Data MICHIGAN BELL TELEPHONE COMPANY (Dollars in Millions) 1993 1992 1991 1990 1989 Revenues Local service . . . . . $1,092.1 $1,168.6 $1,097.7 $1,093.0 $1,082.8 Interstate network access . . 512.6 479.4 474.0 496.2 453.5 Intrastate network access . . 201.5 199.9 182.0 186.4 173.8 Long distance . . . . . . . . 695.8 591.6 582.7 605.3 570.2 Other . . . . . . . . . . . 244.8 239.4 238.9 237.0 234.9 2,746.8 2,678.9 2,575.3 2,617.9 2,515.2 Operating expenses . . . . . 2,152.3 2,103.1 2,043.7 2,038.2 1,957.0 Operating income . . . . . 594.5 575.8 531.6 579.7 558.2 Interest expense . . . . . . . 106.2 109.6 125.3 116.9 117.2 Other (income) expense, net . . . 4.6 9.4 (5.0) (3.8) (3.5) Income taxes . . . . . . . . . 140.5 130.6 120.8 140.8 126.9 Income before cumulative effect of change in accounting principles . . . . . . . . . . 343.2 326.2 290.5 325.8 317.6 Cumulative effect of change in accounting principles . . . -- (448.4) -- -- -- Net income (loss) . . . . . . $ 343.2 $ (122.2) $ 290.5 $ 325.8 $ 317.6 Total assets . . . . . . . . 5,259.2 5,289.9 5,251.8 5,192.8 5,001.1 Telecommunications plant, net . 4,382.8 4,456.1 4,446.5 4,410.4 4,398.3 Capital expenditures . . . . 452.1 523.3 542.2 530.1 501.6 Long-term debt . . . . . . . $1,132.4 $1,085.1 $1,071.0 $1,202.8 $1,174.4 Debt ratio . . . . . . . . . 46.3% 46.4% 41.9% 41.3% 41.3% Pre-tax interest coverage . . 5.74 4.88 4.12 4.70 4.58 Return to average equity * . . . 19.6% (7.1)% 14.0% 16.0% 16.0% Return on average total capital * 13.2% (0.6)% 11.0% 12.2% 12.2% Customer lines at end of year (in thousands) . . . . . . . 4,563 4,431 4,314 4,242 4,150 % Customer lines served by digital electronic offices . . 68% 53% 49% 44% 39% % Customer lines served by analog electronic offices . . . . . 31% 46% 49% 52% 56% Employees at end of year . . . . 14,561 15,142 15,836 16,234 16,785 Customer lines per employee . . . 313 293 272 261 247 Local calls per year (in millions) # . . . . . 14,198 14,555 14,136 14,072 12,679 Calls per customer line . . . . . . . . . . . . 3,112 3,285 3,277 3,317 3,055 * After cumulative effect of change in accounting principles. # Effective August 1991 (MPSC NO.U9004), certain local calls from private line circuits were reclassified to Access Service. The years 1989-1991 have been restated to be on a comparable basis. XXX BEGIN PAGE 15 HERE XXX Item 7.

Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations (Dollars in millions) Following is a discussion and analysis of the results of operations of the Company for the year ended December 31, 1993 and for the year ended December 31, 1992, which is based on the Statements of Income and Reinvested Earnings on page 23 Other pertinent data are also given in Selected Financial and Operating Data on page 14. Results of Operations REVENUES Revenues increased $67.9 or 2.5% due to the following: Increase 1993 1992 (Decrease) %Change Local service . . . . . . . . . . $1,092.1 $1,168.6 ($76.5) (6.5%) The decrease of $76.5 was primarily due to a $119.9 reclassification, at the Company's initiative, of certain measured interzone messages from the local service category to the long distance service category. Without the reclassification, local service would have increased $43.4. This was comprised of $37.6 in volume increases attributable to continued growth in central office custom features and public telephone revenues, and a 3.0% increase in access lines to 4,562,740 from 4,431,174 in the prior year. An additional $5.7 increase resulted from rate changes which consisted of an increase in certain operator assisted services, custom calling features, and the expiration of temporary customer credits in effect during 1992. Increase 1993 1992 (Decrease) %Change Access service Interstate access . . . $512.6 $479.4 $ 33.2 6.9% Intrastate access . . . $201.5 $199.9 $ 1.6 0.8% Interstate access increased $33.2 due to a $16.7 reduction in support payments made to the National Exchange Carrier Association, volume of business increases of $11.3, and a $10.6 increase related to anticipated settlements with other telecommunications providers. These increases were partially offset by $6.0 in rate reductions. The intrastate access increase of $1.6 was mainly the result of the effect of higher calling volumes of $11.3 and true-ups and settlements with other local exchange carriers of $5.2. These increases were offset by $10.8 in rate reductions and $3.3 in various claims and settlements with interexchange carriers. Increase 1993 1992 (Decrease) %Change Long distance services . . . . $695.8 $591.6 $104.2 17.6% The increase in long distance revenues of $104.2 is primarily the result of the $119.9 reclassification related to local service revenues discussed above. Without this reclassification, long distance revenues would have decreased $15.7. Volume increases of $46.9 were more than offset by shifts to discount calling plans of $42.6 and rate reductions totaling $19.3. XXX BEGIN PAGE 16 HERE XXX Increase 1993 1992 (Decrease) %Change Other revenues . . . . . . . $244.8 $239.4 $5.4 2.3% An increase of $5.4 was primarily due to growth in nonregulated revenues (primarily inside wiring services) of $8.7 and $2.2 in Ameritech Publishing, Inc. license fees. This was reduced by a $6.3 increase in uncollectibles resulting from increased write- offs. OPERATING EXPENSES The Company has changed the presentation of its operating expenses in the Statements of Income and Reinvested Earnings to facilitate a better understanding of its operating results. Prior year amounts have been reclassified to conform with this presentation. Operating expenses increased $49.2 or 2.3% primarily due to the following: Increase 1993 1992 (Decrease) %Change Depreciation . . . . . . . . . $543.3 $520.7 $22.6 4.3% Depreciation expense increased $22.6 due mainly to a $13.4 increase in intrastate rates resulting from the Company's ongoing review of the lives of its property. In addition, a $15.6 increase resulted from the continued expansion of the plant investment base. These increases were partially offset by a $6.7 reduction caused by the expiration of FCC-authorized inside wire and reserve deficiency amortization schedules. Increase 1993 1992 (Decrease) %Change Employee-related expenses. . . . . . . . . $705.8 $701.8 $4.0 0.6% The $4.0 increase in employee-related expenses was due to increases of $16.3 in basic wage rates, $5.7 in the provision for team awards and bonus payments, and $5.0 in other employee- related costs, mainly tuition aid and technical training fees, relocation costs and travel expenses. Offsetting these increases were reductions of $21.5 due to lower force levels than the previous year. The remaining offset was primarily due to lower overtime payments recorded in 1993. The Company's total employee count was 14,561 as of December 31, 1993, compared to 15,142 at December 31, 1992. Increase 1993 1992 (Decrease) %Change Taxes other than income taxes . . . . . . . . . . . $132.2 $144.1 ($11.9) (8.3%) The decrease in taxes other than income taxes is due to a $13.2 reduction made to the provision for property taxes to recognize the impact of new state legislation enacted in December 1993 which lowers property tax millage rates in Michigan for December 31, 1993 assessments. Partially offsetting this reduction was a $1.9 increase in other taxes, primarily Michigan single business tax expense, resulting from higher 1993 business volumes. XXX BEGIN PAGE 17 HERE XXX Increase 1993 1992 (Decrease) %Change Other operating expenses. . . . . . . $771.0 $736.5 $34.5 4.7% The growth reported in this category was due to increases of $28.7 in payments for services provided by affiliated companies due in part to a transfer of certain work functions to Ameritech Services, Inc. (a subsidiary jointly owned by the Company and the other four Ameritech landline telephone companies)("ASI"), $8.7 in higher advertising costs, a $5.7 increase in expenses paid to other carriers for access, and a $2.5 increase in the provision made for potential claims and settlements with interexchange carriers. Partially offsetting these increases was a $10.8 decrease resulting from the effects of the work force resizing provision reflected in 1992 results. OTHER INCOME AND EXPENSES Increase 1993 1992 (Decrease) %Change Interest Expense . . . . . . $106.2 $109.6 $(3.4) (3.1)% The decrease in interest expense is attributable primarily to $3.8 in tax and other settlements made in 1992. In addition, interest related to debt decreased $.9 due to lower composite interest rates on short-term debt. These decreases were partially offset by $1.7 of interest related to the 1990 incentive regulation plan. Increase 1993 1992 (Decrease) %Change Other expense, net . . . . . . $4.6 $ 9.4 $(4.8) (51.1)% The $4.8 decrease is primarily the result of $4.0 in higher earnings from ASI in which the Company has a 26% ownership interest. In addition, other expenses were $4.1 lower: $2.4 in lower 1993 costs related to the early retirement of debt, and $1.7 from a 1992 write-off of relocation work performed but not collectible. These reductions in expense were partly offset by a $3.1 increase in 1993 contributions, primarily new commitments to education in the form of educational grants. Increase 1993 1992 (Decrease) %Change Income taxes . . . . . . .. . $140.5 $130.6 $9.9 7.6% The income tax increase of $9.9 was the net effect of several items. There were increases of $9.4 due to higher pre-tax income, $9.0 in adjustments to the provision for future settlements, and $6.1 due to the change to the new 35% tax rate. These were somewhat offset by a one-time $6.8 reduction caused by adjusting the SFAS Nos. 106 and 112 deferred tax asset to reflect the change in tax rate, and a $6.5 true-up in the investment-related components of the 1992 tax provision. The remaining offset is due mainly to a $2.0 increase in investment tax credits amortized in 1993. XXX BEGIN PAGE 18 HERE XXX OTHER INFORMATION Changes in Accounting Principles Effective January 1, 1993, the Company adopted Statement of Financial Accounting Standards ("SFAS") No. 109, "Accounting for Income Taxes." The new accounting method is essentially a refinement of the liability method already followed by the companies of Ameritech Corporation ("Ameritech", the Company's parent) and, accordingly, did not have a significant impact on the Company's financial statements upon adoption. As more fully discussed in Note (C) to the financial statements, effective January 1, 1992, the Company adopted SFAS No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions" and SFAS No. 112, "Employers Accounting for Postemployment Benefits". The cumulative effect of these accounting changes was recognized in the first quarter of 1992 as a change in accounting principles of $448.4, net of a deferred income tax benefit of $225.1. Regulatory Environment Customer demand, technology, and the preferences of policy makers are all converging to increase competition in the local exchange business. The effects of increasing competition are apparent in the marketplace the Company serves. For example, certain large telecommunications providers have recently announced their intentions to provide full local exchange service. Additionally, increasing volumes of intraLATA long distance services purchased by large and medium sized business customers are sold by carriers other than the Company. Recognizing this trend, the Company's regulatory/public policy activities are focused on achieving a framework that allows for expanding competition while providing a fair opportunity for all carriers, including the Company, to succeed. The cornerstone of this effort is Ameritech's "Customers First Plan" that was filed with the FCC on March 1, 1993. In a subsequent filing with the U.S. Department of Justice, Ameritech proposed that the Customers First Plan be implemented on a trial basis beginning in January 1995 in Illinois and other states thereafter. The Customers First Plan proposes to open all of the local telephone business in the Company's service area to competition. In exchange, Ameritech has requested three regulatory changes. First, Ameritech has requested relief from the Modification of Final Judgment ("MFJ") interLATA ban. Such relief would mean that the Company would be allowed to offer all long distance services. Second, Ameritech has requested a number of modifications in the FCC's price cap rules. These modifications would apply only to Ameritech, including the Company, and would eliminate any obligation to refund, in the form of its share of future rate reductions, its share of interstate earnings in excess of 12.25%. The modifications would also provide the Company increased ability to price its interstate access services in a manner appropriate to competitive conditions. Third, Ameritech has requested FCC authority to collect in a competitively neutral manner, the social subsidies currently embedded in the rates that the Company charges long distance carriers for access to the local network. The Michigan Public Service Commission ("MPSC") adopted an incentive regulation plan on March 13, 1990. The incentive regulation plan, which became effective April 1, 1990, was terminated as of December 31, 1991, having been found inconsistent with the Michigan Telecommunications Act ("MTA") effective January 1, 1992. Through the end of 1991, after 21 months under the plan, the Company had recognized a liability of $8.2 for potential sharing of profits with customers. In September 1992, the Company increased this provision to $10.5 in accordance with a tentative agreement reached with the MPSC staff. In January 1993, the MPSC issued an order approving the agreement but also providing that interest be accrued on the $10.5 at 9% per annum since January 1, 1992. As of December 31, 1993, the total liability related to ratepayer sharing is $12.2. XXX BEGIN PAGE 19 HERE XXX In response to the January 1993 order, the Company filed its proposed plan in February 1993 for the matching of shareable earnings to benefit education. This plan proposed to match the original $10.5 plus interest with an equal amount if all amounts would be available for and dedicated to educational telecommunications services. In December 1993, the MPSC issued an order approving an agreement reached between the Company, intervenors, and the MPSC staff, establishing two separate funds dedicated to educational telecommunications projects: the ratepayers' portion and the Company's matching fund. As of December 31, 1993, the amount recorded to recognize the matching portion is $11.3. A three-member Michigan Council on Telecommunications Services for Public Education ("Council") was established to review and make recommendations on all projects funded by the ratepayers' portion. The Company retains control over how the matching funds are expended, which may be in the form of capital, expense or in-kind services, but agrees to work with the Council in making those determinations. IntraLATA Long Distance Service Order On July 31, 1992, MCI Telecommunications Corporation ("MCI") filed a complaint with the MPSC seeking "1+" intraLATA dialing parity for all toll competitors of the Company, alleging that current dialing arrangements violated the Michigan Telecommunications Act. Callers in Michigan must currently dial "10" plus a three digit access code to use the services of the Company's intraLATA toll competitors. The MPSC dismissed MCI's complaint finding no statutory violations. However, as a result of subsequent proceedings in the case, on February 24, 1994, the MPSC issued an order requiring the implementation of "1+" intraLATA toll dialing parity in Michigan. The MPSC order requires dialing parity to be implemented concurrently with the termination of prohibitions against the Company's ability to offer interLATA service, but in no event later than January 1, 1996. The order also requires the establishment of an industry task force to consider all issues involved in the implementation of intraLATA dialing parity. The task force will develop a deployment schedule, identify the costs for deployment, and determine the methodology to recover those costs. The task force is required to file a report with the MPSC no later than September 23, 1994, setting forth its findings and recommendations. The Company believes that the MPSC has not considered all relevant factors in rendering its decision on intraLATA parity. Accordingly, the Company has filed a petition for a rehearing with the MPSC as a first step in bringing further clarification to the issues. In 1993 the Company recorded $695.8 of long distance revenue, of which approximately $634.0 resulted from intraLATA message and unidirectional long distance services. Customer response to dialing parity and the effect on the Company's intraLATA long distance revenue is uncertain. However, it is estimated that approximately 50% of any long distance revenue lost, which could be significant, would be offset by additional access revenue. Effects of Regulatory Accounting The Company presently gives accounting recognition to the actions of regulators where appropriate, as prescribed by Statement of Financial Accounting Standards No. 71, "Accounting for the Effects of Certain Types of Regulation" ("SFAS No. 71"). Under SFAS No. 71, the Company records certain assets and liabilities because of actions of regulators. Further, amounts previously charged to operations for depreciation expense reflect estimated useful lives and methods prescribed by regulators rather than those that might otherwise apply to unregulated enterprises. In the event the Company determines that it no longer meets the criteria for following SFAS No. 71, the accounting impact to the Company would be an extraordinary noncash charge to operations of an amount which could be material. Criteria that give rise to the discontinuance of SFAS No. 71 include (1) increasing competition which restricts the Company's ability to XXX BEGIN PAGE 20 HERE XXX establish prices to recover specific costs, and (2) a significant change in the manner in which rates are set by regulators from cost-based regulation to another form of regulation. The Company periodically reviews these criteria to ensure that continuing application of SFAS No. 71 is appropriate. Status of new business units In February 1993, following a year-long examination of its business called "Breakthrough Leadership," Ameritech announced it would restructure its business into separate units organized around specific customer groups - such as residential customers, small businesses, interexchange companies and large corporations - and a single unit that will run Ameritech's network in Illinois, Indiana, Michigan, Ohio and Wisconsin. The Ameritech Bell Companies will continue to function as legal entities owning current Bell company assets in each state. The network unit will provide network and information technology resources in response to the needs of the other business units. This unit will be the source of network capabilities for products and services offered by the other business units and will be responsible for the development and day-to-day operation of an advanced information infrastructure. All of the market units and the network unit are currently operational. Ameritech has developed a new logo and is marketing all of its products and services under the single brand name "Ameritech." Digital Video Network In January 1994, Ameritech announced a program to launch a digital video network upgrade that is expected, by the end of the decade, to make available interactive information and entertainment services, as well as traditional cable TV services, to approximately six million Ameritech customers. The Company has filed an application with the FCC seeking approval of the program. The application reflects capital expenditures of approximately $55.0 over the next three years. The Company may also, depending on market demand, make additional capital expenditures under this program. The Company anticipates that its capital expenditures for the program will be funded without an increase in its recent historical level of capital expenditures. Termination of publishing services contract On September 9, 1993, Ameritech Publishing exercised its right to terminate its publishing services contract (the "Agreement") with the Company, effective September 8, 1994, or such other mutually acceptable date. Pursuant to the Agreement, which became effective on January 1, 1991, the Company granted a license and provides billing, collection and other services to Ameritech Publishing, and Ameritech Publishing provides directory services for the Company. Ameritech Publishing is a wholly-owned subsidiary of the Company's parent, Ameritech Corporation. The Agreement's initial term was to have been five years, subject, however, to either party's right to terminate on not less than twelve months' prior notice. In 1993, the Company earned fees of approximately $132.7 from Ameritech Publishing and paid Ameritech Publishing approximately $19.8 for services rendered. The Company has begun negotiations with Ameritech Publishing for a new contract. While the Company cannot predict at this time the specific terms and conditions of any new contract it may negotiate with Ameritech Publishing, it anticipates that annual payments from Ameritech Publishing under a new contract could be significantly less than current annual payments under the Agreement. A new contract with Ameritech Publishing could also vary from the Agreement as to duration, services to be provided by the parties, and other provisions. XXX BEGIN PAGE 21 HERE XXX Property Tax Litigation The Company has disputed the manner of assessment of its property taxes in Michigan. In August of 1993, the Michigan Supreme Court agreed to hear certain issues associated with that dispute which involves the 1984-1986 tax years. If the Company is successful in its arguments, it will receive a refund of overpayment of property taxes. If unsuccessful, the Company may be subject to an additional, and possibly substantial, tax liability for those years beyond 1986. An opinion of the court could be issued by the end of 1994. Management of the Company believes that the ultimate resolution of this case will not have a material adverse effect on the Company's financial position or results of operations. Workforce Resizing On March 25, 1994, Ameritech announced that it will reduce its nonmanagement workforce by 6,000 employees by the end of 1995, including approximately 1,560 at the Company. Under terms of agreements between Ameritech, the Communications Workers of America ("CWA") and the International Brotherhood of Electrical Workers ("IBEW"), Ameritech is implementing an enhancement to the Ameritech pension plan by adding three years to the age and net credited service of eligible nonmanagement employees who leave the business during a designated period that ends in mid-1995. In addition, Ameritech's network business unit is offering financial incentives under the terms of its current contracts with the CWA and IBEW, to selected nonmanagement employees who leave the business before the end of 1995. The above actions will result in a charge to first quarter 1994 earnings of approximately $137.8 or $89.2 after tax. A significant portion of the program cost will be funded by Ameritech's pension plan, whereas financial incentives to be paid from Company funds are estimated to be approximately $36.9. Settlement gains, which result from terminated employees accepting lump-sum payments from the pension plan, will be reflected in income as employees leave the payroll. The Company believes this program will reduce its employee-related costs by approximately $78.0 on an annual basis upon completion of this program. The reduction of the workforce results from technological improvements, consolidations and initiatives identified by management to balance its cost structure with emerging competition XXX BEGIN PAGE 22 HERE XXX Item 8.

Item 8. Financial Statements and Supplementary Data Report of Independent Public Accountants To the Shareholder of Michigan Bell Telephone Company: We have audited the accompanying balance sheets of Michigan Bell Telephone Company (a Michigan Corporation), as of December 31, 1993 and 1992, and the related statements of income and reinvested earnings and cash flows for each of the three years in the period ended December 31, 1993. These financial statements and the schedules referred to below are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements and schedules based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of Michigan Bell Telephone Company as of December 31, 1993 and 1992, and the results of its operations and its cash flows for each of the three years in the period ended December 31, 1993, in conformity with generally accepted accounting principles. As discussed in Note (C) to the financial statements, the Company changed its method of accounting for certain postretirement and postemployment benefits in 1992. Our audits were made for the purpose of forming an opinion on the basic financial statements taken as a whole. The financial statement schedules listed in Item 14(a)(2) are presented for purposes of complying with the Securities and Exchange Commission's rules and are not a required part of the basic financial statements. These schedules have been subjected to the auditing procedures applied in our audits of the basic financial statements and, in our opinion, fairly state in all material respects the financial data required to be set forth therein in relation to the basic financial statements taken as a whole. ARTHUR ANDERSEN & CO. Detroit, Michigan January 28, 1994 XXX BEGIN PAGE 23 HERE XXX Statements of Income and Reinvested Earnings MICHIGAN BELL TELEPHONE COMPANY (Dollars in millions) Year Ended December 31, 1993 1992 1991 Revenues . . . . . . . .. . . . . . $2,746.8 $2,678.9 $2,575.3 Costs and expenses Depreciation. . . . . . . . . . . . . 543.3 520.7 507.9 Employee-related expenses. . . . . 705.8 701.8 708.1 Taxes other than income taxes . . . 132.2 144.1 136.9 Other operating expenses. . . . . . 771.0 736.5 690.8 2,152.3 2,103.1 2,043.7 Operating Income . . . . . . . . . . 594.5 575.8 531.6 Interest expense. . . . . . . . . . . 106.2 109.6 125.3 Other (income) expense - net . . . . 4.6 9.4 (5.0) 110.8 119.0 120.3 Income before income taxes and cumulative effect of change in accounting principles. . . . . . . 483.7 456.8 411.3 Income taxes . . . . . . . . . . . . 140.5 130.6 120.8 Income before cumulative effect of change in accounting principles . . 343.2 326.2 290.5 Cumulative effect of change in accounting principles . . . . . . -- (448.4) -- Net income (loss). . . . . . . . . . 343.2 (122.2) 290.5 Reinvested earnings, beginning of year . 2.8 348.5 323.3 Less: Dividends . . . . . . . . . . . 324.6 223.5 265.3 Reinvested earnings, end of year . . $ 21.4 $ 2.8 $ 348.5 The accompanying notes are an integral part of these financial statements. XXX BEGIN PAGE 24 HERE XXX Balance Sheets MICHIGAN BELL TELEPHONE COMPANY (Dollars in millions) December 31, December 31, 1993 1992 ASSETS CURRENT ASSETS Cash and temporary cash investments . . . . $ 17.0 $ -- Receivables, net Customers and agents (less allowance for uncollectibles of $44.9 and $40.6 for 1993 and 1992, respectively) . . . 452.9 458.1 Ameritech and affiliates . . . . . . . . 15.7 16.5 Other . . . . . . . . . . . . . . . . . . 27.8 29.0 Material and supplies . . . . . . . . . . . . . 26.4 28.0 Prepaid and other . . . . . . . . . . . . . 23.0 30.4 562.8 562.0 TELECOMMUNICATIONS PLANT In service . . . . . . . . . . . . . . . 7,452.8 7,315.5 Under construction . . . . . . . . . . . . 106.2 140.2 7,559.0 7,455.7 Less accumulated depreciation . . . . . . . 3,176.2 2,999.6 4,382.8 4,456.1 INVESTMENTS, principally in affiliates. . . . . . 68.5 56.4 OTHER ASSETS AND DEFERRED CHARGES . . . . . . 245.1 215.4 TOTAL ASSETS . . . . . . . . . . . . . . . . . $5,259.2 $5,289.9 LIABILITIES AND SHAREOWNER'S EQUITY CURRENT LIABILITIES Debt maturing within one year Ameritech . . . . . . . . . . . . . . . $ 382.9 $ 264.0 Other . . . . . . . . . . . . . . . . . . 3.2 157.6 Accounts payable Ameritech Services, Inc. . . . . . . . . . 50.6 46.7 Other Ameritech Affiliates . . . . . . . . 47.0 24.5 Other . . . . . . . . . . . . . . . . . . 168.5 183.7 Other current liabilities . . . . . . . . 322.9 326.8 975.1 1,003.3 LONG-TERM DEBT . . . . . . . . . . . . . . 1,132.4 1,085.1 DEFERRED CREDITS AND OTHER LONG-TERM LIABILITIES Accumulated deferred income taxes . . . . . 405.7 440.2 Unamortized investment tax credits. . . . . . 93.7 117.4 Postretirement benefits other than pensions . 636.8 653.1 Long-term payable to affiliate (ASI) for SFAS 106 adoption . . . . . . . . . . 22.9 25.8 Regulatory liability and other . . . . . 230.9 221.9 1,390.0 1,458.4 SHAREOWNER'S EQUITY Common stock ($14 2/7 par value, 120,810,000 shares authorized, 120,526,415 issued and outstanding) . 1,721.8 1,721.8 Proceeds in excess of par value . . . . 18.5 18.5 Reinvested earnings . . . . . . . . . . . 21.4 2.8 1,761.7 1,743.1 TOTAL LIABILITIES AND SHAREOWNER'S EQUITY . $5,259.2 $5,289.9 The accompanying notes are an integral part of these financial statements. XXX BEGIN PAGE 25 HERE XXX Statements of Cash Flows MICHIGAN BELL TELEPHONE COMPANY (Dollars in millions) Year Ended December 31, 1993 1992 1991 CASH FLOWS FROM OPERATING ACTIVITIES: Net income (loss) . . . . . . . . . . . . . $ 343.2 $(122.2) $ 290.5 Adjustments to net income (loss) Cumulative effect of change in accounting principles. . . . . . . . . . -- 448.4 -- Depreciation. . . . . . . . . . . . . . . . 543.3 520.7 507.9 Deferred income taxes, net. . . . . . . . . (18.3) (15.0) (37.2) Investment tax credits . . . . . . . . . . (23.7) (18.9) (18.3) Interest during construction . . . . . . . ( 1.4) ( 1.2) ( 2.2) Provision for uncollectibles. . . . . . . 42.7 36.4 34.9 Change in accounts receivable. . . . . . . (35.4) (56.2) (71.1) Change in materials and supplies . . . . . ( 2.2) 1.0 ( 4.7) Change in prepaid expense and certain other current assets . . . . . . . . . . ( 7.1) 1.2 3.1 Change in accounts payable . . . . . . . . . . 14.1 (26.7) 1.7 Change in accrued taxes . . . . . . . . . . (6.4) (26.4) 19.5 Change in certain other current liabilities . 1.2 22.7 21.8 Change in certain non-current assets and liabilities . . . . . . . . .. (45.9) 17.9 (2.8) Other . . . . . . . . . . . . . . . . . . . ( 0.7) ( 19.5) 0.2 Net cash from operating activities . . . . 803.4 762.2 743.3 CASH FLOWS FROM INVESTING ACTIVITIES: Capital expenditures, net . . . . . . . . (449.5) (515.6) (537.8) Proceeds from (costs of) disposal of telecommunications plant. . . . . . . . . ( 5.2) (11.3) 5.5 Additional equity investments in ASI. . . . . ( 7.8) (10.4) -- Net cash used in investing activities . . . . (462.5) (537.3) (532.3) CASH FLOWS FROM FINANCING ACTIVITIES: Intercompany financing, net . . . . . . . . . 118.9 (37.5) 301.5 Net change in other short-term debt . . . -- -- (210.0) Issuance of long-term debt . . . . . . . 200.0 450.0 50.0 Retirements of long-term debt . . . . . . . . (307.0) (412.2) ( 87.8) Cost of refinancing long-term debt . . . . . ( 11.2) ( 1.7) -- Dividend payments . . . . . . . . . . . . . (324.6) (223.5) (265.3) Net cash from financing activities . . . . . (323.9) (224.9) (211.6) Net increase (decrease) in cash and temporary cash investments. . . . . . . . 17.0 -- (0.6) Cash and temporary cash investments, beginning of year. . . . . . . . . . . . -- -- 0.6 Cash and temporary cash investments, end of year. . . . . . . . . . . . . . . $ 17.0 $ -- $ -- The accompanying notes are an integral part of these financial statements. XXX BEGIN PAGE 26 HERE XXX Notes to Financial Statements MICHIGAN BELL TELEPHONE COMPANY (Dollars in millions) Michigan Bell Telephone Company ("the Company") is a wholly- owned subsidiary of Ameritech Corporation ("Ameritech"). (A) ACCOUNTING POLICIES - The financial statements of the Company reflect the application of the accounting policies described in this note. Basis of Accounting - The financial statements have been prepared in accordance with generally accepted accounting principles. In compliance with Statement of Financial Accounting Standards No. 71, "Accounting for the Effects of Certain Types of Regulation" (SFAS No. 71), the Company, which is still subject to regulation for certain services, recognizes the actions of regulators where appropriate. Such actions can provide reasonable assurance of the existence of an asset, reduce or eliminate the value of an asset or impose a liability. Actions of a regulator can also eliminate a liability previously imposed by the regulator. Transactions with Affiliates -The Company has various agreements with affiliated companies. Below is a description of the significant arrangements followed by a table of the amounts involved. 1. Ameritech Services, Inc. (ASI) The Company has a 26% ownership interest in ASI, an Ameritech-controlled affiliate that provides consolidated planning, development, management and support services to all the Ameritech Bell companies. The Company also has an agreement with ASI whereby the Company provides certain services such as loaned employees to ASI. 1993 1992 1991 Purchase of materials and charges for services . . . . $526.5 $489.4 $397.4 Recovery of costs of services provided to ASI . . . . 11.7 9.3 7.9 2. Ameritech (the Company's parent) Ameritech provides various administrative, planning, financial, and other services to the Company. Such services are billed to the Company at cost. 1993 1992 1991 Charges incurred for services . . . . . . . . . . . . $29.4 $29.7 $29.8 3. Ameritech Publishing, Inc. (API) The Company has an agreement whereby payments are made to the Company by API for license fees and billing and collection services provided by the Company. The Company also purchases directory services from API under the same agreement. 1993 1992 1991 Fees paid to the Company by API . . . . . . . . . $132.7 $130.5 $128.6 Purchases by the Company from API. . . . . . . . . . . 19.8 18.9 18.5 4. Ameritech Information Systems, Inc. (AIS) The Company has an agreement whereby the Company reimburses AIS for costs incurred by AIS in connection with the sale of network services on behalf of the Company by AIS employees. 1993 1992 1991 Charges incurred for services . . . . . . . . . . $13.9 $9.9 $11.1 XXX BEGIN PAGE 27 HERE XXX 5. Bell Communications Research, Inc. (Bellcore) Bellcore provides research and technical support to the Company. ASI has a one-seventh interest in Bellcore and bills the Company for the costs. 1993 1992 1991 Charges incurred for services . . . . . . . . . . . $32.2 $40.7 $39.0 Telecommunications Plant - Telecommunications plant is stated at original cost. The original cost of telecommunications plant purchased from ASI includes a return on investment to ASI. The provision for interstate depreciation, as prescribed by the FCC, is based principally on the straight-line remaining life and the straight- line equal life group (ELG) methods of depreciation applied to individual categories of telecommunications plant with similar characteristics. Effective January 1, 1990, the Company began a phase-in of ELG rates for determination of intrastate depreciation. This method was applied to two classes of plant in 1990, with all other classes (except electromechanical switching) completed in 1991. In 1992 the Company began a cyclical review plan under which the depreciation rate parameters of various classes of plant are under examination on a triennial basis. When depreciable plant is retired, the amount at which such plant has been carried in telecommunications plant in service is charged to accumulated depreciation. The cost of maintenance and repairs of plant is charged to expense. Investments - The Company's investments in ASI (26% ownership and $68.5) are reflected in the financial statements using the equity method of accounting. Material and Supplies - Inventories of new and reusable materials and supplies are stated at the lower of cost or market with cost stated principally at average original cost; for certain large individual items, cost is determined on a specific identification basis. Interest During Construction - Regulatory authorities allow the Company to accrue interest as a cost of constructing certain plant and as an item of income, i.e., allowance for debt and equity funds used to finance construction. Such income is not realized in cash currently but will be realized over the service life of the plant as the resulting higher depreciation expense is recovered in the form of increased revenues. Income Taxes - The Company is included in the consolidated federal income tax return filed by Ameritech and its subsidiaries. Effective January 1, 1993, the Company adopted Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes" (SFAS No. 109). The new accounting method is essentially a refinement of the liability method already followed by the Ameritech companies and, accordingly, did not have a significant impact on the Company's financial statements upon adoption. Consolidated income tax currently payable has been allocated by Ameritech to the Company based on the Company's contribution to consolidated taxable income and tax credits. Deferred tax assets and liabilities are based on differences between the financial statement bases of assets and liabilities and the tax bases of those same assets and liabilities. Under the liability method, deferred tax assets and liabilities at the end of each period are determined using the statutory tax rates in effect when these temporary differences are expected to reverse. Deferred income tax expense is measured by the change in the net deferred income tax asset or liability during the year. In addition, for regulated companies, SFAS No. 109 requires that all deferred regulatory assets and liabilities be recognized at the revenue requirement level. It further requires that a deferred tax liability be recorded to reflect the amount of cumulative tax benefits previously flowed through to ratepayers and that a long-term deferred asset be recorded to reflect the revenues to be recovered in telephone rates when the related taxes become payable in future years. XXX BEGIN PAGE 28 HERE XXX The Company uses the deferral method of accounting for investment tax credits. Therefore, credits earned prior to the repeal of investment tax credits by the Tax Reform Act of 1986 and also certain transitional credits earned after the repeal are being amortized as reductions in tax expense over the life of the plant which gave rise to the credits. Temporary Cash Investments - Temporary cash investments are stated at cost which approximates market. The Company considers all highly liquid, short-term investments with an original maturity of three months or less to be cash equivalents. Short-Term Financing Arrangement - During 1991, Ameritech entered into an arrangement with its subsidiaries, including the Company, for the provision of short-term financing and cash management services. Ameritech issues commercial paper and notes and secures bank loans to fund the working capital requirements of its subsidiaries and invests short-term, excess funds on their behalf (See Notes (D) and (H)). (B) INCOME TAXES - The components of income tax expense (before cumulative effect of change in accounting principles) were as follows: 1993 1992 1991 Federal Current . . . . . . . . . . . $180.7 $162.5 $174.1 Deferred, net . . . . . . . . . . (18.3) (14.8) (36.8) Investment tax credits . . . . . . (23.7) (18.9) (18.3) Total . . . . . . . . . . $138.7 $128.8 $119.0 Local Current . . . . . . . . . . . . . $ 1.9 $ 2.0 $ 2.2 Deferred, net . . . . . . . . . . (0.1) (0.2) (0.4) Total . . . . . . . . . . . 1.8 1.8 1.8 Total income tax expense . . $140.5 $130.6 $120.8 Deferred income tax expense (credits) results principally from temporary differences caused by the change in the book and tax bases of telecommunications plant due to the use of different depreciation methods and lives for financial reporting and income tax purposes. Total income taxes paid were $175.0, $171.7, and $159.1 in 1993, 1992 and 1991, respectively. XXX BEGIN PAGE 29 HERE XXX The following is a reconciliation between the statutory federal income tax rates of 35% in 1993, and 34% in 1992 and 1991, and the Company's effective tax rates: 1993 1992 1991 Statutory tax rate . . . . . . . . . . 35.0% 34.0% 34.0% Reduction in tax expense due to amortization of investment tax credits . . . . . . (4.0)% (3.8)% (4.4)% Effect of adjusting deferred income tax balances due to tax law changes . . . (1.4)% -- -- Benefit of tax rate differential applied to reversing temporary differences . . (3.3)% (3.2)% (4.1)% Depreciation of certain taxes and payroll-related construction costs capitalized for financial statement purposes, but deducted when incurred for income tax purposes . . . . . . . 2.3% 1.8% 1.1% Flow-through of temporary differences related to cost of removal/ salvage credit . . . . . . . . . . . . 0.6% 1.3% 3.0% Other . . . . . . . . . . . . . . . . (0.2)% (1.5)% (0.2)% Effective tax rate . . . . . . . . . 29.0% 28.6% 29.4% The Revenue Reconciliation Act of 1993, enacted in August of that year, increased the statutory federal income tax rate for 1993 to 35 percent. In accordance with the liability method of accounting, the Company adjusted, on the enactment date, its deferred income tax balances not subject to regulatory accounting prescribed by SFAS No. 71 (see Note (A)). The result was a reduction in deferred income tax expense of $6.8, primarily from increasing the deferred tax assets associated with SFAS Nos. 106 and 112 (See Note (C)). As of December 31, 1993 the Company had a regulatory asset of $112.5 (reflected in Other Assets and Deferred Charges) related to the cumulative amount of income taxes on temporary differences previously flowed through to ratepayers. In addition, on that date, the Company had a regulatory liability of $210.4 (reflected primarily in Regulatory Liability and Other) related to the reduction of deferred taxes resulting from the change in the statutory federal income tax rate to 35% and deferred taxes provided on unamortized investment tax credits. These amounts will be amortized over the regulatory lives of the related depreciable assets concurrent with recovery in rates. The accounting for and the impact on future net income of these amounts will depend on the ratemaking treatment authorized in future regulatory proceedings. XXX BEGIN PAGE 30 HERE XXX As of December 31, 1993 and 1992, the components of long-term accumulated deferred income taxes were as follows: 1992 1993 Deferred tax assets Postretirement and postemployment benefits $232.4 $231.7 SFAS No. 71 accounting 97.8 81.9 Other, net 19.0 24.6 Total non-current deferred tax assets $349.2 $338.2 Deferred tax liabilities Accelerated depreciation $733.1 $756.4 Other 21.8 22.0 Total non-current deferred tax liabilities $754.9 $778.4 Net long-term accumulated deferred tax liability $405.7 $440.2 Deferred income taxes in current assets and liabilities are not significant and therefore are not itemized. (C) EMPLOYEE BENEFIT PLANS Pension Plans Ameritech maintains noncontributory defined pension and death benefit plans ("the plans") covering substantially all of the Company's management and non-management employees. The pension benefit formula used in the determination of pension cost is based on the average compensation earned during the five highest consecutive years of the last ten years of employment for the management plan and a flat dollar amount per year of service for the non-management plan. Pension (credit) expense is allocated to subsidiaries based upon the percentage of compensation for the management plan and per employee for the non-management plan. The Company's funding policy is to contribute annually an amount up to the maximum amount that can be deducted for federal income tax purposes. However, due to the funded status of the plans, no contributions have been made for the years reported below. The following data provides information on the Company's credit for the Ameritech plans: 1993 1992 1991 Pension credit $(27.8) $(29.9) $(21.1) Current year credit as a percent of salaries and wages (4.7)% (4.9)% (3.6)% Pension credits were determined using the projected unit credit actuarial method in accordance with Statement of Financial Accounting Standards No. 87, "Employers' Accounting for Pensions." The resulting pension credits are primarily attributable to favorable investment performance and the funded status of the plans. Certain disclosures are required to be made of the components of pension cost and the funded status of the plans, including the actuarial present value of accumulated plan benefits, accumulated projected benefit obligation and the fair value of plan assets. Such disclosures are not presented for the Company because the structure of the Ameritech plans does not permit the plans' data to be readily disaggregated. The assets of the Ameritech plans consist principally of debt and equity securities, fixed income securities, and real estate. As of December 31, 1993, the fair value of plan assets available for plan benefits exceeded the projected benefit obligation (calculated using a discount rate of 5.8% as of December 31, 1993 and 1992). The assumed long-term rate of return on plan assets used in determining pension cost was 7.25% for 1993, 1992, and 1991. The assumed XXX BEGIN PAGE 31 HERE XXX increase in future compensation levels, also used in the determination of the projected obligation, was 4.5% in 1993 and 1992. Postretirement Benefits Other Than Pensions Effective January 1, 1992, the Company adopted Statement of Financial Accounting Standards No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions" (SFAS No. 106). SFAS No. 106 requires the cost of postretirement benefits granted to employees to be accrued and recognized as expense over the period in which the employee renders service and becomes eligible to receive benefits. The cost of health care and postretirement life insurance benefits for current and future retirees was recognized as determined under the projected unit credit actuarial method. In adopting SFAS No. 106, the Company elected to immediately recognize effective January 1, 1992 the transition obligation for current and future retirees. The transition obligation was $608.9 less deferred income taxes of $208.6 or $400.3, net. To this amount, $16.0 was added for the Company's 26% share of ASI's transition obligation, for a total charge of $416.3. As defined by SFAS No. 71, a regulatory asset and any corresponding regulatory liability associated with the recognition of the transition obligation was not recorded because of uncertainties as to the timing and extent of recovery in the rate-making process. Substantially all current and future retirees are covered under postretirement benefit plans sponsored by Ameritech. Such benefits include medical, dental, and group life insurance. Ameritech has been prefunding (including cash received from the Company) certain of these benefits through Voluntary Employee Benefit Associations (VEBAs) and Retirement Funding Accounts (RFAs). The associated plan assets (primarily corporate securities and bonds) were considered in determining the transition obligation under SFAS No. 106. Ameritech intends to continue to fund its obligation appropriately, and is exploring other available funding and cost containment alternatives. Ameritech allocates its retiree health care cost on a per participant basis, whereas group life insurance is allocated based on compensation levels. SFAS No. 106 requires certain disclosures as to the components of postretirement benefit costs and the funded status of the plans. Such disclosures are not presented for the Company, as the structure of the Ameritech plans does not permit the data to be readily disaggregated. However, the Company has been advised by Ameritech as to the following assumptions used in determining its SFAS No. 106 costs. As of December 31, 1993, the accumulated postretirement benefit obligation exceeded the fair value of plan assets available for plan benefits. The assumed discount rate used to measure the accumulated postretirement benefit obligation was 7.0% as of December 31, 1993, and 7.5% as of December 31, 1992. The assumed rate of future increases in compensation level was 4.5% as of December 31, 1993 and 1992. The expected long-term rate of return on plan assets was 7.25% in 1993 and 1992 on VEBAs and 8.0% in 1993 and 1992 on RFAs. The assumed health care cost trend rate was 9.6% in 1993 and 10.0% in 1992, and is assumed to decrease gradually to 4.0% in 2007 and remain at that level. The assumed increase in health care cost is 9.2% for 1994. The health care cost trend rates have a significant effect on the amounts reported for costs each year. Specifically, increasing the assumed health care cost trend rate by one percentage point in each year would increase the 1993 annual expense by approximately 18%. Postretirement benefit costs determined under SFAS No. 106 for 1993 and 1992 were $55.9 and $57.8, respectively. During 1991, the cost of postretirement health care benefits for retirees was $54.3. As of December 31, 1993, the Company had approximately 13,893 retirees eligible to receive health care and group life insurance benefits. XXX BEGIN PAGE 32 HERE XXX Postemployment Benefits Effective January 1, 1992, the Company adopted Statement of Financial Accounting Standards No. 112, "Employers Accounting for Postemployment Benefits" (SFAS No. 112). SFAS No. 112 requires employers to accrue the future cost of certain benefits such as workers compensation, disability benefits, and health care continuation coverage. A one-time charge related to adoption of this statement was recognized as a change in accounting principle, effective as of January 1, 1992. The charge was $48.1, less deferred income taxes of $16.5, for a net of $31.6. To this amount, $.4 is added for the Company's 26% share of ASI's one-time charge, for a total of $32.0. Previously, these costs were accounted for on a cash basis. Current expense levels are dependent upon actual claim experience, but are not materially different than prior charges to income. Workforce Reductions During 1993, 217 management employees left the Company through voluntary and involuntary termination programs. These programs, including termination benefits, settlement and curtailment gains from the pension plan, resulted in a credit to expense of $5.4. The involuntary plan remains in effect until December 31, 1994. During 1992, 210 management employees left the Company through voluntary early retirement programs and involuntary terminations. The net cost of this program, along with other transfers from the pension plan, including termination benefits, and settlement and curtailment gains from the pension plan was $.4. During 1991, the Company also offered most of its management employees an early retirement program. The net cost of that program, including termination benefits and a settlement gain from the pension plan, was $.7. D) DEBT MATURING WITHIN ONE YEAR - Debt maturing within one year consists of the following at December 31: Weighted Average Amounts Interest Rates 1993 1992 1991 1993 1992 1991 Notes payable Parent (Ameritech) $382.9 $264.0 $301.5 3.3% 3.4% 5.1% Long-term debt maturing within one year 3.2 157.6 134.1 -- -- -- Total . . . $386.1 $421.6 $435.6 Average notes payable outstanding during the year . . . . . . $237.8 $223.3 $218.0 3.1%* 3.9%* 6.1%* Maximum notes payable at any month end during the year . . $382.9 $264.5 $301.5 In December 1992, the Company called $150.0 of 8.625% debentures due in 2010. The debentures were retired in February 1993 using funds obtained from long-term borrowings. This debt was classified as Debt Maturing Within One Year as of December 31, 1992. * Computed by dividing the average daily face amount of notes payable into the aggregate related interest expense. During 1991 Ameritech consolidated the short-term financing of its subsidiaries at Ameritech Corporate. See note (A), short-term financing arrangement. XXX BEGIN PAGE 33 HERE (E) LONG-TERM DEBT - Interest rates and maturities on long- term debt, consisting principally of debentures and notes, outstanding at December 31, were as follows: 1993 1992 Thirty-six year 4.625% debentures due August 1, 1996 $ 35.0 $ 35.0 Thirty-seven year 6.375% debentures due February 1, 2005 125.0 125.0 Forty year 7.0% debentures due November 1, 2012 75.0 75.0 Thirty year 7.50% debentures due February 15, 2023 200.0 -- Forty year 7.75% debentures due June 1, 2011 150.0 150.0 Thirty year 7.85% debentures due January 15, 2022 200.0 200.0 Thirty-eight year 8.125% debentures due June 1, 2015 -- 150.0 Seven year 5.875% notes due September 15, 1999 150.0 150.0 Ten year 6.375% notes due September 15, 2002 100.0 100.0 Ten year 9.25% notes due November 15, 1998 100.0 100.0 $1,135.0 $1,085.0 Long-term capital lease obligations . . . . 7.8 10.2 Unamortized discount - net . . . . . . . . . . (10.4) (10.1) Total $1,132.4 $1,085.1 On February 15, 1993, the Company issued $200.0 of 7.5% debentures due February 15, 2023 under a $350.0 shelf registration filed in August 1992. The proceeds from this issuance were used to repay long-term borrowings and for general corporate purposes. On October 29, 1993, the Company called $150.0 of 8.125% debentures due June 1, 2015. The redemption on December 2, 1993, was funded by short-term borrowings from Ameritech. On November 16, 1993, the Company filed a registration statement with the SEC for issuance of up to $450.0 in unsecured debt securities. No issuances have been made under this shelf registration. Early extinguishment of debt costs (including call premiums and write-offs of unamortized deferred costs) were $7.0, $9.4, and $7.2 in 1993, 1992 and 1991, respectively, and were included in other income on the statements of income. (F) LEASE COMMITMENTS - The Company leases certain facilities and equipment used in its operations under both capital and operating leases. Rental expense under operating leases was $40.5, $43.6 and $44.3 for 1993, 1992 and 1991, respectively. At December 31, 1993 the aggregate minimum rental commitments under non- cancelable leases were approximately as follows: Years Operating Capital 1994 . . . . . . . . . . . . . $22.9 $ 4.9 1995 . . . . . . . . . . . . 20.9 4.1 1996 . . . . . . . . . . . . . 14.6 2.4 1997 . . . . . . . . . . . . . 9.7 1.6 1998 . . . . . . . . . . . . 5.2 1.0 Thereafter . . . . . . . . . . 9.0 3.8 Total minimum rental commitments . . . . . . . . $82.3 17.8 Less: amount representing executory costs . . . . . . . . . . . . 3.1 amount representing interest costs . . . . . . . . 3.7 Present value of minimum lease payments $11.0 XXX BEGIN PAGE 34 HERE XXX (G) FINANCIAL INSTRUMENTS - The following table presents the estimated fair value of the Company's financial instruments as of December 31, 1993 and 1992: Carrying Fair Value Value Cash and temporary cash investments . . . . . . . $ 17.0 $ 17.0 Debt . . . . . . . . . . . . . . . . . . . . . . . . . . 1,532.8 1,583.3 Long-term payable to ASI (for postretirement benefits) 22.9 22.9 Other assets . . . . . . . . . . . . . . . . . . . . . . 3.5 3.5 Other liabilities. . . . . . . . . . . . . . . . . . . . . 31.6 31.6 Carrying Fair Value Value Cash and temporary cash investments . . . . . . . $ 0.0 $ 0.0 Debt . . . . . . . . . . . . . . . . . . . . . . . . . . 1,524.5 1,501.8 Long-term payable to ASI (for postretirement benefits ) 25.8 25.8 Other assets . . . . . . . . . . . . . . . . . . . . . . . 7.3 7.3 Other liabilities. . . . . . . . . . . . . . . . . . . . . 17.6 17.6 The following methods and assumptions were used to estimate the fair value of financial instruments: Cash and temporary cash investments: Carrying value approximates fair value because of the short-term maturity of these instruments. Debt: The carrying amount (including accrued interest) of the Company's debt maturing within one year approximates fair value because of the short-term maturities involved. The fair value of the Company's long-term debt was valued based on the year-end quoted market prices for the same or similar issues. Long-term payable to ASI (for postretirement benefits): This item represents the long-term payable to ASI for the Company's proportionate share of ASI's transition benefit obligation related to adoption of SFAS No. 106. Carrying value approximates fair value for this item. Other assets and liabilities: These financial instruments consist primarily of long-term receivables and payables, other investments, and customer deposits. The fair value of these items was based on expected cash flows or, if available, quoted market prices. (H) ADDITIONAL FINANCIAL INFORMATION December 31, 1993 1992 Balance Sheets Other current liabilities: Accrued payroll . . . . . . . . . . . . . $ 23.2 $ 24.4 Compensated absences . . . . . . . . . . . . 50.3 47.4 Accrued taxes . . . . . . . . . . . . . . . 140.1 146.5 Advance billings and customer's deposits . . 58.2 54.6 Accrued interest . . . . . . . . . . . . . . 26.5 26.3 Other . . . . . . . . . . . . . . . . . . . 24.6 27.6 Total . . . . . . . . . . . . . . . . . . $ 322.9 $ 326.8 XXX BEGIN PAGE 35 HERE XXX 1993 1992 1991 Statements of Income Interest expense: Interest on long-term debt . . . . . $ 92.1 $ 91.9 $ 96.0 Interest on notes payable - Ameritech . . 7.5 8.8 9.7 Interest on other notes payable . . . . . -- -- 3.6 Interest on capital leases . . . . . . . . 1.4 1.6 2.0 Other . . . . . . . . . . . . . . . . . 5.2 7.3 14.0 Total . . . . . . . . . . . . . . . $ 106.2 $ 109.6 $ 125.3 Interest paid, net was $102.4, $106.4, and $118.2 in 1993, 1992, and 1991 respectively. 1993 1992 1991 Taxes other than income taxes: Property . . . . . . . . . . . . . . . . $ 99.9 $ 113.7 $ 106.0 Other . . . . . . . . . . . . . . . . . . . 32.3 30.4 30.9 Total . . . . . . . . . . . . . . . . $ 132.2 $ 144.1 $ 136.9 Maintenance and repair expense . . . . . . . $ 463.7 $ 478.8 $ 444.0 Advertising expense . . . . . . . . . . . . $ 30.8 $ 22.1 $ 19.4 Depreciation-Percentage of average depreciable telecommunications plant . . . 7.4% 7.3% 7.0% Revenues from American Telephone and Telegraph Company, consisting principally of interstate network access and billing and collection service revenues, comprised approximately 11%, 12%, and 13%, of total revenues in 1993, 1992 and 1991, respectively. No other customer accounted for more than 10% of total revenues. (I) CONTINGENCIES The Company has disputed the manner of assessment of its property taxes in Michigan. In August of 1993, the Michigan Supreme Court agreed to hear certain issues associated with that dispute which involves the 1984-1986 tax years. If the Company is successful in its arguments, it will receive a refund of overpayment of property taxes. If unsuccessful, the Company may be subject to an additional, and possibly substantial, tax liability for those years beyond 1986. An opinion of the court could be issued by the end of 1994. Management of the Company believes that the ultimate resolution of this case will not have a material adverse effect on the Company's financial position or results of operations. (J) OTHER INFORMATION Michigan Telecommunications Act On January 1, 1992, the Michigan Telecommunications Act of 1991 ("MTA"), Public Act 179, became effective. The new law replaced the former Michigan Telephone Act of 1913 and Public Act 305 and terminated traditional rate-of-return regulation of telecommunication providers within Michigan, including the Company. MTA affords the Company new pricing flexibility in certain areas such as message toll services and encourages the introduction of new services. XXX BEGIN PAGE 36 HERE XXX (K) CALCULATION OF RATIO OF EARNINGS TO FIXED CHARGES The ratio of earnings to fixed charges of the Company for the five years ended December 31, 1993, 1992, 1991, 1990, and 1989 was 5.27, 4.88, 4.12, 4.70, and 4.58 respectively. For the purpose of calculating this ratio: (i) earnings have been calculated by adding to income before interest expense and accounting changes, the amount of related taxes on income, the Single Business Tax, and the portion of rentals representative of the interest factor, (ii) the Company considers one-third of rental expense to be the amount representing return on capital, and (iii) fixed charges comprise total interest expense and such portion of rentals. (L) QUARTERLY FINANCIAL INFORMATION (UNAUDITED) Calendar Operating Net Quarter Revenues Income Income(Loss) 1st . . . . . . . . . . . . .. . $ 667.0 $134.5 $ 74.3 2nd . . . . . . . . . . . . . . . . 683.8 147.7 85.6 3rd . . . . . . . . . . . . . . . . . 696.2 142.1 90.6 4th . . . . . . . . . . . . . . . . . 699.8 170.2 92.7 Total . . . . . . . . . . . . . . $2,746.8 $594.5 $ 343.2 Calendar Operating Net Quarter Revenues Income Income(Loss) 1st . . . . . . . . . . . . . . . . . $ 647.3 $137.3 $(366.0) 2nd . . . . . . . . . . . . . . . . . 671.5 144.1 81.9 3rd . . . . . . . . . . . . . . . . . 683.0 147.3 79.6 4th . . . . . . . . . . . . . . . . . 677.1 147.1 82.3 Total . . . . . . . . . . . . . . $2,678.9 $575.8 $(122.2) Operating income represents revenues less costs and expenses excluding interest expense and other income-net. The fourth quarters of 1993 and 1992 were affected by several income and expense items. The fourth quarter of 1993 was affected by gains from a workforce resizing of $5.4, a reduction in the tax provision of $13.2 due to a change in state property tax law, and charges for the early retirement of debt of $7.0. In the fourth quarter of 1992, the Company recognized higher costs and charges resulting from its market realignment efforts, the early retirement of debt, and increased advertising costs. These costs were offset by gains resulting from workforce resizing and higher than expected pension credits. First quarter 1992 results reflect charges related to the adoption of SFAS Nos. 106 and 112 for certain postretirement and postemployment benefits, as discussed previously in Note (C) above. The charges totaled approximately $448.4. All adjustments necessary for a fair statement of results for each period have been included. (M) EVENT SUBSEQUENT TO DATE OF AUDITORS' REPORT (UNAUDITED) On March 25, 1994, Ameritech announced it would reduce its nonmanagement workforce resulting in an after-tax charge to the Company of $89.2. The charge will be recorded in the first quarter of 1994. The details of this plan are discussed on page 21 in Management's Discussion and Analysis of Results of Operations. XXX BEGIN PAGE 37 HERE XXX Item 9.

Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure No changes in nor disagreements with accountants on any matter of accounting principles or practices, financial statement disclosure or auditing scope or procedure occurred during the period covered by this annual report. PART IV Item 14.

Item 14. Exhibits, Financial Statement Schedules, and Reports on Form 8-K. (a) Documents filed as part of the report: (1) Financial Statements: Page Selected Financial and Operating Data. . . . 14 Report of Independent Public Accountants . . 22 Statements of Income and Reinvested Earnings . . . . . . . . . . . . . 23 Balance Sheets . . . . . . . . . . . . . . . . 24 Statements of Cash Flows. . . . . . . . . . 25 Notes to Financial statements. . . . . . . . 26 (2) Financial Statement Schedules V - Telecommunications Plant. . . . . . . . 41 VI - Accumulated Depreciation. . . . . . . . 43 VIII- Allowance for Uncollectibles. . . . . . 45 Financial statement schedules other than those listed above have been omitted because the required information is contained in the financial statements and notes thereto, or because such schedules are not required or applicable. XXX BEGIN PAGE 38 HERE XXX (3) Exhibits: Exhibits identified below, on file with the SEC, are incorporated herein by reference as exhibits hereto. Exhibit Number 3 Articles of Incorporation of the registrant, as amended March 26, 1990, and by-laws of the registrant, as amended May 7, 1992. 4 No instrument which defines the rights of holders of long and intermediate term debt of the registrant is filed herewith pursuant to Regulation S-K, Item 601(b)(4)(iii)(A). Pursuant to this regulation, the registrant hereby agrees to furnish a copy of any such instrument to the SEC upon request. 10a Reorganization and Divestiture Agreement among American Telephone and Telegraph Company, American Information Technologies Corporation and affiliates dated November 1, 1983 (Exhibit 10a to Form 10-K for 1983 for American Information Technologies Corporation, File No. 1-8612). 10b Agreement Concerning Contingent Liabilities, Tax Matters and Termination of Certain Agreements among American Telephone and Telegraph Company, Bell System Operating Companies, Regional Holding Companies and Affiliates dated November 1, 1983 (Exhibit 10j to Form 10-K for American Information Technologies Corporation, File No. 1-8612). 12 Computation of Ratio of Earnings to Fixed Charges for the five years Ended December 31, 1993. 23 Consent of independent public accountants. (b) Reports on Form 8-K: No report on Form 8-K was filed by the registrant during the last quarter of the year covered by this report. XXX BEGIN PAGE 39 HERE XXX SIGNATURES Pursuant to the requirements of Section 13 or 15(d) 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. MICHIGAN BELL TELEPHONE COMPANY by James W. Trunk James W. Trunk Vice President - Comptroller March 30, 1994 Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the date indicated. Principal Executive Officer: James E. Wilkes James E. Wilkes, President Principal Accounting and Financial Officer: James W. Trunk James W. Trunk, Vice President - Comptroller March 30, 1994 XXX BEGIN PAGE 40 HERE XXX SIGNATURES - (Continued) Ameritech Corporation By Richard H. Brown Richard H. Brown Vice Chairman the sole shareholder of the registrant, which has elected under the law of its state of incorporation to be managed by the shareholder rather than by a board of directors. March 30, 1994 XXX BEGIN PAGE 41 HERE XXX Schedule V -- Sheet 1 MICHIGAN BELL TELEPHONE COMPANY SCHEDULE V - TELECOMMUNICATIONS PLANT (Millions of Dollars) Col. A Col. B Col. C Col. D Col. E Col. F Balance at Balance at beginning Additions Retire- Other at end of Classification of period at cost(a) ments(b) changes(c) period Year 1993 Land . . . . . . . . .. $ 29.3 $ -- $ 0.1 $ -- $ 29.2 Buildings . . . . . . . . . . 612.4 21.3 10.0 -- 623.7 Computers and Other Office Equipment 244.3 13.5 39.9 -- 217.9 Vehicles and Other Work Equipment . 57.7 5.8 3.7 -- 59.8 Central Office Equipment . . 2,966.2 264.5 268.9 1.3 2,963.1 Information Orig/ Term Equipment . . 67.6 9.0 5.6 (0.8) 70.2 Cable and Wire Facilities . 3,305.2 178.3 26.1 -- 3,457.4 Capitalized Lease Assets . 24.2 1.1 2.3 -- 23.0 Miscellaneous Other Property 8.6 (0.1) -- -- 8.5 Total telecommunications plant in service . . . . . . 7,315.5 493.4 356.6 0.5 7,452.8 Telecommunications plant under construction. . 140.2 (34.0) -- -- 106.2 Total telecommunications plant. . . . $7,455.7 $459.4 $356.6 $ 0.5 $7,559.0 Year 1992 Land . . . . . . . . . . $ 29.4 $ -- $ 0.1 $ -- $ 29.3 Buildings . . . . . . . . 592.7 26.4 6.7 -- 612.4 Computers and Other Office Equipment 224.0 29.5 9.2 -- 244.3 Vehicles and Other Work Equipment . 58.3 5.8 6.4 -- 57.7 Central Office Equipment . 2,885.9 240.5 160.2 -- 2,966.2 Information Orig/ Term Equipment . . 86.6 6.1 25.1 -- 67.6 Cable and Wire Facilities . 3,145.7 179.6 20.1 -- 3,305.2 Capitalized Lease Assets . 18.4 6.5 0.7 -- 24.2 Miscellaneous Other Property 7.3 1.3 -- -- 8.6 Total telecommunications plant in service . . . . . . 7,048.3 495.7 228.5 -- 7,315.5 Telecommunications plant under construction. . . 112.3 27.9 -- -- 140.2 Total telecommunications plant. . . $7,160.6 $523.6 $228.5 $ -- $7,455.7 The notes on Sheet 2 are an integral part of this schedule. XXX BEGIN PAGE 42 HERE XXX Schedule V -- Sheet 2 MICHIGAN BELL TELEPHONE COMPANY SCHEDULE V - TELECOMMUNICATIONS PLANT (Millions of Dollars) Col. A Col. B Col. C Col. D Col. E Col. F Balance at Balance at beginning Additions Retire- Other at end of Classification of period at cost(a) ments(b) changes(c) period Year 1991 Land . . . . . $ 28.6 $ 0.8 $ -- $ -- $ 29.4 Buildings . . . . . . . . . 575.3 29.0 11.6 -- 592.7 Computers and Other Office Equipment 207.7 31.2 14.9 -- 224.0 Vehicles and Other Work Equipment . 64.1 5.8 11.6 -- 58.3 Central Office Equipment . . 2,736.9 283.4 165.8 31.4 2,885.9 Information Orig/ Term Equipment . . 553.7 8.0 443.7 (31.4) 86.6 Cable and Wire Facilities . 3,017.6 179.0 50.9 -- 3,145.7 Capitalized Lease Assets . . 21.0 2.2 4.8 -- 18.4 Miscellaneous Other Property 6.5 0.8 -- -- 7.3 Total telecommunications plant in service . . . . . . 7,211.4 540.2 703.3 -- 7,048.3 Telecommunications plant under construction. . . 101.9 10.4 -- -- 112.3 Total telecommunications plant. . . $7,313.3 $550.6 $703.3 $ -- $7,160.6 Notes: (a) Additions, other than to Buildings, include material purchased from Ameritech Services, Inc., a centralized procurement subsidiary in which the Company has a 26 percent ownership interest (see note (A) to Financial Statements). Additions shown also include (1) the original cost (estimated if not known) of reused material, which is concurrently credited to Material and Supplies, and (2) Interest During Construction. Transfers between the classifications listed are included in Column E. (b) Items of telecommunications plant when retired or sold are deducted from the property accounts at the amounts at which they are included therein (estimated if not known). (c) Reflects reclassification of certain subscriber equipment to central office circuit equipment accounts. XXX BEGIN PAGE 43 HERE XXX Schedule VI -- Sheet 1 MICHIGAN BELL TELEPHONE COMPANY SCHEDULE VI - ACCUMULATED DEPRECIATION (Millions of Dollars) Col. A Col. B Col. C Col. D Col. E Col. F Balance at Balance at beginning Depreciation Retire- Other at end of Classification of period expense(a) ments(b) changes period Year 1993 Buildings . . . . . . . $ 146.9 $ 17.2 $ 12.8 $ 0.1 $ 151.4 Computers and Other Office Equipment 147.6 26.3 39.8 -- 134.1 Vehicles and Other Work Equipment . . 18.3 5.4 5.0 -- 18.7 Central Office Equipment 1,217.5 303.0 264.0 (1.8) 1,254.7 Information Orig/ Term Equipment . . 43.9 4.4 6.1 0.4 42.6 Cable and Wire Facilities 1,411.5 183.8 34.3 (1.8) 1,559.2 Capitalized Lease Assets 12.8 3.1 2.2 0.1 13.8 Miscellaneous Other Property 1.1 -- -- 0.6 1.7 Total Accumulated Depreciation. . . . $2,999.6 $543.2 $364.2 $ (2.4) $3,176.2 Year 1992 Buildings . . . . . $ 138.7 $ 16.4 $ 8.1 $ (0.1) $ 146.9 Computers and Other Office Equipment 129.5 27.6 9.5 -- 147.6 Vehicles and Other Work Equipment . . 18.0 6.8 6.5 -- 18.3 Central Office Equipment 1,088.2 286.9 157.6 -- 1,217.5 Information Orig/ Term Equipment . . 62.9 6.6 25.2 (0.4) 43.9 Cable and Wire Facilities 1,265.7 173.1 27.3 -- 1,411.5 Capitalized Lease Assets 10.1 3.3 0.6 -- 12.8 Miscellaneous Other Property 1.0 -- -- 0.1 1.1 Total Accumulated Depreciation. . . . $2,714.1 $520.7 $234.8 (0.4) $2,999.6 The notes on Sheet 2 are an integral part of this schedule. XXX BEGIN PAGE 44 HERE XXX Schedule VI -- Sheet 2 MICHIGAN BELL TELEPHONE COMPANY SCHEDULE VI - ACCUMULATED DEPRECIATION Col. A Col. B Col. C Col. D Col. E Col. F Balance at Balance at beginning Depreciation Retire- Other at end of Classification of period expense(a) ments(b) changes period (Millions of Dollars) Year 1991 Buildings . . . . .. $ 136.1 $ 17.1 $ 14.3 $ (0.2) $138.7 Computers and Other Office Equipment 115.6 27.6 13.7 -- 129.5 Vehicles and Other Work Equipment . . 17.3 10.1 9.4 -- 18.0 Central Office Equipment 934.6 281.6 155.7 27.7 1,088.2 Information Orig/ Term Equipment . . 527.6 6.8 443.8 (27.7) 62.9 Cable and Wire Facilities 1,159.8 161.6 55.7 -- 1,265.7 Capitalized Lease Assets 11.1 3.1 4.1 -- 10.1 Miscellaneous Other Property 0.8 -- -- 0.2 1.0 Total Accumulated Depreciation. . . $2,902.9 $507.9 $696.7 $ -- $2,714.1 Notes: (a) The provision for interstate depreciation as prescribed by the FCC is based on the straight-line remaining life and the straight-line equal life group methods of depreciation applied to individual categories of telephone plant with similar characteristics. Beginning in 1983, the Company has accounted for intrastate depreciation in accordance with MPSC straight-line remaining life depreciation rates and the ten-year amortization of a recognized intrastate reserve deficiency. Beginning in 1990, the Company began a phase-in of equal life group rates for determination of intrastate depreciation. Beginning in 1992, the Company is implementing a cyclical review plan under which the depreciation rate parameters of various classes of plant are under examination on a triennial basis. For the years 1993, 1992, and 1991 depreciation expressed as a percentage of average depreciable plant was 7.4%, 7.3% and 7.0%, respectively. (b) 1991 data includes amortization of the undepreciated balance and retirement of investment in tools and equipment costing less than five hundred dollars but more than two hundred dollars purchased prior to January 1, 1988. 1991 also includes $442.4 in retirements of customer premises wiring assets fully amortized. XXX BEGIN PAGE 45 HERE XXX Schedule VIII MICHIGAN BELL TELEPHONE COMPANY SCHEDULE VIII - ALLOWANCE FOR UNCOLLECTIBLES (Millions of Dollars) Col. A Col. B Col. C Col. D Col. E Additions Balance at Charged Charged to Balance at beginning to other Other end of Classification of period expense accounts(a) Deductions(b) period Year 1993 . . . . . . $ 40.6 $ 42.7 $ 57.5 $ 95.9 $ 44.9 Year 1992 . . . . . . . . 38.2 36.4 50.4 84.4 40.6 Year 1991. . . . . . . $ 72.4 $ 34.9 $ 51.2 $120.3 $ 38.2 (a) Includes principally amounts previously written off which were credited directly to this account when recovered and amounts related to interexchange carrier receivables which are being billed by the Company. (b) Amounts written off as uncollectible.

743368_1993.txt

743368

1993

ITEM 1. BUSINESS GENERAL Bowater Incorporated (together with its consolidated subsidiaries, the "Company") is engaged in the manufacture, sale and distribution of newsprint, directory paper, uncoated groundwood specialties, coated publication and educational workbook paper, market pulp, continuous stock computer forms and lumber. The Company operates facilities in both the United States and Canada, manages and controls approximately 4.0 million acres of timberlands to support these facilities and markets and distributes its various products both domestically and in the export market. On December 31, 1991, the Company acquired 80 percent of the stock of Great Northern Paper, Inc. ("GNP") from Great Northern Nekoosa Corporation ("GNN"), a subsidiary of Georgia-Pacific Corporation. In July 1992, the Company acquired the remaining 20 percent of GNP under the terms of its purchase agreement with GNN. The Company was incorporated in Delaware in 1964. The Company's principal executive offices are currently located at 55 East Camperdown Way, Greenville, South Carolina 29602, and its telephone number at that address is (803) 271-7733. Information regarding segment, geographic area, and net export sales is incorporated herein by reference to pages 8 and 27 of the Company's 1993 Annual Report (the "Annual Report"). Information regarding the pulp and paper industry is incorporated herein by reference to pages 2 through 5 of the Annual Report. Information regarding the Company's liquidity and capital resources is incorporated herein by reference to pages 12 through 14 of the Annual Report. NEWSPRINT, DIRECTORY PAPERS AND UNCOATED GROUNDWOOD SPECIALTIES The Company is the largest manufacturer of newsprint in the United States and, with its Nova Scotia mill, is the third largest manufacturer in North America. Its annual capacity is approximately 8 percent of the North American total. The Company presently manufactures newsprint at five separate locations: Calhoun, Tennessee; Catawba, South Carolina; Millinocket and East Millinocket, Maine; and Liverpool, Nova Scotia. Both the Company's Southern Division and Calhoun Newsprint Company ("CNC") (of which stock with approximately 51 percent voting power is held by the Company and stock with approximately 49 percent voting power is held by Advance Publications, Inc.) are located at Calhoun, Tennessee. The Company's Carolina Division is located at Catawba, South Carolina, and Bowater Mersey Paper Company ("Mersey") (which is owned 51 percent by the Company and 49 percent by The Washington Post Company) is located at Liverpool, Nova Scotia. GNP is comprised of two mills located at Millinocket and East Millinocket, Maine, the Pinkham Lumber Company in Ashland, Maine, and approximately 2.1 million acres of timberlands in Maine. The Calhoun facility, which produces newsprint for Southern Division and CNC, is located on the Hiwassee River in Tennessee and is the largest newsprint mill in North America. At this facility, Southern Division operates four paper machines, which produced 594,550 tons of newsprint and groundwood specialty papers in 1993. Also located at this facility is CNC's No. 5 paper machine, which produced 241,627 tons of newsprint in 1993. The continuing modernization of Southern Division's facilities has contributed substantially to improved product quality and is helping the mill to maintain its position as one of the most productive in the industry. Although Southern Division manages and operates the entire Calhoun facility, CNC owns 68.4 percent of the thermomechanical pulp ("TMP") mill and 100 percent of the recycled fiber plant located at the Calhoun facility. Southern Division owns the remaining 31.6 percent of the TMP mill and 100 percent of the other facilities at this location. These other facilities include kraft and stone groundwood pulp mills, a power plant, water treatment facilities, and other support equipment necessary to produce the finished product. The newsprint machine at the Company's Carolina Division, which produced 240,623 tons in 1993, is one of the largest and most productive newsprint machines in the industry. In 1988, the Company installed a twin-wire former and other ancillary equipment that have enhanced this machine's capacity and permitted it to produce a higher quality product. The Mersey mill is located on an ice-free port providing economical access to ports along the eastern seaboard of the United States and throughout the world. Its two paper machines, built in 1929, were completely rebuilt between 1983 and 1985 and produced 263,306 tons of newsprint in 1993. The mill also operates pulping and other support facilities required to produce the finished product. A new TMP mill was started up in late 1989 and now supplies 100 percent of the pulp to the two newsprint machines. This change has resulted in significant improvements in product quality. The East Millinocket mill is located on the West Branch of the Penobscot River in northern Maine. Its two paper machines (Nos. 5 and 6) were built in 1954 and completely rebuilt in 1986. These two machines produced a total of 276,824 tons of newsprint, directory paper and other groundwood specialties in 1993. The mill also operates a groundwood pulp mill and other support facilities required to produce the finished products. Sulfite pulp is pumped through a pipeline from the Millinocket mill for use at the East Millinocket mill. The Millinocket Mill is located eight miles from the East Millinocket mill, and in 1993 produced 154,207 tons of newsprint, directory papers and uncoated groundwood specialties. These paper grades are used in magazines, catalogs, directories, newspaper advertising inserts and business forms and are sold primarily to customers east of the Mississippi River. During the third quarter of 1993, the Company announced the phased closure of certain older, higher cost operations located at the Millinocket mill. The phaseout will involve the shutdown of the mill's woodyard, groundwood pulping facilities and a small paper machine that produces uncoated groundwood specialties. Approximately 200 positions will be eliminated throughout the mill's operations over a 12 month period as a result of this closure. The Company believes that these changes will significantly improve the mill's cost competitiveness. The production of all five newsprint mills is sold directly by the Company through regional sales offices located in major metropolitan areas of the eastern half of the United States. Advance Publications, Inc. purchases the equivalent of CNC's entire annual output, and The Washington Post purchases approximately 80,000 tons annually. Combined, these two customers in 1993 accounted for approximately 8.7 percent of the Company's consolidated net sales and 21.4 percent of the Company's newsprint sales. The geographical location of the Company's newsprint mills permits distribution of their products by rail, truck, ship or barge. COATED PAPER The Company is the fifth largest producer in the United States and the sixth largest North American producer of coated paper. Coated paper produced by the Company is light weight coated paper ("LWC") and is used in special interest magazines, mail order catalogs, advertising pieces and coupons. The Company manufactures a variety of coated grades on two paper machines (Nos. 1 and 2) at its Catawba, South Carolina, mill site and on three paper machines (Nos. 7, 8, and 10) at its Millinocket, Maine, mill site. The Company's No. 2 machine at Catawba began production in July 1986 and reached its design capacity during 1987. Both machines at Catawba include off-machine coaters. At Millinocket, the Nos. 7 and 8 machines produce a base stock which is coated on an off-machine blade coater while the No. 10 machine has an on-machine roll coater. In 1993, the two coated machines at Catawba produced 333,490 tons of LWC and the three coated machines at Millinocket produced 121,425 tons of LWC. Coated paper is sold by the Company to printers, publishers, mail order houses and paper merchants. It is distributed by truck and rail from the Catawba and Millinocket mill sites, which are strategically located to supply the southeastern and northeastern United States, respectively, as well as jointly serving the midwestern market. MARKET PULP In addition to furnishing its pulp requirements, the Company in 1993 supplied 256,599 tons of bleached kraft market pulp to manufacturers of fine paper, tissues and other paper products from its market pulp facility at Catawba, South Carolina. In 1990, the Company replaced its kraft mill at Calhoun, Tennessee. The new 900 tons per day capacity mill replaced a smaller 34-year old kraft pulp mill. This new mill utilizes the most up-to-date technology and has provided increased capacity, improved pulp quality, reduced energy consumption, and an improved environmental impact. During 1993, in addition to supplying the chemical pulp portion of the newsprint furnish, the new kraft mill produced an additional 42,438 tons of fully bleached market pulp for sale to customers. In 1994, the Southern Division will replace its present recovery boilers, which are 27 and 39 years old, with a new recovery boiler currently under construction. A recovery boiler is an essential part of the kraft pulping process. The new recovery boiler will enable the Company to realize significant cost reductions and meet currently proposed environmental regulations. Most of the Company's market pulp is fully bleached, but small amounts of semi-bleached kraft grades are also produced. In recent years, 70 percent to 80 percent of the Company's pulp sales have been to the export market, which is sold through agents. United States sales are made directly by the Company. COMMUNICATION PAPERS The Company's subsidiary, Bowater Communication Papers Inc. ("BCPI"), manufactures continuous stock computer forms at eight plants in the United States. BCPI markets this product and other business communication papers through its two divisions, Bowater Computer Forms ("BCF") and Star Forms, which use a network of 30 distribution centers to service customers in major metropolitan areas throughout the United States. BCF specializes in direct sales to numerous large-volume end-users, such as banks and governmental entities, while Star Forms concentrates on sales to smaller businesses and individuals through sales to numerous business forms distributors, paper merchants, office product dealers, computer stores and other outlets. LUMBER, STUMPAGE AND OTHER PRODUCTS In connection with its primary business of manufacturing and distributing various paper products and market pulp, the Company is engaged in several business areas related to its primary business. The Company currently owns or manages under lease approximately 4.0 million acres of timberlands throughout eight states and Nova Scotia. Approximately 2.1 million acres of these timberlands were acquired in the GNP acquisition and are located in the State of Maine. The Company also maintains two nurseries from which it supplies seedlings to replace trees harvested from its timberlands, generally planting three trees for each one that is cut. The Company operates three sawmills that produce construction grade lumber. The sawmill at Albertville, Alabama, produced 96.5 million board feet of lumber in 1993. This lumber is sold in the southern and midwestern United States. Mersey operates a small sawmill in Oak Hill, Nova Scotia, the products of which are sold to customers in eastern Canada and the United Kingdom. The Oak Hill sawmill produced 23.7 million board feet of lumber in 1993. The Pinkham Lumber Company sawmill in Ashland, Maine, produced 72.5 million board feet of lumber in 1993, with the majority of this product sold to customers in New England. RECYCLING CAPABILITY The Company has focused its efforts in recent years on meeting the demand for recycled content paper products, which provides an environmental benefit in reducing solid waste landfill deposits and creates a marketing imperative for publishers and other customers trying to meet recycled content standards. The Company broke ground for its first recycling plant in 1990 at Calhoun, Tennessee. The mill has been successful since its startup in 1991. Taking a mixture of 70 percent used newspapers and 30 percent used magazines, the plant utilizes advanced mechanical and chemical processes to produce high quality pulp. When up to 20 percent of this mixture is combined with virgin fiber, the resulting product is comparable in quality to paper produced with 100 percent virgin fiber pulp. Substantial tonnages of recycled content paper have been made available to newsprint customers, while increasing quantities of computer forms papers that contain 20 percent post-consumer or comparable recycled fiber have been shipped to the Company's communication papers group for conversion to computer forms. The first major project at GNP since the acquisition has been the construction of a similar recycling plant to provide recycled fiber for newsprint, directory papers and other groundwood papers at that location. When this second facility reaches full production, expected in the fourth quarter of 1994, the Company will have a combined capacity to supply over 250,000 tons per year of recycled fiber pulp to its paper mills. COMPETITION Newsprint and bleached softwood market pulp, two of the Company's principal products, are consumed in virtually every country of the world and produced in nearly all countries with adequate indigenous fiber sources. No proprietary process is employed in either their manufacture or use. Newsprint and market pulp from a variety of manufacturers may be used with relatively few process changes to produce customer products. The Company faces intense competition in these two products from a number of other producers in the United States and from pulp and paper companies of Canada, Scandinavia and other forested countries. In addition to price, quality, service, and the ability to produce paper with recycled content are important competitive determinants. Competition in the directory and groundwood specialty markets is intense. The Company uses price, quality and service to compete with other producers. The coated paper market is also highly competitive. Price, quality and service are important competitive determinants, but a degree of proprietary knowledge is required in both the manufacture and use of this product which requires close supplier-customer relationships. As with other globally manufactured and sold commodities, the Company's competitive position is significantly affected by the volatility of currency exchange rates. Since several of the Company's primary competitors are located in Canada, Sweden and Finland, the relative rates of exchange between those countries' currencies and the United States dollar can have a substantial effect on the Company's ability to compete. Recently, the Company's competitive position has been adversely affected by the relative strength of the United States dollar against these currencies. In addition, the degree to which the Company competes with foreign producers depends in part on the level of demand abroad. Shipping costs generally cause producers to prefer to sell in local markets when the demand is sufficient in those markets. Trends in electronic data transmission and storage could adversely affect traditional print media, including products of the Company's customers; however, neither the timing nor the extent of those trends can be predicted with certainty. Industry reports indicate that the Company's newspaper publishing customers in North America have experienced some loss of market share to other forms of media and advertising, such as direct mailings and newspaper inserts (both of which are end uses for selected Company products) and cable television. These customers are also facing a decline in newspaper readership, circulation and advertising lineage. The Company does not believe that this is the case in most overseas markets. Part of the Company's competitive strategy is to be a low cost producer of its products while maintaining strict quality standards and being responsive on environmental issues. The Company believes that its large woodland base, relative to its paper production, provides it with a competitive advantage in controlling costs and that its two recycling facilities have further enhanced its competitive position. The Company believes that the cost advantage of these recycling facilities, as compared to the more traditional methods of paper production, should continue until the price for wastepaper significantly rises. The Company's competitive advantage in the communication papers market has been to differentiate itself from others by developing new products, including forms with recycled content, and by gaining the benefits of additional vertical integration, using the capabilities of its paper mills. Paper is the primary cost of this business, and the Company is moving toward providing more of BCPI's paper needs internally to the extent consistent with customer product requirements. The Company believes that, notwithstanding the increase in use of business machines using higher grades of paper, customers that generate high volumes of internal documents will continue to demand groundwood based continuous stock computer forms. RAW MATERIALS The manufacture of pulp and paper requires significant amounts of wood and energy. Approximately 2.9 million cords of wood were consumed by the Company during 1993 for pulp and paper production. The Company harvests wood fiber from Company-owned properties equal to approximately 50% of its total wood fiber requirements with the balance of virgin wood requirements purchased, primarily under contract, from local wood producers, private landowners and sawmills (in the form of chips) at market prices. Wastepaper (in the form of old newspapers and magazines) is purchased from suppliers in the regions of the Company's two recycling plants. These suppliers collect, sort and bale the material before selling it to the Company, primarily under long-term contracts. Steam and electrical power are the primary forms of energy used in pulp and paper production. Process steam is produced in boilers at the various mill sites from a variety of fuel sources. In recent years, the Company has reduced its dependence upon oil and natural gas by increasing its ability to burn wood wastes and coal. Internally generated electrical power at the Calhoun and Catawba facilities is used to supplement purchased electrical power. The GNP operation is totally self-sufficient electrically with six hydroelectric facilities located on the West Branch of the Penobscot River (containing 31 hydroelectric generators) and seven steam turbine generators located in the mill power plants. The Company operates its Maine hydroelectric facilities pursuant to long-term licenses granted by the Federal Energy Regulatory Commission ("FERC") or its predecessor, the Federal Power Commission. The existing licenses for certain dams expired on December 31, 1993. The Company is currently engaged in the multi-year relicensing process to obtain new 30-year licenses. The relicensing proceedings have not yet concluded; however, annual extensions are expected to be granted while FERC proceeds with preparation of an environmental impact statement now scheduled to be issued in the third quarter of 1994. In connection with the relicensing process, various groups have intervened and raised objections that are now being considered by FERC. Although there can be no assurances, the Company believes that, notwithstanding these objections, new licenses will be issued and that such licenses will contain terms and conditions that will allow the Company to maintain most of the benefits that are provided under the existing licenses. In the interim period, the Company will continue to operate under the existing licenses or such annual licenses as FERC issues prior to the conclusion of the pending relicensing proceedings. EMPLOYEES The Company employs approximately 6,600 people, of whom approximately 4,300 are represented by bargaining units. The labor agreement at the Company's Catawba mill, covering all of the plant's hourly employees, was recently extended for four years beginning April 19, 1993. A 1991 labor contract at the Calhoun mill with most of the plant's hourly employees lasts until July, 1996. The labor contract covering all unionized employees at the Mersey mill has been renewed as of April 30, 1993, and expires on April 30, 1998. Contracts covering the large majority of unionized employees of GNP expire in August 1995. All plant facilities are situated in areas where an adequate labor pool exists and relations with employees are considered good. TRADEMARKS AND NAME The Company currently possesses the exclusive worldwide right to use the trademarked Company logo and, in the western hemisphere, the exclusive right to use the trade name "Bowater". The Company considers these rights to be valuable and necessary to the conduct of the Company's business. ENVIRONMENTAL MATTERS For a detailed explanation of the Company's environmental issues, see "Environmental Matters" on page 14 of the Annual Report, incorporated herein by reference. The Company believes that its U.S. and Canadian operations are in substantial compliance with all applicable federal and state environmental regulations, and that all currently required control equipment is in operation. While it is impossible to predict future environmental regulations that may be established, the Company believes that it will not be at a competitive disadvantage with regard to meeting future U.S. or Canadian standards, and that related expenditures and costs will not materially affect the Company's financial position or results of operations. The Company has taken positive action on the municipal solid waste issue by constructing two recycle facilities at its Tennessee and Maine mills. See "Recycling Capability" on page 3. ITEM 2.

ITEM 2. PROPERTIES Reference is made to the information set forth in Item 1, "Business", pages 6 to 8 and the back cover page of the Annual Report for the location and general character of principal plants and other materially important properties of the Company. The Company owns all of its properties with the exception of certain timberlands, office premises, manufacturing facilities and transportation equipment which are leased by the Company under long-term leases. See "Timberland Leases and Operating Leases" on page 26 of the Annual Report, incorporated herein by reference. ITEM 3.

ITEM 3. LEGAL PROCEEDINGS In January 1994, the Company settled for an aggregate sum of approximately $10.5 million all pending lawsuits naming the Company and other parties as defendants in the State Circuit Courts of Hamilton County, Knox County and McMinn County, Tennessee, and in the United States District Court for the Eastern District of Tennessee, that claimed compensatory and punitive damages for wrongful death, personal injury and/or property damage arising out of a series of vehicular accidents that occurred on December 11, 1990, in fog on Highway I-75, which passes in the general area of the Company's Calhoun, Tennessee, mill property. The plaintiffs in these actions had sought to make the Company liable on the theory that the mill's operations created the fog or contributed to its density. The Company's excess insurers reserved rights with respect to coverage of the plaintiffs' claims on various grounds including their assertion that coverage is not available for pollution claims, for consequences expected or intended by the Company or for any punitive damages. On November 22, 1993, the Company filed a complaint in the United States District Court for the Eastern District of Tennessee against its first excess insurer, National Union Fire Insurance Company, which seeks a declaratory judgment in favor of the Company on the issues in dispute with that insurer. The settlements will be funded by the Company's insurance carriers, subject, in the case of approximately $9.5 million funded by the Company's first excess insurer, to subsequent determination of ultimate coverage responsibility in the pending insurance coverage lawsuit. Although no assurance can be provided, the Company believes that it should prevail on the insurance coverage issue. The Company is also involved in various litigation relating to contracts, commercial disputes, tax, environmental, workers' compensation and other matters. The Company's management is of the opinion that the ultimate disposition of these matters will not have a material adverse effect on the Company's operations or its financial condition taken as a whole. ITEM 4.

ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS No matters were submitted to a vote of security holders during the fourth quarter of fiscal 1993. EXECUTIVE OFFICERS OF THE REGISTRANT The Company's executive officers, who are elected by the Board of Directors to serve one-year terms, are listed below. There are no family relationships among officers, or any arrangement or understanding between any officer and any other person pursuant to which the officer was selected. Anthony P. Gammie became Chairman of the Board in January 1985, and has been Chief Executive Officer of the Company since January 1983. He was the President from January 1983 to July 1, 1992. He was President of the Pulp and Paper Group from August 1981 to December 1982, and Executive Vice President from 1979 to 1982. He was a director of Bowater plc until July 1984, and prior to being transferred to the United States at the end of 1978, he was the Chairman and Managing Director of Bowater United Kingdom Limited. He has been a director of the Company since 1979. He is also a director of Alumax Inc. and The Bank of New York. Richard D. McDonough became Vice Chairman on July 1, 1992. He served as Chief Financial Officer of the Company from March 1979 to June 1993 and as Senior Vice President -- Finance from March 1979 to June 1992. He was formerly a Vice President of the Singer Company, where he was employed from 1963 to 1979. He has been a director of the Company since 1979.* Mr. McDonough also serves as a director of Geo International, Inc. John C. Davis became Senior Vice President -- Pulp and Paper Sales in February 1994. Previously he was Vice President -- Pulp and Paper Sales since July 1992 and Vice President -- Marketing of the Pulp and Paper Group and President of Bowater Sales Division since 1983. Robert C. Lancaster became Senior Vice President and Chief Financial Officer on July 1, 1993. He was Senior Vice President -- Finance from July 1, 1992 to July 1, 1993. Prior to that he was Vice President -- Controller from July 1984 to 1992. Previously he was Assistant Controller of ACF Industries Incorporated from 1980 to 1984, and was a Senior Manager with Price Waterhouse, where he was employed from 1968 to 1980. David E. McIntyre became Senior Vice President -- Pulp and Paper Manufacturing in February 1994. Previously he was Vice President -- Pulp and Paper Manufacturing since July 1992, Vice President -- Pulp and Paper Manufacturing Services of the Company's Pulp and Paper Group from 1988 to 1992, and Vice President-Manufacturing Services of the Pulp and Paper Group from 1986 to 1988. Robert J. Pascal became Senior Vice President in February 1994. Previously he was Vice President since December 1986 and President of the Communication Papers Group since December 1990, prior to which he was General Manager of that Group. He was Group Vice President of Pitney Bowes, Inc. from 1981 to 1986. Donald J. D'Antuono was appointed Vice President -- Corporate Development in September 1991. Previously he had been Vice President -- Investor Relations since April 1984. He was Controller from 1977 to 1978, Treasurer of Mersey from 1978 to 1979 and Vice President-Controller of the Company from 1979 to 1984. John P. Fucigna became Vice President -- Finance on July 1, 1992. Prior to that he had been Vice President -- Treasurer since February 1982, and was Treasurer from 1975 to January 1982. Robert D. Leahy was appointed Vice President -- Corporate Relations in March 1993. Previously he served as Director of Media Communications at International Paper Company, (a paper products company), from November 1989 to March 1993 where he was responsible for media, government, and investor relations, as well as employee communications and advertising. Earlier he held various senior level communications/public affairs positions in both corporate and agency settings from 1980 through 1989, most recently as Vice President of Corporate Communications for Endal Corporation, a metal products company, from 1987 to 1989. David G. Maffucci has been Vice President -- Treasurer since July 1, 1993. He served as Treasurer from July 1, 1992 to July 1, 1993. Prior to that he was Director of Financial Planning and Accounting Operations since 1987 and served as Assistant Controller since 1984. Ecton R. Manning has been Vice President since March 1988 and General Counsel since September 1988. Previously he was Vice President, General Counsel and Secretary of U.S. Plywood Corporation from 1985 to 1987, and was Vice President and General Counsel of Continental Forest Industries, Inc., where he was employed from 1973 to 1984. Robert A. Moran has been Vice President -- Pulp and Paper Manufacturing Services since July 1, 1992. Prior to that he was Vice President -- Manufacturing Services for the Pulp and Paper Group since 1991, Director of Planning and Development for the Pulp and Paper Group from August 1988 to November 1991 and also served as Assistant General Manager of the Company's Catawba, South Carolina, mill from April 1988 to August 1988. Michael F. Nocito has been Vice President -- Controller since July 1, 1993. He served as Controller of the Company's Southern Division from October 1, 1992 to July 1, 1993. Prior to this he served as Assistant Controller of the Southern Division since 1988. Mr. Nocito joined the Company in 1978. Aubrey S. Rogers has been Vice President -- Information Services since July 1, 1992. Prior to that he was Vice President -- Information Services of the Pulp and Paper Group since 1990 and Assistant Controller-Director of Planning and Information Services since 1989. He also served in various financial positions of the Company for more than twenty years. Wendy C. Shiba has been Secretary since July 28, 1993, and Assistant General Counsel since June 1993. From January 1992 to June 1993, she was Corporate Chair of the City of Philadelphia Law Department where she supervised the work of forty-five attorneys, paralegals and secretaries and was Associate Professor of Law from 1990 to 1993 and Assistant Professor of Law from 1985 to 1990 at Temple University School of Law where she taught subjects relating to corporate law and served as a consultant in legal writing and corporate law. Earlier she practiced corporate law in the private sector. Phillip A. Temple has been Vice President -- Human Resources and Administration since March 1993. Prior to that time he served as a consultant for two years in the areas of human resources, compensation and benefits. Previously he was Vice President -- Human Resources for the Sara Lee Corporation, a diversified consumer products company, from 1983 to 1991. * Except for the period March 1981 through December 1982. PART II ITEM 5.

ITEM 5. MARKET FOR THE REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS (a) The Company's Common Stock is listed on the New York Stock Exchange (stock symbol BOW), U.S. regional exchanges, the London Stock Exchange and the Swiss Stock Exchanges. Price information with respect to the Company's Common Stock on page 28 of the Annual Report is incorporated herein by reference. (b) As of March 10, 1994, there were approximately 7,150 holders of record of the Company's Common Stock. (c) The Company paid consecutive quarterly dividends of $.18 per common share for the period October 1, 1984, to January 1, 1987. In 1987, the Board of Directors announced two quarterly dividend increases. On January 8, 1987 the quarterly dividend was increased to $.20 per common share effective with the dividend payable on April 1, 1987. On November 18, 1987, the quarterly dividend was again increased to $.23 per common share effective with the dividend payable on January 1, 1988. On November 16, 1988, the quarterly dividend was increased to $.28 per common share effective with the dividend payable on January 1, 1989. On November 15, 1989, the quarterly dividend was increased to $.30 per common share effective with the dividend payable January 1, 1990. On February 26, 1993, the quarterly dividend was decreased to $.15 per common share effective with the dividend payable April 1, 1993. The dividend of $.15 per share was also paid on July 1 and October 1 of 1993. Future declarations of dividends on the Company's Common Stock are discretionary with the Board of Directors, and the declaration of any such dividends will depend upon, among other things, the Company's earnings, capital requirements and financial condition. Dividends on the Common Stock may not be paid if there are any unpaid or undeclared accrued dividends on the Company's outstanding preferred stock, which currently consists of the Company's LIBOR Preferred Stock, Series A, the 7% PRIDES, Series B Convertible Preferred Stock, and 8.40% Series C Cumulative Preferred Stock, and may include, upon the occurrence of certain events, the Company's Junior Participating Preferred Stock, Series A. At December 31, 1993, there were no arrearages on dividends accrued on the Company's LIBOR Preferred Stock, Series A. In addition, the Company's ability to pay dividends on any of its preferred stock and on its Common Stock will depend on its maintaining adequate net worth and compliance with the required ratio of total debt to total capital as defined in and required by the Company's current credit agreement (the "Credit Agreement"). The Credit Agreement requires the Company to maintain a minimum net worth (generally defined therein as common shareholders' equity plus any outstanding preferred stock) of $750 million. In addition, the Credit Agreement imposes a maximum 60 percent ratio of total debt to total capital (defined therein as total debt plus net worth). At December 31, 1993, the net worth of the Company and the ratio of total debt to total capital were $806.9 million and 58 percent, respectively. ITEM 6.

ITEM 6. SELECTED FINANCIAL DATA Incorporated herein by reference to "Financial and Operating Record" appearing on pages 30 and 31 of the Annual Report. ITEM 7.

ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATION Incorporated herein by reference to "Business and Financial Review" appearing on pages 9 to 14 of the Annual Report. ITEM 8.

ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA Incorporated herein by reference are the Consolidated Financial Statements, including related notes, and the Independent Auditors' Report appearing on pages 15 through 29 of the Annual Report. ITEM 9.

ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE None. PART III ITEM 10.

ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT Information regarding the Company's directors is incorporated herein by reference to the material under the heading "Election of Directors -- Information on Nominees and Directors" in the Company's Proxy Statement with respect to the Annual Meeting of Shareholders scheduled to be held May 25, 1994, to be filed pursuant to Regulation 14A under the Securities Exchange Act of 1934 (the "Proxy Statement"). Information regarding the Company's executive officers is provided under the caption "Executive Officers of the Registrant" on pages 6 and 7 of this Form 10-K. Information regarding compliance with Section 16(a) of the Securities Exchange Act of 1934 is incorporated by reference to the material under the heading "Certain Information Concerning Stock Ownership" in the Proxy Statement. ITEM 11.

ITEM 11. EXECUTIVE COMPENSATION Incorporated herein by reference to the material under the headings "Election of Directors -- Information on Nominees and Directors -- Director Compensation", "Executive Compensation", "Human Resources and Compensation Committee Report on Executive Compensation" and "Total Shareholder Return" in the Proxy Statement. ITEM 12.

ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT Information concerning (1) any person or group known to the Company to be the beneficial owner of more than five percent of the Company's voting stock, and (2) ownership of the Company's equity securities by management, is incorporated herein by reference to the material under the heading "Certain Information Concerning Stock Ownership" in the Proxy Statement. The Company knows of no arrangements that may result at a subsequent date in a change of control of the Company. ITEM 13.

ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS Incorporated herein by reference to the material under the heading "Executive Compensation" in the Proxy Statement. PART IV ITEM 14.

ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K (a) The following are filed as a part of this Report on Form 10-K: (1) The following are included at the indicated page in the Annual Report and are incorporated by reference herein: (2) The following financial statement schedules for each of the years in the three year period ended December 31, 1993 are submitted herewith: All other schedules are omitted because they are not applicable, not required, or because the required information is included in the financial statements or notes thereto. (3) (a) Exhibits (numbered in accordance with Item 601 of Regulation S-K): * Filed herewith (dagger) This is a management contract or compensatory plan or arrangement. (b) None. (c) The response to this portion of Item 14 is submitted as a separate section of this report. (d) The response to this portion of Item 14 is submitted as a separate section of this report. SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Company has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. BOWATER INCORPORATED By: /s/ A. P. Gammie A. P. GAMMIE CHAIRMAN AND CHIEF EXECUTIVE OFFICER Date: March 29, 1994 Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Company and in the capacities indicated, on March 29, 1994. INDEPENDENT AUDITORS' REPORT The Board of Directors and Shareholders Bowater Incorporated: Under the date of February 11, 1994, we reported on the consolidated balance sheets of Bowater Incorporated and Subsidiaries as of December 31, 1993 and 1992, and the related consolidated statements of operations, capital accounts, and cash flows for each of the years in the three-year period ended December 31, 1993, as contained in the 1993 Annual Report to Shareholders. These consolidated financial statements and our report thereon are incorporated by reference in the annual report on Form 10-K for the year 1993. In connection with our audits of the aforementioned consolidated financial statements, we also have audited the related financial statement schedules as listed in the accompanying index [Item 14(a)(2)]. These financial statement schedules are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statement schedules based on our audits. In our opinion, such financial statement schedules, when considered in relation to the basic consolidated financial statements taken as a whole, present fairly, in all material respects, the information set forth therein. Greenville, South Carolina February 11, 1994 BOWATER INCORPORATED AND SUBSIDIARIES SCHEDULE II AMOUNTS RECEIVABLE FROM RELATED PARTIES AND UNDERWRITERS, PROMOTERS, AND EMPLOYEES OTHER THAN RELATED PARTIES YEARS ENDED DECEMBER 31, 1993, 1992, 1991 (IN THOUSANDS) BOWATER INCORPORATED AND SUBSIDIARIES SCHEDULE V PROPERTY, PLANT AND EQUIPMENT YEARS ENDED DECEMBER 31, 1993, 1992, 1991 (IN THOUSANDS) (1) Net of completed construction transferred to other property accounts. (2) Assets of GNP, acquired December 31, 1991. BOWATER INCORPORATED AND SUBSIDIARIES SCHEDULE VI ACCUMULATED DEPRECIATION AND AMORTIZATION OF PROPERTY, PLANT AND EQUIPMENT YEARS ENDED DECEMBER 31, 1993, 1992, 1991 (IN THOUSANDS) (1) Component replacements charged to accumulated depreciation. BOWATER INCORPORATED AND SUBSIDIARIES SCHEDULE VIII VALUATION AND QUALIFYING ACCOUNTS YEARS ENDED DECEMBER 31, 1993, 1992, 1991 (IN THOUSANDS) (1) Consists primarily of accounts deemed to be uncollectible. BOWATER INCORPORATED AND SUBSIDIARIES SCHEDULE IX SHORT-TERM BORROWINGS YEARS ENDED DECEMBER 31, 1993, 1992, 1991 (IN THOUSANDS EXCEPT PERCENTAGES) (1) Represents borrowings under available facilities. (2) Represents maximum amount outstanding at any month end during each year. (3) Average amount of short-term borrowings is determined by using the average of month end outstanding balances. (4) Weighted average interest rate computed by dividing short-term interest expense by average short-term borrowings. BOWATER INCORPORATED AND SUBSIDIARIES SCHEDULE X SUPPLEMENTARY INCOME STATEMENT INFORMATION YEARS ENDED DECEMBER 31, 1993, 1992, 1991 (IN THOUSANDS) NOTE: Depreciation and amortization of intangible assets, royalties and advertising costs are not presented since each such item does not exceed one percent of consolidated net sales as shown on the accompanying Consolidated Statement of Operations. EXHIBIT INDEX Exhibit Number Description

25506_1993.txt

25506

1993

ITEM 1 -- BUSINESS Cray Research, Inc. (the Company) was incorporated in 1972 as a Delaware corporation. Its principal corporate and administrative offices are located at 655A Lone Oak Drive, Eagan, Minnesota 55121 (telephone (612) 683-7100). The Company's mission is to provide the leading supercomputing tools and services to help solve its customers' most challenging problems. The computational tools created by the Company consist of high-performance computing systems and related software and are used by scientists and engineers to perform computational research. Computational research, the mathematical modeling and simulation of physical and other quantifiable phenomena, allows researchers to investigate areas that are physically impossible or too time-consuming, dangerous, or expensive to study in any other way. The Company's computational tools are used by scientists and engineers in many commercial industries including aerospace, automotive, chemical/pharmaceutical and petroleum, as well as in many public and private research centers, such as government and environmental science organizations and universities. As of December 31, 1993, the Company had a customer installed base of 321 high-end systems and 184 entry-level systems. Entry-level systems include CRAY Y-MP EL systems and SPARC-based CRAY Superserver 6400 systems. During 1993, 41 new and 19 used high-end systems were accepted by customers, consisting of 18 new and 19 used CRAY Y-MP systems, 22 new CRAY C90 systems, and one new CRAY T3D system. Additionally, a total of 41 entry-level systems were accepted by customers in 1993. SEGMENT DATA The industry segments in which the Company currently operates are the high-performance scientific and commercial segments of the computer industry. PRODUCTS The Company's products consist of the CRAY C90, CRAY T3D and the CRAY Y-MP series of supercomputer systems and related software and peripheral equipment and SPARC-based CRAY Superserver 6400 systems. SUPERCOMPUTER SYSTEMS. The Company's supercomputer systems offer multiple central processing unit (CPU) configurations that operate independently on separate jobs or in combination on a single job. The CRAY Y-MP series of supercomputer systems was first introduced by the Company in 1988. In 1991, the Company began the delivery of enhanced versions of the original CRAY Y-MP system. In 1992, the Company announced the CRAY Y-MP M90 series of supercomputers which features very large shared memory. In 1991, the Company introduced the CRAY Y-MP EL entry-level supercomputer system as the smallest supercomputer in the CRAY Y-MP product line. In 1993, the Company announced enhancements to the CRAY Y-MP EL product line: the CRAY EL98 and the CRAY EL92 systems. And in 1994, the CRAY EL94 system was announced. With the addition of these entry-level products, the Company's product line was extended to the office environment. The CRAY C90 series of supercomputer systems was first introduced in late 1991 as the CRAY Y-MP C90 system, the Company's largest and most powerful supercomputer. At the time of its introduction, the CRAY C90 system was available in configurations of between eight and sixteen CPUs. In March 1993, the Company announced the availability of the CRAY C90 system in smaller, lower- priced configurations and expanded memory. The Cray T3D system was introduced in September 1993 as the Company's first massively parallel processing (MPP) supercomputer system. The CRAY T3D system is a scalable heterogeneous supercomputing system which couples the Company's traditional parallel vector processing capabilities with massively parallel processing. The Company's supercomputer systems span a price range of $150,000 to $74 million. The following table indicates the number of available CPUs, the CPU cycle time and the available amount of memory for the Company's supercomputer systems. CPU cycle time represents the amount of time in which the computer runs through one complete instruction cycle and is measured in nanoseconds (nsec), or billionths of a second. Central memory is measured in megawords. One megaword equals eight megabytes (Mbytes) or eight million bytes. Included as standard equipment on all of the Company's supercomputer systems is an Input/ Output Subsystem which is capable of transferring data directly to and from central memory at extremely high speeds without interrupting central processing operations. The Company's supercomputer systems use the UNICOS operating system, a proprietary operating system which is based on AT&T's Unix System V operating system, and are binary-compatible with each other. Binary compatibility refers to the ability of a computer to run software applications from other computers without modifications to the software. CRAY SUPERSERVER 6400 SYSTEM. In October 1993, the Company introduced the SPARC/Solaris CRAY Superserver 6400 (CS6400) system. The CS6400 system is designed and manufactured by the Company's wholly-owned subsidiary Cray Research Superservers, Inc. (CRS). The CS6400 system is a result of a joint technology agreement and collaboration with Sun Microsystems, Inc. (Sun) signed in January 1992. SPARC is a CPU architecture pioneered by Sun. Solaris is an operating environment developed by Sun based on AT&T UNIX System V. The CS6400 system uses an enhanced version of Solaris. The CS6400 system is a binary-compatible upward extention of Sun's product line. As such, the CS6400 system provides the basis for the Company's focus on the high-performance commercial computing market, as well as a seamless interface from the Solaris environment to the Company's supercomputers. The CS6400 system can be configured with up to 64 SuperSPARC processors, up to 16 gigabytes (GBytes) of central memory, and over 2 terabytes (TBytes) of online storage. PERIPHERAL EQUIPMENT. The Company's Solid-state Storage Device (SSD) is designed to enhance high-end supercomputer system performance by providing high-speed access to large datasets and temporary storage for system programs. Traditional high-speed disk storage units transfer data at rates of up to 20 megabytes per second (Mbytes/sec) compared to a SSD transfer rate of up to 1800 Mbytes/ sec. The SSD is available with memory sizes ranging from 32 megawords to 2048 megawords, at prices ranging from $125,000 to $4.0 million. In February of 1993, the Company introduced the DD-301, the first Intelligent Peripheral Interface, 3.5 inch drive product for Cray Research Supercomputers. Each DD-301 drive delivers a sustained transfer rate of 8.2 Mbytes/sec and has storage capacity of 1.4 Gbytes. The Company also markets three other high-performance disk drives: the DD-60, the DD-62, and DS-42 disk subsystem. With the exception of the CRAY Y-MP EL product line, these disk drives support the mass storage requirements of the Company's supercomputer products. The DD-60 has a storage capacity of 1.96 Gbytes and a sustained transfer rate of 20 Mbytes/sec. The DD-62 has a data capacity of 2.73 Gbytes and a sustained transfer rate of 8.1 Mbytes/sec. The DS-42 disk subsystem consists of a disk controller and a disk cabinet containing up to four DD-42 disk drives. A fully configured DS-42 disk subsystem has a data capacity of 38.9 Gbytes and a sustained transfer rate of 9.6 Mbytes/sec. The DS-42 disk subsystem also supports the mass storage requirements of the Company's previous supercomputer systems. Prices range from $6,000 for a single DD-301 to $600,000 for one DS-42 disk subsystem. In November 1993, the Company introduced the Cray Research Network Disk Array, a bulk storage device designed to reside on high-performance computer networks. This product provides users with a flexible storage device that combines high-speed data transfer with the ability to partition the device to more than one system on the network. SOFTWARE. The Company's software products primarily include operating systems, compilers and applications software. The Company also markets various networking and remote computing/file management software. The Company's current operating system, the UNICOS 8.0 system, functions across all of the Company's supercomputer lines, including the CRAY T3D system. In 1993, the UNICOS operating system was certified as POSIX compliant indicating that it meets requirements for use in open systems environments. The CS6400 product line runs the Sun Solaris operating system enhanced by the Company to improve processor and memory management, incorporate parallel and batch processing capabilities and accomodate the reliability, availability and serviceability (RAS) features of the CS6400 system. The Company's compiler products, Fortran 77, Fortran 90, C, C++ and Ada, support the programming environment for all the Company's supercomputer systems. Beginning in 1993, the Company began releasing new versions of its compilers as a component of a "Programming Environment" -- an integrated software product that combines the compiler, programming tools and other features in one software release. Versions of the Company's Fortran 77, Fortran 90, C and Ada compilers are available in this new Programming Environment. The Company's applications software products include the UNICHEM and CRI/TURBOKIVA products. The UNICHEM product is a software environment for computational chemistry supporting key molecular simulation codes. UNICHEM Version 2.0, released in 1993, is also distributed by Molecular Simulations, Inc. for users of workstations and other desktop systems. The CRI/TURBOKIVA product is a combustion simulation package used by the automotive industry and is based on Los Alamos National Laboratory's KIVA II program. The latest version, CRI/TURBOKIVA 2.0, was released in 1993. In 1993, the Company announced two initiatives designed to oversee development and marketing of the Company's software on the CS6400 system and on non-Cray platforms. In July 1993, the Company announced an agreement with Absoft Corporation to develop software tools that would allow scientists and engineers to write programs on personal computers and then run them on more powerful systems, including the Company's systems. In October 1993, the Company launched CraySoft, an internal software development and marketing initiative. CraySoft's first product, the Network Computing Environment (NQE), supports the use of a set of workstations and supercomputing platforms as a single computational resource, managing distribution of work to the appropriate platform. Beginning in 1994, CraySoft will market several of the Company's compiler programming environment software packages for use on the CS6400 system and non-Cray platforms, including workstations and personal computers. In addition to the Company's applications software products, many third-party software applications are available for use on the Company's supercomputer systems under the UNICOS operating system and any third-party software applications that run in a Sun/Solaris operating environment will run on the CS6400 system. SOURCES AND AVAILABILITY OF RAW MATERIALS Most integrated circuits required for the Company's computer systems are designed by the Company and then manufactured by and purchased from outside sources. The Company manufactures most of the printed circuit boards and some of the logic integrated circuits used in its products. Due to the use of advanced technology components in the Company's products, certain components are available only from a limited number of suppliers. Significant delays in the delivery of a substantial number of these components could adversely affect production schedules, revenues and operating results. The Company believes that its sources of supply for components are adequate for 1994 production needs. PATENTS The Company has obtained patents relating to its computer systems. While the Company may apply for patents as it develops products and processes which it believes to be patentable, the Company believes that its success principally will be dependent upon its ability to design advanced products rather than its ability to secure patents. SEASONALITY The Company's business is not inherently seasonal in nature. However, operating results are significantly influenced by the timing of the availability of new products, the number of computer systems accepted within a reporting period, the configuration of the systems accepted and whether a system is sold or leased. MARKETING AND SUPPORT SERVICES The Company's central marketing activities are located in Eagan, Minnesota and Cray Research Superservers' marketing is located in Beaverton, Oregon. The Company markets its computer systems through its own sales force to customers in North America, Europe, Latin America, the Far East and Australia, and through independent representatives in the Middle East and the Far East. The Company also offers products through distributors and re-sellers in selected markets. The Company offers its systems for sale or lease. Sales include both systems sold to customers or third-party lessors and certain long-term leases that qualify for sales accounting treatment. Operating lease terms generally are for one to three years, with a purchase option entitling the user to a partial lease payment credit in the event of purchase. These operating leases do not return to the Company its selling price plus interest charges during the initial noncancellable term of the lease. In the accounting period in which an operating lease begins, revenue and earnings are lower than the levels which would be achieved if the system were sold. Leases also increase cash requirements. Systems sold to third-party lessors are re-marketed by the Company upon lease termination on a best efforts basis. Maintenance and other support services following installation are performed by hardware engineers and software analysts employed by the Company. Such services are provided under separate maintenance contracts between the Company and its customers. These contracts generally provide for maintenance services for one year and are renewable annually at the customer's election. BACKLOG The Company believes backlog information provides only a limited indication of its expected future revenue. The Company measures backlog using contract value which is based on selling price for sales orders and the guaranteed cash flows for lease orders. The contract value of backlog at December 31, 1993 was $409 million, all of which is expected to be installed in 1994. The contract value of backlog at December 31, 1992 was $417 million, of which $362 million was installed in 1993. Included in the total backlog amount at December 31, 1993, are orders from the United States government for systems, peripherals and upgrades with a total contract value of approximately $109 million; these orders are cancellable under standard termination for convenience clauses included in most U.S. government contracts. COMPETITION Competition in the computer industry is based primarily on equipment performance and reliability, manufacturer reputation, software capability and availability, price, and availability of support services. The Company competes primarily in the market for high-performance scientific and engineering computer systems and believes that it holds a competitive advantage in this market. With the introduction of the CS6400 system in late 1993, the Company will face new competion in the commercial marketplace. There can be no assurance that levels of competition within the markets in which the Company competes will not intensify or that the Company's technological advantages may not be reduced or lost as a result of technological advances by competitors. Furthermore, some of the Company's competitors have significantly greater resources than the Company. The Company's principal competitors include Convex Computer Corporation, Fujitsu, Ltd., Hewlett Packard, IBM, Intel Corporation, NCR, NEC Corporation, Silicon Graphics, Inc., and Thinking Machines Corporation. DEVELOPMENT AND ENGINEERING The Company is committed to leadership in the high-performance scientific, commercial and engineering computing systems market, and its continued success will be largely dependent upon its successful development and introduction of new products and enhancements to its existing product lines. Such product development and enhancements depend not only upon the Company's internal development and engineering activities, but also upon the availability of advanced technology components from outside suppliers as described under "Sources and Availability of Raw Materials" above. The Company's strategy is to continue enhancement of existing products while devoting substantial resources to the development of new products which are expected to provide acceptable returns to the Company. The Company's intention is to spend at least 15% of revenue annually on development and engineering activities for these products. Development and engineering costs, including costs of software development, totalled $146 million in 1993, $162 million in 1992 and $143 million in 1991, or 16.3%, 20.3% and 16.6% of revenue in each respective year. Hardware development and engineering expenditures in 1993 were focused on the same areas as in 1992: the Triton, the Company's next generation high-end parallel vector supercomputer; MPP system development; entry-level system development; and ongoing Cray C90 development and engineering. The MPP Project received funding of $12.7 million over a three year period ended in 1993 from the Advanced Research Projects Agency (ARPA). In the area of software development, the Company is developing new applications software and is continuing to enhance and develop its UNICOS operating system, compilers and application development tools to increase functionality and performance. The Company also is expanding its network communications software to provide increased connectivity to other computer systems. During 1993, the Company completed the development of enhanced versions of several compiler products and began initiatives to develop selected software for use on desktop systems and other non-Cray platforms. ENVIRONMENTAL COMPLIANCE Compliance by the Company with Federal, state and local environmental protection laws during 1993 had no material effect upon capital expenditures, earnings or competitive position and is expected to have none in the foreseeable future. EMPLOYEES As of December 31, 1993, the Company had 4960 full-time employees: 1082 in development and engineering, 1798 in manufacturing, 728 in marketing and sales, 1157 in field service and 195 in general management and administrative positions. The Company has never experienced any material work stoppage due to labor disagreements, and in the opinion of management, the Company's labor relations are satisfactory. No employees are represented by labor unions. FINANCIAL INFORMATION ABOUT DOMESTIC AND FOREIGN OPERATIONS Information concerning revenue, operating profit and identifiable assets by geographic area for 1993, 1992 and 1991 is included on page 32 of the Company's 1993 Annual Report to Stockholders for the year ended December 31, 1993 (hereinafter the "Annual Report"), which information is incorporated herein by reference. The Company's international business is subject to risks customarily encountered in foreign operations, including fluctuations in monetary exchange rates, import and export controls and the economic, political and regulatory policies of foreign governments. While the technological nature of the Company's products may limit the Company's ability to market its products in some foreign countries, the Company does not believe its international business is subject to any special risks. ITEM 2

ITEM 2 -- PROPERTIES The Company's principal properties are as follows: The Company also leases approximately 211,100 square feet primarily for sales and service offices in various domestic locations. In addition, various foreign sales subsidiaries have leased approximately 152,300 square feet of office space. The Company believes its manufacturing and sales facilities are adequate to meet its needs in 1994. The Company plans to spend approximately $86 million on property, plant and equipment in 1994. (See also "Financial Review" on pages 22 through 24 of the Annual Report, which section is incorporated herein by reference.) ITEM 3

ITEM 3 -- LEGAL PROCEEDINGS There are no legal proceedings pending against or involving the Company which, in the opinion of management, will have a material adverse effect upon its consolidated financial position or results of operations. ITEM 4

ITEM 4 -- SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS No matters were submitted to a vote of the Company's stockholders during the quarter ended December 31, 1993. EXECUTIVE OFFICERS OF THE REGISTRANT There are no family relationships among the officers listed, and there are no arrangements or understandings pursuant to which any of them were elected as officers. The officers are elected annually by and serve at the pleasure of the Board of Directors. PART II ITEM 5

ITEM 5 -- MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS "Investor Information," appearing on page 44 of the Annual Report, is incorporated herein by reference. ITEM 6

ITEM 6 -- SELECTED FINANCIAL DATA "Historical Financial Summary," appearing on pages 20 and 21 of the Annual Report, is incorporated herein by reference. ITEM 7

ITEM 7 -- MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS "Financial Review," appearing on pages 22 through 24 of the Annual Report, is incorporated herein by reference. ITEM 8

ITEM 8 -- FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA The consolidated balance sheets of the Company and its subsidiaries as of December 31, 1993 and 1992 and the related consolidated statements of operations, cash flows and stockholders' equity for each of the years in the three-year period ended December 31, 1993, together with the report thereon of KPMG Peat Marwick dated January 25, 1994, appearing on pages 25 through 41 of the Annual Report, are incorporated herein by reference. "Quarterly Financial Data," appearing on page 41 of the Annual Report, also is incorporated herein by reference. ITEM 9

ITEM 9 -- CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE None. PART III ITEM 10

ITEM 10 -- DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT IDENTIFICATION OF DIRECTORS "Election of Directors" in the Company's Proxy Statement for the 1994 Annual Meeting of Stockholders to be held on May 17, 1994 filed or to be filed (hereinafter the "Proxy Statement") is incorporated herein by reference. IDENTIFICATION OF EXECUTIVE OFFICERS Information regarding executive officers of the Company is contained in Part I of this Report on page 7 and is incorporated herein by reference. ITEM 11

ITEM 11 -- EXECUTIVE COMPENSATION "Election of Directors" and "Executive Compensation" in the Proxy Statement are incorporated herein by reference. ITEM 12

ITEM 12 -- SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT "Voting Securities and Principal Holders Thereof" in the Proxy Statement are incorporated herein by reference. ITEM 13

ITEM 13 -- CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS None. PART IV ITEM 14

ITEM 14 -- EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K FINANCIAL STATEMENTS Incorporated by reference into Part II, Item 8 of this Report: FINANCIAL STATEMENT SCHEDULES All other schedules are omitted because they are not applicable, or not required, or because the required information is included in the consolidated financial statements or notes thereto. REPORTS ON FORM 8-K The Company was not required to and did not file any reports on Form 8-K during the three months ended December 31, 1993. EXHIBITS EXHIBITS INDEPENDENT AUDITORS' REPORT ON FINANCIAL STATEMENT SCHEDULES The Board of Directors and Stockholders Cray Research, Inc.: Under date of January 25, 1994, we reported on the consolidated balance sheets of Cray Research, Inc. and subsidiaries as of December 31, 1993 and 1992 and the related consolidated statements of operations, cash flows and stockholders' equity for each of the years in the three-year period ended December 31, 1993, as contained in the 1993 Annual Report to Stockholders. These consolidated financial statements and our report thereon are incorporated by reference in the Annual Report on Form 10-K for the year 1993. In connection with our audits of the aforementioned consolidated financial statements, we also have audited the related financial statement schedules as listed in Item 14 herein. These financial statement schedules are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statement schedules based on our audits. In our opinion, such financial statement schedules, when considered in relation to the basic consolidated financial statements taken as a whole, present fairly, in all material respects, the information set forth therein. KPMG Peat Marwick Minneapolis, Minnesota January 25, 1994 CRAY RESEARCH, INC. AND SUBSIDIARIES SCHEDULE I -- MARKETABLE SECURITIES AND OTHER SECURITY INVESTMENTS DECEMBER 31, 1993 (IN THOUSANDS) CRAY RESEARCH, INC. AND SUBSIDIARIES SCHEDULE V -- PROPERTY, PLANT AND EQUIPMENT AND LEASED SYSTEMS AND SPARES (IN THOUSANDS) CRAY RESEARCH, INC. AND SUBSIDIARIES SCHEDULE VI -- ACCUMULATED DEPRECIATION AND AMORTIZATION OF PROPERTY, PLANT AND EQUIPMENT AND LEASED SYSTEMS AND SPARES (IN THOUSANDS) CRAY RESEARCH, INC. AND SUBSIDIARIES SCHEDULE X -- SUPPLEMENTARY STATEMENT OF OPERATIONS INFORMATION (IN THOUSANDS) SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Company has duly caused this Report to be signed on its behalf by the undersigned, thereunto duly authorized. CRAY RESEARCH, INC. By /s/ JOHN F. CARLSON -------------------------------------- John F. Carlson Chairman and Chief Executive Officer (Principal Executive Officer) By /s/ MICHAEL J. LINDSETH -------------------------------------- Michael J. Lindseth Chief Financial Officer (Principal Financial Officer) By /s/ CHARLES T. ROEHRICK -------------------------------------- Charles T. Roehrick Corporate Controller (Principal Accounting Officer) Dated: March 21, 1994 POWER OF ATTORNEY KNOW ALL MEN BY THESE PRESENTS, that each person whose signature appears above or below constitutes and appoints John F. Carlson and Michael J. Lindseth, or either of them, his true and lawful attorneys-in-fact and agents, with full power of substitution and resubstitution, for him and in his name, place and stead, in any and all capacities, to sign any and all amendments to this Report, and to file the same, with all exhibits thereto and other documents in connection therewith, with the Securities and Exchange Commission, granting unto said attorneys-in-fact and agents, full power and authority to do and perform each and every act and thing requisite and necessary to be done in and about the premises, as fully to all intents and purposes as he might or could do in person, hereby ratifying and confirming all that said attorneys-in-fact and agents, or their substitutes, may lawfully do or cause to be done by virtue hereof. Pursuant to the requirements of the Securities Exchange Act of 1934, this Report has been signed below by the following persons on behalf of the Company in their respective capacities as directors of the Company. EXHIBIT INDEX EXHIBITS FILED AS ITEM 14 TO THE ANNUAL REPORT OF CRAY RESEARCH, INC. AND ITS SUBSIDIARIES ON FORM 10-K FOR THE YEAR ENDED DECEMBER 31, 1993.

109380_1993.txt

109380

1993

ITEM 1. BUSINESS Zions Bancorporation (the Parent) is a multibank holding company organized under the laws of Utah in 1955, registered under the Bank Holding Company Act of 1956, as amended. Zions Bancorporation and its subsidiaries (the Company), is the second largest bank holding company headquartered in Utah and provides a full range of banking and related services primarily in Utah, Nevada, and Arizona. Its principal subsidiaries are banking subsidiaries which include Zions First National Bank, the second largest commercial banking organization in the state of Utah, Nevada State Bank, the sixth largest bank in Nevada and Zions First National Bank of Arizona in Arizona. The Company's business and the businesses of many of its larger borrowers are primarily concentrated in the state of Utah. Consequently, the Company's results of operations and financial condition are dependent upon general trends in the Utah economy and real estate markets. The Company has focused in recent years on maintaining strong liquidity, risk-based capital and cash flow positions and on developing strong internal controls. An increasing focus is currently being placed on strengthening the Company's retail and consumer banking businesses, as well as its small- and medium-sized business lending, residential mortgage and investment activities, and increasing the proportion of fee income in its total revenue mix. The Company's general operating objectives include enhancing the Company's market position in Utah, Nevada, and Arizona through in-market acquisitions of smaller depository institutions, and through the contained development of the Company's present lines of business. At December 31, 1993, the Company had assets of $4.3 billion, loans of $2.2 billion, deposits of $3.0 billion, and shareholders' equity of $.3 billion. A more detailed discussion concerning the Company's financial condition is contained in Part II of this report. THE BANKING SUBSIDIARIES The Banks provide a wide variety of commercial and retail banking and mortgage-lending financial services. Commercial loans, lease financing, cash management, lockbox, customized draft processing, and other special financial services are provided for business and other commercial banking customers. A wide range of personal banking services are provided to individuals, including bankcard, student and other installment loans and home equity credit line loans, checking accounts, savings accounts, time certificates of various types and maturities, trust services and safe deposit facilities. In addition, direct deposit of payroll, social security and various other government checks is offered. Automated teller machines provide 24-hour access and availability to customers' accounts and to many consumer banking services through statewide, regional, and nationwide ATM networks. Zions First National Bank in Utah has developed special packages of financial services designed to meet the financial needs of particular market niches, including the Premier Account for those 50 years and older and the Student Account. The Bank has also established a Private Banking group to service the financial needs of wealthy individuals; an Executive Banking program to service the needs of corporate executives of commercial clients, and an Affinity program which offers discounted financial services to employees of commercial accounts on a group basis. Both Zions First National Bank and Nevada State Bank have established trust divisions which offer clients a variety of fiduciary services ranging from the administration of estates and trusts to the management of funds held under pension and profit sharings plans. They also offer custodian, portfolio, and management services. The Trust Division of Zions First National Bank also acts as fiscal and payment agent, transfer agent, registrar, and trustee under corporate and trust indentures for corporations, governmental bodies, and public authorities. Zions First National Bank is a registered dealer in, and underwriter of, general obligations of state and municipal governments, and a primary dealer in obligations of the United States government and federal agencies. Zions First National Bank also provides correspondent banking services such as cash letter processing, wire services, federal funds facilities, and loan participations. Zions First National Bank's International Banking Department issues letters of credit and handles foreign exchange transactions for customers, but it does not take a trading position in foreign exchange. Zions First National Bank's Grand Cayman branch accepts Eurodollar deposits from qualified customers, and places deposits with foreign banks and foreign branches of other U.S. banks. Zions' banking subsidiaries, however, do not engage in any foreign lending. The Company's commercial banking operations generated net income of $59,932,000 in 1993, a 29.0% increase over the $46,474,000 produced in 1992 and $31,672,000 in 1991. A continuing decline in interest rate levels during 1993, combined with a strong regional economy and the introduction of new credit products, produced a strong loan demand in the Company's commercial banking operations during the year. While average net loans and leases on the commercial banks' balance sheet increased a modest 2.5% to $1,995,728,000 an additional $589,000,000 in consumer and small business loans (excluding long-term residential mortgage loans) were securitized during 1993, in addition to $159,000,000 in loans securitized in December 1992. A significant increase in lending activity was fueled by the introduction of the Home Refinance Loan - a fully amortizing seven or ten-year mortgage - in March 1993. The product, which was highly successful and imitated by a number of competitors, produced nearly $400 million in loan originations in Utah, Nevada, Arizona, and Idaho. The Company's commitment to small business lending was also evident in 1993 as Zions First National Bank was recognized as "Participating Bank of the Year" by the Utah Technology Finance Corporation for making more quality loans than any other financial institution to high-technology companies. Zions First National Bank was also recognized as the largest originator of loans under the U.S. Small Business Administration's 7A and 504 programs in Utah during 1993. Cash generated from the securitization of loans and growth in the banks' deposit base was primarily invested in liquid securities during 1993. Taxable investment securities increased 24.3% to $893,453,000, while tax-exempt securities averaged $120,631,000, a 14.8% increase over the prior year's level. Federal funds sold and securities purchased under agreements to resell increased 168.2% to $645,218,000 in 1993, while interest-bearing deposits held at other institutions decreased 43.5% to $103,867,000. Average assets in trading accounts increased 178.6% to $102,840,000. Total average core deposits increased 8.0% in 1993 to $2,720,828,000. Noninterest bearing demand deposits increased 25.9% to $610,292,000; savings and money market deposits increased 12.7% to $1,595,446,000; and certificates of deposit under $100,000 decreased 16.9% to $515,090,000. Activity in federal funds purchased and securities sold under agreements to repurchase increased 92.1% in 1993 to $775,386,000, primarily as a result of the purchase of Discount Corporation of New York. Borrowings from the Federal Home Loan Bank system also increased 39.8% to support a higher volume of real estate lending during the year. Aggressive installation of ATM's continued during the year, particularly in nonbranch locations. At year end, the number of ATM's in service totaled 175, which included installations at branch offices, stores, shopping centers, airports, university campuses, and U.S. Postal Service facilities in rural Utah communities. Utah Zions First National Bank, founded in 1873, has 84 offices located throughout the state of Utah, plus one foreign office, for a total of 85 banking offices. Zions First National Bank's net income in 1993 was $52,867,000, a 28.2% increase over the $41,241,000 earned in the previous year. This increase was the result of a $32,702,000 growth in revenues, a $25,176,000 increase in expenses, and a $7,474,000 decrease in the provision for loan and lease losses. Zions First National Bank's income tax provision increased $4,809,000. The implementation during 1993 of Statement of Financial Accounting Standards (SFAS) No. 106 and SFAS No. 109, relating to accounting for post-retirement benefits and income taxes, respectively, generated a combined cumulative benefit of $1,435,000. In August 1993, Zions First National Bank completed the acquisition of Discount Corporation of New York, a primary dealer in U.S. government securities. Discount Corporation operates as a division of Zions First National Bank, and has retained its sales and trading office at 58 Pine Street in New York City. The acquisition significantly augments Zions Bank's existing institutional investment sales business, and increases its institutional securities sales capabilities, becoming one of 39 primary dealers of U.S. government securities, and a member of the selling groups of four agencies of the U.S. government. The transaction establishes Zions Bank as a leader in institutional sales and trading in the Intermountain West, and one of only two primary dealers in government securities headquartered in the western United States. During the third quarter, Zions First National Bank also acquired a 25% interest in Bennington Capital Management, an investment advisory firm located in Seattle, Washington, which sponsors the AccessorTM family of mutual funds. The acquisition should enable the Company to more fully participate in capturing the value generated through the sale of mutual funds to its' customers. In October, the merger transaction of Zions Bancorporation and Wasatch Bancorp strengthened Zions Bank's presence in the northern half of fast-growing Utah County, Utah, by adding $75 million in assets and the addition of banking offices operated by Wasatch Bancorp's banking subsidiary, Wasatch Bank. Zions Bank additionally added a new full-service branch in Draper, Utah, a grocery store banking center in South Jordan, Utah, and completed construction of a new 25,000 square foot regional financial center in St. George, Utah, during 1993. Nevada Nevada State Bank, a state-chartered Federal Deposit Insurance Corporation ("FDIC")-insured institution, with its main office in downtown Las Vegas, opened a new grocery store banking center in Henderson, Nevada, during the year, expanding its retail banking offices to 19 in Nevada. Nevada State Bank achieved net income, after the amortization of purchased premium, of $4,691,000 in 1993-an increase of 16.1% over the $4,042,000 earned in 1992. The bank's revenues increased $2,055,000 while operating expenses rose $1,586,000. The provision for loan losses decreased $305,000 and the provision for income taxes increased $478,000. The net effect of the implementation of SFAS No. 106 and SFAS No. 109 was a benefit of $353,000. Arizona Zions First National Bank of Arizona at December 31, 1993 had three offices in the metropolitan Phoenix, Arizona, area. Zions First National Bank of Arizona experienced a strong increase in net income, net of the amortization of purchase premium, as earnings rose 99.3% to $2,374,000 from $1,191,000 in 1992. Revenues increased $547,000 while operating expenses decreased $32,000. The provision for loan losses decreased $175,000 and the provision for income taxes increased $65,000. The net effect of the implementation of SFAS No. 106 and SFAS No. 109 was a benefit in the amount of $494,000. In August, Zions announced an agreement to acquire National Bancorp of Arizona, a $435 million organization headquartered in Tucson; and in October, an agreement was reached to acquire Rio Salado Bancorp, a $107 million banking company in Tempe, Arizona. These organizations bring talented employees and well-established reputations to our business in Arizona. The National Bancorp of Arizona transaction was consummated shortly after year-end 1993, and it is anticipated that the Rio Salado Bancorp acquisition will be completed in the second quarter of 1994. When combined with existing Arizona operations, the resulting organization, which will operate under the National Bank of Arizona name and with that bank's existing management, will have total assets of nearly $630 million, with offices in metropolitan Phoenix, Tucson, and Flagstaff, making it approximately the sixth largest commercial banking organization in Arizona. OTHER SUBSIDIARIES The Company conducts various other bank-related business activities through subsidiaries owned by the Parent and wholly-owned subsidiaries of Zions First National Bank. Zions Credit Corporation engages in lease origination and servicing operations in Utah, Nevada, and Arizona. Zions Life Insurance Company underwrites as reinsurer credit-related life and disability insurance. Zions Insurance Agency, Inc., operates an insurance brokerage business which administers various credit-related insurance programs in the Company's subsidiaries and sells general lines of insurance. The Company's insurance subsidiaries offer customers a full range of insurance products through licensed agents. The products include credit life products, collateral protection products, life policies, homeowners policies, property and casualty policies, and commercial business owner type policies. Zions Data Service Company provides data processing services to all subsidiaries of the Company. In October 1993, Zions Mortgage Company became a subsidiary of Zions First National Bank as ownership was transferred to the Bank from the parent company. Zions Mortgage Company conducts a mortgage banking operation in Utah, Nevada, and Arizona. In 1993, total loans serviced by Zions Mortgage Company increased 23.7% and $844 million in traditional residential mortgages were closed and sold in the secondary market. Zions Investment Securities, Inc., also a subsidiary of the Bank, provides discount investment brokerage services on a nonadvisory basis to both commercial and consumer customers. Personal investment officers employed by the discount brokerage subsidiary in many larger offices provide customers with a wide range of investment products, including municipal bonds, mutual funds, and tax-deferred annuities. SUPERVISION AND REGULATION Bank holding companies and banks are extensively regulated under both federal and state law. The information contained in this section summarizes portions of the applicable laws and regulations relating to the supervision and regulation of Zions Bancorporation and its subsidiaries. These summaries do not purport to be complete, and they are qualified in their entirety by reference to the particular statutes and regulations described. Any change in applicable law or regulation may have a material effect on the business and prospects of Zions Bancorporation and its subsidiaries. Bank Holding Company Regulation Zions Bancorporation is a bank holding company within the meaning of the Bank Holding Company Act and is registered as such with the Federal Reserve Board. Under the current terms of that Act, activities of Zions Bancorporation, and those of companies which it controls or in which it holds more than 5% of the voting stock, are limited to banking or managing or controlling banks or furnishing services to or performing services for its subsidiaries, or any other activity which the Federal Reserve Board determines to be so closely related to banking or managing or controlling banks as to be a proper incident thereto. In making such determinations, the Federal Reserve Board is required to consider whether the performance of such activities by a bank holding company or its subsidiaries can reasonably be expected to produce benefits to the public such as greater convenience, increased competition or gains in efficiency that outweigh the possible adverse effects, such as undue concentration of resources, decreased or unfair competition, conflicts of interest or unsound banking practices. Bank holding companies, such as Zions Bancorporation, are required to obtain prior approval of the Federal Reserve Board to engage in any new activity or to acquire more than 5% of any class of voting stock of any company. Generally, no application to acquire shares of a bank located outside that state in which the operations of the applicant's banking subsidiaries were principally conducted on the date it became subject to the Act may be approved by the Federal Reserve Board unless such acquisition is specifically authorized by the laws of the state in which the bank whose shares are to be acquired is located. Various proposals are currently pending in the U.S. Congress to ease or eliminate these limitations. It is not possible to predict at the present time whether any of these proposals will become law. In the meantime, most states have specifically authorized the acquisition of banks located in those states by out-of-state companies, in many cases subject to various restrictions. The Federal Reserve Board has authorized the acquisition and control by bank holding companies of savings and loan associations and certain other savings institutions without regard to geographic restrictions applicable to acquisition shares of a bank. The Federal Reserve Board is authorized to adopt regulations affecting various aspects of bank holding companies. Pursuant to the general supervisory authority of the Bank Holding Company Act and directives set forth in the International Lending Supervision Act of 1983, the Federal Reserve Board has adopted capital adequacy guidelines prescribing both risk-based capital and leverage ratios. Regulatory Capital Requirements Risk-Based Capital Guidelines The Federal Reserve Board established risk-based capital guidelines for bank holding companies effective March 15, 1989. The guidelines define Tier I Capital and Total Capital. Tier I Capital consists of common and qualifying preferred shareholders' equity and minority interests in equity accounts of consolidated subsidiaries, less goodwill and 50% (and in some cases up to 100%) of investment in unconsolidated subsidiaries. Total Capital consists of Tier I Capital plus qualifying mandatory convertible debt, perpetual debt, certain hybrid capital instruments, certain preferred stock not qualifying as Tier I Capital, subordinated and other qualifying term debt up to specified limits, and a portion of the allowance for credit losses, less investments in unconsolidated subsidiaries and in other designated subsidiaries or other associated companies at the discretion of the Federal Reserve Board, certain intangible assets, a portion of limited-life capital instruments approaching maturity and reciprocal holdings of banking organizations' capital instruments. The Tier I component must constitute at least 50% of qualifying Total Capital. Risk-based capital ratios are calculated with reference to risk-weighted assets, which include both on-balance sheet and off-balance sheet exposures. The risk-based capital framework contains four risk-weighted categories for bank holding company assets -- 0%, 20%, 50%, and 100%. Zero percent risk-weighted assets include, inter alia, cash and balances due from Federal Reserve Banks, and obligations unconditionally guaranteed by the U.S. government or its agencies. Twenty percent risk-weighted assets include, inter alia, claims on U.S. Banks and obligations guaranteed by U.S. government sponsored agencies as well as general obligations of states or other political subdivisions of the United States. Fifty percent risk-weighted assets include, inter alia, loans fully secured by first liens on one to-four-family residential properties, subject to certain conditions. All assets not included in the foregoing categories are assigned to the 100% risk-weighted category, including loans to commercial and other borrowers. As of year-end 1992, the minimum required ratio for qualifying Total Capital became 8%, of which at least 4% must consist of Tier I Capital. At December 31, 1993, the Company's Tier I and Total Capital ratios were 11.01% and 14.34%, respectively. The current risk-based capital ratio analysis establishes minimum supervisory guidelines and standards. It does not evaluate all factors affecting an organization's financial condition. Factors which are not evaluated include (i) overall interest rate exposure; (ii) liquidity, funding, and market risks; (iii) quality and level of earnings; (iv) investment or loan portfolio concentrations; (v) quality of loans and investments; (vi) the effectiveness of loan and investment policies; and (vii) management's overall ability to monitor and control other financial and operating risks. The capital adequacy assessment of federal bank regulators will, however, continue to include analyses of the foregoing considerations and in particular, the level and severity of problem and classified assets. Minimum Leverage Ratio On June 20, 1990, the Federal Reserve Board adopted new capital standards and leverage capital guidelines that include a minimum leverage ratio of 3% Tier I Capital to total assets (the "leverage ratio"). The leverage ratio is used in tandem with the final risk-based ratio of 8% that took effect at the end of 1992. The Federal Reserve Board has emphasized that the leverage ratio constitutes a minimum requirement for well-run banking organizations having well-diversified risk, including no undue interest rate exposure, excellent asset quality, high liquidity, good earnings, and a composite rating of 1 under the Interagency Bank Rating System. Banking organizations experiencing or anticipating significant growth, as well as those organizations which do not exhibit the characteristics of a strong, well-run banking organization described above, will be required to maintain strong capital positions substantially above the minimum supervisory levels without significant reliance on intangible assets. Furthermore, the Federal Reserve Board has indicated that it will consider a "tangible Tier I Capital Leverage Ratio" (deducting all intangibles) and other indices of capital strength in evaluating proposals for expansion or new activities. At December 31, 1993, the Company's Tier I leverage ratio was 5.47%. On December 21, 1993, the OCC, Federal Reserve Board and the FDIC (together, the "Agencies") announced that they are or will be requesting public comment on proposed amendments to the regulatory capital rules to explicitly include in Tier I Capital net unrealized holding gains and losses on available-for-sale securities. Such unrealized gains and losses are currently reported as a component of stockholders' equity following a bank's adoption of SFAS No. 115. As of January 1, 1994, or the beginning of their first fiscal year thereafter, if later, all banks must have adopted SFAS No. 115 for purposes of preparing their Reports of Condition and Income (Call Reports). During the comment receipt and evaluation process, Tier I capital will be calculated as currently defined. Other Issues and Developments Relating to Regulatory Capital Pursuant to such authority and directives set forth in the International Lending Supervision Act of 1983, the Comptroller, the FDIC, and the Federal Reserve Board have issued regulations establishing the capital requirements for banks under federal law. The regulations, which apply to Zions Bancorporation's banking subsidiaries, establish minimum risk-based and leverage ratios which are substantially similar to those applicable to the Company. As of December 31, 1993, the risk-based and leverage ratios of each of Zions Bancorporation's banking subsidiaries exceeded the minimum requirements. On December 19, 1991, the Federal Deposit Insurance Corporation Improvement Act of 1991 ("FDICIA") was signed into law. FDICIA subjects banks to significantly increased regulation and supervision. Among other things, FDICIA requires federal bank regulatory authorities to revise, prior to June 19, 1993, their risk-based capital guidelines to ensure that those standards take account of interest rate risk, concentrations of credit, and the risk of nontraditional activities, as well as reflect the actual performance and risk of multifamily mortgages. On September 4, 1993, the federal banking agencies published in the Federal Register a proposed measure of interest rate risk exposure which measures such exposure as the effect that a specified change in market interest rates would have on the net economic value of banks. Under this proposal, banks (excluding certain "low-risk" institutions as defined therein) would calculate and report estimated changes in their net economic value resulting from the effect of specified changes in market interest rates on their assets, liabilities, and off-balance sheet positions, utilizing either a supervisory model or approved internal models. The proposal sets forth two alternative methods for utilizing such results in assessing institutions' capital adequacy for interest rate risk exposure. One method would require institutions to hold capital equal to the dollar decline in their net economic value exceeding a supervisory threshold of one percent of total assets; the other method provides for an agency assessment of measured interest rate risk exposure and qualitative factors. However, the proposal is still under consideration. The federal banking agencies have also proposed revisions to their risk-based capital rules to ensure that risks arising from concentrations of credit and nontraditional activities are taken into account when assessing an institution's capital adequacy. The proposal calls on institutions to take account of such risks in assessing their capital adequacy rather than imposing explicit capital requirements with respect to them. Because the final terms of the regulators' implementation of this requirement of FDICIA are not yet known, Zions Bancorporation cannot predict the effect the inclusion of these risk factors in the risk-based capital rules of the federal banking agencies will have upon its capital requirements or those of its subsidiaries. FDICIA amended Section 38 of the Federal Deposit Insurance Act to require the federal banking regulators to take "prompt corrective action" in respect of banks that do not meet minimum capital requirements and imposes certain restrictions upon banks which meet minimum capital requirements but are not "well-capitalized" for purposes of FDICIA. FDICIA establishes five capital tiers: "well capitalized," "adequately capitalized," "undercapitalized," "significantly undercapitalized," and "critically undercapitalized." Implementing regulations adopted by the federal banking agencies in September 1992 and effective on December 19, 1992 define the capital categories for banks which will determine the necessity for prompt corrective actions by the federal banking agencies. A bank may be placed in a capitalization category that is lower than is indicated by its capital position if it receives an unsatisfactory examination rating with respect to certain matters. Under the regulations, a "well-capitalized" institution has a minimum total capital to total risk-weighted assets ratio of at least 10 percent, a minimum Tier I capital to total risk-weighted assets ratio of at least 6 percent, a minimum leverage ratio of at least 5 percent, and is not subject to any written order, agreement, or directive; an "adequately capitalized" institution has a total capital to total risk-weighted assets ratio of at least 8 percent, a Tier I capital to total risk-weighted assets ratio of at least 4 percent, and a leverage ratio of at least 4 percent (3 percent if given the highest regulatory rating and not experiencing significant growth), but does not qualify as "well-capitalized. An "undercapitalized" institution fails to meet any one of the three minimum capital requirements. A "significantly undercapitalized" institution has a total capital to total risk-weighted assets ratio of less than 6 percent, a Tier I capital to total risk-weighted assets ratio of less than 3 percent or a Tier I leverage ratio of less than 3 percent. A "critically undercapitalized" institution has a Tier I leverage ratio of 2 percent or less. Under certain circumstances, a "well-capitalized," "adequately capitalized," or "undercapitalized" institution may be required to comply with supervisory actions as if the institution was in the next lowest capital category. Failure to meet capital guidelines could subject a bank to a variety of restrictions and enforcement remedies. Under FDICIA, all insured banks are generally prohibited from making any capital distributions and from paying management fees to persons having control of the bank where such payments would cause the bank to be undercapitalized. Holding companies of significantly undercapitalized, critically undercapitalized and certain undercapitalized banks may be required to obtain the approval of the Federal Reserve Board before paying capital distributions to their shareholders. Moreover, a bank that is not well-capitalized is generally subject to various restrictions on "pass through" insurance coverage for certain of its accounts and is generally prohibited from accepting brokered deposits and offering interest rates on any deposits significantly higher than the prevailing rate in its normal market area or nationally (depending upon where the deposits are solicited). Such banks and their holding companies are also required to obtain regulatory approval prior to their retention of senior executive officers. Banks which are classified undercapitalized, significantly undercapitalized or critically undercapitalized are required to submit capital restoration plans satisfactory to their federal banking regulator and guaranteed within stated limits by companies having control of such banks (i.e., to the extent of the lesser of five percent of the institution's total assets at the time it became undercapitalized or the amount necessary to bring the institution into compliance with all applicable capital standards as of the time the institution fails to comply with its capital restoration plan, until the institution is adequately capitalized on average during each of four consecutive calendar quarters), and are subject to regulatory monitoring and various restrictions on their operations and activities, including those upon asset growth, acquisitions, branching and entry into new lines of business and may be required to divest themselves of or liquidate subsidiaries under certain circumstances. Holding companies of such institutions may be required to divest themselves of such institutions or divest themselves of or liquidate nondepository affiliates under certain circumstances. Critically undercapitalized institutions are also prohibited from making payments of principal and interest on debt subordinated to the claims of general creditors and are generally subject to the mandatory appointment of a conservator or receiver. Other Regulations FDICIA requires the federal banking agencies to adopt, by August 1, 1993, regulations prescribing standards for safety and soundness of insured banks and their holding companies, including standards relating to internal controls, information systems, internal audit systems, loan documentation, credit underwriting, interest rate exposure, asset growth, compensation, fees and benefits, asset quality, earnings and stock valuation, as well as other operational and managerial standards deemed appropriate by the agencies. Upon a determination by a federal banking agency that an insured bank has failed to satisfy any such standard, the bank will be required to file an acceptable plan to correct the deficiency. If the bank fails to submit or implement an acceptable plan, the federal banking agency may, and in some instances must, issue an order requiring the institution to correct the deficiency, restrict its asset growth, increase its ratio of tangible equity to assets, or impose other operating restrictions. On November 18, 1993, the federal banking agencies issued a notice of proposed rule-making setting forth general safety and soundness in areas prescribed in FDICIA and solicited comments regarding the proposed safety and soundness standards. In the view of the federal banking agencies, the proposed standards do not represent a change in existing policies but, instead, formalize fundamental standards already applied by the agencies. In general, the proposed standards establish objectives of proper operations and management while leaving the specific methods for achieving those objectives to each institution. However, the proposal establishes a maximum permissible ratio of classified assets to capital for institutions. The proposal also implements the requirements of FDICIA regarding the submission and review of safety and soundness plans by institutions failing to meet the prescribed standards and the issuance of orders where institutions have failed to submit acceptable compliance plans or implement an accepted plan in any material respect. Because the final terms of the regulators' implementation of this requirement of FDICIA are not yet known, Zions Bancorporation cannot predict the effect of its application to its operations or the operations of its subsidiaries. FDICIA also contains provisions which, among other things, restrict investments and activities as principal by state nonmember banks to those eligible for national banks, impose limitations on deposit account balance determinations for the purpose of the calculation of interest, and require the federal banking regulators to prescribe, implement, or modify standards, respectively, for extensions of credit secured by liens on interests in real estate or made for the purpose of financing construction of a building or other improvements to real estate, loans to bank insiders, regulatory accounting and reports, internal control reports, independent audits, exposure on interbank liabilities, contractual arrangements under which institutions receive goods, products or services, deposit account-related disclosures and advertising, as well as to impose restrictions on Federal Reserve discount window advances for certain institutions and to require that insured depository institutions generally be examined on-site by federal or state personnel at least once every twelve (12) months. In connection with an institutional failure or FDIC rescue of a financial institution, the Financial Institutions Reform, Recovery and Enforcement Act of 1989 ("FIRREA") grants to the FDIC the right, in many situations, to charge its actual or anticipated losses against commonly controlled depository institution affiliates of the failed or rescued institution (although not against a bank holding company itself). FIRREA also explicitly allows bank holding companies to acquire healthy as well as troubled savings associations (including savings and loan associations and federal savings banks) under Section 4 of the Bank Holding Company Act. In connection with this authorization, the Federal Reserve Board has been instructed not to impose so-called "tandem operating restrictions" which might otherwise limit the joint marketing or joint operations of affiliated banks and thrifts beyond those restrictions otherwise embodied in law. FIRREA also relieves bank holding companies that own savings associations of certain duplicative or intrusive savings and loan holding company regulations and, in some instances, allows savings associations that have been acquired by bank holding companies to merge into affiliated banks or become banks themselves. On October 28, 1992, the Housing and Community Development Act of 1992 was enacted which, inter alia, modified prior law regarding the establishment of compensation standards by the federal banking agencies, deposit account disclosures, loans to bank insiders and real estate appraisal requirements; made certain technical corrections to FDICIA; imposed new sanctions upon banks convicted of money laundering or cash transaction reporting offenses; and restricted the methods banks may employ to calculate and refund prepaid interest on mortgage refinancing and consumer loans. In addition, on October 23, 1992, the Depository Institutions Disaster Relief Act of 1992 was enacted, affording the federal banking agencies limited discretion to provide relief from certain regulatory requirements to depository institutions doing business or seeking to do business in an emergency or major disaster area. Zions Bancorporation does not currently expect that the implication of these laws will have a material adverse effect upon its operations and business or upon the operations and business of its subsidiaries. On August 10, 1993, the President signed into law the Omnibus Budget Reconciliation Act of 1993 which contains provisions that, inter alia, affect the amortization of intangible assets by banks, require securities dealers (including banks) to adopt mark-to-market accounting to calculate income taxes, transfer surplus funds from the Federal Reserve System to the Department of the Treasury, authorize the United States government to originate student loans and establish a preference for depositors in liquidations of FDIC-insured banks. Zions Bancorporation is currently assessing the consequences to its operations, earnings and capital position, and that of its subsidiaries of the enactment of this legislation. In addition, a number of legislative and regulatory measures have been proposed to strengthen the federal deposit insurance system and to improve the overall financial stability of the U.S. banking system, including those to authorize interstate banking for national banks, reduce regulatory burdens on financial institutions and regulate the sale of securities and insurance by banks as well as bank involvement in derivative activities. It is impossible to predict whether or in what form these proposals may be adopted in the future and, if adopted, what their effect will be on Zions Bancorporation and its subsidiaries. There are many other regulations requiring detailed compliance procedures which increase costs and require additional time commitments of employees. Regulators and the Congress continue to put in place rules and laws to protect consumers, which have a cumulative additional impact on the cost of doing business. A recent amendment to the Real Estate Settlement Procedures, which becomes effective August 9, 1994, covers most loans secured by 1-4 family dwellings, whether secured by first or junior liens, and appears to add significant new disclosure requirements for banks. Additionally, a recent proposal, out for comment, to amend Community Reinvestment Act compliance rules, if adopted as proposed, would have an impact on allocation of credit to low income areas and could have an overall effect on interest rate margins. At this point, management cannot completely assess how much earnings might be reduced from these consumer laws. Deposit Insurance Assessments The insured bank subsidiaries of Zions Bancorporation are required to pay semi-annual deposit insurance assessments to the Bank Insurance Fund ("BIF"). FDICIA requires the FDIC to establish a schedule to increase the reserve ratio of the BIF to 1.25% of insured deposits (or such higher ratio as the FDIC determines to be justified for any year by circumstances raising a significant risk of substantial future losses) over a 15-year period, and to increase the assessment rate on banks, if necessary, to achieve that ratio. FDICIA also requires the FDIC to establish by January 1, 1994, by regulation, a risk-based assessment system for deposit insurance which will take into account the probability that the deposit insurance fund will incur a loss with respect to an institution, the likely amount of such loss and the revenue needs of the deposit insurance fund. On October 1, 1992, the FDIC published revisions to its deposit insurance regulation to establish a transitional risk-based assessment system pending establishment of a permanent risk-based assessment system by January 1, 1994. Effective January 1, 1993, each insured bank's insurance assessment rate is determined by the risk assessment classification into which it has been placed by the FDIC. The FDIC places each insured bank in one of nine risk assessment classifications based upon its level of capital and supervisory evaluations by its regulations: "well-capitalized" banks, "adequately capitalized" banks or "less-than-adequately capitalized" banks, with each category of banks divided into subcategories of banks which are either "healthy," of "supervisory concern" or of "substantial supervisory concern." An eight-basis point spread exists between the assessment rate established for the highest and lowest risk classification, so that banks classified as strongest by the FDIC are subject to a rate of .23% (the same rate as under the previous flat-rate assessment system) while those classified as weakest by the FDIC are subject to a rate of .31% (with intermediate rates of .26%, .29%, and .30%). The FDIC staff has stated that insured banks will pay an average ratio of approximately .254%. At a meeting on June 17, 1993, the FDIC's board of directors approved revisions to its regulation establishing the transitional risk-based assessment system with respect to the making of supervisory subgroup assignments and review of such assignments by the FDIC, the making of capital group assignments for new institutions by the FDIC, the payment of disputed assessments by institutions and other matters. In addition, on May 25, 1993, the FDIC board of directors voted to amend the current recapitalization schedule for the BIF to reflect the projected achievement by the BIF of a reserve ratio of 1.25% of insured deposits by 2002 (rather than 2006 under the current schedule) and retain the current deposit insurance assessment rates for BIF-member institutions for semi-annual periods beginning July 1, 1993. Zions Bancorporation does not presently expect that implementation of the transitional risk-based deposit insurance assessment system, as so revised, will have a material adverse impact on its overall financial condition or results of operations or those of its bank subsidiaries. It is possible that the FDIC insurance assessments will be increased further in the future. In addition, the FDIC has authority to impose special assessments from time to time. Interstate Banking Existing laws and various regulatory developments have allowed financial institutions to conduct significant activities on an interstate basis for a number of years. During recent years, a number of financial institutions have expanded their out-of-state activities and various states have enacted legislation intended to allow certain interstate banking combinations which otherwise would be prohibited by federal law. The Banking Holding Company Act generally does not permit the Federal Reserve Board to approve an acquisition by a bank holding company of voting shares or assets of a bank located outside the state in which the operations of its banking subsidiaries are principally conducted unless the acquisition is specifically authorized by the statutes of the state in which such bank is located. Under the laws of Utah, Nevada, and Arizona, respectively, any out-of-state bank or bank holding company may acquire a Utah, Nevada, or Arizona bank or bank holding company upon the approval of the bank supervisor of the state. There is no requirement that the laws of the state in which the out-of-state bank or bank holding company's operations are principally conducted afford reciprocal privileges to Utah -, Nevada - or Arizona-based acquirers. The commercial banking subsidiaries are supervised and regularly examined by various federal and state regulatory agencies. Deposits, reserves, investments, loans, consumer law compliance, issuance of securities, payment of dividends, mergers and consolidations, electronic funds transfers, management practices, and other aspects of operations are subject to regulation. In addition, numerous federal, state, and local regulations set forth specific restrictions and procedural requirements with respect to the extension of credit, credit practices, the disclosure of credit terms, and discrimination in credit transactions. The various regulatory agencies, as an integral part of their examination process, periodically review the banking subsidiaries' allowances for loan losses. Such agencies may require the banking subsidiaries to recognize additions to such allowances based on their judgments using information available to them at the time of their examinations. As a consequence of the extensive regulation of the commercial banking business, the Company cannot yet assess the impact of these legislative and regulatory mandates on the commercial banking industry which may increase the cost of doing business that are not required of the industry's nonbank competitors. Federal and state legislation affecting the banking industry have played, and will continue to play, a significant role in shaping the nature of the financial service industry. Various legislation, including proposals to overhaul the banking regulatory system and to limit the investments that a depository institution may make with insured funds, is from time to time introduced. The Company cannot determine the ultimate effect that FDICIA and the implementing regulations to be adopted thereunder, or any other potential legislation, if enacted, would have upon its financial condition or operations. In addition, there are cases pending before federal and state courts that seek to expand or restrict interpretations of existing laws and their accompanying regulations affecting bank holding companies and their subsidiaries. It is not possible to predict the extent to which Zions Bancorporation and its subsidiaries may be affected by any of these initiatives. GOVERNMENT MONETARY POLICIES AND ECONOMIC CONTROLS The earnings and business of the Company are affected by general economic conditions. In addition, fiscal or other policies that are adopted by various regulatory authorities of the United States and by agencies can have important consequences on the financial performance of the Company. The Company is particularly affected by the policies of the Federal Reserve Board which regulate the national supply of bank credit. The instruments of monetary policy available to the Federal Reserve Board include open-market operations in United States government securities; changing the discount rates of member bank borrowings; imposing or changing reserve requirements against member bank deposits; and imposing or changing reserve requirements against certain borrowings by banks and their affiliates. These methods are used in varying combinations to influence the overall growth of bank loans, investments and deposits, and the interest rates charged on loans or paid for deposits. The Company has economic, credit, legal and other specialists who monitor economic conditions, government policies and economic controls. However, in view of changing conditions in the economy and the effect of the credit policies of monetary authorities, it is difficult to predict future changes in loan demand, deposit levels and interest rates, or their effect on the business and earnings of Zions Bancorporation and its subsidiaries. Federal Reserve Board monetary policies have had a significant effect on the operating results of commercial banks in the past and are expected to continue to do so in the future. COMPETITION Zions Bancorporation and its subsidiaries operate in a highly competitive environment. The banking subsidiaries compete with other banks, thrift institutions, credit unions and money market, and other mutual funds for deposits and other sources of funds. In addition, Zions Bancorporation and its bank and nonbank subsidiaries face increased competition with respect to the diverse financial services and products they offer. Competitors include not only other banks, thrift institutions, and mutual funds, but also leasing companies, finance companies, brokerage firms, investment banking companies, and a variety of other financial services and advisory companies. Many of these competitors are not subject to the same regulatory restrictions as are bank holding companies and banks such as Zions Bancorporation and its banking subsidiaries. The Company expects that competitive conditions will continue to intensify as a result of technological advances. Technological advances have, for example, made it possible for nondepository institutions to offer customers automatic transfer systems and other automated-payment systems services that have been traditional banking products. EMPLOYEES The Company employs approximately 2,846 full- and part-time people with approximately 2,651 being employed by the banking subsidiaries. The Company had 2,574 full-time equivalent employees at December 31, 1993, compared to 2,345 at December 31, 1992. Banking subsidiaries had 2,386 full-time equivalent employees at the end of 1993, compared to 1,950 a year earlier. The Company believes that it enjoys good employee relations. In addition to competitive salaries and wages, Zions Bancorporation and its subsidiaries contribute to group medical plans, group insurance plans, pension, stock ownership and profit sharing plans. SUPPLEMENTARY INFORMATION The following supplementary information, which is required under Guide 3 (Statistical Disclosure by Bank Holding Companies), is found in this report on the pages indicated below, and should be read in conjunction with the related financial statements and notes thereto. ITEM 2.

ITEM 2. PROPERTIES In Utah, fifty (50) of Zions First National Bank's eighty-four (84) offices are located in buildings owned by the Company and the other thirty-four (34) are on leased premises. In Nevada, four (4) of Nevada State Bank's nineteen (19) offices are located in buildings owned and the other fifteen (15) are on leased premises, and in Arizona, Zions First National Bank of Arizona owns two (2) offices and leases one (1) office. The annual rentals under long-term leases for such banking premises are determined under various formulas and include as various factors, operating costs, maintenance and taxes. Zions Bancorporation is lessee under a 25-year lease, of which 22 years have expired, of a 14-story building in downtown Salt Lake City, Utah. The Company's subsidiaries have leased the ground floor and two other floors. The J.C. Penney Company, Inc., has subleased nine floors for offices. The remaining two floors are sublet to various tenants. The Company's subsidiaries conducting lease financing, insurance, mortgage servicing, and discount brokerage activities operate from leased premises. For information regarding rental payments, see note 9 of Notes to Consolidated Financial Statements, which appears in Part II, Item 8, on page 57 of this report. ITEM 3.

ITEM 3. LEGAL PROCEEDINGS During 1988, a lawsuit was brought in the United States District Court, Utah District, against Zions First National Bank in connection with its performance of duties as an indenture trustee for certain investors in real estate and other syndication projects. In September 1992, a motion was granted allowing an amended complaint containing allegations that plaintiffs intend to proceed as a class action to recover approximately $23 million, prejudgment interest, attorneys' fees, and additional amounts under certain statutory provisions and common law. No motion to certify the classes has been filed, and the Bank intends to vigorously oppose such motion and to defend the entire action. Although no assurances can be given as to the outcome, the Company continues to believe that it has meritorious defenses to such lawsuit, and that there is insurance coverage for a substantial portion of the amount claimed. The Company is also the defendant in various other legal proceedings arising in the normal course of business. The Company does not believe that the outcome of any of such proceedings, including the lawsuit discussed in the preceding paragraph, will have a material adverse effect on its consolidated financial position. ITEM 4.

ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS No matters were submitted to a vote of security holders during the fourth quarter of 1993. EXECUTIVE OFFICERS OF THE REGISTRANT The names, ages, positions, and backgrounds of the Company's executive officers as of February 28, 1994, are set forth as follows: PART II ITEM 5.

ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS Principal market where common stock is traded: Nasdaq Over the Counter Symbol "ZION" High and low bid quotations on quarterly basis for past three years: Number of common shareholders of record as of latest practicable date: 3,740 common shareholders as of February 28, 1994 Frequency and amount of dividends paid during three years: Description of any restrictions on the issuer's present or future ability to pay dividends: Funds for the payment of dividends by Zions Bancorporation have been obtained primarily from dividends paid by the commercial banking and other subsidiaries. In addition to certain statutory limitations on the payment of dividends, approval of federal and/or state banking regulators may be required in some instances for any dividend to Zions Bancorporation by its banking subsidiaries. The payment of future dividends therefore is dependent upon earnings and the financial condition of the Company and its subsidiaries as well as other factors. ITEM 6.

ITEM 6. SELECTED CONSOLIDATED FINANCIAL DATA The following selected consolidated financial data is derived from the audited consolidated financial statements of the Company. It should be read in conjunction with the Company's consolidated financial statements and the related notes and with management's discussion and analysis of financial condition and results of operations and other detailed information included elsewhere herein. ITEM 7.

ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The following analysis of the Company's financial condition and results of operations as of and for the years ended December 31, 1993, 1992, and 1991 should be read in conjunction with the consolidated financial statements of the Company and detailed information presented elsewhere herein. OPERATING RESULTS Consolidated net income in 1993 increased 22.2% to $53,039,000 from $43,402,000 in 1992 and $29,124,000 in 1991, while net income per share in 1993 increased 17.9% to $4.15 from $3.52 in 1992 and $2.39 in 1991. Earnings results for 1993 were positively affected in the net amount of $1,659,000 or $.13 per share due to the cumulative effect of changes in accounting principles implemented during the first quarter of the year. The earnings results for 1993 represent a historic high for income before income taxes and net income. Some of the factors affecting the favorable level of earnings were a $12,785,000 (8.9%) increase in net interest income, a $3,222,000 (17.0%) increase in service charges on deposit accounts, a $1,966,000 (10.6%) increase in service charges, commissions and fees, a $14,898,000 (226.7%) increase in loan sales and servicing income, and a $7,953,000 (77.6%) decrease in the provisions for loan losses. These increased contributions to income were partially offset by a $13,223,000 (20.0%) increase in salaries and benefits, a $6,263,000 (9.6%) increase in all other operating expenses, excluding a one-time expense of $6,022,000, and a $3,518,000 (16.6%) increase in income taxes. The Company's earnings for the year ended December 31, 1993 were negatively affected by a one-time expense of $6,022,000 in the first quarter related to the early extinguishment of debt consisting of floating rate notes and industrial revenue bonds. The expense is included in other operating expenses. This expense consisted of marking to market an interest rate exchange agreement entered into several years ago in conjunction with the issuance of long-term floating rate notes and writing off deferred costs associated with the notes and bonds. The Financial Accounting Standards Board (FASB) issued SFAS No. 109, "Accounting for Income Taxes," which establishes financial accounting requirements for the effects of income taxes. The statement requires a change from the deferred method of accounting for income taxes to the asset and liability method of accounting for income taxes. Under the asset and liability method, deferred tax assets and liabilities are recognized for the estimated future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases. Under SFAS No. 109, the effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date. Effective January 1, 1993, the Company adopted SFAS No. 109 and reported the cumulative effect of the change in the method of accounting for income taxes in the 1993 consolidated statement of income. The cumulative effect of such change in accounting method increased net income for the year ended December 31, 1993 by $7,419,000. The FASB issued SFAS No. 106, "Employers' Accounting for Postretirement Benefits Other than Pensions," in December 1990. Under SFAS No. 106, the cost of postretirement benefits other than pensions must be recognized on an accrual basis as employees perform services to earn the benefits. Many of the provisions and concepts of SFAS No. 106 are similar to current standards on accounting for pensions. The provisions of SFAS No. 106 are effective for fiscal years beginning after December 15, 1992. The Company has made it a practice to provide certain health care benefits for retired employees. The level of benefits to be paid to employees retiring in the future was also modified in 1992 to require greater contributions from the employee at retirement and a cap on the amount of retiree premiums that will be paid by the Company. Employees hired after December 31, 1992 are not entitled to retiree health benefits. Effective January 1, 1993, the Company adopted SFAS No. 106 and reported the cumulative effect of the change in the method of accounting for postretirement benefits other than pensions in the 1993 consolidated statement of income. The cumulative effect (transition obligation) of such change in accounting method decreased pretax and after-tax net income by $5,760,000 and $3,631,000, respectively. The FASB issued SFAS No. 115, "Accounting for Certain Investments in Debt and Equity Securities," in May 1993. Under SFAS No. 115, certain debt securities, depending on the intention of the holder, and equity securities are designated as trading securities and are marked to market through income, certain debt and equity securities are designated as available for sale and are marked to market through the equity accounts, and certain debt securities are designated as held to maturity and carried at amortized cost. Effective December 31, 1993, the Company adopted SFAS No. 115 and classified its securities according to the pronouncement. The change in the method of accounting for securities had no effect on income for 1993 and resulted in an increase of $432,000 in equity as of December 31, 1993. EARNINGS PERFORMANCE NET INTEREST INCOME, MARGIN, AND INTEREST RATE SPREADS Net interest income is the difference between the total interest income generated by earnings assets and the total interest cost of the funds used to finance assets. Net interest income is the largest component of the Company's revenue. The Company's taxable-equivalent net interest income increased by 8.9% to $160,129,000 in 1993 as compared to $147,060,000 in 1992 and $133,813,000 in 1991. The Company attempts to minimize interest rate movement sensitivity through the management of interest rate maturities and to a much lessor extent the use of off-balance sheet arrangements such as interest rate caps, floors, and interest rate exchange contract agreements. During 1993, the Company had income of $291,000 from the use of such off-balance sheet arrangements compared to income to the Company of $9,000 in 1992 and a cost to the Company of $875,000 in 1991. The Company intends to continue to use such off-balance sheet arrangements to the extent necessary to minimize its exposure to changes in prevailing interest rates. Net interest margin is a measure of the Company's ability to generate net interest income and is computed by expressing net interest income (stated on a fully taxable-equivalent basis) as a percentage of earning assets. The Company's net interest margin was 4.11% for 1993 as compared to 4.49% in 1992 and 4.35% in 1991. The decrease in the margin for 1993 was due primarily to securitization sales of loans and the expansion of investments in security resell agreements during the second half of 1993. Securitization sales of loans converts high margin income from loans to other operating income. The security resell agreements are primarily in U.S. government and U.S. government agency securities which offer low yields but represent virtually no risk to the Company and require low or no consolidated "risk-based" capital. The Company has been entering into the security resell arrangements through the new division in its lead banking subsidiary, Discount Corporation of New York. The Company has chosen this method of investing in very short-term arrangements to increase its net interest income while maintaining its liquidity. The spread on average interest-bearing funds is the difference between the yield on earning assets and the cost of interest-bearing funds. The Company's spread on average interest-bearing funds was 3.62% for 1993 as compared to 3.89% in 1992 and 3.56% in 1991. The spread on average interest-bearing funds for 1993 has also been affected by securitization sales of loans and investments in security resell arrangements. Consolidated average balances, the amount of interest earned or paid, the applicable interest rate for the various categories of earning assets and interest-bearing funds which represent the components of net interest income and interest differentials on a taxable-equivalent basis, and the effect on net interest income of changes due to volume and rates for the years 1993, 1992, and 1991 are shown in tables on pages 17 through 19. Income computed on a taxable-equivalent basis is income as reported in the consolidated statements of income adjusted to make income and earning yields on assets exempt from income taxes comparable to other taxable income. Applied to yields on the obligations of states and political subdivisions thereof and on industrial revenue bonds, this adjustment facilitates analysis. The incremental tax rate used for calculating the taxable-equivalent adjustment was approximately 32% in each of 1993, 1992, and 1991. In the tables for the three years, the principal amounts of nonaccrual and renegotiated loans have been included in the average loan balances used to determine the rate earned on loans. Interest income on nonaccrual loans is included in income only to the extent that cash payments have been received and not applied to principal and is accrued on restructured loans at the reduced rates. Certain restructured loan agreements call for additional interest to be paid on a deferred or contingent basis. Such interest is taken into income only as collected. The analysis in the tables of the effect on net interest income of volume and rate changes, the change due to the volume/rate variance in this analysis has been allocated to volume, except when volume and rate have both increased then this variance has been allocated proportionately to both volume and rate and when rate has increased and volume has decreased then this variance has been allocated to rate. DISTRIBUTION OF ASSETS, LIABILITIES AND SHAREHOLDERS' EQUITY, INTEREST RATES AND INTEREST DIFFERENTIAL AND CHANGES DUE TO VOLUME AND RATES - -------------------- 1 Taxable-equivalent rates used where applicable. 2 Net of unearned income and fees, net of related costs. Loans include nonaccrual and restructured loans. DISTRIBUTION OF ASSETS, LIABILITIES AND SHAREHOLDERS' EQUITY, INTEREST RATES AND INTEREST DIFFERENTIAL AND CHANGES DUE TO VOLUME AND RATES - --------------------- 1 Taxable-equivalent rates used where applicable. 2 Net of unearned income and fees, net of related costs. Loans include nonaccrual and restructured loans. DISTRIBUTION OF ASSETS, LIABILITIES AND SHAREHOLDERS' EQUITY, INTEREST RATES AND INTEREST DIFFERENTIAL AND CHANGES DUE TO VOLUME AND RATES - -------------------- 1 Taxable-equivalent rates used where applicable. 2 Net of unearned income and fees, net of related costs. Loans include nonaccrual and restructured loans. PROVISION FOR LOAN LOSSES The provision for loan losses in 1993 decreased 77.6% to $2,298,000 from $10,251,000 in 1992, and $23,549,000 in 1991. The decrease in loan loss provisions resulted from improved credit risk management and an improved economy which have produced decreases in nonperforming assets and charge offs and an increase in recoveries. OTHER OPERATING INCOME The Company's other operating income increased by 26.3% to $78,127,000 in 1993 as compared to $61,861,000 in 1992, and $51,488,000 in 1991. Service charges on deposits increased by 17.0% in 1993 to $22,216,000, primarily as a result of price increases and higher volumes in 1993. Other service charges, commissions, and fees increased by 10.6% in 1993 to $20,450,000 primarily as a result of increased fees relating to mortgage and other loan originations. Trading account income decreased by 47.0% to $2,350,000 in 1993 as compared to $4,437,000 in 1992 primarily as a result of a gain on the sale of SBA-IO strips in 1992. Loan sales and servicing income increased 226.7% to $21,471,000 in 1993 primarily as a result of an increased volume of consumer and real estate loans sold at the end of 1992 and during 1993. The Company has not recognized an initial gain on the sale of loans but recognizes the income over the servicing life of the sale. Other income decreased by 17.0% in 1993 to $7,035,000 primarily as a result of interest received on federal income tax refunds in 1992. The following table presents the components of other operating income for the years indicated and a year-to-year comparison expressed in terms of percent changes. OTHER OPERATING INCOME OTHER OPERATING EXPENSES Operating expenses increased by 19.5% in 1993 to $156,548,000 as compared to $131,040,000 in 1992, and $117,307,000 in 1991. Employee salary and benefits costs increased by 20.0% in 1993 to $79,245,000, primarily as a result of increased staffing in retail and investment activities, general salary increases and bonuses, commissions, and profit sharing costs related to increased profitability. The Company benefited by a decrease of 85.5% in other real estate expense to $366,000 in 1993 as holding costs declined through the continued sales of other real estate owned properties during 1993. Also, values received in the sales of other real estate owned continued to improve in 1993. F.D.I.C. premiums increased by 13.7% in 1993 to $6,541,000 as compared to $5,752,000 in 1992 due primarily to higher assessment rates. The Company recognized a loss on early extinguishment of debt in the amount of $6,022,000 during 1993. All other expenses increased 12.0% to $24,279,000 in 1993 as compared to $21,781,000 in 1992 primarily due to increases in travel expenses and other miscellaneous expenses. The following table presents the components of other operating expenses for the years indicated and a year-to-year comparison expressed in terms of percent changes. OTHER OPERATING EXPENSES The following table presents full-time equivalent employees and banking offices at December 31, for the years indicated: FULL-TIME EQUIVALENT EMPLOYEES INCOME TAXES The Company's income taxes increased 17.0% to $24,718,000 compared to $21,200,000 in 1992, and $12,975,000 in 1991, primarily due to the increase in before tax income. The Company's effective tax rate decreased slightly to 32.5% in 1993 from 32.8% in 1992 as the increase in tax-exempt income and other lesser factors offset the 1993 increase in the statutory federal rate. QUARTERLY SUMMARY The following table presents a summary of earnings and end-of-period balances by quarter for the years ended December 31, 1993, 1992, and 1991: SUMMARY OF QUARTERLY FINANCIAL INFORMATION (UNAUDITED) ANALYSIS OF FINANCIAL CONDITION LIQUIDITY Liquidity represents the Company's ability to provide adequate funds to meet its financial obligations, including withdrawals by depositors, debt service requirements, and operating needs. Liquidity is primarily provided by the regularly scheduled maturities of the Company's investment and loan portfolios. In addition, the Company's liquidity is enhanced by the fact that cash, money market securities, and liquid investments, net of "short-term purchased" liabilities and wholesale deposits, totaled $1,605.8 million or 55.2% of core deposits at December 31, 1993, as compared to $1,067.6 million or 40.1% of core deposits at December 31, 1992. The Company's core deposits, consisting of demand, savings, and money market deposits, and small certificates of deposit, constituted 96.2% of total deposits at December 31, 1993, as compared to 96.3% at December 31, 1992. Maturing balances in loan portfolios provide flexibility in managing cash flows. Maturity management of those funds is an important source of medium-to long-term liquidity. The Company's ability to raise funds in the capital markets through the "securitization" process and by debt issuances allows the Company to take advantage of market opportunities to meet funding needs at reasonable cost. The Company manages its liquidity position in order to assure its ability to meet maturing obligations. Through an ongoing review of the Company's levels of interest-sensitive assets and liabilities, efforts are made to structure portfolios in such a way as to minimize the effects of fluctuating interest rate levels on net interest income. The parent company's cash requirements consist primarily of principal and interest payments on its borrowings, dividend payments to shareholders, cash operating expenses, and payments for income taxes. The parent company's cash needs are routinely satisfied through payments by subsidiaries of dividends, proportionate shares of current income taxes, management and other fees, and principal and interest payments on subsidiary borrowings from the parent company. INTEREST RATE SENSITIVITY Interest rate sensitivity measures the Company's financial exposure to changes in interest rates. Interest rate sensitivity is, like liquidity, affected by maturities of assets and liabilities. Unlike liquidity, however, interest rate sensitivity is measured in terms of "gaps," defined as the difference between volumes of assets and liabilities whose interest rates are subject to reset within specified periods of time. The Company, through the management of interest rate "maturities" and the use of off-balance sheet arrangements such as "interest rate caps, floors, and interest rate exchange contract agreements," attempts to be reasonably close to neutral. The following table presents information as to the Company's interest rate sensitivity at December 31, 1993: MATURITIES AND INTEREST RATE SENSITIVITY AT DECEMBER 31, 1993 EARNING ASSETS Average earning assets of $3,891.8 million in 1993 increased 18.9% from the 1992 level of $3,272.1 million and the 1991 level of $3,079.4 million. Earning assets comprised 91.3% of total average assets in 1993 compared with 92.3% in 1992, with average loans representing 51.5% of earning assets in 1993 compared to 59.7% in 1992. The volume of liquid money market investments, consisting of interest-bearing deposits, federal funds sold and security resell agreements and other money market investments, increased 68.9% to $770.2 million in 1993 from $456.0 million in 1992. Investment and trading securities increased 29.7% to $1,118.0 million in 1993 from $862.0 million in 1992. The increase was reflected primarily in the taxable securities category. Average loan volume increased 2.5% to $2,003.6 million in 1993 as compared to $1,954.1 million in 1992. The following table sets forth the composition of average earning assets for the years indicated: AVERAGE EARNING ASSETS INVESTMENT SECURITIES PORTFOLIO Investment securities prior to December 31, 1993 were held to maturity and carried at amortized cost. At December 31, 1993 the Company adopted SFAS No. 115, "Accounting for Certain Investments in Debt and Equity Securities" and segregated the portfolio for securities held to maturity, carried at amortized cost, and securities available for sale, carried at market. The following table presents the Company's year-end investment securities portfolio. MATURITIES AND AVERAGE YIELDS OF INVESTMENT SECURITIES The following table presents by maturity range and type of security, the average yield of the investment portfolio at December 31, 1993. The average yield is based on effective rates on book balances at the end of the year. * An effective tax rate of 30% was used to adjust tax-exempt securities yields to rates comparable to those on fully taxable securities. At December 31, 1993, the value of the Accessor Funds Inc. and the Federal Home Loan Bank of Seattle stock each exceeded ten percent of shareholders' equity. LOAN PORTFOLIO During 1993, the Company consummated a revolving consumer loan securitization totaling approximately $190 million and a home refinance loan securitization totaling approximately $159 million. After these sales, loans and leases at December 31, 1993 totaled $2,250,491,000, an increase of 15.7% compared to $1,945,223,000 at December 31, 1992, and $1,890,058,000 at December 31,1991. Loans held for sale, real estate loans, and lease financing increased 3.8%, 63.2%, and 4.8%, respectively, at December 31, 1993 compared to December 31, 1992, while commercial, financial, and agricultural loans decreased 11.3% and consumer loans decreased 17.0%. In the real estate portfolio, construction loans increased $66,649,000 or 74.7%, home equity credit line loans increased $12,224,000 or 8.5%, and 1-4 family residential loans, which include home refinance loans, increased $207,885,000 or 147.8%, and all other real estate secured loans increased $129,894,000 or 45.6%. The table below sets forth the amount of loans outstanding by type at December 31 for the years indicated: LOAN PORTFOLIO The Company has no foreign loans in its loan portfolio. ASSETS MANAGED In recent years, banks and other financial institutions have had an increasing tendency to "securitize" loans by pooling and selling them to investors, with the servicing responsibilities and residual income in excess of financing costs, servicing expenses, and loan losses accruing to the originating institution. The "securitization" of receivables can assist an institution in maximizing its ability to originate loans without large increases in capital, thereby enhancing the return on shareholders' equity. The Company's participation in the "securitization" process, as well as its participation in originating and selling mortgage loans, has increased in recent years. At December 31, 1993, real estate loans serviced for others amounted to $1,466.5 million compared to $1,252.8 million at December 31, 1992, and $1,224.3 million at December 31, 1991. Other loans serviced for investors at December 31, 1993 totaled $373.4 million, compared to $267.9 million at December 31, 1992, and $158.2 million at December 31, 1991. LOAN MATURITIES AND SENSITIVITY TO CHANGES IN INTEREST RATES The following table shows maturity distribution and sensitivity to changes in interest rates of the loan portfolio at December 31, 1993. CREDIT RISK MANAGEMENT Management of credit risk is a primary objective in maintaining a safe and sound institution. To accomplish this task, the Company has written and placed in effect loan policies to govern each of its loan portfolios. Loan policies assist the Company in providing a framework for consistency in the acceptance of credit and a basis for sound credit decisions. Generally, the Company makes its credit decisions based upon debtor cash flow and available collateral. The Company has structured its organization to separate the lending function from the credit administration function to strengthen the control and independent evaluation of credit activities. In addition, the Company has well-defined standards for grading its loan portfolio, and maintains an internal Credit Examination Department which periodically conducts examinations of the quality, documentation, and administration of the Company's lending departments, and submits reports thereon to a committee of the Board of Directors. Emphasis is placed on early detection of potential problem credits so that action plans can be developed on a timely basis to mitigate losses. LOAN RISK ELEMENTS The following table shows the principal amounts of nonaccrual, past due 90 days or more, restructured loans, and potential problem loans at December 31 for each year indicated. Includes loans held for sale. Impact of Nonperforming Loans on Interest Income The following table presents the gross interest income on nonaccrual and restructured loans that would have been recorded if these loans had been current in accordance with their original terms (interest at original rates), and the amount of interest income on these loans that was included in income for each year indicated. Potential problem loans consist primarily of commercial loans and commercial real estate loans of $1 million. Management reviews loans graded "special mention" and monitors the status of such loans for becoming potential problem loans and their likelihood of becoming nonperforming loans. At December 31, 1993, management identified as potential problem loans two loans totaling $1,114,000 compared to three loans totaling $6,263,000, at December 31, 1992, and three loans totaling $5,042,000 at December 31, 1991. Management believes that for the near future, potential problem loans should remain at about the current level. Another aspect of the Company's credit risk management strategy is the diversification of the loan portfolio. At year-end, the Company had 19% of its portfolio in commercial loans, 48% in real estate loans, 16% in consumer loans, 11% in loans held for sale, and 6% in lease financing. In addition, the Company attempts to avoid the risk of an undue concentration of credits in a particular industry or trade group, as indicated by the commercial loan and lease portfolio being allocated over more than 17 major industry classifications. At year end, the largest concentration in the commercial loan and leasing portfolio was in the retail industry group which comprised approximately 17% of the portfolio. The retail group is also well diversified in eight subcategories. Agricultural and mining loans comprise less than 7% of total commercial loans. Segments of the real estate portfolio as a percentage of total loans included 7% constructions loans, 7% home equity credit line loans, 16% 1-4 family residential loans and 18% other real estate-secured loans. The Company has no significant exposure to highly leveraged transactions and has no foreign credits in its loan portfolio. NONPERFORMING ASSETS Nonperforming assets include nonaccrual loans, restructured loans, and other real estate owned. Loans are generally placed on nonaccrual status when the loan is 90 days or more past due as to principal or interest, unless the loan is in the process of collection and well-secured. Consumer loans are not placed on a nonaccrual status inasmuch as they are generally charged off when they become 120 days past due. Loans are restructured to provide a reduction or deferral of interest or principal payments when the financial condition of the borrower deteriorates and requires that the borrower be given temporary or permanent relief from the contractual terms of the credit. Other real estate owned is acquired through or in lieu of foreclosure on credits that are secured by real estate. Nonperforming assets totaled $29,425,000 as of December 31, 1993, an increase of 1.6% from $28,975,000 as of December 31, 1992, but a decrease of 32.7% from the $43,692,000 at December 31, 1991. Nonperforming assets represented 1.32% of net loans and other real estate owned at December 31, 1993, as compared to 1.50% and 2.34% at December 31, 1992 and 1991, respectively. Nonperforming assets as a percentage of net loans and other real estate owned at December 31, 1993 are at their lowest levels since at least 1985, the period where records have been maintained using the present definitions. Accruing loans past due 90 days or more totaled $9,955,000 as of December 31, 1993, as compared to $6,219,000 at December 31, 1992 and $5,131,000 of December 31, 1991. These loans equal .45% of net loans and leases at December 31, 1993, as compared to .32% and .28% at December 31, 1992 and 1991, respectively. Continuous efforts have been made to reduce nonperforming loans and to liquidate real estate owned properties in such a manner as to recover the greatest value possible. Significant steps have been taken during the last few years to strengthen the Company's credit culture by implementing a number of initiatives designed to increase internal controls and improve early detection and resolution of problem loans. The following table sets forth the composition of nonperforming assets at December 31 for the years indicated: *Includes loans held for sale. ALLOWANCE FOR LOAN LOSSES The Company's allowance for loan losses was 2.93% of net loans and leases at December 31, 1993, as compared to 2.97% as of December 31, 1992 and 3.02% as of December 31, 1991. Loan charge-offs decreased 53.7% and recoveries increased 57.2% in 1993 as compared to 1992, which resulted in a ratio of net charge-offs to average loans and leases of (.27)% in 1993, compared to .48% in 1992 and 1.49% in 1991. The allowance for loan and lease losses relative to problem loans continued to strengthen in 1993. The allowance, as a percentage of nonperforming loans, at December 31, 1993 was 247.19%, as compared to 236.37% and 159.88% at December 31, 1992 and 1991, respectively. Nonperforming loans are defined as loans on which interest is not accrued and restructured loans. The allowance, as a percentage of noncurrent loans, was 201.73% at December 31, 1993 as compared to 216.51% and 151.66% at December 31, 1992 and 1991, respectively. Noncurrent loans are defined as loans on which interest is not accrued, plus loans 90 days or more past due on which interest continues to accrue. In analyzing the adequacy of the allowance for loan and lease losses, management utilizes a comprehensive loan grading system to determine risk potential in the portfolio, and considers the results of independent internal and external credit reviews, historical charge-off experience, and changes in the composition and volume of the portfolio. Other factors, such as general economic conditions and collateral values, are also considered. Larger problem credits are individually evaluated to determine appropriate reserve allocations. Additions to the allowance are based upon the resulting risk profile of the portfolio developed through the evaluation of the above factors. SUMMARY OF LOAN LOSS EXPERIENCE The following table shows the changes in the allowance for losses for each year indicated. Review of nonperforming loans and evaluation of the quality of the loan portfolio, as previously mentioned, results in the identification of certain loans with risk characteristics which warrant specific reserve allocations in the determination of the amount of the allowance for loan losses. The allowance is not allocated among all loan categories, and amounts allocated to specific categories are not necessarily indicative of future charge-offs. An amount in the allowance not specifically allocated by loan category is necessary in view of the fact that, while no loans were made with the expectation of loss, some loan losses inevitably occur. The following is a categorization of the allowance for loan losses for each year indicated. DEPOSITS Total average deposits increased 5.8% to $2,820.8 million in 1993 from $2,666.7 million in 1992 and $2,531.8 million in 1992. Total deposits increased 9.3% to $3,024,111,000 at December 31, 1993 compared to $2,764,824,000 at December 31, 1992. The Company's base of core deposits, consisting of demand, savings and money market accounts, increased 21.9% and 12.5%, respectively, comparing December 31, 1993 to December 31, 1992, while certificates of deposit under $100,000 decreased 12.6%. Domestic deposits over $100,000 decreased 6.8% and foreign deposits increased 29.9% respectively, comparing December 31, 1993 to December 31, 1992. The following table presents the average amount and the average rate paid on each of the following categories for each year indicated: AVERAGE DEPOSIT AMOUNTS AND AVERAGE RATES Substantially all foreign deposits are in denominations of $100,000 or more. SHORT-TERM BORROWINGS The following table sets forth data pertaining to the Company's short-term borrowings for each year indicated: (a) Federal funds purchased and security repurchase agreements are primarily on an overnight or demand basis. Rates on overnight funds reflect current market rates. Rates on fixed-maturity borrowings are set at the time of the borrowings. (b) Federal Home Loan Bank advances less than one year are overnight and reflect current market rates or reprice monthly based on a one-month LIBOR as set by the Federal Home Loan Bank of Seattle. Other borrowings are primarily variable rate and reprice based on changes in the prime rate which reflect current market. RETURN ON EQUITY AND ASSETS CAPITAL RESOURCES In recent years, regulations with respect to capital and capital adequacy for commercial banks and bank holding companies have been evolving. At year end, there were two measures of capital adequacy in use as follows: 1. Risk-based Capital Risk-based capital guidelines require varying amounts of capital to be maintained against different categories of assets, depending on the general level of risk inherent in the assets. A capital allocation is also required for off-balance sheet exposures such as letters of credit, loan commitment and interest rate contracts. The risk-based capital guidelines are in full effect in 1993 and 1992. As reflected in the following table, the Company's total risk-based capital ratio was 14.34% at December 31, 1993 and 15.53% at December 31, 1992. The minimum regulatory requirement is an 8% total risk-based capital ratio for a bank to be considered "well-capitalized" under the regulatory definition is 10%. 2. Tier I Leverage Under the risk-based capital guidelines, a bank holding company could, in theory, significantly leverage its capital through the investment in assets with little or no credit risk. The guidelines place a limit on such leverage through the establishment of a minimum level of tangible equity as a percentage of average total assets. The Company's Tier I leverage ratio was 5.47% at December 31, 1993 and 6.24% at December 31, 1992, compared to the minimum regulatory requirement of 4% to be considered adequately capitalized. The following table presents the regulatory risk-based capital at December 31 for the years indicated: * Limited to 1.25% of risk-weighted assets. ** Limited to 50% of core capital and reduced by 20% per year during an instrument's last five years before maturity. DIVIDENDS The Company's quarterly dividend rate was $.28 per share for the third and fourth quarters of 1993, $.21 per share for the first and second quarters of 1993 and the fourth quarter of 1992, and $.18 per share for all other quarterly periods during 1992 and 1991. The annual dividend rate was $.98 for 1993, $.75 for 1992 and $.72 for 1991. During the years 1989 through 1993 there was no preferred stock outstanding. The following table sets forth dividends paid by the Company of each year indicated: FOREIGN OPERATIONS Zions First National Bank opened a foreign office located in Grand Cayman, Grand Cayman Islands, B.W.I. in 1980. This office has no foreign loans outstanding. The office accepts Eurodollar deposits from qualified customers of the Bank and places deposits with foreign banks and foreign branches of other U.S. banks. Foreign deposits at December 31 totaled $68,563,000 in 1993, $52,777,000 in 1992 and $52,993,000 in 1991; and averaged $55,823,000 for 1993, $86,479,000 for 1992 and $62,729,000 for 1991. ITEM 8.

ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA Independent Auditors' Report The Board of Directors and Shareholders Zions Bancorporation: We have audited the accompanying consolidated balance sheets of Zions Bancorporation and subsidiaries as of December 31, 1993 and 1992, and the related consolidated statements of income, retained earnings, and cash flows for each of the years in the three-year period ended December 31, 1993. These consolidated financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Zions Bancorporation and subsidiaries as of December 31, 1993 and 1992, and the results of their operations and their cash flows for each of the years in the three-year period ended December 31, 1993, in conformity with generally accepted accounting principles. As discussed in notes 1 and 12 to the consolidated financial statements, the Company changed its method of accounting for postretirement benefits other than pensions to adopt the provisions of the Financial Accounting Standards Board's Statement of Financial Accounting Standards (Statement) No. 106, "Employers' Accounting for Postretirement Benefits Other than Pensions" on January 1, 1993. As discussed in notes 1 and 6, the Company changed its method of accounting for income taxes to adopt the provisions of Statement No. 109, "Accounting for Income Taxes" on January 1, 1993. As discussed in notes 1 and 3, the Company changed its method of accounting for investments to adopt the provisions of Statement No. 115, "Accounting for Certain Investments in Debt and Equity Securities" on December 31, 1993. KPMG Peat Marwick Salt Lake City, Utah January 25, 1994 ZIONS BANCORPORATION AND SUBSIDIARIES Consolidated Balance Sheets December 31, 1993 and 1992 (In thousands, except share amounts) See accompanying notes to consolidated financial statements. ZIONS BANCORPORATION AND SUBSIDIARIES Consolidated Statements of Income Years ended December 31, 1993, 1992, and 1991 (In thousands, except per share amounts) See accompanying notes to consolidated financial statements. ZIONS BANCORPORATION AND SUBSIDIARIES Consolidated Statements of Cash Flows Years ended December 31, 1993, 1992, and 1991 (In thousands) See accompanying notes to consolidated financial statements. ZIONS BANCORPORATION AND SUBSIDIARIES Consolidated Statements of Retained Earnings Years ended December 31, 1993, 1992, and 1991 (In thousands) See accompanying notes to consolidated financial statements. ZIONS BANCORPORATION AND SUBSIDIARIES Notes to Consolidated Financial Statements Years ended December 31, 1993, 1992, and 1991 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES Business - Zions Bancorporation (the Parent) is a multibank holding company organized under the laws of Utah in 1955, which provides a full range of banking and related services through its subsidiaries located primarily in Utah, Nevada, and Arizona. Basis of Financial Statement Presentation - The consolidated financial statements include the accounts of Zions Bancorporation and its subsidiaries (the Company). All significant intercompany accounts and transactions have been eliminated in consolidation. Certain amounts in prior years' consolidated financial statements have been reclassified to conform to the 1993 presentation. The consolidated financial statements have been prepared in conformity with generally accepted accounting principles. In preparing the consolidated financial statements, management is required to make estimates and assumptions that affect the reported amounts of assets and liabilities as of the date of the balance sheet and revenues and expenses for the period. Actual results could differ from those estimates. Investment Securities - The Company adopted the provisions of Statement of Financial Accounting Standards (Statement) No. 115, "Accounting for Certain Investments in Debt and Equity Securities" on December 31, 1993. Under Statement No. 115, the Company classifies its investment securities in one of three categories: trading, available-for-sale, or held-to-maturity. Trading securities are bought and held principally for the purpose of selling them in the near term. Held-to-maturity securities are those securities which the Company has the ability and intent to hold until maturity. All other securities not included in trading or held-to-maturity are classified as available-for-sale. Trading and available-for-sale securities are recorded at fair value. Held-to-maturity securities are recorded at amortized cost, adjusted for the amortization or accretion of premiums or discounts. Unrealized holding gains and losses on trading securities are included in earnings. Unrealized holding gains and losses, net of related tax effect, on available-for-sale securities are excluded from earnings and are reported as a separate component of shareholders' equity until realized. Transfers of securities between categories are recorded at fair value at the date of transfer. Unrealized holding gains and losses are recognized in earnings for transfers into trading securities. Unrealized holding gains or losses associated with transfers of securities from held-to-maturity to available-for-sale are recorded as a separate component of shareholders' equity. The unrealized holding gains or losses included in the separate component of equity for securities transferred from available-for-sale to held-for-maturity are maintained and amortized into earnings over the remaining life of the security as an adjustment to yield in a manner consistent with the amortization or accretion of premium or discount on the associated security. A decline in the market value of any available-for-sale or held-to-maturity security below cost that is deemed other than temporary is charged to earnings resulting in the establishment of a new cost basis for the security. Premiums and discounts are amortized or accreted over the life of the related held-to-maturity security as an adjustment to yield using the effective interest method. Dividend and interest income are recognized when earned. Realized gains and losses for securities classified as available-for-sale and held-to-maturity are included in earnings and are derived using the specific identification method of determining the cost of securities sold. Loan Fees - Nonrefundable fees and related direct costs associated with the origination of loans are deferred. The net deferred fees and costs are recognized in interest income over the loan term using methods that generally produce a level yield on the unpaid loan balance. Other nonrefundable fees related to lending activities other than direct loan origination are recognized as other operating income over the period the related service is provided. Bankcard discounts and fees charged to merchants for processing transactions through the Company are shown net of interchange discounts and fees expense, and are included in other service charges, commissions, and fees. Mortgage Loan Servicing - Mortgage loan servicing fees are based on a stipulated percentage of the outstanding loan principal balances being serviced and are included in income as related loan payments from mortgagors are collected. Costs associated with the acquisition of loan servicing rights through the purchase of servicing contracts or bulk loan purchases are deferred and amortized over the lives of loans being serviced in proportion to the estimated net loan servicing income. ZIONS BANCORPORATION AND SUBSIDIARIES Notes to Consolidated Financial Statements December 31, 1993, 1992, and 1991 Allowance for Loan Losses - The allowance for loan losses is based on management's periodic evaluation of the loan portfolio and reflects an amount that, in management's opinion, is adequate to absorb losses in the existing portfolio. In evaluating the portfolio, management takes into consideration numerous factors, including current economic conditions, prior loan loss experience, the composition of the loan portfolio, and management's estimate of anticipated credit losses. Management believes that the allowance for loan losses is adequate. While management uses available information to recognize losses on loans, future additions to the allowance may be necessary based on changes in economic conditions. In addition, various regulatory agencies, as an integral part of their examination process, periodically review the Company's allowance for loan losses. Such agencies may require the Company to recognize additions to the allowance based on their judgments using information available to them at the time of their examination. Premises and Equipment - Premises and equipment are stated at cost, net of accumulated depreciation and amortization. Depreciation, computed on the straight-line method, is charged to operations over the estimated useful lives of the properties. Leasehold improvements are amortized over the terms of respective leases or the estimated useful lives of the improvements, whichever is shorter. As of December 31, 1993 and 1992, accumulated depreciation and amortization totaled $55,416,000 and $50,712,000, respectively. Nonperforming Assets - Nonperforming assets are comprised of loans for which the accrual of interest has been discontinued, loans for which the terms have been renegotiated to less than market rates due to a weakening of the borrower's financial condition (restructured loans), and other real estate acquired primarily through foreclosure that is awaiting disposition. Loans are generally placed on a nonaccrual status when principal or interest is past due 90 days or more unless the loan is both well secured and in the process of collection, or when in the opinion of management, full collection of principal or interest is unlikely. Generally, consumer loans are not placed on a nonaccrual status inasmuch as they are generally charged off when they become 120 days past due. Other real estate owned is carried at the lower of cost or net realizable value. Real estate may be considered to be in substance foreclosed and included herein when specific criteria are met. When property is acquired through foreclosure, or substantially foreclosed, any excess of the related loan balance over net realizable value is charged to the allowance for loan losses. Subsequent writedowns or losses upon sale, if any, are charged to other real estate expense. Amounts Paid in Excess of Net Assets of Acquired Businesses (Goodwill) - The Company assesses the recoverability of this intangible asset by determining whether the amortization of the goodwill balance over its remaining life can be recovered through undiscounted future operating cash flows of the acquired operation. The amount of goodwill impairment, if any, is measured based on projected discounted future operating cash flows using a discount rate reflecting the Company's average cost of funds. Off-Balance Sheet Financial Instruments - In the ordinary course of business, the Company has entered into off-balance sheet financial instruments consisting of commitments to extend credit, commercial letters of credit, and standby letters of credit. Such financial instruments are recorded in the consolidated financial statements when they become payable. The credit risk associated with these commitments is considered in management's determination of the allowance for loan losses. Interest Rate Exchange Contracts and Cap and Floor Agreements - The Company enters into interest rate exchange contracts and cap and floor agreements in the management of interest rate risk. The objective of these financial instruments is to match estimated repricing periods of interest-sensitive assets and liabilities in order to reduce interest rate exposure. These instruments are used only to hedge asset and liability portfolios and are not used for speculative purposes. Fees associated with these financial instruments are accreted into interest income or amortized to interest expense on a straight-line basis over the lives of the contracts and agreements. The net interest received or paid on these contracts is reflected in the interest expense or income related to the hedged obligation or asset. ZIONS BANCORPORATION AND SUBSIDIARIES Notes to Consolidated Financial Statements December 31, 1993, 1992, and 1991 Statements of Cash Flows - For purposes of the statements of cash flows, the Company considers due from banks to be cash equivalents. The Company paid interest of $112.6 million, $118.7 million, and $156.9 million, respectively, and income taxes of $23.3 million, $14.9 million, and $13.8 million, respectively, for the years ended December 31, 1993, 1992, and 1991. Loans transferred to other real estate owned totaled $1.2 million, $4.9 million, and $3.6 million, respectively, for the years ended December 31, 1993, 1992, and 1991. Income Taxes - Effective January 1, 1993, the Company adopted the provisions of Statement No. 109, "Accounting for Income Taxes," and has reported the cumulative effect of that change in the method of accounting for income taxes in the 1993 consolidated statement of income. Under the asset and liability method of Statement No. 109, deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases and operating loss and tax credit carryforwards. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. Under Statement No. 109, the effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date. Pension and Other Postretirement Plans - The Company has a defined benefit pension plan covering substantially all of its employees. The benefits are based on years of service and employees' compensation levels. The cost of this program is being funded currently. The Company has other trustee retirement plans covering all qualified employees who have at least one year of service (see note 12). The Company sponsors a defined benefit health care plan for substantially all retirees and employees. Effective January 1, 1993, the Company adopted Statement No. 106, "Employers' Accounting for Postretirement Benefits Other than Pensions," which establishes a new accounting principle for the cost of retiree health care and other postretirement benefits (see note 12). Prior to 1993, the Company recognized these benefits on the pay-as-you-go method (i.e., cash basis). The cumulative effect of the change in method of accounting for postretirement benefits other than pensions is reported in the 1993 consolidated statement of income. Trust Assets - Assets held by the Company in a fiduciary or agency capacity for customers are not included in the consolidated financial statements as such items are not assets of the Company. Stock Options - Proceeds from the sale of stock issued under options are credited to common stock. The Company makes no charges against earnings with respect to stock options issued under its qualified stock option plan. The Company charges income for the difference between the option price and market value on the date of grant with respect to stock options issued under its nonqualified stock option plan. Net Income Per Common Share - Net income per common share is based on the weighted average outstanding common shares during each year, including common stock equivalents, if applicable. Stock Split - On December 18, 1992, the Company's Board of Directors approved a two-for-one split of the common stock. This action was effective on January 26, 1993 for shareholders of record as of January 5, 1993. A total of 6,139,227 shares of common stock were issued and recorded in the form of a stock dividend. All references to the number of common shares and per common share amounts have been restated to reflect the split. Accounting Standard Not Adopted - In May 1993, the Financial Accounting Standards Board issued Statement No. 114, "Accounting by Creditors for Impairment of a Loan." Statement No. 114 requires that impaired loans be measured based on the present value of expected future cash flows discounted at the loan's effective interest rate or, as a practical expedient, at the loan's observable market price or the fair value of the collateral if the loan is collateral dependent. Statement No. 114 is effective for fiscal years beginning after December 15, 1994. Management does not expect Statement No. 114 to have a significant impact on the Company's financial position. ZIONS BANCORPORATION AND SUBSIDIARIES Notes to Consolidated Financial Statements December 31, 1993, 1992, and 1991 2. MERGERS AND ACQUISITIONS On August 11, 1993, the Company acquired all of the capital stock of Discount Corporation of New York (Discount) for approximately $65.7 million in cash. The acquisition has been accounted for as a purchase, and accordingly, the net assets and results of operations are included in the consolidated financial statements since the date of acquisition. The difference between the purchase price and the net book value of Discount of $9.4 million is included in deferred tax assets (grouped with other assets) in the accompanying consolidated balance sheet as of December 31, 1993. The following table presents unaudited pro forma results of operations as if the acquisition had occurred on January 1, 1992. These pro forma results have been prepared for comparative purposes only and do not purport to be indicative of what would have occurred had the acquisition been made at the beginning of 1992 or of results which may occur in the future. Furthermore, no effect has been given in the pro forma information for operating and synergistic benefits that are expected to be realized through the combination of the entities because precise estimates of such benefits cannot be quantified (in thousands, except per share data). On October 29, 1993, the Company and Wasatch Bancorp (Wasatch) consummated their agreement and plan of reorganization whereby the Company issued 373,335 shares of its common stock for 100 percent of the outstanding common stock of Wasatch. The acquisition has been accounted for as a pooling of interests. The consolidated financial statements of the Company for 1992 and 1991 have not been restated and pro forma information giving effect to this acquisition is not provided inasmuch as the historical operations of Wasatch are not significant to the Company. During 1993, the Company acquired a 25 percent interest in Bennington Capital Management, Inc., a Seattle based investment advisor which manages the Accessor(TM) family of mutual funds. This acquisition is accounted for on the equity method. During the two years ended December 31, 1992, the Company also acquired certain assets and certain liabilities of two other financial institutions. These acquisitions have been treated as purchases for accounting purposes and, accordingly, the results of operations of these companies have been included in the consolidated financial statements for periods subsequent to the effective dates of purchase. On January 14, 1994, National Bancorp of Arizona Inc. (NBA) was merged into the Company. Each outstanding share of NBA common stock was converted into .45 shares of the Company's common stock. The Company expects to issue approximately 1,456,400 shares of its common stock for 100 percent of the outstanding common stock of NBA. The consolidated financial statements of the Company do not give effect to this merger, which will be accounted for as a pooling of interests. There are no material intercompany transactions and no material differences in accounting policies and procedures. Pro forma combined financial results that give affect to the merger for the years ended December 31, 1993, 1992, and 1991 are summarized as follows (in thousands, except per share data): ZIONS BANCORPORATION AND SUBSIDIARIES Notes to Consolidated Financial Statements December 31, 1993, 1992, and 1991 3. INVESTMENT SECURITIES Investment securities as of December 31, 1993, are summarized as follows (in thousands): ZIONS BANCORPORATION AND SUBSIDIARIES Notes to Consolidated Financial Statements December 31, 1993, 1992, and 1991 The Company adopted Statement No. 115, "Accounting for Certain Investments in Debt and Equity Securities" on December 31, 1993. The Company recognized a net unrealized holding gain on securities available for sale of $432,000, after related tax effect, at December 31, 1993. Investment securities as of December 31, 1992, are summarized as follows (in thousands): ZIONS BANCORPORATION AND SUBSIDIARIES Notes to Consolidated Financial Statements December 31, 1993, 1992, and 1991 The amortized cost and estimated market value of investment securities as of December 31, 1993, by contractual maturity, excluding mortgage-backed and equity securities, are shown below. Expected maturities will differ from contractual maturities because borrowers may have the right to call or repay obligations with or without call or prepayment penalties (in thousands): Gross gains of $104,000, $423,000, and $760,000 and gross losses of $121,000, $141,000, and $328,000 were realized on sales of investment securities for the years ended December 31, 1993, 1992, and 1991, respectively. Such amounts include gains of $10,000, $105,000, and $283,000, and losses of $32,000, $17,000, and $290,000, respectively, for sales of mortgage-backed securities. As of December 31, 1993 and 1992, securities with an amortized cost of $90,915,000 and $56,239,000, respectively, were pledged to secure public and trust deposits, advances, and for other purposes as required by law. In addition, the Federal Home Loan Bank stock is pledged as security on the related advances (note 7). 4. LOANS AND ALLOWANCE FOR LOAN LOSSES Loans are summarized as follows (in thousands): ZIONS BANCORPORATION AND SUBSIDIARIES Notes to Consolidated Financial Statements December 31, 1993, 1992, and 1991 As of December 31, 1993 and 1992, loans with a carrying value of $302,530,000 and $212,181,000, respectively, were pledged as security for Federal Home Loan Bank advances (note 7). During 1993, 1992, and 1991, the Company purchased mortgage servicing rights totaling $1.7 million, $1.4 million, and $.8 million, respectively. Amortization of purchased mortgage servicing rights totaled $2.6 million, $2.6 million, and $1.8 million for the years ended December 31, 1993, 1992, and 1991, respectively. During 1993 and 1992, consumer and other loan securitizations totaled $349 million and $159 million, respectively (there were no securitizations in 1991). Loan sales income related thereto is recognized on the basis of cash flows received from the securitized assets. Loan sales income, excluding servicing, amounted to $14.7 million in 1993, $1.7 million in 1992, and $3.1 million in 1991. The allowance for loan losses is summarized as follows (in thousands): Included in the allowance for loan losses is an allocation for unused commitments and letters of credit (note 9) that as of December 31, 1993 and 1992, amounted to $1,972,000 and $3,708,000, respectively. Nonperforming loans, leases, and related interest foregone are summarized as follows (in thousands): 5. DEPOSITS Deposits are summarized as follows (in thousands): ZIONS BANCORPORATION AND SUBSIDIARIES Notes to Consolidated Financial Statements December 31, 1993, 1992, and 1991 Interest expense on deposits is summarized as follows (in thousands): 6. INCOME TAXES The Company adopted Statement No. 109, "Accounting for Income Taxes," as of January 1, 1993. The cumulative effect of this adoption was an increase in net income of $7,419,000. Income taxes are summarized as follows (in thousands): A reconciliation between income tax expense computed using the statutory federal income tax rate (35 percent in 1993 and 34 percent in 1992 and 1991), and actual income tax expense is as follows (in thousands): ZIONS BANCORPORATION AND SUBSIDIARIES Notes to Consolidated Financial Statements December 31, 1993, 1992, and 1991 The tax effects of temporary differences that give rise to significant portions of the deferred tax assets and deferred tax liabilities as of December 31, 1993, are presented below (in thousands): A valuation allowance is provided when it is more likely than not that some portion of the deferred tax asset will not be realized. The Company has established a valuation allowance for the net capital loss carryforwards as a result of the uncertainty of realizing offsetting capital gains. The net change in the valuation allowance for 1993 amounted to a decrease of $1,137,000. Deferred income taxes provided on timing differences for 1992 and 1991 are summarized as follows (in thousands): ZIONS BANCORPORATION AND SUBSIDIARIES Notes to Consolidated Financial Statements December 31, 1993, 1992, and 1991 7. FEDERAL HOME LOAN BANK ADVANCES AND OTHER BORROWINGS Federal Home Loan Bank advances and other borrowings as of December 31, 1993 and 1992, include $252,109,000 and $176,816,000, respectively, borrowed by Zions First National Bank, a wholly owned subsidiary, (the Bank) under its line of credit with the Federal Home Loan Bank of Seattle. The line of credit provides for borrowing of amounts up to ten percent of total assets. The line of credit is secured under a blanket pledge whereby the Bank maintains unencumbered security with par value, which has been adjusted using a pledge requirement percentage based upon the types of securities pledged, equal to at least 100 percent of outstanding advances, and, Federal Home Loan Bank stock. There are no withdrawal and usage restrictions or compensating balance requirements. Substantially all Federal Home Loan Bank advances reprice with changes in market interest rates or have short terms to maturity. The carrying value of such indebtedness is deemed to approximate market value. Maturities of outstanding advances in excess of one year are as follows (in thousands): 8. LONG-TERM DEBT Long-term debt is summarized as follows (in thousands): The 8-5/8 percent subordinated notes mature in 2002 with interest payable semiannually. The notes are not redeemable prior to maturity. The floating rate notes and $4.7 million of the industrial revenue bonds were redeemed during 1993. The industrial revenue bonds require mandatory sinking fund redemption in various principal amounts through 1995. The bonds bear interest at rates from 7.40 percent to 7.50 percent. The bonds are secured by an assignment of leases on banking facilities and a data processing center. ZIONS BANCORPORATION AND SUBSIDIARIES Notes to Consolidated Financial Statements December 31, 1993, 1992, and 1991 Maturities and sinking fund requirements on long-term debt for each of the succeeding five years are as follows (in thousands): 9. COMMITMENTS AND CONTINGENT LIABILITIES The Company is a party to financial instruments with off-balance sheet risk in the normal course of business to meet the financing needs of its customers and to reduce its own exposure to fluctuations in interest rates. These financial instruments include commitments to extend credit, standby letters of credit, interest rate caps and floors, and interest rate exchange contracts. Those instruments involve, to varying degrees, elements of credit and interest rate risk in excess of the amount recognized in the balance sheets. The Company's exposure to credit loss in the event of nonperformance by the other party to the financial instrument for commitments to extend credit and standby letters of credit is represented by the contractual notional amount of those instruments. The Company uses the same credit policies in making commitments and conditional obligations as it does for on balance sheet instruments. For interest rate caps, floors, and exchange contract transactions, the contract or notional amounts do not represent exposure to credit loss. Unless noted otherwise, the Company does not require collateral or other security to support financial instruments with credit risk. Notional values of financial instruments are summarized as follows: Commitments to extend credit are agreements to lend to a customer as long as there is no violation of any condition established in the contract. Commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee. Commitments totaling $751,035,000 expire in 1994. Since many of the commitments are expected to expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements. The Company evaluates each customer's credit worthiness on a case-by-case basis. The amount of collateral obtained, if deemed necessary by the Company upon extension of credit, is based on management's credit evaluation of the counter party. Collateral held varies but may include accounts receivable, inventory, property, plant and equipment, and income-producing commercial properties. ZIONS BANCORPORATION AND SUBSIDIARIES Notes to Consolidated Financial Statements December 31, 1993, 1992, and 1991 Standby letters of credit written are conditional commitments issued by the Company to guarantee the performance of a customer to a third party. Those guarantees are primarily issued to support public and private borrowing arrangements, including commercial paper, bond financing, and similar transactions. Standby letters of credit include commitments in the amount of $63,767,000 expiring in 1994 and $6,358,000 expiring thereafter through 2005. The credit risk involved in issuing letters of credit is essentially the same as that involved in extending loan facilities to customers. The Company generally holds marketable securities and cash equivalents as collateral supporting those commitments for which collateral is deemed necessary. The Company enters into interest rate contracts, including interest rate caps, floors, and interest rate exchange contract agreements in managing its interest rate exposure. Interest rate caps and floors obligate one of the parties to the contract to make payments to the other if an interest rate index exceeds a specified upper "capped" level or if the index falls below a specified "floor" level. Interest rate exchange contract agreements involve the exchange of fixed and variable rate interest payments based upon a notional amount and maturity. The fair value of interest rate contracts are obtained from deal quotes, or discounted cash flow analyses. The values represent the estimated amount the Company would receive or pay for comparable contracts, taking into account current interest rates. Notional values of interest rate contracts are summarized as follows (in thousands): The contract or notional amount of financial instruments indicates a level of activity associated with a particular class of financial instrument and is not a reflection of the actual level of risk. As of December 31, 1993 and 1992, the regulatory risk weighted values assigned to all off-balance sheet financial instruments described herein totaled $132,228,000 and $156,188,000, respectively. See note 4 for consideration of financial instruments in management's determination of the allowance for loan losses. During 1988, a lawsuit was brought in the United States District Court, Utah District, against the Bank in connection with its performance of duties as an indenture trustee for certain investors in real estate and other syndication projects. In September 1992, a motion was granted allowing an amended complaint containing allegations that plaintiffs intend to proceed as a class action to recover approximately $23 million, prejudgment interest, attorneys' fees, and additional amounts under certain statutory provisions and common law. No motion to certify the classes has been filed, and the Bank intends to vigorously oppose such motion and to defend the entire action. Although no assurances can be given as to the outcome, the Company continues to believe that it has meritorious defenses to such lawsuit, and that there is insurance coverage for a substantial portion of the amount claimed. The Company is also the defendant in various other legal proceedings arising in the normal course of business. The Company does not believe that the outcome of any of such proceedings, including the lawsuit discussed in the preceding paragraph, will have a material adverse effect on its consolidated financial position. In connection with loans sold to (or serviced for) others, the Company is not subject to significant recourse obligations. ZIONS BANCORPORATION AND SUBSIDIARIES Notes to Consolidated Financial Statements December 31, 1993, 1992, and 1991 The Company has commitments for leasing premises and equipment under the terms of noncancelable leases expiring from 1994 to 2005. Future aggregate minimum rental payments under existing noncancelable leases at December 31, 1993 are as follows (in thousands): Future aggregate minimum rental payments have been reduced by noncancelable subleases as follows: 1994, $695,000; 1995, $636,000; and 1996, $442,000. Aggregate rental expense on operating leases amounted to $3,431,000, $3,017,000, and $2,409,000, for the years ended December 31, 1993, 1992, and 1991, respectively. 10. STOCK OPTIONS The Company has a qualified stock option plan adopted in 1981, under which stock options are granted to key employees; and a nonqualified plan under which options are granted to certain key employees. Under the nonqualified plan, options expire five to ten years from the date of grant. Under the qualified plan, 1,012,000 shares of common stock were reserved. Qualified options are granted at a price not less than 100 percent of the fair market value of the stock at the date of grant. Options granted are generally exercisable in increments from one to four years after the date of grant and expire four years after the date of grant. ZIONS BANCORPORATION AND SUBSIDIARIES Notes to Consolidated Financial Statements December 31, 1993, 1992, and 1991 Transactions and other information relating to stock options are summarized as follows: As of December 31, 1993, there are 104,000 options exercisable at prices from $12.50 to $24.13 per share. For the year ended December 31, 1993, shares obtained through exercise of options had a cumulative average market value of $1,944,000 at the date of exercise. ZIONS BANCORPORATION AND SUBSIDIARIES Notes to Consolidated Financial Statements December 31, 1993, 1992, and 1991 11. COMMON STOCK Changes in common stock are summarized as follows (amount in thousands): 12. RETIREMENT PLANS The Company has a noncontributory defined benefit pension plan for eligible employees. Plan benefits are based on years of service and employees' compensation levels. Benefits vest under the plan upon completion of five years of service. Plan assets consist principally of corporate equity and debt securities, government fixed income securities, and cash investments. The components of the net pension cost for the years ended December 31, 1993 and 1992, are as follows (in thousands): Primary actuarial assumptions used in determining the net pension cost are as follows: ZIONS BANCORPORATION AND SUBSIDIARIES Notes to Consolidated Financial Statements December 31, 1993, 1992, and 1991 The funded status of the plan as of December 31, 1993 and 1992, is as follows (in thousands): In addition to the Company's defined benefit pension plan, the Company sponsors a defined benefit health care plan that provides postretirement medical benefits to full-time employees hired before January 1, 1993, who meet minimum age and service requirements. The plan is contributory, with retiree contributions adjusted annually, and contains other cost-sharing features such as deductibles and coinsurance. Plan coverage is provided by self-funding or health maintenance organizations (HMOs) options. The accounting for the plan anticipates future cost-sharing changes to the written plan, including the Company's expressed intent to increase the retiree contribution rate annually from 30 percent and 40 percent in 1993 for normal and early retirees, respectively, to 50 percent for both in 1996. The Company's retiree premium contribution rate is frozen at 50 percent of 1996 dollar amounts. The Company's policy is to fund the cost of medical benefits in amounts determined at the discretion of management. The Company adopted Statement No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions," as of January 1, 1993. The effect of adopting Statement No. 106 on income before cumulative effect of changes in accounting principles and net income for the year ended December 31, 1993 amounted to a decrease of $5,760,000 and $3,631,000, respectively. The following table presents the plan's funded status reconciled with amounts recognized in the Company's consolidated balance sheet at December 31, 1993 (in thousands): ZIONS BANCORPORATION AND SUBSIDIARIES Notes to Consolidated Financial Statements December 31, 1993, 1992, and 1991 For measurement purposes, an annual rate of increase in the per capita cost of covered benefits (i.e., health care cost trend rate) of 11.67 percent and 9 percent were assumed for the self-funded and HMOs options, respectively, for 1994. The HMOs rate was assumed to decrease gradually to 5 percent by the year 2000 and remain at that level thereafter. The self-funded rate was assumed to decrease gradually to 5.8 percent by the year 2001, and decline to 5.01 percent over the remaining life expectancy of the participants. The health care cost trend rate assumption does not have a significant effect on amounts reported because the Company has capped its retiree premium contribution rates. The weighted-average discount rate used in determining the accumulated postretirement benefit obligation was 7.5 percent at December 31, 1993. The Company has an Employee Stock Savings Plan and an Employee Investment Savings Plan (formerly known as the Salary Reduction Arrangement Plan) (PAYSHELTER). Under PAYSHELTER, employees select from a nontax-deferred or tax-deferred plan and four investment alternatives. Employees can contribute from 1 to 15 percent of compensation, which is matched 50 percent by the Company for contributions up to 5 percent and 25 percent for contributions greater than 5 percent up to 10 percent. Contributions to the plans amounted to $1,175,000, $793,000, and $636,000 for the years ended December 31, 1993, 1992, and 1991, respectively. During 1992, the Company formed an employee profit sharing plan. Contributions to the plan are determined per a formula based on the Company's annual return on equity (required minimum return of 15 percent). Contributions to the plan amounted to $948,000 and $914,000 for the years ended December 31, 1993 and 1992, respectively. 13. QUARTERLY FINANCIAL INFORMATION (UNAUDITED) Financial information by quarter for the three years ended December 31, 1993 is as follows (in thousands, except per share amounts): ZIONS BANCORPORATION AND SUBSIDIARIES Notes to Consolidated Financial Statements December 31, 1993, 1992, and 1991 14. CONCENTRATIONS OF CREDIT RISK Most of the Company's business activity is with customers located within the states of Utah and Nevada. The commercial loan portfolio is well diversified, consisting of more than 17 industry classifications groupings. As of December 31, 1993, the largest concentration of risk in the commercial loan and leasing portfolio is represented by the real estate industry grouping, which comprises approximately 17 percent of the portfolio. The real estate industry grouping is also well diversified over several subcategories. The Company has minimal credit exposure from lending transactions with highly leveraged entities and has no foreign loans. 15. FAIR VALUE OF FINANCIAL INSTRUMENTS Carrying value and estimated fair value of principal financial instruments as of December 31, 1993 are summarized as follows (in thousands): Financial assets and financial liabilities other than investment securities of the Company are not traded in active markets. The above estimates of fair value require subjective judgments, and are approximate. Changes in the following methodologies and assumptions could significantly affect the estimates. Financial Assets - The estimated fair value approximates the carrying value of cash and due from banks and money market investments. For securities, the fair value is based on quoted market prices where available. If quoted market prices are not available, fair values are based on quoted market prices of comparable instruments or using a discounted cash flow model based on established market rates. The fair value of fixed rate loans is estimated by discounting future cash flows using the London Interbank Offered Rate (LIBOR) yield curve adjusted by a factor which reflects the credit and interest rate risk inherent in the loan. Variable rate loans reprice with changes in market rates. As such their carrying amounts are deemed to approximate fair value. The fair value of the allowance for loan losses of $65,267,000 is the present value of estimated net charge-offs. Financial Liabilities - The estimated fair value of demand and savings deposits, and federal funds purchased and security repurchase agreements approximates the carrying value. The fair value of time and foreign deposits is estimated by discounting future cash flows using the LIBOR yield curve. Substantially all FHLB advances reprice with changes in market interest rates or have short terms to maturity. The carrying value of such indebtedness is deemed to approximate market value. Other borrowings are not significant. The estimated fair value of the subordinated notes is based on a quoted market price. The remaining long-term debt is not significant. Off-Balance Sheet Financial Instruments - Commitments to extend credit and letters of credit represent the principal categories of off-balance sheet financial instruments. The fair value of these commitments, based on fees currently charged for similar commitments, is not significant. See note 9 to the consolidated financial statements. ZIONS BANCORPORATION AND SUBSIDIARIES Notes to Consolidated Financial Statements December 31, 1993, 1992, and 1991 16. DIVIDEND RESTRICTION AND CONDENSED PARENT ONLY FINANCIAL INFORMATION Dividends declared by the Company's banking subsidiaries in any calendar year may not, without the approval of the appropriate federal regulator, exceed their net earnings for that year combined with their retained net earnings for the preceding two years. At December 31, 1993, the Company's subsidiaries had approximately $54.6 million available for the payment of dividends under the foregoing restrictions. In addition, the banking subsidiaries must meet various requirements and restrictions under the laws of the United States and state laws, including requirements to maintain cash reserves against deposits and limitations on loans and investments with affiliated companies. During 1993, cash reserve balances held with the Federal Reserve banks averaged approximately $60.3 million. Condensed financial information of Zions Bancorporation (parent only) follows: ZIONS BANCORPORATION Condensed Balance Sheets December 31, 1993 and 1992 (In thousands) ZIONS BANCORPORATION Condensed Statements of Income Years ended December 31, 1993, 1992, and 1991 (In thousands) ZIONS BANCORPORATION Condensed Statements of Cash Flows Years ended December 31, 1993, 1992, and 1991 (In thousands) The Parent company paid interest of $8,577,000, $7,940,000, and $7,255,000 for the years ended December 31, 1993, 1992, and 1991, respectively. ZIONS BANCORPORATION Condensed Statements of Retained Earnings Years ended December 31, 1993, 1992, and 1991 (In thousands) The selected quarterly financial data information required by this item appears on pages 22 and 61 under the caption "QUARTERLY FINANCIAL INFORMATION (UNAUDITED)." ITEM 9.

ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE None. PART III ITEM 10.

ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT The information required by this item, to the extent not included under the caption "Executive officers of the registrant" in Part I of this report, will appear on pages 1 through 6 of the definitive Proxy Statement. Information relating to the directors and executive officers on pages 1 through 6, and information required by Item 405 of Regulation S-K as set forth beginning in the last paragraph on page 7 of the definitive Proxy Statement relating to the 1994 Annual Meeting of Shareholders to be held April 29, 1994, is incorporated herein by reference. ITEM 11.

ITEM 11. EXECUTIVE COMPENSATION The information required by this item appearing on pages 8 through 16 of the definitive Proxy Statement relating to the 1994 Annual Meeting of Shareholders to be held April 29, 1994, is incorporated herein by reference. ITEM 12.

ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT The information required by this item appearing on pages 6 and 7 of the definitive Proxy Statement relating to the 1994 Annual Meeting of Shareholders to be held April 29, 1994, is incorporated herein by reference. ITEM 13.

ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS The information required by this item appearing on page 16 of the definitive Proxy Statement relating to the 1994 Annual Meeting of Shareholders to be held April 29, 1994, is incorporated herein by reference. PART IV ITEM 14.

ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K (a) The following documents are part of this report and appear on the pages indicated: (2) Financial Statement Schedules: Schedules are omitted because the information is either not required, not applicable, or is included in Part II, Items 6-8 of this report. (3) Exhibits: The exhibits listed on the Exhibit Index on page 71 of this report are filed or are incorporated herein by reference. (b) Reports on Form 8-K There were no reports on Form 8-K filed during the quarter ended December 31, 1993. For the purposes of complying with the amendments to the rules governing Form S-8 (effective July 13, 1990) under the Securities Act of 1993, the undersigned Registrant hereby undertakes as follows, which undertaking shall be incorporated by reference into Registrant's Registration Statements on Form S-8 Nos. 33-52878 (filed on October 2, 1992) and 33-52796 (filed on October 2, 1992). Insofar as indemnification for liabilities arising under the Securities Act of 1933 may be permitted to directors, officers, and controlling persons of the Registrant pursuant to the foregoing provisions, or otherwise, the Registrant has been advised that in the opinion of the Securities and Exchange Commission such indemnification is against public policy as expressed in the Securities Act of 1933 and is, therefore, unenforceable. In the event that a claim for indemnification against such liabilities (other than the payment by the Registrant of expenses incurred or paid by a director, officer, or controlling person of the Registrant in the successful defense of any action, suit, or proceeding) is asserted by such director, officer, or controlling person in connection with the securities being registered, the Registrant will, unless in the opinion of its counsel the matter has been settled by controlling precedent, submit to a court of appropriate jurisdiction the question whether such indemnification by it is against public policy as expressed in the Act and will be governed by the final adjudication of such issue. SIGNATURES Pursuant to the requirements of Section 13 or 15(d) 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. March 18, 1994 ZIONS BANCORPORATION By /s/ Harris H. Simmons ------------------------------------ Harris H. Simmons, President and Chief Financial Officer Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the date indicated. March 18, 1994 EXHIBIT INDEX FILED AS PART OF THIS REPORT ON FORM 10-K (Pursuant to Item 601 of Regulations S-K) EXHIBIT INDEX FILED AS PART OF THIS REPORT ON FORM 10-K (continued) (Pursuant to Item 601 of Regulations S-K) * incorporated by reference. EXHIBIT 10.8 ZIONS BANCORPORATION SENIOR MANAGEMENT VALUE SHARING PLAN AWARD PERIOD: 1993 - 1996 Objective: To provide an ongoing multi-year incentive for the senior managers of Zions Bancorporation and its subsidiaries which: A. Focuses managers' attention on the creation of long-term shareholder value; B. Creates an incentive that promotes teamwork across departments and subsidiaries, and which encourages managers to balance profit center accountability with Company-wide goals; and, C. Complements the short-range annual bonuses which reflect the achievement of annual objectives and the Company's short-term profitability. Eligibility: Participants in the Plan shall consist of the senior management group (and certain other key managers) of the Company and its major subsidiaries. Participants for each Award Period shall be specifically identified by the Company's Board of Directors (the "Board") or its Executive Compensation Committee (the "Committee"). Allocation of Awards: It is anticipated that during the first quarter of each year in which the Plan operates, the Board of Directors shall approve the establishment of a pool of Award Funds to be generated during the Award Period, according to the general formula outlined below. Participants shall be designated by the Board or the Committee. Claims against the pool of Award Funds for each Award Period shall be represented by Participation Units ("PU's), and each Participant shall be allocated a specific number of PU's by the Committee. The PU's shall represent a pro-rata claim, in proportion to the total PU's designated for that Award Period, on any Award Funds generated by the Plan during the Award Period. Term: Each Award Period shall consist of a continuous four-calendar-year period. The Plan is intended to constitute a "moving four-year-average" incentive plan, with the anticipation that a new Award Period would be designated each year, with multiple Award Periods overlapping one another. Nevertheless, the establishment of a new Award Period each year is subject to the Board's discretion. Determination of Award Funds: The amount of Award Funds in the pool for each Award Period shall be a function of the mathematical average return on shareholders' equity ("AROE") for each of the four years in the Award Period, together with the aggregate earnings per share ("AEPS") during the Award Period. Each year, the Committee shall establish minimum targets for AROE and AEPS for the Award Period. These minimum targets would both be required to be reached in order for any Award Funds to be earned. Additionally, the Committee may designate Award Fund AROE, with upward adjustments possible if higher levels of AEPS are achieved. The Committee may also designate other conditions and adjustment factors to ensure the Plan's integrity and consistency with shareholder and depositor interests. The 1993 - 1996 Award Period formula for the determination of total Award Funds is as follows: * Minimum AROE: 14.00% * Minimum AEPS: $15.55 Funding of 1993 - 1996 Award Fund Pool: Interim amounts shall be calculated by interpolation. The basic Award Fund amount would be further modified by multiplying the cumulative Award Funds by 1+ [(AEPS - $15.55)/21.6], with a maximum AEPS figure of $22.67 (resulting in a 33% maximum upward adjustment in the Award Funds. For the 1993 - 96 Award Period, the following parameters shall be established, and adjustments made to the Company's earnings calculations, for purposed of determining Award Funds available under the Plan: 1). The Plan is intended to create an incentive for increasing shareholder value. However, this is not to be accomplished by reducing capital levels or assuming extraordinary or unwarranted risks. Accordingly, it is expected that total risk-based capital levels shall be maintained at a level at least 125% of regulatory requirements. 2). The Company's reserve levels are to be conservatively maintained. To the extent that the consolidated Allowance for Loan and Lease Losses is less than 120% of the peer group level, as expressed in terms of reserves/noncurrent loans as reported in the most current Uniform Bank Performance Report available at January 31, 1996, an appropriate adjustment shall be made to after-tax earnings (for purposes of calculating Award Funds only) to compensate for any deficit relative to the 120% minimum target level. Actual reserve levels are, of course, subject to Board and/or regulatory decisions. No upward adjustments shall be made in "pro forma" earnings in the event actual reserve levels exceed 120% of the peer group target. 3). Unless determined otherwise by the Board, in the event of any merger involving an acquisition by Zions for the exchange of Zions' shares in a pooling-of-interests transaction, earnings per share prior to the acquisition date shall, for the purpose of calculating AEPS during the Award Period, be determined using Zions' unrestated numbers. Other Terms and Conditions: The Plan is to be governed and interpreted by the Committee, whose decisions shall be final. The terms of the Plan are subject to change or termination at their sole discretion. The Company shall retain the right to withhold payment of Award Funds to participants in the event of a significant deterioration in the Company's financial condition, or if so required by regulatory authorities, or for any other reason considered valid by the Board in its sole discretion. Participants shall not vest in any benefits available under the Plan until the conclusion of each Award Period. Nevertheless, upon death, permanent disability, or normal or early retirement, participants (or their estates) shall be eligible to receive a proportionate share of Award Funds based upon the number of PU's granted, and the number of full calendar quarters the participant was engaged as an officer of the Company or its subsidiaries prior to death, disability, or retirement. The PU's shall not be transferable without the express approval of the Committee. In the event of the merger or acquisition of the Company, the Plan shall be terminated as of the end of the fiscal quarter preceding the first full quarter before the transaction is consummated. The Board may make any reasonable estimates or adjustments possible in calculating Award Funds for any Award Period, and may, in its sole discretion, distribute benefits to the participants. Earnings per share calculations shall be adjusted to reflect any stock splits, stock dividends, or other such changes in capitalization, at the discretion of the Committee. The award of PU's to any participant shall not confer any right with respect to continuance of employment with the Company or its subsidiaries, nor limit in any way the right of the Company to terminate his or her employment at any time, with or without cause. APPENDIX ZIONS BANCORPORATION VALUE-SHARING PLAN: 1993-96 Calculation of Participation Unit Value Average Annual ROE ("AROE") If the AROE is: Aggregate E.P. S. ("AEPS") Modifier: The basis Participation Unit value determined above shall be adjusted as follows: If AEPS for 1993-96 is less than $15.55, the Participation Units shall have no value. If AEPS is greater than $15.55, the basic amount determined based on AROE shall be multiplied by a factor of: 1+[(AEPS-$15.55)/21.6] (with a maximum factor of 1.33) to arrive at a final total value of each Participation Unit. ****************** Example: If AROE is 18.23% and AEPS is $17.76, each Participation Unit would be worth $16.69. ZIONS BANCORPORATION AND SUBSIDIARIES AT DECEMBER 31, 1993 CONSENT OF INDEPENDENT AUDITORS Zions Bancorporation: We consent to the incorporation by reference in Zions Bancorporation's (i) Registration Statement (Form S-3 No. 33-52586) and related Prospectus pertaining to the Zions Bancorporation Dividend Reinvestment and Common Stock Purchase Plan, (ii) Registration Statement (Form S-8 No. 33-52878) and related Prospectus pertaining to Zions Bancorporation Employee Stock Savings Plan, and (iii) Registration Statement (Form S-8 No. 33-52796) and related Prospectus pertaining to Zions Bancorporation Employee Investment Savings Plan, of our report dated January 25, 1994, relating to the consolidated balance sheets of Zions Bancorporation and subsidiaries as of December 31, 1993 and 1992, and the related consolidated statements of income, retained earnings, and cash flows for each of the years in the three-year period ended December 31, 1993, which report appears in this annual report on Form 10-K for the year ended December 31, 1993. Our report refers to changes in accounting principles relating to the adoption of the Financial Accounting Standards Board's Statements of Financial Accounting Standards No. 106, "Employers' Accounting for Postretirement Benefits Other than Pensions", No. 109, "Accounting for Income Taxes", and No. 115, "Accounting for Certain Investments in Debt and Equity Securities". The audit referred to in the above-mentioned report also included the related financial schedule entitled Short-term Borrowings, for each of the years in the three-year period ended December 31, 1993, included in Part II, Item 7 on page 36. In our opinion, such financial schedule presents fairly the information required to be set forth therein for each of the years in the three-year period ended December 31, 1993. We also consent to the incorporation by reference in Zions Bancorporation's Registration Statement (Form S-8 No. 33-52878) of Zions Bancorporation Employee Stock Savings of our report dated March 16, 1994, relating to the net assets available for benefits of Zions Bancorporation Employee Stock Savings Plan as of December 31, 1993 and 1992, and the related statements of changes in net assets available for benefits for each of the years in the three-year period ended December 31, 1993, which report appears in this annual report on Form 11-K for the year ended December 31, 1993. We also consent to the incorporation by reference in Zions Bancorporation's Registration Statement (Form S-8 No. 33-52796) of Zions Bancorporation Employee Investment Savings of our report dated March 16, 1994, relating to the net assets available for benefits of Zions Bancorporation Employee Investment Savings as of December 31, 1993 and 1992, and the related statements of changes in net assets available for benefits for each of the years in the three-year period ended December 31, 1993, which report appears in this annual report on Form 11-K for the year ended December 31, 1993. KPMG Peat Marwick Salt Lake City, Utah March 29, 1994 SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 ---------------------------- FORM 11-K ---------------------------- ANNUAL REPORT Pursuant to Section 15(d) Of The Securities Exchange Act Of 1934 For The Year Ended December 31, 1993 ZIONS BANCORPORATION EMPLOYEE STOCK SAVINGS PLAN ZIONS BANCORPORATION 1380 Kennecott Building Salt Lake City, Utah 84133 ITEM 1. CHANGES IN THE PLAN The Plan was completely amended and restated as of October 1, 1992. No changes were made in the Plan during the year 1993. ITEM 2. CHANGES IN INVESTMENT POLICY No material changes were made during the fiscal year in the policy with respect to the kind of securities and other investments in which funds held under the plan may be invested. ITEM 3. CONTRIBUTIONS UNDER THE PLAN The Company's contributions are measured by reference to employee contributions and are not discretionary. ITEM 4. PARTICIPATING EMPLOYEES There were 1,524 participating employees in the Plan on December 31, 1993. ITEM 5. ADMINISTRATION OF THE PLAN (a) Zions Bancorporation is the Plan administrator. The Company's Board of Directors has appointed an Administrative Committee consisting of six persons. The Committee has full power and authority to administer the Plan and to interpret its provisions. The present members of the Committee and their positions held are: The address of each fiduciary listed above is 1380 Kennecott Building, Salt Lake City, Utah 84133. (b) No compensation is paid to the Committee members by the Plan. All expenses of the Plan and its administration are paid by the Company. ITEM 6. CUSTODIAN OF INVESTMENTS (a) Zions First National Bank, One South Main Street, Salt Lake City, Utah 84133 is the custodian and trustee. (b) The custodian and trustee receive no compensation from the Plan. ITEM 7. REPORTS TO PARTICIPATING EMPLOYEES Participating employees are furnished an annual statement reflecting the status of their accounts as of the end of the fiscal year. ITEM 8. INVESTMENT OF FUNDS Substantially all of the assets of the Plan are invested in securities of the Company. ITEM 9. FINANCIAL STATEMENTS AND EXHIBITS (a) Financial Statements Schedules - Schedules I, II, and III have been omitted for the reasons that they are not required or are not applicable, or the required information is shown in the financial statements or notes thereto. (b) Exhibits - None Independent Auditors' Report The Trust Committee Zions Bancorporation Employee Stock Savings Plan: We have audited the accompanying statements of net assets available for benefits of Zions Bancorporation Employee Stock Savings Plan as of December 31, 1993 and 1992, and the related statements of changes in net assets available for benefits for each of the years in the three-year period ended December 31, 1993. These financial statements are the responsibility of the plan's administrators. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by the plan's administrators, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the net assets available for benefits of Zions Bancorporation Employee Stock Savings Plan as of December 31, 1993 and 1992, and the changes in net assets available for benefits for each of the years in the three-year period ended December 31, 1993, in conformity with generally accepted accounting principles. KPMG Peat Marwick Salt Lake City, Utah March 16, 1994 ZIONS BANCORPORATION EMPLOYEE STOCK SAVINGS PLAN Statements of Net Assets Available for Benefits December 31, 1993 and 1992 See accompanying notes to financial statements. ZIONS BANCORPORATION EMPLOYEE STOCK SAVINGS PLAN Statements of Changes in Net Assets Available for Benefits Years ended December 31, 1993, 1992, and 1991 See accompanying notes to financial statements. ZIONS BANCORPORATION EMPLOYEE STOCK SAVINGS PLAN Notes to Financial Statements December 31, 1993, 1992, and 1991 (1) Description of the Plan Zions Bancorporation Employee Stock Savings Plan (the Plan) is a single employer contributory plan that is designed to provide retirement benefits for eligible employees under an after tax salary reduction arrangement by offering employees an opportunity to acquire stock ownership in Zions Bancorporation (the Company). (2) Summary of Significant Accounting Policies The following is a summary of significant accounting policies followed by the Plan in the preparation of its financial statements. (a) Basis of Presentation The Plan's financial statements are presented on the accrual basis of accounting. (b) Investments The investment in common stock of the Company is carried at market value in the accompanying financial statements. The investment in the short-term investment fund represents a cash equivalent. Purchases and sales of investments are recorded on a trade-date basis. (c) Costs of Administration All costs of administration are absorbed by the Company. (3) Eligibility Participation in the Plan is voluntary. An employee is eligible to participate on January 1, or July 1, whichever coincides with, or immediately follows, the latter of the date on which the employee completes at least 1,000 hours of service during 12 continuous months and attains the age of 21. As of December 31, 1993 and 1992, there were 1,524 participants and 1,260 participants, respectively, in the Plan. (4) Employee and Company Contributions Each eligible employee who elects to participate makes contributions ranging from one to five percent of their total compensation. Company contributions are equal to 50 percent of the amount contributed by the employee. ZIONS BANCORPORATION EMPLOYEE STOCK SAVINGS PLAN Notes to Financial Statements (5) Allocation of Income or Loss Net appreciation (depreciation) in market value of investments, dividends, and interest income are allocated to each participant's account in proportion to the investment shares held in that participant's account to the total of investment shares held in the Plan. (6) Vesting and Payment of Benefits Employee contributions and the employees' share of the Company contributions are 100 percent vested at all times. Benefits are paid upon death, disability, retirement, or earlier subject to certain restrictions. Benefits are paid in shares of stock. (7) Income Taxes The Plan obtained its latest determination letter on November 5, 1985, in which the Internal Revenue Service stated that the Plan, as then designed, was in compliance with the applicable requirements of the Internal Revenue Code. The Plan has been amended since receiving the determination letter. The Company is in the process of obtaining a new letter for the Plan. However, the plan administrator and the Plan's tax counsel believe that the Plan is currently designed and being operated in compliance with the applicable requirements of the Internal Revenue Code. Therefore, they believe that the Plan was qualified and the related trust was tax-exempt as of the financial statement date. (8) Investment At December 31, 1993 and 1992, investment in common stock of the Company consisted of 214,680 and 164,401 shares, respectively. (9) Plan Amendments The Plan became effective on January 1, 1978, and has been amended and restated at various times thereafter. The Plan was completely amended and restated as of October 1, 1992. The following summarizes the Plan's amended areas: (a) Participant Contributions Participants can elect for either a pretax reduction or post-tax salary reduction of one to a maximum of five percent of total compensation as a participant contribution. (b) Company Contributions Matching contributions are made by the Company on behalf of each participant in the amount of fifty percent of the participant's contributions. SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 FORM 11-K ANNUAL REPORT PURSUANT TO SECTION 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE YEAR ENDED DECEMBER 31, 1993 ZIONS BANCORPORATION EMPLOYEE INVESTMENT SAVINGS PLAN ZIONS BANCORPORATION 1380 KENNECOTT BUILDING SALT LAKE CITY, UTAH 84133 ITEM 1.CHANGES IN THE PLAN The Plan was completely amended and restated as of October 1, 1992. No changes were made in the Plan during the year 1993. ITEM 2. CHANGES IN INVESTMENT POLICY The Plan maintains four separate types of investment funds: (i) company securities, which consists of Company stock and short-term investments pending the acquisition of Company securities; (ii) Fidelity mutual fund, which invests primarily in a diversified portfolio of U.S. common stocks, which are invested to track closely with the Standard and Poors 500 index; (iii) money market fund, which consists of, but is not limited to, certificates of deposit, commercial paper, and U.S. treasury bills; and (iv) fixed income fund, which invests primarily in government, mortgage, and corporate bonds. No material changes were made during the year 1993 in the policy with respect to the kind of securities and other investments in which funds held under the Plan may be invested. ITEM 3. CONTRIBUTIONS UNDER THE PLAN The Company's contributions are measured by reference to employee contributions and are not discretionary. ITEM 4. PARTICIPATING EMPLOYEES There were 1,405 participating employees in the Plan on December 31, 1993. ITEM 5. ADMINISTRATION OF THE PLAN (a) Zions Bancorporation is the Plan administrator. The Company's Board of Directors has appointed an Administrative Committee consisting of six persons. The Committee has full power and authority to administer the Plan and to interpret its provisions. The present members of the Committee and their positions held are: The address of each fiduciary listed above is 1380 Kennecott Building, Salt Lake City, Utah 84133. (b) No compensation is paid to the Committee members by the Plan. All expenses of the Plan and its administration are paid by the Company. ITEM 6. CUSTODIAN OF INVESTMENTS (a) Zions First National Bank, One South Main Street, Salt Lake City, Utah 84133 is the custodian and trustee. (b) The custodian and trustee receive no compensation from the Plan. ITEM 7. REPORTS TO PARTICIPATING EMPLOYEES Participating employees are furnished an annual statement reflecting the status of their accounts as of the end of the fiscal year. ITEM 8. INVESTMENT OF FUNDS As elected by participants, approximately seventy-two percent of the assets of the Plan are invested in securities of the Company, approximately thirteen percent in the Fidelity mutual fund, approximately thirteen percent in the money market fund, and approximately two percent invested in the fixed income fund. ITEM 9. FINANCIAL STATEMENTS AND EXHIBITS (b) Exhibits - None Independent Auditors' Report The Trust Committee Zions Bancorporation Employee Investment Savings Plan: We have audited the accompanying statements of net assets available for benefits of Zions Bancorporation Employee Investment Savings Plan as of December 31, 1993 and 1992, and the related statements of changes in net assets available for benefits for each of the years in the three-year period ended December 31, 1993. These financial statements are the responsibility of the Plan's administrators. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by the plan's administrators, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the net assets available for benefits of Zions Bancorporation Employee Investment Savings Plan as of December 31, 1993 and 1992, and the changes in net assets available for benefits for each of the years in the three-year period ended December 31, 1993, in conformity with generally accepted accounting principles. KPMG Peat Marwick Salt Lake City, Utah March 16, 1994 ZIONS BANCORPORATION EMPLOYEE INVESTMENT SAVINGS PLAN Statements of Net Assets Available for Benefits December 31, 1993 and 1992 See accompanying notes to financial statements. ZIONS BANCORPORATION EMPLOYEE INVESTMENT SAVINGS PLAN Statements of Changes in Net Assets Available for Benefits Years ended December 31, 1993, 1992, and 1991 See accompanying notes to financial statements. ZIONS BANCORPORATION EMPLOYEE INVESTMENT SAVINGS PLAN Notes to Financial Statements December 31, 1993, 1992, and 1991 (1) Description of the Plan Zions Bancorporation Employee Investment Savings Plan (the Plan) is a single employer contributory plan that is designed to provide retirement benefits for eligible employees under a pretax salary reduction (deferral) arrangement and, if employees so elect, an opportunity to acquire stock ownership in Zions Bancorporation (the Company). (2) Summary of Significant Accounting Policies The following is a summary of significant accounting policies followed by the Plan in the preparation of its financial statements. (a) Basis of Presentation The Plan's financial statements are presented on the accrual basis of accounting. (b) Investments Investments in common stock of Zions Bancorporation, Fidelity mutual fund, and fixed income fund shares are carried at market value in the accompanying financial statements. The investments in the money market fund and short-term investment fund represent cash equivalents. Purchases and sales of investments are recorded on a trade-date basis. (c) Cost of Administration All costs of administration are absorbed by the Company. (3) Eligibility Participation in the Plan is voluntary. An employee is eligible to become a participant on January 1 or July 1, whichever coincides with, or immediately follows, the latter of the date on which the employee completes at least 1,000 hours of service during 12 continuous months and attains the age of 21. At December 31, 1993 and 1992, there were 1,405 participants and 1,266 participants, respectively, in the Plan. ZIONS BANCORPORATION EMPLOYEE INVESTMENT SAVINGS PLAN Notes to Financial Statements (4) Employee and Company Contributions Participants may elect to contribute one to fifteen percent of their compensation to the Employee Investment Savings Plan, limited by participant contributions made to Zions Bancorporation Employee Stock Savings Plan. The contributions are invested in one or more of the following investment options: (i) the Company's stock, (ii) the Fidelity mutual fund, (iii) a money market fund, and (iv) a fixed income fund. The Company contributes an amount equal to 25 percent of the contribution made by each participant up to ten percent of their compensation with no match made on contributions in excess thereof. The maximum amount a participant may contribute to the Plan in a calendar year is the lesser of fifteen percent of their compensation, or $8,994, for 1993. (5) Allocation of Income or Loss Net appreciation (depreciation) in market value of investments, dividends, interest income, and capital gains are allocated to each participant's account in proportion to the investment shares held in that participant's account to the total investment shares held in the Plan. (6) Vesting and Payment of Benefits Employee contributions and the employees' share of the Company contributions are 100 percent vested at all times. Benefits are paid upon death, disability, retirement, or earlier subject to certain restrictions. Benefits are paid in shares of stock and/or cash pursuant to the nature of the investment vehicle selected by the participant. (7) Income Taxes The Plan obtained its latest determination letter on November 5, 1985, in which the Internal Revenue Service stated that the Plan, as then designed, was in compliance with the applicable requirements of the Internal Revenue Code. The Plan has been amended since receiving the determination letter. The Company is in the process of obtaining a new letter for the Plan. However, the plan administrator and the Plan's tax counsel believe that the Plan is currently designed and being operated in compliance with the applicable requirements of the Internal Revenue Code. Therefore, they believe that the Plan was qualified and the related trust was tax-exempt as of the financial statement date. ZIONS BANCORPORATION EMPLOYEE INVESTMENT SAVINGS PLAN Notes to Financial Statements (8) Investments The investments in common stock of the Company and the Fidelity mutual fund, consists of 508,875 and 597,903 shares, and 193,923 and 57,336 shares, respectively, at December 31, 1993 and 1992. The investment in the fixed income fund consists of 24,207 shares at December 31, 1993. The net unrealized appreciation (depreciation) in market value for each of the years in the three-year period ended December 31, 1993, in comparison to the market value at the beginning of each year is as follows: (9) Plan Amendments The Plan became effective on January 1, 1984, and has been amended and restated at various times thereafter. The Plan was completely amended and restated as of October 1, 1992. Amendment provisions include the following: (a) Participant Contributions Participants can elect a pretax reduction from one percent to a maximum of fifteen percent of total compensation as a participant contribution, depending in part on the extent to which the participant contributes to the Zions Bancorporation Employee Stock Savings Plan. (b) Company Contributions Matching contributions are made by the Company on behalf of each participant in the amount of twenty-five percent of participant contributions (note 4), but not in excess of ten percent of compensation. (c) Participant Elections Participants may change quarterly investment elections for funds already invested in their accounts. ZIONS BANCORPORATION EMPLOYEE INVESTMENT SAVINGS PLAN Notes to Financial Statements (d) Investment Options The Plan maintains four separate types of investment funds: (i) company securities, which consists of Company stock and short-term investments pending the acquisition of Company securities; (ii) Fidelity mutual fund, which invests primarily in a diversified portfolio of U.S. common stocks, which are invested to track closely with the Standard and Poors 500 index; (iii) money market fund, which consists of, but is not limited to, certificates of deposit, commercial paper, and U.S. treasury bills; and (iv) fixed income fund, which invests primarily in government, mortgage, and corporate bonds. (e) Participant Loans Beginning October 1, 1992, a participant who is an active employee may apply for and obtain a loan of up to fifty percent of the eligible amounts in their account. Loans may not exceed five years and must be secured by the participants account. Loan repayment is made through payroll deduction. (10) Financial Information by Fund Type Financial information by fund type as of, and for the year ended December 31, 1993, are as follows: Statement of Net Assets Available for Benefits by Fund Type December 31, 1993 ZIONS BANCORPORATION EMPLOYEE INVESTMENT SAVINGS PLAN Notes to Financial Statements (10) Financial Information by Fund Type (continued) ZIONS BANCORPORATION EMPLOYEE INVESTMENT SAVINGS PLAN Notes to Financial Statements (10) Financial Information by Fund Type (continued) Statement of Changes in Net Assets Available for Benefits by Fund Type Year ended December 31, 1993 ZIONS BANCORPORATION EMPLOYEE INVESTMENT SAVINGS PLAN Notes to Financial Statements (10) Financial Information by Fund Type (continued)

872553_1993.txt

872553

1993

ITEM 1. BUSINESS Each of the Grantor Trusts, (the "Trusts"), listed below, was formed by GMAC Auto Receivables Corporation (the "Seller") by selling and assigning the receivables and the security interests in the vehicles financed thereby to The First National Bank of Chicago, as Trustee, in exchange for Class A certificates representing an undivided ownership interest that ranges between approximately 91% and 94.5% in each Trust, which were remarketed to the public, and Class B certificates representing an undivided ownership interest that ranges between approximately 5.5% and 9% in each Trust, which were not offered to the public and initially were held by the Seller. The right of the Class B certificateholders to receive distribution of the receivables is subordinated to the rights of the Class A certificateholders. GRANTOR TRUST ------------- GMAC 1990-A GMAC 1991-A GMAC 1991-B GMAC 1991-C GMAC 1992-A GMAC 1992-C GMAC 1992-D GMAC 1992-E GMAC 1992-F GMAC 1992-G GMAC 1993-A GMAC 1993-B _____________________ PART II ITEM 7.

ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Each of the Grantor Trusts, listed in the table as shown below, was formed by GMAC Auto Receivables Corporation (the "Seller") pursuant to a Pooling and Servicing Agreement between the Seller and The First National Bank of Chicago, as trustee. Each Trust acquired retail finance receivables from the Seller in the aggregate amount as shown below in exchange for certificates representing undivided ownership interests in each Trust. Each Trust's property includes a pool of retail instalment sale contracts secured by new, and in some Trust's used, automobiles and light trucks, certain monies due thereunder and security interests in the vehicles financed thereby. The certificates for each of the following Trusts consist of two classes, entitled Asset Backed certificates, Class A and Asset Backed certificates, Class B. The Class A certificates represent in the aggregate an undivided ownership interest that ranges between approximately 91% and 94.5% of the Trusts and the Class B certificates represent in the aggregate an undivided ownership interest that ranges between approximately 5.5% and 9% of the Trusts. Only the Class A certificates have been remarketed to the public. The Class B certificates have not been offered to the public and initially are being held by the Seller. The rights of the Class B certificateholder to receive monthly distributions with respect to the receivables are subordinated to the rights of the Class A certificateholders. Original Aggregate Amount ----------------------------------- Date of Pooling Retail Asset Backed Certificates Grantor and Servicing Finance ------------------------- Trust Agreement Receivables Class A Class B - ------- ----------------- --------- -------- ------- (In millions of dollars) GMAC 1990-A December 20, 1990 $1,162.6 $1,057.9 $104.7 GMAC 1991-A March 14, 1991 891.7 811.4 80.3 GMAC 1991-B September 17, 1991 1,007.4 916.7 90.7 GMAC 1991-C December 16, 1991 1,326.4 1,207.0 119.4 GMAC 1992-A January 30, 1992 2,001.4 1,851.3 150.1 GMAC 1992-C March 26, 1992 1,100.3 1,012.3 88.0 GMAC 1992-D June 4, 1992 1,647.6 1,499.3 148.3 GMAC 1992-E August 20, 1992 1,578.0 1,436.0 142.0 GMAC 1992-F September 29, 1992 1,644.6 1,496.6 148.0 GMAC 1992-G November 19, 1992 1,379.4 1,303.5 75.9 GMAC 1993-A March 24, 1993 1,403.0 1,297.8 105.2 GMAC 1993-B September 16, 1993 1,450.6 1,341.8 108.8 II-1 ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (concluded) General Motors Acceptance Corporation, the originator of the retail receivables, continues to service the receivables for each of the aforementioned Grantor Trusts and receives compensation and fees for such services. Investors receive monthly payments of the pro rata portion of principal and interest for each Trust as the receivables are liquidated. ------------------------ II-2 ITEM 8.

ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA. CROSS REFERENCE SHEET Caption Page - --------------------------------------------------- ------ GMAC 1990-A Grantor Trust, Independent Auditors' Report, Financial Statements and Selected Quarterly II-4 Data for the Year Ended December 31, 1993. GMAC 1991-A Grantor Trust, Independent Auditors' Report, Financial Statements and Selected Quarterly II-9 Data for the Year Ended December 31, 1993. GMAC 1991-B Grantor Trust, Independent Auditors' Report, Financial Statements and Selected Quarterly II-14 Data for the Year Ended December 31, 1993. GMAC 1991-C Grantor Trust, Independent Auditors' Report, Financial Statements and Selected Quarterly II-19 Data for the Year Ended December 31, 1993. GMAC 1992-A Grantor Trust, Independent Auditors' Report, Financial Statements and Selected Quarterly II-24 Data for the Year Ended December 31, 1993. GMAC 1992-C Grantor Trust, Independent Auditors' Report, Financial Statements and Selected Quarterly II-29 Data for the Year Ended December 31, 1993. GMAC 1992-D Grantor Trust, Independent Auditors' Report, Financial Statements and Selected Quarterly II-34 Data for the Year Ended December 31, 1993. GMAC 1992-E Grantor Trust, Independent Auditors' Report, Financial Statements and Selected Quarterly II-39 Data for the Year Ended December 31, 1993. GMAC 1992-F Grantor Trust, Independent Auditors' Report, Financial Statements and Selected Quarterly II-44 Data for the Year Ended December 31, 1993. GMAC 1992-G Grantor Trust, Independent Auditors' Report, Financial Statements and Selected Quarterly II-49 Data for Year Ended from December 31, 1993. GMAC 1993-A Grantor Trust, Independent Auditors' Report, Financial Statements and Selected Quarterly II-54 Data for the period from March 24, 1993 to December 31, 1993. GMAC 1993-B Grantor Trust, Independent Auditors' Report, Financial Statements and Selected Quarterly II-59 Data for period from September 16, 1993 to December 31, 1993. II-3 INDEPENDENT AUDITORS' REPORT March 22, 1994 The GMAC 1990-A Grantor Trust, its Certificateholders, GMAC Auto Receivables Corporation, and The First National Bank of Chicago, Trustee: We have audited the accompanying Statement of Assets and Liabilities of the GMAC 1990-A Grantor Trust as of December 31, 1993 and 1992, and the related Statement of Distributable Income for each of the three years in the period ended December 31, 1993. These financial statements are the responsibility of the Trust's management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. As described in Note 1 to the financial statements, these financial statements are prepared on the basis of cash receipts and disbursements, which is a comprehensive basis of accounting other than generally accepted accounting principles. In our opinion, such financial statements present fairly, in all material respects, the assets and liabilities of the GMAC 1990-A Grantor Trust at December 31, 1993 and 1992, and its distributable income and distributions for each of the three years in the period ended December 31, 1993, on the basis of accounting described in Note 1. s\ DELOITTE & TOUCHE - ---------------------- DELOITTE & TOUCHE 600 Renaissance Center Detroit, Michigan 48243 II-4 GMAC 1990-A GRANTOR TRUST STATEMENT OF ASSETS AND LIABILITIES (in millions of dollars) Dec. 31 Dec. 31 1993 1992 ------- ------- ASSETS $ $ Receivables (Note 2) ................... 207.1 459.8 ------- ------- TOTAL ASSETS ........................... 207.1 459.8 ======= ======= LIABILITIES Asset-backed Certificates (Notes 2 and 3) ...................... 207.1 459.8 ------- ------- TOTAL LIABILITIES ...................... 207.1 459.8 ======= ======= Reference should be made to the Notes to Financial Statements. II-5 GMAC 1990-A GRANTOR TRUST (continued) STATEMENT OF DISTRIBUTABLE INCOME For the years ended December 31, 1993, 1992 and 1991 (in millions of dollars) 1993 1992 1991 ----- ----- ----- Distributable Income $ $ $ Allocable to Principal ............... 252.7 344.1 358.7 Allocable to Interest ............... 27.7 52.9 82.6 ----- ----- ----- Distributable Income ................... 280.4 397.0 441.3 ===== ===== ===== Income Distributed ..................... 280.4 397.0 441.3 ===== ===== ===== Reference should be made to the Notes to Financial Statements. II-6 GMAC 1990-A GRANTOR TRUST (continued) NOTES TO FINANCIAL STATEMENTS NOTE 1. BASIS OF ACCOUNTING The financial statements of the GMAC 1990-A Grantor Trust (the "Trust") are prepared on the basis of cash receipts and cash disbursements. Such financial statements differ from financial statements prepared in accordance with generally accepted accounting principles in that interest income and the related assets are recognized when received rather than when earned and distributions to certificateholders are recognized when paid rather than when the obligation is incurred. All expenses of the Trust are paid by GMAC Auto Receivables Corporation (the "Seller"). NOTE 2. SALE OF CERTIFICATES On December 20, 1990, GMAC 1990-A Grantor Trust acquired retail finance receivables aggregating approximately $1,162.6 million from the Seller in exchange for certificates representing undivided ownership interests of 91% for the Class A certificates and 9% for the Class B certificates in the Trust. The Trust property includes a pool of retail instalment sale contracts for new automobiles and light trucks, certain monies due thereunder, and security interests in the vehicles financed thereby. The Seller has the option to repurchase the remaining receivables as of the last day of any month on or after which the principal balance declines below 10% of the aggregate amount financed. NOTE 3. PRINCIPAL AND INTEREST PAYMENTS Principal (including prepayments) and interest are passed through and distributed pro rata to Class A and Class B certificateholders on each distribution date commencing January 15, 1991. Principal consists of payments on the receivables that are allocable to repayment of the amount sold as determined on a constant interest rate basis (the "actuarial method"). Interest is passed through and distributed to Class A certificateholders at one-twelfth of the pass through rate of 8.25% per annum. Interest consists of payments on the receivables that are allocable to finance charges, using the actuarial method, net of fees and expenses. The rights of the Class B certificateholders to receive monthly distributions with respect to the receivables are subordinated to the rights of the Class A certificateholders. A distribution date is the 15th day of each month (or, if such 15th day is not a business day, the next following business day). NOTE 4. FEDERAL INCOME TAX The Trust is classified as a grantor trust, and therefore is not taxable as a corporation for federal income tax purposes. Each certificateholder will be treated as the owner of a pro rata undivided interest in each of the receivables in the Trust. II-7 GMAC 1990-A GRANTOR TRUST (concluded) SUPPLEMENTARY FINANCIAL DATA (unaudited) SUMMARY OF QUARTERLY DISTRIBUTABLE INCOME (in millions of dollars) 1993 Quarters Principal Interest Total - ------------------------------------ --------- -------- ----- $ $ $ First quarter ...................... 70.0 9.0 79.0 Second quarter ..................... 69.0 7.5 76.5 Third quarter ...................... 61.8 6.2 68.0 Fourth quarter ..................... 51.9 5.0 56.9 --------- -------- ----- Total ......................... 252.7 27.7 280.4 ========= ======== ===== 1992 Quarters Principal Interest Total - ------------------------------------ --------- -------- ----- $ $ $ First quarter ...................... 90.4 16.0 106.4 Second quarter ..................... 90.0 14.1 104.1 Third quarter ...................... 86.1 12.3 98.4 Fourth quarter ..................... 77.6 10.5 88.1 --------- -------- ----- Total ......................... 344.1 52.9 397.0 ========= ======== ===== 1991 Quarters Principal Interest Total - ------------------------------------ --------- -------- ----- $ $ $ First quarter ...................... 86.6 23.4 110.0 Second quarter ..................... 93.2 21.7 114.9 Third quarter ...................... 90.8 19.7 110.5 Fourth quarter ..................... 88.1 17.8 105.9 --------- -------- ----- Total ......................... 358.7 82.6 441.3 ========= ======== ===== II-8 INDEPENDENT AUDITORS' REPORT March 22, 1994 The GMAC 1991-A Grantor Trust, its Certificateholders, GMAC Auto Receivables Corporation, and The First National Bank of Chicago, Trustee: We have audited the accompanying Statement of Assets and Liabilities of the GMAC 1991-A Grantor Trust as of December 31, 1993 and 1992, and the related Statement of Distributable Income for the two years in the period ended December 31, 1993 and the period March 14, 1991 (inception) through December 31, 1991. These financial statements are the responsibility of the Trust's management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. As described in Note 1 to the financial statements, these financial statements are prepared on the basis of cash receipts and disbursements, which is a comprehensive basis of accounting other than generally accepted accounting principles. In our opinion, such financial statements present fairly, in all material respects, the assets and liabilities of the GMAC 1991-A Grantor Trust at December 31, 1993 and 1992 and its distributable income and distributions for the two years in the period ended December 31, 1993 and the period March 14, 1991 (inception) through December 31, 1991, on the basis of accounting described in Note 1. s/ DELOITTE & TOUCHE - ----------------------- DELOITTE & TOUCHE 600 Renaissance Center Detroit, Michigan 48243 II-9 GMAC 1991-A GRANTOR TRUST STATEMENT OF ASSETS AND LIABILITIES (in millions of dollars) Dec. 31 Dec. 31 1993 1992 ------- ------- ASSETS $ $ Receivables (Note 2) ................... 162.0 370.4 ------- ------- TOTAL ASSETS ........................... 162.0 370.4 ======= ======= LIABILITIES Asset-backed Certificates (Notes 2 and 3) ...................... 162.0 370.4 ------- ------- TOTAL LIABILITIES ...................... 162.0 370.4 ======= ======= Reference should be made to the Notes to Financial Statements. II-10 GMAC 1991-A GRANTOR TRUST (continued) STATEMENT OF DISTRIBUTABLE INCOME For the years ended December 31, 1993, 1992 and the period March 14, 1991 (inception) through December 31, 1991 (in millions of dollars) 1993 1992 1991 ----- ----- ----- $ $ $ Distributable Income Allocable to Principal ................ 208.3 290.7 230.6 Allocable to Interest ................ 21.2 41.2 46.7 ----- ----- ----- Distributable Income .................... 229.5 331.9 277.3 ===== ===== ===== Income Distributed ...................... 229.5 331.9 277.3 ===== ===== ===== Reference should be made to the Notes to Financial Statements. II-11 GMAC 1991-A GRANTOR TRUST (continued) NOTES TO FINANCIAL STATEMENTS NOTE 1. BASIS OF ACCOUNTING The financial statements of the GMAC 1991-A Grantor Trust (the "Trust") are prepared on the basis of cash receipts and cash disbursements. Such financial statements differ from financial statements prepared in accordance with generally accepted accounting principles in that interest income and the related assets are recognized when received rather than when earned and distributions to certificateholders are recognized when paid rather than when the obligation is incurred. All expenses of the Trust are paid by GMAC Auto Receivables Corporation (the "Seller"). NOTE 2. SALE OF CERTIFICATES On March 14, 1991, GMAC 1991-A Grantor Trust acquired retail finance receivables aggregating approximately $891.7 million from the Seller in exchange for certificates representing undivided ownership interests of 91% for the Class A certificates and 9% for the Class B certificates in the Trust. The Trust property includes a pool of retail instalment sale contracts for new automobiles and light trucks, certain monies due thereunder, and security interests in the vehicles financed thereby. The Seller has the option to repurchase the remaining receivables as of the last day of any month on or after which the principal balance declines below 10% of the aggregate amount financed. NOTE 3. PRINCIPAL AND INTEREST PAYMENTS Principal (including prepayments) and interest are passed through and distributed pro rata to Class A and Class B certificateholders on each distribution date commencing April 15, 1991. Principal consists of payments on the receivables that are allocable to repayment of the amount sold as determined on a constant interest rate basis (the "actuarial method"). Interest is passed through and distributed to Class A certificateholders at one-twelfth of the pass through rate of 7.90% per annum. Interest consists of payments on the receivables that are allocable to finance charges, using the actuarial method, net of fees and expenses. The rights of the Class B certificateholders to receive monthly distributions with respect to the receivables are subordinated to the rights of the Class A certificateholders. A distribution date is the 15th day of each month (or, if such 15th day is not a business day, the next following business day). NOTE 4. FEDERAL INCOME TAX The Trust is classified as a grantor trust, and therefore is not taxable as a corporation for federal income tax purposes. Each certificateholder will be treated as the owner of a pro rata undivided interest in each of the receivables in the Trust. II-12 GMAC 1991-A GRANTOR TRUST (concluded) SUPPLEMENTARY FINANCIAL DATA (unaudited) SUMMARY OF QUARTERLY DISTRIBUTABLE INCOME (in millions of dollars) 1993 Quarters Principal Interest Total - ------------------------------------ --------- -------- ----- $ $ $ First quarter ...................... 58.0 6.9 64.9 Second quarter ..................... 55.5 5.8 61.3 Third quarter ...................... 50.6 4.7 55.3 Fourth quarter ..................... 44.2 3.8 48.0 --------- -------- ----- Total ......................... 208.3 21.2 229.5 ========= ======== ===== 1992 Quarters Principal Interest Total - ------------------------------------ --------- -------- ----- $ $ $ First quarter ...................... 78.5 12.5 91.0 Second quarter ..................... 75.1 11.0 86.1 Third quarter ...................... 71.9 9.5 81.4 Fourth quarter ..................... 65.2 8.2 73.4 --------- -------- ----- Total ......................... 290.7 41.2 331.9 ========= ======== ===== 1991 Quarters Principal Interest Total - ------------------------------------ --------- -------- ----- $ $ $ Second quarter ..................... 78.6 17.1 95.7 Third quarter ...................... 76.7 15.6 92.3 Fourth quarter ..................... 75.3 14.0 89.3 --------- -------- ----- Total ......................... 230.6 46.7 277.3 ========= ======== ===== II-13 INDEPENDENT AUDITORS' REPORT March 22, 1994 The GMAC 1991-B Grantor Trust, its Certificateholders, GMAC Auto Receivables Corporation, and The First National Bank of Chicago, Trustee: We have audited the accompanying Statement of Assets and Liabilities of the GMAC 1991-B Grantor Trust as of December 31, 1993 and 1992, and the related Statement of Distributable Income for the two years in the period ended December 31, 1993 and the period September 17, 1991 (inception) through December 31, 1991. These financial statements are the responsibility of the Trust's management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. As described in Note 1 to the financial statements, these financial statements are prepared on the basis of cash receipts and disbursements, which is a comprehensive basis of accounting other than generally accepted accounting principles. In our opinion, such financial statements present fairly, in all material respects, the assets and liabilities of the GMAC 1991-B Grantor Trust at December 31, 1993 and 1992, and its distributable income and distributions for the two years in the period ended December 31, 1993 and the period September 17, 1991 (inception) through December 31, 1991, on the basis of accounting described in Note 1. s\ DELOITTE & TOUCHE - ----------------------- DELOITTE & TOUCHE 600 Renaissance Center Detroit, Michigan 48243 II-14 GMAC 1991-B GRANTOR TRUST STATEMENT OF ASSETS AND LIABILITIES (in millions of dollars) Dec. 31 Dec. 31 1993 1992 ------- ------- ASSETS $ $ Receivables (Note 2) ................... 306.4 582.8 ------- ------- TOTAL ASSETS ........................... 306.4 582.8 ======= ======= LIABILITIES Asset-backed Certificates (Notes 2 and 3) ...................... 306.4 582.8 ------- ------- TOTAL LIABILITIES ...................... 306.4 582.8 ======= ======= Reference should be made to the Notes to Financial Statements. II-15 GMAC 1991-B GRANTOR TRUST (continued) STATEMENT OF DISTRIBUTABLE INCOME For the years ended December 31, 1993, 1992 and the period September 17, 1991 (inception) through December 31, 1991 (in millions of dollars) 1993 1992 1991 ------ ------ ------ $ $ $ Distributable Income Allocable to Principal ............... 276.3 340.7 83.9 Allocable to Interest ............... 30.4 51.5 16.5 ------ ------ ------ Distributable Income ................... 306.7 392.2 100.4 ====== ====== ====== Income Distributed ..................... 306.7 392.2 100.4 ====== ====== ====== Reference should be made to the Notes to Financial Statements. II-16 GMAC 1991-B GRANTOR TRUST (continued) NOTES TO FINANCIAL STATEMENTS NOTE 1. BASIS OF ACCOUNTING The financial statements of the GMAC 1991-B Grantor Trust (the "Trust") are prepared on the basis of cash receipts and cash disbursements. Such financial statements differ from financial statements prepared in accordance with generally accepted accounting principles in that interest income and the related assets are recognized when received rather than when earned and distributions to certificateholders are recognized when paid rather than when the obligation is incurred. All expenses of the Trust are paid by GMAC Auto Receivables Corporation (the "Seller"). NOTE 2. SALE OF CERTIFICATES On September 17, 1991, GMAC 1991-B Grantor Trust acquired retail finance receivables aggregating approximately $1,007.4 million from the Seller in exchange for certificates representing undivided ownership interests of 91% for the Class A certificates and 9% for the Class B certificates in the Trust. The Trust property includes a pool of retail instalment sale contracts for new automobiles and light trucks, certain monies due thereunder and security interests in the vehicles financed thereby. The Seller has the option to repurchase the remaining receivables as of the last day of any month on or after which the principal balance declines below 10% of the aggregate amount financed. NOTE 3. PRINCIPAL AND INTEREST PAYMENTS Principal (including prepayments) and interest are passed through and distributed pro rata to Class A and Class B certificateholders on each distribution date commencing October 15, 1991. Principal consists of payments on the receivables that are allocable to repayment of the amount sold as determined on a constant interest rate basis (the "actuarial method"). Interest is passed through and distributed to Class A certificateholders at one-twelfth of the pass through rate of 6.75% per annum. Interest consists of payments on the receivables that are allocable to finance charges, using the actuarial method, net of fees and expenses. The rights of the Class B certificateholders to receive monthly distributions with respect to the receivables are subordinated to the rights of the Class A certificateholders. A distribution date is the 15th day of each month (or, if such 15th day is not a business day, the next following business day). NOTE 4. FEDERAL INCOME TAX The Trust is classified as a grantor trust, and therefore is not taxable as a corporation for federal income tax purposes. Each certificateholder will be treated as the owner of a pro rata undivided interest in each of the receivables in the Trust. II-17 GMAC 1991-B GRANTOR TRUST (concluded) SUPPLEMENTARY FINANCIAL DATA (unaudited) SUMMARY OF QUARTERLY DISTRIBUTABLE INCOME (in millions of dollars) 1993 Quarters Principal Interest Total - ------------------------------------ --------- -------- ----- $ $ $ First quarter ...................... 72.7 9.4 82.1 Second quarter ..................... 74.8 8.2 83.0 Third quarter ...................... 68.3 7.0 75.3 Fourth quarter ..................... 60.5 5.8 66.3 --------- -------- ----- Total ......................... 276.3 30.4 306.7 ========= ======== ===== 1992 Quarters Principal Interest Total - ------------------------------------ --------- -------- ----- $ $ $ First quarter ...................... 87.1 15.1 102.2 Second quarter ..................... 89.5 13.6 103.1 Third quarter ...................... 84.9 12.1 97.0 Fourth quarter ..................... 79.2 10.7 89.9 --------- -------- ----- Total ......................... 340.7 51.5 392.2 ========= ======== ===== 1991 Quarters Principal Interest Total - ------------------------------------ --------- -------- ----- $ $ $ Fourth quarter ..................... 83.9 16.5 100.4 ========= ======== ===== II-18 INDEPENDENT AUDITORS' REPORT March 22, 1994 The GMAC 1991-C Grantor Trust, its Certificateholders, GMAC Auto Receivables Corporation, and The First National Bank of Chicago, Trustee: We have audited the accompanying Statement of Assets and Liabilities of the GMAC 1991-C Grantor Trust as of December 31, 1993 and 1992, and the related Statement of Distributable Income for the years then ended. These financial statements are the responsibility of the Trust's management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. As described in Note 1 to the financial statements, these financial statements are prepared on the basis of cash receipts and disbursements, which is a comprehensive basis of accounting other than generally accepted accounting principles. In our opinion, such financial statements present fairly, in all material respects, the assets and liabilities of the GMAC 1991-C Grantor Trust at December 31, 1993 and 1992, and its distributable income and distributions for the years then ended, on the basis of accounting described in Note 1. s\ DELOITTE & TOUCHE - ----------------------- DELOITTE & TOUCHE 600 Renaissance Center Detroit, Michigan 48243 II-19 GMAC 1991-C GRANTOR TRUST STATEMENT OF ASSETS AND LIABILITIES (in millions of dollars) Dec. 31 Dec. 31 1993 1992 ------- ------- ASSETS $ $ Receivables (Note 2) ................... 496.0 874.6 ------- ------- TOTAL ASSETS ........................... 496.0 874.6 ======= ======= LIABILITIES Asset-backed Certificates (Notes 2 and 3) ...................... 496.0 874.6 ------- ------- TOTAL LIABILITIES ...................... 496.0 874.6 ======= ======= Reference should be made to the Notes to Financial Statements. II-20 GMAC 1991-C GRANTOR TRUST (continued) STATEMENT OF DISTRIBUTABLE INCOME For the years ended December 31, 1993 and 1992 (in millions of dollars) 1993 1992 -------- -------- $ $ Distributable Income Allocable to Principal ...................... 378.5 451.8 Allocable to Interest ...................... 39.7 63.3 -------- -------- Distributable Income .......................... 418.2 515.1 ======== ======== Income Distributed ............................ 418.2 515.1 ======== ======== Reference should be made to the Notes to Financial Statements. II-21 GMAC 1991-C GRANTOR TRUST (continued) NOTES TO FINANCIAL STATEMENTS NOTE 1. BASIS OF ACCOUNTING The financial statements of the GMAC 1991-C Grantor Trust (the "Trust") are prepared on the basis of cash receipts and cash disbursements. Such financial statements differ from financial statements prepared in accordance with generally accepted accounting principles in that interest income and the related assets are recognized when received rather than when earned and distributions to certificateholders are recognized when paid rather than when the obligation is incurred. All expenses of the Trust are paid by GMAC Auto Receivables Corporation (the "Seller"). NOTE 2. SALE OF CERTIFICATES On December 16, 1991, GMAC 1991-C Grantor Trust acquired retail finance receivables aggregating approximately $1,326.4 million from the Seller in exchange for certificates representing undivided ownership interests of 91% for the Class A certificates and 9% for the Class B certificates in the Trust. The Trust property includes a pool of retail instalment sale contracts for new automobiles and light trucks, certain monies due thereunder, and security interests in the vehicles financed thereby. The Seller has the option to repurchase the remaining receivables as of the last day of any month on or after which the principal balance declines below 10% of the aggregate amount financed. NOTE 3. PRINCIPAL AND INTEREST PAYMENTS Principal (including prepayments) and interest are passed through and distributed pro rata to Class A and Class B certificateholders on each distribution date commencing January 15, 1992. Principal consists of payments on the receivables that are allocable to repayment of the amount sold as determined on a constant interest rate basis (the "actuarial method"). Interest is passed through and distributed to Class A certificateholders at one-twelfth of the pass through rate of 5.70% per annum. Interest consists of payments on the receivables that are allocable to finance charges, using the actuarial method, net of fees and expenses. The rights of the Class B certificateholders to receive monthly distributions with respect to the receivables are subordinated to the rights of the Class A certificateholders. A distribution date is the 15th day of each month (or, if such 15th day is not a business day, the next following business day). NOTE 4. FEDERAL INCOME TAX The Trust is classified as a grantor trust, and therefore is not taxable as a corporation for federal income tax purposes. Each certificateholder will be treated as the owner of a pro rata undivided interest in each of the receivables in the Trust. II-22 GMAC 1991-C GRANTOR TRUST (concluded) SUPPLEMENTARY FINANCIAL DATA (unaudited) SUMMARY OF QUARTERLY DISTRIBUTABLE INCOME (in millions of dollars) 1993 Quarters Principal Interest Total - ------------------------------------ --------- -------- ----- $ $ $ First quarter ...................... 96.7 12.0 108.7 Second quarter ..................... 101.1 10.6 111.7 Third quarter ...................... 95.2 9.2 104.4 Fourth quarter ..................... 85.5 7.9 93.4 --------- -------- ----- Total ......................... 378.5 39.7 418.2 ========= ======== ===== 1992 Quarters Principal Interest Total - ------------------------------------ --------- -------- ----- $ $ $ First quarter ...................... 120.6 18.3 138.9 Second quarter ..................... 115.3 16.6 131.9 Third quarter ...................... 109.9 15.0 124.9 Fourth quarter ..................... 106.0 13.4 119.4 --------- -------- ----- Total ......................... 451.8 63.3 515.1 ========= ======== ===== II-23 INDEPENDENT AUDITORS' REPORT March 22, 1994 The GMAC 1992-A Grantor Trust, its Certificateholders, GMAC Auto Receivables Corporation, and The First National Bank of Chicago: We have audited the accompanying Statement of Assets and Liabilities of the GMAC 1992-A Grantor Trust as of December 31, 1993 and 1992, and the related Statement of Distributable Income for the year ended December 31, 1993 and the period January 30, 1992 (inception) through December 31, 1992. These financial statements are the responsibility of the Trust's management. Our responsibility is to express an opinion on these financial statements based on our audit. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. As described in Note 1 to the financial statements, these financial statements are prepared on the basis of cash receipts and disbursements, which is a comprehensive basis of accounting other than generally accepted accounting principles. In our opinion, such financial statements present fairly, in all material respects, the assets and liabilities of the GMAC 1992-A Grantor Trust at December 31, 1993 and 1992, and its distributable income and distributions for the year ended December 31, 1993 and the period January 30, 1992 (inception) through December 31, 1992, on the basis of accounting described in Note 1. s\ DELOITTE & TOUCHE - ----------------------- DELOITTE & TOUCHE 600 Renaissance Center Detroit, Michigan 48243 II-24 GMAC 1992-A GRANTOR TRUST STATEMENT OF ASSETS AND LIABILITIES (in millions of dollars) Dec. 31 Dec. 31 1993 1992 ------- ------- ASSETS $ $ Receivables (Note 2) .............................. 370.7 1,052.5 ------- ------- TOTAL ASSETS ...................................... 370.7 1,052.5 ======= ======= LIABILITIES Asset-backed Certificates (Notes 2 and 3) ................................. 370.7 1,052.5 ------- ------- TOTAL LIABILITIES ................................. 370.7 1,052.5 ======= ======= Reference should be made to the Notes to Financial Statements. II-25 GMAC 1992-A GRANTOR TRUST (continued) STATEMENT OF DISTRIBUTABLE INCOME For the year ended December 31, 1993 and the period January 30, 1992 (inception) through December 31, 1992 (in millions of dollars) 1993 1992 ------- ------- $ $ Distributable Income Allocable to Principal ...................... 681.7 948.9 Allocable to Interest ...................... 35.4 72.0 ------- ------- Distributable Income .......................... 717.1 1,020.9 ======= ======= Income Distributed ............................ 717.1 1,020.9 ======= ======= Reference should be made to the Notes to Financial Statements. II-26 GMAC 1992-A GRANTOR TRUST (continued) NOTES TO FINANCIAL STATEMENTS NOTE 1. BASIS OF ACCOUNTING The financial statements of the GMAC 1992-A Grantor Trust (the "Trust") are prepared on the basis of cash receipts and cash disbursements. Such financial statements differ from financial statements prepared in accordance with generally accepted accounting principles in that interest income and the related assets are recognized when received rather than when earned and distributions to certificateholders are recognized when paid rather than when the obligation is incurred. All expenses of the Trust are paid by GMAC Auto Receivables Corporation (the "Seller"). NOTE 2. SALE OF CERTIFICATES On January 30, 1992, GMAC 1992-A Grantor Trust acquired retail finance receivables aggregating approximately $2,001.4 million from the Seller in exchange for certificates representing undivided ownership interests of 92.5% for the Class A certificates and 7.5% for the Class B certificates in the Trust. The Trust property includes a pool of retail instalment sale contracts for new automobiles and light trucks, certain monies due thereunder and security interests in the vehicles financed thereby. The Seller has the option to repurchase the remaining receivables as of the last day of any month on or after which the principal balance declines below 10% of the aggregate amount financed. NOTE 3. PRINCIPAL AND INTEREST PAYMENTS Principal (including prepayments) and interest are passed through and distributed pro rata to Class A and Class B certificateholders on each distribution date commencing February 18, 1992. Principal consists of payments on the receivables that are allocable to repayment of the amount sold as determined on a constant interest rate basis (the "actuarial method"). Interest is passed through and distributed to Class A certificateholders at one-twelfth of the pass through rate of 5.05% per annum. Interest consists of payments on the receivables that are allocable to finance charges, using the actuarial method, net of fees and expenses. The rights of the Class B certificateholders to receive monthly distributions with respect to the receivables are subordinated to the rights of the Class A certificateholders. A distribution date is the 15th day of each month (or, if such 15th day is not a business day, the next following business day). NOTE 4. FEDERAL INCOME TAX The Trust is classified as a grantor trust, and therefore is not taxable as a corporation for federal income tax purposes. Each certificateholder will be treated as the owner of a pro rata undivided interest in each of the receivables in the Trust. II-27 GMAC 1992-A GRANTOR TRUST (concluded) SUPPLEMENTARY FINANCIAL DATA (unaudited) SUMMARY OF QUARTERLY DISTRIBUTABLE INCOME (in millions of dollars) 1993 Quarters Principal Interest Total - ------------------------------------ --------- -------- ----- $ $ $ First quarter ...................... 206.9 12.4 219.3 Second quarter ..................... 192.5 9.8 202.3 Third quarter ...................... 157.7 7.5 165.2 Fourth quarter ..................... 124.6 5.7 130.3 --------- -------- ----- Total ......................... 681.7 35.4 717.1 ========= ======== ===== 1992 Quarters Principal Interest Total - ------------------------------------ --------- -------- ----- $ $ $ First quarter ...................... 171.8 16.5 188.3 Second quarter ..................... 278.3 21.9 300.2 Third quarter ...................... 263.6 18.4 282.0 Fourth quarter ..................... 235.2 15.2 250.4 --------- -------- ------- Total ......................... 948.9 72.0 1,020.9 ========= ======== ======= II-28 INDEPENDENT AUDITORS' REPORT March 22, 1994 The GMAC 1992-C Grantor Trust, its Certificateholders, GMAC Auto Receivables Corporation, and The First National Bank of Chicago: We have audited the accompanying Statement of Assets and Liabilities of the GMAC 1992-C Grantor Trust as of December 31, 1993 and 1992, and the related Statement of Distributable Income for the year ended December 31, 1993 and the period March 26, 1992 (inception) through December 31, 1992. These financial statements are the responsibility of the Trust's management. Our responsibility is to express an opinion on these financial statements based on our audit. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. As described in Note 1 to the financial statements, these financial statements are prepared on the basis of cash receipts and disbursements, which is a comprehensive basis of accounting other than generally accepted accounting principles. In our opinion, such financial statements present fairly, in all material respects, the assets and liabilities of the GMAC 1992-C Grantor Trust at December 31, 1993 and 1992, and its distributable income and distributions for the year ended December 31, 1993 and the period March 26, 1992 (inception) through December 31, 1992, on the basis of accounting described in Note 1. s\ DELOITTE & TOUCHE - ----------------------- DELOITTE & TOUCHE 600 Renaissance Center Detroit, Michigan 48243 II-29 GMAC 1992-C GRANTOR TRUST STATEMENT OF ASSETS AND LIABILITIES (in millions of dollars) Dec. 31 Dec. 31 1993 1992 ------- ------- ASSETS $ $ Receivables (Note 2) .............................. 311.3 716.3 ------- ------- TOTAL ASSETS ...................................... 311.3 716.3 ======= ======= LIABILITIES Asset-backed Certificates (Notes 2 and 3) .................................. 311.3 716.3 ------- ------- TOTAL LIABILITIES ................................. 311.3 716.3 ======= ======= Reference should be made to the Notes to Financial Statements. II-30 GMAC 1992-C GRANTOR TRUST (continued) STATEMENT OF DISTRIBUTABLE INCOME For the year ended December 31, 1993 and the period March 26, 1992 (inception) through December 31, 1992 (in millions of dollars) 1993 1992 ------- ------- $ $ Distributable Income Allocable to Principal ...................... 405.0 384.0 Allocable to Interest ...................... 31.0 41.2 ------- ------- Distributable Income .......................... 436.0 425.2 ======= ======= Income Distributed ............................ 436.0 425.2 ======= ======= Reference should be made to the Notes to Financial Statements. II-31 GMAC 1992-C GRANTOR TRUST (continued)) NOTES TO FINANCIAL STATEMENTS NOTE 1. BASIS OF ACCOUNTING The financial statements of the GMAC 1992-C Grantor Trust (the "Trust") are prepared on the basis of cash receipts and cash disbursements. Such financial statements differ from financial statements prepared in accordance with generally accepted accounting principles in that interest income and the related assets are recognized when received rather than when earned and distributions to certificateholders are recognized when paid rather than when the obligation is incurred. All expenses of the Trust are paid by GMAC Auto Receivables Corporation (the "Seller"). NOTE 2. SALE OF CERTIFICATES On March 26, 1992, GMAC 1992-C Grantor Trust acquired retail finance receivables aggregating approximately $1,100.3 million from the Seller in exchange for certificates representing undivided ownership interests of 92% for the Class A certificates and 8% for the Class B certificates in the Trust. The Trust property includes a pool of retail instalment sale contracts for new automobiles and light trucks, certain monies due thereunder and security interests in the vehicles financed thereby. The Seller has the option to repurchase the remaining receivables as of the last day of any month on or after which the principal balance declines below 10% of the aggregate amount financed. NOTE 3. PRINCIPAL AND INTEREST PAYMENTS Principal (including prepayments) and interest are passed through and distributed pro rata to Class A and Class B certificateholders on each distribution date commencing April 15, 1992. Principal consists of payments on the receivables that are allocable to repayment of the amount sold as determined on a constant interest rate basis (the "actuarial method"). Interest is passed through and distributed to Class A certificateholders at one-twelfth of the pass through rate of 5.95% per annum. Interest consists of payments on the receivables that are allocable to finance charges, using the actuarial method, net of fees and expenses. The rights of the Class B certificateholders to receive monthly distributions with respect to the receivables are subordinated to the rights of the Class A certificateholders. A distribution date is the 15th day of each month (or, if such 15th day is not a business day, the next following business day). NOTE 4. FEDERAL INCOME TAX The Trust is classified as a grantor trust, and therefore is not taxable as a corporation for federal income tax purposes. Each certificateholder will be treated as the owner of a pro rata undivided interest in each of the receivables in the Trust. II-32 GMAC 1992-C GRANTOR TRUST (concluded) SUPPLEMENTARY FINANCIAL DATA (unaudited) SUMMARY OF QUARTERLY DISTRIBUTABLE INCOME (in millions of dollars) 1993 Quarters Principal Interest Total - ------------------------------------ --------- -------- ----- $ $ $ First quarter ...................... 109.2 10.1 119.3 Second quarter ..................... 109.3 8.5 117.8 Third quarter ...................... 99.7 6.9 106.6 Fourth quarter ..................... 86.8 5.5 92.3 --------- -------- ----- Total ......................... 405.0 31.0 436.0 ========= ======== ===== 1992 Quarters Principal Interest Total - ------------------------------------ --------- -------- ----- $ $ $ Second quarter ..................... 133.1 15.7 148.8 Third quarter ...................... 129.8 13.7 143.5 Fourth quarter ..................... 121.1 11.8 132.9 --------- -------- ----- Total ......................... 384.0 41.2 425.2 ========= ======== ===== II-33 INDEPENDENT AUDITORS' REPORT March 22, 1994 The GMAC 1992-D Grantor Trust, its Certificateholders, GMAC Auto Receivables Corporation, and The First National Bank of Chicago: We have audited the accompanying Statement of Assets and Liabilities of the GMAC 1992-D Grantor Trust as of December 31, 1993 and 1992, and the related Statement of Distributable Income for the year ended December 31, 1993 and the period June 4, 1992 (inception) through December 31, 1992. These financial statements are the responsibility of the Trust's management. Our responsibility is to express an opinion on these financial statements based on our audit. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. As described in Note 1 to the financial statements, these financial statements are prepared on the basis of cash receipts and disbursements, which is a comprehensive basis of accounting other than generally accepted accounting principles. In our opinion, such financial statements present fairly, in all material respects, the assets and liabilities of the GMAC 1992-D Grantor Trust at December 31, 1993 and 1992, and its distributable income and distributions for the year ended December 31, 1993 and the period June 4, 1992 (inception) through December 31, 1992, on the basis of accounting described in Note 1. s/ DELOITTE & TOUCHE - ---------------------- DELOITTE & TOUCHE 600 Renaissance Center Detroit, Michigan 48243 II-34 GMAC 1992-D GRANTOR TRUST STATEMENT OF ASSETS AND LIABILITIES (in millions of dollars) Dec. 31 Dec. 31 1993 1992 ------- ------- ASSETS $ $ Receivables (Note 2) .............................. 702.0 1,270.4 ------- ------- TOTAL ASSETS ...................................... 702.0 1,270.4 ======= ======= LIABILITIES Asset-backed Certificates (Notes 2 and 3) ................................. 702.0 1,270.4 ------- ------- TOTAL LIABILITIES ................................. 702.0 1,270.4 ======= ======= Reference should be made to the Notes to Financial Statements. II-35 GMAC 1992-D GRANTOR TRUST (continued) STATEMENT OF DISTRIBUTABLE INCOME For the year ended December 31, 1993 and the period June 4,1992 (inception) through December 31, 1992 (in millions of dollars) 1993 1992 ------ ------ $ $ Distributable Income Allocable to Principal ...................... 568.4 377.2 Allocable to Interest ...................... 55.4 48.0 ------ ------ Distributable Income .......................... 623.8 425.2 ====== ====== Income Distributed ............................ 623.8 425.2 ====== ====== Reference should be made to the Notes to Financial Statements. II-36 GMAC 1992-D GRANTOR TRUST (continued) NOTES TO FINANCIAL STATEMENTS NOTE 1. BASIS OF ACCOUNTING The financial statements of the GMAC 1992-D Grantor Trust (the "Trust") are prepared on the basis of cash receipts and cash disbursements. Such financial statements differ from financial statements prepared in accordance with generally accepted accounting principles in that interest income and the related assets are recognized when received rather than when earned and distributions to certificateholders are recognized when paid rather than when the obligation is incurred. All expenses of the Trust are paid by GMAC Auto Receivables Corporation (the "Seller"). NOTE 2. SALE OF CERTIFICATES On June 4, 1992, GMAC 1992-D Grantor Trust acquired retail finance receivables aggregating approximately $1,647.6 million from the Seller in exchange for certificates representing undivided ownership interests of 91% for the Class A certificates and 9% for the Class B certificates in the Trust. The Trust property includes a pool of retail instalment sale contracts for new and used automobiles and light trucks, certain monies due thereunder and security interests in the vehicles financed thereby. The Seller has the option to repurchase the remaining receivables as of the last day of any month on or after which the principal balance declines below 10% of the aggregate amount financed. NOTE 3. PRINCIPAL AND INTEREST PAYMENTS Principal (including prepayments) and interest are passed through and distributed pro rata to Class A and Class B certificateholders on each distribution date commencing June 15, 1992. Principal consists of payments on the receivables that are allocable to repayment of the amount sold as determined on a constant interest rate basis (the "actuarial method"). Interest is passed through and distributed to Class A certificateholders at one-twelfth of the pass through rate of 5.55% per annum. Interest consists of payments on the receivables that are allocable to finance charges, using the actuarial method, net of fees and expenses. The rights of the Class B certificateholders to receive monthly distributions with respect to the receivables are subordinated to the rights of the Class A certificateholders. A distribution date is the 15th day of each month (or, if such 15th day is not a business day, the next following business day). NOTE 4. FEDERAL INCOME TAX The Trust is classified as a grantor trust, and therefore is not taxable as a corporation for federal income tax purposes. Each certificateholder will be treated as the owner of a pro rata undivided interest in each of the receivables in the Trust. II-37 GMAC 1992-D GRANTOR TRUST (concluded) SUPPLEMENTARY FINANCIAL DATA (unaudited) SUMMARY OF QUARTERLY DISTRIBUTABLE INCOME (in millions of dollars) 1993 Quarters Principal Interest Total - ------------------------------------ --------- -------- ----- $ $ $ First quarter ...................... 148.6 16.9 165.5 Second quarter ..................... 153.3 14.8 168.1 Third quarter ...................... 140.7 12.8 153.5 Fourth quarter ..................... 125.8 10.9 136.7 --------- -------- ----- Total ......................... 568.4 55.4 623.8 ========= ======== ===== 1992 Quarters Principal Interest Total - ------------------------------------ --------- -------- ----- $ $ $ Second quarter ..................... 50.7 7.6 58.3 Third quarter ...................... 166.9 21.4 188.3 Fourth quarter ..................... 159.6 19.0 178.6 --------- -------- ----- Total ......................... 377.2 48.0 425.2 ========= ======== ===== II-38 INDEPENDENT AUDITORS' REPORT March 22, 1994 The GMAC 1992-E Grantor Trust, its Certificateholders, GMAC Auto Receivables Corporation, and The First National Bank of Chicago: We have audited the accompanying Statement of Assets and Liabilities of the GMAC 1992-E Grantor Trust as of December 31, 1993 and 1992, and the related Statement of Distributable Income for the year ended December 31, 1993 and the period August 20, 1992 (inception) through December 31, 1992. These financial statements are the responsibility of the Trust's management. Our responsibility is to express an opinion on these financial statements based on our audit. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. As described in Note 1 to the financial statements, these financial statements are prepared on the basis of cash receipts and disbursements, which is a comprehensive basis of accounting other than generally accepted accounting principles. In our opinion, such financial statements present fairly, in all material respects, the assets and liabilities of the GMAC 1992-E Grantor Trust at December 31, 1993 and 1992, and its distributable income and distributions for the year ended December 31, 1993 and the period August 20, 1992 (inception) through December 31, 1992, on the basis of accounting described in Note 1. s\ DELOITTE & TOUCHE - ----------------------- DELOITTE & TOUCHE 600 Renaissance Center Detroit, Michigan 48243 II-39 GMAC 1992-E GRANTOR TRUST STATEMENT OF ASSETS AND LIABILITIES (in millions of dollars) Dec. 31 Dec. 31 1993 1992 ------- ------- ASSETS $ $ Receivables (Note 2) .............................. 885.4 1,398.0 ------- ------- TOTAL ASSETS ...................................... 885.4 1,398.0 ======= ======= LIABILITIES Asset-backed Certificates (Notes 2 and 3) ................................. 885.4 1,398.0 ------- ------- TOTAL LIABILITIES ................................. 885.4 1,398.0 ======= ======= Reference should be made to the Notes to Financial Statements. II-40 GMAC 1992-E GRANTOR TRUST (continued) STATEMENT OF DISTRIBUTABLE INCOME For the year ended December 31, 1993 and the period August 20, 1992 (inception) through December 31, 1992 (in millions of dollars) 1993 1992 ------- ------- $ $ Distributable Income Allocable to Principal ...................... 512.6 180.0 Allocable to Interest ...................... 55.1 23.9 ------- ------- Distributable Income .......................... 567.7 203.9 ======= ======= Income Distributed ............................ 567.7 203.9 ======= ======= Reference should be made to the Notes to Financial Statements. II-41 GMAC 1992-E GRANTOR TRUST (continued) NOTES TO FINANCIAL STATEMENTS NOTE 1. BASIS OF ACCOUNTING The financial statements of the GMAC 1992-E Grantor Trust (the "Trust") are prepared on the basis of cash receipts and cash disbursements. Such financial statements differ from financial statements prepared in accordance with generally accepted accounting principles in that interest income and the related assets are recognized when received rather than when earned and distributions to certificateholders are recognized when paid rather than when the obligation is incurred. All expenses of the Trust are paid by GMAC Auto Receivables Corporation (the "Seller"). NOTE 2. SALE OF CERTIFICATES On August 20, 1992, GMAC 1992-E Grantor Trust acquired retail finance receivables aggregating approximately $1,578.0 million from the Seller in exchange for certificates representing undivided ownership interests of 91% for the Class A certificates and 9% for the Class B certificates in the Trust. The Trust property includes a pool of retail instalment sale contracts for new and used automobiles and light trucks, certain monies due thereunder and security interests in the vehicles financed thereby. The Seller has the option to repurchase the remaining receivables as of the last day of any month on or after which the principal balance declines below 10% of the aggregate amount financed. NOTE 3. PRINCIPAL AND INTEREST PAYMENTS Principal (including prepayments) and interest are passed through and distributed pro rata to Class A and Class B certificateholders on each distribution date commencing September 15, 1992. Principal consists of payments on the receivables that are allocable to repayment of the amount sold as determined on a constant interest rate basis (the "actuarial method"). Interest is passed through and distributed to Class A certificateholders at one-twelfth of the pass through rate of 4.75% per annum. Interest consists of payments on the receivables that are allocable to finance charges, using the actuarial method, net of fees and expenses. The rights of the Class B certificateholders to receive monthly distributions with respect to the receivables are subordinated to the rights of the Class A certificateholders. A distribution date is the 15th day of each month (or, if such 15th day is not a business day, the next following business day). NOTE 4. FEDERAL INCOME TAX The Trust is classified as a grantor trust, and therefore is not taxable as a corporation for federal income tax purposes. Each certificateholder will be treated as the owner of a pro rata undivided interest in each of the receivables in the Trust. II-42 GMAC 1992-E GRANTOR TRUST (concluded) SUPPLEMENTARY FINANCIAL DATA (unaudited) SUMMARY OF QUARTERLY DISTRIBUTABLE INCOME (in millions of dollars) 1993 Quarters Principal Interest Total - ------------------------------------ --------- -------- ----- $ $ $ First quarter ...................... 128.3 16.1 144.4 Second quarter ..................... 134.8 14.5 149.3 Third quarter ...................... 129.0 13.0 142.0 Fourth quarter ..................... 120.5 11.5 132.0 --------- -------- ----- Total ......................... 512.6 55.1 567.7 ========= ======== ===== 1992 Quarters Principal Interest Total - ------------------------------------ --------- -------- ----- $ $ $ Third quarter ...................... 46.1 6.2 52.3 Fourth quarter ..................... 133.9 17.7 151.6 --------- -------- ----- Total ......................... 180.0 23.9 203.9 ========= ======== ===== II-43 INDEPENDENT AUDITORS' REPORT March 22, 1994 The GMAC 1992-F Grantor Trust, its Certificateholders, GMAC Auto Receivables Corporation, and The First National Bank of Chicago: We have audited the accompanying Statement of Assets and Liabilities of the GMAC 1992-F Grantor Trust as of December 31, 1993 and 1992, and the related Statement of Distributable Income for the year ended December 31, 1993 and the period September 29, 1992 (inception) through December 31, 1992. These financial statements are the responsibility of the Trust's management. Our responsibility is to express an opinion on these financial statements based on our audit. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. As described in Note 1 to the financial statements, these financial statements are prepared on the basis of cash receipts and disbursements, which is a comprehensive basis of accounting other than generally accepted accounting principles. In our opinion, such financial statements present fairly, in all material respects, the assets and liabilities of the GMAC 1992-F Grantor Trust at December 31, 1993 and 1992, and its distributable income and distributions for the year ended December 31, 1993 and the period September 29, 1992 (inception) through December 31, 1992, on the basis of accounting described in Note 1. s\ DELOITTE & TOUCHE - ----------------------- DELOITTE & TOUCHE 600 Renaissance Center Detroit, Michigan 48243 II-44 GMAC 1992-F GRANTOR TRUST STATEMENT OF ASSETS AND LIABILITIES (in millions of dollars) Dec. 31 Dec. 31 1993 1992 ------- ------- ASSETS $ $ Receivables (Note 2) .............................. 908.7 1,492.8 ------- ------- TOTAL ASSETS ...................................... 908.7 1,492.8 ======= ======= LIABILITIES Asset-backed Certificates (Notes 2 and 3) ................................. 908.7 1,492.8 ------- ------- TOTAL LIABILITIES ................................. 908.7 1,492.8 ======= ======= Reference should be made to the Notes to Financial Statements. II-45 GMAC 1992-F GRANTOR TRUST (continued) STATEMENT OF DISTRIBUTABLE INCOME For the year ended December 31, 1993 and the period September 29, 1992 (inception) through December 31, 1992 (in millions of dollars) 1993 1992 ------ ------ $ $ Distributable Income Allocable to Principal ...................... 584.1 151.8 Allocable to Interest ...................... 55.0 17.9 ------ ------ Distributable Income .......................... 639.1 169.7 ====== ====== Income Distributed ............................ 639.1 169.7 ====== ====== Reference should be made to the Notes to Financial Statements. II-46 GMAC 1992-F GRANTOR TRUST (continued)) NOTES TO FINANCIAL STATEMENTS NOTE 1. BASIS OF ACCOUNTING The financial statements of the GMAC 1992-F Grantor Trust (the "Trust") are prepared on the basis of cash receipts and cash disbursements. Such financial statements differ from financial statements prepared in accordance with generally accepted accounting principles in that interest income and the related assets are recognized when received rather than when earned and distributions to certificateholders are recognized when paid rather than when the obligation is incurred. All expenses of the Trust are paid by GMAC Auto Receivables Corporation (the "Seller"). NOTE 2. SALE OF CERTIFICATES On September 29, 1992, GMAC 1992-F Grantor Trust acquired retail finance receivables aggregating approximately $1,644.6 million from the Seller in exchange for certificates representing undivided ownership interests of 91% for the Class A certificates and 9% for the Class B certificates in the Trust. The Trust property includes a pool of retail instalment sale contracts for new and used automobiles and light trucks, certain monies due thereunder, and security interests in the vehicles financed thereby. The Seller has the option to repurchase the remaining receivables as of the last day of any month on or after which the principal balance declines below 10% of the aggregate amount financed. NOTE 3. PRINCIPAL AND INTEREST PAYMENTS Principal (including prepayments) and interest are passed through and distributed pro rata to Class A and Class B certificateholders on each distribution date commencing October 15, 1992. Principal consists of payments on the receivables that are allocable to repayment of the amount sold as determined on a constant interest rate basis (the "actuarial method"). Interest is passed through and distributed to Class A certificateholders at one-twelfth of the pass through rate of 4.50% per annum. Interest consists of payments on the receivables that are allocable to finance charges, using the actuarial method, net of fees and expenses. The rights of the Class B certificateholders to receive monthly distributions with respect to the receivables are subordinated to the rights of the Class A certificateholders. A distribution date is the 15th day of each month (or, if such 15th day is not a business day, the next following business day). NOTE 4. FEDERAL INCOME TAX The Trust is classified as a grantor trust, and therefore is not taxable as a corporation for federal income tax purposes. Each certificateholder will be treated as the owner of a pro rata undivided interest in each of the receivables in the Trust. II-47 GMAC 1992-F GRANTOR TRUST (concluded) SUPPLEMENTARY FINANCIAL DATA (unaudited) SUMMARY OF QUARTERLY DISTRIBUTABLE INCOME (in millions of dollars) 1993 Quarters Principal Interest Total - ------------------------------------ --------- -------- ----- $ $ $ First quarter ...................... 146.9 16.2 163.1 Second quarter ..................... 151.2 14.6 165.8 Third quarter ...................... 147.3 12.9 160.2 Fourth quarter ..................... 138.7 11.3 150.0 --------- -------- ----- Total ......................... 584.1 55.0 639.1 ========= ======== ===== 1992 Quarters Principal Interest Total - ------------------------------------ --------- -------- ----- $ $ $ Fourth quarter ..................... 151.8 17.9 169.7 ========= ======== ===== II-48 INDEPENDENT AUDITORS' REPORT March 22, 1994 The GMAC 1992-G Grantor Trust, its Certificateholders, GMAC Auto Receivables Corporation, and The First National Bank of Chicago: We have audited the accompanying Statement of Assets and Liabilities of the GMAC 1992-G Grantor Trust as of December 31, 1993 and 1992, and the related Statement of Distributable Income for the year ended December 31, 1993 and the period November 19, 1992 (inception) through December 31, 1992. These financial statements are the responsibility of the Trust's management. Our responsibility is to express an opinion on these financial statements based on our audit. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. As described in Note 1 to the financial statements, these financial statements are prepared on the basis of cash receipts and disbursements, which is a comprehensive basis of accounting other than generally accepted accounting principles. In our opinion, such financial statements present fairly, in all material respects, the assets and liabilities of the GMAC 1992-G Grantor Trust at December 31, 1993 and 1992, and its distributable income and distributions for the year ended December 31, 1993 and the period November 19, 1992 (inception) through December 31, 1992, on the basis of accounting described in Note 1. s/ DELOITTE & TOUCHE - ----------------------- DELOITTE & TOUCHE 600 Renaissance Center Detroit, Michigan 48243 II-49 GMAC 1992-G GRANTOR TRUST STATEMENT OF ASSETS AND LIABILITIES (in millions of dollars) Dec. 31 Dec. 31 1993 1992 ------- ------- ASSETS $ $ Receivables (Note 2) .............................. 335.3 1,288.5 ------- ------- TOTAL ASSETS ...................................... 335.3 1,288.5 ======= ======= LIABILITIES Asset-backed Certificates (Notes 2 and 3) ................................. 335.3 1,288.5 ------- ------- TOTAL LIABILITIES ................................. 335.3 1,288.5 ======= ======= Reference should be made to the Notes to Financial Statements. II-50 GMAC 1992-G GRANTOR TRUST (continued) STATEMENT OF DISTRIBUTABLE INCOME For the year ended December 31, 1993 and the period November 19, 1992 (inception) through December 31, 1992 (in millions of dollars) 1993 1992 ------ ------ $ $ Distributable Income Allocable to Principal ...................... 953.1 91.0 Allocable to Interest ...................... 35.2 4.9 ------ ------ Distributable Income .......................... 988.3 95.9 ====== ====== Income Distributed ............................ 988.3 95.9 ====== ====== Reference should be made to the Notes to Financial Statements. II-51 GMAC 1992-G GRANTOR TRUST (continued) NOTES TO FINANCIAL STATEMENTS NOTE 1. BASIS OF ACCOUNTING The financial statements of the GMAC 1992-G Grantor Trust (the "Trust") are prepared on the basis of cash receipts and cash disbursements. Such financial statements differ from financial statements prepared in accordance with generally accepted accounting principles in that interest income and the related assets are recognized when received rather than when earned and distributions to certificateholders are recognized when paid rather than when the obligation is incurred. All expenses of the Trust are paid by GMAC Auto Receivables Corporation (the "Seller"). NOTE 2. SALE OF CERTIFICATES On November 19, 1992, GMAC 1992-G Grantor Trust acquired retail finance receivables aggregating approximately $1,379.4 million from the Seller in exchange for certificates representing undivided ownership interests of 94.5% for the Class A certificates and 5.5% for the Class B certificates in the Trust. The Trust property includes a pool of retail instalment sale contracts for new and used automobiles and light trucks, certain monies due thereunder, and security interests in the vehicles financed thereby. The Seller has the option to repurchase the remaining receivables as of the last day of any month on or after which the principal balance declines below 10% of the aggregate amount financed. NOTE 3. PRINCIPAL AND INTEREST PAYMENTS Principal (including prepayments) and interest are passed through and distributed pro rata to Class A and Class B certificateholders on each distribution date commencing December 15, 1992. Principal consists of payments on the receivables that are allocable to repayment of the amount sold as determined on a constant interest rate basis (the "actuarial method"). Interest is passed through and distributed to Class A certificateholders at one-twelfth of the pass through rate of 4.30% per annum. Interest consists of payments on the receivables that are allocable to finance charges, using the actuarial method, net of fees and expenses. The rights of the Class B certificateholders to receive monthly distributions with respect to the receivables are subordinated to the rights of the Class A certificateholders. A distribution date is the 15th day of each month (or, if such 15th day is not a business day, the next following business day). NOTE 4. FEDERAL INCOME TAX The Trust is classified as a grantor trust, and therefore is not taxable as a corporation for federal income tax purposes. Each certificateholder will be treated as the owner of a pro rata undivided interest in each of the receivables in the Trust. II-52 GMAC 1992-G GRANTOR TRUST (concluded) SUPPLEMENTARY FINANCIAL DATA (unaudited) SUMMARY OF QUARTERLY DISTRIBUTABLE INCOME (in millions of dollars) 1993 Quarters Principal Interest Total - ------------------------------------ --------- -------- ----- $ $ $ First quarter ...................... 268.1 12.9 281.0 Second quarter ..................... 258.3 10.0 268.3 Third quarter ...................... 230.4 7.3 237.7 Fourth quarter ..................... 196.3 5.0 201.3 --------- -------- ----- Total ......................... 953.1 35.2 988.3 ========= ======== ===== 1992 Quarters Principal Interest Total - ------------------------------------ --------- -------- ----- $ $ $ Fourth quarter ..................... 91.0 4.9 95.9 ========= ======== ===== II-53 INDEPENDENT AUDITORS' REPORT March 22, 1994 The GMAC 1993-A Grantor Trust, its Certificateholders, GMAC Auto Receivables Corporation, and The First National Bank of Chicago: We have audited the accompanying Statement of Assets and Liabilities of the GMAC 1993-A Grantor Trust as of December 31, 1993 and the related Statement of Distributable Income for the period March 24, 1993 (inception) through December 31, 1993. These financial statements are the responsibility of the Trust's management. Our responsibility is to express an opinion on these financial statements based on our audit. We conducted our audit in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audit provides a reasonable basis for our opinion. As described in Note 1 to the financial statements, these financial statements are prepared on the basis of cash receipts and disbursements, which is a comprehensive basis of accounting other than generally accepted accounting principles. In our opinion, such financial statements present fairly, in all material respects, the assets and liabilities of the GMAC 1993-A Grantor Trust at December 31, 1993 and its distributable income and distributions for the period March 24, 1993 (inception) through December 31, 1993, on the basis of accounting described in Note 1. s\ DELOITTE & TOUCHE - ----------------------- DELOITTE & TOUCHE 600 Renaissance Center Detroit, Michigan 48243 II-54 GMAC 1993-A GRANTOR TRUST STATEMENT OF ASSETS AND LIABILITIES (in millions of dollars) Dec. 31 ------- ASSETS $ Receivables (Note 2) .............................. 845.9 ------- TOTAL ASSETS ...................................... 845.9 ======= LIABILITIES Asset-backed Certificates (Notes 2 and 3) ................................. 845.9 ------- TOTAL LIABILITIES ................................. 845.9 ======= Reference should be made to the Notes to Financial Statements. II-55 GMAC 1993-A GRANTOR TRUST (continued) STATEMENT OF DISTRIBUTABLE INCOME For the period March 24, 1992 (inception) through December 31, 1993 (in millions of dollars) ----- $ Distributable Income Allocable to Principal .................... 557.0 Allocable to Interest .................... 35.6 ----- Distributable Income ......................... 592.6 ===== Income Distributed ........................... 592.6 ===== Reference should be made to the Notes to Financial Statements. II-56 GMAC 1993-A GRANTOR TRUST (continued)) NOTES TO FINANCIAL STATEMENTS NOTE 1. BASIS OF ACCOUNTING The financial statements of the GMAC 1993-A Grantor Trust (the "Trust") are prepared on the basis of cash receipts and cash disbursements. Such financial statements differ from financial statements prepared in accordance with generally accepted accounting principles in that interest income and the related assets are recognized when received rather than when earned and distributions to certificateholders are recognized when paid rather than when the obligation is incurred. All expenses of the Trust are paid by GMAC Auto Receivables Corporation (the "Seller"). NOTE 2. SALE OF CERTIFICATES On March 24, 1993, GMAC 1993-A Grantor Trust acquired retail finance receivables aggregating approximately $1,403.0 million from the Seller in exchange for certificates representing undivided ownership interests of 92.5% for the Class A certificates and 7.5% for the Class B certificates in the Trust. The Trust property includes a pool of retail instalment sale contracts for new and used automobiles and light trucks, certain monies due thereunder, and security interests in the vehicles financed thereby. The Seller has the option to repurchase the remaining receivables as of the last day of any month on or after which the principal balance declines below 10% of the aggregate amount financed. NOTE 3. PRINCIPAL AND INTEREST PAYMENTS Principal (including prepayments) and interest are passed through and distributed pro rata to Class A and Class B certificateholders on each distribution date commencing April 15, 1993. Principal consists of payments on the receivables that are allocable to repayment of the amount sold as determined on a constant interest rate basis (the "actuarial method"). Interest is passed through and distributed to Class A certificateholders at one-twelfth of the pass through rate of 4.15% per annum. Interest consists of payments on the receivables that are allocable to finance charges, using the actuarial method, net of fees and expenses. The rights of the Class B certificateholders to receive monthly distributions with respect to the receivables are subordinated to the rights of the Class A certificateholders. A distribution date is the 15th day of each month (or, if such 15th day is not a business day, the next following business day). NOTE 4. FEDERAL INCOME TAX The Trust is classified as a grantor trust, and therefore is not taxable as a corporation for federal income tax purposes. Each certificateholder will be treated as the owner of a pro rata undivided interest in each of the receivables in the Trust. II-57 GMAC 1993-A GRANTOR TRUST (concluded) SUPPLEMENTARY FINANCIAL DATA (unaudited) SUMMARY OF QUARTERLY DISTRIBUTABLE INCOME (in millions of dollars) 1993 Quarters Principal Interest Total - ------------------------------------ --------- -------- ----- $ $ $ Second quarter ..................... 196.7 13.9 210.6 Third quarter ...................... 194.4 11.8 206.2 Fourth quarter ..................... 165.9 9.9 175.8 --------- -------- ----- Total ......................... 557.0 35.6 592.6 ========= ======== ===== II-58 INDEPENDENT AUDITORS' REPORT March 22, 1994 The GMAC 1993-B Grantor Trust, its Certificateholders, GMAC Auto Receivables Corporation, and The First National Bank of Chicago: We have audited the accompanying Statement of Assets and Liabilities of the GMAC 1993-B Grantor Trust as of December 31, 1993 and the related Statement of Distributable Income for the period September 16, 1993 (inception) through December 31, 1993. These financial statements are the responsibility of the Trust's management. Our responsibility is to express an opinion on these financial statements based on our audit. We conducted our audit in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audit provides a reasonable basis for our opinion. As described in Note 1 to the financial statements, these financial statements are prepared on the basis of cash receipts and disbursements, which is a comprehensive basis of accounting other than generally accepted accounting principles. In our opinion, such financial statements present fairly, in all material respects, the assets and liabilities of the GMAC 1993-B Grantor Trust at December 31, 1993 and its distributable income and distributions for the period September 16, 1993 (inception) through December 31, 1993, on the basis of accounting described in Note 1. s/ DELOITTE & TOUCHE - ----------------------- DELOITTE & TOUCHE 600 Renaissance Center Detroit, Michigan 48243 II-59 GMAC 1993-B GRANTOR TRUST STATEMENT OF ASSETS AND LIABILITIES (in millions of dollars) Dec. 31 ------- ASSETS $ Receivables (Note 2) .............................. 1,269.0 ------- TOTAL ASSETS ...................................... 1,269.0 ======= LIABILITIES Asset-backed Certificates (Notes 2 and 3) ................................. 1,269.0 ------- TOTAL LIABILITIES ................................. 1,269.0 ======= Reference should be made to the Notes to Financial Statements. II-60 GMAC 1993-B GRANTOR TRUST (continued) STATEMENT OF DISTRIBUTABLE INCOME For the period September 16, 1993 (inception) through December 31, 1993 (in millions of dollars) ----- $ Distributable Income Allocable to Principal .................... 181.6 Allocable to Interest .................... 13.9 ----- Distributable Income ......................... 195.5 ===== Income Distributed ........................... 195.5 ===== Reference should be made to the Notes to Financial Statements. II-61 GMAC 1993-B GRANTOR TRUST (continued) NOTES TO FINANCIAL STATEMENTS NOTE 1. BASIS OF ACCOUNTING The financial statements of the GMAC 1993-B Grantor Trust (the "Trust") are prepared on the basis of cash receipts and cash disbursements. Such financial statements differ from financial statements prepared in accordance with generally accepted accounting principles in that interest income and the related assets are recognized when received rather than when earned and distributions to certificateholders are recognized when paid rather than when the obligation is incurred. All expenses of the Trust are paid by GMAC Auto Receivables Corporation (the "Seller"). NOTE 2. SALE OF CERTIFICATES On September 16, 1993, GMAC 1993-B Grantor Trust acquired retail finance receivables aggregating approximately $1,450.6 million from the Seller in exchange for certificates representing undivided ownership interests of 92.5% for the Class A certificates and 7.5% for the Class B certificates in the Trust. The Trust property includes a pool of retail instalment sale contracts for new and used automobiles and light trucks, certain monies due thereunder, and security interests in the vehicles financed thereby. The Seller has the option to repurchase the remaining receivables as of the last day of any month on or after which the principal balance declines below 10% of the aggregate amount financed. NOTE 3. PRINCIPAL AND INTEREST PAYMENTS Principal (including prepayments) and interest are passed through and distributed pro rata to Class A and Class B certificateholders on each distribution date commencing October 15, 1993. Principal consists of payments on the receivables that are allocable to repayment of the amount sold as determined on a constant interest rate basis (the "actuarial method"). Interest is passed through and distributed to Class A certificateholders at one-twelfth of the pass through rate of 4.00% per annum. Interest consists of payments on the receivables that are allocable to finance charges, using the actuarial method, net of fees and expenses. The rights of the Class B certificateholders to receive monthly distributions with respect to the receivables are subordinated to the rights of the Class A certificateholders. A distribution date is the 15th day of each month (or, if such 15th day is not a business day, the next following business day). NOTE 4. FEDERAL INCOME TAX The Trust is classified as a grantor trust, and therefore is not taxable as a corporation for federal income tax purposes. Each certificateholder will be treated as the owner of a pro rata undivided interest in each of the receivables in the Trust. II-62 GMAC 1993-B GRANTOR TRUST (concluded) SUPPLEMENTARY FINANCIAL DATA (unaudited) SUMMARY OF QUARTERLY DISTRIBUTABLE INCOME (in millions of dollars) 1993 Quarters Principal Interest Total - ------------------------------------ --------- -------- ----- $ $ $ Fourth quarter ..................... 181.6 13.9 195.5 ========= ======== ===== II-63 PART IV ITEM 14.

ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K. (a) (1) FINANCIAL STATEMENTS. Included in Part II, Item 8, of Form 10-K. (a) (2) FINANCIAL STATEMENT SCHEDULES. All schedules have been omitted because they are inapplicable or because the information called for is shown in the financial statements or notes thereto. (a) (3) EXHIBITS (Included in Part II of this report). -- GMAC 1990-A Grantor Trust Financial Statements for the Year Ended December 31, 1993. -- GMAC 1991-A Grantor Trust Financial Statement for the Year Ended December 31, 1993. -- GMAC 1991-B Grantor Trust Financial Statements for the Year Ended December 31, 1993. -- GMAC 1991-C Grantor Trust Financial Statements for the Year Ended December 31, 1993. -- GMAC 1992-A Grantor Trust Financial Statements for the Year Ended December 31, 1993. -- GMAC 1992-C Grantor Trust Financial Statement for the Year Ended December 31, 1993. -- GMAC 1992-D Grantor Trust Financial Statements for the Year Ended December 31, 1993. -- GMAC 1992-E Grantor Trust Financial Statements for the Year Ended December 31, 1993. -- GMAC 1992-F Grantor Trust Financial Statements for the Year Ended December 31, 1993. -- GMAC 1992-G Grantor Trust Financial Statement for the Year Ended December 31, 1993. -- GMAC 1993-A Grantor Trust Financial Statements for the period March 24, 1993 through December 31, 1993. -- GMAC 1993-B Grantor Trust Financial Statements for the period September 16, 1993 through December 31, 1993. (b) REPORTS ON FORM 8-K. No current reports on Form 8-K have been filed by any of the above-mentioned Grantor Trusts during the fourth quarter ended December 31, 1993 ITEMS 2, 3, 4, 5, 6, 9, 10, 11, 12 and 13 are inapplicable and have been omitted. IV-1 SIGNATURE Pursuant to the requirements of Section 13 of the Securities Exchange Act of 1934, the Trustee has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized. GMAC 1990-A GRANTOR TRUST GMAC 1991-A GRANTOR TRUST GMAC 1991-B GRANTOR TRUST GMAC 1991-C GRANTOR TRUST GMAC 1992-A GRANTOR TRUST GMAC 1992-C GRANTOR TRUST GMAC 1992-D GRANTOR TRUST GMAC 1992-E GRANTOR TRUST GMAC 1992-F GRANTOR TRUST GMAC 1992-G GRANTOR TRUST GMAC 1993-A GRANTOR TRUST GMAC 1993-B GRANTOR TRUST The First National Bank of Chicago (Trustee) s\ Steven M. Wagner ---------------------------------- (Steven M. Wagner, Vice President) Date: March 30, 1994 -------------- IV-2